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TERM-STRUCTURE SPREADS, THE MONEY
SUPPLY MECHANISM, AND INDICATORS
OF MONETARY POLICY
Robert D. Laurent
Working Paper Series
Macro Economic Issues
Research Department
Federal Reserve Bank of Chicago
September, 1990 (WP-90-16)

Term-Structure Spreads, the Money Supply Mechanism,
and Indicators of Monetary Policy
Robert D. Laurent *

The conduct and interpretation of monetary policy has become more
difficult in recent years.

Through the decades of the 1960’s and the

1970’s, increasing reliance was placed on fluctuations in money
growth as an indicator of monetary policy and its impact on future
real income, and through changes in real income, its ultimate impact
on prices.

However, since the beginning of the 1980’s the old

relationship between fluctuations in money growth and subsequent
changes in real income and prices appears to have deteriorated.

This

has led to a search for alternative indicators for monetary policy.

One set of alternative indicators recently gaining popularity has
the form of term-structure spreads.

This author presented a study

that recommended the spread between a long-term treasury bond rate
and the fed funds rate as a useful indicator of the thrust of
monetary policy.*
income growth.

The greater the spread, the greater future real

It was found that a simple form of this spread would

have forecast real income growth better than the same simple form of
a number of other plausible interest-rate based indicators and
monetary aggregate growth rates.

Other studies have also recently

examined the empirical evidence and concluded that the spread between




-2-

a long-term and a short-term interest rate, either the same spread
presented in the author's study or other spreads, could usefully serve as
forecasters of future real income growth.^

The primary bases of these studies has been empirical.

There has been

relatively little exposition of a theoretical basis for the use of a
spread, or even the choice among various specific spreads, as a forecaster
of real income growth.3

Among other results, this emphasis on empirical

evidence has left the impression that the use of a term-structure spread
as an indicator is an approach quite apart and different from the use of
monetary aggregate growth rates popular in previous decades and included
in the current index of leading indicators.

This paper seeks to provide a foundation for the term-structure spread
as an indicator of monetary policy within the same theoretical framework
used to justify the use of money as a monetary policy indicator.

The

first section of the paper begins by briefly reviewing the role played by
money in the history of economic thought and discussing two tenets that
underlie the use of money as an indicator of the thrust of monetary
policy.

These two tenets are then used to discuss probable reasons for

the recent deterioration of money measures as indicators of monetary
policy and to suggest that the money supply mechanism might be a fruitful
area in which to search for an alternative indicator of the thrust of
monetary policy.




-3-

The second section of the paper examines the money supply mechanism
and argues that the significance accorded to reserves in the money supply
process is misplaced.

Rather, the argument is made that an interest rate

spread is really the mechanism through which money supply changes are
produced.

The discussion in this section also emphasizes the crucial, but

often neglected, evidence provided by reserve accounting systems
concerning the nature of the money supply mechanism.

The third section of the paper reconsiders a number of monetary policy
debates of the past three decades in light of this interest rate view of
the money supply mechanism.

It is argued that advocacy of a reserve

targeting procedure is really a desire for the federal funds rate to be
set through a particular mechanism.

This mechanism requires that the

reserve accounting system satisfy certain conditions.

The absence of

these necessary conditions make it clear that the operating procedure
adopted in 1979 could not have been the system desired by reserve
targeting advocates.

The interest rate view of money stock determination

also gives a somewhat different view of the role of reserve requirements
in the conduct of monetary policy and explains why, contrary to
expectations, short-term demand deposit fluctuations increased after the
adoption of the new operating procedure in 1979.

Finally, it is argued

that concentration on a reserves oriented mechanism of money stock
determination leads to a much too pessimistic view of the possibilities of
accurate short-run control of the money stock.

The final section presents evidence that the interest rate view of




-4-

money stock determination, while not recently prominent, has a long
pedigree in the history of economic thought.

The spread itself bears

great similarity to the monetary mechanism advanced by Knut Wicksell in
the early part of this century.

This final section also examines how

o n e ’s leanings toward a monetary policy or expectations interpretation of
the yield curve dictates the particular form of the term-structure spread
selected.

I.

The concept of money has played a prominent role in economic theory,
since at least the end of the 18th century.4

Not only has the concept

of money played a prominent role in the history of economic thought, but
it is likely to continue to play a prominent role.

Its appeal lies in its

ability to elucidate the process of price determination as reflected in
the popular expression that "inflation is caused by too much money chasing
too few goods."

Its primacy in the determination of prices can be grasped

by considering whether inflation (i.e. a sustained rise in general prices)
could even occur in an economy without money (e.g. a barter economy).

As

long as the determination of prices is a significant concern of economics,
the concept of money is likely to continue to occupy a prominent position
in economic theory.

The particular form of money that came to play an important role as an
indicator of monetary policy’s impact on the real economy in the decades
of the 1960’s and 1970’s was fluctuations in the growth rate of real money




-5-

balances.
increase
real

An

increase

in t h e g r o w t h o f real

in f u t u r e real

balances

income growth,

indicated a decrease

this relationship that deteriorated

money balances

while a decrease

in f u t u r e real

i n d i c a t e d an

in t h e g r o w t h o f

income growth.

in t h e e a r l y 1 9 8 0 ' s ,

and

It w a s

inspired the

s e a r c h t h a t l e d t o p r o p o s a l s t h a t a t e r m - s t r u c t u r e s p r e a d b e u s e d as an
indicator o f m o n e t a r y policy.
approach

In a n y s c i e n c e , w h e n o n e t h e o r e t i c a l

is r e p l a c e d b y a n o t h e r ,

o n an e n t i r e l y n e w f o u n d a t i o n .
same foundation and differs

the replacement
Usually,

is s e l d o m ,

if ever,

built

the ne w approach begins with the

by altering some of the superstructure.

Given

t h e p r o m i n e n c e a c c o r d e d t h e c o n c e p t o f m o n e y in t h e h i s t o r y o f e c o n o m i c
thought and the high pr ob ability that
successful

new approach

it wi l l

remain prominent,

any

is l i k e l y t o b e c o n s i s t e n t w i t h a t l e a s t s o m e

e l e m e n t s o f t h e f o u n d a t i o n t h a t u n d e r l i e s t h e u s e o f m o n e y as a n i n d i c a t o r
of m o n e t a r y policy.

One of the principal

t e n e t s u n d e r l y i n g t h e u s e o f m o n e y as an

i n d i c a t o r o f m o n e t a r y p o l i c y is t h e b e l i e f t h a t t h e m o n e t a r y a u t h o r i t y h a s
the c a p a b i l i t y o f se tt i n g the nominal

money stock independently of the

l o n g - r u n q u a n t i t y o f m o n e y t h e p u b l i c d e s i r e s to hold.

It is n o t j u s t

that the m o n e t a r y auth or it y can set the m o n e y stock at wh at ev er
desires,

b u t t h i s m a y b e a d i f f e r e n t level

level

it

than the public desires to hold

over the longer term under present economic conditions.

Indeed,

this

a b i l i t y to se t t h e m o n e y s t o c k o f f o f t h e l o n g - r u n d e m a n d c u r v e for m o n e y
is w h a t g i v e s m o n e t a r y p o l i c y its p o w e r .
the public to get back on
in real




o u tp ut and prices.

It is p r e c i s e l y t h e a t t e m p t o f

its l o n g - r u n d e m a n d c u r v e t h a t p r o d u c e s c h a n g e s

-6-

It m a y s e e m s t r a n g e t h a t t h e q u a n t i t y o f a n y g o o d o r s e r v i c e c a n b e
s e t a t a p o i n t o f f its d e m a n d c u r v e .

The explanation

lies

in t h e

distinction between the short-run and the long-run and the role of m o n e y
as a m e a n s o f t r a n s a c t i o n s .

The mo ne t a r y authority and d e po si to ry

i n s t i t u t i o n s t a k e a d v a n t a g e o f t h e r o l e o f m o n e y as a t r a n s a c t i o n m e d i u m
to ch ange the m o n e y stock by offering such appealing terms to potential
transactions

partners that they temporarily change their m o n e y holdings.

Consider,
reserves

for example,

in t h e f i n a n c i a l

h o w t h e m o n e t a r y a u t h o r i t y c h a n g e s t h e leve l
system.

When a bond dealer sells bonds to the

m o n e t a r y a u t h o r i t y a n d a c c e p t s m o n e y in e x c h a n g e ,

it is u n l i k e l y t h a t t h e

b o n d d e a l e r d e s i r e s t o p e r m a n e n t l y h o l d t h e i n c r e a s e d le vel
balances.

Rather,

attractive price

of money

it is m o r e l i k e l y t h a t t h e d e a l e r h a s b e e n o f f e r e d an

for the bonds and has de ci de d to adju st his po rt f o l i o by

se ll in g the bonds and p u r c ha si ng other assets w i t h the funds.
v i e w s t h e a c c e p t a n c e o f m o n e y as a n i n t e r m e d i a t e s t e p u n ti l
are purchased.

of

Likewise when deposits

The dealer

other assets

increase because a depository

i n s t i t u t i o n ex t e n d s c r e d i t t h r o u g h the p u r c h a s e o f s e c u r i t i e s or th e
m a k i n g o f a loan,
hold the

it is d o u b t f u l

increased deposits.

that the recipient

intends to permanently

Rather the borrower takes credit

in t h e f o r m

o f m o n e y as a n i n t e r i m s t e p t o u s i n g t h e f u n d s o n w h a t e v e r e x p e n d i t u r e s
are planned.®

T h o s e w h o h a v e h a d an i n c r e a s e in t h e i r d e p o s i t h o l d i n g s w i l l
back to equilibrium by increasing their purchases
passing the additional

deposits to others.

in t h e f u t u r e a n d

Of course,

transactions cannot eliminate the increased deposits




move

these additional

but simp ly

-7-

re di st ri bu te t h em to other holders.

E q u i l i b r i u m is o n l y f i n a l l y a c h i e v e d

when the dollar volume of transactions

increases

holders willing to hold the increased deposits

sufficiently to make

permanently.

This ca pability of setting m o n e y independently of the demand
explains

both the power and lagged re s p o n s e of m o n e t a r y policy.

t h e m o n e y s t o c k a w a y f r o m t h e level
current output and prices)

t h a t is d e m a n d e d

is r e m e d i e d t h r o u g h a c h a n g e in e x p e n d i t u r e s

real

a c t i v i t y and/or prices.

in t h e s c e n a r i o a b o v e ,

economic activity depends upon

the

in m o n e y

in c o n s t r a i n i n g t h e m o n e y

s t o c k t h a t c a n be set by the m o n e t a r y authority,

since,

change

in

in r e s p o n s e t o m o n e t a r y p o l i c y .

