Full text of Review (Federal Reserve Bank of St. Louis) : November 1970

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FEDERAL RESERVE BANK
O F S T. L O U I S
NOVEMBER 1970

1

netary and Financial Developments........... 2
LO U RSL
•\

|
J




The International Payments System and
Farm Exports ................................................... 8
Fiscal Policy for a Period of Transition............. 14
Aggregate Price Changes and
Price Expectations............................................ 18

Monetary and Financial Developments

1 H E C R U C IA L problem for stabilization policy
at this time is how to achieve the most tolerable
trade-off between continued downward pressure on
the rate of price increase and slack in economic activ­
ity. Excluding the effects of the automobile strike,
total production is apparentiy increasing slightly, and
a slow recovery seems in prospect. There is also
evidence that the rate of price advance has begun
to decelerate.
A repeat of the 1967 experience, when spending
was excessively stimulated and inflation intensified by
an overreaction by monetary authorities to some cut­
backs in output, must be avoided. Two factors which
make such a recurrence unlikely are that monetary
growth this year has not been so rapid as in 1967,
and the economy today is not so close to full capacity.
However, the strong expectations of price increases
that still prevail will probably allow only gradual
decline in the rate of price increase.
Demand and Production
R a tio S c a le
T r illio n s o f D o lla r s

Q u arte rly Total* at A n nual Rates

Seasonally Adjuited

[2 G N P in 1958 d o lla rs .
P e rce n tag e s a r e o nnu ai ra tes o l change lo r p e rio d s in d ic a te d
la te s t d a ta plotted: 3rd quarter

Page 2



R a tio S c a le
T r illio n s o f D o lla r s

Total spending has increased 4.6 per cent since the
third quarter of 1969, compared with an 8.5 per cent
average annual rate in the preceding two years. Real
product has changed little on balance since the third
quarter of 1969, compared with growth of 2.6 per
cent in the preceding year and a 5 per cent rate
from 1965 to 1968.
Industrial production declined abruptly in Septem­
ber and again in October, after drifting down 3 per
cent in the preceding year. The substantial drop in
industrial production from August to October is at­
tributable largely to the auto strike which began in
mid-September. By comparison industrial production
rose at about a 5.7 per cent average annual rate from
mid-1967 to mid-1969.
The inflation experienced since the mid-Sixties has
stopped accelerating and apparently is moderating.

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

This improvement is a lagged response to the mark­
edly slower growth of total spending, which began
in late 1969 in response to restrictive monetary policy
initiated in early 1969. Consumer prices increased at
a 4.7 per cent annual rate from April to September,
compared with a 6 per cent increase during the
previous 12 months. Wholesale prices of industrial
commodities rose at a 3.5 per cent rate from May to
October, compared with about a 4 per cent rise in the
preceding year. Overall prices (G N P deflator) rose at
a 4.4 per cent rate from the first to the third quarter
of 1970, down from the 5.5 per cent inflation in the
preceding year. An index of prices of 13 raw indus­
trial commodities has declined at about an 11 per cent
rate since early this year.

Monetary Aggregates
The restraint on total spending during the past
year has been fostered by monetary restraint in 1969.
The money stock was about unchanged from June
1969 to February 1970. Since February, the money
stock has increased at about a 5 per cent annual rate.
Previous to the restraint of 1969, money growth had
accelerated from a 2 per cent trend rate in the 1953-65
period, to a 4 per cent trend rate in the 1965-67
period, and a 7 per cent rate during 1967 and 1968.
The recent growth of money has been relatively
rapid by historical standards, but in view of the recent
strong inflation a relatively rapid monetary growth
rate perhaps has been' appropriate. In the long run it
may be desirable for total spending to rise at only
about a 4 or 4.5 per cent annual rate to foster maxi­
mum attainable real growth without inflation, but a
somewhat faster growth in spending may be tem­
porarily desirable because of inflationary expectations
which cannot be changed quickly. Total spending
growth at a 6 or 7 per cent rate, higher than the
most desirable rate in the long run, might permit a
larger expansion in real output and more employ­
ment opportunities during the transition period to a
lower rate of inflation.
A turn to moderate monetary expansion was under­
taken by the System’s Open Market Committee at its
January and February meetings, when its directive to
the operating manager expressed a “desire to see a
modest growth in money and bank credit.”1 The di­
1At the February meeting of the FOMC, the word “modest”
was changed to “moderate,” and this has been used in sub­
sequently published directives (through July meeting). Each
month’s directive is published, with a three-month lag, in
the Federal Reserve Bulletin, Board of Governors, Washing­
ton, D. C.



NOVEMBER 1970

rectives in late 1969 had included no direct reference
to money, and had stated that monetary policies
“shall be conducted with a view to maintaining the
prevailing firm conditions in the money markets.” This
language could be interpreted to mean that no re­
laxation of monetary policy was to be attempted at
the time. Directives published by the FOM C since
January (through the July meeting) have all stated
a desire for “moderate” growth of money and bank
credit.
February seems to be an appropriate base month
for calculating the recent rate of growth in money,
because this was about the time of the definite change
in the policy directive of the FOM C, and because
this seems to be the dividing line between a period
of no money growth and a period of sustained
growth. Other possible base points, such as January
M o n e y Stock
Ratio Scale
Billions of Dollars
230

Monthly A v e ra g e s of D a ily Figu res
__________ S e a s o n a lly A d ju ste d __________

1967

1968

1969

Ratio Scale
Billions of Dollars
230

1970

P e rc e n ta g e s a re a n n u a l ra tes of c h an g e for p e rio d s in d ic a te d .
La test d a ta p io tte d :O c to b e r

and late March or April, which contain large tem­
porary jumps in the money stock, would provide a
relatively poor base for determining a trend.
In the “rate of change” table for the money stock on
the next page, compounded annual rates of change
from various initial months to various terminal months
are displayed, permitting the user to read the rate of
change between any two points in time of the months
covered. The table, which is similar to a mileage
table on road maps, can be read by choosing an initial
month at the top and a terminal month at the left
side, so that the rate of change between the two
months selected is found at the intersection of the
column of the initial month and the row of the ter­
Page 3

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

NOVEMBER 1970

CO M PO UN DED

MONEY S T O C K
ANNUAL R A T E S

IN IT IA L

3- 69
4 -69

8.2

5 -69

4 .7

4 -6 9

5 -6 9

6 -6 9

7 -6 9

8- 69

9-69

1 0- 6 9

11- 6 9

12 -6 9

1- 70

B IL L IO N S

2 -7 0

3-70

4 -7 0

5-70

6-70

7-70

8-70

OF

9-70
1 9 8 .1
1 98.3

1 .2

199.0

6 -6 9

4 .5

2 .8

4 .3

7 -6 9

3 .9

2 .4

3. 1

8 -6 9

2.7

1 .4

1.4

0 .0

-

-C .9

0 .0

199.3
i

199.0

. b\

\

+0 2%

199.0

9 -6 9

2 .2

1 .1

1.1

0 .0

10—69

2 .0

1 .0

1.0

0 .2

-0 .4

0 .3

0 . 6 ^

11-69

1 .9

1 .0

1 .0

0 .4

0 .0

0 .6

0 .9

1 .2 ^

12-69

1.9

1 .1

1 .1

0 .6

0 .4

0 .9

1.2

1 .5

1 .8

1 -7 0

2.6

2 .0

2 .1

1 .8

1 .8

2 .6

3 .2

4. 1

5.5

.. l , i . .

O F C H AN G E

MONTH

7

1 9 9 .I
199.3
199.6
201.1

9 > ^
-I

0/ 2X

1 99.3

0 .7

-...0 . 7 ...

.

0 .0

0. 3

0.4

0 .3

0 .0

-0 .9

3 -7 0

2 .4

1 .9

1 .9

1 .7

1 .7

2 .2

2.5

2 .9

3.3

3 .9

1 .2

1 4. 1 \

4 -7 0

3.0

2 .6

2.8

2 .6

2.7

3 .3

3 .7

4 .3

4 .9

5 .7

4 .4

1 2 .7

5 -7 0

3.1

2 .7

2.8

2 .7

2 .8

3.3

3 .7

4 .2

4.7

5.2

4.2

9 .6

7 .4

3 .6

7 -7 0

2.8

2 .5

2.*6

2 .5

2 .5

2 .9

3.2

3.5

3.8

4. 1

3 .2

6 .1

4 .2

2 .0

1 .2

4 . 2 \

204.3

8 -70

3 .3

3 .0

3.1

3 .0

3. 1

3 .5

3.8

4 .2

4 .5

4 .8

4 .2

6 .8

5 .4

4 .0

4 .2

7 .3

2 06.0

9 -70

3 .2

2 .9

3 .0

3 .3

r s t ii

2 01.5

11

.X

2 03.3

\ +5.2%

203.9
203.6

6 71!

I l0 -7 0 l

3-69

2 .9

3 .0

2 .7

2.8

4-69

5 -6 9

6-69

3 .6

3 .9

4 .2

4 .4

3 .8

6 .0

4 .7

3 .5

3 .4

5 .2

5 .7

U

2.7

3.3

3 .5

3 .7

3 .9

3 .3

5 .2

3 .9

2 .8

2.6

3.7

3 .6

0 .3

7 -6 9

9-69

1 0 -6 9 1 1 -6 9

1 2-6 9

1 -7 0

2 -7 0

3-70

4-70

5-70

6-70

7-70

8-70

IN IT IA L

minal month. For example, the 5.2 per cent annual
rate of increase in money from February to October
is denoted in the table, and the same figure is shown
on the money stock chart as the last bracketed figure.
The column of numbers at the far right gives the
actual average stock of money for each of the ter­
minal months. Each figure along the diagonal edge
of the table represents the rate of change from one
month to the following month.2
The demand deposit component, which comprises
about three-fourths of the money stock, has increased
at a 4.5 per cent annual rate since February. By com­
parison, this magnitude decreased at a 1.2 per cent
rate from June 1969 to February 1970. The currency
component has increased at a 6.9 per cent rate dur­
ing the past eight months, after increasing at a 5.4
per cent during the previous eight months.
Member bank reserves, which underlie bank credit
and the money supply, have increased at a 9.1 per
cent annual rate in the past eight months. Federal
Reserve credit, the most important determinant of
bank reserves, has increased at a 7.9 per cent rate
2This Bank’s Monetary Trends and National Economic Trends
contain similar tables each month on selected financial data.
More up-to-date rates of change regarding financial data
are presented each week in this Bank’s U.S. Financial
Data. To receive these publications, write: Research Depart­
ment, Federal Reserve Bank of St. Louis, P.O. Box 442,
St. Louis, Missouri 63166.

Page 4


1 0 .5 \
2 \
-0 .6 s!

2 06.2
2 0 6 .1

9-70

MONTH

since February compared with a 1 per cent rate from
June 1969 to February 1970.
Money stock plus time deposits, a broader concept
of money which has largely lost its significance in
recent years, has increased at a 14 per cent annual
rate since February. This aggregate declined at a 3.2
per cent rate during the previous eight months when
the money stock was essentially unchanged and dis­
intermediation was occurring. Exclusive of large cer­
tificates of deposit, this measure has grown at a 9.4
per cent rate since February, after declining at a 1.3
per cent rate over the previous eight months. Some
analysts feel this latter refinement of the measure may
be more useful, since the volume of large C D ’s is
most heavily influenced by the fluctuating relation­
ship between Regulation Q ceilings and short-term
market interest rates. Time deposits, other than large
C D ’s, include primarily passbook savings and savings
certificates.
Bank credit has increased at a 9.5 per cent annual
rate from February to October, compared with about
a 1 per cent rate from May 1969 to February 1970, a
period of disintermediation and no monetary growth.
Since February, bank loans have increased at a 5.2
per cent rate as demand has been moderate. Over
the same period, total investments held by banks
have increased at about a 19 per cent rate. The
banks thereby have been able to take advantage of

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

NOVEMBER 1970

M o n ey Stock Plus Time D eposits
Ratio Scale
Billions of Dollars

M onthly A ve rag es o f D a ily F ig u res
S e a s o n a lly A d ju ste d

Ratio Scale
Billions of Dollars
430
420

Kn

410

more rapidly in 1970 than in 1969. Part of the in­
crease in funds at savings institutions probably repre­
sents new saving by consumers and businesses, but
much reflects a redirecting of existing funds from nonfinancial intermediary markets, such as commercial
paper, Eurodollars, and trade and individual credit.

