Dallas S. Batten

R. W. Hafer

English

Research Papers in Economics

Short-Run Money Growth Fluctuations
and Real Economic Activity: Some
Implications for Monetary Targeting
DALLAS S. BATTEN AND 14. W. HAFER
HERE is ample evidence that the rate of infla-
tion is directly related to the long—tenn growth ofthe
money supply. indeed, this relationship has been
demonstrated for various countnes.m The implica-
tion of this finding is that the control of money
growth over the long term is vita) to the control of
inflation, a realization that undoubtedly helps to
explain the fairly recent announceniermts ofmnonetary
growth targets in most of the major industrial
countries 2
Although the money growth/inflation connection
is fairly well—documented, the relationship between
short—nm movements in money growth and eco—
nom ic activity is less well—known. Even though this
connection has been demonstrated for the United
States, its general applicability has not beems tested.~
The purpose of this article, therefore, is to in-
vestigate the relation ship between short—run
movements in the growth of the mnoney stock and
Dallas S. Battemm , --NI55,5ev Gri isvtls Stalmi Iitv coi c I Ims (Isstio ml: Amm
Immtc rmiation sml Comsmpan son,’ this Rc’c it’om (()ctoIse r 198 I ). pp. 7’
12. See sti so Bicharcl T. Scl cIen, hi fiat ion sosci Nionc-tarv c;rosvtis
Fspenit-mice in Fon i’tc c-ms Coo ii tn c-s ofEn rope am, cl Noills Ansenca
Simsc’e 1958,’’ F’eclc-ral Resene ilamsk cml RichiuomscI Ec’mmimoioic
Her ice: (Ncsveoslsem’/Decenslse r 1981). Isp. 19—35.
tm
Of the Group csf Ten countries pins Ssvitzerlamsd, cmiv Iwo.
Belgimiom and Swc’clems, cm ncmt fcmrnsallv aisisonmscc’ inonc-tan
gmocv tis targets cmf some kim mcI. S c-c Om’gams i zatiomi fcmr FcomicsnsIc
C cs—i pe rsstics miami ci Developmssemit, lions’ to cit 1cm i’gc’I.s- onc/li f/a Si ciii
Con fcc,! (Paris:OECD, 1979).
~ti mlton Fri edlmssan and Amsmsa J Sc’imsvartz- ‘Nb iscmv sims ci Bns,n c-s
Cycles,’’ Rc’cicic of’Lc’cniooimca ‘mc! Stntislk’s (Feisnnary 1963),
PP.
32
—
7
3: Williamss Poolc’. “‘I’lsc Reiationslsip of Nloisetarv
1) cccl eratioms s tcm Bus in c- ss Cyci c- Pc:’ak s : Ams cmtisc’r fbi k sit tise
Eviclcmisc’c-’,’’ Journal o/’ hincinc’c )j,mmse 1975m, pp. 697—712: ssocl
Lecmnall C, Amiclersc’is assci Keith NI. Carison_’’A Nlcsnetarist Nlcsdei
for Ec:csnomssic Stsslsilizssticmms,’’ tisis Rc’cic’mc (April 1970), pp. 7—25.
fluctuations in real economic activity.4 Althocmgh
the evidence preseisted in tlsis article is not de-
rived from a rigoromms empirical absalysis, it imsdicates
quite c-omsvincimsglv that virtually every clownturms
its ecomsoissic activity us recent years its each of the
countries examnined was preceded by a significamst
reductioms its tlse grow’tls of its msarrowlv defined
mnoimev scmpplv.
