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3 Strategic Considerations in Monetary
Policy with Private Information:
Can Secrecy Be Avoided?
17 The German Monetary Unification
(Gmu): Converting Marks to
D-Marks
37 The Effects of Financial Innovations
on Checkable Deposits, M l and
M2

THE
FEDERAL
A KI SI KM

JZnXSKoi

A r S T .I/H IS

Federal R eserve Bank of St. Louis
R e v ie w

July/August 1990

In T his Issue . . .

Much recent criticism o f the Federal Reserve System has focused on
the secrecy that surrounds monetary policy decisions. Some observers
have suggested that the Fed disclose the Federal Open Market Commit
tee’s policy decisions immediately, to prevent it from concealing useful
information from the public and to make it more accountable for its
actions.
In the first article o f this Review, “ Strategic Considerations in
Monetary Policy with Private Information,” Seonghwan Oh and Michelle
R. Garfinkel illustrate w hy a central bank may not be able to make
credible announcements about its policy decisions precisely even if it
w ould be better o ff by doing so. The lack o f credibility results from the
public’s knowledge that the central bank gains from "surprising” the
public with its monetary policy actions. Oh and Garfinkel show,
however, the central bank can make announcements that imprecisely
reveal its private information. These imprecise or "noisy” an
nouncements will be credible, only if constraints can be imposed on the
central bank that limit its policy independence. Hence, the authors
argue that, if limiting policy flexibility is costly, the advantages of
avoiding secrecy in monetary policy—even partially—must be carefully
weighed against the cost o f doing so.
* * *
In the second article in this Review, Peter Bofinger provides a detailed
look at “The German Monetary Unification (Gmu): Converting Marks to
D-Marks.” The German monetary union represents the first step in
uniting tw o countries with widely disparate econom ic systems and con
ditions. Bofinger describes these differences and shows how they in
fluence the choice o f the specific conversion rates used to determine the
DM values o f East German financial claims and incom e and salary
payments previously valued in East German marks.
Bofinger also shows how the debate over the “appropriate” conversion
rate was related to a variety o f important concerns facing both East and
West Germans. Among these w ere the resulting debt burdens that East
German firms would face, the associated wealth transfers between East
and West Germany, the impact on the level o f West German govern
ment debt and the possible effect on the West German inflation rate.
Bofinger concludes that the actual conversion rates chosen limit the
wealth transfer from West to East Germany to a relatively small amount
and make it unlikely that West German inflation will accelerate.
* * *

JULY/AUGUST 1990

Conventional wisdom holds that the introduction o f new interestbearing checkable deposits, especially in the early 1980s, had a substan
tial effect on M l and its relationship to econom ic activity. Equally wide
ly shared is the view that these accounts and the subsequent introduc
tion o f new m oney market deposit accounts had little or no effect on
the broader monetary aggregates, such as M2. In the third article in this
Review, “The Effects o f Financial Innovations on Checkable Deposits, M l
and M2,” John A. Tatom examines this financial innovations hypothesis.
As Tatom explains, the hypothesis implies that the growth o f these
new checkable deposits should have reduced the turnover o f total
checkable deposits and boosted the demand both for checkable deposits
relative to currency holdings, and for M l. The growth in m oney market
balances should not have affected the composition or demand for M l
and M2.
Tatom finds that these innovations did not have the statistically signifi
cant effects predicted by the financial innovations hypothesis. In par
ticular, new interest-bearing checkable deposits had no effect on the
turnover rate o f total checkable deposits, the demand for total
checkable deposits relative to currency, or the demand for M l. Also to
the contrary, Tatom finds that M l and M2 demand w ere both affected
by the introduction o f money market balances.
Tatom concludes that analysts o f financial innovation effects generally
have focused on the w rong innovation and the w ron g monetary ag
gregate. His results indicate that the principal influence o f financial in
novations has been the substantial effect o f m oney market balances on
the demand for M2.

FEDERAL RESERVE BANK OF ST. LOUIS

* * *

Seonghwan Oh and
Michelle R. Garfinkel
Seonghwan Oh, an assistant professor of economics at the
University of California, Los Angeles, was a visiting scholar at
the Federal Reserve Bank of St. Louis. Michelle R. Garfinkel is
a senior economist at the Federal Reserve Bank of St. Louis.
Scott Leitz provided research assistance.

Strategic Considerations in
Monetary Policy with Private
Information: Can Secrecy Be
Avoided?

_1_ 11K FEDERAL RESERVE System has been
criticized often for the secrecy that surrounds
monetary policy. In particular, many observers
have questioned the desirability o f the Fed’s
practice o f not disclosing the decisions o f the
Federal Open Market Committee (FOMC) im
mediately following its meeting. This criticism
has been heightened recently by legislation in
troduced in the House o f Representatives, p ro
posing, among other things, that the Fed release
the contents o f the FOMC’s directives immediate
ly after each meeting rather than with a sevenweek delay.1
The econom ic rationale behind this proposal is
that the Fed’s maintained secrecy limits the in
formational content o f prices in financial markets
and thereby detracts from the markets’ ability
to allocate resources efficiently. If, for example,
1Lee Hamilton and Byron Dorgan, HR2735-the Federal
Reserve Reform Act of 1989. See Hamilton (1989) for a
brief discussion of the key changes in the structure of the
Fed proposed by this legislation. As discussed by Goodfriend (1986), however, legislation proposed in this spirit is
not new.

the FOMC voted to maintain its current policy
stance but subsequently added reserves to the
banking system as a technical and temporary
action, market participants might mistakenly in
terpret such an action as a fundamental change
in policy. According to this view, without im
mediate disclosure o f the FOMC's policy direc
tive, confusion about the Fed’s intentions can
add to the variability o f market interest rates.
Those w ho are skeptical o f the value o f this
legislation argue that immediate disclosure of
the FOMC's directive would complicate the im
plementation o f monetary policy.2 For example,
the markets’ response to announcements could
generate large changes in interest rates that, ac
cording to this view, would be excessive and
destabilizing.
2See, for example, Mooney (1989), Rosenbaum (1989) and
Uchitelle (1989). Also, see Goodfriend (1986) for an in
teresting and useful critique of the arguments made for
maintained secrecy at the Fed.

JULY/AUGUST 1990

In the context o f a relatively simple gametheoretic model o f monetary policy, in which
the Central Bank would expect to be better off
if it had no private information, this article
shows w hy the Central Bank cannot reveal its
private information credibly and precisely. The
Central Bank might be able to reveal this infor
mation partially through imprecise or noisy an
nouncements. From the Central Bank’s perspec
tive, however, such announcements are not
costless, nor can they rem ove secrecy from poli
cy perfectly. Hence, the analysis illustrates that,
even if the Central Bank perceived monetary
policy secrecy as undesirable, fully eliminating it
might not be feasible.

STRATEGIC MONETARY POLICY:
THE BASIC MODEL
To address issues o f secrecy in monetary
policy, it is helpful to study a model o f monetary
policy that specifies the objectives and constraints
faced by a Central Bank. Given the particular
specification, the m odel provides a fram ework
for analyzing various strategies for the Central
Bank and, in turn, for predicting which strategy
is optimal for the Central Bank. The model, a
slight variant o f Canzoneri (1985), builds on a
simple specification o f the econom y.3 Output is
given by
(1) y ,= y ° + ( p ,- w t),
w here y „ pt and w, denote, respectively, the
logarithms o f output, prices and nominal wages
in time t; y ” denotes the log o f output that cor
responds to the "natural" rate o f unemployment.
In this model, the natural level o f output is the
one that w ould prevail with a steady rate of
inflation.
The public attempts to specify wages so as to
minimize deviations o f output from its natural
level. Accordingly, it wants to set w t= pt. But, in
this model, prices are not known at the time
wages are set. Hence, wages are set to satisfy
(2) w, = p|,

3The model is intended only to be an illustration, not a
complete characterization of the economy. Canzoneri’s
(1985) model resembles that of Barro and Gordon (1983)
except that it provides a role for the Central Bank to react
to shocks. As will be evident below, this model does not
imply that the first-best policy is a constant money growth
rule. Rather, it is a contingent money growth rule. See
Cukierman (1986) for a helpful review of this relatively new
literature on central bank behavior.

FEDERAL RESERVE BANK OF ST. LOUIS

where p ' denotes the public’s expectation, as
described below, o f the log o f the price level
conditional on information available to the public
at the beginning o f period t. By combining equa
tions 1 and 2, output can be expressed as
follows:
(3) y t=y° + (nt-Tite),
where nt= p , - p t_, is the actual rate o f inflation
in time t; rc' = p ' - p t_, denotes the public’s expec
tation o f inflation.
Equation 3 captures the notion that the longrun Phillips curve, w hich is the relationship
(trade-off) betw een inflation and unemployment,
is vertical. On average, unemployment and, con
sequently, output are independent o f both ex
pected and actual inflation. In any period, h ow
ever, unanticipated inflation can create a wedge
between output and its natural level. Specifical
ly, the existence o f contracts that fix nominal
wages for a specific period means that actual
output can depart from its natural level if people
underestimate or overestimate the future rate
o f inflation.4 The effect o f unanticipated infla
tion on output is only temporary. In this model,
it lasts only one period. The variance o f output
implied by equation 3 is simply the variance of
the market’s inflation forecast error.
The following simple variation o f the quantity
theory equation describes how prices are deter
mined in each period given monetary policy:
(4) p t= mt- y n+ vt,
where v, denotes an innovation to m oney de
mand and mt denotes the log o f the m oney
supply in time t.
Taking the first-difference o f equation 4 and
rearranging shows how monetary policy affects
inflation:
(5) n, = g ,- d „
w here g t= mt- m t_, is the growth rate of
money, the Central Bank’s policy instrument,
and <5t= vt. , - v t denotes a random disturbance.
This disturbance, w hich is bounded betw een

4That unanticipated inflation can drive output above its
natural level would also be implied by the Lucas-type
(1973) supply curve. The important feature of this equa
tion—that output, on average, will be independent of
inflation—assumes that the public forms expectations ra
tionally. The assumption that the elasticity of output with
respect to unanticipated inflation is equal to one is used to
simplify the notation and does not affect the qualitative
results discussed below except where noted.

- D and +D, is assumed to have a zero uncon
ditional mean and a finite, constant variance, a
As revealed by equation 5, the Central Bank’s
control over inflation is imperfect; inflation
depends not only on monetary policy but on the
disturbance to m oney demand. Thus, equation 5
implies that the public’s expectation fo r inflation
in time t equals the difference between its ex
pectation o f m oney grow th in time t, g', and its
expectation o f d„ d'.
Secrecy arises in this model because, in con
trast to the public, the Central Bank has a (non
trivial) forecast o f the disturbance to m oney de
mand.5 The Central Bank’s “private" forecast,
dt ■■Et{c5t}, satisfies

Fig u re 1

S e q u e n c e of E vents in P erio d t.

dt + l

-»-------(------ j------j------------------------------------- 1----------*- time
t
T t
t+1
77e
il t 9

(6) dt= dt+ £„
where Et{ • } denotes the Central Bank’s expec
tation, based on information available to it at
the beginning o f period t, before wage con
tracts are signed. The Central Bank's forecast
error, c„ has an expected value o f zero, a finite
variance, a and no correlation with the Central
Bank’s forecast. The assumption that the forecast
is independent o f the forecast error implies ol =
o2
d+ ol, where a\ is the variance o f the private
forecast.
Although this forecast is made just before
wages are set, the markets’ expectation o f dt
equals zero without any meaningful announce
ments by the Central Bank. W hen the Central
Bank does not attempt to convey its private in
formation, 7i*= g'. The public observes dt after
policy is implemented w hen nt is realized. The
public, however, cannot infer from that obser
vation what the Central Bank’s forecast had
been. Similarly, it cannot identify the Central
Bank’s forecast error. (See figure 1 which sum
marizes the sequence o f events during any
period t.) Nevertheless, people understand the
Central Bank's objectives as described below
and its constraints subject to the unknown dis
turbance dt; they incorporate that understand5That the public does not have a forecast of d, implies
d; = 0, providing that the Central Bank does not com
municate to the public its own forecast. Note that it is not
crucial that the public has no forecast of the disturbance
to money demand. Provided that the Central Bank’s
forecast is private, the following analysis is relevant. Fur
thermore, the private information could be in terms of a
forecast about a supply shock or the Central Bank’s
preferences. The qualitative results to follow would not be
affected. Also, it should be noted that the present model
differs from Canzoneri’s (1985) model in that the timing of
the forecast here is such that, if the Central Bank released
this information, it could be used by the public. The

ing into their expectations o f m oney growth
and, accordingly, their wage specification.
Following Canzoneri (1985), the analysis
assumes that the Central Bank has tw o goals:
output and inflation stabilization. Its expected
lifetime utility in period t = 1 is given by
(7a) Uj = 1 / T ‘ E, {u ,}, 0 < (3 < 1
t= 1

where
(7b) u t= —(yt —y*)2—f(nt—n*)2, f > 0 .
13 is the Central Bank’s discount factor.6 The
parameter f is the weight the Central Bank
places on its objective o f stabilizing inflation
around its target level, rt*, relative to its objec
tive o f hitting its target for the log o f output,
y*. These targets are given and fixed parameters.
The Central Bank’s inflation target need not
be zero. But its objective to stabilize inflation is
consistent with the public's objective to forecast
ing future inflation correctly. In other words,
by minimizing the variability o f inflation, the
Central Bank minimizes the variance o f the pub
lic's inflation forecast error. The Central Bank's
assumed sequence of events, shown in figure 1, is
necessary for the analysis of imprecise announcements
below.
6Note that equation 7 implies that the Central Bank is
infinitely-lived. This assumption is only important for the
discussion of reputational considerations below. This
discussion would be qualitatively the same if, instead, the
Central Bank lived only a finite number of periods, T, pro
vided that T is not known with certainty. In this case, p
would reflect the Central Bank’s chances of survival as
well as its time preference. See Grossman and Van Huyck
(1988), for example.

JULY/AUGUST 1990

objective to stabilize output, however, is consis
tent with the public’s objective to forecast infla
tion correctly only if the Central Bank's target
for output equals the natural level. But, in this
case, the interesting issues revolving around
monetary policy secrecy do not arise.
As in m uch o f this literature, then, the pre
sent analysis assumes that y* > y ”. That is to say,
the Central Bank prefers output to exceed the
public's target. Possible interpretations o f this
assumption could stem from either social welfare
or self-interest considerations.7 It is only im por
tant for the present analysis that the natural
output level or the public’s target for output be
different than the Central Bank’s (given) target.
This assumption implies that the Central Bank
does not have enough instruments to reach its
tw o goals, giving rise to a credibility problem in
policy as illustrated below.
Using equations 3, 5 and 7b and noting that
the public's expectations for inflation, n‘, equals
g '- d ', the Central Bank’s utility in period t can
be written as
(8) ut= —(gt —g[—dt+ d' —A*)2—f(gt —d, —ti’ )2,
where A * = y * - y " > 0 and 6\= 0, without any an
nouncem ents by the Central Bank about its
private forecast. The Central Bank’s problem is
to choose gt to maximize the expected value of
its lifetime utility, after the markets set wage
grow th equal to expected inflation, ti'. The solu
tion depends on h ow the Central Bank treats
the markets’ expectations.

7See Barro and Gordon (1983) and Canzoneri (1985) for a
discussion of possible social-welfare interpretations of this
assumption. These interpretations build on existing distor
tions in the economy. For example, the existence of large
unions that keep real wages too high or the use of income
taxes that influence labor decisions depress average out
put (or the natural level) below the “ potential” level (or
that level considered desirable from a social-welfare
perspective). Although these distortions could be modeled
explicitly here, the associated modifications would add un
necessary complexity to the model without providing much
insight into the issues at hand. But see Cukierman (1986)
for a useful critique of the social-welfare interpretation.
Cukierman (1986) also provides an extensive discussion of
a political interpretation. For example, although the Central
Bank might be an independent institution, it might feel
compelled, in order to preserve its existence or in
dependence, to react to signals by the fiscal authority. The
fiscal authority might be motivated to stimulate the
economy to enhance its chances for re-election.
8ln fact, the same outcome would be obtained if the Central
Bank’s forecast were not known by the public until after

FEDERAL RESERVE BANK OF ST. LOUIS

The First-Best Solution
To see w h y the Central Bank might want to
disclose its private information (that is, its
forecast o f the m oney demand disturbance),
consider the benchmark case wherein the Cen
tral Bank recognizes the impact it can have on
the markets’ expectations and dt is public infor
mation. Furthermore, assume that the Central
Bank can make binding commitments to pursue
an announced policy. In this case, it chooses g„
subject to the restriction that expectations are
consistent with its policy, to maximize its ex
pected lifetime utility. Because o f the stationary
(time-independent) nature o f the model, this
maximization problem reduces to a sequence o f
one-period problems, in which the Central Bank
chooses gt to maximize its expected one-period
utility, shown in equation 8, fo r each period t.
Given the constraint that gt= g', creating sur
prise inflation in an effort to increase output
above its natural level is precluded. Rather, the
Central Bank commits itself to the following
policy:
(9) g, = n* + d„
where gt= g ' for all t. Note equation 9 implies
that, on average, inflation would be equal to the
Central Bank’s target rate. Because the policy
fully accommodates the part o f the disturbance
to m oney demand predicted by the Central Bank,
n' = ti* and wage grow th is set equal to ti*.8
The Central Bank’s expected one-period utility
in this regime can be found using equations 8

wages were set, so that d; still equaled zero. Because the
Central Bank fully accommodates dt, expected inflation, n;,
is independent of d, in this regime. This is not to say that
the Central Bank has no preferences about maintaining
the privacy of its forecast. As will become obvious, the
Central Bank wants to reveal its private forecast so that it
can obtain this outcome. Whether the Central Bank should
accommodate disturbances to the economy is a matter of
controversy. In this model, its motive to react to d, is com
patible with the public’s interests. The public prefers the
Central Bank to react to its forecast, because such reac
tions minimize the variance of the public’s forecast error.
An argument against such a policy, for example, would be
that it is destabilizing because the Central Bank’s
forecasts are inaccurate. As shown below, however, even
if its private forecasts are fairly accurate (provided that
oJ^O), the Central Bank might not find it desirable to react
to its forecast. (Given o5, however, the more accurate the
forecast, the less likely the Central Bank would be willing
to sacrifice flexibility in policy.) The alternative argument
against flexibility in policy in this paper builds on the Cen
tral Bank’s credibility problem.

and 9, with the assumptions that gt'= g t and
d‘ = d t:
(10) Et{ti} = - ( l + f)oe2-A * 2,
for all t, where, as defined previously, a]
denotes the finite variance o f the Central Bank’s
forecast error. It is equal to the variance o f in
flation and output in this regime. The contingent
policy in equation 9 is referred to as the firstbest solution since it yields the highest utility to
the Central Bank among those policies that are
consistent with the public’s expectations.
As demonstrated by Kydland and Prescott
(1977), however, the policy in equation 9 is not
“dynamically consistent.” That is, given the pub
lic’s expectations, the Central Bank has an incen
tive to deviate from the first-best policy. Specifi
cally, given 7i'=n“, the Central Bank would
rather implement the following policy:

and to disclose its private information truthful
ly. Without being able to exploit the dependence
o f its actions on the public’s actions, the Central
Bank chooses g, to maximize its expected oneperiod utility, shown in equation 8, as if it were
not trying to influence g ' or d'.
Before the Central Bank sets g„ the public
specifies wage growth equal to its expectations
o f inflation. Because the public understands the
Central Bank’s maximization problem, it forms
g ' by taking an (unconditional) expectation of
the Central Bank's first-order condition given by
(12) - 2(gt- g ' - d t + d '- A ') - 2 f ( g , - dt- 7i*) = 0,
for each t. Even though the Central Bank
observes d, before the public form s its expecta
tions, without any announcements, d '= 0. Since
the public’s expectation o f gt equals g' and its
expectation o f dt equals d', g'=7i* + A*/f.

(11) gCH=n* + dt + A,/(l + f).
If the Central Bank could create surprise infla
tion with the policy shown in equation 11, it
could augment output above the natural level to
approach its target.9 Such a “cheating” policy
would increase the Central Bank’s expected oneperiod utility by A’ 2/(l+ f).

The M yopic Solution
But, even if the Central Bank could break its
commitment to follow the first-best policy, cheat
ing w ould be impossible as long as people can
not be fooled. That is, rational people will always
anticipate the Central Bank’s incentive to cheat,
if it cannot make binding commitments.
To consider another solution, one that is more
likely to emerge as the equilibrium outcom e
when the Central Bank has private information,
suppose the Central Bank ignores any impact
that it could have on the public's expectations.
This is not to say that the Central Bank actually
fails to understand the impact o f its actions on
the public’s actions that, in turn, influence its
ow n welfare. Rather, given the Central Bank’s
incentive to cheat, it cannot control the public’s
expectations directly unless it could som ehow
be committed to follow an announced policy

9The solution in equation 11 is found by substituting
g ;-d ; = n'into the Central Bank’s expected one-period utili
ty function and maximizing that function with respect to g,.
(See the first-order condition below in equation 12.) The
Central Bank would follow the same cheating strategy if it

People recognize the Central Bank’s incentive
to engineer surprise inflation so as to augment
output above its natural level. To protect
themselves against a decline in their real wage,
then, people specify higher rates o f wage
grow th (equal to g') than in the first-best solu
tion with commitments. Given that specification,
the Central Bank’s policy, g„ w hich is referred
to here as the “m yopic” solution for reasons
that will becom e obvious later, is given by
(13) g, = n* + d t+ A7f,
for each t. With the m yopic policy, the Central
Bank fully accommodates its prediction o f the
m oney demand disturbance as in the first-best
solution. Further, the policy shown in equation
13 validates the public's expectations, implying
an average inflation rate equal to Tt'+A*/f.
W hen the Central Bank acts as if it w ere ig
noring the impact that it can have on the
public’s expectations, the best it can do is to
follow the policy shown in equation 13. This
policy, however, is myopic. Because it essentially
ignores the potential benefit o f reducing the
public’s expectations for inflation, it generates
an "inflationary bias” for the econom y. That is,

had not announced its private information before wages
were set. It should be noted that, since such cheating
strategies are not consistent with the public’s expecta
tions, they are implausible equilibrium strategies and are
assumed not to be observed in equilibrium.

