Fiscal Developments in 1985

The combined fiscal deficit of the major industrial countries increased marginally in relation to GNP in 1985 at the central government level and was stable at the level of general government (Statistical Appendix Tables A16 and A17). The virtual stability of the combined fiscal balance, however, resulted from contrasting movements in the balances of individual countries. The deterioration in the budgetary position of the United States in 1985 was more than large enough to offset a small decline in the composite fiscal deficit of the other six countries. For the entire group, with account taken of cyclical changes in the respective economies, the underlying fiscal impulse was expansionary at the central government level, but broadly neutral at the general government level.

The difference between the expansionary thrust of U.S. fiscal policy and the generally restrictive impulse in the other major industrial countries, taken together, was somewhat greater in 1985 than in 1984. At the general government level, the U.S. fiscal impulse was again equal to about ½ of 1 percent of GNP, while the composite for the other countries shifted appreciably toward restraint. In the United States, the expansionary impulse stemmed from the expenditure side of the fiscal account, being fueled primarily by the defense buildup and secondarily by expansion of state and local government spending. Part of the expenditure impulse, however, was offset by revenue growth associated with the built-in elasticity of the tax system.

Outside the United States, the moderate composite swing toward restraint in 1985 was largely due to developments in Japan and the Federal Republic of Germany. In each of these countries, the general government deficit was reduced by approximately 1 percentage point in relation to GNP. Occurring in a context of little or no change in cyclical influences, these reductions imparted restrictive impulses of broadly similar size. In Japan, the degree of restraint was smaller at the central government level than for the general government sector, while in Germany it was about that same at either level. Moreover, the sources of the restrictive impulses differed in other ways. In Japan, the negative impulse came to a considerable extent from the revenue side of the account, reflecting mainly the built-in elasticity of the tax system, whereas in the Federal Republic of Germany the decline in the fiscal deficit was due mainly to a fall in public investment outlays and restrained growth of social transfers. Although these categories of expenditure were also strongly restrained in Japan, the total withdrawal of stimulus from the expenditure side of the Japanese account was limited by built-in increases in social security outlays and the rise in interest payments.

In France, the thrust of fiscal policy was contractionary in 1985, particularly at the general government level, where the unadjusted deficit is estimated to have declined from 2.8 percent of GDP in 1984 to 2.5 percent in 1985. The central government deficit is estimated to have been marginally reduced from 3.4 percent to 3.3 percent of GDP, and thus to have slightly overshot the target of 3.0 percent of GDP. This withdrawal of stimulus was attributable to a slowing of expenditure growth. The decline in government expenditures as a percentage of GDP was attributable to restraints on increases in both employment and real wages in the government sector, and to deceleration in the growth of social security transfers and subsidies.

In the United Kingdom, government revenue declined in relation to GDP in 1985, reflecting the impact of lower oil prices and certain tax changes introduced in the March 1985 budget. Notwithstanding this relative decline in revenues, the government deficit also decreased moderately as a result of a sharper deceleration in the growth of government spending. In a year of relatively strong expansion of economic activity, however, much of the decline in the ratio of expenditure to GDP was due to cyclical developments. With allowance for those, the moderate change in the actual deficit must be interpreted as essentially neutral in terms of the implied fiscal impulse.

Italy was the only major European country in which the fiscal deficit widened substantially in 1985. The increase amounted to about ½ of 1 percentage point in relation to GDP, whether measured at the general government level or for the central government alone. In either case, about one third of the change could be attributed to cyclical influences in a year of rather weak GDP growth, but the greater part represented growth in the structural deficit. Slower growth of nontax revenue, increased outlays associated with social security benefit payments and other transfers to households, and termination of discretionary measures of restraint in effect during the previous year were the principal factors underlying Italy’s reversion to a more stimulative fiscal stance in 1985.

In Canada, a relatively high rate of economic growth and the implementation of a number of deficit-reducing measures adopted in the context of the May 1985 budget resulted in little change in the fiscal deficit, after three consecutive years of large and growing imbalances. The revenue measures in the budget included an increase in the sales tax, a partial de-indexation of personal income tax brackets, and temporary corporate and personal income tax surcharges. Partly because of lags in collection of the newly increased taxes and partly because government spending declined less in relation to GNP than might ordinarily have been expected in a year of rather buoyant economic activity, the thrust of central government fiscal policy in 1985 was moderately expansionary. In the broader general government accounts, because of the weight of provincial and municipal government transactions not directly affected by the shift in federal government policy, the fiscal impulse calculated for 1985 was also somewhat expansionary, although less than in the preceding two years.

The Outlook for 1986 and 1987

The projections for 1986 presented in Tables A16 and A17 of the Statistical Appendix are generally based on proposed and, in some cases, adopted budgets and medium-term fiscal plans. For the seven countries as a group they indicate a moderately contractionary thrust at the general government level and a somewhat more contractionary thrust at the central government level. On the basis of staff estimates consistent with the general assumption of “present policies,” a further contractionary impulse is indicated for 1987 at both the central and general government levels.

For the United States, the projections are based on the authorities’ “current services” estimates.⁵ Their estimates of the deficit on this basis have been revised downward substantially from those presented in the fiscal 1986 budget. Current services estimates for expenditures have been lowered, reflecting sizable reductions in estimates of defense spending and the first-year spending reductions required under the Gramm-Rudman-Hollings Act (described below). In deriving the projections for 1986, the staff has adjusted the U.S. authorities’ current services estimate for differing assumptions regarding economic growth, employment, inflation, and interest rate developments. According to the staff projections, the federal government deficit (on a “unified budget” basis) would decline by about 1 percentage point to 4¾ percent of GNP in 1986. With little change in the U.S. cyclical position, the thrust of fiscal policy would thus turn contractionary for the first time since 1979. This prospective shift is mostly attributable to cuts in spending and to a reduction in interest rates. Revenue is also projected to increase at a marginally faster rate than GNP, and thus, to impart some contractionary impulse. This essentially reflects the elasticity of the tax system, rather than new discretionary measures.

The overall fiscal deficit at the general government level is expected to remain unchanged in 1986 at about 3½ percent of GNP. An expansionary impulse emanating from the state and local government sector would offset the withdrawal of stimulus by the central government. (Part of the difference between the two “impulse” estimates is also due to differences in coverage between the “unified budget” and the national income accounts, as well as to timing differences between cash transactions and accruals in the federal government account.)

