Full text of Review (Federal Reserve Bank of St. Louis) : May 1983

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

The Review is published 10 times per year by the Research and Public Information Department of
the Federal Reserve Bank o f St. Louis. Single-copy subscriptions are available to the public free of
charge. Mail requests fo r subscriptions, back issues, or address changes to: Research and Public
Information Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri
63166.
Articles herein may be reprinted provided the source is credited. Please provide the Bank’s
Research and Public Information Department with a copy of reprinted material.

Federal Reserve Bank of St. Louis

Review
May 1983

In This Issue . . .

The articles in this Review focus on two controversial issues currently under
public scrutiny. The first article investigates the widespread claims that monetar
ism is dead. The second article assesses the validity of the charge that bank loan
rates — in particular, the prime rate — are “too high, ” given the cost of obtaining
loanable funds.
In the first article, “Are Monetarists an Endangered Species?” Dallas S. Batten
and Courtenay C. Stone investigate the alleged failure of monetarism. They point
out that monetarism can be viewed in two ways: as a scientific theory about the
impact of monetary pressures on the economy, or as a diverse collection of
normative propositions about how fast money should grow or what policy actions
should be taken. The authors suggest that, while disagreements over normative
monetarism are probably unsolvable, debates over scientific monetarism can be
resolved.
Batten and Stone examine four scientific monetarist propositions: 1) There is a
close, stable relationship between M l growth and total spending; 2) Inflation is
primarily a monetary phenomenon; 3) Sufficiently sharp short-run changes in M l
growth produce similar movements in real output; and 4) The rate of M1 growth
can be controlled. None of these propositions, they find, have been discredited by
economic events over the past several years.
Batten and Stone also demonstrate that predictions of the growth of spending,
prices and real GNP derived from these monetarist propositions have held up well
when compared with predictions of two popular, larger non-monetarist structural
models of the economy. They conclude that rumors of the death of monetarism
have been greatly exaggerated.
In the second article, “The Prime Bate and the Cost of Funds: Is the Prime Too
High?” B. W. Hafer investigates the economic forces underlying the prime
lending rate.
Hafer notes first that, since the early 1970s, the prime rate generally has varied
with current credit market conditions: “As the competition for loanable funds and
the cost of liability management have increased with the advent of numerous
financial innovations, banks have become more sensitive to interest rate changes
in establishing their lending rates. ” Consequently, prime rate changes accompany
changes in banks’ cost of funds.
To test this relationship, Hafer examines the effects of movements in the 90-day
CD rate and the federal funds rate — measures of a bank’s cost of short-term funds
— on the prime rate over the period September 1980 to December 1982. His
evidence indicates that a 100 basis-point change in these rates will, after three
months, produce a similar change in the prime rate; changes in the prime rate
generally follow changes in the cost of funds.
3

In This Issue . . .
To see whether the prime rate currently is too high, given the present cost of
funds, Hafer forecasts the prime rate from January through April 1983, using the
actual 90-day CD rate and the federal funds rate for the period. The author
concludes that “relative to their cost of funds, banks have not kept the prime rate
unduly high during the past few months.”

Are Monetarists an Endangered Species?
DALLAS S. BATTEN and COURTENAY C. STONE

ONETARISM has come under increasingly
sharp attack over the past few years. Recent critics
have detailed “The Trouble W ith M onetarism,”
argued that the choice is between Monetarism or
Prosperity and even recoiled in horror from The
Scourge of Monetarism.1 Various accounts of the fail
ure of monetarism in Argentina, Canada, Chile and
Great Rritain have received widespread attention.2
Moreover, monetarism in the United States has been
described as a “God that failed, ” and there have been
numerous reports that monetarism is now virtually
dead.3
'Alan Reynolds, “The Trouble with Monetarism,” Policy Review
(Summer 1982), pp. 19-42; Bryan Gould, John Mills and Shaun
Stewart, Monetarism Or Prosperity (Macmillan Press Ltd., 1981);
and Nicholaus Kaldor, The Scourge o f Monetarism (Oxford Uni
versity Press, 1982).
2See, for example, “Monetarism loses face north of the border,”
Economic Diary, Business Week (December 20, 1982), p. 12; John
Kirbyshire, “Monetarism Remains Economic Scapegoat,” New
York Journal o f Commerce, November 4, 1982; “In Britain, mone
tarism took a heavier toll,” Business Week (April 4, 1983), pp.
66-67; Jeremy Morgan, “Argentina Abandons Monetarism,” New
York Journal o f Commerce, June 19, 1982; and Everett G. Martin,
“Milton Friedman’s Proteges in Chile See Influence Declining
Because of Recession,” The Wall Street Journal, July 27, 1982.
Even discussions of monetarism can produce conflicts; see “Fried
man’s Views Ignite Political Debate in Peru, Washington Post,
November 22, 1981.
3For the most recent citation that monetarism has failed in the
United States, see “The Failure of Monetarism,” Business Week
(April 4, 1983), pp. 64-67. For earlier criticisms, see Andrew F.
Brimmer, “A Return to Monetarism: the Dangers,” American
Banker, February 3, 1983; Stuart E. Eizenstat, “Volcker’s Mone
tarist Policy: Painful, Costly,” The New York Times, October 18,
1982; William D. Nordhaus, “Destroying the Economy to Save It,”
The New York Times, December 26, 1982; Peter Field, “The
Death of Reaganomics,” Euromoney (September 1982), pp. 95107; and Irving Kristol, “The Big Question: Is ‘Reaganomics’
Working?” The Wall Street Journal, October 14, 1982. Apparently
the only nations where monetarism currently is practiced unchal
lenged are the People’s Republic of China and the Soviet Union;
see Leo Goodstadt, “The Great Chinese Economic Retreat,” Euro
money (April 1981), pp. 73-77; Milton Friedman, “Marx and
Money,” Newsweek (October 27, 1980), p. 95; and Milton Fried
man, “Defining Monetarism,” Newsweek (July 12, 1982), p. 64.

The alleged death of monetarism could not have
come at a more inappropriate time. Milton Friedman
and Anna Schwartz have just published a massive
volume entitled Monetary Trends in the United States
and the United Kingdom: Their Relation to Income,
Prices and Interest Rates 1867-1975.4 In that text, they
present extensive and detailed evidence that supports
the basic monetarist propositions regarding the impact
of money on the economy.3 It would be both ironic and
puzzling if, at the very time that their findings are
published, we were to discover that these fundamental
relationships suddenly have broken down.
Yet, this claim is precisely the one that critics of
monetarism have made. They charge that recent finan
cial innovations and the expanding use of previous
financial innovations have so distorted the measure
and meaning of money that monetarism, no matter
how well supported by historical studies, is no longer
valid.6 Since this claim has been made before and
found, in each instance, to be groundless, it should be
met with considerable skepticism.7
4Milton Friedman and Anna J. Schwartz, Monetary Trends in the
United States and the United Kingdom: Their Relation to Income,
Prices and Interest Rates, 1867-1975 (University of Chicago Press,
for the National Bureau of Economic Research, 1982).
°For detailed reviews of the just published Friedman and Schwartz
volume, see David Laidler, “Friedman and Schwartz on Monetary
Trends: A Review Article,” Journal o f International Money and
Finance (December 1982), pp. 293-305; Thomas Mayer, “Mone
tary Trends in the United States and the United Kingdom: A
Review Article,” Journal o f Economic Literature (December
1982), pp. 1528-39; Charles A. E. Goodhart, “Monetary Trends in
the United States and the United Kingdom: A British Review,”
Journal o f Economic Literature (December 1982), pp. 1540-51;
andRobertE. Hall, “Monetary Trends in the United States and the
United Kingdom: A Review from the Perspective of New Develop
ments in Monetary Economics, ” Journal o f Economic Literature
(December 1982), pp. 1552-56.
6For a recent version of this claim, see Edward P. Foldessey, “New
Bank Accounts May Force Fed to End Experiment in Monetar
ism,” The Wall Street Journal, December 28, 1982.
7For an assessment of the “monetarism has failed” claim circa 1972,
see Darryl R. Francis, “Has Monetarism Failed? — The Record
Examined,” this Review (March 1972), pp. 32-38.
5

FEDERAL RESERVE BANK OF ST. LOUIS

This article attempts to assess whether current
rumors of the demise of monetarism are greatly ex
aggerated.