JULY/AUGUST 1990

inflation, on average, exceeds the Central Bank’s
target level by A7f without the benefit o f in
creasing average output above the natural level.
It is important to note that the inflationary bias
w ould emerge even if dt w ere not private infor
mation, as long as the Central Bank did not try
to influence the markets’ expectations.10
The Central Bank’s expected one-period utility
in this regime can be found by using equations
8 and 13 with g' = rc'+ A '/f and d' = 0:
(14) E, { u } = - ( l + f)ot2- ( l + (l/f))A*2,
for all t. Because the variance o f inflation and
output are the same as in the first-best regime,
o\, the only difference betw een equations 10
and 14, A*2/f, is the Central Bank’s one-period
disutility o f the inflationary bias or, equivalent
ly, the inefficiency o f taking the market’s expec
tations as given. Note that the larger A* (which
reflects the difference between the Central
Bank’s and the public’s target for output) and
the smaller f (the Central Bank’s preference for
inflation stability relative to output stability), the
larger is the inflationary bias.
The inflationary bias is not easily avoided
without the ability to make commitments. The
problem stems from the Central Bank's incen
tive to create surprise inflation. This incentive
to cheat, given expectations, ultimately stems
from the insufficient num ber o f instruments
available to the Central Bank. In the present
model, the Central Bank has tw o objectives with
only one instrument. If it had tw o independent
instruments, the Central Bank could achieve
both o f its goals simultaneously.11 Alternatively,
if the Central Bank “ignored” its goal o f output
stabilization or f became infinitely large, then
the credibility problem would disappear and

10ln this regime, as in the first-best outcome, expected infla
tion is independent of d,, since d, is fully accommodated
by the myopic policy. Nevertheless, because the presence
of private information makes it difficult for the Central
Bank to avoid the inflationary bias, as discussed below, it
would like to be able to reveal its private forecast truthfully
and precisely. See, however, Cukierman and Meltzer
(1986) who show that the Central Bank might prefer to
maintain the secrecy of its private information when it can
not control the growth of the money perfectly. In their
analysis, maintained secrecy about its changing
preferences permits the Central Bank to engineer inflation
surprises when desired.
"Actual policy and expected policy are not independent in
struments provided that the public is rational and forwardlooking. If it were not, however, the Central Bank would
optimally announce g* = g ,-A *, where g, = n *+ d t, so that
the Central Bank could systematically fool the public. If the

FEDERAL RESERVE BANK OF ST. LOUIS

there would be no inflationary bias in equilibri
um.12 But, with an insufficient number o f in
struments, the Central Bank’s incentive to sur
prise the public remains, making the first-best
policy dynamically inconsistent and not credible,
thereby calling into question the feasibility of
the first-best solution.

REPUTATIONAL
CONSIDERATIONS
If the Central Bank did not possess any pri
vate information, then a legislated rule could be
imposed to force the Central Bank to follow the
first-best policy. Even if it w ere not feasible to
enforce such a rule, the Central Bank could
recognize the importance o f its "reputation” to
eliminate or mitigate the inflationary bias.13
To see w hy its reputation could be important,
suppose the Central Bank announces that it will
always follow the first-best policy as shown in
equation 9. Further, assume that the public al
ways expects the Central Bank to adhere to that
policy, provided that it never has cheated in the
past by having deviated from the first-best
policy. Through its policy actions, then, the Cen
tral Bank can maintain a reputation for not
deliberately creating surprise inflation.
If, however, the Central Bank w ere to cheat,
then people would expect the Central Bank to
continue to cheat in the future. Once having
lost its reputation by cheating, the Central Bank
is "punished.” Anticipating that the Central Bank
will continue to cheat in the future because it
has done so in the past, people will incorporate
an inflationary bias into their wage specifica
tion. Given this specification for expectations,

public believed that announcement, the Central Bank’s ex
pected one-period utility could increase to -(1 + f)aj.
12lf the objective function in (7) were interpreted as a socialwelfare function, then the analysis above suggests that ap
pointing a “ conservative” Central Banker (i.e., one whose
concern about pursuing a goal of inflation stability exceed
ed that of society) would enhance social welfare. See
Rogoff (1985) for a detailed discussion of this point. In
deed, this is the thrust of Representative Stephen L.
Neal’s recently proposed legislation to make price stability
the ultimate objective of the Federal Reserve System (H.R.
Res. 409). But also see Neumann (1990) who argues that
strengthening the independence of the Central Bank could
similarly help to avoid the credibility problem in monetary
policy without explicitly imposing a goal of price stability
on the Central Bank.
13See, for example, Barro and Gordon (1983).

the Central Bank can do no better than to
follow the m yopic policy shown in equation 13
once having cheated. During the "punishment,”
the outcom e w ould return to the m yopic solu
tion that includes the inflationary bias, A*/f.14
In some cases, the Central Bank’s concern for
its reputation can provide the same result as
binding commitments when there is no private
information. The critical condition is that the
expected long-term gain from eliminating the in
flationary bias must always exceed the expected
short-term gain that could be realized by creat
ing surprise inflation. The long-term gain is
simply the present discounted disutility o f the
inflationary bias, ^ P ^ ^
short-term
gain is the difference betw een the expected oneperiod utility if the Central Bank w ere to cheat
and the expected one-period utility from adhering
to the first-best policy, A*2/(l + f) Note that as the
Central Bank’s discount factor, ft, increases (that
is, as it cares more about the future), the ex
pected long-term gain from maintained reputa
tion is m ore likely to exceed the short-term gain
from cheating in the current period. Hence, as
ft increases, the Central Bank’s concern for its
reputation is m ore likely to support the firstbest outcome.
Even if reputational considerations w ere not a
perfect substitute for binding commitments to
achieve the first-best outcome, they could still
diminish the magnitude o f the equilibrium infla
tionary bias. As long as the threat o f punish
ment is sufficiently large, the Central Bank will
be induced to adhere to the reputational policy

14Making this reputational mechanism effective, in the pre
sent model, requires that the Central Bank is infinitelylived or has a finite but uncertain lifetime, which is consis
tent with the Central Bank’s objective function shown in
(7). If the Central Bank were to live a finite and certain
number of periods, T, then it would always cheat in the
last period, T. But, if the public expects such behavior, the
period T outcome would just be the myopic solution. Along
this line of reasoning, the solution unravels and the
reputational mechanism cannot diminish the inflationary
bias below A*/f. Alternatively, if the Central Bank were
finitely lived, but its preferences were private information
(e.g., the value of the parameter f), the Central Bank
could “ build” credibility as an inflation-fighter by signaling
with monetary policy actions. See, for example, Backus
and Driffill (1985).
15Suppose, for example, that the Central Bank announces
g, = k + 7i* + dt, where k is the average inflation in ex
cess of the optimal rate (0 ^ k < A 7 f) and d, is public infor
mation. (Note that when k = 0, this policy is simply the
first-best one and when k = A'/f the policy is the myopic
one.) Provided that k< A*/f, the temptation for the Central
Bank to cheat, given by (A2+ fak! -2fA'k)/(1 +f), will be

that involves a smaller (if not zero) inflationary
bias.15 Hence, in the reputational equilibrium,
cheating is never observed.
The presence o f private information, however,
greatly complicates this situation, influencing
the possibilities for cheating. Specifically, because
the public does not observe dt (the Central
Bank’s private forecast) directly, it can never be
certain that the Central Bank has actually imple
mented the reputational policy that depends on
dt. The public can easily verify that money
growth equals the Central Bank’s announced
reputational policy. But the public cannot be
sure that the Central Bank’s announcement
about d, is truthful. Indeed, as shown below,
the Central Bank has an incentive to misrepre
sent its private information.

W H Y ARE PRECISE ANNOUNCE
MENTS NOT FEASIBLE?
The existence o f private information weakens
the ability o f reputational considerations to
achieve the efficient outcome. This can be il
lustrated by showing that it is impossible to
force the Central Bank to adhere to the firstbest policy, because the Central Bank cannot
make credible announcements that precisely
reveal its private information.
Suppose that the Central Bank could be forced
to adhere to a specified policy, but could not be
forced to reveal its private information credibly
and precisely.16 For example, the following rule
might be legislated:

positive but will decrease as k increases. The general con
dition for reputational considerations to work is that this
temptation be less than the expected gain to maintained
reputation given by
_ i_ _

(A2.

_ f kA ,

1-/3 V f
)
which is also positive as long as k<A '/f. This gain also
decreases as k increases. Even if the expected present
discounted gain from maintained cooperation is smaller
than the Central Bank’s temptation to cheat for k = 0, the
reputational equilibrium inflationary bias, k, can be less
than A'/f, if the temptation decreases faster than the ex
pected present discounted gain as k < A '/f increases.
16That there is no separate mechanism to force the Central
Bank to reveal its private information might seem puzzling.
For example, in the United States, Congress or the Ad
ministration could set up an agency to monitor the Central
Bank’s activities and take part in formulating monetary
policy, whereby the private forecasts can be revealed to
the public. Why such an arrangement is not adopted is
beyond the scope of this analysis.

JULY/AUGUST 1990

(15) gt = n* + df,
fo r all t, w here df denotes the Central Bank’s
announcement o f its private forecast. If that an
nouncem ent w ere believed by the public, the
public w ould form the following expectations:
g'=n* + df and n‘ = n". With these expectations,
before setting its policy in period t, the Central
Bank w ould announce optimally
(16) d f= d , + A 7 (l + f).
If the public w ere to believe the Central Bank’s
announcement, the Central Bank would be able
to disguise its cheating policy (shown in equa
tion 11) as the first-best policy by overstating
the value o f its forecast.17 In this case, the Cen
tral Bank could drive output above its natural
level by A*/(l + f).
But, as in the case o f simple cheating, the
Central Bank’s incentive to lie, w hich also fun
damentally stems from its incentive to create
surprise inflation, will be fully recognized; as a
result, no one will believe the announcement.
Given that the public cannot determine with
certainty whether or not dA= d„ it can do no
better than to protect itself from surprise infla
tion by setting wage grow th equal to rr* + A’ /f.18
Because the Central Bank’s forecast is private
information, a legislative approach depending on
that information is not effective in achieving a
better outcom e than the m yopic solution.19
Similarly, the Central Bank’s private information
obscures the relevance o f reputational con
siderations to im prove upon the m yopic out
come. Although people can see whether the
Central Bank has implemented its announced
policy—for example, the policy show n in equa
tion 15—they cannot verify that its announce

17This can be seen by substituting equation 16 into equation
15. To verify that equation 16 is the optimal announce
ment, substitute equation 14 into the Central Bank’s oneperiod utility function (8) and choose d * to maximize the
expected value of (8) subject to the public’s expectations
g;—<5;=n*. The Central Bank would lie in the same manner
if it were not necessary to make its announcement until
after the policy was implemented.
18To see this, note if the Central Bank were to act on its in
centive to create surprise inflation given the public’s ex
pectations, it would set its policy optimally to satisfy the
first-order condition in equation 12. Rearranging equation
12 and using Et(d,) = d„ one can verify the following:
q = g '~ d' + fa‘ +A' + d.
1+f
1 +f
Noting that gt - d, equals the Central Bank’s expectation
for inflation given d „ Et (nj, and g;-<J; = n;, the expression
above implies that

FEDERAL RESERVE BANK OF ST. LOUIS

ment truly reflects the value o f its private
forecast (that is, df = dt), unless the forecast
w ere always perfect (that is, £t= 0 for all t).
Hence, the public cannot evaluate the Central
Bank’s reputation based on past policy actions.

A CONSTANT MONEY GROW TH
RULE AND THE ROLE OF NOISY
ANNOUNCEMENTS
Although the Central Bank cannot make credi
ble announcements that precisely state its private
information, it can make announcements that
have some informational content. In a recent
study, Stein (1989) applies the w ork o f Crawford
and Sobel (1982) to show that, through noisy
announcements or "cheap talk,” the Central Bank
can reveal its private information partially. In his
application, w here the Central Bank’s private in
formation concerns its objective for the target
exchange rate, Stein illustrates h ow the Central
Bank can make announcements o f a range in
which its target falls. Because the announce
ment does not state the exact value o f the Cen
tral Bank's target, it is a noisy announcement.
These announcements are a costless form o f
communication in that no resources are used in
making them. But the announcements are credi
ble because the Central Bank w ould incur an
implicit cost if it w ere to lie. This cost is suffi
ciently large to induce the Central Bank to reveal
its private information truthfully, though not
precisely.
An application o f Crawford and Sobel’s (1982)
analysis to the present model, however, shows
that noisy announcements might not be as
"cheap” as Stein’s (1989) analysis would suggest.

Since Et(nt)> n ; for rrj^rr' + A'/f, the Central Bank always
has an incentive to create surprise inflation unless the
public incorporates the inflationary bias A'/f into its wage
specification.
19Garfinkel and Oh (1990a) have shown how a legislative ap
proach that is independent of the Central Bank’s private
forecast can achieve a better outcome than the myopic
solution studied above. With a multi-period (N periods)
average targeting procedure, requiring x g, = NrT, the

Central Bank can diminish the magnitude of the infla
tionary bias that emerges in equilibrium. This procedure is
not efficient, however, in that it necessarily limits the Cen
tral Bank's flexibility to stabilize output and inflation.
Nevertheless, it can permit more flexibility than a strict
constant money growth rule.

In contrast to the present model, Stein’s model
implies that, if it w ere possible to force the Cen
tral Bank to reveal its exchange rate target truth
fully and precisely, then the first-best outcom e
could be obtained. Accordingly, noisy announce
ments alone can easily achieve a better outcome
than no announcements or complete secrecy.

(otherwise desirable) reactions to the part of
m oney demand disturbances predicted by the
Central Bank.22 As such, this rule produces a
higher variance o f the public’s forecast error
for inflation and, hence, a higher variance of
output than in both the first-best and myopic
regimes.

The credibility problem in monetary policy in
the present framework, however, is slightly
m ore complicated. As indicated above, even if it
w ere possible to make the Central Bank reveal
its private forecast truthfully and precisely, im
posing an additional restriction on policy either
through a legislative rule or reputational con
siderations would be necessary to ensure that
the Central Bank follow the first-best policy. That
is, even if the public's expectations, g' and n‘,
included information about d„ the Central Bank
w ould have an incentive to surprise the public
(according to equation 12) unless n't also w ere to
incorporate the inflationary bias, A*/f.20 But the
Central Bank has no motivation to reveal dt if it
cannot reduce or eliminate the inflationary bias
in doing so. Similarly, the Central Bank’s incen
tive to create surprise inflation would not disap
pear if it w ere to make noisy announcements
about its private forecast and could contaminate
those announcements.

The Central Bank's expected utility under this
regime without any announcements is given by

A Constant M on ey Growth Rule
Because o f this incentive to surprise the
market with inflation, limiting the degree o f flex
ibility permitted in monetary policy is necessary
to ensure that the announcements contain some
information while allowing the Central Bank to
avoid the inflationary bias. In other words, a
rule for monetary policy must be imposed to
"tie” the hands o f the Central Bank. As indicated
above, for this constraint to be effective, the
rule must be independent o f the private infor
mation.21 For example, legislation could require
(17)
Although this constant money grow th rule
eliminates the inflationary bias, it precludes any

20See footnote 18.
21Whether it is possible to enforce a legislated rule is
beyond the scope of this paper. Of course, reputational
considerations might be able to support the same rule. To
simplify the discussion, the analysis assumes that it is
possible to enforce a legislated rule that does not depend
on the Central Bank’s private information.
22lf there were another shock, say, in the supply equation,
and the Central Bank’s information about this shock were

(18) Et{u } = -( 1 + f)o2-A * 2,
for all t. Expected utility in this regime will ex
ceed that under the myopic regime only if
A*2/ f > ( l + f)oj.
This condition underscores the Central Bank’s
trade-off betw een eliminating the inflationary
bias and eliminating flexibility in monetary policy
with the constant m oney growth rule. The
larger is the inflationary bias that emerges in
the myopic outcom e (that is, the smaller f and/or
the larger A*), the m ore likely this condition will
be satisfied. The Central Bank is less likely, h ow
ever, to prefer a constant m oney growth rule
over the myopic policy the larger the variance
o f the com ponent o f the money demand distur
bance predicted by the Central Bank, o\, which
captures the expected benefit o f being able to
react to dt. Because the legislated rule in equa
tion 17 does not permit the Central Bank to
react to its forecast o f the disturbance to money
demand to stabilize inflation, the variance o f in
flation and output increase to o]. Nevertheless,
if the possible benefits o f maintained flexibility
are not too large (that is, if o\ is small), the Cen
tral Bank might prefer to be constrained not to
react to its private forecast to avoid the infla
tionary bias.
It is important to note that, even with this
rule, the Central Bank still would not precisely
reveal its forecast. In particular, given g, = n*,
the Central Bank would want to overstate the
value o f its forecast according to
(19) df = dt + A\

not private, then the legislated rule could provide flexibility
to react to this shock. Moreover, not all flexibility needs to
be removed from policy in this model. The constant money
growth rule is not the only way to tie the hands of the
monetary authority to make the announcements mean
ingful. The imposition of a multi-period average targeting
rule that permits some flexibility would also work; however,
with this constraint, the inflationary bias would not be
eliminated totally. See Garfinkel and Oh (1990a).

JULY/AUGUST 1990

Equation 19 illustrates again that the credibility
problem o f monetary policy is not easily resolved
in the presence o f private information. But if dt
w ere not private information, the Central Bank’s
expected one-period utility with a constant
m oney grow th rule w ould be

hand, if the Central Bank announced that dt fell
in the low er range, [-D ,a ], the market would
expect a higher inflation rate equal to the dif
ference between ir' and the expected value of
dt given that it falls som ewhere betw een - D
and a. Call this conditional expectation dL'

(20) E ,{u } = - f o 2- A ' 2.
Hence, the Central Bank would prefer to disclose
dt under a constant m oney growth rule even
though it cannot do so precisely.

If d, is greater than - D but less than a, then
the Central Bank’s expected one-period utility by
announcing dt i [-D ,a ] must be greater than or
equal to that by claiming d, t [a,D] for the
form er announcement to be credible. That is,

Noisy Announcements

(21) - E t{(dL- d t- £ t-A *)2} > - E t{(dh- d t- £ t- A ') 2}.

By making noisy announcements about its
forecast, the Central Bank could enhance its
ow n welfare under the rule. Given that it must
follow the rule in equation 17, the Central Bank
cannot actively pursue its goal to stabilize infla
tion and output by reacting to dt. Making noisy
announcements, as an alternative policy tool,
permits the Central Bank to pursue its goal of
stabilizing output. Specifically, the Central Bank
could partly influence expectations by announc
ing a range in which its forecast falls, thereby
reducing the variance o f the public’s inflation
forecast error and, in turn, reducing the vari
ance o f output.

The inequality in equation 21 would be reversed
if dt were greater than a and less than D. Final
ly, if dt= a, then the Central Bank must be indif
ferent between announcing the higher and
low er ranges.

To take a concrete example, suppose that the
Central Bank announces that d, lies either bet
w een - D and a or betw een a and D.23 For any
announcement to contain some information
about d„ the Central Bank must perceive that
lying is costly. The cost, however, cannot be
directly imposed by the market upon observing
d, because, as mentioned earlier, the market
cannot infer the true value o f dt from that ob
servation. Rather, the cost o f lying about dt is
implicitly contained in how such a lie would af
fect the market’s expectations about d,.
Suppose the Central Bank w ere to announce
that dt fell in the higher range, [a,D]. Given that
announcement and the m oney grow th rule
shown in equation 17, the market form s an ex
pectation about future inflation. This expecta
tion would equal the Central Bank’s target rate
o f inflation, it*, minus the expected value o f dt
given that it lies som ewhere betw een a and D.
Call this conditional expectation dh. On the other

23See the appendix for a more detailed example. Also see
Garfinkel and Oh (1990b).
24Again, see Garfinkel and Oh (1990b). Their analysis pro
duces a somewhat surprising result: under the conditions

FEDERAL RESERVE BANK OF ST. LOUIS

This last condition can be used to determine
the dividing point o f the distribution o f d„ a,
such that for all possible values o f dt, the Cen
tral Bank’s announcement is credible. The deter
mination o f the dividing point from that condi
tion ensures that the Central Bank will not act
on its motive to lie about the range in w hich d,
falls. For example, w hen dt is in the low er range,
the Central Bank will not announce that d, is in
the upper range. If it did so, the public’s infla
tionary expectations would fall by a sufficiently
large amount that, in turn, drives output too far
from the Central Bank’s output target and, hence,
renders lying undesirable.
By making noisy announcements about its
private forecast while adhering to the constant
m oney grow th rule, the Central Bank can en
hance its expected utility above what it would
be w hen it simply follows the rule. This is not
to say that the Central Bank will always choose
to make noisy announcements. As illustrated
with a more specific example in the appendix,
the Central Bank w ould prefer to maintain full
discretion and secrecy, the more it cares about
inflation stability, the less the difference between
its and the public’s output goals, and the more
accurate the private forecast.24
The basic intuition here is essentially the same
as that used w hen discussing the merits o f a

that noisy announcements are more likely to be preferred
by the Central Bank, the credibility problem is more severe
so that, at the same time, these announcements cannot be
particularly informative.

simple constant m oney grow th rule over those
o f the m yopic policy. The presence o f private
information forces the Central Bank to face a
new trade-off betw een removing the inflationary
bias and limiting flexibility in policy. But the
money grow th rule with noisy announcements
is more likely to dominate the m yopic policy
than the rule by itself. Although both output
and inflation will have a greater variance in the
regime with noisy announcements than in the
myopic regime, the variance o f output will be
smaller in this regime than w hen the Central
Bank simply follows a constant m oney growth
rule. The elimination o f the inflationary bias
possible with the constant m oney grow th rule,
com bined with the slight reduction in the vari
ance o f output possible with noisy announce
ments, provide the main benefits that would
make abandoning the m yopic policy—that is,
maintaining complete secrecy with full discre
tion -desirable from the Central Bank’s
perspective.

CONCLUDING REMARKS
This article has examined the possibility o f ful
ly or at least partially removing secrecy in m one
tary policy. In the context o f a model in which
the Central Bank has an incentive to create sur
prise inflation, the Central Bank w ould like to
reveal its private information, w hereby it could
easily avoid an inflationary bias. The Central
Bank’s private information com bined with its in
centive to surprise individuals gives rise to a
credibility problem in monetary policy that is
nearly impossible to resolve. Neither reputational
considerations nor binding commitments to
force the Central Bank to adhere to the firstbest policy are effective in improving upon the
myopic solution if the public never directly ob
serves the Central Bank’s private information.
Although the Central Bank cannot make
precise announcements, it can make announce
ments that partially reveal its private inform a
tion. By announcing a range in w hich its forecast
falls and adhering to the constant money growth
rule, the Central Bank can avoid the inflationary
bias and influence the market’s expectations in
a discrete way to low er output variability below
that generated by a simple constant m oney
growth rule alone. Nevertheless, some secrecy
remains.
M oreover, the Central Bank might prefer to
maintain complete secrecy. Unlike Stein’s (1989)

result that there is always room for im prove
ment with noisy announcements, in the context
o f the more general model developed here, noisy
announcements require constraints on flexibility
that can be permitted in the conduct of
monetary policy—for example, a legislated con
stant m oney grow th rule. The constraints are
costly if they preclude desirable reactions to
disturbances in the economy.
More generally, the analysis suggests that leg
islation requiring the Fed to disclose the FOMC’s
decisions immediately after its meeting might be
o f little value. If the Central Bank has private
information about the econom y that influences
its decisions and has an incentive to surprise
the public, it will not release this information
truthfully and precisely. The Central Bank’s in
centive to misrepresent its private information
detracts from the value o f any information it
releases.
That noisy announcements can w ork in en
hancing the efficiency o f monetary policy only
under restrictive conditions prompts a general
but m ore fundamental conclusion. In the pres
ence o f private information, the Central Bank
faces a trade-off between higher-than-desired
average inflation and limited flexibility. Without
eliminating the ultimate source o f the credibility
problem —namely, that the Central Bank has too
few tools to achieve its ultimate goals—this con
sequence o f the strategic considerations o f m on
etary policy is not easily avoided.