For the other six countries as a group, the 1986 projections indicate little change in the composite fiscal stance. In Japan, the projections for 1986, which are based on the authorities’ budget proposals (with some adjustment) and estimates made by the staff, reflect the expectation of continued efforts to reduce the budget deficit and a further withdrawal of stimulus equivalent to ½ of 1 percent of GNP at either level of government. The Japanese authorities continue to stress the containment of expenditures in a situation featuring strong growth of “entitlement” spending. Social security transfers, in particular, are growing rapidly in response to demographic factors and increasingly wide eligibility of the elderly for pensions. Against this background, containing total expenditures implies that growth in discretionary outlays will have to be especially firmly restrained. Implementation of such an expenditure policy would mean that the steady rise in revenue, which is expected to add about¼ of 1 percentage point to the revenue-GNP ratio, would produce an equivalent withdrawal of stimulus. For the most part, this prospect reflects the elasticity of the tax system, rather than any significant new discretionary measures.

In the Federal Republic of Germany, the 1986 budget has been formulated in line with the authorities’ commitment to medium-term fiscal consolidation. The overall budget deficit is projected to decline by about ¼ of 1 percent of GNP at both levels of government, notwithstanding a larger relative decline in revenue (½ of 1 percent in relation to GNP) due to implementation of previously announced measures of personal income tax relief. The strengthening of the financial position is to be effected by restricting the growth in general government expenditure so as to lower the total by about 1 percent in relation to GNP. This result would reflect above-trend growth in GNP, as well as some futher decline in the underlying share of government expenditure in total output. After allowance for cyclical factors, the withdrawal of stimulus from the expenditure side does not appear to be quite enough to offset the expansionary thrust originating from the revenue side. Accordingly, the overall fiscal impulse is expected to be slightly expansionary, both at the central government level and for the entire general government sector.

In France, the principal objective of the central government’s financial policy in 1986 will again be to limit the budget deficit to 3 percent of GDP. This objective is to be achieved through absolute reductions in some types of outlays and by reducing the real growth rates of other categories of discretionary expenditure. This expenditure restraint would more than offset the effects of a decline in the ratio of revenue to GDP, reflecting, inter alia, an income tax reduction. The net effect at the central government level is expected to be marginally contractionary after cyclical adjustment. At the general government level, the appreciably lower rate of inflation now in prospect will help to lower the rate of increase in social security transfers. The contractionary impulse from the expenditure side will be offset by a fall in the ratio of revenue to GDP stemming from income tax reduction and less rapid growth of social security revenues, and both the stance of fiscal policy and the deficit will be unchanged.

The projections for the United Kingdom are based on the 1986/87 budget made public on March 18, 1986. In 1986, the budget deficit (national income accounts basis) at the central government level is projected to decline slightly as a percentage of GDP. Central government receipts are forecast to fall by almost 1½ percentage points of GDP, with oil revenues dropping sharply and non-oil revenues rising by slightly less than the forecast growth in GDP. Overall, central government outlays are projected to decline by a somewhat greater amount, with the growth in real expenditure held to about 1½ percent. On balance, the contractionary effect of the expenditure restraint would not be large enough to offset the stimulus from slower revenue growth, and the overall thrust of fiscal policy at the central government level would be slightly expansionary in 1986 (equivalent to about¼ of 1 percent of GDP). In the 1985/86 budget, the authorities had penciled in a “fiscal adjustment” for 1986/87, amounting to about 1 percent of GDP in terms of possible reductions in personal income taxes. In the event, the steep drop in oil prices absorbed most of the scope for such reductions, and the actual budgeted cut—a 1 percentage point drop in the basic rate of income taxation—is less than one third of the originally envisaged amount. The staff forecast for 1987 assumes further steps along these lines. A broadly similar picture to that sketched above emerges by focusing on the transactions of the general government.

For Italy, the projections are based on the authorities’ “current trends” estimates, with adjustments for the deficit-reducing measures included in the proposed budget, for the effects of income tax reform, and for expected delays in budget implementation. The central government deficit in 1986 is expected to decline to about 15 percent of GDP, from 16 percent of GDP in the preceding year, which would be about 1 percentage point above the authorities’ target. The ratio of revenue to GDP is expected to grow by ½ of 1 percentage point, more than offsetting the structural growth of expenditure. A relatively contractionary impulse is thus implied, and is expected to be reflected also at the general government level. The projected increase in the relative magnitude of government revenue is partly attributable to tax measures proposed in the budget, including those to increase social security contributions and local taxes.

The 1986 projections for Canada are based on the authorities’ latest estimates as announced in the federal budget of February 1986, with adjustments for differing staff assumptions with respect to growth, inflation, and interest rates. The fiscal deficit is expected to decline by about 1½ percentage points in relation to GNP at the central government level and by almost 2 percent at the general government level. The declines reflect a modest increase in taxes, as announced in the budget of February 1986, and the full-year effects of expenditure restraints and revenue measures contained in the May 1985 budget that will greatly exceed the part-year effects reflected in the 1985 outturn. Deceleration of expenditure growth will result mainly from cuts in federal government employment. In relation to GNP, however, part of the decline in expenditure is expected to stem from a sizable drop in unemployment insurance benefits and other cyclical influences. With allowance for these factors, the overall contractionary impulse imparted to the Canadian economy is projected to be about 1¼ percent of GNP at both the central and general government levels.

For 1987, highly tentative staff projections of the central government fiscal balances of major industrial countries indicate a contractionary composite fiscal thrust equivalent to about¾ of 1 percent of GNP. This would include significant moves toward restraint in the United States, Japan, Italy, and Canada, while fiscal impulses in the Federal Republic of Germany, France, and the United Kingdom are projected to be moderately contractionary or expansionary. The projections for the United States are based on the working assumption that significant cuts in expenditure would be made in relation to the staff’s estimate of the current services deficit for 1987; however, the projections assume that less than half of the potentially very large spending cuts implied by the recently adopted “Gramm-Rudman-Hollings” legislation, described in the following subsection, will be implemented. The full implementation of the cuts provided for under this legislation would imply a further significant reduction of the federal budget deficit in 1987. The contractionary impulse in the United States would be 0.6 percentage points greater than indicated in Statistical Appendix Table A16, and the combined contractionary impulse for all seven major industrial countries would be greater by about¼ of 1 percentage point. The 1987 projections at the general government level (Statistical Appendix Table A17) broadly parallel those for the central government in all countries.

