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FEDERAL RESERVE BANK
O F S T. L O U IS
m ay 1974

Vol. 56, No. 5




How and Why Fiscal Actions Matter
to a Monetarist
An Address by DARRYL R. FRANCIS, President, Federal Reserve Bank of St. Louis
at The University of Southern Mississippi,
Hattiesburg, Mississippi, May 3, 1974

TA

HE TOPIC I have chosen to discuss with you this
afternoon concerns the relation between monetary pol­
icy developments over the past few decades and the
U. S. Government debt. The point emphasized will be
how the Federal Reserve’s response to deficits in the
Federal budgets is related to the growing inflationary
trend experienced in recent years.

THE MONETARY BASE AS A TOOL
OF POLICY
Before getting into what I want to say, it is neces­
sary to introduce an analytical concept we at the
Federal Reserve Bank of St. Louis find very useful. In
order to summarize in a single series the net influence
of all of the monetary actions of both the Treasury and
the Federal Reserve, we employ a concept referred
to as the “monetary base”. The monetary base repre­
sents the net monetary liabilities of the Government1
held by the public.2 The monetary base has been re­
ferred to as “high powered” money because it can be
used as reserves by commercial banks to expand de­
mand deposits by more than the amount of their
reserves.
The approach our staff uses to analyze the factors
influencing the growth of the nation’s money stock —
demand deposits plus currency in the hands of the
1U. S. Treasury and Federal Reserve System.
2Commercial banks and nonbank public.
Page 2



public —holds that the monetary base is the major
determinant of changes in the rate of growth of the
money stock. As the fourth and fifth tiers on the chart
illustrate, the growth rates of the monetary base and
the money stock over periods of several years are
very similar. The primary reason that money grew
somewhat slower on average than the base in the
early 1960’s is that this was a period of very rapid
growth of time deposits at commercial banks, espe­
cially large negotiable CDs. Growth in time deposits
absorbs reserves, or base money, leaving less available
to support the growth of the narrowly defined money
stock.
Since our analysis holds that growth in the base
determines the growth in money, we want to look at
the factors causing the growth of the monetary base.
During the past twenty years, growth of the mone­
tary base has been determined primarily by two
sources — the gold stock and Federal Reserve credit.
An increase in the dollar amount of either of these
sources, other things equal, increases the monetary
base by an equal amount.
In September 1949, when the gold stock source of
the base was at its peak, it comprised almost 58 per­
cent of the monetary base. From 1949 to 1968 the
amount of gold owned by the U. S. Treasury declined
almost continuously. This decline in gold stock con­
tributed a negative influence on the growth of the
base, while increases in Federal Reserve holdings of

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

1974

RATIO SCALE
BILLIONS OF DOLLARS'

—f — Federal Government Debt* — ——
~ 'F e d e ra l Government Debt is total gross public d eb t less d eb t held b y ----U.S. Government agencies and trust funds. The original data may be found —
i the table entitled "Ownership of Public Debt" in the Federal Reserve Bulletin.
------------------- -------------------------Seasonally Adjusted

— -------------------------*■—

'MZM.

RATIO SCALE
BILLIONS OF DOLLARS

Federal Government Debt
3d Held by Federal Reserve System
U p Seasonally Adjusted

-------

Percent of Federal Government D ebt!
Held by Federal Reserve System
---------------------— Seasonally Adjusted

---------------------

—M

RATK isCALE
BULK )NS OF DOLLARS

Monetary Base
Seasonally Adjusted

40
RATIC
RATIO SCALE
BILLIONS OF DOLLARS

Money Stock
ISO— Seasonally Adjusted -j-

RATIO SCALE

1958=100

|

%mm

110 General Price Index
Seasonally Adjusted

The first four shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.
The last shaded area represents Phases I and II of the price-wage control program.
Percentages a re an n u a l rates of change fo r periods in d icated .
Latest d a ta plotted: Money Stock, M onetary Base, and General Price Index-lst quarter 1974; Others-4th quarter 1973




Page 3

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

U. S. Government securities contributed a positive in­
fluence. Other sources, though their net influence has
been positive, have contributed relatively little to
movements in the base during the past twenty years.
From 1952 to the middle of 1961 the monetary base
grew slowly as increases in securities held by the Fed­
eral Reserve System largely offset decreases in the
gold stock. Beginning in the 1960s, increases in Fed­
eral Reserve holdings of Government securities ex­
ceeded reductions in the gold stock, and the monetary
base grew more rapidly. A two-tiered gold system,
established in March 1968, separated the gold market
into private and official sectors, each with its own
price, and changes in official gold holdings came to a
virtual standstill. From April 1968 through 1971, the
gold stock remained roughly constant and contrib­
uted little to changes in the monetary base.
At the end of 1971 and again in 1973, the U. S.
Government changed the official dollar price of gold
— an event commonly referred to as a devaluation.
These two devaluations, by themselves, added about
$2 billion to the monetary base, since the book value
of the gold held by the Government was raised.3
Holdings of Government securities by the Federal
Reserve represent the System’s acquisitions of Federal
Government debt through its open market opera­
tions. These security holdings presently comprise 76
percent of the monetary base, and since the early
1960s changes in security holdings have been the
dominant influence on the growth of the base. Through
purchases and sales of securities, called open market
operations, the Federal Reserve can control the
growth of the monetary base by offsetting or com­
plementing any movements in other sources.

MAY

1974

from the first quarter of 1952 to the third quarter of
1961. Unified budget deficits of $3.4 billion and $7.1
billion in fiscal years 1961 and 1962, respectively, ini­
tiated an increase in the trend rate in the early 1960s.
From the third quarter of 1961 to the fourth quarter
of 1966, net Government debt rose by $20 billion, an
average of about $3.8 billion per year, or at an annual
trend rate of 1.5 percent.4
Large unified budget deficits of $8.7 billion and
over $25 billion were incurred in fiscal years 1967 and
1968, respectively. These deficits further increased the
trend growth rate of Government debt. From the
fourth quarter of 1966 to the fourth quarter of 1970
net Government debt grew by over $28 billion, an
average of over $7 billion per year, or at a 2.6 percent
annual rate.
Federal Government debt held by the Federal Re­
serve System (shown in the second tier of the chart)
rose by only about $0.5 billion per year from 1952
to 1961, but then began to rise more rapidly in the
1960s. Changes in the monetary base during the 1960s
roughly paralleled that of the System’s holding of
debt. The percent of debt held by the Federal Reserve
System is shown on the third panel of the chart.
Between the first quarter of 1952 and the third
quarter of 1961, the proportion of Government debt
held by the Federal Reserve System remained roughly
Growth of Government Debt and Money
lillia a i of D alian

Billions of D o lla rs

5 5 1------------------

1

------------------ 1 55

| C H A N G E IN DEBT HELD BY THE FEDERAL RESERVE SYSTEM

g H i C H A N G E IN M ONETARY BASE
C H AN GE IN M O N E Y STOCK

Growth of Government securities held by the Fed­
eral Reserve System depends on both the growth of
Government debt outstanding, and the percent of
this debt the System decides to purchase. Let’s now
trace the growth of Government debt over the last
twenty years, the acquisition of debt by the Federal
Reserve System, and the reasons for debt acquisition
by the System.

THE INFLUENCE OF FISCAL ACTIONS
ON MONETARY POLICY
Government debt is shown in the top tier of the
chart. The trend growth of Government debt out­
standing oscillated around a one percent annual rate
3Albert E. Burger, “The Monetary Economics of Gold,” this
R eview (January 1974).
Page 4



_L_

'

I/53-IV/56

I/57-IV/60

I/ 6 M V / M

—
L_

I/65 -IV /6 *

I/6 9 -IY /7 2

Note: The d eb t held by the Federal Reserve System plus d eb t held b y the domestic public and
foreigners is net government debt, which is equal to total gross public d e b t minus debt
held by Government agencies and trusts. The m onetary base is net monetary liabilities of
the Government. The money stock |M]) is defined as dem and deposits plus currency held
by the public. Each o f the five groups of bars depict level changes from the beginning to
the end of the period indicated. All data are seasonally adjusted.

4Net Federal Government Debt is total gross public debt
minus debt held by U. S. Government agencies and trust
funds.

