Full text of Review (Federal Reserve Bank of St. Louis) : May 1979

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Energy Prices and Capital Formation:

1972-1977
J O H N A. T A T O M

T1 WO

of the most noteworthy developments in
the U.S. economy during this decade have been the
sharp rise in energy prices in 1973-74 and the sluggish
pace of business investment during the brisk eco­
nomic expansion which followed the 1974-75 reces­
sion. The purpose of this article is to delineate the
connection between these two developments. The
analysis presented provides a perspective on the be­
havior of business investment spending in the recent
past, and the general effects of energy price changes
on investment and productivity.1

I. Investment and Energy Prices:
The Theory
A standard view of the investment decision is that
a profit-maximizing firm determines whether or not
to invest in an asset by comparing the purchase price
of the asset to the present value of the additional net
receipts obtained over the life of the asset. The firm
will invest whenever the purchase price of an asset
is smaller than the present value of net receipts. At

the margin, the present value of the net receipts
attributed to the purchase and use of the asset will
be equal to its purchase price or replacement cost.
A rise in the price of energy resources generally
reduces the incentive for firms to use and, therefore,
to invest in plant and equipment. The net receipts ex­
pected from the asset in future periods are reduced
by an amount equal to the higher energy costs, other
things remaining the same. This, however, ignores
such factors as product prices, the price of capital
goods, and other resource employment, which also af­
fect the investment decision and can be expected to
change when energy resources become more expen­
sive. In order to take these factors into account, the
relationship between the purchase price of a capital
asset and the present value of net receipts can be
rearranged to focus upon the production and capital
employment decision.

This article draws upon the author’s paper “The New Energy
Regime and Investment” ( unpublished) which was prepared
for a Federal Reserve Board of Governors study on Capital
Formation. The author is grateful for the comments on the
earlier paper by Nancy Ammon Jianakoplos, Patrick Lawler,
and Robert H. Rasche.

Since the decision to invest implies that, at the
margin, the price of the capital asset equals the pres­
ent value of the expected net receipts, a “rental price”
can be computed for any capital asset on the basis of
this equality. This rental price is merely the cost per
period of holding and using the capital asset and is
directly proportional to the purchase price of capital
goods2. The optimal amount of capital for a firm to
employ can be determined using this price.

iThere are many factors which may have adversely affected
business investment in plant and equipment in the recent
ast, such as safety and pollution regulations, inflation, large
seal deficits, and increased uncertainty. The significant com­
mon feature of these developments is that they existed to some
extent since the mid-sixties but, prior to 1974, did not seem
to exert the profound influence required to explain recent de­
velopments. These other factors are ignored below.

2Generally, the rental price is the periodic cost of the equity
and debt required to finance the replacement cost of the asset,
the value of the asset lost per period due to depreciation, and
taxes on the revenues from the use of the asset. Since it is
proportional to the purchase price of a capital good, the terms
are used interchangeably below.

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

An additional unit of capital used per period, hold­
ing other resource employment constant, generates
additional output and revenue per period. The prof­
itability of employing additional capital depends upon
a comparison of the additional receipts and the price
of the additional capital. The optimal employment of
capital occurs when all profitable opportunities which
yield greater net revenues than their associated costs
have been exhausted. Thus, at the margin, the optimal
employment of capital occurs when the value of the
marginal product of capital goods equals the rental
price of capital goods. Such a condition may be writ­
ten as:
(1 )

MAY

1979

F ig u r e 1

The Effect o f H igh e r Energy P rice s
on the D e sire d Stock of C apital

P , f* = P k

where Px is a given price of product x, fK is the mar­
ginal product of capital goods (the additional output
produced with the addition of a unit of capital, hold­
ing other resources fixed), and PK is the rental price
of capital. A similar relationship holds for the em­
ployment of every other resource used by an econom­
ically efficient firm.
The principle of diminishing returns plays an im­
portant role in the determination of the optimal cap­
ital usage. The use of more plant and equipment
leads to greater output, but successive additions of
capital result in successively smaller additions to out­
put, unless more of other resources are also employed.
Thus, at some point, the additional output generates
additional revenues sufficient to cover only the price
of capital. In short, the value of the marginal product
[designated PxfK in equation (1) ] declines as employ­
ment of capital increases, other resources remaining
the same.
An increase in the price of energy resources affects
costs of production and prices throughout the econ­
omy. The unit cost of existing output and the cost of
producing additional output tend to rise in proportion
to the share of total cost attributable to energy re­
sources. Moreover, firms reduce energy use as it be­
comes more expensive relative to output prices.
A reduction of energy use, in turn, reduces the
marginal productivity of other resources. Employment
of a non-energy resource will tend to decline unless
its price relative to the output price (e.g., PK/PX for
capital) falls proportionately with the decline in its
marginal product, (e.g., fK for capital). Should such
a decline occur, there would be no change in the
optimal employment of the resource, since equation
(1 ) would hold at the employment rates which were
optimal prior to the energy price boost.



It is unlikely, however, that such a decline in the
“real price” of capital (the price of capital relative
to the price of output) would occur for the typical
firm. If the share of energy costs in the production
of capital goods is the same as the average cost share
for all output, then the price of the nation’s capital
goods will rise in the same proportion as the prices of
all other products. The real price of capital goods is
essentially unchanged, while the marginal productiv­
ity of capital goods is lower. Thus, the desired employ­
ment of capital will fall. Investment slows temporar­
ily to adjust the actual stock of capital to the lower
desired amount.
If the production of capital goods uses relatively
more energy than production of other goods, the price
of capital goods rises even more than output prices.
Since the rental price of such goods is directly pro­
portional to the price of the goods, the real rental
price of capital would rise, further reducing both the
desired capital stock and investment.3
The failure of the relative cost of capital to de­
cline provides an incentive for firms to reduce their
desired stock of capital along with energy usage. The
effect on the aggregate desired stock of capital may
be seen in Figure 1, where initially the demand curve
D indicates the aggregate demand for capital at alter­
3The analysis here can be used to find the inter-industry invest­
ment effects of higher energy prices. These are explored more
fully in Tatom, “The New Energy Regime and Investment.”
Differential adjustments across industries can be expected pri­
marily because the relationship of product prices to the prices
of capital goods is affected differently across industries in
response to an energy price increase.
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F E D E R A L R E S E R V E B A N K O F ST. L O U IS

native prices of capital relative to the price of out­
put, pK- Factors which affect the desired stock of
capital other than the relative cost of its services are
held constant along D. Initially, the economy is as­
sumed to be in equilibrium, given the relative price
of capital p0, holding the actual capital stock, K„.