The “Gramm-Rudman-Hollings” Legislation in the United States

On December 12, 1985, the President signed legislation—the Balanced Budget and Emergency Deficit Control Act of 1985 (widely known as the “Gramm-Rudman-Holiings” Legislation)—stipulating that the federal budget deficit, which reached $210 billion in fiscal year 1985, must be reduced in each fiscal year from fiscal year 1986 to fiscal year 1991 to attain a balanced budget in the latter year. The maximum deficit amounts specified in the Act are shown in the following tabulation:

Fiscal Year	Maximum Deficit (In billions of dollars)
1986	171.9
1987	144.0
1988	108.0
1989	72.0
1990	36.0
1991	—

View Table

Fiscal Year	Maximum Deficit (In billions of dollars)
1986	171.9
1987	144.0
1988	108.0
1989	72.0
1990	36.0
1991	—

The Act provides that automatic spending cuts would be triggered if the Administration and Congress are unable to reach agreement on measures that would achieve these targets. With the exceptions of fiscal years 1986 and 1991, the deficit may exceed the target by up to $10 billion without triggering the mandatory spending cuts; once triggered, however, those cuts must be sufficient to bring the deficit down to the target for that year. For fiscal year 1986, the reduction in outlays is limited by the Legislation to a maximum of $11.7 billion regardless of the amount by which the projected deficit for that year exceeds the maximum; no leeway is allowed for fiscal year 1991.

The first step in the process of expenditure reduction will involve the presentation of a joint report, on August 20 of each year, by the Office of Management and Budget and the Congressional Budget Office to the Comptroller General, who is head of the General Accounting Office. The reports are required to provide:

• (1) estimates of the amount by which the projected deficit exceeds the maximum deficit for the fiscal year covered by the report;

• (2) a set of economic assumptions, including the estimated rate of real economic growth in the fiscal year covered by the report; and

• (3) calculations of the percentages and amounts by which various budget categories must be reduced to eliminate any difference between the projected deficit and the maximum deficit.

The Comptroller General will then review the joint report and issue his own report on August 25 to the President and to the Congress; this report should either confirm or modify the estimates provided by the Office of Management and Budget and the Congressional Budget Office. An order by the President implementing the spending cuts specified by the Comptroller General must be issued on September 1, 1986. Unless Congress acts—and the President agrees—to modify the spending reductions in the Comptroller General’s report by adopting an alternative deficit reduction plan (which could include tax increases as well as alternative spending cuts), the expenditure reductions will take effect on October 1. Any Congressional action taken during September to reduce the gap between the estimates and the maximum allowable deficit will be reflected in a final Presidential order to be issued on October 15, 1986.

Special procedures are to be followed in the event of a recession. Specifically, the Director of the Congressional Budget Office must notify Congress at any time:

• (1) if during the current and preceding quarter, and with respect also to the four quarters following the notification, the Congressional Budget Office or the Office of Management and Budget has projected real economic growth to be less than zero in two consecutive quarters within this six-quarter period; or

• (2) if the Department of Commerce reports that actual real economic growth for the most recent and immediately preceding quarter is less than 1 percent.

Upon receiving such notification, both Houses of Congress will suspend the obligation to achieve the maximum deficit target for the current fiscal year and the next fiscal year, as it applied to Congressional budget resolutions and the President’s budget submissions.

Certain federal programs and activities are exempt from mandatory cuts under the Act. These include social security benefits, veterans’ compensation and pensions, regular state unemployment insurance benefits, medicaid, aid to families with dependent children, food stamps, supplemental security income, and interest on the federal debt. Certain other programs, while not exempt, are subject to special rules limiting the extent of the cuts. For example, programs such as medicare and veterans’ medical care cannot be cut by more than 1 percent in fiscal year 1986 and 2 percent in subsequent fiscal years. Programs with provisions for annual cost of living adjustments, such as pensions, can be cut by no more than the total cost of living adjustment in any one year.

The Act requires that 50 percent of the mandatory cuts come from domestic programs and 50 percent from the defense budget. For fiscal year 1986 only, the Act gives the President authority to exempt all or part of military personnel from cuts; he has chosen to use this authority, and has exempted 93 percent of the fiscal year 1986 appropriations in this area from cuts. The Act also permits the President (for fiscal year 1986 only) to adjust to a limited extent the percentage reductions for particular programs within a given category of defense spending. Except for these special provisions applying to fiscal year 1986, and subject to the exemptions and limitations described above, all programs must be cut on a uniform percentage basis, computed separately for defense and nondefense programs.

For fiscal year 1986, the average of the deficits recently estimated by the Office of Management and Budget and the Congressional Budget Office is $220.5 billion. As indicated above, the Act limits spending reductions to $11.7 billion for the current fiscal year. This figure reflects the fact that the Act restricts deficit reduction measures to a maximum of $20 billion at an annual rate for fiscal year 1986; as the reductions will not take effect until March 1, 1986, the maximum deficit reduction is seven twelfths of $20 billion. The President’s order specifying these cuts was issued February 1, 1986.

On February 7, 1986, a federal court ruled that a crucial provision of the Balanced Budget and Emergency Deficit Control Act of 1985 (the “Gramm-Rudman-Hollings” law) was unconstitutional because it violated the separation of powers among the three branches of government. The court stated that powers conferred by the law on the Comptroller General as part of the provision for the automatic spending reductions were executive powers that could not be exercised by an official who is removable by Congress. The court stayed the effect of its order pending the outcome of an appeal to the Supreme Court.

Calculation of Fiscal Impulse and Fiscal Data Base

This section provides a brief description of how the “fiscal impulse” measure is derived from the “cyclically neutral budget” model, and of the fiscal data used in the analysis undertaken earlier in this Note. The “cyclically neutral budget” technique involves a distinction with respect to government revenues and expenditures between changes considered to be associated with cyclical fluctuations in the output of an economy and other changes, which may be viewed as imparting expansionary or contractionary impulses to the economy independently of the more or less automatic responsiveness of government transactions to cyclical developments. Revenue is regarded as cyclically neutral when it grows in proportion to actual GNP at current prices, and is contractionary (expansionary) when it increases faster (more slowly) than actual GNP. Expenditure other than unemployment insurance benefits is regarded as cyclically neutral if it parallels the movement of potential GNP at current prices, and is expansionary (contractionary) when it increases faster (more slowly) than potential GNP. Year-to-year variations in unemployment insurance benefits are viewed as cyclically neutral—that is, merely reflecting cyclical developments in the economy.⁶ The net “impulse” from changes in revenue and expenditure (that part of any net change in the fiscal balance that cannot be attributed to “cyclically neutral” changes in revenue or expenditure) may be interpreted as a cyclically adjusted indicator (according to the criteria just specified) of stimulative or restrictive shifts in government fiscal operations.⁷ Such changes may be viewed as policy determined either (1) by the introduction of new measures or (2) by the operation of previously existing measures that automatically result in revenue (expenditure) changing disproportionately to the change in GNP (potential GNP) by which “neutrality” is judged.

