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March/ A p r il 1993

V ol. 75, No. 2

Dimensions of
Monetary Policy
Essays in Honor of

Anatol B. Balbach

Proceedings of the
Seventeenth Annual Economic Policy Conference of the
Federal Reserve Bank of St. Louis

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F e d e ra l R e s e rv e B a n k o f St. L o u is
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March/April 1993

In This Issue . . .
iii

Contributing Authors

President’s Message
Thomas C. Melzer

vii

Editor’s Introduction
Michael T. Belongia

xiii

T ed Balbach: A n Appreciation
Armen A. Alchian

M onetary Aggregates, M onetary Policy and Economic Activity
Robert H. Rasche

Com m entary
Julio J. Rotemberg

V iew s on M onetary Policy
W. Lee Hoskins

Com m entary
G eo rg Rich

Financial Regulation and the Com petitiveness of the Large U.S.
Corporation
Harold Demsetz

Com m entary
Charles I. Plosser

A ssessing A pplied Econometric Results
Carl F. Christ

Com m entary
David A. Dickey

MARCH/APRIL 1993

101

Commentary
David Laidler

103

Real Exchange Rates: Some Evidence from the P o stw a r Years
Allan H. Meltzer

118

Com m entary
Pedro Schwartz

133

The Gold Standard, Bretton W oods and O ther M onetary Regimes:
A Historical A ppraisal
Michael D. Bordo

192

Com m entary
Manfred J. M. Neumann

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iii

Contributing Authors
A rm en A. Alchian

M an fred J.M. N eum ann

Department of Economics
University of California
Los Angeles, CA 90024

Universitat Bonn
Lennestrasse 37
D-5300 Bonn 1 Germany

M ichael D. B o rd o

C harles I. P lo sse r

Department of Economics
Rutgers University
New Brunswick, NJ 08903

Department of Economics
University of Rochester
Rochester, NY 14627

C arl F. Christ

R obert H. Rasche

Department of Economics
The Johns Hopkins University
Baltimore, MD 21218

Economics Department
Michigan State University
East Lansing, MI 48823

H a ro ld Dem setz

G eo rg Rich

Department of Economics
University of California
Los Angeles, CA 90024

Schweizerische National Bank
Borsenstrasse 15
8022 Zurich Switzerland

D avid A. Dickey

Julio J. R otem berg

Department of Statistics
North Carolina State University
Raleigh, NC 27695

Sloan School of Management
Massachusetts Institute Technology
Cambridge, MA 02139

W. Lee Hoskins

Ped ro Schwartz

The Huntington National Bank
Huntington Center
Columbus, OH 43287

Antonio Maura, 7
28014 Madrid Spain

David Laidler

Department of Economics
University of Western Ontario
London, Ontario N6A5C2
Allan H. Meltzer

Carnegie-Mellon University
Graduate School of Industrial
Administration
Pittsburg, PA 15213

MARCH/APRIL 1993

President’s Message
It is with great pleasure that we dedicate these
proceedings in honor of Anatol B. (Ted) Balbach
and his years of distinguished service at the
Federal Reserve Bank of St. Louis. Ted first
joined the Bank as a visiting scholar in August
1970. After returning to his position as Dean of
the School o f Business at California State Uni
versity at Northridge one year later, he rejoined
the Bank in August 1972 as a Senior Economist;
in 1975 he became Senior Vice President and
Director of Research, the position he held until
his retirement on Oct. 31, 1992.
The period of his tenure offered a wide spec
trum of research topics for monetary economists,
and Ted led the research staff to put the Bank’s
imprint on most. In the early days, the stress of
4 percent inflation precipitated an ill-advised ex
periment with peacetime wage and price con
trols and the closing of the gold window; a
move to freely floating exchange rates soon fol
lowed. Those days also saw a Republican presi
dent declare “W e are all Keynesians now!” at
the same time serious discontent with that dom
inant paradigm was being articulated.
Building on the foundation already established
by Homer Jones and notable work such as the
Andersen-Jordan equation, Ted led the staff to
write rigorous, but still readable, articles on
controversial topics: the links between money
growth and both nominal spending and the
inflation rate; the link between rapid money
growth and higher, rather than lower, nominal
interest rates; the merits of flexible exchange
rates; and the adverse consequences of uncon
strained discretionary actions in monetary pol
icy. Although this research agenda ran in par
allel to one thread of the academic literature, it
contributed in important ways to making the
controversial issues of the 1970s the common
ground for discussion in the 1990s.
The proceedings o f this conference represent
the main areas of research Ted emphasized dur

ing his tenure at St. Louis. These interests, in
turn, reflect his ongoing concern that a research
department in a Federal Reserve Bank has to be
accountable for its expenditure of taxpayer dol
lars. As such, the research topics must be rele
vant to the concerns of a central bank, and the
lesson of the work must be understandable to a
broad audience. Whatever recognition has ac
crued to the Bank over time can be attributed
in large measure to an adherence to these sim
ple principles.
Many staff members achieved great success
working for Ted and moved on to important
responsibilities elsewhere. This occurred be
cause Ted insisted on high productivity from
the Research staff, while seeing to it that they
received proper credit for their work. Clearly,
he played a key role in the recognition that the
Bank received during his tenure and in the
professional success of many who worked for
him. Nonetheless, Ted, like Homer Jones before
him, was content to be anonymous to most
people.
These proceedings are a small effort to shed
that anonymity and acknowledge that many
people owe a great debt to Ted Balbach. Armen
Alchian's warm opening comments give much of
the flavor of sentiments expressed by speakers
and guests alike. Indeed, the authors o f the
papers in this volume produced papers of uni
formly high quality as a sign of respect for
Ted’s high standards: They knew he would have
been offended by a routine "festschrift” that
stressed style and forgot the substance. Stu
dents of a central bank's responsibilities should
find something of interest in each of these
contributions.

Thomas C. Melzer
President and Chief Executive Officer
Federal Reserve Bank of St. Louis

MARCH/APRIL 1993

vii

Editor's Introduction
The Federal Reserve Bank of St. Louis, held its
first Economic Policy Conference in 1976, in con
junction with the Center for the Study of Ameri
can Business at Washington University. Although
this annual event has grown over time it has
maintained a focus on many of the principles that
Ted Balbach fostered during his tenure as direc
tor of Research. An open exchange of ideas was
high on that list and an annual gathering of
prominent academics to discuss important con
cerns of central banking was but another way in
Ted’s mind to move intellectual debates forward.
With his retirement in October 1992, it was fit
ting, indeed essential, that the beginning of a
new chapter in his life be marked with a tribute
to the legacy he has left for all of us. According
ly, the papers in these proceedings reflect eco
nomic and policy issues that were never far from
Ted’s attention.
The conference’s first session dealt with two is
sues that, more than any others, dominated Ted’s
career at St. Louis: the effects of money on eco
nomic activity and the commitment of the central
bank to a goal of price stability. Robert H. Rasche,
in "Monetary Aggregates, Monetary Policy and
Economic Activity,” investigates the large and un
anticipated shifts in money velocity during the
1980s that led to large errors in predictions of
inflation and growing sentiment that the demandfor-money function is unstable. Rasche’s paper ap
proaches this task from three perspectives: con
troversies of the 1960s and 1970s that have been
resolved, empirical failures of reduced-form spend
ing equations in the 1980s and the short-run ef
fects of changes in the growth rate of the nomi
nal money supply on economic activity.
In reviewing the historical controversies, Rasche
concludes that current mainstream macroeconomic
thought embodies the important elements of the
original Andersen-Jordan equation: changes in
nominal government spending do not produce a
permanent change in nominal income (or velocity)
unless accompanied by a change in the growth

rate of the nominal money stock. He also concludes
that shocks to the level of velocity are permanent.
The first point was contradictory to the dominant
Keynesian paradigm of 25 years ago and the latter
anticipated the now commonplace care that is
given to proper differencing of the data and the
problem of spurious regression relationships.
Just as the world of monetary policy began to
take St. Louis-type arguments seriously, the 1980s
produced a sharp break in trend velocity that dis
credited the Andersen-Jordan equation in the minds
of many. In the second section of his paper, Rasche
explores whether this break more likely reflects a
rejection of the underlying economic relationships
or a specification error arising from a Lucas-type
structural change. Rasche concludes in favor of
the latter, arguing that a sharp break in inflation
ary expectations explains the break in trend veloc
ity. Rasche also discusses how, if this explanation
is correct, simple money growth rate rules for
policy will be dominated by rules with feedback
of the sort described by Meltzer and McCallum.
In the last section of his paper, Rasche inves
tigates a current controversy: whether changes in
nominal money growth affect real output. After
evaluating several vector autoregression (VAR)
models, Rasche concludes that there is evidence
in support of both permanent real output shocks
(of the real business cycle variety) and permanent
money growth shocks on real output. Thus though
the role of money in explaining fluctuations in
real activity is not rejected, Rasche finds room for
contributions from other sources as well.
In his commentary, Julio J. Rotemberg focuses
on Rasche’s claims of finding a stable money de
mand function. After estimating velocity regres
sions in the spirit of Rasche’s analysis, Rotemberg
finds that the apparently stable long-run specifica
tion coincides with an "incredibly unstable” moneydemand function at shorter frequencies. He also
finds that the residuals of such relationships are
highly correlated.

MARCH/APRIL 1993

viii

As reasons for these unsatisfying results,
Rotemberg renews an earlier call from our 1989
conference to use Divisia monetary aggregates
in place of the conventional simple-sum meas
ures. Although he only approximates a crude
Divisia measure of M l, the large break in observed
M l velocity in the early 1980s is reduced substan
tially when based on data from a weighted mone
tary aggregate. Thus other explanations beyond
those offered by Rasche may explain the veloci
ty puzzle or there may be no puzzle to explain.
Rotemberg also extends Rasche’s VAR analysis
with additional support for recent studies that
have shown asymmetric effects of monetary
shocks on output—negative shocks reduce out
put but positive shocks do not increase output.
This asymmetry and other asymmetries affect
ing interest rates are left as important issues to
be investigated in further work.
With this backdrop on how velocity has be
haved over time and how monetary policy
apparently affects economic activity, W. Lee
Hoskins offered a philosophical overview of
how a central bank should conduct itself. In his
"Views o f Monetary Policy,” Hoskins drew on
his previous experience as president o f the Fed
eral Reserve Bank of Cleveland and voting mem
ber of the Federal Open Market Committee to
criticize central banks for their tepid commit
ment to the goal of price stability, if not their
demonstrable bias toward inflationary policies.
These flaws in the charters o f most central banks
can be overcome, in Hoskins' view, only by stat
ing a specific mandate to achieve price stability,
giving the central bank the necessary indepen
dence to achieve that goal and holding it ac
countable for any failure to do so.
With much of the academic literature focusing
on technical issues (for example, interest rate
vs. money stock targets) or public choice argu
ments to explain central bank failures to achieve
price stability, Hoskins advances “a simple and
less elegant explanation...that central bankers
are suffering from a Keynesian hangover.” The
point is that, as products of a generation that
learned an economic model in which central
bankers should attempt to manage fluctuations
in aggregate output, as well as inflation, modern
central bankers are merely employing the train
ing they acquired 20 or more years ago. Thus
when the economy is weak, their vintage of
training indicates a need for monetary stimuluseven if it ultimately will cause higher inflation.
This view, which does not incorporate more re

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cent evidence on the dubious effects of monetary
stimulus on output, also fits nicely with the views
of elected officials more concerned with near-term
issues, such as employment, than with the long
term issue of inflation. In this environment, an in
flationary bias by central banks is not difficult to
understand and the broad reforms Hoskins sug
gests are tied to the argument’s main themes.
In his commentary, Georg Rich largely agrees
with Hoskins’ statement of principles but won
ders whether the gap from theory to practice
can be bridged, and if so, how. Rich first argues
that a mandate to achieve price stability, such
as embodied in legislation proposed by Rep.
Stephen Neal (D-N.C.), is not sufficient to achieve
zero inflation. Instead, Rich argues that an oper
ational rule, perhaps of the form proposed by
Meltzer or McCallum, is needed to keep an ac
cumulation of short run operational decisions
by the central bank from wandering too far
from a long-run policy that will maintain price
stability. At the same time, Rich recognizes that
the need to react to shifts in money demand
raises some doubts about the desirability of
the slow, mechanical paths of adjustment pro
scribed by these rules.
Rich raises other practical issues as well.
Should the central bank, for example, ignore
any effects o f changes in the real exchange rate
or respond to appreciations and depreciations in
the real exchange rate with equal zeal? More
over, should—or can—the central bank disregard
any and all real costs associated with a monetary
policy consistent with the pursuit of price sta
bility? Overall, Rich’s comments suggest areas
where the practical elements of Hoskins’ broad
proposal need to be specified.
The first day’s afternoon session took a detour
from a central bank’s monetary focus to address
related, but often overlooked, themes. The first
is the functioning of competitive markets; price
stability, after all, is not pursued from religious
conviction but rather from the notion that the
market mechanism will allocate resources more
efficiently if economic agents can be reasonably
certain about the future purchasing power of
money. The second detour addresses the issue
of good econometric practice; because Ted be
lieved that economic understanding would ad
vance only after theories were confronted by
the data and refutable null hypotheses were
tested, he viewed good econometric practice as
essential to the work of a central bank.

On the topic of the market mechanism, Harold
Demsetz presented his thoughts in “Financial
Regulation and the Competitiveness of the Large
U.S. Corporation.” In particular, he addresses
the effects of regulation of capital markets on
shareholder control o f corporate management.
When diffuse ownership impedes stockholders
from controlling self-interested corporate man
agement and capital market regulations inhibit
greater concentration of ownership, corporate
efficiency can be impaired.
The story is not quite so simple, however.
First, stockholders enter agreements with man
agement voluntarily and in full knowledge of
potential conflicts of interest. Second, even
though corporate ownership is diffuse, it is not
so diffuse that owners have no incentive or
power to monitor management. Third, though
greater concentration o f ownership might en
hance control of management, this is achieved
at a cost of increased firm-specific risk.
Citing findings of other studies, Demsetz re
ports that the top five stockholders of U.S. cor
porations own about one-fourth o f voting stock,
whereas this share is substantially higher abroad:
50 percent or more in South Africa, 33 percent
in Japan and similarly higher figures for Germany
and Sweden. Demsetz argues that the higher
concentration of ownership abroad can be at
tributed to restrictions in the United States that
prevent or limit banks, insurance companies
and others from taking equity positions in U.S.
corporations. With most U.S. corporate equity
then coming from individual investors, what ef
fect might this have on corporate efficiency?
Demsetz clarifies the issues surrounding the
separation problem of ownership and control by
noting the difference between closed-end and
open-end mutual funds. In the former, investor
funds are converted to assets owned by the
fund', thus a dissatisfied investor can sell his
shares but, because he cannot force the fund to
be the purchaser, there is no threat that poor
performance will threaten management’s control
of the fund’s assets.
In an open-end fund, however, investors who
withdraw funds also diminish the fund’s asset
base. Moreover, it is important to note that this
is different from the sale o f stock in an individ
ual company where, although the share price
might decline, the assets controlled by manage
ment are unaffected. Thus by adding this new
twist to the conditions necessary for the separa

tion problem to be important, Demsetz suggests
an ownership structure that can be quite diffuse
while still exercising effective control over
management.
In his commentary, Charles I. Plosser notes
that this paper, like many others by Demsetz,
raises an issue that (to his knowledge) has been
overlooked by others. And, though he encour
ages efforts to assemble empirical evidence on
the association between corporate ownership
and regulation on the one hand and corporate
performance and control on the other, Plosser
has doubts that the issues are likely to be eco
nomically important.
Plosser's first doubt arises from his belief in
the market mechanism and the ingenuity of in
dividuals. Based on evidence from studies of the
efficacy of other regulations and the typical
response o f individuals to the opportunity of
large rewards for evading regulations, Plosser’s
instinct is that the costs of regulations on cor
porate ownership are small.
He devotes the remainder of his commentary
to the notion of comparative advantage in in
vestments. Some funds, for example, specialize
in risk sharing and as a consequence limit their
stake in any one firm. Not only is there no rea
son to expect that the managers of this type of
fund have an advantage in corporate control,
but there are also suggestions that some of
these funds are largely uninterested in corporate
control. Conversely, other funds specialize in
corporate control by taking large ownership po
sitions in single firms and by so doing do not
diversify risk for their investors. Specialized
funds of these types, in Plosser’s view, are but
one market response to distortions created by
regulation of corporate ownership. At the same
time, new regulation, such as the provisions in
the Financial Institution Reform Recovery and
Enforcement Act that limit bank holdings of
high-risk securities, may create new distortions
that are important for the efficiency of the mar
ket for corporate control.
Carl Christ’s paper, "Assessing Applied Econo
metric Results,” offers both philosophical com
ments on the desirable properties of econometric
models and practical suggestions for evaluating
real models against the standards of an ideal
model.
The standards for accepting or rejecting a
model and the quality o f forecasts are discussed

MARCH/APRIL 1993

in some detail. Christ also offers brief comments
on the more popular methods that have been
applied to macroeconomic time series in recent
years.
Most of Christ’s points are illustrated by a
re-examination of what he calls ‘‘an old, plainvanilla equation that still works, roughly”:
Latane’s (1954) inverse velocity equation. Noting
that the specification of Ml/GNP = a + b (inverse
of long-term bond rate) has some of the proper
ties of a money-demand function—negative in
terest elasticity and income elasticity restricted,
by construction, to equal one—Christ wonders
whether the original equation is stable when so
many money demand equations have exhibited
substantial instability over time. In a variety of
experiments, no demonstrable instability is
found.
Christ notes, however, that this specification
has a number of undesirable characteristics in
cluding strong positive serial correlation. Em
barking on a number o f approaches to this
problem, Christ employs strategies from the
simple addition of an autoregressive term to the
use of an error correction representation with
partial adjustment parameters. He finds equa
tions that fit much better but are terribly unsta
ble over time. In doing so, he highlights the
need for considerable judgment in addressing
the important question of interest while resist
ing the temptation to find models that have bet
ter in-sample descriptive statistics.
Two discussants offered comments on Christ’s
paper: David Dickey on the suggested approach
to econometric modeling and David Laidler,
speaking for the “stochastically challenged" among
us, on the economics of Christ’s chosen exam
ple. Dickey agrees with Christ’s general thrust
and adds a few new examples of subtle relation
ships that are often lost in mechanical transfor
mations of data. That the error term is multi
plicative in a log specification of the Quantity
Equation, and hence implies heterogeneity of
variance in the untransformed data, probably
has not been considered by most economists
who have estimated reduced-form relationships
of this sort. Nor is it always recognized that ex
act relationships hold on some scales but not on
others. Although these might be considered sim
ple examples by some, Dickey’s point reinforces
Christ’s entire theme of taking care with the
economic specification and the raw data used to
estimate it.

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Dickey also comments on Christ's evaluation
of a forecasting model’s performance: Should a
good model see a quadrupling of the root mean
squared error across a forecast horizon o f eight
quarters? At first glance, one might think that
this is a reasonable standard. Dickey shows,
however, that the probability o f such a quad
rupling is high even if the true model is known.
This sobering result suggests a continuing reli
ance on judgment to supplement the informa
tion in econometric forecasts. Finally, on a
related point, Dickey notes that the simple bivariate velocity regression in Christ's paper can
be dressed-up in the adornments of cointegra
tion. But at heart, the main ideas are similar to
those in the original Latane study.
David Laidler applauds Christ for his reitera
tion of a point made at least 25 years earlier
calling for a test of models against data that
were not available when the model was formu
lated. Indeed, Laidler sees a full research agen
da for applied econometricians who might
investigate how a number of the classic equa
tions of the literature fare when confronted by
more recent data. If other relationships were
found to be as stable over time as the Latane
equation, we might come closer to some consen
sus on the enduring long-run relationships that
govern the behavior o f aggregate data.
This view stands in counterpoint to Laidler’s
reading of the money-demand literature and the
philosophy behind its voluminous work. Much
of this work has argued that the demand-formoney function is unstable and has done so
with evidence on some instability in its shortrun dynamics. But Laidler argues that no one
has yet modeled these complex short-run inter
actions and, as such, we never had any reason
to believe that we should be able to find a sta
ble short run money-demand function. Thus it
should not be surprising that more sophisticated
attempts at modeling autocorrelation and other
problems have produced models that are less
robust than simple specifications of the long-run
relationships for which we have a theory.
The conference’s last session addressed topics
in international economics of interest to Ted:
flexible exchange rates, and the gold standard
as a monetary policy rule. On the first topic, Al
lan Meltzer notes that the theoretical case for
flexible exchange rates can go either way: they
may be a relatively low cost way of reducing
the variances of other variables or they may be

a source of excess burden. Surprisingly, how
ever, little empirical evidence has been produced
that permits comparisons of the welfare implica
tions of alternative exchange rate regimes.
Meltzer’s paper is directed to this end.
After reviewing the case for flexible exchange
rates as put forth by Friedman in 1953, Meltzer
offers empirical evidence on several o f the key
issues in the flexible vs. fixed exchange rate de
bate. The first is the possible excess volatility
and welfare burden of flexible rates. Looking at
data since 1973 for both the Bretton Woods and
flexible exchange rate periods and for flexible
rate countries and the members of the Exchange
Rate Mechanism (ERM) Meltzer finds that the
variability of relative prices does not vary sys
tematically across exchange rate regimes. He
also finds no evidence to support the proposition
that output is more variable under a fixed ex
change rate system.
Moving on to policy issues, Meltzer reminds
us that Friedman’s 1953 work attributed a large
role to rearmament in exchange rate determina
tion (because it affects relative prices and the
balance of payments) and distinguished between
permanent and transitory changes in exchange
rates. Incorporating the first idea into an equa
tion for the real exchange rate, Meltzer reports
that “contemporaneous changes in money and
in defense spending are the principal factors
keeping the predicted changes in step with actu
al changes.” He also presents evidence against
the common finding that the exchange rate is
nonstationary. Overall, Meltzer finds much in
his empirical evidence to support the main
propositions in Friedman’s 1953 essay.
Pedro Schwartz agrees with the thrust of
Meltzer’s analysis and applies it to current de
bates over monetary union in Europe. As the
evidence indicates that real and nominal ex
change rates move closely together and that ex
change rate variability does not spill over into
the goods market, an exchange rate objective
does not seem to be an important or proper ob
jective for a central bank. Indeed, with no abili
ty to influence real exchange rates and un
burdened of worries about spillover effects,
Schwartz interprets Meltzer’s evidence as more
support for directing a central bank's attention
to the attainment of price stability.
With regard to European Monetary Union,
Schwartz sees the potential gains associated
with a single currency and the lower transac

tions costs of trade. He also sees, however, the
drawbacks of another political institution, the
European Central Bank, subject to varying de
mands to pursue goals apart from price stabili
ty. Rather than move to a stronger government
institution, Schwartz believes competition be
tween issuers o f money may lead to better re
sults for consumers o f monetary services.
Michael Bordo picks up many of the themes
raised by Meltzer and Schwartz: the welfare
consequences of alternative exchange rate re
gimes, the insulating properties of flexible rates,
rules vs. discretion in the conduct o f monetary
policy, international policy coordination and the
case for international monetary reform. In a
wide-ranging treatment of each issue, Bordo
both reviews the existing literature and offers
new empirical evidence to investigate why some
exchange rate regimes have been more success
ful than others.
On the question of performance, Bordo finds
the Bretton Woods convertible regime of
1959/1970 to dominate all others examined; only
the recent floating rate period comes close to
achieving its level of performance. He also notes
that the classical gold standard performed well
as a nominal anchor but poorly in terms of the
stability of real variables. Moreover, he argues
that the gold standard was more durable than
Bretton Woods because it worked as a contin
gent rule and, as such, allowed the flexibility
for governments to adjust to shocks.
Bordo goes further than Schwartz in conclud
ing from his evidence that monetary arrange
ments that surrender monetary policy autonomy
will not work over time. Because countries will
not surrender this autonomy to another authori
ty whose commitment to price stability they
cannot trust, the key advantage of a flexible
rate regime—the ability to pursue an indepen
dent monetary policy—is still valued highly. The
stresses within the European Monetary System in
September 1992 only reinforce Bordo’s con
clusion.
Manfred J.M. Neumann, who found much
to agree with in Bordo’s paper, first tries to
enhance our understanding of Bordo’s VAR evi
dence by supplementing it with a basic theoreti
cal model. Although this exercise is frustrating
in the sense that it identifies many unknowns
confronting economists and policymakers, it is
highly instructive as to where future research
might be most profitably directed.

MARCH/APRIL 1993

xii

Neumann then spends the remainder of his
commentary on the reasons international mone
tary arrangements tend to break down. His con
clusion is that standards based on commitments
to rules fail because the commitments are ulti
mately not credible. Discussing the relative
merits of two alternatives—precommitment by
one central bank to price stability with all re
maining countries precommitted to fixed ex
change rates vs. precommitments by each na
tion’s central bank to price stability—Neumann
prefers the latter. His reason is that it will pro
vide the ability to absorb idiosyncratic shocks
(of many varieties) while still providing a credi
ble nominal anchor for the price level.
In sum, the papers in this proceedings issue
reflect Ted Balbach’s world view: markets work,

FEDERAL RESERVE BANK OF ST. LOUIS

money matters, and empirical evidence is im
portant. Add to these guideposts the principle
that a policy institution supported by taxpayer
dollars should direct attention to relevant, real
world issues and you have the framework tha
guided the St. Louis Fed’s research effort duri:
his tenure. Although the Bank’s many clients
and all o f those who worked for or with Ted
during his 20 years of service can continue to
enjoy his legacy, his presence at the Bank will
be dearly missed.

Michael T. Belongia
St. Louis, Missouri
April 23, 1993

xiii

Ted Balbach: An Appreciation
Anatol Berkman Balbach. Welcome to what is
naively called the leisure class. And kiss your
leisure good-bye: You had that by working for
the Fed. Retirement? No, you’ve shed that and
now you’re on your own time as you rush from
here to there, no longer working under the
5:00 o'clock mentality. You and Rae have shed
one taskmaster for another. But there is some
good news. You are now old—a senior citizen
or "senile” as I like to say. You’ll get senior dis
counts at restaurants and hotels and theaters,
but not from doctors or hospitals. You’ll get
haircuts that are overpriced.
By the way, I’ll offer you some advice. Because
the capital value of us old people is very small—
w e’ve got a short life expectancy—we lose little
by breaking our contracts and commitments.
You may therefore wonder why I am here even
though I promised to come. Well, I’d really
planned to call at the last minute and say, "I’m
sorry I have to go to the hospital to have an an
giogram and I can’t make it.” I’ve done that
twice already at other places and it’s a good ex
cuse. So why’d I come? Rae—she’s the one. She's
smarter than you or me. She knew what I was
going to do, so she phoned me about a month
ago and said, "I got a golf date for you on Friday
afternoon at Bellerive.” That's why I’m here.
Enough about me and about the wisdom of
maturity. You, Ted, were born in Konigsburg,
Germany, on October 31, 1927, Halloween's day,
a mother’s trick-or-treat. W e are glad to know
now that it was a treat. As a youth I understand
you were drafted into the labor camp and you
shoveled stuff from here to there learning about
comparative advantage. But then something
remarkable happened I’m told. You, in another
labor camp, met your mother quite by surprise.
I think that’s right—a story we have to hear
sometime. You came with her as displaced per
sons to Los Angeles because of the prevalence
in that area of some earlier relatives, immigrant
relatives. Los Angeles still is a haven for refu

gees and in many ways is better for it. Driving
from the west side o f Los Angeles, where UCLA
is, to the east side is like a quick trip through
Israel, Japan, Korea, China, Vietnam, Mexico,
Iran, Armenia and Africa. You came to UCLA,
Ted, after attending high school in Los Angeles,
where you thought you learned to speak English.
Well, your pronunciation was a lot better than
the graduate students we still have there.
But the problem is: Why did you choose
UCLA? You didn't know anything about it ex
cept it was a low-tuition school and near your
home. I presume you hadn’t yet learned about
the principle about the travels of good and bad
grapes. You weren’t shipped very far. To do
you justice, though—and the principle, too—you
really were shipped a long way from Konigs
burg to Los Angeles. So that’s pretty powerful
evidence that you really w ere a good grape.
I can’t say you came to UCLA because I was
there. I only taught statistics during your un
dergraduate years, 1947-51. It might have been
Karl Brunner, about whom I’ll say more later.
You graduated in 1951 and, confronted with
earning a real living, you entered graduate
school. You set a record that will never be
broken, earning your Ph.D. in record time: only
11 years. You must have learned an awful lot,
though the truth is you w ere taken in the U.S.
Army in 1955 until 1957. For that underpaid
service to your new nation and assuming confi
dently your army discharge, I thank you now
on behalf of the people of the United States of
America.
After release from the army, you became an
instructor at the University of California at the
Santa Barbara campus and then a teaching assis
tant at UCLA. You now had to earn a living—
you were married. In ‘52, I believe, you started
as my research assistant, or agent, in managing
a study of common stock prices to test the an
ticipation of inflation, done with Reuben Kessel.

MARCH/APRIL 1993

xiv

You foisted on to me a graduate student, Rachel
Benveniste, you told me would help in the data
collection. She did—she took over and managed
the whole project. I now know that you and
she had something going. I hope you realize
your appointment was close to planned nepotism.
But it worked well, and I soon received an invi
tation to attend the marriage of Rae and Ted. I
wished you both well and that wish has been
granted. What you would have done without
me I don’t know.

Nobel aw ard-winning dissertation I was a
director. But w e all know, o f course, that it
was Harry M arkow itz, whose help I asked
for, w ho really was a director. Incidentally,
upon hearing about Bill Sharpe's receiving
the award, I w ent and got his dissertation
and reread it. It is an astonishing expository
paper; it is beautifully written. I now tell all
the students there, "Go read Bill Sharpe’s dis
sertation. It is so w ell w ritten and it contains
a lot o f good econom ics.”

But for that matter, what of the many other
students I have had who have married in my
class, or at least married later? But only a word
of gratitude. Upon reflection after 50 years ex
perience as a successful though unintended
marriage broker, my conviction is that college's
main function in one in 10 cases is as a marriage
market.

So, when I heard about this honor to you, I
went and got your dissertation. Would I be one
of the signers as I was on Bill Sharpe’s? No. My
God, Ted, if I had signed it, you would be get
ting a Nobel Prize now. But it wasn’t a bad dis
sertation; after all, it was signed by J. Fred
Barron who suffered shortly thereafter a tragic,
debilitating stroke. And by Bob Baldwin of inter
national trade fame and William R. Allen,
author of the best textbook in economics. And
Robert Rutland and Robert Williams.

As I recall your years at UCLA, I’m astounded
at the superb quality of graduate and under
graduate students we had at UCLA in the late
1950s and ’60s. Ted and Rae, you were prime
examples. I used to contend seriously that the
economics department at UCLA during those
years had a ratio of student quality to faculty
quality that was the highest in the nation. I like
ambiguities, but it was true. You, Ted and Rae,
were two of those who helped raise the stature
of UCLA’s department to where Chicago became
known as the "UCLA of the East.”
Speaking o f Chicago, particularly "Chicago
boys,” Rae was, I believe, the first of what real
ly distinguished UCLA from Chicago. W e had
the "UCLA girls” compared to the Chicago boys.
Not many o f you know we had, without ques
tion, the most spectacular female graduate stu
dents: Rae, Anita Dance, Linda Kliger, Judith
Mann, Susan Woodward, Vicki Carnahan to
name only a few. You haven't heard o f most of
them: after graduation they said to hell with it
and they married rich people. Rae married a lit
tle too early.
The question this provokes in my mind is:
"From whence came all these good students?”
The likes o f Walter Oi, Tibor Fabian, Martin
Bailey, Allan Meltzer, Steven Cheung, Mike Mussa, Lee Hoskins, Art Devaney, Jerry Jordan,
Cliff Stone, and Robert Summers, who married
Ken A rrow ’s sister and founded a dynasty. I
apologize to others whom I could name. Of
course I haven't forgotten Bill Sharpe of whose

FEDERAL RESERVE BANK OF ST. LOUIS

And last, the director, Karl Brunner, to whom
you and I owe so much. No one enjoyed his stu
dents more than Karl. He was very demanding.
He treated them as his children, training, dis
ciplining, scolding, abusing and teaching. I have
a hard time speaking about him, such a dear
friend. As a bright side of one who got him to
UCLA, after Lloyd Metzler. He’s the one who
said to me: "He’s the one you should get—the
young man from Switzerland, on a Rockefeller
Scholarship.” So I met with him in Chicago at
the Palmer House hotel. And I was convinced.
So I went back to UCLA and, after some hard
work, convinced the older, senile citizens of the
department to bring him there and they did
and struck a load for all of us.
During his early years at UCLA, Karl inter
rupted his career to study statistics, philosophy
of logic and the scientific method. As a result of
that time taken out, his promotion in rank was
scandalously delayed and denied because they
said he hadn’t published enough. He suffered,
but we gained by what he had learned. The
gains to you are evident in the rigor o f your
dissertation about the meaningfulness and the
evidence pertinent to Clark Warburton’s inter
pretation of the effects of money supply changes.
You showed and told Warburton that he was ar
guing essentially only that money supply changes
predicted changes of the price level better than
would have a purely random prediction.

And it did, but it did not exceed a naive model.
Your dissertation reported evidence consistent
with the implication that the elasticity of the de
mand for money was positive with respect to
wealth and negative with respect to the rate of
interest. You blasted a conception of a distinction
between idle and total cash balances and ended
by saying the data you collected were consistent
with the proposition of money relevance.
But that was way back in the ’50s. Most sig
nificant, in my opinion, was your emphasis on
the evidence of the usefulness o f the higher level
hypothesis, the basic economic model from
which it is derived, the existence and effects of
money supply changes. Money is implied, yet, as
you said in a footnote on page 34, we allow for
information costs. W e now know they will also
imply the real income effects that we attribute
to money. You illustrated in that section that
cheap information about recognition of com
modities reduces those costs as compared to
barter and is the key characteristic explaining
the effects of money—what makes it money. Had
Earl Thompson been there, he’d have explained
why virtually costless recognizable receipts for
prepayment of taxes serve as our money.
As I reread your dissertation, signed September
20, 1962, almost 30 years to the day 1 was read

ing it, I was reminded vividly of the hours we all
spent with Karl Brunner trying to clarify and find
answers to questions like “What is money?” “Why
is it money?” "Why do changes in its supply af
fect real income and employment, even if only
transiently, whereas changes in the supply of
shoes, automobiles and wheat do not?” "What
presumptions or higher-level hypotheses had to
be altered for that effect to be implied?” You had
seen beyond the simple monetary patterns. By
the way, I noticed you labeled your series M l
and M2. Had that been done before or is it origi
nal to you?
Fortunately your early understanding of a
prescription for research remained with you and
is reflected in what you have been doing here
ever since at the St. Louis Fed. Your career exem
plifies and extends the American Promise: im
migrant to honorable success and freedom in a
capitalist economy. Ted and all of you here as
sociated with Ted at the St. Louis Fed, from
Homer Jones to Ted and most likely those who
follow, you have our gratitude. Thank you and
best wishes.

Armen A. Alchian
Professor Emeritus of Economics
University of California-Los Angeles

MARCH/APRIL 1993

R o b ert H. Rasche
Robert H. Rasche is a professor of economics at
Michigan State University.

Monetary Aggregates, Monetary
Policy and Econom ic Activity

LMOST A QUARTER century has passed since
the publication of the (in)famous Andersen-Jordan
(AJ) equation.1For a good portion of that time, Ted
Balbach has been associated with the research
department of the Federal Reserve Bank of
St. Louis, and for a significant fraction of the
period directed the research efforts o f that
department.2 Throughout that period the Bank
consistently advocated a monetarist approach to
monetary analysis and monetary policy. It is
appropriate at this point to look back and exam
ine what lasting influence this perspective has
contributed, both to analysis and to policymaking.

ST. LOUIS ON THE ROLE OF MONEY

This study has three parts. The first is a re
examination of what monetarism and the St. Louis
empirical representation thereof contributed. In
particular, what controversies o f the late 1960s
and 1970s now can be considered settled? The
second examines the empirical failures o f the AJ
equation in the 1980s and argues that these
failures represent specification problems of the
"Lucas variety” and not a rejection of the under
lying theoretical framework. The implication of
such a "Lucas effect” for prominent monetarist
policy prescriptions is then analyzed. The third

Tw o aspects of the AJ equation seemed partic
ularly controversial in the late 1960s. First, the
analysis focused on the relationship between
nominal measures o f fiscal and monetary policy
and nominal income. Second, the analysis focused
on growth rates or first differences. Reduced to
simplest terms, the analysis stated that the growth
in velocity of narrow money, defined as the ratio
of nominal GNP to a weighted moving average
of M l, fluctuated around a positive deterministic
trend and that some fraction o f these fluctuations
were correlated with fluctuations in the growth

part examines the monetarist proposition that
has remained most controversial in recent
years, namely the short-run impact of changes
in nominal money growth on real economic
activity. In particular, the analysis attempts to
address the question raised by Cagan—why do
vector autoregressions (VARs) produce infer
ences about the impact of money on economic
activity that contrasts dramatically with the con
clusions o f historical analyses?3

’ See Andersen and Jordan (1968).
2A precusor of the AJ equation can be found in Brunner
and Balbach (1959). Michael Belongia is responsible for
bringing this well known article to my attention.
3See Cagan (1989).

MARCH/APRIL 1993

of nominal government spending.4This contrasts
sharply with macroeconometric models that were
developed contemporaneously. The implicit reduced
forms of the latter models specified relationships
between the level of nominal money balances and
the level of real output. The models also endogenized
the price level or inflation rate, but the typical
reduced forms implied little if any price level
response over the time periods in the AJ specifi
cation.
The lightning rod in the AJ equation was the
conclusion that a maintained change in nominal
government spending, unaccompanied by changes
in the nominal money stock did not produce a
permanent change in nominal income (or velocity)
and that changes in high employment nominal
tax receipts produced no statistically significant
changes in nominal income (or velocity). These
implications, which dramatically refuted the
fixed-price Keynesian model, did not go un
challenged. Numerous counter regressions were
published which reported that the implied fiscal
policy implications o f the AJ equation were arti
facts of measurement error and/or sample specific.5
The point that seems to get lost in the back
ground of these challenges is the robustness of
the long-run response of nominal income growth
to monetary growth shocks: the conclusion that
monetary shocks, in the absence of fiscal shocks,
have only transitory impacts on velocity growth
held its ground in the face of repeated "regres
sion attacks”.6
In retrospect it appears that in two significant
respects the macroeconomics profession has largely
surrendered and accepted the perspective of the
AJ equation. First, velocity has been rehabilitated
as a useful theoretical device across a broad range
o f macroeconomic thought. Monetarists have
steadfastly maintained the usefulness o f this
concept. Tw o of Greg Mankiw’s (1991) "dubious
Keynesian propositions” speak directly to the
points raised in the AJ equation: Point No. 2—
4This interpretation of the AJ equation was not widely
recognized at the time of publication, I suspect in part
because the original specification was published in first
differences rather that log differences and also because
the specification was never was presented as a hypothesis
about velocity. The original presentation was intended as a
sequel to the Friedman-Meiselman debate. See Jordan (1986).
5See, for example, deLeeuw and Kalchbrenner (1969), Cor
rigan (1970) and Davis (1969).
6For example, Benjamin Friedman (1977) argued that the
original Andersen-Jordan conclusion with respect to fiscal
policy was sample specific. However, the permanent effect
of money growth on velocity is robust to his changes in
sample periods.

FEDERAL RESERVE BANK OF ST. LOUIS

“[T]he lessons of classical economics are not help
ful in understanding how the world works”; and
Point No. 4—[Fliscal policy is a powerful tool for
economic stabilization and monetary policy is
not very important.” Mankiw further asserts
“for purposes o f analyzing economic policy, a stu
dent would be better equipped with the quantity
theory o f money (together with the expectations
augmented Phillips curve) than with the Keynesian
cross.” Some new Keynesians may repudiate
Mankiw, since this statement could be paraphrased
that a student would be better equipped with
the AJ equation (together with the St. Louis
model) than with the Keynesian cross.7 Never
theless, a statement such as this (original or par
aphrase) was heresy 25 years ago, and it can
only be said of the St. Louis view o f monetary
analysis and monetary policy “you've come a
long way baby.”8
Most of the attention that real-business cycle
theorists give to money has focused on the rela
tionship between money and real output in the
short run. Proponents of this approach generally
dismiss any causal effect from money to real
output, arguing that correlations between changes
in money and changes in real output reflect feed
backs from real output onto an endogenous
money stock. This is not a denial o f all signifi
cant parts o f the St. Louis position. Plosser (1991),
for example, argues that "money, without ques
tion, plays the dominant role in determining the
rate of inflation.” Presumably money then also
has important impacts on the path of nominal
income, though real shocks are also important
from this perspective. Real-business cycle spec
ifications have recently expanded to include in
flation and nominal variables. At least some of
these expanded specifications incorporate a
traditional demand-for-real-balances function,
with point estimates o f long-run income elastici
ties that are fairly close to unity.9 Thus these
models do not reject the usefulness of velocity
7See Andersen and Carlson (1970) for a discussion of the
St. Louis model.
eThat the St. Louis view is still contested in discussions of
public policy is evidenced by the report of March 31, 1992,
that 100 economists, including six Nobel Memorial Prize
laureates, sent in an open letter to President Bush, Chairman
Greenspan and members of Congress calling for additional
government spending, lower interest rates and tax credits
for business investment to stimulate economic growth
(“ Top Economists Urge Officials to Boost Federal Spending to
Stimulate Growth” , Wall Street Journal, March 31, 1992,
p. A2).
9See King, Plosser, Stock and Watson (1991).

as a long-run concept relating money to nominal
income.
The second aspect of the evolution of macroeconomic thought toward the AJ equation involves
the modeling of shocks to velocity. The AJ equa
tion was consistently estimated in differenced
form, and thus the implicit assumption of the
specification is that shocks to the level of veloc
ity are permanent. At the time this analysis was
constructed, the discussion of the role of per
manent and transitory shocks that is so prominent
in recent analyses was unforeseen. Nevertheless,
there is vindication for the St. Louis modeling
approach in the now conventional wisdom that
many macroeconomic time series (including
velocity) appear to be "difference stationary"
and that there are serious problems o f "spuri
ous regressions” in estimations involving levels
of such data series.1
0
The conclusion from this discussion is that from
current theoretical and econometric perspectives
there are important ways in which the original
St. Louis analyses "got things right.” Nevertheless,
the AJ equation has disappeared from contem
porary discussions of monetary policy.1 Why
1
then the demise of the AJ equation?

THE DEMISE OF THE AJ EQUATION:
ANALYSIS AND SOME IMPLICA
TIONS FOR MONETARIST POLICY
PRESCRIPTIONS
The demise of the AJ equation is well illus
trated in figure 1. Tw o different measures of
velocity are plotted there. The first is the con
ventional ratio of nominal GNP to M l. The sec10See Nelson and Plosser (1982) and Granger and Newbold
(1974).
"R elatively few attempts to reestimate the St. Louis equation
have occurred in recent years. Batten and Thornton (1983)
extend the sample period through third quarter 1982.
Belongia and Chalfant (1989) estimate regressions using
M1A, M1 and divisia variants of both those aggregates
(including variables for relative energy prices and strike
dummies, but excluding fiscal policy variables) over a first
quarter 1976-third quarter 1987 sample. With the exception
of Divisia M1A they find money growth elasticities that are
significantly less than 1.0. They conclude the following:
“ Results indicate that the M1 and broad aggregates are
all associated with significant structural change in the
money-income relationship around 1981.
Gavin and Dewald (1989) estimated St. Louis equations
(again omitting fiscal policy variables) over second quarter
1961-th ird quarter 1980 and first quarter 1971-fourth quarter
1982 samples. They conclude from out-of-sample forecasting
experiments that “ M1 has done so poorly in the 1980s

ond is the ratio o f nominal GNP to a geometric
moving average of M l, where the weights in
the moving average approximate the weights in
the lag polynomial o f the log of differences in
money in the AJ equation.1 It is clear that the
2
velocity measure implicit in the AJ equation
replicates the behavior o f the traditional M l
velocity quite closely, both before and after
1980. Both measures have a strong positive
deterministic trend that ends in the early 1980s.
This trend was captured in the AJ equation by
a significant positive intercept on the order of
2.5 percent to 3.0 percent per year. With the
break in the trend in velocity in the 1980s, it is
clear that the AJ equation falls apart.
In Rasche (1987) I showed that essentially all
narrowly defined monetary aggregate velocities
in the United States exhibit similar breaks in
their deterministic treads in the early 1980s but
that once these breaks are considered, the time
series properties of the various velocities are
not substantially different in the 1980s com
pared with the earlier period (see figure 2).1
3
Thus to understand the demise o f the AJ equa
tion, it is crucial to understand the origins of
the trend in velocity.
A considerable number and variety o f expla
nations have been advanced for the change in
velocity behavior observed in the 1980s, but
most of these are not consistent with the pat
terns observed in the data.1 Monetarism in gen
4
eral, and the AJ equation in particular, is based
on the proposition that a stable long-run demand
function for money exists; that is, the demand
for real balances depends on relatively few vari
ables, including real income, or wealth, and
various rates of return on nonmoney assets.
that it does worse on average than the monetary base
over the entire postwar period, even though it performed
better than the base for the 30 years before 1980.”
12The weights are taken from Appendix Table 2 in Carlson
(1982) as .40, .40 and .20 on InM,, lnMt _., and lnM,_ 2
respectively.
13These conclusions are not altered by updated data. Over
the sample period first quarter 1948-fo u rth quarter 1981
the mean change in velocity (St. Louis velocity) is 3.45
(3.46) percent per year, and the standard deviation is 4.74
(4.74) percent per year. The mean for the first quarter
1982-th ird quarter 1990 is - .7 2 (-.72) percent per year
and the standard deviation is 6.04 (5.75) per cent per year.
The mean change in the second sample is not significantly
different from zero [p = .49 (.46)). In Rasche (1990) I con
cluded that the velocities of the broadly defined monetary
aggregates M2 and M3 showed little if any changes in
trends at this time.
14See Rasche (1987).

MARCH/APRIL 1993

Figure 1
Velocity Measures First Quarter 1948 through Third Quarter 1990
V e lo city

Figure 2
Growth Rate of St. Louis Equation Velocity Measures First Quarter 1948 through Third
Quarter 1990
Percent

FEDERAL RESERVE BANK OF ST. LOUIS

The theory relates the level o f real balances de
manded to the level of specific variables. How
ever, the AJ equation, proposed as a reduced
form of a model containing such a moneydemand specification, is estimated in difference
form. Such statistical methodology is correct in
that it properly adjusts for the apparent nonstationarities of the observed data series. Unfor
tunately, differencing data series maintains only
short-run relationships among the various series
and overlooks any long-run relationships that
may exist simultaneously.
In the last decade, particularly in the past five
years, innovations in econometric technique allow
for the simultaneous treatment of nonstationary
data and estimation of long-run relationships
among the levels of variables.1 These techniques,
5
namely cointegration analyses, maintain the
spirit of the reduced form approach in differ
ences of the data, but permit the analysis to
incorporate the specification of long-run rela
tionships among the levels of the variables, if
such relationships exist. If identifying restric
tions are satisfied, such a relationship can be
interpreted as the long-run money demand func
tion that is fundamental to the AJ analysis.1
6
Some studies have documented the existence
of such a cointegrating relationship among real
balances, real income and nominal interest rates.1
7
The implied long-run income elasticity o f money
demand in such estimated equations is not sig
nificantly different from unity; hence there is a
long-run stationary relationship between the level
of velocity and the level o f nominal interest rates.
What then of the changes in the mean growth
rate of velocity in the 1980s relative to the mean
growth rate in previous decades? If a stable longrun money demand equation that relates the
level of velocity to the level of nominal interest
rates exists and if the deterministic trend (drift)
in nominal interest rates changes, then the drift
in velocity must change correspondingly to ac
commodate the stable money demand specifica
tion. Hence a reduced form in differences of
15See Granger (1981); Engle and Granger (1987); Johansen
(1988 and 1991); and Phillips (1991).
,6See Hoffman and Rasche (1991b).
17See Hoffman and Rasche (1991a, 1991c and 1992).
18Survey data and inflation forecasts for the United States
are consistent with such an interpretation of the outcome
of the 1981-82 recession.
19The break in velocity drift as a result of a break in
expected inflation is the hypothesis advanced by Milton
Friedman, though to the best of my knowledge he did not

velocity such as the AJ equation, given a stable
money demand function, implies an unchanged
constant only as long as there are no significant
changes in interest rate trends. Since during the
1980s there is a complete break from the upward
trend of nominal rates of the previous two decades,
the break in velocity drift is completely consis
tent with stability o f the money demand function.
Although the velocity break of the 1980s does
not invalidate the theoretical propositions on which
the AJ equation is based, it suggests that some
rethinking o f traditional monetarist policy pre
scriptions is in order. What forces are likely to
generate breaks in interest rate trends? A plau
sible candidate, and the one o f most concern for
monetary policy prescriptions, is inflation expec
tations. Assume that there is an established initial
regime in which expected inflation has a positive
trend. Assume that the monetary authorities
take successful actions to stabilize the inflation
rate and that this regime change is reflected in
the expectation of future inflation at some con
stant rate.1 The likely outcome o f such a policy
8
shift is that the drift in nominal interest rates
will disappear as will the drift in velocity.1
9
This suggests that the time series properties
o f velocity and the constants in reduced form
equations specified in differences are dependent
on specific monetary policy regimes through
expected inflation trends specific to the policy
regimes. If true, this stands as one of the few
clear-cut examples o f a "Lucas effect” beyond
the original Phillips curve example.2
0
One o f the consequences o f such a "Lucas
effect” is that straightforward application of no
feedback monetary growth rules for narrowly
defined monetary aggregates can lead to out
comes different from those predicted or desired.2
1
A monetary authority that desires to stabilize an
inflation that has been drifting upward might
be inclined to set a monetary growth objective
equal to a projected growth rate for natural
output plus a desired stabilized inflation rate,
minus the historically observed drift in the
elaborate the mechanism described here.
20See Lucas (1976).
21ln Milton Friedman’s defense it must be noted that he
originally proposed a no feedback rule in terms of a more
broadly defined aggregate, old M2. An aggregate such as
new M2, in a regime without interest rate ceilings, is unlikely
to suffer from the problem discussed here. For some evi
dence on the stationarity of new M2 velocity over the postAccord period, see Hallman, Porter and Small (1991).

MARCH/APRIL 1993

velocity o f a narrowly defined monetary aggre
gate. If the authority maintains this money
growth rate after expected inflation has stabi
lized, under the above "Lucas effect” the drift
in velocity will have disappeared and the actual
steady rate of inflation will prove to be lower
than the planned inflation rate. During the tran
sition period to the steady inflation regime, the
drift in velocity will be slowing and hence the
growth o f nominal income will drop below the
planned inflation rate plus the projected growth
rate of natural output.2 If the aim of the mone
2
tary authorities is to reduce, as well as to stabi
lize, inflation and if actual and expected inflation
adjust to the change in monetary policy slowly
so that pt > p* while the drift in velocity is in
transition, then real output growth will fall
below q* for some time during the transition
period.2
3
Meltzer [1987] and McCallum [1988] propose
alternatives to a fixed money (base) growth rule
that allow feedback from velocity to the planned
growth in money (base). The rules are designed
to account for permanent shocks to velocity,
but not to respond to transitory velocity shocks.
The rules set the growth rate of the monetary
base equal to a desired growth of nominal
income (p* + q* in the above notation) less a
moving average of the drift in base velocity.2
4
The rules establish base growth consistent with
the planned stable inflation once stabilization is
achieved, and the rules also adjust base growth
to compensate for the declining velocity drift
during the transition period to the stabilized
inflation rate. Thus on the surface it appears
that these feedback rules immunize monetary
policy from the adverse consequences o f the
“Lucas effect” on velocity drift.
However, this conclusion depends critically on
the credibility of the monetary authority. As long
as private agents believe that the monetary au
22Set mt = p* + q * - v, where mt is the maintained growth
rate of the nominal money stock, p* is the planned steady
inflation rate, q* is the projected growth rate of natural
output and v is the historically observed drift of velocity.
Then during a transition period (pt + qt) = (mt + vt) =
(p* + q*) + (vt - v). When the drift in velocity starts to
react to the change in expected inflation, (v, - v) < 0 so

(Pt + qJ < (p * + q*)23(q, - q*) = (p* - pt) + (vt - v ) < 0 .
24McCallum’s rule provides an additional adjustment to base
growth as nominal output is observed to deviate from
nominal natural output.
25See Holbrook (1972). Consider, for example, a feedback
rule of the form: bt = 0(L)LVt + LX, + £t, where b, is the

FEDERAL RESERVE BANK OF ST. LOUIS

thority is following the feedback rule consistently,
inflation expectations should adjust either in antic
ipation of or with the observation over time o f fall
ing inflation. The feedback mechanism will adjust
base growth as desired. Both the Meltzer and McCal
lum rules are deterministic. In practice, stochastic
fluctuations around such deterministic rules will be
observed which may make direct verification of the
rule difficult. If the monetary authority lacks credi
bility, feedback rules such as these could prove
unstable. Suppose the rule is implemented by the
monetary authority and inflation and inflation
expectations begin to stabilize. This lowers the drift
in velocity, and the feedback rule calls fo r
base growth to be adjusted upward (see figure 3).
The McCallum rule, which ultimately restores
nominal income to the specified path o f nominal
potential income, requires that base growth and
nominal income growth overshoot equilibrium
base growth during the transition period (see
figures 3 and 4). If private agents do not under
stand the rule well, or if the increase in base
and nominal income growth is interpreted by
such agents as an abandonment o f the rule,
then inflation expectations could start adjusting
upward. This would change the drift o f veloc
ity, and the rule would then call for reductions
in base growth. It is not difficult to conceive of
a situation where the monetary authority lacks
credibility, in which the Meltzer-McCallum rules
suffer from instrument instability (Holbrook [1972])
if the observed behavior of the monetary base
affects inflation expectations, and through this
the drift in base velocity.2
5
The conclusions from these observations on the
reduced form behavior of velocity is that con
stant growth rules applied to narrowly defined
monetary aggregates are unlikely to be success
ful in stabilizing a nonzero inflation trend. The
success of feedback rules that depend on observed
velocity behavior can depend critically on the
credibility o f the monetary authority. In the
growth rate of base velocity, X, is other factors to which
the feedback rule responds, and t, are random fluctuations
generated by fluctuations of sources of monetary base out
side the control of the monetary authorities and that can
not be perfectly forecasted. Let inflation expectations
respond to observed base growth p f+1 = 8(L)bt. Finally,
let velocity growth respond to trends in inflation expecta
tions: v, = co(L)pf+1. Substituting the latter two equations
into the first equation gives [1 - 0(L)5(L)co(L)L] bt = X, + £t.
Invertibility of the polynomial [1 — 0(L)5(L)co(L)L], and hence
the absence of instrument instability depends upon the
expectation formation mechanism, 5(L).

Figure 3
McCallum Rule: Nominal Income Growth
Percent

Figure 4
McCallum Rule: Base and Base Velocity Growth
Percent

MARCH/APRIL 1993

absence of credibility, the adjustments to the
growth of the aggregate required by the feed
back rule can provoke adjustments to inflation
expectations that introduce instrument instabil
ity into the feedback rule.

CAN THE TRANSITORY RESPONSE
OF REAL OUTPUT TO MAINTAINED
CHANGES IN MONEY GROWTH
BE INFERRED FROM REDUCEDFORM MODELS?
The Role o f Identifying Restrictions
The focus of much of the recent discussion of
the role o f money and monetary policy is not
on the response of nominal income, but rather
on the response o f real output. Cagan (1989)
summarizes a large body of recent empirical
research and reaches the conclusion that "lately ...
monetary research has turned again ... and new
studies claim that money has little or no effect
on output and other real variables.” VARs figure
prominently in recent research and are the
source of much of the evidence from which the
negative conclusions about the impact of nominal
money changes on real output are drawn. Cagan
faults the VAR approach as follows: "The VAR
seems ... to be hopelessly unreliable and low in
power to detect monetary effects of the kind
that we are looking for and believe, from other
kinds of evidence, to exist.” I will argue here
that Cagan's skepticism about the conclusions of
VAR analysis is justified, but for reasons beyond
those he enumerated.
The most important aspect o f VAR analysis is
the one most frequently slighted in drawing con
clusions about policy shocks from such analyses.
VARs are reduced forms of some unspecified
economic model; as such they have common
roots with the AJ equation. Reduced forms, in
themselves, provide no information about the
impact of nominal money shocks, or any other
policy shocks o f interest to economists. To pro
vide such information, VARs must be supplemented
with sufficient identifying restrictions, derived
from some economic model, to uniquely extract
information about the impact of monetary shocks
on real output within the economic structure
defined by the identifying restrictions.
Sims (1986) clearly explains the critical role of
26See Basmann (1963) and Learner (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

identifying restrictions in VAR analysis. Sims defines
the economic model as follows:
m

(1) E A(s)Y(t-s) = E B(s)e(t —s); Var(e(t)) = Q
s=0

s=0

and the corresponding VAR (reduced-form)
model for Y as follows:
m

(2) Y(t) = E C(s)Y(t — + u(t); Var(u(t)) = E
s)
s= 1

Sims notes the following:
The most straightforward example of iden
tifying restrictions on A(0), B(0) and Q is the
Wold causal chain. According to this idea, Q
should be diagonal, B(0) = I and A(0) should
be triangular and normalized to have ones
down the main diagonal when the variables
are ordered according to causal priority.
Using the fact that with B(0) = I, E = A(0) Q
A(0)', the triangularity o f A(0) implies that,
once we have put the variables in proper
order, we can recover A(0) and Q from E as
E ’s unique LDL decomposition. That is, it is
known that there is a unique way to express
a positive definite matrix E in the form LDL’,
where L is lower triangular with ones down
its diagonal and D is diagonal. Applying the
standard LDL algorithm to E gives us A(0) as
L and Q as D. This triangular orthogonalization has become a standard practice as part o f
the interpretation o f econometric models
(emphasis added) (p. 10).
Though this set of identifying restrictions has
become so common in VAR analysis that only
rarely is it acknowledged explicitly, it is neither
unique nor uncontroversial. Criticisms of and
arguments against both the appropriateness and
necessity of the causal-chain (triangular) specifi
cation are longstanding.2 A simple example of
6
the nonuniqueness of this approach is given by
the three separate sets of identifying restrictions
that Sims applies to his six-variable VAR. All of
these identification schemes maintain the assump
tion that Q is diagonal, but they impose differ
ent exclusion restrictions on A(0), including
restrictions that do not impose a triangular
structure on A(0).
Recently, attention has turned to identification
by restrictions on the steady-state coefficient

Table 1
Estimates of Four Variable VAR: 11/1955-IV /1981
Dep. Variable:
•n(Q,_ -i)
ln(Q,_2)
ln (Q ,-3)
ln(Q, _4)
400Aln(Pt _ 1
)
400Aln(Pt _2)
400Aln(Pt _3)
400Aln(P,_4)
ln(Mt _ i)
ln(Mt _ 2)
ln(Mt _3)
ln(Mt _4)
RTB,_,
RTB,_ 2
r t b ,_ 3
r t b ,_ 4
CONSTANT
D67
D79
R2
SEE

ln(Q,)
0.8790
0.0171
-0 .1 5 8 0
0.2778
-0 .0 0 0 5
-0 .0 0 0 7
-0 .0 0 0 6
0.0007
0.3883
0.1956
-0 .4 6 2 6
-0 .1 0 9 5
-0 .0 0 1 5
-0 .0 0 1 9
0.0026
-0 .0 0 2 9
-0 .1 5 3 0
-0 .0 1 0 4
0.0041
0.9900
0.0089

t
7.74
0.11
-1 .0 8
2.51
- 0.86
-1 .1 3
-0 .9 8
1.17
1.99
0.69
- 1 .6 3
- 0 .5 3
-1 .0 8
- 0.88
1.12
-1 .5 7
-1 .3 6
- 2.21
0.54

400Aln(Pt)
-14 .3 77 8
-140.4030
30.2668
-3 .9 9 8 8
0.1616
0.0708
-0 .0 0 9 5
-0 .0 2 6 4
-2 .1 3 6 3
33.6234
-10 .9 30 9
-1 6 .6 63 3
0.6513
-0 .8 3 2 7
0.5965
-0 .1 5 6 5
0.4184
1.2788
-1 .5 5 1 5
0.7000
1.6500

matrix, A = S A(s), rather than by restrictions
£0
=
on A(0).2 This latter approach seems more
7
promising because there appears to be consider
able agreement over a broad range of macroeconomic theories on identifying restrictions
that apply to a steady-state macroeconomic
model.2 In contrast, economic theory provides
8
little if any information about identifying re
strictions on the dynamic structure of macroeconomic specifications. In particular, during
the past 10 years researchers have broadly
debated the identification o f a short-run moneydemand function, to the extent that alleged
short-run money demand functions are at best
problematic and at worst fall into a class of
"incredible” identifying restrictions.2
9
If identification of a short-run money demand
function is “incredible,” then any “ shocks”
extracted from VARs under these restrictions
will at best represent linear combinations of
money-demand and money-supply shocks.
27See Bernanke (1986); Blanchard and Quah (1989); and
King, Plosser, Stock and Watson (1991).
28See Hoffman and Rasche [1991c] for an illustration of how
the restrictions on the KPSW (1991) common trends model
are consistent with the identifying restrictions for the steadystate of a standard textbook macroeconomic model.

t
- 0.68
-0 .5 2
1.11
-0 .1 9
1.43
0.64
-0 .0 8
-0 .2 3
-0 .0 6
0.64
- 0.21
-0 .4 3
2.51
-2 .0 3
1.39
-0 .4 6
0.02
1.47
- 1.11

ln(Mt)
0.0274
0.0091
-0 .0 9 3 0
0.0780
- 0.0002
-0 .0 0 0 3
-0 .0 0 0 6
- 0.0002
1.1862
-0 .1 5 5 5
-0.0131
- 0.0100
-0 .0 0 4 4
0.0039
- 0.0010
0.0007
-0 .1 8 7 9
0.0016
0.0018
0.9900
0.0056

t
0.38
0.10
- 1.00
1.12
-0 .5 4
-0 .6 7
-1 .4 9
-0 .5 3
9.62
-0 .8 7
-0 .7 3
-0 .0 8
-5 .0 3
2.83
-0 .7 0
0.63
-2 .6 4
0.55
0.37

RTB,
-3 .7 5 6 7
4.2816
-1 0 .7 8 8 7
11.3726
0.0770
0.0487
0.0339
-0.0451
22.0609
5.9233
0.8224
-2 9 .0 4 1 7
1.0494
-0 .7 9 9 3
0.7571
-0.3761
-6 .5 2 3 3
-0 .4 7 7 5
1.6174
0.9400
0.7260

t
-0 .4 0
0.35
-0 .8 9
1.25
1.55
1.00
0.67
-0 .8 9
1.38
0.25
0.04
-1 .7 0
9.15
-4 .4 2
4.01
-2 .4 9
-0 .7 1
-1 .2 4
2.61

Under these conditions it is impossible to sepa
rate the impact effects of money on output
from the reaction o f money to output through
whatever reaction function characterizes the
behavior of the monetary authorities.

The Importance o f Specification
and Identifying Assumptions
The questions discussed previously are partic
ularly important in the discussion of the effect
of nominal money shocks on real output. To
illustrate this, consider a four-variable VAR, that
includes real output, inflation, nominal money
(M l) and a short-term nominal interest rate
(Treasury bill rate).3 The general conclusion
0
that has emerged from the study of such VARs
is that “ most of the dynamic interactions among
the key variables can best be explained as aris
ing from an economic structure in which mone
tary phenomena do not affect real variables.
Thus ... monetary instability has not played an
29See Laidler (1982 and 1985); Cooley and LeRoy (1981);
Carr and Darby (1981); Judd and Scadding (1981); and
Gordon (1984). See also Sims (1980).
30These VARs are in the form of Sims (1980) and Litterman
and Weiss (1985).

MARCH/APRIL 1993

Table 2
Estimates of Four Variable VAR: 11/1955-111/1990
Dep. Variable:
ln(Q,_,)
ln(Qt 2)
ln (Q ,-3)
ln(Q,_4)
400Aln(Pt _ 1)
400Aln(P,_z)
400Aln(P,_3)
400Aln(Pt _4)
ln(Mt _,)
ln(Mt _2)
ln(Mt _3)
ln(M,_4)
R T B ,„,
r t b ,_ 2
r t b ,_ 3
r t b ,_ 4
constant

D67
D79
D82
R2
SEE

ln(Qt)
1.1398
-0 .0 4 2 8
-0 .2 0 7 4
0.1281
- 0.0002
-0 .0 0 0 4
-0 .0 0 0 3
0.0007
0.0455
0.2742
-0 .4 0 8 2
0.0837
-0 .0 0 0 4
-0.0031
0.0034
-0 .0 0 1 8
-0.0951
-0.0031
0.0027
- 0.0010
0.9900
0.0090

t
11.85
-0 .3 0
-1 .5 1
1.30
-0 .3 0
-0 .7 1
-0 .4 2
1.15
0.34
1.19
-1 .7 8
0.64
-0 .3 1
-1 .8 3
1.84
-1 .2 4
-1 .0 3
-0 .7 4
0.39
-0 .1 4

400Aln(Pt)
-8 .6 5 4
-4 .8 9 9 8
15.1429
-3 .7 3 2 7
0.1557
0.0775
-0 .0 0 4 0
0.0101
13.1115
-1 7 .6 69 6
15.3508
-7 .5 2 3 6
0.4783
-0.3581
0.1302
0.0592
0.5120
1.4683
-1 .4 6 1 0
-3 .8 3 4 9
0.6900
1.4900

important role in generating fluctuations.”3
1
Estimates of this four-variable VAR are shown
in table 1 and table 2, for sample periods that
begin in second quarter 1955 and end in fourth
quarter 1981 and third quarter 1990, respec
tively. The starting point for both samples is
chosen to avoid the pre-Accord data. The first
sample ends before the apparent break in the
trend of M l velocity discussed previously. The
second sample includes the 1980s. The VAR is
supplemented with three dummy variables cho
sen to define roughly four inflation regimes
with different trends.3
2
The implications of these VARs for the response
of real output to "money shocks” identified by
the Wold causal chain structure with variables
ordered as real output, inflation, money and
interest rates are quite sensitive to the choice of
the sample period (figure 5). Closer examination
reveals that this is associated with dramatically
3 See Litterman and Weiss (1985).
1
32The dummy variables are as follows: D67 = 1.0 for 67:4
and subsequent observations; D79 = 1.0 for 79:3 and
subsequent observations; and D82 = 1.0 for first quarter
1982 and subsequent observations.
33lt is also difficult to reconcile the “ interest rate shock”

FEDERAL RESERVE BANK OF ST. LOUIS

t
-0 .5 4
- 0.21
0.66
-0 .2 3
1.64
0.82
-0 .0 4
0.10
0.58
-0 .4 6
0.40
-0 .3 0
2.51
-1 .2 7
0.42
0.25
0.03
2.06
-1 .2 5
-3 .1 8

ln(Mt)
0.0216
0.0509
-0 .1 0 2 6
0.0369
-0 .0 0 0 3
-0 .0 0 0 5
-0 .0 0 0 5
- 0.0002
1.4116
-0 .2 3 8 9
-0 .1 3 6 8
-0 .0 3 1 6
-0 .0 0 5 6
0.0057
-0 .0 0 0 5
0.0015
-0 .0 6 9 5
0.0019
- 0.0024
- 0.0111
0.9900
0.0062

t
0.33
0.52
-1 .0 9
0.54
-0 .7 5
- 1.22
-1 .2 7
-0 .4 3
15.13
-1 .5 1
-0 .8 7
-0 .3 5
- 7 .1 9
4.88
-0 .3 7
1.47
- 1.10
0.65
-0 .5 0
-2 .2 4

RTB,
11.6235
7.5080
-18 .6 52 3
1.7967
0.1181
0.1022
0.0287
-0 .0 2 2 8
7.3153
-1 6 .9 36 2
17.7711
-9 .6 5 3 0
0.9899
-0 .6 2 7 5
0.5228
-0 .1 9 5 2
-9.3111
-0 .1 5 7 3
1.8046
-0 .1 6 8 3
0.9300
0.7440

t
1.45
0.64
-1 .6 4
0.22
2.50
2.18
0.58
-0 .4 8
0.65
-0 .8 9
0.93
-0 .8 9
10.45
-4 .4 7
3.42
-1 .6 3
- 1.22
-0 .4 4
3.10
-0 .2 8

different long-run responses of the nominal
money stock to the "money shock” (figure 6).
Both samples show the real output response to
the "money shock” rises to a peak and then trails
off. However, the nominal interest rate exhibits
a transitory positive response to the "money
shock” in both samples which is difficult to
reconcile with the identification of the "money
shock” as a monetary policy action (figure 7).3
3
Two other variables of interest are implicit in
the VAR menu: real money balances and veloc
ity. The impulse response function for velocity
to a "money shock” is shown in figure 8. The
implicit velocity response is almost uniformly
negative in both sample periods, and in the
third quarter 1990 sample has the peculiar
characteristic of having a response below -1.0
even after 40 periods.
The realization that the four-variable VAR
identified by the Wold causal chain specification with a
monetary policy action because although the immediate
impact of such a shock on interest rates is positive, the
permanent effects of this shock on nominal rates, inflation,
money and real output are all negative in both sample
periods.