MAY

1979

C h a rt I

Relative Price of Energy*
lnde*

Index

I 97 2 = , °

Q u a r t e r ly D a t a

1 9 7 2 = 1 .0

A rise in the relative price of energy shifts the de­
mand for capital downward, as less energy is used to
produce output with any given stock of capital and
given flow of labor services.4 In effect, the downward
shift in demand to D ' indicates a decline in the mar­
ginal productivity of capital due to employment of
less energy. If the real price of capital remains at p„,
however, the desired capital stock falls to Ki. In the
aggregate, investment declines so as to reduce the
capital stock from K0 to Kj.
A rise in the relative price of energy will cause an
initial reduction in output, induced primarily by a
reduction in the use of energy resources. If the price
of capital rises with the price of output, the desired
capital stock is also reduced. Since capital is more
expensive relative to its productivity, firms will
also economize on its use, temporarily reducing
investment.5
So u rc e s: U.S. D e p a rtm e n t of L a b o r a n d U .S. D e p a rt m e n t of C o m m e rc e

II. The Evidence
There are two basic implications of this theory.
First, a rise in the price of energy relative to output
leads to a decline in the productivity of existing cap­
ital and labor resources. Second, aggregate invest­
ment will slow temporarily, reflecting a decline in
firms’ desired capital use.
The first implication has been supported by an
earlier study which showed that a rise in the rela­
tive price of energy reduces output, holding constant

*T h e P r o d u c e r P rice In d e x o f Fuels, P ow er, a n d R e la t e d P ro d u c ts d iv id e d b y the Im plicit Price
D e fla to r for the P riv a te B u s in e s s Sector.
L ate st d a ta plotted: 4 th q u a r t e r

hours of employment and the flow of capital services."
The period studied is 1948-75, but similar results are
reported for the period prior to the sharp rise in
energy prices in 1973. A recent estimate of the quar­
terly production function (1/48-11/78) is:
y
h
In ( [ - ) = 1.5492 + .7135 In (-=-)
k
(16.33)
(21.69)
k

(2 )

—
4At K0 along D', the relative price of labor is sufficiently lower
for the quantity of labor to be the same as along D. This as­
sumes that the supply of labor to the economy is fixed and
that the shift downward in the marginal product of labor is
reflected in a decline in the real wage. Whether the supply of
labor is affected by an energy-induced fall in the real wage
is unclear. So-called income and substitution effects of a real
wage decline may lead to reductions in labor supply, while an
associated decline in the real value of monetary and physical
wealth tends to increase labor supply. The net effect is as­
sumed to be zero here. Leonall C. Andersen, “An Explanation
of Movements in the Labor Force Participation Rate, 195776,” this Review (August 1978), pp. 7-21, provides evidence
that the permanent net effect arising from the 1974 expe­
rience is zero.
5The results explained in this section may be derived using a
simple aggregate model of output supply and factor employ­
ment. See the Appendix at the end of this article.
Page 4



IV

= .98

S.E. = .007

.1081 In ( — ) + .0045 t
( —6.42)
p
(15.86)
D.W. = 1.92
p=

.79

where y is real output in the private business sector,
k is a measure of the flow of capital services [the
product of the Federal Reserve Board capacity utili­
zation rate and the net stock of private nonresiden•'See Robert H. Rasche and John A. Tatom, “Energy Resources
and Potential GNP,” this Review (June 1977), pp. 10-24,
and “Potential Output and Its Growth Rate — The Domi­
nance of Higher Energy Costs in the 1970’s,” in U.S. Pro­
duction Capacity: Estimating the Utilization Gap (St. Louis:
Center for the Study of American Rusiness, Washington
University, Working Paper 23, December 1977), pp. 67-106.

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

MAY

that the price of capital goods relative
to output prices did not fall subsequent
to the energy price increase.

C h o r l II

R e la t iv e Price o f C a p i t a l G o o d s *

S o u rc e s : U.S. D e p a rtm e n t o f C o m m e rc e a n d U.S. D e p a r t m e n t o f L a b o r
S h a d e d a r e a s r e p r e s e n t p e r i o d s o f b u s in e s s re c e ssio n s.
N o te : First q u a r te r 1 9 4 7 = 1 0 0
*R a tio o f the Im p lic it P rice D e fla to r of N o n re sid e n t ia l Fix e d In ve stm e n t to the Im plicit Price D e fla to r for the
P riva te B u s in e s s Sector.
L atest d a t a plotted : 4th q u a r t e r

tial fixed capital], h is manhours in the private busip
ness sector, ( ^ ) is the producer price index for fuel,
related products, and power deflated by the private
business sector price deflator, and t is a time trend.
The numbers in parentheses are t-statistics.
The significant negative impact of the relative price
of energy on output per unit of capital indicates the
existence and extent of a productivity loss associated
with a rise in the relative price of energy. Chart I
shows that, from the second quarter of 1972 through
the end of 1977, the relative price of energy rose 60
percent ( all percentages are measured as first differ­
ences in logarithms). The direct loss in productivity
(measured relative to labor or capital) is 6.5 percent
(60 X .1081) according to the production function
above. Two-thirds of this loss occurred during the
year from the third quarter of 1973 to the third quar­
ter of 1974, when the relative price of energy rose
40 percent.
The second major implication of the analysis is
that the aggregate desired stock of capital declined
due to the sharp rise in the price of energy relative
to the price of output, and that the recent sluggish
pace of business investment is due, in large part, to
this decline. This result rests upon the assumption



1979

In Chart II, the price of new capital
goods relative to the price of output is
shown for the period 1947-78. It is clear
from the chart that the relative price of
capital goods did not decline subsequent
to the sharp rise in the relative price of
energy in 1973-74. Instead, it increased
until early 1975, and has been fairly
stable since. The rise in the real replace­
ment cost of capital during 1973-74 may
have occurred because the production
of capital goods is relatively more energy
intensive than the production of private
output generally. In this case, the price
of capital goods would rise more than
the average level of output prices
when energy costs rise. The increase
in the real replacement cost of capital
goods further reduces the incentive to
invest.

