Carnegie- Rochester Conference Series on Pub/k Policy 29 (1988) 137- 168

North-Holland
I - l - ED STATES: TI TATI VE REVI E
ROBERT E. LUCAS, JR.*
The Uni versi ty of Chi cago
el tzer*s research career has been so producti ve and so vari ed
that i t woul d be an act of f ol l y, not f ri endshi p, to attempt to revi ew i t
i n a si ngl e paper. Yet I do want to tal k about hi s research on thi s
occasi on, f or research i s what Al l an' s career i s mai nl y about, and I want
to do SO i n detai l , because detai l s are the way schol arshi p i s carri ed
out. Accordi ngl y, I wi l l f ocus my attenti on mai nl y on a si ngl e paper, one
that has i nf l uenced my own thi nki ng on monetary economi cs a great deal ,
Mel tzer' s "The Demand for oney: The Evi dence f romTi me Seri es, " publ i shed
i n the J ournal of Pol i ti cal Economy i n 1963.
Mel tzer' s "Demand f or ?4oney" was one i n a seri es of hi s empi ri cal
studi es i n monetary economi cs, hi ch i nvol ved j oi nt research wi th
Karl Drunner. I t f ol l owed earl i er work by Latane and others, especi al l y
Fri edman, and hel ped to sti mul ate cl osel y rel ated l ater contri buti ons by
Lai dl er and others. ' The shared obj ecti ve of thi s research programwas, i n
Fri edman' s ( 1956) terms, to demonstrate that the demand f or money i s a
"hi ghl y stabl e f uncti on" of a l i mi ted number of vari abl es, to di scover the
most usef ul , operati onal measures of money and these other vari abl es, and
( agai n ci ti ng Fri edman) to work "toward i sol ati ng the numericdl ' constants'
of monetary behavi or. " el tzer' s paper was the f i rst to esti mate an i ncome
4
This paper was prepared for the November ,+ 1987 Carnegie-Rochester Conference.
I would
like to thank John Cochrane, Thomas Cooley, Milton Friedman, Lars Peter iiansen, Robert king,
Leonardo Leiderman, Bennett McCallum, Sherwin Rosen,
Thomas Sargent and Lawrence Summers for
helpful discussions and/or comments on an earlier draft.
I also benefitted from a stimulating
discussion at the Conference. P.S. Eswar-Prasad provided excellent research 8ssisfam?.
Two important sequels to this paper are Brunner and M?lfzer (1963) and Laidler (1966).
Of course, this and other work on money demand was closely related to rther cOnteW.)QrarY
research, especially the earlier contributions of Friedman
(1956) and his students,. and
Friedman (1959). See Laidler (1977) and, more recently,
IvDcCallum and Coocfriend (1987) for
some of the relevant background.
0 167 - 2231/88/$3.50 @ 1988 Elsevier Science Publishers B.V. (North-Holland)
( or weal th) el asti ci ty and an i nterest el asti ci ty SimultaneoUSly from time
series data f roma si ngl e country ( the U. S. ) . The obj ecti ve of the present
paper will be to revi ewand repl i cate these results, to reconsider how they
mi ght be i nterpreted theoreti cal l y,
and to see how wel l they stand up to
the 25 years of newdata that have become avai l abl e si nce el tzer wrote-
An esti mated money demand f uncti on provi des answers to two i mportant
questi ons of economi c pol i cy.
The i ncome el asti ci ty, i n a setti ng i n whi ch
l ong run real output growth i s both f ai rl y predi ctabl e and i nsensi ti ve to
changes i n monetary pol i cy, provi des the answer to the questi on: What rate
of growth of money i s consi stent wi th l ong run pri ce stabi l i ty? The
i nterest el asti ci ty i s the key parameter needed to answer the questi on:
What are the wel f are costs to soci ety of devi ati ons f rom l ong run pri ce
stabi l i ty? Purel y qual i tati ve answers to these questi ons, al ong the l i nes
of "I nf l ati on rates are si gni f i cantl y rel ated to money growth rates" or
"I nf l ati on reduces wel f are" are i nteresti ng and usef ul , perhaps, but surel y
proposi ti ons such as "An Ml growth rate of 3 percent per year wi l l bri ng
about pri ce stabi l i ty" or "A ten percent annual i nf l ati on rate has a soci al
cost equi val ent to a 0. 5 percent decl i ne i n real i ncome" are more
i nteresti ng and, i f accurate, much more usef ul .