Figure 5
Real Output irf to Nominal Money Shock

Figure 6
Nominal Money irf to Nominal Money Shock

MARCH/APRIL 1993

Figure 7
Inflation irf to Nominal Money Shock

Figure 8
Velocity irf to Money Growth Shock

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Johansen Maximum Likelihood Estimation of
Four Variable VECM
ln(M/P), 400*AlnP, InQ, Rtb

Sample

Normalized Cointegrating
Vectors

Max A Test

Trace Test

11/1955— IV/1974

r=0
39.8

r«1
16.9

r«2
.29

r=0
22.9

r«1
16.6

r«2
.29

11/1955— IV/1975

52.1

21.7

2.2

30.4

19.5

11/1955— IV/1976

52.7

20.3

2.4

32.4

11/1955— 111/1979

54.7

20.5

.31

11/1955— IV/1981

67.1

17.2

11/1955— 111/1990

64.8

22.6

P'c

1.0
0.0

0.0
1.0

- 1.0
0.0

.1224
-.9 1 9 8

2.2

1.0
0.0

0.0
1.0

- 1.0
0.0

.1200
-.731 1

18.0

2.4

1.0
0.0

0.0
1.0

- 1.0
0.0

.1185
- .7296

34.1

20.2

.31

1.0
0.0

0.0
1.0

- 1.0
0.0

.1109
-.7 3 1 5

.77

49.9

16.4

.77

1.0
0.0

0.0
1.0

- 1.0
0.0

.0965
- .7498

4.6

41.3

18.9

4.6

1.0
0.0

0.0
1.0

- 1.0
0.0

.0987
-.8 1 0 6

18.9
21.1
25.8

12.9
14.9
19.2

6.5
8.2
11.7

Critical values from Osterwald-Lenum (1990)
10 percent
5 percent
1 percent

28.7
31.5
37.2

15.7
18.0
23.5

6.5
8.2
11.7

defines additional interesting economic meas
ures as linear combinations of the menu entries
raises the following question: Are the results
invariant to the explicit choice of menu entries?
Clearly if the degree of differencing of the vari
ables in the VAR were the same, the OLS esti
mates would produce the same results regardless
of the particular linear combinations explicitly
chosen. However, the degree of differencing
varies among the variables in the typical VAR
study as log levels of real output and nominal
money appear along with log differences of the
price level (inflation). An alternative menu is to
enter real balances along with either inflation or
nominal money growth. The advantage of these
choices is that the three variables that are tradi
tionally included in money-demand specifications—
real balances, real output and nominal interest
rates—now explicitly appear in the VAR.3
4
In table 3, some results are reported from the
34Such a VAR is an expanded version of the VAR used by
Hoffman and Rasche [1992] to investigate long-run money
demand.
35See Johansen (1988 and 1991). This restriction was im
posed because it was never rejected in the three variable

estimation of a VAR with real output, inflation,
real money balances and the Treasury bill rate.
These results indicate the tests for stationary
linear combinations (cointegrating vectors)
among the four variables using the Johansen
maximum likelihood estimator under the restric
tion that the log o f real balances and the log of
real output enter any such cointegrating vectors
with equal and opposite signs.3 Both of the like
5
lihood ratio tests—the trace test and the maximum
eigenvalue test—typically reject the hypothesis
of one or few er cointegrating vectors at the 5
percent level, and in some samples at the 1 per
cent level. In every case the tests fail to reject
the hypothesis that two or few er cointegrating
vectors exist. Thus we conclude that among
these four variables there are two permanent
and two transitory shocks.
To obtain a unique (to a scalar multiple) eco
nomic interpretation o f the two cointegrating
menus investigated by Hoffman and Rasche (1992) and
because in that study the unrestricted long-run income
and interest elasticities were found to be quite imprecise
and sensitive to the choice of the sample period.

MARCH/APRIL 1993

Table 4
Johansen Maximum Likelihood Estimation of
Four Variable VECM
ln(M/P), 400*AlnM, InQ, Rtb
(Real Balances and Real Income Coefficients Constrained)
Sample
11/1955— IV/1981

Trace Test
r=0
65.2

r«1
20.3

Normalized Cointegrating
Vectors

Max X Test
.
r< 2
1.5

r=0
44.9

r<1
18.8

r«2
1.5

P'c

1.0
0.0

0.0
1.0

- 1.0
0.0

.1068(02)
- ,8067(.22)

1.0
0.0

0.0
1.0

- 1.0
0.0

.1088(.03)
- .8867(22)

0.0
1.0

- 1.0
0.0

0.1217
- 1.0000

0.0
1.0

- 1.0
0.0

0.1202
- 1.0000

Wald Test of Overidentifymg Restriction /3
'c(2i4) = - 1 . 0 x2(i) = 1.54 p = .21
11/1955— 111/1990

75.8

26.1

5.3

49.7

20.8

5.3

Wald Test of Overidentifying Restriction /3c(2.4) = - 1 0 x2(i) = -27 p = .60
11/1955— IV/1981

Estim ates of Restricted C ointegration V ectors
1.0
0.0

H/1955— IV/1990

vectors present among these four variables,
identifying restrictions must be imposed on the
estimated matrix o f cointegration vectors.3 In
6
this case the exclusion o f one variable from
each cointegrating vector is sufficient to achieve
identification. The exclusion restrictions intro
duced here eliminate the inflation rate from one
cointegrating vector and real balances from the
other. The resulting identified cointegrating vec
tors, n o r m a liz e d f o r r e a l balances and inflation
respectively, are reported as j)c in table 3. The
remaining unconstrained coefficients in these
matrices are quite stable across sample periods.
The estimated interest rate coefficient in the
cointegrating vector with real balances is close
to the estimate that Hoffman and Rasche ob
tained for the long-run interest semielasticity of
money demand in the United States.3 The esti
7
mated interest rate coefficient in the cointegrat
ing vector with the inflation rate ranges from
-0.9 to -0.7 and is not significantly different from
-1.0 consistent with a long-run Fisher effect,
which implies a stationary real interest rate.3
8
36See Hoffman and Rasche (1991c).
37See Hoffman and Rasche (1992).
38Significance is examined using Wald tests developed by
Johansen (1991). Stock and Watson (1991) also report evi
dence for a stationary real interest rate.
39See Johansen (1991).

FEDERAL RESERVE BANK OF ST. LOUIS

1.0
0.0

The difficulty in interpreting results from this
specification o f the VAR is that nominal money
or its growth rate does not appear explicitly
among the variables in the VAR. An alternative
specification is to replace the inflation rate with
the growth rate o f nominal money and allow
the inflation rate to be determined implicitly by
the identity relating nominal money growth and
real balances to inflation. Some results from the
estimation of this VAR are presented in table 4
using the same sample periods as in table 1 and
table 2. These results are basically the same as
those in table 3. The Johansen likelihood ratio
tests again reject the hypotheses that one or
few er cointegrating vectors exist. When the
identifying exclusion restrictions and normaliza
tion are applied to the two estimated cointegrat
ing vectors (/?'), the interest semielasticity in the
velocity vector is approximately 0.11 and the
interest coefficient in the vector error with the
money growth rate is between -0.8 and -0.9.
The latter estimates are not significantly differ
ent from -1.0 on the basis of a Wald test.3
9

Table 5
Estimates of Four Variable Restricted VECM: 11/1955-111/1990
Dep. Variable:
Aln(M/P)t _ 1
Aln(M/P)t _2
Aln(M/P)t _3
400A2lnMt _ 1
400A2lnM ,_2
400AzlnM,_3
A ln Q ,.,
AlnQ,_ 2
AlnQt _ 3
A R T B ,.,
ARTBt _2
a r t b ,_ 3
CONSTANT
D67
D79
D82
CIV1t _4
CIV2,_ 4
R2
SEE

Aln(M/P)t)
0.3418
0.3287
0.2738

0.0000
-0 .0 0 0 4
- 0.0011
0.1312
0.0903
-0 .0 4 7 3
-0 .0 0 6 6
-0 .0 0 0 5
- 0.0010
-0 .0 1 1 8
0.0004
0.0020
-0 .0 0 3 9
- 0.0121
- 0.0012
0.6100
0.0068

t
2.07
1.98
1.62
0.008
-0 .6 3
-1 .6 1
0.18
1.22
-0 .6 4
-7 .5 5
-0 .4 9
-0 .8 7
-1 .9 7
0.26
0.60
-1 .0 4
-1 .9 6
-1 .8 1

400A2ln(Mt)
44.87
81.18
81.06
-0 .7 5
-0 .7 9
-0 .9 9
-3 .7 3
19.67
-1 6 .4 9
-2 .1 3
-0 .1 5
- 0.20
-8 .9 9
1.06
0.0116
-3 .6 2
-9 .0 3
-1 .0 5
0.54
2.38

t
0.78
1.40
1.37
- 4 .5 6
-3 .8 5
-4 .3 2
-0 .1 4
0.76
-0 .6 4
-6 .9 3
-0 .4 3
-0 .5 0
-4 .3 2
1.91
0.01
-2 .7 7
-4 .1 8
-4 .6 2

Aln(Qt)
0.1106
0.1793
0.1302
-0 .0 0 0 4
- 0.0001
-0 .0 0 0 7
0.0926
0.0598
-0 .1 4 5 2
- 0.0001
-0 .0 0 3 7
-0 .0 0 0 3
-0 .0 1 5 4
-0 .0 0 1 4
0.0022
-0 .0 0 5 5
-0 .0 2 5 8
-0 .0 0 0 8
0.24
0.0087

t
0.52
0.84
0.60
-0 .6 0
-0 .1 7
-0 .8 1
0.98
0.63
-1 .5 4
- 0.11
-2 .8 1
-0 .1 9
- 2.10
-0 .6 7
0.51
-1 .1 4
-3 .2 7
-0 .9 3

ARTB,
-4 1 .3 2
-2 8 .4 7
-6 .9 8
0.1166
0.2007
0.2795
8.22
22.31
0.2366
0.0837
-0 .6 9 7 3
0.1120
-0 .5 9 8 0
-0 .1 4 2 9
1.1099
-0 .3 7 7 7
-0 .5 5 0 4
0.1792
0.4100
0.6914

t
-2 .4 6
- 1.68
-0 .4 1
2.44
3.35
4.18
1.09
2.97
0.32
0.94
-6 .7 3
0.94
-0 .9 9
- 0.88
3.26
- 1.00
- 0.88
2.71

NOTE: CIV1 and CIV2 are the two stationary linear combinations of the four dependent variables.

The vector error correction model (VECM) in
table 4 can be reestimated with the overident
ifying restriction (i'cll 4 = -1.0 imposed. The con
|
strained estimates of / are obtained using the
?'
two-step estimator in Rothenberg and the
asymptotic covariance matrix for / derived by
?'
Johansen.4 The restricted estimates o f /?' are
0
given at the bottom of table 4. These estimates
are used to construct two linear combinations
of the levels of the four different variables to
obtain estimates of the remaining parameters of
the restricted VECM. The estimated coefficients
o f the restricted VECM are shown in table 5 for
the 11/1955—
III/1990 sample.4
1
The interesting question that these results
raise is: Can the two permanent shocks among
these four variables be associated with individ
40Rothenberg (1973) proves that his two-step estimator is a
restricted maximum likelihood estimator when the unres
tricted estimator is asymptoticly normal and coverges at
rate T - 1 . Johansen (1991) shows that his estimator of /3'
/2
is asymptotic normal, but converges at rate T ~ 1. The max
imum likelihood properties of the restricted estimator have
not been established for this case.
41The dummy variables are not important for the estimation
of the cointegrating vector (CIV) involving real balances.
The separation of the shift in the constant of the VECM
into components representing shifts in the deterministic
trend and shifts in the mean of this cointegrating vector

ual variables? Or in the terminology of King,
Plosser, Stock and Watson (KPSW) (1991): Can
we derive a structural model from the reducedform model with steady-state character
istics suggested by economic theory? The interest
ing hypotheses to test are as follows:
• One permanent shock corresponds to a
real-output (productivity) shock as sug
gested by real-business cycle theories; and
• The second permanent shock corresponds
to a money growth-inflation-nominal inter
est rate shock consistent with a broad spec
trum of macroeconomic theories.
The common-trends modeling approach of
KPSW identifies the permanent components of
each time series by restricting them to be ran
dom walks. A common-trends model exists if
indicates that the mean of the CIV is little changed in the
80s compared with the previous 25 years. (See Yoshida
and Rasche [1990].) The dummy variables are important
for the estimation of the second (real interest rate) coin
tegrating vector. They suggest a large increase in the
mean real interest rate during fourth quarter 1979-fourth
quarter 1981 followed by a substantial, though not fully off
setting reduction in the mean real rate after 1981. This is
consistent with the work of Clarida and Friedman (1984),
Huizinga and Mishkin (1986) and Roley (1986) all of whom
found shifts in the relationship of nominal rates and infla
tion in 1979 and 1982.

MARCH/APRIL 1993

the permanent components of each time series
are equal to linear combinations of the orthogonal
permanent shocks that are suggested by eco
nomic theory. In the case under consideration
here, the existence of the hypothesized commontrends model requires that the permanent com
ponents o f real output and money growth are
equal to the two permanent shocks and hence
are orthogonal. These correlations are 0.047
and -0.065 for the samples ending in fourth
quarter 1981 and third quarter 1990, respec
tively. The extent that the permanent compo
nents of real output and money growth violate
the necessary conditions for the existence of a
common-trends model can be judged by the
size of the off-diagonal element of the n matrix
as defined by KPSW.4 In the sample ending
2
fourth quarter 1981 the estimated restricted
VECM implies that n.M = 0.107 and in the sam
ple ending third quarter 1990 the estimated res
tricted VECM implies that rT2 = -0.007 under
1
the identifying restrictions that the permanent
components are random walks. Because the
absolute values of these estimates are both close
to zero, we conclude that the data are consis
tent with a common-trends representation with
independent, permanent real-output and perma
nent money-growth shocks.
KPSW (1991) show how impulse response
functions are constructed for permanent shocks
in such a common-trends model. Graphs of
these impulse response functions are shown in
figures 5-18. The long-run properties of these
impulse response functions are completely
determined by the cointegrating vectors and the
near orthogonality of the permanent compo
nents of real output and money growth. The
long-run responses of velocity, inflation, money
growth and nominal interest rates (figures 14,
16, 17 and 18) to a permanent shock to real
output are all identically equal to zero. This fol
lows from the orthogonalization of the common
trends when real output is ordered before
money growth. The long-run responses of real
output to a permanent money growth shock are
not identically zero (figure 10), reflecting the
small correlations between the permanent com
ponents o f real output and money growth. The
long-run responses of inflation and nominal
interest rates to a permanent money-growth
42See King, Plosser, Stock and Watson (1991).
43See King, Plosser, Stock and Watson (1991).
44See Plosser (1991).
45See Litterman and Weiss (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

shock (figures 11 and 13) are identically equal
to 1.0 as determined by the values o f the esti
mated coefficients in the cointegrating vectors.
In the long run, the level o f velocity is increased
slightly by the permanent increase in money
growth in response to the permanently higher
value of nominal rates (figure 8). The long-run
responses are consistent with the steady-state
properties of most macroeconomic models, but
this is not “news” once the elements of the coin
tegrating vectors have been estimated.
Additional interesting information can be found
in these figures. Estimates for both samples sug
gest that the transitory responses to either per
manent shock die out after two to three years.
These implied lags in the adjustment to the
steady state seem quite short relative to much
of the conventional wisdom, though the length
of the transitory reaction of velocity to a perma
nent money-growth shock is surprisingly similar
to that in the AJ equation.
The reactions to a real-output shock are not
exactly those implied by a pure real-business
cycle model because output effects from this
type o f shock build only gradually (figure 15),
during which period there are highly serially
correlated negative impacts on the inflation rate
(figure 16). The real output response here
is quite similar to the output response to a
"balanced-growth” shock obtained by KPSW in
their six-variable restricted VAR model (figure
6).4 There is a transitory money-growth
3
response (figure 17) associated with the output
shock, but because the money measure here,
M l, includes inside money, this response is con
sistent with the picture drawn by some realbusiness cycle theorists.4
4
At first glance, it appears that the variance
decomposition of real output in this model is
consistent with the conclusion that “monetary
instability has not played an important role in
generating fluctuations.’’4 The variance decom
5
position of real output from the fourth quarter
1981 sample indicates that the permanent
“money-growth” shock accounts for about 23
percent of the variance of real output at all fore
cast horizons. In contrast, the permanent “realoutput” shock accounts for only 7 percent of
the variance of real output at a one-period hori-

Figure 9
T-bill Rate irf to Nominal Money Shock

Figure 10
Real Output irf to Money Growth Shock

MARCH/APRIL 1993

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 13
T-bill Rate irf to Money Growth Shock

Figure 14
Velocity irf to Real Output Shock

MARCH/APRIL 1993

Figure 15
Real Output irf to Real Output Shock

Figure 16
Inflation irf to Real Output Shock

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH/APRIL 1993

zon but increases to 66 percent o f the variance
at a 12-period horizon. When the sample is
extended through third quarter 1990, the per
manent "money-growth” shock accounts for
only 7 percent of the forecast variance at a onequarter horizon, and this declines steadily to
one percent o f the forecast variance at a
12-quarter horizon. In this sample the perma
nent ‘‘real output” shock accounts for 31 per
cent of the forecast variance o f real output at a
one-quarter horizon, and this increases steadily
to 87 percent o f the variance at a 12-quarter
horizon. From this information and the impulse
response functions in figure 10, it is tempting to
conclude that monetary shocks have little shortrun effect on real output.
The variance decomposition o f each cointegrat
ing vector can also be computed. At a onequarter horizon 6 (32) percent of the variance
of real balances around equilibrium real bal
ances is attributable to the permanent "moneygrowth” shock, 27 (24) percent is attributable to
the permanent "real-output” shock, and 67 (44)
percent is attributable to the two transitory
shocks. At a 12-quarter horizon the correspond
ing decomposition is 4 (21) percent and 71 (48)
percent. At a one-quarter horizon the cor
responding decomposition of the variance of the
real interest rate around the equilibrium real
interest rate is 41(3) percent, 1 (1) percent and
58 (96) percent. At a 12-quarter horizon the
decomposition is 24 (10) percent, 20 (27) percent
and 56 (63) percent. These decompositions are
based on the third quarter 1990 (fourth quarter
1981) sample estimates.
It is also possible to allocate the deviation of
actual real balances from equilibrium real bal
ances (or the actual real rate from the equilibrium
real rate) at any point in the sample period to
the history of the permanent and real shocks.
Following KPSW (1991) write Xt= /it +ATt+ r*(L))'7
t
where r){ is a vector of “structural” disturbances.4
6
Let ft'c be the matrix o f cointegrating vectors.
Then » c X, measures the deviations o f actual real
/}' t
balances from equilibrium real balances and the
actual real rate from the equilibrium real rate.
But /J'X, = P'jit + p'cAx, + P'T*(U r}t = /?T*(L)rjt
because / is orthogonal to iu and A.
?'
The fallacy o f concluding that monetary insta
bility is not important for economic fluctuations
from this system under this class of restrictions
46See Appendix B.
47See Friedman (1974) and Andersen and Carlson (1970).

FEDERAL RESERVE BANK OF ST. LOUIS

involves the interpretation o f the "money-growth”
shock (figure 12). Ultimately this shock becomes
a maintained change in the growth o f nominal
money. However this is not the case initially.
For the first two to three years, the money
growth response to the permanent "moneygrowth” shock contains a large transitory com
ponent and the net effect is frequently of the
opposite sign to the permanent effect. This
response pattern certainly does not conform to
the traditional monetarist policy experiment. In
the latter case, the policy intervention involves a
shift from one maintained growth rate of money
(or the monetary base) to a different maintained
monetary growth rate. Under these conditions
the traditional monetarist hypothesis is that the
initial impact o f the policy intervention will
largely affect real output, but that over time
this effect will disappear as the inflation rate
approaches its new steady-state rate.4
7
The only identifying characteristic o f a mone
tary shock in this analysis is the steady-state
restriction that the impulse response of money
growth to such a shock is one. However, this
restriction does not define a unique monetary
shock, but rather a whole class of such shocks.
This is clear from the impulse responses of
money growth to the two "transitory shocks”
that are plotted in figures 19 and 20. By con
struction, in both samples the steady-state
response of money growth (and all other varia
bles defined by the VAR) is zero. Thus it is pos
sible to define the class of monetary shocks
equal to the permanent "monetary shock” plus
any weighted sum of the two transitory shocks
and satisfy the identifying restriction for a
monetary shock. Within this class o f monetary
shocks it is impossible to determine the shortrun impact of monetary policy on real output.
For example, consider defining the response of
real output as the sum of the responses to the
permanent “money-growth” shock and the two
transitory shocks. Such a composite shock has
the identical steady-state response as the perma
nent "money-growth” shock and^so satisfies the
identifying restrictions for a permanent mone
tary intervention imposed by our model. Yet on
a one-quarter forecasting horizon such a com
posite shock accounts for 69 (93) percent of the
variance in real output for the sample period
ending third quarter 1990 (fourth quarter 1981). On
a 12-quarter horizon the fraction of the forecast

MARCH/APRIL 1993

variance in real output attributable to such a
composite shock decreases to 13 (34) percent
for the sample period ending in third quarter
1990 (fourth quarter 1981).

The weighted-sum impulse response functions
for money growth are shown in figures 21 and
22 for the two sample periods. Large transitory
deviations from unity remain in both cases.

The fraction o f the variance o f deviations of
real balances from equilibrium real balances
attributable to this composite shock is 73 (76)
percent at a one-quarter horizon and 75 (66)
percent at a 12-quarter horizon for the sample
period ending third quarter 1990 (fourth quar
ter 1981). The fraction of the variance o f devia
tions of the real interest rate attributable to this
composite shock is 99 (99) percent at a one-quarter
horizon and 80 (73) percent at a 12-quarter hori
zon for the sample periods ending third quarter
1990 (fourth quarter 1981).

The lack of identification of the short-run real
output response in the absence of a specification
of the monetary rule, or monetary policy reaction
function, that prevails during the sample period
can be shown easily using a simple macroeconomic
model that satisfies all of the steady-state iden
tifying restrictions imposed on the VECM. Con
sider the following:

In contrast, the monetary intervention of
traditional monetarist analysis is not contained
in the general class o f monetary shocks defined
as the permanent "monetary shock” plus a
weighted sum o f the transitory shocks. Consider
a regression o f the following form:
(IMPMP, - 1.0) = /JjIMPMTlj + /?,IMPMT2i + £s
where IMPMPi is the impulse response of money
growth to the permanent "money shock” and
IM PM TL and I\lPMT2i are the impulse responses
o f money growth to the transitory shocks. The
traditional monetarist policy experiment is
defined in the class of identified monetary
shocks if there are fas that produce an esti
mated impulse response pattern that replicates
the deviations o f the impulse response function
to the permanent "money shock” from unity.
This result does not hold for either sample period.
For the sample ending fourth quarter 1981,
(IMPMP - 1.0) =

-ll.S g U M P M T ^ )(-10.56)

6.19(IMPMT2i) + l .
(-9.28)

(1)
(2)
(3)
(4)

lnP( = t_,lnP"+ y[lnQ, - lnQ't + £n
']
InMR, = InQ, - 0i, + t 2
t
it = r, + tlnP*+ - InP,
1
lnQt = k + lnAt - art + £3
t

where equation (1) is an expectations-augmented
Phillips curve (Lucas supply function) that relates
deviations o f real output (Q,) from natural out
put (Q't to inflation expectation errors (lnPt)
t ,lnP^. Equation (2) is a money-demand function
that relates real money balances (MRt; InMR, =
InM, - lnPt) to real output and nominal interest
rates (it) with a unitary income elasticity of
money demand. Equation (3) defines nominal
interest rates as the sum o f the real rate (rt) and
the expected future rate o f inflation (tlnP^+ 1
lnPt). Equation (4) defines the demand for real
output in terms of the real interest rate and
autonomous planned expenditures (A,). This
model is closed by two additional specifications.
First, we assume that expectations are gener
ated by adaptive expectations o f inflation:4
8
< ,-iP f = .-aPf-i + A<P,-i - i - t P t - J
5>

where Pt = lnP(-lnP,_1 and t_lPf_itl = J n P ^ . - ln P , . ,

R2 = 0.81 SEE = 1.15

while for the sample period ending third quar
ter 1990,
(IMPMP, - 1.0) =

- 9.06(IMPMTL) (-4.31)
0.94(IMPMT2j) + £
.
( - 1 .0 )

R2 = 0.23 SEE = 2.47
“^Adaptive expectations in the inflation rate are chosen as
an algebraicly convenient way of generating a model that
potentially has transitory real output responses to perma
nent nominal money growth shocks and has the steadystate characteristics of the estimated VECM. This is only
for illustration of the identification problem. In particular,
the type of inflation expectation shift discussed in the sec

FEDERAL RESERVE BANK OF ST. LOUIS

Second, a stochastic monetary rule (policy
reaction function) is specified as follows:
(6) AlnM, = fx + ^Ai, + ^,(AlnM, , - /i) + £4
|
This rule allows for contemporaneous interest
rate smoothing (^,>0) and for offsetting o f past
deviations from the steady-state money growth
tion beginning on p. 3 as the root cause of the shift in
velocity drift is not consistent with an adaptive expecta
tions mechanism.

Figure 21
Weighted Sum of Permanent and Transitory irf

Figure 22
Weighted Sum of Permanent and Transitory irf

MARCH/APRIL 1993

FEDERAL
RESERVE

Table 6
Adjoint Matrix (A*)
- [1 + < 2B]a[1 - (1 - A)B - /JA(1 - B)] + a<D,A[1-B]
D

- [1 + < 2B]a[1 - B]2
t>

[0(1 +<D2B) + <t>i][1 - B]2

°[1 “ B]

BANK
O ST. LOUIS
F

- [ 1 + < 2B][(a + /})(1 -( 1 -A)B)] + « 0 ,A [1 -B ]
D

- [1 + < 2B]ay[1 - (1 - A)B] + 0,[1 -« y A -B ][1 - B ]
t>

- [ 1 + < 2B]/iA[1 -(1 -A)B] - 0>,[1 - B]2
D

[(a + P K 1 -B ) - aprX)

[1 +tf>2B][(1 +oA)(1 - B ) + AB)

[1 + <D
2B][1 - a y A - B][1 - B]

[ 1 + 0 2B][Y(1 -(1 -A )B ) + (1 - B)]2

- [1 - a A - B ]

<J>,[(1+oA)(1-B) + AB][1 - B]

4>,[1 — cryA — B][1 - B ] 2

<t»i[Y-Y(1 -A)B + (1 - B)2][1 - B]

[a y (1 -(1 -A )B ) +
(« + » (1 -B )2 cpyH 1 - B ) ]

det = [1 +<t>2B][oy(1 -(1 -A)B) + (» + /i)(1 -B )2 - a/JyA(1 - B)] + <D,[1 -a y A -B ][1 - B ]

path (^2 0). Thus with appropriate parameter
>
values this specification can accommodate a
range o f central bank behavior from nominalinterest rate smoothing to a stochastic no-feedback
money growth regime. This model can be
reduced to a four-variable VAR in lnQt, lnMRt, i(
and AlnMt, driven by the exogenous variables
InQ", lnAt and the shocks £jt. With some tedious
algebra, the moving average representation of
the model can be expressed as follows:
InQ,
(7)

lnMRt

-ylnQ , + £„
1.0
£ 2,

det

k + InA, + £3
|

i.
. AlnM. _

^ ( l + f )

where the polynomial matrix A* and the poly
nomial det are given in table 6. In the deter
ministic steady state, the impulse response
functions are independent of the parameters of
the monetary rule (^,, <2 and real output
f)
>
responds only to changes in InQn, (1.0). Simi
larly in the deterministic steady-state AlnMt
responds only to (i (1.0). However, the transitory
responses o f real output to money-growth shocks
are not zero. In particular, the greater is the
interest-rate smoothing (^,), the smaller are the
transitory responses of real output to monetary
shocks. Thus estimation of VARs in this type of
model will produce different impulse response
functions based on different behaviors of the
monetary authorities, and it is not possible to
infer from those impulse response functions the
short-run impact o f a change in money growth
under a no-feedback rule, without prior knowl
edge o f the form and parameter values of the
sample period monetary rule(s).
A recent analysis by Strongin (1991) is an attempt
at defining a monetary policy disturbance. His
identifying restriction is that monetary policy
shocks have exactly offsetting impacts on nonborrowed reserves and borrowed reserves and
hence have no effect on total reserves. In con
trast he assumes that "reserve-demand” shocks
in principle affect all three aggregates. Much of
Strongin’s discussion of historical Federal Reserve
operating procedures focuses on the likely dis
49The exclusion of monetary policy disturbances from total
reserve shocks is analogous to identifying the supply function
by the exclusion of income in a classical demand/supply
model.

tribution of reserve-demand shocks (his < para
f
>
meter) between nonborrowed and borrowed
reserves. The size of this parameter is not rele
vant to his identification problem, though it is
important for estimation if the parameter value
differs across subsamples.4 The identifying res
9
triction allows him to construct a measure of
monetary policy shocks but does not address
the structure o f the monetary rule or policy
reaction function. Strongin implicitly assumes
that there is no contemporaneous feedback
from interest rates onto his monetary-policy
shock because both total and nonborrowed
reserves precede the fed funds rate in his Wold
causal chain. Thus his identifying restriction does '
not address all o f the problems raised here.
Unfortunately, inference about monetary regimes
(policy reaction functions) using regression tech
niques has proved illusory. Khoury (1990) reviews
42 attempts at the estimation o f reaction func
tions for the Fed over various sample periods.
He concludes that "the results were in disarray”
and "the specification search showed that very
few variables were robust in a reaction function
... consistent with the lack o f robustness in the
literature.” The additional attempts at developing
reaction functions that are included in Mayer
do not overturn this conclusion.5 Thus it appears
0
appropriate to conclude that at present we lack
adequate information to make inferences from
time series analyses on the vexing question of
the short-run impact of nominal shocks on real
output.

CONCLUSIONS
Significant elements of the St. Louis research
agenda are now widely accepted, at least in U.S.
academic circles and to some extent within the
Federal Reserve System. Nevertheless, issues of
short-run impacts o f monetary policy remain
unresolved. Among these are the following two
critical topics: 1) changes in the drift o f velocity
and the extent to which such changes are
generated by changes in inflation expectations
and 2) the short-run impacts o f nominal money
shocks on real output.
The first o f these questions is critical to the
design of monetary rules and/or operating pro
cedures that will retain credibility during the
50See Mayer (1990).

MARCH/APRIL 1993

transition to an alternative inflation regime. The
second question has long been debated and appears
to be re-emerging as a focus of time series anal
ysis. The analysis presented here suggests that
the information necessary to pursue this agenda
successfully is not yet available. One critical
precondition to such analysis is a reasonable
specification of the monetary regime(s) during
the sample period. In this respect, Cagan’s
(1989) appeal for more "historical” research
warrants careful consideration.
A potential application of such a historical
analysis is a test o f Strongin’s (1991) identifying
restriction for monetary policy shocks. His res
triction provides an estimated time series for
such shocks. W e can infer from published
Records o f Policy Actions of the FOMC the tim
ing and to some extent the magnitude of policy
interventions to change the fed funds rate and/or
borrowed reserves targets.5 If the identifying
1
restriction is valid, time series estimates of the
monetary policy shocks should correlate well
with the data extracted from these historical
records.

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Bernanke, Ben S. “ Alternative Explanations of the MoneyIncome Correlation,” Carnegie-Rochester Conference
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Brunner, Karl, and Anatol B. Balbach. “ An Evaluation of Two
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FEDERAL RESERVE BANK OF ST. LOUIS

Hoffman, Dennis L., and Robert H. Rasche. “ Long-Run
Income and Interest Elasticities of Money Demand in the
United States,” Review of Economics and Statistics
(November, 1991a), pp. 665-74.
________“ The Demand for Money in the U.S. During the
Great Depression and Post War Period: Identifying the
Source of Shifts in Velocity,” mimeo (1991b).

________“ Identification and Inference in Cointegrated Systems:
A Synthesis of Recent Developments,” mimeo (1991c).
________“ Money Demand in the U.S. and Japan: Analysis of
Stability and the Importance of Transitory and Permanent
Shocks,” mimeo (1992).
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lem of Instrument Instability,” American Economic Review
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Huizinga, John, and Frederic S. Mishkin. “ Monetary Policy
Regime Shifts and the Unusual Behavior of Real Interest
Rates,” Carnegie-Rochester Conference Series on Public
Policy (Spring 1986), pp. 231-74.

Business Cycle Interpretation,” in Michael T. Belongia,
ed., Monetary Policy on the 75th Anniversary of the Federal
Reserve System (Boston: Kluwer Academic Publishers,
1991), pp. 245-74.
Rasche, Robert H. “ M1-Velocity and Money-Demand Functions:
Do Stable Relationships Exist?” Carnegie-Rochester Con
ference Series on Public Policy (Autumn 1987), pp. 9-88.
________ “ Demand Functions for Measures of U.S. Money
and Debt,” in Peter Hooper et. al., eds., Financial Sectors
in Open Economies: Empirical Analysis and Policy Issues
(Washington: Board of Governors of the Federal Reserve
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Johansen, Soren. “ Statistical Analysis of Cointegration Vectors,”
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Roley, V. Vance. “ The Response of Interest Rates to Money
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________“ Estimation and Hypothesis Testing of Cointegration
Vectors in Gaussian Vector Autoregressive Models,”
Econometrica (November 1991), pp. 1551-80.

Rothenberg, Thomas J. Efficient Estimation With Apriori Infor
mation (New Haven: Yale University Press, 1974).

Jordan, Jerry L. “ The Andersen-Jordan Approach After Nearly
20 Years,” this Review (October 1986), pp. 5-8.
Judd, John P., and John L. Scadding. “ Liability Management,
Bank Loans and Deposit ’Market’ Disequilibrium,” Federal
Reserve Bank of San Francisco Economic Review (Summer
1981), pp. 21-44.
King, Robert, Charles I. Plosser, James H. Stock, and Mark W.
Watson. “ Stochastic Trends and Economic Fluctuations,”
American Economic Review (September 1991), pp. 819-40.
Khoury, Salwa S. “ The Federal Reserve Reaction Function:
A Specification Search,” in Thomas A. Meyer, ed., The
Political Economy of American Monetary Policy (New York:
Cambridge University Press, 1990).
Laidler, David E.W. The Demand for Money: Theories, Evidence
and Problems (New York: Harper and Row, 1985).

Sims, Christopher A. “ Macroeconomics and Reality,”
Econometrica (January 1980), pp. 1-48.
________“ Are Forecasting Models Usable for Policy Analysis?”
Federal Reserve Bank of Minneapolis Quarterly Review
(Winter 1986), pp. 2-16.
Stock, James H., and Mark W. Watson. “ A Simple Estimator of
Cointegrating Vectors in Hiqher Order Inteqrated Systems,”
mimeo (1991).
Strongin, Steven. “ The Identification of Monetary Policy Dis
turbances: Explaining the Liquidity Puzzle,” Federal
Reserve Bank of Chicago Working Paper W P-91-24,
(December 1991).
Yoshida, Tomoo, and Robert H. Rasche. “ The M2 Demand
in Japan: Shifted and Unstable?” Bank of Japan Monetary
and Economic Studies (September 1990), pp. 9-30.

_______ . Monetarist Perspectives (Cambridge, Massachusetts:
Harvard University Press, 1982).
Learner, Edward E. “ Vector Autoregressions for Causal Infer
ence?” Carnegie-Rochester Conference Series on Public
Policy (Spring 1985), pp. 255-303.
Litterman, Robert B., and Laurence M. Weiss. “ Money, Real
Interest Rates, and Output: A Reinterpretation of Postwar
U.S. Data,” Econometrica (January 1985), pp. 129-56.
Lucas, Robert E. Jr. “ Econometric Policy Evaluation: A Critique,”
Journal of Monetary Economics (Supplementary Series,
Volume 1, 1976) pp. 19-46.
Mankiw, N.G. “ The Reincarnation of Keynesian Economics,”
NBER Working Paper 3885 (October 1991).
McCallum, Bennett T. “ Robustness Properties of a Rule for
Monetary Policy,” Carnegie-Rochester Conference Series
on Public Policy (Autumn 1988), pp. 173-203.
Meltzer, Allan H. “ Limits of Short-Run Stabilization Policy,”
Economic Inquiry (January 1987), pp. 1-14.
Meyer, Thomas A. The Political Economy of American Monetary
Policy (New York: Cambridge University Press, 1990).
Nelson, Charles R., and Charles I. Plosser. “ Trends and
Random Walks in Macroeconomic Time Series: Some
Evidence and Implications,” Journal of Monetary Economics
(September 1982), pp. 139-62.
Osterwald-Lenum, Michael. “ Recalculated and Extended Tables
of the Asymptotic Distribution of Some Important Maximum
Likelihood Cointegration Test Statistics,” Institute of Eco
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Phillips, P.C.B. “ Optimal Inference in Cointegrated Systems,”
Econometrica (March 1991), pp. 283-306.
Plosser, Charles I. “ Money and Business Cycles: A Real

Appendix A
Technical Description
of the Assum ptions in
the Simulation of the
McCallum Rule
The initial regime (periods 1-19) in figures 3
and 4 before the implementation of the McCallum
rule are base velocity growth at tv = .0075 per
period. The monetary base is assumed to grow
at a rate that increases at tr = .0001563 per
period. Thus nominal income growth is increas
ing at a rate of t. = .0001563 per period. The
rate of increase in nominal income growth is
assumed to reflect the trend in inflation, which
in turn is assumed to reflect the trend in nomi
nal interest rates. The trend in nominal interest
rates and the trend in velocity must satisfy the
restriction tv - e rtr = 0 where er is the interest
semielasticity of velocity if base velocity and
interest rates are cointegrated. er is assumed to
be 48, using the estimated semielasticity of M l

MARCH/APRIL 1993

velocity from Hoffman and Rasche [1992]. Nominal
income and nominal potential income are
assumed equal throughout this period.
The regime switch to the McCallum rule is an
nounced and implemented in period 20. The desired
growth rate o f nominal income in the new
regime is .0075 per period. It is assumed that
the announcement of the new policy results in an
immediate elimination of base velocity growth.
It should be noted that the path o f nominal
income growth once the McCallum regime is
implemented is independent of the assumptions
about growth in the prior regime. Nominal income
growth in the McCallum regime is totally deter
mined by the assumed growth of velocity start
ing 16 periods prior to the implementation of
the rule, and the reaction of velocity growth to
the institution o f the new regime. The particu
lar initial conditions for base growth used here
are chosen strictly for consistency with the
assumed initial growth rate o f base velocity.

replications are plotted in Figures A1-A10,
together with confidence bands of ± 1.96*
(standard deviations of the impulse responses
across replications). The graphs suggest that the
short-run responses of real output and velocity with
respect to both permanent shocks are measured
with considerable precision, in particular that the
real output response to a permanent "money
growth” shock is initially significantly positive
and that the real output response of a perma
nent ” real output” shock is significantly less
than 1.0 for about 10 quarters. In contrast, the
measurement of the short-run responses of
inflation, money growth, and interest rates to
both permanent shocks is highly imprecise.

Appendix C
Sources of Data
All data series were extracted from Citibase.
The primary sources are as follows:
Treasury Bill Rate: Three month secondary market
rate. Federal Reserve Bulletin. Table 1.35, line 15.

Appendix B
Confidence Intervals for
Im pulse Response
Functions
Estimates of the precision of the impulse
response functions from the sample ending in
90:3 w ere constructed from a Monte Carlo
integration. The estimated coefficients and covariance matrix o f residuals from a VAR aug
mented by two error correction variables were
shocked using the algorithm described in Doan
[1990], example 10.1. The elements of the coin
tegrating vectors were held constant at their
estimated values, since Johansen [1991], The
orem 5.5, proves that the estimated asymptotic
covariance matrix of I I = a p' depends only on
the estimated asymptotic covariances of a and
the estimated p and not on the estimated asymp
totic covariance of p. 1000 replications on the
parameter values were constructed and the
parameters of the KPSW common trends model
were recomputed for each replication. The
mean value of KPSW’s critical I I , , parameter
across all replications is -.0057 with a standard
deviation of .0371. These parameters were used
to derive impulse response functions. The means
of various impulse responses across the 1000

FEDERAL RESERVE BANK OF ST. LOUIS

M l:

Seasonally adjusted monthly data.
January 1947-December 1958 con
structed following Rasche (1987),
Appendix A.
January 1959-December 1989 Board
of Governors of the Federal Reserve
System, Money Stock Revisions,
March 1990, Table 1.
January 1990-March 1990 Federal
Reserve Bulletin, July 1990, Table
1.21, line 1.
April 1990-June 1990 Federal
Reserve Bulletin, October 1990, Table
1.21, line 1.
July 1990 Federal Reserve Bulletin,
January 1991, Table 1.21, line 1.
August 1990 Federal Reserve Bulletin,
February 1991, Table 1.21, line 1.

GNP:

Seasonally adjusted quarterly data.
January 1947-April 1987 Survey of
Current Business, July 1990
January 1988-March 1990 Economic
Report of the President, February
1991, Table B-l.

Real GNP: Seasonally adjusted quarterly data.
January 1947-April 1987 Survey of
Current Business, July 1990
January 1988-March 1990 Economic
Report of the President, February
1991, Table B-2.

Appendix Figure 1
Velocity irf to Money Growth Shock

Appendix Figure 2
Real Output irf to Money Growth Shock

MARCH/APRIL 1993

Appendix Figure 3
Inflation irf to Money Growth Shock

Appendix Figure 4
Money Growth irf to Money Growth Shock

FEDERAL RESERVE BANK OF ST. LOUIS

Appendix Figure 5
T-bill Rate irf to Money Growth Shock

Appendix Figure 6
Velocity irf to Real Output Shock

MARCH/APRIL 1993

Appendix Figure 7
Real Output irf to Real Output Shock

Appendix Figure 8
Inflation irf to Real Output Shock

FEDERAL RESERVE BANK OF ST. LOUIS

Appendix Figure 9
Money Growth irf to Real Output Shock

Appendix Figure 10
T-Bill Rate irf to Real Output Shock

MARCH/APRIL 1993

Julio J. R otem berg
Julio J. Rotemberg is a professor of economics at the Sloan
School of Management at the Massachusetts Institute of
Technology. He thanks the National Science Foundation for
research support.

Commentary

R
OBERT RASCHE’S PAPER is divided into
three parts. In the first part Rasche argues that
many monetarist propositions have become
widely accepted by macroeconomic theorists.
With this I agree completely. The work of the
so-called New Keynesians should really be called
New Monetarist. Many o f the papers in this
tradition focus exclusively on the effect of monetary
shocks. Moreover, the key building block for these
papers is a quantity equation where velocity is
treated as constant.
This is consistent with a basic monetarist tenet
that money demand is pretty stable and changes
in money represent mainly autonomous changes
in money supply. The second part of Rasche's
paper is concerned with bolstering the view
that money demand, at least in some sense, has
been stable over time. This is the part of the
paper with which I disagree most.
The third part of the paper concerns vector
autoregressions and the ambiguous role they
give to monetary disturbances. Rasche argues
that it is hard to identify the economic meaning
of the residuals in these vector autoregressions.
It is particularly hard to determine which residual
or which combination of these residuals represents
shocks to the money supply. Therefore it is diffi
cult to use these particular statistical techniques for
evaluating monetary policy. I am in basic agree
'Luca s’ data actually run from 1900, so he displays even
more stability than reported here.

FEDERAL RESERVE BANK OF ST. LOUIS

ment with this part of the paper, so when I dis
cuss it, I will mainly elaborate on themes that
Rasche develops.
Let me start with the issues raised by the second
part of the paper. The Andersen-Jordan equation
relates the change in nominal GNP to the change
in money (measured by the monetary base) and
changes in several measures o f fiscal stance.
Regressions of output on money are a basic sta
ple of empirical macroeconomics today, and
Andersen and Jordan deserve credit for pioneer
ing regressions o f this form . As Rasche
emphasizes, such regressions really make sense
only if you can think o f monetary growth as
representing an exogenous impulse. This
requires among other things that money
demand be stable. The instability o f money
demand has been researched at length. One
apparent instability on which Rasche focuses is
the change in velocity’s trend around the early
1980s. He attributes this change to a change in
interest rate trends. The implicit suggestion is
that money demand is stable after all.
Rasche's view, which echoes Lucas (1988), is
that there exists a stable, long-run money demand
equation that can be estimated using levels of
velocity and interest rates.1 This cointegrating
regression explains the trend in velocity with
the trend of interest rates in the pre-1980

Figure 1
Actual and Fitted Velocity
Velocity

period. I have rerun a similar equation using
CITIBASE data from 1959:1 to 1989:2, and the
results are as follows:
GNP
(1)

log(_i w F ) =

‘
R2 = 0.649

1286

(0.029)
D.W.

0 0 6 2 , ’
t

(0.004)
= 0.18,

where i is the interest rate on Treasury bills.
My estimated interest elasticity is a bit smaller than
Rasche’s, but the cointegration result is the same.
To understand what is going on, it is helpful to
look at figure 1, which shows the fitted values of
this regression together with the actual values for
the logarithm o f velocity. W e see that the fitted
values match the trend in velocity rather well
through the early 1980s. The ability o f interest
rates to account for the long-run movements in
velocity is remarkable. I have to confess that
the ability to track the trends in velocity is so
amazing that I wanted to check whether the inter
est rate’s regression coefficient was unchanged from
the pre-1979 to the post-1979 period. I thus ran the
following regression:
GNP
(2) log ( ------) = 1.346 + 0.047/ + O.Olld, * /
Ml
'
'
1
(0.038)
(0.008)
(0.005)
R2 = 0.665

D.W. =

0.16,

where dt represents a dummy variable that
equals zero before 1979:1 and one afterwards.
The coefficient on the interest rate is thus sig
nificantly higher in the second part o f the sam
ple. Therefore all stability problems should not
be considered solved. Nonetheless, it is impressive
that a single interest rate coefficient can track
the trends in velocity.
The question at this point is whether Rasche has
found the money demand equation. An alternative
view is that the ability o f interest rates to explain
long-run trends in money is a coincidence and
that economists should really search for a money
demand equation that explains deviations around
trends. In this view trends in money are caused
by secular changes in regulation and technol
ogy, which have nothing to do with interest
rates. Thus trends in interest rates and velocity
are unreliable sources of information about the
semi-elasticity of money demand with respect to
interest rates.
On a priori grounds, one should prefer Rasche’s
interpretation because it doesn’t rely on anything
outside the model, such as regulatory changes
and technical progress. And yet I must admit
that I resist Rasche’s view that he has found the
true underlying money-demand function. I resist
because I am bothered by the huge residuals in

MARCH/APRIL 1993

this equation. The fitted values are often 20
percent or more away from the actual level of
velocity. Moreover, these huge residuals aren’t
just random; they are strongly correlated with
high-frequency movements in interest rates.
Thus around 1975 when interest rates were
relatively low, velocity was also predicted to be
low. There must have been a huge reduction in
money demand around this period to explain
the actual behavior of velocity. Put differently,
the medium- and high-frequency movements in
interest rates, including the spike of 1979, must
be attributed to large temporary changes in
money demand. I find this hard to believe, how
ever, and tend to trust the conventional wisdom
that attributes many of these changes in inter
est rates to monetary policy. But to believe this
conventional wisdom, you have to believe that
the short-run interest elasticity o f money demand
is different from that estimated by the coin
tegrating regression. In other words, you have
to believe that the cointegrating regression does
not deliver the stable money demand curve that
can be used for short-run policy analysis.
To see what difference this makes, I have rerun
the regression explaining the log of velocity
with interest rates through the end o f 1981 but
adding a trend. In other words, in this regression
the trend is due to technical progress in credit cards
and other advances that allow individuals to
conserve on money balances. In figure 1 the fitted
value with the trend is closer to the actual value
than is the fitted value without the trend. Figure
1 supports Rasche’s view that money demand is
stable after all because it explains long-run swings
but this stability is purchased at a heavy price.
It must be that money demand is incredibly
unstable at short and medium frequencies.
This comment just puts the shoe on the other foot
because it raises the question of why money demand
rose greatly (and velocity declined) in the early
1980s. Although I am far from having a com
plete explanation of this phenomenon, I want to
return briefly to the theme I presented when
I was here three years ago. I said then that sim
ply adding monetary assets that pay different
interest rates makes no sense and that proce
dures such as the Divisia method advocated by
Barnett (1980) should be used instead. This seems
particularly germane to the question of why
velocity fell in the 1980s. The reason is that cur
rency and non-interest-paying demand deposits
2See Rotemberg, Driscoll and Poterba (1992) for a more
detailed analysis.

FEDERAL RESERVE BANK OF ST. LOUIS

did not rise unprecedentedly in this period.
Figure 2 shows the velocity o f the aggregate
that includes only these non-interest-bearing
assets and it continues to trend upward. What
did increase dramatically in this period is the
holding of other checkable deposits that pay
interest. But adding these to the rest is simply
misleading. Other checkable deposits are much
more attractive as savings instruments than the
other components of M l, so they should be
regarded as less monetary.
Exactly how much less monetary than other
checkable deposits is perhaps a matter o f debate.
For current purposes, let me propose that they
are about one-third as monetary as the other
ingredients in M l, so a proper aggregate can be
constructed by adding one-third o f other check
able deposits to the other two monetary compo
nents.2 The logic behind this is as follows. In the
late 1980s the Treasury bill rate used by Rasche
averaged about 7 percent, and interest rates on
other checkable deposits w ere between 4 percent
and 5 percent. Thus the gap between these two
interest rates is about one-third of the gap between
the interest rate on currency and that on Treas
ury bills. Figure 2 displays the result o f treating
other checkable deposits as being one-third as
monetary as the other assets. Little change in
trend can now be detected.
The exercise I just finished is hopelessly
crude, and I am not really trying to push the
idea that the velocity trend is a natural constant.
Rather I am trying to say that the remarkable
fit of the Rasche regression explaining velocity
should be taken with a grain of salt. There are
other plausible reasons for velocity to have
fallen in the 1980s.
In conclusion, even if Rasche’s regression gives
us the true money-demand relation, the volatility
of velocity is substantial. This makes a rule where
money grows at a constant rate unattractive
relative to a rule where monetary changes track
changes in velocity. This raises the following
two related questions. How do you ascertain that
the Fed has done a good job of accommodating
changes in velocity, and how do you measure
actual monetary impulses over and above those
needed to satisfy changes in money demand?
I agree with Rasche’s basic thrust that a purely
statistical approach cannot disentangle the
endogenous and exogenous parts o f changes in

Figure 2
The Velocity of Different Aggregates
V e lo c ity

2 .25 -

1.75 ■ M1 Log Velocity
* Log V elocity of C urrency and
Demand Deposits
- Log Velocity w eighing OCDs by
one-third

I
1959

I
61

money. It is hard to know exactly what is being
captured by innovations in money within typical
VARs. I am particularly bothered by the incon
sistency between regressions of various varia
bles on money and money innovations on the
one hand and regressions that use variables that
reflect changes in Federal Reserve intentions on
the other.
In the case of regressions that use money and
money innovations on the right-hand side, one
generally finds that money raises output and
interest rates. Over the years, several authors
have constructed variables on the basis of the
FOMC minutes that are supposed to reflect
Federal Reserve intentions. Boschen and Mills
(1992) show that all these proxies have similar
correlations with subsequent levels of GNP and
interest rates. In particular, after the proxies
indicate that the Fed wishes to tighten, output
falls while interest rates rise. These opposite
reactions o f output and interest rates are quite
consistent with textbook models and it is incon
sistent with the simultaneous increase in output
and interest rates that tends to follow increases
in money. So how can one reconcile regressions

I
73

I
75

I
77

I
79

I
87

I
1989

on proxies of Fed intentions on the one hand
and regressions on money growth on the other?
One feature o f the U.S. postwar period is that
many of the well-known episodes of changes in
Fed policy involve deliberate tightening to slow
inflation.3 Thus the historical evidence appears
consistent with the asymmetries found by Cover
(1992) and De Long and Summers (1988). These
authors find that output is much more strongly
correlated with negative monetary innovations
than with positive ones. The latter have a small
positive effect on output that is statistically
insignificant.
De Long and Summers construct their innova
tions by running the following regression:
(3) Alog M l, = 0.005 + 0.457 Alog M1m (0.002)
(0.091)
0.145 Alog GNPt l + 6e-5Trend
(0.083)
(2e-5)
R2 = 0.321

D.W. = 1.93

The residuals o f this regression can be used to
construct DM", which equals the smaller of the
residual and zero. Thus this variable captures

3See Romer and Romer (1989).

MARCH/APRIL 1993

negative innovations. As a further analysis of
asymmetries, I considered a regression of the
Treasury bill rate on changes in money and on
DM" over the period 1960:3-1989:2. The results
are as follows:

(4) it =

-0.04 + 1.31itl - 0.68it2 + 0.72i13- 0.5i(4
(0.198) (0.088) (0.151) (0.166) (0.106)

51.4DM
(15)

75.0DM"
(25)

- 10.0DM,"s + 8.2DM"3 - 52.7DM"
(27)
(25)
(22)

R2 = 0.944

4.9DM
(18)

3 4 D M t-3

(17)

- 12.8DMt
(14)

D.W. = 2.13,

where DM represents the change in the logarithm
of M l.
W e see here that, as in typical VARs, lagged
changes in money tend to increase interest rates.
But on the other hand, the effect of lagged nega
tive monetary innovations is negative. This means
that negative monetary innovations actually
raise interest rates; they have the same correla
tion with interest rates as the proxies that indi
cate that the Fed wishes to tighten.4 Combining
these results with those of Cover and those of
De Long and Summers, I conclude that negative
monetary innovations affect the economy as
money supply shocks should, whereas positive
shocks do not.
How should you interpret the positive innova
tions in money in light o f their correlation with
GNP and the Treasury bill rate? One cannot say
that they represent simply monetary accommo
dation to increases in the stochastic component
of the demand for money. Given that these
innovations lead to rises in interest rates, the
accommodation can be only partial. But partial
accommodation of money-demand disturbances
should lead to declines rather than small increases
in output. I am thus inclined to believe that these
positive innovations in money represent in part
accommodation by the Fed of other shocks whose
effect is to increase future output. Thus the Fed
is accommodating increases in money demand
that are due to increases in output rather than mere
4I also checked whether I could detect asymmetric effects on
inflation (to see whether the asymmetric effects on interest

FEDERAL RESERVE BANK OF ST. LOUIS

money-demand disturbances. If this is true, it
suggests that the Fed is sometimes farsighted.
These results can be used to discuss an alter
native explanation of the asymmetries found by
Cover and by De Long and Summers. This alter
native view holds that all monetary innovations
represent exogenous increases in the money
supply but that the effects of changes in the
money supply are intrinsically asymmetric. The
traditional analogy is that monetary policy oper
ates like a string and that strings are useful only
for pulling the economy down, not for pushing
it up. Several theories of such asymmetries have
been proposed. One cause o f this structural asym
metry could be that reductions in reserves force
banks to cut loans, whereas banks can react to
an increase in reserves by raising their holding
of securities. If investment depends on the sup
ply of loans and not on the interest rate and
the supply of loans is affected only by monetary
contractions, then only money-supply reductions
have a powerful effect on the economy. Another
possible cause o f this asymmetry is discussed by
Caballero and Engel (1992) who show that asym
metry is a natural consequence o f the steadystate distribution of prices in an economy with
costs o f price adjustment.
Both o f the preceding hypotheses may well be
able to explain the asymmetry found by Cover
and by De Long and Summers. They cannot, how
ever, explain the asymmetric effect on interest rates
as easily. The asymmetric response of interest
rates casts doubt on the hypotheses by showing that
the effects are asymmetric even in securities
markets, not just in markets subject to frictions
(for example, the market in which banks inter
mediate loans to businesses and the markets in
which firms set prices that are relatively rigid).
As Robert Rasche emphasizes, there is still much
to be done to understand the precise role of mone
tary innovations in statistical models. To understand
this role, we have to connect money innovations
with other historical and institutional data. Only
then can we ascertain the empirical importance
of money-supply disturbances in the economy.

REFERENCES
Barnett, William A. “ Economic Monetary Aggregates: An
Application of Index Numbers and Aggregation Theory,”
Journal of Econometrics (Summer 1980), pp. 11-48.
rates represent asymmetric effects on real returns
as well). Inflation does not appear to respond asymmetrically.

Boschen, John F., and Leonard O. Mills. “ The Effects of
Countercyclical Policy on Money and Interest Rates:
An Evaluation of FOMC Documents,” mimeo, 1992.

Lucas, Robert E. Jr. “ Money Demand in the United States:
A Quantitative Review,” Carnegie Rochester Conference
Series on Public Policy (Autumn 1988), pp. 137-68.

Caballero, Ricardo and Eduardo Engel. ‘‘Price Rigidities,
Asymmetries and Output Fluctuations,” NBER Working
Paper 4091 (June 1992).

Romer, Christina D., and David H. Romer. “ Does Monetary
Policy Matter: A New Test in the Spirit of Friedman and
Schwartz.” in Olivier, Jean Blanchard and Stanley Fischer,
eds., NBER Macroeconomics Annual 1989 (MIT Press, 1989),
pp. 121-70.

Cover, James P. ‘‘Asymmetric Effects of Positive and Negative
Money Supply Shocks,” Quarterly Journal of Economics
(November 1992), pp. 1261-82.
De Long, J. Bradford, and Lawrence H. Summers. “ How does
Macroeconomic Policy Affect Output?” Brookings Papers
on Economic Activity (1988:2), pp. 433-94.

Rotemberg, Julio, John Driscoll and James Poterba. “ Money,
Output and Prices: Evidence from a New Monetary Aggre
gate,” mimeo 1992.

MARCH/APRIL 1993

W. Lee Hoskins
IV. Lee Hoskins is president and chief executive officer of
The Huntington National Bank in Columbus, Ohio. This paper
is given in honor of Ted Balbach and his service to the
Federal Reserve Bank of St. Louis. His resolute pursuit of
sound economics as the bedrock of monetary policymaking
and his indomitable spirit, even when the policy process ran
amok, has served us all well. I thank John Davis, Sandra
Pianatto and members of the Research Department of the
Federal Reserve Bank of Cleveland for helping to shape and
advance my views on monetary policy during my four years
with them.

Views on Monetary Policy

T
„

HE IDEAL MONETARY POLICY requires a
credible and predictable commitment to main
tain the long-term purchasing power of a
currency. The performance o f central banks,
which have traditionally been entrusted with
monetary policymaking, is far from this ideal
simply because a clear mandate for price-level
stability—zero inflation—is absent. In practice,
central banks serve as instruments that govern
ments use to pursue multiple objectives that
they believe serve their interests. Therefore
central banks pursue monetary policies that at
best have only a fragile commitment to price
stability. Governments are currently pursuing
policy coordination or monetary union strate
gies that are little more than attempts to implement
a regime of monetary protectionism, in the
global economy. The future o f monetary policy
rests on the continuing struggle between politi
cians seeking policies that serve their short-term
agendas and global financial markets that limit
the actions o f an individual central bank.
In my remarks I discuss why central banks
have been established, their bias toward infla
tion and the importance o f independence and
accountability to their effectiveness. I also argue
that zero inflation should be the dominant
objective of a central bank and that current

efforts to coordinate monetary policies are
likely to conflict with that objective.

WHY CENTRAL BANKS?
What is the justification for a central bank?
Can some configuration of private institutions in
a so-called free-banking environment perform
the functions o f a government-sponsored mone
tary authority? Are central banks necessary?
In his 1959 Millar Lectures at Fordham
University, Milton Friedman provided a classic
statement o f the economic rationale for central
banks.1 Friedman’s argument appealed funda
mentally to the costs inherent in a pure commoditystandard system, for example, a gold-standard
system. These costs arise both from pure resource
costs and perhaps more significantly from sub
stantial short-run price variability resulting from
inertia in the adjustment of commodity-money
supply to changes in demand. The inefficiencies
these costs represent are a significant disadvan
tage o f commodity-money exchange systems.
As a consequence there is a natural tendency,
borne out by history, for pure commodity standards
to be superseded by fiat money. But particular
aspects of fiat money systems—such as fraudulent

’ These lectures were subsequently published as A Program
for Monetary Stability.

MARCH/APRIL 1993

banking practices, natural monopoly characteristics
and tendencies for localized banking failures to
spread to the financial system as a whole—resulted
in the active participation of government. W e have
come to know this active participation as cen
tral banking.
Rationales for establishing central banks have
not gone unchallenged, not even by Friedman.2
Disruptions in payments can be costly, but so
are the instabilities and inefficiencies caused by
the lack of an effective anchor for the price
level in fiat money systems. Moreover, theoretical
discoveries in finance and monetary economics,
closer attention to the lessons of historical bank
ing arrangements and advances in information
and financial technologies have contributed to a
healthy skepticism about the superiority of central
banks and government regulation to alternative
market arrangements. For example, some o f the
financial-backstop functions performed by central
banks and banking regulators may have weakened
private market incentives to control and protect
against risk.3
Still, those who argue for alternative monetary
structures must at least recognize that their
case rests on untested propositions. Yes, it would
be wrong to accept unthinkingly our current
central banking system as the best alternative
for performing the monetary functions of advanced
economies, but it would also be wrong to claim
that the current central banking system does
not reflect society’s choice of an institutional
arrangement to perform those functions.
It is not sufficient to argue that m arketoriented alternatives to our current central
banking systems functioned better in other
times and places, for example, in 18th-century
Scotland.4 This begs the question of why such a
system did not prove to be sustainable. Nor is it
sufficient to argue that this system would have
prevailed if not for government intervention
and interference. This line o f debate fails to
consider whether a political equilibrium that
would support a market-oriented system in an
advanced economy exists anywhere.
It is premature to claim that some hypothetical
monetary system can or should dominate institu
tional arrangements that have already evolved
from extended political and economic experience.
I believe that the prudent first course is to con
2See Friedman and Schwartz (1986)
3See Goodhart (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

sider the advantages of improving the perform
ance of central banks. The benefits o f a properly
managed fiat currency are considerable, and the
issue is or should be how to provide the central
bank with a proper charter to ensure policy
action that generates price-level stability in the
long term. If such efforts fail, market alterna
tives should be sought.
Because I am most familiar with the Federal
Reserve, let me use it as an example. Before the
creation of the Federal Reserve in 1913, the
country prospered without a central bank.
Broadly speaking, the impetus for creating the
Federal Reserve was a series of banking panics
that led to contractions in money and credit
that in turn caused serious disruptions in eco
nomic activity. The nation sought to improve its
banking system by establishing a means for
providing an elastic money in the context of a
monetary standard based on full convertibility
to gold. The gold link was severely weakened
by the Gold Reserve Act of 1934.
The Federal Reserve was the result of a com
promise between those who would have kept
the banking system entirely private and those
who wanted government to assume a prominent
role in a rapidly growing economy. Other nations
have grappled with the same problems and created
similar institutions. Today many republics of
the former Soviet Union and several eastern Euro
pean nations are facing these same issues. We
now have a world monetary system in which
governments, through central banks, monopolize
the supply and management o f inconvertible
fiat monies.
The displacement o f the commodity standard
that prevailed at the time the Federal Reserve
was founded has exposed problems not other
wise envisioned in 1913. For example, the price
level has no anchor except for that provided by
the resolve of Federal Reserve policymakers.
The quadrupling of prices since 1950 dramati
cally demonstrates the failure of Federal Reserve
policymakers to provide such an anchor for the
monetary exchange system. Fed policymakers’
commitment to price stability is neither as explicit
nor as strong as necessary for the successful
management of a fiat currency. The gradual
demise of our convertible monetary standard
has brought us to a point that requires a basic
4For a discussion of the free banking era in Great Britain,
see White (1984).

change to the framework within which the
Federal Reserve functions if the benefits of a
fiat currency are to be achieved without large
offsetting costs.
The evolution o f the global monetary system
reflects a common, though unstated, acknowledg
ment that the benefits of a fiat monetary standard
are substantial. Wise administration of that
standard requires a central bank in some capacity.
In this context, the essential issue is this: How can
nations achieve the benefits o f a fiat money
standard and simultaneously constrain the exercise
of that power to the service of the public good?
Put another way: How can a nation prevent its
central bank from debasing the monetary standard
it is charged to protect?

