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Chinese Growth:
A Source of U.S. Export Opportunities
William Poole
This article was originally presented as a speech to the Fiscal Affairs and Government Operations
Committee, Council of State Governments’ Southern Legislative Conference (SLC), Louisville,
Kentucky, July 31, 2006.
Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 471-83.

ith all the press reports about
the enormous growth of China’s
exports to the United States, I start
with a story running in the opposite direction. Kanawha Scales and Systems is a
company located in Poca, West Virginia, which
has a population of roughly 1,000. Chinese purchases of this company’s coal-loading machines
have grown to account for about one-third of
the company’s $50 million in annual revenues.1
How many stories are there like the Kanawha
Scales story? Well, I’ll share another example. A
recent report indicates that a group from Kentucky
will be involved in the construction of a Thoroughbred racetrack in China, the first in mainland
China.2 As part of this deal, 1,500 Kentucky
Thoroughbreds will be sold and shipped to China
and it is also possible that a number of Chinese
will come to Kentucky to learn how to be trainers,
exercise riders, jockeys, grooms, and hot walkers.
Are these isolated examples? Just how important to the United States are sales of U.S. goods
and services to China?

My purpose this morning is to convince you
that the answer to this question is clear. Sales of
U.S. goods and services to China are large, are
growing, and are very important to the United
States. In fact, as I’ll detail shortly, firms in the
16 member states of the Southern Legislative
Conference (SLC) are engaged in substantial
exporting activity to China. I’ll discuss major
features of the economic relationship between
the United States and China, but with special
emphasis on U.S. exports to China because that
critically important part of the relationship is not
well understood.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their comments, particularly Cletus C. Coughlin, vice
president and deputy director of research, who
provided special assistance.

TRADE PROSPECTS
1

See www.usatoday.com/money/world/
2006-04-19-china-exports-usat_x.htm.
See http://charlotte.bizjournals.com/charlotte/stories/2006/03/20/
story6.html.

Increases in international trade depend on
three key factors—income growth, reductions in
trade barriers, and declines in transportation costs.

William Poole is the president of the Federal Reserve Bank of St. Louis. The author appreciates comments provided by colleagues at the
Federal Reserve Bank of St. Louis. Cletus C. Coughlin, vice president and deputy director of research, provided special assistance. The
views expressed do not necessarily reflect official positions of the Federal Reserve System.

© 2006, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in
their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made
only with prior written permission of the Federal Reserve Bank of St. Louis.

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Poole

Figure 1
World Merchandise Export Growth and GDP Growth, 1950-2004
Growth (% year/year)
16
12
9.0
2004

Export Growth
8
4

3.7
2004

GDP Growth
0

–0.6
1981

–4

–2.8
1958

–7.3
1975

57
19
60
19
63
19
66
19
69
19
72
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02

–0.6
2001

–8

–2.2
1988

SOURCE: World Trade Organization, International Trade Statistics 2005.

Income growth has been the most important of
these three factors stimulating increased trade
worldwide, with reductions in trade barriers a
distant second and declines in transportation
costs an even more distant third.3 The direct implication of this research finding is that any discussion of trade flows should begin by examining
income growth. In fact, almost without exception
over the past 55 years, growth in world merchandise exports has exceeded growth in gross domestic product (GDP).4 (See Figure 1.)
It is reasonable, therefore, to anticipate a
strong relationship between Chinese growth and
U.S. exports, and that’s exactly what we observe.
The transformation of the Chinese economy has
been accompanied by a huge increase in international trade and capital flows. U.S. exports to
China have also been spurred by reductions in
Chinese trade barriers, especially as part of China’s
3

See Baier and Bergstrand (2001). Trade barriers and transportation
costs are key components of trade costs, which are discussed in
detail by Anderson and van Wincoop (2004).
Using annual data from the World Trade Organization’s
International Trade Statistics 2005, world merchandise export
growth exceeded world GDP growth in all but eight years between
1950 and 2004.

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entry into the World Trade Organization in 2001.
In addition to a substantial decline since 1982
in import tariffs, in 2005 China eliminated the
licenses that were required for the importation
of many goods.5

CHINESE AND U.S. GROWTH
China, with a population in excess of one
billion, has maintained an astonishing rate of
economic growth over the past 28 years. Beginning
in 1978, China embarked on a series of policy
changes that have led to an economy increasingly
reliant on markets and price signals for allocating
productive resources.6
As of July 2006, the Chinese population was
1.3 billion, which is more than four times as large
as the U.S. population of 298 million. In terms of
total production, measured in dollars at purchasing power parity, the Chinese economy is the
5

See “Building Explosion in China Pumps Up Exports from USA,”
a web article at www.usatoday.com/money/world/
2006-04-19-china-exports-usat_x.htm in USA Today.

Prasad and Rajan (2006) estimate that between one-half and twothirds of the Chinese economy is currently market-based.

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Poole

Figure 2
China: The World’s Second-Largest Single Economy in Terms of Purchasing Power Parity
$12.37

U.S.
E.U.
China

$8.16

Japan
India
Germany
U.K.
France
Italy
Brazil
Russia
2

$ Trillions in 2005

SOURCE: CIA World Factbook.

Figure 3
Leading Exporters and Importers in World Merchandise Trade, 2004

Exporters

Value
($ billions)

Share
(%)

Rank

Importers

Value
($ billions)

Share
(%)

Germany

912.3

10.0

United States

1,525.5

16.1

United States

818.8

8.9

Germany

716.9

7.6

China

593.3

6.5

China

561.2

5.9

Japan

565.8

6.2

France

465.5

4.9

France

448.7

4.9

United Kingdom

463.5

4.9

Netherlands

358.2

3.9

Japan

454.5

4.8

Italy

349.2

3.8

Italy

351.0

3.7

United Kingdom

346.9

3.8

Netherlands

319.0

3.4

Canada

316.5

3.5

Belgium

285.5

3.0

Belgium

306.5

3.3

Canada

279.8

2.9

Rank

SOURCE: World Trade Organization.

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Figure 4
China’s GDP per Capita
RMB
12,000
10,000
8,000
6,000
4,000
2,000

0
20
0

5
19
9

0
19
9

19
8

0
19
8

5
19
7

0
19
7

5
19
6

19
6

SOURCE: National Bureau of Statistics, China Statistical Yearbook 2004; National Bureau of Statistics Plan Report.

world’s second-largest economy, trailing only the
United States. In 2005 the Chinese GDP exceeded
$8 trillion, which was roughly two-thirds the U.S.
GDP. (See Figure 2.) Not surprisingly, these two
countries were two of the three leading exporting and importing countries in the world.7 (See
Figure 3.)
The most vivid illustration of rapid Chinese
growth can be seen by examining the Chinese
economy on a per capita basis. Adjusted for inflation, China’s per capita GDP in 2004 was 6.6 times
its 1980 level. (See Figure 4.) Annual growth rates
of real per capita GDP in excess of 5 percent have
been the norm in recent years. (See Figure 5.) In
the late 1970s, China’s real GDP per capita was
slightly less than 5 percent of the U.S. level. Today
it exceeds 10 percent. (See Figure 6.) Thus,
although the overall Chinese economy is large,
China is still a country with a relatively low level
of per capita income. To provide perspective,
7

For 2004, the leading countries in terms of total world exports were
Germany with a 10.0 percent share, the United States with an 8.9
percent share, and China with a 6.5 percent share. In terms of
imports, the leading countries were the United States with a 16.1
percent share, Germany with a 7.6 percent share, and China with
a 5.9 percent share.

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China’s real per capita GDP today is about equal
to U.S. per capita GDP in 1886.

THEORY OF INTEGRATING A
LARGE LABOR-ABUNDANT
COUNTRY INTO THE WORLD
ECONOMY
Some basic economic theory will provide a
foundation for viewing the integration of the
Chinese economy into the world economy. The
analysis applies not only to the integration of
the Chinese economy but also to similar developments that are occurring simultaneously in India
and the countries of the former Soviet Union.8
Economists view the integration of these
economies into the global economy as a labor
“shock.” Their integration can be viewed as a
very large increase in the world’s effective labor
supply. To facilitate my discussion, assume that
the bulk of this increase in the labor supply in
recent years has tended to be low-skilled. Employing this simplifying assumption, two consequences
8

This idea has been expressed by Wolf (2006).

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Poole

Figure 5
Chinese and U.S. Growth Rates of Real GDP per Capita
Percent
15

10
China
5
U.S.
0

–5

0
20
0

5
19
9

0
19
9

5
19
8

0
19
8

19
7

0
19
7

5
19
6

0
19
6

5
19
5

19
5

–10

SOURCE: Penn World Tables (constant prices: chain series).

Figure 6
China’s Real GDP per Capita Relative to the U.S.
Percent
15

0
20
0

5
19
9

0
19
9

5
19
8

0
19
8

5
19
7

0
19
7

5
19
6

0
19
6

5
19
5

19
5

SOURCE: Penn World Tables (U.S. = 100 in current prices).

are a direct result of the increased supply of lowskilled labor. One is that wages of low-skilled
labor in high-income countries will tend to fall,
or to increase more slowly, than before China’s

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

entry into the world trading system. Second, prices
of those goods that require relatively large amounts
of low-skilled labor should tend to decline relative
to the prices of those goods that require relatively

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large amounts of high-skilled labor. For convenience of exposition, I’ll refer to goods produced
with low-skilled labor as “low-tech” goods and
goods produced with high-skilled labor as “hightech” goods. Obviously, there is a continuum of
goods from low to high tech, but the simplification
will make it easy to understand the basic economic
forces at work.
The first effect tends to depress income gains
of low-skilled labor in high-income countries.
Obviously, the share in total population of highskilled workers is greater in high-income countries
than in low-income countries. Because of the large
increase in low-skilled workers worldwide, lowskilled workers in the United States are likely to
experience downward pressure on their real wages
due to the increased competition associated with
Chinese exports.9 The adverse income change
generates demands for a government response to
ameliorate the adverse market change.
The problem is real: Low-skilled workers in
the United States have been adversely affected by
imports of goods produced by low-skilled workers
abroad. However, the nature of the government
response is very important. Trade restrictions that
hinder the importation of goods from China are
unlikely to be a good solution because the United
States would simply be forgoing the benefits of
Chinese imports. Indeed, those lower-priced goods
are important to lower-income, working families
in the United States. The only appealing solution
for the United States as a whole is to adopt policies that will increase the skill levels of affected
workers, so that they can increase their compensation and employment prospects, which will
allow them to adjust to the evolving economic
environment.
Now consider the effect tending to reduce
the prices of goods made with low-skilled labor.
This relative price change, in which low-tech
goods decline in price relative to high-tech goods,
is associated with two other important price
changes. The first involves a country’s terms of
trade, which is the (average) price of a country’s
exports relative to the (average) price of its imports.
9

In fact, declining real compensation for low-skilled workers has
been an issue for many years in the United States.

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In the case of China, the prices of the goods that
China ships to the rest of the world should tend
to decline relative to the prices of goods that it
buys from the rest of the world.
Generally speaking, as the price of Chinese
exports declines relative to the price of its imports,
countries purchasing Chinese goods should
become better off. In theory, the more dissimilar
another country’s production and consumption
is to China’s, the more likely the country is to benefit by China’s integration into the world economy.
Thus, a country such as the United States should
tend to benefit from China’s integration. Of course,
the magnitude of the gains for the United States
depends on the impact of Chinese exports on U.S.
import prices. Recent research by staff economists
at the Board of Governors of the Federal Reserve
System found that Chinese exports have caused
declines, albeit small, in U.S. import prices.10,11
The public-policy challenge is considerable, however, because gains for the United States as a whole
are accompanied by downward pressure on wages
of U.S. low-skilled workers, as already noted.
There is another change that reduces and
possibly negates the net benefits for the United
States. Coinciding with China’s rapid growth
has been substantial increases in China’s imports
of commodities such as oil. In fact, China has
become the world’s second largest consumer of
oil. Chinese demand for oil has undoubtedly
contributed to higher oil prices. Given the scale
of U.S. oil imports, higher oil prices have certainly
reduced the beneficial effects for the United States
of recent developments in China.12
10

See Kamin, Marazzi, and Schindler (2006).

Rodrik (2006) argues that China’s export bundle is more sophisticated than other countries with similar per capita incomes. While
labor-intensive exports, such as toys, clothing, and electronics
products that entail simple assembly operations, are important in
China’s export basket, Rodrik argues that foreign investment has
played a major role in the evolution of Chinese exports. Foreign
investors dominate Chinese exports. Their contribution of advanced
technology, and the resulting transfer of technology, has resulted
in Chinese exports that are relatively more sophisticated than those
of comparably developed countries.

Not surprisingly, oil is at the center of a contentious political issue.
China’s desire for increased oil supplies has led to relationships
with a number of countries, such as Sudan and Uzbekistan, who
many view as unsavory in terms of their records on human rights.

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Poole

Figure 7
Chinese Exports and Imports as a Percent of GDP
Percent
40
35
30
25

Exports

20
15

Imports

10
5

4
20
0

9
19
9

19
9

9
19
8

4
19
8

19
7

SOURCE: IMF, Direction of Trade Statistics, and official Chinese statistics.

HOW CHINESE GROWTH
AFFECTS TRADE
The preceding discussion has focused on the
relative-price impacts of China’s integration into
the world economy. Changes in relative prices,
however, are not the only spur to changes in
economic activity. China’s economy has reached
such a size that in recent years it has served as an
engine of growth not only in Asia but also worldwide. Put simply, a wealthier China means rising
Chinese demand for goods of all sorts, including
high-tech goods that China does not produce.
One manifestation of this fact is that Chinese
growth has resulted in large effects on overall trade
flows. The integration of the Chinese economy
into the world economy can be seen very clearly
by examining how Chinese exports and imports
have changed since the late 1970s. In 1979,
Chinese exports as a share of Chinese GDP was
5 percent. Since then the share has risen to 36
percent. (See Figure 7.) The course of Chinese
imports has taken a similar path, rising from
roughly 6 percent of GDP in 1979 to 34 percent
in 2005. These import and export shares may be
compared with the shares for the United States:
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Imports are 16 percent of U.S. GDP and exports
are 10 percent.
As Chinese exports have grown faster than its
imports, the Chinese trade balance has increased.
A close look at China’s trade balance reveals that
from 1979 to the mid-1990s, the average yearly
balance was roughly zero. (See Figure 8.) Since
the mid-1990s, the balance has tended to rise,
reaching a level of $102 billion in 2005, which is
4.4 percent of China’s GDP.

UNITED STATES–CHINA TRADE
The increase of China’s trade surplus since the
mid-1990s coincides with a substantial increase
in the United States–China bilateral trade balance.
In 1995 the U.S. bilateral trade deficit with China
was approximately $20 billion. (See Figure 9.)
Subsequently, this deficit has increased yearly,
reaching $202 billion for 2005, which was 28
percent of the overall U.S. trade deficit. (See
Figure 10.) Surprisingly, in 1995, China’s share
of the overall U.S. trade deficit was actually larger,
at 35 percent of the overall U.S. trade deficit.
Obviously, since 1995 the growth of U.S.
imports from China has exceeded the growth of
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Poole

Figure 8
China’s Trade Balance, 1979-2005
$ Billions
$101.9
2005

100
80
60
40

$32.0
2004

20
0

19
9

9
19
8

19
8

19
7

–20

SOURCE: China Statistical Yearbook.

Figure 9
U.S.—China Bilateral Trade Deficit and U.S. Trade Deficit
$ Billions
100,000
U.S.–China Bilateral Trade Deficit

0
–100,000

–201.54
2005

–200,000
–300,000
–400,000
–500,000

U.S. Trade Deficit

–600,000
–716.73
2005

–700,000

3
20
0

8
19
9

3
19
9

8
19
8

3
19
8

19
7

–800,000

SOURCE: U.S. Census Bureau, Foreign Trade Statistics.

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Poole

Figure 10
China’s Portion of the U.S. Trade Deficit
Percent
45
35

28.12
2005

25
15
5
–5

20
0

19
9

8
19
8

19
8

19
7

–15

SOURCE: U.S. Census Bureau, Foreign Trade Statistics.

Figure 11
U.S. Exports to and Imports from China
$ Millions
250,000

Import Growth

200,000

150,000

100,000
$45,543
1995
$11,754
1995

50,000

Export Growth

5
20
0

2
20
0

9
19
9

6
19
9

3
19
9

0
19
9

7
19
8

4
19
8

1
19
8

19
7

SOURCE: U.S. Census Bureau, Foreign Trade Statistics.

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Table 1
Top 10 U.S. Exports to China—Ranked by 2005 Exports
HS Industry Codes ($ millions)
Code

Description

2005

Share of U.S.
exports to China (%)

Electrical machinery and equipment and parts thereof;
sound recorders and reproducers, television recorders
and reproducers, parts and accessories

6,851

16.3

Nuclear reactors, boilers, machinery and mechanical
appliances; parts thereof

6,357

15.2

Aircraft, spacecraft, and parts thereof

4,381

10.4

Optical, photographic, cinematographic, measuring,
checking, precision, medical or surgical instruments
and apparatus; parts and accessories thereof

2,397

5.7

Oil seeds and oleaginous fruits; miscellaneous grains, seeds
and fruits, industrial or medicinal plants; straw and fodder

2,289

5.5

Plastic and articles thereof

2,259

5.4

Iron and steel

1,555

3.7

Organic chemicals

1,475

3.5

Cotton, including yarns and woven fabrics thereof

1,411

3.4

Pulp of wood or other fibrous cellulosic material; recovered
(waste and scrap) paper and paperboard

992

2.4

U.S. exports to China. Between 1995 and 2005,
U.S. imports from China increased more than
fivefold, while U.S. exports to China increased
by a factor of 3.6. (See Figure 11.) But note this
important fact: The growth in U.S. exports to
China has been far greater than the growth of U.S.
exports overall. Between 1995 and 2005, total U.S.
exports increased by a factor of 1.6, which is less
than half the rate of increase of U.S. exports to
China. In light of the rapid Chinese growth, it is
not surprising that U.S. exports to China rose
rapidly. It is especially noteworthy that in 1995
China was the 13th leading export market for
goods produced in the United States and in 2005
it was the 4th leading export market. Put simply,
a wealthier China is a better market for U.S. goods
and services, especially for high-tech and agricultural goods, which the United States produces in
abundance.
Chinese purchases of U.S. goods took center
13

See www.usatoday.com/money/world/
2006-04-19-china-exports-usat_x.htm.

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stage during President Hu Jintao’s visit to the
United States last May. During the visit, President
Hu agreed that China would buy $16.2 billion
worth of Boeing jets and various other goods, such
as networking equipment, medical devices, and
beef. A close look at the top 10 exporting industries to China in 2005 reveals that the industry
code including aircraft was the third leading
export industry and that the industry code including medical devices was the fourth leading export
industry. (See Table 1.) The two leading industry
codes were (i) electrical machinery and equipment
and (ii) nuclear reactors, boilers, machinery, and
mechanical appliances. Together, these industries
accounted for 31.5 percent of U.S. exports to
China.
Large multinational corporations play a major
role in U.S. exports to China. However, according
to the U.S. Commercial Service, since 1992 the
number of small and midsize exporters has
increased from 3,143 to 19,201, a gain of 511
percent.13 I opened my remarks today with an
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Poole

Table 2
SLC Top State Exports to China 2005

State

HS
commodity
code

Commodity description

Top export
2005 value
($ millions)

Total 2005
exports value
($ millions)

Top export
as percent of
total exports

Electric machinery, etc.; sound
equipment; TV equipment; parts

1,164.30

4,901.30

23.76

Oil seeds, etc.; misc. grain, seed, fruit,
plant, etc.

1,193.10

1,896.00

62.93

Cotton, including yarn and woven fabric
thereof

760.40

1,411.40

53.87

Pulp of wood, etc.; waste, etc. of paper
and paperboard

139.30

978.70

14.23

Nuclear reactors, boilers, machinery,
etc.; parts

163.90

774.40

21.17

Base metals nesoi; cermets; articles
thereof

77.20

721.50

10.70

Fertilizers

255.10

690.40

36.95

Electric machinery, etc.; sound
equipment; TV equipment; parts

88.30

622.20

14.18

Nuclear reactors, boilers, machinery,
etc.; parts

84.60

499.50

16.94

Plastics and articles thereof

153.40

467.00

32.84

Iron and steel

103.60

400.90

25.85

Nuclear reactors, boilers, machinery,
etc.; parts

55.40

284.30

19.49

Vehicles, except railway or tramway,
and parts, etc.

22.00

164.80

13.38

Inorganic chemicals; precious and rare
earth metals and radioactive
compounds

31.30

144.40

21.66

Plastics and articles thereof

53.90

135.40

39.82

Nuclear reactors, boilers, machinery,
etc.; parts

46.70

94.30

49.55

example of exports sales by Kanawha Scales and
Systems. This same phenomenon of small firms
selling to the Chinese market is found all over the
United States. Consider Sharpe Mixers of Seattle.
This firm makes specialized “absorbers mixers”
that strip sulfur dioxide from power plant emissions. Chinese power plant construction is proceeding rapidly to meet large increases in power
demand. Most of these power plants are coal-fired,
and Sharpe has seen its Chinese business increase
substantially since receiving its first order in 2004.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

This additional business has led to 10 additional
employees for a total of 30.

EXPORTS FROM SLC MEMBER
STATES
Let’s look more closely at the total exports
from the SLC states to China. It turns out that the
two leading export sectors are the same as for the
United States as a whole. Together, these industries—electrical machinery and equipment and
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nuclear reactors, boilers, machinery, and mechanical appliances—accounted for 25 percent of the
SLC states’ exports to China during 2005.
Looking at the SLC states individually, we see
substantial differences in their exports to China.
Electrical machinery and equipment is the leading
export category for only two states—Texas and
South Carolina—while nuclear reactors, boilers,
machinery, and mechanical appliances is the
leading export category for four states—North
Carolina, Missouri, Maryland, and Oklahoma.
(See Table 2.) For the remaining 10 states, various commodity codes appear: plastic products
for Alabama and West Virginia, oil seeds for
Louisiana, cotton for Tennessee, wood pulp for
Georgia, base metals for Virginia, iron and steel
products for Kentucky, fertilizers for Florida,
vehicles and parts for Mississippi, and inorganic
chemicals for Arkansas.
For these states, 2005 exports to China range
from $4.9 billion from Texas to $0.1 billion from
Oklahoma. One fact is that, for SLC states, exports
to China relative to gross state product tend to be
below the national average for all states together.
Using figures for 2005, only 4 of the 16 SLC states
had shares in excess of the national average of
0.36 percent. Those states were Louisiana (1.1),
Tennessee (0.62), Texas (0.50), and South Carolina
(0.45).
What is especially encouraging, however, is
that firms in the SLC states have played a key role
in the growth of exports to China. Comparing
2002 with 2005, total U.S. exports to China
increased by a factor of 1.9. However, 13 of the
16 states represented at this meeting experienced
export growth faster than the national average. The
leader was Tennessee, whose exports increased
by a factor of 4.2. Missouri was the second leading state, with exports to China increasing by a
factor of 3.9. The only states lagging the national
average were Mississippi (1.2), Florida (1.0), and
West Virginia (0.9).

CONCLUSION
My message for you today can be summarized
very succinctly: The growth of the Chinese econ482

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omy has provided and will almost certainly continue to provide U.S. firms with important export
opportunities. This growing demand for U.S.
goods and services provides not only more but
also better-paying employment opportunities.
This simple message is easy to miss because
the continuing integration of China into the world
economy presents both political and economic
challenges. It is still very easy to identify numerous factors that hinder the sales of goods and
services to China by U.S. firms.14 Without question, Chinese infringement of intellectual property
rights remains a problem that limits U.S. exports.
In addition, government procurement policies,
restrictions involving the wholesale and retail
distribution of foreign products in China, and
the lack of transparency of many regulations also
limit U.S. exports.
As I look to the future, I continue to see much
negotiation between the Chinese and U.S. governments as well as many adjustments to the changing economic and political environment by U.S.
firms and consumers. Political pressures will
continue to be felt by U.S. policymakers. Given
the insights from economic theory as well as the
lessons of economic history, my hope is that
policymakers will resist the calls for isolationist
responses. U.S. trade restrictions are highly
unlikely to increase employment opportunities
at home, but clearly would deprive American
consumers of lower-cost goods from China. The
best course of action is to continue to encourage
China to protect intellectual property rights and
to lower barriers on trade.
Taking advantage of the opportunities presented by Chinese growth—rather than simply
attempting to negate the competitive pressures—
is in the best interest of both countries. Opportunities to increase exports are in fact being seized
by U.S. firms, many of which are located in the
16 states served by the Southern Legislative
Conference. Recent export growth by nearly all
of these states has exceeded the national average.
14

E. Anthony Wayne, Assistant Secretary for Economic and Business
Affairs in the U.S. Department of State, enumerated many of the
contentious issues in a speech on May 25, 2005, at the Executive’s
Club of Chicago.

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Poole

In light of the continuing strong Chinese growth
prospects, prospects for exports to China from
the states represented here today are very bright.
I’ll finish with a general comment. For over
70 years, since the Reciprocal Trade Agreements
Act of 1934, the United States has led the way
toward a more open international trading system,
and I am hopeful that this historic process will
continue. Both economic theory and economic
history have provided ample reasons showing
that changes in legislation and regulation that
tilt toward economic isolation are unwise. Our
future prosperity depends on continuing to build
on past successes in extending open markets and
enjoying the fruits of the productivity advances
open markets promote.

Kamin, Steven B.; Marazzi, Mario and Schindler,
John W. “The Impact of Chinese Exports on Global
Import Prices.” Review of International Economics,
May 2006, 14(2), pp. 179-201.
Prasad, Eswar S. and Rajan, Raghuram G. “Modernizing
China’s Growth Paradigm.” American Economic
Review, May 2006, 96(2), pp. 331-36.
Rodrik, Dani. “What’s So Special about China’s
Exports.” NBER Working Paper 11947, National
Bureau of Economic Research, January 2006.
Wayne, E. Anthony. “China’s Emergence as an
Economic Superpower and Its Implications for
U.S. Businesses.” Remarks at The Executives’ Club
of Chicago, International Leadership Conference,
Chicago, IL, May 25, 2005;
www.state.gov/e/eb/rls/rm/2005/46950.htm.

REFERENCES
Anderson, James E. and van Wincoop, Eric. “Trade
Costs.” Journal of Economic Literature, September
2004, 42(3), pp. 691-751.

Wolf, Martin. “The Answer to Asia’s Rise Is Not To
Retreat from the World.” Financial Times, March 15,
2006, p. 17.

Baier, Scott L. and Bergstrand, Jeffrey H. “The Growth
of World Trade: Tariffs, Transport Costs, and Income
Similarity.” Journal of International Economics,
February 2001, 53(1), pp. 1-27.

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F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Money and Monetary Policy for the
Twenty-First Century
Jerry L. Jordan
This essay challenges the conventional wisdom about money and monetary policy. The role of
money in fostering prosperity is a function of the quality, as well as the quantity, of money. Inflation
always harms the performance of an economy. Deflations caused by productivity and innovation
can be virtuous. A definition of a non-inflationary environment is set forth. Rapid real growth and
low unemployment cannot cause inflation. There is no trade-off between inflation and employment.
Higher commodity prices or “weak” exchange rates cannot cause inflation. High market interest
rates are a symptom of inflationary policies. Low interest rates are a reflection of successful antiinflationary policies, not “easy money.” (JEL E41, E42, E51, E52)
Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 485-510.

THE BASICS OF MONEY
Modern market economies would not be
possible without financial stability. However,
as events around the world in the past decade
demonstrated, financial institutions are not
sound and payments systems are not efficient
when the value of money is not stable. Decades
of experience have demonstrated that prosperity
is undermined when the value of money fluctuates. Stabilizing the value of money has become
the primary, if not the sole, objective of central
banks around the world. This is an essay about
money—both the meaning of the word and the
various ways people have sought over time to
stabilize its value. The importance of stable
money—and the roles of governments and central
banks in providing it—will be presented in a different light than it is in the conventional dialogue.
In a superficial sense, after decades of
increase, the number of “monies” circulating in
the world began to decline during the final decade

of the past millennium. It is superficial because
many of the national currencies did not qualify
as “money” in the full sense. There are only a
few “standards of value” that do not need to be
linked to—or defined in terms of—some other
monetary unit. In the same sense that ten “dimes”
or four “quarters” are the same as one U.S. dollar,
many small-country currencies are defined in
terms of the major currency they are tied to.
For the few currencies that do serve as standards of value, the issuing central banks must
take actions, which collectively are referred to as
“monetary policy.” Such policy actions determine
the “quality” of the money over time. A money’s
quality is inversely related to the quantity of other
real resources that are used in the economy alongside money to conduct money-type functions. In
places in the world plagued with unstable money,
people spend much of their time getting paid
more frequently, dealing only in cash, making
more frequent purchases, or hiring expensive

Jerry L. Jordan was the president of the Federal Reserve Bank of Cleveland from March 1992 to January 2003. Previously, he was director of
research at the Federal Reserve Bank of St. Louis. He is a senior fellow at the Fraser Institute and an adjunct scholar at the Cato Institute.
This article was presented in part as the Homer Jones Lecture, March 8, 2006, in St. Louis Missouri, after being printed in Critical Issues
Bulletin 2005, by the Fraser Institute; sections of the article are reprinted here with permission. The author thanks John Chant, Steve Easton,
and Anna Schwartz for comments on drafts of this article.

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money managers and financial advisers. That is,
having money of lower quality means that more
time, effort, and resources are employed in gathering information about relative prices and conducting transactions. Those resources could have been
used to raise the “potential output” of the economy, which is the social payoff for policies that
maintain sound money. The frequently referred
to, but little understood, “cost of inflation” is the
loss of output over time resulting from deterioration of the quality of money.

