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Vol. 7 1 , No.2




March/April 1989

3 U.S. Investm ent in the 1980s:
T h e Real Story
16 T h e FOMC in 1988: U n certain ty’s
E ffects on M on eta ry Policy
34 Interest Rates and Econom ic
Announcem ents
47 Is A m erica Being Sold Out?
65 M on ey and the International
M on eta ry System

THE
FEDERAL
A RESERVE
RANK of
A r ST.I/H IS

1

Federal R eserve B ank o f St. Louis
R e v ie w
March/April 1989

In This Issue . . .




Critics of U.S. fiscal policy in the 1980s argue that U.S. government
deficits have lowered investment, thereby lowering future productivity
and income, while raising future debt-servicing claims against that in­
come. An opposing view argues that fiscal policy boosted investment,
especially from 1981 to 1985.
In the first article in this Review, "U.S. Investment in the 1980s: The
Real Story,” John A. Tatom explains why some measures of U.S. invest­
ment performance look relatively weak in this decade. According to
Tatom, recent real business fixed investment measures are the highest in
nearly 60 years, especially when adjusted for the relatively larger amounts
of unused plant and equipment compared with that during previous in­
vestment booms. The major difference in the data supporting each view is
that the prices of capital goods have fallen sharply compared with other
goods, so that a given share of income devoted to saving and purchases of
capital goods could buy substantially more of them in this decade than
earlier. Analyses that indicate that domestic investment and saving have
been weak reach this conclusion by ignoring this decline in prices, the re­
cent business cycle experience and the decline in labor force growth in
this decade. According to Tatom, the strength of real net investment can
be most easily seen in the resumption of productivity growth, following its
stagnation in the 1970s. This accelerated productivity growth reflects
faster growth in the net capital stock per worker.
* * *
In the second article in this issue, “The FOMC in 1988: Uncertainty’s Ef­
fects on Monetary Policy,” Michelle R. Garfinkel examines the various
economic factors that influenced the deliberations and decisions of the
Federal Open Market Committee in 1988. Garfinkel points out that, among
other things, the potential long-term effects of the stock market crash of
October 1987, the continuing movements in the value of the dollar in
foreign exchange markets and the changing relation between the monetary
aggregates and nominal output generated unusual uncertainty among the
FOMC members about the economic outlook. In light of this uncertainty,
the FOMC sought greater leeway in targeting money growth and adopted
a more flexible strategy for implementing short-run policy.
To understand the intended role of greater flexibility in monetary policy,
Garfinkel reviews the long-run and short-run policy decisions of the FOMC
during 1988. The discussion focuses on how the changing economic en­
vironment and the FOMC’s desire for greater operational flexibility influ­
enced the evolution of monetary policy throughout the year.
* * *
Fluctuations in interest rates are commonly attributed to the value of
some economic indicator. At various times, different statistics have been
thought to affect rates. In the third article in this Review, "Interest Rates

MARCH/APRIL 1989

2

and Economic Announcements," Gerald P. Dwyer, Jr. and R. W . Hafer
investigate whether announcements of government statistics systematic­
ally affect interest rates.
To analyze the effects of such announcements, the authors examine
the behavior of changes in the three-month Treasury bill rate and the
30-year government bond rate around days on which government
statistics are first made public. Focusing on the market’s reaction to the
unexpected part of the announcement, Dwyer and Hafer find that, at
least for 1980 through 1987, there is little empirical support for the no­
tion that interest rates respond in a predictable fashion to unexpected
changes in inflation, real economic activity or the trade balance. They
do find evidence indicating that unexpected changes in money influ­
enced rates, but this occurred only during the early 1980s.
* * *
Since 1981, the U.S. trade deficits on a balance-of-payments basis have
averaged more than $100 billion per year. The inflows of foreign capital
into the United States have transformed the position of the United
States from creditor to debtor. Many observers, politicians and finan­
ciers have decried this shift not only as a sign of current U.S. weakness,
but as the harbinger of future calamity. Economists, conversely, have
generally argued that foreign capital benefits U.S. labor and investors.
In the fourth article of this issue, "Is America Being Sold Out?” Mack
Ott analyzes the controversy surrounding this transformation and the
validity of the concerns about the economic implications of foreign own­
ership of U.S. assets. The article reviews the intensity of public concern
as expressed in opinion polls and takes these expressions as an agenda
for the analysis. Both the scope of current foreign ownership and its
pattern are assessed as well as the prospective foreign ownership if cur­
rent trends continue.
* * *
The final article in this Review is “Money and the International Sys­
tem,” the 1989 Homer Jones Memorial lecture presented by H. Robert
Heller of the Board of Governors of the Federal Reserve System. In his
lecture, Dr. Heller examines the role of money and monetary stability
and the choice between a national or an international monetary
standard.
Dr. Heller begins by discussing the importance of both money that is
broadly accepted as a means of payment and the existence of a stable
price level for economic and political freedom. He notes that monetarists
and "internationalists” generally agree on the importance of human
freedom; however, they differ in terms of the type of monetary stan­
dard they believe will achieve their goal. In his view, monetarists can be
characterized as advocating a national monetary standard with flexible
exchange rates and little, if any, need for international policy coordina­
tion. Internationalists, in contrast, advocate a global monetary standard;
they view the nation-state as a political construct with limited economic
importance. Dr. Heller then introduces some considerations that he
believes can be used to help in deciding which monetary system will be
more useful: among these are the provision of a stable financial environ­
ment and price stability within an economically and financially in­
tegrated system. He concludes by stating that, as global integration of
economic and financial markets proceed and as political interdepen­
dence increases, monetary integration will increase as well.

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3

John A. Tatom

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

U.S. Investment in the 1980s:
The Real Story

A

CENTRAL proposition of conventional
analyses of fiscal policy in this decade has been
that unprecedented federal budget deficits have
crowded out domestic investment, especially
business investment. In this view, the Reagan
administration did not achieve one of its central
goals: to raise investment, productivity and
growth. Instead, investment has been seriously
eroded, and the burgeoning foreign claims on
this nation’s future income will confront a
smaller capacity to generate that income than
would otherwise have occurred. Professor Renjamin Friedman sums up this view of recent
fiscal policy, arguing that it violates “the basic
moral principle that had bound each generation
of Americans to the next since the founding of
the republic: that men and women should work
and eat, earn and spend, both privately and col­
lectively, so that their children and their chil­
dren’s children would inherit a better w orld .”1
An opposing view of fiscal policy argues that
business investment was boosted substantially
by the incentives adopted early in this decade.

'Benjamin Friedman (1988), p. 4. Some of the other
popular proponents of the conventional view include
Business Week (1987) and (1988), Cooper (1986), Frankel
(1986), Benjamin Friedman (1986), Jonas (1986), Kennedy
(1987), Modigliani (1988), Peterson (1987) and Summers
(1987).
2See Milton Friedman (1988), Reynolds (1989), Poole
(1988), Tatom (1985), (1988) and Sinn (1988). The link be­



In this view, the rise in both interest rates and
the value of the dollar in the early 1980s were
reflections of the unusual strength of U.S. in­
vestment and the associated reallocation of
world capital stocks and income toward the
United States.2
This article provides a critical perspective on
the conventional view of domestic investment in
this decade. Although there are measures of in­
vestment that suggest that it was depressed, this
article will show that these measures have cru­
cial limitations. A closer inspection will show
that domestic investment and capital formation
have been relatively strong, especially from
1980 to 1985.

INVESTMENT AND SAVING IN
THE NATIONAL INCOME
ACCOUNTS
Understanding the relationships among domes­
tic investment, the government's budget position

tween the reallocation of U.S. investment abroad to
domestic investment, the nominal supply of dollars for in­
ternational transactions and movements in the exchange
value of the dollar are detailed more fully in Tatom (1986)
and (1987a).

MARCH/APRIL 1989

4

and the nation’s foreign transactions can be
facilitated by considering some national income
and product account (NIPA) identities. Invest­
ment refers to purchases of durable goods that
are used to produce future goods and services,
such as business plant, equipment and inven­
tory purchases and new housing. The accumula­
tion of such real assets through investment has
to be financed and the source of such financing
is saving, the portion of income that is not
spent on current consumption.3
In the NIPA, one way to measure gross na­
tional product or the nation’s gross income is to
add up expenditures or purchases of final goods
and services. The principal types of such pur­
chases of domestic products are personal con­
sumption and housing purchases by households,
purchases by businesses, government (G) or ex­
port sales to foreigners (X). Business purchases
include investment in plant, equipment and in­
ventory changes; business investment spending
and residential investment comprise gross pri­
vate domestic investment (I). Another way of
measuring income is to add up the components
of income according to what households do
with it: pay taxes (T), save (S), or spend on con­
sumption of domestic product or foreign im­
ports (M).
Since consumer purchases appear in both ex­
penditures and income, they cancel each other
out when these two approaches are compared;
the remaining components of purchases (I + G
+ X), by definition, must equal the remaining
uses of income (T + S + M). Such an identity is
written as:
(1) I + G + X E T + S + M.
This identity can be rewritten in a couple of
useful ways. The first way focuses on the gov­
ernment budget and trade deficits and the gap
between domestic saving and investment. The
budget deficit (BD) is the excess of government
spending over receipts, which equals (G-T)
above .4 The trade deficit (TD) is the excess of

3Purchases of consumer durable goods (like automobiles,
furniture and appliances) also involve investment and sav­
ing, but in the NIPA account such purchases are treated
as consumption. Reynolds (1989) includes such purchases
in investment and argues that U.S. investment was
unusually strong in the early 1980s. Like his findings, the
results below would be reinforced if the unconsumed
share of consumer durable purchases were included in in­
vestment and saving.
4Only purchases are included in G, but T is measured net
of transfer payments. Thus, the difference, (G-T),

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imports of goods and services over exports, or
(M-X) above. The identity can be rearranged by
subtracting T, X, and I from both sides, and
substituting the definitions of the deficits to
obtain
(2) BD E TD + (S-I).
This identity shows the relationships of three
gaps: the government budget deficit, the trade
deficit and the gap between private domestic
saving and investment. A government budget
deficit must be financed by an excess of private
domestic saving over investment or by a trade
deficit.
The nation’s trade deficit represents a net
credit flow from foreigners, or asset accumula­
tion by foreigners in the form of loans or eq­
uity holdings in the United States. The trade
surplus is called “net foreign investment” by the
United States in the NIPA accounts. W hen it is
negative, it represents an inflow into the United
States, so the trade deficit can be called “net
foreign saving” (NFS).5
By rearranging identity 2, w e can obtain an
identity of saving and investment, which shows
that saving used to finance private domestic
investment can come from private domestic
sources (S), the government sector (government
saving, or -BD) or foreign savers (NFS). Viewed
this way, the identity emphasizes that changes
in investment must reflect similar changes in
saving. Movements in the budget deficit or
domestic investment relative to domestic saving
have counterparts in the trade deficit.

THE CONVENTIONAL VIEW OF
INVESTMENT IN THE 1980s:
AN EMPHASIS ON CROWDING
OUT
A rise in the budget deficit (BD) due to in­
creased spending or decreased taxes must
change the right-hand side of identity 2 by an

measures the excess of government spending over
receipts, or the budget deficit.
5When the United States has a trade deficit and,
simultaneously, the rest of the world has a balanced
government budget, then the rest of the world must be
saving more than its domestic investment, and this excess
foreign saving equals the NFS of the United States.

5

equal amount. The financing of the deficit re­
quires either increased domestic saving, S, re­
duced domestic investment, I, or increased
foreign saving (which means a larger trade defi­
cit, TD). Generally, the budget deficit must
"crowd out” spending elsewhere by reducing ex­
ports (TD must rise), domestic consumption
spending (S must rise) or domestic investment (I
must fall). The conventional view emphasizes
the crowding out of domestic investment.
Developments in the 1980s, however, indicate
that the foreign sector cannot be ignored. The
trade deficit has risen sharply in the 1980s, re­
ducing the downward pressure on investment
expected in the conventional analysis. To main­
tain and service this rise in net borrowing from
abroad, a future flow of U.S. income has been
promised to foreign savers. Thus, a budget defi­
cit mortgages the future U.S. standard of living
either by reducing the capital stock and future
income or by reducing the amount of future
output that can be consumed domestically, or
both.

A SUPPLY-SIDE VIEW: TAX
INCENTIVES FOR INVESTMENT
The alternative view does not focus on the
budget deficit as either the principal influence
on investment or the most significant macroeco­
nomic change in the 1980s. It focuses instead
on tax changes early in the decade that in­
creased investment incentives and investment,
especially its business component. The supplyside view argues that such tax law changes
raise the optimal capital stock, temporarily rais­
ing investment, despite any indirect effects that
these tax incentives may have on the budget
deficit or interest rates.6
Actions like those adopted in the early 1980s
that provide generous new tax credits for in­
vestment or accelerate depreciation will hasten
the replacement of obsolete plant and equip­
ment and make possible the purchase of new

6There are a variety of arguments that suggest that deficits
do not affect investment via the conventional mechanism,
but they are not the central issue in the investment
debate. Tatom (1985) discusses the effects of budget
deficits on economic activity. In addition, it is arguable
whether tax law changes in the early 1980s raised the
observed budget deficit; instead, these changes mainly off­
set other tax increases. See Tatom (1984) and Meyer
(1983).
7Tatom (1986), (1987a), shows that movements in the value
of the dollar were associated with changes in the U.S.



facilities that otherwise might not have been
considered. Moreover, as investment demand
rises, the demand for funds to finance it in­
creases as well. Firms compete with each other
to attract investment financing by bidding up
returns on both equity and debt instruments.
The cost of capital to firms, including market
interest rates, rises as firms expand investment,
but by less than the value of the new invest­
ment incentives; net of these tax benefits, the
cost of capital falls. The net cost of capital rises
for firms that do not have access to these incen­
tives, however, including foreign firms opera­
ting abroad. Thus, these changes in market
rates of return and the cost of capital result in
a reallocation of capital and production among
nations, expanding domestic investment in the
United States and lowering it abroad .7
Similarly, when such investment incentives
are reduced, the optimal domestic capital stock
declines and the movements in investment, both
domestically and abroad, are reversed. To the
extent that the Tax Reform Act of 1986 re­
versed the earlier incentives, the optimal capital
stock and the pace of domestic investment
declined, despite any positive effects arising
from movements in the budget deficit and in­
terest rates.8

THE GOVERNMENT DEFICIT,
SAVING AND INVESTMENT: THE
RECORD
Figure 1 shows the total government deficit
and net foreign saving measured as shares of
nominal GNP .9 These measures correspond to
two of the gaps in identity 2 above, measured
as shares of nominal GNP. As the figure shows,
budget deficits, especially the federal deficit, are
strongly cyclical; the share of tax receipts tends
to fall while the share of spending, especially
unemployment compensation, rises during the
shaded recession periods. Similarly, cyclical in­

supply of dollars for international asset purchases conse­
quent to changes in investment incentives.
8U.S. investment abroad would also be expected to rise, as
in fact, it did. See Tatom (1987a).
9State and local governments have run budget surpluses in
the 1970s and 1980s, so the total government deficit share
has been smaller than that of the federal government
since 1970. Before 1970, state and local government
budgets were more nearly in balance, so there is little dif­
ference in the two deficit shares before then.

MARCH/APRIL 1989

6

Figure 1
Government Budget Deficit and Foreign Saving
as Shares of GNP
Percent
Percent
7.5 ,----------------------------------------------------------------------------------------------------------- -------------------------------------------------------------

00

II

-2 .5 I S

\Pf

i/

\ j\ l\ i

. V :

/ \

/f

/ U '* /

o.o

_ /*

I

-2 5

- 7.5 L__ ------------ --- ----------- I I --------- --------------------------------i n ........... ' ------- 1—

1948

51

7.5

54

57

60

63

66

creases in income and reductions in unemploy­
ment raise the share of tax receipts, while re­
ducing the government spending share some­
what. Thus, periods of business recession coin­
cide with periods of relatively large deficits.

69

72

75

78

, ,a

81

! ■ Mr,;-' ■-

84

. . a s y - 7.5

1987

Figure 2 summarizes the net relationship of
the government budget deficit and trade deficit
to total domestic investment and the composi­
tion of its financing. The total of government

and foreign saving is shown in the figure, along
with private saving and gross private domestic
investment; all three are measured as shares of
nominal GNP. The rise in the government bud­
get deficit in the early 1980s and its subsequent
reduction dominate the movement in the total
of government and foreign saving; this ratio
falls sharply in 1981-82 and then recovers
somewhat. This total share rises quite sharply
in 1986-88, as tax increases associated with
federal tax reform, especially on income from
capital, reduced the budget deficit and reduced
U.S. investment incentives; the reduction in the
budget deficit exceeded the associated reduction
in net foreign saving. The private saving rate,
which often moves inversely with the budget
deficit share, is unusually high in the early
1980s, but falls beginning in 1985 and reaches

10One of the simple confusions that arises from NIPA ter­
minology is that the net foreign saving rise was actually
associated with a reduction in U.S. investment abroad, not
a rise in foreign investment in the United States. This ac­
counts for the movements in the flow and value of the

dollar in international exchange. Moreover, it means that
the rise in foreign saving was really a reallocation of U.S.
investment spending from foreign to domestic uses. See
also Boskin and Gale (1986), Ohmae (1988) and Tatom
(1986), (1987a).

Net foreign saving has been quite small histor­
ically and, until this decade, was generally nega­
tive; that is, on average, U.S. residents were net
investors abroad. Also, such foreign saving did
not exhibit much variation until the 1980s. As
figure 1 indicates, the recent rise in the govern­
ment deficit was matched, in part, by a rise in
the U.S. trade deficit or net foreign saving.10


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7

Figure 2
Saving and Investment as Shares of GNP
Percent
25

Percent
25

rivate saving

V

r

*\ V

v/Gross private
domestic
investment

'

i/

':2ma

Government
and foreign
saving

1948

51

about 15 percent, near the lowest level shown,
in 1987-88.11
The share of gross private domestic invest­
ment is also strongly cyclical: housing purchases
and new plant, equipment, and inventory pur­
chases fall relatively more than income when
sales are falling and unemployment is rising.
Similarly, as sales growth and employment ex­
pand cyclically, such investment purchases rise
faster than income. The 1980 and 1981-82
declines in the investment share are associated
with recessions. At its peaks in 1980-81 and

11An explanation for this relationship is provided in Barro
(1974), Kormendi (1983), Aschauer (1985) and Tatom
(1985), among others.
12Modigliani (1988) takes another approach to the effects of
the budget deficit. He credits administration policies with
substantially raising the growth of real personal disposable
income per capita (and consumption), but argues that this
is transitory or illusory because it arose from unsustainably



1987

1984, the share of gross private domestic invest­
ment in GNP exceeded 17 percent. This propor­
tion compares favorably with those at earlier
peaks in 1948, 1955-56 and 1972-73, but was ex­
ceeded from 1977 to 1979 and in the 1950
cyclical recovery. Gross private domestic in­
vestment generally does not exhibit unusual
strength as a share of GNP in the 1980s when
compared with its earlier performance; more­
over, like the private saving rate, it falls off
from 1985 to 1988, although not to historically
record lows .12

low taxes or high national borrowing. In fact, however,
from 1980 to 1987, personal disposable income rose 67.3
percent, essentially the same as the 66.9 percent rise in
national income. Moreover, the tax wedge in their dif­
ference rose 71.9 percent, so that taxes actually depress­
ed per capita disposable income and consumption growth
over the period.

MARCH/APRIL 1989

8

Figure 3
Relative Price of Total and Business Fixed Investment Goods
Index (1982 = 100)
105

Index (1982 = 100)
105

100

51
54
57
60
63
66
69
72
75
78
81
84
1987
‘Total” is based on the Implicit price deflators for gross private domestic investment and GNP. “ Business” is based
on the deflators for nonresidential fixed investment and GNP.

Other factors besides the business cycle in­
fluence investment, and these could account for
the apparent lackluster recent performance of
the investment share shown in figure 2. Major
changes in business taxes or other costs
associated with housing, plant, equipment or in­
ventory will influence investment. For example,
when business investment tax credits were sus­
pended in 1966-67 and 1969-71, sharp declines
in the investment share followed. Similarly, the
1986 decline was related, in part, to the end of
the investment tax credit in 1986. Another key
factor has been the cost of operating plant,
13Energy-related

investment is positively related to unex­
pected changes in the relative price of oil and energy.
Thus, the decline in investment in 1986 could be attributed
to a decline in such prices. When investment in petroleum
and natural gas exploration shafts and wells, mining and
oil field machinery, and public utility gas and petroleum


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housing, and especially equipment. In 1974 and
1979, oil prices doubled, substantially raising
the cost of operating plant and equipment. Not
surprisingly, investment fell sharply relative to
GNP both times.13

RELATIVE PRICES AND REAL
INVESTMENT
Another factor that influences the investment
share is the relative price of investment goods.
Total spending on investment or other goods in­

pipelines are excluded from the investment share, the pat­
tern shown in figure 2 and in figures 4 and 5 below re­
mains the same. This is not surprising since the dominant
effect on aggregate investment is typically the opposite to
that in the energy-related sector. See Tatom (1979a,b) for
example.

9

Figure 4
Nominal and Real Gross Private Domestic Investment
as Shares of GNP

1948

51

54

57

60

63

66

eludes both a price and a quantity component;
similarly, the investment share is the product of
the relative price of investment goods and the
quantity of such goods relative to real GNP.
Gross private domestic investment equals the
price (Pj) times the quantity or real investment,
R; similarly, the index for the price of the na­
tion’s output (P) times the measure of the quan­
tity of GNP, called real GNP (X), equals nominal
GNP. Thus, the share of nominal investment is
(PiR/PX) or the product of the relative price
(Pj/P) and the real share of investment (R/X). As
a result, the movements in the nominal share in
figure 2 are only representative of real invest­
ment activity when the relative price of such
goods is unchanged or changes little.
The relative price of investment goods has
fallen sharply in the 1980s, however. As figure
3 shows, the relative price of all investment

14The unusual decline in the relative price of investment
goods could arise because of measurement errors. Such a
suspicion recently has arisen for computer equipment, for
example. Declining computer prices have produced an
unusually large decrease for the nonelectric equipment in­
dustry, but other equipment producers, like electric equip­
ment and transportation equipment, also show unusual
decreases in their relative price. See Tatom (1988).



69

72

75

78

81

84

1987

goods declined about 15 percent from 1980 to
1988; for business plant and equipment, the
decline was about 17 percent. Prices generally
rose 41 percent over the period according to
the GNP deflator, but the deflator for gross
private domestic investment goods rose only
about 23 percent and that for business fixed in­
vestment rose only about 18 percent.14 W hen
the relative price falls, the share of spending
declines proportionately unless the real share of
spending increases. Since the nominal share of
investment did not plummet in the 1980s, the
real share of investment must have risen.

The Share o f Real Investment
R o se in the 1980s. . .
Figure 4 shows the nominal and real share of
investment in nominal GNP and real GNP, re-

The reason for the decline in the price of investment
goods is beyond the scope of this article, but the decline
is relatively greater for internationally-traded goods like
equipment than it is for structures. It is most easily tied to
an unusual rise in productivity in the U.S. traded goods
sector (see Tatom 1988) and to a sharp decline in the
growth of world trade. The latter was associated, at least
in part, with the dramatic decline in world oil trade.

MARCH/APRIL 1989

10

spectively. The performance of the real share
indicates that investment in the 1980s was un­
usually strong and that it was associated with
the unusual decline in the relative price of in­
vestment goods. Indeed, there have been few
periods when real investment was as large a
share of real GNP as it was in 1984-88. In these
earlier periods, however, the unemployment
rate was substantially lower than recently and
measures of capacity utilization were much
higher. Adjusted for this cyclical difference, the
real investment share in the 1980s was un­
precedented in the post-World W a r II era .15

. . . Especially f o r Business Plant
and Equipment
The controversy over investment’s strength
typically focuses on business fixed investment,
not total investment. Movements in inventory or
residential fixed investment could account for
the favorable conclusion from figure 4. Figure 5
shows the share of real nonresidential fixed in­
vestment in real GNP and its cyclically-adjusted
counterpart.16 The case for relatively strong in­
vestment is even stronger in figure 5. Despite
the energy price and recession-induced declines
in the share, the 1986-87 tax-reform-related
decline, and the generally poorer cyclical per­
formance of the economy in the 1980s, the real
business fixed investment share has been quite
strong relative to its history.17 At its lowest level
in 1982, it was generally as high as it had been
at most previous business cycle peaks.

15The share of real gross private domestic investment in real
GNP was 19.6 percent in 1929; from 1930 to 1948, it was
usually in single digits, but it exceeded 15 percent in 1930
(15.2 percent), 1941 (15.3 percent), and in 1946-48 (16.2
percent, 16.7 percent, 18.8 percent, respectively). In 1984,
the share equaled that in 1948, the second highest level in
60 years. In 1929 and 1948, however, cyclical factors
strongly boosted investment; unemployment was 3.2 per­
cent of the civilian labor force in 1929 and 3.8 percent in
1948. In 1984 and 1985, the unemployment rate exceeded
7 percent.
Real business fixed investment in real GNP was 13.1
percent in 1929 and 12 percent in 1930. The share did not
reach a double-digit level again until 1947-48 when it was
about 11.5 percent. This pace was not exceeded until
1978, when it reached 11.6 percent. The 1978 share has
been equaled or exceeded each year since then, except in
1983 when the share was 11 percent. The 1985 share of
12.5 percent was the modern peak.
16The cyclically adjusted share is based on a regression of
changes in the logarithm of the actual share on current
and four significant past changes in the logarithm of the
manufacturing capacity utilization rate for the period
111/1949 to 111/1988. This regression has an adjusted R2 of
0.39, a standard error of 7.76 percent, and a DurbinWatson statistic of 1.89. The regression indicates that a 1
percent rise in the utilization rate raises the share of such

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The cyclically-adjusted share indicates the re­
cent strength quite clearly. This share surged to
record levels when the 1981 tax act was passed
in the third quarter of 1981 and remained there
until tax reform began to reduce business in­
vestment incentives in the first quarter of 1986.
This share has rebounded somewhat since its
trough in the first quarter of 1987.

THE GROSS VS. NET INVESTMENT
CONTROVERSY
One counter argument to the strength of
domestic investment or its business component
is that such spending has been boosted by an
accelerated pace of obsolescence. The increased
obsolescence is associated with an increasingly
shorter-lived capital stock that is of lower quali­
ty. According to this argument, after subtrac­
ting depreciation, new investment has been
depressed compared with its past performance .18
Figure 6 shows net nonresidential fixed invest­
ment as a share of GNP using both nominal and
real measures. Again, relative price movements
affect performance in this decade, but, either
way, the net investment share appears relatively
weak. Compared with a recent peak of about 4
percent in 1979, net investment declines to
about 3Vs percent in 1980-81, and then plum­
mets. Except for a temporary recovery in
1984-85, the shares have been generally lower
in this decade. In particular, net investment fell

investment by 0.9 percent. The adjusted share is com­
puted on the basis of an 82 percent utilization rate, about
the postwar average.
17The decline in the price of investment goods relative to the
GNP deflator or, what is nearly the same, the price
deflator for consumption goods and services, has the
same implication for nominal saving rates as for invest­
ment rates. When the price of goods yielding future con­
sumption services falls relative to current goods and ser­
vices, a given saving rate out of nominal income implies a
proportionately larger real saving rate. Thus, a given flow
of future consumption can be obtained with a propor­
tionately smaller share of saving in nominal GNP. Since
the private saving rate (figure 2) did not decline as sharp­
ly, as the relative price of investment goods, the effective
saving rate was relatively high, especially in 1982-85.
18The methods of estimating discard and obsolescence rates
used in the national income and product accounts have
not been altered since they were introduced in the late
1940s. Many analysts prefer the use of the unadjusted
gross data because of the uncertain accuracy of deprecia­
tion data. See Denison (1979), for example. The Council of
Economic Advisers (1989) discuss this distinction, pointing
out the advantages of the gross measure.