The fiscal impulse measure, as defined above, differs from the measure of “discretionary changes” in budget items employed by the Organization for Economic Cooperation and Development in its Economic Outlook reports. The latter measure is calculated by deducting from the change in the fiscal balance the estimated effect on the budget of the operation of automatic stabilizers. The deduction is based on structural estimates of the automatic responsiveness of revenue and expenditure to cyclical fluctuations in real output, rather than on equiproportionate revenue and expenditure rules.

The fiscal impulse measure also has not taken account of the potentially different aggregate demand effects associated with increases in noninterest expenditure or decreases in revenue as opposed to increases in expenditure due to the effects of inflation on interest payments. In a situation of increasing inflation, nominal interest rates may rise sharply, leading to a significant increase in interest payments and a deterioration in the fiscal position. It has been argued that the implicit amortization component of these interest payments (reflecting the erosion of outstanding debt, in real terms, through inflation) has a much weaker impact on aggregate demand than other types of expenditure or revenue measures. The appropriate adjustment of the fiscal balance for the effects of inflation is itself a matter of controversy, but the effects of such adjustments on the measure of fiscal impulse are likely to be important only in periods when the inflation rate accelerates or decelerates rather sharply. If movements in the expected inflation rate could be assumed to closely parallel movements in the actual inflation rate, then adjustment of the fiscal impulse measure for the effects of inflation would impute a more expansionary (contractionary) character to fiscal policy in a period of declining (increasing) inflation than would be implied by the unadjusted fiscal impulse measure.

The data on central government fiscal balances shown in Statistical Appendix Table A16 generally conform to the standards used in the Fund’s Government Finance Statistics Yearbook, which call for the recording of government transactions on a cash basis and the classification of net government lending (loan disbursements less repayments) with expenditures rather than with financing. For the United Kingdom and Canada, however, and for Japan (in large part), the data are on a national income accounts basis; for the Federal Republic of Germany and France, the data are on an administrative basis and do not incorporate social security transactions in the latter case; and for Italy, the data cover the transactions of the state budget as well as those of several government-owned enterprises but, instead of including the gross revenue and expenditure transactions of social security institutions, include only net transfers from the central government to these institutions. The data on general government fiscal balances, in Statistical Appendix Table A17, cover the consolidated balances of central, regional, and local government units engaged in performing governmental functions but exclude government-owned industrial and commercial enterprises. These data are on a national income accounts basis, and thus exclude net government lending from expenditure. The data in Statistical Appendix Tables A16 and A17 are derived from national sources and Fund staff estimates. The base year for the calculation of the fiscal impulse is 1978. In general, definitions and statistical sources used are the same as in the April 1985 World Economic Outlook exercise except for the Federal Republic of Germany and the United Kingdom. The central government data on Germany have been shifted from a cash to an “administrative” basis in order to remain in agreement with government practice, which first introduced the shift. In addition, the data on growth of potential output in Germany have been revised to take account of new estimates reported by the Bundesbank. The figures related to the Central Government of the United Kingdom have been changed from a cash to a national accounts basis; this shift has been introduced to facilitate the interpretation and forecasting of central government finances in view of recently observed wide and erratic fluctuations in central government net lending to other entities within the public sector. In addition, several other fiscal data series for both central and general government and some of the GNP series have been revised since the publication of the World Economic Outlook, April 1985.

Country Notes

United States—The monetary growth ranges set at the beginning of 1985 were kept substantially the same as in 1984, and were judged to be consistent with “further sustainable economic growth and progress toward reasonable price stability over time.”² At the time it was formulating its 1985 objectives, the Federal Open Market Committee projected that both real GNP and the GNP deflator would increase by 3½ percent to 4 percent during 1985, and it was also assumed that the monetary aggregates would not be appreciably influenced by any new statutory or regulatory developments. In setting a target range of 4-7 percent growth for M1, account was taken of the behavior of M1 velocity during 1984, together with other evidence, which suggested that “the factors responsible for the highly unusual velocity behavior over 1982 and early 1983 have receded.”³ Moreover, in setting growth targets of 6-9 percent for M2 and 6-9.5 percent for M3, it was recognized that a large continuing net capital inflow from abroad might tend to slow the growth of certain components of M2 and M3, thereby restraining the growth of these aggregates in relation to bank credit and credit generally.⁴

As shown in Chart 32, at the time that the Federal Reserve submitted its Monetary Policy Report to the Congress in February 1985, all three monetary aggregates were above the upper bands of their target ranges, as traditionally indicated by growth cones projected from the base-period levels that prevailed in the fourth quarter of 1984. “As a matter of economics and policy, rather than graphics,” however, the Federal Open Market Committee was “not disturbed” by that development; Chairman Volcker indicated to Congress that the aggregates remained within “parallel lines drawn back from the outer bounds of the specified fourth quarter (1985) target ranges to the base period,” and that the Committee contemplated that “as the year progresses, growth will slow consistent with the target ranges.”⁵ At mid-year, however, only M2 and M3 had been brought back within their cones. By that time, interest rates had drifted lower as industrial output remained little stronger than a year earlier, and the Federal Open Market Committee had lowered by roughly 1 percentage point its projections for both real and nominal GNP growth during 1985. In re-examining its targets in July, the Committee expected that the sharp decline in M1 velocity during the first half of the year would be neither extended nor substantially reversed in the second half; however, the high degree of uncertainty surrounding the behavior of M1 velocity was explicitly recognized. Reflecting these various considerations, the base for the target range for M1 was shifted forward to the second quarter of 1985, and the range itself was widened to 3-8 percent for the second half of the year.

Over the next several months, however, M1 continued to grow rapidly. At the October meeting of the Federal Open Market Committee it was suggested that “the recent strength in M1 could not be explained fully by such factors as institutional changes and financial innovations” but should be judged “in the context of the performance of the economy and the relatively moderate growth in the broader aggregates.”⁶ Accordingly, it was decided not to react aggressively to M1 growth above the upper bound of the rebased target range.