A TALE OF TWO MONETARISMS:
SCIENTIFIC PROPOSITIONS VS.
NORMATIVE PRESCRIPTIONS
Perhaps the most significant obstacle to understand
ing many of the current arguments, both for and
against monetarism, is that the term typically is ban
died about with little or no specific reference to its
intended meaning. This is a problem because monetar
ism can refer to two very different kinds of statements.
Monetarism can refer to specific, testable, scientific
propositions; it also can be used to indicate a set of
policy suggestions or alternatives to achieve desired
economic goals.8 In the scientific sense, we can assess
easily whether monetarism has failed. In the norma
tive or policy sense, however, it may be impossible to
agree whether monetarist policies have even been
attempted, let alone have failed.
Monetarism as a Science

Looked at in a scientific sense, monetarism is the
label attached to a common set of theoretical and
empirical propositions regarding the significant and
stable relationship between the money stock and other
important economic variables. There is a methodolo
gy, common to all sciences, that is used to assess the
logical validity and empirical support for competing
theories. Scientific theories never die by themselves;
they are abandoned only when a better theory comes
along. If monetarism, in the scientific sense of the
word, has failed, it must have succumbed to an alterna
tive non-monetarist explanation.
It is clear that, within the scientific framework of the
rise and demise of theories, monetarism has not been
superseded by newer or superior theories of inflation
or real output or spending growth.9 Instead, critics
charge that the behavioral relationships that worked
well in the past have shifted and that the previously
stable relationships underlying the monetarist view
have now become unstable. If this has occurred, then
the propositions labeled monetarism would become
less useful. In the extreme, they would even be re^Tliis distinction is discussed briefly in Milton Friedman’s “De
fining Monetarism.”
^The presumed failure of all economic theories has been noted
recently by John Greenwald, “W here Have All the Answers
Gone?” Time (January 17, 1983), pp. 36-37.
6

MAY 1983

placed by some previously less useful, non-monetarist
theory. This issue is analyzed in the latter part of this
article.
Monetarism as an Economic Policy

In addition to its scientific meaning, however,
monetarism also can be used in a normative or policy
sense. As such, it serves as a label for a set of economic
policy prescriptions intended to achieve certain eco
nomic goals. Of course, such policy prescriptions pre
suppose that monetarism, in the scientific sense, is
valid and that policymakers can exert some control
over money growth.
There are several fundamental problems with
attempting to assess the success or failure of normative
monetarism. First, there may be no common agree
ment on whether a monetarist policy has been fol
lowed; consequently, it will be virtually impossible to
demonstrate that it has failed. To illustrate this prob
lem, consider the data shown in table 1. A number of
countries have announced a variety of monetary aggre
gate targets over the past three years; six of these are
represented in the table. Because these countries have
adopted and publicly announced such targets, numer
ous commentators have labeled their policies as mone
tarist. Because these targets generally were not
achieved and because economic conditions in these
countries over the past three years were generally
poor, it has been charged that monetarism has failed.
At the same time, other analysts have used the same
data to support the opposite conclusion. Because the
announced targets were not achieved, they argue, the
actual behavior of the monetary authorities was clearly
non-monetarist. Further, the resultant adverse eco
nomic conditions are used to demonstrate why mone
tarist policies should have been followed.
A prime example of the problem associated with
determining whether a specific policy is monetarist is
the widespread disagreement over whether the Feder
al Reserve has been following a “monetarist” policy
since October 1979.10 When a group of policymakers,
economists and financial analysts were asked this ques
tion recently by the Joint Economic Committee of the
U.S. Congress, their answers ranged from the strongly
affirmative to the strongly negative to the inscrutably
10On October 6, 1979, the Federal Reserve announced that it had
changed its operating procedures to achieve enhanced control
over money. This change in policy implementation was relaxed in
October 1982.

MAY 1983

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Monetary Aggregate Targets and Monetary Aggregate Growth
for Six Countries: 1979-1982
Annual growth
rates of aggregate

Targeted
aggregate

Country

Canada

Period

Targeted

Actual

11/1979 to quarter
centered on 9/1980

5 to 9%

6.2%

4 to 8

4.81

quarter centered on
9/1980 to present
Japan

M2 plus CDs

111/1979-111/1980
IV/1980— IV/1981
IV/1981— IV/1982

10
10
8

8.4
10.6
8.0

Monetary
base

12/1979-12/1980
12/1980-12/1981
12/1981-12/1982

4
4
3

2.3
-3 .3
8.2

Switzerland

£ M3

2 /1 9 8 0 - 4/1981
2 /1 9 8 1 - 4/1982
2 /1 9 8 2 - 4/1983

7 to 11
6 to 10
8 to 12

19.7
13.3
9.82

IV/1979— IV/1980
IV /1980-IV /1981
IV/1981-IV /1 982

4 to 6.53
6 to 8.54
2.5 to 5.5

7.3
5.0
8.5

Central
Bank Money

IV/1979— IV/1980
IV/1980— IV/1981
IV/1981- IV /1 982

5 to 8
4 to 7
4 to 7

4.8
3.5
6.1

United Kingdom

United States

W est Germany

19/1980 to 2/1983.
*2/1982 to 2/1983.
3Target range for M1B.
4Comparable to 3 .5 -6 .0 percent range for shift-adjusted M1B.

cryptic.11 The basic problem is simply that reasonable
people can differ both on their interpretation of
whether a specific policy is monetarist and whether it is
being carried out in a monetarist fashion.
A different problem with assessments of policy fail
ures is that policymakers and the general public
appear to shift back and forth among a variety of goals;
further, they often fail to agree among themselves on
the likely outcome of policy actions.12 Flip-flopping
between policy goals can lead to erratic policy actions
11Monetarism and the Federal Reserve’s Conduct o f Monetary
Policij, Compendium of Views Prepared for the Use of the
Subcommittee on Monetary and Fiscal Policy of the Joint Eco
nomic Committee, Congress of the United States, 97 Cong. 2
Sess. (U.S. Government Printing Office, December 30, 1982).
12For the apparent “shiftiness” of monetary policy goals, see
Richard Froyen, “A Test of the Endogeneity of Monetary Policy,”
Journal o f Econometrics (July 1974), pp. 17.5-88; Richard K.
Abrams, Richard Froyen and Roger N. Waud, “Monetary Policy
Reaction Functions, Consistent Expectations, and the Burns
Era, ”Journal o f Money, Credit and Banking (February 1980), pp.
30-42; John H. Wood, “A Model of Federal Reserve Behavior,” in
George Horwich, ed., Monetary Process and Policy: A Sympo

that are unlikely to fit neatly into any category —
monetarist or non-monetarist. Disagreement over the
likely outcomes of policy actions will lead typically to
different assessments by policymakers and others
about the “success” of policy actions. To some, policy
will have succeeded; to others, it will have failed.
Debates over whether monetarist monetary policies
have been tried, or whether they have failed, or even
whether they were the appropriate monetarist policies,
are unlikely to be resolved. In the normative sense, a
discussion of whether monetarism has failed is both
inconclusive and, probably, nonsensical as long as
there is such widespread disagreement. These discus
sions only serve to draw attention from the crucial issue
that can be resolved — whether monetarism, in the
siurn (Richard D. Irwin, 1967) pp. 135-66; and Thomas M. Havrilesky, Robert H. Snapp and Robert L. Schwertzer, “Test of the
Federal Reserve’s Reaction to the State of the Economy, ” Social
Science Quarterly (March 1975), pp. 743-52. For a statement of
the failure of monetary policymakers to agree on what the actual
outcome of policy is likely to be, see John M. Berry, “Fed to Resist
Call on Hill for Its Economic Goals,” Washington Post, April 5,
1983.
7