11

Figure 5
Real Business Fixed Investment as a Share of GNP
Percent
14

Percent
14

8

1951
54
57
60
63
66
69
72
1Based on a manufacturing capacity utilization rate of 82 percent.

to nearly its lowest recorded level following the
tax reform act of 1986. Thus, the figure sug­
gests that net investment was indeed quite
weak in the 1980s, especially when nominal
measures are used. The apparent weakness in
the measures, however, is subject to the same
qualifications as gross investment: the real
measures are not as low and, adjusted for
cyclical differences, the real net investment
share was not depressed in the 1980s.19 More­
over, there are other reasons to doubt the valid­
ity of the apparent weakness of net investment.
Did the capital stock become markedly
shorter-lived in the 1980s, raising the rate of
obsolescence of the given stock of business
plant and equipment? One indicator of the

19The higher peaks of the net investment ratio in 1956-57,
1966, 1969, 1973 and 1979 than in 1981 and 1984-85 are
due to cyclical differences noted above. The average
manufacturing capacity utilization rate in those earlier
years was 86.5 percent, significantly higher than the 79.6
percent average in 1981 and 1984-85. When adjustments



1987

changing age of the capital stock is the mix of
plant and equipment; equipment normally has a
much shorter expected service life than struc­
tures do. The top panel of figure 7 shows a
noteworthy shift in the mix of investment from
1980 to 1985. It was not a swing toward equip­
ment, however. Instead, following the sharp up­
ward trend that raised the share of equipment
in total business fixed investment from about 51
percent in 1961 to 67 percent in 1978, the
share declined, especially in 1981-82, then rose,
but did not reach 67 percent again until 1985.
Tax reform reduced the incentive to invest in
structures relatively more than it did to pur­
chase equipment. Thus, the equipment share
surged to record highs in 1986-87. The bottom
panel of figure 7 shows the depreciation rate

like those in footnote 16 are applied to quarterly data
prepared by this Bank, the average real net business fixed
investment share was sharply higher in these three years
than the average for the six previous peak years listed
above.

MARCH/APRIL 1989

12

Figure 6
Net Business Fixed Investment as a Share of GNP
Percent

Percent

4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0

1948

for the net stock of private nonresidential
capital. This rate rose from about 9 percent of
the net capital stock in 1980 to about 9.7 per­
cent in 1984 and 1987. This rise reflects the
pre-1980 increase in the share of shorter-lived
equipment in total investment.
The rise in the depreciation rate suggests that
the increase in the share of real gross invest­
ment overstates the strength of capital forma­
tion.20 But net investment, independent of other
measurement problems, understates capital for­
mation. When scrapped old equipment is replac­
ed by new equipment of equal market value, no

“ Direct estimates show that the average age of the net
nonresidential stock of capital (1982 prices) has not fallen.
The U.S. Department of Commerce (1987) estimates that
the average age generally rose slightly from 1969 to 1981
and that it has been higher in this decade than in the
1970s, on average. The gross stock, a measure that

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1987

net investment occurs. Nevertheless, the newer
vintage plant or equipment embodies a newer
technology and is more productive than the
older, discarded plant or equipment, so that
output rises despite the absence of net
investment.

CAPITAL PER WORKER AND
PRODUCTIVITY
The performance of net investment in figure

6 is misleading for another reason. Gross and
net investment are measures of changes in

removes depreciated capital from the stock estimates only
as it is discarded or removed from service, has a declining
average age in the 1970s, reaching its lowest level in
1981. Its age subsequently rose and has exceeded its
1979 age every year since 1981, and generally by growing
amounts.

13

Figure 7

Share of Equipment in Real Business Fixed Investment and
Depreciation Rate for the Real Net Nonresidential
Capital Stock
Percent

Percent

Share of

1948

51

1987

■
capital goods, but the purpose of investment is
to affect the total plant and equipment available.
Moreover, it is the total quantity of capital per
worker that influences output per unit of labor,
or productivity, and the standard of living, not
the share of new investment goods in output.
Growth in the stock of capital per worker is ex­
pected to alter the way people work and raise
productivity, measured as the rate of output per
individual worker or per hour. Since net invest­
ment is a measure of the change in the capital
stock, it must be added to the existing stock and
the total must be compared to available labor
resources, if a meaningful assessment of the
contribution of capital formation to income per
worker is to be made.
Since 1979, labor force growth slowed mark­
edly. Such a slowing would imply a rise in the
growth rate of capital per worker and produc­
tivity, unless capital stock growth slowed as

21The constant dollar net nonresidential capital stock
measure is described in U.S. Department of Commerce
(1987). Revisions appear in Musgrave (1988). Quarterly net
capital stock data estimated by this Bank, adjusted for the
capacity utilization rate in manufacturing, and data for



much. From 1979 to 1988, the growth rate of
the civilian labor force has been 1.7 percent,
well below the 2.7 percent growth registered
from 1974 to 1979. The growth of the constantdollar net nonresidential fixed capital stock
slowed from a 3.2 percent rate from the begin­
ning of 1974 to the beginning of 1979 to a 2.9
percent rate over the next nine years .21 Thus,
the capital-labor ratio showed faster growth in
the 1980s.
The capital stock grew about 2.4 percentage
points per year faster than the labor force from
1948 to 1973. In response to the oil price shock
in 1973-74, however, the capital stock's relative
growth nearly came to a halt, as firms adjusted
to a lower desired proportion of capital per
w orker .22 Since 1979, relative capital growth
resumed, with capital stock growth averaging
1.2 percentage points faster than the growth of
the labor force, despite the fact that oil and

business sector hours show that the growth of utilized
capital per hour declined from 3.5 percent from IV/1948 to
IV/1973 to 0.6 percent from IV/1973 to IV/1980, and then
rose to 1.5 percent from IV/1980 to IV/1988.
22See Tatom (1982) and (1979a, b).

MARCH/APRIL 1989

14

energy prices had risen about as much in
1980-85 as they had in 1974-78.23
Productivity has reflected the renewed
strength of capital formation as well. Output
per hour in the business sector rose at only a
0.5 percent rate from 1973 to 1980, after rising
at a 2.9 percent rate from the end of 1948 to
the end of 1973. From 1980 to 1985, however,
productivity rose at a 1.6 percent rate, more
than three times faster than in the previous
period .24 Productivity growth subsequently
slowed to a 0.4 percent rate from early 1986 to
the fourth quarter of 1988.

CONCLUSION
U.S. domestic investment, especially business
investment, was unusually strong in the 1980s.
The policies adopted early in this decade con­
tributed to a renewal in the growth of both
capital per worker and productivity compared
with their performance in the 1970s. This
strength is surprising, given the unusual slack
in labor markets, the availability of existing
unused capital goods, and the rise in energy
costs that immediately preceded this decade.
While some measures, like the nominal gross
investment share or net investment shares of
GNP, suggest that investment was not unusually
strong in this decade, this perception is incor­
rect. Such a view exploits appearances arising
from a strong decline in the relative price of in­
vestment goods, the business cycle and a sharp
slowing in labor force growth. W hen these fac­
tors are considered, the strong rise in capital
per worker and productivity, at least until the
effects of the 1986 tax reform set in, are readily
reconciled with a relatively strong performance
of investment.
The differing assessments of investment perfor­
mance in the 1980s are central to correctly
judging past and prospective policies. For exam­
ple, investment performance has deteriorated in
the past two years. Whether this is judged a
continuation of the purported dismal investment
performance of the 1980s or another dramatic

23Evidence for the redistribution of world capital stocks and
productivity toward the United States can be found in
Tatom (1986), and (1987a, b).
24The increase in the constant dollar value of the capital
stock was 19.8 percent from the end of 1980 to the end of
1987, much larger than the 7.1 percent and 12.1 percent
increases in the population and in the civilian labor force,
respectively, for the same period. The current value of the
business capital stock rose 46.1 percent, or by $1.3

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RESERVE
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example of the influence of tax policy on the
economic environment can affect future policy
choices significantly. Proponents of the first
view want to raise taxes to reduce the budget
deficit, which they view as central to the task
of improving the performance of the U.S.
economy, including investment and productivity.
They deny the direct influence of tax policy on
investment behavior, especially in this decade.
Proponents of the second view emphasize that
such a tax change, despite its budgetary implica­
tions, will perversely affect investment and
productivity.

REFERENCES
Aschauer, David Alan. “ Fiscal Policy and Aggregate De­
mand,” American Economic Review (March 1985), pp.
117-27.
Auernheimer, Leonardo. “ Rentals, Prices, Stocks and Flows:
A Simple Model,” Southern Economic Journal (July 1976),
pp. 956-59.
Barro, Robert J. “Are Government Bonds Net Wealth?”
Journal of Political Economy (November/December 1974),
pp. 1095-117.
Boskin, Michael J., and William G. Gale. “ New Results on
the Effects of Tax Policy on the International Location of In­
vestment,” National Bureau of Economic Research Working
Paper No. 1862 (March 1986).
Business Week. “America After Reagan” (February 1, 1988),
pp. 56-57.
________“ It’s Time for America to Wake Up” (Novem­
ber 16, 1987), pp. 158-77.
Cooper, Richard N. "The United States as an Open Econ­
omy,” in R.W. Hafer, ed., How Open is the U.S. Economy?
(Lexington Books, 1986), pp. 3-24.
Council of Economic Advisers. Economic Report of the Presi­
dent, (U.S. Government Printing Office, January 1989).
Denison, Edward F. “ Explanations of Declining Productivity
Growth,” Survey of Current Business (August 1979), pp.
1-24.
Fazzari, Steven M. “Tax Reform and Investment: Blessing or
Curse?” this Review (June/July 1987), pp. 23-33.
Frankel, Jeffrey A. “ International Capital Mobility and
Crowding-out in the U.S. Economy: Imperfect Integration of
Financial Markets or of Goods Markets?” in R.W. Hafer,
ed., How Open Is the U.S. Economy? (Lexington Books,
1986), pp. 33-67.
Friedman, Benjamin M. “ Implications of the U.S. Net Capital
Inflow,” in R.W. Hafer, ed., How Open is the U.S. Econ­
omy? (Lexington Books, 1986), pp. 137-61.
________Day of Reckoning (Random House, 1988).
Friedman, Milton. “ Why the Twin Deficits Are a Blessing,”
Wall Street Journal, December 14, 1988.
trillion, substantially more than the $563 billion rise in net
indebtedness to foreigners, as measured by the
cumulative current account deficit over the same period.
When residential, consumer and government assets are
added in, the rise in domestic current fixed assets for the
same period is about $3.9 trillion, a 46.8 percent increase.
The substantial growth in capital assets relative to debt to
foreigners suggests that the U.S. standard of living has
been boosted by the use of net foreign saving in the 1980s.

15

Jonas, Norman. “ The Hollow Corporation,” Business Week
(March 3, 1986), pp. 57-59.
Kennedy, Paul. The Rise and Fall of Great Powers: Economic
Change and Military Conflict From 1500 to 2000 (Random
House, 1987).
Kormendi, Roger C. “Government Debt, Government
Spending, and Private Sector Behavior,” American
Economic Review (December 1983), pp. 994-1010.
Meyer, Stephen A. “ Tax Cuts: Reality or Illusion?” Federal
Reserve Bank of Philadelphia Business Review
(July/August 1983), pp. 3-16.
Modigliani, Franco. “ Reagan’s Economic Policies: A Criti­
que,” Oxford Economic Papers (September 1988),
pp. 397-426.
Musgrave, John C. “ Fixed Reproducible Tangible Wealth in
the United States," Survey of Current Business (August
1988), pp. 84-87.
Ohmae, Kenichi. “ No Manufacturing Exodus, No Great
Comeback,” Wall Street Journal, April 25, 1988.
Ott, Mack. “ Depreciation, Inflation and Investment Incen­
tives: The Effects of the Tax Acts of 1981 and 1982,” this
Review (November 1984), pp. 17-30.
Peterson, Peter G. “ The Morning After,” The Atlantic Monthly
(October 1987), pp. 43-69.
Poole, William. “ Monetary Policy Lessons of Recent Inflation
and Disinflation,” Journal of Economic Perspectives
(Summer 1988), pp. 73-100.
Reynolds, Alan. “Commentary” in Albert E. Burger, ed., The
U.S. Trade Deficit: Causes, Consequences, and Cures.
(Kluwer Academic Publishers Group, 1989).
Sinn, Hans-Werner. “ U.S. Tax Reform 1981 and 1986: Im­
pact on International Capital Markets and Capital Flows,”




National Tax Journal (September 1988), pp. 327-40.
Summers, Lawrence H. “ The Results Are In on the Deficit
Experiment,” Wall Street Journal, February 20, 1987.
Tatom, John A. “ The Link Between The Value of the Dollar,
U.S. Trade and Manufacturing Output: Some Recent
Evidence,” this Review (November/December 1988), pp.
24-37.
_______ . “Will a Weaker Dollar Mean a Stronger
Economy?” Journal of International Money and Finance
(December 1987a), pp. 433-47.
_______ . “ The Macroeconomic Effects of the Recent
Fall in Oil Prices,” this Review (June/July 1987b), pp. 34-45.
________ “ Domestic vs. International Explanations of Re­
cent U.S. Manufacturing Developments,” this Review (April
1986), pp. 5-18.
________ “Two Views of the Effects of Government
Budget Deficits in the 1980s,” this Review (October 1985),
pp. 5-16.
________ “The 1981 Personal Income Tax Cuts: A
Retrospective Look at Their Effects on The Federal Tax
Burden,” this Review (December 1984), pp. 5-17, and in
Ben Bernanke, ed., Readings and Cases in
Macroeconomics (McGraw Hill Co., 1987), pp. 60-75.
________ “ Potential Output and The Recent Productivity
Decline,” this Review (January 1982), pp. 3-16.
________ “ The Productivity Problem,” this Review
(September 1979a), pp. 3-16.
________ “ Energy Prices and Capital Formation: 1972-77,”
this Review (May 1979b), pp. 2-11.
U.S. Department of Commerce, Bureau of Economic Analysis.
Fixed Reproducible Tangible Wealth in the United States,
1925-85. (GPO, June 1987).

MARCH/APRIL 1989

16

Michelle R. Garfinkel

Michelle R. Garfinkel is an economist at the Federal Reserve
Bank of St. Louis. Thomas A. Pollmann provided research
assistance.

The FOMC in 1988:
Uncertainty's Effects on
Monetary Policy

D

URING 1988, as the economy continued in
an historically long expansion, the Federal Open
Market Committee — henceforth, the "Commit­
tee” — faced the task of pursuing its long-term
objective of reasonable price stability, while pro­
moting growth in output on a sustainable basis
and improvements in the nation’s external ac­
counts.1 As the year began, the Committee
believed that accomplishing this task was com­
plicated by uncertainties associated with the
long-term effects of the stock market crash of
October 1987 and the continuing movements in
the dollar, as well as the changing relation bet­
ween the monetary aggregates and nominal out­
put. In the Committee’s view, these uncertainties,
among others, warranted a greater degree of
flexibility in the implementation of monetary
policy. Otherwise, unexpected economic de­
velopments easily could drive a wedge between
desired and actual outcomes.
To explain the challenge faced by the Commit­
tee and the role of flexibility in meeting that
challenge, this article examines the formulation
of monetary policy by the Federal Open Market

NOTE: Citations referred to as the “ Record” are to the
“ Record of Policy Actions of the Federal Open Market
Committee” found in various issues of the Federal Reserve
Bulletin. Citations referred to as the “ Report” are to the
“ Monetary Policy Report to the Congress,” also found in
various issues of the Bulletin.
'For a description of the Committee’s membership during
1988, see the shaded insert on pages 18 and 19.

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Committee in 1988. The discussion focuses on
how changing economic conditions and the
desire for greater operational flexibility influ­
enced Committee’s decisions during the year.

LONG-RUN OBJECTIVES
As mandated by the Full Employment and Bal­
anced Growth Act of 1978—or equivalently, the
Humphrey-Hawkins Act—the Board of Gover­
nors of the Federal Reserve System reports
semiannually to Congress on the Committee's
annual growth rate targets for monetary and
debt aggregates. In February, the Committee
establishes and reports on its objectives for the
current year; in July, the Committee reports its
progress toward achieving those objectives, its
decision to reaffirm or alter its targets for the
current year and the tentative targets for the
following year. The relevant one-year period for
the growth rate targets is from the fourth quar­
ter of the previous year to the fourth quarter
of the current year .2 Table 1 summarizes the
Committee’s reports to Congress on its long-run
objectives for 1988.

2As discussed by Hafer and Haslag (1988), among others,
such a procedure eliminates the problem of intra-year
base drift; however, it does not circumvent the inter-year
base drift problem.

17

Table 1
The FOMC’s Long-Run Operating Ranges
Ranges
Date of meeting

Target period

July 7, 1987'
February 9-10, 1988
June 29-30, 1988
June 29-30, 19882

IV/1987-IV/1988
IV/1987-IV/1988
IV/1987-IV/1988
IV/1988-IV/1989

M2
5-8%
4-8
reaffirmed
3-7

M3
5-8%
4-8
reaffirmed
3.5-7.5

1Ms.

Seger dissented. She wanted the 1988 target ranges to be the same as those for the
previous year. She stated, however, that she would be willing to reduce these target ranges if
economic developments between July 1987 and February 1988 called for such a move.
2Ms. Seger dissented. Given the prevailing uncertainty about the economic outlook, she prefer­
red to retain the 4-8 percent range for M2 and M3 at that time.

The Committee decided, as it had in the pre­
vious year, not to establish a target range for
M l in 1988:
The behavior of this aggregate in relation to
economic activity and prices has become very sen­
sitive to changes in interest rates, among other
factors, as evidenced by sharp swings in its vel­
ocity in recent years. Consequently, the appropri­
ateness of changes in M l this year will continue to
be evaluated in light of its velocity, developments
in the economy and financial markets, and the
nature of emerging price pressures.3
In setting its 1988 target growth ranges for
the broader monetary aggregates, M2 and M3,
at 4 to 8 percent, the Committee decided to
reduce the lower bound of the range by IV2 per­
centage points below that established for 1987.
The midpoints for the target growth ranges of
these two monetary aggregates also were re­
duced V2 percentage point below the tentative
ranges set for 1988.4 The Committee felt that
such a reduction would help to focus attention on
the need for relatively restrained expansion in
domestic demand to accommodate the adjustment
in the nation's external accounts and would under­
score the Committee’s commitment to achieving
reasonable price stability over time.5

3Record (May 1988), p. 323. See Hafer and Haslag (1988)
for a discussion of the Committee's omission of the M1
target. Stone and Thornton (1987) provide a critical
analysis of the existing explanations for the recent, puzzl­
ing decline in the velocity for M1. Also, Hafer (1986)
discusses the impact that the decline in M1 velocity had
on the decisions of the FOMC in 1985.
“Report (March 1988), p. 152.



Because of continuing uncertainty regarding
the velocities of M2 and to a lesser extent M3,
the members agreed that widening the target
ranges for these aggregates would be appropriate:
In light of the experience of recent years, which
have been marked by large swings in velocity, the
ranges were widened somewhat. Institutional
change is a source of continuing “noise” in the
relationship of money growth to economic activity;
in addition, there clearly is a strong, systematic
sensitivity of velocity to changes in market rates
of interest.6
Moreover, the wider ranges seemed appropriate
given the increased uncertainty about the eco­
nomic outlook due to the decline in the stock
market in October 1987. The Committee noted
that “the eventual effects on domestic demand
of the October stock market plunge and the
subsequent drop in interest rates remained
unclear.”7
At the time the targets were established, the
members believed that the growth in the
broader monetary aggregates would be around
the middle of the targeted ranges. Because of
the sensitivity of the M2 and M3 velocities to
movements in market interest rates and the in­
creased uncertainty about the economic out-

5Record (May 1988), p. 322.
6Report (March 1988), p. 152. Also, see Record (May
1988), p. 322.
7Report (August 1988), p. 525. Also, see Record (May
1988), pp. 320-21.

MARCH/APRIL 1989

18

O rganization o f the Committee
The Federal Open Market Committee
(FOMC) consists of 12 members, including
seven members of the Federal Reserve Board
of Governors and five of the 12 Federal
Reserve Bank presidents. The chairman of
the Board of Governors is traditionally elec­
ted chairman of the Committee. The presi­
dent of the New York Federal Reserve Bank,
also by tradition, is elected the Committee’s
vice chairman. All Federal Reserve Bank
presidents attend Committee meetings and
present their views, but only those who are
current members of the Committee are per­
mitted to vote. Four memberships rotate
among the Bank presidents and are held for
one-year terms commencing March 1 of each
year .1 The president of the New York Federal
Reserve Bank is a permanent voting member
of the Committee.
Members of the Board of Governors at the
beginning of 1988 included Chairman Alan
Greenspan, Vice Chairman Manuel H.
Johnson, Wayne D. Angell, H. Robert Heller,
Edward W . Kelley, Jr. and Martha R. Seger.2
John P. LaW are joined the Board in August
1988.
The following Bank presidents voted at the
meeting on February 9-10, 1988: E. Gerald
Corrigan (New York), Edward G. Boehne
(Philadelphia), Robert H. Boykin (Dallas), Silas
Keehn (Chicago), and Gary H. Stern (Min­
neapolis). In March, the Committee member­
ship changed and the presidents’ voting posi­
tions were filled by E. Gerald Corrigan (New
York), Robert P. Black (Richmond), Robert P.
Forrestal (Atlanta), W. Lee Hoskins (Cleveland)
and Robert T. Parry (San Francisco).
The Committee met eight times at regularly
scheduled meetings during 1988 to discuss
economic trends and decide the future
course of open market operations.3 As in
previous years, telephone consultations were
held occasionally between scheduled meet­
ings. During each scheduled meeting, a direc­
tive was issued to the Federal Reserve Bank
of New York. Each directive contained a

’ Starting in 1990 the one-year terms for membership will
be on a calendar-year basis.
2Mr. Kelley was absent and so did not vote at the August
meeting.

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short review of economic developments, the
general economic goals sought by the Com­
mittee, its long-run monetary growth objec­
tives and instructions to the Manager for
Domestic Operations at the N ew York Bank
for the conduct of open market operations.
These instructions were stated in terms of
the degree of pressure on reserve positions
to be sought or maintained. Directives issued
earlier in the year qualified the degree of
pressure sought with a special reference to
the sensitive conditions in the financial mar­
kets. The reserve conditions stated in the
directive were deemed consistent with spe­
cific short-term growth rates for M2 and M3
which, in turn, were considered consistent
with desired longer-run growth rates for
these monetary aggregates. The Committee
also specified intermeeting ranges in the
federal funds rate. These ranges provided a
mechanism for initiating consultations bet­
ween meetings whenever it appeared that the
constraint of the federal funds rate was in­
consistent with the objectives for the behav­
ior of the monetary aggregates.
The account manager has the primary
responsibility for formulating plans regarding
the timing, types and amount of daily buying
and selling of securities in fulfilling the Com­
mittee’s directive. Each morning the manager
and his staff plan the open market operations
for that day. This plan is developed on the
basis of the Committee’s directive and the lat­
est developments affecting money and credit
market conditions, the growth of monetary
aggregates and bank reserve conditions. The
manager also consults with the Board’s staff.
Present market conditions and open market
operations that the manager proposes to ex­
ecute are discussed each morning in a tele­
phone conference call involving the staff at
the New York Bank, one voting president at
another Reserve Bank, and the staff at the
Board. Other members of the Committee may
participate and are informed of the daily plan
by internal memo or wire.

3No meetings were held in January, April, July or October.

19

The directives issued by the Committee and
a summary of the discussion and reasons for
Committee actions are published in the "Rec­
ord of Policy Actions of the Federal Open
Market Committee.” The “Record” for each
meeting is released a few days after the next
Committee meeting. Soon after its release, it
appears in the Federal Reserve Bulletin. In ad­
dition, "Records” for the entire year are
published in the annual report of the Board
of Governors. The record for each meeting in
1988 included:
( 1 ) a staff summary of recent economic
developments—such as changes in pri­
ces, employment, industrial production
and components of the national income
accounts—and projections of general
price, output and employment
developments for the year ahead;
(2 ) a summary of recent international
financial developments and the U.S.
foreign trade balance;
look, however, the Committee recognized that
outcomes consistent with the Committee’s goals
could differ. Accordingly, the Committee sought
greater leeway in targeting money growth. The
greater leeway or flexibility was afforded by the
1 percentage-point increase in the width of the
targeted ranges for M2 and M3 .8 Furthermore,
to assure the consistency of its actions with its
long-term objectives, the Committee felt, as in
previous years, that it would be necessary to
monitor the behavior of the broader monetary
aggregates in light of indicators of the strength
of expansion of economic activity, price pres­
sures and conditions in financial markets, in­
cluding the market for foreign exchange.9
W hen the Board presented the July Report to
the Congress, the broad monetary aggregates
were growing at annual rates of approximately
7 percent, close to the upper bounds of their
targeted ranges. Nevertheless, the Committee
expected that M2 growth would moderate suffi­
ciently in the second half of 1988 so that its

8Report (August 1988), p. 525 and Record (May 1988)
p. 322. Some members were wary of such widening, as it
might signal “ a further retreat from effective monetary
targeting” and partially remove a “ desirable discipline” re­
quiring re-evaluation of policy if the monetary aggregates
deviated from otherwise narrower targeted ranges. See
Record (May 1988), pp. 322-23.
9Report (March 1988), pp. 152-53. Also, see Greenspan
(1988), pp. 612-13. Nuetzel (1987) discusses the Commit­



(3) a summary of open market operations,
growth of monetary aggregates and
bank reserves and money market condi­
tions since the previous meetings;
(4) a summary of the Committee’s discus­
sion of the current and prospective
economic and financial conditions;
(5) a summary of the monetary policy dis­
cussion of the Committee;
(6 ) a policy directive issued by the Commit­
tee to the Federal Reserve Bank of New
York;
(7) a list of the members’ votes and any
dissenting comments; and
(8 ) a description of any actions regarding
the Committee’s other authorizations
and directives, and reports on any ac­
tions that might have occurred between
the regularly scheduled meetings.
growth rate over the full year would fall
around the middle of its targeted range. The
lower growth rate in M2 for the second half of
the year was thought to be consistent with the
expected and desired lower growth in output
needed to achieve price stability goals. While
some members expected that M3 growth over
the full year would exceed that of M2, they did
not expect it to exceed the upper bound of its
range. Thus, the 1988 growth rate ranges for
M2 and M3 established in February were reaf­
firmed in July 1988.10
In its July Report, the Committee provisionally
set the 1989 target ranges for M2 and M3 at 3
to 7 percent and 3.5 to 7.5 percent, respective­
ly. Given the high levels of resource utilization
and the resurging fears of future inflation at
that time, a majority of the Committee agreed
that reducing the ranges for 1989 would be
consistent with the Federal Reserve System's
goal of price stability and would communicate
the System’s intention to pursue that goal.11

tee’s move to place greater weight on indicators of
economic activity and price pressures relative to the
behavior of the monetary aggregates to guide the im­
plementation of monetary policy. Also, see Heller (1988).
10Record (October 1988), p. 658.
"Report (August 1988), pp. 518-19, and Record (October
1988), p. 658.