H P 1 (HM).lI( H I P H
‘Il-IF Tl.IFORY
There is little disagreemnent that significamst
clsanges us the growth of the nsomsev suppl~’inflmmetsc-e
economic activity. Chamsges in the long—/cnn grcswth
of money, measured by soisse moving average csf
momsev growth overa nunsber of years, affect the rate
of inflatiots. lmscleed, several empirical studies of tlse
timsited States indicate tlsat it mmsav take as loisg as five
years forthe rate csfimsflatioms to reflect completely the
imsspact of a chamsge its msscsnev growth.~More recent
~iis c’ cmvi ci c’isc’c’ isresc-isteci silscm sued s I iglit omi the dci mate- schomit tise
im m ipact cml NI I grcswtls ci cm rim g ise nod s of Iii Isinc’ iaI simm icsvatiom m sims c
imsstitnticmmsal chamtgc. By c’mcammiiisiisg the ccmnnec’tioms hc’tweemi
us ort— rmin fin ctm intio mis in NIl grcmwtl snsci restl ccc) mlom“ic’ ac’tiviIv
sic m’cmss cci nmstries sv i tim cliff crc’ mst Ii mis,, ic istI i mis titcmti om is am, dl nego—
I ati(miss, 5cmmmsc’ cm IscI crstssms cl ims 5) cs I the mc’ laticmmsship ~5 rcsi scm stm Ic-ss i ml 51
chamigimmg fimisomc’isd c-msvircsmmmne-mit slav fir’ gslimccl. For a good
e mcaisspi e of the once mIssintv tlsat m”rvaclc’s cii rrc’mst th (skims 5) on tlsc’ 1
ntore Ificssc’ y of targc’ti isg csss NI 1, scme ,‘\ms thesisv NI. Solon lcsms.
Fmisanci smi 1mm mlcmvatiomis am ‘ci N hisms c’tarv Po lie~,’’Fc’clc-ral Resem’ve
Bammk of New York. Animal /lc’jiom’t, 19’S) (1982), pp. 3—17; ssmsdi
Edward Yarclemn, F. F. I-Inttcsim Ec’oncmnnc’.s- A/crc (jammnscrv 29,
1982’.
tm
Sc’c Dcnis 5, Karmsisskv, ‘‘‘l’isc’ Limik Betweemi Nlomic’v amal Prices
1971—76,’’ this lic’m’ic,c jnm ie 1976), pp. 17—23; Kcitls NI. Carlsomi,
‘‘Time lag Fosmis Nlomiev to Prices,’ timis Rc’cic’ic fOc’tcslsc’r 1980),
isis’ 3—10; ansi joh is A. Taos is, ‘‘Emse m’g\’ Fric’e s simm ci Slsmm rt— Rnis
Ec’cm 11cmIs,ic’ Pc’ rformm lstlscc’,’’ tls is /1cc’ Ic’ mc’ (iso inars’ 1981). isis. 3—17.
15FEDERAL RESERVE BANK OfSt LOUIS
studies also have demonstrated thata lengthy lag
between money growth and inflation is common in
several industrial countries.’ This evidence indi-
cates thatchanges in current money growth have a
relatively small impact on prices in the short run.
For short-run changes in money growth to affect
economic activity, they must initially influencethe
real economy moresignificantly than they influence
prices.7 Indeed, studieshave shownthat,at least for
the United States, sizable reductions in money
growth belowits establishedtrend ratefor onlyafew
quarters have preceded declines in real economic
activity.
The economic theory that “predicts” the results
just described is as intuitively appealing as it is
empirically verifiable. A marked and sustained de-
cline in the growth of the money supply creates a
“monetary disequilibrium”: the quantity ofmoney
thatindividuals desire to holdexceeds the quantity
that they are actually holding. By reducing theft
spending,they can increase their money holdings to
a desired level. Eventually, this reduced spending
will cause the rate of inflation to fall.
In the short run, however, producers who cannot
tell immediately whether this decline in aggregate
demand(spending)is pennanentorjust atemporary
aberration initially react to the reduction in money
growth (and spending) by reducing output. There-
fore, the decline in money growth results in aslow-
down in economic activity; if it is pronounced
enough and sustained long enough, itcan produce a
recession. Only when the decline in spending
(motivated by the monetary disequilibrium asso-
ciatedwiththe reduction in moneygrowth) has been
identified aspermanent will producers reduce their
- prices and increase production back to “normal”
levels. Thus,the impact ofthe monetary contraction
on output eventually vanishes, and, in the long run,
only the rate ofinflation is affected by a sustained
reduction in money growth.’
The potential usefulnessofmonetary targetingfor
economicpolicy purposes is evident from this dis-
‘Batten, “Money Growth Stability and Inflation;” and also
Selden, “Inflation and MonetaryGrowth.”
fl’his article discusses emi/y the impact of changes in money
growth onthe realoutputofthe economy. Itdoesnotinvestigate
the impact ofmoney growthchanges on financial markets.