The Nature of Money
My very great teachers (Alchian, 1977; Brunner
and Meltzer, 1971) taught that a society uses as
money that entity that economizes best on the
use of other real resources to gather information
about relative prices and to conduct transactions.
This makes clear that the common—but wrong—
statement of Gresham’s Law about “bad money”
driving out “good money” needs to be restated.
What we have observed through the millennia
is that high-confidence monies drive out lowconfidence monies (Hayek, 1976, p. 29; Mundell,
1998).
Sometimes economists treat money as a factor
of production that is separate from, and in addition to, land, labor, or capital. This is not a useful
way to think about the role of money in society.
It is derived from—and maybe reinforces—the
idea that there must be enough money in circulation to “meet the needs of trade.” A more fruitful
way to think about the role of money in a market
economy is one in which sound money liberates
resources, especially resources used to gather
information and to conduct private transactions.
This view draws attention to the importance of
the quality of money. That money facilitates transactions appears to be clear to everyone; its role
in enhancing market knowledge about relative
prices, however, is less well understood.
Money’s effectiveness depends largely on its
quality. The quality of money is high when the
value of money is stable. Money prices provide
households and businesses with reliable information about the relative costs of goods and services.
They can make sound economic decisions and
this, in turn, fosters economic prosperity.
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The economic efficiency that comes from a
stable monetary unit of account is one of the
pieces of a Hayekian infrastructure that a market
economy requires. That is, a market economy
requires a foundation of enforceable property
rights, generally accepted accounting principles,
sound financial institutions, and a stable currency.
Where public contracts are not honored and
private contracts are not enforced, markets are
impaired. Where title to property is not certain,
normal banking is not possible. Where financial
statements are not reliable, investment opportunities are obscured. Where the purchasing power
of money is not stable, resources are wasted in
gathering information or are tied up (hoarded)
as stores of value are used in producing and consuming the wrong things.

Money, Prices, and Income
The prices of things people buy and sell and
in which they invest are expressed in terms of
money units. Changes in the money prices of
goods and assets convey information. If an economy’s monetary unit is known to be a stable standard of value, then changes in money prices will
accurately reflect changes in the relative values
of goods and assets. That is, price fluctuations
signal changes in the demand for, and supply of,
goods and assets; resources are then shifted toward
more valued uses and away from those less valued.
This is essential in order for the economy to
achieve the most economically efficient aggregate
output. In other words, standards of living will be
highest when all price changes can be interpreted
as relative price changes. Similarly, all changes
in interest rates would be changes in real interest
rates—a reflection of changes in people’s preferences about time, changes in the pace of innovation, or changes in the economy’s endowment of
productive resources.
Unfortunately, in the world of fiat money,1
one can never be absolutely certain that observed
changes in the prices of specific things or changes
in interest rates reflect real events such as crop
1

Irredeemable paper currency that does not rest on a specie basis
such as gold but derives its purchasing power from the declaratory
fiat of the government issuing it.

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failures, so mistakes are made in the allocation
of productive resources. As a consequence, the
well-being of the society is less than optimal. A
form of monetary static (like a distracting noise)
in the pricing of goods and services occurs when
the standard of value—money—does not mean
the same thing over time. This static means the
signals that are coming to decisionmakers from
observed price changes cannot be relied upon with
certainty when the use of productive resources
is shifting.
In economies where changes in money prices
are contaminated by the changing purchasing
power of money, false signals are being sent to
businesses and households. Bad decisions are
being made, and resources are being misallocated.
Standards of living—real incomes—fail to rise at
their potential rate. Nominal interest rates (that
is, the kind you see quoted every day) respond to
shifting expectations about the future purchasing
power of money. Changes in real interest rates are
obscured, so resources are misallocated. Since
saving and investment decisions are affected,
growth is impaired.
The objective of monetary policy is to minimize the misinformation associated with the
constantly changing (relative) prices of things.
Absence of inflation is the ideal condition in
which businesses and households make all decisions based on the assumption that all price
changes currently observable or expected in the
future are relative price changes; that is, they
reflect changes in the underlying demand for, or
supply of, everything. Naturally, if all price changes
are relative price changes, for every observed or
expected rise or decline in some prices there must
be corresponding price declines and rises in other
prices.2 For this condition to prevail, people—
while they know that some prices will rise and
others will fall—must anticipate that on balance
they are safe in assuming the monetary standard—
money—will buy the same universal array of
goods over time. When innovation occurs and
new goods are invented, the average well-being
of the society is improved but not because the
information content of money has changed.

Innovation involves “creative destruction”—the
economic value of something old is reduced by
the discovery of a new product or more efficient
way of producing the old product. Relative prices
change; a market system treats such changes as
signals that resources are better used by shifting
away from the old and toward the new.
A real increase in particular prices or wages
occurs when there is a shift in demand away from
some other good or factor input3 and toward that
good or factor. When “improved efficiency” means
discovering ways of using the same amount of
labor but less of other factor inputs to produce
the same output, a real wage gain occurs. In such
a circumstance, observed wage increases would
be associated with decreases in output prices to
the extent that the quantity of the good produced
increases as a result of the improved productivity.
An innovation that generally improves productivity in an economy will be associated with
higher real returns to productive capital (including human resources such as labor). The resulting
increase in observed interest rates—which are
themselves relative prices and subject to change—
is a part of the mechanism by which resources
are bid to their higher-valued uses. As will be
discussed later, if governmental (monetary) policies sought to prevent the market from bidding
up interest rates, the resulting expansion of the
central bank’s balance sheet would cause monetary
units to be created at a more rapid rate than people
desire to add to their stocks of money balances.
The effects would be observed in an acceleration
of aggregate spending growth as people seek to
exchange the excess balances for things they prefer. The bidding of the excess money units for
other things causes the money prices to rise—
more money units to acquire the same thing. Price
signals are then distorted by the falling purchasing
power of the money used in the economy.
The challenges to monetary policymakers in
formulating and implementing policy actions to
minimize inflation or deflation will be discussed
in some detail below. Here, the important point
is that frequent changes in the prices of things
3

Appropriately weighted.

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Economists refer to the materials used to make things—wood,
metal, plastics, etc.—as “factor inputs.”

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and changes in market interest rates are normal
occurrences in a market economy, and an understanding of how and why they are changing is
important to both policymakers and the rest of us.

Inflation
It would be hard to get agreement on a definition of inflation and even more difficult to get
agreement on an acceptable measure of inflation.
We have chosen instead to define the conditions
that would prevail when there is an absence of
inflation or deflation. Common usage of the term
“inflation” is misleading because it confuses
cause and effect. Often people think that inflation
occurs because “prices are rising.” But, that is too
simple. Such a diagnosis often leads naive politicians to think the appropriate prescription is either
to put controls in place to prevent prices of things
from going up; or they think the task is to ensure
that incomes rise at least as rapidly so that standards of living do not erode. Both prescriptions
are wrong.
“To inflate” certainly means “to make larger,”
but what is increasing is the number of money
units required to purchase the same basket of
goods over time. The diagnosis should be that
money units are being created at a faster rate than
people want to add to their holdings of them.
“Too much money chasing too few goods” is the
familiar cause of inflation. The appropriate prescription is to avoid creating money at a pace that
is faster than people want to add to their money
balances. How policymakers seek to do this is
discussed in the boxed insert.
The obvious political risk of talking as though
inflation means that prices of things and people’s
wages are rising is that people come to fear that
policymakers are out to deny them the welldeserved wage increase or higher price for their
products that other people seem willing to pay.
Public surveys reveal that people form ideas about
inflation based on prices of things they buy. They
rarely see higher prices of things they sell as anything other than just rewards for their labors.
The expressions “price stability” or “stable
prices” are not more helpful. Prices of things—
both goods for current consumption and investment assets—are constantly changing. All
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innovation implies lower (relative) prices for
previous goods and technology. The familiar
pattern for all newly introduced goods is for their
prices to fall as methods of production and distribution are improved and as economies of scale
are achieved. Conversely, as wealth rises, people
spend a declining share of their income on certain
“necessities” and larger shares of their income
on goods thought of as luxuries. Such shifts in
consumption patterns may be associated with
rising prices of the more sought-after goods. These
are natural manifestations of a market economy.
It would be highly undesirable to have—and to
have policies designed to maintain—stable prices.
People know very well that the money prices
of some things will rise (cars, concert tickets,
impressionist paintings, greens fees, tuition, etc.)
even though they cannot be sure by how much.
Money prices of other things will fall (refrigerators,
telephone calls, computers, televisions, VCRs,
carpets, microwave ovens, etc.), even though they
cannot be sure by how much. Most of the time for
most things (food, gasoline, clothing, prescription
drugs, etc.) they cannot be too certain whether
the money prices in the future will be higher or
lower. Such uncertainties cannot be eliminated
from a market economy. As a consequence, people
have always chosen to use as money (subject to
the effectiveness of criminal prohibitions by
governments) the entity that their own experience
suggests is more likely to be exchangeable in the
future for known quantities of things they desire.
Uncertainty about present and future relative
values of things is precisely why people hold
money balances at all. When alternatives are
available, they will choose to use as money the
currency they are least uncertain about with
respect to future money prices. Because people
know they get hurt by inflation, for over 40 years—
from the 1930s to the 1970s—the U.S. government
made it illegal for American citizens to hold gold
as a way of protecting themselves.
Time and other resources are required to
shop—to gather information about relative prices
of various goods, services, and investment assets.
People will naturally prefer to use the monetary
units that economize best on the use of their time
and productive resources to gather information
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MONEY IS NOT INCOME
As noted earlier, even the word “money” cannot be used without ambiguity. It would be hard
to find anyone who would admit to having more money than they want. But, their behavior suggests
otherwise. Every purchase or investment involves a reduction in money holdings. Acquiring
money balances requires selling something or spending at a slower rate relative to cash income.
The confusion comes from the unfortunate popular habit of using the word money to mean income
or wealth. It is natural for humans to desire more income—ability to consume. Money is the means
by which indirect exchange takes place. It is a good that is held for the services it renders. Like
any other good, a person can certainly be holding more money balances than desired relative to
other things. When one’s money balances are judged to be too large, disposing of excess money
in favor of some thing is the least costly adjustment one can make.
In truth though, people do not normally desire to hold something simply because society treats
it as money. Rather, they desire to have available claims to consumption—they want to buy things.
Naturally, how much they can buy will depend on the prices of things in money units, so the
amount of money they hold will depend on how much they expect things to cost. They form their
expectations about how much things will cost in the future based on the experiences they have
had in the past. If they generally have observed that the money prices of virtually everything they
buy are always rising—a condition usually referred to as inflation—they are rational in thinking
that will also be the case in the future. Under such circumstances, their current money holdings
will be, on average, smaller than if they thought that the money prices of at least some of the things
they want to buy will be lower in the future.

about relative prices and to conduct transactions.
In recent decades, the world has had ample opportunity to observe ordinary people in Latin America,
the former Soviet Republics, and central Europe
choose to use U.S. dollars (and, increasingly,
euros) rather than the currency supplied by their
own governments. Obviously, they do so based
on an expectation that the information available
to them regarding the relative values of things is
more reliable when denominated in dollars than
in rubles, pesos, dinars, or bahts!
Bad experiences have taught most people that
neither inflation nor deflation enhances economic
performance. What also occurs, but is not as easy
to observe, is that unanticipated inflations and
deflations induce redistributions of wealth—
especially between debtors and creditors—but
they leave the average standard of living lower.
According to a former Governor of the Federal
Reserve, “a place that tolerates inflation is a place
where no one tells the truth.” He meant, of course,
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that true changes in the relative values of things
cannot be observed from stated prices when the
purchasing power of money is not stable.
An appropriate policy with regard to money
would be to create the institutional arrangements
that minimize the uncertainty that people encounter about the money prices both of goods available
for current consumption and of investment assets.
Individuals not only want to exchange the proceeds of their current labors for immediate consumption, they want to minimize uncertainty
about their future ability to exchange various
savings and investment assets for subsequent
consumption. The types of money that exhibit
the best track records for minimizing these information costs will be the preferred monies.

Money and Interest Rates
A confusion arising from the popular usage
of the word “money” is that bankers claim to
lend money and bank customers claim to borrow
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money. But, people do not increase their indebtedness in order to hold greater idle cash balances!
The extension of credit by financial intermediaries
does not alter the amount of money in the economy.
Nevertheless, the unfortunate expressions—
“borrowing money” and “lending money”—
contribute to an erroneous idea about the
relationship between the “amount of money” and
observed interest rates. People (and their elected
representatives) believe that interest rates would
be lower if only there were more money available. This Ptolemaic view of the world persists
even in the face of much sad experience that
countries “enjoying” rapid money growth have
high interest rates.
People hold a variety of financial assets—in
addition to money—as stores of value. Often these
assets are claims to certain amounts of money
units at various times in the future. But, they do
not want a certain amount of money in the future.
They want to buy things. If they think the prices
of things they will want to buy in the future will
be higher, they know they will have to have more
money units. Being able to earn higher interest
rates on their assets is one way of having the
greater amount of money that will be required by
the expected higher prices of things. By the same
token, borrowers of money are willing to pay
higher interest rates if they expect their investments to generate larger volumes of money units
as the money prices of things rise.
There is a common fallacy that “low” interest
rates can “cause inflation” and that “high” interest
rates are part of the solution. This is completely
backward. When people—both businesses and
households—start to anticipate that prices will be
rising faster in the future, they make adjustments.
Sometimes they make purchases sooner than
otherwise to “get ahead” of the price rise. They
may even go into debt to do so. They also seek to
minimize any “idle balances” they hold in the
form of cash or low-yielding balances in their
checking accounts. But, while one family or one
business may reduce its money holdings, the economy cannot do so. Actions by anyone to spend
or invest only increases someone else’s money
balances. If everyone is trying to do the same
thing, prices of goods and assets will get bid up—
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the real purchasing power of money falls—and
higher interest rates will have to be offered to
induce people to hold—rather than spend—the
stock of money in circulation.
These market dynamics explain why higher
interest rates are always and everywhere observed
in the places where the value of money is falling
fastest, while the lowest interest rates are observed
where money is holding its value. There is only
one monetary policy that can produce low interest
rates: a policy of stable money. Once people start
to expect the value of money to erode—the average
of money prices to rise—observed interest rates
can also be expected to rise. Any attempts to resist
these natural market dynamics artificially will
only make matters worse.
Even when businesses and households in an
economy expect the value of money to be stable
over time, there will be fluctuations in interest
rates that reflect the changing pace of innovation,
agricultural developments, natural disasters, wars,
and other real events. Monetary authorities cannot
avoid the need to analyze the forces tending to
alter interest rates. Those market dynamics emanating from a monetary imbalance must be
responded to. Errors in interpreting the forces
operating to change interest rates has been the
most common source of mistakes in the formulation of monetary policies in the modern world.

Money and Exchange Rates
People in every modern economy buy things
from, and sell things to, people in other countries.
How much they have to pay when they buy and
how much they can get when they sell depends
on the exchange rate between the domestic money
and the money of the other country. The exchange
rate between any two currencies depends on many
things, including the inflation rates of each country and “acts of God” in one of the countries.
Wealth gains and losses in one country can
result from changes in the exchange rate caused
by developments in the other. When international
terms of trade are altered by foreign developments—wars, agricultural conditions, etc.—there
are redistributional effects in the domestic economy: The effects on import-competing firms is
opposite to that on exporting firms, and the prices
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of tradable goods change relative to the prices of
non-tradable goods. Furthermore, asset prices are
influenced differently than goods prices. In all,
many prices are affected, in different directions,
with some people being positively or negatively
affected relative to other people. None of these
developments, though, has any certain effect on
the stability of the domestic currency.
Even though price indices that include foreign
goods—and domestic goods that compete with
foreign goods—may increase or decrease as a consequence of international developments, it is not
correct to identify such statistical observations
as inflation or deflation. A shortfall of the coffee
crop will influence coffee prices in importing
countries. And, to the extent consumers pay the
higher prices, they will experience a real income
loss and consequently will purchase less of other
things. What is observed is the higher price of
coffee in the price statistics. What is not so readily
observable is the associated lower demand for,
and prices of, other things compared with what
otherwise would have occurred. Relative prices
have changed, but the average of prices depends
on the income and substitution effects and the
choices people make.
It is common—but wrong—for someone to
say that “higher inflation is caused by higher
costs of imports such as oil.” What is true is that
misinterpretation of a “price shock” caused by a
change in the external exchange rate or by a real
event such as a sudden drop in oil production
can result in a mistake in monetary policy. Such
misinterpretations and policy mistakes have frequently resulted in inflations (and deflations) that
could have been avoided.

Money, Growth, and Employment
Contrary to simple intuition, one often sees
news reports suggesting that “too much” economic
growth will reduce the purchasing power of
money—will “cause inflation,” in familiar language. Yet, every person knows that a bumper crop
of anything will yield lower prices and a poor
harvest will be followed by higher prices. It is
simply not logical (or correct) to argue that an
increase in production will foster a general rise
of prices. Concerns that faster total growth of outF E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

put in the economy will cause a fall in the purchasing power of money—inflation—are simply
wrong.4 Similarly, it is false to say that “too many
people working” or “too low unemployment” can
“cause inflation.”5
Market economies have an inherent tendency
to grow. How much growth occurs depends on
incentives for working, for achieving productive
efficiencies, and for introducing new products.
In addition to tax laws and regulation, economic
policies influence these incentives by fostering a
monetary regime that provides reliable information about the relative values of productive
resources, both in the present and in the future.
That happens only when the monetary unit
employed by the economy is of known and stable
value. Anything less than stable money gives inaccurate signals about relative values, so resources
are not allocated to their most productive uses.
Growth, consequently, is less than it would be if
money prices could be relied upon to reflect relative underlying supplies of, and demands for,
productive resources accurately.

Money and Productivity
Traditionally, economists talk about things
being produced using some combinations of land,
labor, and capital, where capital is taken to mean
tools, machines, buildings, and so on. Productivity—productive efficiency—improves when the
same output can be obtained with less of at least
one of these inputs. As noted earlier, economists
sometimes include “money” in the production
function, as a factor of production that is in addition to land, labor, and capital. As such, the
quantity of money appears to be an alternative to
(or maybe in addition to) lumber, copper, workers,
or other factors. This unfortunate way of thinking
about the role of money in the economy tends to
be derived from—and maybe to reinforce—notions
that there is “not enough money” in circulation.
Such a false diagnosis is dangerous because it
usually is accompanied by a prescription that
4

For a discussion of why rapid growth does not cause inflation,
see Federal Reserve Bank of Cleveland (2000).

For further discussion of these issues, see Federal Reserve Bank
of Cleveland (1999).

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the monetary authorities can make people better
off by creating money units at a faster rate. That
is certainly wrong.
It is easy to imagine, and probably common,
for the lending officer of a bank to respond to a
customer’s request to borrow more funds by saying, “I would like very much to lend you some
(more) money but the central bank is making credit
very tight and I have no more to lend…how about
golf on Sunday?” The would-be borrower is left
with the impression that the currently available
stock of money is already being “used” by somebody else and that the central bank is preventing
him from expanding his business by failing to
increase the total availability of money. A popular
(but wrong) conclusion is that the output of the
economy is being restrained by the inadequacy
of money growth.
The alternative way to think about the role of
money is that improving the quality of money
reduces the use of other real productive resources
employed in the task of gathering information
about relative values and conducting transactions
and, therefore, increases the productive potential
of the economy. That is, instead of being a supplement to other productive resources, money that
is more stable liberates such resources from being
employed in activities associated with uncertainties that exist when the purchasing power of
money is unstable. When the form of money available in the economy is not reliable—that is, its
purchasing power over time is not stable—some
of other resources will be employed in dealing
with the uncertainties. As monetary policies to
stabilize the currency start to become effective
and credible, other resources can be redeployed
in more productive ways. In the end, the productive potential of the economy is greatest when
the fewest of other resources are utilized in performing tasks for which money is intended—
gathering information about relative values and
conducting transactions.
From this analysis it should be clear that a
monetary shock—an unanticipated change in the
availability of money—would reduce the potential output of the economy. That is because the
actions taken by businesses and households to
readjust their actual money balances to desired
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levels will cause unavoidable changes in relative
prices and the average level of all prices and, thus,
introduce uncertainty into the economy. Naturally,
such increased uncertainty causes resources to
be committed to hedging, arbitrage, and speculation. Furthermore, since the quality of price
information is diminished, mistakes will be made
in interpreting signals about real demands for, and
supplies of, goods and services. Overproduction
of some things and underproduction of other
things will mean that society’s well-being is less
than it could be.
Resources flow to their highest-valued uses
only when the changing prices of things reflect
shifts in fundamental real demands for, and supplies of, goods, services, and productive resources.
Monetary disturbances introduce price changes
that mask these fundamental forces. Consequently,
excess production of some things and shortages
of other things can occur simultaneously.
In a world with stable population and a given
set of goods and services where no new products
are invented, one would expect the money prices
of final goods to gradually decline at the same
pace as the improving productive efficiency of
the economy’s resources. The gains in wealth to
the society from the higher productivity would
be distributed to inhabitants in the form of “higher
real incomes.” That is, their unchanged money
incomes would gradually command a larger basket
of goods as increased availability of goods and
services pressed down on money prices. This
“productivity norm” (Selgin, 1990 and 1997) for
the average of money prices can be thought of as
a static baseline for the purchasing power of
money: It would tend to rise in an expanding
economy. It neglects population growth, labor
force participation rates, introduction of new
products, external trade, and distortions arising
from tax structures and regulation. Nevertheless,
it describes how people in an economy benefit
from a stable currency.6
6

“An increase in the quantity of goods produced...must bring about
an improvement in people’s conditions. Its consequence is a fall
in the money prices of the goods...But such a fall in money prices
does not in the least impair the benefits derived from the additional
wealth produced...But one must not say that a fall in prices caused
by an increase in the production of the goods concerned is the
proof of some disequilibrium which cannot be eliminated otherwise
than by increasing the quantity of money” (Mises, 1949, p. 431).

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It is important to note that a condition of
“rising purchasing power of money” is most commonly described by the pejorative “deflation.”
This unfortunate custom has caused most
observers to believe that a gradually falling “price
level” is as bad, or even worse than, a gradually
rising “price level.” Our analysis concludes there
can be—and historical experience has demonstrated—“virtuous deflations” during periods of
rapidly rising productivity.7

ucts must also be rapid. In such a regime, one
would expect to see frequent and significant
declines of not only the prices of the inferior
products but also the capital stock that produces
them. That is, “creative destruction” implies
falling prices of both goods and productive assets
that are superseded by superior products. If such
is not observed, it is evidence that the purchasing
power of the currency is not stable.

Countries and Monies
Money and Innovation
People can readily observe the effects of the
introduction of new or better products: The money
prices of old goods fall. The phenomenon is most
obvious in examples such as computers. The
availability of faster machines reduces the demand
for, and therefore the prices of, slower models.
The new availability of improved software, better
fabrics, longer-lasting tires, compact disks with
more capacity, and so on is accompanied by lower
prices of the products they replace. But, if radial
tires are cheaper and last longer than the bias tires
they replace, it means people are richer as their
incomes will acquire a higher standard of living.
That, in turn, means they can consume more of
something else. The increased demand for other
things that is made possible by the availability
of cheaper tires means the money prices of other
things will be higher. Thus, while prices are not
stable, the role played by money is unchanged.
That is, the value of money can be stable even
though the money prices of things must be changing in an expanding economy.
As is the case with increased efficiency in
producing existing products discussed above, the
benefits of greater wealth influence prices in
two ways: (i) lower prices of less desirable older
products and (ii) higher real incomes as a consequence of the lower prices of the goods that are
superseded, allowing greater demand for—and
higher prices of—other goods. If the pace of
innovation is rapid and totally new products as
well as improved products are introduced very
frequently, the pace of obsolescence of old prod7

For more discussion of types of deflations, see Federal Reserve
Bank of Cleveland (2002).

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There are many currencies in the world
today—more than 100. There are only a few standards of value—fewer than a dozen. A hundred
years ago there was only one standard of value—
gold—but already many national currency units.
A dominant trend of the past century was the
proliferation of national currencies, especially as
new nation-states emerged from the breakup of
the colonial empires and the Soviet Union. It
seemed that one criterion of nationhood was a
national currency. That trend may well have been
reversed as the century ended.
The dominant monetary system among
colonies was one that relied on currency boards
for establishing monetary stability (Schwartz,
1993). The newly formed nations, however, abandoned the currency-board system for a number of
reasons. Currency boards lost their standing as
valuable institutions for establishing monetary
stability after World War II because of the dramatic
change in conventional intellectual beliefs, especially the erosion of the legitimacy of imperialism.
Perhaps more significant, however, was the prevailing belief that a central bank, with discretion,
would outperform a rule-bound currency board.
Aside from national pride, the idea that a
nation-state should have its own currency and
independent monetary policy was intellectually
supported by the idea that some positive rate of
inflation was optimal. Even when economists
would not defend deliberate debasement of the
currency, authorities often rationalized inflation
on grounds of political necessity, especially in
the face of often large and growing national debts.
The political expediency of the “unlegislated tax
of inflation” seemed for a while to have had a near
universal appeal. Over time, the political benefits
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of deliberate inflation have been counterbalanced
by financial innovations in domestic and global
markets. In fact, the balance appears now to have
shifted such that the costs associated with rising
inflation outweigh any residual benefits. First
central bankers, then ministers of finance, and
finally politicians generally are finding that a
reputation for tolerance of inflation is undesirable.
Twenty-five years ago, it was fairly common
to hear even prominent, well-respected economists argue the merits of a weak external value
of the national currency (devaluation) in order to
gain some presumed competitive advantage over
trading partners. Such notions now seem increasingly quaint. It is now unimaginable that a politician anywhere would achieve success by arguing
that accelerating inflation and a weak currency
would benefit local constituents. Much of what
has happened in recent years perhaps reflects the
rise in so-called “financial market vigilantism,”
which imposes a level of discipline not anticipated
years ago.
Neither monetary sovereignty nor independent
monetary policy is deemed to be worth very much
in today’s global financial markets. Moreover,
seigniorage is quite small in a noninflationary
world. Hence, it is becoming more widely understood that any net benefits associated with maintaining a national central bank and a national
currency are quite small. Increasingly, the behavior of businesses and households around the world
has included the pragmatic adoption of standards
of value that serve their purposes irrespective of
national origin. For a couple of decades, the people
of the former Yugoslav republics used the Deutsche
mark as their preferred monetary standard for
the same reason that people in many countries
around the world use the U.S. dollar. A reputation
for stability of purchasing power means more to
the consumer than the local content or national
origin of the currency. As we have seen in the case
of consumer goods, when the barriers to the free
importation and use of products and services of
superior quality are removed, people pragmatically choose quality and performance over patriotic gestures.
Reflecting these forces, the importation of
monetary policy from another country has been
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a growing trend in recent years. Just a few years
ago, 11 sovereign countries of Western Europe
implemented their plan to shift monetary policy
decisionmaking from the autonomous national
central banks to a newly created supranational
central bank and phased out the 11 national currencies in favor of a single monetary standard to
be used by all. Soon other countries started giving
up any notions of monetary autonomy and a
national currency. Ecuador and El Salvador are
examples of countries that have joined others in
unilaterally adopting the U.S. dollar as their official standard of value.

GOVERNMENTS AND MONEY
We do not pretend, that a National Bank can
establish and maintain a sound and uniform
state of currency in the country, in spite of the
National Government; but we do say that it has
established and maintained such a currency,
and can do so again, by the aid of that Government; and we further say, that no duty is more
imperative on that Government, than the duty
it owes the people, of furnishing them a sound
and uniform currency.
—Abraham Lincoln (1839)

Abraham Lincoln connected sound banking
with political liberty, affirming that government
has both the ability and the obligation to provide
a stable currency. His belief in the importance of
a sound currency has been shared by most thinkers
for the past 250 years. Lincoln’s view that government would actually provide a stable currency,
however, has enjoyed less acceptance. Skepticism
about the government’s role with regard to money
has been the dominant view since the founding of
the republic. These doubts are well summarized
by the prominent twentieth-century economist
Ludwig von Mises:
Whatever a government does in the pursuit of
aims to influence the height of purchasing
power depends necessarily upon the ruler’s
personal value judgments. It always furthers
the interests of some people at the expense of
other groups. It never serves what is called the
commonweal or the public welfare. (Mises,
1949, p. 422)

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Constitutional forms of government usually
specified a stable currency, but as James Buchanan
observed, such provisions have been inadequate:
This framework role for government also was
considered to include the establishment of a
monetary standard, and in such fashion as to
insure predictability in the value of the designated monetary unit. (It is in the monetary
responsibility that almost all constitutions have
failed, even those that were allegedly motivated
originally by classical liberal precepts. Governments, throughout history, have almost always
moved beyond constitutionally authorized
limits of their monetary authority.) (Buchanan,
1994, p. 4)

Debates about Money
History is unfortunately replete with examples
of governments trying to print money in order to
finance their expenditures. Friedrich von Hayek,
winner of the 1974 Nobel Prize in Economic
Sciences, puts it this way: “History is largely a
history of inflation, and usually of inflations
engineered by governments and for the gain of
governments” (1976, p. 29). In recent times, the
hyperinflation of Germany in the 1920s and of
Bolivia, Argentina, and Brazil in the 1980s are all
examples of governments debasing their currencies and engaging in what Mises called “a fraudulent attempt to cheat the public” (1949, p. 782).
Until the second half of the twentieth century, there was little disagreement that a stable
currency was best; the debate centered on how
to provide it. Following World War II, the notion
that some inflation might be desirable (or at least
should be tolerated) entered debates about public
policy for a relatively short time. But, after painful
inflation experiences in the 1960s and 1970s, the
question of whether to eliminate inflation is no
longer widely debated.
In the closing years of the millennium, the
problem of how to provide a stable value of money
regained prominence. Alternative approaches to
stabilizing currencies were pursued around the
world, and public-policy debates returned to this
issue because people were rethinking the role of
government in their societies. The monetary
institutions likely to appear during the twenty-first
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century will reflect the dynamic economic and
political processes currently at work. It remains
to be seen whether nations achieve and maintain
stable currencies because of government, as
Abraham Lincoln believed, or in spite of government, as thinkers as diverse as James Madison,
Mises, and Hayek contended.
The sentiment that government powers should
be constrained by constitutional design is certainly
not unique to the monetary arena. For example,
James Madison set forth principles of government
that underscore his views on money. In his elaboration of the “rule of law,” he comments, “To trace
the mischievous effects of a mutable government
would fill a volume” (Madison, 1977 [1788]). His
doubts about elected representatives’ ability to
provide a stable currency are reflected clearly in
his adherence to a specie (gold or silver) standard.
Madison’s defense of an exclusive role of Congress
boils down to a distrust of populist sentiments:
“A rage for paper money, for an abolition of debts,
for an equal division of property, or for any other
improper or wicked project, will be less apt to
pervade the whole body of the Union than a particular member of it” (Madison, 1977 [1787]).
The history of money over the past two centuries shows the world groping for different
institutional structures that limit governments’
temptations to debase money in order to satisfy
some short-sighted political objectives. The
approaches used in the past have been functions
of the nature of money prevailing at the time and
of societies’ views about the proper role of government. The approaches used in this century will
surely be different from those of the past two if
either of these two factors changes materially. In
particular, while government will surely have
some responsibility in providing a stable currency,
government’s exact role should not be taken for
granted.
Historical Views of Money. Adam Smith
defined the role of money as a medium of
exchange, describing it as “the great wheel of
circulation” (Smith, 1976 [1776], p. 309). However, money functions in at least two other ways:
as a store of value and as a standard of value
(unit of account). When we hold money, we trust
that it will largely maintain its worth. If the value
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of currency is allowed to erode under conditions
of inflation, the ability of money to serve as a
store of value is seriously hampered. As a unit
of account, money serves as a measuring stick,
telling us how many units of something exchange
for a unit of money.8
An often-overlooked consideration is that,
while money is an integral part of society because
of its service of these three roles, it is not desired
for its own sake. Smith pointed out:
No complaint, however, is more common than
that of a scarcity of money. Money, like wine,
must always be scarce with those who have
neither wherewithal to buy it, nor credit to
borrow it… It is not for its own sake that men
desire money, but for the sake of what they can
purchase with it. (1976 [1776], pp. 458-60)

This confusion between more money and
more purchasing power has contributed in large
part to the pervading lack of trust in the provision
of money by government. As Mises suggests,
governments are often tempted to answer the cry
for more purchasing power by simply creating
more money. But in so doing, the opposite effect
is achieved—the purchasing power of money is
actually reduced. The result, as Alchian and Allen
explain, is inflation: “a rise in the number of dollars required to purchase a given standard of living” (1977, p. 484). If inflation makes individuals
uncertain about what to ask or what to give for
goods or services, then the quality of money deteriorates, reducing its effectiveness as a medium of
exchange. Money is no longer either an efficient
store of value or an efficient unit of account,
because this “ruler” with which we make our
measurements is continually changing.
Three points are clear. First, inflation is highly
undesirable. Second, governments have incentives
to abuse their power of mintage, which, coupled
with historical experience, has slowly created a
8

An appreciation of this role was evident in the thinking of
Thomas Jefferson, who confided to a friend: “There is, indeed, one
evil which awakens me at times, because it jostles me at every turn.
It is that we have now no measure of value. I am asked eighteen
dollars for a yard of broadcloth, which, when we had dollars, I used
to get for eighteen shillings; from this I can only understand that a
dollar is now worth two inches of broadcloth, but broadcloth is no
standard of value. I do not know, therefore, whereabouts I stand in
the scale of property, nor what to ask, or what to give for it” (1819).

