Showing papers in "Journal of Money, Credit and Banking in 1973"

On a Correct Measure of Inflation

Abstract: Two commonly cited and newsworthy price indices are the Bureau of Labor Statistic's Consumer Price Index and the Commerce Department's GNP deflator. These indices have become an important part of our economic intelligence and are frequently considered to be the operational counterparts of what economists call "the price level." They, therefore, often are used as measures of inflation and often are targets or indicators of monetary and fiscal policy. Nevertheless, these price indices, which represent measures of current consumption service prices and current output prices, are theoretically inappropriate for the purpose to which they are generally put. The analysis in this paper bases a price index on the Fisherian tradition of a proper definition of intertemporal consumption and leads to the conclusion that a price index used to measure inflation must include asset prices. A correct measure of changes in the nominal money cost of a giverl utility level is a price index for wealth. If monetary impulses are transmitted to the real sector of the economy by producing transient changes in the relative prices of service flows and assets (i.e., by producing short-run changes in "the" real rate of interest), then the commonly used, incomplete, current flow price indices provide biased short-run measures of changes in "the purchasing power of money." The inappropriate indices that dominate popular and professional literature and analyses

Inflation and Growth: Alternative Approaches

Abstract: This paper develops alternative approaches to the principal relationships and results in the analysis of inflation and growth. Rather than derive new propositions, our purpose is primarily to present an accessible and coherent exposition of existing theories. The issue to be analyzed is how alternative rates of inflation affect realvariables, in particular, steady state per capita consumption, real balances, and real capital. To the extent that inflation represents a tax on real balances, the real effects of altering that tax depend on what we assume about the role and nature of money. Conflicting or ambiguous results derived from alternative theories are primarily the reflection of different hypotheses about the functions of money. Since derivation of such hypotheses from microeconomic foundations continues to be a field of current inquiry, any definite conclusions with respect to the real effects of inflation must await the further development and empirical validation of such theories.l Pending such progress we propose to take stock of competing theories of inflation and growth. There are essentially two approaches to the problem. One strand of the literature initiated by Tobin [12] and Johnson [4] assumes a savings function as well as a demand function for real balances and investigates the comparative statics properties of the implied steady state characteristics of the system. In these formulations real balances are alternatively treated as a consumer or a producer good. In the

Interest Rates and Prices in the Long Run: A Study of the Gibson Paradox

Abstract: This is a study of the relationship between commodity price inflation and interest rates. One of the chief avenues through which inflation has been posited to affect interest rates is through the effect of actual inflation on anticipated inflation, which is then taken to help determine the "nominal" rate of interest. For this reason, the manner in which price anticipations are formed is a topic that cannot help but occupy an important role in a study such as this. Although many papers have been written on the topic,l no single explanation of the relationship between inflation and interest commands wide acceptance. As proof of this statement, it is sufficient to note that the name that Keynes gave to that relationship-the Gibson paradox-has stuck. Keynes's claim was that over long periods of time in the United States, England, and other countries, interest rates had been highly correlated with the aggregate level of commodity prices. Keynes [20] named this empirical regularity the Gibson paradox2 since it seemed

The Markets for Housing and Housing Services

Abstract: In the U. S., and in most other developed countries, decisions about purchasing, producing, and financing housing and housing services have not been left to the unrestricted market decisions of individuals, or other private decision making units. With few exceptions, governments have adopted national housing policies to modify the decisions that would be reached in the market place. The legislated U. S. goal, "a decent home and a suitable living environment for every American family," [report on National Housing Goals, 16, p. 1] is to be achieved by constructing or rehabilitating 26 million housing units by 1978. One principal basis for the development of national housing goals is the belief that, if left unassisted, many households would purchase less housing and fewer housing services than legislatures, other centralized decision making units, and perhaps the public tend to regard as socially desirable. A second reason commonly offered as an explanation of public interest in housing is that relatively large fluctuations in the production of housing are said to be a consequence of public policies, particularly monetary policies. The most common explanation of the relatively wide swings in housing starts is that attempts to slow inflation by monetary policy raise interest rates, and attempts to expand production and employment by monetary policy lower interest rates. Large changes in