MARCH/APRIL 1989

20

Table 2
Actual and Expected Money Growth in
1988
Aggregate
M2
M3

Target range1

Actual2

4-8%
4-8

5.2%
6.3

’The target period for M2 and M3 is from IV/1987 to
IV/1988.
2Data are taken from the Board of Governors’ H.6
release (February 23, 1989).
The Committee also reaffirmed the need to
maintain some flexibility in the general strategy
for monetary policy:
Recognizing the variability of the relationship of
these measures [Ml, M2, M3 growth rates] to the
performance of the economy, the Committee
agreed that operating decisions would continue to
be made not only in light of the behavior of the
monetary aggregates, but also with due regard to
developments in the economy and financial mar­
kets, including attention to the sources and extent
of price pressures and to the performance of the
dollar in foreign exchange markets.12
Continued uncertainties about the economic
outlook and the relation between the growth in
the monetary aggregates and other key economic
variables also prompted the Committee to main­
tain the wider target ranges for M2 and M3
growth and, once again, to forego establishing a
target for M l growth.
Table 2 shows that the actual 1988 growth
rates in M2 and M3 — 5.2 percent and 6.3 per­
cent, respectively — were within their target
ranges; however, M2 and M3 growth rates fluc­
tuated considerably during the year. These fluc­
tuations influenced the Committee’s short-run
policy decisions during 1988.

environment, the changes in short-run monetary
policy necessary to achieve its long-term goals.
The Committee formulates a domestic policy
directive to serve as a basis for the day-to-day
policy implementation between meetings. The
directive is issued to the Federal Reserve Bank of
New York where the Manager for Domestic
Operations of the System Open Market Account
is held responsible for implementing the instruc­
tions stipulated in the directive.
Maintaining the approach used in previous
years, the directives issued during 1988 placed
primary emphasis on the degree of restraint on
reserve positions expected to be consistent with
the Committee’s money growth targets and goals
for the economy. Under the current borrowedreserves operating procedure, the desired degree
of reserve restraint translates into a target for
borrowed reserves (reserves borrowed from the
Federal Reserve Ranks). The target level of bor­
rowed reserves (the borrowings assumption) in­
cludes adjustment plus seasonal borrowings. A
statement in the directive to increase (decrease)
the degree of pressure on reserve positions
would indicate a higher (lower) target level of
borrowed reserves. Inducing the higher (lower)
level of borrowed reserves, for a given discount
rate, would imply an increase (decrease) in the
federal funds rate .13
In the first two directives in 1988, however,
emphasis was also placed on financial market
conditions:
In the aftermath of the stock market crash last Oc­
tober, the Committee modified the System’s pro­
cedures by placing greater emphasis on money
market conditions and less on bank reserve posi­
tions in carrying out day-to-day open market opera­
tions. . . . During this period, it was considered im­
portant to assure the markets of the System’s in­
tention to provide adequate liquidity, and it was
feared that significant variation in money market
conditions could add to the unusual uncertainties
already in the markets.14

SHORT-RUN POLICY OBJECTIVES
The Committee holds eight meetings during
the year to determine, in light of the economic

12Report (August 1988), p. 518.
the amount of borrowed reserves is assumed
to be a negative function of its opportunity cost — that is,
the difference between the discount rate (the interest rate
charged for reserves borrowed from the Federal Reserve
System) and the federal funds rate (the interest rate paid
on reserves borrowed from the other depository institu-

13Specifically,


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At the beginning of 1988, the Committee believ­
ed that, given the fragility of financial markets
evidenced by wide fluctuations in bond and

tions). For a discussion of the implementation of monetary
policy under the borrowed-reserves operating procedures,
see Gilbert (1985), Heller (1988) and Thornton (1988).
14Report (August 1988), p. 528. See also, for example,
Record (February 1988), pp. 116-17, Record (April 1988),
p. 239, Record (May 1988), p. 324, and Record (July
1988), p. 472.

21

equity prices, a policy focused primarily on
meeting reserve objectives could create exces­
sive volatility in those markets. To avoid or to
dampen temporary fluctuations in the money
markets, a policy that was flexible with respect
to meeting reserve objectives seemed appropri­
ate to the Committee.15 Toward the middle of
1988, when it appeared that financial markets
had stabilized, no reference to sensitive condi­
tions in financial markets was made in the
directive.16
In addition to stating the desired degree of
reserve pressure (maintained, increased or
decreased) and possible modifications in the in­
termeeting period, the directives indicated the
expected growth rates in M2 and M3, condi­
tional on the desired degree of reserve pres­
sure, and established a range for the federal
funds rate. If the federal funds rate were to
diverge from the specified range, the chairman
could initiate a Committee consultation in the
intermeeting period.
The following discussion highlights key eco­
nomic developments during 1988 and shows
how they influenced the Committee’s formula­
tion of short-run policy objectives. Tables 3 and
4 summarize the directives issued in 1988.
Table 3 shows the desired degree of reserve
pressure, the expected growth rates of M2 and
M3, and the monitoring range for the federal
funds rate specified in the domestic policy
directives. It also reports the borrowings as­
sumption in effect at each meeting.17 Table 4
lists the policy guides used to determine wheth­
er modifications in the degree of reserve
pressure would be desirable in the intermeeting
period. The ordering of policy guides is as listed
in the directives. Finally, table 5 shows the ac­
tual (revised) intra-year growth rates in M2 and
M3 and the rates expected by the Committee.

February 9-10 Meeting
The data available for review at the first
meeting of 1988 suggested that, although the

15Record (May 1988), p. 324. See also footnote 14. At the
March meeting, however, some members indicated that
such fluctuations in money market interest rates were not
“ detracting from the functioning of the market or the im­
plementation of policy.” Provided that market participants
understood the System’s procedures, fluctuations in
money market interest rates would reveal movements in
expectations of market participants and changes in the
market for reserves and credit. See Record (July 1988),
p. 472.
16Report (August 1988), p. 528, and Record (August 1988),
p. 542.



economy had continued to expand through the
fourth quarter of 1987, growth in output was
slowing toward the end of the year. Moreover,
because consumer spending had slowed sub­
stantially in the late months of 1987, the ob­
served growth in production was associated
chiefly with an increase in inventories. While
Committee members generally thought that in­
creased inventories could exert downward pres­
sure on business activity in the first half of
1988, some members believed such pressure
would be limited.18
The Board’s staff projected that the growth in
output over 1988 would be fueled primarily by
growth in export demand. Their projections in­
dicated that output growth would be sluggish in
the first half of the year, but would build mo­
mentum in the second half. The projected tran­
sition from an expansion driven by growth in
consumer demand to one driven by growth in
export demand generated some uncertainty
among the members about the economic out­
look. In addition, some members expressed con­
cern about the possibility of lagging effects of
the October 1987 stock market crash on con­
sumer and business spending and about the
sensitivity of financial markets.19
The Committee’s long-run concerns centered
on the possibility of higher future inflation
because of the strong growth in demand and
the high levels of capacity utilization. Although
available economic data reflected only modest
wage increases, the Committee thought that
continued expansion with lower rates of un­
employment and rising prices inevitably would
result in higher wage demands and wage in­
creases.20 Furthermore, there was some evi­
dence that higher production costs were
resulting in higher retail prices. The members
believed that "the key to avoiding both more in­
flation or a recession in a period of major ad­
justments in the trade balance would be the dif-

17The borrowing assumptions were not explicitly stated in
the directives.
18Record (May 1988), p. 320.
19lbid., p. 320-21.
20lbid., p. 322. Also, in January, growth in M2 and M3 had
recovered from the sluggish pace at the end of 1987. In
January, M2 grew at an annual rate of 8.8 percent, up
from 2.2 percent in December. Similarly, M3 grew at an
annual rate of 8.1 percent in January, up from 2.4 percent
in December.

MARCH/APRIL 1989

22

Table 3
Date of
meeting

Target
period

M2

Expected
growth
rates

M3

Degree
of
reserve
pressure

Intermeeting
federal
funds
range

Borrowings1
assumption

February 9-10, 1988

November-March

6-7%

Maintain,
with flexibility

4-8%

March 29, 1988*

March-June

6-7

Increase
somewhat
with flexibility

4-8

300

May 17, 19883

March-June

6-7

5-9

400

June 29-30, 19884

June-September

5.5%

7%

Increase slightly

5-9

600

August 16, 1988s

June-September

3.5

5.5

Maintain

6-10

600

September 20, 1988

August-December

3

5

Maintain

6-10

600

November 1, 19886

September-December

2.5

6

Maintain

6-10

600

December 13-14, 19887

November-March

3

6.5

Increase slightly

7-11

500

Maintain
pressure
initially, with
probable increase
later

$200

million

'The borrowings assumption in effect immediately after the December 15-16, 1987, meeting was $300 million. Changes in the
borrowings assumption were made in some of the intermeeting periods. These changes were made in light of incoming
information indicating that increased or decreased pressure on reserve positions was desirable or when a shift in the bor­
rowings function was identified. (See, for example, the discussion of the December meeting.)
2Ms. Seger dissented. She thought that the risk of additional inflation was less than the downside risks; in particular, she
argued that tightening of reserve conditions could be especially harmful, given the sensitivity of financial markets and the
weakened condition of many depository institutions.
3Messrs. Hoskins and Parry dissented. Past efforts to tighten reserves were insufficient, in their view, to counter the addi­
tional inflationary pressures that were inevitable given the current trend of expansion and prospects for future expansion
with already tight labor markets. Thus, failure to tighten reserve conditions now would require much greater tightening in
the future. Mr. Hoskins also noted that growth of the monetary aggregates was already near the upper limit of the target
ranges and that failure to increase the degree of pressure on reserves under current circumstances would detract from
the credibility and consequently effectiveness of monetary policy.
“Messrs. Angell and Kelley and Ms. Seger dissented. They preferred to maintain the current degree of reserve restraint,
at least for the initial period following the meeting. Mr. Angell emphasized that the effects of previous restraining actions
had not yet fully emerged, and expressed concern about the potentially counterproductive effect of further restraint on
the dollar and thus on improvements in the external balances. Mr. Kelley recognized that inflation had the potential to
accelerate, but he felt that there was insufficient evidence to justify further tightening at this time and thereby incur the
risk of undue slowing in economic growth. Ms. Seger stressed that slower economic growth was already suggested by
current business indicators, and in the context of earlier tightening actions whose impact had not yet fully materialized,
she concluded that further tightening would create an unnecessary risk to the economic expansion.
5Mr. Hoskins dissented. Pointing to the current indications of increasing price pressures, he felt that increased pressure
on reserve conditions would be more consistent with the Committee’s long-run price stability objectives. He thought that
such an action would enhance the credibility of the Fed’s stated anti-inflationary intentions.
6Ms. Seger dissented. She believed that the bias in the directive toward further restraint was not appropriate in light of
the recent indications of the slower economic expansion and her outlook for reduced price pressures in the next year.
7Ms. Seger dissented. She thought that the future pace of economic expansion would be compatible with progress in
reducing inflation. In her view, given the restrained growth of the monetary aggregates, additional restrictive actions
could add significantly and unnecessarily to pressures on interest-sensitive sectors of the economy and increase the
downside risks in the economy.


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23

Table 4
Ordering of Guides to Monetary Policy
Date of meeting
February 9-10, 1988 '
Financial markets, business expansion, inflation, foreign
exchange, monetary aggregates.

March 29, 1988
May 17, 1988
June 29-30, 1988

August 16, 1988

Inflation, business expansion, foreign exchange, financial
markets, monetary aggregates.

j
>

September 20, 1988

>

November 1, 1988

Inflation, business expansion, monetary aggregates, foreign
exchange, financial markets.

December 13-14, 1988>
NOTE: This ordering is as listed in the domestic policy directives.

Table 5
Actual and Expected Rates of Money Growth_____________
M2
Period

Expected

November 1987-March 1988

about 6-7%

March-June 1988

M3
Actual1

Expected

Actual*

6 .80/0

about 6-7%

7.2%

about 6-7

6.0

about 6-7

6.5

June-September 19882

about 3.5-5.5

2.9

about 5.5-7

5.2

August-December 1988

about 3

4.0

about 5

5.3

September-December 1988

about 2.5

4.6

about 6

5.8

1Actual growth rates are taken from the Board’s release.
2The June-to-September growth rates for M2 and M3 were revised to 3.5 percent and 5.5 percent,
respectively, from 5.5 percent and 7.0 percent at the August 16 meeting of the FOMC.




MARCH/APRIL 1989

24

ficult task of maintaining restrained growth in
domestic demands over an extended period .”21
In an effort to strike a balance between the
risks associated with a possible weaker expan­
sion in the short run and those of future infla­
tion, the Committee’s directive called for main­
taining the degree of pressure on reserve posi­
tions.22 Because of the uncertainties revolving
around financial market conditions and the
economic outlook, the directive indicated that
some flexibility in the implementation of mone­
tary policy might be appropriate. In particular,
. . . financial market conditions still exhibited some
degree of fragility and, against the background of
substantial uncertainty in the economic outlook,
unanticipated developments might well continue to
warrant occasional departures from the focus on
reserve objectives for the purpose of moderating
temporary fluctuations in money market condi­
tions.23
In addition, depending on financial market con­
ditions as well as forthcoming indications of
economic activity and price pressures, greater
or lesser reserve restraint would be appropriate
in the intermeeting period .24
The Committee anticipated that the reserve
conditions would be consistent with an annual
rate of growth for M2 and M3 of about 6 to 7
percent from November to March. The monitor­
ing range for the federal funds rate was set at
4 to 8 percent.25

March 29 Meeting
In the intermeeting period, strong growth in
M2 and M3 continued.26 The level of adjustment

21Ibid.
22lbid.,

p. 324. There was also concern that further easing of
the degree of reserve pressure could have an adverse ef­
fect on the dollar in foreign exchange markets and on
financial markets, unless market participants believed that
the economy was weakening (Ibid.). It should be noted
that the decline in the borrowings assumption from the
December 1987 to the February 1988 meetings (as shown
in table 3) reflects reduced reserve pressure that had been
implemented in the intermeeting period.
23lbid., p. 324.
24lbid., p. 326.
25lbid.
26ln February, M2 and M3 grew at annual rates of 8.6 and
10.1 percent, respectively, and in March, M2 and M3 grew
at annual rates of 7.8 and 8.2 percent, respectively.
27Record (July 1988), p. 469. Around the time of the
February meeting, the federal funds rate was about 6V2


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Louis

plus seasonal borrowings averaged $238 million,
just above the borrowings assumption, and the
federal funds rate averaged 6.59 percent during
the six-week period ending March 23.27
Economic data indicated that the economy
had continued to expand during the first quar­
ter of 1988; however, growth in output was
slower than that in the last few months in 1987.
A large part of the moderation in output
growth was attributed to the deceleration in in­
ventory investment, as businesses corrected
their previously high inventories. The ongoing
expansion was driven largely by the unex­
pected, marked increase in domestic final de­
mand in the first quarter .28
Although inflation and wage trends essentially
were unchanged, the Committee’s concerns
about future inflationary pressures were not
eased substantially. The February rate of un­
employment was 5.7 percent, its lowest level
since the middle of 1979. Capacity utilization
rates were relatively high in many industries. In
addition, during the intermeeting period, the
dollar had declined 2.25 percent on a tradeweighted basis relative to the other G-10 cur­
rencies. Many argued that this decline, perhaps
reflecting a skepticism in the world market
about the speed with which the U.S. trade
deficit was adjusting, could provide an addi­
tional potential source of upward movement in
prices.29 Moreover, the staff revised upward
their forecasts of future economic expansion.
Committee members generally felt that, with
high rates of capacity utilization in many in­
dustries, additional price pressures would be
created by increased domestic and export de­
mand growth .30

percent. See Record (May 1988), p. 320.
28lbid., p. 468-69.
29lbid. Currencies

of Belgium, Canada, France, Germany,
Italy, Japan, the Netherlands, Sweden, Switzerland and
the United Kingdom are included in the trade-weighted
G-10 index, used by the Federal Reserve Board as a
measure of the relative strength of the dollar in foreign ex­
change markets. When the value of the dollar falls,
holding all else constant, goods produced in the United
States become more attractive to foreign importers and in­
dividuals in the United States than goods produced else­
where. The resulting shift in demand can create domestic
price pressures. Furthermore, a dollar depreciation can in­
crease the cost of production for firms relying heavily on
imported intermediate goods, thereby creating additional
price pressures.
“ Ibid., p. 470-71.

25

In the discussion, some Committee members sug­
gested that the effects of high capacity utilization
had not yet fully shown up in price and wage
growth because of individuals’ expectations of a
policy response to increased inflation.31 Moreover,
consumer prices and wages had not yet exhibited
signs of acceleration because of the recently
declining energy prices and the relatively small in­
creases in food prices.32 Nevertheless, the
members believed that any added pressure on
wages "would make achievement of the ultimate
objective of price stability considerably more dif­
ficult.”33
As table 3 shows, the policy directive issued at
the close of the meeting called for a marginal in­
crease in pressure on reserve positions to slow the
growth of the broader monetary aggregates. Such
an action, reflected in the increased borrowings
assumption, was thought to be consistent with an­
nual growth rates in M2 and M3 of 6 to 7 percent
for the period from March to June, a slowdown
from their rapid growth rates in the first quarter.
Given the uncertainties about the economic
outlook and concerns about the fragility of finan­
cial markets, the Committee again voted to permit
the focus of day-to-day implementation of
monetary policy to shift away from reserve objec­
tives if necessary. Furthermore, depending on for­
thcoming information as indicated in table 4,
greater or lesser reserve restraint would be accep­
table in the intermeeting period. The monitoring
range for the federal funds rate was maintained at
4 to 8 percent.34

M ay 17 Meeting
Immediately following the March meeting,
some actions were taken to firm reserve posi­
tions slightly. Adjustment plus seasonal borrow ­
ings averaged about $330 million during the
four-week period ending April 20 and averaged
$440 million between April 21 and May 4. Addi­
tional restraint on reserve positions was im­
plemented just before the May meeting "in light of
31 Ibid.,

p. 470.
32lbid., p. 469.
33lbid., p. 471.
“ Ibid., pp. 473-74.
35Record (August 1988), p. 539.
36Record (August 1988), pp. 538-39. For example, the
seasonally adjusted consumer price index for all urban
consumers had risen at annual rates of 5.3 percent in



information that indicated considerable strength in
the economy and a related increase in concerns
about the potential for greater inflation.”35 By
the May meeting, the federal funds rate had
risen to 7 percent.
As had been expected, strong growth in do­
mestic and export sectors continued to boost
economic growth. Preliminary statistics sug­
gested that unemployment in April declined to
5.4 percent, its lowest rate since 1974, and
capacity utilization rates had increased substan­
tially. From March to April, the industrial pro­
duction index had risen at an annual rate of 6.4
percent; moreover, the U.S. merchandise trade
deficit had improved in March. The continued
strength in economic expansion was accom­
panied by a slight weakening of the dollar and
signs of increased inflationary pressure and
higher labor costs.36
The staff’s forecasts for the economic outlook
depended partly on how the added risks of
greater inflation and wage growth would affect
financial markets. If the added risks placed
pressures on financial markets so as to restrain
final domestic demand, "the extent and duration
of any pickup of inflation might be limited.”37
The forecasts indicated that, in this case, re­
duced growth in domestic demand combined
with the current large inventories eventually
could reduce the rate of inventory investment.
Furthermore, the staff predicted that growth in
business fixed investment would fall and real
federal purchases would decline. Nevertheless,
in light of the weakening dollar and the high
capacity utilization rate, growth rates of prices
and wages were expected to increase in the
coming quarters .38
The majority of the members generally agreed
that additional restraint was needed. In their
discussion, the risks of excessive expansion and
augmented inflationary pressures seemed to
dominate the economy’s downside risks due to
increased inventories, fragile conditions in finan­
cial markets and a relatively weak outlook for

April and 4.2 percent in March, up from 2.1 percent in
February. Further, the seasonally adjusted producer price
index for finished goods rose 4.6 percent and 3.4 percent,
respectively, in March and April, after not changing in
February. Note that the civilian unemployment rate in April
has been revised to 5.5 percent.
37lbid., p. 540.
38lbid.

MARCH/APRIL 1989

26

construction. In addition, the importance of
maintaining credibility was noted:
...the members generally agreed that some further
tightening of reserve conditions was needed to
counter the risks of rising inflationary pressures
in the economy. A failure to act in timely fashion
not only would be inconsistent with the Commit­
tee’s commitment to achieving price stability over
time but would in fact compound the difficulties
of accomplishing that objective.39
The Committee members disagreed, however,
about the extent and timing of additional
tightening of reserves. Immediate action was
considered by some to be potentially damaging
to financial markets unless market participants
anticipated such an action. Further, the impact
of the previous move to increase pressure had
not yet been fully realized in terms of growth
of domestic demand. Finally, growth in the
monetary aggregates was expected to slow, pri­
marily because of a reversal of the temporary
rise in transaction accounts related to taxes
during April. Yet, others thought that immediate
action could have a favorable effect on inflation
expectations and reduce the need for increased
restraint in the future .40
The Committee’s directive called for maintain­
ing the existing pressure on reserve positions in
the initial period following the meeting with
possibly higher pressure after some weeks de­
pending on forthcoming information .41
In contrast to prior directives since the stock
market crash in October 1987, this directive did
not explicitly include a special reference to the
sensitive conditions in the financial markets that
required some flexibility in the conduct of open
market operations. The members felt that the
“normal” approach to the implementation of
monetary policy—that is, with primary emphasis
on the degree of pressure on reserve positions
and less emphasis on money market conditions
— would be appropriate; the special reference
"no longer served a clarifying purpose in com­
municating the Committee’s intentions.”42
39lbid.
40lbid.,

pp. 540-41.
41The increase in the borrowings assumption from the
previous meeting, as indicated in table 3, reflects actions
in the intermeeting period to increase reserve pressure
and, hence, is consistent with the stated desired degree of
reserve pressure. It should be noted that the increase in
the borrowings assumption does not reflect the expecta­
tion of additional restraint in the beginning of the inter­
meeting period.
42lbid., p. 542.

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The directive issued at the close of this meet­
ing, however, did not fully abandon the spirit of
flexibility; financial markets would continue to
be closely monitored. Although the primary
focus of the directive was placed on meeting re­
serve objectives, changes in those objectives
could be made in light of incoming information
in the intermeeting period. The directive stated
that, depending on further developments in the
economy, "somewhat greater reserve restraint
would, or slightly lesser reserve restraint might,
also be acceptable later in the intermeeting
period .”43
The reserve conditions contemplated by the
Committee were expected to be consistent with
a 6 to 7 percent annual growth rate in M2 and
M3 from March to June. The monitoring range
for the federal funds rate was increased by 1
percentage point to 5 to 9 percent, because of
past actions to increase the pressure on reserve
positions and possible further restraint.44

June 29-30 Meeting
Actions were taken to increase the degree of
pressure on reserve positions as suggested by
the May directive. Adjustment plus seasonal bor­
rowings averaged $530 million in the four
weeks ending June 15. The federal funds rate
rose from 7 percent around the time of the
prior meeting to approximately 7 3/8 to 7Vi per­
cent by the middle of June. Despite the addi­
tional restraint imposed on reserve positions in
the latter part of June, however, adjustment
plus seasonal borrowing averaged only about
$520 million over the two weeks ending June
29. Nonetheless, the federal funds rate rose fur­
ther to about 8 percent and, as expected by
Committee members, growth in M2 and M3 fell
from their robust pace earlier in the year .45
From the May to the June meetings, the
strong expansion in economic activity continued.

43lbid.,

p. 543. As indicated in table 4, although the special
reference to “ sensitive” conditions in financial markets
was absent from the directive, conditions in financial
markets were first on the list of policy guides in the direc­
tive issued at the May meeting.
44lbid.
45Record (October 1988), p. 655. Annualized growth in M2
fell from 8.8 percent in April to 3.9 percent in May, and
annualized growth in M3 fell from 7.8 percent in April to
4.9 percent in May.

27

While unemployment rose to 5.6 percent in
May, it was still below its average in the first
quarter. Moreover, the industrial production in­
dex grew at a relatively fast pace of 6.4 percent
from April to May. The information reviewed
by the Committee indicated that the impetus to
the current expansion was continued growth in
both domestic and export demands. Improve­
ments in the external accounts, due mostly to a
decline in imports, was accompanied by a sharp
appreciation of the dollar.46 Furthermore, signs
of increased price pressures were clear. The
consumer price index was moving at a pace
close to the average in the first quarter, but
producer prices and average hourly earnings
were gaining momentum in May .47
Staff forecasts suggested that the growth in
economic activity would be moderated by sev­
eral factors, including the impact of the drought
on agricultural output and a more pronounced
slowdown in inventory investment than was
originally expected. In addition, recent pres­
sures on financial markets — particularly, the
rise in interest rates — could restrain future
growth in domestic spending. Because of fur­
ther improvements in the U.S. trade balance,
however, the expansion was expected to con­
tinue, though at a reduced pace.48
Concerned about the credibility of its goal to
achieve reasonable price stability, some mem­
bers suggested that maintaining the current
degree of restraint might create a signal of
easier monetary policy. Others felt that increas­
ed restraint might be excessive. In particular,
the effects of earlier actions to place greater
pressure on reserve positions had not yet fully
materialized in terms of the strength of busi­
ness expansion. Moreover, further restraint
would impose added pressure on an already
stronger dollar, supported by recent improve­
ments in the trade balance and expectations of
tight monetary policy, with adverse implications
for the needed improvement in external
balances.49
46lbid.,

pp. 654-55. Since the last meeting, the dollar had
appreciated 6 percent on a weighted average basis in rela­
tion to the other G-10 currencies.
47lbid.
48lbid., pp. 655-57.
49lbid., p. 660.
“ Ibid., pp. 660-61.
51Record (November 1988), p. 755. Revised annual growth
rates in M2 were 5.5 and 4.4 percent, respectively, for



A majority of the members voted for a slightly
increased degree of pressure on reserve posi­
tions, as indicated in table 3. Additional re­
straint or ease would depend on the forthcom­
ing indications of inflationary pressures,
business expansion, future developments in the
foreign exchange and domestic financial mar­
kets and the behavior of monetary aggregates.
The reserve conditions contemplated were ex­
pected to be consistent with annual growth
rates in M2 and M3 of 5.5 percent and 7 per­
cent, respectively, from June to September. The
monitoring range for the federal funds rate was
maintained at 5 to 9 percent.50

August 16 Meeting
Following the June meeting, as specified in
the June directive, more restrictive actions were
taken. In the first two weeks of July, average
adjustment plus seasonal borrowings surged to
$1.3 billion, reflecting a large increase in bor­
rowings over the long July 4 weekend and
other special circumstances. In the subsequent
four weeks, adjustment plus seasonal borrow ­
ings fell back to around the targeted level of
$600 million, and preliminary evidence indicated
that the growth of the broader monetary ag­
gregates, especially M2, fell in July.51
During the intermeeting period, incoming data
indicated a further expansion of economic ac­
tivity and additional inflationary pressures.
Preliminary evidence suggested that the in­
dustrial production index rose at an annual rate
of 13 percent from June to July. Moreover, the
capacity utilization rate for all industries in
June was estimated to be 85.1 percent, up from
the second quarter average of 82.9 percent.52
The seasonally adjusted producer price index
for finished goods had increased at an annual
rate of 6.9 percent from June to July. The
federal funds rate had risen recently from its
average rate in June — from around 7% per­
cent to 7 7/8 percent — and on August 9, the

June and July, and M3 grew at annual rates of 6.8 and
7.3 percent respectively for June and July.
52The estimate for the annual growth rate in the industrial
production index from June to July has been revised to 14
percent. Also, the estimated capacity utilization rate for
total industry during June has been revised to 83 percent.

