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REVIEW OF MONETARY POLICY IN 1977

HEARING
BEFORE THE

SUBCOMMITTEE ON
DOMESTIC MONETARY POLICY
OF THE

COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
NINETY-FIFTH CONGRESS
SECOND SESSION

JANUARY 30, 1978

Printed for the use of the
Committee on Banking, Finance and Urban Affairs

U.S. G O V E R N M E N T P R I N T I N G O F F I C E
22-761 O




WASHINGTON

: 1978

HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN A FFA IR S
H E N R Y S. R E U S S , Wisconsin, Chairman
T H O M A S L. A S H L E Y , Ohio
J. W I L L I A M S T A N T O N , Ohio
G A R R Y B R O W N , Michigan
W I L L I A M S. M O O R H E A D , Pennsylvania
F E R N A N D J. S T G E R M A I N , Rhode Island
C H A L M E R S P. W Y L I E , Ohio
H E N R Y B. G O N Z A L E Z , Texas
J O H N J. R O U S S E L O T , California
J O S E P H G. M I N I S H , N e w Jersey
S T E W A R T B. M c K I N N E Y , Connecticut
F R A N K A N N U N Z I O , Illinois
G E O R G E H A N S E N , Idaho
J A M E S M. H A N L E Y , N e w York
H E N R Y J. H Y D E , Illinois
R I C H A R D K E L L Y , Florida
P A R R E N J. M I T C H E L L , Maryland
W A L T E R E. F A U N T R O Y ,
C H A R L E S E. G R A S S L E Y , Iowa
District of Columbia
M I L L I C E N T F E N W I C K , N e w Jersey
S T E P H E N L. N E A L , North Carolina
J I M L E A C H , Iowa
J E R R Y M. P A T T E R S O N , California
N E W T O N I. S T E E R S , J r . Maryland
,
J A M E S J. B L A N C H A R D , Michigan
T H O M A S B. E V A N S , J r . Delaware
,
C A R R O L L H U B B A R D , J r . Kentucky
,
B R U C E F. C A P U T O , N e w York
J O H N J. L a F A L C E , N e w York
H A R O L D C. H O L L E N B E C K , N e w Jersey
G L A D Y S N O O N S P E L L M A N , Maryland
L E S A u C O I N , Oregon
P A U L E. T S O N G A S , Massachusetts
B U T L E R D E R R I C K , South Carolina
M A R K W . H A N N A F O R D , California
D A V I D W . E V A N S , Indiana
C L I F F O R D A L L E N , Tennessee
N O R M A N E. D ’M O U R S , N e w Hampshire
A
S T A N L E Y N. L U N D I N E , N e w York
E D W A R D W . P A T T I S O N , N e w York
J O H N J. C A V A N A U G H , Nebraska
M A R Y R O S E O A K A R , Ohio
J I M M A T T O X , Texas
B R U C E F. V E N T O , Minnesota
D O U G B A R N A R D , Georgia
W E S W A T K I N S , Oklah o m a
P a u l N e l s o n , Clerk and Staff D irector
M i c h a e l P . F l a h e r t y , Counsel
G r a s t y C r e w s II, Counsel
M e r c e r L . J a c k s o n , M in ority Staff D irector
G r a h a m T . N o r t h u p , D epu ty M in ority 'Staff D irector

S u b c o m m itte e o n D o m e s t ic M o n e ta r y P o l i c y

P A R R E N J. M I T C H E L L , Maryland, Chairman
G E O R G E H A N S E N , Idaho
S T E P H E N L. N E A L , North Carolina
H A R O L D C. H O L L E N B E C K , N e w Jersey
N O R M A N E. D ’M O U R S , N e w Hampshire
A
B R U C E F. C A P U T O , N e w York
D O U G B A R N A R D , Georgia
W E S W A T K I N S , Okla h o m a
B U T L E R D E R R I C K , South Carolina
M A R K W . H A N N A F O R D , California




(n;

CONTENTS

Statem ents

Christ, Carl F., professor o f economics, The Johns Hopkins U niversity—
Hunt, Lacy H., senior vice president and economist, The F idelity Bank &
Fidelcor, Inc_________________________________________________________
McKinney, George W., senior vice president, Irving Trust Co____________
Taub, Leon W., vice president, Chase Econometric A ssociates, ln e ___ __

Page
4
25
27
29

A d d it io n a l I n f o r m a t i o n S u b m it t e d f o r t h e R ecord

Christ, Carl F., prepared statem ent_______________________________ _____
Mitchell, Chairman Parren J., opening statem ent________________________
Taub, Leon W., prepared statem ent____________________________________

10
2
33

A p p e n d ix e s

Appendix I.— “Briefing Papers for Monetary Policy Oversight Hearings,”
prepared by staff, Subcommittee on Dom estic Monetary Policy, Janu­
ary 30, 1978_________________________________________________________
Appendix II.—Additional questions w ith responses from w itnesses--------Appendix III.—A nalysis and comments received from leading economists
regarding economic performance of the U.S. economy in 1977__________




(h i)

57
75
91

REVIEW OF MONETARY POLICY IN 1977
MONDAY, JA N UA R Y 30, 1978
H

o use

D

of

R

e p r e s e n t a t iv e s ,

S u b c o m m it t e e o n
M o n e t a r y P o l ic y o f t h e C o m m i t t e e
on B a n k in g . F in a n c e a n d U r b a n A f f a ir s ,

o m e s t ic

Washington, D.C.
The subcommittee met, pursuant to notice, at 10:10 a.m. in room
2128, Rayburn House Office Building, Hon. Parren J. Mitchell (chair­
man of the subcommittee) presiding.
Present : Representatives Mitchell, Barnard, Hansen, and Caputo.
Chairman M i t c h e l l . The hearing will now come to order, please.
For the benefit of my colleagues who have joined me, we had planned
an executive session this morning primarily to work up areas that we
need to examine during this second half of the 95th Congress, areas
of interest related to monetary policy. If you have not already sub­
mitted to my staff the areas that you would like to pursue and take a
look at this year, please do so as soon as you possibly can. Mr. Hansen,
the ranking minority member, has submitted his list of ideas in the
areas that we need to pursue.
Again, for the benefit of my colleagues and for our witnesses here,
our whip check revealed that most of the members of the subcommittee
will be here. Some went home to their districts over the weekend and
might be having travel problems because of the snow. Others had
early meetings. But I expect more members of the subcommittee to join
us.
I ask unanimous consent that my complete opening statement be
placed in the record.
Our purpose in meeting this morning is to receive testimony on the
performance of monetary policy last year. We will hear from four
experts. They have been selected from among the respondents to a let­
ter which I sent out last December. They were chosen so that we could
hear both from critics and praisers of the 1977 Federal Reserve policy
initiatives.
Since March 1975 the Federal Reserve has been required to appear
before the Congress on a quarterly basis and announce target growth
ranges for monetary aggregates. House Concurrent Resolution 133,
which was incorporated into the Federal Reserve Act as new section
2(A) last year, mandates the setting and disclosure of monetary growth
targets, in part to assist the Congress in its oversight responsibility of
the Federal Reserve System and in part to provide guidelines to avoid
the wide roller-coaster swings of money growth which have long
characterized our economy and intensified beginning in the mid­
sixties.
(1)




2
From the bottom of the 1975 recession until last spring, the Federal
Reserve had both announced and adhered to a moderate money growth
policy. This policy provided the financial framework and foundation
for a sustained economic recovery and a gradual deceleration of
inflation.
But since the spring of 1977, money growth has literally exploded,
greatly exceeding the Federal Reserve’s own target ranges. From the
fourth quarter of 1976 to the fourth quarter of 1977 our basic money
supply, Mi, grew by 7.4 percent. This is more than one-third faster
than the midpoint of the 4*4 to 6y2 percent target range which the
Federal Reserve itself had set for that period, as was disclosed to the
full House Banking, Finance and Urban Affairs Committee by Dr.
Burns last February.
Of the full committee, 31 of the 32 majority members agreed that
Mx growth of about 5y2 percent would be right for 1977. Plans were
made in the Congress by the Budget Committee, the Appropriations
Committee, and other committees, and by businesses, investors, and
consumers based on the assumption that the Federal Reserve would
adhere to and hit its own target for Mi growth. The miss was the most
significant financial event of 1977 and, obviously, the members of the
committee have followed the implications of this wide miss, as I am
certain have our witnesses.
I address that in my statement, and I will see to it that you get
copies of it. I will not take time to read all of it at this time, but it
seems to me one of the major results of that wide miss was to set the
stage once again for a recession.
I stated in October:
I am apprehensive that the course of money growth which the Federal R eserve
has been follow ing recently w ill create a false sense of euphoria for a wT
hile as
the monetary expansion stim ulates output, but inevitably inflation w ill soar
beginning in the latter part of 1978 or early 1979, and a deep recession w ill fol­
low shortly after. I think w e are on a collision path w ith another 1974-75 style
bout w ith stagflation.

Since I made that statement, nothing has happened to change my
mind. Perhaps I am wrong—and, frankly, I hope that I am wrong—
I don’t w
’ant to face another recession. Inflation hurts nearly everyone,
particularly those living on fixed incomes and too poor to own their
own homes. The impact of another recession would be devastating,
especially upon the poor, blacks, and the other minorities.
But the question is—and this is why we have asked you gentlemen
here—how do we avoid it? How do we sustain and enhance the re­
covery while at the same time decelerating inflation ?
I f rapid money growth won’t do the job, will gradual deceleration
work? Would slow deceleration work well enough to reduce black
unemployment below the double digit level and move toward parity
with white unemployment? How long would this take? What else,
apart from a sound monetary policy, do we need ? I am hopeful that
our witnesses today can provide answers to these admittedly difficult
but top priority questions.
[Chairman Mitchell’s opening statement follows:]
O p e n in g S t a t e m e n t of P a r r e n

J. M i t c h e l l , C h a i r m a n

The Subcommittee w ill please come to order. Our purpose in m eeting this
morning is to receive testim ony on the performance o f monetary policy last year.




3
We w ill hear from four experts. They have been selected from among the re­
spondents to a letter which I sent out in December. They w ere chosen so that
we could hear from both critics and praisers of 1977 Federal R eserve policy
initiatives.
Since March 1975, the Federal Reserve has been required to appear before the
Congress on a quarterly basis and announce target growth ranges for the mone­
tary aggregates. House Concurrent R esolution 133, which was incorporated into
the Federal R eserve Act as new Section 2A last year, m andates the setting and
disclosure of monetary growth targets, in part to assist the Congress in its over­
sight responsibility o f the Federal R eserve S y stem ; and in part, to provide guide­
lines to avoid the wide roller-coaster sw ings of money growth which have long
characterized our economy and intensified beginning in the mid-1960’s.
From the bottom of the 1975 recession until la st spring, the Federal Reserve
had both announced, and adhered to, a moderate money growth policy. T his
policy provided the financial framework and foundation for a sustained economic
recovery and a gradual deceleration o f inflation. B ut since the spring of 1977,
money growth has exploded, greatly exceeding the Federal Reserve’s own target
range. From the fourth quarter of 1976 to the fourth quarter o f 1977, our basic
money supply, M l, grew by 7.4 percent. T his is more than one-third faster than
the midpoint of the 4 y2 to 6 y2 percent target range which th e Federal Reserve
itself set for the period, as w as disclosed to the fu ll H ouse Banking Committee
by Dr. Burns last February. Thirty-one of the thirty-two m ajority members of
the full Committee agreed that M l growth o f about 5% percent would be right
for 1977. Plans were made in the Congress by the Budget, Appropriations and
other committees, and by businesses, investors and consumers, based on th e as­
sumption that the Federal R eserve would adhere to and h it its own target for
M l growth. The m iss w as the most significant financial event o f 1977. Let me
explain, very briefly, why.
Expenditures and receipts projections which w e made in the Congress were
thrown out o f whack. T he private sector had to adjust to an unexpected w ind­
fa ll of more than $5 billion in new money which w as generated by the step-up in
money growth. In itially, a step-up in money growth has beneficial effects. It in­
creases spending, and when there is slack in the economy, the rise in spending
speeds up the re-employment of labor and the recovery of production. B ut experi­
ence warns us that if long continued, the step-up in money growth may boomer­
ang, and cause unintended and harm ful changes. Though w ith a lag, it w ill cause
prices to increase faster than they otherw ise would. Accepting increased infla­
tion later on for current increases in production and employment would be a
tolerable trade-off if inflation was the only cost of excessively rapid money
growth. B ut it isn’t.
Even before inflation increases, the expectation o f it feeds back into credit
m arkets and causes longer term interest rates to rise. By itself, that would be
damaging to investm ent in productivity enhancing, job creating, long range capi­
tal projects. But, in addition, short term rates may rise long before inflation
actually accelerates. This is because market psychology may view any recent
step-up in money growth as giving the Federal Reserve less room to maneuver
in the near future, thus portending a near term liquidity squeeze. This would
appear to have happened in 1977. Both short and long term interest rates rose
very nearly in phase w ith the step-up in money growth.
The boomerang doesn’t stop in credit markets. It has real as w ell as financial
effects. As first interest rates and then inflation rise, the demands for housing,
for automobiles and for all other goods fa ll and profit margins narrow’. Produc­
tion and employment are cut back. The end result is recession.
I stated in October that, “I am apprehensive that the course of money growth
which the Federal Reserve has been follow ing recently w’ill create a false sense
of euphoria for a w hile as the monetary expansion stim ulates output. B ut in­
evitably inflation w ill soar, beginning in the latter part of 1978 or early 1979
and a deep recession w ill follow shortly after. We are on a collision path w ith
another 1974-1975 style bout w ith stagflation.”
Nothing has happened since then to change my mind. Perhaps I am wrong.
Frankly, I hope so. The country can’t stand more inflation or another recession.
Inflation hurts nearly everyone, and particularly those living on fixed incomes
and too poor to own their own homes. The impact of another recession would be
devastating, especially on blacks and other minorities. But, how do w^e avoid it?
How do we sustain and enhance the recovery w hile at the same time decelerating
inflation? I f rapid money growth won’t do the job, w ill gradually decelerating




4
it work? Would slow deceleration work w ell enough to reduce black unemploy­
ment below the double digit level, towards parity w ith w hite unemployment?
How long would it take? W hat else, apart from a sound monetary policy, do
w e need? I am hopeful that our w itnesses today can provide answers to these
difficult, top priority questions.

Chairman M i t c h e l l . I will ask whether any of the members have an
opening statement that they want to make. Mr. Barnard ?
Mr. B a r n a r d . Mr. Chairman, I have no opening statement prepared
to make except to say this:
I am delighted to have you gentlemen appear before the subcom­
mittee this morning. As a member of this subcommittee and as a Mem­
ber of Congress I don’t know of any problem that we face in this coun­
try today more serious than the problem of inflation. We have many
remedies that seem to be coming to us from various standpoints as to
what we can do about it, but none of them really seem to be working.
I am looking at these hearings with much interest to see what the
analysis has been for 1977, what the forecast will be for 1978, and what
we need to be doing about this problem.
If you have not already prepared to do so, I would hope that some
of you would address the subject of our $500-billion proposed budget.
I hear some economists saying that Government spending in times of
growth periods does not contribute to inflation.
Gentlemen, I am not an economist, but I can’t believe that.
I think it is something that all of Congress should be very mindful
of as we consider this year’s budget, and that sensitive relationship to
what I feel is one of the greatest problems we have in this country
today.
Mr. Chairman, I say that as an introduction to these hearings, and
thank you very much.
Chairman M i t c h e l l . Thank y o u .
And before I ask Mr. Caputo, a very able member of the subcom­
mittee, if he has a statement, let me take this opportunity to publicly
thank the members of the subcommittee. You made the chairman’s task
much easier last year because of your cooperation and support, and I
do thank all of the members of the subcommittee. Mr. Caputo.
Mr. C a p u t o . I have no statement, Mr. Chairman.
Chairman M i t c h e l l . All right, gentlemen, then let me ask y o u to
proceed in alphabetical order, starting with Professor Christ.
It is obvious from my opening statement and the statement of my
colleague that we have many questions. You may wish to encapsulate
your testimony. Each of you, of course, will be allowed to submit what­
ever statement you want for the record, and if there is no objection, it
will be printed in the hearing record.
With that little bit of background, you may proceed, Mr. Christ.
And, indeed, we do welcome you and all of the witnesses here this
morning.
STATEMENT OP CARL F. CHRIST, PROFESSOR OF ECONOMICS, THE
JOHNS HOPKINS UNIVERSITY

Mr. C h r i s t . Thank you very much, Mr. Chairman.
I have prepared a statement which will take about 15 minutes, but
I see in your opening statement you would like us to limit ourselves
to 5 minutes, so I will try to do that.




5
Chairman M i t c h e l l . I struck that from my remarks because I had
some question about trying to limit witnesses to just 5 minutes, so it
seems to me, if your statement will take only 15 minutes, we can pro­
ceed with it.
Mr. C h r i s t . All right. Thank you.
There are some charts at the end which I believe will be useful
to print in the record, if that could be done.
The statement I want to make comes in nine topics, each of them
quite brief.
First, a profoundly important feature of monetary policy is that it
has different effects in the long run and in the short run. The shortrun effect is concentrated on real output and employment; the longrun effect is concentrated on prices and inflation.
The second topic is the long-run effect. If monetary policy keeps
the average annual growth of the money stock low but above zero
over a long period of time, there will be little or no trend in the price
level over that period, either up or down.
For example, from 1948 to 1961 the money stock grew at only 2
percent a year on the average. This was true for both the monetary
base and Mi, which is currency outside banks plus demand deposits.
Even M2, which is Mx plus time deposits at commercial banks, grew
at only about 3 percent a year then. During that same period, infla­
tion was at an average rate of 2 percent a year as measured by the
Consumer Price Index.
By contrast, from 1971 to 1977 the average annual growth rates
were 6 percent for Mt, 8 percent for the monetary base, and 9 per­
cent for M2. During that period inflation averaged 7 percent a year
as measured by the Consumer Price Index.
These relationships are universal. A stable price level can be had
over long periods if, and only if, the average growth rate of the money
stock is kept low. Similarly, rapid inflation will persist if, and only
if, the average rate of growth of the money stock is kept high. The
experience of many countries confirms this, over many centuries. I
know of no evidence to the contrary.
The third topic is the short-run effect of monetary policy.
When the growth rate of the money stock is increased, and then the
new higher growth rate is maintained, the initial effect is to create a
temporary increase in real output and employment, lasting for per­
haps 2 or 3 or 4 years. But that effect then wears off and we are left
with the long-run effect, which is a higher rate of inflation.
Similarly, when the growth rate or the money stock is reduced, and
then the new lower growth rate is maintained, the initial effect is to
cause a temporary decrease in output and employment, again lasting
for perhaps 2 or 3 or 4 years. That effect then wears off and we are left
with the long-run effect, which is a lower rate of inflation. Both theoret­
ical and empirical economic studies are pointing more and more
strongly to this conclusion.
The fourth topic is an analogy which I have concocted to show how
monetary policy works.
The effect of monetary policy on the economy can be likened to the
effect of a certain type of therapeutic drug on a patient. The patient
has an annoying condition, which can be helped by putting him on a
steady daily dosage of the drug, that is, helped temporarily until his




6
body adjusts to that dosage of the drug, and then he is helped no
longer. But he is now saddled with the cost and the side effects of that
daily dosage of the drug. I f he is to be helped by the drug at this point,
the daily dosage must be increased. He then again experiences relief
temporarily, until his body once again adjusts to the new. higher dos­
age. And so on. If he wants to be free of the cost and the side effects of
the daily dosage, his doctor can take him off the drug, but that must be
done carefully in order to minimize the withdrawal reaction that oc­
curs. I have consulted with a distinguished pharmacological colleague
at Johns Hopkins who tells me there are indeed many drugs of this
type.
The analogy is quite close between the effects of such a drug on the
body and the effects of monetary policy on the economy.
Monetary policy does offer an increase in the growth rate of the
money stock as a remedy for an unemployment rate higher than the
minimum boom-time rate, but it works only temporarily. Its good ef­
fect soon wears off, and its ill effect persists, namely, a higher inflation
rate.
In order to regain the good effect, one must increase the dosage of
the remedy, that is, increase the growth rate of the money stock fur­
ther. But again the good effect wears off, and the ill effect, the infla­
tion, becomes greater. In order to be rid of the inflation, it is necessary
to withdraw the remedy, that is, it is necessary to return the growth
rate of the money stock to a low level. But that has to be done care­
fully, because it can cause withdrawal symptoms in the form of a
temporary economic recession.
Since the good effects of an increase in the growth rate of the
money stock are only temporary, while the bad effects are permanent,
it is wise not to embark on a policy of rapid growth of the money stock
in the first place. Now that we have done so, over the past 10 to 15
years, it is wise to withdraw that drug carefully, so as to return to a
situation of stable prices. We should seek other remedies than mone­
tary policy when we try to reduce the rate of unemployment.
The fifth topic is interest rates. It is important to consider interest
rates when conducting monetary policy. In doing so, we must realize
that here, too, short-run and long-run effects differ.
We know that if the growth rate of the money stock is increased,
the initial effect on interest rates is to lower them. This helps to bring
about the increase in output and employment mentioned earlier, but
that reduction in interest rates is only temporary.
Furthermore, if the growth of the money stock is continued at the
new higher rate, then the inflation rate increases. And when that hap­
pens, interest rates not only go back up to their previous levels, they
go up more than that, and end up higher than they were to begin with.
This is because both borrowers and lenders come to expect that
the more rapid inflation will continue, and so they agree upon interest
rates that are high enough to give a real return to the lender after
adjusting for inflation.
For example, if they agree on a real return of 4 percent, then they
will agree on an interest rate of 9 percent if they expect the inflation
rate to be 5 percent. This example illustrates the main reason why
mortgage interest rates and other interest rates are higher now then
they were in the fifties when inflation was nearly zero.




7
Thus we see that in order to have low interest rates in the long
run, we must have a low inflation rate in the long run. So the way to
bring interest rates permanently down to their traditional low levels
of the fifties and earlier is to bring the inflation to a stop.
The sixth topic is the details of monetary policy in 1977.
The growth rate of the monetary base in 1977 was about 9 percent.
It had been very steady over the past 6 years at about 8 percent, and
was increased slightly in 1977. Thus one can say that from 1971 to 1977
the monetary base was managed in such a way as to insure the con­
tinuation of inflation at a rate in the neighborhood of 6 to 8 percent
with a slight additional inflationary stimulus added in 1977.
The growth rates of Mi and M2 were broadly consistent with this
pattern. In 1977 Mi grew at about 7 percent and M2at about 9 percent.
As noted earlier, from 1971 to 1977 the growth rates were about 6
percent for Mi and 9 percent for M2.
During 1977 and also on the average from 1971 to 1977, the Consumer
Price Index inflation rate was about 7 percent.
What about interest rates in 1977 ?
They rose.
Short-term rates rose from the 4y2 to 5 percent range at the beginning
of the year to the 6 to 7 percent range at the end. Long-term rates rose
also from about 8 percent at the beginning of the year to about 8%
percent at the end.
In my view, this does not represent the effect of any change in the
basic stance of monetary policy. There virtually was no such change,
only a slight increase in monetary growth. Rather, it represents the
adjustment of financial markets to the continuance of inflation at
7 percent a year, combined with the normal cyclical increase of in­
terest rates during a business recovery.
At the beginning of 1977 the real rates of return on short- and
medium-term debt were negative because their interest rates were
below the inflation rate of 7 percent. By the end of the year the com­
bination of the business recovery and the adjustment to a 7 percent
inflation had brought real short-term interest rates up to zero, and
real medium-term rates up to about plus 1 percent. If monetary policy
maintains the growth rate of the monetary base at 8 or 9 percent a
year in the future, interest rates will rise somewhat more and will
settle somewhat above 8 or 9 percent in or near the 10- to 14-percent
range.
Why w
rere the growth rates of the various money stocks increased
slightly in 1977 rather than being held constant or reduced slighty ?
Not being a member of the Federal Reserve Board or the Open Market
Committee, I can only guess. My guess is that it was out of fear of
further short-run increases in interest rates. However, if the aim is
to reduce interest rates, this was a short-sighted policy, for it will
result in higher interest rates once the economy adjusts to the faster
monetary growth and the attendant faster inflation.
The seventh topic is short-run changes in monetary policy.
For judging short-run changes in monetary policy, some economists
prefer to look at Mi and/or M2 rather than the monetary base. We
have seen that the monetary base grew very steadily during 1971-77,
at about 8 percent a year. M2 grew less steadily, as fast as 11 percent




8
for 12 months in 1976-77 and as slow as 7 percent for 12 months in
1974-75. Mi grew still less steadily, as fast as 8 percent for 12 months
in 1972 and as slow as 3 percent for 9 months in 1974-75; it even
declined for 3 months in 1974-75. Some economists argue that it would
be better to prevent substantial variations in the rate of growth of Mi
and/or M2, and at the very least to prevent declines in either one
during depressions. The Federal Reserve has not pursued such a
policy thus far. I believe it would be more likely to be helpful than
harmful. Nevertheless, the Federal Reserve should receive some credit
for not allowing the growth rate of the monetary base to undergo a
down-and-up cycle during the depression of 1974-75. This is ai* im­
provement over the Federal Reserve’s management during previous
business cycles.
Could monetary policy be used in a deliberately countercyclical
way, to inflate the economy during depressions and deflate it during
booms ?
This seems possible in principle. But remember that the output
effects of a change in monetary policy, though temporary, last for 2
or 3 or 4 years. Furthermore, we do not have good reliable knowledge
of just how long they last, and indeed their duration does not appear
to be the same in all cases. Most complete business cycles last about 3
to 5 years, 1 or iy 2 years for the downswing and 2 to 4 years for the
upswing. This means that by the time we recognize the need for a
policy change to combat a depression or soften a boom, it is already
too late to do so by means of monetary policy.
An easy monetary policy, undertaken when a downswing is clearly
upon us, is more likely to aggrevate the next boom than to help com­
bat the downswing. Similarly, with tight money that is imposed when
a boom appears to be getting excessive; it is more likely to aggravate
the next depression than to soften the boom.
Therefore, until economists develop truly reliable ways of fore­
casting when the next boom or depression will be, and how long the
output effects of each monetary policy change will last, it is better
to keep the growth rate of the money stock rather steady throughout
both booms and depressions.
The eighth topic deals with the relation of fiscal policy to monetary
policy.
This hearing is about monetary policy. Of course, monetary policy
is not the only force that affects the economy. Fiscal policy is another
important force, and the two are related.
When the Federal budget has a deficit the Treasury must sell bills
and bonds to cover it. The Federal Reserve has a choice as to whether
to buy some of those bills and bonds or not. If they don’t, the mone­
tary base is not increased, and inflation does not result. But then the
Treasury must compete with private borrowers in the market, which
will drive interest rates up, especially if the deficit is large. Govern­
ment borrowing may then crowd out private borrowing and hence in­
hibit business investment that is needed for growth.
On the other hand, if the Federal Reserve does buy some of those
Treasury bills and bonds, the monetary base is increased, and if it is
done on a large scale, inflation will result.
Therefore, a large continuing Federal deficit presents dangers.
Either the Federal Reserve does succumb to the pressure to hold down




9
interest rates in the short run, which leads to inflation and high interest
rates in the long run, or the Federal Reserve resists the pressure, which
leads to high interest rates immediately and to the crowding out of
private investment, though not to inflation.
The ninth point is the conclusion. My testimony can be summarized
as follows:
Monetary policy can assure long-run stability of the price level. Or
it can assure long-run inflation. It cannot provide a permanent stimu­
lus to output and employment, except at the cost of ever-increasing
doses of monetary growth and ever-accelerating inflation. And mone­
tary policy is not a very good tool for trying to counteract business
cycles, because its effects operate with a delay that is too long and too
unpredictable.
Hence, in our present state of knowledge the best monetary policy
is to keep the growth rate of the money stock low, to avoid inflation,
and keep it rather steady to avoid magnifying the disturbances that
come from other causes.
Are we then helpless to deal with business depressions and unem­
ployment? I think not. But that would lead us beyond the topic of
this hearing today.
Thank you very much.
[Mr. Christ’s prepared statement, with attached charts, follows:]




10
STATEMENT Or CARL F. CHRIST
ALBERT HUTZLER PROFESSOR OF ECONOMICS
THE JOHNS HOPKINS UNIVERSITY
prepared for
HEARING ON MONETARY POLICY IN 1977
U.S. HOUSE OF REPRESENTATIVES
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
of the
COMMITTEE ON BANKING, FINANCE, AND URBAN AFFAIRS

I am glad to be here today to discuss monetary policy in 1977.
1.

Long and Short Run Effects of Monetary Policy
A profoundly important feature of monetary policy is that it has

different effects in the short run and in the long run.
effect is concentrated on real output and employment.

The short run
The long run effect

is concentrated on prices and inflation.
2.

Long Run Effect

of Monetary Policy

Consider the long run effect first.

If monetary policy keeps the

average annual growth rate of the money stock low over a long period of
time, then there will be little or no trend in the price level over that
period, either up or down.

For example, from 1948 to 1961 the money stock

grew at only about 2 percent a year on the average.
both the monetary base and

This was true for

(currency outside banks plus demand deposits).

Even M 2 (M^ + time deposits at commercial banks) grew at only about 3
percent a year then.

During that same period, inflation was at an average

rate of 2 percent a year as measured by the consumer price index (CPI).




11
By contrast, from 1971 to 1977 the average annual growth rates were
6 percent for M^, 8 percent for the monetary base, and 9 percent for M 2 .
During that period, inflation averaged 7 percent a year as measured by the
CPI.
These relationships are universal.

A stable price level can be had

over long periods if, and only if, the average growth rate of the money
stock is kept low.

Similarly, rapid inflation will persist if, and only

if, the average rate of growth of the money stock is kept high.

The

experience of many countries confirms this, over many centuries.

I know

of no evidence to the contrary.
3.

Short Run Effect

of Monetary Policy

Now consider the short run effect of monetary policy.

When the growth

rate of the money stock is increased, and then the new higher growth rate is
maintained, the initial effect is to create a temporary increase in real
output and employment, lasting for perhaps 2 or 3 or 4 years.

But that

effect then wears off, and we are left with the long run effect, which is
a higher rate of inflation.

Similarly, when the growth rate of the money

stock is reduced, and then the new lower growth rate is maintained, the
initial effect is to cause a temporary decrease in output and employment,
again lasting for perhaps 2 or 3 or A years.

That effect then wears off,

and we are left with the long run effect, which is a lower rate of. inflation.
Both theoretical and empirical economic studies are pointing more and mo r e
strongly to this conclusion.




12
4.

Monetary Policy and Drug Therapy
The effect of monetary policy on the economy can be likened to the

effect of a certain type of therapeutic drug on a patient.

The patient

has an annoying condition, Xirtvich can be helped by putting him on a steady
daily dosage of the drug — that is, helped temporarily until his body
adjusts to that dosage of the drug, and then he is helped no longer.

But

he is now saddled with the cost and the side effects of that daily dosage
of the drug.

If he is to be helped by the drug at this point, the daily

dosage must be increased.

He then again experiences relief temporarily,

until his body once again adjusts to the new higher dosage.

And so on.

If he wants to be free of the cost and the side effects of the daily
dosage, his doctor can take him off the drug, but that must be done care­
fully in order to minimize the withdrawal reaction that occurs.

I have

consulted with a distinguished pharmacological colleague at Johns Hopkins
who tells me there are indeed many drugs of this type.
The analogy is quite close between the effects of such a drug on the
body and the effects of monetary policy on the economy.

Monetary policy

does offer an increase in the growth rate of the money stock as a remedy
for an unemployment rate higher than the minimum boom-time rate, but it
works only temporarily.

Its good effect soon wears off, and its ill effect

persists, namely, a higher inflation rate.

In order to regain the good

effect, one must increase the dosage of the remedy, that is, increase
the growth rate of the money stock further.

But again the good effect

wears off, and the ill effect (the inflation) becomes greater.

In

order to be rid of the inflation, it is necessary to withdraw the remedy,
that is, it's necessary to return the growth rate of the money stock to a




13
low level.

But that has to be done carefully, because it can cause with­

drawal symptoms in the form of a temporary economic recession.
Since the good effects of an increase in the growth rate of the money
stock are only temporary, while the bad effects are permanent, it is
wise not to embark on a policy of rapid growth of the money stock in the
first place.

Now that we have done so, over the past 1 0 to 15 years, it

is wise to withdraw that "drug" carefully, so as to return to a situation
of stable prices.

We should seek other remedies than monetary policy when

we.try to reduce the rate of unemployment.
5.

Interest Rates
It is important to consider interest rates, when conducting monetary

policy.

In doing so, we must realize that here, too, short run and long

run effects differ.
We know that if the growth rate of the money stock is increased, the
initial effect on interest rates is to lower them.

(This helps to bring

about the increase in output and employment mentioned earlier.)

But that

reduction in interest rates is only temporary.
Furthermore, if the growth of the money stock is continued at the new
higher rate, then the inflation rate increases.

And w h e n that happens,

interest rates not only go back up to their previous levels, they go up
more than that, and end up higher than they were to b e gin with.

This is

because both borrowers and lenders come to expect that the more rapid
inflation will continue, and so they agree upon interest rates that are
high enough to give a real return to the lender after adjusting for inflation.

22-861 0 - 78 - 2




14
For example, if they agree on a real return of 4 percent, then they will
agree on an interest rate of 9 percent if they expect the inflation rate
to be 5 percent.

This example illustrates the main reason why mortgage

interest rates and other interest rates are higher now than they were in
the 1950's when inflation was nearly zero.
Thus we see that in order to have low interest rates in the long run,
we must have a low inflation rate in the long run.

So the way to bring

interest rates permanently down to their traditional low levels of the
1950's and earlier is to bring the inflation to a stop.
6.

Monetary Policy in 1977
Now let us look at monetary policy in 1977.

monetary base in 1977 was about 9 percent.

The growth rate of the

It had been very steady over

the past 6 years at about 8 percent, and was increased slightly in 1977.
Thus one can say that from 1971 to 1977 the monetary base was managed in
such a way as to insure the continuation of inflation at a rate in the
neighborhood of 6 to 8 percent, with a slight additional inflationary
stimulus added in 1977.
The growth rates of M^ and M 2 were broadly consistent with this
pattern.

In 1977 M^ grew at about 7 percent, and M 2 at about 9 percent.

As noted earlier, from 1971 to 1977 the growth rates were about 6 percent
for M^ and 9 percent for M 2 .
During 1977, and also on the average from 1971 to 1977, the CPI
inflation rate was about 7 percent.




15
What about interest rates in 1977?

They rose.

Short terra rates

rose from the 4£ - to - 5 percent range at the beginning of the year to
the 6 - to - 7 percent range at the end.

Long term rates rose also, from

about 8 percent at the beginning of the year to about 8% percent at the
end.

In my view, this does not represent the effect of any change in the

basic stance of monetary policy.

There virtually was no such change, only

a slight increase in monetary growth.

Rather, it represents the adjustment

of financial markets to the continuance of inflation at 7 percent a year,
combined with the normal cyclical increase of interest rates during business
recovery.

At the beginning of 1977, the real rates of return on short

and medium term debt were negative, because their interest rates were
below the inflation rate of 7 percent.

By the end of the year, the

combination of the business recovery and the adjustment to a 7 percent in­
flation had brought real short term interest rates up to zero, and real
medium term rates up to about +1 percent.

If monetary policy maintains

the growth rate of the monetary base at 8 or 9 percent a year in the
future, interest rates will rise somex^hat more, and will settle somewhat
above 8 or 9 percent, in or near the 10 - to - 14 percent range.
Why were the growth rates of the various money stocks increased slightly
in 1977, rather than being held constant, or reduced slightly?

Not being

a member of the Federal Reserve Board or the Open Market Committee, I can
only guess.

My guess is that it was out of fear of further short-run

increases in interest rates.

However, if the aim is to reduce interest

rates, this was a short-sighted policy, for it will result in higher
interest rates once the economy adjusts to the faster monetary growth and
the attendant faster inflation.




16
7.

Short-Run Changes in Monetary Policy
For judging short-run changes in monetary policy, some economists

prefer to look at M^ and/or M^ rather than the monetary base.

We have

seen that the monetary base grew very steadily during 1971-77, at about
8 percent a year.

M 2 grew less steadily, as fast as 11 percent for 12

months in 1976-77 and as slow as 7 percent for 12 months .In 1974-75.

M^

grew still less steadily, as fast as 8 percent for 12 months in 1972 and as
slow as 3 percent for 9 months in 1974-75; it even declined for 3 months
in 1974-75.

Some economists argue that it would be better to prevent

substantial variations in the rate of growth of M^ and/or M 2 , and at least
to prevent declines in either one during depressions.
has not pursued such a policy thus far.
to be helpf\il than harmful.

The Federal Reserve

I believe it would be more likely

Nevertheless, the Federal Reserve should

receive some credit for not allowing the growth rate of the monetary base
to undergo a down-and-up cycle during the depression of 1974-75.

This is

an improvement over the Federal Reserve’ management during previous
s
business cycles.
Could monetary policy be used in a deliberately countercyclical way,
to inflate the economy during depressions and deflate it during booms?
This seems possible in principle.

But remember that the output effects

of a change in monetary policy, though temporary, last for 2 or 3 or 4
years.

Furthermore, we do not have good reliable knowledge of just how

long they last, and indeed, their duration does not appear to be the same in
all cases.

Most complete business cycles last about 3 to 5 years, 1 or 1^

years for the downswing and 2 to 4 years for the upswing.




This means that

17
by the time vo. recognize the need for a policy change to combat a depression
or soften a boom, it is already too late to do so by means of monetary policy.
An easy monetary policy, undertaken when a doxmswing is elcarly upon us, is
more likely to aggravate the next boom than to help combat the downswing.
Similarly with tight money that is imposed when a boom appears to be
getting excessive; it is more likely to aggravate the next depression than
to soften the boom.

Therefore, until economists develop truly reliable ways

of forecasting when the next boom or depression wili be, and I
k

w

long the

output effects of monetary policy changes will last, it is better to keep
the growth rate of the money stock rather steady throughout both booms and
depressions.
8.

The Relation of Fiscal Policy to Monetary Policy
This hearing is about monetary policy.

the only force that affects the economy.
force, and the two are related.

Of course, monetary policy is not

Fiscal policy is another important

When the Federal budget has a deficit, the

Treasury must sell bills and bonds to cover it.

The Federal Reserve has a

choice as to whether to buy some of those bills and bonds, or not.

If they

d o n ’ the monetary base is not increased, and inflation does not result.
t,
But then the Treasury must compete with private borrowers in the market,
which will drive interest rates up, especially if the deficit is large.
Government borrowing may then crowd out private borrowing and hence inhibit
business investment that is needed for growth.
On the other hand, if the Federal Reserve does buy some of those
treasury bills and bonds, the monetary base is increased, and if it is done




18
on a large scale, inflation will result.
Therefore, a large continuing Federal deficit presents dangers.
Either the Federal Reserve does succumb to the pressure to hold down
interest rates in the short run, which leads to inflation and high
interest rates in the long run, or the Federal Reserve resists the pressure,
which leads to high interest rates immediately and to the crowding out of
private investment, though not to inflation.
9.

Conclusion
My testimony can be summarized as follows.

long-run stability of the price level.

Monetary policy can assure

Or it can assure long-run inflation.

It cannot provide a permanent stimulus to output and employment, except at
the cost of ever-increasing doses of monetary growth and ever-accelerating
inflation.

And it is not a very good tool for trying to counteract

business cycles, because its effects operate with a delay that is too long
and too unpredictable.

Hence the best monetary policy is to keep the growth

rate of the money stock lo w , to avoid inflation, and rather steady, to avoid
magnifying the disturbances that come from other causes.
Are we then helpless to deal with business depressions and unemployment?
I think not.

But that would lead us beyond the topic of this hearing today.




19

AND

MONETARY BASE
ADJUSTED FEDERAL RESERVE

RATIO SCALE
monthly
B I L L I O N S OF D O L L A R S

1972

1973

a v e r a g e s of d a i l y f i g u r e s
seasonally

1974

adjusted

1975

CREDIT

RATIO SCALE
B I L L I O N S OF D O L L A R S

1976

1977

LLUSES OF T H E M O N E T A R Y B A S E A R E M E M B E R B A N K R E S E R V E S A N D C U R R E N C Y H E L D B Y T H E
PUB L I C AND N O N M E M B E R BANKS. A D J U S T M E N T S ARE M ADE FOR R E S E R V E R E Q U I R E M E N T
C H A N G E S A N D S H I F T S IN D E P O S I T S A M O N G C L A S S E S O F B A N K S . D A T A A R E C O M P U T E D B Y
T HIS BANK.
^ F E D E R A L R E S E R V E C R E D I T C O N S I S T S OF F E D E R A L R E S E R V E H O L D I N G S OF S E C U R I T I E S ,
L O A N S , F L O A T A N D O T H E R A S S E T S . A D J U S T E D F E D E R A L R E S E R V E C R E D I T IS C O M P U T E D
BY S U B T R A C T I N G T R E A S U R Y D E P O S I T S A T F E D E R A L R E S E R V E B A N K S F R O M T H I S S E R I E S ,
AND A D J U S T I N G THE S E R I E S FOR R E S E R V E R E Q U I R E M E N T RAT I O C H A N G E S AND S H I F T S
IN T H E S A M E T Y P E O F D E P O S I T S B E T W E E N B A N K S W H E R E D I F F E R E N T R E S E R V E R E Q U I R E ­
MENT R A T I O S APPLY. DATA ARE C O M P U T E D BY THIS BANK.
P E R CENTAGES ARE ANNUAL
LATEST

DATA PLOTTED:




R A T E S OF C H A N G E F O R P E R I O D S

INDICATED.

NOVEMBER
P R E P A R E D BY F E D E R A L

R E S E R V E B A N K OF S T . L O U I S

20
M O N EY S T O C K ( Mi )
RA T I O SCALE

R A T I O SCALE

m o n t h l y a v e r a g e s of d a i l y f i g u r e s

P E R C E N T A G E S A R E A N N U A L R A T E S OF C H A N G E F O R P E R I O D S
L A TEST DATA PLOTTED!

I N D ICATED.

NOVEMBER
P R E P A R E D B Y F E D E R A L R E S E R V E B A N K OF S T . L O U IS

MONEY

STOCK

PLUS

NET

TIME

DEPOSITS

( M 2 > U"

R AT IO SCALE
RA T IO SCALE
MONTHLY AVERAGES OF DAILY FI CURES
B I L L I O N S OF D O L L A R S
SEASONALLY ADJUSTED
^ I L L ' I O N S OF D O L L A R S
820
800
780

*10. !Z/y

760

+> 0 . 9 z /

740
720
700

y
*9. 4ZS*
V s

680
660
640

y

620
600

/S

_

4/ X ^/0 2 .«
/

/ /
/ /
V
T

680
660
640
620
600

r'

580
560

540

540

■nO. l z /

AS
/ /

520 -

520

y

5
=
%

480 r

/sr en w
r.

460

740
720

560

500

760

700

*8. rz

580

820
800
780

,

$
t.

%

♦

♦

1

' 5 ................. 5i------s^ —

§
1.

,

J_.

t

A

500
480
460

U.CURRENCY, DEMAND DEPOSITS. SAVINGS DEPOSITS, TIME DEPOSITS OPEN ACCOUNT PLUS
TIME C E RTIFICATES OF DEPOSIT OTHER THAN NEGOTIABLE TIME CERTIFICATES OF DE­
POSITS ISSUED IN DENOMINATIONS OF *100,000 OR MORE BY LARCE WEEKLY REPORTING
COMMERCIAL BANKS.
PERCENTAGES ARE ANNUAL RATES OF CHANGE FOR PERIODS INDICATED.
LATEST DATA PLOTTEDt NOVEMBER




PREPARED BY FEDERAL RESERVE BANK OF ST.LOUIS

21
MONEY MARKE T R A T E S
PERCENT

M O N T H L Y A V E R A G E S OF D A I L Y F I G U R E S

LATEST DATA PLOTTED.

PERCENT

NOVEMBER
P R E P A R E D B Y F E D E R A L R E S E R V E B A N K OF S T . L O U IS

LONG-TERM

197 2

1 973

U.FHA 9 0 - Y E A R M O R T G A G E S .

IN T E R E S T RATES

1 974
DASHED LINES

19 7 5

1 97 6

19 77

INDICATE DATA NOT AVAILABLE.

U M O N T H L Y A V E R A G E S OF T H U R S D A Y F I G U R E S .
13A V E R A G E OF Y I E L D S O N C O U P O N I S S U E S DU E O R C A L L A B L E IN TE N Y E A R S OR MORE,
E X C L U D I N G I S S U ES W I T H F E D E R A L E S T A T E T A X P R I V I L E G E S .
YIELDS ARE COMPUTEO
B Y T H I S BAN K .
LATEST DATA PLOTTEDt




FHA-OCTOBERt OTHERS-NOVEMBER
P R E P A R E D B Y F E D E R A L R E S E R V E B A N K OF S T . L O U I S

22
PRICES

R A T I O SCALE

RAT I 0 SCALE

PERCENTAGES ARE ANNUAL RATES OF CHANGE FOR PERIODS INDICATED.
LATEST DATA PLOTTED, NOVEMBER

R A T I O SCALE

pR£ p m | ) By FEDERAL RESERVE SANK OF ST. LOUIS

W HOLE SALE PRICES

1967-100

SEASONALLY ADJUSTED

R A T I O SCALE
1967-100

PERCENTAGES ARE ANNUAL RATES OF CHANGE FOR PERIODS INDICATED.
LATEST OATA PLOTTED' NOVEMBER




PREPARED BY FEOERAL RESERVE BANK OF ST. LOUIS

23
DEMAND AND P ROD UCT ION
RATIO SCALE
QUARTERLY TOTALS
T R I L L I O N S OF D O L L A R S
SEASONALLY
2

.

AT A N N U A L
ADJUSTED

RATIO SCALE
T R I L L I O N S OF D O L L A R S

RATES

1.
0.
0.
1
1.
1.
0.
1969

1970

1971

1972

1973

1974
SOURCE.

H6NP

1975
U.S.

1976

19 77

DEPARTMENT OF COMMERCE

IN C U R R E N T D O L L A R S .

I2.6NP IN 1 0 7 2 O O L L A R S .
P E R C E N T A G E S A R E A N N U A L R A T E S OF C H A N G E F O R P E R I O D S
LATEST DATA PLOTTEDt




3RD Q UA RT ER

INDICATED.

P R E P A R E D B Y F E D E R A L R E S E R V E B A N K OF ST.

LOUIS

0.8

24
EMPLOYMENT
RATIO

SCALE

1969

RATIO

1970

1971

1 9 72

1 9 73

1 97 4

1975

1976

SCALE

1 97 7

SOURCE: U.S.DEPARTMENT OF LABOR
PERCEN T A G E S ARE ANNUAL RATES OF CHANGE FOR PERIODS INDICATED.
LATEST DATA PLOTTEO: N OVEMBER PRELIM I N A R Y
RE VISED FROM 1972.

UNEMPLOYMENT

1969

1970

1971

1972

1973

RATE

1974

1975

1976

1977

SOURCEt U.S. DEPARTMENT OF LABOR
P E R CENT OF CIVI L I A N L ABOR FORCE
LATEST DAT A PLOTTEDt NOVEM B E R




PREPARED BY FEDERAL RESERVE BANK OF ST. LOUIS

25
Chairman M i t c h e l l . We thank you very much for your testimony
and, obviously, we will have questions.
If it is all right with my colleagues, I would like to hear from all of
the witnesses first. Is that agreeable? Fine. Mr. Hunt?
STATEMENT OF LACY H. HUNT, SENIOR VICE PRESIDENT AND
ECONOMIST, THE FIDELITY BANK & FIDELCOR, INC.

Mr. H u n t . Thank you very much, Mr. Chairman. It is a pleasure to
be here today.
A strong case can be made that monetary policy in 1977 was on the
overly expansive side. In the past 9 months, the rate of growth in the
narrow money stock has been similar to comparable time spans in
1968, 1972, and 1973, periods when rapid money growth eventually
led to spiraling inflation.
The monetary base, which is high-powered money and the key
underlying determinant of the monetary aggregates, is currently ex­
panding at a near record-setting pace for a 2-year interval. This sug­
gests that unless the growth rate in the base is reduced quickly and
measurably, the pace of expansion in Mx will accelerate further in
coming months.
To some extent, the rate of increase in Mt and the closely related M2
and M3 monetary aggregates has recently been understated. In the
fourth quarter, large denomination certificates of deposit, which are
not included in any of these three aggregates, accelerated quite
sharply. The rapid increase in CD’s tended to diminish the expansion
in demand deposits and the less comprehensive aggregates. The M4
and M5 measures, which do include large CD’s, expanded at their
fastest pace during the final quarter of 1977.
The rise in short- and long-term interest rates since the end of 1976
does not, therefore, reflect an unaccommodative monetary policy. The
upward movement of interest rates stems from an explosive growth in
credit demands, both at the commercial banks and in the nonbank
financial markets. The increase in total commercial bank loans was
almost 9 percentage points faster in 1977 than in 1976. Moreover, net
credit raised in the financial markets by the nonfinancial sector of the
economy was at a record level in both absolute and relative terms in
the third quarter, the period of latest data.
Net credit raised relative to either GNP or the monetary aggregates
is well above the peaks registered in 1969 and 1973. This comprehensive
credit aggregate rose from $284 billion or 16.2 percent of GNP in the
final quarter of 1976 to $370 billion or 19.4 percent of GNP in the third
quarter of 1977.
There is other evidence to suggest that the upward pressure on
long-term interest rates was, in fact, a response to the intensity of
credit demands. A sharp rise in long-term bond yields during 1977
occurred between mid-November and the end of December. This was
T
a period of time when the Federal funds and other short-term interest
rates were essentially stable.
The upward pressure generated by the rising credit demands could
have been moderated by an even faster acceleration in the monetary
base and in the money aggregates. Such a policy, however, would be




26
counterproductive over the longer term since the additional money
growth would further stimulate economic activity, inflation, and
credit demands. This would thereby reintensify the rise of short- and
long-term interest rates.
The very rapid expansion in the money aggregates has already
produced at least two visible results that are disconcerting. First, the
rate of growth of consumer installment and mortgage debt in 1977
was at an unprecedented pace. The explosion in mortgage financing
played an important role in the double-digit spiral of housing prices.
As a consequence of the brisk growth of consumer and mortgage
debt, a heavy and perhaps unsustainable portion of consumer income
is now pledged to debt servicing.
Second, the excess money has spilled into foreign exchange markets,
partly accounting for the strong depreciation of the dollar in the past
year. The decline of the dollar is serving to raise prices for a wide
variety of consumer and industrial products. It should be recalled
that the rapid monetary growth of 1971 and 1973 also resulted in
overexuberaiit real estate and credit growth and foreign exchange
market turbulence.
Business cycle history in the postwar period clearly suggests that
sharp monetary growth is not an inconsequential matter. In the past
25 years, a strong relationship between money and economic activity
has been discernible. Sustained monetary accelerations have eventually
produced rising rates of inflation. Increasing price pressures have, in
the past, necessitated monetary decelerations which have, in turn,
produced either business downturns or business recessions.
In other words, the exuberant monetary growth is disquieting be­
cause it points to higher inflation and the record of the business cycle
clearly reveals that high and rising inflation is ultimately the pre­
cursor of recession and increasing unemployment.
The intensity and/or length of the recessions since 1950 is directly
correlated with the preceding inflation. In other words, when infla­
tionary bouts were relatively mild, recessions were not too deep or
terribly long. But when inflationary outbursts were pronounced, then
the recessions were either steep or extended.
Thus, the shape of the next downturn of the U.S. economy is likely
to be determined by the inflation that ensues in the next year or two. If
inflation were to accelerate sharply, the next downturn could be rela­
tively severe. However, if inflationary pressures are contained, the
next downturn could still be relatively mild.
My own prescription for avoiding a replay of these well-known
cyclical patterns is that the rate of growth in the money supply be
held to no more than 6% percent in 1978, or approximately the same
as the yearly average growth rate for all of 1977.
To implement this policy, the increase in the monetary base should
be restrained at no more than 8.5 percent, or roughly the same mag­
nitude as in 1977.
This prescription, however, would entail reducing the latest 9-month
pace of expansion in Mt about 1 percentage point. This procedure
would lead to further near-term increases in short-term interest rates
and, by a marginal amount, real growth would be less this year.
However, the higher money market yields would serve to stabilize
foreign exchange markets. Also, economic conditions in 1979 would




27
possess less inflation and fewer excesses, and this expansion would have
a better chance of continuing.
Thank you.
Chairman M i t c h e l l . Thank you very much, Mr. Hunt* You have
laid out some hard data before us, and we will be responding to it.
Mr. McKinney, we are delighted to have you, sir.
STATEMENT OF GEORGE W. McKINNEY JR., SENIOR VICE
PRESIDENT, IRVING TRUST CO.

Mr. M c K i n n e y . Thank you, Mr. Chairman, members of the sub­
committee.
I feel a little deferential in tackling the problem of what the Federal
Reserve System did last year and the quality of their work, because
it is so easy to criticize in retrospect what somebody else has done,
especially if you do it with the benefit of hindsight and if you didn’t
actually have the responsibility.
Because of that deferential feeling, I would like to emphasize that
the Federal Reserve did an outstanding job in the conduct of monetary
policy last year. Certainly, the basic thrust of that policy, which was
moderation to limit the availability of money in order to slow infla­
tion, has been in the Nation’s best interests.
Further, the most widely voiced criticism of monetary policy—and
I believe this is the most widely voiced one, that perhaps policy was
too restrictive in late summer and early fall—has proved substantially
invalid, as the revisions of data show that the economy was, in fact,
considerably stronger then than was thought.
Thus, the Federal Reserve shows up even better in light of informa­
tion that was not available to its critics at that time, last summer and
fail.
I think the biggest weakness in Federal Reserve policy formulation
these days stems from the requirement that the Federal Reserve make
quarterly reports to the Congress on its plans for monetary policy,
specifically monetary growth, over the coming year.
This requirement skirts excessive involvement of the Congress in
the detail of how- the Federal Reserve conducts its policies, as distin­
guished from whether or not it achieves its objectives.
Unfortunately, this report to the Congress tends to be focused on an
intermediate and partly irrelevant objective, the money supply, rather
than being focused on the real objective, the ultimate objective of main­
taining monetary conditions conducive to maximum sustainable em­
ployment, production, and purchasing power.
I do not think that the Congress should judge the Federal Reserve
on its money supply targets. They are a means to an end. Instead, the
Federal Reserve should be held accountable under current circum­
stances for the degree of progress the Nation makes in limiting infla­
tion, while simultaneously avoiding recurrence of recession.
Of course, you cairt hold the Federal Reserve accountable for those
fiscal policies which make it more difficult to attain those objectives.
Nevertheless, if that is the standard by which the Federal Reserve is
judged, it has done considerably better than could reasonably have
been expected, even with the benefit of hindsight.




28
An unfortunate side effect of the congressional focus on details of
monetary policy has been that the Federal Reserve has adopted what,
to me, is an untenable approach to monetary policy execution, in that
it keeps one foot in the interest rate camp and the other in the money
supply camp, by setting targets for the Federal funds rate at levels felt
to be consistent with the desired rate of money growth.
This approach does not allow adequately for market reaction to
changes in the money supply. If, for example, the money supply grows
at rates above the announced targets, the market assumes that the
Federal Reserve will have to take positive action to get money growth
back within bounds. Since this will involve higher Federal funds tar­
get rates, both sellers and buyers of money market instruments adjust
their sights accordingly.
As a result, decisions relating to liquid asset holdings or issuance
of liabilities that were associated with the old lower level of interest
rates tend now to be associated with the new higher expected level
of interest rates.
The relationship between money growth and interest rates which
previously existed does not now exist, and the level of the Federal
funds rate, which is consistent with any given rate of money supply
growth, is higher than it was earlier. Thus, the Federal Reserve, when
it starts on a money supply chase intended to bring money supply
growth back within those announced target ranges, thereby stimulates
f aster money growth and creates a great part of the problem that it is
trying to solve.
Ultimately, the Federal Reserve catches up with the moving target,
and the money supply growth slows. This is what I think happened in
1975, in 1976, and again in 1977, when money growth accelerated. The
Federal Reserve tightened in line with a preannounced policy pattern.
The market perceived this; conditions changed; and the money growth
accelerated because the Federal Reserve was following simultaneously
policies of interest rate and money supply growth control.
I think that if the Federal Reserve were not required to state its
money growth targets publicly and if it did not simultaneously attempt
to peg both prices and quantity, this problem of market reaction would
be markedly reduced, and it would be easier for the Federal Reserve
to concentrate on its ultimate objectives.
That was the statement I intended to make, Mr. Chairman.
Could I sneak in just a couple of quick comments on some of the
questions you mentioned in your comments and on one that Mr.
Barnard made, just to create a little discussion later.
Chairman M i t c h e l l . Well, I am certain there will be ample dis­
cussion, but you are perfectly free to sneak something in.
Mr . M c K i n n e y . Let me state my biases quickly.
First, as to how do we sustain and enhance the recovery while at
the same time decelerating inflation, I think there is absolutely no
other policy than the one that the Federal Reserve has been follow­
ing—one of moderation, one of patience, of neither excesses nor
deficiencies, neither too much nor too little, keep everybody a little
unhappy over a sustained period of time until you get the excessive
liquidity out of the economy. I t will take a while, and it will be pain-




29
ful, but I don’t think there is anything else, anything better that can
be done, in the field of monetary policy.
And I will elaborate on that. In connection with Mr. Barnard’s
comments on the $500-billion budget, of course it makes a difference.
It makes an important difference. There is a school of thought that
says that money is coincident with inflation and deflation and that
fiscal policy is coincident with real growth, faster or slower.
I think this is a counterproductive line of argument, and an incor­
rect line of argument. My observations have been that both monetary
and fiscal policy influence total nominal incomes and total nominal
gross national product and total nominal activity, and the split be­
tween inflation and real is not traceable to either fiscal policy or
monetary policy. Therefore, the other half of the policy which w^ould
sustain and enhance the recovery while decelerating inflation requires
moderation in fiscal policy and other governmental measures as well
as those of the Federal Reserve.
Would slow deceleration work well enough to reduce black unem­
ployment below the double-digit level? I think the answer is yes.
To parity with white unemployment? No; not by itself, although
it would tend to move in that direction, toward parity, but not to
parity with white unemployment. I think that does require additional
measures.
With regard to your question, “What else apart from a sound mone­
tary policy do we need?” I think that, No. 1, the most important thing
we need is to make sure that the Humphrey-Hawkins bill does not
get passed because that would be counterproductive to the interests of
minority employment since it simultaneously pegs an unreachable
and unrealistic quantitative target and directs the use of aggregate
monetary and fiscal policies to attain that target.
That would result only in greater inflation and higher—not lower—
levels of unemployment and greater disparities in unemployment.
A second step that I feel would be helpful would be to roll back
the indexing of our minimum wage, which I feel has exactly the same
discriminatory effects.
And finally, I would recommend that the Federal Government serve
as a residuai employer to all at rates below the minimum wage rate.
I thought that might excite a little discussion later.
Chairman M i t c h e l l . Well, I am bleeding just a little bit, really, and
am considering my position that you should get a little more time to
answer those questions. Perhaps that was a fatal mistake on my part.
[Laughter.]
Mr. Taub, we are delighted to have you with us.
STATEMENT OF LEON W. TAUB, VICE PRESIDENT,
CHASE ECONOMETRIC ASSOCIATES, INC.

Mr. T a u b . Mr. Chairman, members of the subcommittee, thank you
for the opportunity to present my views to this subcommittee. I will
summarize my views here today, but request that my entire statement
be placed in the record.
The contents of my testimony can be divided into two parts. First,
I will summarize the major results of a study which I prepared for

22-761 0 - 78 - 3




30
the Subcommittee on Domestic Monetary Policy. Second, I will use
the results of the study to derive inferences concerning the conduct
of monetary policies which were actually followed during 1977.
A little over 1 year ago I directed a study entitled “An Investigation
of the Impact of Alternative Monetary Policies on Recent Business
Cycle Fluctuations.” The purpose of the study was to examine the
consequences of alternative monetary policies for the U.S. economy
during the period 1965 through 1975, and to compare the simulated
outcomes to the path of actual economic behavior during that period.
The most important conclusions which emerged from the study are
as follows:
One, the actual monetary policies followed by the Federal Reserve
System during the past 10 years have been procyclical.
Two, the choice of a level and starting point for a rule-of-thumb
growth target is at least as important as any decision to move to this
type of policy.
Three, rule-of-thumb monetary growth targets can promote stable
economic growth if the target is based upon a 6-month average growth
rate, and if the target is subject to the constraint that quarterly cnanges
in reserves not be negative.
Four, while small single-quarter changes in short-term interest rates
have relatively little effect on long-term rates in the affected quarters,
large changes in short-term interest rates do cause economic instability
and can worsen the prevailing inflation/unemployment tradeoff.
Five, an indication of several monetary indicators viewed collec­
tively can provide a better indication of monetary conditions and the
direction of monetary policy than an analysis of any single indicator,
such as Mx alone.
Six, there appears to be a serious conflict between short-run and
long-run economic goals in the United States. In the short run, an
expansionary monetary policy usually increases real growth much
more powerfully than it increases the rate of inflation. However, in
the long run, beginning in approximately 3 to 4 years, a more expan­
sionary monetary policy leads to a significant increase in the rate of
inflation and a shift in the potential inflation/unemployment trade­
off, to a more unfavorable position.
Seven, proper management of monetary policy requires that the
designated authorities take into account forecasted as well as histori­
cal economic conditions.
I would like now to turn to an evaluation of monetary policy
during 1977.
I believe that the monetary policies which were followed during
1977 were appropriate and consistent with the Nation’s goals of con­
tinuing above-equilibrium growth during the recovery phase of a
business cycle, while attempting to prevent an increase in the longrun rate of inflation.
The criticism that the growth in the money supply was too expan­
sionary cannot be dismissed easily. In the study referred to earlier,
excessive growth in the money supply was shown to lead to an increase
in the long-run rate of inflation, particularly if this excessive growth
was continued well into the peak stage of the business cycle.
There are three reasons why I believe this criticism to be unfair.
First, it must be remembered that economic conditions during the




31
first quarter of this past year were extremely uncertain. Many com­
mentators feared that the great pause of 1976 was the precursor of a
recession in 1977—particularly given the adverse weather conditions
during the early part of the year.
Even though most forecasters—including those at Chase Econo­
metrics—believed that the economic stimulus proposed by President
Carter was sufficient to insure fairly rapid growth through at least
the third quarter of 1977, the Fed could be excused for choosing to
err on the side of excessive ease.
The anemic growth in Mi served as a further, although misleading,
indication that more stimulus might be necessary. In any case, by
May, the inappropriateness of this excessively easy policy was
implicitly acknowledged by the pursuing of a policy which led to a
relatively steady 200-basis-point increase in the Federal funds rate.
Second, during most of 1977 the economy was too weak to have
been able to accommodate additional monetary stringency without
falling short of the Nation’s goal of above-equilibrium real growth.
In order to recognize how badly this economic growth was needed,
it must be remembered that the unemployment rate in December 1976
was an intolerable 7.8 percent. While this rate did fall sharply in
January of 1977, at that time it was not clear how much of this drop
was real and how much was due to the bad weather which was being
experienced at the time.
The precarious nature of the recovery during 1977 and its depend­
ence upon relatively easy monetary policy is illustrated in table 1.
While the aggregate GNP grew at healthy, above-equilibrium rates
during 1976 and 1977, the importance of this extraordinary growth in
the market for residential homes is not generally appreciated.
[Table 1 follows Mr. Taub’s prepared statement.]
As shown in table 1, if one subtracts the growth in GNP due directly
to residential construction and the growth in GNP due to the multi­
plier impact of the increased construction upon the economy, the
economy’s performance during those 2 years appears considerably less
robust. In fact, if the impact of housing construction is omitted, the
growth in real GNP during 1977 was at the lower end of what is gen­
erally considered the economy’s equilibrium long-run growth rate.
Furthermore, table 1 may even understate the importance of housing
in the growth of the economy during 1977. The assumption that the
multiplier impact of residential construction is only two may be overly
conservative, since the purchase of a new home normally induces pur­
chases of other complementary goods such as furnishings, appliances,
and perhaps even automobiles.
Also, there has been a tremendous increase in existing-home resales.
The National Association of Retailers estimates that existing-home
sales grew more than 25 percent during 1977. Since consumers
normally increase their mortgages when moving, high levels of housing
resales increase consumer expenditures by increasing consumers’liquid­
ity. This increase in liquidity may be particularly potent, since con­
sumers also have an increased incentive to buy durables, particularly
those durables which are required to furnish the newly acquired homes.
Had interest rates reached the level at which disintermediation
would have been a serious problem in early 1977, it is extremely likely




32
that much of the growth in residential construction and housing re­
sales would not have occurred, and that the economy's performance
during 1977 would have been far less satisfactory.
Third, it is unlikely that easy monetary policy was or will be respon­
sible for any additional inflation during 1977 and 1978. In the course
of the study referred to earlier, I consistently found that increases in
the money supply at a time when the economy was not operating near
peak capacity promoted significant real growth and very little, or no
inflationary cost.
Rather, it is likely that the increased monetary ease actually acted to
reduce inflation: First, by causing greater real growth and increased
productivity; second, by keeping mortgage interest rates, which enter
the Consumer Price Index directly, stable; and third, by encouraging
additional housing construction, which has acted to moderate—if that
is the word—the tremendous explosion in housing prices which is now
occurring.
However, it is undeniable that the monetary ease during 1977 will
tend to cause increases in the rate of inflation in future years, unless
the rather large increases in the monetary base during 1977 can be
offset in these future years.
To do that, we will need coordinated fiscal and monetary policies
which are designed to stimulate investment and increase the growth
in aggregate supply.
While there is still time to act—and I believe the President’s pro­
posed tax cuts, which are balanced in terms of aiding investment as
well as consumption, are an important step in this direction—inflation
is not a problem which can be cured with a one-shot remedy.
Whatever one thinks of monetary policy during 1977, it is impor­
tant to recognize that sharp oscillations in monetary policy are ex­
tremely harmful to the economy; and that any changes in policy
designed to reduce the long-run rate of inflation should be done gradu­
ally so as not to cause major dislocations in the real sector of the
economy.
For the reasons stated above, I believe that the monetary policy fol­
lowed during 1977 was appropriate. While interest rates did rise sig­
nificantly, real growth was encouraged rather than stymied, and no
major sectors of the economy were squeezed out of the financial
markets.
At the same time, it appears that monetary policies did not cause
any additional inflation in the short run, and may actually have acted
to reduce the rate of inflation during 1977 and 1978.
While these policies might be considered excessively easy in terms
of their impact upon long-run inflation, it is important to recognize
that the rate of inflation in the economy is determined by many factors,
including the type and mixes of fiscal and monetary policies: pnd that,
if one asks monetary policy to bear the entire burden of fighting in­
flation, particularly during a limited time period, one is likely to cause
serious disruptions in the economy and achieve a level of economic
activity which is well below that which could be achieved through a
more balanced mix of policies.
Thank you.
[Mr. Taub’s prepared statement follows:]




33
STATEMENT OF
DR. LEON W TAUB
VICE PRESIDENT
CHASE ECONOMETRIC ASSOCIATES, INC.
before the
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
COMMITTEE ON BANKING, CURRENCY, AND HOUSING
U.S. HOUSE OF REPRESENTATIVES
MONDAY JANUARY 30, 1978
Mr. Chairman and Members of the Committee:
Thank you for the opportunity to present my views to this committee.
During the course of

my

testimony I will refer to a study which I directed

for the Subcommittee on Domestic Monetary Policy.

The conclusions drawn, and

the views I express today do not necessarily represent the conclusions and
views of Chase Econometric Associates, Inc., or the Chase Manhattan Bank, N.A.,
the parent company of Chase Econometric Associates, Inc.

However, the model

used in the performance of this study is the Chase Econometrics Macroeconomic
Model.

The results of these macroeconomic simulations may be attributed to the

model since these results would have been achieved by any independent researcher
using that model.
The contents of my testimony today can be divided into two parts.
First, I will summarize the major results of the study.

