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The Discount Rate and Market Interest
Rates: What’s the Connection?
DANIEL L. THORNTON

A 3 lS C O U N T rate changes invariably send new s
paper reporters to the phone to call their favorite
econom ist to ask the inevitable question: W hat will
this do to m arket interest rates? The im pact of dis
count rate changes on m arket interest rates appar
ently is the source of m uch public confusion and
m isunderstanding.
This confusion arises from a variety of factors.
First, the discount rate is an adm inistered rate set by
the Federal Reserve. Second, high interest rates
often occur w hen the discount rate is high, w hile low
interest rates often occur when the discount rate is
low. Finally, discount rate changes often are asso
ciated with changes in other interest rates in the
same direction. T hese factors have led to a m is
understanding about the pre-em inence of the dis
count rate in credit m arkets.1
The idea of the pre-em inence of the discount rate
steins, in part, from a failure to understand the
m echanism through which changes in the discount
rate are transm itted to m arket interest rates. The
purpose of this article is to analyze the theoretical
basis of the link betw een the discount rate and
m arket interest rates, and to review the recently ob
served relationship betw een these rates in light of
the theoretical discussion.

THE THEORETICAL CONNECTION
BETWEEN THE DISCOUNT RATE AND
MARKET INTEREST RATES
T he discount rate is the interest rate at which
Federal Reserve banks lend reserves to depository
institutions, prim arily to enable these institutions to
m eet their reserve requirem ents.2 T he relationship
1For a recent statement on the importance of the discount rate, see
Saul H. Hymans, et al., “The U.S. Outlook for 1982,” Economic
Outlook USA (Winter 1982), p. 3. F ora statement about the dis
count rate as a pivotal rate in the market, see George McKenney,
The Federal Reserve Discount Window (Rutgers University
Press, 1960), p. 6.
2As a result ofthe Monetary Control Actofl980, enacted on March
31, 1980, all depository institutions will have the same reserve

betw een the discount rate and m arket interest rates
can be illustrated using a simple, static m odel of
interest rates called the loanable funds theory. Ac
cording to the loanable funds theory, interest rates
are determ ined by the intersection of the dem and for
and supply of credit, as illustrated in figure 1. The
dem and for credit consists of investm ent dem and,
governm ent dem and (deficits) and changes in the
dem and for m oney.3 The supply of credit is com
posed of public and private savings and changes in
the supply of m oney. Changes in the discount rate
affect m arket interest rates only to the extent that
they alter the dem and for or the supply of credit.

The Discount Rate and the Supply
of Credit
Changes in the discount rate directly affect the
supply of credit through their im pact on the money
supply. To illustrate this, consider the sim ple m odel
of the money supply given by:
(1) MS = m . B.
The supply of nom inal m oney (Ms) is determ ined by
the product of the m onetary base (B) and the m oney
m ultiplier (m). The m onetary base consists of the
total reserves of depository institutions plus cur
rency held by the nonbank public. The m oney m ulti
plier sum m arizes the effect of all other factors on the
m oney supply and, for the purpose of our analysis, is
requirem ents. The uniform reserve requirem ents will be
phased in over a num ber of years. For more details, see “The
Federal Reserve Requirem ents” (Board of Governors of the
Federal Reserve System, 1981). The M onetary Control Act
also has given thrift institutions access to the discount window
through “extended credit borrowing.” For more details, see
“The Federal Reserve Discount W indow” (Board of Governors
of the Federal Reserve System, 1980).
3The supply curve is sloped positively on the assumption that
higher interest rates encourage more savings and because the
money supply may be positively related to the interest rate (see
footnote 4 below). The demand for loanable funds is downward
sloping due to the downward sloping marginal efficiency of
investm ent and the inverse relationship betw een the demand
for money and interest rates.
3

FEDERAL RESERVE BANK OF ST. LOUIS

assum ed to be constant and independent of m arket
interest rates.4
Total reserves supplied by the Federal Reserve
can be broken dow n into those supplied at the dis
count window, called borrow ed reserves (BR), and
those supplied through open m arket operations,
called nonborrow ed reserves (NBR). The monetary
base, therefore, can be w ritten as the sum of BR,
NBR and currency held by the nonbank public (C).
Thus, equation 1 can be rew ritten as:
(2) MS = m . (BR + NBR + C).
Changes in the discount rate affect m arket interest
rates through their im pact on borrowing from the
Federal Reserve. For example, an incrca.se in the
discount rate w ill reduce the level of borrowing,
ceteris paribus, reducing both the m onetary base
and the m oney supply. As a result, the supply-oferedit schedule in figure 1 will shift to the left and
m arket interest rates will rise. Reducing the discount
rate will have the opposite effect.

Discount Rate Changes and
Depository Institution Borrowing

JUNE/JULY 1982

ing the discount rate.6 Given the nonpecuniary costs
associated with discount window adm inistration, an
increase in the discount rate w ould reduce the level
of borrowing; reductions in the discount rate would
have the opposite effect.
Later, it was recognized that the relationship
betw een the discount rate and borrow ing at the dis
count w indow was not quite so sim ple. Borrowing
from the Federal Reserve is only one of several
m ethods depository institutions use to adjust their
reserve positions. They can borrow from the Federal
Reserve, buy federal funds in the federal funds
market, or sell earning assets, such as short-term
Treasury securities.7 It is not simply the level of the
discount rate that influences a depository institu
tion’s decision to borrow, but the level of the dis
count rate relative to rates on alternative adjustm ent
assets. A financial institution confronted w ith a
reserve deficiency will adjust its reserve position in
the least costly m anner. Thus, the im portant variable
in the decision to borrow is the so-called least-cost
spread betw een the rate on the next best reserve
adjustm ent asset and the discount rate.
In the aggregate, borrow ing is usually represented
by an equation like (3) below, in which (ici) denotes
the discount rate and (ia) denotes the interest rate on
next best reserve adjustm ent asset.8
(3) BR = aH + a! (ia - id), a„ s= 0, > 0
In this equation, a0 denotes a “ frictional” level of

The crucial link betw een the discount rate and
m arket interest rates is the connection betw een the
discount rate and borrowing from the Federal Re
serve. W hen the discount m echanism originally was
form ulated, it was assum ed that banks w ould be re
luctant to be in debt to the Federal Reserve and 6It is still thought that depository institutions are reluctant to
w ould endeavor to repay their indebtedness as soon borrow from the Federal Reserve; however, it has been a long
as possible.5 It was thought that the Federal Reserve standing question w hether the reluctance is inherent or induced.
rationing at the
could control the level of bank borrowing by rein The use of nonpriceClay Andersen, Adiscount window fbegan as
early as 1918. See
Half-Century o Federal
forcing banks’ reluctance to borrow, through the Reserve Policymaking: 1914-1964 (Federal Reserve Bank of
adm inistration of the discount window, and by alter- Philadelphia, 1965).

’Prior to Septem ber 1968, depository institutions could adjust
their reserve position by reducing the level of their deposits
reserves. In September 1968,
4It is sometimes argued that the money supply is positively re and, hence, required lagged reserve accounting, inthe Federal
introduced
which re
lated to interest rates due to changes in the public’s desire to hold Reservereserves in the current week are based on deposit levels
various assets in response to interest rate changes. For an quired weeks previous.
analysis of the monetary base approach to the money supply of two
process, see Jerry L. Jordan, “Elem ents of the Money Stock At the same time, the Federal Reserve changed Regulation D to
Determ ination,” this Review (October 1969), pp. 10-19.
permit a reserve deficiency carryover equal to 2 percent of re
Depository institutions can also adjust
5Winfield Riefler noted that “the reluctance of m em ber banks to quired reserves. by carrying over the deficiency into the their
next
borrow is not based solely upon the philosophy of reserve banks, reserve positionCarryovers in excess of 2 percent of required
reserve week.
however. Indeed, that philosophy merely expresses the desire
reserves are charged a rate 2 percentage points above the lowest
of the great majority of the member banks themselves to remain
month in
out of d e b t.. . and a feeling on their part that borrowing for profit discount rate in effect on the first day of the calendar that only
which the deficiency occurs. It should be noted
is unsound. . . . Long before the establishm ent of the reserve
system, it was one of the fundamental traditions of sound bank borrowing from the Federal Reserve adds reserves to the system
as a whole.
ing practice in this country, that a bank’s operations should be
confined to the resources which it derives from its stockholders 8The borrowing equation usually includes variables to measure
and depositors and interbank borrow ing was at all tim es
the degree of reserve pressure of depository institutions, such as
lim ited.” Winfield Riefler, Money Rates and Money Markets in
the level oforthe change in nonborrowed reserves. Because they
the United States (Harper and Bros., 1930), p. 29.
have no significance for our purpose, they were ignored here.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

thus the m onetary base. As a result, the supply of
credit schedule shifts to the left and m arket interest
rates rise until the least-cost spread is restored.
Thus, increasing the discount rate will, ceteris pari
bus, cause m arket rates to increase.
The extent of the increase in the m arket interest
rate is determ ined by the sensitivity of borrowing
to the least-cost spread (ai) and by the interest
sensitivity of the dem and for credit. The more bor
rowing is interest-sensitive to the least-cost spread
(i.e., the larger ai), the greater will be the shift in
the supply of credit for any change in the discount
rate. The larger the shift in the supply of credit, the
greater the change in the m arket interest rate, for
any given cred it dem and curve. Also, the less
interest-sensitive the dem and for credit (i.e., the
steeper the dem and curve), the greater the change
in the m arket interest rate for any given shift in the
supply schedule resulting from a change in the
discount rate.

F ig u re 1

C re d it M arket E quilibrium
In te re s t ra te

Q u a lit y o f c r e d it

The Discount Rate, Interest Rates and
Monetary Policy

Unfortunately, the above analysis is overly sim ple
in that it ignores the role of m onetary policy in
influencing the link betw een the discount rate and
m arket interest rates. Specifically, the relationship
borrowing (i.e., borrowing that occurs even if the
betw een the discount rate and m arket interest rates
discount rate is not the least costly alternative).9
Given equations 2 and 3, the connection betw een depends on other m onetary policy actions and, in
the d isco u n t rate and m arket in te re st rates is particular, on the operating procedure of the Federal
apparent. Increases in the discount rate reduce the Reserve. For exam ple, if the Federal Reserve were
least-cost spread, w hich reduces borrow ing and to pursue a policy of controlling the level of interest
rates, changes in the discount rate w ould have no
independent impact on m arket rates. The reason
For a discussion of the various theories of depository institutions’ for this is straightforward. U nder an interest rate
borrowing, see Rieffer, Money Rates and Money Markets in the targ etin g p ro ced u re, the T rad in g D esk of the
United States; Lauchlin Currie, The Supply and Control o f Federal Reserve Bank of New York w ould offset any
Money (Harvard U niversity Press, 1934); R obert Turner, m ovem ent in m arket rates by changing the level of
Memher-Bank Borrowing (Ohio State University Press, 1938);
Murray E. Polakoff “Reluctance Elasticity, Least-Cost, and nonborrow ed reserves through open m arket opera
M ember Rank Borrowing: A Suggested Integration,” Journal tions; that is, the leftward shift in the credit supply
o f Finance (March 1960), pp. 1-18; Murray Polakoff and William schedule due to an increase in the discount rate
Silber, “Reluctance and Member-Bank Borrowing: Additional
Evidence,” Journal o f Finance (March 1967), pp. 88-92; and would be offset by a rightward shift resulting from
Stephen Goldfeld and Edward Kane, “The Determinants of F ed eral R eserve open m arket o peratio n s. T he
M ember Bank Borrowing: An Econometric Study "Journal of im pact of the change in the discount rate on the
Finance (September 1966), pp. 499-514.
m arket rate would be nil.10
9The fact that there is usually some level of borrowing even when
the discount rate is above most other short-term market interest
A sim ilar result w ould hold if the Federal Reserve
rates is usually construed as prima facie evidence of the inade chose to control the level or growth of the m oney
quacy of the alternative mechanisms in providing the reserve
adjustment needs of all depository institutions. At the other ex
treme, borrowing takes the form of a subsidy if the discount rate
is substantially below market rates. See R. Alton Gilbert, "Bene
fits of Borrowing from the Federal Reserve when the Discount
Rate is Below Market Interest Rates,” this Review (March 1979),
pp. 25-32.

10It should be noted that the Federal Reserve cannot “peg”
interest rates in an inflationary environment without continually
accelerating the growth rate of money. See Milton Friedman,
“The Role of Monetary Policy,” American Economic Revieiv
(March 1968), pp. 1-17.
5

FEDERAL RESERVE BANK OF ST. LOUIS

supply, and if it effected its control through m onetary
base (or total reserve) targeting. In this instance, an
increase in the discount rate w ould low er the level
of borrow ing and, hence, the m onetary base. If this
change caused the base to deviate from its desired
path, given a m oney growth objective, the Federal
Reserve w ould increase nonborrow ed reserves via
open-m arket operations in order to return the m one
tary base to its desired path. Changes in the discount
rate w ould have no independent effect on either the
m oney supply or m arket interest rates.
The effect of a discount rate change on m arket
rates could be significant w hen the Federal Reserve
targets on nonborrow ed reserves as it currently does.
In this instance, changes in the discount rate alter
aggregate borrowing, the m onetary base and the
m oney supply as before. The m ovem ent in the base
w ould not necessarily be offset through open m arket
operations. As long as nonborrow ed reserves are on
path, the Federal Reserve m ight choose not to offset
changes in borrowings associated with changes in
the discount rate.11 U nder the present system of
lagged reserve accounting (LRA), how ever, the
effect of a discount rate change on aggregate borrow
ing, the monetary base and the money supply will
be m uch smaller.