Chart III shows quarterly estimates of the net
stock of fixed nonresidential capital from 1948-78.7
The trend rate of growth of the stock of plant and
equipment from 1948 to the first quarter of 1975 is
4.1 percent. As the chart indicates, the rate of growth
slowed markedly during 1975-77. From 1/75 to IV/77,
the annual rate of growth averaged only 2.3 percent.
Some slowdown in the rate of capital accumulation
might be expected due to the prior recession and ac­
companying lower levels of capacity utilization and
employment from III/74-I/75. A visual comparison of
earlier recoveries following the shaded recession peri­
ods in Chart III indicates that the recent slowing is
unusual compared to prior early expansion periods.

"The estimates are constructed by interpolating the end of year
net stock prepared by the U.S. Department of Commerce for
the period 1948-75. The interpolation uses quarterly rates of
constant dollar nonresidential fixed investment in the GNP
accounts as weights in finding end-of-quarter net capital
stocks. After 1975, the estimates are based upon the prior
( II/48-IV/75) relationship of the rate of nonresidential
fixed investment ( I t ) and the lagged net capital stock, to
account for depreciation. The equation ( t - statistics in pa­
rentheses ) is:
AK, = 1.012 + .2457 I, - .0252 K, ,
(4 .5 )
(2 9 .2 )
(-2 1 .4 )
R2 = .98
S.E. = .37

D.W. = 2.10
p=

.49
Page 5

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

MAY

1979

C h a rt III

Net Capital Stock

S h a d e d a r e a s r e p r e s e n t p e r i o d s o f b u s in e s s re c e s s io n s .

B q s ic d a t a so u rc e : U.S. D e p a r t m e n t o f C o m m e r c e

P e rc e n ta g e s a r e a n n u a l rates of c h a n g e for p e rio d s indicated.
L a te st d a t a plotte d : 4th q u a r t e r 1 9 7 8

The slowing in capital investment is even more
apparent when viewed relative to the growth of po­
tential private sector employment. Chart IV shows
the historical growth pattern of the capital stock
relative to the high employment supply of workers.
The capital stock in any quarter is measured by the
existing stock at the end of the prior quarter. Poten­
tial private business sector employment is measured
by adjusting the actual labor force, less employment
outside the private sector, for the full-employment
unemployment rate.8 In effect, the employment meas­
ures are estimated under full employment conditions.
Until the third quarter of 1973, the ratio of available
capital to available labor grew at an annual trend rate
of 2.9 percent. From the third quarter of 1973 until
8The full-employment unemployment rate series used is that
developed by Peter K. Clark, “Potential GNP in the United
States, 1948-80,” in U.S. Productive Capacity: Estimating the
Utilization G ap (St. Louis: Washington University, Center
for the Study of American Business, 1977), pp. 21-66. The
series is constructed to find an unemployment rate compa­
rable to four percent in 1955, after adjustment for changes
in the age ana sex composition of the labor force.
Page 6



the end of the recession, the growth rate slowed. Dur­
ing the ensuing expansion, the ratio of capital stock to
potential employment remained virtually unchanged.
Chart III and IV provide illustrations of the slow­
down in capital accumulation implied by the theory
above, and support the claim that this energy-induced
slowdown in capital growth caused a temporary re­
duction in the growth rate of potential output after
1973.9 Two questions obviously arise, however. First,
how large is the energy-induced reduction in the
capital-labor ratio, and to what extent has it already
occurred? Second, how large are the energy-induced
output and capital stock reductions along a high-employment growth path, when the effects of higher
energy prices are aggregated? The output effects are
(1 ) the short-run loss in productivity, given capital
9See Rasche and Tatom, “Potential Output and Its Growth
Rate.” The estimate of the potential growth rate is three
percent from early 1975 through mid-1977. This slowing
should not be confused with the once-and-for-all decline in
productivity, given capital and labor, implied by the theory
and evident in 1974 productivity developments.

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

MAY

1979

C h a r t IV

Full-Em ploym ent C a p ita l-L a b o r Ratio in the Private Sector
R a t i o Sc a l e
T h o u s a n d s of D o l l a r s

(1972 Dollars Per Worker)

R a tio Scale
T h o u s a n d s of D o l l a r s

16

16

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

* A n a n n u a l trend rate of g ro w t h (2 .9 % ) is e stim a te d b y a re g re s s io n o f the lo g a r it h m o f the c a p it a l- l a b o r ratio on tim e fo r the p e r io d 1 / 1 9 5 0 — 11/1972.
S h a d e d a r e a s r e p r e s e n t p e r i o d s o f b u s in e s s r e c e s s io n s .
L a t e s t d a t a p lo tte d : 4th q u a r t e r 1 9 7 8

B a s ic d a t a 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 r c e
a n d U.S. D e p a r t m e n t o f L a b o r

and labor employment in the United States, and
(2 ) the loss in output due to the long-run adjustment
to the energy-induced decline in the capital-labor
ratio.10

mates of a and y, found from the estimated equation
(2) , with standard errors are:

These questions may be answered using the esti­
mate of the production function given in equation (2).
The percentage change in output for a one percent
rise in the relative price of energy in the long run

The short-run capacity loss for each one percent in­
crease in the relative price of energy is found from
the coefficient on the energy price in equation (2),

is (-■“ )> where a and y are the output elasticities

(3 )

a = .6439 (.0271)
y = .0976 (.0137)

which is an estimate of

)> or in this case,
v1 - y '

of iabor and energy employment, respectively.11 Esti­

-.1081. The total response (~~~) measures the long-

10A third effect, due to an energy-induced rise in the relative
price of capital, has not been well substantiated by detailed
econometric analysis and so it is not incorporated in the
estimates in the text. To the extent such an effect exists, the
estimates below are too low.

run effect when capital employment adjusts to its
long-run equilibrium, given an unchanged real price
of capital. The estimates in (3 ) indicate that the longrun output effect is 40.2 percent larger (-.1516) than
the short-run effect. For the rise in the cost of energy
from mid-1972 through 1977, the short-run output

11The production function is y = Aerl h" k0 E7, where E is
energy and a, |3, y, the output elasticities of the respective
inputs which seem to unity. See Rasche and Tatom, “Energy
Resources and Potential GNP.” The derivation of the expres­
sion used here follows from mathematical conditions re­
quired for efficient long-run employment of capital and



energy, given the aggregate supply of labor and the real
rental price of capital. This expression and other mathemati­
cal results below are derived in the Appendix.
Page 7