INFLATIONARY BIAS OF CENTRAL
BANKS
The answer to these questions seems to elude us.
Witness the universal debasement of currencies
by central banks since the loss of a commodity
standard as a price-level anchor. To find the
answer, we must review central bank charters
and the incentives provided to those who con
trol monetary printing presses. Public-choice
economists have focused on this issue and
developed a rich literature; however, I feel they
fail to provide a satisfactory explanation of the
secular bias toward inflation among central
banks (with different charters and varying
degrees of independence from political influence).
Moreover, this approach fails to explain why in
earlier periods governments did not consistently
exploit the opportunities to inflate by realigning
their currencies against gold or dropping their
convertibility.
Another explanation for persistent inflation
that has some appeal is policy mistakes, or inap
propriate targets or operating procedures of
central banks. This explanation also leaves some
unanswered questions. Why aren’t policy mistakes
symmetrical? That is, why don’t they cause defla
tions as well as inflations, leaving the average
price level unchanged over time? Perhaps policy
mistakes are biased toward inflation because of
the operating procedures employed, such as
interest rate targeting. Yet the Bundesbank, which
uses monetary aggregate targets, produces a rising
price level. The Bank of Japan uses interest rate
targets and has generated a similar increase in
its price level during the past two decades. If a
central bank is dedicated to price-level stability

over time, the choice o f targets or operating
procedures probably only influences the variabil
ity o f inflation rates around a zero mean. In short,
a central bank that truly wants to achieve pricelevel stability can do it with any number of
operating techniques, as long as they control
money growth over time.
Perhaps a simple, and less elegant, explanation
for persistent inflation is that central bankers are
suffering from a Keynesian hangover. Central
bankers, politicians and the public are merely
reflecting the prevailing economic dogma that
government has the responsibility and ability to
manage aggregate output and employment, as
well as inflation. I have argued and continue to
believe that a major source o f price-level insta
bility comes from multiple objectives assigned to
central banks—economic growth, employment,
price stability and exchange rates. It is true that
politicians pressure central banks to achieve dif
ferent objectives at different times. Such politi
cal pressure can produce inappropriate policy
actions; however, the responsibility for assign
ing multiple objectives to central banks rests as
much with the economics professions as it does
with politicians. For the last 50 years, many
economists have supported various theories of
business-cycle management, which required that
central banks shift from one objective to another.
Today businessmen, politicians and most economists
continue to believe that if the economy is weak,
the central bank should respond regardless of
the cause of the weakness. And so it does.
Some o f the current discussions about mone
tary policy and the Federal Reserve suggest that
the lessons of the 1970s may be fading from
our memories. Calls for lower interest rates or more
rapid money growth are not at all unusual.
More often than not, those suggestions seem
impelled by desires for growth or desires to o ff
set the problems o f particular sectors of the
economy. They seem based on the notion that
there is a trade-off between inflation and output
or between inflation and employment that can
be exploited by the central bank. Some o f us
learned from the experience of the 1970s that
such a trade-off does not occur over time.
Instead, higher inflation only added to uncer
tainty, distorted resource allocation and reduced
economic performance below the maximum sus
tainable level with price stability.
Members of a central bank policy committee
such as the Federal Open Market Committee
(FOMC) reflect what is believed by the mainstream.

MARCH/APRIL 1993

In January 1990 the National Association of
Business Economists surveyed its members and
asked the following question: "Is reducing the
inflation rate to zero over the next five years
the appropriate objective of monetary policy?”5
More than 80 percent of the respondents
answered no. Their responses indicate that they
believe the FOMC should trade o ff inflation for
some other objective, presumably economic
growth. At about the same time, the House Sub
committee on Domestic Monetary Policy sur
veyed 500 members o f the American Economics
Association who list monetary economics as either
their first or second specialty. The unpublished
survey shows that only a slight majority o f those
who responded favored zero inflation over the
next five years.
I believe that much of the inflationary bias of
central banks over the past 50 years reflects the
prevailing view that output and employment
fluctuations can be smoothed with monetary
policy. Currently, before each FOMC meeting,
members of the Committee are presented with
the policy views of several prominent economists.
Either explicitly or implicitly, these views invari
ably present the policy choice in terms of a
Phillips curve trade-off. Staff projections at the
FOMC meeting also imply such a trade-off, as
do the statements by some FOMC members.
Moreover, policy actions, such as a reduction in
the federal funds rate, often follow the release
o f employment or output statistics, further rein
forcing the notion that the Federal Reserve can
manage real variables. To the extent that this
explanation o f central bank behavior is valid,
inflationary bias will not be eliminated until
there is agreement within the profession on
price-level stability as the dominant objective for
central banks.

INDEPENDENCE AND
ACCOUNTABILITY
The problems that emanate from multiple,
and often incompatible, objectives are well
known. To contribute to maximum economic
growth over time, central banks must achieve
price-level stability. Achieving this goal requires
that central banks be free from political
expediencies—that is, that they have independ
ence within government. Substantial evidence
indicates a link between central-bank independ
5See NABE Policy Survey (1990).

FEDERAL RESERVE BANK OF ST. LOUIS

ence and the ability to achieve price stability.
Recent studies show that countries that grant
their central banks the greatest degree of inde
pendence have had the lowest rates o f inflation.6
Even taking into account other sociopolitical
factors that might cause inflationary pressures,
the degree o f central-bank independence appears
to have an important effect on a country’s infla
tion rate.
However, with independence must come
accountability. Even the clearest objectives will
prove elusive without accountability; independence
without direct accountability is a dangerous
brew for those who drink it. Great harm has
come from well-intentioned, independent cen
tral bankers with little or no accountability—
witness the United States in the 1930s. Many
mechanisms exist today to bring accountability
to central banking; for example, the employ
ment contract of the governor o f the central
bank of New Zealand contains a price-stability
requirement.
The objectives, degree of independence, and
accountability o f the central bank are substan
tially determined by its legal structure. For
example, a clear legislative directive to achieve
price-stability goals above all others and the
freedom to pursue price-stability initiatives
would all but eliminate potential conflict with
other objectives. The vexing question o f what
extent, if any, a central bank should compromise
the price-stability objective to pursue auxiliary
goals, such as smoothing real output fluctua
tions or stabilizing exchange rates, should be
resolved and dictated in the legislative charter.
True independence and strict accountability can
be attained only legislatively.
Compared with the central banks of other
countries, the Federal Reserve System has a
better structure to execute monetary policy
effectively; however, the Fed is not as well posi
tioned as other central banks. The Federal Reserve
is charged with multiple objectives that are
often incompatible but that at least include
price stability. It is functionally independent
within government, but it faces intermittent
challenges to its autonomy. Its independence
comes from both its charter and its practice.
Independence is essentially a delineation
between the responsibilities o f Congress and the
executive branch on one side and the monetary
6See Alessina (1988) and Banaian (1983).

authority on the other to limit the motive and
means to debase the value of the nation's money.
The source of tension between monetary and
fiscal authorities is the central bank’s ability to
create money. Because the creation of fiat money
imposes an implicit tax on money balances, the
monetary authority is one source of government
revenues. For the most part, the long-run viability
o f the government's fiscal operations requires
that its real current debt burden plus the present
value of its expenditures equal the present value
of revenues. Thus if the path of debt plus expendi
tures diverges from the path of explicit tax rev
enues, fiscal viability requires that the discrepancy
be satisfied by seigniorage from monetary growth.
This scenario is typically referred to as fiscal
dominance over the monetary authority.
The original Federal Reserve charter left
many doors open for the executive branch to
influence monetary policy. These were partially
closed when the Banking Act of 1935 removed
the Secretary o f the Treasury and the Comp
troller of Currency from the Board of Gover
nors of the Federal Reserve System. In addition,
the law established the FOMC, with the seven
governors and five o f the Federal Reserve Bank
presidents as voting members, ensuring that
power within the Federal Reserve would be
shared between political appointees and regional
bank presidents. Thus the fire wall that made the
Federal Reserve, and not the executive branch,
responsible for monetary policy objectives was
reinforced. It was strengthened further by the
Treasury-Federal Reserve Accord o f 1951, which
served as a clear statement that the Fed would
not be coerced into solving the federal govern
ment's debt-management problems. The institu
tional structure was designed to ensure enough
Federal Reserve independence within the govern
ment to carry out this mandate without interference.
This independence in principle has held up in
practice. The dramatic increases in federal deficits
in the early- and mid-1980s prompted fiscal
dominance believers to predict that it would be
impossible to achieve and maintain inflation
rates below the disastrous levels of the decade’s
start. So far, this prediction has not come to
pass. In 1983 the federal budget deficit was 3.8
percent of GNP, a level far above the postWorld W ar II average and nearly equal to the
postwar peak realized in 1975. In the same

year, inflation measured by the consumer price
index fell to 3.2 percent—a 16-year low. As the
decade proceeded, the deficit relative to GNP
rose, fell, and rose again to its present level
above 5 percent. The inflation rate was impervi
ous to these patterns.
Astute observers might question the relevance of
the early- and mid-1980s to the fiscal dominance
proposition, because deficits as they are conven
tionally measured do not necessarily reflect the
government’s long-run fiscal operations. To name
just a few o f the problems, the value o f longrun government net liabilities is inherently
ambiguous, the path of future revenues is un
certain and the appropriate method of discounting
future tax and expenditure flows is problematic.
Although sympathetic to this view, I am still left
with the strong suspicion that if any period in
recent history was ripe for the emergence of
fiscal dominance, it was the last 10 years.
Indeed, as the decade progressed and the
predictions of the fiscal-dominance theory failed
to materialize, more sophisticated variants of
the relationship between fiscal and monetary
policy began to find their way into economic
research. The fiscal authority’s reign over the
subservient monetary authority was replaced by
a more subtle and complicated institutional
structure, a world in which fiscal and monetary
authorities played a game of chicken, the out
come of which left both parties less than fully
satisfied.7 Although deficits may be detrimental
to economic performance, the ability of the
Federal Reserve to resist monetizing debt has
protected the economy from even worse conse
quences. The Federal Reserve’s decision to resist
monetizing the federal debt resulted in lower infla
tion and contributed to fiscal reforms that started
with the Gramm-Rudman-Hollings legislation.
In my view the Federal Reserve has sufficient
independence to achieve price stability. The coreproblem, however, is that the Federal Reserve is
not accountable for that objective. Without
accountability, the policy process will be neither
credible nor predictable. The more credible the
commitment to the policy goal, the few er wrong
decisions will be made by the markets. The more
predictable the policy reaction to unforeseen
economic events, the more limited will be the
market reaction to those events. Credibility and
predictability can substantially lower the costs

7See Sargent (1985).

MARCH/APRIL 1993

of achieving and maintaining a stable price level.
Yet with the disintegration of the monetary
aggregates as intermediate policy guides, discre
tionary monetary policy actions may seem espe
cially hard to predict because policy objectives and
accountability for them are unclear. The exist
ing policy process, with its focus on short-term
economic or financial developments does not
provide credibility.
How can we change the process to reinforce
the credibility o f a consistent goal? I think the
most secure way would be to give the FOMC a
legislative mandate to meet a consistent, attainable
and unchanging economic goal. Passage of
House Joint Resolution 409, introduced by Rep
resentative Stephen Neal, would provide that
crucial reinforcement. The Neal resolution simply
directs the Federal Reserve to make price stabil
ity the primary goal of monetary policy and to
achieve that goal within five years. History gives us
little basis for expecting price stability or even a
stable rate of inflation because the FOMC has
had no mandate to produce that result. Giving
the FOMC that mandate and knowing that the
FOMC intended to stabilize the inflation rate at
zero, would provide one gigantic piece of policy
information to any rational decision-maker in
any dollar-denominated market. The Federal
Reserve would remain independent, and it
would retain complete discretion about how to
carry out policy. The only change would be that
Congress would provide more direction about
the basic policy objective, and the Federal
Reserve would be accountable for achieving it.
True accountability would also require an
incentive or enforcement mechanism for achiev
ing the objective.
The FOMC can deliver lower inflation without
a legislative mandate. Of that you should have
no doubt! Inflation is a monetary phenomenon,
and the FOMC is the sole custodian of the quan
tity of money in the United States. If a zeroinflation mandate were in effect, short-term
deviations from zero inflation might occur, but
one way or another the FOMC could provide a
stable price environment. As many scholars
have urged, the FOMC might impose accounta
bility on itself by tying policy actions to some
intermediate target variable by an agreed-on
formula that would ensure price stability. These
days, the most popular candidates for an inter
mediate policy target seem to be nominal GDP
and M2, either of which is thought capable of
producing reasonable price stability. Another

FEDERAL RESERVE BANK OF ST. LOUIS

approach would be for the Committee to specify
achieving the ultimate policy goal as the rule,
while using discretion in choosing actions to
achieve the goal.
Of course having today’s FOMC impose account
ability on itself (by adopting an explicit rule
tying an instrument to a goal) is not a foolproof
way to achieve an official policy goal. Credibility
would have to be earned through predictable
actions consistent with the goal. To adopt an
explicit rule, at least a majority of today’s FOMC
members must not only agree on an overriding
macroeconomic goal, but also renounce some
discretion to pursue other goals. Moreover,
tomorrow’s FOMC could decide to change the
goal and hence the rule. In the current policy
regime, today’s policy choice can in no way
bind tomorrow's. Unless directed by society
through specific mandate, tomorrow’s FOMC
always has the discretion to change the goal.
And with shifting goals there is no accountabil
ity. I believe that the lack of accountability for a
dominant policy goal of price stability is the
major cause of the inflationary bias in the U.S.
economy since W orld W ar II.
Although the specifics of the Federal Reserve
charter differ from those of other central banks, the
problems of conflicting objectives and the lack
of secure independence and explicit accountabil
ity are common to all central banks in varying
degrees. Experience around the world and
through time repeatedly demonstrates that cen
tral banks require independence from day-today political life to perform their price-stability
role. If we could create legal and cultural condi
tions that truly fix a central bank with account
ability for anchoring the price level, the structure
of the central bank itself would become less
important. Those circumstances would be a joy
to behold, but I am afraid they will be some
time in coming.

W HY A ZERO-INFLATION
OBJECTIVE?
I strongly believe for three reasons that the
dominant objective of monetary policymakers
should be price stability. First, in the long run,
a central bank can control the price level of
goods and services denominated in its own cur
rency, but it cannot control the growth of out
put (potential or actual). Second, a credible
commitment to a price-stability objective enables
a central bank to promote economic efficiency

and growth (potential and actual). Third, pricelevel stability, popularly called zero inflation, is
superior to inflation-rate stability.
Among economists, support for the first reason
is nearly universal. There is also widespread
agreement on the second point. A central bank
that pursues price stability promotes economic
efficiency and growth. I would venture further
to say that experience shows that central banks
that have sought to enhance economic growth
directly have failed miserably at providing sta
ble price levels and ironically have undercut eco
nomic growth in the process. The last reason—that
no inflation is preferable to stable, non-zero
inflation—is most contentious, particularly when
people attempt to compare the transitional costs
of achieving price stability with the costs of
stabilizing the inflation rate at the status quo.
The argument that the cost of pursuing a zeroinflation target would outweigh the benefit of
reaching that target has two dimensions. The first
is that the benefit of achieving zero inflation
would be small. The second deals with the costs
of moving from a 4 percent trend rate of infla
tion to zero inflation. This is the transition-cost
argument, which essentially says that even if zero
is the place to be, getting there is not worth the
ride. I believe that the benefits of zero inflation
are great and that the transition costs can be
reduced if the Federal Reserve commits to an
explicit plan for achieving zero inflation.
The interaction between inflation and our cur
rent tax system, especially as it applies to
income generated by capital, represents one of
the more significant channels through which
non-zero inflation can exact economic costs.8
This channel of distortion is often not taken
seriously because people think that its effects
are minimal or that it would be easy to index
the tax system. Correcting the tax code is a
good idea of course, but until that happens,
what possible excuse is there for not letting the
monetary authorities do what is necessary to
improve social welfare?
It is clear that the horrendous U.S. inflation
ary experiences o f the 1970s and early 1980s
created the impetus for the limited inflation
indexation of the current tax system; however,
the job is far from complete. Capital gains, cor
porate depreciation and interest expenses, and
personal interest income remain untouched by
8See Altig and Carlstrom (1990).

efforts to index the tax system for inflation.
Even the bracket indexation implemented by
recent tax reform does not fully protect tax
payers from bracket creep, or nonlegislated
increases in marginal tax rates created by infla
tion. Complete indexation o f the tax code, how
ever desirable it may be, will be extremely
difficult to achieve. Will another inflationary
experience like that of the 1970s be required
to induce further progress on tax indexation?
I fail to understand why some feel that these
inflation-tax interactions are a significant drag
on the economy, yet argue that only Congress
should be concerned with the problem. The prob
lem exists because o f the interactions between
inflation and a tax system based in current dol
lars. Therefore it seems that the responsibility
for minimizing these costs lies as much with
the monetary authorities as with Congress.
Doesn’t it make more sense for monetary
authorities to try to correct the inflation part of
the problem rather than simply hoping that
Congress will implement changes that it may be
unable or unwilling to pursue? W e speak about
the costs of achieving zero inflation, but what
about the costs o f fully indexing the tax system?
Surely they would be significant.
Another area of concern is the role of uncertainty
as a source of inflation costs. How important
are the distortions that arise from price—level
uncertainty? There is a class of models—the
market-clearing, imperfect-information paradigm
associated with Robert Lucas and others—in
which inflation uncertainty harms the economy
by distorting the period-to-period relative price
signals that facilitate the efficient allocation of
scarce resources.9 Despite the pervasive intellec
tual influence exerted by the Lucas framework
to this day, the empirical evidence accumulated
since the development o f the paradigm in the
early 1970s has not been entirely supportive.
This point is not lost on critics, who think that
the lack of evidence on short-term distortions
should persuade us that inflation uncertainty is
simply not that important to social welfare.
Surely the relative-price/aggregate-price confu
sion stressed by the Lucas-type models is a spe
cial type of uncertainty. The failure to find
significant effects from uncertainty that is
resolved within a few quarters tells us next to
nothing about the type o f long-run uncertainty
with which the zero-inflation position has
always been fundamentally concerned.
9See Lucas (1972).

MARCH/APRIL 1993

Indeed, it seems likely that the uncertainty
occurring over extended time horizons is pre
cisely what is most affected by the average
inflation rate.1 This is one reason why I favor a
0
price-level target. An inflation-rate target ena
bles the price level to drift without bound, and
with no enforcement mechanism to ensure that
inflation mistakes will be corrected, the longrun variance of the price level is infinite. When
people have reason to believe that this standard
will erode over time, they invest numerous
resources to protect themselves. Those who
have nominal debt outstanding will drag their
feet in paying it back, whereas creditors will
invest in ways to accelerate the collection of
funds. The private gains to self-protection are
clear, as are the social costs.
Recent experience is the best testimony to the
real resource cost of inflation. During the
1970s, people could see that inflation acceler
ated each year. They guessed, reasonably at the
time, that financial assets had limited value in
protecting their wealth from inflation. Conse
quently, farmland, commercial and residential
property, and precious metals became much
more expensive as people sought to shelter their
wealth. Not only was time spent seeking these
investments, which was socially wasteful, but
also the resource misallocation itself resulted in
a great waste o f land, labor and capital that
society is still paying for today.

assume some frictions. These frictions, coupled
with the inability o f markets to clear, make end
ing inflation appear as costly as it does.
Isn’t it sensible to assume that the implicit sources
of frictions that make lowering the inflation rate
costly would also contribute to making inflation
costly in and of itself? For instance, a variety of
explicit and implicit nominal contracts already
exist, and a transition to zero inflation could alter
the real values of payments from those that
were originally intended. But surely the entire
institutional apparatus that generates these con
tracts must involve resource costs that are posi
tively related to the average rate of inflation.
One should not compare the costs of achieving
zero inflation in non-market-clearing models,
where such costs are high, to the benefits of
being at zero inflation in frictionless, continu
ously clearing models, where the benefits are
low. If we use a model with frictions to meas
ure the cost of getting to zero inflation, then
we should also use such a model to examine the
benefits o f being there. This is one reason I am
skeptical of so many cost/benefit estimates of
reducing inflation.

It is difficult to comprehend how efficient
planning within the public and private sectors
could not be inhibited by this type of long-run
uncertainty. Furthermore, the intuition that longrun inflation uncertainty is costly has empirical
support. In cross-country comparisons, economic
growth is negatively related to the variability of
inflation.1 One finds that the case for reducing
1
price level uncertainty is far more compelling
than a cursory analysis might indicate.

I am also skeptical about transition-cost estimates
that do not account for the possibility that a
price-stability objective will be regarded as
credible by the public. Economic theory and
reasonable model simulations persuade me to
believe that with credible precommitment, a
central bank can greatly minimize private-sector
planning errors during the transition period.
I think that much of the disagreement among
economists on the size of transition costs cen
ters on the ability of a central bank to commit
itself credibly to achieving its objective. Until
I see some hard evidence to dissuade me, I plan
to continue my advocacy o f price stability as the
overriding objective of central banks.

In evaluating the costs of attaining zero infla
tion, economists almost always use models in
which markets do not clear or do not clear
without cost. Gone is the market-clearing,
flexible-price, rational-expectations model. In its
place is a model with price contracts that make
the transition to zero inflation extremely costly.
The source of the friction is usually not entirely
explicit, but the implication is that we must

It still puzzles me that volumes of research have
been published on central bank operating proce
dures and management of monetary aggregates,
yet relatively little research lias been published
on the value of a credible precommitment to a
price-stability objective. My intuition tells me
that the latter is far more important than the
former in terms of economic welfare. Of course,
credibility depends on policy information avail-

10See Ball and Cecchetti (1990).
"S e e Grier and Tullock (1989) and Lebow, Roberts and
Stockton (1990).

FEDERAL RESERVE BANK OF ST. LOUIS

able to market participants so that they can
monitor progress toward the objective.
One major benefit of imposing an explicit inten
tion on monetary policy is that policy actions in the
money market would become far less momentous
than they are now. Currently, detecting a change
in the federal funds rate target from the pat
tern of open market operations is crucial because
it provides markets with one of the few clues as
to what monetary policy the Federal Reserve is
pursuing. Canvassing the positions of individual
FOMC members is a way of predicting future
policy. If policy intent were explicit and credi
ble, however, finding the clues in open market
operations would have less significance.
I see the greatest payoff in more information
about policy intentions. An explicit FOMC com
mitment to price stability would allow markets
to shift resources from watching the Federal
Reserve to watching the economy for produc
tive investment opportunities . Focusing on the
intent of policy contrasts markedly with conven
tional concerns for more certainty about the
current degree of reserve restraint. There are
many ways to reduce uncertainty about the
immediate funds-rate implications of policy, just
as there are many time schedules by which the
FOMC directive might be released. More certainty
about the immediate policy implications of the
federal funds rate might make Fed-watching a
bit easier, but it would not do much to help
identify policy intentions beyond short horizons.
Releasing Fed directives early might provide a
slightly brighter glimmer o f policy intentions,
but only for a slightly longer policy horizon.
We do not need better information about the
latest directive; we need better information
about the process through which all future
directives will be crafted—that is, policy inten
tions. Nothing would provide more insight than
a clearly stated goal

MONETARY POLICY AND
MONETARY PROTECTIONISM
Let me turn now to the effects of interna
tional policy coordination on the pursuit of zero
inflation.1 Exchange-rate regimes and attempts
2
at monetary union are currently undermining
the price-stability objective. Many actions taken

by central banks are not aimed at price stability,
but rather are attempts to establish monetary
protectionism. By monetary protectionism, I refer
to attempts to alter real exchange rates through
manipulation of monetary policies and with the
hope of ultimately promoting a balance-ofpayments objective. In the case o f a deficit
country, monetary protectionists call for an
expansion o f money growth (or lower nominal
interest rates). A monetary expansion, other
things being equal, will produce a nominal
depreciation. If individuals are unable to adjust
prices immediately, or if they are slow in per
ceiving the inflationary aspects of this policy, a
real depreciation will accompany the nominal
depreciation. As most economists realize, how
ever, the inflation rate will eventually respond
to the monetary expansion, offsetting the nominal
depreciation and returning the real exchange
rate to its initial position. Nevertheless, the tenuous,
short-lived relationship between money and the
real exchange rate is seductive enough to con
vince politicians and other fine-tuners that
monetary policy can serve mercantilist designs.
My focus on this issue stems from a firm belief
that central banks can do no better than guar
antee long-run price stability and that any efforts
to limit this guarantee are not likely to raise
world welfare. Central banks can juggle a real
exchange rate and inflation target no better
than they can slide back and forth along a stable
Phillips curve. A central bank that attempts to
maintain price stability and a nominal exchange
rate target has more policy targets than policy
instruments. At times, these two objectives might
be compatible. For example, in the late 1970s,
limiting rapid dollar depreciation through inter
vention could have been compatible with a conractionary monetary policy to eliminate inflation.
As often as not, however, these two policy
objectives will be incompatible, and the central
bank must trade one objective for the other.
Under such conditions, markets will view nei
ther price stability nor exchange-rate stability as
a credible policy. The knowledge that central
banks will deviate from a policy of price stabil
ity to pursue an exchange rate objective will
raise uncertainty about real returns and will
distort the allocation of resources across sectors
and through time. The resources devoted to
protecting wealth from possible inflation could

,2This section summarizes ideas presented in Hoskings and
Humpage (1990).

MARCH/APRIL 1993

be applied to more productive uses under a pol
icy of price stability. Moreover, attempts to
maintain nominal exchange rates will not eliminate
exchange rate uncertainty because countries
will inevitably resort to periodic exchange-rate
realignments. Hedging exchange risk will remain
an important aspect of international commerce.
Although monetary protectionism seems most
prevalent under the present system of floating
exchange rates, it does not follow that floating
exchange rates promote its use. Monetary pro
tectionism can result any time a government
accepts nonmarket criteria for exchange rates.
In principle, a gold standard or a fixed exchange
rate regime can limit the scope of monetary
protectionism because, if all countries play by
the rules of the game, they link money supplies
closely to the flow of international reserves.
In practice, however, such regimes do not
destroy the political motives for monetary pro
tectionism, and examples o f monetary protec
tionism under fixed exchange rates abound.
By allowing some discretion in the choice of
exchange rate adjustments, fixed exchange rate
regimes often produce a mechanism that weakens
the allocative efficiency of exchange markets
and promotes mercantilist objectives.
In contrast to the interventionist literature,
which presupposes an all-wise government act
ing in the public's best interest, a rich, growing
literature on political economy characterizes
elected officials as seeking to enhance their own
power, prestige and wealth by maximizing their
ability to gain votes. Politicians and bureaucrats
attempt to extend the scope of their influence
by responding to the demands of the most polit
ically active constituencies.1 A political justifica
3
tion for exchange rate manipulation is that it defers
criticism and postpones more fundamental actions.
For instance, in 1985 dollar exchange rates
were at their zenith, the U.S. current account
was deteriorating rapidly and evidence sug
gested that the United States was becoming a
debtor country for the first time since World
War I. U.S. manufacturers, facing increasingly
stiff competition worldwide, besieged Congress
for trade legislation. Most important, analysts
increasingly linked the deterioration in the exter
nal accounts with the fiscal policies o f the Reagan
13See Quibria (1989).
14The Group of Seven countries are Canada, France, Italy,
Japan, the United Kingdom, the United States, and West
Germany.

FEDERAL RESERVE BANK OF ST. LOUIS

Administration and Congress. The opportunity
cost of government inaction, measured in terms
of votes lost, seemed to rise sharply in the
early 1980s.
The U.S. current account deficit reflected
imbalances between savings and investment in
the United States, West Germany and Japan.
Politicians, however, cannot easily redress such
structural relationships through fiscal policies
because of strong vested interests in maintaining
various tax and expenditure patterns. Unable to
address these structural problems directly and
quickly, policymakers might resort to exchangemarket intervention. When coordinated through
the Group of Seven, such intervention offers a
highly visible signal that governments are respond
ing to the desires of their constituencies.1
4
Exchange rate policies can also offer temporary
benefits to specific constituencies. When goods
prices are slow to adjust, a nominal currency
depreciation is equivalent to a temporary,
across-the-board tax on imports and a subsidy
to exports. With the terms o f trade temporarily
altered, certain groups in the traded-goods sectors
can realize benefits from monetary protectionism
similar to those afforded by more traditional
forms of protectionism. Ultimately, any benefits
from monetary protectionism dissipate with a
high inflation rate and with reduced credibility
of monetary policy. The inflation costs of mone
tary protectionism, however, are dispersed across
a wider spectrum of individuals and over a
longer time horizon than the benefits. A constit
uency that receives net benefits from monetary
protectionism (export- and import-competing
firms) can exist. Such a constituency is likely to
be more politically cohesive than any constit
uency for price stability. Consequently, a policy
that seems myopic from an economic perspec
tive can be politically attractive.
Another seemingly attractive aspect of mone
tary protectionism is that Congress and the
administration can justify it in terms o f broader
macroeconomic considerations, such as exchange
rate misalignment or current account imbalance,
instead of industry—specific considerations,
such as automobile and steel employment.
Consequently, the rent-seeking aspects o f mone
tary protectionism are less obvious than those
of standard protectionist policies.

Countries interested in establishing exchange
rate targets have a strong incentive to collude
in their efforts with foreign governments.1 In
5
the case where countries attempt to alter nomi
nal exchange rates, such collusion provides tacit
foreign approval of these policies and limits the
chances that a foreign government will take
steps to neutralize the exchange policies of
another government. Sometimes such collusion
involves having cartel members delay policy
negotiations, or exchange rate adjustments,
when individual cartel members face critical
elections. Bretton Woods and the European
Monetary System (EMS) are examples of collu
sion that were fairly successful for a period.
The competitive currency devaluations of the
1930s show what can happen when govern
ments attempt to fix a price but their cartel
breaks down. Coordinated efforts to fix exchange
rates can allow individual countries to influence
the policies of others and to defer some of the
adjustment burdens o f maintaining the peg.
Such mechanisms are found in the EMS and
figure in some proposals for target zones and
for fixed exchange rates. Many support the pro
posal for a European Central Bank for just this
reason. The alternative is to sacrifice monetary
sovereignty to maintain a fixed exchange rate
and to follow the monetary policy of a major
trading partner.
Under floating exchange rates, a rapid
depreciation in the nominal exchange rate in
response to such inflationary policies signals the
market's displeasure and constrains governments.
Through collusion to fix the exchange rate,
however, governments can temporarily blunt
the exchange rate reaction to their policies and
reduce the political costs of pursuing inflation
ary policies. Coordination to limit exchange rate
fluctuations is politically attractive because it
eliminates an important, immediate barometer
of the market’s opinion of government policies.
For their part, central banks often are willing
participants, viewing exchange rate management
as a legitimate aim o f monetary policy. Exchange
rate movements can impart useful information for
policymaking, and as already noted, exchange rate
targets can sometimes be consistent with a
monetary policy of price stability. As often as
not, however, exchange rate policies conflict
with price stability. For example, U.S. purchases
of foreign currencies in 1990 seemed inconsis
15See Vaubel (1986).

tent with a goal of price stability. When these
objectives conflict, the Federal Reserve System is
torn between its independence and its accounta
bility to the broad national policy goals set by
Congress and the Administration. The Federal
Reserve does not wish to appear to the public
as unresponsive to the objectives of Congress
and the administration. Participation also enables
a central bank to influence policy formulations
that it is powerless to prevent. Such reasoning
is a certain sign of a central bank unsure of its
objective and insecure about its independence.
In countries with independent central banks,
intervention policies might enable fiscal agents
to extend their influence beyond the foreign
exchange market to domestic monetary policy.
Elected officials often seek more stimulative
monetary policies than do central banks, hoping
to lower nominal interest rates and to stimulate
real growth and employment. In choosing a
nominal exchange-rate target, intervening and
encouraging the central bank not to sterilize the
intervention, fiscal agents have a mechanism for
such influence that would usually not be open.
At times, however, such as when the central
bank policy committee is not in unanimous
agreement, such an influence, marginal though
it may be, could prove decisive in charting
future monetary policy actions.

INTEGRATED MARKETS AND
POLICY CONSTRAINTS
I have attempted to instill a healthy skepticism
for exchange market manipulation, arguing that
it is a form o f monetary protectionism that harms
economic welfare. Monetary protectionism stems
as a near-term palliative from the political inter
actions between policymakers and constituen
cies with vested interests in particular market
outcomes. Any international monetary order
willing to accept nonmarket criteria for exchange
rates and failing to bind governments with a
price-stability objective is ripe for monetary pro
tectionism. To counter the political incentives
toward monetary protectionism, nations should
adopt monetary mandates, such as the Neal
Resolution in the United States, that focus
monetary policy on achieving and maintaining
long-term price stability.1 This would do more
6
to eliminate exchange market uncertainty and
foster the efficient worldwide use of real
,6See Hoskins (1990).

MARCH/APRIL 1993

resources than any program to manipulate
nominal exchange rates.
My comments are not meant as a blanket con
demnation o f international policy cooperation.
I strongly support cooperation that makes price
stability the dominant objective and recognizes
market-determined exchange rates. Only cooper
ation based on these conditions seems both
feasible and credible because it recognizes that
nations want monetary sovereignty and will
pursue different economic policy objectives.
Contrary to what some might infer, this approach
does not preclude European monetary unification
in the future, but it suggests a different approach
than currently seems to be favored. European
governments are not likely to relinquish national
monetary sovereignty on adoption of a single
market. Consequently, greater exchange rate
flexibility than the EMS currently provides
seems necessary to ensure that exchange rates
do not interfere with the efficient flow of
goods, labor and capital following the removal
of restrictions. The free flow o f resources, if it
occurs, will foster a convergence of policy
preferences within Europe as governments com
pete for these resources by providing stable
economic and political environments. Govern
ments that fail to provide such an environment
will lose resources as markets vote on policies.
The resulting convergence of monetary and fis
cal policies will lead to greater exchange rate
stability. If in time, governmental competition
for resources attains a convergence of macroeconomic policy, issues of national policy sover
eignty will be muted. Only then will monetary
union augment the efficiency gains of a single
market. As seems obvious from recent develop
ments in Europe, efforts to rush monetary
union are efforts that put the cart before the
horse and may well interfere with the progress
toward a single market.
To fix exchange rates before a convergence of
policy preferences within the European Economic
Community seems to ensure that interest rates
and prices will bear more of the adjustment
burden. Moreover, judging from the experience
of Bretton Woods, fixed exchange rates would seem
to guarantee speculators periodic exchange rate
adjustments and to encourage governments to
impede the flow of goods and capital through
the reintroduction o f restraints. The dynamics
of achieving monetary union are as important

FEDERAL RESERVE BANK OF ST. LOUIS

as the goal, and price stability is a more impor
tant goal than either.
Scores of new nations are busy constructing
central banks to implement monetary policy.
Using history as a guide, these new central
banks will try to pursue objectives other than
price stability, especially since they are being coun
seled by central bankers with weak records on
price stability. Short-term political agendas will
likely dominate their policy actions and push
them away from the pursuit of price stability.
Yet it seems that there are powerful market
forces that will crimp the efforts of central
banks to mismanage their currencies.
The integration of world markets, particularly
financial markets, is limiting the degree to which
policymakers are willing to drift away from
price stability, at least for the major economies.
Twenty years ago the Federal Reserve paid
scant attention to the effect of foreign markets
on the price of U.S. government securities and
interest rates in the United States. Yet when
I participated in FOMC deliberations, we almost
always discussed the effect o f a policy action on
long-term Treasury rates, currency values or
the shape of the yield curve. The FOMC now
looks at how world financial markets assess the
credibility of its policy actions with respect to
inflation expectations. This process, in effect,
limits the degree to which the FOMC is willing
to risk inflationary policy actions.
In Europe, smaller countries often peg their
currencies to the German mark, allowing the
Bundesbank to determine their monetary pol
icies. The German central bank is also limited
by world markets in terms of the inflation path
it chooses to pursue. I am not so bold as to
argue that markets will cause central banks to
wither away to agencies that simply pump out
monetary growth rates that provide price stability.
It does seem to me, however, that market forces
are strengthening the hand of central banks in
fighting political pressures for short-term "quick
fixes” to economic problems. Perhaps even poli
ticians will learn the limits of governments in
solving economic problems.
If this view proves incorrect, central banks
will face the prospect o f market participants
developing private money to a much greater
degree than exists today. When government
management o f particular institutions results in
failure, private-sector alternatives appear—
witness the privatization trend in U.S. schools

and courts. Perhaps those who yearn to revisit
the Scottish system of free banking may live to
see a version of it replace central banking. If so,
we are likely to pay a heavy price along the way.

REFERENCES
Alessina, Alberto. “ Macroeconomics and Politics,” Macro
economics Annual (The MIT Press, 1988), pp. 38-43 and
table 9.
Altig, David, and Charles T. Carlstrom. “ Inflation and the
Personal Tax Code: Assessing Indexation,” Federal Reserve
Bank of Cleveland, Working Paper 9006 (July 1990).
Ball, Laurence, and Stephen G. Cecchetti. “ Inflation and
Uncertainty at Short and Long Horizons,” Brookings
Papers on Economic Activity, vol. 1, (1990), pp. 215-54.
Banaian, King, Leroy O. Laney, and Thomas D. Willett.
“ Central Bank Independence: An International Comparison,”
Federal Reserve Bank of Dallas, Economic Review (March
1983), pp. 6-8.

Hoskins, W. Lee. “ The Case for Price Stability,” Economic
Commentary, Federal Reserve Bank of Cleveland (March
1990).
_______ , and Owen F. Hum page. “ Avoiding M onetary
Protectionism: The Role of Policy Coordination,” Cato
Journal (Fall 1990), pp. 541-55.
Lebow, David E., John M. Roberts, and David J. Stockton.
“ Economic Performance under Price Stability,” unpub
lished manuscript, Board of Governors (December 1990).
Lucas, Robert E. Jr. “ Expectations and the Neutrality of Money,”
Journal of Economic Theory (April 1972), pp. 103-24.
NABE Policy Survey. Economists Expect Further Monetary
Easing; Do Not Favor FOMC Restructuring; Oppose Govern
ment Action to Curb Stock Market Volatility (National
Association of Business Economists, 1990).
Quibria, M.G. “ Neoclassical Political Economy: An Application
to Trade Policies,” Journal of Economic Surveys (1989),
pp. 107-36.

Friedman, Milton, and Anna J. Schwartz. “ Has Government
Any Role in Money?” Journal of Monetary Economics
(January 1986), pp. 37-62.

Sargent, Thomas J. “ ‘Reaganomics’ and Credibility,” in Albert
Ando and others, eds., Monetary Policy in Our Times:
Proceedings of the First International Conference Held by
the Institute for Monetary and Economic Studies of the
Bank of Japan (MIT Press, 1985), pp. 235-52.

Goodhart, Charles. The Evolution of Central Banks (MIT Press,
1988).

Vaubel, Roland. “ A Public Choice Approach to International
Organization,” Public Choice, vol. 51(1), (1986), pp. 39-57.

Grier, Kevin B., and Gordon Tullock. “ An Empirical Analysis
of Cross-National Economic Growth, 1951-80,” Journal of
Monetary Economics (September 1989), pp. 259-76.

White, Lawrence H. Free Banking in Britain: Theory, Experi
ence, and Debate, 1800-1845 (Cambridge University
Press, 1984).

MARCH/APRIL 1993

G eorg Rich
Georg Rich is a director and the deputy head of Department I
at the Swiss National Bank.

Commentary

FEE HOSKINS HAS WRITTEN a line paper
on monetary policy. I share most of his views
on the role and duties of central banks. Hoskins
discusses why the conduct of monetary policy
has been entrusted to central banks. He also
examines the conditions that must be satisfied for
c e n tra l b an k s to

p la y an e ffe c t iv e

p o lic y

ro le.

Hoskins’ principal thesis is that central banks are
needed to manage a standard based on fiat money.
But a fiat standard imposes few constraints on
central banks. If central banks are permitted to
issue fiat money, there is always the risk that
they will abuse their powers. Consequently,
under a fiat standard it is necessary to ensure
that central banks act in the public interest.
Why do central banks frequently harm the pub
lic interest by debasing the currency? Hoskins
discusses several possible reasons. He dismisses
the answers offered by public-choice economists
and also rejects the notion that unsatisfactory
performance of central banks is due to the pursuit
of inappropriate targets or operating proce
dures. Instead, he maintains that "central bank
ers are suffering from a Keynesian hangover.”
Frequently they do not direct monetary policy
solely at price stability but attempt to pursue

FEDERAL RESERVE BANK OF ST. LOUIS

multiple objectives that often conflict. Many
central bankers attempt to achieve at least two
goals—to keep prices stable and to smooth cycli
cal fluctuations in output and employment. Too
often, Hoskins maintains, central bankers also
try to manipulate the exchange rate with a view
to strengthening the competitive position of
domestic industry. Of course they do not pur
sue multiple objectives because of a character
defect. They merely reflect prevailing opinions
held by politicians, bankers, economists and
other members of the general public.
In Hoskins' view, the performance of central
banks could be much improved if they were
granted independence from governments and
given a single objective—price stability. The cen
tral banks—though independent—would not be
allowed to choose policy objectives but would
be given a clear legislative mandate to achieve
and maintain price stability. Moreover, they
would be accountable to the public for their
policy actions.
I am largely sympathetic to Hoskins' sugges
tions. An independent central bank with a clear
mandate to pursue price stability is likely to
perform better than an institution attempting to

respond to diverse and conflicting political pres
sures. I also agree with Hoskins that the social
value of a credible price-stability objective is
often underestimated, whereas the costs of
eradicating inflation are overstated.
Thus I support Hoskins’ call for committing
central banks to a price-stability objective. In
my view, however, the story does not end here.
A clear price-stability mandate by itself is not
enough to improve the performance of central
banks. Even if we agree that the objective of
monetary policy should be price stability, we still
have to address a second question: How should
central banks achieve and maintain a stable
price level?
Hoskins plays down the problems of designing
operational policy rules consistent with the
price-stability mandate. Yet as practitioners of
monetary policy know, the translation o f such a
mandate into specific policy rules is far from
trivial. Switzerland offers a good case in point.
I argue that the Swiss National Bank (SNB) pos
sesses a clear mandate to achieve and maintain
price stability even though Swiss law does not
precisely define the objectives of monetary pol
icy. This mandate, albeit informal, rests on a
remarkable consensus among the Swiss public
about the objectives of monetary policy.
The SNB’s informal mandate explains why the
inflation rate in Switzerland has tended to be
low by international standards. Since the begin
ning of 1975—when Switzerland shifted to
money stock targeting—inflation in Switzerland
has averaged 3.5%. This average, however, still
far exceeds the SNB’s stated inflation target of 0
percent to 1 percent. Consequently, the SNB has
failed to achieve price stability despite the informal
mandate. The SNB’s failure to meet its stated
target results largely from two short episodes of
accelerating inflation. From 1979 to 1981 and
from 1989 to 1991, Swiss inflation temporarily
rose to more than 7 percent and 6 percent,
respectively.

NEED FOR OPERATIONAL RULES
The SNB's failure to achieve price stability did
not reflect a Keynesian hangover. Rather, the
SNB encountered various problems when it
attempted to translate its price-stability mandate
into suitable operational policy rules. The need
for operational rules arises because monetary
policy affects the inflation rate witli a long and

frequently variable lag. In Switzerland the time
lag may be as much as three years. Therefore mone
tary policy decisions do not affect the inflation rate
until long after they are implemented. Because
of the lag, such decisions invariably entail a
great deal of uncertainty. Central banks may
err even if they try to adhere closely to their
mandate. Once they recognize their mistakes, it
is usually too late to take corrective action.
To lower the danger of policy blunders, cen
tral banks require reliable early warning signals
or leading indicators of inflation. Operational
rules centered on these leading indicators give
central banks a good chance of accomplishing a
goal of achieving and maintaining price stability.
Do central banks possess reliable leading indica
tors of inflation? This question cannot be answered
straightforwardly. Monetarists tend to empha
size the close relationship between money
growth and the inflation rate. They maintain
that the money stock serves as a good leading
indicator o f price movements. Therefore central
banks are likely to meet the price-stability objec
tive if they adopt an operational rule providing
for steady growth in the money supply.
Most central banks today share the monetarist
view that inflation is due largely to excessive
money growth. Nonetheless, they hesitate to opt
for strategies of steady money growth. The SNB
is no exception. In Switzerland the growth in
both the monetary base and the money stock
M l tend to lead inflation. Therefore the SNB
focuses attention on these two aggregates and
sets an intermediate target for the Swiss mone
tary base. It strives to increase the monetary
base at a rate of 1 percent per year. The SNB
views this target as consistent with price stabil
ity in the medium and long runs.
Although the SNB follows a money-growth rule,
it need not augment the monetary base by 1
percent year after year. Depending on the cir
cumstances, it may temporarily undershoot or
overshoot the 1 percent target. For this reason,
the SNB frames its money-growth rule in terms of
a medium-range target, to be met on the average
of a five-year period. Temporary deviations
from the 1 percent growth path may be
required if serious unexpected shocks hit the Swiss
economy. Two kinds of shocks may prompt the SNB
to deviate: unexpected shifts in money demand
and other unexpected shocks such as excessive
movements in the exchange rate.

MARCH/APRIL 1993

SHIFTS IN MONEY DEMAND
A strategy of steady money growth is effective
only if money demand is stable. In contrast to
many other countries, Switzerland has been
blessed with reasonably stable money-demand pat
terns. But this does not imply that instabilities
have not occurred. Serious instabilities arose in
the late 1980s as a result of two financial inno
vations. A new electronic interbank payments sys
tem and a major overhaul of liquidity requirements,
or minimum reserve requirements, imposed on
banks caused a huge permanent drop in the
demand for base money. Much of that decline
occurred in the first half of 1988, but stability
was not restored until about 1990 or 1991.

With hindsight, various students of Swiss
monetary policy attribute the most recent surge
in the Swiss inflation rate to the SNB's cautious
reaction to the demand shift. The SNB, they
assert, should have acted more aggressively.
The SNB's cautious response no doubt was
equivalent to a temporary easing of monetary
policy. Nonetheless, it cannot be regarded as the
main cause of the rise in inflation. I am not
aware of any economic theory able to explain
how six months of easy money, which the mar
ket correctly regarded as transitory, could have
generated three years of high inflation. For this
reason, I still maintain that central banks should
react cautiously to shifts in money demand.

OTHER UNEXPECTED SHOCKS
It is clear that central banks must adjust the
money supply to permanent demand shifts or
long-lasting temporary demand shifts if they are
to keep the price level stable. It is not always
advisable to react quickly to demand shifts,
however. Money demand is subject to frequent
transitory movements that do not call for a
central-bank response. Moreover, demand shifts
are hard to detect. They often become fully
apparent only after considerable time has elapsed.
For these reasons, Meltzer (1987) and McCallum
(1989, Ch. 16) recommend a slow reaction pattern.
They propose mechanical rules that would prompt
central banks to adjust the money supply gradu
ally to demand shifts. I support Meltzer and
McCallum’s call for a gradual response, but I
doubt that central banks should be committed
to a mechanical reaction pattern. The speed of
the response is likely to depend on the nature
of these shifts. For example, if central banks
know in advance that a major shift will occur,
they should adjust the money supply quickly.

Confronted with the demand shift of the late
1980s, the SNB opted for caution. SNB officials
knew that a shift would occur but did not
know how big the shift would be or how fast
base-money demand would fall. As a result of
the SNB’s cautious response, short-term domes
tic interest rates fell sharply at the beginning of 1988
but rose again as the SNB gradually lowered the
supply of base money. By summer 1988, short
term domestic interest rates returned to their
pre-shift levels. Long-term rates, however, did
not budge. Thus market participants correctly
regarded the fall in short-term interest rates as
transitory.

FEDERAL RESERVE BANK OF ST. LOUIS

Similar problems arise from other unexpected
shocks that may impinge on the central banks’
anti-inflationary monetary policies. In small
countries like Switzerland, central banks are
frequently compelled to take the real exchange
rate into account when setting monetary policy.
Real exchange rate movements often fail to
reflect economic fundamentals. As I pointed out
before, Swiss inflation picked up temporarily in
the early 1980s and early 1990s. Although the
SNB attempted to keep the monetary base on a
growth path consistent with medium-run price
stability, the Swiss franc weakened sharply in
real terms during both periods of high inflation;
that is, the depreciation was much larger than
would have been expected on the basis of infla
tion differentials between Switzerland and other
countries. Therefore the exchange-rate deprecia
tion reinforced the inflationary pressures in
Switzerland. The SNB reacted to this situation
by tightening monetary policy. As a result, the
monetary base fell below the medium-run
growth path. The tightening of the monetary
reins eventually caused the Swiss franc to
appreciate again. In this way, the SNB counter
acted the inflationary pressures emanating from
the exchange rate.
Lee Hoskins takes a dim view o f central-bank
attempts to manipulate the exchange rate. How
ever, he considers only central-bank efforts to
stimulate domestic employment by means of an
exchange-rate depreciation. Such policies, I agree,
may be inconsistent with the mandate to achieve
and maintain price stability. But we should not
overlook the situations in which exchange-rate
movements undermine central banks' antiinflationary policy stances.

Nevertheless, Hoskins’ objections to exchangerate policy are often valid. Exchange-rate policy
may or may not be consistent with price stability.
Swiss experience offers examples of both types
of exchange-rate policy. The SNB did more than
try to counteract excessive real depreciations of
the Swiss franc. In 1978 and 1987 it reacted to
an excessive real appreciation by relaxing mone
tary policy.
Although the real appreciation supported the
fight against inflation, the SNB tried to halt or
even reverse the upward movement in the
exchange rate. The SNB thought that its efforts
to curb the appreciation of the Swiss franc
were consistent with its mandate to stabilize the
price level. In 1978 and 1987 inflation was low
and declining. In principle it followed an opera
tional strategy of gradually lowering the infla
tion rate. In its view a gradual approach would
minimize the real costs of achieving and main
taining price stability. Considering its preference
for gradualism, the SNB did not welcome the
real appreciation of the Swiss franc because it
affected the domestic economy in the same way
an unnecessary tightening of monetary policy
would. Therefore the SNB allowed money
growth to rise temporarily above the level con
sistent with medium-run price stability.
Unfortunately, the SNB’s strategy of adjusting
money growth to the real appreciation of the
Swiss franc turned out to conflict with the
price-stability objective. In both periods inflation
rose again in due course. The two short episodes
of rising inflation are largely explained by the
SNB’s efforts to counteract an excessive real
appreciation of the Swiss franc.
Thus Swiss experience lends at least partial
support to Hoskins’ objections to exchange-rate
policy. However, strict compliance with a pricestability mandate need not imply that central
banks should abstain totally from manipulating
the exchange rate. Even if the SNB tried to rule
out any risks of erring on the side of inflation,
it could not afford to ignore real exchange rate
movements entirely. Instead it had to react
asymmetrically. With an excessive real apprecia
tion of the Swiss franc, the SNB would keep the
monetary base on the medium-run growth path.

Faced with an excessive real depreciation, on
the other hand, it would push the monetary
base below that path. The resulting policy might
be closer to shock therapy than to gradualism.
The real costs of the shock therapy would con
stitute the price the SNB would have to pay for
playing it safe.
In practice, I doubt that central banks are able
to disregard entirely the real costs of eliminating
inflation. The SNB has repeatedly emphasized
that it cannot stabilize the price level without
accepting a temporary increase in unemployment.
But the Swiss public also expects the SNB to
keep the real costs of its anti-inflationary mone
tary policy as low as possible. Therefore the
SNB, in principle, must follow a gradualist
approach. We could probably improve our per
formance if in the future we display greater
reluctance to react to excessive real apprecia
tions of the Swiss franc than we have in the past.

CONCLUSIONS
Let me conclude by emphasizing again that
I agree with the thrust of Hoskins’ reasoning.
Monetary policy should be entrusted to indepen
dent central banks with a clear legislative man
date to achieve and maintain price stability. But
in my view, independence and a clear mandate
are not sufficient to guarantee a good monetary
policy performance. It is also important that
central banks adopt operational policy rules
consistent with their mandate. Although central
banks should be free to choose appropriate
operational rules, they should be committed to
spell out explicitly how they intend to fulfill
their mandates. In particular, they should state
how they intend to respond to shifts in money
demand and other unexpected disturbances.

REFERENCES
McCallum, Bennett T. Monetary Economics (Macmillan,
1989).
Meltzer, Allan H. “ Limits of Short-Run Stabilization Policy:
Presidential Address to the Western Economic Association,
July 3, 1986,” Economic Inquiry (January 1987), pp. 1-14.

MARCH/APRIL 1993

Harold Dem setz
Harold Demsetz is the Arthur Andersen chair in business
economics at the University of California-Los Angeles.

Financial Regulation and the
Competitiveness o f the Large
U.S. Corporation

CENTRAL QUESTION OF THE DAY is
whether U.S. business firms are capable of suc
cess in highly competitive world markets. The
question is embedded in hotly debated calls for
the United States to develop an explicit indus
trial policy, in frequently expressed concerns
about our loss of market leadership in the
computer chip, television and automobile industries,
and in charges of excessive executive compensa
tion. It is important to consider the efficiency of
the large corporation when answering this question,
and what I discuss here is a connection between
corporate efficiency and the regulation of
capital market institutions.
The legal setting of a large U.S. corporation is
usually thought of in terms of regulations that
bear directly on the activities of business firms.
These include business tax policy, environmental
protection legislation, worker safety and health
regulation, and antitrust. Because legal settings
for business vary from nation to nation, regula
tions undoubtedly affect relative efficiencies of
business firms differently in different parts of
the world. Business regulation of this type has
been discussed explicitly on many occasions, so
I set it aside here. Instead, I give attention to
the neglected connection between corporate

efficiency and the regulation of capital market
institutions. My purpose is to show how the
regulation of banks, insurance companies and
mutual funds impinges on shareholder control
of top management in U.S. corporations.
Because most persons at this conference do
not work in corporate economics, it is useful to
begin by considering the potential control
problem created by the diffuse ownership struc
ture on which the modern large corporation
rests—separation of ownership and control. This
well-known agency problem has been around
for some time. Even Adam Smith voiced con
cern in The Wealth o f Nations, precisely because
he believed that those who manage the funds of
others cannot be expected to do as good a job
as if their own funds w ere at stake. Along with
many contemporary economists, the works of
Veblen (1921), Berle and Means (1932), and Galbraith
(1967) build heavily on this corporate control
problem. Their works assert that owners of
shares each have an ownership stake in the cor
poration that is too small to motivate efforts to
control management and that is too small to
convey disciplinary weight even if such efforts
were made.

MARCH/APRIL 1993

Dissatisfied shareholders can do little better than
sell their shares. If such sales are large, the price
per share will fall and adversely affect the terms
on which management can raise new capital
from the capital markets. This price effect
penalizes errant management, but it does so
only indirectly and only to the extent that the
corporation finds it necessary to raise new capital.
The alleged weakening of the link between
ownership and control makes the proposition
correlating private ownership and efficient
resource allocation more problematic in the
minds of some students of the corporation.
Uncontrolled professional management is likely
to see its interest served, at least partly, by high
management compensation, large firm size,
altruism toward friends and community, leisure
and other forms of on-the-job consumption and
by indulging in these to an extent that seems
inimical to shareholder interests.
The thesis appears to be much like that which
popularly explains the failings of socialism. If all
citizens are in principle owners of state property
then no person qua citizen can exercise control
over this property. Ownership is simply too
diffuse to be effective. Managing this property
then becomes the task of state bureaucracies.
State employees, however, have interests that
do not coincide with those of the population at
large, and the pursuit of these interests is not
guided by market incentives. A separation between
ownership and control arises and undermines
the credibility of socialism. The separation thesis
as applied to the large corporation substitutes
professional management for state bureaucracies.1
Studies of corporate takeovers, mainly corporate
takeovers undertaken in the United States during
the 1980s, provide evidence of some instances
of separation between ownership and control.
These show that shareholders of target companies
benefit considerably from a takeover of their
firm. Successful takeovers increase share prices
of target firms by an average of about 30 percent.2
Increases in share price may derive in part from
several aspects of takeovers. The dominant view
'Socialized property and jointly owned corporate property
are, however, far from equivalent. Socialized ownership is
coerced into being, whereas corporate ownership is devised
voluntarily. Given the facts of economic development and
per capita wealth in East and West, we can surmise only
that if there is separation between ownership and control
in the large private corporation, it is less severe by several
orders of magnitude than it is in the socialist state.
2See Jarrell, Brickley and Netter (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

is that most of target shareholder gains derive
from the removal of inept management, whose
presence is consistent with the separation thesis.3
It should be noted, however, that only a small
fraction of corporate assets has become the target
of takeover attempts. This can be interpreted as
statistical support for a proposition contrary to
the separation thesis—that most modern corpo
rations are not afflicted by significant separation
between ownership and control.
The indictment of the modern corporation
implicit in the separation thesis creates its own
puzzle. Because the corporation, including its
ownership structure, arises from contractual
agreements voluntarily entered into, the separa
tion thesis implies that serious, systematic and
persistent errors are made by owners of the
corporation in relying on ownership structures
that are too diffuse. Owners fail to anticipate
that they are abandoning control over their
assets. This is inconsistent with the belief held
by most economists that all parties to an agree
ment reached voluntarily expect to benefit from
the agreement and that if the agreement is used
repeatedly and extensively, this expectation is
usually correct.
However, the empirical supposition of the sepa
ration thesis, the "fact” to which all adherents
to the thesis have subscribed, is not at all fact.
It is simply not the case that the ownership
structure of the typical large corporation is so
diffuse that it undermines the incentive and
power of shareholders to influence manage
ment. That thousands of shareholders jointly
own the typical large corporation is true, but
recent studies show that not every owner of
corporate stock owns an insignificant number
of shares. A few of the thousands o f share
holders usually own a relatively large fraction
of the firm's equity.4 In fact, the typical large
corporation has a more concentrated ownership
structure than serves the separation thesis well.
For Fortune-500-sized U.S. corporations, the
aggregate fraction of equity owned by the five
largest shareholders is about one-fourth, and in
Japan and several important European countries
3Evidence to date seems to indicate that target company
gains do not derive from wealth transferred from bond
holders [Jarrell, Brickley and Netter (1988)] or from most
lower level employees. Although management personnel
are released in disproportionately large numbers from target
companies when a takeover occurs, the mass of laborers
are not.
4Demsetz and Lehn (1985) and Shleifer and Vishny (1986).

this fraction is much larger. The typical case
then is one in which a relatively small number
of shareholders have well focused interests and
nontrivial blocks of votes. Facing such concen
trated share holdings, professional management
cannot be as unguided by shareholder interests
as the separation thesis supposes, although
there surely are some cases in which ownership
structure has become too diffuse to serve share
holder interests well. When this occurs, owner
ship should be restructured.3
Restructuring occurs in two ways. Corporate
takeovers provide a dramatic mechanism for
concentrating existing diffuse ownership struc
tures. Less dramatically but more continuously,
ownership is restructured through the normal
issuing and purchasing of equity shares. At any
given time the diffuseness with which shares of
firms are held varies across corporations, buL
restructuring should adapt ownership structures
to the different situations confronted by different
firms. This implies that observed structures
should bear a sensible relationship to these situ
ations. More specifically, we may posit that vari
ations in ownership structure reflect the benefits
and costs to shareholders of controlling profes
sional management tightly.

must commit to own a controlling share of equity,
and hence the greater is their exposure to firmspecific risk. The risk-adjusted, utility-maximizing
ownership structure for large firms, contrary to
what is suggested by the separation thesis, is
not the single-owner firm.6 It is a more diffuse
ownership structure because the cost of bearing
firm-specific risk should be reflected in the
optimal ownership structure. Nonetheless, this
structure should be one in which enough shares
are owned by a few shareholders that they can
exercise more than a modicum of control over
professional management. The data reveal pre
cisely this—greater diffuseness in ownership
structure for larger firms accompanied by enough
concentration of ownership to imbue large share
holding interests with influence over management.
This pattern of ownership, which suggests that
shareholders choose ownership structures that
maximize the value of their firms, has been con
firmed for Swedish, Japanese and South
African firms.7

Concentrated ownership (and consequent tight
control over management) comes at a cost. If this
cost is high, the ownership structure that is truly
profit maximizing must look much like that of
the single-owner firm. This is the case in partic
ular for large firms because size of firm corre
lates with one of the major costs of concentrated
ownership—the bearing of firm-specific risk.
Because controlling shareholders would tend to
have a large fraction of their wealth invested in
a single firm if this firm is large, they would be
exposing themselves to firm-specific risk. The
larger the firm, the larger is the wealth they

Of course, management cannot be disciplined
so thoroughly by controlling shareholders and
by the threat of corporate takeovers that inept
ness is dethroned at once wherever and when
ever it exists. In this respect, it is important to
remember that ownership is not structured exclu
sively f o r the purpose o f dealing with management
ineptness. Other things matter to ownership
structure and to risk-adjusted profit, such as the
avoidance of firm-specific risk. If ownership is
structured to maximize risk-adjusted utility, it
must not be so tightly structured that all error
in judging professional management is eliminated.
Moreover, because there is a cost to altering the
structure of ownership quickly, profits are also
maximized by tolerating a lag between evidence
of ineptness and altering ownership structure
appropriately. Things will get out of whack on

5There are several ways by which professional management
can be guided to serve shareholder interest in the modern
corporation— concentrated ownership (achieved through
the normal financing of corporations or through corporate
takeovers), the consequences of the capital market’s
measurement of management performance, legal proceed
ings, and compensation systems. Time and space allow
me to consider here only concentrated ownership. This is
unfortunate especially in regard to executive compensation,
for there are new empirical results to report about this. It is
improbable that all these mechanisms transform the modern
corporation into a precise analog of the firm pictured in
neoclassical theory, but they do raise serious questions
about the Berle and Means thesis.

professional managers without error to pursue his chosen
ends. Although risk-adjusted profit always looms important
to this owner, it need not be his sole concern. He might
derive satisfaction from owning a larger firm even if it is
less profitable, or from using the firm ’s assets to cater to
personal utility maximization. The reduction in profit he
thereby bears must not be thought of as a loss sustained
because an agency problem separates his interests from
management's behavior. There is no agency problem
here, there is simply the recognition that in cases such as
this, profit maximization for the owner does not equate to
utility maximization for the owner. This may also hold for
degrees of ownership concentration less than the 100 percent
just assumed.

6I speak somewhat superficially in reference to risk-adjusted
utility maximization. Suppose a real corporation is owned
by a single person, and suppose further that he guides his

7See Bergstrom and Rydqvist (1990), Prowse (1991), and
Gerson (1992).

MARCH/APRIL 1993

occasion, and when they do, dramatic restruc
turing of ownership is more likely to be called
forth in the guise of a corporate takeover.
What seems to be true then is that professional
management is not free of substantive guidance
by shareholders, but that the degree of guidance,
because it responds to problems of risk and
other similar concerns, will not generally be
designed solely for the purpose of controlling
management malfeasance. From a shareholder’s
perspective, the optimal amount of management
malfeasance is positive, not zero. Just what is
optimal, however, is affected by the legal environ
ment, and especially by laws bearing on the
operation of capital market institutions. Ownership
will tend to be more concentrated, and manage
ment malfeasance will consequently be less
pervasive to the extent that these laws do not
raise the cost of maintaining concentrated owner
ship structures.
Recent data reveal a puzzle regarding ownership
concentration. After standardizing for variables
that should influence the ownership structure
of corporations, such as firm size and firmspecific risk, studies of corporate ownership
reveal large differences across countries in the
typical degree to which ownership is concen
trated. Ownership is noticeably more diffuse in
U.S. corporations than in Japanese, European
and South African corporations. In the typical
large corporation in the United States, the top
five shareholders, as a group, own about onefourth of the firm's outstanding voting stock.
Most corporations traded on South Africa’s
Johannesburg Stock Exchange are controlled by
small shareholder groups who own 50 percent
or more of voting stock.8 Ownership structures
in Germany and Sweden are more like South
Africa than the United States.9 In Japan, the five
largest shareholders own about 33 percent of
voting shares.1
0
The differences between the United States
and these other countries are so large that we
must suspect that the cost of concentrating cor
porate ownership differs substantially from one
country to another and for reasons not captured
by the variables being used to index this cost. If a
five-shareholder group owning one-fourth of the
voting equity of the typical large corporation is
8See Gerson (1992).
9See Sundqvist (1986).
,0Prowse (1991).

FEDERAL RESERVE BANK OF ST. LOUIS

a suitable ownership structure in the United
States, why is it not in other countries? A plau
sible source of this difference is in variation
across nations of regulations that impinge on
ownership structure and which make it more
costly to maintain control in the typical large
U.S. corporation than in the typical large nonU.S. corporation. Important capital market insti
tutions in the United States do bear special costs
to hold large stakes in the equities of other com
panies, and our banks are barred from holding
any stake.1
1
One potential source of equity capital is the
investment company, but the Investment Company
Act of 1940 restricts the ability of investment
companies to take concentrated equity positions
in the firms in which they invest if they advertise
themselves as diversified investment companies.
There is a tax advantage to registering as a diversi
fied investment company, since this entitles the
company to pass income through to its investors
without paying taxes, but even investment com
panies that do not register as diversified are
barred from exercising control over any firm
engaged in interstate commerce. Hence funds
channeled through investment companies are
unlikely sources of controlling positions in the
equity of corporations.
Insurance companies are another potentially
important source of equity capital, and most states
do allow insurance companies to invest a percent
age of their assets in common stock. The per
centage varies from state to state but is commonly
about 20 percent. New York, a particularly
important state for insurance, limits the amount
that insurance companies can invest in one
company to 2 percent of the insurance company’s
assets. Most other states have similar restrictions,
but the percentage varies over a large range.
States generally bar insurance companies from
owning more than a stipulated percentage of
the shares of other companies. A common
upper bound is 10 percent. Finally, there fre
quently is a penalty borne by insurance compa
nies that invest in common stock; most states
require that capital be set aside to maintain a
financial cushion against declines in the price of
stock held for investment purposes. Although it
is not impossible to use funds channeled through
1 My summary discussion of the details of some of the relevant
1
legislation rests heavily on work by Paul S. Clyde (1990).

insurance companies to take a concentrated
equity position in a given corporation, it clearly
is an investment tactic that is generally dis
couraged by state-imposed restrictions. Hence, a
second capital market institution is handicapped
in such an undertaking.
For m ore than 60 years the Glass-Steagall Act
has barred banks from directly ow ning equity
in U.S. corporations. There is no counterpart to
this law in South Africa and in much o f W estern
Europe, and only recently has Japan adopted a
similar law. Although banks w ould seem to be
low-cost conduits o f equity capital, Glass-Steagall
forces corporations to raise equity funds from
other sources. In fact, banks play important
equity roles in other nations, w h ere they supply
enough equity to ow n sizeable positions in cor
porate ownership structures. The possible con
nection betw een Glass-Steagall and ownership
structure, how ever, is not generally suspected
even though banks are potentially a major
source o f equity investment capital in the
United States.1 If the behavior o f foreign banks
2
in their ow n countries is a guide to what U.S.
banks would do if allowed to invest in corporate
equity, it seems likely that U.S. banks w ould be
important sources not only o f equity capital, but
also o f concentrated ownership positions. A third
major source o f concentrated ownership is thus
barred by legislation.
Because o f recent court decisions, em ployment
retirem ent funds remain one important source
o f capital that is free to take equity positions,
even concentrated equity positions. In fact, w e
find a fe w o f these funds playing key roles
in monitoring and disciplining corporate manage
ment by virtue o f their large holdings o f stock
in particular corporations. Most notable in this
regard is the California State Employees Retire
ment Fund, but others have also becom e activist.
For reasons discussed later, how ever, I do not
believe that these funds o ffe r m onitoring and
disciplining services as good as those likely to
come from capital market institutions presently
barred or penalized from taking large equity
positions in specific corporations.
The consequence o f these legal barriers is
that corporations housed in the United States
rely on capital that is secured directly from
individual investors to a much greater extent
than corporations located overseas. Really large

controlling positions in the equity o f U.S. corpo
rations are taken mainly by individual and family
investors in the United States. Because o f greater
portfolio specialization, these individuals and
families are exposed to m ore firm-specific risk
than capital market institutions w ould be. M ore
over, individual or family wealth is seldom large
enough to allow concentrated holdings o f the
equity o f large corporations. The heavy reliance
in the United States on this source o f equity
capital results in corporate ownership structures
much m ore diffuse than those that exist fo r
comparable foreign corporations. The optimal
degree o f control exercised by shareholders
over the managements o f their U.S. corporations,
as a result o f such legislation, is less than elsewhere.
Arguments pro and con can be made in regard
to the various legal hurdles that keep important
institutional conduits o f capital from accessing
the equity markets easily. W h atever the truth in
this regard, the effect o f these legal hurdles on
ownership structure and control has not yet
been taken into account. The control problem
created by these hurdles, taken by itself, offers
a novel basis fo r opposing such legislation.
But can institutional investors—fo r example,
investment companies, insurance companies and
banks—be relied on to perform the ownership
function well? Since their capital comes from
diffuse sources, it would seem that their ow n
operations should be subject to the separation
problem believed to plague large corporations.
If so, institutional investors holding controlling
positions in the equity structure o f large corpo
rations cannot be expected to perform the duties
o f ow ner as w ell as investors whose ow n wealth
is at stake. I discuss this issue in the rem ainder
o f this paper, showing that the control problem
can be ameliorated by such institutions but not
as completely as if individuals ow ned concentrated
ownership positions in corporations directly.
There are institutional investors that seem
capable o f circum venting the problem created
by their ow n diffuse ownership structure, and
there are others that seem not so capable o f
doing this. The distinction betw een the tw o lies
in the ease with which individual investors can
reclaim their funds from the institution. The openended mutual stock fund is organized so that
investors can insist that the fund buy back their
shares at the net asset value they represent in

12Exceptions include Prowse (1990) and Gerson (1992).