‘Poole,“TheRelationshipofMonetaryDecelerationsto Business
Cycle Pealcs.” Seealso Economic Report oft/me President (Gov-
ernment Printing Office, 1982), pp. 192-96, for another use of
the theory presented here.
‘The empirical problemhere, ofcourse, is datingthe“long run.”
16
MAY1982
cussion. First, in the long run,permanent changesin
the rateofmoney growth are reflectedbyequivalent
changes in the rate of inflation, other things equal.
Second, if short-run money growth is volatile, the
growth of real output and employment will be
similarly volatile. In other words, sufficiently un-
stable money growth in the short run, that is, a re-
duction in money growth relative to its trend rate,
may cause recessions. Consequently, minimizing
thevariability ofshort-mn money growth appears to
be essential in establishinga stable,non-inflationary
environment for economic growth.
SHORT-RUN MONEY GROWTH
AND ECONOMIC ACTIVITY:
THE EVIDENCE
Wenowinvestigate the validity ofthe conceptual
analysis presented in the preceding section. To
examine the relationship between short-mn fluctu-
ations in money growth and real economic activity, a
sample offour industrializedcountries was selected:
the United States, the United Kingdom, West
Germany and Italy. Moreover, to make the results of
the analysis directly comparable, the narrowdefini-
tion ofmoney for each country is used.”
To illustrate the relationship between short-nm
money growth and real output growth, charts for
eachcountry are presentedfortheperiod 1973 to the
present.11 These charts depict the deviations of
short-run money growth from its trend, measuredby
subtracting the 20-quarter moving average growth
rate of money from its two-quarter moving average
growth rate, In addition, the quarter-to-quarter,
compounded annual rate of growth ofreal GNP is
“The Ml definition is used throughout. It should be noted that
even though thenarrow definition is used,it is notthe variable
used byall the central banksin their policydeliberations. The
countries and theirrespective monetary target(s) are: United
States (Ml, M2), United Kingdom (Sterling MA), Germany
(Central Bank Money Stock)andItaly (Total DomesticCredit).
“The period since 1973 is used fortwo reasons. First, It is char-
acterized as aflexible exchange rate period, ma condition giving
eachcountrymorecontrol over its own domesticmoney supply
and, hence, economic activity than in a fixed exchange rate
period. Whilethe analysis also applies toa Axed exchange rate
period, economic activity of open economies during such a
period may merely reflect economic activity in the United
States. Consequently, we chose the post-1973period because
we are concerned with examining the impact of changes in
short-runmoneygrowth thatare motivatedbychangesin factors
indigenous to the domestic economy. Second, this period
covers time time in which each country’s central bank
announced a monetary aggregate policy target. Prior to 1973,
announced money supply growth targets were not universal.FEDERAL RESERVE BANK OF ST. LOUIS
plotted. Periods in which real output growth was
rmegatn-e fbr two consecutive quarters or more are
denoted b the shaded areas; these designate
periods of recession in these commntries.12
The individual charts reveal that there isacom—
won relationship between sharp reductions in the
short—run growth of money (the two—quarter moving
average) relative to its trend (the 20—quarter moving
average) amid real economnic activity.13 Despite the
wide differences among these countries in terms of
their financial structures, regulations-and monetary
policy objectives, the relationship between short—
run deviations in their money growth from trend and
declines in their real economic activity is quite
simnilar, To see this more clearly, we briefly examnine
the historical record of each country in our sample.
Itit I den States
The chart for the United States reveals three re-
cessions since 1973. As predicted b\- the theoretical
discussion, each recession was preceded by-a sharp
slowingin short—run mnoney growth. Prior to the 1974
recession, for example, short—run money growth fell
fromn slightly over2 percentage points abovetrend to
about 2 percentage points below trend, a change that
is mirrored in the reduction in real GNP growth in
1973. While one may argue that the recession of1974
was supply—oriented — a reaction to the unexpected
OPEC oil shock— the ehamt indicates thatthe depth
and breadth of the downturn was exacerbated by
short—run money growth well below trend in late
l974.m4
MAY 1982
The most recent downturns in economic activity
also are associated with declimies in short—run money
growth. For example. prior t the onset of the II!