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

MAY

loss is 6.5 percent while the long-run response allow­
ing capital to adjust is 9.1 percent.12
The total effect on the demand for capital may be
found from the condition for profit-maximizing capi­
tal demand, pk = (3^, where (3 is the output elas­
ticity of capital and pk is the price of capital relative
to the price of output. Given pk and the parameter
P, the ultimate percentage decline in the desired
capital stock must equal the percentage decline in
output in order to maintain the equality. The elas­
ticity measure for the total output response above
is -.1516. Thus, the 60 percent rise in the rela­
tive price of energy from mid-1972 through 1977
would reduce the capital-labor ratio by 9.1 percent
along its new long-run growth path.13 The decline in
the actual capital-labor ratio relative to its past trend
is 12 percent, when the trend is extrapolated from
mid-1972 through the end of 1977, consistent with
the reduction indicated by energy price considera­
tions alone.
The results indicate the costs associated with the
rise in the relative price of energy from 1972-1977.
In terms of output, the cost of the adjustment by the
end of 1977 was a 9.1 percent reduction, much of
which occurred during the period from 111/73 to
111/74. Most of the loss was due to the direct effect
on productivity of a higher relative cost of energy
and changes in resource allocation, given domestic
capital and labor resources. An estimated 2.6 percent­
age points of the loss in output occurred subsequently,
due to the energy price-induced slowing in capital
formation. The net capital stock at the end of 1977
in the estimates above is $1,031.8 billion (1972 prices),
while the estimates imply it would have been $98.3

12If the price of capital goods relative to output prices is
affectecl by the rise in energy prices, then another element
,

,

,

,

,

,

,

/ P di n Pi

must be added to the long-run output loss ( - a ^

billion larger in the absence of the dramatic change
in energy costs over the preceding five years.14

III. The Remaining Adjustment and
Recent Developments
Energy prices in world markets have not fully ad­
justed to past OPEC actions because of U.S. energy
policy. Decontrol of the U.S. petroleum market will
complete the adjustment and will further affect future
production.
Since 1973, the primary component of energy policy
has been the entitlement program. This program was
intended to hold the cost of petroleum to U.S. refiners
below the OPEC price to allow for a longer transition
period to the higher prices. The average cost of crude
oil to refiners at the end of 1977 was about 18 per­
cent below the cost of imported oil.15 An earlier analy­
sis indicates that, based on this difference, the end of
the entitlements program would add about 7.8 per­
cent to the relative price of energy resources.16 This
increase results from a direct effect on the price of
refined products, cost effects on competing energy
producers, and substitution effects among energy
uses. Given the estimates of the short-run and longrun impacts of higher energy costs above, it is possi­
ble to assess the output loss in the short and long run
due to this change. In the short run, the output loss
is less than 1 percent. Even allowing for the effects
on the demand for capital, the total long-run effect
is a loss in output and capital stock of 1.2 percent.
This loss should be regarded as a maximum esti­
mate, had the crude oil market been completely
decontrolled at the end of 1977. The reason is that
such a policy would increase the responsiveness of
world (U.S.) petroleum supplies to the world price,
increasing the elasticity of demand faced by the domi­
nant firm, the OPEC cartel, and putting downward
pressure on their optimal price. Thus, the effect of

p )>

where P is the output elasticity of capital. One simple esti­
mate of the price responsiveness, for quarterly data from
1948-77, is .0564 when the logarithm of the relative price
of capital is related to the logarithm of the relative price
of energy and constant, and the equation is estimated using
the Cochrane-Orcutt technique. The addition to the output

v

elasticity ( - — = -.1 5 1 6 ) is 2.27 percent. Thus, a 60 per­
cent in energy prices would add only about 1.4 percent to
the output loss over the long run.
13Accounting for the energy price effect on the relative price
of capital would add .0791 to the capital elasticity (in abso­
lute value), implying a 13.8 percent reduction in the capital
stock.
Digitized forPage
FRASER
8


1979

14This estimate is very close to that by Edward A. Hudson
and Dale W. Jorgenson, “Energy Prices and the U.S. Econ­
omy,” Natural Resources Journal (October 1978), pp. 87797, and Data Resources U.S. Review (September 1978), pp.
I.24-I.37. They estimate that by the end of 1976, the U.S.
capital stock was $103 billion (1972 prices) lower than it
otherwise would have been due to energy price
developments.
15This is the percentage excess of the refiner acquisition cost
of imported crude oil over the composite cost in late 1977
reported by the Department of Energy, Monthly Energy
Review (August 1978), pp. 58.
16See Rasche and Tatom, “Potential Output snd Its Growth
Rate,” pp. 93-97.

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

decontrol on production and investment would have
been slight in the United States.
During 1978, there was little change in the relative
price of energy. Although the pace of capital accumu­
lation increased during the year — the net stock of
capital grew 3.5 percent from the end of 1977 to the
end of 1978 — the capital-labor ratio was virtually
unchanged. During the year, the gap between the
U.S. average cost of crude oil and the world price
narrowed, averaging about 12 percent by the end of
1978. Thus, the implied impact of domestic petroleum
market decontrol was reduced sharply.17
Political developments in the Middle East late in
1978 and early in 1979 led to a sharp disruption in pe­
troleum supplies and subsequently changed the struc­
ture of OPEC supply. Coincident with these develop­
ments, OPEC announced an increase in the cartel
price of crude oil by about 14 percent during 1979.
OPEC later adjusted to supply developments by
hastening the announced increase and by allowing in­
dividual countries to impose additional surcharges
on production. The result has been another round of
boosts in petroleum prices in the world market and,
indirectly, the prices of other sources of energy.
It is tenuous to speculate on the final outcome of
recent developments on the price of OPEC crude oil
and the impact on U.S. energy costs. However, nom­
inal energy prices have risen at a 31 percent annual
rate from November 1978 to May 1979. Based upon
an 8.5 percent rate of increase of the implicit price
deflator for private business sector output from the
fourth quarter of 1978 to the first quarter of 1979, the
relative price of energy has been rising at about a 22
percent annual rate. During the six-month period from
17The estimate of this difference is based upon an imputed
cost of imports and U.S. average cost of all crude oil found
by adding the price of an entitlement to the wellhead price
of lower tier oil, plus twenty-one cents, to find the average
world price. The domestic cost is found by subtracting the
entitlement benefit from import cost. The calculation uses
quarterly averages of monthly figures. The comparable figure
for the fourth quarter of 1977 is 16 percent. Data on the
refiner acquisition cost of imported oil during the fourth
quarter of 1978 is not available at the time of this calcula­
tion. The data and definitions of terms are from the Monthly
Energy Review (April 1979). A more detailed discussion of
these terms and the analysis of the entitlement program may
be found in John A. Tatom, “Energy Policy and Prices,”
Business Economics, (January 1979), pp. 14-22.