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

constant at around 11 percent. As net Government
debt increased, securities held by the Federal Re­
serve System increased proportionally, and as the debt
decreased, securities held decreased in the same way.
Variations in Government debt outstanding in the
1950s, especially late in the deoade, were associated
with accelerations and decelerations in growth of the
monetary base. Variations in the base, in turn, were
a major cause of fluctuations in the money stock.
As the trend rate of growth of Government debt in­
creased in the first half of the 1960s, the percent of
the debt held by the Federal Reserve also increased.
The rate of acquisition of debt by the Federal Reserve
was more rapid than the expansion of Government
debt itself. Increased purchases of Government securi­
ties by the Federal Reserve directly increased the
monetary base, increasing its trend rate of growth,
which in turn increased growth of the money stock
and economic activity. As resource utilization ap­
proached its upper limit, as defined by potential out­
put, the rate of inflation increased.
Before looking at the developments in the late
1960s and early 1970s, I want to digress a moment
and discuss with you what I would consider to be
the appropriate relation between a central bank’s hold­
ings of Government debt and the growth of Govern­
ment debt outstanding. If the net amount of public
debt were roughly constant or declining —that is,
Government budgets were in balance or surplus —
then the percent of the debt held by the Federal
Reserve Banks would gradually rise as the level of
System holdings gradually rose. This assumes that
there are no major changes in other factors such as the
gold stock or reserve requirements of member banks.
I believe that monetary policy actions can and
should be geared to providing a relatively steady,
non-inflationary trend growth in the money stock. If
this were the case, the rate at whioh Government debt
is acquired by the central bank would not be influ­
enced by the size of the budgetary deficits or sur­
pluses. Therefore, one would expect that when there
are large budget deficits and the outstanding Govern­
ment debt is rising at a rapid rate, the proportion of
the debt owned by the central bank would decline.
This has not been the case for most of the post-War
period.
In contrast to the relation between the Government
debt and the central bank holdings that I would like
to see, we have had a situation where the monetary
authorities have been principally concerned with the
general level of and trend of market interest rates,



MAY

1974

rather than the growth of the nation’s money stock.
The experience has been that larger deficits have
tended to be accompanied by more than proportional
debt acquisition by the Federal Reserve Banks. The
behavioral sequence is familiar to most market ob­
servers. During periods when deficits are large, up­
ward pressure on market interest rates —downward
pressure on security prices —occurs at the time the
Treasury financings take place. In the past the Fed­
eral Reserve often has “even-keeled” the money mar­
kets —that is, provided reserves through open market
operations to “lean against” the tendency for interest
rates to rise in the short run.
In theory, the Federal Reserve would “unwind”
after the even-keel operation by reducing its portfolio
of securities. In practice, the desire to resist upward
pressure on market interest rates, especially during
periods of a strengthening economy and rising de­
mands for credit, has militated against behaving ac­
cording to this ideal. Also, during past fiscal years of
very large budget deficits, the Treasury has been in­
volved in some sort of financing the majority of the
time, which has left the monetary authorities little
opportunity to “unwind.”
Now let us return to a discussion of the develop­
ments from 1969 to the present. In 1969 the net stock
of outstanding U. S. Government debt declined as the
Federal budget moved into surplus for a while. This
was the result of the so-oalled “fiscal package” of
mid-1968 —whioh consisted of a 10 percent surcharge
on personal and oorporate income taxes and a ceiling
on the growth of Federal expenditures. The amount
of debt held by the Federal Reserve leveled off in
1969, and we experienced a fairly sharp contraction
in the growth rates of the monetary base and the
money stock. These developments gave us a period
of significant monetary restraint, and the ensuing 1970
recession was the consequence.
Since early in 1970 the Federal budget deficits have
been sizable, as is shown by the rise in the outstanding
debt in the top tier of the chart. In the past three
years we have seen a rise in the debt of over $16 bil­
lion per year, or at over a 5 percent annual rate of
increase. This adds up to a rise of over $49 billion.
In the same period the debt held by the Federal
Reserve Banks has risen over $17 billion, an average
increase of $5.8 billion per year.
These developments have fostered a rise in the
monetary base of almost $23 billion, or an increase of
7.7 percent per year since 1970. Similarly, the na­
tion’s money stock rose at a 6.7 percent average rate
Page 5

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

during these three years. In this period we have
experienced the fastest rates of increase in the money
stock and the monetary base since World War II, and
I would submit that the correlation between big Gov­
ernment deficits and rapid increases in the money
stock in recent years, as was true during the second
World War, are high enough to impress even the
most casual of monetary observers.
Having presented my view of the relation between
Government deficits and monetary growth, let me turn
to what I see as being the consequences. I draw your
attention to the lower two tiers on the chart, the
money stock and the general price index. Through
much of the economic history of this country as well
as others for which data are available, the general
relation between monetary growth and the price index
has shown that the rate of inflation reflects the aver­
age rate of growth of the money stock over the prior
two or more years.
The lower two tiers on the chart depict this rela­
tionship. The average rate of money stock growth
of less than 2 percent from 1952 to 1962 was ac­
companied by an average rise in prices at less than
a 2 percent rate through 1965. After money growth
accelerated to a 3.4 percent average rate from 1961
through 1966, the average rate of increase in the gen­
eral price index accelerated to 3.7 percent from the
end of 1965 to early 1969.
Following the period of monetary restraint in the
last half of 1966, the average rate of money growth
accelerated further to a 6 percent rate for the next
four years. With the usual lag, the rate of inflation
began to accelerate, and on balance during the pe­
riod early-1969 to mid-1971, prior to the wage-price
freeze, we experienced a rise in prices at a rate of 5.4
percent. During the three years since the end of the
1970 recession, money growth has averaged 6.7 per­
cent per year. During Phases I and II of the pricewage control program, the average rise in prices was
only 3 peroent, but with the very sharp increases
since the end of Phase II early last year, in the past
five quarters the general price index has risen at an
8 percent average annual rate.
In view of this acceleration in inflation and the
popular notion of a “trade-off” between inflation and
unemployment, let’s look at what we have gained. In
the decade 1952 to 1962 average real output growth
was 3 percent per year, unemployment averaged 4.4
percent, and the general price index rose at less than
a 2 percent average annual rate. Then from 1962
through 1969, with the huge defense expenditure of

Page 6


MAY

1974

Vietnam, output growth averaged 4.6 percent per
year, unemployment again averaged 4.4 percent, and
the rate of inflation doubled from less than 2 percent
before 1966 to almost 4 percent over the next few
years.
In the last period under review, 1969 through 1973,
the average growth in output was only 3.6 percent,
about the same as from 1952 to 1962. Also, in the
recent period we experienced an average unemploy­
ment rate of 5 percent, slightly higher than the 19521962 period. However, the past few years have seen
accelerating inflation, without significant benefits in
terms of more output or less unemployment.

SUMMARY AND CONCLUDING
OBSERVATIONS
Let me now try to summarize my view of the rela­
tion that has existed between Government deficits,
monetary growth, and inflation over the past twenty
or more years. In the decade 1952 until the latter part
of 1961, the net Government debt rose by a total of
about $22 billion. Of that amount, the Federal Re­
serve System, through its open market operations,
purchased and therefore “monetized,” about $5 billion.
This acquisition of Government debt by the central
bank was the primary factor causing a rise in the
monetary base of about $7.5 billion — a growth rate
of only 1.5 percent per year. The relatively slow
growth of Government debt, debt owned by the Fed­
eral Reserve, and the monetary base produced a
growth of our money stock of only $23 billion over
a decade, or a rise of less than 2 percent per year.
That is why prices rose so slowly through the 1950s
and into the early 1960s.
Beginning in the early 1960s, first with the in­
creased emphasis of economic policies on stimulating
real growth and achieving lower unemployment rates,
followed by the massive Federal expenditures associ­
ated with Vietnam, net outstanding Government debt
rose by about $48 billion from late 1961 to late 1970.
In this period, the Federal Reserve System purchased
in the open market about $33 billion of Government
debt, producing a rise in the monetary base of over
$29 billion, and a rise in the money stock of over $73
billion in roughly 9 years. I assert that this was the
original economic policy development underlying our
current troubles. More recently, in only three years,
Government debt has risen another $49 billion, the
Federal Reserve has purchased over $17 billion, giv­
ing us a rise in the monetary base of over $20 billion
and a $48 billion increase in the money stock. Com­

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

bining the periods since 1961, in the past twelve years
the Federal Reserve has acquired over one-half of the
almost $100 billion increase in the net national debt,
contributing to almost a doubling of our money sup­
ply, or in actual dollar terms a $120 billion increase.
In my view, the successive upward ratcheting in
the average growth rate of the money stock has been
the primary cause of the acceleration in the average
rate of inflation. I do not accept the analyses which
point to the food price increases, the petroleum prod­
uct price increases, or other special factors as causes
of the underlying inflationary trend. Certainly these
factors influenced the timing and possibly the magni­
tude of the recent sharp increases in the price indexes;
but a rise in the price of any single commodity does
not cause inflation any more than a fall in the price of
a single commodity causes deflation. No one is arguing
that the recent declines in prices of a number of
agricultural commodities indicate we are experiencing
deflation.
Finally, let me turn to the outlook. My staff tells
me that by mid-year the average rate of increase in
the money stock will have been at 7 percent for
three and one-half years. Past experience would in­
dicate that if this rate of money growth were main­
tained, we would expect also to observe an average
inflation rate of about 7 percent to persist. Thus, our
analysis holds that an essential step towards bringing




