Full text of Review (Federal Reserve Bank of St. Louis) : March 1981

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March 1981
Vol. 63, No. 3

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3 Deficits and Inflation

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11 Navigating Through The Interest Rate
M orass: Some Basic Principles
19 The Impact of Energy Prices and Money
Growth on Five Industrial Countries
27 Recent Revisions of G N P

ERRATUM
In the February 1981 Review ( “Selecting A Monetary Indicator: A Test of the New Monetary
Aggregate5,” p. 13), the sentence, “Based on these tests, [Michael J.] Hamburger concluded that
nonborrowed reserves is a better indicator of policy actions than the other monetary variables
studied” should have read as follows:
. . Hamburger concluded that bank credit is a better
indicator . .

The R e v i e w is published 10 times per year by the Research Department o f the Federal Reserve
Bank of St. Louis. Single-copy subscriptions are available to the public free of charge. Mail requests
for subscriptions, back issues, or address changes to: Research Department, Federal Reserve Bank
o f St. Louis, P.O. Box 442, St. Louis, Missouri 63166.
Articles herein may be reprinted provided the source is credited. Please provide the Bank’s Re­
search Department with a copy of reprinted material.


2


Deficits and Inflation
SCOTT E. HEIN

T
JLHIRTY state legislatures have now approved, and
more are considering, resolutions petitioning for a
constitutional convention that would require a bal­
anced federal budget on a fiscal year basis. The U.S.
Congress is also considering a similar resolution and
appears mindful, especially in deliberations on Presi­
dent Reagan’s proposed tax and budget cuts, of wide­
spread public demand to eliminate federal govern­
ment deficits.
Many discussions of federal government deficits
maintain that deficits cause inflation. The 1979 Mis­
souri State Senate Resolution No. 13, for example,
states, “. . . it is widely held that fiscal irresponsibility
at the federal level, and the resulting inflation is the
greatest threat which faces our Nation today” (italics
added). This article explicitly investigates the linkage
between deficits and inflation to analyze whether
government deficits cause inflation. This linkage is
discussed within a framework in which inflation is a
monetary phenomenon. In this framework, there are
two separate channels through which deficits are
linked to inflation — through their impacts on the
stock of money in the economy, and on an individual’s
desire to hold money balances.

THE CAUSE OF INFLATION
On the simplest level, inflation results from “too
much money chasing too few goods.” While this theory
has been widely cited, a number of specifics must be
explained. First, as used here, “money” refers to a set
of assets that can generally be used as a means of
payment. In the United States, money is usually meas­
ured as the coin and currency circulating in the econ­
omy plus deposits held in transaction or checking ac­
counts.1 This definition of money differs considerably
'T h e m easure of m oney th at m ost closely corresponds to this
definition is M 1B , recently developed by th e F ed eral Reserve
B oard of Governors. F o r a description of this m easure as well
as other newly developed m easures, see R. W . H afer, “T he
N ew M onetary A ggregates,” this R eview (F e b ru a ry 1 9 8 0 ) ,
pp. 2 5 -3 2 .




from the common conception of money as a synonym
for wealth or affluence. An individual can be wealthy
(owning vast amounts of real estate, stocks, bonds,
antiques, etc.), yet at the same time hold little wealth
in the form of money as defined here.2
The total amount ot money in the economy is de­
termined primarily by monetary authorities — in the
United States, this is the Federal Reserve System.
Since all commercial banks and thrift institutions that
issue transaction or checking deposits are required to
hold a specific fraction of these deposits as reserves,
the Federal Reserve can cause changes in the amount
of these deposits either by changing reserve require­
ments on these deposits or by directly changing the
level of reserves. The Federal Reserve most often uses
the latter technique in controlling the money stock.
This is accomplished by changing the level of reserves
through “open market operations,” that is, buying gov­
ernment securities in financial markets to increase re­
serves or selling securities to decrease reserves.
When the Federal Reserve wants to increase bank
reserves, for example, it contacts dealers or financial
institutions that are willing to sell their government
securities. In exchange for the securities, the Federal
Reserve credits the financial institution’s commercial
bank with additional bank reserves equal to the value
of the securities. The commercial bank, in turn, credits
the institution’s account. The net result is that the
-A necdote has it th at the Diners Club credit card originated
w hen some w ealthy individuals w ent to dinner a t a posh
restaurant and, upon receiving the bill, discovered th at col­
lectively they lacked sufficient m oney to p ay the tab. Luckily
for the group, they w ere recognized and their credit w as a c ­
cep ted . Some m em ber of the group, recognizing th at a form al­
ized credit line would be preferrable, thus started the Diners
Club.
W h ile this anecdote clearly points out the difference be­
tw een m oney and w ealth, it should also b e noted th at credit
cards them selves are n ot money. This is n ot to say th at credit
cards are not generally used to initiate the purchase of goods
and services. R ather, it recognizes th at the use of credit cards
simply postpones the exchange of m oney for the goods and
services obtained; individuals still p ay for goods and services
with money.

3

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

Federal Reserve has more government securities, the
commercial bank has larger reserves, and the dealer
has larger deposits with the commercial bank. Both
bank reserves and the money stock have increased. In
addition, the commercial bank finds that it is holding
reserves in excess of what it is required to hold. Thus,
the bank can lend this excess to borrowers, further
increasing the money stock.
Although the Federal Reserve affects the money
supply by buying or selling government securities
(federal debt), there is no direct link between federal
government deficits (financed by issuing federal debt)
and Federal Reserve open market operations. Since a
1951 accord between the Federal Reserve and the
Treasury, the Federal Reserve is no longer directly
responsible for stabilizing government security prices
or for purchasing any given portion of the public
debt. Consequently, federal deficits do not require
that the Federal Reserve purchase more government
securities; therefore, federal deficits, per se, need not
lead to increases in bank reserves or the money supply.
While growth in the stock of money in the economy
is a major determinant of inflation, it represents only
one side of the money market. To determine whether
there is “too much” money in the economy, the other
side of the market — the demand for money — must
also be considered. “Too much” money results only
when the amount of money people have exceeds the
amount they want to hold.
The demand for money is a demand to hold money
balances. Everyone, of course, would like to have
more money — to buy more goods and services or
other assets. This is not the demand for money as used
in this article. For our purposes, individuals demand
money only to the extent they desire to hold a portion
of their wealth in the form of monetary assets, that is,
currency in their pockets and balances in their trans­
action accounts.
In the aggregate, the desire to hold money balances
is determined primarily by four things: individuals’
wealth, the total amount of goods and services pro­
duced, the average price of goods and services, and
market interest rates. The first three factors are posi­
tively related to desired money holdings. Thus, to the
extent that each of these factors grows over time, de­
sired money balances also grow. The fourth factor,
market interest rates, when higher, induce individuals
and firms to reduce their money holdings to take ad­
vantage of higher earnings. In this regard, the rising
interest rates of the last two decades have worked to

4


MARCH

1981

reduce the quantity of money demanded.3
If the stock of money in the economy exceeds the
quantity of money demanded, there is an excess sup­
ply or “too much” money in the economy. This means
that individuals would rather own more goods and
services than hold the “extra” money. The excess sup­
ply of money and the excess demand for goods and
services are two sides of the same problem. The excess
demand for goods and services indicates that individ­
uals would like to purchase more goods and services
than are presently available at current prices. With
output essentially fixed by the technology in place, the
imbalance shown by the excess supply of money and
the excess demand for goods can be eliminated only
if the average price of goods and services rises enough
to remove both the excess demand for goods and serv­
ices and the corresponding excess supply of money.
Thus, an excess supply of money naturally leads to
an increase in the average price of goods and serv­
ices. If, over an extended period, the money stock
grows at a faster rate than the quantity of money de­
manded, the average price of goods and services will
continue to increase, and the economy will experience
inflation. Inflation can be avoided if the growth in the
money stock is held equal to the growth in the quan­
tity of money demanded. This does not mean, how­
ever, that money stock growth must be zero to elimi­
nate inflation. As the economy grows, with more goods
and services being produced and consumed, and with
individuals becoming wealthier, the desire to hold
money balances will naturally grow. If the money
stock grows at the same rate as desired money bal­
ances, there will be no inflation.
In summary, inflation results only when, over a con­
siderable period of time, the money supply grows
faster than the desire to hold money balances. Accord­
ing to this view, federal deficits can cause inflation only
if they lead to continual increases in the money supply
or to continual decreases in money demand. Both of
these alternatives are examined below.
3 M arket interest rates, w hich determ ine the desire to hold
money balances, can be broken into two components. The
first com ponent is a real rate of return, w hich measures the
increased com m and over goods and services th at results from
postponing present consumption. T he second com ponent is a
compensation required for exp ected inflation. If individuals
exp ect a greater rate of inflation in the future, they require
th at they be com pensated for the deterioration in the p ur­
chasing pow er of m oney, thus driving up the m arket rate of
return and reducing the desire to hold money balances. In
periods of hyperinflation, the latter com ponent dominates the
decision to hold m oney and results in a “flight” from the
dom estic money. See Thom as J. Sargent, “T he E nds of Four
Big Inflations,” W orking P aper # 1 5 8 , Fed eral Reserve Bank
of Minneapolis (D ecem b er 1 9 8 0 ) .

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

DEFICITS AND THE MONEY
SUPPLY PROCESS
As indicated before, federal government deficits do
not directly cause money growth. As a practical mat­
ter, however, government deficits can have an im­
portant indirect effect on money supply growth.
When the federal government spends more than it
takes in as revenue, the Treasury must finance the
deficit by borrowing in the private marketplace ( sell­
ing government securities). The increased demand for
credit in financial markets, if not offset by a reduc­
tion in credit demand elsewhere or an increase in
credit supply, naturally puts upward pressure on all
market interest rates.4 Monetary authorities may then
attempt to prevent the rise in interest rates from
taking place.5
To do this, the Federal Reserve will buy govern­
ment securities, thus monetizing part of the public
debt by increasing the level of reserves. The increase
in bank reserves, as explained above, will result in a
larger money stock and, other things equal, a subse­
quently higher rate of inflation. Consequently, there is
an indirect channel — via the response of monetary
authorities to higher interest rates — by which deficits
can influence the inflation rate.
However, the existence of this indirect channel does
not indicate that deficits cause inflation. The deficits
4“W h a t is clear in circum stances like these, when efforts to
restrain m onetary grow th confront strong private credit de­
mands, is th at inevitably large new borrowings by the federal
governm ent, w hether to finance budgetary deficits or offbudget program s, strongly aggravate pressures on interest
rates.” Paul A. V olcker, Chairm an, Board of Governors of the
F ed eral Reserve System, before the Com m ittee on Banking,
Housing, and U rban Affairs, U .S. Senate, Jan u ary 7, 1981.
T he extent of this upw ard pressure will depend, in large
part, on the size of deficit relative to total savings. T he larger
the deficit in com parison to the savings pool, the greater the
upw ard pressure on m arket interest rates. Thus, to the extent
that the tax cuts proposed by the Reagan administration lead
to increased savings, some of the pressure on interest rates
resulting from the anticipated deficits will be m itigated. For
an analysis of the effect of deficits on interest rates, see R ich­
ard W .^ L an g , “T h e 1 9 7 5 -7 6 Fed eral Deficits and the Credit
M arket,” this Review (Ja n u ary 1 9 7 7 ) , pp. 9 -1 6 ; and Michael
J. H am burger and Burton Zwick, “Checking Inflation in Spite
of a Deficit,” Business W eek (M arch 2 3 , 1 9 8 1 ) , pp. 12-15.
The reader is also referred to Adrian W . Throop, “Inflation
Premiums, Bu dget D eficits,” F ederal Reserve Bank o f San
Francisco W eekly L etter (M arch 14, 1 9 8 0 ) , pp. 1-3, for an
interesting discussion of m easuring the size of the deficit in
inflationary times.
BSuch attem pts can o ccu r either as a technical m eans of achiev­
ing a given money grow th rate, or because m onetary authori­
ties simply don’t w ant to see interest rates rise. W h ile the
m otivating factors behind the desire to stabilize interest rates
are not alw ays clear, the im pact of rising real government
borrow ing on m onetary policy will always be the same.




