WORKING PAPER SERIES

Endogenous Money Supply and the Business Cycle

William T. Gavin
Finn E. Kydland

Working Paper 1995-010D

http://research.stlouisfed.org/wp/1995/95-010.pdf

PUBLISHED: Review of Economic Dynamics.

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 ENDOGENOUS MONEY SUPPLY AND THE BUSINESS CYCLE

December 1997

ABSTRACT

This paper documents changes in the cyclical behavior of nominal data series that appear
after 1979:Q3 when the Federal Reserve implemented a policy to lower the inflation rate.
Such changes were not apparent in real variables. A business cycle model with impulses
to technology and a role for money is used to show how alternative money supply rules are
expected to affect observed business cycle facts. In this model, changes in the money
supply rules have almost no effect on the cyclical behavior of real variables, yet have a
signiflcate impact on the cyclical nature of nominal variables. Computational experiments
with alternative policy rules suggest that the change in monetary policy in 1979 may
account for the sort of instability observed in the U.S. data.

KEYWORDS:. Business Cycle Facts, Endogenous Monetary Policy, Real Business Cycles

JEL CLASSIFICATION: E32, E42, E50

William T. Gavin Finn E. Kydland

Vice President Professor of Economics
Federal Reserve Bank of St. Louis Graduate School of
411 Locust Street Industrial Administration
St. Louis, MO 63102 Carnegie Mellon University
(314) 444-8578 Pittsburgh, PA 15213
[email protected] (412) 268-3691
[email protected]

Robert Dittmar assisted in the programming. Dan Steiner and Stephen Stohs provided research
assistance. This paper benefited from comments by David Altig, Mike Bryan, Mike Dotsey,
Milton Friedman, Kevin Lansing, Mike Pakko, Joe Ritter and Ben Russo.
Introduction

One of the main ideas to come out of real business cycle theory is that a significant

share of the variation in the real economy can be accounted for with a simple economic

model of production and consumption that abstracts from money. The credibility of this

finding is associated with the relative stability of the covariance structure of real aggregate

data across time and countries, as documented by Backus and Kehoe (1992). The relative

constancy of the business cycle facts guides model development.

Unfortunately, attempts to include money and inflation are problematic. When

money and prices are added to the data series, the covariance structure becomes unstable and

the search for a monetary structure becomes more complicated. Backus and Kehoe present

evidence contrasting the stability of the covariance structure of real data series with the

instability in the cyclical behavior of money and prices. They use annual data to compare the

correlations measured across three periods, before World War I, the interwar period, and post

World War II. Further evidence on the instability of the output-price correlations can be

found in Cooley and Ohanian (1991), Pakko (1997), Smith (1992), and Wolf (1991). In this

paper, we use postwar quarterly data to document the changes in the nominal data series that

are apparent after October 1979 and to show how change in the money supply rule may

account for such instability.’

The first part ofthis article describes the business cycle facts. There is an important

break in the covariance structure in 1979:Q3 when the Federal Reserve implemented a policy

to lower the inflation rate.2 We present Wald statistics suggesting that the changes in cyclical

behavior are significant. There is some doubt about the validity of the distributional

assumptions underlying the Wald tests. Therefore, we also use Monte Carlo methods to
 2

construct small-sample test statistics which provide strong evidence of a break in the cyclical

behavior of money and prices about the time of the Fed’s policy change.

The second part of the paper experiments with alternative money supply rules in a

business cycle model with impulses to technology. In this model, the cyclical nature of the

nominal variables can be highly sensitive to small changes in the decision rule governing the

money supply. However, suchchanges have almost no impact on the cyclical behavior of

the real variables. Finally, we present results which suggest that attempting to increase

control over the money supply may account for the sort of changes we document.

The Facts

We begin by updating some of the business cycle facts presented in Kydland and

Prescott (1990) and, more recently, in Cooley and Hansen (1995). The Hodrick-Prescott

filter was used to define the business cycle componentsof the data series. The first column

of statistics in Table 1 reports the percentage standard deviation of each variable and the

other columns report the cross-correlations with real GDP. The statistics reported in Kydland

and Prescott used data for a different sample than is used here. For GNP components and

price data, their san~leperiod begins in 1954:Q1 and ends in l989:Q4. Their sample for the

monetary data begins in l959:Q1. We use a sample of data from 1959:Ql through 1994:Q4.

Instead of GNP, we follow current government practice and switch to the GDP data. Despite

these differences in data and time periods, our reported correlation coefficients are, in most

cases, virtually identical to those reported by Kydland and Prescott. The components of

consumption and investment are highly procyclical. Consumption of nondurables and

services is less variable than output, while expenditures on durables and all the components
 3

of investment are much more variable than output in percentage terms.

Like the real variables, the statistics reported for the price level and money supply

measures in Table 2 also appear to have nearly the same variability and cross-correlation

with real output as reported by Kydland and Prescott. Both the GDP deflator and the CPI

move countercyclically. The monetary base varies procyclically and contemporaneously with

output while Ml and M2 move procyclically and lead output by a quarter or two. Measures

of velocity also move procyclically. Base velocity tends to move coincidentally while the

velocity ofMl and M2 lag the cycle in real GDP.