MAY

1974

inflation down to more tolerable rates is to reduce the
average growth of money. Specifically, I would like to
see no more than a 5 percent rate of money growth
in the second half of this year, and then possibly re­
duce it somewhat further next year. This approach
would not bring an early end to inflation, but it would
be tangible progress without necessarily involving the
hardships associated with a recession.
However, although I believe the desirability of
achieving lower average money growth is clear, there
are reasons to be less than optimistic that it will occur.
The Federal budget for fiscal 1975, which begins in
just two months, implies a deficit of about $9 billion,
and many private analysts speculate that it could be
much larger than that. Current estimates are for very
sizable Treasury borrowing in the second half of this
oalendar year. Since we are already faced with a
quite high structure of market interest rates and pros­
pects for a strengthening economy, the temptation
may be great to repeat the ways of the past and add
substantial quantities of securities to the System port­
folio through open market operations. If that were
done, then the pattern I have outlined to you would
be repeated —increases in outstanding Government
debt matched by increased holdings of debt by the
central bank, which means continued rapid growth
of the monetary base and the money stock. That
would mean continued rapid inflation.

Page 7

Economic Slowdown:
Demand or Supply Induced?
GERALD P. DWYER, JR.

ORECASTS of a decline in real product in the
first quarter of 1974, accompanied by substantial in­
creases in prices and an increase in the unemployment
rate, were widely held. Preliminary data for the first
quarter are consistent with these expectations, al­
though the decline in output was greater than gener­
ally anticipated and large by historical standards.
Real product fell in the first quarter at an annual rate
of 5.8 percent, the implicit price deflator rose at an
annual rate of 10.8 percent, and the unemployment
rate rose 0.5 percentage points to 5.2 percent.
The decline in real product, in conjunction with the
slowing of real product growth in the last three quar­
ters of 1973, plays an especially important role in the
formation of expectations about economic prospects
for the rest of the year. Analysts are not agreed in
their interpretations of recent business developments.
Some analysts interpret the deceleration in growth of
real product and the recent decline as indicative of
potential weakness in aggregate demand. On the
other hand, some emphasize the effects of structural
problems —wage and price controls, the oil embargo,
and resource allocation programs —in their interpreta­
tion of recent economic developments. To the extent
that the recent performance of real product reflects
these structural problems, there is little that a program
of stimulating aggregate demand can do to increase
output and employment for the remainder of this
year.

BUSINESS DEVELOPMENTS
Given the severity of the current inflation, it is im­
portant to consider the extent to which recent de­
velopments reflect these structural problems. For if

Page 8


the slowing and decline in real product largely reflect
structural problems, then a policy of stimulating ag­
gregate demand would further aggravate the rate of
inflation.

Total Spending and its Components
Preliminary data indicate that the growth of total
spending slowed in the first quarter from the rapid
pace experienced over the previous three years. Total
spending increased at an annual rate of 4.3 percent
in the first quarter, considerably less than the 10.5 per­
cent rate from the fourth quarter of 1970 to the fourth
quarter of 1973.
Consumption — Personal consumption expenditures,
the largest single component of GNP, rose at an an-

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

Consumption Components of GNP

MAY

1974

Investment Components of Gross National Product

Shad ed a re a s re p re se nt p e rio d s of b usine ss recessions a s defin ed by the N a tio n a l B u re au of
Econom ic Research.
L atest d a ta plotted: 1st q u arter p relim in a ry

nual rate of 9.7 percent in the first quarter, about the
same rate as over the previous three years. A decline
in consumption expenditures on durable goods in the
first quarter was more than offset by accelerated
growth of consumption expenditures on nondurable
goods and services. Recent reductions in spending for
durable goods largely reflect a decline in purchases of
autos and home appliances. Expenditures on durable
goods fell at an annual rate of 3.5 percent in the first
quarter, following a decline at a rate of 20 percent in
the fourth quarter of last year. In comparison, ex­
penditures on durables grew at an annual rate of 16.1
percent from the beginning of the most recent expan­
sion in the fourth quarter of 1970 to the third quarter
of 1973. Consumer spending on nondurable goods and
services increased at an annual rate of 12.2 percent,
compared to a 9 percent rate of increase from the
fourth quarter of 1970 to the fourth quarter of 1973.
Investment —With substantial declines in residen­
tial construction and inventory accumulation, gross
private domestic investment decreased at a 20.8 per­
cent rate in the first quarter. In comparison, gross
investment grew at an annual rate of 15.9 percent
from the fourth quarter of 1970 to the fourth quarter
of 1973.
A decline in auto inventories accounted for much of
the slower inventory accumulation in the first quarter.
This followed a high rate of inventory accumulation
in the fourth quarter. Inventory investment was $7.8
billion at an annual rate in the first quarter, less than
half the $18 billion rate in the previous quarter. Deal


S h a d e d a r e a s re p re s e n t p e rio d s of business re cessio n s a s d e fin ed by N a tio n a l Bureau
of Econom ic R e sea rch .
Latest d a ta plotted: 1st q u arter p re lim in a ry

ers’ inventories of autos fell at a $4.9 billion annual
rate in the first quarter, after climbing at a $4.3 bil­
lion rate in the fourth quarter and rising at an aver­
age rate of $1.6 billion in the first three quarters of
1973.
The decline in spending on residential structures
reflected a variety of factors including higher relative
costs of buying new homes, scarcity of some building
materials, and higher mortgage interest rates. Invest­
ment in residential structures has decreased at an an­
nual rate of 21.9 percent since the second quarter of
1973. This decline follows an annual growth rate of
26.4 percent from the second quarter of 1970 to the
second quarter of 1973.
Government Spending —Total government pur­
chases of goods and services increased at an acceler­
ated 15.2 percent annual rate in the first quarter. In
comparison, government purchases increased at an
annual rate of 8.5 percent from the fourth quarter of
1970 to the fourth quarter of 1973. In recent years,
Federal Government purchases have grown at a
slower rate than state and local government pur­
chases, but in the first quarter, purchases by the Fed­
eral Government accelerated more rapidly than pur­
chases by state and local governments.
Page 9

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

1974

parison, real product grew at a 3.7 percent annual
rate over the period 1955-69.
Industrial production fell from November 1973 to
March of this year at an annual rate of 8.2 percent.
This decline followed growth of industrial production
at a 4.5 percent rate from February to November of
last year and a rapid 12.4 percent rate from January
1972 to February 1973.
Net Exports —In the first quarter, net exports, the
difference between the dollar value of goods and
services exported and those imported, decreased to
an annual rate of $9.5 billion, compared to $12.8 billion
in the fourth quarter of 1973. The value of exports
exceeded imports by $5.8 billion in 1973, following a
deficit of $4.6 billion in 1972. In addition to the de­
valuations of the dollar in 1971 and 1973 and the
floating of exchange rates in 1973, a variety of special
factors intervened to increase the growth of exports
relative to imports in 1973 and early 1974. In particu­
lar, poor harvests in other parts of the world and price
controls contributed to the movement of net exports
into surplus in 1973.

Production and Employment
Production —The decline of real product at a 5.8
percent annual rate in the first quarter followed three
quarters of growth at a 2.5 percent growth rate. The
decrease of real product in the first quarter, $12.6 bil­
lion at an annual rate, is only slightly larger than the
decrease of real auto product, $12 billion at an annual
rate. The growth of real product over the last four
quarters represents a deceleration from the rapid, un­
sustainable 6.5 percent annual rate of increase from
the beginning of the most recent expansion, the fourth
quarter of 1970, to the first quarter of 1973. In com­

Page 10


The decline of industrial production was heavily
concentrated in industries that were affected by
the petroleum embargo and the associated allocation
program in fourth quarter 1973 and first quarter 1974.
Production by the petroleum industry itself, a rela­
tively small component of total industrial production,
declined at an annual rate of 21.6 percent from No­
vember to March. Production fell more in the trans­
portation equipment industry, which includes motor
vehicles and parts, than in any other industry; produc­
tion in this industry fell at an annual rate of 38.4 per­
cent from November to March. Electricity and natural
gas utilities experienced a decline in production at an
annual rate of 12.6 percent. This is not a surprising
consequence of the embargo since a petroleum pro­
duct, residual oil, is used to generate a significant
proportion of electricity. The machinery industry and
the primary and fabricated metals groups also had
decreases in production at annual rates of 10 percent
or more. These declines can be interpreted as the
result of decreased demand by the motor vehicles and
parts industry, as well as of decreased availability of
energy input.
Employment —The decline in real product has been
accompanied by a slowing in the growth of employ­
ment. Following a rapid 3.8 percent increase from the
fourth quarter of 1972 to the fourth quarter of 1973,

