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November 1967

Money, Interest Rates, Prices,
And O u tp u t..........................................


Monetary Policy, Balance of Payments,
And Business Cycles —
The Foreign Experience.....................


Volume 49

Number 11

Money, Interest Rates, Prices,
And Output
T h e MONEY SUPPLY and commercial bank credit
have risen rapidly since January. In recent months in­
terest rates have also risen markedly. These develop­
ments might appear to be a paradox, but a close exami­
nation of economic relationships indicates that they can
be interpreted in a way which is entirely consistent with
economic theory. The developments in financial mar­
kets in the past two years have given rise to consider­
able question concerning the underlying forces affect­
ing interest rates. This note traces these events and re­
lates them to one frequently cited theory. Before dis­
cussing interest rate movements during the past two
years, the current economic situation is briefly pre­

separately, private demand deposits (checking ac­
counts) increased at a 9 per cent rate, currency held
by the public at a 5 per cent rate and time deposits at
a 17 per cent rate. In each case these rates were much
faster than the trend rates.
Underlying the growth of money, total reserves of
member banks increased at a 10 per cent annual rate,
and reserves available for private demand deposits
(total reserves minus required reserves on time, inter­
bank, and Government deposits) increased at a 7 per
cent rate. This increase in total reserves compares with
a 5 per cent average rate of increase from 1964 to 1966
and a 3 per cent trend rate from 1957 to 1964. Federal
Reserve credit, the main source of new reserves, rose
R e s e rv e s of M e m b e r B a n k s

R e c e n t D ev elo p m en ts

Ratio S c a le

M o n th ly A v e ra g e s o f D a ily F ig u re s

Ratio S c a le

The money stock, defined as private demand de­
posits plus currency, rose at an estimated 8 per cent
annual rate from January to October, while money
defined to include time deposits at commercial banks
grew at a 12 per cent rate. Looking at the components
M o n e y Stock
R a tio S c a le
B illio n s o f D o lla rs

R a tio S c a le
B illio n s o f D o lla rs

Monthly A v e ra g e s of D a ily Figure



Plus Time

* A d ju s te d fo r e s tim a te d e ffe c t o f re s e rv e re q u ire m e n t changes.
**U .S . G o v e r n m e n t d e m a n d d e p o s its , d e p o s its d u e to d o m e s tic c o m m e rc ia l b a n k s ,

Apr. '65








Apr.'66 Jan.'67 O cf.67

.....i...... tli



Percentages are annual rates o i change between periods indicated. They are presented to aid in
comparing most recent developments with past "trends."
Latest d a ta plo tted: O cto ber estimated

Page 2

a n d tim e a n d s a v in g s d e p o s its .
••♦ D e p o s its o f m e m b e r b a n k s in c lu d e d in th e u su a l d e fin itio n o f th e m o n e y s u p p ly .
P ercentages a re a n n u a l rates o f c h ange betw een p e rio d s in d ic a te d . They are
p resented to a id in co m p a rin g m ost recent develo p m e n ts w ith past " tre n d s "
L a te s t d a ta p lo tte d : O c to b e r e s tim a te d

at a 12 per cent rate during the January to October
period. The major component of Federal Reserve
credit is the System’s holdings of U. S. Government

Y ie ld s on Selected G o v e rn m e n t Securities
P erCent

P e rC e n t

Most business indicators which in the earlier months
of this year had indicated some softness turned up
during the second quarter and have since risen rapid­
ly. Retail sales increased at a 9.5 per cent annual rate
from late spring to early fall, after about a 6 per cent
increase during the previous twelve months. The growth
trend in these sales from 1957 to 1966 was 5 per
cent per year. Despite a major automobile strike, in­
dustrial production has risen at a 2 per cent rate since
June, after declining at a 3.2 per cent rate from Octo­
ber last year to June. Total employment has risen at
about a 3 per cent rate since late spring, somewhat
faster than the 2 per cent rate of growth from early fall
to late spring.
Gross National Product in current dollars increased
at a sharp 8 per cent annual rate from the second to
the third quarter this year, after growing at only a 3.4
per cent rate from the fourth quarter of 1966. Real
output rose at a 4.2 per cent rate from the second to
the third quarter after growing at only a modest 1 per
cent rate from the fourth quarter 1966 to second quar­
ter this year.
As indicated by the widening gap between the GNP
figures in current and constant dollars on the chart,
overall prices rose at a 3.5 per cent annual rate from
the second to third quarter, up from a 2.3 per cent
rate in the previous two quarters. Both consumer
prices and industrial wholesale prices have been rising again since the May-June period, following a
period of little pressure on prices in the previous few
D e m a n d a n d P ro d u c t io n
R a tio S c a le

Q u a rte rly T o ta ls a tA n n u a l R ates

R a tio S c a le

Latest data plotted: October estimated

Long-term interest rates on both corporate and
Government securities have been rising since early
spring and are now well above the highs of a year
ago. Yields on short-term securities have risen since
mid-year, but are still below 1966 peaks. Since midJune, yields on intermediate-term securities have been
higher than on either short or long-term obligations.
This same relationship existed during the period of ris­
ing rates in the spring and summer of 1966. The im­
plication of this condition may be that the market has
been expecting rates on new issues of short-term secur­
ities to rise in the near-term, but subsequently to
return to a lower level.1

O ne T h eo ry o f F o rc e s A ffe c tin g I n t e r e s t
R a te L ev els 2
In financial markets, interest rates are the prices at
which the quantity supplied and the quantity demand­
ed of particular financial assets are equated. The way
in which the money stock is related to the demand
for any supply of some financial assets is somewhat
complex. On the one hand, an increase in the money
supply and bank credit adds directly to the supply of
1For a discussion of the term-structure of interest rates see
“Changing Structure of Interest Rates” in the June 1967 issue
of this Review.

U .G N P in current d o lla rs.
So urce: U .S. Departm ent o f Commerce
H G N P in 1958 d o lla rs .
Percen ta g e s a re a n n u a l rates of change betw een p e rio ds in d ic a te d . They a re presented to a id in
co m paring most recent develo pm ents with p a st'tre n d s."
Latest d a ta plotted: 3rd q u a rte r pre lim inary

2 For an attempt to estimate empirically the forces affecting
interest rates see W . E. Gibson and G.G. Kaufman, “The Rel­
ative Impact of Money and Income on Interest Rates: An
Empirical Investigation,” Staff Economic Study Number 26;
Board of Governors of the Federal Reserve System.
Page 3

P ric e s
R a tio S c a le


R a tio S c a le


Percentages a re annual rates of change between periods indicated. They are presented to a ia in
comparing most recentdevelopments with past "trends."

changes in rates of monetary growth over several
months or longer work indirectly in the opposite direc­
tion. Prolonged increases in the money supply, at rates
greater than the growth in the demand for money to
hold, cause increases in the demand for goods, serv­
ices, credit, and ultimately in prices. As a result, mar­
ket rates of interest will be adjusted upward as a re­
sponse to more vigorous credit demands and to com­
pensate for the rise in prices and consequent decrease
in the purchasing power of money.
In summary, this theory suggests that the shorter
and longer-run effects may, at times, work against
each other. At other times, as may have been observed
during different periods of the past year and a half,
these forces can both be pushing interest rates in the
same direction.

