monetary and fiscal influences on economic … · activity — the historical evidence* ... ~the...

Monetary and Fiscal Influences on EconomicActivity — The Historical Evidence*

by MICHAEL W. KERAN

In November 1968 this REVIEW included an article which tested the relative importance of monetaryand fiscal influences on economic activity for the postwar period 1953-68. The conclusions of that articlewere that monetary infivences had a stronger, more predictable, and faster impact on economic activity thanfiscal influences.

The intent of this article is to consider the same issue in a longer, historic context (1919-69). 1-lave mone-tary influences dominated economic activity in periods when financial and institutional factors were substan-tially different, as in the 1920’s, and when the general trend of economic activity was largely depressed, as inthe 1930’s? The results presented in this article indicate that monetary influences have dominated fiscal influ-ences on economic activity in all subperiods considered, with the single exception of the years coveringWorld War II. This article also presents evidence that the movements in the money stock have been dom-inated by the behavior of the monetary authorities and not by the behavior of the public.

SUBJECT of continuing interest in professionaland recently in popular economic writing is the rela-tive role of monetary and fiscal influences in deter-mining economic activity.’ This debate has been re-newed by Lconall Andersen and Jerry Jordan(AJ) in an article published in this Review.’ That

article presented evidence which indicated that won-etary influences had a larger, more predictable, andfaster effect on economic activity than fiscal influ-ences in the period from 1953 to 1968.

~The content and presentation in this article have beensubstantially improved by the suggestions of the author’scolleagues in the Research Department of the FederalReserve Bank of St. Louis: Homer Jones, Leonall Andersen,Christopher Babb, Deois Karnosky, and William Yohe. Inaddition, he received valuable comments and criticisms fromOswald Brownlee, Karl Brunner, Philip Cagan, Albert Cox,Milton Friedman, Harry Johnson, John Kalchbrenrier, ThomasMayer, David Meiselman, and Allan Meltzer.

~This issue was first raised in a somewhat different context byMilton Friedman and David Meiselman in “The RelativeStability of Monetary Velocity and the Investment Multi-plier in the U.S.” Stabilization Policies, The Commission onMoney and Credit, Prentice-Ha]l, 1963.

2Leonall C. Andersen and Jerry Jordan: “Monetary and Fis-cal Actions: A Test of Their Relative Importance in Eco-nomic Stahi]ization,” this Review, November 1968.

These results have stimulated considerable interestand discussion.3 The ensuing debate has mainly con-fined itself, however, to the time period used in theoriginal AJ article (1953-68). Since other economicexperiences might suggest a different assessment ofmonetary and fiscal influences, it seems useful to ex-pand the testing periods to include a longer periodin United States economic history.

It is reasonable to assume that tests obtained froma wider range of experience would go a long way3Richard C. Davis, “How Much Does Money Matter?”,Monthly Review, Federal Reserve Bank of New York, June1969; Edward M. Cramlich, “The Role of Money in EconomicActivity: Complicated or Simple?,” Business Economics, Sep-tember 196i; “The Usefulness of Monetary and Fiscal Policyas Discretionary Stabilization Tools,” (presented at the Ameti-can Bankers Association, Conference of University Professors,Milwaukee, September 1969); Frank de Leeuw and JohnKalchbrenaer, ‘Monetary and Fiscal Actions: A Test of TheirRelative Importance in Economic Stabilization — Comment,”this Review, April 1969; Paul S. Anderson, “Monetary velocityin Empirical Analysis,” Controlling Monetary Aggregates, pre-pared by the Federal Reserve Bank of Boston, September 1969;M. J. Artis and A. R. Nobay, “Two Aspects of the MonetaryDebate,” National Institute Economic Review, Vol. XLIX(August 1969), pp. 33-51; and Wilfred Lewis, Jr., “‘Moneyis Everything’ Economics — A Tempest in a Teapot,’ NationalConference Board Record, Vol. VI, No. 4 (April, 1969), pp.32-35.

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FEDERAL RESERVE BANK OF ST. LOUIS

toward answering some of the questions raised aboutthe AJ article. If the dominance of monetary influ-ences prevailed in earlier periods, then confidencein the reliability and stability of the original resultsand their continued applicability is enhanced. Onthe other hand, if the dominance of monetary influ-ences is shown to be confined to only the most re-cent time period, then it could be asserted that specialcircumstances arc at work in the present period whichcould not be relied upon to continue. The intent ofthis article is to test the relative impact of monetaryand fiscal influences on economic activity in theUnited States on a quarterly basis from 1919 to 1969and for selected subperiods.

This article is organized in the following way.First, a brief and highly simplified review is givenof some of the theoretical and statistical issues whichhave been raised in connection with the type of testsused by AJ. This review will allow us to see what canand cannot be deduced from any results. Second, thetest results for the 50-year period from 1919 to 1969,with 200 quarterly observations, will be presented,together with a historical review and comparison.Finally, the statistical reliability of the results will beconsidered.

Theoretical and Statistical Issues

There are two primary ways to study the relativeimportance of monetary and fiscal influences on eco-nomic activity. First, their effects can be inferredwithin the context of a fully specified and statis-tically estimated structural model of the economy, asin the FRB-MIT model.4 The monetary and fiscalvariables are introduced in the structural model atthose points where their functional roles are indicatedby economic theory. The measured impact on eco-nomic activity of the monetary and fiscal variablesis dependent upon the explicit transmission mechan-ism which is postulated and built into the structuralmodel. Second, monetary and fiscal influences can bemeasured by direct estimation of a single regressionequation. In this case, some measure of economicactivity is regressed directly against the monetaryand fiscal variables without specification of a trans-mission mechanism.

4See Frank de Leeuw and Edward M. Gramlich, “The Chan-nels of Monetary Policy,” Federal Reserve Bulletin, June1969. A structural model is one in which the major behavioralassumptions of a theory are explicitly included in the statisticalestimates. It is fully specified if there are as many equationsas there are eadogenous variables.

The Single Equation Approach

NOVEMBER 1969

The Large Structural Model Approach

There are advantages and disadvantages associatedwith each of these approaches. An important ad-vantage of the large structural model is that it allowsone to distinguish between direct and indirect mone-tan’ and fiscal influences, and to see how subsectors -

of the economy are affected. In formal terms a sti-uc-tural model is essentially a hypothesis of the modelbuilders about the interrelations in the economy. Thestatistically estimated equations represent coinpon-ents of that hypothesis. If it turns out that the mode]builders’ view of the economic mechanism is reason-ably correct, then the “structural richness” of thelarge models pennits a wider range of questions tobe answered.

The major disadvantage of structural models is thatthe model builder may have omitted an importantchannel of transmission and, consequently, incorrectlyestimated the inagnituchi of the monetary or fiscalmfluenc s lndeed, es cn if the model builder has agood idea of the transmission channels, it may betechnically impossible to estimate them because thechannels have not or cannot be qtiantified. For exam-ple assuming that the cost of borrowing is an nnportant link in the monetary transmission niechanism,it is quite possible that this is not accurately measuredby market interest rates. Both changes in credit ra-tioning and compensating balance requirements, forwhich there are no available quantified measures,could affect the cost of borrowing yet not be re-flected in changes in market interest rates.

An advantage of the single equation approach isthat if the monetary and fiscal variables are correctlyspecified, and if they are not themselves determinedby economic activity, they will capture the direct andindirect impact of monetary and fiscal influences oneconomic activity, irrespective of the transmissionchannels. The single equation approach avoids theproblem of specifying and measuring specific linkshetween monetary and fiscal influences and economicactivity, and will generally be consistent with a widerange of theories (hypotheses) about the structuralinterrelations in the economy.

One major disadvantage of the single equationapproach used here is that it can deal with only asingle question, the relative impact of monetary andfiscal influences on economic activity. It does notdistinguish between the direct and indirect impactof the monetary and fiscal influences on economic

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1969

activity or how subsectors of the economy areaffected.5 In addition, both the structural model ap-proach and the single equation approach face thesame problem of selecting measures of monetary andfiscal influences svhich are exogenous in a statisticalsense.

in order to derive results which arc’ comparablewith AJ’s work, the single equation approach (theso-called St. Louis equation) is used here. However,before presenting the test results. it would be usefulto consider what can and cannot be implied by usingthis approach. First, as was previously noted, thesingle equation approach restricts us to consideringjust one question the relative impact of monetaryand fiscal influences on economic activity. We cannotsay what the channels of the influence are.

Second, the single equation approach used heredoes not allow us to discriminate between economictheories. Take the generalized statement of the singleequation which is used in this article:

AY = a, + ai AM + a2

AF

where AY = changes in economic activity,

AM = changes in monetary influences,

AF = changes in fiscal influences.

