Wo r k i n g Pa p e r S e r i e s
No 1218 / june 2010
Sectoral money
demand and the
great disinflation
in the US
by Alessandro Calza
and Andrea Zaghini
WO R K I N G PA P E R S E R I E S
N O 1218 / J U N E 2010
SECTORAL MONEY DEMAND
AND THE GREAT
DISINFLATION IN THE US
by Alessandro Calza 1
and Andrea Zaghini 2
NOTE: This Working Paper should not be reported as representing
the views of the European Central Bank (ECB).
The views expressed are those of the authors
and do not necessarily reflect those of the ECB.
In 2010 all ECB
publications
feature a motif
taken from the
€500 banknote.
This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science
Research Network electronic library at http://ssrn.com/abstract_id=1625846.
1 European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany, email: [email protected].
2 Banca d’Italia, Research Department, Via Nazionale 91, I-00184 Rome, e-mail: [email protected].
© European Central Bank, 2010
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ISSN 1725-2806 (online)
CONTENTS
Abstract
Executive summary
4
1 Introduction
7
5
2 Money demand and welfare
11
3 Data issues
14
4 Sectoral money demand
17
5 Welfare cost estimations
21
6 Concluding remarks
26
Notes
28
References
31
Tables
37
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Working Paper Series No 1218
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3
Abstract
Estimates of the welfare costs of in‡ation based on Bailey (1956) are typically computed using aggregate money demand models. Yet, the behavior of
money demand may vary across sectors. Thus, the impact on welfare of in‡ation regime shifts may di¤er between households and …rms. We speci…cally
investigate the sectoral welfare implications of the shift from the Great In‡ation to the present regime of low and stable in‡ation. For this purpose, we
estimate di¤erent functional speci…cations of money demand for US households and non-…nancial …rms using ‡ow-of-fund data covering four decades.
We …nd that the bene…ts were signi…cant for both sectors.
JEL classi…cation: E31, E41.
Keywords: welfare cost of in‡ation, ‡ow of funds data, demand for money.
4
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Working Paper Series No 1218
June 2010
Executive Summary
At the height of the Great Inflation in 1980, the three-month T-bill interest rate stood
at 15%. By the end of the 1990s, it had declined by around two-thirds. There is
general consensus that moving from a regime in which one of the closest empirical
proxies for a short-term risk-free rate was a double-digit rate to one in which both
nominal interest rates and inflation are low and stable has yielded substantial welfare
benefits. Indeed, a substantial body of literature has shown that high and volatile
inflation entails a number of economic and social costs, mainly arising from the
inefficient allocation of resources due to increased uncertainty and distortions to
relative prices.
A specific source of inflation-related welfare costs - the so-called "shoe-leather costs"
- arises when agents inefficiently manage their holdings of monetary balances for
transaction purposes because of inflation. The traditional way to measure the welfare
loss arising from shoe-leather costs is based on the methodology by Bailey (1956). He
suggests that such costs can be measured by the area underlying the inverse money
demand function, which represents the lost consumer surplus (net of seigniorage
revenues) that could be gained from reducing the positive nominal interest rate to
zero. Intuitively, the rationale of Bailey’s approach is that - assuming that monetary
balances yield direct utility via liquidity services and that higher nominal interest rates
increase the opportunity cost of holding monetary balances - higher expected inflation
will lead to agents inefficiently economising on their monetary balances, via its
impact on nominal interest rates.
A large number of studies have used Bailey's approach to estimate the welfare costs
of inflation arising from distortions to money demand. For instance, Fischer (1981)
estimates the cost of a 10% inflation rate at around 0.3% of US GNP per year. A
review by Gillman (1995) reports significantly larger estimates, ranging between
0.85% and 3% of US income, for the same inflation rate. More recently, an influential
study by Lucas (2000) using annual data covering most of the twentieth century
argues that the welfare gains from reducing inflation could be significant. In
particular, reducing the annual inflation rate from 10% to zero would lead to welfare
gains of slightly less than 1% of GNP per year in perpetuity. By contrast, a paper by
Ireland (2009), focusing on the sample 1980-2004, concludes that the welfare gains
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5
from eliminating inflation altogether would be significantly lower in the current
monetary regime of low interest rates. Likewise, Mulligan and Sala-i-Martin (2000)
suggest that the welfare costs at low inflation rates are limited, once one takes into
account changes in portfolio allocation behavior across inflation regimes.