MAY

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

total civilian employment remained virtually un­
changed in the first quarter.
The unemployment rate rose from 4.7 percent in
the second half of last year to 5.2 percent in the first
quarter and fell to 5 percent in April of this year. Re­
strictions on the supply of petroleum, in conjunction
with price controls on petroleum and the Govern­
ment’s mandatory allocation program, accounted for
much of the increase in the unemployment rate from
the fourth quarter of last year to the first quarter of
this year.1

Inflation
The rate of price increase accelerated sharply in
the first quarter. The implicit GNP deflator rose at a
10.8 percent annual rate, following a 7.3 percent in­
crease during 1973. The average annual rate of in­
crease in 1971 and 1972 was 3.5 percent.
Consumer prices rose at a 12.2 percent annual rate
in the first quarter, substantially greater than the 8.4
Table I

1974

percent increase from the fourth quarter of 1972 to
the fourth quarter of 1973. Fuel oil and coal prices
soared at a rate of 155 percent in the first quarter,
gasoline and motor oil prices climbed at an 89 per­
cent rate, and food prices rose at a rate of 18 percent
(Table I).
An increased supply of many food products, which
is likely during the course of this year, will tend to
decrease food prices relative to the prices of other
goods and services.2 This relative decline in food
prices may not, however, be reflected in actual de­
clines of food prices; food prices may only grow
slower than prices of other goods and services. In any
case, recent movements of the wholesale price index
for farm products and processed foods and feeds
suggest that food prices will not continue to rise at
recent rates. This index has varied erratically in recent
months, but recently it has generally been falling or
increasing more slowly than previously. From October
1972 to June 1973, prices of farm products and proc­
essed foods and feeds rose at an annual rate of 47.4
percent, and from June 1973 to April 1974, they rose
at the much slower annual rate of 5.9 percent.

The Consumer Price Index and Components:
1 9 7 1 -1 9 7 4
Annual Rates o f C hange1

W eights2
3nsumer Price Index
(A ll Items)

100%

IV /7 3
to
1/74

1/7 3
to
1/7 4

1/71
to
1/73

1 2 .2%

9 .9 %

3 .8 %

3 .0 %

2 .1 %

Comm odity and Service Groups
Durable Commodities

18 .78%

N ondurable
Commodities
Services

47 .19
34.03

3 .3 %
19.1
8.4

14.5
7.1

4.5
3.8

Expenditure Classes
Food
Housing
Fuel and U tilities

2 2 .4 3 %

18 .1%

1 9 .3%

6 .4 %

33.23

12.3
35.3

8.8
15.5

3.7
4 .7

155.3
24.5

59.2

3.4
5.2

5.2 6

Fuel O il and Coal

0.73

Gas and Electricity
A pparel and Upkeep

2.71
10.63

6.3

10.1
5.4

Transportation

13.88

14.4

7.1

1.5

3.78

89.4

31.8

2.4

19.45

5.9

4.9

3.3

G asoline and
M o tor O il
Health and Recreation

2.4

■All rates of change are based on quarterly averages of the monthly
data.
2These weights are proportions of the index contributed by the
components. The weights are based on a survey o f expenditure
patterns of urban wage-earners and clerical workers taken in
1960-61 and evaluated a t 1963 prices. In other words, the weights
reflect the composition and type of consumer spending as of
1960-61.

iU.S. Department of Labor, Bureau of Labor Statistics, “The
Employment Situation; February 1974,” pp. 4-5.



FINANCIAL DEVELOPMENTS
Money Growth and Inflation
While some of the price increases in recent quarters
are undoubtedly due to reductions in the supply of
food and petroleum, the rate of price inflation is domi­
nated by the growth of the money stock in the long
run.3 From 1952 to 1962, the money stock grew at an
annual rate of 1.8 percent; the general level of prices
also rose at an annual rate of 2 percent from 1955 to
1965. The growth of money accelerated to a 3.9 per­
cent annual rate from 1962 to 1967; the rate of in­
crease of prices accelerated to a 4.1 percent annual
rate from 1965 to 1970. Furthermore, it is evident
from the accompanying chart that the rate of inflation
has increased as growth of the money stock has
increased.
More recently, the growth of money slowed in the
second half of 1973, but it is too early to tell if this
represents a change in the trend growth of money. In
the first quarter of this year, the money stock rose at
2An analysis of recent food price increases and the outlook is
presented by Clifton B. Luttrell and Neil A. Stevens, “The
1974 Outlook for Food and Agriculture,” this Review (March
1974), pp. 11-19.
3For a more extended discussion, see Darryl R. Francis, “How
and Why Fiscal Actions Matter to a Monetarist,” this issue
of the Review, pp. 2-7.
Page 11

MAY

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

1974

Influence of Money on Prices
R atio S e al*

R atio S e a l*
B i l l i o n of D c llir s

1951=100

Seosonolly Adjusted

3 0 0 1---------------------290 ---------------------2 8 0 ---------------------270 ---------------------2 60 ---------------------250 ---------------------240 ---------------------230 ----------------------

220 -------------210 ------ ------200 -------------1 9 0 ---------------------M o m y Stock ll
^ SCALE- !----------------

1 8 0 ---------------------1 7 0 ---------------------160 ---------- -----------

inaex
SCALE | .

__

1950

1951

1952

1953

1954

1955

1956

1957

1958

1459

1960

19*1

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

Sources: Board of Governors of the Federal Reserve System and U.S. Department of Commerce
c-"?cs r-»p'esp"* c c o r i s " f teuiiress recpssinns os d e ^ n *d b y N ational Bureau o f Economic Re:
Li Q u arterly totals of monthly figures.
12 As used in N atio n al Income Accounts.
Latest data plotted: 1st quarter prelim inary

an annual rate of 5.6 percent, compared to a 4.8 per­
cent rate in the second half of 1973 and a 7 percent
average rate from the first quarter of 1970 through
the second quarter of 1973.4
The monetary base, the primary determinant of the
trend growth of money, rose at an 8.7 percent annual
rate in the first quarter of 1974. This is faster than the
7.5 percent annual rate of increase from the first quar­
ter of 1970 to the fourth quarter of 1973.5 Since the
growth rates of the monetary base and the money
stock tend to be similar over extended periods of time,
money stock growth can be expected to accelerate in
the future unless growth of the base slows.
4Money growth rates are based on quarterly averages of the
revised money series. These rates of growth and those using
quarterly rates based on the last month in each quarter are
compared in Anatol Balbach and Jerry L. Jordan, “FOMC
Policy Actions in 1973,” this Review (April 1974).
5The money stock ( M i ) can be expressed as a function of
the monetary base ( B ) and a money multiplier ( m), such
that Mi = mB. The money multiplier summarizes the deci­
sions of the Government, banks, and the public to hold cur­
rency and bank deposits. For a presentation of this analysis,
see Jerry L. Jordan, “Elements of Money Stock Determina­
tion, ’ this Review (October 1969), and Albert E. Burger,
T he Money Supply Process (Belmont, California: Wadsworth
Publishing Co., 1971).
Page 12



Recent Increases in Interest Rates
Substantial increases in the demand for credit
caused short-term interest rates to climb in March,
April, and early May. The prime rate on bank loans
was 11 percent in early May —250 basis points above
its level in early March and 150 basis points above its
level at the beginning of the year. The secondary mar­
ket rate for 90-day certificates of deposit rose to 11
percent in early May, from a low of 8 percent in late
February; this rate was about 9.25 percent at the be­
ginning of the year. The discount rate, which had
been 7.5 percent since August of last year, was raised
to 8 percent at the end of April in response to rising
money market yields.
Long-term rates rose moderately during the first
four months of this year. The long-term Aaa corporate
rate was about 8.35 percent in early May, about 60
basis points above its level at the beginning of the
year.

ALTERNATIVE VIEWS
There are essentially two interpretations of the de­
cline in real product in the first quarter. One view

MAY

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

focuses on the slowing in real product growth which
began in early 1973, and attributes the slowing to a
weakening of aggregate demand. This weakening in
total demand, in turn, is related to a slowing in Fed­
eral expenditure growth, a decline in real money bal­
ances, and increases in interest rates. The other view
is that shifts in demand, with associated adjustments,
and constraints in the growth of aggregate supply
were the major causes of the slowing in real product
growth. This second view can be termed “constrained
aggregate supply.”

