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O C T O B ER 1970

Stabilization Policy and Inflation
I n FLATION, caused by an excessive rise in total
spending, has been a serious national problem since
the mid-Sixties. The monetary and fiscal actions of
the past two years have been successful in moderating
the surge in total spending, and initial adjustments
thereto were manifested by reduced real output. More
recent adjustments apparently have included a de­
cline in the rate of price increase.
An immediate consequence of the batde against
inflation has been insufficient total spending to absorb
the growing labor force and plant capacity. But suc­
cess in correcting established inflation has always been
costly. If the growth of total demand for goods and
services is restrained to a reasonable rate, output and
employment growth will gradually accelerate as in­
flationary forces recede.
Two strategic questions for stabilization policy in
the immediate future are: what is an appropriate rate
of spending growth? and what rate of growth in
money will foster this spending growth? This Bank
has estimated that a 3 per cent rate of increase in
money will provide about a 4.5 per cent rate of
spending growth a year from now, while a 5 per cent
rate of increase in money will provide about a 6.5 per
cent rate of spending growth.1

Monetary Actions
Monetary actions have been a major factor in mod­
erating the growth of total spending in 1969 and 1970,
just as in 1966 and 1967. The money stock did not
grow from April 1966 to January 1967 and then ex­
panded at about a 7 per cent annual rate in 1967.
Similarly, eight months of little expansion in the
money stock from June 1969 to February 1970 have
been followed by about a 6 per cent growth rate in
the money stock since February. In early 1967, total
spending growth slowed markedly to a 3.6 per cent
annual rate in the first half of the year. Similarly,
after autumn 1969, total spending growth slowed to a
4.1 per cent rate. In both instances, monetary au­
thorities reacted to the slowdown by shifting to a
relatively less restrictive monetary policy, with a view
iSee “A Monetarist Model for Economic Stabilization,” this
Review (April 1970), pp. 7-25; and “Economic Slowdown
and Stabilization Policy,” this Review (September 1970),
pp. 6 and 7.

Page 2

M o n e y Stock
Ratio Scale
Billions of D o lla rs
23 0

Ratio Scale
Billions of D olla rs

M o n t h ly A v e r a g e s o f D a i l y F ig u r e s
S e a s o n a lly A d ju ste d


























Jan. 67


tl I 1 I l 1 I I I l



Feb .7 0


Sept 70






P e r c e n t a g e s a r e a n n u a l ra t e s o f c h a n g e fo r p e r i o d s in d ic a t e d .

L a te st d a t a p lo tte d : S e p te m b e r

to avoiding inordinate restraint on total spending and
The more rapid growth of the money stock since
February 1970 has been fostered by increases in Fed­
eral Reserve credit and member bank reserves and
has been accompanied by rapid growth in time de­
posits. Total Federal Reserve credit grew at a 9 per
cent annual rate from February to September, com­
pared with a 2.7 per cent rate from January 1969 to
February 1970. Total member bank reserves grew at
a 9.5 per cent annual rate from February to Septem­
ber 1970.
Time deposits at commercial banks have increased
rapidly in 1970, because banks have been better able
to compete for funds than in 1969. Certain interest
rate ceilings were relaxed in January and completely
suspended on 30- to 89-day large CD’s in June, and
short-term market interest rates have declined. Time
deposits grew at a 12 per cent annual rate from
January to June and at a 35 per cent rate from June
to September. About half of the increase in time de­
posits since February of this year has been in the
form of large negotiable certificates of deposit, repre­
senting largely a reintermediation of funds previously
flowing through nonbank channels.



The inflow of time deposits to commercial banks
has not been at the expense of savings flows into
nonbank financial intermediaries. Net savings flows
to nonbank financial intermediaries have increased
rapidly in 1970 compared with 1969. Savings and loan
shares grew at an 8 per cent annual rate in the first
eight months of 1970 compared with 2.6 per cent in
1969. Mutual savings bank deposits increased at a 6.3
per cent annual rate in 1970 compared with 3.9 per
cent in 1969.
Short-term market interest rates have declined in
1970, because of more rapid monetary expansion and
slower growth of total credit demand. Three-month
Treasury bill rates declined from 7.S7 per cent in
January to 5.84 per cent in early October. The de­
cline in short-term market interest rates relative to
the discount rate, together with the greater ability of
banks to attract time deposit funds, has induced mem­
ber banks to reduce their borrowings at the Federal
Reserve from about $900 million last spring to about
$500 million in late September and early October.
In contrast to short-term interest rates, yields on
long-term corporate bonds have changed little on
balance in 1970, because of continued heavy demands
for funds relative to the supply. Interest rates on
highest grade seasoned corporate bonds, after reach­
ing a peak of 8.60 per cent in mid-1970, declined to
about 8 per cent in early October, about the same as
at the beginning of the year.

Total Spending and Output
Monetary and fiscal restraint in 1969 and 1970 have
been successful in moderating the growth of total
spending. Total spending expanded at a rapid 9.4 per
cent rate from mid-1967 to mid-1968. After imposition
of the surtax and some Government spending cuts in
T a b le 1

C h a n g e s in S p e n d i n g a n d Output
(a n n u a l rates of c h a n g e in current d o lla rs)
11/67 to

S p e n d in g

(G N P )

11/68 to

111/69 to

9 .4 %

7 .8 %

Real O u tp u t

5 .0


-0 .5

C on su m p tio n

4 .5 %


7 .9

6 .9

G ro s s Private Dom estic
Investm ent

1 5 .0


- 4.9

G o ve rn m e n t Purchases of
G o o d s a n d Services

1 1 .2

6 .3

3 .4

Federal G o ve rn m en t
Purchases of G o o d s
a n d Services



— 3 .4

1 2 .7

9 .7

9 .7

State a n d Local
G o ve rn m e n t Purchases
of G o o d s a n d Services

mid-1968, spending grew at a slower, but still rapid,
annual rate of 7.8 per cent until the third quarter of
1969. Following reduced monetary expansion begin­
ning in early 1969, spending slowed to a more moder­
ate 4.5 per cent rate of increase from the third
quarter of 1969 to the third quarter of 1970, a rate
slightly higher than the commonly assumed trend
growth of productive capacity (Table 1).
Growth in real output slowed simultaneously with
the reduction of total spending. The unsustainable 5
per cent increase of real output from mid-1967 to
mid-1968 slowed to about a 3 per cent annual rate
from mid-1968 to the third quarter of 1969, and then
to a 0.5 per cent decline from the third quarter of
1969 to the third quarter of 1970.
Within the private sector, the reduction in spend­
ing growth in the last two years was greater in
investment expenditures than in consumption. Con­
sumer spending growth slowed gradually to a 6.9 per
cent rate in the last year. The trend of gross private
domestic investment changed sharply, slowing from a
15 per cent rate of expansion from the second quarter
of 1967 to the second quarter of 1968, to a 10 per cent
annual rate from the second quarter of 1968 to the
third quarter of 1969, and then to a 4.9 per cent rate
of decline from the third quarter of 1969 to the third
quarter of 1970 (Table 1). The initial absolute de­
cline in investment expenditures occurred about two
quarters after monetary restraint was initiated and
simultaneously with early adjustments in total spend­
ing. The decline was comparable to investment be­
havior at the end of 1966 and the beginning of 1967.
Page 3



Employment responded only slowly to reduced
growth in spending and output. Payroll employment
growth slowed slightly in the last half of 1969 but
nonetheless continued to grow strongly through March
of 1970, before declining at a 2.4 per cent rate from
March to September. In 1969 and early 1970 firms
adjusted mainly overtime and hours of work rather
than reduce their trained labor force. Reduced
spending and production since last spring have forced
employers to reduce their labor force. Despite recent
declines, however, employment relative to population
of working force age (16-64) was higher this past
summer than at any time in the Fifties or the Sixties
before 1967.

Corporate profits after taxes, a major source of in­
vestment funds, responded sharply to reduced total
spending and the continued rise in costs. They de­
clined 12 per cent from the second quarter of 1969 to
the second quarter of 1970 after showing littie net
change in the previous three years. Profits declined
from 6.8 per cent of GNP in 1965 to 5.2 per cent in
1969 and to 4.6 per cent in the first half of 1970.
Purchases of the public sector have also grown
more slowly in the last two years, and priorities have
been shifted. Total government purchases (Federal,
state, and local) have grown at about a 5 per cent
annual rate since mid-1968, compared with about a
14 per cent rate from 1965 to 1968. The trend of
Federal Government purchases has shifted most
markedly, remaining about unchanged since mid1968 after growing at a 14.8 per cent annual rate from
mid-1965 to mid-1968. State and local government
purchases have grown at about a 9.7 per cent annual
rate since mid-1968, compared with a 13 per cent
rate in the preceding three years.
Defense purchases have been cut back severely,
while nondefense purchases of the Federal Govern­
ment have continued to grow. Recentiy, defense
spending has been about $2.4 billion lower than at its
peak at the end of 1968, and 14 per cent fewer people
are currently employed in defense and defense-related
industries than in mid-1968. Defense spending rose
from 8.5 per cent of total spending (GNP) in the
1962-64 period to about 9 per cent at the peak in
1967-68, and has since declined to 7.6 per cent in the
third quarter of 1970.

The unemployment rate averaged 5.2 per cent in
the third quarter of this year compared with 3.6 per
cent a year earlier. The recent 5.2 per cent rate com­
pares with an average of 5.8 per cent in 1961-64 when
prices were not rising significantly. The unemployment
rate for married men in the third quarter of this year
was 2.8 per cent compared with 1.6 per cent a year
earlier and an average of 3.6 per cent in 1961-64.

Price trends over a considerable period of time
generally reflect the trend of spending relative to
the trend of productive capacity. Many prices, how­
ever, are slow to change, and hence overall prices do
not move up quickly when spending growth acceler­
ates, nor stop rising soon after the growth in spending
moderates. Restrictive monetary actions of 1969 and
early 1970 have been sufficient to halt the acceleration
of inflation, and there are scattered indications that
the rate of inflation may be slowing.
Consumer price advances may have moderated since
last April. From April to August, consumer prices rose
at a 4.5 per cent annual rate, compared with a 6 per
cent rate in the preceding year. The decline in recent
months has been the result of a less rapid rise in the
prices of services and food. Although these data sug­
gest that the rate of consumer price advance may
be slowing, it is difficult to say at this time whether
this constitutes the beginning of a definite change in
trend or is merely an irregularity in the series. Such
an irregularity occurred in farm products and food
prices in the summer of 1969.
Wholesale prices of industrial commodities rose at
a 2.1 per cent annual rate from May to September,
compared with a 3.9 per cent rate in the preceding
year. While these developments are encouraging, sim-

OCTOBER, 1970


Ratio S ca le
1 9 5 7 -5 9 = 1 00

Ratio S c a le
1 9 5 7 -5 9 = 1 00

S o u r c e : U .S . D e p a r t m e n t o f L a b o r
P e r c e n t a g e s a r e a n n u a l ra t e s o f c h a n g e fo r p e r i o d s in d ic a t e d .
L ate st d a t a p lo tte d : C o n s u m e r - A u g u s t ; W h o l e s a l e - S e p t e m b e r

ilar consecutive months of improvement in industrial
prices in 1969 did not prove to be lasting. Probably
the most significant improvement in wholesale prices
in 1970 has been the lessening of upward price pres­
sures in the markets for metals. An additional group­
ing of wholesale prices, the daily spot market index
of thirteen raw industrial prices which are believed to
be highly sensitive to demand conditions, has declined
sharply since February of this year. The index reflects
world as well as domestic market conditions.