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consensus among citizens that they cannot trust
their governments with unfettered control over
money. Third, the mechanisms people have contrived to protect themselves from the seemingly
arbitrary debasement of currency have varied
over time.
The Gold Standard. For most of recorded
history, governments have taken some role in
providing money to the economy. In early times,
that role was limited to “authentication,” verifying that coins contained the indicated metals.
Even in historical monarchies, however, the
authorities would occasionally lie to their people
about money. People’s dual reliance on, and
distrust of, government with regard to the value
of money is an age-old phenomenon. The view
that, despite all contrary assurances, governments
will eventually abuse their powers as counterfeiters led countries to develop institutions aimed
at limiting a government’s ability to print additional money. One such method was the gold and
silver standards followed (on and off) by most
countries from 1821 to 1973.
Specie-backed currency took money out of
immediate government control. For example, if
the dollar were defined as equal to 1/20 of an
ounce of gold, then the number of dollars that the
United States could issue would be constrained by
its holdings of gold reserves. Moreover, if Britain
then defined its currency as to equal 5/20 of an
ounce of gold—as it did before World War I—the
exchange rate would be fixed at $5 per pound. If
either government issued more currency than
prescribed by its gold standard—say, to finance a
budget deficit—it would lose gold reserves to the
country with the more stable currency. In this way,
gold strengthened a government’s covenant with
its public not to erode the purchasing power of
its money.
The unfortunate problem with a specie standard was that the value of money was only as
stable as the value of the specie backing it. This
led Benjamin Franklin to note that because “silver
itself is of no certain permanent Value, being worth
more or less according to its Scarcity or Plenty,
therefore it seems requisite to fix upon something
else, more proper to be made a Measure of Values”
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dard could clearly result in undesirable swings
in the purchasing power of money, the costs of
having a fiat currency were thought to be even
higher. In a letter to a friend, Madison stated:
It cannot be doubted that a paper currency,
rigidly limited in its quantity to purposes
absolute necessary, may be equal and even
superior in value to specie. But experience
does not favor reliance on such experiments.
Whenever the paper has not been convertible
into specie, and its quantity has depended on
the policy of the Government, a depreciation
has been produced by an undue increase, or
an apprehension of it. (Madison, 1820)

Later, commenting on a “Report on a State’s
Bank,” Madison wrote, “But I am not yet weaned
from the opinion long entertained, that the only
adequate guarantee for the uniform and stable
value of a paper currency is its convertibility into
specie” (1831; emphasis added). Repeating his
view that a stable paper currency is theoretically
possible, doubts remained: “But what is to ensure
the inflexible adherence of the Legislative Ensurer
to their own principles and purposes?” (1831).
Madison left no doubt about what is essential: a
money that has stable value. His doubts about the
people’s elected representatives providing a stable
currency are reflected clearly in his adherence to
a specie standard, especially given his recognition
that paper money supplied by an honest government is superior to a specie standard.
The quantity theorists of the late nineteenth
century, John Stuart Mill and Alfred Marshall,
also believed that, although a gold standard provided undesirable swings in currency value, it
was the only way for governments to provide a
stable paper currency. Mill observed:
After experience had shown that pieces of
paper, of no intrinsic value, by merely bearing
upon them the written profession of being
equivalent to a certain number of francs, dollars, or pound… governments began to think
that it would be a happy device if they could
appropriate to themselves this benefit… The
only question is, what determines the value
of such a currency…We have seen, however,
that even in the case of metallic currency, the
immediate agency in determining its value is

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its quantity… The value, therefore of such a
currency is entirely arbitrary. (Mill, 1907;
emphasis added)

Citing the nineteenth-century economist,
William Jevons, Mill asserts, “so that the relation
of quantity to uses is the only thing which can give
value to fiat money.” That being the case, Mill
thought that convertibility (to metal) was the only
thing to prevent temptation to “depreciate the
currency without limit” (Mill, 1907).
For the first 195 years following the
Declaration of Independence, most government
paper currencies were linked to specie. The U.S.
dollar was defined in terms of a weight of gold
(or occasionally silver). However, this did not
completely restrain governments from manipulating the value of their currencies. First, in order
to generate revenue, countries would frequently
abandon the gold standard during times of war.
Second, even without officially abandoning gold,
countries could and did periodically redefine the
value of their currencies in terms of gold. Instead
of allowing gold or foreign reserves to consistently
drain from their coffers, they would “be forced”
to devalue their currency.
At first glance, it would appear that a gold
standard provided no real discipline if countries
could devalue their currencies at will. The discipline came from the fact that countries actually
could not do so without suffering a cost. If there
was a threat that a country would devalue its currency, massive speculative attacks would ensue
as investors attempted to shed themselves of that
currency. The devaluing country would eventually
lose massive amounts of foreign reserves (gold
and foreign currencies). Over 1966 and 1967, for
instance, Britain lost nearly 28 million ounces of
its gold reserves defending its currency and, on
a single day, November 17, 1967, lost reserves
valued at more than $1 billion.
The common wisdom is that the frequency
and destabilizing effects of such attacks caused
the Bretton Woods system, and thus the last vestige
of a gold standard, to be abandoned in 1973. While
this is correct on a superficial level, the underlying cause was that, despite the threat of speculative attacks, governments around the world were
unwilling to do what was necessary to maintain
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a stable currency—namely, to limit the supply of
fiat money. Mises was blunt in his condemnation
of deliberate, governmentally engineered devaluations of currency, and his criticism of the stated
as well as the unstated objectives of a devaluation
policy are as relevant today as when he wrote
Human Action over 50 years ago: “It is impossible
to take seriously the arguments advanced in favor
of devaluation” (1949, p. 790).
Alternative Monetary Arrangements
Separation of the Central Bank and the
Treasury. Another way to keep governments
“honest” is to remove the power to inflate from
those with the most incentive to inflate. This is
achieved by making the central bank—which
has the power to inflate—highly independent of
the Treasury—which has the incentive to inflate.
This institutional structure is not a panacea but
has proven especially useful: Studies have shown
that countries where central banks are more independent have lower inflation rates on average
(Alesina and Summers, 1993).
The high-inflation era of the 1970s showed
us what countries unfettered by fixed exchange
rates and a dollar convertible into gold will do
left on their own. Addressing this deficiency,
the U.S. Congress passed House Concurrent
Resolution 133 in 1975, requiring the Federal
Reserve to announce annual targets for monetary
growth rates. In 1978, the Full Employment and
Balanced Growth (Humphrey-Hawkins) Act was
passed, requiring the Federal Reserve to explain
these objectives and any deviations from them.
Most major central banks experimented with this
form of “instruments monitoring” in the 1970s
and 1980s, establishing growth rates for various
money measures in an effort to put boundaries
on the rate of inflation.
Despite the relatively low inflation rates
realized by most industrial countries around the
world since 1983, the call for further institutional
constraints on central banks is growing. One
example is legislation enacted by New Zealand
and other countries that the sole objective of
central banks is to provide price stability.
Currency Boards. An institutional constraint
that has been adopted by smaller countries that
lack an established reputation for low inflation
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is the currency board, similar to those initially
adopted by former colonies. The central idea
behind currency boards is to look more seriously
at the discipline provided by fixed exchange
rates. For example, in order to maintain a fixed
exchange rate between a small country and the
United States, the small country’s monetary policy
must, in essence, be dictated by the United
States. If the United States has the credibility to
maintain low inflation, the hope is that the
country with the currency board will also achieve
credibility over time.
Currency boards are much like a small-scale
version of Bretton Woods except that there is no
longer a link between the dollar and gold to guarantee that the United States will follow a policy
of low inflation. Currency boards are probably
best described as small boats anchoring themselves to a large ship. Because the large ship is
not firmly anchored, the small countries are left
hoping that rough seas will not cause the large
ship and, thus, the small boats to drift too far off
course.
Private Currencies. Perhaps the most interesting mechanism by which a stable currency
might be achieved was proposed by Hayek (1976)
in Denationalisation of Money (see also Friedman
and Schwartz, 1986). Although central banks,
currency boards, and the gold standard each
attempt to restrain a government’s tendency to
inflate, Hayek suggested that governments be
removed altogether from the provision of money.
He contended that if private currencies are
allowed to circulate freely, competition will
ensure that the value of these currencies will
remain constant. If any issuer attempts to collect
too much seigniorage by printing excessive
amounts of its currency, consumers will substitute
out of that currency into a competing currency
with a more stable purchasing power. The offending currency will cease to circulate as money.
Thus, currency issuers will have an incentive to
remain honest.
Writing almost 30 years ago, Hayek was
clearly ahead of his time. His proposal that governments be completely removed from the business
of issuing money is not likely to come to fruition
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sition that competition will provide the necessary
incentive to keep people (or countries) honest is
relevant today. International currencies are
increasingly competing to become the currency
of choice. The rapid “dollarization” or “euroization” in central Europe, the former Soviet Union,
and Latin America shows how a foreign currency
can become a legitimate substitute for a domestic
currency that has failed to maintain its value.
Paradoxically, it may be the end of fixed exchange
rates and the flawed discipline provided by that
system that have allowed internationally competing currencies to flourish.
Recent history teaches us that Hayek was
correct when he pointed out that
Gresham’s law will apply only to different
kinds of money between which a fixed
exchange rate is enforced by law. With variable exchange rates, the inferior-quality money
would be valued at a lower rate and, particularly if it threatened to fall further in value,
people would try to get rid of it as quickly as
possible. The selection process would go on
towards whatever they regarded as the best sort
of money among those issued by the various
agencies [or countries], and it would rapidly
drive out money found inconvenient or worthless. (Hayek, 1976, p. 31)

Money, Taxes, and Deficits
Governments impose taxes on people in a
variety of ways but always on nominal money
prices and incomes. Consequently, debasement
of the currency always generates greater nominal
tax revenue for the taxing authorities. When tax
structures are progressive and not indexed, real
tax revenue rises when the average of money
prices of things rises—the value of a currency
erodes. Furthermore, much of the debt of governments is fixed in nominal money units. Thus,
debasement of the currency works to the advantage
of the governmental taxing and spending authorities. Government’s command over the economy’s
output rises while the government’s creditors are
repaid with reduced purchasing power. The effect
of these institutional arrangements is that the
relative share of the economy absorbed by the
government increases when the purchasing power
of a currency is declining.
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Governments usually require that people’s tax
liabilities be disposed of by remitting liabilities
of the central bank to the account of the Treasury
at the central bank. When governments incur
deficits and issue debt, they are giving to security
holders the promise that they (or their successors)
will raise sufficient tax revenue in the future (or
issue new bonds) to repay the borrowed sums.
At times, the issuance of the debt instruments of
the government (increased supply of securities)
causes at least temporary downward pressure on
security prices (higher interest rates). If the policy
of the central bank is to maintain a fixed level of
market interest rates and accommodate all
demands for credit at that rate, the central bank
will passively expand its balance sheet—issue
greater quantities of currency and bank balances.
Without any corresponding increase in the public’s
desire to hold greater balances, the excess creation
of liabilities of the central bank will result in a
bidding up of the money prices of goods, services,
and other financial assets. This dynamic has been
common even when the central bank is prohibited
from directly purchasing the newly issued debt
instruments of the government.

Root Demands for Fiat Monies
As noted above, people throughout the world
use U.S. dollar notes in everyday commerce even
though their own governments also furnish a
currency. They use the U.S. currency even when
it is illegal to do so. If asked why they do so, they
will say it is simply because the value of the dollar
is more stable than other currencies. Two questions arise: Why isn’t the domestic currency stable,
and why is the value of the dollar more stable?
Both are fiat currencies, that is, their value is not
defined in terms of something else, such as gold.
Both may be legal tender in the home country,
but the U.S. dollar is legal tender in only a few
countries outside the United States.
So, why do money prices rise more rapidly
in terms of one currency than the other? The
answer can only be that some monetary authorities create new units of their currency at a rate
that is faster, relative to demand to hold it, than
other monetary authorities do. Clearly, if the
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amount of money people want to be holding is
always exactly the amount there is, the purchasing power of the currency can be neither rising
nor falling. A disturbance to this happy situation
can occur one of three ways: (i) people decide to
hold less (more) of the currency and the process
of ridding themselves of the excess (or acquiring
larger balances) causes money prices to adjust;
(ii) monetary authorities create money units at
faster (slower) rates than people want to add to
their holdings; (iii) favorable or unfavorable surprises in the amount of things available to purchase (natural disasters, crop failures, bumper
crops, etc.) cause changes in both relative prices
and the average of prices because the society is
richer or poorer.
The first possible disturbance—changes in
people’s desire to hold some of the currency—
raises questions about what goes into a decision
to hold any of a currency, especially if there is
an alternative available. The most fundamental
reason that inferior currencies continue to be held
even though a superior alternative is available is
that taxes must be paid to the domestic governments in units of the national currency. The
necessity to remit tax receipts in the form of the
liabilities of the national central bank ensures at
least some transitory demand for the currency.
Since there is a demand, it would be possible to
constrain the supply so that there is neither an
excess nor a deficient supply relative to the
demand. The reason most, if not all, prices of
things in terms of that currency rise is that the
monetary authorities do not constrain the new
supply to match the demand exactly. The usual
reason they do not do so is that the government
commits to disburse funds to people in amounts
that are greater than the sum of tax receipts and
proceeds from debt issuance.

Introduction of New Monies
There has never been a “phoenix-like” currency.9 Because the central role of money is mini9

“The acceptance of a new kind of money presupposes that the
thing in question already has previous exchange value on account
of the services it can render directly to consumption or production.
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mization of information and transaction costs,
people will not use an entity as money, a medium
of indirect exchange, if they have no prior experience upon which to base their expectations about
the prices of things expressed in terms of the proposed money. Historically, then, new claims to
money (i.e., money substitutes) had to circulate
for a period of time sufficiently long to establish
a “track record” in the minds of people. Warehouse
receipts (such as gold certificates) were an early
type of paper claims to money that evolved into
paper fiat monies.
As described above, U.S. dollars were originally defined to be (and convertible into) specified
amounts of gold. For domestic purposes, dollars
became a fiat currency in 1933 when the government made it illegal for American residents to own
gold. Nevertheless, for official, international payments made by one government to another, dollars
continued to represent claims to gold until the
early 1970s. For the past three decades, dollars
have been simply the liabilities of Federal Reserve
Banks.
In the second half of the twentieth century,
numerous currencies have been introduced by
governments. In every case, the new entity was
initially defined in terms of a known medium of
exchange. After World War II, the German
Deutsche mark was defined to be worth 1/4 of a
U.S. dollar and the Japanese yen was introduced
as 1/360 of a U.S. dollar at a time the dollar was
still defined as 1/35 of an ounce of gold. For over
25 years these currencies were claims to dollars
and, indirectly, to gold.
Newly liberated countries in the final decade
of the twentieth century introduced new currencies but always defined in terms of, pegged to, and
convertible into other familiar national currencies,
such as U.S. dollars, Deutsche marks, British
pounds, or yen. When the domestic experience
with a currency has been favorable for sufficiently
long that confidence about future purchasing
unit if he had no information about its exchange value—its purchasing power—in the immediate past...A medium of exchange
without a past is unthinkable. Nothing can enter into the function
of a medium of exchange which was not already previously an
economic good and to which people assigned exchange value
already before it was demanded as such a medium” (Mises, 1949.
pp. 411, 426).

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power is high, governments have chosen to delink
(float) their nation’s money relative to foreign
currencies.

CENTRAL BANKS AND MONEY
The Tools of Monetary Policy
The tools available to central banks to influence the purchasing power of their currency are
quite few. Since it is their own liabilities that serve
as money, altering the size of the central bank’s
balance sheet is the essential monetary tool. The
assets of the balance sheet usually include loans
to banking companies and securities that may be
denominated in either the domestic currency or
a foreign currency. In either case, the securities
are mostly the obligations of the domestic or a
foreign government. Central banks can, if they
choose, control the size of their balance sheets
very precisely. That being the case, they can unilaterally determine the supply of central bank
money. The demand for central bank money has
several sources: Domestic (and maybe foreign)
households and businesses have a demand for the
notes issued by the central bank; and commercial
banking companies (and maybe others) hold
reserve or clearing balances at the central bank,
based on their business needs or legal reserve
requirements.
Since there is a demand for money from the
central bank and the potential to control the supply, monetary policies to stabilize the value of the
currency are possible. The difficulty is in estimating the demand by people to hold central bank
money. The domestic public’s desire to hold
notes issued by the central bank tends to grow in
proportion to incomes, although changes in the
forgone interest from investments can influence
currency demands (higher market interest rates
mean you hold less cash). Also, the commercial
banks’ demand for balances at the central bank
is a derived demand. The public’s demand for
checking-type accounts and other reservable
deposits at the financial intermediaries determines
the amounts of balances held at the central bank.
If some liabilities of banks, but not others, are subF E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

ject to legal reserve requirements, shifts in the
public’s preferences between types of deposits
will affect the derived demand for balances at the
central bank. Similarly, if different sizes or types
of financial intermediaries are subject to different
legal reserve ratios, shifts in deposit balances
among the institutions will affect the derived
demand for central bank balances. In other words,
institutional arrangements affect the difficulty or
ease of estimating the demand for the liabilities
of the central bank.
Where it is judged to be difficult to estimate
the demand for central bank money, the monetary
authorities typically target an overnight interest
rate at which they passively accommodate
increases and decreases in the demand for their
liabilities. While that ensures that there can be
neither an excess supply of nor an excess demand
for central bank money on an overnight basis, it
does not ensure secular10 stability in the purchasing power of the currency.
The public’s desire to hold balances at the
depository intermediaries is influenced by several
factors—including the opportunity cost of forgone
returns on alternative assets,11 domestic as well
as foreign. This means changes in investment
opportunities as well as consumption plans influence the balances desired by businesses and
households. So, the changing yields on alternative
savings and investment assets have an indirect
effect on the demand for central bank liabilities.
Depending on the source of these changing yields,
the induced change in the outstanding stock of
central bank money may or may not be consistent
with maintaining stable purchasing power at the
initial overnight bank rate.
Knowing the prevailing operating procedures
of central banks is important for understanding
the risk of unintended increases or decreases in
the purchasing power of money. As mentioned
above, it is common for central banks to target an
10

“Secular” means of, or relating to, a long term of indefinite
duration.

When the public holds money, they receive either no nominal
return on their cash, or very little—less than could be earned on
normal investments—on deposits in banks. It is in this sense that
we speak of there being an “opportunity cost” of holding money
(instead of holding interest-bearing investments).

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overnight interbank rate: The operating desk of
the central bank buys and sells (in the market)
securities previously issued by the government.
A purchase of securities by the central bank
increases12 the supply of central bank liabilities
while a sale of securities reduces the supply. In
effect, the operating desk sets a price at which it
is willing to buy (sell) securities from private
holders—the central bank’s demand for the debt
instruments of the government is unlimited at that
price (interest rate). If the market supply of securities to the central bank increases (the demand
by private holders for such securities decreases),
the quantity of central bank money will increase.
For example, if innovations in the economy
raise the perceived returns on real productive
capital (which can mean anything from better
management to new machines), there will be a
tendency for the interest rates offered on financial
instruments to rise as well.13 There will be both
an increase in the demand for loanable funds
(money borrowed from a bank) and a decrease in
the demand to hold fixed-rate instruments such
as government securities. The higher return on
financial assets means a higher opportunity cost
of holding bank notes or low-yielding balances in
banks. This will foster a decline in the quantity
demanded as people and businesses seek to reduce
the amount of money they hold. Other things being
held the same, if the central bank’s operating
procedure involves pegging a nominal overnight
interest rate, the marketplace forces pressing down
on security prices (up on interest rates) will be
met by an expansion in the stock of central bank
money, even though the amount of money
demanded is declining!
Temporarily, the expansion of the supply of
central bank money reduces the upward pressure
on market interest rates even though an excess
supply of money has been created (increased
12

When the central bank purchases a security from the general public
(usually a bank), it pays money for the security. This money is a
liability of the central bank, an increase in money held by the
public, and, of course, a reduction in the number of securities
held by the public.

Higher expected rewards to real productive capital cause people
to buy more of the new productive assets. As they do so, they seek
to reduce their holdings of old financial assets. This will cause the
price of the old assets to fall, which in turn raises their yield.

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supply and falling quantity demanded). Under
such circumstances, the excess supply of such
monies will cause purchasing power to erode as
the weighted average of money prices that are
rising will exceed the weighted average of prices
that are falling. The adjustment process—inflation—will continue (i) until the returns on real
productive capital fall to the initial lower level
or are brought down to that level by the inflation
tax or (ii) until the central bank raises the pegged
level of the overnight bank rate to the point where
the amount of central bank money demanded is
the amount outstanding.
Conversely, if diminished economic prospects
are reducing perceived yields on productive
capital—or are causing a general preference for
more liquidity in the form of secure bank deposits
and other low-risk financial instruments—security
prices will be bid up (market interest rates will
be bid down) and the lower forgone yields will
cause people to try to increase their holdings of
bank deposits and currency. That means greater
demand for central bank money; but the only
source is the central bank. If the monetary authorities do not correctly analyze these fundamental
economic forces and they fail to lower the nominal
overnight intervention rate, the operating desk of
the central bank will be selling (or buying fewer)
securities and the central bank balance sheet will
shrink (supply goes down) or grow too slowly at
a time when the amount of central bank money
demanded is rising. In time, the weighted average
of money prices that are falling will exceed the
weighted average of prices that are rising until
people want to hold balances that are consistent
with the amount of central bank money in circulation. This process, deflation, results in a general
rise in the purchasing power of money.
The critical element, then, in the formulation
of monetary policy actions is ascertaining the
forces at work in the economy that are tending to
press upward or downward on the structure of
market interest rates, including the perceived
yields on real productive capital. Since observed
interest rates in a world of fiat money include an
“inflation premium,” market rates will change
because people come to expect the average of
money prices to rise at a faster or slower rate while
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the expected yields on real productive capital
may be changing simultaneously in the same or
opposite direction. Sifting through the variety of
forces at work is essential in making judgments
about the appropriate level for the overnight bank
rate when deciding on the prices at which government securities will be bought or sold.14

Talking about Monetary Policy
Popular usage by “Fed watchers” of the
expression “monetary policy” is quite different
from the way it is used in this essay. Even qualifiers such as monetary policy objectives and
monetary policy actions usually require elaboration in order to be clear. At least one dictionary
definition of policy is “a high-level overall plan
embracing the general goals and acceptable procedures, especially of a government body.” Yet,
the most frequent references we see in the daily
press about monetary policy include characterizations of policy as “tight” or “easy” or claims
that the monetary authorities are going to “tighten”
or “loosen” monetary policy. How can a “highlevel overall plan” be characterized as tight or
easy? Maybe it is fair to characterize the actions
to achieve the objectives as being “tighter” or
“easier” (than previously?), but it certainly is not
appropriate to talk about the objectives as being
tight or easy.
Even the most avid “fine tuner” of monetary
policy has a long-term objective in mind, and
people who share the same objective may differ
on the appropriate tactics to be successful. Excessive focus on the short-term actions to implement
a policy runs the risk of confusing observers
regarding the ultimate objective. If observers do
not know the intended destination, or do not agree
with the destination, they will naturally secondguess the appropriateness of course corrections.
If the ultimate objective is well understood—
and agreed to—it is reasonable to hold policymakers accountable for actual results. Good
intentions are not enough if the results are bad.
However, the results can be judged as successful
14

See the discussion of targeting interest rates in
www.clevelandfed.org/Annual01/essay.htm.

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or not relative only to what was intended. Without
understanding and agreement about objectives,
there is no way for accountability to be tied to
performance.
The fact that there are long and variable lags
before monetary policies take effect means that
objectives must be stated in a multi-year context.15
If the time horizons of the policymakers and the
observers differ, it may be difficult to get agreement on appropriate weights to give to any transition costs when compared with the benefits of
progress toward achieving the ultimate objective.
As a result, disagreements about the appropriateness of a specific policy action may reflect nothing
more than differences in the preferred time path
to the destination. All that gets lost in the familiar
chatter about whether the policy action represents
“tightening” or “loosening.”

The Formulation and Implementation
of Monetary Policy
The consumption behavior of households
tends to reflect expectations about their longerterm ability to consume. This phenomenon has
been called the life-cycle hypothesis, standard
or standardized income, and, of course, by Milton
Friedman, permanent income (Friedman, 1957).
The basic idea is familiar. Transitory changes in
measured income or cash flow fluctuate around
some longer-term average; household consumption behavior does not fully reflect these transitory changes in the short run. Sharp increases in
measured cash-flow income are not fully reflected
in corresponding increases in current consumption; nor are sudden rapid declines in measured
cash-flow income reflected in corresponding
declines in consumption spending.
15

The time it takes monetary policy to influence the other macroeconomic variables such as nominal and real output and the rate
of change of prices is known as the lag. Sometimes the lag is short
and sometimes it is long. It differs as a function of people’s expectations. After a period of no inflation, people tend to interpret an
increase in prices as temporary and not necessarily a permanent
price increase. After a period of rapid inflation, they interpret an
increase in prices as more inflation. How quickly people adjust to
changes in policy is related to their experience and their underlying conception of why changes are taking place. It is in the sense
that lags depend upon past experience and what people see as
causing the changes that we say that policy lags are long and variable—depending on experience.

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Changing Productivity. Both the theoretical
framework and empirical observations traditionally suggest that permanent income is relatively
steady, while transitory changes in measured
income are more variable. However, it can also
be the case that periods of rising or falling productivity and changes in the pace of technological
innovation produce a generalized perception that
permanent income is rising or falling relative to
measured or cash-flow income. People may come
to form these expectations in a variety of ways.
Rising Productivity. Sustained periods of
steady employment and growing paychecks may
lead people to expect that not only has their real
standard of living risen but that it will continue
to rise in the future, possibly at a faster rate than
previously expected. Or, they may come to expect
fewer or shorter periods of unemployment. Or,
they may observe that their 401K savings plans
or defined-contribution retirement programs now
promise a higher future stream of income than
previously thought. In a variety of ways, people
come to expect that they will be able to consume
more in the present, as well as in the future, than
they previously thought.
As a result of any (or some combination) of
these various forces at work in a “new economy,”
households perceive that their long-term ability
to consume is higher.16 The availability of credit
means that people can increase their spending in
anticipation of the future increase in their incomes.
This, in turn, means households will consume a
greater share of their current measured income
so, consequently, the contemporaneous personal
saving rate will fall. Clearly, this analysis suggests
that, in such an environment, a low or even negative saving rate is unavoidable and is not a problem to be addressed by economic policies.
In the business or entrepreneurial sector, rising
productivity and an enhanced pace of technological innovation mean that the marginal efficiency
of capital is higher.17 Consequently, in return for
giving up consumption today, relatively more will
16

In economists’ jargon, they have moved to a higher indifference
curve.

Again, in economists’ jargon, the production possibility boundary
has both shifted out and changed its shape.