Wage Inflation and the Structure of Regional Unemployment

Abstract: An important implication of classical monetary theory is that, if fully expected and adjusted to, the rate of inflation cannothaveaninfluenceonrealeconomic activity. In the context of the Phillips curve discussions, this basic, classical conclusion has recently been reestablished by neoclassical writers, such as Mortensen [11] and Phelps [13]. According to them, any trade-off that may exist between unemployment and inflation must be caused by adjustment lags, money illusion, and similar frictions which disappear in long-run equilibrium. Any such trade-off is, thus, strictly temporary and, indeed, illusory. Only one rate of unemployment-the natural rate of unemployment-is compatible with a constant rate of inflation. Any attempt by governments to attain a permanently lower or higher rate of unemployment by ordinary fiscal or monetary methods would lead to ever-increasing rates of inflation or deflation. The mechanism through which the Phillips curve becomes unstable is the generation of and adjustment to inflationary expectations. Although the logic of this classical approach cannot be faulted, the empirical evidence on the manner in which expectations are generated and adjusted to is not strong (see Lucas and Rapping [10], Solow [16], and Brechling [5] ).

Assets, Money, and Commodity Price Inflation under Uncertainty

Abstract: Financial assets produce no consumption goods. They cannot be used to satisfy such human desires as food or shelter. Instead, their value stems from claims on future consumption. As these claims fluctuate ln expected magnitude, in risk of being satisfied, and in the time until fulfillment, asset prices also vary. That much economists and men of affairs take for granted. But the precise relations between asset prices and individual expectations, risk preferences, and time preferences are not well understood. Economic tradition has assigned to financial assets the quality of"value storage." Money has received additional credit as a "medium of exchange," that is, a completely "liquid" asset; but both characteristics can be subsumed under the phrase, "claim on consumption." For example, the "liquidity" value of a currency arises from its immediate recognition.l C)ne can easily verify this by noting the differences in waiter response when paying for lunch with dongs in New York and Hanoi; or,

The effects of inflation on the distribution of economic welfare

Abstract: In recent years, the restraint of inflation has been one of the most important considerations of macroeconomic policy. On several occasions drastic measures have been taken to halt inflation. Most often these policies have led to significant unemployment and loss of output. But after a quarter century's experience with inflation, most economists and politicians are looking for new and less draconian tools to combat inflationary tendencies. While most analysts agree that price stability is desirable, there is wide disagreement about the costs of inflation. In general, three reasons for price stability are mentioned. First, price stability encourages a favorable external balance. In an open economy with fixed exchange rates and difficulties of adjusting these exchange rates, there can be little doubt that inflation produces serious social costs. Second, it is sometimes alleged that inflation leads to inefficient resource allocation. There is, however, no evidence that the allocational effects of the mild inflations observed in advanced countries are significant. Third, it is often argued that inflation introduces a significant, arbitrary, and regressive redistribution of ncome. The present study is concerned mainly with the third of these costs of inflation. More precisely, we attempt to determine the effects of alternative inflationary policies on the distribution of lifetime income.l It is useful to lay out briefly the procedures used.

Secular Price Change in Historical Perspective

Abstract: The phenomenon of sustained commodity price rises that has characterized both industrial and less developed economies in the past three decades is only the most recent such episode in the long historical record of secular price changes. This suggests that price history merits some investigation for the light it may throw on contemporary price experience. Before we can hope to interpret the record of history, we need some provisional model to focus our attention on the few variables that might conceivably explain secular price changes. We can then test the model by the historical record. If the inferences drawn from the model do not conflict with the record, the model will survive to the next test. The key variable that I associate with secular price movements is the ratio of the money stock to real output, a rise in the ratio matching secular price inflation, a decline matching secular price deflation. This by itself does not tell us whether the ratio is changing because of influences from the side of money or from the side of output. On a priori grounds, however, a wider possible range of variation may be expected in the numerator than in the denominator of the ratio. At any moment in time, given resources and technology determine real output. Over time, real output will grow, apart from cyclical disturbances and wars (in earlier centuries, also plagues), but sudden, abrupt discontinuities in level are unlikely. On the other hand, by various devices the money stock can be augmented or reduced very sharply in a brief time span, and the historical record provides rich evidence on the use of such devices. A positive link between changes in the money stock per unit of output and secular price movements does not imply a simple proportional relationship between