MARCH/APRIL 1993

the fund’s portfolio. The closed-end stock fund
has no such obligation; an investor w ho wants
to convert his shares in such a fund to cash
may sell them at w hatever market-determined
price they fetch, but he cannot demand their
redem ption by the fund. This is an important
difference w hen it comes to the issue o f separa
tion betw een ownership and control. T o see its
importance, let us reconsider the separation
problem in the context o f the corporation.

T w o conditions must exist fo r the separation
problem to be severe in a corporation. One is
the generally recognized condition that ow n er
ship structure be diffuse. The other is the con
dition that assets made available to a corporation
by shareholders must belong to it and not to
shareholders. This second condition has not
been recognized explicitly in economic litera
ture, but it is important. It refers to the fact
that, although the shareholder may sell his
shares if he is dissatisfied, the shareholder can
not insist that the corporation be the buyer o f
his shares. Thus the corporation, not the share
holder, has title to the productive assets it has
purchased with funds secured from its initial
issue o f stock.1 If shareholders could reclaim
3
these assets, the severity o f the separation
problem w ould be lessened even fo r diffuse
ownership structures. It would be lessened even
m ore if share ownership w ere concentrated,
because shareholders with much at stake will
be m ore attentive to what management has
been doing with the firm ’s assets.

It is not practical to allow shareholders to
reclaim their share o f the firm ’s assets in the
general case o f the business firm. The typical
corporation makes commitments to supply goods
and services that, if they are dependably honored,
require the corporation to have continuing con
trol o f its assets. A steel company cannot relia
bly stand by a commitment to fill an order fo r
steel if its shareholders can force it to sell its
assets to purchase back their stock. The typical
corporation th erefore must be organized in a
w ay that bars investors from reclaiming their
fraction o f the firm ’s assets, and once the typi
cal corporation sells a new issue o f shares, the
funds it acquires belong to it, not to those w ho
purchased the shares.
13Subsequent sale of shares by shareholders has a depressing
effect on the price of the corporation’s stock if enough share
holders offer to sell, and this has some disciplining effect

FEDERAL RESERVE BANK OF ST. LOUIS

Continued control by the firm over its assets
is not a prerequisite to doing business if credi
ble commitments o f this sort are not necessary.
Consider the open-ended mutual stock fund.
This firm gathers capital from investors and
uses its skill to place these funds in the shares
o f other corporations. These shares can be sold
by the mutual stock fund on a m om ent’s notice
should it decide to do so, and in doing so it will
not be jeopardizing any business commitments.
Consequently, investors w h o place their capital
at the disposal o f open-ended mutual funds can
w ithdraw their p ro rata share o f the value o f
the fund's assets should they becom e displeased
with the fund's perform ance. De fa cto , the openended mutual fund is obligated to repurchase
pro rata investment positions. These investors
are not shareholders in the conventional sense.
They are purchasers o f investment services, but
they also are providers o f the capital that is in
turn invested in shareholdings o f other compa
nies. In the absence o f the Glass-Steagall Act,
the same arrangem ent could w ork fo r banks
w ho reinvest depositor funds in the shares o f
other corporations (but probably could not
w ork w ell fo r that part o f bank investments
that constitutes time-commitment loans to busi
ness firms). Should those depositors w ho have
made no commitment to keep their funds with
a bank decide to w ithdraw deposits, the bank
could sell its shareholdings in other corpora
tions to cover the withdrawals.
It is this characteristic, the ability o f investordepositors to reclaim capital from a firm , that
distinguishes these institutions from others fo r
our purposes. The closed-end fund does not have
this characteristic. It is organized like the typical
corporation. It issues shares and converts the
funds from their sale to assets that belong to it.
Dissatisfied shareholders may sell their shares,
but they cannot force the closed-end fund to be
the purchaser. This allows the fund’s management
to make its investment plans without fear o f
being forced to alter them should investor
desires fo r cash or beliefs about the investment
environm ent change, but it also eliminates the
threat to management that it w ill lose control o f
fund assets if the fund perform s poorly.
It is this threat in the case o f the open-end
mutual investment fund that reduces the
on management, but even so, the corporation remains in
control of the assets it has acquired.

severity o f the separation problem. Should
investors becom e dissatisfied in large numbers,
mass withdrawals would diminish the assets
available to a fund’s management, forcing it to
sell the shares they ow n in other companies.
This reduction in the wealth available to the
managements o f these institutions can take
place even if no single investor or small group o f
investors has provided a lion’s share o f the capi
tal being invested. This disciplines the manage
ments o f these institutions in a w ay not available
to stockholders w hen they are disappointed with
the managements o f typical corporations. The large
scale sale o f shares in the typical corporation
depresses share price but does not reclaim assets
from management control.
W hat this means is that managements o f
institutional investors o f the open-ended mutual
fund variety can be disciplined directly by
providers o f capital even w hen there is no con
centrated provision o f this capital. The diffuse
ow n er problem is ameliorated, but only to a
limited extent. It is m ore effectively defused if
capital is provided in concentrated fashion to
the institutional investor, fo r concentration o f
rewards and penalties makes the large share
holder more attentive and astute. Now suppose
that this type o f institutional investor has taken
controlling positions in the equity o f the firms
whose shares it has purchased. The ability o f
even diffuse contributors o f its capital to w ith
draw their assets surely makes the institutional
investor represent its investors’ interests better
than if the threat o f w ithdraw al did not exist—
as long as the ability o f the institution to make
long-term commitments is not important to its
productivity. Because o f this effect, capital secured
from even diffuse sources can be combined w ith
out suffering fully from a separation betw een
ownership and control.1
4
One final point may be raised about another
source o f diffuse ownership in the United States.
The N ew York Stock Exchange (NYSE) requires
that firms it lists raise their equity capital on a
one-share, one-vote basis. The NYSE did not
always use this standard. It was adopted during
the 1920s under considerable pressure from
governm ent and intellectuals w ho feared that
the grow in g use o f differin g vote entitlements
was disenfranchising many equity capital pro
14ln fact, a doctoral dissertation recently completed at UCLA
[Clyde (1990)] gives evidence that institutional investors
behave much as do individual and family shareholders

viders. Nonvoting equity shares are used much
m ore extensively in other countries. This makes
fo r a low er cost o f establishing controlling
equity positions in a company because only vo t
ing shares must be reckoned with w hen con
sidering the direct control o f management.
Discussion o f this issue, how ever, cannot be
undertaken here.

REFERENCES
Bergstrom, Clas, and Kristian Rydqvist. “ The Determinants of
Corporate Ownership — An Empirical Study on Swedish Data,”
Journal of Banking and Finance (August 1990), pp. 237-53.
Berle, Adolf A., and Gardiner C. Means. The Modern Corpo
ration and Private Property (Macmillan, 1932).
Clyde, Paul S. The Institutional Investor as an Effective Moni
tor of Management, UCLA Economics Dept., Ph.D. disser
tation, 1990.
Demsetz, Harold. “ The Structure of Ownership and the
Theory of the Firm,” Journal of Law and Economics
(1983).
_______ . “ Corporate Control, Insider Trading, and Rates of
Return,” American Economic Association: Papers and
Proceedings (May 1986), pp. 313-16.
_______ , and Kenneth Lehn. “ The Structure of Corporate
Ownership: Causes and Consequences,” Journal of Political
Economy (December 1985), pp. 1155-77.
Galbraith, John K. The New Industrial State (Houghton Mifflin,
1967).
Gerson, Josell. “ The Determinants of Corporate Ownership
and Control in South Africa,” UCLA Economics Dept.,
Ph.D. dissertation, June 1992.
Jarrell, Gregg, James A. Brickley, and Jeffrey M. Netter.
“ The Market for Corporate Control: The Empirical
Evidence Since 1980,” Journal of Economic Perspectives
(Winter 1988), pp. 49-68.
Prowse, Stephen D. “ Institutional Investment Patterns and
Corporate Financial Behavior in the United States and
Japan,” Journal of Financial Economics (September 1990),
pp. 43-66.
________“ The Structure of Corporate Ownership in Japan,”
(1991), unpublished manuscript.
Smith, Adam. The Wealth of Nations (Modern Library, 1937),
pp. 713-14.
Shleifer, Andrei, and Robert W. Vishny. “ Large Shareholders
and Corporate Control,” Journal of Political Economy
(1986), pp. 461-88.
Sundqvist, S. Owners and Power in Sweden’s Listed Companies
(Dagens Nyheters Forlag, 1986).
Veblen, Thorstein. The Engineers and the Price System
(1921).
who own controlling positions in the ownership structure of
a corporation.

MARCH/APRIL 1993

Charles I. Plosser
Charles I. Plosser is the John M. Olin Distinguished Professor
of Economics and Public Policy, W E. Simon Graduate School
.
of Business Administration, University of Rochester. Financial
support of the John M. Olin Foundation is gratefully
acknowledged.

Commentary

H
Mil >11 ( DEMSETZ RARELY FAILS to deliver
a creative and thought-provoking paper, and this
one is no exception. I have learned a great deal
from Harold’s writings over the years and usually
find myself persuaded by his arguments. In this
paper Demsetz explores the implications o f cer
tain restrictions on the behavior o f financial insti
tutions fo r the efficiency o f the market for
corporate control. This is a potentially important
consideration and one that, to my knowledge, has
not been systematically investigated.
The basic thesis o f the paper can be summa
rized in three steps. The first step is to recog
nize that the diffusion o f ownership o f large
corporations creates a control problem fo r ow n
ers (that is, stockholders). This well-known
agency problem has long been the focus o f in
tense study by economists. It is important to
recognize, how ever, that the degree o f diffusion
o f ownership reflects both costs and benefits to
shareholders. Th e benefits arise from the reduc
tion o f firm-specific risk borne by owners
through the diversification o f their holdings.
The costs arise from the potential loss o f control
over management.
The second step in the analysis is to argue
that financial regulations limiting the extent o f
ownership in a corporation by certain types o f
institutional investors, including insurance com
panies, investment companies and commercial
banks, potentially raise the costs o f controlling
management. The third step in the argument is
to suggest that this reduced ability o f ow ners to
monitor and control managers reduces the e ffi
ciency o f large corporations and thus tends to

FEDERAL RESERVE BANK OF ST. LOUIS

make them less competitive than corporations in
countries w h ere institutional investors are not
subject to such restrictions.
I have no difficulty w ith the logic or thrust o f
this line o f reasoning. It is rare that regulations
are neutral and thus fail to distort resource allo
cations. The questions I am interested in focus
ing on have to do w ith w hether the market has
created alternative means o f monitoring manage
ment. I f so, then the question is, which means
is most cost efficient?
Demsetz recognizes that concentrated ow n er
ship is not the only means o f exercising control
over management. Boards o f directors p ro vid e
important control mechanisms and have begun
to reassert their authority. The recent cases o f
General Motors, Am erican Express and IBM are
good examples. Management compensation is
another means to align management and share
holder interests. In general, the market fo r cor
porate control is an important monitoring device.
Though it requires individuals or firms to obtain
a concentrated ownership in a company, it does
not necessarily depend on large financial institu
tions acting as the investors doing the m onitor
ing. Large pension funds that are not regulated
like banks or investment companies have be
come increasingly active in m onitoring manage
ment. CALPERS is one o f the most well-known
funds and has been deeply involved in pressur
ing fo r management changes in several com
panies.
Demsetz stresses that there must be a cost to
regulation that prohibits investment companies,

insurance companies and banks from taking po
sitions that encourage them to monitor manage
ment m ore closely. This is undoubtedly true.
But it is an empirical question as to the im por
tance o f these restrictions. I w ould like to sug
gest that there may be reasons to believe the
effects are small—if fo r no other reason than
the marketplace is innovative in getting around
such restrictions, particularly w hen there are
large rewards fo r doing so.
Institutional investors can provide tw o sorts o f
services—risk sharing or diversification and
management monitoring. Th ere is no particular
reason w h y expertise in one activity implies ex
pertise in the other. In fact, it is easy to imagine
that some institutional investors would special
ize in one activity or the other. For example,
Dean LeBaron o f Batterymarch Funds and Rex
Sinquefield o f DFA view themselves prim arily as
portfolio managers. Neither o f them seems to
have the slightest interest in m onitoring manage
ment. W hy? Even though they must file 13d's
indicating w hen they ow n a significant share o f
a particular company, probably only a small
percentage o f their portfolios is made up o f
companies o f which they ow n a significant
share. These fund managers specialize in risk
sharing, not control or monitoring. W h y should
they have a comparative advantage in monitoring
management? Just because they are skilled at
managing risk does not mean they are skilled at
management control. LeBaron has even pushed
the idea o f selling voting rights that w ould allow
the separation and specialization in monitoring
and risk sharing.
W h y should one expect that managers o f
regulated insurance companies or investment
companies have a comparative advantage in
m onitoring management? I f they do not, the
regulation is likely to have little substantive
effect.1
Researchers sometimes feel that banks are
different in this regard. Some view banks as
having access to an informational advantage
over other parties and thus being in a particu
larly good position to exercise control over
management. Indeed, in Japan and to a lesser
extent in Germany, this has been standard prac
tice. I f banks held both debt and equity then
they w ould clearly have a strong interest in

managerial monitoring. It is not clear, how ever,
that they w ould always represent shareholder
interests. It is w orth recalling that the GlassSteagall A ct was not m otivated b y a desire to
limit managerial control by banks but from a
desire to stabilize the payments system involv
ing the other side o f the bank’s balance sheet.
In fact, certain types o f banks are not subject to
these limitations because they are not deposito
ry institutions, and they sometimes do take con
centrated ownership positions.
Th e marketplace has clearly responded to the
demand fo r corporate control through a variety
o f mechanisms and institutional arrangements
that go far beyond the regulated financial inter
mediaries. In the case o f monitoring manage
ment, new funds and partnerships have been
created that specialize in seeking concentrated
ownership fo r the purpose o f control. One o f
the earliest o f these was WESRAY, which was a
partnership betw een W illiam E. Simon and Ray
mond Chambers. Th ey engineered successful
leveraged buyouts (LBOs) fo r Gibson Greeting
Cards, Avis and W ilson Sporting Goods. Kohlberg, Kravis and Roberts (KKR) is another suc
cessful partnership that specializes in obtaining
concentrated ownership fo r the purpose o f con
trolling management. In fact, by 1990, almost
every major investment bank had created its
ow n LBO fund (fo r example, J. P. Morgan and
The First Boston Corp.). These funds and their
managers specialize in ownership and control,
not in providing risk sharing fo r investors. Thus
it w ould appear that financial institutions and
the market have responded to the demand for
corporate control in innovative ways that cir
cumvent some o f the distortions caused by
financial regulations on banks and other institu
tions regarding ownership.
There are other areas w h ere regulation o f
financial institutions may be affecting the m ar
ket fo r corporate control. Many o f the LBO
funds frequently obtain bridge financing from
commercial banks. Unfortunately, under the
Financial Institutions Reform, Recovery and En
forcem ent Act, banks are now much m ore limit
ed in their ability to deliver such financing
because o f direct restrictions on purchases o f
high-risk securities and generally higher capital
requirements. Thus, there remain potentially

1Of course, given the history of regulation, skilled monitors
are likely to have migrated out of managing funds in these
regulated firms.

MARCH/APRIL 1993

important avenues fo r financial regulations on
ownership to affect the efficiency o f the co r
porate control market.
The final element I w ould like to comment on
briefly is what, if anything, all this says about
international competition. It is certainly true
that U.S. corporations operate in a global m ar
ket and that to the extent w e reduce the e ffi
ciency or raise the costs o f corporate control
mechanisms serving to make U.S. companies
better managed, w e put ourselves at a com peti
tive disadvantage. The tw o observations that
Demsetz makes are that many other countries do
not have the same restrictions on ownership by
financial institutions and that in some foreign
countries, structures are less diffuse than in the

FEDERAL RESERVE BANK OF ST. LOUIS

United States. Though both observations are
potentially relevant, it w ould be m ore interest
ing if someone could gather evidence that
linked the cross-country patterns o f ownership
and regulation to patterns o f corporate p e rfo r
mance and corporate control.
In summary, I think this is an interesting
paper that helps focus attention on a set o f is
sues that deserves m ore study. Regulations often
have subtle and unintended effects and in some
cases those may turn out to be o f first-order im
portance. Th e issues discussed in this paper
may fall into this category. Nevertheless, w e
must never underestimate the creative genius o f
m arket participants in circum venting regulations
w hen large profit opportunities exist.

Carl F. Christ
Carl F. Christ is a professor of economics at The Johns Hop
kins University. Helpful comments on an earlier draft were
made by Jonathan Ahlbrecht, Stephen Blough, Pedro de Lima
and William Zame. Any remaining shortcomings are my
responsibility.

Assessing Applied Econometric
Results

M . T IS A GREAT HONOR to be asked to participate
in this conference to celebrate the w ork o f Ted
Balbach, w ho has long upheld the standard o f
relevant, independent, intelligible econom ic
studies at the Federal Reserve Bank o f St. Louis.
My invitation to this conference asked fo r a
philosophical paper about good econom etric
practice. I have organized my view s as follows.
Part I o f the paper defines the concept o f an
ideal econometric model and argues that to tell
w hether a model is ideal, w e must test it against
new data—data that w ere not available when the
model was formulated. Such testing suggests that
econom etric models are not ideal, but are approxi
mations to a changing reality. Part I closes with
a list o f desirable properties that w e can realisti
cally seek in econom etric models. Part II is a
loosely connected set o f comments and criticisms
about several econom etric techniques. Part III
discusses methods o f evaluating econometric
models by means o f their forecasts and summa
rizes some results o f such evaluations, as proposed
in part I. Part IV resurrects an old, plain-vanilla
equation relating m onetary velocity to an interest
rate and tests it with m ore recent data. The rather
remarkable result is that it still does about as
w ell today as it did nearly 40 years ago. Part V
is a b rief conclusion.

H O W TO RECOGNIZE AN IDEAL
M ODEL IF YO U MEET ONE
The Goal o f Research and the
Concept o f an Ideal M odel
The goal o f econom ic research is to im prove
knowledge and understanding o f the economy,
either fo r their ow n sake, or fo r practical use.
W e want to know how to control what is con
trollable, how to adapt to what is uncontrollable,
and how to tell which is which. Th e goal o f
economic research is analogous to the prayer o f
Alcoholics Anonymous (I do not suggest that
economics is exactly like alcoholism)—"God grant
me the serenity to accept the things I cannot
change; the courage to change the things I can;
and the wisdom to know the difference.”
The goal o f applied econometrics is quantitative
knowledge expressed in the form o f mathemati
cal equations.
I invite you to think o f an ideal econometric
model, by which I mean a set o f equations, com
plete or incomplete, with numerically estimated
parameters, that describes some interesting set o f
past data, closely but not perfectly, and that

MARCH/APRIL 1993

Figure 1
Three Methods of Formulating and Estimating a Model and Checking Its
Correspondence with 1950-1991 Data
Method 1

Date of model’s formulation
Estimation period
1991 1992

1950
Method 2

Date of model’s formulation
Estimation period

Prediction period
1971 1972

1950
Method 3

1991 1992

Date of model’s formulation
Estimation period
1950

Prediction Period
1971 1972

______________________ __________ .

1991 1992

Period of data available when model was
formulated

Period of data not yet available when
model was formulated

■H
w ill continue to describe all future data o f that
type.

The N eed f o r Testing Against
N ew Data
H ow can w e tell w hether w e have found an
ideal econom etric model? W e can certainly tell
how w ell a model describes a given set o f past
data. (W e w ill discuss what is meant by a good
description later). Suppose w e have a model in
1992, w ith estimated parameters, that closely
describes past data fo r 1950-91. T o tell w hether it
is the ideal model w e seek, w e must try it with
future data. Suppose that after three years w e
try the model with data fo r 1992-94, and it
describes them closely also. Still, in 1995 all w e
will be sure o f is that it describes data closely
for a past period, this time from 1950 through 1994.
In principle w e can never be sure w e have found
an ideal model because there will always be
m ore future data to come, so w e w ill never be
able to say that a model is ideal. The longer the
string o f future data that a model describes
closely, how ever, the m ore confidence w e have
in it.
Is this only a matter o f the amount o f data that
the model describes, or is there something else
involved? I argue that something else is involved.

FEDERAL RESERVE BANK OF ST. LOUIS

Suppose again that in 1992 w e have a model
that closely describes an interesting data set fo r
the past period 1950-91. Consider the follow ing
three methods, shown in figure 1, by which this
model might have been obtained and by which its
ability to describe data fo r 1950 through 1991 might
have been assessed:
1. It was form ulated in 1992, and fitted to data
fo r the entire period 1950-91.
2. It was form ulated in 1992, fitted to data fo r
the sub-period 1950-71, and used to predict
data from 1972 through 1991.
3. It was form ulated in 1972, fitted to data fo r
the sub-period 1950-71, and used to predict
data from 1972 through 1991.
Methods 1 and 2 d iffer in that method 1 fits the
model to all the available data, whereas method 2
fits it to the first part only and uses the result
to predict the second part, from 1972 onward.
1972 is not a randomly chosen date. It was the
year before the first oil crisis. Method 3 differs in
that the model builder did not y et know about the
oil crisis w hen form ulating the model.
N ow consider the follow ing question: Given the
goodness o f fit o f this model to data fo r the whole
period 1950-91, does you r confidence in the model
depend on which o f these three methods was

used to obtain it? I argue that it should. In par
ticular, I argue that an equation obtained by a
method similar to method 3, which involves
testing against data that w ere not available to
the model builder when the model was formulated,
deserves m ore confidence than the same equation
obtained by either o f the other tw o methods.
The argument has to do with the goal o f an
econom etric m odel—to describe not only past
data, but also future data. It is easy to form u
late a model that can describe a given set o f
past data perfectly but cannot describe future
observations at all. O f course, such a research
strategy should be avoided.
Here is a simple example. Imagine a pair o f vari
ables whose relationship w e want to describe.
Suppose w e have tw o observations on the pair
o f variables. Then a line, whose equation is linear,
will fit the data perfectly. N ow suppose w e obtain
a third observation. It w ill almost certainly not lie
on the line determined by the first two observations.
But a parabola, whose equation is quadratic (of
degree 2), w ill fit the three observations perfectly.
N ow suppose a fourth observation becomes
available. It w ill almost certainly not lie on the
parabola. But a sort o f S-curve, whose equation
is cubic (of degree 3), w ill fit the fou r observa
tions perfectly. And so on. In general, a poly
nomial equation o f degree n w ill fit a set o f
n + 1 observations on tw o variables perfectly,
but a polynomial o f higher degree will be
required if the number o f observations is
increased. Methods o f this type can describe
any set o f past data perfectly but almost cer
tainly cannot describe any future data.
If a model is to describe future data, it needs
to capture the enduring systematic features of
the phenomena that are being modeled and it
should avoid conform ing to accidental features
that w ill not endure. The trouble w ith the exactfitting polynomial approach just discussed is that
it does not try to distinguish betw een the enduring
systematic and the tem porary accidental features
o f reality. In the process o f fitting past data per
fectly, this approach neglects to fit enduring
systematic features even approximately.
This relates to the choice among methods 1, 2
and 3 fo r finding a model that describes a body
o f data. W hen form ulating a model, researchers
typically pay attention to the behavior o f avail
able data, which perforce are past data. One tries
1See Mitchell (1927).

different equation forms and different variables to see
which formulation best describes the data. This pro
cess has been called data mining. As a method o f
formulating tentative hypotheses, data mining is
fine. But it involves the risk o f being too clever,
o f fitting the available data too well and hence o f
choosing a hypothesis that conform s too much
to the tem porary accidental and too little to the
enduring systematic features o f the observed
data. In this respect it is similar to the exactfitting polynomial approach described earlier,
though not as bad.
The best protection against having done too
good a job o f making a model describe past data
is to test the model against new data that w ere
not available w hen the model was formulated.
This is what method 3 does, and that is w hy a
model obtained by method 3 merits m ore confi
dence, other things equal.
T rygve Haavelmo once said to me, not entirely
in jest, that what w e economists should do is
form ulate our models, then go fishing fo r 50 years
and let new data accumulate, and finally come
back and confront our models with the new data.
W esley Mitchell put the matter very well
when he w rote the follow in g:1
1'he proposition may be ventured that a competent
statistician, with sufficient clerical assistance and
time at his command, can take almost any pair
of time series for a given period and work them
into forms which will yield coefficients of cor
relation exceeding + .9. It has long been known
that a mathematician can fit a curve to any time
series which will pass through every point of
the data. Performances of the latter sort have
no significance, however, unless the mathe
matically computed curve continues to agree with
the data when projected beyond the period for
which it is fitted. So work of the sort which
Mr. Karsten and Professor Fisher have shown how
to do must be judged, not by the coefficients of
correlation obtained within the periods for which
they have manipulated the data, but by the co
efficients which they get in earlier or later periods
to which their formulas may be applied.
Milton Friedman, in his review of Jan Tinbergen’s
pioneering model o f the U.S. economy, referred
to Mitchell’s comment and expressed a similar
idea somewhat differently:2
Tinbergen’s results cannot be judged by ordinary
tests of statistical significance. The reason is that
2See Friedman (1940) and Tinbergen (1939).

MARCH/APRIL 1993

the variables with which he winds up, the parti
cular series measuring these variables, the leads
and lags, and various other aspects of the equations
besides the particular values of the parameters
(which alone can be tested by the usual stati
stical technique) have been selected after an exten
sive process of trial and error because they
yield high coefficients of correlation. Tinbergen
is seldom satisfied with a correlation coefficient less
than .98. But these attractive correlation coeffi
cients create no presumption that the relationships
they describe will hold in the future. The multi
ple regression equations which yield them are
simply tautological reformulations of selected
economic data. Taken at face value, Tinbergen’s
work “explains” the errors in his data no less
than their real movements.
That last statement can be strengthened. Tin ber
gen's method, which has been the method o f
most model builders ever since, explains w hat
ever tem porary accidental components there
may be in the data (regardless o f w hether they are
measurement errors), as w ell as the enduring
components.
Most m acroeconom etric models formulated
before the 1973 oil crisis had no variables rep re
senting the prices and quantities o f oil and energy.
Most o f these models w ere surprised by the oil
crisis and its aftermath; and most of them made sub
stantial forecast errors thereafter. Many models
form ulated after 1973 pay special attention to
oil and energy. O f course many o f those models
provide better explanations o f the post-oil-crisis
data than do models that ignore oil and energy.
But my point is different. A model that was fo r
mulated after the oil crisis w a s s p e c ific a lly
designed to conform to data during and after the
crisis, and if there are tem porary accidental va r
iations, the model w ill conform to them just as
much as to the systematic variations. Hence the
task o f explaining data betw een the onset o f the
1972 oil crisis and 1992 is easier fo r a model that
was form ulated in 1992 than fo r a model that
was form ulated before the crisis. Th erefore if
both models do equally well at describing data from
1950 to 1991, the one formulated before the crisis
has passed a stricter test and merits m ore con
fidence.
W hat about the relative merits o f methods
1 and 2? Sometimes method 2 is recom m ended;
that is, it is recom mended that researchers esti
mate a model using only the earlier part o f the
available data and use the later part as a test o f
the m odel’s forecasting ability. W hen thinking
about this proposal, consider a model that has

FEDERAL RESERVE BANK OF ST. LOUIS

been form ulated w ith access to all o f the data.
It does not make much difference w hether part
o f the data is excluded from the estimation pro
cess and used as a test o f that model, as in
method 2, or w hether it is included, as in
method 1. Either way, w e draw the same con
clusions. If the model with a set o f constant
coefficients describes both parts o f the data
well, method 1 w ill yield a good fit fo r the
w hole period and method 2 w ill yield a good fit
fo r the estimation period and small errors fo r
the forecast period. If the model with a set o f
constant coefficients does not describe both
parts o f the data well, in m ethod 1 the residuals,
if examined carefully, w ill reveal the flaws, and
in method 2 the residuals, the forecast errors
or both w ill reveal the flaws. And w ith both
methods 1 and 2 w e have a risk that the model
was form ulated to conform too much to the
temporary accidental features o f the available data.
One notew orthy difference betw een methods 1
and 2 is that if the m odel’s specification is correct,
method 1 w ill yield m ore accurate estimates o f
the parameters because it uses a larger sample
and thus has a smaller sampling error.

Econom etric M odels Are
Approximations
W hen I began w ork in econometrics, I believed
a premise that underlies much econometric w ork—
namely, that a true model that governs the
behavior o f the econom y actually exists, with
both systematic and random components and
with true parameter values. And I believed that
ultimately it would be possible to discover that
true model and estimate its param eter values.
My hope was first to find several models that
could tentatively be accepted as ideal and even
tually to find m ore general models that would
include particular ideal models as special cases.
(One w ay to top you r colleagues is to show that
their models are special cases o f yours. N ow a
days this is called "encompassing.”)
Experience suggests that w e cannot expect to find
ideal models o f the sort just described. W hen an
estimated econom etric model that describes past
data is extrapolated into the future fo r more
than a year or two, it typically does not hold up well.
T o try to understand how this might happen, let
us tem porarily adopt the premise that there is a
true model. O f course, w e do not know the form
or parameters o f this true model. They may or
may not be changing, but if they are changing
according to some rule, then in principle it is

possible to incorporate that rule into a more
general unchanging true model.
Suppose that an economist has specified a model,
which may or may not be the same as the true
model. If the form and parameters o f the
economist’s model are changing according to
some rule (not necessarily the same as the rule
governing the true model), again in principle it
is possible to incorporate that rule into a m ore
general unchanging model.
N ow consider the follow ing possible ways in
which the economist's model might describe past
data quite w ell but fail to describe future data:
1. The form and parameter values o f the
economist’s model may be correct fo r both
the past period and the future period, but as
the forecast horizon is lengthened, the fo re
casts get worse because the variance o f the fo re
cast is an increasing function o f the length o f
the horizon. This w ill be discussed later.
2. Th e form o f the economist’s model may be cor
rect fo r both the past period and the future
period, but some or all o f the true param e
ters may change during the future period.
3. Th e form o f the economist’s model may be
correct fo r the past period but not fo r the
future period because o f a change in the
form o f the true model that is not matched
in the economist’s model.
4. The form o f the economist’s model may be
incorrect fo r both periods but more nearly
correct fo r the past period.
Th e last possibility is the most likely o f the
four in view o f the fact that the econom y has
millions o f different goods and services produced
and consumed by millions o f individuals, each
with distinct character traits, desires, knowledge
and beliefs.
These considerations lead to the conjecture that
the aforem entioned premise underlying econo
metrics is w ron g—that there is no unchanging true
model with true parameter values that governs
the behavior o f the econom y now and in the
future. Instead, every estimated econom etric
model is at best an approximation o f a changing
econom y—an approximation that becomes w orse
as it is applied to events that occur further into
the future from the period in which the model
was formulated. In this case w e should not be
surprised at our failure to find an ideal general
model as defined earlier. Instead, w e should be

content w ith models that have at best only a
tem porary and approximate validity that deteri
orates with time. W e should sometimes also be con
tent with models that describe only a restricted
range o f events—fo r example, events in a parti
cular country, industry or population group.

Desiderata f o r an Econom etric
M odel
If no ideal model exists, what characteristics
can w e realistically strive fo r in econometric
models regarded as scientific hypotheses? The
follow ing set o f desiderata are within reach:
1. The estimated model should provide a good
description o f some interesting set o f past data.
This means it should have small residuals rela
tive to the variation o f its variables—that is,
high correlation coefficients. The standard
errors o f its param eter estimates should be
small relative to those estimates, that is, its
t-ratios should be large. If it is estimated fo r sep
arate subsets o f the available data, all those esti
mates should agree w ith each other. Finally,
its residuals should appear random. (If the
residuals appear to behave systematically, it
is desirable to try to find variables to explain
them.)
2. The model should be testable against data that
w ere not used to estimate it and against data
that w ere not available w hen it was specified.
3. The estimated model should be able to describe
events occurring after it was form ulated and
estimated, at least fo r a fe w quarters or years.
4. The model should make sense in the light o f
our knowledge o f the economy. This means
in part that it should not generate negative
values fo r variables that must be non-negative
(such as interest rates) and that it should be
consistent with theoretical propositions about
the econom y that w e think are correct.
5. Other things equal, a simple model is p re fer
able to a complex one.
6. Other things equal, a model that explains a
w ide variety o f data is preferable to one that
explains only a narrow range o f data.
7. Other things equal, a model that incorporates
other useful models as special cases is p re fer
able to one that does not. (This is almost the
same point as the previous one.)

MARCH/APRIL 1993

In offerin g these desiderata, I assume that the
purpose o f a model is to state a hypothesis that
describes an interesting set o f available data and
that may possibly describe new data as well. Of
course, if the purpose is to test a theory that w e
are not sure about, the model should be constructed
in such a w ay that estimates o f its parameters
w ill tell us something about the validity o f that
theory. The failure o f such a model to satisfy
these desiderata may tell us that the theory it
embodies is false. This too is useful knowledge.

COMMENTS A N D CRITICISMS
A B O U T ECONOMETRIC
TECHNIQUES
Theory vs. Empiricism
T w o general approaches to form ulating a model
exist. One is to consult economic theory. The other
is to look fo r regularities in the data. Either can
be used as a starting point, but a combination
o f both is best. A model derived from elegant
economic theory may be appealing, but unless
at least some o f its components or implications
are consistent w ith real data, it is not a reliable
hypothesis. A model obtained by pure data min
ing may be consistent with the body o f data
that was mined to get it, but it is not a reliable
hypothesis if it is not consistent w ith at least some
other data (recall what was said about this earlier),
and it w ill not be understood if no theory to
explain it exists.

The V A R A pproach
Vector autoregression (VAR) is one w ay o f
looking fo r regularities in data. In VAR, a set o f
observable variables is chosen, a maximum lag
length is chosen, and the current value o f each
variable is regressed on the lagged values o f
that variable and all other variables. No exogenous
variables exist; all observable variables are
treated as endogenous. Except fo r that, a VAR
model is similar to the unrestricted reduced
form o f a conventional econom etric model. Each
equation contains only one current endogenous
variable, each equation is just identified, and no
use is made o f any possible theoretical information
about possible simultaneous structural equations
that might contain m ore than one current
endogenous variable. In fact, no use is made o f
any theoretical information at all, except in the
choice o f the list o f variables to be included and
the length o f the lags. In macroeconomics it is

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not practical to use many variables and lags in a
VAR because the num ber o f coefficients to be
estimated in each equation is the product o f the
number o f variables times the number o f lags
and because one cannot estimate an equation
that has m ore coefficients than there are obser
vations in the sample.

The A R IM A Approach
The Rox-Jenkins type o f time-series analysis is
another w ay to seek regularities in data. Here
each observable variable is expressed in terms o f
purely random disturbances. This can be done with
one variable at a time or in a multivariate fashion.
In the univariate case an expression involving
current and lagged values o f an observable
variable is equated to an expression involving
current and lagged values o f an unobservable
white-noise disturbance; that is, a serially inde
pendent random disturbance that has a mean
o f zero and constant variance. Such a formulation
is called an autoregressive integrated m oving aver
age (ARIM A) process. Th e autoregressive part
expresses the current value o f the variable as a
function o f its lagged values. Th e integrated part
refers to the possibility that the first (or higherorder) differences o f the variable, rather than
its levels, may be governed by the equation.
Then the variable's levels can be obtained from
its differences by undoing the differencing
operation—that is, by integrating first d iffe r
ences once, integrating second differences
twice, and so on. (If no integration is involved,
the process is called ARM A instead o f ARIMA.)
The moving average part expresses the equa
tion’s disturbance as a m oving average o f cur
rent and lagged values o f a white-noise disturbance.
To express a variable in A RIM A form , it is
necessary to choose three integers to character
ize the process. One gives the order o f the auto
regression (that is, the number o f lags to be
included fo r the observable variable); one gives
the order o f the m oving average (that is, the
number o f lags included fo r the white-noise dis
turbance); and one gives the order o f integration
(that is, the number o f times the highest-order
differences o f the observable variable must be
integrated to obtain its levels). The choice o f the
three integers (some o f which may be zero) is
made by examining the time series o f data fo r
the observable variable to see what choice best
conform s to the data. A fter that choice has been
made, the coefficients in the autoregression and
m oving average are estimated. The multivariate
form o f ARIM A modeling is a generalization o f the

univariate form . And, o f course, VAR modeling
is a special case o f multivariate ARIM A modeling.

ory but permit the adjustment path to be deter
mined largely by data.

VAR and ARIM A models can be useful if they
lead to the discovery o f regularities in the data.
If enduring regularities in the data are discovered,
w e have something interesting to try to under
stand and explain. In m y view, how ever, one
disadvantage o f both approaches is that they
make almost no use o f any knowledge o f the
subject matter being dealt with. To use univari
ate ARIM A on an economic variable, one need
know nothing about economics. I think o f
univariate ARIM A as mindless data mining. To
use multivariate ARIMA, one need only make a
list o f variables to be included and choose the
required three integers. To use VAR, one need
only make a list o f the variables to be included
and choose a maximum lag length. Knowledge
o f the subject the equations deal with can enter
into the choice o f variables to be included.

Testing Residuals f o r Random ness

It may seem that the ARIM A approach and the
conventional econom etric model approach are
antithetical and inconsistent with each other.
Zellner and Palm (1974), however, have pointed
out that if a conventional model's exogenous
variables are generated by an ARIM A process,
the m odel’s endogenous variables are generated
the same way.

General-to-Specific Modeling
General-to-specific modeling starts w ith an esti
mated equation that contains many variables
and many lagged values o f each. Its approach is to
pare this general form down to a more specific form
by omitting lags and variables that do not con
tribute to the explanatory p ow er o f the equation.
Much can be said fo r this technique, but o f
course it w ill not lead to a correct result if the
general form one starts w ith does not contain
the variables and the lags that belong in an
equation that is approximately correct.

The E rror Correction Mechanism
The error correction mechanism (ECM) provides
a w ay o f expressing the rate at which a variable
moves toward its desired or equilibrium value
when it is away from that value. Economic theory
is at its best when deriving desired or equilibrium
values o f variables, either static positions or
dynamic paths. ECM has so far not been good
at deriving the path follow ed by an economy that
is out o f equilibrium. Error correction models are
appealing because they perm it the nature o f the
equilibrium to be specified with the aid o f the

I have already discussed testing residuals fo r
randomness. If an equation's residuals appear to fol
low any regular or systematic pattern, this is a sig
nal that there may be some regular o r systematic
factor that has not been captured by the form
and variables chosen fo r the equation. In such a
case it is desirable to try to m odify the equation’s
specification, either by including additional vari
ables, by changing the form o f the equation, or
both, until the residuals lose their regular or
systematic character and appear to be random.

Stationarity
It is often said that the residual o f a properly
specified equation should be stationary, that is,
that its mean, variance and autocovariances
should be constant through time. H ow ever, fo r
an equation whose variables are grow in g over
time, such as an aggregate consumption or moneydemand equation, it would be unreasonable to
expect the variance o f the residual to be constant.
That would mean that the correlation coefficients
fo r the equation in successive decades (or other
time intervals) w ould approach one. It w ould be
m ore reasonable to expect the standard deviation
o f the residual to g ro w roughly in proportion to
the dependent variable, to one o f the indepen
dent variables, or to some combination o f them.

The Lucas Critique
Robert Lucas (1976) w arned that w hen an
estimated econom etric model is used to predict
the effects o f changes in governm ent policy var
iables, the estimated coefficients may turn out
w ron g and hence the predictions may also turn
out wrong. Under what conditions can this be
expected to occur? Lucas says that this occurs
w hen policymakers follow one policy rule
during the estimation period and begin to follow
a different policy rule during the prediction period.
Th e reason fo r this, he argues, is that in many
cases the parameters that w ere estimated are
not constants that represent invariant economic
relationships, but instead are variables that
change in response to changes in policy rules.
This is because they depend both on constant
parameters and on varying expectations that
private agents form ulate by observing policy
makers and trying to discover what policy rule
is being followed. Jacob Marschak (1953) fo re
shadowed this idea w hen he cautioned that

MARCH/APRIL 1993

predictions made from an estimated econometric
model w ill not be valid if the structure o f the
model (that is, its mathematical form and its
parameter values) changes betw een the estimation
period and the prediction period. Th erefore, to
make successful predictions after a structural
change, one must discover the nature o f the
structural change and allow fo r it.
I take this w arning seriously. It need not con
cern us w hen policy variations whose effects
w e want to predict are similar to variations that
occurred during the estimation period. But when
a change in the policy rule occurs, private agents
w ill eventually discover that their previous
expectation formation process is no longer valid and
will adopt a new one as quickly as they can. As they
do so, some o f the estimated parameters will
change and make the previously obtained esti
mates unreliable.

Goodhart’s Law
Lucas’ warning is related to Goodhart’s Law,
which states that as soon as policymakers begin
to act as if some previously observed relation
ship is reliable, it w ill no longer be reliable and
w ill change.3 A striking example is the shortrun, downward-sloping Phillips curve.

Are P olicy Variables Exogenous?
Most econom etric models treat at least some
policy variables as exogenous. But public policy
responds to events. Policy variables are not
exogenous. The field o f public choice studies
the actions o f policymakers, treating them as
maximizers o f their ow n utility subject to the con
straints they face. Econometric model builders have
so far not made much use o f public choice eco
nomics.

BY THEIR FORECASTS YE SH ALL
K N O W THEM (MODELS, T H A T IS)
Methods o f Evaluating M od els’
Forecasts
A conventional econom etric model contains dis
turbances and endogenous and exogenous varia
bles. Typically some o f the endogenous variables
appear with a lag. Consider an annual model with
data fo r all variables up to and including 1992.
Suppose that at the end o f 1992 w e wish to
forecast the endogenous variables fo r 1993, one
3See Goodhart (1981).

FEDERAL RESERVE BANK OF ST. LOUIS

year ahead. This is an ex ante forecast. For this
w e need estimates o f the m odel’s parameters,
which can be computed from our available
data. In addition, w e need 1993 values fo r the
lagged endogenous variables. These w e already
have because w e have values fo r the years 1992
and earlier. Further, w e need predicted 1993
values fo r the disturbances. W e usually use zeros
here because disturbances are assumed to be
serially independent with zero means. (Some
modelers, how ever, would use values related to
the residuals fo r 1992 and possibly earlier years
if the disturbances w ere thought to be serially
correlated.) Finally, w e need predicted 1993
values fo r the exogenous variables. These p re
dictions must be obtained from some source
outside the model.
Our predictions o f the endogenous variables
fo r 1993 w ill be conditional on our estimated
model and on our predictions o f the disturbances
and exogenous variables. If w e make errors in
forecasting the endogenous variables, it may be
because our estimated model is wrong, because
our predictions o f the disturbances or exogenous
variables are w rong, or because o f some combi
nation o f these.
It is possible—and desirable—to test the fo re
casting ability o f an estimated model independently
o f the model user's ability to forecast exogenous
variables. This is done w ith an ex post forecast.
An e,x post forecast fo r one period ahead, say
fo r 1993, is made as follows: W ait until actual
1993 data fo r the exogenous variables are avail
able, use them instead o f predicted values of
the exogenous variables to compute forecasts o f
the 1993 endogenous variables, and examine the
errors o f those forecasts.
W hen comparing forecasts from different m od
els, bear in mind that the models may differ in their
lists o f exogenous variables and that this may affect
the comparison. For example, a model that has
hard-to-forecast exogenous variables is not going
to be helpful fo r practical ex ante forecasting,
even if it makes excellent ex post forecasts.
Errors o f ex ante and ex post forecasts tell us
different things. Ex ante forecasting errors tell
us about the quality o f true forecasts but do not
allow us to separate the effects o f incorrect
estimated models from the effects of bad predictions
o f exogenous variables and disturbances. Ex post
forecasting errors tell us how good an estimated
model has been as a scientific hypothesis, which is

Table 1
Root Mean Square Percentage Errors of Ex Post Forecasts
with No Subjective Adjustments of the Forecasts, from about
1965 to 1973, Averaged over Eight Models__________________
Horizon
Variable
Nominal GNP
Real GNP
GNP Deflator

1 quarter
0.7 .
0.7
0.4

distinct from anyone’s ability to forecast exogenous
variables and disturbances. If you are interested
in the quality o f practical forecasting, you should
evaluate ex ante forecasts. If you are interested
in the quality o f a model as a scientific theory,
you should evaluate ex post forecasts. Ex post
forecasts are usually m ore accurate than ex ante
forecasts because the predictions o f the exogenous
variables that go into ex ante forecasts are
usually at least somewhat wrong.
W hat if w e want to make forecasts two years
ahead, fo r 1994, based on data up to and including
1992? W e need 1993 values fo r the endogenous
variables to use as lagged endogenous values for our
1994 forecast; however, w e do not have actual 1993
data. Hence w e must make a one-year-ahead fo re
cast fo r 1993 as before. Then w e can make our
1994 forecast using our 1993 forecasts as the
lagged values o f the endogenous variables fo r
1994. Thus the errors o f our 1994 forecast w ill
depend partly on the errors o f our 1993 fo re
cast and partly on the values w e use fo r the 1994
exogenous variables and disturbances. If w e want
to make forecasts fo r n years ahead instead o f
tw o years ahead, the situation is similar except
that n steps are required instead o f two. W e can
still consider either ex ante or ex post forecasts.
As before, ex post forecasts use actual values of
the exogenous variables.
W hen making ex ante forecasts, the typical
econom etric forecaster does not automatically
adopt the forecasts generated by a model.
Instead the forecaster compares these forecasts
with his subjective judgment about the future o f
the economy, and if there are substantial dis
crepancies, he makes subjective adjustments to
his m odel’s forecasts. This is usually done with
subjective adjustments to the predicted distur
bances. Thus the accuracy o f ex ante forecasts

4 quarters

8 quarters

2.0
1.9
0.6

4.5
2.5
1.9

typically depends not only on the adequacy of
the estimated model, but also on the model
builder’s ability to forecast exogenous variables
and to make subjective adjustments to the m od
el's forecasts. Paul Samuelson once caricatured
this situation at a meeting some years ago by
likening the process that produces ex ante
econom etric forecasts to a black box inside
which w e find only Law rence R. Klein!

Errors o f Forecasts f r o m Several
Econom etric M odels
Most presentations o f forecasting accuracy are
based on ex ante rather than ex post forecasts,
often with subjective adjustments, perhaps because
o f the interest in practical forecasting. I like to
look at ex post forecast errors without adjust
ments because I am interested in econometric
models as scientific hypotheses.
Fromm and Klein (1976) and Christ (1975)
discuss root mean square errors (RMSEs) o f
ex post quarterly forecasts o f real GNP, nominal
GNP and the GNP deflator one quarter to eight
quarters ahead by eight models with no subjec
tive adjustment by the forecaster. The models
w ere form ulated by Brookings, the U.S. Bureau
o f Economic Analysis, Ray Fair, Leonall Ander
sen o f the Federal Reserve Bank o f St. Louis, T.
C. Liu and others, the University o f Michigan
and the W harton School (two versions). For
GNP they show RMSEs rising from 0.7 percent
to 2.5 or 4.5 percent o f the actual value as the
horizon increases from one quarter to eight
quarters. For the GNP deflator they show
RMSEs rising from 0.4 percent to 1.9 percent,
as shown in table 1.
In a series o f papers over the past several
years, Stephen McNees (1986, 1988 and 1990)
has reported on the accuracy o f subjectively

MARCH/APRIL 1993

adjusted e^ ante quarterly forecasts o f several
m acroeconom etric models, fo r horizons o f one
to eight quarters ahead, and has compared
them w ith tw o simple mechanical forecasting
methods. One is the univariate ARIM A method
o f Charles Nelson (1984), which is called BMARK
(for benchmark). The other is the Bayesian vec
tor autoregression method o f Robert Litterman
(1986), which is called BVAR. The models dis
cussed in McNees (1988) are those form ulated
by the U.S. Bureau o f Economic Analysis, Chase
Econometrics, Data Resources Inc., Georgia
State University, Kent Institute, the University
o f Michigan, UCLA and Wharton.
McNees' results fo r quarterly forecasts may be
summarized in the follow ing five statements:
1. The models' forecast errors w ere usually
smaller than those o f BMARK.4
2. The models’ forecast errors w ere usually slightly
smaller than those o f BVAR fo r nominal GNP
and most other variables and slightly larger
than those o f BVAR fo r real GNP. Thus BVAR
was usually better than BMARK fo r real GNP.5
3. Forecast errors fo r the levels o f variables
became w orse as the forecast horizon length
ened from one quarter to eight quarters,
roughly quadrupling fo r most variables and
increasing tenfold fo r prices. However, fo re
cast errors fo r the growth rates o f many vari
ables (but not fo r price variables) im proved
as the horizon lengthened. In other words,
fo r many variables, the forecasts fo r grow th
rates averaged over several quarters w ere
better than the forecasts fo r short-term fluc
tuations.6
4. Mean absolute errors (MAEs) o f the models'
forecasts o f the level o f nominal GNP w ere
usually about 0.8 percent o f the true level for
forecasts one quarter ahead and increased
gradually to about 2.2 percent fo r forecasts
one year ahead and about 4 percent fo r fo re
casts tw o years ahead. Real GNP forecast
errors w ere somewhat smaller. Errors fo r
other variables w ere comparable. Price-level
forecast errors w ere smaller fo r the onequarter horizon but g rew faster and w ere
larger fo r the two-year horizon.7

5. W hen subjectively adjusted forecasts w ere
compared w ith unadjusted forecasts, the
adjustments w ere helpful in most cases,
though sometimes they made the forecast
worse. Usually the adjustments w ere larger
than optimal.8
One-year-ahead annual forecasts o f real GNP
by the University o f Michigan’s Research Center
in Quantitative Economics, by the Council o f
Economic Advisers and by private forecasters
covered by the ASA/NBER survey all had MAEs
o f about 0.9 percent to 1.1 percent o f the true
level, and RMSEs o f about 1.2 percent to 1.5
percent o f the true level.9 (The relative sizes o f
the MAEs and RMSEs are roughly consistent
with the fact that fo r a normal distribution, the
RMSE is about 1.25 times the MAE.)

Implications o f Worsening Ex Post
Forecast Errors
Because the root mean square error o f an
econom etric m odel’s
post forecasts roughly
quadruples w hen the horizon increases from
one quarter to eight quarters as in table 1, can
w e conclude that the model is no longer correct
fo r the forecast period? The answer is possibly,
but not certainly.
For a static model w e could conclude this because
the error o f each forecast w ould involve distur
bances only fo r the period being forecast, not
fo r periods in the earlier part o f the horizon.
Hence there is no reason to expect great changes
in the size o f the forecasting erro r fo r a static
model as the horizon increases. Small increases
will occur because o f errors in the estimates o f
the m odel’s parameters if the values o f the m od
el's independent variables m ove fu rth er away
from their estimation-period means as the hori
zon lengthens. This is because any errors in the
estimates o f equations’ slopes w ill generate
larger effects as the distance over which the
slopes are projected increases.
But most econom etric forecasting models con
tain lagged endogenous variables. Th erefore, as
noted previously, to forecast n periods ahead,
w e must first forecast the lagged endogenousvariable values that are needed fo r the n-periods-

4See McNees (1988 and 1990).

7See McNees (1988).

5See McNees (1990).

8See McNees (1990).

6See McNees (1988).

9See McNees (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

ahead forecast. This involves a chain o f n steps.
The first step is a forecast one period ahead,
whose error involves disturbances only from
the first period in the n-period horizon. The
second step is a forecast tw o periods ahead,
w hose erro r involves disturbances from the sec
ond period in the horizon and also disturbances
from the first period because they affect the
one-period-ahead forecast, which in turn affects
the two-periods-ahead forecast. And so on, until
the nth step, whose forecast error involves dis
turbances from all periods in the horizon from
one through n. Thus, fo r a dynamic model, the
variance o f a forecast n periods ahead w ill depend
on the variances and covariances o f disturbances
in all n periods o f the horizon, and except in
very special circumstances, it w ill increase as
the horizon increases.
T o decide w hether the evidence in table 1 shows
that the estimated models it describes are incor
rect fo r the forecast horizon o f eight quarters,
w e need to know w hether the RMSEs o f a correct
model w ould quadruple as the forecast horizon
increases from one quarter to eight quarters.
If they would, then the quadrupling observed in
the table is not evidence o f incorrectness o f the
estimated models. If they would not, then evi
dence o f incorrectness exists. W e do not have
enough information about the models underly
ing the table to settle this issue definitively, but
some simple examples w ill illustrate the principle
involved.
Suppose the model is linear and perfectly cor
rect, and suppose it contains lags o f one quarter
or m ore (as most models do). Then the variance
o f the error o f an n-periods-ahead forecast will
be a linear combination o f the variances and
covariances o f the disturbances in all periods o f the
horizon. In the simple case o f a single-equation
model, if the disturbances are serially indepen
dent and if the coefficients in the linear com bi
nation o f disturbances are all equal to one, the
variance o f the linear combination o f distur
bances fo r a horizon o f eight quarters w ill be
eight times that o f one quarter. So the RMSE o f
e,x post forecast errors from a correct model
w ill increase by a factor o f the square root o f
eight (about 2.8) as the horizon goes from one
quarter to eight quarters. I f the coefficients in
the linear combination are less than one, as in
the case o f a stable model w ith only one-period
lags, the variance o f the linear combination fo r

eight quarters w ill be less than eight times that
fo r one quarter. Hence the RMSE o f e?c post
forecast errors from a correct model will
increase by less than a factor o f the square root
o f eight as the horizon goes from one quarter
to eight quarters. In such a case, if the observed
RMSEs approximately quadrupled, it would cast
some doubt on the validity o f the model.
Consider a single-equation model with a single
lag, and no exogenous variables as follows:
y, = a + 0yt_, + e,
w h ere £ is a serially independent disturbance with
zero mean and constant variance o". Suppose that
the values o f a and P are known and thus no fo re
cast error is attributable to incorrect estimates of
these coefficients. Then the variance o f the error
2
o f a one-period-ahead forecast is a", that o f a twoperiods-ahead forecast is (1 + p ) o~, that o f a
three-periods-ahead forecast is (1 + p + p )cf, and
so on. The variance o f an n-periods-ahead forecast
is
' /T' o', which is equal to (1 - /TN a"/( 1 - p i.
)
Table 2 shows how the standard deviation o f
such a forecast error increases as the horizon
increases from one quarter to eight quarters fo r
several values o f the parameter p. Table 2 sug
gests that if the RMSE o f a m odel’s forecasts
quadruples as the horizon increases from one
quarter to eight quarters, either P (the rate o f
approach o f the model to equilibrium) must be
large or close to one, or the model is inade
quate as a description o f the forecast period.
Corresponding expressions can be derived fo r
multi-equation models w ith many lags and serially
correlated disturbances, but they are rather
cumbersome.

AN OLD, P L A IN -V A N IL L A
E Q U A TIO N T H A T STILL W O RK S,
R O UG H LY
Nearly 40 years ago Henry Allen Latane pub
lished a short paper in which he reported that
fo r 1919-52 the inverse o f the GNP velocity o f
M l is described by a simple least squares
regression on the inverse o f a long-term, highgrade bond rate RL as follow s:1
0
(1) Ml/GNP = .100 + ,795/RL, r" = .75
(t-ratio)
(10)

10See Latane (1954).

MARCH/APRIL 1993

Table 2
Standard Deviation of Error of N-Periods-Ahead Forecast
from the Equation yt = a + /?yt_, + et
Relative to the Standard Deviation of t, as a Function of N
and [i, when a and ft Are Known
Horizon, N
2

0.7070
0.8944
0.9486
1.0000

0.50
0.80
0.90
1.00

1.00
1.00
1.00
1.00

1.22
1.34
1.38
1.41

1.37
1.72
1.85
2.00

Here and in what follows, I have expressed inter
est rates in units o f percent per year, so a 5 per
cent rate is entered as 5, not as 0.05, and its inverse
0.20, not 20. The Appendix gives the definitions
and data sources fo r variables in this and sub
sequent equations. Latane showed the unad
justed correlation coefficient r, but showed nei
ther the standard deviation nor the t-ratio o f
the slope. I calculated the adjusted r and the tratio. The latter is the square root o f r2 (df) 1(1 - r 2
),
w h ere df, the number o f degrees o f freedom ,
equals 32.

This specification has some o f the properties o f
a theoretical m oney demand equation—namely, a
positive income elasticity (restricted to be con
stant and equal to one by construction) and a
negative interest elasticity (restricted to have an
absolute value less than one and not constant).
But its least-squares estimate w ould almost cer
tainly be biased or inconsistent, even if the form
o f the equation w ere correct, because the bond
rate is almost certainly not exogenous and hence
not independent o f the equation’s disturbances.

Nevertheless, this specification has continued
to w ork fairly w ell fo r other periods. Nearly 30
years ago Ml/GNP was described fo r 1892-1959
by a similar regression on the inverse o f M oody’s
Aaa bond rate w ith almost the same coefficients,
as follow s:1
1
(2) Ml/GNP = .131 + ,716/RAaa, r 2 = .76
(t-ratio)
(14)
1 See Christ (1963).
1

FEDERAL RESERVE BANK OF ST. LOUIS

8
1.41
2.04
2.39
2.83

oo
1.41
2.24
3.16
oo

For 1959-91 the same specification describes
the ratio o f M l to GNP w ith almost the same
coefficients, as follows:
(3) Ml/GNP = .085 + .774/RAaa, r 2 = .90
(t-ratio)
(13)
(17)
If GNP in equation (3) is replaced by the new
output variable GDP fo r 1959-91, the result is
almost identical, as follows:
(4) Ml/GDP = .086 + ,771/RAaa, ? 2 = .91
(t-ratio)
(13)
(18)
David Dickey’s discussion is based on the
1959-91 data that underlie equation (3).
For 1892-1991 a similar result is again
obtained, as follows:
(5) Ml/GNP = .083 + ,874/RAaa, ? 2 = .89
(t-ratio)
(11)
(28)
Table 3 shows the estimated equations (1) —(5)
and several other estimated equations that w ill
be described soon. Equations ( l 7 and (27 are
)
)
attempts to duplicate the results in equations (1)
and (2) using the same data base that is used in
equations (3), (5) and later equations. The Appen
dix gives data sources.
Figure 2 shows the graphs o f Ml/GNP and
1/RAaa over time. Figures 3 and 4 show the
scatter diagrams fo r equations (3) and (5),
respectively. (I should add that, o f the four

Table 3
Regressions of M1/GNP or M1/GDP on 1/RAaa and Other Variables*
(t-ratios are in parentheses)______________________________________
Estimated Coefficient (and t-ratio)
Eq

Sample

Constant

PLAIN-VANILLA EQUATIONS
1
1919-1952
.100
1'
1919-1952
.136(7)
2
1892-1959
.131
2'
1892-1959
.132(9)
3
1959-1991
.085(13)
4
1959-1991
.086(13)
5
1892-1991
.083(11)
AR(1) EQUATIONS**
15
1960-1991
.013
17
1893-1991
.020
ECM EQUATIONS**
18
1960-1991
.016(2.2)
19
1893-1991
.016(2.1)

1/RAaa

(M1/GNP)_,

(1/R A aa ).,

.795(10)
.713(10)
.716(14)
.712(14)
.774(17)
.771(18)
.874(28)

.75
.75
.76
.73
.90
.91
.89

.62
.38
.36
.48

.56

.267(2.8)
711(7)

.896(26)
.831(12)

-.2 3 9
-.5 9 1

.98
.95

1.82
1.60

.275(2.8)
.593(5)

.857(11)
.807(12)

- .212( —2.2)
- ,428( -3 .6 )

.98
.95

1.78
1.59

'T h e dependent variable is M1/GNP in all equations except equation (4), where it is M1/GDP. Definitions and data sources
for the variables M1, GNP, GDP and RAaa are given in the Appendix. As explained in the Appendix, a uniform set of data
for M1, GNP and RAaa was used for equations (1'), (2'), (3), (5) and later equations; slightly different data were used for
equations (1), (2) and (4). David Dickey’s discussion is based on equation (3) and the data underlying it. Equations (1') and
(2') are attempts to reproduce equations (1) and (2), respectively, using the same data that were used for equations (3), (5)
and later equations.
**AR(1) means “ first-order autoregressive.” ECM means “ error correction mechanism.”

equations that can be obtained by regressing
either the velocity o f M l or its inverse on either
RAaa or its inverse, the form that is presented
here fits the best.)
It is rather remarkable that this plain-vanilla
specification continues to describe the relation
betw een M l's velocity and the long-term Aaa
bond rate with such similar regression and cor
relation coefficients fo r the four periods, espe
cially in view o f the changes in interest-rate
regulation and in the definition o f M l that have
occurred over the last century. How ever, the
differences among the four estimated versions
are not negligible, as seen in a comparison o f
the computed values o f Ml/GNP that they yield.
For 1959-91 these computed values are shown
in figure 5 together with the actual values o f
Ml/GNP. Note that those computed from equa
tions (1) and (2) using 1919-52 and 1892-1959
data are ex post forecasts, whereas those from
equations (3) and (5) using 1959-91 and 1892-1991
data are within-sample calculated values. Figure 6
shows the values o f Ml/GNP obtained when
equation (3) based on 1959-91 data is used to
backcast Ml/GNP fo r 1892-1958, and it also

shows the actual values and the calculated
values from equation (5) using 1892-1991 data.
Th e forecasting and backcasting errors are by
no means negligible, but the general pattern o f
behavior o f Ml/GNP is reproduced.
The estimates o f the plain-vanilla equation are
rather stable across time, as indicated by fig
ures 7 and 8 which show the behavior o f the
slope as the sample period is gradually length
ened by adding one yea r at a time. In figure 7
the sample period starts w ith 1959-63 and is
extended a year at a time to 1959-91. In figure
8 the sample period starts w ith 1892-97 and is
gradually extended to 1892-1991. In each figure
the slope settles dow n quickly after jumping
around at first and varies little as the sample is
extended thereafter.
H ow ever, this simple specification does not by
any means satisfy all o f the desiderata listed
previously. In particular, the 1959-91 DurbinWatson statistic is a minuscule 0.38, and the
1892-1991 Durbin-Watson statistic o f 0.48, is not
much better, which suggests that the residuals
have a strong positive serial correlation. This by
itself would not create bias in the estimates if

MARCH/APRIL 1993

Figure 2
M1/GNP and 1/RAaa, 1892-91

Figure 3
Regression of M1/GNP on 1/RAaa, 1959-91
M1/GNP

1/RAaa

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 4
Regression of M 1/GNP on 1/RAaa, 1892-91
M1/GNP

1/RAaa

Figure 5
Actual, Computed and Forecast Values of M1/GNP from Regressions on
1/RAaa for Four Periods

MARCH/APRIL 1993

Figure 6
Actual, Computed and Backcast Values of M1/GNP from Regressions on 1/RAaa for
Two Periods

Figure 7
Estimates of Slope in Regression of M1/GNP on 1/RAaa for Samples
Starting in 1959 and Ending in 1963...1991

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 8
Estimates of Slope in Regression of M1/GNP on 1/RAaa for Samples
Starting in 1892 and Ending in 1897...1991

the equation form w ere correct and if the dis
turbance w ere independent o f the interest rate
and had zero mean and constant variance. But
it certainly suggests strongly that the equation
has not captured all its relevant systematic fac
tors. The graph o f the residuals o f the 1959-91
equation (3) against time is illuminating. It shows
an almost perfect 12-year cycle o f diminishing
amplitude with peaks (positive residuals) in 1959
(or possibly earlier), 1970 and 1982 and troughs
(negative residuals) in 1965, 1977 and 1990. It also
suggests a negative time trend. The residuals o f
the 1892-1991 equation (5) show a roughly sim
ilar pattern. (See figures 9 and 10.)
The very low Durbin-Watson statistics suggest
that the equation should be estimated either
using the first differences o f its variables, or
better, using the levels o f its variables with a
first-order autoregressive [AR(1)] correction
applied to its residuals. Estimation in levels with
an AR(1) correction w ould be appropriate if the
disturbance u in the original equation w ere
equal to its ow n lagged value times a constant,
p, plus a serially independent disturbance, £,
with constant variance, as follows:
(6) ut = p u t_, + £,

In this case, if the original equation is
(7) y, = a + / x + u, = a + /J , + pu,_, + £t
?,
x
,
the AR(1) correction subtracts p times the
lagged version o f equation (7) from equation (7)
itself and produces the follow ing equation:
(8) y, = py,_, + (1 - p ) a + (ixl - pp\l t + £,
This equation is nonlinear in the parameters
because the coefficient o f lagged x, -ftp , is the
negative o f the product o f the coefficients o f x
and lagged y. If that restriction is ignored and
the coefficient o f lagged x is denoted by y, the
equation becomes as follows:
(9) y, = Py,_, + (1 -

a + Pxt + yx( j + £
,

This equation can be given the follow ing error
correction interpretation. Suppose that the equil
ibrium value y * o f a dependent variable y is linear
in an independent variable x, as follows:
(10) y * = a + lixt
and that the change in y depends on both the
change in the equilibrium value and an error

MARCH/APRIL 1993

Figure 9
Residuals from Regression of M1/GNP on 1/RAaa, 1959-91

Figure 10
Residuals from Regression of M1/GNP on 1/RAaa, 1892-1991

FEDERAL RESERVE BANK OF ST. LOUIS

correction term proportional to the gap betw een
the lagged equilibrium and the lagged actual
values, as follows:
(11) Ay, = 0 A y *+ (1 -

(y *_, - y,_,) +£,

Substitution from equation (10) into equation
(11) implies an equation with the same variables
as the AR(1) equation (8) but with some different
parameters, as follows:
(12) y, = py, , + (1 - p )a + 0/Jx, + (1 - p - 0)/3x, , + £t
If the adjustment parameter 9 in equation (12)
w ere equal to one, then equation (12) would
becom e the same equation as (8).
Estimates in first differences would be appro
priate if the value o f p in equation (6), (7) and
(8) w ere one. In this case, equation (8) becomes
a first-difference equation, as follows:

The least-squares estimate o f equation (8) in
levels with the AR(1) correction fo r 1960-91 is
as follows:
,

= (1 - .896).126 + .267(1/RAaa - ,896/RAaa ,)
(t-ratio) (8)
(2.8)
(26)
with an adjusted R squared o f .98 and D W
equal to 1.82. This is equivalent to the follow ing
equation:
(15) Ml/GNP = .896(M1/GNP) ,
+ .013 + ,267/RAaa - ,239/RAaa ,
There is no evidence o f a trend.
The least-squares estimate in levels with the
AR(1) correction fo r 1893-1991 is as follows:
(16) Ml/GNP - .83KM1/GNP) ,
= (1 - .831).117 + .71 l(l/RAaa - .831/RAaa ,)
(t-ratio) (5)
(7)
(12)
with an adjusted R squared o f .95 and DW
equal to 1.60. This is equivalent to the follow ing
equation:
(17) Ml/GNP = ,831(M1/GNP)_,
+ .020 + ,711/RAaa - ,591/RAaa ,
Th ere is again no evidence o f a trend.