Second« I will

use the results of the study to derive inferences concerning the conduct of the
monetary policies which were actually followed during 1977.
Summary of the Study
A little over one year ago, I directed a study titled An Investigation of
the Impact of Alternative Monetary Policies on Recent Business Cycle Fluctuations.
The purpose of the study was to examine the consequences of alternative monetary




34
policies for the United States economy during the period 1965-1975, and to
compare the simulated outcomes to the path of actual economic behavior during
that period.

The alternative policies were designated in terms of fixed "rule-

of thumb" monetary and reserve growth targets.
The most important conclusions which emerged from the study are as
follows:
1.

The actual monetary policies followed by the Federal Reserve System

during the last ten years have been pro-cyclical.

By contrast, a wide variety

of rule-of-thumb monetary growth targets would have been more successful than
the policies actually followed in meeting the economy's needs for stability by
encouraging less severe recessions and, to a smaller extent, less exuberant booms,
2.

The choice of a level and starting point for a rule-ofrthumb growth target

is at least as important as any decision to move to this type of policy.

If a

rule-of-thumb monetary growth target had been chosen without regard to con­
temporaneous economic developments, the result might have been a substantially
worse economic performance than was actually experienced during the ten year
period.
3.

Rule-of-thumb monetary growth targets can promote stable economic

growth if the target is based upon a six-month average growth rate and if the
target is subject to the constraints that quarterly changes in reserves not be
negative.

However, an attempt to obtain an inflexible monetary growth rate

target on a quarterly basis can be destabilizing or can lead to oscillating
changes in reserves and interest rates.
4.

While small, single-quarter changes in short term interest rates have

relatively little effect on long term rates in the affected quarters, large
changes in short term rates do cause economic instability and can worsen the




35
prevailing inflation/unemployment trade-off.

Also, large oscillations in

interest rates can have significant effects upon income distribution and the
composition of economic activity among the various sectors of the economy.

In

particular, investment seems to be depressed more than consumption by oscillating
monetary policies and interest rates.
5.

An examination of several monetary indicators viewed collectively can

provide a better indication of monetary conditions and the direction of monetary
policy than an analysis of any single indicator such as Ml alone.
6.

There appears to be a serious conflict between short-run and long-run

economic goals in the United States.

In the short run, an expansionary monetary

policy usually increases real growth much more powerfully than it increases
inflation.

However, in the longer run (beginning in three to four years) a more

expansionary monetary policy leads to a significant increase in the rate of
inflation and a shift in the potential unemployment/inflation trade-off to a
more unfavorable position.

In addition, by approximately the tenth year after

the institution of an expansionary monetary policy, the increase in inflation
becomes so great that the economy actually begins to grow more slowly under a
"more expansionary" policy.

Furthermore, the design of the study was such that

this ten year estimate should be treated as an upper bound; the cross-over into
the time at which additional monetary causes slower real growth may occur sig­
nificantly sooner.
7.

Proper management of monetary policy requires that the designated

authorities take into account forecasted as well as historical economic conditions.




36
An Evaluation of Monetary Policy During 1977
I believe that the monetary policies which were followed during 1977 were
(JlnnsC

appropriate and consistent with the nation's goals of continuing equilibrium

A
growth during the recovery phase of a business cycle while attempting to prevent
an increase in the long run rate of inflation.

During 1977 the federal funds

rate rose from approximately 4! to approximately 6*$, an increase of 200
$
basis points.

While the monetary base increased at a relatively rapid rate

of 9.5%, the money supply increased far more slowly—7.2% on an Ml basis and
8.7% on an M2 basis.

To argue that a given policy was correct, one has to

address both the potential criticism that the policy followed was too restrictive
and the potential criticism that the policy followed was too expansionary.

The

former criticism, that the policy followed was too restrictive, can be dis­
missed relatively easily.

The economy did grow rapidly during 1977 and the

current rate of above-equilibrium real growth shows every sign of continuing
through at least the first quarter of 1978.

Interest rates, although rising

steadily for the final three-quarters of the year avoided the levels at which
severe disintermediation would take place.

Furthermore, the fact that the

monetary base grew much faster than the monetary stock indicates that, had the
economy needed additional liquidity, the money stock would have grown to
accommodate these needs without significant increases in interest rates.
The criticism that the growth in the money supply was too expansionary
cannot be dismissed as easily.

In the study referred to earlier, excessive

growth in the money supply was shown to lead to an increase in the long run
rate of inflation, particularly if this excessive growth was continued well
into the peak stage of the business cycle.
There are three reasons why I believe this criticism to be unfair.




37
First, it must be remembered that economic conditions during the first
quarter of the year were extremely uncertain.
the "great pause" of 1976 was the

Many commentators feared that

precursor of a recession in 1977, particularly

given the adverse weather conditions during early 1977.

Even though most

forecasters, including those at Chase Econometrics, believed that the economic
stimulus proposed by President Carter was sufficient to insure fairly rapid
growth through at least the third quarter of 1977, the Fed could be excused
for choosing to err on the side of excessive ease.

The anaemic growth in Ml

served as a further, although misleading, indication that more stimulus might
be necessary.

In any case, by May, the inappropriateness of this excessive­

ly easy policy was implicitly acknowledged by the pursuing of a policy which
led to a relatively steady 200 basis point increase in the federal funds rate.
Second, during most of 1977 the economy was too weak to have been able
to accommodate additional monetary stringency without falling short of the
nation's goal of above-equilibrium real growth.

In order to recognize how

badly this economic growth was needed, it must be remembered that the unemploy­
ment rate in December 1976 was an intolerable 7.8%.

While this rate did fall

sharply in January of 1977, at that time it was not clear how much of this
drop was "real," and how much was due to the bad weather which was being
experienced at the time.

The precarious nature of the recovery during 1977,

and its dependence on relatively easy monetary policy is illustrated in
Table 1.

While aggregate real GNP grew at healthy, above-equilibrium rates

during both 1976 and 1977, the importance of the extraordinary growth in
the market for residential homes is not generally appreciated.

As shown in

Table 1, if one subtracts the growth in GNP due directly to residential con­
struction and the growth in GNP due to the multiplier impact of the increased
construction upon the economy, the economy's performance during these two years




38
appears considerably less robust.

In fact, if the impact of housing construc­

tion is omitted, the growth in real GNP during 1977 was at the lower end of
what is considered the economy's equilibrium long run growth rate.

Furthermore,

even Table 1 may understate the importance of housing in the growth of the
economy during 1977.

The assumption that the multiplier impact of residential

construction was only two, may be overly conservative since the purchase of a
new home normally induces purchases of other complementary goods such as fur­
nishings, appliances, and perhaps even automobiles.
tremendous increase in housing resales.

Also, there has been a

The National Association of Retailers

estimates that existing home sales grew more than 25% during 1977.

Since

consumers normally increase their mortgages when moving, high levels of housing
resales increase consumer expenditures by increasing consumers' liquidity.

This

increase in liquidity may be particularly potent since the consumers also have
an increased incentive to buy durables, particularly those consumer durables
which are required to furnish the newly acquired home.
Had interest rates reached the level at which disintermediation would
have been a serious problem in early 1977, it is extremely likely that much of
the growth in residential construction and housing resales would not have occurred
and that the economy's performance during 1977 would have been far less satis­
factory.
Third, it is unlikely that easy monetary policy was or will be responsible
for any additional inflation during 1977 and 1978.
In the course of the study referred to earlier, I consistently found
that increases in the money supply at a time when the economy was not operating
near peak capacity

promoted significant real growth at very little or no

inflationary cost.

Rather it is likely that the increased monetary ease

actually acted to reduce inflation:




(a) by causing greater real growth and

39
increased productivity; (b) by keeping mortgage interest rates, which enter
the consumer price index directly, stable; and (c) by encouraging additional
housing construction which has acted to moderate, if that is the word, the
tremendous explosion in housing prices which is now occurring.
The Outlook for Long-Run Inflation
However, it is undeniable that the monetary ease during 1977 will tend
to cause increases in the rate of inflation in future years unless the rather
large increases in the monetary base during 1977 can be offset during the
coming years.

To do that, we will need coordinated fiscal and monetary

policies which are designed to stimulate investment and increase the growth in
aggregate supply.

While there is still time to act, and I believe the President's

proposed tax cuts which are balanced in terms of aiding investment as well as
consumption are an imporatnt step in this direction, inflation is not a
problem which can be cured with a one-shot remedy.

Whatever one thinks of

monetary policy during 1977, it is important to recognize that sharp oscillations
in monetary policy are extremely harmful for the economy and that any changes
in policy designed to reduce the long-run rate of inflation should be done
gradually so as not to cause major dislocations in the real sector of the
economy.
Summary
For the reasons stated above, 1 believe that the monetary policy followed
during 1977 was appropriate. While interest rates did rise significantly, real
growth was encouraged rather than stymied, and no major sectors of the economy
were squeezed out of the financial markets.

At the same time, it appears that

monetary policies did not cause any additional inflation in the short run and




40
may actually have acted to reduce the rate of inflation during 1977 and 1978.
While these policies might be considered excessively easy in terms of their
impact upon long run inflation, it is important to recognize that the rate of
inflation in the economy is determined by many factors, including the type and
mixes of fiscal and monetary policies, and that if one asks monetary policy
to bear the entire burden of fighting inflation, particularly during a limited
time period, one is likely to cause serious disruptions in the economy and
achieve a level of economic activity which is well below that which could be
achieved through a more balanced mix of policies.




41
TABLE 1
Impact of Residential Construction Upon
Real Economic Growth
1976
Real Gross National Product
First difference ($ billions)
Percent change

1977

72.5
(6.0)

62.9
(4.9)

8.9
(23.1)

9.2
(19.2)

8.9

9.2

54.7
(4.7)

44.5
(3.6)

Less
Real Residential Construction
First difference ($ billions)
Percent change
Multiplier Impact ($ billions)
(assumed multiplier of 2.0)
Real Gross National Product Not
Attributable to Residential Construction
First difference ($ billions)
Percent change




42
Chairman M i t c h e l l . Thank you, very jnuch, Mr. Taub.
We will proceed under the 5-minute rule.
Very tentatively, in my opinion, Congress is trying to approach
some coordination between fiscal policy and monetary policy. It is
still very tentative as of this point, however. In light of this attempt
to achieve some degree of coordination, the Congress sought to require
that the Federal Reserve report to Congress its monetary targets a
year ahead—and that gives us a sort of base upon which Congress
can judge where we can go with fiscal policy.
In light of your statement, Mr. McKinney, I know your feeling
on i t ; I would like to direct this to Mr. Christ, Mr. Hunt, and Mr. Taub.
Mr. McKinney made the suggestion that we hold the Federal Reserve
accountable for its degree of progress in limiting inflation—I think
that is what you said—while avoiding the recurrence of recession,
instead of setting monetary growth targets and hitting them. May I
have your reactions to Mr. McKinney’s position? We will start with
Mr. Christ, and I would appreciate hearing from each of you three
gentlemen.
Mr. C h r i s t . I think Mr. McKinney is quite right, that the ultimate
purpose of Federal Government monetary and fiscal policy is to mod­
erate inflation, and to maintain real output and employment, so I don’t
disagree with that part of the statement.
It is, of course, correct that the monetary aggregates are only a
means to an end, and are not an end in tnemselves. I think that
experience has made it pretty clear that abrupt changes in the rates
of growth of the monetary aggregates are disturbing, and I think it
is useful to ask the Federal Reserve to state in advance, quarterly,
what the intentions are as to the growth rates of these monetary aggre­
gates—not so much because the maintaining of those aggregates on a
strict, constant path is an end in itself; but rather, because experience
shows that disturbances are in some cases created, and in other cases
amplified, if the monetary policy is conducted in such a way as to
produce important, substantial changes in those growth rates.
Chairman M i t c h e l l . Thank you. Mr. Hunt ?
Mr.‘H u n t . I also agree that the money supply is not the ultimate
objective; that the long-term objective is to have a stable rate of infla­
tion. with a minimal amount of unemployment.
However, I think it is useful for the Federal Reserve to come, on a
quarterly basis, and explain its targets to Congress. I think that when
they miss them as badly as they did in 1977. you should read the riot
act to them.
The swings of this sort as the data and historical experience clearly
reveal—are destabilizing and harmful. They have longer term conse­
quences; I would prefer for the Federal "Reserve to stay with the
targets.
I do agree with one of the other things that George McKinney
mentioned. I believe the Federal Reserve impedes its own operations
by simultaneously trying to have a Federal funds operating target,
and a money supply objective.
In many of the foreign countries, the day-to-day, or call-monev rate,
swings quite widely. The participants in those money markets have
come to know that a 3-percent or a 4-percent swing during the course
of a week is normal, and dominated by seasonal influences.




43
The Federal Reserve should ignore the Federal funds rate, set its
reserve objectives in light of its monetary policy objectives, keep
them reasonably stable, report them to the Congress, and I think
over the longer term its policies will be better.
Chairman M i t c h e l l . Mr. Taub?
Mr. T a u b . Thank you. I do believe it is important to coordinate fiscal
and monetary policy to a greater degree than we are presently doing.
The Fed must be kept independent, and an independent Federal Re­
serve System is important to economic growth. However, that does
not mean that the Congress of America, and the people of America
should not know what the Fed is doing.
I believe that House Concurrent Resolution 133 was extremely im­
portant in requiring the Fed to set monetary target growth, and I
think that that policy could even be expanded slightly—first, by ask­
ing that the Fed report on its belief as to what that monetary policy
will do to interest rates, other financial indicators, and important sec­
tors of the economy such as housing which are affected by monetary
policy.
Second, I believe that the Fed should be asked to compare a longer
time period, and set a growth rate for a longer time period than 3
months. In particular, it could not only set a 3-month growth rate
target, but also set a 6-month growth rate target, based upon the
next 3 months, and the last 3 months. In this case if there is an error
in Fed policy in reaching a target on a 3-month basis, that error is
not completely forgotten. The Fed would have an obligation to set
monetary policy over a 6-month period to be consistent with the
Nation’s goals for employment and inflation.
Chairman M i t c h e l l . Thank you, very much. Mr. Hansen?
Mr. H a n s e n . I would yield to Mr. Caputo.
Mr. C a p u t o . I was curious about the apparent unanimity over the
inevitability of a change in any of the monetary aggregate growth
rates and inflation, for 3 to 4 years, and later. How do you get to
that conclusion?
I think Mr. Christ mentioned two data points which, even if the
two phenomena were utterly random, you would have a 50-percent
chance of reaching your results of the two data points. Do you re­
gress to changes in monetary aggregates against the Consumer Price
Index quarterly data 4 years in the future ? How do you reach the con­
clusions that you each reached in that area ?
Mr. C h r i s t . Well, there are two kinds of approaches to this. One is
a much more simplistic view than that. For example, when gold was
discovered in the New World in the 16th century, the Spanish brought
much gold back to Spain, and there was a substantial increase in prices
in Spain at that time.
You can find similar effects in other places, in centuries past. In more
recent periods, we don’t base the money supply on the quantity of gold.
It is still true that in the periods and places in which the money supply
has grown rapidly there has been rapid inflation.
If you look at the hyperinflation in Germany immediately after
World War II, the money supplies were growing extremely rapidly,
on the order of 1,000 percent a month, and the price level was rising at
rates like that.




44
We can have that, too, in our country if we want to. In dealing with
periods such as postwar American history, where the inflation rates
have been much more moderate than those of the German hyperinfla­
tion, the kind of method that you suggest makes sense. One can conduct
regression analyses and one can use, as a dependent variable in such
an equation, the rate of inflation; and one can use, as explanatory vari­
ables, the rates of growth of money stock 1, 2, and 3 years earlier.
Mr. C a p u t o . Have you done that ?
Mr. C h r i s t . I have not personally done this. I have read a great
number of studies of this sort. One of them was published by this sub­
T
committee, I believe it was last year, which did a very careful job of
exactly that kind of thing, and concluded that in the postwar Ameri­
can experience this relationship, which has been observed in many
other countries and many other places, is still operating.
Mr. H u n t . I have actually performed the type of regression analysis
which you and Professor Christ alluded to in your remarks. I have
not only looked at broad aggregates of the Consumer Price Index—
such as durable, nondurable, and service subcomponents, but I have
examined subcomponents of the wholesale Industrial Price Index, in
order to trace the effects of inflation through the various stages of
production.
The most recent evidence that we have, in terms of looking at
monthly changes in industrial wholesale and subcomponents of con­
sumer prices, is that the lags between acceleration in money growth,
and acceleration in prices is actually shortening.
Mr. C a p u t o . Is actually what ?
Mr. H u n t . I s actually shortening. The lags are becoming shorter.
In fact, some of our latest regression work seems to suggest that a discernable impact on the Wholesale Industrial Price Index is evident
within 7 or 8 months. There is a continuing lag on out to 2y2 and 3
years. The mean, or the midpoint of that impact may now be around
15 or 16 months, in terms of the Consumer Price Index.
Mr. C a p u t o . Mr. McKinney, do you have any comment on that?
M r . M c K i n n e y . Well, your comment was that there is unanimity of
the observation that money supply growth was correlated with infla­
tion. The unanimity does not quite extend to the direct relationship
that I think can reasonably be inferred from some of the comments.
I would like to point out that inflation is caused by a lot of other
things than monetary policy, but, having made that additive com­
ment—not competitive comment—then I would certainlv concur with
the observations, which are the result of an awful long time of watch­
ing by a lot of people, not merely statistical observation but correlation
of theory and qualitative observation over generations that have, I
think, very firmly proved the case.
Mr. T a u b . One purpose of the study which we performed for the
subcommittee was to see if a major macroeconomic model such as the
Chase model, which is generally thought to be primarily Keynesian
rather than monetarist, would still show that increases in money sup­
ply caused additional inflation.
We did find that, in the longer run, that effect did hold.
Mr. C a p u t o . Mr. Hunt, what kind of statistical reliability do we
find in the studies ? Are there very high R squares ?




45
Mr. H u n t . Well, I have estimated the monthly work that I was re­
ferring to you. I have estimated the monthly data since 1965, and
generally speaking, I can explain approximately 86 percent of the
monthly variance in the Industrial Wholesale Price Index.
There are other variables in the equation, as Mr. McKinney sug­
gested, and you have to take those into consideration. The money sup­
ply works both indirectly and directly on the rate of inflation. So, it is
not a single-shot determinant.
Mr. C a p u t o . What are the other variables that seem to have a lot of
explanatory value ?
Mr. H u n t . Well, I think that there are certain factors that are very
difficult to predict. We call exogenous prices, prices that seem to move
in a nonrandom way in relation to money. For example, fuel is one of
the most notable. It is very difficult to ignore fuel, especially in light
of the experience since 1973, when there was a quintupling of oil
prices.
The agricultural cycle is not influenced any significant way by mon­
etary policy changes. There are a number of structural factors having
to do with laws of Congress, for example, changes in the minimum
wage, and its impact—there are other costs that are imposed externally
by the operation of our regulatory procedures, and they, too, can
influence.
And finally, there can be demand that can be generated from outside
of our country. For example, a shift in the trade deficit can impact
upon domestic demand and thereby the rate of inflation. And, as several
other members also suggested, also a shift in the demand from the Fed­
eral Government can influence the rate of inflation.
Mr. C a p u t o . I am afraid my time has expired.
Thank you. I appreciate it.
Chairman M i t c h e l l . M y very distinguished colleague and friend,
M r . Barnard.
Mr. B a r n a r d . Y o u are too flattering, Mr. Chairman.
Chairman M i t c h e l l . I need your vote. [Laughter.]
Mr. B a r n a r d . Last year we had a lot of discussion here, as we have
already alluded to this morning, about the necessity of the Fed fore­
casting what their ambitions would be in the growth rate.
I am interested to know whether or not you think this is some in­
fringement on the independence of the Fed, and second, whether or not
their predictions and their objectives, if they were not consistent with
the administration’s objectives, could somewhat politicize the Fed and
some of its monetary policies ?
Mr. Hunt, I think you hinted that the Fed needed to be taken to task
about not meeting some of their forecasts. How would you consider
that ?
Mr. H u n t . Well, I like Mr. Taub’s suggestion that when the Federal
Reserve makes its quarterly presentation of the projected growth for
the next 3 months, that there should be an examination of how they
did over the prior 3 months, to take into account explicitly whether or
not they hit their objectives.
I think it is desirable to have an independent Federal Reserve Sys­
tem. But, it is also desirable, at the same time, for the Federal Reserve
to know and fully understand the desires of the Congress and the

22-T61 0 - 7 8 - 4




46
administration, and so that the Congress and the administration and
the American public can know if the Federal Reserve is going to
pursue a somewhat independent policy.
M r. B a r n a r d . D o y o u t h in k a 3 -m o n th p e r io d o f t im e is r e a s o n a b le t o
a c h ie v e th o s e g r o w t h p e r io d s ?
Mr. H u n t . I think that they can achieve it within about 75 percent

of their target. More precision than that should not be required. Over
a 6-month time span I think you could achieve somewhat higher
results.
Mr. B a r n a r d . H o w much do you think public attitude has to do with
this ? In other words, we have to get the public accustomed to buying
T
more houses after going into the consumer area. Do you think that they
can adjust their personal attitudes in that period of time?
Mr. H u n t . If you are talking about the consumer and his whole
family, probably not. But the lending institutions who deal with
the consumer,, your commercial banks, your savings and loan institu­
tions, and even, to a growing extent, probably your credit unions
would be able to take account of these adjustments and make their
plans accordingly.
Mr. B a r n a r d . Would any of the other gentlemen like to address that
question ?
M r . M c K i n n e y . I would, sir. Again, I don’t think you are shooting
at the right thing, and I think that whether the Federal Reserve vol­
unteers for it or whether you ask for it, I think that for you to hold
them accountable for an achievement of a money supply target is an
error, it is a mistake. There are many things that influence economic
activity other than money.
As these gentlemen have admitted, the relationship between money
and economic activity is not the only one. There are other factors, and
they are variable, they are in some degree unpredictable. They also
change from time to time. The relationship between money and eco­
nomic growth does not remain constant.
The variability on the short-run basis of other factors is consider­
ably more important than is that of money.
I think you would do better if you asked them how far they thought
they could reduce the inflation rate and how tight a policy they would
have to follow to do it. And I do not believe it is appropriate to meas­
ure the tightness of that policy by the extent to which the money
supply increases or decreases.
An increase of the money supply of x percent under one set of cir­
cumstances is a much tighter poiicy than an increase of the same
amount under another set of circumstances.
Mr. B a r n a r d . Mr. Hunt.
Mr. H u n t . Could I say something? While admitting that there are
other factors that influence the inflation rate besides money, we must
not forget that money is the single most important factor that we can
control. The Congress and the Federal Reserve can’t influence the
pricing of oil on world markets. They cannot control the agriculture
sector.
The tool that you have to insure that we have noninflationary growth
over the longer term is the money supply. That is the only one of the
variables that you have control over. So, if you relinquish your con­
trol over money supply, then inflation becomes a purely random event.




47
It is controlled by whatever the money supply happens to be, by the
swing in oil prices, the swing in agricultural prices, and what is to as­
sure over the longer run that we do not have horrendous conditions ?
The money supply is the principle policy control variable. Like it
or not, that is what policymakers have to contend with.
Mr. B a r n a r d . Not interest rates ?
Mr. H u n t . I don’t believe so. Interest rales, especially your longterm interest rates, are dominated by fluctuations in inflation. Inves­
tors incorporate inflationary expectations in the intermediate and
long-term rates. This is documented, I think, by a lot of people.
Mr. B a r n a r d . Don’t you think the market is changing though, with
the variable interest rates on long-term debt ?
Mr. H u n t . I don’t see any significant move toward variable long­
term interest rates. The mortgage sector, where there has been some
movement is small, the bulk of the financing and the long-term cor­
porate and municipal bond markets are based on fixed rates.
Mr. B a r n a r d . I am afraid my time is fleeting fast.
Mr. Chairman, I would like one of these gentlemen to address if
it can be possible for monetary and fiscal policies to be coordinated.
Mr. M cK inney . T o the extent they are coordinated, it is going to be
somewhat like sleeping with an elephant. I f the elephant rolls over,
you will get squashed, and if you coordinate fiscal and monetary
policy, I am reasonably sure that monetary policy would be squashed
and there would be a politicization of the process.

Mr. B a r n a r d . Mr. Christ.
Mr. C h r i s t . I think that in principle it is certainly possible to co­
ordinate monetary and fiscal policy. I think there is the danger of the
elephant squashing monetary policy, as Mr. McKinney said, but it
is not really required of the Federal Reserve that they do step in and
respond when the budget runs a big deficit. I t is not required that the
Federal Reserve buy a substantial amount of those bills and bonds
which the Treasury issues. However, there is very intense political
pressure on the Federal Reserve to do that, and it is very hard for
the Federal Reserve to resist that pressure. They are regarded as an
independent agency, but I think they all know how they were created.
They were created by the Congress, and they can be abolished by the
Congress as well. This is the reason why they are not totally
independent.
It seems to me, in a democracy such as we have, it is not obvious
that they should be totally independent. There should be a recourse
for the populace in the Nation to bring about the kind of monetary
policy that is wanted, and I think that one of the encouraging things
about hearings like this is that we have a discussion about what the
right kind of monetary policy should be. I think that the discussion
may lead to improved understanding, and if it does, then I think the
deficits will not be so large in the future.
I think you are really on the right track in your Original ques­
tion. If the deficits are not so large in the future, then the pressure
on the Fed to buy bonds to finance those deficits w ill not be so great,
and we won’t have such a great inflation. If the Fed could resist
the pressure to help finance large deficits, we would not have infla­
tion, but we would have a heavy competition between the private




48
sector and the Treasury for funds at a time when the budget runs
a big deficit, and then*it would be likely to push interest rates up.
This always produces large complaints from well-known sectors of
the economy against the high interest rates. That is the source of the
pressure which is very hard for the Fed to resist.
Mr. B a r n a r d . Mr. Chairman, I realize my time is up, but I want
to say that I think the discussion this morning dispells that old
philosophy that economists put end to end could not reach a con­
clusion. I t seems like these gentlemen have reached a conclusion
this morning, and a very happy one.
Thank you very much.
Chairman M i t c h e l l . I would agree on macroeconomic issues. I
hope, however, there would be some dispute on the specific recom­
mendations that Mr. McKinney made. I t is clear that the President
is increasingly calling upon the private sector to do more in terms of
combating unemployment and helping the economy grow. That was
mentioned in his State of the Union message, I believe a greater reli­
ance should be placed upon the private sector to help our somewhat
sluggish economy. In that connection, all of the expert witnesses who
appeared before the Joint Economic Committee’s midyear hearings
last year indicated that there has to be a heavier weight, a heavier
reliance placed upon monetary policy if we are going to call upon the
private sector to do more. Those witnesses came to a kind of consensus
which said, in.effect, that to avoid the danger of recession in 1978 and
to meet the targets for 1981, Mx would have to grow at a rate of about
T
8 percent, and M2 would have to grow’ at a rate of at least 11 percent
for the next several years. In your testimony, Mr. Hunt, I think you
addressed this problem and gave an indication as to where Mi and M2
should be. You seem to be in agreement with this consensus.
I would like to hear from Mr. Christ and Mr. Taub and Mr.
McKinney. The Fed is going to come in with a specific target for Mx
and M2. It is required by law. What should be the upper and lower
ranges of those targets ? Mr. Christ ?
Mr. C h r i s t . This is always a very hard question for next year: it is
an easy question for the long run. I t seems to me, if we want not to
have inflation then we should, 10 years from now, be in a position
where Mi is growing at something like 2 percent a year. How’ we get
there from here is really the hard question, and that goes back to this
drug analogy that I mentioned.
I think we have placed ourselves in a position now where we are
taking a dose of monetary expansion at a rate of about 8 percent a
year on the monetary base, and about 7 percent a year on Mx And if
.
we are going to get off of that, we are going to have to reduce the rate
of growth of the money stock at some point.
Now, either we do that, or we don’t do it. I think one thing that can
be said for the Fed over the last 4 years is that they have not varied
the rate of growth of the monetary base. They have made that ex­
tremely steady. If you look at one of the charts that is in the back of
my testimony, it shows a very, very steady rate of growth of the
monetary base; and Mt and M2 fluctuate between each other, and also
over time, to some extent. But, if the monetary base is growing at a
steady rate of about 8 percent, then M2 and M2 will not stray very far
for very long from that rate.




49
Now, I think what the target should be in the immediate future is
a very touchy question, and it is a little like the question of how fast
the doctor should take the patient off of a drug whose side effects have
now been determined to be harmful, in the form of inflation.
There will never be a perfect time to do this, because there will
never be a time when it won’t either aggravate some little depression
that may be in process, or where it won’t threaten to slow down a boom
which is in process.
I think there is going to be no way to slow down the rate of growth
of the money stock without having some people say “you are
endangering real output.”
And I think our choice is to either decide that we are going to live
with a 6- or 7-percent inflation forever—which means living with in­
terest rates of 10 and 12 percent for mortgages, slowing down grad­
ually. And I think the best policy is probably a very gradual slow­
down. I t is hard to adopt this and make it stick, due to the member­
ship of the Congress changing over 10 years; and maybe 10 years
from now the people who are passing the bills won’t any longer agree
with this position that we ought to slow the monetary growth rates
down to something like 2 percent, and really stop the inflation.
But, I think if we could get a national consensus that we don’t w^ant
inflation, and then we could determine to live through the 3- or 4-year
period of inhibition of real output that that would create, then I think
we would have clear sailing after that. We w^ould then be in a position
where interest rates would be low, and inflation would be gone, and
fluctuations would be moderate. It is just a question of how to get there
from here, and it isn’t easy.
Chairman M i t c h e l l . Well, you have not made my job much easier,
because the Federal Reserve Board is going to give us a specific range
for the year next month. Should the lower bound of Mi be 4% percent ?
Mr. C h r i s t . I w o u l d t h i n k h a l f a p e r c e n t l e s s t h a n i t w a s t h e y e a r
b e fo r e , a n d k e e p d o in g t h a t u n t il in f la t io n is g o n e .
Chairman M i t c h e l l . D o any of you other gentlemen

wish to com­
ment on this ?
Mr. T a u b . Yes, I think that it is now a fairly favorable time to start
reducing the growth in money supply. There are two reasons for th is:
First, the economy is much nearer to high employment than it has
been for a very long time. Second, we are now in a particularly fortui­
tous position: we know that the economy will be growing at a fairly
rapid rate for at least the first quarter, based upon the information we
have already; and we know that, beginning in the fourth quarter when
the proposed tax stimulus, which appears to be virtually certain to be
enacted, takes effect that the economy will grow strongly in the fourth
quarter of this year and the first quarter of next year.
Therefore, there is very little to lose by an additional tightening
now. We don’t have to worry about pushing the economy into a reces­
sion, because we know we will have substantial fiscal stimulus coming
at the end of this year. Now would be a good time to start the process.
Chairman M i t c h e l l . Mr. McKinney ?
Mr. M c K i n n e y . May I comment on the inconsistency of the fact—
which is correct, which he has just pointed out—that we know the
economy will be growing beautifully because of fiscal stimulus; and
that therefore we feel we are in a good position to tighten our monetary




50
policy—a process which shifts economic activity from the free enter­
prise system, from that private economy that Mr. Carter says he wants
to grow, into Government.
It might well be worth considering a little less fiscal stimulus, and
a little more monetary restraint. But, in specific answer to your ques­
tion as to what growth rates: The growth rate should be reduced as
rapidly as is possible without triggering recessions. I submit that
neither you nor I nor Mr. Hunt nor the Federal Reserve knows, in
advance, what that will be.
Therefore, I would suggest that the range for money growth ought
to be a very wide one, in order not to inhibit the Federal Reserve in
following policies that are appropriate to the moment.
Mr. B a r n a r d . Will the gentleman yield ?
Chairman M i t c h e l l . Yes.
Mr. B a r n a r d . Y o u say a “range,” Mr. McKinney. Do you mean 3,
4, or even 6 percentage points ? That is a big range.
M r . M c K i n n e y . If that inhibits the Federal Reserve at any time,
it is not a wide enough range. During 1977, it did. The Federal Reserve
did move outside of it. I think the range ought to be big enough, in
conducting monetary policy, so that, month-to-month, the Federal
Reserve does not move outside of it.
Mr. B a r n a r d . Thank you, Mr. Chairman.
Chairman M i t c h e l l . Mr. Hunt, you wanted to comment on this?
Mr. H u n t . Yes, I would. It seems to me that this expansion is at a
very old age.
I f you look over the postwar period, you will find that the average
of the peacetime recoveries was about 34 months. January is the 34th
month of this expansion. There are a few visible excesses that are
beginning to emerge. Productivity is declining. This suggests that
there will be increased pressure on corporate profit margins, increased
price pressures from the industrial sector—we have had a precipitous
decline of the dollar, which is adding to inflationary pressures.
Also in certain sectors, notably the construction and related sectors,
they arc beginning to get into the bottleneck conditions. If we continue
pursuing a high money growth policy, it is going to give us increas­
ingly a disproportionate amount of inflation. And the greater infla­
tionary evolution during the next 2 years could give us another one of
these hard landings.
I t seems to me we are approaching very quickly a critical turning
point in whether we avoid that merry-go-round that we have been
on since 1950.1 think it is important for the Federal Reserve to move
quickly to lower the targets. I, like Mr. Taub, agree that now is a
propitious time to do so. To delay, I think we will pay in terms of
higher unemployment and slower growth over the longer term.
Chairman M i t c h e l l . The Chair would like to raise one other ques­
tion in connection with this discussion. And I use as my point of focus
some remarks that Mr. McKinney made. I don’t know that they are
in your written testimony, but you referred to “moderation” being
required; that people will have to be a little more unhappy for just
a little longer period until the economy becomes more stabilized.
Generally, is that a correct accounting of the remarks you made?




51
Mr. M c K i n n e y . Yes, sir. I hope that word “unhappy” is not mis­
interpreted. I mean by that, that observers may continue to simultane­
ously feel we are both going too fast and too slow.
Chairman M i t c h e l l . Well, this is the point I am trying to make.
All of us here can be very objective and systematic in our analysis
of data that appears before us, but there are a large number of people
out in the real world who have been unhappy for 8 years, or longer.
I am talking about those who have been and are still unemployed.
From my perspective, it is almost unconscionable that we will have
such high rates of unemployment nationally. And, when you target in
on blacks and other minorities, it is an abomination of the American
system that this persists.
Now, my question is: You suggest or infer that we will have to
live with this high unemployment rate for a wee bit longer; but I
have to balance that out against what it is costing us. When that un­
employment rate remains as high as it is, we are talking about roughly
$14 billion for each 1 percent of unemployment that we have in this
country. That appears not to be a sensible kind of approach to our
economic system. I hope I am making my point clearly. Nowhere in
your testimony did you address or mention the problem of unemploy­
ment. Second, with your remarks that I don’t think were in your pre­
pared testimony, when you talked about folks being unhappy for “just
a little longer,” I immediately thought about the unemployed who have
been unhappy for so long, and the taxpayers who are paying—some
say $14 billion, some say $19 billion for every 1 percent of unemploy­
ment. If I have made my area of concern clear to you, do you wish to
respond to it?
M r. M c K i n n e y . I r e a lly d o , s ir , b e c a u se I a m a t le a s t a s c r it ic a lly
c o n c e r n e d a b o u t t h e s p e c i f ic s o f w h a t y o u w e r e t a l k i n g a b o u t a s y o u
are.

I am absolutely certain I am as concerned about that as you are. But
I think that we are making, as a nation, a serious mistake in the way
in which we hope to address that in many specifics: the use of macroeconomic policies, fiscal policy, monetary policy, aggregate stimulus,
regardless of where it came from, and tfie attempt to move the entire
economy in order to reduce the black unemployment rate.
Mr. M i t c h e l l . Total unemployment rate ?
M r. M cK i n n e y . O r t o m o v e t h e t o t a l u n e m p lo y m e n t r a te t o le v e ls
w h i c h w o u l d h a v e o n c e b e e n t h o u g h t a p p r o p r i a t e i s n o t u n d e r t o d a y ’s
c ir c u m s t a n c e s p o s s i b l e . I t w o u l d c r e a t e i n f l a t i o n w h i c h w o u l d l e a d t o
a d d itio n a l u n e m p lo y m e n t la te r .

However, the problem which you address and which I am critically
concerned about of minority unemployment, youth unemployment,
specific types of unemployment, can be addressed by specific measures
that are targeted toward reducing that kind of unemployment.
I personally think the best way to do it is for the Federal Govern­
ment to offer anyone who wants a job a job whenever they want it,
and it will not be at a net cost to the U.S. Government or to the Ameri­
can people if those jobs are made available at less than the wages that
are paid by business.




52
The necessity for it being less is that we are talking about an adden­
dum to what the private enterprise system can do without tearing itself
apart in today’s inflationary environment.
The whole job cannot be done through macroeconomic stimulus.
Therefore, the Government addenda to that overall stimulus must be
undertaken in a way which aids the problem without exacerbating
the problem. This can only be done through rifleshot approaches to
the unemployment of those who are unemployed under the existing
circumstances.
Chairman M i t c h e l l . I thank you for your statement. However, I do
not quite buy that approach.
Mr. Caputo?
Mr. C a p u t o . I wanted to pursue this further. It is somewhat tedious
but interesting to me—the conclusion that everybody seems to have
reached subject to one constraint, that monetary policy is very pre­
dictable, or inflation is very predictable, based upon changes in mone­
tary aggregates, according to the study that you referred to that this
subcommittee did 23 months ago. This data indicates that except for
unusual changes of import prices and monetary aggregate growths,
something like seven-eights of the change in the Consumer Price Index
today can be described by changes, annual changes, in monthly Mi
data 23 months ago.
How do you reconcile that with the minimum wage, the EPA legis­
lation, with the change in oil prices, even though this is adjusted to a
degree for import price changes, with changes in agricultural policy ?
I would have assumed without benefit of any analytical analysis
that what we did in Congress was far more significant than these data
seem to show.
Mr. C h r i s t . Can I comment on the relation of oil prices and farm
prices and world food prices to inflation in the United States ?
When a country such as the United States is buying something
from abroad—oil or sugar, for example—and the sellers of that are
in a position to raise the price of that product, that need not produce
inflation in the United States in the long run. It depends on the way
we react to it.
It is quite clear that energy now costs us more in real terms than
it used to. We had a choice in the United States in organizing our
monetary policy as to whether to maintain a stable price level in the
face of that increase in energy prices, which would have meant that
other things would have had to become absolutely cheaper in dollar
terms. So if we had stabilized the price level in the United States in
the presence of this oil increase, it would have meant slight declines in
the price of everything except oil, a large increase in the price of oil,
and the average price level could have been kept the same. And that
is what would have happened if we had maintained our monetary
policy in such a way as to stabilize the average price levels.
What we did, in fact, was to say there has been a substantial in­
crease in the price of oil; it won’t do to let the prices of other com­
modities be pushed down through monetary policy; therefore, we will
accommodate the oil price increase by increasing the money stock; and
then people can compute the price index as a whole and find that the
average price level went up, because things other than oil did not




53
change much. They went up a little bit and oil went up a lot. And
so we have this several-percentage-point increase in the average price
level as a result of oil.
The same thing happened with food. We don’t need to have an
increase in the average price level every time there is an increase in
some one particular thing.
If we operate our monetary policy in such a way as to say no
prices ever have to go down, then all price adjustments will have to
take place through increases of some prices while other prices stay
the same. And if we keep doing that on a long-term basis, then the
average price level is going to keep going up, because relative prices
will not stay constant. Something is always getting more expensive
than something else. I f we had stabilized calculator prices over the
last 3 years, we would have a horrendous inflation, because their prices
have been declining.
Mr. H u n t . The way I look at the inflation rates agrees in basic
substance with Professor Christ. Inflation is determined by aggregate
demand and aggregate supply. On the aggregate supply side, the ag­
gregate supply curve is nothing more than the cost curve of firms
producing goods and services. Now, if there is a shift upward in some
basic cost, such as food or agriculture, temporarily that can serve to
raise the price, provided that the aggregate demand curve shifts with
it. In other words, the Federal Reserve accommodates the supply
pressures through a faster growth in money supply.
In the past we have had dislocations in the agricultural sector and
the energy sector. Rather than having a decrease in output the ag­
gregate demand curve has been typically shifted outward through
faster money supply growth or a more stimulative fiscal policy. Policy
actions have usually allowed deflation somewhere else in the economy.
Consequently inflation keeps moving on up, ratcheting on up, with
higher rates of inflation.
Now, I happen to believe that if you look at all of the factors that
influence inflation—and there are many—that changes in money sup­
ply are perhaps the most important.
I don’t want to quibble about that, but monetary growth is the pre­
dominate policy control variable in determining the inflation rate.
There are, of course, other things that Congress could do.
Mr. C a p u t o . Agricultural policy, energy policy, minimum w a g e
policy ?
Mr. H u n t . That i s right.
Mr. C a p u t o . Are you saying then that Fed policy i s the most im­
portant factor ?
Mr. H u n t . Yes, I think over the long run there is very little that
Congress can even do; over the short run, yes; there is a great deal
that they can do, but not over the long run.
Chairman M i t c h e l l . Y o u gentlemen have been very patient with
us, and I think you can sense from our questioning that A are really
ve
groping for answers. You have been helpful in giving us some
direction.
Mr. Hunt, in your testimony you indicated, or you attributed a part
of the rise in interest rates last year to the rise in credit demands rela­




54
tive to GNP. Then, I think, Mr. Christ, your view was that inflation
expectations pulled up the rates; is that correct ?
Mr. C h r i s t . Yes.
Chairman M i t c h e l l . S o, apparently, we have an inconsistency.
Don’t we have a relatively sharp difference of views on this issue ? Is
that correct?
Mr. C a p u t o . Mr. Chairman, if I might excuse myself, I have floor
duty, and I want to apologize to the gentlemen for leaving early.
Chairman M i t c h e l l . Fine. Thank you for being here.
To put it more specifically, are credit demands fed by inflation, or
are they fed by inflationary expectations? That is, i guess, what
I am trying to get to.
Mr. C h r i s t . Well, I noticed the contrast between the two explana­
tions that we gave for the rise in interest rates when Mr. Hunt was
giving his testimony. I am not sure that they are really in conflict
with each other.
The increase in housing, for example, has come in part due to a
situation in which we had a housing depression for several months,
and this was in part because there were regulations imposed
by State governments as to the rates of interest that could be
charged on mortgages. Those regulations had been in effect for
years, and interests for many years were well below the ceilings
T
that were required by those State laws. When we got into an in­
flationary situation and the general level of interest rates rose, then
mortgage interest rates bumped against those ceilings and the market
rates exceeded the ceilings, and many people who were interested
in making: mortgage loans stopped doing so because they could earn
a higher interest rate in some other market than in the mortgage
market. And many States have revised their ceilings.
Maryland’s used to be 6 percent. I think maybe now’ it is 10 per­
cent. I am not quite sure. I t was raised in two stages.
This has happened in other places, so that now the housing market
has had increased access to funds. And there was a time when housing
construction was extremely low, and when you go through a period
like that and then it is over with, the ceilings are higher and the
market interest rates were a little lower in 1976-77 than they had
been at the credit crunch, then you get a big backlog of housing de­
mand and people come forth and want to borrow and purchase houses.
So I think there is not a real conflict between these two explana­
tions.
Also, when you are living in a world when the general prices are
rising at 7 percent a year, you expect the credit demands to rise at
least that fast, measured in money terms, just to keep up with the
inflation. And we are coming out of a business depression in the last
year, and that normally is accompanied by an increase in credit
demands, also.
Mr. H u n t . I don’t view any difference with Professor Christ. On
page 6 he listed the fact that the markets were adjusting to a con­
tinuation of inflation at 7 percent. That was certainly at work last
year. We had a very low inflation rate in the fourth quarter of 1976,
and as the year proceeded it became clear that we were not going to
hold at that lower rate.




55
And he also mentions the normal cyclical increase in interest rates
as credit demands rise cyclically at this stage.
But I would point out that the credit growth of last year was at
unprecedented proportions. There were three large sectors of net
credit demands. In the housing sector inflationary expectations of
consumers are quite high. Individuals look around and they see noth­
ing has held up against the rate of inflation that they can purchase
except a home. Thus they try to get on the front side of the inflation
curve by buying a home and leveraging themselves as much as they
possibly can do so.
There was also a very rapid growth in other consumer types of
debt which were in part related to the fact that they were moving
into these new houses and fixing up older ones.
And a third source of larger credit growth was the Federal Govern­
ment itself and its agencies. And toward the end of last year when
the financial markets had to fund a very significant part of new debt,
they really sagged quite badly, and bond market yields went up, and
there was a considerable erosion of value in the bond market because
of those prices.
But, no; I don’t view our answers in conflict in any way at all.
Chairman M i t c h e l l . Thank y o u .
The last question—well, there are a half dozen questions, but I
would like to ask your indulgence. If we send them to you, would you
respond to them, with particular emphasis upon what I consider to be
the most potentially dangerous economic situation in America, our
black unemployment rate? We must find answers to this problem.
That would have been my last question, but rather than prevail upon
your time any longer, I will send them in writing to you.
Black unemployment is a potentially dangerous situation which is
costly, both in terms of economics and in terms of social/psychological
matters in this country. So the monster is now loose up there.
I thank you gentlemen. It has really been most informative, and I
appreciate your responses to the questions that we will address to you
in writing, and certainly your responses to those this morning.
Thank you very much.
The subcommittee is adjourned.
[Whereupon, at 11:45 a.m., the subcommittee adjourned.]







APPENDIX I

B R I E F I N G

PAPERS
FO R

MONETARY
O V E R S I G H T

P OL I CY
HEARI NGS

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE

COMMITTEE ON BANKING, FINANCE, & URBAN AFFAIRS




JANUARY 30, 1978

P R E P A R E D B Y ST A F F ,
S U B C O M M I T T E E ON
DOMESTIC MONETARY POLICY

(57)

58
E X H I B I T I.

STORY.

Ml is shown in billion-$.

So is the target range.

It was converted to $ levels by multiplying observed Ml in bUlion-$ each
quarter by the Federal Reserve's percentage growth targets and using the result
to show target levels four quarters later.
After entering the target range in March 1976 at its lowest end, Ml
crawled along the bottom until last fall.

In October, Ml was increased to

the middle of the range and kept there through March.

In April, Ml growth

increased at an annual rate of almost 20 percent and hit the top of the target.
In July, growth again approached 20 percent per year and now Ml burst through
the top of the range.
The monetary policies that were followed from early 1975 to October
1976, and which laid the foundation for recovery together with reduced infla­
tion, have ended.

Recent rapid money growth places the economy's stability

in jeopardy.
The situation that is developing is reminiscent of a few years ago
when rapid Ml growth from early 1971 to mid-1973 fueled the inflation which
began in 1973, and which in turn, contributed to the 1974-1975 recession.
The rapid Ml growth since last winter, if long contintued, will surely
recreate the 1973-1975 inflation-recession cycle.

But it will be a tricky

business reducing Ml growth back into the target range.

Decelerations nearly

always slow economic growth for a time, but if we don't decelerate Ml growth
now, we face the danger of accelerating inflation
later on.




and bringing a deep recession

OF

OF
BILLIONS

DOLLARS

1

BILLIONS

DOLLARS

EXHIBIT




60
E X H I B I T 2. S T O R Y . T h i s g r a p h s h ows the p e r c e n t a g e c h a n g e f r o m
a y e a r a go of t h r e e m o n e y s u p p l y m e a s u r e s , Ml, M2, and M3.
M l is c u r r e n c y p l u s d e m a n d d e p o s i t s .
M2 is M l p l u s t i m e d e p o s i t s e x c l u d i n g CD's
M3 is M2 plu s n o n b a n k t h r i f t d e p o s i t s
R oughly speaking,
and d o w n t o g e t h e r .

the g r o w t h s of the t h r e e M's m o v e up

Thus,

it w o u l d n o t a p p e a r to m a t t e r v e r y

m u c h w h i c h of the M ' s is m o n i t o r e d
m o n e t a r y p oli c y .




in m e a s u r i n g the t h r u s t of

22-761
0 - 78




EXHIBIT 2

M O N E Y

YEAR

TO

STOCK MEASURES
YEAR PERCENT CHANGE

MONTHLY DATA

62
EXHIBIT

3.

in M-l

v e l o c i t y b e t w e e n the same q u a r t e r s fro m one y e a r to the

next.

The d a s h e d

STORY.

This g r a p h c h a r t s y e a r l y p e r c e n t a g e c h a n g e s

line is the m e a n v e l o c i t y c h a n g e d u r i n g the

p e r i o d f r o m 1 954 th r u 1977.
Changes

Its v a l u e

is 3.1.

in the rate of rise of v e l o c i t y a p p e a r to be r a n d o m

a r o u n d the 3.1

p e r c e n t trend.

It w o u l d be d i f f i c u l t for the Fed e r a l

R e s e r v e to a n t i c i p a t e t h e s e c h a n g e s .

Al s o ,

to t ry to c o m p e n s a t e for r e c e n t c h a n g e s

it w o u l d a p p e a r r i s k y

in the rate of rise of

v e l o c i t y , as t h e s e can q u i c k l y and u n e x p e c t e d l y reve r s e .




EXHIBIT

3

PERCENT

MONEY VELOCITY (CURRENT GNP / Ml)




64
E X H I B I T 4.

S T ORY.

T h i s g r a p h p l o t s actual

percentage changes

in the CPI b e t w e e n the s a m e m o n t h s f r o m one y e a r to the nex.t
( s o l i d line) a g a i n s t p r e d i c t e d c h a n g e s

( d a s h e d line).

The p r e ­

d i c t e d c h a n g e s w e r e c o m p u t e d f r o m pas t Ml g r o w t h and c h a n g e s
import prices.

in

The Ml g r o w t h us e d is m e a s u r e d b e t w e e n the same

m o n t h s f r o m o ne y e a r to the n e x t and is l a g g e d 23 m o n t h s .

Changes

in i m p o r t p r i c e s , a l s o m e a s u r e d o v e r t w e l v e m o n t h p e r i o d s , are
w e i g h t e d by i m p o r t s as a p e r c e n t of G N P and l a g g e d one m o n t h .
L a g g e d c h a n g e s in Ml g r o w t h w e r e m u l t i p l i e d by w 7 2 5 a n d the
changes

in w e i g h t e d

i m p o r t p r i c e s by 1 . 235.

a d d e d to o b t a i n the p r e d i c t o r
( .725 & 1.235)

(da s h e d line).

The two w e r e then
The m u l t i p l i e r s

w e r e d e r i v e d by c o m p u t e r a n a l y s i s e s t i m a t i n g how

changes

in m o n e y g r o w t h and w e i g h t e d

flation

in the p e r i o d 1 9 4 7 - 1977.

import prices affected i n ­

It is i m p o r t a n t to n o t e th a t the Ml m u l t i p l i e r e x h i b i t s
e x t r a o r d i n a r y long t e r m s t a b i l i t y .
its v a l u e w a s

.76.

For the 1 9 4 7 - 1 9 6 5 p e r i o d

Thi s is po w e r f u l

e v i d e n c e of the s t a b i l i t y

of the r e l a t i o n s h i p b e t w e e n l a g g e d m o n e y s u p p l y and i n f l a t i o n .
In v i e w of the e v i d e n c e ,
i n f l a t i o n can be H c k e d

it is n a i v e to b e l i e v e th a t

w i t h o u t r e d u c i n g m o n e y g r o w t h * or tha t

a c c e l e r a t i n g m o n e y g r o w t h will

not accelerate inflation.

Bu t it is also cl ea r t hat recent inf l at i on ca n no t be fully
e xp l a i n e d b y chan g es in lagged m o n e y g r o w t h and cu rr e nt i mport
prices.

It ap p ears al s o to be p ar t ly self-generating.

Judged by

the gap be t w e e n p r e d i c t e d and a ctual inflation, m o m e n t u m adds
a b o ut 2 p er c e n t per y e a r to CPI.

Poli c ie s o t he r tha n m o n e t a r y

w i l l h av e to be us e d to red uc e infla ti o n momentum.




EXHIBIT 4

PERCENT

---------




C P L YEAR TO YEAR PERCENT CHANGE (OF MONTHLY
0.725 * M1MP(t -23) + 1.235 * PIMMPW(t -I)

DATA)

66
EXHBIT
changes

5.

STO R Y.

in the CPI

T h i s g r a p h or s c a t t e r d i a g r a m m a p s y e a r - o v e r - y e a r
last y e a r a g a i n s t this y e a r ' s a v e r a g e u n e m p l o y m e n t .

T h a t the i n f l a t i o n rate is l a g g e d one y e a r m e a n s tha t the 1976
i n f l a t i o n r a t e and the 1977 u n e m p l o y m e n t rate are l a b e l e d
graph connects contiguous years.

*77^

The

T h e e v i d e n c e p l o t t e d in this

exhibit i n d i c a t e s t h a t a p a r t f r o m the V i e t n a m W a r p e r i o d , a c c e l e r a t i n g
i n f l a t i o n was f o l l o w e d by i n c r e a s e d u n e m p l o y m e n t , and s l o w d o w n s
i n f l a t i o n by r e d u c e d u n e m p l o y m e n t .




in

EXHIBIT 5

SCATTER DIAGRAM
c P I (lagged 1 YEAR) vs UNEMPLOYMENT

CPI

PERCENT

CHANGE

YEARLY AVERAGE OF MONTHLY DATA




68
EXHIBIT 6. STOFY.

This exhibit graphs monthly yields on five and 20-year

U.S. Treasury bonds in the 1972-1977 period.

It is not surprising that

rates on these maturities tended to rise in 1973 and 1974, to fall in 1975
and 1976, and to move up a notch in early 1977.
closely changes in inflation.

These trends followed

An important principle of monetary economics

is that interest rates, at least longer term rates, will tend to follow
inflation rates — rising with inflation and falling as inflation tapersoff.

Inflation accelerated in 1973 and 1974, tapered-off in 1975 and 1976,

but began to accelerate again somewhat in 1977.




EXHIBIT 6

MARKET YIELD ON TREASURY SECURITIES
&

20-YEAR MATURITY ISSUES

PERCENT

5-YEAR




CO

MONTHLY DATA

70
EXHIBIT 7. STORY. This graph plots percentage changes in the CPI measured
between the same months from one year to the next (CPI) and the Federal
funds rate (FFR). It shows that monthly movements in the funds rate occur
very nearly in lock step with changes in the inflation rate measured from
the same month a year ago.

The evidence thus indicates that even short­

term interest rates are very powerfully affected by immediate past
inflation experience.




EXHIBIT 7

CPI,

PERCENT CHANGE FROM A YEAR AGO

PERCENT

vs




MONTHLY DATA

72
EXHIBIT 8. STORY.
"average homebuyer"

This exhibit graphs the interest rate which the
paid

to secure a mortgage during the last two

and one-half years, and the interest rate on long term (20 year)
government securities during the same period.
"stickiness" of mortgage rates.




The graph reveals the

EXHIBIT 8

PERCENT

EFFECTIVE YIELD ON CONVENTIONAL NEW HOME MORTGAGES
MARKET YIELD ON 20-YEAR TREASURY SECURITIES




MONTHLY DATA




A PPEN D IX I I

STCfhCN L. NCAL. N.C.
NORMAN C. D AMOUWS, N.H.
DOUG B'ARNAFO, GA.
WCS WATKINS. OKLA.
BUTLER bf.K KICK, S C .
MARK W. HANNAFORD, CALIF.

BRUCE F. CAPUTO. h

U.S. HOUSE O F REPR ESEN TA TIVES
S UBCOM M ITTEE ON DOMESTIC MONETARY POLICY
OF THE
COM M ITTEE ON BANKING. FINANCE AND URBAN AFFAIRS
N in e t y -F if t h c o n g r e s s

W A S H I N G T O N , D .C .

31 J a n u a r y

20515

1978

Dear
P l e a s e a iswer the s e a d d i t i o n a l ques t i o n s , w h i c h w i l l be
i n c l u d e d in the h e a r i n g record.
( 1 ) W h a t are

the i m p l i c a t i o n s of i n f l a t i o n
for l o n g - t e r m e c o n o m i c growth, and in
the n e a r - t e r m for a c h i e v i n g full e m p l o y ­
me n t ?
Does i n c r e a s e d i n f l a t i o n slow
c a p i t a l i n v e s t m e n t and also does it
c r e a t e s u f f i c i e n t fisc a l and o t her drags
on the e c o n o m y to i n c r e a s e the l i k e l i h o o d
of r e c e s s i o n ?
Or, as some say, is
i n f l a t i o n s i m p l y the pri c e we must pay
to a c h i e v e full e m p l o y m e n t ?

( 2 ) W h a t f i s c a l p o l i c i e s m i g h t be used to
increase meaningful employment opportunities
in i n n e r ci t i e s and for b l a c k s and o t her
minorities?
Th a n k yo i for y o u r t e stimony.




S i n c e r e l y yours,

/>
Rob e r t W e i n t r a u b

(75)

76
THE JOHNS HOPKINS UNIVERSITY
BALTIMORE, MARYLAND 2 1 2 1 S

DEPARTMENT OF POLITICAL ECONOMY
(301) 338-7600

February 13, 1978

U.S. House of Representatives
Subcommittee on Domestic Monetary
Policy
Committee on Banking, Finance & Urban Affairs
Washington, DC 20515

Here for the record are brief answers to the additional questions
Congressman Mitchell mentioned at the hearing of January 31, 1978,
which are set forth in your letter of the same date.
1.

(a)

In the long run, inflation has no important effect on economic
growth, provided that the inflation proceeds at a steady rate
for many years, so that everyone in the economy can become
adjusted to it. This requires perhaps half a century, because
many pension contracts and long term leases stretch out that
long.
However, fluctuations in the inflation rate have disturbing
effects on private investment, thus inhibiting the growth of
productive capital, and reducing the growth of the economy.

(b)

An increase in the rate of inflation is the long-run effect
of an increase in the growth rate of the money stock. The
short-run effect is a temporary decrease in unemployment.
But we cannot create a permanent decrease in unemployment
by repeated doses of this medicine, because the public will
not stand for the resulting acceleration of inflation.

(e)

Fluctuating inflation slows capital investment. And fluctuating
inflation usually follows greatly increased inflation, because
when inflation increases greatly, public opinion demands that
it be stopped or at least slowed.




77
(d)

Inflation does create fiscal drag, if the tax system is pro­
gressive in terms of money income. This can be countered by
changing the tax brackets periodically to match inflation.
But inflation increases the likelihood, or severity, of a
subsequent temporary depression in an indirect way, by creating
a demand for reduced inflation, which when translated into
action has a temporary inhibiting effect on output and
employment.

(e)

The statement that inflation is "simply the price we must pay
to achieve full employment" is incorrect, or at least mis­
leading. If we try to* obtain higher employment, by inflationary
monetary policy, one choice we can make is to buy a temporary
increase in employment with an increase in the long-run in­
flation rate. We did this in 1960-78. A second choice is to
buy a permanent increase in employment with ever-increasing
inflation. Clearly we do not think the second choice is worth
the price. Are we sure about the first?

1. (Summary) Monetary policy is crucial for the inflation rate,
but is not a good tool for reducing unemployment.
2.

To increase employment in inner cities and for blacks and other
minorities, I believe several measures are warranted. Not all fall
under the traditional definition of fiscal policy.
One is to abolish the minimum wage. This would remove the present
legal barrier between those who would willingly work for $5,299 a year
or less (40 hours a week for 50 weeks a year) and those who would
willingly hire them. This is especially important for young women
and young blacks. Notice that while the overall average unemploy­
ment rate rose by a factor of 1.59 from 1955 to 1977, the corresponding
factors for people aged 16-19 are 1.75 for white females, 2.08 for
black females, and 2.76 for black males. (Economic Report of the
President, January, 1978, p. 292.)
Another measure is to replace the present complex of welfare pro­
grams by a negative income tax. The marginal positive tax rate
should be substantially below 100% so as to give an economic in­
centive to work.
Another measure is to improve the performance of the schools. When
(as occurred recently) a school principal can declare that from now
on a degree of functional literacy will be required for high school
graduation, it is clear that we have been short-changing some of our
young students, and we have much room for improvement.

22-761 0 - 78 - 6




78
Another measure is to improve job training and labor market infor­
mation.
Finally, the Federal government might serve as an employer of last
resort, at a wage rate below that of the private sector so as not
to draw workers away from private employment, but above the minimum
guarantee under the negative income tax.
1 hope these brief answers are helpful.




Sincerely yours,

Carl F. Christ
Professor

79

Associate^ Inc.
a Subsidiary of The Chase Manhattan Bank, N.A.
900 17th Street N.W., Washington, D. C . 20006 (202) 785-3520
555 City Line Avenue, Bala Cynwyd. Pennsylvania 19004 (215) 667-7350

Telex: 831609

February 6, 1978

U.S. House of Representatives
Subcommittee on Domestic Monetary Policy
Committee on Banking, Finance, and Urban Affairs
House Annex #2
Washington, D. C. 20515

Enclosed are my answers to the questions raised by Mr. Mitchell.
A.

The Implications of Inflation for Long Term Economic Growth

Increasing inflation acts to depress long term economic growth by
worsening the inflation/unemployment trade-off over time. Excessive
stimulation of the economy does result in both high employment and high
inflation in the short run. However, eventually this extra inflation
reduces economic growth and places the country in a position where
continued high employment can occur only at the price of continually
escalating rates of inflation, a condition which is considered to be
distinctly sub-optimal by those who have experienced it. For this
reason, when the economy approaches full employment, we must be very
careful to avoid excessive further macroeconomic stimulation.
B.

Suggested Fiscal Policy Options for Increasing Inner-City Employment
Opportunities

There are many actions which can be taken to increase employment
opportunities for inner-city residents. The ones that I believe to be
most important are listed below:
1. Continued economic growth. Without continued economic growth
employment producing programs can only provide short term gains,
most of which will tend to be at the expense of other sectors, a
situation which is sub-optimal as well as unstable. Where possible,
our first objective in redistributing income should be to enlarge
the size of the pie, rather than reslicing the original pie.




80
2.

Increased Trageting of programs such as CETA and Local Public
Works based upon need.

3. Adopting localized investment tax credits to encourage construction
and rehabilitation of inner city areaTI Most developed^countries
other than the United States have alreadyadopted regionalized tax cre­
dit programs.
4. Granting wage subsidies for disadvantaged and low income workers.
To derive maximum effect, this program should be set up so that the
wage credits would flow right through to the employees, rather than
be made a portion of the corporate income tax. as is done presently.
Further effectiveness would result if these subsidies would only apply
to jobs in which training, either on-the-job or for a portion of the
day in a classroom, was an established part of the position. Again,
many developed nations already have programs of this type.
5. Continued aid to minority and other small business. Traditionally,
the lifeblood of cities and the clearest avenue for minority group selfhelp has been the growth of small businesses. Recently the establish­
ment of a small business has become much more difficult. The federal
government can help remedy this unfortunate situation by continuing and
expanding existing programs designed to aid small business, and by
establishing offices in each major city designed to help small businesses
cope with government regulations. These offices would be federally
financed business informal*ton centers, presumably staffed by persons
with business experience many of whom would probably be semi-retired.
These persons could help aspiring small businessmen solve the problems
of becoming established and coping with the vast array of impediments
to a new business.
6. Increased direct action designed to increase part-time employment.
The key problems of underemployment, teenage unemployment, and unemployment of other new entrants to the labor force can best be met through
employment programs designed to meet these people's needs. In many
cases these people would prefer part-time employment to full-time employ­
ment, a result of their existing responsibilities either in school or to
their families. A comprehensive system of federally encouraged private
sector part-time employment would impart needed job skills, training,
and employment experience to these people within the framework of their
existing lifestyles.




81
Dealing with structural unemployment is one of the two most crucial problems
facing this country. (The other is establishing a balance between domestic
supplies of energy and our energy needs.) I wish you success in your efforts
to direct and concentrate our nation's efforts upon this problem.




Sincerely yours,

Leon W Taub
Vice President

82
F ID ELC O R . Inc.

Broad & W alnut Streets. Philadelphia. Pennsylvania 1 9 1 0 9

2 1 5 9 8 5 -6 0 0 0

L A C Y H . H U N T , Ph. D . - Vice President & Econom ist 985-8671

F ebruary 27, 1978

S u b c ommittee On Domestic
M o n e t a r y Policy
3154 House Annex 2
W a s hington, D.C.
20515

This letter is in response to your request of January 31,
1978 on a d ditional questions for the hearing record.

©
FIDELCOR

(1) High and rising infla t i o n tends to diminish
l o n g-term economic growth and hamper efforts for a c h ieving
full employ m e n t in the near-term.
When the inflation rate
rises, both consumers and b u s i n e s s m e n tend to b e come more
uncertain.
Hence, consumers increase their rate of saving
and b u s i n e s s m e n initially tend to defer on investment p r o ­
jects.
If an a c c e l e r a t i o n is prolonged, then b u s i n e s s m e n
may cancel capital investments.
There are several channels
w h e r e b y inflation serves to reduce i n v estment in plant and
equipment.
A high rate of inf l a t i o n makes it more d i f ficult
for b u s i n e s s m e n to make cash flow proje c t i o n s for the future
on the basis of current investments.
The high inflation
rate, moreover, tends to increase the u n c e r tainty factor
and, thereby, makes investment less than o t h erwise would
have been the case.
A rising rate of infla t i o n will push
l o n g - t e r m bond yields up and thus also serve as an i m p e d i ­
men t to investment.
The high rate of i n flation combined
wit h the pr o g r e s s i v e structure of the p e r sonal income tax
s y s tem tends to insure the rapid relative growth of the
g o v ernment sector of the economy.
Since the g o v e r n m e n t a l
sector is typically a dis-saver, a high infla t i o n rate
serves to reduce aggregate saving.
As the invest m e n t and
savings process is inextricable, investment must decline.
C o n sequently, I wou l d not accept the n o tion that i n flation
is the price we must pay to achieve full employment.
(2) There are several fiscal policies that m i ght be
employed to i n crease m e a n i n g f u l e m ployment op p o r t u n i t i e s for
m i n o rities in i n n e r - c i t i e s . For one, the m i n i m u m wage law
s hould not p e r t a i n to teenagers.
The m i n i m u m wage law serves
to price ma n y teenagers out of the labor market.
This is
u n f ortunate since these teenagers are desp e r a t e l y in need of
o n - the-job training.
Also, there are many jobs and functions
that would be done in the p r ivate sector if the price were
right.
If there remains serious objection to v o i ding the




83
m i n i m u m wage for teenage workers, the g o vernment might
c o n sider s u bsidizing the m i n i m u m wage for private employers
who hire teenagers.
Such a program, however, should keep
the subsidies in line with the d i s t r i b u t i o n of teenage
empl o y m e n t problems.
In other words, more subsidies
should be paid on behalf of black teenagers than white
teenagers, since the u n employment rate for this group is
m uch higher.
One of this c o u n t r y ’ most urgent needs is
s
to address the u n e m p loyment prob l e m for blacks and other
m i n o r i t i e s at the teenage level.
Young workers must be
made a part of the workf o r c e while they still have the
drive and incentive of youth.
They must not be discouraged
in these important and formative years.




84
Irving Trust
Company
One Wall Street
New York, N. Y. 10015
George W. McKinney, jr.
Senior Vice President

F eb ru a ry 6 , 1978

Thanks fo r the opportunity to elab orate on the q u estio n s
r e la te d to our January 30 testim o n y .
1)
I b e lie v e in flation is d e str u c tiv e of lo n g -te r m ec o n o m ic
grow th in a lm o st any en viron m en t, but that it is p a r tic u la r ly
h arm fu l to a h igh ly co m p lex in d u str ia liz e d econom y su ch a s
o u r s. F o r one thin g, s o c ia l re a ctio n to in ju stic e s and to u n c e r ­
ta in tie s ca u se d by in fla tio n is lik e ly to tr ig g e r ch an ges that
w ould m od ify and sig n ific a n tly w eak en our ec o n o m ic str u c tu r e .
The e ffe c ts of in fla tio n a s a m ean s of a ch iev in g fu ll e m p lo y ­
m en t in the n ea r te r m a re s im ila r ly co u n terp ro d u ctiv e. A t any
g iv en point in tim e , th e re is a tr a d e -o ff b etw een in fla tio n and
u n em p loym en t. But it is the p e r c e iv e d rate of in fla tio n w hich is
re le v a n t. B a sic K eyn esian pump p rim in g w ill g e n e r a lly w ork if
m o d e stly r is in g p r ic e s cut the r e a l w age b elow the m inim u m
n om in al w age w o rk er s a r e w illin g to a cc ep t. But, o v er tim e ,
p eop le b eco m e aw are that in flation is cutting th e ir r e a l w a g e s,
and they fa c to r the in flation into th e ir co n tra c ts and a g r e e m e n ts.
Thus the m in im u m n om in al w age they w ill a c c e p t r i s e s to o ffse t
th e ir ex p ec ta tio n s of in fla tio n . The end r e su lt is that in fla tio n
ca n w ork a s a s h o r t-te r m stim u lu s only if it is a c c e le r a te d g e o ­
m e tr ic a lly so that actu a l in flation in c r e a s e s fa s te r than p e o p le 1s
ex p ec ta tio n s o f in fla tio n in c r e a s e .
In cr ea se d in flation e x a c e r b a te s a ll o f the d isto r tio n s that
tend to o ccu r in the n o rm a l c o u r s e of the ex p a n sio n p hase of the
b u s in e s s c y c le . One illu s tr a tio n is b u sin e s s in v e n to r ie s . In fla ­
tio n and ex p ec ta tio n s of fu rth er in flation ex a g g e ra te the n atu ral
ten d en cy to o v er a cc u m u la te in v en to r ie s at the peak of the boom ,
tying up in d u stria l ca p a city in the production of in v e n to r ie s in ­
stea d of goods fo r con su m p tion. F or th is and s im ila r r e a so n s
in flation is lik e ly to push an econ om y through the b o o m -b u st phase
of the c y c le fa s te r and on a w id er sc a le than w ould o th e rw ise be
the c a s e .