The parameters, cx, and cx2, indicate the magni-tude of the impact of monetary and fiscal influences,respectively, on economic activity, and a0 is a proxyfor the net trend of all other influences on economicactivity. Assume for the moment that the statisticalresults of a test using this format substantially favormonetary influences (AM) over fiscal influences(AF) in determining economic activity (AY). Theseresults do not provide clear-cut evidence to help an-swer the question of whether the Keynesian Income-Expenditure Theory or the Modern Quantity Theoryis a better representation of the economic world.Both theories provide an operational rule for mone-tary influences, and thus the dominance of the inone-tary variable does not discriminate between them.°A test of competing economic theories can be con-

mOae way to handle this disadvantage is to regress the alone-tary and fiscal variables against the components of GNP to seewhich broad sectors of the economy are affected. See LeonallC. Andersen, “Money and Economic Forecasting,” BusinessEconomics, September 1969, for the results of such a test.

6There are a number of empirically estimated Keynesian eco-nomic models which have a “weak’ monetary sector. Evidencethat monetary influences are important would tend to castdoubt on the usefulness of those models. However, this is morea criticism of the particular model and not the underlyingKeynesian theory. Within the context of standard Keynesiantheory, there are circumstances where strong monetary andweak fiscal influences could exist.

ducted only if the alternative behavioral assumptionsare made explicit!

Third, the single equation approach does riotnecessarily tell us anything about monetary and fiscalpolicy decisions of the authorities. If the independ-ent variables have been chosen properly, they willindicate monetary and fiscal influences on the econ-omy. One can assert that such influences are simul-taneously a measure of the policy intentions of theauthorities only if additional external evidence is pro-vided, which indicates that the policymakers haveacted either consciously or otherwise to systematicallycontrol the monetary and fiscal variables used in theequation.8

The third point can be clarified with an example:Assuming there are two countries, A and B. Statisticaltests indicate that the monetary variable dominatesthe fiscal variable in influencing economic activity ineach country. However, it is also known that CountryA does not have a central bank, while Country B

does. Obviously, we can only talk about discretionarymonetary policy in Country B, but we can talk aboutmonetary influence in both countries. In Country A,the monetary variable is dominated by factors otherthan by the actions of a central bank —~perhapsby the domestic gold supply. In Country B (with acentral bank), the monetary variable could be dom-inated by the central bank; however, our statisticalresults do not provide any evidence with respect tothat issue. Such evidence can be derived only by anexplicit investigation of the behavior of the centralbank in Country B. Thus, discretionary monetarypolicy and monetary influences are not necessarilymeasured by the same variable.0

TA test of competing economic theories conceptually could beconducted either with a single reduced-form equation or witha more fully specified structural model. When Friedman andMeiselman, ‘The Relative Stability attempted such a testusing the single equation reduced-fom, approach, a consid-erable controversy occurred within the economics profession.To the best of the author’s knowledge, no one has attemptedto compare competing theories by a test of alternative struc-tural models.5Such information would come from studies of the “reactionfunction” of the policy-making authorities. There have beena number of such studies of the monetary authorities. Forexample: (I) William Dewald and I-larry Johnson, “AnObjective Analysis of the Objectives of American Mon-etary’ Policy, 1952-1961,” Banking and Monetary Studies,ed. Deane Carson (1-lomewood, Illinois: Richard D. Irwin,1963); (2) James W. Christian, “A Further Analysis of theObjectives of American Monetary Policy,” The Journal ofFinance, volume XXIII, June 1968; (3) Michael W/. Keran,and Christopher T. Bahh, “An Explanation of Federal - Re-serve Actions (1933-68),” this Review, July 1969; (4)John Wood, “A Model of Federal Reserve Behavior,” StaffEconomic Study No. 17, Board of Governors of the FederalReserve System.

°Thispoint is quite important and open to some misunderstand-ing, To link monetary policy with the indicator of monetary

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I FEDERAL RESERVE BANK OF ST. LOUIS

Given this array of caveats with respect to thesingle equation appm’oach, it is nevertheless highlyuseful in indicating monetary and fiscal influenceson economic activity. The key reason has alreadybeen discussed. An economy is an extremely complexarray of interrelated and interdependent markets tiedtogether by the price mechanism. Millions of indi-vidual decision-making units participate in thesemarkets. In this complex web of interrelationships,attempts at specific and detailed measurement of thechannels through which monetary and fiscal in-fluences operate on economic activity are quitehazardous.

Given the complexities of the economy and theexisting uncertainty about the transmission mechan-ism, it is useful to meastire the monetary and fiscalinfluences directly, without constraining them to op-erate within our imperfect notions about how theyoperate. Freedom from this type of specification erroris perhaps the principal virtue of the single equationapproach.

Problems of the Single Equation ApproachThe key methodological and statistical problems

with the single equation approach are related toselection of appropriate indicators of monetary andfiscal influences. First, a theoretical justification forusing particular variables is required. Such justifica-tion naturally evolves from the various economic the-ories (hypotheses) which have been developed toexplain the determination of aggregate economic ac-tivity. For example, bank credit or free reserves areunlikely indicators of monetary influence becausethere is no well-specified economic theory from whichthese variables are a derivable consequence. Evenif statistical results indicate a close relation betweenbank credit and economic activity, it is difficult tointerpret the results. On the other hand, the moneystock is a good choice as an indicator of monetaiyinfluence because it plays an important role in boththe Keynesian Income - Expenditure Theory and theModern Quantity Theory of Money.

Second, there must be evidence that the actionsof monetary and fiscal authorities determine the

influence, it is not necessary that the authorities consciouslycontrol the value of the monetary variable. All that isrequired is that in controlling some monetary variable theauthorities in the process also dominate movements in thevariable used to indicate monetary influences. If the author-ities have not deliberately attempted to control the variablewhich is the best indicator of monetary influence, then theirpolicy actions could be criticized. However, this is not neces-sarily an argument against using that variable as an indicatorof monetary influence.

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NOVEMBER 1969

most ments in the v’iri’ible’, selected It is not necess’iry th it the policymike rs have icte d consciously tocontrol the specific variabli s usc d it ms only necessary thi.t policy ictions systematically dominatemovements in the indicated variable.

This leads naturally to the thuird and final condi-tion. To be able to interpret the regression coefficientsmeaningfully in the single equation approach, themonetary and fiscal variables must be statisticallyexogenous. The economic meaning behind this condi-tion is that the variables selected to represent mone-tary and fiscal influences should not be contemporan-eously determined by the behavior of the public, asmeasured by changes in economic activity. If thisexogeneity assumption is not satisfied, the directionof caus~ilityis uncert nn and a close statistical association with economic activity does not provide anyevidence of the magnitude of the impact from mon-etary and fiscal influences This is the so calledreverse causation aigument ‘rg’unst the single equa

hon approach

The next section presents the results of variousstatistical tests of monetary and fiscal influences oneconomic activity. The last section will consider thereverse caus’ttion argument and whether movementsin the monetary variables are dominated by the mon-et’trv authorities or by the public Because thetheoretical justification for the monetary and fiscalvariables used in this article has already been con-sidered in the Ajarticle, it will not be presented here.

Monetary and Fiscal InfluencesThe test procedure used in this article is to regress

quarter-to-quarter changes in a measure of economicactivity against quarter-to-quarter changes in theindicators of monetary and fiscal influence. Becauseof the length of the test period (1919-69), data prob-lems were encountered. For example, the most widelyused measure of economic activity (nominal GNP),and the most widely used measure of fiscal policy(high-employment receipts and expenditures of •theFederal Government), are not available on a quar-terly basis before 1946. These deficiences in the datanecessitated developing proxies for these measures.

A proxy for nominal GNP was constructed tomeasure economic activity. The proxy consists of thescaled product of the Industrial Production Index(IPI) and the Consumer Price Index (CPI), both ofwhich are available on a monthly basis in continuoustime series back to February 1919, Each is the broad-est available measure of real output and prices, and


0+ 0-0-0- 0-0- \____ N 0-o0-o0-\

0-0- 0-0-0- 0- +0-o 0-0- 0- N0-~ o0-

0- N\~~~\->0-0-~-0- ‘+~ -‘-00-, / +~,0- ‘0-0-0-0- N\ 0- 0-0- / 0-,

~1ctes. Hornjnat S$P and. Economk0-AakBy 0-0- ftins-&

0--> 0-0- 0-0- 0-0-0- 0- ~00+\ -~ ~ \0-\N\N0-

~ ~ ~“-~N 0-~0- -

0-0-0-— \0-~~’~0- 0- 0- N0-

0-0- 0--\o0-0- —,<+,—~N 0-0-0-0-0- 0- ~0-oo ~0-

their scaled product is an index of economic activity.To convert this value index into a dollar measure, it

was multiplied by the value of nominal GNP in thebase years of the value index (1957-59) V~ By thismethod an index of quarterly economic activity,measured in billions of dollars, was constructed forthe period 11/1919 to 11/1969.