FEDERAL RESERVE BANK OF ST. LOUIS

scientific sense, has failed. If scientific monetarism has
failed, then discussions over normative monetarist
issues are meaningless; there can be no useful mone
tarist policies if the relationships between money
growth and other important economic variables are
unstable or nonexistent. On the other hand, if scien
tific monetarism has not failed, discussions over
whether some policy can be labeled as monetarist are
mere bagatelles; what matters is not the label attached
to the policy, but the actual pattern of money growth
that the policy produces. The crucial issue that must
be addressed is the success or failure of scientific
monetarism.

MAY 1983

C h a rt 1

G r o w th in th e M o n e y S u p p ly a n d G N P
E x p e n d itu re s in 2 5 C o u n trie s fro m 1 9 6 9 to 1 9 8 0
A n n u a l r at e
Pe rc e nt

FOUR WELL-KNOWN SCIENTIFIC
MONETARIST PROPOSITIONS: HAVE
THEY FAILED?
There are a large number of economic propositions
that have come to be associated with monetarism, or at
least w ith individuals who have been labeled
monetarists.13 We do not intend to investigate all such
propositions. Instead, we focus on what we consider to
be four key monetarist propositions. The first three
13For statements, suggestions and, in some cases, extensive lists of
what monetarism means, see Karl Brunner, “The Role of Money
and Monetary Policy,” this Review 0uly 1968), pp. 9-24; Darryl
R. Francis, “An Approach to Monetary and Fiscal Management,”
this Review (November 1968), pp. 6-10; Allan Meltzer, “Control
ling Money,” this Review (May 1969), pp. 16-24; Karl Brunner,
“The Monetarist View of Keynesian Ideas, ” Lloyds Bank Review
(October 1971), pp. 35-49; A. Robert Nobay and Harry G. John
son, “Monetarism: A Historic-Theoretic Perspective,"Journal of
Economic Literature (June 1977), pp. 470-85; Jerome L. Stein,
ed., Monetarism (North-Holland Publishing Co., 1976); Thomas
Mayer, The Structure o f Monetarism (W. W. Norton & Company,
Inc., 1978), especially p. 2; Brian Morgan, Monetarists and
Keynesians: Their Contribution to Monetary Theory (Halsted
Press, 1978), especially pp. 89-91; Howard R. Vane and John L.
Thompson, Monetarism: Theory, Evidence and Policy (Halsted
Press, 1979), especially pp. 3—16; Douglas D. Purvis, “Monetar
ism: A Review,” Canadian Journal o f Economics (February 1980),
pp. 96-121; David Laidler, “Monetarism: An Interpretation and
an Assessment, ” The Economic Journal (March 1981), pp. 1-28;
and John Burton, “The Varieties of Monetarism and Their Policy
Implications,” The Three Banks Review (June 1982), pp. 14-31.
Needless to say, these are only a few of the huge number of articles
and books on this issue. Moreover, there are a host of alleged
kinds of monetarists and monetarism. John Burton provides the
following listing in “The Varieties of Monetarism”: Marxist,
Friedmanite, rational expectations, global, fiscal, Austrian and
Thatcherite. Herbert Stein, in “Monetarism Under Fire,” AEI
Economist (September 1981), pp. 1-8, distinguishes three cate
gories of monetarists: half-way, true-blue and gold-standard.
Robert D. Auerbach in Monetarism and the Federal Reserve’s
Conduct o f Monetary Policy, pp. 39-45, lists the following kinds
of monetarists: exaggerated or naive, cameo, asymmetric, creep
ing asymmetric, commodity target, distant target, changing target,
multiple target, conventional, central banks, one-issue-at-a-time
and interest rate. Finally, there are numerous different kinds of
pejorative monetarism that are mentioned frequently; among our

GNP expenditures
Source: P a ul F. Sm ith, C o m p a ra tiv e F in a n c ia l Systems (P ra e g e r, 1982), p .5 .

Perc e nt

propositions concern “what money does”; they repre
sent the relationship between money growth and the
growth of aggregate spending, prices and real output.
The fourth proposition focuses on the controllability of
money growth. The first three propositions demon
strate why money matters; the fourth proposition in
vestigates whether monetary policy matters.
Proposition 1: There is a close and stable rela
tionship between the growth o f money and the growth
of total spending. This relationship can be investigated
in a variety of ways. One simple way is to compare the
growth of M l, the narrow monetary aggregate consist
ing of currency and checkable deposits, to the growth
of aggregate spending, measured by Gross National
Product (GNP) or Gross Domestic Product (GDP).
This is done in chart 1 for a large number of countries
for the 1969 to 1980 period. It is clear from the chart
that, in general, there is a very close relationship be
tween growth in money and growth in total spending;
the vast majority of the countries are clustered close to
the 45-degree line that denotes equal growth rates for
both money and spending over the period.
favorites are: miscreant, flinty-eved, macho, knee-jerk, simple,
simplistic and mechanical. Given the above varieties of both
monetarism and monetarists, it is crucial, in any evaluation of
monetarism, that the term be carefully defined and consistently
used.

FEDERAL RESERVE BANK OF ST. LOUIS

A more analytical method of assessing the rela
tionship between growth in M l and GNP for the Unit
ed States involves the use of the St. Louis equation,
which was developed specifically to investigate the
impact of monetary and fiscal actions on GNP.
The St. Louis equation typically is written as:
(1) Yt = constant +

4
4
X irij M t _ f-I- 2 e, E t_j,
i = 0
i = 0

MAY 1983

Table 2
Estimation of St. Louis Equation:
11/1960 to iV/1982______________
Equation Estimated:

g ro w th o f G N P w ith in five q u a rte rs .

Another way of looking at this relationship can be
seen in chart 2, which contains the year-to-year growth
rates of nominal GNP and M l for the United States.
Clearly, changes in the growth of GNP from one year
to the next are positively associated with changes in the
growth of Ml.
If monetarism has failed due to recent financial in
novations, then the relationships estimated in table 2
and shown in chart 2 should have eroded substantially
since late 1979.14 This purported erosion is not appar
ent in chart 2; the link between money growth and
economic activity since III/1979 seems no different
14Sinee it is never possible to identify a single beginning point for a
continuous process like financial innovation, the date of the Fed’s
change in operating procedures (October f979) is used as the
break point in this, and all subsequent, analysis.