1974

Fiscal M e a s u re s
(+ )S « rp U s ; ( - ) D tf i( it

Weak Aggregate Demand
Those analysts emphasizing the weakness of aggre­
gate demand point to the slowing of economic activity
which preceded the Middle-East oil embargo. Real
product grew at an annual rate of 2.9 percent from
the first to the third quarter of last year, significantly
less than its annual trend growth rate of 4.2 percent
from 1958 to 1972. Real expenditures on consumer
durable goods —expenditures on consumer durable
goods adjusted for price increases —fell at a 2.7 per­
cent annual rate from the first to the third quarter,
compared to growth at a 14 percent annual rate over
the previous four quarters. In addition, retail sales
grew at a 3.6 percent annual rate from March to
November in 1973, compared to growth at an annual
rate of 13.4 percent from November 1970 to March
1973. Adjusted for price increases, retail sales actually
fell during this period.
Proponents of this view also point to one or more
measures of stabilization policy that indicate it was
less stimulative in recent quarters than in the prior
three years. The Federal budget, on a national income
accounts basis, was approximately in balance during
calendar year 1973, after an average deficit of $16.7
billion from 1970 through 1972. Some analysts have
referred to the recent behavior of so-called real money
balances —the money stock divided by a price index
—as a measure of the influence of monetary actions.6
The real money stock grew at a 0.7 percent annual
rate in the first half and fell at a 2.9 percent rate in
the second half of 1973, compared to a 3 percent an­
nual growth rate from 1970 through 1972. Also, inter­
est rate increases in 1973 are interpreted by some
analysts as an indication of monetary restraint.

6For a discussion of the problems associated with this indica­
tor and the incorrect policy conclusions that can follow from
its use, see Denis Karnosky, “Real Money Balances: A Mis­
leading Indicator of Monetary Actions,” this Review (Febru­
ary 1974), pp. 2-10.



1966

1967

1968

1969

1970

1971

1972

1973

1974

Sources: U.S. Department of Commerce,
and Federal Reserve Bonk of St. Louis
Latest data plotted: HEB-lst quarter preliminary; NIAB-lst quarter estimated

Constrained Aggregate Supply
Analysts who emphasize constraints on aggregate
supply and adjustments to changes in demand point
out that a dip in the growth of GNP is an expected
consequence of uncertainty caused by the energy sit­
uation and the reduced supplies of some goods.
These analysts also point out that the decline of real
consumer purchases of durable goods or retail sales is
not necessarily an indication of a decline in de­
mand. Consumer purchases of durable goods reflect
the forces of both supply and demand. And a combi­
nation of higher prices and reduced quantities sug­
gests the overwhelming influence of short-run supply
considerations.
Furthermore, even though some components of total
spending declined during the past year, this is not
evidence of a general decrease in demand. On the
contrary, a measure of total demand —total spending
on goods and services —increased at an annual rate of
10.3 percent from the first to the fourth quarter of
1973, virtually the same rate as since the beginning of
the recent expansion. This is during the same period
when real product grew at a slower rate.
Price controls contributed to the decline in the
growth of output, according to the constrained supply
view. By artificially suppressing the prices of some
products which are inputs into production processes,
shortages of many inputs resulted. This supply reduc­
tion would be expected to limit the production of final
goods and services.
Page 13

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

Substantial shifts in demand occurred in the past
year, and such shifts can contribute to a lower rate of
output for a time. Most notable were the shifts in de­
mand, caused by higher petroleum prices and the oil
embargo, away from goods and services using rela­
tively more gasoline and other petroleum products.
Decreases in the output of these goods account for
much of the decline in total real product. In addition,
resources are not transferred instantaneously from
previous uses to new ones.7 Thus, following a shift in
demand, a decline in output and employment usually
occurs for a short period of time.
A decrease in the supply of resources, in this case,
petroleum, can have a similar effect on the quantity of
final goods and services produced. Some industries,
such as electric utilities, were affected directly by re­
duced allocations of petroleum. Furthermore, increases
in the price of petroleum as an input in the produc­
tion process have the effect of reducing output supply
at its current price.

CONCLUSION
In the first quarter, real product declined, unem­
ployment rose somewhat, and the rate of inflation
7For a discussion of the reasons that resources are not shifted
immediately, see Roger W. Spencer, “High-Employment
Without Inflation: On the Attainment of Admirable Goals,”
this R eview (September 1971), pp. 12-26. While that article
specifically applies to workers, the discussion can also be ap­
plied to other resources. For more technical analysis, see
Edmund S. Phelps, et al., M icroeconom ic Foundations o f
Inflation and Em ploym ent Theory (New York: W. W. Norton
& Co., Inc., 1970), esp. Armen A. Alchian, “Information
Costs, Pricing and Resource Unemployment,” pp. 27-52, and
Donald F. Gordon and Allan Hynes, “On the Theory of Price
Dynamics,” pp. 369-93.

Digitized for Page
FRASER
14


MAY

1974

increased to greater than a 10 percent annual rate.
The rather dismal performance of real product in the
first quarter has been interpreted from at least two
different vantage points —one emphasizing that ag­
gregate demand is weak, the other emphasizing that
supply constraints were the major factor. Many weak
demand proponents base their position on such preembargo developments as the slowing in real expendi­
tures on consumer durables and the slower growth of
retail sales. According to this view, these develop­
ments are, in part, a response to the slowing in Fed­
eral expenditure growth, a decline in real money
balances, and increases in interest rates.
The other interpretation of the decline in real pro­
duct in the first quarter concentrates on the factors
operating to reduce the supply of goods and services
available for purchase. The maintenance of and sub­
sequent dismantling of price and wage controls, the
shortages of some petroleum products and the associ­
ated allocation program, and the inability to move
resources immediately in response to a shift in de­
mand — all of these factors are cited as influencing
the production of goods and services.
The data for the past year offer no clear-cut evi­
dence that there has been a substantial weakening in
aggregate demand. Marked shifts in demand have
strained the ability of business to alter its product
mix, especially in view of the distortion of market in­
formation and opportunities resulting from Govern­
ment controls. Now that the embargo is ended and
price controls have been removed from all sectors of
the economy except the petroleum industry, these
constraints on production are easing.

Recent and Prospective Developments in
International Trade and Finance
HANS H. HELBLING

REVIEW of U.S. economic developments in 1973
generally tends to focus on some of the “negative”
domestic events, such as accelerating inflation, slow­
downs in production and employment growth, and
shortages of many necessary inputs to the production
process. However, so often overlooked is this country’s
performance in the international arena. For the first
time in the past three years, our international accounts
registered surpluses or greatly reduced deficits.
This reversal resulted partly from policy actions
initiated by the United States and other industrial
countries in August and December 1971. These ac­
tions were intended to facilitate adjustments in the
then existing balanoe-of-payments disequilibrium. The
expected adjustment began to take hold in mid-1972,
but the speed and magnitude of the adjustment in
1973 was affected by “special” factors prevailing that
year, such as a world-wide economic boom and poor
harvests in many parts of the world.
Although world-wide agricultural developments are
expected to improve and .many economies are be­
ginning to show signs of slowing, 1974 is likely to be
affected by another set of “special” circumstances —
though not in the same direction. In particular, a great
deal of uncertainty exists resulting from the combined
influence of 1) continued U.S. dependence on im­
ported oil, 2) uncertainty about crude oil prices in
world markets, and 3) varying rates of growth in eco­
nomic activity throughout the world.

DEVELOPMENTS IN U.S. TRADE AND
FINANCE PRIOR TO 1973
Economic relationships between the United States
and the rest of the world have undergone an evolu­
tion during the post-World War II era. Reflecting this,
the U.S. external accounts swung from trade surpluses
in the period from the late 1940s to the mid-1960s, to



Comparative Rates of Inflation

Note: The w orld inflation rate is m easured by changes in W ho lesale Price Indexes fo r
eleven m ajo r foreign countries w eighted by their trad e shares with the United States.
The United States in flatio n ra te is measured by changes in th e W h o le s a le Price Index.

trade deficits in 1971 and 1972, and finally, in 1973,
back to a surplus again. At the same time, the U.S.
dollar changed from the world’s strongest currency to
one which was subjected to massive speculation in
foreign exchange markets.
As inflationary pressures developed in the United
States in 1965 (see chart entitled “Comparative Rates
of Inflation”), the trade surplus began to diminish.
Under the prevailing regime of fixed exchange rates,
prices in the U.S. increased relative to foreign price
levels, and the demand for imports accelerated. The
relative price decrease of foreign goods in the United
States and relative price increases of U.S. goods in
foreign markets were conducive to a sharp increase in
imports as a share of U.S. gross national product and
to the continued decline in the U.S. share of world
Page 15