400
390
380
370
360
350
340
330
320
310
1967

1968

1969

1970

300

Perce n ta g es a re a n n u a l ra te s o f ch a n g e for p erio d s in d ica ted .
Latest d a ta plotted : O c to b e r

the reintermediation and monetary expansion to re­
build their liquidity positions, which fell in 1969 when
bank investments declined at about a 6 per cent rate.
Short- and intermediate-term interest rates have
fallen rapidly in 1970, reflecting both the more rapid
monetary expansion and a slowing in demand for
loan funds. Yields on three-month Treasury bills aver­
aged 5.57 per cent and four- to six-month commercial
paper averaged 6.60 per cent in the first half of
November, both down about 2% percentage points
since January. Interest rates on three- to five-year
Government securities declined from 8.14 per cent in
January to 6.76 per cent in the first half of November.
Responding to the same supply and demand condi­
tions as money market rates but usually with some
lag, the prime rate has been lowered three times so
far in 1970. The rate was lowered in March from 8 V2
per cent to 8 per cent, in September to 7% per cent
and, in November to TV* per cent. Following the
changes in other interest rates, the rate which F ed­
eral Reserve banks charge on loans to member banks
was reduced from 6 per cent to 5% per cent this
month.

Time deposits in commercial banks are not homo­
geneous assets, but rather consist of several different
types of accounts, with different interest rate ceilings,
minimum amount requirements, and time-to-maturity
restriction. These different categories have grown at
markedly different rates. Large C D ’s at commercial
banks after dropping $13.1 billion from December
1968 to January 1970 have increased 12.6 billion since
January.
Total time deposits at commercial banks have in­
creased at a 23.5 per cent annual rate since February,
after declining at a 5 per cent rate during the preced­
ing year. Time deposits other than the large C D ’s
have increased at a 14 per cent rate since February,
after declining at about a 3 per cent rate from June
1969 to February 1970.
Net flows of funds into saving and loan associations
and mutual saving banks have been substantial in
1970, but less rapid than the flow of time money other
than large C D ’s into commercial banks. Since Febru­
ary saving and loan shares have increased at a 10
per cent annual rate and mutual saving bank deposits
at a 6.8 per cent rate. These rates compare with a
0.6 per cent rate for savings and loan shares and a
2.6 per cent rate for mutual savings banks deposits in
the previous eight months.
Saving Deposits
R atio S c a le
B illio n s o f D o lla rs

R atio S c a le
Millions o f D o lla rs

S ea so n a lly A djusted

300

------- ------------1300

250

Financial Intermediaries
At the same time that the money stock has risen
more rapidly since early this year, there has also
been a large inflow of time deposits to banks and to
nonbank savings institutions. As a result, total liquid
assets of the public, as generally measured, have risen



Jon 63

1963

1964

1965

1966

1967

1968

1969

1970

1971

30

Com m erciol bonk net time deposits (total time deposits minus la rg e negotiable certificates of deposit)
are monthly averages of da ily fig ures. Savings and loan deposits and mutual savin gs bank deposits ore
end-of.month fig ures. A ll d cra hove been se asonally adjusted by the Fe o e ral Reserve Bank of St. Louis
Percentages a re a nnu al rates o f change for periods indicated.
Latest d a ta plotted-. O cto b e r e stim ated

Page 5

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

This inflow of saving funds seems to have helped
the mortgage markets even though mortgage interest
rates have declined little. Private housing starts have
increased from a 1.3 million seasonally adjusted an­
nual rate in the first quarter to a 1.5 million rate in
the third quarter. By comparison, this measure de­
creased from a 1.7 million rate to the 1.3 million rate
in the preceding year.
The slow growth of savings funds at both bank and
nonbank financial intermediaries from June 1969 to
February 1970 can be attributed to high market rates
and fixed ceilings on interest rates that could be paid
by financial intermediaries. As market interest rates
rose in 1969, the ability of financial intermediaries to
compete for funds was constrained by the maximum
interest rates they were permitted to offer under Reg­
ulation Q and the corresponding regulations of the
Federal Deposit Insurance Corporation and the Fed­
eral Home Loan Bank Board.
Since January, the disintermediation which oc­
curred in 1969 has been reversed, as market interest
rates have declined and Regulation Q ceilings have
been raised Vz to % percentage points in most cate­
gories. Maximum interest rate ceilings for saving and
loan associations regulated by the Federal Home
Loan Bank were also raised and differentiated as to
type of account, maturity, and amount. In addition,
Regulation Q ceilings on 30- to 89- day maturity large
C D ’s were suspended in June, allowing banks to
compete once again with market interest rates, and,
as a result the volume of C D ’s has grown rapidly.

Federal Budget Developments
Federal Government spending on a national in­
come accounts basis has risen at a 7 per cent annual
rate since the second quarter of 1969, compared
with 5 per cent in the previous year and a 15 per cent
average annual rate from mid-1965 to mid-1968. The
share of Federal expenditures for defense has de­
clined since the second quarter of 1969, as defense
expenditures have declined at about a 2 per cent
annual rate while nondefense expenditures have in­
creased at a 14 per cent rate. By comparison, from
mid-1965 to mid-1968 defense and non-defense ex­
penditures rose at rates of 17 and 13 per cent.
The national income accounts budget has moved
sharply from the $9 billion surplus in 1969 to a
deficit at about a $13 billion annual rate in the second
and third quarters of 1970. Although the 10 per cent
surtax expired and Federal expenditures rose rapidly,
using our concept of full employment, approximately

Page 6


NOVEMBER 1970

$16 billion of the shift in the NIA budget can be
attributed to the slowdown in the economy. Approxi­
mately $14 billion of the change was due to the loss
of receipts resulting from the slowdown in personal
income and corporate profits, and about $2 billion
was due to expenditures for unemployment benefits.
It is estimated that a deficit at about an $11 billion
annual rate is being incurred in the fourth quarter
of 1970.
The high-employment budget has shown a some­
what different picture of the Federal budget than the
national income accounts budget because of the slow­
down in the economy. An estimate of the Federal
budget surplus or deficit at a constant level of re­
source utilization provides a measure of changes in
the budget due to changes in the tax laws and to
Congressional provisions for Federal expenditures.
This budget shows a surplus at about a $4 billion an­
nual rate in the second and third quarters and an
estimated surplus at about a $7 billion annual rate
in the fourth quarter. This compares with an average
surplus at about an $11 billion rate from the second
quarter of 1969 to the first quarter of 1970. The budget
outlook for the first half of 1971 is for a surplus at an
annual rate of about $10 billion. This estimate as­
sumes the effects of the proposed speed-up in
collections of estate and gift taxes and the new
tax on lead used in gasoline will appear in the first
half of 1971, and that growth of expenditures through

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

NOVEMBER 1970

SIMULATION OF THE EFFECTS OF MONETARY AND FISCAL ACTIONS*
1970
Projected Rate of Change
in Money Stock

1

1971

II

III

IV

1

II

Adjusted Actual*

1972
III

IV

1

II

Projections

3 Per Cent
Rate of Change in:
Nominal GNP
Real GNP
GNP Price Deflator
Unemployment Rate
Corporate Aaa Rate
Commercial Paper Rate

4.1%
— 1.4
5.5
4.2
7.9
8.6

4.9%
- 0 .1
5.0
4.8
8.1
8.2

5.1%
0.3
4.8
5.2
8.2
7.8

4.9%
0.3
4.6
5.4
7.9
7.4

4.6%
0.3
4.3
5.7
7.9
7.0

4.5%
0.5
4.0
6.1
7.8
6.4

4.5%
0.7
3.8
6.4
7.7
6.1

4.5%
1.0
3.5
6.5
7.6
5.5

4.5%
1.4
3.1
6.8
7.4
4.9

4.5%
1.8
2.7
7.0
7.2
4.4

4.1
— 1.4
5.5
4.2
7.9
8.6

4.9
- 0 .1
5.0
4.8
8.1
8.2

5.1
0.3
4.8
5.2
8.2
7.8

5.3
0.7
4.6
5.4
7.8
7.1

5.6
1.2
4.4
5.7
7.8
6.7

6.0
1.8
4.2
5.9
7.8
6.4

6.3
2.3
4.0
6.1
7.7
6.2

6.5
2.7
3.8
6.1
7.6
5.8

6.6
3.0
3.6
6.2
7.5
5.4

6.7
3.4
3.3
6.3
7.3
5.0

4.1
— 1.4
5.5
4.2
7.9
8.6

4.9
- 0 .1
5.0
4.8
8.1
8.2

5.1
0.3
4.8
5.2
8.2
7.8

5.8
1.2
4.6
5.4
7.7
6.8

6.5
2.1
4.4
5.6
7.7
6.5

7.4
3.1
4.3
5.8
7.7
6.3

8.5
4.3
4.2
5.9
7.7
6.2

8.9
4.7
4.2
5.7
7.7
6.0

8.9
4.9
4.0
5.7
7.5
5.8

8.9
5.0
3.9
5.6
7.4
5.6

5 Per Cent
Rate of Change in:
Nominal GNP
Real GNP
GNP Price Deflator
Unemployment Rate
Corporate Aaa Rate
Commercial Paper Rate
7 Per Cent
Rate of Change in:
Nominal GNP
Real GNP
GNP Price Deflator
Unemployment Rate
Corporate Aaa Rate
Commercial Paper Rate

*The simulation is based on equations using data through III/1970. H igh-employment expenditures are estimated through 11/1971 by this
Bank, and are projected at a 6 per cent rate thereafter. Some actual and projected figures are smoothed to remove irregular fluctuations.

the second quarter of 1971 will continue at about
the same rate as over the past 5 quarters.

Projections
Using this bank’s model as presented in the April
1970 Review, various assumed alternative rates of
change of money can be used to project rates of
change in spending, real product, and prices.3 If a
5 per cent rate of money growth were to be followed
from now until the fourth quarter of next year, total
spending might be growing at about a 6.5 per cent
annual rate a year hence, compared with about a
5.3 per cent rate now. With this growth in total
spending, prices might be rising at about a 3.8 per
cent rate, compared with a 4.6 per cent rate now.
Real output would be expanding at an estimated 2.7
per cent rate, compared with little growth at present.
3See “A Monetarist Model for Economic Stabilization,” this
Review (April, 1970), pp. 7-25. For current simulations see
Quarterly Economic Trends, prepared by this Bank.




If a slower 3 per cent rate of growth in money
were followed until the fourth quarter of next year,
total spending would probably be advancing at a
more moderate 4.5 per cent rate a year hence. Real
output would be advancing at a 1 per cent rate, up
slightly from the present rate. The rate of price
increase would probably decrease about 1 percentage
point from the current rate to a 3.5 per cent rate.
Alternatively, if a faster 7 per cent rate of money
growth were followed, total spending would be grow­
ing at a rapid 9 per cent rate a year hence, and real
product at about a 4.7 per cent rate. Price trends,
however, would show little improvement relative to
the present situation.
These alternative rates of money growth all imply
some expansion in real output and continued infla­
tion. Choice depends upon the real growth we are
willing to give up transitionally in order to move
more rapidly toward a lower rate of inflation.

Page 7

The International Payments System and
Farm Exports
A Speech by DARRYL R. FRANCIS, President,
Federal Reserve Rank of St. Louis, to the
St. Louis Agribusiness and World Trade Clubs, October 22, 1970

J t IS GOOD to have this opportunity to discuss
with you some vital issues of international trade. Each
of us has an interest in this subject — some as pro­
ducers of goods which compete with imports, others
as producers who export part of their output, and all
as consumers who gain from the efficiencies of inter­
national specialization of labor and resource use.
First, I shall briefly review some historical develop­
ments in our international payments system. Then, I
shall discuss certain policy actions that have been
taken to increase foreign trade and, finally, basic fac­
tors which tend to limit foreign trade expansion.

Earlier Payments System

—

Self-Adjusting

In the half century prior to World War 1, the
Western World had a self-equilibrating system of
settling international accounts. Most commercial na­
tions were on the gold standard with the domestic
stock of money tied to the stock of gold. A balanceof-payments deficit led to a gold outflow which, in
turn, led to a reduction in the nation’s money stock.
A decline in the stock of money reduced domestic
demand for goods and services, thereby discouraging
imports and encouraging exports. This process con­
tinued until the balance-of-payments deficit was
eliminated.
With the monetary disruptions during the war,
most nations left the gold standard. In the 1920’s, at­
tempts were made to restore the system, but the rela­
tionships established between currencies and gold
were often set at the pre-war rates, and some im­
portant currencies were overvalued. In those countries
with overvalued currencies, imports were stimulated
and exports declined, thereby depressing their econo­
mies. Attempts were made to make the necessary ad­
justments, but the depression of the 1930’s dealt a
death blow to the gold standard before new equilib­
rium rates could be restored.
Page 8



Losing gold in a period of growing unemployment
like the 1930’s meant further contraction of national
money stocks and further deflation. Most nations con­
sequently broke the link between gold and domestic
money, being unwilling to let international gold move­
ments influence the domestic money stock and in­
come. Following the breakdown of the gold standard,
most nations moved to a gold exchange system in
which national currency values were arbitrarily peg­
ged to the dollar and the dollar pegged to gold.