Multimarket Expectations and the Rate of Interest

Abstract: An adequate theory of the long-term interest rate should relate the relative yields on four types of assets: money, bonds, goods, and the equity claims to the capital stock. A dynamic model, capable of empirical implementation, must also include expected future changes in the relative prices of these four assets. This paper develops such a theory of the interest rate based on multimarket expectations and shows that it is consistent with the experience of interest rates during the past two decades. In The General Theory [17] Keynes stressed the interdependence between the rate of interest and the state of expectations in the stock market. Subsequent empirical developments of the Keynesian model have, however, ignored the role of equities and focused on only two assets: bonds and money.l A particularly important aspect of our study is to reassert the joint dependence of equity and debt yields and to show the importance of expected capital gains on current bond yields. A second major purpose of this paper is to present alternatives to the traditional empirical model of expected price changes. The fixed weight autoregressive distributed lag is generalized to (1) a variable weight model, (2) a variable influence model with fixed relative weights, and (3) a model with multiple exogenous variables. Alternative methods of estimating variable weight and variable influence

Bureaucratic Theory and the Choice of Central Bank Goals: The Case of the Bank of Canada

Abstract: [The Bank of Canada's] reactions reflect the placing of a very heavy implicit weight on price stability compared with higher employment, presumably based on a judgement about the relative economic costs of more unemployment and more price inflation. The evidence examined on the relative economic costs of price inflation and unemployment suggests that the economic costs of inflation are not as high relative to the costs of unemployment as the reactions and statements of the authorities have implied. 127, p. 132] 1

A Theory of the Banking Firm: Comment

Abstract: In the May, 1971, issue of this journal, Michael Klein [3] presents a neoclassical microeconomic analysis of the individual commercial bank, the conclusions of which have important policy implications. As Klein notes, in spite of the importance of commercial banks, little has been done in the way of developing theories to explain the results of optimizing behavior on the part of individual banking units. Such theories are needed as a basis for research in a number of areas

The Demand for Money: The Evidence from the Brazilian Economy

Abstract: It is the purpose of this paper to estimate the demand function for money in the Brazilian economy. Our empirical research is restricted to the period 1948-67. The selection of these two decades is dictated by the availability of data on national income. During this period (a) money income rose at an average yearly rate of 38 percent; (b) the rate of increase in the wholesale prices averaged 31 percent per year; (c) money supply rose at an average yearly rate of 36 percent; (d) the average rise in real income was 5.4 percent, but it fluctuated substantially in the interval -3 to + 15 percent; (e) the rate of change in real balances also presented high fluctuations with an average increase of 3.8 percent and a standard deviation of .084. A more detailed outline of this period is provided by the graphical representation of these variables in Figures 1, 2, and 3. Our empirical analysis rests on the theoretical structure of the modern quantity theory of money. This general approach to macroeconomics takes the demand schedule for real cash balances as a stable relation; changes in the supply schedule originate a process of substitution between money and non-money assets to bring real cash balances to their desired level. Individuals spend more or less in order to

The Transmission Process and the Relative Effectiveness of Monetary and Fiscal Policy in a Two-Sector Neoclassical Model

Abstract: In traditional Keynesian income-expenditure modelsl the assets included appear to be four: money (government demand debt and bank demand deposits), long-term government bonds, private debts, and physical capital. Although there are four assets in these models, there are only two yields: the rate of return on money, which is institutionally set at zero, and the rate of interest, which is common to the other three assets and is usually identified with the rate of interest on long-term government bonds. This reflects the underlying assumption of the Keynesian theory that capital, long-term government bonds, and private debts are perfect substitutes for one another in wealthowners' portfolios. As a result of this assumption there is only one yield differential to explain, or, alternatively, only one portfolio choice-that between money and earning assets. This assumption may also be responsible for the failure of Keynesian models to relate explicitly the stock of real capital to the flow of investment spending [38, p. 106] . One line of development subsequent to Keynes' theory of the demand for money has been the disaggregation of assets other than money and the elaboration of liquidity preference theory into a general theory of the relative prices of assets of different types. In recent years this has led to the formulation of a general theory of asset holdings in which the quantity of each asset held is determined by the rates