Though the obj ecti ve of an economi cs that provi des quanti tati ve
answers to i mportant questi ons of economi c pol i cy i s now very wi del y
subscri bed to, i t i s remarkabl e how l i ttl e attenti on i s pai d i n many of our
di scussi ons to the substance of parameter esti mati on, and how l i ttl e honor
i s pai d to those f eweconomi sts who do i t wel l . Al l of us have sat through
many di scussi ons of econometri c work i n whi ch the theoreti cal underpi nni ngs
of the rel ati onshi ps esti mated and tested and the econometri c methods used
are subj ected to i ntense scruti ny and yet no one seems to care what the
numeri cal resul ts were! Even i n Lai dl er' s ( 1977) survey of the evidence on
money demand, or i n McCal l um and Goodf ri end' s (1987) more recent summary,
i t is di f f i cul t to f i nd cl ear statements of what the money demand f uncti on
i s.
As quanti tati ve economi sts we of ten seemto be, i n Samuel son' s ( 1947)
phrase, "l i ke hi ghl y trai ned athl etes who never run a race, and i n
consequence grow stal e, "
el tzer ran thi s parti cul ar race, i n 1963, and turned i n hi s two
numbers.
uch has happened si nce to monetary theory and to the devel opment
of econometri c methods, and al most three decades of new data have si nce
ailable. I n Section I I I ari ze the evi dence on the i ncome
eal th) and i nterest el asti ci ti es of money demand f ro 1900- 58 data,
essenti al 1
i denti cal to those
el tzer used. Secti on I I I i ntroduces a
138
uti l i ty- theoreti c f ramework f or thi nki ng about money demand, f rom whi ch I
wi l l concl ude that there i s some reason to vi e
0 parameters as
structural , Secti on I V revi ews U. S. ti me seri es evi dence f romthe 1958- 85
peri od, a peri od duri ng whi ch nomi nal i nterest rates reached l evel s about
twi ce the hi ghest l evel s attai ned i n the U. S. i n the earl i er years of the
century. Remarkabl y, i n vi ew of the stri ngent nature of the experi ment,
these newdata preci sel y conf i rmthe esti mates Mel tzer obtai ned i n 1963.
I L REVI EWOF THE EVI DENCE FROH 1900- 1958
The hypotheti cal househol d deci si on probl em underl yi ng the resul ts
reported i n Mel tzer ( 1963) i s that of al l ocati ng a gi ven stock of weal th
across di f f erent assets, gi ven a vector of asset returns. I wi l l come back
to thi s probl em i n more detai l i n Secti on I I I , but I have sai d enough to
rati onal i ze a demand f uncti on f or money of the f orm
M
- = f ( r, w) .
P
Throughout hi s paper, Mel tzer used the l og- l i near f orm:
an( mt) = a -
bpn( rt) + can( wt) + ut , (1)
where mt i s the stock of real bal ances at t, wt i s real weal th or real
i ncome, rt an i nterest rate, ut i s an error term, and a, b and c are
parameters. Mel tzer used a l ong term i nterest rate to measure rt, treated
as a stand- i n f or the enti re vector of returns on al ternati ve assets. He
experi mented wi th a very wi de vari ety of i ncome and weal th vari abl es as
measures of real weal th, and wi th both Ml and M2 as measures of the money
stock. The sampl e peri od was 1900-1958, wi th resul ts al so reported f or the
two subperi ods 1900-1929 and 1930-1958.
l ne experi mental approach Mel tzer used f or measuri ng money and
i s obvi ousl y sui tabl e: we do not have theori es that si ngl e out parti cul ar
measures as cl earl y superi or to others.
One coul d i ndeed cri ti ci ze the
paper f or reporti ng too f ewresul ts, si nce the si ngl e i nterest rate he used
to represent asset returns was arbi trari l y chosen. But much of thi s Weri -
mentati on i ndi cated that the choi ce of money aggregates
cri ti caal y i mportant. Thi s f i ndi ng has been co
research, as descri bed i n Lai dl er ( 1977) . I
139
S uent
report and
repl i cate onl y a smal l subset of i ' &resul ts reported by Mel tzer ( 1963) .