MARCH

1981

themselves do not increase the money stock; only
monetary authorities can do this. Only when mone­
tary authorities attempt to prevent market interest
rates from rising will deficits produce a larger money
supply. If deficits persist over an extended period of
time, Federal Reserve attempts to prevent market
interest rates from rising will result in continual in­
creases in the money stock. Viewed in this fashion,
inflation represents the cost associated with trying to
prevent market interest rates from rising.
Many have argued that such attempts to prevent
interest rates from rising are self-defeating because
market interest rates cannot be controlled over ex­
tended periods of time.6 At best, as this argument
goes, the Federal Reserve can keep interest rates
from rising for only a short period of time by increas­
ing bank reserves and money growth. The inflation
that results from excessive money growth will itself
soon put upward pressure on interest rates. For the
purposes of this analysis, however, it is irrelevant
whether or not the Federal Reserve is “successful”
even in the short run. If they attempt to prevent
interest rates from rising at all, they will have estab­
lished a link between deficits and money growth, and
consequently, between deficits and inflation.

DEFICITS AND THE DEMAND
FOR MONEY
Inflation can also be associated with government
deficits if such deficits induce reductions in the pub­
lic’s desired money balances. There appear to be two
possible channels through which this might occur. The
first channel operates through the effect of changes in
interest rates on the public’s demand for money
balances. A higher level of interest rates will reduce
desired money balances, causing an excess supply of
money.
As a practical matter, this effect is minor. While
the demand for money is sensitive to changes in in­
terest rates, quantitatively the effect is small. It would
take a substantial rise in interest rates to reduce
desired money balances enough to actually produce
a measurable increase in inflation. One estimate indi­
cates that interest rates would have to increase 500
percent (for example, from 5 percent to 25 percent)
to induce the same amount of inflation associated
8See “F e d Cannot Control Interest Rates Because T h at Is N ot
A gency’s Role,” American Banker (Jan u ary 2 6 , 1 9 8 1 ) , text of
speech, “W h y C an ’t the F e d Control Interest R ates?” by
L aw ren ce K. Roos.

5

F E D E R A L . R E S E R V E B A N K O F ST. L O U I S

with a permanent one percentage-point increase in
money supply growth.7
A second channel through which federal deficits
can affect desired money holdings — and the inflation
rate — is changing individuals’ wealth holdings. De­
sired money balances are positively related to an indi­
vidual’s wealth. Thus, if individuals observe their
wealth falling over an extended period of time, their
desired money balances will also fall, and higher infla­
tion will result despite the fact that the growth of the
money stock remains unchanged.
Can deficits themselves cause wealth to decline?
On an individual level, the answer is clearly no.
When the federal government spends more than its
direct receipts, some individuals must reduce their
current consumption of goods and services. In our
country, this reduction is made willingly in exchange
for government securities — promises to repay the
loan in the future that are backed by the taxing
authority of the federal government. Thus, those indi­
viduals who forsake current expenditure to hold gov­
ernment debt should not be worse off or poorer,
because they are doing so voluntarily.
Even though each individual holding government
debt is at least as well off as before, it is entirely
possible that economic participants, on an aggregate
level, feel worse off. This could happen, for example,
if the public feels that the federal government is in­
efficiently using the resources it has acquired through
deficit financing.8 Such perceptions could have signifi­
cant wealth effects if it were commonly perceived
that the government was taking away from (“crowd­
ing out”) private investment, which would have
added to the capital structure of the economy, without
adding anything significant by way of public spend­
7R. W . H afer and S cott E . Hein, “E vid ence on the Tem poral
Stability of the D em and for M oney Relationship in the United
States,’ this R eview (D ecem b er 1 9 7 9 ) , pp. 3 -1 4 .
Some w ould argue th at the size of the federal deficit is
closely w atch ed and figures im portantly in the form ation of
individuals’ inflationary expectations. If deficits grow in size,
individuals will exp ect m ore inflation (driving m arket interest
rates u p ) and, as such, will reduce their desired money bal­
ances. H ow ever, this article argues th at there is no direct
link betw een deficits and inflation. Thus, individuals who ex­
p e ct m ore inflation as a result of larger deficits alone are
acting irrationally. T he crucial question regarding future infla­
tion is the extent to w hich the deficits are monetized. If the
deficit is n ot m onetized, future inflation will not result. Defi­
cits, p er se, are n ot inflationary; thus, the proposition that
individuals will form inflation expectations based on the size
o f the deficit alone is not viable as a long-run proposition.
8This effect seems to have been im portant in E urop ean cases of
hyperinflation following W orld W a r I, as m any defeated
countries ran sizable deficits to make reparations to the W orld
W a r I victors. See Sargent, “T h e E nds of F o u r Big Inflations.”




MARCH

1981

ing in return. People would perceive future private
production capabilities as lower and, if this were not
offset by an equivalent benefit from public spending,
would feel poorer as a result.
While such adverse wealth effects are possible, they
are the direct result of fiscal mismanagement, not
deficit financing. The public could be made to feel
equally worse off, if the federal government were to
raise taxes to finance spending programs that the
public deemed worthless. As long as the federal gov­
ernment allocates resources inefficiently, the public
will be poorer. This is true regardless of how the re­
sources are obtained, that is, through taxation or debt
issuance. On the other hand, if the public approves
of the federal government expenditures, it makes little
difference whether the resources are obtained from
current taxes or from the issuance of debt which will
be paid off by future taxes.9
Federal deficits are associated with declining wealth
only to the extent that they are symptomatic of a
governmental misallocation of resources. In this re­
spect, efforts to legislate a balanced federal budget
are attacking the symptom of the problem (whether
real or imaginary) instead of the problem itself. If the
public perceives that its wealth is falling, it is the
result of mismanagement of fiscal responsibilities, not
deficit spending.
In summary, it appears that deficits have little ef­
fect on the desire to hold money balances. As a result,
inflation is not significantly linked to deficits through
their impact on money demand.

DEFICITS, MONEY AND INFLATION:
EXAMINING THE THEORY
The analysis of this article suggests that inflation
is a result of an excess growth of money in the
economy. Deficits are associated with inflation only
to the extent that they lead to increases in the money
stock. To examine this theory in relation to the experi­
ence of the last 25 years, let’s consider the popular
alternative explanation of inflation, namely, that fed­
eral government deficits directly cause inflation.
9This argum ent presumes th at the public recognizes the “pay
m e now or pay me later” choice betw een a current tax hike
and the issuance of debt. In oth er w ords, when the public
sees the federal governm ent issue debt, it recognizes th at fu­
ture taxes must be raised to p ay off the increase in debt. See
Neil A. Stevens, “G overnm ent D ebt Financing — Its Effects
in View of T ax D iscounting,” this R eview (Ju ly 1 9 7 9 ) , pp.
11-1 9 .

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

First, consider the relationship between federal
deficits and money stock growth. Chart 1 shows the
relationship between the federal government debt
(which rises when the government runs deficits and
falls when it runs surpluses) and the money stock
over the last 25 years. From 1955 through 1974, growth
rates of the federal debt and the money stock move
in tandem, generally accelerating through early 1973.
This accelerating pattern is then broken, as the
growth of both debt and money stock slows some­
what from early 1973 through early 1975 — ironically
enough, a period of recession in which one would
anticipate an increase in debt.
The growth rate of the money stock always exceeds
the growth rate of the federal debt from 1955 through
early 1975, as the Federal Reserve increased the por­
tion of the federal debt it held (see the third tier in
chart 1). Over this period, the Federal Reserve pur­
chased federal debt at a faster rate than the federal
government issued it. This means that bank reserves
grew at faster rates than the federal debt and, thus,
the money supply expanded faster than the debt.10
The experience over this period is fully consistent with
the notion that the Federal Reserve was attempting to
offset the upward pressure on market interest rates
that resulted from the accelerating issuance of federal
debt; acceleration in the growth of the federal debt
was paralleled by an acceleration in money stock
growth.
In 1975, however, there was a clear break in the
prevailing relationship between the federal debt and
the money stock. From 1975 through 1980, the fed­
eral debt grew at a 13.0 percent rate, more than twice
its growth rate from 1967 to 1974. Money growth did
not accelerate to this extent, rising at a 7.1 percent
rate from 1975 through 1980, only slightly above the
6.1 percent rate from 1967 to 1974.
Thus, the period 1975-80 was the first sustained
period since the accord in which the money stock
grew at a slower rate than the federal debt. This
drastic change occurred because the Federal Reserve
did not continue its past practice of increasing the
proportion of the federal debt that it held. In fact,
the Federal Reserve did just the opposite. The pro­
portion of the federal debt held by the Federal Re­
serve fell from almost 24 percent in 1974 to less than
10The relationship betw een federal debt held by the F ederal
Reserve and money grow th is not necessarily a perfectly
stable one. To the extent th at the F ed eral Reserve changes
reserve requirem ents, a given stock of bank reserves results
in a different money stock.




MARCH

1981

18 percent in 1980. Either the increase in the federal
debt over this period did not put auxiliary upward
pressure on market interest rates or the Federal Re­
serve became less concerned with keeping interest
rates down and more directly concerned with money
growth itself. In either case, the close correlation be­
tween debt and money growth was broken.
With this relationship between the federal debt
and the money stock in mind, consider the two alter­
native causes of inflation: (1) excess money growth
and (2) federal deficits. If the first alternative is cor­
rect, growth in the federal debt should generally
underprediet inflation over the 1955-74 period and
overpredict inflation thereafter compared to the rela­
tionship between money growth and inflation. This
should occur because debt grew slower than money
over the early period and faster than money there­
after. If the second alternative is correct, the relation­
ship between inflation and growth of the federal debt
should be closer than that between inflation and
money growth.
Chart 2 shows the relationship between inflation,
money growth and the growth in the federal debt
over the last 25 years. All rates are measured on a
compounded annual rate basis. Inflation is measured
by the four-quarter rate of change in the implicit
GNP deflator. Money growth is measured by the 12quarter rate of change in M1B. This extended period
accounts for the fact that only sustained periods of
excess money growth result in inflation.11 These obser­
vations were lagged two quarters because money
growth has little or no immediate effect on inflation.
Debt growth is similarly measured on a 12-quarter
basis. Lagging the debt measure did not appreciably
improve its relationship with inflation, so it is charted
on a contemporaneous basis.
The chart shows clearly that money growth is more
closely related to inflation than is the growth in the
federal debt. More important, the two propositions
from our theory are borne out. Specifically, relative
to money growth, the growth in the federal debt
underpredicts inflation over the period 1955-74 and
overpredicts inflation over the period 1975-80. Over
the early period, inflation averaged 3.4 percent, the
money growth measure averaged 3.5 percent and the
debt growth measure averaged 2.1 percent. Over the
latter period, inflation averaged 7.5 percent, money
n F o r a m ore technical analysis of this lag, see Keith M. Carl­
son, “T he L a g Fro m M oney to P rices,” this Review (O cto b er
1 9 8 0 ) , pp. 3 -1 0 .

7

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

Influence of Federal G o v e r n m e n t Debt on M o n etar y Expansion
1955

1955

1956

1956

1957

1957

1958

1958

1959

1959

1960

1960

1961

1961

196Z

1962

♦ D a ta p r io r to 1959 a re M l.
S h a d e d a r e a s r e p r e s e n t p e r io d s o f b u s in e s s re c e s s io n s .
P e rc e n ta g e s a r e a n n u a l r a te s o f c h a n g e fo r p e r io d s i n d i c a t e d .
L a te s t d a t a p l o t t e d : 4 t h q u a r t e r


8


1963

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J9 fb \

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F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

C h a rt 2

G r o w t h Rates of M1B, Prices a n d Federal D ebt
Penent

1955 5 6

Percent

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

7 8 79 1 9 8 0

LJ D a t a a r e t w o - p e r i o d l a g o f t h r e e - y e a r g r o w t h r a t e s
[2 G N P d e f l a t o r . D a t a a r e o n e - y e a r g r o w t h r a te s .
[3 T o t a l d e b t , n o t i n c l u d i n g d e b t h e l d b y U.S. a g e n c i e s a n d trus ts. D a t a a r e t h r e e - y e a r g r o w t h r a te s .
Late st d a t a p l o t t e d : 4 th q u a r t e r

growth, 6.4 percent, and debt growth, 11.5 percent.12
This evidence then is consistent with the theory that
inflation is caused by excessive money growth. On

the other hand, the evidence is not consistent with
the view that increases in the federal debt (i.e.,
deficits) cause inflation.

