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November/December 1989

Vol. 71, No.6




3 T h e Cost o f Restricting C orporate
T ak eovers: A Lesson From
S w itzerlan d
12 Do Price Indexes T ell Us About
Inflation? A R eview o f the Issues
31 U nderstanding Nom inal GNP
T argetin g

THE
FEDERAL
A RESERVE
XltANKot
ST.IjOI IS

1

Federal R eserve Bank of St. Louis
Review
November/December 1989

In T h is Is s u e . . .




The merits and demerits of corporate takeovers, especially hostile
ones, became one of the hottest topics of discussion and debate in the
1980s and will likely remain so in the 1990s. In recent years, motivated
in part by concerns that shareholder interests have been ill-served by
this activity, several bills have been introduced in Congress to restrict
such takeovers.
In the first article in this Review, “The Cost of Restricting Corporate
Takeovers: A Lesson From Switzerland,” W erner Hermann and G.J. Santoni analyze the effects of recent changes in Swiss commercial practice
on shareholder wealth. The authors examine Swiss stock market data to
determine what happened when restrictions on the market for cor­
porate control were relaxed. They demonstrate that Swiss shareholders
actually benefited from the move to reduce restrictions on corporate
takeover activity. Thus, current proposals to restrict corporate takeovers
in the United States, the authors say, will likely adversely affect U.S.
shareholders.
* * *

Nominal income targeting, which involves changing the money supply
to counteract movements in nominal GNP, is attracting increasing atten­
tion, particularly among those who would like to establish some con­
straint on monetary policy actions. In the second article in this issue,
"Understanding Nomimal GNP Targeting,” Michael D. Bradley and Den­
nis W. Jansen analyze nominal income targeting from both a theoretical
and a practical standpoint. The authors illustrate several desirable
features of nominal income targeting, among which is its ability to
stabilize output, in a simple macroeconomic model.
Bradley and Jansen point out, however, that ignorance of the correct
equations, parameter values and lag structure that characterize the U.S.
economy sharply reduces the appeal of any monetary policy procedures,
including nominal income targeting, that requires responding to the cur­
rent state of the economy.
*

*

*

NOVEMBER/DECEMBER 1989

2
Because its effects are so pervasive, virtually everyone is concerned
about inflation. In the third article in this Review, "Do Price Indexes Tell
Us About Inflation? A Review of the Issues,” Keith M. Carlson discusses
the broad issues involved in defining inflation and using U.S. price in­
dexes to measure it.
The indexes are examined from two perspectives: that of the in­
dividual attempting to maximize his well-being, and that o f the
policymaker attempting to control inflation. The author concludes that,
to measure and analyze inflation properly, more information is required
than these conventional price indexes provide. A theoretical measure of
price change would include the prices of assets, which serve as proxies
for the prices of future consumption services. From a policymaker’s
perspective, the author concludes, no one price measure has performed
consistently better than another since 1952 when compared with the
Friedman measure of money relative to trend output.


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*

*

*

3
Werner Hermann and G. J. Santoni

Werner Hermann, an economist at the Swiss National Bank,
was a visiting scholar at the Federal Reserve Bank of St.
Louis. G. J. Santoni is a professor of economics at Ball State
University. Santoni’s research was supported by the George A.
and Frances Ball Foundation. Scott Leitz provided research
assistance.

The Cost Of Restricting Cor­
porate Takeovers: A Lesson
From Switzerland
M

ANY PEOPLE in management, labor,
banking and Congress are alarmed about the re­
cent increase in corporate takeovers. These peo­
ple believe that the risk of a takeover is
detrimental to the efficient management of cor­
porations and not in the long-run interests of
the owners (see shaded insert on following
page). As a result, they have advanced various
proposals to restrict corporate takeovers.1
Others have a different view of takeovers,
believing that restrictions o f takeover activity
will be harmful to shareholders’ wealth. They
argue that takeover activity is a simple manifest­
ation of competition in the market for corporate
control.2 Furthermore, by inducing corporate
management to weigh the effect of its decisions
on the present value o f the corporation (and,
thus, share prices), this competition provides
strong protection for the interests o f all share­
holders including those of "non-controlling”
shareholders.3 According to this view, the threat

'These include restricting voting rights to those who have
owned the stock for a minimum of one year, disallowing
interest deductions from taxable income on certain types
of bonds used to finance takeovers and a “ sliding scale”
capital gains tax rate that is lower the longer an asset is
held before sale. In addition, there are at least five Senate
and House panels that are planning to hold hearings on
leveraged buyouts and other types of debt-financed
takeovers. See Hershey (1988), Anders and Swartz (1988),
Norris (1988) and Passell (1988).



of takeovers is important to maintaining an effi­
cient corporate sector.4
A recent change in Swiss commercial practice
provides important new evidence about the con­
sequences of restricting corporate takeovers.
The Swiss Commercial Code in the past has
allowed corporations to build effective barriers
against takeovers. Many Swiss firms have taken
advantage of this legal provision to protect
themselves against foreign raiders. On Nov­
ember 17, 1988, Nestle' (by far the largest Swiss
corporation) announced that it would allow
foreign investors to buy a type o f share that
only Swiss citizens could hold until then. Since
then, a foreign takeover of Nestle' has been
possible, at least in principle.
Nestle’s announcement and the events sur­
rounding it have important implications for U.S.
proposals to restrict takeovers. This paper ex­
amines data on the share prices of Nestle' and

2See Manne (1965), Manne and Ribstein (1988) and Jensen
and Ruback (1983).
3See Manne (1965), p. 113.
4See Manne and Ribstein (1988), p. 29. Some have singled
out an anti-takeover bill approved by the House Ways and
Means Committee on October 15, 1987, as an important
contributing factor to the stock market crash on October
19, 1987. See Ricks (1989).

NOVEMBER/DECEMBER 1989

4

Some Views On Hostile Takeovers
"You’re going to have a bunch of highly
leveraged companies that aren’t going to be
able to weather a financial storm.”
J. L. Lanier Jr., C.E.O.
West Point—Pepperell Inc.
“If it made sense to put the company
together for economic strength in the begin­
ning, then it certainly makes no sense to
break it apart.”
John De Lorean,
former General Motors executive
“I have to wonder if there’s some kind of
structural imbalance in the financial markets
if the same package o f assets broken into
pieces are worth twice what the market puts
on them when all together.”
John R. Hall, C.E.O.
Ashland Oil Inc.
“People are questioning a whole series of
this kind o f activity, particularly in the light
o f all the foreign investment in this country.

They’re questioning the theory that many
people are so enamored with—the whole 'me
now,’ big-hit generation of 28-year-old
millionaires on Wall Street who haven’t con­
tributed to the country’s economy. And a hell
of a lot of people resent that.”
Phillip J. Dion, C.E.O.
Del Webb Corp.
"How could it possibly help the company to
be that much in debt? How does it help the
employees? How can the company progress,
how can they do research and development?”
Gino Pala, C.E.O.
Dixon Ticonderoga Co.
“There is no question that the Committee
on Ways and Means will be looking at
leveraged buy outs and mergers and
acquisitions—and do something about it.”
Dan Rostenkowski, Chairman
Committee on Ways and Means

other Swiss firms around the November 1988
announcement date to analyze the effect of this
sudden change in policy on shareholder wealth.
If the data indicate that investors in Swiss stock
generally benefited when restrictions against
foreign takeovers w ere relaxed, current U.S.
proposals to limit takeovers are likely to be
counterproductive in protecting shareholder
wealth.

it, causing its price to fall and its expected
return to rise until its yield is equal to that of
similar stocks. The reverse holds for any stock
with an expected return higher than other
stocks o f similar risk. An equilibrium exists
when expected returns are equal across stocks
with identical risk characteristics. The
equilibrium return is called the required dis­
count rate.

STOCK PRICE FUNDAMENTALS

Equation 1 calculates the expected rate of
return (r) from holding a share for one year
assuming dividends (d) are paid at year-end:5

Since stock prices represent the market value
of a firm, they play a significant role in the
analysis of this paper. Therefore, it is important
to understand how they are determined.
People value common stock for its expected
return. Since investors may choose among
broad categories o f stock, the expected return
on any particular stock must be equal to the ex­
pected return on other stocks o f similar risk.
For example, if a particular stock is expected to
yield a relatively low return, investors will shun

5See Brealey (1983), pp. 67-72, and Brealey and Myers
(1988), pp. 43-58.

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(1) Et (r,;t+1) = (E,Pt+1 + E,d,+1-P,)/P,
Equation 1 says that the expected return at time
t of holding a share of stock from t to t +1 is
equal to the expected price o f the stock at the
end of the period (EtPt+1), plus the expected
dividend (Etdt+1), less the current price of the
stock (Pt), all divided by the current price.
Equation 2 solves equation 1 for the current
price by noting that the expected return equals
the required discount rate (i) in equilibrium:

5

(2) P, = (EtPl+1 + E,dt+1)/(1 + it).
Equation 2 indicates that investors must fore­
cast the price o f the stock next period. What
are the fundamentals of this price? In principle,
the future price depends on the earnings o f the
company, dividend payments, and the required
discount rate that investors expect to prevail
over the life o f the firm. If dividends are ex­
pected to grow at a constant annual rate (g) and
the discount rate is constant, the calculation
shown in equation 2 can be simplified as in
equation 3:6
(3) Pt = dt(l +g)/(i-g).
Equation 3 gives a relatively simple solution
for the current stock price. For example, sup­
pose the current dividend is $.98, the required
discount rate is 12 percent and the expected
growth rate in dividends is 2 percent. Equation
3 indicates that a share o f stock in this firm will
trade at a price around $10[= $.98(1.02)/(.12 .02)].

TAKEOVERS AND THE
FUNDAMENTALS
Equation 3 is a useful summary of the fun­
damentals that determine stock prices. It in­
dicates that stock prices change when one or
more of the fundamentals change. Furthermore,
it is useful in contrasting the views o f the pro­
ponents and critics of takeovers.
Critics of takeovers believe that competition
for the control of firms adversely affects the
fundamentals. For example, they argue that
takeovers increase tension between manage­
ment, labor and government to the detriment of
future earnings and dividends; or that increases
in the target’s debt-to-equity ratio that accom­
pany many takeovers increases the risk (and the
discount rate) associated with the firm’s ex­
pected earning stream; or that takeover threats
force management to concentrate too heavily on
projects that promise increased earnings in the
near term at the expense of long-term research
and development.
Others argue that the threat of takeovers im­
proves the fundamentals on net because they

6Brealey (1983), p. 69. The current price is defined by
equation 3 only if the expected growth rate of dividends is
less than the discount rate.
7See Manne (1965), Manne and Ribstein (1988) and
Alchian (1977), pp. 227-58.



induce management to use the firm’s resources
in ways that generate higher returns for the
owners. They point out that the interests of
management and shareholders can diverge and
that it is costly for shareholders to monitor
management’s decisions. In the absence of
strong competition from alternative manage­
ment teams, the firm’s managers, acting in their
own interests, can capture a portion of the
stream o f earnings that would otherwise accrue
to the shareholders. This may come in the form
of high management salaries, large expense ac­
counts, plush offices, lengthy vacations and
other forms of shirking. Shirking affects the
distribution of earnings between the firm’s
management and its owners. Furthermore, it
may lower the stream o f earnings generated by
the firm. The cost associated with this type of
behavior, called "agency cost,” lowers the ex­
pected stream o f dividends that accrue to
shareholders and is reflected in lower share
prices.7
The reduction in share price due to agency
costs is a measure of the capital gain that could
be obtained from a successful raid. According
to this argument, competition among alternative
management teams in the market for corporate
control assures that agency costs are kept to a
minimum, resulting in higher share prices for
firm owners.8 Thus, this theory suggests that
takeover activity raises stock prices while the
one mentioned earlier implies the opposite.
What evidence is there to support either
view? Data on U.S. takeovers suggests that they
raise stock prices.9 The recent changes in the
Swiss stock market should make Swiss data par­
ticularly useful in adding to this body of
evidence.

SWISS STOCK MARKET INSTITU­
TIONAL DETAILS
Registered, Bearer and Non-voting
Shares
Swiss law allows corporations to issue several
types of shares called bearer, registered and
non-voting shares. Bearer shares are the equi­
valent of the typical common share issued by

8See Manne (1965), p. 113, and Ruback (1988).
9See Jensen and Ruback (1983).

NOVEMBER/DECEMBER 1989

6
U.S. corporations. Ownership of a bearer share
entitles the holder to the dividends and one
vote at shareholder meetings. They can be
transferred without restriction.
Registered shares differ from bearer shares in
several important respects. For example, the
purchase of a registered share entitles the
buyer to dividends but does not grant the new
owner the automatic right to vote at share­
holder meetings. To obtain voting rights, the
new owner must apply to be “registered” in
the firm ’s book o f shareholders. Until the new
owner is registered, the voting right remains
with the previous (and still registered) owner.
Registration of the new owner, however, is not
automatic. The corporate charter can summarily
exclude certain investors from registration.10
Furthermore, Swiss stockbrokers have declared
publicly that they will refuse to exercise buy
orders from clients that are unlikely to qualify
for registration.11 While registration is often
restricted to Swiss citizens or institutions and,
thus, can effectively prevent foreign takeovers
of Swiss firms, this tool has been used to block
Swiss raiders as well.12
A glance at the stock market page of a Swiss
newspaper reveals that about a third of the Swiss
corporations issue registered shares. Because
these firms typically issue more registered shares
than bearer shares, registered owners hold the
controlling interest in the companies that issue
both.13 Coupled with the provisions regarding
registration, this gives these Swiss firm s iron­
clad protection against hostile takeovers.
Besides registered and bearer shares, large
companies issue securities that pay dividends
but have no voting rights associated with them.
Holders of these non-voting shares (participation
certificates) have virtually the same rights as
voting shareholders, apart from the right to vote.

Different Par Values
Dividend payments and the share of the firm’s
liquidation value that accrue to Swiss stock­
holders are proportional to the par value of the

10See Horner (1988) and Foreman (1988). In the 1930s, this
restriction was used to prevent takeovers of Swiss firms by
firms in Nazi Germany. See “ Shareholders, Who Are
They?” (1989).
"S ee Horner (1988), pp. 70-71, and Foreman (1988).
12See Dullforce (August 9, 1988) and Wicks (August 2,
1988), who report on the takeover battle for La Suisse, a
Swiss insurance company. In that case, the highest Swiss

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Table 1
Swiss Shares and Their Entitlements
Participation

Type of Share______ Dividends___________ Voting
Bearer

Yes

Yes

Registered

Yes

Upon registration

Non-voting

Yes

No

shares they hold. Both registered and bearer
shares carry one vote. Swiss firms, however,
are allowed to issue registered shares with
lower par values than bearer shares. For exam­
ple, let R be a registered share with a par value
o f $50 while B is a bearer share with a par
value of $100. Both shares carry one vote but
the expected stream o f dividends generated by
the registered share is one-half that of the
bearer share. Other things the same, the
registered share will trade at about one-half the
price o f the bearer share. Table 1 summarizes
the participation rights o f the different types of
shares.