85
Inflation is not the p r ic e we pay fo r fu ll em p loym ent; in flation
is a c ir c u m sta n c e w hich m ak es it m ore d ifficu lt to attain and m a in ­
tain fu ll em p lo ym en t.
2)
In r e sp o n se to th is q u estion , I am e n c lo sin g testim o n y w h ich
I p resen te d on F eb ru a ry 1 at the W hite H ouse C on feren ce on B a l­
an ced N ation al G rowth and E con om ic D evelo p m en t. S ince it r e la te s
s p e c ific a lly to the u rgen t n eed for m ean ingfu l em p loym en t op p or­
tu n ities for b lack s and other m in o r itie s , I hope you can in clu d e it
in the r e c o r d of your h e a r in g s.
A lso e n c lo se d i s the T ra n scrip t of P r o c e e d in g s you se n t m e.
I have m ark ed c o r r e c tio n s or c la r ific a tio n s on m o st p a g es.
C o rd ia lly ,

S ub com m ittee on D o m e stic M onetary P o lic y
Room 3154, H ou se A nnex #2
2nd and D S tr e e ts , N. W.
W ashington, D . C. 20515




86
F e b r u a r y 6 , 1978
PEO PLE AND JO BS

One o f ou r n a t i o n 's most g l a r i n g p o l i c y d e f i c i e n c i e s i s i t s f a i l u r e to f u r n is h a s many
employment o p p o r t u n it ie s as a r e needed by o u r young p e o p le and m in o r it y g ro up s. We have no
c l e a r p i c t u r e o f ou r n a t i o n a l o b j e c t i v e s w it h r e s p e c t to employment and r e l a t e d p o l i c i e s ; o u r
l e g i s l a t i o n does n o t r e f l e c t c o h e re n t s ta n d a rd s f o r e v a lu a t in g p ro g re s s to w ard th o se o b je c ­
t i v e s we do a r t i c u l a t e ; we p e r m it i r r a t i o n a l e m o tio n a l b ia s e s to ta k e p re ce d e n ce o v e r re c o g n iz e d
econom ic p r i n c i p l e s .
O BJE C T IV ES
The f o llo w in g o b j e c t i v e s , I b e l ie v e , encompass th e more im p o rta n t g o a ls w h ich sh o u ld be p u r­
sued i n f o r m u la tin g n a t i o n a l p o l i c i e s d e a lin g w it h employment and r e l a t e d s u b je c t s .
1.
To re d u ce i n f l a t i o n . Employment p o l i c i e s a r e one a s p e c t o f th e b ro a d e r t o p ic o f th e eco­
nomic w e llb e in g o f th e n a t i o n ’ s w o r k e rs , and sh o u ld be c o n s id e re d i n t h a t l i g h t .
I t would
a cc o m p lish l i t t l e to f o llo w p o l i c i e s t h a t w ould im prove econom ic c o n d itio n s f o r one group o f
c i t i z e n s b u t t h a t would cau se e q u iv a le n t o r g r e a t e r h a r d s h ip f o r a n o th e r .
In f la t io n in e v ita b ly
h i t s h a r d e s t th e most d e fe n s e le s s o f th e n a t i o n 's c i t i z e n s : th e o ld and r e t i r e d , th o se l i v i n g
on f ix e d s a l a r i e s o r o t h e r f ix e d inco m es, th o se whose incomes a r e in a d e q u a te and u n c e r t a in ,
th o se who c a n ’ t a f f o r d to own t h e i r own homes.
The a c t u a l r a t e o f i n f l a t i o n must exceed th e p e r c e iv e d r a t e o f i n f l a t i o n i f i t i s to be su c­
c e s s f u l as a jo b - c r e a t io n d e v ic e .
Thus o n ly a p r o g r e s s iv e ly h ig h e r i n f l a t i o n r a t e can re d u ce
unemployment i n th e sense u s u a l l y assumed f o r th e P h i l l i p s c u r v e .
U l t i m a t e l y th e l i m i t s o f
such a p o l i c y a r e re a ch e d , and th e u n c e r t a i n t i e s engendered by th e i n f l a t i o n push unemployment
to l e v e l s h ig h e r th a n would have e x is t e d i n th e ab sence o f th e i n f l a t i o n .
I n th e lo n g ru n ,
no demand management p o l i c y can re d u ce unemployment i f i t s im u lta n e o u s ly in c r e a s e s i n f l a t i o n .
Unemployment l e v e l s w i l l n e v e r be s a t i s f a c t o r y u n le s s i n f l a t i o n r a t e s can be red uced to s a t i s ­
fa c to ry le v e ls .
2.
To re d u ce economic h a rd s h ip f o r th o se w it h In a d e q u a te inco m es.
Econom ic h a rd s h ip i s a
r e l a t i v e te rm .
I t can be re d u ce d , b u t i t can n e v e r b e e lim in a t e d . Among o th e r th in g s , th e
s ta n d a rd s by w hich we measure econom ic h a rd s h ip s h i f t c o n t i n u a l l y upward as o u r l i v i n g s ta n d a rd s
in c r e a s e , so someone w i l l a lw a y s be jud g ed by co ntem p o rary s ta n d a rd s (and a p p r o p r ia t e ly ju d g e d )
to be s u f f e r i n g economic h a r d s h ip .
Y e t A m ericans a r e a co m p assion ate p e o p le ; we f e e l t h a t e ve ry o n e sh o u ld have a c c e s s to some
minimum sta n d a rd o f l i v i n g , r e g a r d le s s o f h i s o r h e r own econom ic c a p a b i l i t i e s .
I t i s ap p ro­
p r i a t e t h a t o u r n a t i o n 's a s p i r a t io n s f o r i t s p o o re s t members sh o u ld s h i f t upward as th e n a t i o n 's




87
p r o d u c t i v it y in c r e a s e s .
a s p i r a t io n s to be met.

And, to th e e x te n t f e a s i b l e , a w id e m a jo r it y o f A m ericans w ant th o se

3.
To remove income d i f f e r e n t i a l s t h a t stem from d i s c r i m i n a t i o n o f any s o r t .
The Am erican
c o n s c ie n c e sh ou ld n o t— must n o t— t o l e r a t e a r b i t r a r y l i m i t s to th e p a r t i c i p a t i o n o f i n d i v id u a l s
i n o u r econom ic l i f e .
B u t i t ' s n o t j u s t a m a tte r o f c o n s c ie n c e a lo n e .
From an economic p o in t
o f v ie w , we can not a f f o r d such d is c r i m i n a t i o n .
W henever an i n d i v id u a l i s b a r r e d from p a r t i c i ­
p a t in g f u l l y i n th e n a t i o n ’ s econom ic l i f e , i t shows up i n h i s lo w e r income and h i s lo w e r
s ta n d a rd o f l i v i n g .
B u t th e n a t io n as a w ho le s u f f e r s an e q u iv a le n t d e p r iv a t io n , b ecau se th e
p e rso n c o n t r ib u t e s le s s to th e n a t i o n 's p r o d u c tio n th a n he co u ld and sh o u ld , and th e n a t i o n 's
o u tp u t and consum ption a r e lo w e r b ecau se o f th e i n e f f i c i e n t use o f h i s t a l e n t s .
4.
To p r o v id e maximum o p p o r tu n ity f o r upward econom ic and s o c i a l m o b i l it y f o r e v e r y i n d i v id u a l
member o f our s o c i e t y .
T h is o b j e c t i v e i s v e r y f r e q u e n t ly v i o l a t e d b y s o c i a l l y c o n scio u s i n d i ­
v id u a ls (and l e g i s l a t o r s ) who d o n 't th in k thro ugh th e i m p lic a t io n s o f t h e i r p o l i c y recommenda­
t io n s .
T h is i s a l i v i n g , gro w in g , v i b r a n t s o c i e t y .
I f t h i s s o c i e t y and th e in d i v id u a l s who
make i t up a r e to p ro g re s s o p t i m a l l y , th e r e must be f l e x i b i l i t y f o r th e new id e a to c r e a t e new
m arkets and f o r th e young e n t r a n t to b re a k i n t o o ld m a rk e ts .
Y e t many o f o u r law s and r e g u la ­
t io n s p r o t e c t th e i n t e r e s t s o f th o se a lr e a d y w e l l e n tre n ch e d i n t h e i r economic b a i l i w i c k , to
th e e x c lu s io n o f th e f e l l o w who i s th e re b y d e n ie d a jo b o p p o r tu n ity o r a b u s in e s s o p p o r t u n it y .
The c l a s s i c example i s th e farm a c re a g e a llo t m e n t w h ich ta k e s on a c a p i t a l v a lu e and can be
s o ld as la n d i s s o ld — b j. th e p e rso n who a lr e a d y owned th e farm , to th e young p e rson who w ould
l i k e to g e t i n t o th e fa rm in g b u s in e s s .
Such l e g i s l a t i o n b e n e f i t s th e v e s te d i n t e r e s t — i t g iv e s
a w i n d f a l l to th e farm e r who a lr e a d y has a farm — to th e d e trim e n t o f th e newcomer who has to
p ay more to g e t i n t o th e c lu b .
C la s s l e g i s l a t i o n t y p i c a l l y i n h i b i t s i n d i v id u a l upward m o b i l it y .
As one o f many exam p les, th e
p r e s e n t minimum wage la w p r o t e c t s th e members o f la r g e la b o r u n io n s.
By th e same to k e n , though,
i t a r t i f i c i a l l y adds to unemployment among b la c k s , y o u th s , and o t h e r new e n tr a n t s who f in d i t
much h a rd e r to b re a k i n t o th e la b o r f o r c e .
5.
To v a lu e u s e f u l work as a d e s ir a b le o b j e c t i v e i n i t s e l f .
One o f th e t r a g e d ie s o f th e
G re a t D e p re ssio n o f th e 1930s was th e l a r g e number o f b ro k en l i v e s i t spawned. I t does some­
t h in g t e r r i b l e to a p e r s o n 's p syche to o f f e r th e w o r ld th e b e s t he can g iv e and to f in d o ut
thro ugh a s e r i e s o f r e b u ff s t h a t i t ' s n o t enough.
Our c u r r e n t w e lf a r e system and ou r i n e f f e c ­
t u a l ap p roach to h ig h unemployment r a t e s among y o u th s and m i n o r i t i e s a r e n e e d le s s ly s c a r r i n g
a n o th e r g e n e r a tio n o f l i v e s .
A y e a r ago d ra m a tic p i c t u r e s i n The New Y o rk Times h ig h lig h t e d th e a t t i t u d e o f a la r g e number
o f t h a t c i t y ' s d isa d v a n ta g e d yo u th s tow ard w ork o p p o r t u n it ie s : 12,000 te e n a g e rs w ere photographed
s ta n d in g i n l i n e f o r hou rs i n s u b fr e e z in g te m p e ra tu re s to v i e f o r a li m i t e d number o f temp­
o r a r y jo b s .
I f th e work e t h i c i n th e n a t io n i s i n t r o u b le i t ' s n o t b e cau se o f th e younger
g e n e r a tio n ; by f a r th e m a jo r it y o f them w ant th e c h a lle n g e o f t e s t i n g t h e i r m e t t le , thfe d i g n i t y
o f l i v i n g as c o n t r ib u t in g members o f s o c i e t y . B u t p e e r group a c c e p ta n c e i s e s s e n t i a l to th e
s u r v i v a l o f any s o c i e t a l s ta n d a r d , and we need much more e f f e c t i v e n a t i o n a l le a d e r s h ip to
e n su re th e c o n tin u a t io n o f a h ig h l e v e l o f r e s p e c t f o r p r o d u c tiv e la b o r as a d e s ir a b le a t t r i b u t e
o f th e w ho le i n d i v id u a l and o f th e w ho le s o c i e t y .
6.

To p r e s e r v e i n d i v id u a l freedom as an end i t s e l f .

UNEMPLOYMENT AND INFLATION
Our n a t io n seems b a f f l e d by th e c o n t in u a t io n o f h ig h l e v e l s o f b o th unemployment and i n f l a t i o n .
We h a v e n 't y e t f u l l y grasp ed th e f a c t t h a t , a lth o u g h
th e y can b e s o lv e d o v e r tim e , th e r e i s
no q u ic k c u re f o r th e s e problem s i n t o d a y 's e n v iro n m e n t. They a r e p r i m a r i l y th e h e r i t a g e o f
th e G re a t S o c ie t y and V ie tn a m and th e r e s u l t a n t i n f l a t i o n a r y p r e s s u r e s h e re a t home, to g e th e r
w it h th e w o rld w id e i n f l a t i o n o f th e l a t e s i x t i e s and e a r l y s e v e n t ie s t h a t c u lm in a te d i n th e




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m a s s iv e h ik e i n o i l p r i c e s .
The s t r u c t u r a l im b ala n ce s t h a t r e s u lt e d can not be e x o r c is e d
q u i c k ly ; i t to o k a decade to g e t th e w o r ld ’ s economy t h i s b a d ly o f f b a la n c e and i t w i l l ta k e
some tim e to c o r r e c t th e p roblem .
P a r t o f th e p rob lem i s o u r u n re a s o n a b ly h ig h e x p e c ta tio n s f o r o v e r a l l economic p e rfo rm a n c e .
We d o n 't a p p r e c ia t e th e f a c t th a t r e a l g ro w th , r e a l in v e s tm e n t, and o t h e r im p o rta n t econom ic
m easures have been d o in g much b e t t e r th a n a v e r a g e .
Too much a d d i t i o n a l s tim u lu s w ould choke
o f f th e e x p an sio n and b r in g ab o ut e ve n h ig h e r r a t e s o f unemployment.
Under th e s e c ir c u m s ta n c e s , Governm ent p o l i c i e s sh ou ld be d ir e c t e d f i r s t tow ard s lo w in g i n f l a ­
t i o n by p e r s i s t e n t l y l i m i t i n g m onetary and f i s c a l s tim u lu s , w h ile a t th e same tim e w o rk in g
d e te r m in e d ly to red uce to a minimum th o se f r i c t i o n s t h a t have become a p a r t o f th e p rob lem o f
h ig h i n f l a t i o n and h ig h unemployment.
LIM IT S TO DEMAND STIMULUS
E x p a n s io n a ry demand management p o l i c i e s to d ay can be p r o d u c tiv e o n ly up to a p o in t .
When we
h ave succeed ed i n w o rk in g th e i n f l a t i o n r a t e down to a t o l e r a b le l e v e l , e x p a n s io n a ry demand
management w i l l a g a in be a f e a s i b l e p o l i c y measure from tim e to tim e .
I n th e in t e r i m , th o ugh,
m acroeconom ic p o l i c i e s sh o u ld be m o d era te . They sh o u ld fo cu s on g r a d u a lly r e d u c in g th e i n f l a ­
t i o n r a t e o v e r tim e .
T h is does n o t n e c e s s a r i l y mean co n tin u e d h ig h l e v e l s o f unemployment.
Two th in g s can be done
w h ich w i l l re d u ce unemployment w ith o u t i n c u r r i n g s i g n i f i c a n t a d d i t i o n a l i n f l a t i o n a r y r i s k s .
F i r s t , we can ta k e d e l ib e r a t e a c t io n s to b r in g about a f a v o r a b le change i n th e t r a d e - o f f be­
tween i n f l a t i o n and unemployment; we must s h i f t th e P h i l l i p s c u rv e to th e l e f t .
R e d u cin g th e
i n f l a t i o n r a t e p e r se w i l l tend to b r in g ab o ut t h i s r e s u l t o v e r tim e , b u t th e p ro c e s s can be
h a s te n e d .
B u s in e s s , l a b o r , Governm ent, a g r i c u l t u r e — a l l segments o f ou r economy a r e p erm eated
w it h b a r r i e r s to employment and sp u rs to i n f l a t i o n .
The D a v is- B a c o n A c t and o t h e r Governm ent
m easures th a t r e q u ir e a r t i f i c i a l c o s t in c r e a s e s , a r b i t r a r y u n io n p ro c ed u re s t h a t l i m i t e n t r y
i n t o jo b s o r i n t o th e u n io n s th e m s e lv e s , b u s in e s s p r a c t i c e s t h a t u n n e c e s s a r ily add to c o s ts
and p r i c e s : t h i s C o n fe re n ce sh o u ld recommend a d e te rm in e d e f f o r t to g e t r i d o f th e s e and o t h e r
f r i c t i o n s t h a t w orsen th e in fla tio n - u n e m p lo y m e n t t r a d e - o f f .
Second , we can use ta r g e te d ap p roaches to employment f o r th o se who o th e r w is e would n o t h av e
jo b s .
I n t h i s c o n te x t , I have a s p e c i f i c s u g g e s tio n to make l a t e r . How ever, we sh o u ld ta k e
c a r e to see t h a t such programs a r e c o n s is t e n t y i t h th e o b j e c t i v e s o u t lin e d ab o ve .
U n f o r t u n a t e ly ,
many program s and p roposed program s do v i o l e n c e to th e v e r y o b j e c t i v e s th e y a r e in te n d e d to
a c h ie v e .
THE NEED TO USE ECONOMIC IN CEN TIVES
Pe rh ap s th e b ig g e s t s i n g l e re aso n o u r employment p o l i c i e s have f a i l e d i s b e cau se program s w h ic h
a r e e f f e c t i v e , u s e f u l, and l o g i c a l l y b a se d , f a l l v i c t i m to s p e c i a l i n t e r e s t s .
Our program s a r e
i n i t i a t e d i n th e name o f a w o rth y o b j e c t i v e when th e r e s u l t i s v e r y d i f f e r e n t in d e e d .
The
r e c e n t s i g n i f i c a n t in c r e a s e i n th e minimum wage i s a good exam ple o f b o th .
T h is measure was pushed by u n io n le a d e r s a s a co m p assion ate la w th a t w ould e n su re a d e ce n t
l e v e l o f l i v i n g f o r a l l w o r k e rs .
W hat i t does e n su re i s p r o t e c t io n o f th e u n io n members who
have jo b s , a t th e expense o f b la c k yo u th s and o th e r s i n high-unem ploym ent c a t e g o r ie s .
The h ig h
minimum wage s y s t e m a t i c a l ly f r e e z e s them o u t o f jo b o p p o r t u n it ie s t h a t w ould o t h e r w is e be open
to them , and b lo c k s them from th e o p p o r tu n ity to o b t a in o n - th e - jo b s k i l l s t h a t w ould make i t
e a s i e r f o r them to g e t b e t t e r jo b s l a t e r .
I t a ls o e n su re s a f a s t e r r a t e o f i n f l a t i o n , as up­
ward p r e s s u r e on wages a t th e lo w end o f th e s c a le i s passed up th e l i n e to h ig h e r p a y in g j o b s .
In d e x in g th e minimum wage ex te n d s t h i s p rob lem i n t o th e f u t u r e and g u a ra n te e s t h a t b o th th e
i n f l a t i o n r a t e and unemployment r a t e w i l l b e h ig h e r i n th e y e a r s ahead th a n th e y would o t h e r ­
w is e b e .




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In s t e a d o f u s in g econom ic i n c e n t i v e s to a cc o m p lish o u t o b j e c t i v e s , w h a te v e r th e y may b e , we
f r e q u e n t ly and perhap s
t y p i c a l l y s e t up o u r program s so th e y must u n n e c e s s a r ily h u r d le s tr o n g
econom ic b a r r i e r s .
One o f th e most co gent argum ents f o r t h i s ca se was made b y C o u n c il o f
Econom ic A d v is o r s Chairm an C h a r le s S c h u lt z e i n th e Godkin l e c t u r e s a t H a rv a rd U n i v e r s i t y a
l i t t l e o v e r a y e a r ag o. Y e t A d m in is t r a tio n recom m endations and C o n g re s s io n a l i n i t i a t i v e s con­
t in u e to byp ass th e im p o rta n t p o t e n t i a l f o r p u t t in g m an's n a t u r a l economic i n s t i n c t s to w ork
to a c c o m p lis h , r a t h e r th a n to impede, d e s ir e d o b j e c t i v e s .
One exam ple, w h ich shows up r e g u l a r l y , i s th e u se o f "n e e d " t e s t s t h a t d e te rm in e w h e th e r a
p e rso n w i l l be " i n " o r " o u t " o f a program .
Such t e s t s a r e u n a v o id a b ly i n e q u it a b le (u n le s s th e y
p e rm it b e n e f it s to ta p e r o f f , o r o f f e r i n d i v id u a l c h o ic e r e g a r d in g p a r t i c i p a t i o n ) b e cau se t h e r e ’ s
a lw a y s th e f e l l o w who j u s t b a r e l y f a i l s to q u a l i f y .
The e x t r a d o l l a r o f income t h a t c u t s a
f a m ily o f f frm M e d ic a id
i s u n n e c e s s a r ily u n f a i r as compared to th e nex t-d o o r n e ig h b o r who e a rn s
a d o l l a r l e s s than th e y do.
More im p o r ta n t , though, i s w hat need t e s t s do to i n d i v id u a l
in it ia t iv e .
P e o p le go to g r e a t le n g th s to m a in ta in t h e i r incomes a t th e b e s t p o s s ib le l e v e l ,
and th e y w i l l r e a s o n a b ly t r y to make s u re th e y a r e e l i g i b l e f o r a program i f t h a t i s i n t h e i r
b e s t i n t e r e s t s . Thus need t e s t s , i f th e y r e s u l t i n a ll- o r - n o t h in g e l i g i b i l i t y , a lm o st seem
to be d esigned to p r o v id e i n c e n t i v e s f o r i n d i v id u a l s to h o ld down t h e i r e arned income i n
o r d e r to maximize t h e i r income su p p lem en ts.
PO LICY IMPLICATIONS
What a r e th e p o l i c y i m p lic a t io n s o f th e s e o b s e r v a tio n s ?
1 . Most i m p o r t a n t ly , Government p o l i c i e s sh o u ld be c o n s id e re d a s a w h o le .
T here i s an u rg e n t
need f o r Government p la n n in g — n o t Government p la n n in g o f th e p r i v a t e economy, b u t Government
p la n n in g o f th e b u s in e s s o f Governm ent.
Government p o l i c i e s r e l a t i n g to unemployment sh o u ld
be c o n s id e re d i n t h e i r e n t i r e t y : employment o p p o r t u n i t i e s , income su p p lem en ts, ta x in g and
sp end ing program s.
O n ly to o f r e q u e n t ly an i n d i v i d u a l program i s e v a lu a te d a c c o r d in g to i t s
i n d i v id u a l im p act on th e v a r io u s segments o f s o c i e t y .
F o r exam ple, e v a lu a t io n s o f c o m p a ra tiv e
income l e v e l s sometimes ig n o re payment I n k in d , noncash income sup p lem ents, and c o n s id e r o n ly
th e cash p aym ents. Or an i n d i v id u a l program w i l l be e v a lu a te d a c c o r d in g to w h e th e r i t i s
p r o g r e s s iv e o r r e g r e s s iv e .
I t i s v i r t u a l l y im p o s s ib le to d e s ig n s p e c i f i c program s so t h a t each
has th e d e s ir e d d egree o f p r o g r e s s i v i t y ; b e s id e s , th e r e l e v a n t f a c t o r i s th e im p act o f th e
w ho le system .
The system sh ou ld have a p r o g r e s s iv e im p act on i n d i v i d u a l s ' incomes ( w it h a
minimum number o f d i s c o n t i n u i t i e s i n t h a t p r o g r e s s i v i t y ) b u t i t i s n o t a t a l l n e c e s s a r y f o r
i n d i v i d u a l programs to have s i m i l a r c h a r a c t e r i s t i c s .
A n e g a t iv e income ta x as a s u b s t i t u t e
f o r — n o t a supplem ent to — o u r p r e s e n t co n g lo m era te o f w e l f a r e program s w ould be a h i g h l y
c o n s t r u c t iv e s te p i n t h i s d i r e c t i o n .
2.
Program s sh o u ld in c lu d e as much i n d i v id u a l freedom o f c h o ic e as p o s s i b l e , to a c h ie v e
maximum e f f i c i e n c y and maximum i n d i v i d u a l i n c e n t i v e .
As a s p e c i f i c i l l u s t r a t i o n , th e e f f e c ­
t iv e n e s s o f o u r combined income a s s is t a n c e and employment programs w ould be m a rk e d ly im proved
i f income a s s is t a n c e paym ents w ere same i n a l l p a r t s o f th e n a t io n .
G e o g rap h ic d i f f e r e n t i a l s
have been j u s t i f i e d on th e grounds t h a t th e y r e f l e c t d i f f e r e n c e s i n th e c o s t o f l i v i n g .
Such
an argument f l i e s i n th e f a c e o f r a t i o n a l econom ic a n a l y s i s ; d i f f e r e n t i a l paym ents m o tiv a te
th e r e c i p i e n t to s t a y i n th e h ig h c o s t a r e a , even though i t may be and u s u a l l y i s an a r e a
where e n t r y l e v e l jo b s te n d to be s c a r c e .
O ver tim e , th e number o f r e c i p i e n t s i n th e h ig h
c o s t a re a s tend to in c r e a s e , n o t so much b e cau se th e y come th e r e f o r t h a t s p e c i f i c re a s o n , b u t
b e cause th e r e i s l e s s in c e n t i v e f o r them to go e ls e w h e r e .
U n ifo rm paym ents w ould make i t
le s s c o s t l y f o r th e r e c i p i e n t to move i n t o a lo w c o s t a r e a , o r perhap s to go w here he th in k s
a jo b m ight be found .
As an exam ple, t y p i c a l income a s s is t a n c e paym ents i n New Y o rk C i t y now exceed median e arn e d
income i n some s e c t io n s o f th e n a t io n .
E q u a l paym ents w ould h e lp s o lv e New Y o rk C i t y ' s
f i n a n c i a l p ro b le m s.
They w ould s im u lt a n e o u s ly r a i s e th e s ta n d a rd o f l i v i n g i n o t h e r a r e a s
as w e lf a r e r e c i p i e n t s moved e ls e w h e re and to o k w it h them incomes t h a t w ould add to income
flo w s i n lo w e r - c o s t , low er-incom e a r e a s .




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3.
A lm ost u n lim it e d F e d e r a l l y sp onso red t r a i n i n g programs would be l e s s c o s t l y than th e
c u r r e n t unemployment s i t u a t i o n .
The i n t o l e r a b l y h ig h unemployment among b la c k te e n a g e rs and
o t h e r d is a d v a n ta g e d groups i s a c r i t i c a l l y dangerous p roblem f o r o u r s o c i e t y .
I t must be s o lv e d
i f o u r n a t io n i s to c o n tin u e to move fo rw a rd . I f th e s e young p e o p le a re p ro v id e d w it h s k i l l s
i n volum e, th e y w i l l u l t i m a t e l y f in d a way to use them.
And th e c o s t o f t r a i n i n g i s s m a ll i n
co m p arison w it h th e c o s ts o f id le n e s s f o r more than one t h i r d o f an im p o rta n t segment o f o u r
s o c ie t y .
4.
Econom ic l o g i c su g g e sts t h a t th e F e d e r a l Government sh o u ld a t a l l tim es s e r v e as a r e s i d u a l
e m p lo y er— n o t o f th e fa v o r e d few who happen to be chosen f o r a program t h a t em braces a s p e c i f i c
number o f p e rs o n s , b u t as a r e s i d u a l e m p loyer o f a l l who w is h jo b s a t some r a t e o f p ay b elow
th e minimum wage p a id by p r i v a t e i n d u s t r y .
The s p e c i a l c irc u m s ta n c e th a t d i f f e r e n t i a t e s to d a y ’ s econom ic problem s from th o se o f a n o n - in ­
f l a t i o n a r y e n viro n m e n t i s th a t a p p r e c ia b ly more macroeconomic s tim u lu s w i l l a lm o st s u r e l y
engender a d d i t i o n a l i n f l a t i o n , w ith o u t d o in g much f o r th e unemployment r a t e .
In d e e d , we can
u l t i m a t e l y e x p e ct th e unemployment r a t e to w orsen i f we o v e r s t im u la t e th e economy.
T h e r e fo r e
m acroeconom ic s tim u lu s won’ t employ a l l th o se whom we w ould l i k e to have jo b s , and th e w i s h f u l
atte m p t to do i t anyway w ould do more harm than good.
I f we keep a t i t , we can lo w e r th e i n ­
f l a t i o n r a t e to a t o l e r a b le l e v e l o v e r a p e r io d o f tim e , and Wt* can once a g a in have an e f f i ­
c i e n t l y f u n c t io n in g economy.
I n th e m eantim e, though, 35% o f o u r b la c k te e n a g e rs do n o t have
and can n o t g e t jo b s .
The F e d e r a l Government sh o u ld f i l l th e gap u n t i l th e economy i s a b le
to ab so rb them in t o th e p r i v a t e economy.
B u t how? The c o s t would be e x o r b it a n t i f a l l who w ant jo b s w ere h ir e d a t go in g w ag es.
T h e re ­
f o r e o n ly a lu c k y few c o u ld hope to b e n e f i t from Governm ent h i r i n g program s, s in c e th e number
co ve re d would n e c e s s a r i l y be l i m i t e d .
Those who would n o t be in c lu d e d would b e as much w ith o u t
jo b s as th e y w ere b e f o r e , and t h e i r h a r d s h ip would n o t be re d u ce d .
Then th e r e a r e a l l s o r t s
o f problem s r e l a t i n g to t r i g g e r p o in t s to s t a r t and s to p such program s, to sa y n o th in g o f th e
i n e v i t a b l e p o t e n t i a l f o r p o l i t i c a l f a v o r i t i s m f o r th o se who a r e co v e re d .
A compromise betw een d e s i r a b l e o b j e c t i v e s i s needed.
A s o lu t io n w h ich p e rm its i n d i v id u a l s
to choose w h e th e r o r n o t to p a r t i c i p a t e i s to o f f e r to a l l who a r e n o t employed b y th e p r i v a t e
s e c t o r th e o p p o r tu n ity f o r employment i n p u b lic s e r v i c e jo b s , b u t a t wages b e lo w th o se p a id
i n th e p r i v a t e s e c t o r .
As th e p r i v a t e s e c t o r s u b s e q u e n tly d e ve lo p s th e c a p a c it y to employ more
p e rs o n s , th e y w i l l a u t o m a t ic a lly be drawn from th e ran k s o f p u b lic s e r v i c e jo b s , s in c e p r i v a t e
in d u s t r y w ould p ay m ore.
T h e re w ould be no prob lem o f t r i g g e r p o in t s , f o r as econom ic circ u m ­
s ta n c e s im prove and more g e t p r i v a t e jo b s , p u b lic s e r v i c e p a y r o l l s w ould a u t o m a t ic a lly be
re d u ce d .
I n f u t u r e b u s in e s s c y c l e s , r e s i d u a l Government p u b lic s e r v i c e jo b s w ould r o u t i n e l y
p r o v id e employment f o r th o s e l e t o u t o f p r i v a t e jo b s when such jo b s w ere need ed , and j u s t as
r o u t i n e l y r e le a s e them to th e p r i v a t e s e c t o r when th e need was gone.
U n f o r t u n a t e ly , p u b lic s e r v i c e employment o f su b m a rg in al em ployees a t go in g wages must e i t h e r
be l i m i t e d i n number, w h ich le a v e s some i n d i v id u a l s e x a c t ly where th e y w ere b e fo r e and i s no
improvement a t a l l f o r them, o r o f f e r jo b s to a l l comers i n w h ich ca se i t i s h i g h l y i n f l a t i o n a r y
and i n th e lo n g ru n s e l f - d e f e a t i n g .
Such m easures a s th e Humphrey-Hawkins b i l l w ould do p a r ­
t i c u l a r damage to th e n a t i o n ’ s employment and w e lf a r e o b j e c t i v e s , s in c e i t r e q u ir e s th e u se
o f macroeconom ic s t i m u l i i n an atte m p t to a c h ie v e an u n r e a l i s t i c q u a n t i t a t i v e unemployment
ta rg e t.
We need to p r o v id e more jo b s to d a y , p a r t i c u l a r l y f o r m in o r it y y o u th s .
To p r o v id e them th ro ugh
a g g re g a te demand s tim u lu s , though, would be h i g h l y i n f l a t i o n a r y and w ould be s e l f - d e f e a t i n g
i n t h a t th e jo b s w ould n o t be fo rth c o m in g .
The jo b s sh o u ld be made a v a i l a b l e th ro u g h t a r g e te d
employment program s.
How ever, i n o r d e r to p r o v id e th e a d van tag e s to a l l who w is h them, n o t
to j u s t a s e l e c t few , th e jo b s sh o u ld be a v a i l a b l e to a l l com ers.
And to a v o id i n f l a t i o n ,
to keep th e c o s t o f such a program w i t h i n bounds and to p r o v id e c o n tin u in g i n c e n t i v e to move
in t o p r i v a t e employment whenever i t i s a v a i l a b l e , th o se jo b s sh o u ld be a v a i l a b l e o n ly a t r a t e s
b e lo w th o se p a id b y p r i v a t e in d u s t r y .




George W. M cKinney

A PPEN DIX I I I

GEORGE HANSEN. IDAHO
HAROLD C. HOLLENBECK. N_l.
BRUCE F. CAPUTO. N.V.

FARREN J. MITCHELL. MD., CHAIRMAN
STEPHEN L. NEAL. N.C.
NORMAN E. D'AMOURS, N.H.
DOUG BARNARD. OA.
WES WATKINS, OKLA.
BUTLER DERRICK. S.C.
MARK W. HANNAFORD, CALIF.

U.S. H O U S E O F R E P R E S E N TA TIV E S
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE

COM M ITTEE ON BANKING. FINANCE AND URBAN AFFAIRS
N in e t y - F i f t h C o n g r e s s

W A S H IN G T O N , D .C .

20515

December 12, 1977

My Subcommittee on Domestic Monetary Policy is planning a review of
the monetary policies which took place during 1977. I am very interested in
obtaining your views on this subject.
In addition to any comments you would like to make, I would particularly
like to know whether you think monetary policy was conducted effectively during
the past year; the ways in which you think it could have been improved, if
any; what recommendations for change you would suggest; whether you think the
focus has been on monetary aggregates or interest rates, and whether you would
change the focus. Of course, any other thoughts which you would like to
share would be appreciated. Please send your response to Robert Weintraub,
Staff Director, Subcommittee on Domestic Monetary Policy, Room 3154 House
Annex #2, 2nd & D Sts. S.W., Washington, D.C. 20515.
Currently, my plans are to publish a compendium of the views of a
select group of eminent economists on this subject, which we are now soliciting.
We may also convene a panel early in the year to discuss the monetary policies
of 1977. I will keep you apprised of our progress in reviewing recent monetary
policy, and if I may, possibly call on you for further assistance early next
year.
Thanking you in advance for your time in responding to this request,
I remain,




Sincerely,

Parren J. Mitchell, M.C.

(»d

92
G raduate S c h o o l

of

B

u s in e s s

S t a n f o r d U n i v e r s i t y , S t a n f o r d . C a l i f o r n i a 94305

GEORGE
F rank E . B
of

L. BACH

uck

P

E c o n o m ic s

P u b l ic P

January 20, 1978

ro fesso r
and

o l ic y

The Honorable Parren J. Mitchell
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
Washington, D.C. 20515
Dear Representative Mitchell:
In reply to your letter of December 12, I am pleased to
comment briefly on monetary policy during 1977.
Given the difficulties it faced and the crossfire of
pressures from different groups in the economy, I believe that
Federal Reserve policy deserves reasonably high marks for 1977.
Three issues seem to me to be uppermost in making such an eval­
uation.
1) Did the Federal Reserve strike about the right balance
on the expansion-restraint issue? It is easy to argue that the
Fed was not expansionary enough in view of the substantial un­
employment during the year, or that it was over-expansionary
in view of the continued inflation with more inflation probable
for 1978-79. But the real economy grew about as fast as was
consistent with continued stable growth (4.3 million new jobs
is an impressive performance). And I think the Board deserves
good marks for recognizing that there is no longer a simple
tradeoff between inflation and unemployment in making monetary
policy, and that, simply increasing the money stock faster
would probably have done more to restimulate inflation than to
reduce unemployment faster. I commend the Fed, too, for con­
tinually stressing the case for a gradual reduction in the
growth rate of the monetary aggregates. Only widespread ex­
pectations of a stable, less inflationary growth will make such
a result possible.
Second, has the Fed used the right tools in carrying out
its stabilization policies? This comes down largely to the
question of primary focus on the monetary aggregates or mar­
ket interest rates. My conviction is that neither the Fed,
the Administration, nor Congress can be counted on to "fine
tune" the economy effectively. Even with the best of inten­
tions, attempts at continuous fine tuning are likely to




93
destabilize more than stabilize the economy. Thus, I believe
the Fed should focus mainly on one of the monetary aggregates
(I prefer the "reserve base" since the Fed can directly control
that), operating with a rebuttable presumption of stable growth
in the aggregate. If special circumstances in the money markets
seriously threaten major, cumulative instability in the real
economy, the Fed should temporarily act to restore financial
and money market stability, but such an action should be the
exception, not the rule. On the whole, I think the Fed has,
perhaps understandably, placed too much emphasis on keeping
short term rates stable, relative to focus on the monetary
aggregates.
How to get the growth rate in the money stock back down
to a less inflationary rate is a difficult question. To re­
duce inflation to, say 2 or 3 percent per annum will require
a reduction in the money stocl& growth rate by at least half.
A firm but gradualist policy like that enunciated by the
Board in 1977 is probably the best alternative. A case can
be made for taking a short, sharp revision to further reduce
inflationary expectations and wage-price behavior, but the
costs seem to me too heavy to accept. To obtain wage-price
behavior consistent with high employment and low inflation
will require establishing a new set of economy-wide expectations
of
stabler prices and growth.
Third, is the Fed too"independent." producing disruptive
lack of coordination between monetary and fiscal policy? I
think the present degree of independence of the Fed is about
right. Broadly speaking, the Fed should participate in de­
veloping the government's economic goals, and should basically
go along with these goals. But it should have considerable
independence in implementing the goals through monetary policy,
while at the same time recognizing its inescapable responsibility
to be concerned with effective financing of deficits which Con­
gress and the Administration (perhaps mistakingly) incur. While
some members of the Administration or the relevant Congressional
committees may w ish to dictate the details of monetary policy,
this would seem to me a serious mistake. Monetary policy is a
complex and detailed problem, and I know of no evidence to
suggest that Congressional committees, or the White House and
Treasury, can manage such policy more effectively than members
of the Federal Reserve Board.
Federal Reserve officials have historically placed a little
more emphasis on restraining inflation than have administrations
and congresses. This is probably to the good, given the infla­
tionary biases of Congress and Administrations—and indeed, was
in the minds of the founders of the Fed when it was partially
insulated from the day-to-day political process. I know of no
evidence that during 1977 the Fed's special concern with

22-761 0 - 78 - 7




94
inflation seriously disrupted the nation's economic stabilization
policies. It is understandable that the Administration and some
members of Congress may have been irked at some disagreements
in detail, but these were not differences that led to disruptive
weaknesses in overall stabilization policy. My main suggestion
would be a somewhat closer day-to-day working relationship be­
tween the Fed, the White House and the Treasury, as has been
true with a number of other Administrators since World War II.




Sincerely

6.L. Bach

95
DEAN WITTER REYNOLDS INC.

130 Liberty Street, New York, NY 10006 Telephone (212) 437-3000
February 14, 1978
Mr. Parren J. Mitchell, M.C.
c/o Mr. Robert Weintraub
Staff Director
Subcommittee on Domestic Monetary Policy
Room 3154 House Annex #2
2nd & D Sts. S. W.
Washington, D.C. 20515
Dear Mr. Mitchell:
Congress has made the single most important contribution to monetary
policy in recent years, namely, the requirement that the Fed make public in
advance its growth targets for M-l and M-2. But the presumption has been
that the Fed would more or less adhere to these self-imposed targets.
Defacto changes in targets which became evident (say after 3 months) should
therefore have been the subject of hearings. In short, congressional
hearings should make clear the seriousness with which the oversight commit­
tee views failure to honor preannounced targets, while those who support
or reject the Fed's new posture can be heard. This would reinforce the
pre-notification procedure's basic message which is that monetary policy
is too important to be framed in secret by the Fed with justification
after the fact.
In table one, we have listed Fed targets and the actual levels
achieved for M-2, since this is now the most significant measure of monetary
growth, technical changes in corporate savings account^ interchangeability
for demand deposits having made M-l a less reliable indicator. Clearly the
Fed has not adhered to targets: M-2 growth has been at the extreme upper end
or outside its target zone for the past year. In the following comments we
view the significance of this prospectively, and from an historical perspec­
tive.
Money supply as measured by M-2 last grew at better than 9-9.5% rates
in 1971-72. This posed no problems for maintaining real growth and employ­
ment in those years but, arguably, rapid M-l and M-2 growth in this period
set the stage for world-wide boom in 1973-74 and a speculation in raw
materials that may have influenced the size of the oil price increase. Or
to put the matter negatively, the severe inflation of 1973-1975 was not
entirely a function of oil price increase: runaway money creation rates
certainly played a part in exacerbating the situation.




96
Yet the Fed's rhetoric in this period was uarelievedly "conservative”
just as it has been more recently. This has led many to wonder if the Fed
has been entirely "above board" in its dealings with Congress and with the
many "publics" that are influenced by its policies. Alternatively, the
lack of connection between the Fed's actions and its words has led others
to the conviction that the money supply creation rate is out of control,
that is, given the prevailing political environment, monetary policy is
no longer an effective check on fiscal policy. This not only undermines
confidence, but it may lead to expectational price boosts that would not
be justified given the level of economic activity.
This view encapsulates a wide range of possible responses to recent
Fed actions, and our "prospective" view must be equally brief. The accom­
panying charts show levels and changes in national debt and money supply
(in terms of M-2). In 1971-1972, M-2 growth was far in excess of debt
creation rates. In 1976-1977, the opposite has been true. Does this mean
that, in one respect at least, the Fed is now doing a better job? Relative­
ly speaking, yes. But as we move into 1978 and 1979, debt growth rates
should rise. The Carter prosposals will result in a $73 billion deficit
with off-budget financing included. In full employment terms, this is
$37 billion in the third year of a recovery - not a source of confidence
for dollar holders or for long term investors in job-creating plant.
Furthermore, We are entering a period in which debt financing will increase
with money creation rates also at high levels.
Of course the danger is that the Fed — not wishing to undermine the
good effects of tax cuts — will monetize this debt at demoralizing rates
as 1978 draws to a close. The prospects for 1979 — which the Fed's
actions seek to insure — are therefore put in jeopardy. Many observers
who anticipate no thoroughgoing examination of this threat by Congress's
oversight committees, therefore anticipate a crunch in 1979 coming on the
heels of the dollar crisis. This would lead to recession not just in the
United States, but in a world that is increasingly unstable politically.
What would be the impact on Europe? On the frail economics of the third
world? Fears of this sort have already had the effect of depressing
another major source of job-creating long-term capital, namely, the stock
market. Many people feel that the situation is already so far advanced
that the real monetary option is now to monetize enough debt to simply
erase the rate buildup — inflationary consequences be damned.
In view of this increasing loss of confidence, (1) we urge public
hearings to examine monetary policy in conjunction with its chief condi­
tioning agent, namely, fiscal policy over which Congress has some control.
(2) W e also urge that deviations from target growth for the monetary
aggregates be explained — and hopefully justified — once the deviations
have become apparent. (3) W e compliment the Congress on its wisdom in
experimenting with prenotification in the monetary policy area. This can
lead to major improvements on the way we make not only monetary policy,
but also fiscal policy in the years to come.




My Best Regards,

Arnold X. Moskowitz

97
TABLE 1
ANNUAL MONEY GROWTH RATE TARGETS
_________ M-l_______
Dates

__________ M-2

Target

Actual

Target

Actual

2nd Qtr 75 - 2nd Qtr 76
3rd Qtr 75 - 3rd Qtr 76
4th Qtr 75 - 4th Qtr 76

5.0 - 7.5%
5.0 - 7.5
4.5 - 7.5

5.2%
4.6
5.6

8.5 - 10.5%
7.5 - 10.5
7.5 - 10.5

9.6%
9.3
10.9

1st
2nd
3rd
4th

4.5
4.5
4.5
4.5

6.0
6.0
7.3
7.4

7.5
7.5
7.5
7.0

10.9
10.6
10.9
9.6

Qtr
Qtr
Qtr
Qtr

76
76
76
76

-

1st
2nd
3rd
4th




Qtr
Qtr
Qtr
Qtr

77
77
77
77

-

7.0
7.0
6.5
6.5

- 10.0
- 9.5
- 10.0
- 10.0




MONEY SUPPLY ( M2) AND NATIONAL OEBT
YEAR OVER YEAR PERCENT CHANGE

* D W R F O R E CA S T OF P E R C E N T CH A N G E IN N A T I O N A L D EB T
STAR T IN G F I R S T Q UARTER, 1978.

SIOK'EY SUPPLY <M2> AMD NATXOK'ftL DEBT

900B
I
L
I
I
0

N
-S

M
■
O




■300

FED M-2.
TARGETS

300-

'800

700-

•700

600-

'600

500-

•500
NATIONAL
v DEBT

400-

•400

300-

'300

280-

-200

100-

*100

0-

’0

1919

1920

1930

1940

1959

1969

1973

1989

B
I
L
L
I
0

N
S

D
E

6
T

100
TH E JOHNS H O PKIN S U N IV E R S IT Y
BALTIMORE, M A RY LA N D 2 1 2 1 8

January 13, 1978

d e p a r t m e n t o f p o l i t i c a l ECONOMY
(301) 338-7600

Subcommittee on Domestic Monetary
Room 3154 House Annex No. 2
2nd and D streets S.W.
Washington, D.C. 20515

Policy

This letter is in reply to Congressman Mitchell’ request of December 12 for
s
my views on the monetary policies employed in 1977. The points he asked about
provide an excellent point of departure.
1. Whether monetary policy was conducted effectively during the past year.
No, not as well as it could and should have been. There was too much emphasis
on the short run, and not enough on the long run.
2. Ways in which monetary policy could have been improved.
Consistent with the previous point, the central emphasis belongs on the long-run
effects of monetary policy. In particular, if inflation is to be stopped,
and if market interest rates are to be returned to their traditional ranges
of 3 to 5 percent, it will be necessary to maintain over the long run an
average rate of growth of the money stock somewhere in the vicinity of 1 to 3
percent a year. In 1977, M^ grew at 7 percent, while M 2 and the monetary base
grew at 9 percent.
3. Whether the focus has been on monetary aggregates or interest rates.
It seems clear that the focus of action has been on interest rates, for the
Federal funds rate was kept rather stable, while the growth rates of the monetary
aggregates were allowed to move substantially above the ranges announced in
advance as targets by the Federal Reserve.
4. Whether the focus should be changed.
Yes, it should be placed upon the monetary aggregates. The reason is related
to the problem of myopia in monetary policy, mentioned above. Market interest
rates can indeed be held within a narrow range for a time by monetary policy,
but only by permitting large variations in the growth rate of monetary aggregates,
which will create or worsen economic disturbances in the future. In contrast,
if the growth rate of monetary aggregates is kept low on the average (to assure
a steady price level in the long run), and is kept approximately constant (to
minimize disturbances to the economy), then the fluctuations of interest rates,
though not completely absent, will be small, rarely if ever outside the range
of 3 to 5 percent, and will have no serious ill effects.
Monetary policy is related to fiscal policy. If the Federal budget has a large
deficit, as at present, that deficit must be financed somehow. In the long run,
the only two ways of financing a continuing deficit are by borrowing from the
public and borrowing from the Federal Reserve. Borrowing from the public is
not seriously inflationary, but if done on a large scale, it has the ill effect




101
of bidding up interest rates and crowding out the private investment that is
needed to maintain and increase productive capacity. Borrowing from the Federal
Reserve creates an increase in the monetary base and hence in the money stock,
and, if carried to excess as in 1977, makes price stability impossible. Hence
large deficits over the long run are undesirable.
Empirical evidence is accumulating to support these propositions about monetary
policy and its effects.
(a) A steady rate of growth of the money stock, at whatever rate, will create a
steady inflation at about the same rate (actually slightly slower, because some of
the new money goes to satisfy the increased demand for real holdings of money as
the economy grows). In particular, a steady growth of the money stock at about
1 to 3 percent a year will produce price stability.
(b) A new permanent steady growth rate of the money stock, higher than in the
preceding several years, will result in temporarily higher output and employment
for perhaps 2 or 3 or 4 years, followed by a new permanently higher steady
inflation rate. Similarly, a new permanent steady growth rate of the money
stock, lower than before, will result in temporarily lower output and employment,
followed by a new permanently lower steady rate of inflation.
(c) If monetary policy is used to try to maintain output and employment
permanently above the levels they would have under stable prices, continuously
larger doses of increased growth rate of the money stock are required. The
result is continuously accelerating inflation, which is unacceptable to public
opinion. Then, when monetary policy is altered to slow the inflation, the
effect is to worsen or create a depression, as in 1974-75.
(d) Market interest rates under long-run inflation will be higher than under
price stability. This is because borrowers and lenders include in their
calculations an interest premium to compensate for the decline in value of the
dollar during the term of the loan.
These propositions strongly suggest that monetary policy ought to be conducted
with a view to the long run objective of price stability. If this is done,
then, after an adjustment period to recover from past mistakes, we can achieve
not only price stability, but also low interest rates, and also less severe
economic fluctuations than we have brought upon ourselves in recent years.
On the other hand, if we continue to attempt to use monetary policy to achieve
short-run expansionary goals immediately, we will create inflation for the long
run, and we will create a series of future short runs that will be worse than
what we can attain if we choose an appropriate long-run policy now.
I take the liberty of enclosing a copy of an article I wrote for the November
issue of Johns Hopkins Magazine dealing with these matters.




Sincerely yours,

Abram G. Hutzler Professor
of Economics




102

103

1973, America has experienced
! the worst unemployment rates
since the Great Depression of the
1930s, and the worst peacetime infla­
tion in memory. We have had inflation
rates exceeding 12 per cent a year, and
unemployment rates approaching 9
per cent of the labor force. T he "eco­
nomic misery index,” that is, the sum
of the inflation rate and the unem­
ployment rate, rose to 20 per cent in
1974; it is still high, 13 per cent. By
contrast, from the end of World War II
until about 1967. it averaged roughly
7 per cent.
Is it necessary to endure high rates
of both unemployment and inflation
from now on?
The answer is no. We can bring in­
flation to a stop, and we can avoid
severe bouts of unemployment, like 9
per cent. But we cannot keep the un­
employment rate from rising occasion­
ally above 6 or 7 per cent. In fact, we
probably cannot even hold the longrun average unemployment rate down
to 6 or 7 per cent—unless we make
some important changes in labor and
welfare policies. More about those
later.

S

in c e

In 1960, they began to use easymoney policies to stimulate the econ­
omy and cut down on unemployment.
They did not realize that the desirable
effect on unemployment would last
only a few years, while the long-run
result would be to increase the rate of
inflation. By 1974, when the inflation
rate reached 12 per cent, the public
outcry was so great that inflation be­
came the number one priority, and
easy-money policies were reversed. The
result was the deepest depression since
the 1930s. The inflation rate did, how­
ever, come down dramatically, reaching
5 per cent by 1976. The unemployment
rate fell from 9 per cent to 7 per cent;
but then, after some relief from infla­
tion, concern about unemployment
caused monetary policies to be eased
again, before inflation was halted. In ­
flation is now running at about 7 per
cent. There is danger that monetary
policy will be eased again, and that
we will go through another cycle like
the last—except that we will start the
next one with an inflation already
moving.
This process resembles what happens
when a crowd of passengers on an
excursion boat all runs to the starboard
side to look at something: the boat
begins to lean over to starboard. Afraid
of capsizing, everyone runs over to the
port side to counteract the threat. Of
course, the boat not only rights itself,
but continues to roll until it leans to
port. Again afraid of capsizing, the
crowd rushes back to starboard, and
the cycle continues. It would be better
to sit still and stop rocking the boat.

is not necessarily bad, for
if inflation were to occur at a steady
rate for a long time, everyone would
come to expect it and would adjust to
it. As long as the rate of inflation were
less than, say, 50 per cent a year,
steady and correctly anticipated infla­
tion would pose no particular problem.
Rental contracts would have escalator
clauses. Loan contracts would be writ­
ten at a rate of interest higher than the
h y h a s our stabilization
inflation rate, to provide the lender a
policy been such a fiasco for
return in terms of real purchasing
the last decade? In my view,
power. Pension plans, too. could be
it has been because public officials written with escalator clauses.
only
understood how to reduce unemploy­
If inflation becomes very rapid, it
m ent in the short run; they failed to
imposes a burden even if its rate is
understand the complex relations be­
predictable. Money is an extremely
tween policies affecting unemployment
efficient device for conducting trade,
and inflation, Io n ; range.
but if its value depreciates too fast,

W
22

J o h n s H o p k in s M a g a zin e




I

n fla tio n

people will stop using it, and will turn
to barter and to shorter pay-periods. In
the great German inflation of 1921-23,
prices rose a thousandfold during the
peak month. Workers clamored to be
paid twice a day, and spent their wages
as soon as paid; during that month, the
German people reduced the amount of
real purchasing power they kept on
hand—in the form of money—by 97
per cent.
It is useless, however, to debate vari­
ous rates of predictable inflation. In
sad fact, if inflation is allowed to
occur at all, it occurs at a varying rate
and is correctly anticipated by almost
nobody. Therefore, not knowing what
prices they can sell their products for
tomorrow, firms cannot calculate what
to pay today for equipment, labor, and
raw materials. Home buyers do not
know what house to buy, at what
mortgage interest, because they cannot
predict the real purchasing power of
the payments they promise to make.
Employees and employers do not know
what kind of pension plan will be fair
to both. Suppose a tenant and landlord
expect inflation for the next ten years
to be at 7 per cent, and agree to a tenvear lease with rent rising 7 per cent a
year. Then the dollar rent in the tenth
year will be double the initial dollar
rent. If the inflation stops, the tenant
will be cheated, because the real pur­
chasing power of his rent will have
doubled by the tenth year. If the infla­
tion rate rises to 14 per cent, the land­
lord will be cheated, because the pur­
chasing power of the rent he receives in
the tenth year will be cut in half. Thus
inflation at changing rates—which
means effectively any inflation—is
bad even if it is mild, because it cannot
be correctly anticipated. ITnpredictable
inflation clouds long-term transactions
with uncertainty, which inhibits the
smooth functioning of the economy.
And it causes unfair transfers of wealth
between creditors and debtors.
inflation? Experi­
ence shows that it is always
associated with a rapid rate of
growth of the stock of money in the
economy. No rapid inflation has ever
continued for long without a rapid
increase in the money stock. And no
substantial period of price stability has
ever occurred in the presence of a
rapid increase in the money stock.
In America, a stable price level calls
r h a t causes

W

104
for a long-run growth rate of the money
stock at about 1 to S per cent a year.
Some small increase is needed because
the population is growing, so there are
more people every year who want to
keep some money on hand; and also
because real income per person is
growing, so that each person wants to
keep a little more money on hand than
the year before. But if the money stock
grows faster than about I to 3 per cent
a year on the average, we have infla­
tion. Since 1972 there has been 9 per
cent growth per year in the money
stock (defined to include currency plus
commercial-bank checking and savings
deposits), and inflation has been at 8
per cent a year. From 1948 to 1960, the
money stock grew at 3 per cent a year,
and inflation held at 2 per cent a year.
I'd like to emphasize one point here:
An increase in the rate of growth of
the money stock does reduce unemploy­
ment, but only temporarily. Over the
long run, the policy that is needed to
hold the average inflation rate to zero
is independent of the policy needed to
reduce the average rate of unemploy­
ment. Monetary policy is appropriate
for inflation control, and labor market
policy for reducing unemployment.
The two policies neither reinforce nor
interfere with each other, in the long
run.
W hat causes unemployment? Break
the question into two parts. First, what
causes fluctuations in unemployment?
Since World War II, it has ranged be­
tween 3 and 9 per cent of the labor
force. Unemployment rises whenever
the total demand for goods and services
drops, relative to the economy’s capac­
ity to produce. And unemployment
declines whenever total demand rises,
relative to capacity. Demand in the
private sector normally fluctuates, as
consumers decide how and when to
spend their incomes, and as business
firms decide how and when to expand
their plants, equipment, and inven­
tories. Government influences total
demand directly, by its own decisions
about purchases of goods and services
for programs such as defense, foreign
aid, medical care, and so on. Govern­
m ent also influences total demand in­
directly, by changes in taxes and
income-transfers, because these influ­
ence the spendable income of the
private sector.
The second part of the unemploy­
ment question is, what determines the




average level of unemployment in the
long run? This is the level about which
unemployment fluctuates, up and
down, in the short run. From 1900 to
1929, unemployment averaged 4.7 per
cent of the labor force. From 1948 to
1960 it averaged 4.6 per cent. (Of
course it was much higher in the Great
Depression, and much lower during
World War II.) From 1961 to the
present it has averaged 5.4 per cent.
The average level of unemployment,
leaving aside business cycles, depends
on the job-seeking behavior of workers
and the hiring and layoff behavior of
employers. When a worker enters the
labor force, or loses her (or his) job.
she must decide what kind of job to
look for, and whether to accept or re­
ject each particular offer. These de­
cisions depend on what other uses she
has for her time, and what resources
she can fall back on until she finds an
acceptable job. A worker's decision
whether to quit an unsatisfying job
depends on the same factors. These
factors do not depend on the long-run
average rate of inflation. Similarly, a
firm’s hiring or layoff decisions are
based on whether each worker's contri­
bution to output is expected to justify
the cost of hiring and paying her.
which depends hardly at all on the
long-run average rate of inflation.
o n e t a r y p o l i c y is the branch of
government policy that controls
i the stock of money and its
rate of growth. Monetary policy, then,
is crucial for controlling inflation. If
inflation is to be stopped, monetary
policy must see to it that the money
stock does not grow rapidly. Congress
has delegated the conduct of monetary
policy to the Federal Reserve System.
Research shows that when monetary
policy increases the growth rate of the
money stock, the first effect is a
temporary boom, an increase in busi­
ness output and employment which
dies away in a few years. T he later
effect is an increase in the rate of infla­
tion. which does not die away. Con­
versely, a decrease in the rate of growth
of the money stock causes the same
effects in reverse: first a temporary
depression of output and employment,
followed by a reduction of the inflation
rate that does not die away.
Fiscal policy is the branch of govern­
ment policy that controls government
expenditures, taxation, and the differ­

M

ence between them (the deficit, if
expenditures exceed taxes, or the sur­
plus, if the other way around). Con­
gress controls fiscal policy.
Research on fiscal policy shows that,
provided the growth rate of the money
stock is kept constant, an increase in
government spending (or a cut in
taxes) in real terms creates a temporary
boom in output and employment, and
little effect on inflation. And a cut in
government spending (or a tax in­
crease) in real terms creates a temp­
orary depression in output and em­
ployment, and little effect on inflation.
Experience shows, both here and
abroad, that it is not possible to devise
monetary and fiscal policies that will
hold unemployment permanently be­
low the normal level, without incurring
ever-accelerating inflation. Experience
also shows that no society will tolerate
ever-accelerating inflation.
The most promising monetary
policy, therefore, is to keep the growth
rate of the money stock slow and
steady. One to 3 per cent a year is
about right. Rapid growth of the
money stock over any long period is
Carl F. Christ has been a professor of
political economy at Hopkins since 1961.
The author of Econometric Models and
Methods, he is on the editorial board of
the American Economic Review.
N o v e m b e r 1977

23

105

to print the dollars they wanted to
buy. And thus we imported their infla­
tion.
Since 1971, however, we have not
maintained our exchange rate at any
particular level. We have allowed the
exchange rate between dollars and
other currencies to be set by the bids
and offers of Americans who want to
buy foreign goods and securities, and
of others who want to buy American
goods and securities. This is called a
flexible exchange rate; its effect is that
inflation is not transmitted across
international borders. If other coun­
tries have rapid inflation and we
choose not to, then their citizens will
buy fewer dollars per unit of inflated
foreign currency. Their inflation will
not be imported by us.
could be used to
reduce average unemploy­
ment. in the long run? There
are five important possibilities. The
first would be to improve job skills.
The second would be to improve the
functioning of labor markets by pro­
viding better information about the
availability of jobs and labor. No one
disputes that both are good to do. The
other three are more controversial.
Indeed. I do not .support all of thorn.
The third would be to al»>l:>h the
minimum wage law. I'ruler current
law. it is illegal to hire people at less
than minimum wage, now S2.30 per
hour or S 1.600 for a year of 50 weeks
at 10 hours a week. There are respon­
sible people who are ready, willing,
and able to work, and who would pre­
fer to work for S2.25 an hour rather
than not to work at all. But they do
not have the choice. Whenever the
minimum wage is raised, it leads firms
to fire (or not hire) workers whose
services, though valuable, are not as
valuable as the wage that Congress has
said is the lowest that may be paid.
Unfortunately, as I write Congress is
engaged in raising the minimum wage
again, probably to S2.65 an hour or
S5.300 a year. Of course the minimum
wage helps those who remain em­
ployed. It is obvious that if a firm can
afford (and has) two employees at
S2.30 an hour, but can afford only
one at S2.65, then a rise in the mini­
mum wage to S2.65 will harm the one
who is fired, but will benefit the one
who is kept on. Less obviously, the rise
in the minimum wage also benefits
rHAT p o l i c i e s

bad because it will guarantee inflation.
Varying growth of the money stock is
bad because it will rock the economic
boat, producing booms and depressions.
T he most promising fiscal policy is
to run budget deficits during recessions,
and small surpluses in booms. This
oscillation can easily be made auto­
matic, by setting government tax
schedules and expenditure programs at
the right levels, then leaving them
alone. In a boom, incomes rise and
more taxes are collected, which moves
the budget toward surplus. In a re­
cession. incomes fall and less taxes are
collected, while expenditures for un­
employment compensation increase.
This moves the budget toward deficit.
Thus fiscal policy will automatically
exert a stimulating effect during re­
cessions, a retarding effect during
booms.
Why not deliberately cut tax rates,
increase government spending, and
increase the growth rate of the money
stock when a depression is coming, in
order to head it off? And why not raise
taxes, cut back government expendi­
tures, and cut the growth rate of the
money stock when a boom is coming,
in order to keep it from getting out of
hand? A fine idea, if public officials
could see far enough ahead and act
quickly enough. But sad to say. fiscal
policy makers cannot often reverse
their field inside of six months (though
monetary policy makers c a n ); the em­
ployment effects of a change in fiscal
or monetary policy do not get fully
24

J o h n s H o p k in s M a g a z i n e




underway for a year or a year and a
half; business depressions usually last
about a year or a year and a half; and
we cannot accurately predict the
arrival of the next business downturn
or upturn a year or two ahead of time.
So an attempt to head off the next
depression is likely to tome too late,
and aggravate the next boom instead.
Similarly, an attempt to soften the next
boom is likely to be too late, and
exacerbate the next depression instead.
Such maneuvers are another case of
rocking the boat.
does not struggle alone
with inflation: other countries
have it too, some much more
badly than we do. Does their inflation
make it hard for us to control ours?
That depends on our foreign cur­
rency exchange system. Until 1971, we
kept the value of the dollar fixed in
relation to other currencies. We did so
by buying dollars with gold or foreign
currency whenever their price threat­
ened to rise, and selling dollars when­
ever their price theatened to fall. This
is called maintaining a fixed exchange
rate: one of its effects is to help infla­
tion move across international borders.
Before 1971, when a customer country
had inflation and we did not, our
goods looked cheap. T o take advantage
of the bargain, they had to buy dollars
to send here in payment. But since we
did not allow the value of the dollar to
rise, we had to increase the supply of
money to meet their demand; we had
A m e ric a

W

106
skilled workers, even those who are
paid much more than the minimum.
It does so by removing the possibility
that a firm will hire several low-wage
unskilled workers to do a clerical job,
for example, that could also be done
by one skilled worker with a computer, i
The fourth measure would be to
replace the present welfare system with
a negative income tax. Under present
law, a welfare recipient who gets a job
is required to declare his earnings to
the welfare administrators, who are
required to cut his welfare allowance
by the entire amount of the earnings.
Thus there is no financial incentive for
a person on welfare to take a job un­
less it pays more than the welfare
allowance, which many part-time jobs
do not. Under the negative income
tax, each family having no income
would pay a negative tax, that is,
would receive a payment from the US
Treasury. The amount might be, say,
SI,000 a year per person, or per adultequivalent person. Then each such
family, if it earned an income, would
have to pay part of its earnings in
taxes but could keep the rest. If this
tax rate were, say, 50 per cent for a
family of four earning S3,000, the
family’s income after tax would be
the sum of $4,000 of negative tax, plus
50 per cent of the S3,000 earned, for a
total of S5,500. T hat family would then
have a financial incentive to work at
a job that paid $3,000, whether parttime or full-time. The main advantage
of the negative income tax over the
present welfare system is that it would
provide incentive for more people to
work. Furthermore, it would be much
cheaper and simpler to administer.
T he fifth measure would be to re­
duce the generosity of the weekly pay­
ments made to unemployed people.
Unemployment compensation in
America is based on the wage received
for previous work, so that a highly paid
person gets more unemployment com­
pensation than a person who had been
earning low pay. In Britain, until
recently, the amount of unemployment
compensation was virtually the same
for everyone, being a fraction of the
normal income of an unskilled worker.
British unemployment rates were con­
siderably lower than ours for many
years. Then Britain changed her un­
employment compensation system to
make it similar to ours, with benefits
roughly proportional to previous




over long periods. And it must be
steady, in order to avoid rocking the
boat with booms and depressions.
Therefore, monetary policy must pro­
vide a slow and roughly constant rate
of growth of the money stock.
Even though a rise in the growth
rate of the money stock will stimulate
employment in the short run, this
policy should not be followed. Why
not? Because the effect on employment
will soon wear off, and will be followed
by an increase in the rate of inflation.
Then, to slow that inflation, the
growth rate of the money stock will
have to be reduced, which will increase
unemployment again. This is the story
of American policy beginning in 1960.
The easy money policies of 1960-73 did
give us low unemployment in 1966-69,
but not thereafter. And the inflation
that they caused gave rise to restrictive
monetary policy in 1974-75, which
drove unemployment up to almost 9
wages. This was no help to the un­
per cent in the spring of 1975. The
skilled, of course, but it gave a big hike
easy money policies of 1960-73, to­
in unemployment compensation to
gether with their aftermath, did not
skilled and highly paid workers. The
really succeed in reducing unemploy­
result was a substantial increase in
ment: they merely postponed it from
British unemployment. The reason,
1966-69 until 1975 and 1976.
clearly, is that when the financial loss
The stabilization policies followed
from a spell of unemployment is re­
in 1948-1960 could be improved upon,
duced, people feel they can afford to
yet they were highly successful in com­
look longer and more carefully for a
parison with those followed since 1960.
new job. As a result, unemployment
In 1948-60 the growth of the money
increases.
stock was kept slow and fairly steady.
Of these last three measures. I sup­
Automatic fiscal stabilizers were in
port the abolition of the minimum
effect. The inflation rate was about 2
wage law and the replacement of wel­
per cent, a rate which gave concern at
fare by the negative income tax. I do
the time but looks awfully good to us
not support the reduction of unem­
now. Unemployment rose mildly in the
ployment compensation. For one thing,
recessions of 1949, 1954, and 1958, but
our family structure is not as capable
did not exceed 6.8 per cent for any
of dealing with such problems as it
calendar year.
was a century ago. For another, un­
There is no doubt that we can elimi­
employment is largely influenced by
nate inflation if we adopt a monetary
forces beyond the control of the indi­
vidual worker; it seems only just to
policy that provides for growth of the
money stock at an average rate of 1 to
share the burdens of unemployment
3 per cent, and that we cannot do so if
among all taxpayers, whether unem­
we permit rapid monetary growth. We
ployed or not. However, we must real­
can reduce the severity of business
ize that the average level of unemploy­
cycles if we keep the monetary growth
ment will be higher with such a system
rate steady, instead of allowing it to
than it was without it.
decline in depressions and rise in
booms, as it has done for 50 years and
r e a r e now ready to return to
the complex relations, longmore.
T he real question is whether we will
run and short-run. between
have
policies that affect inflation and unem­ the wisdom to forego the quest for
short-term gains, and to choose a more
ployment. We have seen that the
stable long-term path. If we do, we will
growth rate of the money stock must
find a more satisfying series of short
be slow on the average over long peri­
runs.
ods, in order to insure zero inflation

W

N o v e m b e r 1977

25

107

HOOVER INSTITUTION
ON WAR, REVOLUTION AND PEACE
Stanford, California 94305

January 17, 1978

Subcommittee on Domestic
Monetary Policy
Room 3154.House Annex No. 2
Second and D Streets, S.W.
Washington, DC 20015

We are responding jointly to Congressman Mitchell's letter of
December 12 requesting comments on the conduct of monetary policy
in 1977 and recommendations for changes in 1978.
Several years ago we organized the Shadow Open Market Committee,
a group of professional economists from industry and universities
who meet semi-annually to discuss current economic policy and to
make policy recommendations. In March 1977, the Committee
recommended that the growth rate of money— currency and demand
deposits—be held to an annual rate of 4% per cent, a rate of
growth at the minimum of the Federal Reserve's recommended range.
By September, it was apparent that the growth of money was above
the Federal Reserve's maximum. The Committee recommended steps to
remove part of the excess and to return to a 4% per cent growth
rate. Copies of the Committee's recommended policy statements in
1977 are enclosed.
The principal reason that the Federal Reserve exceeded their targets,
and ours, is that the Federal Reserve uses inefficient and ineffective
methods of controlling money. They concentrate on short-term interest
rates.
The Federal Reserve will not control money or monetary aggregates
unless they adopt new procedures. The focus on short-term rates of
interest should be abandoned.
As long as the Federal Reserve retains present operating procedures
and does not make well-known changes in rules and operating procedures
that facilitate control of monetary aggregates, there is considerable
doubt about their intentions. There is very little evidence that the
Federal Reserve has taken the steps required to carry out effectively
H. Con. Res. 133 and subsequent legislation.