Tabl e 1 transcri bes resul ts i i 3 Mel tzer ( 1963) . Li ne 1 i s equati on ( 3)
on p. 225, wi th R2 reported i nstead of R and "standard errorP i nstead of
"t- stati sti cs. "
2 Li nes 2, 3, 5, 6, 7 and 3 are f romTabl e 2, p. 232- Li ne 4 i s
f romTabl e 1, p. 229. Of course,
al l regressi ons reported i n thi s and al l
other tabl es i n thi s paper were esti mated wi th constant terms. Si nce the
uni ts of the dependent vari abl e I used are not meani ngf ul , I wi l l not
report these constants.
The ce, Aral f i ndi ngs i n l i nes l-3 of Tabl e 1 ( these and al l subsequent
ref erences are to tabl es i n thi s paper) , conf i rmed by other resul ts i n the
ori gi nal paper, are the weal th or i ncome el asti ci ti es of about uni ty and
the strong, negati ve ef f ect of i nterest rates on real bal ances demanded.
Noti ce that nei ther f i ndi ng shows up very cl earl y when the peri od i s
di vi ded i n two, as reported i n l i nes 4- 8 of Tabl e 1. For the earl y peri od,
the i ncome and weal th el asti ci ti es di verge, i n di f f erent di recti ons, f rom
uni ty and the i nterest el asti ci ti es are much reduced. Mel tzer does not
report the resul ts wi th weal th onl y f or 1930-1958. Fromwhat i s reported,
however, i t appears that the resul ts f or the f ul l peri od were mai nl y
di ctated by events i n the l atter hal f .
Tabl e 2 contai ns my repl i cati ons of the resul ts i n Tabl e 1. 3 I dropped
*The residuals from my replications of Mel tzers equations show very severe
autocorrelation, and it is clear from the Durbin-Watson statistics reported in Meltrer (1964)
that this is also true of his original
regiessions. As a result, I do not know how to
interpret the standard errors reported in these tables. I experimented with a variety of
methods for correcting for serial correlation, but obtained only wildly erratic elasticity
estimates.
3For money, I used Ml throughout the paper. For 1900-14, this series is taken from
Historical Statistics (1960), series X267.
From 1914-47, it is from Friedman and Schwartz
(1970), pp. 704-718, column 7. For 1948-85, it is the IMF series 3 from the International
Monetary Funds International Financial Statistics tape. (The primary source for these IMF
data is the Federal Reserve Bulletin.)
For 1900-49, real wealth is from Goldsmith (1956), Table W-3, column 1 (total national
wealth at 1929 prices).
For 1950-57, this series is from Historical Statistics (1960),
series F446.
For 1884-1975, real income is real net nationai product from Friedman and Schwartz
(1982), Table 4.8. For 1976-85, it is taken from various July issues of the Survey of Current
Easiness. The price level (used to deflate Ml) is the imp1 icit NNP deflator from the same
sources. Permanent income is the geometrically weighted sum of current and Past real NNPs
used in Friedman (1957). The weight on current income is .J3.
The long term interest rate (used only for 1900-57) is the basic yield on 20 year