NESTLING UP TO SHARE
HOLDERS
To the surprise o f many market participants,
the common Swiss practice o f discriminating
against foreign investors was suddenly changed
on November 17, 1988. Nestle’, the Swiss multi­
national foods group, decided to register shares
of foreign investors. Nestle' had been repeatedly
criticized for attempting to take over firms in
countries outside Switzerland while being pro­
tected from foreign acquisition. In a release that
accompanied the announcement, Nestle’s finance
director explained that “there was a contradic­
tion between being multinational in our
behavior and national in our share control.”14

bidder for La Suisse withdrew his offer after the La Suisse
board announced that it would refuse to register the bid­
der's shares.
13See “ Shareholders, Who Are They?” (1989). For the
number of shares issued of each type, see Swiss Bank
Corporation, (1987).

7

Because of Nestle’s relative size, its decision
was viewed as extremely important by market
participants.15 Since then, several other Swiss
firms have made similar announcements.16 Fur­
thermore, the Swiss parliament is currently con­
sidering revisions to the commercial code that
would make Swiss firms more accessible to out­
siders. In part, such revisions have been pro­
mpted by Swiss shareholders who claim that
they are adversely affected by anti-takeover
rules. On the other hand, some Swiss citizens
believe that hostile takeovers could harm Swiss
companies and that management should be pro­
tected from raiders. Although the outcome of
this debate is uncertain, the decision by Nestle’
and other Swiss lirms to liberalize shareholder
registration marks a significant step in changing
Swiss commercial practices regarding corporate
takeovers.
The theory of the market for corporate con­
trol suggests that impediments to takeovers are
costly, which means that they reduce share­
holder wealth. According to this theory, one
consequence of reducing impediments to take­
overs is that the capitalized value o f the firm in­
creases. To test this, data on Nestle’s share
prices before and after November 1988 are ex­
amined. Since Nestle’s decision is viewed as hav­
ing important consequences on the entire Swiss
stock market, share price data on 44 other
firms traded on the Zurich exchange are ex­
amined as well.17

THE SWISS EVIDENCE
To determine the effect of the loosening of
voting restrictions on corporate shares in
Switzerland, daily closing prices are analyzed at
three points in time: the last trading days in
December 1985, July 1988 and December 1988.
The July 1988 date leads Nestle’s announcement
by about three months to minimize the possibili­

14A practical motivation for the decision was suggested by
William Dullforce who commented that “ Nestle's access to
capital markets was restricted by the differentiation bet­
ween registered and bearer shares.” See Dullforce
(November 18, 1988).
15The value of Nestle shares account for about 10 percent
of the total Swiss stock market. See “ Shareholders, Who
Are They?” (1989), p. 69.
16The most recent firm to make a similar announcement is
Jacobs Suchard, a coffee and chocolate concern. See
Wicks (June 22, 1988).



ty that advance information about the forthcom­
ing announcement might affect prices. The
December 1988 date is the month immediately
following the announcement month. The reason
for choosing the December 1985 date is discuss­
ed below. The sample consists of nine firms
that issue only bearer and non-voting shares, 21
firms that issue all three types of shares and 15
that issue only registered and bearer shares. A
list of the firms appears in the appendix. The
data are adjusted for differences in par values
between different share types of the same
company.

Did Registered Shares Trade at a
Discount to Bearer Shares?
The first question examined is whether regis­
tered shares typically traded at a discount to
bearer and non-voting shares of the same firm
before November 1988.18 Table 2 shows the
ratios of the prices of registered to bearer and
registered to non-voting shares for the same
firm at three points in time: December 1985,
July 1988 and December 1988.
The 36 firms in this sample differ in several
respects. Some issue non-voting shares; others
do not. In addition, some o f the firms in the
sample issue registered and bearer shares with
the same par values while others issue these
shares with different par values. Table 2 ex­
amines data on the price ratios while controlling
for these differences.
Panel A o f table 2 shows the mean of the
ratio o f registered to bearer share prices for
the 21 companies that issue all three types of
shares. The data are prices for the close of the
last trading day of the month. The null hypothe­
sis that the mean of the price ratios is one is re­
jected at a 5 percent significance level for the
two dates before November 1988 but not for
the December 1988 prices. The ratios for the
December 1985 and July 1988 dates are indis­
tinguishable in a statistical sense, suggesting

,7The Zurich stock exchange is the largest in Switzerland.
More than 400 Swiss and foreign companies are listed on
this exchange along with a much larger number of bonds.
18Some have argued that tax considerations and differential
transaction costs imply that registered shares will sell at a
discount to bearer shares. Since these factors did not
change during the period analyzed, however, they cannot
explain significant changes in relative share prices
associated with Nestle’s decision to allow foreigners to
purchase its registered shares.

NOVEMBER/DECEMBER 1989

8

Table 2
Price of Registered Relative to Bearer
Shares For Selected Months
Panel A: Firms Issuing All Three Share Types With the
Same Par Values
Dates
12/85
7/88
12/88
Mean
t-score

.770*
5.22

.798*
3.75

.960
1.47

N = 21
Panel B: Firms Issuing Only Registered and Bearer Shares
With Different Par Values1
Dates
12/85
7/88
12/88
Mean
t-score

.859*
2.60

.890*
2.86

.962
.98

N = 10
Panel C: Firms Issuing Only Registered and Bearer Shares
With the Same Par Values
Dates
12/85
Mean
t-score

.767*
5.66

7/88
.799*
5.10

12/88
.870*
3.53

N =5
* Significantly different from 1.0 at the 5 percent level.
1 Prices adjusted for differences in par values.
that the discount on registered shares prevailed
long before Nestle’s announcement.19 This dis­
count vanished, however, by December 1988.
The panel B data differs from the panel A
data in two respects. The price ratios in panel B
cover firms that issue only registered and
bearer shares (no non-voting shares). Further­
more, the par values of each firm’s registered

19The discount is present in data extending back to
December 1975.

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shares are lower than the par values of the
bearer shares for the firms in this panel. Since
the stockholders of Swiss firms share dividends
in proportion to the par values of the shares
they hold, registered shares with lower par
values than bearer shares should sell at a dis­
count to bearer shares regardless of ownership
restrictions on registered shares. To control for
this "par value” effect, the registered share
prices of the panel B firms are adjusted for dif­
ferences in the par values.
The results shown in panel B are similar to
the panel A results. The mean of the ratios of
registered to bearer share prices is significantly
less than one before November 1988 but is
statistically indistinguishable from one for the
December 1988 data.
The data in panel C cover firms issuing only
registered and bearer shares with the same par
values. The results shown are similar to the
panel A and B results for data before November
1988. The result for the December 1988 data
differs, however. While the ratio of registered
to bearer share prices is numerically higher for
the December 1988 data than it was previously,
it still is significantly less than one.

The Increase In Nestle’s Market
Value
Table 3 shows the change in the market value
of Nestle’ shares from the end of July 1988 to
the end of December 1988. As shown, the
market value of Nestle’ increased by almost 22
percent subsequent to its November policy
change. Of course, this figure may over- or
understate the change in value due to the policy
change because other factors that affect stock
prices may have changed.
To control for this, table 4 shows the percen­
tage changes in the prices of bearer and non­
voting shares for the firms in our sample that
do not issue registered shares. Since the Nestle’
announcement pertained only to the treatment
of registered shareholders, it is unlikely that the
announcement would affect the share prices of
firms that issue no registered shares. Changes
in the prices of these firms between July and
December 1988 can be used to proxy the effect
of changes in other factors on Swiss stock
prices.

9

Table 3
The Change in the Market Value of Nestle:
July 1988-December 1988
Panel A: End of July 1988
Type of share
Non-voting
Bearer
Registered

Price
(in SFr)

Number of shares
outstanding

Market value
(millions of SFr)

1,315
8,550
4,150

1,000,000
1.073.000
2.227.000

1,315.00
9,174.15
9,242.05

Market Value July 1988

19,731.20

Panel B: End of December 1988
Price
Type of share
(in SFr)
Non-voting
Bearer
Registered

Number of shares
outstanding

Market value
(millions of SFr)

1,000,000
1.073.000
2.227.000

1,320.00
7,768.52
14,943.17

1,320
7,240
6,710
Market Value December 1988

24,031.69

Change in Market Value (millions of SFr) = 4,300.49
Percentage Change = 21.80%

Table 4
A Proxy For The Effect Of
Other Factors (changes in the share
prices of firms that issue no registered
shares)___________________________
Average percent
change
7/88—12/88

t-score

Bearer

-7.97%

1.88

Non-voting

-9 .2 0

2.00

Type of Share

N=9
The data in table 4 indicate that the share
prices of these firms did not rise from July to
December 1988. While the point estimates of
the average percentage change are negative in
both cases, they are not significantly different
from zero. Thus, these data suggest that other
general influences did not raise or lower Swiss



stock prices from July to December 1988. Con­
sequently, the 22 percent increase in the mar­
ket value of Nestle" can be taken as a "ball park”
estimate of the rise in value associated with its
change in registration policy.

The Nestle Announcem ent and the
Share Prices o f Other Firms
The data in table 2 suggest that the ratio of
registered to bearer share prices rose from July
to December 1988 for the 36 firms that issue
both types of shares. The data in table 5 show
that the increase in this ratio resulted from a
significant increase in the price of registered
shares rather than from a decline in the price
of bearer shares. This is important in evaluating
whether the change in policy actually augments
the shareholders’ wealth. Any change that re­
duces the differences between the share types
will cause their prices to converge even though
stockholder wealth may not increase. For exam­
ple, if the share prices converge because bearer
and non-voting share prices generally decline
while registered share prices remain unchang­
ed, aggregate stockholder wealth will fall. If
registered share prices increase while other

NOVEMBER/DECEMBER 1989

10

Table 5
Percentage Changes In Share Prices:
July—December 1988______________
Average percent
change
7/88—12/88

t-score

N

Registered

14.95%*

5.44

36

Bearer

-1.79

.71

36

.13

.03

21

Type of share1

Non-voting

* Significantly different from zero at the 5 percent level.
1Twenty-one of the 36 firms in this sample issue all three types
of shares. Fifteen of the firms issue only registered and
bearer shares.
share prices are constant, however, aggregate
wealth will increase.
The data in table 5 are consistent with the se­
cond case. Registered share prices increased by
about 15 percent from July to December 1988
while changes in the prices of bearer and non­
voting shares are not significantly different
from zero. Again, the table 4 data suggest that
the increase in registered share prices is not
due solely to other factors.

CONCLUSION
Recent experience with corporate takeovers
has raised concerns that the capital o f corporate
shareholders is being held hostage by Wall
Street power brokers. Accordingly, various re­
forms designed to reduce takeover activity have
been proposed.
This paper examines an economic theory that
treats the control of a firm as a valuable asset.
The theory suggests that takeovers represent
trades of this asset in a market for corporate
control and that such market competition pro­
vides strong protection for the interests of
shareholders.
Data on the Swiss stock market are analyzed
to determine whether restricting the market for
corporate control affects stockholder wealth.
Until recently, ownership restrictions on Swiss
registered shares had prevented foreign citizens
from competing for control of many Swiss
firms. These restrictions were relaxed in Nov­

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ember 1988. Data analyzed in this paper suggest
that the registered share prices o f firms rose by
about 15 percent while the prices o f bearer and
non-voting shares were roughly constant follow­
ing the relaxation. The data suggest that restric­
ting competition in the market on corporate
control can have serious adverse consequences
on the wealth of shareholders. Since recent pro­
posals to reform the takeover market in the
United States intend to restrict this activity,
they are likely to be counterproductive in pro­
tecting shareholder capital.

REFERENCES
Alchian, Armen. Economic Forces at Work (Liberty Press,
1977).
Anders, George, and Steve Swartz. “ Some Big Firms to
Break Up Stock into New Securities,” Wall Street Journal,
December 5, 1988.
Brealey, R. A. An Introduction to Risk and Return from
Common Stocks (The MIT Press, 1983).
Brealey, Richard, and Stewart Myers. Principles of Corporate
Finance (McGraw Hill, 1988).
Burrough, Brian. "Circus-Like Takeover Contest for RJR
Nabisco Inc. Brings Forth 2 New Bids of More Than $108 a
Share,” Wall Street Journal, December 1, 1988.
“ CEOs React to RJR - and Ross Johnson.” Wall Street Jour­
nal, December 2, 1988.
Dullforce, William. “ Swiss Life Wins Battle for La Suisse,”
Financial Times, August 9, 1988.
_______ . “ Nestle'to End Foreign Shares
Discrimination,” Financial Times, November 18, 1988.
_______ . “ Nestle Breaks Market Mould,” Financial
Times, November 22, 1988.
Foreman, Craig. “ Nestle' Copycat Fears Cloud Swiss
Stocks,” Wall Street Journal, November 21, 1988.
Grossman, Sanford J., and Oliver D. Hart. “ One Share-One
Vote and the Market for Corporate Control,” Journal of
Financial Economics (January/March 1988), pp. 175-202.
Hershey, Robert D. Jr. “ Congress Is Moving Closer to
Weighing Buyout Curbs,” New York Times, December 5,
1988.
Horner, Melchior R. “The Value of the Corporate Voting
Right: Evidence from Switzerland,” Journal of Banking and
Finance (v. 12, 1988) pp. 69-83.
"Japan’s Bias Against Domestic Mergers May Become Trade
Issue, Tokyo Fears,” Wall Street Journal, December 1, 1988.
Jarrell, Gregg A., and Annette B. Poulson. “ Dual Class
Recapitalizations As Antitakeover Mechanisms: The Recent
Evidence,” Journal of Financial Economics (January/March
1988), pp. 129-52.
Jensen, Michael C., and Richard S. Ruback. “ The Market for
Corporate Control: The Scientific Evidence,” Journal of
Financial Economics (April 1983), pp. 5-50.
Jensen, Michael C., and Jerold B. Warner. “ The Distribution
of Power Among Corporate Managers, Shareholders and
Directors,” Journal of Financial Economics (January/March
1988), pp. 3-24.

11

Marine, Henry G. “ Mergers and the Market for Corporate
Control,” Journal of Political Economy (April 1965), pp.
110- 20 .

Manne, Henry G., and Larry E. Ribstein. “ The SEC v. the
American Shareholder,” National Review (November 25,
1988), pp. 26-29.
Norris, Floyd. “A New Defense in Hostile Bids,” New York
Times, December 1, 1988.
Passell, Peter. “ How to Defuse the Buyout Bomb,” New York
Times, December 7, 1988.
Ricks, Thomas E. “ SEC Staffers Link ‘87 Crash to House
Panel,” Wall Street Journal, May 4, 1989.
Ruback, Richard S. “ Coercive Dual-Class Exchange Offers,”
Journal of Financial Economics (January/March 1988), pp.
153-73.