Current System Not Self-Adjusting
The gold exchange system automatically permitted
free currency convertability among participating
countries. Under the present system, funds flowing
out of a country reduce its international reserves
just as under the gold standard in former years. Now,
however, these flows can be offset by central bank
actions, and they have no automatic impact on do­
mestic money, prices, and income. Actions can be
taken by central bankers to reduce the stock of money
and the demand for goods and services and put a
brake on domestic prices when international reserve
outflows occur, but such actions now reflect conscious
policy rather than the automatic operation of the sys­
tem. Because of these destabilizing effects on domestic
income and prices, such actions are taken with ex­
treme caution. We are thus at times tom between
actions for implementing balance-of-payments objec­
tives and actions for optimum domestic conditions.
A few nations have altered their exchange rates
when large excesses or shortages developed in their
foreign exchange accounts. The United Kingdom re­
duced the value of the pound as a result of a large
and continuous deficit, while Germany increased the
value of its currency following a large and continuous
surplus. This method of changing the terms of trade
has not proven a practical solution to the United

NOVEMBER 1970

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

States, as the dollar is a key international reserve cur­
rency widely held for official balances. Any reduction
in its value in terms of gold would result in an im­
mediate loss to all foreign dollar holders.
Other methods used to maintain a balance-of-payments surplus include tariffs, import quotas, capital
export controls, and foreign travel restrictions. Each
of these methods, however, tends to reduce the vol­
ume of international trade. In most instances, they
are arbitrary and subject to extreme abuse by the
enforcing agencies.
The special drawing rights (SD R s) activated by
the International Monetary Fund (IM F ) early this
year extended the period over which an imbalance
of international payments can occur. These rights es­
sentially increase the quantity of international money
by a regulated amount of SDRs each year, with the
IM F acting as a clearing agent. Although serving to
ease the problem of short-run payment imbalances,
SDRs do nothing to alter the terms of trade or re­
verse basic imbalances. Terms of trade between two
nations are altered in the market by changes in na­
tional price levels and exchange rates. The SDRs
permit more time for a nation to take actions to alter
the terms of trade and are beneficial in this respect.
Nevertheless, if basic steps are not taken to equilib­
rate the terms of trade, an imbalance of international
payments on the basis of fixed exchange rates cannot
persist indefinitely without total loss of foreign ex­
change holdings.

Recent U. S. Experience

ume of transactions to be settled and the synchroniza­
tion of receipts and payments. Since international
trade by the United States accounts for only about
one-sixth of the world’s total, we apparently do not
need two-thirds of the free world’s stock of gold pos­
sessed twenty years ago. Yet, in view of the volume
of our international transactions and the foreign
claims held on the United States, we do need a siz­
able stock of gold. Most importantly, however, we
require means for altering the balance of payments to
avoid further loss of liquidity. To alleviate this prob­
lem, I would suggest greater flexibility in setting ex­
change rates between the dollar and other currencies.
A system of “crawling” exchange rates, whereby the
rates are permitted to change a small amount each
week or month toward new market levels when im­
balances occur, would be a major improvement over
the current system. By altering rates to meet payment
imbalances, the monetary authorities can concentrate
on the appropriate actions for domestic stabilization.

Protection

—

The Major Trade Restraint

Although the international payments system has
imperfections, it probably is not the major factor
tending to retard trade growth. Policies designed to
protect domestic producers from foreign competition
have probably been a more important restraint to
foreign trade. All commercial nations pursue protec­
tionist policies which reduce the quantity of goods
and services available to consumers, and we are
equally guilty of this practice. When the nation was
young, it levied tariffs for income in preference to
domestic taxes. Later, tariffs were raised to protect
our so-called infant industries from foreign competi­
tion. The protectionist argument still prevails in one
form or another. Between 1865 and 1935 our average
rate on dutiable imports never fell below 39 per cent,
except for the period during and immediately follow­
ing the First World War when other nations had a
very small output of civilian goods for export.1 The
Underwood Law in 1914 imposed an average rate of
29 per cent on dutiable imports, which was raised to
39 per cent in 1923 under the Fordney-McUmber Law
and further increased to 53 per cent in 1930 under
the Hawley-Smoot Law.

With this background, let us briefly review the U. S.
situation with reference to the balance of payments
and holdings of foreign exchange. Following World
War II, this country had a gold balance of $24 billion,
or about two-thirds of the free world’s stock of gold.
We were likewise endowed with a large portion of
the free world’s productive capacity. Justifiably, do­
mestic policies were instituted to provide other na­
tions of the free world with a better balance in foreign
exchange. We generally maintained expansive mone­
tary and fiscal policies and engaged in massive for­
eign aid programs, which tended to reduce U. S. gold
stocks. By early 1968 our gold stock had declined to
$10.7 billion, only slightly more than one-fourth of the
world’s total. Our gold holdings have since increased
slightly, but the basic factors underlying our balanceof-payments position have not improved.

Since the Reciprocal Trade Agreements Act of 1934,
the nation has pursued an announced policy of “free­
ing” international trade. Numerous tariff reductions
have been negotiated. Nevertheless, duties have of-

Our needs for foreign exchange, like an individ­
ual’s needs for cash balances, depend upon the vol­

!Don D. Humphrey, American Imports (New York: The
Twentieth Century Fund, 1955), p. 74.




Page 9

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

ten remained so high and other restrictions so effec­
tive that foreign trade has not been greatly freed.

Protection Through Nontariff Barriers
While tariffs have traditionally been the chief means
of protecting domestic producers from foreign com­
petition, other protective devices have increasingly
been used in recent years. Chief among them are
import quotas; domestic subsidies; bilateral trade
agreements; import licensing; domestic monopolies
operating under governmental authority; and “volun­
tary” controls, such as the case of cotton textiles. In
some instances, the restrictions have involved special
legislation. In others, informal agreements have been
sufficient to limit trade to arbitrarily determined lev­
els. With the aid of one or more of these measures,
nations can maintain tariff duties at relatively mod­
erate levels and still protect producers from foreign
competition. This change in method of protection
provides an opportunity for great obscurity in discuss­
ing trade policies and results of tariff reduction agree­
ments. A reduction in tariff rates may have little
meaning, since real barriers to trade often remain
unchanged.
International trade barriers are as unreasonable un­
der competitive production and marketing conditions
as are trade barriers between states, cities, or comi­
ties. To the extent that they reduce the volume of
goods and services traded, they reduce welfare.
Our country has not been innocent with respect to
the use of these protective devices. Even in agricul­
ture, which has such a large stake in free trade, we
have established highly protectionist policies. We
have sugar import quotas which, based on the New
York wholesale price, cost U. S. consumers an addi­
tional 4 cents for each one pound of sugar pur­
chased.2 We have subscribed to international trade
agreements which set minimum prices on coffee and
wheat, thereby limiting trade in these commodities.
We have meat import quotas which provide limits on
imports of beef. Our cotton export subsidy, designed
to offset the trade-retarding features of our domestic
price support program, is sufficient to permit exports
of cotton to Japan and imports of goods made from
the cotton to the U.S. for sale in competition with our
own mills. In order to avoid excessive disruptions
from such competition, however, we have a tacit
agreement with the Japanese to limit cotton goods
exports to the United States. Such tacit arrangements
international Monetary Fund, International Financial Sta­
tistics, Sept. 1970, p. 29.
Page 10



NOVEMBER 1970

are apparently preferred over formalized legal actions,
but, if they are equally effective in reducing trade,
they are likewise equally effective in reducing welfare.

Domestic Subsidies Restrictive
Also important in limiting foreign trade are produc­
tion controls and subsidies. For a number of years,
the British have subsidized their farm production,
maintaining excessive labor in agriculture which, in
effect, limits their imports and our exports of farm
products to them. These workers could produce more
real income in nonfarm pursuits, and, under free
trade conditions, the British would export more non­
farm products and import more farm products, thereby
enhancing their total production and welfare.
Our own domestic farm programs inhibit world
trade. Despite an announced policy of free trade
since 1934 and lower tariff rates, our domestic farm
policies have probably offset the advantages gained
from the reduced tariff levies. Farm production con­
trol and price support programs were initiated in the
mid-1930’s which contributed to higher farm produc­
tion cost and higher prices for farm products both
here and abroad. Our farm products became less
competitive in the world market. Worse, from a longrange view, our policy of arbitrary farm product pric­
ing at higher than free market levels led to a loss of
confidence in the United States as a long-run source
of farm products. This move from competitive to ar­
bitrary pricing indicated to our customers abroad that
hereafter prices of U.S. farm commodities would be
in excess of free market prices. Higher export prices
in turn indicated higher food and fiber costs to im­
porting nations. Their costs of imported food thus
hinge on the decisions of our price-making authorities,
who are likely to be more influenced by political pres­
sures at home than by living costs elsewhere.

International Trade Impeded
Our tariff reduction policies have not led to more
trade relative to total output. In the 1920-34 period,
prior to the Reciprocal Trade Agreements Act, U.S.
commodity exports averaged 5.1 per cent and im­
ports 4.1 per cent of gross national product (T able 1).
In contrast, since the announced liberal trade policies
in the mid-1930’s, total exports have averaged only
4.1 per cent and imports only 2.9 per cent of GNP.
The proportion of foreign trade in farm products de­
clined even more sharply than the total. Commercial
farm exports declined from 17.4 per cent of farm out­
put in the 1920-34 period to 8.6 per cent since 1934,

NOVEMBER 1970

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

Restrictive Arguments Fallacious

Table 1

Foreign Trade Relative
to Total U.S. Economy and to Agriculture
Per Cent of GNP
Period
1920-24
1925-29
1930-34
1920-34
1935-39
1940-44
1945-49
1950-54
1955-59
1960-64
1965-69
1935-69

Exports

Imports

6.4%
5.0
3.4
5.1
3.2
5.0
5.2
4.1
4.1
3.8
3.9
4.1

4.6%
4.3
3.1
4.1
2.7
1.9
2.3
2.9
2.8
2.8
3.4
2.9

Per Cent of
Cash Farm Receipts
Commercial
Farm Exports'’
21.3%
16.4
13.5
17.4
9.6
3.1
6.0
7.4
8.0
10.0
1 2.0
8.6

Farm
Imports
22.0%
20.6
15.5
19.9
14.8
10.7
9.4
14.0
12.6
10.8
10.4
10.9

♦Commercial (dollar) sales; that is, shipments under specified
Government-financed programs are excluded.
S o u rce s: USDA, A gricultu ral S tatistics, F arm Income Situation , and
F o reign A gricultu ral Trade o f the United S ta t e s ; U. S.
Department o f Commerce, Survey o f Current B u sin ess and
The S tatistical H istory o f the United S ta te s.

and imports declined from 19.9 to 10.9 per cent. In
the five-year period 1965-69, commercial farm exports
totaled 12 per cent of cash farm receipts, somewhat
above the 1935-69 average but well below the per
cent exported prior to the so-called change to more
liberal trade policies. Furthermore, export subsidies
such as government credits and guarantees, govern­
ment commodity sales at less than market prices, and
export payments in cash were responsible for a large
portion of recent exports. We view such practices as
“dumping” when other countries export products to
us under similar conditions.
Thus, despite our announced freer trade policies,
our new barriers to international trade have offset our
trade-freeing actions. The trade barriers are usually
imposed in such a way as to inhibit trade growth
rather than have a strong immediate impact, and thus
become successively more restrictive over time.
It is my conclusion that the predominent political
forces in most nations today do not really want large
increases in foreign trade. Large gains in trade upset
markets and cause changes in resource use. Some
hardships occur in the short run in the relatively less
efficient industries. Gains occur immediately, how­
ever, in the relatively more efficient industries and
among all consumer groups. In the longer run, all
groups gain from the greater efficiency of interna­
tional specialization. But, neither this nation nor other
nations have to date indicated a willingness to adopt
policies that will assure these major gains at the ex­
pense of minor adjustments among some producer
groups.