L a te s td a ta plotted: Septem ber p re lim in ary

lendable funds. An increase in money results in the
bidding up of the prices of financial assets, causing
interest rates to be lower than they otherwise would
On the other hand, some argue that a rise in the
money supply and bank credit also has expansionary
effects on the total demand for goods and services. If
dollar balances and credit are increased rapidly, given
existing assets, incomes, prices, and interest rates,
people will attempt to exchange the “excess money”
for goods, services, or other financial assets. Any in­
crease in demand for goods and services will result
initially in the running down of inventories and, sub­
sequently, a rise in production and an increase in
credit demands. If the increased demands for credit
which result from a large monetary expansion are
greater than the supply of credit created, net upward
pressure on interest rates will result after some lag.
If the rates of increase in money supply, credit,
and total demand are faster than the rates at which
output can be increased, prices will rise. Rising prices
also cause increased demands for credit, since more
funds are needed to finance a given volume of goods.
With expectations of inflation, borrowers are willing
to pay higher rates since they expect to repay with
cheaper dollars, and lenders charge higher rates in
order to net the same real return in the process of al­
locating limited funds.
According to this view, marked and sustained
changes in monetary growth have opposite short and
long-run effects on interest rates. Rapid increases
of the money supply will cause interest rates to be
lower over an immediate short period than they other­
wise would be. However, the effects of sustained

Page 4

I n t e r e s t R a te M o v em en ts I n t h e L ast
Two Y ea rs
The strength of monetary forces and the responsive­
ness of spending, prices, and interest rates to these
forces has been given a rigorous test over the past
two years. The rapid monetary growth of 1965 and
early 1966 was suddenly halted in the spring of 1966
only to be fully resumed since the beginning of the
current year. Compared with a 3.2 per cent trend rate
of growth from 1961 to 1965, money rose 6 per cent
from the spring of 1965 to the spring of 1966, remained
about unchanged the remainder of that year, and sub­
sequently has risen at an 8 per cent rate. Interest rates,
output, and prices responded to both of these sharp re­
versals of monetary growth in a manner consistent with
the theory outlined above.
The advanced rate of monetary growth during
1964 and early 1965 contributed to increases in output
and employment, but increases in total demands for
goods, services, and credit did not proceed at rates
greater than the growth in production. Consequently,
prices and interest rates remained relatively stable.
Toward the end of 1965 and in early 1966, the expan­
sion in economic activity fostered an increase in the
demands for credit, producing increasing upward pres­
sure on interest rates. This force on rates was mod­
erated to some extent in the short-term by rapid in­
creases in the money supply and bank credit. How­
ever, it is argued that the rapid growth in money
caused still further stimulation of spending and credit
demands, resulting finally in additional upward pres­
sure on interest rates.
When the growth in the money supply was halted
in the spring of 1966, this argument continues, the
short-run impact was reversed, reinforcing the upward

pressure on interest rates. At the same time, the longerrun impact of previous money injections continued to
be upward for several months. The rapid monetary
growth of 1965 and early 1966 provided an expan­
sionary force on spending and output, creating up­
ward pressure on prices into the fall of the year. Thus,
interest rates were influenced by both the continuing
impact of the previous period of rapid monetary ex­
pansion and the immediate effect of the reduced rate
of growth in money. Sharply rising interest rates
throughout the summer and into the early fall of 1966
were the result.
By the fall of 1966, when the public protests against
rising prices and interest rates were loudest, a major
source of the inflationary pressure (rapid monetary
expansion) had long since disappeared, and economic
forces were well advanced in the reversal process.
Some economic analysts were already pointing out
that the lack of monetary growth since spring would
have d elay ed contractionary effects which would
soon be felt.3 The thrust of economic expansion began
to weaken in late 1966 despite the most stimulative
Federal budget in twenty years. With demand for
goods slowing, credit demands eased, causing a def­
inite downward trend in interest rates in late 1966 and
early 1967.
Shortly after the turn of the year came the second
sharp reversal in monetary growth in less than a year.
For the first few months, as in the previous summer,
short and long-run effects worked in the same direc­
tion. The rapid growth in the money stock and avail­
able credit produced downward pressure on interest
rates, supplementing the trend caused by easing credit
demands and reduced pressure on prices.
Following the rapid growth of money early in the
year, economic activity gained momentum in the late
spring. At this time, most interest rates reached lows
for the cycle discussed and began rising. Since then
the short-run effect of monetary growth on interest
rates has still been downward as the money supply
and bank credit continue to grow at rapid rates. How­
ever, the upward longer-run effects, via stimulation of
spending and credit demands, have again been domi­
nant, as they had been in late 1965 and early 1966. On
balance, this is causing upward pressure on interest
rates once again.
Expectations of renewed price inflation have in3‘‘Monthly Economic Letter”, First National City Bank of New
York, September, 1966. And, Karl Brunner, “U.S. Economy
in Cross-Currents Between Monetary and Fiscal Policy: A
Reconsideration of the New Economics”, Bulletin of Business
Research, (Ohio State University, February, 1967). (Publica­
tion of a previously delivered speech)

creased as upward price trends accelerated during the
summer. Adherents to this theory might conclude
that the rapid monetary growth through October of
this year may have been sufficient to place strong upwafd pressure on prices and interest rates for some
time into the future. So long as the rate of monetary ex­
pansion continues to be relatively high, the theory in­
dicates that there will continue to be strong forces
leading to higher prices and interest rates. However,
if the rate of monetary growth is sharply curtailed
with the intention of eventually stopping inflation and
achieving lower rates, the short-run effects of the re­
duced volume of funds would result in even higher
interests rates over the near future. This analysis in­
dicates that the economy, as in the spring of 1966,
must be willing to bear the temporary cost of higher
interest rates in the near term if goals of sustainable
growth in total demand, relative price stability, and
a lower level of interest rates are subsequently to be

“ T h e D ifferen tia l I m p a c t ” o f
S ta b iliza tio n Policy
An interest rate is a price, and as is true of all prices,
interest rates serve a rationing function.4 Interest rates
are the price that allocates available funds between
businesses and households. At the same time, they
serve to divide the funds among different businesses
and among different households. Expected profitability
of alternative uses of funds is one of the factors affect­
ing businesses’ decisions concerning the amount of
funds they demand at various levels of interest rates.
Similarly, households’ decisions concerning credit pur­
chases and saving are affected by their income con­
straint and willingness to delay some consumption
In a period of economic expansion, it is reasonable
to expect that anticipated profits from investment op­
portunities in plant and equipment, inventories, land,
and housing will improve, but each by different amounts, and that financial assets such as bonds will be
sold in order to take advantage of these favorable op­
portunities. With a given supply of funds, the price of
bonds will fall (yields will rise) to the point where the
marginal investor is indifferent between the return on
bonds and the anticipated return from other invest­
ment opportunities.
4 We usually talk about interest rates with reference to mar­
ketable securities, but it is important to remember that the
interest rate applies to all goods. The rate of interest reflects
the price or cost of the convenience of earlier availability,
natural preference for more certain rather than less certain
consumption rights, and the economy’s ability to use resources
to increase total output.
Page 5

In the process, some business and household units
are “priced out of the market”. This could be called a
“differential impact”, a term which applies equally
well to any pricing or allocation mechanism. Any
change in price or method of allocation may be un­
desirable to some individuals or sectors of the econo­
my. A tax increase, on personal or corporate incomes,
on sales or on property, also will be painful to those
who must pay more. Less disposable income con­
strains the volume of purchase, but prices will change
in response.
If there are not monetary actions constraining the
volume of available funds, or fiscal actions constraining
disposable incomes or government expenditures, then
prices and interest rates will rise as the market mecha­
nism allocates scarce resources. Inflation causes reallo­
cation of both wealth and command over real out­
put. This is harmful to certain groups of the economy.
Finally, allocation by any non-market means, such
as price controls and rationing, is undesirable to some.
In a free market economy, interest rates act to al­

Page 6

locate money balances—
which represent command over
real output—
among individuals, firms, and the govern­
ment sector. A rising interest rate, and possibly a de­
creasing supply of funds at each level of interest rates,
at a time that restraint is initiated, forces certain in­
dividuals and firms to reduce their command over real
output. This is very disturbing to those adversely ef­
fected. However, these temporary ill effects should be
weighed against the real benefits for the whole econo­
my from reducing inflationary pressures in the longerrun. In addition, as this theory suggests, the adverse al­
location of funds from certain groups will only be
temporary since rates are expected to decrease once
inflation is controlled.5
5 For other recent discussions of the present financial situation
which employ similar theoretical analysis, see A. James Meigs,
“A Monetary View,” prepared for a session of the National As­
sociation of Business Economists, Detroit, Michigan, September
29, 1967. Also, Ralph F. Leach, “Marking Treasury Issues
With Conversion”, The Weekly Bond Buyer, October 23,
1967, pp. 9-11, and Roy L. Rierson, “Fed’s Dilemma . .
The Weekly Bond Buyer, October 23, 1967, pp. 12-14. Also
see “Trends and Recent Relationships in Yields on U.S. Govern­
ment Securities”, in the October 1967 issue of Economic Re­
view, Federal Reserve Bank of Cleveland.