MAY

1979

November to May, the relative price of energy in­
creased about 11 percent, implying a short-run pro­
ductivity loss and price level rise, according to the
estimates above, of 1.2 percentage points. The implied
long-run productivity and capital stock reduction is
1.7 percent.18

IV. Conclusion
The large increase in the cost of energy resources
from 1972 to 1977 has had profound effects on pro­
ductivity, investment, and the long-term growth path
of the U.S. economy. In addition to a direct loss in
productivity of about 6.5 percent, a reduction in the
desired capital-labor ratio has further aggravated pro­
ductivity growth. Since 1975, growth in the capital
stock has barely kept pace with growth in the labor
force available to the private sector. This develop­
ment represents a significant departure from the
trend growth in the oapital-labor ratio, a trend which
contributed significantly to overall economic growth
in the United States prior to 1973.
The analysis and estimates here indicate that a drop
of at least 9 percent in the desired capital-labor
ratio is to be expected from the sharp rise in the rela­
tive cost of energy which occurred from mid-1972
through 1977. This represents about three years growth
in capital relative to labor on the pre-1974 trend.
Once such an adjustment is completed, there is no
reason to presume that other forces contributing to
capital formation will be offset by the effects of past
energy price changes. Unfortunately, recent events in
the world petroleum market suggest that another round
of lesser adjustments of resource allocation, capital
formation, and economic growth will occur before
such forces again dominate the scene.
18Of course, these increases do not fully reflect OPEC actions
as existing policy insulates U.S. energy prices from OPEC
actions. Thus, recent energy price increases in the United
States ( and their effects) are only about half as large as they
would have been otherwise. The remainder of the increase
will be phased in over the next eighteen months under the
administration’s decontrol proposal. It would be erroneous to
conclude that these developments increase the cost to U.S.
consumers of a decontrol program, since decontrol yields pos­
itive net benefits to U.S. consumers. The adverse impacts as­
sociated with such a program are indeed larger, but the net
benefit to eonsumers of decontrol is correspondingly larger.
See Tatom, “Energy Policy and Prices.”

Page 9

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

MAY

1979

APPENDIX
Higher Energy Costs: The Long Run and the Short

The results discussed in this paper may be demonstrated
using a simple model of aggregate production. Consider a
general aggregate production function with the assumption
of profit-maximization and the most general assumptions
for short- and long-run resource constraints. Assume that
aggregate output, y, depends upon the use of labor (h ),
capital (k ), and energy (e ), y = f (h, k, e ), given tech­
nology. The short run is characterized by fixed supplies of
labor and capital resources (h", k") and by a given relative
price of energy resources, p°, determined in the world mar­
ket. In the long run, the supply of capital is variable as firms
can add to or subtract from the stock of capital depending
on their incentives. The relative price of capital (measured
relative to the price of output) is assumed to be given in
the long run. The long-run supply of labor and relative
price of energy are assumed to be the same as in the
short run (h°, p°).
The profit-maximizing choice of an input is determined
by equating the marginal cost (price) of the resource to
the value of its marginal product, f; = plt where f; is the

Table I

A Simple Model of Aggregate Supply
and Resource Markets
Production Function:

y = f(h, k, e)

First-Order Conditions For
Profit-Maximization:

Ph = fh

p i = fk
p» = f«

Short-run Resource Supply Assumptions:

h = h”
k = k°
p. = p?

Long-run Resource Supply Assumptions:

h = h°
pk = pS
p. = pS

Definitions: y =
h=
k=
e=
Pt, =

output
labor
capital
energy
wage of labor relative to the price of
output
pt = rental price of capital relative to the
price of output
pe = price of energy relative to the price of
output

10
Digitized forPage
FRASER


marginal productivity of resource i (

dy

) and pi is the

rental price of the resource relative to the price of aggre­
gate output. The production function, profit-maximizing
demand for each of the three inputs, and the three supply
equations which hold in the short run or the long run can
be used to determine output and employment of each re­
source as well as their relative prices. The short-run and
long-run models are shown in Table I. By differentiating
each system of equations, the short-run and long-run re­
sponse to a rise in the relative price of energy may be
found to be those indicated in Table II.
The critical unknown determinant of the effects shown
in Table II is the sign of fy for i, j = k, h, e. This term
indicates the effect of an increase in the employment of
factor j on the marginal productivity of a resource i. The
typical response is positive; employment of more of one
resource is generally responsible for increased marginal
productivity of the other resources.1 The generality of the
results in Table II indicates the importance of the sign of
fij. The signs of fec, fkk, fhh are assumed to be negative,
indicating diminishing returns to the employment of each
resource.
The short-run output effect discussed in the text rests
upon the assumptions of a positive marginal product of
energy and diminishing returns to the employment of
energy resources, given capital and labor. The effect arises
solely due to the reduction of energy employment, given
the assumptions concerning the supply of labor and capital.
Under the assumption that energy resources augment the
marginal productivity of capital and labor, the real rental
price of capital and labor must fall to maintain their em1TVie term fij is positive in the three factor Cobb-Douglas pro­
duction function where the resources are substitutes, or Ou
> 0. The term fij is also positive if Otj < 0, or the resources
are complements. The determinant of the negative _capital
stock effect can be referred to as “q-complementarity” which
must be the case if Otj < 0 and will be the case for CobbDouglas and CES production functions where Otj > 0, or
resources are “p-substitutes.” On this terminology and these
relationships, see John R. Hicks, “Elasticity of Substitution
Again: Substitutes and Complements,” Oxford Econom ic
Papers, 22, no. 3 (November 1970), pp. 289-296, and Ryuzo
Sato and Tetsunori Koizumi, “On The Elasticities of Substitu­
tion and Complementarity,” Oxford Econom ic Papers, 22, no.
1 (March 1973), pp. 44-59. Whether capital and energy are
substitutes or complements (in the “p” sense) is a continuing
controversy. See Ernst R. Bemdt and David O. Wood, “En­
gineering and Econometric Interpretations of Energy-Capital
Complementarity,” American Econom ic Review , (June 1979),
pp. 342-354. Fortunately, the issue does not affect the capital
stock-investment result, but it is important for such questions
as short-run output supply effects and changes in the amount
of energy used per unit of capital.