“ Shareholders, Who Are They?” The Economist (January 28,
1989), p. 69.
Stulz, Rene’ M. “ Managerial Control of Voting Rights: Finan­
cing Policies and the Market for Corporate Control,” Jour­
nal of Financial Economics (January/March 1988), pp.
25-54.
Swiss Bank Corporation. Handbuch der Schweizer Aktien
(1987).
Wicks, John. “ Suchard Lets Foreigners Own Registered
Shares,” Financial Times, June 22, 1988.
_______ . “ Unprecedented Battle of La Suisse Suitors,”
Financial Times, August 2, 1988.
“ Will Others Follow RJR as it Pioneers Megadeal Frontier?”
Wall Street Journal, December 2, 1988.

Appendix
Firms Included in the Tests
Types of Shares Issued
Firm

Registered

Bearer

Non-voting

/
/
/
/
/
/
/

/
/
/
/
/
/
/

/
/

/
/

Elekrowatt
Fortuna
Gotthard Bank
Interdiscount
Pirelli
VP Bank Vaduz
Walter Rentsch
Zuercher
Ziegeleien
Zellweger
Allusuisse
B.S.I.
Bank Leu
Bobst
Brown Boveri
Buehrle
Ciba Geigy
Feldschloesschen
Georg Fischer
Haldengut
Jacobs Suchard
Konsumverein
Zurich
Moevenpick
Nestle




I
/
/
/
/
/
/
/
/
/
/
/
I
/

I

I

/
/
/
/
/
/
/
/
/
/
/
/

I

I

/
/
/
/
/
/
/
/
/
/
/
/

Types of Shares Issued
Firm

Registered

Bearer

Non-voting

/
/

/
/

/
/

Sandoz
Schindler
Swiss Bank
Corporation
Schweizer Rueck
Union Bank of
Switzerland
Zurich Insurance
Globus

/
/

/
/

/
/

/
/
/

/
/
/

/
/
/

Accu-Oerlikon
Charmilles
Credit Suisse
Crossair
Frisco Findus
Hermes
Hero
Huerlimann
Mikron
Usego
Eichhof
Holzstoff
Hypo Brugg
Sibra Holding
Swissair

/
/
/
/
/
/
/
/
/
/
/
/
/
/
/

/
/
/
/
/
/
/
/
/
/
/
/
/
/
/

NOVEMBER/DECEMBER 1989

12
Keith M. Carlson

Keith M. Carlson is an assistant vice president at the Federal
Reserve Bank of St. Louis. Thomas A. Pollmann provided
research assistance.

Do Price Indexes Tell Us
About Inflation? A Review of
the Issues
13
-U E C A U S E its effects are so pervasive, vir­
tually everyone is concerned about inflation.
While understanding the concept o f inflation
seems to be easy enough, finding a meaningful
measure of it is much more difficult than it
might appear. For us as consumers and citizens,
to understand how inflation is defined and the
extent to which the commonly used price in­
dexes actually measure it is clearly important.
This article describes the broad issues involved
in defining inflation, then examines how useful
the commonly used U.S. price indexes are in in­
terpreting and understanding it.

INFLATION: DEFINITIONS AND
CONCEPTS
Because there is substantial controversy about
precisely what inflation is, a variety of defini­
tions of inflation have cropped up over the
years.1 Definitions of inflation generally fall into
two classifications: descriptive ones, which focus
on the symptoms o f inflation, and causal ones,
which focus on the reasons for inflation. A
typical descriptive definition of inflation is a

'For a general discussion of inflation, particularly its effects,
see the section on “ Inflation: Impact and Measurement” in
Alchian (1977).
2Alchian and Klein (1973).

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“continuous rise in the general level o f prices.”
A typical causal definition is "too much money
chasing too few goods." While other variations
of these definitions could be cited, these two
provide a point of departure for our analysis.
The “continuous” part of the descriptive
definition refers to the sustained nature of the
increases as opposed to temporary short-term
movements in prices (for example, the effects of
a drought), or one-time jumps in the price level
(for example, resulting from an increase in an
excise tax). In recent years, short-term price
movements have reflected primarily price vola­
tility in the markets for energy and food. The
“general” part of the descriptive definition
refers to the average behavior of prices as op­
posed to movements in the prices o f individual
commodities or services. As Alchian and Klein
(1973) indicate, a general measure o f inflation
should be based on the prices of all present and
future consumption services.2 Their theoretical
measure of inflation is defined as the change in
the nominal cost of achieving a given level of
well-being over time, or what could be termed
loosely as changes in the cost of living.3

3To avoid confusion with the consumer price index, which
is sometimes referred to as a measure of the cost of liv­
ing, Alchian and Klein refer to their measure as “ the cost
of life.”

13
The causal definition o f inflation—too much
money chasing too few goods—is a carryover
from the writings of nineteenth-century econo­
mists who defined inflation as a continuous
decline in the purchasing power of money.4
Money is accorded a causal role because it
serves as the medium o f exchange. Friedman
refines the causal definition by stating that "in­
flation is always and everywhere a monetary
phenomenon . . . and can be produced only by a
more rapid increase in the quantity of money
than in output.”5
This discussion suggests that the important
aspects o f inflation, properly defined and mea­
sured, are its broad and continuous nature and
its monetary underpinnings. A key question that
follows from combining the descriptive and caus­
al aspects of inflation is to what extent the U.S.
price indexes reflect these aspects.

Measuring the Cost o f Living
Since inflation refers to changes in the gener­
al level of prices, it is useful to examine the
measurement of the cost o f living. A theoretical
measure of the cost o f living, like the one pro­
posed by Alchian and Klein, is based on a long­
term goal of maximizing economic well-being.
Individuals (or society) decide how to maximize
their well-being in terms of both current and
future consumption; this means that the prices
of both current and future consumption of
goods and services must enter into the cost of
achieving a level o f economic well-being. (For a
numerical example, see the shaded insert on the
following page.) As Alchian and Klein point out,
however, because separate futures markets exist
for only a small number of commodities, price
quotations for future consumption goods and
services are generally not available. Fortunately,
asset prices, which are the prices for the sources
of future consumption services, provide a good
proxy and are readily available.
Our theoretical measure of the cost of living
should include all asset prices that yield present
and future consumption services. Thus, such a
measure would include the prices of both new
and used cars, new and used appliances and
furniture and asset prices that yield a monetary
(pecuniary) return, like financial assets (stocks,
bonds, savings accounts) and land.

4Bronfenbrenner (1968) and Allen (1975).
5Friedman (1966), p. 25.
6The periods shown correspond for the most part with
changes in the rate of increase of consumer prices. It will



The asset prices to be considered for this
measure would not necessarily be limited to
assets actually held by individuals because the
asset combination that would yield the desired
consumption pattern might differ from the
assets that are actually held. The objective un­
derlying the construction of this measure is to
determine the money cost of achieving the indi­
viduals’ maximum level o f well-being.
Table 1 provides a list o f the major com­
ponents of household net worth for selected
years since W orld War II. Although net worth
has changed little relative to personal consump­
tion since 1952, its composition has changed
substantially. Tangible assets, in particular, land,
now constitute a larger portion o f net worth
than in 1952. Households are now net debtors
with respect to credit market instruments; they
were net creditors in 1952. Also, holdings of
equity in noncorporate business are now much
less important relative to total net worth than
they were in 1952. To measure the theoretical
cost of living, however, we must examine
changes in the prices o f these diverse compo­
nents of net worth.
Table 2 summarizes U.S. trends in prices of
current consumption goods and services, along
with those for selected assets for selected peri­
ods from 1952-88.GFor the full period, prices of
both common stock and land have increased
more than consumer prices. For the shorter
periods, which range from six to 13 years in
length, a theoretical measure of price change in­
cluding asset prices would imply substantially
different effects on the cost of maintaining an
individual’s well-being than implied by consider­
ing only prices of current consumption. The ex­
tent o f these effects, o f course, would depend
on the individual’s preferences for current vs.
future consumption.
A theoretical measure o f the cost of living, as
defined by Alchian and Klein, provides a basis
for measuring inflation primarily as viewed by
individuals. Changes in that measured cost of
living correspond to the "general” part of the
descriptive definition of inflation. The theoreti­
cal measure also provides a standard for com­
parison in evaluating the price indexes that are

be shown later that they also correspond to marked and
sustained changes in the growth of money relative to
output.

NOVEMBER/DECEMBER 1989

14

A Num erical Example of Theoretical (AlchianKlein) Cost-of-Living Index
Suppose that an individual is achieving a
certain level o f well-being by allocating his in­
come of $1,000 as follows:
Initial situation:

Present consumption
Future consumption

Price

Quantity

Price
x
quantity

$ 4
20

159.6
18.1
Total

$ 638
362
$1,000

Present consumption includes units purchas­
ed of food, clothing, shelter, etc., and future
consumption includes allocations to common
stocks, bonds, etc. Suppose that the prices of
both present and future consumption change,
but income is unchanged at $1,000. The in­
dividual responds, maximizing his well-being
by shifting his allocation as follows:

ferent amounts, the individual has to adjust
his allocation. Exactly how much the quantity
purchased of each good changes depends on
the preference of the individual.
The price of present consumption goods
and services has risen by 25 percent and
future consumption goods and services by 50
percent, and clearly the individual’s well­
being has declined. How much have average
prices increased? The theoretical price index
asks what the money cost was o f achieving
the level of well-being that was achieved in­
itially. Given the changed relative price struc­
ture ($5/$30 instead of $4/$20), assume that
the individual could achieve his previous well­
being with present consumption of goods and
services of 171.5 units and future consump­
tion of goods and services of 16.3 units. The
money cost in the second period is

Changed situation:

Present consumption
Future consumption

Price

Quantity

Price
x
quantity

$ 5
30

126.4
12.3
Total

$ 632
368
$1,000

With the prices of present and future con­
sumption goods both rising, although by dif­

used in the United States. Left unexamined,
however, is the "continuous” part of the defini­
tion. Presumably, an individual is concerned
with changes in the cost o f living regardless
where they came from or whether they are
continuous.7 Policymakers, on the other hand,
though concerned with movements in the gen­
eral level of prices, have to differentiate be­
tween movements of prices that are continuing
and those that are temporary (or short term).
To gain an understanding of the continuous
aspect of inflation, it is helpful to turn to the
causal definition of inflation—"too much money
chasing too few goods.”

HTiis is not to say that individuals are oblivious to the
source of price change. Rather than complicate the
analysis by introducing expectations, the analysis focuses

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$5(171.5) + $30(16.3) = $1,347.
The index of the money cost of achieving a
level of well-being has increased by 35 per­
cent ((1347/1000)-l)xl00. If the individual’s
wealthholdings actually increased from one
situation to the next, then that increase could
be compared with the change in the money
cost of achieving a level of well-being.

Monetary Inflation
Policymakers are concerned about inflation
because one of their goals is to control it. This
means they must use measures of price move­
ments in such a way that the inflationary ef­
fects of their actions are readily identifiable.
This might mean that the price measure most
relevant to them differs from that most relevant
to individuals.
Singled out for emphasis here is the causal
definition of inflation that stresses the role of

on measuring the change in the money cost of maintaining
individuals’ well-being, that is, measuring what happened
to prices rather than what is expected to happen.

15

Table 1
Distribution of Household Net Worth (dollar amounts in billions) 1
1988
1972
1952
Percent
Percent
Percent
of
of
of
Amount
total
Amount
total
Amount
total
Net worth
Tangible assets
Reproducible assets
Residential structures
Nonprofit plant & equipment
Consumer durables
Land
Total net financial assets
Deposits & credit market
instruments
Checkable deposits & currency
Other time & savings deposits
& MMF shares
Credit market instruments
Corporate equities plus net
security credit
Life insurance & pension
fund reserves
Equity in noncorporate business
Miscellaneous assets
Memo:
Personal consumption expenditures
(flow during the year)

$15,446.6
6,538.4
5,203.9
3,067.3
290.4
1,846.2
1,334.5
8,908.2

100.0%
42.3
33.7
19.9
1.9
12.0
8.6
57.7

$3,853.3
1,411.8
1,217.7
704.2
88.8
424.7
194.1
2,441.5

100.0%
36.6
31.6
18.3
2.3
11.0
5.0
63.4

$1,102.2
373.7
337.1
187.3
15.8
134.0
36.6
728.5

100.0%
33.9
30.6
17.0
1.4
12.2
3.3
66.1

1,251.8
515.7

8.1
3.3

367.7
142.4

9.5
3.7

156.2
62.3

14.2
5.7

2,525.3
-1,789.2

16.3
-11.6

563.7
-338.4

14.6
-8 .8

79.8
14.1

7.2
1.3

2,217.8

14.4

905.9

23.5

168.6

15.3

2,866.0
2,373.8
198.8

18.6
15.4
1.3

469.2
667.4
31.3

12.2
17.3
0.8

92.1
301.6
10.0

8.4
27.4
0.9

$3,227.5

20.9%

$757.6

19.7%

$219.1

19.9%

1 Year-end outstandings
SOURCES: Federal Reserve Flow of Funds and U.S. Department of Commerce

Table 2
Rates of Change for Prices of Current Consumption and Selected
Assets
Average rate of change
Full period
Subperiods
1952-88
1982-88
1972-82
1965-72
1952-65
Consumer prices,
all items
Common stock prices
Land prices
Home prices
New
Existing




4.2%
6.8
8.3
N.A.
N.A.

3.5%

8.7%

4.1%

1.3%

13.8
4.8

1.3
14.5

3.5
6.2

9.9
6.4

8.7
5.8

10.8
10.6

4.9
N.A.

N.A.
N.A.

NOVEMBER/DECEMBER 1989

16
monetary forces.8 As Friedman’s research in­
dicates, the continuous aspect of inflation is at­
tributable primarily to growth in the quantity of
money relative to output. His preferred measure
of money, based on extensive research, is M2,
and his measure of output is "trend real GNP.”
The use of trend real GNP permits the influence
of other slow-changing factors to come into
play. Such factors include changes in the quanti­
ty and quality of the labor force (or population),
capital formation and technological changes.
From this causal view of inflation, policy­
makers would be interested in a price measure
that reflects movements, probably with a lag, in
the money-output measure.9 The previous dis­
cussion of the descriptive definition of inflation
suggests that policymakers might prefer a mea­
sure o f price change that excludes the in­
fluences of temporary factors.

USING THE U.S. PRICE INDEXES
TO MEASURE INFLATION
The U.S. price measurement system consists
primarily of three sets of price indexes: the con­
sumer price indexes, the producer price indexes
and the deflators implicit in the GNP accounts.10
(For a basic review of index numbers, see the
shaded insert at right.) Each month, announce­
ments about the latest readings of these indexes
are made. The consumer and producer price
indexes are prepared monthly; the implicit defla­
tors are prepared only quarterly, although revi­
sions are announced monthly. This section sum­
marizes the origins of each index, as well as
their coverage, uses and limitations, and con­
cludes with an evaluation of the cost of living in
light of the theoretical (Alchian-Klein) definition.
The following section examines the indexes in
the context of Friedman’s causal definition of
inflation.