The Role of Lagged Reserve Accounting
The present system of lagged reserve accounting,
w hich was introduced in Septem ber 1968, has m ade
depository institutions’ dem and for reserves less
responsive to in terest rate changes.12 Thus, any
change in the supply of reserves, either through
changes in NBR or the discount rate, produces a
larger change in the rates on reserve adjustm ent
assets, such as federal funds and Treasury bills.
lr The reader might legitimately inquire as to why the Federal
Reserve would not offset all changes in aggregate borrowing if
it did not desire a change in the money supply. Unfortunately,
there is no simple answ erto this question. Recently the Federal
Reserve has attem pted to offset changes in borrowing only
if they are viewed to be perm anent in some sense. See David E.
Lindsey, “ Nonborrowed Reserve Targeting and M onetary
C ontrol” in Improving Money Stock Control: Problems,
Solutions and Consequences, conference cosponsored by
the Federal Reserve Rank of St. Louis and the C enter for
the Study of Am erican Rusiness, W ashington University,
October 30-31, 1981 (forthcoming).
It should be noted, however, that if the Federal Reserve were
to offset all changes in borrowings that move them off their
nonborrowed reserve path, they would essentially be targeting
on total reserves or the base.
12Since this article was completed, the Federal Reserve Board
adopted a resolution to return to contemporaneous reserve
accounting.

JUNE/JULY 1982

In order to see this point, consider the following
sim ple m odel of the m arket for reserves. Reserves
are supplied by the Federal Reserve either through
open m arket operations or at the discount window.
NBR are determ ined solely by Federal R eserve
actions and are independent of m arket interest rates.
In contrast, BR are related to interest rates via equa
tion 3. Depository institutions’ dem and for reserves
is com posed of their dem and for required reserves
(as determ ined by their deposit levels) and their
dem and for excess reserves. U nder a system of con
tem p oran eo us reserv e acco un tin g (CRA), both
required reserves and excess reserves are assum ed
to be negatively related to the rate on reserve adjust
m ent assets.13 This equilibrium is illustrated in
figure 2a by the intersection of Rs and R^.
U nder a system of LRA, current required reserves
are determ ined by depository institutions’ deposits
of the prior two weeks. The dem and for current
required reserves is com pletely insensitive to the
interest rates on reserve adjustm ent assets. T he
interest responsiveness of the dem and for reserves
is d eterm ined solely by the dem and for excess
reserves. Thus, dem and for reserves under LRA is
less interest-sensitive (steeper), as illustrated by Rj
in figure 2b.14
The im pact of a change in the discount rate under
CRA and LRA is illustrated in figure 2. An increase
in the discount rate reduces the am ount of reserves
supplied at each m arket rate, shifting the reserve
supply curve to R^. G iven that the dem and for
13Under CRA, depositoiy institutions must weigh the marginal
costs of having to adjust their reserve position either at the
discount window or in the market with the marginal gain from
making additional loans and investm ent and, thereby, creating
additional deposits. Thus, when either the discount rate or the
rates on alternative adjustm ent assets increase relative to
depository institutions’ lending rates, they respond by curtail
ing their lending and investm ent activities, which reduces
their deposit liabilities and their dem and for required reserves.
Thus, the demand for required reserves would be interestsensitive under CRA. Under LRA, the demand for required
reserves is determ ined by deposit levels two weeks previous
and, hence, is independent of current interest rates.
Excess reserves are thought to be held as a source of liquidity
for the depository institution. As such, the opportuntiy cost of
holding excess reserves is income forgone by not investing
them in some income-generating asset, like federal funds. Thus,
the dem and for excess reserves is thought to be responsive to
changes in market interest rates. The dem and for excess
reserves, however, is generally not thought to be responsive
to interest rates.
14The equilibrium market rate is shown the same for both CRA
and LRA for ease of illustration. This accommodation to con
venience does not affect the conclusions.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

F ig u re 2

The Effect of Discount Rate Change Under Contemporaneous and Lagged Reserve Accounting

reserves is less interest-sensitive under LRA, inter
est rates m ust rise by more in order to restore m arket
equilibrium . Thus, a change in the discount rate will
result in a larger change in the interest rates on
reserve adjustm ent assets, and a sm aller change in
aggregate borrowing, the m onetary base and the
m oney supply.

The Effect on Other Market Rates
A change in the discount rate has its initial effect
on the m arket interest rate of reserve adjustm ent
assets. The extent to w hich a change in the m arket
rates of these assets spills over to other m arket
in terest rates depends on the substitutability of
assets in the portfolios of financial interm ediaries
and the public. To illustrate this point, assum e for
sim plicity that depository institutions use only one
asset as an alternative to borrow ing from the Federal
Reserve, and that this asset is not held in the port
folios of the rest of the private sector of the economy
(e.g., federal funds). Thus, there are no close substi
tutes for this asset in the portfolios of nondepository
institutions. In this case, the initial im pact of a
change in the discount rate w ould be reflected
prim arily in the m arket rate of this asset. The effect
on other m arket interest rates w ould m aterialize
only as depository institutions m odified their lend
ing and investm ent activities in light of the higher
m arginal cost of reserve adjustm ent funds.

The Discount Rate and the Demand
for Credit
The discount rate also affects m arket interest rates
via the dem and for credit through the so-called
announcem ent effect. According to this view, the
business and financial com m unities regard discount
rate changes as signals of the future direction of
monetary policy. D iscount rate changes are thus said
to alter expectations about the future of business
profits and the direction of interest rates.
Unfortunately, the im pact of the announcem ent
effect depends on the exact nature of these expecta
tion effects.15 To illustrate this, consider the follow
ing: If the Federal Reserve increased the discount
rate, individuals m ight interpret this action as an
indication that a slow er rate of m onetary growth, a
low er rate of inflation and, hence, low er interest rates
will soon follow. If this w ere the case, they m ight
15Warren Smith has argued that the exact impact of the an
nouncement effect depends on the market perception of the
efficacy of monetary policy, the elasticity of interest rate expec
tations and the distributions of these expectations among bor
rowers and lenders in the market. See W arren Smith, “ Instru
ments of General Monetary Control,” National Banking Review
(September 1963), pp. 47-76; “The Discount Rate as a Credit
Control W eapon,” Journal o f Political Economy (April 1958),
pp. 171-77; and “On the Effectiveness of Monetary Policy,”
American Economic Review (September 1956), pp. 588-606.
7

JUNE/JULY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

F ig u re 3

Discount Rate Change and Expectations Effects
In te re s t ra te

reduce their current dem and for credit in anticipa
tion of low er future interest rates. The dem and for
credit w ould shift to the left and, ceteris paribus,
current interest rates w ould fall. T he com bined
effects of a discount rate increase on the supply of
and the dem and for credit in this instance, under
nonborrow ed reserve targeting, are illustrated in
figure 3a. An increase in the discount rate shifts both
th e supply-of-credit and th e dem and-for-credit
schedules to the left. M arket interest rates w ould rise
or fall depending on w hether the shift in the dem and
curve is small or large, relative to the shift in the
supply curve.
Conversely, individuals m ight interpret the dis
count rate increase as an indication that m arket
interest rates will tem porarily rise. In this case, the
current dem and for credit w ould increase. U nder
these circum stances, an increase in the discount rate
w ould shift the supply of credit to the left and the de
m and for credit to the right as illustrated in figure 3b.
M arket in terest rates w ould then have risen in
response to a discount rate change.16
16Warren Smith has commented that, rather than changing the
demand for credit in the short run, a discount rate increase may
merely induce market participants to shift to different term
assets in response to expectations of higher or lower future
interest rates. If this were the case, the yield curve would shift
with changes in the discount rate. See Smith, “The Discount
Rate as a Credit Control W eapon.”

In te re s t ra te

It should be noted, how ever, that there are those
who question w hether there should be any signifi
cant expectational effect associated w ith a discount
rate change. They argue that a discount rate change
is only one of a m yriad of signals that individuals
receive concerning the direction of econom ic activ
ity and interest rates; therefore, it is doubtful that
changes in the discount rate alone have any signifi
cant im pact on the dem and for credit.
Furtherm ore, it has been noted that changes in
the discount rate are som etim es m erely technical
adjustments, designed to bring the discount rate in
line with changes in m arket interest rates. Thus, if
discount rate changes are com monly interpreted as
signals of policy change, they may be m isinter
preted. It has even been suggested that, given the
Federal Reserve Banks’ tendency to m ake these
technical adjustm ents, a failure to change the dis
count rate w hen m arket rates are changing could be
construed as a change in Federal Reserve policy.17
17For a recent interpretation of discount rate changes as technical
adjustments, see Hymans, et. al., “The U.S. Economic Outlook
for 1982.” For an interesting look at various interpretations of a
discount rate change, see Charles Walker, “ Discount Policy in
Light of Recent Experience,” Journal o f Finance (May 1957),
pp. 223-37; Milton Friedm an, A Program for Monetary Stabil
ity (Fordham University Press, 1959); and Ralph A. Young,
“Tools and Processes of Monetary Policy,” in Neil H. Jacoby,
ed., United States Monetary Policy (Fredrick A. Proeger,
1964), pp. 24-72.

FEDERAL RESERVE BANK OF ST. LOUIS

The Discount Rate and the Level of
Market Interest Rates
Up to this point, the discussion has been solely in
term s of the effect of changes in the discount rate
on m arket interest rates. Nothing has been said about
the relationship betw een the level of the discount
rate and the level of m arket interest rates. Thus, one
additional point m ust be m ade before proceeding to
the em pirical analysis. The point is that there are
num erous factors that affect the supply of and the
dem and for credit besides the discount rate. Thus,
there is no one level of m arket interest rates that
necessarily corresponds to any given level of the
discount rate. It would not be surprising, then, to
find th at other factors dom inate m ovem ents in
m arket interest rates in the longer run. This is
especially true w hen one recognizes that the dis
count rate is an adm inistered rate that is changed
infrequently.

THE DISCOUNT RATE AND MARKET
INTEREST RATES:
THE RECENT EXPERIENCE
Now consider the em pirical evidence on the rela
tionship betw een the discount rate and m arket
interest rates. The data analyzed is from January
1978 to April 1982, a period chosen because it is
tim ely and because it is characterized by markedly
different Federal R eserve operating procedures.
Until O ctober 6,1979, the Federal Reserve followed
a procedure of federal funds rate targeting; that is,
it conducted open m arket operations in such a
way as to keep the federal funds rate in a narrow
range established by the Federal O pen M arket Com
m ittee (FOMC). Also, the Federal Reserve followed
a policy of changing the discount rate frequently
to m aintain a fairly constant federal funds rate/
discount rate differential.
Since O ctober 1979, the Federal R eserve has
pursued a policy of controlling the m onetary aggre
gates through a nonborrow ed reserve targeting
procedure.18 Thus, the announced federal funds
18For a discussion of the Federal Reserve’s operating procedure
since October 6, 1979, see Stephen Axilrod and David E. Lind
sey, “ Federal Reserve System Implementation of Monetary
Policy: Analytical Foundations of the New Approach,” Ameri
can Economic Review (May 1981), pp. 246-52; R. Alton Gilbert
and Michael E. Trebing, “The FOMC in 1980: A Year of
Reserve Targeting,” this Review (August/September 1981),
pp. 2-22; Richard W. Lang, “The FOMC in 1979: Introducing
Reserve Targeting,” this Review (March 1980), pp. 2-25; and
Lindsey, “ Nonborrowed Reserve Targeting and M onetary
Control.”