108
W e b e lieve t hat substantially greater focus on monetary aggregates
and reductions in the growth rates of the aggregates are p a r t of
an effective economic policy to reduce inflation and unemployment.
Sincerely yours,

Karl B r unner

Enclosures




Allan H

109
SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers
September 19, 1977
PPS - 77-6

1. Shadow Open Market Committee Members - September 1977
2. SOMC Policy Statement, September 19, 1977
3. Position Papers prepared for September 1977 meeting.
THE FEDERAL BUDGET - Rudolph G. Penner, AEI
FINANCING THE GOVERNMENT DEFICIT - Robert H. Rasehe, Michigan
State U.
BRIEFING FOR THE SOMC - Wilson E. Schmidt, Virginia Polytechnic Insjitutete
THE DILEMMA OF INFLATIONARY POLICIES - Karl Brunner, University
of Rochester

22-761 0 - 78 - 8




110
SHADOW OPEN MARKET COMMITTEE
Meets Monday, September 19th, 1977, 9:00 a.m. to 4:00 p.m. at the Princeton
Club, 15 West 43rd Street, New York, New York.
Members
Professor Karl Brunner, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester,
Rochester, New York.
Professor Allan H. Meltzer, Graduate School of Industrial Administration,
Carnegie-Mellon University, Pittsburgh, Pennsylvania.
Mr. H.Erich Heinemann, Morgan Stanley <c Company, Inc., New York, New York.
5
Dr. Homer Jones, retired Senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Missouri.
Dr. Jerry Jordan, Oanior Vice President and Chief Economist, Pittsburgh National
Bank, Pittsburgh, Pennsylvania.
Professor Thomas Mayer, University of California at Davis, California.
Dr. Rudolph Penner, American Enterprise Institute, Washington, D. C.
Professor Robert Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan.
Professor Wilson Schmidt, Department of Economics, Virginia Polytechnic
Institute, Blacksburg, Virginia.
Dr. Beryl Sprinkel, Senior Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois.
Dr. Anna Schwartz, National Bureau of Economic Research, New York, New York.
Dr. William Wolman, Senior Editor, BUSINESS WEEK, New York, New York




I ll
Policy Statement
Shadow Open Market Committee
September 19, 1977
The policies that produced sustained recovery, rising employment and lower
inflation have ended. Government spending is growing again at a faster rate than
the economy. The growth rate of money — currency and demand deposits — has
returned to the high levels of 1968, 1972 and early 1973. The budget deficit is
rising.
Prospects for the economy in 1978 and 1979 as a result appear less attractive
than when this Committee met last March. Inflation is expected to increase next
year and the growth of real output is expected to fall. The reasons for slower
growth and higher inflation differ, however. Capacity utilization is high in many
industries, and real growth must slow to the trend rate of capacity growth — three
to four percent per year. Accelerating inflation and an enhanced risk of recession
are mainly the result of the inappropriately expansionary monetary policy that the
Federal Reserve pursued during the past two years, and particularly during the past
six months.
Increased money growth in 1977 has restricted the choice of policies for 1978
to three principal alternatives. None of the three is attractive, but there are
important differences. At its meeting today the Shadow Open Market Committee
discussed these differences and recommended that the Federal Reserve return to a
policy of eliminating inflation gradually, while minimizing the risk of a large
recession.
Three Options
The Federal Reserve has three options. (1) It can continue on the path of
rapid money growth that has prevailed in 1977, (2) It can accept the errors of the
past year while immediately restoring the policy of slowing inflation, (3) Or in some
measure it can correct for the excessive money growth of the past year, and once
again restore a policy of ending inflation.




112
The first option minimizes the risk of recession in 1978, but would result in
increased inflation. By maintaining the recent high rate of money growth, real
growth might temporarily be higher than otherwise, but at the cost of higher
inflation later. As inflation increases, the demands to do something about inflation
increase. Controls on wages and prices would become more likely. But controls, if
adopted, would ultimately prove to be useless against inflation. Shortages of goods,
services, and materials used in production would be the inevitable result. Sooner or
later money growth would be reduced as part of a new, anti-inflation policy. This
option adds to real growth in 1978 at the cost of higher inflation. This policy would
squander the progress that has been made in restoring stability. The benefits of
this option seem small when compared to the costs.
The second option would be to accept higher inflation as an unavoidable, but
temporary, consequence of excessive money growth. Money growth would be
reduced to an annal rate of 4% starting from present levels. This policy means that
the Federal Reserve's summer errors would be translated into a recession. Output
growth under this policy would probably be less than the trend rate.
The third option is to partially correct the summer bulge in the money stock.
This bulge can be partly eliminated without severe consequences for real growth
because the economy has not yet adjusted to the higher level.
At the previous meeting of this Committee, in March 1977, we recommended
that the growth rate of money be held between 4% and 4s% during the year ending
in the first quarter 1978. The growth rate of money for the second and third
quarter has been over twice the rate we recommended. The annual rate of money
growth is far above the 5£% midpoint of the target chosen by the Federal Open
Market Committee, November 1976, and reaffirmed at subsequent meetings. By
their standards, as well as ours, the growth rate of money has been excessive.
This Committee has affirmed repeatedly that stable growth, lower inflation,
and recovery from recession can be achieved together if proper policies are chosen.
The Federal Reserve’s 1977 excesses may mean that a recession will once again
follow when it attempts to reduce inflation.




113
Recom mendations
The inordinate growth of money in the last six months stemmed from two
episodes. In March and April, Federal Reserve credit was increased rapidly to keep
interest rates from rising; consequently the money stock jumped. But this only
postponed the rise in interest rates to the end of April.
Again in June and July, Federal Reserve credit growth was accelerated to
keep short-term interest rates from rising and the stock of money rose rapidly. But
the rise of interest rates was only postponed one month.
The Federal Reserve has not been able to prevent a rise of short-term
interest rates this year. It has only been able to obtain slight delays of rate rises.
And it has done this only at the expense of losing control of the amount of Federal
Reserve Credit and the money stock.
The failure of the Federal Reserve to reach its targets is not an accident.
Excessive money growth has been the result of inappropriate procedures for
controlling the stock of money. The Federal Reserve has continued to concentrate
on short-term changes in interest rates and has ignored the movements of the
monetary base and other determinants of the stock of money. The result has been
excessive money growth in periods of expansion, and insufficient money growth in
recession.
This Committee has warned repeatedly that current procedures for
controlling money are inadequate. The result of those procedures is that stable
high output has not been achieved; inflation has increased; price and wage controls
have become more likely;, and the risk of returning to a stop and go economy is
greater.
In addition to the change in procedures, the Shadow Open Market Committee
recommends that the summer bulge in money be removed by reducing the current
level of the money stock by $4-billion, the reduction to be accompanied by an
announcement that the step has been undertaken to return the money stock to the
level it would have reached if the most recent error in monetary policy had not
occurred. Subsequent to the correction, money growth should resume at a constant
annual rate cf 4l%.
A stop-go monetary policy is not inevitable. We urge, again, that the Federal
Reserve refrain from trying to control short-term interest rates. It should not take
the Federal Funds rate as its operating target. Instead, it should adopt procedures
to directly control money. If it does so, the Federal Reserve is fully capable of
achieving its announced targets for money growth.




114
The return to stability with rising real income cannot be achieved by
monetary policy alone. The growth rate of government spending is high and rising.
A rising share of resources absorbed by government means fewer resources for
private investment, slower growth of private output and fewer jobs in the private
sector.
We project that the budget deficit for fiscal 1978 and the borrowing by off
budget agencies will require the private sector to absorb about $60-t>illion in new
government securities. This amount is much larger than appropriate under current
conditions. We recommend that nothing further be done to increase the budget
deficit and government borrowing in 1978 and that the budget deficit be reduced in
1979. The Congress and Administration should adopt a program to limit the growth
of government spending, so as to achieve and maintain the balanced budget
promised by the Administration for fiscal 1981.




115
THE FEDERAL BUDGET
A Report Prepared for the Shadow-Open Market Committee

Rudolph G. Penner
American Enterprise Institute

Background
Table 1 shows the evolution of the 1977 and 1978 Budgets from the "lameduck” recommendations submitted by President Ford in January 1977 through the
official July 1977 estimates of the Carter Administration.




116
Table 1
Budget Recommendations, Ford and Carter, Fiscal Years
1977 and 1978
(billions of dollars)
1977

1978

1976
Actual

Ford
(J a n .)

Carter
(Feb.)

Carter
(July)*

Ford
(J a n .)

Carter
(Feb.)

Carter
(July)*

Outlays

$365.7

$411.2

$417.4

$406.4

$440.0

$459.4

$462.9

Receipts

299.2

354.0

349.4

358.3

393.0

401.6

401.4

$ 66.5

$ 57.2

$ 68.0

$ 48.1

$ 47.0

$ 57.7

$ 61.5

Deficit

In the July estimates, refunds under the earned income credit which had earlier
been defined as an outlay were redefined to be reductions in receipts. This has
the effect of lowering 1978 receipts and outlays by $0.9 billion.




117
Through the first six months of 1977, changes in the economic assumptions,
technical estimating changes, and Congressional actions, all influenced the budget
totals, but the most important changes were the result of shifts in Presidential
policy. The most significant Presidential initiatives were as follows:
.The Ford recommendations provided a major net permanent tax cut of $14.6
billion for 1978 compared to the levels implied by constant tax law. Outlays were
cut $5.4 billion from current policy levels.
.Prior to taking office, President Carter announced his own "stimulus
package" as a substitute for the Ford tax cuts. The package consisted of minor
permanent tax cuts, a major temporary tax rebate worth $11.4 billion, and
increases in spending on accelerated public works, public service employment,
countercyclical revenue sharing and training programs. This package was worth
$15.7 billion in 1977 and $15.9 billion in 1978.
.In February, President Carter submitted a more complete set of revisions to
the Ford Budget. The net result was an increase in Ford’s recommended 1977
deficit from $57.2 to $68.0 billion while the 1978 deficit was increased from $47.0
to $57.7 billion. The increase in the deficits was less than the value of the stimulus
package primarily because of the rejection of the Ford tax cut. Carter also
assumed that his package would lead to a somewhat more ebullient economy, and
made other minor program changes and changes in the estimates.
.In April, the re-acceleration of the economic recovery and developing
Congressional hostility to the rebate proposal led to its withdrawal by President
Carter.
As shown in the table, the withdrawal of the rebate combined with the net
impact of the policy initiatives and re-estimates significantly reduced the July
estimate of the 1977 deficit compared to that shown in the February Budget
Revisions. However, those portions of the stimulus package that were retained
have a major spending impact in 1978, and as a result the deficit increases by $13.4
billion in that year. Because the Carter estimates presume a continuing strong
recovery, which would reduce the deficit significantly given constant policies, the
increase in the unified deficit between 1977 and 1978 represents a strong
discretionary shift toward an expansionary fiscal policy between the two years.




118
This shift appears somewhat less significant if national income accounting
(NIA) definitions are used to compute Federal expenditures and revenues. The NIA
Budgets consistent with Carter's July estimates are provided in Table 2.
Table 2
President Carter's July Budget Estimates on a National
Income Accounting Basis, Fiscal 1977 and 1973
(billions of dollars)
1977

1978

Expenditures

417..2

469.3

Revenues

365..4

415.3

51,.8

54.0

Deficit

It should be emphasized that although the $2.2 billion increase in the NIA
Budget deficit seems small, it still represents a significant shift toward expansion
in discretionary policy. One can get a highly imperfect measure of discretionary
shifts using revenues and expenditures calculated as if the economy were at full
employment. Official full employment estimates have not been provided by the
new Administration, but my own crude estimates suggest that the full employment
deficit rises by more than $15 billion between 1977 and 1978 on an NIA basis.
All of the above is based on the Administration's July estimate of the Budget.
No forecast of Budget totals is completely reliable. The following section explores
some of the most important estimation problems in order to develop somewhat
more precise forecasts of the Budget's likely impact over the next few quarters.




119
Estimating Problems
While monetarists, fiscalists, and rational expectations theorists can engage
in lively debates regarding the impact of the budget on the economy, there is no
denying that the economy has a major impact on budget totals. On the outlay side,
changes in the unemployment rate have a major impact on unemployment benefits;
changes in interest rates alter the cost of the national debt; and changes in the rate
of inflation have a major impact on outlays on indexed programs such as social
security, food stamps, school lunches, etc.
The sensitivity of unified budget outlays to hypothetical changes in various
economic variables is provided in Table 3 for the 1977 Budget.
The revenue side is even more sensitive to economic changes. A one
percentage point change in the forecast of money GNP in fiscal 1977 would affect
revenue estimates by more than $4 billion with the exact amount highly dependent
on how the change affected personal income (for personal income taxes), corporate
profits (for corporate taxes), and wages and salaries (for payroll taxes).
For the purposes of the analysis in this paper the Administration's July
economic forecast will be accepted. This is shown in Appendix Table A.
Even if the economic forecast underlying budget estimates is precisely
correct, there is plenty of room for error. For example, corporations have
considerable discretion regarding the timing of their tax payments out of given
corporate profits; one is never sure what proportion of the eligible population will
claim benefits in entitlement programs; and in recent times, OMB has been
bedeviled by overestimates of spending for non-entitlement programs—the socalled "shortfall" problem.
In February, the Carter Administration estimated 1977 unified outlays at
$416.5 billion. Definitional changes, involving the earned income credit, and the
withdrawal of the rebate lowered this figure to about $413 billion. However, the
July update estimates outlays at only $406.4 billion. This reduction of more than
$6 billion is primarily due to the shortfall problem. The very latest official
estimate lowers 1977 outlays further to $404 billion and it is quite possible that
actual outlays will be two or three billion lower than this figure.
There is no simple explanation for this phenomenon and the following attempt
at a description of the problem must be regarded as being highly oversimplified.
OMB has had a tendency to overestimate spending for a very long time, but the
problem did not attract much public attention until the shortfall became especially
large during fiscal 1976 and the transition quarter. While a large number of random
events conspired against OMB in 1976 and made the problem especially serious,
there are a number of continuing political and administrative factors which create
a very strong bias toward overestimation.




120

Table 3
Sensitivity of FY 1977 Budget Outlays to
Economic Assumptions
(billions of dollars)
Inflation (effect on indexed program only)
One percentage point increase in CPI level by:
First quarter, CY 1976
Third quarter, CY 1976
First quarter, CY 1977

Addition to
Outlays
$1 . 1
0.4
0.2

Interest Rates
One percentage point increase* by:
January 1, 1976
July 1, 1976
October 1, 1976
January 1, 1976
July 1, 1977

$2.3
1.8

Unemployment Rate (unemployment assistance only)
One percentage point increase for fiscal year

$2.5

1.3

0.8
0.1

*The increase is assumed to be for short-term rates with a somewhat smaller increase
in long-term rates.




121

Whenever Congress undertakes a new policy direction at the behest of an
Administration there is a strong tendency on the part of the Executive Branch to
claim that it will be implemented posthaste. This is especially true when the policy
is aimed at some perceived national "emergency" as in energy or in fighting
unemployment. For example, it was claimed that the accelerated public works
program would be implemented with far greater alacrity than was assumed by most
experts, but the official claims had to be duly reflected in the Budget.
Even when there are no political pressures of this type, the bureaucracy has a
difficult time adjusting to policy shifts. The spending of money requires a great
deal of work. Proposals have to be studied; contracts have to be negotiated and
signed; etc. There is a pervasive human tendency to believe that more work can be
accomplished within a certain time period than is practically possible. Typically,
insufficient allowances are provided for vacations, illnesses, and the myriad of
other things that can go wrong.
As experience builds with e new program direction the outlay forecasts should
become more precise, and there is some evidence that this is now occuring in the
defense sector. That sector had to live with severe budget stringency in the post
Viet Nam era and it was slow to adjust to large increases in procurement allowed in
the 1976 and 1977 budgets. While significant defense shortfalls will occur in the
1977 budget, it appears likely that the gap will be closed somewhat in 1978.
However, in that year the bureaucracy will still be struggling with the
implementation of the relatively new stimulus programs, and a significant shortfall
is likely relative to program size, particularly in the public works component of the
package.
As a result of such factors, it has already been noted that 1977' unified
outlays are likely to be around $401 or $402 billion. Outlays in 1978 could be seven
or eight billion lower than the $462.9 estimated in July even if the Administration’s
economic forecast and policy stance remains constant.
However, because both 1977 and 1978 outlays will fall short of the July
estimates the increase in the deficit between the two years will be only slightly
lower than was discussed earlier.




122

Short-Run Fiscal Policy Implications
In order for there to be no shortfall from the July estimates in the NIA
budget for 1977, expenditures would have to soar at an annual rate exceeding forty
percent in the last quarter of the fiscal year, that is, the third calendar quarter of
1977. This is clearly unreasonable and no one expects it. While quarter-by-quarter
estimates of the shortfall are treacherous, to say the least, I guess that, despite the
shortfall, there will be a major surge in spending during the third and fourth quarter
of this calendar year as the stimulus programs get rolling—albeit behind schedule.
Again, the tentative nature of any estimate must be emphasized, but it is not
unreasonable to expect annual rates of growth of NIA spending between 15 and 20
percent during the last half of this calendar year with a deceleration to the seven
to ten percent level in the first three quarters of calendar 1978.
It would, however, be unwise to conclude that the expansionary impact of the
surge in spending over the last half of this year will be as great as is suggested by
these estimates. If the acceleration occurs, it will, in large part, be due to
extraordinary rates of growth in the grants component of the NIA budget.
Virtually, the entire stimulus package is financed by grants and is implemented at
the state and local level. Although the accelerated public works and public service
jobs components of the package have been designed to reduce the extent to which
the funds can be used to undertake projects that would have been undertaken in any
case at the state and local level, considerable "substitution” *is sure to occur
anyway. Thus, to some degree, these programs simply reduce state and local
deficits or raise surpluses at the expense of the Federal deficit. This is even more
true of the counter cyclical revenue sharing component of the package. As a
result, the surge in grants is unlikely to have the same expansionary impact as
would a similar surge in the purchases or transfer component of the NIA budget.
Long-Run Fiscal Policy Issues
President Carter has promised to balance the Budget in fiscal 1981. Barring
an economic slowdown which would cause the abandonment of this promise, he will
have to adopt a fairly stringent 1979 Budget if his 1981 goal is to have any hope of
realization. OMB has revealed that for planning purposes it is using a 1979 outlay
figure of about $500 billion. Such planning figures seldom endure until the final
Budget is presented, but if this one should happen to hold, the implied real increase
in spending over the July estimates for 1978 is less than one percent. A 1978
shortfall of seven to eight billion would raise the implied rate of real growth in
1979 spending to over two percent, but still implies great stringency between the
two years.




123
Over the longer run, the nature of the Administration's tax reform package
will be of significant importance to the long-run budget outlook and to the
allocation of resources.- In this regard, the proposed net revenue loss associated
with tax reform may be as important as the compositional changes in the tax
structure.
Since the Korean War, the ratio of total Government receipts to GNP has
been held remarkably constant. There is no clear trend in the ratio and its average
since 1953 has been 18.6 percent, exactly the level achieved in fiscal 1976. To
maintain relative stability in the ratio, numerous discretionary tax cuts have been
necessary to offset the effect of inflation and real growth pushing income
taxpayers into higher and higher tax brackets.
Because of the current high inflation rate, constant tax law implies a very
rapidly increasing tax burden, because taxpayers are pushed into higher brackets at
a much faster rate than they were in the past.
In 1978 the expected ratio of receipts to GNP is 19.6 percent or only slightly
above the historical average of 18.6 percent. Given the Administration’s economic
projections it will rise to almost 22 percent by fiscal 1981 if tax laws remain
unchanged. Returning the 1981 ratio to the 19.6 percent prevailing in 1978 would
require a massive tax cut of over $60 billion in 1981 dollars. There is a clear
conflict between the historical tendency for the Congress to keep the ratio of
receipts to GNP relatively constant and the Administration’s desire to obtain the
revenues necessary to facilitate budget balancing in 1981.
The announced goal of the Administration is to hold outlays to 21 percent of
the GNP in 1981 compared to the 22.6 implied byd the July estimates for 1978. A
balanced budget obviously implies that receipts will have to equal 21 percent of
GNP and they have not reached this level since the Korean War—although they
came close during the Viet Nam War. Whether or not the Congress will accept the
implied increase in the tax burden will be one of the more interesting fiscal policy
questions of the next three years. All of this, of course, accepts the relatively
optimistic economic projections of the Administration. This is not the place for a
detailed critique of those projections, but any slowdown in the recovery could cause
the dream of a balanced budget to be postponed for many years.







Appendix Table A

President Carter's July 1976 Economic Forecasts and
Long-Run Projections
(Calendar’
Years: dollars i b l i n )
n ilos
Actual
1976

Forecast
1977
1978

1979

Projection
1980
1981

1982

1,692
11.6

1,883
11.3

2,106
11.9

2,345
11.3

2,592
10.6

2,836
9.4

3,081
8.6

1,265
6.1

1,330
5.1

1,399
5.3

1,468
5.0

1,545
5.2

1,621
4.9

1,690
4.3

1,375
890
148

1,526
991
173

1,698
1,105
199

1,894
1,231
223

2,097
1,366
246

2,294
1,495
268

2,493
1,624
291

5.1
4.6

5.9
6.5

6.3
6.1

6.1
5.9

5.1
4.6

4.3
4.2

4.2
4.2

CPI:
Year over year
December over December

5.7
4.8

6.5
6.9

6.0
6.1

5.9
5.7

5.0
4.5

4.3
4.3

4.3
4.2

Unemployment rates (percent)
Total:
Yearly average
Fourth quarter

7.7
7.9

7.0
6.6

6.3
6.1

5.7
5.5

5.2
5.0

4.8
4.6

4.5
4.4

Gross national product
Current doll r :
as
Amount
Percent change
Constant (1972) dollars
Amount
Percent change
Incomes (current dollars)
Personal income
Wages and salaries
Corporate profits
Prices (percent change)
GN1‘ deflator:
Year over year
Fourth quarter over fourth quarter

Insured1^

6.4

Interest rate, 91 day Treasury b l s .(percent)
il

2
)

5.1

4.2

3.7

3.2

3.0

2.8

4.8

Federal pay raise, October (percent)

6.5

6.5

6.5

6.0

5.5

5.0

5.0

4.9

5.0

5.0

5.0

5.0

5.0

1) Insured unemployment as a percentage of covered employment; includes unemployed workers receiving extended benefits.
2) Average rate of new issues within period.

The forecast assumes continuation of current market rates.

125
FINANCING THE GOVERNMENT DEFICIT
By
Robert H. Rasche
Michigan State University
The following comments are divided into essentially two parts. In Section I,
an explicit financing relationship for the U.S. government is derived, which relates
the deficit or surplus (unified budget) plus the deficit or surplus of off budget
agencies to changes in the net sources base and other factors. I have included a
discussion of what items are involved in these other factors, and identified the
items which must be forecast in order to make a projection of the impact of a
projected deficit or surplus in the private capital markets under different
assumptions about monetary policy.
I welcome any comment on the
appropriateness of the categories which I have devised, and/or the techniques which
I propose to forecast some of the components. In addition, I would appreciate any
helpful suggestions on forecasting the component of the relationship related to
foreign transactions.
In Section II, I have made some comments on things which I see as significant
factors in recent financing, and make some rough guesses as to what the coming
fiscal year may bring.
I. Components of the Financing Identity
and Some Forecasting Proposals
At various meetings in the past, I have tried a number of semi-systematic
presentations of the relationship between the government deficit or surplus and
various components of the financing problem. I have finally made the.effort to
trace down a systematic relationship between changes in the net source base and
the deficit or surplus. The relationship is derived from two basic identities: the
first the so called means of financing identity data for which the available in
various Treasury publications, and the second the balance sheet of the Federal
Reserve System which is presented in the Consolidated Statement of Condition in
the Federal Reserve Bulletin. Several other minor definitions also enter tino the
computations. The details of the development are presented in the Appendix to
this paper. The data for fiscal years 1974-1976, and quarterly thereafter, are
presented in Table 1. It should be noted that all data are derived from changes in
end-of-quarter stock figures and are seasonally unadjusted, hence they are not
compatable with the average of daily figures, seasonally adjusted data which are
usually cited.

22-761 0 - 78 - 9




126
It seems to me that the goal of this type of investigation is to be able to
attem pt to project the amount of financing through private credit markets which
will be associated with a projected deficit and proposed (or projected) growth paths
of the base. As can be seen from Table 1, in reality this does not amount to a
straightforward subtraction of the change in the base from the projected deficit, as
the issue is typically presented in the textbook discussion of the subject. There are
a large number of other components in the relationship, some of which have been
and can be quite important in at least short run financing developments. I shall
first try to identify what is in the various groupings which I have developed and
then discuss how they have affected recent financing and speculate on some future
developments.
The first category is an approximation to the volume of funds raised by the
Treasury in credit markets from private sources. It is the total amount of Treasury
and Agency debt issued outside of the Treasury less the change in debt holdings by
the Federal Reserve and Foreign official institutions. The latter is not quite
accurate, as it excludes changes in holdings of agency debt by such institutions,
since I have been unable to find any published source in which this information is
tabulated separately. It is also possible that since this is an attem pt to meeisure on
a net basis, changes in acceptances held by the Federal Reserve System (which now
appear in category VII) should be subtracted from this grouping.
The second, third and fourth categories are self explanatory. The fifth, which
involves foreign transactions probably needs some explanation, particularly with
respect to the treatm ent of ’’swaps.” When the Fed engages in ’’swap” operations,
the two accounts which are involved are the other assets of the Federal Reserve
System (denominated in foreign currencies) and foreign deposits at the Federal
Reserve. For example, when the Fed obtains foreign currencies in a ’’swap"
operation, it increases both other assets and foreign deposits.1^ Thus, category V is
unaffected by foreign currency swap operations.
1) See Federal Reserve Bank of New York, Glossary: Weekly Federal Reserve
Statements, p. 18.




127
Categories VI and VII are also fairly clear. Category VIII warrents some
explanation, since a number of the items are not familiar, and the definitions are
not easily available. First, other cash and monetary assets of the Treasury includes
Treasury Cash and the Gold Balance as sub items. Thus, VII essentially includes net
cash and monetary assets of the Treasury which involves basically time deposits,
some cash items in process of collection, and some miscellaneous transit items.
The other two categories which are difficult to identify are Miscellaneous Treasury
Liabilities and Miscellaneous Treasury Assets. Much of what is included in these
2 )'
entries is of the nature of float.
However, there are two important exceptions
which arise out of the pecularities of the book valuation of Treasury securities.
The book valuation of all government securities is at par, not at issue price.
Hence, the discrepancy between the book value of the debt issue (changes in which
are indicated under I above), and the actual revenue raised from a debt sale has to
be accounted for somehow. This is handled in the miscellaneous asset and liability
accounts. If debt is sold at a discount (as for example with a Treasury Bill auction,
then the outstanding value of the debt is increased by the par value of the bills on
the books of the Treasury, and the discount is entered as a miscellaneous asset
account entitled "deferred interest (discount) on marketable United States Treasury
securities." On the other hand, if a note or bond is issued at a premium, then the
par value of the issue is added to the value of the outstanding debt, and a
miscellaneous liability item entitled "deferred interest (premium) on public debt
subscriptions, United States Treasury" is increased by the amount of the premium.
I have been unable to determine if these miscellaneous accounts are left unchanged
until the time that the debt issue is retired, or if some schedule is used to allocate
the discount or premium into interest paid over the life of the security. Judging
from the accounting practices of the Federal Reserve, which also carries its
government securities at par value, I suspect that the premium or discount is
gradually phased out over the life of the security. 3) In any case, the changes in
these categories, particularly the asset item have been substantial at times in the
recent past, and their character is such that their behavior should not be the
random kind of behavior that can be expected from the float type items which
comprise the remainder of the entry.
2) See the Combined Statement of Receipts, Expenditures and Balances of the
United States Government.
3) See Federal Reserve Bank of New York, Glossary: Weekly Federal Reserve
Statements, p. 13, "Other Liabilities and Accrued Dividends."




128
The final category is that of deposit funds. Deposit funds are defined as:
combined receipt and outlay accounts established to account for
receipts that are either (a) held in suspense temporarily and later
refunded or paid into some other fund of the government upon admin­
istrative or legal determination as to the proper disposition thereof, or
(b) held by the government as a banker 01* agent for others and paid out
at the direction of the depositor. Such funds are not available for
paying salaries, expenses, grants, or other outlays of the government.
I have made a preliminary attem pt to reconcile the identity which I have
derived with the published information in the Flow of Funds data. I am rather
pessimistic that the Flow of Funds source will ever prove useful in tracking down
the identity. Some of the items just cannot be identified in the Flow of Funds data;
some of the published categories combine items from different categories which I
have defined (though this is probably surmountable with the use of unpublished
data), and most troublesome of all, in places where the categories would seem to
match up, the numbers frequently are completely dissimilar (even when looking at
the seasonally unadjusted flows in the Flow of Funds accounts). I intend to pursue
this investigation somewhat further, but it may prove that to obtain any sort of
time series on the various elements of the financing process, the original sources
will have to be painstakingly pulled together.
What about forecasting of the impact of the projected deficits on domestic
credit markets? One category, the net source base, is close to the monetary base
concept which is of major concern to this committee. We can project our desired
growth of this aggregate, or we can project our best guess estimate of what
actually will occur, given the existing management techniques for monetary policy.
A second category which seems to warrent some consideration from the
perspective of economic theory is the foreign transaction category, V. I think that
this grouping comes pretty close to the concept which is referred to as the balance
of payments in the literature on the monetary theory of the balance of payments,
though not being an expert in that area, I may be mistaken. In any case, I would
like some discussion of how forecasts of this component could be developed.
4) Combined Statement of Receipts, Expenditures and Balances of the United
States Government, 1976, p. 3.




129
The remaining items of the identity have large random behavior about which
there is very little that economic theory can tell us. It seems to me that these are
things for which a pure time series approach to forecasting, such as that of BoxJenkins is not only highly useful, but also highly appropriate.
II. Some Issues in Recent Government Financing
With the exception of the transition quarter, a common characteristic of the
last several years has been the fact that the government has had to go to the
private capital markets for considerably less than the total financing which is has
required. In part this is due to the rapid growth of the monetary base with which
we are all familiar. An additional factor which has made an important contribution
is the item which I have entitled changes in Foreign Transaction Balances. In
particular, over the last four quarters tabulated in Table 1, over six billion dollars
of the deficit has been financed by increases in this item. For the most part this
reflects increases in Foreign Official holdings of U.S. Government securities. In
the two prior fiscal years, foreign official holdings of U.S. Government securities
increased by four billion dollars. Thus, the recent rate of increase reflects a
doubling of the rate of acquisition. I suspect that these may reflect changes in
holding by the Germans and Japanese for the most part, but I have to confess that I
have not tracked things down, and I shall defer to other expertise in this area. The
one thing which seems clear is that there is considerable management of the float
going on, and if anything it has increased substantially in recent months.
What impact on the private capital markets can be expected in the coming
fiscal year? The present official projections of the fiscal 1978 budget deficit are in
the neighborhood of 60 billion dollars. In addition, something has to be added for
off budget agencies. The major contributors to the off budget deficit are the
postal service and the Federal Financing Bank. In the recent past, the deficit in
this category has been reduced somewhat because of unexpectedly favorable
experience on the part of the postal service. Judging from recent pronouncements,
and the political opposition to cost cutting innovations such as the abolition of
Saturday delivery and the consolidation of rural postal facilities, the recent
experience cannot be extrapolated into the future. Therefore, it is likely that
something of the order of 10 billion should be added for required off budget
financing. If we scale down the official budget deficit estimates somewhat to
account for the positive serial correlation of the OMB- forecasting errors in the
recent past (the so called budget underruns), then it seems appropriate to conclude
that something approaching, but probably not exceeding 70 billion dollars of
financing will be required over the next fiscal year.




130
The net source base amounted to about 120.6 billion dollars (seasonally unad­
justed) at the end of June, 1977. If we assume a growth rate of the order of six
percent per annum for the next fifteen months (on the assumption that this is a
likely outcome, not a desirable outcome), about seven billion would be financed by
increases in the base (given growth in the money stock over the last two months,
this might be regarded as too high for a likely outcome, although care should be
taken to distinguish growth in the monetary base in the last few weeks because of
increases in borrowing which does not count in the net source base). If we assume
that changes in foreign transaction balance increase at somewhere between the
four billion annual rate of 75-76, and the eight billion rate of recent months, and
further assume that the net impact of the remaining components is of the order of
one billion dollars one way or the other, then the total borrowings which will be
required in the private capital markets can be projected at somewhere around 55 to
60 billion dollars.




131
APPENDIX
Derivation of the U.S. Government
Financing Identity
The basic identity and data for the financing requirement are found in the
Monthly Treasury Statement of Receipts and Expenditures, and in the Federal
Reserve Bulletin.1 The first relationship is found in a table entitled "Means of
Financing." This equation indicates that the
Unified Budget Deficit (+) or Surplus (-)
plus

Transactions not applied to the current year’s deficit or
surplus

equals

Changes in U.S. Government and Agency Securities held by
the Public (net of securities held as investments by
government accounts)

plus

Change in accrued interest payable on public debt securities

plus

Changes in deposit funds

plus

Changes in miscellaneous liability accounts of the Treasury

less

Changes in U.S. Treasury Operating Cash (including balance
held at Federal Reserve Banks + Tax and Loan account
balances + demand balances held at other depositories)

less

Changes in total holdings of SDR’s net of changes in SDR
certificates issued to Federal Reserve Banks

less

Changes in gold tranche drawing rights

less

Changes in other cash and monetary assets

less

Changes in miscellaneous asset accounts of the Treasury

1) -Other helpful, though not necessarily complete or accurate tables can be found
in the monthly Treasury Bulletin. Additional sources of information of a fiscal year
basis are the Annual Report of the Secretary of the Treasury and the Combined
Statement of Receipts, Expenditures and Balances of the United States
Government. The latter is the most comprehensive, informative, and probably the
most accurate.




132
The second identity is the balance sheet of the Federal Reserve System found
in the Consolidated Condition Statement. This identity can be solved for the
Treasury Balances with the Federal Reserve System and substituted into the Means
of Financing identity. Two additional identities are useful:
(1) Gold Stock

= Gold Certificates held by Federal Reserve
Banks + Balance of Gold
(2) Treasury Cash
= Federal Reserve Notes held in the Treasury
+ Treasury currency held in the Treasury.
Finally the definition of Transactions not applied to current year's deficit or
surplus is required. This is perhaps the most elusive component of the whole
problem; as far as I can discover, the only place where the data are regularly
published is in the Monthly Treasury Statement. This aggregate consists of:
Deficit (+) or Surplus (-) of Off Budget Agencies (including
the Federal Financing Bank in recent years)
plus

Seigniorage

plus

Increment on gold

plus

Net gain/loss from U.S. currency valuation adjustment

plus

Net gain/loss from IMF loan valuation adjustment (starting
fiscal 77)

plus

Change in interest receipts on government accounts to
accrual.

Manipulation of these identities gives the nine categories listed in Table 1,
where the components of each category are as follows:
I. Borrowing from Private Capital Markets
la. (+) Borrowing from the Public
lb. (-) Changes in Federal Reserve Holdings of U.S. Government
Securities
Ic. (-) Changes in Federal Reserve Holdings of Agency Issues
Id. (-) Changes in U.S. Government Securities Held by Foreign
Official Institutions (from Table 3.13, Federal Reserve
Bulletin. Foreign official holdings of agency issues are
not published separately)




133
II. Change
Ha.
lib.
He.

in Net Source Base
(+) Change in Member Bank Desposits at Federal Reserve Banks
(+) Change in Currency in Circulation
(-) Change in Member Bank Borrowings from the Federal
Reserve

III. Change in Federal Reserve Float
Ilia. (+) Change in Deferred Availability Cash Items
Mb. (-) Change in Cash Items in Process of Collection
IV. Change in U.S. Treasury Cash Balances
IVa. (+) Change in Tax and Loan Account Balances
IVb. (+) Change in Balances a t Other Depositories (demand)
V. Change in Foreign Transaction Balances
Va. (+) Change in Foreign Deposits at the Federal Reserve
System
Vb. (-) Change in other Federal Reserve Assets Denominated
in Foreign Currencies (swaps)
Vc. (+) Change in U.S. Government Securities Held by Foreign
Official Institutions
Vd. (-) Change in the U.S. Gold Stock
Ve. (-) Change in SDR Holdings
Vf. (-) Change in Gold Tranche Drawing Rights
Vg. H Change in Loans to IMF (fiscal 1977 only)
VI. Change in Interest Accruals
Via. (+) Change in Accrued Interest Payable on U.S. Government
Securities
VIb. (-) Conversion of Interest Receipts on Government Accounts
to Accrual




134
VII. Change in Excess of Miscellaneous F.R. Liabilities over Miscellaneous
Assets
Vila.
Vllb.
VIIc.
VHd.
Vile.
VHf.
Vllg.

VIII. Change
Villa.
VUIb.
VIIIc.
VUId.
VIHe.
VIHf.
VUIg.
VIHh.
Villi.
VUIj.

(+)
(+)
(+)
(-)
(-)

Change in Other Deposits at Federal Reserve Banks
Change in Other Liabilities of Federal Reserve
Change in Federal Reserve Capital Accounts
Change in Other Federal Reserve Loans
Change in Acceptances Held by Federal Reserve
Banks
(-) Change in Bank Premises and Operating Equipment
(-) Change in Other Federal Reserve Assets (excluding
those denominated in foreign currencies (swaps)
in Miscellaneous Treasury Accounts
(+) Change in Treasury Cash
<+) Change in Balance of Gold
(+) Change in Misc. Treasury Liability Accounts
(-) Change in Other Cash and Monetary Assets of the
Treasury
(-) Change in Misc. Treasury Asset Accounts
(-) Seigniorage
(-) Increment on Gold
(-) Net Gain of Loss From U.S. Currency Valuation
Adjustment
(-) Net Gain or Loss From IMF Loan Valuation Adjustment
(-) Change in Treasury Currency Outstanding

IX. Change in Deposit Funds
IXa.
(+) Change in Allocations of SDR’s
IXb.
(+) Change in Other Deposit Fund Balances




TABLE 1
FISCAL YEARS

Plus

Unified Budget Deficit (+) or Surplus
Off Budget Agency Deficit (+) or Surplus

1975

1976

TQ

76

77

77

1976

1974

IV

I

II

3460
2675

43604
9546

65605
8016

12700
2005

22785
-415

18692
4269

-8620
-106

6135

53150

73621

14705

22370

22961

-8726

(+) Borrowing from Private Capital Markets -2146

40422

67069

14813

15011

16495

-112691

Equals Total Financing Required
Sources of Financing
I.
II.
in .

(+) Changes in Net Source Base
(+) Change in F.R. Float

IV.

(-) Change in U.S. Treasury Cash

V.
VI.

(+) Change in Interest Accruals

VII.

(+) Change in Misc. F.R. Accts.

9890

5897

9413

-577

3403

2076

-305

-249

506

-1786

580

396

-685

48

-2298

-4424

1045

1258

-2842

597

-811

(+) Change in Foreign Transaction Balances -3863

2805

2046

851

1325

2161

2475*

46

399

915

144

1207

-647

477

214

-2202

-85

433

178

595

-138

VIII. (+) Change in Misc. Treasury Accts.

-35

319

-1884

-319

-2642

3582

-557

IX.

-19

597

-1024

34

657

-33

-262

(+) Change in Deposit Funds

a) Preliminary - Based on two months data on Foreign Official Debt Holdings.




136
BRIEFING FOR THE SHADOW OPEN MARKET COMMITTEE

By
Wilson E. Schmidt*
There has been a great deal of excitement over our international transactions
in the last six months.
There has been fear that our excess of imports over exports could not last,
that it has caused or would cause a depreciation of the dollar which leads to
inflation, that it causes unemployment, and that it stimulates protectionist
pressure in the United States. There has been continued pressure on the part of the
U.S. Government to stimulate the two other supposed locomotives of the world
economy, Germany and Japan. And there has been concern about the repayment of
our credits to foreigners and our ability to repay our debts.
Actually, very little of importance happened that is worth noting, with one
exception.
The exception is that the International Monetary Fund in April backed off its
notion of norms or zones for exchange rates for the purpose of guiding countries’
exchange rate inter ention over four-year periods with its implicit danger of fixing
rates. Instead the new rules continue to call for intervention to prevent disorderly
markets, though, as Dr. Burns has indicated, no two men can agree on what such
conditions are (a view expressed in my September 1975 SOMC paper), so this is
hardly a meaningful guideline but few would interpret it to be the equivalent of
target zones. The new rules also call upon the members to avoid manipulating
exchange rates to prevent effective balance of payments adjustment or to gain an
unfair advantage. Again it is hard to know what this means and the Fund has said
"difficult judgments will have to be made.” In any event, zoning is gone.

♦Professor of Economics, Virginia Polytechnic Institute and State University




137
The amount of intervention chiefly by the G-10 countries in the six months
ending in July hit a record high of $7 billion per month against an average of about
$4 billion since the float began. But the data do not reveal how much of this was
sustained, unidirectional intervention, as against mere diddling with the rates. U.S.
intervention fell from $3.2 billion in the six months ending January 1977 to $1.5
billion through August 1977, though these are crude estimates. Much more
persuasive and heartening is the rise in the proportion of world trade by countries
whose currencies are not maintained within relatively narrow margins in terms of
any currency, group of currencies, or composite of currencies. On the basis of 1975
world imports, the proportion has risen from 43% at the end of 1975 to 52% at the
end of 1976 and now to about 55%. (This figure understates the amount of trade
subject to floating; all imports by countries that fix on something from countries
that fix on nothing, so that the imports are subject in fact to floating, are excluded
from the numerator, e.g., imports by Germany, Belgium, and the Netherlands from
the U.S.)
Most attention has been given to our excess of imports over exports of $15
billion during the first half of the year. The Secretary of the Treasury reportedly
has projected this to reach $25 billion or maybe a bit more for the year. Little
attention has been given the inflows of capital and other transactions that must
offset it under the floating exchange rate system.
During the first half of the year, the growth in foreign official assets in the
U.S. was $11.4 billion, covering three-quarters of the trade balance. About $9.7
billion was placed in U.S. Government securities, equal to almost half of the
increase in Federal debt outstanding, thereby easing the Treasury’s need to finance
the budget deficit from the private sector or the Fed. It is difficult to tell how
much of this constitutes direct intervention in the foreign exchange markets. Not
an insubstantial part of the growth in foreign official assets must be attributed to
interest income on those assets - if one assumes a 6% yield, $3 billion over the first
half of the year, leaving $8.4 billion to be explained otherwise during the first half
of the year. In 1976, the OPEC countries accounted for somewhat more than half
of the increase in our liquid foreign official liabilities. This held true for the first




138
quarter of 1977 also. But in the second quarter, their share fell to under 15% and
the portion attributable to industrial countries rose to over three-quarters. While
there are no data, this sharp shift probably reflects the efforts of the UK, Italy,
and France to increase their gross international reserves by intervention in the
foreign exchange market, buying dollars and thus preventing a depreciation of the
dollar.
The trade figures have exhilarated some people, especially some in the
Department of Commerce which has programs to stimulate exports that are under
attack. The Department is now even talking about a basic deficit. One high Com­
merce official is quoted as stating that it will take us a decade to get back into
equilibrium, as if equality of exports and imports implies equilibrium. It is hard to
justify costly export promotion schemes when we finance a large part of our
imports with loans at zero real rates of interest, that is after allowing for the
effect of U.S. inflation on the nominal returns in dollars to foreigners.
On the other hand, the trade balance has depressed others. One distinguished
economist worries that we will not be able to repay our external debts. But since
our interest payments to foreigners slightly more than offset our interest income
from foreigners, it is hard to see that the United Sates is anywhere near the parlous
condition to the weakest LDCs when the average LDC has a ratio of debt service to
exports of 16%.
Others believe that the trade deficit has depressed the dollar which in turn
causes inflation. Without accepting the proposition that depreciation of the dollar
leads to inflation, we need only note that the average value of the dollar in terms
of 46 main trading countries fell by six tenths of one per cent from the beginning of
the year through the end of July. What seems to have caught the public’s eye is the
substantial appreciation of the market and the yen, but of course those two
currencies are not the whole story.




139
Still others are concerned with the growth of protectionist sentiment at home
because of the trade balance. Labor in particular has been pressing for protection.
But such efforts are likely to lead to little for labor as a whole. Though the
estimates are dated, the amount of labor contained in a million dollars of our
exports is just about the same as the arnount of labor contained in a million dollars
of U.S. production that competes with imports. The imposition of import
restrictions might help labor in the protected industry but the consequent reduction
in imports will lead to an appreciation of the dollar which will deter our exports by
a similar amount, hurting labor in the export industries.
Finally, there are those who complain that the trade imbalance destroys jobs
and slows the growth of GNP. It is doubtful that this fear is well founded. The
evidence suggests that changes in money are more important and more lasting by
far than changes in the federal budget (and thus, by inference, more important than
changes in the trade balance) in determining the level of aggregate demand. Since
our international transactions cannot affect the stock of money and the monetary
base because we are floating, the relationship between our trade balance and the
state of employment is very weak and short-lived.
In another unimportant development, the Administration continues to push its
locomotive theory, pressing the surplus countries, such as Germany and Japan to
expand domestic demand. A 1% increase in the combined GNP of Germany and
Japan would cause the rest of the world’s output to rise by only 12/100 of 1% with
fixed exchange rates. With floating, the impact will be even smaller.
The next Administration push will be to obtain congressional support for the
Witteween facility, a fund of approximately $10 billion to be loaned in almost equal
shares to the International Monetary Fund by the industrial and the OPEC
countries. The issue here is adjustment versus financing of deficits. The loans
under the new facility to countries in balance of payments difficulty will be of
longer maturity (up to seven years) than the normal Fund loans (up to five years).
By and large, the world has sought to meet the challenge of the OPEC surpluses by
borrowing to cover them rather than simply letting the oil producers hold and
invest the currencies they have gained. The longer adjustment is delayed, the
harder it is to achieve. The new facility on this test appears to be a continued step
in the wrong direction.




140
The Dilemma of Inflationary Policies




Karl Brunner
University of Rochester
and
Hoover Institution
Position paper prepared for the 9th
meeting of the Shadow Open Market
Committee
September 19, 1977
PPS-77-5

141
!• The Re-Emergence of an Old Problem
Over recent years inflation has dominated the official attitude and
pronouncements of the Federal Reserve Authorities. This attitude was expressed
by. the Federal Reserve’s management of new procedures developed under House
Concurrent Resolution 133. The Resolution recommends that the Federal Reserve
Authorities pursue a policy of monetary control conducive to longer-range stability
of the price-level. For two and a half years the Federal Reserve announced in
quarterly Hearings before the Senate or House a target range for the monetary
growth rate with the average money stock observed in the quarter preceding the
Hearings serving as the basis for this targeted monetary growth. Thus, monetary
policy was formulated in terms of a target range containing the acceptable paths of
the money stock.
Under the circumstances changes in the target range apparently reflect
modifications in the course of policy. They seem to signal the general trend in
monetary affairs to be expected over the near future. The information collected in
Table 1 presents the official signals conveyed to the public since the middle of
1975. The target range guiding growth paths for
and M2 drifted generally
lower. The upper boundary for
was lowered from 7.5% to 6.5% and from 10.5%
to 9.5% for !< . The lower boundary of the range for M- was lowered from 5.0% to
' ;■
t
1
4.5% and from 8.5% to 7% for
At one single occurrence (in November 1976)
the Federal Reserve raised the upper boundary on M2* They simultaneously
lowered, however, the upper boundary placed on
The official actions can also
be described by the changes in the mean growth between the upper and lower
boundary. The mean path for
was lowered over the past two years from 6.25%
to 5.5% and from 9.5% to 8.25% for
The trend summarized in Table 1 apparently nudges the inherited rate of
inflation to lower levels. We seem to be assured a persistent decline in the magni­
tude of inflation over the period 1977/79. The Shadow Open Market Committee
noted this pattern in previous sessions. It also approved the generally modest rate
of monetary growth maintained in the average over a 12 month period. It
expressed, however, some concern about the violatile behavior of monetary growth

2 2 -7 6 1 0 - 7 8 - 1 0




142
observed within one year. It also warned that the Federal Reserve's internal pro­
cedures were ill suited to execute an effective monetary contol. The traditional
mode of implementing policy would remain, in the Shadow Committee's view, an
uncertain and unrealiable instrument for the purposes defined by the House
Concurrent Resolution 133. The Committee emphasized, moreover, the potential
drift built into monetary growth as a result of the peculiar targeting techniques
evolved by the Federal Reserve Authorities.
Table I: The Target Range on Growth
Rates for
and M2

12-MONTH GROWTH RANGE TARGETS: Ml
Congres­ B s *
ae
sional
Quarter
Hearing Of the
Date
Forecast
5/77
2/77
11/78
7/76
5/76
2/76
7/75
5/75

Q1 77
Q4 76
Q3 76
Q2 76
Q1 76
Q4 75
Q2 75
3/75

Targeted Ml
Growth Range
For Next 12 Months
Range
Avertge
4.5
4.4
4.5
4.5
4.5
4.5
5.0
5.0

to 6.5%
to 6.5%
*0 6.5%
to 7.0%
to 7.0%
to 7.5%
to 7.5%
to 7.5%

SOURCE: Federal Reserve Bulletin




5.50%
5.50%
5.50%
5.75%
5.75%
6.00%
6.25%
6.25%

12-MONTH GROW T H RANGE TARGETS: M2
Congres­
sional
Hearing
Date

Base
Quarter
Of the
Forecust

5/77
2/77
11/76
7/76
5/76
2/76
7/75
5/75

Q1 77
Q4 76
Q3 76
Q2 76
Q1 76
Q4 75
Q2 76
3/75

Targeted M2
Growth Range
For Next 12 Months
Range
Average
7.0
7.0
7.5
7.5
7.5
7.5
8.5
8.5

to
to
to
to
to
to
to
to

9.5%
10.0%
10.0%
9.5%
10.0%
10.0%
10.5%
10.5%

8.25%
8.50%
8.75%
8.50%
8.75%
8.75%
9.50%
9.50%

143
The potential dangers posed by the Federal Reserve’s institutional inheritance
emerged this year with a sharper focus. We also possess at this stage a sufficient
segment of observation in order to assess the basic trend in our monetary affairs.
Table II summarizes the relevant information bearing on our problem. The crucial
aspect deserving our attention is the remarkable acceleration in
and Mg
maintained since the second half of 1974. The growth rate of Mj more than
doubled and the growth rate of Mg increased by almost 70% over the past three
years.
Monetary growth rates computed between corresponding months in
successive years, between average values of successive two-quarter periods or
between shifting two-quarter intervals reveal the same basic pattern. We observe
over two and a half years a positive drift persistently raising monetary growth.
Table II: Accelerations and Decelerations in Ml and M2

%
Period
QI:76
QI:75
QII:74
QII:73
Ql:72

to QII:77
to QI:76
to QI:75
to QII:74
to QII:73

Growth
6.5
4.8
3.1
5.7
8.0

%
Period
QI:76
QI:75
QII:74
QII:73
QI:72

to
to
to
to
to

Growth
QII:77
QI:76
Q1-.75
QII:74
QII:73

10.7
9.4
6.3
8.7
10.0

SOURCE: Federal Reserve Bank of St. Louis

An inspection of the data so far available for the current calendar year
confirms this pattern.
Monetary growth in the second quarter exceeded
substantially the upper target boundary even without the pressures to finance a tax
rebate. There also exist indications of continued excessive monetary growth during
the third quarter. Moreover, the week ending with August 17, 1977, shows a money
stock 7.1% above the value in the corresponding week in 1976. We also note that
monetary growth over successively shorter intervals all ending with the central
week in August exhibit an accelerating pattern. An increasing growth exceeding
the upper target boundary dominates the observations accruing since our last
meeting in March 1977. The data in Table III effectively summarize the problem.
In a similar vein the growth rate of Mg exceeded in recent months the upper target




144
boundary for the respective magnitude.
Table III: Annual Growth Rate of
Different Periods in 1977

Over

COMPOUNDED ANNUAL RATES OF CHANGE, AVERAGE OF FOUR WEEKS ENDING:
8/18/76 11/17/76 1/19/77 2/16/77 3/16/77 4/20/77 5/18/77 6/15/77
To the Average
of Four Weeks
Ending:
2/16/77
3/16/77
4/20/77
5/18/77
6/15/77
7/20/77
8/17/77
SOURCE:

5.0
4.9
6.1
6.5
6.0
6.8
7.1

3.7
3.8
6.0
6.5
5.8
7.0
7.3

0.4
5.4
6.4
5.4
7.1
7.4

9.6
9.5
7.5
9.0
9.2

11.9
8.5
10.1
10.1

5.2
8.7
9.0

8.4
8.9

Federal Reserve Bank of St. Louis

II. The Fragile State of Anti-Inflationary Policies
In 1963/64 Allan Meltzer and I concluded in a study on Federal Reserve
Policy-Making prepared for the House Committee on Banking and Currency that
the negative association between actual monetary management and professed
policies reflected the central problem of Federal Reserve policy-making. This
negative association was produced in past decades by a systematic
misinterpretation of monetary actions and the prevailing monetary state. The
underlying conception about the monetary process governing the Reserve
institution’s approach for over fifty years unavoidably determined the
misinterpretations of events observed during the 1930’s, the 1950’s, and into the
1960’s.
This systematic misinterpretation seems barely the appropriate explanation
of the current developments described in the previous section. The discrepancy
between anounced policy and actual monetary growth is probably attributable to
the operation of internal implementation procedures well adjusted to the old
conception prevailing until the middle 1960’s centered on free reserves and money
market conditions.
The disposition to failure built into the traditional
implementation is occasionally activated by an institutional inheritance stressing
interest rate policies and emphasizing orderly money markets. This inheritance is
re-enforced by regular Congressional pressure insisting that the Federal Reserve
apply its resources to maintain interest rates at a low level. Lastly, we also note
that the targeting technique actually practiced by the Federal Reserve Authorities
offers supplementary opportunities for the built-in disposition of failure.




145
Our recent experience thus reveals that the execution of effective monetary
control designed to lower the rate of inflation requires attention to institutional
implementation beyond broad announcements. It also involves a continuous
political struggle with the inflationists in Congress and the Administration. It is
unfortunate in this context that the advocates of inflationary policies rarely
acknowledge this implication of their proposals. The inflationary consequences are
usually hidden beyond a package of worthy intentions directed towards lower
interest rates, lower unemployment, or larger government expenditures. And once
inflation emerges as a result of such endeavors, aggravated by even higher interest
rates and barely lowered unemployment, there always will exist opportunities (and
$ incentives) to direct public attention away from the relevant causes of the new
inflationary burst. The interaction between media and political process tends to
spin a web of deceit and ignorance covering the nature of the ongoing inflation. It
follows that a persistent pattern of anti-inflationary policies may have a
comparatively low political survival value. It certainly requires substantial courage
and determination by the policy-makers involved in monetary affairs.
III. The Dilemma c" Monetary Policy
What are the implications of recent monetary trends? We suppose for this
purpose that monetary growth (M^) proceeds into 1978 at an annual rate of about
7%. At this rate the underlying "permanent” inflation rate will measure around 6%
p.a. The actual rate of inflation will be higher, however. The acceleration of
monetary growth will raise longer-run inflationary anticipations, and thus the
actual inflation rate observed in 1978 would contain a temporary acceleration
component. I expect that this revision of inflationary anticipations would add
(temporarily) one to one and a half percentage points to the actual rate beyond the
permanent inflation rate, i.e., the rate of inflation observed next year under' the
circumstances will be about 7% - 7.5%. My estimate of the growth rate of nominal
GNP for 1978 under the same circumstances is around 10.5% p.a. The growth rate
in real GNP would therefore subside in the context of the recent monetary growth
path to about 3% - 3.5%.




146
This estimated trend forms the basis for two alternative scenarios of mone­
tary policy. The first scenario involves a reversal of the pattern emerging in the
recent past. It would lead the Federal Reserve back to a determined antiinflationary course. Suppose that this is expressed by a monetary growth of about
4.5% for 1978, i.e., a monetary growth along the lower boundary of the last
announced target range. The growth in nominal GNP along this monetary path
would be (at the most) about 8.0% and will probably be 7% - 7.5%. But the
permanent inflation rate in 1978 remains in the range between 5% and 6% as a
result of the past monetary acceleration. Moreover, revisions of inflationary
anticipations may still be more affected by the recent acceleration and the
persistent uncertainties imposed by the Carter Administration. The actual rate of
inflation would probably stay above 6% under the circumstances. It follows that
real growth subsides to a figure below 2%. A substantial retardation in economic
activity with probably even a minor decline for about one quarter seems
unavoidable in the context of this scenario. The reversal in policy to an antiinflationary stance should thus be expected to produce a mini-recession and a
corresponding increase in the rate of unemployment.
The second scenario describes a very different policy. It assumes an
essentially accommodating behavior on the part of the Federal Reserve
Authorities. Such behavior would be designed to appease Congressional pressures
directed at interest rates and unemployment. It would also appease the inflationist
groups within the Carter Administration. An accommodating policy could barely
settle along a monetary growth path of 7% discussed above. Even along this path
real growth subsides and the unemployment rate remains above 6%. The second
scenario thus foresees an acceleration in monetary growth beyond 1% to, say 8.5%.
The permanent inflation rate increases to 7% -7.5% and the actual rate bulges
along an accommodating monetary path temporarily to a range around 8% - 8.5%.
The rate of real growth would thus be confined to a range of about 4% - 4.5%. An
accommodating policy may thus be expected to raise somewhat the level of real
growth. But inflation would definitely accelerate with corresponding increases
over the whole range of interest rates.




147
Accommodation could, of course, continue beyond 1978. The effect on real
growth rapidly declines, however, and the spillover of nominal expansion raising
inflation probably increases. Inflation approaches on this course in 1979 a threshold
of double digit figures. With Presidential elections less than two years away, the
probability of "forceful financial leadership" increases again. At some stage
accommodation will end and new efforts will be made to cope with the recent burst
of inflation. The ensuing reversal in monetary policy unleashes a substantial
retardation of economic activity. This retardation would probably lower output
over several quarters and also raise at least one year the rate of unemployment.
The tacit abandonment of anti-inflationary policies by Congress, the Carter
Administration, and the Federal Reserve Authorities created an unfortunate but
unavoidable dilemma for monetary policy. Our relevant choice is between a
reversal in policy now or a reversal at a later stage. A reversal now brings forth a
mini-recession in 1978 at an inflation rate of 6% - 6.5% and lower inflation rates
beyond 1978. The delay of the reversal means that we eventually reap a larger
recession in activity at a substantially higher rate of inflation requiring a much
longer time period to tame inflation.
The ongoing debate about the proper course of financial policies offers an
alternative formulation of the relevant options. It is frequently argued that the
social costs associated with an anti-inflationary policy are too large. A wiser
course involving a comparatively negligible social cost, it is suggested, accepts the
prevalent inflation and accommodates monetary policy correspondingly. The social
cost of an anti-inflationary monetary policy is well established. The assessment of
the first scenario fully acknowledges this fact. The issue between the two options
does not center on this acknowledgement but on the proper recognition of the
social costs associated with a course of permanent and accommodating inflation.
The advocates of permanent inflation argue that the social cost of this second
option is quite negligible, essentially associated with the lower level of real money
balances resulting from higher anticipated inflation. The argument advanced
implicitly assumes that an accommodating policy of permanent inflation can be
reasonably expected to follow a stable path. This assumption seems essentially
naive and seriously faulty. It fails to appreciate the political context of financial
policy-making. This context produces two sets of events which raise the social cost
associated with a policy of permanent inflation to substantial levels.




148
The first set of conditions refers to the increasing likelihood of an erratic and
unstable inflation. An accommodating policy of persistent inflation introduces
pervasive incentives into the social system to explore opportunities for
accelerating wage and price setting as a means of competitive wealth transfers in
the expectation that the emerging price-wage policies will be validated (in the
average) by an accommodating policy. Such explorations in price-wage policies
tend to exploit the political process to generate an appropriate accommodating
stance in financial policies. It follows under the circumstances that a permanent
policy of accommodating inflation will experience repeated waves of increased
inflation. We also observe, moreover, that every major acceleration in price
movements introduces new political opportunities and raises political rewards for
the supply of "leadership in the fight against inflation”. This pattern has been
observed in many countries all over the world on repeated occasions. The resulting
shifts in financial policies unleash the unavoidable retardation of economic activity
expressed by a decline in output and rising unemployment. A policy of permanent
inflation very likely produces, therefore, sequences of substantially accelerated
price movements intermittently interrupted by declines in output and higher
unemployment. An accommodating inflation policy may thus easily produce two or
three recessions, combined with continued inflation, over a ten-year span. The
current value of the costs determined by the future series of recessions forms a
first component in the relevant social cost of permanent inflation.
The first set of conditions yields still another cost component in our
tabulation. The increasing uncertainty bearing on the course of financial policies
over the next two or three years affects the price-wage contracting on labor and
output markets in a manner probably raising the natural level of unemployment.
The current value of the future stream of social costs associated with a higher
natural level of unemployment forms the second strand in the total social cost to
be considered.




149
The second set of conditions fostered by a policy of accommodating
permanent inflation determines two more cost components. The experiences of
many countries indicate the rising probability of price-wage controls, or controls
over interest rates, as inflation accelerates. Such controls occur in a variety of
shifting forms. They usually affect the quality and volume of output and longerrange investment programs. They lower incentives to produce and dampen the
willingness to expand productive facilities. The magnitude of these effects depends
on the particular controls and their mode of administration. Controls and political
institutions replacing market mechanisms also raise the level of uncertainty
bearing on the crucial rules of the game confronting agents in the private sector.
Obscure rules with shifting interpretations and frequent changes in rules affecting
a broad range of a firm’s activities emerge from the operation of political
institutions' "controlling” wages, prices, and interest rates. The combined effect
operating via incentives and uncertainty lowers the level of normal output for given
levels of inputs, raises the natural level of unemployment, and lowers the real rate
of growth associated with any level of output. The current value of future
reductions in normal output and of lowered growth in real output form the third and
fourth component of the,total social cost associated with an accommodating policy
of permanent inflation. The social cost of persistent inflation involves thus
substantially more than some "negligible esoteric consideration" based on
economizing responses in the use of money induced by higher anticipated rates of
inflation. At least one of the four components of the total cost resulting from an
inflationary policy is of the same nature as the social cost of an anti-inflationary
policy. It expresses the welfare loss associated with temporarily lower output. A
crucial difference between a determined anti-inflationary policy and its inflationist
alternative should be noted in this context. A single, once and for all and
temporary loss occurs in the case of anti-inflationary policy. The alternative
unleashes a series of repeated losses due to the inherent instability of inflationist
policies. The comparative advantage of an anti-inflationary program increases
with the inclusion of the three additional cost components associated with the
inflationist policies. A determined effort to remove inflation over the next four
years will certainly involve some costs to our society. But I submit as my
considered judgment that the social cost of an inflationist course in our financial
policies substantially exceeds the cost of an anti-inflationary monetary policy.




150
IV. The Recommendation
Three times within the past ten years, the Federal Reserve Authorities
abandoned opportunities to curb inflation. The mini-recession of 1966/67 rapidly
retarded the price movements set in train in 1965. A stable course of moderate
policies in 1967/68 would have brought the U.S. economy back to a stable price
level. This opportunity was lost in a pronounced shift towards an expansionary
policy in early 1967. This policy resulted to a major extent from intentions to
moderate the incipient increase in interest rates. Thus emerged the inflationary
burst observed in 1968/69.
The shallow recession of 1970 broke the momentum of price movements. This
opportunity was not exploited by the Federal Reserve Authorities. A continuous
acceleration of monetary growth from early 1970 to the middle of 1971 contributed
to maintain the inherited rate of inflation. An anti-inflationary course was
initiated by the Federal Reserve Authorities with President Nixon’s "New Economic
Policies” and again abandoned in the spring of 1972. The consequences became
visible several months before the OPEC-ECLAT in the Fall of 1973.
And now looms a fourth opportunity lost.
Monetary growth drifted
increasingly towards the wrong track.
We inherited thus a situation which
precludes an easy and comfortable solution. All our options involve more or less
unpleasant consequences. The Shadow Committee should certainly urge that the
Federal Reserve Authorities return to a moderate growth path along the lines
suggested in our previous recommendations.
These recommendations were
determined by our objective to restore over several years a stable price level. The
return to our original growth path may be executed in two distinct modes. In one
case the Federal Reserve Authorities follow a growth path of 4.5% until the end of
1978 based on the observed average for the third quarter of 1977. In the other case
the Federal Reserve Authorities move the money stock until the first quarter 1978
back to the growth path implicit in the Shadow Committee’s proposal made in
March 1977 and proceed subsequently along this growth path. I submit at this stage
without further discussion the first mode to the Shadow Committee's attention.
The Committee's attention should also be directed, once more (remember Cato's
Ceterum censco...), in view of recent developments, to the proper implementation
of an effective monetary control.




151
The social cost of the recommendation is immediately visible. But the public
should recognize the larger cost of a permanent drift into inflation. The cost of
the Latin-Americanization of the U.S. economy is substantial indeed. This cost is
distributed over the future, however, and policy-making appears to operate with a
pronounced myopic bias. The disregard of future costs will not exorcise them and
most of us would still experience the unfortunate consequences of an inflationist
policy. The U.S. economy and our welfare would be better served with a
determined program initiated now and maintained over four years to lower
monetary growth to a level compatible with a stable price level. This was, at
some occasion, the intention of House Concurrent Resolution 133.