Monetary Policy, Balance of Payments,
And Business Cycles
The Foreign Experience

A t BOTH the academic and policy level, the study
of business cycles has been eclipsed in recent years.
This development probably stems from the fact that
in the industrial countries of the world, deep or pro­
longed recessions have not been a serious problem
since World War II. In the less developed countries,
the issue of economic growth holds the dominant posi­
tion in theoretical and policy discussion.
Although the urgency to understand and correct the
business cycle, which characterized professional and
government thinking some years ago, is no longer
present, it is still a subject worthy of inquiry. In the
first half of 1967 there were slowdowns of varying
degree in the economies of the United States, United
Kingdom, France, and Germany. Only Italy and Japan,
among the major industrial countries, grew at a satis­
factory rate.1
This article is another step in the long history of at­
tempts to explain the business cycle. In simple terms,
this explanation of the cycle is as follows: An increase
in the money supply eventually causes income and im­
ports to increase. The rise in imports leads to a decline
in the balance of payments, forcing the monetary au­
thorities to contract the money supply. Although the
purpose of this contraction is to strengthen the balance
of payments by reducing imports, it also has the effect
of reducing domestic income. The decline in imports
will eventually correct the balance of payments and
allow the authorities to switch again to an easy mone­
tary policy. The resulting increase in money leads
again to income and imports growing. As long as this
sequence continues, there will be periodic fluctuations
!The major difference between postwar business cycles and
prewar cycles is in the degree of severity. During the 1930’s the
peak-to-trough decline in per capita income was 25 per cent
in some countries, while in the 1950’s and 1960’s cyclical de­
clines in per capita income have been measured in fractions of
a per cent. Put in another way, the prewar business cycle can
best be visualized in terms of changes in the level of income,
while postwar cycles can best be viewed in terms of changes
in rate of growth of income. Reflecting this difference between
prewar and postwar business cycles, the description of cycles
in this article will be in terms of rates of change in income
rather than in terms of the level of income.

in income, imports, the balance of payments, and
money. If monetary policy were directed at contain­
ing domestic inflationary pressures (rather than wait­
ing for balance-of-payments problems to appear), this
sequence of events would be broken, and cyclical fluc­
tuations in income might be moderated in amplitude
and frequency.
It is the proposition of this article that monetary
policy followed by most of the countries of Europe and
Japan has been sensitive to balance-of-payments prob­
lems and that this is the major cause of most of the
business cycle fluctuations in the postwar period. The
remainder of this article is designed to substantiate
this proposition. First a model is presented which ex­
plains the observed economic behavior. (The model
is presented in a more technical form in the Appen­
dix. ) The bulk of the article consists of an examination
of recent business cycles in Japan, Italy, Germany,
France, and the United Kingdom, to see if the model
is consistent with that experience.

T h e B u sin ess C y cle M o d el
A model which attempts to explain any phenomenon
must be based on the behavior of the elemental deci­
sion-making units in that area. In economics, these are
the consuming household, the producing firm, and the
government authorities who make policy decisions.
There are four assumptions in this model regarding
behavior of the economy’s elemental decision-making
Money and Economic Activity. First, it is assum­
ed that in any economy which has experienced rapid
growth, expectations of households and firms about the
future are optimistic, which gives them strong incen­
tives to invest and consume. In this context, short-term
growth in production and income depends upon the
rate at which money and credit are made available to
the private sector. The rate of growth in money, there­
fore, determines the short-term growth rate in the
economy, and if there are fluctuations in the growth of
Page 7

money, there will also be fluctuations in the growth of
income and production.
The relationship between income and money can be
formulated as follows:

Change in money leads to a change in income. The
arrow indicates the direction of causality. The plus sign
above the arrow indicates that the relationship is posi­
tive; i.e., an increase in money will lead to an increase
in income, or a decrease in money will lead to a de­
crease in income. This relationship must not be con­
sidered as occurring instantaneously. It is quite reason­
able to expect that there will be some time lag between
the change in money and the resulting change in in­
come. It typically takes some time before investment
and consumption plans are reflected in actual spend­
ing flows.
Although this resembles the modern quantity theory
of money it differs from the usual presentation in that
it is based on a more restrictive set of assumptions. If
the forces which create strong private demand should
disappear, i.e., loss of optimistic expectations by firms
and households, the rate at which money is made avail­
able to the economy may not result in a predictable
change in income.

The monetary authorities will respond to an increase
in prices with a decrease in the growth in money, i.e.,
the relationship is negative. On the other hand, they
will respond to a balance-of-payments surplus with an
increase in the growth of money, i.e., the relationship
is positive. The length of time which it takes for either
prices or the balance of payments to affect these policy
decisions is a measure of the time lag between the
emergence of a problem and the decision of the au­
thorities to take corrective actions.
An important policy issue is whether the monetary
authorities should respond primarily to external prob­
lems, such as balance-of-payments deficit, or to internal
problems such as a rise in prices. In general, the mone­
tary authorities have not been restrictive in the face of
moderate domestic inflation because of the fear it
would interfere with growth. Instead, monetary policy
has commonly become restrictive when there was a
balance-of-payments deficit, because the only way to
maintain a desired stock of international reserves
(short of devaluation) has been by taking restrictive
actions. For simplicity of explanation, it is assumed
here that the authorities in charge of monetary policy
respond either to price changes or to the balance of
payments, but not to both at the same time. (This as­
sumption will be considered in more detail below.)

Balance-of-Payments Determinants. The third
relationship postulated does not represent a statement
about behavior of decision-making units in the usual
sense of the word. Rather, it provides a convenient
method of isolating the influences on the balance of
Monetary Policy. The second assumption is in
payments. The balance of payments can be defined as
regard to the behavior of the monetary authorities
who control growth in the money stock. Their policy
targets are either:
Bal. of Pmts.=Exports-Imports+Net Capital Inflow.
a. to prevent inflation, i.e., stabilize the price level2.
b. to correct balance-of-payments deficits.
These relationships may be visualized as follows:

In the short run (with which this business cycle
analysis is concerned) exports depend largely upon
external factors, such as the level of total demand in
foreign countries.3 Imports are dependent upon the
level and growth in domestic income, while net capital
movements are influenced by both foreign and do­



2 Alternative domestic policy targets like economic growth or
full employment are assumed to be dealt with by fiscal policy
and other stabilization tools.

Page 8

3 Some economists believe exports are influenced by business
cycle factors, growing slowly in periods of boom and rapidly
in periods of recession. There is little evidence to support this
position. But over a longer period than generally associated
with a 3-to-5 year business cycle, domestic factors probably
play a major role in the growth of exports. Changes in domestic
relative to foreign prices can have a very important impact
on both exports and imports. However, in the absence of de­
valuation, such price changes are gradual. Other factors,
such as the size of the capital plant, the productivity of labor,
the degree of innovation of the business community, etc., are
also of considerable importance in the long-term growth of
exports. However, in the fairly short run, export growth is
largely dependent upon total demand conditions in the rest of
the world.

mestic factors.
A basic assumption of this model is that the balance
of payments is dominated by fluctuations in imports
and that exports and capital movements play a sub­
sidiary role. This allows us to say that cyclical balanceof-payments problems are largely due to domestic
factors and not to external factors.
Under such circumstances, the relationship between
changes in imports and the balance of payments can
be visualized as follows:



The balance of payments will be negatively related
to the change in imports because a rise in imports must
be paid for by drawing down foreign exchange re­
serves, creating a deficit in the balance of payments.
The time lag in this case is a measure of how long
imports would have to rise before they exceeded the
level of exports and net capital inflow and therefore
resulted in a deficit in the balance of payments.

The Model. The preceding four statements repre­
sent a very simple set of assumptions about economic
behavior. If all four relations are presented together,
it would look as follows:


(+ >


(+ )
— ■ Payments — ■>


(+ )


There are two alternative transmission mechanisms
by which this model of economic behavior could
operate. If monetary policy is responsive to price con­
siderations, the upper channel would operate. An in­
crease in income would lead to an increase in prices.
The price rise would induce the authorities to take
a restrictive monetary policy, causing income to de­
cline, reducing the pressure on prices, and allowing
the authorities to initiate an easy money policy.

