Economic Theory and Forecasting

Occasionally this Review publishes articles of a more technical nature. These articles result from basic research efforts of staff economists.

It!0dUC1.jUii by the Department of Commerce in Business Cycle Developments. This technique consists of examining a wide range of economic data from previous business I HE ECONOMIC FORECASTS for 1967 have cycles to discover those time series which typically been duly recorded and only await the passage of show peaks and troughs before peaks and troughs time to see how accurate they were. This article does are observed in general business conditions. not attempt to add an additional forecast to those already made. Rather, it specifies some of the common The leading indicators approach is widely reported underlying assumptions or theories which major and discussed in the financial press. In the December groups of forecasters accept and which they implicit- 1966 issue of Business Cycle Developments (which pre- ly or explicitly take into account in constructing a sented the best information then available, when most forecast. forecasts of 1967 were being completed), the leading indicators were giving conflicting evidence about the It is hoped that this review of forecasting as- future. A sampling of leading indicators published in sumptions will help clarify some of the differences the December issue is presented in the accompanying which separate those who forecast a substantial de- table. Some indicators showed continued expansion, cline in the growth of gross national product (GNP) others had turned down, and many were indeter- in 1967, with a resulting increase in unemployment, minate. For example, in the last half of 1966 new from those who project a high rate of growth in GNP orders received by durable goods industries and and a continued tight labor market. plant and equipment contracts and orders tended to There is widespread interest in economic forecast- increase at about the same rate as during the whole ing. It is of concern to the private citizen because of of the 1961-66 expansion period. By comparison, pri- the information it may provide regarding his future vate nonfarm housing starts and stock market prices, income and employment. It is of interest to business two other leading indicators, showed well-publicized firms which desire to plan their investment and pro- decreases. (Since December the stock market has duction programs appropriately. It is of interest to the shown renewed strength.) Also, many of the “coin- Government because its policy actions can affect the cident indicators,” those which generally move simul- level of economic activity. Policymakers have some taneously with peaks and troughs in business cycles, idea of a socially desirable level of economic activity. registered advances. Given this conflicting evidence An accurate forecast tells what the actual level of plus uncertainties regarding Government spending economic activity is most likely to be. ‘When actual for Vietnam, it is not surprising that there was a con- and desired levels differ, appropriate application of siderable degree of uncertainty in the projections of monetary, fiscal, or other public policy may serve to many forecasters.’ move the actual closer to the desired value. To evaluate the mass of largely conflicting evidence Empirical Earccast.s available to forecasters, some judgment about what are important and what are secondary causes of Methods of economic forecasting may be divided in- changes in the economy are needed. It is in this to two major classes. One class uses primarily an em- context that the second class of forecasting tools (the pirical approach, while the other class combines economic theory with empirical evidence. The best- Some attempts have been made to apply an objective statis- known empirical approach to forecasting is the lead- tical test to see if a mixture of leading and coincident indica- ing indicators” technique. This was originally devel- tors point to continued expansion or contraction. For example, see Leonall C. Andersen, “A Method of Using Diffusion oped by the National Bureau of Economic Research Indexes to Indicate the Direction of National Economic (NBER) during the 1920’s, and since 1961 data for Activity,” 1966 Proceedings of the Business and Economic Statistics Section, American Statistical Association (Washington, applying this technique have been published monthly D.C.), pp. 424-434.