12The read er can see th a t m oney grow th underpredicts inflation
by a sizable am ount over the period 1 9 7 4 -7 6 . This is the
result of a one-tim e w ealth loss following the significant oil
p rice increases of late 1 9 7 3 and early 1 9 7 4 . T h e w ealth loss
resulted in reductions in the quantity of m oney dem anded
and, as a result, inflation w as greater than m oney growth
alone w ould suggest. A similar phenom enon is observed in

1 9 8 0 , b ut on a sm aller scale. F o r technical discussions of this
effect, see Denis S. K am osky, “T he Link Betw een Money
and Prices — 1 9 7 1 -7 6 ,” this R eview (Ju n e 1 9 7 6 ) , pp. 1 7 -2 3 ;
and R obert H. R asche and John A. T atom , “E n erg y R e­
sources and Potential G N P,” this R eview (Ju n e 1 9 7 7 ) , pp.
10-2 4 .




9

F E D E R A L . R E S E R V E B A N K O F ST. L O U I S

SUMMARY AND CONCLUSION
This article has described how federal deficits could
cause inflation within a monetary framework. The
potential link between federal deficits and inflation
has been traced through the impact of deficits on the
money stock and on the desire to hold money. It
was argued that the link between deficits and money
growth is not a causal one, in the strict sense of the
word; that is, deficits need not directly cause increases
in the money stock. Only when monetary authorities
attempt to prevent interest rates from rising will fed­
eral deficits lead to increases in the money stock and,
subsequently, inflation. This link was apparently im­
portant from 1955 through early 1975. More recently,
however, the link appears to have been broken, either


10


MARCH

1981

because monetary authorities have shown more con­
cern about money growth and less about the level of
interest rates or because recent deficits have not put
undue pressure on market interest rates. Over the
period 1975 to 1980, the rate of increase in the federal
debt has been almost twice that of money growth and
inflation.
Two possible channels by which deficits could re­
duce the desire to hold money balances were also
detailed. These channels, operating through rising
market interest rates and reduced wealth, are direct
conduits by which deficits could directly lead to infla­
tion. Neither of these channels, however, is relevant
to recent inflation in the United States.

Navigating Through The Interest Rate
Morass: Some Basic Principles
by G. J. SANTONI and COURTENAY C. STONE

I n ancient times, the Delphic oracle was renowned
for providing cryptic, often meaningless, answers to
important questions. In recent times, this Delphic
tradition has seemingly inspired much of the popular
discussion about the causes and consequences of in­
terest rate movements. Without difficulty, one can
find comments which indicate that interest rates are
simultaneously too high and too low; or, that high
interest rates are “caused” both by slower money
growth and expansionary money growth; or, to cite
one of the more puzzling pieces of analysis, that the
dollar will rise in foreign exchange markets because
of interest rate movements, whether interest rates rise
or fall.1
Discussions of interest rate movements and their
consequences are frequently misleading and often
mistaken. In large part, the errors in such discussions
stem from the absence of a theoretical framework with
which to assess and evaluate the behavior of interest
rates. The purpose of this article is to introduce some
basic economic concepts about interest rates. It is
intended to provide the reader with the minimal back­
ground necessary to analyze some of the more com­
mon assertions regarding interest rates.
!O u r personal favorite is the follow ing: “ Said B ache Halsey
Stuart Shields in its foreign exchange weekly report, ‘If rates
go higher it helps th e dollar on a real rate of return basis;
if rates go low er it reflects confidence that the U .S. will shortly
experience a decline in the rate of inflation.’ So, either way,
the dollar benefits.” This appeared in “ D ollar Soars in F a ce
of L ow er Interest Rates as Focus Shifts to M ore Fundam ental
F a cto rs,” T he Money Manager (F eb ru ary 2 , 1 9 8 1 ) , p. 12.




DIFFERENT INTEREST RATES MOVE
SIMILARLY OVER TIME
Theoretical discussions of interest rates typically
refer to something called “the rate of interest.” Yet,
there is a wide variety of interest rates, each of
which is important for a specific type of financial
transaction. Charts 1 and 2 depict the movements of
several of these interest rates over the past few years.
Three things are immediately obvious: First, there are
differences — in some cases, sizable — between the
levels of these interest rates. For example, Federal
Housing Administration (FHA) mortgage rates ex­
ceed the yield on state and local Aaa bonds by as
much as 300 to 600 basis points during the 1976-80
period (chart 2 ).2
Second, short-term interest rates are generally more
variable than long-term rates. For example, the rate
on 3-month Treasury bills (chart 1) ranged from be­
low 5 percent (in 1976 and 1977) to over 15 percent
(in 1980), a movement of more than 1,100 basis points.
In 1980, 3-month Treasury bill rates fluctuated more
than 800 basis points. On the other hand, the yield on
long-term Treasury securities (chart 2) ranged from
7.20 percent to 12.39 percent over the 1976-80 pe­
riod, a difference of about 500 basis points. In 1980,
the range was 265 basis points (from 9.74 percent to
12.39 percent).
2One p ercen tage point is equal to 1 0 0 basis points.

11

F E D E R A L . R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

C h a rt 2
C h a rt >

L on g -T erm In te re s t R a te s

Short-Term Interest Rates
Percent

1976

M o n th ly A v e ra g e s o f D a ily F ig u re s

1977

1978

1979

1980

Perteilt

PerceRt

M o n t h ly A v e r a g e s o f D a ily F ig u re s

Percent

19 81
1976

!_[_ Beg i n n in g N o v e m b e r 1, 1 9 7 9 , d a t a a r e 4 -m o n th c o m m e rc ia l p a p e r ra te s .
L a te s t d a ta p lo tte d : A p r i l

|_Li

1977

F H A 3 0 - y e a r m o r tg a g e s .

1978

1979

1980

1981

D a s h e d lin e s i n d i c a t e d a t a n o t a v a i l a b le .

| ^ 2 |M o n th ly a v e r a g e s o f T h u rs d a y f ig u r e s .
H i A v e r a g e o f y ie ld s o n c o u p o n is s u e s d u e o r c a l l a b l e in 10 y e a r s o r m o r e ,
e x c l u d i n g is s u e s w ith fe d e r a l e s ta te ta x p r i v i le g e s .

Y ie ld s a r e c o m p u te d b y

th is b a n k .

Third, and most important for this article, although
there are differences among interest rates, charts 1
and 2 clearly show one significant feature common to
all: interest rates generally move together over time.
For example, interest rates generally declined through­
out 1976, rose steadily in 1977 and 1978, and followed
similar up-and-down patterns in 1979 and 1980.
Because this article is concerned with the factors
that produce similar movements in all interest rates,
the discussion focuses on “the rate of interest,” rather
than referring to specific interest rates.

THE INTEREST RATE: THE PRICE
OF WHAT?
Many discussions of interest rates go astray from
the start because the rate of interest is never cor­
rectly defined. It is generally conceded that the rate
of interest is a price that is paid or received for some­
thing; the problem lies in correctly determining what
it is the price of. In this section, we show that it is
the price of consuming goods now rather than later.

Nominal Prices, Inflation and the
Price of Money
The price of anything is simply the rate at which
it can be traded or exchanged for something else.
12




L a te s t d a ta p lo t t e d : A p r i l

The prices that we observe every day are nominal
prices: they specify the rate at which specific goods
are exchanged for money. If one gallon of milk can
be purchased for two dollars, we typically say that
the price of milk is $2.00 per gallon. However, we can
also correctly say that the price of money is one-half
gallon of milk per dollar. The price of money in terms
of any specific good is simply the inverse of the nomi­
nal price of that good.
Inflation occurs when there is a general rise in the
nominal prices of all goods and services over an
extended period of time. This movement is typically
measured by increases in various indices, such as the
consumer price index (CPI) or the GNP implicit
price deflator. When nominal prices of goods and
services are generally rising, these indices display
similar behavior.
Just as the price of money in terms of a specific
good is the inverse of that good’s nominal price, the
price of money in terms of a composite measure of all
goods and services is obtained simply by calculating
the inverse of the general price index. Thus, inflation
can be considered as a general rise in the nominal
prices of goods and services or, equivalently, as a gen­
eral fall in the price (or value or purchasing power)

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

Relative Prices and Economic Behavior
Table 1

GNP Implicit Price Deflator and the
Price of Money: 1970-1980
Year

GNP Implicit
Price Deflator/100
(1972 = 1.00)

Price of
Money1
(1972 = 1

1970

.91

1.10

1971

.96

1.04

1972

1.00

1.00

1973

1.06

.94

1974

1.15

.87

1975

1.26

.79

1976

1.32

.76

1977

1.40

.71

1978

1.50

.67

1979

1.63

.61

1980

1.77

.56

*The “p rice of money” is the inverse of the numbers shown
in colum n 2.

of money. The relationship between one general meas­
ure of prices (the GNP implicit price deflator) and
the price of money over the past decade is shown in
table 1. The price (or value) of a dollar fell from 1.00
in 1972 to .56 in 1980 in terms of the nominal prices
of goods and services. This indicates that a dollar
could be purchased in 1980 for about half the goods
and services that it cost in 1972.
By remembering this inverse relationship between
the nominal prices of goods and the price of money,
you will avoid making the most persistent error that
pervades interest rate discussions. The interest rate is
frequently, but erroneously, called the price of money.
A simple comparison of the movement of interest rates
(charts 1 and 2) with the movement of the price of
money (table 1) demonstrates the fallacy inherent in
this view. The price of money declined consistently
throughout the 1970s. Interest rates, on the other hand,
generally increased over this period. Whatever price
the interest rate represents, it is clearly not the price
of money.3
3N or is it the p rice paid for the use of m oney: “Experience
shows th at nearly every student of econom ic science has . . .
acquired a num ber of crude and usually false ideas on this
im portant subject. Such, for instance, is the idea th at interest
is the p rice paid for the ‘use of m oney’ . . . ” Irving Fisher,
T he R ate o f Interest (N ew York: T he M acm illan C o., 1 9 0 7 ) ,
p. 3.




A relative price of one good measures the rate at
which that good can be directly exchanged for an­
other good. When money is used in the process of ex­
change, relative prices between goods are not immedi­
ately observed; they are easily calculated, however, as
the ratio of the nominal prices of any two goods. For
example, if the nominal price of milk is $2.00 per gal­
lon and the nominal price of eggs is 50 cents per
dozen, the relative price of milk (in terms of eggs) is
four dozen eggs per gallon of milk.
Changes in relative prices, not those in nominal
prices per se, are the ones that affect economic be­
havior. If wages rise relative to the prices of machin­
ery, employers will reduce their use of labor and sub­
stitute more capital goods in production. If the price
of American cars (including costs of operation) rises
relative to that of foreign cars, consumers will pur­
chase fewer U.S.-produced autos and more foreignproduced cars. When the price of beef rises relative to
that of chicken or pork, we consider it only rational to
purchase more of the relatively cheaper meats and
fewer of the more expensive steaks. This response to
relative price changes is so universal and thoroughly
documented that it is called the “law of demand.”

The Interest Rate: The Relative Price
of Earlier Availability
The interest rate is the price that we see quoted in
lending and borrowing transactions in credit markets.
It is generally expressed as the premium that must be
paid in an exchange between current and future dol­
lars. For example, if you can borrow $100 now in ex­
change for $110 to be paid to the lender in one year,
the rate of exchange between future and current dol­
lars is 1.1 dollars in one year per dollar of credit now.
This rate of exchange is generally designated by the
implied rate of interest — in this example, 10 percent.
This is why the rate of interest is called the price of
credit.
However, this designation obscures the significant
role that the interest rate plays in economic decisions.
The interest rate would exist even in the absence of
financial markets. Stripped of the mystique associated
with complex financial transactions, the interest rate is
simply the price paid for obtaining the use of goods
13

FE DE RA L . R E S E R V E B A N K O F ST. L O U I S

now — it is the price paid for earlier availability of
goods and services.4
Consider what this concept reveals about its im­
pact on the decisions that people make. As the price
paid for earlier availability, the interest rate measures
the rate at which people exchange the use of goods
and services today for their use at some time in the
future. If, for example, the annual rate of interest is
10 percent and nominal prices are not expected to
change, every dozen eggs, ton of steel and quart of
milk you use today “costs” you 1.1 times that amount
of eggs, steel and milk that you would have had next
year if you had only saved (refrained from using
them) now.
We noted previously that an increase in the relative
price of anything that we buy will induce us to buy
less of it and more of other things that are now rela­
tively cheaper. An increase in the interest rate means
that the cost of consuming goods today rises in terms
of the future goods that must be given up. Because
the interest rate is the price that reflects the options
available to individuals through time, it is the one
price that pervades all of the economic decisions that
people make. Specifically, the decisions that, in the
aggregate, determine the economic progress of a na­
tion — how much to save and invest — are fundamen­
tally related to the rate of interest that people expect
to prevail. It is no wonder that interest rate move­
ments provoke such widespread concern.