One reason for some optimism regarding price
prospects in the near future, despite only uncertain
improvements so far, is that growth in total spending
has remained moderate for over a year. Past experi­
ence indicates that changes in spending growth have
usually affected output initially, and about three
quarters after the reduction in spending and output,
a reduction in the rate of inflation has generally be­
come evident. Since monetary restraint was initiated
in early 1969, and did not materially reduce spending
until the last half of 1969, the lags in price adjust­
ments have not been unexpectedly long, especially
in view of the strong upward price momentum which
had developed. An increasingly larger impact on
prices can be expected as the period since the onset
of restraint lengthens, provided stimulative stabiliza­
tion policies are not pursued too actively.

Inflationary Expectations and
Monetary Policy
The course of total spending is influenced primarily
by monetary and fiscal actions. Inflationary expecta­
tions, which are formed and dissipated only slowly,
have their main effect on the division of total spend­
ing between prices and real output. Some of the im­
pact of inflationary expectations since mid-1969 has
been manifested in a slowing of real output growth.
Inflationary expectations continue to have a bearing
on the formulation of monetary policy. Monetary au­
thorities are currently faced with five years of cumu­
lated inflationary expectations. Monetary actions to
combat inflation must now be sufficiently strong to
break the pattern of inflationary expectations if the
ground work is to be laid for resumed real growth
with relative price stability.
A vital current question is whether the slowing of
real output growth from mid-1968 through mid-1969
and then three or four quarters of no expansion in late
1969 and in 1970 has been sufficient to reduce infla­
tionary expectations adequately. The more expansion­
ary monetary actions thus far in 1970 may contribute
to real output growth and greater employment, and
probably do not run a risk of fostering a growth of
total spending which reinforces inflationary expecta­
tions. But significantly more rapid monetary expan­
sion than has prevailed so far in 1970, if continued for
any length of time, is likely to prolong the inflation
problem unduly. Total spending growth must be
appropriately limited if we are to complete within a
reasonable period the transition to an economy of
relative price stability.
Page 5

Some Lessons to be Learned
from the Present Inflation
A Speech by DARRYL R. FRANCIS, President, Federal Reserve Bank
of St. Louis, to the University of Miami Commercial Bank Forum,
Doral Country Club, Miami, Florida, September 24, 1970
I t IS GOOD to have this opportunity to discuss
with you some of my views regarding the inflation
which has plagued our economy for the past five or
six years. It seems important to me that all of us
understand current economic stabilization problems
and the efforts of our public officials to handle them.
If our economy is ever to contain inflation, we must
have leaders who are aware of the causes of inflation,
of its costs to our society, and of the difficulties
inherent in reducing inflation once it is allowed to
run rampant.
Since late 1964 prices have been rising with increas­
ing rapidity, with effective attempts to control this
situation only in the last two years. Now that we
have undergone for several years our worst inflation
since World War II, it is timely to reflect on this
experience and to draw some conclusions. If the
obvious lessons of the last six years are remembered
in the future, the likelihood of repeating unnecessary
mistakes should be reduced considerably. Only by
avoiding such mistakes can our economy experience
economic growth at a high level of employment with
a reasonable stable price level. These, of course, are
widely accepted national economic goals.

The Current Inflation
Before going to the main part of my remarks, let
me review the course of the present inflation and
steps we have taken to curb it. Our economy had a
period of substantial price stability from 1958 to 1964.
During this period the wholesale price index was
virtually unchanged, the consumer price index rose
about one per cent a year, and the GNP price de­
flator rose at only a slightly faster rate than con­
sumer prices. Those six years of relatively stable prices
marked the end of the inflation generated during
World War II and the Korean War. By 1964 we had

Page 6

achieved a high level of resource utilization, and
prospects were good for continuing price stability.
Our economy was moving into a period when it could
be said that the goals of economic stabilization had
been essentially achieved.
But, then, from 1964 to just recently, an era of
ever more rapidly increasing prices developed. This
inflation was caused by growth of total spending for
goods and services at an eight per cent annual rate
from 1964 to 1968, or about twice as rapid as our
economy’s ability' to increase the production of goods
and services. This excessive expansion in total spend­
ing was fostered by very stimulative monetary actions
of the Federal Reserve System, supported by the Ad­
ministration, the Congress, and public opinion. The
nation’s money stock, except for a brief interlude in
1966, rose at rates which approximated those prevail­
ing during the World War II and the Korean War
One of the main reasons for such extremely high
rates of monetary growth appears to have been a de­
cision to expand welfare programs and the Vietnam
War simultaneously and to finance these increases, in
large part, by inflating the monetary system rather
than exclusively by taxes or borrowing from the
planned saving of the public. These latter two sources
of Government finance are basically noninflationary,
because most of an increase in Government expendi­
tures is then made at the expense of private expendi­
tures.® On the other hand, when increased Govern­
ment expenditures are accompanied by excessive
monetary expansion, there is little, if any, direct reduc­
tion in private spending. In fact, there are strong
secondary repercussions from such a method of Gov­
ernment finance which greatly enlarge spending by
business firms and consumers.
‘ For further elaboration of this point, see “The ‘Crowding
Out’ of Private Expenditures by Fiscal Policy Actions,” on
pages 12-24 of this Review.


Significant actions to curb inflation, either fiscal or
monetary, were delayed well into 1968, despite
acknowledgment of the existence of a serious inflation
and often-expressed desires to do something about it.
Then, in mid-1968 a program of reducing the rate of
increase in Government spending and increasing taxes
was adopted with a view to bringing the excessive
rate of growth in total spending more into line with
growth in potential output of goods and services.
However, it was not until the rate of growth in the
money stock was reduced markedly in 1969 that the
stage was set to bring total spending more in line
with growth in our economy’s productive potential.
Curbing such a long inflation has proven, once
again, to be both slow and costly. Only in recent
months has there been any evidence of a slowing in
the rate of price increase, and the period is still too
short to conclude definitely that there has been a
marked waning of inflation. I am confident, though,
that if monetary growth is limited to a moderate rate
for the next several months, there will be significant,
but slow, abatement of inflation. On the cost side of
setting the stage for reducing inflation, there has been
a slowdown in output of goods and services accom­
panied by a rise in unemployment. It should be
pointed out, however, that the present slowdown has
been much less than during any of the other such
slowdowns during the past twenty-five years.

Some Lessons
I turn now to the main theme of this discussion —
some lessons to be learned from the present inflation.
In developing these lessons, I will point up some of
the failures of commonly accepted economic ideas
regarding economic stabilization which have been in­
strumental in permitting our present inflation to de­
velop. By the commonly accepted economic ideas, I
mean the form of analysis taught in the majority of
undergraduate economics courses for the past twentyfive years. Although most economists have now ad­
vanced beyond this rather limited analysis, it still per­
meates the thinking of the general public, many busi­
ness and financial leaders, news writers, politicians,
and public policymakers.

Inflation a Monetary Phenomenon
One lesson, and I believe the most important, is that
inflation is primarily a monetary phenomenon, where­
as the conventional view has placed great stress on
Government deficits, union power, and business
monopolies as causes of inflation. There is now con­


siderable evidence from studies at our Bank and
by others that the excessive total spending which led
to a high and accelerating rate of price advance was
generated, for the most part, during 1964 to 1968 by
the exceedingly high rate of monetary expansion of
that period.
As I pointed out earlier, rapid growth in Govern­
ment spending and deficits is not a major source of
inflation unless accommodated by growth in the money
stock. Likewise, upward pressures on prices from
union or business monopoly actions are not likely to
initiate a period of inflation unless accompanied by
rapidly rising total spending. Such a rise in total
spending requires expansive actions on the part of
monetary authorities. Thus, the price level effect of
often mentioned fiscal and monopoly causes of infla­
tion can be contained if they are not validated by
monetary actions which generate a rapid growth in
total spending.

Popular Economic Analysis Inadequate
Another lesson to be learned from our recent in­
flation is that the popular economic analysis of the
past quarter century has been ill-equipped to correct
inflation. A major aspect of this conventional analysis,
as I mentioned earlier, is that the general price level
is believed to be only remotely influenced by mone­
tary actions. Instead, in addition to fiscal actions, con­
siderable emphasis is given to controlling undesired
price level movements by measures to reduce monop­
oly power or by exertion of Government pressure, such
as guidelines, to induce those who set prices to act in
a manner consistent with national objectives. This
view, which was developed in large part from the
experience of the Great Depression of the 1930’s, is
still prevalent in the economic theory which underlies
much of popular thought regarding economic stabili­
zation. By being developed within such a depression
orientation, this body of theory is not particularly
useful, in my opinion, in developing programs to cope
with an inflationary situation such as we have ex­
perienced since 1964. Also, reliance on such devices
as the wage-price guidelines during the 1960’s became
a substitute for sound stabilization policy, and thereby,
contributed to the emergence of inflation.

Roles of Monetary and Fiscal Actions
A further lesson from our experience of recent
years is that monetary actions rather than fiscal
actions should be given the major role for stabilizing
Page 7


the economy. Until recently, fiscal actions in the form
of Government spending and taxing programs have
been given the main emphasis in economic stabiliza­
tion efforts to the virtual exclusion of monetary ac­
tions. Such a development was an outgrowth of con­
ventional economics, which for the past thirty-five
years has taught that Federal Reserve actions exer­
cise little influence on total demand for goods and
services. According to this conventional thought,
changes in the money stock bring about changes in
market interest rates, while total demand is little
influenced by interest rate movements. Consequently,
monetary actions have been thought to be of little
use in any program of economic stabilization. On the
other hand, increased Government expenditures are
viewed as adding directly to total demand, and tax
reductions are thought to add to disposable income
which subsequently is used to purchase goods and
services. Consequently, this view has argued that
fiscal actions have an immediate and powerful
influence on total spending.
This conventional analysis, possibly because of its
simplicity which helps in the teaching of under­
graduate economics, has received wide acceptance as
evidenced in discussions of economic stabilization by
the general public, in the press, in the Congress,
and even in some of the Reports of the Council of
Economic Advisers during the mid-1960’s. It should
be pointed out that this view of the influence of
fiscal actions does not take into consideration the
importance of choice among the three alternative
means of financing Government expenditures — taxes,
borrowing from the public, and monetary expansion.
At the St. Louis Federal Reserve Bank we have
reported several studies regarding the relative im­
portance of monetary and fiscal actions for economic
stabilization. Our empirical studies for the United
States economy from 1919 to 1969 and for several
foreign countries in the post-World War II period
support the view that monetary actions, measured by
changes in the money stock, should receive the main
emphasis in economic stabilization, not fiscal actions.
The accelerating inflation of the last half of the
1960’s can be attributed, in large part to the great
emphasis given to fiscal actions and the downgrading
of monetary influence. Monetary authorities did not
reduce the rapid rate of monetary expansion during
a large part of that period because there was a desire
to let fiscal actions curb inflation and a belief by
some that only fiscal actions would be effective. Then,
when restrictive fiscal actions were taken in mid-1968
— the surtax and slower increases in Government

Page 8


spending — many economists, on the basis of preva­
lent theories, predicted “fiscal over-kill” by early 1969.
In response to such predictions, monetary authorities
engaged in even more expansionary actions in the last
half of 1969. Continuation of accelerating inflation
after fiscal actions had been expected to provide a
quick cooling of the inflationary fires should bum
firmly into our memories the lesson that monetary
actions are more effective than fiscal actions in
promoting economic stability.
But I do not want there to be any misunderstanding
regarding our view concerning fiscal actions. Some
have interpreted us as saying that Government spend­
ing and taxing have no influence on the course of the
economy, but this is not the case. Our research indi­
cates that accelerations and decelerations in the rate
of increase in Government spending, even if there
is no accommodating change in money, cause cor­
responding short-run changes in total spending. Also,
financing of large Government deficits has in the past
caused the Federal Reseive to expand the money
stock at excessive rates. This was one reason for rapid
monetary growth in 1967 and 1968. Finally, Govern­
ment spending and taxing programs, insofar as they
affect the amount of resources allocated to private
investment and to Government outlays of a similar
nature, may have a significant influence on long-run
economic growth.

ltnplementation of Monetary Policy
An additional lesson we have learned from our pres­
ent inflation is that the usual method of carrying out
monetary policy in the 1950’s and 1960’s was faulty.
Although stated monetary policy was to control infla­
tion, the method used for implementing this policy
actually contributed to the inflation rather than to its
Discretionary monetary policy was reinstated in
1951, after its suspension during World War II and
up through the early part of the Korean War. The pur­
pose of the 1951 change was to permit monetary
authorities to fight the inflation of the Korean War.
In conducting its monetary policy responsibilities since
then, the Federal Open Market Committee until very
recently has relied largely on measures of money
market conditions as guides to its operations. I am
sure that most of you are familiar with the view that
falling interest rates or rising free reserves indicate
easy monetary actions, while tight actions are indi­
cated by rising interest rates or falling free reserves.