MARCH/APRIL 1989

28

Board increased the discount rate from 6 per­
cent to 6.5 percent.53
By the August meeting, the expansion in
economic activity appeared to have strengthen­
ed, with indications of accelerating prices and
labor costs. Total nonfarm payroll employment
rose sharply in June and July, and the
unemployment rate in July was below the
second-quarter average. While the consumer
price index had not risen substantially, chiefly
because of declining oil prices, recent move­
ments in the producer price index were indica­
tive of accelerating prices. The dollar had risen
2.5 percent compared with the other G-10 cur­
rencies since the June meeting, reflecting fur­
ther improvement in the trade balance and the
recent tightening of reserve conditions.54
Other effects of the previous tightening were
starting to emerge. In particular, the expansion
of the monetary aggregates had exhibited a
marked deceleration in recent months, and in­
terest rates had risen 50 to 75 basis points since
the June meeting. The staff continued to expect
pressures in financial markets to restrain do­
mestic spending. Despite the appreciation of the
dollar, the staff expected continued improve­
ments in the nation’s trade balance to be the
driving force to further economic expansion.
The relatively high rates of capacity utilization
were perceived to point to increased infla­
tionary pressures .55
The members agreed that, given the recent
rise in the discount rate, it would be appropri­
ate to maintain the current degree of pressure
on reserve conditions. While many members
felt that further tightening of reserve conditions
might well be needed, others thought that
previous moves to tighten might prove to be
sufficient. Some members argued that increased
pressure could induce an excessive, upward
movement in the dollar and thereby inhibit fur­
ther improvement in the external balance. Some
also expressed concerns that an increase in in­

53By the August meeting, the federal funds rate was approx­
imately 8 1/8 percent. See Record (November 1988), p.
755.
54lbid., pp. 754-55.
55lbid., pp. 755-56.
56lbid., p. 757.
57lbid., pp. 758-59. An increase in the discount rate without
a change in the borrowings assumption is a restrictive
policy. To maintain the borrowings assumption with a
given increase in the discount rate that initially reduces

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FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

terest rates could have adverse effects on debt­
ors and troubled financial intermediaries.
Others pointed out that increased inflationary
pressures would have a similar effect by foster­
ing even higher nominal interest rates.56
As reported in table 3, the directive adopted
by the Committee called for maintaining the
current reserve conditions, although greater or
lesser restraint might be appropriate in the in­
termeeting period, depending on the behavior
of prices and economic indicators. The reserve
conditions contemplated by the Committee were
expected to be consistent with annual growth
rates of approximately 3.5 and 5.5 percent,
respectively, for M2 and M3 from June to Sep­
tember. In light of the recent increase in the
discount rate, the directive increased the federal
funds monitoring range to 6 to 10 percent.57

Septem ber 20 Meeting
Reserve conditions hardly changed in the in­
termeeting period. The federal funds rate aver­
aged about 8 1/8 percent over the period, close
to the level prevailing at the time of the August
meeting, and the growth of the monetary ag­
gregates continued to decline.58
Information available for review at the
September meeting suggested a slight modera­
tion in expansion of economic activity from the
intense pace earlier in the year. The moderation
was especially evident in labor markets; al­
though there were substantial gains in nonfarm
payroll employment in July and August, the
pace of growth had slowed, and the unemploy­
ment rate rose to 5.6 percent in August. Simi­
larly, capacity utilization rates remained
generally high, but rates in manufacturing
edged lower. Further, gains in industrial pro­
duction in August were much smaller than they
had been in previous months.59
Recent developments in domestic spending
also suggested that the pace of economic expan-

the level of borrowed reserves, the Federal Reserve must
remove nonborrowed reserves from the economy until the
federal funds rate increases enough to restore the level of
borrowed reserves back to its assumed level.
58Record (January 1989), p. 21. M2 grew at an annual rate
of 2.3 percent in August, while M3 grew at an annual rate
of 4.6 percent over the same period.
59lbid., p. 20 .

29

sion was slowing. Growth in sales of nondur­
able goods was sluggish and the level of sales of
durables had fallen in July and August. In addi­
tion, the U.S. merchandise trade deficit had
dropped substantially in July, primarily because
of a reduction in imports. The weakening of the
dollar earlier in the intermeeting period, at­
tributed to reports of soft employment condi­
tions, was virtually offset by the strengthening
of the dollar due to the trade reports .60
Despite evidence that economic growth was
slowing from its pace in the summer, price
pressures persisted. While the seasonally ad­
justed producer price index of finished goods
increased at an annual rate of 3.4 percent in
August, down from a 6.9 percent increase in Ju­
ly, the seasonally adjusted consumer price index
for all urban consumers increased at an annual
rate of 5.2 percent in July, up from 4.1 percent
in August and 4.2 percent in June. Increased
price pressures were perceived to be driven by
the substantial increases in food prices resulting
from the summer drought and increasing
gasoline prices.61
In their discussion of objectives for short-run
policy, the members took into account the re­
cent moderation in monetary growth. (Table 5
shows the deceleration in the expansion of M2
and M3 from June to September.) In the view
of at least some members, this moderation
would tend to restrain future domestic spend­
ing, thereby reinforcing the recent slowdown of
the economic expansion. Although some mem­
bers felt that previous actions to tighten might
prove to be sufficient to achieve expansion in
economic activity consist with reasonable price
stability, many remained concerned that the
risks of inflation might intensify:
Some favorable developments that had tended to
dampen inflation, such as declining oil prices and
a rising dollar, might well be reversed. More fun­
damentally, given current utilization rates of labor
and other production resources, the economy was
probably near the point where expansion at a rate
somewhat above the economy’s trend growth po­
tential could result in greater pressures on wages
and prices.62
Some members, pointing to recent movements
60lbid.,

pp.

20-21 .

61lbid.
62lbid.,

p. 22.
63lbid., p. 21 .
“ Ibid., p. 23.



in expectations of inflation as revealed in finan­
cial markets, especially for long-term debt, saw
a greater possibility that the economy might be
on a less-inflationary course .63
The Committee’s directive called for an un­
changed degree of pressure on reserve condi­
tions until more information, suggesting the
desirability of an alternative policy action, be­
came available. (See tables 3 and 4.) Those
believing that inflation could intensify were will­
ing to wait for additional evidence. The pre­
vious restrictive policy actions might have been
sufficient to avoid additional inflation. Further
tightening could have a disruptive impact on
financial markets and an unwanted effect on
the dollar that could hamper or even reverse
improvements in the U.S. external balances.
The Committee was prepared to take the
measures needed to carry out its anti-inflationary commitment. In particular, all members
agreed to adopt a
. . . directive that would more readily accom­
modate a move toward firming than an adjust­
ment toward easing in the weeks ahead. Some
commented that near-term developments were not
likely to call for a policy change in this period,
while others saw a greater likelihood that intermeeting developments would point to the desir­
ability of some firming. The potential need for
some easing was viewed as remote.64
The members expected that the contemplated
reserve conditions would be consistent with an­
nual growth rates of 3 percent and 5 percent,
respectively, for M2 and M3 over the period
from August to December. The monitoring
range for the federal funds rate was maintained
at 6 to 10 percent.65

N o v e m b e r 1 Meeting
Between the September and November meet­
ings, adjustments plus seasonal borrowings
averaged about $630 million, just above the bor­
rowings assumption, and the average federal
funds rate rose to about 8 Vi percent. Growth in
the monetary aggregates continued to fall in
September; preliminary data indicated that M2
growth had been particularly weak in October.66
65lbid.

66Record (February 1989), p. 67. Revised statistics indicate
that M2 grew at annual rates of 2.1 and 2.9 percent,
respectively, in September and October. The annualized
growth rate for M3 increased from 3.6 percent in
September to 5.4 percent in October.

MARCH/APRIL 1989

30

Reinforcing the evidence from the previous
meeting, the data available at the November
meeting revealed a moderation in the expansion
of economic activity. Although the civilian
unemployment rate fell to 5.4 percent in
September, third-quarter growth in total nonfarm payroll employment fell from its pace in
the first half of the year. Preliminary evidence
showed that industrial capacity utilization fell
slightly in September, but the rate was still
relatively high, and the pace of growth in in­
dustrial production slowed from its fast pace in
the summer months. Moreover, private domes­
tic final demand exhibited substantially slower
growth in the third quarter than it had in the
first half of the year .67

The Committee welcomed evidence of a
slowdown in economic growth; however, the
evidence did not mitigate its concern about the
risks of greater inflationary pressures in the
future. At the producer and consumer levels,
inflation had declined slightly in September
relative to August, because of falling energy
prices, and wage increases were modest. But,
the third-quarter average rates of growth in the
consumer and producer price indexes exceeded
their respective average growth rates for the
first half of 1988.68 Furthermore, the dollar had
depreciated significantly relative to the other
G-10 currencies since the August meeting.69

Forecasts by the staff suggested that "any
decline in inflation would be limited, largely
because of continuing pressures stemming from
still strong demands pressing against reduced
margins of unutilized labor and other produc­
tion resources.”70 The majority of the members
expected that the economic expansion would
continue at a more moderate pace in the com­
ing months "partly in light of the monetary
policy tightening that already had been imple­
mented this year .”71 Additional improvements in
67lbid.,

p. 66.
68lbid., pp. 66-67. For example, in the third quarter, annual
growth in the seasonally adjusted consumer price index
rose to 4.7 percent, up from 3.7 percent in the first quarter
and 4.5 percent in the second quarter.
69lbid., p. 67. Between August and October, the dollar had
depreciated 3.25 percent on a trade-weighted basis in rela­
tion to the other G-10 currencies.
70lbid., p. 68.
71Ibid.

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

the trade balance and increases in inventory in­
vestments were expected to contribute to con­
tinuing economic growth.
Despite the Committee’s concern about future
inflationary pressures, a majority of the mem­
bers believed that the “current relatively bal­
anced performance of the economy and the
uncertainties surrounding the outlook argued
for an unchanged policy at this point.”72 As
table 3 indicates, the directive called for main­
taining the current degree of pressure in
reserve positions. However, most of the mem­
bers believed that policy implementation should
continue to be especially alert to possible
economic developments that could warrant
some firming in the intermeeting period. Placing
additional or less pressure on reserve positions
might be acceptable depending on developments
in the intermeeting period. (See table 4.) Most of
the members anticipated that additional re­
straint would be warranted in the intermeeting
period .73 The reserve conditions contemplated
were expected to be consistent with annual
growth rates of 2 Vz percent and 6 percent,
respectively for M2 and M3 from September to
December .74

D ecem b er 13-14 Meeting
In the several weeks after the November
meeting, it became apparent that the relation
between borrowed reserves and the federal
funds rate had changed. The demand for bor­
rowed reserves seemed to shift back so that a
given level of borrow ed reserves was associated
with a higher federal funds rate. To accom­
modate the shift, the borrowings assumption
was reduced, thereby putting downward pres­
sure on the federal funds rate. Because incom­
ing information indicated that the strength of
economic expansion was greater than expected
and contained greater potential for inflation
than desired by the Committee, the accommoda­
tion was only partial; therefore, the adjusted
72lbid.,

p. 69.
p. 69-70. Such a “ bias” toward potential restraint
appears to have been partly driven by what the Committee
perceived as a “ continuing need to sustain the System’s
commitment to its long-run objective of controlling inflation,
including the desirability of making clear that the current
rate of inflation was unacceptable.” See Record (February
1989), p. 69.
74lbid., p. 70.
73lbid.,

31

borrowings assumption was expected to be con­
sistent with a slightly higher federal funds rate.
The average rate at which federal funds traded
over the intermeeting period rose from around
8 V4 percent to 8 V2 percent. In general, rates in
short-term credit markets and, to a lesser ex­
tent, those in long-term credit markets, rose
over the intermeeting period. Growth in the
broader monetary aggregates exceeded the
Committee's expectations.75

1989 would not be consistent with avoiding
higher inflation in the future because of the
already high rates of resource utilization:

The information reviewed at the December
meeting pointed to a rapid economic expansion,
once the effects of the drought were removed.
The strength of the expansion appeared greater
than what the Committee had perceived it to be
at the previous meeting. Although the unem­
ployment rate rose from 5.3 percent in October
to 5.4 percent in November, total nonfarm
payroll employment made large gains in those
two months. Preliminary evidence indicated that
the industrial production index rose sharply
over the intermeeting period and capacity
utilization rates for November were relatively
high by recent standards.76 Further, while
growth in overall consumer spending appeared
to moderate, total retail sales increased marked­
ly over the intermeeting period .77

The risks of greater inflation would be augmen­
ted if the dollar fell substantially from its cur­
rent level.

There was no clear evidence that the general
price level was accelerating. But the greaterthan-expected economic expansion, accompanied
by signs of accelerating labor costs as well as a
weakening of the dollar in foreign exchange
markets, increased the Committee’s concerns
about future inflation.78 Most members believed
that, without additional restrictive policy ac­
tions, potential growth in economic activity in
75lbid.,

p. 71, and Record (Federal Reserve Press Release,
February 10, 1989), p. 4. M2 grew at an annual rate of 6.9
percent and M3 grew at an annual rate of 6.6 percent in
November. At the December meeting, the Committee
reviewed the procedures for the implementation of
monetary policy, in light of the recent unusual behavior of
the relation between borrowings and the federal funds
rate. In the several weeks prior to the meeting, once the
fundamental change in that relationship had been iden­
tified, day-to-day policy actions were carried out with some
flexibility. Some members suggested that a move to place
more emphasis on the federal funds rate relative to the
degree of pressure on reserve positions might be ap­
propriate since the unusual behavior of the relationship be­
tween the federal funds rate and borrowing could con­
tinue. Because of the perceived advantages of the current­
ly used operating procedure, however, it was decided that
no changes in the procedures for policy implementation
would be made, although “ flexibility would remain impor­
tant in accomplishing Committee objectives under chang­
ing circumstances.” [Record (Federal Reserve Press
Release, February 10, 1989), pp. 15-16.]




. . . in the absence of a timely move to restraint,
greater inflation would become embedded in the
economy, especially in the labor-cost structure. A
new wage-price spiral would then be very difficult
to avoid and the critical task of bringing inflation
under control would be prolonged and much
more disruptive.79

Many members believed that, if the inflation
condition were allowed to worsen, rising inter­
est rates due to greater inflationary expectations
eventually could lead to a downturn in the
economy. Other members were more concerned
about the downside risks associated with addi­
tional restrictive actions:
In addition to job and output losses, a recession
could impede progress in bringing the federal
budget into balance and could have severe reper­
cussions on the viability of highly leveraged bor­
rowers and many depository institutions.80
In general, the members perceived that risks of
greater inflation in the future would pose a
greater threat to future growth in economic ac­
tivity than would a slightly more restrictive
policy.81
The uncertainties about the impact of further
monetary restraint generated some disagree­
ment among the members about the exact tim­
ing and degree of additional restraint. On the
one hand, a gradual restraining policy would

76Record (Federal Reserve Press Release February 10,
1989), pp. 1-2. The capacity utilization rates for the total
industry rose from 83.7 percent in September to 84.0 per­
cent and 84.1 percent, respectively, in October and
November. The industrial production index rose at an an­
nual rate of 7.2 percent in October and 4.4 percent in
November, up from 0.9 percent annual rate of growth in
September.
77lbid., pp. 2-3. Total retail sales rose at annual rates of 20.1
percent and 15.7 percent, respectively, in October and
November, after having declined at an annual rate of 2.6
percent in September.
78lbid., pp. 6-8 . Over the intermeeting period, the dollar’s
trade-weighted exchange index fell approximately 2.3
percent.
79lbid., p. 8 .
80lbid., p. 7.
81lbid., p. 10 .

MARCH/APRIL 1989

32

minimize the possible disruptive effects in dom­
estic and international financial markets; im­
mediate action could lead to an escalation of in­
terest rates in world markets, with especially
damaging consequences for less-developed debt­
or nations. Moreover, sharp tightening could im­
pose excessive restraint on the growth of the
monetary aggregates and, ultimately, on the
growth of economic activity. On the other hand,
it was thought that immediate tightening could
contain perceived increased price pressures and
inflationary expectations more effectively. With­
out some tightening, growth in M2 and M3
could accelerate.82
The directive called for an immediate slight
increase in the degree of pressure on reserve
conditions, as shown in table 3. Further tighten­
ing actions would be implemented at the begin­
ning of 1989 unless economic and financial con­
ditions were to deviate substantially from the
Committee’s expectations (see table 4). Given the
reserve conditions contemplated by the Commit­
tee, growth in M2 and M3 were expected to be
3 percent and 6 V2 percent, respectively, from
November 1988 to March 1989. Because of the
restrictive policy actions specified in the direc­
tive and those expected to be implemented in
the intermeeting period, the monitoring range
for the federal funds rate was raised to 7 to 11
percent.83

CONCLUSION
The Committee’s uncertainty about the econ­
omic outlook motivated it to adopt a more flexi­
ble strategy for the implementation of monetary
policy in 1988. This additional flexibility mani­
fested itself in long-run goals for money growth
and in short-run policy implementation. The
changing economic environment played an im­
portant role in the evolution of policy in 1988
in terms of the changing emphasis toward mon­
etary restraint.
At the beginning of the year, the Committee
believed that sharp fluctuations in money
market interest rates should be resisted. In ad­
dition, it was concerned that economic growth
82lbid.,

pp. 10-11. The members also discussed the implica­
tions for the tightening of reserve positions combined with
an increase in the discount rate. Despite the fact that a
rise in the discount rate could communicate the Commit­
tee’s commitment to fight inflation, an increase in the dis­
count rate was not seen as an appropriate policy action at
that time by most members. Like a sharp, immediate in­
crease in the degree of pressure on reserve positions, an


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FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

could slow substantially. Consequently, the Com­
mittee placed greater weight early in the year
on conditions in financial markets in the im­
plementation of policy, though the latter also
would continue to be guided by the behavior of
the monetary aggregates, price pressures and
other indications of economic activity. The addi­
tional flexibility permitted temporary departures
from reserve objectives to avoid unusual fluc­
tuations in money market interest rates.
As the year progressed, it became increasingly
apparent to the Committee that financial mar­
kets were sufficiently stabilized and that the
stock market collapse in the previous year
would not have a devastating effect on aggre­
gate economic activity. Accordingly, the Com­
mittee abandoned some of the additional flex­
ibility it had sought since October 1987, and
returned to its earlier practice of placing pri­
mary emphasis on reserve positions. At the
same time, incoming information heightened the
Committee’s concerns about future inflation.
Specifically, the strength of the economic expan­
sion was perceived to be incompatible with the
Committee’s long-term goal of reasonable price
stability. In response to the increased risks of
future price pressures, the Committee moved
toward a more restrictive monetary policy star­
ting in late March.
In the second half of the year, when the in­
creased risks of future price pressures came to
the forefront of the Committee’s concerns, the
uncertainty stemming from the dollar’s move­
ments and the impact of previously implemen­
ted restrictive monetary policy on the economy
were given increased emphasis in the Commit­
tee’s deliberations. As the dollar gained notable
strength against other major currencies in the
summer and there were some indications of a
moderating economic expansion, no changes in
the degree of pressure on reserve positions
were made. W hen the dollar started to decline
in foreign exchange markets, there was also in­
creasing evidence that the economic expansion
was more in line with the Committee’s goal of
price stability and again, no policy changes

increase in the discount rate could disrupt domestic and
international financial markets. Nevertheless, the Commit­
tee did not rule out the possibility during the intermeeting
period and agreed to call a special consultation in the
event that the Board of Governors agreed to increase the
discount rate (Ibid., p. 11.).
83lbid., pp. 13-15.

33

Hafer, R.W., and Joseph H. Haslag. “ The FOMC in 1987:
The Effects of a Falling Dollar and the Stock Market Col­
lapse,” this Review (March/April 1988), pp. 3-16.

were made. By the end of the year, when signs
of a rapid economic expansion re-emerged and
the dollar’s value started to fall in foreign ex­
change markets, the Committee responded
quickly by tightening monetary policy further.

Heller, H. Robert. “ Implementing Monetary Policy,” Federal
Reserve Bulletin (July 1988), pp. 419-29.

REFERENCES

Nuetzel, Philip A. “The FOMC in 1986: Flexible Policy for
Uncertain Times,” this Review (February 1987), pp. 15-29.

Gilbert, R. Alton. “ Operating Procedures for Conducting
Monetary Policy,” this Review (February 1985), pp. 13-21.
Greenspan, Alan. “ Statement to Congress,” Federal Reserve
Bulletin (September 1988), pp. 607-13.
Hafer, R.W. “The FOMC in 1985: Reacting to Declining M1
Velocity,” this Review (February 1986), pp. 5-21.




Stone, Courtenay C., and Daniel L. Thornton. “ Solving the
1980s’ Velocity Puzzle: A Progress Report,” this Review
(August/September 1987), pp. 5-23.
Thornton, Daniel L. “The Borrowed-Reserves Operating
Procedure: Theory and Evidence,” this Review
(January/February 1988), pp. 30-54.

MARCH/APRIL 1989

34

Gerald P. Dwyer, Jr. and R. W. Hafer

Gerald P. Dwyer, Jr., a professor of economics at Ciemson
University, is a visiting scholar and R. IV Hafer is a research
officer at the Federal Reserve Bank of St. Louis. Kevin L.
Kliesen provided reasearch assistance.

Interest Rates and Economic
Announcements

T

HE ANNOUNCEMENT of some government
statistic, like the latest unemployment rate or
the nation’s most recent trade balance, often is
used as the rationale for observed changes in
financial markets that day. One reporter, for ex­
ample, suggests that
[i]n the early 1980s, investors were overly con­
cerned with credit and monetary figures, focusing
on Federal Reserve data. These days, professionals
are preoccupied with inflation, the dollar and the
health of the economy.1
Another reporter points out the unsystematic
nature of such interpretations with the wry
comment that
[tlhe trade deficit doesn't matter as much any
more. At least, not to the stock market. At least
not this month.2
Do announcements of government statistics
systematically affect financial markets? There is
a substantial literature on the relationship be­
tween interest rates and stock prices and an­
nouncements of the money stock. Overall, this
evidence supports the conclusion that announce­
ments of the money stock had an important in­
fluence on interest rates in the early 1980s.3

'Wallace (1988).
2Sease (1989).
3This is less obvious for stock prices. As Thornton (1989)
has demonstrated, money announcements are not suffi


This influence arose when the Federal Reserve
first announced in October 1979 that it would
use the money stock as a target for monetary
policy, then largely disappeared in 1982 and
1983 when the Federal Reserve moved away
from monetary aggregate targeting .4
Existing studies of the relationship between
interest rates or stock prices and announce­
ments of other economic data find little
evidence that either is affected by these an­
nouncements. For example, Pearce and Roley
(1985) investigate the effect of unexpected
changes in inflation and real activity on stock
prices and find little response of stock prices.
Hardouvelis (1987) examines this relationship for
interest rates and stock prices and finds that
they are systematically affected only by an­
nouncements of the money stock.
One common aspect of these studies is that
they examine subperiods associated with
changes in monetary policy. Changes in policy
regimes provide an obvious basis on which to
expect changes in the effect of money stock an­
nouncements on financial markets. There is no
obvious reason, however, for changes in the ef-

ciently important for stock prices to be reliably associated
with changes in the money stock.
4See Gilbert (1985) and Thornton (1988) for a discussion of
the changes in operating procedures.

MARCH/APRIL 1989

35

fects of announcements of other economic data
to occur only when the Federal Reserve changes
operating procedures .5 It is quite possible that a
temporal association between interest rates or
stock prices and the announcement of a par­
ticular statistic is fleeting compared to estimates
based on multi-year sample periods of about
three years.
The purpose of this paper is to examine the
temporal response of short- and long-term in­
terest rates to announcements of certain key
government statistics. Unlike previous studies,
w e do not constrain the investigation by using
only time periods of alternative monetary policy
operating procedures. Rather, we attempt to
determine whether the different announce­
ments vary in importance over different time
periods, even as short as one year.

MONEY, INFLATION AND REAL
ACTIVITY
W e examine the relationship between changes
in interest rates and announcements using re­
gressions that can be written as
(1 ) ARt = a + /3Ut + £t ,
where ARt is the change in the interest rate in
period t, U, is a vector of the unexpected parts
of the announcements of some government
statistics, £t is the error term, and a and ft de­
note the set of parameters to be estimated. W e
focus on the unexpected parts of the announce­

5Using only these periods to look for changes in the effect
of announcements on financial markets becomes increas­
ingly implausible as the changes in operating procedures
become more distant in the past.
6The lack of generality of the proposition that asset prices
are affected only by the unexpected part of announce­
ments is made by, among others, LeRoy (1982), especially
pp. 205-08. It can, however, be justified as an approxima­
tion (Sims, 1984). The extension to interest rates, an in­
verse function of the price, can be justified as an
approximation.
7Some have found that the expected component of the
change in money also exerts a statistically significant ef­
fect on changes in interest rates. See, for example, Hein
(1985) and Belongia and Sheehan (1987). Several studies
have shown, however, that such results may stem from
certain anomalies in the data. For example, Belongia,
Hafer and Sheehan (1986) find that the significance of ex­
pected changes in money stems from one observation in
which a benchmark revision in the data coincided with a
so-called Social Security week. The removal of this obser­
vation reduces expected money’s coefficient to statistical
insignificance. Other researchers, for example, Clark, et al.
(1988), also have argued that the inclusion of Social

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ments because, when the change in the price of
an asset like Treasury securities or stocks is
measured over a short period, the change in the
asset’s price may be affected only by the unex­
pected part of the announcement.6 For the most
part, previous empirical analyses indicate that
changes in interest rates are systematically
associated only with the unexpected part of
weekly announcements of the money stock.7 In
addition to the money stock announcements, we
study the effects of announcements of inflation,
real economic activity and the trade balance.
W e examine the effects on both short- and
long-term interest rates. Under the expectations
hypothesis of the term structure, any differen­
tial response of interest rates reflects differen­
ces in the impact of the unexpected change in
economic variables on current and predicted
future short-term interest rates.8 If the expected
change in money, inflation, industrial produc­
tion, etc., is partly transitory, then the effect on
the current short-term rate will be larger than
on the long-term rate.9

Unexpected M o n ey
The evidence in previous studies clearly in­
dicates that the relationship between changes in
interest rates and the unexpected part of the
money announcement in the early 1980s is posi­
tive. There are three possible explanations for
this association: an "expected liquidity” effect;
an "expected inflation” effect; and a “real
economic activity” effect.10

Security weeks leads to the spurious result that expected
changes in money influence interest rate changes. For a
discussion of the effects of Social Security weeks on the
observed changes in money, see Hafer (1984).
8The evidence in Flavin (1984) and Campbell and Shiller
(1987), for example, indicates that the expectations
hypothesis accounts for much of the variation of long-term
interest rates relative to short-term rates.
9Under the expectations hypothesis of the term structure,
the change in the long-term interest rate is the sum of the
discounted change in expected future interest rates, a
term due to the return from holding the bond and terms
due to the expected short-term rates appearing in one but
not the other bond. See Flavin (1984), p. 231. If the coeffi­
cient relating the changes in expected interest rates to the
unexpected part of the announcement decreases with term
to maturity, then the usual algebra indicates that the
response will be less for long-term interest rates.
’ “Cornell (1983) and Sheehan (1985) discuss these explana­
tions and provide useful surveys of the evidence.