MAY

F E D E R A L . R E S E R V E B A N K O F S T . L O U IS

Selected Measures
of International Trade Performance

exports (see chart entitled “Selected Measures of In­
ternational Trade Performance”). As private and gov­
ernment capital continued to flow out and as the trade
surplus narrowed, the basic balance deficit increased.1

1974

Nom inal and Effective Dollar D evaluation
P « r c « it

Ph c m I

N o te : N o m in a l d e v a lu a tio n is m e a s u re d b y th e c h a n g e in th e d o l l a r p r ic e o f g o ld .
E ffe c tiv e d e v a lu a tio n is m e a s u re d b y th e a p p r e c ia tio n o f e le v e n m a jo r c u rre n cie s
r e la t iv e to th e p a r v a lu e s w h ic h p r e v a ile d a s o f M a y 1970. The a p p r e c ia tio n is
th e n w e ig h te d b y s e p a r a te e x p o r t a n d im p o r t s h a re s w ith th e U n ite d States

In 1971 it became obvious that the disequilibrium
in the U.S. basic balance was unsustainable. As a re­
sult, confidence in the maintenance of the interna­
tional price of the dollar eroded to such an extent that
the foreign demand for dollars as an international cur­
rency declined significantly. Increasing deficits in both
the liquidity and the official settlements balances pre­
cipitated an international monetary crisis in the spring
of 1971.2 In August 1971 the United States responded
to this crisis by suspending the convertibility of offi­
cially held foreign dollars into gold, imposing a 10
percent surcharge on merchandise shipped to this
country, and letting it be known to their trading part1In addition to goods, services, and unilateral transfers, the
basic balance includes long-term capital movements. Ideally,
this balance should be in equilibrium over time such that
outflows of long-term capital are offset by inflows resulting
from a trade surplus (or vice-versa). If a temporary imbal­
ance exists, the deficit (surplus) could be financed by tem­
porary short-term capital inflows (outflows). Since 1949 the
U.S. basic balance, however, has been persistently in deficit,
which has given rise to the accumulation of foreign owned
dollar balances. As the basic balance deficit increased in re­
cent years, the accumulation of actual dollar balances by
foreigners apparently exceeded desired dollar balances.
2The liquidity balance, in addition to the basic balance, in­
cludes non-liquid short-term private C E u p ita l and errors and
omissions. This balance is a measure of potential short-term
claims of foreigners, both private and official, against the
U.S. dollar. The official settlements balance adds changes in
liquid private capital to the liquidity balance. Thus, if private
foreigners sell short-term dollar claims to their central bank,
the official settlements deficit would exceed the liquidity
deficit by the amount of the sale.

Page 16


b a s e d o n 1 9 72 t r a d e d a ta .
L a te s t d a t a p lo tte d : A p r il

ners that changes in the international competitive
position of the United States were necessary. Spe­
cifically, there was an expressed desire for equilibrium
in the basic balance. International negotiations and
departures from a fixed exchange rate resulted in the
depreciation of the dollar relative to other currencies
(see chart entitled “Nominal and Effective Dollar
Devaluation”).3
It seems that international trade and financial trans­
actions between the United States and the rest of the
world have responded to these actions. Beginning in
mid-1972, U.S. imports from foreign countries in3At the December 1971 Smithsonian Conference, new ex­
change rates were negotiated and the United States lifted
the surcharge on imports. The permissible range of exchange
rate flexibility was also widened from 1.0 percent to 2.25
percent on each side of the par value. The U.S. received
commitments from its major trading partners concerning a
reduction of trade restrictions. However, this did not result
in a calm and stable international environment, and specula­
tion against the dollar continued. The following major events
transpired since December 1971: In May of 1972 the original
Common Market countries, the United Kingdom, and Den­
mark jointly agreed to a narrow range of exchange rate
flexibility of 1Vs percent among themselves while maintaining
the 2.25 percent intervention band on either side of the par
value vis-a-vis all other currencies. In June, due to turmoil
in exchange markets, the United Kingdom and Denmark
withdrew from this arrangement and permitted their curren­
cies to float.

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

1974

creased at a lower rate, while U.S. exports to foreign
countries increased at a higher rate than in 1971. In
early 1973 the level of U.S. exports exceeded the level
of U.S. imports, and a trade balance surplus of $0.7
billion was realized for the entire year.

ECONOMIC SETTING IN 1973
The new set of negotiated exchange rates which
had been in effect throughout 1972 apparently did
not restore complete confidence in the international
financial system. During early 1973 international
capital movements increased to such an extent that
foreign central banks were either unwilling or unable
to support the new exchange rates. First, Italy and
Switzerland stopped supporting official exchange
rates. This had the effect of accelerating the capital
inflows into Japan and Germany.4
Finally, on February 9, foreign exchange markets
were closed. Following consultations and negotiations
among several countries, the United States announced
on February 12 its decision to devalue the dollar with
respect to gold by an additional 10 percent. The
Japanese Government also decided to let the ex­
change rate for the yen be determined primarily by
market forces. When Japanese exchange markets re­
opened on February 14, the yen-dollar exchange rate
rose about 18 percent above the previously fixed rate.
These actions, however, still failed to convince for­
eign holders of dollars that equilibrium exchange rates
had been established, and massive conversion of dol­
lars into foreign currencies continued. On March 2
the official foreign exchange markets were closed
again and were not reopened until March 19, 1973.
During this period several European countries (Bel­
gium, Denmark, France, Germany, Netherlands,
Norway, and Sweden) decided to abandon the fixed
exchange rates between their respective currencies
and the dollar in favor of floating rates; however, due
to the strong trade ties between these countries, they
decided to maintain fixed exchange rates relative to
each other.
In this environment of flexible exchange rates, the
international price of the dollar continued to decline
until early July. At this time various central banks, in­
cluding the Federal Reserve System, indicated their
willingness to intervene in foreign exchange markets.
4U.S. liabilities to foreign central banks increased by about
$9.0 billion between December 1973 and March 1974. Be­
tween February 1 and February 9, the German Central Bank
alone bought $6 billion.



Although the actual intervention was minimal in
amount, the international price of the dollar stabilized.
During August the dollar exohange rate began to
increase, probably prompted by the trade surplus
which had developed during the previous month.
Late in October the rate increased sharply, apparently
reflecting continued and increasing U.S. trade sur­
pluses as well as anticipations that the Middle-East
oil embargo would affect economic conditions more
adversely abroad than in the United States. In spite of
these increases in the dollar exchange rate during the
latter part of 1973, the average international price of
the dollar for 1973 was still below that of 1972. As a
result, the competitiveness of U.S. goods in world
markets continued to improve.
In addition to the dollar s lower international price,
there were other influences which contributed to the
improved competitive position. During 1973 most
major industrial countries were in the upswing phase
of a business cycle which began in 1971; however, the
U.S. cyclical expansion began a year earlier and the
peak was reached in the first quarter of 1973 (see
chart entitled “Comparative Rates of Change in Real
Output”). Also, the rate of inflation was greater in
most European countries and Japan. Both of these
factors operated to increase foreign demand for U.S.
exports relative to U.S. demand for imports.
Page 17

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

1974

the current account balance in 1973 registered sur­
pluses amounting to $6.9 billion and $3 billion,
respectively.

Comparative Rates of Change
in Real Output

U.S. Balance of Payments and Components
(+)Sirplas; (-)Dificlt

196*

1969

1970

1971

1972

1973

S o u rc e s : U .S . D e p a r t m e n t o f C o m m e rc e , D e u tsch e B u n d e s b a n k , C o u n c il o n
I n t e r n a tio n a l E c o n o m ic P o lic y , a n d B a n k o f J a p a n
N o te : T h e v e r t ic a l l in e c e n te r e d in 1971 se rv e s a s a r e fe r e n c e to th e
tr o u g h s o f G e r m a n y Ita ly , a n d J a p a n .

Poor harvests in many parts of the world contrib­
uted to a large increase in the demand for U.S. agri­
cultural goods. At the same time, price controls on
some farm products tended to restrict agricultural
output in the United States. The combination of these
two influences contributed to sharply rising prices for
agricultural exports. On the import side, however, the
quantity of domestically-produced crude oil continued
to decline and U.S. oil imports increased in order to
make up the difference between domestic produc­
tion and desired domestic consumption.

THE 1973 INTERNATIONAL ACCOUNTS
As a result of these events, the U.S. trade balance,
generally considered an indicator of the U.S. compe­
titive position in international markets, was in surplus
by $0.7 billion in 1973. This followed two years of
deficits amounting to $2.7 billion in 1971 and $6.9
billion in 1972. On balance, U.S. exports in 1973 in­
creased by 44 percent over 1972. After adjusting for
higher prices, exports rose by 23 percent. Imports, on
the other hand, increased by only 5 percent in real
terms over 1972.® The goods and services balance and
5These percentages are derived from value and quantity in­
dexes representing export and import totals for 1972 and
1973.