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

MAY

1979

Table II

The Effect of a Rise in
the Relative Price of Energy
Short Run
~ .
° utPut:
Labor Employment:

fe

dy
“5 7

=

^

=

T.7

„ „
< 0

0

dc

Energy Employment:

Relative Price of
L ab o r:

Relative Price of
Capital Services:

* |D( = - (

f

=

0

=

J~

=

fc7

<

0

--------------------\ d \-------------------<

f. „
f—

< 0°*

0

dp*
"d^T

1

< 0 s8

(ink

£

< 0

fc.

"dp~ =

fkk fee - fke )

- ( f c fkk - fk fke) „ „„„
---------- |D!---------- < 0
0

11

Capital Employment: “jp

Long Run”

„

< 0

( fck fce - fck fce)

, ...

0

< 0.

‘ “Sign depends upon fc« and/or fc« > 0.

ployment. If energy employment has no effect on the pro­
ductivity of capital and labor, no shift in demand for
capital and labor occurs. If increases in energy employ­
ment reduced the marginal productivity of labor or
capital, the demand price of the factor would rise.
The long-run effects of a rise in the relative price of
energy are also unambiguous, given that fke > 0. Not only
are output and energy usage reduced as in the short run,
the employment of capital is also reduced. Of course, this
result arises from a temporary reduction in investment to
achieve the smaller amount of capital desired. The results
show that the economy will reduce the use of capital goods
since they have become more expensive in relation to the
productivity of such goods. Subtracting the long-run out­
put effect from the short-run effect results in:
.

.

fke

( fe fke fee

|D

fk fee )
|

which is positive, given that fke is positive (fee, |D[ < 0 ).
Thus, the long-run output effect of the rise in the relative
cost of energy is larger than the short-run effect. Similar
computations indicate that the long-run reduction in en­
ergy usage and the decline in the real wage rate of labor
are also larger than in the short run. The increased size
of the long-run effects arises from the reduction of capital
employment through a temporary reduction in investment.
For the particular case of a Cobb-Douglas production
function, the model is even simpler. The production func­
tion is y = A h“ k? e?, where ex, |3, y are the respective
output elasticities of the inputs: labor, capital, and energy
and they sum to one. The term A is a scale factor; a rate



of neutral technological change (r) over time (t) is omit­
ted here for simplicity and to avoid notational confusion.
Yy

The first order conditions are: pe = — , ph = -g , and pk =
(3y

k . For the analysis in the text, it is most convenient to

compute the effects in Table II in elasticity form. Since
labor and the relative price of energy are fixed in the
short and long run, the production function can conveni­
ently be rewritten as:
(2) In y = In A* +

In h +

In k -

^ y " ln

by substituting the first-order condition for energy employ­
ment in the production function. Then, given labor and
capital employment, the short-run effect of a rise in the
, ,.
.
r
_ . d In y _
y
----- y_y .
relative price or energy is ^
The first-order condition for capital employment re­
quires: In k = In P + ln y - In pk. In the short-run
(d ln k = 0 ), a decline in output is reflected in an equal
percentage decline in the real value of capital, pk. The longrun results require d ln pk = 0, so d ln k = d ln y. Substitut­
ing the expression for ln k in (2) and differentiating with re,
, . d In y
d ln k
y
spect to In pe results m
given
pk and h. The implied long-run decline in the real wage
(

) is also ( - ^ ), given labor employment and the

real price of capital.
Page 11

Monetary Targets —Their Contribution to
Policy Formation
Remarks by LA W REN CE K. ROOS, President, Federal Reserve Bank of St. Louis
Before a Conference on Monetary Targets, The City University,
London, England, May 10, 1979

F IRST of all, I want to thank the organizers of this
conference for inviting me to participate in these very
timely discussions. I can recall no period in recent
history when economic issues have weighed as heavily
on people’s minds as they do now, and it is encourag­
ing to know that so many of you, representing differ­
ent nations and diverse points of view, are devoting
your time and talents to search for a better way to
assure the future growth and stability of the econo­
mies of the Free World.
In my remarks this afternoon, I shall concentrate
on monetary policymaking as it is conducted in the
United States with specific attention to monetary ag­
gregate targeting. In so doing, I will first describe
the process of monetary policymaking in my country,
follow that with a discussion of some of the problems
inherent in that process, and finally, offer for your
consideration some recommendations for changes
which I believe would alleviate at least some of the
present causes of economic instability.
From the outset, it is only fair to admit that my
viewpoint is neither reflective of the prevailing opin­
ion within the Federal Reserve System nor does it
enjoy the enthusiastic support of all opinion-molders
within the United States. While this lack of wide­
spread acceptance occasionally generates a degree
of frustration for me and my colleagues at the Federal
Reserve Bank of St. Louis, it does not diminish our
concern that current monetary policymaking prac­
tices are not achieving the goals for which they are
intended. We are convinced that, in order to minimize
the instability that has become characteristic of eco­
nomic events over the past two decades, we must
take a fresh approach to policymaking.
Proceedings of this conference will be published by Macmillan
later this year under the title, “Monetary Targets. ’ Edited by
Professor Brian Griffiths and Geoffrey E. Wood of the Centre
for Banking and International Finance, The City University,
London, England.
12
Digitized Page
for FRASER


I also want to emphasize that I am fully aware
that the recommendations I shall present will not, in
themselves, assure the immediate or painless eradi­
cation of inflations and recessions. But, if they will
at least enable us to eliminate money-induced eco­
nomic fluctuations, we will have accomplished signifi­
cant progress.
Let’s first consider the process by which U.S. mone­
tary policy is currently conducted.
I am sure you are aware that since the development
of the Federal funds market, the commercial banking
system in the United States in general does not main­
tain any substantial excess reserves. As a result, sub­
stantive increases in deposits and, thus, in money
stock can occur only if the Federal Reserve supplies
additional reserves to the banking system, either
through its open market operations or through a re­
duction in reserve requirements. Since reserve re­
quirement changes are infrequently used to affect re­
serve availability, open market operations are in
reality our principal tool of money management.
As you know, the Federal Open Market Committee
of the Federal Reserve meets ten times each year and
at each meeting establishes two primary targets: a
range for the Federal funds interest rate and a growth
range for the monetary aggregates. These targets are
set by a majority vote of the Federal Open Market
Committee and a directive is given to the open mar­
ket trading desk at the Federal Reserve Bank of New
York to implement the decisions of the Committee.
If market forces threaten to move the Federal funds
rate above the upper limit of the Committee’s pre­
scribed range, the trading desk, in order to resist the
rise in the Federal funds rate, purchases securities
in the open market, thereby supplying additional re­
serves to the banking system. Conversely, if the mon­
etary aggregate growth rates reach the upper limits
of their ranges, the desk withdraws reserves by selling

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

MAY

1979

securities, thereby limiting money expansion and caus­
ing upward pressure on the Federal funds rate.

interest rates, even if it has meant destabilizing money
growth.