If monetary policy is responsive to the balance of
Price and Import Determinants. The final be­
payments, the lower channel would operate. A rise in
havioral assumption in this model is that changes in
income in one time period will cause imports to in­
imports and prices depend upon changes in domestic
crease and, after some time lag, the balance of pay­
ments to deteriorate. A weak external sector will cause
the authorities to implement a tight money policy,
which in time will reduce income. (Thus, an increase
(+ )
in income in a previous period will lead to a decrease
in income in the present period.)
The decrease in income will cause imports to de­
crease and the balance of payments to improve. The
authorities will now end the tight money policy, and
income will increase. (Thus, a decrease in income in
the present period will lead to an increase in income
in some future period.)
Changes in imports and prices are assumed to be
positively related to changes in income. When income
rises, there is an increase in the demand for all goods
and services, including those from abroad. The in­
creased income also puts upward pressure on prices.
In this case there is not likely to be much of a time
lag between changes in income, and changes in prices
and imports.
change in relative prices will also affect imports. However,
in the absence of devaluation, such changes are usually mod­
erate in the short run.


In formal terms, both of these channels would lead
to cyclical fluctuations in income. However, as a prac­
tical matter, the channel which operates through the
balance of payments has a much sharper impact on
the cyclical fluctuations in income. This is true for two
reasons. First, price increases can usually be observed
to occur earlier than balance-of-payments weakness in
response to a rise in imports, inducing an earlier mone­
tary response. Second, when a balance-of-payments
weakness occurs, it requires strong monetary actions
to prevent international reserves from falling below
Page 9

some minimum desired level.5 A country which takes
frequent but moderate adjustments in money policy,
in the face of price increases, is less apt to have sharp
fluctuation in the growth in income than a country
which has less frequent but more abrupt changes in

is measured by the customs trade balance7, i.e., ex­
ports minus imports. Real output is measured by quar­
terly per cent changes in industrial production (quar­
terly GNP figures are not available in most cases), and
imports are measured as quarterly per cent changes
in the customs value of imports.

This is illustrated by the business cycle experience
of Germany and Japan, both of which have grown
rapidly in the last fifteen years. Germany has had only
one business cycle decline, while Japan has had four.
This is because the Germans have been very concern­
ed even about moderate domestic inflation, and have
taken prompt but modest, monetary actions when
faced with price increases. As a result, the growth in
real product has been relatively smooth. On the other
hand, Japan has taken restrictive monetary actions
only when faced with a serious balance-of-payments
problem. To be successful in this case required a sharp­
ly restrictive monetary policy which would contract
income and imports. '

The peaks and troughs in the trade balance are in­
dicated by stars. The time between a peak and a trough
is a period of trade-balance weakness, and the time
between a trough and a peak is a period of trade-bal­
ance improvement or strength. The starred turning
points in the money time series indicate changes in
monetary policy which are assumed to be in response
to changes in the trade balance. A peak in the money
series represents a change toward tight money policy,
while a trough represents a change toward an easy
money policy. Changes in monetary policy, which are
strictly in response to domestic factors, are not starred.
For example, Germany did not have a serious weakness
in the trade balance from 1951 to the second half of
1964. In this period monetary policy was obviously
not responsive to external factors. However, policy
was periodically tightened to contain domestic infla­
tionary conditions.

T h e E v id en ce
The recent business cycle experience of several in­
dustrialized countries will be considered to see how
well the model explains actual business cycle devel­
opments.6 This examaination excludes the United
States. Monetary policy in the United States has, at
different times, been responsive to both domestic price
problems and to the balance-of-payments constraint.
However, the size of the United States and the role of
the dollar as the major reserve currency make a simple
application of this model difficult. Future studies along
the lines of this article will deal explicitly with the
United States.
In the accompanying charts, quarterly observations
of four strategic variables are presented for each coun­
try. Monetary policy is measured by quarterly per cent
changes in the money supply. The balance of payments

5 It can be observed that in general, the desired level of reserves
is below the actual level for countries with an experience of
increases in reserves (France, Italy, and Germany). Thus, no
matter how large the stock of international reserves, a sub­
stantial decline is considered undesirable by most monetary
6 While the evidence presented in this article is impressionistic,
based on casual observations of certain economic time series
for each country, statistical tests have also been applied and
have yielded encouraging results. A more comprehensive
analysis of the lapanese case has also provided quite satisfac­
tory results. Copies of a lapanese study, Monetary Policy and
the Business Cycle in Postwar Japan, are available on request
from this Bank.

Page 10

The stars on the production series represent the
turning points in domestic production which are pos­
tulated to be in response to the starred changes in
monetary policy. The import series is not starred; how­
ever, it can be observed that the cyclical pattern of
imports is much the same as that of production.
7 The trade balance is taken as a proxy for the overall balance
of payments because the figures are easily and quickly avail­
able to both policy makers and the general public. The obvious
weakness of this procedure is that it disregards several signif­
icant components of the overall balance. For instance, a deficit
on the trade account might be offset by surplus on the invis­
ibles and/or capital account, and what would otherwise show
up in our analysis as a decline in a country’s international
reserves would, in reality, be nothing of the sort.
While recognizing this possibility, it should be remembered
the trade balance is the most volatile component of the bal­
ance of payments. The balance on invisibles tends to remain
rather constant from one period to the other. To the extent
it has a cyclical pattern, it is the same as that of the trade
balance. Likewise, long-term capital flows tend to move in
response to international differences in real rates of return on
productive factors and, consequently, does not exhibit much
short-term variance on the basis of business cycle factors.
Finally, short-term capital movements, while volatile, arise
primarily in response to international differences in interest
rates and cannot, therefore, be counted on with any degree of
certainty to counteract a deterioration of the trade balance for
an extended period. Consequently, a weakness in the trade
balance, regardless of whether it is accompanied by an im­
mediate decline in the stock of international reserves, is in­
dicative of weakness in the overall balance of payments. It
should be kept in mind, however, that it is not the level of the
trade balance but the direction in which it is moving that is



The model explains the Japanese business cycle
quite well. Japan has had three cyclical downturns in
production since 1956. Japan has also had three periods
when the trade balance deteriorated sharply and three
periods when monetary policy was tight. The timing
of these developments is consistent with the assump­
tions in our theoretical model. A sharp rise in imports
in the late boom phase of the business cycle, when
domestic sources of supply become scarce, leads to a
rapid deterioration in the trade balance with a two-tothree-quarter time lag. The deterioration in the trade
balance (tier 3 on the chart) was followed by a tight­
ening in monetary policy (tier 2 on the chart) and
with a short time lag, to deceleration in production
and imports (tier 1 on the chart).

Quarterly Dato at Annual Rates

P er C e n tC h a n g e


P er C e n t C h a n g e


64.2 \




! ' v / V:

\ j J




r~\ i

1yC '

/ A

/ t






P e rC e n t C h a n g e


4 \ */
ndustria 1Produ ction




\ /


Per C e n t C h a n g e

The decline in imports results in an improvement
in the trade balance. This permits the monetary au­
thorities to ease their tight money policy, and produc­
tion and imports are allowed to resume their growth
rate. Monetary policy continues to be easy until another
balance-of-trade problem emerges.
As can be seen in the following table, the average
growth rate of the money stock was twice as rapid
between 1960 and 1964 than in the previous four-year
period.8 This acceleration of the money stock put a
considerable amount of pressure on the economy which
could not be met by domestic production which in­
creased at the same rate in each period. As a result,
prices and imports accelerated sharply. (Note the
similarity in the cyclical and secular patterns of money
and imports.) This acceleration in imports caused in­
ternational reserves to decline moderately at a time
when Japan’s international transactions almost dou­
3rd quarter 1956
3rd quarter 1960
3rd quarter 1960
3rd quarter 1964
(per cent change)

International Reserves


- 10

As a result of this generally easier monetary stance,
there were two periods of balance-of-payments weak­
ness and two corresponding business cycle declines in
sThis period corresponds to the tenure of Mr. Ikeda as Prime
Minister of Japan. His major political slogan was to Double
National Income In Ten Years. In pursuit of this goal, he fol­
lowed an aggressively easy monetary policy.