Despite the fact that international welfare could
be greatly enhanced through freer trade practices,
the arguments of trade restrictive proponents have
been predominent in determining public policies
among leading commercial nations during the last
half century. Reasons given for import restrictions are
as follows:
1. Large imports of farm products lower domestic
prices and farm incomes;
2. It is unfair to domestic labor to compete with
producers under “sweatshop” conditions abroad;
3. Imports are not a reliable source of vital prod­
ucts, such as food and critical defense items;
and
4. Excessive imports damage vital defense indus­
tries which are necessary for survival.3
Implicit in each of these arguments are the beliefs
that import restrictions aid certain producer groups,
or that some industries are so vital to national survival
that we cannot afford to take the risk of relying on
imports exclusively for such products.
The argument that import restrictions aid some pro­
ducer groups is true only in the short run. Over the
longer run, labor and other resources adjust to new
supply and demand conditions, and real gains accrue
to all groups. Furthermore, even in the short run such
restrictions are at the expense of the rest of the nation.
Let us take agriculture as an example and consider
the impact of greater exports of American farm prod­
ucts to Western Europe. Such exports will first cause
a reduction in prices to European farmers and a re­
duction in food costs to European consumers. Their
farm incomes will decline, providing incentive for
farm workers to seek higher paying jobs in the non­
farm sector. The larger nonfarm labor force, which is
relatively more efficient, will achieve greater output
of nonfarm goods and services, and exports of these
products to the United States will increase. Greater
efficiencies will occur in both their farm and nonfarm
sectors, and a larger volume of all products will be
available at lower prices, enhancing real incomes and
welfare. On the American scene, the larger volume of
farm exports will tend to increase domestic farm
prices and incomes. This will attract new resources
into agriculture from other sectors or, more likely, re­
duce the outflow of resources from agriculture. The
larger imports of nonfarm products by the United
States will reduce demand for resources in our non­
:iHumphrey, Chapter 7.
Page 11

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

farm sector, but, similar to the European case, the
increased efficiencies will provide more goods and
services to our people.
The argument that imports from low-cost factories
abroad are unfair to labor is similar to the farm im­
port argument. Import restrictions aid workers in im­
port-competing industries in the short run, but injure
workers in export industries. But, once workers and
other resources have adjusted to the new market
forces, greater output is achieved and the benefits of
greater production efficiency accrue to all.
Almost all major countries subscribe to the “vitalindustries” argument for protection. Certain industries
are assumed to be vital for national survival. England,
for example, has in the past attempted to maintain
domestic food production at about 50 per cent of do­
mestic usage. These policies originated from a lack of
confidence in supplies from abroad at critical periods,
such as during wartime blockades. Many other na­
tions, including our own, prefer to maintain sufficient
resources in vital lines of production to provide a
minimum level of output in case of loss of supplies
from abroad. Oil and sugar quotas here are an exam­
ple of such protection. Nations are willing to maintain
production of these vital products, despite the fact
that such inefficient use of resources is a waste of ef­
fort. Protection for these industries against competi­
tion from abroad maintains stability of employment
for a few at the expense of many. Nations are willing
to tax more for defense items and pay higher prices
for the civilian output of such industries in order to
maintain these industries, despite the fact that meth­
ods of modem warfare have made such excuses obso­
lete. Nations now have the power to destroy one
another long before supplies of such critical products
are depleted. The solution lies in increased confidence
that world trade channels will remain open and sup­
ply sources unimpaired.
From the standpoint of U.S. agriculture, we look
abroad at the rapid growth of Western European na­
tions and see great opportunities for farm commodity
exports, provided these nations will only open their
trade doors and invite us in. It is my conclusion that
we have not earned the invitation. Despite our num­
erous pronouncements, our policies have not con­
tributed to two-way trade arrangements. We have
done little to merit the dependence by Western Euro­
pean nations upon us for an indefinite source of vital
products at competitive prices. We have followed
neither tariff, quota, or other import regulatory poli­

Page 12


NOVEMBER 1970

cies nor domestic pricing policies that are conducive
to free trade.
Although the arguments are overwhelming in favor
of more trade between nations, I am quite pessimistic
as to its future course. Forces tending to reduce wel­
fare through trade barriers are better financed and
more powerful than the forces active in promoting
welfare through freeing trade channels. As an indica­
tion of the power of protective groups, about 590
import quota proposals were introduced in the recent
session of Congress prior to the end of August.4 One
bill, approved by the House Ways and Means Com­
mittee, was described by the New York Times as the
“most protectionist and reactionary trade legislation
in forty years.”5 Signs admonishing us to purchase
American goods and protect American jobs can be
observed daily. Only the textbooks, however, are
available to point out the gains from free trade, and
few professors are reporting the story to the general
public.

Summary
In summary, our international payments system has
imperfections. It is not self-equilibrating as it was
under the gold standard prior to World W ar I. It has
not, however, been the major factor tending to retard
foreign trade growth. This growth has been retarded
because neither the political forces in this nation nor
other nations are willing to forego the short-run in­
terests of a few producer groups for the general wel­
fare of the nation.
There are few who deny the gains from greater
exports, but powerful groups fear a rise in imports.
Both exports and imports enhance total welfare. The
removal of trade restrictions would be especially
beneficial to American agriculture. We have a major
relative advantage in the production of farm commodites. Under free world trade policies and free
domestic producing conditions, world-wide food prices
could be lowered and world diets improved. The Re­
ciprocal Trade Agreements Act, the recent Kennedy
Round, and numerous other acts were designed to
achieve these objectives. Proposed modem liberal
policies, however, are often followed by restrictive
actions more typical of the mercantilist ages. In prac­
tice we still follow the obsolete theories of several
centuries ago.
Most of the arguments used against free trade
practice are not applicable to modem world condi­
Hnternational Commerce, Sept. 7, 1970, p. 10.
5New York Times, Sept. 21, 1970.

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

NOVEMBER 1970

tions. The implied disruptions in local industries are
generally overstated and are often excuses for main­
taining resources in inefficient lines of production.
Current unemployment insurance and labor retrain­
ing social programs minimize hardships to the labor
force resulting from the change. Little capital loss
would likely occur, as our heavily capitalized indus­
tries are better able to compete in the world market
due to technological change. The vital-industries argu­
ment is no longer applicable, since, in case of all-out
war under modem conditions, no industry is secure
regardless of where it is located.

exists. We must be willing to remove barriers, permit
major increases in imports, and oppose the power of
producer groups who have made their short-run in­
terest paramount to the welfare of the nation. We
must be willing to dismantle our inefficient produc­
tion controls in agriculture and assure foreign con­
sumers that our farm products will be available at
competitive prices. A move toward free trade is a
move toward less Government control of prices and
production and greater reliance on market forces for
resource adjustment.

The United States should take the lead in dropping
all trade barriers. Tariffs are not the only item to
consider. We should move immediately to build world
confidence in us as a supplier and market. Real ac­
complishments will require more than the rhetoric of
recent decades followed by high level conferences,
which tend to free trade where no potential trade

These moves are counter to the great surge to al­
leviate all individual hardships through general legis­
lation which temporarily aids the few but reduces
national welfare. Their adoption can reverse the trend
to isolationism in the current century and greatly en­
hance the welfare of both our own citizens and those
of the rest of the world.




Page 13

Fiscal Policy for a Period of Transition
Remarks by the Honorable MURRAY L. W E ID E N R A U M , Assistant Secretary
of the Treasury for Economic Policy, before the Annual Meeting
of the Roard of Directors of the Federal Reserve Rank
of St. Louis, Little Rock, Arkansas, October 8, 1970

I t IS a great personal pleasure for me to address
this combined meeting of the Board of Directors of
the Federal Reserve Bank of St. Louis and of its
Little Rock branch. As a St. Louisian, I am keenly
aware of the important contribution that this institu­
tion is making to our region.
As an economist, I am perhaps even more aware of
the very useful role of the Eighth Federal Reserve
District in emphasizing the importance of monetary
factors in our national economy. I come here to pay
tribute to the pioneering work of the Bank and its
economists even though my own approach to eco­
nomic policy may differ in some substantial respects.
I thought that it might be useful today if I pro­
vided some thoughts on that area of economic policy
in which I have particular involvement, and that is
fiscal policy. Before turning to the outlook for the
economy and the budget, I would like to offer some
personal observations on the role of fiscal policy.
Only a few years ago, it seemed that fiscal policy
was all that mattered. Monetary considerations were
largely ignored. In good measure because of the work
of economists specializing in monetary policy, I be­
lieve that shortcoming has been corrected. As modem
economists in general now realize, money, of course,
does matter. However, as with many things in life,
there is always the danger that the correction will be
carried too far.
I sense a parallel here with the dentist who sees
me as two rows of teeth surrounded by a lot of mis­
cellaneous matter. Similarly, exclusive focus on a sin­
gle economic variable, no matter how important, is
bound to ignore significant characteristics of our com­
plicated economic structure. The fiscal position of the
Government, of course, is also important in economic

Page 14


policy, and from at least two standpoints. On the one
hand, government spending and taxing have a direct
impact on the levels of income and output in the
economy and, hence, on the allocation of resources.
On the other hand, there is the fiscal effect on credit
markets as the Government competes for investment
funds to finance its deficits and related governmentsponsored operations.
Impacts of Fiscal Policy
I thought that it might be helpful if I turn directly
to some of the more recent, and controversial, in­
stances of the use of fiscal policy. Events following
the tax cut of 1964 seemed to verify the predictability
of fiscal policy in promoting, as forecasted, a sub­
stantial expansion in the nation’s output and employ­
ment. The belated tax increase of 1968 did not quite
live up to that earlier standard of predictability in
terms of producing the forecasted behavior in total
spending.
The reasons are complex and deserve careful study.
It does seem to me that disillusionment with fiscal
policy, while understandable, is decidedly premature.
My own analysis of the experience with the imposi­
tion of the income tax surcharge in 1968 convinces
me that changes in taxation do have a visible impact
on the allocation of personal income among consump­
tion, taxation, and saving. The available data do show
that increases in income taxes, temporary or perman­
ent, do have the desired effects; they do tend — as
would be expected — to depress both personal con­
sumption expenditures and personal saving.
However, the precise proportions of these impacts,
as we have seen, may vary according to the changing
influence of many factors, including consumer expec­

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

NOVEMBER 1970

tations concerning the future. Hence, the repercus­
sions may be more modest than had been expected,
at least by some analysts, but the results seem to me
to be quite clear. A complicating consideration in
analyzing the repercussions may be the swamping of
effects from tax changes because other factors were
operating. This does not mean that the tax changes,
per se, were not effective; they may merely be hidden
under the surface of more dramatic events.
For example, consumer spending averaged 78.2
per cent of personal income in the eighteen months
before the Federal income tax surcharge was enacted
in July 1968, and 77.3 per cent in the 18 months after
that tax increase became effective. If we make what
often is the heroic assumption that all other factors
were held constant, it would appear that the 10 per
cent surcharge caused the proportion of personal in­
come which was devoted to consumption to decline
by nine-tenths of one percentage point. Similarly, the
proportion of income saved dropped by 1.3 percentage
points.
A somewhat more sophisticated analysis would
make some allowance for the lags that may occur be­
tween the time that personal income is changed and
a shift in consumer spending patterns is evident. For
example, the authoritative study at the University of
Michigan by George Katona and E va Mueller of the
1964 tax legislation revealed a lag between tax action
and personal spending of perhaps 6 months or more.
For purposes of illustration, let us assume a more
modest three-month lag for the temporary 10 per cent
increase in Federal income tax rates enacted in 1968.
Hence, let us analyze the relationship between con­
sumer spending and saving in a given quarter of a
year and the income received in the preceding quar­
ter. On that basis (see Table 1), the imposition of
the income tax surcharge was followed by a drop of
1.2 percentage points in the proportion of personal
Table I

EFFECT OF THE SURCHARGE O N
CONSUMER SPENDING AND SAVING

income devoted to personal consumption expendi­
tures, and a decline of one percentage point in the
savings ratio for the time periods under study. In an
economy the size of our own, a one percentage point
shift is quite striking when we translate it into billions
of dollars.
I suggest that, in retrospect, the direct economic
impact of the surcharge was as we should have ex­
pected: the major share of the higher taxes came out
of funds that consumers otherwise would have de­
voted to personal consumption expenditures, and the
remainder came out of income that would otherwise
have been saved and invested. To me, this experi­
ence vindicates rather than discredits the usefulness
of fiscal policy for purposes of economic stabilization.
Our experience to date with the phase-out of the
surcharge tends to confirm the pattern of adjustment.
Both consumer spending and consumer saving have
risen as a proportion of personal income, and, here
again, a lagged reaction may be developing. The im­
pact on saving seems to have been greater in the im­
mediate period than it is likely to be in subsequent
months when consumers have had time to adjust their
consumption patterns to their higher disposable in­
come. Hence, we can expect the savings ratio to re­
cede somewhat from its current peak. Certainly, the
phase-out of the surcharge has contributed to the
higher level of economic activity and, together with
appropriate monetary policy, has enabled us to make
the current economic adjustment to a less inflationary
economy without the customary recession.
Hence, the current wave of skepticism concerning
the effectiveness of fiscal policy seems quite ill-ad­
vised, and I do sense its ebbing. Although fiscal
measures have helped to slow down the economy,
what neither fiscal nor monetary restraint has done
was to arrest quickly a strong inflationary momentum.
This should provide a sobering experience
for advocates in either camp.