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be available for consumption tomorrow. Real
interest rates rise as new opportunities bring a
higher rate of return on new business investment.
These higher real interest rates are not a matter
of policy choice or of anyone’s discretion. Rather
they are a manifestation of economic forces that
result in better uses for available productive
resources. With households and businesses both
increasing their claims on current productive
resources, real interest rates must rise in competitive markets.
Gold Standard. Higher real interest rates
need not imply higher nominal interest rates.
Just to exclude complications for the moment,
consider the case under a gold standard. Increased
productivity growth and technological innovation in an environment of monetary stability
implied by a gold standard means that the price
level falls. That is, output of goods and services
increases because of higher productivity but the
quantity of money—gold—remains in relatively
fixed supply. Thus, the purchasing power of
money rises in the face of greater productivity.
The falling price level means that greater permanent real income can be distributed to society
with the same level of nominal income. The
falling price level also implies that unchanged
nominal interest rates, or possibly even lower
nominal interest rates, correspond to higher real
interest rates. These higher real rates are the
essential market mechanism by which competition between consumers and investors rations
present consumption against augmented future
consumption. But, we’re not on a gold standard.
Fiat Money. The alternative to commodity
money, as we have seen, is “managed money,”
a discretionary monetary policy regime using a
procedure that “pegs” the interest rate. The
upward pressure on real interest rates that is a
necessary consequence of greater productivity
and the faster pace of technological innovation
initially will put upward pressure on nominal,
i.e., market, interest rates. Greater and greater
injections of central bank money will then be
necessary to keep the pegged level of the nominal overnight interbank rate unchanged. Rising
market interest rates mean that the opportunity
cost of holding money balances is rising. That,
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in turn, means the quantity of money demanded
declines and the rate at which money changes
hands increases as households and businesses
seek to rid themselves of undesired money holdings. This combination of excess money holdings
and the faster growth of central bank money
means that a higher rate of nominal final demand
growth would be accommodated by a more
expansionary rate of money growth. Again, too
much money chasing after too few goods. In such
an environment, the increase in nominal interest
rates, while initially reflecting upward pressure
on real interest rates, would be augmented by a
rising inflation premium. The overnight interbank rate would be under persistent upward
pressure so long as it continued to lag behind
market-determined interest rates.
This dynamic process describes an environment in which acceleration in the pace of technological innovation and productivity growth could
inadvertently become an inflationary process. A
central bank’s actions to maintain an unchanged
overnight rate would accommodate nominal price
increases by failing to accommodate increases in
the real interest rate. As a result, credit markets
would be unable to play their role in rationing
available real productive resources amongst
heightened competing demands that reflect the
increased return to real capital. Of course, this
analysis is symmetric: A sustained deceleration
of the pace of technological innovation and productivity growth would imply a fall in the equilibrium real rate and a necessity to reduce the
central bank’s intervention rate in order to avoid
a procyclical downward thrust of monetary
injections.

Policy Neutrality
In the analysis above, “real interest rates”
refer to inflation-adjusted nominal interest rates,
that is, anticipated yields on an investment after
allowing for changes in the purchasing power of
money. For example, the rate of inflation that is
expected over the life of a bond is subtracted from
the nominal yield to obtain the real yield.
Sometimes one hears or reads references to
the “real federal funds rate” or “real overnight
interbank rate.” This makes no sense. Because
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there is no meaningful one-day inflation rate,
there is no statistical measure of anticipated
changes in the purchasing power of money in a
single day that can be used to measure a real
return for one day.
As an alternative to referencing “real interest
rates,” economists employ a concept of a “natural
rate of interest.” While this natural rate cannot
be observed, the forces that would tend to cause
cyclical or secular increases or decreases would
include such factors as the changing productivity trends and pace of technological innovation
discussed above. Sometimes the natural rate is
associated with the average rate of real output
growth over long periods. Demographic patterns,
political and economic institutional arrangements,
and even geopolitical developments will also
influence this “natural” rate.
One thing that does not influence the natural
rate is the overnight, interbank rate targeted by
central banks. It is simply impossible for central
banks to “push up” or “hold down” market interest
rates. However, actions by the central bank to
target an overnight intervention rate in the face
of sometimes strong pressures at work on market
interest rates have a major impact on the performance of an economy over time.
As defined above, a world without inflation
is one in which people make decisions in the
confident expectation that all observed changes
in money prices of goods, services, and assets are
changes in relative prices, and all observed changes
in interest rates are changes in real rates. That is,
the “inflation premium” in nominal interest rates
is zero, so only those forces that influence the
natural rate of interest are causing changes in
market interest rates.
A neutral monetary policy would be one in
which injections of liquidity by the central bank
are faster or slower as necessary to maintain this
non-inflationary environment. When forces are
at work to raise the natural rate of interest, actions
to peg the intervention rate at an unchanged level
would require larger and larger injections of central bank money. However, as described above,
in that same environment the quantity of money
people want to hold idle is declining. Increasing
supply and falling demand is not neutral.
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To remain neutral, the intervention rate targeted by the central bank must rise in concert
with a rising natural rate. Likewise, if the pace of
technological advance and productivity growth
slows, it is necessary to reduce the intervention
target rate in order to maintain the neutral stance.
These dynamics show that changes in the targeted
intervention rate cannot be taken as indications
of the “tightness” or “easiness” of the thrust of
policy. The mere observation that the announced
target rate has been increased or decreased does
not indicate that the stance of policy actions is
more “stimulative” or “restrictive.”
On the contrary, failure to change the target
rate in concert with forces influencing the natural
rate would mean that policy actions have become,
de facto, more or less expansionary. The paradox,
then, is that maintaining neutrality of the thrust
of monetary policy actions requires changes in the
announced target intervention rate as frequently
as policymakers obtain information indicating
that the natural rate of interest has risen or fallen.

COMPETING CURRENCIES
The concepts of competitive money, currency
boards, and the independence of the central bank
were no doubt far from the mind of Abraham
Lincoln when he spoke of the government’s obligation to provide a stable currency. However, these
are a few of the mechanisms by which governments have tried to achieve this end. It must be
remembered, however, that these different options
are not independent.
The potential for the forces of competition
that have served market economies so well to
discipline a country’s ability to print money freely
is particularly promising. According to Hayek,
“[i]t might prove to be nearly as difficult for a
democratic government not to interfere with
money as to regulate it sensibly” (1976, p. 74;
emphasis added). He argues that countries around
the world should abolish “any kind of exchange
control or regulation of the movement of money
between countries” and provide “the full freedom
to use any of the currencies for contracts and
accounting” (1976, p. 74). Further, there should
be “the opportunity for any bank located in these
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countries to open branches in any other on the
same terms as established banks” (1976, p. 17).
Laws could be changed in various ways in
the United States to foster more effective competition. For example, federal law (Title 31, Section
5103) states that “United States coins and currency
(including Federal Reserve notes…) are legal
tender for all debts, public charges, taxes, and
dues. Foreign gold and silver coins are not legal
tender for debts.” This law might be altered so
that contracts written in terms of foreign or alternative domestic monetary units, including specie,
could compete with dollars. Almost 30 years ago,
the British House of Lords “ruled that in English
courts, foreign creditors could now have their
claims recognized in their own currencies” (The
Financial Times, 1975).
Governments must have a role in the enforcement of contracts. As Mises observed in Human
Action, the laws and courts of a country
define what the parties to the contract had in
mind when speaking of a sum of money…They
have to determine what is and what is not legal
tender. In attending to this task the laws and
the courts do not create money [emphasis in
original]…In the unhampered market economy
the laws and the judges in attributing legal
tender quality to a certain thing merely establish what, according to the usages of trade, was
intended by the parties when they referred in
their deal to a definite kind of money” [emphasis added]. (Mises, 1949, p. 780)

Legislation requiring enforcement of “specific
performance” by the courts would increase the
opportunity for currency competition. Currently,
in most countries of the world, when there is a
dispute involving a contract that is stated in terms
of a currency or unit (such as gold) other than the
national currency, courts will not require performance in the stated unit but will require that an
“equivalent payment” in the national currency
be paid.
Money in the twenty-first century will surely
prove to be as different from the money of the
past century as that money was from that of the
nineteenth century. Just as fiat money replaced
specie-backed paper currencies, electronically
initiated debits and credits will become the domF E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Jordan

inant payment modes, creating the potential for
private money to compete with government-issued
currencies. Such competition between private and
governmental monies may help countries around
the world to finally live up to Lincoln’s challenge
of fulfilling “the duty [government] owes the
people, of furnishing them a sound and uniform
currency.”

SUMMARY
Stable money enhances growth. Whenever the
purchasing power of money is falling (the impact
on the weighted average of all prices from those
that are rising exceeds that of those that are falling)
productivity improvements are smaller. The faster
the average of prices rise, the slower the productivity improvements. This result is unavoidable
because the changes in money prices of goods and
factors of production do not accurately reflect
changes in relative values. Consequently, businesses and households make mistakes that they
would not have made if they could be confident
that all observed price changes are the result of
shifts in the supply of, or demand for, some things
rather than other things. Furthermore, when the
value of money is not stable, changes in interest
rates are not necessarily changes in real interest
rates. To the extent that changes in interest rates
reflect uncertainty about the future purchasing
power of money, mistakes in the allocation of
resources occur.
The most common forms of money in use in
the world today are the liabilities of central banks.
The almost universal requirement that taxes be
paid to governments in the form of the liabilities
of a central bank ensures that there is a demand
for such liabilities. However, to some extent the
demand for central bank liabilities is a derived
demand, dependent on people’s usage of the liabilities of financial intermediaries such as banks.
Institutional arrangements such as interest prohibitions or ceilings and idle reserve requirements
can affect the demand for central bank liabilities,
making the amount demanded at any time difficult
to estimate.
Central banks control the supply of central
bank money by acquiring or disposing of securiF E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

ties, usually those issued by a sovereign government. In effect, central banks choose levels of
nominal interest rates at which they have a horizontal demand for the liabilities of the government. If they guess correctly, the rate at which
private holders supply securities to the central
bank will generate additional central bank liabilities at the same rate as businesses and households
desire to add to their holdings (indirect in the
case of “inside money,” the deposit liabilities of
financial intermediaries). The value of money is
stable when there is neither an excess supply of
nor an excess demand for the liabilities of the
central bank.
When the public’s supply of securities to the
central bank changes, the growth rate of central
bank liabilities also changes. If the public’s demand
(direct and indirect) for central bank liabilities is
not changing in the same direction and by the
same amount, the average purchasing power of
money (the weighted average of the prices of goods
and services) will rise or fall as people seek to dispose of excess, or acquire additional, obligations
of the central bank. Such adjustments alter relative
prices and induce resource reallocations! Unavoidably, then, output potential is temporarily reduced.
Maximum output—and highest standards of living—is achieved only when the purchasing power
of money is stable.

REFERENCES
Alchian, Armen. “Why Money?” Journal of Money,
Credit, and Banking, February 1977, 9(1, Part 2),
pp. 133-40.
Alchian, Armen and Allen, William R. Exchange and
Production: Competition, Coordination, and Control,
2nd ed. Belmont, CA: Wadsworth Publishing, 1977.
Alesina, Alberto and Summers, Lawrence H.
“Central Bank Independence and Macroeconomic
Performance: Some Comparative Evidence.”
Journal of Money, Credit, and Banking, 1993, 25(2),
pp. 151-62.
Brunner, Karl, and Meltzer, Allan H. “The Uses of
Money: Money in the Theory of an Exchange

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Economy.” American Economic Review, December
1971, 61, pp. 784-805.
Buchanan, James M. “Notes on the Liberal
Constitution.” Cato Journal, Spring-Summer 1994,
14(1), p. 1-9; see p. 4.
Federal Reserve Bank of Cleveland. “Governments
and Money.” 1995 Annual Report, 1995;
www.clevelandfed.org/annual/essay.htm.
Federal Reserve Bank of Cleveland. “Theory Ahead
of Rhetoric: Economic Policy for a ‘New Economy’.”
1999 Annual Report, 1999;
www.clevelandfed.org/Annual99/theory.htm.
Federal Reserve Bank of Cleveland. “Theory Ahead
of Rhetoric: Measurement and the ‘New Economy’.”
2000 Annual Report, 2000;
www.clevelandfed.org/Annual00/essay.htm.
Federal Reserve Bank of Cleveland. “Rhetoric Aligned
with Theory: Talking Productively about Interest
Rates.” 2001 Annual Report, 2001;
www.clevelandfed.org/Annual01/essay.htm.
Federal Reserve Bank of Cleveland. “Deflation.”
2002 Annual Report, 2002;
www.clevelandfed.org/Annual02/essay.cfm.
Financial Times, November 6, 1975.
Franklin, Benjamin. A Modest Enquiry into the
Nature and Necessity of a Paper-Currency.
Philadelphia, PA: New Printing Office, 1729.
Friedman, Milton. A Theory of the Consumption
Function. Princeton, NJ: Princeton University Press,
1957.
Friedman, Milton, and Schwartz, Anna J. “Has
Government Any Role in Money?” Journal of
Monetary Economics, January 1986, 17, pp. 37-62.
Hayek, F.A. Denationalisation of Money: An Analysis
of the Theory and Practice of Concurrent Currencies.
London: Institute of Economic Affairs, 1976, p. 29.
Jefferson, Thomas. Letter to Nathaniel Macon,
Monticello, January 12, 1819.

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Jordan, Jerry L. “Governments and Money.” Cato
Journal, Fall/Winter 1996, 15(2-3), pp. 167-77;
www.cato.org/pubs/journal/cj15n2-3-2.html.
Lincoln, Abraham. “Many Free Countries Have Lost
Their Liberty.” Speech on the Subtreasury,
Springfield, Illinois, December 26, 1839.
Madison, James. “The Utility of the Union as a
Safeguard against Domestic Faction and Insurrection
(continued).” The Federalist, No. 10. Franklin
Center, PA: The Franklin Library, 1977 [1787].
Madison, James. “Alleged Danger from the Powers of
the Union to the State Governments Considered.”
The Federalist, No. 45. Franklin Center, PA: The
Franklin Library, 1977 [1788].
Madison, James. Letter to C.D. Williams, February
1820.
Madison, James. Letter to Mr. Teachle, March 15, 1831.
Mill, John S. Principles of Political Economy,
Laurence Laughlin, ed. New York: D. Appleton, 1907.
Mises, Ludwig von. Human Action: A Treatise on
Economics. New Haven, CT: Yale University Press,
1949.
Mundell, Robert. Uses and Abuses of Gresham’s Law
in the History of Money, 1998;
www.columbia.edu/~ram15/ grash.html.
Schwartz, Anna J. “Currency Boards: Their Past,
Present, and Possible Future Role.” CarnegieRochester Conference Series on Public Policy,
December 1993, 39, pp. 147-85.
Selgin, George. “Monetary Equilibrium in the
‘Productivity Norm’ of Price Level Policy.” Cato
Journal, 1990, 10, pp. 265-87.
Selgin, George. Less than Zero: The Case for a
Falling Price Level in a Growing Economy. IEA
Occasional Paper. London: Institute of Economic
Affairs, 1997.
Smith, Adam. An Inquiry into the Nature and Causes
of the Wealth of Nations, Edwin Cannan, ed.
Chicago: University of Chicago Press, 1976 [1776].

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APPENDIX
The American “Dollar” and Other Monetary Terms
Just what is a “dollar” anyway? Everyone knows what gold is; they know what silver is; or at least
there are some guys in the lab who will tell us the gold or silver content of any piece of metal. But a
“dollar”? We have pieces of paper saying “one dollar” and other pieces of paper saying more dollars.
We have stocks and bonds that are quoted as being traded for so many dollars and everyone keeps getting
bills from the electric company, the gas company, and the IRS to send them so many dollars. Fortunately,
employers have agreed to give us some dollars every month. Now, if we can just keep a balance between
the number of dollars our employer promises to give us each month (assuming we can trust him) and
the number of dollars all kinds of people say we must turn over to them—or we’ll hear from their
lawyers—we’ll be okay.
Back to the beginning. What is this thing called a “dollar” that some people promise to give us and
other people insist that we give to them? Well, it turns out that some valley in the Bohemian part of what
we now call the Czech Republic has a lot to do with it. There, coins were made out of metal to help people
make indirect exchanges between what they produced and what they wanted. The German word for
valley is thal and it was common to refer to the metal coins produced in the valley as taler coins (the
“h” being silent in German). That was often shortened to simply talers. In English, taler coins or talers
sounded like dollar coins, or simply dollars, which was how the British referred to some metal coins
made in Spain.
After the Spanish staked their claims on large chunks of the “new world,” they started getting boat
loads of gold and silver and stamping out a lot of coins. The Spanish monetary unit at the time was the
real, and an eight-reales coin—a “piece of eight”—was referred to by English-speakers as a “dollar.”
The American colonists kept their accounts in British pounds, shillings, and pence but they did not
have available to them very many British coins. What they had mostly were Spanish and Portuguese
coins, and the most common coin available to them was the Spanish “dollar” coin. Other coins available
were the Spanish doubloon and pistole, the Portuguese moidore and johannes, and the French guinea
and pistole. (Compared with these alternatives, we are fortunate that the coins the colonists had most
of were Spanish dollars.)
Because the proportion of precious metal in all these coins varied and the colonists kept their books
in terms of British pounds, it was necessary to define each of the various other metal coins in terms of
British pounds. Keeping pounds as the unit of account but using Spanish dollars as the dominant medium
of exchange was, of course, a very cumbersome arrangement. As British subjects, however, the colonists
did not have a good alternative.
After the Declaration of Independence, it finally became opportune to think about a unique monetary
system appropriate to the newly evolving nation. It seems that Thomas Jefferson quite pragmatically
concluded that, since the most familiar coin in use was the Spanish dollar coin, it would be best to
adopt a “dollar” as a standard. That meant a dollar had to be defined in terms of something of known
value—other than British pounds. He also concluded that since “every schoolboy” could multiply and
divide by ten, it would be best to have money units that were in terms of tenths of a dollar and multiples
of ten dollars. Jefferson found the British use of eighths of a money unit to be cumbersome, at best. So,
even though the Spanish had minted a “dollar coin” to be a “piece of eight” (consisting of eight reales),
the colonists ultimately defined a dollar coin to be 24.75 grains of pure gold or 371.25 grains of pure
silver. They further decided to mint a ten-dollar gold coin as well as a one-dollar gold piece and a onedollar silver piece, and to mint silver coins of one-tenth of a dollar and copper coins of one-hundredth
of a dollar.
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Thus, the dollar—like every other thing that has served as money—was initially defined in terms
of something of known value. Only gradually during the twentieth century did people come to accept
that the word “dollar” stood in its own right as a concept of value. In other words, for almost 200 years
a dollar was a claim to money—gold—and formally became money only in 1973 when the link to gold
was severed.

A Dollar as Money Is Distinct from Assets Denominated in Dollars
Currently, there is only one source of dollars: the liabilities of Federal Reserve Banks. Everything
else is a substitute for, or claim to, dollars. Actual dollars come in two forms: Federal Reserve notes and
balances (deposits) at Reserve Banks that are maintained by depository institutions, such as a commercial
bank. All transactions using Federal Reserve notes are final, certain, immediate, and (often) anonymous.
That is why people like using them. Although you do not see it directly, all taxes paid by households
and businesses to the federal government must be in the form of a transfer of ownership of balances held
at a Federal Reserve Bank to the account of the U.S. Treasury at the Federal Reserve Banks.
People commonly exchange promises to pay and receive certain amounts of dollars at definite times
in the future (bonds). Ultimately, the payor is giving a promise (which the courts will enforce) to acquire
and deliver to the payee a certain number of Federal Reserve Bank notes or bank balances denominated
in dollars (that are claims to balances at the Federal Reserve Banks) at a certain date in the future.
Consequently, only dollars serve the function of money—indirect exchange—in the United States.
Claims to money—such as balances at financial intermediaries (banks and so on)—are a part of the
monetary system. Yet, it is important to distinguish between various stores of wealth (mainly, financial
assets) that are denominated in units of money and the entity that serves as money. The purchasing
value of the dollar, for example, is not influenced by the aggregate “dollar value” of equity markets,
debt markets, money-market funds, foreign-held “eurodollar” balances, or any other instruments that
are specified in legal contracts to pay and receive dollars.

Some Monetary Terms
Coin metal tokens used as media of exchange, either full-bodied (i.e., containing the amount of
precious metal indicated by the standard) or merely representational (like paper notes)
Currency (i) name of a unit of account, e.g., “dollar,” “pound,” “yen”; (ii) paper notes used as a
medium of exchange
Monetary standard the (legal) (official) definition of the value of a currency in terms of something
else, like, e.g., gold, silver, or the discretion of the government (fiat)
Dollar (i) liability of Federal Reserve Banks; (ii) U.S. unit of account and medium of final exchange;
(iii) U.S. legal tender—a judicially enforceable right to receive payment or compensation in a certain
currency
Indirect exchange interpersonal exchange of goods or services that employs an intermediate entity
(money) rather than direct barter of final consumables
Money (i) standard of value; (ii) media of exchange used in indirect exchange; (iii) that entity that
economizes best on the use of other real resources in gathering information about relative values and
conducting transactions

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Rising Natural Gas Prices and
Real Economic Activity
Kevin L. Kliesen
In the aftermath of the disruptions caused by hurricanes Katrina and Rita, natural gas prices rose
to record-high levels. Because natural gas is an important energy source for the U.S. economy,
there was widespread concern that these high prices might cause a significant slowing in the
economy—especially among those manufacturing industries that heavily consume natural gas.
The analysis presented in this article suggests that output is responsive to natural gas prices in
some manufacturing sectors. Although perhaps significant, this result must be balanced against
the finding that, when the analysis is extended to the macroeconomy (real gross domestic product
growth), increases in crude oil prices significantly predict real gross domestic product growth, but
natural gas prices do not. (JEL Q41, Q43)
Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 511-26.

eginning in early 2002, prices of crude
oil and natural gas began to trend
upward. By September 2005, as the
damage to the production, refining,
and distribution facilities in the Gulf Coast by
hurricanes Katrina and Rita became clearer,
natural gas prices rose to record-high levels in
both nominal and real dollar terms. Although
crude oil prices rose to a record-high level in
nominal terms, they remained below the recordhigh levels in real terms seen in early 1981. Previous research has shown that sharply higher oil
prices have preceded all but one of the postWorld War II recessions. However, less is known
about the relationship between rising natural gas
prices and macroeconomic activity, despite the
fact that many manufacturing industries and,
increasingly, electric utilities are heavy consumers of natural gas. Accordingly, one might
reasonably assume that record-high levels of
natural gas prices might have significant adverse
consequences for U.S. macroeconomic activity.
This article examines developments in natural

gas prices and highlights recent trends in natural
gas usage at both the industry and national levels.
The article concludes with some empirical findings that generally suggest that rising natural gas
prices predict growth in only a handful of manufacturing industries. Perhaps surprisingly, higher
natural gas prices do not predict slower growth
for the three industries where expenditures on
natural gas are a relatively large share of total
industry shipments: primary metals, nonmetallic
mineral products, and chemicals. In terms of the
aggregate economy, increases in crude oil prices
significantly predict the growth of real gross
domestic product (GDP), but increases in natural
gas prices do not.

TRENDS IN NATURAL GAS PRICES
From 1954 to 1978, the price of natural gas
transported through the interstate pipeline system
was regulated by the Federal Power Commission.
Under this system, price-setting was based on pro-

Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis. The author thanks Hui Guo, David Henry, and Crawford Honeycutt
for comments and suggestions, and Joshua Byrge, John McAdams, and Joshua Ulrich for research assistance.

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Figure 1
Natural Gas Prices at the Wellhead
Dollars Per Thousand Cubic Feet
8
7

Nominal

Real

5
4
3
2
1
0
1949

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

SOURCE: U.S. Energy Information Administration.

duction costs and applications for rate increases
moved slowly through the bureaucratic process.1
As a result, prices changed very little from year
to year. As seen in Figure 1, from 1949 to 1978,
wellhead prices averaged $0.21 per thousand
cubic feet (mcf), with an annual standard deviation
of $0.20 per mcf.2 Although phased deregulation
began with the passage of the Natural Gas Policy
Act of 1978, prices began to rise in the mid-1970s,
a period of turmoil in international energy markets that saw a sharp increase in crude oil prices.
Eventually, natural gas prices peaked in 1984 at
$2.66 per mcf (nominal). Prices subsequently
retreated modestly and then remained fairly stable
for several years: From 1986 to 1999, natural gas
prices averaged $1.87 per mcf, with a standard
1

Yang (1977) and Ott and Tatom (1982b) discuss the history of
natural gas regulation and deregulation.

The wellhead price is that received at the point of production
(when the gas reaches the surface). According to the EIA, this price
is calculated by dividing the total reported value at the wellhead
by the total quantity produced. The latter is the amount reported
by the appropriate agencies of individual producing states and the
U.S. Mineral Management Service. The wellhead price includes
all costs prior to shipment from the lease, including gathering and
compression costs, in addition to state production, severance, and
similar charges. See the glossary in the U.S. Energy Information
Administration’s Annual Energy Review 2004 (2005); e.g., “mcf”
indicates one thousand cubic feet and one cubic foot is equal to
1,031 BTU; www.eia.doe.gov/kids/energyfacts/science/
energy_calculator.html#natgascalc.

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deviation of $0.24 per year. Following the 2001
recession, natural gas prices began to rise noticeably. By 2004, gas prices in both real and nominal
dollars were at record-high levels.
In late August 2005, Hurricane Katrina made
landfall near New Orleans, Louisiana, and then
about one month later, Hurricane Rita made landfall near the Texas-Louisiana border. These two
hurricanes caused significant damage to the Gulf
Coast’s production, refining, and distribution
facilities. In response, natural gas prices surged.
Over the first seven months of 2005, natural gas
prices at the wellhead averaged $6.06 per mcf.
By August 30, a day after Katrina’s landfall, prices
in the spot market, which typically include a
premium above the wellhead price, had surged
pass $12 per million British thermal units (BTU),
and by September 22, 2005, the day before Rita’s
landfall, the spot price had risen to $15.00 per
million BTU.3 Over the final four months of the
year, with a significant percentage of natural gas
production in the Gulf still shut-in, the wellhead
price averaged approximately $10 per mcf.
Viewed from a slightly longer-term perspec3

In anticipation of Hurricane Rita’s landfall, natural gas shipments
to the Henry Hub, Louisiana, delivery point were suspended on
September 23. Deliveries resumed on October 7. One thousand
cubic feet of natural gas is approximately equal to 1 million BTU.

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Figure 2
Energy Consumption by Major Source
Percent of Total BTU
50

0
1949

1954

1959

1964

1969

1974

Coal
Natural Gas
Petroleum

1979

1984

1989

1994

1999

2004

Nuclear Electric Power
Conventional Hydroelectric Power

SOURCE: U.S. Energy Information Administration.

tive, the hurricanes exacerbated recent trends in
higher natural gas prices. In their August 9, 2005,
Short-Term Energy Outlook (pre-Katrina), the U.S.
Energy Information Administration (EIA) noted
several factors that were expected to keep natural
gas prices at high levels over the near term:
The natural gas market is likely to stay tight
over the next couple of months, with prices
projected to rise further as the winter heating
season increases demand. Although natural
gas storage remains above the 5-year average,
several factors are expected to continue to support high natural gas prices, including: high
world oil prices; continued strength in the
economy; the expectation that Pacific Northwest hydroelectric resources will be below
normal through the rest of the year; limited
prospects for growth in domestic natural gas
production; and concerns about the potential
effects of hurricanes.

U.S. NATURAL GAS CONSUMPTION
Rising natural gas prices are a concern in the
macroeconomy because many industrial and
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

utility sectors are intensive users of natural gas
and most households rely on gas to heat their
homes during the winter months. In late 2005,
anecdotal reports from the manufacturing sector
suggested that high energy prices had indeed
raised input costs and precipitated price surcharges among some industries. Examples of this
nature were regularly cited in the Institute for
Supply Management Report on Business for the
manufacturing and nonmanufacturing sectors
and in the Federal Reserve’s “Beige Book.” The
purpose of this section is to quantify natural gas
usage in the U.S. economy—both in comparison
with other sources of energy and usage by sector.
Petroleum products remain the largest
source of energy for the U.S. economy. As seen
in Figure 2, 40.2 percent of U.S. energy consumption in 2004 (based on BTU) was derived from
petroleum products such as oil, gasoline, and
diesel fuel. Energy consumption derived from
natural gas was the next largest source (23.1
percent), followed closely by coal (22.5 percent).
The percentage of energy derived from natural
gas consumption has been falling since 1971,
when it peaked at nearly 32.4 percent of total
BTU. By 1986, the percentage of total energy from
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Table 1
Natural Gas Consumption by Sector
End-use sectors (% of total)
Residential*

Commercial†

Industrial‡

Transportation§

Total end use

Electrical power¶

1950

20.8

6.7

59.4

2.2

89.1

10.9

1960

25.9

8.5

48.2

2.9

85.6

14.4

1970

22.9

11.3

43.8

3.4

81.4

18.6

1980

23.9

13.1

41.2

3.2

81.5

18.5

1990

22.9

13.7

43.1

3.4

83.1

16.9

2000

21.4

13.6

39.8

2.8

77.7

22.3

2004

21.9

13.4

37.7

3.1

76.0

24.0

NOTE: *Consumption by private households. †Consumption by nonmanufacturing establishments. ‡Consumption by establishments
engaged primarily in processing unfinished materials into another form of product; this includes mining, petroleum refining manufacturing, and (beginning in 1996) agriculture, forestry, and fishing. §Natural gas transmission (pipeline) fuel and natural gas delivered
for use as vehicle fuel. ¶Electric utilities and independent power producers.
SOURCE: U.S. Energy Information Administration, Annual Energy Review, 2004 (2005).

natural gas had fallen to just under 22 percent;
however, it has since stabilized. Consumption of
nuclear energy and conventional hydroelectric
power sources are significantly smaller, both less
than 10 percent of the total.
Table 1 details natural gas consumption in
the economy by the four major end-use sectors
(residential, commercial, industrial, and transportation) and by the electrical power–generating
sector. Traditionally, the industrial sector has been
a heavy consumer of natural gas.4 For instance,
in 1950 it accounted for nearly 60 percent of total
natural gas consumption.5 The next highest enduser was the residential sector (20.8 percent),
followed by the commercial (6.7 percent) and
transportation (2.2 percent) sectors. (See Table 1
for sector descriptions and definitions.) Over time,
there has been a shift in usage shares away from
the industrial sector toward the commercial and
electrical power generation sectors. In 1950, the
4

Consumption by establishments engaged primarily in processing
unfinished materials into another form of product; this includes
mining, petroleum refining manufacturing, and, beginning in 1996,
agriculture, forestry, and fishing.