Such a view was in general agreement with the
widely held belief that monetary actions work pri­
marily through changes in market interest rates. It
also was in agreement with the view that the Federal
Reserve has great ability to “set” market interest
rates. Recent research and experience, however, have
tended to reject these propositions. For example,
rapid monetary expansion, such as in 1967 and 1968,
stimulates total spending and thereby generates rap­
idly growing demand for credit and rising interest
By using market interest rates to indicate the thrust
of monetary actions, many public policymakers con­
cluded that despite very rapid monetary growth,
rising interest rates were evidence of monetary re­
straint during 1967 and 1968. In fact, there was a
belief by many that the extent of the increase in
market interest rates was too great because of the
dislocations which occurred in the savings and hous­
ing industries. There was a desire to hold back the
extent of interest rate increases, but attempts to do so
required injections of bank reserves which contributed
to a rapid growth in the money stock. This, in turn,
fostered excessive total demand and fed further the
fires of inflation. In retrospect, it is now apparent that
the traditional reliance on such measures of money
market conditions as market interest rates contributed
to our present inflation.
Sound economic stabilization requires guides to
the thrust of monetary actions other than money
market conditions. Recent experience demonstrates
that use of a monetary aggregate, such as the money
stock, would have produced far better results than we
got during the last half of the 1960’s. Excessive total
spending followed the very rapid rates of monetary
expansion from early 1965 to early 1966 and during
1967 and 1968. But when money ceased to grow in
the last eight months of 1966 and grew only slowly
in 1969, total spending slowed markedly after a short
lag. Conclusions I have advanced from this casual
analysis have been supported by a growing body of
empirical research.

Importance of Price Anticipations
A further lesson concerns the importance of price
anticipations in the inflationary process and in the
curbing of inflation. As I mentioned earlier, much of
economic theory upon which recommendations for
stabilization actions during the 1960’s rested did not
give adequate consideration to the basic forces in­
fluencing the price level. Little consideration was


given to the well-known fact that consumers, business­
men and labor unions do take into consideration
anticipated price level changes when making decisions
to purchase goods and services in the present and
when negotiating contracts for the future. Once
growth of total demand exceeds growth of potential
output and inflation has been underway for a period
of time, these decision-makers tend to extrapolate
the past trend of prices into the future in an attempt
to protect their positions from the ravages of inflation.
This process provides a momentum to inflation
which causes prices to continue to rise. This infla­
tionary momentum may carry on well after public
policy steps have been taken to bring total demand
growth into line with potential output growth. Such
a development has been seen in recent experience in
which, after a year or so of reduced rate of growth
of total spending, the price level has continued to
rise rapidly.
Another manifestation of inflationary expectations
during the past several years has appeared in financial
markets. There is a considerable body of economic
theory which holds that market interest rates are
greatly influenced by expected price level movements.
This proposition was not incorporated into the con­
ventional theory underlying stabilization efforts of the
1960’s. We who maintain that market interest rate
movements reflect inflationary expectations argue that
when prices are expected to rise, borrowers are willing
to pay higher interest rates because they will pay
back with depreciated dollars. In addition, any delay
in making purchases using borrowed funds will result
in high costs in the future. We also argue that lenders
will ask for higher interest rates in order to protect
the purchasing power of their funds. Thus, both de­
mand and supply forces during a period of inflation
lead to higher and higher interest rates.
Many who followed conventional views were at a
loss to explain the marked rise in interest rates from
1965 to 1968 at a time when the money stock was
rising rapidly. At the St. Louis Federal Reserve Bank
we have reported empirical evidence that inflation
caused almost all of this increase in market interest
rates. The recent experience demonstrates that rapid
monetary expansion produces high, not low, interest
rates. The truth is the reverse of conventional wisdom
regarding interest rate movements.
This lesson leads to the conclusion that the theo­
retical foundation of economic stabilization must give
adequate recognition to the pervasive influence of
Page 9


price level expectations. Not to do so, would be to
repeat the mistakes of the past. I believe that this
lesson has already shown up in the expressed views
of many policymakers, but there has been little evi­
dence that it has been learned by the general public,
by the Congress, or by economic commentators in
the news media and market news letters.


Regulation Q and Control of Inflation

reduced purchasing power of fixed income groups and
of holders of wealth in the form of fixed money claims.
It is true that if inflation is anticipated correctly, a
large number of individuals can adjust their contracts
and wealth holdings so as to avoid most of the effects
of rising prices. And, in recent years Congress has
kept Social Security benefits more or less abreast of
the price increase, thereby helping to maintain the
purchasing power of a large number of retired

Another lesson from the recent experience is that
ceilings on interest rates paid by commercial banks
on time deposits, set by the Federal Reserve under
Regulation Q, are not an effective device for slowing
growth in total spending, as many maintained in the
late 1960’s. Instead, such ceilings merely create in­
efficiencies in our financial markets. Commercial bank­
ers are well aware of the rechanneling of loan funds
away from banks and into such markets as the one
for commercial paper when free market interest rates
exceed Regulation Q ceiling rates.

However, when the rate of inflation is changing
rapidly, and holders of wealth attempt to adjust their
holdings, there are losses in addition to that from
reduced purchasing power. For example, the great
drop in the bond market during our present inflation
and the recent bear stock market are partly a con­
sequence of attempts of investors to adjust to ac­
celerating inflation. This recent experience demon­
strates that even the stock market may not be a very
good hedge against inflation when the rate of price
advance is accelerating.

Some have argued that since banks can make fewer
loans under such circumstances, total spending will be
restrained. The fact of the matter is that while spend­
ing by potential bank borrowers may be reduced,
spending by those who have access to the money
markets will rise by about the same amount. As a
result, total spending is little affected by manipulation
of Regulation Q interest rate ceilings.

There are also considerable losses to the whole
economy resulting from the adjustment process which
accompanies accelerations in the rate of price advance.
Inefficiencies develop in product, resource, and finan­
cial markets in the process of adjusting prices and
contracts to rising prices. Normal business transac­
tions become more difficult. For instance, we have
reports that some business firms in recent years quoted
list prices only on a day-to-day basis. Their salesmen
were required to contact the home office before any
price could be quoted. Labor contract negotiations
become more difficult to settle. In financial markets
investors have to pay greater attention to ascertaining
the impact of inflation on their portfolios and on
alternative outlets for their funds.

These ceiling rates on time deposits, however, have
led to inefficiencies in the flow of funds and in utiliza­
tion of real resources in recent years. As a result of
Q, customary movements of loan funds from one
corporation to another through commercial bank
channels flow instead through the more direct com­
mercial paper market or through the less direct and
less efficient Euro-dollar market. Such rechanneling
of loan funds reduces the size of the commercial bank­
ing system relative to the total market for funds, a
process which is not essential for stabilization policy.
Other interest rate ceilings, including state usury laws
and ceilings set on funds raised by savings and loan
associations and mutual savings banks, also lead to
less efficient channeling of funds and use of resources.

Costs of Adjusting to Inflation
Another lesson from recent experience is that there
are great costs of adjusting to accelerating inflation.
Everyone is familiar with such losses from inflation as

Page 10

Costs of Curbing Inflation
A final lesson is that curbing a rapid, prolonged
and accelerating inflation is a slow and difficult proc­
ess, and is not without considerable costs. As I
mentioned earlier, anticipations of price increases
provide a powerful momentum to inflation. Such an­
ticipations respond slowly to actual price movements
and are not reduced until the rate of inflation has
actually subsided for some time. As a result of this
slow process of reducing anticipated rates of price
increase, the general price level continues to rise
rapidly for some time after restraint is applied to
growth in total spending.


Many have been surprised and disappointed that
restraint of the past two years has not produced
greater results in terms of the price level. Some have
even expressed despair at ever seeing relative price
stability again. It should be pointed out, however,
that inflation was permitted to develop for almost
five years before effective restraint was applied. By
then, inflation was moving along under its own mo­
mentum, and only moderate restraint was applied. It
should, therefore, not be surprising that five years of
inflation cannot be eliminated in a short period of
time. Moreover, it should be remembered that the
inflations of World War II and the Korean War were
not curbed until the late 1950’s and that much greater
restraint was applied in that effort.
There is also considerable cost in eliminating infla­
tion. With restricted growth in total spending and
with prices continuing to rise for some time, output
of goods and services stagnates or is reduced. As a
consequence, there is a loss of jobs and income to
many individuals and a loss of goods and services to
the whole of our society. Labor strife is accentuated,
as we now see, when unions attempt to catch up
with inflation and to anticipate further inflation at a
time of declining corporate profits.


Let me now draw a few general conclusions from
this discussion of our recent experience. Inflation, be­
cause of the many problems and costs it creates,
should never be permitted to start. This may seem
obvious and trivial, but many have argued that these
costs are small compared to alleged large gains flow­
ing from a high level of employment. Our research
indicates, however, that inflation is not required for
our economy to have a high level of employment.
Another conclusion is that the main body of eco­
nomic thought of the 1950’s and the 1960’s has not
proven very useful in handling economic stabilization
problems. In fact, there is considerable evidence that
reliance on this body of thought contributed greatly
to the present inflation —both as a cause of rapid
price level advances and as a hindrance to their
Finally, monetary policy has a major responsibility
for promoting price level stability. If such policy is
to be applied in an effective manner, the public, the
Congress, the Administration, and the Federal Re­
serve should reflect on the lessons to be learned from
the experience of the past six years.

