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

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FEDERAL RESERVE BAN K
OF ST. LOUIS
SEPTEMBER 1970

Economic Slowdown and
Stabilization Policy

ST LO UlS

Selecting a Monetary Indicator —
Evidence from the United States and
Other Developed Countries...................... 8

EIC5HTH C
. A.
LITTLE R O C K

V o l. 5 2 , N o .

Economic Slowdown and Stabilization Policy

HE PACE OF real economic activity remains
sluggish, as the response to last year’s monetary
and fiscal restraint continues. Despite the slowdown
in production and employment, the pace of inflation
has not yet moderated significantly.
Major questions regarding the economy include:
(1) How long will real economic activity continue so

sluggish and, once recovery begins, how strong will it
be? (2) What are the prospects for an easing in infla
tionary pressures? The course of prices and output in
coming quarters will be influenced greatly by mone
tary and fiscal actions which have already occurred,
as well as by forthcoming actions.

D em and and Production
Ratio S c a le
Trillions of D o lla rs

Q u arte rly Totals at Annual Rates
S e a s o n a lly A djusted

Ratio S c a le
Trillion s o f D o lla rs
1.1

1.0
.9

L l G N P in current dollars.
[2 G N P in 1958 dollars.
Pe rce n ta g e s a re annual rates of change for p eriods in d icated .
Latest d a ta plotted: 2nd quarter

Page 2

Source: U.S. Department of Commerce

Pattern of Econom ic
Slowdown
Growth of total spending for
goods and services began slowing
in late 1969, in response to antiinflationary monetary and fiscal
actions. Such spending rose at a
4 per cent annual rate from third
quarter 1969 to second quarter
1970, following an 8 per cent aver
age rate of advance in the previ
ous five quarters. Continued rapid
increases in prices, reflecting ex
cessive total demand in the pre
vious five years, along with the
reduction in growth of total spend
ing, resulted in a decline in real
product. Total real output (GNP
adjusted for changes in prices),
which rose at a 3 per cent average
annual rate in the five quarters
ending third quarter 1969, de
clined at a 1 per cent rate from
third quarter 1969 to second quar-

FEDERAL RESERVE BANK OF ST. LOUIS

ter 1970. Industrial production,
which is usually more sensitive
than total output to changes in
total spending, has decreased at a
3 per cent average annual rate
since mid-1969. This decline in
production follows a rise of 4.9
per cent from mid-1968 to mid1969 and a 6.5 per cent gain in
the previous year.

SEPTEMBER, 1970

Prices
Ratio S c a le

Ratio Scale

1 9 5 7 -5 9 = 1 0 0

Moderated growth of total
spending and output first had
little effect on employment growth
which did not slow appreciably
until early this year. Firms apparendy were reluctant to reduce
their work forces until the reduced
growth of total spending proved
more than temporary. By historical
standards, the labor market was
very tight early in 1969, with almost
65 per cent of the population of
labor force age employed, com
pared with an average of 62 per
Source: U.S. D epartm ent of Labo r
Perce n ta g e s a re annual rates of ch ange for p erio d s ind icated .
cent in the Fifties and early
Latest d ata plotted: Consumer-July;
Sixties. Because labor had been
W h o le sale Industrial-August
unusually scarce, the competitive
the same as in the previous year. In contrast, consumer
costs of hiring and training personnel probably con
prices rose at a 3.8 per cent average rate in 1967 and
tributed to employer reluctance to lay off workers in
late 1969 and early 1970. Reflecting this lag in ad
1968 and at a 1.2 per cent rate in the 1961-64 period.
justment of the work force to changes in the growth
Wholesale industrial prices have risen at about a 4 per
of total spending, total employment did not slow
cent rate since last fall, about the same as in the
significantly until March of this year, but has since
previous year.
declined at a 2 per cent rate. Nevertheless, 64 per
Continued rapid inflation in the face of moderated
cent of the population of working force age has
growth of spending, output and employment is con
been employed this summer, a greater proportion than
sistent with past experience in the U.S. economy
at any time in the Fifties and Sixties prior to 1967.
(Table I).
Slowing of growth in spending,
output and employment has not yet
resulted in a clear reduction in the
rate of increase of prices. Inflation
apparently is no longer accelerat
ing, but a decline in the rate of ad
vance of prices has not yet been
firmly established. The broadest
measure of prices, the implicit price
deflator for GNP, increased at a
5.4 per cent annual rate in the first
half of 1970, about the same as in
the last half of 1969. Consumer
prices have increased at about a 6
per cent rate since December, about

Table 1

Demand, Production and Prices
Annual Rates of Change
Total
Demand

Period

Real
Product

Period

Prices

11/54 to

1/57

1/57 to

11/58

0.3

- 2 .5

1/58 to IV/59

11/58 to

1/60

8.2

6.4

IV/59 to IV/60

1.9

1/60 to

1/61

0.1

— 1.6

IV/60 to IV/61

1.1

IV/64 to

1/66

10.3

8.2

IV/65 to IV/66

3.5

1/66 to

11/67

6.0

2.8

IV/66 to

11/67

2.4

11/67 to 111/69

8.5

3.8

11/67 to

11/70

4.7

111/69 to

4.1

— 1.1

11/70

7.3%

4.5 %

IV/55 to

1/58

3.7%
1.6

Page 3

FEDERAL RESERVE BANK OF ST. LOUIS

For example, in 1957-58 the rate of price in
crease did not begin to recede until about a year
after output growth slowed, and in 1960-61 the lag
was about three quarters. The main difference be
tween the most recent period and other periods of
slowdown is the greater momentum that inflation was
allowed to achieve in the 1964-69 period than in previ
ous periods. The length of time required to achieve
relative price stability, such as during the 1961-64
period, is likely to be considerable. Not only has in
flation been allowed to achieve rates higher than in
other inflationary periods in the postwar U.S. economy,
but the degree of monetary and fiscal restraint has
been less than in other such periods.

Recent Monetary and Fiscal Actions
The course of spending, output and prices in recent
quarters appears to have responded normally to mon
etary and fiscal actions. Economic developments in
the second half of 1970 will depend in large measure
on policy actions already taken in the first half of the
year. Both monetary and fiscal actions have been
more expansive in 1970 than in 1969, though such
stimulative policy actions have persisted for only a
relatively short period.
Fiscal actions —Federal budget actions in the first
half of 1970 were dominated by several factors affect
ing disposable income: a 6 per cent pay increase for
Federal employees, retroactive to the beginning of
the year; an increase in the Social Security benefit
schedule, also retroactive; and a reduction in the tax
surcharge on January 1. Reflecting these actions, the
high-employment budget moved from a surplus of
about $11 billion in the year ending in first quarter

Page 4

SEPTEMBER, 1970

1970 to a $3.6 billion rate in the second quarter of
1970. This reduced rate of surplus was in marked
contrast to the $10 billion average annual rate of
deficit in the high-employment budget in 1967 and
1968.
The national income accounts budget moved from
a $9 billion surplus in 1969 to a $14 billion annual
rate of deficit in the second quarter of this year. This
budget, in contrast with the high-employment budget,
is influenced by variations in growth of total spending
in the economy, as well as changes in Federal ex
penditures and tax rates. Consequently, the national
income accounts budget is misleading as a measure
of fiscal actions. Reduced growth of total spending,
and thus of income and profits, contributed to a drop
in Federal tax receipts at a $5 billion annual rate
from fourth quarter 1969 to second quarter 1970.
Monetary actions —Monetary actions became rela
tively expansionary in early 1970. The money stock
rose at a 5 per cent annual rate from the three months
ending February 1970 to the three months ending in
August, after changing little in the second half of 1969.
Acceleration of money stock growth reflected
more rapid expansion of Federal Reserve credit and
bank reserves since February. Federal Reserve credit
grew at a 7 per cent annual rate from February to
August, compared with a 3 per cent increase in the
previous year.
M o n e y Stock

,-,-

R atio S c a le
B illio n s o f D ollars

230

is of Dollars

1962

R atio S c a le
B illio n s o f D o lla rs
230

Monthly Averages of Dally Figures
Seasonally Adjusted

Weekly Averages of Daily Figures
Seasonally Adjusted
Billions of Dollars

1964

1965

1966

1967

il rates of change for periods indicated.
Latest data plotted: August

1968

» t

1969

1970

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

Money Market Rates

B a n k C redit*

Ratio Seal*

Ratio Scale

A ll C o m m e rcial B anks

Ratio S ca le
Billions of D ollars

Ratio S ca le
Billions o f Dollars
500

Monthly Averoges ol Daily Figures

500 r

A/V v ,

Regula ion Q
Maximu mRated
r -------i.

/ <
/ r**

-057.