36

The expected liquidity effect is based on the
supposition that a larger forecast error is asso­
ciated with an expectation that the Federal
Reserve will engage in more contractionary
open market operations in the near future
relative to what they would have done other­
wise. As a result of the expected contractionary
open market operations, near-term interest
rates increase. The expectation of higher in­
terest rates in the near future, though, raises
current rates to maturity on securities that ma­
ture after the expected contractionary open
market operations.11 An unexpected increase in
the money stock is thus associated with an in­
crease in interest rates.
An alternative explanation can be cast in
terms of expected inflation. Under this explana­
tion, an unexpected increase in money leads
economic agents to revise their expectations of
future inflation upward. Because nominal inter­
est rates are the sum of the real interest rate
and the expected inflation rate, an unexpected
increase in expected inflation, ceteris paribus,
leads to an increase in nominal interest rates.
The real economic activity effect predicts that
interest rates will respond positively to an unex­
pected money increase. According to this ex­
planation, the money announcement reveals in­
formation about money demand in the econ­
omy. If the announced stock of money depends
on the demand for money, an announced
money stock greater than expected indicates
that money demand is greater than expected. If
the demand for money depends, among other
things, on expectations of future real economic
activity, an unexpected increase in the money
stock reflects an increase in expected real activi­
ty.12 Because economic activity and real interest
rates are positively correlated, an unexpected
increase in the money stock is associated with
an increase in real and nominal interest rates.

Unexpected Inflation
Whether announcements of inflation are
related to changes in interest rates due to an ef­
fect on expected monetary policy or expected
inflation, an announcement that inflation is
greater than expected can result in an increase
in interest rates. If an announcement of infla-

"T he current one-day rate also can increase because of in­
tertemporal substitution.
12See Fama (1982).



tion greater than expected for the recent period
increases expected future inflation, there is a
direct effect on the nominal interest rate. On
the other hand, with a goal of lower inflation,
the Federal Reserve may be expected to offset
the higher inflation (or the perception of higher
future inflation) by a more restrictive monetary
policy. In either case, an unexpected increase in
inflation increases nominal interest rates. As for
the money stock, the relative effect on short­
term and long-term rates reflects how perma­
nent the change in inflation is expected to be.
The more transitory it is, the smaller the
relative effect on long-term rates.

Real Activity
An unexpected increase in real activity raises
nominal interest rates through two channels.
One is from agents’ revised expectations that
future real activity will be higher, thus causing
expected real interest rates and, hence, nominal
rates to increase. The other is from the ex­
pected reaction of the Federal Reserve. If
economic agents expect the Fed to tighten
monetary policy on news of stronger future
economic growth, then interest rates can in­
crease because of the expected liquidity effect.

Trade Balance
The trade balance is exports minus imports.
W hen exports are less than imports, the trade
balance is negative, a situation that character­
izes most of the 1980s. An announcement of a
larger-than-expected trade balance can increase
or decrease nominal interest rates. A larger
trade balance today is associated with larger
trade balances in the future.13 Even with this
qualification, however, the effect of announce­
ments of trade balances on interest rates is am­
biguous. Because the trade balance is the nega­
tive of the capital account, a larger trade bal­
ance is associated with a smaller balance on
capital account. A larger trade balance and a
smaller balance on the capital account can be
associated with either a decrease in the supply
of foreign funds to the United States or a
decrease in the demand for funds in the United
States. A decrease in the supply of funds would
be associated with an increase in interest rates

13There is evidence of positive autocorrelation in the data.
Over the sample period used in this paper, the first six
values of the autocorrelation function are 0.85, 0.85, 0.83,
0.80, 0.76 and 0.75.

MARCH/APRIL 1989

37

in the United States.14 A decrease in demand
would be associated with a decrease in interest
rates in the United States. Given these two
possibilities and no ancillary evidence to support
either, the hypothesized effect on nominal inter­
est rates of an unexpected increase in the trade
deficit is uncertain.

THE DATA
Daily interest rates on three-month Treasury
bills and 30-year Treasury bonds are used in
our empirical analysis. These rates are closing
quotes supplied by the New York Federal
Reserve, calculated as averages of rates re­
ported by primary government security dealers
between 3:15 p.m. and 4:00 p.m. Eastern Stan­
dard Time. The changes in rates are measured
as the difference between the interest rate from
one day’s close to the next.15
To estimate the unexpected part of the an­
nounced values of the economic series, we use
the initial announced values of the series minus
the median response from the survey conducted
by MMS International.16 This widely used sur­
vey polls approximately 50 to 60 government
securities dealers weekly, asking them to indi­
cate their expectation of the change in the nar­
row money stock (M l). At most a week before
an announcement of several other economic
series, the survey participants also are asked to
indicate their forecasts of the change in other
series, such as the Consumer Price Index.
In this study, we use the survey forecasts for
M l, the Consumer Price Index (CPI), the Pro­
ducer Price Index (PPI), the industrial produc­
tion index, the unemployment rate and the
trade balance. Because the survey forecasts of
the price indexes and industrial production are

14We assume that the United States is not small relative to
the rest of the world.
15The three-month Treasury bill rate is measured using the
standard discount interest rate formula. The bond rate is
the yield to maturity.
16MMS International and Douglas K. Pearce provided
several of the series examined here. Actual changes in the
series are taken from relevant government and Federal
Reserve publications.
17The F-statistic for testing the hypothesis that the variance
of the change in the Treasury bill rate is the same on days
with these announcements and days without these an­
nouncements is 1.86 with 679 and 1292 degrees of
freedom, which has a marginal significance level of less
than 0.001. The F-statistic for testing this hypothesis using
the variance of the change in the Treasury bond rate is
1.43, also with 679 and 1292 degrees of freedom and a
marginal significance level less than 0.001.

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all measured in terms of monthly percentage
changes, the unexpected part of the announced
values also are measured as a monthly percen­
tage change. The actual and the forecasted un­
employment rates are both measured as percen­
tages of the number of unemployed relative to
the labor force. The forecasts of M l and the
trade balance are stated in terms of their dollar
values. W e measure the unexpected part of
these variables as the percentage difference be­
tween actual and forecasted values relative to
the actual values.
Although other economic variables obviously
might be included in this analysis, the series us­
ed in this study represent a broad range of
economic activity, reflecting changes in infla­
tion, real activity and foreign trade. Moreover,
the variances of changes in the Treasury bill
rate and the Treasury bond rate are greater on
the days with these announcements than on
other days.17
To abstract from the effects of intervening an­
nouncements, w e include in our regressions
changes in interest rates only for those days on
which these announcements occur. Since past
intervening announcements are prior informa­
tion and, under rational expectations, are uncor­
related with the current unexpected change,
this restriction does not bias our analysis. A
future unexpected change in a variable will be
currently unknown and, under rational expecta­
tions, also would be uncorrelated with the cur­
rent unexpected change.18
Means and standard deviations of the unex­
pected changes in M l, the price indexes, in­
dustrial production, the unemployment rate and
the trade balance are presented in table l . 19

18This and the prior statement assume that the forecasts are
essentially the same as rational expectations. It is, of
course, true that our estimated coefficients can be affected
by other events on the same day that are correlated with
excluded variables.
19There are 95 months used in table 1. There are only 94
observations for the unexpected change in the CPI,
because the survey value is missing for the announcement
in January 1986. There are 94 observations on the unex­
pected change in unemployment, because the Treasury
bill rate is not available for April 5, 1985, when the
unemployment rate was announced. Therefore, we do not
use this observation. Finally, 93 observations are used for
the trade balance, because only 11 values were announc­
ed in 1987: and two values were announced on the same
day in April 1987. We use just the announcement for the
more recent month, March.

38

used to estimate the unexpected parts of the
series being announced.20

Table 1
Descriptive Statistics on
Measures of the Unexpected Part
of Announcements (February 1980 to
December 1987)_________________
Variable
Narrow money
stock
Consumer
price index
Producer
price index
Unemployment
rate
Industrial
production
Trade balance

Mean

Standard
deviation

0.06%

.46%

Number of
observations
376

-0.01

.20

94

-0.10

.34

95

0.01

.21

94

-0 .0 3
-13.18

.39
98.23

95
93

Given the numerical precision of the data and
the size of the associated standard errors, all
but one of the mean forecast errors (our
measures of the unexpected components of the
announcements) are not different from zero.
For example, the unemployment rate is an­
nounced as a percentage, say, 5.4 percentage
points and is forecasted to this same level of
numerical precision. A mean of 0.01 is zero
within the precision of the data. Only one of
the six series, the producer price index, has a
mean value that is significantly different, both
numerically and statistically, from zero at the 5
percent marginal significance level. This cursory
analysis of the data along with other work in­
dicates that these survey data are useful ap­
proximations of rational expectations and can be

20For other analyses of this data, see, among others, Pearce
and Roley (1985).
21For example, the forecast errors for the CPI measure of
the inflation rate range in increments of 0.1 from -0.6 to
0.5. The modal error is zero, and the forecast errors are
dispersed around this value, not (as would be possible) vir­
tually always .1 or .2 in absolute value. Similar comments
apply to the PPI and the industrial production index. The
forecast errors of the unemployment rate, also measured
to a precision of 0.1 percentage points, range from -0.5 to
0.7 by increments of 0.1.
22As noted above, previous researchers generally delineate
sample periods by changes in monetary policy operating
procedures. These include the October 6, 1979, shift away



An issue that generally is not dealt with when
using these data is the fact that the measure­
ment of the expected and actual changes in
some of the variables is only in increments of
0.1. That is, forecasts and actual values for the
CPI, the PPI and the industrial production index
are all collected as monthly percentage changes
with only one digit after the decimal point. Be­
cause there is a relatively small range of fore­
cast errors at this level of precision, there are a
limited number of values that the forecast er­
rors actually take. Even so, the information in
table 1 indicates that there is sufficient variation
to estimate a meaningful relationship between
these data and changes in interest rates.21

EMPIRICAL RESULTS
The period used in our analysis runs from
February 1980 through December 1987. The
beginning of the period is dictated by the lack
of survey forecasts of the trade balance prior to
that time. The end of the period is dictated by
data availability. The vector of observations for
each right-hand-side variable includes zeros for
those days when a series is not announced.

Regressions b y Year
Previous analyses generally estimate equation
1 over all of the available data and for periods
corresponding to changes in the Federal Re­
serve’s operating procedures.22 Because w e are
concerned with the pattern of the coefficient
estimates on money and other variables over
time, w e ignore these particular periods and
estimate equation 1 for the full period and for
each year. Because w e have no a p rio ri informa­
tion that dictates the correct periods, this ap­
proach allows us to gauge the effects of the

from emphasizing the behavior of the federal funds rate
and placing more importance on the behavior of the
monetary aggregates and the October 1982 shift back to
interest rates. While statistical tests generally do not reject
the use of these breakpoints, it has been questioned
whether the procedures used are adequate to reject the a
priori break point being tested. That is, if October 6, 1979,
is not the true breakpoint in the relationship but another
relatively close date is, the test procedures used will not
reject October 6 as the break. Indeed, evidence presented
in Hafer and Sheehan (1989), based on time-varying
parameter estimates, indicates that the often-used October
1979 and October 1982 sample breaks are not consistent
with the data.

MARCH/APRIL 1989

39

Table 2
Change in Treasury Bill Rate and Unexpected Part of Announcements
Period

Constant

UM11

UCPI

UPPI

UU

UIP

UTB2

R2/OW

1980-87

0.007
(0.86)
0.016
(0.43)
0.022
(0.66)
-0.009
(0.34)
0.001
(0.15)
0.008
(0.67)
0.004
(0.40)
-0.006
(0.95)
0.034
(2.12)*

0.183
(7.70)*
0.284
(3.80)*
0.351
(4.25)*
0.227
(2.75)*
0.154
(5.48)*
0.036
(0.89)
0.031
(0.64)
-0.049
(1.59)
0.004
(0.11)

0.066
(0.58)
0.129
(0.31)
0.155
(0.47)
0.019
(0.06)
-0.105
(0.87)
-0.011
(0.05)
-0.010
(0.03)
0.065
(0.48)
0.083
(0.42)

0.082
(1.30)
0.248
(1.10)
0.602
(1.24)
-0.187
(0.66)
0.033
(0.54)
0.027
(0.29)
0.064
(0.75)
-0.038
(1.16)
0.115
(0.75)

-0.164
(1.53)
-0.418
(1.07)
-0.543
(1.10)
0.112
(0.31)
-0.250
(2.07)*
0.072
(0.51)
-0.059
(0.27)
-0.107
(1.61)
0.050
(0.21)

0.019
(0.33)
0.112
(0.56)
0.058
(0.22)
-0.060
(0.50)
0.043
(0.74)
0.080
(0.94)
0.512
(3.76)*
0.173
(2.69)*
-0.106
(0.63)

-0.009
(0.38)
-0.379
(1.45)
-0.018
(0.36)
0.016
(0.39)
-0.052
(0.44)
-0.129
(1.00)
-0.111
(0.57)
-0.027
(0.29)
-0.039
(0.13)

0.08
2.01
0.14
1.73
0.14
2.02
0.02
2.46
0.24
1.92
-0 .04
1.99
0.13
2.13
0.06
2.02
-0 .08
2.16

1980
1981
1982
1983
1984
1985
1986
1987

NOTE: Absolute value of t-statistics in parentheses. An asterisk denotes significance at 5 percent marginal significance level.
R2 is the adjusted coefficient of determination, and DW is the Durbin-Watson test statistic.
’ Each of the right-hand-side variables is the unexpected part of the announcement of a variable. The variables: M1 is the
money stock; CPI is the Consumer Price Index; PPI is the Producer Price Index; U is the civilian unemployment rate;
IP is industrial production; and TB is the trade balance.
2Reported coefficients are estimated coefficients times 100.
unexpected parts in the announcements over
time. While the choice of a year is admittedly
arbitrary, it is long enough that some precision
in the regression coefficients is possible but
short enough that it is unlikely to miss an esti­
mable transitory change in the coefficients.23
The regression results are reported in table 2
for the change in the Treasury bill rate.24 Based
on a 5 percent marginal significance level, only
unexpected money (UM1) has a statistically sig­
nificant coefficient in the full-period regressions.
This result does not mean, however, that other
economic variables do not influence Treasury
bill rate changes during the period. On the con­
trary, the annual regression results indicate that

23lt is possible, of course, that the estimated coefficients
change with each announcement. Without the imposition
of constraints on the way that the coefficients change,
however, such a specification is not estimable. Our regres­
sion coefficients can be interpreted as estimates of the
average coefficient in a given year.

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unexpected unemployment (UU) is marginally
statistically significant at the 5 percent level for
1983. It also appears that unexpected changes in
the industrial production index (UIP) are associ­
ated with increases in the short-term interest
rate in 1985 and 1986. In none of the annual
regressions, however, do unexpected changes in
the Consumer Price Index (UCPI), the Producer
Price Index (UPPI) or the trade balance (UTB)
have statistically significant coefficients.
The regressions using the change in the 30year Treasury bond rate are presented in table
3. The regression for the full period again has a
statistically significant estimated coefficient for
the unexpected part of M l. The magnitude of

24Again note that the estimation uses only unexpected
changes in the variables. Since correlations between the
expected and unexpected values reveal that the two series
are uncorrelated, omitting the expected values does not
bias the estimated regression coefficients.

40

Table 3
Change in 30-year Treasury Bond Rate and Unexpected Part of Announcements
Period

Constant

UM1

UCPI

UPPI

uu

UIP

UTB1

R2/DW

1980-87

0.003
(0.68)
- 0.004
(0.27)
0.023
(1.26)
-0.001
(0.09)
-0.001
(0.08)
-0.004
(0.34)
0.003
(0.23)
-0.001
(0.07)
0.014
(1.29)

0.074
(5.54)*
0.149
(4.57)*
0.105
(2.30)*
0.049
(1.14)
0.114
(4.32)*
0.036
(0.93)
0.015
(0.30)
-0.011
(0.25)
-0.012
(0.49)

0.092
(1.46)
0.120
(0.65)
0.152
(0.84)
0.110
(0.67)
-0.101
(0.89)
0.199
(1.03)
-0.008
(0.02)
0.137
(0.70)
0.015
(0.11)

0.088
(2.48)*
0.226
(2.29)*
0.315
(1.18)
0.002
(0.01)
0.055
(0.97)
0.079
(0.87)
0.076
(0.86)
-0.019
(0.40)
0.148
(1.43)

-0.052
(0.87)
0.016
(0.10)
-0.208
(0.76)
-0.071
(0.38)
-0.171
(1.50)
-0.113
(0.83)
-0.064
(0.29)
0.035
(0.37)
0.141
(0.89)

0.027
(0.87)
0.163
(1.87)
0.114
(0.79)
-0.016
(0.26)
0.018
(0.33)
-0.056
(0.69)
0.151
(1.08)
0.116
(1.25)
-0.223
(1.96)*

-0.009
(0.74)
-0.180
(1.58)
0.001
(0.04)
-0.011
(0.51)
-0.185
(1.64)
-0.076
(0.62)
-0.118
(0.59)
0.095
(0.72)
0.381
(1.91)

0.05
2.23
0.24
2.06
0.03
2.32
-0.04
2.59
0.17
2.15
-0.0 2
2.00
-0.0 5
2.12
-0.04
2.15
0.07
1.85

1980
1981
1982
1983
1984
1985
1986
1987

NOTE: Absolute value of t-statistics in parentheses. An asterisk denotes significance at 5 percent marginal significance level.
'Reported coefficients are estimated coefficients times 100.
the estimated coefficient is less than one-half
that of the short-term Treasury bill rate, a re­
sult that is consistent with previous work.25 In
addition to money announcements, the fullperiod regression suggests that unexpected
changes in the PPI have a positive and statistic­
ally significant effect on the change in the
Treasury bond rate.

often is negative, it is positive for 1987. For the
other years, the estimation results are consis­
tent with the proposition that unexpected parts
of announcements of variables besides money
have little effect on the change in the 30-year
rate.

Except for 1980, however, the separate annual
results provide little evidence that the unex­
pected changes in these economic variables
have much effect on changes in the long-term
interest rate. In the results for 1980, unexpec­
ted money and inflation measured by the PPI
are statistically significant at the 5 percent level.
The coefficient on industrial production is signi­
ficant at the 5 percent level in 1987. Note, how­
ever, that the sign of this estimated coefficient
(negative) is incorrect. The estimated coefficient
for the unexpected part of the trade balance is
significant at the 6 percent marginal significance
level in 1987. Interestingly, while the coefficient

Stability Tests
An important aspect of the regression results
in tables 2 and 3 is the variability in the estim­
ated coefficients over time. For example, con­
sider the magnitude of the estimated coeffici­
ents on unexpected money from 1980 to 1987
in table 2. Based on the annual regression re­
sults, the estimated coefficient peaks at 0.35 in
1981 and declines to essentially zero in 1987.
This result is consistent with the hypothesis that
unexpected changes in the money stock are
associated with changes in interest rates early
in the period but not recently.

25For example, see Cornell (1983).



MARCH/APRIL 1989

41

To investigate whether the estimated coeffi­
cients from the various years are statistically
different, two tests are conducted. One test
determines whether the coefficients for each
variable change over time. W e test whether
each variable’s coefficients are equal from 1980
to 1987. The results of these tests, regardless of
the interest rate used, are consistent with the
hypothesis that only the coefficients on unex­
pected money vary across years. The F-statistic
for unexpected money when the change in the
Treasury bill rate is used is 4.46. The result us­
ing the Treasury bond rate is an F-statistic of
2.68. Both are statistically significant at less than
the 1 percent marginal significance level.26 The
F-statistics for the remaining variables are in­
significant: they almost never even exceed
unity.27
While this test has reasonable power against
the alternative hypothesis that the coefficients
are nonzero and change over several of the
years, it generally has low power against the
alternative that a variable has a nonzero coeffi­
cient for a relatively short period such as one
year. Consequently, testing the coefficients over
single years is a useful additional test.
Testing the hypothesis that a coefficient in
any single year is the same as in the remainder
of the years provides at most marginal evidence
of coefficient instability across the period.28 Us­
ing a 5 percent marginal significance level, tests
using the Treasury bill regressions indicate that
the coefficient on the unexpected part of the
trade balance in 1980 is statistically different
from the coefficients in the rest of the period:
the estimated t-statistic is -2.33.29 With the ex­
ception of unexpected money, each of the other

26The results from a standard F-test are consistent with the
null hypothesis of overall coefficient stability. In this test,
each variable including the constant is allowed to take dif­
ferent values for each year. This unrestricted equation is
compared with the equation where all estimates are fixed
for the full period. The calculated F-statistic for changes in
the Treasury bill rate is 1.24. When the change in the
Treasury bond rate is used, the F-statistic is 1.06. Both of
these values are less than the 5 percent critical value.
Such a test, however, may mask changes in one or two
variables' coefficients. Given the number of variables and
time periods, changes in the estimated coefficient for
some variable can be swamped by the stability of the
others.
27Using the change in the Treasury bill rate, the variables
and corresponding F-statistic are: CPI (0.08); PPI (0.95);
unemployment (0.64); industrial production (0.61); and
trade balance (0.85). Using the change in the Treasury
bond rate, the F-statistics are: CPI (0.25); PPI (1.08);
unemployment (0.36); industrial production (1.24); and
trade balance (0.98).

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coefficients for the Treasury bill rate is equal
over time. Besides unexpected money, only the
unexpected part of the industrial production in­
dex in 1980 has a coefficient for the Treasury
bond rate that is statistically different from the
remaining years (t = 2.30).
These test results are largely consistent with
the hypothesis that the response of interest
rates to unexpected changes in the variables
other than money are constant and equal to
zero.

Rolling Regression Estimates
Breaking the eight years into annual segments
to estimate the changes in the coefficients over
time may obscure changes that occur during
the years. To investigate the evolution of the es­
timated coefficients, it is worthwhile to examine
the coefficients in a relatively unrestricted man­
ner. This can be done by estimating regressions
that roll through the sample. Equation 1 is esti­
mated for successive 12-month periods, adding a
month and dropping a month as the estimation
of the regression coefficients rolls through the
full period.30 The first 12-month period begins
in February 1980 and ends in January 1981; the
last sample ends with December 1987. While us­
ing a 12-month period for the rolling regres­
sions still has an arbitrary element, the
estimated coefficients for any 12-month period
are readily available and can be examined.31
To show how the estimated coefficients have
evolved over the period, the estimated coeffi­
cients for both the Treasury bill and Treasury
bond rates are plotted in figure 1. In interpret­
ing these plots, it is important to note that, be-

28This test is first run with the coefficients of all other
variables allowed to be different, then with the coefficients
of all the other variables besides money set equal for all of
the years. In the text, we report the results with the coeffi­
cients of other variables besides money set equal to each
other for all of the years. The results with other coeffi­
cients allowed to vary are little different than those
discussed.
29Given the multiple tests across variables and years, there
are good reasons to use a smaller significance level. If
one desires an overall 5 percent significance level for all
the tests combined, the correct significance level for
testing the stability of the coefficients for each year and
each variable is about one-tenth of 1 percent.
30Loeys (1985) examines the effects of unexpected money
on interest rates in a similar manner.
31We also estimated the rolling regressions using successive
18-month periods. There are only minor changes in the
results.

42

Figure 1
Panel A
The Coefficients of the Unexpected Component of
M1 for the 3-Month Treasury Bill

The Coefficients of the Unexpected Component of
M1 for the 30-Year Treasury Bond

_

Panel B
The Coefficients of the Unexpected Component of
CPI for the 3-Month Treasury Bill

The Coefficients of the Unexpected Component of
CPI for the 30-Year Treasury Bond

Panel C
The Coefficients of the Unexpected Component of
PPI for the 3-Month Treasury Bill

The Coefficients of the Unexpected Component of
PPI for the 30-Year Treasury Bond

NOTE: A dashed line indicates significance at the 5 percent level.



MARCH/APRIL 1989

43

Panel D
The Coefficients of the Unexpected Component of
The Unemployment Rate for the Treasury Bill

The Coefficients of the Unexpected Component of
The Unemployment Rate for the Treasury Bond

------------------------------------------------------------------.4 >----------- .----- |

4

........... I ________I__________I__________1__________I__________I______
1981
82
83
84
85
86
1987

Panel E
The Coefficients of the Unexpected Component of
Industrial Production for the 3-Month Treasury Bill

The Coefficients of the Unexpected Component of
Industrial Production for the 30-Year Treasury Bond

-

Panel F
The Coefficients of the Unexpected Component of
The Trade Balance for the 3-Month Treasury Bill


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The Coefficients of the Unexpected Component of
the Trade Balance for the 30-Year Treasury Bond

44

cause common observations in regressions are
separated by less than 12 months, the estimated
regression coefficients within a 12-month period
are not independent. This implies that some
smoothness in the plotted variation of the coef­
ficient estimates is to be expected even if all
estimated coefficients are zero and any varia­
tion is random.
In addition, the coefficient estimates for the
two interest rates are not statistically indepen­
dent. The simple correlation of the change in
the bill rate and the bond rate is 0.658 for 1980
through 1987 on days with announcements, a
correlation that is statistically significant at the
5 percent level. This means that, if the
estimated coefficient of industrial production,
for instance, increases in the regression for the
bill rate, the estimated coefficient of industrial
production in the regression for the bond rate
is likely to increase as well, even if the increase
is due to random variation. Despite these
caveats, these estimates are useful because they
make it possible to examine the inter-year
changes in the estimates for all possible dates.
Panel a of figure 1 shows the estimated coeffi­
cients on unexpected changes in M l.32 The esti­
mated coefficients in the regression for the bill
rate and the bond rate track each other with a
larger estimated coefficient for the bill rate until
1984, when the estimated coefficients converge
to zero. Finding that the effect of unexpected
money on changes in the interest rate becomes
smaller after the shift in the Federal Reserve’s
operating procedure in late 1982 is consistent
with previous work.33
Panels b and c show the estimated coefficients
of unexpected increases in the inflation rate as
measured by the CPI and the PPI. In the regres­
sions for the Treasury bill rate, not one esti­
mated coefficient is statistically significant for
any 12-month period using a 5 percent marginal
significance level. In the regressions for the
Treasury bond rate, only estimated coefficients
for the PPI in nine months in 1981 and three
months in 1984 are statistically significant using
a standard 5 percent marginal significance level.
There is no evidence that the unexpected part
of announcements of the CPI affect interest
rates for any period as long as 12 months from
1980 to 1987. One interpretation consistent with
these regression results is that there is some

32Dashed lines denote statistical significance at standard 5
percent marginal significance level.



evidence of a relationship between the unex­
pected part of inflation as measured by the Pro­
ducer Price Index in 1980, but little afterwards.
Such an interpretation requires that the point
estimates of the regression coefficients be view­
ed as indications that the unexpected parts of
the announcements had stronger implications
for inflation over a period longer than the
three-month maturity of the Treasury bill rate.
Real activity is represented by the unemploy­
ment rate (an inverse indicator) and industrial
production. The estimated coefficients of the
unemployment rate are presented in panel d. In
the regressions for the Treasury bill rate, the
coefficient of the unemployment rate is negative
and statistically significant at the 5 percent
marginal significance level during late 1983 and
early 1984. While the estimated coefficient for
the bond rate is not statistically significant dur­
ing this period, the negative and smaller (in
magnitude) coefficient is consistent with the
hypothesis that the unexpected part of an­
nouncements of the unemployment rate affect
interest rates in this period. The estimated coef­
ficients for industrial production (panel e) also
provides some evidence consistent with the
hypothesis that announcements of it have af­
fected interest rates. In particular, from
mid-1985 through much of 1986, the Treasury
bill and bond rates both have sharply increasing
estimated coefficients on unexpected increases
in industrial production. For the Treasury bill
rate equations, these coefficients are significant
at the 5 percent level. The positive sign is con­
sistent with a rationalization in terms of
monetary policy, with higher growth being
followed by expectations of relatively contrac­
tionary monetary policy, and in terms of ex­
pected higher future growth signaling higher
real interest rates.
Finally, the estimated coefficients for the trade
balance, shown in panel f, never provide much
support for a systematic relationship except per­
haps at the start of the sample. Not one of the
168 estimated coefficients in the regressions for
the bill and bond rates is statistically significant
using a 5 percent marginal significance level.