.
m iM ,^ +

i = 0

where Y, M and E are the annualized quarterly growth
rates of GNP, M l and high-employment government
expenditures, respectively, m; and ej represent the
impact of current and lagged values of M and E, re
spectively, the constant term represents the impact of
other influences on GNP growth, and i = 0, . . ., 4
shows that the equation investigates the extent to
which GNP growth in quarter t is affected by the
current and past four quarters’ growth in M and E.
Table 2 shows the results of estimating this equation
over the period from 11/1960 to IV/1982. There are
three key aspects to these results. First, as the R2
shows, the estimated equation accounts for a sizable
proportion of the actual fluctuations in GNP growth; in
this instance, about 30 percent of the variation in Y is
explained by the variables on the right-hand side of the
equation. Second, the explanatory power of the equa
tion is derived solely from the monetary variables; only
the estimated coefficients on M are statistically differ
ent from zero. Third, the sum of the coefficients on M
is not significantly different from one; this indicates
that, other things unchanged, any given change in the
growth of M l will produce the same change in the

Y, = constant +

ef E, j + u,

i = 0

Coefficient

Estim ate1

Constant

1.67 (1.31)

m0
m.
ITI2
m3
1TI4
Sm,

0.34*
0.43*
0.30*
0.05
- 0 .1 4
0.98*

(2.98)
(5.47)
(3.11)
(0.63)
(1.21)
(4.85)

e0
ei
e2

0.07
0.03
-0 .0 1
0.01
0.04
0.14

(1.62)
(0.75)
(0.30)
(0.19)
(1.05)
(1.36)

e3
e4
Se(
R* = .31

DW = 1.89

SE = 3.83

'Absolute values of t-statistics in parentheses.
'Statistically significant at the 5 percent level.

from that which existed during the previous two de
cades.
Of course, visual evidence is never conclusive;
appearances always can be deceiving. What is signifi
cant is that there is no statistical support that the
relationship between money and spending in the St.
Louis equation has broken down in recent years.
When the parameters of the St. Louis equation were
tested for their structural stability, the hypothesis that
the structure had “slipped” in the later period was
rejected.15 Thus, there does not appear to have been a
I5The stability of the coefficients in equation 1 is examined by
estimating
4

= a<) + a]D +

4
+

i=0

e i iE t _ i

m iiili-i +

4
£

i=0

iri2iDMt_i

e 2 iD E , _ i + et,

i=0
i= 0
where D, a dummy variable, equals f from 11/1960 to III/1979 and
0 otherwise. The stability test for the coefficients on M l growth is
conducted by testing the joint hypothesis that all of the estimates
of m2i are simultaneously equal to zero. The calculated F-statistic
for this test is 2.01; the critical F-value is 2.72 for the 5 percent
significance level. Consequently, the hypothesis that the coef
ficients on M1 growth have changed since III/1979 can be rejected
at the 5 percent significance level.
9

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

C h a rt 2

G r o w th R ates o f M l a n d N o m in a l G N P a
Percent

Percent

L i E a ch lin e r e p re s e n ts a f o u r - q u a r t e r g r o w t h ra te . The v e r t ic a l l in e b e t w e e n I I I / 7 9 a n d I V / 7 9 in d ic a t e s th e c h a n g e in F e d e r a l R e s e rv e o p e r a t in g
p r o c e d u r e s a n d th e b e g in n in g o f f i n a n c ia l in n o v a t io n s .

sudden failure of monetarism in the 1980s, at least as
judged by the relationship between money growth and
the growth of total spending.16
The second and third propositions are concerned
with how changes in money growth affect the two
fundamental components of nominal GNP growth —
real GNP growth and price growth (inflation).
Proposition 2: Inflation is primarily a monetary phe
nomenon. This proposition states that there is a close
positive relationship between the trend growth in
money and the growth in prices over long periods of
time. One example of the universality of this rela
tionship is shown in table 3 for a variety of countries
16For further evidence that innovations have had no significant
impact on M l, see John A. Tatom, “Recent Financial Innovations:
Have They Distorted the Meaning of M l?” this Review (April
1982), pp. 23-35 and “Money Market Deposit Accounts, SuperNOWs and Monetary Policv,” this Review (March 1983), pp.
5-16.
10FRASER
Digitized for

Table 3
Money Growth and Inflation A cross
Countries: 1973-1980_____________
Average annual rates of
Country

M1 growth

Inflation1

Italy

18.3%

17.6%

United Kingdom

13.0

16.4

France

10.9

10.6

Japan

9.4

7.0

Canada

8.9

10.0

Germany

8.7

4.7

Netherlands

8.4

7.8

Belgium

6.6

7.4

United States

6.4

7.7

Switzerland

3.8

3.6

'M easured by GNP deflator.

MAY 1983

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 3

M l G ro w th a n d Inflation Q
Pe rc en t

1960 61

Pe rce nt

81 1982

Q The M l g r o w t h lin e re p re s e n ts a t w e lv e - q u a r t e r m o v in g a v e r a g e o f M l g ro w th . The q u a r t e r - t o - q u a r t e r r a te o f c h a n g e o f th e G N P d e f la t o r is
d is p la y e d in th e in f la tio n lin e . The v e r t ic a l lin e b e tw e e n 111/79 a n d I V / 7 9 in d ic a te s th e c h a n g e in F e d e ra l R e serve o p e r a t in g p r o c e d u r e s a n d th e
b e g in n in g o f f in a n c ia l in n o v a tio n s .

over the period from 1973 to 1980. With few excep
tions, those countries with the greater M l growth also
had the higher rates of inflation.
Another way to assess the relationship between
price changes and money growth is to separate the
monetary and non-monetary influences on prices to
determine their relative importance at various points
in time. Since it is the trend growth in money that
influences prices, the monetary influence on the rate of
inflation in any period is the growth in money over
some fairly long past period.1' Chart 3 reports the
long-term rate of M l growth (measured by its 12quarter moving average) and the quarter-to-quarter
11There is exhaustive literature attesting to the existence of a long
lag between money growth and inflation rates. For recent evi
dence, see Keith M. Carlson, “The Lag From Money to Prices,”
this Review (October 1980), pp. 3-10; John A. Tatom, “Energy
Prices and Short-Run Economic Performance,” this Review (Janu
ary 1981), pp. 3-17; and Dallas S. Batten, “Money Growth Stabil
ity and Inflation: An International Comparison,” this Review
(October 1981), pp. 7-12.

rate of growth of the implicit price deflator for GNP for
the United States. In general, the path of inflation
follows that of long-run money growth. In fact, after
accounting for oil-price shocks, long-run M l growth
explains over 80 percent of the variation in the quarterto-quarter rate of inflation.18
lsSee Carlson, “The Lag From Money to Prices." The results of
estimating a similar inflation equation over the 11/1960 to IV/1982
period are:
12

P, = -0.866 + 1.091 2 M,_, -1.736 D1 + 0.695 D2
(2.19) (13.30) i = 0
(3.43)
(1.42)
- 0.001 |V , + 0.065 p'_ -0.005 p. :i
(0.11)
(3.96) ' (0.29)
R2 = .83
SE = 1.19
DW = 1.88
where Pt is the rate of inflation (measured by the GNP price
deflator) in quarter t, D1 and D2 are dummy variables for the
control and decontrol phases of the Nixon wage-price control
period, p' is the growth rate of the relative price of energy and the
absolute values of t-statistics are in parentheses.
11

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

C h art 4

Deviations of Short-Run M oney Growth from Trend 11

11111111111

1960 61

iim m iiiiiiii

iiiin iiiiiiiiiiii

in m i

iih iiiiiiiiiiiiiiiiiii

81 1982

[_1 T h e p lo t te d lin e r e p r e s e n t s a t w o - q u a r t e r m o v in g a v e r a g e o f m o n e y g r o w t h m in u s a t w e lv e - q u a r t e r m o v in g a v e r a g e o f m o n e y g r o w t h . The
v e r t ic a l lin e b e t w e e n 111/79 a n d I V / 7 9 i n d i c a t e s th e c h a n g e in F e d e r a l R e s e r v e o p e r a t i n g p r o c e d u r e s a n d th e b e g i n n i n g o f f i n a n c i a l in n o v a t i o n s .
S h a d e d a r e a s r e p r e s e n t p e r i o d s o f b u s in e s s r e c e s s io n .