Estimations of the welfare costs of inflation are usually based on aggregate money
demand functions, i.e. equations representing the equilibrium demand for real
monetary holdings for the US economy as a whole. However, empirical evidence (e.g.
Goldfeld 1976, and Jain and Moon 1994) shows that money demand behavior
significantly differs across US sectors, suggesting that the application of Bailey's
(1956) methodology to measure shoe-leather costs may yield different results across
sectors.
Allowing for sectoral heterogeneity in the estimation of money demand functions is
potentially very important for policy purposes since it implies that different categories
of agents may have diverging views on the welfare losses associated with living in a
high inflation environment or on the benefits stemming from moving to a low
inflation environment. In particular, US households and firms may differently value
the permanent welfare benefits that they secured with the regime shift from the Great
Inflation to the current environment of moderate and stable inflation and interest rates.
The purpose of this paper is to analyse the welfare impact for households and firms of
the modern disinflation using Bailey's methodology. In order to do so, we estimate
different functional specifications of sectoral money demand for households and nonfinancial firms, using flow of funds data covering the period from 1959 to 2006. Our
estimates of the welfare gains for households amount to between approximately 1/6%
and 1/3% of annual private consumption (depending on whether a log-log or a semilog function is used) and for firms between 1/9% and 1/4% of business GDP, thus
suggesting that households might have benefited slightly more than firms from the
shift to the present low inflation regime. However, once we rescale these figures to a
common transaction variable, the estimated sectoral welfare gains turn out to be of
similar magnitude across sectors. Once we aggregate across sectors, our results are
closer to the inflation costs reported by Fischer (1981) and Ireland (2009) than to
those by Lucas (2000).
6
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Working Paper Series No 1218
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1
Introduction1
At the height of the Great In‡ation in 1980, the three-month T-bill interest
rate stood at 15%. By the end of the 1990s, it had declined by around twothirds. There is general consensus that moving from a regime in which one of
the closest empirical proxies for a short-term risk-free rate was a double-digit
rate to one in which both nominal interest rates and in‡ation are low and
stable has yielded substantial welfare bene…ts. Indeed, a substantial body
of literature has shown that high and volatile in‡ation entails a number
of economic and social costs, mainly arising from the ine¢ cient allocation
of resources due to increased uncertainty and distortions to relative prices.
Additional sources of welfare costs associated with in‡ation include high
risk premia, the interaction between in‡ation and the tax code, ine¢ cient
distraction of resources from production of goods to …nancial activities, lower
capital accumulation and arbitrary redistribution of wealth (see for instance
Dri¢ ll et al. 1990, and Fischer 1995).
A speci…c source of in‡ation-related welfare costs - the so-called “shoeleather costs” - arises when agents ine¢ ciently manage their holdings of
monetary balances for transaction purposes because of in‡ation. The traditional way to measure the welfare loss arising from “shoe-leather costs” is
based on the methodology by Bailey (1956). He suggests that such costs
can be measured by the area underlying the inverse money demand function,
which represents the lost consumer surplus (net of seigniorage revenues) that
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Money demand and welfare
An issue that has received signi…cant attention in the literature on the welfare
costs of in‡ation is the choice of functional form for the long-run money demand relationship. The two main competing speci…cations are: 1) Meltzer’s
(1963) log-log function and 2) Cagan’s (1956) semi-log function. The log-log
function is speci…ed as follows:
log(m) = log(A) + log(y)
log(r)
(1)
where m are monetary balances, y is a measure of the volume of transactions,
r is the nominal interest rate (the opportunity cost of holding the non-interest
bearing asset), A > 0 is a constant,
and
denote the elasticities (in
absolute values) with respect to the transaction variable and the interest
rate, respectively. Money and scale variables are typically measured in real
terms. Similarly, the semi-log function is as follows:
log(m) = log(B) + log(y)
where B > 0 is a constant and
r
(2)
denotes the absolute value of the interest
rate semi-elasticity.
