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FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

A Monetary Analysis of the Administration’s
Budget and Economic Projections
KEITH M. CARLSON

Teconomic
JL H E adm inistration s budget proposals and
report, presented to Congress and the

This article analyzes the role of monetary actions
in the current administration’s economic framework.
nation in early February, have generated consider­ The discussion evaluates the consistency of the
able controversy.1 The prospect of historically large adm inistration’s economic projections, given the
deficits through 1987 has especially unsettled many structure of the economy and past experience with
observers. Many question the plausibility of the lags in the effect of economic policy. The basis for
adm inistration’s econom ic forecast, w hich they this evaluation is a monetary model of the U.S. econ­
consider too optimistic.
omy developed at the Federal Reserve Bank of St.
Louis.3 The implications of the analysis also are
Economic forecasts have always been a critical applied
to the federal budget outlook.
part of the budget process. One can see, however,
how their importance is magnified in an inflationswollen economy. A re-estimate of GNP growth by MONETARY ANALYSIS AND
only 1 percent, for example, results in a change of THE ECONOMIC REPORT
$13 billion in federal budget receipts within two
The Economic Report of the President and The
years.2 In addition, federal expenditures in recent
years have become more sensitive to the pace of Annual Report of the Council of Economic Advisers
inflation and output, as the num ber of inflation- (CEA Report) together provide a concise summary of
indexed programs and income-security programs, the economic philosophy behind the adm inistra­
which automatically change in response to economic tion’s decision-making. President Reagan’s report
devotes relatively little space to the subject of
conditions, has increased.
monetary policy, although the president states sup­
Aside from the budget issue, the administration’s port for “ . . . a policy of gradual and less volatile
projections are of general interest because they reduction in the growth of the money supply.”4 This
reflect the philosophy that guides the administra­ support contrasts with President Carter’s statem ent a
tion’s economic policies. This year’s budget and year earlier “ . . . that public opinion not hold the
economic report provide the first detailed statement Federal Reserve to such a rigid form of monetary
of the administration’s economic philosophy. One targeting as to deprive it of the flexibility it needs to
key difference from the previous administration’s conduct a responsible monetary policy.”5
philosophy is in the interpretation and role of mone­
tary actions in the determination of economic events.
The most explicit discussion of the role of mone­
tary actions in the ad m in istratio n ’s econom ic
framework is in the CEA Report. For example, in the
opening chapter, which summarizes current eco­
1Budget o f the United States Government for Fiscal Year 1983 nomic conditions, the CEA singles out the varying
(hereafter referred to as Fiscal 1983 Budget) and the 1982
Economic Report o f the President, which also includes the 1982
Annual Report of the Council of Economic Advisers (hereafter
referred to as CEA Report).
2See Fiscal 1983 Budget, p. 2:9.




3For details of this model, see the appendix.
41982 Economic Report o f the President, p. 8.
s1981 Economic Report o f the President, p. 13.
3

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

and generally restrictive rate of monetary expansion
as the chief culprit responsible for the economy’s
unsatisfactory performance in the 1979-81 period.
The CEA goes on to say that “continued monetary
restraint and a reduction of the within-year vari­
ability of money growth . . . are necessary both to
reduce inflation and provide the basis for sustained
economic growth.”6
The CEA Report’s overall theme is that the federal
government’s role in economic affairs should be
reduced. Consistent with that them e is a program to
control inflation, which, as the CEA states forcefully,
is essentially a monetary phenomenon. Thus, . . a
decrease in money growth is the necessary strategy
to end inflation.”7 In light of the important role that
expectations play in the inflationary process, the
CEA is very specific: “For the Federal Reserve, this
means setting money growth targets consistent with
a sustained decrease in the rate of inflation and then
adhering to those targets.”8
After establishing these guidelines for an antiinflationary monetary policy, the CEA details the
economic prospects for 1982, 1983 and beyond.
Assumptions about money growth, however, do not
play an explicit role in its economic forecasts. In­
stead, the CEA’s forecasts follow the traditional
“ adding-up” approach typical of previous CEA
Reports; that is, the activity of individual sectors are
forecast and summed to obtain an aggregate forecast.
Oddly enough, the CEA, after em phasizing the con­
nection betw een money growth and nominal magni­
tudes like GNP and the price level, and recognizing
the relationship betw een deviations of m oney
growth from trend and the movements ot real GNP,
slights the role of money growth in their projections,
particularly for 1982 and 1983.9
61982 CEA Report, pp. 24-25.
’ Ibid., p. 55.
aIbi(L, pp. 59-60.
9The CEA attempts to correct for this oversight. It notes that:
Concerns have been expressed that the Federal Reserve’s targets
for money growth are not compatible with the vigorous upturn in
economic activity envisioned late in 1982. . . We believe that such
fears, while understandable on the basis of recent history and
policies, are unjustified in light of current policies and the Admin­
istration’s determination to carrv them through. (1982 CEA Report,
p. 25.)

This statement contrasts sharply with a statement found else­
where in its report:
Indeed, changes in the trend of the growth rate of nominal GNP
over the period 1960 to 1981 are almost entirely attributable to
changes in the trend of the growth rate of the money stock (M l), as
opposed to changes in the trend of the growth rate of velocity (Chart
3-3). (1982 CEA Report, p. 63.)


4


ADMINISTRATION ECONOMIC
PROJECTIONS
E ver since enactm ent of the C ongressional
Rudget and Im poundm ent Control Act of 1974
(hereafter referred to as the Control Act), the in­
cum bent administration has been required each year
to present five-year projections ofthe federal budget.
Thus, the current budget and econom ic reports
cover the period through 1987.
The administration also must set five-year num er­
ical goals for several key economic indicators under
the provisions of the Full Em ployment and Ralanced Growth Act of 1978 (Humphrey-Hawkins).
This act originally specified the following goals: an
unemploym ent rate of 4 percent and a rate of in­
crease in consumer prices of 3 percent by 1983, and
an interim goal for federal outlays to equal 21
percent of GNP by 1981. However, the act allowed
a change in this tim etable if deem ed necessary, and,
in January 1980, President Carter extended the
timetables for unemploym ent to 1985 and for infla­
tion to 1988.

A Review o f Previous Long-Term
Projections
Incum bent administrations have been presenting
long-term economic projections since the passage of
the Control Act in 1974. Table 1 summarizes these
projections.10 They represent the efforts of three
different administrations: President Ford’s.in 197577, President C arter’s in 1978-81 and President
Reagan’s in early 1982.
The table indicates that, for each administration,
the one-year forecasts have been quite accurate for
all of the indicators.11 In fact, the record for GNP is
good as far as four years ahead. For all the other major
indicators, the forecasts tend to deteriorate beyond
the two-year horizon. This may reflect the practice
10The table is limited to the official reports published in January
or February of each year and thereby excludes revised esti­
mates when a new administration comes into power and those
contained in the mid-session review of the budget.
11The root-mean-squared errors for table 1 are as follows:
Real
GNP
Unemployment
GNP GNP deflator
rate
1 year ahead
0.92
1.00
0.97
0.22
2 years ahead
1.01
1.32
1.72
0.45
3 years ahead
1.14
2.77
1.16
2.6.3
4 years ahead 0.98
3.72
.3.59
1.75
5 years ahead 2.46
4.45
4.88
1.97
6 years ahead 2.16
5.16
5.10
2.22

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

Table 1
Administration Economic Projections (percent)
Date of forecast

1975

1976

1977

1978

1979

1980

10.8

1981

1982

1983

1984

1985

1986

1987

G NP

Early 1975

7.2

1976

12.6

12.4

12.0

10.8

12.4

12.2

12.4

11.9

10.9

9.1

11.0

11.3

11.6

10.5

7.9

6.4

11.0

11.2

10.8

10.5

9.6

11.3

9.5

10.1

9.4

7.9

6.3

8.3

10.7

12.8

12.9

12.0

11.0

11.4

13.1

12.3

11.8

11.0

10.2

8.1

11.5

10.2

9.7

9.2

1977
1978
1979
1980
1981
1982
A ctua l1

8.0

12.4

12.0

8.8

8.5

9.0

11.4

10.9

11.6

4.8

5.6

6.5

6.5

6.5

6.2

5.7

5.9

6.5

6.5

4.9

5.2

5.1

5.9

5.5

3.9

3.5

4.7

4.8

4.8

5.0

4.7

4.2

3.3

2.5

4.2

4.7

4.4

3.4

-0 .6

1.7

4.3

5.0

4.9

0.9

3.5

3.5

3.7

3.7

3.7

0.2

5.2

5.0

4.7

4.4

Real G NP

Early 1975

-3 .3

1976
1977
1978
1979
1980
1981
1982
A ctua l1

-1 .1

5.4

5.5

4.8

3.2

-0 .2

4.0

4.7
4.3

2.0

Price d eflato r

Early 1975

10.8

1976

7.5

6.5

5.1

4.1

5.9

6.2

6.1

5.0

4.2

4.0

5.6

5.9

5.4

4.7

3.8

2.8

6.1

6.2

5.7

5.2

4.7

4.2

7.7

6.8

5.7

4.5

3.4

2.8

8.9

8.8

8.2

7.4

6.8

6.1

10.5

9.3

8.5

7.8

7.0

1977
1978
1979
1980
1981
1982
A ctua l1

7.9
9.3

5.2

6.0

5.0

4.7

6.3

4.6

4.5

5.8

7.3

8.5

9.0

9.2

7.9

7.5

6.9

6.2

5.5

7.7

6.9

6.4

5.8

5.2

4.9

7.3

6.6

5.7

4.9

4.8

4.7

6.3

5.9

5.4

5.0

4.5

4.1

6.0

6.2

5.7

4.9

4.2

4.0

7.0

7.4

6.8

5.9

5.1

4.3

7.8

7.5

7.1

6.7

6.3

6.0

7.1

6.4

5.8

Unem ploym ent rate

Early 1975

8.1

1976
1977
1978
1979
1980
1981
1982
A ctua l1

8.9
8.5

7.7

7.1

6.1

5.8

7.1

7.9

5.3

7.6

1As of February 1982




5

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

economic policies. According to the most recent
CEA report, “The events of the past 15 years are a
good illustration of the danger of pursuing economic
policies based on short-run analysis and focused on
immediate problems. Sound policy requires em ­
phasis on a time horizon during which the some­
times lengthy, and usually unpredictable, lags in
economic processes can work.”12

C h a rt 1

Inflation an d U n em p lo y m e n t
In f la t io n ro te LL
P trC S lt

lAnm m l

Current Projections

0

((

3

4

5

6

7

8

9

U n e m p lo ym e n t rate 12
Percent
S o u r c 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 tm e n t o f L a b o r
L i P e r c e n t a g e c h a n g e in th e G N P i m p l i c i t p r i c e d e f l a t o r .
[2^ P e r c e n t o f c i v i l i a n

l a b o r fo r c e .

whereby assumptions for the current and next year
are called “forecasts,” but beyond the next year are
labeled “projections consistent with moving grad­
ually toward relatively stable prices and maximum
feasible employment.” For the longer term, these
projections seemingly ignore or seriously misjudge
some fundamental economic constraints.
The failure of the U.S. economy to achieve relative
price stability and “full employment” is obvious
when one compares the projection record for these
two indicators with actual performance. (For addi­
tional historical perspective, see chart 1.) Since the
start of publishing long-term projections, each ad­
ministration has projected a general decline of both
inflation and unemployment. The actual perform­
ance of the economy, of course, has been far different.
Though the rate of inflation declined from 1975 to
1976, it has accelerated on an annual average basis
each year since then. The unem ploym ent rate did
fall from 1975 through 1979, but since then has risen
sharply. Such persistent forecast errors are probably
a reflection of the fact that each administration gives
insufficient weight to the long-term effects of its



Table 2 summarizes the Reagan adm inistration’s
economic projections. The nominal GNP goal for
fourth quarter 1987 is $5,248 billion, which would
mean a 9.8 percent average annual rate of increase
from 1981 to 1987. This rate would be distributed as
a 4.4 percent rate of expansion in real GNP and a 5.2
percent rate of increase in the GNP deflator. In 1987,
according to these projections, real GNP would be
growing at a 4.3 percent rate, the GNP deflator would
be rising at a 4.4 percent rate and the unemployment
rate would decline to 5.2 percent by the fourth
quarter.
As a part of its program, the administration has
proposed a budget plan aim ed at a year-by-year
reduction in the size of the federal deficit. Federal
outlays are projected to decline to 19.7 percent of
GNP in fiscal 1987 compared with an estimated 23.5
percent in fiscal 1982. More importantly, however,
the administration announced its support of a m one­
tary policy that will produce continued gradual
reductions in the rate of monetary growth.
F ro m th e fo u rth q u a rte r o f 1979 to th e fo u rth
q u a rte r of 1980, M l (cu rren cy p lu s c h eck a b le d e ­
posits) g rew at a 7.3 p e rc e n t an n u al rate. T h e A d m in­
istration assum es a g radu al b u t stead y red u c tio n in
th e grow th o f m on ey to o n e -h alf th a t rate b y 1986.13