(t-l) to the succeeding quarter (Hi).
★ indicates peaks and troughs which are postulated to be related to trade-balance considerations.
Sources of basic data: IMF and OECD

the 1960-64 period. In contrast, during the 1956-60
period of generally more restricted growth in money,
there was only one period of balance-of-payments
weakness and one business cycle decline. This implies
not only that monetary policy directed at the balance of
payments will lead to business cycle fluctuations, but
that the more expansionary the secular tone of policy,
the more frequent the cyclical downturns are likely to
be. (A more technical exposition of this process is
given in the Appendix under the discussion of differ­
ence equations.)
This point may be clarified by examining the most
recent Japanese business cycle downturn in some
detail. In 1962, a period of recovery in the trade bal­
ance, the monetary authorities introduced an easy
policy in order to encourage recovery of domestic
production. In late 1962 and early 1963, however, the
growth in the money stock was increased at a 40 per
cent annual rate. In previous periods of early cyclical
upswing, it was rarely permitted to increase above 20
Page 11

per cent. Production responded to this easing of mone­
tary policy about as quickly as in previous upturns.
However, imports, following the pattern of the growth
in money, accelerated more rapidly than in previous
upturns. This caused the trade balance to deteriorate
during 1963 and early 1964. The monetary authorities
were compelled again to restrain actively the growth
in the money supply, which pushed domestic produc­
tion down after only a very short period of growth.
It is fairly obvious that if the Japanese authorities
had continued this type of expansionary policy, it
would have led to additional fluctuations in the trade
balance and sharp and frequent cyclical movements
in domestic production. However, the 1963-64 experi­
ence apparently made them realize that an easy money
environment made business cycle fluctuations sharper.9
When the trade balance started to improve in the
last half of 1964 and into 1965, the monetary response
was very cautious and the degree of easing was far
more moderate than in the past. Although it took
longer for industrial production to pick up than in the
past, when it did so, it did not lead to rapid emergence
of domestic inflationary pressures. Thus, imports grew
only moderately in 1965 and 1966.

recession was sufficient to push imports down, leading
to moderate improvement in the trade balance from
the middle of 1957, and substantial improvement in
1958. As a result, monetary policy eased toward the
end of 1957 and the domestic economy started to re­
sume its growth rate from early 1958.
The Italian monetary authorities followed a rela­
tively moderate policy through early 1961. However,
from the middle of 1961 until early 1963, monetary
policy became more expansionary, perhaps because
of the emergence of a new political coalition in the
government. Domestic production had been growing
at a very satisfactory 12 per cent annual rate from
1959 to 1961, and the expansionary policy was not able
to increase that growth rate. As a matter of fact, growth
in domestic production was somewhat slower during
the period of expansionary monetary policy. How­
ever, total demand pressures generated by easy money
pushed imports up sharply in 1962 and the first half
of 1963, forcing the trade balance into substantial
The 1962-63 decline in the trade balance was much
larger than from 1956 to 1957, and, as a result, the

In the first half of 1967, Japan enjoyed a period of
rapid economic expansion, with industrial production
rising markedly. In spite of that domestic boom, im­
ports did not accelerate. However, because of weak­
ness in several of Japan’s major foreign markets, ex­
port growth has temporarily weakened and has caused
the trade balance to decline moderately. Monetary
policy became less expansionary in early 1967 and the
discount rate was increased in August. The trade ac­
count stopped deteriorating in the third quarter of
1967. The model would imply that monetary policy
will start easing again and domestic production will
exhibit only a modest deceleration in early 1968.

The Italian experience in the last decade is also
consistent with the relationships postulated in this
model. Italy has had two business cycles since 1956
and also two periods of weakness in the trade balance.
The timing of these events is consistent with our
model. The first cycle started in 1956 with a moderate
weakening in the trade balance which, in turn, led to a
moderate tightening of monetary policy and to a mod­
erate deceleration in domestic production. This mini­

9 This expansionary policy could have also reduced the long­
term growth rate. Fluctuations in production reduced the sales
and profits of Japanese business and their incentives to under­
take new investments.

Page 12

Federal Reserve Bank of St. Louis

The annual rote of change recorded for any quarter (t) is the annual rate of change from the previous quarter
(t-1) to the succeeding quarter |t+1),
★indicates peaks and troughs which are postulated to be related to trade-balance considerations.
Sources of basic data: IMF and OECD

authorities seemed to have felt that monetary policy
also had to be more restrictive. The money supply,
which at its peak in the first quarter of 1963 was grow­
ing at a 20 per cent annual rate, declined to a 4 per
cent annual growth rate by the fourth quarter of the

G erm an y
P e r C e n tC h a n g e



P e rC e n tC h a n g e

/ \


/ ^




Im is




The sharp decline in the growth of money had a
substantial effect on domestic production, which fell
from an 11 per cent increase in the second quarter of
1963 to a 9 per cent rate of decrease in the second
quarter of 1964. This was associated with a more than
proportional decline in imports, which led to an im­
provement in the trade balance from the first half of
1964, and allowed the authorities to ease monetary
policy from the second half of 1964.

Q uarterly Data at Annual Rates
Se ason ally Adjusted



/ V



ndustri 1Production

V A .


P er C e n t C h a n g e

P e r C e n tC h a n g e




% /



— y \

~ \





B illio n s o f D o lla rs

B illio n s o f D o lla rs

This easier money policy was not as excessive as in
1962 and early 1963. The growth in the money supply
was kept significantly below what it had been prior to
the decline in the trade balance in 1963. In spite of
this more conservative monetary policy, domestic
production responded promptly and resumed a 10-12
per cent growth rate in 1965 and 1966. Although im­
ports responded to the growth in production, it was
not as sharp as in previous periods of early cyclical
upswing. As a result, the trade balance continued
strong through the middle of 1967.
In several important respects the monetary policy
experiences of Japan and Italy were similar in the last
cycle. In each country a more expansionary policy than
usual was initiated (prior to the most recent cycle)
which did nothing to stimulate the real growth rate
but did trigger an acceleration in imports and a decline
in the trade balance. In each country the monetary au­
thorities seemed to have concluded that an unusually
expansionary policy could not contribute to the real
growth rate, but only add to the instability of the econ­
omy. As a result, the policies followed in the last two
years or so have been relatively more moderate in each

In the German case, the policy authorities were
more sensitive to domestic price increases than was
the case in Japan or Italy. The model would imply that
under such circumstances Germany would be less
subject to business cycle fluctuations. This has been
the case. Germany is now in the midst of its first
cyclical downturn in sixteen years. From 1951 until
1964, Germany did not experience any serious weak­
ness in its balance of trade or unusually sharp cyclical
movements in production. The success at keeping the
economy from overheating, prevented an acceleration

V in d ica te s peaks and troughs which are postulated to be related to trade-balance considerations.
Sources of basic data: IMF and OECD

of imports and kept the trade balance from weaken­
ing. As a result, Germany was able to avoid the ne­
cessity of a sharply restrictive monetary policy. Thus,
a policy which was not explicitly directed at achieving
external stability, turned out, in fact, to make an im­
portant contribution to such stability.
With the trade position in reasonable balance,10 it is
obvious that monetary policy did not need to be sensi­
tive to external consideration. It was unnecessary for
the German economy to be subject to sharp periodic
deflationary policies. By taking small corrective actions
early, large corrective actions were not necessary at a
later date.
In spite of the continuation of a conservative mone­
tary policy during the middle of the 1960’s, imports
accelerated and the trade balance deteriorated in 1964
and 1965.
Even though Germany’s holdings of international
10 “Reasonable balance” in the sense that there was little devi­
ation from the secular trend.
Page 13

reserves were unusually large ($7.9 billion at the end
of 1964), she responded to a deterioration in her trade
balance with the same vigor as Japan, whose inter­
national reserves were clearly inadequate ($2.0 billion
at the end of 1964). The time lag between the deteri­
oration of the trade balance and the tightening of
monetary policy was a relatively long one. This lag in
response is probably due to the fact that the decline
in the trade balance started from an historic high trade
surplus, and during the first few quarters was consider­
ed a healthy adjustment. When the trade surplus slid
below its normal range of about $1.5 billion, the mone­
tary authorities became concerned.
There was a sharp deceleration in the money supply
in early 1965. As would be expected from this model,
the rate of growth of both industrial production and
imports declined substantially in the face of tight
money, and by the middle of 1965 the decline in the
trade balance had been halted. The deterioration,
however, had carried the trade balance to its lowest
level in ten years, and a restrictive monetary policy
was maintained through mid-1966.
This experience again illustrates the priority given
balance-of-payments considerations by many foreign
monetary authorities. Even with a large level of in­
ternational reserves, Germany accepted a substantial
decline in the rate of growth in domestic output to
correct a deterioration in the trade balance. Only
in late 1966 and early 1967, after the trade balance
was again in substantial surplus, did the authori­
ties allow the money supply to increase. Our model
would indicate a continuing easy monetary policy
throughout this year, which should stimulate the re­
newed growth in domestic output and employment in