This proxy for economic activity clearly has a num-ber of defects. The service industries, levels of gov-ernment and agriculture are excluded. In addition,industrial production traditionally grows at a fastertrend rate than overall real output because it is moreresponsive to increases in productivity. Also, it shows

iOThe formula used to compute this measure of economicactivity (Y) is:

IPI • CPI1

= 1 10,000 J • ($457.4 billion)

larger swings over the business cycle than does nom-inal GNP. However, for the purpose of measuringthe changes in economic activity from one quarter tothe next, this proxy appears to be both useful andreasonably accurate.” Chart I shows the quarter-to-quarter rates of change in nominal GNP and in ourproxy from 1947 to 1969.1The regressions between rates of change of nominal GNP

(GNP) and our proxy variable (Y) appear as follows:

1/1947 — IV/1952

CNP = 3.78 + .45 Y

(3.53) (8.24)1/1953 — 1/1969

GNP = 3.42 + .40 Y(11.44) (15.80)

R2= .74

11W = 1.82

H2

= .80D-W = 1.55

~W4P0-W4?0-~4 ~lts 0-5S$7—’-59l$j~— t96&0-’t94!>0-~1flt wn~1W3;0-_N *eta-~*nsf /0- 0- N 0-’ N N

0-- ~ N0->~ — ~ M N *~)ht water E qPa4d~alnd flN - flj 0-~0- PrW ~0-/~ $~*tPt_tleafl~N ~ ~0- 0- 0-0-0-0-0-0- N

NO ->0- 0- 0- 0,0-N 0-0-0-0- 0- >N0-0-000-0-

10 0- 0-0- 0- 0-0-0-0-

0-0- >00-000-0-0- 0-0- 0-No0-0- ~0-\ 0-0-0-

0-\N\

P N NN N N N >0

0-0-: 0- o t~& ~ ~ 3°S*’c~SMO* ~0 ES alt,&~r*4ytsat~N 0-N°0- 0-0-0-

oo0-_N0- ~0- o0- 0-~\ °0->0° °°~

Page 9


As a measure of fiscal influence, changes in the

national debt (AD) and actual Federal Governmentexpenditures (SE) (purchases of goods and servicesplus transfer payments) were used. Data on tax re-ceipts are available, but because of the strong influ-ence which economic activity has on the value of taxreceipts, it was not used.

Because ~D is also influenced by changes in taxreceipts, only the results using Government spendingare reported. The use of Federal Government spend-ing as our single measure of fiscal influence is not asserious a drawback as it might first appear. Andersenand Jordan (AJ) found that the strongest measure offiscal influence was achieved by using Federal Gov-ernment expenditures alone. The observed level ofGovernment spending which is used from 1919 to1945 is not significantly diflerent from the high-employment level of Government spending which Ajused, and which is used here for the subperiods from1946 to 1969.m2

As measures of monetary influence, three varia-bles were tested: total reserves of member banks, themonetary base, and the narrowly defined money stock(currency holdings of the nonbank public and privatedemand deposits). The separate use of monetary andfiscal variables in these regressions implies that onecan think of monetary and fiscal influences as havingseparate impacts on economic activity. This may notbe the case. One well-known fiscal influence on mon-etary actions can occur because of “even-keel” ac-tions. “Even-keel” is the policy of the Federal Reserveto stabilize money market conditions during periodswhen the LTnited States Treasury is floating a newissue of securities. Thus, an increase in Governmentspending financed by an increase in debt could in-duce an increase in the money stock because ofFederal Reserve “even-keel” actions. This issue canbe dealt with only by asserting that all factors whichaffect the money stock are monetary and all factorswhich affect Government spending are fiscal. This isnot unreasonable, since the Federal Reserve couldstop even-keel actions if it chose to do so.

The tests of monetary and fiscal influences werernn using four measures of change: quarterly first

differences, quarterly central differences, quarterlyfirst rates of change, and quarterly central rates ofchange. Only the results with quarterly first differ-

12The only difference between the observed levels of Gov-ernment spending and the high-employment level of Gov-ernment spending is an adjustment for unemploymentcompensation payments. These payments did not start until1937 and did not amount to a significant figure until afterWorld War II. See Chart III for sources of data for Coy-emment spending, money stock, and economic activity.

NOVEMBER 1969

encc s of the money stock and Government expenditures are r ported in this ‘irticle Hox~e~ci alternative

measures of change md mIte rn-itnc mc isures of monetary mnd fisc il influenccs gi~e substantially similarresults~’3

In each test the form of the equation was estim-ated with money alone, fiscal alone, and a combina-tion of the two. Alternative time lags between t-1and t-1O were tried using the Almon distributed-lagtechnique.i4 The form of the equation selected andthe time lags to represent each time period werechosen on the basis of minimum standard error ofestimate adjusted for degrees of freedom.~

The total period was divided into five subperiods:1919-29, when economic conditions were generallyprosperous; 1929-39, when economic conditions weregenerally depressed; 1939-46, when the United Stateswas approaching or was in a total war situation;

1947-52, the early postwar adjustment period andfinally, 1953-69, a period when economic conditionswere again generally prosperous. These subperiodscover a sufficiently wide range of economic condi-tions to provide an indication of monetary and fiscalinfluences under a variety of economic circumstances.

A summary of the regression results is reportedin Table I. For the total period 1919-69, the mone-tary variable is statistically significant and the fiscalvariable is statistically insignificant at the 95 per cent

confidence level. In the five subperiods, the monetaryvariable is significant in all but the subperiod cover-ing the war years, 1939-46, The absence of a statis-tically significant monetary variable in this period isprobably due more to the inadequacies of the datathan to a lack of a relationship. Because of price

~The other results are available upon request.“The Almon lag technique, by constraining the distribution

of coefficients to fit a polynomial curve of n degree, isdesigned to avoid the bias iii estimating distributed-lagcoethcieuts which may arise from multicolliriearity in the lagvalues of the independent variables. The theoretical justifi-cation for this procedure is that the Almoms constrainedestimate is superior to the unconstrained estimate because itwill create a distribution of coefficients which more closelyapproximates the distribution derived from a sample of infin-ite size. In order to minimize the severity of the Almon con-straint, the maximum degree of the polynomial was usedin each case. The maximum degree is equal to the numberof lags plus one of the independent variables up to five lags.Following the convention established by Shirley Almon,“The Distributed Lag J3etsveen Capital Appropriations andExpenditures,” Econometrica, Vol. XXXIII, No. 1 (January1965), if there are n lags, t4-l and t—n--l are both con-strained to zero. The regressions were also run withoutconstraining the beginning and ending values to zero, andthe results are virtually identical.

iSFor a discussion of this criteria for selecting lags, see Leon-all Andersen, “An Evaluation of the Impact of Monetaryand Fiscal Policy on Economic Activity,’ Papers and Pro-ceedings, Business and Economic Statistics Section, Ameri-can Statistical Association, August 1969.

Page 10


Table I

INDICATORS OF MONETARY (i~M) AND FISCAL laE)

INFLUENCES ON ECONOMIC ACTIVITY tAY)

aY a,4a,aM-- a

0~,arte’IyFir,I DMarencos — Bl! ions ° Dollars I

Time Pcr,ods loge a’. a 02

(suml OurnI D W

11/19)9 ——1,69 1-6 1.92 289 .07 .32

2.34) (4311 (.28) 1.15II 1919—-- 11,29 1-3 36 5.62 -. 35

(.51) (3.16) 1.58111/1929 — II.~39 ‘-5 .51 540 79/ 39

).5~l 13.41) (1.95) 1 86IlIzi 939— V.46 1-5 632 1.21 .35 .66

(1.39) .59) I 81) 1.60

/1947— lV-52 1-10 365 13.82 - 3.37 .72(.84) (351) (4.12) 2.74

I,’ 1953—I ‘69 1-4 1.42 8.85 .84 .4/74( (4.70) Ii 07) 1.71

Nn~n itegrc~eior-i,- ff1..- ,c r,!-. p rt tI—.-tc, p f~1~t:ri :~,ht-,r~’t tatnt n’. -‘spec r briArfl~,,,. ‘~i’’s’~,,’ i’~ r,;.’~’j’,

1h - me —

I) ~\‘ I ‘I’’ IH,!’.~!’~~u~,Lags ar,- eclimc’ xl cr. the ‘naIl:,, C mm rn on—, ..t.’u:.lar,l error. adi 02! 0! tilT dir,. —

of freedom.I —.maLI ‘.4(0 LI :tLv’I ~rl’’P.’.D hp,:.’—. . ~‘,,.(, I~,~Ofl~’~ftfllLI

In general, the results with respect to both mnone-tary and fiscal variables for the period 1919-69 andthe subperiods conform closely to the results reportedin the AJ article for the period 1953-68. The co-efficient of determination (H2), which measures theper cent of variations in L~sYdue to variations in ~Mand ~E, is lower than that reported by AJ. This resultis not surprising considering that our proxy is prob-ably inferior to nominal. GNP as a measure ofeconomic activity.

implies that for every $1 increase inthe money stock there will be a$5.50 increase in economic activityafter three to five quarters. Theseare remarkably stable coefficients. Inthe postwar suhperiods, however, thecoefficients are substantially larger,and they are also different withrespect to each other. In the 1947-52period the coefficient on the mon-etary variable is 13.82 with a ten-quarter lag in its impact. In the1953-69 period the coefficient is 8.85with a four-quarter lag. What doesthis variation in the value of themonetary coefficients imply?