Page 7 4

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combination of economic theory and empirical evi- and the other is the income-expenditure theory. The dence) plays an important role.2 quantity theory of money dominated economic thinking until the middle of the 1930’s when John Maynard Lord Keynes’ income-expenditure theory came into Economic Theory and Forecasting prominence. The quantity theory has recently re- A theory which attempts to explain the determi- emerged under the intellectual leadership of such nants of national income should also provide some in- economists as Professor Milton Friedman of the sights into the future level of national income. This University of Chicago and Professor Karl Brunner of is especially true if changes in the determinants of Ohio State University. However, the income-expend- income as postulated by the theory generally occur iture theory is still dominant in professional economic prior to actual changes in income. For example, if thinking. one knows for some previous time period (t-1) the value of the determinants of income, one is in a Because of the important role these two theories strong position to predict the value of income in the play in influencing the thinking of present-day econ- subsequent time period (t). But even if there is no omists and economic policymakers, it is useful to time lag between the theoretical determinants of in- (1) review briefly the rationale of each theory; (2) come and their effect on income, theory may, never- consider the experience of each theory in explaining developments in national income during the present theless, help in forecasting. The determinants of in- business cycle (1960 to 1966); (3) indicate how each come may be easier to predict, or certainly more theory might forecast national income for 1967, and subject to direct influence by the monetary or fiscal (4) consider the possibility of a mix of these two authorities, than the aggregate level of income. theories. Since economics is far from an exact science, more than one theory about the operation of the economy The Theoretical Frameworks3 may be consistent with the available statistical evidence. Theories of national income determination The proponents of the quantity theory of money representing the two major schools of thought which consider that the desire to hold a given stock of money presently influence professional economic thinking in is predictably related to income, wealth, interest rates, the United States are considered here in a highly and possibly some other strategic economic variables. simplified form. One is the quantity theory of money 3 The following is an extremely simple statement of what are in fact highly complex explanations of the determination of 2 theory plays a larger role than facilitating forecast- national income, The interested reader is referred to any ing—it also helps explain the underlying structural relations in standard text on national income analysis for a more complete the economy. The application of theory, mathematical reason- discussion, e.g., Gardner Aekley, Macroeconomic Theory (New ing, and statistical technique to establish the actual value of York: The Macmillan Company, 1961), and Joseph P. these structural relations is called econometrics. Forecasting is Mc}Cenna, Aggregate Economic Analysis (New York: Henry only one application of the results of this type of research. Holt and Company, Inc., 1955).

I - Page8 -- -- - Based on the value of these variables, all spending cause of changes in income. This is not only because units are considered to desire a certain amount of autonomous spending is a component of income, but money to hold. This theory also postulates that dis- also (and more importantly) because autonomous cretionary actions by the Federal Reserve can alter spending actually induces changes in consumption. the actual stock of money relative to the desired The Government, through its control of expenditures, stock, thereby setting into action a course of events affects the level of autonomous spending, thereby in- which leads to a change in income and interest rates. fluencing consumption and GNP. When the actual stock of money differs from the desired stock, a response is induced on the part of The formal structure of each theoretical model is the public to re-establish the desired relation. This presented in the following highly simplified equations: attempt to shift between money and other financial Quantity Theory of Money assets or commodities affects interest rates and aggregate demand and through these the level of prices 1. ~Y, n_—c + v (AM)tn and real output. Income-Expenditure Theory The income-expenditure theory divides expenditures 2. i~Y~= a + b (~A)tn into two groups—those which are induced or are dependent on current income and those which are Y= GNP autonomous or are independent of current income. Money° Most consumption spending is considered to depend Autonomous spending upon income and is therefore the major induced ex- t=-: time unit which is one-quarter of a year penditure. Autonomous expenditures (as defined in t-n, t-m= different possible time lags between this article) are investments of business firms, govern- (M) and (Y) and between (A) and (Y) ment expenditures, the net export surplus, and some ~=. change between quarters minor items.4 Although autonomous spending is independent of current income, it is, of course, dependent The symbols, c, v, a, b, represent specific statistical- on something. Government spending depends upon the ly determined values relating (M) to (Y) and (A) policy decisions of the President, Congress, and their to (Y). The quantity theory of money (equation 1) advisers; business investment depends upon such says that short-term movements in GNP (a Y) arc factors as expectations of future sales, changes in largely determined by changes in the stock of money technology, and interest rates; exports depend upon aM). The income-expenditure theory (equation 2) income and prices in the rest of the world and the says that changes in autonomous spending (~A) de- 7 exchange rate. By definition, the sum of induced and termine short-term movements in CNP (AY). autonomous expenditures is equal to the total value of all goods and services produced in the economy, i.e., (Continued from col. 1) GNP. Thus, autonomous spending is one component because of scare buying. (2) There may be a change in tastes of CNP, but the level of GNP does not directly deter- of the public or temporary saturation of the market which mine the amount of autonomous spending. could decrease consumption of some product although income is unchanged. The first factor has been sufficiently unpredict- able that it would be unprofitable to incorporate it into a The proponents of the income-expenditure theory general theory explaining consumption. The second factor postulate that consumption expenditures are very may be of major importance in analyzing a particular com- modity market (like autos), but it has not been a major factor closely tied to the level of income and thus cannot in causing changes in overall consumption. generally act as a substantial initial cause of short- °Several definitions of money are used in economic literature. term changes in income.5 Consequently, changes in The standard definition of money, which is used here, is cur- rency held outside of commercial banks plus demand deposits autonomous expenditures are considered the major adjusted (referred to as Ml). Some economists consider this definition too narrow because it excludes other impurtant sources of household and business liquidity. A broader defi- ~There is considerable controversy among economists about nition which is sometimes used is Ml plus time deposits in which components of income are induced and which are commercial banks (referred to as M2). autonomous. See Appendix, page 14, for some discussion of t this and other issues. Those economists who consider that both theories jointly ex- 5 plain how GNP is determined might say that monetary vari- The income-expenditure theory considers certain exceptions in ables (through the interest rate) will affect autonomous the dependence of consumption on income. (1) A shar spending, while autonomous variables (through demand for change in the public’s expectations about future prices or avai - bank credit, etc.) will affect the money supply. According to Q ability, such as took place in the early months of the Korean this view, independent changes in either money or autonomous War, can temporarily increase the consumption-income relation variables, or both, determine the level of GNP.