300

+ 89%^

7
1 V '‘6.4
1

*297.

200
126%^-'-

1962

i
I
I

1963

-S

Jan.'62
...

1962

1963

1964

1965

-957.

-— ^

3-Mor Ih Treasury Bills

13°j8
-

+297.

+1927.

+89%
+2197.

Inve tments
100

'—

+ 69%^-

Loans

V sTO

284.1

*1237.

200

*4\ ;
/ \ /

4U 9

Total
*167.

4- to 6- lonth
Prin e Comme rcial Pape

♦9 87.

27.

400

1966

100

1 1967t

... "
tl t

.......

1968

1969

° £
3 -1 t i_
1970

90
80
70

‘ Data are estimated by the Federal Reserve Bank o( St. Louis.
Percentages are annual rates oi change (or periods indicated.
Latest data plotted: August estimated

1964

1965

1966

1967

1968

1969

1970

[l_Rate on deposits in am ounts of $100,000 or more maturing in 90-179 days.
Latest da ta plotted: August

More rapid expansion of Federal Reserve credit
and the money stock since early 1970 has been accom
panied by a sharp acceleration in the growth of time
deposits, reflecting primarily a decline in market in
terest rates and changes in Regulation Q. This regula
tion has been changed twice this year (January 21
and June 24), each time in the direction of increasing
the maximum rates which banks are permitted to
offer on time deposits. As a result, banks became more
competitive in bidding for funds, and time deposits at
commercial banks have increased sharply since Janu
ary. Total time deposits increased at an 11.5 per cent
annual rate from January to June. Since June, these
deposits have increased yet more rapidly, at a 37 per
cent annual rate, reflecting the suspension of ceilings
on rates paid for large certificates of deposit maturing
in 30 to 89 days. Over half of the increase in time
deposits since June has been in large certificates of
deposit. Since January, these CD’s outstanding at
commercial banks have increased by $9 billion, off
setting a large part of the $13 billion decline from
December 1968 to January 1970.
The large inflow of time deposits has been accom
panied by an increase in bank credit at a 10 per cent
annual rate since February. Over the previous year,
the level of bank credit remained essentially un
changed. The recent upsurge of bank credit reflects
partly an increase in Federal Reserve credit, and to
that extent represents an increase in total credit in the
economy. But the bulk of the increase in bank credit

reflects rather a reintermediation of funds previously
flowing through nonbank credit channels. From late
1968 to early 1970, banks were not able to compete
effectively for funds with open market interest rates
which were generally above the Regulation Q ceilings.
With the increase in ceilings in 1970 and the general
decline in short-term market interest rates, banks have
been able to bid funds away from these other markets.
The yield on Treasury bills fell from a 7.87 per cent
average in January to 6.41 per cent in August. Long
term corporate rates, however, rose slighdy on bal
ance; the rate on corporate Aaa bonds rose from 7.91
per cent in January to 8.13 per cent in August.

Projections of Total Spending,
Prices and Output
Monetary and fiscal actions of recent months will
continue to affect total spending in the second half of
1970, but a more complete assessment of forthcoming
developments requires assumptions about the future
course of monetary and fiscal actions.
The pattern of fiscal actions for the year ending
June 30, 1971 can be assessed by looking at Federal
budget plans for that period. Current estimates in
dicate Federal spending in fiscal 1971 will be about
5 per cent higher than last year. The large increase in
expenditures in the second quarter of calendar 1970
was associated with the Government pay increase and
rise in Social Security benefits, and is not considered
indicative of a trend. To provide projections of total
spending, prices, and output beyond mid-1971, Fed
eral expenditures were assumed to grow at a 6 per
cent annual rate after mid-1971.
Page 5

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

Table II

SIMULATION OF THE EFFECTS OF MONETARY AND FISCAL ACTIONS*
Prrii

1970

Onto r\( Chnnnt*
in Money Stock

1971
III

Actual

1972
ill

Projections

3 Per Cent
Rate of Change in:
Nominal GNP
Real G N P
G N P Price Deflator

3.3%
— 2.9
6.6

4.9%
0.6
4.3

5.5%
0.6
4.8

4.3%
— 0.3
4.6

3.1%
— 1.2
4.3

2.9%
— 1.1
4.0

6.5%
2.7
3.8

5.3 %
1.8
3.5

4 .9 %
1.8
3.1

4.6%
1.8
2.7

Unemployment Rate

4.2

4.8

5.2

5.5

5.8

6.2

6.6

6.7

6.9

7.1

Corporate Aaa Rate

7.9

8.1

7.7

7.6

7.5

7.3

7.0

Commercial Paper Rate

8.6

8.2

7.5

7.2

6.7

6.2

5.8

5.3

4.8

4.3

3.3
— 2.9
6.6

4.9
0.6
4.3

6.0
1.1
4.9

5.6
0.9
4.7

5.0
0.5
4.5

5.2
0.9
4.2

8.8
4.6
4.1

7.5
3.5
3.9

7.2
3.4
3.7

6.8
3.3
3.5
6.3

5 Per Cent
Rate of Change in:
Nominal G N P
Real GNP
G N P Price Deflator
Unemployment Rate

4.2

4.8

5.2

5.4

5.7

6.0

6.2

Corporate Aaa Rate

7.9

8.1

7.6

7.7

7.6

7.5

7.4

7.2

Commercial Paper Rate

8.6

8.2

7.2

7.0

6.7

6.3

6.1

5.8

5.4

5.1

•The simulation is based oni equations estimated through 11/1970. High-employment expenditures are estimated through 11/1971, based on the
Federal budget as revised in May 1970. Thereafter, expenditures are projected at a 6 per cent rate.

For purposes of projecting total spending, two alter
native courses of monetary action are considered. A
5 per cent rate of growth in money for the two-year
period starting in second quarter 1970 would be con
sidered as a moderately stimulative course of mone
tary action. A 3 per cent rate of monetary expansion
for the next two years would be a moderately restric
tive monetary policy.
An optimal rate of monetary expansion must be
selected on the basis of a choice among attainable
combinations of price and output increases in coming
quarters. With the effects of past excessive total de
mand still working through the economy, a period of
relatively slow advances in output is probably neces
sary to complete the adjustment from the accelerating
inflation experienced since 1965. If the most likely
length of this correction process is not taken into ac
count in the determination of stabilization actions,
what might appear to be a strong recovery, resulting
from stimulative monetary and fiscal actions, would
prove only temporary. The adjustment process in
volved in unwinding from the 1965-69 inflation can
be expected to be long and painful, but it may be
even more painful if not consistently pursued.
Estimates made by this Bank indicate that if Fed
eral expenditures grew at a 5 to 6 per cent annual
rate and the money stock were increased at a 5 per
cent rate from the quarter ending in June, the growth
rate of total spending would most likely be about 5
to 6 per cent in the year ending in mid-1971, and
7 to 8 per cent in the following year (Table II ) 1.

Page 6

Real product would grow moderately in the coming
year, then increase at about a 3.5 per cent rate in the
year ending in mid-1972. Such a policy would most
likely result in the rate of increase in prices being
down to about 3.5 per cent by mid-1972.
A slower rate of growth of money, for example 3
per cent, would probably result in a more moderate
4 per cent advance of total spending in the coming
year, about the same as in the first half of 1970. From
mid-1971 through mid-1972, total spending would in
crease about 5 per cent. Real product, under such a
policy, would most likely decline slightiy through mid1971, then increase slowly in the following year. Such
total spending growth would probably reduce the rate
of inflation to below 3 per cent by mid-1972.

Reliability of Projections: A Postscript
Economic forecasting based on econometric models
continues to be imprecise, and information concern
ing the past forecasting performance of a given model
should be carefully considered before such a model is
used as a guide in policy formulation. To assist the
reader in forming his own judgment about the re
liability of projections based on research conducted
at this Bank, some comparisons are presented to cast
light on the model’s forecasting reliability.
To examine the reliability of projections, the equa
tions of the model were estimated using the experi
'See “A Monetarist Model for Economic Stabilization,” this
Review (April 1970), pp. 7-25.

