AN EXAMINATION OF THE FEASIBILITY OF MEASURING NATIONAL INCOME FROM MONETARY DATA. APPROVEDs. Major Professor. fessor. Dean *of the Graduate School

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1 AN EXAMINATION OF THE FEASIBILITY OF MEASURING NATIONAL INCOME FROM MONETARY DATA APPROVEDs ^ Majr Prfessr fessr Chairman f the Department f Ecnmics Dean *f the Graduate Schl

2 AA-. Repass, William F., An Examinatin f the Feasibility f Measuring Natinal Incme frm Mnetary Data. Master f Science (Ecnmics), August, 1972, 139 PP 30 tables, bibligraphy, 60 titles. The ubiquitus grwth, in recent decades, f state cntrl and interventin in ecnmic affairs has necessitated mre cmprehensive systems f infrmatin n the perfrmance f natinal ecnmies. As natins were transfrmed int industrially advanced regins, their evlutin required a cncmitant recnstructin f ecnmic dctrine that had previusly stressed the principles f laissez-faire, a prime example being that f the United States. The cmplexity f scial, plitical and ecnmic frces underlying the peratin f the technically advanced regins n lnger permitted therists t view ecnmic systems as self-regulating mechanisms. "Mixed ecnmies" with resultant state planning were needed t synchrnize the activities f businessmen with the public well-being. In rder t direct the activities f gvernments, systems f natinal accunts were develped mre extensively t elucidate the functinal relatinships between majr cmpnents f the ecnmic systems. Nne f the preceding, hwever, shuld be interpreted t suggest that the underdevelped cuntries have nt cntributed t the need fr the develpment f natinal accunting systems. State interventin in these areas will almst certainly be the

3 rule in rder t prvide fr the cultural and ecnmic prerequisites t grwth, that is, t create climates cnducive t prgress by initiating prgrams t rid the ppulatins f debilitating diseases, and t prvide educatin fr the eradicatin f illiteracy, as well as ther cultural impediments t mdernizatin. In additin, gvernment participatin will be required t prvide the infrastructure systems f transprtatin, cmmunicatins, pwer facilities, etc.--which are initially unattractive investments fr the businessman, but nevertheless critical ingredients t grwth. It seems clear, then, that even fr cuntries f primitive ecnmic structure, t develp accunting systems which will reflect tempral changes in aggregate incme is indispensable t planning. Given the imprtance f statistics n aggregate utput, the purpse f the paper is t explre, mre fully, ne particular aspect f ecnmic accunting, measurement f natinal incme. Since data prblems ften inhibit attempts t measure natinal incme by cnventinal methds, particularly in less develped regins, the paper fcuses attentin n alternative techniques f measurement with majr emphasis n prcedures emplying mnetary data. In the first chapter, the uses, as well as the cncept f natinal incme, are discussed. The secnd chapter examines the theretical feasibility f measuring incme frm the mney stck and velcity. In the third chapter, natinal incme estimates fr frty-fur

4 cuntries cvering a perid f five years are generated frm data n the supply f mney and velcity emplying the techniques f multiple regressin analysis. The final chapter, then, brings theretical cncepts and practical applicatin int sharp relief thereby graphically illustrating the feasibility f estimating natinal incme frm mnetary data.

5 AN EXAMINATION OF THE FEASIBILITY OF MEASURING NATIONAL INCOME FROM MONETARY DATA THESIS Presented t the Graduate Cuncil f the Nrth Texas State University in Partial Fulfillment f the Requirements Fr the Degree f MASTER OF SCIENCE By William F. Repass, B. S. Dentn, Texas August, 1972

6 TABLE OF CONTENTS LIST OF TABLES Page iv Chapter I. INTRODUCTION 1 The Uses f Natinal Incme Statistics The Cncept f Natinal Incme II. THEORETICAL FEASIBILITY OF MEASURING NATIONAL INCOME FROM MONETARY DATA 12 Theretical Justificatin Theretical Limitatins Incme Studies III. NATIONAL INCOME ESTIMATION 47 Methdlgy Variables Emplyed Natinal Incme Estimates} Develped Cuntries Underdevelped Regins Develped and Less Develped Regins IV. CONCLUSION 85 APPENDIX 89 BIBLIOGRAPHY 135 iii

7 LIST OF TABLES Table I. II. III. IV. VI, VII, VIII, IX, XI XII XIII Accuracy f Statistics: Varius Regins. Estimating Equatins fr Natinal Incme Expressed in Internatinal Units, 1937 Natinal Incme, 1937 Velcity f Mney fr the United States, Net Natinal Prduct in Current Prices, 183^-181*3 Reprted and Calculated Incmes fr Selected Cuntries, Simple Crrelatin f Eight Variables n Natinal Incme, ^..... Estimating Equatins Reprted and Estimated Natinal Incme fr Cuntries Used in Deriving the 196^ Estimating Equatins Natinal Incme Estimates fr Selected Underdevelped Cuntries, 19 6k Simple Crrelatin Cefficients Between the Lgarithms f Mney Supply, Velcity and Exprts, Develped Cuntries, 196^ Estimating Equatins: Develped Cuntries.. Simple Crrelatins Between Mney Supply in Relatin t Exprts and Velcity, Develped Cuntries, ls6k-1968 *.... Page 8 13 lfc kl **3 k iv