The CEA notes that inflationary expectations must
adjust speedily to the anti-inflationary monetary
regime in order to attain these economic goals.14

A MONETARY ANALYSIS OF
ADMINISTRATION PROJECTIONS
In sharp contrast to previous administrations, the
present administration has explicitly spelled out a
target path for monetary growth. It is therefore of
121982 CEA Report, pp. 49-50.
l3Ibicl„ p. 206.
14Ibid., p. 26.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

Table 2
Administration’s Economic Projections: 1982-87 (from
fiscal 1983 budget)1
GNP
(billions of
dollars)
IV/1981 Actual

Real GNP
(billions of
1972 dollars)

Prices
(1972=100)

Unem ploym ent
rate

M1
(billions of
dollars)

$2995
(9.7)

$1498
(0.8)

200.0
(8.8)

8.4%

IV/1982

3307
(10.4)

1543
(3.0)

214.4
(7.2)

8.4

457.4
(4.7)

IV/1983

3671
(11.0)

1623
(5.2)

226.2
(5.5)

7.6

477.9
(4.5)

IV/1984

4038
(10.0)

1702
(4.9)

237.2
(4.9)

6.8

498.1
(4.2)

IV/1985

4417
(9.4)

1781
(4.6)

248.1
(4.6)

6.2

517.8
(4.0)

IV/1986

4819
(9.1)

1857
(4.3)

259.5
(4.6)

5.6

537.0
(3.7)

IV/1987

5248
(8.9)

1937
(4.3)

270.9
(4.4)

5.2

555.5
(3.4)

1981-87

(9.8)

(4.4)

(5.2)

6.6

(4.1)

$436.7
(5.0)

NOTE: All GNP data adjusted to February 1982 revision of NIA accounts; M1 reflects revision
of February 1982. M1 figures correspond to m onetary policy assum ption stated in the
1982 CEA Report.
'Rates of change in parentheses.

interest to see how the administration’s projections
compare with those derived from an explicitly mone­
tarist model. The framework used for this compar­
ison is a revised and updated version of the “ St.
Louis model.”15
According to the St. Louis model, nominal GNP is
determ ined directly by a reduced-form equation
relating the percent change in GNP to current and
past changes in money (M l) and high-employment
federal expenditures (national income accounts
basis). Estimates of this equation indicate that the
growth of federal spending has little net effect on
GNP over a period of a year or m ore.16 The primary
factors affecting GNP growth are the rate of change
of money and trend velocity, as em bodied in the
coefficients of the equation.

The change in GNP is distrib u ted betw een
changes in the price level and output via a price
equation. The price equation specifies the percent
change in the GNP deflator as a function of energy
prices, demand pressure and the recent history of
price change.17 Over the long run, the estimated
change in the price level is dominated by the trend of
money growth. Given the change in GNP and the
change in the price level, the change in output is
found via the GNP identity; that is, GNP equals
price level times output.
The unem ployment rate also is solved for as a part
of the St. Louis model. Estim ated changes in output
along with assumptions about the growth of poten­
tial output provide the basis for calculating the
unemploym ent rate via Okun’s Law.18

15For a discussion of the original model, see Leonall C. Andersen
and Keith M. Carlson, “A M onetarist Model for Economic
Stabilization,” this Review (April 1970), pp. 7-25. For a detailed
summary of the model in revised and updated form, see the
appendix.
18For a recent study of the impact of fiscal actions on GNP, see R.
W. Hafer, “The Role of Fiscal Policy in the St. Louis Equation,”
this Review (January 1982), pp. 17-22.

17For a further discussion of the role of energy prices in the
determination of the price level, see John A. Tatom, “Energy
Prices and Short-Run Economic Performance,” this Review
(January 1981), pp. 3-17.
18Arthur M. Okun, “Potential GNP: Its M easurem ent and Sig­
nificance,” 1962 Proceedings o f the Business and Economic
Statistics Section o f the American Statistical Association, pp.
98-104.




7

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

Table 3
St. Louis Model Projections for 1976-81: An Ex Post Comparison
Adm inistration Projections as of Mid-1977

GNP

Real GNP

Prices

Unem ploym ent rate

M1

1976 Actual
1977

11.6%

6.0%

5.3%

7.7%

11.3

5.1

5.9

7.0

e xp licit

1978

11.9

5.3

6.3

6.3

assum ption

1979

11.3

5.0

6.1

5.7

1980

10.6

5.2

5.1

5.2

1981

9.8

4.9

4.3

4.8

1982

8.6

4.3

4.2

4.5

11.0

5.1

5.5

6.1

1976-81

No

1977 St. Louis M odel Projections with Adm inistration G N P Path

GNP

Real GNP

Prices

Unem ploym ent rate

M1

1976 Actual

11.6%

6.0%

5.3%

7.7%

1977

11.2

5.2

5.7

7.1

6.8

1978

12.1

5.7

6.1

6.1

7.7

1979

11.1

4.5

6.5

5.7

7.8

1980

10.7

2.9

7.6

5.6

6.8

1981

9.7

0.5

9.1

6.5

6.0

1982

8.7

-0 .8

9.5

8.2

5.1

11.0

3.8

7.0

6.5

7.0

1976-81

5.1%

A ctual Perfo rm ance Using D ata as of F ebruary 1982

GNP

Real GNP

Prices

Unem ploym ent rate

M1

1976 Actual
1977

10.9%

5.4%

5.2%

7.7%

11.6

5.5

5.8

7.1

7.7

1978

12.4

4.8

7.3

6.1

8.2

1979

12.0

3.2

8.5

5.8

7.8

1980

8.8

-0 .2

9.0

7.1

6.3

1981

11.4

2.0

9.2

7.6

6.9

1976-81

11.2

3.0

7.9

6.9

7.4

5.7%

NOTE: Adm inistration and St. Louis Model projections taken from November 1977 Review.

To illustrate the projection performance of the St.
Louis model, table 3 presents an ex post summary of
projections made in this Review in the fall of 1977.19
The relevant projection period at that time was 197781. The administration’s GNP projections at that
time implied a path of declining growth in money, a
19Keith M. Carlson, “ Economic Goals for 1981: A Monetary
Analysis,” this Review (November 1977), pp. 2-7. The major
differences in the model used at that time and the version
described in the appendix are in the treatm ent of energy prices
and the adjustm ent for serial correlation.
8



path that was used in simulating the St. Louis model.
Since the actual path of monetary expansion was
similar to that assumed in simulating the model and
that implicit in the administration’s projections, the
growth of GNP was forecast with considerable
accuracy by both the administration and the model.
There w ere differences, however, betw een the
administration’s and the St. Louis m odel’s forecasts
for real GNP, the price level and the unem ploym ent
rate, particularly after 1978. In contrast to the ad­
ministration’s forecast, the model projected a slow­

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

Table 4
St. Louis Model Simulations: 1982-87 (assuming
administration’s GNP path)1
GNP
(billions of
dollars)
IV/1981 Actual

Real GNP
(billions of
1972 dollars)

Prices
(1972=100)

Unem ploym ent
rate

M1
(billions of
dollars)

$2995
(9.7)

$1498
(0.8)

200.0
(8.8)

8.4%

$436.7
(5.0)

IV/1982

3306
(10.4)

1538
(2.7)

215.1
(7.5)

8.8

471.2
(7.9)

IV/1983

3670
(11.0)

1603
(4.3)

229.1
(6.5)

8.1

507.0
(7.6)

IV/1984

4037
(10.0)

1662
(3.7)

243.2
(6.2)

7.7

540.0
(6.5)

IV/1985

4416
(9.4)

1720
(3.5)

257.1
(5.7)

7.5

572.9
(6.1)

IV/1986

4819
(9.1)

1787
(3.9)

270.2
(5.1)

7.2

606.7
(5.9)

IV/1987

5249
(8.9)

1861
(4.1)

282.8
(4.6)

6.8

641.3
(5.7)

1981-87

(9.8)

(3.7)

(5.9)

7.7

(6.6)

’ Rates of change in parentheses.

ing in output and an acceleration of the price level in
the latter part of the period, both of which occurred.

The results of this simulation, shown in table 4,
should be compared with those in table 2. It should
be noted first that the path of money growth required
to attain the administration’s projected GNP path is
substantially higher than what they explicitly state
Simulation Using Administration
as
desired. Assuming that this GNP path is attained,
GNP Growth Path
however, the St. Louis model indicates that the
The first issue addressed here is the feasibility of administration’s projections are indeed optimistic.
the output and inflation scenarios. The analysis does The model indicates an unem ploym ent rate of 6.8
not, at this point, examine the question whether percent in late 1987 in contrast to the adm inis­
GNP can be attained with the administration mone­ tration’s projected 5.2 percent rate, with annual real
tary assumptions; it focuses exclusively on its pro­ growth averaging 0.7 percent lower for the model
jections of inflation and output growth, given its path simulation. The model is also more pessimistic on
for the growth of GNP. The assumptions used for the inflation, indicating an annual average inflation rate
other exogenous variables in the St. Louis model are of 5.9 percent instead of the administration’s esti­
as follows: potential GNP is assumed to grow 3.3 mated 5.2 percent.
percent per year from late 1981; growth in highemployment federal expenditures is projected at 6.3 Alternative Simulations
percent per year; and the change in the relative price
Since the adm inistration explicitly supports a
of energy is assumed to be zero.20
monetary policy of gradual reduction in the rate of
monetary growth, the results of this scenario, in
20These assumptions are designed to be consistent with the ad­ which M l growth is reduced gradually and steadily
ministration’s, even though they do not provide specific esti­
mates of these variables in either the CEA Report or the Fiscal to a 3.7 percent rate in 1986, are summarized in table
1982 Budget. For a discussion of prospects forreal GNP growth, 5. All other assumptions are the same as in the
previous simulation.
see 1982 CEA Report, pp. 115-17.



MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

As might be expected, the model shows a growth
rate of nominal GNP much less than the adminis­
tration has projected (compare with table 2). The
CEA is aware of this discrepancy, but does not ex­
plain why the assumed growth of velocity should far
exceed its historical rates of growth (see chart 2).21
For this scenario of a gradual reduction of money
growth, the model indicates that the administration’s
inflation goal is easily achieved; in fact, the simulated
inflation rate falls well below the administration’s
projected rate after 1983.22 The simulated path for
real GNP, however, is considerably different than
the administration has projected. In the early years,
1982-84, the model simulates much slower output
growth, followed by faster growth in the later years.
As a result, the simulated unem ploym ent rate is still
at a high 6.9 percent in late 1987 compared with an
administration estimate of 5.2 percent.
Finally, a third simulation was run, based on a
constant 5 percent annual growth in money through
1987. The results are shown in table 6. This steady
money growth path comes closer to attaining both of
the adm inistration’s inflation and unem ploym ent
goals than either of the simulations summarized in
tables 4 and 5. With steady 5 percent money growth,
inflation averages 3.9 percent per year for the pro­
jectio n period, and the unem ploym ent rate is
brought to near 6 percent by late 1987.

C h a rt 2

R ate o f C h a n g e of M l V e lo c ity 11

LL D a ta a r e t w o - y e a r r a te s o f c h a n g e , u s in g fo u r th q u a r t e r d a t a . D a s h e d l i n e is i m p l i c i t in
a d m in is t r a t io n p r o je c tio n s . V e lo c ity is G N P d i v i d e d b y M l .

The more fundamental question yet to be an­
swered is how the administration expects GNP to
Money Growth and the Administration's grow rapidly if money growth gradually declines.
With the administration making explicit statements
Projections: The Basic Conjiict
about interest rates falling in future years, appar­
The administration has emphasized that it is im­ ently the result of declining inflation, velocity
portant to establish credibility in economic policy in growth might be expected to slow rather than accel­
order to “ break the back” of inflation expecta­ erate. Furthermore, velocity growth historically has
tions. Behind this strategy is the presumption that, if been remarkably stable over time, an observation
inflation can be reduced more rapidly than past that the CEA itself has em phasized.23 Thus, while
relationships would indicate (e.g., faster than is the output-inflation breakdown of GNP in the St.
em bodied in the estimates from St. Louis model), Louis model may be open to question, there seems to
greater output growth would result. This prospect be little reason to question its GNP projections.
would produce a brighter outlook for the interim
years than shown in the simulations em ploying THE FEDERAL BUDGET OUTLOOK
gradual money reduction (table 5). There is little AND
ECONOMIC PROJECTIONS
likelihood, however, that the unem ploym ent rate
would be reduced to as low as the administration’s
The administration’s economic projections are of
estimate of 5 percent.
interest because they indicate how the nation’s
economic welfare can be expected to change in
coming years. They are also of interest because of
21See footnote 9.
their impact on estimates of the budget deficit. The
22Over the long run in the St. Louis model, the inflation rate
approxim ates the rate of m onetary grow th. Prior to the
achievem ent of this equilibrium, however, the St. Louis model
oscillates.