Once again, there appears to be no significant break
down in this relationship after late 1979: the long-run
rate of money growth has declined during the past
years as has the rate of inflation. Moreover, an econ
ometric investigation indicates that there has been no
breakdown in the Ml-inflation relationship over the
past three years.19
Proposition 3: Short-run changes in money growth,
if sufficiently sharp, produce real output movements.
Conceptually, a change in money growth creates a
monetary disequilibrium: the quantity of money that
individuals desire to hold differs from the quantity that
they actually are holding. By altering their rate of
spending, they attempt either to increase or to de
crease their money holdings to a desired level. Even
tually, as discussed previously, this change in the rate
19A more rigorous investigation of a breakdown in the money
growth-inflation relationship entails conducting a test similar to
that in footnote 15 for the inflation equation cited in footnote 18.
The calculated F-statistic for this test is 1.53, well below the
critical value of 2.72 at the 5 percent significance level. The
hypothesis that the coefficients on M l growth in the inflation
equation have changed since III/1979 can be rejected.
12

of aggregate spending will cause a change in the rate
of inflation.
In the short run, however, producers cannot tell
immediately whether this change in the rate of aggre
gate demand (spending) is permanent or merely tem
porary; thus, they respond initially by changing their
rate of production. That is, the change in money
growth results in a deviation of real economic activity
from its “normal” rate. Only when the change in
spending (motivated by the monetary disequilibrium)
has been identified as perm anent will producers
change their prices and return production back to its
normal rate. Thus, the impact of a change in the rate of
money growth shows up initially and temporarily on
output and employment.20
This proposition is demonstrated in chart 4, which
reports the deviation of short-run M l growth (mea-°For a discussion of the microeconomic rationale behind the timing
of the effect of changes in money growth on real output (initially)
and prices (ultimately), see Carlson, “The Lag From Money to
Prices,” pp. 6-8.

FEDERAL RESERVE BANK OF ST. LOUIS

sured by its two-quarter moving average) from its longrun trend (measured by its 12-quarter moving aver
age). The shaded areas represent periods defined as
recessions by the National Bureau of Economic Re
search. Every downturn in economic activity in the
last two decades has been associated with a substantial
slowing in money growth relative to its trend;
every substantive slowdown in short-run M l growth
has been associated with an economic downturn.21
Although the 1966 episode was not technically labeled
a recession, the United States experienced a “growth
recession”; real GNP growth fell from about 10 percent
to zero following the dramatic decline in money growth
in 1966.
There appears to be no breakdown in this rela
tionship since late 1979. In fact, this proposition is
supported quite strongly by recent events. For exam
ple, money growth declined substantially in early 1980
(almost 5 percentage points below its trend); accom
panying this decline in M l growth, real economic
activity declined rapidly and dramatically. By the third
quarter of 1980, money growth had rebounded and the
economy began pulling out of a short-lived recession.
When short-run money growth declined from 5Yz per
centage points above its trend in IV/1980 to about 4
percentage points below its trend by IV/1981 (an un
precedented drop), however, the economy headed
into its second recession in as many years, a recession
from which we have only recently begun to recover.
Proposition 4: Monetary authorities can control the
rate o f money growth. Within the context of monetary
policy, the first three monetarist propositions are rel
atively unimportant unless the growth of money is
controllable. The money definition that we have used
in this study, M l, consists of currency and checkable
deposits, the two things generally offered and accepted
in exchange for goods and services. The monetary
authority cannot control M l directly because the
checkable deposits that make up a large part of M1 are
created by depository institutions. The monetary au
thority, however, through its open market operations
21Again, this proposition has been documented extensively. See, for
example, Milton Friedman and Anna J. Schwartz, “Money and
Business Cycles,” Review o f Economics and Statistics (Supple
ment: February 1963), pp. 32-78; William Poole, “The Rela
tionship of Monetary Decelerations to Business Cycle Peaks:
Another Look at the Evidence, "Journal o f Finance (June 1975),
pp. 697-712; Dallas S. Batten and R. W. Hafer, “Short-Run
Money Growth Fluctuations and Real Economic Activity: Some
Implications for Monetary Targeting,” this Review (May 1982),
pp. 15-20; and Dallas S. Batten and R. W. Hafer, “Is There a Role
for Monetary Targeting?” Review o f Business and Economic Re
search (forthcoming, 1983). The last two articles cited above de
monstrate that similar results are found across countries as well.

MAY 1983

Grow th in Reserves and D em and Deposits
in 24 Countries from 1969 to 1980
Annual

rate

Percent

E q u a l grow th ra te s—

P H IL IP P IN E S •
M A L A W I*
S O U T H A F R IC A .
CYPRUS.
CANADA#
FRAN C E'
T H A IL A N D .
GERMANY
A U S T R IA * y
•^ N O R W A Y
r B E LG IU M
•N E T H E R LA N D S
A U S T R A L IA

20
Demand

30
d eposits

S o urce: P a u l F. Sm ith, C o m p a ra tiv e F in a n c ia l System s (P rae ge r, 1982), p.11.

and lending to depository institutions, can control the
stock of reserves held by depository institutions upon
which these checkable deposits are based. As a result,
the monetary authority can control the growth of
money supply indirectly by controlling the rate of
growth of these reserves.22
In the very short run, changing asset preferences of
individuals may cause discrepancies between the rate
of growth of reserves and that of checkable deposits.
Yet, over longer periods of time, these growth rates
conform closely across a wide variety of monetary in
stitutions, as exhibited in chart 5 for a large number of
countries. This chart illustrates that, over time, re
serve growth and demand deposit growth are asso
ciated closely. Moreover, because checkable deposits
are a large portion of the M l definition of money,
reserve growth is, then, a prerequisite for money
growth.
This analysis neglects the role that currency plays in
the money supply process. Since currency in the hands
of the nonbank public is another potential source of
bank reserves, changes in the public’s demand for
currency also may be the source of monetary expansion
22See Anatol B. Balbach, “How Controllable is Money Growth?”
this Review (April 1981), pp. 3-12.
13

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

C h a rt 6

G ro w th of M l a n d the A d ju sted M o n e ta ry B a se

I f 60

81 1982

|_1_ Each lin e re p re s e n ts a f o u r - q u a r t e r m o v in g a v e r a g e . The v e r tic a l lin e b e tw e e n 111/79 a n d I V / 7 9 in d ic a te s th e c h a n g e in F e d e ra l R e serve o p e r a tin g
p ro c e d u r e s a n d th e b e g in n in g o f fin a n c ia l in n o v a tio n s .