If t h e d e m a n d f o r m o n e y is n o t a f a c t o r

in t h e e c o n o m i c r e s p o n s e t o a c h a n g e

an i m b a l a n c e

leading to a change

T h e ti m e be tween the initial

a n d t h e u l t i m a t e e q u i l i b r i u m is t h e l a g

By moving

(consistent with

the m o ne ta ry authority produces

that

for m o n e y

it is t h e c r i t i c a l

in t h e m o n e y s t o c k .

This

factor

is c l e a r

impact of a given m o n e y stock on future

its r e l a t i o n s h i p r e l a t i v e t o t h e q u a n t i t y

of m o n e y demanded at current economic conditions.

So a second tenet

underlying advocacy of a monetary policy implemented through money stock
control

is t h a t m o n e y d e m a n d be a d e q u a t e l y p r e d i c t a b l e .

economics

t h i s t e n e t w a s e x p r e s s e d as an a s s u m p t i o n t h a t

m o n e y is s t a b l e . ”

That

In t h e j a r g o n o f
"the demand

is, t h a t t h e q u a n t i t y o f m o n e y d e m a n d e d c o u l d

fo r
be

e s t a b l i s h e d s u f f i c i e n t l y a c c u r a t e l y as a f u n c t i o n o f o t h e r e c o n o m i c
variables.6

The simplest demand
money demanded




f u n c t i o n i m a g i n a b l e is o n e w h e r e t h e q u a n t i t y o f

is j u s t a f r a c t i o n o f t h e t r a n s a c t i o n s d e s i r e d

(or t h e

-8-

l e ve l

o f i n c o m e - s e r v i n g as a p r o x y f o r t r a n s a c t i o n s ) .

any ac ce le ra ti on or deceleration
ac ce leration or dece le ra ti on

in t h e m o n e y s t o c k wi l l

in i n c o m e .

r e l a t i o n s h i p s e r v e d r e a s o n a b l y we l l
re al

money balances were included

Though simple changes
of mo n e t a r y policy,

in real

This means that

unti l

Indeed,

lead to a future

just this simple

t h e l a t e 1 9 7 0 's a n d c h a n g e s

in t h e i n d e x o f l e a d i n g

in

indicators.

m o n e y b a l a n c e s w e r e u s e d as a n i n d i c a t o r

theory had long recognized that other

factors could

affect the de ma nd for m o n e y and influence the rela ti on sh ip between m o n e y
and income.

One factor that had long been re cognized was the influence of

interest rates.

Since

interest payments w e r e prohibited on m a n y

tran sa ct io ns -ty pe deposits,

changes

in t h e leve l

of interest rates

affected the opportunity cost of holding these deposits.
l e ve l

o f i n te re st rates,

paying deposits

the more expensive

The higher the

it is t o h o l d n o n - i n t e r e s t

an d so th e lower t h e d e m a n d for t r a n s a c t i o n - t y p e

deposits.^

Another
innovation.

f a c t o r k n o w n t o a f f e c t t h e d e m a n d f o r m o n e y is t e c h n o l o g i c a l
A n y innovation that produces a m o re attractive method of

p e r f o r m i n g t r a n s a c t i o n s wi l l
transactions

balances.

cause substitution out of prev io us ly existing

For example,

the introduction of checking deposits

reduces the demand

for currency,

reduces the demand

for ch e c k i n g accounts.

In t h e p e r i o d a r o u n d

while the introduction of credit cards

1980 a n u mb er of changes oc c u r r e d th at could have

be en e x p e c t e d to a f f e c t the d e m a n d for money.

First,

depository

institutions w e r e allowed to pay interest on transactions




balances.

Even

-9-

in t h e m o s t s t a b l e o f e n v i r o n m e n t s t h i s w o u l d p r o d u c e a d i s t u r b a n c e t o t h e
demand
rates

for money.

Depository institutions would establish new interest

for t r a n s a c t i o n s - t y p e de p o s i t s on w h i c h

prohibited.

interest had fo r m e r l y been

As n e w in te re st rates are establ is he d,

adjust their deposit holdings.

deposit holders would

This entire process would

be s t r e t c h e d

over t i m e w i t h a tr a n s i t i o n period of some v o l a t i l i t y be tw ee n the original
demand
been

for m o n e y and a d i f f e r e n t de m a n d for m o n e y a f t e r t h e c h a n g e s have

implemented.

In p r a c t i c e ,
complicated.

t h e actual

First,

deposit deregulation process was even more

n o t all

deposits were deregulated

pr ohibited on demand deposits.
transaction-type deposits,
and depositors
is m u c h

This meant that to obtain

i n t e r e s t on

n e w c a t e g o r i e s of de p o s i t s ha d to be c r e a t e d

had to shift holdings to these new deposits.

like that of a technological

were eliminated

- i n t e r e s t is still

innovation.

in s t e p s o v e r a p e r i o d o f t i m e ,

Second,

This

process

the ceilings

c a u s i n g an e x t e n s i o n and

c o m p l i c a t i o n o f the tr a n s i t i o n between the original

and deregulated

equilibriums.

A second
money around

factor that could have been expected to alter the demand
1980 was a chan ge

the period from 1950 to
interest rates

1980,

in t h e b e h a v i o r o f i n t e r e s t r a t e s .
i n te re st ra tes g e n e r a l l y rose.

ha ve g e n e r a l l y fallen.

This

Over
1980

latter m o v e has re du c e d the

opportunity cost of holding transaction-type deposits
whose

Since

fo r

and other deposits

i n t e r e s t r a t e s h a v e b e e n h e l d a r t i f i c a l l y low.

T h e c o m b i n e d e f f e c t s o f all




t h es e chan ge s on t h e d e m a n d

for va r i o u s

-10-

combinations of deposits
outcome

has

been difficult to determine.

One very likely

is t h a t t h e d e m a n d f o r a v e r y i n c l u s i v e a g g r e g a t e l i k e M 3 w o u l d

increase.

And

in f a c t ,

growth

in t h e r a t i o o f G r o s s N a t i o n a l

Product to

M3 ap pe a r s to ha v e d e c l i n e d s i n c e t h e s e ch anges.

In t h e f a c e o f t h e s e c h a n g e s

it b e c a m e m o r e d i f f i c u l t t o i n t e r p r e t

w h a t a g i v e n c h a n g e in t h e m o n e y s t o c k i m p l i e d f o r f u t u r e i n c o m e l e v e l s .
Given that the problems
d e m a n d for money,

ap p e a r to be a r i s i n g f r o m d i s t u r b a n c e s to t h e

it s e e m s n a t u r a l

to e x a m i n e t h e m o n e y s u p p l y p r o c e s s for

alternative indicators of the thrust of mo n e t a r y policy.
au th or it y has always

been able to take actions that could affect the m o n e y

s t o c k i n d e p e n d e n t l y of the d e m a n d for money.
movements

The monetary

Theory suggests that

in t h e m o n e y s t o c k r e l a t i v e t o t h e d e m a n d f o r m o n e y c a n s e r v e as

an i n d i c a t o r o f t h e t h r u s t o f m o n e t a r y p o l i c y o n f u t u r e i n c o m e l e v e l s .

In

t h e pa st t h e d e m a n d for m o n e y has often been c o n s i d e r e d so s t a b l e t h at
changes

in t h e m o n e y s t o c k w e r e d i r e c t l y u s e d as a n i n d i c a t o r o f m o n e t a r y

policy,

essentially assuming that the demand

of income.

However,

for m o n e y w a s a f u nc ti on o n l y

the creation of new deposit categories,

dere gu la ti on of interest rates and the sharp change
behavior

in t h e

1 9 8 0 ’s p r o d u c e d c h a n g e s

rendered simple movements

the

in i n t e r e s t r a t e

in t h e d e m a n d

for m o n e y wh i c h

in t h e m o n e y s t o c k l e s s e f f e c t i v e as an

indi ca to r of m o n e t a r y policy.

These changes
the

in t h e d e m a n d f o r m o n e y d i s t u r b b o t h t h e m o n e y s t o c k a n d

impact of a given m o n e y stock on future income and prices.

But there

is n o r e a s o n w h y t h e s e c h a n g e s s h o u l d a f f e c t t h e m e c h a n i s m b y w h i c h t h e
m o n e t a r y a u t h or it y acts to change the m o n e y stock.




It s e e m s o n l y n a t u r a l

-11-

t o e x a m i n e t h i s m e c h a n i s m as t h e s o u r c e o f an a l t e r n a t i v e
m o n e t a r y policy.

Indeed,

it is b a s i c a l l y s u c h a n a p p r o a c h t h a t h a s l e d

m a n y advo ca te s o f m o n e y st oc k control

t o s u p p o r t a p o l i c y t a r g e t s u c h as

the mo n e t a r y base under present conditions.®

This approach moves

focus to an ea r l i e r s t a g e of the m o n e y s u p p l y process
reserves
control

indicator of

the

- in t h i s c a s e ,

- s o as t o s i m u l t a n e o u s l y i n c r e a s e t h e m o n e t a r y a u t h o r i t y ’s
over the

disturbances.

indicator,

and insulate the indicator from demand

The next section argues that the m o n e y supply process

operates not through reserves,

but t h r o u g h an i n t e r e s t r a t e spread.

II.

How does the mo n e t a r y authority affect the m o n e y stock?

The standard

m o n e y and banking t e xt bo ok teaches the beginning student a two step
process

in w h i c h t h e m o n e t a r y a u t h o r i t y f i r s t c h a n g e s t h e leve l

reserves

in t h e s y s t e m a n d t h e r e b y d i s t u r b s t h e le vel

at de p o s i t o r y institutions.
disturbance
t h e leve l

These

by changing their asset holdings

each succeeding

and

in t h e s y s t e m a n d t r a n s m i t t i n g s m a l l e r d i s t u r b a n c e s

in e x c e s s r e s e r v e s t o o t h e r d e p o s i t o r y i n s t i t u t i o n s .
continues with each

of excess reserves

institutions then respond to the

in t h e i r e x c e s s r e s e r v e s

of deposits

of

This process

i n s t i t u t i o n p a s s i n g o n an e v e r s m a l l e r d i s t u r b a n c e t o

i n s t i t u t i o n un til

some m u l t i p l e o f the original

deposits

in t h e s y s t e m h a v e c h a n g e d b y

c h a n g e in r e s e r v e s .

In t h i s v i e w o f t h e

m o n e y supply process the mo ne ta ry authority changes the m o n e y stock by
i n i t i a l l y c h a n g i n g t h e level




of reserves and through the operation of a

-12-

“r e s e r v e m u l t i p l i e r "

p r o d u c e s a c h a n g e in t h e level

o f the m o n e y stock.