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

put change corresponded closely
to total spending change, and
SIMULATION OF THE EFFECTS OF MONETARY AND FISCAL ACTIONS*
the model succeeded in produc
1969
1970
ing that similarity of movement.
IV
II
III
1
II
1
For the six-quarter period, total
Rate of Change in Nominal G N P
output increased at a 0.7 per cent
8.4%
3.9%
3.3%
4.9%
Actual
7.5%
7.3%
average annual rate; the model
6.4
Model Estimate
6.2
5.7
4.9
4.0
7.6
estimated a 1.4 per cent average
Rate of Change in Real GN P
2.2
- 0 .9
- 2 .9
0.6
Actual
2.6
2.7
rate.
0.5
— 0.2
2.2
3.2
1.7
1.3
Model Estimate
Forecasting the course of prices,
Rate of Change in G NP Price Deflator
5.8
4.9
4.7
6.6
4.3
which
has been a prime concern
Actual
4.6
4.4
4.1
4.4
4.4
4.2
Model Estimate
4.3
in the U.S. economy in recent
Unemployment Rate
years,
did not satisfy the criterion
3.4
4.2
3.5
3.6
3.6
4.8
Actual
of avoiding over- or under-estima
4.1
4.4
3.9
4.7
Model Estimate
3.6
3.7
tion. The model did succeed in
Corporate Aaa Rate
6.9
7.5
7.9
8.1
6.7
7.1
Actual
that it did not project any decline
7.2
6.9
Model Estimate
6.6
6.8
7.1
7.1
in the rate of price advance before
Commercial Paper Rate
1970, though it did not succeed in
6.7
7.5
8.5
8.6
8.6
8.2
Actual
projecting the degree to which in
5.8
6.2
6.7
6.9
6.5
5.9
Model Estimate
flation accelerated in 1969 and
*The simulation is based on equations estimated through IV/1968. Model estimates indicate what
the model would have projected when the simulation starts in 1/1969, using actual subsequent
early 1970.
changes in money and high-employment expenditures.
The upward movement of un
employment as a percentage of the labor force in 1969
ence of the period from 1953 through 1968. Observa
and 1970 was projected by the model, though the in
tions since the beginning of 1969 can then be used
crease was over-estimated in 1969. The long-term
to gauge the performance of the model in simulating
interest rate was tracked very closely by the model in
the effects of monetary and fiscal actions in 1969 and
1970. For 1969 and 1970, observed monetary and
1969, but the projections fell below the actual rates in
fiscal developments were treated as if they were
the first half of 1970. Since only two quarters have tran
known in advance to the forecaster; thus forecasts
spired yielding these discrepancies between actual and
of these policy variables were not considered as a
predicted, it is probably too early to form a judgment as
factor contributing to error in the projections.
to whether the criterion of marked and sustained overThe results of this simulation experiment are
or underestimation is violated. The short-term interest
shown in Table III. Observed values for the varia
rate was consistently underestimated by the model,
bles are shown along with model estimates. Econo
though the pattern of increasing through 1969 and then
metric model-building has not yet progressed to the
declining in 1970 was projected by the model.
point where the models are able to capture accurately
Conclusions
quarter-to-quarter movements in the variables. What
A continuing period of uncomfortable adjustment
is important in assessing forecasting reliability is the
to reduced inflation may be in prospect for the U.S.
degree to which marked and sustained over- or under
economy. Given Federal budget plans for fiscal 1971,
estimation is avoided.
stimulative monetary actions could bolster output and
Examination of the forecasts of total spending for
employment, but any significant gains in the battle
1969 and the first half of 1970 indicates that the
against inflation would be sacrificed. On the other
model succeeded in projecting the pattern of total
hand, more restrictive actions aimed at reducing the
spending growth. The model underestimated the in
inflation rate rapidly would probably give rise to fur
crease of total spending in the second and third
ther cutbacks in output and employment.
quarters of 1969, and overestimated the change in
Projections based on research at this Bank appear
succeeding quarters. For the six quarters as a whole,
to be most reliable with respect to growth of total
total spending increased at a 5.9 per cent average
spending. Projections of the other variables of the
annual rate, while the model projected a 5.8 per cent
model, though useful and informative, should be ac
rate of increase.
cepted tentatively. Additional observations will pro
Model forecasts of real output change also tracked
vide further basis for a judgment about the reliability
actual movements quite closely on average. Real out
of model projections for these variables.
Table III

Page 7

Selecting a Monetary Indicator —Evidence from
the United States and Other Developed Countries
by MICHAEL W. KERAN

X HERE IS a long tradition of comradeship between
central bankers of different countries. This is due not
only to the similarity of professional backgrounds of
central bankers but, perhaps more importantly, to
the similarity of monetary tools and technical prob
lems in the conduct of monetary policy.
Most central banks have a common set of mone
tary tools:1
(1) the discount rate, or the price at which it loans
reserves to the banking system;
(2) open market operations and “window guid
ance,” or the quantity of direct reserves it provides;
and
(3) reserve requirements, or the amount of reserves
that the banking system is required to hold as idle
balances and therefore cannot use for loans and
investments.
Which of these tools will be dominant depends
upon the institutional and financial conditions of each
country. In the United States, with its well-developed
short-term financial markets, the primary monetary
tool is Federal Reserve open market operations. In
Germany, where the short-term money market is not
eAn earlier version of this paper was presented on June 10,
1970, in Seoul, Korea, on the occasion of the twentieth
anniversary of the Bank of Korea. The author gives special
thanks to Professors Karl Brunner and Allan Meltzer, and to
his colleagues Leonall Andersen, Christopher Babb and
Keith Carlson, for helpful comments.
1These monetary tools represent indirect controls of the central
bank on the banking system, because they constrain only the
total balance sheet of the banking system, and the banks are
free to adjust the individual components of their portfolio.
The central bank may also have monetary tools which di
rectly affect specific sectors of the banking system’s balance
sheet. Interest rate ceilings on time deposits constrain a seg
ment of the banking system’s liabilities; quantitative limits on
the amount of business loans restrict a component of a bank’s
assets. The discussion with respect to the indicator question
applies to both direct and indirect central bank tools.
Digitized for Page
FRASER
8

well developed, and where large reserve injections
come from balance-of-payments surpluses, the pri
mary monetary tool is changes in reserve require
ments (Mindestreservepolitik). In Japan, where com
mercial banks are in large and continuous debt to the
central bank, the primary monetary tool is rationing
central bank credit through the discount window
(Madoguchi Shido). In Korea, the primary tools are
reserve requirements and rationing at the discount
window ( Chan-gu Kyu-jai).
Once monetary policy is determined and the mone
tary tools activated, the next question central bankers
face is “are net monetary influences on the economy
moving in line with policy?” In a world of uncer
tainty, this question can only be answered in the con
text of a properly specified indicator of monetary in
fluence on the economy.
This article will (1) briefly discuss the need for an
indicator and the method of testing alternative indi
cators; (2) develop the criteria of a good indicator;
(3) present statistical evidence regarding which in
dicator has given the most consistently correct infor
mation for various periods of American history and
for recent experience of other developed countries;
and (4) consider the general factors which would
make one indicator superior to another.

The N eed for An Indicator
An indicator is defined here to be some readily
observable economic time series which can be used
to “scale” monetary or fiscal influences on economic
activity. If the indicator shows an increase, we want
to be able to say with some confidence that monetary
or fiscal influences are easier or tighter, depending on
what sign the indicator is postulated to have.

FEDERAL RESERVE BANK OF ST. LOUIS

In a world of perfect knowledge of the financial
and economic interrelationships in an economy, one
would not need an indicator of monetary influence.
Given a particular monetary policy goal, such as to
restrict total demand, the policymaker could directly
link the manipulation of his monetary tool (open
market operations, reserve requirements, or the dis
count rate) to a desired change in total demand. This
would be possible because, with perfect knowledge
of the relationships in the economy, the policymaker
would know the exact linkage between his manipula
tion of the monetary tool and its consequence with
respect to total demand.
Unfortunately, we do not have perfect knowledge
about the links between monetary tools and financial
markets or between financial markets and real mar
kets. We know relatively little about the transmission
mechanism between central bank actions and the final
effect on the economy. This uncertainty is not only
due to a lack of statistical data, since it exists in all
countries irrespective of whether they have strong or
weak statistical gathering services.
An example may help illustrate the problem of un
certainty in the implementation of monetary policy.
Suppose the United States wishes to follow a restric
tive monetary policy. To do this the Federal Reserve
may raise the discount rate, raise reserve requirements,
or sell Government securities on the open market.
However, any of these movements in the monetary
tools may not by themselves lead to tight mone
tary influences on the economy. A rise in the discount
rate may not raise the relative price of central bank
credit if, because of an increase in the demand for
credit, money market interest rates rise by as much as,
or more than, the rise in the discount rate. An increase
in reserve requirements designed to impound reserves
may be offset by an increase in Federal Reserve float,
because of a rise in bank transactions. The reserves
lost by the banking system through Federal Reserve
selling of Government securities may be neutralized
by a gold inflow.
Some of these neutralizing influences can be ac
counted for and offset by the central bank. However,
given the current state of knowledge about economic
relationships, many other factors which could neu
tralize Federal Reserve actions are not known. The
central bank needs a summary indicator of net mone
tary influences on the economy as a check against
whether the manipulation of its monetary tools is
achieving the previously established goals.