The higher average value of the monetary co-efficients in the postwar subperiods over the prewarsubperiods is due to the weakness in the proxy se-lected to measure economic activity. The most com-plete measure of economic activity is nominal GNP.However, it is available on a quarterly basis onlysince 1946. As previously indicated, our proxy foreconomic activity tends on the average to grow morerapidly than nominal GNP because its “real” com-ponent is measured by industrial production. Thisfactor did not bias the value of the coefficients in theprewar subperiods, because the Great Depression in-sured that our proxy did not grow significantlybetween 1919-29 and 1929-39. For the postwar sub-periods, however, the substantial and continuous in-creases in economic activity probably have causedan upward bias in the size of the monetary variablecoefficient presented in Table I.. For the 1953-69period, AJ had a monetary variable coefficient witha four-quarter lag of 5.63, using nominal GNP.This value is almost identical to prewar subperiodswhen economic activity is measured with our proxy.

The difference in the values of thecoefficients between postwar subpe-nods is due to the different length oflags. These lags are selected on thebasis of minimum standard error ofestimate, adjusted for degrees of free-dom. The results for the 1947-52 sub-period with a four-quarter, rather

than a ten-quarter lag, had a mone-controls, the measure of economic activity was sub- tary variable coefficient of 7.24. This value is quitestantially understated between 1939 and 1946. There- close to the 8.85 value for the 1953-69 subperiodfore, it is not surprising that the variables measuring where the minimum standard error estimate was withthe influences of stabilization actions were not a four-quarter lag.statistically significant in that period.

The fiscal influence was statistically significant inonly one of the five subperiods, 1947-52. However,the sign of the coefficient is negative due to specialfactors which are explained below.

Because of the major importance of the monetaryinfluence, it is useful to look at the estimated co-efficients of the monetary variable during the varioussubperiods. In both of the prewar subperiods, 1919-29and 1929-39, the estimated coefficients on the mone-tary variable are almost the same, around 5.50. This

Page 11


Thus, it is quite possible that if quarterly nominalGNP figures were available back to 1919, the esti-mated value of the monetary coefficients would havebeen close to 5.50 in all subperiods.

Testing PropositionsThe propositions which AJ tested were whether

monetary or fiscal influences were (1) stronger, (2)more predictable, and (3) faster in their impact oneconomic activity. They concluded that the evidencefor the 1953-1968 period strongly favored the domin-ance of monetary over fiscal influences. These samepropositions are tested in this article and provideadditional evidence that monetary influences consist-ently have been stronger, more predictable, andfaster in their effect on economic activity than havefiscal influences. The results are detailed below.

Which is Stronger? — To measure the relativestrength of monetary and fiscal influences, we needto know which has the largest impact on economicactivity. This question can be answered by makingan appropriate comparison of the coefficients of themonetary and fiscal variables. If the variables onwhich these coefficients are estimated have the samedimension and magnitude of variation, then the com-parison can be made directly. These conditions, how-ever, are not satisfied with these data. Money is astock variable measured as first differences, and Fed-enal Government spending is a flow variable meas-ured as first differences at annual rates. Also, thedegree of variation in the two variables differs sub-stantially. In general, the fiscal variable has fluctuatedmore than the monetary variable (see Chart III onpages 16 and 17).

To make the estimated coefficients of the mone-tary and fiscal variables comparable for an assessmentof their relative impact on economic activity theywere transformed into beta coefficients. The sum”

T4b~eifflTA COEFFICIENTS

Stwm} (anal

_________________ 331 — 02641/*919 fl/fl 515

ff1192, 11/39 593 SO

111/1939 11/44 153 191/19 tV/fl I Ifl 2 34

1/1933 8/69 J26~ 1 9

eoeflieims echo a Ctim im eCho dende ml

S emmett epesod e AxtImmiOol S ens ~Jelm W I

p1$LnS*eant at tt~e9.5% Isv of eenhdemtse~

NOVEMBER 1969

118

t VAWES

SM SI an~j Cmafl

119t9 1/69 4, 1 ~6

181919 0.59 16 11-111929 11/39 361 inII 1*39 IV 46 39 81

1194 1V62 351 413

1963 1/1969 479 1-0

S S I so

psi ~v u~e1~’l~ ~‘S ~nat

\} p

beta coefficients arc presented in Table II. For thewhole period the monetary influence is large andstatistically significant, while the fiscal influence isnegative and statistically insignificant. This resultalso applies to each of the subpeniods, except forWorld War II and the early postwar periods (1939-52). During the World War II years the monetaryinfluence is statistically insignificant and negative, andthe fiscal influence is insignificant and positive. Forthe early post-World Wan II years the fiscal influ-ence is statistically significant and negative. Thispostwar regression result seems to be due to specialfactors which are outlined below.

Which is More Predictable? — The monetary onfiscal variable with the more statistically significantcoefficient is also more reliable in that its relationshipto economic activity is more predictable. Statisticalsignificance is measured by the t values of the co-efficients of the monetary and fiscal variables whenmeasured against the same dependent variable, whichin this case was AY. A t value is a statistical in-dicator of the confidence one may have that the“true relationship” between the independent anddependent variable has the same sign as the statis-tically estimated coefficient of that relationship. Thelarger a t value, the more confidence we have thatthe monetary and fiscal variables are related to eco-nomic activity. The t values of the sum coefficientsare presented in Table III. For the whole period, the

value of the monetary variable is substantiallylarger than the t value of the fiscal variable. Thesame statement also holds \vith respect to the t valuesof the monetary and fiscal variables in the sub-periods, with the exception of the war and earlypostwar periods (1939-52). Thus, in general, themonetary variable has a more predictable effect oneconomic activity than the fiscal variable.

Page 12


Which Works Faster? — The relative promptness ofmonetary or fiscal influences can be measured byobserving which variable has a shorter time lag ininfluencing economic activity. This can be seen inthe quantenly patterns of the regression coefficientsafter they have been transformed into beta coeffi-cients. The latter are plotted in Chart II and arederived from the same set of statistical results sum-marized in Table I. The fiscal variable has about thesame impact as the monetary variable in the con-temporaneous quarter during the total period 1919-

1969. However, in the succeeding quarters the fiscalinfluence declines and becomes negative, while themonetary influence continues to be positive throughthe third lagged quarter. The quarterly pattern ofthe monetary influence in the subperiods is quitesimilar to that of the total period. The pattern of thefiscal influence varies irregularly over subpeniods.However, in all subperiods except the war period1939-46, the monetary variable has a consistentlyfaster influence on economic activity than the fiscalvariable.

Page 13


Historical ReviewThe statistical results reported above are estimated

on the basis of the average response of economicactivity to monetary and fiscal influences within eachof the periods selected. A different way of lookingat monetary and fiscal influences on economic activityis to investigate specific historic episodes. Chart IIIon pages 16 and 17 is designed to assist in that inves-tigation. In the lower tier of the chart the monetaryand fiscal variables are plotted as rates of change ona common axis. In the upper tier of the chart eco-nomic activity is also plotted in its nate-of-changefonmn.16

The most interesting comparisons are to be foundwhere the monetary and fiscal influences are operat-ing in opposite directions. In those periods the move-nient in economic activity will indicate which infirm-ence is dominant, The monetary and fiscal variablesmove in opposite directions in the periods 1919-21,1931-32, 1939, 1948-50, and 1966-67. In each of theseyears economic activity, after a short lag, moved inthe same direction as the monetary variable and inthe opposite direction to the fiscal variable. As amatter of fact, all cyclical movements in the moneystock were followed by proportional cyclical move-ments in economic activity. Of the twelve cyclicalmovements in economic activity from 1919 to 1969,eleven are preceded by corresponding movements inthe money stock.17 The single exception is thedeceleration in economic activity in 1951, which isdiscussed below.

1919-1929 — Although this period was one of gen-eral economic prosperity, there rvere three cyclicaldeclines in this ten-year period, The first and mostsevere occurred in late 1920 and early 1921. Duringthe remainder of the 1920’s two shorter and milderdeclines occurred; in late 1923 to early 1924, and in1927.

Each of these cyclical movements in economicactivity is matched by a corresponding movement inthe money stock. Money switched from a 15 per centrate of increase in the fourth quarter of 1919 to a 16per cent rate of decline in the first quarter of 1921..This was the sharpest five-quarter deceleration in themoney stock recorded during our fifty-year period.The money stock had pronounced, though milder,decelerations in 1923 and late 1926.

t6Rates of change are used to allow comparisons over longtime periods on a similar basis.