Th er e have been a number of studies of the m o n e y supply process that have
e s t i m a t e d r e s e r v e m u l t i p l i e r s t h a t c o u l d o s t e n s i b l y be u s e d f o r p u r p o s e s
of accurate monetary control.9

H o w e v e r useful

t h e m o n e y m u l t i p l i e r a p p r o a c h m a y b e as a p e d a g o g i c a l

device to teach students that depository institutions create money,
careful

consideration makes

it c l e a r t h a t it c a n n o t b e an a c c u r a t e

description of the money supply mechanism.

It s i m p l y d o e s n o t m a k e s e n s e

t h e o r e t i c a l l y . 10

Depository institutions change the mo ne y stock by exchanging assets
(loans and investments) w i t h the public.

T h e r e s e r v e m u l t i p l i e r model

t r e a t s e a c h d e p o s i t o r y i n s t i t u t i o n as a n i s o l a t e d ,
mechanistically changes
reserve position.

its a s s e t h o l d i n g s

In p r a c t i c e ,

there

independent entity that

in r e s p o n s e t o i t s e x c e s s

is a v a i l a b l e a m a r k e t

(the federal

funds market) w h e r e de pository institutions can change their reserve
levels

by lending or borrowing reserves

and which allows th em to ma ximize

returns

in a m o r e r e a l i s t i c m a n n e r t h a n a s s u m e d

model.

T h i s m a r k e t t r a n s m i t s t h e p r e s s u r e s o f t h e r e s e r v e m a r k e t t o all

de pository institutions,

in t h e r e s e r v e m u l t i p l i e r

irrespective of their excess reserve positions,

and t h e r e l a t i o n s h i p betw ee n t h e fed funds ra te and t h e ma rginal
av ailable on loans and investments determines the changes
i n s t i t u t i o n ’s a s s e t h o l d i n g s a n d
higher the funds rate

rate de p o s i t o r y institutions can earn on assets,
will

sell




in a d e p o s i t o r y

its i m p a c t o n t h e m o n e y s t o c k .

(a n d e x p e c t e d f u t u r e f u n d s r a t e s )

assets and act to reduce deposits

The

relative to the

the more

and money.

return

institutions

Even a deposi to ry

-13-

i n s t i t u t i o n w i t h e x c e s s r e s e r v e s wi l l
channel

the funds

sell

loans and securities

into the fed funds m a r k e t

if t h e r a t e o n f e d f u n d s

hi gh r e l a t i v e to the ra te a v a i l a b l e on assets.
r e s e r v e d e f i c i e n c y wi l l
cover

p u rc ha se assets,

its r e s e r v e n e e d s w i t h

creating deposits

fed funds purchases,

institutions

in t h e f e d e r a l

c o n s i s t e n t l y sell
funds

funds,

in t h e m a r k e t .

on that side of the

consistent buyers

be de fi ci en t,
these

textbook scenario,
holdings

funds market.

M a n y s m al l

institutions

institutions to concentrate

in w h i c h t h e y h a v e a

Indeed, m a n y l a rg e i n s t i t u t i o n s ar e n o t o n l y

in t h e f u n d s m a r k e t ,

b u t b u y an a m o u n t g r e a t e r t h a n

If c u t o f f f r o m t h e m a r k e t ,

they would not only

in t h e i r r e s e r v e p o s i t i o n .

responded to their excess reserve positions

in t h e

in t h e f u n d s m a r k e t .

It m a y s e e m t h a t c o n t r a s t i n g t h e r e s e r v e s
view of mo ne y stock determination

and the interest rate spread

is m u c h a d o a b o u t n o t h i n g .

both th e q u a n t i t y o f r e se rv es and the funds rate are fact or s




as

If

t h ey would long ago have cut back on their asset

and reduced borrowings

for reserves,

depository

while ma n y large institutions consis te nt ly buy

but a c t u a l l y be o v e r d r a f t e d

institutions

of

of money stock

in t h e b e h a v i o r o f i n d i v i d u a l

intermediation process

their required reserves.

n o t t h e leve l

in t h e m o n e y s t o c k .

T h e funds m a r k e t allows

comparative advantage.

and

It is t h e r e l a t i o n s h i p

E v i d e n c e s u p p o r t i n g t h e in terest ra te model
d e t e r m i n a t i o n c a n be o b s e r v e d

and money,

if t h e f e d f u n d s r a t e is

b e t w e e n t h e funds r a t e and th e ra t e on ba n k assets,
that determines changes

is

Even an i n s t i t u t i o n w i t h a

low re l a t i v e to the ra te a v ai la bl e on assets.

reserves,

and

After

all,

in t h e m a r k e t

w h e r e o n e is t h e q u a n t i t y s u p p l i e d a n d t h e o t h e r

is t h e

-14-

price determined.

Is t h e c h o i c e o f o n e o r t h e o t h e r n o t s i m p l y a

distinction without a difference?
that there

is a re al

First,

There are compelling reasons

di ff erence between these two views.

the i n te re st rate v i e w does not of fe r the federal

a l o n e as t h e d e t e r m i n a n t o f t h e m o n e y s t o c k ,
between the federal
So a rise

to believe

funds rate

but rather the re la ti on sh ip

funds rate and rates available on longer t e rm assets.

in t h e f e d e r a l

f u n d s r a t e wi l l

not necess ar il y result

in a

s m a l l e r m o n e y s t o c k if r a te s on l o ng er t e r m c r e d i t r i s e e v e n more.
Similarly,

if lo n g e r r a te s

fall,

r a t e an d n o t p r o d u c e an i n c r e a s e

Second,

there

it is p o s s i b l e t o l o w e r t h e f e d e r a l

funds

in t h e m o n e y s t o c k .

is a n h i s t o r i c a l

episode that makes

that the two views are not equivalent.

In O c t o b e r

it a b s o l u t e l y c l e a r

1 9 7 9 t h e Fe d, w h i c h h a d

been un su c c e s s f u l l y trying to slow the ec on o m y by gr ad ua ll y raising the
federal

funds rate,

targeting.

s w i t c h e d t o a p o l i c y it d e s c r i b e d as r e s e r v e

Reserve targeting appears to require that the mo ne ta ry

a u t h o r i t y set total

reserves

as a m e a n s o f c o n t r o l l i n g m o n e y .

However,

t h e r e s e r v e a c c o u n t i n g s y s t e m in e f f e c t a t t h e t i m e w a s a l a g g e d r e s e r v e
system under which depository institutions’ reserve requirements
current w e e k w e re based on their deposits two weeks
system,

d e p o s i t o r y i n s t i t u t i o n s c a n n o t c h a n g e t h e leve l

reserves
a leve l

previous.

in t h e

Under this

of required

set two weeks earlier and so the m o n e t a r y au thority must provide
o f total

reserves.

r e s e r v e s a t l e a s t eq u a l

t o t h e level

of required

Under the textbook vi ew of the mo ne y supply process this would

s e e m to p r o d u c e an i n s u r m o u n t a b l e p r o b l e m if t h e Fed d e s i r e d a r e d u c t i o n
in t h e m o n e y s t o c k .




There

is n o w a y t h e m o n e t a r y a u t h o r i t y c a n r e d u c e

-15-

reserves

b e l o w t h e level

In p r a c t i c e ,

actual

of required reserves

set two w e ek s earlier.

policy targeted unborrowed reserves.

t h a t e v e n t h o u g h t h e F e d h a d t o p r o v i d e a level
a b o v e t h e leve l

it w o u l d h a v e d e s i r e d ,

reserves that was

it c o u l d r u n a c o n t r a c t i o n a r y

p o l i c y by f o rc in g up t h e fed funds rate.
reserves

o f t o ta l

This meant

It d i d t h i s

by providing

fewer

through the open ma rket desk and forcing the system to borrow

more of the required reserves through the discount w i n d o w . 1*

In t h i s

w a y the m o n e t a r y a u t h o r i t y rais ed the funds rate and pr od u c e d a
contraction

in b a n k a s s e t h o l d i n g s

and deposits

t h a t r e s e r v e s c o u l d be r e d u c e d t w o w e e k s

in t h e c u r r e n t w e e k so

in t h e f u t u r e .

Reserve targeting under lagged reserve accounting strongly suggests
that the money supply mechanism works through the interest rate view
described earlier.

It m a k e s

it a b s o l u t e l y c r y s t a l

me chanism does not w o r k through reserves
This episode also makes

clear that the

as d e s c r i b e d

in t h e t e x t b o o k s .

it c l e a r t h a t r e s e r v e a c c o u n t i n g ,

while often

t h o u g h t to be a n a r r o w an d r e m o t e s u b j e c t of l i t t l e i n t e r e s t to a n y o n e but
technicians,

can give v e ry valuable clues to the nature of the m o n e y

supply process.

III.

The

interest rate spread view of the m o n e y su pply m e c h a n i s m gives a

d e c i d e d l y d i f f e r e n t v i e w of,

and n e w insights

in to,

prominent m o n e t a r y po licy issues of recent decades.




a number of the
If m o n e t a r y p o l i c y

-16-

impacts on the m o n e y stock through

interest rates,

can

it m a k e s e n s e t o

a r g u e fo r a p o l i c y c o n d u c t e d t h r o u g h t a r g e t i n g r e s e r v e s ?
targeting reserves

( w h e t h e r u n d e r s t o o d b y all

its a d h e r e n t s o r n o t ) ,

perfectly consistent with a mechanism operating through
What advocates of reserve targeting are re al ly proposing
m e c h a n i s m to se t t h e a p p r o p r i a t e federal

A policy of

funds rate.

interest rates.
is a n a u t o m a t i c

T h e i r re al

objection

is n o t t o t h e c o n c e p t o f i n t e r e s t r a t e s p l a y i n g a p r o m i n e n t r o l e
d e t e r m i n i n g t h e m o n e y stock,
is d e t e r m i n e d .

but rather to h o w t h e crucial

T h e y are skeptical

a u t h o r i t y t o k n o w t h e r i g h t leve l

Advocates of m o n e t a r y control

in

fed funds r a te

of the ability of the m o n e t a r y
of in te re st rates.

t h r o u g h r e s e r v e t a r g e t i n g r e a l l y h a v e in

m i n d an a u t o m a t i c m e c h a n i s m for s e t t in g t h e c o r r e c t fed fu nds rate.
mechanism operates through the
excess reserves
reserves).

(i .e.

is

This

interaction between the fed funds rate and

the discrepancy between reserves and required

A physical

a n a l o g y w o u l d be a balance.

The q u an ti ty of

r e s e r v e s t h a t c o r r e s p o n d s t o t h e d e s i r e d leve l

of deposits

m o n e t a r y a u t h or it y on one pan of the balance.