JUNE/JULY 1982

rate range has been m uch w ider since O ctober 6,
and the federal funds rate has exhibited more dayto-day variability. M oreover, the average daily
spread betw een this rate and the discount rate
has been much w ider.19
Establishing the precise relationship betw een the
discount rate and m arket interest rates is extrem ely
difficult. Ideally, sets of equations representing
the dem and for credit, the supply of credit and a
m arket-clearing condition should be specified. In
this way, one could not only estim ate the extent of
the im pact of a discount rate change on various
m arket interest rates, but also identify the m ost sig
nificant source of the change (i.e., its effect through
the supply of or the dem and for credit).20 In practice,
however, this is difficult. As a result, the im pact of a
discount rate change on m arket interest rates is
usually estim ated w ith a reduced-form m odel, which
19For a discussion of the relationship betw een the federal funds
rate and the FOM C’s announced federal funds rate range, see
Lang, “The FOMC in 1979: Introducing Reserve Targeting”;
and Gilbert and Trebing, “The FOMC in 1980: A Year of
Reserve Targeting.”
20One possible way to identify a separate announcem ent effect
is to specify a general model of the supply of and the demand
formoney. This could be done by simply includingthe discount
rate as a separate variable in the demand for money and supply
of money functions, and testing to see w hether it has a signifi
cant effect on either or both. However, the correspondence
betw een the discount rate and market interest rates, due to the
fact that discount rate changes tend to follow market interest
rate changes, biases this test toward the rejection of the an
nouncement effect unless one has precise knowledge of the
Federal Reserve’s discountrate reaction function. This problem
could be overcome by sim ply estim ating a reduced-form ,
equilibrium money stock equation. This equation would have
the money stock a function of the exogenous variables of the
system: aggregate income, the monetary base and the discount
rate.
A significant discount rate effect would be clear evidence of
an announcem ent effect, since the impact of a discount rate
change on the money supply would be incorporated in the base.
Unfortunately, an insignificant discount rate will not neces
sarily im ply the absence of an announcem ent effect; this
result could also be obtained if the money supply is relatively
interest-inelastic.Thus, one would have to show both that
the money supply schedule is interest-clastic and an insignifi
cant discount rate in such a reduced-form equation to argue
convincingly that there is no announcem ent effect. Regretablv, practical problems make this virtually impossible.
It is possible to show that the discount rate is insignificant in a
reduced-form equation, employing seasonally adjusted data,
for the 10/1979 — 10/1981 period. The money supply equation
exhibits some interest elasticity, however, only if seasonally
unadjusted data is used. Because personal income (the only
available monthly income series) is available only on a season
ally adjusted basis, it is impossible to estimate the reducedform equation using seasonally unadjusted data. Thus, the
insignificant discount rate variable in the seasonally adjusted,
reduced-form equation is not conclusive evidence against an
announcem ent effect.
9

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

does not perm it one to differentiate betw een supplyside and dem and-side effects.21

The Discount Rate and Market Rates
To determ ine the effect of discount rate changes
on m arket in terest rates, the follow ing equation
was estim ated using both the federal funds and the
3-month Treasury bills to represent alternative ad
justm ent assets:
(4)

A iat

10
1 SjAiat.j

j= l

t>2 A D R t

+ et

This equation was estim ated using daily data for the
period from January 10, 1978, to April 13, 1982, and
for subperiods of federal funds rate targeting and
NBR targeting.22 The 10-day distributed lag of the
m arket rate was included to capture the effect of
other factors on the m arket rate before the discount
rate change.
Table 1 presents estim ates of equation 4.23 The
change in the discount rate, denoted by ADR, equals
the change only on the day that it becam e effective.
T he ADR variable was partitioned into technical
ch an g es—A D R T — and n o n tech n ical ch an g es—
ADRNT—to test w hether there is a different effect
if discount rate changes are m ade solely for tech
nical reasons (i.e., to keep the discount rate in line
w ith m arket interest rates [see insert, page 12]).24

21Among the studies that have attem pted to test for an an
nouncem ent effect using a reduced-form model are: H. Kent
Baker and James M. Meyer, “ Impact of Discount Rate Changes
on Treasury Bills,” Journal o f Economics and Business (Fall
1980), pp. 43-48; Douglas R. M udd, “ Did D iscount Rate
Changes Affect the Foreign Exchange Value of the Dollar
During 1978?” this Review (April 1979), pp. 20-26; Rodger
Waud, “ Public Interpretation of Federal Reserve Discount Rate
Changes: Evidence on the ‘Announcement Effect,’” Econometrica (March 1970), pp. 231-50; and Raymond Lombra and
Raymond Torto, “ Discount Rate Changes and Announcement
Effects,” Quarterly Journal o f Economics (February 1977),
pp. 171-76.
22The data were partitioned on Septem ber 19, 1979, the effective
date of the last discount rate change prior to the implementation
of the new operating procedures on October 6, 1979.
23The equations were estimated with ordinary least squares (OLS)
and with a maximum likelihood procedure that adjusts for
first-order autocorrelation. OLS results are reported if the
estimate of the coefficient of autocorrelation was not significant
ly different from zero. The results, however, were essentially
invariant to the estimation technique.
24Discount rate changes were made for purely technical reasons
on May 11 and July 3, 1978, and on May 30, June 13, July 28,
1980, and Decem ber 4, 1981.
Digitized for10
FRASER

Also, a discount rate surcharge variable, ASC, was
included in some of the regressions in the NBR tar
geting period to capture any effect of the Federal
R eserve’s surcharge on large, frequent borrow ers.25
The results for the entire period indicate that a
discount rate change has a significant positive effect
on both the federal funds and the Treasury bill rates.
W hen the equation is estim ated for subperiods of
federal funds rate and NBR targeting, how ever, the
results change. The coefficient on A DR is not sig
nificantly different from zero for the Treasury bill
rate during the period of federal funds rate targeting.
In contrast, the coefficient on A D R is significant
for both m arket rates during the period of NBR
targeting. Furtherm ore, the coefficient estim ates on
ADR are larger during the latter period.
The preceding section noted that discount rate
changes would not affect m arket interest rates if the
F ed eral R eserve targ eted on them , b u t w ould
affect m arket rates under NBR targeting. The results
for the Treasury bill rate equation correspond with
this analysis, b ut the results from the federal funds
rate equation do not. If depository institutions pri
m arily rely on the federal funds m arket to adjust
their reserve positions, how ever, it is conceivable
that m ost of the im pact of a discount rate change
could be absorbed by the federal funds rate w ith
virtually no spillover to other m arket rates. This
even seems likely w hen one recognizes that the
F ederal R eserve has never follow ed a policy of
rigidly pegging the level of the federal funds rate.
In addition, discount rate changes generally w ere
m ade in order to keep the rate spread betw een the
discount rate and the federal funds rate in a fairly
narro w b an d d u rin g th e fu n d s rate ta rg e tin g
period.26 Thus, during this period, discount rate
changes may have been anticipated and fully re
flected in m arket rates before the discount rate
change. The Federal Reserve allowed the spread
betw een the discount and the federal funds rates to
be much larger and variable during the NBR target-

25The Federal Reserve first introduced a surcharge of 3 percent
to the basic discount rate for large and frequent borrowers on
March 17, 1980. The effective surcharges and dates are: 3 per
cent on March 17, 1980, removed May 7, 1980; 2 percent on
November 17, 1980; 3 percent on D ecem ber 5, 1980; 4 percent
on May 5, 1981; 3 percent on Septem ber 22, 1981; 2 percent on
October 13, 1981, removed November 17, 1981.
26The average spread betw'een the discount and the federal funds
rates betw een discount rate changes ranged from 50 to 100
basis points.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

Table 1
Estimates of Equation 4
Period

Constant

ADR

ADRNT

ADRT

ASC

Sum of lags

R2/SEE

-.2 6
(8.84)

.117
.648

-.41

.12 1

Federal Funds Rate
1/10/784/13/82

.007*
(.476)

.487
(2.831)

.003*
(.185)
1/10/789/19/79

.023
(2.892)

.006*
(.217)

-.2 5 3

(14.76)

.312
(2.247)

-1 .4 6 2
.431

-.583 *
(1.564)

(3.023)

1.378

.323
.252

-.6 8

.332

.414*
(1.679)

-.1 9
(4.92)

.110

-.2 8 3

-.092 *
(.239)

.250

-.3 2 6
.884
(3.006)

.007*
(.237)

.646

-.61
(16.00)
(19.28)

.553
(2.300)

.0 0 1 *
(0.057)
.0 0 1 *
(.105)

-.134 *
(.462)

.736
(3.678)

.023
(2.963)
9/20/794/13/82

-.5 3 6

-.3 2

.114

.803

(8.58)
.423
(2.823)

-.4 5 3

.375

-.4 2 6

.800

-.1 4
(3.59)

.119
.792

-.2 2

.12 0
.797

N.A.

.046
.230

.308

-.0 8
(2.64)

.051
.228

-.2 2 6

N.A.

.067
.095

-.3 8 4

N.A.

.068
.095

.286

-.038*
(.098)

(5.73)

.261

.687
(2.206)

N.A.

.050
.286

-.12
(3.07)

.059
.282

(2.501)

Treasury Bill Rate
1/10/784/13/82

.0 02 *
(.307)

.357
(5.655)

.000 *
(.028)
1/10/789/19/79

.010
(2.103)

.473
(6.234)
.028*
(.454)

.0 10

.054*

(2.13)
9/20/794/13/82

(.839)

.0 0 2 *
(.181)

.0 0 1 *
(.067)

-.167*
(.970)

.434
(4.979)

- . 0 0 2*
(.157)
.003*
(.199)

.104*
(.942)

.613
(5.687)

.1 1 0 *

.349

(.778)

.396
(4.546)

.094*
(1.762)
.573
(5.056)

.139*
(.967)

.124

.13
(3.33)

.053
.283

.064*

.262

N.A.

.059
.285

(1.153)

The absolute value of the "t-ra tio s " are in parentheses below each coefficient.
'Indicates the coefficient is not sig nifica nt at the .05 level.
N.A. indicates the equation was estimated with ordinary least squares.

ing period. H ence, discount rate changes may not latter period w ere 100 basis points in absolute value.
have been anticipated as w ell during this period, Thus, one could argue that only larger discount rate
resulting in a more significant announcem ent effect changes have a significant effect on m arket interest
rates.
on the dem and side.
Furtherm ore, the absolute value of discount rate
To further investigate the relationship betw een
changes w ere larger in the latter period. The nine discount rate changes and m arket interest rates, the
discount rate changes in the early period averaged equations were re-estim ated using both ADRNT
50 basis points, w hile each of the 11 changes in the and ADRT, w hich reflect nontechnical and technical

JUNE/JULY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Reasons for Changes in the Discount Rate
Date

Change

Reason

May 11, 1978

6V2

to 7%

July 3, 1978

7 to

7 V4%

August 21, 1978

7'/4 to

7%%

Action taken in view o f recent disorderly c on ditions in foreign exchange markets, as
well as the continuation of serious dom estic inflation.

S ep tem be r22 ,1978

7% to

Action taken to bring discount rate in closer alignm ent w ith short-term interest rates,
and as a furthe r step to strengthen the dollar.

O ctober 16, 1978

81/ 2%

Action taken to bring the discount rate in closer alignm ent w ith short-term interest
rates, and in recognition of the continued high inflation rate and of the current
international financial condition.

November 1, 1978

81/2 to

91 %
/2

Action taken to strengthen the dolla ran d to counter con tinu ing dom estic inflationary
pressures.

July 20, 1979

9’/2 to 10%

Action taken in view of the recent rapid expansion of the m onetary aggregates, to
strengthen the do lla r on foreign exchange m arkets and to bring the discount rate
into alignm ent w ith short-term interest rates.

August 17, 1979

1 0 to 1 0 1/ 2%

A ction taken in view of the con tinu ing strong inflationary forces and the relatively
rapid expansion in the monetary aggregates.

Septem ber 19,1979

1 0 V2 to 1 1 %

A ction taken to bring the discount rate into alignm ent w ith short-term interest rates,
and to discourage excessive borrow ing from the discou nt w indow .

O ctober 9, 1979

12%

Action taken to bring discount rate into closer alignm ent with short-term rates,
and to discourage excessive borrow ing.

February 15, 1980

to 13%

Concern about the increased price of im ported o il adding to inflationary pressures
underscored the need to raise the discount rate and maintain firm con tro l over the
growth of money and credit.

May 30, 1980

13 to

12%

Action taken entirely in recognition of recent substantial declines in short-term
market interest rates to levels below the discount rate.

June 13, 1980

1 1%
10%
1 1%

Essentially the same as above.

Septem ber 26,1980

12
11
10

November 17, 1980

12%

Action taken in view of the current level of short-term interest rates and the recent
rapid grow th in the m onetary aggregates and bank credit.

December 5, 1980

to 13%

Action taken in light of the level of market rates and consistent with the existing
policy to restrain excessive grow th in money and credit.

May 5, 1981

13 to 14%

Action taken in light of the current levels in short-term market interest rates and the
need to maintain restraint in the monetary and credit aggregates.

November 2, 1981

14 to 13%

Action taken against the background of recent declines in short-term interest rates
and the reduced level of adjustm ent borrow ing at the discou nt w indow . It is
consistent w ith a pattern of continued restraint on the growth of money and credit.

December 4, 1981

13 to

12%

Action taken to bring the discount rate into better alignm ent w ith short-term interest
rates that were prevailing recently in the market.

July 28, 1980

Action taken to bring discount rate in closer alignm ent with short-term interest rates.
Essentially the same as above.

Essentially the same as above.
Action taken as part of a continuing policy to discourage excessive growth in the
monetary aggregates.