REFERENCES
Backus, David, and John Driffill. “ Inflation and Reputation,"
American Economic Review (June 1985), pp. 530-38.
Barro, Robert J., and David B. Gordon. “ Rules, Discretion
and Reputation in a Model of Monetary Policy,” Journal of
Monetary Economics (July 1983), pp. 101-21.
Canzoneri, Matthew B. "Monetary Policy Games and the
Role of Private Information,” American Economic Review
(December 1985), pp. 1056-70.
Crawford, Vincent P., and Joel Sobel. “ Strategic Information
Transmission,” Econometrica (November 1982), pp. 1431-51.
Cukierman, Alex. “ Central Bank Behavior and Credibility:
Some Recent Theoretical Developments,” this Review (May
1986), pp. 5-17.
Cukierman, Alex, and Allan H. Meltzer. “A Theory of Am
biguity, Credibility, and Inflation under Discretion and
Asymmetric Information,” Econometrica (September 1986),
pp. 1099-128.
Garfinkel, Michelle R., and Seonghwan Oh. “ Strategic
Discipline in Monetary Policy with Private Information: Op
timal Targeting Periods,” UCLA Working Paper No. 584
(January 1990a).

JULY/AUGUST 1990

_______ “ When and How Much To Talk: Credibility and
Flexibility in Monetary Policy With Private Information,”
Federal Reserve Bank of St. Louis Working Paper No.
90-004 (June 1990b).
Goodfriend, Marvin. “ Monetary Mystique: Secrecy and Cen
tral Banking,” Journal of Monetary Economics (January
1986), pp. 63-92.
Grossman, Herschel I., and John B. Van Huyck. “ Sovereign
Debt as a Contingent Claim: Excusable Default, Repudia
tion, and Reputation,” American Economic Review
(December 1988), pp. 1088-97.
Hamilton, Lee H. “ Regulating the Federal Reserve Board,”
Christian Science Monitor, October 20, 1989.
Kydland, Finn E., and Edward C. Prescott. “ Rules Rather
than Discretion: The Inconsistency of Optimal Plans,” Jour
nal of Political Economy (June 1977), pp. 473-91.
Lucas, Robert E., Jr. “ Some International Evidence on
Output-lnflation Tradeoffs,” American Economic Review
(June 1973), pp. 326-34.

Mooney, Richard E. “ Don’t Fiddle with the Fed,” New York
Times, October 3, 1989.
Neumann, Manfred J.M. “ Precommittment to Rules in
Monetary Policy: A Comment,” in Michael T. Belongia, ed.,
Monetary Policy on the 75th Anniversary of the Federal
Reserve System, Proceedings of the Fourteenth Annual
Economic Policy Conference of the Federal Reserve Bank
of St. Louis (Kluwer Academic Publishers, forthcoming).
Rogoff, Kenneth. “ The Optimal Degree of Commitment to an
Intermediate Monetary Target,” Quarterly Journal of
Economics (November 1985), pp. 1169-89.
Rosenbaum, David E. “ Little Chance Seen for Bills on Fed
Rein,” New York Times, October 10, 1989.
Stein, Jeremy C. “ Cheap Talk and the Fed: A Theory of Im
precise Policy Announcements,” American Economic
Review (March 1989), pp. 32-42.
Uchitelle, Louis. “ Moves On in Congress to Lift Secrecy at
the Federal Reserve,” New York Times, August 24, 1989.

Appendix
Why Not Complete Secrecy?—An Example
This appendix illustrates with a simple exam
ple h ow noisy announcements w ork and under
what conditions the Central Bank would prefer
to use them rather than not reveal anything
about its private forecast. For simplicity in what
follows, suppose that 6t has a uniform distribu
tion bounded by - D and D.1 Consider the sim
plest example w here there is only one dividing
point, a1( over that distribution.2 Then, given an
announcement by the Central Bank, say, that dt
falls in the low er range, [ - D.a^, and (17) in the
main text, the public will form expectations ac
cording to the following:

w hich dt falls, it must always be indifferent b e
tween announcing the ranges, [-D ,a ,] and [a,,D]
w hen dt= a r

- D + a,
(Al) ti'( - D , a,) = i t -------- ----- •

D +a
- Et(( — - —L - a, - £ t-A *)2],

With this influence on the public’s expecta
tions, it is important to ensure that the Central
Bank will announce the correct range. For ex
ample, if d, e [ —D,a ,], the Central Bank should
not announce dt £ [a,,D], To guarantee that the
Central Bank will not misrepresent the range in

1Hence, the probability that dt = d, where d is any possible
realization of d„ is the same for any value of d: 1/2D. The
distributions of d, and t, are not specified here. They need
only be independent random variables with zero means
and finite variances that sum to the variance of d,. See
Crawford and Sobel (1982) for a more general analysis of
the noisy announcement equilibrium.

FEDERAL RESERVE BANK OF ST. LOUIS

Formally, this condition, called the "arbitrage
condition,” is written as
(A2) Et(u([-D ,a,], dt)] = E,fc([a,,D], dt)],
or equivalently,
—D + a
- E t[ ( ---- -— L - a .- t .- A * ) 2} =

w here dt= a,. For this condition to be satisfied,
at must equal -2A*.
The basic idea here is that, given that the
Central Bank must follow the constant m oney
growth rule, its incentive to lie depends on its

2See Garfinkel and Oh (1990b) for a derivation of a more
general noisy announcement equilibrium of size n in this
framework. (In this particular example, with n = 2, a0= - D
and a; = D.)

forecast. The dividing point a,, determined from
the arbitrage condition, implies that if the Cen
tral Bank w ere to overstate the value o f its fore
cast, when dt< a j, it would have to do so by an
amount so large that it is too costly to lie.

nouncements with any number o f dividing
points (greater than or equal to 1) will always
be better than a simple constant m oney growth
rule provided that the first step is greater than
- D .4

Note that the dividing point is such that for
d ^ a , the announcement is m ore precise—that
is, informative. M ore generally, w hen there are
n steps, the subintervals becom e longer as they
move away from the low er bound. For example,
consider w hen there are tw o dividing points, at
and a2. In this case, the arbitrage condition re
quires aj= - D /3 - 4 A ” and a2= D /3 -4 A ‘ . The
length o f the first interval from - D to a1 equals
2D /3-4A *; the length o f the next interval equals
2D/3; and, the length o f the last interval equals
2D/3 + 4A*. W hen the disturbance is smaller
(closer to -D ), the Central Bank's incentive to
overstate the value o f the forecast is smaller.

In addition, the Central Bank’s utility under
this regime can be greater than that under the
m yopic regime. In the present example, this
condition is given by

Although a constant money growth rule is not
first-best in that it does not permit (otherwise
desirable) reactions to the Central Bank’s fore
casts o f money demand disturbances, it does
eliminate the inflationary bias. W hen the Cen
tral Bank also makes noisy announcements, it
can enhance its expected welfare above that
with a simple constant m oney grow th rule. With
only one dividing point, its expected one-period
utility is given by:
(A3) u = - ( 6 A*2+ D 2(f + |))/3,
which is always greater than the Central Bank’s
utility w hen it simply follows a constant m oney
grow th rule, provided that A *<D /2.3 Note that
this condition will be satisfied by the require
ment that a, > - D . M ore generally, noisy an-

3See Garfinkel and Oh (1990b), who show that, for a
general noisy announcement equilibrium of size n, the
Central Bank’s expected one-period utility is given by u, =
-(A *2(n2+ 2) + D2(f+ 1/n 2))/3. Under the specifications for
the distribution of <5t, the one-period expected utility for the
Central Bank is -(1 +f) D2/3 - A * 2 when it follows a simple
constant money growth rule. This can be easily verified by
either using the above expression for expected utility with
n = 1 or by using equation 18 and noting that the variance
of a random variable which has a uniform distribution
bounded by x, and x2 is given by (X j-x ^ /1 2 .
4This no-nonsense condition is automatically satisfied by
the requirement that the partition equilibrium of size n is
feasible. See Garfinkel and Oh (1990b).
5ln the myopic regime, the Central Bank’s one-period ex
pected utility is - (1 +f)(1 - a 2)D2/3 -(1 +(1/f))A'2 since, by
the definition of a] 1 - a 2= o,2/oj.

(A4) D2(a2(l + 4 f)-3 (1 -cr))/12 < A2( l - f ) /f ,
where a1=a\lal with 0 < a < l . 5 The parameter a
captures the degree o f accuracy o f the Central
Bank's forecast. As a approaches 1, the Central
Bank’s forecast is generally m ore accurate.
The condition in (A4) is weaker than that for
a strict rule to dominate the myopic policy. Nev
ertheless, this condition is quite strong, reflecting
the idea that, although the inflationary bias can
be avoided, the resulting loss o f flexibility in
this regime can be costly. In fact, when the
monetary authority's forecast is extremely ac
curate (that is, a approaches 1), a sufficient con
dition for the myopic policy to dominate the
constant m oney grow th rule with noisy an
nouncements and one dividing point, a,, is simp
ly that f > l . If the Central Bank cares more
about inflation stability than about output stabil
ity (and its forecast is extremely accurate), then
it will not prefer noisy announcements, with a,,
over the myopic policy. W hen a is close to 1, it
can be shown that, given that f > l , noisy an
nouncements with any number o f partitions will
not be desired by the Central Bank.6
Nevertheless, noisy announcements might en
hance the Central Bank’s utility if f < l . Even if
a strict constant m oney growth rule without

6See Garfinkel and Oh (1990b). The intuition here, as
discussed in the main text, follows simply from the trade
off between the benefits of reducing the inflationary bias
and the benefits of maintained flexibility. Assuming that a
is sufficiently close to 1, the larger is f, the smaller is the
inflationary bias that emerges in the myopic regime and
the smaller is the benefit of avoiding the inefficiency of
that bias relative to the expected costs of not reacting to
money demand disturbances. In the case that the elasticity
of output with respect to unanticipated inflation were not
equal to 1, the sufficient condition for the Central Bank to
prefer the myopic policy is that f be greater than the
square of that elasticity. The smaller that elasticity, the
greater the likelihood of the Fed preferring the myopic
policy. For example, if the elasticity were equal to 1/2,
then f > 1/4 would imply that the myopic policy dominates
the constant money growth rule with noisy
announcements.

JULY/AUGUST 1990

any announcements does not dominate the m yo
pic policy, there can be room fo r improvement
with noisy announcements and the strict rule.
In the case o f one dividing point, there can be
room for improvement provided that f < 1/2
even w hen the private forecasts are extremely
accurate (that is, a is close to one). More
generally, the condition in equation A4 implies
that noisy announcements are m ore likely to be
preferred over no announcements with full flex

FEDERAL RESERVE BANK OF ST. LOUIS

ibility in monetary policy, the less accurate the
Central Bank's forecast (when there is a smaller
desire for flexibility in monetary policy). Fur
ther, the larger the difference betw een the out
put goals o f the Central Bank and the public
and the smaller the Central Bank’s relative pre
ferences for inflation stability, the Central Bank
is less likely to prefer complete secrecy over
noisy announcements.

Peter Bofinger
Peter Bofinger, an economist at the Landeszentraibank in
Baden-Wiirttemberg, Germany, was a visiting scholar at the
Federal Reserve Bank of St. Louis. Scott Leitz provided
research assistance.

The German Monetary
Unification (Gmu): Converting
Marks to D-Marks1

TJLHE

MONETARY and econom ic unification of
the East and W est German econom y is a task
without precedent in peacetime econom ic histo
ry. It not only merges tw o countries with strong
ly divergent income and productivity levels, but
also unifies tw o economies with radically dif
ferent econom ic structures—the German Dem o
cratic Republic's (GDR) centrally planned econ o
my and the Federal Republic o f Germany’s (FRG)
"social market econom y.” Although conventional
wisdom calls for gradualism in the process of
monetary and econom ic unification o f capitalist
economies and in the transition process from
socialism to a market econom y, in the German
case, these tasks will be accomplished virtually
overnight.2
The legal basis for the unification process is
the treaty ratified by the East and West German

1At the present time, discussion and analysis of the Gmu
has appeared primarily in German newspapers. I do not
quote these articles explicitly in the paper. Publications of
the Deutsche Institut fuer Wirtschaftsforschung, Berlin, of
Norbert Kloten, Karl Otto Poehl, Helmut Schlesinger and
Horst Siebert provided valuable insights and analysis. I
have profited from many discussions with Norbert Kloten
and members of the Research Department of the Federal
Reserve Bank of St. Louis and of the Volkswirtschaftliche
Abteilung der Landeszentraibank in Baden-Wuerttemberg.

parliaments on June 21, 1990, which took effect
on July 1, 1990. The agreement outlines the
principles for monetary union, the econom ic
and social community o f the tw o states and the
fiscal reform o f East Germany.
The arrangements for monetary union, which
involved the replacement o f the East German
“Mark” (M) by the West German "Deutsche
Mark" (DM), established the rates at which East
German financial stocks and flows would be
converted from their Mark values to D-Mark
values. A 1M:1DM rate was applied to East Ger
man wages, salaries, rents, leases and pensions.
Savings accounts o f GDR citizens w ere con
verted at a 1M:1DM rate up to a limit o f M
4,000 (approximately $2,425 at the current
DM/$ exchange rate) for persons betw een 15
and 59 years o f age. The corresponding limit

2For the standard arguments, see Committee for the Study
of Economic and Monetary Union (1989), (“ Delors Commit
tee” ). In the debate on economic transformation of
socialist countries see, for instance, Daviddi and Espa
(1989). There seems to be, however, a growing awareness
that partial reforms generate only limited success; see Roe
and Roy (1989).

JULY/AUGUST 1990

was M 6,000 for older persons and M 2,000 for
younger persons. A 2M:1DM rate was used to
convert all other financial assets and liabilities
o f GDR residents. Mark assets held by individuals
w ho live outside the GDR w ere converted at a
3M:1DM rate.
The legal fram ew ork for the econom ic com
munity betw een the tw o states and for the
transformation o f East Germany’s econom ic
order involves nearly a complete adoption o f
the FRG’s econom ic laws and regulations by
East Germany. These changes include the
restoration o f private property and competition
in East Germany and the free movement of
goods, services, labor and capital between East
and West Germany. In addition, social welfare,
pensions, unemployment and health insurance
programs similar to those in West Germany
were introduced into East Germany; any deficits
in these new programs will be financed tem
porarily by the FRG. Pensions in East Germany
w ere converted to DM values based on net East
German incomes; an East German w orker can
receive a maximum pension of 70 percent o f his
or her net incom e after 45 years o f employ
ment. The agreement also guarantees that the
DM value o f East German pensions cannot fall
below their form er Mark equivalents.
Under the agreement, the East German
government will abolish its old system o f high
tax levies on state enterprises and introduce, in
stead, a system o f income and value added taxes
consistent with those o f West Germany. Future
debt issues by the GDR government must be
issued directly via the Deutsche Bundesbank or
with its approval. The FRG will finance two
thirds o f the East German deficits from 1990
through 1994. For this purpose, a “German Uni
ty” fund o f DM 115 billion was launched; it will
be financed by a combination o f bond issues
(DM 95 billion) and expenditure reductions in
the FRG central government budget (DM 20
billion).

3See the detailed report of the Institute for International
Finance (1990).
“Data for the GNP are not available.
5The lower figure is an estimate of the Kiel Institute for
World Economics; the higher figure was estimated by the
five leading economic research institutes of the Federal
Republic in their report of April 12, 1990.
6At the present DM/Dollar exchange rate of about 1.65 DM
per Dollar, this equals $9,000 to $13,000. For comparison,
1989 per capita income in the United States was $21,000.

FEDERAL RESERVE BANK OF ST. LOUIS

GOALS AND PROBLEMS OF
THE GMU
The paper starts with a short analysis o f the
econom ic situation in East Germany after the
fall o f the Wall. It tries to identify both the
goals o f the East German people and those of
the W est German government w hich together
have led to the present unification o f both Germanys. A brief outline o f the reform s necessary
to transform the East German econom y are
discussed first. The rest o f the paper focuses on
monetary unification, certainly the most con
troversial issue in the debate over unification.

The East German Econom y After
the Wall Fell
The deep econom ic malaise o f the East Ger
man econom y provides a good example o f the
general failure o f the centrally planned
econom ic systems o f Eastern Europe.3 Prior to
W orld W ar II, the part o f Germany that now
makes up the GDR was essentially as developed
as those regions w hich now constitute the FRG.
Data for 1936, for example, show that per
capita income was 993 Reichsmark in the East
and 996 Reichsmark in the West.
Today, o f course, it is not as easy to assess
the relative per capita incomes o f the tw o Germanys. The GDR’s administratively-set domestic
prices and exchange rates do not accurately
reflect its econom ic conditions; consequently,
“official” data, w hen available, must be treated
with skepticism. For example, the East German
Statistical Office recently published the first o f
ficial income estimate for East Germany; it
reported that GDP was M 353 billion for 1989.4
Most West German estimates o f the GDR’s 1989
GNP range from M 280 billion to M 300 billion.5
If a 1M:1DM conversion rate is used with these
estimates, the GDR’s 1989 per capita income
was somewhere between DM 15,000 and DM
21,000,6 only about half o f that estimated for

Table 1

Basic Data for East and West Germany (1988)
Unit

East Germany

West Germany

Area

thousands of sq. miles

41,768

96,094

Population

thousands

16,675

61,715

Employment
Agriculture1
Manufacturing1
Services1
Trade and transport1

thousands
% of total
% of total
% of total
% of total

8,594
11
47
25
18

27,306
5
40
36
19

GNP

Mark/D-Mark billion (1989)

280-350

2,260

GNP per capita

Mark/D-Mark (1989)

Gross monthly salary

Mark/D-Mark

1,250

3,192

Net monthly salary

Mark/D-Mark

1,050

2,153

Monthly social security
retirement benefits

Mark/D-Mark

450

1,597

100

17,000-21,000

Labor productivity as a percent of
West German labor productivity

36,600

1Data are for 1987.
SOURCES: Official statistics of the GDR compiled by the Deutsche Bundesbank and Deutsches Institut fuer Wirtschaftsforschung.

the FRG (DM 36,600) in 1989 (table 1). Thus,
despite East Germany’s good educational system,
its per capita income and, by proxy, its labor
productivity, is estimated to be, at best, only
half that o f West Germany.7 Of course, these
comparative productivity figures are likely to
prove misleading if used to predict what might
occur after unification takes place; for example,
GDR products previously produced and sold
under a central plan designed to achieve autarky
may not be able to com pete effectively with
goods that can now be imported from the West.
The econom ic disparity between the FRG and
the GDR is further demonstrated by the ex
tremely high environmental pollution in East
Germany, its obsolete infrastructure, outdated
manufacturing plants and the generally poor
quality o f its housing stock. Another indication

H'he 50 percent estimate for the GDR’s relative labor pro
ductivity was made by the Deutsches Institut fuer Wirt
schaftsforschung, Berlin, in 1987 for the year 1983. It is
nearly identical to Collier’s (1985) estimate of 54 percent
and to cross-country comparisons (see Cornelsen and

o f the disparity between the tw o Germanys is
shown by the relatively high proportion o f total
employment devoted to agriculture and
manufacturing in the GDR (58 percent) com
pared to that in the FRG (45 percent); indeed,
the GDR's current proportion o f employment in
agriculture and manufacturing is roughly iden
tical to that w hich prevailed in the Federal
Republic over 20 years ago.8
In the past, the large difference in living stan
dards between the tw o German states could be
maintained only by the GDR’s actions to close
its borders with the W est and prohibit virtually
all unauthorized movement o f labor, capital,
goods and services betw een East and West Ger
many. Since the border became permeable in
autumn 1989, m ore than 2000 East German
citizens have moved into West Germany daily;

Kirner (1990)). However, the Kiel Institute for World
Economics estimates that GDR labor productivity is only
about 35 percent of West German levels.
8See Gerstenberger (1990).

JULY/AUGUST 1990

as a result, betw een then and the first several
months o f 1990, the GDR’s population decreased
by about 500,000 persons.
This massive exodus was possible only
because the West German constitution grants
citizenship status to all East Germans. Among
other things, this allowed East Germans w ho
m oved to West Germany to obtain immediate
social benefits (unemployment benefits, retire
ment insurance and aid to the disadvantaged)
that are tied to West German income levels.
FRG unemployment payments, for example, are
about 68 percent o f West German net incomes;
in comparison, net incomes in the GDR are only
about one-third o f that in the FRG.9 The
substantial difference between West German
unemployment benefits and East German in
com e levels explains, in part, the massive migra
tion o f East German workers. However, these
specific incentives w ere eliminated on July 1,
1990, w hen the social community between both
states was established. From that date, all social
benefit payments to East Germans will be based
on East German income levels, not on those in
W est Germany.
The migration o f many skilled w orkers to the
FRG caused the econom ic situation in the GDR
to substantially deteriorate. Since November
1989, GDR industrial production and em ploy
ment has decreased and most East German
enterprises have been unable to fulfill their pro
duction plans. By the end o f April 1990, in
dustrial production was 4.5 percent below its
level one year before, and the number of
employed persons had fallen by 4.6 percent.
Shortages o f goods and services produced grow
ing social unrest in East Germany.