Having set the q u an ti ty of

reserves on one side of the balance,
done.

t h e m o n e t a r y a u t h o r i t y ’s t a s k is

The fed funds rate should then be de te rmined solely by the

difference
t h e leve l
system.
l e ve l

is s e t b y t h e

(excess reserves)

b e t w e e n t h e le vel

of required reserves
If d e p o s i t s

of reserves

a r e low,

supplied,

of reserves su pplied and

b a s e d o n t h e level

of deposits

so th a t r e q u i r e d r e s e r v e s

are below the

th e fed funds ra t e s t ar ts to fall.

funds rate falls depository institutions respond by purchasing
securities,
fall




increasing deposits

in t h e f e d f u n d s r a t e .

and required reserves

T h e f u n d s r a t e wi l l

in t h e

As th e
loans and

and da mpening the

c o n t i n u e t o fall

until

-17-

deposits have
t h e level
level.
reserves
wi ll

of reserves

Conversely,

into balance with

provided and the funds rate settles at the correct

if t h e c u r r e n t level

a r e g r e a t e r t h a n t h e level

rise,

deposits

increased enough to move required reserves

of deposits

is s u c h t h a t r e q u i r e d

of reserves provided,

i n d u c i n g d e p o s i t o r y i n s t i t u t i o n s t o sell

a n d r e q u i r e d r e s e r v e s unti l

the funds rate

assets,

decreasing

t h e y a r e in b a l a n c e w i t h t h e level

of

r e s e r v e s p r o v i d e d and t h e funds ra t e sett le s at t h e c o r r e c t h i g h e r level.

At times during the debate between reserve targeting advocates
interest rate targeting advocates
targeting advocates were
interest rates was

and

it m a y h a v e s e e m e d t h a t r e s e r v e

implying that a policy implemented through

inherently unstable.

Much of this criticism was really

d i r e c t e d at a p e r c e i v e d t e n d e n c y on t h e pa rt of t h e m o n e t a r y a u t h o r i t y to
peg interest rates

at a fixed rate.

Reserve targeting advocates

argued

th a t r a te s s h o u l d be a l l o w e d to m o v e m o r e f r e e l y and th a t a r e s e r v e
t a r g e t i n g p r o c e d u r e w o u l d g u id e t h e rates to the r i gh t level.
in te re st r a t e model

developed

The

in t h e p r e v i o u s s e c t i o n s u g g e s t s t h a t w h a t

re se r v e t a r g e t i n g advocates r e a l l y w a n t e d was a s y s t e m w h e r e the fed funds
rate would automatically move with the rate of return on assets available
to d e p o si to ry institutions.

There

is n o i n c o n s i s t e n c y b e t w e e n r e s e r v e

t a r g e t i n g a n d a p r o m i n e n t r o l e fo r i n t e r e s t r a t e s
mechanism.

Indeed,

in t h e m o n e y s u p p l y

it is e v e n p o s s i b l e t o v i e w t h e m o n e y s t o c k t a r g e t as

a guide th at helps the m o n e t a r y a u t h o r i t y set the proper

Given the vi ew above of reserve targeting,

i n t e r e s t ra t e .

it b e c o m e s

immediately

c l e a r t h a t t h e r e s e r v e o p e r a t i n g p r o c e d u r e a d o p t e d b y t h e F e d in 19 79
could not have been the procedure that m o n e t a r y control




advocates were

-18-

seeking.

U n d e r t h e l a g g e d r e s e r v e s y s t e m in o p e r a t i o n a t t h e t i m e t h e r e

w a s no w a y for th e s y s t e m to o p e r a t e like the b a la nc e d e s c r i b e d a b o v e and
have changes
rate.

in t h e c u r r e n t le vel

of deposits

in te ra ct w i t h t h e fed funds

So t h er e w a s no w a y of havi ng the fed funds ra te guide d e p o s i t o r y

i n s t i t u t i o n s t o m o v e c u r r e n t d e p o s i t s t o a level
of reserves
was,

provided.

in f a ct ,

rate.

c o n s i s t e n t w i t h t h e level

The reserve operating procedure adopted

in 1 9 7 9

a d i f f e r e n t w a y o f having the Fed d e t e r m i n e th e fed funds

Instead of the Fed d e t e r m i n i n g a pr e s e l e c t e d ra te d i r e c t l y t h ro ug h

open market operations,

the rate

(which w a s n o t l i k e l y to be k n o w n

b e f o r e h a n d b y t h e Fe d ) w a s d e t e r m i n e d b y t h e i n t e r a c t i o n o f t h e level
unborrowed reserves

of

supplied by the Fed through the open ma rk et d e sk and

t h e b e h a v i o r o f d e p o s i t o r y i n s t i t u t i o n s a n d t h e F e d ’s d i s c o u n t o f f i c e r s

in

d e t e r m i n i n g t h e s p r e a d b e t w e e n t h e fe d f u n d s r a t e a n d t h e d i s c o u n t r a t e
n e c e s s a r y t o p r o d u c e t h e r e q u i s i t e level

In t e r m s o f t h e b a l a n c e m o d e l

of borrowed reserves.

of reserve targeting de scribed earlier,

there w e r e r e al ly two problems with this n e w op erating procedure.
that

One was

it b e c a m e c l e a r t h a t t h e r e w e r e s o m e t i m e s w h e n t h e m o n e t a r y

a u t h or it y could not set reserves
This was

the problem described

low enough on one side of the balance.

in t h e p r e v i o u s s e c t i o n a n d t h e r e a s o n w h y

lagged reserve accounting drew increasing criticism after the adoption of
the n e w op erating procedure and was e v e n tu al ly changed.
problem was that

The second

lagged reserves always prevented the new operating

pr oc ed ur e from functioning like a true reserve targeting procedure because
it p r e v e n t e d c h a n g e s
fed funds rate.
changes

in t h e c u r r e n t level

of deposits

In t e r m s o f t h e b a l a n c e a n a l o g y t h i s p r o b l e m m e a n t t h a t

in c u r r e n t d e p o s i t s c o u l d n o t c h a n g e t h e leve l




from affecting the

of required

-19-

rese rv es on the o t he r side o f the balance.

The description of what

is e n t a i l e d

in a r e s e r v e t a r g e t i n g p r o c e d u r e

gives some insight into the role of reserve requirements
policy.
rate

The role of reserve requirements

in m o n e t a r y

is t o h e l p s e t t h e f e d f u n d s

in a s y s t e m w h e r e p o l i c y is d i r e c t e d t o c o n t r o l l i n g a n a g g r e g a t e a n d

conducted through reserve targeting.
i f p o l i c y is d i r e c t e d t o c o n t r o l

Reserve requirements make sense only

o v e r a n a g g r e g a t e a n d p o l i c y is

implemented through reserve targeting.
control

ov e r an ag gr eg at e,

E v e n if p o l i c y is d i r e c t e d t o

if th e funds ra t e

is b e i n g s e t in s o m e o t h e r

w a y than the r e s e r v e t a r g e t i n g m e c h a n i s m de s c r i b e d above,
requirements

reserve

a r e s u p e r f l u o u s t o t h e c o n d u c t o f m o n e t a r y p o l i c y . 12

T h i s v i e w o f t h e m o n e y s u p p l y p r o c e s s as o p e r a t i n g t h r o u g h t h e
r e l a t i v e p o s i t i o n o f t h e fe d f u n d s r a t e a n d m a r k e t r a t e s a l s o h e l p s
explains
in 1979.

a surprising consequence of the new operating procedure adopted
When the new operating procedure was adopted

it w a s w i d e l y

t h o u g h t th a t w h i l e s h o r t - t e r m fed funds v o l a t i l i t y w o u l d increase,
s h o r t - t e r m v o l a t i l i t y in t h e m o n e y s t o c k w o u l d d e c l i n e .
a r o s e b e c a u s e t h e o l d s y s t e m o f p e g g i n g t h e federal
to am plify the effects of shifts
changes

in t h e m o n e y s t o c k .

d e m a n d for money,
rates.

For example,

if t h e r e w e r e a n i n c r e a s e

t h e r e w o u l d b e an i n c r e a s e in b o t h m o n e y a n d

Under the old

interest rate targeting procedure,

f u n d s r a t e b a c k t o t h e t a r g e t level




funds rate was thought

in t h e d e m a n d f o r m o n e y i n t o e v e n l a r g e r

authority w o ul d respond by increasing reserves,

further.

This expectation

in t h e

interest

the monetary

t h e r e b y l o w e r i n g t h e fed

a n d i n c r e a s i n g d e p o s i t s st il l

Thus the interest rate targeting regime was thought to buy

-20-

i n t e r e s t r a t e s t a b i l i t y at t h e e x p e n s e of i n c r e a s e d d e p o s i t v o l a t i l i t y .

The n e w op er at in g procedure of 1979-1982 did increase fed funds
v o l a t i l i t y as e x p e c t e d ,

b u t it a l s o

increased weekly deposit volatility.

T h e r e a s o n for th i s ca n be e x p l a i n e d by t h e i n t e r e s t - r a t e s p r e a d v i e w o f
the m o n e y su pp ly me ch an is m described earlier.
s t o c k control

What advocates of money

w a n t e d fr om incr ea se d funds ra te v o l a t i l i t y was a sy s t e m

where a change

in t h e

interest rate on ea rning assets av ailable to

depository institutions was automatically matched by a change
funds rate.

in t h e f e d

This would reduce the vo latility of the difference between

the rates and the volatility of the resultant deposit changes.
the effect of lagged reserves was to prevent the movements
funds rate from ma tc hi ng the changes
depository institutions.

The

However,

in t h e f e d

in t h e r a t e o n a s s e t s a v a i l a b l e t o

i n c r e a s e d v o l a t i l i t y in t h e f e d f u n d s r a t e

with the adoption of the new operating procedure only served to increase
the v o l a t i l i t y o f the d i f f e r e n c e between the fed funds r a t e and the rate
on assets

available to depository institutions.

equilibrium by having depository institutions
assets

(and c h a n g e deposits)

u n ti l

e q u i l i b r i u m w i t h t h e fe d f u n d s r a t e

Since the system came to

p u r c h a s e o r sell

earning

the rate on these assets moved
(a n d e x p e c t e d

into

future fed funds rates),

i n c r e a s e d v o l a t i l i t y in t h e d i f f e r e n c e b e t w e e n t h e s e r a t e s

led to

i n c r e a s e d s h o r t - r u n d e p o s i t v o l a t i l i t y . 13

Finally,

the

interest rate vi ew of mo ne y determination provides

somewhat different view of the possibilities
control.

Typically,

for a c c u r a t e m o n e t a r y

advocates of monetary targeting have conceded that

a c c u r a t e m o n e t a r y control




a

is n o t p o s s i b l e

in t h e s h o r t - r u n ,

but that

-21-

s u f f i c i e n t l y a c c u r a t e longer-run control

is p o s s i b l e b y c o n t r o l l i n g t h e

m o n e t a r y base or some variant of reserves.
provided

Supporting evidence

is u s u a l l y

in t h e f o r m o f e x t e n s i v e s t u d i e s o f t h e l o n g - r u n s t a b i l i t y o f

various reserve multipliers.*4

It is v e r y l i k e l y t h a t t h e e v i d e n c e f r o m r e s e r v e m u l t i p l i e r s t a b i l i t y
is t o o o p t i m i s t i c w i t h r e g a r d t o t h e d e g r e e o f m o n e t a r y c o n t r o l

possible

under the present reserve accounting system with reserve targeting.