Applying Bailey’s method to the log-log money demand function (1), we
obtain the following measure of the welfare costs associated with a positive
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the post-1980 data are better described by a semi-log function. In the author’s view, the monetary policy regime shift following the appointment of
Paul Volcker as Chairman of the Federal Reserve in 1979 and the reforms to
the regulatory framework introduced by the Depository Institutions Deregulation and Monetary Control Act in 1980 led to a shift in money demand
behavior warranting a change in the preferred speci…cation.
As our study focuses on a sample period (1959-2006) which entirely comprises that examined by Ireland (1980-2006), but is shorter and only partly
overlapping with Lucas’ (1900-1994), it is di¢ cult to tell ex-ante which of
the two alternative speci…cations is likelier to prove more appropriate. Thus,
in the empirical analysis we consider both speci…cations and we separately
assess their associated welfare cost functions.
3
Data issues
The empirical exercise is based on a sample period spanning from the …rst
quarter of 1959 (the earliest date for which data on sectoral monetary holding are available) to the fourth quarter of 2006. Since we want to study
the welfare gains of the modern disin‡ation for di¤erent sectors of the US
economy, it is important to ascertain whether this sample period adequately
captures the shift from the double-digit in‡ation rates during the Great In‡ation to the present regime of low and stable in‡ation. The sample pre-dates
the switch to the Great In‡ation by around one decade, indicating that the
14
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GH5FH=B; 85H9 =G 589EI5H9 B 588=H=CB 65G98 CB 5 F9J=9K C: 97CBCA9HF=7 9GH=
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15
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6IG=B9GG 85M +<9 GK99D ACJ9A9BHG D9F:CFA98 6M 65B?G =BJC@J9 CB@M F9
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in the demand for money from economic agents, who are likely to perceive
themselves to own signi…cantly larger holdings of transaction deposits than
reported by banks in their balance sheets. Therefore, in order to understand
the money demand behavior of US households, it is essential to add the estimated amount of transaction deposits involved in the retail sweep programs
to the holdings of checkable deposits reported in the ‡ow-of-funds statistics.
In this paper we use the estimates of transaction deposits a¤ected by the
retail sweep programs documented in detail in Cynamon et al. (2006),6 that
have been used in previous empirical money demand studies (e.g. Dutkowsky
and Cynamon 2003, Dutkowsky et al. 2006, and Ireland 2009).
4
Sectoral money demand
Equilibrium money demand relationships are conventionally estimated in a
cointegration analysis framework. As a preliminary step, the statistical properties of the variables are examined using standard unit root tests (augmented
Dickey-Fuller and Phillips-Perron) as well as the KPSS stationarity test. The
results - not reported for the sake of brevity - suggest that over the considered
sample period all the variables can be modelled as I(1) in levels.
We test for cointegration using two sets of single-equation tests: (1) the
error-correction model (ECM) tests by Zivot (1994) as described by Maddala
and Kim (1998); and (2) the Phillips-Ouliaris (1990) residual-based tests.
The …rst Zivot test involves the preliminary estimation of a two-step error
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J9FM @5F;9 BIA69F C: :57HCFG DCH9BH=5@@M 5V97H=B; ACB9M 89A5B8 69<5J=CF
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89F H<9 5@H9FB5H=J9 :IB7H=CB5@ :CFAG :CF 6CH< H<9 <CIG9<C@8 5B8 H<9 7CFDCF5H9
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D9F=C8 =H =G =ADCFH5BH HC H9GH :CF H<9 GH56=@=HM C: H<9 G97HCF5@ ACB9M 89A5B8
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this purpose, we use the MeanF and SupF tests for cointegrated regression
models - based on the mean and maximum, respectively, of Chow-type statistics for all possible break points - suggested by Hansen (1992). The MeanF
test is designed to detect gradual shifts over time that result in model instability, while the SupF test is more appropriate to reveal instability arising
from an abrupt regime shift. Since the null hypothesis is stability, a low pvalue of the test statistic (say below 0.10) should be interpreted as indicative
of parameter instability. In this empirical application, the tests are based on
the fully modi…ed OLS estimates reported in Tables 2 and 3.10
The results of the test indicate that the null hypothesis of joint parameter
stability of the sectoral models cannot be rejected at the conventional significance levels, suggesting that the models capture fairly stable relationships
over the sample period considered.