corporate bonds
in Historical Statistics (1960). series X346. The short term rate for 1900-
75 ;S the 6 month commercial paper
rate from Friedman and Schwartz (1982), Table 4.8, column
6. For 1976-85 I used Table 8-68 in the Economic Report of the President (1987).
140
TABLE 1
Meltrer (1963) Results
Dependent variable: hlM,/P)
Coefficients on:
(standard errors)
-
Line Years
&n(r) n (W/PI n(Y/P) R2
1 1900-58
2 1900-58
3 1900-58
4 1900-29
5 1900-29
6 1900-29
7 1930-58
8 1930-58
-.949
t.0441
-.79
f.083)
-.92
t.0531
-.32
1.107)
- .05
(.094)
-.22
l.122)
-.69
t.160)
-1.15
t.0971
1.11
t.026)
.97
(.103)
1.84
t.1141
.48
( ,240)
1.35
t.1551
1.05
t.0411
.13
t.0931
.70
(.45)
.3l
t.1941
.94
t.0941
-.lO
t.125)
.984
.960
.980
. 960
.960
,960
.902
.980
1958 f romthe sampl e because I coul d not f i nd w f or that year. Otherwi se,
1 attempted to f ol l ow the sources and procedures descri bed i n Mel tzer
( 1963) . One can see that l i nes 1 and 2 f romTabl es 1 and 2 are very cl ose,
though cl oser f or the i ncome regressi on than the
eal th regressi on- When
both vari abl es are i ncl uded ( l i ne 3) I obtai ned very di f f erent resul ts f rom
hi s, f or reasons I cannot expl al tl . Noti ce, however, that el tzer' s and my
eMmates of the sumof these c&f i ci ents are very cl ose: I suspect thi s
is al l ei ther of us i s esti mati r- i c, wi th much preci si on. The other stri ki ng
di f f erence i s i n l i ne 4 of Tabl es 1 and 2: my
eal th el asti ci ty f or t
subperi od i s wel l bel ow one; el tzer' s is 1. 8,
I wanted to use a graphi cal cl evi ce to hel p me see ho
theory one obtai ns i th di f f erent
questi on i s not very wel l posed, b
exhi bi ts three seri es, al l f or the f
l/P; the "predi cted" l/P f rom l i ne
f roml i ne 2 of Tabl e 2. One c
trend f rom1930 on than i n the
regressi ons track thi s wel l ( of course,
wi th the i nterest rate al SO
i ncl uded as a regressor) .
Real bal ances di d not decrease nearl y as much as
di d NNP i n the 193Os, but they i ncreased much more than i ncome i n the
1940s. I concl ude ( though thi s i s the sort of i ssue reasonabl e peopl e can
di sagree on) that current i ncome i nduces
f l too much" cycl i cal responsi veness
i n predi cted money demand,
rel ati ve to weal th, and that weal th or some
other Woothed" i ncome measure i s pref erred as the regressor- Thi s i s al so
the concl usi on reached by Lai dl er ( 1977) .
I n Tabl e 3, I report the consequences of some vari ati ons on Mel tzer' s
resul ts. The obj ecti ve of thi s experi mentati on i s to l ocate a versi on of
Mel tzer' s model that i s reasonabl y f ai thf ul , conceptual l y and quanti -
tati vel y, to the ori gi nal and i s at the same ti me i nexpensi ve to test on
more recent data. 4
Li ne 1 i n Tabl e 3 uses permanent i ncome ( def i ned by Fri edman' s di s-
tri buted l ag on current and past real NNP' s) i n pl ace of weal th. Thi s
change does an excel l ent j ob of reproduci ng l i ne 1 of ei ther Tabl e 1 or 2.
From a compari son of Fi gure 1 wi th Fi gure 2, one can see that permanent
i ncome behaves more l i ke weal th than l i ke current NNP i n the 1930s.
Li nes 2 and 3 report two vari ati ons on l i ne 1. I n l i ne 2, the l ong
i nterest rate used by Mel tzer i s repl aced by a short rate. I wi l l expl ai n
my strong pref erence f or the l atter i n Secti on I I I . The short rate ( over
thi s peri od) vari es sympatheti cal l y wi th the l ong, but wi th more ampl i tude:
hence i ts smal l er coef f i ci ent. Otherwi se, thi s vari ati on doesn' t matter
much. I n l i ne 3, 1 use an unl ogged short rate. The i ssue between the
di f f erent f uncti onal f orms i n l i nes 2 and 3 i s mai nl y aestheti c: the semi -
el asti ci ty at the sampl e mean val ue of r ( 3. 26 f or 1900- 57) i s, f romthe
esti mate of the el asti ci ty i n l i ne 2, ( . 18) / ( 3. 26) = , 055. Froml i ne 3,
thi s same semi - el asti ci ty i s esti mated at . 07. ( I n thi s, as i n al l other
economi c appl i cati ons wi th hi ch I am f ami l i ar, the choi ce of f uncti onal
f orm i s of l i ttl e substanti ve consequence. ) Thus I wi l l take Tabl e 3 as
justifying my ref erri ng to the model reported i n l i ne 3 as Wel tzer' s
theoryn.
4The variations reported in Table 3 are very close to results in Laidler (1966). Laidle
used U.S. annual series from 1892-1960, and deflated real balances and permanent income oh
population.