Excluding the electric power sector (the “end-use” sectors),
industrial consumption usage was nearly 67 percent of all end-usage
in 1950. By 2004, its end-usage share had dropped to 49.5 percent.

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electric power sector accounted for about 11
percent of natural gas consumption, while the
commercial sector consumed a little less than 7
percent. Since then the shares of the commercial
and electrical-generation sectors have doubled,
while there has been relatively little change in the
share of natural gas consumed by the residential
and transportation sectors. Although industrial
usage still accounts for the largest share of total
consumption in 2004, its share has declined by
more than a third.
One of the purposes of this article is to assess
whether changes in natural gas prices help to
predict changes in the growth of manufacturing
and aggregate output and whether changes in gas
prices matter more than changes in crude oil
prices. This is difficult to accomplish because
energy consumption by industry is not available
on a timely basis. However, the EIA periodically
surveys manufacturers about their energy use.
This is known as the Manufacturing Energy
Consumption Survey (MECS).
According to the 2002 (latest) MECS, six
industries accounted for a little more than 83
percent, or 5,400 trillion BTU, of the roughly
6,500 trillion BTU of natural gas consumed by
manufacturers in 2002: chemicals, petroleum and
coal products, primary metals, food, paper, and
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Kliesen

Table 2
Percentage of BTU Usage in the Manufacturing Sector Derived from Natural Gas (in trillion BTU)

NAICS code

Subsector and industry

Total*

Natural gas†

Gas BTU
as a % of total

1,123

582

51.83

Importance in
industrial
production‡

311

Food

8.32

312

Beverage and tobacco products

105

43.81

2.64

313

Textile mills

207

36.23

0.62

314

Textile product mills

48.33

0.52

315

Apparel

53.33

0.68

316

Leather and allied products

57.14

0.11

321

Wood products

377

15.12

1.58

322

Paper products

2,363

504

21.33

2.77

323

Printing and related support

46.94

2.09

324

Petroleum and coal products

6,799

878

12.91

2.22

325

Chemicals

6,465

2,307

35.68

10.38

326

Plastics and rubber products

351

128

36.47

3.62

327

Nonmetallic mineral products

1,059

422

39.85

2.27

331

Primary metals

2,120

704

33.21

2.50

332

Fabricated metal products

388

210

54.12

5.76

333

Machinery

177

46.33

5.40

334

Computer and electronic
products

201

32.34

8.25

335

Electrical equipment, appliances,
and components

172

30.81

2.12

336

Transportation equipment

429

203

47.32

10.91

337

Furniture and related products

39.06

1.69

339

Miscellaneous manufacturing

45.07

3.24

22,666

6,468

28.54

77.71

Total

NOTE: *”Total” is the sum of all of the listed energy sources, including “miscellaneous manufacturing,” minus the shipments of energy
sources produced onsite. It is the total amount of first use of energy for all (fuel and nonfuel) purposes. †”Natural gas” includes natural
gas obtained from utilities, local distribution companies, and any other suppliers, such as independent gas producers, gas brokers,
marketers, and any marketing subsidiaries of utilities. ‡Relative importance estimates the contribution of the industry to the growth
of total industrial production in the following year.
SOURCE: U.S. Energy Information Administration, 2002 Energy Consumption by Manufacturers (Table 1.2) (www.eia.doe.gov/emeu/
mecs/mecs2002/data02/shelltables.html) and Board of Governors of the Federal Reserve System (industrial production data).

nonmetallic mineral products (see Table 2). The
chemical industry consumed the most natural gas
(2,307 trillion), accounting for about 36 percent
of the total manufacturing BTU usage. The next
largest user, petroleum and coal products, used
about a third as much natural gas as the chemical
industry. In terms of their relative importance,
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

these industries accounted for about 30 percent
of total industrial production in 2005. Table 2 also
shows that there are four industries that derive
at least 50 percent of their energy demand from
natural gas: leather and allied products, fabricated
metal products, apparel, and food. However,
these four gas-intensive industries combined
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Table 3
Natural Gas Expenditures as a Percent of Manufacturing Shipments, 1998 and 2002
NAICS code

Manufacturing industry

2002 share

1998 share
0.39

311

Food

0.55

312

Beverage and tobacco products

0.19

0.14

313

Textile mills

0.76

0.59

314

Textile product mills

0.40

0.28

315

Apparel

0.19

0.13

316

Leather and allied products

0.30

0.16

321

Wood products

0.31

0.24

322

Paper products

1.36

0.99

323

Printing and related support

0.24

0.17

324

Petroleum and coal products

1.44

1.57

325

Chemicals

1.62

1.37

326

Plastics and rubber products

0.37

0.27

327

Nonmetallic mineral products

1.86

1.39

331

Primary metals

2.06

1.62

332

Fabricated metal products

0.42

0.33

333

Machinery

0.17

0.13

334

Computer and electronic products

0.10

0.05

335

Electrical equipment, appliances, and components

0.25

0.15

336

Transportation equipment

0.13

0.11

337

Furniture and related products

0.17

0.16

339

Miscellaneous manufacturing

0.13

0.15

Total

0.64

0.49

Average wellhead price, $ per thousand cubic feet

2.95

1.96

SOURCE: U.S. Energy Information Administration (energy expenditures data) and the U.S. Department of the Census (manufacturing
shipments data).

account for a much smaller share of industrial
production, about 15 percent.
Table 3 provides an alternative method of
measuring the intensity of natural gas usage.
This table shows the dollar value of the industry’s
total expenditures on natural gas as a percent of
its total shipments in the 2002 and 1998 MECS
years. Recall from Table 2 that the three most
gas-intensive industries were leather and allied
products, fabricated metal products, and apparel.
Each of these three industries relies on natural
gas for more than 50 percent of its total BTU usage.
As shown in Table 3, though, the three most gas516

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intensive industries in 2002 were primary metals,
nonmetallic mineral products, and chemicals. The
paper and petroleum and coal products industries
were the only other industries where expenditures were more than 1 percent of total industry
shipments in 2002. Compared with 1998, expenditures on natural gas as a share of shipments for
all industries rose from about 0.5 percent to 0.6
percent, even though the nominal price of natural
gas rose by slightly more than 50 percent. Still,
as a percent of total shipments, expenditures on
natural gas are fairly small for all manufacturing
industries.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Kliesen

ENERGY PRICES AND THE
MACROECONOMY
Economic theory predicts that a large increase
in the relative price of energy will increase the
per-unit cost of output, thus increasing the output
(supply) price. Hence, in the standard textbook
model (for example, see Abel and Bernanke, 2005),
a rise in energy prices, in the absence of a fiscal
or monetary policy response, reduces aggregate
output and employment and raises the price level.
One rule of thumb is that a $10 per barrel rise in
oil prices will reduce real GDP by 0.4 percent
after four quarters.6 As an important energy input
in the U.S. economy, increases in natural gas
prices would be expected to have virtually the
same effect in the textbook model as a rise in
crude oil prices. Accordingly, one should expect
that the effects of an increase or decrease in natural
gas prices on economic activity would be conceptually similar as that for crude oil prices.

Oil Price Effects
There is much research that explores the
relationship between energy prices and economic
activity, and a reading of this literature suggests
that oil prices matter. This should probably not
be surprising given that petroleum still accounts
for 40 percent of U.S. energy usage. The prevailing
view is that increases in oil prices reduce real
GDP growth for several quarters. The size of the
effect varies, but earlier studies seem to suggest
larger effects than later studies. This could reflect
the fact that the U.S. economy has become more
energy efficient over time.7
For a recent survey, see Jones, Leiby, and
Paik (2004). Hamilton (1983), among many others,
has documented a negative and significant relation between oil price changes and future GDP
growth. Early research efforts by the Energy
Modeling Forum at Stanford University (1987),
which employed several well-known macroeconomic forecasting models in use at the time, were
consistent with Hamilton’s findings. Conversely,
6

See Council of Economic Advisers (2005, p. 32).

Energy consumption per unit of GDP (thousands of BTU per one
dollar of real GDP) declined by 41 percent from 1979 to 2004.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

recent research by Barsky and Kilian (2004) suggest that the causality runs in the other direction.
That is, stronger (weaker) macroeconomic growth
increases (decreases) the demand for oil and thus
the price of oil.
Hooker (1996) found that Hamilton’s result
breaks down after 1986, a year in which, perhaps
not coincidentally, there was a sharp, unexpected
drop in oil prices. The unstable oil-macroeconomy
relation possibly reflected the fact that Hamilton
had implicitly assumed a symmetric effect of oil
shocks in his linear specification: An increase
(decrease) in oil prices reduces (raises) future GDP
growth. This specification is consistent with the
view of some transmission channels—for example,
Rasche and Tatom (1977a,b), Baily (1981), Energy
Modeling Forum (1987), and Wei (2003).8
However, the effect can be also asymmetric.
In particular, a sharp oil price change—either
increase or decrease—affects the macroeconomy
adversely for at least two reasons. First, it raises
uncertainty about future oil prices and thus causes
delays in business investment (e.g., Bernanke,
1983, and Pindyck, 1991). Similarly, Guo and
Kliesen (2005) found that oil price volatility—a
measure of uncertainty—reduced real GDP growth
and other measures of macroeconomic activity
over the period 1984-2004. Second, it induces
costly resource reallocations (e.g., Lilien, 1982,
and Hamilton, 1988). Overall, whereas an oil
price increase has a negative effect on future
GDP growth, the effect of an oil price decrease is
ambiguous. Subsequent work by Hamilton (1996
and 2003) revealed asymmetries with respect to
oil price changes and real GDP growth.

Natural Gas Price Effects
The literature examining the relationship
between natural gas prices and macroeconomic
activity appears to be considerably more sparse.
However, because natural gas consumption in the
aggregate economy is about half as much as petroleum (in terms of BTU), it might be reasonable to
conclude that rising natural gas prices might have
smaller aggregate effects than do oil prices. Early
8

Also see Jones, Leiby, and Paik (2004) for discussion on various
transmission channels of oil shocks.

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work in this area appeared in a special issue of
the October 1982 Contemporary Policy Issues.
There were three papers in this issue that studied
the effects of lifting natural gas price controls (i)
on regional economic activity (Leone, 1982), (ii)
on the distribution of income between households
and suppliers (Stockfisch, 1982), and (iii) on inflation (Ott and Tatom, 1982a). The general conclusion of the papers was that the presumed effects
of natural gas decontrol (higher prices, higher
inflation, and falling real incomes) were not
expected to be significant. According to the Energy
Modeling Forum (1987), a 10 percent increase in
natural gas prices was found to have roughly the
same effect on real GDP growth (two years after
the shock) as a 20 percent increase in oil prices.
According to the median result of 11 models, a
50 percent oil shock reduced real gross national
product by about 1.5 percent after one year and by
a little less than 3 percent by the end of two years.9
At the disaggregated level, Cullen, Friedberg, and
Wolfram (2005) studied the effects of anticipated
and unanticipated shocks to household disposable income arising from increased energy expenditures on household consumption. They found
that increases in energy prices reduce consumption among lower-income households, but only
when the increase is unanticipated.
More recently, the Energy Modeling Forum
at Stanford University hosted a conference in
December 2005: “World Natural Gas Markets and
Trade.” According to an Economics and Statistics
Administration (2005) study prepared for the U.S.
Congress, a permanent $1 increase in natural gas
prices (wellhead price) over the period 2000-04
reduced real GDP growth by 0.1 percentage points
per year.10 Studies by Global Insight and Oxford
Economics Forecasting were cited as showing
similar results.
However, because some manufacturing industries are more natural gas–intensive than others, it
9

Using a general-equilibrium framework, Guerrieri (2005) found
that a 50 percent permanent increase in the price of oil reduced
U.S. real GDP growth by 0.6 percent after one year and 1.9 percent
after two years (relative to the baseline forecast).

The study used an interindustry model of the U.S. economy
developed at the University of Maryland (INFORUM LIFT);
www.stanford.edu/group/EMF/projects/emf23/Henry.pdf.

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is possible that the disaggregated effects are more
significant. The next section examines this issue.

EMPIRICAL ANALYSIS
This analysis will test whether higher natural
gas prices predict the growth of U.S. manufacturing output and real GDP: Aggregate manufacturing
output will be measured using the manufacturing
component of the industrial production (IP) index;
the disaggregated measures are IP output at the
three-digit NAICS level for all manufacturing
industries.11 The IP indices are published monthly
by the Federal Reserve Board of Governors. The
natural gas price data series used in the empirical
analysis is the producer price index (PPI) for natural gas, which is a commodity index published
monthly by the Bureau of Labor Statistics. One
potential shortcoming of this approach is that
natural gas prices paid can vary significantly
across industries. For example, the 2002 MECS
found that the average price paid by three-digit
NAICS industries varied between $3.37 and $5.47
per million BTU; the standard deviation was $0.57
per million BTU. Although the use of price-hedging
arrangements such as fixed-price or futures markets contracts may allow some firms to pay less
on average than other firms, it seems reasonable
to conclude that, eventually, all firms must bear
price increases or decreases based on market
trends.
The empirical analysis will follow the general
form of a simple least-squares regression:
(1)
n

∆ ln( X t ) = at + ∑ bi ∆ ln( X t − i ) + ci ∆ ln( Pt − i ) + εt ,
i =1

where at is a constant, Xt is output, and Pt is the
PPI measure of natural gas prices. The maximum
lag length is set to 12 for the monthly analysis and
4 for the quarterly analysis, and the optimum lag
length is determined by using the Akaike information criterion (AIC) statistic. The sample period
begins in January 1979, which immediately fol11

Total industrial production also includes output produced by
mines and utilities. Thus, the analysis presented in this paper
excludes the effects of higher natural gas prices on these sectors.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Kliesen

Table 4
Do Changes in Natural Gas Prices Affect the Industrial Sector?
IP sector

Lags (AIC)

Sum of ci coefficient

p-Value

Manufacturing

0.0033

0.862

Food

0.0013

0.709

Beverages and tobacco products

0.0232

0.419

Textile mills

–0.0499

0.416

Textile product mills

–0.0381

0.844

Apparel

0.0276

0.284

Leather and allied products

0.0379

0.255

Wood products

–0.0031

0.791

Paper products

–0.0091

0.791

Printing and related support activities

0.0062

0.920

Petroleum and coal products

–0.0063

0.256

Chemicals

–0.0033

0.519

Plastics and rubber products

–0.0030

0.612

Nonmetallic mineral products

0.0186

0.192

Primary metals

–0.0170

0.614

Fabricated metal products

–0.0007

0.800

Machinery

–0.0254

0.148

Computers and electrical products

–0.0158

0.371

Electrical equipment, appliances, and components

–0.0372

0.841

Transportation equipment

–0.0063

0.61

Furniture and related products

–0.0155*

0.077

Miscellaneous manufacturing

–0.0031

0.742

NOTE: The table reports the general form of the model that was run over the period January 1979 to February 2006:
n

∆ ln(IP _ Sectort ) = at + ∑ bi ∆ ln(IP _ Sectort − i ) + ci ∆ ln( PPI _ NatGast − i ) +et .
i =1

IP is industrial production (total and individual industry), and PPI_NatGas is the producer price index for gas fuels. The p-values are
from the test of the null that all of the lags of PPI_NatGas are equal to zero. The optimum lag length chosen by the AIC statistic. For
the reported p-values, ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively.

lows the commencement of U.S. natural gas deregulation, and extends through February 2006.
The results are reported in Table 4.12 Each
row reports the results of separate regressions for
total manufacturing output and industry output
at the three-digit NAICS level. Following Hamilton
12

In results not reported here, the growth of U.S. manufacturing
output (log change) was regressed on a constant, the growth (log
change) in natural gas prices, and its coefficient was positive and
not significantly different from zero. In fact, the adjusted R2 of the
equation was negative. This regression was subsequently augmented
(i) with last period’s output growth and (ii) by cyclical changes in

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

(2003), the table regresses contemporaneous output growth (log change) on an equal number of
its lags and lags in the log change in natural gas
prices. As Hamilton showed, even though the
individual coefficients of the lagged energy prices
may not be significantly different from zero, collectively they may be significantly different from
economic activity, as measured by the unemployment rate. The
adjusted R2 of the final specification was only about 20 percent.
For brevity, the results are not published here, but are available
from the author.

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Figure 3
Hamilton Transformations of Petroleum and Natural Gas Prices (36 months)
Percent
40
PPI Gas

PPI Oil
30
25
20
15
10
5
0
1958

1963

1968

1973

1978

1983

1988

1993

1998

2003

NOTE: Shaded bars indicate recessions.

zero.13 As indicated by the p-value, a simple F-test
is used to determine whether the sum of the coefficients on the natural gas prices is significantly
different from zero.
The results in Table 4 are revealing. First,
changes in natural gas prices do not significantly
predict total manufacturing output. Although the
sum of the coefficients in the aggregate regression
is positive, it is not significantly different from
zero. Second, regressions at the three-digit NAICS
level reveal that the furniture and related products
sector is the only industry where changes in natural gas prices help to predict output growth. In
this case, the sum of the coefficients is negative,
as expected, and significant at the 10 percent level.
The other regressions in Table 4 suggest that
changes in natural gas prices do not help to predict output growth for the remaining industries.
In fact, the sum of the coefficients for 6 of the 21
industries is positive, with 12 of the industries
reporting p-values greater than 0.5.
13

This amounts to running a constrained and unconstrained regression (with and without the lags on natural gas prices).

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Using An Alternative Measure of
Natural Gas Prices
Hamilton (2003) showed that an asymmetric
measure of oil prices helps explain real GDP
growth. To test whether there are similar asymmetries with respect to natural gas prices, this
article constructs two transformations of monthly
natural gas prices that are consistent with his
findings. The first is the percentage difference in
the maximum price (log) over the most recent 12
months. The second uses a 36-month interval. If
the percentage difference is negative, that month’s
observation is arbitrarily set to zero. Thus, in the
Hamilton framework, only energy price increases
matter; energy price decreases do not matter.
Figure 3 plots the transformation for crude oil
and natural gas prices for the 36-month interval.
The figure shows that price increases for crude
oil tend to be larger before 1990, while natural
gas price increases tend to be larger after 1990.
Tables 5 and 6 attempt to assess whether
Hamilton’s transformations for natural gas and
crude oil prices help to explain growth of manufacturing output at the aggregate and disaggregated
level. Table 5 uses Hamilton’s price changes over
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Kliesen

Table 5
Do Increases in Crude Petroleum and Natural Gas Prices Affect Manufacturing Activity?
A Test Using Hamilton’s 12-Month Specification
Crude petroleum

Natural gas

Lags (AIC)†

Sum of ci
coefficient

p-Value

Lags (AIC)†

Sum of ci
coefficient

p-Value

Manufacturing

–0.0206

0.535

–0.0099

0.555

Food

0.0150

0.190

0.0027

0.707

Beverages and tobacco products

0.0348

0.113

0.0070

0.803

–0.1079

0.176

–0.0592**

0.035

Textile product mills

–0.1498*

0.057

–0.0583

0.336

Apparel

0.0000

0.656

–0.0427

0.149

Leather and allied products

–0.0017

0.114

–0.0849

0.172

–0.2520**

0.040

–0.0319

0.945

–0.0147

0.554

–0.0787**

0.027

IP sector

Textile mills

Wood products

Paper products

Printing and related activities

–0.0312

0.276

–0.0263

0.631

Petroleum and coal products

–0.0946***

0.010

–0.0103

0.261

Chemicals

–0.0109

0.501

0.0002

0.987

Plastics and rubber products

–0.0281

0.133

–0.0146

0.217

Nonmetallic mineral products

–0.1034***

0.008

0.0171

0.252

Primary metals

–0.0522

0.601

–0.0283

0.514

Fabricated metal products

–0.0249*

0.051

–0.0137

0.656

Machinery

–0.009

0.772

–0.0256

0.324

Computer and electrical products

–0.0077

0.958

–0.0358

0.167

Electrical equipment, appliances,
and components

–0.0499

0.877

–0.0639

0.490

Transportation equipment

–0.0698*

0.080

–0.0307

0.222

Furniture and related products

–0.0574

0.121

–0.0231

0.228

Miscellaneous manufacturing

–0.0132

0.716

–0.0188

0.182

NOTE: The table reports the general form of the two regressions (for the separate energy price series) that were run over the period
January 1979 to February 2006:
n

∆ ln(IP _ Sectort ) = at + ∑ bi ∆ ln(IP _ Sectort − i ) + ci ∆ ln( H 1.PPI _ Energy t − i ) + et .
i =1

IP is industrial production (total and individual industry), and H1.PPI_Energy is the producer price index for natural gas and domestic
crude petroleum production transformed according to Hamilton (2003); the transformation period is 12 months. The p-values are from
the test of the null that all of the lags of H1.PPI_NatGas are equal to zero. For the reported p-values, ***, **, and * denote significance
at the 1, 5, and 10 percent levels, respectively. †The optimum lag length was chosen by the AIC statistic.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

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Table 6
Do Increases in Crude Petroleum and Natural Gas Prices Affect Manufacturing Activity?
A Test Using Hamilton’s 36-Month Specification
Crude petroleum

Natural gas

Lags (AIC)†

Sum of ci
coefficient

p-Value

Lags (AIC)†

Sum of ci
coefficient

p-Value

Manufacturing

–0.0444

0.125

–0.0186

0.365

Food

0.0086

0.509

0.0000

0.996

Beverages and tobacco products

–0.0470

0.151

–0.0802**

0.033

Textile mills

–0.0532

0.151

–0.0426**

0.033

Textile product mills

–0.1869**

0.016

–0.1159

0.434

Apparel

0.0088

0.403

–0.020

0.651

Leather and allied products

–0.0070

0.120

–0.1143**

0.013

–0.3299**

0.021

–0.0639

0.631

–0.0115

0.659

–0.0623*

0.097

IP sector

Wood products

Paper and products

Printing and related support

–0.0452

0.358

–0.0172

0.610

Petroleum and coal products

–0.1157***

0.004

–0.002

0.342

Chemicals

–0.0157

0.395

0.0049

0.713

Plastics and rubber products

–0.0343

0.105

–0.0144

0.342

Nonmetallic mineral products

–0.1478***

0.002

0.0091

0.674

Primary metals

–0.0534

0.678

–0.0438

0.481

Fabricated metal products

–0.0681***

0.003

–0.0157

0.608

Machinery

–0.0637

0.365

–0.0944**

0.022

–0.0360

0.725

–0.0773**

0.016

–0.0883

0.412

–0.1101

0.309

Computers and electrical products
Electrical equipment, appliances,
and components
Transportation equipment

–0.0892**

0.048

–0.0181

0.573

Furniture and related products

–0.1564***

0.003

–0.0296

0.263

Miscellaneous manufacturing

–0.0294

0.328

–0.0292**

0.049

NOTE: The table reports the general form of the two regressions (for the separate energy price series) that were run over the period
January 1979 to February 2006:
n

∆ ln(IP _ Sectort ) = at + ∑ bi ∆ ln(IP _ Sectort − i ) + ci ∆ ln( H 3.PPI _ Energy t − i ) + et .
i =1

IP is industrial production (total and individual industry) and H3.PPI_Energy is the producer price index for natural gas and domestic
crude petroleum production transformed according to Hamilton (2003); the transformation period is 36 months. The p-values are from
the test of the null that all of the lags of H3.PPI_NatGas are equal to zero. For the reported p-values, ***, **, and * denote significance
at the 1, 5, and 10 percent levels, respectively. †The optimum lag length was chosen by the AIC statistic.

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F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Kliesen

a 12-month period, and Table 6 uses price changes
over a 36-month period. The latter corresponds
with the 3-year period that Hamilton used in his
2003 article. As in Table 4, Tables 5 and 6 report
the number of significant lags of the natural gas
variable based on the AIC criteria, as well as the
sum of the coefficients of the lags. The tables also
report the p-values for the lags at the conventional
1, 5, and 10 percent levels of significance.
Switching to the Hamilton transformation
for natural gas prices produces results that are
broadly consistent with the theory noted above.
Table 5 shows that, for total manufacturing output,
the sum of the lagged coefficients on gas prices
is negative (first line); however, they are still not
significantly different from zero (p-value of 0.56).
This result is essentially the same for crude oil
prices. Table 5 also shows that when Hamilton’s
12-month specification is used, the number of
industries where increases in gas prices significantly predict industry output growth increases
from one to two: textile mills and paper products.
In both cases, the effects of higher gas prices
linger from 6 to 12 months. Perhaps of greater
interest, Table 5 also shows that there are six
manufacturing industries that are significantly
affected by changes in crude oil prices—three
times the number that are affected by increases
in natural gas prices. The sum of the coefficients
on each of these industries is the expected sign.
Table 6 is an extension of Table 5. In this case,
results are reported using the 36-month specification. In this specification, changes in natural
gas prices have a negative effect on the growth of
manufacturing output (line 1), but the p-value is
still insignificant (0.37). Unlike Table 5, which
showed comparable results for increases in oil
and gas prices on total manufacturing output, the
first line of Table 6 shows that the sum of the
coefficients on crude oil prices (–0.044) is more
than twice as large as that for natural gas prices
(–0.019), but the p-value for crude oil is not significant. Another interesting difference between the
results in Tables 5 and 6 is that the number of
industries that are significantly affected by changes
in natural gas prices increases from two to seven.
As before, the sum of the coefficients is still negaF E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

tive. Combined, these seven industries comprise
about a quarter of manufacturing’s total weight
in IP (reported in Table 2). Also of interest, higher
gas prices do not significantly help predict output
growth in the three industries where expenditures
on natural gas were the largest percentage of total
industry shipments: primary metals, nonmetallic
mineral products, and chemicals (see Table 3).
This might explain why the aggregate effect (line 1)
is not significant. As an aside, the finding for the
chemical industry is particularly interesting, since
it is by far the largest user of natural gas (see
Table 2).
Finally, Table 6 shows that increases in crude
oil prices have similar predictive effects on output when the Hamilton specification is extended
to 36 months. In this case, the number of industries where increases in crude oil prices significantly predict output increases from six to seven.
Again, the sum of the coefficients in each case
has the expected negative sign. As with the seven
industries in the previous paragraph, these seven
industries also combine to comprise about a quarter of manufacturing’s weight in IP.

Extending the Analysis to the Aggregate
Level
The basic conclusion of the results presented
in Tables 5 and 6 is that crude oil prices seem to
have a more significant predictive effect for manufacturing industry output growth using Hamilton’s
12-month specification, but essentially comparable effects when the specification is extended to
36 months. Table 7 reports an extended version
of Hamilton’s findings to assess whether this finding holds for real GDP. Hamilton (2003) found that
the explanatory power of his 3-year specification
for oil price increases was much more significant
than the 1-year specification in explaining real
GDP growth.14 Using data from the first quarter
of 1979 through the fourth quarter of 2005, Table
7 shows that this is still the case: The p-value using
Hamilton’s 12-quarter specification is significant,
14

Hamilton’s results are based on data that begin in 1948, a much
longer time series than reported here. As in Hamilton’s work,
Table 7 uses four lags and it adopts Hamilton’s convention of using
the log change in quarterly real GDP (not annualized).

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Table 7
Do Changes in Natural Gas Prices Matter for Real GDP Growth?
Hamilton regressions: energy prices

F-Statistic

p-Value

4-Quarter transformation
Crude oil prices

1.349

0.258

Natural gas prices

0.549

0.701

Crude oil prices

3.550***

0.0096

Natural gas prices

1.613

0.177

12-Quarter transformation

NOTE: The regressions present statistics from the following specification:
n

∆ ln( real _ GDPt ) = at + ∑ bi ∆ ln( real _ GDPt − i ) + ci ∆ ln( PPI _ Energy t − i ) + et ,
i =1

where n = 4. PPI_Energy is the producer price index for gas fuels and domestic crude petroleum production transformed according to
Hamilton (2003). The model is estimated over the period 1979:Q1-2005:Q4. For the reported p-values, ***, **, and * denote significance
at the 1, 5, and 10 percent levels, respectively.

but it is not significant for the 4-quarter
transformation.
Table 7 also reports tests of whether changes
in natural gas prices predict real GDP growth.
The evidence presented in the table suggests that
that is not the case. Unlike increases in crude oil
prices, increases in natural gas prices do not significantly predict real GDP growth using either
of Hamilton’s specifications. These results are
generally consistent with the total manufacturing
results reported earlier.

CONCLUSION
In the aftermath of the disruptions caused by
hurricanes Katrina and Rita, natural gas prices
faced by consumers and producers rose to recordhigh levels. Because natural gas is the second
most important energy source for the economy,
there was widespread concern that these high
prices might cause a significant slowing in the
economy and among those manufacturing industries that depend heavily on natural gas as a source
of energy. The analysis presented in this article
offers some support for the latter contention, but
only when prices are transformed according to
the specification suggested by Hamilton. However,
the results using Hamilton’s specifications indi524

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cate that changes in natural gas prices do not cause
significant output effects for the two manufacturers
that are the most-intensive users of natural gas
(primary metals and nonmetallic mineral products), although they do cause significant output
effects for other, less-intensive manufacturers
(such as machinery and computers and electrical
products). While perhaps significant, this result
must be balanced against the finding that, when
the analysis is extended to the macroeconomy
(real GDP), increases in crude oil prices significantly predict real GDP growth, but natural gas
prices do not.