8 LIST OF TABLES Cntinued Table XIV. Estimated and United Natins Natinal Incme Prjectins fr the Develped Cuntries Used in Deriving the Estimating Equatins, 1968 pjgg 6l XV. Simple Crrelatin Cefficients Between the Lgarithms f Mney Supply, Exprts and Velcity in Relatin t the Lgarithms f Natinal Incme, Underdevelped Cuntries, 196^ XVI. Estimating Equatins: Underdevelped Cuntries 6k XVII. Estimated and United Natins Natinal Incme Prjectins fr the Underdevelped Cuntries Used in Deriving the Estimating Equatins, XVIII. Simple Crrelatin Cefficients Between the Lgarithms f Mney Supply, Velcity and Exprts in Relatin t the Lgarithms f Natinal Incme, Develped and Underdevelped Cuntries, 196^ k XIX. Estimating Equatins: Develped and Underdevelped Cuntries 76 XX. Estimated and United Natins Natinal Incme Prjectins fr the Cuntries Used in Deriving the Estimating Equatins, XXI. Mnetary Data Used in Deriving the Incme Equatins XXII. Natinal Incme Estimates fr Develped Cuntries Used in Deriving the Estimating Equatins, l$6k-is XXIII. Natinal Incme Estimates fr Develped Cuntries Used in Deriving the Estimating Equatins, 196^-1968, Where Exprts Were Substituted fr Velcity 126

9 LIST OF TABLES Cntinued Table XXIV. XXV. XXVI. XXVII. XXVIII. XXIX. XXX. Natinal Incme Estimates fr Underdevelped Cuntries Used in Deriving the Estimating Equatins, 196^ , Natinal Incme Estimates fr Underdevelped Cuntries Used in Deriving the Estimating Equatins, 196^-1968, Where Expert Were Substituted fr Velcity... Natinal Incme Estimates fr Develped and Underdevelped Cuntries Used in Deriving the Estimating Equatins, 196^ , Natinal Incme Estimates fr Develped and Underdevelped Cuntries Used in Deriving the Estimating Equatins, 196^-1968, Where Exprts Were Substituted fr Velcity.., Test f Significant Difference in Ppulatin Multiple Cefficients f Crrelatin, Develped Cuntries in Relatin t Underdevelped Cuntries, 196^ < Test f Significant Difference in Ppulatin Multiple Cefficients f Crrelatin, Develped Cuntries in Relatin t Develped and Underdevelped Cuntries, 196^-1968., Test f Significant Difference in Ppulatin Multiple Cefficients f Crrelatin, Underdevelped Cuntries in Relatin t Develped and Underdevelped Cuntries, 196^ Page ^ vi

10 CHAPTER I INTRODUCTION The ubiquitus grwth, in recent decades, f state cntrl and interventin in ecnmic affairs has necessitated mre cmprehensive systems f infrmatin n the perfrmance f natinal ecnmies. As natins were transfrmed int industrially advanced regins, their evlutin required a cncmitant recnstructin f ecnmic dctrine that had previusly stressed the principles f laissez-faire, a prime example being that f the United States. The cmplexity f scial, plitical and ecnmic frces underlying the peratin f the technically advanced regins n lnger permitted therists t view ecnmic systems as self-regulating mechanisms. "Mixed ecnmies" with resultant state planning were needed t synchrnize the activities f businessmen with the public well-being. In rder t direct the activities f gvernments, systems f natinal accunts were develped mre extensively t elucidate the functinal relatinships between majr cmpnents f the ecnmic systems. Nne f the preceding, hwever, shuld be interpreted t suggest that the underdevelped cuntries have nt cntributed t the need fr the develpment f natinal accunting systems. In the future it is unlikely that underdevelped areas will develp by fllwing the principles f laissezfaire where state directin is at a minimum. Rather

11 they will develp as mixed r fully regimented ecnmies. They will be characterized either as "assisted" transitins t industrializatin in the sense that state interventin is limited in extent r time r as "engineered" transitins where the state prvides mst f the driving frce.1 State interventin in these areas will almst certainly be the rule in rder t prvide fr the cultural and ecnmic prerequisites t grwth, that is, t create climates cnducive t prgress by initiating prgrams t rid the ppulatins f debilitating diseases, and t prvide educatin fr the eradicatin f illiteracy, as well as ther cultural impediments t mdernizatin. In additin, gvernment participatin will be required t prvide the infrastructure--systems f transprtatin, cmmunicatins, pwer facilities, etc.--which are initially unattractive investments fr the businessman, but nevertheless critical ingredients t grwth. It seems clear, then, that even fr cuntries f primitive ecnmic structure, t develp accunting systems which will reflect tempral changes in aggregate incme is indispensable t planning. Given the imprtance f statistics n aggregate utput, the purpse f the fllwing paper is t explre, mre fully, ne particular aspect f ecnmic accunting, measurement f natinal incme. Since data prblems ften inhibit attempts t measure natinal incme by cnventinal methds, particularly ^Daniel Creamer, "Uses f Natinal Incme Estimates in Under-develped Areas," Incme and Wealth, Series III, edited by Miltn Gilbert (Baltimre, 1953)» P«219.

12 3 in less develped regins, the paper fcuses attentin n alternative techniques f measurement with majr emphasis n prcedures emplying mnetary data. In the present chapter, the uses, as well as the cncept f natinal incme, are discussed. This will be useful later in evaluating the desirability f estimating natinal incme by uncnventinal techniques. The secnd chapter examines the theretical feasibility f measuring incme frm the mney stck and velcity. In the final chapter, natinal incme estimates fr frty-fur cuntries cvering a perid f five years are generated frm data n the supply f mney and velcity emplying the techniques f multiple regressin analysis. The final chapter, then, brings theretical cncepts and practical applicatin int sharp relief thereby graphically illustrating the feasibility f estimating natinal incme frm mnetary data. The Uses f Natinal Incme Statistics One f the mtivating cnsideratins in preparing natinal incme estimates represents "the effrt by ecnmists and ther students f human sciety t perceive the ecnmy f the natin as a whle; t define the particular aspect that reflects in clear fcus its essential functins and structure; t distinguish its majr cmpnents--grups f ecnmic activity; and t find a basis upn which bth the parts and the whle can be measured t secure cmparable magnitudes." 2 2 Ibid., p. 215.