A problem arises when both the Federal funds rate
and the growth of monetary aggregates simultaneously
reach the upper or lower limits of their prescribed
ranges. When this happens, the Open Market Desk
faces a dilemma of whether to let the Federal funds
rate exceed its prescribed limits in order to keep
money stock growth within established ranges, or to let
money overshoot or undershoot its target range in
order to meet the prescribed Federal funds target.

The procyclical effect of this bias toward interest
rate stabilization has contributed materially to the
host of economic ills that have plagued our nations —
accelerated inflation, deepened recessions, incompati­
ble monetary growth among nations, exchange rate
volatility, domestic and international trade restrictions,
and, in all probability, lower economic growth than
would otherwise have occurred. Because interest rate
stabilization has had these undesirable effects, it is
only natural to question why, after all that has hap­
pened, we continue to use, defend, and protect inter­
est rate targeting as a preferred method of policy­
making? There are several contributing factors.

Let’s examine the published history of the behavior
of interest rates and the monetary aggregates in the
period since long-term monetary aggregate growth
ranges were first announced in 1975. In the forty-seven
months in which short-term policy ranges have been
set, the Federal funds interest rate has fallen outside
of its target ranges only five times; in the same fortyseven periods, M-1 growth has fallen outside of its
ranges twenty-three times, essentially 50 percent of
the time.
The monetary aggregates (M-1) have tended to
exceed their targets during periods of rising Federal
funds rates, to fall short of their targets during periods
of falling Federal funds rates, while usually remaining
within their targets during periods of stable Federal
funds rates. For example, from June to December
1976, the Federal funds rate fell from 5.6 percent to
4.5 percent and monetary aggregates fell short of their
target ranges three out of seven months. From April
to October 1977, when the Federal funds rate rose
from 4.7 percent to 6.5 percent, the monetary aggre­
gates exceeded their targets five out of seven months.
From October 1977 to March 1978, the Federal funds
rate remained fairly stable at approximately 6.6 per­
cent, and monetary aggregates remained within their
ranges.
Two conclusions can be drawn from these observa­
tions. First, it is clear that in periods of incompati­
bility between the Federal funds ranges and the mon­
etary aggregates targets, the Federal funds rate has
reigned as the primary target in the conduct of mone­
tary policy, and adherence to monetary aggregate
ranges has played, at best, only a secondary role.
Secondly, the principal thrust of monetary policy has
been to stabilize the Federal funds rate and to resist
both upward and downward market pressures on in­
terest rates, even if it has meant permitting the growth
of monetary aggregates to fall outside of their ranges.
Thus, monetary policy in the United States, either by
design or by default, has been fashioned to stabilize



The first — and perhaps the most troublesome be­
cause it represents a crucial analytical error on the
part of monetary policymakers — is a failure to dis­
tinguish between the economic consequences arising
from changes in people’s demand for money and
those created by changes in credit markets. Changes
in money market conditions and changes in credit
market conditions have substantially different eco­
nomic effects and require fundamentally different mon­
etary policy responses. Interest rate stabilization is a
justifiable monetary policy response to changes in
money demand but leads to significant procyclical
consequences when used to resist changes in the
credit market.
To illustrate what I mean, let’s examine the effects
of changes in the demand for money. People — house­
holds and businesses — tend to hold a certain amount
of money in cash or similar liquid assets for their
present spending needs and for protection against
unforeseen future needs. The amount of such assets
they desire to hold varies from time to time. A funda­
mental goal of monetary policy should be to provide
enough money to satisfy people’s money demand. If
individuals and businesses want to hold more money,
it is the responsibility of the central bank to supply
the necessary amount of money to satisfy that desire.
If they want to reduce their money holdings, the
money supply should be reduced.
Consider how interest rate stabilization fits into
this money demand equation. If individuals and busi­
nesses decide for one reason or another to increase
their holdings of cash balances, they can do so either
by reducing their spending or by selling off other
assets. In either case, the normal result is an increase
in interest rates, a decline in demand for newly-pro­
duced goods and services, a decline in output, and
Page 13

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

a decline in prices. Assuming that the legitimate goal
of monetary policy is to achieve stability of output
and prices, the correct policy response to increases
in money demand is to supply more money to the
economy. This, in turn, has the effect of exerting
downward pressure on interest rates and preventing
decreases in output and prices. Thus, interest rate
stabilization is justifiable when it is used as a response
to changes in the demand for money.
Interest rate stabilization, however, is not an appro­
priate response to increases in the demand for credit.
If individuals or businesses resort to borrowing in
order to expand their current spending, the results
are significantly different from those I have previously
discussed in connection with changes in money de­
mand. Increased borrowing causes interest rates to
rise. However, neither output nor the price level is
necessarily affected by such increased borrowing, as
any increased spending by borrowers is offset by
reduced spending on the part of lenders. Since credit
demand tends to rise in periods of economic expan­
sion and fall in times of contraction, monetary policy
geared toward increasing the money supply to resist
increases in interest rates emanating from rising credit
demand merely adds to the underlying growth of
spending. Conversely, reducing the money supply to
resist reductions in interest rates during periods of
decreasing credit demand results inevitably in aggra­
vating the downward movement of output and prices.
Thus, efforts by monetary policymakers to stabilize
interest rates in the face of fluctuations in credit
demand have the effect of accentuating rather than
stabilizing changes in output and prices.
Much of the inflation we are presently experienc­
ing can be attributed to monetary policy directed
toward the stabilization of interest rates in times of
rising credit demand. This, in turn, has reflected a
failure on the part of policymakers to differentiate
between the economic consequences of money market
disturbances and those created by changes in credit
markets.
A second factor contributing to continued concen­
tration on interest rate stabilization is a fundamental
misconception of exactly what monetary policy can
and cannot accomplish. Regardless of its goals and
purposes, monetary policy as practiced in free market
economies can directly affect only one variable, the
rate of growth of the money stock. And it is the rate
of growth of this variable that affects economic
activity and price levels throughout the economy.
Monetary policymakers frequently go astray when­
ever they assume that their policy actions can affect
Page
14