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Macroeconomics. Fifth Edition. Boston: Pearson
Addison Wesley, 2005.
Baily, Martin Neal. “Productivity and the Service of
Capital and Labor.” Brookings Papers on Economic
Activity, 1981, 1, pp. 1-50.
Barsky, Robert B. and Kilian, Lutz. “Oil and the
Macroeconomy Since the 1970s.” Journal of
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Bernanke, Ben S. “Irreversibility, Uncertainty, and
Cyclical Investment.” Quarterly Journal of
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Hooker, Mark A. “What Happened to the Oil Price–
Macroeconomy Relationship?” Journal of Monetary
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Council of Economic Advisers. Economic Report of
the President. Washington, DC: U.S. Government
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Jones, Donald W.; Leiby, Paul N. and Paik, Inja K.
“Oil Price Shocks and the Macroeconomy: What
Has Been Learned Since 1996?” Energy Journal,
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Cullen, Julie B.; Friedberg, Leora and Wolfram,
Catherine. “Do Households Smooth Small
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and Unanticipated Variation in Home Energy Costs.”
CSEM Working Paper 141, Center for the Study of
Energy Markets, University of California Energy
Institute, 2005.
Economics and Statistics Administration. “Impacts
of Rising Natural Gas Prices on the U.S. Economy
and Industries: Report to Congress.” U.S. Department
of Commerce, June 29, 2005; www.esa.doc.gov.
Energy Modeling Forum. “Macroeconomic Impacts
of Energy Shocks: A Summary of the Key Results,”
in B.G. Hickman, H.G. Huntington, and J.L. Sweeney,
eds., Energy Modeling Forum Report 7. Volume 1.
Stanford University/North Holland, 1987.
Guerrieri, Luca. “The Effects of Oil Shocks on the
Global Economy.” Unpublished manuscript,
Federal Reserve Board, 2005.
Guo, Hui, and Kliesen, Kevin L. “Oil Price Volatility
and U.S. Macroeconomic Activity.” Federal Reserve
Bank of St. Louis Review, November/December
2005, 87(6), pp. 669-83.
Hamilton, James D. “Oil and the Macroeconomy
since World War II.” Journal of Political Economy,
April 1983, 91(2), pp. 228-48.
Hamilton, James D. “A Neoclassical Model of
Unemployment and the Business Cycle,” Journal
of Political Economy, 1988, 96(3), pp. 593-617.
Hamilton, James D. “This Is What Happened to the
Oil Price–Macroeconomy Relationship.” Journal of
Monetary Economics, 1996, 38(2), pp. 215-20.
Hamilton, James D. “What Is an Oil Shock.” Journal
of Econometrics, 2003, 113(2), pp. 363-98.

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Leone, Robert A. “Impact of Higher Natural Gas Prices
on the Northeast Regional Economy.” Contemporary
Policy Issues, October 1982, 1(1), pp. 1-8.
Lilien, David M. “Sectoral Shifts and Cyclical
Unemployment.” Journal of Political Economy,
August 1982, 90(4), pp. 777-93.
Ott, Mack and Tatom, John A. “Are There Adverse
Inflation Effects Associated with Natural Gas
Decontrol?” Contemporary Policy Issues, October
1982a, (1), pp. 27-46.
Ott, Mack and Tatom, John A. “A Perspective on the
Economics of Natural Gas Decontrol.” Federal
Reserve Bank of St. Louis Review, November 1982b,
64(9), pp. 19-31.
Pindyck, Robert. “Irreversibility, Uncertainty, and
Investment.” Journal of Economic Literature,
September 1991, 29(3), pp. 110-48.
Rasche, Robert H. and Tatom, John A. “The Effects of
the New Energy Regime on Economic Capacity,
Production, and Prices.” Federal Reserve Bank of
St. Louis Review, May 1977a, 59(5), pp. 2-12.
Rasche, Robert H. and Tatom, John A. “Energy
Resources and Potential GNP.” Federal Reserve
Bank of St. Louis Review, June 1977b, 59(6),
pp. 10-24.
Stockfisch, J.A. “The Income Distribution Effects of a
Natural Gas Price Increase.” Contemporary
Economic Policy Issues, October 1982, 1(1), pp. 9-26.
United States Energy Information Administration.
Annual Energy Review 2004, U.S. Department of
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Wei, Chao. “Energy, the Stock Market, and the PuttyClay Investment Model.” American Economic
Review, March 2003, 93(1), pp. 311-23.
Yang, Jai-Hoon. “The Nature and Origins of the U.S.
Energy Crisis.” Federal Reserve Bank of St. Louis
Review, July 1977, 59(7), pp. 2-12.

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The Transition to Electronic Communications
Networks in the Secondary Treasury Market
Bruce Mizrach and Christopher J. Neely
This article reviews the history of the recent shift to electronic trading in equity, foreign exchange,
and fixed-income markets. The authors analyze a new data set: the eSpeed electronic Treasury network. They contrast the market microstructure of the eSpeed trading platform with the traditional
voice-assisted networks that report through GovPX. The electronic market (eSpeed) has greater
volume, smaller spreads, and a lower estimated trade impact than the voice market (GovPX).
(JEL G14, G12, D4, C32)
Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 527-41.

n the past 15 years, advances in information technology have revolutionized electronic trading—posting quotes, transacting,
and confirming orders electronically. Electronic methods have grown to dominate trading
in major asset markets, such as equities, foreign
exchange, and most recently U.S. Treasuries.
The Securities and Exchange Commission
(SEC) (2000) defines electronic communications
networks (ECNs) as “electronic trading systems
that automatically match buy and sell orders at
specified prices.”1 ECNs have several advantages
over other systems, such as open-outcry trading
floors or telephone trading. First, ECNs permit
users all over the world to trade, without regard
to physical location. Second, ECNs permit the
number of traders, the size of trades, or the asset
to vary costlessly. Third, ECNs automate the processing and clearing of trading, reducing the risk
of clearing errors and facilitating risk management
(Bank for International Settlements [BIS], 2001).
1

One should not confuse ECNs, which offer firm prices and immediate execution, with other forms of trading that use electronic
technology.

The advantages of ECNs are most evident in the
markets for more liquid and homogenous assets.
In contrast, assets whose trading requires more
customization—that is, negotiation over quantities
and settlement details—will benefit from human
brokers. Barclay, Hendershott, and Kotz (2006)
discuss the conditions under which voice brokers
outperform ECNs in conveying complex information (“market color”) during trading for lessliquid assets or nonstandard instruments.
By dramatically reducing the cost of trading
for relatively liquid and homogeneous assets,
electronic trading has facilitated portfolio management for institutional investors and banks. Rising
volume has mirrored the fall in the cost of trading,
enabling customers to rebalance portfolios more
quickly, making them less risky.
This article scrutinizes a previously unexamined data set, the U.S. Treasury bond market
data from the eSpeed ECN, founded by Cantor
Fitzgerald and Co. We have a complete record of
trades and quotes from eSpeed for 2004, and we
contrast the ECN market with similar 1999 data
from GovPX, a joint venture among voice brokers.
Compared with GovPX, eSpeed exhibits much

Bruce Mizrach is an associate professor of economics at Rutgers University, and Christopher J. Neely is a research officer at the Federal
Reserve Bank of St. Louis. The authors thank Bill Emmons, Michael Fleming, Ken Garbade, Laura Lipscomb, and Dan Thornton for helpful
comments on preliminary drafts and Justin Hauke for outstanding research assistance.

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lower spreads and a smaller impact on prices
from order flow. A detailed understanding of
market microstructure can contribute to better regulation and improvements to market architecture.

STAGES OF THE TREASURY
BOND MARKET
The sale of Treasuries undergoes three distinct
phases: primary, on-the-run, and off-the-run.
Each of these three stages has a distinct market
structure.

The Primary Market
In the first or primary stage, the U.S. Treasury
auctions off debt to the public. Garbade and Ingber
(2005) describe this process in detail.2 The
Treasury provides a predictable flow of auction
information to “promote competitiveness by
enhancing market transparencies” and to improve
the size of offerings. Since August 8, 2002, the
Treasury has made auction announcements (for all
new securities) at 11:00 a.m. eastern time. There is
also a stable schedule3 for auctions. For example,
3- and 6-month bills are auctioned weekly; 2- and
5-year notes are auctioned monthly; 30-year bonds
were reintroduced on February 9, 2006, after a 5year hiatus, and are auctioned in February and
August each year.
A few days prior to the auction, the specific
dollar amount (par value) of the securities to be
auctioned is announced and the when-issued
security market begins. The when-issued market
continues until settlement of auction purchases.
Nyborg and Sundaresan (1996) document that
when-issued trading provides important information about auction prices prior to the auction
and also permits market participants to reduce
the risk they take in bidding.4
2

See the glossary for definitions of terms.

The Treasury auction schedule can be found at: www.treasury.gov/
offices/domestic-finance/debt-management/auctions/.

On August 20, 1998, the Treasury shortened the when-issued period
for 13- and 26-week bill auctions. Similarly, the Treasury shortened
the when-issued period by two days for 2-year notes, beginning with
the August 2, 2002, auction. Fleming (2002) and Garbade and Ingber
(2005) discuss the results of such changes in when-issued periods.

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Bids for Treasury auctions can either be competitive bids by primary dealers or noncompetitive
bids by firms and individuals. Firms and individuals can also competitively bid through brokers
and primary dealers. Competitive bids specify a
price to be bid and a quantity sought. In the recent
past, there have been two types of auctions:
multiple-price and single-price.
Garbade and Ingber (2005) discuss the transition from multiple-price auctions to single-price
auctions. Historically (prior to 1992) multipleprice auctions were used to sell Treasury securities. In multiple-price auctions, the competitive
bids were ranked to determine the highest yield
that will sell all the Treasuries. The average yield
for all accepted competitive bids is called the
stop-out yield. First, all noncompetitive bids are
satisfied at the stop-out yield and then the remainder of the auctioned securities are allocated to
competitive bidders with the lowest bid yield
(highest bid price). Competitive bids above the
stop-out yield are not filled, whereas those at the
stop-out yield may be only partially filled.
The Treasury began to experiment with singleprice auctions in 1992 for the 2- and 5-year notes
(Garbade and Ingber, 2005). In this auction design,
all securities are allocated to bidders at the price
implied by the highest accepted yield. In October
1998, the Treasury adopted this procedure for all
maturities, safeguarded by quantity restrictions
on the amount a single bidder can purchase.
Upon completion of the auction, the most
recently issued bill, note, or bond becomes onthe-run and the previous on-the-run issue goes
off-the-run. Both on-the-run and off-the-run
trading occurs in the secondary Treasury market.
Secondary market participants are often divided
into two parts: the sell side and the buy side. The
primary securities dealers constitute the sell side,
while the diverse group of final users of Treasury
bonds constitutes the buy side. The buy side
includes commercial and investment banks,
insurance companies, financial firms, investors,
and pension funds—those who use Treasuries
for speculation, as well as for hedging real and
financial risk.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Mizrach and Neely

Figure 1

Figure 2

Secondary Government Bond Market,
2005 Market Share

ECN Trading of On-the-Run Treasury
Securities, 2005:Q3 Market Share

3%
9%

39%

61%
60%
28%

BrokerTec
ICAP

eSpeed

Cantor Fitzgerald

SOURCE: Federal Reserve Bank of New York primary dealer
data, eSpeed and ICAP 2005 financials, and author’s estimates.

Tullett Prebon
Hilliard Farber

SOURCE: Federal Reserve Bank of New York primary dealer
data, ICAP 2005 Annual Report, eSpeed Quarterly Report, and
market estimates from www.espeed.com and www.cstplc.com
(Tullett Prebon).

The Overall Secondary Market
It is difficult to get primary source data for all
secondary market transactions, therefore we will
use market-share5 estimates made by the Federal
Reserve and industry participants. Figure 1 shows
that, in 2005, two large interdealer brokerage (IDB)
firms dominate the overall secondary market:
ICAP PLC, with a 60 percent market share, and
Cantor Fitzgerald, with 28 percent. Both of these
firms trade a large array of fixed-income financial
instruments, including swaps, and mortgagebacked and agency securities, using both electronic and voice-brokered systems. We describe
these two firms and their purely electronic
Treasury platforms in greater detail in the next sec5

Mizrach and Neely (2005) explore a related concept known as
information share. This is a statistical measure of where (in which
market) price discovery takes place. From 1995 to 1999, we found
the spot and futures markets played nearly equal roles, with futures
dominating after 1999.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

tion. Tullett Prebon,6 with 9 percent, and Hilliard
Farber & Co., with 3 percent, complete the secondary Treasury market.
On- and off-the-run markets differ by volume
and trading methods. We turn first to the more
liquid on-the-run market.
On-the-Run. There is much more secondary
volume in on-the-run securities than off-the-run
securities, with the former representing 70 percent of all trading volume (Fabozzi and Fleming,
2005). Because of this liquidity difference, offthe-run securities trade at a higher yield (lower
price) than on-the-run securities of similar maturity. The amount by which the off-the-run yield
exceeds the on-the-run yield is known as the
6

Collins Stewart Tullett PLC is an agglomeration of a number of
prior firms: (i) Collins Stewart Ltd. was a London-based financial
services firm founded in 1991; (ii) Tullett & Riley was founded in
1971, originally focusing on foreign exchange; (iii) Tokyo Forex
took a stake in Tullett in 1986, creating Tullett & Tokyo; (iv) in 2000,
Tullett & Tokyo merged with Liberty Brokerage to create Tullett &
Tokyo Liberty; (v) Prebon was formed in 1990 following the merger
of three leading London-based money broking businesses, Babcock
& Brown, Kirkland-Whittaker, and Fulton Prebon; (vi) Prebon’s
close business alliance with the Tokyo-based Yamane Tanshi provided its current title of Prebon Yamane. Collins Stewart acquired
Tullett in March 2003 and Prebon in October 2004. The firm’s IDB
business uses the name Tullett Prebon.

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liquidity premium. Trading of benchmark (onthe-run) issues is commoditized, and nearly all
of it has migrated to the electronic networks.7
Figure 2 shows market share estimates for
the ECN portion of the on-the-run market in the
third quarter of 2005.8 We estimate that on-the-run
trading for this quarter was $21.19 trillion.9 In
their financial filings, eSpeed reports transactions
volumes of $8.014 trillion during the quarter. We
then estimate BrokerTec ECN volume of $12.29
trillion.10 These figures imply on-the-run ECN
market shares, 61 percent for BrokerTec and 39
percent for eSpeed, as reported in Figure 2, which
are consistent with industry estimates for that
time (Kutler, 2006). eSpeed reports that it has
gained market share since the third quarter of
2005, however.11
We now turn to the more numerous but less
actively traded off-the-run issues.
Off-the-Run. Off-the-run securities require
more customization—that is, negotiation over
quantities and settlement details—and thus
benefit from human brokers. Although assets
themselves don’t change when they go off-therun, they do become more heterogeneous with
respect to depth, the quantity the dealer is willing to sell at the bid or offer. Therefore they
require more negotiation in trading. Barclay,
Hendershott, and Kotz (2006) report that transaction volume falls by more than 90 percent, on
average, once a bond goes off-the-run. There is
a large number of issues—99 notes and 43 bonds
as of February 2006—but, with each being relatively illiquid, most off-the-run trading occurs
in traditional voice networks.
7

Commoditized securities are those that are undifferentiated and
liquid and trade only on price. See the glossary for further
definitions.

Electronic trading in fixed income refers to both electronically
brokered, voice-assisted transactions and pure ECN trades. We
focus only on the latter here.

Total Treasury market trading volume averaged $473 billion per
day or $30.27 trillion for the whole quarter. Assuming 70 percent
was on-the-run, we arrive at the $21.19 trillion estimate.

ICAP’s BrokerTec reports a 58 percent overall secondary market
share in their filings, and we assume the same market share in the
on-the-run portion.

Cantor Fitzgerald reported a market share gain since 2005:Q3 in a
personal communication.

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ESpeed does not compete with BrokerTec in
off-the-run trading, but the voice-assisted part
of Cantor Fitzgerald does compete with ICAP.
Because neither firm breaks out their off-the-run
voice-assisted trading from their overall figures,
we cannot estimate a market share for off-the-run
trading.

THE GROWTH OF ELECTRONIC
TRADING
Compared with equity or foreign exchange
markets, bond markets were slower to adopt
electronic trading. The bond market is large and
decentralized, such as the NASDAQ equity market
or foreign exchange market, but has more varied
assets—many types of bonds, maturities, coupons,
strips, etc. Two boxed inserts in this article
describe the growth of electronic trading in equity
and foreign exchange markets. The greater complexity of trading in sundry instruments, each of
which has less liquidity than large capitalization
stocks or the major currencies, retarded the transition to electronic trading.
Electronic communications can play different
roles in the trading process. For more than a
decade, bond trading screens have displayed
quotes from dealers that helped to initiate voice
transactions. This section focuses on the completely electronic trading through ECNs. These
ECNs permit dealers to post transactable prices
and quantities and execute trades electronically.
Cantor Fitzgerald introduced the first ECN in
bond markets, eSpeed, in 1999. A consortium of
Wall Street firms, including Morgan Stanley and
Goldman Sachs, launched a competitor, BrokerTec,
the same year. BrokerTec began commercial operations in 2000. ICAP PLC, a global, London-based
IDB, acquired BrokerTec in April 2003. On-therun trading is now almost completely electronic,
with the market split roughly 60-40 between the
two ECNs, as Figure 2 illustrates. While these
ECNs (eSpeed and BrokerTec) have captured most
bond market trading activity, voice brokerage
systems are used for trading in less liquid assets
or more complex deals.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Mizrach and Neely

History of Cantor Fitzgerald
Bernie Cantor and John Fitzgerald founded
the firm of Cantor Fitzgerald in 1945 to provide
investment advice to wealthy individuals. Cantor
Fitzgerald rose to prominence as a Wall Street
bond market broker. Cantor’s fortunes rose in 1972,
when it bought a controlling interest in Telerate
and began to post bond prices for its bond dealer
clients through the Telerate computer network.
Customers purchased the data streams and naturally directed business toward its source, Cantor.
The strategy was so successful in generating trading volume that Cantor gained a “nearly monopolistic” bond market share (Zuckerman, Davis,
and McGee, 2001).12 Rising federal government
budget deficits in the 1980s aided Cantor’s fortunes
by greatly expanding the bond market. By the early
1990s, Cantor Fitzgerald had 20 to 25 percent of
the IDB market (SEC, 1992).
In 1991, demands by the SEC and bond market
dealers for greater transparency led to the formation of GovPX, a joint venture among five IDBs.13
Cantor was the only IDB that did not participate
in GovPX. GovPX was established to provide realtime interdealer trade prices and volume for U.S.
Treasury bonds. The information is made publicly
available, distributed through the Internet and
data vendors.
As electronic trading became commonplace
in the equity and foreign exchange markets, Cantor
followed suit by starting the first electronic brokerage system for bonds, eSpeed, in March 1999.
Cantor subsequently spun off eSpeed in a
December 1999 public offering, but retains a
controlling interest. ESpeed Inc. is listed on the
NASDAQ and trades under the symbol ESPD.
12

Rust and Hall (2003) present a model to explain the differences in
microstructure between markets. They motivate their paper by
observing that Cantor Fitzgerald has been a successful market
maker in the U.S. Treasury bond market, but such an outcome—
a single market maker—has not emerged in the market for steel.
The original IDBs reporting to GovPX were Garvin Guy Butler,
Liberty Brokerage, Hilliard Farber, RMJ, and Tullet & Tokyo
Securities. As the structure of the market changed, so did the
brokers reporting to GovPX. Fleming (2003), which examines
the period 1997-2000, listed GovPX coverage as including GarbanIntercapital, Hilliard Farber, and Tullett & Tokyo Liberty. After
ICAP’s purchase of GovPX in January 2005, ICAP PLC was the
only broker reporting through GovPX.

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The terrorist attacks of September 11, 2001,
struck Cantor particularly hard, destroying its
offices in the World Trade Center and killing 658
employees. Despite this tragedy, eSpeed became
one of the two dominant trading platforms in the
IDB market for U.S. Treasuries.

ICAP and BrokerTec
Cantor was not alone in seeing the potential
of an electronic IDB bond-trading system. In 1999,
several other Wall Street firms, including Morgan
Stanley Dean Witter & Co. and Goldman Sachs
Inc., founded BrokerTec Global LLC. ICAP is the
product of a merger between Garban PLC and
Intercapital PLC in September 1999; originally
called Garban-Intercapital, the name was changed
to ICAP in July 2001. ICAP is currently the world’s
largest IDB with revenues of £794 million, and
operating profits of £122.7 million. The company
trades publicly on the London Stock Exchange
under the symbol IAP.
In February 2000, Garban-Intercapital
launched the Electronic Trading Community
(ETC), a hybrid voice/electronic brokering system
for the Treasury market. They eventually struck
alliances with Tullett & Tokyo Liberty in November
2000 and SunGard in September 2001.
ICAP realized that it needed to grow its ECN
business and bought BrokerTec’s Treasury platform in April 2003 for $185.9 million. The U.S.
Department of Justice approved the purchase
after restructuring commission agreements
between the pre-merger entities (Department of
Justice, 2003). ICAP has used the BrokerTec
platform to form partnerships similar to the one
with MarketAxess in March 2004 (Wall Street &
Technology, 2004). ICAP also acquired the data
provider GovPX Inc., in January 2005.

Recent Competition
ESpeed briefly had a dominant 70 percent
share in on-the-run trading, but BrokerTec gained
market share with lower transactions costs. Cantor
Fitzgerald filed a lawsuit alleging patent infringement on eSpeed’s trading systems. The case, filed
in January 2003, was dismissed in February 2005
by a Delaware court.
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ELECTRONIC TRADING IN EQUITY MARKETS
The equity markets were the first to embrace electronic trading. Over-the-counter stocks have
traded electronically at least since the creation of the National Association of Security Dealers
(NASD) automated quote (NASDAQ) system in 1971. NASDAQ was a dealer market without a
central trading floor. It was a distant second competitor to the floor-based New York Stock Exchange
(NYSE).
The Philadelphia Stock Exchange was one of the first floor exchanges in the United States to
introduce electronic trading with the PACE (Philadelphia Automated Communication and
Execution) System in 1975. PACE permitted two-party trading from anywhere in the world but
allowed for only limited information flow. Purely electronic limit order books began with Instinet
in 1979. Instinet provided interdealer equity trading in both NYSE and NASDAQ securities.1
Despite the early adoption of this technology, U.S. equity markets tended to lag behind foreign
markets in establishing electronic markets. ECNs were created in Toronto in 1977, Tokyo in 1982,
Paris in 1986, Australia in 1990, Germany in 1991, Israel in 1991, Mexico in 1993, and Switzerland
in 1995 (Economides and Schwartz, 1995).
The Chicago Board of Trade (CBOT) moved the equity futures and options markets significantly
toward electronic trading with the successful introduction of GLOBEX, in 1994. The CBOT followed
this effort with GLOBEX2, in 1998, which permitted round-the-clock trading.
Christie and Schultz (1994) triggered a watershed in electronic trading by finding NASDAQ
market makers to be colluding over spreads. Following this discovery, in 1997, the SEC allowed
electronic communication networks (ECNs) or alternative trading systems (ATS) to compete with
NASDAQ dealers on an equal footing. This legal deregulation sparked a surge in electronic trading
in U.S. equity markets. However, in moving to electronic trading through independent ECNs, the
U.S. equity markets have differed from those in the rest of the world, where existing exchanges
have largely developed electronic trading.
By 2004, ECNs had grabbed a dominant market share of equity trading. In 2005, both NASDAQ
and the NYSE initiated mergers with their major electronic competitors. NASDAQ completed its
merger with Instinet in 2005 and the NYSE with Archipelago in March 2006. Even with major
changes and new electronic competition, the market has reorganized as a duopoly.
Although NASDAQ dealers held only a 35 percent market share in October 2005, this figure
understates the market power of the for-profit NASDAQ. The combined market share of NASDAQ’s
own anonymous trading facility SIZE, and the Brut and Instinet ECNs that NASDAQ has acquired,
gives this ECN more than three-quarters of the market (Mizrach, 2005).
Going forward, it appears that a hybrid market model with floor-based, open-outcry trading
will co-exist with electronic trading both through limit order books and the NASDAQ dealer
structure. Both NASDAQ and NYSE are now able to trade securities listed on the rival exchange.
In August 2006, NASDAQ handled 12.5 percent of the volume in NYSE-listed securities, while
the NYSE processed 21.3 percent of the trading in NASDAQ listings.

532

A limit order is a request to buy or sell a security at a specific price. Market orders are buy/sell orders that are to be executed immediately, at current market prices.

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ELECTRONIC TRADING IN EQUITY MARKETS, cont’d
Figure B1
ECN Share in Over-the-Counter Equities
A. Trading Volume of NASDAQ-Listed Shares
Brut
13%

SIZE
2%

NASDAQ
35%
ArcaEX
24%

INET
26%

NOTE: Brut is the Brass Utility ECN, ArcaEX is the Archipelago ECN, INET is Instinet, and SIZE is the NASDAQ anonymous
trading facility. All other NASDAQ market markers are grouped into the NASDAQ 35 percent share. NASDAQ acquired BRUT
in September 2004 and Instinet in December 2005.
SOURCE: Securities Industry News, Bloomberg, Instinet, Archipelago, and NASDAQ.

B. ECN’s Share of Trading Volume in NASDAQ-Listed Shares
Market Share
70
60
50
40
30
20
10
0
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

NOTE: The figure shows the growth of ECN trading since they entered the NASDAQ quote display in 1996.
SOURCE: Smith (2002), Merrill Lynch, Bloomberg, Instinet, Archipelago, and NASDAQ.

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ELECTRONIC TRADING IN FOREIGN EXCHANGE MARKETS
The foreign exchange market is made up of customers, dealers, and IDBs. Customers are firms
or individuals who buy or sell foreign exchange to hedge risk associated with business activities
or balance sheet exposure, to manage investment portfolios, or to import/export goods and services.
Hedge funds and pension funds, for example, frequently use the foreign exchange market to improve
their investment performance. Corporations might buy foreign exchange to purchase needed
intermediate goods from foreign suppliers. Dealers, who typically work for banks, stand ready to
“make a market”—that is, to quote prices at which they are ready to buy or sell foreign exchange.
Dealers wish to profit from the spread between the prices at which they buy and sell, as well as
to take calculated intraday positions in currencies to profit from short-term expected changes in
exchange rates. Dealers carefully manage their currency positions—especially overnight—to reduce
their exposure to adverse exchange rate movements. Therefore, most trading in the foreign exchange
market is between dealers who are seeking to manage their currency exposure. Interdealer brokers
exist to facilitate this trading by matching buyers and sellers of foreign exchange. They do not take
positions of their own.
Until the early 1990s, all foreign exchange trading was conducted via telephone. Reuters
introduced the Reuters Market Data Service (RMDS) in February 1981, which permitted the
exchange of information over computer screens, but did not allow actual trading. Reuters Dealing
2000-1 replaced RMDS in 1989. The new system facilitated direct trading that used to take place
over the telephone (Rime, 2003).
Reuters continued to lead electronic trading in foreign exchange when it launched Dealing
2000-2 (D2000-2) in 1992. This network brokered trades between ex ante anonymous parties.
Competitors soon followed, however. Minex launched an automated trading system in April 1993
and a consortium of large banks—ABN-AMRO, Bank of America, Barclays, Chemical, Citibank,
Citicorp, Commerzbank, Credit Suisse, Lehman Brothers, Midland, J.P. Morgan, NatWest, Swiss
Bankcorp, and Union Bank of Switzerland—followed suit by creating Electronic Broking Service
(EBS) in April 1993, which later bought out Minex in 1996 (Chaboud and Weinberg, 2002).
For the first few years of their existence, the electronic trading systems’ (ETS) share of foreign
exchange trading grew slowly. But the figure shows that electronic trading was clearly the dominant method of operation in the interdealer market by the late 1990s. Chaboud and Weinberg (2002)
estimate the share of interdealer trading volume executed through electronic platforms to be over
60 percent by 2001. Voice trading remained important for customers and for less-liquid currencies.
This is consistent with the general observation that electronic trading has its greatest advantages
in the most liquid markets for homogenous assets.
Reuters and EBS remain the principal ETSs in the interdealer foreign exchange market as of
early 2006. The latest incarnation of the Reuters network is called D3000. EBS has the foremost
market share in trading in the two largest currency pairs, the euro-dollar and dollar-yen, while
Reuters has a leading share in British pound currency pairs and the major market shares in a
broader selection of exchange rates, including emerging market rates.

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ELECTRONIC TRADING IN FOREIGN EXCHANGE MARKETS, cont’d
In recent years, the already large foreign exchange market has continued to grow. The Bank
for International Settlements reports that foreign exchange trading volume grew by 36 percent,
from 2001 to 2004 (BIS, 2005). Some of this growth has occurred on exchanges such as the
Chicago Mercantile Exchange, which currently handles only a very small proportion of the foreign
exchange market. In the midst of this expansion, the dealer market has consolidated; more trading is done by fewer and larger banks.
These large banks have their own (bank-specific) electronic trading platforms that allow direct
bank-customer trading. The three banks with the highest volumes are Deutsche Bank, UBS, and
Barclays, according to Kimbell, Newby, and Skalinder (2005). But there are now a number of smaller
electronic networks that facilitate transactions between customers and dealers (e.g., FX All, FX
Connect, and Currenex) and between customers without dealers (e.g., OANDA, HotSpot FX, IG
Markets, FXDealerDirect, DealStation, ChoiceFX, Deal4Free Forex, GFT’s DealbookFX, GCI, IFX
Markets, and Grain Capital). These ECNs enable non-bank actors—such as hedge funds—to trade
at prices that are very close to those enjoyed by the largest banks.

Figure B2
Electronic Trading in Foreign Exchange Markets
Market Share of ECNs in Foreign Exchange Market Transactions
Percentage of Transactions
70
60
50
40
30
20
10
0
1989

1992

1995

1998

2001

2004

NOTE: Precise estimates of electronic foreign exchange broking systems’ market share are difficult to come by because of
the foreign exchange market’s decentralized nature. The BIS (2004) estimates the 2004 number and states that the share
increased slightly in that year by an unspecified amount.
SOURCE: Estimates for 1989-2001 are from Chaboud and Weinberg (2002). The BIS provides the 2004 number.

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Transactions costs have fallen dramatically
over the past decade. Fleming (1997) reports fees
paid by the trade initiator of $39 per $1 million
of bonds in the voice-brokered GovPX markets.
By 2005, these fees had fallen by more than 90 percent to $2.50 on eSpeed and $2.00 on BrokerTec
for the best customers (Kruger, 2005).
ESpeed’s price improvement facility, a tool
that allowed traders to offer prices between the
quotes, reportedly also hurt them in the marketplace (Computer Business Review, 2005). The
price improvement system proved complex and
unpopular with customers. Quantity, rather than
price negotiation, had been standard in the industry in the days of voice brokerage, and eSpeed
eliminated the price-improvement tool in January
2005. These changes seem to have stabilized a
duopoly in ECN on-the-run trading with the
market split 60-40 between BrokerTec and
eSpeed, respectively.