The

m o n e t a r y a u t h o r i t y has t y p i c a l l y ta rg e t e d the funds ra te w i t h i n a n a r r o w
range over the period when these reserve multipliers were calculated.
e s s e n c e o f a funds ra te t a rg et in g proc ed ur e
changes

in t h e leve l

(and t h e funds rate)

of required reserves,
stable.

The

is m o v i n g r e s e r v e s t o m a t c h
s o as t o k e e p e x c e s s r e s e r v e s

This policy makes the multiplier look more

s t a b l e th a n w o u l d be th e c a s e if t h e m o n e t a r y a u t h o r i t y i n d e p e n d e n t l y set
a d e s i r e d level

of reserves

t o a d j u s t t o t h e leve l

On t h e o t he r hand,
possible

a n d t h e level

of required reserves we re forced

of reserves.

the v i e w that a c cu ra te m o n e t a r y control

in t h e s h o r t - r u n

is fa r t o o p e s s i m i s t i c ,

based on the sh or t-term behavior of the multiplier
irrelevant.

A c c u r a t e m o n e t a r y control

is n o t

and the typical

evidence

is a c t u a l l y

e v e r y s e t t l e m e n t p e r i o d is v e r y

p o s s i b l e a n d t h e e v i d e n c e c a n be o b t a i n e d f r o m a r e l a t i v e l y s i m p l e
m i c r o - a n a l y s i s o f the individual

depository institution.

This assertion

m a y s e e m w i l d l y o p t i m i s t i c in l i g h t o f t h e p r e v a i l i n g o p i n i o n r e g a r d i n g
the possibilities
again,

fo r a c c u r a t e s h o r t - r u n m o n e t a r y c o n t r o l .

an hi st or ic al

provides valuable




However once

episode and the evidence from reserve accounting

insight.

In t h e w a k e o f t h e G r e a t D e p r e s s i o n o f t h e

-22-

1 9 3 0 ’s, a n u m b e r o f e c o n o m i s t s

advocated one-hundred percent reserve

r e q u i r e m e n t s as a m e a n s o f gi v i n g t h e m o n e t a r y a u t h o r i t y a b s o l u t e l y
accurate control

over money.

Whatever the other draw-backs of one-hundred

percent reserve requirements,

no economist expressed doubt that such a

system would provide accurate short-run mo n e t a r y control.

Yet no one

conducted any studies of the likely reserve multipliers under such a
system.

The reason

the behavior of the

is t h a t a n a l y s t s c o u l d
individual

immediately see by considering

institution that one-hundred percent

r e s e r v e r e q u i r e m e n t s w a s a s y s t e m in w h i c h e x c e s s r e s e r v e h o l d i n g s w o u l d
be e s s e n t i a l l y zero,

and ac c u r a t e control

into accurate control

over reserves would translate

over money.

O n e - h u n d r e d p e r c e n t r e s e r v e r e q u i r e m e n t s m a k e it c l e a r t h a t r e s e r v e
accounting,

a n d its

impact on individual

accurate m o n e t a r y control.
requirements make
the fundamental

Indeed,

bank behavior,

is t h e k e y t o

one-hundred percent reserve

it c l e a r t h a t a c c u r a t e m o n e t a r y c o n t r o l

problem.

As noted,

m o n e y s u p p l y a c c u r a t e l y in t h e

is n o t r e a l l y

e c o n om is ts k n e w h o w to control

1 9 3 0 ’s.

the

A system of one-hundred percent

reserve requirements would give accurate mone ta ry control,

b u t it w o u l d

al s o s t i m u l a t e the se ar ch for i n st ru me nt s t h a t w o u l d gi ve t h e se rv i c e s of
demand deposits
requirements.

but be e x e m p t
T h e re al

from one-hundred percent reserve

pr ob l e m o f m o n e t a r y control

is h o w t o c o n t r o l

m o n e y w i t h o u t p u t t i n g s u c h o n e r o u s t a x e s o n t h e t a r g e t a g g r e g a t e as t o
d e s t r o y its

In t h e

i n t e g r i t y . 15

1 9 7 0 ’s t w o s y s t e m s w e r e p r o p o s e d t h a t r e p r e s e n t e d g r e a t

improvements




in p o t e n t i a l

mo n e t a r y control.

Poole

[21]

proposed a system

-23-

of one-hundred percent marginal
improve mone ta ry control,
However,

reserve requirements that would greatly

even with fractional

the m o n e t a r y control

reserve requirements.

a c c u r a c y of even the Poole proposal

as r e s e r v e r e q u i r e m e n t s w e r e l o w e r e d t o v e r y l o w l e v e l s .
p r o p o s e d a re s e r v e a c c o u n t i n g sy s t e m that,
system,

Laurent

h e l d in s o m e p r e v i o u s w e e k .

appropriately named-lead reserves)
m o n e t a r y control

in t h e c u r r e n t

This re verse lag

(or m o r e

system would allow very accurate

e v e r y se tt le me nt period,

reserve requirements.

[IS]

reversing the lagged reserve

would have depository institutions satisfy deposits

week with reserves

declined

n o m a t t e r h o w l o w t h e le vel

of

It s h o u l d b e n o t e d t h a t n e i t h e r o f t h e s e p r o p o s a l s

involved any macro-analysis

at al l.

is n o t t h r o u g h m a c r o - a n a l y s i s ,

T h e path to a c c u r a t e m o n e t a r y control

but rather through a m i c r o - b a n k

analysis.*6

IV

The previous sections of the paper have advanced the view that the
m o n e y s u p p l y m e c h a n i s m op e r a t e s t h r o u g h t h e r e l a t i o n s h i p b e t w e e n t h e fed
funds rate set by t h e Fed and rates on ea rn in g assets av a i l a b l e to
depository institutions.
advanced

in t h e e c o n o m i c d e b a t e s o f r e c e n t y e a r s ,

inferred that this
economists
believers

W h i l e t h i s v i e w ha s n o t b e e n p r o m i n e n t l y

is a n e w i n s i g h t .

in t h e h i s t o r y o f e c o n o m i c t h o u g h t ,

some of the most prominent
including most especially

in a p r o m i n e n t r o l e f o r m o n e y in e c o n o m i c t h e o r y ,

recognized the role of interest rates




Indeed,

it s h o u l d n o t be

have clearly

in t h e m o n e y s u p p l y m e c h a n i s m .

-24-

Mil t o n F r i e d m a n ,

as s t r o n g a n a d v o c a t e as a n y o f i n t e r p r e t i n g m o n e t a r y

policy through m o n e y stock changes,

s t a t e d in C o n g r e s s i o n a l

testimony

[ 5]

" T h e p r e s e n t p r o c e d u r e is a c a r r y o v e r f r o m t h e t i m e b e f o r e 1 9 7 0 w h e n
t h e F e d h a d m o n e y m a r k e t c o n d i t i o n s as its o b j e c t i v e s .
The present
p r o c e d u r e i n v o l v e s s e t t i n g a m o n e y s u p p l y t a r g e t , t h e 5 t o 7 1/ 2 p e r c e n t ,
f o r e x a m p l e , t h a t Dr. B u r n s s e t t h e o t h e r da y , a n d t h e n a s k i n g t h e s t a f f
to c a l c u l a t e w h a t federal funds r a t e w o u l d lead to t h a t m o n e y s u p p l y
t a r g e t b e in g achieved, and then as ki ng the N e w Y o r k Federal R e s e r v e B a n k
to pe g t h e Federal fu nds ra t e at th a t level.
N o w in p r i n c i p l e t h a t m e t h o d c o u l d w o r k .
In p r i n c i p l e t h e r e is a
Federal funds ra t e t h a t w o u l d induce the commercial banks, th e m e m b e r
banks, to add t o t h e i r r e s e r v e s t h a t amount w h i c h w o u l d be n e c e s s a r y to
produce the desired growth target.
In p r i n c i p l e , t h e r e f o r e , it c o u l d
work; but u n fo rt un at el y there are two major slips between that principle
and the practice.
T h e f i r s t s l i p is t h a t t h e F e d c a n n o t p r e d i c t w h a t t h e r i g h t F e d e r a l
f u n d s r a t e is.
T h e F e d e r a l f u n d s r a t e t h a t is r i g h t d e p e n d s o n t h e r a t e s
a t w h i c h c o m m e r c i a l b a n k s c a n l e n d as we l l as t h e c o s t o f f u n d s t o t h e m .
T h e F e d e r a l f u n d s r a t e is t h e c o s t o f f u n d s b u t it d o e s n ' t te ll
you
a n y t h i n g a b o u t t h e r a t e a t w h i c h t h e y c a n le nd .
In o r d e r t o b e a b l e t o p r e d i c t
y o u h a v e to be a b l e to p r e d i c t th e

what the right
rates at w h i c h

Federal funds r a t e
t h e y c a n l e n d ..."

is,

It c o u l d n o t b e s t a t e d m o r e c l e a r l y t h a t t h e p r o b l e m in t h e c e n t r a l
bank trying to control
interest rates

m o n e y t h r o u g h s e t t i n g an i n t e r e s t rate,

p l a y n o r o l e in t h e m o n e y s u p p l y p r o c e s s ,

d i f f i c u l t y o f k n o w i n g th e c o r r e c t rate.
s t a t e s t h a t t h e c o r r e c t level

is n o t t h a t

but rather the

The Friedman quote also clearly

for t h e federal

funds rate depends on the

r a t e a t w h i c h d e p o s i t o r y i n s t i t u t i o n s c a n le nd .

The concept of monetary policy operating through the relationship
between two

interest rates

is a i d e a p o p u l a r i z e d a t l e a s t as l o n g a g o as

the beginning of this century by Knut Wicksell,
economist.
central

bank,

of capital.




Wicksell

distinguished two rates

and a natural

rate determined

the prominent Swedish

- a market rate set by the
by the marginal

A m a r k e t ra te set b e lo w the natural

productivity

rate results

in an

-25-

e x p a n s i o n a r y m o n e t a r y policy,
natural

rate produces

w h il e conv er se ly a m a r k e t rate set above the

a contra ct io na ry m o n e t a r y policy.

Wicksell

himself

v i e w e d h i s w o r k as d i r e c t e d at t h e p r o b l e m o f d e t e r m i n i n g w h a t le vel
bank notes would

be is sued by a b a n k i n g s y s t e m w i t h a central

n o n - c o n v e r t i b l e bank notes.
ba nking s y s t e m w i t h a central

His analysis

of

b a n k and

is r e l e v a n t t o a n y m o d e r n

bank and fiat money.