13 The general purpse, then, f natinal incme statistics suggests that they are equally relevant fr develped and underdevelped natins. One particularly useful applicatin f incme prjectins is that they prvide data n the past perfrmance f the ecnmy frm which gvernment plicies can be evaluated, as well as prviding infrmatin t frecast cnsequences f future actin.^ In Puert Ric, fr example, it was believed, during the 19^0's, that absentee wnership cntrlled a large prtin f the ecnmy. Hwever, natinal accunts "indicated that the net external flw f prperty incme was less than five percent f the net incme prduced in Puert Ric during the decade f the 19^0 1 s.clearly, then, natinal expenditure accunts prvided infrmatin upn which mre effective plicy culd be initiated. In additin t the use f accunts by gvernments, business and labr rganizatins ften find the statistics instrumental in decisin making. "Businesses find in the accunts factual data abut the distributin f natinal expenditure, i.e., which markets are expanding and which are cntracting. 11 -' Labr ^Harld C. Edey and Alan T. Peacck, Natinal Incme and Scial Accunting (Lndn, 195**)» pp * ^Creamer, p. cit., p ^Mshe Yanrsky, Scial Accunting Systems (Chicag, 19^5), p. 11.

14 unins, n the ther hand, are ften interested in the distributin f incme shares relative t ttal prductin.^ Nt nly d the accunts prvide data fr analysis, but they als supply a means by which infrmatin can be catalgued and cllected.'' In terms f catalguing ecnmic statistics, "an accunting apprach prvides a pwerful means f handling the prblems f cnsistency in definitins when we pass frm general theretical definitins t detailed descriptins f their empirical cunterparts." As a means f cllecting data fr analysis, a natinal accunting system serves three functins: a. An accunting apprach indicates what infrmatin must be cllected and hw it must be arranged in rder t realize in numerical terms any particular theretical system capable f such regulatin. b. An accunting apprach prvides a basis fr cllecting ecnmic infrmatin by means f sampling surveys f the different types f transactr. This basis ffers the pssibility f better cverage, increased accuracy, the estimatin f sampling errr and reduced cst. c. An accunting system apprach enables the mst efficient use t be made f the infrmatin available by bringing t light the many relatinships cnnecting elements in a system f transactins, thus prviding a basis fr the adjustment f the bservatin.9 6 Ibid., p. 11. ''Richard Stne, Functins and Criteria f a System f Scial Accunting," Incme and Wealth, Series I, edited by Erik Lundberg (Baltimre, 195l7» p. ^. 8 Ibid., p Ibid., p. 7.

15 The purpse, then, f ecnmic accunts is nt nly t prvide data fr interpretatin, but als t prvide a means by which diverse scial phenmena can be rganized fr study. Anther imprtant functin derived frm systems f accunts n natinal expenditure is their use in educatin.* T the extent that accunts illuminate the interrelatedness between the varius aggregates f the ecnmy, they are particularly useful as pedaggical tls. Prbably ne f the mst extensive uses f statistics n natinal incme has ccurred n the internatinal level. As the fllwing qutatin suggests, internatinal develpment rganizatins, like natinal ecnmies, have a requisite interest in incme statistics. When an internatinal rganizatin is established the questin f financial cntributins arises and it is usually decided that rich cuntries shuld cntribute mre than pr nes. If aid is t be allcated, sme rules are needed as a basis and these rules are likely t take accunt f needs. The cntinuatin f such grants must bear sme relatinship t perfrmance and the cntributins f different cuntries t a cmmn effrt must depend in sme sense n ability t pay. In additin t these practical administrative needs there is the further fact that partners in a cmmn enterprise will wish t be kept infrmed f ne anther's situatin and prgress, fr in this way dangerus situatins and cstly mistakes may be avided.h ^Yanvsky, OJD. cit., p. 13* ^Kurt Hansen and Richard Stne, "inter-cuntry Cmparisns f the Natinal Accunts and the Wrk f the Natinal Accunts Research Unit f the Organizatin fr Eurpean Ecnmic C-peratin," Incme and Vealth, Series III, edited by Hiltn Gilbert (Baltimre, 1953)> P«101.

16 Given the need fr natinal expenditure statistics t develpment agencies, it is nt surprising that such rganizatins ften attempt internatinal cmparisns f incme. Hwever, there are several factrs which suggest that ecnmic accunts are nt particularly well suited fr this purpse, and therefre can prvide, at mst, nly a summary ntin f the disparities in the levels f incme between regins. First, in cmparing internatinal levels f incme there is usually substantial variatin in the quality f the data used in generating the measures, particularly between develped and underdevelped natins.^ T the extent that reasnably, reliable estimates f aggregate utput can be btained in the industrially advanced regins while tenuus estimates usually characterize the prer regins suggests that any attempt t measure differences in incmes will be distrted. The Office f Statistical Standards f the United States Bureau f the Budget has prepared a survey cncerning the quality f data available in varius regins.*3 The results f the study are listed in Table I. The average expected errr in generating incme statistics frm natins classified as "very gd" was listed as apprximately 1 P Oskar Mrgenstern, jdn the Accuracy f Ecnmic Observatins (Princetn, 1963)1 P> xbid., p. 279.

17 8 TABLE I ACCURACY OF STATISTICS: VARIOUS REGIONS* Type f Regin Very Gd Gd Fair Weak Number Cntinent: Africa Nrth America Suth America 2 k 2 Asia Eurpe and Oceania Surce: Oskar Mrgenstern, On the Accuracy f Ecnmic Observatins (Princetn, 19^3)> P* 229. ten percent.the expected errr f incme estimates in the ther regins was nt given. Hwever, t the extent that seventeen cuntries were classified as "very gd" while twenty natins were categrized as weak, suggests cnsiderable variatin in the quality f data between regins. Secnd, effrts t secure cmparable magnitudes via exchange rate cnversin ignre the diverse institutinal structures in which prductin ccurs between natins. As Frankel states, "The creatin f incme takes place within a scial 1U Ibid., p. 279.