CONCLUSION
How do financial markets respond to the
unexpected part of announcements of govern-

33See, for example, Hardouvelis (1987) and Hafer and
Sheehan (1989).
MARCH/APRIL 1989

45

ment statistics? Based on the evidence presented
in this article, the answer is, very little. Using
regression analysis, statistical tests of coefficient
stability and rolling regressions to detect coeffi­
cient variability from 1980 to 1987, we find that
only the unexpected changes in the money
stock have a systematic effect on interest rates.
Even then, it appears that the significant effects
peter out by late 1982.
For none of the other variables examined do
w e find evidence of a reliable effect on interest
rates over the period. This set of variables in­
cludes measures of inflation, real economic acti­
vity and foreign trade. Failing to find any sys­
tematic relationship between interest rate
changes and these non-monetary variables has
two implications. One is that explanations of the
response of interest rates to monetary an­
nouncements that emphasize changes in econ­
omic agents’ expectations of future inflation and
real economic activity may be off the mark for
1980 through 1982. If these explanations were
correct, such effects should be evident when in­
flation and real variables themselves are used.
Our results, however, reveal little effect from
the unemployment rate or industrial production.
Theories that are premised on the response of
interest rates to expected changes in monetary
policy are more consistent with our empirical
results.
The other implication concerns the effect on
interest rates perceived by financial market
analysts when government statistics are an­
nounced. W e find no consistent response of in­
terest rates, either short term or long term, to
unexpected changes in the different non-mone­
tary variables. W e do find evidence consistent
with the hypothesis that the unexpected parts
of announcements of the Producer Price Index
in 1980, the unemployment rate in 1983 and in­
dustrial production in 1980, 1985 and 1986 are
associated with changes in interest rates. The
relative infrequency of these significant effects
can be interpreted in one of two ways. The
first is that, of the 80 estimated annual coeffi­
cients, it is hardly surprising that five are
statistically significant at the 5 percent marginal
significance level. A conclusion that all of the
coefficients are zero is therefore consistent with
the results. The second is that, except for an­
nouncements of the money stock in the early
1980s, responses of interest rates to an­
nouncements are episodic, short-lived affairs.


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REFERENCES
Belongia, Michael T., R. W. Hafer, and Richard G. Sheehan.
“ On the Temporal Stability of the Interest Rate-Weekly
Money Relationship,” Review of Economics and Statistics
(August 1988), pp. 516-20.
_______ . “A Note on the Temporal Stability of the In­
terest Rate-Weekly Money Relationship,” Working Paper
86-002, Federal Reserve Bank of St. Louis (1986).
Belongia, Michael T., and Richard G. Sheehan. “ The Infor­
mational Efficiency of Weekly Money Announcements: An
Econometric Critique,” Journal of Business and Economic
Statistics (July 1987), pp. 351-56.
Campbell, John Y., and Robert J. Shiller. “ Cointegration and
Tests of Present Value Models,” Journal of Political
Economy (October 1987), pp. 1062-88.
Clark, Truman A., Douglas H. Joines, and G. Michael
Phillips. “ Social Security Payments, Money Supply An­
nouncements, and Interest Rates,” Journal of Monetary
Economics (September 1988), pp. 257-78.
Cornell, Bradford. “ The Money Supply Announcements Puz­
zle: Review and Interpretation,” American Economic Review
(September 1983), pp. 644-57.
Fama, Eugene F. “ Inflation, Output, and Money,” Journal of
Business (April 1982), pp. 201-32.
Flavin, Marjorie. “ Time Series Evidence on the Expectations
Hypothesis of the Term Structure,” in Karl Brunner and
Allan H. Meltzer, eds., Monetary and Fiscal Policies and
Their Applications, Carnegie-Rochester Conference Series
on Public Policy, Volume 20 (Amsterdam: North-Holland,
1984).
Gilbert, R. Alton, “ Operating Procedures for Conducting
Monetary Policy,” this Review (February 1985), pp. 13-21.
Hafer, R. W. “ Comparing Time-Series and Survey Forecasts
of Weekly Changes in Money: A Methodological Note,”
Journal of Finance (September 1984), pp. 1207-13.
Hafer, R.W., and Richard G. Sheehan. “On the Response of
Interest Rates to Unexpected Weekly Money: Are Policy
Changes Important?” Federal Reserve Bank of St. Louis
Research Paper 87-005 (revised, February 1989).
Hardouvelis, Gikas A. “ Macroeconomic Information and
Stock Prices,” Journal of Economics and Business (May
1987), pp. 131-40.
Hein, Scott E. “The Response of Short-Term Interest Rates
to Weekly Money Announcements: A Comment,” Journal of
Money, Credit and Banking (May 1985), pp. 264-71.
LeRoy, Stephen F. “ Expectations Models of Asset Prices: A
Survey,” Journal of Finance (March 1982), pp. 185-217.
Loeys, Jan G. “ Changing Interest Rate Responses to Money
Announcements: 1977-83,” Journal of Monetary Economics
(May 1985), pp. 323-32.
Pearce, Douglas K., and V. Vance Roley. “ Stock Prices and
Economic News,” Journal of Business (January 1985), pp.
49-67.

46

Sease, Douglas R. “ Trade Deficit’s Impact Declines Despite
Jitters,” Wall Street Journal, February 21, 1989.
Sheehan, Richard G. “Weekly Money Announcements: New
Information and Its Effects,” this Review (August/September
1985), pp. 25-34.
Shiller, Robert J., John Y. Campbell, and Kermit L.
Schoenholtz. “ Forward Rates and Future Policy: Inter­
preting the Term Structure of Interest Rates,” Brookings
Papers on Economic Activity (1: 1983), pp. 173-217.




Sims, Christopher A. “ Martingale-like Behavior of Prices and
Interest Rates,” University of Minnesota Center for Eco­
nomic Research Discussion Paper No. 205.
Thornton, Daniel L. “Why Do Market Interest Rates Respond
to Money Announcements?” Federal Reserve Bank of St.
Louis Research Paper No. 88-002, 1988.
_______ . “The Borrowed-Reserves Operating Procedure:
Theory and Evidence,” this Review (January/February
1988), pp. 30-54.
Wallace, Anise C. “The Numbers that Move the Market,”
New York Times, June 5, 1988.

MARCH/APRIL 1989

47

Mack Ott

Mack Ott is a senior economist at the Federal Reserve Bank
of St. Louis. Erik A. Hess provided research assistance.

Is America Being Sold Out?
T

HE LAST time the U.S. current account
balance was in surplus was in 1981. During the
seven years 1982-88, U.S. deficits averaged over
$100 billion. Capital inflows from foreign in­
vestors have reduced the U.S. foreign invest­
ment position steadily from a net U.S. claim of
$141.1 billion at the end of 1981 to net foreign
claims on the United States of $368.2 billion at
the end of 1987.

status are each addressed. W e begin with an
overview of recent public opinion polls about
foreign investment in the United States, and
then consider the data on foreign investment.
The potential for a foreign takeover of the U.S.
economy and the pattern of foreign investment
in the United States relative to U.S. investment
abroad are examined.

Much of the commentary on this reversal has
presumed the loss of U.S. economic sovereignty,
declining opportunities for American labor, and
a reduction in the U.S. standard of living. In
rebutting these concerns, analysts have general­
ly concentrated on selected aspects of the
phenomenon. For example, recent articles have
focused on the relative pace of foreign direct in­
vestment, in particular, Japanese direct invest­
ment, while others have singled out the benefits
of capital inflows for both American investors
and labor1

FOREIGN INVESTMENT IN THE
UNITED STATES IN THE 1980s

This article takes a broader perspective to
review the full range of concerns about foreign
investment, both from a logical and an empiri­
cal vantage. The public concerns about the flow
of foreign investment and its anxiety about the
implications of the U.S. net international debtor

1Anderson (1988) focuses on direct investment mispercep­
tions, Little (1988) discusses the relatively small magnitude
of both direct and portfolio investment, Makin (1988b)
discusses the Japanese investment patterns in the United
States, Rosengreen (1988) discusses direct investment by
foreigners and compared with U.S foreign direct invest­
ment and Weidenbaum (1988) argues that capital inflows
are beneficial. Francis (1988) recounts an interview with
Milton Friedman in which he argues that the U.S. foreign



In assessing the implications of foreign invest­
ment in the United States during the 1980s, it is
useful to examine three dimensions of the
foreign capital inflows. First is the perception of
foreign investment as reported by the media
and recorded in public opinion polls. Since
perceptions are often as important as facts, it is
appropriate to begin with them. If there were
no perceived threat, it is unlikely that any
policy actions would be considered; certainly,
the threat of foreign ownership of U.S. assets
would not be an issue in the public forum. Sec­
ond is the pattern of foreign investment. The
concern seems to be chiefly that foreigners will
obtain control of certain U.S. industries vital to

asset position is understated to the extent that he doubts
the U.S. is a net debtor. Ulan and Dewald (1989) estimate
adjustments to obtain a corrected U.S. net international in­
vestment balance. From a different vantage, Hweko and
Chediek (1988) describe the ruinous consequences follow­
ing Argentine dictator Juan Peron’s drive for “ economic
independence” through import substitution and restrictions
on foreign investment.

MARCH/APRIL 1989

48

national security, industries traditionally
dominated by U.S. firms, or high-technology in­
dustries. Third is the reported magnitude of
foreign investment. If the magnitude of such in­
vestment is negligible, there cannot be much
threat to U.S. overall interests. If the magnitude
is substantial, the inflow of foreign capital must
be evaluated on its merits.

The Perception o f Foreign Invest­
ment in the United States
Opinion polls unambiguously reveal that the
American public is concerned about increased
foreign ownership of U.S. firms and real estate.2
A poll by the Roper Organization in March 1988
found that 84 percent of the respondents
thought that foreign companies buying more
companies and real estate in America is not “a
good idea for the U.S.” In the same poll, by a 49
percent to 45 percent plurality, respondents
disapproved of new jobs for Americans in
foreign-owned plants, and at least 72 percent
thought that foreign companies’ investments
should be restricted.3 In May 1988, a CBS
News/NewYork Times survey found that 51 per­
cent of a national sample agreed that the "in­
crease in foreign investment poses a threat to
American economic independence.'4 Similar
findings were reported by other polling firms.5
Moreover, the uneasiness is not limited to
Americans outside of the opinion-making elite.
Last year, Sen. James Exon of Nebraska sup­
ported legislation “to give the Pentagon the right
to veto” foreign takeovers of defense contrac­
tors; this provision was ultimately incorporated
in the 1988 trade act. The political attrac­
tiveness of the issue is very strong:
Actions from Japanese land purchases in Hawaii to a
British corporate takeover attempt in Pittsburgh fuel
grass-roots worries. ‘The farther away you get from
Washington,’ the greater the reaction ‘that America

2For a comprehensive accounting of this view, see Tolchin
and Tolchin (1988). Other briefer accounts, supporting in
varying degrees the Tolchins’ concerns, are in Baer
(1988), Burgess (1989), Fierman (1988), Jenkins (1988),
Norton (1988), O’Reilly (1988), Skrzycki (1988), and ‘‘Mr.
Greenspan on the Gas Tax” (1988). Even those who make
their skepticism obvious—such as Friedman (1988),
Kinsley (1988), Makin (1988a,b), “ Buying into a Good
Thing” (1988)—imply that the notion has received such
frequent airing as to become conventional wisdom.
3Baer (1988), p.24.
4“ Opinion Roundup” (1988).
5Hamilton, Frederick & Schneiders reported that “ 78 per­
cent of Americans favor laws limiting foreign investment in

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should belong to Americans,’ says one antitakeover
group official.6

The political furor and public uneasiness con­
tinue in early 1989. A controversial bill calling
for greater disclosure by foreign investors was
scheduled for a quick vote in the House of
Representatives but was withdrawn by the
Speaker of the House after an “explosion of pro­
test in the Bush administration.”7 In a survey
for the Washington Post-ABC News Poll in midFebruary 1989, “Forty-five percent said Japanese
citizens should not be allowed to buy property
in the United States, and eight of 10 said there
should be a limit on how many U.S. companies
the Japanese should be allowed to buy.”8

The Pattern o f Foreign Investment
in the United States in the 1980s
There has been pronounced opposition to
direct investment in the United States by
foreigners, especially the Japanese. Direct in­
vestment is defined as a 10 percent or greater
ownership share in a firm. Foreign direct in­
vestment in American firms has been the focus
of the greatest unease. Such investment can
take place either through stock purchases or
the creation of new enterprises in the United
States by foreigners, with or without U.S. part­
ners. The seriousness of this concern is ex­
emplified by excerpts from an editorial by
Malcolm Forbes:

BEFORE JAPAN BUYS TOO MUCH OF THE
U.S.A.
W e must instantly legislate a presidentially ap­
pointed Board o f Knowledgeables whose approval
would be required before any foreign purchase of
any significance would be allowed o f any conse­
quential U.S. company—regardless o f size. . . .It’s
one thing fo r the Japanese and Germans and
others to buy U.S. government bonds to finance
our huge trade imbalances with them. But it’s a

real estate and business” [Jenkins, p. 45] and Smick
Medley & Associates found that “ nearly 80 percent of
Americans outside of the opinion-making elite would like to
limit foreign buying, and 40 percent want to halt it
altogether. 'Joe America is nervous and suspicious,’ says
the firm’s president, David Smick. 'He is worried about
losing control over his destiny.’” [Fierman, p.54]
6Jaroslovsky (1988).
7Birnbaum (1989).
8Morin (1989).

49

Figure 1

U.S. vs. Foreign Direct Investment

1973

75

77

79

whole and totally impermissible other thing for
them to use their vast billions o f dollars to buy
great chunks of America’s big businesses, or take
over the high-tech, medical or other strategic, vital
U.S. concerns.9

Figure 1 shows that since the advent of
floating exchange rates in the early 1970s,
foreign direct investment in the United States
has grown faster than U.S. direct investment
abroad—an annual growth rate of 18.7 percent
vs. 7.6 percent. Consequently, the relative size
of foreign direct investment has risen—from
about 22 percent of U.S. foreign direct invest­

9Forbes,(1988).Similar views are recounted in Makin
(1988b) and expressed throughout Tolchin and Tolchin
(1988).
10Note that the U.S. government gold stock reported in table
1 is vastly understated relative to its market value. In the
table, the official U.S. government gold entry is computed



81

83

85

1987

ment in 1975 to about 85 percent in 1987. Of
the $41.5 billion of direct U.S. investment by
foreigners in 1987, nearly half, $19.1 billion,
was in U.S. manufacturing.

The Magnitude o f Foreign Invest­
ment in the United States in the
1980s
Table 1 shows the estimated composition of
foreign investment in the United States and of
U.S. investment abroad at the end of 1975 and
1980-87.10 These data reveal that, since 1975,

using an accounting price of $42.22 per troy ounce. If its
value were computed using a value closer to its market
value in the 1980s, say $400 per ounce, the entry in table
1 for U.S. official gold would be about $100 billion rather
than $11 billion.

MARCH/APRIL 1989

Table 1
Foreign investment in the
United States
Official
U.S. Government securities
Private, nonbank
Direct investment
Private and non-U.S.Treasury securities
U.S. Treasury securities
U.S. bank liabilities
Other
U.S. investment abroad
Official
Gold
Private, nonbank
Direct investment
Securities
U.S. bank claims
Other
Net foreign assets in the
United States
SOURCE: Scholl (1988), table 2.




1975

1980

1981

1982

1983

1984

1985

1986

1987

$220.9

$500.8

$578.7

$688.0

$784.4

$829.6

$1060.9

$1340.7

$1536.0

86.9
63.6
77.6
27.7

176.1
118.2
173.3
83.0

180.4
125.1
202.3
108.7

189.1
132.6
243.4
124.7

194.5
137.0
284.7
137.1

199.3
143.0
350.0
164.6

202.6
143.4
474.4
184.6

241.7
177.3
620.7
220.4

283.1
219.0
684.7
261.9

45.7
4.2
42.5
13.9

74.1
16.1
121.1
30.4

75.1
18.5
165.4
30.6

93.0
25.8
228.0
27.5

113.8
33.8
278.3
26.9

127.3
58.2
312.2
31.0

206.2
83.6
354.5
29.4

308.8
91.5
451.6
26.6

344.4
78.4
539.4
28.8

$295.1

$607.1

$719.8

$824.9

$873.9

$896.1

$950.3

$1071.4

$1167.8

16.2
11.6
159.0
124.0
34.9
59.8
18.3

26.8
11.2
278.0
215.4
62.6
203.9
34.7

30.1
11.2
291.7
228.4
63.4
293.5
35.8

34.0
11.1
283.2
207.8
75.5
404.6
28.6

33.7
11.1
291.0
207.2
83.8
434.5
35.1

34.9
11.1
300.6
211.5
89.1
445.6
30.0

43.2
11.1
343.1
230.2
112.8
447.4
29.0

48.5
11.1
392.8
259.6
133.2
507.3
33.3

45.8
11.1
455.6
308.9
146.7
547.9
30.1

-$74.2

-$106.3

-$141.1

-$136.9

-$89.4

-$3.5

$110.7

$269.2

$368.2

FEDERAL RESERVE BANK OF ST. LOUIS

The Composition of Foreign Investment in the United States and U.S. Investment Abroad (billions of dollars)

51

foreign assets in the United States have in­
creased much faster than U.S. assets abroad.
This pattern of faster foreign asset growth is
even more pronounced if the comparison is
made from 1981, the last year of an American
trade surplus, to 1987. From a net claim on
foreigners of $141.1 billion, the United States
has become the world’s largest debtor, with
estimated net liabilities to foreigners of $368.2
billion. During this interval, foreign assets in­
creased by 165 percent compared with 62 per­
cent for U.S. assets abroad.
The disparity in accumulation is even greater
for assets held by private investors, that is, total
foreign investment less U.S. securities held by
foreign governments and central banks. Over
the seven years 1981-87, private foreign invest­
ment in the United States more than tripled,
from $398 billion to $1253 billion. The bulk of
these capital inflows have gone into foreign
holdings of U.S. securities— corporate stocks
and bonds and government notes and bonds—
and liabilities of U.S. banks—deposits by foreign­
ers. Together, these two asset categories ac­
count for about three-fourths of the increase in
private foreign investment in the United States,
$643 billion of the $855 billion total.
The size of the foreign claims raises another
issue, the cost of servicing the net foreign in­
debtedness. Peter Drucker (1988) has called this
"the looming transfer crisis”:
. . .ours is the only major industrial country that
has a significant foreign indebtedness, not only
governmental but private as well, and that
therefore has a significant foreign exchange re­
quirement. By 1991 we will need close to $1
billion to cover our foreign exchange remittances,
about $500 million for the federal debt. . . .And
there is no way to earn that in our foreign trans­
actions. No way. Even if we balance our trade, we
won’t have that much surplus.
Starkly put, Drucker believes that the accu­
mulation of U.S. assets by foreigners will force
the United States to repudiate its debts, either
directly, indirectly by inflation or by reducing
the nominal value of the dollar: "As long as we
can knock down the dollar without domestic in­
flation, I think that is the best thing to hope
for.” Such a policy would be injurious not only

" “ Political leaders should remember that foreign investors
are very anxious to invest in the United States, and that
they invest primarily for market share and profits, and
everything else is secondary.” [Tolchin and Tolchin (1988),



to foreign investors but to U.S. interests as well.
To see why, consider why foreigners invest in
the United States and how U.S. labor and in­
vestors each benefit from such investment.

W HY DO FOREIGNERS INVEST IN
THE UNITED STATES?
There are three reasons for foreign invest­
ment in the United States or for U.S. investment
abroad: greater profit, lower risk and the trade
deficit. The first, greater profit, is the funda­
mental reason, as it is for any other investment
choice. The investor chooses one asset over
another because it has a higher risk-adjusted
rate of return. Both critics of foreign invest­
ment such as the Tolchins (1988) and defenders
of unimpeded capital flows such as Makin
(1988a,b) and Poole (1988) are agreed: Foreign
investment is motivated primarily by profit.11
Speaking of the capital flows from Japan and
Europe to the United States, Poole observes that:
Tw o rate o f return conditions are relevant. First,
Japanese saving invested in the United States is in
the interest o f the U.S. if the rate o f return w e
pay to the Japanese is less than the return we
earn on the invested capital, and there is no
evidence that this condition is not met. Second,
Japanese investment in the United States is in the
interest o f Japan if the rate of return Japan
receives in the United States is greater than the
rate o f return available in Japan. Given the
declines in Japan’s growth rate and investment
share, and evidence that the rate o f return in the
Japanese equity and fixed income markets is ex­
tremely low, it is highly likely that both o f these
rate-of-return conditions w ere met from 1981 to
1985, and perhaps later. For Europe, it seems
clear that the declining investment share is a
supply-side problem; incentives to produce are too
low because o f high marginal tax rates and labor
market rigidities. Europe also provides substantial
subsidies to weak and inefficient enterprises. U.S.
policies have, if anything, raised European growth
in the 1980s by providing a large market for Euro­
pean exports. Thus, the tw o rate-of-return condi­
tions discussed fo r Japan also apply to Europe.12

One important implication of Poole’s discussion is
that Drucker’s concern about being able to fi­
nance the U.S. foreign obligations becomes moot.

p.271] See also Poole (1988), p.44.
12Poole (1988), pp.45-6.

MARCH/APRIL 1989

52

The second motivation for foreign investment
is to reduce the risks of wealth loss due to un­
foreseen exchange rate changes.13 This proposi­
tion is simply an extension of the risk reduction
principle of portfolio diversification to interna­
tional alternatives. Portfolio diversificationspreading wealth across several assets rather
than a single security—reduces losses due to un­
foreseen events.
Similarly, exchange rate risk can be hedged
by holding several assets denominated in dif­
ferent currencies rather than all in a single cur­
rency. The investor's wealth is insured against
rising or falling by the full amount of any un­
foreseen exchange rate change. A corollary of
this is that multinational firms can reduce the
unforeseen variability of their production costs
and market sales by producing and selling in
several countries rather than in a single one.
The third reason for foreign investment is
that it accompanies trade deficits. Foreign in­
vestment induced by higher yields or portfolio
diversification occurs whether or not interna­
tional trade is in balance; however, trade
deficits imply that net foreign investment m ust
occur in the amount by which trade is in
deficit.14 Yet it would be incorrect to infer from
this accounting identity that trade deficits cause
foreign capital inflows. In other words, foreign
investment is not undertaken simply to finance
the trade deficit; indeed, it may well be that the
capital inflows cause trade deficits:
The international accounts too, are more likely be
driven from the capital side than the merchandise
side. In this era o f instant capital transactions, a
year's worth o f world trade amounts to only a

13Anticipated changes in exchange rates are reflected in the
differences between the rates of return on assets in dif­
ferent currencies. For example, if it is widely anticipated
that the British pound sterling will decline by 5 percent in
exchange value vs. the dollar in the coming year, then the
interest rate on British securities will be 5 percent higher
than the interest rate on U.S. securities of similar risk.
This relation between interest and exchange rates is
known as interest rate parity; for a discussion, see Koedijk
and Ott (1987), pp. 5-7.
14Actually, the recorded capital inflows—the capital account
balance—have been persistently smaller than the broadest
measure of the trade deficits—the current account
balance—throughout the 1980s. This error—the statistical
discrepancy—has averaged over $20 billion annually,
which is between one-seventh and one-fifth of the current
account deficit. For a review of the relation between the
international trade and capital accounts and the statistical
discrepancy, see Ott (1988), pp 3-13.

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week's worth o f capital flows. The U.S. trade
deficit arose when U.S. banks stopped exporting
capital to developing nations, and when, because
o f the Reagan tax cuts, the U.S. economy was the
only growth opportunity in the world. These
developments resulted in a tremendous net capital
inflow; the deficit in merchandise trade was
necessary to balance the equation.15

Thus, capital flows appear to be generated by
investors’ self-interested profit-seeking. There is
broad agreement that, whatever other effects
international capital flows may have on
domestic economies, foreign investment makes
investors and sellers of assets wealthier than
they would be if their investment and sales
were restricted to domestic assets and buyers.
Nonetheless, this leaves open the issue of how
labor is affected by international capital flows.

BENEFITS TO DOMESTIC LABOR
OF FOREIGN INVESTMENT
Labor and the owners of capital share the
value added in production created by transfor­
ming raw materials into output. Capital is just a
generic term for the tools, buildings, land,
patents, copyrights, trademarks and goodwill
that labor uses to convert one set of goods—
raw materials—into another—finished output.
The value of each factor of production in a
market economy is its opportunity cost, that is,
what the raw materials, labor or capital could
produce in their most profitable alternative
application.
In most cases, labor and capital are com­
plementary, so that an increase in the quantity
of one raises the productivity, hence, the value

15Bartley (1988). See also Tatom (1987, 1989). Poole (1988),
p. 42, points out that “ the issue of causation is complex
and should be discussed with care.” Heller (1989), p. 2,
notes that foreigners are financing attractive investments
for which U.S. total saving is insufficient:
...the [domestic government] deficit is still substantial in relation
to domestic savings and uses up funds that are needed for private
sector investment. Thus far the US economy has enjoyed the con­
fidence of foreign investors, preventing serious ‘crowding-out’ of the
private sector in financial markets.

Wayne Angell, Heller’s colleague on the Board of Gover­
nors of the Federal Reserve System, also has observed
that the capital inflows are beneficial:
“ I’m not irritated or upset about capital inflows into the United
States. Capital inflows do tend to increase our productivity.” “ Capital
Inflows Called Helpful" (1988)

53

of the services, of the other. For example, pro­
viding an auto mechanic or a carpenter with
more tools increases the amount or quality of
work they can accomplish; this increase in pro­
ductivity leads to a rise in their wages, or, at
the same wages, to an increase in the number
of them employed.
Consequently, to the extent that foreign in­
vestment is an increment of capital that would
otherwise not be available for labor to use, the
foreign capital must unambiguously be
beneficial to labor.16 Equally true, the availabili­
ty of foreign capital lowers the cost of capital to
owners; this makes additions to plant and equip­
ment cheaper, makes possible some investment
projects that otherwise would not occur and
raises the value of firms.17 Thus, even if the
foreign capital does not directly affect the
ownership of the firm, it benefits labor and
asset owners by lowering interest rates, the cost
of capital.
This discussion can be summarized in five
postulates about the expected gains and losses
from the addition of foreign capital:
(i)
Labor gains as the incremental capital
raises the productivity of labor, increasing
the amount of labor that can be employed
or the wages of those who are employed;
(ii)

Owners of firms—the shareholders—
benefit by the lower interest rates implied
by higher asset prices;

(iii)

Consumers gain as a result of the lower

16Recent media discussions of worker views on foreign
ownership of their firms have revealed a general absence
of hostility by workers and their unions, emphasizing in­
stead the benefits of the employment made possible by
the capital inflow. Holusha (1989) quotes two automobile
workers at the Nummi joint venture of Toyota and General
Motors as follows:
"I can’t honestly say I like it better [than when it was a G.M. plant],
but I’m working and that’s better.”

and

“ We got a second chance here, and we are trying to take advantage
of it. Many people don’t get a second chance.”