MAY

1979

only one specific market without affecting all markets.
Interest rate stabilization often carries with it the
temptation to try to affect particular markets by
manipulating interest rates. If, for example, policy­
makers assume that certain markets such as housing,
credit, or the international exchange market are bell­
wethers of economic activity, interest rate manipula­
tion might seemingly offer a legitimate way to affect
one or more of those markets. What they sometimes
fail to take into consideration is that any attempt to
use monetary policy to stabilize unemployment in a
particular market will have the effect of destabilizing
other markets and will lead to an increase in the
general price level. Furthermore, policy aimed at sta­
bilizing financial markets in order to prevent interest
rates from falling causes contraction in output and
employment. Unfortunately, even after it becomes
apparent that such manipulation causes detrimental
results in other sectors of the economy, parochial
pressures often persist.
If it were only understood that monetary policy is
a powerful tool in the stabilization of general eco­
nomic activity and the price level, but is a weak and
very costly tool for the stabilization of individual
economic sectors and markets, perhaps the bias to­
ward interest rate control would abate. A great im­
provement in the effectiveness of monetary policy
could be expected if policymakers were to recognize
that decisions to increase or decrease the growth of
money stock can provide an environment in which
free markets can function efficiently, but that their
effect on particular transactions is minimal.

A third reason for interest rate stabilization is the
benefit it offers government. Whether we agree or
disagree with the spending and revenue policies of
our governments, interest rate stabilization by a cen­
tral bank removes an important budgetary constraint
on government. As we know, expenditures by govern­
ment must be financed either by raising taxes or by
deficit spending. In a democracy, increases in taxes
are ultimately subject to review by the citizenry at
the polling booth. Budget deficits financed by the pri­
vate sector necessarily entail an increase in interest
rates to induce the public to hold more government
debt and are, thus, open to public scrutiny. It is
only when a central bank stabilizes interest rates that
government expenditures can be increased in a seem­
ingly “painless” and relatively hidden manner without
a tax increase or a rise in interest rates. To be sure,
transfer of wealth still occurs through subsequent
inflation but only with a lag of a couple of years and
without clear public recognition of what induced the

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

inflation. Thus, interest rate stabilization makes possi­
ble increased government spending without public
awareness and without voter approval. While I am
not suggesting that this practice is consciously being
employed at present, it does represent a powerful in­
centive for government to encourage interest rate
stabilization.
In closing, let me summarize the points I have tried
to make. I have described the mechanics of U.S.
monetary policymaking and implementation. I have
shown how establishing multiple targets for the Fed­
eral funds interest rate and the monetary aggregates
has frequently resulted in incompatability, with the
Federal funds rate usually emerging as the dominant
target. I have suggested that, in recent years, mone­
tary policy in the United States and elsewhere has
been directed toward interest rate stabilization.
Whenever that has occurred, whether in the United
States or in other nations, it has led to destabilization
of economic activity and accelerated inflation.
I have identified what I perceive to be some of
the more important reasons for continued adherence
to disproven policies: the confusion between money
demand and the credit market; an unwillingness to
admit that monetary policy is a very poor and very
costly means of manipulating individual markets;
and the fact that interest rate stabilization relieves
government of important budgetary constraints. All
of these are powerful social and political factors and
it is not surprising that changes in the manner of
conducting monetary policy are hard to come by.
I am convinced that there is a better way to ac­
complish the goals of monetary policy. That better
way is to control the growth of the money stock so
that it is consistent with the potential growth of
output and with a predetermined — preferably zero —
rate of inflation. In order to achieve this goal, how­
ever, it will be necessary to abandon interest rate
targeting and to announce publicly what our mone­
tary policy goals are and what mechanism will be
used to achieve them. Only if we are prepared to
take these steps can we realistically hope that mone­
tary policy will become a stabilizing rather than a
disruptive force.
I know that these proposals are not new and that
contrary arguments persist against the feasibility of
controlling the growth of money. Critics continue to
assert that money stock growth cannot be measured
with precision and thus cannot be controlled. My




MAY

1979

response to that argument is that a policy of explicitly
controlling the growth of money has not been given
a fair chance in the United States; in other economies
that have made the effort, it has worked well. A
second and more serious criticism is that, if money
demand changes do indeed occur, a steady growth
of money stock would lead to instability in economic
activity. Empirical evidence clearly indicates that,
over periods of a year or more, income velocity
changes very slowly and predictably. In the very few
instances when sudden changes in money demand
have occurred, such as the one induced by the OPEC
shock in 1973 and 1974, or those induced by institu­
tional changes, they have been of temporary duration
and were readily recognizable. Should exogenous
changes occur, the rate of money growth can be tem­
porarily changed to meet specific situations, and such
changes should be announced publicly and the ra­
tionale behind them explained. A third frequently
directed argument against a constant rate of money
growth is that, if labor unions demand wage increases
or businesses set prices in excess of the rate of growth
of productivity, unemployment would result. This, I
think, emphasizes the critical importance of central
bank credibility. If it becomes clear that monetary
authorities are going to adhere to their announced
money growth targets, I doubt that businesses or
unions would risk the loss of sales or employment
that would accompany exorbitant wage or price
demands.
I would stress that we can no longer enjoy the
luxury of procrastination. We cannot be content
merely to debate and theorize as to the best methods
of conducting monetary policy. The time has come
to learn from our past policy errors.
Interest rate stabilization as a means of seeking
economic stability has had its day in court and its
results have certainly been less than satisfactory. We
are still experiencing persistent and accelerating in­
flation, and we again face the grim prospect of re­
cession. If we respond as we have in the past, if we
persist in repeating past errors, we will have failed
in our responsibilities as monetary policymakers. We
must be prepared to try new methods which offer
the potential for success. Targeting on interest rates
at the expense of stabilizing the growth of the money
supply has brought us the situation we face today.
If we feel that there is a better way — and I firmly
believe there is — I suggest that we move ahead
without further delay.

Page 15