THE EXPECTED RATE OF INTEREST
IS ALWAYS POSITIVE
The rate of interest that people expect to receive
from saving and investing is always positive. There
are two primary reasons that this is so. The first rea­
son concerns the fact that resources can be used pro­
ductively over time. The second reason is that people
have “positive time preference.”

Resources Have Productive Uses
The interest rate is always positive because re­
sources can be used in ways that increase their value
over time. Today’s steer can be slaughtered now or
placed on a feed lot to grow in weight and size,
yielding more beef and a larger hide in the future.
There are a wide variety of goods which grow in value
4F o r a com prehensive discussion of interest rates, see Armen
Alchian and W illiam R. Allen, Exchange and Production:
Competition, Coordination, and Control (B elm ont, California:
W adsw orth, 1 9 7 7 ) , pp. 4 2 4 -5 9 .

14




MARCH

1981

over time. Some goods, (e.g., steers, trees, wheat)
physically grow larger over time; other goods (e.g.,
whiskey, cheese, wine) improve in quality with age.
Still other goods (e.g., steel, coal, oil, labor) can be
converted into capital goods (e.g., machines, trucks,
autos). Since we live in a world in which more wheat,
smoother whiskey and more trucks in the future are
the costs of consuming wheat, whiskey and leisure
time now, the price of earlier availability — the rate of
interest — is always positive.5

People Have Positive Time Preference
People prefer consuming goods presently to con­
suming similar goods in the future. This is called posi­
tive time preference.6 It means that people value the
present use of resources (goods) more highly than
they value the future use of resources. Since this is
the case, they must be induced to forego the present
use of resources by the payment of a positive rate of
interest. Because of positive time preference and be­
cause it is possible to use resources in ways that are
productive (increase their value) over time, people
who give up the use of resources now will demand
to be paid a positive interest rate for doing so; after
all, they could always keep the resources themselves
and receive the potential gains directly. Similarly,
people who want to use resources (e.g., steers) cur­
rently, either to consume them (as steaks) or invest
them (on feed lots) will always have to pay a posi­
5This view has a considerable history and is w idely held am ong
economists. Irving Fisher, T he Theory o f Interest (N ew York:
Kelley and Millman, 1 9 5 4 ) , p. 1 9 2 , argues: “In the real w orld
our options are such th at if present incom e is sacrificed for the
sake of future incom e, the am ount of future incom e secured
thereby is greater than the present incom e sacrificed . . .
N ature is, to a great extent, reproductive . . .” See also Jack
Hirshleifer, Price Theory and Applications (E n glew ood Cliffs,
N .J.: P rentice-H all, 1 9 7 6 ) , pp. 3 9 9 -4 0 8 and pp. 4 1 5 -3 2 ; Fisher,
T he Rate o f Interest, p. vii; F ran k H . Knight, Risk, Uncer­
tainty and Profit (N ew York: Kelley and Millman, 1 9 5 7 ) ,
p. xli; and Frank H. Knight, “The Business C ycle, Interest,
and M oney: A M ethodological A pproach,” Review o f E conom ­
ics and Statistics (M ay 1 9 4 1 ) , p. 2 2 1 .
'■See, for example, E ugen von Bohm -Baw erk, C apital and In­
terest (Sou th Holland, 111.: L ib ertarian Press, 1 9 5 9 ) , p. 2 5 9 ;
Jack H irshleifer, Investment, Interest and Capital (E n g lew o od
Cliffs, N .J.: P rentice-H all, 1 9 7 0 ) , p. 1 1 7 ; and M ancur Olson
and M artin J. Bailey, “Positive Tim e Preference,” Journal o f
Political Econom y (F e b ru a ry 1 9 8 1 ) , p. 1 -25. Olson and Bailey
state in their conclusion: “ . . . tire case for positive tim e p ref­
erence is absolutely compelling . . .”
F o r a standard textbook discussion of the issue, see Daniel
O rr, Property, Markets, and Government Intervention (P acific
Palisades, C al.: G oodyear Publishing C o., 1 9 7 6 ) , p. 1 7 5 : “Al­
m ost any individual, if pressed w ith careful questioning, will
declare th at he would prefer to receive a dollar today, rath er
than tom orrow. A fter all, receip t today perm its all the alter­
natives that receip t tom orrow does . . .; and other alternatives
are opened up b y the choice to take the dollar today . . .”

MARCH

FE DE RA L . R E S E R V E B A N K O F ST. L O U I S

tive rate of interest; competition among prospective
borrowers alone will assure this.7

EX ANTE AND EX POST RATES
OF INTEREST
The previous section points out that the expected
rate of interest is always positive; people will not
forego the present use of goods ( save or invest) unless
they expect to receive a positive return from doing so.
The expected rate of interest, the rate that determines
the extent of saving and investment, is sometimes
called the ex ante rate of interest. This interest rate is
forward looking; it is this anticipated return that moti­
vates individuals to make specific economic decisions
regarding how resources will be used.
This rate of interest must be carefully distinguished
from the actual rate of return that is ultimately re­
ceived. The rate of return actually earned as a con­
sequence of each decision is called the ex post rate of
interest. The ex post rate is the hindsight rate of inter­
est, and, as such, can be negative, positive or zero.
Because it is unknown at the time the decision is
made, the ex post interest rate is irrelevant for deter­
mining economic decisions. There is no way to undo
past actions.
To see why ex post returns, per se, do not affect
individuals’ decisions, consider the following example.
Suppose you are offered an opportunity to bet on the
outcome of a coin toss. You are convinced that the
coin is a fair coin; moreover, you will be allowed to
toss the coin. The following odds are offered: if the
coin turns up “heads,” you win $100; if the coin turns
up “tails,” you pay $50. Since, in your estimation, the
coin is as likely to turn up heads as it is tails on each
toss, your ex ante or expected gain is $25 on each
coin toss.8
7As F ried rich A. H ayek points out: “Th ere can be no doubt
that the existence of such a positive rate of profit [a positive
real return] on investments is the main source of demand for
loans of m oney, since com m and over present money is com ­
m and over present resources w hich can be turned into future
commodities a t a profit. And there can also be little doubt
that the existence of such a rate of profit is at least one of the
reasons w hy people who m ight themselves employ the money
profitably, will not be willing to lend it w ithout special re­
muneration . . .” The Pure Theory o f Capital (C h icag o : U ni­
versity of C hicago Press, 1 9 4 1 ) , p. 3 5 5 .
8T he expected gain (loss, if n egative) is equal to the probabil­
ity of heads ( . 5 ) multiplied by your winnings if heads comes
up ( $ 1 0 0 ) , minus the probability of tails ( . 5 ) multiplied by
your loss if it comes up ( $ 5 0 ) . Th ere is, of course, one sub­
stantial difference betw een this exam ple and credit m arket
transactions. T he coin toss is a zero-sum gam e; the expected
gain to one individual equals the expected loss to another. In
credit markets, both borrowers and lenders expect to gain from
the transaction; econom ic exchange is a positive-sum gam e.




1981

Because you expect to win, you naturally accept the
bet. You flip the coin and it turns up tails. You have
just lost $50 as a result of your decision to bet. The
ex post return from having bet reflects the change in
your wealth; it is a negative $50.
What does this example show? First, ex ante and
ex post returns can differ significantly because they
represent entirely different concepts. Since they ad­
dress different issues, different information is used in
their calculation. The ex ante return used to make the
decision was related to the various possible outcomes
and the probability of each outcome. The ex post re­
turn, however, reflects solely the change in wealth that
actually results from the decision.
Note, further, that the actual return resulting from
past decisions is not relevant to subsequent decisions
unless it somehow affects the current ex ante return.
For example, suppose you can continue to bet on the
toss of the coin under the same conditions at the
same odds. Because you have acquired no information
that would lead you to change your expected gain
from betting, you would rationally continue to play
the game. Your initial loss is what is called a “sunk
cost;” it can not be recovered no matter what you do.
The only things that are relevant in the process of
making decisions are the expected returns of the op­
portunities that you presently confront.
To summarize, the ex ante rate of interest is the one
individuals use to make savings and investment de­
cisions; this forward-looking rate guides resource use.
The ex post rate of interest, on the other hand, is
backward-looking; it tells you how well you actually
did.

NOMINAL AND REAL RATES
OF INTEREST
In general, the interest rates with which we are
most familiar (e.g., those quoted in financial markets)
are expressed as the rate of exchange between current
and future dollars rather than between current and
future goods and services. These published interest
rates are formed in the process of contracting between
borrowers and lenders and express the rate at which
a loan is expected to appreciate (in terms of dollars)
over the contract period. Therefore, all interest rates
quoted in financial markets are ex ante interest rates.
There are immense gains to both borrowers and
lenders from specifying contracts in terms of money,
the medium of exchange, rather than directly in terms
of the actual goods and services; if this were not so,
15

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

we would observe considerably more “barter” loans.
Specifying these contracts in terms of money, how­
ever, introduces an additional complication into the
determination of the interest rate. This problem re­
quires a discussion of the distinction between the
nominal and real interest rate.9
In the absence of an expected inflation, the rate of
interest on credit transactions will be the same
whether money or goods and services are specified
in the loans. If nominal prices are expected to remain
unchanged, the price of money is likewise not ex­
pected to change. Thus, it will not matter whether
loan contracts are specified in goods or money; they
will yield equivalent interest rates.
The interest rate implied by the rate of exchange
between present and future goods is called the real
rate of interest. The interest rate implied by the rate
of exchange between present and future money is
called the nominal rate of interest. Because it repre­
sents an exchange between money now and money in
the future, the nominal interest rate is influenced by
the expected change in the nominal prices of goods
and services over the contract period.
The following example highlights the relationship
between the real and nominal rates of interest. Sup­
pose that wheat currently sells for $4.00 per bushel
and that you have 100 bushels of wheat. If the annual
real rate, of interest is currently 10 percent and if nomi­
nal prices are expected to remain unchanged, it makes
no difference to you whether you lend 100 bushels
of wheat now in exchange for 110 bushels next year,
or sell the wheat for $400 and lend the proceeds in
exchange for $440 next year. Because the two options
are identical, the nominal interest rate (the rate on
the exchange of current for future money) is equal to
the real rate (the interest rate on the direct exchange
of current for future wheat).
If, however, the nominal prices of all goods are ex­
pected to rise by, say, 5 percent during the year, the
nominal rate of interest must rise by 5 percent as
well to compensate the lender for the reduced value
of the future money that will be received. Thus,
although the real rate remains unchanged, the nominal
rate of interest rises to 15 percent; it is equal to the
sum of the real rate (10 percent) plus the expected
rate of inflation (5 percent).
9Fro m this point on, the term “ex ante” is deleted to simplify
the discussion. H ow ever, since the discussion is intended to
analyze interest rates that affect behavior, references to “the
rate of interest” refer to the ex ante interest rate unless other­
wise noted.