Source: Federal Reserve Bulletins released the m onth of o r one month after the announced change in the discount rate.

changes in the discount rate, respectively. D iscount
rate changes that are m ade purely for technical
reasons m ight have less of an im pact on m arket
rates in that either (1) the Federal Reserve offsets
their effect on the supply of credit through open
m arket operations because they w ere not intended
as a change in policy, or (2) the announcem ent effect
was w eaker because m arket participants do not view
such changes as indications of a change in Federal
Digitized for12
FRASER

Reserve policy.27 If either of these is true, the coef
ficient on ADRNT will be larger than the coefficient
on ADR, and the coefficient in A D RT will not be
statistically significant. Table 1 shows that these
27Under LRA a change in the discount rate produces a much
smaller change in aggregate borrowing than under contempo
raneous reserve accounting. Thus, the level of open market
operations required to offset the effect of this change on money
is much smaller.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

would be reflected in m arket rates rather quickly, so
that m ovem ent in these rates betw een discount rate
changes w ould be dom inated by other factors.30
This is borne out in a casual observation of the rela
tionship betw een the discount rate and m arket rates
over this period as shown in chart 1.
It is clear from this chart that m arket interest rates
varied from levels substantially above the discount
rate to levels substantially below it over this period.
This m erely reflects the previously noted fact that
The Effects of the Surcharge
there is no level o f market interest rates that
necessarily
T he effects of the discount rate surcharge on count rate. corresponds to a given level of the dis
m arket in terest rates during the NBR targeting
period are mixed. W hen the discount rate surcharge
Furtherm ore, there w ere at least three occasions
variable is added to the federal funds rate equation, when discount rate changes w ere closely followed
the coefficients on the discount rate variables b e by m ovem ents in the 3-month Treasury bill rate in
come smaller. Furtherm ore, the coefficients on the the opposite direction (June 13, 1980, D ecem ber 5,
surcharge variables are statistically significant. 1980, and May 5, 1981). In the last instance, the
T hese results indicate a significant positive sur federal funds rate and the Treasury bill rates m oved
charge effect on the federal funds rate. In addition, in opposite directions. The federal funds rate rose
they indicate that the estim ates of the discount rate from early May to m id-July 1981, then declined. In
effect alone are unduly large w hen the surcharge contrast, the bill rate fell from early May to early
variable is ignored. This is likely because of the July, then rose until late August. Thus, it is difficult
interaction of discount rate and surcharge effects.29 to find any co n sisten t longer-term relatio n sh ip
een
of the
W hen the surcharge variable is included in the betwarketthe level rates. discount rate and the level
of m
interest
Treasury bill rate equation, the coefficients on the
discount rate variables are essentially unaffected.
The coefficients on the ASC variable are insignifi CONCLUSIONS
cant and small. Thus, it appears that the surcharge
M arket interest rates are influenced by num erous
has no appreciable im pact on the Treasury bill rate.
factors that affect the supply of and dem and for
credit. One of these factors is the discount rate. The
im pact of the discount rate on m arket rates varies
The Levels o f the Discount Rate and
with the Federal R eserve’s operating procedures. If
Market Rates
the Federal Reserve is controlling interest rates, the
The fact that discount rate changes have a signifi m onetary base or total reserves, changes in the dis
cant im m ediate effect on m arket interest rates does count rate have no effect on interest rates indepen
not mean that there is a significant relationship b e dent of the general tenor of monetary policy; the
tw een the level of the discount rates and the level Federal Reserve simply w ould offset the effect of
of m arket rates. One w ould anticipate that any effect discount rate changes through open m arket opera
of a discount rate change on m arket interest rates tions. If the Federal Reserve is targeting on non
borrowed reserves, changes in the discount rate are
more likely to have an im pact on m arket rates, espe
28The results presented in this section appear to be robust. They cially under lagged reserve accounting.
are essentially unchanged if the equation is estimated in level

results w ere obtained in every instance. Thus, it
appears that only discount rate changes that are
m ade for nontechnical reasons have a significant
im pact on m arket interest rates. The coefficient on
ADRNT in the Treasury bill rate equation, however,
was not significant during the early period. D iscount
rate changes appear to have had no im pact on the
3-month Treasury bill rate under interest rate target
ing, regardless of the reason for the change.28

form, although the R2s are much larger. Also, essentially the
same results are obtained by a statistical comparison of the onedav percentage changes in the market rates on the day the dis
count rate change became effective with the 10-day and 20-day
growth rates prior to the discount rate change.
29It is important to include the surcharge variable in the latter
period because some of the changes in the discount rate and the
surcharge overlap. The overlapping dates are: November 17,
1980, D ecem ber 5,1980, and May 5, 1981. Failure to include the
surcharge could result in a spurious estimate of the discount
rate effect.

30In an effort to uncover a possible lagged response of the
federal funds rate to discount rate changes, equation 4 was
estimated with a 20-day distributed lag of the ADR variable.
None of the lagged variables, however, was significant except
for the seventh day. It is interesting to note that, since most of
the discount rate changes became effective on a Monday, the
seventh-day lag would be W ednesday, the close of the “reserve
week.” This result, however, is perhaps too tentative to assign
any significance to it.
13

FEDERAL RESERVE BANK OF ST. LOUIS

C h art

JUNE/JULY 1982

Selected Interest Rates
Percent

W eekly a v e r a g e s of da ily rates

1978

1979

Percent

‘ R a t e c h a n g e s w h e n o n e o f t h e t w e lv e R e s e r v e B a n k s h a s t h e a p p r o v a l o f t h e F e d e r a l R e s e r v e B o a r d to c h a n g e

Data indicate that changes in the discount rate
have produced a significant, albeit varied, im m e
diate im pact on both the federal funds rate and the
3-month Treasury bill rate since January 1978. The
effect of a discount rate change on the federal funds
rate was significant for periods of both federal funds
rate targeting and nonborrow ed reserve targeting.
D iscount rate changes significantly affected the
Treasury bill rate, however, only in the period of
n o n b o rro w ed re serv e targ etin g . F u rth erm o re,
changes in the discount rate that w ere m ade for
purely technical reasons had no effect on either
m arket interest rate, w hile changes in the Federal

1980

1981

1982

its d is c o u n t r a t e .

R eserve’s surcharge on large, frequent borrowers
during the nonborrow ed reserve targeting period
had a significant effect only on the federal funds
rate.
T here is virtually no evidence, how ever, that
discount rate changes have had a significant, inde
pendent effect on m arket rates in the longer run.
Therefore, w hile changes in the discount rate do
produce changes in m arket interest rates in the short
run, they do not appear to be the most significant
factor affecting the level of m arket interest rates
in the longer run.

Inflation Misinformation and
Monetary Policy
LAWRENCE S. DAVIDSON

C onsum er prices, held back by the recession and an
other drop in gasoline and car prices, rose only two-tenths
of one percent in February from January’s level, contin
uing the sharp decline in the inflation rate. . . . It shows a
steady decline in inflation over the past several m onths.1

T H E above excerpt is a perfect exam ple of m is
information, a problem that stems from confusing the
m easurem ent o f price change with the m easurem ent
and causes of inflation. The failure to distinguish the
symptoms — like changing gasoline prices — from
the causes of inflation can lead to serious policy
errors.
Th is article presents evidence to support the
hypothesis w hich states that efforts to counteract
short-term price changes generally are unnecessary
and counterproductive.2 We begin by analyzing the
behavior of the individual com ponents of the per
sonal consum ption expenditures index to determ ine
the “causes” of observed quarterly changes in the
Lawrence S. Davidson, an associate professor of business eco
nomics and public policy at Indiana University, is a visiting
scholar at the Federal Reserve Bank of St. Louis.
'New York Times, March 24, 1982.
2This does not imply, however, that such price changes do not
impose costs on certain groups. Policymakers may wish to enact
legislation to address these problems. It is argued here only that
such increases do not warrant macroeconomic remedial policy.
Alan Blinder comes to the same conclusion: “ From the macro
perspective, the volatility of the CPI often distracts attention
from the economy’s underlying or ‘baseline’ rate of inflation. I
speculate that extreme swings in the CPI inflation rate occa
sionally contribute to extreme swings in national economic
policy.” Alan Blinder, “The Consumer Price Index and the
M easurem ent of Recent Inflation,” Brookings Papers on Eco
nomic Activity (February 1980), p. 564.

average price level. We then analyze the perform
ance of a variable series constructed to approxim ate
the cyclical or nontrend m ovem ents in the m easured
inflation rate. An analysis of this series reveals why
the public should be reluctant to pressure policy
makers into reacting quickly to even large short-run
changes in the m easured inflation rate. Finally we
present data which suggest that m onetary policies to
com bat short-run changes in the inflation rate raise
the risk of increasing the underlying or long-term
trend of inflation.

Two Views of Inflation: Arithmetic
vs. Monetary
The m easurem ent of inflation necessarily begins
with a price index. The most w idely known and used
index is the consum er price index (CPI), an index of
the average price of a fixed basket of goods and serv
ices chosen by a typical urban family. The fixedw eight personal consum ption expenditures price
index (PCEI), though sim ilar in most respects to the
CPI, is preferable to it in one particular asp ect— its
treatm ent of the w eight of housing costs.3 The im
portant points for our discussion are:
(1) The PC EI is a w eighted average of individual goods
prices,
(2) T he value of the PC EI in any given m onth can be
greatly influenced by changes in the price of indi
vidual com m odities.

The m easured inflation rate is a sim ple m athe
m atical transfonnation of the above price index. For
exam ple, instead of saying that the value of the PC EI
rose from 100 to 104, the inflation rate expresses this
3For more on this problem, see Blinder, “The Consumer Price
Index and the M easurem ent of Recent Inflation,” pp. 539-65.
15

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

price rise as a percentage change. In the above ex
am ple, we w ould say that the inflation rate was 4
.104 - 100, inn
percent, or (---- --------- ) x 100 percent.

change in relative dem and does not cause sustained
inflation, though it does cause perm anent changes in
relative prices and may cause a tem porary change in
the price level.
Calculating the inflation rate in this way leads one
Relative price changes also occur w hen there are
to the valid conclusion that a large increase in the changes in supply conditions.5 T hese include rela
price of one good (e.g., food) can cause a large change tive changes in labor productivity, wages or other
in the value of the PC EI and, therefore, in the m ea costs associated with the production process. Such
sured inflation rate. It is incorrect, how ever, to say changes in a given individual m arket can cause the
that food prices cause inflation.
cost-per-unit to rise, which in turn causes its relative
price to rise. W ith a given income, people who con
This is because the arithm etic view tells only part
o f the story. Individual prices rise and fall, often in tinue to buy the higher-priced item w ill b e forced to
seem ingly random and unpredictable ways. Econ spend less on other goods, w hich puts dow nw ard
omists call these relative price changes (since indi pressure on these prices. This “cost-push” example
vidual prices are changing relative to one another). has the same outcom e as the xelative dem and ex
M onetary and fiscal policy are not designed to be ample: relative prices are perm anently changed, the
effective in changing relative prices. T hese and price level may change tem porarily, but inflation is
other macro stabilization policies are better suited to unaffected.
affect the joint m ovem ent of all prices, or inflation.
In the case of increases in the price of inputs like
oil, which are used to produce many goods, the in
To understand inflation, we m ust first distinguish
betw een inflation and relative price changes. Rela creases in the price level may be more pervasive and
tive prices are determ ined by the supply and d e sustained. If increases in the price of oil are “pushed
m and conditions in the markets for individual goods. through,” causing the retail price of m ost goods to
For exam ple, suppose that there w ere a change in rise, individuals whose income has not sim ilarly
people’s tastes that caused them to spend more of risen are able to buy few er goods and services at the
th eir incom e on recreation and less on durable higher prices. Roth the quantity dem anded and
goods, w hile other saving and spending plans re supplied are, therefore, low ered. This low er rate of
m ained the same. This change in relative dem and output is perm anent unless incomes rise. A tax re
should raise the relative price of recreational goods bate accom panied by an increase in the growth rate
and services w hile lowering that of durables. Since of m oney could tem porarily raise incomes enough to
total spending rem ains unchanged, the total dem and restore dem and to the earlier rate of production, but
for all goods and services is unchanged; only the w ill lead to another increase in the price level as
allocation of d em and across m arkets has b een individuals attem pt to buy more of all goods.
altered. Therefore, the overall price level is the
The point of these exam ples is that a variety of
same; only relative prices have changed.
factors affecting the cost and relative dem and struc
If individuals tem porarily reduced saving so they tures in individual markets can cause relative prices
could continue purchasing the sam e am ount of to change. T he co nstrain t th at b in d s th e price
durable goods while purchasing more recreational changes in all the m arkets is total spending, or in
services, then the total dollar dem and and the price come. W ithout a com m ensurate increase in spend
level w ould be higher.4 Individuals w ould be acting ing, none of these factors can cause all prices to rise,
as if they were given more income, causing them to that is, none can lead to a perm anent rise in the
spend m ore. O nce they replenish their savings, price index.
how ever, total dem and and the price level w ill re
turn to their original lower levels. Thus, a perm anent The Relationship Retween Inflation and
4If all individuals reduced their savings, there would be less
loanable funds available for business investment. Therefore, the
increase in consum er spending facilitated by the temporary re
duction in saving would be offset by a decline in business spend
ing on investm ent goods. Although the consum er price index is
temporarily increased, an investm ent deflator would be lower. A
combined measure of overall consumer and business prices
would be unaffected by this change in saving.