The Disparate Goals o f East Ger
mans and West Germans
Given the circumstances described above, the
goals o f the GDR population are quite evident:
They want to improve their relatively low stan
dard o f living as quickly as possible. Given the
disappointing econom ic results associated with
socialism, they w ere generally unwilling to ex
periment with a system part-way betw een
socialism and capitalism. They chose, instead,

Pensioners moving to West Germany received an average
pension of DM 1,121 (1988), more than twice the average
East German pension in Marks.
10ln fact, almost all West German economists as well as the
Bundesbank preferred a more gradual approach involving

FEDERAL RESERVE BANK OF ST. LOUIS

immediate and complete integration with the
Federal Republic o f Germany even though they
knew that it would require total restructuring
of the East German econom ic and political
systems.
The extreme political uncertainty in the GDR
after the Wall fell, the obvious desire o f the
East German population to unify both countries
and the massive outflow o f East Germans into
West Germany, w hich aggravated housing p ro
blems in the FRG, left little room for political
maneuvering in West Germany and little time to
find a solution that w ould satisfy both East and
W est Germans. Legally, o f course, West Ger
many could not oppose rapid unification; the
W est German constitution (Article 23 o f the
“Basic Law") explicitly permits the East German
states to join the Federal Republic without re
quiring the consent o f either the W est German
Government or its Parliament. This excluded a
variety o f possible partial solutions and gradual
approaches.10
Therefore, the main task facing West Ger
many was to design a unification strategy that
would restore the confidence o f East Germans
in the future prospects o f East Germany and, at
the same time, be compatible with the chief in
terests o f W est Germans. Consequently, the
debate in West Germany focused on the possi
ble costs o f the unification process. Among the
costs mentioned were:
1. The possible increase in the West German
inflation rate,
2. The prospects o f either higher taxes or
higher interest rates (due to increased FRG
borrowing) resulting from increased FRG
expenditures for East Germany, and
3. The wealth transfer from W est Germans to
East Germans associated with the replace
ment o f Mark-denominated savings and cur
rency in the GDR by DM-denominated m on
etary assets.
Once the actual conversion rates are chosen,
it is possible, albeit tentatively, to assess the im
pact o f monetary unification on matters that
concern the East and West Germans. The ten-

either flexible or fixed exchange rates between the two
currencies as an intermediate stage during the period of
economic transformation in the GDR.

tative nature o f the assessment is chiefly due to
the absence o f reliable data on the East German
econom y and to the simultaneity o f the
monetary and political integration with the
transformation o f the East German economy.
The short-term focus o f the analysis should not
lead to the impression that the risks and p ro
blems associated with unification o f the two
Germanys are either substantial or pervasive.
The strong overall consensus in both German
states is that the long-term prospects o f unifica
tion are positive and that East Germany has the
potential to repeat the “econom ic miracle”
achieved by West Germany from the 1950s to
the present.11

REAL SECTOR REFORM
Although this paper focuses primarily on
monetary unification, a brief discussion o f the
econom ic reform s necessary in the real sector
o f the GDR econom y is needed. The Gmu itself
will not improve the econom ic situation in East
Germany substantially; it can provide, however,
a sound monetary fram ew ork for an overall
restructuring o f the GDR’s econom ic and legal
system.
A cornerstone o f real sector reform in the
GDR will be the introduction o f free-market
pricing and production. Previously, most pro
duction and prices had been set by government
agencies in accordance with their central plans.
One consequence o f this system—as in many
other socialist countries—was that these prices
had been held essentially unchanged for years
despite changes in demand and cost condi
tions.12 For example, the GDR’s official index for
consum er prices has shown virtually no m ove
ment over the entire post-W orld W ar II era.
Moving to a market-based econom y will re
quire a number o f changes. First, the current
pricing structure is distorted by large subsidies
for some industries, especially food and energy
(their subsidies totaled M 50 billion in 1988,
about one-third o f total private expenditures in
the GDR) and heavy taxes on other industries,
primarily consum er durable goods (the tax total
ed M 43 billion in 1988). These distorting in
fluences on prices will have to be reduced.

Second, the central planning approach to pric
ing and production must be replaced by the
usual market mechanisms that determine these
decisions in free-market economies. Not only
must prices be set by market conditions rather
than by government bureaucrats, but also the
extensive system o f state-owned enterprises
must be privatized as well. In order fo r market
prices and wages to successfully provide the
signals for reallocating resources, the traditional
"soft budget constraint” o f state-owned enter
prises has to be replaced by the “hard budget
constraint” o f profits, losses and, if necessary,
strict bankruptcy laws.13
Third, the “Kombinate,” which are con
glomerates o f GDR firms that produce similar
products, have created an extremely high
degree o f horizontal concentration in the GDR
economy; this has contributed to the GDR price
inflexibility discussed previously. Consequently,
price reform requires that these "Kombinate” be
dismantled as soon as possible. However, even if
this is not immediately forthcoming, the in
troduction o f the freely convertible D-Mark will
create a m ore competitive environment because
it will significantly open up the GDR's econom ic
relations with West Germany and the rest of
the world.
Thus, while there are many open questions
concerning specific details o f how the divergent
legal systems will be reconciled and how
privatization will be achieved, there is wide ac
ceptance that these are the central elements of
real sector reform and that they will take
place.14

DETERMINING THE EAST
GERMAN-WEST GERMAN
MONETARY CONVERSION RATE:
PRINCIPLES AND PROBLEMS
As noted previously, the major controversy
over unification focused on monetary
unification—that is, h ow to determine the rates
at which GDR financial stocks and flows
denominated in Marks would be converted into
their appropriate D-Mark values. The main
reason for the intensive debate was that none

11See Institut der deutschen Wirtschaft (1990).

13See Sokil and King (1989).

12See the survey conducted by Commander and Coricelli
(1990).

14See e.g. “ Reform” (1990).

JULY/AUGUST 1990

o f the existing exchange rates betw een the
Mark and the D-Mark seemed relevant for
determining the D-Mark value o f GDR financial
stocks and flows after unification. In this
respect, the Gmu is quite different from the fo r
mation o f a monetary union between tw o or
m ore market economies. For instance, the ap
propriate conversion rate was easily determined
w hen Saarland, w hich had becom e independent
from Germany after the W orld W ar II, was
unified with the FRG in 1959. In this instance,
Saarland’s financial flows and stocks, which had
been denominated in French Francs prior to
unification, w ere simply converted to their DM
values at the prevailing market exchange rate
between the Franc and the D-Mark.
In the case o f Gmu, however, all existing ex
change rates w ere either highly distorted or
essentially devoid o f econom ic significance. The
same criticism applies to the m acroeconom ic
data that might otherwise have been used to
calculate an "equilibrium exchange rate” on the
basis o f the traditional exchange rate models.15

The Flaws with Using Existing Ex
change Rates f o r Conversion
After the fall o f the Wall, the one market ex
change rate betw een Mark and D-Mark was the
DM price for Mark bank notes that had been il
legally "exported” from the GDR to West Ger
many. However, this rate, which is shown in
figure 1, is not representative o f the underlying
fundamental relative price o f Marks in terms of
DMs for several reasons. First, it was subject to
speculative influences which made it very
volatile.16 Second, it reflected demands by East
Germans for certain goods (e.g., consum er elec
tronics and coffee) that w ere highly taxed in the
GDR; table 2 shows that the Mark prices o f these
products in the GDR w ere about five times
higher than their D-Mark prices in West Ger

15See Frenkel and Goldstein (1986), Williamson and Miller
(1987).
16lt varied from 16:1 (November 17, 1989) to 3:1 after the
definitive conversion rate for non-GDR residents had
become public.
17See Wolf (1985b, pp. 215).
18See Cornelsen and Kirner (1990).
19Until 1989, this rate was also used for the “ forced ex
change” (“ Zwangsumtausch” ) of DM 25 for West Ger
mans who wanted to visit East Germany. From the begin
ning of 1990, West German travelers could exchange DMarks at a 1:3 rate against Marks.

FEDERAL RESERVE BANK OF ST. LOUIS

many. Third, the arbitrage (flow) o f subsidized
East German products to the West has remained
relatively weak due to transaction costs and
trade restrictions.
Another possible candidate for the "true ex
change rate” to use for conversion purposes
might have been the so-called “Devisenrentabilitaet” (foreign exchange profitability) o f GDR
exports in terms o f their DM equivalent. This
rate is calculated by dividing the Mark value of
the aggregate GDR exports by their DM revenue
when they are sold to West Germany. In 1989,
this ratio, w hich was used by the GDR govern
ment for all internal conversion calculations,
was 4.4 Marks per DM. Again, however, this
ratio does not indicate what the market ex
change rate would be. First, the domestic prices
o f many GDR export products w ere artificially
high due to taxes imposed by the GDR; conse
quently, the numerator o f the ratio is heavily
influenced by tax policy, not econom ic values.
Second, export decisions w ere made by the GDR
government primarily to obtain foreign ex
change to finance its imports. It is evident that
this non-market allocation process, which is
typical o f centrally planned econom ies,17 is not
representative o f market-based trade; among
other consequences, it can lead to exports with
very low profitability.18
A third alternative is the official 1M:1DM ex
change rate set in the past by the East German
Government.19 Like all such official exchange
rates established in socialist countries, this was
an arbitrary rate used primarily as an accoun
ting unit w hich embodies no useful econom ic
information relevant to determining the rate to
use for Gmu conversion purposes.20 All foreign
exchange transactions w ere conducted at flexi
ble (implicit) exchange rates w hich w ere the
ratios o f the internal Mark price to the world
market DM price o f each product.21

20The same criticism applies to the exchange rates agreed
to by the East and West German governments in
December 1989 when they established a fund to exchange
bank notes for travel: Each East German citizen was entitl
ed to purchase up to 100 DM at a 1DM:1M rate and an
additional 50 DM at a 1DM:5M rate.
21See Wolf (1985b).

Figure 1
Exchange Rate for Mark Banknotes (M per DM)
Daily values for bid and ask prices
October 2, 1989-April 4, 1990
Percent

Percent

1989

The Problems with Using
Exchange Rate Models to Deter
mine the Conversion Rate
The lack o f reliable market exchange rates to
use in setting the Gmu conversion rate might
tempt one to consider using one or m ore tradi
tional exchange rate models to calculate an ap
propriate "equilibrium exchange rate.” Several
approaches to exchange rate determination ap
pear in the international econom ics literature;

1990

among the alternative approaches are purchas
ing pow er parity (PPP), structural exchange rate
models and the so-called "underlying balance ap
proach’’.22
A detailed discussion o f these approaches is
beyond the scope o f this paper. However, they
have limited usefulness in the Gmu context
because they w ere developed primarily to ex
plain exchange rate fundamentals in economies
with open financial markets. All variants o f PPP,

22See, for instance, Frenkel and Goldstein (1986).

JULY/AUGUST 1990

Table 2

Consumer Prices of Selected Goods and Services in the GDR
and the Federal Republic of Germany (1985)_______________
Good/Service
Potatoes (5 kg)
Tomatoes (1 kg)
Rye Bread (1.5 kg)
Beef (1 kg)
Chocolate (100 g)
Coffee (250 g)
Jeans (men’s)
Brown Coal (50 kg)
Radio/Cassette Recorder
Color TV
Rent (1 bedroom)
Electricity (75 kwh)
Haircut (man)
Railway Ticket (50 km)

Price in
(M) GDR
M4.05
4.40
0.93
9.80
3.85
25.00
135.00
3.51
1,160.00
5,650.00
75.00
7.50
1.90
4.00

Price in
(DM) FRG
DM5.32
2.10
4.54
19.45
0.89
5.25
59.90
19.40
199.95
1,199.00
390.00
29.30
11.25
9.20

M price as a percent
of the DM price
76
210
21
50
433
476
225
18
580
471
19
26
17
43

SOURCE: Materialien zum Bericht zur Lage der Nation, 1987, pp. 513, 516, 732-735.

for example, rely on the “law o f one price”
holding in integrated and competitive markets.23
The relative version o f PPP, developed by
Gustav Cassel to determine equilibrium ex
change rates after W orld W ar I,24 relates the re
quired exchange rate adjustment betw een the
currencies o f tw o countries with different infla
tion rates. However, this procedure requires the
existence o f an unbiased base period in the
past, a condition which clearly is not met in the
GDR setting.
The absolute version of PPP avoids the base
period problem by defining an equilibrium ex
change rate as the ratio o f the price o f a stan
dard market basket o f goods in one currency to
the price o f the same basket in another curren
cy. Thus, the consumption basket o f an average
GDR household could provide one basis for ab
solute PPP calculations o f an appropriate
Mark/D-Mark exchange rate. In 1985, for exam
ple, the goods and services w hich made up this
basket (excluding rents) had a DM equivalent
value w hich was 10 percent higher than their

23See Cassel (1918, p. 413): “ As long as anything like free
movement of merchandise and a somewhat comprehen
sive trade between the two countries takes place, the ac
tual rate of exchange cannot deviate very much from this
purchasing power parity.”
24See Dornbusch (1987).

http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

Mark price.25 If w e assume that the GDR price
level has remained unchanged while the market
basket’s DM equivalent value has risen at the in
flation rate in West Germany since 1985, the
price differential w ould be about 15 percent in
1989. Thus, an absolute PPP exchange rate based
on consum er prices (for a given market basket
o f goods and services) w ould be 1.15DM:1M or
a 1DM:0.9M conversion rate. However, due to
high subsidies and the existence o f a "monetary
overhang” (explained later in the paper), in
dicative o f an excess demand for goods in the
GDR, the econom ic relevance o f such calcula
tions is severely limited.26
Because most structural exchange rate models
(e.g., those based either on the monetary ap
proach with fixed or flexible prices or on the
portfolio balance approach) require either short
term or long-term PPP to hold, they are beset
with the same conceptual drawbacks as the sim
ple PPP calculations already discussed. In addi
tion, they presume that people are able to
engage in unlimited arbitrage betw een financial
^Including rents the difference was 25 percent.
26An alternative PPP measure, the “ Devisenrentabilitaet,”
yields an equilibrium exchange rate of 1DM:4.4M.
However, the problems of this specific measure have
already been discussed.

markets in the respective countries; this condi
tion did not exist in the GDR prior to the Gmu.27

W H AT FINANCIAL STOCKS AND
FLOWS WERE CONVERTED?
In order to clarify the issues associated with
the Gmu, this section presents a brief discussion
o f the main items whose values w ere converted
from Marks to DMs in the process o f monetary
unification. Throughout the paper, a distinction
will be made between financial stocks and
financial flow s.

Conversion o f the Stock o f GDR
Monetary and Financial Assets and
Liabilities
The stock o f financial assets in the GDR is
represented by the consolidated balance sheet
o f its banking system presented in table 3. In
contrast to how these accounts would be drawn
up in the United States, the loans and liabilities
o f the central bank ("Staatsbank”) must be add
ed to the state-owned commercial banks on a
consolidated basis. As is typical in most central
ly planned economies, the GDR did not permit
direct financial transactions betw een enterprises
and households ("dichotomized money sup
ply”).28 Therefore, this consolidated balance
sheet presents a comprehensive picture of the
stock o f all financial assets and liabilities in East
Germany.
The principal items on the asset side o f the
banking system w ere loans to state-owned
enterprises, housing (chiefly state-owned), direct
credits to the government, and claims on for
eigners. Loans to households w ere negligible,
making up less than 1 percent o f all bank assets.
In contrast, such loans represent about 23 per
cent o f bank assets in the Federal Republic.
Savings o f private households are the
important liability of the GDR’s banking
The consolidated balance sheet prior to
Gmu also shows a considerable amount

most
system.
the
of

27This also excludes the application of the “ underlying
balance approach to exchange rate assessment,” which
was developed by the International Monetary Fund. Accor
ding to Williamson and Miller (1987, p. 10), who have
elaborated this method, the “ fundamental equilibrium ex
change rate” is defined as the rate “ which is expected to
generate a current account surplus or deficit equal to the
underlying capital flow over the cycle, given that the coun-

foreign liabilities. However, the bulk o f these
foreign liabilities (M 96 billion) was simply an
accounting item ("Richtungskoeffizient”) arising
from the GDR’s practice o f valuing its foreign
assets and liabilities at a 1DM:4.4M exchange
rate rather than at its “official” 1DM:1M ex
change rate. After Gmu, o f course, the DM
denominated foreign debt o f the GDR will be
valued at its face value. The revaluation o f
foreign assets and liabilities also reduced the
amount o f external claims (from M 45 billion to
DM 36 billion) and the debt o f the government
(from M 61 billion to DM 12 billion).
After revaluation o f foreign assets and liabili
ties and the overall 1DM:2M conversion o f all
domestic items, except for the limited 1DM:1M
conversion o f savings, the liabilities o f the GDR
banking system (DM 246 billion) exceeded its
assets (DM 220 billion) by DM 26 billion. This
difference was created by the asymmetric con
version o f the left and the right side o f the con
solidated balance sheet produced by an effective
1DM:1.4M conversion rate o f total savings. To
equilibrate their balance sheets, East German
banks w ere given interest-bearing government
assets from an equalization fund established by
the GDR for this purpose. Except for this fund,
the post-Gmu balance sheet shows that the net
bank debt o f the actual GDR government sector
is relatively small (DM 7 billion).

Conversion o f Financial Flows
The 1DM:1M conversion rate for financial
flows determined the D-Mark equivalent for
Mark-denominated wage and rent contracts in
existence prior to July 2, 1990. Although these
contracts can (and undoubtedly, will) be renego
tiated after this date, a legal transformation of
existing contractual obligations from their pre
vious Mark payments into DM payments (“rekurrenter Anschluss”) was required.29 For all
new contracts and those old contracts for which
payments could be adjusted immediately or on
short notice, the conversion rate was irrelevant.
GDR pensions w ere treated somewhat differ-

try is pursuing ‘internal balance’ as best as it can and not
restricting trade for balance of payments reasons.”
28See Wolf (1985a).
29Poole (1990) emphasizes, on purely economic grounds,
that “ any attempt to convert prices of goods and services
from OM (Ostmark) to DM through central direction can
only cause great difficulty.”

JULY/AUGUST 1990

Table 3

Consolidated Balance Sheet of the Banking System of the GDR as of May 31 1990
Assets
1. Lending to domestic
borrowers
Total
Government
of which
Lending in connection
with the revaluation of
external liabilities
Claims on the government
from the initial provision
of notes and coins in 1948
Enterprises
Housing sector
Individuals (excluding
housebuilding loans)

2. External claims
(a) CMEA countries
(b) Western industrial and
developing countries

3. Participations

4. Other assets
Total
Balancing item
Total

DM
M
Conver
billion sion rate billion

Liabilities

M
Conver
DM
billion sion rate billion

397.4
60.6

1. Deposits from domestic
non-banks
Total
Government

249.9
10.8

31.2
4.9
231.7
102.6
2.5

45.0
17.4

—

2:1*

—

—
115.8
51.3

2:1

1.3

—
—

3.1

36.3
8.7
27.6

1:1

2:1

1.1

1.5

446.6

—

219.6

—

26.4

446.6

1.81:1

—

2:1

156.6
5.4

—

2:1
2:1

—

27.6

1.1

180.7
12.3

246.0

Enterprises
Individuals
Giro and savings
balances of
individuals
Residents
Non-residents
Life insurance

57.0
182.1

165.6
2.3
14.2

2. External liabilities
152.5
(a) CMEA countries
1.1
(b) Western industrial and
developing countries
55.0
(c) Provisions for external
liabilities (“ Richtungskoef
fizienten” )1
96.4
3. Currency in circulation
(excluding the banks’ cash
holdings)

13.6

4. Accumulated profits/
reserve funds/guarantee
funds
5. Other liabilities
Total
Balancing item
Total

2.05:1'

—

27.8
123.4

1.44:1“ 115.2
2.05:1'
1.1
2:1
7.1

_
—

55.6
0.6
55.0

—

2:1

6.8

23.4

1:1

23.4

7.2

2:1

446.6
—
446.6

—

—
1.81:1

3.6
246.0
—
246.0

1These are actually liabilities of the banking sector to the government, which might also be shown in liabilities item 1. In
this table, they are shown in connection with the external liabilities of the GDR because the item may also be regarded
as a kind of “ value adjustment” for the external liabilities, which are otherwise put at too low a value in GDR Mark.
’ Conversion of a balance of M 24.5 billion, which results after offsetting the lending from the revaluation of external
liabilities (M 31.2 billion) and claims arising from the initial provision of notes and coins in 1948 (M 4.9 billion) against
provisions for external liabilities (“ Richtungskoeffizienten” ) to the same amount.
‘ External claims (assets item 2 (b)) and external liabilities (liabilities item 2(b)) are here still valued at the accounting
rates of the end of 1989. The market rates of June 30, 1990 are to be used for the final conversion. The amounts
shown will then presumably be somewhat lower (liabilities item 2(b) also includes foreign currency deposits from
residents).
'Conversion rate for balances of non-residents arising on and after January 1, 1990 3:1, otherwise 2:1.
dConversion rate of 1:1 for M 2,000 x 3.2 million = DM 6.4 billion; M 4,000 x 10.1 million = DM 40.4 billion and M
6,000 x 3.0 million = DM 18.0 billion yields a total of DM 64.8 billion; the remainder (M 100.8 billion) was converted at
a rate of 2:1.
'Balances as at the end of 1989 amounting to M 2.1 billion were converted at 2:1, the remainder at 3:1.
'Partly offset against lending in connection with the revaluation of external liabilities (M 31.2 billion) and claims arising
from the initial provision of notes and coins in 1948 (M 4.9 billion); the arithmetical remainder (M 60.1 billion) was used
to reduce the balancing item.

FEDERAL RESERVE BANK OF ST. LOUIS

ently. As already mentioned, the social union
adjusted the GDR pension system to make it
consistent with West German standards; among
other things, this meant that the DM value o f
GDR pensions was not less than their previous
Mark value.

Implications o f the Conversion
Rate f o r Price Stability in
Germany
For West Germans, w ho traditionally have
placed a very high social value on price stabili
ty, concern over the implications o f the Gmu on
the inflation rate played a predominant role in
the choice o f the conversion rate. The existence
o f an excess supply o f money, which, by
Walras’ Law, reflects rationing on goods and
labor markets,30 is a widely acknowledged o c
currence for centrally planned economies, in
cluding the GDR.31 Many observers expected
that a flat 1M:1DM conversion o f the East Ger
man m oney stock would produce a rise in the
price level and, hence, a transitory increase in
the measured rate o f inflation for the integrated
German currency area after the Gmu.

about 13 percent o f W est Germany’s GNP, or
some measure o f potential output determined
by relative labor productivity estimates. This lat
ter method32 uses the proportion o f the East
Germany population to West German population
(about 26 percent) and the estimated average
GDR labor productivity relative to that in West
Germany (about 50 percent) to obtain a relative
GDR potential production o f about 13 percent,
w hich is identical to the relative GNP differen
tial noted above. Use o f a lower estimate o f the
GDR productivity differential, for instance, the
30 percent estimate o f the Kiel Institute for
W orld Economics, reduces the GDR's potential
production to only about 10 percent o f that in
the FRG.

The expected impact o f monetary unification
on the German inflation rate can be determined
as follows: First, estimate a hypothetical GDR
money stock that would be compatible with
stable DM prices in the GDR; second, compare
this hypothetical m oney stock with the actual
DM money stock o f the GDR after conversion.
If the actual money stock exceeds the hypotheti
cal one, the conversion could produce a tem
porary increase in inflation in both Germanys;
otherwise, the conversion does not have infla
tionary implications.