16



MARCH

1981

The nominal interest rate observed in financial mar­
kets is equal to the sum of the real interest rate and
the expected rate of inflation over the contract
period.10

A LITTLE THEORY GOES A LONG WAY
The theoretical discussion of interest rates devel­
oped in this article provides a means of interpreting
many statements about interest rate movements. Con­
sider, for example, the following popular misconcep­
tions about interest rates.
Error # 1 : “Slower Money Growth Drives Up In­
terest Rates.” This is perhaps the most widespread
misconception that exists about interest rate move­
ments. It derives, in part, from the fallacy that the
interest rate is the price of money. If the interest
rate were the price of money, then reduced growth
of the money supply (relative to the growth in money
demand) would indeed cause interest rates to rise.
However, as noted earlier, the interest rate is not the
price of money.
Because the price of money is the inverse of the
nominal prices of goods and services, reduced money
growth will increase the price of money and reduce
the rate at which nominal prices of goods and serv­
ices are rising. In other words, slower money growth
reduces the expected rate of inflation. Since the nomi­
nal interest rate equals the real interest rate plus the
expected rate of inflation, slower money growth will
also reduce nominal interest rates.
A casual observation of the data indicates the close
link between “tight” money growth and low interest
rates over long time periods. Over shorter periods,
however, there is an ambiguous relationship between
movements in money growth and interest rates. For
example, as shown in chart 3, we can easily find pe­
riods when money growth and interest rates moved
in similar directions (e.g., March-April 1980, Julymid September 1980) or in opposite directions (e.g.,
November-mid December 1980, January-March 1981).
What is important here, however, is that we can
demonstrate, using this simple theoretical frame­
work, that the initial statement is specious.11
10T he discussion in this article ignores the effects of taxes on
nominal interest rates.
n A m ore com prehensive analysis of the relationship betw een
money grow th and interest rates w ould focus on w hether the
m oney grow th was anticipated or not, w hether it was ex­
pected to be perm anent or not, and w hether short-term or
long-term rates of interest w ere being analyzed. These neces­
sary additional qualifications provide further evidence for the
vacuousness of the statem ent, “ Slower money grow th drives
up interest rates.”

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

C hart 3

Levels of M1B and Selected Interest Rates

1980

1981

♦ W e e k l y a v e r a g e s of d a i l y m a r k e t yie ld s.

Error # 2 : “Higher U.S. Interest Rates Increase the
Dollar’s Value In Foreign Exchange Markets.” Once
again, remember that the nominal interest rate equals
the sum of the real interest rate and the expected
rate of inflation. Unless we know why U.S. nominal
interest rates are rising, we cannot possibly tell
whether the foreign-exchange value of the dollar will
rise or fall. If, for example, U.S. nominal interest rates
have increased because the expected rate of inflation
has risen, the international price of the dollar will



fall; greater U.S. inflation means a lower price of the
dollar regardless of the market in which it is traded.
If, on the other hand, U.S. nominal interest rates
have increased because the real interest rate has
risen, we do not know how the dollar will respond in
foreign exchange markets. If advances in U.S. tech­
nology have opened up new and highly profitable
investment opportunities, both the real and nominal
interest rates will rise, and the value of the dollar will
17

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

increase as foreign capital is drawn into the United
States. However, if major political instability should
arise in the United States, both U.S. real and nominal
rates of interest will rise, and the foreign-exchange
value of the dollar will fall as domestic and foreign
investors withdraw their funds from the United States.
In general, the relationship between movements in
U.S. interest rates and the foreign-exchange value of
the dollar is ambiguous.12 Changes in U.S. nominal
interest rates indicate nothing about how the foreignexchange value of the dollar will respond. The theo­
retical framework developed here points out the
nature of the ambiguity and indicates the addi­
tional information necessary to determine the actual
relationship.
Error # 3 : “The Real Interest Rate Is Negative.”
There are two different real interest rates: the ex ante
real interest rate and the ex post real interest rate.
The ex ante real interest rate is the real return that
you expect to earn (or pay) when you lend (or bor­
row). The ex ante real interest rate is always positive
except in certain bizarre scenarios.13 People will never
willingly save, lend or invest if the expected return
is negative.14
In the world as we know it, people are generally
unwilling to deliberately reduce their wealth. Nega­
tive ex ante interest rates mean that lenders are know­
ingly transferring some of their wealth to borrowers
and that borrowers are knowingly increasing their
wealth at the lenders’ expense. Competition among
borrowers to obtain wealth from lenders, and deci­
sions by some prospective lenders to become bor­
rowers instead, eliminate any prospect that the ex­
12This discussion assumes th at foreign ex ante real interest
rates and exp ected inflation rates rem ain unchanged. A more
com prehensive analysis w ould incorporate the m ovem ents in
U .S. interest rates relative to foreign interest rates. See, for
exam ple, Douglas R. M udd, “Do Rising U .S. Interest Rates
Im ply a Stronger D ollar?” this R eview (Ju n e 1 9 7 9 ) , pp.
9 -1 3 .
13F o r exam ple, “ . . . a world in w hich the only provisioning
for the future consisted of carrying over initial stocks of
perishable food, clothing and so forth and if every unit so
carried over into the future w ere predestined to m elt aw ay
. .
w ould provide the preconditions for a negative ex ante
real interest rate. T he quote is from Irving Fisher, The
Theory o f Interest and C apital (N e w York: Augustus M.
Kelley, 1 9 6 5 ) , p. 9 1 .
14This observation has even reached C ongress: “T h e public
simply will not hold securities unless yields exceed expected
inflation.” M inority Views, Monetary Policy for 1981, Fifth
R eport b y the C om m ittee on Banking, F in an ce, and U rban
Affairs, 9 7 Cong. 1st Sess., H . Rept. 9 7 -1 0 , p. 15.

18




MARCH

1981

pected interest rate is negative. To be sure, charity
does exist. For example, some parents give some of
their wealth to their children. However, the imper­
sonal nature of credit markets rules out their serving
as charitable institutions.
It is always possible, of course, that the ex post real
rate of interest for some people is negative; the future,
after all, is uncertain. For instance, the actual rate of
inflation could be significantly higher than was gener­
ally expected. As a result, the ex post real interest
rate could be negative for lenders, indicating an un­
expected wealth transfer from lenders to borrowers.
For the borrowers, of course, this unexpected wealth
gain means that their ex post real return is not only
positive, it is considerably higher than they initially
expected.
Negative ex post real interest rates are, by their
very nature, unexpected. Consequently, although they
do occur and have real effects on individuals’ wealth,
they are meaningless for prospective savings and in­
vestment decisions.
What can we conclude about the statement, “The
real interest rate is negative”? If it indicates that the
expected real interest rate is negative, the statement
is false; the expected real interest rate is always posi­
tive. If it indicates that past lending or borrowing
decisions have resulted in unexpected wealth trans­
fers, it reminds us that decisions involving the future
are always uncertain.

SUMMARY
Discussions of interest rate movements and their
consequences are frequently misleading and often
mistaken. In large part, the errors in such discussions
stem from the absence of a theoretical framework from
which to assess and evaluate the behavior of interest
rates.
This article presented a simple theoretical discus­
sion of interest rates. The important distinctions be­
tween ex ante and ex post interest rates on the one
hand, and nominal and real interest rates on the
other, were introduced and explained.
Finally, the concepts introduced in this article
were applied to several commonly observed state­
ments concerning interest rates. The widely-held
views exemplified by these statements were shown
to be invalid.

The Impact of Energy Prices and Money
Growth on Five Industrial Countries
R. W. HAFER

X N the winter of 1973-74, the Organization of Petro­
leum Exporting Countries (OPEC) quadrupled the
price of oil from $3 a barrel to about $12 a barrel, a
fourfold increase that, along with a marked slowing
of money growth, precipitated one of the longest and
deepest post-war declines in economic activity in most
industrial nations. The subsequent recession was fol­
lowed by a period of relatively rapid economic ex­
pansion in most of these nations, only to be halted
by yet another explosion in energy prices in 1979 and
1980. Once again, it appears that this price increase
has been accompanied by sharply reduced money
growth.
This article discusses the impact of recent energy
price changes and monetary growth on the economic
performance of five major industrial countries: Can­
ada, Germany, Japan, the United Kingdom and the
United States. The analysis focuses on the growth of
real output, industrial production and consumer
prices, and changes in the level of the unemployment
rate over the 1979-80 period.

ENERGY PRICES, MONEY GROWTH
AND ECONOMIC ACTIVITY
A rise in energy prices represents an increase in the
cost of a significant productive input. Consequently, an
increase in energy prices relative to other prices pre­
cipitates a decline in the amount of goods and services
supplied by the economy at any given level of prices.1
A higher general price level is then necessary if the
'Jo h n A. T atom , “E n erg y Prices and Short-Run E conom ic
P erform ance,” this Review (Jan u ary 1 9 8 0 ) , pp. 3 -1 7 .




same amounts of labor (given a nominal wage rate),
capital and energy inputs are to be used. Because of
the increase in energy prices and the economic obso­
lescence of existing plant and equipment, however,
producers will reduce their use of energy. The re­
sults of these related actions are a decline in real
output and an increase in the price level. Thus, the
level of prices consistent with maintaining full employ­
ment of labor and capital increases, and the actual
and full-employment level of output (potential out­
put) falls as a consequence of the energy price
increase.
Just as an increase in the relative price of energy
precipitates a reduction in economic activity, so a sub­
stantial decrease in the growth of the money supply
relative to its trend path also leads to declining
economic activity. For example, a significant reduc­
tion in money growth relative to trend has preceded
almost every economic contraction in the United
States since the latter part of the 19th century.2 Asso­
ciated with these contractions are declines in produc­
tion and concomitant increases in idle resources (i.e.,
unemployment). Thus, restrictive money growth, in
the short-run, reduces the economy’s output of goods
and services. There is evidence, however, that the gen­
eral level of prices is temporarily unaffected by such
restrictive money growth.3
-S ee Milton Friedm an and Anna J. Schw artz, “Money and
Business C ycles,” Review o f Econom ics and Statistics ( F e b ­
ruary 1 9 6 3 ) , pp. 3 2 -6 4 and W illiam Poole, “T he Relationship
of M onetary D ecelerations to Business Cycle Peaks: Another
Look at the E vid en ce,” Journal o f Finance (Ju n e 1 9 7 5 ) , pp.
6 9 7 -7 1 2 .
3See Keith M. Carlson, “T he L a g from M oney to P rices,” this
Review (O cto b er 1 9 8 0 ) , pp. 3 -1 0 .

19

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

C hart 1

Relative Price of Energy to Final Users*
1972=100

1972=100

S o u rc e : O E C D , E c o n o m ic O u t l o o k
♦ E n e r g y c o m p o n e n t o f c o n s u m e r a n d w h o l e s a l e p r i c e i n d ic e s d i v i d e d b y t o t a l i n d ic e s e x c l u d i n g e n e r g y .
R e l a t i v e e n e r g y p r ic e s a t th e w h o l e s a l e l e v e l h a v e

b e e n w e i g h t e d b y th e s h a r e o f in d u s t r y in to ta l

fin a l e n ergy d e m a n d .
N o t e : D a t a fo r 1 9 8 0 a r e e s t i m a t e d .

The 1973-74 and 1979-80 episodes of generally de­
clining economic activity in the five countries are
characterized by both higher relative energy prices
and restrictive money growth. Consequently, the anal­
ysis presented above is necessary to understand the
recent economic events. It will be evident that the
relationships outlined above generally hold across the
countries examined.

prices (to final users) to the price of final goods —
for the five countries since 1972.4 The 1973-74 increase
in OPEC oil prices is clearly shown in the general
increase in relative energy prices: the simple average
annual rate of increase during 1973-74 for the five
countries was about 16 percent.

ENERGY PRICES

4T h e relative prices of energy are com puted by dividing the
energy com ponent of the w holesale and consum er p rice indices
by the total index excluding the energy com ponent. See O r­
ganization for E co n o m ic Co-O peration and D evelopm ent
( O E C D ) Econom ic Outlook (D ecem b er 1 9 8 0 ) , p. 5 2 .