For 1985 as a whole, M1 in the United States expanded by nearly 12 percent (fourth quarter 1984 to fourth quarter 1985), while the growth rates of M2 and M3 were held within their target ranges. Nominal interest rates continued to decline in 1985 and early 1986, most markedly for long-term maturities, and the Federal Reserve lowered its discount rate by ½ of 1 percentage point in May 1985 and by another ½ point in early March 1986. The monetary targets for 1986, as adopted in February, have retained the 6-9 percent range for M2 growth while narrowing the M3 range slightly, also to 6-9 percent. The range for M1 was set at 3-8 percent, the same as the revised range that the Federal Open Market Committee adopted last July for the second half of 1985.

Federal Republic of Germany—In 1985, monetary developments in the Federal Republic of Germany were consistent with the plans established by the authorities at the end of 1984. For the period from the fourth quarter of 1984 to the fourth quarter of 1985, the Central Bank Council had indicated a target range of 3-5 percent for the growth of central bank money. This range was based on projections that both potential output and prices would increase about 2 percent. No allowance for a change in the velocity of circulation was included. During the target period, central bank money expanded at a seasonally adjusted annual rate of about 4½ percent, toward the top end of the target corridor (Chart 32) and much the same as the rate experienced in 1984.

Both short-term and long-term interest rates declined steadily from March until August-September 1985 (Chart 33). These declines reflected a number of factors, including the continued slowing of domestic inflation and strong foreign demand for deutsche-mark-denominated financial assets. Although German interest rates declined by somewhat less than comparable U.S. dollar interest rates during this period, the reduction in market interest rates had created a situation by mid-August in which the Bundesbank was able to lower both its discount and Lombard interest rates by ½ of 1 percentage point to 4 percent and 5.5 percent, respectively. German interest rates increased somewhat in the fourth quarter of 1985, but began to decline again in 1986. In early March 1986, the Bundesbank reduced its discount rate by another ½ of 1 percentage point to 3.5 percent.

In December 1985, the Deutsche Bundesbank set a new target range of 3.5-5.5 percent for the growth of central bank money for the period from the fourth quarter of 1985 to the fourth quarter of 1986. This target range is based on an estimated potential real output growth of 2.5 percent in 1986 and a projection of around 2 percent for underlying price inflation. The target range does not make any allowance for changes in the income velocity of central bank money.

During 1985, the monetary authorities also took measures to increase the competitiveness of the German financial markets. In May, for example, the range of assets available on German markets was expanded with the admission of various new financial instruments (such as floating rate notes, zero-coupon bonds, dual-currency bonds, and bonds linked to currency and interest rate swaps), which had previously been excluded. Moreover, in December, the Central Bank Council recommended a reduction and restructuring of reserve ratios, having the effect of reducing the reserves credit institutions are required to hold by about DM 8 billion. As part of these changes, liabilities in foreign currencies to non-residents will largely be freed from the minimum reserve requirement, but certain newly issued bank bonds with an original maturity of less than two years will be subjected to minimum reserve requirements. In addition, the Bundesbank indicated that it would not object if credit institutions domiciled in the Federal Republic of Germany issued deutsche-mark-denominated paper having the character of certificates of deposit.

Japan—In recent years, monetary policy in Japan has attempted to influence interest rates and the growth of money and credit through intervention in the money markets and through variations in the discount rate. While credit ceilings are still a potential instrument of monetary control, they have not been used for several years. The change in the implementation of monetary policy reflects the evolution of the Japanese financial market that has occurred in response to a gradual process of financial deregulation. In the past two years, this has included the liberalization of the foreign exchange market (for example, by increasing the scope of transactions that could be undertaken by foreign exchange banks and currency brokers), the introduction of new financial instruments (such as bankers’ acceptances, bond futures, and money market certificates), expansion of the Euroyen bond market, and allowing foreign financial institutions improved access to Japanese markets. As a result, market forces have played an increasingly important role in the determination of domestic interest rates, and the linkages between Japanese and international financial markets have been strengthened.

The Japanese authorities have regarded movements in the broad money stock (M2 + CDs) and interest rates as the primary indicators of monetary conditions. The demand for M2 +CDs is regarded as more stable than that for narrower aggregates, while data for even broader aggregates are available only with longer reporting lags.⁷ Although there is no formal targeting of monetary aggregates, the Bank of Japan announces in the first month of each quarter a projection, with a loosely specified range, for the year-on-year growth of M2 + CDs measured from the same quarter of the previous year. The Bank of Japan’s projection for the first quarter of 1986 was 9.0 percent. In general, actual growth rates have been in line with official forecasts (Chart 32).

M2 + CDs expanded by 9 percent during 1985 in contrast to an average of approximately 7½ percent during the previous three years (Table 25). During much of last year, however, the primary focus of monetary policy was on exchange rate objectives. The sharpest change in monetary conditions during the year occurred following the September 22 Group of Five meeting, at which the five largest countries expressed themselves in favor of an orderly appreciation of non-dollar currencies (including the Japanese yen). The Bank of Japan decided not to sterilize the shortage of funds in the interbank market that resulted from its intervention in foreign exchange markets, and also decided not to accommodate the seasonal increase in the demands for funds in the domestic money market. As a result, short-term interest rates increased by 1-1½ percentage points by the end of October, effectively eliminating the short-term differential between nominal interest rates on Japanese and U.S. assets. This rise in short-term interest rates, however, was more than reversed by early 1986 as the yen strengthened further and the Bank of Japan reduced its discount rate by ½ percentage point in order to support domestic demand. The discount rate was reduced ½ of 1 percentage point further in early March.

United Kingdom—Since fiscal year 1980/81, monetary policy in the United Kingdom has been formulated in the context of a medium-term financial strategy designed to achieve lower rates of inflation through a progressive lowering in the growth rates of the targeted monetary aggregates. The specific set of targeted aggregates has varied with changes in their perceived usefulness as indicators of monetary conditions during a period of extensive financial liberalization. In addition, various supplementary indicators, including the exchange rate, have been taken into account in interpreting financial conditions and in determining interest rate policy. The budgets for fiscal years 1985/86 and 1986/87 reaffirmed the Government’s commitment to the medium-term financial strategy and to maintaining monetary conditions consistent with declining growth of nominal GDP and inflation, with short-term interest rates to be set at levels needed to achieve this objective.