18 framewrk and a scial situatin. What incme 'is' and hw it is valued is determined by the scial circumstances and surrundings in which the individual finds h i m s e l f. " ^ The fact that different scial values exist fr different prducts between cuntries implies that "what is regarded as 'incme* in ne f them will be s different frm, and incapable f cmparisn with, what is 'incme' in anther. Hie cmparisn C f gds and services_j7 fails cmpletely t indicate their relative imprtance in the value pattern f life and activity in the different scieties f which they frm a part. In ther wrds, end prducts in the frm f gds and services d nt tell us the meaning which the sciety in questin ascribes t their prductin, and t their use. 1 ' Althugh the uses f natinal incme statistics just mentined are by n means exhaustive, they reflect sme f the mre prevalent ways in which data n aggregate utput are frequently emplyed. The imprtant pint is that systems f natinal accunts are indispensable t natins, irrespective f their ecnmic structure. The Cncept f Natinal Incme Up t this pint, the term natinal incme, has been used withut an expressed definitin. Unfrtunately, there are ^S. Herbert Frankel, "Cncepts f Incme and Welfare In Advanced and Under-develped Scieties With Special Reference t the Intercmparability f Natinal Incme Aggregates," Incme and Wealth, Series III, edited by Miltn Gilbert (Baltimre, 1953), p l6 Ibid., p Ibid., pp. I65-I66.

19 10 many cnceptual differences between natins cncerning the nature f natinal incme. Hie cncept varies frm natin t natin reflecting diversity in methds f measurement t the extent that n unifrm definitin applicable fr all cuntries exists. As Kuznets statest Natinal incme may be defined as the net value f all ecnmic gds prduced by the natin. Each term in this definitin--"net value," "ecnmic gds," "prduced,""natin" is circumscribed by a wide area f reference accepted by cmmn agreement and a substantial periphery subject t cntrversy and treated differently frm time t time, cuntry t cuntry, and investigatr t investigatr.18 Rather than pursue a discussin cncerning the diverse cnceptual prblems in defining natinal incme between natins, which wuld be beynd the scpe f this paper, natinal incme, fr present purpses, refers t the definitin adpted by the United Natins. Natinal incme accrding t this criterin cmprises the fllwing cmpnents: a. Cmpensatin f emplyees b. Incme frm unincrprated enterprises c. Incme frm prperty d. Saving f crpratins e. Direct taxes n crpratins f. General gvernment incme frm prperty and entreprenuership issimn Kuznets, Natinal Incme and Its Cmpsitin, (New Yrk, Wl)» p. 3.

20 11 g. Less interest n the public debt h. Less interest n cnsumers' debt*9 As stated, each cmpnent will vary frm regin t regin, but fr the purpses f this paper they will be viewed in terms f a "wide $rea f reference accepted by cmmn agreement."^ 19williara I. Abraham, Natinal Incme and Ecnmic Accunting (Englewd Cliffs, 19^9)» P* 104. ^Kuznets, p. cit., p. 3»

21 CHAPTER II THEORETICAL FEASIBILITY OF MEASURING NATIONAL INCOME FROM MONETARY DATA The inaccessibility f reliable data is a recurrent theme in natinal incme estimatin, particularly fr underdevelped natins. Despite the effrts f the United Natins, the paucity f data has yielded traditinal estimates which have been justifiably questined. The prblem f btaining reliable statistics has led ecnmists t devise techniques f estimatin mre suitable t the existing data. One rather unrthdx apprach was initiated by Olsn in 19^8. Using Clin Clark's cncept f an internatinal unit, Olsn expressed natinal incme in terms f a cmmn unit f purchasing pwer. The internatinal unit was defined t be "the amunt f gds and services which ne dllar wuld purchase in the United States ver the average f the perid M * Estimating equatins fr natinal incme in 1937 were derived by regressing bserved incme (I) expressed in internatinal units t varius cmbinatins f: ttal energy cnsumptin excluding human (E), emplyed ppulatin (P), number ^Ernest C. Olsn, "Factrs Affecting Internatinal Differences in Prductin," American Ecnmic Review, XXXVIII (May, 19^8),

22 13 f livestck (L) and area f cultivated land (A). The estimating equatins are listed in Table II. TABLE II ESTIMATING EQUATIONS FOR NATIONAL INCOME EXPRESSED IN INTERNATIONAL UNITS, 1937* Estimating Functin I - bp k E^ I - bp k E^A I» bp k E^L Regressin Equatin Lg I» Lg b + k Lg P + 1 Lg E - l.kys Lg P Lg E Lg I «Lg b + k Lg P + j Lg E + Lg A - 1.^ Lg P Lg E Lg A Lg I «Lg b + k Lg P + j Lg E + LgL Lg P Lg E LgL Cefficient f Determinatin O I «bp k E^L A Lg I» Lg b + k Lg P + j Lg E + Lg L + Lg A Lg P Lg E Lg L Lg A.944 Surce: Ernest C. Olsn, "Factrs Affecting Internatinal Differences in Prductin," American Ecnmic Review, XXXVIII (May, 19^8), 507, 510. As shwn frm Table II, the mst reliable estimating equatin resulted when bserved incme was expressed as a functin f all variables emplyed. This equatin, as evidenced by the cefficient f determinatin, explained ninety-fur percent f

23 14 the variatin in the lgarithms f bserved incme between natins. Natinal incme estimates derived frm the equatins are presented in Table III. Observed and calculated incme in Table III refers t natinal incme expressed in internatinal units. TABLE III NATIONAL INCOME, 1937* (Millins f Internatinal Units) Cuntry Observed Calculated Incme Incme** f(p,e) f(p,e,l) f(f,e,a) f(p,e,l,a! United States 71,177 53,300 72,280 64,670 66,400 Canada 5,978 5,336 5,724 6,631 4,403 Argentina 7,369 3,292 5,670 4,030 5,582 United Kingdm 27,857 20,860 19,050 17,620 22,960 Nrway 815 1,923 1,503 1,785 1,479 Sweeden 2,316 2,726 2,265 2,777 2,022 Denmark & Iceland 1,326 1,329 1,311 1,381 1,235 Finland 770 1,216 1,027 1, France 15,036 12,370 14,440 13,520 14,660 Prtugal Netherlands 2,925 2,949 2,507 2,534 2,852 Belgium & Luxemburg 2,740 4,468 3,244 3,793 3,479 Germany & Austria 26,068 23,700 26,310 22,620 29,490 Switzerland 1,916 1,333 1,061 1,109 1,222 Baltic States Pland 4,072 5,510 5,857 5,752 5,688 Czechslvakia 2,463 4,695 4,170 4,612 4,037 Hungary 1,462 1,331 1,158 1,412 1,000 Balkan States 5,110 5,352 6,578 5,630 6,776 Australia 3,610 2,558 4,028 3,078 3,890 New Zealand 1, ,027 Japan 10,119 12,350 7,207 10,320 7,116 Surce! Olsn, p. cit., p Observed Incme refers t natinal incme expressed in internatinal units.