Individual Price Changes

A rise in the m easured inflation rate always hides a
great deal of information. The increase may result
5Foram ore detailed explanation of cost-push inflation, see Dallas
S. Batten, “ Inflation: The Cost-Push Myth,” this Review (June/
July 1981), pp. 20-26.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

Table 1
Means and Standard Deviations of Percentage Changes in
the PCEI and Its 18 Major Components1
11/1959 - IV/1967
Category

W eight

Mean

Standard
deviation

1/1968 - 1/1981
Mean

Standard
deviation

M otor vehicles

.052

1.13%

3.85%

5.06%

4.83%

Furniture

.045

0.30

1.16

3.69

2.56

O ther durables

.017

1.27

1.69

5.01

3.36

Food

.261

1.82

2.37

6.96

4.58

Clothing

.082

1.66

1.55

3.81

2.26

Gas & oil

.031

1.62

4.81

10.58

17.29

Fuel oil & coal

.012

1.01

4.33

14.72

20.05

O ther nondurables

.081

1.78

1.29

5.71

3.31

Housing services

.137

1.53

0.45

5.54

1.84

Housing operations

.060

1.73

1.69

6.57

3.24

T ransportation services

.037

2.32

1.97

7.33

4.82

Personal care services

.019

2.76

1.76

7.15

3.02
4.09

Medical services

.058

3.76

1.88

7.64

Personal business services

.054

3.39

3.44

7.11

3.23

Education & research

.013

2.87

1.66

7.50

2.67

Recreation services

.022

3.53

1.90

5.11

1.88

Religious & welfare

.015

1.61

3.09

7.31

3.66

Net foreign travel

.003

1.62

5.29

7.67

14.96

1.000

1.85

0.98

6.34

2.39

PCEI

’ Figures are averages of annualized quarterly rates of change.

from all prices rising together, or m erely one price
rising by itself. Furtherm ore, this change may prove
to be either tem porary or perm anent. Policymakers
concerned with the causes of and cure for inflation
would find this hidden inform ation highly relevant.
Consider the behavior of the individual prices of
goods and services included in the PC EI over the
past 23 years. Table 1 lists various information about
the 18 major categories that make up this index.
Because inflation generally has been higher since
1968, the table can be conveniently divided into two
periods: a nine-year period before 1968 and a 14year period afterward. The table shows the m ean and
the standard deviation for the PC EI and each of its 18
com ponents over both periods. This PC EI is afixedw eight version, which retains the weights from the
first quarter of 1959.6 The w eights are the p er
6A fixed-weight index is used because variable-weight indices,
when used to compare quarter-to-quarter changes, mix together

centages of total ex p en d itu re allocated to each
com ponent.
The m easured average yearly inflation rate more
than tripled from 1.85 percent in the initial period to
6.34 percent in the latter. The standard deviation, a
m easure of dispersion around the average, more than
doubled. In the 1968-81 period, the annualized
quarterly inflation rate averaged 6.34 percent per
year, but the average deviation in any particular
quarter was about 2.4 percent. This im plies that the
inflation rate was betw een 1.5 percent and 11.1 per
cent, 95 percent of the tim e. D uring this period
price and quantity change. The fixed-weight index is a measure
of pure quarter-to-quarter price change. Once fixed, no set of
weights perfectly captures the buying patterns of the average
household over a long period of time. We arbitrarily chose to use
weights from the beginning of the sample period. Using weights
from the end of the period would not measurably alter the results
here. This is because the weights have not changed enough on
individual price components to change the behavior of the over
all measured inflation rate.
17

FEDERAL RESERVE BANK OF ST. LOUIS

(1968-81), selected categories averaged betw een:7
Housing services: 1.9% to 9.1%
M otor vehicles: —1.0% to 14.6%
Fuel oil and coal: -24.6% to 54.02%

Fuel oil and coal prices, the fastest-growing con
sum er prices, averaged over 14 percent per year, fol
lowed closely by gas and oil at about 10.6 percent per
year. Furniture (3.7 percent) and clothing (3.8 per
cent) were the most slowly growing consum er prices.
The evidence from table 1 suggests that the m ea
sured inflation of the recent past is not the result of
all prices rising at the same rate each quarter. T hese
figures, how ever, say very little about the role of
particular relative prices as causes ofsustained price
change. For exam ple, fuel oil and coal prices rose, on
average, faster than any of the other prices. But these
increases w ere anything but gradual or persistent. O f
the 88 quarters from 11/1959 to 1/1981, the inflation
rate of fuel oil and coal exceeded the rate ofthe PCEI
only 45 tim es. That means during 43 ofthe quarters,
fuel oil and coal prices rose more slowly than overall
inflation. In 22 of these quarters, the absolute price
of fuel oil and coal fell (a negative inflation rate for
this category). D uring these 88 quarters, there was
not a single episode w hen the inflation rate on fuel
oil and coal increased for more than four consecutive
quarters. This pattern (though not necessarily the
m agnitude) of volatility is typical of m ost price
com ponents. Chart 1, w hich presents the growth
rates of the PC EI and two of its com ponents, reveals
the oscillatory behavior of the PCEI. Note that there
has been only one episode since 1959 w hen the
overall PC EI inflation rate clim bed consecutively
for more than three quarters. More will be said about
that episode below.
It is cum bersom e to discuss each individual price
change and its im plications for the m easured overall
inflation rate. Therefore, we introduce a summary
m easu re of n o n p ro p o rtio n al or re lativ e p rice
7These confidence intervals assume that quarterly inflation rate
changes are normally distributed. A normal distribution roughly
means that quarterly inflation rate values fall equally above and
below the mean and that most ofthe values are close to the mean.
The standard deviation of a random variable measures how much
these quarterly inflation rate changes differ from the mean value
on the average. The 95 percent confidence interval contains any
observations of the quarterly inflation rate that are within two
standard deviations of the mean. Since the mean and standard
deviation are respectively 6.34 percent and 2.39 percent, there is
a 95 percent probability that the quarterly inflation rate is be
tween 1.5 percent (= 6.34 percent - 2 (2.39 percent)) and 11.1
percent (= 6.34 percent + 2 (2.39 percent)). Similar confidence
intervals can be constructed for any of the inflation rate series.

JUNE/JULY 1982

changes (RELP). The RELP series is constructed as
follows: For each quarter, subtract the rate of change
of the overall PC EI (which is, by definition, the
average inflation rate of all com ponents) from each of
the 18 com ponent inflation rates. Then m ultiply the
absolute value of each of these 18 deviations for this
quarter by its w eight and add them .8 This gives the
value of RELP for each quarter.
If all prices grow at the same rate, RELP w ill equal
zero. If, how ever, a few prices rise significantly
faster during the quarter than the rest, the value of
RELP will rise. If these prices then decelerate (and/
or ifth e others accelerate), so that all prices are again
rising more equally, RELP will fall.
As chart 2 shows, the RELP m easure has a num ber
of interesting features:
(1) The greatest increases in RELP cam e in 1972 and
1973 during food-price shocks, during wage and
price decontrol and after oil prices quadrupled.
(2) W hile the value of RELP fell from the end of 197.3
until 1978, it generally averaged a higher value than
before 197.3.
(3) W hile RELP show ed no obvious trend before 1970,
its average value has been rising since then (from
about 1.62 before 1971 to 3.46 thereafter).9

In summary, inflation has been anything but a
smooth, upw ard transition in all prices. It is typified
by a few prices racing ahead of the others, then
falling back relatively quickly. In one episode,
RELP accelerated for seven consecutive quarters,
but this was an unusual period, typified by a series of
food supply shortfalls, wage and price decontrol and,
finally, the oil crisis.
One im plication of this evidence is that individual
price changes have a significant — albeit tem porary

8The same category weights used to construct the overall PCEI
are used here.
9While we have noted how RELP arithmetically “causes” price
change, others have argued that increases in the inflation rate
have caused higher levels of relative price change. One can see
from chart 2 that there is a correlation betw een the average
percentage change in the PCEI and the average value of RELP.
The implication of this finding is that higher average inflation
rates, which raise the value of RELP, increasingly confuse eco
nomic agents and raise the likelihood of reduced output and
higher unemployment rates. See, for example, Mario I. Blejer
and Leonardo Leiderm an, “On the Real Effects oflnflation and
Relative-Price Variability: Some Empirical Evidence,” Review
o f Economics and Statistics (November 1980), pp. 539-44; and
Milton Friedman, “Nobel Lecture: Inflation and Unemploy
m ent,” Jonmal o f Political Economy (June 1977), pp. 451-72.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 1

G ro w th Rates o f the PCEI a n d Tw o C om ponents

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 2

R e la tiv e Price C h a n g e a n d the A v e ra g e In fla tio n R ate

1959

— im pact upon overall changes in the m easured
inflation rate. This finding has im portant policy con
tent. M acroeconomic policies, which are designed to
affect incomes or spending, are not efficient devices
for com bating the frequent and quickly reversible
relative price changes. T herefore, policy aim ed
exclusively at stabilizing all changes in the inflation
rate will be unproductive. It may even be counter
productive if the relative price changes are both
highly unpredictable and transient.

1981

Nonmonetary Price Change
M onetarists have argued that the dom inant deter
m inant of sustained sp ending change is m oney
growth. Therefore, they say, it is prim arily sustained
m oney growth that produces inflation (a sustained
increase in the prices of all goods and services).
Past studies have found that the underlying infla
tion rate is significantly related to past growth rates

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

of the money supply.10 Carlson finds that, since the ones. T herefore, the average value of A w ould
1970s, about 12 quarters of past m onetary growth be zero.
translate into an equal sustained change in the infla
It is
that
discussion does not
tion rate. Thus, we assum e that a sim ple 12-quarter imply im portant to note valuethis PDEV is zero. The
that the average
of
moving average of money growth rates approximates
for two
the monetary influence on sustained inflation.11 For average value of PDEV need not equal zerosuggests
reasons. First, the theory discussed here
exam ple, if this moving average rate equals 4 per that m onetary grow th affects the average of all
cent, then we assum e that m oney is responsible for prices. This does not m ean that m oney growth is the
an underlying inflation rate of 4 percent in a given source of all changes in consumer goods prices as
quarter. If the inflation rate actually is 6 percent in m easured
PCEI. Second,
that quarter, then the residual 2 percent can be at affect the by theof inflation for there are factors that
rate
some tim e w ithout
tributed to nonm onetary causes of price change.
being a constant source of its variability. For ex
M onetarists also believe that there are num erous am ple, the trend rate of growth of labor force pro
sources of price change, yet only changes in money ductivity may keep the inflation rate above or below
growth can perm anently alter the rate of inflation. any given sustained m onetary growth rate for some
Therefore, we expect that nonm onetary factors will period of tim e.12
som etim es affect short-term m easured inflation
(3) Even if
revers
rates. If these nonm onetary sources of m easured ible, there could A w ere transient and totally were
be room for policy action if it
inflation arise unexpectedly over tim e, and if they
This
only tem porarily affect the inflation rate, then the predictable.policy. would givetopolicymakers tim e to
formulate a
According the m onetarist
only lasting, predictable and controllable source of negative As will follow positive ones. This view,
rela
inflation w ould be m onetary growth.
tionship, how ever, should not allow for reliable
One way to determ ine if the monetary explanation predictions of A over time.
of inflation is valid is to exam ine the im pact of non
Chart 3 presents
and its change, A.
m onetary influences on price changes to see if they 1959 to 1981, PDEV PDEV averaged -0 .0 9 and From
and A
0.01,
have any long-run influences on inflation. To do this, respectively. Prior to 1973, PDEV was generally
we define nonm onetary price change as the m ea negative; thereafter it was positive. The overall and
sured inflation rate of a given quarter, m inus the subperiod averages are shown in table 2.
12-quarter moving average of m oney growth rates.
We then examine the behavior of this series (referred
Judging from the average value of PD EV in the
to as PDEV) and the changes in it (henceforth called two subperiods, m oney growth does not fully ex
A). The m onetarist view of inflation w ould be sup plain the average inflation rate in either period. In
ported by a variety of evidence about PDEV and A: the earlier period, inflation was 0.87 percent below
growth
to
(1) If changes in nonm onetary inflation, A, are the 3.56 percent inflationrate of money. From 1973the
1981, however,
was 1.21 percent above
tem porary, then positive values of A soon would be 6.42 growth rate of m oney.13
follow ed by negative ones. Accordingly, PD EV
would rise and then fall toward its original value.
12One measure ol labor productivity is output per hour ot all
persons in the private business sector. After increasing at a 2.9
(2) If the increases in A are totally reversible, then
percent annual rate from 1961 to 1971, it rose at only a 1.2
over the sample period the sum of the negative As
percent annual rate from 1971 to 1980.
would be exactly equal to the sum of the positive 13As a check on these results, an alternative proxy for PDEV was
10Keith M. Carlson, “The Lag from Money to Prices,” this Review
(October 1980), pp. 3-10; and Denis S. Kamosky, “The Link
Between Money and Prices: 1970-76,” this Review (June 1976),
pp. 17-23.
''T h ese studies of money and prices use econometric methods
and employ distributed lag functions. Furthermore, these rela
tionships have been found using the overall gross national
product deflator. Therefore, this 12-quarter moving average is
only a rough approximation of the influence of money on the
trend rate of inflation. However, this moving average as well as
longer moving averages and econometric proxies behave quite
similarly and therefore the qualitative findings here would not
be seriously changed by using these other measures. See foot
notes 13 and 16 for more details on one econometric variant.

developed. In this case, the monetary contribution to inflation is
estimated from an econometric price equation. This equation
relates the percentage change in the PCEI to a 12-quarter
Almon lag on growth rates of M l, contemporaneous and two lag
values of relative energy prices, and two dummy variables for
the control and decontrol phases of the Nixon wage-price con
trols. PDEV' is calculated by subtracting from the actual rate of
change of the deflator its predicted value based only on the
monetary part of the estimated equation.
The average value of PDEV from 1959 to 1981 is .097, veiy close
to the .090 value of the variant reported in the text. The values of
PDEV' over the early and later subperiods are -.5 4 and .50,
respectively. This version of PDEV suggests a smaller, but still
evident, contribution of nonmonetary factors to the measured
inflation rate over the two subperiods.
21

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 3

Measures of N onm onetary Inflation

NO TE: S h a d e d a re a re p re se n ts th e 95 p e rc e n t c o n fid e n c e in te rv a l.