Page 11

The “Crowding Out” of Private Expenditures
by Fiscal Policy Actions
Fiscal policy — F ed eral G overnm ent spending and taxing program s — was given the dom inant
role in econom ic stabilization efforts during th e d ec a d e o f the I9 6 0 ’s. T h e in com e tax cut o f 1964
was design ed to accelerate the m ovem en t tow ard full em ploym en t after abou t th ree years o f what
was considered by som e a rather slow rate o f econom ic expansion follow ing the recession o f 1960-61.
T he incom e tax surcharge an d a reduction in th e rate o f increase in G overnm ent spending w ere
ad o p ted in 1968 to curb th e inflation o f the last h alf o f th e I9 6 0 ’s.
T he theoretical rationale frequ ently given by stabilization officials for such reliance on fiscal actions
w as the sim ple K eynesian m ultiplier analysis fou n d in a large num ber o f econom ic textbooks. T h e sim ­
ple form o f the m ultiplier process holds that an increase in G overnm ent expenditures or a d ecrease in
the rate o f taxation induces rep ea ted rounds o f spending by consum ers and business firms, resulting
in a m ultiple expansion o f total spending. A m ultiple reduction o f total spending is said to result
from fiscal changes opposite those just m entioned. This analysis gives little recognition to the influ­
en ce on total spending o f financing a deficit, or disposing o f a surplus, by altering th e am ount o f G ov­
ernm ent borrow ing from the gen eral p u blic or th e rate o f m onetary expansion.
T he extent to w hich this analysis g u ided th e recom m endations o f stabilization authorities dur­
ing the 1960’s is in dicated by an exam ination o f th e A n n u a l R e p o r t s o f the President’s Council o f
E conom ic Advisers (CEA). T he m ultiplier process just m en tion ed p la y ed an im portant role in sh a p ­
ing the CEA ’s view o f econom ic stabilization and was sp elled out several tim es in th e A n n u a l
R epo rts.

T he CEA ’s A n n u a l R e p o r t for 1964, A ppendix A, outlined the m ultiplier process by w hich an
$11 billion tax cut w ould produ ce a $30 billion increase in total dem and. A ccording to this outline,
a tax cut o f this size w ou ld first increase consum ption by $9 billion, w hich in turn “w ou ld g en erate
still fu rther increases in incom es and spending in an endless, but rapidly diminishing, chain.” This
w ould result in adding $18 billion to GNP from in creased consum ption alon e “ — not just on ce, but
year-in and year-out . .
But the m ultiplier process is not com p lete at this point. In response to
rising incom e, expenditures fo r plant and equipm en t, inventories, residential construction, and state and
local governm ent program s w ould expand, and by the multiplier process w ou ld a d d another “$10 to
$14 billion to GNP.” In this analysis, how ever, no m ention w as m ad e regarding the G overnm ent financ­
ing requirem ents o f the prop osed tax reduction.
In discussing th e prop osed incom e surtax as a m eans o f reducing inflation, th e A n n u a l R e p o r t
for 1968 argued that the sam e m ultiplier process w as relevant. T he CEA asserted,
. . th e e c o ­
nom ic effects o f a tax increase are the mirror-image o f the expansionary effects accom p lish ed by tax
T he view that changes in G overnm ent expenditures an d tax rates exercise a pow erful influence
on total spending, w ithout regard to changes in th e volum e o f G overnm ent d eb t outstanding or in
the rate o f monetary expansion, has also b een prevalent am ong many others. A bout four hundred
professional econom ists signed a statem ent supporting th e R evenue Act o f 1964 as a m eans of
stimulating total dem and. Politicians, public figures, an d econom ic com m entators have com e g en ­
erally to support fiscal actions explicitly, but m ore frequ en tly implicitly, on th e basis o f th e sim ple
m ultiplier analysis.
This view has b een challen ged by a num ber o f econom ists on th e grounds that it d oes not
give ad equ ate recognition to the financing o f G overnm ent expenditures. T hey argue that G overn­
m ent spending financed by taxes or borrow ing from saving o f th e gen eral pu blic m ay red u ce other
spending to such an extent that there will b e little, if any, net increase in total spending. This is
frequ ently referred to as the “crow ding out” o f private expenditures by fiscal actions. A ccording to these
econom ists, stabilization recom m endations b ased on th e prevailing m ultiplier analysis o f th e 1960’s
are erroneous.
T he folloioing article by
theory from A dam Smith to
ity. T hey find that “crow ding
M oreover, the em phasis on
lization program s during the
post-Keynesian econom ics.

R oger W . Spencer and W illiam P. Y ohe provides a survey o f econom ic
the present regarding th e influence o f fiscal actions on econom ic activ­
out” has been the dom inant view during th e past two hundred years.
the sim ple Keynesian m ultiplier analysis in d evelopin g econom ic stabi­
1960’s is not in gen eral agreem en t w ith K eynes’ own view s or w ith

Roger W . S pencer is an econom ist o f th e F ed eral Reserve B ank o f St. Louis. W illiam P. Y ohe
is Professor o f E conom ics at D uke University and was a visiting scholar at th e F ed eral R eserve
Bank o f St. Louis for a period o f tim e in 1969 and 1970.

Page 12


Fiscal policy provides additional spending
in a w orld o f sparse spending opportunities.
But it does not provide a new source of
finance in a w orld w here spending is con ­
strained by sources o f finance. T he govern­
m ent expenditures are financed in d eb t
m arkets in com petition with private expen di­
tures. T he case least favorable to fiscal policy
is that in w hich the additional governm ent
borrow ing sim ply CROW DS OUT o f the
m arket an equ al (or conceivably even greater)
volum e o f borrow ing that w ould h ave financed
private expenditures.1 (Italics and capitaliza­
tion added)

Changes in Government expenditures and taxes,
the policy arm of Keynesian economics, have come
under attack recently for their apparent failure to
secure desired stabilization goals. Several studies, in
this Review and elsewhere, have concluded that in­
creases in Government expenditures, which are not
accompanied by money creation, induce temporary
increases in nominal GNP with no net effect over a
longer period of time.2 Monetary actions, in contrast,
have been found to exert an important influence on
economic activity quite apart from fiscal develop­
ments. Much of the rebuttal of these articles has
been focused on debating the strengths of the mone­
tary variables rather than the weaknesses of the fiscal
“The authors wish to acknowledge the helpful comments on
earlier drafts of: Leonall C. Andersen, Karl Brunner, Keith
M. Carlson, E. G. Corrigan, John M. Culbertson, R. Alton
Gilbert, Thomas M. Havrilesky, Jerry L. Jordan, Michael W.
Keran, Laurence H. Meyer, and. Clark A. Warburton. The
authors are solely responsible for the analysis and conclu­
sions presented in the article.
ijohn M. Culbertson, Macroeconomic Theory and Stabiliza­
tion Policy (New York: McGraw-Hill Book Company, 1968),
p. 463.
2Leonall C. Andersen and Jerry L. Jordan, “Monetary and
Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization,” this Review (November 1968);
Leonall C. Andersen and Keith M. Carlson “A Monetarist
Model for Economic Stabilization,” this Review (April 1970);
Michael W. Keran, “Monetary and Fiscal Influences on Eco­
nomic Activity —The Historical Evidence,” this Review ( No­
vember 1969), and “Monetary and Fiscal Influences on
Economic Activity — The Foreign Experience,” this Review
(February 1970); John Deaver, “Monetary Model Building,”
Business Economics (September 1969). Also, in this vein, see
Milton Friedman and David Meiselman, “The Relative Sta­
bility of Monetary Velocity and the Investment Multiplier in
the United States, 1897-1958,” in Stabilization Policies, Com­
mission on Money and Credit (Englewood Cliffs, N.J.:
Prentice-Hall, Inc., 1963).
3The monetary variables most often employed in these arti­
cles are changes in money and the monetary base. The
primary fiscal spending variable is changes in high-employment Government expenditures. For a defense of the fiscal
position, see Murray Weidenbaum, “Is Fiscal Policy Dead?,”
Financial Analysts Journal ( March-April, 1970) and E. G.
Corrigan, “The Measurement and Importance of Fiscal Policy
Changes,” Federal Reserve Bank of New York Monthly Re­
view (June 1970).


This article surveys a large body of economic litera­
ture, in search of some reasonable rationale which
could explain the poor showing of the Government
spending multipliers in the previously mentioned reduced-form statistical studies. Two possible reasons
why these multipliers fail to achieve the high magni­
tudes promised by a mathematical derivation of the
basic “Keynesian” multiplier are that many Keynesian
models do not capture (1) the displacement of
private spending by Government spending (the
“crowding-out” effect), or (2) leakages associated with
consumer or Governmental propensities to spend.
The leakages are usually accounted for in the more
sophisticated econometric models, resulting in lower
multipliers than those derived from the elementary
models, but failure to allow for the possibility of
crowding out makes even these multipliers higher
than warranted.
Worldwide acceptance of the Keynesian theory,
and increasing Government intervention in economic
affairs, represent the trend of post-depression thinking
on stabilization policy.4 There seems to be a growing
belief, however, that fiscal policies developed and ap­
plied in a society operating at a low level of resource
utilization are not necessarily applicable under highemployment, inflationary conditions. Further, the evi­
dence presented by one analyst casts doubt on the
efficacy of fiscal policies even during the deflationary
Pure fiscal actions, which entail changes only in
Government expenditure and tax programs, are rare;
most stabilization actions involve a mixture of (1)
4See, for example, Robert Lekachman, The Age of Keynes
(New York: Random House, 1966). The difficulty of gen­
eralizing “Keynes’ view” or “the Keynesians’ view” has been
pointed out by Axel Leijonhufvud ( “Keynes and the Key­
nesians: A Suggested Interpretation,” American Economic
Review, May 1967, Papers and Proceedings, p. 401).
One must be careful in applying the epithet ‘Keynesian’
nowadays. I propose to use it in the broadest possible
sense and let ‘Keynesian economics’ be synonymous with the
‘majority school’ macroeconomics which has evolved out of
the debates triggered by Keynes’s General Theory . . . .
Within the majority school, at least two major factions
live in recently peaceful but nonetheless uneasy coexistence.
With more brevity than accuracy, they may be labeled the
‘Revolutionary Orthodoxy’ and the ‘Neoclassical Resurgence’.
. . . . The orthodoxy tends to slight monetary in favor of
fiscal stabilization policies. The neoclassical faction may be
sufficiently characterized by negating these statements. As
described, the orthodoxy is hardly a very reputable position
at the present time. Its influence in the currently most
fashionable fields has been steadily diminishing, but it
seems to have found a refuge in business cycle theory —
and, of course, in the teaching of undergraduate macro­
5Keran, “Monetary and Fiscal Influences on Economic Activ­
ity — The Historical Evidence,” p. 23.
Page 13


fiscal (tax-financed Government spending), (2 ) mone­
tary (Federal Reserve actions) and (3) debt man­
agement (changes in the maturity or value of the
debt) policies. For example, the offering of Treasury
bonds to finance a deficit constitutes debt manage­
ment policy (or fiscal policy, by more conventional
definitions) at first, but the subsequent purchase of
such bonds (or perhaps the failure to purchase such
bonds) by the Federal Reserve is generally construed
to be monetary policy. Thus die existence of Govern­
ment bonds clouds the distinction between the two
basic economic stabilization policies — monetary and
The method of financing Government expenditures
influences economic stabilization efforts. There are
two conflicting views regarding the extent of this in­
fluence. Funds for Government spending are obtained
by taxing the public, borrowing from the public,
and/or money creation. Monetarists (those who favor
monetary over fiscal stabilization policies) generally
assert that Government spending financed by either
taxing or borrowing from the public is mainly a re­
source transfer from the private sector to the Govern­
ment, with little net effect on total spending. Monetary
expansion, even if unaccompanied by an increase in
Government spending, has a strong, stimulative in­
fluence on the economy.
Contemporary Keynesian theory holds that all of
the three techniques of Government finance involve
something more than a simple resource transfer from
the private to the Government sector. An expansion­
ary effect on the economy may be achieved by a rise
in Government spending matched by an increase in
tax receipts, or by a rise in Government spending
financed by bond issuance either to the public or the
monetary authorities.
The monetarists’ view that Government spending
financed by taxes or borrowing from the public merely
displaces, or “crowds out,” private spending is not a
new one. It was, in fact, the dominant view before
the Keynesian revolution of the 1930’s. Classical econ­
omists including Adam Smith and David Ricardo,
and neo-classicists including F. A. Hayek and R. G.
Hawtrey, found little use for fiscal stabilization efforts.
Keynes, at first a fairly orthodox neo-classical econo­
mist, altered his view's on many issues prior to the
publication of The General Theory o f Employment,
Interest and Money, including a downgrading of the
fiscal crowding-out concept.6 Since it was Keynes’
6John Maynard Keynes, The General Theory of Employment,
Interest and Money (New York: Harcourt, Brace and Com­
pany, 1936). His book will be referred to as The General
Theory throughout the remainder of this article.