base of the banking system. Prices began to rise, and
both industrial production and imports rose rapidly.
By the end of 1961, definite softness began to develop
in the trade balance. While the monetary authorities
had followed a relatively passive discretionary policy,
the operation of a mechanism similar to the interna­
tional gold standard largely determined the growth
in money. Passively allowing changes in the interna­
tional reserve to dominate growth in the money stock
accomplished the same result as if the Bank of France
had followed a discretionary policy in response to the
balance of payments.
The gradual weakening in the French trade position
from late 1961 was accompanied by a gradual tighten­
ing of monetary conditions beginning in mid-1962. As
would be expected, production and imports decel­
erated by late 1963, leading to an improvement in the
trade balance beginning in mid-1964.
Monetary policy was moderately easier after re­
covery in the trade balance in late 1964 and 1965, and
industrial production rose sharply. However, the limit­
ed monetary expansion kept inflationary pressures con­
tained, and imports failed to increase as rapidly as in
previous periods of early cyclical upswing. Despite

P er C e n t C h a n g e


Impo Is





1 \/l










■ t A




Quarterly Data at Annual Kates
Seasonally Adjusted

P er C e n tC h a n g e

w i-\ V





dustria Produc




\ l




France has experienced two business cycles since
1958 and is probably now entering its third cyclical
decline. In each case, the behavior of industrial pro­
duction, the trade balance, and the money supply have
conformed to the pattern postulated in the theoretical
After the franc devaluation11 in late 1958, the French
trade balance, facilitated by a rapid advance in ex­
ports, moved from deficit to substantial surplus. The
money supply expanded rapidly as the inflow of for­
eign exchange substantially broadened the reserve
11A devaluation, even though a discretionary policy available
to the monetary authorities, is considered to be exogenous
under the system postulated by this model. As such, the
model makes no attempt to explain or predict such an event.

Page 14


(t-1| to the succeeding quarter (t+1).
★indicates peaks ond troughs which are postulated to be related to trade-balance considerations.
Sources of basic data: IMF ond OECD


this relatively mild increase in imports, poor perform­
ance in exports during 1965 and 1966 caused the trade
balance to soften, and a decline was initiated which
continued through the first quarter of 1967.

U n ite d K in g d o m
Q uarterly Data at Annual Rates
Seasonally Adjusted

P e rC e n tC h an g e



In response to this most recent weakening in the
trade balance, French authorities have operated, since
mid-1966, to decelerate the money stock. The tighter
money conditions have resulted in a deceleration in in­
dustrial production and imports.


sis Ts


P e rC e n tC h ang e



I v£ x


y v


\ I p»rls



n utri 1P d tio v
d s ro uc n



P e rC e n tC h ang e

P e rC e n tC h an g e

The trade deficit improved significantly in the second
quarter of 1967, recovering more than half of the
loss suffered in the previous six quarters of decline. On
the basis of the model, one would expect monetary
policy to now be easy and production to recover in the
near future.




JA s/
Billions of D ollars

Mone Y
' V

- v /

s ~ '

V rv \



Billio n s of D ollars

United Kingdom
The U.K. experience does not conform to the be­
havioral assumptions of the model as well as the other
countries considered. Specifically, the monetary au­
thorities have not consistently responded to a weakness
in the trade balance with a policy of tight money.12
However, this piece of contrary evidence with respect
to the behavior of the model actually strengthens its
reasonableness. The monetary response to the trade
balance is a discretionary action by most monetary
authority and not an automatic response. They could
have decided to ignore the external position in deter­
mining policy. The fact that the authorities in most
countries did not ignore the international trade posi­
tion while the United Kingdom attempted to ignore it,
shows the relative consequence of both acts. The other
countries have had only temporary balance-of-payments problems, while the United Kingdom has ex­
perienced serious weakness in her trade balance and
speculative attacks against her currency for the last
three years.
The U.K. trade balance has shown weakness three
times in the last decade: in 1957, 1960, and most re­
cently from 1964 through 1967. There have also been
three cyclical declines in the U.K. domestic produc­
tion. The 1957 weakness in the trade balance did not
induce a restriction in the money supply, although
there was a cyclical decline in industrial production
and imports which was presumably brought on by a
restrictive fiscal policy.
12 The average postwar growth rate of the United Kingdom has
been less than that of any of the major industrial countries.
This has affected the expectations of consumers and produc­
ers. They are not as optimistic about the future as the other
Europeans, Japanese, or even Americans. Thus, the basic
economic behavior which links money to income may not
hold with respect to the United Kingdom.

The annual rate of change recorded for any quarter (t) is the annual rate of change from the previous quarter
(t-1) to the succeeding quarter (HI).
•C h a n g e in s e rie s .
V in d ica tes peaks and troughs which are postulated to be related to trade-balance considerations.
Sources of basic data: IMF and OECD

In 1960 a restrictive monetary policy was introduced
because of a deterioration in the trade balance, caus­
ing domestic production and imports to decline. The
trade balance improved rather promptly in late 1960
and 1961. Monetary policy eased and production re­
covered, but grew at a very modest rate through 1962.
There was considerable controversy within the United
Kingdom in the early 1960’s about the appropriateness
of what was called a “stop-and-go” policy, allowing the
balance of payments tail to wag the domestic economic
dog. The resulting fluctuations in income, prices, and
interest rates were alleged to have weakened the sec­
ular growth in domestic production. For this reason,
monetary policy received considerable criticism.
Perhaps in response to this criticism the money sup­
ply accelerated beginning in mid-1962. Production and
imports accelerated beginning in early 1963 causing the
trade balance to start weakening in late 1963. This
weakness has continued through 1967. Public debate
has attributed the unusual length of this trade weak­
ness to the policy makers’ decision to avoid applying
restrictive policies. The deterioration in the U.K.’s
trade position was obvious as early as the first quarter
of 1964, while the introduction of a restrictive mone­
tary policy cannot be observed until the first quarter of
Page 15

1966. This is about a two-year lag in the response of
monetary policy to a weakness in the trade position.13
The “Tory” Government, which was in power until
October 1964, was probably reluctant to take restrictive
actions because of impending general elections. The
succeeding Labor Government, in the past as the op­
position party, criticized the Troy Government for
“stop-and-go” economic policy. The new labor govern­
ment hoped to avoid a substantial slowdown in the
domestic economy by attempting to correct the balance
of payments by means which would not require con­
tracting the whole economy.
The first action of the Labor Government was to
impose an additional 15 per cent duty on almost all
imports in November, 1964. The initial effect of this
action was, as expected, a reduction in imports. How­
ever, because domestic demand had not been signif­
icantly restrained, production continued at only a
slightly reduced rate, and import growth was resumed
in the second quarter of 1965.
Although a ceiling was imposed on bank credit in
1965, this did not start to cramp the liquidity position
of firms and households until the first quarter of 1966.
Monetary policy was unusually restrictive in the
second and third quarters of 1966. Industrial produc­
tion and imports began to show some weakness in the
first half of 1966, and decline in the second half of the
year.14 This softness in imports, combined with an im­
pressive growth in exports in the last half of 1966, sub­
stantially strengthened the trade balance in the fourth
quarter of 1966. This improvement, however, proved
very temporary, as the trade position again weakened
sharply in the first half of 1967.15
13 The real lag in the response of monetary policy may have
been more or less than two years. Data on U.K. money supply
are only published for four days of the year since 1964. They
are: March 31, June 30, September 30, and December 31.
Data for all other countries are available at least once a
month, and for the United States, daily. Because data for
any one day can be biased either up or down by random
events, percentage changes in the U.K. money stock show
a strong saw-toothed movement which makes it difficult to
pick turning points.
14 A drastic and widely reported set of administrative restric­
tions were imposed in 1966. In the April budget message,
a selective employment tax was proposed to go into effect in
the fall. In July, an absolute freeze was imposed on wages,
other income sources, and prices. As drastic as these actions
were, they took place when production and imports were
already weakening.
15Foreign confidence in the value of the British pound sterling
has moved in line with the strength of the trade balance.
When the trade balance deteriorated sharply in 1964, there
was a large speculative attack against sterling which was met
by a large drawing from the IMF plus support from foreign
central banks. There was a moderate renewal of the spec­
ulative attack in 1965 because the improvement in the
trade balance was not progressing as fast as had been expect
Page 16