This approach can be used to determine the
”non-inflationary" conversion rates for different
monetary aggregates; various estimates are
shown in table 4. Applying the West German
ratio between potential output to the stock of
currency yields a conversion rate o f about
1M:1DM for East German currency holdings. To
calculate a non-inflationary M l money measure
for the GDR requires determining the "m o
neyness” o f the various GDR deposit categories.
If the "Spargiro” (M 69.0 billion) and deposits of
enterprises are essentially demand deposits and
the "Buchsparen” (M 90.7 billion) are essentially
the same as traditional savings deposits included
in M3, the pre-Gmu GDR M l m oney stock was
about one-third of that in West Germany. Thus,
the non-inflationary conversion rate for the
GDR’s M l m oney stock would lie in the
1DM:2.4M to 1DM:3.3M range. Using the M3
money stock, the non-inflationary conversion
rate would lie within 1DM:1.5M and 1DM:2M.33

To accomplish the first step requires
calculating the East German m oney demand
after the Gmu. To do this, o f course, one has to
estimate the velocity o f m oney and potential
nominal production o f the GDR econom y. The
following estimates are based on the assumption
that both relative and absolute DM prices in the
GDR as well as the GDR’s velocity o f m oney will
be identical to their W est German counterparts
after unification. GDR potential production can
be estimated either by using its GNP, w hich is

Comparing East and West German money
stock measures is always problematical because
there is a much wider spectrum o f financial op
portunities available to West German investors.
Their savings in long-term time and savings
deposits, bank savings bonds and other financial
instruments issued by banks, which are called
"monetary capital” and not included in M3, are
larger than the M3 m oney stock. Adding these
financial assets to the West German M3 money
stock yields a liquidity stock measure (L).

30See Commander and Coricelli (1990), p. 3.
31See Sokil and King (1989).
32lt which was suggested by the President of the Kiel In
stitute for World Economics, Horst Siebert.

33ln West Germany, the money stock M3 includes currency
in circulation (excluding banks’ cash balances), sight
deposits, time deposits with a maturity of less than four
years and savings deposits at statutory notice.

JULY/AUGUST 1990

Table 4

Conversion Rates on the Basis of a Non-lnflationary Money Stock
for the GDR (1989)_______________________________________

Currency
M14
M35
L<s

Actual values

Non-inflationary
values for the GDR

GDR'
FRG
(M billion) (DM billion)

A2
B3
(DM billion)

17.0
146.6
252.0
252.0

146.9
450.6
1255.5
2738.3

19.1
59.9
167.0
364.2

14.7
45.1
125.6
273.8

Conversion rates
A

1:0.9
1:2.4
1:1.5
1:0.7

1:1.2
1:3.3
1:2.0
1:0.7

’ Values for the GDR include deposits of enterprises and households with the banking system.
2Assuming that GDR potential output is 13.3 percent of FRG potential output.
3Assuming that GDR potential output is 10 percent of FRG potential output.
4Currency in circulation and domestic non-banks’ sight deposits.
5M1 plus domestic non-banks' time deposits and funds borrowed for less than 4 years plus
savings deposits at statutory notice.
6M3 plus saving deposits at agreed notice, long-term time deposits, bank savings bonds and
other financial instruments held by private households and enterprises with banks.
SOURCE: Deutsche Bundesbank, Monatsberichte, Jahresbericht 1989 der Staatsbank der DDR.

In contrast, savings deposits and currency are
the only financial stores o f value available in
East Germany.34 Thus, for East Germany, L and
M3 are identical. Using the L measure, the noninflationary conversion rate would be about
1DM:1M. However, in order to make the con
verted East German L measure truly com
parable to the West German L, about 50 per
cent o f East German savings would have to be
“frozen” for about four years.

in a range between 1DM:1.5M to 1DM:2M.
While the latter value was recom m ended by the
Bundesbank, the political compromise reached
between the two governments led to an average
conversion rate o f about 1DM:1.7M. While the
estimated non-inflationary conversion rates
shown in table 4 are subject to considerable
uncertainty, the final conversion program
chosen for the Gmu seems unlikely to produce
any substantial inflationary impact on prices in
the new DM currency area.

As table 4 shows, an assessment o f the infla
tionary impact associated with the Gmu depends
on which monetary aggregate is regarded as the
one linked most closely to inflation. Most
econom etric estimates for the Federal Republic
show a very stable relationship between the
m oney stock, M3, and inflation (and nominal
GNP); this is the reason why the Bundesbank
uses M3 as its main inflation indicator and as its
central intermediate monetary policy target.35
Taking M3 as the benchmark money stock for
non-inflationary purposes suggests that the con
version rate for the GDR money stock should lie

The Effect o f the Velocity Assump
tion on the Non-lnflationary Con
version Estimates

34ihis aspect was emphasized by the East German Central
Bank (“ Staatsbank” ) in an official statement of April 3,
1990.

FEDERAL RESERVE BANK OF ST. LOUIS

The non-inflationary conversion calculations
described above assumed that the velocity of
the appropriate m oney stock in the GDR is iden
tical to that in the FRG. Some observers in the
Federal Republic have argued that countries
with higher per capita income levels have dif
ferent monetary velocities from those in lessdeveloped countries. Figures 2 and 3 show the
results of a cross-country analysis comparing

35See Deutsche Bundesbank (1989a), Schlesinger and
Jahnke (1987).

Figure 2
Velocity of M1 and GNP per Capita for OECD
Countries
Velocity

Velocity

5000

10000

15000

20000

25000

GNP per capita

per capita nominal incomes and velocities for
the M l and M3 m oney stocks in OECD coun
tries in 1987. The figures indicate that per capi
ta incom e has no significant influence on the
velocity o f money. However, the marked intercountry differences in the velocity o f m oney
serves as yet another reminder that the noninflationary GDR m oney stock calculations are
subject to considerable uncertainty.

Implications o f the Gmu on the
“Competitiveness” o f East German
Enterprises
The potential impacts o f the Gmu on the
unemployment rate in the GDR and its
econom ic growth prospects w ere another im

portant determinant o f the conversion rate.
While West Germans w ere concerned about the
possible fiscal costs o f unemployment payments
to East Germans, the East Germans, as noted
earlier, w ere primarily interested in the p ro
spects for employment and for raising their
standard o f living as quickly as possible. These
prospects depend fundamentally on how com
petitive the GDR firms will be after the central
planning process is dismantled and the econom y
o f the GDR is opened up to w orld markets.
While it is evident that the conversion o f enter
prise debt has a direct impact on the financial
structure and capital costs o f firms in East Ger
many, the implications o f the conversion rate
for wages in the GDR are m ore difficult to
evaluate.

JULY/AUGUST 1990

Figure 3
Velocity of M3 and GNP per Capita for OECD
Countries
Velocity
2.5

Velocity
2.5

5000

10000

15000

20000

25000

GNP per capita

The Impact o f the Conversion o f
Enterprise Debt
The 1DM:2M conversion rate for financial
stocks determines the debt burden and interest
payments of enterprises after the unification
process.36 It has important consequences for the
costs o f capital and for the projected privatiza
tion o f East German firms. The latter, an essen
tial element o f the process o f econom ic
transformation, requires that the firms to be
privatized must have a positive net worth. For
enterprises that will remain under state ow ner
ship, the ratio o f their DM equity to their total
36Again, the conversion rates which were put forward in the
debate varied widely, ranging from a 100 percent debt
relief which was recommended by the five leading German

FEDERAL RESERVE BANK OF ST. LOUIS

DM assets after conversion will play a key role
in determining whether they can survive with a
"hard budget constraint,” i.e. without subsidies
from the government.
Because there is no data on the debt-equity
ratios o f East German enterprises, it is difficult
to assess the implications o f the 1DM:2M con
version rate on their financial situation and on
their interest payments. To get a rough estimate
o f the sustainability o f alternative debt burdens,
however, the proportion o f GDR potential out
put to FRG potential output can be used; as
already mentioned, estimates vary between 10
economic research institutes in their report of April 12,
1990, over the 1:2 rate, which was proposed by the
Bundesbank, to a full 1:1 conversion.

and 13 percent. According to Bundesbank (1989)
statistics, the net financial debt o f West German
enterprises (excluding housing and the financial
sector) was DM 681.5 billion and the book value
o f their non-financial assets totaled DM 1096.5
billion in 1988. The FRG figures indicate that a
1DM:1M conversion for the debt o f GDR enter
prises w ould have produced a relatively large
DM 175 billion net debt (see table 3), about 26
percent o f the West German level.37 If East Ger
man firms’ nonfinancial assets are w orth about
10 to 13 percent38 o f that for West German
firms, the right side o f their balance sheets
would have exceeded the left side (DM 110-140
billion) by huge amounts, even if West German
firms' balance sheets contain extensive hidden
reserves. Without further debt reduction,
privatization o f virtually all East German firms
would have been impossible. According to West
German bankruptcy law, w hich requires
bankruptcy proceedings if a firm has negative
net worth, most East German firms would have
had to be declared bankrupt.
Of course, an outright cancellation o f all GDR
enterprise debt would have avoided these p ro
blems. However, this "solution” was dismissed
for tw o reasons: First, firms with permanent
net debt levels are com m on in all industrialized
countries; second, it w ould have led to a huge
increase in the government debt as described
later in this paper. The debt reduction39 achiev
ed by the 1DM:2M conversion rate places the
average ratio o f equity to assets for GDR enter
prises in a range between 20 and 37 percent,
which should allow the privatization o f at least
some firms. By comparison, the average equity
to asset ratio is about 20 percent in West Ger
many and 50 percent in the United States.40
Because the results are quite sensitive to the
estimate o f the value o f real assets in the GDR,
it is difficult to assess whether the interest
burden o f East German firms will be similar to
the West German enterprise sector or whether
it will be significantly higher. In addition, it is
not yet clear whether East German firms will
have to pay market-determined interest rates on
their debt after monetary unification.

37A high debt burden is regarded as a typical concomitant of
the central planning mechanism, which gives enterprises
automatic bank credits inducing large hoardings of inven
tories or camouflaging cost overruns, waste and sales in
the black market (Grossman 1989, p. 31).
380n the basis of a Cobb-Douglas production function and
assuming an identical elasticity of output with respect to

W A G E C O N V E R S IO N
The second determinant o f East German
firms’ post-conversion competitiveness are the
DM wages they will have to pay. While neither
the GDR nor the FRG government should deter
mine wages after the transition to a market
economy, their treaty established a wage con
version rate to define the financial obligations
o f existing contracts for the time immediately
after July 2, 1990. However, the actual conver
sion rate chosen has implications for wage
levels and competitiveness only if nominal DM
wages in the GDR after conversion are inflexible
dow nw ard and if initial DM wages are set “too
high” com pared with labor productivity.
These considerations would have called for a
conversion rate that reduced average wages
below the level indicated by the GDR's average
productivity. The advantage o f this low starting
level for wages is that it would have allowed
w orkers and firms in East Germany to
renegotiate their contracts more easily after
Gmu. This w ould have enabled them to
establish a wage structure m ore closely mat
ching sectoral productivity differentials than the
prior GDR wage structure, in w hich wages
w ere relatively uniform regardless o f productivi
ty differences.
To evaluate the competitiveness o f East Ger
man firms after a 1DM:1M wage conversion,
their labor productivity relative to that in com
parable West German firms must be compared
with their relative DM wages. These com
parisons would require information on the pro
ductivity o f individual firms or, at least, in
dividual sectors in the GDR after July 2, 1990.
Unfortunately, such sectoral data are not
available at all; moreover, estimates o f labor
productivity in the GDR after the transition to a
market econom y are very difficult to determine
ex ante. However, the experience following the
West German currency reform in June 1948
shows that large productivity gains can be
achieved rather quickly; these gains arise from
better incentives associated with the market
process and increased availability o f inputs. In

capital as in West Germany, Alexander and Gagnon (1990)
estimate the level of the East German capital stock to be
10.4 percent of the West German capital stock.
39A strategy of recapitalization is now also suggested for
other Eastern European countries. See Hinds (1990, p. 44).
40See Bank for International Settlements (1989, p. 86).

JULY/AUGUST 1990

the GDR, where such incentives are lacking,
shortages o f specific inputs are often reported
to have led to significant decreases in output
and productivity.41
On the other hand, the far-reaching restruc
turing o f production processes will not be possi
ble without some tem porary output disrup
tions.42 If these positive and negative effects
roughly cancel each other in the first few
months after conversion, the GDR’s productivity
should reach about 50 percent o f that in West
Germany, w hich is consistent with past
estimates made by the Deutsches Institut fuer
Wirtschaftsforschung.
Before the conversion took place, the average
monthly salary o f a w orker was M 1250 in the
GDR and DM 3192 in West Germany. With the
1DM:1M conversion o f the initial nominal
wages, monthly wage costs (including
employers’ contributions to social security) for
East German firms would be about 37 percent
o f West German wages.43 Thus, the average DM
wage level in the GDR after the conversion is
not so high relative to the average productivity
differential betw een GDR and FRG w orkers that
it would preclude future wage negotiations.
However, the initial wage differential cannot
be held constant by the government after the
Gmu. Therefore, the medium-term outlook for
employment as well as for foreign and West
German investment in the GDR will depend
mainly on the rate o f subsequent wage in
creases in the GDR. If these exceed the growth
o f productivity in the GDR, employment and in
vestment in GDR firms will fall.

41According to a survey of the Institut der deutschen Wirtschaft, about one third of all GDR employees had to sus
pend their work for two or more hours per day because of
shortages and defective machines.
42ln the past, all decisions on investment, production and
sales were made by the central planning bureaucrats;
managers of firms were mainly responsible for technical
operations.
43The 1DM:2M conversion rate proposed by the Deutsche
Bundesbank differs less from the 1DM:1M rate chosen
than one might assume at first glance. In its calculations,
the Bundesbank assumed that all subsidies would be
removed before conversion, requiring an increase in Mark
wages of about 25 to 30 percent to compensate for this ef
fect. If these new Mark wages were then converted at a
1DM:2M rate, the effective conversion rate between initial
East German Mark wages and DM wages after the Gmu

FEDERAL RESERVE BANK OF ST. LOUIS

Implications o f the Conversion
Rate f o r GDR Real Incom es and
Labor Migration
Because the unification process has been
driven primarily by the desire o f East Germans
to improve their standard o f living, the effects
o f monetary unification on the FRG-GDR real in
com e differential w ere intensively discussed in
both East and West Germany. However, since
wages will be renegotiated after the Gmu,
monetary unification will have only a short-term
impact after July 2, 1990.
An estimate o f the change in East German
real incomes resulting from the Gmu can be
calculated by assuming that nominal wages in
the GDR will remain constant after conversion
and after the various subsidies are abolished.
The basis for comparing pre- and post-Gmu real
incomes in the GDR is the consumption basket
of an average GDR household that was discuss
ed earlier.
The abolition of trade restrictions and
product-specific taxes and subsidies will produce
price structures and a price level in East Ger
many similar to that in West Germany. Thus,
the Gmu will cause a "one-shot" consum er price
increase o f about 15 percent for the unchanged
GDR consum er goods basket.44 In addition, the
increase in social security contributions, due to
the introduction o f the West German social
security system into East Germany, will reduce
the average net monthly incom e o f an East Ger
man w orker from M 1050 to DM 983 after
unification. Together with the one-shot price ad
justment in consum er goods, real incomes in
the GDR will be reduced by about 21 percent.45

would have been about 1DM:1.2M. Including the
employer’s contribution to social security, the initial labor
costs in the GDR would have been about one third of the
West German level if the 1DM:2M conversion rate had
been used.
■^This change from Mark prices to D-Mark prices has no ef
fect on the overall German inflation rate which is measured
on the basis of the DM equivalent of goods and services.
45These orders of magnitude show that conversion rates for
GDR incomes considerably above 1DM:1M, for instance,
1DM:2M or 1DM:3M, would have strongly increased the
movement of workers from East to West Germany. Assum
ing constant consumption patterns, a 1DM:2M (1DM:3M)
rate would have reduced GDR real incomes by 57 percent
(70 percent) compared to their pre-Gmu levels.

The above calculations overstate somewhat
the negative welfare implications o f unification.
Households will adjust to the price changes by
purchasing more o f the goods with relatively
cheaper DM prices and less o f those whose
prices rose m ore because they had been heavily
subsidized in the past. The prospective adjust
ment o f the previous Mark price structure to
the DM price structure is indicated in table 2.
As no detailed data on consumption patterns of
East Germans are available, the quantitative
relevance o f this substitution effect is difficult
to evaluate.46 The same comment applies to the
positive welfare effects attributed to prospective
quality improvements in available consumer
goods; after the Gmu, East Germans will be able
to buy W est German products which, on
average, are o f better quality than their East
German counterparts.
On balance, the real incom e o f East Germans
and the real income differential between East
and W est Germany will remain essentially un
changed immediately after the Gmu, with real
net incomes in the East about 50 percent lower
than in the West. This result reflects the fact
that monetary unification by itself can only
create a fram ework for real sector reform.
Significant improvements in East German living
standards will only be generated by better
allocation o f their resources and increased in
vestment. Thus, the incentive for East German
workers, especially skilled workers, to move to
the Federal Republic o f Germany remains at
least as strong as it was before the Gmu.
However, the prospect o f a rapid and wideranging restructuring o f the GDR econom y has
already im proved the motivation o f East Ger
mans to remain in the GDR and contribute to
its econom ic recovery. The num ber o f GDR
citizens moving to the FRG, which reached a
monthly peak o f 133,000 in November 1989, fell
to only 19,000 by May 1990.

The Gmu Wealth Transfer Between
East and West Germany
The Gmu will result in a wealth transfer from
West Germany to East Germany.47 The
mechanisms and the quantitative effects o f this
wealth transfer, however, remain uncertain.

46An analysis of the Deutsches Institut fuer Wirtschaftsforschung comes to the result that private households
can compensate the price effect by reducing their con
sumption of foods by 10 percent.

To examine this issue, even if a definitive
answer is not forthcoming, it is useful to start
with an example o f a hypothetical currency
unification between tw o market economies, e.g.,
between France and West Germany. Suppose
that the DM is to be replaced by the Franc and
that the current market exchange rate
(1DM = 3FF) will be used to convert all DM
financial and real stocks and flows in their
Franc equivalent. In this case, there is no
transfer o f real wealth; simply multiplying all DMark prices by three does not reallocate wealth
within Germany nor between France and the
Federal Republic.48 Redistribution o f wealth bet
w een creditors and debtors in both countries
could occur only if that currency unification
leads to unexpected changes in inflation and if
some debtors or creditors had been expecting a
parity adjustment. In this case, the net transfer
between the tw o countries w ould then be deter
mined by creditor/debtor relations between
France and Germany and by the direction of
the change in expectations.
In the Gmu case, there is no wealth transfer
between GDR residents and West Germans due
to unexpected exchange rate variations because
there w ere virtually no financial linkages bet
ween individuals or enterprises in both coun
tries prior to the Gmu. The asymmetric conver
sion o f assets and liabilities, however, transfers
GDR debt to the FRG (see shaded insert). Before
the Gmu, the aggregate wealth o f the East Ger
man econom y consisted o f its aggregate real
assets and its aggregate net foreign claims
(debts); domestic financial claims and liabilities
simply cancel out in the aggregation process.
Because monetary unification has no implica
tions for the GDR’s foreign claims and liabilities,
it can increase the wealth o f the GDR only if its
domestic financial assets, which are mainly sav
ings, are converted at a higher rate than its
domestic liabilities.
In a closed econom y, even this asymmetric
conversion would have no aggregate effect on
the econom y’s wealth; the gap between assets
and liabilities in the consolidated banking
system would have to be filled by government

47See, for instance, Poole (1990).
" I t is assumed that a procedure for an equitable distribution
of seignorage can be devised.

JULY/AUGUST 1990

Mechanics of the Wealth Transfer Effected
by Gmu
The total wealth (W,) o f each econom ic
agent in the GDR is the sum o f its real
wealth (RW,) plus its net monetary wealth
(NM,):

Canceling all intra-GDR financial claims and
liabilities (RC GDR = R LGDR) yields total wealth
before Gmu:
(4a) RW = RRW + R(CF - LF)

(1) W, = RW, + NM,
Net monetary wealth is the sum o f claims on
other GDR residents (C,GDR) and on foreigners
(C/) minus liabilities against GDR residents
(LjGI5R) and foreigners (L;F):

The asymmetric conversion o f intra-GDR
financial liabilities and claims (RC ,GDR> RL GDR)
requires the creation o f an equalization item
(E) which leads to:
(5) R C GI>R = RL GDR + E

(2) NM, = C GDR + C,F - Li - L,r
Substituting (2) in (1) yields:
(3) W, = RW, + (C GDR - L™11) + (C,F - LiF)

If this equalization item is regarded as a
financial liability o f West Germany, (5) can be
substituted in (4):
(6) RW = RRW + R (CF - LF) + E.

Total wealth o f the GDR is the sum o f in
dividual total wealth:
(4) RW = RRW + R(CGDR - L GDR)
+ R(CF - L,F)

Comparing 4a and 6 shows that the wealth
transfer, which is directly associated with
Gmu, depends on the amount o f this
equalization item.

bonds.49 In the case of Gmu, the gap is closed
by bonds w hich are issued by equalization
funds established by East Germany. While these
bonds are formally a debt o f the East German
government, they can actually be regarded as a
financial obligation o f West Germany. This con
clusion is based on the wide-ranging financial
support that West Germany agreed to provide
to the East German public sector and the pro
spect o f rapid political unification. The wealth
transfer directly produced by Gmu is thus iden
tical to the amount o f bonds needed to equalize
the consolidated balance sheet o f the East Ger
man banking system after the Gmu.50

At the moment, most GDR firms are ow ned by
the state. To the extent that these assets are
transferred to a com m on German government,
the net wealth transfer arising from the money
stock conversion will be reduced. The same
result would occu r if these firms are sold at
market prices and the proceeds are then used
to repay part o f the GDR government debt. This
latter option is presently being discussed in the
Federal Republic.

A second determinant of the wealth transfer
betw een East and West Germany is the distribu
tion of the GDR’s real wealth after conversion.

The consolidated balance sheet o f the GDR’s
banking system in table 3 shows that the
1DM:2M conversion o f the GDR enterprise sec-

49This was the case in the West German currency reform of
1948.
“ Gmu would have indirect wealth effects if it contributes to
non-competitive wages and if these wages are inflexible

FEDERAL RESERVE BANK OF ST. LOUIS

The Direct Impact o f Gmu on Ger
man Government Debt

downward, which would require unemployment benefits
from West Germany to East Germany.

tor’s net debt and the limited 1DM:1M conver
sion o f savings (including currency) implies a
DM 26 billion (5.3 percent) increase in the Ger
man central government debt. The impact of
this asymmetric conversion would have been
even higher if it w ere not for the "Richtungskoeffizient” discussed previously.
Using an assumed 8 percent interest, this ad
ditional debt will increase the German govern
ment's interest payments by DM 2.1 billion,
about 0.7 percent o f its total expenditure. A
uniform 1DM:1M conversion o f enterprise debt,
savings and currency would have produced a
DM 76 billion increase in government debt. If
this debt w ere borne mainly by West German
tax payers, this would have been identical to a
wealth transfer o f DM 1230 from each West
German—in the form of an interest-bearing and
non-repayable IOU—and would have provided each
East German with an additional DM 4560. This
example illustrates why the 1DM:1M conversion
rate for savings was controversial in West Ger
many after it had become evident that a 1DM:1M
rate for enterprise debt was impracticable.

transfer from the West Germans to East Germans
has been widely overestimated. The ultimate out
come of unification will be determined by the
productivity of East German firms, the real in
come necessary to encourage East German
workers to remain in the GDR and the actual
wage and income levels that will be achieved in
East Germany.
Monetary unification has only have a short-term
impact on the initial wages and incomes in the
GDR. Because the conversion rates are compatible
with the more pessimistic estimates of the pro
ductivity differential between East and West Ger
many, they do not appear to have produced the
problem of too-high initial GDR wage levels and
possible downward-stickiness of wages in the face
o f some initial unemployment pressures. Whether
the prospects provided by the economic and
social community o f the two states and the farreaching financial assistance offered to East Ger
many by the West German government will suf
fice to keep skilled workers in the GDR remains
open to question.

