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For release on delivery
Expected about 2:30 p.m. (E.D.T.)
September 10, 1979




Statement by

Nancy H. Teeters
Member

Board of Governors of the Federal Reserve System

before the

Subcommittee on Oversight
of the Committee on Ways and Means

United States House of Representatives

Septend>er 10, 1979

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I appreciate the opportunity to appear before this subcommittee
to discuss the recent study by the Internal Revenue Service on unreported
income.

In view of the technical issues involved in this study, I have asked

some staff members from the Federal Reserve System to be present today.
I r Chairman, I would like to introduce to you and the other members of the
l.
subcommittee, Mr. Jared Enzler, Mr. Richard Porter, Mr. James Stull and
Mr. William Wallace from the Board staff and Mr. Robert Laurent from the
Federal Reserve Bank of Chicago, who will answer any technical questions
that you may have.
Activities giving rise to unreported income, whether earned from
legal or illegal sources, have been called the underground economy.

The

scope and nature of the underground economy has an important bearing on U.S.
tax policy and also may be relevant to the understanding of developments in
the economy and financial markets.

For these reasons, the Board welcomes

any efforts that may be made to measure the extent of the underground
economy.
Underground activity by its very nature is difficult to measure
directly.

As a result, economists have resorted to various indirect

methods of estimation.

One much-discussed method which is evaluated in

the IRS study— and one which I understand that you would like us to comment
upon— uses the tatio of currency in circulation to demand deposits to
extract estimates of the size of underground economic activity.

According

to this approach, movements in this ratio from its value in the years
1937-1941 have been interpreted as reflecting changes in the underground
economy exclusively.

However, there are significant analytical and

measurement problems in drawing inferences about underground activity
on the basis of movements in the ratio of currency to demand deposits.




-2First of all, even though the Federal Reserve's data on currency
and demand deposits are highly accurate and measured on a consistent basis
over time, there are no reliable estimates on what portion of the U.S. currency
in circulation is held in the United States and what portion is held
abroad.

U.S. currency balances may be held abroad as a store of wealth

and, in a few countries, such balances evidently even serve as a major
medium of exchange.

Therefore, fluctuations in the currency ratio may

reflect changes in economic and political conditions abroad.
Apart from variations resulting from currency held abroad,
movements in the currency to deposit ratio also reflect domestic above­
ground economic activity.

In fact, as the IRS study noted, research by

the Federal Reserve staff indicates that both the trend and cyclical
movements in the currency to deposit ratio over most of the 1960s and
1970s can be explained adequately by movements in real income and consumption
expenditures, prices, and interest rates — variables which are recognized
as important determinants of currency and deposit holdings.
Since mid-1974, however, the currency to deposit ratio has moved
up more sharply than can be accounted for by movements in those determinants.
The increase in the ratio appears to be a result of a downward shift in
the demand for demand deposits and not an upward shift in the demand
for currency*

Currency holdings continue to be predicted accurately by

movements in real consumption expenditures, prices, and interest rates.

The

weakness in demand deposit growth, on the other hand, appears to be associated




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with a variety of new developments in the money market.

For households,

innovations such s s NOW accounts, ATS accounts, and money market mutual
funds have become increasingly important substitutes for demand deposits.
For business firms, sluggish deposit growth has reflected the growing
use of cash management techniques and deposit substitutes such as security
repurchase agreements.
Thus, there are plausible explanations of the post World War II
rise in the ratio of currency to deposits which do not rely on the growth
of an underground economy.

I do not mean to imply that the underground

economy does not exist or that currency is not used more extensively as
a medium of exchange for underground transactions.

The point is that

other factors affect the currency to deposit ratio, and they must be taken
into account when separating above-ground currency holdings from under­
ground currency holdings.
Moreover, even if this separation could be accomplished with
precision, it is by no means clear what magnitude of underground GNP is
associated with underground currency holdings.

Presumably, underground

currency holders are somewhat restricted from exchanging currency for
demand deposits or for interest-bearing assets.

Therefore, it is quite

possible that the income velocity of underground currency is less than
that of above-ground currency where there are no restrictions on such
exchanges.
Finally, whatever the advantages and problems with the currencybased approach to estimating the underground activity, it is obviously
useful to try to estimate underground activity directly, as the IRS has
done in its study.

The approach taken by the IRS appears to be helpful

and merits careful consideration.




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