Page 18


p r iv a te c a p ita l, n e t n o n liq u id s h o rt-te rm p r iv a te c a p ita l, a llo c a tio n s o f
s p e c ia l d r a w in g r ig h ts , a n d n e t e rro rs a n d o m issio n s. The o f fic ia l
se ttle m e n ts b a la n c e is the sum o f th e a b o v e a c c o u n ts p lu s n e t flo w s o f liq u id
p r iv a t e c a p ita l.
L atest d a t a p lo tte d : 4th q u a r t e r p re lim in a ry

The U.S. basic balance (current account plus long­
term capital), which is considered an indicator of
underlying, or long-term, trends in the U.S. interna­
tional economic position, was also in surplus by $1.2
billion. This balance has been persistently in deficit
since 1949, reaching $9.8 billion in 1972.
The deficits in both the net liquidity and the official
settlements balances ($7.8 and $5.3 billion, respec­
tively), were significantly smaller than in 1971 and
1972 (see the accompanying chart entitied “U.S. Bal­
ance of Payments and Components” and Table I).
Had it not been for large speculative dollar outflows
over the course of a few days in early 1973, even these
balances might have been in, or near, surplus.

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

Long-Term Capital

Table I

U. S. BALANCE OF PAYMENTS, 1973

4.2

Net outflows of long-term
capital (portfolio and direct in­
vestment) in 1973 amounted to
$1.8 billion. In 1971 and 1972
these outflows amounted to $6.7
billion and $1.5 billion, respec­
tively. The small net change
over 1972 occurred mainly in
private long-term capital trans­
actions. Direct investment ex­
penditures by U.S. corporations
abroad resulted in an outflow of
$4.9 billion in 1973, compared
to $3.4 billion in 1972. An out­
flow of $2 billion, which oc­
curred during the first quarter,
may have been in anticipation of
the February dollar devaluation.
Direct investment expenditures
in the United States on the part
of foreign corporations (long­
term capital inflows) increased
sharply to $2.1 billion, compared
to $0.2 billion in 1972. While
U.S. purchases of foreign securi­
ties increased to $0.8 billion in
1973, compared to $0.6 billion in
1972, foreign purchases of U.S.
securities declined to $3.2 bil­
lion, compared to $3.7 billion in
1972.

4.8

Foreign Direct Investment
in the United States

(In B illions o f Dollars)

Net
Balance
Merchandise Trade:
1. Exports _______
2. Imports _______

+

Services:
1. M ilita ry Receipts _________ __ ______
+
2. M ilita ry Payments _________________
3. Income on U. S. Investments A broad
+
4. Payments fo r Foreign Investments in U. S...... - ...... ..—
5. Receipts from Travel & Transportation _________ _+
6. Payments fo r Travel & Transportation ____________—
7. O ther Services (n e t) ______________________ ___+

+

0 .7

+

6.2

1.0

+
—
+
—
—
—

+

1.2

2.1

0.8
1.5
0.9
1.8

+

0.5
4 .7

Balance on Short-term Private C apital .....
VI.

3.0

4.9
4.1

Balance on Long-term C apita l _________________
Short-term Private Capital.1. N o n liq u id Liabilities __
2. N o n liq u id Claims _____

+

3.9

Basic Balance ..... ...................... ........................ ...............
V.

6.9

1.2
2.6

Balance on Transfer Payments
Long-term C apita l:
1. Direct Investment Receipts ____________________
2. Direct Investment Payments ___________________
3. P ortfolio Investment Receipts ....................................
4. P ortfolio Investment Payments _______________ __
5. Government Loans ( n e t ) __ ________ __________
6. O ther long -term (n e t) _______________________

+

8.7

11.0

Current Account Balance ___ _____
IV.

0.7

8.8

Goods an d Services Balance ___ _______ __________
Transfer Payments:
1. Private ________
2. Government ___

+

2.4
4.5
18.6

Balance on Services ________________________ __

III.

Cumu­
lative
Net
Balance

70.3
69.6

Merchandise Trade Balance
II.

M iscellaneous:
1. A llo cation o f Special D raw ing Rights (SDR)
2. Errors and Omissions ____________________

4.8

Balance on Miscellaneous Items _______ _______

—

N et L iqu idity Balance ........................... ............................
V II.

1974

Liquid Privote C apita l:
1. Liabilities to Foreigners ______ __ ___ __________ +
2. Claims on Foreigners _____________________ ____ —

7.8
4.4
1.9

Balance on Liquid Private C apital __________ ___
O fficial Settlements Balance ................................. ..........

+

2.5
5.3

The O fficial Settlements Balance is Financed by Changes in :
U.
1.
2.
3.

S. Liabilities to Foreign O fficial Holders:
Liquid L ia b ilit ie s _________ ________________ ___ +
Readily M arketable Liabilities _________ ____ ___ +
Special Liabilities _______ _________ __ _______ —

U.
1.
2.
3.
4.

S. Reserve Assets:
G old ......................... .......................................................
Special D rawing Rights
Convertible Currencies ...
IMF G old Tranche .........

4.4
1.1
0.5

Balance on Liab ilitie s to Foreign O ffic ia l Holders

Balance on Reserve Assets _________
Total Financing o f O ffic ia l Settlements Balance
♦There was no SD R allocation for 1978.
N O T E : Figures may not add because of rounding.




+

5.1

+

0.2

0.0

0.0
0.2
0.0

+

5.3

A significant change with
respect to long-term capital
transactions during 1973 was the
increase in foreign direct invest­
ments in the United States. It
is difficult to determine, how­
ever, to what extent this was due
to the reduction in the interna­
tional price of the dollar. In
general, one would expect in­
vestment decisions to be based
on rate-of-retum considerations.
It seems that these considera­
tions tilted in favor of investing
in the United States.
*
A number of factors, not all
mutually exclusive, may have
Page 19

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

R a tls S t a l l

Ratio of United States Labor Costs
to Selected Foreign Countries

MAY

R it it S c ilt

Source: U.S. Department of Labor
Note: Data represent the ratio of the indexes of unit labor costs for the designated countries. Foreign
unit labor cost indexes are calculated from cost data expressed in U.S. dollars.
•The European Economic Community includes Belgium, France, Germany, Italy, Luxemburg, and
Netherlands.

influenced this investment development: 1) produc­
tion costs abroad rose faster than in the United
States over a number of years (see chart entitled
“Ratio of United States Labor Costs to Selected For­
eign Countries”); 2) certain countries (Germany,
Japan) experienced labor shortages; 3) as foreign
corporations grew in size they may have decided to
diversify internationally as a hedge against domestic
uncertainty and to improve profitability; 4) an in­
creasing U.S. market share of many foreign firms may
have made it more profitable for them to service the
U.S. market from plants located within this market,
rather than by producing abroad and shipping to the
United States.
While the above factors were probably important
elements in the formation of investment decisions by
foreign corporations, it is not likely that these influ­
ences materialized suddenly in 1973. It is more
probable that the increase in foreign investment ex­
penditures in the United States was triggered by the
reduction in the international price of the dollar. This
depreciation reduced the probability of further de­
preciation and the resulting capital losses which could
be sustained by foreign investors.

Short-Term Capital
The net outflow of short-term capital (nonliquid
private short-term capital, errors and omissions, and
liquid private capital)6 increased during 1973 to $6.5
6Non-liquid short-term private capital refers to capital inflows
or outflows (liabilities or claims) with maturities of one year
or less that are not readily transferable, such as trade financ20
Digitized for Page
FRASER


1974

billion, compared to $0.5 billion in 1972. However,
they remained well below the levels of 1970 and 1971.
The large 1973 outflows of short-term capital were
concentrated in the first quarter and were influenced
by anticipations of capital gain by switching out of
dollars into foreign currencies under the fixed ex­
change rate system that existed during this period.
After the first quarter of 1973, the incentives for
capital gains in foreign currencies were reduced by
decisions of European countries and Japan to stop
pegging their exchange rates. During the second quar­
ter, for example, the international price of the dollar
was still declining, but short-term private capital out­
flows ceased and a $1 billion inflow (including errors
and emissions) was recorded. During the third quar­
ter there was a short-term capital outflow of $0.4 bil­
lion. Reflecting the uncertainties associated with the
oil embargo, there was an inflow of $2.5 billion in the
fourth quarter.