“Milton Friedman and Anna Schwartz made a similar obser-vation in “Money and Business Cycles,” Review of Eco-nomics and Statistics, Febrnary 1963.

NOVEMBER 1969

Fcdcnsl Gorrnment spmndtng shorrcd stmbstintmalfluctuation in the earlier part of the period and verylmttle movement mn thi mmddle md I itF. m put of thepcmiod This experience rcflcctcd the demobilmzatmouafter World Vm’ar I and the conservative spendingpolicies of the Harding and Coolidge administrations.

The statistical results reported in Table I, page 11,omit the fiscal variable entirely for this subpeniod, be-cause its inclusion raises the standard error of theestimate (adjusted for degrees of freedom) andthus contributes nothing to the explanation of move-ments in economic ietivitv This is not truc of anyother subperiod in this study.

1929-1939 — The first part of this period is un-doubtedly the most depressed in the entire economichistory of the Unmt d Statc It was not the sharpnessof the decline tInt was so disistmous There weremore rapid declines in both 1920 and 1937. Its dura-tton was disastrous Economic activity declined at anannual rate of 20 percent or mormi for ten of theeleven quarters between late 1929 and late 1932.Sust uned recovery did not start until the middle of1933, when 25 per cent of the labor force was un-employed and the price level was 24 per cent belowits 1929 level This recovery listed with one sigmficant interruption in 1937, through the end of theperiod.

Monetary influences during this period have beencharacterized by a number of observers as beingespecially ineffective. The results presented in thisarticle indicate that quite the opposite was the case.Monetary influences played an important role in thedeclines in economic activity in 1929-33 and 1937-38,and in the recovery in the intervening years.

Although the initial decline in the third quarterof 1929 apparently was not due to tight money in-fluence (the money stock did not decline until thefourth quarter of 1929), the fact that the economicdecline lasted for more than three years is associatedwith a decline in the money stock.mS The initial fivequarters of decline in the money stock were rela-tively mild. After reaching an annual 9 per cent rateof decline in the first quarter of 1930, it slowed to a3 per cent rate of decline in the fourth quarter of1930. Then, for the next four quarters, the moneystock decelerated substantially and reached an an-nual rate of decline of 18 per cent in the fourth

iSMilton Friedman and Anna Schwartz, A Monetary Historyof the United States, (Princeton, New Jersey: PrincetonUniversity Press, 1963), chapter 7, go into considerabledetail describing bow Federal Reserve actions dominatedmovements in the money stock during this period.

Page 14


quarter of 1931. For the next six quarters the de-clines became progressively smaller. Finally, at theend of 1933 the money stock registered the first

quarterly increase since the third quarter of 1929.The money stock had shown continual quarterlydeclines for almost four years.

Economic activity moved parallel with the moneystock pattern in 1929-33. Although the first year de-cline was substantial, it was less than the four-quarterdecline in 1920-21, and only moderately greater thanthe four-quarter decline in 1923-24. In the first halfof 1931 the rate of decline actually slowed, respond-ing to the less restrictive monetary influences, How-ever, in the next year the decline in economic activityincreased sharply. In the year ending June 1932, itdeclined by 37 per cent. In late 1932, economic activ-ity finally stopped declining, and in early 1933 itstarted to increase. This increase generally continueduntil the middle of 1937, when it was temporarilyreversed by the tight money influence which de-veloped in late 1936.

During this period fiscal influences, as measuredby changes in Federal Government expenditures,were quite erratic. They were highly expansionaryin the years 1931, 1933 to early 1934, 1936, and 1938.On the other hand, they were restrictive in the years1932, 1935, and 1937. This pattern sometimes con-

formed with and sometimes opposed monetary in-fluences. But in every case economic activity movedconsistently with the direction and magnitude ofmonetary influences.

1939-1946 — Data for the war years are presentedto make the series complete. However, with compre-hensive price controls tending to create a discrepancybetween the equilibrium and observed growth ratein economic activity, there is little to be learned aboutmonetary and fiscal influences from this period. Ourresults indicate that the monetary variable was notstatistically significant during this period. The fiscalvariable had a strong positive influence in the quarterin which the Government spending took place, buttended to “washout” after five quarters, leaving onlya small positive net influence.

1947-1952 — There were three cyclical expansionsin this period: early 1947-48, late 1949 and 1950, andin 1952. There were cyclical contractions in the inter-vening years. The movements in the money stock dida good job of “tracking” the movements of economicactivity during this period, with the single exceptionof the deceleration in economic activity which oc-curred in 1951. This is the only deceleration in

economic activity in the fifty-year period which wasnot anticipated by movements in the money itock.

A quite plausible explanation for this phenomenais provided by Friedman and Schwartz.hO In March1951 the United States Treasury Department and theFederal Reserve reached an “Accord,” which per-mitted the latter to abandon its war-induced policyof pegging the price of Government bonds. Eventhough the Federal Reserve did not take advantageof this increased flexibility in policy actions immedi-ately, the public act of abandoning support of theGovernment bond market greatly reduced the ap-parent liquidity of the public. The public was nolonger assured that conversions between Governmentbonds and money could take place at a fixed andknown price. This caused a substantial, one-time in-crease in the liquidity demand for money balancesrelative to income, and a decrease in the velocity ofmoney in a period when velocity had typically beenrising.

This experience suggests not only that permanentchanges in the demand for money independent ofchanges in income can weaken the observed relationbetween money and income, but that such changesin money demand are relatively rare. Such changesgenerally have been associated with some specifichistoric event which changes the previous institutionalrelations with respect to the liquidity of nonmoneyassets.

The other unique factor about this subperiod isthat the fiscal variable is statistically significant andnegative. Weidenbaum has provided a plausible ex-planation for this.2°He has shown that Governmentspending influences economic activity not when thebills are paid and the goods are delivered to the Gov-ernment, but when the orders are placed with in-dustry, which must then hire employees and openplants to produce the products.

This discrepancy does not lead to serious bias inmeasuring Government spending except when thereis a sharp acceleration or deceleration in this variable.This was clearly the case in the Korean War, whenGovernment spending went from an annual rate ofdecline of 38 per cent in the second quarter of 1950to an annual rate of increase of 83 per cent in thefirst quarter of 1951 and then fell to an annual rateof increase of 13 per cent in 1952. This “whiplash”

iiFriedin~nand Schwartz, pp. 598 and 612.tm0

Mnrray L. Weidenbanm, “The Federal Government Expend-ing Process,” Federal Expenditure Policy for EconomicGrowth and Stability, (washington, D.C.: Joint EconomicCommittee of Congress, U.S. Government Printing Office,November 1957), pp. 493-506.

Page 15

TV

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Page 16

Government Expenditures Chart Ill

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________________ ________________ ________________ ________________ ________________ ________________ ________________ I’

1947 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973Sources: Money Supply: 1919-46, Milton Friedman & Anna J. Schwortz’A Monetary History of the United States;1947 1969’Board of

Governors of the FederalReserve System;Federal Government Spending: 1917 28, estimated from U.S. Historical Statistics,Bureauof Census; 1929.1945, estimated from National Income & Products Supplement, U.S. Departmentof Commerce;1946-69, Federal Reserve Bank of St. LouIs; Economic Activity: Industrial Production Index, Board of Governors of the FederalReserve System; Consumer Price Index, U S. Department of Labor

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Page 17


movement in Government spending follows by abouttwo or three qnarters an equally sharp movement ineconomic activity. As a result, AY and ~E movedin opposite directions in this period. This is the causeof the statistically significant negative coefficient ofAE with respect to ~Y.

If we had chosen a somewhat longer time periodin which to measure the impact of monetary and fis-cal influences, the strong negative offset estimatedwith respect to AE xvould have lost its statisticalsignificance. We would have had results for the earlypost-World War II subperiod which were comparableto the results of the other subperiods.2’

1953-1969 — This is the period which was coveredin the original AJ study. While their measure ofeconomic activity, nominal GNP, differs from theproxy used here and described in footnote 10, theirresults and ours are similar in most respects, as canbe seen in the comparison of summary results inTable IV.