For fiscal year 1984/85, the authorities had adopted £M3 as the sole broad money target, while the wide monetary base MO was introduced as the target for narrow money.⁸ In accordance with the medium-term financial strategy, the target ranges for 1984/85 were set at 4-8 percent annual growth for MO and 6-10 percent for £M3, and it was projected that by fiscal year 1988/89 these target ranges would decline to 0-4 percent annual growth for MO and to 2-6 percent annual growth for £M3. In the 14 months to April 1985, MO grew within its target range at an annual rate of 5.7 percent, while £M3 grew somewhat above its target range at an annual rate of 11.9 percent (Chart 32).⁹ In the new budget year, the growth rates of the two aggregates began to diverge more strikingly: MO grew at an annual rate of 3.5 percent in the 12 months to February 1986 (compared with its 1985/86 target range of 3-7 percent), while £M3 grew by 14.8 percent (compared with its target range of 5-9 percent).

The authorities attributed the strong growth of £M3 to a permanent shift in the demand for broad money, reflecting developments in financial markets arising from decontrol of the banking system and the restoration of positive real interest rates during the early 1980s. The associated downturn in velocity had not been sufficiently factored into the fiscal year 1985/86 target range for £M3, and with financial liberalization having altered the usefulness of the broad aggregates as indicators of financial conditions, the authorities downgraded the role of £M3 and upgraded that of the exchange rate. This development was foreshadowed in January 1985 by the abandonment of the “decoupling policy,” which had focused interest rate policy almost exclusively on domestic indicators and objectives. At that time, the authorities allowed short-term interest rates to rise by 4½ percentage points to 14 percent in order to halt the depreciation of the pound relative to the U.S. dollar. Subsequently, as the pound strengthened, interest rates were allowed to decline by 2½ percentage points, despite the overshooting of the £M3 target.

In January 1986, amid falling oil prices, renewed downward pressure on the pound and the continued buoyancy of bank lending prompted the authorities to let base interest rates rise by 1 percentage point. Despite further easing of the exchange rate and upward pressure on interest rates, a further increase was resisted. While the authorities are paying close attention to the exchange rate as an indicator of monetary conditions, they do not have an exchange rate target. Indeed, they appear willing to countenance declines in the effective value of sterling associated with falling oil prices to the extent that the effects of the two factors on the inflation rate are broadly offsetting.

In mid-March 1986 the authorities released their budget for 1986/87, including new monetary target ranges. The target ranges for fiscal year 1986/87 were set as annualized growth rates of 2-6 percent for MO and 11-15 percent for £M3. The day after the budget was released, base interest rates were reduced by 1 percentage point.

France—In 1985, inflation and interest rates in France continued the declines that began several years earlier. Measured by the consumer price index, inflation has fallen continuously from over 13 percent in 1981 to less than 5 percent from fourth-quarter 1984 through fourth-quarter 1985. Since 1981, both short-term and long-term nominal interest rates have been reduced by more than 5 percentage points. Because inflation and nominal interest rates have moved together in the period since mid-1983, however, real interest rates have generally remained within the range of 4-6 percent.

In 1984, the French authorities began to formulate their monetary target in terms of M2R (M2 held by residents), rather than total M2.¹⁰ In that year, M2R growth somewhat exceeded the upper bound of the target range of 5.5 to 6.5 percent (Chart 32). For 1985, monetary policy was again formulated in terms of M2R and the target growth rate range was set at 4-6 percent. During the first half of 1985, the expansion of M2R generally exceeded the upper bound, and this led the authorities to take measures in June designed to restrict the extension of credit by banks and to restrain capital inflows through the balance of payments. These measures included a lowering of the limits on bank lending not subject to penalty rates, holding down new foreign borrowing, and encouraging the private sector to repay foreign debt in advance of maturity.

In order to reflect recent financial innovations and institutional changes in the banking system, such as the introduction of instruments similar to claims on money markets funds, the authorities have chosen to change their definitions of the monetary aggregates from a classification based on institutional criteria to a new system based on the nature and the substitutability of the financial assets involved. The authorities have adopted the redefined concept of M3 as the target aggregate for 1986.¹¹ The 1986 target range has been set at 3-5 percent, 1 percentage point lower than the 1985 target range for M2R, to indicate the continuing commitment of the authorities to reduce inflation.¹² The authorities have also reiterated their intention to move away from the present system of credit controls toward a system based on the control of interest rates, in order to give market forces more influence on the allocation of credit.

Canada—From 1975 until late 1982, the Canadian monetary authorities set a specific target range for the growth of M1 as a policy guide in their attempts to achieve sustained economic expansion and long-term price stability. In November 1982, however, the Bank of Canada abandoned the practice of monetary targeting. It was felt that the relationship between the monetary aggregates (particularly M1), nominal income, and interest rates had become unstable as a result of financial innovations (such as the introduction of interest-bearing checkable accounts and the wide spread availability of cash management facilities for businesses). These innovations in the financial sector led to a shift of funds from accounts classified as part of M1 (currency and non-interest-bearing demand deposits) into deposits bearing market-related interest rates.¹³ As a result of the inflows into these types of deposits, there was a sharp divergence between the rates of growth of M1 and M1A (which includes interest bearing checking accounts). While M1 increased at an annual average rate of 3.3 percent during 1981-84 (Table 25), the average rate of growth for M1A was 12.0 percent. Consequently, after mid-1981 the income velocity of M1 increased, while that of M1 A declined. Since its decision to abandon monetary targeting, the Bank of Canada has implemented its monetary policy with reference to a variety of economic and financial indicators, including in particular the exchange rate between the Canadian dollar and the U.S. dollar.

During 1985, the sharp divergence between the growth rates of M1 and M1A continued, but the growth of both aggregates accelerated substantially relative to their earlier pace. M1 and MIA expanded by 9.4 percent and 38.3 percent, respectively, in 1985, having grown by 0.3 and 21.7 percent, respectively, in 1984. The authorities attributed the acceleration of the growth of M1A to an ongoing substitution of interest bearing checking accounts for other types of deposits. In addition, the more rapid growth of M1 since mid-1985 has been associated in part with changes in the amount of bank float (that is, changes in the amount of checks and other items that have been deposited or cashed but not yet debited from the accounts on which they were drawn).