152
Policy Statement
Shadow Open Market Committee
March 7, 1977

For the past several years the Administration and the Federal Reserve have
pursued policies that fostered recovery, increased employment and reduced
inflation.

The economy is now closer to the long-term goal of high employ­

ment without inflation than many believed possible a year or two ago.
Currently, statements by the Administration and actions of the Administration
and the Congress suggest that this approach has ended.

Emphasis appears to

have shifted to the system of priorities and fine tuning based on the mistaken
belief that policymakers can reduce unemployment without increasing inflation.
Fine tuning, whenever it has been tried, has resulted in higher inflation
and often higher unemployment.
At its meeting today, the Shadow Open Market Committee took note of some
disquieting policy proposals and actions. These include (1) a package of
stimulants to bring about a short-term blip in employment and consumption,
but little encouragement to capital formation -- a crucial determinant of
productivity increases that sustain long-term growth of employment and
standards of living; (2) proposed changes in taxes and in minimum wages that
increases unemployment and reduce incentives to work; (3) pressure on
foreign governments to inflate their economies in the hope of gaining support
for inflationary policies in the United States; (4) an increased growth rate
of money, currency and demand deposits that stimulates the economy now, but
raises the rate of inflation in future years.
We do not accept the view that capital formation can be encouraged only by
stimulating consumption expenditures.




Lagging investment is more likely to

153
revive if businessmen can confidently look forward to an environment in
which government deficits do not absorb $100-$150-billion of private sector
savings in the next two years.

Real savings would then be available to

finance expenditures on plant and equipment.
It is miguided to attempt to stimulate consumption expenditures by expansive
monetary and fiscal policies in response to supply cutbacks in a period
such as the extremely cold winter of 1976-77.

Production of money is no

cure for the shortfalls in the production of goods.
If the proposal to raise minimum wages is adopted, this will lead to higher
unemployment, particularly for new entrants into the labor force.

The

result will be to increase pressure on thfe Federal Reserve to increase the
monetary growth rate and ultimately to raise the inflation rate.
We should refrain from pressuring foreign governments to inflate their
economies.

They are better judges than we are of their own national

interests.
A return to high employment without inflation will not be achieved by fine
tuning the economy.

It is doubtful that employment and output will be in­

creased, on average, during the next three to five years, by a policy of
increasing employment now and slowing inflation "later."

A lasting recovery

with low inflation can be achieved if, instead of fine tuning, we proceed
gradually to achieve both boals; higiher employment and a stable price level.
The Committee recommends that the growth rate of money — currency and demand
deposits — be held in the range of 4 to 4-1/2% for the next year.

A 4 to

4-1/2% rate of monetary growth would bring the stock of money to approximately
$320-billion in the third quarter 1977 and to $326-billion in the first
quarter 1978.




These projections are made from the average $313-billion that

154
would have prevailed in first quarter 1977 if our previous recommendations
had been followed.

Currently, we anticipate an average money stock of

$315-billion for the first quarter, so the policy we recommend requires the
Federal Reserve to offset the recent surge in money and then maintain a
less inflationary policy..
The Choices Before Us
We recognize that the policy we recommend reduces the measured growth rate
of money, temporarily, by removing the recant bulge in money growth.

From

4th quarter 1976 to 4th quarter 1977, our proposal brings the growth of
money to approximately 4-1/2%, near the lower end of the Federal Reserve
target for money, but is still far above the rate ultimately required to
achieve price stability.

The recommended rate of growth is one percentage

point lower than the growth rate endorsed by Chairman Reuss of the House
Banking Committee and more than thirty members of Congress.
A more rapid growth of money in the next few quarters might possibly lead
to a temporary increase in employment and real product.
The effects of higher monetary growth are not, however, limited to the
response of output in 1977 or 1978.
actual and anticipated inflation.

Increased monetary growth raises
The increase in inflation is not immediate­

ly apparent but would become apparent in 1978 and 1979.

Once again, we

would be faced with the choice we had in 1966, 1969, 1974 and in the intervening
years — to accept more inflation or to shift "priorities" from reducing
unemployment to reducing inflation.

Guidelines and guideposts -- under old

or new names -- will neither reduce inflation nor change the outcome.
The choice before us is to trade a short-term increase in employment for
higher longterm inflation, or to gradually but steadily moVe toward high
employment without inflation.

The Administration and much of the Congress

appear to have chosen a course that will lead to higher inflation.




155
The Federal Reserve flirts with the prospect of supporting the policy
by increasing the rate of monetary growth.
The rate of monetary expansion consistent with high employment and stable
prices is in the neighborhood of 2% per year.

Higher rates of monetary

expansion move us away from our long-term goals and increase the difficulty
of restoring full employment and ending inflation.

SHADOW OPEN MARKET COMMITTEE MEMBERS
Prof. Karl Brunner, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester, Rochester,NY,
Prof. Allan H. Meltzer, Graduate School of Industrial Administration, C a m e g i e Mellon University, Pittsburgh, Pa.
Mr. H. Erich Heinemann, Morgan Stanley § Company, Inc., New York, N.Y.
Dr. Homer Jones, retired senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Mo.
Dr. Jerry Jordan, Vice President and Chief Economist, Pittsburgh National Bank,
Pittsburgh, Pa.
Prof. Thomas Mayer, University of California at Davis, Calif.
Prof. A. James Meigs, Dept, of Economics, Claremont Men's College, Claremont, Calif.
Prof. Wilson Schmidt, Dept, of Economics, Virginia Polytechnic Institute,
Blacksburg, Va.
Dr. Beryl Sprinkel, Senior Vice President and Economist, Harris Trust and
Savings Bank, Chicago, 111.
Dr. Anna Schwartz, National Bureau of Economic Research, New York, N.Y.
Dr. William Wolman, Senior Editor, BUSINESS WEEK, New York, N.Y.




156

HOOVER INSTITUTION
ON WAR, REVOLUTION AND PEACE
Stanford, California 94305

January 25, 1978

The Honorable Parren J. Mitchell* Chairman
Subcommittee on Domestic Monetary Policy
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
Washington, D.C. 20515
Dear Congressman Mitchell:
This is in reply to your letter of December 12, 1977 asking for my views
on the conduct of monetary policy during 1977.
Monetary policy during 1977 was not in my opinion conducted effectively.
This year offered a splendid opportunity to make a small step in the
direction of reducing the monetary pressure toward inflation. That situa­
tion was recognized by the Federal Reserve Board in its announced targets
for the growth in monetary aggregates. These targets were reduced modestly.
Had the announced targets been achieved, the Federal Reserve System would
have deserved applause for an excellent policy. Unfortunately the targets
were not achieved. While the target rates were reduced, the actual rates
of monetary growth increased: this was true of the monetary base and of Mi
though not to the same extent of M 2 * Indeed for the base and Mi, it is
necessary to go back to the monetary expansion that preceded the double­
digit inflation of 1974 to observe comparably high rates of growth. As a
result, we have, for the fourth time in the past fifteen years, paid the
cost of a recession to stem inflation and then thrownaway the prize by
starting off on a new inflationary path (see attached Newsweek column, "Why
Inflation Persists," Newsweek, October 3, 1977).
The failure of the Fed to achieve its targets was linked directly, in my
opinion, to its continued attempt to ride two horses at the same time—
monetary aggregates and interest rates—and to its obsolete operating
techniques that use the federal funds rate as an operational tool. The
effect of trying to hold down interest rates in the short run at the cost
of unduly high monetary growth rates will be to raise interest rates in the
longer run as inflation increases and raises the inflationary premium em­
bodied in interest rates.
My major recommendation for change is one that I have made repeatedly—in
testimony before your committee and in the public press: the singleminded adherence by the Federal Reserve to its proper objective, control of
the quantity of money; the abandonment of the futile attempt to control in­
terest rates; the adoption of more effective techniques of controlling the




157
m o n e t a r y aggregates that use as the key operating instrument the volume of
the m o n e t a r y base or of unborrowed reserves, rather than the federal funds
rate.
Y our c ommittee will p erform a great public service if it can promote these
changes.
Sincerely yours

Mil t o n Friedman

E nclosure

22-761 0 - 7 8 - 1 1




158
By Milton Friedman

Why Inflation Persists
early three years ago, I wrote in this
space: “Four times in the past fif­
teen years we have started on a cure for
inflation. Three times we have aban­
doned the cure before it had time to
complete its task—in 1963, 1967, 1971.
Each time, the result has been a higher
plateau of inflation, producing a new
attempt at a cure. Will we make the same
mistake the fourth time in 1975? Or this
time, w ill we have the courage and the
wisdom and the patience to see the gure
through?” ( N e w s w e e k , Nov. 4, 1974.)

N

A BA N D O N IN G T H E C UR E

As of today, the answer is that we have
made the same mistake a fourth time.
Once again, we have paid the cost of a
recession to stem inflation, and, once
again, we are in the process of throwing
away the prize. From a high of more than
12 percent in 1974 (from December 1973
to December 1974) inflation fell to less
than 5 per cent (December 1975 to D e­
cember 1976). It has now risen sharply,
may temporarily recede as we work
through the bulge produced by the spe­
cial problem of the hard winter, but then,
I fear, will resume its upward march, not
to the “modest” 6 per cent the Adminis­
tration is forecasting, but to at least sever­
al percentage points higher and possibly
to double digits again by 1978 or 1979.
There is one and only one basic cause
of inflation: too high a rate of growth in
the quantity of money—too much money
chasing the available supply of goods
and services. These days, that cause is
produced in Washington, proximately,
by the Federal Reserve System, which
determines what happens to the quantity
of money; ultimately, by the political
and other pressures impinging on the
System, of which the most important are
the pressures to create money in order
to pay for exploding Federal spending
and in order to promote the goal of “full
employment.” All other alleged causes
of inflation—trade union intransigence,
greedy business corporations, spend­
thrift consumers, bad crops, harsh win­
ters, OPEC cartels and so on—are either
consequences of inflation, or excuses by
Washington, or sources of temporary
blips of inflation.
There is one and only one basic cure
for inflation: slowing monetary growth.
But that cure is easier to state than to put
into effect: witness our repeated aban­
donment of the cure. The Fed is sup­
posedly independent. But, as Dooley
said of the Supreme Court, “It follows
the election returns.” Its behavior re­




minds me of nothing so much as the
remark attributed to a U.S. Army officer
in Vietnam, “We destroyed the village in
order to save it.” Similarly, the Fed re­
frains from using its independence be­
cause it is afraid of losing it.
Listen to Chairman Arthur F. Burns in
testimony to the House of Representa­
tives (July 29, 1977):
“The trend of growth in monetary ag­
gregates, I regret to say, is still too rapid.
Even though the Federal Reserve has
steadily sought during the past two years
to achieve lower ranges for monetary
expansion, the evolution of its projec­
tions has been extremely gradual; in­
deed, at the pace we have been moving
[note: w ith respect to projections, not
behavior] it would require perhaps a
decade to reach rates of growth consist­
ent with price stability. I must report,
moreover, that despite the gradual re­
duction of projected growth ranges for
the aggregates during the past two years,
no meaningful reduction has as yet oc­
curred in actual growth rates.”
Meaning: promises have been in the
right direction but too modest; perform­
ance has been in the wrong direction.
T H E P ER FO R M A N C E O F T H E FED

The following table documents Chair­
man Burns’s description of performance:
the high rates of monetary growth from
1971 to early 1973 fostered the inflation
that peaked in 1974. The sharply lower
monetary-growth rates from 1973 to 1975
produced the serious recession of 197475 and the subsequent tapering off of
inflation. The sharp rise in early 1975
sparked the recovery; the slowdown in
late 1975 produced the economic pause
in the second half of 1976 that played
such a prominent role in the Ford-Carter
election batde. Since then, monetary'
growth has been rising, not falling, and is
now about back where it was in 1972.
Recent Rates of Monetary Growth
(per cent per year)
December 1971 to January 1973
January 1973 to February 1975
February 1975 to June 1975
June 1975 to December 1975
December 1975 to June 1976
June 1976 to August 1977

Mi
9.3
4.5
9.5
2.8
5.8
7.1

2

M
11.4
7.7
12.0
7.0
10.5
10.9

Inflation will not be stopped by­
words, only by actions. At the moment,
we have the worst of two worlds. Nom­

inal independence
of the Federal Re­
serve without its ef­
fective exercise per­
mits Congress and
the President to
evade responsibili­
ty for the creation of
money to finance large government
deficits. The power of Congress to legis­
late and of the President' to approve
such deficits without explicit responsi­
bility- for the resulting monetary growth
gives the Federal Reserve an excuse for
its inflationary behavior.
Again, let me quote Chairman Burns,
this time from a speech on Aug. 13,1977,
proclaiming “The Importance of an In­
dependent Central Bank”:
“Theoretically, the Federal Reserve
could thwart the non-monetary pres­
sures that are tending to drive costs and
prices higher by providing substantially
less monetary growth than would be
needed to accommodate these pressures
fully. In practice, such a course would
be fraught with major difficulty' and con­
siderable risk. Every time our govern­
ment acts to enlarge the flow of benefits
to one group or another the assumption
is implicit that the means of financing
will be available. A similar tacit assump­
tion is embodied in every pricing deci­
sion, wage bargain, or escalator arrange­
ment that is made by private parties or
government. The fact that such actions
may in combination be wholly incom­
patible with moderate monetary expan­
sion is seldom considered by those who
initiate them.”
FISH OR C U T B A IT

It matters little whether the Federal
Reserve is unable or unwilling to exer­
cise its independence in deeds as well as
words. In either case, let us be done with
the fiction that “independence” is some­
how or other a bastion against inflation.
Let us put the responsibility' for the rate
of monetary growth—and therewith for
the subsequent rate of inflation—square­
ly and openly on the Administration and
Congress. Instead of simply requiring
the Federal Reserve to report its “projec­
tions” or “targets” for monetary growth,
let the Congress require the Fed to
achieve specified rates of monetary
growth (or specified levels of the quanti­
ty of money) widiin specified ranges of
tolerance. That would combine respon­
sibility and power. It would also enable
the ordinary’ citizen to know whom to
hold accountable for inflation.

o

Newsweek, O ctober 3 , 1 977

159
M O R G A N STANLEY INTMSNATIONAI,
Incorporated,

1251 Avenue o f the American
New York, N. Y. 10020

January 27, 1978

Subcommittee on D omestic Monetary Policy
R o o m 3154, H o u s e A n n e x #2
2nd and D Streets, S. W .
Washington, D. C. 20515

Please convey m y thanks to Mr. Mitchell for his letter of D e c e m b e r
12, referring to the plans of his Subcommittee on Domestic Monetary Policy to re­
view the mon e t a r y policies which wer e applied during 1977. H e invited m e to sub­
mit m y view on this subject.
I should like to say at the outset that in general I found Little to criti­
cize in the stance of m o n etary policy during 1977. It wa s a year in which the econo­
m y continued to m o v e ahead at a good pace - and although both inflation and u n e m ­
ployment remained undesirably high, s o m e mo dest impr o v e m e n t w a s registered in
both of these factors. Despite their improvement, however, they did continue to
pose a difficult d i l e m m a for the monetary authorities, and it s e e m s to m e that the
Federal Reserve handled this situation with considerable courage and skill. I was
especially pleased by their ability in the past few months to achieve a reasonable
balance between rapid m o n e y growth rates and rising interest rates.
With inflation frequently constituting a m a j o r cause of u n e m p loyment
in the longer run, it might be argued that a central bank could fight both evils by
concentrating rather single-mindedly on an anti-inflationary posture.
But clearly
a central bank cannot close its eyes to the short-run adverse effects, on production
and employment, of an anti-inflationary policy if it is pushed to extremes. The
central bank should always approach such a situation with caution and humility, recog­
nizing that there is only so m u c h that monetary policy by itself can accomplish in c o m ­
batting these evils.
Last year probably too m u c h w a s expected of monetary policy,
w h e n greater emphasis might have been placed by the government on "structural"
approaches to the u n e m p l o y m e n t p r o blem and on long-term measures, whether of tax
policy or otherwise, to increase productivity and discourage excessive w a g e and
price increases.




160
While I w a s rather well satisfied with monetary policy's performance,
as I have indicated, I did not and do not feel happy with certain aspects of the tech­
niques employed.
Specifically, I mistrust the use of short-term targets for the
m o n e y aggregates as a reliable intermediate objective through which to achieve
the System's basic goals, such as diminished inflation, stronger economic growth,
and reduced unemployment.
Certainly the m o n e y aggregates are very important
data that should be watched carefully, but equal attention m u s t be paid to basic sta­
tistics on the course of the real economy, conditions in the credit markets (including
interest rates, credit aggregates and ma r k e t atmosphere), international developments,
and general evidence of public confidence or lack of it. M y o w n view is that the
S y s t e m in recent years has placed too m u c h stress, in its policy statements and pub­
lications, on the setting of rather precise target ranges for m o n e y growth over rela­
tively short time periods. I think this has given a false impression of precision,
w h e n in fact such short-run statistics are subject to serious misinterpretation,
whether because of faulty seasonal adjustments or unexplained changes in depositors1
habits or a variety of haphazard developments.
Unfortunately, the credit markets
have seized on these statistics as reliable signals of S y s t e m policy or future policy
intentions, and to s o m e extent the S y s t e m m a y have aided and abetted such m i suse of
the data, whether intentionally or otherwise.
The academic c o m m u n i t y m u s t also
share the b l a m e for this state of affairs, and I would not exempt government officials
to w h o m these m o n e y aggregates have offered a simple "handle" w h ereby to judge or
criticize m o n e t a r y policy. Unfortunately, there is no simple handle to monetary
policy.
T o put the matter another way, I have always felt that sound central
banking m u s t rely essentially on wise judgments based on experience and careful e x a m i ­
nation of all the available relevant data.
Effective policy can be seriously jeopardized
by attempts to rely too heavily on mechanical formulas.
I hope that these c o m m e n t s m a y be of s o m e interest in connection with
the review being undertaken by Mr. Mitchell's Subcommittee.
With kind personal regards,




Yours sincerely,
Alfred Hayes
Ch a i r m a n

161

B

)

BANKOF a m e r i c a

W A LTER

E. H O A D L E Y

Ex ecu tiv e Vice P re sid en t

January 9, 1978

Mr. Parren J . M itch e ll, M C.
.
Subcommittee on Domestic Monetary Policy
Room 3154 House Annex #2
2nd & D Sts. S.W.
Washington, D.C. 20515
Dear Mr. M itchel1:
I'm glad to respond to your request for m views on monetary
y
policy in 1977. As a matter of general policy I must say, however,
that I am r e a lly not interested in "Monday morning quarterbacking,"
p a rtic u la rly , when the future is so much more important. This is
esp e cia lly true when the U.S. economy is being massively affected
by structural changes which are highly disruptive of conventional
approaches to economic p o licie s.
As for monetary policy in 1977, I would have much preferred —
1.

Less preoccupation with e ffo rts to meet a rb itra ry
targets for monetary aggregates and more s e n s itiv ity
to tracking actual and expected changing conditions
in the real world economy.

2.

More attention to the weakening U.S. d o lla r and the
in s ta b ility i t has created throughout the fin an cial
markets of the world.

I would always commend the Federal Reserve for its determination
to restrain in fla tio n which the U.S. voters rig h tly judge to be our
number one national problem for the future. My concern, however,
is that monetary as other major p o licies formulated in Washington
more and more tend to re fle c t excessive "macro m entality" and succeed
in confusing and fru stratin g grass roots people as well as often
negating, in fa c t, the achievement of many of the desired policy
objectives.




162
W now have a confidence c r is is in our country — not an
e
economic c r is is . Hence, how and why policy is made, announced?
and implemented are at le a st as important as what the policy
change it s e l f may be.




Executive Vice President

163
FIDELCOR, Inc.

Broad & Walnut Streets, Philadelphia, Pennsylvania 19109

215 985-6000

L A C Y H . H U N T , Ph. D. - Vice P resident & Economist 985-8671

J a n u a r y 6,

1978

S u b c o m m i t t e e on D o m e s t i c
M o n e t a r y Policy - Ro o m 3154
H o u s e A n n e x #2
S e c o n d & D S t s., S.W.
W a s h i n g t o n , D.C.
20515

0

F IDELCOR

T h i s is in r e s p o n s e to th e r e c e n t l e t t e r
from Congressman Mitchell requesting my views
o n d o m e s t i c m o n e t a r y p o l i c y d u r i n g 1 9 77.
I am s t r o n g l y c o n v i n c e d that the g r o w t h
r a t e of 7 . 4 % in M l in t h e p a s t 12 m o n t h s is too
f a s t if o u r o b j e c t i v e is to h o l d the U.S . i n f l a ­
t i o n r a t e b e l o w 6%.
W h i l e it is t r u e t h a t m o n e t a r y g r o w t h s l o w e d
in N o v e m b e r a n d D e c e m b e r , t h i s is m o r e of a n i l l u ­
s i o n t h a n f a ct.
The n a r r o w m o n e y s tock i ncreased
b y o n l y $ 1 . 2 b i l l i o n b e t w e e n O c t o b e r 26 a n d D e c e m ­
b e r 28, w h i l e M 2 r o s e b y $ 6 . 3 b i l l i o n .
Although
this slower grow t h may seem a w e l c o m e resp i t e from
t h e e x t r e m e l y f a s t e x p a n s i o n of th e p r i o r s i x m o n t h s ,
it s h o u l d b e n o t e d t h a t l a r g e d e n o m i n a t i o n CDs,
w h i c h a r e e x c l u d e d f r o m the M l a n d M 2 m e a s u r e s , r o s e
by $8.8 billion.
T h i s s t e e p r i s e in CDs s e r v e d to
d e p r e s s the t i m e d e p o s i t r a t i o and , therefo.re, p u s h e d
t h e m o n e y m u l t i p l i e r to t h e l o w e s t l e v e l s of th e
year.
C o n s e q u e n t l y , th e s l o w d o w n in Ml, M 2 a n d M 3
i n t h e f o u r t h q u a r t e r o c c u r r e d w h i l e th e M 4 a n d M5
monetary aggregates accelerated.
I n v i e w of n o n - m o n e t a r y f a c t o r s o p e r a t i n g in
1 9 7 7 , it is n o t s u r p r i s i n g t h a t s h o r t - t e r m i n t e r e s t
r a t e s a d v a n c e d b y 20 0 b a s i s p o i n t s w h i l e l o n g - t e r m
y i e l d s i n c r e a s e d b y 80 b a s i s p o i n t s .
T h i s is s u g ­
gested by four basic factors.
First, ag gregate
c r e d i t d e m a n d s in a b s o l u t e t e r m s a n d r e l a t i v e to
g r o s s n a t i o n a l p r o d u c t w e r e at r e c o r d l e v e l s d u r i n g
1 9 77.
A m a i n e x p l a n a t i o n f o r t h e s t r o n g g r o w t h in
t h e c r e d i t d e m a n d s f o r 1 9 7 7 w a s d u e to a s u b s t a n ­
t i a l s t e p - u p in U.S. T r e a s u r y b o r r o w i n g .
Second, banking




164
sector liquidity deteriorated significantly during
th e y e a r as the c o m m e r c i a l b a n k s w e r e c a l l e d u p o n
to s u p p l y an i n c r e a s i n g s h a r e of the r a p i d c r e d i t
growth.
Third, c o r p o r a t e sector l i q u i d i t y decl i n e d
in 1 9 7 7 in r e s p o n s e to a s u b s t a n t i a l l y s l o w e r g r o w t h
in e c o n o m i c e a r n i n g s , w h i c h in turn, r e f l e c t e d t h a t
c o r p o r a t e c o s t s b e g i n to r i s e m o r e r a p i d l y t h a n p r i c e s .
F o u r t h , i n f l a t i o n a r y e x p e c t a t i o n s of i n v e s t o r s a c c e l ­
e r a t e d d u r i n g 1 9 7 7 , a n d p a r t i c u l a r l y as t h e y e a r d r e w
to a c l o s e .
In s u m m a r y , a n o v e r l y a c c o m m o d a t i v e p o l i c y of
t h e F e d e r a l R e s e r v e l a s t y e a r u n d o u b t e d l y s e r v e d to
m o d e r a t e a n u p w a r d m o v e in i n t e r e s t r a t e s t h a t w a s
p r o p e l l e d by f u n d a m e n t a l a n d n o n - m o n e t a r y f o r c e s .
T h i s o v e r l y r a p i d r a t e of m o n e t a r y g r o w t h d u r i n g
1 9 7 7 , h o w e v e r , is l i k e l y to b e r e f l e c t e d in m o r e
i n f l a t i o n in 1 9 7 8 a n d y e a r s to come.
I h a v e e n c l o s e d th e F i d e l i t y E c o n o m i c s B u l l e t i n
f o r the p a s t t h r e e m o n t h s in w h i c h I d i s c u s s t h e s e ,
and related subjects.
Sincerely yours,

Lacy^fa. H u n t
Senior Vice President
& Economist

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December

30,

1977

T H E D E F I C I T F I N A N C I N G T A S K IN 1 9 7 8
by
L a c y H. H u n t
Senior Vice President & Economist

This month:
Funding

$60 B i l l i o n Of N e w T r e a s u r y D e b t
Th e C a p i t a l S p e n d i n g L a g
Are Stocks Cheap?

T h e L a s t 1 9 7 8 F o r e c a s t Of 1 9 7 7

Funding

$ 6 0 B i l l i o n Of N e w T r e a s u r y D e b t

In c a l e n d a r y e a r 1 9 7 8 , the f e d e r a l g o v e r n m e n t c o u l d
s e l l a p p r o x i m a t e l y $60 b i l l i o n of n e w p u b l i c d e b t s e c u r i ­
t i e s i n o r d e r to f u n d its d e f i c i t .
This compares with net
n e w i s s u e s of $53 b i l l i o n in the 12 m o n t h s e n d e d in N o v e m b e r .
S i n c e o u r 1 9 7 8 e s t i m a t e i s . w i t h o u t a l l o w a n c e fo r a p r o p o s e d
t a x cut, t he a c t u a l f i n a n c i n g c o u l d b e e v e n h i g h e r .
In
a d d i t i o n to the n e w i s s u e s of d i r e c t T r e a s u r y o b l i g a t i o n s ,
t h e f e d e r a l l y s p o n s o r e d a g e n c i e s s u c h as th e F e d e r a l N a t i o n a l
M o r t g a g e C o r p o r a t i o n , th e F e d e r a l H o m e L o a n B a n k s a n d o t h e r
s i m i l a r e n t e r p r i s e s a r e l i k e l y to i s s u e $16 b i l l i o n of n e w
d e b t , $ 13 b i l l i o n m o r e t h a n in th e p a s t 12 m o n t h s .
Four
factors suggest these increased debt offerings are likely
to i n t e n s i f y u p w a r d p r e s s u r e s on m o n e y a n d c a p i t a l m a r k e t
y i e l d s a n d d i m i n i s h th e f l o w of f u n d s i n t o p r i v a t e v e n t u r e s .
F i r s t , t o t a l c r e d i t d e m a n d g r o w t h is a l r e a d y at p e a k
levels.
In the t h i r d q u a r t e r , n e t e x t e r n a l f u n d s r a i s e d
b y t h e n o n f i n a n c i a l s e c t o r , as m e a s u r e d in th e f l o w of
f u n d s a c c o u n t s , w e r e at a r e c o r d $ 3 7 0 b i l l i o n a n n u a l r a t e .
I n t h e t h i r d q u a r t e r of thi s y e a r , n e t f u n d s r a i s e d w e r e
1 9 . 3 % of G N P . D u r i n g the p e a k of the p r i o r c y c l e in the
f i r s t q u a r t e r of 1 9 7 3 , the r a t i o of n e t e x t e r n a l f u n d s to
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GNP wa s 16.8%.
In f a ct, the c r e d i t - t o - G N P r a t i o in the s e c ­
o n d q u a r t e r of t h i s y e a r m o v e d s l i g h t l y a b o v e the 1 9 7 3 p e a k .
C r e d i t r a i s e d r e l a t i v e to the b r o a d M 3 m o n e y s t o c k w a s 2 7 . 8 %
in t he t h i r d q u a r t e r , w e l l a b o v e the 2 4 . 7 % p e a k r e g i s t e r e d
in e a r l y 1 9 73.
S e c o n d , in 1 9 7 8 the T r e a s u r y w i l l h a v e a n e x ­
t r e m e l y l a r g e r e f i n a n c i n g t a s k b e c a u s e $ 5 2 . 7 b i l l i o n of p r i v a t e ­
ly h e l d m a r k e t a b l e c o u p o n i s s u e s w i l l m a t u r e .
This compares
w i t h $ 3 5 . 2 b i l l i o n in 1 9 7 7 , $ 3 0 . 8 b i l l i o n in 1 9 7 6 a n d $ 1 8 . 1
b i l l i o n in 1 9 7 5 .
Privately held securities exclude those
owned by Fed and offic i a l accounts.
T h i r d , t h e r e a r e s i g n s of d e c r e a s i n g b a n k i n g l i q u i d i t y .
T h e a b i l i t y of c o m m e r c i a l b a n k s to m e e t f u t u r e i n c r e a s e s in
credit dema n d s has d iminished.
F r o m l a t e A p r i l to e a r l y
December, weekly reporting commercial banks increased large
d e n o m i n a t i o n CDs b y $15 b i l l i o n w h i l e t h e y w e r e n e t s e l l e r s
of T r e a s u r y s e c u r i t i e s .
F o r a l l b a n k s , the l o a n - t o - i n v e s t m e n t r a t i o in N o v e m b e r w a s 2.42, up s h a r p l y f r o m 2 . 1 7 in
N o v e m b e r 1 9 76.
F i n a l l y , m a n u f a c t u r i n g l i q u i d i t y , as m e a s u r e d
by the F e d e r a l T r a d e C o m m i s s i o n , d e c r e a s e d d r a m a t i c a l l y this
year.
In t he t h i r d q u a r t e r , c a s h a n d e q u i v a l e n t s as a p e r ­
c e n t a g e of c u r r e n t a s s e t s f e l l to 14%, the t h i r d c o n s e c u t i v e
d r o p a n d d o w n f r o m 1 7 % in the f o u r t h q u a r t e r of 1 9 7 6 .
The
c u r r e n t a n d q u i c k r a t i o s a l s o d e c l i n e d in the t h i r d q u a r t e r ,
c o n t i n u i n g t h e i r i r r e g u l a r s l i d e t h a t b e g a n in m i d - 1 9 7 6 .
P e r h a p s the s i n g l e m o s t i m p o r t a n t i s s u e
f a c i n g the
f i n a n c i a l m a r k e t s in 1 9 7 8 is w h o w i l l b u y the $60 b i l l i o n
of n e w T r e a s u r y d e b t .
T h e i m p l i c a t i o n s of f u n d i n g this d e b t
w i l l v a r y s i g n i f i c a n t l y , d e p e n d i n g on w h o u l t i m a t e l y p u r ­
c h ases the debt.
As s u g g e s t e d by e c o n o m i c t h e o r y , t h e r e a r e
d i f f e r e n t c o n s e q u e n c e s of s e l l i n g U.S. g o v e r n m e n t d e b t to
(1) t h e F e d e r a l R e s e r v e , (2) the f o r e i g n c o m m e r c i a l b a n k s ,
(3) t h e U . S . c o m m e r c i a l b a n k s an d (4) the p r i n c i p a l n o n b a n k
f i n a n c i a l i n s t i t u t i o n s a n d the d o m e s t i c n o n f i n a n c i a l s e c t o r .
A s a l e of T r e a s u r y d e b t to the F e d e r a l R e s e r v e w o u l d
b e e q u i v a l e n t to f u n d i n g the T r e a s u r y d e b t w i t h the c r e a ­
t i o n of h i g h p o w e r e d m o n e y .
In e s s e n c e , t h e r e w o u l d b e no
d i f f e r e n c e b e t w e e n this t r a n s a c t i o n and simp l y r u n n i n g g o v e r n ­
m e n t a l p r i n t i n g p r e s s e s in o r d e r to p a y for the d e f i c i t .
A s s u c h , f i n a n c i a l m a r k e t p r e s s u r e s a r e n o t l i k e l y to
d e v e l o p w h e n g o v e r n m e n t d e b t is s o l d d i r e c t l y to t h e Fed.
T h e o r e t i c a l l y , the F e d e r a l R e s e r v e c o u l d b u y a l l of the
new Treasury debt.
T h e r e are, h o w e v e r , p r a c t i c a l l i m i t s
to t h e d e g r e e of F e d s u p p o r t to the T r e a s u r y m a r k e t s i n c e
F e d p u r c h a s e s w o u l d t e n d to s t i m u l a t e a g g r e g a t e d e m a n d
w h i l e s u p p o r t i n g a n i n c r e a s e d e x p a n s i o n in m o n e t a r y g r o w t h .
If t h e M l m o n e y s u p p l y , f o r e x a m p l e , w e r e to g r o w b y 7% %
o r $ 24 b i l l i o n a n d the m o n e y m u l t i p l i e r w e r e 2.6, (the
s a m e as t h i s y e a r ’ a v e r a g e r a t i o of M l to th e m o n e t a r y
s
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b a s e ) , t h e n t h e F e d m i g h t p u r c h a s e $9 b i l l i o n of T r e a s u r y
secu r i t i e s next year.
If, on the o t h e r h a n d , the F e d w e r e
to p u r c h a s e $12 b i l l i o n of n e w d e b t , the m o n e y s u p p l y m i g h t
t h e n g r o w b y $31 b i l l i o n or at a 9h% a n n u a l r a t e .
Hence,
b y b u y i n g o n l y $4 b i l l i o n d o l l a r s m o r e of T r e a s u r y d e b t ,
th e F e d w o u l d r a i s e m o n e y s u p p l y g r o w t h a n a d d i t i o n a l two
percentage points.
In c e r t a i n r e s p e c t s , f o r e i g n c e n t r a l b a n k p u r c h a s e s
of U . S . T r e a s u r y s e c u r i t i e s a r e s i m i l a r to t h o s e of the
Federal Reserve.
F o r e i g n central banks can also pu r c h a s e
T r e a s u r y s e c u r i t i e s at the s t r o k e of the b o o k k e e p e r ’ pen.
s
However, foreign central bank purchases have been determined
l a r g e l y as a c o n s e q u e n c e of the t r a d e b a l a n c e of the U n i t e d
S t a t e s a n d th e p e r f o r m a n c e of t h e d o l l a r v i s - a - v i s o t h e r
m a j o r c u r r e n c i e s in th e f o r e i g n e x c h a n g e m a r k e t s .
When
t h e U . S . d o l l a r h a s d e p r e c i a t e d a g a i n s t the G e r m a n m a r k ,
f o r e x a m p l e , to a g r e a t e r e x t e n t t h a n w a s d e e m e d d e s i r a b l e
by the G e r m a n
p o l i c y m a k e r s , th e B u n d e s b a n k p r i n t e d G e r m a n
m a r k s i n o r d e r to b u y U . S . d o l l a r s a n d t h e n it r e i n v e s t e d
t h o s e a c q u i r e d d o l l a r s in U.S. g o v e r n m e n t s e c u r i t i e s .
In 1 9 7 1 a n d 1 9 7 2 , y e a r s w h e r e th e d o l l a r w a s u n d e r
a t t a c k in th e f o r e i g n e x c h a n g e m a r k e t s , f o r e i g n c e n t r a l
b a n k s i n c r e a s e d t h e i r h o l d i n g s of U.S. g o v e r n m e n t s b y $20
b i l l i o n a n d $18 b i l l i o n , r e s p e c t i v e l y .
In t h e f i r s t e l e v e n
m o n t h s of t h i s y e a r , f o r e i g n c e n t r a l b a n k h o l d i n g s of g o v ­
e r n m e n t s i n c r e a s e d b y a n e s t i m a t e d $25 b i l l i o n , a r e c o r d
amount.
M o s t of t h e s e i n v e s t m e n t s r e s u l t e d f r o m c u r r e n c y
s u p p o r t o p e r a t i o n s b y G e r m a n y , J a p a n a n d the U n i t e d K i n g d o m .
As the 1971 and 1972 e x p e r i e n c e has taught, f o r e i g n c o m ­
m e r c i a l b a n k d e m a n d for T r e a s u r y s e c u r i t i e s is g o v e r n e d
by a s e l f - l i m i t i n g process.
Eventually, our excess a g g r e ­
g a t e d e m a n d a n d e x c e s s m o n e t a r y g r o w t h w a s t r a n s m i t t e d to
th e r e s t of the w o r l d .
Th e 1 9 7 1 - 1 9 7 2 s u p p o r t o p e r a t i o n s
of t h e f o r e i g n g o v e r n m e n t s r e s u l t e d in s h a r p l y f a s t e r m o n e ­
t a r y g r o w t h of f o r e i g n c u r r e n c i e s .
The faster m o n e t a r y
e x p a n s i o n , in t u rn, p r o d u c e d a d d i t i o n a l e c o n o m i c g r o w t h
and h i g h e r inflation.
T h e r e b y , i n f l a t i o n in t h e U n i t e d
S t a t e s w a s t r a n s m i t t e d to the r e s t of th e w o r l d .
Simul­
t a n e o u s l y , t h e f a l l i n g d o l l a r r a i s e d p r i c e s of i m p o r t s
i n t o t h e U . S . m a r k e t w h i l e l o w e r i n g e x p o r t p r i c e s of U.S.
g o o d s in f o r e i g n m a r k e t s .
By m i d - 1 9 7 3 , a f t e r a l e n g t h y
l ag, thie d o l l a r s t a b i l i z e d in th e e x c h a n g e m a r k e t s a n d
f o r e i g n d e m a n d for U . S . T r e a s u r y s e c u r i t i e s a b a t e d c o n s i d ­
erably.
I n r e c e n t m o n t h s , m o n e t a r y g r o w t h in G e r m a n y , the
United K in gdom and several c ontinental European countries
h a s b e g u n to s u r g e in r e s p o n s e to f o r e i g n c u r r e n c y s u p p o r t
operations.
A l s o , t h e d e c l i n e of t h e d o l l a r h a s b e g u n to
e n h a n c e t h e c o m p e t i t i v e n e s s of U. S . p r o d u c t s at h o m e a n d
.■
"

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abroad.
These factors
f o r e i g n d e m a n d f o r U.S.
in 1978.
Our estimate
Treasury securities may
in 1 9 7 8 .

s h o u l d u l t i m a t e l y s e r v e to r e d u c e
T r e a s u r y s e c u r i t i e s at s o m e p o i n t
is t h a t f o r e i g n d e m a n d f o r U . S .
o n l y a m o u n t to $15 to $20 b i l l i o n

The U.S. c o m m e r c i a l b a n k d e m a n d for g o v e r n m e n t s e c u ­
r i t i e s is s o m e w h a t s i m i l a r to F e d e r a l R e s e r v e d e m a n d .
If t h e c o m m e r c i a l b a n k s h a v e e x c e s s r e s e r v e s , t h e y m a y
u t i l i z e t h e s e e x c e s s r e s e r v e s to p u r c h a s e g o v e r n m e n t d e b t
p r o v i d e d t h e F e d e r a l R e s e r v e d o e s n o t a c t to o f f s e t the
i n c r e a s e d u t i l i z a t i o n of e x c e s s r e s e r v e s .
If the c o m m e r c i a l
b a n k s do n o t h a v e e x c e s s r e s e r v e s a n d t h e y w i s h to p u r c h a s e
T r e a s u r y debt securities, then they must sell o t her assets.
In v i e w of r e c e n t t r e n d s , it is n o t l i k e l y t h a t th e c o m ­
m e r c i a l b a n k s m a y b e a d d i n g to t h e i r h o l d i n g s of T r e a s u r y
s e c u r i t i e s in 1 9 7 8 .
B e t w e e n June and November, c o m m e r c i a l
b a n k s r e d u c e d t h e i r h o l d i n g s of T r e a s u r y s e c u r i t i e s b y
$10.3 billion.
The fact that banks have b e e n s e l l i n g r e l a ­
t i v e l y e x p e n s i v e CD s in o r d e r to c o v e r t h e i r g r o w i n g
c r e d i t d e m a n d s c l e a r l y s u g g e s t s t h a t this p r o c e s s is n o t
a b o u t to b e r e v e r s e d .
W e e s t i m a t e t h a t the U . S . c o m m e r c i a l
b a n k s m a y r e d u c e t h e i r h o l d i n g s of g o v e r n m e n t s a n o t h e r $10
b i l l i o n next year.
T h e c r u x of the d e f i c i t f u n d i n g p r o b l e m s for 197 8 ,
t herefore, falls into focus.
T h e r e a r e $60 b i l l i o n of n e w
T r e a s u r y s e c u r i t i e s c o m i n g to m a r k e t a n d the n e t d e m a n d
f r o m the F e d e r a l R e s e r v e , f o r e i g n c e n t r a l b a n k s a n d U.S.
c o m m e r c i a l b a n k s m a y t o t a l l e s s t h a n $15 b i l l i o n .
This
w o u l d r e s u l t in t h e T r e a s u r y h a v i n g to f u n d $45 b i l l i o n of
d e b t w i t h th e p r i v a t e n o n b a n k s e c t o r of the e c o n o m y .
Under
t h i s a s s u m p t i o n , t h e r e is b a s i c a l l y no d i f f e r e n c e b e t w e e n
t h e f u n d i n g of the d e f i c i t for the T r e a s u r y a n d t h a t of
f u n ding the d e f i c i t for a large c o r p o r a t i o n .
A l t h o u g h the
T r e a s u r y is t h e n a t i o n ' s f i r s t b o r r o w e r , n e w i s s u e s of d e b t
w ou ld require higher interest rates and necess itate a tr a n s ­
f e r of r e s o u r c e s f r o m th e p r i v a t e s e c t o r to t h e p u b l i c s e c ­
tor.
In o t h e r w o r d s , it is v e r y l i k e l y t h a t d e f i c i t f i n a n c ­
i n g in 1 9 7 8 w i l l s e t up t h e c l a s s i c a l c r o w d i n g o u t p h e n o m ­
enon.
Next year, short- and long-term yields might rise
1 2 5 b a s i s p o i n t s a n d 60 b a s i s p o i n t s , r e s p e c t i v e l y .
In s u m m a r y , the T r e a s u r y d e b t f i n a n c i n g t a s k l o o m s
as o n e of th e m a j o r i s s u e s f o r 1 9 7 8 .
T h e c o s t s of r u n n i n g
large and c o n t i n u o u s bu d g e t d e f icits will be c o m e quite
o b vious unless ec o n o m i c a c t i v i t y and p r i v a t e credit demands
weaken significantly.
In f a c t , in th e p a s t two m o n t h s ,
t h e r e h a s b e e n a s h a r p r i s e in b o n d y i e l d s a l t h o u g h the
Federal Reserve policy was accommodative and Treasury bill
yields actually declined.
This e x p e r i e n c e s u ggests that
b o n d m a r k e t p a r t i c i p a n t s a r e a l r e a d y b e g i n n i n g to r e s p o n d
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to t h e p r e s s u r e of the m o u n t i n g n e w s u p p l i e s of T r e a s u r y
debt.
The 1978 e x p e r i e n c e should p r o v i d e ample d e m o n s t r a ­
t i o n t h a t a t a x cu t w i t h o u t a c o m p a r a b l e r e d u c t i o n in g o v ­
e r n m e n t s p e n d i n g is no t r u e ta x cut.
The Capital Spending Lag
T h e p r o s p e c t fo r h i g h e r l o n g - a n d s h o r t - t e r m i n t e r e s t
r a t e s i n 1 9 7 8 is e s p e c i a l l y d i s c o u r a g i n g in v i e w of the
p r o n o u n c e d l a g in c a p i t a l s p e n d i n g in t h i s c y c l e .
Table I
d o c u m e n t s the s e v e r i t y of the c a p i t a l s p e n d i n g s l u m p .
This
t a b l e s h o w s t h e r a t i o of r e a l n e w p l a n t a n d e q u i p m e n t e x p e n ­
d i t u r e s r e l a t i v e to r e a l c o n s u m p t i o n o u t l a y s .
Plant and
e q u i p m e n t o u t l a y s are d e f l a t e d by the w h o l e s a l e pri c e i ndex
f o r m a c h i n e r y a n d e q u i p m e n t s i n c e t h i s s e r i e s s e e m s to b e s t
c o r r e s p o n d to w h a t b u s i n e s s m e n s a y a r e t h e i r a c t u a l c o s t s
for ne w p l a n t and equi p m e n t .
The i n v e s t m e n t - t o - c o n s u m p t i o n
r a t i o h a s d e c l i n e d f r o m a p e a k of 1 3 % i n 1 9 6 6 a n d 1 9 6 7 to
a r o u n d 1 0 % t h i s y e a r , a d e c l i n e of n e a r l y o n e - t h i r d .
We
n o w c o n s u m e a l m o s t $10 f o r e v e r y d o l l a r w e r e i n v e s t in p r o ­
d u c t i v e o u t l a y s , c o m p a r e d w i t h a n $8 f i g u r e in 1 9 6 6 a n d
1967.
T h i s s h o u l d n o t b e s u r p r i s i n g i n v i e w of t h e d e c l i n e
of r e a l c o r p o r a t e p r o f i t s s i n c e 1 9 6 6 .
Corporate profits
a f t e r t a x e s in 1 9 7 2 d o l l a r s w i t h a d j u s t m e n t f o r i n v e n t o r y
g a i n s a n d th e d i f f e r e n c e in d e p r e c i a t i o n b e t w e e n h i s t o r i c a l
a n d r e p l a c e m e n t c o s t s h a v e d e c l i n e d s i n c e 1 9 6 5 a n d 1966.
I n t h e f i r s t t h r e e q u a r t e r s of t h i s y e a r , r e a l p r o f i t s
w e r e s l i g h t l y l e s s t h a n $50 b i l l i o n c o m p a r e d w i t h $ 6 1 . 6
b i l l i o n in 1 9 6 5 a n d 1966.
C o r p o r a t e p r o f i t s this y ear are
o n l y s l i g h t l y b e t t e r t h a n th e a v e r a g e c o r p o r a t e p r o f i t s
f rom 1964 t h r o u g h 1976.
This year, e c o n o m i c prof i t s are
a v e r a g i n g o n l y 6 . 6 % of t o t a l c o r p o r a t e d o m e s t i c i n c o m e .
T h i s f i g u r e is w e l l b e l o w the 1 9 6 4 to 1 9 7 6 a v e r a g e of 8 . 6 %
a n d t he 1 9 6 5 h i g h of 13%.
In v i e w of the c a p i t a l s p e n d i n g lag, t h e p r o p o s e d
$25 b i l l i o n t a x cu t f o r 1 9 7 8 is s o m e t h i n g of a m i x e d b l e s s ­
ing .
Without question, corporate profits are under p r e s ­
s u r e a n d as a r e s u l t , th e r e i n v e s t m e n t r a t e in t h i s c o u n t r y
is l a g g i n g b a d l y .
Fro m that v i e w p o i n t , c o r p o r a t e tax r e ­
l i e f is n e e d e d .
H o w e v e r , th e d e c r e a s e in f e d e r a l i n c o m e
t a x e s w i l l at t h e s a m e t i m e , w o r k to l o w e r c o r p o r a t e p r o f i t ­
a b i l i t y in i n v e s t m e n t t h r o u g h o t h e r c h a n n e l s .
The enla r g e d
deficit will heighten inflationary pressures, increase
m o n e y and b o n d y i e l d s and this w i l l r e d u c e c o r p o r a t e e a r n ­
ings.
A l s o , th e h e a v i e r T r e a s u r y b o r r o w i n g w i l l d i m i n i s h
the f l o w of cr e d i t into n e w p l a n t and e q u i p m e n t e x p e n d i t u r e s .
T h u s , i n t h e f i n a l a n a l y s i s , it w o u l d be p u r e h a p p e n s t a n c e
w h e t h e r t h e s o - c a l l e d t a x c u t is b e n e f i c i a l to t h e c o r p o r a t e
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sector.
Are

Stocks

Cheap?

T h ere are o c c a s i o n a l r eports from b r o k e r a g e hous e s
a n d o t h e r c o m m e n t a t o r s tha t s t o c k p r i c e s at t h e s e l e v e l s
contain "real value."
It is c o m m o n p l a c e in m a n y of t h e s e
a n a l y s e s to p o i n t o u t h o w p r e c i p i t o u s l y th e p r i c e e a r n i n g s
r a t i o h a s d e c l i n e d in the p a s t 15 y e a r s or so.
The ea r n ­
i n g s f i g u r e s are , h o w e v e r , b a s e d u p o n r e p o r t e d f i g u r e s ,
not true profits.
T h i s r a i s e s the q u e s t i o n of w h e t h e r
the p r i c e e a r n i n g s r a t i o h a s d e c l i n e d s i g n i f i c a n t l y in
r e a l t e r m s in the p a s t 15 y e a r s a n d w h e t h e r , in f a c t , t h e r e
is g r e a t v a l u e f o r c u r r e n t e q u i t y p u r c h a s e s .
To p r o v i d e a v i e w p o i n t o n th i s q u e s t i o n , w e h a v e c a l ­
c u l a t e d the p r i c e e a r n i n g s r a t i o for the S t a n d a r d a n d P o o r
5 0 0 I n d e x o n the b a s i s of c o r p o r a t e p r o f i t s a f t e r t a x e s in
1 9 7 2 d o l l a r s a n d a d j u s t e d for
inve n t o r y gains and u n d e r ­
depreciation.
P e r h a p s n o t s u r p r i s i n g l y , w e f i n d t h a t in
t he f i r s t t h r e e q u a r t e r s of this y e a r the r a t i o of e q u i t y
p r i c e s to r e a l e a r n i n g s w a s a b o u t two or i d e n t i c a l l y the
s a m e a v e r a g e t h a t p r e v a i l e d f r o m 1 0 6 4 to 1 9 77.
In fact,
t h e t h i r d q u a r t e r of 1 9 7 7 f i g u r e w a s o n l y s l i g h t l y b e l o w
t h e a v e r a g e a n d c o n s i d e r a b l y a b o v e the r a t i o t h a t e x i s t e d
f r o m 1 9 6 4 to 1 9 6 7 .
Even this r evised pri c e earnings
r a t i o m a y be o v e r s t a t e d .
Ar t h u r Burns, Chase E c o n o m e t r i c s
a n d s e v e r a l o t h e r s h a v e c a l c u l a t e d t h a t the g o v e r n m e n t a d ­
j u s t m e n t f or u n d e r d e p r e c i a t i o n is f a r too low.
The Last

1 9 7 8 F o r e c a s t Of 1 9 7 7

T h e r e a r e s e v e r a l c h a n g e s in o u r c u r r e n t f o r e c a s t .
We
n o w e x p e c t ne’ G N P to i n c r e a s e b y 4 . 1 % in 1 9 7 8 , c o m p a r e d
al
w i t h 4 . 9 % thi s y e a r .
This slight incr e a s e from my p r e v i o u s
f o r e c a s t f o r 1 9 7 8 of 3 . 7 % r e f l e c t s the c o m b i n e d e f f e c t s of
u p w a r d a d j u s t m e n t s to c o n s u m e r s p e n d i n g a l o n g w i t h a d o w n ­
w a r d r e v i s i o n to p l a n t a n d e q u i p m e n t i n v e s t m e n t a n d m i n o r
c h a n g e s to i n v e n t o r y i n v e s t m e n t an d n e t e x p o r t s .
F o r n e x t y e a r , w e e x p e c t c o n s u m p t i o n e x p e n d i t u r e s to
r i s e b y 9.0%, d o w n f r o m a 1 0 . 6 % g a i n in 1 9 7 7 .
Investment
in p l a n t a n d e q u i p m e n t e x p e n d i t u r e s a r e n o w p r e d i c t e d to
r i s e by 1 0 . 3 % n e x t y e a r , o f f f r o m 1 4 % t h i s y e a r .
This
c h a n g e is n e c e s s i t a t e d b y the l a t e s t C o m m e r c e D e p a r t m e n t
s u r v e y on p l a n t and e q u i p m e n t s p e n d i n g plans.
This survey
i n d i c a t e d o n l y a 9% r a t e of a d v a n c e d u r i n g th e f i r s t h a l f
of t h e y e a r .
W e a n t i c i p a t e d tha t t o t a l g o v e r n m e n t e x p e n d i ­
t u r e s w i l l r i s e b y 1 3 . 4 % n e x t y e a r , c o m p a r e d w i t h 9 . 4 % in
1977.
Housi ng starts should average 1.85 mill i o n units,
v e r s u s 1.96 this year.
T h e h o u s i n g s e c t o r s t i l l s e e m s to
I
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possess some upward momentum.
P e r m i t s r o s e a g a i n in
N o v e m b e r a n d f u t u r e m o r t g a g e c o m m i t m e n t s of th e s a v i n g s
a n d l o a n a s s o c i a t i o n s h a v e c o n t i n u e d to m o v e up at a
h e a l t h y p a c e in r e c e n t m o n t h s .
Nevertheless, housing
s t a r t s s h o u l d p e a k in the f i r s t q u a r t e r of the y e a r , a n d
t h e n t r e n d d o w n d u r i n g t h e r e s t of 1 9 7 8 in r e s p o n s e to
d i m i n i s h i n g f l o w s of f u n d s i n t o the t h r i f t i n s t i t u t i o n s .
W e c o n t i n u e to f o r e c a s t t h a t n e w c a r s a l e s w i l l d r o p
in 1 9 7 8 .
T o t a l c a r s a l e s a r e e x p e c t e d to b e 1 0 . 7 m i l l i o n
u n i t s i n 1 9 7 8 , a d e c l i n e of 5 0 0 , 0 0 0 u n i t s .
S a l e s of d o m e s ­
t i c a u t o m o b i l e s a r e e x p e c t e d to d e c r e a s e b y o n l y 2 0 0 , 0 0 0 ,
to 8 . 9 m i l l i o n .
The a u t o m o b i l e m a r k e t has a l r e a d y b e g u n
to e x h i b i t w e a k n e s s .
T h i s is n o t s u r p r i s i n g .
S a l e s of
b i g t i c k e t i t e m s , s u c h as c a r s , g e n e r a l l y p e a k w e l l b e f o r e
t h e d o w n t u r n of the o v e r a l l e c o n o m y .
Inventory investment
is e x p e c t e d to b e a b o u t $20 b i l l i o n in 1 9 7 8 , c o m p a r e d w i t h
a r o u n d $18 b i l l i o n t h i s y e a r .
Net exports are still a n t i c i ­
p a t e d to i m p r o v e , h o w e v e r , th e g a i n is s o m e w h a t l e s s t h a n
in o u r p r i o r f o r e c a s t .
W e l o o k fo r a $ 4 . 3 b i l l i o n n e t e x ­
p o r t d e f i c i t , $4 . 6 b i l l i o n l e s s t h a n t h i s y e a r .
The m a i n
r e a s o n f o r t h i s a d j u s t m e n t is t h a t t h e f l o w of A l a s k a n oi l
has b e e n somewhat slower than we a n t i c ipated.
Moreover,
i m p o r t s of o i l h a v e a c c e l e r a t e d in r e s p o n s e to g o v e r n m e n t a l
e f f o r t s to s t o c k p i l e oil.
T h e p a t t e r n of e x p e c t e d g r o w t h in 1 9 7 8 r e m a i n s as in
our prev i o u s forecast.
We exp e c t that g r o w t h w i l l av e r a g e
b e t w e e n 4% a n d 5% i n t h e f i r s t two q u a r t e r s of t h e y e a r
b e f o r e d r o p p i n g s h a r p l y in t h e s e c o n d h a l f of th e y e a r .
B y t h e f o u r t h q u a r t e r of 1 9 78, w e a n t i c i p a t e t h a t the o v e r ­
a l l g r o w t h of the e c o n o m y w i l l b e e s s e n t i a l l y s t a g n a n t .
T h e d o w n t u r n of th e e c o n o m y l a t e n e x t y e a r w i l l b e d u e to
factors we have p r e v i o u s l y discussed.
The infl ation rate
is r i s i n g .
T h i s w i l l , in t u rn, d i m i n i s h th e g r o w t h in r e a l
i n c o m e a n d l i q u i d i t y a n d t h e r e b y set t h e s t a g e f o r the
economic downturn.
O t h e r c y c l i c a l f o r c e s w i l l b e at w o r k
late in the year.
C o n s u m e r s w i l l b e m o r e o v e r e x t e n d e d in
t e r m s of t h e i r d e b t o b l i g a t i o n s , p r o d u c t i v i t y w i l l h ^ v e
m o d e r a t e d s h a r p l y f u r t h e r a n d p r e s s u r e in l a b o r a n d p r o d u c t
m a r k e t s shou l d be m o r e evident.
W e h a v e n o t a s s u m e d a t a x cut in o u r o w n f o r e c a s t .
P e r h a p s s u c h an a s s u m p t i o n is a n e r r o r .
We wo u l d note, h o w ­
e v e r , t h a t ta x c u t s h a v e n e v e r c o m e o n as a d v e r t i s e d .
The
tax cuts that w e r e i n i t i a l l y p r o p o s e d in 1962 w e r e not e n ­
a c t e d u n t i l 1 9 64.
T h e t a x r e b a t e s of 1 9 7 5 c a m e l a t e r t h a n
e x p e c t e d a n d the t a x r e b a t e s of 1 9 7 6 n e v e r m a t e r i a l i z e d .
Also, we b e l i e v e that i n f l a t i o n a r y p r e s s u r e s w i l l be m o r e
i n t e n s e at m i d - y e a r t h a n now.
Thus, there r emains some
l i k e l i h o o d t h a t p o l i c y m a k e r s w i l l p e r c e i v e t h a t th e d o w n ­
t u r n is, i n f a c t , d u e to t h e r i s i n g i n f l a t i o n .
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-8TABLE I
A N A L Y S I S OF N E W I N V E S T M E N T TO C O N S U M P T I O N R A T I O A N D
R E A L E Q U I T Y P R I C E E A R N I N G S RATIO ,

R a tio: New
Plant & Equipment
Expenditures
To C o n s u m p t i o n *
_____ (Percent)_____

Corp. P r o f i t s
A f t e r Taxes W i t h
IV A and CC A D J
(Bil. 1972 $)

1964-1977

Ra t i o : Corp.
Profits After
T a x e s * * To
Domestic
Corp. I n c o m e
( P e r cent)

Ratio: S&P 5 00
I n d e x To Corp.
Profits After
Taxes**
(Ratio)

1964

1 1.3

52.4

11.9

1965

12.2

61.2

13 . 0

1.441

1966

13.2

62.9

12.6

1.355

1967

12.8

58.5

11.4

1.571

19 6 8

12.2

55.6

10.2

1.775

1969

12.8

47.8

8.3

2.047

1970

12.6

36.3

6.3

2.293

1971

12.0

41.0

6.9

2 . 397

1972

12.1

50.5

8.1

2.162

1973

12.6

48.2

6.9

2.228

1974

12.5

27.0

3.2

3.068

1975

10.6

38.1

5.9

2.261

1976

10.1

46.8

6.7

2.180

1977

10.3

49.7

6.6

2.025

1977 I

10.2

43.8

5.9

2.324
1.984

1.553

1977 II

10.3

49.9

6.6

1977 III

10.4

55.5

7.3

1.767

Average
19 6 4 - 7 6

12.1

48.2

8.6

2.025

* N e w P l a n t a n d E q u i p m e n t E x p e n d i t u r e s d e f l a t e d by the W h o l e ­
s a l e P r i c e I n d e x for M a c h i n e r y and E q u i p m e n t , 197 2 * 100.
** W i t h IVA a n d CCADJ.
SOURCES:

•ECONOMICS




U.S. D e p a r t m e n t of C o m m e r c e , B u r e a u of E c o n o m i c
A n a l y s i s ; U.S. D e p a r t m e n t of L a b o r , B u r e a u of
Labor Statistics; Standard & Poor's Corporation.