Taken as a whole, the statistics show little change with the addition of five years to

the sample. However, if we break the sample after 1979:Q3, we see a significant change in

some of the facts. The correlations among the real variables are apparently unaffected, but

the correlation between real output and the nominal variables is altered dramatically. We

should note that one real variable, velocity, also appears to behave differently across the two

periods. In general, we include velocity with the monetary variables because the demand for

real balances may depend on the money supply rule.

Table 3 reports the results forthe real variables when we treat 1979:Q3 as a

breakpoint in the data. It was at the end of this quarter that the Federal Reserve announced a

majorchange in operating procedures and a new commitment to reducing the inflation rate

through controlling the money supply. Apparently, this policy change had almost no

measurable effect on the cyclical behavior of hours worked oron the components of

consumption and investment.

In contrast to the results for the real variables shown in Table 3, the business cycle

facts for prices and money shown in Table 4 are different in the two periods. The variability
 4

of the price measures is similar across periods. However, the negative cross-correlations

between the deflator and real GDP become much larger in absolute value for leads of three to

five quarters. The absolute values of the contemporaneous and lagging correlations fall. The

differences across periods for the CPI are similar to differences observed in the GDP deflator.

Substantial changes occur in the variability of the monetary aggregates around trend.

The narrow monetary aggregates, the monetary base and Ml, are less variable before

1979:Q3 than afterward, while the broad monetary aggregate, M2, becomes less variable after

1979:Q3. All of the aggregates are less procyclical in the second period than in the first. The

contemporaneous correlation of the monetary base with real GDP falls by about one-fourth,

from 0.46 to 0.34. The contemporaneous correlations ofMl and M2 drop dramatically, from

0.71 to 0.18 and from 0.64 to -0.04, respectively.3

To test whetherchanges in the correlation coefficients are statistically significant, we

construct a Wald test to compare the null hypothesis that the correlation coefficient in the

latter period is equal to the correlation coefficient in the earlier period against the alternative

that they are not equal.4 Ifthe two data series are treated as random samples drawn from a

bivariate normal distribution, then the Wald statistic is distributed as a Chi-square with one

degree of freedom. The 10 percent critical value is 2.71.

Table 5 reports the Chi-square statistics for the real variables. It includes the results

oftesting 77 cross-correlations between real GDP and other real variables across the two

periods. Only in two cases (highlighted in Table 5) do the calculated statistics exceed the ten

percent critical value. In contrast, the top panel of Table 6 reports the results of testing 55

cross-correlations calculated between real GDP and nominal variables. Here, 33 of the 55 are

above the 10 percent critical value. For every nominal variable, at least part of the cross-
 5

correlation structure is significantly different after l979:Q3. The bottom panel of Table 6

presents results for velocity. Here, 20 of 33 statistics exceed the ten percent critical value.

Of course, we cannot be sure how much the actual data differ from the maintained

assumptions ofthe Wald test. However, the main point is simply to emphasize the

difference between the nominal and real cases.

We provided a check on the reliability of the Wald test by constructing simulated

critical values from 1000 repetitions of the following experiment. Using actual data from the

earlier period (not deviations from trend), we estimated a bivariate vector autoregression that

includes real GDP and one of each of the other variables. In every case, we recovered

estimates of autoregressive parameters and the covariance matrix. Then these estimates were

used with a random number generator to create 1000 artificial series foreach pair. Each

series is 144 periods long. These series were then detrended, the sample split at period 83

(corresponding to 1979:Q3 in the U.S. sample), and the cross-correlations calculated for each

subsample. For each artificial series, the Wald test was constructed to determine stability

across the two periods. The 1000 test statistics were sorted by size, and the one-hundredth

largest is reported in parentheses in Tables 5 and 6.

Use of the simulated critical value makes the two rejections forthe real data no longer

significant (see Table 5). In the case of the nominal variables and velocity shown in Table 6,

the number of significant changes drops from 33 to 20 out of 55. For the velocitymeasures,

we find that 12 of the 33 tests reject the null hypothesis. Even though there is a reduction in

the number ofrejections using the Monte Carlo method, a dramatic difference in the cyclical

stability of real versus nominal variables remains.

 6

A Model of Aggregate Fluctuations With Monetary Policy.~

The model used here—a modification of one developed by Kydland (1991) to

examine the role of money in business cycles—is based on a neoclassical growth model with

technology shocks. In each period, the consumer decides how to allocate time between work

and leisure. Larger money balances increase the amount of time that can be allocated to these

two activities. Money enters the economy as a government transfer. In Kydland, the money

supply is treated as an exogenous univariate process. In this paper, the money supply

function also depends on last period’s output. This extension allows us to investigate the

implications of a central bankts decision about whether to focus more sharply on nominal or

real variables.