Page 9 The obvious policy difference between the two (A), consumption (C), and GNP (Y) are plot- theories is that the first emphasizes the role of money ted for the same time period. The relationship and central bank monetary policy in determining between (SM) and (~Y) or (AA) and (~Y) can GNP, while the second emphasizes the role of auton- be estimated statistically to get a quantitative measure omous expenditures and Government fiscal policy in of the value of the relation and its statistical signifi- determining GNP. In the event that movements in cance. Using the same data as plotted in Charts 1 and money and autonomous expenditures are in different 2, the following estimates were computed: directions, very different conclusions as to the future The Quantity Theory course of GNP would be forecast by proponents of 2 la. ~ = 5.61 3.94 (aM) ., r nr .553 each of the theories. H- 1 (.69) A case in point is the recent economic experience in The Income-Expenditure Theory this country. From the second to the fourth quarter 2 of 1966 the economy experienced a period of tight 2a. aY~ 4.94 + 1.08(aA)1.1 r :.n .400 money but a continuing stimulative fiscal policy. The (.24) proponents of the quantity theory might reasonably The quantity theory result indicates that in each quar- forecast for 1967 a marked decline in the growth of ter GNP (Y) will increase $5.6 billion (at annual rates) GNP and real output. On the other hand, proponents plus $3.9 billion for every $1.0 billion increase in the 0 of the income-expenditure theory would most likely stock of money (M) three quarters previously. The expect continued growth in GNP at a relatively rapid number in brackets (.69) is a measure of the degree rate. of error in this estimate, As it is only about one-sixth the value of the coefficient (3.94), one can be reasonably confident that the relationship is statistically ~ •.. & &.... significant. The coefficient of determination (r2) indicates that 55 per cent of the variance in (~Y) could One way to examine these theories is to compare 1 movements in GNP with each of the theoretically he explained by changes in (AM)~.3. ° postulated determinants of GNP, i.e., money and 0 autonomous spending, to see how closely each has The three-quarter lag in the quantity theory and the one- quamter lag in the income-expenditure theory are based on best 0 moved with GNP. Because there are strong upward statistical fit. 30 trends in money, GNP, consumption, and autono- Using the broader definition of money (M2), the relation between (M) and (Y) is even closer. Changes in (AMa),., mous spending, turning points in the data may not explain 67 per cent of the variance in (AY). easily be observed. To remove most Chart 1 of the trend and therefore to con- Changes in Nominal GNP and Money Supply Quarterly Data otAnnual Rates,SeasanalfyAdiu,tedij. Billions of Dollars centrate on the cyclical elements in Billions of Doll o rs income, its components, and money, 20 20 quarterly changes in each series are 8 used. 15