In each case the monetary and fiscal measuresare the same (the money stock and governmentspending). Only the measure of econonmie activitydiffers. The first equation is based on our proxy ofeconomic activity and is drawn from Table I. Thesecond equation is based on nominal GNP.22 In eachcase the monetary variable has a positive coefficientwhich is statistically significant and the fiscal variablehas a coefficient which is statisticially insignificantand close to zero in value. Both equations are suffi-ciently well specified to pass the Durbin-Watson(D-W) test for autocorrelation, and the lag struc-tures arc the same when selected on the basis ofminimum standard error of estimate. The value of

2tThis is shown by the following regression:

1/1947 — IV/1956(Quarterly First Differences)

a aAY = 1.11 + 7.82 ~AM~—,— 1.13 ZAEm~.m B

2= .27

.48) (3.31) i=o (1.76) i=o D-W = .98where ~ stands for sum of monetary or fiscal influence fromperiod t to period t-3. Lags were selected on the basis ofminimum standard error of estimate adjusted for degreesof freedom.

tm2The results with respect to nominal GNP differ slightly fromthe original Andersen-Jordan results because of the differentlag structure. The lag structure in their original article(contemporaneous and three-lag valnes) was selected onthe basis of mimiinmum standard error of the coefficientattached to the monetary variable. The presemit lag structure(contemporaneous and four-lag values) was selected onthe basis of minimum standard error of the entire equationadjusted for degrees of freedom. In this case, the differentcriteria did not change the results in any significant way.

Table IV

MONETARY AND FISCAL INFLU NCES ONECONOMIC ACTP/ITY MEASURED AS A PROXY

CAY) AND AS NOMINAL ONP fAGNP)(I 1953 1 19691

Depend in Canstant Monetary Fisc& RT

Variable Legs tern, latin ace Intluence 0 Wcm a AM azAE

an’ +4 142 8.85 —.84 47.77) (470) (L07) 171

Aow~ t 4 259 5.63 08 65(3 19) (6.94) 24) 1 78

No lime so e ffisn a beta e,them ‘5 aloep beio e heoffhien clod art eaR,

tis p erito Va ~Oii n ad mmtv LI hIh~piseUb amt n h dped ,rbi 11W,

the flurbi -W S on I

the monetary coefficient is greater with the proxymeasure of economic activit (AY) than with nom-inal GNP (AGNP), which is due to the greater aver-age value and amplitude of the proxy. The coefficientof determination (R2) is larger with AGNP thanwith AY. This is as would be expected if, as seemsreasonable, nominal GNP is superior to our proxy asan indicator of economic activity.

There were four cyclical declines in this period,each of which was led by a decline in the moneystock. Government spending registered three cyclicaldeclines, two of which corresponded to periods ofdecline in the money stock and one (in 1967) whichdid not. As noted in our investigation of earlier pe-riods, economic activity declined following a declinein Government spending only when accompanied bya decline in the money stock.

Determining the Values of the Monetaryand Fiscal Variables

An assessment of the reliability of the relationspresented above will depend upon whether theestimated coefficients for the monetary and fiscalvariables are exogenous. This problem arises in allstatistical work, and no fully satisfactory solution hasbeen found to test for exogeneity in either singleequation or in large structural models.23 Ho\vever,in the single equation test of monetary and fiscal in-fluences on economic activity employed here, onepotential source of bias is found in the so-called “re-verse-causation” argument. This asserts that time ob-served correlation between M and Y is not becausechanges in M cause changes in Y. hut because changes

a:lJn statistical theory, a variable is exogenous if it is un-correlated with the “true” error term of the equation.Unfortunately, only the measured error term in any equa-tion is observable, so this test cannot be made.

Page 18

IFEDERAL RESERVE BANK OF ST. LOUIS

in Y cause changes in M. If this possibility cannot berejected. then a snore elaborate statistical test isneeded to compare monetary and fiscal influenceon economic activity.24

The fiscal variable used here (total Federal Gov-ernment spending, including transfer payments) isgenerally accepted as being determined by the fiscalauthorities and not by the behavior of the public inthe marketplace. For the purposes of our test wewill assume that the fiscal variable is statistically inde-pendent or exogenous. With respect to the monetaryvariable (the narrowly defined money stock), there isconsiderable controversy as to whether its value isdetermined by the monetary authorities or by thepublic. For this reason we will concentrate our em-pirical investigation on the money variable. It will beshown that the reverse-causation argument is notsupported by the evidence. In addition, the availableevidence indicates that the actions of the monetaryauthorities dominate the movements in the moneystock.

Does Economic Activity Affect Money?

In order to evaluate the significance of the re-verse-causation argument, we need some indicator ofthe public’s potential influence on the money stock.The indicator chosen is our proxy variable for eco-nomic activity (Y). This proxy has two advantages:first, it is the broadest available measure of aggregateeconomic activity and, as such, most actions of pri-vate decision-making units in the economy are re-flected in it. Second, it allows us to consider direcilythe important statistical question of whether move-ments in Y lead to movements in M.

In order for economic activity to affect the moneystock, it must operate through some transmissionmechanism.25 The Brunner-Meltzer money stockidentity provides a useful structure within which toconsider the several ways that economic activity couldaffect the money stock,2°In this context the money

tm4At the least, one would need an equation to explain themonetary and fiscal variables by factors which themselveswere independent of income.

amThe approach used here to test for the influence of thepublic on the money stock was suggested by the work ofLeonall C. Andersen, “Additional Empirical Evidence onthe Reverse-Causation Argument,” this Review, August1969.

tm6For a systematic exposition of this approach, see AlbertBurger, “An Analysis and Development of the Brunner-Meltrer Nonlinear Money Supply Hypothesis,” WorkingPaper No. 7, Federal Reserve Bank of St. Louis, May 1969.

NOVEMBER 1969

stock (M) is defined as the product of the moneymultiplier (m) and monetary base (B):

M = ruB

The sources of the monetary base consist of variouskinds of credit extended by the monetary authoritiesto the rest of the economy. The use of the monetarybase is divided between currency holdings of thenonbank public and reserves of commercial banks.

The money multiplier, which is defined as

1+k___r (1+r+g)+k

is largely determined by the behavior of the public,including commercial banks; k represents the ratio ofprivate currency holdings to private demand depos-its; T represents the ratio of private time deposits toprivate demand deposits; g represents the ratio ofGovernment deposits in commercial banks to privatedemand deposits; and r represents the ratio of totalbank reserves and total bank deposits.27

Economic Activity and the Monetary Base — Theinfluence of economic activity on the money stockcould operate either through the monetary base (B)or the money multiplier (m), To test whether eco-nomic activity has influenced the monetary base,regressions were run for the total period (1919-69),and for each of the five subperiods reported above.The results are presented in Table V. For the entire50-year period changes in the monetary base have astatistically significant relation with changes in eco-nomic activity. However, economic activity explains atmost only 4 percent of the variance of the changes inthe monetary base; that is, the 112 was .04. Forevery $1 billion increase in economic activity, thereis associated only an $8 million increase in •the basein the same quarter.

Equally weak relations between AY and AB werefound in the subperiods. Only the first (1919-29)and the last (1953-69) subperiods had statisticallysignificant coefficients, while the 112 varied hehveen.01 and .15.

These results imply that the public, operatingthrough economic activity, has only a small effect onthe monetary base, and that this effect has varied

2mFor a detailed discussion of the determinants of the multi-plier and its influence on the money stock, see Philip Cagan,Determinants and Effects of Changes in the U.S. MoneyStock, 1875-1960, (New Yorlc National Bureau of EconomicResearch, 1965); and Jerry L, Jordan, “Elements of MoneyStock Determnination”, this Review, October 1969.

Page 19


substantially over time in bothdegree and significance. Allow-ing for the influence of laggedvalues of AY on AB does notchange the results presentedin Table V, except for 1947-52when the R2 increases to .24and the coefficient becomesstatistically significant.

Monetary Authorities and the

Monetary Ba-se — Another po-tential source of control of themonetary base is through theactions of the monetary au-thorities. There have been anumber of studies which haverelated policy targets of themonetary authorities, such asincome stabilization, to variousindicators of monetary actions,such as the money stock (Dc-wald and Johnson), total member bank reserves(Dewald), free reserves (Wood), and the monetarybase (Keran and Babb). All these studies concludethat the monetary authorities have dominated move-ments in the money stock or some closely allied vari-able. The last named study will he briefly reviewedhere because it deals explicitly with control of themonetary base by the authorities.

with respect to income, employment, and prices, re-flected in the Federal Reserve Open Market Commit-tee policy statements as proxied by the level of freereserves (FR); an even-keel objective with respectto Government debt financing, measured bychanges in the national debt (AD); and a financialobjective with respect to stability of the financialsystem, measured by deviations of Corporate Aaabond yields from “normal” yield levels (r-r~) ~ Inaddition, economically “random” events, such aschanges in the price of gold in 1934 and changes inpresidential administrations, have also influenced theactions of the monetary authorities with respect tochanges in the monetary base (A B). These eventsare represented by “dummy variables” in Table VI.

Two of the three subperiods considered by Keranand Babb were approximately the same as subperiodsin the present study (1/1953 to IV/1968) and 1/1940to IV/l952). Another subperiod in that study was re-estimated to match the 1929-39 subperiod in thisstudy. The results are presented in Table VI. In eachcase, fifty percent or more of the variations in ABare explained by the actions of the monetary authori-ties. In contrast, where the actions of the publicwere assumed to operate, the best results explainedfifteen percent or less of the variance in AB (see

28They have also shown that in the 1953-68 period, FederalReserve open market operations (adjusted for changes inreserve requirements) were also explained by the samethree objectives plus an additional money market objective,which in effect offset the noncontrolled sources of themonetary base.