The Economy

The model economy is inhabited by many households that are all alike. Their

available time, T, is spent in three basic activities: input in market production, leisure, and

transaction-related activities such as trips to the bank, shopping, and so on. The role of

money is to make the third activity less time consuming. By holding larger money balances,

households have more time for work and/or leisure.

Assume that the time spent on transactions-related activities in period t is given by the

expression

m~
(A)
0
— ~~~(—)
p’c,

where m~is the nominal stock of money, p~is the price of physical goods relative to that of
 7

money, and c~is consumption expenditures. By restricting o~~änd

~2 to have the same sign

and o2 < 1, the amount of time saved increases as a function of real money holdings in

relation to consumption expenditures, but at a decreasing rate. Leisure in period t is

= T — n~ — +
p,c,

where n~is time spent in market production.

Each household maximizes

E f3~u(c~,~1),

where 0 < [~< 1 is a discount factor. The functional form of the current-period utility

function is

I1I~
k t’tJ
~\— ~ [t t
1 ~p 11
j
-Y
‘
l-y

where 0< ~t < 1 and y >0 but different from one. This CES function, with unitary

substitution elasticity between consumption and leisure, was chosen because it is consistent

with postwar U.S. data in which long-run hours worked per person remain roughly constant

despite the large increase in real hourly compensation.

The household’s stock of capital, k, is governed by the law of motion,

k~+,= (1-ô)k~+x~,

where 0 < ô < 1, ô is the depreciation rate, and x~is investment. The budget constraint for the

typical individual is c~+ x~+ ~ = w~n~

+ n1~/Pt+ ~ where v~is a nominal lump-sum
 8

transfer from the government.

Aggregate output, Y~,is produced using labor and capital inputs:

=C~+ X~=Z~N~°K,~°,
Y~

where Z1 is the technology level and X~is the total of investment expenditures. The

technology changes over time according to Z~1= pZ~+ ?..~+,,where 0<p < 1. The innovations

are assumed to be normally distributed with positive mean and variance o~

Laws of motion analogous to those of individual variables describe the aggregate

quantities of capital and the addition of the stock ofcapital initiated in each period. The

distinction between individual and aggregate variables is represented here by lower and

upper-case letters, respectively. This distinction plays a role when computing the equilibrium

of a model with government policy in which the equilibrium is not simply the solution to a

stand-in planner’s problem.

Calibration

The model is calibrated using empirical estimates of steady-state relations among the

model’s variables and parameters. Most of the estimates come from long-run or average

values. Measurements from panel data also are used. The parameter 0 in the production

function equals the model’s steady-state labor share of output and is set equal to 0.65. This is

in line with estimates obtained forthe United States if approximately half ofproprietors’

income is considered to be labor income. We use a quarterly depreciation rate of 0.025.

Turning to the household sector, the annual real interest rate is 4 percent, yielding a

quarterly discount factor, ~, of approximately 0.99. The risk-aversion parameter, y, is set

 9

equal to two, which means more curvature on the utility function than that corresponding to

logarithmic utility. This value is consistent with the empirical findings of Neely, Roy, and

Whiteman (1996).

We calibrate the money-time tradeoff so that the implied money demand function is

consistent with the empirical evidence summarized by Lucas (1994) and Mulligan and Sali-

Martin (1997). The money demand relationship in the model has a unitary elasticity of the

scale variable (consumption). When we set ~2 (the curvature parameter in the money-time

trade-oft) equal to -1, the interest rate elasticity equals -0.5.

With the steady state output and money stock normalized to unity, the steady-state

price level is determined by choosing the annual income velocity of money to be

5.3—approximately equal to the average ofMl velocity between 1959 and 1994. Given the

price level, we derive ~ from the household’s first order condition for the choice of money

holding:

r ~ m i-~

= C (—) 2

where the real “age rate, w, equals the steady state marginal product of labor, and r is the

quarterly real interest rate. The implied value of o, is -0.0034. The magnitudes of o~and ~2

can be understood through a marginal evaluation around the average. If the real money stock,

rn/p, is increased by 1 percent relative to its steady state, then a household’s resulting weekly

time saving is less than a minute.

Without loss of generality, we choose time units so that n + 12 = 1. In line with the

panel-data estimates of Ghez and Becker (1975), we set n so that n/(n+~)= 0.3. The
 10

remaining parameter ji, the share of consumption in the utility.function, usually is determined

from the condition MU, / MU~= w and usually turns out to be close to n in magnitude. In

this case, because of the dependence of time (and therefore 12) on m/pc, the corresponding

condition can be written as

= + ~1~2(ffl)(~)
2
u2 w c PC

The implied value for p is 0.33.

The model economy we use in our computational experiments is a quadratic

approximation around the steady state. The resulting structure fits into the general

framework outlined in Kydland (1989), and the dynamic competitive equilibrium is

computed using the method described there.

Monetary Policy

We modify the basic model to include a monetary policy function that changes the

money supply growth rate in response to last period’s level of output and the money stock.