Digitized for 10
FRASER


23See footnote 9.

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Table 5
St. Louis Model Simulations: 1982-87 (assuming
declining growth rate of money from 5.0 percent rate in 1981-82)1
GNP
(billion s of
dollars)

Real GNP
(billions of
1972 dollars)

Prices
(1972=100)

$2995
(9.7)

$1498
(0.8)

200.0
(8.8)

8.4%

IV/1982

3227
(7.7)

1501
(0.2)

215.0
(7.5)

9.7

457.4
(4.7)

IV/1983

3472
(7.6)

1528
(1.8)

227.3
(5.7)

9.9

477.9
(4.5)

IV/1984

3727
(7.3)

1581
(3.5)

235.8
(3.7)

9.7

498.1
(4.2)

IV/1985

3989
(7.0)

1659
(4.9)

240.7
(2.1)

9.0

517.8
(4.0)

IV/1986

4259
(6.8)

1754
(5.8)

242.9
(0.9)

8.0

537.0
(3.7)

IV/1987

4534
(6.5)

1860
(6.0)

244.0
(0.4)

6.9

555.4
(3.4)

1981-87

(7.2)

(3.7)

(3.4)

8.9

(4.1)

IV/1981 Actual

U nem ploym ent
rate

M1
(billion s of
dollars)
$436.7
(5.0)

1Rates of change in parentheses.

Table 6
St. Louis Model Simulations: 1982-87 (assuming
steady growth rate of money of 5.0 percent)1
GNP
(billion s of
dollars)

Real GNP
(billions of
1972 dollars)

Prices
(1972=100)

Unemploym ent
rate

M1
(billion s of
dollars)

$2995
(9.7)

$1498
(0.8)

200.0
(8.8)

8.4%

IV/1982

3233
(8.0)

1504
(0.4)

215.0
(7.5)

9.6

458.6
(5.0)

IV/1983

3495
(8.1)

1537
(2.2)

227.5
(5.8)

9.7

481.5
(5.0)

IV/1984

3779
(8.1)

1580
(4.0)

236.6
(4.0)

9.3

505.6
(5.0)

IV/1985

4085
(8.1)

1683
(5.3)

243.0
(2.7)

8.4

530.8
(5.0)

IV/1986

4416
(8.1)

1784
(6.0)

247.7
(2.0)

7.3

557.4
(5.0)

IV/1987

4774
(8.1)

1895
(6.2)

252.3
(1.8)

6.1

585.3
(5.0)

1981-87

(8.1)

(4.0)

(3.9)

8.4

(5.0)

IV/1981 Actual

$436.7
(5.0)

’ Rates of change in parentheses.




11

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Table 7
Alternative Budget Estimates: Fiscal 1987 (billions of dollars)
Receipts
Adm inistration estimates from
fiscal 1983 budget

Outlays

Surplus/D eficit

$926

$979

$ -5 3

St. Louis model sim ulation using
adm inistration's GNP path

926

1028

-1 0 2

St. Louis model sim ulation assuming
declining grow th rate of money

781

925

-1 4 4

St. Louis model sim ulation assuming
steady 5 percent grow th of money

829

940

-11 1

At the same time, federal outlays have become
increasingly sensitive to variations in economic
activity. The usual effect via unem ploym ent insur­
ance continues to operate, but, like the revenue side,
a given unem ploym ent rate now involves a greater
amount of dollar expenditures than before. In addi­
tion, automatic changes in outlays for a num ber of
welfare programs occur when the economy slows
down or speeds up. In fact, approximately 30 percent
Economic Activity and the Budget
of federal outlays now are indexed to inflation.
Although the effect of the budget on economic Finally, interest payments on the national debt, an
growth is still an open issue, there is no question that important endogenous component of the budget,
the budget is sensitive to the pace of economic ac­ reflect both the size of the deficit and the level of
tivity. This relationship received added emphasis in interest rates.
this year’s budget docum ent as budget figures
appear to have become more and more sensitive to Budget Implications of
economic conditions.
Alternative Simulations
In prior years, analyses of the connection betw een
To examine the sensitivity of budget estimates to
the budget and the economy focused on government
revenues. Given our tax laws, different revenue alternative economic assumptions, budget equa­
estimates depend on the assumptions made about tions were added to the St. Louis model. The growth
GNP and such related indicators as wages and of receipts was specified as a function of the growth
salaries, and corporate profits. The relationship still of nominal GNP, using the elasticity im plied in the
holds, of course, but the size of today’s economy is so administration’s budget document.25 The growth of
large that a given growth rate of GNP translates into a outlays was expressed as a function of the growth of
much different dollar amount of federal revenues output and the rise in prices, again using the relevant
than it did just a few years ago. This relationship elasticities from the budget document.
betw een GNP and government revenues is impor­
Table 7 summarizes the budget results for fiscal
tant because public attention seems to focus on the 1987 for all three simulations. Only results for fiscal
dollar size of the federal deficit.

size of prospective deficits has become an issue
among economic analysts, presumably because they
consider it an indicator of the government’s impact
on credit markets and, thus, on long-term economic
growth.24 However, as is shown below, the process
of estimating the deficit is an imprecise exercise.

24Such an effect is not in the St. Louis model; incorporation of this
presum ed relationship betw een the size of the deficit and the
rate of economic growth would require specifying potential
output as a function of either the size of the deficit or the size of
government. The only role for federal deficits in the St. Louis
model is their possible relationship to the rate of money growth.
Digitized for 12
FRASER


25Fiscal 1983 Budget, pp. 2:6-13. The im plied elasticities are
found by com paring the budget effects of three econom ic
scenarios. These scenarios are higher inflation/same growth,
higher growth/lower inflation, and lower growth/higher infla­
tion, w ith all alternatives defined w ith reference to the
administration’s basic economic projections (summarized in
table 2).

FEDERAL RESERVE BANK OF ST. LOUIS

1987 are given to ease the comparison of alternative
policy scenarios. Moreover, focusing on 1987 illus­
trates the imprecision that encompasses any budget
estimates, because a small change in growth rates can
translate into a difference of many billions of dollars.
All sim ulations assume that the basic proposals
contained in the fiscal 1983 budget are enacted.26
The differences in results reflect only the impact of
differing economic assumptions.
The first simulation, using the administration’s
GNP path as shown in table 4, yields a deficit of $102
billion; the administration estimates $53 billion.
The estimate for receipts is the same as the adm in­
istration’s because the growth of nominal GNP is the
same. Outlays are higher for this simulation because
of higher inflation estimates, which push up outlays
for indexed programs, and lower real growth esti­
m ates, w hich boost outlays for unem ploym ent
com pensation and other unem ploym ent-related
welfare programs.
The second simulation, based on a gradual re­
duction of money growth (see table 5), yields a much
larger deficit in 1987 than the administration pro­
jects. Outlays are less than projected by the admin­
istration because inflation is slower, but receipts fall
26This also assumes the Economic Recovery Tax Act of 1981 is left
intact. The basic proposals them selves have been revised since
February, but details await the outcome of negotiations be­
tw een Congress and the administration. The purpose of the
estimates presented here is to illustrate the budget impact of
alternative economic assumptions without actually attempting
to forecast the size of the deficit.




MAY 1982

even more sharply because the growth of nominal
GNP is much less rapid. As a result, the deficit is
estimated at $144 billion for 1987 — despite the
incorporation of the administration’s proposals to
reduce government programs in the 1983 budget.
The third simulation, based on steady 5 percent
money growth (see table 6), yields a slightly larger
deficit than the simulation using the administration’s
GNP path. However, both outlays and receipts are
lower than in that case.

SUMMARY AND CONCLUSIONS
The administration has presented a controversial
set of economic assumptions and budget projections
for the years through 1987. Some simulations of a
monetarist model, however, demonstrate that the
adm inistration’s projections contain fundamental
inconsistencies. Based on U.S. economic experience
since 1960,
(1) the administration’s estimates for GNP growth are
inconsistent with its stated monetary targets; and
(2) given its GNP growth path, its estimates of real
growth, unemployment and, to a lesser extent, infla­
tion appear too optimistic.
These conclusions also indicate that the admin­
istration’s estimates of the size of the federal deficit
are imprecise. Given the administration’s budget
plan, the pattern of declining growth in money that it
supports will result in a deficit of about $144 billion
in 1987, $93 billion more than is projected in the
fiscal 1983 budget.

13

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Appendix
Revised Form of St. Louis Model

1

The version of the St. Louis model used for the slack variable is entered in real rather than nominal
simulations in this article is summarized in table 1, terms; and (3) where relevant, the m odel’s equations
with the coefficients given in table 2. Equations 1, 2 have been corrected for serial correlation problems.
and 4 are estimated with Almon constraints on the
coefficients. Equation 1 is estim ated with ordinary
least squares. Three characteristics differentiate this 'F o r further discussion, see Keith M. Carlson and Scott E. Hein,
“An Analysis of a Modified St. Louis M odel,” a paper prepared
model from the original version published in 1970: for
the Spring Conference on Comparing the Predictive Per­
(1) most variables are entered in rate-of-change form formance
of Macroeconomic Models at Washington University
rather than first-difference form; (2) the dem and in St. Louis (April 20, 1982).

Table 1

Table 2

The Model

In-Sample Estimation: 1/1960-IV/1980
(absolute value of t-statistic in
parentheses)

(1) Y, = C 1 +

2 CMj (M,.j) +
i= 0

4
(2) P, = C2 + 2 CPE, (PE,.j) +
1=1

2 CE; (E,_i) + el,
i= 0
5
2 CDi (X,. - XF,V)
i= 0

(1) Y, = 2.44 + 0.40 M, + 0.39 M,., + 0.22 M,.2 + 0.06 fClt.3
(2.15) (3.38)
(5.06)
(2.18)
(0.82)
- 0.01 M,_4 + 0.06 f£, + 0.02 Em - 0.02 E,_2
(0.11)
(1.46)
(0.63)
(0.57)

+ CPA (PA,) + CDUM1 (DUM1)
+ CDUM2 (DUM2) + e2,

- 0.02 E,_3 + 0.01 E,_4
(0.52)
(0.34)

21
(3) PA, =

2

CPRL,(PH)

i= 1

(4) RL, = C3 +

20
2 CPRL, (P,.;) + e3,
i= 0

(5) U, - UF, = CG (GAP,) + CG1 (GAP,.,) + e4,

R 2

= 0.39

SE = 3.50

DW = 2.02

(2) P, = 0.96 + 0.01 PE,., + 0.04 PE,.2 - 0.01 PE, .3
(2.53) (0.75)
(1.96)
(0.73)
+ 0.02 PEt.4 - 0.00 (X, - XF,*) + 0.01 (X,., - X F *,)
(1.38)
(0.18)
(1.43)

(6) Y, = (P,/100) (X,)
(7) Y, = ( (Y^Y,.,)4 - 1) 100
(8) X, = ( (X,/X,.,)4 - 1) 100
(9) P, = ( (P,/P,.1)4 - 1) 100
(10) GAP, = ( (XF, - X,)/XF,) 100
(11) XF* = ( (XF,/X,.,)4 - 1) 100

+ 0.02 (X,.2 - XFt*.2) + 0.02 (Xt_3 - XFf. 3 )
(4.63)
(3.00)
+ 0.02 (X,_4 - XF,*4) + 0.01 (X, 5 - XFt*5) + 1.03 (PA,)
(2.42)
(2.16)
(10.49)
- 0.61 (DUM1t) + 1.65 (DUM2t)
(1.02)
(2.71)
R2 = 0.80

Y
M
E
P
PE
X
XF
RL
U
UF
DUM1
DUM2

=
=
=
=
=
=
=
=
=
=
=
=

nom inal GNP
money stock (M1)
high em ploym ent expenditures
GNP deflator (1972 = 100)
relative price of energy
ou tput in 1972 dollars
potential ou tput (Rasche/Tatom)
corporate bond rate
unem ploym ent rate
unem ploym ent rate at fu ll employment
con tro l dumm y (111/1971-1/1973 = 1; 0 elsewhere)
post control dum m y (1/1973-1/1975 = 1; 0 elsewhere)

Digitized for 14
FRASER


SE = 1.28

(4) RLt = 2.97 + 0.96

DW = 1.97

p = 0.12

DW = 1.76

p = 0.94

20
2 P,.,
i= 0

(3.12) (5.22)
R2 = 0.32

SE = 0.33

(6) U, - UFt = 0.28 (GAP,) + 0.14 (GAP,.,)
(11.89)
(6.31)
R 2 = 0.63 SE = 0.17 DW = 1.95 p i = 1.43 pz = 0.52