24 15 As evidenced by Table III, mst f the regins used in deriving the estimating equatins culd be classified as develped. This prbably reflects the fact that reliable estimates f the variables used in the estimating equatins were nt available fr the underdevelped regins. Olsn's technique, then, suffers frm the prblem characteristic f many such diverse methds, a scarcity f data. A prevalent trend in natinal incme accunting, hwever, has fcused attentin n the use f mnetary data as a ptential predictr f incme. There are several tenable reasns which can be advanced fr the feasibility f using data n the stck f mney and velcity t generate statistics n natinal expenditure. The strategic advantage f mnetary data fr natinal incme estimatrs is that they are likely t be statistically independent f the kinds f data generally used in cnstructing natinal incme estimates. Any infrmatin they prvide is a net additin t ther infrmatin rather than simply a refrmulatin f such infrmatin.^ In a study recently cnducted, Friedman estimates yearly net natinal prduct figures fr the United States cvering the perid 1869 t 1879 In ding this Friedman suggests, "with but a negligible exceptin, nt a single number used in the 2 Miltn Friedman, "Mnetary Data and Natinal Incme Estimates," Ecnmic Develpment and Cultural Change, IX (April, 1961), 268.

25 16 calculatin f the net natinal prduct figures fr the decade has been used in cmputing this estimate."3 In additin t an independent check n traditinal measures, prjectins based n mnetary data are likely t be subject t errrs cmmensurate with cnventinal methds. This is true, in part, since fewer variables are emplyed when natinal incme is measured frm mnetary data. Als, the simpler assumptins underlying mnetary estimates f incme are cnducive t smaller errrs f estimatin. The simpler, direct assumptin relating the grwing demand fr mney t the rise in mney incme prvides satisfactry results while cmplying with the principle f "Occam's Razr" the simpler the assumptins underlying the thery, the less chance f errr.** Friedman suggests in his study n net natinal prduct* Of curse, the mnetary estimates t are subject t errr and cannt be taken as entirely accurate. Hwever, the fact that the mnetary estimates indicate an errr in the net natinal prduct figures in the directin f rughly the same rder f magnitude as that suggested by independent evidence is sme testimny t bth the accuracy f the underlying mnetary data and the validity f the relatins used t cnvert the rate f change f the mney stck int an estimate f the rate f change f incme. The mnetary estimates imply that the rati f the I869 t 1879 net natinal prduct estimates understates the 3lbid., p ^J. W. Duggar, "An Examinatin f the Feasibility f Using Mnetary Data fr Natinal Incme Estimates," Internatinal Review f Incme and Wealth, IY (December, 1968), 313

26 17 "true" rati by eighteen percent. The maximum estimated errr cited by Kuznets is thirteen percent.^ Mnetary data, in additin t the advantages already mentined, have the added quality f becming available early in a cuntry's develpment. There are three factrs which explain why this is true. First, gvernments, during early perids f a natin's develpment, cntrl the issuance f currency in rder t direct cinage and t verify its weight and finenessin additin, gvernments generally cntrl the issue by ther institutins f fiduciary currency.? In directing the issuance f currency, gvernmental agencies ften keep recrds f such activities and these prvide vital statistics n the mney supply. Secnd, private banks, because their grwth depends, in part, n the public's cnfidence in their financial stability, ften publish recrds f their accunts even thugh there is n bligatin t d s. A bank can attract depsits, r induce persns t hld ntes, nly insfar as it can instil ptential depsitrs and ntehlders with cnfidence... that the bank will meet its cmmitments prmptly, and that a wide range f persns will be willing t accept its liabilities in discharge f debt.9 ^Friedman, p. cit.» p ^Ibid., p. 270.?Ibid., p Ibid., p lbid.. p. 270.

27 18 Third, banks are usually subjected t gvernmental cntrl sner than ther institutins and this frequently results in the reprting f balance sheet data. This arises in large measure because the particular functin that mney perfrms enhances the chance that fraudulent issue will ccur and because the pervasive character f the mnetary nexus means that the failure f a bank t live up t its prmises is peculiarly likely t have effects n third parties ther than either the bank r its direct clientele. Mnetary data, then, because f their advantages in terms f reliability and accessibility, are ften useful estimatrs f natinal incme. In additin, there are theretical reasns which suggest the ptential feasibility f generating incme estimates frm data n the stck f mney and velcity. Theretical Justificatin It is clear that mney, by facilitating the prcess f exchange, is indispensable t a highly specialized ecnmy in which an infinite number f transactins must be cnsummated. "The questin at issue is, therefre, whether mney exerts an imprtant independent influence, nt whether it is the nly surce f business fluctuatins. "* * Irving Fisher, in The Purchasing Pwer f Mney, expressed, using the famus equatin f exchange, the mst fundamental relatinship between mney and natinal incme. 10 Ibid., p ^Miltn Friedman, The Optimum Quantity f Mney and Other Essays (Chicag, 19^9)» P» 266.