NOVEMRFR 1969

Table VI

THE INFLUENCE OF STABILIZATION (FR), EVEN-KEEL (AD) AND

FINANCIAL. (r-r) OBJECTIVES OF THE MONETARY AUTHORITIESON THE MONETARY BASE CAB)

As —~: ci FR . c~AD — c. ~

I Quarterly First Differences — B.Uior’s a’ DollorsI

lime Stabilization Even Koci Financial Dum myPeriods Objective Objs.ctive Objective Va,obte’ P

2D~W

ci FR cAD c. Ir-r: III ‘1929 —-. IV/1939 .33 .219 .401 553 .59 1.75

(6.16) 12.86) 13.65j 11.95)t/1940—IV/1952 .01 070 .469 — .46 1.90

1.37) (6.32) 1.811I/1953—IV/1968 .19 cmii .123 415 .69 1.84

12.28) (1 73) 2.69) 15.581

‘;..r ic, s’., F. I... iw~ h, (;:o: In—. I.qlu,s u,rl, r,.ePsi,’s

.,,.,.: ;i’,s’is’t . —.i,.~.,.,j .‘. oI ~.:.n:I,: rI:s.l..j,ii,..’~au, It,. ,}~i.~flj~_

I h ‘,-,iifl.,r.’.;r ih. .::‘:s..,s,lc,r~,.:,..F.l. Ii ‘V:, 0.t lm.j.Isii..\~at‘Ii :t. t!cs—u’ u’~s’—nitlu- flmnmy V,,ri,,F,Ir I. ‘I. —iynr,d:,arc.rmt f’,r Tm. on ‘F.’ ama i:Ifl l.a.,. of Lhc

rsao Sn ‘ho pnc .1 guli~ in I’,.bruar~ i’J. 5. Is ,~-um.v the’ aluc f If,.’ Is.’ ‘,r..ts..,.,l,,‘iar’.evc of 1314 mcI zero fe— asI csh’ r.,’,art’’’ . i’: .ua.i.l,i’ ins- 1)Lm,ns V,,rioL’l,:,rruuni,, fo, tb,oh,,’, ..‘, Tire—..’ •,:d ,jno,s,is,——.,,, I,,,.,-’,,. r...,,

1:1—I,, J~.l:’i,s,.

Keran and Babh found that a large proportionof the movements in the monetary base can be ex-plained by the desire of the monetary authorities toachieve three objective : a stabilization objective

1~bt,V

THE INFWENC~OF ECONOMK ACTIVITY tAYON THE MONETARY BASE (AB}

~8t b. )nAY(Qvarteriy ffsrst Di*osences St lion of D*lfurz)

ton

~o b~AY R~ OW8JW19—t/ivst .008 04 58

t81~7} (298)ifl 1919 (1/1929 012 •Ot 12 .64

(6*) 1242)IL) 1929 11/1939 20 004 02 85

391 1)111/ 939’— Pt/i94& 99 912 .01 1 09

r730 (114)1/)947—IV/1952 12 01 08 97

1145) 1176)1/19 a 1/1969 24 012 15 87

14241 1 4*)

N Ii In t.a CIt cia C t Ri

is its sail, e

~ ;1

m C ed V tabe D~W

Page 20


The values of the coefficients in Table VI for theprewar (1929-39) and postwar (1953-68) subperiodswere similar with respect to the income stabilizationobjective (FR) and the financial stabilization objec-tive (r-r~) ,~°supporting the hypothesis that the mon-etary authorities have acted in a largely consistentmanner in controlling the monetary base (AB). Dur-ing the war and early postwar period (1940-52), theFederal Reserve followed a single-minded policy ofsupporting the Government bond market. The resultsin Table VI reflect this, with only the even-keel vari-able statistically significant in that subperiod.

Table VII presents the results relating changes in themoney stock (AM) to changes in the monetary base(AB) and economic activity (AY). Assuming that themonetary authorities determine movements in thebase, and that the public operating through economicactivity influences the money multiplier, our resultsindicate that for the total period (1919-69) both themonetary authorities (AB) and economic activity(AY) explain 67 per cent of the variance in AM.However, the beta coefficients, which indicate the“typical” influence of each independent variable onthe dependent variable, show that the monetary au-thorities operating through the base LAB) have animpact on the money stock (AM) which is 3½timesas large as the public influence operating througheconomic activity (AY). The results for the subperiodsare substantially the same as for the total period. Thecoefficient for the monetary base is statistically sig-nificant in all subperiods, while that for economicactivity is statistically significant in only the first twosubperiods (from 1919 to 1939). There was one sub-period (1929-39) where the beta coefficients in-dicated that economic activity was more importantthan the monetary base in determining movements

Table V). The acceptable Durbin-Watson statistics in Economic Activity and the Money Multiplier —

Table VI suggest that no important explanatory varia- Another channel through which economic activitybles have been omitted from the monetary authori- could influence the money stock would be through itsties’ explanation of AB. On the other hand, low influence on the money multiplier. As indicated above,Durbin-Watson statistics in Table V imply that im- most of the ratios which are involved in determin-portant explanatory variables have been omitted from ing the multiplier depend upon the behavior of thean economic activity explanation of AB. public, including commercial banks.

The results presented here indicate that it is thebehavior of the monetary authorities (Table VI)rather than economic activity (Table V) which havedominated movements in the monetary base (AB).There is no evidence that the reverse-causation argu-ment holds with respect to AB.

20For an explanation of all variables used in Table VI andof the difference in the even-keel sign between (1929-39)and (1953-68), see Keran and Babb, pp. 9-15.

Table VII

RELATIVE INFLUENCE OF ECONOMIC ACTIVITY EAY) AND THEMONETARY BASE CAB) ON THE MONEY STOCK (AM)

AM. = ci, -— ci AY. ‘- ci. AB,

C Quarterly Frst Differences —-— iiilions or DaIle151

Time - Bela ~oefticionIs -

Periods dr d4’Y dAB. R2

D-W AvIl/1919—I/1969 .094 .023 1 89 .67 1.32 .198 755

V.441 13611 117.781

11/1919 — 11/ 1929 .075 025 241 .61 1.43 .288 .640(1.72) 12.49) 15.57)

111/1929 — 11/1939 .064 .063 .71 .42 1.21 .546 .351(.63) (4.45) 2.86)

III/1939—IV/1946 .82 022 1.69 57 1.73 .18] .791(2.521 (1.45) 16.35)

l/1947—IV/1952 .37 .019 1.46 .46 .97 .230 .598(2.27) (1.4]) (3.63)

1/1953 — 1/1969 .032 .014 1.94 .59 1.56 .166 .696124) (1 921 (8.00)

N’’ss, 1t,.:,.....,,r’,..,,.l’:,’r.~,_.t,,. iits to’’ li.cj.’c,. :1’’: ‘‘ vaiu~s a; ‘‘‘a’ I.sC,,.s ‘-ash lli,’,,’’. ‘wIt--i is’5.’,m’’s.sht..-—. R- I,,. ~

-.-..Isss,.,,_,,Iu.,i,,.s,.lc.,t ~ss’:,s,,’.;-h,,’h ,. ~ Iv’,’ ri~ii,.r’.- ‘‘, ‘he,’li’’c’,s,:’-”, ~,. .ini-I,’ r,.w -— he ~ W:,i

Pasr,’’I


Table VIII

RELATIVE INFLUENCE OF ECONOMIC ACTIVITY CAY) AND THEMONETARY BASE CAB) ON THE MONEY MULTIPLIER (Am)

Am, e. -F e, AY.-- e AB,IOuurIcrly Fi’sI Differences —— B,ihans ol Dollars)

Time Beta Co :ft-c,e isPeriods e e,A’Y erABI D-W Av AB

11/1919—-- 111969 .001 001 03 I? .96 .194 ‘ .288‘ 03, 14.201

II 1919—lI 1929 011 .004 16 .16 1.45 438 .403(1.62) 12.53) (2.37)

111/1929—11-1939 --.004 001 .16 .50 .98 .441 .575(.21) (4.04) (5.16~

111/1939 — IV, 1946 .038 .001 .034 .32 I 27 .274 - 528(3.05) 11.321 (3.34)

1,1947 — IV! 1952 .008 0031 .028 24 .95 .062 -.308(2.24) (1.45) (2.98)

l/1953—I,1969 .0001 .0001 .01! .09 1.56 .100 .332

(.15) (2.18) (2.66)

N’.,’. it,-~’,_,,,r. ‘,,,‘,lr,’,i.. ,, , .1. .- ‘-“L.a - U,-,’ t’’ ‘‘‘sa—a5-, a, ‘1..,..,, 1. ‘-‘rh--,s ‘!:‘‘‘‘‘L’I In ‘s--a—h, .. 515’- - ‘l’i:c’~,’~’’,I;s...iI -5,icl,,..,-,1

55,t,;-i I.~’’.,’:n’s’’’-,u .‘,s-. -;‘-,s’s.—’s,-.’.ll’ 1—\\

in the money stock. The strength of the economicactivity variable in that period reflects the substantialdecline in the multiplier. The multiplier declined dur-ing the early part of that period (1929-33) due toa change in the currency-deposit ratio (k), whichreflected the run on banks by households as they at-tempted to convert their bank deposits into currency.