Under current conditions, one aim of monetary policy has been to try to reduce interest rates so as to promote economic expansion, provided these interest rate movements do not conflict with the objectives of maintaining a reasonably stable exchange rate and low inflation. Thus, when confronted with the downward pressure on the Canadian dollar that resulted from an increase in U.S. interest rates in the first half of 1984, the Canadian authorities allowed domestic interest rates to increase. Similarly, in early 1985, Canadian interest rates, especially short-term rates, were allowed to rise as U.S. interest rates firmed and the U.S. dollar strengthened relative to the Canadian dollar. However, the subsequent decline in U.S. interest rates permitted reductions to take place in Canadian rates also. As a result, average interest rates (both nominal and real) in Canada were about 2 percentage points lower in 1985 than in 1984.

In September 1985, two bank failures occurred (the first in Canada in more than sixty years). One of the banks involved had received considerable support in the form of an infusion of funds from federal and provincial governments and other Canadian banks. These failures led to liquidity problems in certain small Canadian banks as a result of large deposit withdrawals. However, the authorities felt that this episode did not threaten the financial position of the banking system as a whole and did not raise major problems for the implementation of monetary policy.

Italy—Although the Italian authorities do not announce targets for monetary aggregates in their management of monetary affairs, overall economic policy is based on plans that include projections for a broad range of monetary and credit aggregates, including total domestic credit and its components and the financial assets held by the private sector. Since the beginning of 1984, the authorities have sought to influence financial conditions through their policies regarding the monetary base and interest rates, rather than through direct controls over the availability of domestic credit.¹⁴ For 1985, the authorities’ plans included a continued deceleration in rates of monetary and credit growth. This was viewed as consistent with both a further reduction in inflation and some expansion of real output. However, the planned deceleration was achieved only for credit to the private sector, which is estimated to have grown by 12.6 percent in 1985 (15.6 percent in 1984).¹⁵ Credit to the state sector expanded by an estimated 21.7 percent in 1985 (22.8 percent in 1984), which was more than 2.5 percentage points above the projected increase of 19.0 percent. M2 is estimated to have increased by about 11.2 percent (the central projection was 10 percent), as the sharp loss in foreign reserves registered in the fourth quarter led to a marked slowdown of the monetary aggregates. The monetary base adjusted for the automatic increase in reserve requirements is projected to have grown by 14.6 percent, 4.6 percentage points above the initial target.

The major source of liquidity growth was the public sector deficit. As in several recent years, it was originally planned to keep the fiscal deficit unchanged in nominal terms. However, the state sector borrowing requirement is estimated to have been approximately 13 percent higher in 1985 than originally planned, and the deficit therefore rose to 16.0 percent of GNP instead of the originally projected 14.4 percent. Similar difficulties in controlling the size of the public sector deficit have been experienced during most of the 1980s.

Although the central bank no longer has a legal obligation to underwrite the public sector deficit, it was felt that financing the larger than anticipated deficit through the issuance of nonmonetary obligations would require increases in interest rates that were not warranted in the face of an already weak demand for credit by the private sector. In 1985, 26 percent of the public sector deficit was financed by credit extended by the Bank of Italy, against 11 percent in 1984. As a result, in 1985 central bank credit to the Treasury accounted for approximately 145 percent of the increase in the monetary base, against about 72 percent in 1984.

On average, both short-term and long-term interest rates in Italy were lower during 1985 than during 1984 (Chart 33). Short-term rates fell from slightly more than 17 percent in 1984 to about 15 percent in 1985, and long-term rates fell from 15 percent to around 13 percent during the same period. Given the concomitant reduction in inflation, however, real interest rates showed a much smaller decline, and began to rise again after the middle of 1985.

The authorities’ plans for 1986 envisage a 9.5 percent increase in credit to the private sector,¹⁶ along with a 9 percent increase in the stock of M2. Partly because of the recent decline in the cost of oil imports, it is envisaged that these growth rates for money and credit would support a 10.5 percent rise in nominal GNP. The deficit of the state sector is projected to increase somewhat in nominal terms but to decline to about 14½ percent as a share of GNP.

Review of 1985 and Outlook for 1986

Table 26 summarizes the sharp contrasts in the “velocity puzzles” that different central banks encountered in pursuing their 1985 monetary growth targets. In the Federal Republic of Germany and Japan, the changes in velocity during 1985 were similar to the 1984 experiences. In France, the apparent decline in M2R velocity during 1985 (based on incomplete data) more closely resembled the average 1970-85 experience than the experiences of 1983 and 1984, and it appears that the 1985 monetary growth target was exceeded (Chart 32). For each of the targeted aggregates in the United States, and for sterling M3 in the United Kingdom, the sharp declines in velocity contrasted strongly with both the 1984 experiences and the average annual changes over the period since 1970. To some extent, the velocity declines in the United States may have reflected the lower level of interest rates. In any case, however, the rapid growth of money demand relative to nominal GNP led the authorities during the course of the year to stop aiming at the M1 target in the United States and the sterling M3 target in the United Kingdom.

Table 26.

Five Major Industrial Countries: Recent and Implied Changes in Annual Velocities of Targeted Aggregates, 1970-85¹

(In percent per annum)

¹The definitions of monetary aggregates used in this table are those employed by the monetary authorities of the individual countries. Velocity changes represent changes from year to year in the ratios of average annual money stocks to annual GNP levels; such changes do not correspond to velocity changes during policy periods.

²Percentage changes between implied velocity levels for the indicated year and actual velocity levels for the previous year. Implied velocity levels are based on the nominal GNP projections adopted in the World Economic Outlook and the average money stocks that would prevail during the year if money growth coincided with the upper or lower bounds of the target ranges. The actual changes in velocity may fall outside these bounds if the monetary aggregates do not grow in their target ranges or if the GNP projections are incorrect.

³1976-85.

⁴There is no formal targeting of monetary aggregates by the Bank of Japan. This calculation assumes that the projected rate of growth of M2 + CDs for the first quarter of 1986 is maintained throughout 1986.

⁵Based on incomplete data for 1985.

Table 26.