1980-111/1980 recession, nioney growth fell from
about 3 percentage points above trend to over 4
percentage points below trend. Although money
growth’s sharp rebound during late 1980 helped
proclimeethe turnaround in real GNP growth in early-
1981, the equally dramnatic downturn in money
growth relative totrend during 1981 has precipitated
vet another reduction in real economic activity.
Indeed, since 1/1980, short—run money growth has
[itlIen short of trend almost 90 percent of the time,
and real GNP growth has been negative almost 40
percent of the timne, Clearly, the dramatic slowing in
short—run money growth relative to its long—run trend
andl the imicrease im) its volatility during the past two
years has-c been associated with substantial reduc-
tions in real economnic activity over this period.
The United. Kingdom
The accompanying chart indicates that the United
Kingdom has experienced anumber of’recessiomis’’
during the briefperiod studied. Of the six recessions
shown, all but one were preceded by sharp reduc-
tions in short—rnm money growth. For instamice, prior
to the 1V/1973-I/1974 downturn, mnoney growth fell
from about 5 percentage points above trend to more
than 10 percentage points below trend, ar s-ersal of
about 15 percentage points in less than one year.
Likewise, the 1/1977—11/1977 recession eamne on the
heels of a drop in money growth to more than 5
percentage points below its tremwl.
Theperiod since late 1978 is interesting because it
reveals the eflimet on the economy 0fasustained
redmmction in short—rmmn money growth helow its
trendl. Although money growth did not dlii) farbelow-
trend prior to the IV/1978—I/1979 recession, short—
rmmn money growth fell fromn over 15 percentage
points u/wee tremd in IV/1977 to its trend level
in only three quarters, a change that is associated
with the dlrOp im real GNP growth from IV/1 977 to
1/1979. Also, the impact ofthe nature ofthe money
growth decline dluring the period from JV/1977 to
1/1981 is reflected b relatively stagnant outptmt
growth during this period.
Finally, the 1\71974-TI1/1975recession represents
an anomaly to the theory. The recession was not
preceded hy a downturn in short—run mnoney growth
relative to its trend; instead, money groveth in-
creased faster than its trend rate prior to this reces—
17
I ~fl ic recessions in the Um i let! States are tho Sc’ dclii icd iv the
National Rnreai i cml Eusmm c 0) ic Research - Si nec rices sions are
sot fin-mnall v dc-flned in the otlmc- r co iintne s in tim c- 5 ample, thc
general! accepted nile of tim umoh isthat a rc’ce55 0~ ‘5 md icated
1)y at least two commsc-cutiye qciarters of ciccliii jimg rca! GNP
maThe purpose of this article is tic toen iploy statistical is ctliocis to
investigate rigorolls!v tI ic moo’ me v/real oritpiit ic latinnship in
those enon tries. 1mm stead, we are si inp Iy sipplyi m ig the geime rmd
i niphca tic)ii s cmi the reseaivh that Imas been c-csnclucted for the
U 1)1ted States Ici an aim al vs is csl timese ensi mm tries, as a hi-st atte im ipt
to 5cc if cmiipi rica! cc!atinii ships s tin iiat to tli cmse in the United
States can he bummcI. Ohvi Ocisiv. th c- tiini ii g oftimc- mm iomicy growth!
real iii it1) cit re Iatioi is!) i p immmcy he cliffcremit ae cciss edo i ~d eS mmii ci -
mm fact. th i 20—cjuarter aimci two—cluarter clist ncti cam s Immav not he
c-n mm p1etciv applm cab! cm to mill. TIme Sc results, howeVet, appear to he
cjriite rob mist and!, con sc-c ju cmlit! v, we s Inft Scm the cmiiccniviii eec!
rc- mmclcc the cmhl fgaticmmiof an a! tens ati ye interpre taticmo oft! me data.