Short-Run Money Growth Fluctuations
and Real Economic Activity: Some
Implications for Monetary Targeting
DALLAS S. BATTEN AND R. W. HAFER
h er e is ample evidence that the rate of infla­
tion is directly related to the long-term growth of the
money supply. Indeed, this relationship has been
demonstrated for various countries.1 The implica­
tion of this finding is that the control of money
growth over the long term is vital to the control of
inflation, a realization that undoubtedly helps to
explain the fairly recent announcements of monetary
growth targets in m ost of the major industrial
countries.2
Although the money growth/inflation connection
is fairly well-documented, the relationship between
short-run movements in money growth and eco­
nomic activity is less well-known. Even though this
connection has been demonstrated for the United
States, its general applicability has not been tested.3
The purpose of this article, therefore, is to in­
vestigate the relatio n sh ip b etw een short-run
movements in the growth of the money stock and

T

'D allas S. Batten,“Money Growth Stability and Inflation: An
International Comparison,” this Revieiv (October 1981), pp. 712. See also Richard T. Selden, “Inflation and Monetary Growth:
Experience in Fourteen Countries of Europe and North America
Since 1958,” Federal Reserve Bank of Richmond Economic
Review (November/December 1981), pp. 19-35.
zO f the Group of Ten countries plus Switzerland, only two,
Belgium and Sweden, do not formally announce monetary
growth targets of some kind. See Organization for Economic
Co-operation and Development, Monetary Targets and Inflation
Control (Paris:OECD, 1979).
3Milton Friedman and Anna J. Schwartz, “ Money and Business
Cycles,” Revieiv o f Economic* and Statistics (February 1963),
pp. 32-78; W illiam Poole, “The R elationship of M onetary
Decelerations to Business Cycle Peaks: Another Look at the
Evidence,” Journal of Finance (June 1975), pp. 697-712; and
Leonall C. Andersen and Keith M. Carlson,“A M onetarist Model
for Economic Stabilization,” this Review (April 1970), pp. 7-25.



fluctuations in real economic activity.4 Although
the evidence presented in this article is not de­
rived from a rigorous empirical analysis, it indicates
quite convincingly that virtually every downturn
in economic activity in recent years in each of the
countries examined was preceded by a significant
reduction in the growth of its narrowly defined
money supply.

MONEY AND ECONOMIC ACTIVITY:
THE THEORY
T here is little disagreem ent that significant
changes in the growth of the money supply influence
economic activity. Changes in the long-term growth
of money, measured by some moving average of
money growth over a num ber of years, affect the rate
of inflation. Indeed, several empirical studies of the
United States indicate that it may take as long as five
years for the rate of inflation to reflect completely the
impact of a change in money growth.5 More recent
4The evidence presented also sheds light on the debate about the
impact of M l growth during periods of financial innovation and
institutional change. By examining the connection between
short-run fluctuations in M l growth and real economic activity
across countries with different financial institutions and regu­
lations, some understanding of the relationship’s robustness in a
changing financial environm ent may be gained. For a good
example of the uncertainty that pervades current thinking on the
future efficacy of targeting on M l, see Anthony M. Solomon,
“ Financial Innovations and Monetary Policy,” Federal Reserve
Bank of New York, Annual Report, 1981 (1982), pp. 3-17; and
Edward Yardeni, E. F. Hutton Economics Alert (January 29,
1982).
5See Denis S. Karnosky, “The Link Between Money and Prices —
1971-76,” this Review (June 1976), pp. 17-23; Keith M. Carlson,
“The Lag From Money to Prices,” this Review (October 1980),
pp. 3-10; and John A. Tatom, “Energy Prices and Short-Run
Economic Performance,” this Revieiv (January 1981), pp. .3-17.
15

FEDERAL RESERVE BANK OF ST. LOUIS

studies also have dem onstrated that a lengthy lag
betw een money growth and inflation is common in
several industrial countries.6 This evidence indi­
cates that changes in current money growth have a
relatively small impact on prices in the short run.
For short-run changes in money growth to affect
economic activity, they must initially influence the
real economy more significantly than they influence
prices.7 Indeed, studies have shown that, at least for
the United States, sizable reductions in money
growth below its established trend rate for only a few
quarters have preceded declines in real economic
activity.8
The economic theory that “predicts” the results
just described is as intuitively appealing as it is
empirically verifiable. A marked and sustained de­
cline in the growth of the money supply creates a
“monetary disequilibrium ” : the quantity of money
that individuals desire to hold exceeds the quantity'
that they are actually holding. By reducing their
spending, they can increase their money holdings to
a desired level. Eventually, this reduced spending
will cause, the rate of inflation to fall.
In the short run, however, producers who cannot
tell immediately whether this decline in aggregate
dem and (spending) is perm anent or just a temporary
aberration initially react to the reduction in money
growth (and spending) by reducing output. There­
fore, the decline in money growth results in a slow­
down in economic activity; if it is pronounced
enough and sustained long enough, it can produce a
recession. Only w hen the decline in spending
(motivated by the monetary disequilibrium asso­
ciated with the reduction in money growth) has been
identified as permanent will producers reduce their
prices and increase production back to “normal”
levels. Thus, the impact of the monetary contraction
on output eventually vanishes, and, in the long run,
only the rate of inflation is affected by a sustained
reduction in money growth.9
The potential usefulness of monetary targeting for
economic policy purposes is evident from this dis­
6Batten, “ M oney Growth Stability and Inflation;” and also
Selden, “ Inflation and Monetary Growth.”
7This article discusses only the impact of changes in money
growth on the real output of the economy. It does not investigate
the impact of money growth changes on financial markets.
8Poole, “The Relationship of Monetary Decelerations to Business
Cycle Peaks.” See also Economic Report o f the President (Gov­
ernm ent Printing Office, 1982), pp. 192-96, for another use of
the theory presented here.
9The empirical problem here, of course, is dating the “long run.”
Digitized for 16
FRASER


MAY 1982

cussion. First, in the long run, perm anent changes in
the rate of money growth are reflected by equivalent
changes in the rate of inflation, other things equal.
Second, if short-run money growth is volatile, the
growth of real output and em ploym ent w ill be
similarly volatile. In other words, sufficiently un­
stable money growth in the short run, that is, a re­
duction in money growth relative to its trend rate,
may cause recessions. Consequently, minimizing
the variability of short-run money growth appears to
be essential in establishing a stable, non-inflationary
environm ent for economic growth.

SHORT-RUN MONEY GROWTH
AND ECONOMIC ACTIVITY:
THE EVIDENCE
We now investigate the validity of the conceptual
analysis presented in the preceding section. To
examine the relationship betw een short-run fluctu­
ations in money growth and real economic activity, a
sample of four industrialized countries was selected:
the U nited States, the U nited Kingdom, W est
Germany and Italy. Moreover, to make the results of
the analysis directly comparable, the narrow defini­
tion of money for each country is used.10
To illustrate the relationship betw een short-run
money growth and real output growth, charts for
each country are presented for the period 1973 to the
present.11 These charts depict the deviations of
short-run money growth from its trend, m easured by
subtracting the 20-quarter moving average growth
rate of money from its two-quarter moving average
growth rate. In addition, the quarter-to-quarter,
compounded annual rate of growth of real GNP is
10The M l definition is used throughout. It should be noted that
even though the narrow definition is used, it is not the variable
used by all the central banks in their policy deliberations. The
countries and their respective monetary target(s) are: United
States (M l, M2), U nited Kingdom (Sterling M3), Germany
(Central Bank Money Stock) and Italy (Total Domestic Credit).
"T h e period since 1973 is used for two reasons. First, it is char­
acterized as a flexible exchange rate period, a condition giving
each country more control over its own domestic money supply
and, hence, economic activity than in a fixed exchange rate
period. W hile the analysis also applies to a fixed exchange rate
period, economic activity of open economies during such a
period may merely reflect economic activity in the United
States. Consequently, we chose the post-1973 period because
we are concerned with examining the impact of changes in
short-run money growth that are m otivated by changes in factors
indigenous to the dom estic economy. Second, this period
covers the tim e in w h ich each co u n try ’s cen tral bank
announced a monetary aggregate policy target. Prior to 1973,
announced money supply growth targets were not universal.

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

plotted. Periods in which real output growth was
negative for two consecutive quarters or more are
denoted by the shaded areas; these designate
periods of recession in these countries.12
The individual charts reveal that there is a com­
mon relationship betw een sharp reductions in the
short-run growth of money (the two-quarter moving
average) relative to its trend (the 20-quarter moving
average) and real economic activity.13 Despite the
wide differences among these countries in terms of
their financial structures, regulations and monetary
policy objectives, the relationship betw een shortrun deviations in their money growth from trend and
declines in their real economic activity is quite
similar. To see this more clearly, we briefly examine
the historical record of each country in our sample.

The United States
The chart for the United States reveals three re­
cessions since 1973. As predicted by the theoretical
discussion, each recession was preceded by a sharp
slowing in short-run money growth. Prior to the 1974
recession, for example, short-run money growth fell
from slightly over 2 percentage points above trend to
about 2 percentage points below trend, a change that
is mirrored in the reduction in real GNP growth in
1973. While one may argue that the recession of 1974
was supply-oriented — a reaction to the unexpected
OPEC oil shock — the chart indicates that the depth
and breadth of the downturn was exacerbated by
short-run money growth well below trend in late
1974.14
12The recessions in the United States are those defined by the
National Bureau of Economic Research. Since recessions are
not formally defined in the other countries in the sample, the
generally accepted rule of thumb is that a recession is indicated
by at least two consecutive quarters of declining real GNP.
13The purpose of this article is not to employ statistical methods to
investigate rigorously the money/real output relationship in
those countries. Instead, we are simply applying the general
implications of the research that has been conducted for the
United States to an analysis of these countries, as a first attempt
to see if empirical relationships similar to those in the United
States can be found. Obviously, the timing of the money growth/
real output relationship may be different across countries and,
in fact, the 20-quarter and two-quarter distinctions may not be
completely applicable to all. These results, however, appear to be
quite robust and, consequently, we shift to the unconvinced
reader the obligation of an alternative interpretation of the data.
14The oil price shocks of 1973-74 and 1979-80 resulted in dis­
similar monetary growth rates in the United States. For a dis­
cussion of this, see R. W. Hafer, “The Impact of Energy Prices
and Money Growth on Five Industrial Countries,” this Review
(March 1981), pp. 19-26.



The most recent downturns in economic activity
also are associated with declines in short-run money
growth. For example, prior to the onset of the II/
1980-III/1980 recession, money growth fell from
about 3 percentage points above trend to over 4
percentage points below trend. Although money
growth’s sharp rebound during late 1980 helped
produce the turnaround in real GNP growth in early
1981, the equally dram atic dow nturn in m oney
growth relative to trend during 1981 has precipitated
yet another reduction in real economic activity.
Indeed, since 1/1980, short-run money growth has
fallen short of trend almost 90 percent of the time,
and real GNP growth has been negative almost 40
percent of the time. Clearly, the dramatic slowing in
short-run money growth relative to its long-run trend
and the increase in its volatility during the past two
years have been associated with substantial reduc­
tions in real economic activity over this period.

The United Kingdom
The accompanying chart indicates that the United
Kingdom has experienced a num ber of “recessions”
during the brief period studied. Of the six recessions
shown, all but one were preceded by sharp reduc­
tions in short-run money growth. For instance, prior
to the IV/1973-I/1974 downturn, money growth fell
from about 5 percentage points above trend to more
than 10 percentage points below trend, a reversal of
about 15 percentage points in less than one year.
Likewise, the 1/1977-11/1977 recession came on the
heels of a drop in money growth to more than 5
percentage points below its trend.
The period since late 1978 is interesting because it
reveals the effect on the economy of a sustained
reduction in short-run m oney growth below its
trend. Although money growth did not dip far below
trend prior to the IV/1978-I/1979 recession, shortrun money growth fell from over 15 percentage
points above trend in IV/1977 to its trend level
in only three quarters, a change that is associated
with the drop in real GNP growth from IV/1977 to
1/1979. Also, the impact of the nature of the money
growth decline during the period from IV/1977 to
1/1981 is reflected by relatively stagnant output
growth during this period.
Finally, the IV/1974-III/1975 recession represents
an anomaly to the theory. The recession was not
preceded by a downturn in short-run money growth
relative to its trend; instead, money growth in­
creased faster than its trend rate prior to this reces17

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

M o n e y an d O utput G ro w th in Selected Countries

United States
Percent

Percent

1973
Li C o m p o u n d e d

1974
annual

[2 T w o - q u a r t e r m o v i n g
Shaded


18


areas

1975
rates

1976

1977

of change.

average

money

g row th

1978

1979
Source:

rate

m inus the

represent p erio d s o f e c o n o m ic dow nturn.

2 0 -q u a r te r m oving

1980

1981

I n t e r n a t i o n a l F i n a n c i a l S ta t is t ic s

average m oney

grow th

rate.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

M oney and Output Grow th in Selected Countries

West Germany
Percent

1973
|J_ C o m p o u n d e d

1974

[2 T w o - q u a r t e r m o v i n g
Shaded




areas

1975

1976

1977

a n n u a l rates o f c h a n g e .
average

m oney g row th

1978

1979
Source:

rate

m inus th e

2 0 - q u a r t e r m oving

1980

1981

I n t e r n a t i o n a l F i n a n c i a l S t atis tic s

average

m oney

grow th

rate.

represent p e rio d s o f e c o n o m ic d o w n tu rn .