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November

28,

1977

M O R E I N F L A T I O N ON THE H O R I Z O N
by
L a c y H. H u n t
Vice President & Economist

This month:
Price Level Determinants
M o r e On Social

Security

Forecast Update
The Ener g y Debate

Price Level Determinants
E v i d e n c e is m o u n t i n g t h a t i n f l a t i o n a r y p r e s s u r e s
a r e l i k e l y to b e m o r e i n t e n s e in 1 9 7 8 t h a n t h i s y e a r .
This stems from our a s s e s s m e n t that six m a i n p rice level
determinants are turning adverse.
First, produc tivity
is m o d e r a t i n g s h a r p l y b e c a u s e l e s s e f f i c i e n t p l a n t ,
e q u i p m e n t a n d l a b o r a r e n o w b e i n g u s e d to m e e t i n c r e m e n t a l
demand.
In t h e p a s t f o u r q u a r t e r s , p r i v a t e p r o d u c t i v i t y
r o s e b y 1 . 8 % , s u b s t a n t i a l l y l e s s t h a n the 5 . 2 % p a c e of
the p r i o r s i x q u a r t e r s (i.e. the f i r s t p a r t of thi s e x ­
pansion).
In v i e w of the p r o l o n g e d s l u m p in c a p i t a l
s p e n d i n g , a c o n t i n u i n g e r o s i o n of p r o d u c t i v i t y g a i n s is
likely.
S e c o n d , w a g e d e m a n d s h a v e a c c e l e r a t e d r a p i d l y in
recent m o nths and are c o n s i d e r a b l y g r e ater than a year
ago.
In the 12 m o n t h s e n d e d in O c t o b e r , the h o u r l y e a r n ­
ings i ndex for p r o d u c t i o n w o r k e r s on p r i v a t e n o n a g r i c u l t u r a l p a y r o l l s r o s e b y 7 . 8%.
This was a pe rcentag e point
f a s t e r t h a n f o r the c o m p a r a b l e f i g u r e l a s t O c t o b e r .
In
t h e y e a r e n d e d in O c t o b e r , m a n u f a c t u r i n g w a g e r a t e s w e r e
up 8 . 4 % .
T h e s e e m i n g l y h i g h u n e m p l o y m e n t r a t e is a m i s ­
l e a d i n g i n d i c a t o r of l a b o r m a r k e t c o n d i t i o n s .
Reports
of s h o r t a g e s of s k i l l e d w o r k e r s a r e m o r e f r e q u e n t , h e l p
w a n t e d a d v e r t i s i n g is w i t h i n a f r a c t i o n of its p r i o r
ECONOMICS

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THE FIDELITY BANK
c y c l i c a l p e a k s of 1 9 7 3 a n d 1969, and i n i t i a l u n e m p l o y m e n t
c l a i m s w e r e at a y e a r l y l o w in m i d - N o v e m b e r .
Salary costs
w i l l be b o o s t e d f u r t h e r in e a r l y 1978, w h e n the m i n i m u m
w a g e a n d t h o s e t i e d to it go up s i g n i f i c a n t l y .
Third,
c o s t s of f r i n g e b e n e f i t s w i l l r i s e d r a m a t i c a l l y n e x t y e a r
in r e s p o n s e to h i g h e r u n e m p l o y m e n t an d s o c i a l s e c u r i t y
t a x e s as the g o v e r n m e n t a t t e m p t s to a v e r t b a n k r u p t c y of
th e o l d a g e b e n e f i t s s y s t e m .
F o u r t h , the d o l l a r h a s d e c l i n e d p r e c i p i t o u s l y a g a i n s t
v i r t u a l l y all ot h e r m a j o r curr e n c i e s .
T h i s is s e r v i n g to
b o o s t c o s t s for a w i d e v a r i e t y of c o n s u m e r g o o d s a n d i n d u s ­
trial products.
Th e t r a d e w e i g h t e d m e a s u r e s of the i n t e r ­
n a t i o n a l v a l u e of the d o l l a r u n d e r s t a t e the i m p o r t a n c e
of the d e c l i n e of the d o l l a r o n the f o r e i g n e x c h a n g e m a r ­
kets.
T h i s is b e c a u s e the d o l l a r h a s a p p r e c i a t e d v i s - a - v i s
t he C a n a d i a n d o l l a r a n d the M e x i c a n p e s o .
S i n c e m a n y of
t he t r a n s a c t i o n s w i t h C a n a d a an d M e x i c o a r e b a s e d on the
d o l l a r , as thi s t r a d e is b e t w e e n s u b s i d i a r i e s of the s a m e
U . S . c o m p a n i e s , the f u l l e f f e c t of the C a n a d i a n a n d M e x i c a n
d e p r e c i a t i o n has not been realized.
F i f t h , m o n e t a r y g r o w t h has b e e n e x t r e m e l y q u i c k .
In
t he p a s t s i x m o n t h s , the r a t e of m o n e y g r o w t h has b e e n
f a s t e r t h a n in a n y c o m p a r a b l e s p a n of 1968, 1 9 7 2 or 1973,
p e r i o d s w h e r e m o n e y e x p a n s i o n led to s p i r a l i n g i n f l a t i o n .
It s e e m s t he F e d has, in e f f e c t , d e c i d e d n o t to a v e r a g e
d o w n t h e f a s t e r m o n e t a r y g r o w t h of the s e c o n d a n d t h i r d
quarters.
T h e g r o w t h t a r g e t s e s t a b l i s h e d for the f o u r t h
q u a r t e r a r e so l i b e r a l t h a t t h e y do no t i m p l y a v e r a g i n g
down.
T h u s , the F e d h a s e a s e d m o n e t a r y p o l i c y o p e r a t i o n s
a n d p u r c h a s e d s h o r t - r u n s t a b i l i t y in i n t e r e s t r a t e s at the
e x p e n s e of l o n g e r - t e r m i n s t a b i l i t y a n d i n f l a t i o n .
Although
th e m o n e y s u p p l y h a s b e e n s l u g g i s h in the m o n t h of N o v e m b e r ,
t h i s is t y p i c a l f o r thi s m o n t h .
M o r e o v e r , the m o n e t a r y
base has a c c e l e r a t e d sharply.
In the p a s t two m o n t h s , the
b a s e h a s g r o w n at a v e r y s w i f t 1 1 . 4 % p a c e , s u b s t a n t i a l l y
f a s t e r t h a n the y e a r - t o - y e a r g a i n of- 8.8%.
S i x t h , in o n e of the l i t t l e n o t i c e d r e c e n t d e v e l o p ­
m e n t s , t he b u d g e t d e f i c i t d e e p e n e d d r a m a t i c a l l y in the
third quarter.
On a n a t i o n a l i n c o m e a c c o u n t s b a s i s , the
f e d e r a l b u d g e t d e f i c i t w a s at a $ 5 9 . 5 b i l l i o n a n n u a l r a te,
up s h a r p l y f r o m a $ 4 0 . 3 b i l l i o n r a t e in the s e c o n d q u a r t e r .
T h e i n c r e a s e d d e f i c i t w a s d u e to a s h a r p a c c e l e r a t i o n in
t h e g r o w t h of e x p e n d i t u r e s .
E x p e n d i t u r e s r o s e at a 2 2 . 4 %
r a t e in the t h i r d q u a r t e r , c o m p a r e d w i t h an 8% r a t e of i n ­
c r e a s e in the s e c o n d q u a r t e r .
sures
'—

In v i e w of the l i k e l y b u i l d - u p of i n f l a t i o n a r y p r e s ­
in 1 9 7 8 , it is s t i l l r e a s o n a b l e t h a t the c y c l i c a l

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p e a k of t he e c o n o m y w i l l o c c u r l a t e in 1 9 7 8 or in 1979.
W h e t h e r o n e w i l l e v o l v e t h e n a n d w h e t h e r the d o w n t u r n
w i l l q u a l i f y as a l e g i t i m a t e r e c e s s i o n h i n g e s on c r i t i c a l
m o n e t a r y a n d f i s c a l p o l i c y d e c i s i o n s y e t to be m a d e .
A
c o n t i n u a t i o n of r e c e n t l a r g e g a i n s in m o n e y w o u l d u n d o u b t ­
e d l y l e n g t h e n the r e c o v e r y .
However, such money growth
w o u l d e v e n t u a l l y r e s u l t in s u b s t a n t i a l l y h i g h e r i n c r e a s e s
in i n f l a t i o n a n d i n t e r e s t r a t e s , a n d t h e n a h a r d l a n d i n g .
B u t , if the F e d s t a b i l i z e s m o n e t a r y g r o w t h on a c o n t i n u i n g
b a s i s , the n e x t d o w n t u r n m a y be r e l a t i v e l y m i l d .
A further
e n l a r g e m e n t in the b u d g e t d e f i c i t m i g h t s e r v e to e x t e n d
this e x p a n s i o n .
T h i s a p p r o a c h a l s o w o u l d be c o u n t e r p r o ­
d u c t i v e f o r the l o n g - r u n .
The larger d e f i c i t s w o u l d serve
to h e i g h t e n i n f l a t i o n , i n c r e a s e i n t e r e s t r a t e s a n d c o u l d
e v e n t u a l l y l e a d to a m o r e s e v e r e d o w n t u r n .
In o t h e r w o r d s , the o p t i o n s c u r r e n t l y f a c i n g the
e c o n o m y a n d its m o n e t a r y a n d f i s c a l p o l i c y m a n a g e r s a r e
no l o n g e r e a s y o n e s .
A d d i t i o n a l m e a s u r e s of s t i m u l a t i o n
w i l l be i n c r e a s i n g l y less r e l iable.
They will wor k only
f o r the s h o r t - t e r m a n d at the e x p e n s e of s u b s t a n t i a l l y
m o r e i n f l a t i o n o v e r the l o n g e r - t e r m .
Th e c o m i n g e x p e r i e n c e
could once ag a i n d e m o n s t r a t e that h i g h and ris i n g i n f l a t i o n
is t h e p r e c u r s o r of d o w n t u r n a n d a d v a n c i n g u n e m p l o y m e n t .
M ore On Social Security
L a s t m o n t h , as an a l t e r n a t i v e to h i g h e r p a y r o l l ta x e s ,
w e p r o p o s e d e x t e n d i n g the f u l l e l i g i b i l i t y a g e of the
s o c i a l s e c u r i t y s y s t e m in o r d e r to a v e r t b a n k r u p t c y of
the system.
S e v e r a l a s k e d w h e t h e r thi s w o u l d l e a d to
additional overall unemployment.
Some felt older w o r k e r s
m i g h t r e m a i n in the w o r k f o r c e a n d t h a t j o b o p p o r t u n i t i e s
for y o u n g e r e m p l o y e e s w o u l d be r e d u c e d and u n e m p l o y m e n t
w o u l d rise.
A c o m p l e t e a n a l y s i s of e x t e n d i n g the f u l l e l ­
i g i b i l i t y a g e s u g g e s t s the u n e m p l o y m e n t r a t e m i g h t a c t u a l l y
fall r ather than rise.
F i r s t , the i n f l a t i o n set o f f by
the h i g h e r s o c i a l s e c u r i t y t a x e s is a v o i d e d .
Second,
t h e r e is no r e d u c t i o n in t h e s t a n d a r d of l i v i n g of t h o s e
p a y i n g the h i g h e r t a x e s a n d t h e i r d e m a n d f o r c o n s u m e r g o o d s .
T h e h i g h e r s o c i a l s e c u r i t y t a x e s , w h i c h w o u l d c o m e of f the
top, w o u l d r e d u c e d e m a n d for a w i d e v a r i e t y of c o n s u m e r
goods.
T h i s w o u l d , in t u r n , l e a d to h i g h e r u n e m p l o y m e n t .
T h i r d , a n d m o s t i m p o r t a n t l y , the u n e m p l o y m e n t r a t e is a
f u n c t i o n of l o n g - t e r m e c o n o m i c g r o w t h w h i c h , in turn, is
a f u n c t i o n of l o n g - t e r m p r o d u c t i v i t y .
S i n c e the o l d e r
w o r k e r s , w h o r e m a i n on the j o b a r e l i k e l y to be q u i t e e x ­
p e r i e n c e d at t h e i r jo b , it is r e a s o n a b l e to a s s u m e that
t h e i r a v e r a g e p r o d u c t i v i t y w o u l d be h i g h e r t h a n t y p i c a l
new workers.
With overall productivity higher, longer-term
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g r o w t h w o u l d be g r e a t e r a n d
on a v e r a g e , be lo w e r .
Forecast

the u n e m p l o y m e n t

rate would,

Update

O u r f o r e c a s t f o r the n e a r - t e r m an d for 1 9 7 8 is v i r t u ­
ally unchanged.
W e e x p e c t r e a l g r o s s n a t i o n a l p r o d u c t (GNP)
to r i s e at a 4 . 2 % r a t e t h i s q u a r t e r , f o l l o w e d b y a 4 . 8 %
p a c e of e x p a n s i o n in the f i r s t q u a r t e r of n e x t y e a r a n d
g r o w t h t a p e r i n g o f f o v e r the f i n a l t h r e e q u a r t e r s of 1978.
W e p r o j e c t a b o u t 5% r e a l g r o w t h t h i s y e a r a n d 3 . 6 % n e x t
year.
W e a n t i c i p a t e t h a t th e c o n s u m e r p r i c e i n d e x (CPI)
w i l l r i s e by 7 . 2 % n e x t y e a r , 0.6 of a p e r c e n t a g e p o i n t
f a s t e r t h a n thi s y e a r .
T h e i m p l i c i t p r i c e d e f l a t o r is p r o ­
j e c t e d to go up 6 . 4 % in 1 9 78, v e r s u s 5 . 5 % t h i s y e a r .
We
a n t i c i p a t e t o t a l a u t o m o b i l e s a l e s of 1 0 . 5 m i l l i o n in 1978,
0.7 m i l l i o n less than this year.
W e l o o k for 8.7 m i l l i o n
in d o m e s t i c ca r s a l e s , c o m p a r e d w i t h 9.3 m i l l i o n in 1977.
T h u s f a r in the n e w m o d e l y e a r , d o m e s t i c ca r s a l e s h a v e
b e e n r u n n i n g at a 9 . 3 m i l l i o n a n n u a l r a t e .
A l t h o u g h thi s
w a s in l i n e w i t h o u r p r i o r f o r e c a s t , it is c l e a r t h a t the
new m odel cars have been i n itially well received.
We a n t i c ­
i p a t e h o u s i n g s t a r t s of 1 . 9 1 m i l l i o n u n i t s f o r 1978, 5 0 , 0 0 0
units less than this year.
We e x p e c t the u n e m p l o y m e n t r a t e
w i l l a v e r a g e 6 . 9 % in 19 7 8 , 0.2 p e r c e n t a g e p o i n t s les s t h a n
this year.
On the i n t e r e s t r a t e f r o n t , w e a n t i c i p a t e t h a t the
f e d e r a l f u n d s r a t e w i l l a v e r a g e 6 . 7 % f o r the f o u r t h q u a r t e r
a n d t h e f i r s t q u a r t e r of n e x t y e a r .
This stems from our
i n t e r p r e t a t i o n of w h e r e the Fed ha s r e c e n t l y set its m o n e ­
tary t a rgets.
W e c o n t i n u e to a n t i c i p a t e a r i s e of 100
b a s i s p o i n t s in the s e c o n d a n d t h i r d q u a r t e r s of the y e a r .
In v i e w of th i s s c e n a r i o f o r s h o r t - t e r m i n t e r e s t r a t e s ,
the n e w l y i s s u e d " A a " u t i l i t y n o t e s h o u l d r i s e to s l i g h t l y
m o r e t h a n 9% b y the t h i r d q u a r t e r of n e x t y e a r , a b o u t 70
basis points h i gher than current levels.
O n e a r e a w h e r e w e do a n t i c i p a t e i m p r o v e m e n t in the
e c o n o m i c o u t l o o k n e x t y e a r is the t r a d e b a l a n c e .
Foreign
s a l e s of a g r i c u l t u r a l p r o d u c t s s e e m l i k e l y to r i s e a n d the
p r i c e s of t h e s e p r o d u c t s h a v e a l s o g o n e up in r e c e n t m o n t h s .
T h i s s t e m s f r o m p o o r c r o p s in the S o v i e t U n i o n a n d C h i n a .
T h e s h a r p d e c l i n e of the d o l l a r a g a i n s t the J a p a n e s e y e n
a n d t he G e r m a n m a r k s h o u l d s e r v e to s l o w i m p o r t s of t h e s e
c o u n t r i e s to the U n i t e d S t a t e s .
T h e a p p r e c i a t i o n of the
y e n h a s g r e a t l y i m p r o v e d the c o m p e t i t i v e p o s t u r e of the
r e d e s i g n e d s m a l l A m e r i c a n ca r s a n d the n e w f o u r - d o o r
C h e v e t t e s e e m s to be e n c r o a c h i n g on the J a p a n e s e ca r m a r k e t
in t h e U n i t e d S t a t e s .
A l s o , the f l o w of A l a s k a n o i l is
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becoming more steady.
T h u s , w e e x p e c t that the d e f i c i t
o n n e t e x p o r t s of g o o d s a n d s e r v i c e s w i l l be o n l y $1 . 3
b i l l i o n in 1 9 78, c o m p a r e d w i t h $8.5 b i l l i o n this y e ar.
T h i s w o u l d i m p l y that the t r a d e d e f i c i t m i g h t be $23 b i l ­
l i o n n e x t y e a r , c o m p a r e d w i t h $30 b i l l i o n t h i s y e a r .
The En e r g y D e b a t e
T h e e n e r g y d e b a t e c u r r e n t l y g o i n g on in C o n g r e s s is
so c r i t i c a l to the f u t u r e of this c o u n t r y that s o m e c o m m e n t s
f r o m a n e c o n o m i c p e r s p e c t i v e are in o r d e r .
Th e P r e s i d e n t
d e s e r v e s s u b s t a n t i a l c r e d i t for s t a t i n g b l u n t l y the s t a r k
f a c t s a b o u t the n a t i o n ’ e n e r g y c r u n c h a n d for p r e s e n t i n g
s
t h e m in t he m o s t s o m b e r of ton e s .
T h i s is no t e m p o r a r y
s i t u a t i o n t h a t c a n b e b r u s h e d a s i d e by p i e c e m e a l e f f o r t s
or b y o c c a s i o n a l e x h o r t a t i o n s to c o n s e r v e .
The P r e s i d e n t
is a l s o to be c o m m e n d e d in that his p r o g r a m a c c e p t s the
b a s i c p r i n c i p l e th a t d o m e s t i c e n e r g y p r i c e s m u s t r i s e to
w o r l d p r i c e s a n d in l i n e w i t h t r u e r e p l a c e m e n t v a l u e .
B a s i c e c o n o m i c s t e a c h e s tha t e n e r g y c o n s e r v a t i o n a n d e f f i ­
c i e n t u s e of f u e l ca n n o t be a c c o m p l i s h e d w i t h o u t fai r
market prices.
B u t , w h a t the P r e s i d e n t d o e s n o t r e c o g n i z e is that
g o v e r n m e n t c o n t r o l s a n d i n t e r f e r e n c e a r e an i m p o r t a n t c a u s e
of o u r c u r r e n t p r e d i c a m e n t .
N a t u r a l gas p r i c e s h a v e b e e n
c o n t r o l l e d by the F e d e r a l P o w e r C o m m i s s i o n s i n c e the
mid-1950s.
These p rice con t r o l s have been i n e f f i c i e n t and
they are t e r ribly outmoded.
M o r e o v e r , the b e l o w m a r k e t
p r i c e s , w h i c h h a v e b e e n a b y - p r o d u c t of the c o n t r o l s , h a v e
d i s c o u r a g e d the p r o d u c t i o n a n d s e a r c h fo r n e w n a t u r a l gas.
W h i l e t he P r e s i d e n t is w i l l i n g to a l l o w s o m e w h a t h i g h e r
p r i c e s , he p l a n s to e x t e n d the s y s t e m of p r i c e c o n t r o l s .
T h i s a p p r o a c h is n o t d e s i r a b l e .
Instead, controls should
be d i s m a n t l e d e n t i r e l y on a l l n e w gas w e l l s .
Prices will
r i s e on the i n c r e m e n t a l s u p p l y
gradually.
M o r e i m p o r t a n t l y , the h i g h e r p r i c e s w i l l b r i n g
on n e w s u p p l i e s t h a t c a n s u s t a i n o u r s t a n d a r d of l i v i n g .
T h e n e w s u p p l i e s w i l l e n c o u r a g e the d r i l l i n g for m e t h a n e
t r a p p e d in coa l , for the g e o p r e s s u r e d m e t h a n e t h a t e x i s t s
at d e p t h s of 1 5 , 0 0 0 f e e t or m o r e , a n d f o r n a t u r a l gas in
the m o r e r e m o t e o f f s h o r e a n d m o u n t a i n o u s r e g i o n s of this
country.
S o m e of the P r e s i d e n t ’ s t a t e m e n t s on the i s s u e of
s
n a t u r a l g as d e r e g u l a t i o n h a v e b e e n l e s s t h a n h e l p f u l .
In
a n e w s c o n f e r e n c e s e v e r a l w e e k s ago, the P r e s i d e n t c h a r g e d
t h a t the oil a n d gas p r o d u c e r s w e r e t r y i n g to " s t a g e the
b i g g e s t r i p - o f f in h i s t o r y . "
In h i s r e c e n t n a t i o n a l l y
t e l e v i s e d a d d r e s s , he r e p e a t e d that the o i l c o m p a n i e s
l— .. E C O N O M I C S




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THE FIDELITY BANK
- 6 -

" w a n t e d i m m e d i a t e a n d p e r m a n e n t d e r e g u l a t i o n of gas p r i c e s
w h i c h w o u l d c o s t c o n s u m e r s $70 b i l l i o n or m o r e b e t w e e n n o w
and 1985."
E a r l i e r s t a t e m e n t s i n d i c a t e d th a t d e c o n t r o l
w o u l d b e u s e l e s s b e c a u s e l i t t l e gas r e m a i n s to be fo u n d .
T h e s e s t a t e m e n t s s u g g e s t a m i s u n d e r s t a n d i n g of the i s s u e s
at h a n d .
T o t a l d e r e g u l a t i o n of a l l n a t u r a l gas ha s s i m p l y
not been proposed.
P r i c e d e r e g u l a t i o n is a d v o c a t e d o n l y
f o r the n e w gas t h a t ha s n o t y e t b e e n d i s c o v e r e d .
If the
P r e s i d e n t ' s a s s u m p t i o n is c o r r e c t , t h a t l i t t l e a d d i t i o n a l
n e w g a s is l i k e l y to b e d i s c o v e r e d , the h i g h e r p r i c e s w o u l d
a p p l y to o n l y a s m a l l i n c r e a s e in q u a n t i t y a n d no r i p - o f f
could occur.
As t he P r e s i d e n t r e q u e s t e d , the H o u s e of R e p r e s e n t a ­
t i v e s p a s s e d a b i l l t h a t w o u l d set a c e i l i n g at $ 1 . 7 5 p e r
t h o u s a n d c u b i c f e e t (MCF) o n n e w n a t u r a l gas.
The Senate,
h o w e v e r , v o t e d to d e r e g u l a t e n e w gas.
The H o use v e r s i o n
is n o t in th e i n t e r e s t of the A m e r i c a n c o n s u m e r .
Deals
a r e b e i n g m a d e to i m p o r t l i q u i f i e d n a t u r a l gas f r o m A l g e r i a
a n d I n d o n e s i a at $ 3 . 5 0 p e r M C F a n d C a n a d i a n a n d M e x i c a n
n a t u r a l g as a b o v e $ 2 . 0 0 p e r M C F .
H e n c e , if c o n t r o l s on
n e w g a s a r e r e t a i n e d , d o m e s t i c s u p p l i e s w o u l d c o n t i n u e to
s h r i n k a n d i m p o r t s of a n a t u r a l gas f r o m f o r e i g n p r o d u c e r s
w o u l d rise.
T h i s w o u l d w o r s e n the t r a d e b a l a n c e an d l o n g e r t e r m i n f l a t i o n a r y p r e s s u r e s w o u l d be m o r e s e v e r e .
R e c o g n i z i n g that d o m e s t i c oil p rices are b e l o w w o r l d
p r i c e s , the A d m i n i s t r a t i o n p r o p o s e s a w e l l h e a d tax tha t
w-ould b r i n g d o m e s t i c p r i c e s in l i n e w i t h w o r l d p r i c e s .
In
t h e g u i s e of r a i s i n g the d o m e s t i c o i l p r i c e s to the w o r l d
l e v e l , t h i s w e l l h e a d ta x c o u l d c o n s t i t u t e the l a r g e s t
p e a c e t i m e ta x i n c r e a s e in the h i s t o r y of the U n i t e d S t a t e s .
I n s t e a d of a d d i n g the c o m p l i c a t i o n of a n e w tax a n d the
a s s o c i a t e d p a r a p h e r n a l i a , it w o u l d be fa r b e t t e r to p h a s e
o u t a l l p r i c e c o n t r o l s an d let the m a r k e t r a i s e p r i c e s to
t he w o r l d l e v e l .
T h i s w o u l d p r o v i d e d o m e s t i c oi l c o m p a n i e s
w i t h t h e s a m e i n c e n t i v e to p r o d u c e o i l w h i c h o u r b u o y a n t
d e m a n d i n s u r e s fo r f o r e i g n p r o d u c e r s .
If the m a r k e t is
a l l o w e d to set the p r i c e , th i s w o u l d b r i n g f o r t h a d d i t i o n a l
s u p p l i e s a n d p r o v i d e e n e r g y c o m p a n i e s w i t h th e e a r n i n g b a s e
to d e v e l o p a l t e r n a t i v e s u p p l i e s .
T h i s , in t u rn, c o u l d l e a d
to l o w e r p r i c e s in th e f u t u r e .
Bu t , if th e c o s t to the c o n ­
s u m e r r i s e s d u e to a t a x i n c r e a s e , the p r i c e of o i l w i l l
r i s e n o w a n d p e r m a n e n t l y , s i n c e p r o d u c t i o n w o u l d n o t be
forthcoming.
F o r t u n a t e l y , the S e n a t e d e f e a t e d the w e l l h e a d
tax.
N o w , t h e r e is a p o s s i b i l i t y t h a t the w e l l h e a d t a x m a y
b e c o m b i n e d w i t h the p l o w b a c k p r o v i s i o n , so t h a t the ta x
w o u l d b e r e d u c e d to t h e e x t e n t t h a t the p r o d u c e r s u s e the
m o n e y f o r e x p l o r a t i o n a n d d e v e l o p m e n t of n e w oil.
Although
t h e p l o w b a c k p r o v i s i o n c o m b i n e d w i t h the t a x m a y be the
u l t i m a t e p o l i t i c a l s o l u t i o n , the m a r k e t a p p r o a c h is s t i l l
the b e s t .
u

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THE FIDELITY BANK
O c t o b e r 28,

1977

EXCESSES
by
L a c y H. H u n t
Vice President & Economist

This Month:
C r e e p i n g In
Crowding-Out
Social

Security Fiasco

Outlook Update

Creeping

In

The U.S. e c o n o m y has p l o d d e d t h r o u g h a d i f f i c u l t
year.
T h i s y e a r ’ i n f l a t i o n r a t e is l i k e l y to b e a f u l l
s
p e r c e n t a g e p o i n t f a s t e r t h a n in 1 9 76, w h i l e the p a c e of
r e a l g r o w t h s h o u l d f a l l w e l l b e l o w t h a t of l a s t y e a r .
A f t e r M a y , the u n e m p l o y m e n t r a t e s t o p p e d d e c l i n i n g .
Since
e a r l y J a n u a r y , s h o r t - t e r m i n t e r e s t r a t e s h a v e a d v a n c e d 200
b a s i s p o i n t s a n d b o n d m a r k e t y i e l d s h a v e r i s e n 50 b a s i s
points.
T h e s t o c k m a r k e t h a s e x p e r i e n c e d its w o r s t p e r ­
f o r m a n c e s i n c e 19 7 4 .
B u s i n e s s c o n f i d e n c e is at a l o w
e b b , t h e m a s s i v e t r a d e d e f i c i t is at a n u n p r e c e d e n t e d
l e v e l a n d t he d o l l a r h a s b e e n t h o r o u g h l y d r u b b e d in the
foreign exchange markets.
A nati o n a l energy p o l i c y has
still not been determined.
Tax r e f o r m m e a s u r e s that
could undermine longer-term capital formation seemingly
l u r k in t he b a c k g r o u n d .
The g o v e r n m e n t a l budget i m b a l ­
a n c e is h u g e a n d l a r g e r d e f i c i t s a r e p r o m i s e d as a c u r e - a l l
for any p o t e n t i a l problem.
The F e d eral Rese r v e either
l a c k s t h e w i l l , a b i l i t y or p o l i t i c a l c l o u t to s t a b i l i z e
m o n e t a r y g r o w t h at a n o n i n f l a t i o n a r y p a c e .
T h e d r i f t of r e c e n t e c o n o m i c d e v e l o p m e n t s c l e a r l y
p a i n t s a p i c t u r e of a n e c o n o m y w i t h p r o b l e m s a n d w o r r i e s
o n i ts m i n d .
O n e m a j o r r e a s o n f o r the t u r n of d e v e l o p -

•—

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THE FIDELITY BANK -------------------------------------------------2-

m e n t s , a n d o n e t h a t w e h a v e d i s c u s s e d in p r e v i o u s i s s u e s ,
is t h a t t h e c u r r e n t e x p a n s i o n h a s b e g u n to d e m o n s t r a t e
t h e p r o p e r t i e s of th e f i n a l p h a s e of a b u s i n e s s c y c l e
expansion.
A n o t h e r e x p l a n a t i o n is t h a t a n u m b e r of e x c e s s e s
h a v e s t a r t e d to a p p e a r .
T here are n u m e r o u s f actors that su g g e s t this r e c o v e r y
is i n i t s f i n a l s t a g e .
F i r s t , t h i s e x p a n s i o n is a g i n g .
In O c t o b e r , t h e U. S . e c o n o m y e n d e d the t h i r t y - f i r s t m o n t h
of this g r o w t h period.
T h i s t i m e s p a n is w i t h i n e i g h t
m o n t h s of t h e l o n g e s t p e a c e t i m e r e c o v e r y of the p o s t w a r
p e r i o d a n d o n l y t h r e e m o n t h s l e s s t h a n th e a v e r a g e of
these expansions.
S e c o n d , p r o d u c t i v i t y g r o w t h is m o d e r ­
a t i n g s h a r p l y b e c a u s e less e f f i c i e n t plant, e q u i p m e n t
a n d l a b o r a r e n o w b e i n g u s e d to m e e t i n c r e m e n t a l d e m a n d .
T h i r d , t h e a u t o m o t i v e a n d h o u s i n g s e c t o r s a r e in the v i c i n i t y
of t h e i r p r i o r p e a k l e v e l s of d e m a n d .
Automobile sales
t h i s y e a r s h o u l d b e n e a r l y as h i g h as in t h e p r e v i o u s p e a k
y e a r of 1 9 7 3 .
W h i l e h o u s i n g s tarts are b e l o w the p e a k
l e v e l s of 1 9 7 2 a n d 1 9 7 3 , t h e y a r e a b o v e t h e p e a k s in 1 9 6 8
and 1969.
In 1 9 7 2 a n d 1 9 7 3 , h o w e v e r , s t a r t s w e r e b o l s t e r e d
by federally subsidized units and substantial overbuilding.
This suggests these factors can provide little additional
t h r u s t to t h e e c o n o m y .
F o u r t h , i n v e s t m e n t in p l a n t a n d
e q u i p m e n t is b e g i n n i n g to a c c e l e r a t e .
While plant spending
is n o t a l l t h a t ’ d e s i r e d , it is b e i n g c o m p e n s a t e d f o r b y
s
s t r e n g t h in s t a t e and l o cal g o v e r n m e n t spe n d i n g .
Finally,
the st o c k m a r k e t has d r o p p e d s h a r p l y this year.
The stock
m a r k e t is n o t so f i c k l e as to s e l l o f f 2 0 % f o r no f u n d a m e n ­
tal reason.
T h e o t h e r m a i n e x p l a n a t i o n f o r th e m a l a i s e is
t h a t e x c e s s e s h a v e b e g u n to e m e r g e .
W h i l e the c u r rent
e c o n o m i c e x p a n s i o n h a s n o t w i t n e s s e d a q u a d r u p l i n g of o i l
p r i c e s , s u b s t a n t i a l o v e r b u i l d i n g of i n v e n t o r i e s , s h o r t a g e s
a n d c o m m o d i t y s p e c u l a t i o n ; a c a r e f u l a n a l y s i s of th e c u r ­
r e n t s c e n e d o e s s u g g e s t t h a t e a r l y s i g n s of s o m e e x c e s s e s
h a v e b e g u n to a p p e a r .
A l t h o u g h t h e s e i m b a l a n c e s a r e in an
e m b r y o n i c stage and could still be r e v e r s e d w i t h o u t s i g ­
n i f i c a n t rep e r c u s s i o n s , they are present, n e v e r t h e l e s s .
F ive such i m b a l a n c e s can be identified.
F i r s t , i n s p i t e of t h e h i g h u n e m p l o y m e n t r a t e , t h e r e
a r e i n c r e a s i n g l y m o r e f r e q u e n t r e p o r t s of s h o r t a g e s of
skilled workers.
T h e i n d e x of h e l p w a n t e d a d v e r t i s i n g is
w i t h i n 5 . 5 % of i t s 1 9 7 3 p e a k a n d o n l y 2% f r o m w i t h i n t h e
1969 peak.
Second, there has been real estate s pecula tion
i n C a l i f o r n i a a n d i n o t h e r p a r t s of t h e W e s t a n d S o u t h w e s t .
A n o v e r h a n g of u n s o l d n e w h o u s i n g u n i t s is d e v e l o p i n g in
p a r t s o f C a l i f o r n i a . T h e r e a r e s h o r t a g e s of c e r t a i n b a i l d i n g
ECONOMICS




BULLETIN

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THE FIDELITY BANK --------------------------------------------- m a t e r i a l s a n d p r i c e s of t h e s e i t e m s h a v e r i s e n s u b s t a n ­
tially .
T h i r d , th e d o l l a r h a s d e c l i n e d s h a r p l y a g a i n s t the
J a p a n e s e yen, the G e r m a n m a r k and mos t ot h e r E u r o p e a n c u r ­
rencies.
T h i s is l i k e l y to b o o s t c o s t s f o r m a n y c o n s u m e r
goods and i ndustrial products.
The large trade deficit
a n d t h e s p e c u l a t i v e o u t f l o w f r o m th e d o l l a r h a s l e d to a
s i z e a b l e a c c u m u l a t i o n of s h o r t - a n d i n t e r m e d i a t e - t e r m l i a ­
b i l i t i e s i n t h e h a n d s of t h e f o r e i g n c e n t r a l b a n k s .
Rising
gold s p e c u l a t i o n s u g g e s t s excess l i q u i d i t y m a y be d e v e l o p ­
ing in i n t e r n a t i o n a l f i n a n c i a l m a r k e t s .
F o u r t h , t h e b u d g e t d e f i c i t is c l e a r l y e x c e s s i v e f o r
t h i s s t a g e o f th e r e c o v e r y .
E a r l i e r in the p o s t w a r period,
compensatory fiscal policy was practiced.
In o t h e r w o r d s ,
b u d g e t d e f i c i t s w e r e u s e d to s t i m u l a t e th e e c o n o m y d u r i n g
p r i o r r e c e s s i o n s a n d e a r l y in p r e v i o u s e x p a n s i o n s .
B u t as
earlier expansions matured, budget deficits were reduced
s h a r p l y a n d w e r e g e n e r a l l y r e l a t i v e l y s m a l l in o r d e r to
avoid overheating.
In f a c t , in m o s t c a s e s th e b u d g e t w a s
in surpl u s . We are c u r r e n t l y e n t e r i n g the e l e v e n t h q u a r ­
t e r of t h i s e x p a n s i o n .
A t t h i s p e r i o d in t h e 1 9 5 4 - 1 9 5 7
e x p a n s i o n , the E i s e n h o w e r b u d g e t w a s i n s u r p l u s .
The same
w a s t r u e f o r th e c o m p a r a b l e K e n n e d y b u d g e t in t h e 1 9 6 1 - 1 9 6 5
expansion.
By t h e e l e v e n t h q u a r t e r of t h e 1 9 7 0 - 1 9 7 3 i n f l a ­
t i o n a r y e x p a n s i o n , t h e b u d g e t w a s in d e f i c i t b y o n l y $6
b i l l i o n as t h e N i x o n A d m i n i s t r a t i o n w a s p r a c t i c i n g s o m e t h i n g
k n o w n as " i m p o u n d i n g . ” T h e b u d g e t d e f i c i t fo r th e n e x t y e a r
w i l l b e at l e a s t $ 5 0 b i l l i o n a n d p e r h a p s as m u c h as $70 b i l ­
lion, a m o u n t s that are s u b s t a n t i a l l y m o r e than this year.
F i f t h , m o n e t a r y g r o w t h is b e c o m i n g e x c e s s i v e l y r a p i d .
The m o s t rece n t t w o - q u a r t e r g r o w t h rat e for the n a r r o w m o n e y
s t o c k e x c e e d s t h e f a s t e s t t w o - q u a r t e r p e r i o d in e i t h e r 1 9 6 8
or 1972 or e a r l y 1973.
T h e m o n e y g r o w t h of t h e s e p r i o r
y e a r s n e c e s s i t a t e d r e s t r a i n t in 1 9 6 9 , 1 9 7 3 a n d 1 9 7 4 in
o r d e r to o v e r c o m e s p i r a l l i n g i n f l a t i o n .
In t h e p a s t tw o
q u a r t e r s , M l h a s g r o w n at a 9% r a t e , c o m p a r e d w i t h r a t e s of
8 . 7 % a n d 8 . 2 % f o r th e s e c o n d h a l v e s of 1 9 7 2 a n d 1 9 6 8 , r e ­
spectively.
T h e m o s t r e c e n t g r o w t h in the m o n e t a r y b a s e is
s t i l l a s h a d e l o w e r t h a n f o r t h e h i g h p e r i o d in e a r l y 197 3 ,
b u t it is s u b s t a n t i a l l y a b o v e t h e l a t e 1 9 6 8 r a t e .
The
same holds for the M2 and M3 m o n e y stocks.
T h e g r o w t h in
t h e m o n e t a r y b a s e is n o w m o r e r a p i d in t h i s r e c o v e r y t h a n
it w a s i n t h e c o m p a r a b l e 30 m o n t h s of t h e 1 9 7 0 - 1 9 7 3 e x p a n ­
sion.
M l , M 2 a n d M 3 h a v e i n c r e a s e d s l i g h t l y l e s s in the
p a s t 30 m o n t h s t h a n in c o m p a r a b l e p e r i o d s of 1 9 7 0 to 1973.
The d i f f e r e n c e s are, h o w e v e r , v e r y m o d e s t .
In t h e p a s t
30 m o n t h s , M l is up 1 6 . 7 % , v e r s u s 1 9 . 7 % in th e c o m p a r a b l e

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p e r i o d f r o m 1 9 7 0 to 1 9 7 3 , w h i l e M 3 is up 3 3 , 6 % in t h e l a s t
30 m o n t h s , o n l y 1.2 p e r c e n t a g e p o i n t s l e s s t h a n in the p r i o r
expansion.
A c o n t i n u a t i o n of s u c h l a r g e g a i n s in m o n e y
w o u l d p e r m i t the e c o n o m y to e x p a n d f u r t h e r t h r o u g h 1 9 7 8
and into ea r l y 1979.
H o w e v e r , s u c h g r o w t h in th e m o n e t a r y
a g g r e g a t e s w o u l d b r i n g w i t h it s u b s t a n t i a l l y h i g h e r i n c r e a s e s
in i n f l a t i o n a n d i n t e r e s t r a t e s t h a n w e a r e f o r e c a s t i n g .
H e n c e , if t h e F e d f a i l s to c o n t a i n m o n e y g r o w t h , a h a r d
l a n d i n g in 1979 w o u l d be i n e v i t a b l e .
On th e o t h e r h a n d ,
if t h e F e d e r a l R e s e r v e a c t s to b r i n g d o w n t h e m o n e t a r y
g r o w t h r a t e s q u i c k l y a n d s u c c e s s f u l l y , th e l a t e 1 9 7 8 a n d
e a r l y 1 9 7 9 d o w n t u r n m a y be r e l a t i v e l y m i l d .
Crowding-Out
" C r o w d i n g - o u t " is th e t e r m t h a t r e f e r s to t h e i m p a c t
of s a l e s of n e w T r e a s u r y d e b t o n t h e f i n a n c i a l m a r k e t s a n d
the eco n o m y .
P r o v i d e d o t h e r d e t e r m i n a n t s of i n t e r e s t r a t e s
d o n o t c h a n g e , a d e f i c i t f u n d e d b y t h e s a l e of d e b t to t h e
p r i v a t e s e c t o r w i l l s e r v e to r a i s e i n t e r e s t r a t e s a n d t h e r e ­
b y r e d u c e f u n d s a v a i l a b l e f o r th e f i n a n c i n g of p r i v a t e e x p e n ­
ditures.
T h i s d i m i n i s h e d a b i l i t y of t h e p r i v a t e s e c t o r of
t h e e c o n o m y to f u n d it s e x p e n d i t u r e s in the f i n a n c i a l m a r k e t s
im p l i e s that p r i v a t e e x p e n d i t u r e s w i l l be r educed.
This
c o n c e p t w a s d i s c r e d i t e d i n th e m i n d s of s o m e m a r k e t p r a c t i o n e r s b e c a u s e c r o w d i n g - o u t w a s u s e d to j u s t i f y a f o r e c a s t
of s u b s t a n t i a l l y h i g h e r i n t e r e s t r a t e s f o r l a t e 1 9 7 5 a n d 197 6 .
S o m e p r o p o n e n t s of th e c r o w d i n g - o u t t h e s i s a r g u e d t h a t th e
h u g e b u d g e t d e f i c i t of t h a t t i m e w o u l d l e a d to r a p i d l y r i s ­
ing m o n e y and b o n d y i e l d s .
This did not happen.
Instead,
i n t e r e s t r a t e s d e c l i n e d s h a r p l y as p r i v a t e c r e d i t d e m a n d s
f e l l r a p i d l y a n d s u f f i c i e n t r e s o u r c e s w e r e a v a i l a b l e to
co v e r the d e f i c i t .
A l t h o u g h inter e s t rates did not rise
i n l a t e 1 9 7 5 a n d 1 9 7 6 , t h i s is n o t p r o o f t h a t c r o w d i n g - o u t
d i d not , in f a c t , o c c u r .
If t h e 1 9 7 5 a n d 1 9 7 6 T r e a s u r y
borro wing had been less sizable, more funds would have been
a v a i l a b l e to t h e p r i v a t e s e c t o r .
C i r c u m s t a n c e s a r e n o w r i p e to p r o d u c e a c l a s s i c t e x t ­
b o o k c a s e of c r o w d i n g - o u t .
H u g e b u d g e t d e f i c i t s at t h i s
m a t u r e s t a g e of t h e c y c l e a r e u n p r e c e d e n t e d .
Moreover,
private credit demands are expanding.
In f a c t , in th e
p a s t t h r e e q u a r t e r s , t o t a l l o a n s at c o m m e r c i a l b a n k s h a v e
i n c r e a s e d at a n n u a l r a t e s of 9 . 2 % , 1 2 . 6 % a n d 1 4 . 3 % .
Our
c a l c u l a t i o n s i n d i c a t e t h a t if g r o w t h in M l is h e l d to a
6% to 7% r a n g e in 1 9 7 8 , th e h e a v y T r e a s u r y b o r r o w i n g
s c h e d u l e d f o r the n e x t y e a r w i l l s e r v e to a d d to u p w a r d
p r e s s u r e s on s h o r t - and l o n g - t e r m i n t e r e s t rates.
The
e f f e c t of c r o w d i n g - o u t wij.1 f i r s t r e d u c e f l o w s of f u n d s
to t h e t h r i f t i n s t i t u t i o n s a n d t h e r e b y p r o d u c e a l o w e r
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THE FIDELITY BANK ------------------------------------------ ------5-

l e v e l of h o u s i n g s t a r t s .
N e x t , the p r o c e s s w i l l r e s u l t
i n r e d u c e d f l o w of c r e d i t to the c o n s u m e r s e c t o r .
Finally,
t h e r e w i l l b e l e s s e n e d c r e d i t a v a i l a b i l i t y to s m a l l b u s i n e s s
a n d the a g r i c u l t u r a l s e c t o r .
T h e o n l y c a v e a t t h a t w e m a k e in
o f f e r i n g t h i s p r o j e c t i o n is t h a t m o n e t a r y g r o w t h n o t s u b ­
s t a n t i a l l y e x c e e d 6 1 / 2 % on a v e r a g e .
If m o n e t a r y g r o w t h
c o n t i n u e d at a 1 0 % or 1 2 % or h i g h e r r a t e , t h e n i n t e r e s t
rates could be hel d down.
W h i l e c r o w d i n g - o u t w o u l d not
bec o m e v i s i b l e under these c i r c u mstances, u l t i m a t e l y
there w o u l d be a s i g n i f i c a n t i n f l a t i o n a r y outburst.
Social Security Fiasco
F o r s e v e r a l y e a r s , s t u d e n t s of s o c i a l s e c u r i t y h a v e
b e e n a r g u i n g t h a t s e r i o u s i m b a l a n c e s w e r e d e v e l o p i n g in
the p rogram.
No w , t h e r e is g r o w i n g r e c o g n i t i o n of this
d i s t u r b i n g d e v e l o p m e n t in p o l i t i c a l c i r c l e s .
This year,
the o l d a g e s u r v i v o r s a n d d i s a b i l i t y i n s u r a n c e f u n d s w i l l
i n c u r a h u g e $6 b i l l i o n d e f i c i t t h a t w i l l d o u b l e b y 1981.
M o r e o v e r , the e x p e c t e d d e f i c i t s of the c o m i n g f i v e y e a r s
w i l l e n t i r e l y e l i m i n a t e the a s s e t s a c c u m u l a t e d b y t h e s e
funds.
I n o t h e r w o r d s , the s o c i a l s e c u r i t y s y s t e m is on
t h e v e r g e of i n s o l v e n c y a n d a t a x p a y e r b a i l o u t is n e e d e d .
A t a x p a y e r b a i l o u t of the s o c i a l s e c u r i t y p r o g r a m
c a n b e a c c o m p l i s h e d b y e i t h e r of two a p p r o a c h e s .
On the
o n e h a n d , w e c o u l d r a i s e the t a x b a s e on e m p l o y e e c o n t r i b u ­
t i o n s a n d u n c a p or h i k e m a t e r i a l l y th e b a s e for e m p l o y e r
contributions.
T h i s a p p r o a c h w o u l d h a v e th e h i g h l y u n d e ­
s i r a b l e s i d e e f f e c t of r e d u c i n g the r e a l f a m i l y i n c o m e .
W i t h real i ncome down, d emand for c o n s u m e r goods can surely
b e e x p e c t e d to b e p a r e d .
Raising business taxes would
strengthen i nflationary forces.
F o r t h o s e f i r m s a b l e to
p a s s a l o n g th e h i g h e r c o s t s , the p r i c e s of t h e i r p r o d u c t s
w o u l d rise.
F o r t h o s e f i r m s u n a b l e to p a s s a l o n g the
h i g h e r t a x e s to c o n s u m e r s , t h e i r d e m a n d f o r l a b o r w o u l d
d e c l i n e a n d t h i s a l s o w o u l d t e n d to p r o d u c e a l o w e r s t a n ­
d a r d of l i v i n g fo r t h e w o r k i n g s e c t o r of the p o p u l a t i o n .
A v a r i a n t of th i s a p p r o a c h w o u l d p l a c e a l l g o v e r n m e n t e m ­
p l o y e e s u n d e r the p r o g r a m .
W h i l e this plo y w i l l solve
t h e n e a r - t e r m p r o b l e m , it w o u l d , at the s a m e time, r e d u c e
t h e t a k e - h o m e p a y of t h e s e w o r k e r s , t h e i r s t a n d a r d of
living w o u l d fall, they w o u l d buy less cars and o t her c o n ­
s u m e r i t e m s a n d the e c o n o m y w o u l d b e a d v e r s e l y a f f e c t e d .
U n f o r t u n a t e l y , w e a p p e a r on the v e r g e of c o n t i n u i n g thi s
f i r s t a p p r o a c h t h a t h a s p r o v e d so o b v i o u s l y u n s u c c e s s f u l .
T h i s p a s t w e e k , the S e n a t e F i n a n c e C o m m i t t e e v o t e d h i g h e r
b a s e l e v e l s f o r th e s o c i a l s e c u r i t y ta x for e m p l o y e e s a n d
e mployers, al o n g w i t h h i g h e r tax rates.

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A s i m p l e r a n d f a r l e s s c o m p l i c a t e d w a y of a p p r o a c h i n g
the p r o b l e m a l s o e x i s t s .
Instead, we could r e c o g n i z e that
t i m e a n d d e m o g r a p h i c s h i f t s h a v e u n d e r m i n e d the s o c i a l s e ­
curity program.
T h e a d v a n c e s in m e d i c a l t e c h n o l o g y a n d the
g r e a t e r g e n e r a l l o n g e v i t y could be a c k n o w l e d g e d .
One such
s o l u t i o n w o u l d b e to i n c r e a s e the f u l l e l i g i b i l i t y a g e f r o m
65 to 66 o r 66 1/2 a n d f u r t h e r e x t e n d th i s a g e as n e e d e d ,
w i t h a l i k e l y t a r g e t b e i n g a g e 70 b y t h e e n d of the c e n t u r y .
By e x t e n d i n g t h e e l i g i b i l i t y age, the t r u s t f u n d s w o u l d h a v e
t h e i n c o m e f r o m th e o l d e r w o r k e r s w h o r e m a i n i n t h e w o r k ­
f o r c e w h i l e n o t h a v i n g to p a y b e n e f i t s to t h o s e w o r k e r s c u r ­
r e n t l y t u r n i n g 65.
T h i s a p p r o a c h w o u l d t h e r e b y s o l v e the
problem.
W h i l e there are a r g u m e n t s aga i n s t this solution,
t is a l t e r n a t i v e n e e d s to b e a i r e d .
I personally believe
t h a t t h i s l a t t e r a p p r o a c h is far m o r e d e s i r a b l e t h a n s e t ­
t i n g o f f a n a d d i t i o n a l w a v e of i n f l a t i o n a n d u l t i m a t e l y
p a y i n g s o c i a l s e c u r i t y b e n e f i t s in s u c h h i g h l y i n f l a t e d
dollars that retired p e r s o n s are tricked w h e n they find
that their b e n e f i t s are far less than p lanned.
Outlook Update
T h e t h i r d q u a r t e r r e s u l t s w e r e a b o u t as e x p e c t e d .
G r o w t h i n r e a l G N P w a s 3 . 8%, c o m p a r e d w i t h o u r f o r e c a s t
o f 3%.
O u r e s t i m a t e of i n v e n t o r y i n v e s t m e n t w a s c o n s i d ­
erably lower than the actual.
B e f o r e a c k n o w l e d g i n g this
f o r e c a s t m i s s , w e w o u l d p r e f e r to w a i t u n t i l th e t h i r d
q u a r t e r r e v i s i o n s , w h e n w e e x p e c t th e n u m b e r to be r e ­
In v i e w of the s t r o n g e r t h a n e x p e c t e d
stated downward.
i n v e n t o r y i n v e s t m e n t in th e t h i r d q u a r t e r , w e h a v e r e d u c e d
o u r f o r e c a s t f o r the f o u r t h q u a r t e r to 4. 2 % .
O u r c u r r e n t f o r e c a s t f o r r e a l g r o w t h f o r 1 9 7 8 is
3.6%, c o m p a r e d w i t h an e s t i m a t e d 4.8% this year.
The q u a r ­
t e r l y t r e n d f r o m t h e f i r s t to the f i n a l q u a r t e r is 4 . 4 % ,
3.4%, 1 .9% and -0.5%.
We expect that the CPI w i l l rise by
7% a g a i n s t 6 . 6 % t h i s y e a r .
T h e h i g h e r r a t e of i n f l a t i o n
is m a i n l y d u e to a f u r t h e r s l o w i n g in p r o d u c t i v i t y a l o n g
w i t h a f u r t h e r r i s e in w a g e r a t e s .
W a ges w i l l be b o o s t e d
b y a h i k e in t h e m i n i m u m w a g e a n d n o n - a g e c o s t s w i l l b e
r a i s e d by h i g h e r s o c i a l s e c u r i t y and u n e m p l o y m e n t c o m p e n s a ­
t i o n t a x e s in b u s i n e s s .
T h e r i s e in w a g e r a t e s c o u p l e d
w i t h t h e s l o w i n g in p r o d u c t i v i t y a n d t h e m o r e m o d e s t e c o ­
n o m i c g r o w t h i n d i c a t e s to us t h a t r e a l a f t e r t a x c o r p o r a t e
p r o f i t s w i l l d e c l i n e 5 . 7 % in 19 7 8 , a f t e r r i s i n g 7 . 4 % t h i s
year.
A m o n g o t h e r k e y c o m p o n e n t s of o u r f o r e c a s t , w e e x p e c t
t o t a l a u t o m o b i l e s a l e s of 1 0 . 6 m i l l i o n , d o w n f r o m 1 1 . 2 m i l ­
lion.
We anticipa te that hous ing starts will decline from
a 2 m i l l i o n p a c e i n t h e b e g i n n i n g of 1 9 7 8 to a b o u t 1. 8 m i l ­
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lion by y e ar-end.
W e e x p e c t b u s i n e s s f i x e d i n v e s t m e n t to
r i s e 1 3 . 8 % i n 19 7 8 , d o w n f r o m 1 4 . 4 % t h i s y e a r .
Consumption
e x p e n d i t u r e s a r e p r o j e c t e d to go up a b o u t 7% in 1 9 7 8 , c o m ­
p a r e d w i t h a 1 0.3% i n c r e a s e this year.
Total government
s p e n d i n g s h o u l d r i s e 1 4 . 4 % , s u b s t a n t i a l l y b e t t e r t h a n th i s
y e a r ’ 9.9% gain.
s
D u e to th e f l o w of A l a s k a n o i l a n d a n
a s s u m e d s t r e n g t h e n i n g of U . S . e x p o r t s b e c a u s e of b e t t e r
f o r eign e c o nomic c o n ditions, we a n t i c i p a t e a $1.3 b i l l i o n
d e f i c i t of n e t e x p o r t s of g o o d s a n d s e r v i c e s in 1 9 7 8 , c o m ­
p a r e d w i t h this y e a r ’ $10.1 b i l l i o n deficit.
s
In the m o n e y and c a p i t a l m a r k e t s , we a n t i c i p a t e that
the F e d e r a l funds rat e w i l l rise ab o u t 100 b a s i s poi n t s
b e t w e e n n o w a n d t h e t h i r d q u a r t e r , th e t i m e w h e n w e c u r ­
rently expect interest rates will peak.
Depending upon
p o l i t i c a l p r e s s u r e s , this w o u l d m e a n that the p r i m e rate
c o u l d m o v e i n t o a n 8 . 5 % to 9% r a n g e .
A c o n t i n u a t i o n of
t h i s y e a r ’ p o l i t i c a l p r e s s u r e s w o u l d r e s u l t in a n a r r o w ­
s
i n g o f s p r e a d b e t w e e n th e F e d e r a l f u n d s r a t e a n d t h e p r i m e
rate.
In th e l o n g - t e r m m a r k e t , y i e l d s s h o u l d r i s e 60 b a s i s
p o i n t s f r o m c u r r e n t l e vels and p e r h a p s s o m e w h a t more.
Thus,
our f o r e c a s t w o u l d p l a c e the p e a k n e w l y i s s u e d "Aa" u t i l i t y
b o n d at 9% i n t h e t h i r d q u a r t e r , c o m p a r e d w i t h a c u r r e n t
l e v e l of 8 . 4 % , a n d 7 . 9 0 % at t h e b e g i n n i n g of 1 9 7 7 .

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PITTSBURGH NATIONAL BANK
5T H & WOOD
P IT T S B U R G H , PA . 1 5 2 2 2
J E R R Y L .J O R D A N
S E N I O R VICE P R E S I D E N T & E C O N O M I S T

Congressm an Parren J. M itchell/ M .C .
U .S . House of R epresentatives
Subcommittee on Domestic Monetary Policy
of the Committee on Banking, Finance & Urban Affairs
W ashington, DC 20515
Dear Congressman M itchell:
I am pleased to have th is opportunity to provide comments on the
conduct of monetary policy in 1977. I do not believe th a t monetary policy
w as conducted effectively la s t y ea r, and as a consequence some adjustm ent
c o sts are going to be incurred to correct the e x c e sse s th at have occurred.
My interpretation of policy actio n s la s t year is th at th e Federal Reserve tried
to employ two short-run operating targ ets sim ultaneously — the money supply
and market in tere st ra te s — and wound up creating the w orst of both w orlds.
I do not believe th at even more rapid growth of the money supply
would have prevented the sharp in cre a se s of short-term market in terest r a te s .
Except in the very short run (two or three months) it is wrong to consider
in te re st ra tes and money supply a s altern ativ e policy ta rg e ts . I believ e the
reason th at short-term in terest ra te s have rise n so sharply th is year is b ecau se
the money supply has grown e x c e ssiv e ly . Although th is contradicts conventional
w isdom , if the Federal Reserve had achieved growth of the money supply w ithin
the target ranges announced earlier th is y ear, I doubt short-term in te re st ra te s
would have risen as much as they d id .
At each Open M arket Committee meeting the Federal Reserve
policym akers view th e growth of the money supply and changes in short-term
in te re st rates during the subsequent month or two a s moving in opposite
d irectio n s. However, market particip an ts understand th at over a somewhat
longer period the a ctu a l re s u lts w ill be the ex act o p p o site. If th e money supply
grows more rapidly than previously, or more rapidly than desired by the monetary
a u th o rities, market particip an ts understand it w ill be n ecessary for th e Federal
Reserve subsequently to adopt more restric tiv e reserv e supplying operations and
allow short-term in tere st ra te s to ris e in order to slow the growth of th e money
supply. If growth of the money supply falls short of the Federal R eserve's




187
targ ets or the trend ra te , then th e markets understand th at short-term in terest
ra tes w ill remain the same or decline somewhat as long as growth of money
and bank reserv es is below the targ ets or the trend ra te .
The behavior of the Treasury b ill futures market provides evidence
regarding the attitu d es of financial market particip an ts tow ards the money
supply and market in te re st ra te s . W henever th e money supply is announced
to have increased sharply, Treasury b ill futures market in te re st ra te s rise
sharply. On the other hand, when the money supply is unchanged or d ec lin e s,
in te re st rates on the Treasury b ill futures market also d eclin e .
During the p a st year actio n s by th e Federal Reserve were criticized
a s being too expansionary by those who em phasis the money supply, and too
re stric tiv e by those th at em phasize movements in short-term in te re st ra te s .
I agree th at there is too much em phasis placed on the w eekly money supply
num bers, and I also believe th at there is too much em phasis placed on daily
and w eekly movements in short-term in terest ra te s . The monetary authorities
should be Concerned with the trend of growth of the money supply over a
period of several months and longer, and w ith the general pattern of in te re st
ra te s and inflation over a b u sin ess c y c le . Short-run preoccupation w ith
movements of in te re st ra te s can cau se the central bank to get su b stan tially
off of its long-run path , ultim ately causing a co stly correction in terms of
inflation, output, and employment.
Since the cen tral bank d e sire s to operate on a w eekly ta rg e t, and
participan ts in money and credit markets w ill alw ays look for a w eekly
number to gauge cen tral bank policy by, I would urge th at th e recommendations
of the Federal Reserves own internal studies*under the "Committee on the
D irective" be im plem ented. On two sep arate o ccasio n s in the p ast decade
the Federal Open Market Committee has authorized extensive stu d ies of
p olicies for formulation and im plem entation of monetary policy, and both
reports recommended increasing the em phasis on a reserve aggregate
m easure, such a s the monetary b a se , as the short-run operating targ e t.
Many other central banks of the w orld, Germany and Switzerland
in particular, have had considerable su c c e ss w ith using th eir version of
the monetary b ase a s an operating ta rg e t. A number of stu d ies on the U. S.
monetary system suggest that employing the monetary b ase as a w eekly and
monthly operating targ et would produce re s u lts th a t are preferable to either
in te re st rates or the money supply.




188
The behavior of the central bank in 1977 has been somewhat of
a paradox in other re s p e c ts . The Federal Reserve frequently em phasizes
th at the short-run money supply s ta tis tic s are unreliable and they have
lim ited ability to control the money supply in the short run. A number of
stu d ie s, including one commissioned by the Federal Reserve System, have
made specific recommendations for improving the quality and re lia b ility of
the money s ta tis tic s and for making in stitu tio n al changes which would
enhance the ab ility of the cen tral bank to achieve its own money supply
growth ta rg e ts. The Federal Reserve failure to make progress tow ards
implementing any of th e se s ta tis tic a l or procedural reforms is discouraging
at b e st. An appropriate role for C ongressional oversight of monetary policy
in 1978 would include in sista n c e th at the central bank make tangible pro­
gress tow ards improving the s ta tis tic s and control tech n iq u es, or explain
its reasons for maintaining the sta tu s quo.
In 1978, if growth of the money supply continues to exceed the
F ed's long run ta rg e ts, short-term in te re st ra te s w ill continue to rise
sharply, disinterm ediation w ill occur, and th e dollar w ill continue to
decline on foreign exchange m arkets. In co n trast to 1977, I would expect
sharper in creases in long-term in te re st ra tes the faste r the growth of money
th is year. This would be caused by th e observation and fears of acceleratin g
inflation over the next few y e a rs .
The most constructive thing the Fed can do at th is point is to
make it clear th a t it is going to im mediately return to its announced policy
of gradually reducing th e trend growth of the money supply. In such an ev en t,
I doubt long-term in tere st ra te s would rise significantly from present le v e ls .
Sincerely,

Otr. Jordan enclosed two studies, which follow.)




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7

PH7S3URSH Wfrr;0>JRL BKAH
P ITTS B U R G H . P E N N S YLV A N IA 15230

"DEFENDING” THE DOLLAR
Jerry L. Jordan
The price of the U.S. dollar in foreign exchange markets relative to other
major currencies — notably the German Deutschmark and the Japanese Yen —
has declined sharply this year. Said somewhat differently, the number of D-marks
or Yen that would be received in exchange for one U.S. dollar has gone down and,
of course, the number of D-marks or Yen that a foreign consumer must give up
in order to acquire one U.S. dollar also has fallen.
Foreign officials have not been very happy about this development, and news­
papers have carried numerous quotes of foreign individuals pleading that the United
States should "do something" to "aid”, support”, or "defend” the dollar. There
are only a few options available to the Federal Reserve System as a means of
influencing the price of the dollar on international exchange markets, and they
all nave "side effects" that must be considered. Foreign central banks can take
actions to influence the exchange rate between their currency and the U.S. dollar
without influencing the U.S. money supply, but Federal Reserve intervention on
foreign exchange markets may have a direct influence on the money supply of
foreign countries. Also, actions to influence exchange rates, like actions to influence
short-term market interest rates, can have opposite effects in the long run than
in the short run.
Central banks of other countries hold assets considered to be "foreign re­
serves" — a large part of which are usually U.S. government securities. When they
want to "support" their own currency on foreign exchange markets, they can sell
the U.S. Treasury securities and use the dollars received to buy their own currency
in the market. When they want to "support" the dollar, they simply create more *
of their own currency to pay for dollars purchased in the foreign exchange market.
If they do not want the growth of their own money supply to be more rapid as a
result of the intervention, they must take offsetting actions such as raising reserve
requirements or selling domestic securities on the open market.
The only "foreign reserve" held by the Federal Reserve System in any sigr.if.eant quantity is gold. Presumably, the U.S. could sell some of its gold for
foreign currency and use the foreign currency to "buy" dollars on foreign exchange
markets. Such actions would contract the U.S. monetary base and money supply,
and the Federal Reserve would have to decide whether that was desirable from
a domestic monetary policy standpoint.

*Tney always convert dollar balances into U.S. Treasury securities or some
other dollar denominated interest bearing asset.
2

The U.S. has taken the position that gold has been "demonitized" and has
no role as an international reserve or monetary asset, but continues to hoard
its stockpile.

22-761 0 - 78 - 13




190
The only other way the Federal Reserve could intervene to "support” the
dollar on foreign exchange markets is to borrow some foreign currency from another
central bank and use it to buy dollars. Such borrowings of foreign currency from
a foreign central bank are referred to as "swaps”.
Swaps
Central banks arc the only organizations that can literally write-up both
sides of their balance sheets with the stroke of a pen. The partners in a swap each
simply increase an asset item and a liability item on their books. Initially, the
Federal Reserve Bonk records an increase in foreign owned balances (denominated
in dollars) as a liability. The U.S. dollars M
puttf into the account of the foreign
central bank are literally created — nobody else has less dollars as a result. Like­
wise, the Fed’s newly acquired asset — a balance at the foreign central bank —
was created.
At this initial point nothing has happened to the money supplies of either
country since central bank balances are not counted. However, since the purpose
of the swap was to enable the Federal Reserve to intervene, the foreign country
money supply will increase and the U.S. money supply will contract as the Fed
acquires dollars through the sale of the foreign currency. But, foreign central
banks don't hold large idle balances at the Fed since they don't earn interest, so
U.S. Treasury securities are purchased by the Federal Reserve on behalf of foreign
central banks. Foreign balances at the Federal Reserve decline as the Treasury
securities are paid for, and that increases the U.S. money supply. This increase
in the U.S. money supply offsets the decrease caused by Fed intervention on foreign
exchange markets. The net effect of Federal Reserve "support of the dollar" using
foreign currencies acquired through swaps is no change in the U.S. money supply,
and an increase in the foreign money supply. “
The foreign central bank must either
take offsetting action or^ccept the implications of an acceleration in the growth
of its own money supply.
At least a temporary effect of the central bank intervention to "support the
dollar" is on interest rates on short-term U.S. Treasury securities, similar to the
effects of open market purchases by the Fed. But a major difference compared
with purely domestic operations is that the U.S. monetary base (and money supply)
is not expanded by the Fed purchases of securities for foreign accounts. Unless
there is some offsetting actions by the foreign central bank, the effect is as though
the Federal Reserve acquired the authority to conduct open market operations
using another country's money supply.

3

In most respects the results are exactly the same as when the foreign
central bank buys dollars for its1own account. One difference which may
contribute to the desire to see the Fed do the intervening is that the
exchange risk associated with intervention facilitated by swap agreements
is usually shared on a 50-50 basis between the participating countries.




191
Exeh.-yigc Rato Pressures
A wide variety of factors are often cited as rctiUsesn of a change in the ex­
T
change rate between the currencies of two countries. Changes in the relative rates
of real economic growth, inflation, economic policy actions of government, or
political uncertainty car. all contribute towards making the goods or securities
of another country look more or less attractive.
In 1977 the growth of total demand for goods and services in the United
States was much stronger than our major trading partners. Real output growth
and inflation both accelerated sharply compared to late 1976 and compared to
other countries. Part of this stronger growth in demand was reflected in a sharp
increase in imports of foreign goods. Since our trading partners did not increase
their demand for our exports as much, nor did they desire to acquire a sufficient
quantity of securities denominated in dollars, the exchange rate between dollars
and other major currencies has declined substantially.
The price of the dollar on foreign exchange markets will stop declining only
when foreign demand for our goods and securities matches our demand for their
goods and securities. Attempts might be made to bring this about in a number
of ways, including changes in quotas, tariffs, capital controls, reference prices
or other government mandated changes in the terms of trade. But all such actions
would impose some costs on the consumers of at least one of the countries involved.
And as long as total demand and inflation in the U.S. continued at a more rapid
rate than other industrialized countries, the exchange rate would be under downward
pressure.
To achieve and maintain stable exchange rates over an extended period of
time, countries cannot experience widely divergent rates of inflation. This suggests
that there are only two basic approaches to "defending” the international price
of the dollar. One would be to halt the erosion of the domestic price of dollars
in terms of goods and services — that is, end inflation. The other would be to get
other industrialized countries to inflate along with us. The later alternative seems
to be the most likely approach.
Throughout 1977, U.S. government officials have been "encouraging” foreign
countries — again, notably Germany and Japan — to adopt more stimulative monetary
and fiscal policies. Since U.S. economic policies have become increasingly stimulative
in 1977, and inflation will accelerate further in 1978, a dramatic increase in total
spending in Germany and Japan would be necessary to close the gap.
However, recently the central bank of Germany announced that the target
growth rate for their central bank money (similar to the U.S. monetary base) for
1978 is 8 percent, the same as for 1977. Also, they emphasized that this would
imply a growth of only 5 to 6 percent from the end of this year to the end of next
year, in view of the accelerated growth that has occurred in recent months. If
participants in foreign exchange markets expect that the German monetary authorities
will limit their actual monetary growth to the announced targets, but expect that
the Federal Reserve will continue to exceed its1 announced targets for 1978, the
U.S. dollar will continue to be under downward pressure, relative to the D-mark,
on foreign exchange markets.




192

p it t s s u p .s :-:

riprnoKSi

srnx

P IT T S B U R G H . P E N N S YLV A N IA 15230

NEAR-TERM BENEFITS, LONGER-TERM COSTS

Jerry L. Jordan
Senior Vice President «c Economist
3
Except for faster inflation, 1978 will be a pretty good year. In the first half oil
prices will remain unchanged, real output growth is likely to be stronger than
in the second half of 1977, and the unemployment rate can be expected to decline
to somewhere between 6 and 6 s percent.
The Lags of Policy Actions
Monetary and fiscal policy actions in 1977 were more stimulative than at
any time in several years. A substantial body of economic research supports the
view that the initial impact of an acceleration in the growth of the money supply
and government spending is on the growth of real output and employment. The
8.3 percent average growth of the narrow definition of the money supply (Ml)
during the last three quarters of 1977, especially when accompanied by a sharp
acceleration in the growth of government spending, should foster a rate of growth
of total spending in the economy (GNP) in the 11 to 12 percent range during the
first half of 1978. The increased growth of nominal spending is likely to be com­
posed of growth of real output of more than 5 percent and inflation of 6 to 7 per­
cent.
Looking further ahead, if monetary and fiscal stimulus in 1978 are similar
to the last three quarters of 1977, normal lag relationships suggest that in 1979
the rate of inflation would increase further, probably to the range of 7 to 9 per­
cent. Growth of real output and employment still would be positive, although
slower, so long as the strong stimulus is maintained.
Re-Assessment of Economic Policies
It seems probable that a change in priorities for economic policies is likely
around mid-1978. Inflation, will have risen from less than a 4 percent rate in
the fall of 1977 to over a 8 percent rate in the spring of 1978, and will continue
to accelerate. The unemployment rate will have declined from 7 percent in the
fall of 1977 to less than 6 ? percent by mid-1978. In such an environment it may
turn out that a Congress facing an election in the fall will decide that tax cut
stimulus is not the appropriate economic policy action for the second half of 1978.
One response might be to reduce the growth of government spending in the
fiscal 1979 budget and to plan a marked reduction in the deficit by foregoing the
tax cut. This could be combined with a reduction of money growth. Such actions
— slower growth of goverment spending and money supply — in the second half
of 1978 would slow the growth of total spending in the economy in 1979. The
same relationships between policy actions and economic activity that indicate
strong growth of total spending in the economy which will occur in the first half
of 1978, would also indicate a marked reduction in output growth in 1979.




193
The dilemma is simply that once monetary growth and government spending
have accelerated to new higher rates, as in 1977, there are only two options available
to policymakers. The high rates of growth can be maintained indefinitely and
the average rate of inflation will rise to new correspondingly high rates, or growth
of money and government spending can be reduced to or below the previous trend
rate. However, the initial impact of the deceleration of money growth and reduced
growth of government spending is on real output and employment. The rate of
inflation can be expected to begin to slow only after a lag of some two or three
years.
These relationships have proven to be reliable regardless of the proximity
of the economy to full employment and full capacity utilization. There are good
reasons to believe that underutilized economic capacity at present is not near
so large as the physical capacity utilization data might suggest. Nevertheless,
policymakers' perceptions of the economy's proximity to full utilization of its
resources are bound to be a factor later this year since the unemployment rate
still will be around 6 percent and the capacity utilization numbers will not indicate
severe supply constraints. There will be some doubt as to whether a significant
move toward monetary and fiscal restraint is appropriate.
Some observers will argue that the accelerating inflation is not attributable
to "demand pull", but that the inflation is caused by "cost push" forces. Such
reasoning would be used to support arguments in favor of direct restraints on
priccs and wages, rather than monetary and fiscal restraint, as an appropriate
policy for don 1inf? with inflation.
A combination of direct restraints on waj?<\s and prices (roiiplod with continued
strong monetary and fiscal stimulus could potentially postpone the occurrence
of a recession in 1979, but at a cost of substantially increasing the probability
of a much more severe contraction in 1980 or later. At the present time it is
likely that the adoption of monetary and fiscal restraint in the second half of
1978 would produce a recession in 1979 that would be relatively mild — on the
order of magnitude of the mini-recession in 1967 or the shallow recession in 1970.
However, if strong monetary stimulus continued for another year or two, possibly
accompanied by some form of incomes policy, then the next recession would be
more severe than 1970 — possibly approaching the 1974-75 contraction.
Interest Rate Patterns
Short-term market interest rates rose about two percentage points in the
last nine months of 1977, but are still well below the levels of longer-term yields.
Such a sharply upward sloping yield curve is an unusual condition for the last months
of the third year of economic expansion. During 1978 the yield curve should
flatten further, and the expectation of somewhat faster inflation suggests that
both short- and long-term yields will rise.
For those who choose to assume that restrictive monetary and fiscal actions
will be adopted later this year, and a recession will occur in 1979, a downward
sloping yield curve should be expected prior to the economic contraction. That
would suggest a rise in short-term market interest rates of at least two percentage
points from present levels, with relatively little upward movement in longer-term
yields. This pattern would be consistent with little change in expectations about
the long-run average rate of inflation, while increased short-term credit demands
are not "accommodated" by the Federal Reserve.
For those who choose to assume that monetary growth will remain rapid
this year and into 1979, a more substantial rise in longer-term interest rates
should be expected. This does not imply that the rise in short-term yields will
be less, but only that the yield curve will shift to higher levels and still be somewhat
upward sloping a year from now.




194

Massachusetts Institute of Technology
Alfred P. Sloan School of Management
50 Memorial Drive
Cambridge, Massachusetts, 02139

Franco Modigliani
Institute Professor




December 30, 1977

Subcommittee on Domestic Monetary Policy
Room 3154 House Annex #2
2nd and D Streets, S.W.
Washington, D. C. 20515

I received a letter from Parren Mitchell asking
me to send to you my views on the monetary policies
which took place during 1977. Enclosed is a copy of
my statement.
Sincerely yours,

195
CRITICISM OF MONETARY POLICY IN 1977
by Franco Modigliani

Monetary policy in 1977 has been rather unsatisfactory.

Its failures

are a matter of both form and content.
From the point of view of form, I would continue to recommend that the
Federal Reserve should state its primary target in terms of a target growth of
money income broken down into real income growth and price changes.

At the

beginning of the calendar year, this target should presumably coincide with
that set forth by the Administration with the consent of Congress through the
budget process.

This target should be revised if and when new evidence suggests

that it is no longer appropriate.

Together with the income growth target, the

Federal Reserve should indicate the growth of the main monetary aggregates and
the broad path of short term interest rates, which, in its view, is appropriate
to the achievement of that target.

The Federal Reserve should then be free to

revise these intermediate targets with appropriate explanation as to why a
different growth of the aggregates was appropriate to achieve an unchanged
income target — e.g., evidence that current and prospective aggregate output
was growing faster or slower than target.

It should also feel free to depart

from the stated targets for awhile, but again, with an explanation of the reason
for such departure.

For instance, departure may be justified by short run fluctu­

ations in the demand for money, while income remains on its desired broad path.
Finally, the success or failure of the Fed should be judged primarily by its
success or failure in achieving the income target and not by success or failure
in achieving the monetary growth and interest rate targets.
With respect to content, monetary policy in 1977 has been excessively
tight.

This is largely because the target growth for Ml was set too low at




196
the beginning of the year — at least on the assumption that the Fed was trying
to achieve the Administration's target.

The chosen growth target for Ml pre­

supposed a continuation in the rapid rise in velocity of circulation of Ml,
interest rate constant, which was very unlikely to be realized, and in fact,
was not realized.

(It is, of course, possible that the Fed never accepted the

Administration’ growth target, and was covertly aiming for a lower one, but
s
if so, this should be regarded as an unbearable situation whose repetition
must be avoided through the approach stated in the first paragraph.)
The Federal Reserve appears to have responded to the inadequacy of its
Ml target, in part by allowing Ml to grow well above target through much of
the year.