and contraction. Thus, both reserve availability and
the amount of currency in the hands of the public must
be controlled by the monetary authorities if they desire
to control money growth.
The monetary base is the sum of bank reserves and
currency in circulation. In the United States, it repre
sents a liability of the Federal Reserve. Even though
the Federal Reserve does not possess discretionary
control over all of the items in its balance sheet, it does
have sufficient control to determine the level and
growth of the monetary base it desires, even on a
weekly basis.23
The link between the monetary base and the money
supply is the money multiplier. Changes in this multi
plier reflect changes in the public’s preferences for
various financial assets. Since these changes can either
intensify or mitigate the impact of Federal Reserve
actions, control of the monetary base may still be
23See Balbach, “How Controllable is Money Growth?”
Digitized for14
FRASER

associated with periods of highly variable money
growth if changes in the m ultiplier are highly
unpredictable.24 This, however, does not appear to be
the case over periods of one year or more.
Chart 6 contains four-quarter moving averages of the
rates of growth of the adjusted monetary base and Ml.
Except for the period in the mid-1970s, money growth
and base growth have moved together fairly closely. In
fact, a 1 percentage-point increase in the rate of base
growth leads to approximately a 1 percentage-point
increase in money growth.2’
24For a discussion of this point covering the growth of money in
1982, see R. W. Hafer and Scott E. Hein, “The Wayward Money
Supply: A Post-Mortem of 1982,” this Review (March 1983), pp.
17-25.
25This can be seen more clearly from the following estimated rela
tionship between base growth and M l growth:
M, = -0.344 + 0.921 B,
(0.51) (9.27)
R2 = .49
SE = 2.29

DW = 1.92

where B is the growth rate of the adjusted monetary base.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

Table 4

C h art 7

Average Absolute Forecast Errors:
IV/1979—IV/1982

N o m in a l Incom e Forecast Errors of
A lternative M o d e ls
Actual minus Predicted Values

Rate of growth of
Model

Nominal GNP

Real GNP

GNP Deflator

St. Louis

4.95%

3.96%

1.49%

Wharton

4.62

3.42

1.56

Chase

4.92

3.95

1.38

Further, there appears to be no breakdown in this
relationship since late 1979. Except for the period of
credit controls (11/1980-111/1980), there has been little
difference between the rate of base growth and the rate
of money growth during the post-III/1979 period.26

A CLASH OF COMPETING MODELS:
MONETARIST VS. NON-MONETARIST
VIEWS OF THE ECONOMY
As stated earlier, monetarism can be rejected only if
there is an alternative explanation of macroeconomic
behavior that has greater explanatory or predictive
power. The following experiment was conducted to
ascertain whether the primarily non-monetarist eco
nomic theories inherent in two of the popular large
macroeconomic models could explain economic be
havior over the past three years as well as a monetarist
model. The St. Louis equation (equation 1) and the
inflation equation cited in footnote 18 were estimated
over the period from 11/1960 to III/1979. The rates of
growth of nominal GNP (total spending), real GNP
(real output) and the GNP price deflator then were
forecast for the next 13 quarters (that is, from IV/1979
to IV/1982). These forecasts were compared to those of
the Wharton and the Chase Econometrics models. The
average absolute forecast errors for each of these three
models are reported in table 4; the quarterly forecast
errors for each variable are shown in charts 7, 8 and 9.

1 97 9

1982

S o u rc e s : The C o n f e r e n c e B o a r d S t a t is t ic a l B u lle tin a n d F e d e ra l R e s e rv e B a n k
o f St. L o u is

C h art 8

R e al Incom e Forecast Errors of
A lternative M o d e ls
Actual minus Predicted Values
Pe rc e n t

P e rc e n t

It should be noted, at the outset, that the empirical
deck was stacked against the monetarist forecasts; they
26Again, the stability issue is tested as in footnote 15 for the equation
cited in footnote 25. In this case, the calculated F-statistic is 1.64,
below the critical value of 3.09 at the 5 percent significance level.
Consequently, the hypothesis that the relationship between base
growth and money growth has changed since III/1979 can be
rejected.

S o u rc e s : The C o n f e r e n c e B o a r d S t a t is t ic a l B u lle tin a n d F e d e r a l R e s e rv e B a n k
o f St. L o u is

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

C h art 9

Price Forecast Errors of A lternative M o d e ls
Actual minus Predicted Values
Perte it

Percent

! \ \

h
/
r w\ A
ftf \J\

Wharton jl
Chase f
St. Louis

' rN
/
/

H I

1 1 //

1 11

SUMMARY AND CONCLUSIONS

\\ 1

l/\ \
A ' \

///

\ \

\
\

U
\ !t

1 979

1 98 2

S o u r c e s : The C o n f e r e n c e B o a r d S t a t is t ic a l B u lle tin a n d F e d e ra l R e s e rv e B a n k

were obtained using coefficients from empirical rela
tionships that were estimated through III/1979 and
never updated. The forecasts from both Chase and
Wharton were one-quarter-ahead forecasts derived
from models that were re-estimated constantly over
the period from IV/1979 to IV/1982.2' Despite this
estimation bias favoring the non-monetarist models,
there is virtually no difference in the comparative
short-run forecasts for recent years between the pre
sumably outdated monetarist model and the updated
non-monetarist ones. For example, while the average
annual absolute forecast errors for nominal GNP using
the St. Louis model was 4.95 percent, the Chase result
was virtually identical, and Wharton’s was nearly as
large. From the results in table 4, it is clear that neither
of the two alternative models has outperformed this
27This estimation bias was introduced to compensate for the fact that
actual values of the right-hand-side variables were used to derive
the St. Louis forecasts, while Chase and Wharton did not know
these values when they made their forecasts. This type of compari
son obviously is not the ideal one; it is, however, the best that can
be accomplished without access to the estimated parameters of
the Chase and Wharton models. For similar comparisons of these
models’ long-run properties, see Keith M. Carlson and Scott E.
Hein, “Four Econometric Models and Monetary Policy: The
Longer-Run View,” this Review (January 1983), pp. 13-24.
Digitized for16
FRASER

versionOft of a monetarist model over the past three
years.
Moreover, the information in charts 7, 8 and 9 re
veals that the relative performance of the St. Louis
forecasts generally has remained constant throughout
the forecast period. That is, the St. Louis forecasts did
not collapse, relative to those of Chase and Wharton, as
financial innovation continued throughout the forecast
period. If monetarism has died, it surely was not killed
off by the superior performance of whatever theoreti
cal relationships underlie these major non-monetarist
economic models.
Monetarism can be viewed in two ways. It is a scien
tific theory that stresses the importance of focusing on
the level or growth of money in order to understand
the behavior of such key macroeconomic variables as
prices, real output and spending. As a scientific theory,
it also stresses the importance of focusing on the be
havior of the monetary authority in order to under
stand how and why money grows the way it does.
Monetarism also can be viewed as a diverse collection
of normative propositions about how fast money should
grow or what the proper monetary policy should be.
While disputes over normative propositions are gener
ally insolvable, the validity of scientific propositions
can be examined.
This paper has assessed the claim that monetarism,
in the scientific sense, has failed, by testing four key
monetarist propositions to see whether they can ex
plain economic events over the past three years. Con
trary to recent rumors of the death of monetarism, we
found that the four propositions tested were as valid
and useful over the past three years as they had been
over the prior 20 years. Moreover, when compared
with the predictive behavior of two well-known non
monetarist econometric models, we found that a sim
ple monetarist analysis worked equally well in explain
ing the economic patterns of spending, output and
prices over the past three years. Rumors of the death of
monetarism have, indeed, been exaggerated.
28Similar results are obtained when root mean square errors
(RMSE) are compared for the three models. This method of
summarizing forecast errors gives more weight to large errors than
does the average (mean) absolute error.
Model
St. Louis
Wharton
Chase

RMSE for forecasts of the
growth rate of
Nominal GNP
Real GNP
GNP Deflator
5.99%
5.03%
1.74%
5.18
4.06
1.83
5.68
4.54
1.69

The Prime Rate and the Cost of Funds
Is the Prime Too High?
R. W. HAFER
I^ A N K lending rates recently have received con
siderable attention in the popular press.1 There
appears to be widespread opinion that the rates
charged by banks exceed their cost of funds by an
abnormal amount. The purpose of this article is to
assess whether banks’ lending rates during the past few
months have been “too high” relative to other market
rates. Because the prime rate generally is viewed as a
benchmark lending rate for banks, the analysis focuses
on the recent behavior of this rate relative to other
market interest rates.