19

sion. This may have been an attempt to use monetary
policy to offset, at least partially, the dislocations
created by the OPEC oil shock that lowered the
growth of real GNP. Interestingly, the U.K. response
to the 1978-79 OPEC oil shock was to decrease the
short-mn growth of the money stock, as shown in the
chart.15

growth relative to its trend rate. This pattern is es­
pecially evident for the II/1974-II/1975 and 11/1980III/1980 recessions.

CONCLUSIONS

The evidence presented here suggests that sizable
and sustained reductions in short-run money growth
West Germany
below its trend rate portend declines in the growth of
real GNP. Of the 14 recessions in the four countries
The chart for West Germany again supports the examined, only one — the IV/1974-III/1975 reces­
theoretical discussion. Each of the two recessions is sion in the United Kingdom — was not preceded by a
preceded by periods of money growth below trend. substantial decline in short-run m oney growth.
Although the timing is different for each episode, the Moreover, in only one instance — the III/1975-IV/
reaction of the real economy to declines in short- 1976 period for W est Germany — did short-run
run money growth is clear and consistent.
money growth fall substantially below trend without
W est Germ any also presents a case in which a recession following. In that instance, however,
money growth fell below trend and no technical West German real GNP growth fell from about 10
recession occurred. From III/1975 to IV/1976, percent to zero, a result consistent with the theo­
money growth fell from about 7 percentage points retical discussion.
above trend to about 5 percentage points below
Thus, the evidence indicates that policymakers
trend. Although no recession followed, the level of should be concerned with short-run fluctuations in
real GNP growth fell sharply as the theory predicts: the growth of the m oney supply relative to its
the growth rate of real GNP fell from about 10 per­ trend.16 If this evidence is at all useful, it dem on­
cent in IV/1975 to zero in 11/1977. Thus, while strates how robust the relationship betw een money
technically no recession followed the decline in growth and real economic activity is over the short
m oney growth, real GNP growth was curtailed run. Coupled with previously reported research
sharply, an example of a “growth recession.”
indicating a direct, positive link betw een longerterm money growth and inflation, the em pirical
evidence favors a steady growth of the money stock
Italy
in both the short and long run as the most effective
The relationship between real GNP growth and means of achieving economic stability.
money growth relative to trend in Italy, once again,
is consistent with theoretical expectations. Of the
three recessions since 1973, each was preceded by a 16This evidence contradicts the recent claim that “the [money
growth] volatility issue itself is a hoax. No one as yet has been
period of sharp reductions in short-run m oney
15Hafer, “Impact of Energy Prices and Money Growth.”


20


able to demonstrate that the reported volatility in money has any
impact on either the pace of economic activity or inflation.”
Aubrey G. Lanston & Co., Inc., Newsletter (March 22, 1982).

Money, Credit and Velocity
MACK OTT

S h a k e s p e a re : “ N e ith e r b o rro w e r, n o r a le n d e r b e ”
(H am let, I, iii, 75, P olo nius to L aertes)
G o eth e: “ L e t us live in as sm all a circle as w e w ill, w e are
e ith e r deb to rs or cred itors b efo re w e h av e h ad tim e to look
aro u n d .” (.E lective A ffinities, Bk. II, C h. 4)

I^ .E C E N T L Y , many critics of monetary policy,
and some monetary policymakers as well, have as­
serted that the links betw een monetary aggregates
and national economic policy variables—that is,
GNP, inflation and real economic growth—have
been severed by a host of financial and credit market
innovations. If these critics are correct, then a
monetary policy based on targeting the growth of a
m onetary aggregate would becom e increasingly
ineffective and inappropriate, as credit arrange­
ments are substituted for monetary payments.1
The puipose of this article is to provide a theo­
retical framework in which to assess these claims
The author, an associate professor of economics at The Pennsyl­
vania State University, is a visiting scholar at the Federal Reserve
Bank of St. Louis.
•For examples, see Neil G. Berkman, “Abandoning Monetary
Aggregates,” in Controlling Monetary Aggregates III, pro­
ceedings of a conference sponsored by the Federal Reserve Bank
of Boston (October 1980), pp. 76-100; Benjamin M. Friedman,
“The Relative Stability of Money and Credit ‘Velocities’ in the
United States: Evidence and Some Speculations,” NBER Work­
ing Paper No. 645 (March 1981); Anthony M. Solomon, “Finan­
cial Innovation and Monetary Policy” (remarks before the Joint
Luncheon of the American Economic and American Finance
Associations, Decem ber 28, 1981); James M. Tobin, “ Inflation,”
in E ncyclopedia oj Economies, D ouglas G reenw ald, ed.
(McGraw-Hill, 1982), pp. 510-23. For the contrary position—i.e.,
that monetary policy should be undertaken through effective
control ofa monetary aggregate—see Milton Friedm an, “Mone­
tary Policy: Theory and Practice,"Journal o f Money, Credit and
Banking (February 1982), pp. 98-118; and Allan H. Meltzer,
Robert H. Rasche, Stephen H. Axilrod, and Peter Sternlight,
“Money, Credit, and Banking Debate: Is the Federal Reserve’s
M onetary Control Policy M isdirected?” journal o f Money,
Credit and Banking (February 1982), pp. 119-47.



and to examine empirical evidence bearing on their
purported policy consequences. The analysis pre­
sented in this article does not support the critics’
assertions. This conclusion rests on two arguments.
F irst, the relation betw een m oney and credit
requires that the amount of credit granted match the
anticipated amount of money that will be available to
settle the debt when it comes due. Thus, regulating
the rate of monetary growth, which in turn regulates
the anticipated future quantity of money, deter­
mines the amount of credit and the conditions under
which it is granted. This constraining influence of
monetary growth on credit would be undone only if
the relation betw een money and income growth
departed from its historical pattern.
That it has not is the second argument: the em­
pirical evidence on velocity, the relation between
money growth and income growth, reveals no sig­
nificant change during the last two years from its
previous history. C onsequently, despite recent
claims to the contrary, the growth of the monetary
aggregates is still reliably linked to the economic
variables of interest to policymakers.

MONEY, CREDIT AND EXCHANGE
In contemporary societies, the exchange of goods
is indirect. The purchase or sale of goods, w hether in
organized markets or through informal arrange­
ments, is almost always in exchange for money or
m oney-denom inated prom ises. D irect bartering
of one good for another is either nonexistent or
unimportant.
The reason for this is at once obvious, yet theo­
retically challenging to elucidate. In the intro­
duction to his book, The Theory o f Money, Jurg
Niehans observes:
Economists (and laymen) have always felt that the
use of a medium of exchange increases the efficiency
21

FEDERAL RESERVE BANK OF ST. LOUIS

o f an econom y. T h e gain w as u su ally co n sid ered to b e
large. It has bo th q u a litativ e an d q u a n titiv e aspects.
T h e q u a litativ e aspects ap p e a r w h en m o n etary ex­
ch ange is co m p ared w ith b arter. C lassical an d n e o ­
classical econo m ists w ere g raph ic in d e scrib in g th e
“ d o u b le co in cid e n ce o f w an ts” of th e h u n g ry tailo r
an d th e sh iv erin g b a k er w h ich w o u ld be n ecessary for
an ex ch an ge in a b a rte r econom y an d th e narrow
lim itation s it im po ses on th e d iv isio n o f labor. T he
u se o f m o n ey w o u ld in c re ase w e lfa re by fre ein g
ex chan ge from th e shack les of th e d o u b le co in ci­
d e n ce o f w an ts.2

Robert Clower succinctly summarized the results
of these advantages as imposing a constraint on*the
exchange process: “Money buys goods and goods
buy money; but goods do not buy goods.”3 In other
words, it is the nature of a system of monetary ex­
change to replace the cumbersome barter exchange
of goods with two non-synchronized m onetized
exchanges: a sale of goods for money and a later
purchase of goods by money. This exchange attrib­
ute in turn has implications for both the appropriate
definition of money and for the monetary arrange­
ments used in exchange.4
First, the period betw een the sale of one good for
money and the subsequent purchase of another good
may be long enough or predictable enough to allow
the interim holding of funds in a non-transaction
account. This implies that the appropriate monetary
aggregate may not be narrowly defined money (i.e.,
M l), but a broader aggregate (e.g., M2) which con2Jurg Niehans, The Theory o f Money (Johns Hopkins University
Press, 1978), p. 2.
3Robert W. Clower, “A Reconsideration of the Microfoundations
of Monetary Theory,” Western Economic Journal (March 1967),
p. 6. Also, see Karl Brunner and Allan H. Meltzer, “The Uses of
Money: Money in the Theory of An Exchange Economy,” Amer­
ican Economic Review (Decem ber 1971), pp. 784-805.
4Milton Friedman and Anna Schwartz described this attribute as
“the separation of the act of purchase from the act of sale,” but
criticized the medium of exchange approach as being too narrow
to capture the essential nature of money:
In order for the act of purchase to be separated from the act of sale,
there m ust indeed be something that will be generally accepted in
payment—this is the feature emphasized in the “medium of ex­
change” approach. But also there must be something that can serve as
a temporary abode of purchasing power, in which the seller holds the
proceeds in the interim betw een sale and subsequent purchase or
from which the buyer can extract the general purchasing power with
which he pays for what he buys. . . . Both features are necessary to
perm it the act of purchase to be separated from the act of sale, but the
‘something’ that is generally accepted in paym ent need not coincide
with the ‘something’ that serves as a temporary abode of purchasing
power; the latter may include the former and more besides.

Milton Friedman and Anna Schwartz, Monetary Statistics o f
the United States: Estimates, Sources, Methods (NBER, 1970),
pp. 106-07.
Digitized for
22FRASER


MAY 1982

tains w hat M ilton F riedm an characterizes as
“temporary abodes of purchasing power” that are
readily convertible at low cost into an exchange
medium.5
Second, if the purchase of the good to be financed
by the proceeds from the sale of another good pre­
cedes the sale of that other good, then the anticipated
future sale proceeds may be used to mediate the
earlier purchase. Of course, an exchange arrange­
m entlike this is a familiar part of modern economies;
such purchases are said to be made “on credit.”
Credit is granted by sellers or other third party
lenders to buyers precisely on the basis of the
buyer’s anticipated future receipts (with the lender
concurring) and, of course, is measured in monetary
units. As a consequence, credit is as much of a
medium of exchange as is money.6
While both credit and money are used to mediate
exchange, they are obviously different entities. The
quantity of money circulating in an economy is a
stock; its units are used repeatedly in a sequence of
exchanges. Credit, on the other hand, is a flow and is
transaction-specific; it can only mediate the trans­
action for which it was created.7
5Two goods that are perfect substitutes are economically the same
good. If two durable goods are costlessly transformable, one into
the other, then they are perfect substitutes in an inventory. On
this criterion, if the cost of transferring funds from a savings
account to a demand account or to currency were zero, then,
clearly, savings accounts would be economically indistinguish­
able from demand accounts or currency and would be exchange
media. Conversely, if the costs of transfer were prohibitively
large, savings accounts would not be a close substitute for
demand deposits. Hence, as Friedm an and Schwartz argue, the
question of what money is cannot be settled on an a priori basis,
but is an empirical question which, in part, depends on how
costly inter-deposit transfers are.
6This observation has led Clower and others to argue that some
measure of credit availability or line of credit be included in the
policy relevant concept of money: . . for most practical pur­
poses, ‘money’ should be considered to include trade credit as
well as currency and demand deposits.” Robert W. Clower,
“Theoretical Foundations of Monetary Policy,” in Monetary
Theory and Monetary Policy in the 1970s, George Clayton, John
C. Gilbert and Robert Sedgwick, eds. (Oxford University Press,
1971), p. 18. See also Arthur B. Laffer,“Trade Credit and the
Money Market” (March 1970), pp. 239-67; and J. Stephen Ferris,
“A Transactions Theory of Trade Credit Use,” Quarterly Journal
o f Economics (May 1981), pp. 243-70.
7It has been argued that credit is not an exchange medium, but
m erely an arrangem ent that raises the velocity of money.
Ironically, the same argum ent was once used against including
demand deposits in money. As Friedm an and Schwartz point out,
much of the 19th century debate betw een the banking and cur­
rency schools centered on whether bank notes and deposits were
money or merely “means of raising the velocity of bank vault cash
but not as adding to the quantity of money.” Friedm an and
Schwartz, Monetary Statistics o f the United. States, p. 95.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