W i c k s e l l ’s a n a l y s i s

n o t o n l y e s t a b l i s h e d t h e d e t e r m i n a n t s o f f i a t m o n e y in s u c h a s y s t e m ,
also resolved a paradox that had often troubled economic observers.
paradox,

l a b e l e d G i b s o n ’s p a r a d o x b y e c o n o m i s t s ,

high

This

notes that theory clearly

i n d i c a t e s t h a t a n e x p a n s i o n a r y p o l i c y is i m p l e m e n t e d b y l o w e r i n g
rates,

it

interest

yet periods of heightened economic activity are characterized by

interest rates.

Wicksell's

interest rate mechanism explains the

p a r a d o x - p o l i c y is e a s e d b y l o w e r i n g t h e m a r k e t r a t e r e l a t i v e t o t h e
natural

rate,

b u t as t h e e c o n o m y s t r e n g t h e n s t h e n a t u r a l

rate rises.

W i c k s e l l ’s i n t e r e s t r a t e m e c h a n i s m is c l e a r l y s i m i l a r t o t h e m o n e y
supply mechanism advanced earlier

in t h i s p a p e r .

Wicksell

viewed the

fundamental

p r o b l e m o f m o n e t a r y p o l i c y to be e s t a b l i s h i n g t h e d e t e r m i n a n t s

of prices.

Even a cu rs or y reading of Wicksell

n o t v i e w his

makes

it c l e a r t h a t h e d i d

i n t e r e s t r a t e m e c h a n i s m as b e i n g in a n y w a y in c o n f l i c t w i t h

a prominent role for money.
pr ef ac e to his

book

Indeed,

as W i c k s e l l

Interest and Prices

described

it in t h e

[28]:

"If t h e m o n e t a r y in st it ut io ns of fer th eir m o n e y or t h e i r c r e d i t on
a b n o r m a l l y f a v o u r a b l e terms, this m u s t l o g i c a l l y le ad to an i n t e n s i f i e d
us e o f m o n e y or c r e d i t on the part o f the public.
A r i s e in p r i c e s is t h e
r e s u l t , a n d w e h a v e s e e n t h a t p r i c e s wi l l c o n t i n u e r i s i n g s o l o n g as
c r ed it re ma in s easy.
A t i g h t e n i n g o f c r e d i t has, o f c o u r s e , t h e o p p o s i t e
effect.
A v e r y i m p o r t a n t q u a l i f i c a t i o n is, h o w e v e r n e c e s s a r y .
T h o u g h it is
c a l l e d f o r b y t h e v e r y n a t u r e o f t h e s e p h e n o m e n a , it is f r e q u e n t l y
o v e r l o o k e d , a n d h a s t y c o n c l u s i o n s , w h i c h t h e f a c t s fail t o s u p p o r t , a r e
the result.
T h e r a t e o f i n t e r e s t c h a r g e d fo r l o a n s c a n c l e a r l y n e v e r be



-26-

e i t h e r h i g h o r l o w in i t s e l f , b u t o n l y in r e l a t i o n t o t h e r e t u r n w h i c h
c a n , o r is e x p e c t e d to, b e o b t a i n e d b y t h e m a n w h o h a s p o s s e s s i o n o f
money.
It is n o t a h i g h o r l o w r a t e o f i n t e r e s t in t h e a b s o l u t e s e n s e
w h i c h m u s t b e r e g a r d e d as i n f l u e n c i n g t h e d e m a n d f o r r a w m a t e r i a l s ,
l a b o u r , a n d l a n d o r o t h e r p r o d u c t i v e r e s o u r c e s , a n d s o i n d i r e c t l y as
d e t e r m i n i n g the m o v e m e n t of prices.
T h e c a u s a t i v e f a c t o r is t h e c u r r e n t
r a t e o f i n t e r e s t o n l o a n s as c o m p a r e d w i t h w h a t I s h al l b e c a l l i n g t h e
natural ra te o f i n te re st on capital.
T h i s n a t u r a l r a t e is r o u g h l y t h e
s a m e t h i n g as t h e re al i n t e r e s t o f a c tu al b u s i n e s s .
A m o re accurate,
t h o u g h r a t h e r a b s t r a c t , c r i t e r i o n is o b t a i n e d b y t h i n k i n g o f it as t h e
r a t e w h i c h w o u l d b e d e t e r m i n e d b y s u p p l y a n d d e m a n d i f real c a p i t a l w e r e
l e n t in k i n d w i t h o u t t h e i n t e r v e n t i o n o f m o n e y .
It is r e m a r k a b l e t h a t t h i s p r o p o s i t i o n - f u n d a m e n t a l l y v e r y s i m p l e ,
indeed almost self-evident - though occasionally alluded to by economists,
h a s n e v e r , t o m y k n o w l e d g e , b e e n u s e d as t h e f o u n d a t i o n f o r a c o m p l e t e
theory of mo n e y and prices."
Essentially,

Wicksell

vi ewed his

i n t e r e s t r a t e r e l a t i o n s h i p as b e i n g

t h e m o n e t a r y p o l i c y m e c h a n i s m d e t e r m i n i n g m o n e y an d ,
prices.

through money,

He s a w no c o n f l i c t b e t w e e n an i n t e r e s t r a t e m e c h a n i s m an d a

prominent role for money.

W h i l e t h e a t t r a c t i o n s o f W i c k s e l l ’s a p p r o a c h h a v e l o n g b e e n
appreciated,

t h e r e is a p r o b l e m in a p p l y i n g it t o t h e c o n d u c t a n d

interpretation of m o n e t a r y policy.
is u n o b s e r v a b l e .

T h e p r o b l e m is t h a t t h e n a t u r a l

W h il e the m a r k e t rate can be e a si ly observed,

setting of the ma r k e t rate e f fe ct iv el y hides the natural
presentation earlier

rate.

t h e r e is n o w a y t o o b s e r v e t h e n a t u r a l

However,

the
The

in t h i s p a p e r i n d i c a t e s t h a t c u r r e n t l y t h e r a t e m o s t

d i r e c t l y i n f l u e n c e d b y t h e F e d is t h e o v e r n i g h t f e d f u n d s r a t e .
though,

rate

Again

fed funds rate.

t h e p o s i t i o n o f t h e fed funds r a t e at t h e v e r y s h o r t e s t e n d

of the yield curve does suggest another possibility.

Is it p o s s i b l e t h a t

the r e l a ti on sh ip between the fed funds rate and the yi el d on longer te rm
r a t e s m i g h t g i v e a c l u e as t o w h e t h e r t h e m a r k e t f e d f u n d s r a t e w a s s e t




-27-

high or low?

T h e le vel

the fed funds r a t e

and slope of the yield curve

in t h e v i c i n i t y o f

is l i k e l y t o b e h e a v i l y i n f l u e n c e d b y t h e F e d ’s t a r g e t

f e d f u n d s r a t e a n d m a r k e t e x p e c t a t i o n s as t o e x p e c t e d
However,

as o n e m o v e s

future Fed moves.

fu rt h e r out on t h e y i e l d c u r v e t h e i n f l u e n c e of Fed

p o l i c y in d e t e r m i n i n g r a t e s s h o u l d d i m i n i s h .

Th i s s u g g e s t s t h a t a useful

c o m p a r i s o n m i g h t be be t w e e n a l o n g - t e r m r a t e and t h e fed funds rate.

In t h e a u t h o r ’s e a r l i e r s t u d y t h e d i f f e r e n c e b e t w e e n t h e 2 0 - y e a r
c o ns ta nt m a t u r i t y t r e a s u r y rate and the fed funds ra te
equivalent

b a s i s ) w a s u s e d as a n

indicator of mone ta ry p o l i c y . ^

greater the algebraic difference the easier
m o r e l i k e l y t h a t real

e c o n o m i c a c t i v i t y wi l l

smaller the algebraic difference,
sl ow er will

This

is m o n e t a r y p o l i c y a n d t h e
expand

future.

all

in t h e f u t u r e .

The

It m i g h t s e e m

l o n g - t e r m i n t e r e s t r a t e as t h e n a t u r a l

is n e i t h e r n e c e s s a r y n o r l i k e l y t o be t r u e .

view of the world,

The

the tighter m o ne ta ry policy and the

e c o n o m i c a c t i v i t y e x p a n d in t h e

tempting to think of the

(on a b o n d

t h a t is r e q u i r e d

rate.

In t e r m s o f W i c k s e l l ’s

is t h a t t h e s p r e a d b e t w e e n t h e

l o n g r a t e a n d t h e f e d f u n d s r a t e be p o s i t i v e l y r e l a t e d t o t h e d i f f e r e n c e
be tw ee n the natural
view,

fed funds ra te and t h e m a r k e t fed funds rate.

the spread between

provides

the l o ng -t er m ra te and the fed funds

an i n d i c a t o r o f

In t h i s

rate

m o n e t a r y policy by providing a trace of the

spre ad be tw ee n the natural

fed funds rate and the m a r k e t r a t e set by the

Fed.

An alternative

i n t e r p r e t a t i o n o f an i n t e r e s t r a t e s p r e a d

by the re cognition that the yield curve contains
future interest rates.




is p r o v i d e d

implicit forecasts of

A downward sloping yield curve can be interpeted

-28-

as c o n s i s t e n t w i t h e x p e c t a t i o n s o f d e c l i n i n g

in te re st r a te s w h i l e an

u p w a r d s l o p i n g y i e l d c u r v e c a n b e i n t e r p r e t e d as c o n s i s t e n t w i t h
expectations of rising

interest rates.

S i n c e i n t e r e s t r a t e s t e n d t o be

po sitively associated with economic activity,

t h e y i e l d c u r v e c a n be

v i e w e d as c o n t a i n i n g m a r k e t f o r e c a s t s a b o u t f u t u r e e c o n o m i c a c t i v i t y .
t h e e x t e n t t h a t o n e is i n c l i n e d t o t h i s

interpretation of the y i el d curve,

o n e w o u l d be l i k e l y to us e g o v e r n m e n t s e c u r i t i e s
long-term yields,

for bo th t h e s h o r t and

s o as t o a v o i d t h e p r o b l e m s o f c h a n g i n g c r e d i t r i s k s .

The majority of spreads
long-term governments
themselves to the

To

advanced have been differences

and sh ort-term governments,

in y i e l d s

between

and so have lent

interpretation that they are extracting a m a rk et

f o r e c a s t a b o u t f u t u r e e c o n o m i c a c t i v i t y . 18

Though the two
incompatible,

interpretations of the yi el d curve are not completely

t h e r e is a v e r y real

d i f f e r e n c e in t h e t w o v i e w s .