Chart 1 shows what has happened to one measure
of the relative price of energy — the ratio of energy
20




The recent boost in oil prices has again led to in­
creases in relative energy prices. In the United States,

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

Chart 2

M o n e y Growth

Sources: B ank o f C a n a d a , B a n k o f C a n a d a R e v ie w ; D eu tsch e B u n d e s b a n k , M o n t h ly R e p o rt o f the D eutsche B u n d e s b a n k ;
B a n k o f J a p a n , E c o n o m i c S t a t i s t i c s M o n t h l y ; U. K. C e n t r a l S t a t i s t i c a l O f f i c e ,

F in a n c ia l S tatistics; B o a rd of

G o v e r n o r s o f t h e F e d e r a l R e s e r v e Sy st e m .
♦ B e c a u s e o f d a t a l i m i t a t i o n s , p e r i o d c o v e r e d is I V / 1 9 7 9 t o 111/1980

for example, relative energy prices increased at about
a 20 percent annual rate during 1979-80; Canada,
Germany and the United Kingdom sustained increases
of about 8 percent. Just as in the 1973-74 period, the
most dramatic increase occurred in Japan; relative
energy prices increased at a 60 percent rate during
1979-80.5
5Although there are similar m ovem ents in relative energy prices
in ch art 1 during the 1 9 7 3 -7 4 and 1 9 7 8 -8 0 periods, the observed
differences are due to the varying im pacts of higher oil
prices across countries. Because the relative energy prices
reported in ch art 1 are based on the energy components of
the wholesale and consum er price indices, the differential
im pact of a change in the price of oil can be explained by
the speed at w hich prices of the energy and fuels constituting
the indices’ energy com ponent adjust to the oil price increase.
To do this, the change in the energy com ponent of the whole­
sale price index is divided by the rise in the im port price of
oil. Because the coverage of the energy prices is not identi­
cal, the ratio (know n as the pass-through ratio ) is not di­
rectly com parable across countries. T h ey m ay, how ever, give
an insight into the different countries’ price response to the
increased oil price.
T h e pass-through ratios calculated for the 1 9 7 8 -8 0 period
suggest th at the relatively larger increases in the relative




MONETARY GROWTH
The rise in oil prices during the 1973-74 period was
accompanied by generally higher prices, reduced real
economic output and lower growth of the money
stock. The data in chart 2 reveal that the general
response to the recent oil price shock again was to
slow the growth of the money supply. Using the
IV/1975-IV/1978 period for comparison, money stock
growth has slowed considerably in Germany, Japan
price of energy to final users for the U nited States and
Japan are explained by the fact th at a given change in oil
prices passes through each index’s energy com ponent faster
than the others: the pass-through ratios are 0 .6 9 and 0 .8 1 ,
respectively. T he lower ratios for the United Kingdom
( 0 .5 1 ) , C anada ( 0 .4 1 ) and Germ any ( 0 .2 9 ) suggest that
the speed with which oil price increases feed into the energy
com ponent of the price index is less for these economies. These
ratios are explained by differing responses of prices for com ­
peting fuels, changes in controls over both dom estic production
and pricing of com peting fuels, and different tax structures on
energy use in the countries.
F o r a com plete description of the pass-through ratio, see
O E C D Econom ic Outlook (D ecem b er 1 9 8 0 ) , p. 5 1 -5 3 .

21

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

C hart 3

Real G N P

So urc es : B a n k o f C a n a d a , Ba n k o f C a n a d a R ev ie w ; S t a t i s t i c a l S u p p l e m e n t s to the M o n t h l y Repo rts o f th e D e u ts c h e
B u n d e s b a n k ; B a n k o f J a p a n , E co n om ic S ta ti s tic s M o n t h l y ; I n t e r n a t i o n a l M o n e t a r y Fund, I n t e r n a t i o n a l F i n a n c i a l
Sta ti st ic s; D e p a r t m e n t o f C o m m e r c e , B u r e a u o f E c o n o m i c A n a ly s i s .
♦ B e c a u s e o f d a t a l i m i t a t i o n s , p e r i o d c o v e r e d is I V / 1 9 7 9 t o 111/1980.
**Because o f

d a t a l i m i t a t i o n s , p e r i o d c o v e r e d is I V / 1979 to 11/1980.

♦ ♦ ♦ D a ta a re Real GDP.

and the United Kingdom, while decreasing slightly in
the United States. In contrast, Canada’s money growth
has actually been faster since IV/1979.

decline in economic activity than would have resulted
from the energy shock alone.6

Chart 2 may not provide the most accurate descrip­
tion of the sharp declines in money growth instituted
by the various governments. By examining money
growth rates over shorter time intervals, the degree
of monetary tightness is more fully revealed. Consider,
for example, Canada and the United States. Chart 2
reveals no slowing in monetary growth for Canada
and very little for the United States. From IV/1979
to 11/1980, however, a far different picture emerges:
the growth rate of money in Canada during this
period is 1.6 percent; in the United States it is 1.8
percent. Each of these figures reveals a tightening in
money growth relative to trend and, other things
equal, portends a decline in economic activity.

ECONOMIC ACTIVITY

Money growth was sharply reduced in all five coun­
tries up to the second quarter of 1980. This is similar
to the 1973-74 period and has produced a greater

"Gross national p roduct is the total m arket value of all goods
and services produced in the econom y during a given period
of tim e. R eal G N P is this figure adjusted for changes in
prices.

22




Real GNP
The growth of an economy’s real gross national
product (real GNP) is a widely used indicator of an
economy’s overall economic performance.7 To illus­
trate the magnitude of the recent downturn in eco­
nomic activity, chart 3 shows the growth rates of real
GNP for the five countries during three time periods.
The first period, IV/1975-IV/1978, is used as a refer­
ence period and represents the expansion phase of the
6See John A. T atom , “E n erg y Prices, E co n o m ic Perform ance
and M onetary Policy,” Fed eral Reserve Bank of St. Louis
W orking P aper No. 8 1 -0 0 7 ( 1 9 8 1 ) , p. 3 4.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

C h a rt 4

Industrial Production
Percent

C o m p o u n d e d A n n u a l Rates o f C h a n g e

Canada

Germany

Japan

United Kingdom

12

United States

S o u rc e s: I n t e r n a t i o n a l M o n e t a r y F u n d , I n t e r n a t i o n a l F i n a n c i a ! S t a t i s t i c s ; S t a t i s t i c a l S u p p l e m e n t s to th e M o n t h l y
R e p o r t s o f th e D e u ts c h e B u n d e s b a n k ; B a n k o f J a p a n , E c o n o m i c S t a t i s t i c s M o n t h l y ; B o a r d o f G o v e r n o r s o f
t h e F e d e r a l R es e r v e S y st e m .
* B e c a u s e o f d a t a l i m i t a t i o n s , p e r i o d c o v e r e d is I V / 1 97 9 to 111/1980.

most recent business cycle. The other periods, IV/1978IV/1979 and IV/1979-IV/1980, illustrate the general
downturn in real GNP growth following both the
sharp increase in energy prices and the reductions in
money growth rates.
As chart 3 shows, Canada, the United Kingdom and
the United States experienced marked deviations from
previous real GNP growth in IV/1978-IV/1979. Of
these three, the United States sustained the sharpest
decline in real economic activity with a 3.5 percentagepoint decline in the growth rate of output compared to
the preceding three-year period. The downturn in real
economic growth is even more pervasive during IV/
1979-IV/1980; all countries except Japan registered
a negative growth in real GNP. Moreover, the data in
chart 3, since they are calculated for four-quarter
periods, reduce the large fluctuations that actually
took place in each country. For example, from 1/1980



to 11/1980, real GNP decreased at rates of 4.3 percent
in Canada, 7.5 percent in Germany, 9.8 percent in
the United Kingdom and 9.9 percent in the United
States. In each case, these one-quarter rates of change
were some of the largest declines in output growth
in the post-war period.
Japan apparently has maintained much of its growth
during the recent period. The most recent growth rate
of 4.8 percent reflects only a slight decline from the
previous 6.1 percent rate. Looking at the one-quarter
growth rates, however, reveals a substantial slowing in
Japan’s real economic activity, much like the other
countries: from 1/1980 to 11/1980, Japan’s real output
increased at only a 2.5 percent rate, down sharply
from the previous quarter’s expansion rate of 7.6 per­
cent. Thus, Japan also has experienced a marked slow­
down in its rate of output growth following the recent
surge in energy prices and reduced money growth.
23

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

Table 1

Unemployment Rates
Canada

1975

1976

1977

1978

6.9%

7.1%

8.1%

8.4%

7.5%

7.5%

3.8

3.8

2.1

2.0

Germany

4.7

4.6

4.6

4.3

Japan

1.9

2.0

2.0

2.2

1979

1980

United Kingdom

3.9

5.3

5.8

5.8

5.4

6.8

United States

8.5

7.7

7.1

6.0

5.8

7.1

S ource: O ECD.

Industrial Production
The slowing in economic activity also is evidenced
in industrial production growth ( chart 4). Again, with
the exception of Japan, the growth of industrial pro­
duction (a measure of the output in the manufactur­
ing, mining and utility sectors) has turned negative
during the past year. The largest decline occurred in
the United Kingdom with an 11.4 percent decrease
in 1980.
Examining the quarterly growth rates reveals that
each country experienced the largest decline in indus­
trial production growth during the first few quarters
of 1980: industrial production decreased, on average,
at about a 10 percent rate from 1/1980 to II/1980.8
Similarly, Japan’s industrial production decreased at
about a 9 percent rate from 11/1980 to III/1980. The
interesting feature of these figures is the coincidence
among countries of the decline in industrial produc­
tion, which suggests that the energy price shock, com­
bined with similar monetary policies, have had similar
impacts.

Employment
The unemployment rate typically declines during
the expansion phase of the business cycle and in­
creases during economic contractions, generally fol­
lowing economic activity with a short lag. The recent
declines in the production of goods and services indi­
cated in charts 3 and 4 suggest that unemployment
has increased in these countries.
The association of output growth and unemploy­
ment is illustrated by the United States’ experience
8T he figures for each country are: C anada - 1 0 .2 p ercen t; G er­
m any, - 9 . 0 p ercen t; Jap an , 0 .6 percen t; U nited Kingdom,
- 1 1 .8 p ercen t; and the U nited States, - 1 9 .2 percent.

Digitized for 24
FRASER


since 1975 (table 1). The unemployment rate, at 8.5
percent in 1975, declined throughout the next five
years to a level of 5.8 percent in 1979, then jumped
to over 7 percent in 1980. Similarly, the jobless rate
in the United Kingdom increased from 5.4 percent in
1979 to 6.3 percent in 1980, a period of economic
contraction.
The unemployment rates in the other countries
have remained relatively stable during the past few
years. In Japan, for example, the unemployment rate
remained near 2.0 percent throughout 1975-80. In
Germany, on the other hand, the reported unemploy­
ment rate actually has declined during this period.
The differences in labor market response to a down­
turn in economic activity can be explained by differ­
ent institutional factors among the countries. Figures
on German unemployment data, for example, do not
include “guest workers” ( temporary foreign workers).
The impact of this group on the reported statistics is
shown in the unemployment rate for 1977 that in­
cludes the approximately 440,000 guest workers who
emigrated from Germany: 6.4 percent.9 This figure is
significantly larger than the 4.6 percent reported in
table 1, an indication of the difficulties that inter­
country differences in data reporting cause in meas­
uring the actual rise in unemployment accompanying
a decline in economic activity.