The Demand for Money and the Choice of a Permanent Income Estimate: Some Canadian Evidence, 1926-65

Abstract: A permanent income hypothesis of the demand for money has been widely tested in the United States and elsewhere. Frequently, the test results have been used to judge the correctness of alternative shortand long-run demand formulations. Interest has centered on the correct specification of the opportunity costs of holding money,l the stock adjustment lag for money balances,2 and the budget constraint term.3 But despite its widespread use, almost no attention has been given to the actual estimation of the unobservable permanent income term.4 Without exception, the investigators accepted Friedman's assumption of an adaptive expectations model to estimate the level of expected income [13], and many have accepted Friedman's belief [14] that the horizon used for consumption decisions might also apply to financial asset decisions.5 As a

The Markets for Housing and Housing Services: Comment

Abstract: Arcelus and Meltzer (A-M) are to be commended for their courage in undertaking the ambitious task they set for themselves in their paper "The Markets for Housing and Housing Services." They are also to be commended for the vigor with which they attack widely held views about the relation between the availability of mortgage credit and housing starts. As A-M point out, the conventional wisdom has had a strong impact on public policy. It is important both for the sake of knowledge and better public policy that the underlying analytic framework be continuously scrutinized and tested. It is only through such exarnination that unsubstantiated hypotheses can be discarded to be replaced by hypotheses in closer agreement with the facts. But before the revisionist view of A-M is accepted, it too should be subjected to critical examination. Such an examination raises some serious questions about the specification of the A-M model and the strength of their econometric evidence. These questions are so serious that one is led to reject A-M's principal Emding. Until these shortcomings are corrected, A-M's policy recommendations are resting on "a blend of conjecture and casual empiricism." Later sections of this paper examine in turn the speciElcation of the model, the strength of the econometric evidence, and the simulation results. But before looking at these points, it will be useful to examine A-M's caricature of the conventional wisdom.

Income Velocity, Interest Rates, and the Money Supply Multiplier: A Reinterpretation of the Long-Term Evidence

Abstract: This paper attempts to throw some light upon the disagreement between Friedman and Schwartz and Latane concerning the signif1cance of the rate of interest as a determinant of velocity. In what is now a classic article, Latane [9] found a close relation between velocity and interest rates for the period from 1909 to 1958. The long-term interest rate alone accounted for a large fraction of the variation in the velocity of money and the relation did not seem to change over the period. Friedman and Schwartz [4, pp. 648-55] on the other hand, have challenged the importance of interest rate movements as a determinant of velocity. They argued that if Latane's analysis is extended to cover a longer time period (for which it is necessary to use a monetary aggregate which includes time deposits) major inconsistencies between the secular movements of velocity and interest rates appear. The analysis of this paper attempts to explain these discrepancies by considering the simultaneous movements that occurred over the period in the inverse of the money supply multiplier, a variable which is shown to be related to competitive interest payments on money. Once this additional variable is introduced, the major discrepancies are eliminated and the velocity-interest rate relationship remains intact over the longer time period for the more inclusive definition of money. The sig-

Secular Inflation and the International Monetary System

Abstract: The present international monetary system, which has prevailed since the end of the second world war with the brief exception of the crisis period from August 15, to December 18, 1971, is a system of exchange rates fixed in principle, though the par values of the individual national currencies and hence the exchange rates among them are fixed subject to alteration by international agreement in cases of "fundamental disequilibrium." As is well known from the theory of money for a closed economy with a single common currency, and hence absolute rigidity of the exchange rates among the moneys used in its various regions, rigidity of exchange rates means that any monetary impulse, whether inflationary or deflationary, will propagate itself throughout the whole area of the national economy. It should be kept in mind, though, that in the case of either deflation, or of inflation occurring in a situation of less than "full employment," the response of the economy for the period relevant to economic policy-making may be predominantly an adjustment of quantities of production and employment rather than of money prices and wages. To operate satisfactorily from the point of view of the policy objectives of its member countries with respect to achieving some combination of reasonable stability of prices and reasonably low unemployment, therefore, such a system, to be generally tolerable, must include provision for a reasonably steady expansion of international liquidity at a rate consistent with world price stability, or at least a close enough approximation to world price stability. Under the theory of the