5
Welfare cost estimations
In this section, we estimate the welfare gains associated with the transition
from a regime of high in‡ation to one in which in‡ation is stable at low levels.
In order to calculate the welfare triangles, we use the estimates of the longrun coe¢ cients ;
and
in Tables 2 and 3, and calibrate the values of the
constants A and B so that they equal the average value over the sample of
my r
and my e
r
(as suggested by Lucas 2000). The estimated long-run
coe¢ cients together with the constants de…ne the horizontal position and
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;=6@9
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6
Concluding remarks
This paper presents empirical estimates of the welfare cost of in‡ation in
the US economy in the spirit of the literature initiated by Bailey (1956) and
Friedman (1969) and, more recently, revisited by Lucas (2000) and Ireland
(2009). This literature focuses on a speci…c source of in‡ation-related welfare
losses: the shoe-leather costs that arise when agents ine¢ ciently economise
on their monetary balances for transaction purposes because of positive in‡ation.
The main innovation of the paper is to look at the issue from a sectoral
perspective. Indeed, estimates of the welfare costs of in‡ation are usually
based on money demand functions for the economy as a whole. However,
empirical evidence (e.g. Goldfeld 1976, and Jain and Moon 1994) shows that
money demand behavior signi…cantly di¤ers across US sectors, suggesting
that the application of Bailey’s (1956) methodology to measure shoe-leather
costs may yield di¤erent results across sectors.
Allowing for sectoral heterogeneity in the estimation of welfare costs of
in‡ation is potentially very important for policy purposes since it implies
that di¤erent categories of agents may have diverging views on the welfare
losses associated with living in a high in‡ation environment or on the bene…ts
stemming from moving to a low in‡ation environment. In particular, US
households and …rms may di¤erently value the permanent welfare bene…ts
that they secured with the regime shift from the Great In‡ation to the current
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Notes
1
We are grateful to Masao Ogaki and to Giuseppe Grande, Paul
Kramp, Qiang Li, Francesco Lippi and an anonymous referee for many interesting suggestions and comments. The views expressed in this paper are
those of the authors and do not necessarily re‡ect the opinions of Banca
d’Italia or the European Central Bank.
2
Based on household survey data, the authors argue that when interest
rates are low, the interest rate elasticity of aggregate money demand becomes
very small since only a limited fraction of households participates in …nancial
markets due to the reduced incentive to hold interest-bearing assets. As a
result, when nominal interest rates are close to zero, money demand hardly
reacts to changes in interest rates, so that reducing in‡ation can no longer
bring signi…cant welfare gains via its stimulating e¤ect on monetary balances.
3
Mulligan and Sala-i-Martin’s (2000) study on US households is an ex-
ception.
4
According to the Friedman’s (1969) rule, the optimal amount of money
is given by the level of money demand in correspondence to a zero nominal
interest rate, which requires a de‡ation rate equal to the real rate of return
on capital.
5
Craig and Rocheteau (2005) point out that an alternative approach to
measuring the welfare cost of in‡ation based on the search theory of monetary
exchange yields similar result to Bailey’s welfare triangles only under the
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ECB
Working Paper Series No 1218
June 2010
Table 1. Cointegration tests
HOUSEHOLDS
FIRMS
Semi-log
Log-log
Semi-log
Log-log
Zivot’s two-step ECMa
3:837
3:915
3:619
2:552
Zivot’s one-step ECMb
13:676
12:479
19:217
13:146
Phillips-Ouliaris Ztc
3:660y
3:383yy
3:680y
3:134
Phillips-Ouliaris Zqc
26:003y
22:182yy
24:588y
17:970
Notes: *, y, yy, denote statistical signi…cance at the 5%, 10% and 15% critical levels, respectively
a) The statistic for Zivot’s two-step ECM-based test is distributed as a standard t-distribution.
b) The statistic for Zivot’s one-step ECM-based test is distributed as
2
(3):
c) The Zq and Zt statistics are computed using the Newey-West estimator of the error variance
2=9
with lag truncation q = 4, following the sample-dependent rule q = 4(T =100)
.