INFLATION
A sustained increase in the general level of prices is
determined primarily by previous money growth over
an extended period of time. Short-term deviations of
9The E ffect o f OPEC Oil Pricing on Output, Prices and
Exchange Rates in th e United States and Other Industrialized
Countries, Congressional B u d get Office (F e b ru a ry 1 9 8 1 ) ,
p. 61.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

Chart 5

Consumer Prices
Percent

Percent

C o m p o u n d e d A n n u a l Rates of C h a n g e

-----120

__ IV/1975 toIV/1978
ill IV/1978 toIV/1979
16h c ^ * lv/1979

Canada

f0

18

|V / 1 9 8 0

Germany

-

Jap a n

United Kingdom

16

United States

Sources: Internation al M o n e t a r y Fund, I n t e r n a t i o n a l Fina ncial Statistics; Bank of J a p a n , Eco nom ic Statistics Monthly;
D e p a r t m e n t of L a b o r, B urea u of Labo r Statistics

changes in the price level from this underlying, or
monetary, rate of inflation occur for a variety of rea­
sons. One example is the sharp increase in the price
of energy relative to other goods caused by OPEC
actions.10 Thus, the energy price increases during
1973-74 and 1979-80 precipitated declining real eco­
nomic output and increases in the price level.11
As illustrated in chart 5, with the exception of the
United Kingdom, consumer prices increased at rela­
tively moderate rates from IV/1975 to IV/1978. With
the exception of Germany and Japan, the inflation
rates have reached double-digit levels over the IV/
1978-IV/1980 period following the recent oil price
shock.12

Changes in the rate of inflation across the countries
examined in chart 5 imply certain changes in foreign
exchange markets. Exchange rate movements result
from changes in the relative prices of foreign and
domestic goods. If, for example, foreign goods be­
come less costly relative to domestic goods (i.e., the
foreign inflation rate is less than the domestic rate),
the demand for foreign goods and, hence, foreign
money rises. Consequently, the international value of
the domestic currency falls with respect to the foreign
currency.

presented
E co n o m ic

This relationship between relative price movements
and exchange rate movements is verified by foreign
exchange market developments in the 1979-80 period.
As an example, the difference between the inflation
rates in the United States and Canada in 1979 was
about 3 percentage points (12.7 percent minus 9.5
percent). In 1980, however, this difference fell to
about 1.5 percentage points. As the foregoing discus­
sion suggests, the U.S. dollar appreciated (increased

12T he recent increase in the inflation rate in the face of de­
clining econom ic activity is a phenom enon similar to that
of the last downturn. F o r a discussion of this period, see

Donald S. K em p, “E con om ic A ctivity in Ten M ajor Indus­
trial Countries: L a te 1 9 7 3 through M id -1976,” this Review
(O cto b er 1 9 7 6 ) , pp. 8 -1 5 .

10F o r a discussion of the theory underlying this proposition
and its application to the 1 9 7 1 -1 9 7 6 period in the United
States, see Denis S. Karnosky, “T he L ink Betw een Money
and Prices — 1 9 7 1 -1 9 7 6 ,” this Review (Ju n e 1 9 7 6 ) , pp.
1 7 -2 3 .
“ E m p irical evidence supporting this claim is
in T atom , “E n e rg y Prices and Short-Run
Perform an ce.”




25

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

in value) with respect to the Canadian dollar. Calcu­
lating the inflation differentials from the data in chart
5, we find that the relative rate of inflation declined
when compared to Germany and Japan in the 1979-80
period. In contrast, inflation increased in the United
States compared to the United Kingdom over the
period. With the exception of Japan, the relationship
described above is supported: the U.S. dollar appre­
ciated against the German deutschemark and depreci­
ated against the English pound during the 1979-80
period.

CONCLUSION
Recent actions taken by OPEC have increased
sharply the relative price of energy in the five in­
dustrial countries examined in this article. Monetary
growth followed a generally restrictive pattern in
1979-80, similar to that in 1973-74. As a consequence
of both OPEC actions and reduced money growth, the
economies of Canada, Germany, Japan, the United
Kingdom and the United States have been burdened
with declines in real GNP and rising rates of inflation

Digitized for26
FRASER


MARCH

1981

during the past two years. In Canada, the United
Kingdom and the United States, unemployment rates
have remained abnormally high or have increased in
recent years.
Periods of declining economic activity and rising
prices create problems in selecting the appropriate
monetary policy response. A sharp, prolonged de­
crease in money growth intended to inhibit upward
pressure on prices due to rising energy prices will
aggravate the decline in real economic activity. On
the other hand, an increase in money growth intended
to offset the decline in real GNP will contribute to
even greater future inflation. One recent study indi­
cates that, with no change in money growth, rising
energy prices will affect the rate of inflation only
temporarily. Moreover, increasing the rate of growth
of money only temporarily reduces the increased un­
employment that accompanies the slowdown.13 This
suggests that stable money growth may well be the
correct response to such supply shocks.
13T atom ,
“E n erg y
P erform an ce.”

Prices

and

Short-Run

E conom ic

Recent Revisions of GNP
KEITH M. CARLSON

C j TROSS national product (GNP) is the market
value of goods and services produced by labor and
property supplied by residents of a country before
the deduction of depreciation charges for capital
goods. This measure is widely accepted as the most
comprehensive measure of national economic activity.
Its use is no longer restricted to economists; nonecon­
omist professionals and laymen now rely on this meas­
ure in the planning and coordination of a variety
of activities. The availability of estimates is taken for
granted; the reliability and accuracy of these estimates
are seldom questioned.
The task of preparing and distributing estimates
of GNP rests with the Bureau of Economic Analysis
(BEA) for the U.S. Department of Commerce. Al­
though much work was done during the 1930s and
early 1940s in developing estimates of national eco­
nomic activity, it was not until 1947 that the De­
partment of Commerce started regularly publishing
national income and product statistics within the
framework of a comprehensive national economic ac­
counting system. These statistics have since been pub­
lished in the Department of Commerce’s monthly pub­
lication, Survey of Current Business.
Since the publication of the 1947 National Income
Supplement, the Department of Commerce has pub­
lished seven comprehensive revisions of the national
income and product accounts. The main purpose of
these revisions is to make use of new source data;
however, from time to time, the department develops
new estimating procedures and makes definitional and
conceptual changes. The latest of these revisions was
published in December 1980.1

BASIS FOR RECENT REVISIONS
The recent revisions apply primarily to estimates
since 1968. New information from the 1972 inputoutput tables, the 1977 economic censuses (mining,
manufacturing, wholesale and retail trade, construc­
tion, transportation, selected services and govern­
ments) and the 1973 and 1976 Taxpayer Compliance
Measurement Program provide the basis for the bulk
of the changes.2 The most important conceptual
change involves the redefinition of GNP to include
reinvested earnings of incorporated foreign affiliates
of U.S. direct investors and eliminate those of incorpo­
rated U.S. affiliates of foreign direct investors.3 Re­
invested earnings are the difference between an
affiliate’s after-tax earnings and dividends paid to
stockholders.

Summary of GNP Revisions
Table 1 compares the previous and revised esti­
mates of GNP for 1979, the year in which the revision
was the largest. Each side of the table represents
an alternative but equivalent method of calculating
the value of GNP. The left-hand side of the table
shows GNP in terms of the costs incurred and the
profits earned in its production. These are charges
against GNP, which consist of factor charges, that is,
the incomes of factors of production (labor and prop­
erty), and nonfactor charges, which include indirect
-T h e input-output tables summ arize inter-industry flows of pro­
duction, showing how m uch of each industry’s output is sold
to every other industry and to final buyers, and how m uch of
each industry’s inputs are bought from each other industry and
from the factors of production.

This article focuses on the nature of the most recent
revisions on GNP estimates and their implications in
interpreting and analyzing economic trends.

T he T axp ayer Com pliance M easurem ent Program is con­
ducted by the Internal Revenue Service and is based on a
sample of individual incom e tax returns for the purpose of ob­
taining data on the nature and extent of com pliance w ith the
Internal Revenue laws.

1F o r a full discussion of th e revision, see “T h e National In­
com e and P roduct A ccounts of the U nited States: An Intro­
duction to the Revised E stim ates for 1 9 2 9 -8 0 ,” Survey of
Current Business (D ecem b er 1 9 8 0 ) , pp. 1-26.

3U .S. (fo reig n ) direct investors are U .S. (fo reig n ) residents
who own or control 10 p ercen t or m ore of the voting securities
of an incorporated foreign ( U .S .) business enterprise or an
equivalent interest in an unincorporated foreign ( U .S .) busi­
ness enterprise.




27

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

MARCH

1981

Table 1

1979 GNP (in billions of current dollars)
Income Approach
National income
Compensation of
employees
Proprietors’ income
with inventory
valuation and
capital consumption
adjustments
Rental income of
persons with
capital consumption
adjustment
Corporate profits
with inventory
valuation and
capital consumption
adjustment

Change

Revised

Expenditure Approach

Previous

Change

Revised

$1,924.8

$38.5

$1,963.3

Personal consumption
expenditures

$1,509.8

$ 1.1

$1,510.9

387.2

28.6

415.8

1,459.2

130.8

26.9

1.7

0.8

3.6

1,460.9

131.6

30.5

178.2

18.7

196.8

129.7

13.7

143.4

Indirect business
tax and nontax
liability

189.5

-1.1

188.4

Business transfer
payments

10.2

-0.7

9.4

3.7

-1.5

2.2

2 .3

0 .7

3.1

Capital consumption
allowances with
capital consump­
tion adjustment
243.0

10.7

253.6

45.1

2,413.9

Net interest
Plus:

Previous

Statistical
discrepancy

Plus: Gross private
domestic
investment
Plus: Net exports of
goods and
services

-4 .6

18.0

13.4

Exports

257.5

23.9

281.3

Imports

262.1

5.9

267.9

476.4

-2 .7

473.8

2,368.8

45.1

2,413.9

Plus: Government
purchases of
goods and
services

Less: Subsidies less
current surplus
of government
en te rpris e s

Plus:

Equals: Charges against
gross national
product

2,368.8

business taxes and capital consumption allowances
(depreciation).
The right-hand side of table 1 gives GNP in terms
of expenditures according to four major market cate­
gories: (1) personal consumption expenditures, (2)
gross private domestic investment, (3) net exports of
goods and services, and (4) government purchases of
goods and services. These categories conform to the
operational definition of final products as those pur­
chases not resold during the accounting period.
The comparison of previous and revised estimates
reflects all statistical and definitional factors under­

28


Equals: Gross national
product

lying the revisions. These revisions represent, in total,
1.9 percent of the previous GNP estimate for 1979.
On the income side, the largest changes resulted from
revisions in corporate profits, net interest and capital
consumption allowances. On the expenditure side, the
major changes were in gross private domestic invest­
ment and net exports of goods and services.

Redefining GNP: The Conceptual Change
The major conceptual change in the recent revision
is the treatment of reinvested earnings of incorporated
foreign and U.S. affiliates of direct investors in the
estimation of GNP. Since GNP can be derived in two

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

ways (see table 1), the conceptual change must show
up in both methods of GNP calculation.
Prior to the revision, the net inflow of reinvested
earnings of foreign and U.S. affiliates of direct in­
vestors was not included in the measure of corporate
profits. Since GNP, as measured by the income
method, is the sum of all income earned by labor and
property of U.S. residents, including that from foreign
ventures, the exclusion of these reinvested earnings
was inconsistent.4 The magnitude of this inconsistency,
however, was small until recently. Including these
earnings in the estimate of GNP requires calculating
the difference between reinvested earnings of incorpo­
rated foreign affiliates of U.S. investors and reinvested
earnings of incorporated U.S. affiliates of foreign in­
vestors. Because these reinvested earnings are much
larger for U.S. investors than for foreign investors, the
effect of the change is to increase the measure of U.S.
GNP, especially in recent years. This effect was esti­
mated at $15.1 billion in 1979.
On the income side, corporate profits were in­
creased, representing an increase in income originat­
ing in foreign countries but accruing to domestic
residents; this magnitude is well in excess of the in­
come originating domestically but accruing to foreign
residents. The effect of this conceptual redefinition
accounts for 33 percent of the revised increase in
GNP in 1979.
On the expenditure side of table 1, the effect of
the redefinition is reflected in net exports. Reinvested
earnings of an affiliate of a U.S. investor is an export
of the service of capital; that of an affiliate of a
foreign investor is an import of the service of foreign
capital. With exports of capital services exceeding
imports, the basis is provided for an upward revision
of GNP as measured by expenditure for final product.

Other Sources of Revision:
Statistical Changes
The definitional change accounted for 33 percent
of the revision in 1979 GNP; the remaining 67 per­
cent was attributable to statistical considerations.
These statistical revisions reflected: (1) new and re­
vised data from regularly used sources that become
available every few years (called benchmark revi­
4This conceptual change puts the national incom e accounts on
the sam e basis as the balance of paym ents accounts. Rein­
vested earnings w ere introduced into the balan ce of paym ents
accounts in 1 9 7 8 . See Survey o f Current Business, P a rt II
(Ju n e 1 9 7 8 ) , p. 7.