DATA SOURCES AND ANALYSIS
To study trading activity, spreads, and price
impact, we rely on two publicly available historical transactions databases. The first is GovPX,
which consolidated voice-brokered interdealer
quotes and trades from Garban-Intercapital,
Hilliard Farber, and Tullett & Tokyo Liberty during our sample period of 1999. Fleming (2003)
describes the characteristics of liquidity in this
market in the period from 1997 to 2000. Our
second source is the eSpeed ECN, which recently
began to offer a transactions database.
Both the GovPX and eSpeed data sets have
their limitations. GovPX does not provide a reliable indicator of transactions after March 2001.
The market share of voice-brokered trading has
also substantially diminished since 1999. The
eSpeed data set is from 2004, contains only onthe-run securities, and includes transactions but
no quotes.

held by the public grew from $3.64 trillion in fiscal year 1999 to $4.31 trillion in fiscal year 2004.14
Figure 3 shows the average daily trading volume
in Treasuries from 1994 to 2005. Since its 1999
nadir of under $200 billion per day, the average
volume of such transactions by primary dealers
has almost tripled to nearly $575 billion.
GovPX trading volume declined markedly
after 1999 as ECNs, such as eSpeed and BrokerTec,
began to attract business. Because the GovPX trade
volume data become very thin after 1999, this
paper will contrast GovPX data from 1999–the
last year in which voice-brokered trading predominated—with eSpeed data from 2004.
While we omit the exact figures to protect
confidentiality, the data show a dramatic increase
in trading volume between 1999 and 2004, which
dwarfs the tripling of the government bond market
over the same period. It seems likely that the lower
cost of trading through ECNs has facilitated much
higher turnover, attracting new participants to the
Treasury market. More than 50 percent of bids and
offers on BrokerTec are now from algorithmic
trading firms (Safarik, 2005) rather than the primary dealers.

Spreads
A standard measure of liquidity is the bid/ask
spread. Dealers in the Treasury market post quotes,
along with depth, to both buy and sell Treasuries.
A combination of inventory and adverse selection
costs explains the existence of spreads in the
interdealer market. The inventory component is
the cost of keeping a ready supply of securities
for sale. The adverse selection component is due
to the risk that the dealer’s counterparty has private information about future price changes,
which could lead to losses for the dealer. Adverse
selection is less of a problem in the Treasury market (which is driven by publicly available information) than in equity markets (in which private
14

Trading Activity
Trading volume continues to grow in the
government bond market much faster than the
supply of Treasuries. The marketable federal debt
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The debt figures are available at www.publicdebt.treas.gov/opd/
opdpdodt.htm. Ironically, market participants and the Federal
Reserve were concerned about running out of Treasuries just a
few years ago when federal budget surpluses were growing. Alan
Greenspan (2001) testified in January 2001: “At zero debt, the
continuing unified budget surpluses currently projected imply a
major accumulation of private assets by the federal government.”

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Figure 3
Average Daily Treasury Volume
U.S. $ Millions
600

500

400

300

200

100

0
1994 1995

1996

1997

1998

1999

2000

2001 2002

2003

2004

2005

NOTE: The figure displays average daily volume of U.S. Treasury securities primary dealer transactions, by year.
SOURCE: Federal Reserve Bank of New York primary dealer data.

information is more important). We measure this
markup for the GovPX data in 1999 and the
eSpeed data in 2004.
The most basic measure of the bid/ask spread
is the quoted spread. The quoted spread is the
gap between lowest ask price, pat, and the highest
bid, pbt.15 It is computed in percentage terms to
compare spreads across securities and over time:
(1)

stq = 100 ×

( pta − ptb ) .
pta

Unfortunately, the eSpeed database does not
include posted bid and ask prices, and we must
compute an alternative measure based on
transactions.
A commonly used procedure, first proposed
by Thompson and Waller (1988), is to measure
the spread for day t with the mean absolute change
in the transactions prices:
15

Many transactions take place within the quoted spread, though.
GovPX provides a workup facility to increase the transaction size
but not change the price. Until January 2005, the eSpeed network
provided an explicit mechanism for trading between the bid and
ask, a process known as price improvement.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

(2)

StTW = ∑ pi − pi −1 / T + ,
i =i

where T + is the number of transactions in which
the price changes on day t. The correlation
between quoted spreads and the transactions
measure is 0.99 in the GovPX data.
Table 1 summarizes the differences in
Thompson and Waller (1988) bid-ask spreads as
on-the-run trading moved to ECNs.
The GovPX voice market spreads average
0.8344 basis points for the 2-year note in 1999,
compared with 0.2053 for the eSpeed ECN quotes
in 2004, a reduction of 75 percent. The reduction
is similar for other maturities: 0.8834 basis points
in the 5-year, or 76 percent; 1.7167 basis points
in the 10-year, or 82 percent; and, finally, 4.2622
basis points in the 30-year, or 78 percent. These
substantial declines are statistically and economically significant.

MARKET IMPACT
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Table 1
Spreads in the Voice and ECN Markets
GovPX

eSpeed

∆ Spread

Percent change

2-year

0.8344

0.2053

–0.6291

–75

5-year

1.1572

0.2738

–0.8834

–76

10-year

2.0986

0.3819

–1.7167

–82

30-year

5.4484

1.1862

–4.2622

–78

NOTE: The GovPX estimates are from 1999, and the eSpeed estimates are from 2004. The spread units are in basis points (hundredths
of a percent).

Table 2
Market Impact Estimates for the Voice and
ECN Markets
GovPX

eSpeed

2-year

0.4235

0.2321

5-year

0.9368

0.1709

10-year

0.9066

0.1850

30-year

2.2936

0.2749

The bivariate VAR assumes that causality
flows from trade initiation to returns by permitting rt to depend on the contemporaneous value
for x 0t , but not allowing x 0t to depend on contemporaneous rt. The quote revision model is specified
as follows:
(3)

(4)
NOTE: These are the 15-minute cumulative market impact
effects for the January 1999 GovPX database and for the
January 2004 eSpeed transactions based on the VAR analysis
shown by equations (3) and (4). The units are in basis points
(hundredths of a percent).

revealing private information about fundamentals
to other market participants. One would like to
know how much trades impact prices. Price
impact increases the cost of large trades, and such
costs are often larger than brokerage commissions
and spreads. This section examines the interaction
between trades and quotes using the vector autoregressive (VAR) system methods that Hasbrouck
(1991) introduced.
Hasbrouck proposed to study intraday price
formation with a standard bivariate VAR model.
Time t here is measured in 1-minute intervals.
Let rt be the percentage change in the transaction
price. x 0t is the sum of signed trade indicators (+1
for buyer initiated, –1 for seller initiated) over
minute t. Fortunately, both data sets directly indicate trade initiation as a “hit” –1 or a “take” +1.16
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i =1

i =0

i =1

rt = ar ,0 + ∑ ar ,i rt − i + ∑ br ,i xt0− i + ε r ,t ,
xt0 = ax ,0 + ∑ ax ,i rt − i + ∑ bx ,i xt0− i + ε x ,t .

We estimate two versions of the VAR model
for each instrument: One version uses GovPX
data from 8:20 to 15:00 each day in January 1999,
and the other version uses similar eSpeed data
from January 2004. The original number of observations varied from instrument to instrument
before aggregating to one-minute frequency. For
example there were 17,127, 62,175, 75,791, and
19,706 observations for the 2-, 5-, 10-, and 30-year
bonds for the Cantor data. After aggregating to
one-minute returns there were 8,000 observations
for the 20 trading days in the Cantor data and 7,600
observations for the 19 trading days in the GovPX
data. To allow comparison with other more-recent
market impact studies, such as Cohen and Shin
(2003), we include 15 lags of the signed trades.17
16

In microstructure databases, this inference is usually determined
by distance from the quote midpoint.

Given the potentially unusual distribution of the order flow variable, xt0, we considered nonlinear specifications—products of leads
and lags—but they do not enter the VAR significantly or change
substantially the market impact estimates. There does not appear
to be any significant nonlinearity in the dependent variable.

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Mizrach and Neely

Our estimates show that trade indicators are
positively autocorrelated and highly predictable.
In other words, buyer- (seller-) initiated trades
reliably tend to follow buyer- (seller-) initiated
trades. As one might expect from simple versions
of the efficient markets hypothesis, returns are
not very predictable, except through contemporaneous orders. That is, net buyer- (seller-) initiated
trades are associated with contemporaneous price
increases (decreases).
The market impact of the trade can be measured by the dynamic effect on subsequent trade
prices. The impact grows over time, generally
stabilizing after about 15 minutes. We report 15minute impact estimates in Table 2 for the 2-, 5-,
10-, and 30-year bonds. GovPX estimates for
January 1999 are reported in the first column, and
eSpeed estimates for January 2004 are reported in
the second column. The coefficients are in basis
points (hundredths of a percent).
The smallest GovPX market impact is for the
2-year note. Nonetheless, a one-unit ($1 million)
buy order still moves trade prices by 0.4235 basis
points, nearly double the eSpeed impact for the
same issue. The relative market impact is inversely
related to the relative volumes of the two markets.
For the other issues, the GovPX market impact is
five to eight times as large, with the latter figure
for the illiquid 30-year Treasury. On average, the
eSpeed market impact is 73.6 percent lower than
that of GovPX.
We believe that market impact is the most
comprehensive measure of market quality, reflecting spreads, depths, and trading volume. The
eSpeed ECN seems to illustrate that electronic
trading in the secondary Treasury market benefits
market participants by reducing spreads and
transactions costs.

CONCLUSION
This article has reviewed the growth of ECNs
in equity, foreign exchange, and the U.S. Treasury
markets. The growth of such ECNs has enabled
firms and individuals to trade and rebalance their
portfolios at much lower cost, thereby enabling
them to reduce the risk to which they are exposed.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

In particular, this article has examined the growth
of electronic competition in the secondary market
for U.S. Treasury bonds. The eSpeed and
BrokerTec ECNs have captured virtually the entire
market for the on-the-run Treasuries. This paper
has studied transactions from eSpeed for 2004, a
data set that has not yet been explored in the literature, and documented improvements over the
earlier voice-assisted technology. The eSpeed ECN
has greater volume, smaller spreads, and a lower
estimated impact of a trade. Lower spreads can
benefit smaller traders by lowering their costs of
portfolio rebalancing. A smaller market impact
ensures that institutional investors get similar
benefits.

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Market Makers: A Theory of Competitive Exchange.”
Journal of Political Economy, April 2003, 111(2),
pp. 353-403.

Garbade, Kenneth D. and Ingber, Jeffrey F. “The
Treasury Auction Process: Objectives, Structure,
and Recent Adaptations.” Federal Reserve Bank of
New York Current Issues in Economics and Finance,
February 2005, 11(2), pp. 1-11.

Safarik, Daniel. “Fixed Income Meets the Black Box.”
Wall Street & Technology, October 24, 2005, pp. A7.

Greenspan, Alan. “Outlook for the Federal Budget
and Implications for Fiscal Policy.” Testimony
before the Committee on the Budget, U.S. Senate,
January 25, 2001.
Hasbrouck, Joel. “Measuring the Information Content
of Stock Trades.” Journal of Finance, March 1991,
46(1), pp. 179-207.
Kimbell, Deborah; Newby, Andrew, and Skalinder,
David. “The Big Get Bigger—But Is It for the Best?”
Euromoney, May 2005, 36(433), pp. 74-85.

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Securities and Exchange Commission, Department of
the Treasury, Board of Governors Federal of the
Reserve System. Joint Report on the Government
Securities Market. 1992.
Securities and Exchange Commission and Department
of the Treasury. Special Study: Electronic
Communication Networks and After-Hours Trading.
2000.
Smith, G.W. “ECN Market Share Analysis: Fourth
Quarter 2001.” Equity Research, J.P. Morgan
Securities Inc., January 30, 2002.
Thompson, Sarahelen. R., and Waller, Mark L. “The

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Mizrach and Neely

Intraday Variability Of Soybean Futures Prices:
Information and Trading Effects.” Review of Futures
Markets, 1988, 7(1), pp. 110-126.

Zuckerman, G.; Davis, A. and McGee, S. “Before and
After: Why Cantor Fitzgerald Can Never Re-create
What It Once Was.” Wall Street Journal, October
26, 2001, p. A1.

Wall Street & Technology. Electronic-Trading
Newsflashes, March 29, 2004.

GLOSSARY
Agency securities are issued by institutions established by the U.S. government, such as the Student
Loan Marketing Association (Sallie Mae). Such institutions were created to lower borrowing costs
in favored sectors of the economy.
Algorithmic trading is the practice of automatically transacting based on a quantitative model.
A broker is a firm that matches buyers and sellers in financial transactions. Brokerage firms in bond
markets do not trade for their own account. An interdealer broker (IDB) is an intermediary providing
trading services to hedge funds, institutions, and other dealers. IDBs handle the majority of Treasury
securities transactions in the secondary market.
A commoditized security has been altered to increase its liquidity, making it an undifferentiated product
traded solely on price.
Depth is the quantity the dealer is willing to sell at the bid or offer.
Electronic communications networks (ECNs) are electronic trading systems that automatically match
buy and sell orders at specified prices.
A limit order is a request to buy or sell a security at a specific price. Market orders are buy/sell orders
that are to be executed immediately, at current market prices.
A mortgage-backed security is a bond whose payoff is backed by the payments on a pool of mortgages,
such as those issued by Freddie Mac.
On-the-run refers to the most recently auctioned Treasury security of a particular maturity. After the
next auction, the other bonds go off-the-run.
The quoted spread is the gap between lowest ask price and the highest bid.
Trading in on-the-run and off-the-run securities makes up the secondary Treasury market.
Strips are portions of securities that have been separated into different assets. U.S. Treasury bonds, for
example, are often split into principal and interest components and each can be separately owned.
Such division permits the construction of zero-coupon bonds. STRIPS stands for “Separate Trading
of Registered Interest and Principal Securities.”
Parties to an interest rate swap exchange interest payments on a notional principal amount. Typically,
one party pays a fixed interest rate, while the other party pays a floating rate.
When-issued bonds are those Treasuries whose auctions have been announced but that have not yet
been delivered.

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What Are the Odds?
Option-Based Forecasts of FOMC Target Changes
William R. Emmons, Aeimit K. Lakdawala, and Christopher J. Neely
This article uses probability forecasts derived from options to assess evolving market uncertainty
about Federal Reserve monetary policy actions in a variety of recent events and episodes. Options
on federal funds futures contracts reveal a complete probability density function over possible
Federal Reserve target rates, thus augmenting the expectations provided by federal funds futures
contracts. Option-based forecasts are most useful when more than two federal funds target outcomes
are plausible at an upcoming policy meeting. (JEL E47, E52, G13)
Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 543-61.

ptions on federal funds futures
contracts provide information
about market expectations of
Federal Open Market Committee
(FOMC) monetary policy actions above and
beyond that provided by federal funds futures
contracts alone. In particular, options provide
important information about the dispersion and
skewness of market expectations. Under some
assumptions, option prices imply a complete
probability density function (PDF) over possible
FOMC target-rate choices.
This article uses the method of Carlson, Craig,
and Melick (2005) to extract an implied riskneutral probability density function over possible
future federal funds target rates from daily option
prices. Option-based forecasts are most useful
when more than two federal funds target outcomes
are plausible at an upcoming FOMC meeting. If
only one or two meeting outcomes are plausible,
a futures-based forecast is simpler and more
appropriate.

FEDERAL FUNDS FUTURES
OPTIONS
The Chicago Board of Trade has offered futures
contracts written on the federal funds rate since
1988. For more than a decade, trading volumes
in these contracts remained miniscule in comparison with other interest rate futures contracts, such
as 3-month eurodollar and long-term Treasury
securities. Researchers nonetheless have found
that federal funds futures contracts provide useful
information about market expectations of shortterm interest rate movements (Poole, Rasche, and
Thornton, 2002; Sack, 2004; and Piazzesi and
Swanson, 2005).
For reasons that are not well understood,
trading volumes in the federal funds futures contracts increased dramatically after 2000.1 This led
to the introduction, in 2003, of exchange-traded
1

See Carlson, Craig, and Melick (2005) for a more extensive discussion of federal funds futures options contracts and market conventions. The Chicago Board of Trade provides contract specifications
and current market prices for both federal funds futures and futures
options at
www.cbot.com/cbot/pub/cont_detail/0,3206,1525+14453,00.html.

William R. Emmons is a senior economist, Aeimit K. Lakdawala was a research associate at the time this article was written, and
Christopher J. Neely is a research officer at the Federal Reserve Bank of St. Louis.

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THE FEDERAL FUNDS FUTURES AND OPTIONS-ON-FUTURES MARKETS
The 30-day federal fund futures contract is an interest rate derivative, which has been traded
on the Chicago Board of Trade since October 3, 1988. The volume of trading on federal funds has
grown dramatically since the market’s inception, reaching almost 6.3 million contracts traded in
2002. Prices on the federal funds futures markets are quoted as 100 minus the average daily federal
funds overnight rate for the delivery month. That is, a price quote of 96.1 implies an average daily
interest rate of (100 – 96.1 =) 3.9 percent for the delivery month.
Contracts are settled in cash, at 2:00 p.m. central time, on the last trading day of the month.
The final settlement price for the contract is the average daily federal funds overnight rate for the
delivery month, as reported by the Federal Reserve Bank of New York. The average is calculated
over calendar days. The notional contract size is $5 million, which means that a rise in the contract
price of 1 basis point nets (costs) a holder of a long (short) position $41.67. The $41.67 is the increase
in the interest earned from a 1-basis-point rise in interest rates on a deposit held for 30 days, using
a day count of 360 days per year (41.67 = 5,000,000 * 0.0001 * 30/360). The minimum quote size
is one-half of 1 basis point.
The Chicago Board of Trade has sponsored trading American options on federal funds futures
contracts since March 14, 2003.1 Strike prices are created every 6.25 basis points. The asset underlying the options contract is one federal funds futures contract. Option premia are quoted in basis
points and the minimum tick size is one-quarter of 1 basis point or $10.4175. Options contracts
trade until the last business day of the delivery month.
Because other short-term interest rates closely track the federal funds rate, federal funds futures
can be used to hedge general short-term interest rate risk and/or speculate on future short-term
interest rates. And the design of the options on federal funds futures permits speculators to invest
based on detailed views on the likely path of the future funds rate. Therefore a variety of users
find federal funds futures and options on federal funds futures to be useful. Users of options on
federal funds futures include issuers of commercial paper, portfolio managers, dealers in government securities, hedge fund managers, and even foreign exchange dealers.
1

American options can be exercised any time until expiry; European options can be exercised only at expiry.

options contracts written on federal funds futures
contracts. A federal funds futures call option, for
example, gives the buyer the right, but not the
obligation, to obtain a long position in the referenced federal funds futures contract at a prespecified price. The options are American-style
(i.e., they can be exercised at any time up to or at
maturity) and are settled in cash rather than by
actual delivery of the futures contract. Trading
volume in federal funds futures options has varied
considerably over time, but substantial amounts
of open interest have been observed in some contracts. The first boxed insert, on the federal funds
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futures and options-on-futures markets, reviews
the specifications of those derivative contracts.
Finance theory long has recognized that a
rich set of option contracts written on any underlying financial instrument or economic variable,
such as an interest rate (or interest rate futures
contract), can provide a great deal of information beyond simple expectations of a future price.
In particular, option prices reveal how much
investors are willing to pay for a chance to profit
from an “extreme” future movement in the spot
price of the reference instrument, either up or
down. Therefore, option prices can potentially tell
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Emmons, Lakdawala, Neely

us about investors’ expectations, including how
likely “extreme” movements are thought to be.
Changes in estimated probability density
functions over time illuminate how market uncertainty about Federal Reserve monetary policy
intentions or actions evolved during significant
episodes or events during the period June 2003
through April 2006.2 The events we study are as
follows:
• A pre-commitment to extended policy
accommodation: In August 2003, the
Federal Reserve publicly committed itself
to maintaining monetary policy accommodation for a “considerable period.”
• A signal of an impending target change: In
May 2004, the Federal Reserve signaled that
its first target-rate increase in four years was
forthcoming.
• A pre-commitment to gradual removal of
policy accommodation: Beginning in June
2004, the Federal Reserve publicly committed itself to a policy of raising the federal
funds target rate at a “measured pace.”
• Devastating hurricanes: In August and
September 2005, a series of hurricanes
devastated parts of the U.S. Gulf Coast,
creating uncertainty about their economic
impacts and the Federal Reserve’s likely
response.
• Congressional testimony and public communication: Reports of Chairman Bernanke’s
April 2006 testimony before the Joint
Economic Committee whipsawed financial
markets.
In each case, we study the federal funds
futures option–implied probabilities assigned by
market participants to possible Federal Reserve
target-rate choices at upcoming meetings. In the
first and third cases listed above, our data allow
us to evaluate the (evolving) credibility of Federal
Reserve commitments to future actions. The second and fourth cases are examples of market
uncertainty about both economic fundamentals
2

In related research, Neely (2005) relates surprises in federal funds
target changes to large changes in the implied volatility of 3-month
eurodollar rates.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

and the Federal Reserve’s likely reactions to these
fundamentals. Finally, the last case clearly illustrates pronounced market reactions to Federal
Reserve communication efforts.
The remainder of the article is organized as
follows. The next section briefly discusses federal
funds futures contracts as market-based indicators
of expected monetary policy actions. Then, we
describe option contracts on federal funds futures
and explain how one can extract probability density functions over future Federal Reserve targetrate choices from such option prices. Finally, we
use daily option-derived risk-neutral probability
density functions to explore the evolution of
market uncertainty about future interest rates
during several recent episodes.

FEDERAL FUNDS FUTURES
CONTRACTS AND EXPECTED
MONETARY POLICY ACTIONS
Figure 1 displays the implied federal funds
rate from the futures contract closest to expiration
(heavy black line), as well as the implied average
rate on every third federal funds rate futures contract traded between May 1, 2003, and February 9,
2006 (all other lines). Several futures contracts
trade on any given day, each written on a different
future month. For example, 12 different futures
contracts traded on December 2, 2005—one
referring to each month from December 2005
through November 2006. Figure 1 shows only
those from December 2005 and March, June, and
September 2006.
The final settlement price on each month’s
contract depends on the average effective daily
federal funds rate during that contract month.
That is, the December 2005 settlement price was
95.84, calculated as 100 minus the 30-day average
of actual effective federal funds rates observed
during December 2005, which was 4.16 percent.
As each contract trades over time—until settlement on the first business day after the end of
the contract month—the market price converges
toward the final settlement price. The figure illustrates that the volatility of futures prices varies
over time, indicating that uncertainty about future
interest rates likewise varies. Note that, while
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Emmons, Lakdawala, Neely

Figure 1
Daily Federal Funds Target Rate and Futures-Implied Yields Between May 1, 2003, and February
9, 2006
Implied Federal Funds Rate

Jun 03

Sep 03
Dec 03
Mar 04

Jun 04
Sep 04
3

Dec 04
Mar 05
Jun 05

Sep 05
Dec 05
Mar 06

Jun 06
Sep 06

0
May 1
03

Implied Federal Funds Rate on
Contract Closest to Expiration
Sep 12
03

Jan 26
04

Jun 8
04

Oct 20
04

Mar 3
05

Jul 15
05

Nov 28
05

Trading Day

NOTE: The thick black line is the implied federal funds rate from the contract closest to expiration. The other lines represent implied
yields from daily settlement of federal funds futures contracts traded between May 1, 2003, and February 9, 2006.

uncertainty (volatility) about a particular contract’s
settlement price decreases over time, the decline
in uncertainty is not monotonic.
Federal funds futures contracts usefully gauge
market expectations about future FOMC monetary
policy actions, although there are more sophisticated approaches to forecasting rate changes and
levels (e.g., Sarno, Thornton, and Valente, 2005).
There is some evidence that econometric models
may improve on the implied forecasts from futures
prices, particularly at long horizons, where risk
premia might be larger and futures trading volume
is much lower.
Expected federal funds targets derived from
federal funds futures contracts represent only the
central tendency (the mean) of market expectations, not the dispersion of expectations about
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potential outcomes. Dispersion of expectations
increases with the forecast horizon. The next
section explains how options on short-dated
money-market instruments inform us about
expected volatility (uncertainty), the direction
of risks (asymmetry), and the relative probability
of extreme events (kurtosis). One can interpret
the dispersion of expectations as measuring the
public’s uncertainty about monetary policy.

OPTIONS ON FEDERAL FUNDS
FUTURES CONTRACTS
Option contracts written on federal funds
futures contracts provide a tool to measure (and
speculate on) the uncertainty among market participants about future monetary policy actions.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

The Bank of England has used the information
contained in option prices for informational purposes for some time, and other central banks may
follow.
There is a large academic literature that uses
market data to forecast interest rates. Recent examples using data from the federal funds futures
market to forecast future Federal Reserve policy
actions include Poole, Rasche, and Thornton
(2002), Sack (2004), and Piazzesi and Swanson
(2005). Another strand of the literature investigates
the use of options on interest rate futures contracts
to assess market expectations of future short-term
interest rates. Papers investigating option-based
forecasts include Abken (1995), Soderlind and
Svensson (1997), Bliss and Panigirtzoglou (2002),
Andersen and Wagener (2002), Hordahl and Vestin
(2005), and Carlson, Craig, and Melick (2005).
This article builds on the option-based forecasting
research pioneered in these papers.

How Liquid Are Federal Funds Futures
and Futures Options?
Although one would like to estimate expectations of federal funds rate targets for the indefinite
future, futures and futures-option contracts do not
have sufficient liquidity to derive expectations
more than a few months ahead. Figure 2 shows
trading volume and open interest (log scale, by
forecast horizon) for futures and options on futures
for trading days in November 2005. The greatest
trading volume occurs in options on futures contracts expiring 1 to 3 months in the future; there
is still non-negligible volume in options 4 to 5
months ahead and practically no volume more
than 6 months ahead. The open interest charts
tell a similar story. Open interest falls off from 3 to
4 months and then to very low levels at 6 months.
Thus, futures and options on futures may not
be very informative at long horizons. Note, however, that the trading volume and open interest
in options—which include all strike prices—are
much greater than that in the underlying futures
contract. Fluctuations in trading volume over
longer periods appear to indicate that trading
increases during turbulent periods, precisely
when information is most needed.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Probability Densities Over the Federal
Funds Target Rate
The payoffs to options on federal funds
futures depend only on the average federal funds
rate over the contract expiration month. Therefore,
the price of the option provides some information on the likelihood of various outcomes. For
example, if the price of a given call option rises,
then—all else equal—the market expects a greater
probability of a higher final settlement price (a
lower interest rate).
To translate option prices into risk-neutral
probabilities of specific outcomes, however, one
must make some assumption about the risk premia that investors require (or are willing to pay)
to take certain risks. Carlson, Craig, and Melick
(2005) compare the task of obtaining probabilities
from option prices to estimating the probability
of a fire from the price of fire insurance. If fire
insurance companies demand a risk premium to
insure houses, then one must know this premium
to accurately estimate the probability of a fire from
the price of insurance and the firm’s contingent
liability.
Similarly, to infer the probability density
function over possible federal funds target rates
from option prices, one must make some assumptions about risk premia embedded in federal funds
futures prices. One hypothesis is that the marginal
investors (buyers and sellers) are risk-neutral (i.e.,
that observed prices are actuarially fair). However,
Hordahl and Vestin (2005), among others, find
evidence of important differences between riskneutral and objective (i.e., realized) probability
distributions in bond prices.
In general, it is not clear whether these discrepancies represent risk premia in the economic
sense of compensation for risk. Piazzesi and
Swanson (2005) document substantial prediction
biases in federal funds futures prices and label
them risk premia. Table 1, excerpted from Piazzesi
and Swanson (2005), shows the estimates of the
difference between futures-rate predictions and
realized interest rates n months ahead. The estimated regression is as follows:
(1)

ftn − rt + n = α ( n) + εtn+ n ,

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Figure 2
Trading Volumes and Open Interest on Federal Funds Futures and Futures Options During
November 2005
Weekly (5-Day) Moving Average
of Volume: Options

18,000

3,000

Weekly (5-Day) Moving Average
of Volume: Underlying Futures

December 05
January 06

16,000

February 06

14,000
12,000

March 06

2,000

April 06

10,000

May 06

8,000

June 06

6,000

1,000

4,000
2,000
0
Nov
1

Nov
6

Nov
11

Nov
16

Nov
21

Nov
26

Dec
1

0
Nov
1

Open Interest: Options

Nov
6

Nov
11

Nov
16

Nov
21

Nov
26

Dec
1

Open Interest: Underlying Futures

1,000,000

100,000

100,000
10,000
10,000
1,000
1,000

100
Nov Nov
1
6

Nov
11

Nov
16

Nov
21

Nov
26

Dec
1

100
Nov
1

Nov
6

Nov
11

Nov
16

Nov
21

Nov
26

Dec
1

NOTE: The figure displays open interest (lower panels) and trading volumes (upper panels) from federal funds futures contracts (right
panel) and option contracts (left panel) in November 2005. The vertical scales for the lower panels are in logarithmic form.

where ftn is the n-period-ahead interest rate
implied by the federal funds futures price in
month t and rt +n is the actual (realized, ex post)
average funds rate in month t +n, to which the
federal funds futures price should converge. Thus,
the value of α (n) in the table corresponding to the
1-month horizon (3.4) indicates that the futuresimplied forecast of the interest rate exceeds the
realized 1-month-ahead interest rate by 3.4 basis
points, on average.
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Table 1 indicates that the forecasted federal
funds rate exceeds the actual rate by 3 to 6 basis
points per month of the forecast horizon. At a 6month horizon, Piazzesi and Swanson estimate a
73-basis-point risk premium on an annualized
basis. This appears implausibly large to Carlson,
Craig, and Melick (2005), who point out that one
observes only a prediction bias; its meaning is
unclear. For this reason, they assume no risk
premium at all.
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Emmons, Lakdawala, Neely

Table 1
Piazzesi and Swanson (2005) Estimates of Federal Funds Futures Risk Premia
n

α (n)

6
36.7

3.4

7.4

12.5

19.2

27.6

(t-statistic)

(3.9)

(3.6)

(3.2)

(3.1)

Annualized

41.2

44.6

49.9

57.6

66.3

73.4

NOTE: The table is excerpted from Piazzesi and Swanson (2005). The table shows results from regressing the difference between the
implied average federal funds rate, n months ahead, on the realized federal funds rate for that month, from 1988:10 to 2003:12:
(n) . Standard errors are heteroskedastic and autocorrelation consistent; t-statistics from those standard errors are in
ftn – rt+n = α (n) + ε t+n
parentheses; α (n) is measured in basis points.