Page 14


theory of the proper use of fiscal policy which even­
tually became the dominant view, we will develop at
some length Keynes’ thinking on the subject. Because
Keynes was strongly aware of the traditional neo­
classical views on fiscal theory, he hedged his argu­
ments more carefully than many of his successors.
Keynes’ General Theory analysis, in contrast to the
focus of the classical school on long-run supply factors,
was oriented toward short-run demand considerations.
Both views were couched predominantly in real (ra­
ther than nominal) terms. Consequently, crowdingout analysis derived from either of these two ap­
proaches deals primarily with the displacement of
real private spending by Government spending.7
A summary of classical, neo-classical and Keynes’
early views on fiscal crowding out will be presented
first. Next, we will trace Keynes’ later fiscal views,
underscoring the assumptions on which his final posi­
tion was built. The subsequent section examines bondand tax-financed crowding out, based principally on
a Keynesian analytical framework outlined by Rich­
ard Musgrave. Finally, we discuss alternative frame­
works and some empirical evidence bearing on the
crowding-out issue.

Summary of Classical, Neo-Classical and
Keynes’ Early Views on Fiscal Crowding Out
The mainstream of economic thought prior to the
publication of Keynes’ General Theory in 1936 did
not favor Government spending for stabilization pur­
poses.8 There was some opposition to an enlarged
"The crowding-out phenomenon may be described in conven­
tional mathematical symbols in the following manner:
a) Real crowding out
dM” = 0
b) Nominal crowding out

dM = 0
These relations imply that:
c) d(Y»-G»)
dM = 0
d) d(Y-G)




dM = 0
Y = total spending, G = Government spending, and M =
money supply.
Relation (b ) most closely represents the empirical crowdingout results reported in studies cited in footnote 2.
8A more detailed discussion of classical, neo-classical and
Keynes’ early views on crowding out will be presented in a
forthcoming Working Paper of the Federal Reserve Bank
of St. Louis.


role for Government spending purely from a philoso­
phical view, but much of the criticism of increased
Government intervention was based on crowding-out
Adam Smith, for example, opposed extensive Gov­
ernment involvement for both philosophical and
crowding-out reasons. For the most part, Smith (writ­
ing in 1776) considered Government labor “unproduc­
tive,” and condemned the transfer of resources from
the private sector, whether through taxation or bor­
rowing. Borrowing funds from the public to finance
Government spending was asserted to involve the
“destruction of some capital which had before existed
in the country; by the perversion of some portion of
the annual produce which had before been destined
for the maintenance of productive labour, towards
that of unproductive labour.”0 Smith believed that
“saving is spending,” because one man’s saving
becomes another man’s investment. Later classical
economists, such as John Stuart Mill and J. B. Say,
writing primarily in the first half of the nineteenth
century, saw in Adam Smith’s maxim a guarantee of
full employment. That is, Government spending was
considered unnecessary as a stabilization tool, because
private investment was sufficient to utilize the funds
provided by private saving.
The most elementary case for crowding out may be
examined in a “Say’s Law” framework. Say’s Law is
widely known as “supply creates its own demand.”
More specifically, if output (supply of goods and
services) is determined by the behavior of profit
maximizing producers, competitive labor markets, the
existing stock of capital goods, and the state of tech­
nology, then relative prices will tend automatically to
adjust so as to eliminate a deficiency or excess of
demand. In an economy in which Say’s Law is op­
erative, attempts by the Government to increase total
spending, by raising Government expenditures and
financing the increasing budget by either borrowing
from the public or taxation, merely induce changes
in relative prices so as to reallocate the same level of
real output.
The two cases —bond- and tax-financed Govern­
ment expenditures — involve changes in the structure
of prices (principally interest rates) to restore
equilibrium at full employment, so they represent the
tendency of a market economy ultimately to neu­
tralize disturbances ( in this instance budgetary
°Adam Smith, The Wealth of Nations (New York: Random
House, Inc., 1937), p. 878.


shocks). Without the Government’s presence, private
propensities to spend the full-employment level of
real income for either consumption or investment sum
to one as a consequence of automatic price adjust­
ments; adding a Government propensity to spend
correspondingly reduces private propensities, in order
to maintain total propensities to spend equaling one.10
Neo-classical business cycle theories became an im­
portant part of economic stabilization literature in
the early twentieth century. One of these theories,
over-investment financed by “forced” saving, was
equally applicable for any sector favored over others
for loan extension by the banking system. If, for ex­
ample, the Government were to borrow from banks
to finance its investment spending, the increased pur­
chasing power of the Government would allow it to
bid resources away from other sectors and, under fullemployment conditions, drive up the price level. The
higher price level would serve as a deterrent to “real”
consumer or private investment spending which
would otherwise have taken place.
A good example of this view is found in the testi­
mony of the English economist, R. G. Hawtrey, be­
fore the Macmillan Committee in 1930. Hawtrey
denied the usefulness of Government spending, re­
gardless of financing even under depression conditions:
On the matter of government spending [to bring
England out of her stagnation], Hawtrey stated that
whether the spending came out of taxes or loans
from savings, the in creased governm ental ex p en di­

tures w ould m erely rep lace private expenditures.
He even considered the “radical” idea of government
spending out of new bank credit, but predicted that
the result of such a policy would be inflationary and
a threat to the gold standard, thus forcing up the
bank rate of interest and causing credit contraction.
Such a plan, for him, would only defeat itself, since
government expenditures out of bank credit would
mean the end of cheap money for free enterprise.11
(Italics added)

Keynes advocated Government spending as a stim­
ulative economic measure twelve years before the
publication of The G eneral Theory, but he attached
the “rider” that such spending should be financed by
monetary expansion.12 He emphasized (in 1929) that
10See, for example, Culbertson, p. 333.
n Lawrence R. Klein, The Keynesian Revolution (London:
The Macmillan Company, 1968), pp. 45-46. Hawtrey’s
business cycle theory was based on easy money creating
additional working capital and inducing inventory
12Roy Forbes Harrod, The Life of John Maynard Keynes
(New York: Harcourt, Brace and Company, 1951), p. 441.
Keynes was only one of a number of economists of the


the central bank had the power to defeat expan­
sionary fiscal actions and thus
. . ensure that the
expenditure financed by the Treasury was at the ex­
pense of other business enterprise.”13 The British
Treasury, however, like Hawtrey, took the position
that Government spending, regardless of financing,
simply displaced private spending.
Keynes continued to press his fiscal policy argu­
ments in the years preceding The General Theory,
but eventually downgraded the necessity of mone­
tary expansion accompanying increased Government
spending in order for such spending to have an ex­
pansionary effect. Development of the liquidity pref­
erence theory of interest and the fiscal multiplier
theory, particularly the latter, were the keys to
Keynes’ ability to shift money into the background of
his analysis. The liquidity preference concept led to
the idea that more efficient utilization of the existing
money stock (increased velocity) was encouraged by
increased Government expenditures, while the mathe­
matical formulation of the multiplier (by R. F. Kahn,
a student of Keynes) indicated that the increased
taxes and saving generated by the rise in Govern­
ment-induced income would be just enough to cover
the financing of the deficit.

Keynes’ General Theory View of
Fiscal Crowding Out
A detailed explanation of the workings of the mul­
tiplier was one of the chief contributions of The
General Theory, as was the discussion of the qualifica­
tions of multiplier analysis. The investment multiplier
(k ), wrote Keynes, “tells us that, when there is an
increment of aggregate investment, income will in­
crease by an amount which is k times the incre­
ment . . .”14 The principle of the multiplier provides


“an explanation of how fluctuations in the amount of
investment, which are a comparatively small propor­
tion of the national income, are capable of generating
fluctuations in aggregate employment and income so
much greater in amplitude than themselves.”15
The multiplier concept of an increment of new in­
vestment spending being transmitted from pocket to
pocket and thereby increasing total spending by some
multiple is easier to grasp intuitively than mathemati­
cally. Keynes, himself searching for the proper mathe­
matical rationale for his deficit spending ideas, was
quick to seize and popularize Kahn’s version. He and
Kahn realized some of the limitations of their formal
multiplier theory, but the scores of articles published
during the past three decades, which clarify or repu­
diate “the Keynesian multiplier,” suggest the inade­
quacy of its treatment in The G eneral Theory.
The significance of the multiplier may be examined
from the crowding-out point of view, to the extent that
the multiplier represents causal relations rather than the
ex post tautology that the change in income must, by
definition, equal some multiplier times the increment
of investment.16 Keynes, in The General Theory,
provided one of the most cogent and clear crowdingout arguments to be found. Although he wished to
move money to a supporting rather than leading role
in his General Theory analysis, he recognized that
monetary influences could overcome his newly de­
veloped multiplier and liquidity preference constructs.
Contrary to expressions found in the present “con­
ventional wisdom,” Keynes hedged his arguments
considerably. He pointed out that,
If, for example, a Government employs 100,000
additional men on public works, and if the multi­
plier . . . is 4, it is not safe to assume that aggregate
employment will increase by 4 0 0 ,0 0 0 . F o r the new
policy may have adverse reactions on investm ent
in other directions. . . . The method of financing the
policy and the increased working cash, required by
the increased employment and the associated rise of
prices, may have the effect of increasing the rate of
interest and so retarding investm ent in oth er d irec­
tions, unless the monetary authority takes steps to the
contrary; whilst, at the same time, the increased cost
of capital goods will reduce their marginal efficiency

Twenties and Thirties who advocated governmental deficit
spending to spur economic activity. Twelve University of
Chicago economists, for example, recommended deficit
spending in a 1932 memorandum to a member of Congress:
“Convinced that pump-priming deficits would induce at
best only temporary revival, the Chicago economists recom­
mended that deficits should continue until recovery was in­
disputably established. These would be financed by selling
new issues of bonds to the reserve banks or by exchanging
them for bank deposits and Federal Reserve notes,” See J.
Ronnie Davis, “Henry Simons, the Radical: Some Docu­
mentary Evidence,” History of Political Economy, Fall, 1969,
pp. 389-90.
13See John Maynard Keynes, Essays in Persuasion (New
York: Harcourt, Brace and Company, 1932), p. 126.

i5Jbid., p. 122.

14Keynes, The General Theory, p. 115. The multiplier con­
cept may be formalized as AY = kAI where AY is the
change in income, AI is the change in investment and k is
the multiplier. Investment refers to outlays on newly cre­
ated plant and equipment and housing, and additions to
inventories. A similar multiplier is developed for changes
in Government expenditures (A G ).

16R. F. Kahn ( Economic Journal, 1931, p. 188) was quite
aware of the causal vs. tautological nature of the equality
between the increase in the rate of investment expenditure
and the subsequent streams of generated saving. The equal­
ity, he wrote, “far from being the logical consequence of
summing an infinite geometrical progression, is in reality
self-evident in nature . . .”