(18) Ml/GNP = ,857(M1/GNP) ,
(t-ratio)
(11)
+ .016 + ,275/RAaa - ,212/RAaa
(2 .2)
(2 .8)
( - 2 .2)
with an adjusted R squared o f .98 and DW
equal to 1.78. This is quite close to the AR(1)
result in equation (15), which suggests that the
adjustment coefficient 9 in equation (12) is not
very different from one. The hypothesis that in
equation (18) the coefficient o f lagged 1/RAaa is
equal to the negative o f the product o f the
coefficients o f 1/RAaa and lagged Ml/GNP, as
required by equation (8) and as satisfied by
equation (15), is strongly accepted by a Wald
test (the p-value is .59).
Least-squares estimation o f equation (12) for
1893-1991 (again without restricting 9 to be one)
yields the follow ing equation:

(13) Ay, = /?Ax, + e,

(14) Ml/GNP - ,896(M1/GNP)

Least-squares estimation o f the ECM equation
(12) fo r 1960-91 (without restricting 9 to be one)
yields the follow ing equation:

(19) Ml/GNP = ,807(M1/GNP) ,
(t-ratio)
(12)
+ .016 + ,593/RAaa - ,428/RAaa ,
(2.1)
(5)
(-3 .6 )
w ith an adjusted R squared o f .95 and D W
equal to 1.59. This is quite close to the AR(1)
result in equation (17), which again suggests
that the adjustment coefficient 9 in equation
(12) is not very different from one. The hypothesis
that in equation (19) the coefficient o f lagged
1/RAaa is equal to the negative o f the product
o f the coefficients o f 1/RAaa and lagged Ml/GNP,
as required by equation (8) and as satisfied by
equation (17), is accepted by a W ald test (the
p-value is .11).
Equations (15), (17), (18) and (19) are better
than the plain-vanilla equations (3) and (5) in
some respects, and w orse in others. They have
substantially higher adjusted R-squared values,
much less serial correlation in their residuals,
no evidence o f a time trend, and significant
coefficients. The ECM equations (18) and (19),
how ever, are very unstable over time. In equa
tion (18) the coefficient o f 1/RAaa varies from
about .6 fo r 1960-70, to .05 fo r 1960-78 and
1960-81, to .3 fo r 1960-86 and 1960-91. In
equation (19) the coefficient o f 1/RAaa varies
almost as much but remains at about .7 or .6 for
samples that include at least the years 1893-1950.

MARCH/APRIL 1993

Table 4
Regressions of A(M1/GNP) on A(1/RAaa) without a Constant*
(t-ratios are in parentheses)_______________________________
Eq

Sample

24
25

1960-1991
1893-1991

Coef of
A(1/RAaa)

.380(3.6)
.494(4.1)

.05
.15

1.23
1.76

‘ Definitions and data sources for the variables M1, GNP and RAaa are given in the appendix.

I conjecture that in the AR(1) equations (15) and
(17) the coefficient o f 1/RAaa is also unstable
across time because the AR(1) and ECM equa
tion estimates are quite similar.
By comparing equations (12) and (18), one can
solve fo r the 1960-91 estimates o f the four
parameters p, a, / and 0, in that order, to
3
obtain:
(20) p = .857, a = .112, ft = .441 and 8 = .624
This implies that the equilibrium relation in
equation (10) em bedded in the ECM is as
follows:
(21) (Ml/GNP)* = .112 + ,441/RAaa
Similarly, by comparing equations (12) and (19)
one can solve fo r the 1893-1991 estimates o f
the four parameters as follows:
(22) p = .807, a = .083, / = .855 and 6 = .694
?
This implies that the equilibrium relation in
equation (10) embedded in the ECM is as
follows:
(23) (Ml/GNP)* = .083 + ,855/RAaa
The tw o equilibrium relations in equations (21)
and (23) fo r the tw o periods 1960-91 and
1893-1991 are quite different, which is consis
tent with the instability o f the ECM specification
across time.
Now let us return to the first-difference equation
(13). The least-squares estimate fo r 1960-91 is
as follows:
(24) A(M1/GNP) = .380A(l/RAaa), r 2 = .05
(t-ratio)
(3.6)

FEDERAL RESERVE BANK OF ST. LOUIS

with D W = 1.23. For 1893-1991 it is as follows:
(25) AIMl/GNP) = .494A( 1/RAaa), ? 2 = .15
(t-ratio)
(4.1)
w ith D W = 1.76. Table 4 shows the estimated
equations (24) and (25). The estimates o f this
first-difference specification are not quite as
stable across time as those o f the specification
in levels o f the variables. This can be seen by
comparing equations (24) and (25) and also from
figures 11 and 12, which show the values o f the
estimates as the sample is increased one yea r at
a time, starting respectively w ith 1960 and 1893.
In each figure the estimates stabilize after an
initial period o f instability, but the values at
which they settle d iffer by a factor o f about .75.
If a constant term is included in equation (24),
which implies a trend term in equation (3), the
constant is small but significantly negative, the
slope falls to about .3, and the adjusted Rsquared and D W values im prove slightly. The
estimated slope, how ever, becomes w ildly unsta
ble across time. I f a trend variable is included
in equation (3), its coefficient is small but signifi
cantly negative, the interest-rate coefficient falls
to .49 and remains highly significant, the
adjusted R-squared and the D W values rise
slightly, and again the estimated slope is w ildly
unstable across time.
If a constant term is included in equation (25),
it is small and insignificantly negative, the rest
o f the equation is almost unchanged, and the
slope becomes quite unstable through time,
varying from .6 to zero and back to .6 again.
If a trend is included in equation (5), its co effi
cient is small but significantly negative, the
interest-rate coefficient is almost unchanged at
.81, the adjusted R-squared value rises a bit, the
D W value rises a bit, and the coefficient is
again w ildly unstable across time.

Figure 11
Estimates of Slope in Regression of A(M1/GNP) on A(1/RAaa) for
Samples Starting in 1960 and Ending in 1962...1991
10

\+ 2 Standard Error
♦

Estimates of Slope

.♦** - 2 Standard Error
-5

-10
1962

------- 1-------1
------- 1
--------1
------- 1
--------1
------- 1
--------1
------- 1
--------1-------1-------T
1
64

1990

Figure 12
Estimates of Slope in Regression of A(M1/GNP) on A(1/RAaa) for
Samples Starting in 1893 and Ending in 1896...1991

MARCH/APRIL 1993

On the whole, the first-difference specification
does not stand up well.
W here do matters stand? On the one hand,
w e have the plain-vanilla equation such as equa
tion (3), which fits only m oderately w ell and has
severe serial correlation in its residuals but has
an estimated slope that is rather stable across
time. On the other hand, w e have m ore compli
cated dynamic equations such as the ECM equa
tion (18), which fit much better and have nice
Durbin-Watson statistics but have estimated
coefficients that vary greatly across time. Nei
ther is quite satisfactory, but if the aim is to
find an estimated equation that w ill describe the
future as w ell as it does the past, I think I would
now bet on the plain-vanilla specification, even
though the relation o f its estimated coefficients
to structural parameters is unclear.

CONCLUSION
Econometrics has given us some results that
appear to stand up w ell over time. The price
and income elasticities o f demand fo r farm
products are less than one. The income elastic
ity o f household demand fo r food is less than
one. Houthakker (1957), in a paper com
m em orating the 100th anniversary o f Engel’s
law, reports that fo r 17 countries and several
different periods these income elasticities range
betw een .43 and .73. Rapid inflation is associated
w ith a high grow th rate o f the money stock.
Some short-term m acroeconom etric forecasts,
especially those o f the Michigan model, are
quite good.
But there have also been some nasty surprises
about which econometrics gave us little or no
w arning in advance. The short-run downwardsloping Phillips curve met its demise in the
1970s. (Milton Friedman [1968] and Edmund
Phelps [1968] predicted that it would.) The oil
em bargo o f 1973 and its aftermath threw most
models off. The slowdown o f productivity
grow th beginning in the 1970s was unforeseen.
The money demand equation, which appeared
to fit w ell and be quite stable until the 1970s,
has not fit so w ell since then.
H ow then should w e approach econometrics,
fo r science and fo r policy, in the future? As fo r
science, w e should form ulate and estimate
models as w e usually do, relying both on economic
theory and on ideas suggested by regularities
observed in past data. But w e should not fail to
test those estimated models against new data

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that w ere not available to influence the process
o f formulating them. As fo r policy, w e should
be cautious about using research findings to
predict the effects o f any large policy change o f
a type that has not been tried before.

REFERENCES
Christ, Carl F. “ Interest Rates and ‘Portfolio Selection’
among Liquid Assets in the U.S.,” in Christ et al., Meas
urement in Economics: Studies in Mathematical Economics
and Econometrics in Memory of Yehuda Grunfeid (Stanford
University Press, 1963).
________“ Judging the Performance of Econometric Models
of the U.S. Economy,” International Economic Review
(February 1975), pp. 54-74.
Friedman, Milton. Review of “ Business Cycles in the United
States of America, 1919-1932” by Jan Tinbergen, American
Economic Review (September 1940), pp. 657-60.
_______ . “ The Role of Monetary Policy,” American Eco
nomic Review (March 1968), pp. 1-17.
Fromm, Gary, and Lawrence R. Klein. “ The NBER/NSF Model
Comparison Seminar: An Analysis of Results,” Annals of
Economic and Social Measurement (Winter 1976), pp. 1-28.
Goodhart, Charles. “ Problems of Monetary Management:
The U.K. Experience,” in A. S. Courakis, ed., Inflation,
Depression, and Economic Policy in the IVesf (Barnes and
Noble Books, 1981).
Houthakker, Hendrik. “ An International Comparison of
Household Expenditure Patterns, Commemorating the
Centenary of Engel’s Law,” Econometrica (October 1957),
pp. 532-51.
Kendrick, John. Productivity Trends in the United States
(Princeton University Press, 1961).
Latane, Henry Allen. “ Cash Balances and the Interest Rate—
A Pragmatic Approach,” Review of Economics and Statistics
(November 1954), pp. 456-60.
Litterman, Robert B. “ Forecasting with Bayesian Vector
Autoregressions— Five Years of Experience,” Journal of
Business and Economic Statistics (January 1986),
pp. 25-38.
Lucas, Robert E. Jr. “ Econometric Policy Evaluation: A Critique,”
The Phillips Curve and Labor Markets, Carnegie-Rochester
Conference Series on Public Policy, vol. 1, (North-Holland,
1976), pp. 19-46.
Marschak, Jacob. “ Economic Measurements for Policy and
Prediction,” in William C. Hood and Tjalling C. Koopmans,
eds., Studies in Econometric Method, Cowles Commission
Monograph No. 14 (Wiley, 1953), pp. 1-26.
McNees, Stephen K. “ The Accuracy of Two Forecasting
Techniques: Some Evidence and an Interpretation,” New
England Economic Review (March/April 1986), pp. 20-31.
________“ How Accurate Are Macroeconomic Forecasts?”
New England Economic Review (July/August 1988),
pp. 15-36.
. “ Man vs. Model? The Role of Judgment in Fore
casting,” New England Economic Review (July/August 1990),
pp. 41-52.
Mitchell, Wesley C. Business Cycles: The Problem and Its Set
ting (National Bureau of Economic Research, 1927).
Nelson, Charles R. “ A Benchmark for the Accuracy of
Econometric Forecasts of GNP,” Business Economics
(April 1984), pp. 52-58.

Phelps, Edmund. “ Money-Wage Dynamics and Labor-Market
Equilibrium,” Journal of Political Economy {Pan II, July/August
1968), pp. 678-711.
Tinbergen, Jan. Business Cycles in the United States of
America, 1919-1932, Statistical Testing of Business Cycle

Theories, vol. 2, (League ot Nations, 1939).
Zellner, Arnold, and Franz Palm. “ Time Series Analysis and
Simultaneous Equation Econometric Models,” Journal of
Econometrics (May 1974), pp. 17-54.

A p pen dix
On Data F or T ables 3 and 4
A . DataJ'or equations ( l ') , (2 '), (3), (5), (1 4 -1 9 ),
and (2 4 -2 5 ):

1957 (Government Printing
Office, 1960), p. 656, series
X-333.
1939-91: Econom ic Report o f the
President, 1992, p. 378.

M l = currency plus checkable deposits, bil
lions o f dollars
1892-1956, June 30 data: U.S. Bureau
o f the Census. Historical Statistics
o f the U.S. fr o m Colonial Times to
1957 (Government Printing Office,
1960), p. 646, series X-267.
1957-58, June 30 data: Economic Report
o f the President, 1959, p. 186.
1959-91, averages o f daily data fo r
December, seasonally adjusted: Eco
nomic Report o f the President, 1992,
p. 373.
Note: Decem ber data, seasonally
adjusted, are close to June 30 data.
GNP = gross national product, billions o f dollars
per year
1892-1928: Kendrick (1961), pp. 296-7.
1929-59: Economic Report o f the
President, 1961, p. 127.
1960-88: Econom ic Report o f the
President, 1992, p. 320.
1989-91: Survey o f Current Business,
July 1992, p. 52.
RAaa = long-term high-grade bond rate, percent
per year
1892-1918: Macaulay's unadjusted
railroad bond rate, U.S. Bureau o f
the Census. Historical Statistics o f
the United States fr o m Colonial Times
to 1957 (Government Printing Office,
1960), p. 656, series X-332.
1919-91: Moody's Aaa corporate bond
rate:
1919-38: U.S. Bureau o f the Census.
Historical Statistics o f the United
States fr o m Colonial Times to

Note: For pre-1959 data I used sources
that w ere available in 1960, in an
attempt to make equation 2' reproduce
the 1892-1959 equation 2, which
originally appeared in Christ (1963).
These same sources also yield equation
1', which is an approximate reproduc
tion o f the 1919-52 equation 1, from
Latane (1954).
B. Data f o r 1959-91 f o r equation (4):
M l = currency plus checkable deposits, billions
o f dollars: same as above.
GDP = gross domestic product, billions o f dol
lars per year: Econom ic Report o f the
President, 1992, pp. 298 or 320.
RAaa = M oody’s Aaa corporate bond rate, per
cent per year: same as above.
C. Data f o r 1919— f o r equation (1), as
52
d escrib ed in Latane (1954), p. 457 :*
M l:

"demand deposits adjusted plus cur
rency in circulation on the mid-year
call date, (Federal Reserve Board Data).”
U.S. Bureau o f the Census. Historical
Statistics o f the United States fr o m
Colonial Times to 1957 (Government
Printing Office, 1960). Series X-267

GNP:

"Departm ent o f Commerce series from
1929 to date; 1919-28 Federal Reserve
Board estimates on the same basis
(National Industrial Conference Board,
Econom ic Almanac, 1952, p. 201).”

'Though Latane’s work was published in 1954, research
analysts at the Federal Reserve Bank of St. Louis used
more recent data to replicate his work.

MARCH/APRIL 1993

RAaa: "interest rate on high-grade long-term
corporate obligations. The U.S. Treasury
series giving the yields on corporate
high-grade bonds as reported in the
Federal Reserve Bulletin is used from 1936
to date. Before 1936 w e use annual aver
ages o f Macaulay’s high-grade railroad
bond yields given in column 5, Table
10, o f his Bond Yields, Interest Rates,
Stock Prices,” pp. A157-A161. Macaulay,
Frederick R. Bond Yields, Interest Rates,
Stock Prices (National Bureau o f Economic
Research, 1938).
D. Data f o r 1892—1959 f o r equation (2), as
d escribed in Christ (1963), pp. 2 1 7 -1 8 ;2
M l: “ currency outside banks” plus “ demand
deposits adjusted”, “ billions o f dollars as
o f June 30.”
2Though Christ’s work was published in 1963, research
analysts at the Federal Reserve Bank of St. Louis used
more recent data to replicate his work.

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U.S. Bureau o f the Census. Historical Statis
tics o f the United States fr o m Colonial Times
to 1957 (Government Printing Office, 1960).
Series X-267

U.S. Bureau o f the Census. Historical Statis
tics o f the United States fro m Colonial Times
to 1957; Continuation to 1962 and Revisions
(Government Printing Office, 1965).
Series X-267

RAaa: "long-term interest rate (M oody’s Aaa
corporate bond rate, extrapolated
before 1919 via Macaulay's railroad
bond yield index)”, "percent per year.”
GNP: "gross national product, billions o f dollars
per year.”

David A. Dickey
David A. Dickey is a professor of statistics at North Carolina
State University.

Commentary

IRST, LET ME EXPRESS my appreciation fo r the
invitation to participate in this conference. I have
made several visits to the Federal Reserve Bank
o f St. Louis and have enjoyed the hospitality o f Ted
and his associates. Carl Christ’s paper was interest
ing and thoughtful, prompting us to look again at
some philosophical issues in econometric modeling.
Tryin g to describe an ideal econom etric model
makes sense to me. W hen I am in the market fo r
a car, camera or other piece o f technological equip
ment, I often look at the top-of-the-line item to see
what it can do and then decide which features
I can give up to make my purchase affordable.
Carl Christ has done the same sort o f shopping
fo r an econom etric model, searching fo r the best
o f all possible models. W e likely cannot afford it,
in the sense that w e cannot really afford to fo r
mulate a model now and go fishing fo r several
years w hile test data accumulates. Nevertheless,
looking at the top-of-the-line type o f model will
let us see an upper bound on what w e can expect
models to give us and will give us a target point
to m ove tow ard even though w e have no hope
o f actually hitting the target.
Researchers see some o f the same statistical
strengths and weaknesses o f econometrics when
they apply statistics to the biological and physical
sciences. In both sciences you must decide which
independent variables are o f interest. Often these
are control variables like fertilizer, water, insec
ticides or in our case, interest rates. In actual

agricultural practice, insecticide and w ater are
often applied in response to observations on the
state o f the grow ing plants. Similarly in economics,
it is often hard to tell if a control variable, the
Aaa bond rate, fo r example, is a response to
observations on the econom y or a driver o f them.
Agronomists perform greenhouse experiments
in which they fertilize plants in amounts long
and short o f the perceived optimum to map out
a response curve fo r yield as a function o f fe r
tilizer. In contrast, economists are reluctant to
experim ent by (knowingly) setting control varia
bles at nonoptimal values.
It is w ell known in agriculture that greenhouse
results often do not translate directly to the field,
so agronomists, like econometricians, distinguish
micro from macro environments. Biologists also
typically know the lag relationships, if any,
involved in their experiments. Yield in August may
be related to fertilizer application in June, but
when do w e finish harvesting the effects o f a bank
closure or a tax increase? Biological organisms in
the field and the econom y respond to a great
number o f inputs and a big decision is which to
put into the model and which to leave as part
o f the erro r term.
An aspect o f model choice that Christ does not
particularly stress is the choice o f model form .
This is sometimes chosen to fit the data at hand
w ell and so can be part o f a data mining operation.
Many physical models, as w ell as econometric

MARCH/APRIL 1993

models, are not linear. Einstein’s famous E = MC2
is an example. In economics, the well-known MV = PY
can be made linear by taking logarithms. Such
transformations have implications fo r variance on
the original scale—a point I think is not often
appreciated. If log(M) = log(P) + log(Y) - log(V) +
e with e normal, then MV = PY[exp(e)] and therefore
the error is multiplicative, causing heterogeneity
o f variance in the untransformed data. Further,
nonlinear models like MV = PY pose problems of
aggregation. For example, suppose such a rela
tionship holds in all segments o f an economy.
W ill it then hold in the aggregate? Not necessarily.
T o illustrate, note that
(20M2) = (4)( 10)
and
(12)(6) = (18)(4).
H ow ever, if w e average 20 and 12, average 2 and
6, average 4 and 18, and average 10 and 4, w e
find that (16)(4) = 64, but that (H )(7 ) = 77. So apart
from any estimation errors, even exact relation
ships can hold on some scales but not on others.
Despite all these potential problems, people
have an inherent tendency to observe their
environm ent and draw inferences. Th ere seems
to be an optimism that with enough information
w e can solve any o f our problems, regardless o f
w hether they are economic problems, medical
problems or other kinds o f problems. Attempts
at problem solving w ill certainly persist, and
analysis and criticism o f these attempts, such as
Christ's, are w orthw hile activities. In fact, I think
one o f his main points is that w e are all statisti
cians, observing our w orld and m odifying our
models based on the data. This may be done
w ith or without numerical calculation. Model
selection is influenced by our previous observa
tions in a w ay that is hard to quantify.
I found the Mitchell quote from 1927 somewhat
offensive. The idea that with enough calculations,
any tw o series can be found correlated at 90
percent surely cannot be true o f inform ed and
careful statisticians and econometricians. N ever
theless, I can agree w ith the nature, if not the
extent, o f the problem. I can imagine someone
noticing how a black cat had crossed his path on
several occasions before a misfortune, thus giving
birth to a superstition.
Surely, how ever, the past must be somewhat
like the future. Living in North Carolina, fo r

FEDERAL RESERVE BANK OF ST. LOUIS

example, I do not carry earthquake insurance,
but I might if I lived in San Francisco. I suspect
that early mankind anticipated being cold in
w inter even without a good understanding o f
m eteorology. I do not think w e should dismiss
modeling as a w hole based on Lucas-critique
types o f considerations. Christ gives an example
o f a simple model that seems to have held up
over a fairly long period. This is good news and
I would go further to suggest that w e not give
up on statistical modeling even if w e can’t get
quite such good results every time. Along these
lines, I agree with Christ that ARIM A and VAR
are not as inform ative as a good econom etric
model, but they may do less damage to our
understanding o f the econom y than a m ediocre
econom etric model.
As a technical person, I feel obliged to address
at least one or tw o technical points. I note that
in the paper, some time was spent trying to decide
w hether a quadrupling RMSE would b^reasonable in a good forecasting model. W hen w e look
at the theoretical forecast erro r variances, w e can
argue that this variance could not increase by more
than a factor o f eight in going from a one-stepahead to an eight-step-ahead forecast. To com
pensate fo r the difference betw een estimated
and theoretical MSEs, it is then concluded that
if the estimated error mean square goes up by
a factor o f 16 (RMSE up by a factor o f four)
our model would be suspect. The probability o f
this quadrupling o f sample RMSE w ould depend
on the autocorrelation and the number o f fo re
casts used to estimate RMSE; fo r example, if w e just
look at a single one-step-ahead residual and a
single eight-step-ahead residual, the estimated
RMSEs w ill simply be the ratio o f the absolute
errors and hence w ill vary a lot around the
true values.
Suppose MSE is calculated by averaging the
squares o f k independent one-step-ahead errors
e(n + l ) and the squares o f the k corresponding
eight-step-ahead errors
z(n + 8) = e(n + 8) + r e(n + 7) + r2 e(n + 6) +
.... + r 7 e(n + 1)
from an AR(1) w ith autoregressive param eter r.
I estimated the probability that the sum o f k values
z(n + 8)~ is m ore than 16 times the sum o f the k
corresponding values e(n + l ) by a Monte Carlo
experiment with 10,000 replicates at each r and k.
Figure 1 summarizes the results w ith r = 0.5,
0.6, 0.7, 0.8 and 0.9. The num ber o f forecasts

Figure 1
Probability of Quadrupling
(versus number of squares in RMSE and first order autocorrelations)

from which RMSE is calculated is k = l, 2, 3 or
4. It is seen that, because o f the variation in
RMSE around its theoretical expected value, the
probability o f the eight-step-ahead RMSE exceed
ing four times the one-step-ahead RMSE can be
reasonably large (greater than 0.2 in the case
that k = 1) even with a perfect model and relatively
mild autocorrelation. As k gets large, and hence
as RMSE converges to the theoretical value dis
cussed in the paper, the probability declines.

Figure 1 shows the empirical frequency o f RMSE
quadrupling.
As another m inor technical point, I w ould like
to say that a lot o f new ideas are the same old
vanilla ones with a fe w sprinkles throw n on. In
his figure 3, Christ plots the inverse velocity
against the inverse Aaa bond rate data with
connecting lines indicating the time order o f the
data and w ith the regression line overlaid. W e

MARCH/APRIL 1993

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MARCH/APRIL 1993

100

could think o f this as the end view o f a threedimensional picture, which w e rotate and tilt a bit
in figures 2 and 3. The line is seen as the end o f
a three-dimensional plane. The data wander pretty
far up and dow n and right and left but never get
too far from the plane. Projections into the wall
and floor o f the plot show the tw o nonstationary
looking series, also depicted in Christ’s figure 2.
The tightness o f the data about the plane shows
that a linear combination o f the tw o series looks
fairly stationary. This is the idea o f cointegration.
Regression is one w ay o f finding cointegration in

FEDERAL RESERVE BANK OF ST. LOUIS

bivariate series. Other methods may give slightly
different planes, but w e can see that the main
ideas o f this currently popular econometric method
are quite close to simpler time-tested ones.

In closing, I think w e are at an exciting time fo r
econometrics. Some o f the computational burdens
have been lifted, and w e can concentrate m ore
on proper m odel form s and form ulation methods.
Philosophical guidance such as that offered by
Christ is important to keep in mind in our search.

101

D a v i d L a id le r

David Laidler is a professor of economics at the University of
Western Ontario, London, Canada.

Commentary

fA R L CHRIST’S PAPER is a w orth y tribute
to Ted Balbach. It is broad ranging, thoughtful
and provocative; and it deals with serious issues
too. M oreover, no small matter fo r this discus
sant, it is readily accessible to the stochastically
challenged. The best compliment I can pay it is
to add a fe w reflections o f my ow n on the
questions it raises.
It must now be at least 25 years since I first
heard Carl Christ discuss the importance o f test
ing models against data that had not been used
to build them. Even then he distinguished be
tween data generated before and after not just
the m odel’s estimation period, but also the actu
al time at which the model was constructed.
This last distinction is not often made, but Carl
convinced me that it is m ore important than w e
might think. I am glad he still stresses it. The
simple fact is that what w e know about eco
nomic history influences how w e build our
models in ways that w e barely recognize. Sup
pose w e decided today to build a model o f the
U.S. business cycle, to estimate it fo r the period
1948-70, and then to test it further against data
fo r 1971-92. W hen w e constructed our model,
w ould w e be able to ignore the tw o oil price
shocks during the 1970s, and would w e even be
right to ignore them if w e could? But if w e did
rem em ber the activities o f the Organization o f
Petroleum Exporting Countries, would it really
be the case that the structure fitted to the data
fo r 1948-70 would yield parameter estimates
unaffected by any influence from data generated
after 1970?
It is at least safer, and more convincing too, if
w e test our models against really new data—data

o f which w e w ere unaware at the time those
models w ere constructed. 1 must confess, though,
that the first time I heard Carl Christ make this
point, I was discomfited by his argument. In the
1960s I was estimating demand-for-money func
tions, and I did not much like the idea o f waiting
another decade or so before submitting my
results to a journal. The right scientific approach
was all w ell and good in its place it seemed to
me, but there w ere more mundane matters to
consider—promotion and tenure, fo r example.
But here w e are 25 years later, and the back is
sues o f economics journals are full o f empirical
studies, which w ere influential in their time but
are now half forgotten, whose results could be
subjected to real tests. How would the Jorgenson
investment equation or the Andersen-Jordan
equation stand up?1 There is a market niche
here waiting to be filled by applied econom etri
cians, not least those currently w orryin g about
the above-mentioned publishing criteria fo r pro
motion and tenure.
In his paper, Christ has shown us how to do
such w ork with his investigations o f what he
calls the plain-vanilla velocity equation, first pro
posed by Henry Latane’ in 1954. This rather odd
equation has held up surprisingly well. The use
o f the inverse o f the rate o f interest as an argu
ment surely (as Robert Rasche has suggested to
me) reflects Latane’ 's reluctance to use
logarithms to deal with a nonlinear relationship
in an age when such a transformation o f data
had to be carried out using tables and much
tedious interpolation therefrom . In the light of
Carl's results I am relieved to be able to report
that, even before reading his paper, I had decid-

1See Jorgenson (1963) and Andersen and Jordan (1968).

MARCH/APRIL 1993

102

ed to retain the paragraph dealing with L a ta n e’s
study in the new edition o f Demand f o r Money.2
From a certain view'point, the survival o f the
Latane" equation for a full three and a half de
cades is remarkable. It is, after all, best inter
preted as a rearrangem ent o f a supply-anddemand-for-money system, and as Carl also tells
us, the last tw o decades have not been kind to
empirical demand-for-money functions. But at
least one precedent in the literature occurred,
namely Robert E. Lucas Jr.’s demonstration that
Allan Meltzer's long-run demand-for-money
function also seems alive and w ell when viewed
in light o f m ore recent data.3
N ow w e must not claim too much here, and
Carl does not. The Latane" equation displays many
faults calculated to shock the econom etric
purist—fo r example, auto-correlated residuals.
W hen these are attended to w ithin sample, the
out-of-sample perform ance o f the m ore sophisti
cated formulation seems to deteriorate. Similar
ly, Lucas showed that though subsequent data
still seemed to move around M eltzer’s relation
ship, they did so w ith a great deal o f complex
serial correlation. But still, I think there is a les
son to be learned here, one which I began to
develop in the second (1977) edition o f Demand
f o r Money and w hich w ork using co-integration
techniques is now tending to support. The les
son is this: what w e call the long-run demandfor-m oney function is indeed a stable structural
relationship, give or take ongoing institutional
change, which w e often deal with by adapting
our w ay o f measuring money. What w e call the
short-run function, how ever, is not structural at
all. It is rather an ill-understood, quasi-reduced
form characterizing the mutual dynamic interac
tion o f the money supply and the variables on
which the demand fo r money depends in the
long run.
This w ay o f looking at things helps explain
w hy co-integration studies produce evidence
consistent with the existence o f a stable longrun demand-for-money function and w hy simple
regressions o f the type estimated by Latane’ and
M eltzer hold up rather well. As David Dickey
has told us here, simple regression is one w ay
o f looking fo r co-integration. It also helps ex
plain w hy the error correction mechanisms as
sociated with co-integration relationships are
complicated and unstable, w hy the dynamics of
2See Laidler (1993).
3See Lucas (1988) and Meltzer (1963).

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so-called short-run demand-for-money functions
have tended to break down as sample periods
are extended, and w h y more sophisticated esti
mation techniques, designed to cope with autocorrelated residuals, applied to relationships like
the Latane equation produce results that are
less robust over time than the plain-vanilla ver
sion. Have w e not, after all, known all along
that changes in the money supply affect the
econom y with long and variable time lags,
which, among other things, involve feedbacks to
the money supply itself? And if w e have known
that all along, should w e be surprised if w e get
now here with studies o f m onetary dynamics
that do not begin by specifying a model o f the
aforem entioned interaction that will perm it us
to identify the structural parameters o f the sys
tem w e are investigating?
It is all much easier said than done, o f course,
but it w ill not be done if no one tries, and I
hope therefore that Carl Christ’s striking results
fo r Latane’s equation w ill prompt someone to
carry his investigation further.

REFERENCES
Andersen, Leonall C., and Jordan, Jerry L. "Monetary and
Fiscal Actions: A Test of Their Relative Importance in Eco
nomic Stabilization,” this Review (November 1968), pp.
11-24.
Jorgenson, D.W. “ Capital Theory and Investment Behavior,”
American Economic Review (May 1963), pp. 247-59.
Laidler, David. The Demand for Money—Theories, Evidence
and Problems, 4th ed. (Harper-Collins, 1993).
Latane, Henry. “ Cash Balances and the Interest Rate— a
Pragmatic Approach,” Review of Economics and Statistics
(November 1954), pp. 456-60.
Lucas, Robert E. Jr. “ Money Demand in the United States: A
Quantitative Review,” Money, Cycles and Exchange Rates:
Essays in Honor of Allan H. Meltzer (Carnegie-Rochester
Conference Series on Public Policy (Autumn 1988), pp.
137-67.
Meltzer, Allan H. “ The Demand for Money—the Evidence
From the Time Series,” Journal of Political Economy (June
1963), pp. 219-46.

103

Allan H. M e ltz e r
Allan H. Meltzer is a professor of political economy and public
policy at Carnegie Mellon University and a visiting scholar at the
American Enterprise Institute. Thanks to Craig Hakkio, Carl Christ
and Bennett McCallum who commented on an earlier draft and
to Jeffrey Liang who contributed more than the usual assistance.
A preliminary version was presented at the 1992 Western
Economic Association session honoring Milton Friedman on
his 80th birthday.

Real Exchange Rates: Some
Evidence f rom the Postwar Years

HE MOVE TO FLEXIBLE EXCHANGE RATES
early in 1973 is the type o f experim ent that
economic researchers experience rarely. A marked
change in m onetary regim e from fixed to flexible
rates was follow ed by years o f floating rates.
Initially, some governm ents may have thought o f
flexible rates as a tem porary expedient to last only
until new parities w ere firm ly established. Within
a few years, how ever, the governm ents o f prin
cipal developed countries, including the United
States, accepted flexible rates as a durable arrange
ment. Although there has been considerable inter
vention in the currency markets, attempts at
policy coordination and talk about target zones
(particularly in recent years), the dollar and sev
eral other currencies have continued to float.
Most major trading countries have reduced or
rem oved exchange controls and other restric
tions on capital mobility.
A frequent, and probably the dominant, assess
ment o f experience with flexible rates is that they
have not w orked as anticipated. Robert Aliber
(1992, p. 44) w rites that "Few o f the advantages
noted by proponents o f floating exchange rates
have been realized in the 1970s and the 1980s.”
Krugman and M iller (1992, p. 1) share this view
and, in addition, criticize theories o f exchange
rate determination. They write that “ interventionist

economists believed that left to themselves
exchange markets w ould introduce unnecessary
and harmful volatility into the exchange rate.”
These w riters summarize the current state o f
research as showing that m onetary models
"have had almost no empirical success. Indeed,
money supplies, if they enter at all, typically
enter w ith the w ro n g sign.” (ibid, p. 9)
Singleton (1987, p. 9) reports the professional
judgment that "b y most measures, exchange rates
have been relatively unstable since 1973.” He re
cognizes, how ever, that the instability may reflect
uncertainty that the public faces in adjusting to
information about the future. And he notes that
observed variability o f exchange rates may have
low er w elfa re costs than alternative regimes.
Mussa (1986) studied fluctuations in bilateral
exchange rates fo r the principal market econo
mies. He showed that the variability o f bilateral
real exchange rates from 1957 to 1984 was eight
to 80 times higher in flexible-rate periods. There
w ere no examples o f low er variability under flex
ible rates among the 17 countries studied. The
reason is clear from Mussa's data. Under flexi
ble exchange rates the variability o f nominal
exchange rates increases much m ore than the
variability o f the ratio o f relative price levels
declines. In fact, the variance o f bilateral rela

MARCH/APRIL 1993

104

tive price levels was not always low er in flexiblerate regimes.
Mussa did not draw any conclusion about the
w elfare properties o f alternative regimes. The
increased variance o f bilateral real exchange
rates may substitute fo r the variance o f other
variables, may be absorbed at relatively low
cost by hedgers and speculators in financial
markets, or in part may represent permanent
shocks, such as the oil shocks o f the 1970s and
1980s, that require adjustment o f relative prices
and real values. But the alternative is also plau
sible. Some o f the higher variances under fluc
tuating rates may be the source o f excess burden.
A main problem in reaching a judgment about
the operation o f fluctuating rates is that there is
no benchmark fo r comparing alternative regimes.
Economic models o f exchange rates have per
form ed poorly compared with statistical models
such as the random walk. Many papers report that
there is no significant relation, often no evidence
o f any reliable relation, betw een exchange rates
and other economic variables. Meese and Rogoff’s
(1983) well-known paper found that a random
walk perform ed as w ell out o f sample as any
estimated structural model. This suggests that
many changes in exchange rates are random
events, unrelated to policy or macroeconomic
perform ance. Chinn (1991) summarizes recent
tests fo r cointegration o f real and nominal ex
change rates w ith standard economic aggregates
such as money and output at home and abroad
or, fo r nominal exchange rates, relative rates o f
inflation. The tests reject cointegration, suggest
ing that there is no long run relationship between
exchange rates and any o f these aggregates.
Critics have commented especially on the rela
tively large change in dollar exchange rates in
the 1980s. Even Haberler (1987), a long-time
proponent o f floating refers to “ the widespread
disenchantment with floating exchange rates.”
Critics have not been satisfied with computa
tions showing that the variances o f exchange
rates, like the prices o f other traded assets,
exceed the variances o f prices o f current pro
duction. Nor have they accepted as sufficient
explanation fo r observed variability that foreign
exchange markets, like other markets fo r traded
'See Frenkel (1983).
2The qualification is needed because some testable proposi
tions result. Changes may be unbiased or larger in periods
of large shocks such as wars and oil price changes.
3See Wallich (1984).

FEDERAL RESERVE BANK OF ST. LOUIS

assets, respond to new information, which arrives
continuously in a changing w orld .1 Without
evidence showing that the news is systemati
cally linked to exchange rate changes and that
the adjustments are tow ard a new equilibrium,
the proposition is nearly em pty.2
A longer summary o f the large literature on
flexible rates w ould belabor the obvious. Neither
the critics nor the proponents o f flexible exchange
rates have produced much evidence on which
to base comparative judgments about exchange
rate regimes. Claims that variability is larger or
too large are meaningless unless an alternative
is specified and its properties compared. Yet it
is common to find statements that flexible rates
have not w orked as expected. They "do not sub
stantially shield a country from events abroad”;
that “ current account imbalances have been pro
tracted”, and that "w ide movement and reversals
have contributed to the widespread impression
that floating rates tend to overshoot.” "Although
clean floating has not yet becom e a dirty word,
the simple faith that the market is always right
has been shaken.”3
This paper reconsiders experience under flexible
exchange rates. Section 1 summarizes the claims
about flexible rates in Milton Friedman's classic
1953 paper to show that Friedman’s claims are
m ore modest than is often supposed. Section 2
presents some key facts about exchange rates
and comparative variability o f several variables
under fixed and flexible rates. Section 3 esti
mates a model o f the so-called real exchange
rate under Bretton W oods and flexible rates
and tests fo r the effect o f econom ic aggregates
on the exchange rate. The m odel incorporates
some o f the principal variables affecting exchange
rates suggested by Friedman. Section 4 discusses
some limitations o f the results. A conclusion
completes the paper.

FR IE D M AN ’S CASE FOR FLEXIBLE
EXCHANGE RATES
In "T h e Case fo r Flexible Exchange Rates,”
w ritten shortly after the Bretton W oods System
started, Friedman claims four benefits fo r flexi
ble rates: (1) increased liberalization o f trade, (2)
avoidance o f direct controls, (3) facilitation o f

105

rearmament, and (4) harmonization o f internal
monetary and fiscal policies.4 The point that
concerned later critics most, variability or insta
bility, is dismissed early with the claim that
exchange rate instability reflects instability in
the econom y and is not a property o f a flexible
or floating rate system. This claim is not selfevident, and it has not been accepted by the
principal critics o f flexible rates. Friedman
appears to have anticipated this outcome. He
devotes m ore space to refuting or dismissing
the charge o f instability than to making the
positive case fo r the four benefits claimed for
flexible rates.
Friedman’s essay does not claim that flexible
exchange rates are optimal fo r all countries or
even fo r a single country. W hen discussing the
form er sterling bloc, he considers a mixed sys
tem in which groups o f countries may elect to
maintain fixed exchange rates internally and
flexible rates against all other groups or coun
tries. Although there are structural differences
betw een the sterling bloc and the proposed
European M onetary Union, Friedman anticipates
the principal issues: policy harmonization, avoid
ance o f trade controls and exchange restrictions,
absence o f a political authority and, in the absence
o f controls, the need to choose betw een unem
ploym ent and exchange rate changes in the
short term.

by the critics o f flexible rates. The critics typi
cally argue that speculation is (or can be)
destabilizing.
Friedman considers and rejects some common
conjectures about destabilizing speculation. His
main argument is that there is no empirical
foundation fo r these claims. Appearances to the
contrary are misleading and subject to misin
terpretation. A main problem in any study is to
separate the actions o f speculators based on
correct predictions o f parity changes and actions
that cause parity changes that would have been
avoided. These problems arise under an adjustable
peg, but Friedman claims they would be prevented
under continuous adjustment o f flexible rates.
Friedman is cautious, how ever. He avoids a gen
eral claim that speculation is stabilizing. Instead,
he argues that if destabilizing speculation is com
mon, governments (or exchange stabilization funds)
would profit by intervening. And he recognizes
that governm ents may have m ore information
or m ore timely information that gives them an
advantage over private speculators. He is willing
to let a governm ent agency intervene to smooth
tem porary fluctuations if they can do so profita
bly (p. 188), but he is skeptical that they would
be able to profit consistently. They are less likely
to profit, he claims, than private speculators who
risk their ow n wealth.

Recognizing that optimality o f flexible rates can
not be established, Friedman limits his claim to the
judgment that flexible exchange rates are more
desirable socially than the four alternative means
o f offsetting changes in international position.
The fou r alternatives are: (1) official changes in
currency reserves; (2) changes in domestic price
levels and incomes; (3) periodic realignment o f
parities; and (4) direct controls.

The reason fo r choosing flexible rates is that
other means o f adjustment are less satisfactory.
Fixed exchange rates w ere maintained in the
19th century because the public and govern
ments tolerated larger fluctuations in domestic
prices and employment than would be accepta
ble in the late 20th century. Direct controls are
least satisfactory because they introduce distor
tions and do not correct permanent differences in
relative prices in foreign and domestic markets.

The key conditions are posited. First, with flexi
ble exchange rates, there are "broad, active, and
nearly perfect markets ... in foreign exchange”
w henever they are permitted. Second, a fixed
but adjustable exchange rate “ insures a maxi
mum o f destabilizing speculation. Because the
exchange rate is changed infrequently and only
to meet substantial difficulties, a change tends
to come w ell after the onset o f difficulty, to be
postponed as long as possible.”5 These condi
tions, it seems fair to say, have not been accepted

Tim ing o f adjustments is a source o f variabil
ity about which little is known with precision.
Anticipating future discussion, Friedman con
siders overshooting and undershooting o f ex
change rates. Overshooting arises because initial
adjustment is borne by prices that adjust most
readily. The exchange rate is such a price. Later
other prices adjust, and the overshooting reverses,
although it may be replaced by undershooting
o f the final change, follow ed by a series o f ad
justments around the new equilibrium.

4The essay was written in 1950 but not published until 1953.
5See Friedman (1953), pp. 162-64.

MARCH/APRIL 1993

106

Thus Friedman recognizes that there will be
variability and fluctuations o f exchange rates,
not prompt, rapid adjustment from the old to
the new equilibrium. The possibility that the
fluctuations, though not destabilizing, produce
excess burden and w elfare loss is not addressed
directly. Friedman’s main response to this central
issue is comparative. His conclusion can be sum
m arized in tw o paragraphs.
First, comparison o f exchange rate regimes
must include the costs o f adjustment under
alternative policies. The comparison cannot be
limited to the size o f changes in exchange rates
or the variability o f exchange rates under dif
ferent regimes. Changes in the relative prices o f
goods and services are not the same under dif
ferent policies. W ith gradual adjustment o f real
wages and other relative prices, labor market
adjustment, hence unemployment rates, w ill dif
fe r under different regimes. And direct controls
introduce distortions and w elfare losses.
Second, there is no presumption that social costs
could not be increased by flexible exchange
rates. “ About all one can say ... is that there
seems no reason to expect the timing or pace of
adjustment under the assumed conditions [flexi
ble exchange rates] to be systematically biased
in one direction or the other from the optimum
or to expect that other techniques o f adaptation through internal price changes, direct controls,
and the use o f m onetary reserves with rigid ex
change rates—w ould lead to a m ore nearly opti
mum pace and timing o f adjustment.”6

EXCHANGE RATE CHANGES AN D
V A R IA B IL IT Y , 1973-90
Excessive variability is one o f the main issues
raised by the critics o f flexible rates. Evidence
o f increased variability o f real or nominal ex
6See Friedman (1953). The conflicts in the system devel
oped more slowly than Friedman predicted. He predicted
that “ direct controls over exports and imports would be
reimposed on a large scale within two or three years at
the most.” This prediction was inaccurate. The United
States introduced some controls on capital movements in
the 1960s, but the trend in the 1950s and 1960s was
toward reduction of trade barriers under General Agree
ment on Tariffs and Trade rules. The conflicts in the sys
tem were resolved partly by changes in parities abroad but
mainly by inflation in the 1960s and early 1970s.
7The so-called real exchange rate measures the ratio of the
price level in the United States to a weighted average of
foreign price levels expressed in a common currency.

FEDERAL RESERVE BANK OF ST. LOUIS

change rates after 1973 is easy to produce. To
draw any conclusion about the effects on w el
fare, tw o issues must be resolved. First, as
Friedman noted, increased variability o f exchange
rates may reduce variability o f output, con
sumption, em ployment or other variables o f
interest to consumers. Reduced variability o f
these variables can produce a w elfa re gain
despite the increased variability o f exchange
rates. Second, increased variability o f exchange
rates may result from real shocks, such as an
oil shock, or from policy activism, or it may
reflect increased knowledge o f the operation o f
exchange markets.

This section considers changes and variability
o f exchange rates and some other variables under
Bretton W oods and flexible rates. Figure 1 shows
the monthly trade-weighted nominal and real ex
change rate fo r the United States, using Federal
Reserve weights, fo r the period 1973-90. A rise
in the index is an appreciation o f the dollar. T w o
facts are immediately apparent. First, real and
nominal exchange rates m ove together and by
similar amounts.7 This fact has been demonstrated
repeatedly fo r bilateral rates. See Mussa (1986)
and Edwards (1989) fo r studies o f developed
and developing countries. Second, trade-weighted
exchange rates moved over a relatively w ide
range during the 18-year period. The movement
is dominated by a persistent appreciation from
1980 to 1985 follow ed by a persistent deprecia
tion lasting to early 1987. Both exchange rates
then returned to approximately the same range
they had left in 1979.

Other measures o f trade-weighted exchange
rates developed by the International M onetary
Fund (IMF) using wholesale prices or unit labor
costs in the various countries to compute real
exchange rates show the same general pattern.
Experiments with different w eighing patterns

107

Figure 1
Trade-Weighted Nominal and Real Exchange Rates
Index (1973:3=100)

Monthly 1973:1 to 1990:12

160150140130120110 100-

9080-

do not appear to change the general features,
although computed variances and ranges d iffer
fo r the individual measures.8
The exchange rate data shown in figure 1 raise
tw o issues that w ill concern us. First, w hy do
real and nominal exchange rates move together?
Second, is the higher variability o f real exchange
rates under fluctuating exchange rates caused
by policy actions, or is there evidence o f excess
burden arising from increased variability unrelated
to policy action?

sumer price indexes fo r the tw o countries. In
the first years, the real and nominal exchange
rates differ; consumer prices rose m ore rapidly
in Japan than in Germany. In real terms Japan
paid m ore yen per mark than in nominal terms.
A fter 1976, the tw o price levels had about the
same rate o f change, so the real and nominal
exchange rates are often indistinguishable on
figure 2.

The similarity o f real and nominal exchange
rate changes in figure 1 is not peculiar to U.S.
data. Figure 2 shows monthly values o f the ex
change rate o f the Japanese yen fo r the German
mark during the period 1973-90. The real ex
change rate is obtained using the relative con

Mussa’s (1986) study o f changes in bilateral
exchange rates fo r a broad sample o f developed
countries during the years 1957-1984 found the
same result. Under flexible exchange rates, changes
in nominal and real exchange rates are highly
correlated, but changes in nominal or real ex
change rates are not closely correlated with
changes in the ratio o f price index numbers.

8Becketti and Hakkio (1989) computed the correlation
between innovations in seven alternative measures of
trade-weighted exchange rates. Most of the correlations
are above 0.9 using quarterly data for 1976 to 1988. They
show that similar results hold for percentage rates of
change of exchange rates.

the start of each decade-1960, 1970 and 1980-to adjust for
changes in relative trade shares. The main conclusion
sensitive to the change in weights is that the variance of
the trade-weighted real exchange rate is lower for the
alternative measure. I have used the Federal Reserve
index throughout.

The Federal Reserve index uses weights reflecting country
shares of world trade. I computed an alternative index
based on U.S. trade weights and reweighted the index at

MARCH/APRIL 1993

108

Figure 2
Real and Nominal Yen/DM Exchange Rates
Yen/DM

Monthly 1973:1 to 1990:12

150140-

120

110 -

100

60 I------ 1-----1----- 1-----1----- 1----- I------1----- 1----- 1-----1.....................................................
- - - - - - - .
1973 74

76 77

79 80

M eltzer (1990) considered the variability of
multilateral exchange rates using data from the
IMF. Real exchange rates are based on both
relative wholesale prices and relative unit labor
costs, and variances are used to measure varia
bility. Again, countries with flexible exchange
rates had greater variability o f nominal and real
exchange rates than countries in the European
Monetary System (EMS) that maintained an ad
justable peg with other members of the EMS.
Changes in real and nominal exchange rates
w ere highly correlated under flexible rates. H ow
ever, the variability o f relative unit labor costs
was typically low er in the countries with flexi
ble exchange rates, whereas the variability of
wholesale price ratios was higher.
Table 1 summarizes these data. Both nominal
(N) and real (R) exchange rate changes are more
variable under flexible exchange rates than under
fixed but adjustable rates, whereas relative prices
are not. The variability o f R or N under flexible
rates is significantly different at the 1 percent
level from the variability experienced under
EMS or the mixed regimes (denoted other) that
had crawling pegs or some other type o f par
tially fixed nominal exchange rate during this

FEDERAL RESERVE BANK OF ST. LOUIS

84 85

87 88

89 90 1991

period. Changes in multilateral real exchange
rates are 4 or 5 times m ore variable in flexiblerate countries than in the EMS. Generally, the
variances fo r “ other” countries lie betw een the
variances fo r the EMS and flexible-rate coun
tries. The exception is IJ]L —the variability of
C
changes in relative prices based on unit labor
costs, IJ C has been low er on average under
,L
flexible rates, although the difference betw een
regimes is not significant by the usual standards.
The much-discussed increase in the variability
o f real exchange rates in a flexible exchange rate
regim e may reflect only that flexible exchange
rates change m ore frequently, whereas the rela
tive price ratios are not much affected by the
change in regime. Using the terms o f trade as a
measure o f relative prices, table 2 shows that
the variances o f relative price ratios do not dif
fe r systematically across exchange rate regimes.
Variability o f the terms o f trade rose in all coun
tries but to different degrees unrelated to the
exchange rate regime. The comparatively high
variability o f Japan’s terms o f trade suggests
that there is no simple relation betw een the
variability o f this measure and the grow th of
trade.

109

Table 1
Variances of Changes in Relative Prices, Real and Nominal
Exchange Rates 1/1979-111/1989__________________________
Average Quarterly Values x 100
Flexible Rates2
EMS1
Pwp
R ulc

RWp
N

Other3

.007
.037
.154
.158
.143

.013
.017
.037
.033
.025

P ULC

.017
.030
.058
.059
.043

’ Austria plus seven EMS countries (Belgium, Denmark, France, Germany, Ireland, Italy,
Netherlands)
2Japan, Switzerland, United Kingdom and the United States
3Norway, Spain, Sweden, Finland and Canada
Source: IMF where N s Ft + P
NOTE:
P
R
N

is the first difference of the logarithm of the relative price of domestic to foreign goods or services.
is the first difference in the logarithm of the real exchange rate
is the first difference in the logarithm of the nominal exchange rate

Table 2
Variances under Fixed and Flexible Rates
United States, Germany, Japan and the United Kingdom
(quarterly values at annual rates)
Real GNP or GDP
Period
1/1960—
111/1971
1/1973-111/1991
Relative value
1/1973-11/1975
111/1975-11/1980
111/1980—
111/1987
IV/1987-111/1991

U.S.
11.0
15.7
1.4
24.2
19.7
13.3
5.2*

Germany
27.9
8.5
0.3
10.6*
7.1*
6.6*
3.5*

Japan
32.3
11.3
0.3
37.4
5.1*
5.8*
7.8*

TOT
U.K.
30.0
32.6
1.1
70.5
59.8
10.6*
11.0*

U.S.
15.5
92.2
5.9
202.3
60.2
61.7
71.0

Germany
26.0
92.5
3.6
285.2
52.4
78.2
24.8*

Japan
23.5
390.8
16.6
237.7
431.1
388.8
170.8

U.K.
25.9
62.6
2.4
197.3
40.8
31.6
27.6

TOT is terms of trade; variances are squared deviations from x, = (Xt - X t _ 1)/Xt _ 1
NOTE: * denotes that the variance is lower than under Bretton Woods.

Table 2 also compares real output variances
under fixed and flexible exchange rates in four
countries. Th ere is no relation betw een the rela
tive variances and the m onetary system. Real
ouput variability declined in the same prop or
tion in Germany and Japan with (mainly) fixed
and flexible rates respectively and rose m oder
ately in the United States and the United Kingdom.9

The last fou r lines o f the table show variances
fo r subperiods. The oil shocks o f the 1970s in
creased the variances in table 2 in the early
years o f flexible rates. Variability o f output fell
in the United States in each successive period.
In all countries the variance o f real GDP was
low er in 1987-91 than under the Bretton
W oods regime.

9Meltzer (1986) reports similar results for the four countries
using unanticipated variances. Unanticipated variances
were computed using forecasts obtained from a multistate,
univariate Kalman filter.

MARCH/APRIL 1993

110

The countries shown in table 2 have different
exchange rate systems. Japan and the United
Kingdom had flexible exchange rates during the
period, although the United Kingdom fixed to
the exchange rate mechanism (ERM) o f the EMS
at the end o f the period. Germany has been in
the fixed-but-adjustable-rate ERM system since
March 1979, and it experim ented with other
fixed-but-adjustable-rate systems with its neigh
bors beginning in the mid-1970s. The mark fluc
tuated, how ever, against the dollar, yen and
many other currencies.
Though the variability o f Germany’s output
grow th is, on average, lowest o f the countries
in table 2, this cannot be attributed entirely to
the reliance on fixed-but-adjustable rates. Varia
bility o f output grow th in Germany was also
low er than in Japan or the United Kingdom
during the Bretton W oods period, and the rela
tive decline in variability is the same fo r Ger
many and Japan. Further, during 1975-80 and
1980-87, periods o f declining inflation, variabil
ity o f Japan’s output grow th is comparable to
(and even slightly below ) Germany’s.
The main conclusion drawn from table 2 is
that there is no basis fo r a general proposition
that output is more variable under fixed rates
than under flexible rates. Relative prices (terms
o f trade) are m ore variable in all countries after
1973, but the increase is smallest in the United
Kingdom.

POLICIES A N D REAL EXCHANGE
RATES
Friedman (1953) made tw o suggestions that
have been overlooked. He gave prom inence to
policy—particularly rearm am ent—as one o f the
main factors affecting U.S. real exchange rates.
Rearmament changes relative prices and the bal
ance o f payments (Friedman, pp. 159-60). Also,
Friedman distinguished permanent and transi
tory changes in exchange rates. He noted the
different response o f speculators to changes
that w ere expected to reverse and those that
w ere expected to persist.1
0
Real governm ent spending fo r defense rose
and fell during the postwar years. Spending
rose during the Vietnam W a r and declined dur,0See Friedman (1953, p. 162). I began work on the relation of
permanent and transitory fiscal and monetary changes to
real exchange rates before I reread Friedman’s essay. I was
pleased to find that the results I had obtained provided
evidence on some of his principal propositions.

FEDERAL RESERVE BANK OF ST. LOUIS

ing the 1970s both absolutely and relative to
real output. Spending rose again in the 1980s,
reached a peak in the mid-1980s and declined
modestly to the end o f the decade. Maintained
changes in the level o f real defense spending
act like any fiscal change. Increases in real
defense spending raise aggregate spending and
interest rates. Higher interest rates attract a
capital inflow, appreciating the exchange rate.
In the absence o f capital controls and restric
tions, the capital inflow reverses the rise in the
interest rate. Reductions in real defense spend
ing have the opposite effects.1 The sign o f real
1
defense spending per unit o f output should be
positive.
Real money balances also affect real exchange
rates. Injections o f money tem porarily increase
real balances, and if the price level does not
adjust instantly, the increase in m oney depreci
ates the real exchange rate. Reductions in real
balances brought about by reductions in m oney
or by a rise in prices fo r a given quantity o f
money appreciate the exchange rate.
Let r, the real exchange rate, have a perm a
nent and transitory component, so that
(1) r, = r, + ut
w h ere r, is the permanent component and ui is
the transitory disturbance. In the absence o f
changes in defense spending, real U.S. money
balances and foreign real balances, the expected
value o f the exchange rate is the permanent
value. The current permanent value is a weighted
average o f last period's exchange rate and any
persistent effect o f defense spending (relative to
GDP) and real money balances at home and abroad
as shown in equation (2).
(2) rl = ar[ , + (1 - a) f (d {,m {,m ^ + v t,
Combining equations (1) and (2) gives equation
(3), a testable equation fo r the real exchange rate.
(3) r, = art t + (l - a)
w h ere

+ £
,

has the usual properties.

I f the real exchange rate is mainly a random
walk, r, = r, j plus a transitory w hite noise term.
"D efense spending is a large share of government spend
ing on goods and services. It has the advantage of being
independent of income and hence a good measure of the
thrust of exogenous fiscal policy. It also permits a test of
Friedman’s proposition.

111

Table 3
Determinants of the Real Exchange Rate*
(t statistics in parentheses)______________
Periods
RER,_1
m.
mf
dt
constant
R2/DW
p(AR1)

(1)
1962-91
Annual
0.80
(6.40)
-0 .1 5
(4.45)
0.28
(2.55)
5.32
(2.92)
53.64
(3.26)
0.89/1.89
0.09(0.36)

(2)
1972-91
Annual
0.72
(3.69)
-0 .1 6
(4.49)
0.26
(1.72)
9.75
(1.92)
44.59
(2.45)
0.78/2.03
-0.11(0.26)

(3)
11/1971 —
IV/1991
Quarterly
0.82
(11.76)
-0 .1 1
(2.60)
0.07
(0.52)
3.37
(1.62)
20.87
(2.42)
0.92/1.95
0.26(1.75)

(4)
1962-91
Annual
0.67
(5.37)
-0 .1 3
(3.87)
0.21
(1.77)
5.88
(2.82)
62.31
(3.16)
0.88/1.92
0.14(0.50)

(5)
1972-91
Annual
0.55
(3.12)
-0 .1 6
(4.43)
0.16
(1.06)
13.02
(2.45)
52.53
(2.63)
0.77/2.00
-0.10(0.23)

*See appendix for definition of variables. p(AR1) is the coefficient of the AR1 serial correlation
correction and its t-statistic.

But if m onetary and fiscal actions have persist
ent effects, these effects w ill be found signifi
cant in estimates o f equation (3). Equation (3)
therefore permits a test o f the influence o f the
defense spending share and real money bal
ances against the alternative hypothesis that real
exchange rates are approximately a random walk
and independent o f systematic m onetary and
fiscal effects. If the real exchange rate is mainly
a random walk, a is close to one. If there are
persistent and systematic effects o f money and
the defense spending share, current values o f
these variables will have a significant effect on
the real exchange rate.
The first tw o columns o f table 3 show estimates
fo r 1962-91 and 1972-91 based on annual data;
the form er includes the fixed exchange rate period,
whereas the latter does not. The tw o sets o f
estimates are similar. The standard errors o f
estimate fo r the tw o equations are 5.9 and 6.8,
a difference o f approximately 1 percent o f the
mean value o f the real exchange rate. The implied
standard erro r o f estimate fo r the Bretton W oods
period is 3.6, about half the value fo r the flexi
ble rate period. These values suggest that transi
tory random variation increased under flexible
rates, but the increase is much smaller than is
commonly alleged. A main reason is that the
estimates here rem ove the effects o f permanent
changes in m, m*, and d. These variables, par
ticularly real money balances, have significant
effects on the trade-weighted real exchange rate.

One problem with these estimates is that the
coefficient o f m* is much larger than the co effi
cient o f mt using annual data. The difference may
not be meaningful, how ever. The definitions o f
money d iffer (as described in the Appendix), and
the difference in coefficients is not significant.
Figure 3 shows the actual and predicted val
ues o f table 3 using equation (1). Many o f the
claims about exchange rate instability are based
on the relative changes in the 1980s. The chart
suggests that much o f the swing in the tradeweighted real exchange rate during the 1980s is
driven by the variables in the model. The defense
spending share rose by m ore than a percentage
point in the early 1980s then fell after the mid
dle o f the decade. Real money balances moved
in the opposite direction, falling through 1982,
then rising, particularly in 1985 and 1986. The
forecasts and actual values are extrem ely close
fo r 1981-83. Th ere is some evidence o f o v er
shooting by the actual rate in 1984-85, but the
errors are not much larger than the standard
error o f estimate. The subsequent decline in the
forecast value lags the actual decline, however,
in 1986 and 1987. Th e largest error in the
29-year span is in 1986.
The third column in table 3 shifts the time
interval from annual to quarterly data. The
results are similar to the annual data except
that mt* is no longer significant. Current real
money balances remain significant at the usual
level, and the defense spending share nearly so.

MARCH/APRIL 1993

112

Figure 3
Trade Weighted Real Exchange Rate
Index (1973:3=100)

The dependent variable in the regressions
reported in the first and third columns o f fig
ure 3 is the average trade-weighted real exchange
fo r the period. The fourth and fifth columns
repeat the regressions fo r annual data using the
monthly average value fo r Decem ber as the de
pendent variable. The results are similar.
Th e estimates in table 3 permit a test o f the
unit coefficient on RER( , implied by the randomwalk hypothesis. All o f the estimates are below
unity, but tw o are not significantly different
from unity; these are in the first and second
columns o f table 3. The estimates in the third
and fifth columns d iffer from unity by m ore
than tw o standard errors, so they reject this
central implication o f the random walk.
Recent w ork on the causes o f fluctuations em
phasizes the importance o f real shocks to aggre
gate supply as a cause o f fluctuations. The effects
on the real exchange rate o f the rise and fall o f
the relative price o f oil in the 1970s and 1980s
is an obvious candidate fo r investigation. The
relative price o f oil can be included in equation
(2) as an additional variable affecting the perma
nent component o f the real exchange rate. Annual
data fo r 1972-90 and 1962-90 reject the effect;

FEDERAL RESERVE BANK OF ST. LOUIS

the coefficient o f the relative oil price is small
(-0 .0 3 ) in each period and has a standard error
larger than the estimated coefficient.
The use o f real m oney balances combines the
separate effects o f money and prices. To sepa
rate the effect o f policy actions from the effects
o f prices, I first differentiate m, = (M/p) then
lag the denominator by one period to get
dM,

dp,

P.-1

(4) dm,

The first term is the real value (in past prices)
o f the current change in nominal balances. The
second is the revenue from the inflation tax on
last period’s real money balances. T o estimate
responses to these variables, I take first d iffe r
ences o f equation (3) using equation (4) to re
place dmr
Table 4 shows estimates relating the annual
change in the real exchange rate to changes in
some policy variables and real shocks. I have
omitted the change in m* to conserve a degree
of freedom. Am* typically has a small negative
coefficient and is not significant. Changes in
money and changes in defense spending relative

113

Table 4
Response of ARER to Changes in
Policy
Periods
ARERt _ 1
AM,/p, _ i
Ad,
Inflation tax
A real debt

(1)
1972-90
Annual
0.60
(3.05)
-0 .3 9
(4.42)
23.91
(2.62)
-0.01
(0.07)
-0 .0 0 5
(0.93)

A gov’t net worth*
A RGDP
constant
R2/DW
P(AR1)

0.07
(2.39)
13.95
(1.23)
0.59/1.79
-0.19(0.43)

(2)
1972-89
Annual
0.72
(6.66)
-0 .4 7
(8.41)
13.86
(3.60)
-0.001
(0.00)

0.004
(0.30)
0.03
(1.81)
19.32
(2.47)
0.80/2.51
-0.68(2.51)

t-statistics are in parentheses. Coefficients of ARER»_-| are
significantly different from unity at the 2a level.
'T h e data are from Bohn (1992). These data are available
only through 1989. For other data, see appendix.

to GDP have considerable effect. For example a
0.1 percentage point change in the share o f
defense spending changes the real exchange
rate betw een 1.4 percentage points and 2.4 per
centage points based on the tw o equations. The
1982 increase in defense spending alone appre
ciated the dollar by 8.7 percentage points using
the coefficient estimate fo r 1972-89.1
2
The inflation tax is not significant in the re
gression or in alternative estimates. This is un
satisfactory. Without a significant response to
inflation, the equations imply that a change in
nominal money has a permanent effect on the
real exchange rate. If the equations are inter
preted as short-term responses, they leave an
important part o f the dynamics unspecified.
Much recent discussion o f the appreciation o f
the real exchange rate in the early 1980s, fo l
low ing the Reagan tax cuts, linked the apprecia
tion either to the budget deficit or to the increased
after-tax return to real capital. The change in
the real value o f governm ent debt measures the

part o f the current federal budget deficit financed
by borrow ing. I used the change in real GDP
(RGDP) as a measure o f the real return to real
capital. This variable also captures the effects o f
changes in real output emphasized in the busi
ness cycle literature. Because real output is close
to a random walk, changes in RGDP are a meas
ure o f unanticipated changes.
The change in RGDP has a significant effect
on the change in the real exchange rate. The
size o f the coefficient is misleading because the
changes are in billions o f dollars. A m ore sug
gestive comparison is given by the change in
the real exchange rate induced by changes in
RGDP and the defense spending rates during
four years o f appreciation— 1981-84. The total
appreciation o f the real exchange rate fo r this
period is 44. The coefficients in the first column
o f table 4 assign slightly less than half o f this
change to the change in the defense spending
ratio and slightly m ore than half to the change
in RGDP. These calculations neglect other varia
bles, particularly changes in money and lags o f
the real exchange rate. And the calculation
overstates the importance o f supply shocks or
changes in tax rates because the changes in
RGDP include the recovery from the 1981-82
recession that would have occurred in the
absence o f tax changes or supply shocks.
The response to deficit finance, measured by
the change in real governm ent debt, is small
and insignificant. A problem with testing fo r
effects o f the budget deficit is the incomplete
and imprecise w ay in which the deficit is meas
ured. Eisner and Pieper (1984) called attention
to this problem and showed that there are large
differences betw een current accounting meas
ures and measures o f a m ore economically rele
vant magnitude. Bohn (1992) computed a measure
o f governm ent net w orth that includes principal
government assets and liabilities other than Social
Security and Medicare liabilities. The second
column substitutes the change in real govern
ment net w orth from Bohn fo r the change in
the real value o f the federal debt as a measure
o f the deficit. Governm ent’s net w orth is nega
tive, and if properly measured, the level o f
governm ent net w orth is the value o f future tax
payments. Changes in net w orth have no signifi
cant effect. The responses to changes in RGDP
and changes in the defense spending share both
fall. Each explains a smaller fraction o f the

12l neglect possible changes in the properties of the error
term when taking first differences of equation (3).