Five Major Industrial Countries: Recent and Implied Changes in Annual Velocities of Targeted Aggregates, 1970-85¹

(In percent per annum)

						Implied Velocity Change Assuming Monetary Growth Target:2
		Average Annual change	Yearly Changes			Upper bound	Lower bound	Upper bound	Lower bound	Target Ranges 1986
			1983	1984	1985	1985		1986
		(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)
United States		(1970-85)
	M1	2.3	-3.4	3.8	-3.0	1.3	3.1	-2.9	0.1	3-8
	M2	-0.3	-4.5	2.8	-3.0	-1.3	0.5	-1.9	-0.1	6-9
	M3	-1.4	-2.4	0.9	-3.2	-2.4	-0.4	-1.4	0.3	6-9
United Kingdom		(1970-85)
	M0	4.4	3.0	0.4	4.7	2.2	3.8	0.7	4.3	2-6
	M3	0.23	-1.8	-0.1	-2.7	-1.1	0.4	-7.3	-4.2	11-15
Germany, Fed. Rep. of		(1971-85)
	Central bank money	-0.7	-2.5	0.4	—	0.1	1.3	0.9	2.1	3.5-5.5
Japan		(1970-85)
	M2 + CDs	-2.3	-3.1	-1.3	-1.9	-1.8	-1.8	[-4.5]4	[-4.5]4	9.04
France		(1970-85)
	M2R	-0.6	1.0	0.5	-0.8	1.6	2.6	…	…	…
	M3	…	…	…	…	…	…	1.65	3.65	3-5

¹The definitions of monetary aggregates used in this table are those employed by the monetary authorities of the individual countries. Velocity changes represent changes from year to year in the ratios of average annual money stocks to annual GNP levels; such changes do not correspond to velocity changes during policy periods.

²Percentage changes between implied velocity levels for the indicated year and actual velocity levels for the previous year. Implied velocity levels are based on the nominal GNP projections adopted in the World Economic Outlook and the average money stocks that would prevail during the year if money growth coincided with the upper or lower bounds of the target ranges. The actual changes in velocity may fall outside these bounds if the monetary aggregates do not grow in their target ranges or if the GNP projections are incorrect.

³1976-85.

⁴There is no formal targeting of monetary aggregates by the Bank of Japan. This calculation assumes that the projected rate of growth of M2 + CDs for the first quarter of 1986 is maintained throughout 1986.

⁵Based on incomplete data for 1985.

View Table

Table 26.

Five Major Industrial Countries: Recent and Implied Changes in Annual Velocities of Targeted Aggregates, 1970-85¹

(In percent per annum)

						Implied Velocity Change Assuming Monetary Growth Target:2
		Average Annual change	Yearly Changes			Upper bound	Lower bound	Upper bound	Lower bound	Target Ranges 1986
			1983	1984	1985	1985		1986
		(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)
United States		(1970-85)
	M1	2.3	-3.4	3.8	-3.0	1.3	3.1	-2.9	0.1	3-8
	M2	-0.3	-4.5	2.8	-3.0	-1.3	0.5	-1.9	-0.1	6-9
	M3	-1.4	-2.4	0.9	-3.2	-2.4	-0.4	-1.4	0.3	6-9
United Kingdom		(1970-85)
	M0	4.4	3.0	0.4	4.7	2.2	3.8	0.7	4.3	2-6
	M3	0.23	-1.8	-0.1	-2.7	-1.1	0.4	-7.3	-4.2	11-15
Germany, Fed. Rep. of		(1971-85)
	Central bank money	-0.7	-2.5	0.4	—	0.1	1.3	0.9	2.1	3.5-5.5
Japan		(1970-85)
	M2 + CDs	-2.3	-3.1	-1.3	-1.9	-1.8	-1.8	[-4.5]4	[-4.5]4	9.04
France		(1970-85)
	M2R	-0.6	1.0	0.5	-0.8	1.6	2.6	…	…	…
	M3	…	…	…	…	…	…	1.65	3.65	3-5

¹The definitions of monetary aggregates used in this table are those employed by the monetary authorities of the individual countries. Velocity changes represent changes from year to year in the ratios of average annual money stocks to annual GNP levels; such changes do not correspond to velocity changes during policy periods.

²Percentage changes between implied velocity levels for the indicated year and actual velocity levels for the previous year. Implied velocity levels are based on the nominal GNP projections adopted in the World Economic Outlook and the average money stocks that would prevail during the year if money growth coincided with the upper or lower bounds of the target ranges. The actual changes in velocity may fall outside these bounds if the monetary aggregates do not grow in their target ranges or if the GNP projections are incorrect.

³1976-85.

⁴There is no formal targeting of monetary aggregates by the Bank of Japan. This calculation assumes that the projected rate of growth of M2 + CDs for the first quarter of 1986 is maintained throughout 1986.

⁵Based on incomplete data for 1985.

Columns (5) and (6) of Table 26 provide an alternative perspective of the contrasting velocity puzzles and macroeconomic conditions that different central banks encountered in 1985. These columns indicate the ranges for velocity that were implied a year ago by the monetary growth targets that had then been announced, in combination with the nominal GNP forecasts adopted in the World Economic Outlook, April 1985. The sharp declines in velocity that occurred during 1985 in the United States and for sterling M3 in the United Kingdom were substantially outside the ranges implicitly expected a year ago, as was the decline in M2R velocity in France. By contrast, the velocity change for MO in the United Kingdom exceeded the range of expectations held a year ago, while the velocity changes for central bank money in Germany and M2 + CDs in Japan were close to last year’s expectations.

Columns (7) and (8) of Table 26 project the velocity changes implied by combining the monetary target ranges that have been announced for 1986 with the staffs nominal GNP forecasts. It should be emphasized that the projections for GNP growth that are used in the construction of these columns are not those of the authorities, and that the year-over-year changes do not correspond to policy periods in any country. It is noteworthy, however, that the 1986 target ranges for the United States suggest that the velocities of all three targeted aggregates most likely will continue to decline, although at more gradual rates than during 1985, while the monetary targets for the United Kingdom imply a continuing sharp divergence of MO and M3 velocities. It may also be noted that for Japan, growth of M2 + CDs at the recent projection of 9.0 percent would (under WEO output projections) imply an unusually sharp decline in velocity, which has had a remarkably stable downward trend since the mid-1970s.

The variability of velocity in recent years, particularly in the United States, the United Kingdom, and Canada, and the decisions to de-emphasize or abandon certain monetary targets in those countries, has rekindled the debate over the appropriate conduct of monetary policy. The average inflation rate in the major industrial countries has now been reduced to little more than half of its level in the decade through 1976. With unemployment high and the global economy strained by a widespread need to grow out of severe debt burdens, it has been argued that the formulation of monetary policy in some countries should devote relatively higher priority to sustaining output and employment than could be done when inflation was the major short-run danger. Regardless of the extent of agreement on the desirability of promoting growth, however, there is disagreement both about the inherent ability of monetary policy to achieve this objective, and about the possible long-run inflationary consequences of attempting to do so.