In his counterpart to line 1 of Table 3 (his Table 2, A, p.548) he obtained
Permanent income and interest elasticities respectively of 1.51 and .25. His counterpart of my
I ine 2 (also Table 2,
A in his paper) are 1.39 and . 16. He did not try unlogged intecest
rates.
142
TABLE 2
fi2pl icat ions
Dependent wwiable: Rn(M,/P)
Coefficients on:
(standard errors)
Line Years h(r) In W/P) en (Y/p) R2
1900-57
1900-57
1900-57
1900-29
1900-29
1900-29
1930-57
1930 -57
1930-57
-1 .PJ_
t.9 1)
,457
a .d77)
.90
( .089)
-.21
( .099)
- .07
(.119)
-.20
t.098)
-1.72
(.139)
-.55
(.141)
-.78
,264
1.32
t.056)
.49
(.I221
.86
l.051)
.65
f.149)
1.53
4.163)
.34
.332
1.04
t.0361
.68
(: .095)
.73
(.057)
.I9
t.132)
l 93
t.0751
.75
.19t
.957
.971
.978
.957
.932
.960
-901
.937
.939
Let me concl ude thi s secti on wi th a somewhat l ess f ormal summary of
the i nf ormati on on i ncome and i nterest el asti ci ti es contai ned i n thi s 1900-
57 sampl e. Over thi s peri od, real Ml bal ances grew at the annua7 rate of
. 03X6 and real permanent i ncome at the rate . 03126. Short term i Kerest
rates f l uctuated between . 69 ( duri ng Worl d War I I ) and 7. 4 ( i n 1920) but
wi th a negl i gi bl e trend. Hence the rati o of the money growth rate to the
i ncome growth rate, 1. 07, i s a good esti mate of the i ncome el asti ci ty. Thi s
i s about the number obtai ned, under vari ous assumpti ons, i n Tabl e 3.
Over
l ong peri ods, i t must al ways be the case that the trend in the dependent
vari abl e must be ' expl ai ned" by that subset of the regressors that have
trends, i s appl i cati on, real i ncome does and i nterest rates do not.
Now i mposi ng an i ncome el asti ci ty of uni ty, the semi-elasticity Of
money demand i th respect to the i nterest rate i s j ust the ~10
Of l n( M1/ Pyp) agai nst rs. Thi s pl ot i s di spl ayed i n Fi g
"esti mati on metho f l - get the i nto
trends and then get the i nterest el asti ci
1930
Year
L .
1940 1950
1960
Actual Ml/P
--_-- Predicted Ml/P using current income (line 2, Table 1).
. . . . . Predicted Ml/P
using wealth
(line 1, Table 1).
144
100
Figure 2
I
Year
Actual Ml/P
----- Predicted Ml/P using current income (line 2, Table 1).
. . . . . Predicted Ml/P using permanent income (line 1, Table 3).
145
TABLE 3
Variations on Table 2 for 1900-1957
Dependent variable: ~n(Ml/P)
Coefficients on:
(standard errors)
Line an(r) Wrs)
r
S
an (y,)
R*
1 -.77 1.03 ,939
t.0441
f.021)
2 -.18
f.025)
3 -.07 1.06 .963
f.0111 t.042)
- does not depend very cri ti cal l y on our abi l i ty to characteri ze the
resi dual s accuratel y, or even on the resi dual s havi ng a common structure
over the enti re peri od. Si nce we have much more %eason, to whi ch I wi l l
turn i n the next secti on, f or bel i evi ng these el asti ci ti es to be stabl e
e have reason to bel i eve anythi ng i n parti cul ar about the resi dual s,
thi s seems to me a desi rabl e f eature. '
Of course, no esti mati on method i s sati sf actory under al l assumpti ons
about the errors, and the cri ti cal assumpti on here i s that the errors are
trend- f ree. I f there were i mportant techni cal changes, not occurri ng i n
terest rate movements, permi tti ng agents to economi ze on
bal ances my method ( and el tzer' s too) has understated the
I do not see ho one can l earn more about thi s
by exami ni ng the seri es at hand.
These informal remarks are not intended as a substitute for econometric theory.
One
would certain I y have a better understanding of the estimates reported here and below i f one
could write down a bel ievable stochastic model and use it to derive the properties of these
estimates explicitly. But I have not done this and so am obliged to follow a second best route
and explain why I proceeded as I did in a looser (and hence less informative) way.
146