Page 16



F ig u r e 1

C rowding Out in an IS-LM Framework




to the private investor, and this will require an actual

fall in the rate of interest to offset it.17

The multiplier limitation outiined above by Keynes
can be summarized within the conventional IS-LM
curve framework. In the IS-LM system, a set of
equations is postulated regarding propensities to
spend, to save, and to hold money balances.18 The
system may be reduced to two equations. One con­
tains various combinations of income (Y ) and interest
rates (r) at which investment equals saving; this is
referred to as the IS curve and represents the real
sector of the economy. The other equation contains
various combinations of Y and r at which money de­
manded equals the money stock in existence; this is
labeled the LM curve and represents the financial
sector. The two equations may then be solved simul­
taneously to determine equilibrium values of the in­
terest rate and income.
If the LM curve is steeply sloped as shown in part
(A) of the accompanying figure, the increase in Gov­
ernment spending reflected in the rightward shift of
the IS curve affects a sharp rise in interest rates (from

17Keynes, The General Theory, pp. 119-20. (Italics added
except for “fall” )
18See, for example, Gardner Ackley, Macroeconomic Theory
(New York: The Macmillan Company, 1961), pp. 359-98.

r! to r2) and little or no change in income (Yx to Y2).
A sharply rising LM curve implies that the retarding
effects of such actions on private investment are sub­
stantial. Only by shifting the LM curve to the right,
through monetary expansion for example, will a sig­
nificant rise in income occur (from Yx to Y3). Keynes,
by mentioning this multiplier limitation, supplied a
strong theoretical basis for the crowding-out thesis,
and thereby shifted the discussion to a quantitative
plane involving determination of the slopes of the
IS-LM curves and the substitutability of Government
and private spending.
Keynes recognized a second way, based on business
psychology, in which Government spending could
crowd out private spending. “With the confused
psychology which often prevails, the Government pro­
gramme may, through its effect on ‘confidence’, in­
crease liquidity-preference or diminish the marginal
efficiency of capital, which, again, may retard other
investment unless measures are taken to offset it.”19
I!lKeynes, The General Theory, p. 120. Daniel Throop Smith,
“Is Deficit Spending Practical?”, Harvard Business Review
(Vol. 18, 1939), pp. 38-9, was particularly concerned about
the business confidence aspect of the crowding-out thesis.
A continued experience with deficits which do not produce
sustained recovery, as in this country, or a recent infla­
tion and collapse, as in continental European countries,
is likely to make a deficit matter for concern and anxiety,
And, if there is disbelief in the benefits of a deficit, then
Page 17


If the increase in Government spending (shown by
the shift of IS to IS' in part B of Figure 1) has an
adverse effect on liquidity preference, the LM curve
shifts to the left (LM ') and income increases only
slightly from Y, to Y2. If the marginal efficiency of
capital is adversely influenced, this may be shown by
a leftward shift of the IS curve from IS' to IS", also
resulting in a small increase in income from Yt to Y2.
The magnitude of these shifts of the curves depends,
of course, on the assumed response of “business con­
fidence” to increased Government spending.
Keynes also noted a potential multiplier leakage in
the hypothesized tendency of the marginal propensity
to consume to diminish as employment increases. This
introduces the state of economic activity as an influ­
ence on the efficacy of the multiplier. Thus Keynes
could, without reservation, recommend any sort of
public works (pyramid building, wars) during periods
of unemployment, “if only from the diminished cost
of relief expenditure, provided that we can assume
that a smaller proportion of income is saved when
unemployment is greater; but they may become a
more doubtful proposition as a state of full employ­
ment is approached. Furthermore, if our assumption
is correct that the marginal propensity to consume
falls off steadily as we approach full employment, it
follows that it will become more and more trouble-

the new money spent by the government may well be
more than offset by additional withdrawals of private
money which would otherwise be spent. Likewise, if con­

sumer incomes do increase immediately as a result of the
deficit, business may anticipate that the increase is tem­
porary and refrain from long-term commitments.
. . . Consumer income arises primarily out of the pro­
cesses of the production and distribution of goods and
services. Therefore, if private spending decreases by as
many dollars as government spending increases (and it
takes only a very small proportionate decrease in private
spending to offset a large proportionate increase in gov­
ernment spending), then on balance there is no net in­
crease in consumer income. Furthermore, even if there is
an immediate net increase in consumer income, there may
be enough flexibility in our economic system in the form
of idle capacity, especially during a depression, to obviate
any necessity of spending on capital goods to provide
consumer goods. Also, if there is an actual increase in
consumer income and spending but it is believed that
the demand is an artificial one dependent upon a con­
tinuation of government deficits which cannot last in­
definitely, business will be loath to make long-term
capital commitments. In such circumstances business at
most will make up deferred maintenance and build up
inventories creating an artificial “boomlet” which is not
likely to develop into a sustained recovery. This seems
to have been particularly true in 1936 and 1937. (Italics
This analysis implies that, dependent upon the time pe­
riod specified, Government spending may not only crowd
out an equal magnitude of private spending but an even
greater amount. The multiplier would then be negative
rather than zero or positive.

Page 18


some to secure a further given increase of employ­
ment by further increasing investment.”20
A related leakage was that of an increase in em­
ployment which tends, “owing to the effect of dimin­
ishing returns in the short period, to increase the
proportion of aggregate income which accrues to the
enterpreneurs, whose individual marginal propensity
to consume is probably less than the average for the
community as a whole.”21 Moreover, the impact of
the multiplier might be reduced by those unemployed
consumers formerly existing on negative savings, pri­
vate or public, whose employment would diminish
negative savings, and thereby, the marginal propen­
sity to consume.
An additional caveat to those who would mechan­
istically apply the multiplier was that, “In any case,
the multiplier is likely to be greater for a small net
increment of investment than for a large increment;
so that, where substantial changes are in view, we
must be guided by the average value of the multi­
plier based on the average marginal propensity to
consume over the range in question.”22
These multiplier modifications and many more can
be found in the post-General Theory literature,23 but
enough has been introduced here to indicate that the
value of the Government spending multiplier may be
positive, zero or negative. It should be pointed out
that although Keynes was aware of some of the lim­
itations of the multiplier (as demonstrated above),
he did not emphasize them, partly because of his
desire to put a simple rationale for Government spend­
20Keynes, The General Theory, p. 127. One implication of this
analysis is that increased Government spending, for the rea­
sons given, may not only be less effective at stimulating the
economy near full employment than at substantially less than
full employment, but also relatively ineffective at slowing it.
zlIbid., p . 121.
22 Ibid.

23See Hugo Hegeland The Multiplier Theory (New York:
Augustus M. Kelley Publishers, 1966) p. 73: “The basic
weakness of the multiplier theory lies in its assumptions,
which in fact eliminate the real problems involved and
make the theory almost a truism.”
One example of post-Keynesian criticism of the mechani­
cal application of the multiplier can be found in Gardner
Ackley, “The Multiplier Time Period: Money, Inventories,
and Flexibility,” American Economic Review (June, 1951)
pp. 350-368. Ackley notes that the existence of inventories
serves as a buffer providing a potentially long and variable
lag between a change in consumer expenditures and a
change in production rates. An argument made by Milton
Friedman is that Government expenditure increases may be
viewed by consumers as adding only to transitory income
(i.e., temporary income.) He argues that the marginal
propensity to consume out of transitory income is zero. See
Milton Friedman, A Theory of the Consumption Function
(Princeton: Princeton University Press, 1957), p. 26.

OCTOBER, 1970


ing during the depression in the hands of the policy­
makers as expeditiously as possible.24

A Basic Keynesian Framework for
Crowding-Out Analysis
A number of attempts were made after Keynes to
spell out more formally the relationships governing
the conditions under which Government spending
would add to total spending or crowd out a significant
volume of private spending. Richard Musgrave de­
veloped one of the most efficient frameworks for
analyzing the crowding-out phenomenon of those con­
structed in the approximately three decades follow­
ing The General Theory.25
There are three basic sectors of the economy and
three basic “effects” in the Musgrave framework.26
24The crowding-out issue emerged in a different context in
at least one of Keynes’ post-General Theory essays. In
Paul Davidson, “Keynes’s Finance Motive,” Oxford Economic
Papers (March 1965), pp. 48-49, Keynes is quoted from
an April 18, 1939 letter to the London Times, in which he
explains his approach to financing Government expenditures
for rearmament: “If an attempt is made to borrow them
[the savings which will result from the increased produc­
tion of non-consumption (war) goods] before they exist,
as the Treasury have done once or twice lately, a stringency
in the money market must result, since, pending the ex­
penditure, the liquid resources acquired by the Treasury
must be at the expense of the normal liquid resources of
the banks and of the public.”
25See Richard A. Musgrave, The Theory of Public Finance
(New York: McGraw-Hill, Inc., 1959), pp. 526-55.
Others outlining frameworks under which crowding out
might be analyzed include Alvin H. Hansen, Monetary
Theory and Fiscal Policy (New York: McGraw-Hill Inc.,
1949), pp. 167-73, and Abba P. Lerner, “The Burden of
the National Debt,” in Income, Employment and Public
Policy, Essays in Honor of Alvin H. Hansen (New York:
W. W. Norton and Company, Inc., 1948), pp. 255-75.
Lemer, for example (p. 26 9 ), states that “The sale of gov­
ernment bonds diminishes liquidity, tends to raise interest
rates, and discourages investment. The government should
therefore not borrow unless it wishes to bring about these
deflationary effects.”
20The following is the linear form of Musgrave’s basic
(1 ) Y = C + I + G
(2 ) C = a + c ( Y - T ) + wM
(3 ) I = d — ei
(4 ) i = U/Ma • ( 1 - P ) / P
( 5) Ma = M - M t
( 6) Mt = 1/ V • Y
( 7) G = T
Y = income, C = consumption, I = investment, G =
Government spending, T = tax yield, M = total money
supply, Ma = asset money, Mt = transactions money,
V = income velocity, i = “the” market interest rate,
c = marginal propensity to consume, w = a wealth para­
meter, e = an investment parameter, U = bond coupon
bill, P = fraction of claims ( asset money and Government
debt) people wish to hold in form of Government debt, a =
intercept term, d = intercept term.
The Government budget constraint, G = T, could be
modified to permit deficit finance through changes in money
or Government bonds. A rough approximation of the Gov­
ernment budget constraint for the above system of equa­
tions might take the form G = T + AM + AU.

Government, consumer, and investment spending com­
prise the three sectors, and income, wealth, and sub­
stitution are the three effects. Income effects are those
related to changes in disposable income. Wealth ef­
fects occur with changes in the level of wealth, the
ratio of wealth to income or changes in the level or
structure of debt claims (money and/or Government
bonds). Substitution effects result from saving or
spending incentives provided by a particular Govern­
mental tax or expenditure policy. Income and wealth
effects are interdependent; the initial effect may be
one or the other, but both effects become operative
as the adjustment proceeds. For example, an increase
in investment may occur as a result of a change in
income because of a change in the propensity to in­
vest. The income effect would be followed by a wealth
effect as changes in the interest rate and the ratio of
wealth to income occur over the period of adjustment.
Musgrave assumes that consumption is altered
through income effects and/or wealth effects. Invest­
ment is influenced by changes in income and/or (via
interest rates) changes in the level or structure of
claims, while the substitution effect, which does not
appear explicitly in the model, may be operative
through changes in profitability due to taxation.
Wealth and income effects are seen most clearly
by comparing the private sector’s response to a variety
of policy actions. The accompanying table illustrates
a basic cataloguing of budget policies within the Mus­
grave framework. It gives various combinations of
stabilization actions by arraying changes in the supply
of Government debt against changes in the supply of

T a b le 1


Fiscal Finance

C h a n g e in S u p p ly of M o n e y
C h a n g e in *
S u p p ly o f D ebt




Deficit finan ce d
b y mix of d eb t
a n d m on ey
Deficit financed
b y new m on ey
D ebt retirem ent
finan ce d b y
new m on e y



Deficit financed M o n e y retirem ent
b y debt
financed b y
b o rro w in g



Eq u a l c h a n g e in M o n e y retirem ent
tax y ie ld a n d
finan ce d b y
e x p e n d itu re s
current su rp lu s
D eb t retirem ent
finan ce d b y
current surp lu s

C urrent su rp lu s
used to retire
m ix of m on e y
a n d debt

♦Changes in the supply of debt refer to changes in coupon bill or
m aturity value rather than to changes in the m arket value of the
total debt outstanding.