BOTH CREDIT AND MONEY ARE
NECESSARY FOR MONETIZED
EXCHANGE

receive money or a promise to deliver money at a
specified future time.
If only commodities were exchanged, it would be
possible always to use money alone and never incur
The epigraphs from Shakespeare and Goethe rep­ a debt. Services, however, by their very nature,
resent conflicting views on the desirability and cannot be exchanged without one party, either seller
inevitability of credit; to wit, while money and credit or buyer, extending credit to the other. Hence, a law
are alternative exchange media, would either be attem pting to enforce Shakespeare’s adm onition
sufficient to m ediate all exchanges w ithout the would not prohibit the sale of apples, automobiles or
other? Could any of us, as Polonius suggests, avoid clothing; it would, however, prohibit the renting of a
credit transactions completely? Conversely, could house, the purchase of a ski-lift ticket or the hiring of
credit function as we know it without a monetary labor. In each of these latter examples, the trans­
framework? Not surprisingly, the answer to both action entails the exchange of money before or after
questions is no. Hence, the advice of Polonius is as the completion of the activity with, necessarily, a
fatuous as the character offering it. Both credit and concomitant issuance of credit.9
money are necessary in the exchange process, each
fulfilling functions that the other could not.
Thus, Goethe was right; each of us inevitably
engages
credit transactions every day. For ex­
In order to establish this com plem entarity of ample, weinextend
to our employer and receive
money and credit, consider the exchange process as it from our electriccredit
utility.
If services of any form are
a contractual arrangem ent betw een buyer and to be exchanged, credit must
be offered either by the
seller.8 Under this characterization, the exchange seller—as in the typical employm
arrangem ent
and the settlem ent of the contract need not coincide where wages are received after theentservices
have
in time so that either credit or money can mediate an been delivered—or by the buyer—as in entertain­
exchange. In the case of a credit transaction, at the
activities where the purchase of a ticket pre­
time of the exchange the buyer incurs a contractual ment
cedes
the concert, game or movie.10
liability tor ^.subsequent settlement toclearhis debt.
Using this contractual approach, we can now dem ­
credit is inextricably bound up with sell­
onstrate why Goethe’s claim of the inevitability of ingClearly,
services
in a monetized economy in order to
credit in any society is correct.
avoid the problem of making an indefinitely large
num ber of infinitesimal cash payments. Yet money
and credit are simply alternative means of lowering
Credit and the Exchange o f Services
the cost of exchanging goods relative to a primitive
barter system. Thus, even some commodities might
Two types of goods are voluntarily offered for be too costly to exchange in customary ways if credit
exchange in markets: commodities and services. By were ruled out (e.g., hom e-delivered newspapers or
definition, a commodity is a tangible physical entity raw materials purchased by firms).11
not intrinsically dependent on time (e.g., an apple, a
phonograph record or an automobile), while a ser­ 9Note that this would also rule out the existence of any firm other
vice is an activity or process that is intangible and than owner-operated producers of commodities.
intrinsically sensible only with the passage of time 10Barter exchange of services is conceivable as suggested in the
maxim, “You scratch my back and I’ll scratch yours.” Yet, even
(e.g., a gardener’s chores, a concert or a taxi ride). In a
here, credit sneaks in unless the exchange is simultaneous.
m onetized economy, sellers of either type of good
8Under Anglo-American law, an enforceable contract must have
three elements:
(1) There must be an offer;
(2) There must be an acceptance precisely matching the offer—
else it is a counter-offer;
(3) There m ust be consideration—i.e., the offeror or acceptor
must make some performance that would be a detrim ent to
him if the agreem ent were not fulfilled.
See “Contract” and other referenced citations thereunder in
Henry Campbell Black, Black’s Law Dictionary, 5th ed. (West
Publishing Co., 1979), pp. 291-94, 277.



“ Credit extended by sellers of raw materials is an especially
important example. If credit were not extended to producers,
either deliveries would have to be made more frequently (in
smaller lots) to match producers’ cash flow from sale s of output,
or the material-using firms would have to tie up more of their
capital in raw material inventories and, hence, less in the capital
to process these materials. Alternatively, firms would find it
more advantageous to be vertically integrated—i.e., to own their
suppliers—than to acquire these materials from other firms. See
“Credit Allocation: An Exercise in the Futility of Controls”
(Citibank Economics Dept., 1979), p. 40. In any case—more
frequent delivery, larger inventories in capital, or more vertical
integration—resources would be less productively allocated
than when credit is extended.
23

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

The Relationship Between Money
and Credit

exchange system functions.12 From this vantage,
they have docum ented that, in moving from barter to
indirect exchange, the m ost useful function of
prim itive monies is the com m only-agreed-upon
Money and credit are both substitutes and com­ valuation unit.13
plements in the exchange process. On the individual
level, money and credit are potential substitutes for
Finally, credit mediation of exchange is facilitated
mediating any exchange of commodities. On the by the universal acceptability of money as a means of
societal level, money and credit are complements in settlem ent—the standard of deferred payment func­
the exchange process; each provides a function tion. All credit contracts can be settled (directly or
necessary to some exchanges that the other cannot through civil courts) by means of a money payment;
fulfill. In fact, credit is a more general medium of that is, money is legal tender in our economy. This
exchange than money in that it facilitates exchange general agreem ent on the m eans of settlem ent
involving time—both in permitting the sale of ser­ makes credit less costly to extend, thereby increas­
vices and in perm itting differing delivery dates in ing its availability for exchange mediation. A decen­
exchanges of commodities; money without credit tralized use of credit requires that individuals and
can act as the exchange medium only for a com­ firms be able to clear their debts individually (i.e.,
modity. Yet, money is likewise crucial to the func­ pairwise) with some mutually agreeable means of
tioning of credit through its role as the primary settlement; without such agreem ent on the means of
means of settlement.
settlement, credit clearing would require a costly
centralized
M onetary theorists generally have agreed that “barter club.”system of record-keeping much like a
money in modern economies is anything that fulfills
all of the following functions:
1.
2.
3.
4.

Medium of exchange,
Store of value,
Unit of account,
Standard of deferred payment.

THE RELATION OF CREDIT
EXPANSION TO MONETARY POLICY

Credit is not money, but the promise of future
money to the lender in return for the temporary use
Most economists have argued that the crucial char­ of current purchasing power—goods or money—
acteristic in this list is its functioning as a medium of extended to the borrower. Two errors that violate
exchange. Typically, they have argued that any this logic occur every day in the financial press:
durable good can fulfill the remaining three func­
tions, but only money can fulfill the first.
12See Philip Grierson, “The Origins of Money,” Research in
However, we have seen that credit also fulfills the
Economic Anthropology, Vol. 1 (JAI Press, Inc., 1978), espe­
cially pp. 9-12 for evidence on the importance of standard of
medium of exchange function. Credit in our dis­
value in explaining early monetary systems. See also George
cussion has taken a special form—namely, credit
Dalton, “Primitive Money,” American Anthropologist (1965:1),
measured in units of money and, implicitly, with the
pp. 44-65; and Denise Schmandt-Besserat, “The Earliest Pre­
cursors of W riting,” Scientific American (June 1978), pp.50-59.
deferred payment to be made in units of money. In
exchange systems with money and credit acting as 13In this context, it is ironic and revealing that contemporary
“barter clubs” use dollars as the unit of account but not as an
exchange m edia, the other three functions in
exchange medium. Consider these descriptions from “As Barter
money’s repertoire take on an importance not ap­
Boom Keeps Growing,” U.S. News and World Report (Sep­
tem ber 21, 1981), p. 58:
parent in the conceptual monetary exchange models
A participant lists items for sale, and they are advertised to the other
without credit.
m embers. If a listed item is sold, the former owner is issued trade
credits—sometimes called trade dollars. These credits can later be
used to purchase goods and services from other m em bers. . . “We
W ithout agreement on the unit of account, credit
don't make outright trades; we perform a banking function. . .”
transactions would have all the disadvantages of
This is also the method by which every “barter exchange”
in the article appears to be organized:
barter except simultaneity. Anthropologists, in con­ profiled
Besides credits, most barter exchanges issue barter cards that can
trast to economists, have placed more emphasis on
be used for purchases at participating merchants. Through the Trade
Bank International exchange, a Memphis dentist began receiving
the unit of account function because their focus is on
customers who used their barter cards for dental work. W ithin a
how a monetized exchange system evolves from a
year’s time, the dentist accum ulated enough trade dollars to buy
carpeting for his office, install new signs and pay for flying lessons.
barter system rather than how an extant monetized
Digitized for
24FRASER


FEDERAL RESERVE BANK OF ST. LOUIS

1. R eferrin g to th e in te re st rate as th e p rice of m oney;
2. Id en tify in g av ailab le cre d it as m o n ey .14

The first error is so commonplace that its repeti­
tion makes it seem valid; nonetheless, the interest
rate is not the price but the rental rate for a dollar or,
properly expressed, any other good. The price of a
dollar is a dollar’s worth of something—certainly
more than a mere percentage of a dollar. No one
would refer to the rental rate at Hertz as the price of a
new Ford, or to the rent on a house as its purchase
price, but the confusion of interest on credit with the
price of money has become so common that the error
no longer jangles our sensibilities. Yet the distinc­
tion is not only obvious but as important for money
and credit as for owned and rented automobiles.
Similarly, the second error, referring to available
credit as money, also escapes rebuke through fre­
quent use. The annual total of credit extensions is
many times larger than the year-to-year increases in
either M 1 or M2, and, in recent years, has been larger
than the stock of M l. Considering the consumer
sector (which accounts for over 60 percent of na­
tional income), a large share of credit extensions,
almost two-thirds, are by institutions other than
commercial banks and, therefore, do not entail
monetary expansion. Considering only installment
consumer credit, about 40 percent of such credit is
extended by non-depository institutions with about
20 percent being extended by retailers and gasoline
companies. In these retail extensions, money affects
the transaction only through the anticipated mone­
tary settlem ent.15
These errors are substantive for they focus the
public’s evaluation of monetary policy on regulating
the flow of credit instead of controlling the growth of
the stock of money. Controlling the rate of growth of
the money stock in a predictable fashion enhances
the predictability of the future availability of the
means of settlement. This regularity of monetary
expansion makes for better-informed, intertemporal
decision-making and, therefore, contributes to the
stabilization of credit markets. When non-monetary
shocks occur, the predictable availability of quan­
tities of m oney in the system allow s m arket-

MAY 1982

determ ined signals—that is, interest rate changes—
to allocate credit efficiently to adjust to the shocks.
Conversely, attempting to control interest rates
requires the monetary authority, in effect, to allocate
credit at the cost of making the growth rate of mone­
tary expansion less predictable; since this makes the
real future value of the means of settlem ent more
variable, credit transactions become riskier, and
credit markets less stable. W hen non-m onetary
shocks occur, the less predictable quantities of
means of settlem ent with relatively fixed interest
rates impede market signals from efficiently allo­
cating credit.
Since both money and credit are exchange media,
the key to effectively controlling either or both of
them must be first to isolate their interconnections
and mutual dependencies. This article has argued
that credit is unavoidable and that a money means of
settlem ent is necessary for a decentralized credit
system. What it now addresses is how monetary and
credit expansion relate to each other and how both of
these relate to national income.

Credit and Money Creation
In contemporary market economies, the money
supply grows through two types of credit transac­
tions: the central bank creating deposits (money) and
bank reserves by buying government securities, and
depository institutions creating deposits (money)
from increased reserves by granting loans.16
Of course, not all credit extensions entail mone­
tary expansion. There are three distinct sources of
credit extension: (1) bank and non-bank depository
institutions (commercial banks, savings and loans,
credit unions, m utual savings banks); (2) non­
depository financial interm ediaries (finance com-

16In other words, modern monetary systems have a fiat base—
literally money by decree—with depository institutions, acting
as fiduciaries, creating obligations against them selves with the
fiat base acting in part as reserves. The decree appears on the
currency notes: “This note is legal tender for all debts, public
and private.” W hile no individual could refuse to accept such
money
for debt repayment, exchange contracts could easily be
14Recent examples are (1) "The price of money—the interest
to thwart its use in everyday commerce. However, a
rate—reflects, therefore the interaction of millions of partici­ composed
forceful explanation as to why money is accepted is that the
pants in the credit market. . H em y Kaufman, Washington
federal government requires it as payment for tax liabilities.
Post, Septem ber 23, 1981; (2) “As long as the Federal Reserve
Anticipation
of the need to clear this debt creates a demand for
Board maintains its current course, credit—or money available
the pure fiat dollar, guaranteeing its exchange value. See Abba
to lend—will remain tight." Harry B. Guis, Christian Science
P. Lerner, “Money as a Creature of the State,” American Eco­
Monitor, Septem ber 21, 1981.
nomic Review (May 1947), pp. 312-17; and Ross M. Starr, “The
15Souree: Federal Reserve Bulletin (January 1982), Tables 1.21,
Price of Money in a Pure Exchange Monetary Economy with
Taxation,” Econometrica (January 1974), pp. 45-54.
1.56, 1.57, 1.58, 2.16.