SEPTEMBER, 1970

By observing the movement of the indicator, the
central bank should be able to determine whether
monetary influences are expansionary, contractionary,
or neutral. If the indicator shows monetary influences
are expansionary, and policy calls for contraction,
then the monetary tools can be manipulated in a
more contractionary way. If the monetary indicator
is moving in the same direction as that called for by
policy, then the monetary tools need not be mani
pulated as vigorously as in the previous case.

Method of Testing An Indicator
The indicator problem can be considered either in
the context of a large structural model or in the con
text of a single equation, reduced form approach.
The single equation approach will be used here.2
The single equation approach to the indicator issue
has a number of virtues. First, it includes most of
the monetary and fiscal variables that are components
of the economic theories developed in most textbooks,
and which are used in the estimations of most structural
econometric models. Generally, it is these monetary
and fiscal variables which are, within the framework
of these large models, the dominant factors influenc
ing economic activity. Thus, if the monetary and
fiscal variables are properly specified, the single equa
tion approach will include the generally recognized
major factors in economic stabilization. Second, there
is a considerable degree of uncertainty, given our
lack of knowledge about the economic world, as to
the major channels by which these monetary and
fiscal variables influence the economy. In conse
quence, it is a useful research strategy to consider
these issues by employing the single equation ap
proach where the transmission mechanism is not
2In the case of a large structural model, a theory is stated
about the interaction of decision-making units in the econ
omy. Such a theory would, naturally, include information
about how monetary and fiscal policy tools affect economic
activity. The monetary or fiscal indicator would be implicit in
the hypothesized structure of the economy and, by standard
theoretical analysis, could be made explicit. Different indi
cators could be derived analytically from alternative theories
about the structure of the economy. If we are not certain
which of the hypothesized economic structures is “true,” then
even if we have the optimal indicator for each structural
theory, we do not necessarily have the “true” indicator of
monetary or fiscal influences. For an example of analytically
deriving monetary indicators from a number of structural
econometric models, see Richard Zecher, “An Evaluation of
Four Econometric Models of the Financial Sector,” Disserta
tion Series No. 1, Federal Reserve Bank of Cleveland Eco
nomic Papers (January 1970).
Page 9

FEDERAL RESERVE BANK OF ST. LOUIS

specified.3 Third, this approach is consistent with a
wide range of theories (hypotheses) about the struc
tural interrelations in the economy.
The key to the single equation approach is the
proper specification of the monetary and fiscal varia
bles. On the fiscal side, there is general consensus
that some measure of changes in government spending
and tax rates transmits important fiscal influences. On
the monetary side, there is a controversy as to the ap
propriate measure of monetary influences. Some eco
nomic theorists and model-builders use various market
interest rates as a measure of monetary influences;
others use various monetary aggregates. To help re
solve which class of measures provides the better indi
cator of monetary influences, a statistical test is
employed. For this test, a representative of each class
of indicators is selected; a long-term interest rate and
the narrowly defined money stock. The test would allow
us to assert one of three propositions: (1) the money
stock is superior to long-term interest rates as an indi
cator; (2) long-term interest rates are superior to the
money stock as an indicator; or (3) neither the money
stock nor interest rates are clearly superior as an
indicator.

Criteria for Selecting An Indicator
There are no generally accepted criteria of a good
indicator wifh the single equation approach. Three
criteria are suggested here which are plausible, but
not necessarily exhaustive: (1) to be useful as a
guide to central bank policy implementation, an in
dicator should be responsive to the monetary tools
of the central bank; (2) in order to interpret move
ments in the indicator as expansionary or contrac
tionary, it should have a theoretically unambiguous
association (or sign) with total demand; (3) to be of
practical use to central bankers, it should have a high
degree of statistical association (with the theoretically
expected sign) with total demand. If the indicator
changes in value today, we want to be able to predict
with some degree of confidence what will happen to
total demand in the future.
How do the money stock and interest rates com
pare with the criteria of a good indicator? With respect
to the first criterion, the central bank’s ability to sub3This, of course, would only give a first approximation meas
urement of impact, which could later be refined when we
have greater confidence in the structural models. Indeed, the
results of the single equation estimates could help guide
structural model-builders in the most fruitful direction.
Digitized for Page
FRASER
10

SEPTEMBER, 1970

stantially affect interest rates or the money stock is
widely accepted among economists. This is based on
the general proposition that because a central bank
has, in effect, unlimited financial resources, it can
determine the value of any financial variable, including
interest rates or the money stock ( but not both simul
taneously ). There has been a relatively limited amount
of empirical work directed to the question of re
sponsiveness of monetary indicators to central bank
tools, but what has been done supports this general
proposition.4
It is also not hard to find theoretical justification
for the role of both interest rates and the money stock
as an important element in the transmission of cen
tral bank actions to the rest of the economy. Both the
Keynesian Income-Expenditure Theory and the
Modern Quantity Theory of Money place money and
interest rates in strategic roles.5 These two theories
differ substantially with respect to how money and
interest rates operate on the economy, but do not
differ on the proposition that both variables are im
portant. In the Keynesian theory, the money stock is
positively associated and interest rates are negatively
associated with economic activity. In the Quantity
theory, the money stock is also positively associated
with economic activity; however, the interest rate
link to economic activity is ambiguous, because the
link between money and interest rates is negative in
the short run but it could be positive in the long run.
Both interest rates and the money stock pass the
first two tests of a good indicator, which leaves the
third criterion for differentiating between money and
interest rates. Which of these two variables has been
observed to have the closest statistical association
(with the expected sign) with economic activity?
4See A. Burger, An Explanation of the Money Supply Process,
Wadsworth Publishing Company (forthcoming); Keran and
Babb, “An Explanation of Federal Reserve Behavior (193368),” this Review (July 1969); Allan Meltzer, Controlling
Money, this Review (May 1969); John Wood, “A Model of
Federal Reserve Behavior,” Staff Economic Study No. 17,
Board of Governors of the Federal Reserve System; and
Zecher, An Evaluation of Four Econometric Models of the
Financial Sector; G. Kaufman, “Indicators of Monetary
Policy,” National Banking Review, June 1967.
“Until recently, most econometric models along Keynesian lines
have ignored the explicit role of money. However, more recent
work, specifically the MIT-FRB model, has included monetary
aggregates. Keynesian economic theory is compatible with
eimer a monetary or interest rate measure of central bank
actions.
The quantity theory of money also treats interest rates as
the strategic price variable which transmits monetary influ
ences to the rest of the economy. See Milton Friedman “The
Quantity Theory of Money —A Restatement,” in Studies in
the Quantity Theory of Money, (Chicago: University of
Chicago Press, 1956), pp. 3-21.

FEDERAL RESERVE BANK OF ST. LOUIS

Statistical Tests of Alternative Indicators
A number of recent studies in this Review have
measured the relative impact of monetary and fiscal
influences on economic activity in the United States
and in other developed countries.6 The single equa
tion tests were of the following general form:
where

AY — do “I- cci AM

0C
2 AF -t- e

Y is a measure of economic activity ( total demand)
M is a measure of monetary influence
F is a measure of fiscal influence
A is quarterly change

The symbol a , stands for the coefficient relating
monetary influences to economic activity. The symbol
a 2 is the coefficient relating fiscal influences to eco
nomic activity. The symbol a 0 represents the coeffi
cient for the trend value of all other influences on
economic activity. The symbol e represents the error
term or nontrend values of all other influences on
economic activity.
These earlier studies found this single equation ap
proach useful, as a first approximation, in measuring
monetary and fiscal influences on total demand.
This same single equation approach is used here to
test alternative monetary indicators. One difference
from earlier studies is that alternative monetary indi
cators must be estimated in separate equations, be
cause they are conceptually measuring different as
pects of the same phenomenon.7
All variables are measured as quarterly differences
or changes from one quarter to the next. The data
are drawn from fifty years of American history
(1919/11 to 1969/IV), divided into a total and five
sub-periods, and the postwar periods of five other
developed countries: Canada, Germany, Japan, South
Africa, and the United Kingdom.8 All equations were
estimated using the Almon distributed lag technique
(see Appendix for discussion).
6The rationale for this approach to empirical estimation has
been discussed before and will not be repeated here. The in
terested reader is referred to Andersen and Jordan, “Mone
tary and Fiscal Actions: A Test of Their Relative Importance
in Economic Stabilization,” this Review (November 1968);
DeLeeuw and Kalchbrenner, “Comment,” this Review (April
1969), and Keran, “Monetary and Fiscal Influences on Eco
nomic Activity —The Historical Evidence,” this Review ( No
vember 1969).
7Fiscal indicators are included in the statistical estimations,
but are not considered explicitly in the text which is con
cerned only with monetary indicators. If the fiscal variables
had not been included, the estimated coefficients of the
monetary variables could have been biased or their statisti
cal significance over- or under-stated.
8Detailed description of data and sources is given in the
Appendix.