In contrast, the small average values of A in both
periods reveal that the average change in PDEV was
nearly zero. This suggests that, although factors
other than m oney help to detennine the average
level of the inflation rate, short-run changes in these
nonm onetary factors tend to offset one another over
time.
O ut of 88 quarters, PDEV fell (A was negative) 45
tim es. Further, there w ere 56 times when a rise in
PDEV was followed by a fall, or vice versa. Using a
statistical test designed to m easure the regularity of
these changes, we find no significant relationship
betw een A values over tim e.14 This m eans that
changes in the rate of nonm onetary price change are

not correlated with past changes. Thus, persistent
nonm onetary effects on changes in the inflation rate
are not evident, and past values of A are not reliable
predictors of future ones.
This sim ple test says nothing about the size of
changes in PDEV, especially over specific episodes
w ithin the sample period. We can use a standard
statistical procedure to indicate w hether any given
PDEV or A is worth worrying about (large enough to
be considered a statistically im portant deviation
from zero). For exam ple, in chart 3, note that PDEV
is less than zero during most quarters prior to 1973. Is
this evidence that nonm onetary factors w ere holding
inflation substantially below the rate dictated by
money?

14See Edward J. Kane, Economic Statistics and Econometrics
(Harper & Row, 1968), especially pages 364-65, for a description
of this runs test.

To answ er this question, we analyze w hat m ight
be called “large” values of PDEV. Values of PDEV

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

Table 2
Nonmonetary Price Change
1959-1972
PDEV

1973-1981

1959-1981

-0.87 %

1.21%

-0 .0 9 %

-0.06%

0.15%

0.01%

or A in chart 3 that fall outside the shaded area are
evidence that nonm onetary factors caused large
price changes.15 A num ber (say three or four) of
consecutive quarters of large and rising values of
PD EV or rising As w ould be considered evidence of
the persistent effect of nonm onetary factors on price
change.
Chart 3 reveals that the only run of large PDEV
values occurred over the four-quarter period from 1/
1974 to IV/1974.16 Here, nonm onetary factors con
tributed to inflation rising significantly faster than
mortey for one year. Another episode, from 11/1972 to
IV/1972, which lies near the rejection region, com
prises three quarters w hen inflation grew slower
than m oney. These episodes deserve additional con
sideration since it could be argued that system atic
nonm onetary factors caused sustained inflation
above and below the m oney growth rate.
W hat happened during 1974 had its beginning in
IV/1973 w hen the prices of fuel oil and coal rose at an
annualized rate of 63 percent, and gas and oil prices
15O ur sample yields only one estimate of the true mean of PDEV.
The shaded area in chart 3 is called a confidence interval. This
shows by how much the mean could vary in repeated samples
without refuting that the population mean is zero. Thus, if we
took another independent sample and found a non-zero value
for the mean that was inside the confidence interval, it would
not refute the hypothesis that the population mean is zero. The
area outside the confidence interval is called the rejection re
gion. If a sample mean lies in this zone, it rejects the hypothesis
that the mean value of nonmonetary inflation is zero. By choos
ing a level of confidence higher than 95 percent, say 99 percent,
the area in chart 3 would be wider and there would be no runs
of PDEV values in the rejection area. Lowering the confidence
level to 90 percent does not change the results, though there are
two episodes that nearly fall into the rejection region: I/1980-IV/
1980 and II/1972-IV/1972. The former period witnessed severe
oil price shocks while the latter, which is discussed more in the
text, occurred during wage and price controls.
16The econometric variant of PDEV discussed in footnote 13
yields the same general conclusion: the largest values of PDEV
occur during 1974. Using this variant of PDEV, however, there
is no series of consecutive values of PDEV in the rejection area.
This is even stronger evidence than that presented in the text for
the transitory nature of changes in nonmonetary inflation.

increased by 33 percent. In 1/1974 both energy
groups again had large annualized rate increases of
91 percent and 63 percent, respectively. T hese in
creases, though very large, accounted for only about
half of the increase in the m easured inflation rate of
the first quarter in 1974. In fact 17 of the 18 com
ponent prices accelerated — an historical rarity.
By 11/1974 the inflation rate of energy item s,
though still high, was falling dram atically. Judging
from food and energy prices alone, the overall
inflation rate could have fallen as low as 7.4 percent
(from 12.4 percent in 1/1974) had it not been for an
increase in the relative price of motor vehicles and
nondurables (other than food and energy). T he
overall inflation rate stayed at 9.6 percent in III/1974
and inched up to 9.7 percent in IV/1974 despite the
fact that energy prices had leveled off. In the last
quarter, the problem appears to be the 12 percent
increase in food prices. Given the large w eight on
food prices, m easured inflation could have been
down to about 8 percent or less had it not been for
this single event.
To sum m arize, this historical period found non
m onetary sources of inflation persistently greater
than zero. It followed, however, on the heels of an
unprecedented jum p in the rate of increase of energy
prices. It appears that w ithin six m onths the peak
nonm onetary effect had been reached.17 Further, it
appears that events beyond the second quarter of
1974 w ere separate but adjacent periods of equally
bad luck. In the first quarter of 1974, m ost prices
responded to the oil crisis. If the subsequent in
creases in m otor vehicles, nondurables and food
prices at various tim es in the next nine m onths were
related to earlier energy price increases, then we do
have a single episode. Even in this interpretation,
the bulk of the effect of PD EV occurred w ithin six
m onths, and traces of it w ere scarce within 12.18
The other interesting episode occurred in 1972
w hen inflation was below the tren d grow th of
money. This episode shows that the more stringent
17Using very different methods, John A. Tatom, “Energy Prices
and Short-Run Economic Performance,” this Review (January
1981), pp. 3-17, also found a very short peak in the inflation rate
attributable to energy prices. His econometric model of the
price level used the GNP implicit price deflator and found it to
peak within four quarters after the rise in energy prices.
18The Labor D epartm ent attributed the large increases in food
prices over the last half of 1974 to poor w eather and crop fail
ures. See Toshika Nakayama, Lloyd E. W igren and Paul
Monsen, “ Price Changes in 1974 — An Analysis,” Monthly
Labor Review (February 1975), especially page 15.
23

JUNE/JULY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 4

D eviations from Trend of Inflation and M o n e y G ro w th

S h a d e d a re a s re p re s e n t p e rio d s o f la rg e p ric e in c re a s e la s tin g tw o o r m ore q u a rte rs in w h ic h th e m e a s u re d in fla tio n ra te g re w fa s te r th a n its tre n d .
NO TE: The c o lo re d lin e h ig h lig h ts the b e lo w -tre n d o r re d u c tio n in m o n e y g ro w th th a t g e n e r a lly fo llo w e d la rg e , a b o v e - tre n d in fla tio n in c re a s e s .

phases of the Nixon wage-price controls effectively
kept m easured inflation from catching up to trend
m oney growth (w hich accelerated from about 5
percent at the end of 1971 to 6.5 percent by the last
quarter of 1972). It is interesting that w hen the less
restrictive Phase III of the controls began in January
1973, PD EV quickly turned positive as prices began
to make up for lost ground.

Money Growth and Inflation
M isi nfo rmat ion
The previous sections suggest that the m ain cause
of sustained increases in m easured inflation is not

changes in relative prices. The data presented in this
section show that the trend growth rate of m oney
rose from about 2 percent in the early 1960s to 7
percent in the early 1980s. This section suggests that
this rising trend stems from an information problem .
We already have shown that the m easured inflation
rate often accelerates w hen relative prices change. If
policymakers m isread such tem porary increases as
perm anent changes in the inflation rate, they may
em ploy a contractionary m onetary policy. We show
below that tight m oney periods have usually fol
lowed large increases in the m easured inflation rate
but have been followed by periods of m onetary
expansion. At the end of each cycle, the trend growth
rate of both m oney and prices has been higher.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 5

Trend G ro w th R ate of M l
Percent

Percent

1959

1981

S h a d e d a re a s r e p r e s e n t p e r io d s d u r in g w h ic h th e m e a s u re d in f la t io n ra te w a s g re a te r th a n its tre n d .

Chart 4 plots the deviations from trend for both the
annualized quarterly rates of growth of the CPI and
M l.19 The shaded vertical bars represent episodes of
large price increases, lasting two or more quarters, in
w hich the m easured inflation rate grew faster than its
trend. In each case, we find these above-trend price
increases accom panied by large reductions in the
growth rate of m oney and/or below -trend m onetary
growth.20
19Above we argued that the PCEI is a better measure of price
change, and therefore the CPI is not used throughout this
article. In this section, however, it is important to use the CPI
because it is announced more regularly (monthly instead of
quarterly) and probably is used more widely. The results in
chart 4 are not greatly altered when the PCEI is used instead of
CPI, since the two generally move together. One important
exception occurred during the first two quarters of 1979. The
rate of change of the CPI increased in both quarters; the rate of
change of the PCEI fell. Therefore, if the PCEI were used in the
analysis in the text, there would be one less historical episode
w hen m easured inflation rose in two or more consecutive
quarters.

T hese reductions, how ever, w ere generally of
short duration. C hart 5 presents the 12-quarter
m oving average o f th e an n u alized p ercen tag e
change in M l. The shaded vertical bars refer to the
same periods of large price increase as those in chart
4. C hart 5 shows that the contractions in money fol
20The theme of this article is that all short-term changes in pub
lished indices of prices do not dem and policy responses. The
evidence, however, suggests that monetary growth has fallen
after large short-term m easured price increases. This does not
imply that monetary policy is solely determ ined by price
changes or that it always responds to them. The behavior of
money is determ ined by several factors, and to argue that all
monetary changes are attributable to price change would be
incorrect. The evidence does suggest, however, that large short
term increases in measured inflation above its 12-quarter trend
have been associated with subsequent large short-term de
creases in the rate of growth of money below its 12-quarter
trend. Stanley Fischer, “Relative Shocks, Relative Price Vari
ability, and Inflation,” Brookings Papers on Economic Activity
(February 1981), pp. 381-431, in an econometric investigation,
also finds evidence that monetary contractions trail inflation
surges following relative price shocks. See especially page 408.
25

FEDERAL RESERVE BANK OF ST. LOUIS

lowing these large price increases generally had
only tem porary effects on the trend growth rate of
m oney and therefore on a variety of m easures of
inflation.
These abrupt contractions in m onetary growth
generally have been offset by subsequent m onetary
expansions. Furtherm ore, these variations in m one
tary growth have had severe side effects. Poole finds
that monetary decelerations generated recessionary
conditions in the U nited States.21 Batten and H aler
come to the same conclusion in their analysis of the
im pact of short-run m oney growth in the U nited
States, Britain, W est Germ any and Italy.22

SUMMARY AND CONCLUSIONS
This article provides evidence of an information
problem inherent in policies that respond to ob
served changes in the m easured inflation rate. The
evidence is not inconsistent w ith the theory that
short-run bouts of tight m oney follow short periods
21William Poole, “The Relationship of Monetary Decelerations
To Business Cycle Peaks: Another Look at the Evidence,”
journal o f Finance (June 1975), pp. 697-712.
22Dallas S. Batten and R. W. Hafer, "Short-Run Money Growth
Fluctuations and Real Economic Activity: Some Implications
for Monetaiy Targeting, this Review (May 1982), pp. 15-20.

Digitized for26
FRASER

JUNE/JULY 1982

of rising inflation, help to quickly generate reces
sionary co n d itio n s, lead to su b seq u en t longer
periods of expansionaiy m onetary policy and result
in a rising trend growth rate of the m oney supply.
The information problem that sets off these cycles is
the m isinterpretation of increases in m easured price
change as sustained inflation. We have provided
evidence that nonm onetary sources of m easured
inflation are frequent, highly variable and quickly
self-reversible. Therefore, em ploying policy to off
set these individual shocks is difficult to accomplish
or to justify.
This analysis has broad im plications for policy
makers. First, short-term changes in m easured infla
tion do not call for an activist m onetary policy.
Second, a policy of steadily declining m onetary
growth will contribute to m ore econom ic stability,
while it reduces the underlying rate of inflation.
Finally, there is a need to distinguish the nature of
the causes of individual bouts of price change as the
first step in policy formulation. A sustained increase
in the rate of change of all prices, once uncovered, is
im portant information w hich policym akers can use
to guide monetary and fiscal policies. O f course, the
evidence reported here suggests that policym akers
could ignore short-run m easurem ents of inflation
altogether by simply concentrating on the appro
priate long-term m onetary target.