The alternatives we examine are all specific instances of the following general rule:

M,÷,—M,=v0+v1Y~1 +v2M~÷E~,

where v, is the proportional response to last period’s output level, v2 is the response to the

money stock, and , is the money supply shock in period t. If both v, and v2 are 0, the money

supply is a random walk. To judge the magnitude of v,, we note that the steady state value of
 11

Y is one. We do not estimate orcalibrate the policy function in this paper. Recent work by

Salemi (1995) suggests that, in future research, we may be able to calibrate the various policy

rules that were in effect in the United States in the post-war period. In this paper we merely

show that the quantitative implications of alternative policy rules on the nominal-to-nominal

and nominal-to-real correlations can be large.

Table 7 includes cyclical statistics calculated from the model economy with a

fixed money stock; that is, with the v,’s and the variance of set equal to 0. Like the U.S.

economy, our model’s consumption and investment are highly procyclical. In percentage

terms, consumption is less variable, and investment is much more variable, than output. The

price level is countercyclical. Velocity in the model moves procyclically.

With no money-stock variability, the variability ofthe price level in this model is

below that observed in U.S. data. Still, with the benchmark of a constant money stock,

variation in technology produces a cyclical standard deviation of the price level equal to 0.45,

about half the standard deviation of the GDP deflator in the U.S. data (0.87 for the full

sample [see Table 2]). When the benchmark assumptions are changed by increasing the

variance of the money supply shock, the cyclical standard deviations of the price level and the

money stock increase. When the standard deviation of the money supply shock is raised to

0.3 (0.6) percent per quarter, the standard deviation of the price level rises to 0.59 (0.89)

percent. Raising the variance of the money supply shock tends to dampen the cyclical

behavior of both money and prices. The contemporaneous correlation between output and

the price level rises from -0.92 in the base case to -0.70 (-0.47) when the standard deviation

of the money supply shock is raised to 0.3 (0.6) percent per quarter.

The sensitivity of the nominal-real covariance structure to variation in the policy

 12

parameters is reported in Figures 1 and 2. As in Table 7, the results ofeach experiment are

averages of 100 independent model histories, each of the same length as the full U.S. sample.

Each experiment uses different combinations of v1 (between 0.05 and -0.05) and v2 (between

0 and -0.1). The ranges were chosen because the cyclical properties of money and the price

level were sensitive to choices for values within these ranges. For these computational

experiments we have set the standard deviation of the money supply shock, ~,to 0.3 percent

at a quarterly rate. Note that even when the variance of this error is set to 0, allowing money

supply growth to be correlated with output induces realistic levels of variability in money and

the price level.

We begin by looking at the behavior of the model economy when the cyclical

response of policy to real output, v,, was varied between -0.05 and 0.05. Figure 1 shows the

0
standard deviation of the price level, ci1,, and money stock, m~ Remember that the price level

and the money stock are measured as log deviations from trend. When the standard deviation

ofthe money shock was raised from zero to 0.3 percent in the base case, the standard

deviation of the price level rose from 0.47 to 0.59. When money supply growth is made

mildly procyclical (that is, when v1 is set equal to 0.015), the standard deviation of the price

level falls to 0.41 percent. For the range of values examined, Urn is relatively unaffected by

the choice of v1.

Panel B shows how the cyclical behavior of the price level and the money stock is

affected by changes in v1. The procyclical response of money growth that minimizes the

variance of the price level also makes the price level acyclical. Increasing v1 above 0.0 15

induces procyclical movements in the price level. Lowering the parameter below 0.0 15

makes the price level countercyclical.

 13

The cyclical behavior of the money stock does not appearto be highly sensitive to the

choice of v,, but that appearance comes from looking only at the contemporaneous

correlation between money and output, p(y~,m~).

Figure 1 panel C shows the cross-

correlations between output and the money stock at leads and lags of 3 quarters, p(y,,ni,~3).

When money supply growth is procyclical (v1 = 0.05), the money stock leads the cycle,

p(y~,m,3)= 0.28. When money growth is countercyclical (v1 = -0.05) the money stock lags

the cycle, p(y~,m,÷3=) 0.15.

The sign of the policy response to output was an important factor in determining the

cyclicality ofthe price level. When examining the effect of alternative responses to real

output, we set v2 arbitrarilyclose to zero. Figure 2 shows what happens as the value of v2 is

lowered from zero to -0.1. For these experiments, we assume that policy is procyclical

(v1=0.05). This allows us to show how responding to the money stock can undo the effects of

a procyclical policy on the price level. if we assume there is no response to output, the price

level is highly countercyclical for all values of v2 that we examined.

When v2 is close to zero and v1 is set to 0.05, o~is 0.90 percent per quarter (see

Figure 2, panel A). By lowering v2 to a value around -0.035, we can reduce the standard

deviation of the price level to 0.17 percent. The standard deviation of the detrended money

stock is relatively unaffected by changes in v2. As v2 is lowered from 0 to -0.1, 0rn declines

very gradually from 0.46 to 0.44.