SEPTEMBER, 1970

For each country, and for each period of American
history, three tests were performed, and the results are
summarized in Tables I, II, and III of the Appendix.
The first test consisted of regressing changes in eco
nomic activity against changes in Government spend
ing, the Government tax rate,9 and the money stock.
Government expenditures and tax rates are the indi
cators of fiscal influence, and the money stock is the
indicator of monetary influence. The second test was
identical to the first test, except that changes in long
term interest rates were substituted for the money
stock as the indicator of monetary influence. In the
third test, the level of long-term interest rates was
used for the monetary indicator.10
Several interesting observations could be made on
the basis of these statistical results. However, just
one question will be considered —whether the money
stock or interest rates is a more reliable indicator
of monetary influence. According to the discussion in
the previous section, the monetary variable which is
most consistent in predicting future movements in
economic activity is a superior indicator. Predictable
association of one of a number of independent varia
bles with respect to the dependent variables is
measured by the “t” statistic. A “t” statistic of 1.96 or
larger for a coefficient is considered statistically sig
nificant within the conventional 95 per cent confi
dence intervals. A “t” statistic of less than 1.96 is not
considered statistically significant. The higher the “t”
statistic, the greater confidence one has that the es
timated coefficient is drawn from the same “universe”
as the “true” coefficient. To facilitate comparisons of
the “t” values for the monetary “sum” coefficients in
the Appendix, they have been grouped into Table I.
Of the eleven test periods —six from the United
States and five from other countries —only in two
9Total tax receipts are a function of both the level of income
and the average tax rate established by the Government. Only
the tax rate can be considered a policy variable, because
changes in tax receipts due to changes in GNP are not di
rectly controllable by Government action. To take account
of this consideration, the tax variable in this study is com
puted as an average tax rate on all sources of income
as follows:
where Tx is total receipts and Y is nominal GNP.
The change in the tax rate is scaled by the level of (Y) to
convert it into a billions of dollars equivalent.
10There are two exceptions in the use of long-term rates,
Japan and South Africa. A short-term rate was used for
Japan because the long-term rates are subject to informal
interest rate ceilings imposed by the government. A short
term rate was used for South Africa because no suitable
long-term rate was available.
Page 11

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

Table 1

“ t” VALUES OF ALTERNATIVE
MONETARY INDICATORS

Expected Sign
Estimated Signs
United
States 1919-69
1919-29
1929-39
1939-46
1947-52
1953-69
Canada
1953-69
Germany 1960-69
Japan
1955-69
South
Africa 1955-69
United
King
dom
1954-69

Monetary Influences Meas ured by
Changes tn
Level Of
Money
Interest
Interest
Stock
Rates
Rates
Positive ( + ) Negative ( — ) Negative ( — )

+ 4.08
+ 3.22
+ 2.48
+ 1.49
+ 9.35
+ 5.38
+ 5.62
+ 2.82
+ 2.76

+ .46
— .22
— 3.13
+ 1.76
+ 2.60
+ 1.01
— 2.95
— 1.87
+ -21

+ -42
- .1 1
- .76
— 3.12
+ .17
+ 5.19
+ 2.44
+ 1.02
- 1 .7 0

+ 2.58

— 1.01

+ 2.22

+ 4.61

— .99

+ 3.22

of monetary indicators would not have supported the
superiority of a monetary aggregate over an interest
rate measure. However, such a result is not likely,
because most monetary aggregates move in line with
the money stock, and most interest rates move in line
with the long-term bond rate. In this type of test,
it is unnecessary for the magnitudes of the movements
to be similar.

periods did changes in interest rates (column 2) have
a statistically significant negative value (U.S. 1929-39
and Canada). In the other nine periods, the change
in the interest rate coefficient was significantly posi
tive in one period (U.S. 1947-52), and statistically
insignificant in the eight other periods. Clearly,
changes in interest rates do not give a systematic or
consistent indication of monetary influences on eco
nomic activity and thus are not a reliable indicator.

A second test of alternative monetary indicators
consists of looking at the average quarter-by-quarter
pattern of their association with economic activity, in
contrast with their total (sum) association with eco
nomic activity (Table I). The charts on the next
page present the results of such a test for changes
in money and changes in interest rates, where
each chart can be thought of as representing the
pattern of statistically estimated coefficients relating
changes in money (the solid line) and changes in
interest rates (the dotted line) to changes in eco
nomic activity. Because the money stock and interest
rates are measured in different dimensions, the esti
mated coefficients have been multiplied by the ratio
of the standard deviation of the independent and
dependent variables, so that the coefficients can be
compared directly. When the estimated coefficients
are thus modified, they are referred to as Beta
coefficients.11

The statistical test was also performed using levels
of interest rates and first differences for the other vari
ables (column 3). These results are less satisfactory
than using changes in interest rates. Of the eleven
test periods, only one had a statistically significant
and negative coefficient. That result occurred for the
United States in 1939-46. Of the other ten cases
considered, four are statistically significant but of the
wrong sign (positive), and six are statistically
insignificant.

The pattern of the Beta coefficients for the money
variable (AM) is very similar for all periods and
countries represented. The coefficients have a con
sistently positive value through most of the time pe
riods. If there are any negative coefficients on the
money variable, they appear in the longest lag time
period, usually in excess of t-4. The only exception to
this “standard” pattern is the United Kingdom, where
there is one virtually zero value of the AM coeffi
cient in the middle of a pattern of positive coefficients.

The money stock, on the other hand, had a posi
tive relationship with economic activity in all eleven
periods and was statistically significant in all but one
period, World War II (U.S. 1939-46). In spite of the
wide diversity of institutions and economic circum
stances represented in the different time periods and
different countries, changes in the money stock have
almost always led to a predictable change in eco
nomic activity in the direction consistent with eco
nomic theory.

The Beta coefficients for changes in interest rates
(AR) also have a degree of consistency. However,
it is not the kind of consistency which increases pol
icymakers’ confidence in interest rates as an indicator.
In all but one case, changes in interest rates show an
initial positive association with economic activity
which only gradually diminishes and becomes a nega
tive association after three to five lagged quarters.
The interest rate coefficient has the theoretically ex
pected negative association with economic activity
consistendy only in the case of the United States from

With respect to the propositions considered on page
10, the one which is most consistent with the evi
dence just presented is (1) the money stock is
superior to long-term interest rates as an indicator of
monetary influence. It is possible that a different pair
Digitized for Page
FRASER
12

11The results for the War and immediate Postwar periods for
the United States and South Africa are omitted from the
chart, because of space limitations. The pattern of the Beta
coefficients for the omitted periods is quite similar to that
of the included periods.

SEPTEMBER, 1970

FEDERAL RESERVE BANK OF ST. LOUIS

Beta Coefficients of Alternative M onetary Indicators
First Differences

United States
.6

-.2

-.4

-.6
t+
t-1

CANADA

II '19 — ll'29

.2 -/

-.2

-.4

-.6

-.2

-.4
I
t

t-1

t-2 t-3

I____ L

-.6

J ____ L

t-4 t-5
153 — Iir69_

.6
.4

AR \

-.2
-.4

............ -....... ... .... ..... -___________ 1
t+1 t
t-1 t-2 t-3 t-4 t-5

Other Developed Countries

V7
\/

1........ 1.

-L..

G erm a n y

.6
4

.2
0
.2
4
6

.6
.4
.2

0
-.2
-.4

-.6
Note: Beta coefficients are for changes in the money stock (AM} and interest rates (AR)- These Beta coefficients are calculated as the
products of the regression coefficients for the respective variables and the ratio of the standard deviation of the independent
variables to the standard deviation of the dependent variable (AY) or (AGNP). Lags were selected on the basis of the minimum
standard error of the estimate adjusted for degrees of freedom.

Page 13

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

1929 to 1939. In the Canadian case, interest rates
have a small positive influence in the initial quarter,
and consistently negative influences in all subsequent
quarters. It is not surprising that these two cases are
also the only ones where the sum coefficients were
statistically significant and negative, as described in
Table I, column 2.