These results are not changed when lagged valuesof AY and AB are added to explain AM. With fourlags the statistical significance of the coefficient forAY disappears in 1919-29, while in 1953-69 the co-efficient for AY becomes negative. This latter resultis inconsistent with the usual reverse-causation argu-ment, which asserts a positive relationship.

The results presented in Table VII imply that eco-nomic activity has had some influence on changes inthe money stock, presumably through its influenceon the money multiplier, especially in the important1929-39 period. However, the observed influence of

economic activity on the money stock would over-state its true influence if offset by the actions of themonetary authorities operating through the monetarybase. For example, if part of the actions of the mone-tary authorities had been designed to offset the in-fluence of economic activity on the money multiplier,then the observed association of economic activityand the money stock would be, at least, statisticallyambiguous.

operating through the monetary base (AB), on themoney multiplier (Am). In the total period and inall subperiods the influence of economic activity(AY) is positive and the influence of the monetarybase (AB) is negative. The beta coefficients indicatethat in all subperiods (including 1929-39), the mone-tary authorities offset or more than offset the influenceof the public on the money multiplier. Thus, thesignificance of the association of economic activityand the money stock reported in Table VIII is weak-ened, because those movements in the money multi-plier induced by economic activity have been offsetby changes in the monetary base.

The conclusions which can be drawn from thesestatistical tests are (1) that the monetary base is thedominant factor in determining movements in themoney stock, both directly (Table VII) and indirectly(Table VIII), by offsetting other influences on themoney stock; and (2) that the monetary authoritiesare the dominant factor in determining movementsin the monetary base (Table VI) - Thus, for the pur-poses of the single equation regressions used in thisarticle, there are no statistical reasons for not treat-ing the money stock as substantially controlled bythe monetary authorities in all suhperiods (including1929-39).

SummaryThe intent of this article is to measure the impact

Table VIII indicates this is the case. It shows the of monetary and fiscal influences on economic activ-relative impact of the public operating through eco- ity over as long a period of American history asnomic activity (AY), and the monetary authorities available data permit (1919-69), and for selected

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stock since 1919 has been followed by a proportionalcyclical movement in economic activity.

Both the statistical results and the historical in-vestigation provide strong support for the case thatmonetary influences have a significant impact on eco-nomic activity over the business cycle. An importantimplication of these results is that monetary policyshould be given a central role in any economicstabilization program.

aume author was surprised at the consistency of the mone-tary influence during the various suhperiods. Before con-ducting the research reported in this article, he consideredthat monetary influences on economic activity were stronglysignificant only during ?eriods of generally strong businessconditions like the 1920 s and 1960’s, while fiscal influenceswere dominant in periods of generally weak business condi-tions like the 193

0’s. In the March 1967 issue of this Review

(page 14), he said: “during the 1930’s business expectationsof the future were so badly impaired by the depression ex-perience that even large change in financial variables likemoney,...would not be sufficient to induce new invest-meat and consumption.” In the November 1967 issue (page8) he made the same statement in a slightly differentcontext: “If the forces which create strong private demandshould disappear, i.e., loss of optimistic expectations by firmsand households, the rate at which money is made availableto the economy snay not result in a predictable change inincome.’

The results reported in this article do not support theabove quotations. Monetary influences have dominated fiscalinfluences on economic activity in both periods of secularboom and periods of secular recession.

This article is available as Reprint No. 47.

subperiods. This was done to see if different financialinstitutions, Government involvement in the economyand general economic conditions which existed dur-ing this long period have substantially affected therelative impacts that monetary and fiscal influenceshave had on economic activity.

For the whole period and for each of the sub-periods (except the \var years 1939-46), the rela-tive impacts of monetary and fiscal influences havebeen remarkably stable. Changes in the money stock(the indicator of monetary influence) have consist-ently had a larger, more predictable, and faster im-pact on changes in economic activity than havechanges in Federal Government spending (the in-dicator of fiscal influence). This basic relationshipis observed in the economically depressed period of1929-39 and in the prosperous periods 1919-29 and1953-69,~°

A historical investigation of the past fifty yearsreveals that in every case where the monetary varia-ble and the fiscal variable moved in opposite direc-tions, economic activity moved in the direction of themonetary variable and opposite in direction to thefiscal variable. Every cyclical movement in the money

The Appendix to this article, which begins on the next page, considersthe fiscal influence in more detail.

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APPENDIX

Table IX shows the impact of fiscal influences (mcasuredby changes in Feder-il Covesnment spending) on ceo-nosnic tctisity without takng mon tar influences intoconsideration. Notice in Table IX that the ign andstatist’cal significance of the fl cal influence differ substantially from the results presented in Table I wheremonetary influence a e explicitly accounted for. In Ta-ble IX the fiscal influences are po itive and statisticallsignificant fot the entire period - nd foi esch of the subperiods The single exception ‘s the perod 1947-52where special factois explained in the text tended tobias the fi cal measure. On thc other I md the fiscalinfluences mea ured in Table I ~sere statistically insign-flcant and negative for the entire period and for eachof the sub-periods ig-ssn ‘. ith the singlc e ception of thepe 10 1 1947 52.

Thbt IX

IMPAa OP FISCAL (NP UENCES (AEON ECONOMIC ACTIVITY LAY

Sf f0 IAE

f~itst0 ffererscss Br! seas oi fl~tlc5

tag I I £8f wa) re/ow11/1919 1 1949 4 Zn . 3

15161 G1} 96

1/9*9 8 1929 173 32 411 441 (278 LIt

III 19 9 11/1939 tO 3,45 1828 14(2251 (2 8~ 149

111/1939 1V/1944 419 53 6%1 9 1 (211) 1,43

1/1947 IV 1952 14 9~38 149 -0991) (1 76) St

I 1953.’—8/1969 13 604 171 08295 (215) 13

11 ‘Begs -~ elI ala n bete at o Kit de

nab ohs - on inth in unite va,ableDW 15DumnW is

R I 5 ‘, tuna5i i r

The results in Table IX, where the fiscal influencesare positive and statistically significant, do not differ-entiate between the alternative methods of financingGovernment spending. Table I, however, by explicitlyincluding changes in the mnoney stock, implies thatGovernment spending financed by money creation isaccounted for by the mnonetary variable. Only that portionof Government spending which is financed by taxationand selling bonds to the public is measured by thefiscal variable.1 These results indicate that the strengthof the fiscal influences on economic activity is dependentupon the method of financing Government spending.If spending is financed by increases in the money stock,it has a measurable effect on economic activity. If it isfinanced by taxe.s or selling bonds to the public, thereis no measurable fiscal influence on economic activity.

Most writers on public finance andfiscal policy2 have generally assertedthat the impact of Government spend-ing on the economy is influenced byhow the spending is financed. Themost expansionary method is throughincreasing the money supply, and theleast expansionary method is throughincreases in taxes. The results pre-sented in this Appendix are consistentwith those assertions.tmThe role of commercial banks is ambiguous

in this analysis. If banks buy Govemmentbonds and induce the Federal Reserve toincrease total reserves, it is treated as anincrease in the snoney supply by the mon-etary authorities. However, if the com-mercial banks buy Government bonds,independent of any increase in reserves,it is treated the same as a purchase ofbonds by the general public.

lRichard Musgrave, The Theory of PublicFinance, (New York: McGraw-Hill, 1959);Alvin Hansen, Monetary Theory and FiscalPolicy, (McGraw-Hill Company, 1949);and 0. H. Brownlee and E, D. Allen, TheEconomics of Public Finance, Second Edi-tion, Englewood Cliffs, New Jersey: Pren-tice-Hall, Inc., 1956).

Most of the readers of this article will not be sur- A cosnparison of the results in Table I and Table IX in-prised with our results, which indicate that monetary dicates that fiscal influences on eeonomnie activity mayinfluences have had a major impact on economic activity. he strongly dependent upon how Coversunent spendingMost economists believe that money snatters. However, is financed, Federal Govennnent expenditures can bethey may be surprised at the consistently weak Or non- paid for either by tax receipts from the public, by issuingexistent fiscal influence which our results imply. This bonds to the public, or by expansion of the money supply.Appendix will explore one possible explanation for thesesurprising results.

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monetary and fiscal influences on economic … · activity — the historical evidence* ... ~the...

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