This, per se, was a step in the right direction, but since the Fed

never changed its target

or explained why it was appropriate to exceed it,

the impression was created that the Fed was losing control of Ml, and that a
severe tightening was in the offing, which had very damaging effects on
financial markets and most likely on the stock market in particular.
What is particularly puzzling in this whole episode is that the growth
of M2 was never significantly above target, yet the Fed appears to have made
little effort to call attention to this fact or to the fact that in the pre­
sent circumstances M2 is likely to be a more reliable indicator than Ml.
But even though Ml was allowed to exceed target, still its growth was
inadequate.

The evidence for this proposition is first that with almost

certainty, real growth this year will fall short of the Administration's target,
and second, short term interest rates rose not far from 200 basis points in the
last six months or so.

This rise seems hardly appropriate for an economy whose

growth rate is still sluggish compared with the existing slack.




Indeed, the

197
prevailing view is that growth in the coming year will be definitely unsatis­
factory unless we proceed with a substantial tax cut.
This leads me to my final criticism of both the style and content of
monetary policy.

In my view, the Federal Reserve by adhering too closely

to the monetarists*

prescription of constant and very limited growth in

monetary targets, has made it impossible to use monetary policy for the one
function for which it has always been recognized — namely, that of restraining
or stimulating investment.

At the present time, everybody agrees that we should

have more investment and less government deficit.

The way to achieve that tar­

get, as is well known, is to pursue an easy monetary policy and a tight fiscal
policy.

But, because the Fed can not be brought to pursue an easier monetary

policy, we are forced to do with a low level of investment whose unfavorable
effect on income must then be offset by more and more deficit through tax
cuts and expenditure programs.
I

would very much hope that the Administration, and Congress in its

supervisory capacity, can promptly bring pressure to bear to end this
paradoxical situation.




198
Ir v in g T r u s t C o m p a n y
O n e W a ll S t r e e t

N ew Y o rk ,

N.Y.

10015

G e o r o e W . M c K in n e y , j *.
■BNIOS VIC* FRlfllDlNT

D e c e m b e r 30, 1977

S u b c o m m i t t e e o n D o m e s t i c M o n e t a r y Policy
R o o m 3154, H o u s e A n n e x #2
2nd & D Streets, N. W .
Washin g t o n , D. C. 2 0 5 1 5

This is in r esponse to C o n g r e s s m a n Mitchell's request for vi e w s o n
1977 m o n e t a r y policy.
N othing is easier than to criticize w h a t s o m e o n e else has done, with
benefit of hindsight a n d without having h ad the actual responsibility. In
v i e w of that fact, I w a n t to e m p h a s i z e m y feeling that the F e d e r a l R e s e r v e
did a n outstanding job in the conduct of m o n e t a r y policy in 1977. Certainly
the basic thrust of that policy--to limit the availability of m o n e y in o r d e r
to sl o w inflation--has b e e n in the nation's best interests. Further, the
m o s t wid e l y voiced criticism of m o n e t a r y policy (that perh a p s policy w a s
too restrictive in late s u m m e r a n d early fall) has b e e n p r o v e d substantially
invalid as revisions of data s h o w that the e c o n o m y w a s considerably stronger
than w a s thought at the time. T h u s the F e d e r a l R e s e r v e s h o w s u p eve n
better in the light of information that w a s not available to its critics at the
time.
T h e only significant w e a k n e s s in m y m i n d s t e m s f r o m the r e q u i r e m e n t
that the F e d e r a l R e s e r v e m a k e quarterly reports to the C o n g r e s s on its
plans for m o n e t a r y policy o v e r the c o m i n g year. This r e q u i r e m e n t skirts
excessive i n v o l v e m e n t of the C o n g r e s s in the detail of h o w the F e d e r a l
R e s e r v e conducts its policies (as distinguished f r o m w h e t h e r it achieves
its objectives). This report to the C o n g r e s s tends to be focused o n a n
i n t e r m e d i a r y objective--the m o n e y supply--rather than the ultimate
objective of maintaining m o n e t a r y conditions conducive to m a x i m u m
sustainable e m p l o y m e n t , production, a n d purchasing p o w e r . T h e C o n g r e s s
should not b e judging the F e d e r a l R e s e r v e on its m o n e y supply targets;
they a re a m e a n s to a n end. Instead, the F e d e r a l R e s e r v e should be held
accountable, u n d e r current circumstances, for the d e g r e e of p r o g r e s s the
nation m a k e s in limiting inflation while avoiding r e c u r r e n c e of recession.




199
Of course, the F e d e r a l R e s e r v e cannot be held accountable for those
fiscal policies w h i c h m a k e it m o r e difficult to attain these objectives.
Nevertheless, if the F e d e r a l R e s e r v e is judged by this standard, it has
d o n e better than could reasonably have b e e n expected, e v e n with benefit
of hindsight.
A n unfortunate side effect of the Co n g r e s s i o n a l focus on the details of
m o n e t a r y policy has b e e n that the F e d e r a l R e s e r v e has adopted a n untenable
a p p r o a c h to m o n e t a r y policy execution, in that it k e e p s one foot in the interest
rate c a m p a n d the other in the m o n e y supply c a m p (by setting targets for the
F e d e r a l funds rate at levels felt to be consistent with the desired rate of
m o n e y growth). This a p p r o a c h does not allow adequately for m a r k e t reaction
to c h a n g e s in the m o n e y supply. If, for ex a m p l e , the m o n e y supply g r o w s at
rates a b ove the a n n o u n c e d targets, the m a r k e t a s s u m e s that the F e d e r a l
R e s e r v e will h a v e to take positive action to get m o n e y g r o w t h b a c k within
bounds. Since this will involve higher F e d e r a l funds target rates, both
sellers a n d b uyers of m o n e y m a r k e t instruments adjust their sights accordingly.
A s a result, decisions relating to liquid asset holdings (or issuance of liabili­
ties) that w e r e associated with the l o w e r level of interest rates tend to be
associated with a new, higher expected level of rates. T h e relationship b e ­
t w e e n m o n e y g r o w t h an d interest rates w h i c h previously existed is n o longer
valid, a n d the level of the F e d e r a l funds rate w h i c h is consistent with a given
rate of m o n e y supply g r o w t h is higher than formerly. T h u s the F e d e r a l
Re s e r v e , w h e n it starts on a " m o n e y supply chase" intended to bring m o n e y
supply g r o w t h within target ranges, thereby stimulates faster m o n e y g r o w t h
an d creates part of the p r o b l e m it is trying to solve. Ultimately the F e d e r a l
R e s e r v e catches u p with the m o v i n g target, a n d m o n e y supply g r o w t h slows.
This h a p p e n e d in 197 5, in 1976, and again this year.
If the F e d e r a l R e s e r v e w e r e not required to state its m o n e y g r o w t h tar­
gets publicly, a n d if it did not simultaneously attempt to peg both price and
quantity, this p r o b l e m of m a r k e t reaction w o u l d be m a r k e d l y r e d u c e d a n d it
w o u l d be easier for the F e d e r a l R e s e r v e to concentrate on its ultimate
objectives.
If y o u decide to c o n v e n e a panel to discuss m o n e t a r y policies, I w o u l d
of c o u r a e be glad to participate in it if y o u wish. T h a n k y o u for the o p p o r ­
tunity to c o m m e n t .




Y o u r s v e r y truly,

200
Beryl W .Sprinkel
Executive Vice President and Economist

HARRIS
BANK




J a n u a r y 4, 1977

E n c l o s e d is m y r e s p o n s e to the i n t e r e s t i n g
and relevant questions raised by
C o n g r e s s m a n M i t c h e l l c o n c e r n i n g 1977
domestic monetary policy.
As you can
tell from m y comments, I w a s n ' t too happy
w i t h the w a y t h i n g s t u r n e d out, a n d I t r i e d
to r a t i o n a l i z e the r e s u l t s .
C o n g r e s s m a n M i t c h e l l i n d i c a t e d t ha t h e
m i g h t w a n t to c a l l o n m e for f u r t h e r
a s s i s t a n c e i n e a r l y 1978.
I would be very
p l e a s e d to p r o v i d e w h a t e v e r a i d I can.
B e s t w i s h e s for a h a p p y a n d p r o s p e r o u s
N e w Y ear.
Sincerely,

Subcommittee on Domestic
Monetary Policy
R o o m 3154 H o u s e A n n e x #2
2nd & D S t r e e t s , S.W.
W a s h i n g t o n , D.C.
20515

j p

r*

201
M o n e t a r y P o l i c y in P e r s p e c t i v e
I n m y op i n i o n , m o n e t a r y p o l i c y w a s e x c e s s i v e l y e x p a n s i v e
in 1977 a nd w e w i l l s u f f e r t h e c o s t of h i g h e r i n f l a t i o n in
the y e a r s to come.
I a g r e e w i t h the s t a t e d o b j e c t i v e of the
F e d e r a l R e s e r v e to g r a d u a l l y r e d u c e m o n e t a r y a g g r e g a t e
g r o w t h unt i l g r o w t h in the m o n e y s u p p l y is c o m m e n s u r a t e w i t h
r e a l o u t p u t g rowth.
A l t h o u g h the r e is so m e c y c l i c a l v a r i a t i o n
in v e l o c i t y of c i r c u l a t i o n of mo n e y , tot a l s p e n d i n g h as r i s e n
at a b o u t the sam e r a t e as M - 2 g r o w t h s i n c e 1960.
(See a t t a c h e d
chart)
In o t h e r word s , M - 2 p e r u n i t of r e a l G NP ha s r i s e n at
the same p a c e as inflat i o n .
If w e a re to e v e r h a v e s t a b l e p rices,
M - 2 g r o w t h m u s t e v e n t u a l l y b e r e d u c e d to 3 to 4% p e r year, the
p r o j e c t e d s e c u l a r g r o w t h in r e a l GNP.
H o w e v e r , a n a t t e m p t to
a c h i e v e l ower m o n e y s u p p l y g r o w t h q u i c k l y w o u l d a l m o s t c e r t a i n l y
induce a painful recession.
H e nce, I p r e f e r g r a d u a l i s m to a
m o n e t a r y crunch.

T he l a t e s t d a t a i n d i c a t e t h a t M - 2 g r e w 9.0% d u r i n g the p a s t
y e a r w h i l e M - l g r e w 7.3%. N o t o n l y d i d m o n e t a r y g r o w t h
a c c e l e r a t e in 1977 b u t d u r i n g m u c h of the y e a r b o t h M - 2
an d M - l e x c e e d e d the ta r g e t s e s t a b l i s h e d by the F e d e r a l
Reserve.
To c o m p o u n d the d i f f i c u l t y , e c o n o m i s t c r i t i c s
fro m P r e s i d e n t C a r t e r ' s A d m i n i s t r a t i o n h a v e a r g u e d t h a t the
F e d e r a l R e s e r v e d i d n o t c r e a t e e n o u g h n e w mone y !
W h y d i d m o n e y g r o w t h a c c e l e r a t e this y ear.
S o m e say h i g h e r
g r o w t h w a s in r e s p o n s e to A d m i n i s t r a t i o n pr e s s u r e .
Others
a l l e g e t h a t Dr. B u r n s w a s r u n n i n g for r e a p p o i n t m e n t as C h a i r m a n
of the F e d e r a l R e s e r v e Board.
I b e l i e v e b o t h of t hese
e x p l a n a t i o n s a re w r o n g .
In fact, there has long b e e n a t e n d e n c y for m o n e y c r e a t i o n
to be p r o - c y c l i c a l , n o t c o u n t e r - c y c l i c a l .
Two examples will
suffice.
B e g i n n i n g in the fall of 1974 and c o n t i n u i n g u n t i l
F e b r u a r y 1975, m o n e y s u p p l y g r o w t h d e c l i n e d s h a r p l y d e s p i t e
the f a c t t h a t the e c o n o m y w a s in se r i o u s r e c e s s i o n a n d the
F e d e r a l R e s e r v e t a r g e t e d i n c r e a s e d m o n e t a r y growth.
This
p a s t y e a r the r e a l e c o n o m y r o s e at a r a t e w e l l in e x c e s s of
l o n g - t e r m trend, y e t m o n e t a r y g r o w t h a c c e l e r a t e d w e l l a b o v e
target.
T he e x p l a n a t i o n for this p r o - c y c l i c a l p a t t e r n of
m o n e t a r y g r o w t h lies in the t e c h n i q u e s u s e d b y the F e d e r a l
O p e n M a r k e t C o m m i t t e e in e x e c u t i n g poli c y .
The Committee
a t t e m p t s to s i m u l t a n e o u s l y a c h i e v e m o n e y s u p p l y a nd fed funds




202
t a r g e t s — a d i f f i c u l t i f n o t im p o s s ib le
ca n r e a d i l y a c h ie v e e i t h e r t a r g e t o n ly
c h a n g in g th e o t h e r .

ta sk .
The B oard
b y a b a n d o n in g o r

D u r i n g a p e r i o d of d e c l i n i n g e c o n o m i c a c tivity, the d e m a n d
for c r e d i t u s u a l l y s u b s ides, t h e r e f o r e p l a c i n g d o w n w a r d
p r e s s u r e o n s h o r t - t e r m i n t e r e s t rates.
The money market
d e s k c a n r e t a r d a d e c l i n e in the fed funds t a r g e t b y s e l l i n g
G o v e r n m e n t s e c u r i t i e s a n d c o n t r a c t i n g b a n k r e s e r v e s a n d the
m o n e t a r y base.
H o w e v e r , this a c t i o n r e s u l t s in m o n e t a r y
g r o w t h b e l o w the s t a t e d a g g r e g a t e target, as o c c u r r e d fro m
f al l 1974 u n t i l F e b r u a r y 1975.
Conversely, during periods
o f r i s i n g b u s i n e s s a c t i v i t y suc h as this p a s t year, r i s i n g
credit demands typically exert upward pressure on short-term
i n t e r e s t rates.
T h e F e d e r a l R e s e r v e c a n r e t a r d the f ed funds
r a t e f r o m r i s i n g ab o v e t a r g e t b y b u y i n g G o v e r n m e n t sec u r i t i e s .
T h i s a u g m e n t s b a n k r e s e r v e s and the m o n e t a r y base, a n d h e n c e
m o n e t a r y g r o w t h a c c e l e r a t e s a b o v e target.
T y p i c a l l y the
f ed f unds t a r g e t is a d j u s t e d u p w a r d s l o w l y — 1/8 of 1%.
W h e n the h i g h e r r a t e w h i c h p e r m i t s p r o p e r a g g r e g a t e g r o w t h
is e v e n t u a l l y atta i n e d , i t is a c h i e v e d o n l y af t e r a s u b ­
stantial money supply over-shoot.
I n m y o p i n i o n , a c h i e v i n g p r o p e r g r o w t h in m o n e t a r y a g g r e g a t e s
is c r i t i c a l if e c o n o m i c s t a b i l i t y a n d g r o w t h are to b e
promoted.
U t i l i z a t i o n of an i n t e r i m i n t e r e s t r a t e t a r g e t
m a k e s a t t a i n m e n t of m o n e t a r y a g g r e g a t e t a r g e t s e x t r e m e l y
d i f f i c u l t for r e a s o n s e x p l a i n e d above.
Th e r e f o r e , I w o u l d
r e c o m m e n d a b a n d o n i n g the s h o r t - r u n f e d e r a l funds target,
w h i l e c o n c e n t r a t i n g on r e g u l a t i n g g r o w t h in the m o n e t a r y b a s e
a n d h e n c e the m o n e y supply.
At

le a s t

th re e

a d v a n ta g e s

w o u ld

ensue:

1.

T h e F e d e r a l R e s e r v e w o u l d c e r t a i n l y co m e c l o s e r to
a c h i e v i n g its m o n e t a r y a g g r e g a t e t a r g e t s . T h e F e d
h as a b s o l u t e c o n t r o l o v e r the b a se.
A l t h o u g h th e r e
is n o t a p e r f e c t c o r r e l a t i o n b e t w e e n th e b a s e a n d
M -l a n d M-2, the r e l a t i o n is m u c h c l o s e r t h a n the
c o r r e l a t i o n b e t w e e n the f ed funds rate a n d M - l a n d M-2.

2.

S h o r t - t e r m i n t e r e s t r a t e v o l a t i l i t y w o u l d b e redu c e d ,
in m y o p inion.
U n d e r p r e s e n t o p e r a t i n g p r o c e d u r e , the
c y c l i c a l r i s e in s h o r t - t e r m r a tes is s o m e t i m e s d e l a y e d
b y p r o m o t i n g h i g h e r g r o w t h in the m o n e y supply.
But
m o r e m o n e y g r o w t h a s s u r e s g r e a t e r c r e d i t d e m a n d s as
s p e n d i n g r i ses m o r e r a p i d l y and m o r e m o n e y leads
to h i g h e r inflat i o n .
B o t h the i n c o m e an d i n f l a t i o n
e f f e c t s a s s u r e e v e n h i g h e r i n t e r e s t ra t e s in l ater periods.
T h e c o n v e r s e is true in p e r i o d s suc h as 1 9 7 4 - 7 5 w h e n low
money growth assured an even more severe recession
a n d w e a k e r c r e d i t de m a n d s .
L o w i n t e r e s t ra t e s c a n
b e c o m e a l a s t i n g w a y of life o n l y if the m o n e y s u p p l y
e v e n t u a l l y gr o w s in line w i t h re a l o u t p u t growth,
t h e r e b y a s s u r i n g low r a t e s of i n f lation.
An attempt




203
to p r o m o t e low e r i n t e r e s t r ates v i a h i g h m o n e t a r y
g r o w t h as in 1977, v i r t u a l l y a s s u r e s h i g h e r i n f l a t i o n
an d h i g h e r i n t e r e s t rates.
T o p u t it d i f f e r e n t l y ,
K e y n e s i a n p o p u l i s t s c a n a t t a i n th e i r l a u d a b l e o b j e c t i v e
of low i n t e r e s t ra t e s o n l y b y f o l l o w i n g the m o n e t a r i s t
p r e s c r i p t i o n of g r a d u a l l y r e d u c i n g the r a t e of m o n e t a r y
g r o w t h u n t i l it is e v e n t u a l l y c o m m e n s u r a t e w i t h real
o u t p u t i n c r e a s e s a n d h e n c e lo w e r infl a t i o n .
3.

A f t e r a b r i e f l e a r n i n g period, I ' m c o n v i n c e d the
m o n e y m a r k e t s w o u l d r e a c t less to the r e g u l a r T h u r s d a y
r e l e a s e of the w e e k l y m o n e y s u p p l y n u m b e r s .
U n d e r p r e s e n t g r o u n d rules it is v i r t u a l l y c e r t a i n
t h a t a w e e k l y o v e r - s h o o t in m o n e y w i l l lea d to h i g h e r
s h o r t - t e r m rat e s si n c e it is b e l i e v e d the F e d m u s t
a l l o w the fed funds rat e to rise.
U n d e r the p r o p o s e d
change, t he m a r k e t w o u l d p a y m o r e a t t e n t i o n to c h a n g e s
in b a s i c F e d e r a l R e s e r v e s t r a t e g y c o n c e r n i n g the
p r o j e c t e d r a t e of r i s e in the b a s e w h i c h is u n d e r the
c o n t r o l of the F e d e r a l O p e n M a r k e t C o m m i t t e e .

In summary, I b e l i e v e m o n e t a r y p o l i c y w a s too e x p a n s i v e
in 1977 d u e to a d h e r e n c e to fed funds r a t e targets.
P o l i c y e x e c u t i o n c o u l d b e i m p r o v e d by f o c u s i n g F e d e r a l
R e s e r v e a c t i o n s o n a c h i e v i n g g r o w t h in the m o n e t a r y b a s e
th a t is b e l i e v e d to be c o n s i s t e n t w i t h m o n e y s u p p l y targets.
C u r r e n t F e d e r a l R e s e r v e s t r a t e g y of g r a d u a l l y r e d u c i n g
m o n e t a r y g r o w t h is correct. W h a t is n e e d e d is a n o p e r a t i n g
t a c t i c t h a t w i l l a s s u r e b e t t e r p e r f o r m a n c e in a c h i e v i n g the
stated objective.

B e r y l W. Sprinkel, E x e c u t i v e V i c e P r e s i d e n t a n d E c o n o m i s t
Th e H a r r i s T r u s t & S a v i n g s B a n k
C h icago, Il l i n o i s




204

1915

20




25

30

35

40

45

50

55

60

65

70

75

80

205

YaleUniversity

New Haven, Connecticut 06520

DEPARTMENT OF ECONOMICS
Cowles Foundation for Research in Economics
Box

2125,

Yale Station

December 20, 1977

Subcommittee on Domestic Monetary Policy
U. S. House of Representatives
Room 3154, House Annex No. 2
2nd & D Sts. S.W.
Washington, D. C. 20515

In response to Congreeman Mitchell’ request of
s
December 12, I do not have time to write anything new
on the subject. I enclose two recent published articles
bearing in part on the subject, and you are welcome to
use excerpts.
Sincerely,

Enclosures

22-761 0 - 7 8 - 1 4




206
T H E N E W Y O R K T IM E S, SUNDAY, N O V E M B E R 20, 1977

Can Carter Afford Arthur Burns?
By JA M E S T O B IN
In January P resident C a rte r w ill have
a chance, the o n ly chance during his
te rm , to influence the m on e ta ry and
credit policies o f the governm ent over
w hich he presides. Those policies w ill
be pervasive, p o w e r fu l-e v e n decisive
— determ inants of the course o f the
economy: production, unem ploym ent,
profits, In fla tio n , Interest rates, stock
prices. T h e y w ill affe ct th e fortunes
of m ost w orkers, businessmen and In­
vestors m ore s ig nificantly, i f less vis*
ib ly, th a n alm ost a ll th e legislation and
adm in istration th a t com m ands the at*
tention o f Congress, the executive
branch and the public.
As M r. C a rte r is w e ll aw are, the elec­
to ra te holds him responsible fo r the
perform ance o f the economy. H e is
bound, therefore, to take m ost serious*
ly his designation o f a chairm an o f the
board o f governors o f th e Federal Re­
serve System to serve fro m Jan. 31,
1978, not a t the President’s pleasure
bu t fo r a fu ll fo u r years.
Th e Fed m akes m o n e ta ry policy.
S pecifically, its decision-m aking body
is th e Federal Open M a rk e t C om m ittee,
w hich m eets m o n th ly in W a shington
and som etim es m ore fre q u e n tly by tele­
phone. T h e m embers o f th e com m ittee
are the seven governors (o f w hom one
is the designated chairm an) and five
o f the 12 presidents o f d is tric t Federal
Reserve banks. The governors are ap­
pointed b y the President and confirm ed
by the S enate fo r 14-year term s. One
vacancy occurs e very tw o years; the
n e xt one, not th a t o f the c u rre n t chair­
m an, also occurs a t th e end o f January.
The d is tric t ba n k presidents are only
in the rem otest sense Federal officers.
T h e y are appointed by the boards o f
directors o f th e banks, subject to ap­
proval by th e board o f governors in
W a shington. Th e y are n o t subject to
P residential approval o r S enate c o n fir­
m ation; th e y serve in d e fin ite term s;
th e y a re paid m ore like private bank
executives than G overnm ent officials.
A ll 12 pa rticipa te in m eetings o f the
Open M a rk e t Com m ittee; pf th e ir fiv e
votes, the N e w Y o rk president alw ays
has one and the fo u r others are rotated.
N o rep resentative o f the President
o f the U nite d States— not the S ecretary
of Tre as ury, n o t the chairm an o f the
Council o f Econom ic A dvisers— is a l­
low ed to attend, th e com m ittee’s m eet­
ings even to observe and listen, m uch
less to express view s o r to vote. This
biza rre apparatus dates from the B ank­
ing A c t o f 1935, am ending th e Federal
Reserve A c t o f 1913. N eith e r la w a n tici­
pated th a t the agenda o f c entral banks
w ould becom e so c entral to th e eco­
nom ic policies of dem ocratic govern­
m ents.
Th e chairm an o f the Fed has o r*
one vote in the Open M a rk e t Com:tee, but in practice the com m it:
m est in v ariab ly follow s hid lead. In c : c




Th* New York Timtt

are several reasons: fe a r th a t open dis­
sent w ill im peril the independence o f
the Fed, th e chairm an's role as public
spokesman and his com m and over th e '
adm in is tra tive and research staffs, the
chairm an’s influence in appointm ents
of new governors and dis tric t bank
presidents and the chairm an’s personal
and in tellectual force.
President C a rte r has inherited a
chairm an and a board appointed by his
Republican predecessors; 10 o f the 12
hank presidents also assumed office
since 1969. A new chairm an w ill not
find it easy to change policy, especially
if the outgoing chairm an stays on the
board.
These are the reasons w h y the desig­
nation o f a chairm an is the only real
opportunity M r. C a rte r w ill have to in ­
fluence an agency whose actions are
crucial to his economic goals and to
th e record by w hich he w ill be judged.
I f he replaces A rth u r F. Burns, he w ill
no t be threatening the C onstitution or
even the independence of the Federal
Reserve System . T he statute d e liberate­
ly sets the chairm an’s term a t fo u r
years to give the P resident this lim ited
pow er, w ith no presum ption th a t in­
cum bents w ill be retained. D esignating
a new chairm an w ould not politicize
a technical professional position; the
office is po litic al, in the sense th a t high
oolicv is at. sf*k«5. M r. Burns’s profes­
sional distinctio n and long career of
dedicated public service are n o t in
:estion; the y do not entitle him to
•ii« tenure.

In a sim ilar situation in 1962, it is
true, President Kennedy reappointed
W illia m M cChesnev M a rtin . Like M r.
Burns today, M r. M a rtin enjoyed g reat
support in financial and business c ir­
cles suspicious o f a new D em ocratic
A dm inistration , and his retention
helped to reassure them . B ut there is
a significant difference. A fte r some
early polemics, M r. M a rtin had reached
a modus vivendi w ith th e n e w A dm inis­
tration. U nder his leadership the Fed
broadly supported the K ennedy-Johnson economic strategy throughout the
1961-65 recovery. In his O ct. 26 speech
at Spokane, M r. Burns called fo r a sim i­
la r fiscal strategy today, bu t he gave
no indication th a t he w old satisfy the
m o netary needs o f an expanding econo­
m y as M r. M a rtin did in the early
1960’s.
H o w has the Fed exercised its re­
sponsibility during M r . Burns's tenure
as chairm an? In th e fu tu re his tory o f
m o netary policy, tw o principal tnemes
w ill stand out: F irst, during this period
th e Fed changed sig n ifica n tly its w a y
o f de fining, fo rm u la tin g and executing
m one ta ry policy. Second, beginning in
1974 the Fed undertook a crusade
against in fla tio n and gave it p rio rity
o v er other economic goals.
T h e firs t change reflected the in flu ­
ence of M ilto n Friedm an and other
m onetarists although the y have not
been e n tirely satisfied. P reviously the
Fed had geared its policy to general
economic and fina n c ia l conditions; ex­
p lic it form ulas w ere not used, much
less announced.
D u rin g M r. Burns’s tenure, the Open
M a rk e t C om m ittee began to form ulate
and announce its policy in term s of
ta rg et ranges fo r gro w th of several
m onetary aggregates, notably M - l, the
na rro w m oney stock— currency and de­
m and deposits held by the nonbank
pubiic. Each qua rte r y ear- ih ead targets
are announced; the range fo r M - l is
curre ntly 4 to UK percent.
The Fed’s m arksm anship is im perfect
because it does not d irec tly control M - l
o r othe r aggregates. The Fed buys and
sells T reasury bills, usually under
repurchase agreem ent. The re are m any
loose joints in the linkage betw een

207
- 2 CAN CARTER AFFORD ARTHUR BU RN S?

7

i

? * > ■
these operations and M - l. Fed opera­
tions can, how ever, directly control the
in te res t rate on Federal funds, over­
night loans betw een banks. The M -l
outcom e then depends on how banks
an d depositors all over the country re­
spond to th a t rate and to a m yriad
Of oth e r events. Each m onth the Open
M a rk e t C om m ittee
reconsiders its
Operating ta rg et fo r the Federal-funds
rate, raising it if M - l is too high, low er­
ing if M - l Ts too low . Predicting these
m oves fro m w e e k ly m onetary statis­
tics, v o latile and erra tic as they are,
has become an obsessive W a ll S treet
pastim e, generating ridiculous w eekly
gyrations in stock prices.
Y et investors have been quite right
this y e a r to fe a r th a t M - l could be
held to ta rg e t only by sharply higher
interest rates, dam aging both the dis­
counted value and the prospect o f fu ­
tu re corporate earnings. Th e Fed has
raised the funds rate 2 00 basis points
in 1977. Though higher s hort-term In­
te res t rates inauce the public to m akedo w ith less cash, m oney grow th still
exceeds the target.
I t n ever seemed lik e ly th a t M - l
g ro w th o f 4 to 6 1; percent was con­
/




sistent w ith 11 to 12 percent grow th o f
d ollar gross n a tio n a l product (5 to 6
percent higher production plus 6 per­
cent higher prices). I t w ould have taken
an e xtraordinary increase in the e ffi­
ciency w ith w hich the public uses the
m oney stock to produce such a big in­
crease in velocity (G .N.P. divided b y
M - l) . V elocity did rise s ig nificantly in
1975 and 1976, reconciling the Fed’s
m oderate m oney stock targets w ith
g row th in G .N.P. w ith o u t an upw ard
*.rend of interest rates. B ut interest
boosts in 1977 have already damaged
the prospects fo r G.N.P. grow th ne xt
year; and the fu rth er increases needed
to return M - l prom ptly to ta rg et range
w ould bring about a recession as surely
as the Fed’s double-digit interest rates
did in -the spring of 1974. The A dm in­
istration is certa in ly right to ask the
Open M a rk e t Com m ittee to place the
economy’s health above the Fed’s selfimposed m oney stock targets.
T he problems ju s t discussed, arising
from short-run v o la tility o f m oney
stock statistics and from v a ria b ility of
v elocity, could be- avoided if the Fed’s
y e a r-a n e a d ' targets w ere ranges fo r
g row th of do llar G.N.P. (m oney stock
tim es velo c ity) ra th er than fo r M - l (o r
other m onetary aggregates) alone.
A fte r all,. G .N.P. grow th is the bottom
line; m oney stock control is means, not

end. G .N.P. grow th targets w ould also
fa c ilita te consistency w ith the econom­
ic projections and objectives adopted
in th e budget decisions of the Adm inis­
tration and Congress. I t is unfo rtunate
that, under M r. Burns's leadership, th e
Fed has elevated m oney stock gro w th
rates to m uch g reater sym bolic signifi­
cance in the public m ind th a n the y ob­
serve.
The deeper purpose o f c urre nt Fed
policy is to conquer in fla tio n , and its
premise is th a t the battle can be w on
by— and o n ly by— reducing m onetary
grow th rates. Tne Fed has no direct
handle on prices and wages. Even if
it successfully controls the grow th of
money supplies and total spending, the
Fed cannot determ ine the w ay spending;
splits betw een production and prices
o r betw een em ploym ent and wages. S ix
percent r>nce inflation and 8 percent
w age infla tio n are, fo r historical rea­
sons, solidly entrenched in U nited
States industry tod.ay. Experience since
1974 confirm s th a t these hard-core
trends m e lt very slo w ly even w hen un­
em ploym ent and excess capacity arc
high. If, fo r e::ample the Fed contrives
fo r 1978 a 9 percent grow th in dollar
spending instead o f 11 percent grow th,
the result w ill not be 4 percent infla ­
tion instead of 6 percent; i t w ill be
much closer to 3 percent production
grow th instead of.5 percent. M aybe M r.
Burns’s slow m onetary cure fo r in fla ­
tion is the rig h t choice even though i t
im plies protracted stagnation w ith un­
em ploym ent 7 percent o r higher. B u t
President C a rte r’s goals— fu ll em ploy­
m ent, budget balance m any others—
w ould be doomed. W hether he reap­
points M r. Burns o r not th e President
w ill surely w ish to take this unique op­
portun ity to come to some understand­
ing about th e future course o f mone­
ta r y policy and its place in the general
economic s trategy o f the G overnm ent.
Jomes Tobin is S terling Professor of
Economics at Yale University.

208
ECONOMIC OUTLOOK. U.S.A.
Autumn 1977, Vol. 4, No. 4

The Economic Impasse: Is There A Way Out?
lames Tobin*
Sterling Professor of Economics
Yale University

The Faltering Recovery
After two and a half years of slow and incomplete recoveiy
from the 1974-75 recession, the world economy is faltering.
The advanced industrial countries as a group, the OECD area,
are slipping into a growth recession, perhaps worse. The United
States so far appears to be an exception. But here too the
pace of recovery is slowing and confidence in its future is low
and falling.
The OECD group, and the United States in particular, have
been aiming for full recovery in 1980-81, six or seven years
after the onset of recession. This was surely not an ambitious
timetable, but now we are significantly behind schedule. If
current weakness is allowed to develop into another recession,
in 1984 the noncommunist world may well be looking back
on a full decade of stagnation. The potential consequences
are frightening: among them are generations of youth denied
work experience, rampant protectionism between and within
nations, reduced long-run growth prospects after years of
subnormal capital investment, desperation in poor third world
countries deprived of export markets, social and political
instability spreading even beyond those Western European
democracies already vulnerable.

Inaction and Impasse
Facing those dangers, the major governments on whose
policies the course of the world economy depends are doing
little or nothing. Their inaction reflects in varying propor­
tions complacency and paralysis. Two of the three "locomo­
tives” of the world economic train, Germany and Japan, are
not unhappy with their large export surpluses, strong cur­
rencies, and relatively low or declining inflation rates; they
enjoy the international political and economic power they
derive from this state of affairs. Anyway, the unemployment
resulting from declining internal growth is mostly outside their
borders. The policy impasse in the United States', the third
and major locomotive, is the subject of this article.
The impasse is that our government cannot, by the conven­
tional monetary and fiscal tools of demand management,
engineer simultaneously significant reductions in both inflation
and unemployment. At any rate, it cannot do so within any
reasonable time, for example before the next Presidential
election. Yet the public, encouraged by politicians and pundits
of all persuasions, expects timeiy achievements on both fronts.
The Administration has promised to take us from 6% inflation,
7% unemployment in 1977 to 4% and 4%% in 1981.
Why do these modest goals seem so improbable? There
are several reasons. The principal one is simply that the hard
core inflation rate, about t>% is terribly stubborn. It is rein­
.
forced by. and reinforces, the inflation of labor costs, around
7% in wages but 9% in total hourly compensation. Since 1975
these rates have scarcely abated, in spite of substantial un­
employed labor and capacity (see Chart 1). It is true that the
double-digit inflation of 1973 and 1974 receded fairly quickly.
Most of that decline simply reflected the cessation, in some
cases the reversal, of the extraordinary increases in commodity
prices of those years. Continued improvement has been hard
*D r. Tobin was a member o f the President’s Council o f Economic
Advisors in 1961*62.




to come by, and would become even harder if unemployment
and excess capacity were further reduced. The present pattern
is solidly entrenched — in existing labor contracts, in expec­
tations, in widespread indexation, in patterns of emulation,
comparison, and neverrending catch-ups.

The Fed vs. Inflation
Like other central banks, the Federal Reserve regards the
conquest of inflation as its sacred duty. The Fed's determina­
tion to force disinflation by starving the economy for cash
balances ha» only been strengthened by the failure of the
policy to date. The Fed’s 1977 monetary targets — 4 to 6Yi%
for Ml. 7 to 9%% for M2 — seemed when announced inade­
quate for the projected 12% growth in dollar GNP, 6% real
growth combined with 6% inflation. Only a miraculous spurt
of monetary velocity, it seemed, could avoid collision between
the recovery and the Fed's targets. The miracle didn't happen.
The Fed has raised the Federal Funds rate nearly 200 basis
points since January but has not succeeded in holding monetary
aggregates down to target. The Fed's increases in interest
rates, triggering expectations of more to come, deserve much
of the blame for the 1977 bear market in stocks and for slowing
the recovery (see Chart 2).
While long term bond and mortgage rates have so far been
quite stable, continued rise of short rates, including the prime
rate, will soon affect those markets too. Residential construc­
tion has been a bright spot in the economic scene, but we are
not far from interest rate levels that will retard the flow of
funds into mortgage-lending institutions.

Chart 1. Q U A RTERLY C H A N G ES IN
AV ER A G E HO URLY COM PENSATION* AND
GN P IMPLICIT P R IC E D EFLATO R

•AvWQt hourly compensation •» •mpk>y««s nonfirm buwnMs Mctor
SourcM. U S. Opart m*nts ot
and Labor

209
Chart 2. R E C E N T M OVEM EN TS O F
TH E F E D E R A L FU N D S RA TE AND
COMMON ST O CK P R IC E S
Pwcam

indax*

full capacity.2 For some this is an empirical proposition. For
many others it is simply an implication of their faith in markets
— they work promptly to eliminate excess supplies or
demands, so smoothly that the economy is never far from its
equilibrium. It follows that full employment is whatever
employment rate we have.

The Failures of Current Policy

‘ Standard 1 Poor * price index of 400 industrial stocks
|1®41-43»100)
Source* Federal Reserve System; Standard ft Poor s Corooration

Yet in today's Looking-glass world of economic discussion,
the Fed is bn the defensive not for untimely increases in short
term interest rates but for permitting monetary growth to
exceed the Fed’s own targets. The critics include not only
Milton Friedman and the monetarist Shadow Open Market
Committee but the liberal chairmen of the House and Senate
monetary committees.1

The Monetarist Argument
Monetarists and their converts in central banks, here and
abroad, argue that the monetary authorities must not accom­
modate the ongoing inflation. But the most the authorities
can do is to restrict the growth of spending. They do not
control the split of nominal income increases between output
growth and price inflation. Given the stubborn momentum of
the price trend, the impact of monetary restriction is on real
output.
Some monetarists blindly ignore this fact. Some admit that
output and employment will suffer “temporarily" but contend
that markets will eventually accommodate wages and prices
to noninflationary monetary growth. The ultimate gain, they
assure us, is worth the initial pain; anyway we cannot escape
punishment for past sins. Some advocates of this policy believe
that a firm stance of “no accommodation,'* credible to business
and labor alike, will greatly accelerate the desired disinflation.
Many monetarists are quite content to retard output growth
because they believe the economy is already, with 7% un­
employment and 17% excess capacity, at full employment and
■Friedman. “W hy Inflation Persists.” Newsweek. O ctober 3. 1977.
SOMC Policy Statement of September 19.1977. issued by Allan Meitzer.
Cam egie-Mellon University. The press has reported criticisms of the
Federal Reserve for excessive monetary growth by Henry Reuss.
Chairman o f the Hou$e Banking Committee. Parren Mitchell. Chairman
of the House Domestic Monetary Policy Subcommittee, and W illiam
Proxmire, Chairman of the Senate Com m ittee on Banking, Finance,
and Urban Affairs.




Widespread acceptance of monetarist orthodoxy in business
and financial circles contributes to the current paralysis of
policy. As securities market investors, the wealthy may be
scared of the Fed's restrictive monetary stance. As influential
citizens, they so strongly support Chairman Bums that the
President hesitates to use his prerogative to appoint a new
Fed Chairman next January. Stymied on monetary policy, the
Administration and the Congress turn to fiscal measures.
Stymied again! Thanks in no small part to Burns* ridicule and
moral condemnation of the universal “rebate'* last spring, its
support evaporated and the President withdrew the proposal.
Further proving his fiscal conservatism and anti-inflationary
dedication, the President promises a balanced budget in 198081 and resolutely resists the temptation to stimulate a lagging
economy. But these and other efforts to please his predeces­
sor’s constituencies are not enough to gain their approval,
their confidence^ their investments — and, we may be sure,
their votes. They never are. As previous Democratic adminis­
trations have sooner or later found, the only way to make
American business prosper is to ignore the doctrinaire macroeconomic advice of its spokesmen.
Following their counsels of caution is proving counter­
productive in several ways. One argument for go-slow recovery
was to avoid inflationary bottlenecks and shortages, giving
business time to build new capacity. But without current and
prospective demand and profitability, there is little incentive
to undertake such investment. In real volume, non-residential
fixed investment still falls 5% short of its 1974 first quarter
rate. Intentions surveys show improvement — perhaps 6-8%
in real fixed investment —but not enough to sustain vigorous
recovery or to make up for past shortfalls. With industrial
common stocks selling at 1965 prices, while capital goods are
now twice as expensive, the climate is not favorable for an
investment boom.
Instead of capacity shortage in steel, for example, we face
a world-wide glut. The American steel industry and union are
mounting a powerful political campaign for protection against
imports, unbecoming though it may seem to those who remem­
ber the costly labor contract and the price increases of last
winter.
In a soft economy, the Administration is generally vulner­
able to pleas for protection of American jobs and profits; its
tactical response in textiles and television has been to yield in
substance while loyally adhering to free trade in principle.
Likewise, failure to restore prosperity and reduce unemploy­
ment has increased the obligations the government feels to
satisfy sectoral interests in inefficient and inflationary ways;
minimum wage increases, farm price supports and acreage
limitations, cargo preferences. Other Administration measures
and proposals, e.g. energy taxes and prices and social security
taxes, have intrinsic merit. But their effects on inflation statis­
tics. temporary to be sure but untimely, will do macroeconomic
damage unless monetary targets are raised to accommodate
them.
2H erb ert Stein. “ Full Em ploym ent at Last.” Walt Street Journal.
September 14. 1977. suggests the strong possibility that today's 7%
unemployment is full employment.
T h e Conference Board's Measure of Business Confidence. 75% in
M arch 1976 and 71% in M ay 1977, fell to 59% in August 1977.

210
they got the worst of Nixon's episodic wage and price controls.
Now everything is taboo, from full-fledged controls to advisory
guideposts — including even proposals, for prenotification and
hearings on major wage contracts and price increases, once
espoused by Chairman Bums, whose free enterprise credentials
are impeccable. The Council for Wage and Price Stability is
obliged to keep a low profile. The semi-official Labor-Management Committee moderated by Professor John Dunlop, former
Secretary of Labor, is an important avenue of communication
between the private sector and the federal government. The
one subject they do not discuss is the setting of wages and
prices.
The taboo, it is worth noting, does not reflect general public
opinion. Although, as anti-inflation hawks frequently remind
us. survey respondents regard inflation as a very serious, often
the most serious, economic problem, the remedy they instinc­
tively support is not tight money but direct control.4

Some Alternatives
Let me recapitulate. Carter, Burns, and Congress cannot
disinflate by conservative monetary and fiscal policies without
many more years of high unemployment and excess capacity,
carrying staggering economic costs and serious risks tc the
body politic. Quite possibly they cannot disinflate even with
those costs and risks. One alternative, clearly, would be to
accept the 6% inflation and to gear monetary and fiscal policy
to speedy completion of the recovery, relying on present and
future indexation to mitigate the costs of inflation, while
avoiding demand-pull accelerations of inflation in the future.
As preferable as this course would be to prolonged stagnation,
it is vety unlikely to be acceptable to a government so com­
mitted and a public so persuaded to whip inflation now. or
anyway some day. The only other possibility is to engineer
directly a mutual de-escalation of wage and price inflation. A
4% wage, 2% price inflation would have essentially the same
real results for all concerned as an 8% wage. 6% price pattern,
and would be much more pleasant. But how do we get there
from here?
It is now clearer than ever that President Carter made a
fateful mistake when he backed off his campaign rhetoric and
foreswore incomes policies of all kinds. He did so to reassure
nervous business and labor leaders, both of whom were certain

*Gallup Poll of December 1976 reported 46% in favor o f “having the
government bring back wage and price controls.*' 39% opposed. 15%
no opinion. Both in August 1971 and in August 1974 the same question
yielded 50% in favor. 39% opposed, 11% no opinion. T h e percentage
naming inflation or high cost of living as “the most important problem**
was 81% in September 1974 and in July 1977 reached its lowest point
since then, 32%.

Actual and Projected Economic Indicators
seasonally adjusted
Annual Data

Quarterly Data
ECONOMIC INDICATOR

ACTUAL
197S

1977

1976

Actual

1978

Proj.

3rd

1975 1976 1977

1601 16S1 1692 1727 1755 1811 1870 1911 1966 2023 2071 2121

1529 1706 1890

4th
1. GROSS NATIONAL PRODUCT
(annual rate, billion $)

PROJECTED

1st

2nd

3rd

4th

1st

2nd

3rd p

4th

1st

2nd

2. GNP IMPLICIT PRICE DEFLATOR
(1972-100)
130.2 131.4 133.1 134.6 136.4 138.1 140.5 142.3 144.4 146.5 148.6 150.8 127.2 133.9 141.3
3. GNP IN CONSTANT DOLLARS
(annual rate, billion 1972 $)

1230 12S6 1272 1284 1287 1311

1331

1343 1360 1375 1391 1405 1202 1275 1336

4. INDUSTRIAL PRODUCTION
(1967*100)

123

127

129

131

132

134

137

139

141

143

145

147

118

130

138

S. UNEMPLOYMENT RATE
(percent)

8.S

7.6

7.5

7.8

7.9

7.4

7.0

7.0

6.9

6.8

6.7

6.6

8.5

7.7

7.1

83.1

90.4

93.1

94.0

90.9

97.2 104.3 103.0 106.4 108.3 109.6 112.0

73.4

6. CORPORATE PROFITS
AFTER TAXES
(annual rate, billion $)
7. EXPENDITURES FOR NEW
PLANT and EQUIPMENT
(annual rate, billion S)

92.1 102.7

111.8 114.7 118.1 122.6 125.2 130.2 134.2 138.4 143.0 148.0 152.6 156.6 112.8 120.2 136.4

.

8 NEW PRIVATE HOUSING
UNITS STARTED
(annual rate, millions)

1.37

1.40

1.44

1.S7

1.77

1.76

1.90

2.05

2.06

2.06

2.05

2.03

1.16

1.54

1.94

9. CHANGE IN BUSINESS
INVENTORIES
(annual rate, billion $)

•3.6

14.S

18.3

21.S

•0.9

13.8

21.7

19.8

16.3

16.0

17.4

16.0 •11.5

13.3

17.9

10. CONSUMER DURABLE
EXPENDITURES
(annual rate, billion $)
11. NATIONAL DEFENSE
PURCHASES
(annual rate, billion S)

144.3 153.3 1S6.7 1S9.3 166.3 177.0 178.6 177.7 181.4 18S.2 188.9 193.0 132.9 158.9 178.7
86.7

86.3

86.0

86.4

88.4

89.7

93.4

97.3 100.0 102.0 104.2 106.8

83.9

86.8

95.1

^Preliminary data: line six is the estimate of the ASA-NBER panel of forecasters.
Sources: Projections: American Statistical Association-National Bureau o f Economic Research panel of forecasters, adjusted by Editor for
differences between actual and projected 1977:3 values. (Note: forecasts were released in August 1977.)
Actual Data: Departments o f Commerce and Labor, Board of Governors of the Federal Reserve System.




211
Guideposts with Rewards and Penalties

1971.

extra point on its profits for every point its wage increase
exceeds the guidepost. Similar incentives for avoiding mark­
up inflation might be necessary but are more difficult to devise.
In any case, the government might insure compliant workers
against real income loss by offering tax rebates in case cost of
living inflation fails to follow wages down. Certainly there would
be inefficiencies, distortions, inequities. These should not be
considered in a vacuum, but weighed against the colossal costs
of the orthodox route to disinflation. In present circumstances
we can afford to take some innovative risk; we can't afford
not to. The big question is this: Is there enough leadership
and statesmanship in Washington to guide us out of the
impasse?
October 1977

NEW PRIVATE HOUSIN G UNITS STA RTED

B U S IN E S S CAPITAL O UTLAYS

Toothless guideposts may be too ineffectual and full controls
too rigid. The most promising approach is to combine guideposts with rewards for compliance and possibly penalties for
noncompliance. These inducements could be built into the
tax system, along lines originally proposed by Henry Wallich
and Sidney Weintraub.* For example, give every firm and its
employees rebates of one point of their payroll taxes for eveiy
point by which their average wage increase for the year falls
short of the wage guidepost. In addition, tax every firm an
* Tax-Based Incomes Policy,” Journal of Economic Issues, June
“A

BDNomofOoMn

MWtom of Units

HIGH
MEOIUI
LOW

UNEM PLOYM EN T RA TE

C O N SU M ER D U RABLE OUTLAYS

PWCOTt

ACTUAL




PROJECTED

ACTUAL

PROJECTED

HIGH
MEDIUM
LOW

HIGH
MEDIUM
LOW

212
The Ohio State University

Journal of Money,
Credit, and Banking
Editorial Office
H agerty Hall
1775 C ollege R oad
C olu m bus, O hio 43210

February 14, 1978

P hone 614 422-7834

Congressman Parren J. Mitchell
Chairman
Subcxximittee on Domestic Monetary Policy
of the Cornnittee on Banking, Finance
and Urban Affairs
U.S. House of Representatives
Washington, DC 20515
Dear Congressman Mitchell:
Enclosed for your information is a brief response to
your inquiry concerning my views of monetary policy in
1977.
Thank you very much for asking.
Sincerely,
f a V-&
William G. Dewald
Professor of Economics
and Editor of JMCB

Enclosure




213
Statement
Evidence in recent years is persuasive that both monetary growth and
government spending have significant effects on aggregate demand over a
period of a year to a year and a half— a short period by conventional
monetarist wisdom.

But it isn't much consolation for advocates of dis­

cretionary monetary and fiscal policies because the evidence is also per­
suasive that changes in monetary growth and government spending have been
the major contributing factors to economic instability.
Though one cannot very sensibly attribute the shock of oil price in­
creases in 1974-75 to the monetary and fiscal authorities, it seems that
even in this instance they succeeded in making a bad situation worse by
first clamping on the monetary brakes in 1974 and subsequently stepping
on the monetary accelerator.

After inflationary expectations had been

cooled by the 1974-75 recession, the authorities managed to confound not
only U.S. citizens but interested parties around the world by reigniting
inflationary expectations.

The authorities were responsible for suc­

cessively higher annual rates of monetary growth in 1975, 1976, and 1977;
and this was not danped much by restrictive fiscal policies.
In 1977, there was something of a repeat of the 1974-75 experience.
Higher import prices and a hard winter in the first quarter of the year
generated seme price increases that damped real growth.

Late in 1976 and

early 1977 monetary and fiscal policy were also corrparatively nonexpansionary.

But later in the year, even as real growth slowed, both policies

as measured by accelerating monetary growth and government spending became
increasingly expansionary, raising expectations in the minds of consumers




214
and businesses about the prospect of stepped up inflation

followed by

restrictive policy actions and recession.
Though I do not care to make a fetish out of it, there appears sate
merit in directing the authorities in the future to aim at stabilizing
spending grcwth or aggregate demand growth rather than at moderating in­
flation or variation in the unemployment rate.

Aggregate supply vari­

ations because of bad crops, oil embargoes, strikes, blizzards, and the
like can certainly cause real problems.

But year in and year out in­

flationary and recessionary disturbances generally have come from the ag­
gregate demand side.

Since there are in fact quite paverful policies to

influence aggregate demand quickly, the authorities could contribute to
economic stabilization, compared with their historical performance, if
they simply aimed at stabilizing grcwth in aggregate demand or, in this
age of accountability, if they wDuld at least take responsibility for its
variation.




215

Associate^ Inc.
a S u b s id ia ry o f T h e C h a s e M a n h a tta n B ank, N .A .
9 0 0 17th S tre e t N .W ., W a s h in g to n , D . C . 2 0 0 0 6 (2 0 2 ) 7 8 5 -3 5 2 0
5 5 5 C ity L in e A v e n u e , B a la C y n w y d , P en n s y lva n ia 1 9 0 0 4 (2 1 5 ) 6 6 7 -7 3 5 0

T e le x : 8 3 1 6 0 9

January 19, 1978
The Honorable Parren J. Mitchell
U.S. House of Representatives
Subcommittee on Domestic Monetary Policy
of the
Committee on Banking, Finance and Urban
Affairs
Washington, D.C. 20515
Dear Mr. Mitchell:
Thank you for providing me with the opportunity to present my views on
the conduct of monetary policy.
The events of the past few weeks demonstrate the importance of maintaining
a vigilant check upon the persons responsible for the conduct of monetary policy.
During 1977, monetary policy was carried out in a reasonably effective manner.
However, during 1978, there appears to have been a significant, sudden tightening
of monetary policy, a potentially counter-productive move which may have been
related to the President's decision not to re-appoint Dr. Burns. I believe that
before the President reached his decision there was considerable pressure upon
Dr. Burns to maintain a policy consistent with both the President's and Congress'
economic goals. With the decision made, the Federal Reserve was then able to
concentrate more heavily upon the short run aspects of credit demand and financial
transaction which appear to have dominated Federal Reserve policy in the past.
The conclusions of my study, An Investigation of the Impact of Alternative
Monetary Policies on Recent Business Cycle Fluctuations, which was prepared for
your Subcommittee during 1976, include the following:
1)

Proper management of the money supply can aid substantially in the
nation's quest for economic stability and growth.

2)

Large oscillations in monetary conditions can have significant effects
upon income distribution and the composition of economic activity.

3)

In the operation of monetary policy there appears to be a serious
conflict between short run and long run economic aoals.

4)

Actual monetary policies followed by the Federal Reserve have been
pro-cyclical during the past ten years.

In total, this study indicates that historically there appears to have been
a tendency on the part of the Federal Reserve to overact to short run concerns




216
at the expense of achieving the country's economic goals. The experience of
1977 indicates that strong steady pressure by the government can help to counter­
act these pressures and insure that the Fed will be more responsive to the political
process. Of course, the question as to whether or not additional pressure will
lead to greater stability in monetary policy remains open. However, the limited
evidence for 1977 suggests that a slight reduction in the independence of the
Federal Reserve would not be harmful.




Sincerely yours

Leon W Taub
Vice President

217
An Investigation of the
I
mpact of Alternative M onetary Policies

qh

Recent Business

a study prepared
for

The Subcommittee on Domestic Monetary Policy
Committee on Banking , Currency ,and Housing
U.S. House of Representatives




Leon W Taub
Chase Econometric A s s o c ./ In c .
900 17th St r e e t , N.W.
Was h i n g t o n , D.C. 20006
Au g u s t , 1976

218
TABLE OF CONTENTS

Preface

i

Executive Summary

SECTION I

-

ii

INTRODUCTION

Project Description

1.1

A Description of the CEAI Macroeconmic Model

1.9

Simulation Capabilities of the CEAI Macroeconomic Model

1.16

Limitations of the CEAI Macroeconomic Model

1.22

SECTION II

-

DISCUSSION OF THE SIMULATIONS

1975, First Quarter

2.1

1973, First Quarter

2.7

1971, Third Quarter

2.24

1965, First Quarter

2.36

SECTION III




-

SUMMARY OF RESULTS

219

PREFACE

T h is

s tu d y

w as p e r f o r m e d

D o m e s t ic M o n e t a r y
H o u s in g

of

th e

E c o n o m e tr ic
The
of
D r.

P o lic y ,

U .S .

T a u b w as

L ea M u ts c h le r
G ay L a n e .




th e

on B a n k i n g ,

R e p r e s e n ta tiv e s

by

CEAI U n ite d

a s s is te d

S u b c o m m itt e e

by

on

C u rren cy

an d

C h ase

In c.

r e p o r t w as p r e p a r e d

CEAI u s i n g

th e

C o m m itte e

H o u se o f

A s s o c ia te s ,

fo r

by

and M ic h a e l

o th e r

L e o n W.

S ta te s
CEAI

D u rst,

Taub,

V ic e

P r e s id e n t

M a c r o e c o n o m ic M o d e l.
s ta ff

m em bers

in c lu d in g

R esearch A s s is t a n t s ,

and

220

EXECUTIVE SUMMARY
The purpose of this study is to examine the consequences of
alternative monetary policies for the United States economy during
the period 1965-1975 and to compare the simulated outcomes to the
course which the economy actually followed during that period.

The

alternative policies were designated in terms of fixed "rule-of-thumb"
monetary and "non-borrowed reserves" growth targets.
The most important conclusions which emerge from this study are
as follows:
1)

The actual monetary policies followed by the Federal Reserve

System during the last 10 years have been procyclical.

By contrast,

a rule-of-thumb monetary growth target type of policy would have led
to less severe recessions and, to some extent, less exuberant booms.
A wide variety of rule-of-thumb monetary growth targets would have been
more successful than the policies actually followed in meeting the
economy's need for stability, particularly during recession periods.
2)

The events of 1973-74 -- the quadrupling of frcc-market oil

prices by OPEC, the price increases in bauxite, phosphates and other
raw materials, the ending of wage/price controls, and the massive
devaluation of the dollar, among others -- were so serious that they
could not have been fully offset by monetary policy alone.

However,

had a more stable monetary policy been pursued, the 1974-75 recession
would have been significantly less severe.




221

3)

The choice of a level and/or starting point for a rule-of-thumb

growth target is at least as important as a decision to move to a ruleof-thumb type policy.

If a rule-of-thumb monetary growth target had been

chosen poorly or without regard to contemporaneous economic developments,
the result would have been a substantially worse economic performance than
was actually experienced during the 10 year period.
4)

Rule-of-thumb monetary growth targets can promote stable economic

growth if the target is based on a six-month average growth rate, and if the
target is subject to the constraint that quarterly changesi in reserves not
be negative.
5)

An attempt to attain an inflexible monetary growth rate target on

a quarterly basis can be destabilizing or can lead to oscillating changes in
reserves and interest rates.

Similarly, attempts to achieve a monetary growth

target without a constraint on reserves can lead to destabilizing and/or oscil­
lating changes in other monetary indicators.
6)

Single-quarter changes in short-term interest rates, which can result

from attempts to achieve a rigid monetary growth target, have relatively little
effect on long-term rates in'the affected quarters.

Nevertheless, large changes

in short-term rates do cause some economic instability, and can worsen the
prevailing inflation/unemployment tradeoff.

Also, large oscillations in

interest rates and reserve aggregates can have significant effects on income
distribution and on the composition of economic activity among the various
sectors of the economy.

In particular, investment seems to be depressed more

than consumption by oscillating monetary policies and interest rates.

22-761 0 - 78 - 15




222

7)

A rule-of-thumb reserves growth target yields results which

are closely akin to the simulated results of a monetary growth target,
while causing less instability in the short-term money markets and
slightly improving the economy's unemployment/inflation tradeoff.
8)

An examination of several monetary aggregates taken together

can often provide a better indication of monetary conditions and the
direction of monetary policy than an analysis of just Ml (currency
plus demand deposits) alone.
9)

There appears to be a serious conflict between short-run and

long-run economic goals in the United States.

In the short-run, an

expansionary monetary policy increases real growth much more power­
fully than it increase inflation.

However, in the longer-run (beginning in

three to four years), a more expansionary monetary policy leads to a
significant increase in the rate of inflation and a shift in the potential
unemployment/inflation trade-off to a more unfavorable position.

In

addition, by approximately the tenth year after the institution of the
expansionary monetary policy, the increase in inflation becomes so great that
the economy actually begins to grow more slowly under a ’
’
more expansionary"
policy.

(While this slowdown in real growth could presumably be

postponed by further increases in monetary growth rates, traditional
economic wisdom holds that a policy of "escalating the speed of the
treadmill" will have an extremely unfavorable end result.)
10) Proper managment of the monetary aggregates requires that the
designated authorities take into account forecasted, as well as historical,
economic conditons.

Changes in monetary policy should me made with

great care, since monetary policy has substantial long-run as well as
short-run economic consequences.




223

In interpreting the results of this study, it is important to note
that the prices of some critical primary goods -- food, fuel, and imported
goods — are assumed to be exogenous.

This is the assumption usually made

when simulating the Chase Econometrics Macroeconomic Model, since prices
of these critical primary goods are often dominated by outside events
such as changes in the weather, actions of cartels, political crises,
and foreign regulations and currency market interventions.

For short-

run simulations, the lack of response of these exogenous prices is unlikely
to be a serious shortcoming.

In the longer-run simulations, however, these

exogenous prices could have led to a significant understatement of the
inflationary impact of monetary policy and to an overstatement of the real
growth impact.

This possible source of error could have been avoided by

linking satellite models to the Chase Econometrics Macroeconomic Model.
However, such a task would have exceeded the time and cost constraints
of this project and hence has been reserved for future study.




224
SECTION

I

INTRODUCTION
1

.1

PROJECT DESCRIPTION

It has often been argued that monetary policy has accentuated rather
than dampened the business cycle in the United States.

In 1957, Milton

Friedman, after analyzing the course of monetary policy, concluded, , The
f
record is one of repeated mistakes in the use of existing

monetary policy

tools, mistakes that were themselves a major source of economic instability."1
These arguments are usually based upon the apparently excessive rates of
growth in money supply which seem to precede almost every boom, as well as
the much smaller rates of growth (and even contractions) which seem to pre­
cede every trough.
The most outrageous example of this was in 1929-1931.

Although the

peak of the 1929 boom (as estimated by the National Bureau of Economic
Research) was in June. 1929, the New York Federal Reserve Bank raised the
discount rate (from 5 percent to 6 percent) as late as August, 1929.

From

June, 1929, to Scptemeber, 1932, the money supply fell 11 percent and total
Reserve credit fell approximately 33 percent!
Fortunately, the experience of 1929-32 has never been repeated. However,
the improvement seems to have been one of degree rather than direction.

As

shown in Figure 1.1, the "money supply growth test" indicates that the same
type of pro-cyclical monetary policy has accompanied each of the post-war
business cycles.

(Recession periods as designated by the National Bureau

of Economic Research are shown as shaded.)

For example, the money supply

grew approximately 8.4 percent in 1972 and 6.2 percent in 1973.

In 1974,

despite (or because of) the huge exogenous price increases caused by OPEC,
the ending of wage-price controls, the devaluation of the dollar, and the
^Consumer Installment Credit, Part II, Volume 2, National bureau of Economic
Research and the Board ot Governors of the Federal Reserve System, 1957, p. 101*




PERCENT CHANGE IN Ml MONEY SUPPLY
YEAR TO YEAR

1.1

PERCENT

FIGURE




226
1.3

jump in worldwide commodity prices, the money supply grew only 5.1 percent.
During the first quarter of 1975, the money supply grew at an annual rate
of less than 1 percent.

Similar graphs showing alternative measures of

monetary conditions tell the same story.

For example, one measure of

monetary policy often used by Chase Econometric Associates, Inc. (CEAI)
is the non-borrowed monetary base minus the currency.

This measure closely

approximates non-borrowed reserves, adjusted for changes in reserve requirements.
The non-borrowed monetary base minus the currency component grew rapidly through
the end of 1972. However, its growth then became extremely erratic. The nonborrowed monetary base minus currency grew less than 3/4 of one precent during
the first half of 1973,
three quarters.

but then grew almost 6 percent during the next

These rates of growth might not have been too harmful,

but beginning in the second half of 1974 a powerful squeeze was put on the
money markets and the non-borrowed monetary base minus currency fell
almost 1.5 percent!

The change in monetary conditions from the perspective

of the non-borrowed monetary base minus currency (NMBXC) is shown in Figure 1.2.
The behavior of interest rates also seems to indicate that Fed policy
accentuated rather than moderated the business cycle.

As late as the third

quarter of 1972, when the boom was clearly established, the 90 day Treasury
bill rate averaged less than 4.25 percent!

Just as short-term rates were

slow to rise during the recovery, they were also slow to fall as the economy
weakened.

During the fourth quarter of 1974, the 90 day Treasury bill rate

was still well above seven percent.

In fact, after dropping to 5.4 percent

in the second quarter of 1975, the 90 day Treasury bill rate again rose to
6.33 percent during the third quarter.

The post-war relationship between

the Treasury bill rate and the business cycle is shown in Figure 1.3.




PERCENT CHANGE IN NMBXC
YEAR TO YEAR
16.0

12 .0
FIGURE
1.2




SI 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76
DATE QUARTERLY * 1/51 - 1/76

1.3




FIGURE

PERCENT

RATE ON 3-MONTH TREASURY BILLS

229

The tendency to ease monetary conditions significantly during a recovery
and then suddenly tighten them before a peak has resulted in monetary policies
which at least initially seem inappropriate and overly erratic.
Judgmental analysis, based on graphs such as the ones shown here,
can be extremely useful in highlighting the problems and presenting the
implications of recent Fed policies.

However, judgmental analysis

provides, an incomplete understanding of many crucial aspccts of the
Fed's policies.

Econometric models add to judgmental analysis by pro­

viding estimates of the consequences of alternative types of monetary
policies which might have been followed, and by providing quantative
answers to questions such as:
. After considering the nature of the lags in our economic
system, did monetary policy add significantly to post-war
economic instability?
. Would "rule of thumb" monetary policies have been more
counter-cyclical than the policies actually followed?
. How much less (more) unemployment would have resulted had
various "rule of thumb" monetary policies been followed?
. How much less (more) inflation would have resulted had
various "rule of thumb" monetary policies been followed?
When would changes in policy have to be made in order
to ameliorate the impact of the business cycle?
To throw light on questions such as these, the Subcommittee on Domestic
Monetary Policy of the House Committee on Banking, Currency, and Housing com­
missioned Chase Econometric Associates, Inc. to use its macroeconomic model of the
economy to investigate the impacts of possible alternative monetary policies
on recent business cycle fluctuations.

In particular,Chase Econometrics

was asked to calculate what the impact w o u l d have been of various types of
monetary policies designed to be less erratic than the ones actually pursued.




230
1.7
Although it was undoubtedly hoped that at least some of the policies, some
chosen with the art of hindsight and others consistent with long prescribed
Monetarists' rules, would prove to be extremely good policies and would serve
as a model for future policies, the major objective of the study was to test
a variety of less erratic policies to determine if the extra stability alone
would have been beneficial.

Toward that end, the staff of the Subcommittee

specified that the wide variety of simulations listed below be performed.

Simulation
Number

Starting
Date

Subsequent Quarter Ml
Annual Growth Rate Targets

1

1975, First
Quarter

10 percent in each quarter.

2

1973, First
Quarter

Continue at 9 percent.

3

1973, First
Quarter

8.75%, 8.5%, 8.25%, 8%, 7.75%, 7.5%,
7.25%, 7%, 6.75%, 6.5%, 6.25%, 6%,
5.75%.

4

1971, Third
Quarter

5.75%, 5.5%, 5.25%, 5%, 4.75%, 4.5%,
4.25%, 4%, Continue at 4 percent.

5

1965, First
Quarter

4.25%, 4.5%, 4.75%, 5%, 5.25%, 5.5%,
5.75%, 6%, 6.25%, 6.5%, 6.75%, 7%,
7.25%, 7.5%, 7.75%, 8%, Continue at
8 percent.

6

1965, First
Quarter

Continue at 4 percent.

7

1965, First
Quarter

3.75%, 3.5%, 3.25%, 3%, 2.75%, 2.5%,
2.25*, 2%, 1.75*0, 1.5 o, Continue at
1.5*.




231
1.8

In addition, CEAI performed the following simulations.
Annual Monetary Targets

Starting Date
1973, First Quarter

9 percent Ml growth but with a restraint
upon contractions in the non-borrowed
monetary base minus currency.

1973, First Quarter

8 percent growth in the non-borrowed
monetary base minus currency.

1971, Third Quarter

2.2 percent growth in the non-borrowed
monetary base minus currency.

1965, First Quarter

Steady growth in the non-borrowed
monetary base less currency at its
average rate for the 1965.1-1976.1
period.

These simulations were devised by the staff of CEAI as interesting variants
of the simulations suggested by the staff of the Subcommittee.
In order to gauge the usefulness of these simulations, it is important
to have a general understanding of the CEAI Macroeconomic Model and its
simulation capabilities.

A brief description of the model and a discussion

of its simulation capabilities are presented in the remaining three portions
of this Section.

Sections II and III respectively contain a discussion of

each simulation and a listing of the major results of each run.




232
1.9

A DESCRIPTION OF THE CEAI MACROECONOMIC MODEL

GENERAL
When econometric models were first developed, it was fashionable
to call them "Keynesian" or "monetarist", according to the philosophical
bent of the author and the lines along which the model was constructed.
Before long, it became clear that all of these models had serious d e ­
ficiencies.

As Haberler has pointe&*Out, may theories of the business

cycle seem to have considerable validity and it is foolish to claim that
a single relationship is the exclusive cause of business cycles.

2

If a

single business cycle hypothesis is absurd, no model with a single set
of causal relationships can possibly claim to describe reality.
Recognizing this truism, most model builders have expanded their
models to include a wide variety of empirically valid relationships.
A major strength of multivariate econometric techniques is that they are
able to handle these diverse relationships.