In a world of perfect knowledge about the financial
and economic structure, both the money stock and
interest rates would give identical information about
monetary influences on the economy.13 The indicator
problem arises because there is ignorance at the
empirical level about exact specification of the link
ages of monetary and other variables in the economy
and the time lags associated with them. The evidence
In the other six cases in the chart, the pattern of
which was considered above suggests that the money
the interest rate coefficients is such as to virtually
stock has an overwhelmingly more predictable asso
wash out any consistent effect on economic activity.
ciation with economic activity than interest rates.
The early positive influences are matched by the later
Knowledge is one of our scarcest resources, and it
negative influences. This is also consistent with Table
apparently
takes less knowledge to properly evaluate
I, column 2, where the value of the “t” statistic in
the
impact
of the money stock than the impact of
dicated that these same six cases had statistically in
interest
rates.
Conversely, to see the workings of in
significant sum coefficients.
terest rates it takes more knowledge of the workings
The results presented in Table I and the chart are
of the economy than we currently have. There are a
highly consistent with each other, and provide a
number of possible reasons for this state of affairs:
strikingly strong case that monetary influences, meas
1. Difference between theoretical and actual
ured by changes in the money stock, have a more
measures. The range of interest rates which are theo
predictable and uniform pattern of effect on economic
retically relevant in indicating monetary influence on
activity than monetary influences, measured by
economic activity is much broader than that available
changes in long-term interest rates.
in the published interest rate series. The transmission
of monetary impulses to the rest of the economy op
What do these results imply for the monetary pol
erates through changing prices of a wide range of
icymaker? If he desires to minimize his errors in pre
assets and liabilities, which is equivalent to changes
dicting the effects of his actions on the economy, he
in their associated interest rates. The value of finan
will use the money stock as an indicator of monetary
cial assets reflected in the yield on any one type of
influence. This selection is not dependent on his ac
bond may be too narrow to represent the wide spec
ceptance of a “Quantity Theory” view of the trans
trum of assets and liabilities represented in the bal
mission mechanism. It is equally consistent with a
ance sheets of households and firms which transmit
Keynesian view of the transmission mechanism which
also postulates a positive association of money with < monetary influences.
The measured money stock, on the other hand, is a
economic activity. Rather, the selection is based on the
much more complete enumeration of the liquidity
empirical observation that interest rates have proven
position of all households and firms. Only commercial
to be a misleading indicator in most periods, while
bank demand deposits and currency issued by the
the money stock has proven to be an accurate in
central bank and Government can perform the role
dicator in virtually all periods.12
of a medium of exchange. Even other financial in
stitutions must hold their working balances as demand
Why is Money Superior to Interest Rates
deposits in a commercial bank. Therefore, the ob
as an Indicator?
served money stock series comes closer to a theoreti
The empirical results just discussed should not be
cal measure than the observed interest rate.
interpreted as denying the central role of interest
2. Difference between real and nominal values.
rates in transmitting monetary influences to the rest
It is generally asserted that it is changes in real
of the economy. The large body of theoretical litera
interest
rates which affect economic activity, but
ture on the paramount role of interest rates is not in
only changes in nominal interest rates are actually
dispute. Most monetarists acknowledge the role of
measured and reported. The difference between
interest rates in the transmission mechanism.
real and nominal interest rates is the result of
12For another study along similar lines see M. Hamburger
the change in prices which is expected to occur
“Indicators of Monetary Policy: The Arguments and the
between now and the maturity of the financial in
Evidence,” The American Economic Review, May 1970, and
M. Willms, “An Evaluation of Monetary Indicators in Ger
many,” in K. Brunner, ed., Proceedings of the First European
Conference on Monetary Theory ana Monetary Policy,
forthcoming.

Digitized for Page
FRASER
14

13See Karl Brunner and Allan Meltzer “The Nature of the
Policy Problem” in Targets and Indicators of Monetary
Policy, (San Francisco: Chandler Publishing Co., 1969).

SEPTEMBER, 1970

FEDERAL RESERVE BANK OF ST. LOUIS

strument.14 Measurement of these expected price
changes is both conceptually and empirically a diffi
cult process, subject to many errors. If nominal in
terest rates are rising because of expected inflation in
the future, the real interest rate may actually be un
changed or falling. Thus, to evaluate monetary ac
tions in a period of inflation or deflation by looking
at nominal interest rates may be misleading. This
problem does not arise with measurements of the
money stock, because in its most generally used form
it is nominal values of money which influence nominal
values of economic activity.
3.
Confusion between supply and demand. Even
if one could measure real interest rates, the change
in interest rates may be due to a change in the de
mand for credit rather than to a change in the supply
of credit, engineered by the central bank. In a period
of economic expansion, the demand for credit in
creases, which pushes interest rates up. In a period
of economic decline, there is typically a reduction in
the demand for credit, which pushes interest rates
down. Such movements in interest rates are not the
result of central bank action but of feedback from
the rest of the economy. Yet, if interest rates are used
as an indicator of monetary influence, it would ap
pear as if the central bank has taken countercyclical
actions when, in fact, it may have taken no action at
all.
This problem is not as serious when the money
stock is vised as an indicator. Most studies on the
determinants of the supply of money lead to the con
clusion that central bank operations dominate the
money stock and tend to offset demand-induced
changes in the money stock.15 In other words, the
behavior of the public, acting on the demand side of
the market, does not bias the money stock as an in
dicator of monetary influence as much as it does in
terest rates.

4. Greater stability in the demand for money than
in the demand for commodities. If our current state
of knowledge allows us to more accurately predict
the demand for money than the demand for goods
and services, then the money stock will be more
closely related to economic activity than interest
rates in any statistical analysis.18 This point can be
illustrated in a standard Keynesian LM-IS framework,
as in Figure I.
Figure I

The D e m a n d for M o n e y (LM0)
a n d C o m m o d itie s (IS-IS')

interest rate, r is the nominal interest rate, and pe is the rate
of change in expected prices of goods and services over the
life of the financial assets. If price expectations are formed
very slowly, then the gap between real and nominal interest
rates will be small. Until quite recently, this was the gen
erally held position among economists. However, Yohe and
Kamosky (this Review December 1969) have developed new
evidence which indicates that price expectations are formed
quite rapidly, thereby creating a substantial gap between
real and nominal interest rates even during relatively short
periods of inflation and deflation.

If the demand for money is well specified, then the
locus of points representing the LM curve can be
described by a line ( LM0). If the demand for com
modities, however, has a large random (stochastic)
element, the IS curve can be described only as a
band, the dimensions of which are IS —IS'. In this
circumstance, the link between any interest rate R0
and income would be represented by the gap Y0 - Yx.
On the other hand, the relationship between any given
money stock M0 (which is implied by a given LM
curve) and income would be represented by the band
Y2 - Y3. Because the spread between Y0 and Y! is
greater than the spread between Y2 and Y3, the degree
of statistical association between changes in R and
changes in Y would be less than between changes in
M and changes in Y.

1BSee John Wood, “A Model of Federal Reserve Behavior,”
Staff Economic Studies No. 17, Board of Governors, 1968.
Also, “An Explanation of Federal Reserve Actions,” this
Review, July 1969. “Reply to Comments on the St. Louis
Position,’ August 1969, and “Comment,” May 1970.

16The rationale for the greater stability for the demand for
money than the demand for commodities is presented by
William Poole in “Optimal Choice of Monetary^ Policy In
struments in a Simple Stochastic Macro-Model.” Quarterly
Journal of Economics, May 1970.

14The difference between real and nominal interest rates can
be presented as follows: r* = r — pe, where r* is the real

Page 15

FEDERAL RESERVE BANK OF ST. LOUIS

5.
Government controls. Governments historically
have imposed ceilings on interest rates. When such
ceilings exist, interest rates cannot be used simul
taneously as an indicator of monetary influence on
the economy. An indicator that is not allowed to
move with changes in market forces can give mis
leading and wrong information. This point applies
only to the use of legal authority to control interest
rates by fiat. The use of standard monetary tools to
control interest rates does not, of course, weaken its
role as an indicator.
Usually when an interest rate is used to measure
monetary influence, it is selected from among those
which are not under direct government constraints.
For example, the corporate Aaa bond rate, which is
used in the statistical tests on the United States, has
always been free of legal constraints. However, when
the government controls one interest rate, like that
which banks can pay on time deposits (Regulation
Q), credit flows away from banks and into other fi
nancial markets in which the rates are uncontrolled.
These distortions in credit flows could distort the in
terest rate quoted in those markets as an indicator
of monetary influence.
It is, of course, possible that interest rate controls
on time deposits could distort the money stock, es
pecially when money is defined to include time de
posits. However, the money stock definition used here
includes only demand deposits and currency, and
therefore the distorting effects of controls are apt to
be minimized.