In Chart 1 quarterly changes in money and GNP are plotted from 10 1958 (4th quarter) to 1966 (4th quarter). In Chart 2 quarterly changes in autonomous spending 5

8 The generally accepted convention in 0 computing changes for any time period (t) is to consider the difference between (t-1) and (t). However, there is no necessary reason for this. The change at -5 (t) could also be measured as the difference between (t) and (t+1). The value of the change at (t) used here is the average of these two measures of change. 10 The practical advantage of this approach 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 U. Change recorded for a quorter ftf is t,otl the change from the previous quarter It-f) to thesucc eeding is that it reduces macli of the randonj quarter ft+lf. See toot,ore Sot text. statistical “noise” (movement) which re- Source of basic doto: u.s. Deportment of Commerce and Board of Governors sults from the use of first differences com- ol the Federal Reserve System 0 putations. l.otestdota planed: 4th quarter estimated

Page 10 Chort2 movements in GNP are associated Changes in GNP, Consumption, and Autonomous Spending with large movements in money. QuortertyDoto otAenuolkates.SeanonolfyAdiusfedU. For example, the sharp deceleration Billions of Dollors GKP (Y) 2 Bflhions of Dollars in money in late 1959 and early 20 20 1960 compared with a sharp de- 15 15 celeration in GNP in mid- and late 10 10 1960. 5 5 Changes in autonomous expen- 0 0 ditures (A) are related to changes

-5 -5 in CNP (Y) and consumption (C)

15 15 in Chart 2.” In this case there is

10 also a similarity between the move- 10 ments in the time series, \vith (A) 5 ~ slightly leading (C). The major de-

0 0 ccleration in autonomous spending

I I .5 .1 ..l___i__J___.& ~ from the second quarter of 1960 to (Al 15 Aulonomous Spending 15 the fourth quarter of 1960 com- _____ pares \vith the deceleration in con- 10 10 sumption spending from the third 5 5 quarter of 1960 to the first quarter

0 o of 1961. The acceleration in auton- _____ III omous spending beginning in the .5 1958 1959 1960 1961 1962 1963 1964 1965 1966_____ 1967 first quarter of 1961 compares with to U. Chong erecor ded for a quarter if) is halt the change from the previous quarter the succeeding quarter fit). See tootnote 8 of text the acceleration in consumption and L~Y&&C+A GNP from the second quarter of Source of basic data: 3,5. Deportment of Commerce talentdata plooed: 4th quarterestim oted 1961. Complementary movements The income-expenditure theory result indicates that between these two series are observed for other time fl in each quarter GNP increases $4.9 billion plus $1.1 periods. There is, however, one case where a decelera- billion for every $1.0 billion increase in autonomous tion in autonomous spending (from the third quarter spending (A) in the previous quarter. This co- of 1962 to the first quarter of 1963) was not associated efficient is also statistically significant and 40 per cent with any significant deceleration in the growth of of the change in (~Y), can be explained by changes consumption spending. in (AA)~ . 1 I ~&fl&6\P Forecasts In Charts 1 and 2 turning points can be observed 1 To forecast national income for 1967 on the basis in each series. ’ In Chart 1 the upper turning points,in of the two theoretical frameworks requires a projec- the money time series generally occur in the same tion of the course of money and autonomous spend- quarter as the upper turning points in the income ing during 1967. The best statistical fit observed be- series. On the other hand, the lower turning points in tween money and GNP over the last eight years was money lead the lower turning points in income by with changes in money three quarters before the two to three quarters. One possible implication of changes in GNP. Thus, on the basis of currently avail- this is that GNP responds promptly to a decline in a able information the quantity theory would indicate monetary variable but responds sluggishly to an in- that, given the decline in the stock of money through crease. Even quite small movements in GNP appear to the fourth quarter of 1966, it is highly probable there be associated with small movements in money. The will he a substantial slowdown in the growth of GNP moderate deceleration in money in the middle of at least until the third quarter of 1967. Given the stock 1962 is related to the moderate deceleration in GNP in late 1962 and early 1963. On the other hand, larger “We cannot compare statistically the relationship between autonomous spending (A) and CNP (Y) in the same time period because (A) is a component of (Y). Variations in “The turning points or peaks and troughs in the first difference autonomous spending would lead to variations in income not series are not the same as business cycle turning points as because of the causal link postulated in the theory but determined by the National Bureau r,f Economic Research. because of a statistical artifact. To avoid this problem, (A) NBER business cycle turning points are determined from a can either be related to the other component of income number of factors, hut they are influenced heavily by the which, in this case, is consumption spending (C), or (A) level of income. One would expect the NBER turning points can be related to (Y) with a time lag. The second possibil- O to occur after turning points described here because a decel- ity is considered here and the first is considered in the eration in income generally occurs before a decline in income. Appendix.