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Working Paper Series No 1218
June 2010
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Table 2. Long-run money demand functions of households
LOG-LOG
SEMI-LOG
DOLS(2,2)a
0:530
0:118
0:537
2:520
ARDL(2)b
0:536
0:133
0:545
2:521
FMOLSc
0:534
0:127
0:528
3:038
EY(2)d
0:522
0:129
0:537
2:562
(0:02)
(0:03)
(0:04)
(0:01)
(0:02)
(0:04)
(0:03)
(0:03)
(0:01)
(0:03)
(0:03)
(0:01)
(0:30)
(0:84)
(0:60)
(0:79)
Notes: Standard errors in parenthesis. **, * denote statistical signi…cance
at the 1% and 5% critical levels, respectively. Number of lags (and leads
for DOLS) in levels speci…ed next to the estimator. Newey and West
standard errors except for FMOLS (quadratic spectral kernel).
a) Dynamic OLS by Saikkonen (1991).
b) Autoregressive distributed lag model by Pesaran and Shin (1999).
c) Fully modi…ed method of Phillips and Hansen (1990).
d) Engle and Yoo’s (1991) three-step Engle and Granger procedure.
38
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Working Paper Series No 1218
June 2010
Table 3. Long-run money demand functions of …rms
LOG-LOG
SEMI-LOG
DOLS(5,5)
0:536
0:220
0:547
4:860
ARDL(2)
0:571
0:195
0:568
4:558
FMOLS
0:522
0:272
0:521
6:280
EY(2)
0:512
0:182
0:534
4:589
(0:04)
(0:08)
(0:09)
(0:03)
(0:05)
(0:09)
(0:08)
(0:08)
(0:04)
(0:06)
(0:06)
(0:01)
(0:72)
(1:46)
(1:07)
(1:33)
Note: See notes to Table 2.
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Working Paper Series No 1218
June 2010
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Table 4. Stability tests of sectoral money demand functions
HOUSEHOLDS
Log-log Semi-log
MeanF
SupF
1:241
[p 0:20]
3:070
[p 0:20]
0:967
[p 0:20]
2:557
[p 0:20]
FIRMS
Log-log
4:733
[p=0:14]
8:286
[p 0:20]
Semi-log
4:419
[p=0:17]
7:886
[p 0:20]
Notes: Tests based on fully modi…ed OLS estimates over the sample’s
trimmed region [0.15,0.85]. P-values are based on asymptotic distributions
calculated using Monte Carlo simulations by Hansen (1992).
40
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Working Paper Series No 1218
June 2010
Table 5. Welfare cost of in‡ation for households (as a percentage
of consumption)
LOG-LOG
w(0:15) w(0:05)
SEMI-LOG
w
w(0:15) w(0:05)
w
DOLS
0:23
0:09
0:14
0:33
0:04
0:29
ARDL
0:26
0:10
0:16
0:33
0:04
0:29
FMOLS
0:25
0:09
0:15
0:39
0:05
0:34
EY
0:25
0:10
0:15
0:33
0:04
0:29
Note: Model speci…cations as in Table 1.
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Working Paper Series No 1218
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Table 6. Welfare cost of in‡ation for …rms (as a percentage of
business GDP)
LOG-LOG
w(0:15) w(0:05)
SEMI-LOG
w
w
DOLS
0:19
0:08
0:11
0:26
0:04
0:22
ARDL
0:17
0:07
0:10
0:24
0:04
0:21
FMOLS
0:24
0:11
0:13
0:31
0:05
0:26
EY
0:16
0:06
0:09
0:24
0:04
0:21
Note: Model speci…cations as in Table 2.
42
w(0:15) w(0:05)
ECB
Working Paper Series No 1218
June 2010
Table 7. Welfare gains from a ten percentage point reduction in
in‡ation (as a percentage of GDP)
HOUSEHOLDS
FIRMS
AGGREGATE
Log-log Semi-log
Log-log Semi-log
Log-log Semi-log
w(0:13)
0:13%
0:17%
0:13%
0:16%
0:26%
0:33%
w(0:03)
0:03%
0:01%
0:04%
0:01%
0:07%
0:02%
0:10%
0:16%
0:09%
0:15%
0:19%
0:31%
w
Note: Estimates of welfare costs obtained using DOLS speci…cations in Tables 2 and 3.
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