Panel B shows that the price level is highly procyclical when the money supply is

close to a random walk and becomes countercyclical as v2 passes though -0.35. The money

stock becomes slightly less countercyclical as v2 goes from 0 to -0.1. Panel C shows that the

cross-correlations between output and money at leads and lags of 3 quarters display the same
 14

pattern; that is, the correlations rise as v2 is lowered to -0.1.

To summarize the main results in Figures 1 and 2, we find that changes in the money

supply process have significant effects on both the variability of the price level and the size

and sign of the correlation between the nominal variables and output. These dramatic

changes in the covariance structure of the nominal series occur in a model in which the

monetary rule has almost no impact on real variables. Of all the real variables, hours worked

is the most affected by the alternative monetary regimes. Even so, the results are not shown

here because the differences are not apparent at two significant digits. We also experimented

with alternative specifications of the business cycle model, including versions with time-to-

build for capital. In all cases, the results are basically the same as for the particular model

presented in this paper. Changes in the monetary policy rule have large effects on the

correlations among nominal variables and on the cross-correlation structure between nominal

and real series, without having any noticeable impact on the real variables.

Conclusion

The behavior of money and prices over the business cycle defies simple classification

in empirical regularities. We documented the relative instability of the behavior of nominal

variables vis-à-vis the behavior of real variables. Looking at the stability of cross-

correlations between real GDP and each of seven real variables—personal consumption

expenditures, expenditures on nondurables and services, expenditures on consumer durables,

private domestic investment, fixed investment, hours worked, and productivity—we found

that only in two of 77 cases did the ~2 statistic reject the null hypothesis of stability at the 10

percent critical level. When we constructed Monte Carlo estimates of the statistic’s
 15

distribution, even those two rejections were overturned. The results for the nominal

variables—GDP deflator, CPI, monetary base, Ml and M2—were much different. Here, we

were able to reject stability in 33 of 55 cases using the 10 percent critical region of the

asymptotic distribution. When we used the simulated critical values, the number of

rejections dropped to 20.

In the second part of the paper, we explored the possibility that the instability in the

cyclical behavior of the nominal data is caused by instability in the money supply function.

We modified a real business cycle model with a labor-leisure trade-offby adding a time-

saving role for money balances. We also included a monetary policy function that could react

to both real output and the money stock. In a variety ofexperiments testing the sensitivity of

the model to the policy function parameters, we found that the cross-correlations of nominal

variables with real GDP are sensitive to the specification ofthe policy rule. Whether the

price level is procyclical orcountercyclical depends importantly on whether the money stock

is allowed to react to real factors and to the amount of persistence that the authorities induce

in money supply shocks. These findings are obtained in a model in which the specification of

the monetary rule has almost no impact on the cyclical behavior of real variables.
 16

Endnotes

1. Bryan and Gavin (1994) show how the change in the money supply rule in the third quarter of
1979 might explain the change in the cross-correlation between inflation and monetary base
growth that occurred about that time.

2. Rolnick and Weber (1994) show that the covariance structure of money, output, and prices
seems to depend on whether a country is on a fiat or commodity money standard. Within a fiat
money regime, Friedman and Kuttner (1992) use results from vector autoregressions to argue that
a deterioration in nominal-real relationships followed the Federal Reserve’s policy change in
l979:Q3.

3. Cooley and Hansen (1995) report business cycle facts in Table 7.1. Their statistics for the CPI
and the GDP price index are similar to those we report in Table 4 for the period from l959:Ql to
l979:Q3. The facts they report about the monetary aggregates are an average of the experience
in both periods.

4. See Ostle (1963) pp. 225-227, for a detailed description ofthe test statistic used.
 17

References

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Cooley, Thomas F. and Gary D. Hansen. “Money and the Business Cycle,” Chapter 7
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, and Lee K Ohanian. “The Cyclical Behavior of Prices,” Journal of

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 18

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 Table 1.
Cyclical Behavior of U.S. Quarterly Data / Real Variables
(Deviations From Trend)

Std, CorrelatiOns with RGDP from 1959;Q1 to 1994:Q4

Variable x Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+l) x(t+2) x(t+3) x(t+4) x(t+5)
GDP in 1987 Dollars 1.62 0.05 0.25 0.46 0.68 0.86 1.00 0.86 0.68 0.46 0.25 0.05
(RGDP)

Consumition 1.23 0.27 0.45 0.62 0.77 0.87 0.88 0.73 0.54 0.33 0.10 -.09

Durables 5.00 0.34 0.48 0.59 0.71 0.78 0.80 0.61 0.40 0.18 -.04 -.22

Nondurables and 0.83 0.18 0.38 0.57 0.73 0.84 0.86 0.74 0.59 0.40 0.19 0.01
Services
Private Domestic 7.72 0.14 0.29 0.46 0.63 0.79 0.91 0.76 0.55 0.31 0.08 -.15
Investment
Fixed Investment 5.63 0.15 0.32 0.50 0.68 0.83 0.90 0.81 0.63 0.42 0,19 -.03

Hours Worked (Estab.) 1.54 -.19 -.01 0.19 0.42 0,67 0.88 0.92 0.86 0.73 0.56 0.37
Productivity 0.80 0.47 0.54 0.55 0.56 0.47 0.35 -.01 -.26 -.48 -.58 -.59
(RGDP/Hrs Worked)

Source: Authors’ calculations.

