The effects of proximate determinants of the money supply in the interwar period.

• Author: McMillin, W. Douglas
• Position: July 1922-June 1938

1. Introduction

   Recent studies of the role of monetary policy in the interwar period and the Great Depression of 1929-33 typically focus on the money supply or the monetary base.(1) For several reasons, however, it is instructive to study the separate impact of money's three proximate determinants.

   In this paper we focus on the interwar period and present empirical evidence on the importance of the three proximate determinants of the money supply in explaining fluctuations in output and prices. We define the interwar period as July 1922-June 1938 for reasons explained in Beard and McMillin |2~.

   As developed by Friedman and Schwartz |15~ and extended by Cagan |10~, changes in the M2 stock of money can be attributed arithmetically to changes in three proximate determinants--the monetary base, the ratio of currency to deposits (the currency ratio) and the ratio of reserves to deposits (the reserve ratio).(2) The three proximate determinants are affected by different economic forces or react differently to the same variables. Each is under the immediate control of different economic agents.

   Changes in any one of the three proximate determinants can have, and have had, important effects on the stock of money. Cagan |10~ analyzed in detail the contribution of changes in each of the three proximate determinants to cyclical fluctuations in the rate of change in the money stock over the long period 1877 to 1954. The base and the reserve ratio were each responsible for about one-fourth of these variations; the currency ratio was the most important single contributor, being responsible for roughly one-half of the variations. While the contribution of the currency ratio varied from cycle to cycle, major deviations occurred at times of financial panics when it often played a dominant role. Cagan found that the establishment of the Federal Reserve reduced the relative importance of changes in the reserve ratio and increased the relative importance of changes in the base. While the amplitude of cyclical movements in the reserve ratio fell after 1914 and the ratio itself trended downward, there was a sharp increase in the reserve ratio in the 1930s. A series of bank crises that raised both the currency and reserve ratios and resulted in a drastic decline in the money supply is the key ingredient in Friedman and Schwartz's |15~ well-known explanation of the Great Depression. The roles of the currency and deposit ratios have been widely discussed, for example by Temin |30~, Mayer |21~, Boughton and Wicker |8~, Wicker |32;33~, and Trescott |31~. A considerable literature suggests a variety of other explanations for the Great Depression.(3) In an influential paper, Bernanke |3~ argued that financial shocks had important nonmonetary effects on economic activity in addition to their shocks via the money supply. These shocks increased the cost of credit intermediation and led to a subsequent fall in output. In testing his hypothesis, Bernanke used the deposits of failed banks and the liabilities of failed businesses as joint proxies for the cost of financial intermediation. He also used the yield differential between Baa corporate and long-term Treasury bonds as a single proxy.(4) A recent study by Raynold, Beard and McMillin |23~ that uses Bernanke's proxies also points to an important role for the nonmonetary effects of financial factors in explaining economic activity. Thus, it seems useful to include these proxies for the nonmonetary effects of financial shocks in systems that also include the three proximate determinants of the money supply. An interesting question is whether the currency and reserve ratios proxy the same economic forces proxied by Bernanke's variables. Following Barro |1~, Rush |25;26~, for example, considers the base multiplier as a suitable proxy for the level of financial intermediation in his studies of the gold standard era and the period 1920 to 1983.

   In section II, we outline the empirical model used, and in section III we discuss our empirical procedures and results. The conclusions are summarized in section IV.

2. Model Specifications

   We use monthly data for the interwar period in estimating and analyzing four vector autoregression (VAR) models from which we calculate variance decompositions (VDCs). These models share four variables: government expenditures, output, the price level and the interest rate. A five-variable model includes the money supply and a seven-variable model drops the money supply and includes the monetary base, the reserve to deposit ratio, and the currency to deposit ratio. An eight-variable model adds an interest rate differential as a proxy for the cost of financial intermediation, and a nine-variable model replaces the interest rate differential with the deposits of failed banks and the liabilities of failed businesses. Cumulative impulse response functions (CIRFs) are also calculated for the eight- and nine-variable systems.

   The empirical counterparts to the model variables are as follows. The interest rate (CPRATE) is the 4-6 month yield on prime commercial paper which comes from Banking and Monetary Statistics 1914-1941 (Board of Governors of the Federal Reserve System, 1943). The price level measure (WPI) is the wholesale price index and comes from the 1933, 1938, and 1943 editions of the Statistical Abstract of the United States. Output is measured by the industrial production index (IP) with 1977 as the base year. Data for IP are taken from the 1985 revision of Industrial Production (Board of Governors of the Federal Reserve, 1985). Money (M2) is Friedman and Schwartz's |15~ measure of M2 and is taken from their Table A-1, as is the monetary base (BASE). Government expenditures (EXP) include purchases of goods and services and the small amount of transfer payments in our sample. Separate series on purchases and transfer payments were unavailable. EXP is measured in billions of dollars and is taken from Firestone's |14~ Table A-3, and are deflated by WPI. The currency ratio (CURRT) and reserve ratio (RESRT) are, respectively, the ratios of currency held by the public and bank reserves to adjusted deposits, all commercial banks. These ratios are the inverse of the ratios of adjusted deposits to currency held by the public and bank reserves from Table B-3 of Friedman and Schwartz |15~. The real value of the deposits of failed banks (DEPFAIL) is measured in millions of dollars and its nominal counterpart comes from various issues of the Federal Reserve Bulletin. The real value of the liabilities of failed commercial businesses (LIABFAIL) is measured in millions of dollars and its nominal version comes from various issues of the Survey of Current Business. In both cases, real values were obtained by deflating the nominal series with WPI. Following Bernanke |3~, the yield differential (FDIF) is calculated as the fitted value of a regression of the difference (in percentage points) between the yields on Baa corporate and long-term U.S...