MARCH/APRIL 1993

114

Figure 4
Annual Changes in Real Exchange Rates

change in the real exchange rate during 1981 to
1984 (and other periods). The implied change in
the real exchange rate resulting from changes
in RGDP and the defense spending share are
now approximately 25 percent and 29 percent
respectively.
Figure 4 shows predicted and actual changes
in the real exchange rate based on the estimates
in the second column o f table 4. Inspection sug
gests that the equation explains the annual changes
more accurately fo r the 1980s than fo r the 1970s.
This is particularly true in 1974 and 1975. There
are only three years in which actual and p re
dicted changes go in opposite directions—1975,
1978 and 1983. Actual and predicted changes
move together during the appreciation and sub
sequent depreciation o f the dollar in the 1980s.
The equation suggests that contemporaneous
changes in money and in defense spending are
the principal factors keeping the predicted changes
in step with actual changes.

LIM ITATIO N S
The empirical results are subject to some limi
tations. This section briefly discusses some pro
blems arising from the absence o f a structural

FEDERAL RESERVE BANK OF ST. LOUIS

model, neglect o f simultaneity, and problems o f
stationarity.
First, the estimates are obtained from a simple
model o f permanent and transitory changes, not
from a structural model. The equations are nei
ther structural equations nor reduced form s o f
a structural model. An advantage o f the model
is that it nests the effects o f money and defense
spending within a popular statistical model, the
random walk.
Second, several o f the variables such as the
price level, output, the real value o f m oney and
the defense spending share are simultaneously
determined. Simultaneity has been neglected
throughout. Th e changes reported in table 4
and the use o f lagged prices rem oves some o f
these problems. That the principal results are
unaffected suggests that simultaneity may not
impart serious bias to the estimates in table 3.
Third, many studies o f exchange rates have
investigated the stationarity o f exchange rates.
Tests o f non-stationarity at first seemed to sup
port the hypothesis. M ore recent w ork using
longer time series, how ever, casts doubt on this
conclusion. Engel and Hamilton (1990) did not
test fo r stationarity, but they found persistent

115

departures from a random walk. Earlier, Krasker
(1980) coined the term peso problem fo r persist
ent deviations o f exchange rates in a particular
direction. Papers by Huizinga (1987), Hakkio and
Joines (1990), Lothian (1991), and Diebold, Husted,
and Rush (1991) are part o f the grow in g liter
ature rejecting non-stationarity based on evidence
that real exchange rates return to a mean value.
A main reason fo r the differences in findings
betw een earlier and later studies is the use o f a
longer span o f years. Some early studies used
daily or monthly data to obtain a larger number
o f observations. Recent studies suggest that an
increased number o f high-frequency observa
tions is a poor substitute fo r the relative paucity
o f low -frequency data.1
3
The principal conclusion to draw from many
o f the studies is that the real exchange rate is
subject to persistent and transitory changes.
Some changes in the real exchange rate persist
fo r long periods. Some o f the changes are re
versed quickly. Diebold, Husted, and Rush (1991)
conclude that on average the half-life o f a shock
to the real exchange rate has been about three
years. This finding is similar to the decay rates
implied by the coefficients on annual values of
the lagged real exchange rate in table 3.
Inspection o f figure 1 suggests that the mul
tilateral real exchange rate remained within a
range o f 95 ± 15 from 1973 to 1980 and
returned to approximately the same range in
1987. T o test fo r stationarity, I used quarterly
data fo r first quarter 1973 to fourth quarter
1990 but omitted the sharp appreciation and
depreciation from third quarter 1980 to first
quarter 1987.1 The coefficient o f the lagged
4
multilateral real exchange rate on the change in
the real exchange rate is -0.14 with a t-statistic
o f 2.72. The Dickey-Fuller test statistic is 2.93 at
the 5 percent level and 2.60 at the 10 percent
level. On this basis, I reject non-stationarity.

CONCLUSION
Milton Friedman’s (1953) essay on flexible
exchange rates anticipated much o f the discus
sion and many o f the controversies o f the next
40 years. Friedman did not claim that flexible
exchange rates would be stable rates. Stability

depends on the size and frequency o f shocks.
Friedman claimed that flexible exchange rates
w ould (1) contribute to trade liberalization, (2)
avoid reliance on direct controls, (3) facilitate
rearmament and (4) allow countries to follow
domestic policies to achieve price stability.
Several o f these conjectures w ere correct.
Direct controls on capital movements have been
reduced since 1973 in all developed countries
and in some developing countries. It seems
likely that rearmament (defense spending)
w ould have provoked greater conflict about
payments imbalances in the 1980s under fixed
exchange rates than under the system that
prevailed. Flexible rates permitted countries to
choose how much o f the stimulus emanating
from the United States they wished to absorb.
Many countries, indeed most developed coun
tries, both purchased dollar securities and
appreciated their currency.
The average rate o f inflation has been
brought dow n under flexible rates, and some
countries have achieved price stability at times.
Trade restrictions, how ever, increased in the
1980s, particularly in the United States, and the
movement toward trade liberalization slowed.
Friedman did not argue that exchange rates
would be stable. He argued that the path fo l
low ed by real exchange rates w ould depend on
the real and m onetary disturbances to which
the econom y is subject and on the persistence o f
shocks. Critics argued that destabilizing specula
tion and random movements dominate exchange
rate changes and create an excess burden. This
burden, some suggested, could be reduced by
fixing exchange rates or establishing target zones.
The paper does not address the issue o f
excess burden. H ow ever, I compare variability
o f output and the terms o f trade fo r fou r coun
tries under the Bretton W oods System and the
different regimes adopted after 1973. There is
no evidence that real output is generally more
variable under flexible exchange rates. Term s of
trade are m ore variable after 1973, but the data
do not suggest that the increased variability is
mainly the result o f the exchange rate regime.
Further, I compare levels and changes in real
exchange rates to the values predicted by a model.

13Hakkio and Rush (1991) reach the same conclusion based
on more formal tests.
14The hypothesis implies and the data suggest that the ap
preciation and depreciation in this period is mainly the
result of policy action.

MARCH/APRIL 1993

116

The forecast errors do not give evidence o f
large, persistent errors. On the contrary, the
models call the turning points in the level and
changes in the exchange rate with considerable
accuracy. Th e data suggest, how ever, that there
is m ore unexplained variability o f real exchange
rates after 1973 than before when measured by
the standard error o f estimate fo r the regres
sion equation.
The evidence also suggests that much o f the
m ovem ent in both levels and changes in annual
values o f the U.S. multilateral real exchange
rate is explained by permanent or persistent
changes in a fe w variables. The principal varia
bles are real m oney balances and the share o f
defense spending in GDP. W hen the change in
real balances is separated into variables measur
ing the current change in nominal money and
the current change in the price level, the data
suggest that the change in nominal money
(measured at past prices) has a m ore important
short-run effect. Quarterly data on levels o f the
variables support the principal findings.
M onetary and fiscal variables are nested w ith
in a random walk model o f the real exchange
rate. If the random-walk component dominated
the exchange rate, the data would reject the re
levance o f the m onetary and fiscal variables.
The tests based on annual and quarterly data and
on annual changes support the opposite conclusion:
m onetary and fiscal effects are persistent and
reliable, and their effect is contemporaneous—
w ithin the current year or quarter. O f course,
none o f the findings here deny that the random
walk may dominate levels or changes o f the ex
change rate at higher frequencies.
T w o principal observations about fluctuating
exchange rates during the past 20 years are:
(1) the close relation betw een real and nominal
exchange rates and (2) the sharp appreciation
and subsequent depreciation o f the real dollar
exchange rate in the 1980s. 1 conjecture that
the principal reason fo r the correspondence
betw een movements in real and nominal ex
change rates is that real exchange rates are
driven by contemporaneous permanent changes
in real variables, particularly real defense spend
ing and real m oney balances, whereas nominal
exchange rates are driven by the nominal val
ues o f the same variables. Much o f the short
term effect o f money on the real exchange rate
appears to be the result o f changes in nominal
money, so it would not be surprising to find that
changes in nominal m oney balances have a sig
nificant effect on the nominal exchange rate also.

FEDERAL RESERVE BANK OF ST. LOUIS

D A T A A P PE N D IX
Nom inal exchange rate (FNER): Index o f the
trade-weighted foreign exchange value o f the
United States dollar compiled by the Federal
Reserve. The index is a geom etric average o f 10
industrialized countries’ dollar value o f their
currencies w eighted by their shares o f w orld
trade betw een the years 1972 and 1976. The 10
countries are Germany, Japan, France, United
Kingdom, Canada, Italy, Netherlands, Belgium,
Sweden and Switzerland.
Trade-weighted price level (TW CPI): Geometric
average o f 10 industrialized countries’ consumer
price indexes w eighted by their shares o f total
w orld trade.
Real exchange rate: FNER deflated by the ratio o f
the United States consumer price index (CPI) to
the 10 countries’ trade-weighted CPI.
Real money balances (m): United States M l
m onetary aggregate deflated by the United
States CPI.
Defense spending share (d): Ratio o f the United
States defense spending in current dollars to
GDP in current dollars.
Foreign money balances (T W N M ): Arithm etic
average o f indexes o f M2 m onetary aggregates
o f Canada, Germany, Great Britain, and Japan
(M2 &, CD), w eighted by their shares o f total
w orld trade betw een the years 1972 and 1976.
Foreign real money balances: T W N M deflated by
TW CPI.
Real government net worth: Real governm ent
deficit measured by the US governm ent real net
w orth from Bohn (1992).
Relative price o f oil: Oil price measured by com
posite refiners' acquisition cost deflated by GNP
deflator.
Real federal debt: Gross federal debt net o f Fed
eral Reserve holdings deflated by the CPI.

REFERENCES
Aliber, Robert Z. “ The Case for Flexible Exchange Rates
Revisited,” University of Chicago (unpublished).
Becketti, S., and Hakkio, C. “ How Real is the 'Real
Exchange Rate’?” draft Federal Reserve Bank of Kansas
City (April).
Bohn, H. “ Budget Deficits and Government Accounting,”
Carnegie Rochester Conference Series on Public Policy
(December 1992), pp. 1-83.
Chinn, M. “ Some Linear and Nonlinear Thoughts on
Exchange Rates,” Journal of International Money and
Finance (June 1991), pp. 214-30.
Diebold, F.X., Husted, S., and Rush, M. “ Real Exchange
Rates under the Gold Standard,” Journal of Political Econ
omy (December 1991), pp. 1252-71.

117

Edwards, S. Real Exchange Rates, Devaluation, and Adjust
ment: Exchange Rate Policy in Developing Countries (MIT
Press, 1989).

Krasker, W. “ The ‘Peso Problem’ in Testing the Efficiency of
Forward Exchange Markets,” Journal of Monetary Eco
nomics (April 1980), pp. 269-76.

Eisner, R. and Pieper, P. “ A New View of the Federal Debt
and Budget Deficits,” American Economic Review (March
1984), pp. 11-29.

Krugman, P., and Miller, M. “ Why Have a Target Zone?”
Carnegie Rochester Conference Series on Public Policy
(forthcoming).

Engel, C. and Hamilton, J.D. “ Long Swings in the Dollar: Are
They in the Data and Do Markets Know It?” American
Economic Review (September 1990), pp. 689-713.

Lothian, J. “ A History of Yen Exchange Rates,” in W.T.
Ziemba, W. Bailey, and Y. Hamao, eds., Japanese Finan
cial Market Research (Elsevier, 1991).

Frenkel, J. “ Turbulence in the Foreign Exchange Markets
and Macroeconomic Policies,” in L. Melamed, ed., The
Merits of Flexible Exchange Rates (George Mason Univer
sity Press, 1988), pp. 445-69.

Meese, R. and Rogoff, K. “ Empirical Exchange Rate Models
of the Seventies: Do They Fit Out of Sample?” Journal of
International Economics (February 1983), pp. 3-24.

Friedman, M. “ The Case for Flexible Exchange Rates,” in
Friedman, M., ed., Essays in Positive Economics (Univer
sity of Chicago Press, 1953).

Meltzer, A.H. “ Size, Persistence and Interrelation of Nominal
and Real Shocks,” Journal of Monetary Economics (Janu
ary 1986), pp. 161-94.

Haberler, G. “ The International Monetary System and
Proposals for International Policy Coordination,” in Cagan,
P., ed., Contemporary Economic Problems (American
Enterprise Institute, 1987), pp. 63-96.

_______ . “ Some Empirical Findings on Differences Between
EMS and Non-EMS Regimes,” Cato Journal (Fall 1990),
pp. 455-83.

Hakkio, C. and Joines, D. “ Real and Nominal Exchange
Rates Since 1919,” working paper, Federal Reserve Bank
of Kansas City (September 1990).

Mussa, M. “ Nominal Exchange Rate Regimes and the
Behavior of Real Exchange Rates: Evidence and Implica
tions,” Carnegie Rochester Conference Series on Public
Policy (Autumn 1986), pp. 117-213.

Hakkio, C. and Rush, M. “ Cointegration: How Short is the
Long Run?” Journal of International Money and Finance
(December 1991), pp. 571-81.
Huizinga, J. “ An Empirical Investigation of the Long-run
Behavior of Real Exchange Rates,” Carnegie Rochester
Conference Series on Public Policy (Autumn 1987), pp.
149-214.

Singleton, K. “ Speculation and the Volatility of Foreign Cur
rency Exchange Rates,” Carnegie Rochester Conference
Series on Public Policy (Spring 1987), pp. 9-56.
Wallich, H. “ Floating as Seen from the Central Bank,” in L.
Melamed, ed., The Merits of Flexible Exchange Rates
(George Mason University Press, 1988), pp. 395-403.

MARCH/APRIL 1993

118

Pedro Schwartz
Pedro Schwartz is a professor in the history of economic
thought at the Universidad Anto'noma de Madrid and executive
vice president at NERA Madrid.

Commentary

.LLA N MELTZER HAS PRESENTED a paper
that rescues Milton Friedman's 1953 defense o f
flexible exchange rates from its critics and p re
sents an impressive amount o f empirical evidence
against today’s received opinion favoring fixed
exchanges. Nothing is m ore bracing than the
refutation o f conventional wisdom nor m ore
satisfying than the vindication o f the simple
faith that the market is always right against the
latest interventionist fads o f central bankers,
w hich is what I take to be the practical conse
quence o f the paper. Anything that could make
Europeans think again about imposing a con
trived m onetary union in the EC is most welcome.
M y comments start w ith M eltzer’s summary
o f Friedman’s case fo r floating rates. Then 1
make a quick evaluation o f the force o f the data
presented in refutation o f those w ho have as
serted that flexible exchange rates have not
w orked as anticipated. I make this evaluation
without in any w ay claiming, how ever, to have
redone M eltzer’s calculations or amassed some
different evidence. The reason fo r not focusing
on the empirical part o f M eltzer’s paper, except
as evidence o f how the w orld seems to func
tion, becomes apparent in the follow ing section.
A fter a simple-minded expose" o f what M eltzer’s
results mean fo r the day-to-day business o f a
central banker and a portfolio manager, I try to
contrast the empirical relations given in M eltzer’s
paper w ith the assumptions implicit in the
project fo r a European M onetary Union. Finally,
I reflect on the conditions that explain w hy
m onetary zones appear and on w hether the
benefits o f a freely floating independent curren
cy becom e larger than the costs.

1See Friedman (1953).

FEDERAL RESERVE BANK OF ST. LOUIS

M eltzer underlines h ow Friedman refrained
from claiming too much fo r floating exchange
rates and also h ow prescient he was about
problems that w ould plague fixed exchanges at
the time w hen the Bretton W oods accord was
being implemented.
Friedman, as I have confirm ed by rereading
his 1953 paper, did not present flexible exchange
rates as optimal under all circumstances. He
started by defining the new arrangem ent he
wanted to criticize:1

the Western nations seem to be committed to a
system of international payments based on ex
change rates between their national currencies
fixed by governments and maintained rigid ex
cept for occasional changes to new levels.

He then prudently said that “w hatever may
have been the merits o f this [Bretton W oods]
system fo r another day it is ill suited to current
economic and political circumstances.” If the
fixed exchange system must have had some
merit w hen it was being used within currency
zones—some as large as the one in which he
lives—fo r Friedman, the flexible rates system
had the superior political consequences, namely:
(a) fostering the liberalization o f trade; (b)
reducing the need fo r exchange controls; (c)
easing the path fo r necessary extraordinary ex
penditures, such as the rearmament that turned
out to be necessary w ith the Cold W ar; and (d)
alleviating the constant brushes betw een central
bankers and treasuries over domestic m onetary
and fiscal policies.

119

These indirect advantages are important and
correspond contrastingly w ith the political ad
vantages claimed by those w ho defend pegging
exchanges o f countries or a group o f countries
to some standard or to some m ore reliable cur
rency. In this case the political advantage lies in
putting a check on the oversupply o f money
and forcing m onetary authorities to minimize
their inflation tax and maintain the value o f
money. An exchange fixed onto gold, some
basket o f goods or another reliable currency
such as the deutsche mark is a sort o f superin
dependence clause in the central bank bylaws
because it turns the Bank in effect into a cur
rency board.
In M eltzer's paper there is little discussion o f
possible data related to these elements o f com
parative advantages o f flexible vs. fixed exchange
rates from the political and social point o f view.
In his paper there is a useful explanation o f
what Friedman really meant, but not an em piri
cal evaluation o f the relative size o f the func
tional relationship he posited. The elements o f a
comparative analysis o f floating exchange rates
vs. fixed are listed by Meltzer, but their quan
titative importance is not evaluated.
Recognizing that optimality of flexible rates can
not be established, Friedman limits his claim to
the judgment that flexible exchange rates are
more desirable socially than the...alternative
means of offsetting changes in international po
sition... (1) official changes in currency reserves;
(2) changes in domestic price levels and in
comes; (3) periodic realignment of parities; and
(4) direct controls.
O f these, periodic realignments are the most im
portant fo r a judgment on the functioning o f
the European Monetary System (EMS).
I found a rem ark in M eltzer’s conclusion that
“ several o f ...[the four] conjectures w ere cor
rect.” These conjectures are such things as the
positive political effects on the liberalization of
trade. Regarding Friedman's (b) avoidance o f
direct controls, M eltzer says the following:
Direct controls on capital movements have been
reduced since 1973 in all developed countries
and in some developing countries.
W ith respect to Friedman’s (c), M eltzer notes
the following:
It seems likely that rearmament (defense spend
ing) would have provoked greater conflict about
payments imbalances in the 1980s under fixed
exchange rates than under the system that
prevailed.

Finally, there is the follow ing indirect treatment
o f the possible evidence on Friedman’s (d), the
harmonization o f internal monetary and fiscal
policies:
Flexible rates permitted countries to choose
how much of the stimulus emanating from the
United States they wished to absorb. Many
countries, indeed most developed countries,
both purchased dollar securities and appreciat
ed their currency.
that is, they both absorbed and sterilized the
stimulus.
This is ve ry little on a large part o f the con
troversy about fixed vs. flexible exchange rates,
but it w ill have to be a topic fo r a different
paper because M eltzer prefers to concentrate
on a previous problem that Friedman dealt with
implicitly, though at length. Says M eltzer:
The point that concerned later critics most,
variability or instability, is dismissed early with
the claim that exchange rate instability reflects
instability in the economy and is not a property
of a flexible or floating rate system . . Friedman
appears to have anticipated this outcome. He
devotes more space to refuting or dismissing
the charge of instability than to making the
positive case for the four benefits claimed for
flexible rates.
This is also what M eltzer does, in the belief that
the question o f overshooting and o f destabilizing
speculation has to be resolved before the politi
cal cost-benefit analysis o f flexible rates can be
addressed.
The evidence M eltzer does present bears on
five points that w ould clearly be important as
preconditions fo r evaluating Friedman’s main
political theses: (1) w hether the variability o f ex
change rates in the main OECD countries in
creased after the breakdow n o f Bretton W oods—
especially w hether the EMS currencies showed
less variability; (2) w hether and over w hat period
can exchange rates be considered to m ove along
a random walk; (3) connected w ith 2., w hether
money supply and governm ent spending policies
do affect real and m oney exchange rates signifi
cantly; (4) connected w ith 3., w h y real and
m onetary rates seem to m ove together; and (5)
w hether exchange rates are congenitally unsta
ble, w hether they show a tendency to return to
mean values and if so, over what period.
The results presented by M eltzer are most
valuable and should becom e standard w ith the
profession if confirm ed by rerunning them fo r

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120

different periods and countries, and especially
fo r the present episode o f instability in the EMS.

REAL CAUSES
And the yearly and quarterly movements o f
exchange rates are not random because

V A R IA B IL IT Y A N D ITS POSSIBLE
W ELFAR E EFFECTS
The figures presented fo r 1973 through to
1990 m oved over a relatively w ide range. This
behavior o f the exchanges could, as Friedman
said, turn out to reduce the variability in some
real phenomena, such as output or employment.
The variability could also derive from m ore
acute and frequent real shocks in this period.
This is as may be, but M eltzer concentrates
on w hether the variability is m erely apparent
and is robust under different measures used. If
the said variability could be traced to the m ore
frequent movements in a flexible regim e but
left relative prices unmoved, the visible variabili
ty could have only small real consequences. See
table 1: R, the real exchange rate, and N, the
nominal rate, varied much less in the EMS
countries than in other OECD countries. (One
w ould in any case want to see the variance af
ter what happened on September 26.) The rela
tive price changes betw een countries, how ever,
w ere unaffected by the exchange regime.

changes in money and changes in defense
spending relative to GDP have considerable ef
fect. For example, a 0.1 percentage point change
in the share of defense spending changes the
real exchange rate between 1.4 percentage
points and 2.4 percentage points. ... The 1982
increase in defense spending alone appreciated
the dollar by 8.7 percentage points.
Not only governm ent expenditures, but also
increases in real GDP and changes in real money
balances seem to have significant effects on the
real rate o f exchange. W ithin the black box, w e
could surmise that increases in expenditures
w ill contribute to raising interest rates and at
tracting foreign capital and that increases in
GDP w ill also lead to higher rates through the
same mechanism and through the increased de
mand fo r money. On the other hand, a fall in
real money supply w ill also push up the real ex
change rate. Deficits, on the other hand, seem
to have no significant effect o f the real (and
money) rates.

REAL A N D M ONEY EXCHANGE
RATES

At the end o f his paper, M eltzer has a section
on the possible limitations o f his empirical find
ings. One is possible simultaneity, which he cor
rects by lagging and fo r which he finds no
evidence o f relevance. Another is that the results
are not derived from a structural model, but
from a simple model o f permanent and transitory
changes w hich is, by the way, a traditional
Friedmanite approach. M eltzer maintains that
the w hole empirical exercise “nests the effects
o f money and defense spending within a popular
statistical model, the random walk,” so signifi
cant departure from the null hypothesis would
precisely be a most striking refutation o f the
random walk theory o f foreign exchanges.

David Ricardo in 1817, in the passages o f his
Principles w h ere he discussed the distribution o f
precious metals in the world, under the gold
standard, saw that advances in productivity in a
country led first to a fall in costs and real prices,
then to an accumulation o f reserves and an in
crease in m oney prices, and finally fo r a time to
an overvaluation o f the m oney exchange rate
until domestic prices fell to an equilibrium. The
process w ould be the inverse fo r a country fall
ing back in productivity. Hence the tendency o f
real and m oney exchanges to fluctuate constant
ly in separate directions turned out to be
characteristic o f a fixed exchange rate regime.
(Of course, it is contrary to the rules o f a fixed
interest regime, especially o f the gold standard
fo r the bank to sterilize foreign funds.)

I can summarize the results w ith a quotation:
"transitory random variation increased under
flexible rates, but the increase is much smaller
than is commonly alleged”; and a m ove from an
nual to quarterly data does not significantly
change the results. Daily data would, how ever,
probably show much m ore randomness.

In contrast, it was therefore expected that,
under a flexible exchange regim e, because the
inflow o f money from increased productivity
and exports does not go into reserves but into
foreign exchanges, the index o f m oney prices
would be governed much m ore directly by the
prices o f tradeable goods.

THE R A N D O M W A L K M ODEL

FEDERAL RESERVE BANK OF ST. LOUIS

121

M eltzer gives an additional reason fo r the
joint m ovem ent o f real and nominal rates. He
has shown reductions in real balances to be a
pow erful cause o f the increase o f real exchange
rates: and real balances also govern m oney ex
change rates.

NON-ST A T IO N A R IT Y
One last element in the description o f a flexi
ble exchange rate regim e is the rejection o f
non-stationarity by M eltzer. That there are ob
servably persistent departures from a random
walk led some authors to think that speculation
could be permanently destabilizing. H ow ever, if
one uses a longer span o f years it becomes
clear that exchanges are subject to both persis
tent and transitory changes. I take it that the
persistent changes are responsible fo r the time
illusion o f non-stationarity. If the average real
life o f a shock is 3 years, the period fo r return
to the mean rate o f exchanges can be long: but
return to the mean they do (I should add, if
there are no capital or trade controls).
Though it may be subject to correction from
further empirical research, the picture o f the
exchange w orld given by M eltzer’s empirical
research is striking, both fo r the central banker
and the investor. I read these provisional con
clusions w ith some trepidation, but hope to be
corrected by the audience before I becom e a
central bank govern or or a large investor.
First, real and money exchanges m ove together.
Price indexes w ill m ove up or dow n w ith the
real exchange rate and w ill be governed by the
real causes o f real exchange appreciation or
depreciation. In an open economy, therefore, a
central banker can aspire to a steady or zero in
flation rate only as an average over a long
period—perhaps a three-year half-life.
Second, there is money to be made in foreign
currency (at least until everybody starts reading
M eltzer) because o f long-term systematic and
predictable forces in the foreign currency m ar
ket. Government expenditures, GDP grow th and
reductions in real balances portend o f revalua
tions to come (as long as people do not expect
the Government to inflate the accumulated debt
away). To put it in another way, a good long
term investment in a country blessed w ith a
central bank that does not panic can discount
exchange fluctuations if it has enough capital or
is not subject to quarterly scrutiny at the stock
market.

Third, the variability observed w hen exchanges
float does not seem to spill over into the goods
and services market because it does not affect
relative prices. Hence the decision to float or to
fix w ill have to be taken on sociopolitical grounds
and cannot be settled on evidence o f persistent
overshooting.
N ow given all this, the arguments w ith which
the m onetary part o f the Maastricht Treaty is
being defended begin to sound less convincing.
The follow ing pros and cons are usually
presented.
The reduction in transaction costs from hav
ing to deal in a single currency is a benefit.
Cecchini has calculated a once-and-for-all gain
equivalent to 4 percent o f European GDP. This
may be exaggerated and is much low er than the
recurrent gain from the single market.
Another benefit is the control o f the central
bankers o f the constituent states by a European
Central Bank (ECB) w ith the express duty to de
fend the value o f the single currency. This has
the follow ing tw o drawbacks, how ever. The
first is the suspicion that the states’ central
bankers do not want to reduce their sovereignty,
but want rather to increase it w ith their seat on
the ECB’s executive committee because the mar
kets themselves have made state central banks
lose much o f their freedom ; the other drawback
is that the new ECB w ill have quite a task being
independent and refraining from playing with
the exchanges, as can be guessed by the pres
sures recently put on the Bundesbank.
Th e solution to the difficulties posed by a
m onetary union among w idely differing coun
tries is problematic. W e have already seen the
points that Friedman foresaw w ould plague such
a m onetary union: policy disharmonies and the
possible pressure fo r a central governm ent (a
sure cause o f friction in Europe); a temptation
to impose exchange or capital and trade con
trols; and indifference to implementing cushions
to prevent unemployment in the less productive
parts o f the union.
The question is then, w hy do I sometimes ad
vocate a currency board fo r small countries,
which is a strict form o f m onetary union, and
w h y are the m onetary unions made up o f rather
large countries and sometimes o f a large econo
m y such as Germany and its close surrounding
trade partners?

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Let us imagine a w orld o f competing monies
that float against each other. Th eir market share
w ill be decided as in any other oligopolistic in
dustry, the producers obtaining a seignorage or
markup over marginal cost, a markup limited
by potential entry; and demand being fo r the
well-known services that m oney provides. These
services are: fo r transactions (of which a part is
coinage fo r small change subject to the metal
content being o f less than face value); fo r pricing
goods, services and savings; and fo r holding a
real cash balance.
The picture that em erges from this is not only
that o f a w orld divided horizontally in zones,
but also a w orld subject to a division in layers,
w here different currencies may be used for
different purposes: fo r example, deutsche marks
or dollars fo r trade, Swiss francs fo r pensions,
and pesetas fo r local payments.
Apparently it w ould be ideal fo r consumers o f
money, especially those that need it to produce
goods and services, if all dealings could be in
only one currency. This in fact is not necessarily
so, fo r all the reasons w e have noted in this
commentary. The union could, how ever, be ap
proximated by the market, and the study o f the
non-stationarity hypothesis w ill confirm that
over long periods currencies tend to stay around

FEDERAL RESERVE BANK OF ST. LOUIS

their historical rates. I f there w ere m onetary
competition, I doubt that there w ould be more
than three currencies circulating in the United
States. The smaller nations around Germany
that trade intensely w ith her and that have simi
lar economic structures to her—fo r example,
the Benelux nations, Austria and S w itzerla n d w ili find it in their interest to stick to the
deutsche mark. Only competition w ill tell how
big m onetary zones must be.
Avoiding hyperinflation and enjoying the serv
ices o f a currency that is reasonably stable fo r
purposes o f valuing goods, services and savings
may lead some people to ask that the issuer o f
m oney be separated from the creator o f the
budget deficit as they have recently been in the
Baltic States and the Ukraine. In other places,
such as Hong Kong, a currency board that pegs
the local m oney to the dollar may inspire confi
dence in a highly volatile situation.
In questions o f currency w e live very much in
a second-best world.

REFERENCES
Friedman, Milton. “ The Case for Flexible Exchange Rates,”
in Friedman, Milton, ed., Essays in Positive Economics
(University of Chicago Press, 1953).

123

M ich a el D. B o r d o
Michael D. Bordo is a professor of economics at Rutgers
University and a research associate of the National Bureau of
Economic Research. For excellent research assistance I
would like to thank Jakob Koenes. For helpful comments and
suggestions I am grateful to Barry Eichengreen, Allan Meltzer,
Leslie Presnell, Hugh Rockoff and Anna Schwartz.

The Gold Standard, Bretton
Woods and Other Monetary
Regimes: A Historical
Appraisal
IN TR O D U CTIO N
Tw o Questions
W hich international m onetary regim e is best
fo r economic performance? One based on fixed
exchange rates, including the gold standard and
its variants? Adjustable peg regimes such as the
Bretton W oods system and the European M one
tary System (EMS)? Or one based on floating
exchange rates? This question has been debated
since Nurkse's classic indictment o f flexible rates
and Friedman’s classic defense.1
W hy have some m onetary regimes been more
successful than others? Specifically, w hy did the
classical gold standard last fo r almost a century
(at least fo r Great Britain) and w hy did Bretton
W oods endure fo r only 25 years (or less)? W hy
was the EMS successful fo r only a fe w years?
This paper attempts to answer these questions.
To answer the first question, I examine em piri
cal evidence on the perform ance o f three m one
tary regimes: the classical gold standard, Bretton
Woods, and the current float. As a backdrop, I
examine the mixed regime interwar period. I answer
the second question by linking regim e success

to the presence o f credible commitment mechan
isms, that is, to the incentive compatibility fea
tures o f the regime. Successful fixed-rate regimes,
in addition to being based on simple transparent
rules, contained features that encouraged a center
country to enforce the rules and other coun
tries to comply.

The Issues
These questions touch on a number o f im por
tant issues raised in economic literature. The
first is the effect o f the exchange rate regime
on welfare. The key advantage o f fixed
exchange rates is that they reduce the transac
tions costs o f exchange. The key disadvantage is
that in a w orld o f w age and price stickiness the
benefits o f reduced transactions costs may be
outweighed by the costs o f m ore volatile output
and employment.
Helpman and Razin (1979), Helpman (1981)
and others have raised the w elfare issue. This
theoretical literature concludes that it is difficult
to provide an unambiguous ranking o f exchange
rate arrangements.2
M eltzer (1990) argues the need fo r empirical

1See Nurkse (1944) and Friedman (1953).
2See DeKock and Grilli (1989 and 1992).

MARCH/APRIL 1993

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measures o f the excess burdens associated with
flexible and fixed exchange rates—the costs o f
increased volatility on the one hand compared
with the output costs o f sticky prices on the
other hand. His comparison o f EMS and nonEMS countries in the postwar period, however,
does not yield clear-cut results.
Earlier literature comparing the m acroeco
nomic perform ance o f the classical gold stand
ard, Bretton W oods and the current float also
yielded mixed results. Bordo (1981) and Cooper
(1982) showed that the classical gold standard
was associated w ith greater price level and real
output volatility than post-W orld W ar II arrange
ments fo r the United States and United Kingdom.
On the other hand, Klein (1975) and Schwartz
(1986) presented evidence that the gold stand
ard provided greater long-term price stability
than did the post-W orld W ar II arrangements.3
Bordo (1993) compared the means and stand
ard deviations o f nine variables fo r the Group
o f Seven countries under the three regimes, as
w ell as the interw ar period.4 According to these
measures, the Bretton W oods convertible period
from 1959 to 1970 was the most stable regim e
fo r the majority o f countries and variables
examined. Eichengreen (1992a) measured volatil
ity applying tw o filters (the first difference of
logarithms and a linear trend).5 Comparing Bret
ton W oods and the float fo r a sample o f 10
countries, he found no clear-cut connection
betw een the volatility o f real grow th and the
exchange rate regime. He also found no signifi
cant difference in the correlation o f output vola
tility across countries between the tw o regimes.
A second issue is w hether the exchange rate
regim e provides insulation from shocks and
m onetary policy independence. Under fixed
rates, coordinated m onetary policy may provide
effective insulation from common supply shocks,
but not from country-specific shocks. Under
3This result is disputed by Meltzer and Robinson (1989).
4The Group of Seven countries are Canada, France, Ger
many, Italy, Japan, the United Kingdom and the United
States.
5Eichengreen followed the methodology of Baxter and
Stockman (1989).
6Similarly a monetary union such as the proposed Euro
pean Monetary Union could provide effective insulation
from common supply shocks for its members. However,
giving up monetary independence imposes additional bur
dens in the case of member-specific (regional) shocks,
Feldstein (1992).
7Addressing the issue of the optimum currency area, Bay
oumi and Eichengreen (1992b, 1992c and 1992d) also

FEDERAL RESERVE BANK OF ST. LOUIS

flexible rates, country-specific shocks can be o ff
set by independent m onetary policy.6
The evidence on this issue is limited. Bayoumi
and Eichengreen (1992a) applied the BlanchardQuah approach to show that both supply (per
manent) and demand (tem porary) shocks, fo r a
sample o f five countries, w ere considerably greater
under the gold standard than under post-W orld
W a r II regimes. H ow ever, they found little dif
ference in the incidence o f shocks betw een
Bretton W oods and the floating exchange rate
regime. Th eir results also showed that the dis
persion o f shocks across countries was higher
under the gold standard than under the tw o
m ore recent regimes and slightly higher under
Bretton W oods than under the floating exchange
rate regime. They attributed the ability o f the
gold standard to withstand greater shocks to evi
dence o f a faster speed o f adjustment o f both
prices and output, as measured by impulse
response functions.7
A third issue is the case fo r rules vs. discre
tion. A fixed exchange rate may be view ed as a
commitment mechanism or rule. It binds the
hands o f policymakers to prevent them from
follow ing inflationary discretionary policies.8
Th e m onetary authority, in a closed econom y or
under flexible rates, might be tempted to engi
neer an inflation surprise to raise revenue.9 The
outcome is higher inflation because the public,
assuming rational expectations, w ill anticipate
the policy. W e re some credible mechanism,
such as a m onetary rule, in place the expansion
ary policy w ould not be implemented. Alterna
tively, a commitment to a fixed exchange rate
through a pledge to maintain gold convertibility,
fo r example, could achieve the same results, but
because it is more transparent, it w ould possibly
cost less.1 Such binding commitments may, h ow
0
ever, be undesirable in the presence o f extrem e
emergencies such as major wars, supply shocks
or financial crises.1 Under such circumstances
1
apply this methodology to examine the incidence of
shocks within Western Europe and within regions of North
America.
8See Kydland and Prescott (1977), Barro and Gordon
(1983), and Persson and Tabellini (1990).
A lternatively the monetary authority may create an inflation
surprise to offset a labor market distortion that raises the
unemployment rate above some desired level.
,0See Giavazzi and Pagano (1988).
"S e e Rogoff (1985a) and Fischer (1990).

125

a contingent rule, or one with escape clauses
that allow m em ber countries to suspend parity
(convertibility) tem porarily, may be optimal.1
2
The rule constrains the governm ent to adhere to
the fixed exchange rate except in the case o f a wellunderstood em ergency, when it can suspend
parity (convertibility under the gold standard)
and issue fiat money. Once the em ergency has
passed, with allowance fo r a suitable delay, the
authority is expected to return to the rule—that
is, to the fixed rate at the original parity. I f the
public believes in the governm ent's commitment
to return to the rule, the governm ent w ill be able
to raise m ore revenue than it could with no credi
bility. The inflation rate during the em ergency
w ould be higher than under the rule (when p re
sumably it would be zero) but less than in the
case o f pure discretion. The pattern o f alternat
ing fixed and floating exchange rate regimes
over the past 200 years may be w ell explained
by adherence to a rule with an escape clause.1
3
On the other hand, in a regim e o f floating
exchange rates the inflationary bias o f discre
tionary policy may be overcom e by instituting
credible m onetary rules or other commitment
mechanisms, such as an independent conserva
tive central bank.1 Such mechanisms may pre
4
vent the perceived disadvantage o f sacrificing
national sovereignty to the supernational dic
tates o f a fixed exchange rate.
A fourth issue is that o f international coopera
tion and policy coordination. Recent game theory
literature has demonstrated that coordination o f
policies (by fixing exchange rates) can offset spill
over effects from uncoordinated policy actions.1
5
Cooperative fixed exchange rate arrangements,
how ever, unless enforced by a supernational au
thority whose pow er exceeds national sovereignty,
tend to break down as individual members de
value. Cooperation is m ore likely, without a
supernational authority, in a w orld o f repeated
games because the benefits o f reputation can
offset the advantages to each country o f cheat
ing.1 But even in this case, cooperation betw een
6
nations may produce an inflationary bias when
no credible commitment mechanism is present
to prevent governm ents from follow ing discre
12See Bordo and Kydland (1992), Flood and Isard (1989a
and 1989b), and DeKock and Grilli (1989 and 1992).
13See DeKock and Grilli (1989) and Giovannini (1992).
14See Rogoff (1985a).

tionary policies.1 Thus fo r an international m one
7
tary arrangement to be effective both betw een
countries and within them, a consistent credible com
mitment mechanism is required. Such a mechanism
likely prevailed under the gold standard but
was less evident under Bretton Woods.
A fifth and final issue is the case fo r international
m onetary reform . Several, prominent proposals
have been made to reform the present managed
floating exchange rate regim e and move it back
tow ard one o f greater fixity. These proposals in
part derive from a perception, based on the
historical record, that fixed exchange rates are
preferable to the current float. These proposals
include McKinnon's case fo r a gold standard w ith
out gold, Mundell’s proposal to target the real
price o f gold and the case fo r target exchange
rate zones presented by Williamson and Bergsten.1 Even m ore immediate is the m ove to con
8
vert the adjustable peg o f the EMS to a
unified currency area with irrevocably fixed
exchange rates.

O verview
The paper accomplishes a number o f tasks.
The next section answers the first question,
which international monetary regim e is best fo r
economic perform ance, by presenting a compila
tion o f statistical evidence on different aspects
o f the perform ance o f alternative m onetary
regimes. The measures cover the stability o f
several macroeconomic variables; the dispersion
o f macroeconomic variables across countries;
the persistence o f inflation; forecast errors in
inflation and growth; the incidence o f supply
(permanent) and demand (temporary) shocks;
the dispersion o f shocks betw een countries; and
the mean response o f prices and output to sup
ply and demand shocks. The third section
stresses the importance o f adhering to credible
rules in a historical examination o f three inter
national m onetary regimes: the classical gold
standard, Bretton W oods and the EMS. The
final section answers the question w hy some
regimes endured longer than others. It con
cludes by discussing w hy even a regional
exchange rate arrangem ent—the EMS—has con
siderable difficulty surviving.
16See Dominguez (1993).
17See Rogoff (1985b).
,aSee McKinnon (1988), Mundell (1992), Williamson (1985a)
and Bergsten (1992).

15See Hamada (1979) and Canzoneri and Henderson (1988
and 1991).

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126

The statistical evidence on perform ance o f alter
native monetary regimes in the next section makes it
clear that the performance o f regimes in the postW orld W ar II era is superior to that o f the regimes
in the preceding half century. The key exception
is the classical gold standard, which exhibits the
lowest inflation persistence and a relatively high
degree o f financial market integration. The Bretton
W oods convertible regim e from 1959 to 1970 per
form ed the best by far on virtually all criteria.
The greater durability o f the gold standard com
pared w ith Bretton W oods cannot be explained
by a low er incidence o f shocks. The key expla
nation fo r its success lies with the credibility o f
the commitment to the gold standard rule of
convertibility by England and the other core
countries and its near universal acceptance. As a
contingent rule, it was flexible enough to w ith
stand the major shocks that buffeted it. The
Bretton W oods adjustable peg was in some re
spects similar to the gold standard contingent
rule, but it invited speculative attack hence
weakening the escape clause. Unlike England,
the leading country before W orld W ar I, the
United States, the dominant country under Bret
ton Woods, maintained a credible commitment
to a noninflationary policy fo r only a fe w years.
The world, faced with im ported inflation in the
late 1960s, lost the incentive to follow its leader
ship, and the system collapsed in 1971.
Th e longevity o f general floating exchange
rate regimes since 1973 suggests that the lessons
o f Bretton W oods have been w ell learned. Coun
tries are willing to subject their domestic policy
autonomy neither to that o f another country
whose commitment they cannot be sure o f in a
stochastic world, nor to a supernational m onetary
authority they cannot control. Even the recent
experience o f the EMS—a regional exchange rate
arrangement betw een countries supposedly pur
suing common goals—revealed differing national
priorities in the face o f asymmetric shocks that
placed intolerable strains on the system.
19l also examined the period (1946-73) which includes the
three years of transition from the Bretton Woods adjusta
ble peg to the present floating regime. The results are
similar to those of the 1946-70 period.
20The common world price level under the gold standard,
however, exhibited secular periods of deflation and infla
tion reflecting shocks to the demand for and supply of
gold. See Bordo (1981) and Rockoff (1984). A welldesigned monetary rule, it is argued, could have prevented
the long-run swings that characterized the price level
under the gold standard. See Cagan (1984).
21See Giovannani (1992).
22See Bordo and Schwartz (1989a).

FEDERAL RESERVE BANK OF ST. LOUIS

THE PERFO RM ANCE OF A L T E R
N ATIV E M O NETAR Y REGIMES
T o make the case fo r one m onetary regim e
over another, empirical and historical evidence
on their perform ance is crucial. In this section
I present some evidence on different aspects o f
the macroeconomic perform ance o f alternative
international m onetary regimes over the past
110 years. The comparison fo r the seven largest
(non-Communist) industrialized countries (the
Group o f Seven countries) is based on annual
data fo r the classical gold standard (1881-1913),
the interw ar period (1919-39), Bretton W oods
(1946-70), and the present floating exchange
rates regim e (1971-89). The Bretton W oods
period (1946-70) is divided into tw o subperiods:
the preconvertible phase (1946-58) and the con
vertible phase (1959-70).1
9
The comparison relates to the theoretical issues
raised by the debate over fixed vs. flexible ex
change rates. According to the traditional view,
adherence to a (commodity-based) fixed exchange
rate regime, such as the gold standard, ensured
long-run price stability fo r the w orld as a w hole
because the fixed price o f gold provided a nomi
nal anchor to the w orld money supply. Individ
ual nations, by pegging their currencies to gold,
fixed their price levels to that o f the w orld .2 A
0
fixed-rate system based on fiat money, how ever,
may not provide a stable nominal anchor unless
a credible commitment mechanism constrains
the grow th o f the w orld ’s money supply.2 The
1
disadvantage o f fixed rates is that individual
nations are exposed to both monetary and real
shocks transmitted from the rest o f the w orld
through the balance o f payments and other
channels o f transmission.2 The advantage o f
2
floating exchange rates is to provide insulation
from foreign shocks. The disadvantage is the
absence o f the discipline o f the fixed-exchangerate rule because m onetary authorities might
adopt inflationary policies.

127

Theoretical developments in recent years have
complicated the simple distinction betw een fixed
and floating exchange rates. In the presence o f
capital mobility, currency substitution, policy
reactions and policy interdependence, floating
rates no longer necessarily provide insulation
from either real or m onetary shocks.2 M oreover,
3
according to recent real business cycle approaches,
there may be no relationship betw een the inter
national monetary regim e and the transmission
o f real shocks.2 Nevertheless, the comparison
4
betw een regimes may shed light on these issues.
One important caveat is that the historical
regimes presented here do not represent clear
examples o f fixed and floating exchange rate
regimes. The interw ar period comprises three
regimes: a general floating rate system from
1919 to 1925, the gold exchange standard from
1926 to 1931 and a managed float to 1939.2
5
Th e Bretton W oods regim e cannot be character
ized as a fixed exchange rate regim e throughout
its history: The preconvertibility period was close
to the adjustable peg envisioned by its architects,
and the convertible period was close to a de fa cto
fixed dollar standard.2 Finally, although the
6
period since 1973 has been characterized as a
floating exchange rate regime, at various times it
has experienced varying degrees o f management.

Stability and Convergence
Table 1 presents descriptive statistics on nine
macroeconomic variables fo r each Group of
Seven country, with the data fo r each variable
converted to a continuous annual series from
1880 to 1989. The nine variables are the rate o f
inflation; real per capita growth; money growth;
short-term nominal interest rates; long-term
nominal interest rates; short-term real interest
rates; long-term real interest rates; and the
absolute rates o f change o f nominal and real
exchange rates. The definition o f the variable
23See Bordo and Schwartz (1989a).
24See Baxter and Stockman (1989).
25To be more exact, the United States stayed on the gold
standard until 1933, and France stayed until 1936. For a
detailed comparison of the performances of these three
regimes in the interwar period, see Eichengreen (1991a).
26Within the sample of seven countries, Canada floated from
1950 to 1961.

used, fo r example, M l vs. M2, was dictated by
the availability o f data over the entire period.
For each variable and each country I present
tw o summary statistics: the mean and standard
deviation. For the countries taken as a group,
I show tw o summary statistics: the grand mean
and a simple measure o f convergence defined
as the mean o f the absolute differences betw een
each country's summary statistic and the grand
means o f the group o f countries.2 I comment
7
on the statistical results fo r each variable.
In fla tio n . Countries using the classical gold
standard had the lowest rate o f inflation and
displayed mild deflation during the interw ar
period. The rate o f inflation during the Bretton
W oods period was on average and fo r every
country except Japan low er than during the
subsequent floating exchange rate period. The
average rate o f inflation in the tw o Bretton
W oods subperiods was virtually the same. This
comparison, how ever, conceals the importance
o f tw o periods o f rapid inflation in the 1940s
and 1950s and in the late 1960s. See figure l . 2
8
Thus the evidence based on country and period
averages o f very low inflation in the gold stand
ard period and o f a low er inflation rate during
Bretton W oods than the subsequent floating
period is consistent with the traditional view on
price behavior under fixed (commodity-based)
and flexible exchange rates.
In addition, the inflation rates show the highest
degree o f convergence betw een countries during
the classical gold standard and to a lesser extent
during the Bretton W oods convertible subperiod
compared with the floating rate period and the
mixed interw ar regime. This evidence also is
consistent with the traditional view o f the oper
ation o f the classical price specie flo w mechanism
and commodity arbitrage under fixed rates and
insulation and greater m onetary independence
under floating rates.2
9
series around the G-7 aggregate. I calculated this alterna
tive measure of convergence for the data in table 1. The
results are very close to those reported here for virtually
every variable.
2aThe data sources for figure 1 and all subsequent figures
are listed in the Data Appendix to Bordo (1993).
29For similar evidence see Bordo (1981), Darby, Lothian
et.al. (1983) and Darby and Lothian (1989).

27This is a very crude measure of convergence or diver
gence between the different countries’ summary statistics.
Because it is based on the average for the whole period, it
suppresses unusual movements within particular sub
periods. Bayoumi and Eichengreen (1992d) presented an
alternative measure of convergence or dispersion—the
GDP-weighted standard deviation of the individual country

MARCH/APRIL 1993

FEDERAL RESERVE

Table 1
Descriptive Statistics of Selected Open Economy Macroeconomic Variables, the Group of Seven Countries
1881-1989 Annual Data: Mean, Standard Deviation

BANK O ST. LOUIS
F

Gold Standard
(1881-1913)

Interwar
(1919-1938)

Bretton Woods
(Total)
(1946-1970)

Bretton Woods
(Preconvertible)
(1946-1958)

Bretton Woods
(Convertible)
(1959-1970)
Standard
Deviation

Floating Exchange
(1974-1989)
Standard
Deviation

Mean

Standard
Deviation

Mean

2.4
3.7
2.7
5.6
4.5
2.7
3.8

2.6
2.2
4.0
4.1
4.6
3.0
11.5

2.8
4.6
2.1
5.6
4.7
3.9
5.8

3.5
2.5
6.2
5.1
7.3
3.9
16.0

2.6
3.4
3.2
5.5
5.1
2.9
3.8

1.5
1.5
1.8
3.6
1.3
1.5
2.1

5.6
9.4
3.3
8.8
2.6
7.3
12.9

2.4
6.1
1.2
3.2
2.4
2.6
4.6

7.8
1.5

3.6
0.9

4.6
2.0

4.2
1.1

6.4
3.0

3.9
0.9

1.9
0.5

7.1
2.8

3.2
1.2

0.0
1.2
2.6
1.3
2.0
0.2
0.9

8.1
4.5
8.5
7.2
6.1
8.8
4.7

2.0
2.1
5.0
3.9
8.1
2.5
5.6

2.8
1.8
3.3
2.1
2.7
2.6
3.3

1.8
2.1
7.3
4.6
5.7
2.4
5.2

3.4
2.2
3.9
2.7
1.1
3.3
4.4

2.9
2.3
3.5
3.9
8.9
3.5
5.8

1.9
1.4
2.6
1.3
2.5
1.7
1.9

2.1
1.5
2.1
1.7
3.5
1.3
2.5

2.7
4.2
1.9
1.5
1.1
2.4
2.2

3.7
1.0

1.2
0.7

6.8
1.5

4.2
1.7

2.7
0.4

4.2
1.7

3.0
0.9

4.4
1.6

1.9
0.4

2.1
0.5

2.3
0.7

6.1
2.1
5.7
2.1
7.2
7.4
3.2

4.1
1.7
4.7
4.7
14.5
5.3
3.1

0.6
0.8
1.3
6.4
0.5
1.1
3.6

8.6
4.7
10.1
8.5
9.7
4.7
6.2

6.3
3.2
12.8
11.5
16.2
6.0
13.3

5.8
3.2
5.9
7.5
16.2
4.0
7.8

6.4
1.7
17.6
14.7
20.1
5.1
15.9

8.3
2.9
5.6
7.2
21.8
3.2
10.5

7.0
5.5
10.9
8.6
14.9
8.3
12.4

1.5
2.9
4.7
6.5
7.0
3.9
2.0

8.6
13.5
5.7
8.8
5.8
10.6
13.4

2.4
5.5
4.5
3.4
6.3
3.9
4.9

4.8
2.1

5.4
2.4

2.0
1.7

7.5
2.0

9.9
4.1

7.2
3.7

11.6
6.2

8.5
4.4

9.7
2.6

4.1
1.7

9.5
2.1

4.4
1.0

Standard
Deviation

3.1
3.1
2.6
4.9
5.5
1.4
3.2

- 1 .8
- 1 .5
-2 .1
2.2
- 1 .7
- 1 .9
-1 .1

7.6
7.8
4.7
9.1
7.3
6.1
11.7

1.0
0.9

3.4
1.0

-1 .1
1.0

United States
United Kingdom
Germany
France
Japan
Canada
Italy

1.8
1.1
1.7
1.5
1.4
2.3
1.0

5.1
2.4
2.9
4.6
3.8
2.8
4.0

mean
convergence

1.5
0.3

United States
United Kingdom
Germany
France
Japan
Canada
Italy
mean
convergence

Mean

United States
United Kingdom
Germany
France
Japan
Canada
Italy

0.3
0.3
0.6
0.0
4.6
0.4
0.6

mean
convergence

Standard
Deviation

Mean

Real per capita growth1

Money Growth1

128

Standard
Deviation

Mean

Inflation PGNP1

Gold Standard
(1881-1913)
Mean

Standard
Deviation

Interwar
(1919-1938)
Mean

Standard
Deviation

Bretton Woods
(Total)
(1946-1970)
Mean

Standard
Deviation

Bretton Woods
(Preconvertible)
(1946-1958)
Mean

Standard
Deviation

Bretton Woods
(Convertible)
(1959-1970)
Mean

Standard
Deviation

Floating Exchange
(1974-1989)
Mean

Standard
Deviation

Short-term interest rate
United States
United Kingdom
Germany
France
Japan
Canada
Italy

4.8
2.8
3.2
2.5
2.4
n.a.
n.a.

0.9
0.8
0.9
0.6
0.5

3.5
3.0
4.6
3.1
2.0
0.9
n.a.

2.0
1.8
1.6
1.4
0.5
0.4

3.4
4.0
4.0
4.1
6.5
2.9
n.a.

1.9
2.5
1.5
1.9
0.8
2.0

2.0
2.3
4.1
3.2
6.9
1.4
n.a.

0.9
1.8
1.1
1.5
1.0
1.1

4.8
5.8
4.0
5.1
6.3
4.6
n.a.

1.6
1.6
1.7
1.9
0.6
1.3

8.9
11.2
5.9
10.3
5.2
10.3
n.a.

2.6
2.1
2.4
2.6
2.0
2.8

3.1
0.7

0.7
0.2

2.9
0.9

1.3
0.6

4.2
0.8

1.8
0.4

3.3
1.5

1.2
0.3

5.1
0.6

1.4
0.4

8.6
2.1

2.4
0.3

United States
United Kingdom
Germany
France
Japan
Canada
Italy

3.8
2.9
3.7
3.2
n.a.
3.5
4.2

0.3
0.2
0.2
0.3

0.6
0.7
1.6
0.8
0.8
0.6

3.9
5.2
6.3
5.7
7.0
4.5
6.0

1.3
1.8
0.7
0.8
0.1
1.5
0.7

3.0
3.9
5.9
5.8
n.a.
3.3
6.3

0.4
0.8
0.5
0.5

0.4
0.5

4.2
4.1
6.8
4.6
n.a.
4.7
5.9

0.5
0.4

5.0
6.6
6.7
5.7
7.0
5.8
5.7

1.1
1.3
0.7
1.0
0.1
1.1
0.7

10.4
12.1
7.8
10.9
7.1
11.0
13.7

2.1
2.8
1.5
2.4
1.8
2.0
3.3

mean
convergence

3.6
0.4

0.3
0.1

5.1
0.9

0.9
0.3

5.5
0.8

1.0
0.5

4.7
1.3

0.5
0.1

6.1
0.6

0.9
0.3

10.4
1.7

2.3
0.5

4.8
2.9
2.4
2.8
-1 .5
n.a.
n.a.

2.0
2.3
2.3
6.4
5.5

3.8
4.2
5.1
1.2
1.4
- 0 .8
n.a.

6.7
7.1
5.2
14.7
8.8
1.3

0.3
-0 .1
2.2
- 0 .9
1.9
- 0 .3
n.a.

3.9
3.4
2.6
5.2
2.5
4.2

-1 .6
- 2 .4
3.0
- 3 .3
3.4
- 2 .6
n.a.

4.7
3.2
3.6
6.9
3.5
4.8

2.4
2.3
1.6
1.2
1.1
2.2
n.a.

0.4
1.1
1.5
1.4
1.6
0.8

2.5
1.3
2.5
2.1
1.4
3.1
n.a.

2.8
5.1
1.9
2.8
3.5
3.2

2.3
1.5

3.7
1.8

2.5
1.9

7.3
3.0

0.5
1.0

3.6
0.8

- 0 .6
2.5

4.5
1.0

1.8
0.5

1.1
0.4

2.2
0.6

3.2
0.7

mean
convergence
Long term interest rate

MARCH/APRIL

United States
United Kingdom
Germany
France
Japan
Canada
Italy
mean
convergence

1993

129

Real short term interest rate2

FEDERAL RESERVE BANK

Table 1 (continued)
Descriptive Statistics of Selected Open Economy Macroeconomic Variables, the Group of Seven Countries
1881-1989 Annual Data: Mean, Standard Deviation_____________________________________________________
Gold Standard
(1881-1913)

O ST. LOUIS
F

Mean

Standard
Deviation

Interwar
(1919-1938)
Mean

Standard
Deviation

Bretton Woods
(Total)
(1946-1970)
Mean

Standard
Deviation

Bretton Woods
(Preconvertible)
(1946-1958)
Mean

Standard
Deviation

Bretton Woods
(Convertible)
(1959-1970)
Mean

Standard
Deviation

Floating Exchange
(1974-1989)
Mean

Standard
Deviation

Real long term interest
rate2
3.9
2.2
4.4
2.7
2.0
3.8
1.4

3.8
3.7
0.9
3.1
4.2
3.1
4.8

-0 .1
1.5

5.8
2.5

2.9
0.8

1.1
0.4

2.9
1.0

3.5
0.7

0.8
6.2
3.8
7.7
37.2
1.9
20.6

3.3
2.4
4.4
30.5
1.8
14.1

7.9
5.3
11.3
47.9
1.9
27.4

0.7
1.5
1.3
1.1
0.2
1.4
0.2

0.8
4.0
2.1
3.3
0.2
2.0
0.2

10.0
9.3
10.7
8.8
3.7
10.9

4.7
8.2
7.8
9.5
2.4
9.0

11.2
10.1

8.1
7.7

14.5
12.9

0.9
0.6

1.8
1.2

8.9
1.8

6.9
2.3

6.5
9.3

- 0 .7
-0 .8
4.3
-1 .2
n.a.
- 0 .7
-1 .5

4.5
1.5

8.5
2.5

1.4
0.9

4.0
1.6

0.2
0.1
0.0
4.5
0.0
1.5

6.8
3.9
18.4
6.8
2.7
13.6

7.9
9.5
15.6
9.0
3.4
20.1

0.7
2.4
1.8
2.5
15.9
1.6
7.4

0.9
1.3

7.5
4.5

9.4
4.2

4.6
4.0

4.1
2.4

3.4
0.4

3.4
1.3

United States4
United Kingdom
Germany
France
Japan
Canada
Italy

0.2
0.2
0.0
2.9
0.0
1.4

mean
convergence

0.7
0.9

3.7
3.0
2.9
3.5
n.a.
2.9
4.2

2.2
2.5
2.4
6.5

4.4
2.6
4.4
6.2

Nominal exchange rate5

130

0.7
1.0
0.9
1.0
1.3
0.7
2.2

3.6
2.8
2.8
4.4
1.3
3.8
9.4

6.8
7.1
6.0
15.1

mean
convergence

4.4
12.9

2.5
3.2
4.3
1.8
1.7
3.4
2.3

0.8
1.1
4.3
0.4
1.7
1.3
0.3

4.6
5.4
6.9
1.0
n.a.
5.4
3.4

United States
United Kingdom
Germany
France
Japan
Canada
Italy

Bretton W oods
Bretton W oods
Bretton Woods
Gold Standard
Interw ar
(Total)
(Preconvertible)
(Convertible)
Floating Exchange
(1881-1913)_____________(1919-1938)_____________(1946-1970)_____________(1946-1958)_____________(1959-1970)_____________(1974-1989)
Mean

Standard
Deviation

Mean

Standard
Deviation

Mean

Standard
Deviation

Mean

Standard
Deviation

Mean

Standard
Deviation

Mean

Standai
Deviatic

Real exchange rate3,5
United States4
United Kingdom
G erm any
France
Japan
Canada
Italy

1.7
2.4
4.3
6.6
2.6
2.1

1.5
1.2
5.0
5.5
2.2
1.7

8.5
5.8
9.0
7.8
3.2
13.3

10.0
9.2
6.9
7.2
2.8
16.9

1.7
4.2
2.8
4.1
3.5
2.4
8.0

1.0
6.5
5.1
5.6
2.9
2.3
18.7

5.9
3.9
6.2
4.8
3.3
13.1

8.2
7.3
7.7
4.1
2.5
25.2

1.7
2.5
1.9
2.5
2.7
1.5
2.4

1.0
3.9
1.8
2.9
1.5
1.7
1.6

12.3
8.8
9.2
9.6
3.8
8.6

6.1
8.2
7.7
8.9
2.0
7.8

mean
convergence

3.3
1.5

2.9
1.6

7.9
2.3

8.8
3.2

3.8
1.3

6.0
3.8

6.2
2.3

9.2
5.4

2.2
0.5

2.1
0.8

8.7
1.4

6.8
1.8

Data Sources: See Data Appendix to Bordo (1993).

MARCH/APRIL
1993

131

'M e a n grow th rate calculated as the tim e coefficient from a regression of the natural logarithm of the variable on a constant and a tim e trend.
C a lc u la te d as the nom inal interest rate minus the annual rate of change of the consum er price index (CPI).
3Absolute rates of change.
4T rade-w eighted nom inal and real exchange rate starting in 1960.
C a lc u la te d as the nom inal exchange rate divided by the ratio of foreign CPI to the U.S. CPI.

132

Figure 1
Inflation Rates, 1880-1989, G7 Countries
Percent
4 0 -i------------------------------------------------------

30-

----------1
----------1
----------1
----------1
---------- 1
----------1
----------1
----------1--------- 1
----------1
---------1880

1890

1900

1910

U.S.

------

1920

1930

U.K.

1940
------

1950

Germany

1960

1970
------

1980
Canada

Percent

France

FEDERAL RESERVE BANK OF ST. LOUIS

------

Italy

------

Japan

1990

133

The Bretton Woods convertible subperiod had
the most stable inflation rate o f any regime as
judged by the standard deviation. By contrast,
the preconvertible Bretton Woods period exhibited
greater inflation variability than either the gold
standard period or the recent floating exchange
rate period. The evidence of a high degree of
price stability in the convertible phase of Bretton
Woods is also consistent with the traditional
view that fixed rate (commodity-based) regimes
provide a stable nominal anchor; however, the
remarkable price stability during this period
may also reflect the absence of major shocks.
Real p e r capita GNP. Generally, the Bretton
Woods period, especially the convertible period,
exhibited the most rapid output growth of any
monetary regime, and not surprisingly the interwar period the lowest (see figure 2). Output
variability was also lowest in the convertible
subperiod o f Bretton Woods, but because of
higher variability in the preconvertible period,
the Bretton Woods system as a whole was more
variable than the floating exchange rate period.
Both pre-W orld W ar II regimes exhibit higher
variability than their post-World W ar II coun
terparts.3 The divergence of output variability
0
between countries was also lowest during the
Bretton Woods regime, with the interwar regime
showing the highest divergence.3 The greater
1
convergence of output variability under Bretton
Woods may reflect conformity between countries’
business fluctuations, created by the operation
of the fixed exchange rate regime.3
2
M oney g ro w th (M2). Money grew consider
ably more rapidly across all countries after
World W ar II than before the war (see figure 3).
There is not much difference between Bretton
Woods and the subsequent floating exchange
rate regime. Within the Bretton Woods regime,
money grew more rapidly in the preconvertibility
period than in the convertibility period. Money
growth rates showed the least divergence between
30Baxter and Stockm an (1989) and Eichengreen (1992a) use
residuals from a linear trend to the logarithm of real output
as a detrending filte r rather than the logarithm ic first d iffe r
ence used here. A ccording to th e ir results, real output
va riab ility is not greater in the floating than in the fixed
period.
31However, using th e ir alternative m easure of convergence—
the G DP-weighted standard deviation of the individual
country series around the G-7 aggregate— Bayoum i and
Eichengreen (1992a) report th a t the lowest degree of dis
persion of real GDP growth was in the floating rate period,
followed by the Bretton W oods convertible period. Sim ilar
results hold for the real GNP per capita data in table 1.
For Bayoum i and Eichengreen (1992a) the decline in the

countries during the fixed-exchange-rate gold
standard and the convertible Bretton Woods
regime, with the greatest divergence in the
preconvertible Bretton Woods period and the
interwar period.
Like inflation and real output variability, money
growth variability was lowest in the convertible
Bretton Woods period. This, however, was not
the case for the preconvertible period, which
was the most variable of any regime. It also
exhibited the greatest divergence in variability
between countries. To the extent that one of
the properties o f adherence to a fixed-exchangerate regime is conformity o f monetary growth
rates between countries, these results are sym
pathetic to the view that the Bretton Woods
system really began in 1959.
Short-term and long-term interest rates.
The underlying data for short-term and long
term interest rates are seen in figures 4 and 5.
As in other nominal series, the degree o f con
vergence of mean short-term interest rates is
highest in the convertible Bretton Woods
period. Long-term rates are most closely related
in the classical gold standard regime, with the
convertible Bretton Woods period not far behind.
McKinnon (1988) has similar findings. He views
them as evidence of capital market integration
under fixed exchange rates. The lack o f conver
gence in the preconvertibility Bretton Woods
period reflects the presence of pervasive capital
controls. Convergence of nominal interest rates
would not be expected under floating exchange
rates. Convergence of standard deviations is also
highest in the gold standard period followed by
Bretton Woods. Long-term rates were most stable
and least divergent under the classical gold stand
ard, followed by the two Bretton Woods subperiods,
with floating exchange rates the least stable. The
evidence that nominal interest rates are more
stable and convergent between countries under
fixed exchange rate (commodity-based) regimes
is consistent with the traditional view.
dispersion of real growth and the rise in the dispersion of
inflation rates between the Bretton W oods convertible
period and the float have the follow ing explanations: the
move to fle xib le rates allowed countries to stabilize th e ir
relative growth rates in the face of asym m etric supply
shocks at the expense o f th e ir relative inflation rates. They
also report that, when they apply the linear trend filte r of
Baxter and Stockm an (1989), evidence of a rise in the
cross country correlation between o utput m ovem ents after
1970 is considerably reduced.
32See Bordo and Schw artz (1989a) and Darby and Lothian
(1989).

M ARCH/APRIL 1993

134

Figure 2
Per Capita Income Growth Rates, 1880-1989, G7 Countries
Percent

------

U.S.

------

U.K.

------

Germany

------

Canada

Percent

------

France

FEDERAL RESERVE BANK OF ST. LOUIS

------

Italy

------

Japan

135

Figure 3
Money Growth Rates, 1880-1989, G7 Countries
Percent

------

U.S.

------

U.K.

------

Germany

------

Canada

Percent

------

France

------

Italy

------

Japan

M ARCH/APRIL 1993

136

Figure 4
Short-Term Interest Rates, 1880-1989, G7 Countries
Percent

------

U.S.

-------

U.K.

------

Germany

-------

Percent

France

FEDERAL RESERVE BANK OF ST. LOUIS

------

Japan

Canada

137

Figure 5
Long-Term Interest Rates, 1880-1989, G7 Countries
Percent

------

U.S.

-------

U.K.