Percentage Distribution of Personal Income
Personal
Consumption Personal
Personal
Expenditures Savings Taxes, etc.
Total
1 8 Months Before the
Tax Surcharge
Average of quarterly data for
January 1967 — June 1968
18 Months After Imposition
of Tax Surcharge
Average of quarterly data for
July 1968 — December 1969

79.8

78.6

6.3

5.3

13.9

16.1

N o te : Consumption anti saving are lagged one quarter (see text).




100.0

100.0

To this observer, one clear lesson of the
last few years is the importance of the F ed ­
eral fiscal position to money and capital
markets. Federal deficits at high employ­
ment spell trouble in terms of overstrained
financial markets and upward pressures on
interest rates.
To be sure, a distinction between “passive
deficits” (resulting from economic slowup)
and “active deficits” (to stimulate economic
growth) still can be made. As economic
Page 15

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

slowup develops, Federal receipts fall, and, indeed,
this was a factor in the more-than-projected deficit
of the past fiscal year. This has meant more Federal
financing and more pressure in financial markets,
already feeling the effects of continuing heavy pri­
vate requirements for liquidity. Interest rates, of
course, nevertheless have subsided somewhat — but
not yet in as substantial a degree as has character­
ized many other cyclical slowups. The small declines
of yields in both short- and long-term markets have
been one manifestation of this.
And, as long as the economic adjustment now un­
derway remains small, as it has, the pressure in finan­
cial markets will place limits to the decline in yields.
The risk is now turning in the other direction —to
higher yields, should the recovery now apparentiy in
progress move up too fast. Unfortunately, this could
channel the flow of funds to sectors other than those
with high national priority — allocation of credit to
housing, state and local governments, small business­
men, etc.
Hence, appropriate fiscal policy in an economy of
high employment must play a strategic role; the links
between fiscal and monetary policies are complex
and unbreakable.
Some fiscal skeptics fail to see how a few billion
dollars —of government money —can matter one way
or another. What some of the critics forget is that the
extra Federal borrowing, while small relative to total
output, impinges on credit markets whose short-run
capacity is limited. This can be disruptive in terms
of the functioning of markets, the allocation of credit
among different classes of borrowers (e.g., for home
m ortgages), and the level of interest rates.
We do need to recognize the practical limitations
under which fiscal policy operates. There are serious
barriers to very frequent changes for short-run stabi­
lization purposes. Political restraints may at times re­
sult in an inappropriate fiscal policy. Certainly, the
$25 billion budget deficit in the fiscal year 1968 was
a mark of wrong, but not of ineffectual, fiscal policy.
In retrospect, we would have hoped that fiscal effects
then were weaker than they actually were.
To sum up, there are many sides to the economic
elephant, around which economists are stumbling and
of which we are taking various measurements. Money
matters, as do fiscal actions. The state of our economic
knowledge does not justify a doctrinaire dismissal of
either stabilization policy approach. We have too few
Digitized for Page
FRASER
16


NOVEMBER 1970

effective economic policy tools to be in a position to
abandon any.
Indeed, as we examine economic policy in recent
periods, we do indeed find that we have continued
to utilize fiscal tools. For example, at the President’s
request, the Congress passed several revenue-raising
measures last year which were designed to assist in
dampening down a then overheated economy.
The items that I have in mind include extending
the 10 per cent income tax surcharge from June 30,
1969 to December 31, 1969, and, at a five per cent
rate, to June 30, 1970. Also, scheduled reductions in
selected excises were postponed one year (and the
Administration has asked that these tax reductions be
postponed again).
It is clear to me that fiscal measures continue to
play an important, but not solitary, role in the execu­
tion of national economic policy.
Federal-State-Local Relations
I would like to turn briefly to an aspect of fiscal
and economic policy that often is overlooked in dis­
cussions of national trends —the interrelationships be­
tween the Federal Government and state and local
governments. The Federal Government, as we know,
possesses rather potent monetary and fiscal tools
which it can use to help promote economic stabiliza­
tion and growth.
In contrast, state and local governments, far more
limited in their fiscal capabilities, are more in the po­
sition of reacting to aggregate economic trends. Many
local governments, for example, find themselves in a
budgetary bind when so much of their income comes
from sources not responsive to economic growth, such
as the property tax.
Mindful of the financial problems facing state and
local governments, the Nixon Administration has ad­
vanced an innovative program for sharing a portion
of Federal revenues with states, counties, and cities.
Under the revenue-sharing proposal, a percentage of
the Federal personal income tax base — the fairly
steadily rising total of individual taxable incomes re­
ported to the Internal Revenue Service — will be dis­
bursed each quarter to every state, county, and city
in the nation.
Although revenue sharing will not be a panacea, it
should help to strengthen the capability of state and
local governments to respond to the needs of their
citizens.

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

The Outlook
My own reading of the economic tea leaves leads
me to believe that the economy is in the process of
turning up while inflationary pressures are being re­
duced. However, it is important during this period of
transition to keep the inevitable month-to-month
fluctuations in their proper perspective.
For the period immediately ahead, each month’s
statistics are not likely to steadily reflect an upturn
in the level of economic activity nor a downward
trend in the rate of inflation. In fact, a short pause
or even a temporary turn for a month or so in some
of these statistical series is quite likely and, in some
cases, has been occurring. We need to avoid confus­
ing these volatile and temporary fluctuations with
changes in the underlying trend.
It is when we examine these underlying trends that
we find the basis for the expectations of advancement
in the level of economic activity and a continued re­
duction in the rate of price increases. Perhaps the
major and very real change that we have been wit­
nessing is in the general atmosphere of improved
expectations.
Despite the current strike in the automobile in­
dustry, I anticipate that real GNP will rise in the
third quarter of 1970. The results for the fourth quar­
ter will depend in good measure on the extent to
which the strike will continue. In any event, I would
expect the current work stoppage merely to slow
down or interrupt the recovery which is already under
way.
My own evaluation of the economic outlook leads
me to conclude that the upturn will be moderate
enough to be accompanied by continued measureable
progress in bringing down the rate of inflation. The
performance of both consumer prices and wholesale
prices in recent months is quite reassuring on that
score: ignoring inevitable month-to-month fluctua­
tions, the trend in 1970 to date shows a dampening
in the rate of inflation. My forecast for the coming
year is along the same lines: ignoring inevitable
month-tO-month fluctuations, the outlook is for a fur­
ther dampening in the rate of inflation. The specific
degree of improvement in the price level, of course,
will depend in part on the results of decisions in the
private sector on wages and other elements of costs
and prices.
Given this background of economic developments,
the budget situation is a source of considerable at­
tention. It is too early for any definitive statement on



NOVEMBER 1970

the prospects for the fiscal year 1971. There are still
actions which can, and should, be taken on both the
revenue and expenditure sides which would hold
down the likely deficit to reasonable proportions.
The budget rule announced by the President on
recent occasions certainly provides a good and clear
guide: to keep expenditures within the limits of the
revenues that our Federal tax structure provides at
full employment. By following this guideline, we will
restore budgetary balance when the economy is op­
erating at full potential.
Keeping expenditures within full employment rev­
enues will not be easy to do, especially if new initia­
tives are to be pursued, let alone the general updrift
in costs of existing programs. It is likely to require
hard decisions on the expenditure side —perhaps
some program deferrals, reductions and phase-outs.
In the area of military spending, the leading indica­
tors all portend a continued slowdown in dollar terms
and a further decline in real terms in coming months.
In the longer run, the trend of defense expenditures
will depend on the course of international develop­
ments and this nation’s reaction to them.
In the area of civilian government outlays, I am
struck by the cogency of the recent warning of C as­
par Weinberger, the Deputy Director of the Office of
Management and Budget: “A pilot project normally
turns into an essential program in three years . . . The
distance from an urgent priority to an untouchable
sacred cow is usually no more than five fiscal years.”
A fiscal policy adequate and proper for the transi­
tion to a period of renewed growth but lessened in­
flationary pressures calls for a tighter control over
Federal spending. To keep expenditures within the
revenues that can be expected when the economy
returns to full employment will require hard choices
among alternative spending programs.
There is much talk these days about the need to
change our priorities. But, there are two parts to the
process. The attractive and much easier part of in­
creasing spending for high priority items has, as we
would expect, received the great bulk of the atten­
tion. We now need to focus on the second and
harder step which is necessary in order to achieve
the required shift of resources: identifying those pro­
grams of lower priority which can be reduced, post­
poned, or even eliminated and then taking action to
do so. Not until this second step is accomplished will
the necessary changes in priorities truly be effected.
Page 17

Aggregate Price Changes and Price Expectations
by RAY C. FA IR

Economic events since 1965 have intensified interest in the problem of infla­
tion. A fundamental question is how to forecast movements in the price level.
Explaining and forecasting the price level has been one of the most difficult prob­
lems associated with econometric model building.
The following article by Professor Ray Fair of Princeton University was pre­
pared for presentation to a seminar at this Bank. Professor Fair has developed a
short-run forecasting model ivhich includes the price level as one of the variables
to be forecast. The key variable in his price equation is a measure of current
and past demand pressure. In contrast to Andersen and Carlson (April 1970
R e v i e w ) , he has found, using nonlinear techniques of estimation, that it is not
necessary to include explicitly a measure of price expectations in order to obtain
a satisfactory explanation of changes in the price level. In addition, by refining
the measure of potential output, the explanation of prices is improved further.
Professor Fair’s results suggest that the price level is demand-determined.
Cost-push or mark-up factors do not need to be introduced explicitly in order to
explain upward movements in prices in the face of sluggish economic activity.
Such a phenomenon can be explained as the result of the delayed effect of past
demand pressure on prices.
This article is presented in hopes of stimulating further discussion and re­
search into the problems of explaining and forecasting movements in the price
level.

PRO BLEM common to models in which nominal
GNP is determined independently of the price level
is the determination of the price level given the
level of nominal GNP. Once the price level is de­
termined, real GNP is then by definition equal to
nominal GNP divided by the price level. In Section I
of this paper the theory and basic specification of
the price equation developed in an earlier paper1
are discussed, and various versions of the equation
are estimated and examined. In Section II the Andersen-Carlson price equation2 is then analyzed. Ander­
sen and Carlson for their model have a price expecta­
tions term in their basic equation, and the primary
aim in Section II is to evaluate the importance of
this term.
'Ray C. Fair, “The Determination of Aggregate Price
Changes,” Research Paper No. 25, Econometric Research
Program, Princeton University, February 1970.
2Leonall C. Andersen and Keith M. Carlson, “A Monetarist
Model for Economic Stabilization,” this Review (April 1970),
pp. 7-25.

Page 18


The Determination of
Aggregate Price Changes3
In most macroeconomic models the expenditure
equations are in real terms, prices are determined
in a wage-price sector by various cost and excess
demand variables, and money expenditures are de­
termined by multiplying the real expenditures by
their respective prices. In most of these models the
wage-price sector has tended to be a large source of
error.4 The simultaneous and lagged relationships
•'The price equation described in this section is discussed in
more detail in Fair, “The Determination of Aggregate Price
Changes.” The price equation is also discussed in Ray C.
Fair, A Short-Run Forecasting Model of the United States
Economy (Lexington, Massachusetts: D. C. Heath and Com­
pany, forthcoming 1971), Chapter 10, within the context of
an overall forecasting model. In Andersen and Carlson,
footnote 17, my paper, “The Determination of Aggregate
Price Changes,” was listed as forthcoming in the Journal
of Political Economy. This is an incorrect reference, and I
assume responsibility for this error.
4See, for example, Gary Fromm and Paul Taubman, Policy
Simulations with an Econometric Model (Washington, D .C .:
The Brookings Institution, 1968), p. 11, for a discussion of
the limited success so far achieved by the Brookings model
in this area.