The Consum er Price Index
The consumer price index (CPI), perhaps the
best-known price index available for the United

8For a general discussion of alternative theories of inflation,
see Frisch (1983).
9This reasoning is somewhat circular. The point to be em­
phasized here is that prices have to be monitored con­
tinuously by policymakers to determine the ap­
propriateness of their policy indicator.
10For an alternative discussion of U.S. price indexes, see
Webb and Willemse (1989).
"Since 1978, there have been two CPIs—CPI-U and CPI-W.
CPI-U is for all urban consumers, covering about 80 per
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States, is a measure of price change for a fixed
market basket of goods and services purchased
by urban consumers.11 The CPI is familiar to
almost everyone because:
(1) it measures prices that consumers can re­
late to easily in their everyday purchases;
(2) it is available each month, announced with
a short lag and receives substantial cover­
age by the media;
(3) it provides considerable detail on compon­
ents of the index and geographical differ­
ences in prices; and
(4) its long historical record provides perspec­
tive on similar price movements in the
past.
H istory— The consumer price index was
developed during W orld War I in an attempt to
arrive at a fair wage scale for workers in ship­
building yards. Initially, expenditure data were
gathered for wage-earner families in 92 cities
while price data were gathered for retail stores
in 32 cities; in 1919, "cost-of-living” indexes
were published semiannually for these 32 cities.
A national index was published in 1921 with
data compiled back to 1913. Quarterly indexes
were published in 1935 and monthly indexes
were initiated in 1940.
The first expenditure survey covered the
years 1917-19, followed by surveys for 1934-36,
1947-49, 1950, 1960-61, 1972-73 and 1982-84.
The purpose of these surveys is to update the
weights assigned to particular items in the con­
sumer’s budget.12 Table 3 shows how the
weights have changed over the years, reflecting
the changing patterns of consumer spending.
The CPI, with its updated expenditure sur­
veys, is a "shifting-weight” index. This means
that each time a new survey is conducted, the
weights used to compute the index are changed;
the past data, however, are not revised. Thus,
the CPI data reflect changing weights and dif­
ferent measurement procedures over time. This

cent of the population. CPI-W is for urban wage earners
and clerical earners which covers about 45 percent of the
population. Unless denoted otherwise, the CPI-U measure
is the one used in this article.
12The Labor Department also changes the reference base
period from time to time, that is, the base year that is call­
ed 100. The choice of the base year, which, incidentally,
need not be the same as the year of the expenditure
survey, is of no particular significance other than to pro­
vide the user of the index with a point of reference.

17

Index Numbers: Some Basics
An index number is a measure of some­
thing of interest relative to a specific stan­
dard for comparison. The simple price index,
for example, could be a comparison of the
price of a particular commodity with its price
in a base year or, at a given time, a compari­
son with its price in a particular geographical
area. Major U.S. price indexes combine many
prices in such a way that the index number
measures the weighted average price change
over time.1

An Example
The problems inherent in the construction
and application of an index number can be
enumerated with a simple example. Suppose
we are interested in constructing an index of
prices received by U.S. farmers for their ma­
jor crops in 1986 compared with 1982. The
basic data are:

Wheat
Oats
Soybeans
Corn

Prices
(dollars/bushel)
1982
1986
$2.34
$3.55
1.49
1.16
5.69
4.65
1.49
2.68

Quantities
(millions of bushels)
1982
1986
2087
2765
593
385
2007
2190
8253
8235

One method would be to add the four
prices for 1986, divide by 4 and compare this
with a simple average for 1982. This pro­
cedure would ignore the relative importance
of the different commodities in the produc­
tion mix. A more reasonable method would
be to allow for this relative importance.
One way to measure relative importance is
to consider quantities, for example, the bush­
els of each commodity relative to total bush­
els. The weighted average of price relatives
would be as follows:

Price relative
(P1986/Pi 982)
Wheat
0.66
0.78
Oats
0.82
Soybeans
Corn
0.56
* Proportion of total bushels in 1982

Relative importance*
0.20
0.04
0.16
0.60

The price relative is simply the 1986 price
divided by the 1982 price. In other words,




prices of commodities in 1982 serve as a
base year, where Pi982 = 1.00. To get the
weighted index, multiply each price relative
by its relative importance and sum to obtain
0.63. The result is an index (with 1982 = 1.00)
of major crop prices in 1986 relative to 1982
using 1982 production as weights.

Fi.xed- Weight Formulas
Most price indexes use fixed-weight for­
mulas. The two most common are:
1^, = ^ Pi
P0

2

and I* = ^ Pi
* P0

q0

q,

.

The first formula uses the quantities, q, in
period 0 as weights; the price index in period
1 relative to period 0 is labeled ij, where "L ”
denotes a Laspeyres-type index. It compares
a hypothetical expenditures (or sales) total
(Z pi qo) with actual expenditures (X po qo) in
the base period. The second formula is the
same except that the quantities in period 1
are used as weights; this is called a Paaschetype index. For this index, actual expendi­
tures in period 1 are compared with a hypo­
thetical total in period 0. The objective is the
same for both: to isolate the change in prices
when expenditures or sales change from one
period to the next. Holding the quantities
fixed means that an identical basket of goods
and services is being priced in successive
periods. Alternatively, the "standard of liv­
ing,” or consumer welfare, is being held cons­
tant between the two periods.

Substitution Bias
Price indexes are constructed mainly be­
cause all prices do not move proportionately.
Because of disproportionate change, the fixedweight indexes are subject to substitution
bias. This bias occurs because an identical
market basket is being used to weight the im­
portance of prices. When substitution among
goods is possible, however, consumers will
buy more of those goods whose prices rise
most slowly, or fall in relative terms, and less
of those goods whose prices rise most rapid­
ly. In other words, given the new prices,
there is a different market basket that would
leave the consumer's level of well-being cons­
tant, or, as explained in the principles of

NOVEMBER/DECEMBER 1989

18
economics, “on the same indifference curve.”
If such an index were constructed, it would
measure the change in the “true cost of liv­
ing.” The Laspeyres index tends to assign too
much weight to those goods whose prices
rise most rapidly, while the Paasche index
assigns too little weight to those goods. Thus,
these indexes, when computed for consum­
ers, are measures of average change in prices
for goods and services purchased for family
living and technically not cost-of-living in­
dexes because they do not hold the standard
of living constant.
Although the direction of bias in the fixedweight indexes is generally known, its magni­
tude is not. Triplett surveys some empirical
work on the bias in cost-of-living indexes and
reports that “the empirical results indicate
merely that the bias is small enough that it
can probably be neglected as a matter of
practical importance, whether the index is to
be used for escalation o f income payments,
or as a macroeconomic policy indicator.”2

calculating annual rates o f change. In this
way, all movements o f the index, regardless
of the time interval, are converted to a stan­
dardized period o f one year.
For monthly data, the formula for a com­
pounded annual rate of change is:

CARo,. =

r

12/1

-1 ^J x 100,

where CAR0,. is the compounded annual rate
of change of the index (I) from month 0 to
month t. It is the percent change that would
occur if the change from 0 to t were main­
tained for 12 months.
For quarterly data, the formula is:

CARo,. =

- l j x 100,

where t is the number o f quarters in the
interval.
For annual data, the formula is:

Annual Rates o f Change: Con­
verting a Price Index to an Infla­
tion Measure

CARo,. = j ^ _ L ^

Following the movements o f a price index
(or any economic time series) is facilitated by

where t is the number of years in the
interval.

1For an overview of the early literature on price measure­
ment and index number theory in general, see Diewert
(1988).

procedure is followed primarily to avoid legal
problems that might arise because of contracts
that use the CPI as a basis for wage or price
escalation.
C overage— The CPI is derived from a sample
o f prices o f essentially everything that consum­
ers purchase for day-to-day living. Among these
are prices of food, clothing, shelter, transporta­
tion, medical care, entertainment and personal
care. Sales, excise and real estate taxes are also
included, but income and Social Security taxes
are not. The weights and composition of the in­
dex are currently based on the Survey of Con­
sumer Expenditures for 1982-84. Table 4 sum­
marizes the coverage and weights for CPI-U in
1988.

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X 1 0 °'

2Triplett (1975), p. 28.

Uses and lim itations— The CPI is common­
ly used as a measure of the cost o f living and,
relatedly, as an index to deflate income pay­
ments or other contracts involving monetary
payment. As pointed out in the shaded insert on
index numbers, the CPI is only approximate and
might not be appropriate for a particular con­
sumer whose expenditure pattern differs from
the typical urban consumer. It is commonly us­
ed, however, because it is readily available and
understandable.
The CPI is also used to deflate time series of
nominal data so that they can be interpreted in
real terms. Nominal data series mean little
without accompanying information on price
changes. Dividing the nominal data by a price

19

Table 3
Percent Distribution of CPI Market Basket for Wage Earners and
Clerical Workers (selected years)__________________________
Major group

1935-39

1952

1963

1972-73

1988

Food and beverages
Housing
Apparel
Transportation
Medical care
Entertainment
Other goods and services

35.4%
33.7
11.0
8.1
4.1
2.8
4.9

32.2%
33.6
9.4
11.3
4.8
4.3
4.8

25.2%
34.9
10.6
14.0
5.7
3.9
5.7

20.4%
39.8
7.0
19.8
4.2
4.3
4.5

19.6%
39.8
6.4
19.1
5.1
4.1
5.9

Table 4
Consumer Price Indexes by Commodity and Service Group
Relative
1988 index*
importance
(1982 - 84 = 100)
(December 1988)
All items
Commodities
Food and beverages
Commodities less food and beverages
Nondurables less food and beverages
Apparel commodities
Other
Durables
Services
Rent or shelter
Household services less rent
Transportation services
Medical care services
Other services

118.3 (122.6)
111.5 (114.9)
118.2 (121.5)
107.3 (110.7)
105.2 (107.0)
113.7 (115.7)
103.2 (104.9)
110.4 (116.1)
125.7 (130.9)
N.A. (132.0)
N.A. (115.3)
128.0 (133.2)
138.3 (149.4)
132.6 (141.8)

100.0%
45.3
17.7
27.6
15.9
5.8
10.2
11.6
54.7
27.2
9.3
6.7
4.8
6.7

* Figures in parentheses are 1988 index converted to 1982 = 100.
index, which equals 1.0 in the base period,
yields a deflated series in base-year prices. For
example, personal income divided by a con­
sumer price index provides a measure of real
personal income. If this measure rises over
time, it is usually interpreted as a rise in the
standard of living. Other economic series that
are commonly deflated with the CPI are retail
sales, measures of earnings and consumption
components of the gross national product.

The two most commonly heard criticisms
leveled against the CPI are that (1) it is a fixedweight index and (2) it does not capture quality
changes of consumer goods accurately.13 The
fixed-weight criticism focuses on the substitu­
tion bias that is inherent in its construction.
Those goods whose prices increase the most are
purchased in smaller quantities, and those that
rise the least are purchased in larger quantities.
(See the shaded insert on page 14 for a

13For a survey of the validity and accuracy of price indexes,
see Triplett (1975).



NOVEMBER/DECEMBER 1989

20
numerical example of the cost-of-living index.)14
It is unclear, however, given the U.S. price ex­
perience, that this bias is serious enough to dis­
tort the index for the purposes of most users.
The second criticism about quality measure­
ment is relevant because, in the face of rapidly
changing technology and tastes, the methods of
adjustment will always be subject to criticism.
While the CPI's construction does adjust for
quality change, some analysts have found the
adjustment too large for some goods.15
Evaluation— The CPI covers the prices of
current consumption goods and services only;
these goods constitute only a portion of an in­
dividual’s wealth. Thus, implicit in the CPI’s con­
struction is that economic well-being depends
primarily on current, not future, consumption. If
an individual’s well-being depends on his holdings
of wealth, however, asset prices should be in­
cluded, because they serve as a proxy for the prices
of future consumption goods and services.
The prices of some newly produced assets,
like household furnishings, other consumer
durables and new cars, are included in the CPI.
But uses of consumer savings, like purchases of
stocks, bonds and real estate, are not included.
In fact, Alchian and Klein argue that the CPI
was more accurate as a price index before 1983
when the price of new housing was included.16
Since 1983, a rental equivalence measure of
shelter costs has been used. This measure is an
estimate of the cost of renting housing equal to
those provided by owner-occupied housing.

The P rod u cer Price Index
Another well-known U.S. price index is the
producer price index (PPI), which measures
average changes in prices received in primary

14For example, energy prices rose at an annual rate of 12.9
percent between 1972-73 and 1982-84, compared with a
rate of increase of 8.4 percent for the all-items CPI.
Although the weight for energy products in the consumer’s
market basket changed from 8.6 percent in 1972-73 to 7.4
percent in 1982-84, the CPI from January 1978 through
1987 was calculated using the 1972-73 weights. This is
just one example of substitution bias.
15Triplett (1975), pp. 30-48. The objective in constructing a
price index is to compare prices of goods of constant
quality. Triplett reviews studies of this problem, focusing
on automobiles, household appliances and medical care
services.
The Labor Department uses several methods of adjusting
for quality change. The usual method is to collect data
from companies on costs involved in connection with the

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markets by producers o f commodities in all
stages of processing. While the CPI is a measure
of prices paid by consumers in the final com­
mercial transaction, the PPI is a measure of
prices received by producers in the first com­
mercial transaction.
H istory— The PPI is one of the oldest eco­
nomic time series compiled by the federal gov­
ernment. Known as the wholesale price index
until 1978, the index originated in an effort to
investigate the effect of tariff laws on trade,
domestic production and prices of agricultural
and manufactured goods. The series, first pub­
lished in 1902, is available from 1890 to the pre­
sent time.
The index initially was a simple unweighted
average of the prices of about 250 commodities.
A system for weighting was introduced in 1914,
and other major changes were introduced in
1952, 1967 and 1978. Such changes primarily
expanded the samples of commodities. By 1987,
the index covered more than 3,000
commodities.
In 1978, the analytical focus was shifted from
a classification by commodity (there are two
major classifications: farm products and process­
ed foods, and feeds and industrial commodities)
to one based on stage-of-processing, that is,
degree of fabrication (finished goods, intermedi­
ate goods and crude materials). The commodi­
ties framework had organized products by simi­
larity of end use or material composition and,
as a result, reflected many stages of processing.
Although still published, this classification has
been de-emphasized because o f the possibility of
counting price changes more than once through
several stages of processing.17 The stage-ofprocessing classification is an improved measure
of price change.

quality change. For example, if the selling price of a new
model car increases by $500 and companies report that
$200 of that increase is attributable to governmentmandated safety equipment, the price increase is
estimated at $300. For further discussion, see Bureau of
Labor Statistics (1988), p. 127.
16Alchian and Klein (1973), p. 178.
17The Bureau of Labor Statistics (1982) example is that, ac­
cording to the commodity classification, if the price of cot­
ton were to rise and be passed through to producers of
cotton yarn, then to cotton fabric, and finally to shirts, the
initial price increase would have been recorded four times.
If prices were increasing at the same rate at all stages,
there would be no major distortion. Otherwise, multiple
counting can provide biased and misleading results.