THE PRIME RATE AND THE COST OF
FUNDS
The prime rate quoted in the press and discussed by
the public commonly is considered to be the interest
rate charged to a bank’s most credit-worthy corporate
customers for short-term loans. The prime rate is not,
however, the rate charged to each and every corporate
borrower; each loan and prospective borrower have
their own characteristics that may necessitate different
lending rates.2 For example, the loan rate charged to a
specific customer reflects that customer’s credit wor
thiness, previous relationship with the bank, the ma
turity of the loan, the nonfee services provided by the
bank in maintaining the loan, the use of fixed or flexible
maturities and rates, and other factors.
'See, among others, Hobart Rowan, “Reagan Says Lower Rates Up
to Ranks,” Washington Post, February 24, 1983; Teresa Carson,
“Reagan Latest to Criticize Rank Rates, ” American Banker, Febru
ary 24, 1983; “More Pressure on Loan Rates,” New York Times,
February 27, 1983; and Leah R. Young, “Charges Against Ranks on
Rates Unfounded’, ” New York Journal o f Commerce, March 18,
1983. For an interesting comparison of today’s arguments, see
Leonard Silk, “The Mystery of High Rates,” New York Times,
March 17, 1982.
2The following discussion draws on Gerald C. Fischer, “The Myth
and the Reality of the Prime Rate," Journal o f Commercial Bank
Lending (July 1982), pp. 16-26.

Before the 1970s, the prime rate was relatively slow
to adjust to market conditions. For instance, between
1929 and 1969, the prime rate changed only 40 times,
an average of once per year and less often than market
interest rates. In contrast, since 1970 the rate has
changed an average of about 13 times per year.
This shift in the prime rate’s more frequent adjust
ment to credit market conditions occurred in 1972
when the First National City Bank of New York, known
today as Citibank, announced that its prime rate would
be pegged to the 90-day commercial paper rate. This
change was important because it directly linked the
prime rate to current credit market conditions. Fur
thermore, as the competition for loanable funds and
the cost of liability management have increased with
the advent of numerous financial innovations, banks
have become more sensitive to interest rate changes
when establishing their lending rates.3
The increased sensitivity of the prime rate to market
rates has accompanied certain changes in the credit
market. The rapidly expanding use of the commercial
paper market as an alternative to bank funding is one
example. Another is the increased competition coming
from money market funds which has increased the
need for flexibility in the income stream from the
bank’s loan portfolio. More recently, the volatility of
market rates has contributed to more frequent changes
in the prime rate. Because of this sensitivity, there
should be a close empirical relationship between the
bank’s cost of funds and the prime rate. If such a
relationship exists, it can be used to assess the current
level of the prime rate with respect to other interest
rates that reflect the prevailing cost of funds facing
banks.
3Ibid. See also, Michael A. Goldberg, “The Pricing of the Prime
Rate, ” Journal o f Banking and Finance (July 1982), pp. 277-96.
17

MAY 1983

FEDERAL RESERVE BANK OF ST. LOUIS

To investigate this issue, two interest rates are used.
One important source of loanable funds is the 90-day
certificate of deposit (CD) market; as such, the 90-day
CD rate is a useful measure of a bank’s cost of funds.
Although recent financial innovations may have less
ened the once primary position held by the CD mar
ket, it remains a key source of funds.4 The federal funds
rate — the rate charged for overnight funds — also is a
useful measure of the bank’s cost of funds. It not only
measures the bank’s cost of short-term funds, but also
is watched by credit market participants as a guide to
Federal Reserve actions. In other words, it is viewed as
an indicator of whether current credit demands are
being matched by the reserves supplied to the banking
system.
The Evidence

Chart 1 plots the prime rate, the 90-day CD rate and
the federal funds rate for the period September 1980 to
December 1982.° As illustrated, the prime rate tends
to follow movements in the other interest rates, albeit
with a slight lag. This tendency reflects the previously
mentioned sensitivity of the prime rate to other market
rates — that is, the effect of current and past costs of
the bank’s managed liabilities.
The data in chart 1 can be translated into a regression
relationship to provide a more rigorous assessment of
4For example, as ofyear-end 1981, negotiable CDs at large weekly
reporting banks with assets of $750 million or more totaled
$137,490 million. Consumer and industrial loans (C&I) were
$195,499 million. Thus, the ratio of CDs to C&I loans was 0.7. In
December 1982, however, the ratio fell to 0.6 as negotiable CDs
fell to $132,340 million, and C&I loans increased to $216,860
million.
rTh is period is examined because it represents the data available
since the advent of numerous deregulation measures. One such
change is the reserve requirement for different banks on large
CDs. To ensure compatibility, only the period since late 1980 is
used. In addition, Goldberg has examined the period from 1975 to
1980 and found similar results.
The prime rate used is the average of daily rates reported by five
of the nation’s ten largest banks (by size of deposits, as of December
31, 1980). The monthly average includes all calendar days; rates for
weekends and holidays are same as the preceding business day.
The CD rate is the secondary market rate, monthly average of
daily rates, excluding weekends and holidays. The daily rate is an
average of the rates offered by five or more dealers. The source is
table 1.35, in any Federal Reserve Bulletin.
The federal funds rate used is a monthly average of daily rates;
the rate for weekends and holidays is the preceding business day’s
rate. The daily rate is determined by averaging the rates from
approximately six brokers in the federal funds market reporting to
the New York Federal Reserve Bank’s trading desk. The individual
rates are “weighted” by the volume of transactions and, therefore,
amount to the “effective” rate.
Digitized for 18
FRASER

the prime rate level relative to other market rates. To
do this, the following equation was estimated:
N
(1) PRt = a 0 +