 Table 2.
Cyclical Behavior of U.S. Quarterly Data / Nominal Variables and Velocity
(Deviations From Trend)

Std.
Correlations with RGDP from 1959:Q1 to 1994:Q4
Variable x Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)
GDP Deflator 0.87 -.57 -.65 -.71 -.72 -.67 -.58 -.46 -.33 -.18 -.04 0.10

CPIU 1.42 -.60 -.71 -.76 -.77 -.71 -.59 -.42 -.26 -.07 0,11 0.27

MonetaryBase 0.88 0.11 0.20 0.26 0.32 0.37 0.38 0.34 0.29 0.22 0,14 0.09

Ml 1.94 0.24 0.30 0.35 0.39 0.38 0.31 0.20 0.10 0.01 -.05 -.07

M2 1.38 0.40 0.51 0.59 0.62 0.58 0.45 0.26 0.08 -.09 -.25 -.37

Base Velocity 1.40 -.35 -.24 -.08 0.13 0.34 0.55 0.50 0.39 0.28 0.18 0.07

Ml Velocity 2.29 -.38 0.32 -.25 -.13 0.03 0.22 0.26 0.26 0.24 0.20 0.14

M2 Velocity 1.71 -.56 -.51 -.41 -.23 0.01 0.29 0.37 0.40 0.41 0.42 0.40

Source: Authors’ calculations.

 Table 3. Cyclical Behavior ofReal Variables in Subperiods

Std. Correlations with RGDP from 1959:Q1 to 1979:Q3

Variable x — Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)
Real GDP 1.67 0.03 0.24 0.46 0.69 0.86 1.00 0.86 0.68 0.45 0.22 -.01

Consumption 1.26 0.19 0.40 0.59 0.78 0.87 0.89 0.74 0.54 0.30 0.02 -.21
Durables 5.18 0.29 0.46 0.58 0.72 0.80 0.83 0.67 0.45 0.20 -.07 -.28
Nondur. & Serv. 0.86 0.10 0.31 0.53 0.73 0.83 0.84 0.73 0.56 0.35 0.09 -.14
Pvt. Dom. Invest 7.78 0.14 0.29 0,46 0.64 0.78 0.91 0.76 0.57 0.34 0.11 -.15
Fixed Investment 5.87 0.13 0.31 0.50 0.70 0.83 0.89 0.79 0.62 0.41 0.17 -.07

Hours (Estab.) 1.58 -.23 -.06 0.16 0.39 0.63 0.85 0.92 0.86 0.74 0.56 0.34
Productivity 0.89 0.45 0.54 0.57 0.60 0.51 0.38 0.00 -.24 -.48 -.59 -.61

Std. Correlations with RGDP from 1979:Q4 to 1994:Q4

Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t÷2) x(t+3) x(t+4) x(t+5)
Real GDP 1.56 0.07 0.26 0.45 0.64 0.87 1.00 0.87 0.67 0.47 0.30 0.14
Consumption 1.18 0.38 0.53 0.64 0.74 0.86 0.87 0.71 0.54 0.37 0.22 0,07
Durables 4.72 0.41 0.52 0.60 0.67 0.74 0.74 0.52 0.34 0.14 0.00 -.14

Nondur. & Serv. 0.80 0.31 0.49 0.61 0.71 0.85 0.88 0.77 0.62 0.48 0.34 0.21
Pvt. Dorm Invest 7.63 0.12 0.26 0.43 0.60 0.80 0.91 0.77 0.50 0.26 0.04 -.16
Fixed Investment 5.22 0.18 0.34 0.48 0.65 0.84 0.93 0.83 0.65 0.43 0.23 0.02
Hours (Estab.) 1.54 -.14 0.05 0.24 0.46 0.73 0.91 0.93 0.85 0.72 0.57 0.40
Productivity 0.66 0.52 0.53 0.51 0.46 0.39 0.29 -.06 -.33 -.51 -.58 -.59

Source: Authors’ calculations.