28 19 The equatin f exchange relates t all purchases made by mney in a certain cmmunity during a certain time. And in the grand ttal f all exchanges fr a year, the ttal mney paid is equal in value t the ttal value f the gds bught. The equatin thus has a mney side and a gds side.*^ Expressed in mathematical frm, the equatin is given by the fllwing: where, MV. PQ, M represents the ttal stck f mney in a cmmunity, V represents the transactins velcity f circulatin, r the number f times mney turns ver in a given perid f time, P represents the price level, and Q represents the ttal vlume f gds bught.*3 The left side f the equatin represents the mney side, and the right side, the gds side. The equatin expresses, then, the relatinship that the ttal amunt f mney spent (MV) must equal the dllar value f the ttal number f gds bught (PQ). It is, theretically pssible, therefre, t measure the amunt f incme spent, and thus received in an ecnmy by multiplying the stck f mney used in transactins by the intensiveness (velcity) with which the mney is used. 12irving Fisher, The Purchasing Pwer f Mney (New Yrk, 1931), PP ibid., p. 26.

29 20 Excluding fr the mment the necessity f being able t measure the mney supply and its velcity, in rder fr changes in the mney supply t reflect changes in nminal incme, tw assumptins must be made. These assumptins are: (1) The demand fr mney (the reciprcal f velcity), that is the desires f cnsumers t hld mney balances equal t a certain prprtin f incme, must be independent f changes f in the mney supply. (2) The demand fr mney must be a stable functin.*** If, as is ften inferred frm the equatin f exchange, changes in the quantity f mney invariably result in equal prprtinate changes in nminal incme, then clearly, velcity must be stable, and the variables which influence the demand fr mney must be independent f the variables which influence the supply f mney. If this were nt the case, that is if the quantity f mney demanded were functinally related t changes in the stck f mney, then any increase in the mney supply culd be ffset by reductins in the transactins velcity f circulatin t the extent that nminal natinal incme wuld remain unchanged r wuld increase prprtinately less than the increase in the stck f mney used fr transactins. ^Edgar Feige, The Demand fr Liquid Assets: A Tempral Crss-Sectin Analysis (Englewd Cliffs, 196^), p. 11.

30 21 If an increase in the mney supply by the mnetary authrities induced peple t hld a larger prprtin f their incme in mney balances (increased the demand fr mney), then there wuld be a less than prprtinate Increase in nminal incme. As a result f this interdependence between the stck f mney and velcity, an increase in the mney supply wuld be accmpanied by a decline in velcity resulting in nminal incme increasing by a less than prprtinate amunt. The failure f cntemprary ecnmists t realize the frm in which changes in the demand fr mney are expressed in statistical data appears t be due t an errneus assumptin that changes in the quantity f mney reflect changes in the demand fr mney. This assumptin carries with it the assumptin that in practice the decisins which simultaneusly increase the vlume f bank assets and the mney supply are made by custmers f the bank. Scrutiny f the cnditins under which lans and investments are acquired r relinquished by the banking system that is, f the dminant frces influencing the ttal amunt f bank lans and investments shws that this assumptin is incrrect. The quantity f mney is dminated by factrs n the supply side; that is, by the decisins f bank fficials respecting their lans and investments, and by the cnditins established by law and central bank peratins under which bank fficials make thse decisins.*-5 It is similarly incrrect t assume that changes in the demand fr mney r the habits f the use f mney reflect changes in the quantity f mney. The demand fr mney is mre *-5ciark Warburtn, "The Secular Trend in Mnetary Velcity," Quarterly Jurnal f Ecnmics, LXIII (February, 19^9)» 69.

31 22 apprpriately determined by institutinal factrs such as the prcesses f prductin and marketing that exist in the ecnmy. As Laidler suggests, Once it has been argued that the demand fr mney stems frm its use in the transactinsmaking prcess, it is but a shrt step t saying that the exact amunt f mney needed t carry ut any given vlume f transactins is determined by the nature f the prductin prcess as it exists in any particular ecnmy. Once the matter is psed in this way, therizing abut the demand fr mney inevitably begins t cncentrate n the nature f this prductin prcess. The institutinal arrangements surrunding the settlement f accunts then cmes in fr study. First, the extensive use f credit affects the amunt f mney peple need t hld in relatin t their i n c m e. i n an ecnmy where there is widespread use f credit, cnsumers wuld apparently need less mney n hand t finance a given vlume f transactins. Similarly, amng businesses, the practice f granting trade credit wuld induce businessmen t hld less mney in rder t maintain transactins. Secnd, the cmplexity f cmmunicatins netwrks in an ecnmy influences the demand fr mney.in a natin where funds culd be transmitted by telephne r telegraph, there wuld be less need t hld mney balances than there wuld be in an ecnmy where funds were primarily transferred by mail. l^david Laidler, The Demand fr Mney; Theries and Evidence (Scrantn, 19&9)» PP* ^5-^6 "~ ^Ibid., p. 1*6. ^ I_bid., p. 46.

32 23 Third, the degree f independence between business firms is anther factr affecting the demand fr mney.*9 T the extent that there is a high degree f vertical integratin, there wuld be less purchases made frm the raw material t the final prduct stage. This, then,wuld imply that ecnmies characterized by a high degree f vertical cmbinatins wuld subsequently have less need t maintain mney balances in rder t finance a given vlume f sales. Furth, the general level f ecnmic develpment is a factr affecting the demand fr mney. "The mnetizatin f the ecnmy tgether with a decrease in payments in kind and agricultural dependence increases the relative need fr mney balances."^0 Similarly, as ecnmic develpment prceeds, the number f wage earners wuld increase s that the length f time between pay perids wuld influence the demand fr mney. 2 * Hie lnger the perid f time between paydays, the larger wuld be the demand fr mney since relatively mre mney in relatin t incme wuld need t be held in rder t maintain a given level f transactins. Als, the rate f interest may be imprtant in determining the demand fr mney. 22 With high interest rates, the increased ^Ibid., p. 1*6. 20 Duggar, p. cit., p *Warburtn, jg. cit., p Ibid., p. 89.