21

Table 5
Producer Price Indexes by Stage of Processing
1988 index
(1982 = 100)

Relative
importance
(December 1988)

Finished goods
Finished consumer goods
Finished consumer foods
Finished consumer goods, excluding foods
Nondurable goods less food
Durable goods
Capital equipment

108.0
106.2
112.6
103.1
97.3
113.7
114.3

100.0
74.2
25.8
48.4
32.8
15.6
25.8

Intermediate materials, supplies and components
Materials and components for manufacturing
Materials for food manufacturing
Materials for nondurables manufacturing
Materials for durable manufacturing
Components for manufacturing
Materials and components for construction
Processed fuels and lubricants
Containers
Supplies

107.1
113.2
105.9
112.9
118.8
112.3
116.1
71.3
120.1
113.7

100.0
50.9
3.3
16.3
12.1
19.2
12.7
11.3
4.2
21.0

Crude materials for further processing
Foodstuffs and feedstuffs
Crude nonfood materials

95.9
106.0
85.5

100.0
43.8
56.2

Coverage— The coverage of the PPI differs
from the CPI (compare tables 4 and 5). Pro­
ducer price indexes do not reflect changes in
prices for services, housing and used cars, all of
which are in the consumer price index. Pro­
ducer price indexes measure changes in capital
equipment and materials purchased by busi­
nesses but not by consumers. In addition, for
the most part, the PPI is not available on a
regional basis.
In the preparation of stage-of-processing price
indexes, products are categorized by degree of
fabrication—finished goods, intermediate mater­
ials, supplies and components, and crude mater­
ials for further processing. Finished goods are
commodities that are ready for sale to final
user, whether it is the consumer or a business.
Intermediate materials, supplies and components



are commodities that have been processed but
require further processing. Crude materials are
products entering the market for the first time.
A fixed-weight procedure is used in calcula­
ting the PPI. Weights are based on the total net
selling value of commodities flowing into pri­
mary markets. They are based on values of
shipments in the 1982 economic censuses.
Uses and lim itations— The PPI is often inter­
preted as an indicator of inflation, with the
stage-of-processing framework supposedly facili­
tating the analysis of the inflation transmission
process. For example, the news media treat
movements in the PPI as predictors of future
movements in the CPI. Generally, however, the
coverage of the CPI and the PPI differ so much

NOVEMBER/DECEMBER 1989

22
that the relationship between them is tenuous.18
For example, the PPI includes no services, while
services receive a weight of about one-half in
the CPI. In addition, the PPI excludes prices of
imported goods which are included in the CPI.
The PPI index is used as a deflator for certain
economic time series to obtain estimates of
physical volume. These series relate to specific
producer activities like inventories, sales, ship­
ments and capital equipment purchases. Accor­
ding to the Department of Labor, the PPI is
used in the private sector for industry analyses
since it is the only index available that is consis­
tent with the Census Bureau’s Standard Indus­
trial Classification (SIC) code. It is also used as
an escalator in sales contracts.
Evaluation— The coverage of the PPI is even
more limited than that of the CPI. It does not
cover retail transactions or services; instead, it
covers only newly produced goods and captures
only the price of the first transaction. The chief
defect of the PPI, according to the Department of
Labor, is that it has been formulated in an ad hoc
fashion, not corresponding to any underlying
theoretical construct.19 Although this theoretical
deficiency has been corrected to some extent,
since the PPI focuses on prices paid by producers
of goods, it still is unclear whose well-being is
really being measured with the PPI.20

The G N P Implicit Price Deflator
The most general measure of prices for the
U.S. economy is the GNP implicit price deflator.
Included are the prices of consumption, invest­
ment, government services and net exports. In
contrast to the CPI and the PPI, it is released
quarterly; these quarterly data are revised mon­
thly, however, as information becomes available.
In general, the procedure for obtaining the
GNP deflator is as follows:

18Coverage of the PPI differs substantially from that for the
CPI. The relative importance (weighting) of various com­
ponents in 1988 are as follows:
Producer prices

Food
Energy
Less food
and energy
Services
Commodities

Consumer
prices

Finished
goods

Intermediate
materials

Crude
materials

16.2%
7.3

25.8%
8.8

5.2%
11.4

43.8%
36.9

76.5
50.8
25.7

65.3
0.0
65.3

83.4
0.0
83.4

19.3
0.0
19.3


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(1) divide detailed components of current dollar
GNP by the price index corresponding to the
component of spending;
(2) sum these deflated spending components to ob­
tain an estimate of constant dollar, or real, GNP;
then
(3) divide the estimate of current dollar GNP by the
estimate of real GNP to obtain the estimate of
the GNP implicit price deflator.
The price indexes are obtained from many
sources, including the Bureau of Labor Statistics,
Census Bureau, Department o f Agriculture and
the Interstate Commerce Commission. The im­
plicit deflator that results from the procedure
described above is a weighted average of the
component price indexes, where the weighting
is determined by the composition of constantdollar GNP. Since this composition changes from
one period to the next, movements in the im­
plicit price deflator reflect changes in GNP com­
position as well as prices.21
To avoid problems associated with changing
GNP composition, the Commerce Department
also prepares fixed-weight price indexes for
GNP and its components; these reflect price
changes alone. Currently, the weights used for
the fixed-weight price indexes are based on the
composition of output in 1982 (see table 6).
H istory— The mobilization for W orld W ar II
and its aftermath was primarily responsible for
the development of the GNP accounts. As Ruggles points out, "The central questions posed by
the war were how much defense output could
be produced and what impact defense pro­
duction would have upon the economy as a
whole.”22 Concern with real output meant that
deflators had to be developed. The GNP de­
flator, as it is currently known, was initially
published in 1951, although there were implicit
measures of GNP prices as early as 1942.

Moore (1983), pp. 172-73, concludes that the value of the
PPI in predicting the CPI is poor.
19Bureau of Labor Statistics (1982), p. 51.
20See Bureau of Labor Statistics (1986) for discussion of
theoretical considerations.
21For an example illustrating the effect of changing GNP
composition, see Bureau of Economic Analysis (1985),
p. 6. It concludes that the GNP implicit deflator “ can give
misleading signals of price change, and therefore its use
as a measure of price change should be avoided.”
22Ruggles (1983), p. 17.

23

Table 6
GNP Implicit Price Deflators by Major Type of Product
1988 deflator
Constant
dollar weight
(1982 = 1.00)
GNP
Goods
Personal consumption
Business investment
Federal purchases
State and local purchases
Net exports
Exports
Imports
Services
Personal consumption
Federal purchases
State and local purchases
Net exports
Exports
Imports
Structures
Residential investment
Nonresidential investment
Federal purchases
State and local purchases
Uses and lim itations— The GNP deflator
was not designed as a price index, because it
reflects changes in the composition of GNP, as
well as prices. The fixed-weight deflator is de­
signed as a measure of price change. The differ­
ences between the GNP deflator and the fixedweight index can be significant over either
short or long periods, if there are large changes
in GNP composition.

1.217
1.100
1.144
0.972
0.960
1.027
0.942
0.956
1.335
1.348
1.241
1.363
1.212
1.218
1.182
1.196
1.148
1.218
1.200

100.0%
44.1
32.8
10.3
2.4
1.9
-3 .2
46.4
32.1
5.5
8.1
0.7
9.5
4.8
3.0
0.3
1.4

However, the GNP price indexes include prices
of newly produced tangible assets; if their
prices and prices of existing assets move togeth­
er, the GNP price index might contain reliable
information about the prices of future consump­
tion goods and services. Generally, however, the
usefulness of the deflator to individuals in as­
sessing changes in their well-being is ques­
tionable because the deflator reflects many
prices that are of only marginal interest to the
individual. Examples are business investment,
government purchases and exports. The exclu­
sion of financial and existing assets also in­
dicates that the deflator is limited in coverage
compared with the theoretical measure dis­
cussed above.

GNP-based deflators are useful primarily to
government policymakers and academicians
because they provide a measure of price change
for the economy as a whole. Foreign and do­
mestic investors, as well as the general public,
also find them of interest because they have
been used as a measure of the success or fail­
ure of macroeconomic policy.

Summary and References

Evaluation— Of the three major U.S. price
indexes, the GNP deflator has the broadest
coverage: its covers all currently produced
goods and services. Compared with our theoret­
ical measure of well-being, the GNP price in­
dexes are subject to the same criticism as were
the CPI and the PPI because the prices of ex­
isting assets and financial assets are excluded.

The features associated with the major U.S.
price indexes are summarized in table 7. For ad­
ditional details on these indexes including their
construction, the reader is referred to the BLS
Handbook o f Methods for the CPI and the PPI
and the July 1987 Survey o f Current Business
for the GNP deflator. These also contain exten­
sive references for even further detail.23

“ Another useful reference, although dated, is Backman and



Gainsbrugh (1966).
NOVEMBER/DECEMBER 1989

24

Table 7
Measures of U.S. Prices
Consumer Price Index
Basic description

Measure of price change
for a fixed market basket
of goods and services
purchased by all urban
consumers

Source

Bureau of Labor
Statistics, U.S.
Dept, of Labor
Monthly, released
about the 20th day of
the following month

Frequency

Publication

Base year
Weighting

Summary data from the
Consumer Price Index
news release and
Monthly Labor Review
1982-84 = 100
Derived from Consumer
Expenditure Survey for
1982-84

Revisions

The not seasonally
adjusted CPI is never
revised. Seasonally
adjusted CPI is revised
each January.

Historical data

Monthly to Jan. 1913

INFLATION MEASUREMENT AND
MONETARY INFLATION
The discussion thus far has focused on the
U.S. price indexes as measures of changes in
the cost of maintaining an individual's level of
well-being. Although policymakers are interested
in movements in the general level of prices,
they are also interested in the composition of
the price change. In particular, policymakers

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Producer Price Index

Implicit Price Deflator

Measure of average
change in prices
received in primary
markets by producers
of commodities in all
stages of processing

Weighted average of
the detailed price
indexes used in
the deflation of GNP,
where weights are
composition of
constant-dollar output
Bureau of Labor
Bureau of Economic
Analysis, U.S. Dept,
Statistics, U.S.
Dept, of Labor
of Commerce
Quarterly, first
Monthly, released
estimate released
about the 10th day
about the 20th day
of the following
of the following
month
quarter
Summary data from the Gross National Product
Producer Price Index
news release and
news release and
Survey of Current
Monthly Labor Review Business
1982 = 100
1982 = 100
Derived from net
Composition of
constant-dollar output
selling value of all
in current period
commodities.
Weights based on 1982 (fixed-weight deflators
economic censuses.
use composition of
output in 1982)
Each quarter’s
Data for four months
earlier are revised
estimates are revised
each month, and
for two successive
seasonally adjusted
months and again for
estimates are
previous three years
revised each
in July.
January.
Monthly to Jan. 1890.
Quarterly to 1946 and
Prior to 1978,
annually to 1929
called wholesale
price index

focus on that portion o f inflation that is related
to their actions in stabilizing economic activity.
Most of the better-known measures of price
change reflect both policy-induced inflation as
well as relative price changes caused by sectoral
shifts in supply or demand (for example, the ef­
fects of drought and supply cutbacks by oil
cartels). Policymakers have to be able to identify
the sources of price movements in order to con­
trol inflation. This involves formulating a causal
definition of inflation and testing it empirically.

25
The particular definition chosen here is that
inflation is a monetary phenomenon. To assess
the usefulness of the price indexes to policy­
makers, one must adopt a specific measure of
monetary action. While several measures are
available, only the monetary measure preferred
by Friedman is examined here. The Friedman
measure is the ratio of the M2 money stock
relative to trend real GNP.24 His choice of mea­
sure is based on the quantity theory of money
as well as extensive empirical research.25 The
presumption is that M2 can be controlled by the
monetary authority and that trend output chan­
ges only slowly in response to such factors as
population change and the rate o f productivity
advance. Consequently, policy-induced inflation
is related to the growth rate of M2.26
By examining the U.S. price indexes in com­
parison with the money-output measure, we are
asking which index provides the best informa­
tion about policy-induced inflation or disinfla­
tion. Since the money-output measure is an em­
pirical generalization, one must continuously
monitor its performance as a policy guide. Be­
cause the general level of price change reflects
both temporary relative price movements and
the effects of policy with a lag, the relationship
between the indexes and the money-output
measure must be scrutinized carefully.

U.S. Price Indexes and the M on eyOutput Measure
The performance of each of the major U.S.
price indexes in comparison with the moneyoutput measure is summarized in figure 1. The
causal definition of inflation indicates that the
focus should be on general trends of different
measures rather than year-to-year movements.
A casual analysis of figure 1 suggests that, while
there is generally a positive relationship be­
tween each price index and the money-output
measure, these measures diverge considerably
at times.
Recalling that these indexes include the in­
fluence of temporary factors, which might mask
the movement of policy-induced inflation, two
"special” indexes are charted in figure 2 along
with the money-output measure. The fixed-

24M2 includes mainly currency held by the nonbank public,
demand deposits, other checkable deposits, money market
deposit accounts and savings and small time deposits.
25Friedman and Schwartz (1963, 1982). See also Hallman,
Porter and Small (1989).



weight deflator was mentioned previously as a
better measure of price change than the GNP
deflator, although it includes the influence of
temporary factors. The other measure charted
in figure 2 is consumer prices excluding the
prices of food and energy. This index is pre­
pared by the Department of Labor, and some
analysts have suggested that it could be used as
a measure of policy-induced inflation.27 Compar­
ing figure 2 with figure 1, it is not immediately
obvious that these special indexes provide better
information to policymakers about their con­
tribution to inflation.
Because there is a general similarity of up­
ward movement in all of the indexes, it is not
possible to discern if the relationship between a
particular price measure and the money-output
measure is superior to the others. Also, the
figures do not allow for a presumed lag from
money to prices. Friedman and other econo­
mists generally agree that money affects prices
with a long, and possibly variable, lag.28 These
issues can be investigated by examining in detail
the rates of change of the different measures.
Using rates of change permits a more rigorous
analysis o f the strength of the relationship be­
tween an index and the money-output measure.
Table 8 summarizes the results of a correla­
tion analysis. The rates of change of each price
index were lagged behind the money-output
measure from zero to four years. For the con­
temporaneous (no lag) and one-year lag, the cor­
relation coefficients w ere not statistically signifi­
cant from zero. When the money-output mea­
sure was lagged two or three years, the correla­
tion coefficient was significant for all of the
price measures. For the four-year lag, all coeffi­
cients were significant except for producer
prices. The lagged effect of money to prices is
clear, but whether the most highly correlated
lagged relationship is two, three or four years is
not. The differences in the significant correla­
tion coefficients for a given price measure
across the different lag lengths were not
significant.
The question of whether one price measure is
consistently related more closely with the
money-output measure is not answered by this

26This relationship is simple to understand because the
velocity (turnover) of M2 has shown little trend over the
years.
27Eckstein (1980) and Gordon (1987).
28Friedman and Schwartz (1982), and Friedman (1989).