 Table 4. Cyclical Behavior of Nominal Variables and Velocity in Subperiods

Std. Correlations with RGDP from 1959:Q1 to 1979:Q3

Variable x Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)
GDP Deflator 0.78 -.41 -.52 -.66 -.74 -.72 -.65 -.55 -.42 -.23 -.04 0.18
CPIU 1.38 -.49 -.67 -.81 -.86 -.83 -.74 -.57 -.38 -.16 0.09 0.30
Monetary Base 0.69 -.21 -.12 0.00 0.15 0.32 0.46 0.54 0.58 0.53 0.44 0.35

Ml 0.94 -.16 0.03 0.28 0.52 0.65 0.71 0.67 0.56 0.41 0.27 0.11
M2 1.63 0.45 0.61 0.73 0.78 0.76 0,64 0.45 0.20 -.04 -.28 -.46
Base Velocity 1.07 -.10 0.07 0.24 0.44 0.61 0.79 0.60 0.40 0.23 0.09 -.07
Ml Velocity 0.96 -.11 -.04 -.01 0.09 0.27 0.51 0.39 0.29 0.20 0.11 003
M2 Velocity 1.59 -.62 -.63 -.59 -.44 -.23 0.07 0.17 0.29 0.39 0.49 0.55

Std. Correlations with ROD? from 1979:Q4 t. 1994:Q4

Variable x Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)
GDP Deflator 0.97 -.78 -.84 -.81 -.72 -.63 -.50 -.36 -.24 -.13 -.04 .02
CPIU 1.43 -.78 -.78 -.71 -.64 -.55 -.38 -.21 -.08 0.04 0.14 0.22

Monetary Base 1.10 0.44 0.54 0.55 0.51 0.46 0.34 0.19 0.09 0.02 -.04 -.06
Ml 2.82 0.51 0.51 0.47 0.42 0.33 0.18 0.02 -.09 -.15 -.18 -.16

M2 0.94 0.28 0.28 0.25 0.22 0.14 -.04 -.18 -.21 -.21 -.23 -.23
Base Velocity 1,82 -.62 -.55 -.38 -.15 0.13 0.40 0.45 0.40 0.33 0.26 0.17
Ml Velocity 3.40 -.61 -.55 -.42 -.26 -.06 0.17 0.28 0.31 0.31 0.27 0.20
M2 Velocity 1.90 -.48 -.35 -.17 0.05 0.33 0.60 0.63 0.54 0.44 0.34 0.24

Source: Authors’ calculations.

 Table 5. Tests for Stability of Real Variables

Chi-square test for equality of correlations across sample periods (Break in 1979:Q3)

Variable x x(t-5) x(t-4) x(t-3) x(t-2) x(t-l) x(t) x(t+l) x(t+2) x(t+3) x(t+4) x(t+5)

. 1.30 0.99 0.23 0.20 0.11 0.16 0.13 0.00 0.19 1.29 2.55
Consumption
(6.12) (5.77) (5.59) (6.52) (8.36) (9.05) (6.04) (5.31) (5.40) (6.16) (6.80)

0.64 0.23 0.01 0.29 0.69 1.94 1.70 0.52 0.10 0.15 0.62
D urabies
(5.91) (5.96) (6.67) (7.64) (8.37) (7.44) (5.01) (4.41) (4.78) (5.10) (5.51)

Nondurs.+ 1.63 1.44 0.40 0.07 0.13 0.56 0.31 0.29 0.87 2.40 4.10
Srvcs. (5.68) (5.32) (4.96) (5.87) (7.57) (10.15) (7.96) (7.64) (7.44) (7.87) (8.07)
0.01 0.03 0.06 0.14 0.11 0.01 0.01 0.32 0.24 0.15 0.01
Investment
(5.82) (6.10) (5.76) (6.10) (6.95) (9.25) (4.82) (3.07) (3.00) (3.21) (3.62)

. 0.08 0.03 0.01 0.26 0.09 1.93 0.45 0.08 0.04 0.13 0.26
Fixed Invest.
(6.86) (6.68) (7.47) (7.71) (9.45)
(7.95) (5.47) (4.65) (4.56) (5.32)
0.23 0.39 0.23 0.24 1.07 2.98 0.51 0.07 0.10 0.00 0.18
Hours Worked (6.22) (6.18) (5.80) (5.22) (4.51) (5.61) (9.07) (9.49) (7.88) (6.99) (6.67)

~ 0.25 0.01 0.26 1.20 0.77 0.35 0.12 0.31 0.06 0.00 0.05
Productivity
(9.69) (8.40) (6.80) (5.31) (4.87) (4.85) (3.76) (4.21) (5.77) (6.63) (7.07)

Note: Shading indicates that the Waid statistic rejects stability assuming the asymtotic 10% critical value, 2.71. Simulated 10% critical values are shown in
parentheses.

Source: Authors’ calculations

 Table 6. Tests for Stability ofNominal Variables

Chi-square test for equality of correlations across sample periods (Break in 1979:Q3)

Variable x x(t-5) x(t-4) x(t-3) x(t-2) x(t-l) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)

3.58 0.03 1.05 1.74 1.88 1.25 0.41 0.00 0.80

GDPDeflator (10.76) (11.10) (11.94) (11.87) (10.39) (9.04) (8.06) (7.64) (7.42)

CPIU 1.87 1.84 8.97 10.65 6.28 3.47 1.31 0.08 0.26
(7.37) (9.70) 1 6 (10.89) ~6.56~ .83) (6.05) (6.66) (7.06)

0.97 0.69 5.62 8.62 6.06

Monetary Base (7.24) (8.02) (7. 3 (9.56) (10.43)