Short-Run Money Growth Volatility:
Evidence of Misbehaving Money Demand?
SCOTT E. HEIN

T HE
A

last tw o years have b een anything b u t
tranquil for the U.S. economy. Interest rates, for
example, have been high and volatile. Twice during
this period they rose to record levels: the prim e rate
hit20 percent in April 1980, then rose to 21.5 percent
in January 1981. Two recessions have occurred
during this brief period, one of w hich apparently still
lingers. Significant financial changes have taken
place w ith an influx of deposits into m oney m arket
m utual funds and an outflow from small tim e and
savings deposits. T he nationw ide legalization of
NOW accounts in early 1981 also resulted in a siz
able reallocation of funds. Amid all of these devel
opm ents, m oney growth also has been quite volatile.
Should the volatility of short-run m oney growth be
a m atter of concern? There appear to be two distinct
schools of thought with regard to this question. One
school argues that such volatility is not really a
problem . It holds that “the need for precise short-run
m oney supply control is technically questionable.” 1
The other school argues that such volatility damages
the economy. For exam ple, M ilton Friedm an, in
evaluating m onetary policy over the last couple of
years has w ritten that “the yo-yo swings in monetary
growth affected the econom y directly, as w ell as
through in terest rates. Each surge in m onetary
growth was followed after some m onths by an ac
celeration in spendable income, output and em
1Stephen H. Axilrod and David E. Lindsey, “Federal Reserve
System Im plem entation of Monetary Policy: Analytical Foun
dations of the New Approach,” American Economic Review
Papers and Proceedings (May 1981), p. 252. Also, see George W.
McKinney, Jr., “The Name of the Game,” Economic View from
One Wall Street (February 26, 1982).

ploym ent; and each decline in monetary growth, by
a retardation.”2
Som ewhat surprisingly, the two schools do not
disagree about theoretical issues. Both schools agree
that, in theory, the desirability of stabilizing shortrun money growth depends on the stability of the
public’s dem and for money. Achieving stable money
growth benefits the economy only if the public’s
dem and for m oney does not change unexpectedly.
The issue that separates the two schools of thought
is chiefly an em pirical one: has money dem and been
reasonably stable? Those who argue that the vola
tility of short-run m oney growth in the past has not
been a problem hold that m oney dem and has been
subjected to a series of unpredictable shifts. Ac
cording to this reasoning, holding the rate of money
growth in a tight band w ould have im posed sig
nificant costs on the economy. Suppose, for example,
the public wants to hold larger money balances. If
such a preference is thw arted by an adherence to
p re-estab lish ed m onetary targets, the econom y
w ould be subjected to unnecessary restraint. Indi
viduals seeking to build their m oney balances will
reduce their dem and for goods and services and
financial assets, resulting in an econom ic slowdown.
The other school argues that m oney dem and has
been basically stable. In this view, as Friedm an
contends, rapid money growth overstim ulates the
economy, ultim ately causing inflation, w hile slug
gish money growth imposes undue restraint.
2Milton Friedman, “The Yo-Yo Economy,” Newstceek (February
15, 1982). Also, see Milton Friedman, "The Federal Reserve and
Monetary Instability,” Wall Street Journal, February 1, 1982.
27

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

This article examines the evidence to determ ine
w hether m oney dem and behavior over the last two
years has been erratic enough to justify the observed
volatility in money growth.

ities “ can ‘create’ a product w ithout necessarily
being lim ited by the dem and for it.”3 Thus, one
should not necessarily interpret changes in money
growth as shifts in money dem and.

MONEY GROWTH AND THE DEMAND
FOR MONEY

A CONVENTIONAL MONEY DEMAND
EQUATION AND THE EVIDENCE
OF SHIFTS

Chart 1 provides evidence on short-run (quarterly)
money growth volatility. The chart plots, for each
quarter since 11/1962, quarterly money growth (at an
annual rate) less the average of money growth over
the prior 12 quarters. Thus, for exam ple, the —2.0
percent reading for III/1962 shows that m oney grew
2 percentage points less in that quarter than its
average growth rate in the previous three years.
The volatility shown in this chart has two different
dim ensions. One dim ension is simply the magni
tude of the deviation from trend. For example, in the
third quarter of 1980, m oney grew at a rate 8 per
centage points above trend, the largest positive
deviation in the last 20 years. In the second quarter
of 1980, money grew at a rate over 10 percentage
points below trend, the largest negative deviation in
the last 20 years. Thus, according to such a m easure,
m oney growth has been quite volatile over the last
two years.
T he second dim ension is the frequency w ith
which deviations of money growth relative to trend
ch an g e signs. The chart show s that m o n e y g ro w th
relative to trend frequently has changed sign from
positive to negative, and vice versa, over the last two
years. This fluctuation stands in sharp contrast to the
historical norm w hereby money growth usually is
above or below trend for several quarters in a row.
Thus, the increased frequency of change of quarterly
m oney growth relative to trend also supports the
view that m oney growth over the last two years has
been volatile.

One can analyze money dem and on a m ore so
phisticated basis by using econom etric techniques.
This article provides no new analysis on this topic;
instead it describes how such evidence can be
evaluated.
Econom ic theory holds that nom inal m oney bal
ances relative to the general price level (generally
called “real” m oney balances) are the relevant quan
tity m easure for dem and analysis (just as standard
dem and theory explains the dem and for physical
goods and services, not the dollar value of those
goods and services). Thus, w hen one focuses on real
m oney, one recognizes that the usefulness of m oney
clearly depends on the price of goods and services.
For exam ple, if the quantity of m oney that people
hold remains unchanged w hile the average price of
goods and services fall, a given stock of m oney will
have greater value; that is, it will perm it the purchase
of more goods and services. Thus, the econom ically
m eaningful m easure is the m oney stock relative to
the average price of goods and services.4
Analysts com monly hypothesize that real m oney
balances move opposite to a change in m arket in
terest rates and in tandem with a change in real
income. A change in m arket interest rates negatively
affects the dem and for real balances, because it
represents the opportunity cost of holding money. If
m arket interest rates rise, individuals forgo more
interest incom e by holding m oney and thus are ex
pected to desire less m oney balances. As real income
rises, how ever, individuals will w ant larger real
m oney balances to purchase more goods and serv
ices. Thus, a change in real income is expected to
have a sim ilar effect on desired real m oney balances.

The increased volatility in m oney growth alone
does not dem onstrate that the dem and for money
was unstable. Such a conclusion im plicitly holds that
the growth of the nom inal m oney stock is com pletely
dem and-determ ined, ignoring com pletely the ac
tions taken by monetary authorities. Since monetary 3Stephen H. Axilrod, “ Monetary Policy, Money Supply, and the
authorities can change bank reserves, reserve re Federal Reserve’s O perating Procedures,” Federal Reserve
quirem ents or the discount rate, it is entirely pos Bulletin (January 1982), p. 13.
a
interpretation of changes in real balances,
sible that changes in nom inal m oney growth reflect 4For A.discussion of theDenis S. Karnosky, “Real Money Balances:
see B. Balbach and
their actions, instead of shifts in the public’s desired A Good Forecasting Device and a Good Policy Target?” this
m oney holdings. In other words, m onetary author Review (September 1975), pp. 11-15.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 1

Quarterly M l G ro w th Relative to Trend
Percent

A Typical Empirical Money Demand
Equation

Percent

the com bination of the estim ated regression coeffi
cients and the values of the independent variables.

To em pirically investigate the dem and for money,
the relationship betw een real m oney balances (M/
P)t and current interest rates (it), real income (yt), and
lagged real balances (M/P)t.i, is estim ated using
m ultiple regression analysis. T he equation to be
estim ated is typically w ritten as:

Last period’s real balances are usually included in
em pirical estim ations of m oney dem and to capture
an assum ed adjustm ent process. Because of relevant
transaction costs of adjusting real money balances, it
is usually presum ed that actual balances only slowly
adjust to desired levels. The lagged value of real
balances is included to capture such an adjustm ent
(1) (M/P), = ft, + fti, + f t y, + f t (M/P),.! + et.
process. By including lagged real m oney balances in
The coefficients j8o Pi, P 2 an<3 P3 show how desired the equation, we are assum ing actual real balances
real m oney balances respond to changes in the re only partially adjust to current changes in interest
spective independent variables. The residual, et, is rates or real income.
assum ed to be a random variable that fluctuates
about zero. It represents the unexplained variation of
A com m on procedure used in evaluating the
actual real m oney balances from that predicted by behavior of m oney dem and is to consider how well

FEDERAL RESERVE BANK OF ST. LOUIS

an em pirical relationship such as equation 1 sim u
lates or predicts actual real m oney balances beyond
the estim ation period.5 Chart 2 plots the level of real
m oney balances sim ulated with equation 1 and the
actual real m oney balances for the out-of-sample
interval I/1980-I/1982.6 Table 1 sum m arizes these
results using a variety of statistical m easures.7
5This procedure apparently dates back to Stephen M. Goldfeld,
“The Case of the Missing Money,” Brookings Papers on Eco
nomic Activity (3:1976), pp. 683-730. One crucial difference
between Goldfeld's evidence and more recent interpretations is
that Goldfeld provided evidence of sustained one-sided simu
lation error. Logically, Goldfeld’s findings suggest a shift. More
recent discussions incorrectly deduce a shift from a single pe
riod’s simulation error. This point is subsequently more fully
developed. For a more recent application, see Brian Motley,
“Innovation and Money Dem and,” Federal Reserve Bank of San
Francisco Weekly Letter (January 1, 1982).
E stim ating equation 1 in natural log (In) form yields the fol
lowing coefficient estimates and summary statistics for the 1/
1960-IV/1979 sample period (absolute value of t-statistics in
parentheses):
(1') In (M/P)t = 0.34 + 0.07 In yt - 0.01 In RCP,
(1.41) (3.94)
(3.27)
+ 0.85 In (M/P)t.j - 0.02 D1
(13.69)
(3.89)
R2 = 0.94

where M is M l, P is the GNP deflator, yt is real GNP, and RCP is
the commercial paper rate.5 The estimated coefficient on In yt
(0.07) indicates that a 1 percent increase in real income this
quarter is usually associated with a 0.07 percent increase in real
money balances. In a similar vein, the interest rate coefficient
suggests that a 1 percent increase in interest rates (for example,
from 10.0 percent to 10.1 percent) will lead to a 0.01 percent
decline in real balances. Finally, the coefficient on lagged real
balances (0.85) indicates that real balances will adjust to desired
levels at a rate of 15 percent (1.00-0.85) per quarter. Thus, the
long-run response to changes in interest rates and real income is
much higher than the short-run response. In the out-of-sample
simulations reported below, these coefficients along with actual
values of the right-hand side variables are used to project the
dependent variable.
This relationship is similar to that in R. W. Hafer and Scott E.
Hein, “The Shift in Money Demand: What Really H appened?”
this Review (February 1982), pp. 11-16. However, the passbook
rate variable is excluded since its coefficient was insignificant.
The equation was estimated using the Hatanaka two-step pro
cedure to correct for first-order serial correlation in the residuals.
D1 is a dummy variable that takes on a value of 1 after 1/1974,
capturing a one-time shift in the demand for money. The stan
dard error of the estimated regression is 0.0045 and the estimate
of the serial correlation coefficient is 0.35.
7The equation simulates the natural log of real M l balances. Table
1 presents the antilog of these simulated values, that is, levels of
real money balances. Such a transformation, being nonlinear,
will not yield optimal predictions. However, it does yield a better
“feel” for the size of errors.
These simulations are static (when actual values of the lagged
dependent variable are used) rather than dynamic (when pre
dicted values of the lagged dependent variable are used). See
Scott E. Hein, “ Dynamic Forecasting and the Dem and for

JUNE/JULY 1982

THE SECOND QUARTER OF 1980
Much hoopla has been made of the difference
betw een the sim ulated real balances in the second
quarter of 1980 and the actual balances at that time.
Real money balances in that period turned out to be
alm ost $7 billion below w hat equation 1' predicted.
Such a finding has been interpreted as evidence that
m oney dem and shifted dow nw ard significantly in
11/1980.

Simulation Errors and Shifts
Equating a “ shift” with a sim ulation error, how
ever, is clearly inappropriate. D eviations of real
balances from predicted or sim ulated values do not
provide evidence of a behavioral shift in the rela
tionship. Recall that w hen the equation is estim ated,
it is assum ed that actual real m oney balances will
fluctuate randomly around its predicted or sim u
lated level. By assum ption, the actual and sim ulated
real m oney balances will usually deviate from each
other by some unknown random value. Thus, we
should expect sim ilar fluctuations to occur out-ofsam ple. W hen considering only one sim ulation
error, it is im possible to ascertain w hether one is
observing a shift (as represented by a change in
one ol the coefficients), or sim ply a large random
fluctuation.8
W hen the deviations are consistently one-sided,
how ever, one can conclude that a “ shift” in the
behavioral relationship has occurred (i.e., one of the
coefficients, /30, /3i, /8o or j83, has changed). Chart 2,
however, shows no evidence of consistent one-sided
errors. Thus, there is little evidence from these
sim ulations to indicate a “ shift” in the behavioral
relationship.
M oreover, recognize that if policym akers incor
rectly equate prediction errors with shifts in money
dem and, then they will view any observed behavior
in real m oney balances as correct. Thus, in either the
case of rapid or slow m oney growth, no corrective
action w ould be called for. However, if these dis
turbances are not true shifts in m oney dem and,
policymakers will actually allow m oney growth to
fluctuate more than necessary.
Money,” this Review (June/July 1980), pp. 13-23, where it is
argued that static forecast errors provide a better foundation from
which to judge shifts in the dem and for money.
8This is true regardless of the size of the error, because there is
always a positive probability of drawing from the extreme tails of
a normal probability distribution.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 2