Page 19


We assume that the ratio of consumption to income
will increase (that is, the ratio of saving to income
will fall) with increases in the supply of money, or
(with some qualification) the supply of public debt
and the level of investment will rise with an increase
in the supply of money and will fall with an increase
in the supply o f debt. It is then possible to determine
whether each policy mix is expansive or restrictive.
Policies 3, 4, and 8 are expansionary, policies 6, 7,
and 9 are restrictive, and policies 1, 2, and 5 contain
ambiguous effects. Policy 2, a deficit financed by debt
issue, most closely approximates the bond-financed’
crowding-out case. Policy 1 approximates the tax-financed crowding-out case. Note that neither policy 1
or 2 involves changes in the supply of money. These
two cases will be examined separately, to ascertain
which factors are involved in determining whether
purely budgetary actions result in an expansionary
effect on the economy, or simply crowd out private

Bond-Financed Changes in Government
What actually happens in the case of bond-financed
Government expenditures depends to a large extent
on the movement of the interest rate. There will be
an expansionary income effect (Government spend­
ing adds directly to income) which may be aug­
mented by a stimulative wealth effect on consump­
tion (more bonds held by the public), if the interest
rate remains relatively unresponsive.27 If the increase
in the supply of Government bonds is accompanied
by a sharp rise in the interest rate, the expansionary
income effect could be countered by: (1) a smaller
net wealth effect (since the market value of the Gov­
ernment debt varies inversely with the interest rate);
(2) displacement of private investment, which re­
sponds negatively to a rise in the bond interest rate;
and (3) a diversion of funds from consumption into
27The wealth effect, as described by Musgrave, does not
consider the issue of future tax liabilities associated with
Government debt. Even if the interest rate responds negli­
gibly to an increase in Government bonds, the rise in the
value of the debt (positive wealth effect) may be partially
offset by the discounted future tax liability required to pay
the interest on the debt. The impact of the future tax liability
on aggregate demand in the current period depends upon (a)
the degree to which the bond-holding public considers
future tax liabilities, (b ) the maturity of the debt, and (c )
the anticipations of the public as to the nature of the future
taxes to be levied (on the income from labor or capital)
to pay the interest on the debt. See Boris P. Pesek and
Thomas R. Saving, Money, Wealth and Economic Theory
(New York: The Macmillan Company, 1967), Chapter 10,
who argue that the tax liability offset to the wealth effect is
only partial and not total as some analysts have suggested.

Page 20


Government bond purchase (voluntary saving), hav­
ing an initially restrictive effect.
The response of total spending to bond-financed
Government expenditures is ambiguous. If savers are
indifferent between the holding of bonds and money,
the interest rate does not rise, the net market value
of the debt increases by this means of financing, and
a strong wealth effect may be realized. At the other
extreme, savers insisting on holding a fixed ratio of
money and debt would result in a rise in the interest
rate, no change in the value of the debt (gains from
the acquisition of new bonds being offset by capital
losses suffered from the holding of old bonds), and
no wealth effect.
Actual conditions, according to Musgrave, fall some­
where in the middle. During a depression, the interest
rate is hkely to be relatively unresponsive. The im­
plication is that the interest rate is likely to be most
responsive during periods of rapid expansion. A more
detailed model might consider the effects of price
expectations and varying default risks on interest
rates (and, consequently, private spending), and
present a wider spectrum of private and public assets.
The introduction of fractional reserve banking
(which is excluded from the above discussion) into
the system complicates the argument somewhat, but
the essential principles remain unchanged. In prac­
tice, as Buchanan points out, commercial bank pur­
chases of Government bonds out of excess reserves
permit the full expansionary effect to take place
( money creation), but bonds purchased when reserves
are not in excess have the same effect as borrowing
from the public. In the latter case, “The expansionary
effects of the public spending side of the deficit are,
to a considerable extent, offset by the reduction in
private investment caused by the tightening up of
funds available for private securities.”28

Tax-Financed Changes in Government
The most obvious crowding out of private expendi­
tures by Government spending, involving the involun­
tary transfer of funds from the private to the Govern­
ment sector, is the case in which expenditures are
financed by taxation. A balanced-budget multiplier
equal to one (total spending increases by an amount
equal to an increase in Government spending financed
by taxes) is the usual upper limit assigned to taxfinanced Government expenditures. This result is
28James M. Buchanan, The Public Finances
111.: Richard D. Irwin, 1965), p. 99.



generally deduced from the assumption that the
Government’s propensity to spend for goods and
services out of tax revenue is 100 per cent, while
private propensities to spend after-tax income are less
than 100 per cent.29
Most simple models, including Musgrave’s, do not
allow adequately for potential leakages from the Gov­
ernment balanced-budget multiplier, but by injecting
debt considerations into the discussion of an increase
in Government expenditures met by a rise in taxes,
Musgrave uncovers potentially adverse influences on
private spending. If an initial rise in income is gen­
erated by a balanced-budget change, a drain on asset
money would develop (because of the increased
transactions demand for money) which tends to have
a detrimental effect on investment. The rise in income
relative to a constant money supply may have a de­
pressing effect on consumption, especially so the more
the drop in net wealth (that is, a fall in the value of
the debt) produced by a rising interest rate.
Most observers, however, ignore debt considera­
tions in their analysis of the limitations of the unitary
balanced-budget multiplier. The large number of as­
sumptions necessary to the determination of a uni­
tary balanced-budget multiplier, disregarding debt
problems, reflects to some extent its implausibility.30
Baumol and Peston discuss the issue in terms of leak­
29One observer has relied strongly on a positive balancedbudget multiplier to support his argument for the expan­
siveness of bond-financed Government expenditures. See
Robert Eisner, “Fiscal and Monetary Policy Reconsidered,”
American Economic Review (December 1969), pp. 897905. Eisner finds Government expenditures, regardless of
the financing, to be the controlling exogenous variable in
slowing or stimulating the economy ( “monetary measures
are likely ultimately to be as limited in their impact in
combating inflation as they have long been recognized to
be limited in combating a deep depression. . . . “Public
works or, more generally, government investment and con­
sumption, reemerge in their early role as prime weapons in
the arsenal against depression and take on analogous im­
portance in any struggle against inflation,” p. 904). His
model shows that whether Government spending financed
by bond issue is expansionary (increase in prices) or offset
depends on the interest and wealth elasticities of real
money and commodity demand. He presents no empirical
justification for his conclusion that bond-financed Govern­
ment expenditures are expansionary, but concludes that to
argue against an expansion “would be to argue that a
deficit-financed increase in Government expenditures can
be deflationary while the same increase in Government
expenditures would be inflationary if fully supported by
taxes.” (p. 903) His balanced-budget multiplier analysis
ignores its numerous limitations as discussed above.
30James Buchanan provides a list of seven assumptions under­
lying the unitary balanced-budget multiplier in The Public
Finances, pp. 78-80. These are: 1) The entire amount of
the Government spending change must take the form of
purchases of real goods and services currently produced;
2 ) the balanced-budget change must be financed through
taxes having about the same effects as the personal income


ages from the multiplier, and conclude that, in es­
sence, a rise in Government spending financed by
taxation may crowd out an equivalent or greater
magnitude of private spending.31 The basis for their
reasoning is that, although the Government’s marginal
propensity to spend exceeds that of the private sec­
tor, Government spending is subject to significant
leakages before its influence on private spending is
The existence of these “leakages” in a governmental
tax-expenditure program — the nonredistributional
effects on private consumption, the purchase of items
on capital account and of goods from abroad — is,
of course, well known, though no attempt seems to
have been made to take account of them in the
literature. Possibly some of the writers had them in
mind but considered them unimportant, since pre­
sumably none of them considered the unit multiplier
figure as more than an approximation to the empiri­
cal magnitude in view of the recognized qualifica­
tions. The magnitude of the leakages may indeed be
rather small, and it is very tempting to conclude
that if 10 per cent of the government’s balanced
budget expenditure is “leaked,” the multiplier will be
reduced from unity to say about 0.9. However, we
argue now that fairly small leakages can even pro­
duce a negative balanced budget multiplier.
. . . Thus the multiplier will be positive, zero, or
negative as the marginal propensity to save and im­
port of the private sector is greater than, equal to,
or less than k, the government’s ‘marginal propensity
to leak.’32

Alternative Frameworks for Analysis
of the Crowding-Out Effect
If, as has been maintained, the method by which
Government spending is financed matters to both
private and overall spending, it would seem that cur­
rent analysis should explicitly account for it in dis­
cussions of the Government expenditure multiplier.
Quite often, however, current analysis ignores the
potential crowding out of private spending when Gov­
ernment expenditures are financed by bond sales or
tax; 3) the public spending must not exert substitution ef­
fects on the pattern of private spending; 4) the marginal
propensity to save for taxpayers must be equal to the
marginal propensity to save for the suppliers of Govern­
ment goods and services; 5 ) investment spending must not
be altered significantly by the budgetary change; 6 ) the
monetary-banking framework must permit attempted changes
in spending to be carried out; 7) individual behavior in
earning income must not be directly affected by the bud­
getary change.
31W. J. Baumol and Maurice H. Peston, “More on the Multi­
plier Effects of a Balanced Budget,” American Economic
Review (March 1955).