REFERENCES
SUMMARY
The set o f conversion rates chosen for the Gmu
has important implications for the debt burden of
East Germany’s enterprise sector, for the wealth
transfer between both German states and for the
level of West German government debt. The
1DM:2M conversion rate for enterprise debt may
cause some financial difficulties for many GDR
firms, but it will also lay the groundwork for the
privatization of the more profitable enterprises.
This result is a necessary precondition for the
GDR’s transition to a market economy. The ceil
ings for the 1DM:1M conversion of savings limit
the wealth transfer from West Germany to East
Germany to a relatively small amount. The same
applies to the required increase in German
government debt and its interest payments.
A (transitory) rise in the inflation rate of the
common German currency area is unlikely after
the Gmu. The post-conversion money stock in the
GDR seems to be roughly compatible with the
GDR money demand at the new DM prices.
The medium- and long-term impacts of
monetary unification on the competitiveness of
GDR firms, on unemployment and relative living
standards in East Germany, and on the wealth

Alexander, Lewis S., and Joseph E. Gagnon. “The Global
Economic Implications of German Unification,” International
Finance Discussion Papers, No. 379 (Board of Governors of
the Federal Reserve System, April 1990).
Bank for International Settlements. 59th Annual Report
(Basle, Switzerland, 1989).
Cassel, Gustav. “Abnormal Deviations in International Ex
changes,” Economic Journal (December 1918), pp. 413-15.
Collier, Inwin L. “The Estimation of Gross Domestic Product
and its Growth Rate for the German Democratic Republic,”
World Bank Staff Working Papers, No. 773, Washington, D.C.,
1985.
Commander, Simon, and Fabrizio Coricelli. “ Levels, Rates
and Sources of Inflation in Socialist Economies: A Dynamic
Framework,” paper prepared for a seminar in Laxenburg,
Austria, March 6-8, 1990.
Committee for the Study of Economic and Monetary Union.
“ Report on Economic and Monetary Union in the European
Community,” Luxembourg, 1989.
Cornelsen, Doris, and Wolfgang Kirner. “Zum Produktivitaetsvergleich Bundesrepublik-DDR,” Deutsches Institut
fuer Wirtschaftforschung-Wochenbericht, April 5, 1990, pp.
172-74.
Daviddi, Renzo, and Efisio Espa. “The Economics of Rouble
Convertibility: New Scenarios for the Soviet Monetary
Economy,” Banca Nazionale del Lavoro Quarterly Review
(December 1989), pp. 441-65.
Deutsche Bundesbank. “The Monetary Union with the Ger
man Democratic Republic,” Monthly Report of the Deutsche
Bundesbank (July 1990).
_______ “The Deutsche Bundesbank. Its Monetary Policy
Instruments and Function,” Deutsche Bundesbank Special
Series No. 7 (Frankfurt, 1989a).

JULY/AUGUST 1990

_______ . “ Enterprises’ Profitability and Financing in 1988,”
Monthly Report of the Deutsche Bundesbank, (November
1989b).
Dornbusch, Rudiger. “ Purchasing Power Parity,” in John
Eatwell, Murray Milgate, and Peter Newman, eds., The New
Palgrave: A Dictionary of Economics (London, 1987), pp.
1075-88.
Frenkel, Jacob, and Morris Goldstein. “A Guide to Target
Zones,” IMF Staff Papers, Vol. 33 (December 1986), pp.
633-73.
Gerstenberger, Wolfgang. “ Das zukuenftige Produktionspotential der DDR—ein Versuch zur Reduzierung der
Unsicherheiten,” ifo-schnelldienst (July 1990), pp. 13-22.
Grossman, Gregory. “ Monetary and Financial Aspects of
Gorbachev’s Reform,” in Christine Kessides et al., eds.,
Financial Reform in Socialist Economies (Washington, D.C.:
World Bank, 1989), pp. 28-46.
Hinds, Manuel. “ Issues in the Introduction of Market Forces
in Eastern European Countries,” paper presented at an
Economic Institute of the World Bank Conference in Warsaw,
Poland, March 12-13, 1990.
Institut der deutschen Wirtschaft. “ Sozialvertragliche
Ausgestaltung der Deutsch-Deutschen Wahrungsunion,”
Report for the State of Lower Saxony from March 12, 1990.
Institute of International Finance. “ Building Free Market
Economies in Central and Eastern Europe: Challenges and
Realities” (Washington, D.C., 1990).
Poole, William. “The German Democratic Republic:
Economic Goals, Constraints and Monetary Reform,” Shadow

FEDERAL RESERVE BANK OF ST. LOUIS

Open Market Committee: Policy Statements and Position
Papers, March 18-19, 1990.
“ Reform der Wirtschaftsordnung in der DDR und die
Aufgaben der Bundesrepublik, Stellungnahme einer deutschdeutschen Arbeitsgruppe,” Deutsches Institut fuer
Wirtschaftforschung-Wxhenbericht, February 8, 1990, pp.
65-71.
Roe, Alan, and Jayanta Roy. “Trade Reform and External
Adjustment: The Experience of Hungary, Poland, Portugal,
Turkey, and Yugoslavia,” Economic Development Institute of
The World Bank Seminar Report, No. 16, Washington, D.C.,
1989.
Schlesinger, Helmut, and Wilfried Jahnke. “ Geldmenge,
Preise und Sozialprodukt,” Jahrbuecher fuer Nationaloekonomie und Statistik, Vol. 205, pp. 410-26.
Sokil, Catherine, and Timothy King. “ Financial Reform in
Socialist Economies: Workshop Overview,” in Christine
Kessides et al., eds., Financial Reform in Socialist Economies
(Washington, D.C.: World Bank, 1989).
Williamson, John, and Marcus H. Miller. “Targets and In
dicators: A Blueprint for the International Coordination of
Economic Policy,” Policy Analyses in International Economics,
Number 22, September 1987.
Wolf, Thomas A. “ Economic Stabilization in Planned
Economies,” IMF Staff Papers, Vol. 32 (March 1985a), pp.
78-129.
_______ "Exchange Rate System and Adjustment in
Planned Economies,” IMF Staff Papers, Vol. 32 (June 1985b),
pp. 211-47.

John A. Tatom
John A. Tatom is an assistant vice president at the Federal
Reserve Bank of St. Louis. Kevin L. Kliesen provided research
assistance.

The Effects of Financial
Innovations on Checkable
Deposits; M l and M2

URING THE EARLY 1980s, several new
types o f financial assets w ere authorized by
Congress and included in the definitions of
various monetary aggregates. The principal
new accounts w ere NOW accounts, which
w ere authorized nationwide in January 1981,
and money-market deposit and super-NOW ac
counts, w hich becam e available in Decem ber
1982 and January 1983, respectively. Their
growth and inclusion in monetary aggregates
gave rise to increased uncertainty in explaining
movements in the monetary aggregates and
questions about the relationship o f the m one
1These uncertainties have been a continuing source of con
cern for the Federal Open Market Committee (FOMC).
This concern has focused primarily on M1. See Hafer
(1986) and Nuetzel (1987) for discussions of uncertainties
associated with M1. In 1981, when the authority to offer
interest-bearing checkable deposits was extended nation
wide, the FOMC announced targets for the old M1-type
measure that excluded such new deposits and for an
M1-type measure that added these so-called other
checkable deposits. See Tatom (1982) and Thornton
(1982) for an analysis of the 1981 developments and their
effects on monetary policy; the latter article discusses the
evolution of the current M1 measure following the 1980
redefinitions discussed in Hafer (1980). In 1983, the FOMC
refrained from targeting on M1 and indicated a greater
reliance on M2. See Hafer (1985) for a discussion of the
effects of 1983 innovations on policy deliberations.

tary aggregates to various measures o f econom
ic perform ance.1
The widely accepted view is that these finan
cial innovations have rendered M l less useful,
or even useless, as a monetary policy target.2
The related view—that the broader aggregate
M2 has been unaffected by these innovations
and therefore remains a useful target—is almost
as widely shared. While an apparent change in
the linkage between M l and econom ic perfor
mance in the 1980s has buttressed the impres
sion that financial innovations distorted M l and
Mascaro and Marlow (1989), Friedman (1988), Haraf
(1986), Hetzel (1989), Hetzel and Mehra (1989), Judd and
Trehan (1987), Judd, Motley and Trehan (1988), Keeley
and Zimmerman (1986), Kopcke (1987), Porter and Offenbacher (1984), Mehra (1989), Roth (1987), Siegel (1986),
Simpson (1984) and Wenninger (1986). In short, this view
is widespread. Earlier studies disputing these claims in
clude Cook and Rowe (1985), Gavin (1987), Hein (1982),
Jordan (1984) and Tatom (1982, 1983a, 1983b). These
studies follow an earlier theoretical and empirical tradition
which suggested the ineffectiveness of deposit rate regula
tions. This literature includes such works as Barro and
Santomero (1972), Bradley and Jansen (1986), Cox (1966),
Frodin and Startz (1982), Kareken (1967), Benjamin Klein
(1970, 1974), Michael Klein (1974), Saving (1971, 1977,
and 1979), Santomero (1974), Startz (1979) and Tatom
(1971).

2Some examples are: Hafer (1984), Barnett (1982), Spindt
(1985), Morris (1982), Cox and Rosenblum (1989), Darby,

JULY/AUGUST 1990

impaired its usefulness, few quantitative studies
have assessed the actual effects of financial in
novations on the monetary aggregates.
This paper first describes the financial innova
tions hypothesis that M l, but not M2, has been
significantly affected by the introduction and
grow th o f these new assets. It then assesses the
validity o f this hypothesis by examining whether
the turnover rate for checkable deposits, cur
rency preferences, and M l and M2 demand
(velocity) have been affected as the hypothesis
suggests.3

MONETARY AGGREGATES AND
FINANCIAL INNOVATIONS
Table 1 shows the components of M l and M2
in 1989. M l consists o f currency in the hands
o f the public, demand deposits, other checkable
deposits and travelers checks. Other checkable
deposits include accounts on which financial in
stitutions can make explicit interest payments.
During the 1970s, a few states authorized interest-paying negotiable order o f withdrawal
(NOW) accounts. In 1978, checkable accounts
with automatic transfer from interest-paying
savings accounts (ATS) w ere authorized by the
Federal Reserve System.
As figure 1 shows, the share o f other check
able deposits in total checkable deposits (demand
and other checkable deposits) rose from about
10 percent in late 1980 to m ore than 25 percent
by the end o f 1981, the first year that nation
wide NOW accounts w ere authorized. This share
continued to rise, in part because o f the intro
duction o f super-NOW accounts (interest-bearing
other checkable deposits with unregulated inter
est rates) in early 1983. By 1989, other check
able deposits had risen to $278.5 billion, nearly
half o f total checkable deposits and about 36
percent o f M l.
M2 is the sum o f M l, saving and small time
deposits at all financial institutions, overnight
(and continuing contract) repurchase agreements
issued by all commercial banks, overnight Eurodol
lars issued to U.S. residents by foreign branches
o f U.S. banks and m oney market accounts (MM),
3Numerous other financial innovations have occurred over
the past several decades. This article focuses solely on
the introduction of the principal new types of monetary
assets that are included in the monetary aggregates.
Moreover, the analysis is limited solely to the effects of

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1

M1 and M2 in 1989 (billions of dollars)
Components
Currency
Demand deposits
Other checkable deposits
Travelers checks
M1
Money market mutual
funds component1
Money market deposit
account balances
Savings
Small time
Overnight Eurodollars2 and
repurchase agreements
M2

Amount
$217.5
280.4
278.5
7.3
$783.7

$276.3
475.0
410.0
1,105.5
79.1
$3,129.53

General purpose and broker-dealer funds.
Eurodollar deposits issued to U.S. residents by foreign
branches of U.S. banks.
Components do not add to total because of rounding.

which include both general purpose and brokerdealer m oney market mutual funds (MMMF) and
money market deposit accounts (MMDA). Money
market deposit accounts, which have unregu
lated interest rates, w ere authorized at the same
time as super-NOW accounts and became avail
able in Decem ber 1982. Within the first tw o
quarters o f 1983, they had grow n to 17 percent
o f M2 (figure 2). Some o f this growth apparently
came at the expense o f m oney market mutual
fund accounts, since the total share o f m oney
market accounts, MMDA and MMMF, rose by
less than 17 percentage points; the share of
total m oney market balances, rose from 10 per
cent to about 24 percent o f M2 at the time.
Since there is little difference between MMDAs
and MMMFs, which becam e available in 1978,
they are grouped together here as money mar
ket accounts. The share o f MM in M2, called
s22 below, rose to nearly 25 percent o f M2 by
1989 (see table 1 and figure 2).
these innovations on M1 and M2; it ignores the effects on
broader aggregates or on differently weighted aggregates,
like the divisia or turnover-weighted aggregates. These
other measures are discussed by Barnett (1982) and
Spindt (1985).

Figure 1

Share of Other Checkable Deposits in Total
Checkable Deposits
Seasonally Adjusted
Quarterly Data

Percent

o I.......
1970

Percent
60

...................................................................................................1 o
71

1989

Figure 2

Share of Money Market Instruments in M2
Percent
30

Percent
30

Quarterly Data

Money Market Balances1

Money Market Deposits

1974
75
76
77
78
79
80
81
82
83
84
85
86
87
88
'Money market balances include both the money market deposit account and money market mutual fund
components of M2, which are not seasonally adjusted.

1989

JULY/AUGUST 1990

THE FINANCIAL INNOVATIONS
HYPOTHESIS
The financial innovations hypothesis described
here focuses primarily on the effects o f the
grow th o f these new assets on M l. According to
this hypothesis, the introduction o f interestbearing checking accounts made depositors
m ore willing to hold savings balances in their
checking instead o f their savings accounts.
Thus, the grow th o f other checkable deposits,
especially nationwide NOW accounts in 1981
and super-NOW accounts in 1983, was expected
to boost total checkable deposits and M l and
raise the interest elasticities of their demands.4
In addition, movements o f funds from savings
to checkable deposits w ere expected to take
place among com ponents o f M2, so that the
total demand for M2 was unaffected by shifts to
other checkable deposits. Similarly, the shift of
funds into MMDAs was expected to flow from
other com ponents o f M2, especially MMMFs;
thus, the expansion of MMDAs was not ex
pected to boost M2.5 One implication o f this
hypothesis is that the growth o f MMDAs, or of
MMMFs earlier, did not affect the demand for
M l, its use or its composition.6 If these assets
provide transaction services that are substitutes
for total checkable deposits, however, then
shifts to these balances should reduce the de
mand for total checkable deposits relative to
currency holdings, or raise the currency ratio.
Such shifts would also reduce the overall de
mand for M l. W hether m oney market innova
tions had any significant effects is also tested
below.
The surge in the share o f MMs in M2 in early
1983 was associated with a sharp rise in M2
4Rasche (1988a) cites several studies which argue that
financial innovations lowered the interest elasticity of
money demand. More recent proponents of a financial in
novations effect argue for an increase in this elasticity.
Rasche (1987, 1988a and 1988b) has provided evidence
for a rise in the interest elasticity of M1 demand, but he
does not link this to financial innovations. Friedman (1988),
Moore, Porter and Small (1988), Carlson (1989), Mehra
(1989) and Poole (1988) also have pointed to the rise in
the interest elasticity of M1 demand, although for different
reasons. The first four studies suggest that this effect
arose from financial innovations, while Poole suggests that
it is not a recent development; instead, only its recognition
is recent.
5See Thornton (1983). In late 1982, the FOMC anticipated
that maturing all-savers certificates and the impending in
troduction of MMDAs would temporarily boost M1 and, to
a lesser extent, M2. The FOMC decided in October 1982
to set no short-run objective for M1, but to place greater

FEDERAL RESERVE BANK OF ST. LOUIS

growth from a 9.1 percent rise in the four
quarters o f 1982 to a 16.6 percent annual rate
in the first half o f 1983. While this movement
ran counter to the financial innovations hypo
thesis, many thought that it was transitory and
carried little implication for future econom ic
perform ance.7

Testing the Financial Innovations
Hypothesis
In this article, the financial innovations hypo
thesis is tested by examining w hether these new
assets have influenced the use, composition or
demand for total checkable deposits, M l and
M2 as predicted. If total checkable deposits and
M l are boosted by inflows o f savings into other
checkable deposits, then the total checkable
deposit turnover rate—the ratio o f debits on
total checkable deposits to total checkable de
posits—should be inversely related to the share
o f other checkable deposits in total checkable
deposits (si = OCD/TCD). Similarly, the desired
ratio o f the currency com ponent o f M l to the
total checkable deposit com ponent also should
be inversely related to s i.8
W hen the effects o f other checkable deposits
on M l and M2 are investigated, the innovations
measures used are their ratios to M l ( s l l =
OCD/M1) and to M2 (sl2 = OCD/M2), respectively.
If M l is increased by an inflow o f savings into
other checkable deposits, then the demand for
M l, given its other determinants, must be posi
tively related to s l l . According to the financial
innovations hypothesis, the impact of money
market balances, measured relative to M l (s21 =
MM/MI), on M l demand is zero. Similarly, if the
hypothesis is correct, the demand for M2 should
weight on M2. There was no indication that M2 would rise
relative to M1, especially by as much as it did.
6Some analysts, however, point to the similarities between
super-NOW and money market accounts; the latter offer
limited checking services and unregulated interest rates.
They suggest that money market balances are close
substitutes for M1. See Cox and Rosenblum (1989) and
Motley (1988), for example.
7For example, the FOMC’s initial target range for M2 an
nounced in February 1983 called for M2 growth in the
7-to-10-percent range from the February-March average to
the fourth quarter of 1983. This range was viewed as com
parable to the 1982 range of 6 to 9 percent, allowing for a
further boost to M2 due to new MMDAs. Hafer (1985)
discusses these developments and their effects on the
FOMC deliberations in detail.
8The appendix to this article presents a more formal discus
sion of the tests of the effects of financial innovations.

be unrelated both to other checkable deposits,
measured by sl2, and to m oney market bal
ances, measured by s22.

Testing f o r a Shift in the Interest
Rate Elasticity
The effect o f other checkable deposits on the
interest elasticity o f each relationship also is ex
amined. The financial innovations hypothesis in
dicates that the weighted average cost o f hold
ing total checkable deposits and M l and the in
terest elasticity o f various monetary linkages are
functions o f the relative size o f other checkable
deposit balances. The implication is that the
relevant interest elasticity rose, on average, after
the introduction o f other checkable deposits.
Under the financial innovations hypothesis, the
rise in the interest elasticity is a function o f si,
the relative size o f other checkable deposits.
Thus, if P0 is the interest elasticity before the
introduction o f other checkable deposits (that is,
when s i is zero), then following this innovation
the interest elasticity becom es ft* = p 0+pi si.
In the log-linear relationships estimated below,
the interest elasticity following the advent o f
other checkable deposits is found from the ft
coefficients in the expression: [30 Ini + /3,(sl Ini);
the interest elasticity is (30 plus p l weighted
(multiplied) by the average value o f si. In a
first-difference equation, the appropriate expres
sion is: P0 Alni + /}, A(sl Ini). W hether the in
terest elasticity has increased as a result o f this
financial innovation is indicated by the sign and
statistical significance o f /?,.
In summary, in this study the financial in
novations hypothesis is rejected if: (1) measures
o f other checkable deposit innovations have no
significant effect on the M l-related variables
and their interest elasticities, (2) these same
measures have a significant effect on the size or
interest elasticity o f M2 demand, or (3) mea
sures o f m oney market innovations have any
significant effect on the use, com position or de
mand for M l or the demand for M2. These re
lationships are examined below.

FINANCIAL INNOVATIONS AND
THE DEPOSIT TURNOVER RATE
The turnover o f other checkable deposits,
their debits per dollar o f deposits, is low er than
the turnover o f demand deposits. For example,
in May 1989, the annual rate o f debits per dol
lar o f demand deposits at banks outside New
York (where demand deposit turnover is nearly
seven times larger) was 467.5; turnover on ATS
and NOW accounts at commercial banks was
only 18.2 times per year, m uch closer to the 3.6
rate on savings deposits at commercial banks.9
The similarity betw een the turnover o f ATS and
NOW balances and that on saving deposits is
sometimes taken as evidence to support the
financial innovations hypothesis.
The hypothesis says that other checkable de
posits include balances that would have been
held in savings or other non-M l balances before
interest-bearing checking accounts becam e avail
able. As these savings flow ed into other check
able deposits, the turnover o f total checkable
deposits should have fallen, and its interest elas
ticity should have been altered.
Figure 3 shows the natural logarithms o f the
turnover rate for demand deposits and total
checkable deposits (demand, ATS and NOW
balances) since 1970. Turnover has a strong up
w ard trend; for example, the turnover rate of
demand deposits m ore than doubled from 1970
to early 1979. The tw o measures began to de
viate in late 1978, w hen ATS accounts w ere in
troduced, reflecting the low er turnover rates
for ATS and NOW balances. The upward surge
o f demand deposit turnover, especially in 1981,
suggests that low er turnover deposits w ere
switched from demand deposits to the new ac
counts. M ore important, however, the turnover
rate for total checkable deposits rose in 1981,
counter to the decline predicted by the financial
innovations hypothesis. Overall, the turnover
rate for total checkable deposits looks more like
a continuation o f the 1970-78 demand deposit
turnover series than does the demand deposit
turnover series itself.

9These data are available in the Federal Reserve statistical
release, G.6, Debits and Deposit turnover at Commercial
Banks. Debits on ATS and NOW accounts, like those on
demand deposits, typically are third party payments; debits
on savings, on the other hand, typically are in-bank
withdrawals. Moreover, deposit turnover is substantially
larger for business accounts than individuals; only the lat
ter, however, can legally hold NOW and ATS accounts.