Conclusion
The main point of this article is that selection of an
indicator of central bank actions need not be made
only on theoretical grounds. If we are not certain of

Digitized for Page
FRASER
16

SEPTEMBER, 1970

the theoretical structure of the economy, the selection
of the indicator can also be made on empirical
grounds. We have observed, in a wide range of his
torical and institutional contexts, that the money stock
is a reliable and predictable indicator of monetary
influence, and that interest rates are not. The reasons
for this difference in results stem largely from the fact
that it apparendy takes more knowledge about the
workings of the economic system to evaluate the im
pact of interest rates than to evaluate the impact of
the money stock. There are at least five possible fac
tors responsible for this: (1) the reported interest
rates do not cover all the financial markets which
transmit monetary influences to the rest of the eco
nomy; (2) the data reported are of nominal interest
rates, while it is real interest rates which affect eco
nomic activity; (3) it is difficult to distinguish
changes in interest rates which are induced by de
mand pressures of the public from those caused by
central bank actions; (4) uncertainty about the de
mand for commodities relative to the demand for
money increases the uncertainty of the relation of
interest rates to economic activity; (5) Government
interest rate ceilings in some markets induce arbitrage
flows which distort the movements of interest rates in
other markets.
We can summarize these factors by saying that
they represent the greater degree of knowledge we
must have about the economic system to make inter
est rates a successful indicator of monetary influence
on economic activity. This does not imply that the
money stock is not subject to some of the same uncer
tainties as those attached to interest rates. Rather, the
statistical results suggest that the uncertainties are
less with the money stock than with interest rates.
This article is available as Reprint No. 59

The statistical appendix begins on the next page.

STATISTICAL APPENDIX

The following tables summarize the
regression results which are the basis
for the assertions in the text. The
only aspect of these results which
is discussed in the text are the “t”
values on the alternative monetary
variables. There are other implications
which can be drawn from these re
sults. Specifically, the fiscal variables
play a stronger role and have greater
statistical significance when an inter
est rate, rather than the money stock,
is used as the monetary variable. This
result is not surprising. Omitting
money from the equation allows the
Government deficit to be financed by
increases in the money stock rather
than just through increases in debt
sales to the public. Thus, following
the analysis of Fand (this Revieiv,
January 1970), one would expect a
stronger measured fiscal influence
when interest rates are the monetary
variable, and a weak fiscal influence
when the money stock is the mone
tary variable. This point and others
will be developed in a future article.
The Almon lag technique was used
to estimate all equations presented
below. By constraining the distribu
tion of coefficients to fit a polynomial
curve of n degree, it is designed to
avoid the bias in estimating distrib
uted lag coefficients which may arise
from multicollinearity in the lag values
of the independent variables. The
theoretical justification for this pro
cedure is that the Almon constrained
estimate is superior to the uncon
strained estimate, because it will cre
ate a distribution of coefficients which
more closely approximates the dis
tribution derived from a sample of
infinite size. In order to minimize the
severity of the Almon constraint, the
maximum degree of the polynomial
was used in each case. The maximum
degree is equal to the number of lags

Table 1

UNITED STATES
Monetary and Fiscal Influences on
Economic Activity
(Quarterly First Differences — Billions of Dollars)
A y t = oco + oci A m + a * A e + 0 C3 A tx tt
Period

Lags*

Constant
Term

Monetary
Influence

Otl
(Sum)

Fiscal
Influences
a2
(Sum)

RV
D-W

a3
(Sum)

11/1919 - 111/1969

t— 8

1.24
(1.18)

4.55
(4.08)

( -

.09
.40)

- 3 .7 3
( — 2.61 )

.39
1.84**

11/1919 - 11/1929

t— 2

111/1929 - 11/1939

t— 4

Ml/1939 - IV/1946

t— 8

1/1947 - IV /1952

t— 8

1/1953 - 111/1969

t— 4

— .41
! — -66)
- 1 .1 7
(- 1 .3 4 )
- 5 .1 0
( - -95)
— 3.57
( - 1 .0 5 )
1.24
(-63)

5.61
(3.22)
4.10
(2.48)
4.40
(1.49)
27.74
(9.35)
9.25
(5.38)

.06
(.11)
-2.91
( - -97)
— 6.70
(- 2 .8 7 )
- 4 .6 0
(- 6 .6 6 )
- .87
1
( - 1 .0 5 )

- 7 .5 8
( — 3.36)
1.1 1
(.49)
10.97
(1.64)
9.43
(3.33)
- .18
( - -15)

.52
1.90
.35
1.47
.85
2.64
.85
3.25**
.49
1.61

A y t = - cxo + (Xi A r + a 2 A e + 0C3 A tx tt
Period

Lags*

Constant
Term

Monetary
Influence

ai
(Sum)

Fiscal
Influences
a2
(Sum )

R2 /
D-W

as
(Sum)

11/1919 ■111/1969

t— 5

3.86
(3.46)

18.03
(46)

.97
(1.95)

— .54
( — .45)

.26
1.86**

11/1919 - 11/1929

t— 4

111/1929 - 11/1939

t— 3

111/1939 - IV/1946

t— 6

1/1947 - IV/1952

t— 7

1/1953 - 111/1969

t—4

.34
(•54)
- 2 .4 4
(- 2 .0 2 )
12.94
(3.19)
6.27
(3.91)
6.60
(2.65)

— 1.78
( - -22)
- 3 4 .9 0
(- 3 .1 3 )
249.58
(1.76)
141.67
(2.60)
18.32
(1.01)

1.19
(1.24)
3.40
(1-53)
2.70
(3.70)
2.95
(2.13)
.68
(.38)

- 9 .2 5
( - 2 .3 2 )
— 2.95
( - 1 .4 0 )
-10.25
( - 4 .1 8 )
- 6 .8 2
( - 2 .6 9 )
1.1 1
(.47)

.66
2.19
.34
1.83**
.76
1.77**
.61
3.03**
.44
1.95**

Note: Regression coefficients are the top figures; their “t ” statistics appear below each

f
ft

coefficient, enclosed by parentheses. R- is the per cent of variation in the dependent
variable which is explained by variations in the independent variables. D-W is the
Durbin-Watson statistic.
A Y is measured as a proxy for economic activity because quarterly GNP data are
not available before 1947. This proxy is equal to the Industrial Production Index
times the Consumer Price Index, times GNP in the base year of these indexes.
The ta x variable is computed as follows:
A tx = A

*
**

Page 17

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

term £t equals [p • £t-i + Hi ] with (it normally distributed.
In the cases where the D-W statistic is significantly
greater or less than 2, autocorrelation in the error term
is indicated, and the “t” values of the coefficients will be
biased. In such cases, unbiased estimates of the “t” values
can be obtained by transforming the original equation,

plus one of the independent variables up to five lags. If
there are n lags, t + 1 and t — n — 1 are both constrained
to equal zero.1 The regressions were also run without con
straining the beginning and ending values to zero, and the
results are virtually identical.
The Durbin-Watson (D -W ) statistic is constructed to
equal 2 (1 —p), where it is hypothesized that the error

oc0 + 2 0Ci Xt,i,
i=l

iThis follows the convention established by Shirley Almon,
“The Distributed Lag Between Capital Appropriations and
Expenditures,” Econometrica, January 1965.

into (Yt - pYt-i) = oco (1 — p) + 2 oci(Xt,i - pXt-i,i),
i=l

Table II

OTHER DEVELOPED COUNTRIES
Monetary and Fiscal Influences
on Economic Activity
(Quarterly First Differences — Billions of National Currency)

Agnp = ao + oci Am + a 2 Ae + 0C
3 Atxtt
Country and
Time Period

Lags*

Constant
Term

Monetary
Influence

Fiscal
Influences

CXI
(Sum)

a2
(Sum)

R2/
D-'

a3
(Sum)

Canada
11/1953 - 11/1969

t— 6

.27
(1.77)

6.11
(5.62)

— 2.62
(- 1 .6 0 )

1.43
(.96)

Germany
111/1960 - 11/1969

t— 6

— 7.13
(- .8 5 )

10.58
(2.82)

2.60
(.7 2)

-2 .4 0
(.00)

.66
2.01 *

Japan
11/1955 - 11/1969

t— 3

— .04
( - .35)

2.81
(2.76)

1.73
(2.61)

3.23
(.46)

.74
1.91 *

South Africa1
11/1955 - 1/1969

t— 6

.05
(2.03)

3.02
(2.58)

.91
(0.76)

- 2 .4 0
( - 2 .4 4 )

.46
1.86

United Kingdom1
111/1954 - 11/1969

t— 6

.15
(2.11)

3.40
(4.61)

— .89
( — 1-38)

.35
(•65)

.52
2.17

.46
2.00

Agnp = ao + a i Ar + cc2 Ae + 0C3 Atxtt
Country and
T im e

P e r io d

Lags*

R2/

Constant

Monetary

F is c a l

Te rm

In f lu e n c e

In f lu e n c e s

ai
(Sum)

a2
(Sum)

D-W

as
(Sum )

Canada
11/1953 - 11/1969

t- 9

.46
(2.49)