Although we are uncertain about the existence
and magnitude of risk premia in futures prices,
we think that it is reasonable to assume that the
prediction bias is 1 basis point per month in the
empirical work that follows. For our purposes in
illustrating broad movements of market expectations over time, the precise nature of our riskpremium assumption is not critical. The second
boxed insert, on risk premia versus term premia,
discusses whether one should interpret any
observed prediction bias in the federal funds
futures market as a term premium, a common
interpretation of a risk premium in fixed-income
markets.
In addition to a risk premium in the level of
the futures price, there might be significant risk
premia associated with exposure to option-price
changes caused by changing volatility. Such premia are more difficult to estimate, although some
researchers have begun to do so. Nevertheless,
even in the presence of constant but unknown
risk premia, changes in estimated PDFs still
presumably tell us about changes in the true,
physical density.

Estimating Federal Funds Target
Probability Densities
Densities for asset prices (or interest rates)
have been derived under a variety of assumptions
about the functional form of the distribution. For
asset prices that take continuous values, such as
equities or foreign exchange, estimating densities
quickly becomes very complicated and technical.
Fortunately, the fact that the federal funds target
rate historically has taken on a discrete set of
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

values—in multiples of 25 basis points since
1989—greatly simplifies its estimation.
Consider a scenario in which the Fed is certain
to choose from only three possible target rates,
{T1, T2, and T3}. Each of these three targets implies
a unique average federal funds rate {FT,1, FT,2, and
FT,3} for the month of the FOMC meeting if the
target is known to change only on the date of the
FOMC meeting, day N. Given an initial value for
the federal funds target at the start of the month,
T0, and a given target, T1 (set at the FOMC meeting), one can solve for the average federal funds
rate, FT,1, that T1 implies, as follows:
(2)

FT ,1 = T0 N / 30 + T1(30 − N ) / 30.

If three options, with strike prices X1, X2, and
X3, are actively traded on a given day, where X1
is the strike on a call and X2 and X3 are the strikes
on puts, then the probability of the selection of
each target can be estimated using the following
regression:
(3)
e r (T −t )C (t,T , X 1, Ft )
 r (T −t )

P(t,T , X 2 , Ft ) =
e
e r (T −t ) P(t,T , X , F )
3 t 

 max(0, FT ,1 − X 1 ) max(0, FT ,2 − X 1 ) max(0, FT ,3 − X 1 ) π 1   εt ,1 
 max(0, X − F ) max(0, X − F ) max(0, X − F )   ε 
2
T ,1
2
T ,2
2
T ,3  π 2  +  t ,2  ,

 max(0, X − F ) max(0, X − F ) max(0, X − F ) π  ε 
3
T ,1
3
T ,2
3
T ,3   3 

 t ,3 

where the variables on the left-hand side are the
riskless values of the current option prices at
expiry and the explanatory variables are the payoffs to the options under the three states of the
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RISK PREMIA VERSUS TERM PREMIA IN THE
FEDERAL FUNDS FUTURES MARKET
Futures prices of non-storable commodities embody only market expectations of future supply
and demand conditions. Non-storable commodities are perishables—things that cannot be set
aside and carried into future periods. Fresh eggs, for example, are non-storable because they spoil
quickly and cannot be frozen or otherwise preserved.
Federal funds futures prices reflect the value today of a future claim on deposit balances at
the Federal Reserve (reserves). Reserves are non-storable because a bank cannot hold reserves today
to satisfy future reserve requirements. Thus, today’s federal funds futures prices reflect market
expectations of future reserve-market conditions. In other words, they are an indicator of future
Federal Reserve monetary policy actions.
There could be a market-risk or liquidity premium associated with trading of federal funds
futures contracts because their expected returns co-vary with other returns and because this market
is not perfectly liquid. However, any such premium should not be thought of as a traditional term
premium. Because every future period’s reserve-market conditions are independent of all previous
period’s conditions—that is, there is no possible riskless arbitrage between them—we would not
expect any systematic relationship between a futures price and the contract’s term to maturity
(i.e., a term premium).

world (possible FOMC target-rate choices).3 The
coefficients {π 1, π 2, π 3} are the probabilities that
set the expected payoffs of the options (right-hand
side) equal to the values of the options at expiry.
Probabilities of specific targets on FOMC meeting
dates can be calculated from probabilities of the
average funds rates over a month, as in (2).
Carlson, Craig, and Melick (2005) discuss in
detail how the system can be estimated by ordinary least squares, imposing equality restrictions
such as π 1 + π 2 + π 3 = 1. Alternatively, one can
numerically maximize the likelihood function,
under some assumption about the distribution of
the error terms. Estimation by maximum likelihood permits more elaborate constraints, such as
positive probabilities or requiring the probabilities
to be consistent with the futures-implied rate.
As discussed earlier, Piazzesi and Swanson
(2005) showed that, on average, federal funds
3

Notice that this estimation method assumes (counterfactually)
that the options are European—that is, that they can be exercised
only at maturity. The discrepancy introduced by this assumption
is likely to be small, as the amount of early exercise of federal
funds options is very small.

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futures prices have implied interest rates that
exceeded the actual realized federal funds rate.
To adjust for this bias, the estimated probabilities
can be constrained to imply a risk-adjusted target.
However, because Piazzesi and Swanson’s (2005)
estimate of the risk premia may be too large, we
adjust the federal funds futures–implied rate
downward by 1 basis point for each month of
the forecast horizon.
How should one interpret the error terms?
The error terms result from market frictions such
as (i) bid-ask spreads in both the option and the
underlying asset, (ii) imperfect liquidity, and (iii)
approximations in formulating the model, such
as incorrect market risk premia, imposition of zero
probabilities to unlikely actions, and ignoring the
possibility of early exercise. In the absence of such
approximations and frictions, the probabilities
would be estimated exactly and the estimation
would be an inversion of prices to probabilities.
The facts that the errors are small and the probabilities are precisely estimated indicate that the
approximations are probably reasonable and the
frictions unimportant.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

Let’s consider a concrete example. After the
June 25, 2003, FOMC meeting, the federal funds
target rate stood unchanged at 1 percent. What
probabilities did the option market assign to various outcomes at the August 12, 2003, FOMC meeting? There were 13 options (seven calls and six
puts) with eight different strike prices on June 25.
The five possible targets that the Fed was likely
to choose from were 0.5, 0.75, 1, 1.25, and 1.5.
The following system is estimated by maximum
likelihood:
(4)
0.00250 0.0101
0.00250 0.0726
 

0.00501 0.1351
 

0.02003 0.1976
0.03506 0.2601
 

0.05259 0.3226
0..17280 = 0.4476
 

0.14775  0
 

0.10017  0
0.05259  0
 

0.00751  0
0.00250  0
 

0..00250  0

0
0

0
0.0363

0
0

0.0988
0.1613

0
0

0.2863
0.0
0262

0.1250
0.1875

0
0.3488

0
0

0.1250
0.0625

0.2863
0.2238

0
0

0.1613
0.0363




0 

0 
0   π 0.55 

0  π 0.75 
0   π 1.0  + εt ,


0.5101 π 1.25 
π 
0.4476  1.5 
0.3851

0.3226
0.1976

0.1351
0
0

where εt is a 13-by-1 vector of normally distributed
errors.
It is instructive to see how one transforms the
market data to the data in (4). The first variable
on the left-hand side (0.00250) is the price of the
first call option, with a strike price of 99.3125,
evaluated at the expiration date of the option, in
about 3 months (e r(T–t)C(t, T, X1, Ft )), at an interest
rate of 0.925 percent. The variable in the first row,
first column, on the right-hand side is the payoff
to a call option with a strike of 99.3125, assuming
that the FOMC chooses a target rate of 0.5 percent
on August 12. A target of 1.0 percent prior to
August 12, combined with a move to 0.5 percent
on August 12, would produce an average target
rate of 0.6774 (= 1 * 11/31 + 0.5 * 20/31) during
August, which translates into a final settlement
price on the futures contract of (100 – 0.6774 =)
99.3226. If that 0.5 percent target were chosen, a
call option with a strike of 99.3125 would be worth
(99.3226 – 99.3125 =) 0.0101, using the formula
max(0,FT,1 – X1). Similarly, if one looks at the first
row, second column, which assumes that the
FOMC chooses a 0.75 percent target on August 12,
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

the final settlement price for the futures contract
would be 99.1613 (= 100 – 1.0 * 11/31 – 0.75 *
20/31) and so a call option with a strike of 99.3125
would be worthless. That is, the term in the first
row, second column of the right-hand side is 0.
Each column of the regressor matrix is associated
with a unique FOMC target, and each row is
associated with a unique option.
Estimating this system, subject to the following constraints that the probabilities are positive
and sum to 1 and that the mean of the PDF equals
the term premium–adjusted futures price, produces the following coefficients for the five elements of the π vector: π = {0.114, 0.188, 0.697, 0, 0}.
The standard errors for the estimated probabilities
range from almost zero to 0.015.
The estimation constrains the probabilities
to generate the interest rate implied by the futures
price, adjusted for risk. In the example, the futures
price for August was 99.045, which implied an
interest rate of 0.955 percent for August. Adjusting
this implied interest rate for the 67-day forecast
horizon—June 25 through August 31—and assuming 1 basis point every 30 days, one obtains a riskadjusted implied rate for August of (0.955 – (67/30)
* 0.01 =) 0.9327. When numerically optimizing the
likelihood function to calculate probabilities, one
can force the implied interest rate to equal this
risk-adjusted interest rate. In the present example,
one can verify that the estimated probabilities
imply a federal funds rate for August of 0.9327
percent.4
To informally assess the importance of the
constraints—the fit of the model—one can estimate the unconstrained model to see whether
the results are sensitive to the imposition of the
constraints. If the results are highly sensitive, it
might suggest that the model doesn’t fit the data
well and the probabilities are not reliable. Reassuringly, the unconstrained system produces a
plausible and roughly similar probability vector
of π = {0.050, 0.226, 0.686, 0.023, 0.013}, whose
standard errors are of similar magnitudes to those
from the constrained system.
4

The federal funds rates implied by the five targets (0.5 to 1.5
percent) are 0.6774, 0.8387, 1, 1.1613, and 1.3226. Thus, the
expected funds rate is 0.9327 (= 0.6774 * 0.11439026 + 0.8387 *
0.18845445 + 1 * 0.69715529 + 1.1613 * 0 + 1.3226 * 0).

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Finally, one might wonder whether a normal
likelihood function for the errors is appropriate.
The error terms, εi , cannot literally be normal, as
unbounded support for ε would be inconsistent
with the requirement that option prices must be
non-negative. To investigate whether the distributional assumption for ε is important, we reestimated the example with a truncated normal
distribution that required option prices be nonnegative. The truncated distribution produced
comparable results with those from a normal
distribution. The estimated probabilities for the
five targets were 0.1057, 0.2059, 0.6884, 0, and 0,
respectively. The largest change in a probability
estimate from the normal distribution was a very
modest 1.7 percentage points.

USING OPTIONS TO GAUGE
MARKET UNCERTAINTY ABOUT
FUTURE FEDERAL FUNDS
TARGETS
Even when the strategy driving monetary
policy decisions is well understood and when
the central bank seeks to operate in a transparent
manner, market expectations can change when
the policy strategy changes or when new information about economic conditions arrives. This
section uses daily PDFs to explore the evolving
uncertainty among market participants about
future monetary policy actions.

August 2003: FOMC Pre-Commits to
Monetary Policy Accommodation for a
“Considerable Period”
By the fall of 2002, U.S. inflation was consistent with price stability as commonly understood
today (i.e., inflation was of little consequence in
making economic decisions). In fact, inflation had
declined so much that the Federal Reserve began
to consider further declines to be unwelcome
because they might lead to deflation.
Financial analysts may have misinterpreted
statements by Federal Reserve officials in the fall
of 2002 and the spring of 2003 to imply that there
would be a prolonged period of lower short-term
rates and/or the purchase of long-term bonds by
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the Fed in order to implement “easier” monetary
policy (Neely, 2004). Moreover, the FOMC statement of May 6, 2003, was widely misinterpreted
to confirm such incorrect beliefs.5 Thus, by early
June 2003, bond markets had come to expect lower
interest rates for a longer period than may have
been warranted by the state of the economy. Neely
(2003) provides some evidence to suggest that
these developments were related to expectations
of lower real growth, rather than lower inflation.
The top panel of Figure 3 shows that, in the
days prior to the June 25, 2003, FOMC meeting,
investors perceived a 50 to 70 percent chance that
the target rate would be lowered from 1.25 percent
to 0.75 percent. This is indicated by the thick,
light-blue line in the top panel of the figure, which
plots the daily implied probability estimates
associated with each possible target rate.
The FOMC, in fact, decided to cut the target
rate only from 1.25 percent to 1.00 percent. This
action not only resolved the near-term uncertainty
investors faced, but also caused them to revise
their expectations for future monetary policy. The
second panel of Figure 3 shows that expectations
during July of further rate cuts at the August meeting rapidly declined. The two lines showing the
probabilities assigned by investors to a 0.75 percent target and to a 0.50 percent target after the
August meeting converged toward zero as July
passed. By late July, markets were fairly certain
that the FOMC would choose a 1 percent target
at the August meeting.
The third panel of Figure 3 shows the analogous probabilities of various target outcomes for
the December 2003 meeting, as assessed each
day from June onward. This panel shows that by
late July or early August, markets had started to
assign positive probabilities to the possibility of
an increase to 1.25 or 1.50 percent at the December
meeting.
To reassure markets that the target rate would
not be raised in the near future, the FOMC issued
a statement after the August 12, 2003, meeting
5

The May 6, 2003, statement contained the following sentence:
“The probability of an unwelcome substantial fall in inflation,
though minor, exceeds that of a pickup in inflation from its already
low level”; www.federalreserve.gov/boarddocs/press/monetary/
2003/20030506/default.htm.

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

Figure 3
Option-Implied Probabilities of Federal Funds Target Rates To Be Chosen at the June, August,
and December 2003 Meetings
June 2003 FOMC Meeting
1
0.25
0.5
0.75
1
1.25

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
May 21
03

May 28
03

Jun 3
03

Jun 9
03

Jun 13
03

Jun 19
03

Jun 25
03

August 2003 FOMC Meeting
1

June 25:
FOMC Meeting

0.9
0.8

0.5
0.75
1
1.25
1.5

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Jun 2
03

Jun 12
03

Jun 24
03

Jul 7
03

Jul 29
03

Jul 17
03

Aug 8
03

December 2003 FOMC Meeting
1
0.9
0.8

0.5
0.75
1
1.25
1.5

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Jun 2
03

Jul 2
03

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Aug 2
03

Sep 2
03

Oct 2
03

Nov 2
03

Dec 2
03

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that contained the first commitment by the FOMC
that the current low target rate would persist:
“The Committee judges that, on balance, the risk
of inflation becoming undesirably low is likely to
be the predominant concern for the foreseeable
future. In these circumstances, the Committee
believes that policy accommodation can be maintained for a considerable period.”6 This language
was repeated in the September 16, 2003, FOMC
statement. The bottom panel of Figure 3 illustrates
that, in the 3 months after August 12, market
expectations coalesced on the idea that a 1 percent
target would be the outcome of the December
meeting. The FOMC announcements successfully
anchored market expectations on a 1 percent funds
target rate for at least the next 4 months.

May 2004: FOMC Signals Its First Rate
Increase in Four Years
The Federal Reserve never defined what a
“considerable period” was, but no one doubted
that the FOMC’s target rate would be raised eventually. From Figure 4 it appears that speculation
about impending rate increases began in earnest
in March 2004 and that expectations about the
timing and magnitude of rate increases evolved
considerably during the course of the year.
Figure 4 displays a term structure of expected
target rates extracted from 1-, 3-, 6- and 9-monthahead federal funds futures contracts on each
trading day during 2004. The fixed calendarmonth nature of federal funds futures contracts
means that the “roll forward” day occurs on the
first trading day of each month. For example, on
May 28, 2004, the expected average funds rate for
“next month” referred to the average for June 2004
and was 1.02 percent.7 The next business day was
June 1, when the May contract was settled and
“next month” became July 2004. The thin line
representing the 1-month-ahead expected federal
funds rate shows a jump to 1.23 percent on June 1,
6

Press release issued by the Federal Reserve’s FOMC, August 12,
2003; www.federalreserve.gov/boarddocs/press/monetary/2003/
20030812/.

The average effective rate can deviate slightly from the FOMC’s
target rate because of daily fluctuations in actual reserve-market
conditions.

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implying that market expectations for a 25-basispoint increase by “next month”—effectively, by
the end of June—was considered very likely.
Figure 4 allows us to pinpoint evolving market
expectations about the timing of the first target
increase in four years. The line representing 9month-ahead expectations shows that, during
January and February 2004, market expectations
were for a funds target in the 1.25 to 1.50 percent
range during October and November 2004. But
when would these increases occur? The line representing 3-month-ahead expectations jumped
abruptly on May 3, 2004, from 1.11 percent to 1.27
percent. This coincided with the roll-forward
from July to August 2004 of the 3-month-ahead
contract. The jump implies that market expectations at that time (May 3) were tilted toward an
initial increase in the funds target at the August
10 meeting, rather than at the June 29-30 meeting. Only later during May 2004 did expectations
shift toward an initial increase at the June meeting, as described above in the context of the 1month-ahead contract.
The distance between the 1-, 3-, 6- and 9month-ahead implied yields in the figure illustrates the expected pace of funds target increases
at any given point in time. On June 14, 2004, for
example, the market expected the funds target
to average 1.33 percent during July 2004 (next
month), 1.85 percent during September 2004 (3
months ahead), 2.44 percent during December
2004 (6 months ahead), and 2.95 percent during
March 2005 (9 months ahead). In the event, the
actual average effective funds rates during those
months were 1.26, 1.61, 2.16, and 2.63 percent,
respectively.
Given the difficulty of separating the timing
from the magnitude of future rate increases from
federal funds futures alone, it is helpful to examine
risk-neutral PDFs derived from federal funds
futures options. The top panel of Figure 5 displays
the evolving probabilities attached to various possible rate targets to be chosen at the June 2004
FOMC meeting. While Figure 4 demonstrates that
market expectations of a sequence of future rate
increases emerged after the May 4, 2004, FOMC
meeting, the top panel of Figure 5 shows that, in
early summer of 2004, market participants became
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

Figure 4
Federal Funds Futures–Implied Yields from Contracts Traded in 2004
3.5
1-Month
3-Month
3

6-Month
9-Month

2.5

Average Effective
Federal Funds Rate

1.5

0.5
January

February

March

May

June

July

September October December

NOTE: The figure shows the average federal funds rates implied by the 1-, 3-, 6-, and 9-month-ahead federal funds rate futures contracts for 2004.

convinced that the rate increases were to start with
the June FOMC meeting. The bottom panel of
Figure 5 shows that the FOMC’s June 30 decision
to raise the funds target from 1.00 percent to
1.25 percent prompted agents to expect further
increases at the August meeting.

June 2004: FOMC Pre-Commits to
Increasing Its Target Rate at a
“Measured Pace”
Apparently wary of disrupting financial markets with rapid rate increases, the FOMC signaled
after its June 30, 2004, meeting that it intended
to raise its target rate gradually over time: “With
underlying inflation still expected to be relatively
low, the Committee believes that policy accommodation can be removed at a pace that is likely
to be measured. Nonetheless, the Committee will
respond to changes in economic prospects as
needed to fulfill its obligation to maintain price
stability.”8 Figure 4 shows that, after the FOMC’s
June 30 statement, with the target rate at 1.25
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

percent, expectations of longer-term increases
moderated and stabilized. That is, the level and
volatility of the 3-, 6-, and 9-month-ahead implied
rates declined and stabilized after June 30. This
suggests that the “measured pace” language was
well-understood by market participants.
The bottom panel of Figure 5 confirms this
view by showing probabilities of targets to be
chosen at the August 2004 FOMC meeting. Prior
to the June 2004 FOMC meeting there were substantial expectations of a 50- or even 75-basispoint increase, to 1.75 or 2.0 percent at the August
meeting. But after the statement at the June FOMC
meeting, the market gradually became convinced
that the increase was going to be in increments
of 25 basis points, to 1.5 percent at the August
2004 meeting.
8

Press release issued by the Federal Reserve’s FOMC, June 30, 2004;
www.federalreserve.gov/boarddocs/press/monetary/2004/
20040630/default.htm.

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Figure 5
Option-Implied Probabilities of Federal Funds Target Rates To Be Chosen at the June and
August 2004 FOMC Meeting
June 2004 FOMC Meeting
1
0.9

May 4:
FOMC Meeting

0.8
0.7

0.75

0.6
0.5

1
1.25
1.5

0.4

1.75

0.3
0.2
0.1
0
4/1/04

4/14/04

4/26/04

5/6/04

5/18/04

5/28/04

6/10/04

6/22/04

August 2004 FOMC Meeting
1
0.9
0.8

June 30:
FOMC Meeting
1

0.7

1.25
1.5

0.6

1.75
0.5

0.4
0.3
0.2
0.1
0
6/1/04

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2006

6/23/04

7/6/04

7/16/04

7/28/04

8/9/04

F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

Figure 6
Federal Funds Futures–Implied Yields from Contracts Traded in 2005
5

1-Month
3-Month

4.5

6-Month
Average Effective Federal Funds Rate

3.5

2.5

2
January

March

May

July

September

November

NOTE: The figure shows the average federal funds rates implied by the 1-, 3-, 6-, and 9-month-ahead federal funds rate futures contracts for 2005.

August/September 2005: Gulf Coast
Hurricanes Create Uncertainty About
the FOMC’s Likely Rate Increases
The devastation along the Gulf Coast caused
by hurricanes Katrina and Rita in August and
September 2005 substantially revised market
expectations about monetary policy actions.
Figure 6 displays the federal funds futures–implied
target rates derived from 1-, 3-, and 6-month-ahead
futures contracts traded in 2005. The impact of the
hurricanes, especially Katrina, is clearly visible
about September 1, 2005. Fearing that Katrina
might significantly slow the U.S. economy, market
participants revised down their expectations of
3- and 6-month-ahead target rates.
One also can examine the PDFs from option
prices before and after Katrina’s second landfall
(near New Orleans, after traversing the southern
tip of Florida) on August 29 to infer the evolution
of expectations for the November 1, 2005, FOMC
meeting over this turbulent period. The upper left
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

panel of Figure 7 shows that, on August 23—when
the funds target was 3.5 percent—the markets
expected a greater-than-80 percent chance of a
4.0 point target rate at the November 1 meeting,
with some modest chance of a 3.75 or 4.25 percent
target. On September 1, three days after Katrina
made second landfall, market expectations of
the funds target on November 1 had declined
and dispersed significantly (top right subpanel).
The mean futures rate was 3.74 percent, and the
chances of a funds target of 3.5, 3.75, or 4.0 percent were approximately 38, 31, and 28 percent,
respectively. In other words, the markets assessed
the probability that the target at the November
meeting would be 4.0 percent or greater declined
from about 90 percent to about 30 percent.
By September 8, panic had subsided a bit;
the bottom-left subpanel shows that the implied
probabilities of 3.75 and 4.0 percent targets were
48 percent and 42 percent, respectively (bottomleft subpanel). Finally, by September 30—after a
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Figure 7
Option-Derived Probability Density Functions (PDF) Surrounding Hurricane Katrina
Pre-Katrina PDF
(November FOMC Meeting)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

3.95
August 23

3.25

3.5

3.75

1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

4.25

3.81
September 8

3.25

3.5

3.75

4.25

3.74

September 1

3.25

Post-Katrina PDF 2
(November FOMC Meeting)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

Post-Katrina PDF 1
(November FOMC Meeting)

3.5

3.75

4.25

Post-Katrina PDF 3
(November FOMC Meeting)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

3.97
September 30

3.25

3.5

3.75

4.25

NOTE: The figure shows option-implied probability density functions around the time of Hurricane Katrina, which made second landfall
on August 29, 2005. The vertical bars denote the rate implied by the federal funds futures contract price.

25-basis-point target increase to 3.75 percent at the
September 20 FOMC meeting—the PDF showed
that market expectations had returned to approximately the pre-Katrina level, with a more-than-90
percent chance of a 4.0 target at the November
meeting (bottom-right subpanel).
Figure 8 shows another way of looking at the
same information; it plots the probabilities of
various outcomes at the November meeting over
time. Four days after Katrina made landfall, the
possibility that the Fed would increase the funds
rate all the way to 4.0 percent by November 1
declined significantly, from 85 percent to 25 percent. At the same time, the possibility that the
FOMC would not change the funds target at all
increased to almost 30 percent for a day.
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April 27, 2006: Chairman Bernanke
Testifies Before the Joint Economic
Committee
The weeks prior to the May 10, 2006, FOMC
meeting were unusually active ones in the federal
funds futures and options markets. Market expectations were quite sensitive to incoming economic
data and statements. For example, the top panel
of Figure 9 shows that strong reports on housing
and durable goods on April 25 and 26 raised the
expected federal funds rate from 5.11 percent to
5.16 percent and the lower panel shows that the
implied probability of a 5.25 percent target rate
after the June FOMC meeting rose from under 40
percent to about 60 percent.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W

Emmons, Lakdawala, Neely

Figure 8
Option-Implied Probabilities of Federal Funds Target Rates To Be Chosen at the November 2005
FOMC Meeting
1
0.9

3.25
3.5

0.8

3.75
4.25

0.7
0.6

September 20:
FOMC Meeting

0.5
0.4

Katrina:
2nd Landfall

0.3
0.2
0.1
0
8/19/05

8/26/05

9/2/05

On April 27, Chairman Bernanke (2006)
spoke before the Joint Economic Committee of
Congress on the outlook for the U.S. economy.
The Chairman was broadly optimistic about the
state of the U.S. economy, describing the prospects
for maintaining solid growth as “good” and the
outlook for inflation as “reasonably favorable.”
The Chairman went on to note that the FOMC
had increased the federal funds rate by 25 basis
points at each of its previous 15 meetings and
that the current federal funds target was 4.75
percent. The Chairman cautioned that
[P]olicy will respond to arriving information
that affects the Committee’s assessment of the
medium-term risks to its objectives of price
stability and maximum sustainable employment…[A]t some point in the future the
Committee may decide to take no action at one
or more meetings in the interest of allowing
more time to receive information relevant to
the outlook. Of course, a decision to take no
action at a particular meeting does not preclude
actions at subsequent meetings, and the
Committee will not hesitate to act when it
determines that doing so is needed to foster

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9/9/05

9/16/05

9/23/05

9/30/05

the achievement of the Federal Reserve’s
mandated objectives.

Economists might interpret such a comment
as a judicious statement of the obvious: The
FOMC’s policy decisions will respond to news
and changing economic conditions. It was widely
reported that financial markets interpreted the
statement to mean that a pause in the interest rate
increases was imminent. Equity markets rallied;
the S&P 500 finished up over 4 points on April 27.
The top panel of Figure 9 shows that the expected
federal funds target for the May FOMC meeting fell
from 5.16 percent to 5.07 percent between April 26
and April 28 in response to the Chairman’s testimony. The lower panel shows that this was generated by a shift in the probability of a 5.25 percent
target from 60 percent to 23 percent and a similar
rise in the probability of a 5.0 percent target.

SUMMARY
This article uses the method of Carlson, Craig,
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Emmons, Lakdawala, Neely

Figure 9
Expected Federal Funds Targets and Option-Implied Probabilities of Federal Funds Target Rates
To Be Chosen at the May 2006 FOMC Meeting
Percent
5.25
Futures Price
May 5: April
employment report

5.20

Apr 18: March
FOMC minutes released
Mar 28: FF target
raised to 4.75%

Apr 13: March
retail sales report
Apr 7: March
employment report

5.15

Apr 27: Chairman
addresses JEC
May 10:
FOMC meeting

Apr 25,26:
Housing
and durable
goods reports

5.10

5.05

5.00
Mar
27

Apr
6

Apr
1

Apr
11

Apr
16

Apr
21

Apr
26

May
1

May
6

May
11

Probability of Various FF Targets after June 28-29 FOMC Meeting
Implied Probability
1.00
5.00%
May 5: April
employment report

5.25%
All Others
0.75

Apr 18: March
FOMC minutes released
Mar 28: FF target
raised to 4.75%

Apr 13: March
retail sales report
Apr 7: March
employment report

Apr 27: Chairman
addresses JEC
Apr 25,26:
Housing
and durable
goods reports

May 10:
FOMC meeting

0.50

0.25

0.00
Mar
27

Apr
1

Apr
6

Apr
11

Apr
16

Apr
21

Apr
26

May
1

May
6

May
11

NOTE: FF, Federal funds; JEC, Joint Economic Committee.

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Emmons, Lakdawala, Neely

neutral probability density function over possible
future federal funds target rates from daily option
prices. Option-based forecasts are most useful
when more than two federal funds target outcomes
are plausible at an upcoming FOMC meeting. If
only one or two meeting outcomes are plausible,
a futures-based forecast is simpler and more appropriate.
We assess evolving market uncertainty about
Federal Reserve monetary policy actions in a
variety of recent events and episodes, including
(i) a commitment by the FOMC to maintain monetary policy accommodation for a “considerable
period”; (ii) a signal by the FOMC that the first
target-rate increase in four years was forthcoming;
(iii) a commitment by the FOMC to raise the target
rate over time at a “measured pace”; (iv) the
devastating aftermath of Hurricane Katrina; and
(v) April 2006 testimony by Chairman Bernanke
before the Joint Economic Committee. These
episodes illustrate how federal funds futures
options can be used to supplement the information derived from federal funds futures and other
sources of market expectations about Federal
Reserve monetary policy actions.

REFERENCES
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Full text of Review (Federal Reserve Bank of St. Louis) : November/December 2006, Vol. 88, No. 6

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