33 2k pprtunity cst f hlding nn-incme earning mney balances culd lessen the desires f cnsumers and businessmen t maintain these balances. Althugh this list is nt exhaustive, it illustrates the cmplexity f factrs that determine the demand fr mney and therefre its reciprcal, velcity. The imprtant thing abut this view is that things like credit practices, cmmunicatins and such, thugh they can certainly change ver time, d nt alter rapidly. Thus, if ne thinks f them as being the principal determinants f the demand fr mney in an ecnmy, he wuld argue that, ver shrter time perids, there is little scpe fr variatin in the amunt f mney demanded relative t the vlume f transactins being undertaken. He wuld thus expect the velcity f circulatin t be stable ver such perids and, taking a lnger view wuld expect changes in velcity t be rather slw and lngdrawn-ut, respnding t slw institutinal changes. Thus, as a gd shrt run apprximatin, the transactins velcity f circulatin cmes t be treated as a cnstant. Empirical evidence testifying t the stability f velcity in the United States is presented in Table IV. It shuld be nted frm Table IV that, althugh velcity has nt been cnstant ver the years, it has remained relatively stable suggesting that slw, institutinal changes were respnsible fr its variatin, nt simply changes in the mney supply. Additinal velcity estimates cvering a perid f five years fr 2 3Laidler, j>. cit., p. U6,

34 25 TABLE IV VELOCITY OF MONEY FOR THE UNITED STATES, I869-I96O* Year Velcity** Year Velcity** Year Velcity** I ** ** I I876 ** I

35 26 TABLE IV Cntinued Year Velcity*^ Year Velcity^ Year Velcity^ ^ ^ ^ ^ ^ 1.^ ^ U ^7 I ^ ^9 I ^ ^3 I960 I.69 19^ Surce: Miltn Friedman and Anna Schmitz, A Mnetary Histry f the United States» (Princetn, 1963), p Velcity «Mney incme divided by mney stck. Mney = Currency plus demand depsits. frty-fur cuntries are listed in Appendix A. These figures als indicate a stable, but nt cnstant, relatinship ver the perid studied. Theretical Limitatins As an instrument in measuring natinal incme, the equatin f exchange, being an identity, cannt be impugned n theretical grunds. Hwever, because it is a tautlgy, there

36 27 are several reasns why the variables in the equatin are difficult t bring int line with the theretical cncept* First, there seems t be little general agreement amng ecnmists cncerning an apprpriate definitin f mney supply. As H. G. Jhnsn suggests, While the treatment f mney as an asset distinguished frm ther assets by its superir liquidity is cmmn grund amng cntemprary therists, the transitin frm the cnceptin f mney as a medium f exchange t mney as a stre f value has raised new prblems fr debate amng mnetary therists. These prblems result frm recgnitin f the substitutability between mney (cnventinally defined as a medium f exchange) and a wide range f alternative financial assets.^ This distinctin has resulted in frmulatins n the definitin f mney n "a priri" grunds generally stressing the medium f exchange and liquidity functins f mney.^ Cntemprary writers wh stress the medium f exchange functin argue that the primary rle f mney is t facilitate transactins, and therefre shuld nly include currency plus demand depsits. Althugh it is clear that mney defined accrding t this criterin shuld include nly items which can be used as a medium f exchange, there are several prblems inherent with the apprach. ^H. G. Jhnsn, "Mnetary Thery and Plicy," American Ecnmic Review, LII (June, 1962), 351. ^Miltn Friedman and Anna Schwartz Mnetary Statistics f the United States (Sew Yrk, 1970), p. 10U.

37 28 A minr difficulty with this apprach is that the apparently simple criterin f whether an item directly serves as a medium f exchange turns ut, n clse examinatin, t be an uncertain guide t the classificatin f assets. At first glance, currency clearly seems t satisfy this criterin. Yet United States currency includes ten-thusand dllar ntes. These can seldm be used directly as means f payment; they must first be cnverted int smaller denminatins. Shuld they therefre be excluded frm the ttal termed mney? Hw abut five-thusand dllar bills; ne-thusand dllar bills? Hw d we decide which denminatins are media f exchange, which near-mney assets? A hlder f a demand depsit may nt be able t effect transactins with persns he des nt knw by direct transferral f his check; he may first have t "cash" a check at his bank r with smene wh knws him. On the ther hand, banks have ften been willing t transfer time depsits frm party t party, smetimes even by the clse equivalent f checks. Many peple in the United States, and even mre in ther cuntries, pay a part f their bills by cnverting currency int pstal mney rders r their equivalent. Are the mney rders t be regarded as the medium f exchange, and currency nt. 26 Althugh these examples may seem trivial, they are significant in that they expse the ambiguus nature f the medium f exchange cncept. Yet, inclusin f items which may r may nt serve as a medium f exchange is nly part f the prblem. 2 '' Cursry reflectin suggests that the theretical limitatin f mney t nly currency and demand depsits leaves ut a lt that influences peple's willingness t spend r invest. Certainly, in many peple's minds the sum f "mney" they hld is made 26 Ibid.. p "Will the Real Mney Supply Please Stand Up?," The Mrgan Guaranty Survey (New Yrk, 1971), p«8.

38 29 up f a much wider range f financial assets than just currency and demand depsits. And thus if "mney," as the thery suggests, is the critical factr in cnditining spending, there is gd reasn t cnsider the use fr analytical purpses f a statistic that includes mre than just currency and demand depsits.28 The majr questin, then, is "whether the essential feature f mney is its use as a means f payment."^9 In rder fr transactins t take place, there must clearly be smething which serves as a medium f exchange. It is nt clear, hwever, whether transactins "cash" must be held in "active" balances such as currency and demand depsits.3 This suggests that, in rder t determine the supply f mney used as a medium f exchange, it is desirable t include balances, such as time depsits in cmmercial banks, which als serve as a "temprary abde f purchasing pwer. Bth features are necessary t permit the act f purchase t be separated frm the act f sale, but the "smething" that is generally accepted in payment need nt cincide with the "smething" that serves as a temprary abde f purchasing pwer: the latter may include the frmer and mre besides. Sme ecnmists argue, then, that mney supply defined as a medium f exchange must include thse balances nt held in the 28 Ibid., p. 8. ^yriedman and Schwartz, j. cit., p James Tbin, "The Interest-Elasticity f Transactins Demand fr Cash," Review f Ecnmics and Statistics, XXXVIII (August, 1956), ^Friedman and Schwartz, p. cit., p Ibid., pp