NOVEMBER/DECEMBER 1989

26

Figure 1
Money (M2) Relative to Trend Output
and U.S. Price Measures
Consumer Prices, All Items
Index 1982 = 100
Annual Data
Index 1982 = 100
150 ,-------------------------------------------------------------------------------------------------------------------- ,150

75

50

GNP Deflator
Index 1982 = 100
150

Index 1982 = 100
150

125

125

100

100

75

75

50

50

Producer Prices of Finished Goods
Index 1982 = 100
Index 1982 = 100
150 i-------------------------------------------------------------------------------------------------------------------- 1150

25
1952

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27

Figure 2
Money (M2) Relative to Trend Output
and Alternative Price Measures
Consumer Prices, Excluding Food and Energy

150.-----------------------------------:----------------------------------

Index 1982 = 100

Annual Data

125

25
Index 1982 = 100
150

lndex 1982 = 100
150
125

GNP Fixed-Weight Deflator
Index 1982 = 100
150

125
100

25
1952



1988

NOVEMBER/DECEMBER 1989

28

Table 8
Correlation of Price Indexes with Money-Output Index (1960-88)
Money (M2) minus trend growth of GNP
No lag

1-year lag

2-year lag

3-year lag

4-year lag

Consumer prices, all items

.10

.25

.54*

.62*

.50*

Consumer prices, excluding
food and energy

.14

.19

.46*

.70*

.63*

GNP deflator

.27

.29

.48*

.57*

.52*

GNP fixed-weight deflator

.21

.31

.56*

.65*

.60*

Producer prices of finished goods

.09

.29

.56*

.52*

.32

Rates of change

•Significant at 5 percent level

Table 9
Rates of Change of Money and U.S. Prices
Average rate of change
subperiods
1972-82
1965-72

Full period
1952-88

1982-88

Money (M2) relative to
trend output

4.3%

5.0%

6.2%

4.8%

2.1%

Consumer prices, all items

4.2

3.5

8.7

4.1

1.3

Consumer prices, excluding
food and energy

N.A.

4.3

8.1

4.3

N.A.

GNP deflator

4.4

3.3

8.0

4.7

2.2

GNP fixed-weight deflator

N.A.

3.7

7.1

3.3

N.A.

Producer prices of finished goods

3.6

1.3

9.1

2.9

0.8

analysis. For the three- and four-year lag, con­
sumer prices, excluding food and energy, and
the GNP fixed-weight deflator appear to be the
most highly correlated, but the closeness o f fit
is not significantly different from that for the
other measures for a given lag.
Another way o f examining these alternative
price measures is to compare their trends for
the 1952-88 period. Table 9 summarizes the
movements of the same price measures shown
in table 8. The subperiods are the same as in
table 2 and conform with periods of marked

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and sustained change in the growth of money
relative to output. For the full period, 1952-88,
all of the price measures for which data are
available conform closely with the rate of
change of the money-output measure. The
possible exception is producer prices, which in­
creased at a 3.6 percent average rate compared
with a 4.3 percent rate for money-output.
An examination o f rates of change indicates
that, without exception, accelerations and
decelerations in the money-output measure
were accompanied by movements in the same

29
direction for each of the price measures. The
rates of change of the price measures were
more closely associated with the money-output
measure in the two earliest periods than in the
1972-88 period. This generally reflects volatile
movements in the prices of energy and agricul­
tural products during the 1970s and 1980s.
These sharp movements in relative prices can
produce rates o f change that differ for periods
as long as 10 years from those for the moneyoutput measure. They tend to cancel over
longer periods, however, as shown by the rates
of change for the full period.
Comparing each price measure with the
money-output measure does not indicate a clear
superiority of one measure over another, al­
though producer prices have shown the largest
average absolute deviation. For the subperiods
chosen, there is not enough information to
draw a definite conclusion. For each o f the subperiods in the 1965-88 period, however, the
consumer price measure excluding food and
energy appears to conform more closely to
movements in the money-output measure than
does consumer prices for all items. Similarly,
the fixed-weight deflator has accompanied
movements in the money-output measure more
closely than the GNP deflator during the
1972-88 period.

CONCLUSIONS
Because inflation is a vital concern in making
economic decisions, it is important to unders­
tand the price indexes used to measure it. Con­
sumers, businesses and governments need to
understand changes in price trends so they can
make rational economic decisions. Policymakers,
in particular, must be keenly aware o f price
trends so they can take appropriate actions.
This article described these indexes and analyzed
them to determine what they tell us about infla­
tion. The indexes were examined from two per­
spectives: that of the individual, attempting to
maximize his well-being, and that of the policy­
maker, attempting to control inflation.
For the United States, there are three major
price indexes: the consumer price index, the
producer price index and the GNP implicit price
deflator. To measure and analyze inflation pro­
perly, more information is required than these
conventional price indexes provide. The price
system encompasses many more markets than
those for currently produced goods and ser­
vices. A theoretical measure of price change



would include, for example, prices o f common
stock, real estate, land, etc. Although no such
broad measure of price change is available, the
concept is useful for decisionmakers.
A broad theoretical price measure should be
o f interest to policymakers, but their focus is
generally on the causes o f inflation. In particu­
lar, their interest is in discovering the composi­
tion of price change and identifying the portion
associated with policy actions. Using the Fried­
man monetary measure of money relative to
trend output as a standard for comparison, we
found that, with the possible exception of pro­
ducer prices, all o f the well-known measures of
price change were closely related to his mea­
sure when examined over the full period since
1952. The lag between money growth and infla­
tion was confirmed, although we could not be
precise about the length of the lag. Although
less closely related than over the full period, all
the price measures that were examined moved
with marked and sustained changes in the
growth rate of money relative to output. No
price measure, however, performed consistently
better than another from one period to the next.

REFERENCES
Alchian, Armen A. Economic Forces at Work (Liberty
Press, 1977).
Alchian, Armen A., and Benjamin Klein. “ On a Correct Mea­
sure of Inflation,” Journal of Money, Credit and Banking
(February 1973), pp. 173-91.
Allen, Roy G. D. Index Numbers in Theory and Practice
(Aldine Publishing Company, 1975).
Backman, Jules, and Martin R. Gainsbrugh. Inflation and the
Price Indexes, Materials Submitted to the Subcommittee on
Economic Statistics of the Joint Economic Committee of
the Congress of the United States (U.S. Government Prin­
ting Office, July 1966).
Bronfenbrenner, Martin. “ Inflation and Deflation,” Inter­
national Encyclopedia of the Social Sciences, Vol. 7 (Mac­
millan and The Free Press, 1968), pp. 289-300.
Bureau of Economic Analysis, U.S. Department of Com­
merce. Survey of Current Business (GPO, May 1985 and Ju­
ly 1987).
Bureau of Labor Statistics, U.S. Department of Labor. BLS
Handbook of Methods, Bulletin 2285 (GPO, April 1988).
________Producer Price Measurement: Concepts and
Methods (June 1986).
_______ . BLS Handbook of Methods, Volume 1, Bulletin
2134-1 (GPO, December 1982).
Diewert, W. Erwin. The Early History of Price Index Research,
Working Paper No. 2713 (National Bureau of Economic
Research, September 1988).
Eckstein, Otto. Tax Policy and Core Inflation, A Study Pre­
pared for the Use of the Joint Economic Committee of the
Congress of the United States (GPO, April 10, 1980).

NOVEMBER/DECEMBER 1989

30
Friedman, Milton. “ Whither Inflation?” Wall Street Journal,
July 5, 1989.
_______ . “ What Price Guideposts?” in George P. Schultz
and Robert Z. Aliber, eds., Guidelines, Informal Controls,
and the Market Place (University of Chicago Press, 1966),
pp. 17-39.
Friedman, Milton, and Anna J. Schwartz. Monetary Trends in
the United States and the United Kingdom (University of
Chicago Press, 1982).
_______ . A Monetary History of the United States, 1867-1960
(Princeton University Press, 1963).
Frisch, Helmut. Theories of Inflation (Cambridge University
Press, 1983).
Gordon, Robert J. Macroeconomics, 4th ed. (Little, Brown
and Co., 1987).


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FEDERAL
BANK OF ST. LOUIS
Federal Reserve Bank
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Louis

Hallman, Jeffrey J., Richard D. Porter, and David H. Small.
M2 Per Unit of Potential GNP as an Anchor for the Price
Level, Staff Study 157 (Board of Governors of the Federal
Reserve System, April 1989).
Moore, Geoffrey H. Business Cycles, Inflation, and
Forecasting, 2nd ed. (Ballinger, 1983).
Ruggles, Richard. “The United States National Income Ac­
counts, 1947-1977: Their Conceptual Basis and Evolution,”
in Murray F. Foss, ed., The U.S. National Income and Pro­
duct Accounts: Selected Topics (The University of Chicago
Press, 1983), pp. 15-105.
Triplett, Jack E. “ The Measurement of Inflation: A Survey of
Research on the Accuracy of Price Indexes,” in Paul H.
Earl, ed., Analysis of Inflation (Lexington, 1975), pp. 19-82.
Webb, Roy H., and Rob Willemse. “ Macroeconomic Price In­
dexes,” Federal Reserve Bank of Richmond Economic
Review (July/August 1989), pp. 22-32.

31

Michael D. Bradley and
Dennis W. Jansen

Michael D. Bradley is an associate professor of economics at
The George Washington University. Dennis W. Jansen, an
associate professor of economics at Texas A & M University,
was a visiting scholar at the Federal Reserve Bank of St.
Louis. Lora Holman provided research assistance. The authors
would like to thank Geoffrey Wood for his helpful comments.

Understanding Nominal GNP
Targeting
T

JL HROUGHOUT 1989, popular wisdom held
that the U.S. monetary authority was faced with
a daunting policy task: it should not permit too
much money growth and cause prices to rise
too rapidly, but it should not allow too little
money growth and cause the economy to tip in­
to recession as real output would fall. Sympathy
for monetary policymakers, however, is not
necessarily widespread among economists. Many
economists deny that the tradeoff between infla­
tion and output growth exists in the long run.
Moreover, even those who grudgingly agree
that the tradeoff may exist in the short run
contend that monetary policymakers create pro­
blems for themselves by attempting to exploit
the possible output-inflation tradeoff.
What alternative policy guidelines exist? Among
a variety of alternatives, there has been recent
emphasis on something called nominal income
targeting.1 Using this approach, the monetary
authority would ignore the presumed trade-off
between inflation and real output growth; in­
stead, it would simply adjust money stock
growth to achieve some targeted level or growth
rate in nominal GNP. In this paper, we examine

this policy alternative. W e first make the theo­
retical case favoring nominal GNP targeting.
Given this theory, we then turn to the practical
aspects of targeting nominal GNP.

TARGETING NOMINAL GNP: THE
THEORY
In this section, we set out the theoretical case
favoring nominal GNP targeting. In doing so, we
abstract from technical and operational pro­
blems and focus instead on the implications of
nominal GNP targeting for stabilizing price and
output within a widely used macroeconomic
model. Later we will return to the issue of how
to actually set up and utilize nominal GNP
targeting.
Naturally, the economic implications of alter­
native monetary policies depend to a large ex­
tent on the macroeconomic framework being
used for the analysis. W e employ a particular
version of what is perhaps the most widely
used framework for analyzing macroeconomic

'See McCallum (1987), McNees (1987), Carlson (1988) or
Kahn (1988) for examples of policy-oriented discussions of
nominal GNP targeting.



NOVEMBER/DECEMBER 1989

32

larger average money balances to purchase the
same real quantity of goods and services. In­
creased money demand bids up the interest
rate, and higher interest rates imply less con­
sumption and investment spending.2

Figure 1
Price
Level

QF|

O u tpu t

fluctuations, the textbook aggregate supplydemand model.

A Stochastic Aggregate SupplyDem and M odel
A graphical representation of the textbook ag­
gregate demand-supply model is given in fig­
ure 1. This model specifies that the aggregate
price level (P) and the level of real output (Q)
are set by the intersection of the aggregate
supply and demand curves. As figure 1 shows,
the aggregate demand curve slopes downward;
that is, there is an inverse relationship between
the aggregate price level and the demand for
real output. This inverse relationship can arise
for either of two reasons. As the price level
rises, the purchasing power o f money balances
declines, reducing wealth and hence reducing
the quantity of consumption goods demanded.
In addition, the higher price level leads to an in­
crease in the quantity of nominal money de­
manded because the higher prices require

2With the inflation rate held constant, the increase in the
nominal interest rate implies an equivalent increase in the
real interest rate.
3Early versions of this theoretical approach were developed
by Fischer (1977) and Gray (1976). See Barro (1977) for a
criticism of this approach. Optimal fixed wage contracts

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The aggregate supply curve slopes upward in
figure 1. There are several explanations for the
positive slope o f the aggregate supply curve. W e
concentrate on a particular, widely used ex­
planation: that the nominal wages of workers
are set by agreement for a fixed period of time
and the amount of employment is determined
by the employer. This agreement can either be
a formal contract or an informal handshake
(also called an implicit contract) between labor
and management; in either case, nominal wages
adjust slowly to unexpected changes in the
economic environment. As a result, profits rise
as prices rise and fall as prices fall. Firms res­
pond to these changes in profits by appropriate
changes in output and employment.3
This response does not describe the situation
relevant for expected changes in the economic
environment, however, because expected changes
are taken into account when nominal wage
agreements are made. Thus, figure 1 also in­
cludes a vertical line labeled Qn, which indicates
the supply curve relevant when expected changes
occur. The superscript FI stands for "full infor­
mation,” to indicate that this is the supply curve
applicable when the only changes in the eco­
nomic environment are those expected to occur
when wage agreements were signed. Notice that
this curve does not show a direct relationship
between price and quantity. In fact, it shows
that, for expected changes, the relevant supply
curve is vertical at the output level labeled QFI.
The output level QFI does not change when
prices change because workers and firms, when
negotiating wage agreements, will adjust the
nominal wage to compensate for changes in the
price level. Thus, an expected increase in the
price level will be compensated by an increase
in the contracted nominal wage.
This vertical aggregate supply curve is a re­
flection of the “natural rate hypothesis.” The

can be found from microeconomic contracting models
such as Azariadis (1975); these are models of fixed real
wage contracts that shift risk from workers to firms.
McCallum (1987) gives a pragmatic argument for the
prevalence of nominal wage contracts as opposed to real
wage contracts.