The

interest rate spread between a long-term rate and the fed funds rate
d e s i g n e d t o g a u g e w h e t h e r t h e f e d f u n d s r a t e is s e t h i g h o r lo w.
approach

is

This

is m o r e a m e n a b l e t o a n i n t e r p r e t a t i o n as a g a u g e o f p o l i c y s i n c e

it c o n t a i n s t h e f e d f u n d s r a t e t h r o u g h w h i c h m o n e t a r y p o l i c y is c u r r e n t l y
implemented.

The

interest rate spread between a long-term and short-term

government security yield

is m o r e a m e n a b l e t o a n i n t e r p r e t a t i o n o f

capturing market expectations of future interest rate movements.
latter approach
are formed.




This

is m o r e s e n s i t i v e t o t h e s u b t l e t i e s o f h o w e x p e c t a t i o n s

-29-

Conclusion

The conduct and interpretation of m o n e t a r y po licy have become mo re
difficult

in t h e

1 9 8 0 ’s as t h e r e l a t i o n s h i p b e t w e e n f l u c t u a t i o n s

m o n e y g r o w t h a n d real

economic activity that were formerly relied upon

appear to have deteriorated.
various

Recently,

a number of studies have suggested

forms of the spread between a long-term interest rate and a

s h o r t - t e r m i n t e r e s t r a t e as an a l t e r n a t i v e
m o n e t a r y policy.
empirical

indicator of the thrust of

T h e s e s u gg es ti on s ha ve been based a l m o s t e x c l u s i v e l y on

tests of the forecasting abilities of the spreads and have

a p p e a r e d to i n vo lv e an e n t i r e l y d i s t i n c t ap pr oa ch
based

in real

indicators.

approach

from the previous mo ne y

This paper argues that the interest rate spread

is e n t i r e l y c o n s i s t e n t w i t h t h e t h e o r y t h a t u n d e r l i e t h e u s e o f

m o n e y as a n i n d i c a t o r o f m o n e t a r y p o l i c y .

It a r g u e s t h a t t h e p r o b l e m s

w i t h m o n e y as a n i n d i c a t o r o f m o n e t a r y p o l i c y s t e m f r o m r e c e n t
d i s t u r b a n c e s to the d e ma nd for money.
situation,

indicator o f m o n e t a r y policy.

T h e p a p e r a r g u e s t h a t t h e us ual
in t h e m o n e y s u p p l y p r o c e s s

rate spread

is m i s p l a c e d .

Instead,

an i n t e r e s t

a n d t h e f e d f u n d s r a t e is t h e k e y m e c h a n i s m in t h e m o n e y

supply process.
issues

This view gives a different interpretation of a number of

in m o n e t a r y p o l i c y i n c l u d i n g :

reserve targeting procedure,
money supply mechanism,




e m p h a s i s o n r e s e r v e s as t h e k e y

between the rate on earning assets available to de po s i t o r y

institutions

recent

in s u c h a

it w o u l d s e e m r e a s o n a b l e t o l o o k at t h e m o n e y s u p p l y p r o c e s s

fo r a n a l t e r n a t i v e

element

The paper argues that

the me ch an is m underlying a

the importance of reserve accounting

in t h e

the true nature of the operating procedure adopted

-30-

in O c t o b e r

1979 ,

the role of reserve requirements

appropriate analytical

in m o n e t a r y c o n t r o l ,

the

f r a m e w o r k for a n a l y z i n g t h e s h o r t - r u n

c o n t r o l l a b i l i t y of the m o n e y stock,

and the feasibility of accurate

short-term monetary control.

T h e paper th e n argues t h a t the role o f an in te re st r a t e s p r e a d
money supply mechanism,
debates,
Wicksell.

while not recently prominent

in m o n e t a r y p o l i c y

has a long pe d i g r e e going ba ck at least to the ti me o f K n ut
Finally,

the paper argues that the particular

form of the

i n t e r e s t r a t e s p r e a d a d v a n c e d as a f o r e c a s t e r o f f u t u r e re a l

growth

cr i t i c a l l y de pe nd en t on the implicit v i ew the researcher has of the
i n f o r m a t i o n c o n t a i n e d in t h e t e r m s t r u c t u r e o f i n t e r e s t r a t e s .




in t h e

is

FOOTNOTES
* Se ni or Economist, Federal Re s e r v e B a n k of Chicago.
T h e a u t h o r is
indebted to Hilton Friedman, T o m Gittings, T o m Humphrey, Bob Keleher, Dick
Kopcke, Ken Kuttner, Charles Lieberman, To m Mayer, L a r r y Mote, Stev e
St ro ng in , an d Do n W i l s o n for t h ei r v a l u a b l e commen ts .
The views expressed
are solely those of the author and do not necessarily represent the views
o f t h e Federal R e s e r v e B a n k of Chicago, t h e Federal R e s e r v e System, or
those who have helped with their comments.
1. S e e

[18].

2. S e e [ 1] ,[ 2 ] , [ 9 ] , [ 2 2 ] , a n d [26].
T h e r e has al so has been increased
attention paid to interest rate differences between commercial paper and
T r e a s u r y b i l l s as i n d i c a t o r s o f f u t u r e i n c o m e g r o w t h ,
s e e [ 3] a n d [26].
3. F o r a v i e w t h a t a r g u e s f o r a u c t i o n m a r k e t p r i c e s as i n d i c a t o r s o f
m o n e t a r y p o l i c y , i n c l u d i n g , b u t n o t l i m i t e d to, i n t e r e s t r a t e s p r e a d s , s e e
[13] a n d [14].
4.

See

[10].

5. T h i s a r g u m e n t is m o r e e x t e n s i v e l y d e v e l o p e d in [16].
One can also
c o n s i d e r t h e e x t r e m e c a s e o f t h e c e n t r a l b a n k j u s t d r o p p i n g c u r r e n c y on
the s i d e w a l k to d e m o n s t r a t e the point.
D o e s it r e q u i r e a f o r t u i t o u s
i n c r e a s e in t h e d e m a n d f o r m o n e y t o p r o d u c e a n i n c r e a s e in t h e m o n e y
stock?
Hardly.
B y o f f e r i n g m o n e y in e x c h a n g e fo r t h e m e r e p h y s i c a l
e f f o r t o f b e n d i n g o v e r a n d p i c k i n g it up, o n e c a n b e a b s o l u t e l y c e r t a i n
t h a t t h e m o n e y s t o c k w i l l i n c r e a s e b y t h e full a m o u n t d r o p p e d o n t h e
sidewalk.
6. T h e c l a s s i c r e f e r e n c e in d i s c u s s i n g t h e t h e o r y b e h i n d t h e r o l e o f t h e
d e m a n d f o r m o n e y in a m o n e t a r y p o l i c y i m p l e m e n t e d t h r o u g h m o n e y s t o c k
c o n t r o l is [ 4].
7. E v e n i f i m p l i c i t i n t e r e s t is p a i d o n d e p o s i t s f o r w h i c h e x p l i c i t
i n t e r e s t is f o r b i d d e n , o n e w o u l d st ill e x p e c t a r e d u c t i o n in d e m a n d f o r
t h e d e p o s i t s as i n t e r e s t r a t e s r i s e .
P a y i n g i m p l i c i t l y in s e r v i c e s is
i n h e r e n t l y i n e f f i c i e n t r e l a t i v e t o p a y i n g in moffey, a n d t h e c o s t o f t h i s
i n e f f i c i e n c y wi l l r i s e t h e g r e a t e r t h e a m o u n t p a i d i m p l i c i t l y .
8. Se e ,
[25].
9. Se e ,

for ex ample,

for ex a m p l e

the Shadow Open Market Committee recommendation

in

[24].

10. T h e m a t e r i a l in t h i s s e c t i o n a n d t h e n e x t s e c t i o n
f r o m p a r t s o f t h e a u t h o r ' s e a r l i e r w o r k [19].

borrows heavily

11. A m o r e d e t a i l e d d e s c r i p t i o n o f t h e o p e r a t i o n o f t h e d i s c o u n t w i n d o w
a n d its r o l e in t h e n e w o p e r a t i n g p r o c e d u r e is p r o v i d e d in [ 8 ] , [ 1 2 ] , a n d
[19].




12.
As n o t e d above, e v e n w h e n d e s c r i b e d as r e s e r v e t a r g e t i n g (1979 1982) m o n e t a r y p o l i c y w a s n o t i m p l e m e n t e d by t a r g e t i n g total r e s e r v e s .
In
actual practice, t h e Fed has n e v e r o p e r a t e d by t a r g e t i n g total r e s e r v e s
a n d a l l o w i n g t h e fu nds r a t e t o be se t b y t h e d i f f e r e n c e b e t w e e n r e s e r v e s
and re quired reserves based on current deposits.
13.
F o r a n o t h e r v i e w o f d e p o s i t v o l a t i l i t y in t h i s p e r i o d , w h i c h t h o u g h
d i f f e r e n t , a l s o e m p h a s i z e s s u p p l y c o n s i d e r a t i o n s , s e e [11].
14.

Again,

see

[24].

15.
A n a l t e r n a t i v e a p p r o a c h is t o a d o p t 1 0 0 p e r c e n t r e s e r v e r e q u i r e m e n t s
but pay interest on re quired reserves to avoid the pr oblem of destro yi ng
the integrity of deposits.
F o r a n a p p r o a c h a l o n g t h i s l i n e s e e [ 5].
W h i l e t h i s a p p r o a c h s e e m s p e f e c t l y j u s t i f i a b l e t h e o r e t i c a l l y , it is n o t
t r i v i a l t o d e t e r m i n e t h e c o r r e c t level o f i n t e r e s t r a t e s t o p a y o n
reserves.
F o r a d e s c r i p t i o n o f t h e p r o b l e m s s e e [21].
16. S e e [15], [20] , a n d [27].
Of course,
d e s i r a b i l i t y o f ac c u r a t e m o n e t a r y control
the target m o n e t a r y aggregate.

as n o t e d e a r l i e r , t h e
depends upon a stable demand

for

17.
In a n idea l e n v i r o n m e n t o n e w o u l d p r o b a b l y p r e f e r t o u s e t h e r a t e o f
return on lo ng -t er m private issue debt of a co nstant quality.
This would
avoid problems of the idiosyncrasies of government debt issue under a
n o n - p r o f i t m a x i m i z i n g s y s t e m (e.g. t h e c o n g r e s s i o n a l c e i l i n g s o n t h e
q u a n t i t y of long -t er m debt issued).
However, recent years have witnessed
a g r e a t i n c r e a s e in e v e n t r i s k in t h e p r i v a t e d e b t m a r k e t s a n d r e s u l t a n t
t u r m o i l in t h e c r e d i t r a t i n g s o n p r i v a t e d e b t .
18.
S e e [ 2 ] , [ 2 2 ] , a n d e s p e c i a l l y [ 9] as e x a m p l e s o f i n t e r p r e t i n g t h e
s p r e a d as a n e x t r a c t i o n o f m a r k e t i n t e r e s t r a t e e x p e c t a t i o n s .
An
i n t e r e s t i n g v a r i a n t o f t h i s a p p r o a c h is [ 7] w h i c h a d j u s t s i n t e r e s t r a t e
e x p e c t a t i o n s f o r e x p e c t e d c h a n g e s in i n f l a t i o n .