‘
4
The cal price shocks of 1973—74 mimic! 1979—Sd) resulted in chs—
similar mnonc’tarv growth rates in the Uniter! States. For a chs—
cussion of this, seeR. W. Umsfcr. ‘The impact cmi Emmergv Pricc’s
mimic] 151 oncv Grcmwtli or, Five hid ‘astrial Cciii mitries.” this Bc’cm c’
(March 1981), pp- 19-26.FEDERAL RESERVE SANK OF ST. LOUIS MAY 1982
Money and Output Growth in Selected Countries
United States
Perceimt
IS
10
S
0
-5
-10
-15
United Kingdom
Percent
30
25
20
35
10
S
0
4
-10
-15
Percent
15
1973 1974 3975 1976 3977 1978 1979 1980 3981
Compounded annual roiem of rhonge. Source: international Financial Sioiimticm
C .,‘~“
Shaded areoi represent periodm of economic downturn.
Percent
30
25
20
15
10
5
0
-20
-5
-30
18
-15
0FEDERAL RESERVE BANK OF ST. LOIHS MAY 1982
Money and Output Growth in Selected Countries
West Germany
Percent Percent
IS
10
5
0
-5
Italy
10
-IS
1973 1974 1975 1976 1977 1978 1979 1980 1981
:3 Compounded annual ratem of change. - Source: International Finoncioi Stotimiicm
Shaded areas represent pedodsof economic downturn. -
19sion. This mayhavebeen an attemptto use monetary
policy to offset, at least partially, the dislocations
created by the OPEC oil shock that lowered the
growthofreal GNP.Interestingly,theILK,response
to the 1978-79 OPEC oil shock was todecrease the
short-mn growthofthe moneystock, as showninthe
chart.15
West Germany
The chart for West Gennany again supports the
theoretical discussion. Eachofthe two recessions is
precededby periods ofmoney growth below trend.
Althoughthe timingisdifferentfor eachepisode,the
reaction ofthe real economy to declines in short-
run money growth is clear and consistent
West Germany also presents a case in which
money growth fell below trend and no technical
recession occurred. From 111/1975 to IV/1976,
money growth fell from about 7 percentage points
above trend to about 5 percentage points below
trend. Although no recession tbllowed, the level of
real GNP growth fell sharply asthe theory predicts~
the growth rateof real GNP fell from about 10 per-
cent in IV/1975 to zero in 11/1977. Thus, while
technically no recession followed the decline in
money growth, real GNP growth was curtailed
sharply, an example ofa “growth recession.”
Italy
The relationship between real GNP growth and
money growth relative to trend in Italy,once again,
is consistent with theoretical expectations. Of the
three recessions since 1973, each was precededby a
period of sharp reductions in short-run money
lSj-jafer, “Impact ofEnergy Pricesand Money Growth.”
growth relative to its trend rate. This pattern is es-
peciallyevident for the 1111974-11/1975 and 11/1980-
111/1980 recessions.
CONCLUSION S
The evidence presentedheresuggests thatsizable
andsustained reductions in short-mn money growth
belowits trendrateportend declines in thegrowthof
real GNP.Ofthe 14 recessions in the fourcountries
examined, only one — the IV/1974-III/1975 reces-
sion in theUnited Kingdom — was notprecededbya
substantial decline in short-run money growth.
Moreover, in only one instance — the III/1975-IV/
1976 period for West Germany — did short-run
moneygrowth fall substantiallybelowtrend without
a recession following. In that instance, however,
West German real GNP growth fell from about 10
percent to zero, a result consistent with the theo-
retical discussion.
Thus, the evidence indicates that policymakers
should be concerned with short-run fluctuations in
the growth of the money supply relative to its
trend.1’ If this evidence is at all useful, it demon-
strates how robust the relationship between money
growth and real economic activityis overthe short
run. Coupled with previously reported research
indicating a direct, positive link between longer-
term money growth and inflation, the empirical
evidence favors a steady growthofthe money stock
in both the shortandlong run as the most effective
means of achieving economic stability.
“This evidence contradicts the recent claim that “the Imoney
growth) volatility issue itself is a hoax. Noone as yethas been
able todemonstratethatthereportedvolatility inmoneyhasany
impact on eitherthe pace of economic activity or Inflation?’
Aubrey C. Lanston & Co., tnt’., Newsletter (March 22, 1982).
20

Short-run monetary growth fluctuations and real economic activity: some implications for monetary targeting

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Short-run monetary growth fluctuations and real economic activity: some implications for monetary targeting

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