33

shift to the left, until it intersects the new ag­
gregate demand curve at point C, where the de­
mand curve crosses the full information ag­
gregate supply curve. When workers become
fully informed and have changed their nominal
wage accordingly, changes in aggregate demand
result only in price level changes.

Figure 2
Price
Level

QR

One implication of this analysis is that an ex­
pected increase in demand only produces
higher prices. In figure 2, this is illustrated by
the movement of the economy from the in­
tersection of the original aggregate demand
curve and O,F0' at point A to the intersection of
the new aggregate demand curve and O/0‘ at
point C, without the intervening short-run
equilibrium at point B.

Output

natural rate hypothesis states that the full
employment level of output is independent of
the price level. In this model, the vertical line
Q fi represents the natural rate hypothesis.
Monetary policy works by inducing move­
ments in the aggregate demand curve. As the
nominal money stock rises, wealth rises and the
interest rate falls at any given price level; as a
result, the demand for goods rises. Graphically,
the aggregate demand curve shifts to the right.
Thus, expansionary policy (increases in the
money stock) shifts the aggregate demand curve
to the right, and contractionary policy (de­
creases in the money stock) shifts it to the left.

The analysis of a decline in aggregate demand
is symmetric to the above analysis. An unex­
pected decline in aggregate demand leads initial­
ly to lower prices and output on the short-run
aggregate supply curve at point D. After firms
adjust workers’ nominal wages downward in re­
sponse to lower prices, the full information
level of output, point E, is achieved once more.
Unexpected changes in supply, termed supply
shocks, are different from demand shocks
because they shift both the short-run and the
full information aggregate supply curves. For
example, suppose that the negative supply shock
illustrated in figure 3 occurs, shifting both the
long-run and short-run aggregate supply curves
to the left.

Figure 3

To illustrate what this model implies, consider
the results of an unexpected increase in ag­
gregate demand, illustrated in figure 2. Since
the short-run aggregate supply curve has a
positive slope, the aggregate demand increase
will produce increases in both price and output
until such time as wages are renegotiated. In
figure 2, the short-run equilibrium occurs at
point B, the intersection of the short-run ag­
gregate supply curve with the new, unexpected­
ly higher aggregate demand curve.
Of course, when workers revise the terms of
their labor contracts in response to an unex­
pected rise in prices, nominal wages will rise
and the short-run aggregate supply curve will



Output

NOVEMBER/DECEMBER 1989

34

The short-run equilibrium occurs at point F, the
intersection of aggregate demand with the new
short-run aggregate supply curve. The full in­
formation output also declines from QF0' to QFI
because the supply shock has reduced the quan­
tity of output firms want to produce even if
wages and prices fully adjust to the shock. The
adjustment from short-run equilibrium at point
F to full information equilibrium at point G oc­
curs when workers renegotiate their nominal
wages upward, shifting the short-run supply
curve leftward again until it intersects the new
full information output level QFI at point G.
Why does the full information output level
shift in response to supply shocks? By defini­
tion, the full information output level is the one
that will be produced when the economy com­
pletely adjusts to any disturbance. Thus, a nega­
tive supply shock reduces the full information
level of output because it reduces the produc­
tive capacity of the economy.
Notice that a reduction in the full information
level of output need not be permanent. That
depends on the nature of the supply shock. If it
is only temporary, the full information output
level will return to QFI after the shock dissi­
pates. Nonetheless, the decline in QFI from QFI
to QFI represents the reduction in potential out­
put, however temporary, that occurs in con­
junction with a negative supply shock.
Finally, the analysis of a positive supply shock
is symmetric to the analysis of a negative supply
shock. Consider a positive shock to supply. The
full information level of output shifts from QFI
to Qfi as the short-run aggregate supply curve
also shifts to the right. If the shock is unex­
pected, initial equilibrium is at point I, and after
all wage adjustments have been made, the econ­
omy will produce at the full information level of
output at point J.

M onetary Policy in the Aggregate
Demand-Supply M odel
The aggregate supply-demand framework we
employ assumes that random shocks occur to
both demand and supply curves. Demand
shocks include unexpected changes in business
or consumer confidence, income taxes, ex­
change rates, monetary policy or government

4The stochastic disturbances that affect the economy need
not all originate from factors exogenous to the policymak
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spending. These lead to unexpected changes in
one or more of the components o f aggregate de­
mand: consumption, investment, government
spending and net exports. Supply shocks include
unexpected changes in the production process,
such as oil price surprises, droughts or techno­
logical change, that enhance or diminish the ag­
gregate quantity of goods supplied.
Before examining how monetary policy might
respond to these shocks, the goals of policy
must be discussed. W e assume that the mone­
tary authority wants to stabilize the price level
and/or the level of output. In the model pre­
sented, the only level o f real output that can be
achieved after wages have fully adjusted to
shocks is the full information level of output.
Furthermore, in the short run, before contracts
are renegotiated, output deviates from full in­
formation output only when shocks occur.
Thus, output stabilization implies that the
monetary policymaker seeks to stabilize output
at its full information level. In achieving this
goal, the policymaker attempts to keep output
where the private sector would produce if it
recognized and fully adjusted to the shocks
disturbing the economy.4
W e consider three types of policy targets.
Price level targeting involves setting the money
stock so that the aggregate demand curve
strikes the aggregate supply curve at a point
like point A in figure 2. Thus, the price level
target might be P . When demand or supply
shocks occur, the monetary authority will at­
tempt to maintain the short-run equilibrium
price level at P0. In contrast, real output target­
ing involves changing the money stock so that
the aggregate demand curve intersects the ag­
gregate supply curve at Ov the target level
for real output. Because the full information
output level, QFI, is the level that would be
achieved after all adjustments have taken place,
the monetary authority would set the real out­
put target at this value. Finally, nominal GNP
targeting involves setting the money stock so
that the product of the equilibrium price (P)
and equilibrium output (Q) equals the target for
nominal GNP, (PQ)*. Under this procedure, the
monetary authority does not attempt to deter­
mine the specific price and real output com­
ponents of nominal GNP; instead, the
policymaker is concerned with their product.

ers. Stochastic shocks that originate with unexpected
policy actions can also adversely impact the economy.

35
What actions can be taken in the face o f de­
mand and supply shocks? If aggregate demand
shifts unexpectedly to the right, as was illus­
trated in figure 2, stabilizing the price level re­
quires the policymaker to contract the money
stock; this would shift the aggregate demand
curve back to its original position and restore
the original price level, P0, at point A. This same
monetary policy response is also necessary to
stabilize either real output or nominal GNP.5
Thus, for demand shocks, the policy response is
identical regardless of the specific goal of the
policymaker. Because demand shocks move
prices and output in the same direction, a
policy that offsets price changes will also offset
output and nominal GNP movements simultane­
ously. This result is not true, however, for
supply shocks.
The graphical representation o f a negative
supply shock is presented in figure 3. As the
supply shock shifts the aggregate supply curve
to the left (from ASo to ASJ, the resulting inci­
pient shortage of goods at the initial price level
puts upward pressure on the price level. The
rise in prices, which reduces the aggregate
quantity of goods demanded, continues until the
reduced quantity demanded is equal to the
lower quantity supplied (point F).
An important feature of this model is the rela­
tion between the intersection of the full infor­
mation output level and the short-run aggregate
supply curve for various values of the supply
shock. In figure 3, a negative supply shock
shifts both Qfi (from QFI to QFI) and the shortrun aggregate supply curve to the left. The in­
itial intersection of short-run aggregate supply
and full information output occurred at point A;
after the shock, these curves intersect at point
H. Similarly, a positive supply shock would shift
both QF1 (from QFI to QFI) and the short-run ag­
gregate supply to the right. In this case, shortrun aggregate supply and full information out­
put would intersect at point K after the shock.
It can be demonstrated that these intersec­
tions of short-run aggregate supply and full in­
formation output occur at the same level of

5lt may seem perverse for monetary policy to attempt to
reduce real output! Recall, however, that we are abstrac­
ting from the growth in output. As a result, this seemingly
perverse policy is just the graphical analog of trying to
smooth out cyclical variations in real output that occur
along the economy’s long-run growth path.
6See Bean (1983) or Bradley and Jansen (1989) for a for­
mal demonstration of this claim.



nominal spending. In other words, the value of
PoQo at point A, PiQi at point H and P2Qj at
point K are identical.6 The dashed line connec­
ting these points contains all possible intersec­
tions of short-run aggregate supply and full in­
formation output after a supply shock, but with
the nominal wage held constant. Since these in­
tersection points are points o f identical nominal
spending, the dashed line connecting them is
called a rectangular hyperbola. This result is
generated by the contract market structure of
the labor market; it is not a feature of all ag­
gregate demand-aggregate supply models. This
model is used because it provides a strong
theoretical rationale for the use of nominal GNP
targeting.
In the absence of any policy response, the
negative supply shock shown in figure 3 would
move the economy from equilibrium at point A
to point F in the short run and then to point G
in the long run. Monetary policy actions design­
ed to maintain the price level at its original
value would decrease the money stock to re­
duce the demand curve. In figure 3, point B is
the new short-run equilibrium following the
supply shock and the reduction in aggregate de­
mand required to keep the price level at P . In
this case, however, price stabilization produced
a larger decline in real output than did the in­
itial negative supply shock.
On the other hand, maintaining real output at
(J-<) would require sufficient growth in the
money stock to shift the aggregate demand
curve to the right to point C. In this case, the
original output level, O^, is maintained, but the
price level has jumped sharply. Moreover, the
inflationary impact of output stability does not
stop at point C. Because the rise in output
prices is a surprise to workers and other input
suppliers, input prices will rise and the shortrun aggregate supply curve will shift to the
left again. Thus, even without further policyinduced demand changes, the price level will be
driven up further; if monetary policy responds
again to maintain real output, the price spiral
will continue onward and upward.7

7Point B is also a temporary position. When output is below
its natural or full employment rate, unemployment is also
high. This unemployment will eventually push down wages
and costs, moving the short-run aggregate supply curve to
the right and intersecting the long-run aggregate supply
curve at a point like D. Thus, price stabilization policy in
the natural rate model may perversely lead to deflation.

NOVEMBER/DECEMBER 1989

36
Finally, consider what happens with nominal
income targeting. In this case, the monetary
authority adjusts the money stock to keep
nominal GNP at its target level. In this model,
the intersection o f the short-run aggregate
supply and full information output after a supp­
ly shock occurs at the same level o f nominal
spending as their intersection before a supply
shock. For example, in figure 3, points A and H
are intersections o f full-information output and
short-run aggregate supply before and after a
supply shock. Nominal GNP targeting requires
reducing the money supply enough to move the
economy from point F after the supply shock
occurs to point H; nominal spending at point H
is equal to nominal spending at the initial equi­
librium point A. Because a supply shock causes
short-run aggregate supply and full information
output to intersect at points of constant nominal
spending, nominal GNP targeting keeps the
economy at its full information output level.
That is, under nominal GNP targeting, the ag­
gregate demand will always intersect the shortrun aggregate supply curve at the full informa­
tion output level f o r any value o f the supply
shock.
Nominal income targeting yields two potential
improvements over policies designed to stabilize
the price level as the level o f real output. First,
nominal income targeting permits both price
and output to adjust simultaneously; thus, it
avoids more extreme movements in either price
or output alone that occur when policy is di­
rected toward stabilizing one of these variables.
Second, in the model we discuss, nominal in­
come targeting also enables the economy to
avoid the changes in nominal wages that pro­
duce a second set of adjustments. Nominal
wages will not change because nominal GNP
targeting always stabilizes output at the full in­
formation output level, the level firms would
choose to produce if they could recognize and
fully adjust to the shocks confronting them.
Thus, nominal GNP targeting responds as well
as price or output level targeting to demand

8Note that this case does not rule out fluctuations in real
GNP, as shocks to the aggregate supply function will alter
real GNP and price while keeping nominal GNP constant.
These shocks to aggregate supply can be anything that af­
fects the ability of the economy to produce output, such as
changes in production technology, exogenous OPEC oil
price shocks and droughts. All of these factors may alter
the natural rate of output; under nominal GNP targeting,
actual real output will also change to remain equal to the
natural rate of output.

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shocks and is superior to either in responding
to supply shocks, especially if policy is directed
toward keeping output at the full information
level.

TARGETING NOMINAL GNP:
COULD IT W ORK IN PRACTICE?
Despite concern expressed by some commen­
tators about the division o f nominal GNP into its
real GNP and price level components, nominal
GNP targeting is “perfectly" stabilizing at the on­
ly sustainable output level, the “natural” or full
information rate of output.8 Monetary policy­
makers need not be concerned with anything
except the nominal GNP target itself because the
real GNP level achieved will automatically be
the full information rate o f output!9
Thus, one key result o f nominal GNP targeting
is that policymakers don’t have to estimate the
natural rate o f output as they would under a
real GNP targeting procedure. Under nominal
GNP targeting, hitting the preannounced target
is sufficient to generate an equality between the
actual and full information rate of real GNP, even
if the policymaker knows nothing about the fu ll in­
formation rate o f output at any point in time.
The obvious question is, To what extent do
these results apply to the real economy?

Can the M onetary Authority Con­
trol Nominal GNP?
Targeting nominal GNP requires that the mon­
etary authority control nominal GNP. That is, a
change in the money stock must lead to a
predictable consequent change in nominal GNP.
Few economists doubt that, in broad terms,
nominal GNP can be influenced by the mone­
tary authority. For example, the St. Louis equa­
tion, which has been used to aid policymaking
at the Federal Reserve Bank of St. Louis and
elsewhere, demonstrates the relationship be­
tween changes in the money stock and subse-

9Stabilizing nominal GNP is not a desirable goal in and of
itself; instead, it is desirable because of its implications for
stabilizing output at the full information level. In this sense,
nominal GNP targeting actually represents an “ intermedi­
ate target” of policy. An intermediate target is one that is
adopted because, by achieving it, one also achieves the
ultimate policy goals.