25

FEDERAL RESERVE BANK OF ST. LOUIS

panies, investm ent banks, brokerages, insurance
companies); and (3) sellers of goods (retail and trade
credit). In the first case, a depository institution
lends money to a borrower who in turn uses these
funds to purchase goods or repay debts; the credit
extension entails monetary expansion of purchasing
pow er because it consists of checkable deposit
expansion. During the last three decades, loans by
such depository institutions have accounted for
between 35 and 50 percent of the annual total of
credit market funds extended to the non-financial
sector.17 Alternatively put, more than half of the
credit extended annually in U.S. financial markets
does not entail deposit expansion.
In the second case, a non-depository institution
(e.g., a consumer finance company) issues the credit
or buys the accounts receivable of a credit-issuing
seller. The latter method of credit extension is called
factoring, and non-depository institutions fund this
activity by either selling debentures directly or by
acting as an agent for a depository institution. Under
either method, the extension of credit does not entail
an expansion of deposits but a reallocation of exist­
ing deposit holdings.18
Finally, in case three, credit may be extended
directly by the seller of goods and held as accounts
receivable. Often this credit is financed by the sale of
commercial paper issued by the seller/credit-issuer
(e.g., firms with their own financial subsidiaries such
as Sears or General Motors). In these instances,
whether the firm holds its own accounts receivable,
factors its accounts receivable or sells commercial
paper, the extended credit represents an increase in
purchasing power not created by checkable deposit
expansion.
17Source: Board of Governors, Federal Beserve System. Of
course, this credit expansion is limited by bank reserves under a
given set of reserve requirements and is consequently directly
controlled by the monetary authority. For this form of credit,
additional credit control authority would be superfluous. This
case also covers bank credit card usage since credit issued by a
sellerto abuyer against a bank card becomes a demand deposit
increm ent as soon as the seller/credit-issuer submits the credit
invoice to the agent bank. In both types of credit extension,
direct or credit card, a depository institution creates money
matching the extended credit.
18If a depository institution issues a loan to a creditor using the
accounts or debt as collateral, then the credit extension has the
same one-for-one expansion of deposits as if the loan were
directly placed. From 1977 through 1980, the percentage of
installm ent loans by non-depository institutions was .39, .37,
.40, .45 respectively; source: Federal Reserve Bulletin (Sep­
tem ber 1981), table 1.57. A breakdown for non-installm ent
credit has not been present in the Bulletin since 1975, but from
1965 tol975, commercial banks extended only about one-third
of single-payment non-installment loans.
Digitized for 26
FRASER


MAY 1982

In the second and third cases, credit extensions
substitute for monetary mediation, while, in the first
case, a dollar of money is created by each dollar of
credit extended. Thus, for the case of loans by de­
posit creation, credit expansion has no apparent
impact on the relation betw een the narrowly defined
money supply and income since M l and credit move
together; however, in the latter two cases, credit
substitutes for money w hich apparently w ould
change the ratio of income to money supply.
Yet, to the extent that credit arrangements in­
creasingly provide as ready a source of purchasing
power as narrowly defined money (M l), the ap­
pearances of these cases are somewhat misleading.
There should be an incentive to reduce M l holdings
and to increase the non-M l portion of M2 holdings.
For example, given the rising acceptability of bank
credit cards—about 30 percent of U.S. retail and
service establishments accepted them in 1972, ap­
proximately 50 percent in 1981—the utility of hold­
ing a reserve of currency or dem and deposit balances
in order to m ediate unforeseen or spur-of-themoment purchases has been significantly reduced
for consumers.19 Still, to clear the short-term credit
card debt at m onth’s end, a ready source of funds to
shift to demand or other checkable deposits remains
necessary. Consequently, even if the proportions of
cash and credit purchases were constant, given the
increasing acceptability of credit as an exchange
medium, it would not be surprising to see consumer
holdings of dem and deposits decline relative to
purchases (i.e., to have had a rising velocity).

IMPLICATIONS OF RISING CREDIT
FOR MONETARY GROWTH AND
ECONOMIC ACTIVITY
If all credit extensions represented monetary ex­
pansion, then controlling monetary growth would
control credit. The same constraint that limiting
reserves imposes on deposit expansion also limits
19The total num ber of merchant (i.e., retail and service) estab­
lishments in the United States rose less than 2 percent per year
during the 1960s and 1970s, while the num ber of merchant
outlets accepting MasterCard and VISA rose at over 8 percent
and 9 percent per year, respectively. (Sources: Statistical
Abstract o f the United States, 1980 (U.S. Dept, of Commerce,
Bureau of the Census), 101st ed., and data supplied by VISA and
MasterCard). To estimate the percentage of merchants accept­
ing bank cards, we estimated total merchants for 1981 by ex­
trapolating the 2 percent annual growth rate from 1977 forward.
This was then divided into the num ber of merchant outlets that
accept MasterCard.

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

credit extensions, and inflation policy can properly
focus on controlling m oney growth, leaving the
market to allocate credit. As we have seen, however,
depository institutions account for less than half of
the credit annually extended in the United States.
C onsequently, m ight not the purchasing power
created by non-deposit credit extensions render
monetary policies undertaken through control of
monetary growth rates ineffective? The answer is
no: money in its role as the means of settlem ent
constrains non-depository as well as depository
credit.
If an increase in the use of credit alters the moneyincome relationship, the income velocity of money
will rise. That is, if a larger share of transactions by
households or firms can be m ediated by credit, those
households and firms, relative to their incomes, will
plan to hold less M l and more of other assets, includ­
ing non-M l deposits. As this substitution occurs, the
ratio of nominal income to M l (velocity) will rise.
W hether such a change will occur for all monetary
aggregates, narrow and broad, depends on the extent
to which substitutions of non-M l assets for M l
com prise deposits included in other m onetary
aggregates.20
Velocity, v, which is the ratio of nominal gross
national product, Y, to money, M,

(.3)

v = P + y -

M,

from equation 1, w here' indicates the annualized
growth rate of each variable. From equation 3, we
obtain
(4)

P = v — y + M,

which shows the significance of velocity for m one­
tary policy with the inflation rate, P, as its target.
As is obvious from equation 4, if velocity is con­
stant (v = o), then the inflation rate will be equal to
the difference betw een the growth rates of real
output, y, and money, M; if v is relatively constant
but non-zero, then inflation would be the difference
betw een the growth rates of money and real output
plus that of velocity. If v does not depend on M or y,
then equation 4 im plies that if v is simply pre­
dictable, even if not constant, then controlling the
money supply is tantamount to controlling inflation.22
This interpretation abstracts from variations in
real output, but, to the extent that fluctuations in the
growth rate of money exacerbate such variations,
setting a constant growth rate of money reduces that
source of disturbance. Non-monetary disturbances
to real output growth (e.g., the OPEC oil embargo),
of course, may cause inflation to deviate from its
anticipated path, but over longer periods of time, a
steady growth rate of money will smooth real income
growth as well as facilitate inflation predictability.
is the rationale for a policy of targeting on the
measures the turnover rate of the average dollar in This
growth
of money and why its effectiveness
M, that is, how many times a dollar was used in a dependsrate
upon
the predictability of velocity.23
transaction involving Y during the year.21 Express­
Assessing the predictability of a variable involves
ing nominal income as the product of the price level,
two separate evaluations: point forecasts and vari­
P, and real output, y,
ability. The shorter the time period considered, the
(2)
Y = Py,
relatively more important is the latter characteristic;
we obtain an equation for the growth rate of velocity, that is, while a short-run forecast of a variable may
rarely be precise, if that variable does not fluctuate
wildly in a fashion out of keeping with its history,
“ Essentially, this is again Friedm an’s argument that the defini­ then describing it as predictable is sensible.
tion of money is not an a priori hut an empirical issue. “The

selection [of money’s definition] is to be regarded as an em­
pirical hypothesis asserting that a particular definition will be
most convenient for a particular purpose because the magnitude
based on that definition bears a more consistent and regular
relation to other variables relevant for the purpose than do
alternative magnitudes of the same general class. . . . It may
well be that the specific meaning it is most convenient to attach
to the term money differs for different periods, under different
institutional arrangements, or for different purposes.” Fried­
man and Schwartz, Monetary Statistics o f the United States, p.
91.
21The reciprocal of velocity measures the average holding period
of a dollar, how long betw een final income transactions. This
period is germane to the Friedm an notion of temporary abode of
purchasing power.



22Note that for policy purposes we need not know precisely why
the growth rate of velocity is predictable; for the purpose of
formulating an inflation policy through control of a monetary
aggregate, it is sufficient that it is predictable.
23For a more detailed statement, see Milton Friedman, “A Theo­
retical Framework for Monetary Analysis, ’’Journal o f Political
Economy (March/April 1970), pp. 193-238. Friedm an also
argues that monetary policy is not useful in counter-cyclical
policy because of lags in its impacts and that, consequently, it is
more useful if steady or predictable; see his American Eco­
nomic Association Presidential Address, “The Role of M onetaiy
Policy,” American Economic Review (March 1968), pp. 1-17,
and his “ Monetaiy Policy” lecture cited in footnote 1.
27

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

C h art 1

Income, M o n e y an d Credit
Billions of D ollars

3 0 0 0 1------ ------ r

HAS RISING CREDIT SIGNIFICANTLY
AFFECTED THE RELATIONSHIP
RETWEEN MONEY AND INCOME?

markets by firms, consumers and the government,
plus trade credit extended betw een firms.24 On a
sem i-log chart, constant grow th rates graph as
straight lines, and equal growth rates appear as
There are several ways to assess the impact of parallel lines. In this format, it is plain that from 1959
rising credit on the money-income link. Three dif­ to 1981 credit’s growth was the fastest of the aggre­
ferent procedures are used here: (1) a consideration gates, that GNP and M2 have grown at roughly equal
of the levels of GNP, money and credit; (2) an ex­ rates, and that all three grew somewhat faster than
am ination of consum er deposit holdings, credit M l. The credit magnitude grew at an average rate of
extensions and purchases; (3) observations of the 9.2 percent per year, while M2 grew at about the
same rate as GNP during the last two decades—8.3
growth rates of M l and M2 velocities.
First, we can see w hether the relationship be­
that it is the flow of credit—i.e., extensions—not the stock
tween money and income growth appears to have 24Note
of debt that is relevant here. Credit, as discussed earlier, is
changed in recent years by simply looking at the data transaction-specific and can mediate only that transaction for
which it is extended. Even if the promissory note from a pre­
on income, money and credit presented in chart 1.
vious credit transaction were subsequently used as collateral for
Chart 1, using a semi-log scale, depicts annual GNP,
another credit transaction, there would be another credit ex­
M l and M2 holdings, and credit flows, with the last tension for that transaction. Unlike past money expansion, the
defined as the quantity of funds raised in credit
stock of past extensions is, in itself, irrelevant.

Digitized for 28
FRASER


FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1982

C hart 2

V elo cities of M l a n d M 2

The ratio of credit to income, while persistently
percent and 8.2 percent per year, respectively. In
contrast, M l grew at a 5.2 percent rate.
rising, probably understates the importance of credit
explaining the rise of M l velocity. The credit total
In chart 2, the velocities of M l and M2 are dis­ in
is
misleadingly low since it represents quarterly
played. The approximate constancy of the M2 veloc­ balance
sheet changes in debt. If credit is extended
ity is clearly evident here, as well as the persistent and repaid
within the period of observation (one
rise of M l velocity. Not so evident, however, is the quarter for the
data in chart 1), there is no change in
relatively constant rate of M l velocity growth. Over the credit balance
and, thus, no evidence that this
the 1959-81 period, M l velocity grew at around credit extension took
place; nonetheless, such ex­
3.2 percent. Indeed, except for a noticeable slowing tensions of credit would
have m ediated exchanges
in the late ’60s, the velocity growth rate of both old and contributed to spending
and economic activity.
M l and new M l has been betw een 3 percent and 4
percent since 1950.25
A second way to assess the impact of credit use is to
focus on the behavior of individuals and families—
25Recently, Robert E. W eintraub, senior economist for the Joint in particular, to examine their holdings of demand
Economic Committee of the U.S. Congress, made a similar and other checkable deposits as compared to credit
point in a letter to the Wall Street Journal, October 14,1981: “As
a matter of logic, offshore and other new financial developments in mediating consumer purchases. Table 1 presents
can contribute to inflation only if they contribute to the rate of data on consumer deposit holdings, credit exten­
rise of money’s velocity. However, they have not. Since the
early 1950’s, the rate or rise of M IB’s velocity has been quite sions and purchases in the U.S. economy during the
1970s. By focusing on the consumer sector, three
steady, 3.2% yearly.”