39 30 frm f currency r demand depsits,but nevertheless are being maintained t facilitate transactins ver extended perids* A few numbers shw the empirical imprtance f recgnizing the asset as well as the medium f exchange rle f whatever is regarded as mney at least fr persnal as ppsed t business balances. Cnsider the definitin f mney currently favred by thse wh emphasize the medium f exchange rlet currency plus demand depsits. In the United States in 1966, this ttal was equal t the value f fur mnths' persnal dispsable incme, abut ne mnths 1 in currency and three mnths' in demand depsits. Rughly tw-thirds f the currency and tw-fifths f the demand depsits were held by individuals and the rest by businesses. On the average, therefre, individuals held in currency abut three weeks incme, in demand depsits abut five weeks', r a ttal amunt equal t tw mnths' dispsable incme* Is it plausible that anything like this large a sum was held fr the narrw medium f exchange functin f mney alne that is, fr mechanical transactins needs? When mney has been an unattractive asset t hld, as in hyperinflatins, the quantity held, expressed in terms f incme r in real value, has smetimes fallen t less than ne percent f its initial value. This quantity represents an estimate f the irreducible minimum necessary fr transactins purpses. And even in much mre mderate inflatins, the quantity held has ften fallen t ne-half r ne-third f its level when prices are stable. Applied t the United States, this experience wuld imply that, fr individuals and businesses cmbined, rughly ne t tw days incme is the hard cre, as it were, f what might be called transactins balances prper, and ne t tw mnths' incme is the level f balances that can be maintained fr extended perids withut serius transactins difficulties.33 It is dubtful, then, that mney shuld be viewed slely n the basis f a medium f exchange. Cnsequently, it is equally incrrect t define mney strictly in terms f currency and demand depsits. 33ibid., pp

40 31 Of curse, the medium f exchange functin can be defined t include general acceptability in payment, as well as a temprary abde f purchasing pwer, but t d s wuld nly braden the definitin f mney t the extent that the term wuld be f little use in deciding n anempirical cunterpart.3** A similar attempt t escape frm the difficulties f identificatin f mney is t be fund in the distinctin smetimes drawn between "active mney" and "idle mney." But this distinctin is at best misleading. N asset is in actin as a medium f exchange except in the very mment f being transferred frm ne wnership t anther, in settlement f sme transactin, and n class f assets used in this way can lgically be excluded frm the class f active mney. Between transactins all mney is idle. Yet if activity is held t cver the state f being held in readiness against pssible use in exchange, then all mnetary assets are active all the time. It is nt merely that we cannt easily earmark fr statistical assessment the quantity that is active; there is n such quantity, except in the all embracing sense f all thse gds r claims regarded by their wners as ptentially useful fr settling market cmmitments.35 In ther wrds, the questin f which near-mnies t include and which t exclude becmes the central issue. As Latane suggests, "there is n reasn, in thery, t include, fr instance, time depsits in mney if savings bank depsits, building and lan shares, and shrt term gvernment bligatins, fr example, are excluded."36 3^1bid.. p r. s. Sayers, "Mnetary Thught and Mnetary Plicy in England," The Ecnmic Jurnal t LXX (December, i960), %. A. Latane, "Cash Balances and the Interest-Ratet A Pragmatic Apprach," Review f Ecnmics and Statistics, XLII (Nvember, 1954), 4^7.

41 32 The dilemma f which near-mnies t include has led therists t simply define mney supply bradly in terms f liquidity. Yet, there seems t be n general cncensus, wing, as suggested, t an absence f theretical justificatin in categrizing assets, cncerning a definitin f liquidity. The generally accepted characteristics f liquidity, stability f value, and marketability, are t ambiguus in delineating between what items shuld r shuld nt cmprise mney supply defined in this manner.37 Fr example, assets which have a stable value, that is, can be sld at a predetermined fixed sum, wuld include Series E United States gvernment bnds, cash values f life insurance plicies, time depsits, and savings and lan shares.38 On the ther hand, marketable United States gvernment securities, crprate bnds, and cmmercial paper wuld nt be cnsidered liquid by this criterin.39 if marketability is the characteristic t be emphasized, then gvernment securities and crprate bnds wuld be cnsidered liquid, while time depsits and savings and lan shares wuld nt.** Althugh the equatin f exchange expresses aa identity between mney supply, velcity, and natinal incme, it des 3?Friedman and Schwartz, p. cit., p Ibid., p ibid., p i * Ibid., pp

42 33 nt prvide any theretical basis fr defining the variable mney supply. If, as the equatin implies, mney shuld include nly items used in facilitating transactins, then, as has been shwn, this apparently narrw theretical cnstruct becmes, n reflectin, a much brader cncept where, ultimately, inclusin f items rests n blurred gradatins f liquidity. The prblem, as indicated, is that there is simply n thery available with which t justify a definitin f mney. Given the preceeding argument, if mnetary data are t be used in ecnmic analysis, then, as suggested by Friedman, Angell and thers, the apprpriate definitin f mney supply shuld be selected n empirical g rundsif, fr instance, natinal incme estimatin is the bject f a study, then the definitin f mney which yields the mst accurate estimates shuld be used* T put the matter differently, the ecnmic thery accepted at any time is in part a systematic summary f the empirical generalizatins that have been arrived at by students f ecnmic phenmena. This thery implicitly cntains a specificatin f the empirical cunterparts t the cncepts in terms f which it is expressed therwise it wuld be pure mathematics. But the specificatin may be mre r less precise, mre r less definite. As the thery is refined and imprved, it will generally lead t mre precise specificatins, and cnversely, as we find ne cunterpart r the ther t be mre useful, it will enable us t refine the thery. It is ur judgement that ecnmic thery des nt, as yet, ^James W. Angell, The Behavir f Mney (New Yrk, 1969), pp. 6-9.