MARCH

1981

sions), (2) new and revised data from regularly used
sources that become available annually, (3) data from
sources previously not available, (4) new estimating
techniques, and (5) new classifications. Only the
largest of these statistical changes are highlighted
here.5
Income side
As indicated in table 1, the largest
changes on the income side were for corporate profits,
net interest and capital consumption allowances. Since
$15.1 billion of the $18.7 billion revision in corporate
profits was attributable to the inclusion of reinvested
earnings, the effect of statistical revisions on corporate
profits was quite small.
The other substantially revised component of na­
tional income was net interest. The revision resulted
from a BEA study of corporate income tax returns,
which indicated that interest receipts were a smaller
proportion of business receipts of corporate credit
agencies other than banks and savings and loan asso­
ciations (for example, credit unions, credit card com­
panies, finance companies) than previously estimated.
As a result, the reduction in interest receipts received
by businesses increased the amount of net interest re­
ceived by households.
The final component of GNP from the income side
that was affected substantially by the revision was the
capital consumption allowance (depreciation). This
nonfactor charge against GNP was revised upward by
almost $11 billion in 1979 to reflect faster growth in
the gross capital stock than originally estimated (see
revision of gross private domestic investment below).
In addition, there were a number of small changes
involving reestimates of corporate profits and pro­
prietors’ incomes.
Expenditure side
Aside from the revision of net
exports of goods and services, the only other substan­
tially revised component of final expenditure was gross
private domestic investment. The revision was quite
large, amounting to $28.6 billion in 1979.
Most of this revision stemmed from the use of data
received from new benchmark sources, primarily the
1972 input-output tables, as well as preliminary esti­
mates for the 1977 input-output tables, and the 1977
economic censuses. As a result of these new sources
and regular sources made available on an annual
basis, revisions in estimates of producers’ durable
equipment accounted for $21.2 billion of the total
upward revision in gross private domestic investment.
6F o r a com plete discussion of these statistical revisions, see
Survey o f Current Business (D ecem b er 1 9 8 0 ) .

29

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

Table 2

GNP (in billions of current and 1972 dollars) and GNP Deflator
GNP IN CURRENT DOLLARS
Previous

1960

Revised

GNP IN 1972 DOLLARS
Previous

GNP DEFLATOR

Revised

Level

Change

Level

Change

Level

Change

Level

Change

$ 506.0

4.0%

$ 506.5

3.8%

$ 736.8

2.3%

$ 737.1

2.2%

Previous
Level
68.7

Change

Revised
Level

Change

1.7%

68.7

1.6%

0.9

69.3

0.9

1961

523.3

3.4

524.6

3.6

755.3

2.5

756.6

2.6

69.3

1962

563.8

7.7

565.0

7.7

799.1

5.8

800.3

5.8

70.6

1.8

70.6

1.8

1963

594.7

5.5

596.7

5.6

830.7

4.0

832.5

4.0

71.6

1.5

71.7

1.5

1964

635.7

6.9

637.7

6.9

874.4

5.3

876.4

5.3

72.7

1.6

72.8

1.5

1965

688.1

8.2

74.3

2.2

74.4

2.2

1966

753.0

3.2

1967

796.3

1968
1969

691.1

8.4

925.9

5.9

9.4

756.0

5.8

799.6

868.5

9.1

935.5

7.7

1970

982.4

1971

1,063.4

1972

1,171.1

929.3

6.0

9.4

981.0

6.0

984.8

6.0

76.8

3.3

76.8

5.8

1,007.7

2.7

1,011.4

2.7

79.0

2.9

79.1

3.0

873.4

9.2

1,051.8

4.4

1,058.1

4.6

82.6

4.5

82.5

4.4

944.0

8.1

1,078.8

2.6

1,087.6

2.8

86.7

5.0

86.8

5.1

5.0

992.7

5.2

1,075.3

-0.3

1,085.6

-0.2

91.4

5.4

91.5

5.4

8.2

1,077.6

8.6

1,107.5

3.0

1,122.4

3.4

96.0

5.1

96.0

5.0

10.1

1,185.9

10.1

1,171.1

5.7

1,185.9

5.7

100.0

4.1

100.0

4.2

5.8

105.8

5.8

105.7

5.7

1973

1,306.6

11.6

1,326.4

11.8

1,235.0

5.5

1,255.0

1974

1,412.9

8.1

1,434.2

8.1

1,217.8

-1 .4

1,248.0

-0.6

116.0

9.7

114.9

8.7

1975

1,528.8

8.2

1,549.2

8.0

1,202.3

-1.3

1,233.9

-1.1

127.2

9.6

125.6

9.3

1976

1,702.2

11.3

1,718.0

10.9

1,273.0

5.9

1,300.4

5.4

133.7

5.2

132.1

5.2

5.5

141.7

6.0

139.8

5.8

1977

1,899.5

11.6

1,918.0

11.6

1,340.5

5.3

1,371.7

1978

2,127.6

12.0

2,156.1

12.4

1,399.2

4.4

1,436.9

4.8

152.1

7.3

150.1

7.3

1979

2,368.8

11.3

2,413.9

12.0

1,431.6

2.3

1,483.1

3.2

165.5

8.8

162.8

8.5

1959-64

5.5%

5.5%

4.0%

4.0%

1.5%

1.5%
3.6

1964-69

8.0

8.2

4.3

4.4

3.6

1969-74

8.6

8.7

2.5

2.8

6.0

5.8

1974-79

10.9

11.0

3.3

3.5

7.4

7.2

ANALYTICAL IMPACT OF
RECENT REVISIONS
When economic data are revised, a question natur­
ally arises whether the previous interpretation of
past events should be changed significantly. If so,
a reassessment of the role of public policy may be
required. Since the most recent GNP revision involves
a redefinition of GNP as well, the continued use of
that measure for analytical purposes also requires
examination.

Interpretation of Recent Trends
Table 2 shows the previous and revised estimates
of GNP, real GNP and the implicit GNP deflator.6

30


Although the differences appear to be substantial for
1969 through 1979, the rates of change for these three
key variables are only negligibly affected by the revi­
sions. Since it is rates of change that provide the basis
for interpreting the direction and magnitude of move­
ment of the economy, the revisions do not appear to
have significantly affected previous interpretation of
economic events. Although small on a year-to-year
basis, the revisions do accumulate over time. For ex­
ample, GNP in 1972 dollars advanced at a 3.5 percent
average rate from 1974 to 1979, compared with a pre­
6Tables 2 and 3 show the revisions back through 1 9 6 0 . All of
the m ajor G N P series w ere revised back through 1 9 2 9 . Prior
to 1 9 6 0 , annual revisions w ere of a m agnitude of 0 .5 p ercen t
or less.

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

1981

Table 3

GNP and GDP (in billions of current and 1972 dollars) and Implicit Price Deflator
CURRENT DOLLARS
GNP

1972 DOLLARS

GDP

Level

Change

Level

3.8%

$ 502.9

GNP

Change

Level

3.8%

$ 737.1

IMPLICIT PRICE DEFLATOR
GDP

GNP

Change

Level

Change

2.1%

$ 731.8

Level

Change

GDP
Level

Change

1960

$ 506.5

2.1%

68.7

1.6%

68.7

1961

524.6

3.6

520.7

3.5

756.6

2.6

751.0

2.6

69.3

0.9

69.3

0.9

1962

565.0

7.7

560.5

7.6

800.3

5.8

793.8

5.7

70.6

1.9

70.6

1.9

1963

596.7

5.6

591.8

5.6

832.5

4.0

825.6

4.0

71.7

1.6

71.7

1.6
1.5
2.2

6.0

74.4

2.2

74.4

977.5

6.1

76.8

3.2

76.8

3.2
3.0
4.3

6.0

6.8

876.4

1965

691.1

8.4

685.2

8.4
9.5

750.3

921.4

6.0

984.8

632.3

9.4

1.5

929.3

6.9

756.0

72.8

868.9

637.7

1966

5.2

72.8

5.3

1964

1.6%

1967

799.6

5.8

793.7

5.8

1,011.4

2.7

1,003.9

2.7

79.1

3.0

79.1

1968

873.4

9.2

866.7

9.2

1,058.1

4.6

1,050.0

4.6

82.5

4.3

82.5

1969

944.0

8.1

937.1

8.1

1,087.6

2.8

1,079.7

2.8

86.8

5.2

86.8

5.2

91.5

5.4

91.4

5.4

1970

992.7

5.2

985.4

5.2

1,085.6

-0.2

1,077.6

-0.2

1971

1,077.6

8.6

1,068.5

8.4

1,122.4

3.4

1,112.9

3.3

96.0

4.9

96.0

4.9

1972

1,185.9

10.1

1,175.0

10.0

1,185.9

5.7

1,175.0

5.6

100.0

4.2

100.0

4.2

1973

1,326.4

11.8

1,310.4

11.5

1,255.0

5.8

1,239.9

5.5

105.7

5.7

105.7

5.7

114.9

8.7

1974

1,434.2

8.1

1,414.4

7.9

1,248.0

-0.6

1,230.7

-0.7

114.9

8.7

1975

1,549.2

8.0

1,531.9

8.3

1,233.9

-1.1

1,220.0

-0.9

125.6

9.3

125.6

9.3

1976

1,718.0

10.9

1,697.5

10.8

1,300.4

5.4

1,284.8

5.3

132.1

5.2

132.1

5.2

1977

1,918.0

11.6

1,894.5

11.6

1,371.7

5.5

1,354.7

5.4

139.8

5.8

139.8

5.8
7.4
8.5

1978

2,156.1

12.4

2,126.2

12.2

1,436.9

4.8

1,416.8

4.6

150.1

7.4

150.1

1979

2,413.9

12.0

2,370.1

11.5

1,483.1

3.2

1,455.9

2.8

162.8

8.5

162.8

1959-64

5.5%

5.5%

4.0%

3.9%

1.5%

1.5%

1964-69

8.2

8.2

4.4

4.4

3.6

3.6

1969-74

8.7

8.6

2.8

2.7

5.8

5.8

1974-79

11.0

10.9

3.5

3.4

7.2

7.2

vious estimate of 3.3 percent. The rise in the GNP
deflator during this period is now estimated at a 7.2
percent average rate, compared with the previous esti­
mate of 7.4 percent.
Probably the most important revisions from the
standpoint of implications for public policy involve
investment and saving. Estimates of both were raised
sufficiently to raise the ratio of each relative to GNP
in recent years. For example, the ratio of nonresidential fixed investment to GNP in 1979, originally esti­
mated at 10.8 percent, was revised to 11.6 percent.
Previous conclusions about the severity of the nation’s
capital formation problem will require renewed study
in light of these revisions.



Analysis of Economic Relationships
GNP is defined as income earned by the labor and
property of U.S. residents. As such, it includes a
considerable and growing portion that originates in
the rest of the world. How good, then, is it as a meas­
ure of U.S. economic activity? An alternative meas­
ure of U.S. economic activity is gross domestic prod­
uct (GDP). GDP is defined as the value of production
attributable to factors of production actually located
in a given country regardless of their ownership; that
is, GDP equals GNP minus the product of U.S. resi­
dents originating in the rest of the world. Incorpo­
rating reinvested foreign earnings into estimates of
GNP thus widened the difference between GNP and
GDP.
31

The nation’s primary economic goals are stated in
terms of employment, price stability and economic
growth. Since GNP is a measure of all income earned
by U.S. residents, it is a better measure of the nation’s
welfare than GDP. GDP, however, can be thought of
as a measure of the economic performance of the
U.S. economy because it focuses attention on the
origin of income and product, rather than ownership.
Consequently, the difference between GNP and GDP
provides one indication of the contribution of interna­
tional investment to the general welfare of the U.S.
residents. Moreover, certain economic analyses might
be more appropriately conducted using GDP instead
of GNP, simply because income originating abroad is
not directly relevant to some issues. For example,
studies of the productivity problem are best done
with GDP; similarly, analysis of the impact of mone­



tary and fiscal policy would seem more relevant in
terms of GDP than GNP.
Table 3 compares the rates of change for GNP and
GDP in both current and constant dollars and for
their respective implicit price deflators. As shown in
this table, the two deflator measures are identical
from 1960 to 1979. The current and constant dollar
measures occasionally deviate by more than 0.1 per­
cent after 1962, but their growth rates move consist­
ently in the same direction.
The rates of change shown in table 3 do not pro­
vide clear support for switching analytical emphasis
from GNP to GDP. However, the growing wedge be­
tween GNP and GDP suggests, at least, that GDP
should be watched along with, GNP in assessing eco­
nomic developments.