------

Germany

-------

Canada

Percent

-------

France

-------

Italy

------

Japan

MARCH/APRIL 1993

138

Real short-term and real long-term
interest rates. For the underlying real short
term and real long-term interest rate data, see
figures 6 and 7. The real interest rates are e^c
post rates calculated using the rate of change of
a consumer price index.3 Unlike the nominal
3
series, the degree of convergence in means
between real short-term interest rates is lowest
in the floating exchange rate period, next lowest
in the Bretton Woods convertible period and
highest in the preconvertible period. For long
term real rates, as in the case of nominal rates,
convergence is highest under the gold standard
followed by the Bretton Woods convertible regime.
It is lowest under preconvertible Bretton Woods.
The real short-term interest rate is most stable
across countries during the Bretton Woods con
vertible period. It also shows the least amount
of divergence in standard deviations. The same
holds for real long-term interest rates.
The behavior of real interest rates across
regimes is consistent with McKinnon’s explana
tion.3 He argued that fixed exchange rates
4
encourage capital market integration by elimina
ting devaluation risk. This reduces variability
in short-term real interest rates. Similarly,
real long-term interest rates are stabilized by
pooling across markets, which reduces capital
market risk.
N om inal and real exchange rates. The
lowest mean rate of change of the nominal ex
change rate and the least divergence between
rates of change occurred during the Bretton
Woods convertible and gold standard periods,
with the former exhibiting the lowest degree of
divergence. Exchange rates during the precon
vertibility Bretton Woods regime changed almost
as much as during the floating period. This
mainly reflected the major devaluations of 1949
(see figure 8).3 Nominal exchange rates were
5
least variable in the gold standard and converti
ble Bretton Woods periods and the most varia
ble and most divergent in the Bretton Woods
preconvertible period.
As with the nominal exchange rate, the lowest
mean rate of change in the real exchange rate
33Define the real interest rate as rt = it - Alog Pt; w here it is
the nom inal interest rate and Alog Pt = log Pt - log Pt _ n
is the percentage change in the consum er price index.
34See M cKinnon (1988).
35See Bordo (1993) table 2.
36Also see D ornbusch (1976).
37Stockm an (1983 and 1988) argues that greater variability

FEDERAL RESERVE BANK OF ST. LOUIS

across countries and the least divergence
between countries was in the Bretton Woods
convertible period, with the divergence in gold
standard period next smallest (see figure 9). The
highest rate of change was in the floating
exchange rate period. Similarly data from the
Bretton Woods convertible period had the
lowest standard deviation across countries and
the least divergence between standard devia
tions, with the gold standard again next in these
rankings. The other regimes were characterized
by much greater variability and divergence.
These results shed light on the relationship
between the nominal exchange rate regime and
the behavior of real exchange rates. Mussa
(1986) presented evidence for 16 industrial
countries in the post-World W ar II period
showing the similarity between nominal and
real exchange rate variability under floating
rates. His explanation for greater real exchange
rate variability under floating rates than under
fixed rates is nominal price rigidity.3 The expla
6
nation may, however, be questioned. For exam
ple, a fixed nominal exchange rates may produce
greater trade stability that will be reflected in
the real exchange rate, as is evident for both
the Bretton Woods and gold standard periods.
Yet as Eichengreen (1991b) points out and as
can be seen in table 4, these results could be
explained by the fact that both periods were
characterized by few shocks.3
7
Finally, based on monthly data between 1880
and 1986 for the United Kingdom and the United
States, Grilli and Kaminsky show that, with the
exception of the post-World W ar II period, no
clear connection exists between the nominal
exchange rate regime and the variability of real
exchange rates.3 My results for the Group of
8
Seven countries show a clear correlation
between nominal exchange rate rigidity and
lower real exchange rate variability for the gold
standard and Bretton Woods convertible regime.
For the preconvertible Bretton Woods periodde ju r e a type of fixed exchange rate regime—
the correlation is not evident. I do not distin
guish between fixed and flexible periods in the
interwar segment as do Grilli and Kaminsky,
in real exchange rates under floating rates than under
fixed rates reflects the response of real exchange rates to
productivity shocks, with changes in the real exchange
rate producing nom inal exchange rate volatility. This vo la
tility is offset under fixed rates by exchange m arket in te r
vention.
38See G rilli and K am insky (1991).

139

Figure 6
Real Short-Term Interest Rates, 1880-1989, G7 Countries
Percent

----- -

U.S.

------

U.K.

------

Germany

------

Canada

Percent

Japan

------

France

M ARCH/APRIL 1993

140

Figure 7
Real Long-Term Interest Rates, 1880-1989, G7 Countries
Percent

------

U.S.

------

U.K.

------

Germany

------

Canada

Percent

France

FEDERAL RESERVE BANK OF ST. LOUIS

------

Italy

------

Japan

141

Figure 8
Absolute Change in Nominal Exchange Rates, 1880-1989, G7 Countries
Percent

------

U.K.

------

Germany

------

Canada

Percent
140—
i—

1880

1890

1900

France

1910

1920

1930

------

1940

Italy

1950

1960

1970

------

1980

1990

Japan

M ARCH/APRIL 1993

142

Figure 9
Absolute Change in Real Exchange Rates, 1880-1989, G7 Countries

1880

1890

1900

---------1
--------- 1
-------- ---------- 1
_l--------- (-----— ,--------- 1
1910
1920
1930
1940
1950
1960
1970
1980
Germany

U.K.

1990

Canada

i’ * ~ -i — — r—------ 1-------- 1--------1
--------- 1-------- 1-------- 1-------- r
1880

1890

1900

1910

France

FEDERAL RESERVE BANK OF ST. LOUIS

1920

1930

------

1940

Italy

1950

1960

1970

------

1980

Japan

1990

143

hence that period cannot be used in the com
parison.3
9
In summary, the Bretton Woods regime exhibited
the best overall macroeconomic performance of
any regime. This is especially so for the con
vertible period (1959-70).4 As the summary
0
statistics in table 1 show, both nominal and real
variables were most stable in this period. The
floating exchange rate regime, on most criteria,
was not far behind the Bretton Woods converti
ble regime, whereas the classical gold standard
exhibited the most stability and the closest con
vergence of financial variables.
The preconvertible Bretton Woods period (194658) was considerably less stable for the average of
all countries for both nominal and real variables
than other regimes. Also both nominal and real
variables did not vary nearly as closely together.
These differences likely reflect the presence of
pervasive exchange and capital controls before
1958 and, related to these, more variable and
more rapid monetary growth. These data, how
ever, are limited. Although they show excellent
performance for the convertible Bretton Woods
regime, they do not tell us why it did well—
whether it reflected a set of favorable circum
stances, whether it reflected the absence of
aggravating shocks, whether it reflected stable
monetary policy by the key country of the sys
tem, the United States, or whether it masked
underlying strains to the system.

Inflation Persistence
A second piece of evidence is persistent infla
tion. Evidence of persistence in the inflation
rate suggests that market agents expect the
monetary authorities to continually follow an
inflationary policy; its absence would be consis
tent with the belief that the authorities are fol
lowing a stable monetary rule, such as the gold
standard's convertibility rule. Barsky (1987) pre
sented evidence for the United Kingdom and
United States based on both autocorrelations
and time series models that inflation under the
39M eltzer (1990) in a com parison of EMS and non-EMS contries in the floating rate period also finds a strong correla
tion between changes in nom inal and real exchange rates.
40M cKinnon (1992) treats the period 1950 to 1970 as the
de facto dollar standard. He view s this period rather than
1959 to 1971 as the appropriate one for m aking the type
of regim e com parisons undertaken here. I m ade the same
calculations as those shown in table 1 for the period 1950
to 1971. V irtu a lly every variable for each country exhibited
greater instability than in the 1959 to 1970 period. This
reinforces my choice o f dates.

gold standard was very nearly a white-noise
process, whereas in the post-World War II
period, the inflation rate exhibited considerable
persistence. Alogoskoufis and Smith (1991) also
show, based on AR(1) regressions of the infla
tion rate, that inflation persistence in the two
countries increased between the classical gold
standard period and the interwar period and
between the interwar period and the post-World
W ar II period.4
1
Table 2 presents the inflation-rate coefficient
from the type of AR(1) regressions on consumer
price index inflation estimated by Alogoskoufis
and Smith, for the Group of Seven countries
over successive regimes since 1880, as well as
the standard errors and the Dickey-Fuller tests
for a unit root.4
2
The results, as in Alogoskoufis and Smith, show
an increase in inflation persistence for most
countries between the classical gold standard
and the interwar period, and also between the
interwar period and the post-World War II
period as a whole. Within the post-World War
II period, inflation persistence is generally lower,
with the exceptions of France and Japan, in the
preconvertible Bretton Woods than the convertible
period. This suggests that though the immediate
post-World W ar II period was characterized by
rapid inflation, market agents may have expected
a return to a stable price regime. The higher
degree of persistence in the convertible regime
suggests that this expectation lost credence. Finally,
the evidence that persistence was generally
highest during the floating exchange rate regime
may imply that the public realized that there
was no longer a stable nominal anchor.

Forecast Errors in Inflation and
Growth
A third piece of evidence relates to the forecast
errors of inflation and real output growth. Accord
ing to Meltzer and Robinson (1989), “ a welfare
maximizing monetary rule would reduce varia
bility to the minimum inherent in nature and
41Also see Alogoskoufis (1992), who attributes the increase
in persistence to the accom m odation by the m onetary
authorities of shocks. This evidence is also consistent with
the results of Klein (1975).
42Eichengreen (1992b) also presents these statistics fo r four
of the countries.

MARCH/APRIL 1993

Table 2
Persistence of CPI Inflation: Group of Seven Countries 1880-1989
Annual Data: Coefficient of AR1 Regression; (Standard error); t-s ta tis tic for unit root test
United States
AR1
Standard
Error
Coefficient
Gold Standard
Interw ar
Bretton W oods
Total)
Bretton W oods
(Preconvertible)
Bretton W oods
(Convertible)
Floating Exchange
Post W orld W ar II

United Kingdom
tstatistic

AR1
Standard
Error
Coefficient

tstatistic

AR1
Standard
Error
Coefficient

tstatistic

(0.18)
(0.17)

4.05
3.18

0.30
0.35

(0.17)
(0.19)

4.03
3.37

0.51
0.51

(0.16)
(0.21)

3.06
2.33

-0 .2 2
0.42

(0.18)
(0.24)

6.78
2.42

0.49

(0.19)

2.68

0.33

(0.20)

3.35

- 0 .0 3

(0.21)

4.90

0.56

(0.16)

2.75

0.41

(0.27)

2.19

0.15

(0.29)

2.93

- 0 .0 7

(0.31)

3.00

0.60

(0.27)

1.48

1.07
0.68
0.65

(0.20)
(0.18)
(0.12)

- 0 .3 5
1.78
2.92

0.57
0.69
0.75

(0.34)

1.26
1.63
2.50

0.44
0.83
0.31

(0.31)
(0.14)
(0.15)

1.81
1.21
4.60

0.12
0.85
0.69

(0.14)
(0.16)

6.29
0.94
2.82

(0.19)
(0 1 0 )

Italy

Canada

Japan
tstatistic

AR1
Standard
Coefficient
Error

tstatistic

AR1
Standard
Coefficient
Error

tstatistic

0.22
0.70

(0.18)
(0.25)

4.331
1.20

0.08
0.35

(0.18)
(0.20)

5.11
3.25

0.28
0.28

(0.14)
(0.18)

5.14
4.00

0.52

(0.18)

2.67

0.39

(0.19)

3.21

0.21

(0.12)

6.58

0.47

(0.27)

1.96

0.32

(0.28)

2.43

0.18

(0.18)

4.56

0.18
0.70
0.54

(0.31)
(0.19)
(0.13)

2.64
1.58
3.54

0.81
0.75
0.65

(0.20)
(0.17)
(0.11)

0.95
1.47
3.18

0.38
0.75
0.28

(0.29)
(0.17)
(0.10)

2.14
1.47
7.20

For data sources see ta b le 1.
The 5 percent sig n ifica n ce level for unit root test with 25 observations is 3.00.
1G N P d eflator was used because o f unavailability of CPI data.

AR1
Standard
Error
Coefficient

0.27
0.45

AR1
Standard
Error
C oefficient
Gold Standard
Interw ar
Bretton W oods
(Total)
Bretton W oods
(Preconvertible)
Bretton W oods
(Convertible)
Floating Exchange
Post W orld W ar II

________________ Germ any_________________________ France

tstatistic

(0.11)

145

institutional arrangements.” They measure varia
bility by the mean absolute error (MAE) of a oneperiod forecast based on the univariate multistate
Kalman Filter (MSKF). Following their approach,
table 3 presents the MAEs for inflation and real
growth for the Group of Seven countries over suc
cessive regimes. The MSKF forecasts incorporate
both transitory and permanent shocks to the rateof-change series.4
3

absence of shocks to the underlying environment.
One way to shed light on this issue, following
earlier work by Bayoumi and Eichengreen, is to
identify underlying shocks to aggregate supply
and demand.4 According to them, aggregate
4
supply shocks reflect shocks to the environment
and are independent of the regime, but aggregate
demand shocks likely reflect policy actions and
are specific to the regime.

The smallest forecast errors for inflation on aver
age were for the Bretton Woods convertible period,
followed by the gold standard and the floating rate
periods. The largest errors were for the interwar
period, followed by the preconvertible Bretton
Woods period. The most notable exception to
the pattern was the United Kingdom, where the
floating rate period exhibited the largest varia
bility.

The approach used to calculate aggregate sup
ply and demand shocks is an extension of the
bivariate structural vector autoregression (VAR)
methodology developed by Blanchard and Quah.4
5
Following Bayoumi and Eichengreen (1992a),
I estimated a two-variable VAR on the rate of
change of the price level and output.4 Restric
6
tions on the VAR identify an aggregate demand
disturbance, which is assumed to have only a
temporary effect on output and a permanent
effect on the price level, and an aggregate sup
ply disturbance, which is assumed to have a
permanent effect on both prices and output.4
7
Overidentifying restrictions, namely, restrictions
that demand shocks are positively correlated
and supply shocks are negatively correlated
with prices, can be tested by examining the
impulse response functions to the shocks.

For real growth, as for the inflation rate, the
lowest MAE, on average, occurred in the con
vertible Bretton Woods period. Another excep
tion to this pattern was Japan. The highest MAE
was again in the interwar and the preconverti
ble Bretton Woods period. The floating exchange
rate period, though more variable than the con
vertible Bretton Woods period, was slightly less
variable than the gold standard regime.
These results are quite consistent with those
o f table 1. The Bretton Woods convertible
period was the most stable both in an ep post
and ex ante sense. The performance o f the gold
standard and the float, however, are not much
worse, at least for real growth for the float and
inflation for the gold standard.

Dem and and Supply Disturbances
An important issue is the extent to which the
performance of alternative monetary regimes,
as revealed by the data in the preceeding tables,
reflects the operation of the monetary regime in
constraining policy actions or the presence or
43M eltzer and Robinson (1989) present th e ir results for
levels, grow th rates, and perm anent growth rates of the
series. I present only growth rates to m ake the results
com parable to those in table 1.
44See Bayoum i and Eichengreen (1992a, 1992b, 1992c and
1992d).
45See Blanchard and Q uah (1989).

The methodology has important limitations
that suggest that the results should be viewed
with caution. The key limitation is that one can
easily imagine frameworks in which demand
shocks have permanent effects on output, where
as supply shocks have only temporary effects.4
8
I estimated supply (permanent) and demand
(temporary) shocks, using annual data for each
of the Group o f Seven countries, over alterna
tive regimes in the period 1880-1989. The VARs
are based on three separate sets of data—1880-1913,
1919-39 and 1946-89—with the war years omit
ted because complete data on them were avail
able for only four o f the countries.4 The VARs
9
have two lags. I also did the estimation for
supply shocks are orthogonal; the fo u rth is that dem and
shocks have only tem porary effects on output, that is, that
the cum ulative effect of dem and shocks on the rate of
change in output m ust be zero.
48See Keating and Nye (1991).
49For results using the com plete data set for these four
countries, see appendix table 1 and appendix fig u re 1.

46Both variables w ere rendered stationary by first differencing.
47S pecifically, four restrictions are placed on the m atrix of
the shocks: two are sim ple norm alizations, which define
the variances of the shocks to aggregate dem and and
aggregate supply; the third assum es that dem and and

M ARCH/APRIL 1993

FEDERAL

Table 3

RESERVE

Forecast Errors in Inflation and Real Growth: Group of Seven Countries 1880-1989
Annual Data: Mean Absolute Errors Using the Multistate Kalman Filter____________

BANK

Bretton W oods
Bretton W oods
Bretton W oods
Gold Standard
Interw ar
(Total)
(Preconvertible)
(Convertible)
Floating Exchange
(1880-1913)___________ (1919-1939)____________(1946-1970)____________(1946-1958)____________(1959-1970)____________(1973-1989)

O ST. LO UIS
F

G rowth

Inflation

Growth

Inflation

G rowth

Inflation

Growth

Inflation

Growth

Inflation

G rowth

Inflation

United States
United Kingdom
G erm any
France
Japan
Canada
Italy

2.04
1.42
1.69
2.25
1.69
1.58
2.08

1.59
2.10
1.69
2.47
3.95
0.80
2.01

4.79
4.11
8.07
5.54
2.71
7.16
2.08

4.61
4.41
3.97
7.07
6.83
3.99
7.58

3.22
1.41
2.77
1.51
1.59
2.19
4.21

2.32
1.47
2.59
3.13
2.63
1.92
6.35

5.02
1.82
3.24
2.28
0.98
3.06
7.04

3.44
1.76
4.99
4.62
5.48
2.96
10.53

1.28
0.97
2.49
0.87
1.60
1.24
1.15

1.12
1.15
1.18
2.14
0.96
0.79
1.81

1.65
2.83
1.49
1.47
1.34
1.72
1.14

2.46
4.66
1.30
2.74
2.95
2.29
3.84

Average

1.82

2.09

4.92

5.50

2.41

2.92

3.35

4.82

1.37

1.31

1.66

2.89

146

Note: For data sources, see table 1.

147

aggregated price and output data for the Group of
Seven countries.5
0
The overidentifying restrictions that demand
shocks be positively correlated and supply shocks
be negatively correlated with the price level are
satisfied for all countries for the two post-World
W ar II regimes. But for the period before World
W ar II, for a number of countries, including the
United States, United Kingdom, and France, they
are not. Supply shocks were positively correlated
with prices. This can be seen in the impulse
response functions displayed in figure 10. Fig
ure 10 shows the impulse responses, to one
standard deviation shocks in aggregate supply
and aggregate demand, on output and prices for
the Group of Seven countries aggregate by regime.5
1
Keating and Nye (1991) attempted to explain this
result by possible hysteresis effects. Bayoumi and
Eichengreen (1992a) argued that the perverse
impulse response patterns for the classical gold
standard and interwar periods reflected the
interaction of a positive aggregate demand curve
with a very steep aggregate supply curve. They
explain the positively sloped aggregate demand
curve as reflecting the effects of gold discover
ies induced by the supply shock of agricultural
settlements in the United States and Australia.
These results may also reflect a limitation of the
Blanchard-Quah methodology.
Table 4 presents the standard deviations of
supply and demand shocks for the Group of
Seven countries and the Group of Seven coun
tries taken as a whole (Group of Seven aggregate)
by regime. I also show, following Bayoumi and
Eichengreen, the weighted average of the indi
vidual country shocks.5 Figures 11 and 12 show
2
the shocks for the Group of Seven aggregate
and for each of the seven countries.
50The G roup of Seven aggregate incom e growth and infla
tion rate are a w eighted average of the rates in the d iffe r
ent countries. The weights for each year are the share of
each c o u n try’s nom inal national incom e in the total incom e
in tlfe G roup of Seven countries, w here the national
incom e data are converted to U.S. dollars using the actual
exchange rates.
51The im pulse response functions were calculated from
VARs run for the separate regim e periods. Because the
num ber of observations was lim ited, the Bretton W oods
regim e could not be split into the two subperiods shown in
preceding tables.

Table 4 shows for the Group of Seven aggre
gate that the convertible Bretton Woods regime
was the most tranquil of all the regimes—neither
supply nor demand shocks dominated. It was not,
however, that much less turbulent than the suc
ceeding float. The interwar period, unsurpris
ingly, shows the largest supply and demand
shocks.5 Sizeable supply and demand shocks
3
that are two or three times greater than the
post-World W ar II period also characterize the
classical gold standard.5
4
For individual countries, the Bretton Woods
convertible period was the most stable in four
countries and the flexible exchange rate period
was the most stable in three. The difference
between the convertible Bretton Woods period
and the floating exchange rate period, however,
was not great in any country. The interwar
period as expected was the most volatile. Both
types of shocks were the largest in every coun
try except the United Kingdom. Finally, in the
majority of countries, with the principal excep
tions being the United Kingdom and Germany,
both supply and demand shocks were consider
ably greater in the gold standard period than in
the post-World W ar II period.
The dispersion o f demand shocks across coun
tries, as measured by the GNP-weighted stand
ard deviation of the individual country shocks
around the Group of Seven aggregate, reveals
very little difference between the gold standard
and the post-World War II regimes, with the
convertible Bretton Woods regime displaying
the highest degree of convergence. Dispersion
is much greater in the interwar period. The
dispersion of supply shocks is considerably
greater during the gold standard and the inter
war periods than in any of the post-World
W ar II regimes.

•

1920s and early 1930s reveal a m ajor negative dem and
shock consistent with Friedm an and S chw artz’s (1963)
attribution of the onset of the G reat Depression to
m onetary forces. A fter 1931, negative supply shocks
predom inate, consistent w ith B ernanke’s (1983) and
Bernanke and Jam es (1991) explanation for the severity of
the G reat Depression that stresses the collapse of the
financial system.
54Though the shocks are sm aller, the rankings by regim e for
the weighted average of individual country shocks are sim
ilar to the G-7 aggregate.

52See Bayoum i and Eichengreen (1992a).
53The results for the G roup of Seven in the interw ar period
(figures 11 and 12) as well as those for four countries
(appendix figure 1) are sim ila r to those reported for the
United States by C ecchetti and Karras (1992), who esti
m ate a three-variable VAR with m onthly data. The late

M ARCH/APRIL 1993

148

Figure 10
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines) and
Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989
Effects of Aggregate Demand Shocks, 1881-1913

Effects of Aggregate Supply Shocks, 1881-1913

FEDERAL RESERVE BANK OF ST. LOUIS

149

Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)
and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989

Effects of Aggregate Demand Shocks, 1919-1939

Effects of Aggregate Supply Shocks, 1919-1939

M ARCH/APRIL 1993

150

Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)
and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989
Effects of Aggregate Demand Shocks, 1946-1970

Effects of Aggregate Supply Shocks, 1946-1970

FEDERAL RESERVE BANK OF ST. LOUIS

151

Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)
and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989

Effects of Aggregate Demand Shocks, 1946-1989

Effects of Aggregate Supply Shocks, 1946-1989

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152

Effects of Aggregate Supply Shocks, 1971-1989

FEDERAL RESERVE BANK OF ST. LOUIS

Table 4
Supply (Permanent) and Demand (Temporary) Shocks: 1880-1989
Annual Data: Standard Deviations of Shocks (percent); Dispersion of shocks across countries (percent)
Gold Standard
1883-1913

Interwar
1921-1939

Bretton Woods
(Total)
1948-1970

Bretton W oods
(Preconvertible)
1948-1958

Bretton W oods
(Convertible)
1959-1970

Floating Exchange
1973-1989

Post WW II
1948-1989

Demand

Supply

Demand

Supply

Demand

Supply

Demand

Supply

DemandI

Supply

Demand

Supply

Demand

Supply

United States
United Kingdom
G erm any
F rance
Japan
C anada
Italy

2,03
2.66
2.37
4.58
4.85
0.93
3.16

3.81
2.16
2.32
3.75
3.39
2.75
3.13

4.45
1.93
4.47
7.17
6.28
4.01
7.40

6.73
3.52
3.13
5.19
5.36
8.61
4.14

2.33
2.62
2.88
3.50
3.18
2.42
2.76

1.54
1.95
2.65
1.75
2.56
2.60
1.75

3.11
3.06
1.85
3.23
4.05
3.09
2.93

1.98
2.61
2.87
1.61
1.97
3.70
1.85

1.37
2.26
3.34
3.77
2.83
1.74
2.56

1.07
1.14
2.66
1.84
2.78
0.98
1.73

1.72
3.57
1.66
1.93
2.39
2.66
3.58

1.94
4.31
1.39
1.52
2.50
2.10
1.91

2.07
3.03
2.36
2.84
2.75
2.48
3.30

1.68
3.10
2.20
1.70
2.69
2.47
2.47

G7
G 7*
D ispersion

1.56
1.49
3.94

2.21
2.08
5.03

3.09
2.99
8.25

4.12
4.61
8.58

1.24
1.11
3.93

0.86
0.81
2.38

1.99
1.64
3.44

1.00
1.01
1.89

0.75
0.75
4.09

0.80
0.71
2.54

1.50
1.40
3.53

0.96
1.60
2.74

1.40
1.28
3.69

0.91
1.32
2.63

G 7 *: W eighted average of individual country shocks; the weights are calculated as the share of each co u n try’s National Income in the Total Incom e in the G7 countries,
w here the G NP/G D P data are converted to dollars using the actual exchange rate.
D ispersion = D (w e ig ht^sh o ck-E w e ig h ty shockj)2)0-5
for i = United States, United Kingdom , G erm any, France, Japan, C anada, Italy

MARCH/APRIL
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153

G7: G 7-aggregate data

154

Figure 11
Supply and Demand Shocks: G7 Aggregate, 1880-1989, Annual Data
Percent

Figure 12
Supply and Demand Shocks: 1880-1989, United States
Percent

-16
1880

1890

1900

1910

FEDERAL RESERVE BANK OF ST. LOUIS

1920

1930

1940

1950

1960

1970

1980

1990

155

Figure 12 (continued)
Supply and Demand Shocks: 1880-1989, United Kingdom
Percent
10

-10
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

1950

1960

1970

1980

1990

Supply and Demand Shocks: 1880-1989, Germany
Percent
10

-10
1880

1890

1900

1910

1920

1930

1940

M ARCH/APRIL 1993

156

Figure 12 (continued)
Supply and Demand Shocks: 1880-1989, France
Percent

-16
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

Supply and Demand Shocks: 1880-1989, Japan
Percent
18—---------------------------------------------------------------------------------------------- ---------------------------------1
I Supply
14-

-10
K Demand
-14-|-----------1
-----------1
----------- 1
-----------1
-----------1
----------- 1
-----------1
----------- ,-----------1
----------- 1
----------t
--------- 1
--------- 1
--------- 1
--------- 1
--------- 1
--------- 1
--------- 1
--------- 1
--------- r
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990

FEDERAL RESERVE BANK OF ST. LOUIS

157

Figure 12 (Continued)
Supply and Demand Shocks: 1880-1989, Canada
Percent
16

-16
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

1940

1950

1960

1970

1980

1990

Supply and Demand Shocks: 1880-1989, Italy
Percent
20

-20
1880

1890

1900

1910

1920

1930

M ARCH/APRIL 1993

158

In sum, the evidence on supply and demand
shocks is quite similar to the measures of vola
tility drawn from the forecast errors using the
MSKF. The gold standard regime, as well as the
interwar period, emerges as a relatively unstable
period stressed by widely dispersed supply shocks.
By contrast, the Bretton Woods convertible period
is the most stable, with the floating exchange
rate period not far behind.
These results raise the interesting question,
why in the past century was the classical gold
standard so durable in the face of substantial
shocks, whereas Bretton Woods was so fragile
in the face of the mildest shocks?

Responsiveness to Shocks
The final piece of evidence to be calculated in
the comparison of regime performance is the
response of the price level and output to the
aggregate supply (permanent) and aggregate
demand (temporary) shocks. Evidence of a more
rapid adjustment of prices and output to shocks
may help explain why one regime may have
been more durable than another.
A measure of speed of response can be gleaned
from the impulse response functions derived
from the bivariate VABs. In addition, as a crude
measure o f response speed, which allowed easy
comparison of all seven countries during the
four regimes, I calculated the mean absolute lag
of the response functions.5 Table 5 presents
5
these measures.
The response o f output to both demand and
supply shocks for the Group o f Seven aggregate
and for most of the individual countries was
markedly more rapid under the gold standard
regime than under the postwar regimes (an ex
ception is the U.S. response to demand shocks)
and within the postwar regimes was slightly
more rapid under the Bretton Woods regime
than the floating exchange rate regime. The
response of prices to both demand and supply
shocks was considerably more rapid during the
gold standard (and the interwar) regime than
the postwar regimes for the Group o f Seven
and most countries.5 Within the postwar
6
period, it was considerably more rapid under
55T he form ula was S i | A c, | / S | Aq | for i = 1 to 40,
w here i is the year and A C the im pulse response, cal
;
cu la tin g absolute changes because of the presence of
both positive and negative responses. T his m easure is
only a rough approxim ation because it is not possible to
calculate the standard errors.

FEDERAL RESERVE BANK OF ST. LOUIS

Bretton Woods than under the floating exchange
rate period.
Perhaps the gold standard was able to endure
the greater shocks that it faced because o f both
greater price flexibility and greater factor mobil
ity before W orld W ar I. Alternatively, the gold
standard was more durable than Bretton Woods
because before W orld W ar I, suffrage was limited,
central banks were often privately owned and,
before Keynes, there was less understanding of
the link between monetary policy and the level
of economic activity. Hence there was less of an
incentive for the monetary authorities to pursue
full employment policies, which would threaten
adherence to convertibility.
In addition, the Bretton Woods regime was both
more stable and seemingly more flexible than
the floating exchange rate regime and yet more
fragile. This suggests that its collapse is attribut
able less to outside shocks to the environment
or the structure of the Group of Seven economy
and more to flaws in the design of the regime.

Summary
The performance of alternative international
monetary regimes suggests that the Bretton
Woods convertible regime (1959-70) was the
most stable, followed by the floating exchange
rate and the classical gold standard regimes.
The stability of forecast errors to both inflation
and growth paralleled that of the e \ post data.
Limited inflation persistence—evidence for
credibility o f the nominal anchor—was lowest
during the classical gold standard. Though con
siderably higher than under the gold standard,
persistence was less under Bretton Woods than
under the float. Under Bretton Woods the nomi
nal anchor of the U. S. commitment to peg the
price of its currency to gold was apparently still
effective. Finally, supply shocks were greater
and less symmetric, and demand shocks were
greater under the classical gold standard than
under the post-World W ar II regimes. A more
rapid response of both prices and output to these
shocks also occurred under the gold standard.
The question still remains why some fixed
exchange rate regimes endured longer than others
56As m entioned above, according to the overidentifying
restrictions of the Bayoum i-E ichengreen-Blanchard-Q uah
approach, supply shocks should have produced a negative
response in prices, not the positive one shown here for the
pre-W orld W ar II periods.

159

Table 5
The Mean Lag of Adjustment to Demand and Supply Shocks,
G7 Countries 1880-19891
Gold
Standard

Interw ar

Post World
W ar II

Bretton
W oods

Floating
Exchange

United States

a)
b)
c)
d)

2.77
1.65
1.61
2.24

3.79
2.89
1.65
2.31

2.16
2.68
2.21
2.55

2.29
1.85
2.12
3.06

3.65
6.48
4.64
5.52

United Kingdom

a)
b)
c)
d)

2.52
2.13
1.88
3.14

2.01
1.97
1.48
3.06

3.38
4.93
1.96
3.04

4.24
3.06
2.39
2.23

3.43
4.46
2.62
2.44

G erm any

a)
b)
c)
d)

2.74
2.23
1.87
2.03

3.08
2.86
3.09
3.50

2.70
2.67
1.86
1.92

3.48
3.13
1.80
2.85

3.53
6.06
2.22
4.14

Canada

a)
b)
d)

1.76
1.75
1.20
2.51

2.53
1.87
1.36
2.62

2.55
2.75
2.32
2.87

3.12
1.79
1.52
2.98

2.40
2.67
2.26
2.98

France

a)
b)
c)
d)

1.79
1.70
1.85
2.85

3.84
2.60
2.05
4.80

2.19
1.83
2.54
1.92

3.50
3.06
2.19
3.50

4.97
5.53
3.79
6.02

Japan

a)
b)
d)

2.67
1.85
1.96
1.52

4.16
3.87
3.41
3.13

2.94
2.70
2.97
4.69

3.14
1.99
1.96
2.81

4.55
9.42
3.66
8.34

Italy

a)
b)
c)
d)

2.13
1.71
2.43
1.66

2.50
1.60
1.57
2.19

3.51
4.20
6.20
6.68

1.86
1.43
1.63
1.66

2.99
5.57
1.94
3.02

Average

a)
b)

2.34
1.86
1.83
2.27

3.13
2.52
2.09
3.09

2.77
3.11
2.87
3.38

3.09
2.33
1.94
2.73

3.63
5.74
3.02
4.63

2.19
1.38
1.78
2.10

3.61
2.68
2.63
3.35

3.27
6.00
4.18
4.74

4.59
5.14
6.03
5.11

5.16
11.83
6.14
11.26

c)
d)
G 7 aggregate

a)
b)
o)

d)
a)
b)
c)
d)

Effect
Effect
Effect
Effect

of
of
of
of

tem porary shock on output
tem porary shock on prices
perm anent shock on output
perm anent shock on prices

1the mean lag of adjustm ent is calculated as:
D i|ACj| / 2 |Ac,| for i = 1 to 40
w here c, is th e value of the im pulse response function in period i.

MARCH/APRIL 1993

160

or why the world periodically shifted between
fixed and flexible rates. The durability of the
gold standard may be due to greater price flexi
bility and factor mobility before W orld W ar I
that allowed the world economy to respond to
shocks more rapidly. It also may be due to the
absence of discretionary monetary policies dedi
cated to maintaining full employment. But the
fragility of the most stable regime, Bretton
Woods, in the face o f mild shocks, suggests that
an understanding of its demise requires a closer
look at the history, institutions and rules of
behavior of alternative monetary regimes.

THE GOLD STA ND AR D , BR ETT O N
W O O D S, A N D THE EMS AS
COM M ITM ENT MECHANISMS
Perhaps the answer to the foregoing questions
concerning regime performance and durability
may be linked to the commitment technology of
the regime. In this section I argue that the gold
standard rule of convertibility was a credible
commitment mechanism that was crucial to its
success and that the absence of such a mech
anism underlies the failure of the Bretton Woods
variant. The EMS, though not anchored to gold
convertibility, may have been successful for sev
eral years because it embodied a commitment
technology reminiscent of the gold standard.
However, like Bretton Woods, it was subject in
September 1992 to intolerable strains because
the commitment mechanism proved to be not
credible for many of the members.
Under the classical gold standard, the monetary
authorities committed themselves to fix the prices
of their currencies in terms of a fixed weight of
gold and to buy and sell gold freely in unlimited
amounts. The pledge to fix the price of a coun
try’s currency in terms of gold represents the
basic rule of the gold standard. The fixed price
of domestic currency in terms of gold provided
a nominal anchor to the international monetary
system. Under the Bretton Woods system only
the United States fixed the price of its currency
in terms of gold. All other convertible currencies
were pegged to the dollar. Also, under Bretton
Woods, free convertibility of gold into dollars was
limited. Thus Bretton Woods was a weak variant
of the gold standard. Although the Bretton Woods
system in its convertible phase (1959-71) was
the most stable monetary regime of the past
57See Kydland and Prescott (1977) and Barro and Gordon
(1983).

FEDERAL RESERVE BANK OF ST. LOUIS

century, it was short lived. It collapsed both
because of fatal flaws in its design (the adjusta
ble peg in the face of improved capital mobility
and the confidence problem associated with the
gold dollar standard) and the lack of commit
ment by the United States to the gold standard
convertibilty rule.
The EMS, although not based on gold, incor
porated many of the features of the Bretton
Woods adjustable peg system. Its success in
promoting the convergence of inflation rates
among its members in the 1980s has been
linked to the presence of an effective commit
ment mechanism—the adherence by the German
central bank to price stability and the willing
ness o f other members to tie their currencies to
the German mark. However, like Bretton Woods,
it suffered serious stress in September 1992 in
the face of massive shocks because of the basic
incompatibility o f pegged exchange rates, capital
mobility and policy autonomy. Both the center
country and the members were unwilling to
commit to a common policy.
An overview of the three regimes as embodying
the operation of credible monetary rules follows.

The Gold Standard as a Commitment
Mechanism
In the recent literature on the time inconsistency
of optimal government policy, the absence o f a
credible commitment mechanism leads govern
ments, in pursuing stabilization policies, to pro
duce an inflationary outcome.5 In a closed
7
economy environment, once the monetary authority
has announced a given rate of monetary growth,
which the public expects it to validate, the au
thority then has an incentive to create a mone
tary surprise to either reduce unemployment or
capture seigniorage revenue. The public, with
rational expectations, will come to anticipate the
authorities’ perfidy, leading to an inflationary
equilibrium. A credible precommitment mech
anism, by preventing the government from
cheating, can preserve long-run price stability.
The gold standard rule of maintaining a fixed
price of gold can be viewed as such a mechanism.
The gold standard rule can be viewed as a form
of contingent rule or a rule with escape clauses.5
8
The monetary authority maintains the standard—
that is, keeps the price of the currency in terms of
gold fixed—except in the event of a well-understood
58See Grossm an and Van H uyck (1988), DeKock and G rilli
(1989), and Bordo and Kydland (1992).

161

emergency, such as a major war or a financial cri
sis. In wartime it may suspend gold convertibility
and issue paper money to finance its expenditures,
and it can sell debt issues in terms of the nominal
value of its currency on the understanding that debt
will eventually be paid o ff in gold. The rule is con
tingent in the sense that the public understands that
the suspension will last only for the duration of the
wartime emergency plus some period of adjustment.
It assumes that afterward the government will
follow the deflationary policies necessary to resume
payments at the original parity. Following such
a rule will also allow the government to smooth
its revenue from different sources o f finance, such
as taxation, borrowing and seigniorage.5
9

historical evolution itself of the gold standard.
Gold was accepted as money because o f its
intrinsic value and desirable properties. Paper
claims, developed to economize on the scarce
resources tied up in a commodity money, became
acceptable only because they were convertible into
gold. An alternative commitment mechanism
was to guarantee gold convertibility in the con
stitution. This was the case for example in
Sweden before 1914, when laws pertaining to
the gold standard could be changed only by two
identical parliamentary decisions with an elec
tion in between.6 Convertibility was also
2
enshrined in the laws of a number of gold
standard central banks.6
3

According to Bordo and Kydland (1992), the
gold standard contingent rule worked success
fully for three core countries of the classical
gold standard: the United Kingdom, the United
States, and France. In all these countries the
monetary authorities adhered faithfully to the
fixed price of gold except during major wars.
During the Napoleonic W ar and W orld W ar I
for England, the Civil W ar for the United States,
and the Franco-Prussian War for France, specie
payments were suspended, and paper money
and debt were issued. But in each case, after
the wartime emergency had passed, policies
leading to resumption were adopted.6 Indeed,
0
successful adherence to the rule may have ena
bled the belligerents to obtain access to debt
finance more easily in subsequent wars. Other
countries, such as Italy, which did not continu
ously maintain gold convertibility, nevertheless
adopted policies consistent with long-run con
vertibility.6
1

The gold standard originally evolved as a domes
tic commitment mechanism, but its enduring
fame is as an international rule. The classical
gold standard emerged as a true international
standard by 1880 following the switch by the
majority of countries from bimetallism, silver
monometalism and paper to gold as the basis of
their currencies.6 As an international standard,
4
the key rule was maintenance o f gold converti
bility at the established par. Maintenance of a
fixed price of gold by its adherents in turn
ensured fixed exchange rates. Recent evidence
suggests that, indeed, exchange rates through
out the 1880-1914 period were characterized
by a high degree o f fixity in the principal coun
tries. Although exchange rates frequently deviated
from par, violations of the gold points and de
valuations were rare.6
5

The gold standard rule may also have been
enforced by reputational considerations. Longrun adherence to the rule was based on the
59See Lucas and Stokey (1983) and M ankiw (1987).
60A case study com paring British and French finances d u r
ing the N apoleonic W ars shows that Britain was able to
finance its w artim e expenditures by a com bination of
taxes, debt and paper m oney issue— to sm ooth revenue;
whereas France had to rely prim arily on taxation. France
had to rely on a less e fficient m ix of finance than Britain
because she had used up her cred ib ility by defaulting on
outstanding debt at the end of the Am erican R evolutionary
W ar and by hyperinflating during the Revolution. Napoleon
ultim ately returned France to the bim etallic standard in
1803 as part of a policy to restore fiscal probity, but
because of the previous loss of reputation France was
unable to take advantage of the co n tin ge n t aspect of the
b im etallic standard rule. See Bordo and W hite (1991).

According to game theory literature, for an
international monetary arrangement to be effec
tive both between countries and within them, a
time-consistent credible commitment mechanism
is required. Adherence to the gold convertibility
rule provided such a mechanism. In addition to the
who present evidence of expected appreciation of the
greenback d u ring the Am erican C ivil W ar based on a
negative interest diffe re n tia l between bonds that were paid
in greenbacks and those paid in gold.
G iovannini (1992) finds that the variation of both
exchange rates and short-term interest rates varied w ithin
the lim its set by the gold points in the 1899-1909 period
consistent with m arket ag e nts’ expectations of a credible
com m itm ent by the four " c o re ” countries to the gold
standard rule in the sense of this paper.
62See Jonung (1984).
63See G iovannini (1993).
64See Eichengreen (1985).
65See O fficer (1986) and Eichengreen (1985).

61The behavior of asset prices (exchange rates and interest
rates) suggests that m arket agents viewed the com m itm ent
to gold as credible. See Roll (1972) and C alom iris (1988),

M ARCH/APRIL 1993

162

reputation of the domestic gold standard and con
stitutional provisions that ensured domestic com
mitment, adherence to the international goldstandard rule may have been enforced by other
mechanisms. These include improved access to
international capital markets, the operation of
the rules o f the game, and the hegemonic
power of England.
Support for the international gold standard
likely grew because it provided improved access
to the international capital markets of the core
countries. Countries were eager to adhere to
the standard because they believed that gold
convertibility would be a signal to creditors of
sound government finance and the future abil
ity to service debt.6
6
This was the case both for developing countries
seeking access to long-term capital, such as
Austria-Hungary and Latin America, and for
countries seeking short-term loans, such as
Japan, which financed the Russo-Japanese war
of 1905-06 with foreign loans seven years after
joining the gold standard.6 Once on the gold
7
standard, these countries feared the consequences
of suspension.6 That England, the most success
8
ful country of the nineteenth century, as well
as other progressive countries were on the gold
standard was probably a powerful argument
for joining.6
9
The operation of the rules of the game,
whereby the monetary authorities were sup
posed to alter the discount rate to speed up the
adjustment to a change in external balance, may
also have been an important part o f the com
mitment mechanism to the international gold
standard rule. To the extent the rules were fol
lowed and adjustment facilitated, the commit
ment to convertibility was strengthened and
conditions conducive to abandonment were
lessened.
Evidence on the operation of the rules of the
game questions their validity. Bloomfield (1959),
in a classic study, showed that, with the principal
exception of England, the rules were frequently
violated in the sense that discount rates were
66A case study of C anada during the G reat Depression pro
vides evidence for the im portance of the credible com m it
m ent m echanism of adherence to gold. C anada
suspended the gold standard in 1929 but did not allow the
C anadian dollar to depreciate nor the price level to rise for
tw o years. C anada did not take advantage of the suspen
sion to em erge from the depression because of concern
for its cred ib ility with foreign lenders. See Bordo and Red
ish (1990).
67See Y eager (1984), Fishlow (1989) and Hayashi (1989).

FEDERAL RESERVE BANK OF ST. LOUIS

not always changed in the required direction
(or by sufficient amounts) and in the sense that
changes in domestic credit were often nega
tively correlated with changes in gold reserves.
In addition, a number of countries used gold
devices—practices to prevent gold outflows.
For the major countries, however (at least
before 1914) such policies w ere not used exten
sively enough to threaten the convertibility to
gold—evidence o f commitment to the rule.7
0
Moreover, as McKinnon (1992) argues, to the
extent that monetary authorities followed Bagehot’s rule and prevented a financial crisis while
seemingly violating the rules of the game, the
commitment to the gold standard in the long
run may have been strengthened.
An additional enforcement mechanism for the
international gold standard rule may have been
the hegemonic power of England, the most
important gold standard country.7 A persistent
1
theme in the literature on the international gold
standard is that the classical gold standard of
1880 to 1914 was a British-managed standard.7
2
Because London was the center for the world's
principal gold, commodities and capital markets,
because of the extensive outstanding sterlingdenominated assets, and because many countries
substituted sterling for gold as an international
reserve currency, some argue that the Bank of
England, by manipulating its bank rate, could
attract whatever gold it needed and, further
more, that other central banks would adjust
their discount rates accordingly. Thus the Bank
of England could exert a powerful influence on
the money supplies and price levels of other
gold standard countries.
The evidence suggests that the Bank did have
some influence on other European central banks.7
3
Eichengreen (1987) treats the Bank of England
as one engaged in a leadership role in a Stackelberg
strategic game with other central banks as fol
lowers. The other central banks accepted a
passive role because they benefited from using
sterling as a reserve asset. According to this
interpretation, the gold standard rule may
68See Eichengreen (1989a) and Fishlow (1987 and 1989).
69See Friedm an (1990) and G allarotti (1991).
70See Schw artz (1984).
71See Eichengreen (1989b).
72See Bordo (1984).
73See Lindert (1969).

163

have been enforced by the Bank of England.7
4
Thus the monetary authorities of many coun
tries may have been constrained from following
independent discretionary policies that would
have threatened adherence to the gold standard
rule.
Indeed, according to Giovannini (1989), the gold
standard was an asymmetric system. England
was the center country. It used its monetary
policy (bank rate) to maintain gold converti
bility. Other countries accepted the dictates
of fixed parities and allowed their money sup
plies to respond passively. His regressions
support this view—the French and German
central banks adapted their domestic policies
to external conditions, whereas the British
did not.
The benefits to England as leader o f the gold
standard—from seigniorage earned on foreignheld sterling balances to returns to financial
institutions generated by its central position in
the gold standard and to access to international
capital markets in wartime—were substantial
enough to make the costs of not following the
rule extremely high.
The classical gold standard ended in the face
of the massive shocks of World W ar I.7 The
5
gold exchange standard, which prevailed for
only a few years from the mid-1920s to the
Great Depression, was an attempt to restore the
beneficial features of the classical gold standard
while allowing a greater role for domestic stabil
ization policy. This in turn created a growing
conflict between adherence to the rule and dis
cretion. It also attempted to economize on gold
reserves by restricting its use to central banks
and by encouraging the use of foreign exchange
as a substitute. As is well known, the gold ex
change standard suffered from a number of
fatal flaws.7 These include the use of two
6
reserve currencies (the pound and the dollar),
the absence of leadership by a hegemonic
power, the failure o f cooperation between the
74A ccording to Eichengreen (1989a), the Bank of E n g la n d ’s
ability to ensure co n ve rtib ility was aided by the coopera
tion of other central banks. In addition, as m entioned
above, belief based on past perform ance that England
attached highest p riority to co n ve rtib ility encouraged
stabilizing private capital m ovem ents in tim es of threats to
convertibility, such as in 1890 and 1907.

key members (England, France and the United
States), and the unwillingness of its two strongest
members, the United States and France, to fol
low the rules of the game. Instead they exerted
deflationary pressure on the rest o f the world
by persistent sterilization of balance-of-payment
surpluses. The gold exchange standard collapsed,
but according to Friedman and Schwartz, Temin,
and Eichengreen, not before transmitting defla
tion and depression across the world.7
7

The Bretton W oods International
Monetary System
The planning that led to Bretton Woods aimed
to prevent the chaos of the interwar period.7
8
The perceived ills to be prevented included (1)
floating exchange rates that were condemned as
subject to destabilizing speculation; (2) a gold
exchange standard that was vulnerable to prob
lems of adjustment, liquidity and confidence,
which enforced the international transmission
of deflation in the early 1930s; and (3) the
resort to beggar-thy-neighbor devaluations,
trade restrictions, exchange controls and bilater
alism after 1933. To prevent these ills, the case
for an adjustable peg system was made by
Keynes, White, Nurkse and others.7 The new
9
system would combine the favorable features of
the fixed exchange rate gold standard—stability
of exchange rates—and of the flexible exchange
rate standard—monetary and fiscal independence.
Both Keynes, leading the British negotiating team
at Bretton Woods, and White, leading the Ameri
can team at Bretton Woods, planned an adjustable
peg system to be coordinated by an international
monetary agency. The Keynes plan gave the Inter
national Currency Union substantially more
reserves and power than the United Nations Stabili
zation Fund proposed by White, but both institu
tions would have had considerable control over the
domestic financial policy of the members.
The British plan contained more domestic policy
autonomy than did the U.S. plan, whereas the
76See K indleberger (1973), Tem in (1989), and Eichengreen
(1992c).
77See Friedm an and Schwartz (1963), Tem in (1989) and
Eichengreen (1992c).
78T his section draw s heavily on Bordo (1992).
79See Bordo (1993).

75The standard deviations of both supply and dem and
shocks during W orld W ar I for the countries for which we
have continuous data were tw o to three tim es as great as
du ring the classical gold standard. See appendix table 1
and figure 1.

M ARCH/APRIL 1993

164

American plan put more emphasis on exchange
rate stability. Neither architect was in favor o f a
rule-based system.8 The British were most con
0
cerned with preventing the deflation of the 1930s,
which they attributed to the constraint of the gold
standard rule and to deflationary U.S. monetary pol
icies. Thus they wanted an expansionary system.
The American plan was closer to the gold
standard rule in that it stressed the fixity of
exchange rates. It did not explicitly mention the
importance of rules as a credible commitment
mechanism, but there were to be strict regula
tions on the linkage between UNIT AS (the pro
posed international reserve account) and gold.
Members, in the event o f a fundamental dis
equilibrium, could change their parities only
with approval from a three-quarters majority of
all members of the fund.8
1
The Articles of Agreement of the International
Monetary Fund incorporated elements of both the
Keynes and White plans, although in the end, U.S.
concerns predominated.8 The main points of the
2
articles were: the creation of the par value system;
multilateral payments; the use of the fund's
resources; its powers; and its organization.

The Par Value System
Article IV defined the numeraire o f the interna
tional monetary system as either gold or the U.S.
dollar of the weight and fineness on July 1, 1944.
All members were urged to declare a par value
and maintain it within a 1 percent margin on
either side of parity. Parity could be changed in
the event of a fundamental payments disequili
brium at the decision o f the member, after con
sultation with other fund members. The fund
would not, however, reject the change if it was
not more than 10 percent; if the change was
more than 10 percent, the fund would decide
80ln the sense of a com m itm ent m echanism to prevent the
tim e consistency problem . A ccording to M eltzer (1988) and
M oggridge (1986), Keynes had a strong preference for
rules over discretion, interpreting rules in the traditional
sense.
8,See G iovannini (1993).
82At the same tim e as the A rticles of A greem ent for the
International M onetary Fund were signed, the International
Bank for R econstruction and D evelopm ent (the W orld
Bank) was established. The C harter of the International
Trade O rganization (ITO) was drafted and signed in 1947
but never ratified. It was succeeded by the General A gree
m ent for T ariffs and Trade (GATT) o rigina lly negotiated in
G eneva in 1947 as an interim institution until the ITO
cam e into force.

FEDERAL RESERVE BANK OF ST. LOUIS

within 72 hours. Unauthorized changes in the
exchange rate could make members ineligible to
use the fund’s resources, and if a member continued
to make unauthorized changes, it could be expelled
from the fund. A uniform change in par value of
all currencies (in terms o f gold) required approval
by a majority of all voting fund members and
also had to be approved by every member with
10 percent or more of the total quota.

Multilateral Payments
Members were supposed to make their curren
cies convertible for current account transactions
(Art. VIII), but capital controls were permitted
(Art. VI.3). They were also to avoid discrimina
tory currency and multiple curency arrange
ments. Countries could avoid declaring their
currencies convertible, however, by invoking
Art. XIV, which allowed a three-year transition
period after establishment of the fund. During
the transition period, existing exchange controls
could be maintained.8
3

The Fund’s Resources
As under the White plan, members could
obtain resources from the fund to help finance
short- or medium-term payments disequilibria.
The total fund, contributed by members quotas
(25 percent in gold and 75 percent in currencies)
was set at $8.8 billion. It could be raised every
five years if the majority of members wanted to
do so. The fund set a number of conditions on
the use of its resources by deficit countries to
prevent it from accumulating soft currencies
and from depleting its holdings o f harder cur
rencies.8 It also established requirements and
4
conditions for repurchase (repayment o f a loan),
including giving the fund the right to decide the
currency in which repurchase would be made.
83Under Art. XIV, three years after M arch 1, 1947, the IMF
w ould begin reporting on the countries with existing con
trols, two years later it would begin co n sulting w ith in d ivid
ual m em bers and advising them on policies to restore
paym ents e q uilibrium and convertibility. C ountries that did
not m ake satisfactory progress w ould be censured and
ultim ately asked to leave the fund. In fact, the fund always
accepted the m em b e r’s reason for rem aining under Art.
XIV.
84M em bers could draw on th e ir quotas w ithout condition.
Beyond that, referred to later as the cred it tranches,
although not spelled out in the articles, increasingly more
exacting conditions were required.

165

In the case o f countries prone to running large
surpluses, the scarce currency clause (Art. VII)
would come into play. If the fund’s holdings of a
currency were insufficient to satisfy the demand
for it by other members, it could declare it scarce
and then urge members to ration its use by dis
criminatory exchange controls.

the fixed price o f gold at $35 per ounce, which
the U.S. was to maintain, represented the nomi
nal anchor of the system. Members were required
to maintain parity o f their exchange rates in
terms of dollars (or gold). Also, like the gold
standard, it was a rule with an escape clause.
Members at their initiative could alter their par
ities in the event of a fundamental disequilibrium.

The P ow ers o f the Fund

The architects never spelled out exactly how
the system was supposed to work. Subsequent
writers, however, have suggested a number of
salient features.8 First, currencies were treated
6
as equal in the articles. This meant that in theory
each country was required to maintain its par
value by intervening in the currency o f every
other country—a practice that would have worked
at cross purposes. In fact, because the United
States was the only country that pegged its cur
rency in terms o f gold (bought and sold gold),
all other countries would fix their parities in
terms of dollars and would intervene to monitor
their exchange rates within 1 percent of parity
with the dollar.

The fund had considerably less discretionary
power over the domestic policies o f its members
than either of the architects wanted, but it still
had power to influence the international mone
tary system strongly. These powers included its
authority to approve or reject changes in parity;
the use of multiple exchange rates and other
discriminatory practices; the conditionality implicit
in members’ access to the credit tranches of
their quotas, which was made explicit by 1952; its
authority to declare currencies scarce; its authority
to declare members ineligible to use its resources
(used against France in 1948 following an unap
proved devaluation); and its ultimate authority
to expel members.8 The fund also had consider
5
able power as the premier international mone
tary organization in consulting and cooperating
with national and other international monetary
authorities.

Organization
The fund was to be governed by a board of
governors appointed by the members. The board
would make the major policy decisions, such as
approving a change in parity. Operations of the
fund were to be directed by executive directors
appointed by the members and a managing direc
tor selected by the executive directors. Major
changes such as a uniform change in the par
value of all currencies or the second amend
ment to the articles, which created the special
drawing right (SDR), would require a majority
vote by the members. The number o f votes in
turn was tied to the size o f each member’s quota,
which was determined by its economic size.
Though the articles could not be interpreted
strictly as a return to the gold standard rule of
the fixed price o f gold with free convertibility,
85See Diz (1984) for a discussion of co n d itio na lity im p licit in
m em bers’ access to the cred it tranches of th e ir quotas.
86See, for exam ple, Tew (1988), Scam m ell (1976) and
Y eager (1976). For W illiam son (1985b) it was a com pre
hensive set o f rules for assigning m acroeconom ic pol-

Second, countries would use their international
reserves or draw resources from the fund to finance
payments deficits. In the case o f surpluses, coun
tries would temporarily build up reserves or re
purchase their currencies from the fund. In the
event of medium-term disequilibria, they would use
monetary and fiscal policy to alter aggregate
demand. In the event of a fundamental disequil
ibrium, which was never defined but presumably
reflected either some permanent structural shock
or sustained inflation, a member was supposed to
alter parity by an amount sufficient to restore exter
nal equilibrium.
Third, capital controls were permitted to prevent
destabilizing speculation from forcing members to
alter their parities prematurely or unintentionally.

THE H ISTO R Y OF BR ETT O N
W O O D S: PR E -C O N VE R T IB ILIT Y
1946-58
The international monetary system that began
after W orld W ar II was far different from the
system that the architects of Bretton Woods
envisioned. The transition period from war to
icies— exchange rates to m edium -run external balance,
m onetary and fiscal policy to short-run internal balance
and international reserves—to provide a b u ffer to allow
short-run departures from external balance.

M ARCH/APRIL 1993

166

peace was much longer and more painful than
anticipated. Full convertibility of the major
industrial countries was not achieved until the
end of 1958, although the system had started
functioning normally by 1955. Tw o interrelated
problems dominated the first postwar decade:
bilateralism and the dollar shortage.

Bilateralism
The legacy of W orld W ar II for virtually every
country except the United States was one of
pervasive exchange controls and controls on
trade. No major currency except the dollar was
convertible.8 Under Art. XIV of the Bretton
7
Woods agreement, countries could continue to
use exchange controls for an indefinite transi
tion period after the establishment of the Inter
national Monetary Fund (IMF) on March 1, 1947.
In conjunction with exchange controls, every
country negotiated a series of bilateral pay
ments agreements with each of its trading part
ners. The rationale for the continued use of
controls and bilateralism was a shortage of
international reserves. After the war, the econo
mies of Europe and Asia were devastated. To
produce the exports needed to generate foreign
exchange, industries required new and improved
capital. There was an acute shortage of key
imports, both foodstuffs to maintain living
standards and raw materials and capital equip
ment. Controls allocated the scarce reserves.

The Dollar Shortage
By the end of World W ar II, the United States
held two-thirds of the world’s monetary gold
stock (see figure 13). The gold avalanche in the
United States in the 1930s was the consequence
of both the dollar devaluation in 1934, when
the Roosevelt administration raised the price of
gold from $20.67 per ounce to $35.00, and capi
tal flight from Europe. During the war, gold
87U nder the classical gold standard, co nvertibility meant the
ab ility of a private individual to freely convert a unit of any
national currency into gold at the o fficia l fixed price. A
suspension of co n ve rtib ility m eant that the exchange rate
between gold and national currency becam e fle xib le but
the individual could still freely transact in either asset. See
T riffin (1960). By the eve of W orld W ar II, co nvertibility
referred to the ability of a private individual to freely make
and receive paym ents in international transactions in term s
of the currency of another country. Under Bretton W oods,
c o n ve rtib ility m eant the freedom for individuals to engage
in cu rre n t account transactions w ithout being subject to
exchange controls. Tew (1988) defines this as m arket con
ve rtib ility and d istinguishes it from official co nvertibility
w hereby the m onetary authorities of each country freely

FEDERAL RESERVE BANK OF ST. LOUIS

inflows continued to finance wartime expendi
tures by the allies. At the end of W orld W ar II,
gold and dollar reserves in Europe and Japan
were depleted. Europe ran a massive current
account deficit, reflecting the demand for essen
tial imports and the reduced capacity o f the
export industries. The Organization for Euro
pean Economic Cooperation (OEEC) deficit,
aggravated by the bad winter of 1946-47,
reached a high of $9 billion in 1947. The OEEC
deficit equaled the amount of the U.S. current
account surplus, which was large because the
United States, as the only major industrial coun
try operating at full capacity, supplied the
needed imports. The dollar shortage was likely
aggravated by overvalued official parities set by
the major European industrial countries at the
end of 1946.8
8
By the mid-1950s both problems had been
solved. The currencies of western Europe were
virtually convertible by 1955 and their current
accounts were generally in surplus. The key
developments in this progress were the Mar
shall Plan and the European Payments Union.

The Marshall Plan
The Marshall Plan funneled approximately $13
billion in aid (grants and loans) to western Europe
between 1948 and 1952.8 The plan required
9
the recipients to cooperate in the liberalization
of trade and payments. Consequently, the OEEC
was established in April 1948. It presided over
the allocation of aid to members based on the
size of their current account deficits. U.S. aid
was to pay for essential imports and to provide
international reserves. Each recipient govern
ment provided matching funds in local currency
to be used for investment in the productive
capacity o f industry, agriculture and infrastruc
ture. Each country also had a delegation of U.S.
administrators that advised the host govern
ment on the spending o f its counterpart funds.
buy and sell foreign exchange (prim arily dollars) to keep
the parity fixed (within the 1 percent m argin) and the
United States freely buys and sells gold to m aintain the
fixed price of $35 an ounce (within the 1 percent m argin).
He refers to both m arket and official co n ve rtib ility as B ret
ton W oods convertibility. See also M cKinnon (1979) and
Black (1987).
88See T riffin (1957).
89See M ilward (1984) and H offm an and M aier (1984).

167

Figure 13
Monetary Gold and Dollar Holdings: the United States and the Rest of the World,
1945-1971 Billions of U.S. dollars

The plan encouraged the liberalization o f intraEuropean trade and payments by granting aid
to countries that extended bilateral credits to
other members. Finally, the European Payments
Union (EPU) was established in 1950, under the
auspices of the OEEC, to simplify bilateral clear
ing and pave the way to multilateralism.
By 1952, in part thanks to the Marshall Plan,
the OEEC countries had achieved a 39 percent
increase in industrial production, a doubling of
exports, an increase in imports by one-third and
a current account surplus.9
0

The European Payments Union
and the Return to Convertibility
It took 12 years from the declaration o f offi
cial par values by 32 nations in December 1946
to achieve convertibility for current transactions
by the major industrial countries, as specified
by the Bretton Woods Articles. The Western
European nations tried several schemes to facili
tate the payments process before establishing
the EPU in 1950.9'
The EPU, established September 19, 1950, by
the OEEC countries, initially was to run for two
years, renewable thereafter on a yearly basis.
It followed the basic principle of a commercial
90Solom on (1976).

bank clearinghouse. At the end of each month,
each member would clear its net debit or credit
position (against all other members) with the
EPU (the BIS acting as its agent). The unit of
account for these clearings was the U.S. dollar.
The EPU also provided extensive credit lines.
The EPU was highly successful in reducing the
volume o f payments transactions and provided
the background for the gradual liberalization of
payments so that by 1953 commercial banks were
able to engage in multicurrency arbitrage.9 On
2
December 27, 1958, eight countries declared
their currencies convertible for current account
transactions.
The movement to convertibility was aided by
the devaluations of 1949. Following a specula
tive run on the pound in the summer of 1949,
the British, 24 hours after informing the IMF,
devalued the pound by 30.5 percent. Shortly
thereafter, 23 countries reduced their parities
by similar magnitudes in most cases.
The devaluations of 1949 were important for
the Bretton Woods system for two reasons. First,
they, along with the Marshall Plan aid, helped
move the European countries from a current
account deficit to a surplus, a movement impor
tant to the eventual restoration of convertibility.
Second, they revealed a basic weakness of the
92Tew (1988) and Yeager (1976).

9 Kaplan and Schleim inger (1989).
1

M ARCH/APRIL 1993

168

adjustable peg arrangement—the one-way option
of speculation against parity. By allowing
changes in parity only in the event of a fun
damental disequilibrium, the Bretton Woods sys
tem encouraged the monetary authorities to
delay adjustment until they were sure it was
necessary. By that time, speculators also would
be sure and they would take a position from
which they could not lose. If the currency is
devalued, they win and if it is not, they just lose
the interest (if any) on the speculative funds.9
3
The crisis associated with the 1949 sterling
devaluation in turn created further resistance
by monetary authorities to changes in parity,
which ultimately changed the nature of the
international monetary system from the adjusta
ble peg intended by the Bretton Woods Articles
to a fixed rate regime.
Other developments in the preconvertiblity
period included the decline of sterling as a
reserve asset and the reduced prestige of the
IMF. The IMF by intention was not equipped to
deal with the postwar reconstruction problem.
Although some limited drawings occurred
before 1952, most of the structural balance of
payments assistance in this period was provided
by the Marshall Plan and other U.S. assistance,
including the Anglo-American Loan of 1946. The
consequence of this development is that other
institutions such as the BIS, the agent for the
EPU, emerged as competing sources of interna
tional monetary authority.9
4
The fund’s prestige was dealt a severe blow
by three events in the preconvertibility period.
The first event was the French devaluation of
January 1948, which created a multiple exchange
rate system. The fund censured France for
creating broken cross rates between the dollar
and the pound. France was denied access to the
fund's resources until 1952. France ended the
broken cross rates in October 1948 and adopted
a unified rate in the devaluation of 1949. Since
France had access to the Marshall Plan, the fund’s
actions had little effect. The second event was the
sterling devaluation of September 1949, when
the fund, instead of being actively involved in
consultation, was given 24 hours perfunctory
notice. The third event was the decision by
Canada to float its currency in September 1950.
Though the fund was highly critical of the action,
it was unable to prevent it. The Canadian dollar
floated successfully until 1961.
93See Friedm an (1953).
94See M undell (1969).

FEDERAL RESERVE BANK OF ST. LOUIS

Finally, the fund’s resources were inadequate
to solve the emerging liquidity problem o f the
1960s. The difference between the required
growth of international reserves (to finance the
growth of real output and trade and to avoid
deflation) and the growth in the world’s mone
tary gold stock was met largely by an increase
in official holdings of U.S. dollars resulting from
growing U.S. balance-of-payments deficits. By
the time full convertibility was achieved, the
U.S. dollar was serving the buffer function
intended by the Bretton Woods Articles for the
fund’s resources.9
5

THE H IST O R Y OF B R ET T O N
W O O D S: THE H EYD AY OF
BR ETT O N W O O D S 1959-1967
With current account convertibility established
by the western European industrial nations at the
end of December 1958, the full-blown Bretton
Woods system was in operation. Each member
intervened in the foreign exchange market,
either buying or selling dollars, to maintain its
parity within the prescribed 1 percent margins.
The U.S. Treasury in turn pegged the price of
the dollar at $35 per ounce by freely buying
and selling gold. Thus each currency was
anchored to the dollar and indirectly to gold.
Triangular arbitrage kept all cross rates within
a band of 2 percent on either side of parity.
Through much of this period, capital controls
prevailed in most countries except the United
States in one form or another, although by the
mid-1960s their use declined while increasing in
the United States.
The system that operated in the next decade
turned out to be quite different from what the
architects had in mind. First, instead of a system
of equal currencies, it evolved into a variant of
the gold exchange standard—the gold-dollar sys
tem. Initially, it was a gold exchange standard
with two key currencies, the dollar and the
pound. But the role of the pound as key cur
rency declined steadily throughout the 1960s.
Concurrently with the decline of sterling was
the rise in the dollar as a key currency. Use of
the dollar as both a private and official interna
tional money increased dramatically in the
1950s and continued into the 1960s. With full
convertibility, the dollar’s fundamental role as
95See Mundell (1969).

169

intervention currency led to its use as interna
tional reserves. This was aided by stable and
low monetary growth and relatively low infla
tion (before 1965). See figure 1 and table 1.
The gold exchange standard evolved in the
post-World War II period for the same reasons
it did in the 1920s—to economize on non-interestbearing gold reserves. By the late 1950s, the growth
of the world's monetary gold stock was insuffi
cient to finance the growth of world real output
and trade.9 The other intended source of inter
6
national liquidity—the resources of the fund—
was also insufficient.
The second important difference between the
convertible Bretton Woods system and the inten
tions of the Bretton Woods Articles was the evo
lution of the adjustable peg system into a virtual
fixed exchange rate system. Between 1949 and
1967, very few changes in parities of the Group
of Ten countries occurred.9 The only excep
7
tions were the Canadian float in 1950, devalua
tions by France in 1957 and 1958, and minor
revaluations by Germany and the Netherlands in
1961. The adjustable peg system became less
adjustable because the monetary authorities,
based on the 1949 experience, were unwilling
to accept the risks associated with discrete
changes in parities—loss of prestige, the likeli
hood that others would follow and the pressure
o f speculative capital flows if even a hint of a
change in parity were present.
As the system evolved into a fixed exchange
rate gold dollar standard, the three key prob
lems of the interwar system reemerged: adjust
ment, liquidity and confidence. These problems
dominated academic and policy discussions dur
ing the period.