37

quent changes in nominal GNP over a period of
several quarters.10
Of course, questions about the controllability
o f nominal GNP are really questions about the
impact o f money on the components of spen­
ding. They apply equally well to the price or
output level. To see this, assume that policy­
makers adopt a real GNP target. Policymakers
might proceed with the two-step procedure
described recently by Benjamin Friedman (1988),
in which policymakers first choose a target
value for real GNP, then estimate the value of
the money stock consistent with their real GNP
goal. The estimated money stock is an in­
termediate target o f policy in lieu of attempting
to hit the real GNP target over periods shorter
than a quarter. This procedure works only if
achieving the money target is related to achiev­
ing the real GNP target. But such a relationship
between money and nominal GNP is exactly
what is required for nominal GNP targeting to
be practical.11
Moreover, as discussed earlier, hitting a nomi­
nal GNP target will automatically guarantee hit­
ting a real GNP level equal to the full informa­
tion rate of output. Since this is not measured
directly, but is, instead, estimated from various
sources, it is useful to know that hitting a tar­
geted nominal GNP level, that can be measured
directly, will keep real GNP at its full informa­
tion rate.12

D o Policym akers K n ow Enough
A bou t the Econom y?
A common criticism o f policymaking is that
economists and policymakers do not know
enough about how the economy functions to
have a model that describes accurately the
behavior o f macroeconomic variables like real

10The historical reference is Andersen and Jordan (1968)
and Andersen and Carlson (1970). A recent update is
reported in Carlson (1986).
"F o r a critical analysis of intermediate targeting, see B.
Friedman (1975, 1988).
12One issue in the controllability of nominal GNP arises
because nominal GNP is only observed every quarter, and
even then is available only with a lag of several weeks.
The question arises whether quarterly observations on
GNP are sufficiently timely to allow the monetary authority
to target nominal GNP. This issue is specious. First, no
technical issue prevents more frequent (e.g., monthly)
observation of nominal GNP. Second, numerous economic
variables are observed more frequently than nominal GNP
and are related to nominal GNP both theoretically and
statistically. These can be used to forecast movements of



GNP and the price level. In this case, it has
been argued that policy action based on a flaw­
ed or incomplete model might cause more harm
than good. To avoid this problem, Milton Fried­
man and others have advocated policy rules
that do not depend on the state o f the econ­
omy; these rules are called "non-contingent”
monetary policy rules.
Milton Friedman and others have emphasized
that "long and variable lags” exist between
changes in money aggregates and the full re­
sponse o f GNP. Because the variability in these
lags is neither predictable nor well understood,
Friedman argues that ignorance o f the causes
and patterns o f variability in the lag structure
justifies the use of a constant money rule, such
as having a money aggregate grow at exactly 3
percent per year forever. This type of money
rule is non-contingent; that is, it does not vary
even though nominal GNP, the price level
and/or real output varies.
In contrast, nominal GNP targeting can be
achieved only with a state-contingent money
rule. For example, a rule specifying 3 percent
annual nominal GNP growth requires faster
money growth when nominal GNP growth is
less than 3 percent and slower money growth
when nominal GNP growth is above 3 percent.
In practice, nominal GNP targeting is a "feed­
back” money rule, with the feedback running
from observed GNP changes to money growth.
One approach to evaluating the potential use­
fulness o f state-contingent money rules is to see
whether there is a rule whose favorable proper­
ties are robust across alternative theoretical
models. This is analogous to Bennett McCallum’s
search for a money rule with desirable proper­
ties across alternative empirical models. The
shaded insert describes a nominal GNP rule pro­
posed by McCallum that satisfies the criterion of

nominal GNP between observations. Over a decade ago,
LeRoy and Waud (1975, 1977) demonstrated that such
forecasts could be made with data observed at different
frequencies using a statistical approach known as the
Kalman filter. Thus, monthly or even weekly estimates of
nominal GNP are available as guides to policymakers.
Finally, it is important to note that alternative policies such
as price level targeting or real GNP targeting also face the
observability question. The price level and real output are
also observed quarterly, although various components of
the price level such as the Consumer Price Index and the
Wholesale Price Index are observed monthly. Thus,
targeting other variables does not avoid any problems
associated with infrequent measurements of the targeted
variable.

NOVEMBER/DECEMBER 1989

38

McCallum's Nominal GNP Rule
Recently, Bennett McCallum has recom­
mended a particular rule for targeting
nominal GNP that uses the monetary base.
This rule specifies how the policymaker can
adjust the monetary base to counteract a por­
tion o f the current change in nominal GNP.
The reason that only a portion of the total
change in nominal GNP is offset is to avoid
an instrument instability problem with use of
the monetary base. The proposed policy is
nondiscretionary: it embodies a targeted path
for nominal income growth of 3 percent per
year. The particular rule he recommends is:
Abt = 0.00739 - (l/16)(v_, - vt_17) +
A(x*_, - xt_,),
where Abt is the change in the (natural
logarithm o f the) monetary base, v, is (the
natural logarithm of) base velocity, xt is (the
natural logarithm of) nominal GNP and x* is
the target path for (the natural logarithm of)
nominal GNP. Since this rule applies quarter­
ly, the constant o f .00739 yields a 3 percent
annual growth in the monetary base, ceteris
paribus. This rule specifies that the monetary
base grows at 3 percent per year, with devia­
tions from the 3 percent rule for changes in
a 16-quarter difference in velocity, and for
deviations o f nominal GNP from target. The
base target is deterministic, simply growing
at 3 percent per year.
McCallum’s rule has the monetary base
responding to a 16-quarter difference in
velocity in an attempt to detect and respond
to permanent changes in velocity. A one-time
permanent increase in velocity will lead to a
reduction in the monetary base growth rate
spread over a 16-quarter interval, after which
it returns to its 3 percent per annum rate. If
the velocity change lasts only one quarter,
then the response of base growth is positive
for one quarter, negative for the following


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quarter, and afterwards returns to its steady
3 percent per annum rate (absent further
changes in velocity).
The term A(x*_, - xt_,) in the base rule in­
dicates the response of base growth to last
quarter’s deviation o f nominal GNP from
target. The parameter A indicates the speed
with which deviations o f nominal GNP from
target are corrected. The larger is A, the
quicker is the deviation of nominal GNP from
target corrected by base growth. Too large a
value for A can cause dynamic instability,
however, so this parameter must be chosen
with care. McCallum recommends a value of
.25, which would generate an increase in
base growth o f 1 percent per year for each 1
percent deviation o f nominal GNP from its
targeted path.
To investigate the properties of this propos­
ed rule, McCallum conducts simulation ex­
periments from which he concludes that the
adoption o f his rule over the 1954-85 period
would have produced a root mean square er­
ror (RMSE) of nominal income of 2 percent
vs. an actual RMSE over this period of nearly
6 percent.
An issue that McCallum does not address is
deviations o f real GNP from the natural rate
o f output under his rule relative to the actual
experience. Indeed, this is difficult to assess
for several reasons. First, measures o f the
natural rate o f output such as potential GNP
are, at best, rough constructs. Second, alter­
native macroeconomic models reach very dif­
ferent conclusions about the decomposition of
nominal GNP into its real GNP and price level
components. Therefore, McCallum’s rule, even
if it smooths nominal GNP relative to the his­
torical experience, may not be optimal be­
cause part of the historical experience may
reflect changes in the natural rate o f output,
to which real GNP and, under some monetary
procedures, nominal GNP should respond.

39
generating desirable results in simulations
across a variety of empirical models.
Of course, it is difficult to evaluate the robust­
ness of a policy rule across alternative theoreti­
cal constructs; moreover, even doing so is no
guarantee that the theoretical constructs con­
sidered actually contain one that conforms
"closely” (somehow defined) to the underlying
“real-world” economy. Still, the exercise is worth
conducting, if only to pinpoint the limitations of
our knowledge of the economy. Indeed, such ig­
norance of how the economy works was pre­
cisely the reason Friedman used to advocate his
constant money growth rule.
While such an exercise is complicated by the
plethora of theoretical macroeconomic con­
structs available today, many that incorporate a
natural rate structure on the supply side seem
to show that a nominal GNP target, i f achievable
on a timely basis, will better stabilize the econo­
my than a non-contingent policy rule, such as a
fixed money growth rule. The specific statecontingent money rule found to be best, how­
ever, differs significantly across these models.
Moreover, these models essentially ignore the
effect o f the lags that would be present in em­
pirically implementing the state-contingent
money rule.
After incorporating both the effect of these
lags and the inconsistencies across models in
ranking alternative state-contingent monetary
policy rules, the presumed advantages of
nominal GNP targeting become more tenuous.13
For instance, the advantage of using nominal
GNP targeting in the model described in this
paper depends on the ability of the policymaker
to recognize and respond to changes in nominal
GNP more quickly than the private sector can
recognize and respond to shocks to the
economy. While this may seem reasonable for
the model we use, other theoretical models
yield other conclusions.

,3Bean (1983), however, demonstrates that nominal GNP
targeting in a multiple-period, wage-contracting setting is
still preferable to money targeting. In this case, the
nominal GNP target is a prospective target, in which ra­
tional forecasts of next period’s nominal GNP are held
constant while the actual value of next period’s nominal
GNP may vary with unanticipated shocks. In this case,
however, nominal GNP targeting is itself dominated by a
more general state-contingent rule. Bradley and Jansen
(1989) extend Bean’s results to a model with elastic labor
supply and wage indexing to price.
14See Rasche (1973) for an early example.
15See Bradley and Jansen (1988) for an analysis of price
level targeting in a more recent version of this model.



For example, one aggregate demand-supply
model generates a positively sloped aggregate
supply curve by assuming that workers have in­
complete information about the current eco­
nomic environment; specifically, they lack infor­
mation on the current prices of goods that they
purchase infrequently. Workers accept nominal
wage offers based on their forecasts of the
price level rather than the price level itself.
Nominal wages are assumed to be set by an
auction market for labor services, in which the
wage adjusts instantaneously to current eco­
nomic conditions.14 In this case, a larger-thanexpected rise in the price of all goods means
that workers’ forecast of the price level are
below the actual price level, thereby inducing
workers to accept lower nominal wage offers
than usual. Until workers discover what has
happened to the price level (which includes
observing prices for goods purchased relatively
infrequently), they will continue to offer their
labor services at a lower real wage than the one
they would demand if they were fully informed.
This lower real wage induces firms to expand
employment and output. In this alternative
framework, nominal GNP targeting may be
preferable to a fixed money rule; but price level
targeting always works to keep real GNP at the
natural rate.15
Thus, even within an aggregate demandsupply framework, different underlying assump­
tions about how the labor market operates will
produce different evaluations of the relative
usefulness of alternative policy rules. Until
economists can agree on a model that reason­
ably explains changes in the state of the
economy, it is difficult to take the policy recom­
mendations from any particular model very
seriously. In particular, advocates of nominal
GNP targeting cannot point to overwhelming
theoretical justification for their policy recom­
mendation.16 Consequently, while the theoretical

16An additional point in the issue of ignorance of the true
model is the well-known result of William Brainard (1967).
If the parameter values of the economic model are not
perfectly known, policymakers should respond cautiously
when employing any state-contingent policy rule, including
nominal GNP targeting. Investigating the properties of
nominal GNP targeting in a variety of theoretical or em­
pirical models is one way to assess the importance of this
ignorance of the true model for policy prescriptions. Since
the true model is almost certainly unknown to anyone not
practicing mysticism in academic or policymaking garb,
however, the theoretical case for any state-contingent
policy rule is again weakened.

NOVEMBER/DECEMBER 1989

40
model outlined earlier in this paper strongly
supports the usefulness of nominal GNP target­
ing, a similar model that differs only in the
underlying assumptions about the labor market
suggests that price level targeting is superior to
nominal GNP targeting.

CONCLUSION
The potential usefulness of nominal GNP tar­
geting for monetary policy purposes has gained
widespread attention in recent years. Nominal
GNP targeting has several useful features in the
context of a simple theoretical model; chief
among them is the stabilization of real GNP at
its natural rate of output. Moreover, this stabili­
zation occurs automatically, without monetary
policymakers having to know what the natural
rate of output actually is. Finally, in the case of
demand (but not supply) shocks, nominal GNP
targeting will also provide price level stabilization.
While nominal GNP targeting may be superior
theoretically to alternative policy targets, several
problems arise when considering real-world ap­
plications of nominal GNP targeting. Ignorance
of the correct equations, parameter values and
lag structure that characterize the U.S. economy
reduces the appeal of nominal GNP targeting.

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RESERVE BANK OF ST. LOUIS
Federal Reserve Bank
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FEDERAL RESERVE BANK OF ST. LOUIS
REVIEW INDEX 1989

JANUARY/FEBRUARY
R. Alton Gilbert, “ Payments System Risk: What
Is It and What Will Happen If We Try To Reduce
It?”
Keith M. Carlson, “ Federal Budget Trends and
the 1981 Reagan Economic Plan”
Cletus C. Coughlin and Geoffrey E. Wood, “ An
Introduction to Non-Tariff Barriers to Trade”
Michael T. Belongia and Werner Hermann, “ Can
a Central Bank Influence Its Currency’s Real
Value? The Swiss Case”
MARCH/APRIL
John A. Tatom, “ U.S. Investment in the
1980s: The Real Story”
Michelle R. Garfinkel, “ The FOMC in
1988: Uncertainty’s Effects on Monetary Policy”
Gerald P. Dwyer, Jr. and R. W. Hafer, “ Interest
Rates and Economic Announcements”
Mack Off, “ Is America Being Sold Out?”
H. Robert Heller, “ Money and the International
Monetary System”
MAY/JUNE
Jeffrey D. Karrenbrock, “ The 1988 Drought: Its
Impact on District Agriculture”
Lynn M. Barry, “ Eighth District Banks: Back in
the Black”
Thomas B. Mandelbaum, “ The Eighth District
Business Economy in 1988: Still Expanding, But
More Slowly”
R. W. Hafer and Scott E. Hein, “ Comparing
Futures and Survey Forecasts of Near-Term
Treasury Bill Rates”
Gerald P. Dwyer, Jr. and R. Alton Gilbert, “ Bank
Runs and Private Remedies”




JULY/AUGUST
Michelle R. Garfinkel, “ What Is An ‘Acceptable’
Rate of Inflation? A Review of the Issues”
R. W. Hafer, “ Does Dollar Depreciation Cause
Inflation?”
Cletus C. Coughlin and Thomas B. Mandelbaum,
“ Have Federal Spending and Taxation Con­
tributed to the Divergence of State Per Capita In­
comes in the 1980s?”
Dennis IV. Jansen, “ Does Inflation Uncertainty
Affect Output Growth? Further Evidence”
Daniel L. Thornton, “ Tests of Covered Interest
Rate Parity”
SEPTEMBER/OCTOBER
Karl Brunner, “ The Role of Money and Monetary
Policy”
Michelle R. Garfinkel, “ The Causes and Conse­
quences of Leveraged Buyouts”
Michelle R. Garfinkel and Daniel L. Thornton,
“ The Link Between M1 and the Monetary Base
in the 1980s”
Jurgen von Hagen, “ Monetary Targeting with Ex­
change Rate Constraints: The Bundesbank in
the 1980s”
NOVEMBER/DECEMBER
Werner Hermann and G. J. Santoni, “ The Cost
Of Restricting Corporate Takeovers: A Lesson
From Switzerland”
Keith M. Carlson, “ Do Price Indexes Tell Us
About Inflation? A Review of the Issues”
Michael D. Bradley and Dennis W. Jansen,
“ Understanding Nominal GNP Targeting”

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