Improvement in the trade position in the last half
of 1966 led to some easing in monetary policy, as in­
dicated by an acceleration in the money stock from
the fourth quarter of 1966. The central bank discount
rate was reduced in three successive stages from 7 per
cent in January 1967 to 5.5 per cent in May. Industrial
production, which had declined in the second half of
1966, responded to the stimulus with a modest im­
provement toward the middle of 1967.
Although imports have fluctuated sharply in late
1966 and early 1967, they have shown a moderate net
increase in the twelve months ending September
1967.16 Exports, on the other hand, have declined in
recent months. This was an important cause of the
softening in the trade balance in the first three quar­
ters of 1967.
The recent economic experience of the United King­
dom presents an interesting exception to the model.
The most recent softening in the U.K. trade balance
has been only partially due to a rise in imports. A major
factor has been the fall in export demand. The model
assumes a steady growth in exports, because the post­
war experience of most industrial countries has been of
this nature. Until now, the cyclical decline in income of
most industrial countries has been relatively moderate,
and, therefore, developments in no one country have
caused serious disruption in the export performance of
other countries. However, in late 1966 and 1967 there
were simultaneous weakenings in the economies of
the United States, France, and Germany, as well as the
United Kingdom. Although the cyclical decline in each
case has been moderate, the cumulative impact has
had a significant effect on the exports of the United
Kingdom, which trades very heavily with these coun­

C o n clu sio n
In general, the business cycle developments abroad,
which are reviewed above, can be understood reason­
ably well on the basis of the highly simplified model

(Continued from Col. 1)
ed. The weakening in the trade balance in the middle of
1966 resulted in a very heavy speculative attack against
sterling, which required substantial support from other for­
eign central banks. The sharp improvement in the trade
balance in the last half of 1966 caused a reversal in specula­
tion against sterling in the early months of 1967. This
allowed the Bank of England to repay most of the loans to
the foreign banks by May of 1967. When the trade balance
showed another sharp deterioration in the first half of 1967,
speculation again developed against sterling in the summer.
16 Imports decelerated in the months preceding removal of the
import surcharge in November, and accelerated rapidly im­
mediately after the tax was dropped. This event would be
considered as exogenous to the workings of our model.

developed in the first part of the article. However, it
should be kept in mind that this model does not fit all
countries or all business cycle movements. It is most
useful when monetary policy is intimately linked with
the target of balance-of-payments equilibrium, and
when fluctuations in the balance of payments are due
largely to internal rather than external causes. Whether
this model will continue to provide a useful frame­
work for understanding future business cycle develop­
ments depends upon whether the special assumptions
made in the model continue to be applicable.
1. If the optimistic expectations about the future
which have characterized investment and consumption
decisions are impaired, then the tremendous thrust of
private demand forces which have made monetary
policy so important will not be present. It that case,
the relationship between money and income may no
longer hold, and a more complex set of economic fac­
tors would have to be considered in determining the
short-run movements in income and production. In a
period of depressed private expectations, a national
income analysis along more traditional Keynesian lines
may be more appropriate.
2. If the present system of fixed exchange rates
should be abandoned, this would free monetary policy
from explicitly responding to balance-of-payments
considerations. Although one can never predict what
is in store tomorrow, such a development is not given
serious consideration by current policy leaders.
3. If fluctuations in the balance of payments are
caused by external rather than internal factors, the
balance of payments will no longer be dominated by
import changes. In the last fifteen years, fluctuations
in imports ( and therefore domestic factors) have
dominated the balance of payments in the countries
considered in this article, while exports have experi­
enced a relatively steady growth. This favorable ex­
port experience will continue as long as two factors
are present.
(a ) The major industrial countries of the world
experience only mild business cycles. This
will keep their imports from declining over a
long period, and the exports of other coun­

tries will grow with relative stability.
(b ) The business cycle patterns of a large group
of industrial countries have generally not
moved simultaneously with one another. If
the pattern should coincide in the future,
then even if the cycle in each country is mild,
the cumulative impact on another country’s
exports could be substantial. This seems to
have been a major factor in the most recent
weakness in the U.K. trade position. It may
also have been a contributory factor in the
recent weakness in the trade balance of Japan
and France.
There are two major implications of this model: (1 )
A monetary policy which is responsive only to balanceof-payments factors will lead to fluctuations in do­
mestic income and to larger fluctuations in the bal­
ance of payments than would be the case if monetary
policy was directed toward achieving domestic price
stability. The reason for this is fairly obvious. If fluct­
uations in the balance of payments are caused by
domestic factors, then a policy which directly stabi­
lizes the domestic economy would also stabilize the
balance of payments. (2 ) The more expansionary the
monetary policy, the sharper the fluctuations in income
and in the balance of payments.
Recent Japanese and Italian experiences confirm
this second result. In each country an expansionary
monetary policy led immediately to deterioration in
the balance of payments and to the need to reimpose
restrictive policy, causing a contraction in domestic
production. An expansionary monetary policy within
the context of this model is highly unstable.
If monetary policy, however, is responsive to domes­
tic inflationary pressures, as well as to the balance-ofpayments factors, it may well avoid the cycle which is
inherent in the model. This can be seen from the Ger­
man experience over the last decade and a half. Mone­
tary policy was made moderately restrictive on fre­
quent occasions in order to contain domestic inflation­
ary pressures. Although this led to some moderate
fluctuations in production, they were not sharp enough
to be labeled as business cycle downturns until 1966.

ic h a e l



era n

The Appendix to this article begins on next page.

Page 17

The underlying structure and rationale for this model
is presented in more technical terms in this Appendix.

Money and Economic Activity In formulating our theo­
retical model, short-term changes in income are postu­
lated to depend on the rate at which money is made avail­
able to the private sector. This relationship is expressed by
the following structural equation.1
1. Yt = ao + ai (M)t-m

when the balance of payments (B) dominates policy, it
could be described as follows:

The reason for adopting the quantity theory of money
approach rather than the more conventional income-expenditure is because it is believed to correspond more ac­
curately to the observed developments in the postwar

2b. Mt = b3 — be (P)t-o

Most industrial countries have enjoyed a prolonged
period of relative prosperity since 1950, free from protract­
ed declines in income or severe inflationary pressures. As a
result of this solid pattern of experience, the expectations of
households and firms, concerning the future, have become
generally optimistic. W ith interest rates higher than in
prewar years, the speculative and precautionary demand
for cash balances has become minimal. The incentive of
households and firms to maintain a strong liquidity position
in expectation of future losses of income is no longer very
Under these circumstances the public’s desired cash bal­
ances tend to be largely based on transactions needs, which
make the demand for money a function of such economic
variables as income and wealth. Assuming that the authori­
ties can control the supply of money, if actual cash balances
are changed by monetary policy, the public will be forced
to hold a different stock of money than it desired at pres­
ent levels of income and interest rates. In their efforts to
reestablish a desired cash balance, households and firms
will change their spending decisions. This will affect the
demand for goods, and, therefore, production and income
as well as the demand for securities and interest rates.
If future growth in income and production should be
slower than in the last fifteen years, or if a major world­
wide recession were to develop, perhaps the assumptions
which underlie this version of the quantity theory would
no longer apply. In such a case, the Keynesian incomeexpenditure approach might be a superior method of deter­
mining the level of income in the short run.