INTERNATIONAL ECONOMIC
POLICIES OF 1973
The most significant international development
during 1973 was the decision of many governments to
institute flexible exchange rates. The specific reasons
for resorting to floating exchange rates differed from
country to country, but in each case it was a prag­
matic solution motivated by national self-interest.
For example, in the case of Japan and Switzerland,
as well as the members of the jointly floating Euro­
pean currency block, floating resulted in an increase
in the international prices of these currencies. If the
central banks of these countries had intervened in
exchange markets in order to maintain fixed exchange
rates, they would have had to issue domestic currency
as they bought foreign currency. This would have
tended to expand their domestic money stocks, which
in turn, would have intensified their inflationary
pressures.
In the case of the United Kingdom and Italy, float­
ing of the pound and the lira resulted in a reduction
in the international prices of these currencies. If the
central banks of these countries had tried to maintain
the previously fixed exchange rates, they would have
had to sell other currencies and reduce their stocks of
international reserves. This would have tended to
contract their domestic money stocks resulting in de­
flationary consequences.
ing and cash items in the process of collection. Errors and
omissions is an adjustment entry for statistical discrepancies,
and includes largely short-term capital outflows not captured
by the regular reporting channels.

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

CONCLUSION AND PROSPECTS
FOR 1974
Throughout 1973 it became increasingly apparent
that the international monetary system had evolved
away from fixed exchange rates to a new, yet unde­
termined, payments mechanism. For many countries,
however, experience with flexible exchange rates may
strongly influence the future international monetary
system.
At one time, fixed exchange rates were deemed an
absolute necessity for a smoothly functioning inter­
national monetary system. However, as demonstrated
last year, many countries would rather permit the
international prices of their currencies to adjust to
market forces than to force the necessary adjustment
onto the domestic sector of their economies. As far as
the United States is concerned, the new floating ex­
change rate environment resulted in a depreciation of
the dollar against major foreign currencies in 1973.
There is no doubt that international trade between
the United States and the rest of the world was in­
fluenced by these new price relationships. However,
it is difficult to say with certainty whether the 1973
swing from deficit to surplus resulted mainly from the
reduction in the international price of the dollar. It is
likely that a combination of other influences were in­
strumental in determining this turnaround in the
trade balance.
Even though the U.S. economy had been in upswing
for the three years through first quarter 1973, the rate
of increase of U.S. imports declined in mid-1972. Im­
ports of manufactured goods during 1973 increased
only 2 percent in volume, compared to 13.5 percent
in 1972 and 6.5 percent in 1971.7 This suggests that
the dollar devaluation, which simultaneously reduced
the foreign currency cost of U.S. exports and increased
the dollar cost of imports, had a very strong effect in
reducing U.S. demand for imports.8
The U.S. balance of payments for 1974 will be af­
fected by many events. Since about 1966 U.S. domes7Council on International Economic Policy, International E co­
nomic Report o f the President, 1974, p. 32, and U.S. Depart­
ment of Commerce, Overseas Business Reports.
8In an analysis of U.S. trade performance in 1972, William
Fellner suggested that in a period of cyclical upswing the
ratio of the U.S. import growth rate to the export growth rate
should increase in comparison to a previous time period
(1964-1971). Since such an increase in the ratio was not ob­
served, Fellner reasons that the reduction in the international
price of the dollar exerted a strong influence during 1972.
See William Fellner, “Controlled Floating and the Confused
Issue of Money Illusion,” American Enterprise Institute
(February 1974).



MAY

1974

tic production of petroleum has leveled off while U.S
consumption has increased at a rapid rate (see chart
entitled “United States Petroleum Supply and De­
mand”). The difference between domestic production
and consumption has been made up by increased im­
ports. In 1973, for example, U.S. consumption of petro­
leum was 17.3 million barrels per day (MBD) and
imports amounted to 6.2 MBD, 35.8 percent of
consumption.

United States Petroleum Supply and Demand
R a tio Seal*
M illio n s of la r r e l s Per D ay

rw „

R atio Scale
M illio n s of B arrels Per Day

.3 1__ I__ I__ I__ __ l__ I__ I____ l__ I__ I__ __ I__ I__ I__ __ I__ I__ I__ __ I__ l__ I__ __ I__ I__ I__
1946

1950

1954

1958

1962

1966

1970

.3

1973

Sources: Bureau of Mines, 1946-1955; American Petroleum Institute, 1956-1971;
and Chase Manhattan Bank, 1972-1973

At the same time, prices of imported oil increased
sharply. For example, the average price per barrel of
imported oil was $2.75 in January 1973 and climbed
to $11 in March 1974. U.S. expenditures for imports
of petroleum and petroleum products climbed from
$4.6 billion in 1972 to $8 billion in 1973.® Many pro­
jections for 1974 indicate that U.S. expenditures for
oil imports will rise to about $25 billion.10 This would
imply a trade deficit for the United States in 1974,
and indeed, preliminary first quarter trade data lend
support to this conjecture.
Moreover, sharply increased expenditures for oil
imports are projected for other industrial countries.
The oil-exporting countries will therefore gain in­
creased revenues, and these revenues will have to be
disposed of one way or another. That is, they must
either import more goods and services or invest their
oil earnings in foreign assets.
9See Survey o f Current Business (March 1974), p. 38.
10See, for example, the International Econom ic R eport o f the
President (March 1974), p. 107.
Page 21

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

Selected Short-Term Money Market Ratesa
P trc tit
---

Parent
It

E n d -o f-M o n th D a ta

1974

It is likely that oil-producing countries will not make
completely offsetting purchases of imports from the
industrial countries. Thus, oil-producing countries will
seek investment opportunities in the industrialized
countries. It is also likely that the flow of these invest­
ment funds to the United States will be greater than
U.S. expenditures for oil imports. In this situation the
U.S. trade balance may be in deficit, but the other
international accounts of the United States may not
be affected adversely.
Although U.S. short-term interest rates have in­
creased since late February, the U.S. rates are still
below those in most major foreign countries (see chart
entided “Selected Short-Term Money Market Rates”).
If this differential is maintained, it may stimulate out­
flows of dollars into foreign money markets, thus lead­
ing to an increase in the quantity of dollars supplied.
This would exert pressure toward a decline in the in­
ternational price of the dollar.
Persistent acceleration of U.S. consumer price in­
creases may be perceived by private international
holders of dollar assets as an indication that the rate
of inflation is likely to continue rather than to abate.
Such anticipation may motivate an attempt to switchout of dollars into real assets. The recent surge in the
price of gold would support this explanation.

1973

1974

S o u rc e ; W o r ld F in a n c ia l M a r k e ts . M o r g a n G u a r a n ty T ru s t Co.
l_l_The f o llo w in g ra te s w e re used:
B e lg iu m — 4 -m o n th F o n d s d e s R entes c e rtific a te s
C a n a d a — 3 -m o n th p r im e fin a n c e c o m p a n y p a p e r
F ra n c e — 3 -m o n th in t e r b a n k m o n e y a g a in s t p r iv a te p a p e r
G e r m a n y — 3 -m o n th in te r b a n k d e p o s its
I t a ly — in te r b a n k d e p o s its o f u p to o n e -m o n th m a tu r ity
J a p a n — c a ll m o n e y ra te
U n ite d K in g d o m — 3 -m o n th lo c a l a u th o r ity d e p o s its ;
* 3 -m o n th in te rb a n k d e p o s its
U n ite d S ta te s — 3 -m o n th p rim e in d u s tria l p a p e r
E u r o d o lla r r a te — p rim e b a n k 's b id r a te fo r 3 -m o n th d e p o s its in L ondon


Page 22


On January 23 the United States suspended con­
trols on foreign lending by U.S. financial institutions,
and foreign investment by U.S. corporations. In addi­
tion, the Interest Equalization Tax was removed.
This may again work toward future increases in the
quantity of dollars supplied to foreign exchange mar­
kets. In short, although the dollar depreciation and
emerging oil problems should increase the quantity of
dollars demanded in international markets, differences
in interest rates and rates of inflation, as well as the
relaxation of U.S. capital controls may work toward
an increase in dollars supplied to foreign markets.

F E D E R A L R E S E R V E B A N K O F S T . L O U IS

MAY

1974

Publications of This Bank Include:
Weekly

U. S. FINANCIAL DATA

Monthly

REVIEW
MONETARY TRENDS
NATIONAL ECONOMIC TRENDS

Quarterly

SELECTED ECONOMIC INDICATORS - CENTRAL
MISSISSIPPI VALLEY
FEDERAL BUDGET TRENDS
U. S. BALANCE OF PAYMENTS TRENDS

Annually

ANNUAL U. S ECONOMIC DATA
RATES OF CHANGE IN ECONOMIC DATA
FOR TEN INDUSTRIAL COUNTRIES
(QUARTERLY SUPPLEMENT)

Single copies o f these publications are available to the public without charge.
For information write: Research Department, Federal Reserve Bank of St. Louis,
P. O. Box 442, St. Louis, Missouri 63166.




Page 23