The Adjustment Problem
The adjustment issue focused on how to achieve
it in a world with capital controls, fixed exchange
rates and domestic policy autonomy. Various pol
icy measures were proposed to aid adjustment,
including income policies, rescue packages, capi
tal and trade controls, a mix o f monetary and
fiscal policy, and the injection of new liquidity.

Of particular interest during the period was
asymmetry in adjustment between deficit countries
like the United Kingdom and surplus countries
like Germany and between the United States as
the reserve currency country and rest of the world.
Both the United Kingdom and Germany ran
the gauntlet between concern over external
convertibility and domestic stability. The United
Kingdom alternated between expansionary pol
icy that led to balance-of-payments deficits and
austerity. Germany alternated between a balanceof-payments surplus that led to inflation and
austerity.
The United States had an official settlements
balance-of-payments deficit in 1958 that per
sisted, with the notable exception o f 1968-69,
until the end o f Bretton Woods. See figure 14.
With the exception of 1959, however, the
United States had a current account surplus
until 1970. The balance-of-payments deficit
under Bretton Woods arose because capital out
flows exceeded the current account surplus. In
the early postwar years, the outflow consisted
largely of foreign aid. By the end of the 1950s,
private long-term investment abroad (mainly
direct investment) exceeded military expendi
tures abroad and other official transfers.9
8
The balance-of-payments deficit was perceived
as a problem by the U.S. monetary authorities
because of its effect on confidence. As official
dollar liabilities held abroad mounted with suc
cessive deficits, the likelihood increased that
these dollars would be converted into gold and
eventually the U.S. monetary gold stock would
reach a point low enough to trigger a run.
Indeed the U.S. monetary gold stock by 1959
equalled total external dollar liabilities and the
rest of the world's monetary gold stock exceeded
that of the United States. See figure 13. By 1964
official dollar liabilities held by foreign mone
tary authorities exceeded the U.S. monetary
gold stock.
A second reason the balance-of-payments
deficit was perceived as a problem was the dol
lar’s role in providing liquidity to the rest of the
world. Elimination of the U.S. deficit would cre
ate a worldwide liquidity shortage.

96See T riffin (1960) and G ilbert (1968).
97The G roup of Ten countries were Belgium , Canada,
France, W est G erm any, Italy, Japan, the N etherlands,
Sweden, United Kingdom , and the United States. Sw itzer
land was an associate member.
98See Eichengreen (1991c).

M ARCH/APRIL 1993

170

Figure 14

Balance of Payments: United States, 1950-1971 Millions of U.S. dollars

For the Europeans, the U.S. balance-ofpayments deficit was a problem for different
reasons. First, as the reserve currency country,
the United States did not have to adjust its
domestic economy to the balance of payments.
As a matter of routine, the Federal Reserve
automatically sterilized dollar outflows. The
asymmetry in adjustment was resented. The
Germans viewed the situation as the United
States exporting inflation to surplus countries
through its deficits. Their remedy was for the
United States (and the United Kingdom) to pur
sue contractionary monetary and fiscal policy."
In fact, U.S. inflation was less (on a GNPweighted average basis) than that of the rest of
the Group of Seven countries before 1968. See
figures 1 and 15. The French resented U.S.
financial dominance and the seigniorage they
believed the United States earned on its out
standing liabilities. Acting on this perception,
the French in 1965 began to systematically con
vert outstanding dollar liabilities into gold. The
French solution to the dollar problem was to
double the price of gold—the amount by which
" S e e E m m inger (1967).
’ “ See Rueff (1967).
101See Despres, K indleberger and Salant (1966).

FEDERAL RESERVE BANK OF ST. LOUIS

the real price of gold had declined since 1934.
The capital gains earned on the revaluation of
the world's monetary gold reserves would be
sufficient to retire the outstanding dollar (and
sterling) balances. Once the United States
returned to balance-of-payments equilibrium,
the world could return to a fully functioning
classical gold standard.1 0
0
Some economists argued that the U.S. balanceof-payments deficit was not really a problem.
The rest of the world held dollars voluntarily
because o f their valuable service flow; the
deficit was demand determined.1 1
0
The policy response of the U.S. monetary
authorities was fourfold: to impose controls on
capital exports; to institute measures to improve
the balance of trade; to alter the monetary fis
cal policy mix; and to employ measures to stem
the conversion of outstanding dollars into gold.
During this period, various solutions to the
U.S. adjustment problem were proposed: provi
sion of an alternative international reserve

171

F ig u re 15

Inflation Rates in the United States, G7 and G7 Excluding the United States, 1951-1973
Percent

media to increase world liquidity; an increase in
the price of gold, either unilaterally, which would
devalue the dollar against other currencies, or by
a uniform change in all parities as under Art. IV;
and increased exchange rate flexibility.1 2
0
The U.S. balance-of-payments policies were in
the main ineffective.1 3 As long as the United
0
States maintained relatively stable prices, as it
did before 1965, the system could be preserved
for a number of years. The real problem was
that of the gold exchange standard—a converti
bility crisis was ultimately inevitable. The twin
solutions advocated at the time of an increase in
the price o f gold and an increase in world liquidity
by creation of an artificial reserve asset would
not have permanently eradicated the problem.1 4
0
,02T he official view, w hich was stron g ly opposed to increased
exchange rate fle xib ility, is in m arked contrast to the aca
dem ic view, which by the end of the decade was solidly in
favor of increased fle xib ility, as evident at the fam ous Burq enstock C onference. See Halm (1970) and also Johnson
(1972a).
103See M eltzer (1991).
104Even at a higher gold price, w orld gold production w ould
e ventually be inadequate to produce long-run price sta b il
ity. In the long-run, w hen account is taken of gold as a
durable exhaustible resource, deflation is inevitable. See

The Liquidity P ro b lem
The liquidity problem, posed by Robert Triffin
and others, evolved from a shortfall of mone
tary gold beginning in the late 1950s. The real
price o f gold had been falling since W orld War
I I and would eventually reduce world gold
production. This happened in the early 1950s
but was offset by new sources o f production.
Gold production declined again in 1966. More
over, the falling real price would stimulate pri
vate demand for gold and it seemed unlikely
that Russian gold sales would make up much of
the shortfall. The prospect o f the world mone
tary gold stock growing enough to finance the
growth o f world real output and the value of
trade (without deflation) seemed dim. As can
clearly be seen in figure 16 for the Group of
Bordo and Ellson (1985). M oreover, an increase in w orld
liq u id ity by an a rtificial reserve asset, if convertible into
gold, would not rem ove the basic co n ve rtib ility problem .
See M cKinnon (1988). Finally as Tow nsend (1977), Salant
(1983) and Buiter (1989) point out, the gold exchange
standard as a type of com m odity stabilization schem e is
bound to collapse in the face of unforeseen shocks. See
G arber (1993). A ccording to M eltzer (1991), however, a 50
percent gold revaluation w ould have succeeded in preserv
ing the Bretton W oods system well into the 1970s had the
United States not follow ed an inflationary policy in the late
1960s.

M ARCH/APRIL 1993

172

Figure 16
The Growth of the Monetary Gold Stock, the Growth in International Reserves and the
Growth of the Volume of Real Trade and Real Income, G 7 ,1951-1973
Percent

opened in 1958 between the growth of output
and the volume of trade and the growth of
Group of Seven gold reserves. As can be seen in
figure 17, the shortfall for the Group of Seven
countries, excluding the U nited States, was made
up by a drain on the U.S. monetary gold
reserves until 1966.
As Triffin (1960) pointed out, dollars supplied
by the U.S. deficit could not be a permanent
solution to the impending gold shortage because
with continuous deficits, U.S. monetary gold
reserves would decline both absolutely and rela
tively to outstanding dollar liabilities until an
eventual convertibility crisis. Should the U.S.
monetary authorities close the deficit before
such a crisis, however, it would create a mas
sive shortage of international liquidity and the
prospect of world deflation. New sources of
liquidity were required, answered by the crea
tion of the special drawing rights in 1967. By
the time SDRs were injected into the system in
1970, however, they exacerbated worldwide
inflation.
105A lthough according to M eltzer (1991), there is little evi
dence in asset m arkets through the 1960s of a growing
loss of confidence in the dollar. Real interest rates did not

FEDERAL RESERVE BANK OF ST. LOUIS

The perceived key problem of the convertible
Bretton Woods period was the confidence crisis
for the dollar.1 5 As argued by Triffin (1960),
0
Kenen (1960) and Gilbert (1968), the gold-dollar
system that evolved after 1959 was bound to be
dynamically unstable if the growth of the world
monetary gold stock was insufficient to finance
the growth of world output and trade and to
prevent the U.S. monetary gold stock from
declining relative to outstanding U.S. dollar lia
bilities. The pressure on the U.S. monetary gold
stock would continue, as growth o f the world
monetary gold stock declined relative to the
growth o f world output and trade and as the
world substituted dollars for gold, until it trig
gered a confidence crisis that led to the collapse
of the system, as occurred in 1931. At the same
time, however, as fears over U.S. gold converti
bility threatened the dynamic stability o f the
Bretton Woods system, gold still served two
positive roles.
Gold was the numeraire of the system; all
rise sign ifica n tly relative to trade w eighted real interest
rates. Nor did the gold and foreign exchange m arkets sug
gest a flig h t from the dollar.

173

Figure 17
The Growth of the Monetary Gold Stock, the Growth in International Reserves and the
Growth of the Volume of Real Trade and Real Income, G7 Minus the United States, 1951-1973
Percent

currencies were anchored to its fixed price
through the U.S. commitment to peg its price.
Until 1968 gold still served as backing to the
U.S. dollar with a 25 percent gold reserve
requirement against Federal Reserve notes; the
requirement may have served as a brake on
U.S. monetary expansion.
The first glimpse of a confidence crisis was
the gold rush of October 1960 when speculators
pushed the free market price of gold on the
London market up from $35.20 (the U.S. Treas
ury’s buying price) to $40. See figure 18. This
first significant runup in gold prices since the
London gold market was reopened in 1954 was
supposedly triggered by concerns over a Democratic
victory in the 1960 U.S. Presidential election.
U.S. monetary authorities feared that private
speculation in the gold market might spill into
official demands for conversion. Consequently,
remedial action was taken quickly. The Treas
ury supplied the Bank of England sufficient gold
to restore stability, and the monetary authori
ties of the Group of Ten countries agreed to
refrain from buying gold above $35.20. In suc

ceeding months, the London Gold Pool, which
agreed to buy or sell gold to peg the price at
$35 an ounce, was formed between the United
States and seven other countries. The pool
became official in November 1961. For the next
six years, it succeeded in stabilizing the price of
gold but did not prevent a steady decline in the
U.S. monetary gold stock. See figure 13. In fact,
though the central banks in the seven other
countries supplied 40 percent of the gold
required to stabilize the price of gold, they
replenished their monetary gold stocks outside
the pool by converting outstanding dollar
balances into gold at the U.S. Treasury.1 6
0
During the period 1961-67, the United States
made a series o f arrangements to protect its
monetary gold reserves. These included a net
work of swap arrangements with other central
banks, the issue of Roosa bonds, and moral sua
sion. France, however, did not go along with
these efforts and began its campaign against the
dollar in February 1965.
The period was marked by two sets o f under

106See Meltzer (1991).

M ARCH/APRIL 1993

174

Figure 18
London Gold Price
Dollars per ounce

lying forces that would undermine the dollar’s
relationship to gold—growing gold scarcity and
a rise in U.S. inflation. W orld gold production
leveled o ff in the mid-1960s and even declined
in 1966, while at the same time private demand
soared, precipitating a drop in the world mone
tary gold stock after 1966. Indeed, beginning in
1966, ,the London Gold Pool became a net seller
of gold. Also, U.S. money growth accelerated in
1965, in part to finance the Vietnam War, and
inflation began to rise (figures 1 and 15). The
current account surplus began to deteriorate in
1964 (figure 14), as did U.S. competitiveness,
mirrored in a rise in the ratio o f U.S. unit labor
costs relative to trade weighted unit labor
costs.1 7 The balance-of-payments deficit w or
0
sened between 1964 and 1966 but was reversed
in 1966 by capital inflows triggered by tight
monetary policy.
After the devaluation of sterling, which the
United States tried unsuccessfully to prevent,
pressure mounted against the dollar via the
London Gold market. From December 1967 to
107See M eltzer (1991).
108See Solom on (1976).
109See G ilbert (1968) and Johnson (1968).

FEDERAL RESERVE BANK OF ST. LOUIS

March 1968 the Gold Pool lost $3 billion in gold,
with the U.S. share at $2.2 billion.1 8 The
0
immediate concerns o f the speculators may
have been fears o f a dollar devaluation, but
according to Gilbert and Johnson, it reflected
the underlying gold scarcity.1 9 In the face of
0
the pressure, the Gold Pool was disbanded on
March 17, 1968, and a two-tier arrangement
replaced it. Henceforth, the monetary authori
ties o f the Gold Pool agreed neither to sell nor
to buy gold from the market. They would trans
act only among themselves at the official $35
price. In addition, on March 12, 1968, the
United States removed the 25 percent gold
reserve requirement against Federal Reserve
notes. The key consequence of these new
arrangements was that gold was demonetized at
the margin. The link between gold production
and other market sources of gold and official
reserves was cut. Moreover, in the following
years, the United States put considerable pres
sure on other monetary authorities to refrain
from converting their dollar holdings to gold.

175

By 1968 the international monetary system
had evolved very far indeed from the model of
the architects of the Articles of Agreement. In
reaction to both developments in financial mar
kets and the confidence problem, the system
had evolved into a de fa c to dollar standard.
Gold convertibility, however, still played a role.
Though the major industrial countries tacitly
agreed not to convert their outstanding dollar
liabilities into U.S. monetary gold, the threat of
their doing so was always present. At the same
time, as the countries of continental Europe and
Japan gained economic strength relative to the
United States, they became more reluctant to
absorb outstanding dollars. They also were
reluctant to adjust their surpluses by revaluing
their currencies, increasingly coming to believe
that adjustment should be undertaken by the
United States.

The system had also developed into a de fa c to
fixed exchange rate system. Unlike the classical
gold standard, however, where the fixed exchange
rate was the voluntary focal point for both
internal and external equilibrium, in the Bretton
Woods system exchange rates became fixed
because members feared the consequences of
allowing them to change. Nevertheless, because
of increased capital mobility, the pressure for
altering the parities of countries with persistent
deficits and surpluses became harder to stop
through the use of domestic policy tools and the
aid of international rescue packages. Pressure
increased from both academic and official
sources for greater exchange rate flexibility.
By 1968, the system had also evolved a form
of international governance that was quite dif
ferent from that envisioned at the beginning.
Instead of a community o f equal currencies
managed by the IMF, the system was managed
by the United States in cooperation with the
other members of the Group of Ten countries.
In many respects, it was closer to the key cur
rency system proposed by Williams.1 0
1

According to Dominguez (1993), the IMF was
designed to facilitate international cooperation
by serving as a commitment mechanism. It was
to use its influence and its financial

to enforce the par value system. It did not,
however, have sufficient power to prevent
devaluations by major countries and its financial
resources were too limited to provide adequate
adjustment assistance for them. The IMF still
had an important role as a clearinghouse for
different views on monetary reform, as a center
of information, as the principal voice for the
countries of the world other than the Group of
Ten countries, as these countries' primary
source of adjustment assistance and finally as
an important partner in the major Group of
Ten rescue packages.
In sum, the problems of the interwar system
that Bretton Woods was designed to prevent
reemerged with a vengeance. The fundamental
difference, however, was that the system was
not likely to collapse into deflation as in 1931
but rather explode into inflation.

THE CO LLAPSE OF BR ETTO N
WOODS
After the establishment of the two-tier arrange
ment, the world monetary system was on a de fa c to
dollar standard. The system became increasingly
unstable until it collapsed with the closing of
the gold window in August 1971. The collapse
o f a system beset by the fatal flaws of the gold
exchange standard and the adjustable peg was
triggered by an acceleration in world inflation,
in large part the consequence of an earlier
acceleration of inflation in the United States.
Before 1968, the U.S. inflation rate was below
that of the GNP weighted inflation rate of the
Group of Seven countries excluding the United
States (see figure 15). It began accelerating in
1964, with a pause in 1966-67. The increase in
inflation in the United States and the rest o f the
world was closely related to an increase in
money growth and in money growth relative to
the growth of real output. (See figures 19 and
20.) Indeed, a prevalence o f excess demand
shocks in the mid- and late 1960s is apparent
for the United States and other Group of Seven
countries in figures 11 and 12.
Darby et al (1983) provided considerable evi
dence on the transmission of inflation in the

1,0See W illiam s (1936 and 1943) and Johnson (1972b).

MARCH/APRIL 1993

176

Figure 19
Money (M1) Growth Rates in the United States, G7 and G7 Excluding the United States,
1951-1973
Percent

Figure 20
Money (M1) Less Real Output Growth in the United States, G7 and G7 Excluding
the United States, 1951-1973
Percent

FEDERAL RESERVE BANK OF ST. LOUIS

177

Bretton Woods system. Their regression anal
yses led to a number of important conclusions.
First, U.S. inflation was caused by lagged U.S.
money growth. Second, U.S. money growth was
independent of changes in international
reserves—the balance of payments had no effect
on the Federal Reserve’s reaction function.
Third, U.S. money growth had strong and sig
nificant effects on money growth in seven
major countries. These lags were very long—
up to four years—and reflected the fact that
central banks in the seven countries sterilized
reserve flows partially. Finally, money growth
in the seven countries explained inflation in
these countries with a significant lag.1 1
1
The key transmission mechanism of inflation
was the classical price specie flow mechanism
augmented by capital flows. Little evidence for
other mechanisms including commodity market
arbitrage was detected.1 2 According to these
1
authors, the Bretton Woods system collapsed
because of the lagged effects of U.S. expansion
ary monetary policy. As the dollar reserves of
Germany, Japan and other countries accumu
lated in the late 1960s and early 1970s, it
became increasingly more difficult to sterilize
them. This fostered domestic monetary expan
sion and inflation. In addition, world inflation
was aggravated by expansionary monetary and
fiscal policies in the rest of the Group of Seven
countries, as their governments adopted fullemployment stabilization policies. The only
alternative to importing U.S. inflation was to
float—the route taken by all countries in
1973.1 3
1
The crisis mounted from 1968 to 1971. The
U.S. current account balance continued to
deteriorate in 1968, but the overall balance of
payments exhibited a surplus in 1968 and 1969
thanks to a large short-term capital inflow. The
capital inflow was activated by events in the
eurodollar market. In the face of tight monetary
policy in 1968-69 and Regulation Q ceilings on
time deposits, deposits shifted from U.S. banks
to the eurodollar market. U.S. banks in turn
borrowed in the eurodollar market, repatriating
these funds. In 1970, as U.S. interest rates fell
111See Darby et al (1983)
1,2See Darby et al (1983).
113Except for the case of Japan, there is little evidence for
the leading alternative explanation for the collapse— that it
reflected grow ing m isalignm ent in real exchange rates
between the U nited States and her p rincipal com petitors in
the face of d ifferential pro d u ctivity trends. See M arston

in response to rapid monetary expansion and
Regulation Q was suspended for large certifi
cates o f deposit, the borrowed funds returned
abroad and the deficit grew to $9 billion,
exploding to $30 billion by August 1971 (see fig
ure 14). The dollar flood increased the reserves
o f the surplus countries, auguring inflation. Ger
man money growth doubled from 6.4 percent
to 12 percent in 1971, and the German inflation
rate increased from 1.8 percent in 1969 to 5.3
percent in 1971.1 4 Pressure mounted for a
1
revaluation of the mark. In April 1971 the dol
lar inflow to Germany reached $3 billion. On
May 5, 1971, the German central bank sus
pended official operations in the foreign
exchange market and allowed the deutsche
mark to float. Similar action by Austria, Bel
gium, the Netherlands and Switzerland fol
lowed.1 5
1
In the following months, many began advocat
ing ending the dollar’s link with gold. In April
1971, the U.S. balance of trade turned to deficit
for the first time and influential voices began
urging dollar devaluation. The decision to sus
pend gold convertibility was triggered by
French and British intentions in early August to
convert dollars into gold. On August 15 at Camp
David, President Nixon announced that he had
directed Secretary Connolly "to suspend tem
porarily the convertibility of the dollar into gold
or other reserve assets.” The accompanying pol
icy package included a 90-day wage-price
freeze, a 10 percent import surcharge and a 10
percent investment tax credit.1 6
1
The U.S. decision to suspend gold convertibil
ity ended a key aspect of the Bretton Woods
system. The remaining part o f the system—the
adjustable peg—disappeared 19 months later.
The Bretton Woods system collapsed for three
basic reasons. First, two major flaws under
mined the system. One flaw was the gold
exchange standard, which placed the United
States under threat of a convertibility crisis. In
reaction it pursued policies that in the end
made adjustment more difficult.
(1987) and Eichengreen (1992b).
114See M eltzer (1991).
115See Solom on (1976).
116See Solom on (1976).

M ARCH/APRIL 1993

178

The second flaw was the adjustable peg. Because
the costs o f discrete changes in parities were
deemed high, in the face of growing capital
mobility, the system evolved into a reluctant
fixed exchange rate system without an effective
adjustment mechanism.
Finally, U.S. monetary policy was inappropri
ate for a key currency. After 1965, the United
States, by inflating, followed an inappropriate
policy for a key currency country. Though the
acceleration of inflation was low by the stand
ards of the following decade, when superim
posed on the cumulation of low inflation since
World War II, it was sufficient to trigger a
speculative attack on the world’s monetary gold
stock in 1968, leading to the collapse of the
Gold Pool.1 7 Once the regime had evolved into
1
a de fa c to dollar standard, the obligation of the
United States was to maintain price stability.
Instead, it conducted an inflationary policy,
which ultimately destroyed the system.

to Giovannini (1993), the Bretton Woods system
was an asymmetric solution to Mundell’s n-1
currency problem.1 9 The United States as the
1
nth country, had to maintain the nominal
anchor by following a stable monetary policy. In
addition, it had to supply the dollars demanded
by the rest of the world as reserves.
The rest of the world had to accept, through
its commitment to fixed parities, the price level
set by the United States. But because o f the ad
justable peg, it had the option to change parities.
The rule was defective for the nonreserve cur
rencies because the fundamental disequilibrium
contingency was never spelled out and no con
straint was placed on the extent to which domestic
financial policy could stray from maintaining ex
ternal balance. In addition, with growing capital
mobility, the option to change parities became
less viable.

One can view the Bretton Woods system as a
set of rules or commitment mechanisms.1 8 For
1
nonreserve-currency countries the rules were to
maintain fixed parities, except in the contin
gency of a fundamental disequilibrium in the
balance of payments, and to use fiscal policy to
smooth out short-run disturbances. The U.S.
enforcement mechanism—access to its open cap
ital markets—was presumably its dominant
power because the IMF had little power.

For the United States this rule suffered from
a number o f fatal flaws. First, because of the
fear of a confidence crisis, the gold convertibil
ity requirement may have prevented the United
States in the early 1960s from acting as a center
country and willingly supplying the reserves
demanded by the rest of the world. Second, as
became evident in the later 1960s, this require
ment was useless in preventing U.S. monetary
authorities from pursuing an inflationary policy.
Finally, although a mechanism was available for
the United States to devalue the dollar, mone
tary authorities were loath to use it for fear of
undermining confidence. No effective enforce
ment mechanism existed. Ultimately, the United
States attached greater importance to domestic
economic concerns than to its role as the center
of the international monetary system.

For the United States, the center country, the
rule was to fix the gold price of the dollar at $35
per ounce and to maintain price stability. If a
majority o f Bretton Woods members (and every
member with 10 percent or more of the total quotas)
agreed, however, the United States could change
the dollar price of gold. There was no explicit
enforcement mechanism other than reputation and
the commitment to gold convertibility. According

Thus although the Bretton Woods system can
be interpreted as one based on rules, the system
did not provide a credible commitment mech
anism.1 0 The United States was unwilling to
2
subsume domestic considerations to the respon
sibility of maintaining a nominal anchor. At the
same time, other Group o f Seven countries
became increasingly unwilling to follow the dic
tates of the U.S.-imposed world inflation rate.

D ID THE BR ETTO N W O O D S
SYSTEM O PE R A TE AS A SYSTEM
BASED ON CREDIBLE RULES?

” 7See G arber (1993).
118 See M cKinnon (1992) for his version of the rules of the
Bretton W oods A rticles and the dollar standard. Also see
G iovannini (1993) and O bstfeld (1993).
,19See M undell (1968).
120G io va n nini’s (1993) calculations show that d u ring the Bret
ton W oods convertible period cred ib ility bounds on interest
rates for the m ajor currencies, in contrast to the classical
gold standard, were frequently violated.

FEDERAL RESERVE BANK OF ST. LOUIS

179

The failure of the Bretton Woods rule sug
gests a number of requirements for a welldesigned fixed exchange rate system. These
include the following:
• that the countries follow similar domes
tic economic goals (underlying inflation
rates);
• that the rules be transparent; and
• that some central monetary authority
enforce them.
The recent EMS system was quite successful for
a number of years because it seemed to encom
pass these three elements. Its recent crisis, how
ever, reflected the emergence of some of the
same problems that led to the breakdown of
Bretton Woods. I discuss these issues below in
the following subsection.

PO ST BRETTON WOODS: MANAGED
FLO A TIN G A N D THE EMS
As a reaction to the flaws of the Bretton Woods
system, the world turned to generalized floating
exchange rates in March 1973. Though the early
years of the floating exchange rate were often
characterized as a dirty float, whereby mone
tary authorities extensively intervened to affect
both the levels of volatility and exchange rates,
by the end of the 1970s it evolved into a system
where exchange market intervention occurred
primarily to smooth out fluctuations. Again in
the 1980s exchange market intervention was
used by the Group of Seven countries as part of
a strategy o f policy coordination.1 1 In recent
2
years, floating exchange rates have been assailed
from many quarters for excessive volatility in
both nominal and real exchange rates, which in
turn increase macroeconomic instability and
raise the costs o f international transactions.
The attack cites the favorable experience of
the EMS from 1987 to 1991 in producing ex
change rate and price stability as a recommen
dation for a return to a global system of fixed
exchange rates. It is argued that recent attempts
at policy coordination can be formalized and ex
tended to a more general managed system based
on either close policy coordination (to keep ex
change rates within specified target zones) or a

renewed gold standard. In this paper I do not
consider the merits or drawbacks o f policy
coordination in general, but I examine the EMS
briefly as a monetary regime similar to Bretton
Woods.1 2 Of interest is whether lessons for the
2
international monetary system can be derived
from its experience.
The EMS, like the Bretton Woods system,
represents an agreement among countries to set
exchange rate parities, to manage intra-European
Community exchange rates and to finance exc
hange market intervention. Like Bretton Woods,
it is an adjustable peg system.
The origins of the EMS date back to the Bretton
Woods period. The case for stable exchange
rates within Europe was made in the context of
the European Common Market (EEC). In addi
tion to a strong dislike by Europeans for flexible
exchange rates—based on their perception of inter
war experience and their belief that exchange
rate volatility reduces trade in highly open
economies—the key motivation for extensive
policy coordination to stabilize exchange rates
was the common agricultural policy established
in 1959.1 3
2
Food prices in the community are set in terms
of a central unit o f account (the ECU) but quoted
in local currency. Consequently, any changes in
exchange rates lead to changes in local prices.
During the Bretton Woods era, a system of sub
sidies and taxes was worked out to insulate the
local economy from policy realignments. This
led to an asymmetric adjustment between hard
currency countries reluctant to lower their
agricultural prices and soft currency countries,
which allowed their prices to rise. The result
was overproduction of agricultural products
and an ever-increasing fraction of the EEC
budget allocated to subsidize agriculture.
Early attempts to stabilize intra-European
exchange rates during the Bretton Woods era
were unsuccessful, as was the Snake in the
Tunnel agreement o f the 1970s. The EMS, estab
lished in 1979, was a formal attempt to overcome
earlier obstacles to exchange rate stabilization.
It was designed to prevent the defects o f the
Bretton Woods system, including: the asymmetric
adjustment mechanism, with the United States
as the center, setting the tune for the rest of

121 See Bordo and Schwartz (1991).
122See Feldstein (1988) and Bordo and Schw artz (1989a).
123See Giavazzi and G iovannini (1989).

M ARCH/APRIL 1993

180

the world; the problems associated with grow
ing capital mobility; and the dramas of parity
realignments. Instead, the EMS designed a set of
intervention rules that would produce a sym
metric system of adjustment; create a mechanism
to finance exchange market interventions; and
establish a code of conduct for realigning parities.1 4
2
Like Bretton Woods, the EMS was based on a
set o f fixed parities called the exchange rate
mechanism (ERM). Each country was to estab
lish a central parity o f its currency in terms of
ECU, the official unit of account. The ECU con
sisted of a basket containing a set number of
units of each currency. As the value of curren
cies varied, the weights of each country in the
basket would change. A parity grid of all
bilateral rates could then be derived from the
ratio of members’ central rates. Again, like Bret
ton Woods, each currency was bounded by a
set of margins o f 2.25 percent on either side of
parity, creating a total band of 4.5 percent (for
Italy, and later the United Kingdom, when it
joined the ERM in 1990, the margin was set at 6
percent on either side of parity). The monetary
authorities of both the depreciating and appre
ciating countries were required to intervene
when a currency hit one o f the margins. Coun
tries were also allowed, but not required, to
undertake intramarginal intervention. The indi
cator of divergences, which measured each cur
rency’s average deviation from the central
parity, was devised as a signal for the monetary
authorities to take policy actions to strengthen
or weaken their currencies. It was supposed to
work symmetrically.
Intervention and adjustment was to be
financed under a complicated set of arrange
ments. These arrangements were designed to
overcome the weaknesses of the IMF during
Bretton Woods. The very short-term financing
facility (VSTF) was to provide credibility to the
bilateral parties by ensuring unlimited financing
for marginal intervention. It provided automatic
unlimited lines of credit from the creditor to
the debtor members. The short-term monetary
support (STMS) was designed to provide short
term finance for temporary balance of pay
124See Giavazzi and G iovannini (1989).
125 A t its outset, there was considerable doubt that the EMS
would be successful at w ithstanding the strains of greatly
divergent m oney growth and inflation rates am ong its
m em bers. See Fratianni (1980). See Giavazzi and G iovan
nini (1989); Fratianni and von Hagen (1990 and 1992); and
M eltzer (1990).

FEDERAL RESERVE BANK OF ST. LOUIS

ments disequilibration. The medium term finan
cial assistance (MTFA) would provide longer
term support.
Unlike Bretton Woods, where members (other
than the United States) could effectively decide
to unilaterally alter their parities, changes in
central parities were to be decided collectively.
Finally, like Bretton Woods, members could (and
did) impose capital controls. These have recently
been phased out.
The evidence on the performance of the EMS
indicates that it was successful in the latter half
of the 1980s at stabilizing both nominal and real
exchange rates within Europe, at producing credi
ble bilateral bands and at reducing divergence
between members’ inflation rates.1 5
2
Giavazzi and Pagano (1988), Giavazzi and
Giovannini (1989), and Giovannini (1989) make a
strong case that the success of the EMS was
largely due to the fact that it was an asymmet
ric system with Germany acting as the center
country. The other EMS members adapted their
monetary policies to maintain fixed parities with
Germany. Also, according to the aforementioned
writers, the Bundesbank exhibited a strong credi
ble commitment to low inflation and the other
members of the ERM, by tying their currencies
to the deutsche mark, used an exchange rate
target as a commitment mechanism to success
fully reduce their own rates of inflation. Evidence
for the asymmetry hypothesis is based on the
fact that the Bundesbank intervened only when
bilateral exchange rates were breached, whereas
the other countries engaged in intra-marginal
intervention, and on evidence of asymmetrical
behavior of interest rates in Germany and the
other EMS countries. In the period preceding
several EMS realignments, non-German EMS
interest rates changed drastically, whereas no
change was observed in their German counter
part. Evidence that the Bundesbank’s reputation
was responsible for the disinflation of the 1980s
is based on an out-of-sample simulation of a
VAR to predict the inflation rate. Downward
shifts in the predicted values of inflation for a
number o f countries after the advent o f the
EMS makes the case. That inflation expectations

181

were significantly reduced only in France and
Italy several years after the advent of the EMS
(the argument goes) may reflect slow learning
or alternatively that these countries used the
EMS to justify following unpopular austerity
policies.
Fratianni and von Hagen (1990 and 1992) dispute
both the asymmetry and the imported disinflation
hypotheses.1 6 Evidence based on Granger causal
2
ity tests from a structural VAR suggests that the
German monetary base was not insulated from
other EMS base movements nor were non-German
EMS monetary bases insulated by the German
monetary base from external shocks. In this
interpretation, the EMS is a coordinated mone
tary policy system with all members playing
a role.
Finally, Fratianni and von Hagen (1990) pro
vide evidence that the EMS has reduced intraEuropean exchange rate volatility; however, this
reduction has been at the expense of increased
volatility of non-EMS currencies. Thus they
argue that the EMS is on net balance beneficial
to welfare because intra-EMS trade exceeds
external trade. They also show that although
the advent of the EMS has not reduced inflation
uncertainty relative to non-EMS countries, it has
reduced the effects of foreign inflation shocks
on the members.
Despite its favorable performance since the
mid-1980s, the EMS was recently subjected to
the same kinds of stress that plagued Bretton
Woods. September 1992 and November 1992
marked a series of exchange rate crises in
Europe that paralleled the events of 1967 to
1971. Precipitated by concerns that French vot
ers would reject the Maastricht Treaty on Euro
pean Monetary Union in a referendum on
September 20, speculators staged attacks early
in the month on the Nordic currencies and then
later on the Italian lira, the British pound, the
French franc, and other weaker currencies. The
crisis led to the disabling o f the ERM. Both Italy
and the United Kingdom left it while Spain,
Portugal and Ireland reimposed or strengthened
existing capital controls: in November Sweden
floated and Portugal and Spain devalued.

The fundamental causes o f the crisis, like
the crises that plagued Bretton Woods, lay in
large part with the exchange rate system. The
EMS, like Bretton Woods, is a pegged exchange
rate system that requires member countries to
follow similar domestic monetary and fiscal
policies and hence have similar inflation rates.
This is difficult to do in the face of both differ
ing shocks across countries and differing national
priorities. Under Bretton Woods, capital con
trols and less integrated international capital
markets allowed members to follow divergent
policies for considerable periods. Under the
EMS, the absence of controls (after 1990) and
the presence o f extremely mobile capital meant
that any movement o f domestic policies away
from those consistent with maintaining parity
would quickly precipitate a speculative attack.
Also, just as under Bretton Woods, the adjusta
ble peg in the face o f such capital mobility
became unworkable. Thus the difference
between the two regimes when faced with
asymmetric shocks or differing national priori
ties was the speed of reaction by world capital
markets.
Though the fundamental cause of the crisis
was similar in the two regimes, the source of
the problem differed. Under Bretton Woods, the
shock that led to its collapse was an accelera
tion o f inflation in the United States, ostensibly
to finance the Vietnam War, as well as social
policies, and to maintain full employment.
Under the EMS, the shock was bond financed
German reunification and the Bundesbank’s sub
sequent deflationary policy. In each case, the
system broke down because other countries
were unwilling to go along with the policies of
the center country. The commitments to price
stability by both the center country and the
other members were not shown as credible.
Under Bretton Woods, Germany and other west
ern European countries were reluctant to
inflate or revalue and the United States was
reluctant to devalue. Under the EMS, the United
Kingdom, Italy, Spain, Portugal, Ireland and
Sweden were unwilling to deflate and Germany
was unwilling to revalue. As under Bretton
Woods, although the EMS had the option for a

126Also, C ollins (1988) and Eichengreen (1992d) present evi
dence that EMS m em bership m ay not have been responsi
ble for reducing the inflation rates of EMS countries. Their
cross-country regressions show that EMS m em bership had
little e ffect on inflation perform ance. Changing p ublic a tti
tudes tow ard inflation w ithin each country represent a
more im portant determ inant. See Giavazzi and Collins (1992).

M ARCH/APRIL 1993

182

general realignment, both improved capital
mobility and the Maastricht commitment to a
unified currency made it an unrealizable
outcome.
Thus the lesson from both the EMS and Bret
ton Woods is that pegged exchange rate systems
do not work for long no matter how well they
are designed. Pegged exchange rates, capital
mobility and policy autonomy just do not mix.
During the heyday of Bretton Woods years ago,
the case made for floating exchange rates for
major countries still holds. This is not to say
that if European countries were completely will
ing to give up domestic policy autonomy, they
could not eventually form a currency union
with perfectly fixed exchange rates. In an
uncertain world subject to diverse shocks, the
costs for individual countries of doing so are
apparently extremely high.

CONCLUSION
This paper examines statistical evidence on
the performance of alternative monetary
regimes over the past century. It also examines
some aspects of the history of these regimes.
Both statistical and historical evidence may help
provide answers to the question why some
regimes have been more successful than others.
They also have implications for current issues
in international monetary reform and the ongo
ing debate over rules and discretion.
The statistical evidence on performance of
alternative monetary regimes in the second sec
tion leads to the conclusion that the Bretton
Woods convertible regime from 1959 to 1970
was by far the best on virtually all criteria, but
that the recent floating regime is not much
worse. Indeed, it is clear that the performance
of the regimes in the post-World W ar II era is
superior to the performance of regimes in the
preceding half century. Finally, though the clas
sical gold standard does relatively poorly in
terms of the stability of real variables, it per
formed best on inflation persistence and financial
market integration—evidence for the successful
operation of gold as a nominal anchor.
This evidence leads to the following question:
Why was Bretton Woods so stable yet so fragile
and the classical gold standard so unstable and
yet so durable? The answer may be due in part
to the shocks the two regimes faced. This, how
ever, seems unlikely because the gold standard
was subject to both supply and demand shocks

FEDERAL RESERVE BANK OF ST. LOUIS

that were a multiple of those facing Bretton
Woods. It could also be due to greater flexibility
of wages and prices and greater factor mobility
before W orld W ar I, which meant that adjust
ing to the greater shocks did not have as serious
consequences on real activity and employment
as later in the twentieth century. Alternatively,
political economy factors—such as a more
limited suffrage; less concern over the main
tenance of full employment; limited understand
ing of the link between monetary policy and the
level of economic activity; and hence loss o f an
incentive for monetary authorities to pursue
policies that would threaten adherence to
convertibility—could be responsible. These
hypotheses clearly need more investigation.
It also could be due to regime design and
especially the incentive compatibility features of
the regime. The classical gold standard may have
been so successful because of the credibility of
the commitment to the gold standard rule of
convertibility and because o f its near universal
acceptance. In turn, the credibility of the gold
standard may stem from the origins of gold as
money and the importance of Great Britain, the
most important commercial nation of the nine
teenth century, in enforcing the rules. England’s
commitment to convertibility in turn was aided
by stabilizing private capital flows.
The classical gold standard for the core coun
tries worked as a contingent rule or a rule with
escape clauses. As a consequence, it was flexible
enough to withstand major shocks. It also ena
bled governments to finance major wars flexi
bly, by allowing them to leave the gold standard
and temporarily use seigniorage to finance
unusual government expenditures. The rule
may have endured because the requisite defla
tion required to restore convertibility after the
emergency had passed may not have had severe
effects on real variables. This may have been
because wages and prices were highly flexible.
Alternatively the deflation accompanying re
sumption may have had significant real effects
but no political constituency strong enough to
oppose it existed.
The classical gold standard collapsed under
the unprecedented shocks of W orld W ar I. It
was reinstated as the short-lived gold exchange
standard. Its brief life reflected the fatal flaws
made famous by the Triffin dilemma. But regard
less o f the weakness of the gold exchange stan
dard, it suffered from the absence o f an effec
tive commitment mechanism. There was no cen

183

ter country to enforce the rule, just three rivals
pulling in different directions. Also, it was the
beginning o f an era when countries were less
willing to go along with the gold convertibility
rule because they attached greater weight to
the objective of domestic economic stability.
The Bretton Woods system was set up to pre
vent the perceived flaws of the classical gold
standard and the trauma of the interwar
period. The Bretton Woods adjustable peg was
in some respects similar to the gold standard
contingent rule, but it invited speculative
attacks, hence compromising its role as an
escape clause. Bretton Woods evolved into a
gold exchange standard fraught with the adjust
ment, liquidity and confidence problems of the
interwar period. Though the problems of the
gold exchange standard could possibly have been
corrected by raising the price of gold, as it turned
out, it evolved into an asymmetric dollar stand
ard. The United States maintained the credible
commitment to a noninflationary policy for only
a few years. By the mid-1960s it shifted to an
inflationary policy to further its domestic inter
ests. The rest of the world, faced with imported
inflation, soon lost the incentive to follow U.S.
leadership and the system collapsed in 1971.
The advent o f the general floating exchange
rate system in 1973 and its longevity suggests
that the lessons of Bretton Woods have been
learned well. Countries are not willing to sub
ject their domestic policy autonomy to that of
another country of whose commitment they
cannot be sure in a stochastic world nor to a
supernational monetary authority they cannot
control. The key advantage of floating exchange
rates stressed a generation ago by Milton Fried
man and Harry Johnson—the freedom to pursue
an independent monetary policy—still holds today.
Major countries can design domestic monetary
policy rules to achieve domestic price stability
without the costs o f giving up their policy
autonomy.
The experience of the EMS reveals that coun
tries that have similar goals and face similar
shocks can establish a regional exchange rate
regime. This regime requires both a credible
commitment mechanism and the willingness of
member countries to give up sovereignty for a
higher purpose. As attested to by the events of

September and November 1992, however, the
durability o f such an arrangement seems doubt
ful, as was the case for Bretton Woods, in an
uncertain world subject to diverse shocks
where national priorities can change and com
mitments can be broken. Some have argued
that the EMS can be preserved only by precom
mitment to price stability and fixed exchange
rates by independent central banks.1 7 Others
2
argue that the only solution is rapid movement
to a unified currency enforced by a European
central bank.1 8 As Feldstein (1992) points out,
2
however, full-fledged monetary union com
pletely precludes the use of domestic monetary
policy. To the extent that country-specific
shocks dominate common shocks and labor is
relatively immobile between European coun
tries, the benefits o f permanently fixed
exchange rates may not outweigh the cost of
increased economic dislocation.1 9
2
Finally, proposals for monetary reform, such
as exchange rate target zones or targeting the
real price of gold, though possibly of scientific
merit, would work only if nations are willing to
give up domestic autonomy and follow credible
commitments. The history of international
monetary regimes casts doubt on the likelihood
that the nations of the world will do so in the
forseeable future.

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MARCH/APRIL 1993

FEDERAL

Appendix Table 1

RESERVE

Supply (Permanent) and Demand (Temporary) Shocks: 1880-1989
Annual Data: Standard Deviations of Shocks (percent); Dispersion of shocks across countries (percent)

BANK

Gold Standard

O ST. LOUIS
F

Dem and
United States
United Kingdom
C anada
Italy
G4
G 4*
Dispersion

Supply

2.36
3.09
1.01
4.79
2.23
2.10
2.69

4.77
3.09
2.80
5.00
3.53
3.30
4.30

Dem and
U nited States
U nited Kingdom
C anada
Italy
G4
G 4*
D ispersion

Supply

5.06
2.96
3.65
10.98
3.66
3.79
3.93

7.76
3.18
3.55
7.95
5.87
5.89
4.60

4.27
4.34
6.47
10.60
4.53
4.30
3.87

Demand

Supply

Demand

9.36
4.32
6.45
8.50
6.82
6.64
7.03

6.73
6.18
6.28
11.56
6.73
6.35
4.15

6.31
5.23
8.01
6.46
4.67
5.12
5.50

2.22
5.59
2.31
18.29
2.49
1.99
5.62

Bretton W oods
(Convertible)
1959-1970
Demand
1.15
1.71
0.97
2.71
0.95
0.90
1.61

1940-1945

Supply

Supply
1.87
1.32
1.56
2.21
1.50
1.47
2.10

Floating Exchange

1.46
3.27
2.41
3.43
1.41
1.56
2.07

7.10
7.15
6.68
4.92
5.91
6.30
6.96

Demand

Supply

3.69
2.42
2.67
8.15
2.67
2.76
2.82

5.72
2.47
2.73
5.86
4.33
4.38
3.40

Post W W II
1946-1989

1973-1989
Demand

Supply

Bretton W oods
(Total)
1946-1970

188

Bretton Woods
(Preconvertible)
1946-1958

Demand

W orld W ar II

1919-1939

1914-1918

1883-1913

Interw ar

W orld W ar 1

Supply
2.47
4.81
2.71
2.63
2.56
2.37
2.05

Demand
2.92
2.85
2.59
6.78
2.25
2.34
2.57

Supply
4.55
3.49
2.75
5.01
3.60
3.59
2.79

G4: G 4-aggregate data
G 4 *: W eighted average of in d ivid u a l country shocks; the weights are calculated as the share of each co u n try’s N ational Incom e in the Total Incom e in the G4 countries,
w here th e G N P/G D P data are converted to dollars using the actual exchange rate.
D ispersion = 2 (w eightj(sho ck|- 2 w e ig h t,'sh o ck,)2)0-5 for i = United States, United Kingdom , Canada, Italy.

189

A p p e n d ix F ig u re 1

Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data,
United States
Percent
20-

Supply

------ 1-------- 1-------- 1
--------- 1-------- 1-------- 1-------- 1-------- 1-------- 1-------- 1
—
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data,
United Kingdom
Percent

-------1-------- 1
--------- 1-------- 1-------- 1-------- 1
--------- 1
--------- 1
—
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

M ARCH/APRIL 1993

190

Appendix Figure 1 (continued)
Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data, Canada
Percent

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data, Italy
Percent

-40
1880

1890

1900

1910

FEDERAL RESERVE BANK OF ST. LOUIS

1920

1930

1940

1950

1960

1970

1980

191

Appendix Figure 1 (continued)
Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data, G4
Percent
12

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

M ARCH/APRIL 1993

Manfred J. M. Neumann
M a n fre d J .M . N e u m a n n is the d ire c to r o f the In s titu te fo r In te r
n a tio n a l E c o n o m ic s a n d a p ro fe s s o r o f e c o n o m ic s a t the
U n iv e rs ity o f B onn.

Commentary

J V i l C H A E L BORDO PROVIDES US with a
comprehensive, scholarly study o f the history of
the three main international monetary regimes:
the gold standard, the dollar standard, and the
floating exchange rate. He focuses on two
important questions. First, which regime provided
the best performance with regard to the levels
of inflation and real growth? Second, what
makes an international monetary regime viable?
Because I am not a historian, I will limit my
comments to two areas. I will first discuss the
comparative evidence on the performance of
the three monetary regimes and use Bordo’s
statistics to infer a little more information on
the role of demand shocks under the different
regimes. Thereafter I will concentrate on the
important issue of determining a monetary
system’s credibility. I find Bordo's thoughtful
discussion of the issue useful. I should add,
however, that sometimes he takes the literature
too seriously—especially the affirmative litera
ture on the European Monetary System (EMS).
Nevertheless, Bordo forces us to consider which
monetary system or standard, if any, can solve
the credibility problem in terms of firmly
anchoring market expectations about its
viability.
1The G roup of Seven countries are Canada, France, Germany,
Italy, Japan, the United Kingdom and the United States.

FEDERAL RESERVE BANK OF ST. LOUIS

W H IC H REGIME PERFORM ED
BEST?
It is natural to evaluate the welfare implica
tions of monetary regimes by asking what
different regimes achieve with respect to the
level and stability o f inflation and real growth.
Any monetary regime can be described as a
mechanism or device that delivers an average
rate of monetary expansion and a variance of
money growth. With respect to economic per
formance, the essential difference is whether a
particular regime provides governments with
more or less freedom to manipulate the aver
age rate of and the variance of monetary expan
sion. It follows that regime differences should
be reflected in inflation levels and variances of
inflation and per capita growth.
Table 1 draws from Bordo's tables 1 and 4. I
consider the Group of Seven countries as a
whole, the United States, Germany and France
and concentrate on the three major periods: the
pre-World W ar I gold standard, the Bretton
Woods system of the 1950s and 1960s, and the
floating exchange rate in place since the
mid-1970s.1 Note that, in contrast to Bordo, I do
not separate out the favorable performance of
the Bretton Woods convertible subperiod

193

Table 1
Inflation, Real Growth and Shocks in Different Monetary
Regimes for the Group of Seven Countries, the United States,
Germany and France1
______________________________________
Gold Standard
1881-1913

Bretton W oods
1946-1970

Floating
1974-1989

Mean

Var

Mean

Var

Mean

Var

Inflation
Mean G roup of Seven
United States
G erm any
France

1.0
0.3
0.6
-0 .0

11.56
9.61
6.76
24.01

3.6
2.4
2.7
5.6

21.16
6.76
16.00
16.81

7.1
5.6
3.3
8.8

10.24
5.76
1.69
10.24

Per capita growth
Mean G roup of Seven
United States
G erm any
France

1.5
1.8
1.7
1.5

13.69
26.01
8.41
21.16

4.2
2.0
5.0
3.9

7.29
7.84
10.89
4.41

2.1
2.1
2.1
1.7

5.29
7.29
3.61
2.25

Dem and shocks
Mean G roup of Seven
United States
G erm any
France

8.64
4.12
5.62
20.98

7.91
5.43
8.29
12.25

6.26
2.96
2.76
3.72

Supply shocks
Mean G roup of Seven
United States
G erm any
France

9.27
14.52
5.38
14.06

4.47
2.37
7.02
3.06

5.01
3.76
1.93
2.31

'T h e se data com e from tables 1 and 4 in the Bordo article in this R e view . The 1.69 estim ated
variance of inflation for G erm any in the floating exchange rate period is based on a standard
deviation of 1.3. This differs from the 1.2 standard deviation in B ordo’s table 1 because of
differences in rounding of the standard deviation.
The G roup of Seven countries are C anada, France, Germ any, Italy, Japan, the United Kingdom
and the United States.

(1959-1970) in terms of inflation and output.
The subperiod looked good on the surface; how
ever, it was in fact the period when the break
down of Bretton Woods was programmed. More
generally speaking, for any regime we might
find e,x post a good looking subperiod.2
As Bordo and others have pointed out, the
data permit the following observations:
• First, average inflation was negligible under
the gold standard and highest under the
floating exchange rate.
• Second, the variability of inflation, as
well as that of real growth, was higher
under the gold standard than under the
floating exchange rate.
2As Anna Schwartz pointed out in the discussion, an evalu
ation of the EMS that bypasses the m ost recent period,

• Third, the Bretton Woods regime exhibited
the highest variability of inflation, whereas
output variability was closer to its level
under the float than under the gold
standard.
The first observation on average inflation per
formance is well known and understood. It is
widely accepted that the classical gold standard
prevented the manipulation of monetary expan
sion by enforcing a direct link between the base
money stock, the national stock of gold and the
balance of payments. Though devaluation was
possible by raising the gold parity in national
currency, it was rare. Thus the gold standard deliv
ered the lowest average rate of inflation, given that
the available gold stock did not grow much.
when the EMS cam e close to collapse, would be seriously
m isleading.

MARCH/APRIL 1993

194

At the other extreme, fiat money cum floating
does not put any external constraint on domes
tic money production. Thus governments are
free to use money production to collect inflation
tax and to dampen the business cycle. The addi
tional advantage to governments of the floating
exchange rate is that the regime spares them
the political cost of negotiating devaluation. In
sum, the floating exchange rate is the monetary
regime most conducive to inflationary policies.
Finally, the Bretton Woods system was in
between the gold standard and the floating
exchange rate in that it started as a gold
exchange standard but was permitted to
degenerate into a pure fiat money standard (the
dollar standard) during the early 1960s when
the United States gold stock fell short of the
value of outstanding dollar liabilities.
More interesting than the average inflation
performance is the observed difference in the
volatility of inflation and output growth among
regimes. But to what extent can this volatility be
attributed to the operation of the different
monetary systems?

EX PLO R ING THE ROLE OF
DEM AND SHOCKS
Apart from determining the level of inflation,
monetary regimes differ with respect to nomi
nal demand shock variability. I propose the
following conjectures.
First, nominal demand shock variability is
highest under the floating exchange rate and
lowest under the gold standard. This reflects
the differences in the limits to monetary discre
tion. Because the degree of monetary discretion
is close to zero under the gold standard and
unlimited under the floating exchange rate, we
should observe that the variance of inflation
was caused predominantly by nominal demand
shocks under the floating exchange rate but by
supply shocks under the gold standard.
Second, in a fixed-exchange rate system the
system leader sets the floor for nominal demand
shock variability. Consequently, for the Bretton
Woods period we should observe that nominal
demand shock variability was lowest in the
United States. Similarly, during the floating rate
period nominal demand shock variability should
have been lower in Germany than in any other
3See B ordo’s table 4.

FEDERAL RESERVE BANK OF ST. LOUIS

member country of the European snake or EMS.
Checking the empirical validity of these con
jectures requires estimating the variance of
nominal demand shocks. Bordo’s study provides
us with some valuable information in this
respect. Following Blanchard and Quah (1989)
and Bayoumi and Eichengreen (1992) in particu
lar, he has estimated for each country and each
monetary regime a bivariate vector autoregres
sion (VAR) for the rates of change of the price
level and output. The lower panel of table 1
provides the variances of the estimated aggregate
supply and demand shocks.3 Under the straight
forward assumption that the distribution of real
demand shocks was the same over the different
monetary regimes, differences in demand shock
variability can be attributed to the operational
differences of the regimes.
The empirical findings are mixed. The data
reject our first conjecture. For the Group of
Seven countries demand shock variability was
highest under the gold standard and lowest
under the potentially permissive floating exchange
rate regime. The most puzzling aspect is the
high demand variability during the gold stand
ard period because not only was monetary pol
icy discretion constrained by the rules of the
regime, but also fiscal discretion was negligible,
at least by today’s standards.
Our second conjecture, in contrast, is con
firmed. Demand shock variability was lowest in
the United States during the Bretton Woods
period and in Germany during the float. More
over, it can be shown for Germany using an
F-test that the demand shock variance o f the
float differed significantly from its value under
Bretton Woods at the 1 percent level of sig
nificance. In the United States the level of
significance was 10 percent.
Though we have not seen any test statistics of
Bordo’s VAR estimates, let us assume that the
estimates are clean. On this assumption we may
use them to investigate the contribution of the
aggregate demand shocks to the variability of
inflation and output growth under the different
monetary regimes. To do so requires a model of
aggregate supply and demand to determine the
unknown price elasticities of aggregate demand
and supply.
Table 2 provides the bare bones o f such a
model. The model is written in logs and has a

195

Table 2
A Minimal Structure
(1) y = 6 + a (p (2) y = p (m -

E _ ! p)

O utput supply
O utput dem and

(3) 0 = 8 _ i + s

Productivity

(4) m = m _ , + d

M oney stock

Solutions
(5) it = p -

p_,

=d _ ! - - y - s

(6) Ay = y - y . , = s +

[p (d -

+ ~ - + j IP < d

-1

d _ ,) - (s -

d - i) -

(s -

s _ ,)l

s _ ,)]

Variances

(7 o* = fL ± Ji r02 + ?s!i
) w
d
(a + PY L

, _ a2 + P2

(8) ohy

(a + p)2 °s

P2 J

, ^ 2 (a PY

+ (a + p)2 °d

Table 3
The Contribution of Demand Shocks to the Variability of Inflation and Real
Growth1
Bretton Woods
Variance

Gold Standard
Variance
Actual

Adjusted Adjusted percentage
of actual

Actual

Adjusted Adjusted percentage
of actual

Floating Exchange Rate
Variance
Actual

Adjusted Adjusted percentage
of actual

Inflation
Mean G roup of Four
United States
G erm any
France

10.6
9.6
6.8
24.0

4.8
3.5
3.3
12.0

(45)
(36)
(49)
(50)

12.1
6.8
16.0
16.8

5.2
4.2
6.0
7.4

(43)
(62)
(38)
(44)

6.1
5.8
1.7
10.2

2.5
2.4
1.5
2.4

(41)
(41)
(86)
(24)

Real growth
Mean G roup of Four
United States
G erm any
France

15.9
26.0
8.4
21.2

8.8
13.8
5.2
13.1

(55)
(53)
(59)
(62)

7.5
7.8
10.9
4.4

4.4
6.0
5.8
2.6

(59)
(77)
(53)
(59)

4.7
7.3
3.6
2.3

2.8
4.2
2.6
0.8

(60)
(58)
(72)
(35)

’ The Group of Four countries are Canada, France, Germ any and the United States. The adjusted
variance excludes the contribution of supply shocks.

Lucas-type supply equation and an aggregate
demand equation. The evolution of prices and
output is driven by productivity and the money
supply (both modeled as random walks) with
shocks d and s assumed to be independently
distributed. The model's solutions [equations (5)
and (6)] show that it meets the restrictions used
in Bordo’s VAR estimates. Supply shocks have
permanent effects on the price level and output,

whereas demand shocks have no permanent
effect on output.
Given the variances of inflation, real growth,
demand and supply shocks, equations (7) and (8)
can be used to compute the slope coefficients in
a p - y plane o f aggregate demand, - 1 1(), and
aggregate supply, 1la. Solving by numerical
iteration does not yield real solutions in all

MARCH/APRIL 1993

196

cases—notably the Bretton Woods convertible
subperiod.4 Given the estimates o f the slope
coefficients, we can compute the contribution of
the variance o f aggregate demand shocks to the
observed variances of inflation and real growth
in table 3.
Table 3 presents for each monetary regime
the measured variances of inflation and real
growth, as well as adjusted variances, which
exclude the contribution to volatility of the
aggregate supply shocks. The numbers printed
in parentheses indicate the percentage share in
the measured variance of the contribution of
the demand shock variance. Note that data from
only four of the Group of Seven countries are
included; data from Italy, Japan and the United
Kingdom had to be removed because it was
impossible to compute the slope coefficients for
these countries (in at least one subperiod).
Table 3 can be summarized as follows:
• First, for the United States, the leader of
the Bretton Woods regime, we find that
the variances of inflation and real growth
were dominated by the volatility of demand
shocks during this period. About 62 per
cent of the variance of inflation and 77
percent of the variance of output growth
can be attributed to the variance of demand
shocks. Similarly, we find that for Germany
under the floating regime the inflation
and the output variance were dominated
by demand shocks, which accounted for
86 percent of the inflation variance and
72 p ercen t o f the output variance.
• Second, for the four Group of Seven
countries we find that demand shocks
produced a higher inflation variance
under Bretton Woods (5.2) than under
the gold standard (4.8) or the floating
exchange rate (2.5). The result probably
reflects the differential performance of
the two leading countries.
• Third, for the four Group of Seven countries
as a whole, the variance of demand shocks
did not dominate the inflation variance
under any of the three monetary regimes.
Its contribution never exceeded 45 per
cent. Thus we find over all regimes that
the inflation variance was dominated by
4O f the up to four real solutions for each case, I chose the
one w hich com bines a negative slope of aggregate dem and
w ith a positive slope of aggregate supply.

FEDERAL RESERVE BANK OF ST. LOUIS

the volatility of aggregate supply shocks.
This is a little surprising. Are we prepared
to accept that systematic differences in the
level of demand shock variability are not
a characteristic feature o f international
monetary systems?
W e cannot, however, rule out that these findings
are statistical artifacts enforced by an inability
to separate demand from supply innovations
accurately in the VAR estimation. Bordo himself
has noted that in some cases the overidentifying
restriction (according to which positive supply
shocks should permanently raise output and
drive down the price level) is not satisfied.
Another indication of a possibly insufficient
identification is the estimated change in the
slopes o f aggregate supply and demand between
regimes. Figure 1 presents the average slopes of
aggregate supply and demand for the four
Group o f Seven countries. What effect do we
expect monetary regimes to have on these
slopes?
Consider the model printed in table 4 which
provides more structure than the model in table 2.
Because the model is linear in logs, the size of
the alpha and beta coefficients depends on the
agents’ price responsiveness, as well as on the
share in output of the respective input in the
production function or of the respective
expenditure.
Comparing the regimes of the gold standard
and Bretton Woods periods, we find that both
aggregate supply and demand schedules were
steeper under Bretton Woods. I would have
expected the opposite on the argument that the
economies were generally more open to interna
tional trade under Bretton Woods than before.
Comparing the Bretton Woods regime with
the float, we observe that the aggregate supply
schedule became steeper under the floating
exchange rate but the aggregate demand sched
ule became more flat. The first observation is in
line with the model in table 4 because the posi
tive dependence o f the nominal exchange rate
(its log is denoted by e) on the domestic price
level implies a steeper aggregate supply schedule.
For the same reason, the demand schedule should
also be steeper under floating. However, the data

197

Figure 1

G-4

Output

Figure 2

United States

Output

M ARCH/APRIL 1993

198

Table 4
Slopes and Exchange Rate Regimes
Model
( 1 ) y d = 0 o g - P i [ i - ( E p c + i - P c)l + f t > ( P * + e - p ) ;
(2) ys = e + o 1( p - E _ 1p ) - o 2(pR* + e - p )
(3) pc = yp + (1 - y ) ( p * + e )
(4) m = p + y - A i
(5) i = i* + E e + 1 - e
Slopes
Fixed rates: e = 0

yd : —— —

P +P
-\Y 2

y • — + a2
a1 I—
Flexible exchange rates

(fcr*fe) 0 - If) * 0 If
.
ys : ---------------------------------

"1+<,2 0 " I p )

do not comply. Also note that the United States
data imply that both schedules are more flat
under the float. See figure 2.
In sum, I agree with Bordo that his VAR esti
mates should be viewed with great caution.
Moreover, because we are after the differential
effect of monetary regimes, a serious drawback
is that we cannot differentiate between nominal
demand shocks, which we wish to study, and
real demand shocks, which are irrelevant because
they are not caused by the monetary regime.
Also, I must emphasize that we are studying
international regimes, which implies that we
cannot treat countries as independent entities.
Monetary regime shocks are transmitted inter
nationally. For example, a nominal demand
shock produced by the Fed will show up in Ger
many as a demand shock that raises German
output temporarily and German prices perma
nently. At the same time, however, the shock
will show up in Germany as a supply shock,
changing the relative price of imported raw
materials. This reduces German output perma

FEDERAL RESERVE BANK OF ST. LOUIS

nently and raises German prices permanently.
Consequently, the identifying restrictions of
Bordo’s VAR estimates will classify the nominal
demand shock from the United States as a sup
ply shock in Germany.
In conclusion, I believe we have to make
another, more sophisticated attempt at inves
tigating the conjecture that international mone
tary regimes systematically differ with respect to
the variability they impose on world economies.

THE CREDIBILITY PR O BLEM
I now take up the fundamental question of
which international monetary system, if any,
can solve the credibility problem in the sense of
firmly anchoring market expectations about the
viability of the system?
Bordo’s careful examination of the history of
monetary regimes leads him to conclude that an
international monetary system will be stable if
its rules are credible. The rules will be credible
if the member countries of the system are ready

199

to honor the rules. And member countries will
honor the rules if there is a center country that
enforces the rules. Accordingly, the classical
gold standard did not break down because the
United Kingdom, its center country, was com
mitted to convertibility. In contrast, the United
States, as the center country of Bretton Woods,
was not committed to convertibility and main
tenance of price stability. Bretton Woods
consequently broke down. Finally, Germany’s
commitment to price stability made the EMS a
successful and viable system. Unfortunately, the
latter prediction held only until last September.
Though Bordo’s reasoning makes a lot of
sense, it fails to address two essential questions.
First, by which means or under what conditions
will the center country be able to enforce the
rules? Second, and more fundamentally, what
conditions are required to make the center
country keep its commitment?
In my view, any international monetary sys
tem that is based on commitment to rules will
be fragile. Commitment should be replaced by
precommitment. The game theory reformulation
of the pathbreaking analysis by Kydland and
Prescott proves that governments cannot com
mit to price stability.5 In contrast to commit
ment, precommitment does not depend on a
government's good will or interest. Instead it is
created by setting up an external mechanism
that effectively ties the hands of current and
future governments.
An international monetary regime will be sta
ble and therefore durable if it provides the
institutional constraints for a subgame-perfect
supergame. The fundamental constraint is effec
tive precommitment by all member govern
ments. There are two types of precommitment:
precommitment to price stability at home and
precommitment to a fixed exchange rate vis-avis another currency. Consequently, we can
design two alternative regimes.
A first regime resembles the EMS but commit
ment is replaced by precommitment. The center
country precommits on price stability at home
by providing its central bank with the constitu
tional status of independence from government.
Elsewhere I have laid out a sufficient set of
institutional elements that provides an incentivecompatible status of independence.6 The other
countries precommit on a fixed exchange rate

vis-a-vis the center currency by writing the
fixed exchange rate into the country’s constitu
tion as Sweden did during the gold standard.
The alternative international regime is created
by an agreement that all governments precom
mit to price stability at home by providing their
central banks with constitutional independence.
Which of the two regimes is preferred? The
first regime provides price stability for all coun
tries in the medium to long run. The precom
mitment to fixed exchange rates by n-1 members
implies that idiosyncratic shocks will be dis
tributed over member countries at full force, as
was the case under the classical gold standard.
Because fiscal policy is an important source of
idiosyncratic shocks, the regime will hardly be
attractive without a (enforceable) rule prohibit
ing public deficits.
The alternative regime of uniform precommit
ment to price stability at home might be rejected
by some as a nonsystem. But semantics apart, the
setup is not to be equated with unconstrained
floating. The regime will provide nominal ex
change rate stability though not fixity. Depending
on the judgment of central bankers, the regime
might evolve into an adjustable peg system where
up to n-1 central banks unilaterally peg their
currencies to the currency of a center country
in a flexible manner. This means that in the ad
vent of a sizable country-specific shock at home or
in the center country, they will permit exchange
rate adjusting. In contrast to the non-precommitted
governments in Europe, the independent central
bankers will have no interest in defending mis
aligned exchange rate parities.
In conclusion, the Bretton Woods system and
the EMS broke down because both systems were
built on unenforceable commitment instead of
precommitment.

REFERENCES
Bayoum i, Tam in, and Barry Eichengreen. “ Shocking Aspects
of European M onetary U n ifica tio n ,” NBER W orking Paper
No. 3949 (January 1992).
Blanchard, O livier, and Danny Quah. “ The Dynam ic Effects of
Aggregate Dem and and A ggregate S upply D isturbances,”
A m e ric a n E c o n o m ic R e v ie w (Septem ber 1989), pp. 6 5 5-73.
Kydland, F.E., and E.C. Prescott. “ Rules Rather than Discretion:
The Inconsistency of O ptim al P lans,” J o u rn a l o f P o litic a l
E cono m y, (June 1977), pp. 4 7 3-91.
Neum ann, M .J.M . “ P recom m itm ent by C entral Bank Inde
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5See Kydland and Prescott (1977).
6See N eum ann (1991).

MARCH/APRIL 1993

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Full text of Review (Federal Reserve Bank of St. Louis) : March/April 1993: Dimensions of Monetary Policy : Essays in Honor of Anatol B. Balbach: Proceedings of the Seventeenth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis

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