Ml 1.69 0.51 6. 6.65 2.40

(5.92) (6.89) (9,19) (8.81)

M2 1.22 5.51 5.95 0.94 0.08 2.29

(8.75) (8.76) (6.86) (7.85) (9.50) (10.48)

Tests for Stability of Velocity

Chi-square test for equality of correlations across sample periods (Break in 1979:Q3)

Variable x x(t-5) x(t-4) x(t-3) x(t-2) x(t-1) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)

. 1.46 0.00 0.43 1.09 1.87

Base Velocity (4.91) (4.46) (5.05) (4.98) (4.54)

. 6.17 4.40 5.03 0.47 0.02 0.50 0.96 1.00

Ml Velocity ~7.67~ ) ~7.8Q~ (6.71) (5.67) (6.08) (5.92) (5.84)

1 ~5 427 825 ~423 010 101

M2 Velocity
(10.28) O0.29~ ~9.17~ ~8.24~ (9.53) (10.20)

Note: Shading indicates that the Wald statistic rejects stability assuming the asymtotic 10% critical value, 2.71. Simulated 10% critical values are shown in
parentheses; Light shading indicates that stability is not rejected using the simulated critical values.
Source: Authors’ calculations.
 Table 7. Cyclical Behavior of Economy with Fixed Money Stocka

Cross-Correlation of 0 utput with

Std.
Variables x Dev. x(t-5) x(t-4) x(t-3) x(t-2) x(t-l) x(t) x(t+1) x(t+2) x(t+3) x(t+4) x(t+5)
Output 1.33 -0.01 0.11 0.26 0.45 0.70 1.00 0.70 0.45 0.26 0.11 -0.01
(0.17) (0.10) (0.10) (0.10) (0.09) (0.07) (0.00) (0.07) (0.09) (0,10) (0.10) (0.10)

Consumption 0.52 -0.13 -0.01 0.14 0.35 0.62 0.97 0.75 0.56 0.40 0.27 0.16
(0.07) (0.09) (0.08) (0.09) (0.08) (0.06) (0,01) (0.06) (0.09) (0.11) (0.11) (0.12)

Investment 3.86 0.04 0.16 0.30 0.48 0.71 0.99 0.66 0.40 0.20 0.05 -0.07
(0.50) (0.11) (0.11) (0.11) (0.10) (0.07) (0.00) (0.06) (0.09) (0.10) (0.09) (0.10)

Hours 0.59 0.07 0.18 0.32 0.50 0.72 0.99 0.64 0.37 0.16 0.01 -0.11
(0.08) (0.11) (0.11) (0.11) (0.10) (0.07) (0.00) (0.06) (0.09) (0.09) (0.09) (0.09)

Price Level 0.45 0.20 0.09 -0.07 -0.28 -0.56 -0.92 -0.76 -0.61 -0.47 -0.36 -0.25
(0.07) (0.09) (0.08) (0.08) (0.07) (0.05) (0.02) (0.06) (0.09) (0.11) (0.11) (0.12)

Velocity 0.93 0.09 0.20 0.34 0.51 0.72 0.98 0.63 0.35 0.14 -0.01 -0.13
(0.12) (0.12) (0.11) (0.11) (0.10) (0.07) (0.01) (0.06) (0.09) (0.09) (0.09) (0.09)

a These are the means of 100 model histories, each of which was 144 periods long. The numbers in parentheses are standard deviations.

Source: Authors’ calculations.

 Figure 1: AlternatiVe Responses toAReal Output
A: Standard Deviation of the Price Level and the Money Stock
Standard Deviation

-0.05 -0.04 -0.03 -0,02 -0.01 0 0.01 0.02 0.03 0.04 0.05

VI

B: Cyclical Behavior of Money and the Price Level

Correlation
i.0

0.8

0.6

0,4

0.2

0.0

-0.2

-0.4

-0.6

-i.o
-0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05

VI

C: Cross-Correlation between Output and Money

(With Money Leading and Lagging 3 Quarters)
Correlation
0,4

0.3

0.2

0.1

0.0

-0.1

-0.2

-0.3

-0.4
-0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05

Vi

Note: v2 was set equal to 0 and o~was set equal to 0.3 percent per quarter.
 Figure2: Alternative Responses to Money Stock
A: Standard Deviation of the Price Level and the Money Stock
Standard Deviation
1.00

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.0(1
-0.1 -0,09 -0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0,02 -0.01 0
V
1

B: Cyclical Behavior of Money and the Price Level

Correlation

-0.1 -0.09 -0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0,02 -0.01 0
V
1
C: Cross-Correlation between Output and Money
(With Money Leading and Lagging 3 Quarters)
Correlation
0.4

0.3

0.2
— - p(y~,m1÷3)
0,1

0.0

-0.1

-0.2

-0.3 ?~‘ ~
-0.4
-0.1 -0.09 -0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0.02 -0.01 0

VI

Note: v2 was held constant at 0.05 and o~was set to 0.3 percent per quarter.