Actual and Simulated Real M l

1980

1981

1982

Other Evidence o f a Money Demand Shift

These techniques, once in place, lead to permanent
decreases in desired real m oney balances relative to
Few who argue that a shift occurred in 11/1980 a given level of real income and interest rates. In
base their case on die one sim ulation error ofchart 2, other words, m oney dem and shifts dow nw ard fol
however. Two auxiliary argum ents also are used to lowing a sharp rise in interest rates. Such an argu
support the notion that there was a dow nshift in m ent has been used to explain the abnorm al b e
m oney dem and. One argum ent is that a dow nshift havior of m oney dem and since 1974 and is used now
occurred “ in response to the very high and record to bolster the evidence of another downshift.
levels of short-term interest rates reached in early
Chart 2 proves false this explanation of the 11/1980
spring.”9 This argum ent holds that a sharp rise in
in terest rates, especially one th at pushes rates decline in real balances. W ere there actually a
beyond previous peaks, causes firms and individuals decline in the dem and for real cash balances caused
to institute new cash m anagem ent techniques.10 by individuals and firms instituting new cash m an
agem ent techniques in response to high interest
rates, one should observe a level of real money
balances that is consistently below sim ulated levels
9Axilrod and Lindsey, “Federal Reserve System Implementation following the “dow nshift.”
of Monetary Policy,” p. 251.
10One of the earliest espousals of this hypothesis can be found in
Richard D. Porter, Thomas D. Simpson, and Eileen Mauskopf,
“ Financial Innovation and the Monetary Aggregates,” Brook-

tugs Papers on Economic Activity (1:1979), pp. 213-29.
31

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

Table 1
Out-of-Sample Simulations of a Money
Demand Equation (billions of dollars,
seasonally adjusted)
Date

Actual
(Mt/Pt)

Simulated
(M,/Pt)

E rror1

1/1980

$230.1

0.0

11/1980

223.0

229.8

- 6 .8
3.9

111/1980

225.8

221.9

IV/1980

226.2

226.0

0.2

1/1981

223.5

226.4

-2 .9

11/1981

225.2

222.7

2.5

111/1981

220.1

225.5

- 5 .4

IV/1981

218.3

219.5

-1 .2

1/1982

221.9

218.2

3.7

Summary Statistics
Mean error:

0.6717

Mean absolute error:

2.9621

Root-mean-squared error:

3.6635

T heil’s inequality coefficient:

0.0164

Fraction of error due to
(A) Bias:

0.03

(B) Variation:

0.03

0.94

''Actual less simulated

If this shift w ere perm anent, as this argum ent
suggests, the prediction error should rem ain nega
tive for all quarters after 11/1980. Chart 2 shows,
how ever, that the equation does not consistently
overpredict real balances after 11/1980. Actual real
balances in II1/1980, instead, w ere slightly higher
than the relationship would suggest. Further, real
balances were slightly higher, on average, than the
equation im plies for the full III/1980-I/1982 period.
Thus, one cannot em pirically support the argum ent
that a persistent, sizable dow nshift in money d e
m and was precipitated by record interest rates in
11/1980.
T he second argum ent in support of a m oney
dem and dow nshift in 11/1980 contends that the im
position of credit controls in M arch 1980 was re
sponsible for a decrease in desired real balances.
Such an argum ent contradicts econom ic theory,
however. W ith credit controls explicitly lim iting the
extension of bank credit, individuals and business

firms w ould desire larger m oney balances for antic
ipated transactions or precautionary purposes. Thus,
theory suggests an in crease in m oney dem and
during this period, not a decrease.
Thus, both auxiliary argum ents in favor of a b e
havioral shift in m oney dem and in 11/1980 lack
either logical foundation or supportive em pirical
evidence. M oreover, if there was a behavioral shift
in m oney dem and, the excess supply (supply ex
ceeding dem and) of m oney m ust have been offset by
an increase in dem and elsew here. In other words, if
econom ic participants actually w anted less m oney
balances, they m ust have desired m ore of som ething
else in exchange. There is little evidence, however,
of increased dem and for labor, goods and services, or
financial assets in the economy.
Further, the generally declining interest rates in
this period do not necessarily suggest a behavioral
dow nshift in money dem and as many insist. D e
clining interest rates do suggest an excess supply of
credit, which can come about either because of an
increase in credit supply or a decrease in credit
dem and. O nly an increase in the supply of credit (as
individuals becom e more w illing to give up m oney
today in exchange for a prom ise of m oney in the
future) w ould be consistent w ith the notion of a
dow nshift in m oney dem and in 11/1980, since there
is no evidence of an increased dem and elsew here
which w ould be required to offset the decreased
dem and for both credit and money. Yet, there ap
pears little evidence of an increased supply of credit
in th is period. Chart 3 s h o w s that the total funds
raised by nonfinancial sectors declined m arkedly in
11/1980. Thus, the fall in rates in the second quarter
of 1980 is b etter explained by w eakening credit
dem ands associated with the recession, rather than
the increased supply of credit.

If No Shift, Then What?
If m oney dem and did not shift in 11/1980, why
w ere real money balances low relative to predicted
levels? Perhaps the irregular behavior occurred on
the “ supply side.” Robert W eintraub has suggested,
for example, that slow m oney growth resulted from
an unexpected decline in the m oney m ultiplier (the
ratio of M l balances to the m onetary base), in re
sponse to a sizable shift in the desired currency
holdings, as consum ers becam e wary about the
acceptability of credit cards during the control pe

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 3

Credit M arket Funds Raised by Nonfinancial Sectors

1976

1977

1978

1979

1980

1981

_______ S ource: B o a rd o f G o v e rn o rs o f the F ed era l Reserve System

riod.11 Such a change would drive up die currencydeposit ratio and reduce the m oney m ultiplier.
If the m oney m ultiplier declines, banks have to
reduce the am ount of deposits they create for a given
am ount of source base (or bank reserves). According
to W eintraub’s hypothesis, M l balances declined
because monetary authorities did not anticipate the
increased dem and for currency and offset it by in
creasing the base. Therefore, the observed decline
in real m oney balances was due, not to a reduction in
the demand for real balances, but to this unantici
pated change in the supply of m oney caused by an
increased dem and for currency as a result of the
credit controls.
'Robert W eintraub, The Impact o f the Federal Reserve System’s
Monetary Policies on the Nation’s Economy (Second Report),
Staff Report of the Subcom m ittee on Domestic M onetary
Policy, House Committee on Banking, Finance and Urban
Affairs, 96 Cong. 2 Sess. (Government Printing Office, 1980), p.
17.

Although individuals w anted to hold as much, if
not more, M l balances following the imposition of
the credit controls, the banking system precluded
these dem ands from being satisfied. Once credit
controls were rem oved, the W eintraub hypothesis
suggests, the m ultiplier w ould come back w ithin its
historical ranges (see chart 4). Thus, real money
balances could be expected to return to more his
torical levels as well. This is indeed w hat happened:
actual real balances rose to about $226 billion in
III/1980 (see chart 2).
Therefore, one can interpret the behavior of real
balances in 11/1980 as evidence of a supply-side
lim itation, not a decrease in the dem and for money.
In this light, the large sim ulation error is m erely
evidence of tem porary disequilibrium . Real money
balances deviated from predicted levels, not b e
cause individuals desired less money, but because
m onetary authorities did not anticipate the effect of
33

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

C h a rt 4

M l M ultiplier and Ratio of Currency to Total Checkable Deposits

credit controls on the way people decided to hold
their money.
John Judd and John Scadding also argue that “the
rapid m onetary deceleration in the second quarter of
1980 (as w ell as the rapid growth in the first and third
quarters) was caused, not by a m oney -demand shift,
but by a money-supply ‘shock’.” 12 W hile disagree
ing w ith W eintraub about the m echanics of the
supply shock (Judd and Scadding trace the supply
shock to the contraction in bank loans that followed
12John P. Judd and John L. Scadding, “Liability Management,
Bank Loans, and Deposit ‘Market’ Disequilibrium ,” Federal
Reserve Bank of San Francisco, Economic Review (Summer
1981), p. 21.
Digitized for 34
FRASER

the Special C redit Control Program of 1980), Judd
and Scadding, like W ein trau b , recog n ize th at
“changes in the.ssupply ofm oney can dom inate shortrun m ovem ents in the m onetary aggregates.”13 The
im portant point here is not to differentiate betw een
the W eintraub and Judd-Scadding hypotheses, but
to recognize that both views explain the contraction
in m oney growth by supply-side occurrences. Thus,
deviations of actual real balances from those sim u
lated by a m oney dem and equation may be evidence
of supply shocks, rather than dem and shifts as many
suggest.
13Ibid., p. 22.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1982

THE NATIONWIDE NOW ’
EXPERIENCE IN 1981: ANOTHER
SHIFT?

larger-than-expected balances. In chart 2, w here
observed (not shift-adjusted) real m oney balances
are shown, however, no consistent underprediction
occurred during the last five quarters. In fact, the
The sim ulated values of real m oney balances also equation slightly overpreclicts real money balances.
allow an evaluation of the im pact of the nationw ide Thus, it does not appear that the nationw ide legal
legalization of NOW accounts on the dem and for ization of NOW accounts increased desired M l
money. It has been argued that the introduction of balances in any im portant way.16
NOW accounts m ight result in an increased dem and
for M l balances, supposedly because of the explicit
interest paid on such balances.14
The Federal O pen M arket Com m ittee (FOMC)
apparently believed such a result likely. In the first
place, the FOM C increased the targeted growth
ranges for M l balances in 1981. In addition, the staff
of the Federal Reserve Board of Governors devel
oped a “ shift-adjusted” M l m easure that w ould
subtract the “artificially induced” dem and resulting
from the nationw ide introduction of NOW accounts.
This adjustm ent was determ ined, in large part, by
surveying new NOW account depositors about the
original source of the funds they deposited into these
accounts. Asking such a question, however, provides
little, if any, inform ation about d esired m oney
holdings.15 An analysis of a conventional m oney
dem and relationship should be a b etter vehicle to
address this issue.

CONCLUSION

Many analysts of m onetary policy have used the
recent financial innovations and the volatility of
m oney growth as am m unition against pre-established m onetary growth targets. These innovations
supposedly have caused unpredictable swings in
m oney dem and. T he behavior of actual m oney
growth has been taken as evidence of such swings.

This article offers a counter argum ent. To begin
with, swings in m oney growth are reliable indicators
of m oney dem and only to the extent that the supply
of m oney has not itself been shocked. In the face of
such shocks, large fluctuations in m oney growth
cannot be interpreted as evidence of m oney dem and
shifts. The second quarter of 1980 was an episode of
unusual m oney grow th caused, not by shifting
If the nationw ide legalization of NOW accounts m oney dem and, but rather by supply-side occur
had actually resulted in an increased desire to hold rences. \1 1 balances fell because the banking system
M l balances, the conventional money dem and rela was unable to support the public’s desired deposit
tionship should have consistently underpredicted levels. The lesson learned from this episode is that
real balances after the nationw ide introduction of
these accounts. In other words, actual (real) M l
balances should have been consistently above the 1GW hile no apparent irregularities exist when M l is used, this is
level sim ulated by the equation, as individuals held
not the case when the shift-adjusted measure is employed.

14Much of the discussion about the impact of NOW accounts lias
centered on the minimum balance requirem ents of such ac
counts. Since minimum balance requirem ents are higher on
NOW accounts than on conventional demand deposits, it has
been argued that M l will grow. David E. Lindsey, “Nonbor
rowed Reserve Targeting and Monetary Control,” paper pre
sented at Economic Policy Conference on “Improving MoneyStock Control: Problems, Solutions, and Consequences,” has
correctly pointed out, however, that the issue is one of money
demand. No adjustment need be made if the demand for M l
remains unchanged.
15See John A. Tatom, “Recent Financial Innovations: Have They
Distorted the M eaning of M l?” this Review (April 1982), pp.
23-35. Some have argued that the shift adjustm ent was devel
oped to capture thesourees of NOW inflows rather than the uses.
Such an adjustment should not have been incorporated in the
targeting of the money aggregates then!

Many have recognized this fact. See, for example, Motley,
“ Innovation and Money D em and;” and John W enninger,
Lawrence Radecki and Elizabeth Hammond, “Recent Insta
bility in the Demand for Money,” Federal Reserve Bank of New
York Quarterly Review (Summer 1981), pp. 1-9, where many
explanations of such anomalous behavior are provided. The
point of the present article, however, is that such explanations
are not required. A puzzle exists only when the questionable
shift-adjusted measure is used. Just because individuals are
moving funds from savings to NOW accounts does not indicate,
as the shift-adjustment procedure suggests, that more M l bal
ances are desired. There are always people moving funds from
savings accounts to dem and deposits. Such movement of funds,
however, have never before been taken to suggest that the
demand deposit measure should be adjusted. Why should such
movements of funds now provide any more useful information?
While it is clearly possible that the introduction of explicit
interest payments on checkable deposits did result in an in
creased demand for M l balances, surveying individuals to find
out where funds for new NOW accounts came from is not going
to be useful in addressing such an issue. Examining a money
demand equation, which is a useful procedure, shows no evi
dence of an increased demand.

one-tim e deviations of real m oney balances from
predicted levels do not necessarily indicate a shift in
m oney dem and. Such a deviation could just as well
denote a tem porary money m arket disequilibrium ,
caused by the growth of the m oney supply or a ran
dom fluctuation.

ship. A conventional m oney dem and equation,
how ever, shows evidence of neither sustained p e
riods of overprediction (a downshift) nor sustained
p eriods of u n d erp red ictio n (an upshift) in the
underlying em pirical relationship. Thus, w hile sig
nificant financial innovations have occurred in the
last two years, there is little evidence that these
One precondition for a “ shift” in m oney dem and is innovations resulted in m oney dem and shifts. The
a set of consistent, one-sided prediction errors, de M l m easure continues to have significant econom ic
rived from an estim ated m oney dem and relation and policy content.

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FRASER