In fact, to use econometric

techniques properly, an economist must attempt to include all economically
valid links in each equation.

A model which is built to describe only one

type of linkage is almost certain to be econometrically unsound and yield
poor forecasts and simulations.
The CEAI Macroeconomic model is most properly termed an "eclectic"
model, since it incorporates many empirically verifiable components of a

^Haberler, Gottsfreid, Prosperity and Depression, George Allen and Univin,
London, 1964, P. 361.




233
1. 10

wide variety of economic theories.

An economist looking at the income

multipliers in the consumer durable functions would probably call the
Model "Keynesian11, yet the same economist looking at the well developed,
simultaneous and lagged links between the real and monetary sectors would
be justified in calling the model "monetarist".

The specification of the

consumer non-durable and service functions provides strong empirical
support for Friedman's permanent income hypothesis; the wage and price
sectors embody, in part, a "Cambridge" factor-cost theory of price
determination, and the treatment of the financial aspects of investment
and savings would be acceptable to most "neo-classical" economists.

Even

a "Marxist" would find consolation in the relative income terms which enter
into each of the consumption functions.

While it is not possible to

incorporate all valid economic relationships in a finite model, the CEAI
Model does incorporate many of the diverse economic relationships which
exist.

The great strength of the CEAI model is the skill with which these

relationships have been tested, combined, and quantified.

OVERVIEW

The Chase Econometrics Macroeconomic Model is a regression-based
model of the United States economy.

It can be used to analyze the

consequences of economic and political events on approximately 470
volatile economic indicators.

Forecasts are generally prepared ten

quarters into the future on a quarterly basis and ten years into the




234
l.n

future on an annual basis.

However, even on a quarterly basis, the

model satisfies the requirements of long run homogeneity, and can
therefore be used for long-run as well as short-run simulations 4itd
forecasting.

The major sectors of the model and a brief description

of the economic theory behind them are presented below. A copy of the
full equation book of the CEAI U.S. Macroeconomic Model has been made
available to the staff of the Subcommittee.
Consumption of Durable Goods - Purchases of durable goods are treated
as a substitute for saving.

When faced with a change in income, consumers

have the choice of either saving their income in liquid form or adding to
their stock of durables.
short.

As such, the lags on the income term are generally

The maximum lag is four quarters and the average lag is one quarter.

Credit availability is also important, since purchases of durable goods
fall during periods of monetary crunches.

Other important variables in

this sector include relative prices, changes in the distribution of income
(primarily among profit type income, wages, and transfer payments), the
unemployment rate (as an expectational variable), housing starts, and
demographic variables.
Consumption of Nondurables and Services - The model uses a modified
permanent income hypothesis to forecast consumption of nondurables and
services.

Changes in this sector occur relatively slowly in response to

changes in income.
in the sector.




Of course, the impact is different for each variable

The lags for consumption of clothing are almost as short as

235
1.12

in the durable goods equations.

At the other extreme they extend to

fifteen quarters for consumption of housing services.

Relative prices

and changes in income distribution are also important in these functions.
Investment in Plant and Equipment - Investment in plant and equipment
is predicted through an Evans "double-peaked" investment function.

In the

short run,output is quite important in determining investment as a modifi­
cations variable.
long lags.

However, the major determinants of investment occur with

They include output, as well as the financial desirability of

additional investment.

The last term, the financial desirability of addi­

tional investment, is calculated following D.W. Jorgenson's work on the
rental cost of capital.

The lags on this term are such that the primary

influence occurs with a one-to-two-year lag, depending upon the type of
investment being considered.
Investment in Residential Structures - Housing starts are determined
by both demand variables (income, population, the unemployment rate, and
the stock of unsold homes), and supply variables (credit availability in
various nonlinear and asymmetrical forms).

Of these factors, the most

important in the short run is credit availability.

As will be noted in

the discussion of the monetary sector, the Chase Model is unique in including
non-price credit rationing as a key variable in the monetary sector. The
variable is important in predicting housing starts as well as consumption
of durables.
Government - The government revenue equations are quite straight­
forward.

In general, each type of revenue is predicted as a function of

an endogenous tax base (e.g. wages, coporate profits) and an exogenous
tax rate.

All equations are in level form except for social security

contributions which are in first difference form.




Most government

236
1.13

expenditure variables are exogenous, the major exception being unemployment
benefits.

In the short run, government expenditures have a greater impact

on the economy than changes in taxes or changes in transfer payments.
However, these types of expenditures also tend to be more inflationary
than changes in the tax structure or transfer payments.
retard consumption and slow down the economy.

Higher prices

Therefore, in the long run,

tax changes actually have a greater multiplier than government purchases.
The major exception to this "rule” is that government expenditures which
increase labor productivity lower prices and have the highest multiplier
of all.

After four quarters the multiplier for defense expenditures is

approximately 2.3; non-defense expenditures,1.1; personal income tax pay­
ments , 1.4.
The Monetary Sector - The principal exogenous variable in the monetary
sector is the non-borrowed monetary base minus currency.

This is roughly

equivalent to non-borrowed reserves adjusted for changes in the reserve
requirements, although"non-borrowed reserves"of non-member banks are also
included.

In the remainder of this report, when the phrase "non-borrowed

reserves" appears in quotation marks, it should be understood to refer
to this variable. Under current conditions, a one percent change in non-borrowed
reserves changes constant dollar GNP by approximately 0.1 percent.

Changes in

"non-borrowed reserves" flow through the federal funds rate to affect other short­
term interest rates.

Other variables affecting short-term interest rates include

the inflation rate, the government deficit, the private sector demand for
funds, and the rate of economic activity.

Long term interest rates are

determined by the inflation rate with very long lags (up to eighteen quarters),
the volume of new corporate issues, and corporate industrial production,
cash flow, and investment plans.




Short-term interest rates are also

237
1.14

significant in determining long-term rates.

However, the "elasticity"

is asymmetrical and nonlinear, and ranges from 0.2 to 0.4.
The money supply equations are reduced-form equations including
terms such as income, total savings, the inflation rate, and the non­
borrowed monetary base minus currency.

Changes in interest rates are

also used to capture the shifts betwsen the various monetary aggregates.
The equation for loans is quite important since it enters many of the
monetary equations,including the equation which predicts credit rationing.
Loans are a function of interest rates, investment, production, cash
flow, and (with a negative sign) the value of corporate bond issues.
The term for non-price credit rationing is unique to the Chase Model.
Credit rationing has three components: Ml, the ratio of loans to deposits,
and deposits of funds in thrift institutions. This term is very useful
since it measures monetary tightness not reflected in interest rates,
either because of institutional rigidities, non-price market discrimination,
or wage/price restraints.
Prices and Wage Rates - The price sector is extremely important to the
Chase Model.

Increases in the inflation rate reduce consumer expectations,

depress jfeal income, raise interest rates, and cause tighter monetary conditions
(assuming cet. par, monetary policy). The tightened monetary situation,in turn,re­
duces both consumption and investment. The key exogenous variables in the price
sector are prices received by farmers,the wholesale price index for petroleum,and
the price of imported raw materials.

These prices flow through the other

wholesale price indices to the total wholesale price index.

They then flow

through the consumer price indices to the total consumer price index.

Both

the wholesale price index and the consumer price index are determined through
identities.

The GNP deflators are then calculated through the aforementioned

22-761 0 - 78 - 16




238
1.15

price indices.

Wage rates are determined by the previous level of in­

flation, the unemployment rate, the rate of capacity utilization, and
the change in production.

Wage rates are then used to calculate normal

unit labor costs,which in turn are a significant input in the price
equations.

It is important to note that in the Chase Model, a tightening

in money supply results in higher interest rates, the short-run impact of
which is a higher rate of inflation than would ordinarily occur.

This

relationship explains a portion of the behavior of the economy in mid1974.

Of course, the long-run (1 year +) impact of tighter monetary policy

is a reduction in inflation.
Output and Income - Once the level of final sales inventories, prices,
and wage rates have been forecasted, the calculation of income is quite
straightforward.

Output and man-hours worked are direct functions of final

sales plus inventories.
week.

Employment is computed by average hours worked per

Total wages are simply equal to the wage rate times man-hours.

Once

supplements are added to total wages (supplements are endogenous but are primarily
a function of other labor income,which is exogenous), the total wage bill to
the employer can be calculated.
profits.

One key equation in the income sector is

Profits are a function of output, capacity utilization, prices,

unit labor costs, and the ratio of investment to GNP.
directly affect corporate profits.

Interest rates also

Peak capacity is calculated through a
o<

Cobb-Douglas production function of the form Output * A (K)
whereof®

1/3.

By calculating this production function,

(L)

| -oc y f

e

we can define

capacity utilization in such a way that changes in investment and employment
affect the calculation of peak capacity.

This methodology provides a better

estimate of capacity utilization than is used in most models, and is very
important in correctly predicting prices and investment.




239
1.16

SIMULATION CAPABILITIES OF THE CEAI MACROECONOMIC MODEL

No model could ever simulate actual economic conditions perfectly.
Even an ideal model would fail to capture movements in the published data
which reflect random disturbances and normal errors in data collection.
Therefore, before the main part of the work on this project could commence,
it was necessary to create a series of baseline scenarios.

Each experi­

mental simulation could then be compared to its own baseline with full
confidence that all differences were caused by the changes made, rather
than by any possible spurious simulation characteristics of the model.
To prepare the baseline simulations, the CEAI model was used to
"forecast the past."
starting-point

A simulation was prepared beginning in each of the

quarters, and running through the first quarter of 1976.

Hie version of the model used, May 1976 (Version 29), was the most recent
version available at the time the project was begun.
each of the exogenous inputs were fed into the model.

The actual values of
No adustments of

any type were made to the constant terms of the equations in the model.
The results of these simulations are shown on Tables 1.1 - 1.4.
This procedure for creating the baselines provided an extremely power­
ful test of the model's simulation capability.

In the most extreme case, the

model was called upon to "forecast" for well over 10 years with no "model
management" of any type.
As shown in Table 1.1, the model proved itself to be

an

extremely good

representation of the economic relationships which determined the course of
the economy since 1965.

Even during 1975, the last year of the simulation

period and perhaps the most difficult post-war year to simulate, the cumulative




240
1.17

error in real Gross National Product was less than 2 percent.

The cumulative

inflation discrepancy, as measured by the Consumer Price Index, was less
than 4 percent.

Since these two small errors offset each other, current-

dollar Gross National Product was predicted within .1 percent!

For most

variables, the average absolute error was approximately 1 percent, which is
very close to being within the error tolerance of the data.

The model was

able to capture both the timing and the severity of all peaks and troughs
and showed no tendency to explode or to tail off into a depresssion.
The other baseline simulations yielded similar results; the comparisons
are shown in Tables 1.2 - 1.4.

In each simulation, the model proved to be

extremely capable of determining the economic consequences of a wide range
of exogenous shocks and major policy changes.




SIMULATION CAPABILITIES OF THE CEAI MACRO-ECONOMIC MODEL
Table 1.1

“

1965 First Quarter Simulation
(Actual Exogenous Inputs)

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

Gross National Product
(Current Dollars)
Actual History
688.1
Baseline
690.9
Difference
-2.8
% Difference
-.4

753.0
741.6
11.4
1.5

796.3
808.6
-12.3
-1.5

868.4
887.4
-19.0
-2 . 2

935.5
934.0
1.5

982.4
986.8
-4.4
-.4

1063.4
1072.8
-9.4
-.9

1171.1
1189.9
-18,8
-1 . 6

1306.3
1320.2
-13.9
-1 . 1

1406.9
1416.0
-9.1

1498.9
1497.4
1.5

Gross National Product
(Constant Dollars)
Actual History
925.9
918.7
Baseline
Difference
7.2
.8
% Difference

981.0
945.1
35.9
1.9

1007.7
991.6
16.1
.5

1051.8
1043.3
8.4

1078.8
1050.8
28.0

1075.3
1060.7
14.6
1.3

1107.5
1106.7

1171.1
1189.0
-17.9
-1.5

1233.4
1251.2
-17.8
-1.4

1210.7
1233.4
-22.7
-1.9

1186.1
1208.1
-2 2 . 0
-1 . 8

4.5
4.2
.3

3.8
4.2
-.4

3.8
4.1
- .3

3.6
3.8

3.5
4.6
-1 . 1

5.0
5.8

5.9

5.6
5.4

4.8
4.4
.4

5.6
5.3
.3

S .3
7.9
.4

94.4
94.4

97.3
97.8
-.5
-.5

104.2
106.2
-2 . 0
-1.9

109.8
111.7
-1.9
-1.7

116.3
117.0
-.7

133.1
129.3
3.8
2.9

147.7
142.2
5.5
3.7

161.2
154.9
6 .3
3.9

194.8
191.5
3.3
1.7

206.5
197.5
9.0
4.4

214.5
203.5

228.8
216.7
1 2 . 1

277.7
263.0
14.7
5.3

289.5
278.5

1 1 . 0

263.3
248.5
14.8
5.6

1965

Consumer Price Index
Actual History
Baseline
Difference
% Difference
Money Supply (Ml)
Actual History
Baseline
Difference
% Difference
Treasury Bill Rate
Actual History
Baseline
Difference




167.1
168.4
-1.3
-0 . 8
3.95
4.29
-.34

174.9
174.6
.3
.2

4.88
5.08
- . 2 0

10 0 .0

101.7
-1.7
-1.7
181.8
182.1
-.3
- . 2

4.33
4.98
-.65

- . 2

5.35
5.55
- . 2 0

2 .6

6.69
5.54
1.15

- . 8

- . 6

.8
.1

6 .1

-. 2
121.3
1 2 0 .8

.5
.4

5.1

5.3

6.44
4.35
2.09

4.34
3.13
1 . 2 1

.2

125.3
123.0
2.3
1 .8

245.0
231.5
13.5
5.5
4.07
3.29
.78

7.02
6.44
.58

- . 6

7.87
8.26
-.39

.1

1 1 . 0

3.8
5.82
6 .2 1

-.39

1.17a

Unemployment Rate
Actual History
Baseline
Difference

.8

.2

SIMULATION CAPABILITIES OF THE CEAI MACRO-ECONOMIC MODEL
Table 1.2
1971 Third Quarter Simulation
(Actual Exogenous Inputs)

1971

1972

19731974

1975

1063.4
1064.9
-1.5
-.1

1171.1
1171.6
-.5
-.04

1306.3
1303.7
2.6
.2

1406.9
1403.3
3.6
.3

1498.9
1491.1
7.8
.5

Gross National Product
(1972 Dollars)
Actual History
Baseline
Difference
% Difference

1107.5
1109.8
-2.3
-.2

1171.1
1177.7
-6 . 6

1233.4
1238.1
-4.7
-.4

1210.7
1219.5
-8 . 8
-.7

1186.1
1192.3
-6.2
-.5

5.9
6.0
-.1

5.6
5.5
.1

4.8
4.5
.3

5.6
5.4
.2

8.5
8.1
.4

Consumer Price Index
Actual History
Baseline
Difference
% Difference

121.3
121.6
-.3
-.2

125.3
125.6
-.3
-.2

133.1
133.1
0
0

147.7
147.0
.7
.5

161.2
160.7
.5
.3

Money Supply (Ml)
Actual History
Baseline
Difference
.^Difference

228.8
229.1
-.3
-.1

245.0
244.1
.9
.4

263.3
261.8
1.5

277.7
276.9
.3

289.5
292.9
-3.4
-1.2

4.34
4.20
.14

4.07
3.80
.27

7.02
6.80
.22

7.87
8.63
-.76

5.82
6.53
-.71

Unemployment Rate
Actual History
Baseline
Difference

Treasury Bill Rate
Actual History
Baseline
Difference




- . 6

.6

.8

1.17b

Gross National Product
(Current Dollars)
Actual History
Baseline
Difference
%Difference

SIMULATION CAPABILITY OF THE
CEAI MACROECONOMIC MODEL

T a b l e 1.3

1973 First Quarter Simulation
(Actual Exogenous Inputs)
1973

Gross National Product
(Current Dollars)
Actual History
Baseline
Difference
% Difference
Gross National Product
(1972 Dollars)
Actual History
Baseline
Difference
% Difference
Unemployment Rate
Actual History
Baseline
Difference
Consumer Price Index
Actual History
Baseline
Difference
% Difference
Money Supply (Ml)
Actual History
Baseline
Difference
% Difference
Treasury Bill Rate
Actual History
Baseline
Difference




1974

1975

1406.9
1397.1
9.8
.7

1,498.9
1488.1

1233.4
1224.2
9.2
.7

1210.7
1208.1
2.6
.2

1186.1
1183.5

4.8
4.9
-.1

5.6
5.8
-.2

8.5
8.4

133.1
133.8
-.7
-.5

147.7
148.0
-.3
-.2

161.2
161.8
-.6
-.4

263.3
264.8
-1.5

277.7
280.2
-2.5
-.9

289.5
296.4
-6.9
-2.3

1306.3
1295.6
10.7
.8

- . 6

7.02
6.95
.07

7.87
8.46
.59

10.8

.7

2.6

.1

.1

5.82
6.40
.58

S
oo

SIMULATION CAPABILITY OF THE
CEAI MACROECONOMIC MODEL

1975 First Quarter Simulation
(Actual Exogenous Inputs)

1975.1

1975,2

1975.3

1975.4

1976.1

Gross National Product
(Current Dollars)
Actual History
Baseline
Difference
% Difference

1433.6
1446.2
-12.6
-.9

1460.6
1463.1
-2.5
-.2

1528.5
1519.9

1572.9
1570.8

Gross National Product
(Constant Dollars)
Actual History
Baseline
Difference
% Difference

1158.6
1170.6
-12.0*
-1.0

1168.1
1167.4
.7
.1

1201.5
1188.7
12.8
1.1

8.1
7.8
.3

8.7
3-7
0

Consumer Price Index
Actual History
Baseline
Difference
% Difference

157.0
157.7
-.7
-.4

159.5
160.2
-.7
-.4

162.9
163.8
-.9

Money Supply (Ml)
Actual History
Baseline
Difference
% Difference

282.6
285.3
-2.7

287.8
291.6
-3.8
-1.3

292.9
296.0
-3.1
-1.1

5.40
6.71
-1.31

6.33
6.54
-.21

Unemployment Rate
Actual History
Baseline
Difference

Treasury Bill Rate
Actual History
Baseline
Difference




- . 1

5.87
6.64
-.77

8 .6

2.1

1619.2
♦1600.2
19.0

.6

.1

1. 2

1216.2
1207.2
9.0
.7

1241.2
1217.3
23.9
1.9

8.5
9.0

7.6
9.1
-1.5

8 .6
8 .6

0

-.5

165.5
166.3
-1.3
-.8

- . 6

294.7
299.9
-5.2
-

1.8

5.68
6. 21

-.53

167.1
168.6
-1.5
-.9
296.9
303.5
-

6.6

-

2.2

4.95
5.41
-.46

245
1.22

LIMITATIONS OF THE CEAI MACROECONOMIC MODEL

If one is desirous of testing the economic consequences of past
and proposed policy actions, one must use models.

Economics is different

from sciences such as physics, biology, or chemistry, since in economics
it is not possible to perform experiments on test samples and observe
the results.

Econometric models are the only way to test economic policies

under conditions in which all other factors are held constant.
All models of the economy are, of course, limited.
infinitely complex and models are finite.

The world is

Even worse, there are many

relationships in the economy which are only partially understood by
economists.

Also, the data which economists must use to construct their

models are limited, imprecise, and often subject to revision.

At CEAI,

we are acutely conscious of the limitations as well as the strengths of
our models.
There are four

major limitations of the CEAI U.S. Macroeconomic

model of which the reader should be aware, before reading Section II of
this report.

First it must be realized that some prices—primarily oil,

farm goods, and imported raw materials—are taken to be exogenous.

(Many

components of these products are forecasted using other CEAI models.
However, only the macroeconomic model was used for this project.)

It is

certainly possible that large changes in the U.S. money supply could have
some effect upon these prices which the CEAI macroeconomic model cannot
capture.

Nevertheless, this problem is unlikely to be significant except

perhaps in the long-run simulations.
Second, it is very difficult to capture the economic changes which
result from changes in asset holdings. Wherever possible (such as in the




246
1.23

automobile and housing start equations), CEAI has tired to capture asset
effects.

However, we do not attempt to predict or simulate the stock

market, nor do we attempt to make judgments such as, "A six-month decline
in the stock market will not cause stock holders to re-evaluate their real
wealth but an eight-month decline will."

Since data on consumer asset

holdings in the United States are so poor and forecasts of these holdings
would require one to forecast the stock market, many linkages in this
area must be omitted.
The United States has not experienced a hyper-inflation in the post­
war period.

From other countries' experiences, we know that in hyper-

inflationary conditions some economic relationships are completely
reversed.

(Consumers normally consume less as prices increase.

in a hyper-inflation there is a flight from cash.)

However,

Thus, the model is un­

likely to be able to simulate those conditions which will lead to or
involve a hyper-inflation.
Finally, in the real world, lag structures are likely to be continuous,
while in a model they must be discrete.

Thus, a model's simulations may

indicate certain oscillations which would be far more dampened in actual
experience.

Therefore, to interpret the simulations, one should look at

emerging and continuing trends rather than a single isolated quarter.




247
SECTION

DISCUSSION

OF

II

THE

SIMULATIONS

2. 1

1975, First Quarter

1974

was a year of great uncertainty.

Despite a significant slow­

down in real income, final sales, and production, many observers did not
recognize until the very end of the year that a true recession
us.

was upon

The first simulation presumed that the Fed followed its actual policies

through 1974, but that beginning in the first quarter of 1975 it took an
extremely strong anti-recessionary stance.

The assumed implementation of

this stance was in the form of a target annual growth rate of 10 percent in Ml.
The simulation indicates that this policy would have been only partially
successful. By the end of 1975,(when the economy was growing rapidly even under
the baseline (actual history,) assumptions, real GNP would have been only .5 percent
higher and the unemployment rate only
the baseline.

.2

percentage points lower than under

Short term interest rates would have moved somewhat erratically,

with a peak at the end of 1975.

While the short-run effect on inflation would

have been negligible, the money supply was more than 3.5 percent higher than
in the baseline, implying that this simulation probably would have shown
growing inflation through 1976 had the simulation been continued.
An attempt to continue the 10 percent growth-rate policy in the first
quarter of 1976 would have had extremely serious consequenccs. The model
indicated that no reasonable open market policy operations would have been
sufficient to cause Ml to grow 10 percent in that quarter.

(Money market

observers are well aware of the difficulties the Fed encountered in reaching
for its more modest growth-rate target.)

In the actual simulation we

expanded the monetary base by $4 billion in 1976.1.

This resulted in Ml

growing 5.5 percent, while M2 and M4 grew 13.3 and 15.6 percent respectively.




248

It could certainly be argued that these growth rates were consistent
with the type of policy desired.
During 1976.1, real GNP was .9 perccnt higher under this scenario.
However, a wage-price spiral was clearly beginning to develop.

Despite

the substantially lower interest rates caused by the large increase in the
monetary base, both the Consumer Price Index and the implicit GNP deflator
were

.2

points, or approximately

. 1

percent, higher than in the baseline.

The wage rate in manufacturing was .4 percent above its baseline value.
The results of this simulation are shown in Table 2.1 and Figures 2.1 and
2 *2 ’

CONCLUSIONS
1)

If Fed policy is designed to react to recent economic conditions

rather than to forecasted conditions, it can only be of limited use in
ameliorating the severity of recessions, even disregarding the obvious
problem that before the peak, the policy will be aimed in the wrong direction.
After the peak has been observed to have passed, even a quick reaction by
the Fed will be late.

The simulation indicates that the lags in monetary

policy are so long that the recession is likely to be over before much of
the policy’ impact is felt.
s
2) The lag between a change in monetary policy and its impact on in­
flation is substantially longer than the lag between the change in policy
and its impact on real growth in a recessionary environment.
3)

Attempts to achieve a high monetary growth target in a single

quarter may prove futile.

The expansion of reserves necessary to achieve

a 10 percent growth rate of Ml in 1976.1 would have been so great that it
would have flooded the economy with liquidity.




MAJOR ECONOMIC INDICATORS
1975 10 Percent Ml Growth vs. Baseline

1975.3

1975.4

1975.2

Gross National Product
(Current Dollars)
10% Ml Growth
Baseline
Difference
% Difference

1447.1
1446.2
.9
.1

1467.9
1463.1
4.8
.3

1526.4
1519.9
6.5
.4

1580.3
1570.8
9.4

Gross National Product
(Constant Dollars)
10% Ml Growth
Baseline
Difference
% Difference

1171.5
1170.6
.9
.1

1171.9
1167.4
4.5
.4

1193.6
1188.7
4.9
.4

1213.3
1207.2
6.1
.5

Wage Rate in Manufacturing
10% Ml Growth
Baseline
Difference
% Difference
Consumer Price Index
10% Ml Growth
Baseline
Difference
% Difference
Treasury Bill Rate
10% Ml Growth
Baseline
Difference




4.69
4.68

.6

5.02
5.01

1976.1

1616.9
1600.2
16.7
1.0

1228.5
1217.3
11.1
.9

4.77
4.77

4.89
4.88

5.17
5.15

. 01

.01

.01

.02

.02

.21

.14

.21

.32

.40

157.7
157.7
.0

160.0
160.2
-.2

163.5
163.8
-.3

166.8
166.8
.0

168.8
168.6
.2

.0

-.1

-.2

.0

.1

5.41
6.64
-1.23

4.33
6.71
-2.39

6.81
6.54
.26

6 .8 6

6.21
.65

3.10
5.14
-2.31

TABLE

1975.1







252
2 .6

4)

Since the relationship between changes in reserves and changes in

money supply contains a significant lag, attempts to achieve a high monetary
growth target in a single quarter may result in so great an addition to
reserves that excessive tightening may be required in subsequent quarters.
(The required increases in reserves in 1975.1 and 1975.2 were so great that
to achieve a steady 10 percent Ml growth rate, it was necessary to decrease
"non-borrowed reserves" during 1975.3.)

Thus, attempts to slavishly achieve

a given Ml target in every quarter may result in severe oscillations in
monetary policy.
5)

Several monetary aggregates should be used in conjunction with Ml

to determine monetary conditions and the impact of a given monetary policy
since institutional changes, particularly in the short run, can easily
distort the growth rate of a single monetary aggregate.

For example, in

the "10 percent growth rate" simulation Ml grew only 5.5 percent during
1976.1.

However M2 and M4 grew 13.3 and 15.6 percent respectively during

the same period.

Clearly, any analysis of monetary conditions which ignored

the growth rates of M2 and M4 would give an incorrect analysis of the
simulated conditions.




253
2.7

1973, l rst Quarter
;i

Four alternative simulations were generated beginning in 1973.1.
The purpose of these simulations was to determine whether the Fed could
have prevented the 1974/75 recession by following a less erratic monetary
policy (as discussed in Section I) than the one actually pursued.

The

results of the simulations indicate that the exogenous shocks faced by
the economy— the quadrupling of oil prices, the "food shortage11, the
successive devaluations of the dollar, and the sharp escalations in the
prices of many other raw materials (phosphate, bauxite, etc.)—were so
great that the Fed could not have offset the impact of the massive decline
in real disposable income through monetary policy.

However, by following

a less erratic course, the Fed could have moderated the recession substantially
and reduced the collapse in income and employment actually experienced.
Moreover, the simulations indicate that a more moderate policy would have
resulted in a relatively small inflation penalty.
The following alternative simulations were used to test the hypothesis
that Fed policy was needlessly destabilizing during the period 1973.1 1976.1.
(a)

9 Percent Ml Growth—changes to "non-borrowed reserves" such

that money supply (Ml) continued to grow at the approximate 9 percent
annual growth rate of 1972.4.
(b)

9 Percent Ml Growth with Judgment--The same changes as in (a),

except that deviations from the target were permitted if the 9 percent
growth rate could only be achieved by a severe reduction in "non-borrowed
reserves."

22-761 0 - 78 - 1 7




254
2. 8

(c) Declining Ml Growth—Changes to "non-borrowed reserves" such that
the money supply growth rate declined from the 9 percent average annual rate
of 1972.4 by .25 percent in each quarter, to 5.75 percent by 1976.1.
(d)

8

Percent NMBXC Growth--Changes to "non-borrowed reserves" such

that "non-borrowed reserves" grew at an

8

percent average annual growth

rate during each quarter.
Simulations (a) and (c) were chosen by the staff of the Subcommittee on
Domestic Monetary Policy to represent two diverse types of non-erratic
monetary policy.

Simulations (b) and (d) were suggested by Chase Econometrics

during the course of this study as interesting variants of simulations (a)
and (c).
These alternative simulations indicate that a wide variety of non­
erratic monetary policies would have resulted in substantially less economic
disruption than was actually experienced during the 1974-1975 period.

A

summary of the economic impacts for simulations (a) and (c) is given in
Table 2.2.

The CEAI Macroeconomic Model indicates that the unemployment

rate would have been

.8

percent lower than the baseline under scenario

(a) and .5 percent lower than the baseline under scenario (c), had the
policies represented in the scenarios been followed.
shown in Figures 2.3 and 2.4.

These results are

Thus, the erratic monetary policy actually

followed cost the economy an average of 460,000 jobs during 1975, even
relative to a policy which called for the growth in the money supply to
decline steadily (but slowly) before and through the recession!

The

cumulative inflation penalty paid for this more expansionary, but more
stable policy was only
simulation.

.8

percent during 1975, the third year of this

The model indicates that the tight Fed policy in 1973-74

did nothing to slow the growth of the 1973-74 inflation bubble but caused




Table 2.2
MAJOR ECONOMIC INDICATORS
1973 Alternative Simulations (a) § (c)

1973

1974

1975

1298.0
2.4
1297.3
1.7

1415.3
18.2
1409.7
12.6

1517.9
29.8
1504.3
16.2

Gross National Product
(Constant Dollars)
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference from Baseline

1226.3
2.1
1225.8
1.6

1222.1
14.0
1217.8
9.7

1200.5
17.0
1191.7
8.2

Unemployment Rate
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference from Baseline

4.9
0
4.9
0

Consumer Price Index
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference from Baseline

133.8
0
133.8
0

147.9
.1
147.9
.1

162.6
.8
162.6
.8

Money Supply (Ml)
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference

267.0
2.2
266.1
1.3

291.0
10.8
286.9
6.7

317.2
20.8
306.2
9.8

Treasury Bill Rate
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference from Baseline

6.43
-.52
6.59
-,36

7.68
-.78
8.10
-.36

6.9
-.5
7.6
1.2




5.47.6
-.4 -.8
5.5
-.3

T ABLE

Gross National Product
(Current Dollars)
a) 9% Ml Growth
Difference from Baseline
c) Declining Ml Growth
Difference from Baseline

w<
^
7.9
-.5

FIGURE 2,3

GNPB
GNP9
GNPD

GNP 1972 •— BASELINE
GNP 1972 S --9 X Ml GROWTH
GNP 1972 •— D ECLIN IN G Ml GROWTH

1260

1240-

256

8 12204
o




1200 -

1180-

1160

r

74
DATE QUARTERLY*

r

4>72 - 1/76

257




258
2.12

serious reductions in real income and employment during 1974-75.

The

major beneficial result of the policy actually pursued was a slightly
reduced inflation rate in 1975.

The different inflation consequences

of these policies are shown in Figure 2.5.
This is not to imply that either of the two alternative policies
which we have simulated would have been optimal.

In fact, both policies

would have had serious deficiencies that one would hope could have been
remedied had the Ml Growth "rule-of-thumb" been revised periodically.
The problems can be seen in the quarterly detail provided in Table 2.3.
In the 9 Percent Ml Growth case, a serious wage-price spiral seems to be
developing by the end of 1975.

The Consumer Price Index rose .4, .8 ,

and .5 index points faster than the baseline in 1975.3, 1975.4, and 1976.1
respectively.

Presumably the differential would have grown even larger,

had the model simulation been continued.

A wage-price spiral also appeared

to be developing in the Declining Ml growth simulation, although the spiral
was not as severe.

(The Consumer Price Index grew .4 index points faster

than the Baseline in 1976.1).

The apparent paradox can be resolved by

noting that under the Declining Ml Growth simulation, the money supply
grew far faster than the baseline through 1976.1.
The simulations indicate that if a higher Ml growth policy were followed
through 1975.1 or 1975.2, it would then have been appropriate to shift grad­
ually to a more restrictive policy despite the depths of the recession.
only alternative, would have been spiraling inflation.
be surprising.




This should

not

The 1975.1 simulation indicates that a shift in monetary

The

FIGURE 8,5

CPI

PCIB
P C I9
PCID




CONSUMER P R IC E IN D EX— BASELINE
CONSUMER P R IC E IN D EX— 9* Mi GROUTH
CONSUMER PR ICE IN DEX— D ECLININ G Mi GROUTH

1973 ALTERNATIVE SIMULATIONS (a) § (c)
Quarterly Detail-Changes from Baseline
1975.1

1975.2

1975.3

1975.4

1976.1

Gross National Product
(Current Dollars)
9% Ml Growth
Declining Ml Growth

29.9
19.6

32.7
19.5

28.7
14.6

28.0
11.4

33.4
14.0

Gross National Product
(Constant Dollars)
9% Ml Growth
Declining Ml Growth

19.9
12.7

21.0
12.3

15.2

6.1

11.7
1.5

14.6
3.2

-.7
-.5

-.8
-.5

-.8
-.5

-.7
-.3

-.6
-.2

.4
.4

.4
.4

.8

1. 6
1.5

2. 1

.7

19.2
11.4

18.9
9.1

61.2
23.7

62.8
19.0

74.3
32.4

Unemployment Rate
9% Ml Growth
Declining Ml Growth
Consumer Price Index
9% Ml Growth
Declining Ml Growth
Money Supply (Ml)
9% Ml Growth
Declining Ml Growth
Treasury Bill Rate
9% Ml Growth
Declining Ml Growth




-.95
-.50

-1.89
-1.06

2.39
3.25

2.49
2.93

1.9

-2.95
-3.44

to

i

261
2 .15

policy should indeed occur, if possible, before the peak.

In a mild,

"easy money" recession it would seem that the shift should occur at or
shortly after the trough. In a serious recession, particularly one char­
acterized by tight monetary policy, some delay would be in order since
the rate of inflation is typically lowest during the first stage of a
recovery.

A little more inflation during a period of relatively stable

prices might well be desirable given the large economic and social costs
of very high unemployment during a trough and during the first pha.se of a
recovery.

However, it should be kept in mind that any extra stimulation

will lead, eventually, to additional inflation.
One other disturbing aspect of the Declining Ml Growth simulation
is that by the end of the simulation period, real GNP is only slightly
higher than in the baseline scenario, while the level of prices is
approximately 1 percent higher than in the baseline.

This result stems

from the comparison of an income flow (GNP) with the level of inflation.
Real wealth and well-being would be much greater under the Declining Ml
Growth scenario than under the baseline even if the final periods’GNP
levels had been identical.

The extra income, investment, and consumption

gained by the more moderate policy during 1974-75 improves the well-being
of the United States and would only be "lost" if real GNP fell below that
of the baseline scenario.

These considerations raise the issue of the

long-run benefits of alternative monetary policies, a question which
will be addressed in the discussion of the longer-run simulations pre­
sented in the later sections of this report.
One negative aspect of these simulations is the wide fluctuation
in short-term interest rates.

2 2 - 7 6 1 0 - 7 8 - 18




The fluctuations are not as harmful as

262
2.16

they first appear, since few effects of these fluctuations carry into
the long-term money markets, as shown in Table 2.4.

Nevertheless, as

we will show below, it would be desirable to avoid the fluctuations if
possible.

The easiest way to do this would seem to be to fix a "non­

borrowed reserves1 target rather than an Ml target.
'

As indicated in

Table 2.4, (Note 1975.1, 1975.3, and 1976.1 in particular), most of
the wide fluctuations in interest rates are eliminated by the use of this
type of target.

In fact, a fixed ’
'non-borrowed reserves 11 target seems

to lead to at least as stable a time pattern of interest rates as the
policy which the Fed actually followed during the period.

These results

are illustrated in Figures 2.6 and 2.7.
The
istics.

8

% NMBXC Growth scenario shows several other favorable character­

Although the final (1976.1) money supply and real growth statistics

were almost identical to the Declining Ml Growth scenario, the Consumer
Price Index was 1.3 index points lower! Even more significantly, in both
of the final two simulation periods, the rate of inflation was no higher
than in the baseline scenario despite the fact that the final level of Ml
was significantly higher!
There was some real growth trade-off relative to the Declining Ml
Growth scenario, since for a portion of the simulation the unemployment
rate rose as much as .2 percentage points higher than in the Declining Ml
Growth simulation.

Nevertheless, most of the real growth improvement in

the Declining Ml Growth simulation was captured while the negative inflation
aspects of that scenario were almost entirely avoided.

Considerable further

study would be required to determine all of the causes and policy implica­
tions of this result.




However, it seems clear that the extra financial

INTE R E S T RAT E & M O N E Y M A R K E T B E H A V I O R
_______ 1973 Alternative Simulations
1974.1
Teasury Bill Rate
Baseline
a) 9% Ml Growth
b) 9% with Judgment*
c) Declining Ml Growth
d) 8 %'NMBXC Growth
AA Utility Bond Rate
Baseline
a) 9% Ml Growth
b) 9% with Judgment*
c) Declining Ml Growth
d) 8 % NMBXC Growth




1974.4

1975.1

1975.2

1975.3

7.26
6.14

8.38
6.67

9.66
8.85

8.53
9.05

6.34
5.39

6.54
4.65

6.51
8.90
7.40
9.76
6.50

8.71
7.45
9.15
6 . 1 2

6.39
2.19
5.38

9.78
10.78
10.13
11.28
9.81

9.52
10.98
10.19
11.24
9.55

9.18
8.03
9.76
7.85
9.23

6.43
7.38

7.18
7.94

9.38
8.72

9.42
8 .6 8

5.84
7.40

5.48
6.72

8.62
8.07

9.49
8.60

10.51
9.97

9.95
10.06

9.29
8.74

9.87
8.71

8 .2 2

8 .8 6

10.27

8 .6 8

9.27

1 0 . 0 1

10.29
9.92

9.02
9.81

9.19
9.96

274.9
281.7

278.2
287.8

282.0
294.1

285.6
300.6

287.9
307.1

294.8
313.7

279.2
278.2

284.4
282.6

289.4
287.7

294.5
291.6

299.3
295.2

303.9
300.2

299.4
320.5
324.3
308.5
305.3

1975.4

6 . 2 1

303.3
327.5
327.2
313.0
309.8

1976.1

5.63
2 .6 8

307.1
331.2
331.1
317.4
315.0

2.4

* Same as (a) until 1975.3

1974.3

TABLE

Money Supply (Ml)
Baseline
a) 9% Ml Growth
b) 9% with Judgment*
c) Declining Ml Growth
d) 8 % NMBXC Growth

1974.2

FIGURE 8.6

—

RTBB
RTB8
RTB9

TREASURY B IL L RATE— BASEL IN E
TREASURY B IL L RATE— 8X HMBXC GROUTH
TREASURY B IL L RATE— 9X Ml GROUTH

13.0-,

10 0 -

g

8. 0

cc

£
IU
g
£




6

.0 -

4.0-

2

,0 -

— I----------1
--------- r--------- 1
----------1
----------1
----------1
----------1
----------1
----------1
----------1
----------i t —

73

74
DATE Q UARTERLY»

75
4/78 - 1/76

,
1

|

76

RTB8
RTB9

TREASURY B IL L RATE— 8X NHBXC GROWTH
TREASURY B IL L RATE— 9* Mi GROWTH

265




FIGURE 2.7

------------

266




PCID
PC I8

CONSUMER PRICE IN D EX— D ECLIN IN G Mi GROWTH
CONSUMER PRICE IN D EX— 8* NMBXC GROWTH

267




FIGURE S . 9

268
2.22

stability resulting from the "non-borrowed reserves" target has longrun as well as short-run benefits.

Comparisons of real growth and

inflation in the Declining Ml Growth and

8

% NMBXC Growth runs are

shown in Figures 2.8 and 2.9.
Simulation(b)— 9% Ml Growth with Judgment — was an experiment with
a constrained Ml Growth target.

The "judgmental" rule was simply that if

the 9 percent growth rate target would require a susbstantial drop in
"non-borrowed reserves ’ 1 in any quarter, no change in reserves would be made.
In the following quarters, reserves would be adjusted so that the money supply
would be brought back to its target growth path.

As shown in Table 2.3, this

procedure did dampen the most serious fluctuations in interest rates.

More

importantly, the use of this rule, even in its limited form, did reduce infla­
tion without reducing real growth.

In the Judgment run, the Consumer Price

Index was .5 index points lower and real GNP was $1 billion higher than in
the straight 9 Percent Ml Growth scenario.
The distributional consequences of the "judgmental" policy are also
extremely interesting.

The extra financial stability and lower inflation

lead to a significant shift from consumption to investment. In 1976.1,con­
sumption is $3.8 billion lower and investment is $4.9 billion higher under
the Judgment scenario.

While the bulk of this extra investment is in

residential structures, all the components of investment showed significant
gains.

On the income side, the results are also interesting.

Profits after

taxes rose $1.7 billion, or 2 percent, in the Judgment scenario, while
employee compensation rose only $ 1




. 2

billion,or

1

percent.

269
2.23

CONCLUSIONS
1)

The 1974-75 recession was significantly more serious than it

would have been had a less erratic monetary policy been followed beginning
in 1973.

This conclusion holds for a wide variety of "non-erratic" policies.

Of course, one would like to determine monetary policy with the aid of
either superb forecasts or "20-20 hindsight"

However even without these

aid% the performance of the economy could have been improved if the Fed
had chosen any one of a number of reasonable monetary condition targets
and applied them consistently.
2)

A less erratic monetary policy would have had no significant

effect upon the 1973-74 inflation rate.

However, if a relatively high

(9 percent) Ml growth target had been chosen and maintained through 1976.1,
the rate o f inflation during the 1975-76 recovery would have been signifi­
cantly higher, and a wage-price spiral would be developing.
3)

Since monetary policy decisions affect the economy with long lags,

the course of monetary policy should be based upon the economic conditions
expected during the next

.12

months,at least as much as the economic conditions

prevailing at the time (or immediately before) the decisions are made.
at a trough,

a "backward looking" monetary policy may have adverse con­

sequences during the next stage of the business cycle.
4)

Even

Short-run stability of monetary policy is ncccssary to achieve

maximum real growth with a minimum of inflation.

A fixed non-borrowed

reserves target appears to be more likely to achieve this goal than a
policy based upon a money supply growth target.

If there is a desire

to use a money supply growth target, the target should be subject to a
constraint that non-borrowed reserves should not fall.




270
2.24

1971, Third Quarter

The simulations considered thus far have been primarily concerned
with the effects of monetary policy during or after a peak.

Sincc the

simulations were run through 1976.1 only, they were able to provide
relatively little information on the consequences of alternative monetary
policies during periods well before a cycle peak.

While it is natural

for a study which has been proposed in 1976 to concentrate first
upon recessions, it is necessary also to examine monetary policy during
the recovery phase.

If alternative monetary policies during a recovery

would have resulted in less inflation, it may be that any ensuing peak
could have been postponed and any ensuing recession could have been
less severe.

This analysis is particularly timely since the. U.S.

economy is presently in the growth phase of a recovery.
To test the effects of monetary policy over a full business cycle,
several simulations with earlier starting dates were specified by the
staff of the Subcommittee.

In one simulation, "non-borrowed reserves"

were adjusted so that the money supply (Ml) grew 5.75 percent in the third
quarter of 1971.

"Non-borrowed reserves" were then adjusted so that the

money supply growth rate declined by .25 percent in each subsequent
quarter to a level of 4 percent in the second quarter of 1973.

Further

changes were made to "non-borrowed reserves" in order to maintain a 4
percent growth rate in Ml.

An attempt was made to continue this "rule-

of-thumb" through 1975 and the first quarter of 1976.

However, this

attempt proved unsuccessful since, given previous changes, the con­
tinuance of a 4 percent growth rate rule would have required unacceptably




271
2.25

large reductions in total reserves in some periods and absurdly large
expansions in total reserves in others.

After discussions with the

staff of the Subcommittee,it was decided to tolerate deviations from
the established "rule-of-thumb" in any given quarter if the deficiency
or surplus in growth was made up in the subsequent quarter.
The set of instructions embodied in this simulation
cause a significant

did not

deviation from the policy actually followed until

the second quarter of 1972.

However, by 1972.2 a significant tightening

of monetary policy was required.

During the second and third quarters of

that year interest rates rose .7 and
baseline respectively.

2 . 8

percentage points above the

While this differential narrowed considerably in

subsequent quarters as the baseline monetary policy tightened, interest
rates were generally higher and monetary growth generally lower than the
baseline during the second half of 1972 and all of 1973.
By the end of 1973, the effects of the tighter policy on real growth
were quite significant.

Real GNP was 1 percent lower than in the baseline

simulation with a difference of
and investment in equipment.
higher than the baseline.

2

percent in consumption of durable goods

The unemployment rate was .4 percentage points

However, the improvement in inflation

1973 was barely significant.

during

By the fourth quarter,the Wholesale Price

Index and GNP deflator were only .2 percent and the Consumer Price Index
only .1 percent lower than the baseline.

These small declines represent

an extremely unfavorable inflation/unemployment tradeoff.
This simulation indicates that a shift to a tighter monetary policy
during the growth phase of a recovery may significantly slow the recovery
while having iittle short-run impact on prices.




This is particularly true

272
2.2(>

in this case, since the 1970 recession was a fairly severe one, preceded
and, as we will note later,intensified by a tightening in monetary policy.
(Notethe contrast between this simulation and the 1973 simulation.

The

latter simulation exhibits a greater inflationary impact during the
recovery,

presumably the result of the easier monetary policy coming

on top of the extra liquidity provided during and before the recession
in the 1973 simulation.)

In the 1965.1 set of simulations we will

see some evidence that over the long run,

an easier monetary policy

would have caused substantial additional inflation.

Nevertheless, the

results of this simulation indicate that the rapid expansion of the money
supply during 1972 seems to have had a net beneficial effect upon the
economy during 1972-1973.
It has been argued that this extra expansion of the money supply was
harmful to the economy in 1974-75 since it allowed the economy to grow
at an unsustainable rate.

However, the simulation indicates that a

slower steady growth in the money supply would not have prolonged the
recovery.

The real growth differential between the baseline and the 4

percent Ml Growth simulation remained in the range of 1 percent through
the first quarter of 1975.

This real growth differential then began to

grow rapidly, peaking the third quarter of 1975 at 1.7 percent.

With

respect to the unemployment rate, the differential peaked in the fourth
quarter of 1975 when unemployment was almost 1 percentage point higher
in the tighter monetary policy simulation than in the (actual monetary
policy) baseline.
The differences in the movement of the inflation rate occured pri­
marily during the period 1973.4 through 1975.2 when monetary policy
seems to have almost no impact on real growth.




During this period with

273
2.27
4 percent Ml Growth the implicit GNP deflator grew .5 percent less than
the baseline.

This is a particularly significant movement since the money

supply grew only 2.5 percent less than the baseline during this period.
Beyond 1975.2, the inflation rate differential was maintained, but did
not grow despite the continually tighter monetary policy embodied in
the simulation.

(The cumulative movements in the Consumer Price Index

were similar, although single-period observations varied due to the
large fluctuations in interest rates in both the baseline and the speci­
fied simulation).

The results of this simulation are shown in Table 2.5

and Figures 2.10-2.11.
Several caveats are necessary in interpreting the results of the
4% Growth simulation.

First, the implicit monetary policy spccificd

was sometimes tighter and sometimes looser than the policy actually
followed, particularly on a quarterly basis.

Second, the specified

rule-of-thumb resulted in a monetary policy which was even more erratic
than the baseline, if interest rate and reserve aggregate standards are
used.

Third, the economy was buffeted by a series of exogenous shocks in

1973, just at the time when the specified policy was beginning to have a
significant impact.

Nevertheless, the simulation indicates that a tighter

monetary policy during the 1971-74 recovery would have slowed

the growth of

the recovery without having had a major impact upon inflation until 1974.
Furthermore, the 4 percent Ml Growth simulation indicates the danager
of an inflexible rule-of-thumb policy.

During 1974, when the economy needed

extra money to cope with the events of 1973-74, the inflexible 4 percent ruleof-thumb resulted in a de facto tightening of monetary policy.
favorable impact upon the economy in 1975 resulted.

A severe, u n ­

It appears that the impact

was particularly severe since, under this scenario, there was little extra
liquidity in the economy at that time.




Table 2.5
MAJOR ECONOMIC INDICATORS
1971 4 Percent Ml Growth vs. Baseline
1971
Gross National Product
(Current Dollars)
4% Ml Growth
Baseline
Difference
% Difference
Gross National Product
(Constant Dollars)
4% Ml Growth
Baseline
Difference
% Difference
Unemployment Rate
4% Ml Growth
Baseline
Difference
Consumer Price Index
4% Ml Growth
Baseline
Difference
% Difference
Money Supply (Ml)
4% Ml Growth
Baseline
Difference
% Difference
Treasury Bill Rate
4% Ml Growth
Baseline
Difference




1972

1973

1974

1975

1064.8
1064.9
-.1
0

1169.5
1171.6
-2.1
-.2

1292.0
1303.7
-11.7
-.9

1383.8
1403.3
-19.5
-1.4

1463.7
1491.1
-27.4
-1.9

1206.5
1219.5
-13.0

1176.6
1192.3
-15.7
-1.3

1109.6
1109.8
-.2

1175.4
1177.7
-2.3

1228.6
1238.1
-9.5

0

-.2

-.8

-

1.1

to
6.0
6.0
0

229.0
229.1
-.1
0
4.26
4.20
.06

6.0

.6

.7

133.1
133.1

146.8
147.0

0

0

-.2

-.1

160.2
160.7
-.5
-.3

241.7
244.1
-2.4
-1.0

252.2
261.8
-9.6
-3.8

262.1
276.9
-14.8
-5.6

272.0
292.9
-20.9
-7.7

4.44
3.80
.64

7.44
6.80
.64

.1

121.6
121.6
0
0

4.8
4.5
.3

5.6
5.5

125.7
125.6
.

1

0

5.4

8.91
8.63
.28

8.8
8.1

6.68

6.53
.15

S
E

275







CPI71B
CPI714

FIGURE 2.11
CONSUMER PRICE INDEX— BASELINE
CONSUMER PRICE INDEX — AH Ml GROWTH

170

160

150

to
05

140

130

120

72

73
74
75
DATE QUARTERLY’ 2/71 - 1/76

76

277
2.31

Since the 1973.1 simulations using a "non-borrowed reserves" target
proved so favorable in terms of improving the unemployment/inflation
tradeoff,an additional simulation was performed starting in 1971.3 in
which "non-borrowed reserves" were required to grow at a
rate.

2 . 2

percent annual

This resulted in a final level of "non-borrowed reserves" exactly

equal to the level in the 4 percent Ml Growth simulation.

This "steady"

monetary policy resulted in the money supply (Ml) being $10 billion higher
than in the previous simulation in 1976.1 (although Ml was still $16 billion
below the baseline). This simulation also differed from the previous one
in that it called for a uniform policy through the simulation period
rather than a policy in which monetary policy gradually tightened through
1973.2 and then held steady.
The results, shown on Table 2.6, are quite interesting.

As in the

4% Ml Growth simulation, real GNP grows more slowly than in the baseline
during 1972, and for much of 1975.

Also as in the 4 percent Ml Growth

simulation, in 1974 and early 1975, the rates of growth in real GNP and
inflation were essentially unchanged, although the levels were lower.
Finally, in both simulations, the inflation rate did not decline signifi­
cantly until the very end of the simulation.
reserve target simulation,

However, in the non-borrowed

the sharp slowdown in real growth in 1973 is

avoided.
The magnitudes of the differences from the baseline in real growth
and inflation were also significantly different between the 4% Ml Growth
and Non-borrowed Reserve Target simulations.
in the

By the end of 1973,real growth

Non-borrowed Reserves Target simulation was only .4 percent lower

than in the baseline.

By the end of the simulation period, this real

growth differential had grown to only
differential.

2 2 - 7 6 1 0 - 7 8 - 19




.8

percent, approximately the peak

Table 2.6
MAJOR ECONOMIC INDICATORS
Cumulative Percent Difference from 1971 Baseline

1972.1
1974.1

1972.2
1974.2

i972.3
1974.3

1972.4
i974.4

1973.1
1975.1

1973.2
1975.2

1973.3
1975.3

1974.4
1975.4

-.3
-1 . 1

-.4
-1 . 0

-.5
-.9

-.7
-1.4

-.9
-1.7

-1 . 0
-1 . 2

-.3
.3

-.3
-.3

-.3
-.3

Gross National Product
(Constant Dollars)
4% Ml Growth

0

-1 . 0
"Reserves" Target

- . 1

-1

. 1

- . 1

- . 2

-.3

-.3

-.5

- . 2

- . 2

- . 6

- . 6

2

Consumer Price Index
4% Ml Growth

0

0

.3
"Reserves" Target




TABLE

- . 1

-.4

0

0

- . 2

- . 2

.2

-.4
. 1

-.3

0
- . 1

.1

0

0

-.5

0

- . 1

-.5

-.3

- . 2

- . 1

- . 1

- . 1

- . 2

-.4

-.4

-.3

-.3

-.4

279
2.3 3

This contrasts with a much larger peak differential of 1.7 pcrcent and
a final differential of .9 percent in the same (negative) direction
between the 4 percent Ml Growth simulation and the baseline.

In terms

of inflation, the final period differentail in the Non-borrowed Reserves
Target simulation was .7 percent.

The final (and peak) period inflation

differential was only .3 percent in the 4 percent Ml Growth Rate simulation.
Thus, the Non-borrowed Reserves Target simulation yielded higher growth
and lower inflation than the 4 percent Ml Growth Rate simulation despite
the fact that both simulations ended with the same level of non-borrowed
reserves.

This comparison indicates clearly the advantages of a relatively

stable monetary policy.

These results are demonstrated graphically in

Figures 2.12 and 2.13.
CONCLUSIONS
1)

A stable monetary policy, in terms of the growth in reserves and

the level of interest rates, appears highly desirable in improving the
economy's real growth/inflation tradeoff.
2)

Unchanging, rule-of-thumb

monetary policies are not likely to be

able to meet the varying needs of the economy.
3)

Following a more restrictive monetary policy during 1971-72 would

have reduced real growth significantly, while the rate of inflation would
have been virtually unaffected until early 1974.

However, a tighter monetary

policy beginning in 1971.3 would have reduced inflation slightly during the
1974-75 period.







FIGURE 2 12
GNP 1972 %—BASELINE
GNP 1972 %— 4% Ml GROUTH
GNP 1972 *—RESERVES TARGET

BILLION

1972

GNP71B
GNP714
GNP71R

DATE QUARTERLY-

2/71 - 1/76




FIGURE 2 12A
NON-BORROUED BASE MINUS CURR (ACTUAL)
NON-BORROUED BASE MINUS CURR (2 2% GROWTH

BILLION

NMBXCA
NMBXC2

DATE QUARTERLY■ 2/71 - 1/76

CPI71B
CPI714
CPI71R

FIGURE 3 13
CONSUMER PRICE INDEX—BASELINE
CONSUMER PRICE INDEX— A% Ml GROWTH
CONSUMER PRICE INDEX—RESERVES TARGET

CPI

282




----------

73
74
75
DATE QUARTERLY’ 2/71 - W 6

283
2 . 3<>

1965, First Quarter

One extremely interesting result of both simulations which started
in 1971.3 was that during the first quarter of 1976, real growth is
higher under the tight monetary policy simulations than in the baseline.
However, the 1971.3 simulations alone do not indicate whether this higher
real growth was due to cyclic conditions or whether the negative effects
of a tighter monetary policy can be completely eliminated if one's time
horizon is sufficiently long.

To test the impact of monetary policy over

a "long-run" simulation period encompassing more than one cycle, the
staff of the Subcommittee specified the following three simulations,
each beginning in 1965.1:
a.

8 Percent Ml Growth - The
to be increased gradually
percent annual rate. The
was then to be maintained
period.

rate of growth in Ml was
until it reached an 8
1.5 percent growth rate
through the simulation

b.

4 Percent Ml Growth - The rate of growth of Ml was
to be maintained at a 4 percent annual rate through
the simulation period.

c.

1.5 Percent Ml Growth - The rate of growth of Ml was
to be reduced gradually to 1.5 percent. The 1.5 per­
cent growth rate was then to be maintained through the
simulation period.

Simulations (a) and (c) were chosen to represent two extreme types of
monetary policy.
albeit

one

which

Simulation (b) was choscn to represent a middle course,
is

more

restrictive

than

the

policy

actually

followed. Since many previous simulations had demonstration the difficulties
of reaching a target growth rate in any single quarter, it was agreed that
whenever the resulting fluctuations were deemed too great, it would be
satisfactory if the target were reached over a six-month span.




284
2.37

The cyclical aspects of these simulations indicated that the policies
actually followed by the Fed were pro-cyclical during the recession periods
covered.

In each of the simulations, including simulation (c), the 1.5

Percent Ml Growth Rate case,

real growth grew or fell Jess during 1970 and

1975 than during the (actual monetary policies) baseline!

In simulations

(a) and (b) real GNP grew more, or fell less, than in the baseline during
both 1967 and 1974.

The results of these simulations for these critical

years are shown in Table 2.7.

Thus, it seems clear that monetary policy

as actually followed during the last decade was more pro-cyclical than
almost any

rule-of-thumb

policy would have been.

Perhaps even more significant are the long run implications of these
scenarios.

At first, it might be imagined that at least one of these

radically different monetary policies would have led to a spiralling
recession, "stagflation," super-boom, or at least to wide variations in
interest rates in the final years of the simulation.
occurred.

Yet none of this

For example, for 1975 the Treasury bill rate differed from

the baseline by less than .60 percentage points in every case.
differences were greater for long-term rates.

The

However, even here, the

largest difference in, for example, the AA Utility Bond rates was 1 per­
centage point in 1975 (Interestingly, the lower inflation and real growth
resulting from the slower Ml growth scenario caused the lowest long-term
interest rates, despite the presumably "tighter" monetary policy.)
This is not to say that the differing monetary policies did not have
great impacts on the economy.

However, it does appear that to the extent

that the model represents the complex inter-relationships of the economy,
the American economy is incredibly stable and able to adjust reasonably
well to even massive exogenous shocks and major differences and/or errors
in policy.




TABLE 2.7
REAL GROWTH BEHAVIOR DURING RECESSIONS

1967

1970

1974

1975

Percent Change in
Real Gross National Product
Baseline

4.9

.9

-1.4

% Ml Growth

5.3

1.5

-.9

4% Ml Growth

5.2

1.4

-1.4

-

1. 6

1.4% Ml Growth

4.6

1. 2

-1.7

-

1.2

8

2.1

TABLE
2.7




-

-1.5

286
2.39

Since the simulations are compared to a baseline, it is to be
expected that significant differences would appear at different times.
Simulations (a),

" 8

Percent Ml Growth,” and (c), "1.5 Percent Ml Growth,"

showed very significant differences from the baseline by 1967, while
simulation (b) "4 Percent Ml Growth," resulted in only minor differences
from the baseline until 1972.
As shown in Table 2.8, the 1965.1 simulations demonstrate a tremendous
difference between the short-run unemployment/inflation tradeoff and the
long-run unemployment/inflation tradeoff.

By 1966, simulations (a) and (b)

both exhibited significant differences from the baseline in real growth
in the directions one would expect.

In simulation (c) cumulative real growth

was .4 percent lower than the baseline.
in inflation were a trivial
ments in real growth.

. 1

For both simulations, the changes

percent, in the same directions as the move­

(It should be recalled that the immediate impact of

tighter monetary policy is higher interest rates and higher inflation.)
Until late 1968 the unemployment/inflation tradeoff was clearly in favor
of the higher monetary growth scenarios.
tive real growth in simulation (a) was

1 . 6

For example, during 1969, cumula­
percent higher than the baseline

and 1.7 percent higher than in simulation (c).
By 1975, the tradeoff had become much less pronounced.

In simulation

(a), real growth was 1.8 percent higher than the baseline and 3.6 percent
higher than in simulation (c).

In terms of the unemployment rate, the

advantage gained by the easier monetary policy was

1 . 2

percentage points

realtive to the baseline and 3 percentage points relative to simulation (c).
However, the differences in inflation were also substantial.

In simulation

(a),prices were 6.3 percent higher than the baseline by 1975 and 12,6 percent




TABLE 2.8
SUMMARY OF THE 1965.1 SIMULATIONS
(PERCENT DIFFERENCES FROM TOE BASELINE*)

Gross National Product
(Constant dollars)
Cumulative Difference
a) 8 % Ml
b) 4% Ml
c) 1.5% Ml
Yearly Difference
a) 8 % Ml
b) 4% Ml
c) 1.5% Ml

Unemployment Rate
Cumulative Difference
a) 8% Ml
b) 4% Ml
c) 1.5% Ml

1968

1969

.7

.7
-.3
-1.4

- . 2

-1.3

-1 . 0

0

.9

.6

- . 1

- . 1

. 1

- . 1

-.4

-.7

.5

- . 1

.3

0

- . 1

-.3

- . 1

0

.2

-.3

- . 1

2 . 2

1 . 8

.3

-.4
-.7

. 1

.5
.3

.4

.8

1.7

. 1

-.4
-1 . 6

0

0

0

. 1

0

0

0

. 1

0

- . 2

-.9

-1.5

0

- . 1

.2

.4

.9

0

0

0

. 1

0
0
0

-.1
.1
.2

* Actual differences for the Unemployment rate




. 1

1 . 6

1971

-.4
-.7
- . 6

2.9
.4
-1.9

1972

1973

1.4
-1 . 0
-2 . 0

-1.5
-2.4

-.4
- . 6

-.4

.8

- . 6

-.5
-.4

3.9
.5

4.8

-2 . 6

-3.6

.2

1974

1975

1.3
-1.5
-2 . 6

-1 . 0
-1 . 8

.5
0
- . 2

5.4
-.9
-5.0

1 . 8

.5
.5
.8

6.3
-1 . 2
-6.3

2.8

Yearly Difference
a) 8 % Ml
b) 4% Ml
c) 1.5% Ml

- . 1

1967

TABLE

Consumer Price Index
Cumulative Difference
a) 8 % Ml
b) 4% Ml
c) 1.5% Ml

1970

1966

.4

1965

0

.3
.1

- . 1

0

- . 1

- . 2

-.7

- . 6

-.3
0
.3

-.3
.1
.6

-.5
.1
.7

-1.0
-.1
.7

1 . 2

1 . 0

.4
-.4

-.7

-1.1
.1
1.0

-i.o
.6
1.5

. 1

.9
-.3
-1 . 0

-.6
.8
1.7

-1 . 1
-1.4

.9
-.3
-1.3

-.6
.9
1.9

-1.2
.8
1.8

.6

%




FIGURE 2.14
GNP, Q TR -TO -Q TR
GNP, Q TR -TO -Q TR
GNP, Q TR -TO -Q TR
GNP, G TR -TO -Q TR

PNP6SB
PNP6SS
PNP654
PNP658

PCT
PC T
PCT
PCT

GRUTH—
GRUTH—
GRUTH—
GRUTH—

B ASELIN E
1. SX Ml GROWTH
4* Ml GROWTH
8H Ml GROWTH

12.0

8.0

4 .0

0

- 4 .0

-8 064

65

66

67

68
69
70
71
72
DATE ANNUAL* 1/64 - 1/75

73

74

75

FIGURE 2.15
C P I, Q TR -TO -Q TR
C P I- Q TR -TO -Q TR
C P Ii Q TR -TO -Q TR
C P I * Q TR -TO -Q TR

PCT
PCT
PCT
PCT

GRUTH— BASELINE
GRUTH— 1 .BX Ml GROWTH
GRUTH— 4H H I GROWTH
GRUTH— BX Ml GROWTH

PERCENTAGE

PCP6SB
PCP65S
PCP654
PCP658




DATE ANNUAL • i/6 4 - 1/75

290
2.-1.T

higher than simulation (c) by the same date.

Perhaps most significantly,

during 1975, real growth, for the first time, was actually greater in
simulation (c) than in simulation (a). This means that the difference
in the inflation rate (2

. 2

percent) was so great that the impact of the

easier monetary policy was completely overcome.
In analyzing these simulations, it should be recalled from Section I
that the prices of several basic commodities — farm goods, petroleum,
and imported goods — are exogenous to the model.

Thus, especially in

the long run, the differences in inflation for the alternative monetary
policies may be underestimated in this study. This fact is particularly im­
portant, since changes in those prices which are exogenous to the Chase Macroeconomic Model would generally have a greater effect on real income than changes
in prices resulting endogenously from a wage-price spiral.

This problem

could be remedied by running satellite models which are designed to pre­
dict the prices which are entered exogenously into the Chase Macroeconomic
Model.

However, such a task was outside the scope of this project.
It should also be remembered that simulations (a) and (c) required,

respectively, a continual loosening and tightening of monetary policy,
rather than a one-time change.

Thus, the policies were not fully implemented

until late 1968 and 1967, respectively.
Simulation (b) is quite interesting in that it demonstrates the con­
sequences of maintaining a fixed "rule-of-thumb" monetary policy in the face
of changing economic conditions.

If it is assumed that the actual mix of

fiscal and monetary policies followed was able on average to achieve the
desired unemployment/inflation tradeoff possible at a given time, it is
clear that through 1970, simulation (b) represented an acceptable policy.




291
2.44

Until 1971, the only difference between simulation (b) and the baseline
was a slight dampening of both the peak and the trough during the 19681970 period.

However, when the "underlying" rate of inflation in the

economy began to grow at greater than historical rates, the policy used
in simulation (b) became increasingly restrictive relative to the baseline.
As a result, during the period 1973-1975 the simulated unemployment rate
averaged almost 1 percentage point higher than the baseline.

Thus, even

with fixed goals, it is necessary to change monetary policy targets on at
least an occasional basis.

Further evidence that a "fixed" policy will

have differenct consequences under varying economic conditions is provided
by a supplemental simulation performed by Chase Econometrics.

In this

simulation, "non-borrowed reserves" were increased steadily at their averag.e
rate of growth for the 1965.1-1976.1 period.

This resulted in a policy which

was on average more expansionary than the policies actually followed prior
to and during 1970, and more contractionary than the policies followed there­
after.

Given the lags in the unemployment/inflation tradeoff discussed

earlier, these differences resulted in both lower real growth and higher
inflation by 1975, despite the previously noted tendency for the economy,
as represented by the CEAI model, to react favorably to the stabilizing
impact of a "non-borrowed reserves" target.
One interesting question which remains is, "Would a combination of
alternative fiscal and monetary policies have been able to promote a better
unemployment/inflation tradeoff than the tradeoff actually achieved?"

It

appears that this would have been the case, particularly in the long run
(5

to

10

years) when monetary policy seems to have a considerable direct

impact upon inflation.

However, this question was outside the scope of

this study and must be reserved for future study.




292
2.45

CONCLUS IONS
1)

Monetary policy, as actually followed seems to have been pro­

cyclical in the 1970 recession and 1967 "growth recession" as well as during
the 1974-1975 recession, although in some cases expansionary monetary policy
during recessions seems to have promoted a faster recovery than would have
occurred with a stable monetary policy.
2)

Monetary policy seems to have a much greater short-run impact upon

real growth than upon inflation.

Thus, for the range of policies considered

by this study, the short-run (0-4 years) unemployment/inflation tradeoff
of a more restrictive monetary policy will almost always be unfavorable.
The short-run unemployment/inflation tradeoff of a more expansionary policy
will almost always be favorable.
3)

In the longer-run (5-10+ years) the unemployment/inflation trade­

off of a more restrictive monetary policy become increasingly less unfavorable.
It is not possible to specify when the trade-off becomcs favorable, since
this requires

a) an analysis of the social costs of unemployment and in­

flation^) a system for discounting over time, and c) an analysis of possible
offsetting fiscal policies.

Nevertheless, there does appear to be a sub­

stantial conflict between our society's short-run and long-run economic
goals.
4)

While a variety of "rule-of-thumb" monetary policies would have been

more counter-cyclical than the policies actually followed during the last
decade, a refusal to change monetary policy when economic conditions changed
would have had even more harmful impacts.

In particular, a fixed monetary

policy target during the decade studied would almost certainly have been
either too expansionary during the first half of the decade or too restictive
during the second half.




o