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

in the wage-priee sector make the sector difficult to
specify and estimate with precision, and the pos­
sibility of errors compounding in the sector during
simulation is generally quite large.
The model of price determination described here
bypasses the whole wage-price nexus and essentially
takes prices as being determined by current and
past aggregate demand pressures. The price equation
of the model can thus be considered to be a reduced
form equation of a more general wage-price model.
The equation is also similar to simple Phillips-curve
equations, where wage changes (or price changes)
are taken to be a function of excess supply (as
approximated by the unemployment rate) in the
labor market.

The Theory
The theory behind the model is quite simple.
Aggregate price changes are assumed to be a function
of current and past demand pressures. Current de­
mand pressures have an obvious effect on current
prices. If there is current excess demand, then prices
are likely to be bid (or set) higher, and if there is
current excess supply, then prices are likely to be bid
(or set) lower.
There are two ways in which past demand pres­
sures can affect current prices. One way is through
the lagged response of individuals or firms to various
economic stimuli. It may take a few quarters for some
individuals or firms to change their prices as a result
of changing demand conditions. This may, of course,
not be irrational behavior, since individuals or firms
may want to determine whether a changed demand
situation is likely to be temporary or permanent
before responding to it. The other way in which past
demand pressures can affect current prices is through
input prices. If, for example, past demand pressures
have caused past input prices to rise, this should lead
to higher current output prices, as higher produc­
tion costs are passed on to the customer. The lag in
this case is the time taken for higher input prices to
lead to higher costs of production5 and for higher
costs of production to lead to higher output prices.
It may also take time for input prices to respond
to demand pressures, which will further lengthen the
lag between demand pressures and output prices.
Note that nothing specifically has been said about
w age rates. Labor is treated like any other input —
5Since firms stockpile various inputs, this lag is not neces­
sarily zero.



NOVEMBER 1970

demand pressures are assumed to lead (usually with
a lag) to higher wage rates, which then lead (perhaps
with a lag) to higher output prices. The present
approach avoids the problem of having to determine
unit labor costs or wage rates before prices can be
determined.
The present model is thus based on the simple
theory that price changes can ultimately be traced
to the existence of excess demand or supply in the
market. If this is true, then for purposes of explaining
aggregate price changes, one may not have to specify
the intermediate steps between demand pressures
and price changes, but may be able to specify price
changes as direct functions of current and past de­
mand pressures.

The Measurement of Potential Output
Potential output plays an important role in the
work below, and two measures of potential output
have been considered in this study. The first measure
is the potential GNP measure of the Council of
Economic Advisers (C E A ), which grew at a 3.5 per
cent annual rate from 11/1955 through IV/1962, at
a 3.75 per cent annual rate from 1/1963 through
IV/1965, and at a 4 per cent annual rate from 1/1966
through 11/1970. The second measure considered
here, a potential GNP measure developed by the
author,6 is similar in concept to the C EA measure.
“Potential GNP” is meant to refer to that level of
GNP that could be produced at a 4 per cent un­
employment rate.
In Table I on the next page, the actual values of
real GNP, the estimated values of this second measure
of potential GNP, and the percentage changes (at
annual rates) of the second measure of potential
GNP are presented quarterly for the I/1954-II/1970
period. One of the basic differences between the
potential GNP series presented in Table I and the
CEA series, aside from the smoother nature of the
latter, is the relatively slow growth of the series in
Table I during the last two quarters of 1965 and all
BThe measure is described in Fair, “The Determination of
Aggregate Price Changes,” and in Fair, A Short-Run Fore­
casting Model of the United States Economy, Chapter 10.
There is one basic difference between the measure of
potential output described in these two works and the
measure used in this paper. In a recent study by the author,
“Labor Force Participation, Wage Rates, and Money Illu­
sion,” Research Memorandum No. 114, Econometric Research
Program, Princeton University, September 1970, wage rates
were found to have a significant effect on the labor force
participation of some age-sex groups, and in the construc­
tion of the potential labor force series in this study (a series
that is needed for the construction of the potential output
series), account was taken of this effect.
Page 19

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

NOVEMBER 1970

Table 1

ESTIMATES OF POTENTIAL REAL GNP
(Billions of 1958 Dollars)
Percentage Change *
in Potential GNP

Quarter

Real
GNP
(X )

Potential
GNP
<XF )

1954 1
II
III
IV

402.9
402.1
407.2
415.7

426.0
429.6
432.8
436.6

3.7%
3.3
3.0
3.5

1955 1
II
III
IV

428.0
435.4
442.1
446.4

440.6
444.7
449.1
453.0

3.7
3.7
3.9
3.5

1956 1
II
III
IV

443.6
445.6
444.5
450.3

456.5
460.1
464.4
468.0

3.1
3.1
3.7
3.1

1957 1
II
III
IV

453.4
453.2
455.2
448.2

471.6
475.6
480.6
485.8

3.0
3.5
4.1
4.3

1958 1
II
III
IV

437.5
439.5
450.7
461.6

490.3
494.4
498.4
503.4

3.7
3.4
3.2
4.1

1959 1
II
III
IV

468.6
479.9
475.0
480.4

507.7
51 2.8
517.7
521.7

3.4
4.0
3.8
3.1

1960 1
II
III
IV

490.2
489.7
487.3
483.7

530.0
534.8
539.4
545.0

6.3
3.6
3.5
4.1

1961 1
II
III
IV

482.6
492.8
501.5
511.7

550.6
555.7
560.6
564.1

4.1
3.7
3.6
2.5

1962 1

519.5

567.8

2.6

Quarter

Real
GNP
(X )

Potential
GNP
<XF )

1962 II
III
IV

527.7
533.4
538.3

572.9
579.0
585.6

3.6%
4.3
4.5

1963 1
II
III
IV

541.2
546.0
554.7
562.1

592.5
598.8
604.4
609.1

4.8
4.2
3.7
3.1

1964 1
II
III
IV

571.1
578.6
585.8
588.5

615.4
621.1
627.3
632.4

4.2
3.7
4.0
3.3

1965 1
II
III
IV

601.6
610.4
622.5
636.6

638.3
644.2
648.8
653.6

3.7
3.7
2.9
2.9

1966 1
II
III
IV

649.1
655.0
660.2
668.1

657.0
660.2
664.2
667.8

2.1
2.0
2.5
2.2

1967 1
II
III
IV

666.6
671.6
678.9
683.6

672.8
678.1
685.3
691.4

3.0
3.2
4.2
3.5

1968 1
II
III
IV

693.5
705.4
712.6
717.5

696.6
701.5
707.3
713.3

3.0
2.9
3.3
3.4

1969 1
II
III
IV

722.1
726.1
730.9
729.2

720.0
726.0
733.5
739.0

3.8
3.3
4.2
3.0

1970 1
II

723.8
724.9

746.9
753.6

4.2
3.6

Percentage Change*
in Potential GNP

-Annual rates o f change computed here differ slightly from annual rates of change computed elsewhere in this Review and in other
publications o f this Bank. The formula for quarterly annual rates of change used here is as follow s:
quarter-to-quarter
rate (in per cent) =

\(
l\

of 1966. This slow growth is due primarily to the
Vietnam troop buildup during the period. As m eas­
ured by the national income accounts, average output
per government worker is less than average output
per private worker, and the movement of workers
from private to government work (as when the level
of the armed forces is increased) has a negative effect
on total potential output.

Specification of the Price Equation
The first question that arises in specifying the
price equation is what measure of demand pressure
should be used. Two measures, denoted as D ? and
D t respectively, were considered in this study:
(1) D? = x r - X t
(2) D t = ( X { — Xt-i) - (Yt — Yt-i)

Page 20


1

Vt-i

1

)

1 -4

\

• 100

Yt denotes the level of money (current dollar) GNP
during period t, X t denotes the level of real (constant
dollar) GNP, and X f denotes the level of potential
(real) GNP. D? as defined by (1) is the difference
between potential and actual real GNP and is a
commonly used measure of demand pressure.7
(X f —X t- i ) in (2) is the change in real GNP during
period t that would be necessary to make real GNP
equal to potential real GNP (to be referred to as the
“potential real change in GNP” ), and (Yt—Y t-j) is
the actual change in money GNP during period t.
D t as defined by (2) is thus the difference between
7The notation adopted for this article is designed to be as
consistent as possible with the notation in Andersen and
Carlson. Note, however, that the sign of D, in equation
(2) is reversed from that in Andersen and Carlson.

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

the potential real change in GNP and the actual
money change. D t can also be considered to be a
measure of demand pressure. If, for example, the po­
tential real change in GNP is quite large, then the
money change can be quite large and still lead to
little pressure on available supply, but if the potential
real change is small, then even a relatively small
money change will lead to pressures on supply.
By definition, money GNP is equal to real GNP
times the GNP deflator. If the deflator is taken to be
endogenous, then whether D? or D t should be
used as the measure of demand pressure in the
equation determining the deflator depends on whether
real GNP is taken to be endogenous, with money
GNP being treated as the “residual,” or whether
money GNP is taken to be endogenous, with real
GNP being treated as the “residual.” In the Fair
model, for example, the expenditure equations are
in money terms and money GNP is endogenous.
Likewise, in the Andersen and Carlson model, the
expenditure equation is in money terms. In these
models it would not be appropriate to use D? in
the equation determining the deflator, since the real
GNP part of D? is determined as money GNP
divided by the deflator (that is, as the residual) and
thus the deflator enters on both sides of the equation.
It would be appropriate to use D t, however, as long
as it could be assumed that the variables and error
terms that determine money GNP in the models are
independent of the error term in the equation de­
termining the deflator. Conversely, for models in
which real GNP is endogenous and is determined by
variables and error terms that are independent of
the error term in the equation determining the defla­
tor, it would be appropriate to use D? in the equa­
tion, but not D t.
In most large-scale macroeconomic models, of
course, money GNP, real GNP, and the GNP deflator
are all endogenous in that they are all determined
within a simultaneous system of equations. No one
variable can be considered to be determined simply
as the ratio or product of the other two. Since in
most of these models the expenditure equations are
in real terms, however, it is probably true that money
GNP is closer to being the residual variable in these
models than is real GNP.
Whether a given expenditure equation in a model
should be specified in real or money terms depends
on whether spending units take money income and
other money variables as given and determine how



NOVEMBER 1970

much money to spend as a function of these (and
other) variables, or whether they deflate money
income and the other money variables by some price
level and determine how many goods to purchase as
a function of these “real” (and other) variables. In
the first case the number of goods purchased is the
residual variable ( people plan to spend a given
amount of money, and real expenditures are deter­
mined merely as money expenditures divided by the
price level), and in the second case the money value
of goods purchased is the residual variable (people
plan to purchase a given number of goods, and
money expenditures are determined merely as real
expenditures times the price level).
In the long run it seems clear that real expendi­
tures are determined by real variables, as standard
economic theory suggests, but in the short run the
case is not so clear. Given the uncertainty that exists
in the short run and the lags involved in the collec­
tion and interpretation of information on price
changes, people may behave in the short run in a
way that is closer to the first case described above
than it is to the second.
An argument can thus be made for specifying
expenditure equations in short-run models in money
terms, although even for short-run models it may be
the case that some equations should be specified in
real terms. It may also be the case that consumption
expenditure equations should be specified in the
manner suggested by Branson and Klevorick8 to
incorporate money illusion direcdy. Whatever the
case, D t has been used as the excess demand variable
for most of the work below, on the assumption that
in the short run real GNP is closer to being the
residual variable than is money GNP. Some results
using D? will also be presented.
The price deflator that has been used for the
estimates below is actually not the total GNP deflator,
but the private output deflator. Because of the way
the government sector is treated in the national in­
come accounts, the GNP deflator is influenced rather
significantly by government pay increases, such as
those that occurred in III/1968 and III/1969, and
the private output deflator is likely to be a better
measure of the aggregate price level. The private
output deflator will be denoted as P t.
In the table on the next page, values of the private
output deflator and demand pressure are presented
8William H. Branson and Alvin K. Klevorick, “Money Illu­
sion and the Aggregate Consumption Function,” The Ameri­
can Economic Review (December 1969), pp. 832-849.
Page 21

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

NOVEMBER 1970

Table II

VALUES OF PRIVATE OUTPUT DEFLATOR (Pt)
Quarter

Pt

A ND DEMAND PRESSURE (D t)