Determinants of Monetary Policy The authorities in
charge of monetary policy are assumed to respond either
to domestic price changes or to balance-of-payments con­
siderations. It is assumed that policy cannot simultaneously
be utilized to achieve both objectives. Thus, in periods
iTime lags in this and subsequent equations indicate the fjct
that relationships between an independent variable ( like M )
and a dependent variable (like Y) are not instantaneous.
The exact duration of time lag can only be determined by
a statistical analysis of each case. If the equation reads
Yt = a0 + ai (M)t-=, it should be interpreted as follows: If
it is third.quarter of 1967, then t-2 would be the first quarter
of 1967; Yt will increase by an amount equal to a0 plus ai
times (M )t-:. If (M ) increased by 5 per cent, then Yt will
increase by a0 + a i(5 ).

Page 18

2a. Mt = bo + bi (B)t-n
If price changes (P) dominate policy, it would be stated as

This is not to imply that achievement of one goal, such
as price stability, would not contribute to achieving the
other goal, or that the authorities could not shift goals. It
only implies that they are concerned with one goal at a
time. The evidence presented with this model indicates
that the authorities in the countires considered are mainly
concerned with the balance of payments. Within the con­
text of price rises in the past fifteen years, most of these
authorities have not been overly concerned with price in­
Equations 2a and 2b are expressions of the preferences
of the monetary authorities. As such, they may not only
shift between policy objectives, but also may respond to
the same policy objective in different ways at different
times. Such changes in emphasis are exogenous to the
model. An example may help clarify this point. In the
case of Japan, monetary policy was more expansionary
in the 1960-64 period than in the 19 5 6 -6 0 period (6 0 per
cent versus 120 per cent increase in money) because an ex­
pansionist minded prime minister was in office. This change
to a more expansionary monetary policy did not mean that
the balance-of-payments constraint was ignored. It did
mean that the values of (bo) and (bi) were larger in the ex­
pansionary period than in the less expansionary period.
This can be seen from the following regressions taken from
Japanese data: (Figures in parenthesis are standard errors).
19 5 6 -6 0 (16 quarters)
Mt = 2 .7 + .09 (B)t-i

r2 = .37

1 960-64 (16 quarters)
Mt = 5 .6 + .34 (B)t-i

r2 = .88

In general, the more expansionary the policy, the larger
the value of (bi), because the policy authorities must be
even more sensitive to balance-of-payments deterioration in
such periods.

Balance-of-Payments Determinants The balance of pay­
ments is usually defined by the following identity:
Balance of Payments =

Exports — Imports +
Net Capital Inflow.

In this analysis, however, the balance of payments is postu­
lated to depend only upon the direction and rate of change
in imports.
3. Bt = C — ci (Im)t-p

An increase in imports leads to a
Figure A
balance-of-payments deficit; i.e., the
relationship is negative. The defini­
tional relationship between the bal­
ance of payments and imports is of
course, in the same time period. How­
ever, the behavioral relationship postu­
lated in equation 3 between the bal­
ance of payments and imports has a
time lag. This time lag is a statistical
artifact. It results from comparing
rates of change in a flow (imports)
with the level of a residual (the bal­
ance of paym ents). A time series,
which is otherwise synchronous to another time series,
would appear to lead if measured as a rate of change.

Price and Import Determinants Changes in national in­
come are assumed to affect both prices and imports in a
positive way. This would be stated as follows:
4a. Imt = do + di (Y)t
4b. Pt = d= + dn (Y)t
When income rises at its full-employment growth rate or
less, the pressure for price increases is weak. Thus, the
price cofficient (ds) is assumed to be less than (1.0). On
the other hand, the value of the coefficient (di) is assumed
to be greater than (1.0) as both the income and substitution
effects tend to push imports up with a rise in income and to
push imports down with a fall in income.

Difference Equation This model of business cycle devel­
opments can be analyzed in formal mathematical terms by
the use of difference equation techniques. The solution of
the difference equation traces out a path over time. This
path may have a cyclical pattern, depending upon the
values of the coefficients in the model. Because monetary
policy is postulated to respond either to balance-of-payments considerations or to changes in prices, there are two
alternative versions of this model. The first version in which
monetary policy responds to the balance of payments can
be expressed formally with four structural equations drawn
from the previous discussion.





a o “ I- a i ( M ) t - m

2a. Mt = bo -f- b i ( B ) t - n

B t = co — ci (Im)t-p

4a. Imt = do + dt ( Y ) t
The reduced form of this system of equations is as follows:
Yt = Ao - A i (Y)t-z
where Ao — ao ~f- boai j cobiai ■ doCibiai,
Ai = aibiCidi,
and z = m + n + p.
The rate of change in income (Y) in any time period (t)
depends upon the rate of change in income in some prev­
ious time period (t-z). In these circumstances the expression
for (Y)t will have the properties of a homogeneous first
order difference equation because whatever the size of

F igure B

F igure C

the time lag (t-z), the value A i(Y )t-z + Ao uniquely deter­
mines the value of Y t. The value of A i determines the
cyclical properties of the model.
If the value of Ai is positive, i.e., greater than zero, then
the rate of change in income (Y ) will not have a cyclical
pattern. If the value of Ai is negative, the time path of (Y)
will oscillate in a regular cyclical pattern. In this latter case
there are three possible types of cycles. If the value of
Ai is equal to minus one (Figure A), the cyclical path of
(Y ) will be of constant amplitude. If the value of Ai is less
than zero but greater than minus one (Figure B), the
cyclical path of (Y ) will be damped with the fluctuations
becoming smaller. If Ai is less than minus one (its absolute
value is greater than minus one), the cyclical path of (Y)
will be explosive, with the fluctuations becoming larger in
each succeeding period (Figure C).
On a priori grounds, we can postulate that the value of
Ai in our model of the business cycle will be negative. This
is because in equation 3 the value ci is negative. An
increase in imports will decrease the balance of payments.
As the coefficients in all the other equations are positive,
the product of (aibiCidi = At) will be negative.
From the experience of the postwar period, we know
that there have been no explosive business cycles; thus,
the value of Ai for all of the countries considered in this
model is most likely between zero and minus one. (Figure
B ) The reason that the actual postwar business cycles have
not damped toward zero is that exogenous events, like cur­
rency devaluation, international crises, natural disasters,
etc., also affect imports, balance of payments, and income.
If monetary policy becomes more expansionary, the
value of the coefficient bi will be larger; that is, there will
be a larger increase in the money supply for any given
improvement in the balance of payments. A larger value
for bi will increase the absolute value of At. As the absolute
value of Ai becomes larger and approaches the value of
minus one, the business cycle will also exhibit a larger
amplitude. Thus, the more expansionary is monetary policy,
the sharper the fluctuations in income.
The second version in which monetary policy is domi­
nated by domestic price considerations, can be expressed
in three structural equations.

Y t = ao -f- ai ( M ) t-m

2b. M t = b* - ba (P)t-o
4b. Pt = & + ds (Y)t
Page 19

Using the same process of algebraic substitution as in
the first case, this could be' reduced to the following dif­
ference equation:
Yt = A* - As (Y)t-z

where A2 = a0 + b=a. + d=b.:ai,
A3 = aibs ds,
and z = m + o.
In formal terms this version of the model has the same
cyclical properties as the first version; i.e., both Ai and A
are negative. There are, however, several important dif­
ferences which make this version of the model exhibit
considerably less cyclical movement. First, the lag struc­
ture is shorter in this model. In a formal sense this is true,
because there are only two lags in this version (z = m + o),
while there are three lags in the previous version
(z = m + n + p). In an economic sense, the shorter time
lag is due to monetary policy responding directly to changes
in prices, while in the first version it responds to an in-

crease in imports only, after the consequences of this in­
crease are reflected in a deterioration in the balance of
payments. Second, the response mechanism in the second
version is smaller than in the first version; i.e., the absolute
value of As will be closer to zero than the absolute value
of Ai. This is because the value d will be smaller than the
value of di for reasons which have already been mentioned.
Also, the value of b.i will be less than the value of bi be­
cause the policy response to a domestic problem which has
been recognized and dealt with in its early stages can be
more moderate than the policy response to an external
problem toward which the authorities are very sensitive for
international reasons.
Because the absolute value of As is typically smaller than
the absolute value of Ai, the cyclical fluctuations in income
will be smaller if monetary policy responds to price changes
than if it responds to balance of payments considerations.
A monetary policy which takes prompt but moderate
action, will have a smaller effect on the business cycle than
a policy which takes infrequent but sharp actions.

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