The Tolchins’(1988) single out Volkswagen of America as
being “ a notable exception to the anti-union flavor of
many foreign owned companies.” (p. 178) Ironically, the
other foreign automakers castigated by the Tolchins con­
tinue operations and employment of labor in the United
States, while Volkswagen ceased U.S. production in 1988.
17The elimination of restrictions on foreign ownership can
raise the wealth of domestic asset owners, as recently il­
lustrated in a policy change by Nestle, a Swiss corpora­
tion; see Dullforce (1988a). In late November 1988, Nestle
announced that, henceforth, it would sell registered shares
to any buyer, whether or not that buyer was a Swiss resi­
dent. As a result of the eradication of the distinction bet­
ween its two types of common stock, registered (formerly
restricted to residents) and bearer (available to



prices of goods implied by the increased
labor productivity;
(iv)

The profitability of financial intermediaries
may decline since the value of their ser­
vices in bringing borrowers and lenders
together is inversely related to the supply
of capital. Moreover, the entry of foreign
financial intermediaries makes the industry
more competitive, which also tends to
reduce the rate return;

(v)

Savers may lose interest income as a result
of lowered interest rates due to the
greater capital availability. This loss is off­
set, to some extent, as they receive capital
gains on their existing fixed-rate portfolio
holdings for the same reason as in (ii).

Since foreign investment raises the amount of
capital available, labor productivity rises as does
the absolute income of labor. Labor is better off
with more capital than with less, and the na­
tionality of the investor is a matter of indif­
ference to labor.18

THE MYTHICAL THREAT OF
W ITH D R A W A L OF FOREIGN
CAPITAL
In early 1989, the U.S. economy continues its
longest peacetime expansion on record, so the
dangers of foreign investment are posed as the
potential calamity of an abrupt foreign
withdrawal. This scenario was described by a

nonresidents), common shares of both types now sell for
about the same price. Before the change, bearer shares
had sold for about twice the price of registered shares.
See Financial Times Market Staff (1988). Removing the
restriction on foreign buyers' ability to buy the resident
shares realized a 40 percent wealth gain for Swiss resi­
dent shareholders. Nestle reportedly makes up about 11
percent of the capitalized value of the Swiss stock market
shares, and its decision may influence other Swiss cor­
porations’ equity policies. This change opens up the
possibility of foreign ownership of Swiss corporations; ap­
parently, Swiss Nestle stockholders are willing to bear this
cost. The Governor of the Swiss National Bank also has
argued that the market for financial assets in Switzerland
must not discriminate on the nationality of the buyer if the
country is to remain an important center for capital tran­
sactions; see Dullforce (1988c). Similar arguments are of­
fered in a discussion of the European Community’s
eradication of capital restrictions by Greenhouse (1988).
18ln the 1988 Presidential campaign, the Democratic can­
didate, Michael Dukakis, told a group of workers at a St.
Louis automotive parts plant, “ Maybe the Republican
ticket wants our children to work for foreign owners....but
that’s not the kind of a future Lloyd Bentsen and I and
Dick Gephardt and you want for America.” The workers
addressed by the candidate had been employed by an
Italian corporation for 11 years. ’’Dukakis-BentsenGephardt” (1988).

MARCH/APRIL 1989

54

Figure 2
U.S. Dollar Exchange Rates vs. Japan, U.K.
and West Germany
1980 = 100
175

1973

1980 =

74

75

76

77

78

79

prominent New York investment banker as
follows:
The dollar will eventually fall, he notes, and when
it does and interest rates decline in a period of
recession, foreign investors would withdraw their
portfolio investments, triggering a banking crisis.
These foreign investors then could use their in­
flated portfolios to make direct investments of
American industry at "bargain basement
prices... .We will have financed our deficit by
putting up permanent assets.’’19

80

81

82

83

84

85

86

100

175

1987

foreign withdrawal. Thus, to evaluate the dan­
gers posed by foreign ownership of U.S. assets,
one must investigate not just the likelihood of
each of these events but their joint likelihood,
including whether they are mutually consistent.

Decline o f the Dollar

This scenario entails the confluence of four
events: a decline in the dollar’s exchange value;
a cyclical decline in U.S. interest rates; a
withdrawal and subsequent re-entry of foreign
investment; and a banking crisis induced by the

From its peak in February 1985, the exchange
value of the dollar averaged against the prin­
cipal industrial currencies has fallen more than
40 percent.20 As shown in figure 2, it has fallen
by about one-third against the pound, by
almost one-half vs. the yen and by over twofifths in terms of the Deutsche mark. Yet, there
has been no sign of a widespread flight from

19Attributed to Felix Rohatyn, p.28, in Tolchin and Tolchin
(1988); this scenario is repeated nearly verbatim on pp.
197-98 and again on p. 201. See also Baer (1988), Fierman (1988), Jenkins (1988), Makin (1988a,b) and Norton
(1988).

20The trade-weighted exchange rate of the dollar against the
other Group of Ten countries plus Switzerland hit a peak
of 158.43 (1973 = 100.00) in February 1985; it was below
90.0 in late 1987 and has a value of 91.88 in January
1989, a 42 percent decline from its early 1985 peak.


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55

dollar assets. Even the record stock-market crash
of October 1987, when the dollar's exchange value
was at its nadir, did not suffice to trigger a
massive withdrawal of foreign capital.21

Cyclical Decline o f U.S. Interest
Rates
Generally, differences in interest rates in one
currency vs. another are just sufficient to offset
the anticipated depreciation of the higherinterest currency vs. the lower-interest curren­
cy as reflected in their forward exchange rate.22
While interest rates do decline in recessions, the
benefit to an investor from selling U.S. assets
and shifting to another currency at such times
is limited by the likely state of other economies.
The world's major economies are so economical­
ly integrated that periods of recession in the
U.S. economy are generally also periods of
recession in the other economies in which at­
tractive substitute investments would be
available. Consequently, to the extent that both
interest rates and asset prices were to fall in
the U.S. economy, the same pattern is likely to
have occurred in the rest of the industrial
economies as well, so a shift from U.S. to
foreign assets would accrue no profit. If other
economies' asset prices and interest rates had
not fallen with those in the United States, then
the depreciation of the dollar’s exchange rate
would obviate the benefit of such a withdrawal.

21ln part, this is simply an illustration of the intercon­
nectedness of the world’s economies. All major stock
market around the globe crashed together:
All major world markets declined substantially in that month
[October 1987], which is itself an exceptional fact that contrasts
with the usual modest correlations of returns across coun­
tries....The United States had the fifth smallest decline, i.e., the fifth
best performance, in local currency units. However, because the
dollar declined against most currencies, the U.S. performance
restated in a common currency was only 11th out of 23....[A]n at­
tempt was made to ascertain how much of October’s crash could
be ascribed to the normal response of each country’s stock market
to a worldwide marketmovement. A world market index was con­
structed and found to be statistically related to monthly returns in
every country during the period from the beginning of 1981 up until
the month before the crash. The magnitude of market response dif­
fers materially across countries. The response coefficient, or
“ beta” was by far the most statistically significant explanatory
variable in the October crash. It swamped the influences of the in­
stitutional market characteristics. Roll (1989), pp.65-6

22This relation between interest rate differences and an­
ticipated exchange rate changes (primarily due to inflation
rate differences) is called covered interest parity (CIP). The
evidence supporting the absence of profitable speculative
opportunities due to CIP is overwhelming. While there is
also evidence of risk premia in interest differentials, such
evidence also suggests that these premia are a return for
the cost of risk-bearing, not a pure profit. See Koedijk and
Ott (1987).



Withdrawal and Subsequent
R e-entry o f Foreign Investment
Investors withdrawing their funds from U.S.
assets must do it in two steps—first selling the
asset and then using the cash (dollar) proceeds
to buy another asset, either another U.S. asset
or a foreign currency. An investor selling an
asset from a portfolio is, by that action, buying
something else—a stock, a bond, a piece of real
estate, a quantity of money denominated in
some currency.23 W hen the dollar proceeds are
exchanged for foreign currency, some other in­
vestors will acquire the original asset and the
U.S. dollars. In the spirit of the scenario, if only
domestic U.S. investors are buying the U.S.
assets from the prior foreign owners, both a
U.S. capital outflow and a sharply declining
dollar exchange rate will occur. The capital
outflow can only occur if the United States has
a trade surplus.24 In reality, massive withdraw­
als of foreign capital cannot occur in the short
run. Prices and exchange rates adjust first; in­
ternational payments flows adjust with a sub­
stantial lag. Nonetheless, if this unlikely abrupt
swing from trade deficit to surplus were to oc­
cur because of the foreigners' panic sales, the
assets would end up in U.S. investors’ hands at
considerably lower prices. If foreigners repur­
chased them shortly thereafter, the result
would be increased prices and an appreciation
of the exchange value of the dollar with the
resulting profit accruing to domestic owners.

23The scenario at this point makes a distinction between
foreign investors’ portfolio and direct investment:
“ ...withdraw their portfolio investments...then could use
their inflated portfolios to make direct investments at
bargain basement prices...” This presumes a distinction
between bond and stock prices which is inconsistent. Ac­
cording to the scenario, the dollar and all other U.S. asset
prices fall, so it would be irrelevant where foreign in­
vestors’ portfolios were initially invested. Moreover, since
direct investment is simply a 10 percent or greater holding
in a corporation, the distinction between “ portfolio” and
“ direct investment” holdings of common shares is one of
degree, not of kind.
24lt is unlikely, but conceivable that a swap of U.S. assets
for foreign assets could take place without any impact on
the balance of payments; however, this would require that
the assets exchange in exactly balanced total values, the
value of U.S. assets sold equaling the value of foreign
assets sold. In contrast, the scenario being reviewed
postulates a declining dollar, suggesting that the U.S.
assets are no longer as desirable as they were at their
prior prices. Consequently, with falling U.S. asset prices
and foreigners engaging in net sales, a capital outflow is
implied. This can only occur if the trade balance is
registering a surplus.

MARCH/APRIL 1989

56

Banking Crisis23
Here the scenario presumes that foreigners,
having sold their portfolios, then convert their
dollar deposits to nondollar currencies. To do
so, they must buy these currencies from others
who, in turn, end up holding dollar deposits.
This would put downward pressure on the
dollar's exchange rate and would be associated
with a capital outflow from the United States.
Such substantial withdrawals—even if replaced
dollar for dollar in aggregate—would increase
the uncertainty entailed in asset-liability
management decisions at individual depository
institutions.
In particular, this uncertainty would com­
plicate the matching of the duration of assets
and deposit liabilities. The likely response of
depository institutions to these portfolio shifts
would be an increase in their demand for
reserves, reflected in a rise of the federal funds
rate. Yet, the stress of an abrupt rise in deposit
turnover—whether or not it is associated with a
net outflow of funds from depository
institutions—does not necessarily imply a bank­
ing crisis. Such an implication would require
that the Federal Reserve take no action to ac­
commodate an abrupt shift in the public’s port­
folio preferences. The Fed can and has accom­
modated such increases in the public's demand
for liquidity and the rise in depository institu­
tions’ demand for reserves.26

O verview o f the Foreign
Withdrawal Myth
In summary, the scenario is extremely unlike­
ly to occur. It is internally inconsistent and
depends on inept U.S. monetary policy actions
and irrational investment behavior by both
domestic and foreign investor. Since interest

25A “ banking crisis” can be defined as a widespread loss of
confidence in the solvency of depository institutions
resulting in runs on banks or abrupt rises in interest rates
to deter withdrawals. From the public’s point of view, such
shifts in portfolio preferences away from deposits can be
characterized as an increase in liquidity preference. Such
a crisis could very well be precipitated by sharp declines
in stock and bond prices if deposit holders feared that
banks’ direct losses on portfolio investments or indirect
losses through loans secured by securities endangered
their deposits.
26For example, by a combination of increased open market
purchases of U.S. securities and the indication of greater
accommodation through the discount window, the Fed ob­
viated a potential liquidity crisis in the U.S. financial
system following the October 1987 stock market crash.

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rates are linked through integrated international
capital markets, the presumed low U.S. interest
rates and a depreciating dollar are inconsistent.
Investors, U.S. resident and foreign, are unlikely
to believe that the U.S. monetary authorities
would be passive in the event of a U.S. banking
crisis. They could profit by buying U.S. assets at
prices temporarily depressed by any general
foreign withdrawal and subsequently selling
them back to other chagrined but wiser foreign
investors. In short, rational expectations and the
profit motive induce competitive behavior which
nullifies the threat of widespread foreign capital
withdrawal, the same profit motive that induced
the foreign investment in the first place.27

HAS FOREIGN DIRECT INVEST­
MENT CHALLENGED CONTROL OF
DOMESTIC U.S. INDUSTRIES?
Misperceptions about the distribution of
foreign ownership pervade discussions about
foreign investment in the United States. First, as
can be seen in table 1, most foreign investment
is concentrated in portfolio and bank deposits.
In 1987, foreigners held only about 17 percent
of their U.S. assets in direct investment; if of­
ficial assets are excluded, the share of direct in­
vestment rises to about 21 percent. In contrast,
U.S. direct investment abroad is about 26 per­
cent of the total or 27 percent of private invest­
ment. As the table shows, U.S. direct investment
abroad exceeds foreign direct investment in the
United States. Moreover, the excess of U.S.
direct investment widened in 1987 to $47 b illion
from $39.2 billion at the end of 1986.
The acceleration of U.S. foreign direct invest­
ment beginning with 1985 is obvious in figure
1. U.S. foreign direct investment fell from 1981
to 1982 and was stagnant until 1985; during this

27Another interpretation of this scenario is that it is simple
lobbying for restrictions on foreign buyers and foreign in­
termediaries. The scenario is intended to engender doubt
about the benefits of unhindered foreign capital inflows.
The policy implication contingent on finding the scenario
credible would be to restrict U.S. investment by foreigners
and foreign investment intermediaries. These restrictions
would lower the supply of capital and raise interest rates
and other costs of financing domestic investment and cor­
porate restructuring. As a result, the services of domestic
financial intermediaries would rise in value. In short, the
argument is of a piece with all regulatory arguments for
restrictions on entry or output—that the increased safety,
purity or quality of the licensed practitioners justifies the
reduced supply and higher cost. See Stigler (1971).

57

period, foreign direct investment in the United
States accelerated. Since 1985, however, U.S. in­
vestment abroad has outpaced foreign direct in­
vestment in the United States. While there is a
lively debate about why this resurgence of U.S.
direct investment has occurred, most analysts
argue that it reflects the tax reforms of 1986:
Nonresidential [U.S.] fixed investment rose substan­
tially in 1983-84, but reached a peak in 1985 and
then fell somewhat. The tax reform discussion,
which began in earnest with the Treasury I tax
proposal in November 1984, killed the investment
boom. Further evidence for this view is that U.S.
direct investment abroad rose substantially at the
same time.28

The second misperception about foreign direct
investment in the United States is the apparent
belief that the Japanese are the principal
foreign direct investors.29 This notion is incor­
rect. As figure 3a indicates, Japanese direct in­
vestment in the United States ranks a distant
third behind that of the British and the Dutch.
In fact, the European Community holds about
three-fifths of the foreign direct investment in
the United States—$157.7 billion of the $261.9
billion in 1987—nearly five times the Japanese
stake. Of the total investment, direct, portfolio
and bank deposits, Burgess (1988) notes that “at
the end of 1987, Europeans had holdings of
$785 billion, compared to Japan’s $194 billion
...[of] assets of all kinds—wholly owned com­
panies, stocks, bonds, bank deposits, real
estate.”
The third misperception is that foreign direct
investment is concentrated in the manufacturing
sector. As shown in figure 3a and 3b, the share
of U.S. direct investment by foreigners in
manufacturing is just over one-third, 35 per­
cent, slightly less than the 41 percent share of
U.S. direct investment abroad in manufacturing.
In terms of country shares, the Japanese have
less than one-sixth of their U.S. direct invest­
ment in manufacturing. The top four areas of
direct investment show substantial similarity. In

28Poole (1988), p. 46. See also Tatom (1987, 1989).
29For example, see O’Reilly (1988). This view also is implicit
in the excerpt of the editorial by Malcolm Forbes (1988) on
pages 48-49. Its inaccuracy is addressed in Makin (1988b)
and Rosengren (1988).
30Rosengren (1988), p. 50, illustrates this with a clear exam­
ple of the financial integration of takeovers:

descending order, manufacturing, trade,
petroleum and finance are the largest foreign
direct investment areas in the United States,
while manufacturing, petroleum, finance and
wholesale are the largest U.S. direct investment
areas abroad.
Considered at the level of individual firms, the
Japanese record is even less obtrusive.
Rosengren (1988) reports that Japan’s acquisi­
tion of 94 U.S. companies during 1978-87 rank­
ed fifth compared with the 640 taken over by
the British, 435 by the Canadians, 150 by the
Germans and 113 by the French. Considering
the year 1987, the Japanese tied for fifth place
with the Germans at 15 acquisitions, well
behind the pace of the British (78), the Cana­
dians (28), the French (19), and the Australians
(17). Rosengren argues that these company pur­
chases tend to be reciprocal in two respects.
First, the U.S. list of companies purchased has
nearly the same country rank order as the
foreign purchases in the United States, and the
particular industries also were similar for the
U.S. and foreign direct. Second, both U.S. and
foreign firms tend to make acquisitions of firms
in their own industries as a means of extending
their markets.
The upshot of Rosengren’s study is that
foreign acquisitions of U.S. firms have exhibited
much the same patterns as U.S. acquisitions of
foreign firms with a twist reflecting the increas­
ing international integration of business: "[M]any
of the foreign acquisitions are partnerships be­
tween foreign investors and U.S. banks and in­
vestment companies.”30

IS THERE ANY CREDIBLE
DANGER FROM FOREIGN
CAPITAL?
Any credible threat from foreign investment
must ultimately depend on the share of foreign

pany. Depending on how the deal is structured, those who pro­
vide the financing may have a substantial stake in the outcome
of the acquisition. For example, when Beazer, a British company
announced its $1.85 billion hostile bid for Koppers, much of the
financing was provided by a U.S. company, Shearson/American
Express. Shearson/American Express not only provided $500
million in debt financing, it also agreed to purchase 46 percent of
equity.

Classifying an acquisition as “ foreign” can be misleading since
the bulk of the purchase may be financed by a domestic com­



MARCH/APRIL 1989

58

Figure 3a
Distribution of Foreign Direct Investment in the
United States, ($261.9 Billion), 1987
U.K.

29%

M anufacturing
35%

Trade
18%

Netherlands
18%

Other
P etroleum

19%

14%

Japan
13%

S w itzerland

6%

O ther

Canada

Germ any

25%

8%

8%

by Country

Financial Institution s

9%

by Industry

Figure 3b

Distribution of U.S. Direct Investment Abroad,
($308.8 Billion), 1987
U.K.

17%

M anufacturing
Berm uda

W holesale

41%

Netherlands
O ther

Japan

31%

5%

P etroleum

22 %
Canada
22 %

Sw itzerland
7%

Germ any
8%

by Country

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O ther
12%

Financial In stitutions
16%

by Industry

59

Figure 4

U.S. Net Reproducible Fixed Capital Stock
at Market Prices
Billions of dollars

Billions of dollars

1 4 ,0 0 0

1 4 ,0 0 0

Consumer Durables

12,000

Government
10,000

8,000

1973

75

77

79

ownership of the stock of U.S. assets. That is, a
small proportional share of U.S. capital held by
foreigners is sufficient to preclude the possibili­
ty that foreign investment in the United States
is deleterious. In this section, we show that the
foreign share of U.S. capital, current and pro­
spective, is too small to support the critics’
concern.

The Miniscule Share o f Foreign
Ownership o f U.S. Capital
The market value and the composition of the
U.S. reproducible fixed net capital stock from
1973 to 1987 is shown in figure 4. From 1973,
when its market value was $3.6 trillion, it has
grown to $12.2 trillion at the end of 1987. D ur­
ing the period of large U.S. current account

31Government capital, valued at its current estimated
replacement cost, consists of government buildings, plant
and equipment used in government production and roads,



83

85

1987

deficits beginning in 1982, its annual increase
has averaged more than $0.5 trillion—that is,
more than five times the average capital
inflow—an annual growth rate of about 5.5 per­
cent. Its composition in 1987 was $4.1 trillion of
producers’ plant and equipment, $2.4 trillion of
government capital, $4.0 trillion of residential
capital and $1.7 trillion of consumer durable
goods such as automobiles, household fur­
nishings and equipment.31 For purposes of this
analysis, w e will consider the share of the net
U.S. reproducible tangible capital stock (less
consumer durables) that the net foreign invest­
ment could command as collateral.
The composition of U.S. assets held abroad
and foreign assets held in the United States are
shown in table 1. Considered as a potential

bridges, waterway improvements, etc. State and local
governments hold about two-thirds of the public capital
stock and the federal government one third.

MARCH/APRIL 1989

60

F ig u re 5

Ratio of Net Foreign Assets to Net Reproducible
Capital Stock Excluding Consumer Durables

claim collateralized by the U.S. capital stock, the
estimated foreign holding of U.S. claims at yearend 1987, $1.54 trillion, was about 12.5 percent
of the U.S. reproducible capital stock and 14.6
percent of the nonconsumer capital stock. Con­
sidered as a claim on the producer capital stock,
$4.1 trillion, it amounted to a 37.4 percent
claim. Subtracting estimated U.S. assets abroad
at year-end 1987, $1.17 trillion, from the
foreign claims yields net foreign assets in the
United States, $0.37 trillion, so that the percent­
age foreign claim on the net U.S. reproducible
nonconsumer capital stock at the end of 1987
was 3.5 percent.
In summary, the net current share of U.S.
assets owned by foreigners is implausibly low to
substantiate any potential cornering of U.S.
asset markets. Even so, this leaves open the
question of whether the trend of increasing
foreign ownership poses any such likelihood.

Sustained Capital Inflow s A re In ­
sufficient to Threaten U.S.
Econom ic Sovereignty
The U.S. Commerce Department estimates
that the U.S. international investment position

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became a net foreign claim in 1985 for the first
time since 1914, -$110.7 billion (see table 1).
Figure 5 shows this net foreign investment
claim as a share of the net U.S reproducible
nonconsumer capital stock. Reflecting the U.S.
trade deficits during the 1980s, the foreign
claim has grown at an average of over $80
billion per year since 1981. Since becoming a
net claim, the foreign percentage claim has
risen to 3.5 percent of this U.S. wealth measure.
Even if the capital inflows persisted indefinite­
ly at their 1988 level of about $120 billion, this
need not result in an eventual foreign control of
the U.S. economy in the sense of majority
foreign ownership of U.S. nonconsumer assets.
This is because the U.S. capital stock also is
growing. If either the inflation of replacement
prices of physical capital or real capital ac­
cumulation is fast enough, the share of foreign
capital could rise for a period of years and
then decline. The maximum the foreign share
would attain and the time at which it would
top out vary with the assumed rates of capital
stock growth and the rate of capital price
appreciation.

61

Figure 6

Foreign Share of Net U.S. Reproducible Capital
Stock Excluding Consumer Durables Collaterized by
Net Foreign Investment with Constant Capital Inflows
and Declining Capital Inflows

H H H
The U.S. capital stock grows each year by the
amount by which gross investment in new
buildings, roads, housing and industrial plant
and equipment exceeds the scrappage and
depreciation of the existing stock. The market
value of this stock also rises with inflation. As
was shown in chart 4, the estimated market
value of the U.S. nonconsumer capital stock
grew from $7.9 trillion at the end of 1981 to
$10.5 trillion at the end of 1987. Over this
period, the implicit annual rate of inflation of
capital stock replacement cost has averaged

32The period 1981-87 and the constant $120 billion inflow
are used in this discussion as they maximize the growth of
and the peak share attained by foreign capital. More
plausible rates are considered below. Nonetheless, the
fact that even indefinitely sustained capital inflows of over
$100 billion would be insufficient to support any traumatic
restructuring of the U.S. economy is consistent with
Mussa’s conjecture about surprisingly large equilibrium



about 2.3 percent, and the annual growth of
the real net stock (at 1982 prices) has averaged
about 2.2 percent. The sum of these two effects
in the 1980s has implied a nominal capital stock
growth rate of 4.5 percent. Combining these re­
cent trends, w e can determine the long-term
consequences of a continued capital inflow.32
As shown in figure 6, under these assump­
tions, which are most favorable to the threat
scenario, the foreign share actually would rise
to a maximum of 14.4 percent in the year 2015

U.S. current account deficits: As a result of the higher
growth rate of the U.S. population, its relatively younger
age distribution, the size of the U.S. economy and its at­
tractive investment opportunities, “ ...we should have an
equilibrium current account deficit of roughly one percent
of our GNP.” See Mussa (1985, p.146). In terms of the
1988 level of GNP of $5 trillion, this would imply an
equilibrium capital inflow of $50 billion.

MARCH/APRIL 1989

62

and then decline.33 Since the assumed sustained
capital inflow is probably larger than most
analysts would assume, this is a worst-case
scenario. For example, under growth and inflation
rates averaged over the the full floating-rate era,
1973-87, the constant $120 billion capital inflow
would generate a peak share of 10.2 percent in
2004. Finally, if the capital inflow declines over
the near future as it has since 1987, then the
foreign share would peak in 1997 at about 7.3
percent.
Consequently, the growth of the foreign share of
U.S. capital, while large by 20th century ex­
perience, does not approach the share necessary
to corner the market. Even when expressed as a
claim on a subset of U.S. wealth—excluding con­
sumer durable goods, land, and human capital—
and presuming an investment pattern which
foreign investment has not exhibited, the share of
foreign investment does not present a credible
takeover threat to the American economy.

IS THE UNITED STATES REALLY
A NET DEBTOR?
Much of the concern about the economic
security of the United States was triggered by
the Department of Commerce estimate that the
U.S. net international investment position
became negative in 1985 (see table 1). The prox­
imate cause of the declining U.S. net investment
position is the U.S. current account deficits
since 1981. There is no question that the U.S.
international investment balance has declined as
a result of the relatively faster foreign invest­
ment in the United States than U.S. investment
abroad. In other words, there is no question
that the net capital flows have been into the

33The year t* foreign share, s(t*), of the U.S. nominal non­
consumer capital stock is the ratio of the sum of the initial
foreign net holding, $368.2 billion, of the nominal capital
stock plus the integral of the annual capital inflow, $120
billion, reduced by the rate of inflation of capital stock
replacement cost, to the growing real capital stock whose
1987 value is $10,514.3 billion:
t*
($368.2 + $120 / e~u,d t)
0

s(t*) = -------------------------------------$10,514.3 e“ *
where s(t*) = share of net U.S. nonconsumer capital
collateralized against net foreign investment at
end of year t*;
u = implicit rate of inflation of net capital stock’s
replacement cost;

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United States. Conversely, there is a very real
question whether the U.S. position has yet
become negative. The primary basis for this
skepticism is that direct investment is recorded
at its historic cost, which understates the cur­
rent market value by amounts that grow over
the years.
Recently, Ulan and Dewald (1989) have
estimated the net U.S. investment position [NIIP]
adjusting for the understatement of U.S. direct
foreign investment:
When direct investment is revalued to market, we
estimate that the U.S. NIIP as about $400 to $600
billion more than the official NIIP indicates
through the end o f 1987, though, by all but the
earnings measure, the NIIP is below its peak
values of 1980 or 1981.34

In terms of the official Commerce Department
data reported in table 1, this would imply that
the U.S. position at the end of 1987 was a net
U.S. claim on foreigners of between $31 and
$231 billion. If the midpoint of this range is us­
ed as the appropriate point estimate, then given
the estimated $120 billion capital inflow in 1988,
the United States still held a net claim on
foreigners as of the end of 1988.