Percentage Change*
in Pt

Dt

Quarter

Pt

Percentage Change'
in Pt

Dt

1963 II
III
IV

105.70
105.88
106.23

1.19%
.69
1.30

50.8
47.9
43.3

1964 1
II
III
IV

106.47
106.82
107.21
107.70

.91
1.31
1.49
1.82

41.4
39.7
37.8
40.4

1965 1
II
III
IV

108.24
108.77
108.96
109.30

2.02
1.93
.71
1.27

32.1
29.7
23.0
12.2

1966 1
II
III
IV

1 10.08
111.15
112.03
112.91

2.84
3.88
3.18
3.14

.9
- 2 .7
- 3 .4
- 7 .2

1967 1
II
III
IV

1 13.54
114.08
115.19
1 16.28

2.24
1.89
3.89
3.79

1.0
1.4
- 2 .7
- 2 .5

1968 1
II
III
IV

117.21
118.38
119.37
120.65

3.18
4.01
3.34
4.29

— 6.0
- 1 5 .2
— 15.8
— 14.9

1969 1
II
III
IV

122.08
123.54
124.88
126.33

4.74
4.78
4.34
4.61

- 1 3 .7
— 12.2
— 11.5
— 1.0

1970 1
II

127.96
129.22

5.16
3.94

9.9
18.2

1956 1
II
III
IV

93.15
93.97
95.14
95.89

4.07%
3.52
4.99
3.16

8.3
10.9
14.4
14.6

1957 1
II
III
IV

96.87
97.52
98.45
98.82

4.07
2.70
3.82
1.50

13.9
19.2
21.0
35.4

1958 1
II
111
IV

99.52
99.77
100.07
100.48

2.84
1.02
1.20
1.61

48.9
53.3
45.8
39.7

1959 1
II
III
IV

100.99
101.23
101.64
101.78

2.02
.99
1.61
.55

36.5
31.3
40.7
40.2

1960 1
II
III
IV

102.24
102.67
102.84
103.34

1.79
1.69
.67
1.95

37.1
42.9
50.2
58.6

1961 1
II
III
IV

103.58
103.61
103.59
104.10

.92
.12
- .0 8
1.96

66.6
61.8
58.5
48.1

1962 1
II
III
IV

104.44
104.58
104.79
105.09

1.31
.52
.82
1.13

46.0
44.0
44.1
44.6

1963 1

105.38

1.13

48.8

*Annual rates o f change computed here differ slightly from annual rates of change computed elsewhere in this Review and in other pub­
lications of this Bank. The formula for quarterly annual rates of change used here is as follows:
vt
quarter- to-quarter
11
1 • 4 • 100
rate (in per cent) =
V ,- !

)

quarterly for the I/1956-II/1970 period.9 The values
of demand pressure were constructed using the
potential GNP measure presented in Table I. Notice
that demand pressure was quite large during the
early 1960’s, when there was little increase in the
aggregate price level, and that it was much smaller
(and in fact negative) during the late 1960’s, when
the price level was increasing quite rapidly. (Low
values of D t correspond to periods of high demand
pressure).
The basic equation explaining the change in the
deflator is specified as:
(3 )

Pt -

P t -i = a 0 + oti ( ---------------------- *----------------- ^ +

\

. 1

«2 +

~

n

2

/

El

D t - i+1

i= 1

where £t is the error term and n is the number
of periods over which lagged values of the demand
pressure variable have an influence on the current
9Pt is taken to be in units of 100, rather than in units of 1.

Page 22


j

change in the deflator. — v D t - i + i is the simple
i= 1

n-quarter moving average of D. Equation (3 ) is
consistent with the theory expounded above. The
current change in the price level is taken to be a
function of current and past demand pressures, as
measured by the n-quarter moving average of D.
A nonlinear functional form has been chosen, the
functional form being similar to that used in studies
of the Phillips curve, where the reciprocal of the
unemployment rate is most often used as the ex­
planatory variable.
Equation (3 ) is nonlinear in a 2 and must be
estimated by a nonlinear technique.10 In studies
of the Phillips curve in which the reciprocal of the
unemployment rate is taken to be the explanatory
variable, a coefficient like a 2 in equation (3) does
not arise, since it is assumed that as the unemploy­
ment rate (excess supply) approaches zero, the
10The technique that was used for this purpose is described
in footnote 11.

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

NOVEMBER 1970

change in wages (or prices) approaches infinity. In
the present case, no such assumption can be made.
D t is a simple and highly aggregative measure of
demand pressure, and there is no reason why zero
values of D t should correspond to infinite changes in
the private output deflator. Indeed, D, has actually
been negative during part of the sample period, as
can be seen from the accompanying table. Even
D ° (potential minus actual real GNP) has been
negative during part of the sample period, and again
there is no reason to think that a zero or slightly
negative gap between potential and actual real GNP
should result in an infinite change in the price level.
Potential GNP is not meant to refer to maximum
GNP, but to that GNP level that is capable of being
produced when the unemployment rate is 4 per cent.
Including a 2 in equation (3) allows the equation
to estimate the value of the moving average variable
that would correspond to an infinite rate of change
of prices. Including a 2 in equation (3), in other
words, allows the excess demand variable in the
equation to differ from the “true” measure of excess
demand ( “true” meaning that zero values of this
variable correspond to infinite price changes) by

some constant amount and still not bias the estimates
of oc0 and 0^. The error will merely be absorbed in
the estimate of a 2.

The Results
Equation (3) was estimated for the I/1956-II/1970
sample period for various values of n.11 Various
weighted averages of the current and past values of
D were also tried in place of the simple average
specified in equation (3 ). The equation finally chosen
used the simple average of current and past values
of D and a value of n equal to 8. The results of
nThe quarters III/1959, IV/1959, 1/1960, IV/1964, 1/1965,
and 11/1965 were omitted from the sample period because
of the steel and automobile strikes. These six quarters
were also omitted for the work in Fair, A Short-Run
Forecasting Model of the United States Economy.
The equation was estimated by an iterative technique.
The equation to be estimated is first linearized by means
of a Taylor series expansion around an initial set of pa­
rameter values. Using the linear equation, the difference
between the true value and the initial value of each of
the parameters is then estimated by ordinary least squares.
The procedure is repeated until the estimated difference
for each of the parameters is within some prescribed
tolerance level. Convergence is not guaranteed using this
technique, but for most of the work in this study, achieving
convergence was no problem.

Table III

PARAMETER ESTIMATES OF EQUATION

Pt -

F t - , = a 0 + a , ^ a2 + J _ £ ^

. +1^

(3 )

+ et

Actual and Predicted Values of the
percentage change in Pt (annual rates)

ao

(a)
(b)
(c)
(d)
(e)
(f)

OCl

0(2

— .99
( - 1 .0 1 )
— 1.85
( — 90)
— .51
( - 1 .4 8 )
1.08
(2 7 .1 6 )
.87
(2 4 .7 6 )

156.4
(1 .3 7 )
309.9
(0 .6 2 )
67.2
(1 .7 0 )

— 3.21
( - 0 .5 8 )

948.6
(0 .3 5 )

76.1
(2 .3 6 )
1 15.8
(1 .1 8 )
35.4
(2 .2 9 )
.01 76a
< - 14.29)
•0203a
( - 12.12)
225.0
(0 .6 3 )

S.E.

R2

D-W

1

II

1969
III

1970
IV

1

II

4.74% 4.78% 4.34%

4.61% 5.16% 3.94%

Actual

.1 84

.827

1.83

4.41

4.55

4.63

4.55

4.27

3.78

Predicted

.220

.755

1.33

4.04

4.06

4.05

3.88

3.58

3.13

Predicted

.190

.817

1.75

4.41

4.52

4.53

4.45

3.99

3.41

Predicted

.195

.803

1.61

4.08

4.13

4.14

4.10

3.93

3.66

Predicted

.221

.746

1.31

3.88

3.90

3.85

3.75

3.51

3.19

Predicted

.186

.734

1.95

3.88

3.96

3.98

3.94

3.77

3.44

Predicted

Note: “ t” statistics appear with each regression coefficient, enclosed
*Assumptions used to estimate equation (3) :
by parentheses. R2 is the percent of variation in the dependent
(a) n=8, Table I values o f XF
variable which is explained by variations in the independent
t
variable. S.E. is the standard error of the estimate. D-W is
(b) n=8, CEA values o f XF
the Durbin-Watson statistic.
t
(c ) n=8, Table I values XF, D* used instead o f D.
t
(d) linear version o f (a)
(e) linear version o f (b)
(f ) n=8, Table I values of XF, sample period ending in IV/1968.

t

aEstimate o f the coefficient o f the demand pressure variable.




Page 23

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

estimating this equation are presented in line (a ) of
Table III. The potential GNP series presented in
Table I was used for the estimates in line (a).
The estimates of a 0, a , and a 2 are fairly collinear, and thus the t-statistics presented in line (a )
of Table III are low. When, for example, the value
of a 2 was set equal to 76.1 (the estimated value)
and equation (3 ) estimated by ordinary least squares,
the resulting t-statistics for a 0 and cxi were 9.02 and
15.48 respectively. The fit of the equation is quite
good, with a standard error of only .184.12 The
inflation in 1969 and the first half of 1970 was
captured fairly well, with errors in the six quarters
of —.33, —.23, + .2 9 , —.06, —.89, and —.16 per cent
respectively.13 As measured by the Durbin-Watson
statistic, there appears to be little evidence of serial
correlation in the equation.
Equation (3 ) was also estimated using the CEA
measure of potential GNP, and these results are
presented in line (b) of Table III. The standard error
of the equation is .220, which is considerably larger
than the standard error in fine ( a ) , and the inflation
in 1969 and 1970 was considerably underpredicted
by the equation. The results are clearly not as good
as those achieved in line (a ) using the potential
GNP estimates presented in Table I, which perhaps
indicates that the potential GNP series in Table I
is a better measure of supply constraints than is the
trend series of the CEA.
Equation (3 ) was also estimated using D ° instead
of D as the demand pressure variable, and these
results are presented in line (c) of Table III. The
results are almost as good as those achieved in fine
( a ) using D, but the fit is slightly worse and the
inflation in 1969 and 1970 was not captured quite as
well. The results thus seem to indicate that D is the
better measure of demand pressure, although as dis­
cussed above, whether D ° or D should be used in
the equation depends on whether real GNP of money
GNP is closer to being determined as the residual
variable in the short run.
As mentioned above, equation (3 ) was estimated
for values of n other than 8 and for weighted averages
other than the equally weighted average. In par­
ticular, various declining weighted averages were
tried. None of these results were an improvement
12Remember that Pt is in units of 100.
13Although the equations in Table III were estimated using
Pt — Pt—i as the dependent variable, the actual and predicted
values given for the I/1968-II/1970 period in the table
are in terms of percentage changes at annual rates.