£
Pi it i + et»
i = 0

where PRt represents the prime rate, it_j stands for
contemporaneous and lagged values of the CD rate or
the federal funds rate, and e t is a random error term.
The lags are included to reflect the pattern observed in
chart l.6
Table 1 reports the results from estimating equation
1 over the period September 1980 to December 1982.7
As hypothesized, movements in the prime rate are
explained reliably by both the CD rate and the federal
funds rate as proxies for the bank’s cost of loanable
funds.8 Each regression outcome suggests that the
prime rate reflects not only the marginal cost of acquir
ing additional funds (represented by the contempo
raneous term), but also the cost of managing existing
liabilities.9
Another interesting aspect of the results in table 1 is
the different long-run effects. For example, a 100
basis-point change in the CD rate results in a 106
eA similar equation is estimated in Goldberg, “The Pricing of the
Prime.” In that study, however, only the CD rate is used.
7The lag length was selected to minimize the standard error of the
equation. In each case, adding another lag did not improve the fit
significantly.
The Durbin-Watson statistic for the equation using the CD rate
falls in the indeterminate range. Applying a first-order autocorrela
tion correction procedure yielded an estimated value of rho that
was not statistically different from zero at the 5 percent level.
Consequently, the OLS results presented in table 1 are used in the
analysis.
8An alternative equation was estimated using the 4-month commer
cial paper rate to explain movements in the prime rate. This rate
was used because it represents an alternative source of funds for
firms and, therefore, a competitive rate vis-a-vis the prime rate.
The outcome of the estimation is
PR, = 0.63+ 0.628 CPR, + 0.401 CPR,_, + 0.184 CPR,_,
(1.09) (11.55)
(5.77)
(2.75)
R2 = 0.982 SE = 0.374 DW = 1.83 p = 0.33

where p is the first-order serial correlation coefficient. The results
are quite similar to those presented in table 1.
9Goldberg, “The Pricing of the Prime, ” points out that this indicates
that banks engage in average-cost pricing. In other words, “banks
price their prime rate on the basis of some average of their current
ly — and previously — issued, but still outstanding, costs of
managed liabilities” (p. 292).
As noted by Goldberg, the estimated constant term (a0) repre
sents the bank’s profit margin. Note that the constant term is
significantly different from zero for both of the equations reported
in table 1, but is not in the equation using the commercial paper
rate (fn. 7).

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

Chart 1

The Prime Rate, 9 0 - D a y CD Rate
and Federal Funds Rate
Percent

Percent

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1983

Table 1
Regression Estimates of the Prime Rate: September 1980 to
December 1982
Sum mary
Estim ated coefficients2
Rate1

statistics3

oto

Spi

R2/SE

1.58
(3.94)

0.564
(11.63)

0.338
(4.62)

0.164
(3.37)

1.064
(38.32)

0.983
0.360

1.45

2.80
(5.43)

0.542
(6.80)

0.181
(1.39)

0.243
(3.04)

0.966
(27.35)

0.970
0.487

1.73

1CD is the 90-day CD rate and FF is the federal funds rate.
2t-statistics appear in parentheses.
3R2 is the adjusted coefficient of determ ination; SE is the regression standard error; and DW is the
Durbin-Watson statistic.

basis-point change in the prime after three months.10A
similar change in the federal funds rate produces a 97
basis-point change in the prime, a change that is not
significantly different from 100 basis points. Note,
however, that these changes occur over a three-month
horizon; about 55 percent of the effect on the prime
rate occurs simultaneously with changes in the CD and
federal funds rates.
This evidence suggests that the prime rate closely
reflects the costs faced by banks in acquiring new and
in managing existing loanable funds. Moreover, the
full effect of a change in the cost of funds on the prime
rate is not immediate, but takes place over several
months. Consequently, reductions in the CD and the
federal funds rates are unlikely to produce immediate
declines of equal magnitude in the prime rate; they will
do so only with a lag of about three months.11
10Goldberg reports that, for the period January 1975 to October
1980, the summed effect of changes in the CD rate on the prime
rate is 1.076. For the period January 1977 to October 1980, the
sum is 1.094. Thus, our result is consistent with those from earlier
periods.
The summed effect of the CD rate, however, is statistically
different from unity (t = 2.31). This result is expected given the
cost, over-and-above interest, that the bank faces when it issues a
new CD. One major cost is the reserves that the bank must hold
for each CD issued. Currently, the required reserve ratio is 3
percent. It one calculates the “effective” cost of issuing a CD —
one that incorporates both the interest expense and the opportun
ity cost incurred by holding non-interest-bearing reserves against
the CD — a CD rate of 10 percent then becomes 10.31 percent.
Thus, for a 100 basis-point change in the CD rate, the change in
the effective cost to the bank actually is 103 basis points. Indeed,
the summed effect reported in table 1 does not differ from an
effective rate of 1.03. The hypothesis that
= 1.03 cannot be
rejected at any reasonable level of significance (t = 1.22).
"The effect of average-cost pricing during periods of rising and
falling interest rates has been noted by Goldberg, “The Pricing of
20

Table 2
Actual and Forecasted Values of the
Prime Rate: January 1983 to April 1983
Forecasted values using
Period

Actual

January 1983

11.16%

10.67%

11.36%

February

10.93

10.63

11.15

March

10.50

10.72

11.20

April

10.50

10.77

11.77

Forecasting the Prime Rate

The equations in table 1 were estimated through
December 1982 to permit out-of-sample forecasts of
the prime rate to be obtained for the first four months
of 1983. If recent levels of the prime rate are signifi
cantly greater than those forecasted using the regresthe Prime.” For example, he states that “During a period of
declining interest rates . . . their past-issued, but still outstand
ing, liabilities are more expensive than their currently-issued
managed liabilities. This leads to a situation where their average
(over time) cost-based formula calls for a prime rate substantially
in excess of the bank’s prime customer’s cost of commercial paper
financing” (p. 288).
It also should be noted that evidence exists suggesting that
banks switch from average-cost pricing to marginal-cost pricing
during periods of declining market rates. In other words, banks
may price discriminate in favor of their best customers by offering
“below prime” loans. Because the sample used here is too restric
tive to test this hypothesis (the available data is quarterly), the
reader is referred to Goldberg (pp. 289-92) for a discussion of and
empirical results favoring the “below prime” lending scenario.

FEDERAL RESERVE BANK OF ST. LOUIS

sions reported in table 1, then recent criticisms may be
justified. If not, then the recent behavior of the prime
rate simply reflects the underlying relationship be
tween a bank’s cost of funds and its lending rate cap
tured in equation 1.
The prime rate forecasts based on the equations in
table 1 and the actual prime rate for January through
April 1983 are shown in table 2. During January, the
actual prime rate exceeded the rate forecasted with the
CD rate by about 50 basis points. In contrast, the
prime rate was 20 basis points less than the one fore
casted using the federal funds rate. In each instance,
however, the forecast errors were not unusually large
for the estimated equation; they were within two stan
dard errors of the regression standard errors.
The lagged effect of the recent changes in the cost of
funds (see chart 1) on the prime become more apparent
in February, March and April. During February, for
example, the average forecast error falls to 26 basis
points. By March and April, however, the predicted

MAY 1983

prime rate exceeds the actual rate by an average of 46
basis points and 77 basis points, respectively. Given
recent movements in the cost of funds, the results in
table 2 indicate that the prime rate has not been too
high relative to other market rates during the past few
months.

CONCLUSION
Have banks kept the prime rate “too high?” The
evidence presented in this article suggests that, rela
tive to their cost of funds, banks have not kept the
prime rate unduly high during the past few months.
The prime rate adjusts, with a lag, to changes in the
cost of acquiring and managing loanable funds. These
costs are represented here by the 90-day CD rate and
the federal funds rate. The well-established empirical
relationship between the prime rate and these mea
sures explains why the prime rate has not decreased as
fast as these other rates during early 1983.

“The Supply-Side Effects o f Economic Policy

”

“Improving Money Stock Control”
Single copies of these publications, the proceedings of the 1980 and 1981 economic
policy conferences co-sponsored by the Federal Reserve Rank of St. Louis and the
Center for the Study of American Rusiness, Washington University, are available
in limited supply to our readers.
If you are interested in obtaining a copy of these publications, please address your
request to Editor, Review, Federal Reserve Bank of St. Louis, P.O. Box 442, St.
Louis, Missouri 63166.