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"New Indexes of Coinci de nt
and L e a d i n g E c o n o m i c Indicators", K e n n e d y School o f G o v e r n m e n t ,
Harvard Un i v e r s i t y and Department of Economics, Northw es te rn
U n i v e r s i t y , A p r i l 1989.




[27] V a n H o o s e , D a v i d . " R e v e r s e - L a g R e s e r v e A c c o u n t i n g , B a n k B e h a v i o r
and M o n e t a r y Cont ro l: A Formal A n a l y s i s , " A t l a n t i c E c o n o m i c
J o u r n a l . ( S e p t e m b e r 1 9 89 ), pp. 3 4 - 3 8 .
[28] W i c k s e l l , K n u t . I n t e r e s t a n d P r i c e s : a s t u d y o f t h e c a u s e s
r e g u l a t i n g t h e v a l u e o f m o n e y . M a c M i l l a n , L o n d o n 19 62 .




Working Papers and Staff Memoranda
The following lists papers developed in recent years by the Bank's research
staff. Copies of those materials that are currently available can be obtained by
contacting the Public Information Center (312) 322-5111.
Working Paper Series
A series of research studies on regional economic issues relating to the
Seventh Federal Reserve District, and on financial and economic topics.
REG IO N A L ECO N OM IC ISSUES

Taxation of Public Utilities Sales: State Practices
and the Illinois Experience

DianeF.SiegelandWilliamA.Testa

WP-86-1

Measuring Regional High Tech Activity with Occupational Data

WP-87-1

Alternative Approaches to Analysis of Total Factor Productivity
at the Plant Level

WP-87-2

AlenkaS.GieseandWilliamA.Testa

RobertH.SchnorbusandPhilipR.Israilevich

Industrial R&D An Analysis of the Chicago Area

WP-87-3

Metro Area Growth from 1976 to 1985: Theory and Evidence

WP-89-1

Unemployment Insurance: A State Economic Development Perspective

WP-89-2

AlenkaS.GieseandWilliamA.Testa
WilliamA.Testa

WilliamA.TestaandNatalieA.Davila
AWindow of Opportunity Opens for Regional Economic Analysis:
BEA Release Gross State Product Data
AlenkaS.Giese

WP-89-3

Determining Manufacturing Output for States and Regions

WP-89-4

The Opening of Midwest Manufacturing to Foreign Companies:
The Influx of Foreign Direct Investment
Alenka S.Giese

WP-89-5

PhilipR.IsrailevichandWilliamA.Testa




l

A New Approach to Regional Capital Stock Estimation:
Measurement and Performance

WP-89-6

Why has Illinois Manufacturing Fallen Behind the Region?

W P-89-7

Regional Specialization and Technology in Manufacturing

W P-89-8

Theory and Evidence of Two Competitive Price Mechanisms for Steel

WP-89-9

AlenkaS.GieseandRobertH.Schnorbus
WilliamA,Testa

AlenkaS.GieseandWilliamA.Testa

ChristopherErceg,PhilipR.IsrailevichandRobertH.Schnorbus

Regional Energy Costs and Business Siting Decisions:
An Illinois Perspective

W P-89-10

Manufacturing’s Changeover to Services in the Great Lakes Economy

W P-89-12

DavidR.AllardiceandWilliamA.Testa
WilliamA.Testa

Construction of Input-Output Coefficients
with Flexible Functional Forms

WP-90-1

Regional Regulatory Effects on Bank Efficiency

W P-90-4

Regional Growth and Development Theory: Summary and Evaluation

W P-90-5

Institutional Rigidities as Barriers to Regional Growth:
A Midwest Perspective

WP-90-6

PhilipR.Israilevich

DouglasD.EvanoffandPhilipR.Israilevich
GeoffreyJD.Hewings

MichaelKendix

ISSUES IN FIN A N CIA L REGULATION

Technical Change, Regulation, and Economies of Scale for Large Commercial
Banks: An Application of a Modified Version of Shepard's Lemma

DouglasD.Evanoff,PhilipR.IsrailevichandRandallC.Merris




WP-89-11

2

Working paper series continued

Reserve Account Management Behavior: Impact of the Reserve Accounting
Scheme and Carry Forward Provision

WP-89-12

Are Some Banks too Large to Fail? Myth and Reality

WP-89-14

Variability and Stationarity of Term Premia

W P-89-16

A Model of Borrowing and Lending with Fixed and Variable Interest Rates

WP-89-17

Do "Vulnerable" Economies Need Deposit Insurance?: Lessons from the
U.S. Agricultural Boom and Bust of the 1920s

WP-89-18

The Savings and Loan Rescue of 1989: Causes and Perspective

W P-89-23

The Impact of Deposit Insurance on S&L Shareholders’Risk/Retum Trade-offs

WP-89-24

Payments System Risk Issues on a Global Economy

W P-90-12

DouglasD.Evanoff
GeorgeG.Kaufman

RamonP.DeGennaroandJamesT.Moser
ThomasMondschean

CharlesW.Calomiris
GeorgeG.Kaufman

ElijahBrewerIII

HerbertL.BaerandDouglasD.Evanoff
M ACRO ECO N OM IC ISSUES

Back of the G-7 Pack: Public Investment and Productivity
Growth in the Group of Seven

WP-89-13

Monetary and Non-Monetary Sources of Inflation: An Error
Correction Analysis

W P-89-15

Trade Policy and Union Wage Dynamics

W P-89-19

DavidA.Aschauer

KennethN.Kuttner
EllenR.Rissman




3

Working paper series continued

Investment Cyclicality in Manufacturing Industries

WP-89-20

Labor Mobility, Unemployment and Sectoral Shifts:
Evidence from Micro Data

WP-89-22

BruceC.PetersenandWilliamA.Strauss

PrakashLoungaru,RichardRogersonandYang-HoonSonn
Unit Roots in Real GNP: Do We Know, and Do We Care?

WP-90-2

Money Supply Announcements and the Market's Perception
of Federal Reserve Policy

WP-90-3

Sectoral Shifts in Interwar Britain

W P-90-7

Money, Output, and Inflation: Testing the P-Star Restrictions

WP-90-8

Current Real Business Cycle Theories and Aggregate Labor
Market Fluctuations

WP-90-9

LawrenceJ.ChristianoandMartinEichenbaum
StevenStronginandVefaTarhan

PrakashLoungaruandMarkRush
KennethN.Kuttner

LawrenceJ.ChristianoandMartinEichenbaum

The Output, Employment, and Interest Rate Effects of
Government Consumption

WP-90-10

Money, Income, Prices and Interest Rates after the 1980s

WP-90-11

Real Business Cycle Theory: Wisdom or Whimsy?

WP-90-13

Macroeconomic Models and the Term Structure of Interest Rates

WP-90-14

S.RaoAiyagari,LawrenceJ.ChristianoandMartinEichenbaum
BenjaminM.FriedmanandKennethN.Kuttner
MartinEichenbaum
StevenStrongin




4

Working paper series continued

Stock Market Dispersion and Real Economic Activity:
Evidence from Quarterly Data

WP-90-15

Prakash Loungam, Mark Rush and William Tave

Term-Structure Spreads, The Money Supply Mechanism,
and Indicators of Monetary Policy
Robert D. Laurent




WP-90-16

5

Staff Memoranda
A series of research papers in draft form prepared by members of the
Research Department and distributed to die academic community for review
and comment. (Series discontinued in December, 1988. Later works appear in
working paper series).
Risks and Failures in Banking: Overview, History, and Evaluation

SM-86-1

The Equilibrium Approach to Fiscal Policy

SM-86-2

Banking Risk in Historical Perspective
GeorgeG. Kaufman

SM-86-3

GeorgeJ.BenstonandGeorgeG.Kaufman

DavidAlanAschauer

The Impact of Market, Industry, and Interest Rate Risks
on Bank Stock Returns

SM-86-4

Wage Growth and Sectoral Shifts: New Evidence on the
Stability o f the Phillips Curve

SM-87-1

Testing Stock-Adjustment Specifications and
Other Restrictions on Money Demand Equations

SM-87-2

The Truth About Bank Runs

s m -87-3

On The Relationship Between Standby Letters of Credit and Bank Capital

SM-87-4

Alternative Instruments for Hedging Inflation Risk in the
Banking Industry

SM-87-5

The Effects of Regulation on Bank Participation in the Market

SM-87-6

Bank Stock Valuation: Does Maturity Gap Matter?

SM-87-7

ElijahBrewer,IIIandChengFewLee
EllenR.Rissman

RandallC.Merris

GeorgeG.Kaufman

GaryD.KoppenhaverandRogerStover

GaryD.KoppenhaverandChengF.Lee
GaryD.Koppenhaver
VefaTarhan




6

StaffMemoranda continued

Finite Horizons, Intertemporal Substitution and Fiscal Policy

SM-87-8

Reevaluation of the Structure-Conduct-Performance
Paradigm in Banking

SM-87-9

Net Private Investment and Public Expenditure in the
United States 1953-1984

SM-87-10

DavidAlanAschauer

DouglasD.EvanoffandDianaL.Fortier
DavidAlanAschauer

Risk and Solvency Regulation of Depository Institutions:
Past Policies and Current Options

SM-88-1

Public Spending and the Return to Capital

SM-88-2

Is Government Spending Stimulative?

SM-88-3

Securities Activities of Commercial Banks: The Current
Economic and Legal Environment

SM-88-4

A Note on the Relationship Between Bank Holding Company
Risks and Nonbank Activity

SM-88-5

GeorgeJ.BenstonandGeorgeG.Kaufman

DavidAschauer
DavidAschauer

GeorgeG.KaufmanandLarryR.Mote

ElijahBrewer,III

Duration Models: A Taxonomy
G. O
.Bierwag,GeorgeG.KaufmanandCynthiaM.Latta

SM-88-6

Durations of Nondefault-Free Securities

G.O.BierwagandGeorgeG.Kaufman

Is Public Expenditure Productive?

DavidAschauer




SM-88-7

StaffMemoranda continued

Commercial Bank Capacity to Pay Interest on Demand Deposits:
Evidence from Large Weekly Reporting Banks

SM-88-8

Imperfect Information and the Permanent Income Hypothesis

SM-88-9

ElijahBrewer,IIIandThomasH.Mondschean
AbhijitV.BanerjeeandKennethN.Kuttner

Does Public Capital Crowd out Private Capital?

SM-88-10

Imports, Trade Policy, and Union Wage Dynamics

SM-88-11

DavidAschauer
EllenRissman




S