32Ibid., pp. 144 and 145.
Page 21


One possible reason for this oversight is that the
numerous attempts to clarify the principles enunciated
in Keynes’ General Theory have resulted in serious
oversimplification of the complete Keynesian doctrine.
This oversimplification has taken place at both basic
and advanced levels of economic analysis. At the
basic level, the “45-degree diagrams” popularized in
principles text books leave no room for budget financ­
ing considerations.33 Similarly, the fundamental twoequation Keynesian model popularized in elementary
text books, and its usual extensions, encourage the
mechanical “cranking out” of fiscal multipliers which
omit adequate treatment of the financing issue.34
The Hicksian IS-LM analysis, formulated to sum­
marize Keynesian macroeconomic theory, represents
oversimplification at a fairly advanced level (see
figure 1). An increase in Government spending is
demonstrated by a rightward shift of the IS curve,
which, as explained above, may result in a rise in
both the interest rate and income. If the analysis stops
here (as it frequently does), it is difficult to discern
how the increased expenditure is financed. In reality,
the shift from an equilibrium to a disequilibrium po­
sition may bring about simultaneous changes in in­
come, wealth, interest rate, money demand and
money supply variables, and tax functions, depend­
ing on the source of finance. An approximation of the
effects of movements in the key variables, as a new
equilibrium position is established, may be achieved
by altering the slopes and positions of the IS and LM
curves, but the framework of analysis, without an
explicit Government budget constraint, is not condu­
cive to such shifts.35
William L. Silber sets forth conditions under which
Government spending can be contractionary in a
properly specified IS-LM framework.30 Utilizing a
framework of analysis similar to that of Musgrave, he
33See, for example, Paul Samuelson, Economics, 8th edition
(New York: McGraw-Hill Book Company, Inc., 1970),
p. 317.
M( l ) C = a + bY
( 2) Y = C + I + G
Substituting (1 ) into (2 ) and solving for Y gives:
Y = a /1 —b + 1 /1 —b + G / l —b where
5Y/5G = 1/1 — b = Government spending multiplier
35“The Hicks-Hansen diagram has elegant simplicity which
appeals to many. It has the disadvantage, however, that
most of the ‘works’ are out of sight. This means that we
need to use another diagram (or an extra mental calcula­
tion) to determine the effect of a displacement of the
equilibrium on the other variables of our system.” See
Ackley, p. 372.
38William L. Silber, “Fiscal Policy in IS-LM Analysis: A Cor­
rection”, forthcoming in the Journal of Money Credit and


Page 22


finds that a rise in the supply of Government bonds
which increases wealth also increases the demand for
money (represented in the IS-LM framework by a
leftward shift of the LM curve). Silber concludes:
It has been demonstrated that traditional IS-LM
analysis has not treated the bond-finance and new
money-finance cases of government deficits symmetri­
cally. W hen proper treatment is given to the former
case, we found that in the simple world of IS-LM
analysis government expenditures financed by selling
bonds to the public can be contractionary. Even when
GNP does go up due to AG, the increase that occurs
is overstated in the traditional (but incomplete)
IS-LM model of income determination. The failure
to incorporate the monetary effects of d e b t finance
into the LM function is the major source of confu­
sion. While other studies have treated this ques­
tion, it has never been formally incorporated into
IS-LM models. This had led to incorrect conclusions
regarding the multiplier affects of government

The many income-expenditure econometric models
which have emerged in the 1960’s appear to be wellsuited to handle the problems of simultaneity and
the Government budget constraint. Unfortunately,
some explicit provision for the fact that Government
expenditures must be financed by taxing, borrowing
from the public, or money creation has often been
omitted from monetary and fiscal policy simulations
of these large models. A model which includes, for
example, Government purchases of goods and services,
transfer payments, taxation, the change in the sales
of Government bonds to the public, and the change
in the stock of high-powered money, should be closed
by the specification of the relationship between the
items representing Government expenditures and the
items representing Government “income.”
Closure of the above system implies that in simu­
lating the economy’s response to alternative monetary
and fiscal actions, it is not possible to change only one
of the five variables at a time when evaluating mul­
tipliers. Carl Christ provides the following example
relating Government expenditures to Government
. . . if government purchases are increased, then
either transfers must be cut, or tax payments must
rise, or government debt must be issued to the pri­
vate sector, or high powered money must be issued,
or some combination of these. The effect of the in­
crease in government purchases will depend upon
what combination of them is chosen.37
37Carl Christ, “Monetary and Fiscal Policy in Macroeconomic
Models” (Paper presented at the Sixteenth Annual Con­
ference on the Economic Outlook, Ann Arbor, Michigan,
November 14-15, 1968), p. 102.


Thus, those models which purport to be able to say
something like “A $1 billion increase of Government
purchase of goods and services results in a one-quarter increase in income of $2.5 billion” should also
make statements regarding another fiscal/monetary
variable which changes in order for the statement to
have meaning. With no way to determine how the
$2.5 billion increase in income is generated, it may be
falsely attributed to a fiscal action when, in reality, a
monetary action is responsible. That is, if changes in
money are not held constant in the analysis, the esti­
mated increase in income arising from a change in
the independent fiscal policy variable may not be ac­
curately captured. Consequently, the model would
not measure accurately fiscal crowding out.
One analyst gives several examples of how, by
failure to incorporate correctly the Government bud­
get constraint, a number of income-expenditure mod­
els overestimate the impact of Government actions
on income. His own reduced form empirical evidence
leads him to conclude that “These results are consist­
ent with a simple Keynesian multiplier from a deficit
financed by bond purchases, with respect to the in­
come of the private sector equal to zero.”38
Neglect of the Government budget constraint is not
the only reason why fiscal crowding out has not ap­
peared in some structural econometric models. If such
monetary variables as money demand and supply
are omitted completely from the model, the “real”
sector of the economy —which normally includes Gov­
ernment spending actions —will, by default, dominate
income changes. In terms of IS-LM analysis, omission
of the LM curve (which reflects money demand and
supply functions) would severely restrict the possible
emergence of the crowding-out effect.
Evidence presented in this Review is consistent
with the thesis that failure to identify monetary vari­
ables adequately leads to suppression of the crowd­
ing-out effect. Michael Keran found that the use of
interest rates rather than monetary aggregates as
monetary variables in his reduced-form equations re­
sulted in the elimination of the fiscal crowding-out
phenomenon.39 His study suggests that proper spe­
cification of monetary actions, in terms of monetary
aggregates rather than interest rates, assists empirical
estimators in uncovering fiscal crowding-out influences.
38Robert Auerbach, The Income Effects of the Government
Deficit (Ph.D. Dissertation, University of Chicago, 1969),
Appendix A and p. 49.
39Michael W. Keran, “Selecting a Monetary Indicator —Evi­
dence from the United States and Other Developed Coun­
tries” (this Review), September 1970.


Karl Brunner and Allan Meltzer have developed
(in a preliminary paper) a framework of equations
couched in terms of elasticities of interest rates, prices,
wealth, and anticipations. Their approach to macroeconomic analysis, in contrast to the standard Keyne­
sian framework, emphasizes the whole spectrum of
relative price adjustments (which includes changes
in the prices of goods and services as well as interest
rate responses) to monetary and fiscal actions.40 “The
role of the relative price process is particularly exam­
ined together with the responses resulting from the
interaction of the asset markets. The orthodox Keyne­
sian view of a reliable and direct’ effect of fiscal
policy on income disolves rather thoroughly. The an­
alysis establishes that monetary and fiscal policy are
equally ‘indirect’ and dependent on stimuli conveyed
by relative price changes and adjustments in wealth
Brunner and Meltzer believe their analysis “pro­
vides a foundation for the proposition that changes
in budgetary variables (Government expenditures or
taxes) exert by themselves relatively litde effect on
economic activity or price-levels. The crucial effect
depends on the financing.” They find that the Gov­
ernment expenditures elasticity of aggregate demand
“varies between less than 1/5 up to unity . .
the higher values achieved through the injection of
base money. “The pure fiscal effect of Government
expenditures thus amounts to at most 1/5 measured
in terms of elasticities.”42
Even the more conventional econometric models
may uncover crowding-out influences, if interest rate
effects are permitted to develop over a substantial
period. Private spending is curtailed over time by a
rise in interest rates generated by expanded Govern­
ment spending, but the result is not immediate. This
40Crowding out in a relative price context may be illustrated
by the following simple example: If a newly-issued Gov­
ernment construction contract enables a Government enter­
prise to bid against private firms for construction and other
workers in a near-fully employed community, the private
firms must raise wages to retain their workers. Those pri­
vate firms losing workers will probably have to curtail out­
put, while those retaining workers with higher wages may
attempt to pass along the higher costs in the form of price
increases. The higher prices would be most noticeable in
the construction sector, but, with the general rise in pur­
chasing power, could be transmitted throughout the com­
munity. Also, the higher prices of residential construction
could cause households to shift expenditures away from
housing into less expensive alternatives.
41 Karl Brunner and Allan Meltzer, “Fiscal and Monetary
Policy in a Non-Keynesian World,” (paper prepared for
private circulation), p. 6.

*2Ibid., pp. 57 and 57a.
Page 23


is particularly true of corporations whose decisions to
invest are based on the economic climate which exists
well before actual outlays are made. The specification
of the lags involving interest-sensitive private spend­
ing plans may play a strong role in determining the
time lag necessary for crowding out to occur.
The FRB-M IT model, which is characterized by
rather long lag structures, demonstrated complete
crowding out of private spending by Government
actions, when model simulations were tracked over a
long period. “In the long run, and by this we mean a
long run of ten or fifteen years, the [FRB-M IT]
model is classical in that the only permanent effect
of fiscal policy is to raise prices and the transactions
demand for money and, in the presence of a fixed
supply of money, interest rates sufficiently to crowd
out enough real private expenditures that the ultimate
real income effect of Government spending is zero.”43
Fiscal crowding out emerges in the reduced form
equations published in this Review only after a pe­
riod of time, even though it is a much shorter period
of time than that of the FRB-M IT model. Govern­
ment spending, as measured by high-employment ex­
penditures, exercises a strong influence on GNP
(assuming a constant money supply) in the current
quarter and the next quarter, but the Governmentspending effects wash out over approximately a oneyear period. These results should not be interpreted
to suggest that “Government spending doesn’t matter.”
It matters very much over a certain period. Moreover,
if Government spending were to accelerate rapidly
rather than be held to a once-and-for-all increase, the
impact on GNP would be considerable over the period
of acceleration and somewhat beyond.

A number of plausible theories have been devel­
oped over the years which substantiate the view
that Government expenditures, depending on the
source of finance, may crowd out a roughly equivalent
magnitude of private expenditures. This view, in fact,
was the dominant classical and neo-classical view,
persisting at least until the publication of Keynes’
General Theory.
Keynes himself discussed crowding out in detail in
T he General Theory. He indicated that the fiscal


multiplier might not generate the increases in em­
ployment given by a mechanical manipulation of the
equations centering on his consumption function, be­
cause of the restrictive assumptions upon which his
equations were based. Keynes noted several factors
tending to offset the influence of increased Govern­
ment expenditures: possible adverse reactions on pri­
vate investment, “confused” business psychology, and
a tendency of the marginal propensity to consume to
decline with rises in employment.
A significant number of additional limitations to the
Keynesian multiplier have been pointed out in the
post-General Theory literature. One of the most seri­
ous deficiencies of the fiscal multiplier appears to be
its asymmetry; that is, the crowding out of private
spending is theoretically more likely at full-employment than at considerably less than full-employment
conditions. Since the unemployment rate has rarely
exceeded seven per cent in the past three decades,
compared with an average unemployment rate of 18
per cent in the 1930’s, the crowding-out effect has
probably been much stronger in recent years than
during the period in which Keynesian multiplier the­
ory was developed.
Wealth, income, and substitution effects, important
factors in the determination of the degree of crowd­
ing out, are often incorporated in econometric models,
but failure to impose the Government budget con­
straint or treat adequately the monetary variables in
the system of equations probably has led to under­
statement of the crowding-out effect.
More research on the time interval of crowding-out
influences should be conducted to improve stabiliza­
tion policy recommendations. Articles published in
this Review suggest that Government expenditures
financed by taxes or borrowing from the public are
important over a very short period, but their tendency
to crowd out private expenditures obviates any
significant, lasting influence. This conclusion is sup­
ported by other research, which indicates that crowd­
ing out does indeed occur, but over a much longer
time period.44 These results suggest that the main
dispute regarding the crowding out effect centers
on the length of time involved. The rationale and
some empirical verification of the existence of crowd­
ing out have been established —precise relationships
and time periods remain a subject of further research.

43Edward M. Gramlich, “Recent Experience with the FRBMIT Model,” (paper presented to the Committee on Bank­
ing and Credit Policy, New York, November 6, 1969), p. 6.

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This article is available as Reprint No. 60.