29

FEDERAL

CO

o

RESERVE

C onsum er Expenditures and M ediations

_

V e lo c ities

(6)

(7)

(8)

(9)

(10)

(11)

(12)

Consumer M2
deposits

(5)
Total
consum er
credit
extensions

Personal
consum ption
expenditures

Total
cash
purchases

Percent
cash
purchases

6 + 1

6 -3

7 -3

6 -4

$ 54.0

$ 458.5

$187.1

$ 634.1

$ 447.0

59.1

532.3

215.8

692.6

476.8

(1)

(2)

(3)

(4)

Year

Demand
deposits

O ther
checkable
deposits

Total
checkable
deposits

1970

$ 53.6

$ 0.4

1971

58.6

0.5

70.5%

11.83

11.74

8.27

1.38

68.8

11.82

11.72

8.07

1.30

1972

65.4

0.6

66.0

609.8

240.8

767.0

526.2

68.6

11.73

11.62

7.97

1.26

1973

70.1

0.8

70.9

654.8

269.0

834.3

565.3

67.8

11.90

11.77

7.97

1.27

1974

73.3

0.9

74.2

694.4

269.4

914.1

644.7

70.5

12.47

12.32

8.69

1.32

1975

78.0

1.6

79.6

796.2

280.7

1016.9

736.2

72.4

13.04

12.78

9.25

1.28

1976

82.6

3.2

85.8

921.2

318.2

1127.9

809.7

71.8

13.65

13.15

9.44

1.22

1977

91.0

4.8

95.8

1034.8

373.5

1254.5

881.0

70.2

13.79

13.09

9.20

1.21

1978

97.4

7.8

105.2

1117.5

424.2

1416.6

992.4

70.1

14.54

13.47

9.43

1.27

1979

99.2

17.7

116.9

1200.1

465.8

1582.3

1116.5

70.6

15.95

13.54

9.55

1.32

1301.7

74.3

17.10

13.49

10.03

1.36

1432.3

74.1

22.05

11.86

8.90

1.36

1980
1981

102.4
86.6

27.4
74.4

129.8
161.0

1286.2
1400.8

449.3
477.2

Notes: (1) Gross IPC Consum er demand deposits, year-end figures. Source:
Federal Reserve B ulletin. Figure fo r 1981 is preliminary.
(2) NOW and ATS accounts, credit union share drafts and demand
deposits at m utual savings banks. Source: Federal Reserve Board.
(3) IPC consum er demand deposits plus other checkable deposits.
(4) M2 m inus o ve rn ig h t E urodollars m inus overnight RPs m inus
money m arket m utual funds minus currency minus demand de­
posits plus IPC consum er demand deposits plus other checkable
deposits. Source: Federal Reserve Bulletin.

1909.5

(5) Consum er in sta llm e nt cre d it extensions plus no n-installm en t
consum er credit outstanding. The installm ent fig u re is 12 times
the December total fo r that year, w hile the non-installm ent figure is
tw o times the December total (under the assum ption of a sixm onth, term -to-m aturity structure of non-installm ent credit, on
average). Source: Federal Reserve Board.
(6) Expressed at annual rates. Source: Departm ent of Commerce.
(7) Personal consum ption expenditures less total consum er credit
[Col (6) - Col (5)].
(8) The ratio of total cash purchases to personal consum ption ex­
penditures [Col (7) - Col (6)[.

MAY 1982




1751.0

OF ST. LOUIS

Co nsu m er Deposits and Credit

BANK

Table 1
Consumer Deposits, Credit, Expenditures and Deposit Velocities (amounts in billions of dollars)

FEDERAL RESERVE BANK OF ST. LOUIS

technical national income accounting and com­
parability problems are avoided. First, all personal
consumption expenditures are final goods trans­
actions and appear in GNP; in fact, they are over 60
percent of this measure. Hence, all the credit ex­
tensions to consum ers are used for final goods
purchases. In contrast, commercial credit and trade
credit may be financing intermediate goods. Second,
a direct comparison of credit use and demand de­
posit holdings for an identifiable set of buyers is
made possible; hence, characterizations about the
relative use of credit and dem and deposits in rela­
tion to income are facilitated. Third, data on credit
extensions are available so that a truer picture of
credit utilization can be obtained than when using
balance sheet changes in debt.
The data in table 1 characterize the m anner in
which households have made their purchases and
held their deposits during the last 12 years; these
data are based on fourth quarter and D ecem ber
observations in each year. Clearly evident is the
recent substitution of non-bank checkable deposits
for dem and deposits (columns 1 and 2), as well as the
steady decline in holdings of demand deposits rela­
tive to total purchases (column 6) m easured by their
velocity (column 9). Conversely, the ratio of pur­
chases to total consumer checkable deposits, the
velocity of total checkable deposits (column 10), rose
much more gradually and fell abruptly in 1981 to
about its level in 1970.
As the data indicate, the proportions of consumer
transactions initially mediated by money and credit
(column 6) varied only slightly during the 1970s; the
share of purchases that were mediated by currency
and demand deposits rem ained around 70 percent
(assuming a six-month term to m aturity in non­
installment credit) over the decade. Thus, over this
period of rough constancy in the distribution oftypes
of mediation, the ratio of consumer expenditures to
demand deposit holdings by consumers (column 9)
increased by almost 45 percent. Conversely, the
ratio of purchases to total checkable deposits rose
only 15 percent through 1980 (column 10). More­
over, in 1981, demand deposits fell abruptly (column
1) and other checkable deposits rose even more
sharply (column 2) after the institution of NOW
accounts nationwide. As a result, the velocity of total
cheekables fell in 1981 to approximately its 1970
value.
If we assume a narrow or transactions medium
definition of money, M l, the observations over 197080 would be evidence of a decline in the quantity of



MAY 1982

m oney dem anded by households. On the other
hand, if we consider total cheekables in 1981 or
assume a broader temporary-abode-of-purchasingpower definition, M2, then the ratios of consumer
expenditures to the consumer deposit holdings pro­
vide contrary evidence. As shown in column 12 of
the table, the ratio of consumer expenditures to the
sum of household dem and deposits, saving and
small time deposits, and money market mutual funds
varied comparatively little relative to the demand
deposit and total cheekables ratios. Thus, under the
broader definition, the quantity of money dem anded
—at least the consumer portion—does not appear to
have declined during the 1970s. In particular, 1980
and 1981 do not appear to be qualitatively different
than the earlier years.
The third m anner of assessing credit’s impact is to
determ ine w hether the trends in the income veloc­
ities of the m onetary aggregates have changed
significantly in recent years. As we saw in the slopes
of M l and M2 velocities in chart 2, monetary aggre­
gate velocities had strong trends in their growth over
the two decades 1959-81. While on a quarter-toquarter basis velocity growth rates exhibit signifi­
cant variability, chart 2 suggests that over longer
periods velocity growth is fairly regular. This trend
regularity is substantiated in chart 3, which plots the
growth rates of M l and M2 velocities. In this chart,
quarter-to-quarter (QQ), four-quarter moving aver­
age (4QMA) and 20-quarter moving average (Trend)
growth rates appear. While QQ is highly variable for
both M 1 and M2, the 4QMA for each has a markedly
smaller amplitude; considering ± 4 percent bands,
only one observation for M l’s velocity growth and
three observations for M2’s velocity growth lie
beyond them . Also, the trend for each strongly
underscores the apparent tendencies in chart 2; in
each case, M l and M2 velocities have stable trends,
especially when m easured over periods longer than
a year. In particular, the charts do not reveal recent
velocity growth to have been qualitatively different
than in earlier years.
This lack of change in M l and M2 velocity growth
is even more apparent in table 2, which displays
velocity growth rates, their standard deviations, and
their ranges for 1961-81, for five-year subperiods,
and for the year 1981; growth rates are computed for
two observation frequencies: quarter-to-quarter
(QQ) and four-quarter moving average (4QMA).
Consider the behavior of M l velocity computed
on a quarterly basis. Over the entire 1961-81 period,
it has had an average growth rate of 3.16 percent per
31

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 3

Ve lo city G r o w t h Rates

Note:

QQ

-

qu arter-to -q uarter

4 Q M A = fo u r-q u a rte r m o v in g a v e r a g e


32


MAY 1982

MAY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Table 2
Annual Growth Rates of M1 and M2 Velocities During 1961-81
Aggregate i

Observation
frequency

M1

QQ

Mean
SD
Range

3.25
3.62
-4 .4 7 , 13.90

3.71
2.62
- 1.18, 9.44

1.96
3.02
-4 .0 6 , 7.08

4QMA

Mean
SD
Range

3.12
1.58
-1 .0 1 ,6 .9 8 .

3.17
1.79
- 1.01, 5.86

QQ

Mean
SD
Range

.17
4.05
-8 .2 3 ,1 1 .7 5

4QMA

Mean
SD
Range

.04
2.36
-5 .3 2 , 6.31

M2

Velocity G rowth at Annual Percentage Rates during:
1961-81
1961-65
1966-70
1971-75

1976-80

1981

3.64
3.64
-3 .3 6 , 9.00

3.39
3.49
-4 .1 6 , 10.02

4.74
9.13
-4 .4 8 , 13.90

2.36
1.52
-.0 9 , 5.15

2.94
1.16
.70, 5.47

3.77
1.51
1.86, 6.98

4.35
1.39
2.61, 6.01

-.5 9
2.62
- -4.32, 4.36

.68
3.54
-7 .8 1 , 5.75

-.2 8
4.13
-8 .2 3 , 6.26

.81
4.87
-6 .0 9 , 11.75

.47
8.03
-7 .0 0 , 10.83

-1.25
1.87
5.32, 2.29

1.06
1.72
-2 .7 6 , 3.01

-.6 5
2.41
-4 .4 6 , 3.96

.60
2.68
-3 .8 4 , 6.31

year. As was apparent in chart 3, quarter-to-quarter
fluctuations can be significant; yet, over the two
decades, the standard deviation of its growth rate has
remained about 3.00. W hile extrapolating the longrun velocity growth rate of M l to 1981 underesti­
mates the observed growth rate, the 4.74 percent rate
is well within one standard deviation of either the
1976-80 mean or that of the full 1961-81 period, and
represents a fluctuation that is comparatively small
in terms of the range of observed growth rates during
either the subperiod or the full period as shown in
chart 3.
For M l, QQ and 4QMA have roughly the same
average growth rates; for M2, the 4QMA growth rate
is relatively more volatile than the QQ growth rate.
Yet, in absolute terms the difference between QQ
and 4QMA is about equal for M l and M2 for the
entire 1961-81 period ( —.13) and for each subperiod
except 1976-80 and 1981. For both M l and M2, the
variability (SD) of 4QMA is naturally significantly
less than that of QQ. The standard deviations of
velocity growth computed on a four-quarter moving
average are about one-half of the quarterly version
for M l and the base and betw een one-half and twothirds for M2. Moreover, the standard deviation for
1981 is smaller than for the preceding subperiod.
The implication is, as usual, that quarterly monetary
statistics are a less useful guide to the longer-run
behavior of m oney than averages over longer
periods.



2.06
1.41
.23, 3.66

In summary, w hether we look at M l or M2, the
information displayed in chart 3 and compiled in
table 2 conveys the same message: namely, the
behavior of monetary aggregate velocities in 1981 is
not qualitatively different than over the preceding
20-year period or any of the subperiods. This is
clearest when considering the four-quarter moving
average growth rates, though the more volatile
quarter-to-quarter rates tell essentially the same
story. While velocity growth rates were higher in
1981 than in preceding subperiods during 1961-81,
there is no evidence that credit use and financial
innovations have severed the link betw een mone­
tary aggregates and the inflation rate.

CONCLUSION
Much of the current debate over U.S. economic
policy has focused on the wisdom of targeting a
monetary aggregate to control inflation. Some critics
of such policies have alleged that financial innova­
tions have both made money uncontrollable and
severed its predictable link with national income
and prices. Others have argued that non-monetary
assets or liabilities may have a closer link than
money to income over the long run. This article has
focused on the predictable linkage issue by exam­
ining the principal function of money and credit, the
mediation of exchange. Since credit’s mediation
33

FEDERAL RESERVE BANK OF ST. LOUIS

function depends crucially on the predictable source
of monetary settlement, there is no theoretical sup­
port for assertions that the increasing use of credit
has severed money’s link to income. In terms of the
empirical evidence for the year 1981, both M l and
M2 velocities grew reasonably close to their trend
rates. This is grossly inconsistent with assertions that
monetary policy is ineffective.
While the controllability issue has not been ad­
dressed in this article, an analysis of the changes in
monetary aggregates in relation to Federal Open
Market Committee (FOMC) directives during 1981
suggests that both M l and M2 movements were


34


MAY 1982

strikingly in accord with the intentions of the
FOMC.26
Consequently, there appears to be no reasonable
foundation—theoretical or empirical—for abandon­
ing the use of a monetary aggregate as the vehicle for
monetary policy. Unless or until velocity becomes
more unpredictable or fluctuates over ranges not
previously observed, the usefulness of monetary
aggregates in controlling inflation and maintaining
economic stability will be undiminished.
26See Daniel L. Thornton, "The FOMC in 1981: Monetary Con­
trol in a Changing Financial Environm ent,” this Review (April
1982), pp. 3-22.