Page 24


NOVEMBER 1970

over the results presented in line (a) of Table III.
The fits were worse, and for the values of n less than
8 and for the declining weighted averages, the infla­
tion in 1969 and 1970 was underpredicted much more
than it is in line (a) of Table III. As can be seen from
Table II, D t was negative and large in absolute value
throughout 1968. Only including the current and one-,
two-, and three-quarter lagged values of D in the
equation, for example, was not enough to capture
the demand pressure which built up during 1968
and which presumably led to the large price increases
in 1969 and 1970. Going from n equal to 4 to n equal
to 8 substantially improved the ability of the equa­
tion to explain the inflation in 1969 and 1970.
Various linear versions of equation (3 ) were also
estimated, and the fit of each of the linear versions
was always worse than the fit of the corresponding
non-linear version, and the inflation in 1969 and 1970
was always underpredicted more. An example of this
can be seen from line (d) of Table III, where the re­
sults of estimating the linear version of the equation
estimated in line (a ) are presented. Also, for pur­
poses of comparison in the next section, the results
of estimating the linear version using the C EA m eas­
ure of potential GNP are presented in fine (e ) of
Table III.
Finally, equation (3) was estimated for the sample
period ending in IV/1968 instead of 11/1970, and
the equation was used to predict values for the four
quarters of 1969 and the first two quarters of 1970
( D being treated as exogenous). The results are
presented in line (f) of Table III. The coefficient
estimates are much different for the shorter period,
although the collinearity among the estimates makes
the results look more different than they actually are.
More importantly, however, the equation did not
extrapolate as well into 1969 and 1970. A fairly high
rate of inflation was still forecast by the equation for
the I/1969-II/1970 period, but not as high as actually
occurred. It was necessary, in other words, to estimate
equation (3 ) through the end of the sample period
before it was capable of accounting for the rapid rate
of inflation in 1969 and in the first half of 1970.
This result is not necessarily surprising, however.
As can be seen in Table II, the price increases in
the four quarters of 1969 and the first quarter of 1970
were considerably larger than for any other quarter
of the sample period, and similarly the values of
1
8 *
—- s
Dt—i+i were considerably smaller in 1969
8 j= i
than for the rest of the sample period. As a practical

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

NOVEMBER 1970

Annual Rates of Change in Prices: Actual and Predicted Values a

1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

*The following quarters were excluded: 111/59, IV /59, and 1/60 because of the steel strike, and IV/64, 1/65, and 11/65 because of the
automobile strike.
(X Implicit price deflator for total private gross national product, 1958 =100.
Note: Annual rates of change computed here differ slightly from annual rates of change computed elsewhere in this Review and in other
publications of this Bank.
_
The formula for quarterly annual rates of change used here is as follows: ^uar*®r *° Puar^®r - / Vf \ _] .4.100
rate (in per cent)
\"v71/

matter, one generally cannot expect an equation that
has been estimated by least squares to extrapolate
well into periods in which the values of the dependent
and independent variables are considerably different
from what they were during the period of estimation.
It is encouraging that the equation did not forecast a
lessening of the rate of inflation in the I/1969-II/1970
period, but only failed to forecast the acceleration of
the rate of inflation. It is also somewhat encouraging
that a Chow test rejected the hypothesis that the
coefficients of equation (3) were different for the
I/1969-II/1970 period than they were for the 1/1956IV/1968 period.14
To give the reader an idea of how well the model
has explained the price deflator, the actual and
predicted values of the percentage change in P,
l4The estimated value of the F-statistic was 1.38, which
compares with a 5 per cent value of 2.81 (at 3,46 degrees
of freedom). Because of the nonlinear nature of equation
(3 ), the use of the Chow test in the present circumstances
must be interpreted with some caution.



are plotted in the chart above. The predicted values
from the equations estimated in lines (a) and (f) of
Table III are plotted in the chart. As can be seen
from the chart, the rate of inflation in 1969 and 1970
is not captured as well by the equation estimated only
through 1968. Otherwise, the price deflator appears
to be explained quite well by the two equations.
In summary, then, a simple excess demand equa­
tion like (3 ) appears to be capable of explaining
most of the inflation in 1969 and in the first half of
1970, in addition to explaining quite well the price
changes in the other quarters of the sample period.
However, the equation did have to be estimated
through the end of the sample period in order to
account for the acceleration of the rate of inflation
in the I/1969-II/1970 period, which means that the
possibility that the equation is not stable over time
cannot be ruled out. More observations are needed
before the usefulness of an equation like (3 ) for
forecasting or other purposes can be established.
Page 25

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

The Effect of Expectations
on Aggregate Price Changes
Andersen and Carlson have a price expectations
term in a linear version of an equation like (3).
They use a polynomial distributed lag of D as the
demand pressure variable and take the dependent
variable to be the dollar change in total GNP due to
the price change. The price expectations term is a
17-quarter distributed lag of past changes in the GNP
deflator divided by the unemployment rate.15 The
lag coefficients are taken from a long-term interest
rate equation. Andersen and Carlsons results indicate
that the demand pressure variable and the price ex­
pectations term are about equally important in ex­
plaining the change in price, although they state that
“the influence of these two variables should perhaps
be viewed in combination, rather than as independent
and separate influences.”16 They do report in foot­
note 24, however, that the fit of the equation was
much worse without the price expectations term, and
that the estimates of the coefficients of the demand
pressure variable were only slightly larger. This, they
argue, provides some evidence that the price ex­
pectations term can be interpreted as an independent
and separate influence.
Given the reduced form and highly aggregative
nature of an equation like (3), it is not clear that
a price expectations term like that of Andersen and
Carlson should be interpreted as providing an esti­
mate of the effect of price expectations on aggregate
price changes. Since the price expectations term is a
distributed lag of past price changes, it is likely
that this term and the lagged values of the demand
pressure variable will be picking up similar effects.
As discussed in the previous section, the lagged
values of the demand pressure variable are designed
to pick up the lagged behavioral response of in­
dividuals and firms and the effect of changing input
prices, and it is likely that lagged price changes will
pick up some of these effects as well. Conversely,
it is likely that the lagged values of the demand
pressure variable will pick up some of the effects
of price expectations, since past demand pressures
15The price expectations term is also multiplied by GNP
lagged one quarter to scale the term in dollar units. The
unemployment rate is used “as a leading indicator of future
rice movements.” The price change each quarter is divided
y the unemployment rate of that quarter to reflect the
fact that “if unemployment is rising relative to the labor
force, decision-making economic units would tend to dis­
count current inflation in forming anticipations about future
price movements.” (Andersen and Carlson, p. 13.)
16Andersen and Carlson, p. 13.

Page 26


NOVEMBER 1970

may be as important in determining future price
expectations as are past price changes. It thus seems
that very little confidence should be placed on the
results of any attempt to separate the influence of
price expectations from other influences by including
both a distributed-lag price term and a distributedlag demand pressure term in an aggregative equation
like (3).
A number of distributed-lag price terms were
added to equation (3 ) to see if these terms improved
the explanatory power of the equation. The results
were not very sensitive to the use of alternative
distributed lags, and only the results achieved using
the Andersen-Carlson distributed lag will be pre­
sented here. The distributed lag that was used is
the following:
(4 )

DLAGt = S7 Pi -(Pt~1~ Pt~i^ l)
i= 1

U t-i

where U t- i is the unemployment rate during quar­
ter t —i. The values of p s are presented in Andersen
and Carlson, Table II, page 12. The one-quarter
lagged value of Moody’s Aaa corporate bond rate
(denoted as R t- i ) was also added to some of the
equations, and some of these results will be reported
below. The bond rate is significantly influenced by
past price changes, and Andersen and Carlson found
R t- i to be significant when included instead of the
distributed-lag price term in their price equation.
The results of adding D LA G t and R t_! to the
equation estimated in line (a) of Table III are pre­
sented in lines (a) and (b) of Table IV. The co­
efficient estimates of both variables are of the wrong
sign, and the fits of the equations are not improved
from the fit of the equation in line (a) of Table III.
Because of collinearity problems, the t-statistics in
Table IV are low. When the value of a 2 was set
equal to the estimated value for each equation and
the equation estimated by ordinary least squares,
the resulting t-statistics for a 0 and cci were —7.63
and —10.51 for the equation in line (a) of Table IV,
and —7.87 and —10.70 for the equation in line ( b ) .
The resulting t-statistic for the coefficient of D LA G t
was -.7 8 , and the resulting t-statistic for the coeffi­
cient of R t-i was —.12. In summary, then, the demand
pressure variable completely dominated D LA G t and
R t- i for the price equation estimated in line (a) of
Table III.
Since Andersen and Carlson used the Council of
Economic Advisers’ measure of potential GNP and
the linear version of the price equation, D LA G t and

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

NOVEMBER 1970

Table IV

Results of Adding Distributed-Lag Price Term (D LAG t ) and M oody’s A aa Corporate Bond Rate (Rt- i )
to Equations ( a ) and (e ) of Table III*
Actual and Predicted Values of
the percentage change in Pt
(annual rates)
A
a0

(a )
(b)
(c)
(d)

- .8 1
( - 1 .5 8 )
— .93
( - 1 .0 8 )
.65
(8 .4 2 )
.52
(2 .8 5 )

A
ai

A
0C2

126.2
64.9
(1-54) (2 .5 1 )
147.3
73.2
(1 .0 8 ) (1 .7 3 )
— .0 16 8“
( — 8.98)

est. of
DLAGt

est. of
Rt—l

- .0 0 5 0
( - 0 .6 9 )
- .0 0 4 0
( —0.08 )
.0177
(3 .1 9 )

— .0176“
( - 8 .4 4 )

.0697
(2 .0 2 )

1969
S.E.

R-

D-W

1

II

1970
III

IV

1

II

4.74% 4.78% 4.34% 4.61% 5.16% 3.94%

Actual

.185

.829

1.85

4.44

4.59

4.66

4.55

4.21

3.63

Predicted

.186

.827

1.83

4.41

4.55

4.63

4.55

4.27

3.78

Predicted

.203

.790

1.55

4.14

4.23

4.31

4.29

4.18

3.97

Predicted

.215

.766

1.41

4.01

4.13

4.1 1

4.08

3.96

3.72

Predicted

♦Combinations used:
(a) DLAGt added to (a) o f Table III

Note: “ t” statistics appear with each regression coefficient, enclosed
by parentheses. R2 is the percent of variation in the dependent
variable which is explained by variations in the independent
variables. S.E. is the standard error of the estimate. D-W is
the Durbin-Watson statistic.

(b) Rt_ ! added to (a) o f Table III
(c) DLAGt added to (e) o f Table III
(d) Rt—1 added to (e) of Table III
aEstimate o f the coefficient o f the demand pressure variable.

R t- ! were also added to this type of an equation. In
particular, the variables were added to the equation
estimated in line (e) of Table III.17 The results are
presented in lines (c) and (d) of Table IV. Both
D LA G t and R t-i are now significant in the equation,
and the fits have been improved over the fit of the
equation in line (e) of Table III. In particular, the
addition of D LA G t has improved the equation con­
siderably. This result is thus similar to the result
achieved by Andersen and Carlson. The distributedlag price term is not as significant here as it was for
Andersen and Carlson, but this is due in large part
to the different demand pressure variables used. The
use of the eight-quarter moving average here instead
of the five-quarter declining average used by Ander­
sen and Carlson took away some of the significance
of D LA G t.
It should be noted, of course, that the fit of the
equation in line (c) of Table IV is worse than the
fit of the equation in line (a) of Table III, and that
the inflation in 1969 and 1970 was not captured
quite as well. It was very evident from all of the
results that D LA G t and R t- i (and the other distributed-lag price variables considered) were most
significant in the equations using the CEA measure
of potential GNP and in those equations using
weighted averages of the demand pressure variable
17It should be noted that this equation is
the Andersen-Carlson equation because
weighted averages used for the demand
and the different price variables used.
estimation also differ slightly.



not identical to
of the different
pressure variable
The periods of

of less than about six quarters. The
also significant in many of the linear
price equation, although they were
for the linear equation in line (d) of

variables were
versions of the
not significant
Table III.

The overall results thus indicate that the distributedlag price variables do not improve the explanatory
power of the best-fitting versions of equations like
(3) , but that they are of some help in the poorer
fitting versions. Because the importance and signifi­
cance of the distributed-lag price variables are de­
pendent on the particular demand pressure variable
used and on the functional form of the equation, the
results also suggest that it would be unwise to inter­
pret the distributed-lag price term in a particular
equation as measuring the effect of price expectations.
Both the distributed-lag price terms and the dis­
tributed-lag demand pressure terms appear to be
picking up similar effects.
Finally it should be stressed that equation (3 ) was
developed primarily for forecasting purposes and
should be judged primarily on these grounds. Its
reduced-form nature makes it of little use in analyz­
ing questions about the structure of wage and price
determination. In line with this comment, this paper
should not necessarily be interpreted as a serious
criticism of the Andersen and Carlson specification
of the price equation. It does not appear that the
distributed-lag price term is really needed in the
best-fitting versions of the price equation, but there
is nothing wrong theoretically with including it in
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F E D E R A L R E S E R V E B A N K O F ST. L O U IS

those versions in which it is significant. Both
values of the demand pressure variable and
price changes are likely to be picking up
effects, and it is an empirical question as to
is the best way to specify these effects.

NOVEMBER 1970

lagged
lagged
similar
which

An important property of the Andersen-Carlson
version of the price equation is that it takes a rela­
tively long time for the rate of inflation to subside
in their model once it has begun. This is because of
the large coefficient estimate of the distributed-lag
price term in their equation and thus the large weight

given to the sum of past price changes.18 The fore­
casts from the Andersen-Carlson model thus tend to
be rather pessimistic with respect to slowing down
the rate of inflation in 1971 and 1972. This is in
contrast to the forecasts from the Fair model, which
tend to be much more optimistic in this regard. The
events during 1971 and 1972 should thus provide a
good test of the forecasting accuracy of the two
equations.
18From Tables II and III of Andersen and Carlson, it can
be seen that the sum of past price changes has a weight
of .96(.86) = .8256 in their equation.

This article is available as Reprint No. 61

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