JULY/AUGUST 1990

Figure 3
Demand Deposit and Total Checkable Deposit Turnover
Seasonally Adjusted
Monthly Data

Logarithm
7.0

Demand deposit
turnover
Total checkable
deposit turnover

1970

Deposit turnover measures are velocity mea
sures; as such, they are related to the same fac
tors, like interest rates and income, that influ
ence the demand for money. Higher interest
rates, by increasing the cost o f holding check
able deposits, should reduce the quantity of
these deposits demanded and increase their
turnover rates. As incom e rises, the demand for
these deposits should rise; whether the turn
over rate rises or falls, however, depends on
whether debits rise m ore or less than the de
mand for checkable deposits. The continuous
annualized grow th rate o f monthly total check
able deposit turnover, CDT, was estimated as a
function o f the continuous annualized rates of
increase o f the three-month Treasury bill rate,
R, and real personal income, y, for the period
January 1979 to January 1989.
The financial innovations hypothesis indicates
(1) that a rise in s i should significantly reduce
the turnover o f total checkable deposits and (2)
that a rise in m oney market balances, measured
here by a rise in the ratio o f m oney market
balances to total checkable deposits, s2, should
not affect it. This was tested by adding current

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Federal Reserve Bank of St. Louis

1989

and up to 12 lagged values o f the annualized
first-differences o f s i and s2, labeled D sl and
Ds2, respectively, to the turnover equation; ad
ding lagged effects beyond one month, h ow
ever, was uniformly unnecessary.
The estimate for total checkable deposit turn
over that contains the most statistically signifi
cant innovations term is:
(1) CDTt= 13.00 - 0.043R, + 0.110R,_,
(5.22) (-1 .3 6 )
(3.62)
- 1.013yt_, + 0.227Dsl._,
(-2 .4 5 )
(0.76)
Pt = 0.255
(2.80)

P2 = 0.244
(2.68)

R2 = 0.15

S.E. = 29.255

D.W. = 2.00

(The numbers in parentheses in the equation
estimates reported here are t-statistics.)
The results in equation 1 show that the share
o f other checkable deposits has not significantly
depressed the turnover o f checkable deposits;
instead, the estimated effect is positive, but

statistically insignificant.10 This result is counter
to the financial innovations hypothesis.
If financial innovations increased the interest
elasticity o f total checkable deposits turnover,
then the coefficients on the interest rate terms
(R„ Rt_,) in equation 1 should be related to si.
To test whether these coefficients have increas
ed with the rise o f the share o f other checkable
deposits in total checkable deposits, the an
nualized change in the product (sljlnR,) for the
current and past month are added to equation 1.
The sum o f these coefficients is positive, 0.03, but
it provides no significant explanatory pow er to
the equation. The F-statistic for testing whether
these coefficients are zero is F2112 = 0.04, well
below the critical value (5 percent) o f 3.08.
Thus, financial innovations, as defined here,
have had no significant effect on the interest
elasticity o f total checkable deposit turnover.
Again, this result is counter to the financial in
novations hypothesis.

FINANCIAL INNOVATIONS AND
THE CURRENCY-DEPOSIT RATIO
The currency ratio, the ratio o f currency held
by the public to its total checkable deposits, is a
principal determinant o f the m oney multiplier
(the ratio o f a monetary aggregate to the ad
justed monetary base). M oreover, it is the prin
cipal channel through w hich financial innova

10Either the current or first-lagged value of Ds1 is strongly
and positively statistically significant when added to an
identical equation for demand deposit turnover growth.
When both current and lagged Ds1 values are included,
however, neither is statistically significant. The standard
error of the estimate is lower when the current value is us
ed instead of the lagged value. The coefficient on the cur
rent value is 1.025 (t = 3.49). The result in equation 1 is
unaffected by regressing the growth rate of total debits on
the same right-hand-side variables and on the growth rate
of total checkable deposits; the coefficient on Ds1t_, is
0.282 (t = 0.95) in this case. Finally, when equation 11 in
the appendix is estimated using the nonlinear least
squares method, neither f nor gd is significantly different
from zero. The estimates of f and gd are 0.005 (t = 0.01)
and 0.021 (t = 0.37), respectively.
The turnover rate for deposits, excluding demand
deposits in New York (and their debits) was also examin
ed. Its growth rate is white noise and is independent of in
terest rates or real personal income. It is also not signifi
cantly correlated with the current or lagged values of the
changes in the financial innovation shares. For example,
the correlation coefficient for the growth rate of turnover of
total checkable deposits, excluding New York demand
deposits, and the first lagged change in s1 is 0.023. This
insignificnat correlation rejects the implication of the finan
cial innovations hypothesis that this correlation is
significantly negative.

tions can affect the link betw een Federal Re
serve actions and the monetary aggregates.11
The desired ratio o f currency to total checkable
deposits is the outcom e o f a portfolio decision
based on the relative costs and benefits of
holding each means o f payment. If total check
able deposits now include a larger com ponent
o f savings balances than they did earlier, then
the increase in the share o f other checkable
deposits in total checkable deposits should have
lowered the currency ratio. In addition, if money
market accounts are a substitute for checkable
deposits included in M l, then the introduction
and spread o f money market holdings should
have reduced total checkable deposits relative to
currency holdings and raised the currency ra
tio.12 According to the financial innovations hy
pothesis outlined above, however, this latter ef
fect should be zero.
Figure 4 shows quarterly data on the ratio of
the currency and the checkable deposit com
ponents o f M l. This ratio does not decline in
early 1981 or early 1983 when the largest boosts
in savings held in other checkable deposits pre
sumably w ould have occurred. Nor does the
currency ratio rise in early 1983 when m oney
market accounts surged.
A modified time series model is used to test
the effects o f these shifts on the currency ratio.
The grow th rate o f the currency ratio can be
described as a first-order autoregressive time

"T he adjusted monetary base is described in Gilbert (1980
and 1987). A recent analysis of the behavior of the
multiplier and its determinants can be found in Burger
(1988).
12The effect of nationwide NOW accounts on the currency
ratio is tested in Tatom (1982). A model of the demand for
currency and demand deposits is used to test whether
other checkable deposits lowered desired currency
holdings relative to total checkable deposits. The tests re
ject the financial innovations hypothesis. Rasche and
Johannes (1987) show that the 1981 shift to NOW ac
counts included a shift of savings to these accounts equal
to about the 27.5 percent of such funds in the first four
months of 1981. While this proportion also was suggested
by the staff of the Federal Reserve Board, they suggested
that it would have a continuing effect and applied it for all
of 1981. Rasche and Johannes, on the other hand, argue
that this shift significantly, but only temporarily, reduced
the currency ratio and raised the money multiplier. They
find no evidence that the shift to other checkable deposits
or money market accounts had a permanent effect on the
currency ratio or the multiplier. See Rasche and Johannes
(1987, pp. 60-69).

JULY/AUGUST 1990

Figure 4

Currency/Deposit Ratio1
Seasonally Adjusted
Quarterly Data

Percent
45

■

■ +

i . »

i ’

V 1 S

1 1

1959
61
63
65
67
69
71
73
75
77
1Ratio of Currency Component to Checkable Deposit Component of M1

1
79

• fl
81

it ?
83

1
85

I
87

1989

series process; tw o other factors also have had
a major impact on the currency ratio over the
past 15 years and they are controlled for in the
following estimates.13 The first factor is energy
prices, which rose sharply in 1973-74 and in
1979-81 and fell sharply in 1986. A rise in ener
gy prices raises expenditures that use currency
relatively m ore than it raises expenditures that
rely m ore heavily on checkable deposits. Thus,
the currency ratio rises when energy prices in
crease.14 The second factor is the transitory ef
fect o f the credit control program in 1980,
which temporarily boosted currency demand
relative to checkable deposits in the second

quarter o f the year. Credit limitations increase
the use o f currency, especially in transactions
that would otherwise be facilitated by retail
credit.15 Finally, the current and past quarter's
three-month T-bill rates are included to examine
the interest rate elasticity o f the currency ratio;
longer lags for the interest rate variables are
not statistically significant.

13Rasche and Johannes (1987) argue for the superiority of a
time series model over a structural approach like that used
in Tatom (1982); the modifications here are made to in
clude the sizable known effects of the two energy price
shocks and to test whether the currency ratio’s interest
elasticity was affected.

checkable deposits. A related argument is that a change
in the mix of personal consumption expenditures toward
nondurable purchases raises the currency ratio. See
Dotsey (1988).

14Tatom (1985) provides evidence that money demand is af
fected by energy price increases. The currency-ratio effect
may arise, at least in part, through gasoline purchases
that affect currency demand more than the demand for

FEDERAL RESERVE BANK OF ST. LOUIS

The model o f the currency ratio, k, estimated
for the period III/1959 to IV/1989 is shown in
the first column o f table 2. The dependent vari
able, kt, is the annualized continuous rate of
growth o f the currency ratio. The annualized

15The effect of the credit control program on the money
stock is discussed in Tatom (1982) and Hein (1982). Also
see Wallace (1980) for an analysis of the effects of credit
controls on currency demand.

continuous rate o f increase o f the relative price
o f energy resources, p', is measured by the
ratio o f the producer price index for fuel, p ow
er and related products to the implicit price
deflator for business sector output. The creditcontrol variable, D80, equals one in the second
quarter o f 1980, negative one in the third quar
ter o f 1980, and zero otherwise. These indepen
dent variables are generally strongly statistically
significant in the estimates shown in table 2.18
W hen current and lagged (up to four) values
o f D sl or Ds2 w ere added to the model, only
the estimate with the current-quarter change in
s i (Dsl), shows a statistically significant innova
tions effect; it is reported in the second column
o f table 2. Although, the negative coefficient on
D s lt is not statistically significant at a 5 percent
level in a two-tail test, it is significantly negative
using a one-tail test o f the negative effect pre
dicted by the hypothesis.17 No other individual
or group o f current or lagged changes o f the
financial innovations variables are as signifi
cant.18 These results suggest that growth in
other checkable deposits has significantly low
ered the currency ratio, w hich is consistent
with the financial innovations hypothesis.19
This effect is weak, however, and is quite sen
sitive to the exclusion o f only one observation—
the second quarter o f 1981. W hen this quarter
is omitted, the coefficient on D sl falls in ab
solute value to -0 .0 7 3 , and its t-statistic falls to
-0 .8 9 , which is far from statistical significance
even with a one-tail test. Thus, the significant
result for D sl, in table 2 is spurious. The largest
rise in the s i measure occurs in 1/1981 not in
the second quarter; the omission o f the 1/1981
observation, however, does not affect the signif
icance o f Dsl,. The decline in the significance of
D sl when the 11/1981 observation is omitted
16The F-statistic for a Chow test of the stability of the equa
tion using the first and second half of the whole sample
period is F s.n i =0.64, well below the 5 percent critical
value of 2.30. Thus, the stability of the currency ratio
estimate cannot be rejected.
17ln earlier versions of this article, this effect was insignifi
cant even with a one-tail test. For example, before the
February 1990 benchmark revisions, the estimate for the
period 111/1959 to 111/1989 had a coefficient of
— 0.101 (t = -1.24). The critical t-statistic value for a onetail test is about 1.65. The significance of the rest of the
results reported here was not so affected. The nonlinear
least-squares estimate of equation 17 in the appendix
(when g equals zero) yields essentially the same result as
in the text; in particular, the point estimate of f is 0.1324
(t = 1.83). The g parameter is set equal to zero in this
estimate because it is not significantly different from zero
when freely estimated.

Table 2

Tests for the Ratio of Currency to Total
Checkable Deposits (k)
Dependent Variable: 400Alnk
Period: 111/1959 to IV/1989
Constant

0.496
(1.70)

0.750
(2.32)

0.419
(1.37)

K-,

0.503
(7.28)

0.477
(6.81)

0.503
(7.20)

0.013
(1.95)

0.011
(1.75)

0.014
(2.02)

R,-,

0.025
(3.83)

0.028
(4.16)

0.023
(3.28)

p ;-

0.058
(3.13)

0.059
(3.21)

0.053
(2.81)

D80

11.292
(4.73)

10.783
(4.53)

11.398
(4.75)

-0.135
(-1 .7 9 )

Ds1,

-0.011
(-0 .3 9 )

D(s1, InRJ

0.037
(1.30)

D(s1,_, InR,.,)

0.55

0.56

0.55

S.E.

3.052

3.023

3.054

D.W.

2.11

2.10

2.13

-1.01

-0 .9 2

-1 .2 0

18For example, the coefficient on Ds2 is 0.013 when added
to the equation in the first column, and its t-statistic is only
1.19.
19Although Rasche and Johannes find a significant transitory
decline in the currency ratio in early 1981, this is not
found in the error in either the first or second quarter of
1981 for the first equation in table 2. This difference may
arise because they use monthly, seasonally unadjusted
data, while seasonally adjusted quarterly data are used
here. In the form estimated, their four-month long reduc
tion corresponds to one observation here. The tests here
cannot readily determine whether such a brief transitory
effect of financial innovations took place.

JULY/AUGUST 1990

does not occur from a decline in the variance of
D sl; the standard deviation of D sl rises from
0.076 to 0.082 when the 11/1981 observation is
omitted. The significant result in table 2 arises
from a spurious decline in the currency ratio in
n/1981, when s i growth was relatively large.
The third column in table 2 examines whether
the interest elasticity o f the desired currency
ratio increased in absolute value as a result of
financial innovations. The results show a posi
tive, but statistically insignificant, change in the
interest elasticity. Neither interaction term is in
dividually statistically significant, and the test
statistic that they are jointly zero, F2114 = 0.91,
is not statistically significant. Therefore, the
hypothesis that financial innovations raised the
interest elasticity o f the currency ratio is
rejected.

FINANCIAL INNOVATIONS AND
MONEY DEMAND
The evidence above on financial innovations
influence on total checkable deposit turnover
and the currency ratio rejects the financial in
novation hypothesis. These results do not ad
dress the m ore familiar literature on M l de
mand or the velocity problem; nor do they ex
amine the implications o f the financial innova
tion hypothesis for M2.
Figure 5 shows the income velocity o f M l and
M2 measured by the ratio o f nominal gross na
tional product to M l and M2, respectively.
Movements in velocity inversely reflect m ove
ments in m oney demand. The velocity o f M l has
a strong positive trend until 1981, while M2
velocity does not appear to have a noticeable
trend either before or after 1981. These velocity
20Both Hetzel and Mehra (1989) and Judd, Motley and
Trehan (1988) take this view; indeed, the central issue in
the money demand literature, according to these papers,
seems to be, first, whether the recent shifts and instability
of M1 demand are permanent or will disappear after some
transition to a deregulated environment, and second, if the
breakdown in M1 demand is only transitory, whether its
statistical properties will dominate those of M2 demand
when M1 demand “ settles down.” Judd, Motley and
Trehan are more optimistic about a return to normal than
Hetzel and Mehra. More recently, Hetzel (1989) and Mehra
(1989) provide arguments intended to reinforce their view.
Carlson and Hein (1980), Hafer (1981) and Tatom (1983a)
report evidence on the breakdown of the M2-GNP link
after 1977, however. Tatom (1983b) and Darby, Poole, et
al. (1987) provide a fuller treatment of the potential causes
and consequences of the change in the behavior of M1
velocity.
21Rasche (1988a) extends his 1987 M1 analysis to M2, M3
and broader measures.

FEDERAL RESERVE BANK OF ST. LOUIS

patterns often are cited as evidence that the de
mand for M l, but not for M2, becam e less
stable in the early 1980s, supporting the finan
cial innovations hypothesis.20

The Demand f o r Ml
Rasche provides a model o f the demand for
M l and other monetary aggregates, w hich he
argues has been stable for a long time.21 He ex
plains that the shift in M l velocity behavior is a
"shift in the drift” attributable to a change in
the systematic components o f velocity that are
impounded in the mean o f the growth rate
specification or in the trend o f the level o f ve
locity.22 Rasche also finds evidence that the in
terest elasticity o f M l demand rose after 1981.
He argues, however, that the timing o f financial
innovations and their purported effect on M l
demand are inconsistent with the timing o f the
"shift in the drift” that he finds. Rasche’s evi
dence also indicates that the demand for M2
is stable.
In Rasche’s model, m oney demand, that is,
nominal m oney per dollar o f GNP, depends upon
the interest rate (the three-month Treasury-bill
rate), real income and unanticipated inflation. In
quarterly estimates, real income, x, is measured
by real GNP, and unanticipated inflation, P“, is
measured by the residuals from an M AI model
o f changes in the annualized continuous rate o f
increase o f the implicit price deflator for GNP.
The incom e and interest rate effects on m oney
demand occur over three quarters.23
An unrestricted version o f Rasche’s M l de
mand equation, estimated for the period 11/1953
to IV/1989 is;
22This argument rules out shifts in M1 velocity due to
changes in its response to economic factors that deter
mine it or to changes in the error structure of the random
elements that affect it. These two sources are typically the
basis for claims of increased uncertainty or increased in
stability in a demand function. Rasche conjectures, how
ever, that the shift in the drift arises from the decline in in
flationary expectations or a rise in the instability of the
economy, but he finds no direct evidence supporting these
arguments.
23Several coefficient restrictions are tested in Rasche (1987)
and used in Rasche (1988a, 1988b). These are not impos
ed here because they could bias the tests of the financial
innovations hypothesis.

Figure 5

Income Velocities of M1 and M2
Seasonally Adusted

(2) M l, - GNP, = -1 .9 8 9 - 0.036[400/3(lnR,-lnR,_3)]
(-4 .5 3 ) (-4 .4 0 )
- 0.517 P" - 0.703 x,
(-4 .1 6 )
(-1 1 .9 7 )
+ 0.407 [400/2(lnx,_,-lnx,_3)]
(4.17)
+ 2.336 D82, - 0.141 D82.DR13,
(3.28)
(-6 .0 7 )
R2 = 0.68

D.W. = 1.92

S.E. = 2.679

p = 0.227
(2.74)

24Rasche (1988a) omits the first and second quarters of both
1980 and 1981 in arriving at his stability results. These
quarters are included here; the adjusted R2 and standard
error actually improve when these quarters are included in
estimating equation 2. For the M2 results, the adjusted R2
reported below falls slightly when these quarters are in

where GNP is nominal GNP, and GNP and x are
the annualized continuous growth rates o f nom
inal and real GNP, respectively, D82 equals one
from 1/1982 on and zero earlier, and DR13, is
the variable in brackets in the second term on
the right-hand-side o f the equation.24 The signifi
cant intercept shift (D82) changes the 2.0 per
cent trend rate o f velocity increase until 1982
into a 0.35 percent trend rate o f decline subse
quently; the latter rate, however, is not signifi
cantly different from zero. The last term in
equation 2 tests w hether the magnitude o f the
interest elasticity o f m oney demand rose; accor
ding to the estimate, it rose significantly in ab
solute value.

eluded, but no other noticeable changes occur in any of
the coefficients,

JULY/AUGUST 1990

To test whether the rise in s l l has raised M l
demand, the variable 400 A sll is added to the
equation. The financial innovations hypothesis
predicts that its coefficient should be significant
ly positive. W hen this variable is added to equa
tion 2, however, its coefficient is negative, but
statistically insignificant, -0 .0 6 3 (t = —0.58). This
result refutes the financial innovations hypothe
sis about the effect o f the growth of other
checkable deposits on M l demand.25
To test w hether the rise in m oney market
deposits influenced M l demand, w hich the fi
nancial innovations hypothesis denies, the money
market innovation measure, 400 As21, is added
to the M l demand equation; the result is:
(3 )M lt-G N P ,= -1 .9 1 8 - 0.035[400/3(lnRt- lnR,_3)]
(-4 .4 5 ) (-4 .3 5 )
- 0.533 P" - 0.699 xt
(-4 .3 4 )
(-1 2 .1 0 )
+ 0.392 [400/2(lnxt_ ,- l n x t_3)]
(4.08)
+ 2.432 D82, - 0.161 D82.DR13,
(3.49)
(-6 .6 3 )
- 0.034 400As21t
(-2 .3 6 )
R2 = 0.70

D.W. = 1.91

S.E. = 2.636

P = 0.22
(2.67)

The m oney market innovations term is signifi
cantly negative; the introduction and grow th of
m oney market balances has statistically signifi
cantly reduced M l demand. The coefficient on
the innovations term is small, however; the rise
in s21 to 1, about its level currently, has re
duced the demand for M l by 3.4 percent.
25The absence of an effect of s11 on M1 demand implies
that the growth of other checkable deposits is offset, dollar
for dollar, by reductions in M1A (M1 less other checkable
deposits). A similar test of whether no other checkable
deposits should be added to M1A to obtain a stable de
mand is easily rejected. The proportion of other checkable
deposits that must be added to M1A to obtain an ag
gregate whose demand is invariant to shifts in other
checkable deposits is not significantly different from 100
percent. This rejects the usefulness of M1A, or at least the
hypothesis that its demand is invariant to financial
innovations.
26When equation 20 in the appendix is estimated with the
same non-innovation variables as in equation 2, the esti
mate of f, 0.014, is not significantly different from zero

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Federal Reserve Bank of St. Louis

The proportion o f MM that are transaction
balances can be estimated from the coefficient
on the innovations variable. The latter coeffi
cient equals - g / ( l + gs21), w here g is the share
o f transaction balances in MM, according to the
derivation in the appendix to this article (eq.
20). Since the mean level o f s21 is 21.85 percent
during the sample period, the estimated average
value of g is 3.4 percent.26
A skeptic might argue that the significance of
the last tw o terms in equation 2 actually dem on
strates the validity o f the financial innovations
hypothesis. After all, the demand fo r M l rose
and its interest elasticity increased, just as the
hypothesis predicted. Rasche’s timing argument
indicates this is a spurious relationship, but more
formal tests are possible. A test o f w hether the
rise in the interest elasticity is related to the growth
of other checkable deposits rejects this skeptical
view. The term (sltlnRt- s l , _ 3lnRt_3) 400/3 re
lates the shift in the interest elasticity systemati
cally to the share o f other checkable deposits
following the financial innovations hypothesis.
W hen this innovations-related shift in the in
terest elasticity is used in place o f the post-1981
shift variable D82DR13 in equation 2, its t-statistic is still significant, but low er (-3 .4 4 vs.
-6.07); m oreover, the equation’s standard error
rises (2.80 vs. 2.68). W hen both variables are in
cluded in equation 2, however, the t-statistic
for the innovations-related shift variable falls to
-1 .4 3 , while the t-statistic for D82DR13 re
mains strongly significant (t= 4.83).27
Similarly, the hypothesis that D82 is a proxy
variable fo r the sharp rise in other checkable
deposits in the early 1980s is tested by com par
ing the effect of A s ll on equations 2 and 3 with
and without D82. W hen this is done for equa
tion 2, the t-statistic for 400 A s ll, is -0 .1 0
when D82 is omitted and, as indicated above,
-0 .5 8 when D82 is included. W hen both are in(t = 0.15). The estimate for g, 0.037, however, is statistical
ly significant (t = 2.40).
27These tests were also conducted using equation 3 instead
of equation 2. When both measures are included in the
equation, the shift in the interest elasticity in 1982 remains
strongly significant (t= -5.36), while the s1-related interest
elasticity shift is not (t= -1.00). The coefficient (-0.031)
on the money market innovations term, 400 As21t, remains
significant in this case (t= -2.12).

eluded, however, the coefficient on D82 (2.425)
is the same size as in equation 2 and it remains
statistically significant (t = 3.32). The use o f A sll
and the sl-related shift in the interest elasticity,
in place o f the 1982 constant and interest rate
shifts, also are easily rejected w hen tested joint
ly. Thus, the grow th o f the other checkable
deposits does not account for the significance of
the last tw o terms in equation 2. Similar results
are obtained w hen these same substitutions are
made in equation 3 and the significance o f the
money market innovations term remains unaf
fected by these changes.