CONCLUSION
The joint implication from analysis of the three
aspects of foreign investment in the United
States—the effects on labor and investors, the
threat of withdrawal, and the relative size of the
foreign claim—is that the capaital inflows are
beneficient. The capital inflows benefit labor and
management, entrepreneurs and investors alike.
Workers benefit from the greater abundance of
tools; the increased capital raises labor’s produc-

g ■ growth rate of real net capital stock due to in­
vestment, foreign and domestic.
^Ulan and Dewald use three different methods to estimate
the capital gains in the U.S. foreign direct investment and
the foreign direct investment in the United States: stock
price indexes, corporate earnings, investment goods price
deflators. Their estimates based on the capitalization pro­
vide the largest estimate of the U.S. undervaluation and
provide the clearest rebuttal of the transfer problem outlin­
ed by Drucker (1988). Their adjustments omit the U.S.
gold stock, which would add about $90 billion to the U.S.
position as reported by the Commerce Department (see
note 3 above); however, they also do not allow for a poten­
tial write-down of U.S.bank holdings of LDC debt which
they report would reduce the U.S. investment position by
about $50 billion.

63

Anderson, Gerald H. “ Three Common Misperceptions about
Foreign Direct Investment,” Economic Commentary,
Cleveland Federal Reserve Bank, July 15, 1988.
Baer, Donald. “Anxiety in America’s Heartland,” U.S. News
and World Report (April 25, 1988), p 24.
Bartley, Robert L. “Whither Voodoo Economics?” Wall Street
Journal, August 18, 1988.
Birnbaum, Jeffrey H. “Wright Angers Some With Call for
Vote On More Disclosure by Foreign Investors,” Wall Street
Journal, February 17, 1989.
Burgess, John. “ British Investments in the U.S. Out-pace
Japan’s, Study Finds,” Washington Post, January 27, 1989.
“ Buying into a Good Thing.” National Review (October 14,
1988), p. 17.
“Capital Inflow Called Helpful.” New York Times, May 25, 1988.
Drucker, Peter. “ The Looming Transfer Crisis,” Insti­
tutional Investor, June 6, 1988, p. 29.
“ Dukakis-Bensten-Gephardt,” Wall Street Journal, October
11, 1988.
Dullforce, William. “ Swiss Life Wins Battle for LaSuisse,”
Financial Times, August 8, 1988a.
_______ . “ Nestle to End Foreign Shares Discrimination,”
Financial Times, November 18, 1988b.
_______ . “ Nestle Breaks Market Mold,” Financial Times,
November 22, 1988c.
Fierman, Jaclyn. “The Selling of America (Cont'd),” Fortune
(May 23, 1988), pp. 54-64.

Financial Times Market Staff. “ Nestle Bearers Plummet
after Hours on Shock News,” Financial Times,
November 18, 1988.
Forbes, Malcolm S. “ Before Japan Buys Too Much of the
USA,” Forbes (January 25, 1989), p. 17.
Francis, David R. “ US Not a Debtor Nation, But the Idea
Doesn’t Worry Economist,” Christian Science Monitor,
July 2, 1988.
Friedman, Milton. “ Why the Twin Deficits Are a Blessing,”
Wall Street Journal, December 14, 1988.
Greenhouse, Steven. “ Europeans Adopt Plan to End Curbs
on Capital FLows,” New York Times, June 17, 1988.
Heller, H. Robert. “ Mr. Heller Examines the US Economy
and Monetary Policy,” Speech at the University of St.
Gallen, February 2, 1989, BIS Review, no. 35 1989, pp.1-7.
Hewko, John, and Jorge Chediek. “The Economic and
Political Awakening of Argentina’s Peronists,” Wall Street
Journal, March 11, 1988.
Holusha, John. “ No Utopia, but to Workers It’s a Job,” New
York Times, January 29, 1989.
Jaroslovosky, Rich. “ Foreign Takeovers Emerge as an
Increasingly Hot Political Issue,” Wall Street Journal,
April 1, 1988.
Jenkins, Holman, Jr. “Anxiety Rises as Foreigners Buy
American,” Insight (March 28, 1988), pp. 44-45.
Kinsley, Michael. “ Deficits : Lunchtime Is Over,” Time
(October 3, 1988), pp 27-28.
Koedijk, Kees, and Mack Ott. “ Risk Aversion, Efficient
Markets and the Forward Exchange Rate,” this Review
(December 1987), pp. 5-13.
Little, Jane Sneddon. “ Foreign Investment in the United
States: A Cause for Concern?” New England Economic
Review (July/August 1988), pp 51-58.
Makin, John H. “ Is Foreign Investment Taking Over
America?” Washington Post, February 28, 1988a.
________ “Japan’s Investment in America: Is It a Threat?”
Challenge (November/December 1988b), pp. 8-16.
“ Mr.Greenspan on the Gas Tax.” Washington Post,
March 7, 1988.
Morin, Richard. “Americans Rate Japan No. 1 Economic
Power,” Washington Post, February 21, 1989.
Mussa, Michael. “ Commentary on “ Is the Strong Dollar
Sustainable?’ ” in The U.S. Dollar —Recent developments,
Outlook, and Policy Options (Federal Reserve Bank of Kan­
sas City, October 1985).
Niehans, Jurg. International Monetary Economics, (John
Hopkins University Press, 1984).
Norton, Robert E. “ Fleeing from the Almighty Dollar,” U.S.
News and World Report (June 13, 1988), pp 47-48.
“ Opinion Roundup.” Public Opinion, (November/
December 1988), p.29.
O’Reilly, Brian. “Will Japan Gain Too Much Power?” Fortune
(September 12, 1988), pp. 150-153.
Ott,Mack. “ Have U.S. Exports Been Larger than Reported,”
this Review (September/October 1988), pp. 3-23.

35“ Buying into a Good Thing,” ( 1988). Another economist,
Jurg Niehans, expresses the idea in the context of net in­
vestment this way: "Countries are debtors if their invest-

ment opportunities are greater than their wealth and are
creditors if their wealth exceeds their investment oppor­
tunities.” Niehans (1984), p. 107

tivity and increases its employment or wages.
Management benefits from the greater capital
availability and lower interest rates; the capital
inflows facilitate long-range planning, and the
rise in labor productivity enhances management
productivity as well. Entrepreneurs benefit from
the lower interest rates due to a greater abun­
dance of capital; this increases the range of pro­
fitable projects and new firm startups. And in­
vestors benefit since a more capital-abundant
economy is a richer economy, regardless of
who owns the capital.
The United States has imported capital
throughout the 1980s, but far from signaling an
economy in decline, such investment by
foreigners is a measure of the economy's vigor.
William Baumol aptly sums up this positive
aspect of foreign capital inflows: "...relatively
declining nations send their funds abroad
because their decline makes it profitable to in­
vest elsewhere.”35 Clearly, foreign investment in
the United States does not signify the selling out
of America.

REFERENCES




MARCH/APRIL 1989

64

Poole, William. “ U.S. International Capital Flows in the
1980s,” in Shadow Open Market Committee, March 1988, pp.
42-47.
Roll, Richard W. “The International Crash of 1987,” in
Robert Kamphuis, Roger Kormendi and J.W. Henry Wat­
son, eds., Black Monday and the Future of Financial
Markets (Mid America Institute, October 1988), pp. 37-70.
Rosengren, Eric S. “ Is the United States for Sale? Foreign
Acquisitions of U.S. Companies,” New England Economic
Review (November/December 1988), pp. 47-56.
Scholl, Russell B. “ The International Investment Position of
the United States in 1987,” Survey of Current Business
(June 1988), pp. 76-84.
Skrzycki, Cindy. “America on the Auction Block,” U.S. News
and World Report (March 30, 1987), pp. 56-58.
Stigler, George. “ Theory of Regulation,” Bell Journal of Eco­
nomics and Management Science (Spring 1971), pp 3-21.


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Bank of St.
Louis

Tatom, John A. “ Will a Weaker Dollar Mean a Stronger
Economy?” Journal of International Money and Finance,
1987, pp 433-47.
________ "U.S. Investment in the 1980s: the Real Story,”
this Review, (March/April 1989), pp. 3-15.
Tolchin, Martin, and Susan Tolchin. Buying into America—
How Foreign Money Is Changing the Face of Our Nation,
(Times Books, 1988).
Ulan, Michael, and William G. Dewald. “ The U.S. Net Inter­
national Investment Position: The Numbers Are Misstated
and Misunderstood,” U.S. State Department mimeo,
February 199.
Weidenbaum, Murray. “ Foreign Investment Could Be an
Asset, Not a Liability,” Christian Science Monitor,
August 24, 1988.

65

H. Robert Heller

H. Robert Heller is a member of the Board of Governors of the
Federal Reserve System. This paper, the third annual Homer
Jones Memorial Lecture, was presented at the University of
Missouri-St. Louis on April 6, 1989.

Money and the International
Monetary System

I AM VERY HONORED to have been invited to
deliver the annual Homer Jones memorial lec­
ture. In deference to his memory, I believe it is
appropriate that this lecture be concerned with
some of the enduring themes that pervade
thinking about money.
Many distinguished economists have pondered
the role of money and prices and the question
of whether it is more appropriate to organize
our monetary affairs along national lines or to
adhere to an international monetary standard.
In arriving at an answer, they have addressed
important aspects of freedom, liberty and
sovereignty.
That the debate is still not settled definitively
attests to the complexity of the topic. As a mat­
ter of fact, the current debate about the desir­
ability of a common European monetary stan­
dard and about the formation of a European
central bank has revived many of the old
arguments.
My central theme today will be the role of
money and monetary stability and the choice
between a national monetary standard and an
international one.
I have a personal reason for choosing this
topic. For many years it has troubled me that
some of my friends and colleagues view them­
selves as monetarists and analyze domestic
policy from that perspective, while another


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group of my friends maintains that fixed ex­
change rates are the glue that holds the world
economy together. From the perspective of that
group, the world would be a better place if we
would only adopt a gold standard.
This division reminds me of the time when I
set out on my first trip to Latin America. As I
was leaving, an expert on the region told me:
“Young man, as you travel from country to
country in Latin America, you cannot fail to
notice that half of the central bankers you en­
counter will advocate fixed exchange rates,
while the other half see flexible exchange rates
as the only solution to their country’s problems.
Pretty soon you will also learn that virtually all
of them attended the University of Chicago. As
far as I can tell, the only reason for their dif­
ferent convictions is that the first group studied
in Chicago in a year when Harry Johnson and
Robert Mundell taught the Monetary Workshop,
while the second group took the course in a
year when Milton Friedman was teaching it.”
Eventually, I learned that the views of the two
groups could be reconciled on the global level
because there the conceptual and behavioral
assumptions underlying the two approaches
converge. If there were only one world econom­
ic and financial system, the debate about fixed
versus flexible exchange rates would not have
been joined in the first place. Unfortunately,
that is not the world w e live in.

66

But even for the world we live in, there is a
surprisingly close association among the global
level of international reserves (or the global
monetary base), the world money supply and
the world price level. That finding, however,
does not answer the question of whether finan­
cial stability is best achieved by having individu­
al nations manage their own monetary affairs in
an independent, decentralized manner; by rely­
ing on a global monetary constraint to impose
monetary discipline; or by seeking a workable
compromise that we can all live with.
Clearly, I will not be able to do justice to all
the complexities and nuances of the topic in
such a limited span of time. Brevity may, how­
ever, allow me to bring some of the issues
sharply into focus and to crystallize some of the
arguments.
I will first consider the roles of money in the
economy and then discuss some of the prob­
lems of defining monetary stability. I will then
turn to the role of freedom in determining the
ideal monetary system and finally present the
rudiments of a workable monetary system that
represents a viable compromise for our im­
perfect world.

THE ROLES OF MONEY
Money enhances economic freedom. In the
absence of money, w e would still be free to
make choices, but these choices would be cost­
ly, cumbersome and constrained.
To see how money enhances economic free­
dom, it is useful to remind ourselves that
money fulfills several distinct roles: it serves as
a unit of account, a medium of exchange and a
store of value.
As a unit of account, money enhances free­
dom of choice by permitting price comparisons
to be made more readily. It lowers information
costs and thereby improves the choices available.
As a medium of exchange, money allows in­
dividuals to better exercise their freedom to ac­
quire goods and services by lowering transac­
tion costs. Without money, people could barter
but this process would certainly be troublesome
and expensive.
As a store of value, money permits people to
exercise intertemporal choices by allowing them
to accumulate funds and to spend them later.




One may even argue that money increases
political freedom. Not only does money offer
greater independence and freedom of decision
making, but as a generally acceptable means of
payment and store of value, it enables the in­
dividual to reject one political system and use
his life savings to live somewhere else, under a
different political regime.
Thus, it is not surprising that politically re­
pressive regimes tend to provide their citizens
with a money that has little or no international
acceptability. Furthermore, they tend to punish
those who try to enhance their freedom of
choice and scope for independence by accumu­
lating foreign currencies. Nor is it surprising
that often, in times of extreme political suppres­
sion, gold has become an increasingly valuable
treasure.

MONEY AND THE PRICE LEVEL
Money can fill these various roles in an op­
timal fashion only if it is a stable unit of ac­
count, a stable means of exchange, and a stable
store of value. In other words, money should
provide a consistent yardstick, and that can be
true only in a non-inflationary environment.
Unfortunately, the measurement of inflation
itself poses not only conceptual, but also prac­
tical problems. If money itself is the yardstick,
how can its value be defined in terms of some­
thing else? If the monetary unit, say the dollar,
were to be defined in terms of gold, isn’t gold
then the yardstick? In that case, gold will at
least perform as the unit of account while the
dollar may serve as the means of exchange and
the store of value.
The value of a national currency may also be
defined or measured in terms of other national
currencies. But obviously this definition cannot
be used for all currencies: The "last” currency
must be defined in terms of something else.
There must be an ultimate yardstick. The Bretton Woods system solved this problem by defin­
ing the value of all currencies in terms of the
dollar, and defining the dollar in terms of gold.
Within a country, the price level is typically
the measuring rod for the value of its currency.
However, the definition of the price level is not
as unambiguous as it may seem at first sight.
Most customary measures of the price level
have the disadvantage of relying on weighted
averages of transaction prices of current goods

MARCH/APRIL 1989

67

and services. These are the familiar GNP deflat­
ors and the indices of producer prices and con­
sumer prices. For instance, as a measure of the
value of the stock of money, the GNP deflator is
flawed. It is a concept that has meaning only
for the prices of goods that are produced dur­
ing a certain period — that is, a flow concept.
But how about the prices of assets such as
commodities and real estate? Aren’t they rele­
vant when it comes to judging whether we are
in an inflationary or a deflationary situation? It
is arguably more appropriate to measure the
value of money in terms of other assets because
money itself is an asset. While a good case can
be made for considering prices of tangible
assets in assessing the value of money, matters
become increasingly complex as we broaden the
spectrum to include financial assets. One may
also make a good case that stock prices are a
convenient proxy for real asset values. But
other influences, such as a change in manage­
ment or changes in tax-law, may also influence
the value of a stock.
Matters become even more complicated in the
case of bonds. While they are an asset on one
individual's balance sheet, they are a liability on
someone else’s balance sheet. Their value is also
directly influenced by monetary policy, and it is
easy to get into circular reasoning in that con­
nection. Although bond prices do give useful in­
formation, it is probably better to consider that
information separately from information con­
veyed by changes in real asset prices.
I conclude from this discussion that if we are
interested in the stability of money as a unit of
account, store of value and means of transac­
tion, the appropriate indices for changes in the
value of money should incorporate prices that
reflect these functions. That is, asset prices,
commodity prices and intermediate as well as
final goods prices might appropriately be given
attention in defining and measuring price
stability and the value of money.

GOLD AS A MONETARY
STANDARD
Given the complexities of measuring the price
level itself and of defining the value of money,
it is not surprising that over the centuries peo­

1I will avoid the interesting debate on silver and bimetallism
and concentrate simply on gold.

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ple, in seeking simplicity and expediency, have
focused on gold as a universal constant that
served as a practical unit of account, a medium
of exchange and a store of value.
Gold has served as money over centuries of
human history.1 Moreover, many distinguished
economists have advocated a gold standard at
some point in their professional lives. But many
of them have subsequently abandoned their
beliefs that gold can serve as a national, let
alone a global, money and have come to ad­
vocate alternative systems.
I argued earlier that money plays an impor­
tant role in maintaining and enhancing econom­
ic and political freedom. To my mind, gold fails
to meet this crucial test for a monetary stan­
dard. The two largest gold-producing countries
in the world are the Soviet Union and South
Africa; as key suppliers, they wield considerable
influence over the market price of gold.
I
view neither one as an economically or
politically reliable and stable supplier. Thus, I
would not entrust them with the power over
our economic, financial and, indeed, political af­
fairs that a move to a gold standard would en­
tail. This objection seems to me so fundamental
as to make further debate of the pros and cons
of a gold standard unproductive and pointless.
There is simply no reason why free, democratic
nations should cede such an important part of
their sovereignty into uncertain hands. Of
course, everyone should be free to choose to
hold gold, and to use it as a store of value or as
a medium of exchange between willing in­
dividuals. Governments should neither fix the
price of gold nor impede its private use.

FREEDOM AND THE MONETARY
SYSTEM
Choosing an international monetary system in­
volves profound constitutional questions that af­
fect a nation's sovereignty.
The deep desire to protect and foster human
freedom unites the advocates of a national
monetary rule and the proponents of an overar­
ching international monetary standard. For
simplicity’s sake, I will refer to them as the

68

monetarists and the internationalists. The two
groups also distinguish themselves in their ad­
vocacy of flexible and fixed exchange rates
respectively.
Both the monetarists and the internationalists
hold the view that government should serve the
people and that the role of government should
be strictly limited. In the economic realm, both
groups believe in price stability as the key ob­
jective of monetary policy. They also want to
limit the role of government, and therefore ad­
vocate the adoption of “monetary constitutions”
or predetermined rules for carrying out policy.
In that, they are united against the interven­
tionist view, which holds that active governmen­
tal decision making is a positive force that is
needed to bring about economic stability, effi­
ciency and welfare maximization.
But the monetarists and the internationalists
adhere to different philosophical concepts about
which monetary arrangements best protect
human freedom. The monetarists believe that
human freedom is protected best when govern­
mental authority is exercised at the most decen­
tralized level of government; the interna­
tionalists believe that a global monetary rule
would minimize the chance of inappropriate in­
terference by national governments by taking
monetary decision making out of their hands.
Thus, monetarists and internationalists tend to
differ in their prescriptions for organizing the
monetary system. In addition, different em­
pirical judgments about the way the world
works underlie the two approaches.
Monetarists argue that to preserve individual
freedom, the power of the state should be
limited. They claim that the only consistent way
to accomplish this objective is to disperse
governmental power through decentralization to
the lowest level possible. National government
should exercise only those powers that cannot
be delegated to regional or local governmental
units.
While monetarists believe that the power to
create money and regulate its value should be
exercised at the national level, they also believe
that the authorities should be constrained by a
domestic monetary growth rule.
From this belief it follows that the govern­
ment should not be externally constrained. For
the monetarists, preserving that independence is
a key requirement of any international mone­



tary system. Consequently, the international
monetary system should be constructed so that
monetary decisions are taken at the lowest level
of decentralization possible, namely, the nation.
Flexible exchange rates are therefore advocated
by the monetarists as a means of preserving the
political and economic independence of the
country. Under such a system, international
policy coordination is not only unnecessary, it is
even undesirable because it will inevitably in­
fringe upon the freedom of the nation-state. In­
stead, flexible exchange rates are advocated as a
buffer between countries.
In contrast, internationalists argue that in­
dividual economic freedom can be attained best
in a system in which one common international
currency is used throughout the world. In such
a system, individuals are free from national
economic and financial constraints and can max­
imize their welfare unhampered by national
boundaries and political intrusions. They are at
liberty to engage in transactions with anybody
anywhere in the world. In the view of many in­
ternationalists, an international gold standard
provides such a system, in which gold serves as
the actual medium of exchange. Such a system
eliminates the uncertainties imposed by fluctua­
tions in exchange rates, and maximization of
global welfare therefore becomes a genuine
possibility.
The true internationalist sees the nation-state
largely as a political construct that has only
limited economic importance. A common global
monetary standard will allow individuals to
maximize their economic as well as their politi­
cal welfare.
The two sides are united in their view that
the preservation and enhancement of individual
freedom are the ultimate and overarching goals
of any social order. That is the ideal. They both
wish to attain that ideal by minimizing the
political and economic power of the state. Fur­
thermore, they assume that competitive forces
will bring about economic adjustment in a
speedy and efficient manner.
The question is whether reality can approach
this ideal view of the world, or whether the im­
perfections that still beset the world call for a
compromise that may fall short of the ideal
systems represented by pure monetarism or
pure internationalism.

MARCH/APRIL 1989

69

A PRAGMATIC APPROACH
While at present important interpreting forces
are shaping the global economy, I believe that
the world is still an imperfect place. Economic
conditions and the degree of economic integra­
tion vary around the globe. Relatively few true
global markets exist, and the various national
and regional markets are linked with differing
degrees of perfection.
In other words, despite greater globalization
the economic and financial world remains a
patchwork. Some would argue that patchwork
makes the world even more interesting and
beautiful — and in a world with positive infor­
mation costs, the one may be just as efficient as
the other.
The problem confronting us is therefore one
of constrained optimization and of the develop­
ment of rules that will permit maximum free­
dom in the economic and political realm while
taking into account the need for collective deci­
sion making in certain areas.
Nowhere is the need for such an accommoda­
tion more apparent than in the monetary
sphere. Just as separate monies issued by in­
dividual persons would lose their usefulness, so
would a global monetary standard not necessari­
ly serve everyone best. The debate about the
advantages and disadvantages associated with a
common monetary standard and a central bank
for Europe reveals the problems and the issues
involved.
Let me set out what I consider to be some
relevant considerations that should guide us in
deciding what monetary system will serve us
best.
First of all, the goal of monetary policy should
be to provide a stable financial environment so
that private decision makers can maximize their
welfare. A stable monetary standard will help to
minimize transaction costs and aid in rational
economic decision making. Stability in this sense
can be defined as the absence of any bias in
decision making that would be induced by a
tendency for the price level to vary systematic­
ally. This state of affairs will be reached when
the change in the general price level is close
enough to zero that economic agents can ignore
it in their decision making.
Second, price stability is meaningful only in
an economically and financially integrated area.

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The world w e live in does not yet represent
such a market area. National borders, artificial
or informal barriers to economic and financial
flows, information barriers and the like, all con­
tribute to a compartmentalization of the world
economy.
Third, a common indicator, such as a global
commodity basket, can provide a useful refer­
ence point for national and international policy
makers. Not only is such a reference point
helpful in introducing sensitive asset prices into
the decision making process, but also it gives
important information about the development of
global inflationary or deflationary pressures. In­
deed, the use of such an indicator of commodi­
ty prices was agreed upon at the Toronto sum­
mit meeting of the industrialized nations.
Fourth, more or less homogeneous economic
and financial zones constitute the optimal do­
mains for various monies or monetary stan­
dards. As economic and financial integration
progresses and as the barriers between econom­
ic regions fall, the natural monetary domain
also grows. At present, such progress is par­
ticularly pronounced in Europe, which is rapid­
ly moving toward becoming an integrated
economic and financial entity. As a conse­
quence, talk about European monetary integra­
tion nowadays is more than theoretical specula­
tion, and it may well move into the realm of
reality in the not too distant future.
Fifth, it should be recognized that monetary
integration has not only economic, but also
political significance. The road to this common
monetary standard can be the formation of a
joint political decision-making body, the delega­
tion of the monetary decisions to a common
central bank, adoption of a commodity or gold
standard or the formal or informal acceptance
of a standard represented by another monetary
authority. In the last case, the political under­
pinnings of that decision-making body must be
sufficiently similar to the political beliefs and
priorities of all participants to avert substantive
conflicts.
As the global integration of economic and
financial markets proceeds and as political in­
terdependence increases, it stands to reason
that monetary integration will increase as well.
In that connection it is important that pro­
gress in one area be accompanied by progress
in the other areas. Just as it would be unrealis­

70

tic to expect rapid political integration, it is
unrealistic to push monetary integration too far
out in front. Time for adjustment and consen­
sus formation must be permitted.
But as confidence in economic and financial
integration grows and as political cooperation
becomes an enduring reality, progress toward
greater monetary integration will be made as
well. That is, the monetary domains will tend to
expand, and over time we will move closer to a
global monetary standard.
What does all that imply for the real world
that we live in?
In exploring that question, we must remem­
ber the lessons of history. Soon after the
establishment of a government for the United
States, the First Bank of the United States was
founded, in 1789. Its charter was not renewed,
and it was succeeded by the Second Bank of the
United States, which ceased to exist in 1836.
Why? Simply because the economic and political
consensus in the young nation was too weak to
support a uniform monetary policy. The in­
terests of the merchants and traders of the East
could not yet be reconciled with the priorities
of the farmers and settlers of the South and
West. Thus, the United States had to do without
a central bank until the formation of the Federal
Reserve System, only 75 years ago. Even then,
the design of the System recognized the need to
assure representation of the views of the vari­
ous regions of the country, as well as those of
the banking, commercial, industrial, agricultural
and public interests.
On our own continent, we see an everincreasing integration of the economic and
financial affairs of the United States and Canada.
The U.S. dollar is used widely in Canadian
capital markets. It is also used as a medium of
exchange and a store of value in much of Latin
America. But clearly no political base is in place
for monetary integration among the various coun­
tries of the American continent.
Matters have proceeded further in Europe,
where the movement toward economic integra­
tion has been accompanied by the establishment
of common administrative and political institu­
tions. This development sets the stage for the
debate about the desirability of establishing a
central bank for Europe, which could issue a



common currency and administer a common
monetary policy.
It is instructive to trace the development of
the European Community because it illustrates
the interdependence of economic, monetary and
political integration. An economic beginning was
made by the original six signatories to the Trea­
ty of Rome, which established the European
Economic Community. Gradually, other nations
entered the economic union.
In the monetary sphere, Belgium and Luxem­
bourg have long had a common currency. The
common monetary arrangements of the Euro­
pean “snake” constituted essentially an experi­
ment, but taught important lessons that were
incorporated into the more formal European
Monetary System. While the original members
of the European Economic Community are now
all participants in the European Monetary
System, some of the countries that joined the
Community later have not yet taken this step.
Overall, progress has been gradual and some­
times marked by disappointments and setbacks.
All this has been accompanied by the establish­
ment of common European political institutions
and by the development of an administrative ap­
paratus that has progressed from exercising
coordinating functions to playing an important
decision-making role. Thus, a growing economic
and political consensus has been forged that
may in due course serve as a foundation for a
common European currency and a common
monetary policy.
I have previously advocated the establishment
of unitary exchange rates as an intermediate
step that the Europeans might take. Under such
an arrangement, all exchange rates would be
aligned so that one German mark would equal
one French franc, one British Pound, and so on.
The institutional arrangements of the current
European Monetary System (EMS) would be
maintained. Under such a scheme, the various
currencies would soon be accepted across the
continent, and in effect a uniform means of ex­
change for the continent would be created. If
the arrangement were successful, a full
monetary union and European central bank
might follow in due course.
The formation of a European currency area
would undoubtedly have implications that

MARCH/APRIL 1989

71

would transcend European borders. Already
quite a few African countries peg their curren­
cies to those of European countries, and it can
be expected that these and possibly others
would want to peg to a common European cur­
rency as well.

What may we conclude from this discussion?
One, the choice of a monetary standard and a
monetary system involves important political
choices and is rooted in basic ideas about how
best to protect and preserve freedom. Those
choices, then, must be made with great care.


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A certain congruence among political, econom­
ic, financial and monetary arrangements is
needed if such arrangements are to find public
acceptance and if they are to be viable.
Two, as the world becomes more integrated,
progress toward the establishment of broader
monetary domains can also be made.
I believe that w e are privileged to live in a
time in which w e are witness to considerable
progress on all these fronts and in which we
can participate in building a more integrated
world, where economic and political decisions
can be made with increasing freedom for all
people.

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St. Louis, Missouri 63166

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