— 6.45
( — 2.95)

7.83
(3.90)

4.08
(1.77)

.35
2.15

Germany
111/1960 - 11/1969

t— 6

11.92
(2.90)

- 2 5 .5 5
(- 1 .8 7 )

— 3.14
( - .79)

- 9 .3 5
( - -85)

.37
2.43

Japan
11/1957 - 11/1969

t— 5

— .12
(41)

.09
(.21)

5.07
(4.79)

2.60
(.47)

.85
2.53

South Africa1
11/1955 - 1/1969

t— 5

.06
(1.93)

- .15
(- 1 .0 1 )

2.69
(2.64)

-2.41
(- 1 .9 4 )

.48
2.17

United Kingdom1
111/1954 - 11/1969

t— 7

.37
(4.22)

.66
(.92)

.07
(.10)

.27
1.90

.63
.99)

N o te : Regression coefficients are the top figures; their “t ” statistics appear below each

tf
*
**
1

coefficient, enclosed by parentheses. R 2 is the per cent of variation in the dependent
variable which is explained by variations in the independent variables. D-W is the
Durbin-Watson statistic.
Tx
The tax variable is computed as follows: A tx = A

Lags selected on the basis of minimum standard error adjusted for degrees of
freedom.
A transform ation of this equation was made to eliminate possible bias in reported
“t ” values. For details, see tex t of this Appendix.
A proxy for economic activity is used for the United Kingdom because GNP does
not give statistically significant results. The proxy is equal to the Industrial
Production Index, times the Consumer Price Index, times GNP in the base year
of these indexes. Gross Domestic Product (GDP) was used for South Africa.

Page 18

and using the “t” values obtained from
the latter form. Those cases where the
“t” values of the transformed equa
tion were used are starred (* *) next
to their respective D-W statistics. In
these cases the results reported from
the transformed equation are the “t”
and D-W values. The values of the
coefficients and R2 are from the origi
nal equation.2

Data Sources
Canada — Gross National Product:
Canadian Statistical R eview , Domin
ion Bureau of Statistics; Money Stock:
International Financial Statistics, IM F;
Interest Rates ( Long-term Govern
ment Bond Yield): International F i
nancial Statistics, IM F; Government
Receipts and Expenditures: Canadian
Statistical R eview , Dominion Bureau
of Statistics.
Germany — Gross National Product:
International Financial Statistics, IMF;
Money Stock: International Financial
Statistics; IM F; Interest Rates (Mort
gage Bond Yield): International F i
nancial Statistics, IM F; Government
Receipts and Expenditures (Federal
finance on a cash basis): M onthly R e
port o f th e D eutsche Bundesbank.
Japan — Gross National Product:
Annual R eport on N ational In com e
Statistics, Economic Planning Agency
of Japan and N ihon K eizai Shimbun;
Money Stock: E con om ic Statistics
Monthly, Bank of Japan; Interest Rates
(Bank Lending R ate); Main E con om ic
Indicators, OECD; Government Re
ceipts (Tax and Stamp Revenue) and
Government Expenditures (Treasury
Cash Payments): Basic D ata fo r E c o
nom ic Analysis 1964, 1968, 1969, and
E conom ic Statistics Monthly, Statistics
Department of the Bank of Japan.
2See Arthur S. Goldberger, Econometric
Theory, (New York: John Wiley and
Sons, 1964) pp. 236-8 for further
discussion.

FEDERAL RESERVE BANK OF ST. LOUIS

SEPTEMBER, 1970

Table III

UNITED STATES
Monetary and Fiscal Influences on
Economic Activity
(Quarterly First Differences — Billions of Dollars)1
A Y t ; = oto + oci R + a.-> A e + 0 C3 A tx tt
Lags*

Period

Constant
Term

Monetary
Influence

cx0

Oil
(Sum)

Fiscal
Influences

a-z
(Sum )

11/1919 - 111/1969

t— 5

2.37
(.53)

.38
(.42)

.96
(1.81)

11/1919 - 11/1929

t— 4

111/1929 - M/1939

t— 4

111/1939 - IV / 1946

t— 6

1/1947 - IV/1952

t— 8

1/1953 - 111/1969

t— 6

1.13
(.15)
3.02
(•40)
128.62
(3.41)
- 3 0 4 .3 8
( - .19)
— 28.66
( - 4 .1 3 )

— .16
( - - ID
- 1 .3 7
( - .76)
- 4 3 .6 5
(- 3 .1 2 )
115.10
(.17)
9.74
(5.19)

1.17
( 82)
4.41
(1.44)
3.86
(6.06)
2.78
(.77)
— 1.74
(- 1 7 5 )

R2/
D-W

0t3
(Sum)
— .54
( - -50)
— 10.04
(- 2 .6 3 )
— 3.55
(- 1 .3 5 )
- 1 2 .0 7
(- 5 .9 9 )
— 9.25
(- 1 .5 3 )
— 1.02
( - -70)

South Africa — Gross Domestic
Product: South A frica R eview , Gov
ernment of South Africa; Money Stock:
International Financial Statistics, IMF;
Interest Rates (Treasury Bill Rate)
International Financial Statistics, IM F;
Government Receipts and Expendi
tures: International Financial Statis
tics, IMF.

.26
1.86**
.65
2.16
.31
1.84* *
.84
2.21
.59
2.78**
.63
1.97

OTHER DEVELOPED COUNTRIES

United Kingdom — Industrial Pro
duction Index and Consumer Price
Index, 1963 = 100: Main E con om ic
Indicators, OECD; Money Stock: In
ternational Financial Statistics, IMF;
Interest Rates (Long-term Govern
ment Bond Yield): International F i
nancial Statistics, IM F; Government
Receipts and Expenditures: Interna
tional Financial Statistics, IMF.

(Quarterly First Differences — -Billions of National Currency)1
A g n p = oto + ocj R +
Country and
Time Period

Lags*

A e + 0(3 A tx tt

Constant
Term

Monetary
Influence

ai
(Sum)

Fiscal
Influences
0(2

(Sum)

R2/
D-W

CX3
(Sum)

Canada
11/1953 - 11/1969

t- 2

— .69
(- 1 .3 4 )

.28
(2.44)

1.20
(1.14)

.92
(1.28)

.30
1.68

Germany
111/1960 - 11/1969

t— 7

— 4.16
( - .24)

2.66
(1.02)

— 4.03
( - .99)

— 2.83
( - .24)

.34
2.50

Japan
11/1957 - 11/1969

t— 5

2.96
(1.60)

— .37
(- 1 - 7 0 )

4.20
(3.53)

3.62
(-61)

South Africa
11/1955 - 1/1969

t— 6

— .09
(- 1 .3 4 )

.04
(2.22)

3.20
(4.15)

— 3.10
(- 2 .6 9 )

United Kingdom^
111/1954 - 11/1969

t— 8

— 1.03
(- 2 .3 1 )

.30
(3.22)

- 1 .4 9
(- 1 .5 3 )

.84
2.51 **
.47
1.93

.86
.40
2.38
(1.11)
N o te : Regression coefficients are the top figures; their “t ” statistics appear below each
coefficient, enclosed by parentheses. R 2 is the per cent of variation in the dependent
variable which is explained by variations in the independent variables. D-W is the
Durbin-Watson statistic.
t
A Y is measured as a proxy for economic activity because quarterly GNP data for
the U .S. are not available before 1947, and because quarterly GNP data for the
U.K. do not give statistically significant results. The proxy is equal to the Indus
trial Production Index, times the Consumer Price Index, times GNP in the base
year of the indexes. Gross Domestic Product (GDP) was used for South A frica.
ft
The tax variable is computed as follows:
Tx
A tx = A
) *Y
♦
**
1

United States — Industrial Produc
tion Index, 1957-59 = 100: Board of
Governors of the Federal Reserve Sys
tem; Consumer Price Index, 1957-59 =
100: United States Department of La
bor; Money Stock: Board of Governors
of the Federal Reserve System and the
Federal Reserve Bank of St. Louis;
Government Receipts and Expendi
tures: Daily Treasury Statem ent, Office
of the Secretary of the Treasury of the
United States and Federal Reserve
Bank of St. Louis.
In each case, the seasonally adjusted
series for gross national product, gross
domestic product, money stock, gov
ernment expenditures and government
receipts were used. The interest rate
series are not seasonally adjusted.
The seasonally adjusted industrial
production index and the unadjusted
consumer price index were used in
the construction of the proxy variable
(Y) which was used for the United
States and the United Kingdom.

Page 19

SUBSCRIPTIONS to this bank’s

R e v ie w

are available to the public without

charge, including bulk mailings to banks, business organizations, educational
institutions, and others. For information write: Research Department, Federal
Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166.