The Demand f o r M2
The M2 m oney demand equation that uses the
same set o f variables for the same period as the
M l estimate is:
(4) M 2,-GNP, = 1 .3 8 5 - 0.055 DR13, - 0.734 P“
(3.63) (-7 .8 2 )
(-7 .4 1 )
-0.761x, + 0.428[400/2(lnx,.1 - lnx,_3)]
(-1 5 .9 5 )
(5.25)
-0 .8 2 2 D82t - 0.072 D82.DR13,
(-1 .3 2 )
(-3 .6 2 )
R2= 0.77
S.E. =2.177

D.W. = 1.90

P = 0.289
(3.55)

Unlike the M l estimate, the M2 estimate sug
gests that there was no significant shift in the
M2 demand intercept after 1981. The interest
elasticity o f M2 demand rose significantly after
1981, however, like that for M l demand.
The financial innovations hypothesis suggests
that these innovations should have had no ef
fect on the demand for M2. To test the hypoth

28No attempt was made to adjust the T-bill rate for the
average rate paid on the components of M2 in order to
better measure the opportunity cost of M2. Rasche (1988a)
notes that, in an estimate like equation 4, inferior overall
results were found when such a measure is used instead
of the T-bill rate.
29When D82, and D82.DR13, are added to the estimate they
are not statistically significant; the coefficient on D82, is
-0.894 (t= -1.39), and that for the shift in the interest
elasticity is -0.033 (t= - 1.60).
30These results do not depend on the inclusion of the four
quarters that Rasche omits in his study. When these
quarters are omitted, the standard error falls to only 1.926
percent and the other properties of the estimate are nearly
identical. The same results also obtained when all four
quarters of 1983, during which the largest shifts occurred,
are omitted; in particular, the t-statistic for the s22 innova
tion term is 2.49.

esis, the same procedure used for M l was fol
lowed for M2.28 The results indicate that the
contemporaneous rise in the share o f money
market balances in M2 (s22) has a statistically
significant effect on the demand for M2, but
that no other financial innovation variable (lags
o f s22 or current and up to four lagged values
o f sl2) has a significant effect. M oreover, when
the contemporaneous share o f money market
balances is included in the equation, neither the
intercept shift nor the interest elasticity shift is
statistically significant. The estimate, without the
insignificant variables, is:29
(5) M2, - GNP, = 1.422 - 0.052 DR13, - 0.711 P"
(3.55) (-7 .7 3 )
(-8 .2 9 )
-0.802x, + 0.373[400/2(lnx,_, - lnx,.,)]
(-1 8 .4 8 )
(4.67)
+ 0.261 400As22,
(6.04)
R2= 0.81
S.E. = 2.006

D.W. = 1.79

P = 0.44
(5.75)

The result that the rise in the share o f money
market deposits significantly raised the demand
for M2 runs counter to the financial innovations
hypothesis.30 According to the estimate, a 25
percent share o f m oney market deposits in M2
(nearly its share at the end o f 1989) raises M2
demand relative to GNP by about 6.5 percentage
points.31
Figure 6 shows the grow th rate o f M2 mea
sured over four-quarter periods since 1978 and
an adjusted grow th rate that removes the effect
o f shifts in m oney market funds from M2 using
the estimated effect in equation 5.32 The m oney-

31The theoretical value of the coefficient on 400 As22, is
Q,/(1 -g, s22), where g ] is the proportion of MM balances
that are not close substitutes for the rest of M2. This ex
pression is derived in the appendix to this article. The
sample estimate of g^ given the sample mean value of
s22 of 5.39 percent, is 25.7 percent. When equation 22 in
the appendix is estimated using the nonlinear least
squares method and with the same other variables as in
either equations 4 or 5, the other checkable deposit in
novation's coefficient is not significantly different from
zero, but the money market innovation term is. Using this
method, the trend shift and interest-elasticity shift again
are insignificant when the money market innovation term
is included. For the counterpart to equation 5 in the text,
the nonlinear least squares estimate of g, is nearly the
same, 24.2 percent, (t = 5.17).
32This adjustment subtracts 0.261 s22, from the logarithm of
M2 to obtain a series that is independent of s22.

JULY/AUGUST 1990

Figure 6

The Growth Rate of M 21
Percent
15.0

Seasonally Adusted
Quarterly Data

Percent
15.0

2.5
1978
79
80
81
82
'Current rise from four quarters earlier.

market-induced shift in M2 demand had the
greatest effect on the measured grow th rate in
1983. In other periods, the grow th rate o f M2
has been affected only slightly. The adjusted
grow th rates ranged from 6.3 percent to 9.8
percent from 1980 until 1987. The sharp accel
eration o f M2 growth from 1980 to 1983 and
subsequent slowing can be explained by the ef
fect o f financial innovations, in this case, by the
grow th o f m oney market balances.
The effects on M2 velocity are shown in fig
ure 7. Actual M2 velocity appears to vary about
its mean in figure 7. W hen adjusted for shifts
arising from m oney market accounts, however,
M2 velocity has a positive trend, especially since
the mid-1960s.

CONCLUSION
The financial innovations hypothesis that the
introduction and acceptance o f other checkable

FEDERAL RESERVE BANK OF ST. LOUIS

1989

deposits, especially NOW and super-NOW ac
counts, have seriously, and perhaps permanent
ly, distorted the measurement and effectiveness
o f M l, but not M2, is widely accepted today.
The counterpart o f this hypothesis—that the in
troduction and grow th o f m oney market assets
like m oney market deposit accounts had no ef
fects on M l and M2—is as widely endorsed. A
systematic investigation o f this hypothesis,
which focuses on the turnover rate o f check
able deposits, the desired currency-deposit pre
ferences o f m oney holders, and the velocity or
demand fo r M l and M2, however, generally re
jects its claims.
The financial innovations hypothesis implies
that the turnover o f total checkable deposits
and the currency ratio will decline significantly
as the share o f other checkable deposits rises.
The analysis here indicates that the turnover of
total checkable deposits was not affected by
these financial innovations. There was a signifi-

Figure 7

The Effect of Money Market Accounts on M2 Velocity
Ratio
1.85

Seasonally Adjusted
Quarterly Data

Ratio
1.85

1.80

1.75

1.70

1.65

1.60

1.55

1.50

1.50
1959

cant decline in the currency ratio associated
with the rise in the share o f other checkable
deposits in total checkable deposits, but this
significance is spurious in light o f its sensitivity
to the omission o f only one observation and its
refutation in the other tests presented here.
The introduction and growth o f other check
able deposits has had no significant effect on
the velocity o f (demand for) M l. While there is
evidence o f a shift in M l velocity and its interest
elasticity after 1981, the tests here reject the
financial innovations hypothesis that these shifts
w ere related to the rise in the share o f other
checkable deposits in M l in the early 1980s.
The introduction o f m oney market deposit ac
counts and the earlier introduction o f money
market mutual funds have had a significant ef
fect on the demand for monetary aggregates.
The expansive growth o f these new balances
has had no effect on the composition o f M l or
the use o f checkable deposits. The demand for
M l, however, was reduced slightly because of
the grow th o f money market balances. More im

1989

portant, the growth o f these balances was asso
ciated with a significant rise in the demand for
M2. As a result, M2 velocity was depressed by
the growth o f m oney market balances. Ironically,
this reduction has provided unwarranted sup
port to the view that M2 velocity is stationary
and M2 demand is stable. Movements in the
share o f m oney market accounts have ac
counted for much o f the variation o f M2 growth
over the past 10 years or so.
Proponents o f the view that financial innova
tions have distorted M l apparently have been
focusing on the w rong innovation. According to
the evidence here, explicit interest-bearing ac
counts have not affected the use o f checkable
deposits, the composition o f M l or the demand
for M l (or M2 for that matter). Instead, the
growth o f m oney market balances has signifi
cantly affected the aggregates, raising M2 de
mand and depressing its velocity. Money market
deposits also appear to provide substitute trans
action services for M l, so that their growth has
had a small depressing effect on the demand
for M l.

JULY/AUGUST 1990

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JULY/AUGUST 1990

Appendix

A Formal Statement of the Hypotheses Tested
The financial innovations hypothesis, as
presented and tested in this paper, states that
the introduction and grow th o f other checkable
deposits, OCD, distorted the measurement of
both total checkable deposits and M l, but left
the overall demand for M2 unaffected. M ore
over, according to this hypothesis, the introduc
tion and grow th o f m oney market balances (MM)
had no effect on M2. Instead, the grow th o f
these balances came at the expense o f other
non-M l funds within M2, so that it had no ef
fect on total checkable deposits, M l demand, or
the composition o f M l.
The hypothesis suggests that some fraction, f,
o f other checkable deposits is not held as total
checkable transaction balances and that money
market deposit balances do not yield transaction
services or are not held as part o f total check
able transaction balances. Thus, the amount of
total checkable deposits, TCD, that are "truly"
transaction balances equals (1-fsl) TCD, where
s i is the share o f other checkable deposits in
total checkable deposits. If some proportion, g,
o f MM are also transaction balances, then the
total MM com ponent o f transaction balances can
be written as gs2, w here s2 is the ratio o f MM
to TCD. Total transaction balances, TTB, can be
defined as:
(1) TTB - ( l - f s l + gs2) TCD.
In this framework, the financial innovations
hypothesis is that l > f > 0 and g = 0.
Prior to financial innovations, s i and s2 w ere
zero and TTB equaled TCD. The effective quan
tity o f M l was C + TCD, w here C is the curren
cy com ponent o f M l. The effective quantity o f
M l, designated M l*, when si and s2 are not
zero, is C + TTB, or Ml-fOCD + gMM. If s l l is
defined to be the ratio (OCD/M1) and s21 is de
fined to be the ratio (MM/MI), then
(2) M l* = M l ( l - f s l l + gs21).
Since M l equals (1 + k) TCD, w here k is the
ratio o f currency to total checkable deposits,
s l l equals s l/(l + k) and s21 equals s2/(l + k).

1Since M2 = (1 + k + t) TCD, where t is the ratio of the nonMl components of M2 to M2, the ratios s12 and s22 are
simply (1 + k + t)“ ‘ times s1 and s2, respectively.

FEDERAL RESERVE BANK OF ST. LOUIS

An effective quantity o f M2, called M2*, can
be defined similarly. W hether or not certain
proportions o f OCD and MM balances are ap
propriately considered part o f TTB and M l*,
they are definitionally part o f M2. This is the
central reason that the hypothesis claims that
M2 is unaffected by these innovations. If, h ow
ever, some fraction o f these new deposits are
not close substitutes for M2, then the effective
quantity o f M2, M2*, should exclude these frac
tions o f the new deposits.
In particular, if some fractions, f o f other
checkable deposits and gt o f MM balances, are
held for non-M2*-related reasons, then shifts in
holdings o f these funds will boost M2 relative to
M2*, that is,
(3) M2* = M 2 ( l - f 1s l 2 - g 1s22),
where sl2 is the ratio o f other checkable depos
its to M2 and s22 is the share o f m oney market
balances in M2. According to the financial in
novations hypothesis, the grow th o f other check
able deposits or MM involves substitutions within
M2 and does not affect its total; therefore, M2
equals M2* and gi and f ± equal zero.1
The hypothesis is tested below using the rela
tionships in equations 1-3. In particular, tw o im
portant econom ic variables, the turnover rate
for total checkable deposits and the currency
ratio, relate debits and currency holdings,
respectively, to desired holdings o f checkable
transaction balances. Movements in other check
able deposits or m oney market deposits have
predictable or systematic effects on the ratio of
checkable transaction balances to observed total
checkable deposits and, therefore on debits or
currency holdings relative to total checkable
deposits. Similarly, growth in these new assets
affects the relationship o f M l* and M2* to their
observed counterparts and, therefore, systemati
cally affect the relationship o f the observed ag
gregates, M l and M2, to the factors that influ
ence the demands for M l* and M2*, respectively.
The hypothesis also suggests that the interest
elasticity of demand for transaction balances,

M l and M2 have been affected by financial in
novations. The specific form o f the hypotheses
and tests are derived below.

THE TURNOVER RATE FOR
TOTAL CHECKABLE DEPOSITS
The turnover rate for total checkable transac
tion deposits is the ratio o f debits, D, on these
deposits to their total, TTB. If v, the turnover
rate o f deposits held for transaction purposes is
a function o f a vector o f variables, z0, then
(4) D = v(z0)TTB.
Substitution o f equation 1 in equation 4 yields:
(5) D = v(z0) (1 - f s l +gs2) TCD.
The left-hand side o f equation 5 includes any
third-party debits on MM balances held for
third-party payment, i.e., as checkable transac
tion balances, (gMM). For simplicity, assume that
debits include only third-party payments and
thus exclude cash-withdrawal debits on both
TCD and MM balances. If debits on money
market balances, Dm, are also a function of
gMM and the vector zQ above, or
(6) Dm = vm(zo) gs2 TCD,
then the debits measured against total checkable
deposits D„ are

balances (relative to TCD) will affect the turn
over o f total checkable deposits. The sign o f this
effect depends on whether 6 is positive, zero or
negative, or whether transaction balances in
MM have relatively low, the same or high turn
over com pared with the weighted average turn
over o f total transaction balances, v.
A log-linear specification o f v(zo) is used,
where zQ includes the current and past interest
rate (i„ it_,) and real personal income, y „ or
(9) lnv, = P0 + /?, Ini, + fi1 Ini,., + /?3 lny,.
The log-linear specification o f equation 8 is
(10) lnd, = P0 + (}l Ini, + P2 Ini,., +

lny,

+ l n ( l - f s l + gds2),
where vm/v is assumed constant. W hen equation
10 is differenced, the result is:
(11) Alnd, = (3I Alni, + ft2 Alni,., + P3 Alny,
+ A l n ( l- f s l + gds2).
The last variable in equation 11 is unknown
because f, g and 6 are unknown. This problem
is addressed indirectly in the paper.2 If f, g and
6 are constants, then
(12) A ln ,(l-fs l+ gds2) = ---------- --------- dsl
1 - fs l +gds2
+ ------- ^ ------- ds2.
1 - fs l +gds2

(7) Dt = D - D m = v(z0) [ l - f s l + gs2d] TCD,
where 6 = (l-vm/v) and the turnover ratio for
total checkable deposits is
(8) d = D./TCD = v(z0)[l - fs l + gs2d].
A rise in s i reduces the turnover ratio for total
checkable deposits; if f is zero, however, then
movements in s i have no effect on v. If g and
vm are not zero, movements o f funds into MM

2All the estimates in this article contain a term like
Aln(1 —fsl + gds2) in equation 11. Estimating the constants
like f and (g<J) directly by non-linear least-squares yields no
differences from the result reported in the text for the
financial innovations hypothesis. If f is correlated with
movements in s1 or its counterpart measures below, the
estimated coefficient on the share variables would be bias
ed; if the correlation is positive, as proponents of the
financial innovations might argue, this biases up the coeffi
cient and biases the tests in favor of the financial innova
tion hypothesis. The same argument applies to g. The op
posite bias would arise if f and the other checkable
deposit share were negatively correlated, but this is
counterintuitive. There is no a priori reason to expect f or
g (or f ] and g, below) to change, especially to change
systematically with movements in the shares, however.

The difference in the logarithm in the last term
in equation 11 can be approximated using the
total differential o f the expression in paren
theses and replacing d sl and ds2 with Asl and
As2.3
Thus, equation 11 can be written as:
(13) Alnd, = p0 + /?, Alni, + P2 Alni,_, + p3 Alny,

+ P4 Asl. + P5 As2.>

3The coefficients on As1 and As2 involve s1 and s2. These
coefficients are estimated as constants and are evaluated
at the sample period average values for f, gd, s1 and s2.
Note that gd is estimated from the s2 coefficient; conse
quently, the hypothesis that g equals zero cannot be
tested. If d equals zero (the turnover of transaction
balances held in MM is the same as for the rest of such
balances), then the coefficient on s2 will be zero; however,
this does not imply that g is necessarily zero.

JULY/AUGUST 1990

where /30 is an intercept which should have a
value of zero, unless a significant time trend has
been omitted from equation 10. Under the finan
cial innovations hypothesis, P4< 0 and P5= 0.

The Interest Elasticity o f the
Turnover Rate
The financial innovations hypothesis tested in
the text implies that the interest elasticity o f
m oney demand rose as a result of financial in
novations. Since turnover is a velocity measure,
a test is conducted o f whether the interest
elasticity o f the turnover rate o f total checkable
deposits rose in proportion to the growth o f si.
In equations 9 and 10, this elasticity is constant
and equals (Pt +P2). If Pl and P2 are functions of
s i, for example, /3j=/?,”+ /},' si, and P2= P2
+ P2 s i ,.,, then the terms (/}, Ini, + P2 lni,_,)
in equations 9 and 10 must be replaced with
(/3,° Ini, + 13/ si, + /J2°lni,_, +
s l,_ 1lni,_1). In
equation 13, P° replaces
p2 replaces P2,
and the additional terms / } / A(sl,lnit) and
P2' A(sl,_jlni,_,) must be included. W hether the
interest elasticity rose depends on whether P/,
p2' and (P/ + P2’) are statistically significantly
positive.

THE CURRENCY RATIO
The currency ratio is the ratio o f currency to
total checkable transaction balances. Currency
demand relative to total checkable transaction
balances is
(14) C = k(z,) TTB,
where z, is a vector o f the determinants o f the
desired ratio. With the advent o f OCD and MM
balances, currency holding competes with all
other transaction-related balances, or TTB. Sub
stitution o f equation 1 in equation 14 yields
(15) C = k(z,) ( 1 - f s l +gs2) TCD.
W hen s i rises, currency demand declines, given
TCD, z 1( f and g, if 0 < f < l . Changes in s2 have
no effect on the currency ratio under the hy
pothesis that g = 0.
The variables in z, that determine the desired
currency ratio, and are controlled for in testing
the financial innovations hypothesis, include the
autoregressive component, a first lag of the cur
rency ratio, the current (i,) and past (it_,) in
terest rate, energy prices, pe, and a credit con

FEDERAL RESERVE BANK OF ST. LOUIS

trol dummy variable, c. The first-difference of
the log-linear form o f equation 15, with the ap
propriate substitutions for z,, is:
(16) Aln(C/TCD), = d0 + d, Alni, + d2 Alni,.,
+ d3 Alnp' + d4 D80
+ c55 Aln(C/TCD),_,
+ Aln(l - f s l + gs2),
where D80 equals Ac.
The last term on the right-hand-side can be
approximated using the same argument used
above for equations 11 and 12 since
d l n ( l - f s l + gs2) equals [ - f / ( l - f s l + gs2)]dsl
+ [ g / ( l - f s l +gs2)]ds2. Thus, equation 16 can be
written as:
(17) Ain(C/TCD), = d0 + d, Alni, + d2Alni,_,
+ d3Alnp[ + d4 D80
+ [ —f / ( l - f s l + gs2)] Asl,
+ [g/(l - fs l +gs2)] As2,.
The financial innovations hypothesis, 0 < f < l , is
tested by whether Asl, has a significant negative
coefficient. The hypothesis g = 0 is tested by
whether As2, has a significant coefficient.
W hether the interest elasticity o f the currency
ratio is affected by the grow th o f s i is also
tested. The sum (d, + d2) in equation 16 or 17 is
the interest elasticity o f the currency ratio. If
each o f these components is a function o f si,
then the interest components in k(z,) can be
written as (d," + d /s l) Ini, + (d2° + d2' si) lni,_,,
and [d,°+ d2°+ d / si, + d2' sl,_,] is the interest
elasticity o f currency demand in this case. In
the first-difference form given in equation 17,
the interest rate components are replaced with
d^Alni, + d2"Alni,_, + d /A ( s l, Ini,)
+ d2' A (sl,„,lni,_,). If financial innovations affect
the interest elasticity, then 6/ and/or d2' are
significantly different from zero. Since d, and d2
are negative, for the interest elasticity to
becom e larger in absolute value requires that,
d /, d2'< 0 and (d / + d2')< 0 .

MONEY DEMAND
Suppose “true" or effective M l demand, M l*,
is a function of a vector o f variables z 3. Substi
tuting equation 2 yields:
(18) (1 - f s l l +gs21)M l = D(z2).
In log-linear form, this equation can be re
arranged as

(19) InMl = ln[D(z2)] - l n ( l - f s l l + gs21).
W hen this is first-differenced and a similar
substitution is made for the last term as was
made in equation 13 and 17, the result is:
(20) AlnMl = Aln[D(z2)] + d6 A sll,
+ d7 As21„
where
d6 = f /( l - f s ll + g s 2 1 ) , and
d7 = - g /( l - f s l l + gs21).
If f is zero, then d6 equals 0. If 0 < f < l ,
however, then d6 is positive; that is, a rise in
s l l should raise M l demand, given the variables
in z 2. If g equals 0, then d7 equals 0; if g is
positive, then d7 is less than zero.
The variables included in z 2 are the interest
rate, income and unanticipated inflation. The
specification o f ln[D(z2)] also includes a shift in
the interest rate elasticity o f m oney demand
and a shift in the level of M l demand, where
both shifts occu r in 1982. Therefore, tests are
conducted to determine if these tw o com
ponents o f z2 arise from financial innovations.

For M2 demand, the same set o f tests are con
ducted. In particular, if "true” M2 demand, M2*
in equation 3, is a function o f variables z 3, E(z3),
then substituting this in equation 3 yields
(21) ( l - f ,s l 2 - g ,s 2 2 ) M2 = E(z 3).
In the text, the z 3 vector includes the same set
o f other m oney demand variables as M l, that is,
z 3 equals z 2. In differenced log-linear form and
using the exact differential to derive the
discrete A l n ( l - f 1s l2 g 1s22), equation 21 becomes
(22) AlnM2, = Ain E(z3) + d8 As22, + d9 Asl2,
where
d8 = [g,/(1 - f , s l 2 - g 1s22)] and
d, = [f ,/(l-f,s l2 -g ,s 2 2 ) ].
Under the financial innovations hypothesis, f ,,
g,, dg and d9 are all zero. The coefficients dg
and d9 are positive if the proportions g, o f MM
or f 1 o f OCD are positive; this result would in
dicate that these proportions are not a close
substitute, given z 3, for the rest o f M2.

JULY/AUGUST 1990

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St. Louis, Missouri 63166

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Full text of Review (Federal Reserve Bank of St. Louis) : July/August 1990

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