Page 11 of money through 1966, continuation of the average suiting forecast of GNP will also be poor. But this relationship between money and CNP which has does not imply that the theory underlying the fore- existed over the past eight years would imply a cast is necessarily wrong. growth in nominal GNP of about $22 billion (at S an annual rate) from the fourth quarter 1966 to According to the Department of Commerce-SEC the third quarter 1967. This is about one-half the rate Survey of Business Intentions released in December of growth for the same period in 1966. To estimate 1966, investment in 1967 will be 7 per cent above the GNP for all of 1967 requires a prediction of changes 1966 level. The increase from the fourth quarter of in the stock of money during the first quarter of 1967. 1966 to the fourth quarter of 1967 will be smaller Money declined about $1 billion in the last half of (perhaps a 4 per cent increase). On the other hand, 1966. It has shown little change thus far this year Government spending, especially because of the Viet- from the average of the fourth quarter of 1966. If nam War, is estimated in the budget to be about 13 this unchanged state continues during the rest of the per cent or $16 billion higher in the fourth quarter of first quarter of 1967, then GNP would increase about 1967 than in the fourth quarter of 1966. The export $28 billion or 3.7 per cent from the fourth quarter of surplus should also be larger. On the assumption of 1966 to the fourth quarter of 1967, or from $759 billion no significant increase in tax rates,~the sum of all to $787 billion. This is much smaller than the $55 of this autonomous spending should grow at a healthy, billion or 7.8 per cent increase from the fourth quar- though somewhat reduced, rate in 1967 as com- ter of 1965 to the fourth quarter of 1966. pared with 1966. This would imply a fourth quarter to fourth quarter increase in GNP of $45 to $50 Given the way in which the quantity theory has billion, about 6.5 per cent. Making the same assump- been stated here, there is no way of knowing how the tion about prices as in the discussion of the quantity increase in GNP in 1967 will be distributed between theory, this forecast would imply growth in real out- price increases and real increases. However, there put of approximately 4 per cent. This is the same as seems to be wide agreement that even svith a decline the rate of growth in capacity. Consequently, the in the growth of GNP the inflationary momentum labor market will continue to remain tight, with the developed in 1966 will carry over into 1967 in the unemployment rate at 4 per cent or below. Professor form of cost-push, with average prices increasing Lawrence Kline of the University of Pennsylvania, a about 2.5 per cent. The growth in real output consist- leading exponent of the income-expenditure school. 0 ent with this calculation would be between 1.0 and has constructed an econometric model of the U.S. 1.5 per cent from the fourth quarter of 1966 to the economy. The output of this model as reported in fourth quarter of 1967, down substantially from the the December 3, 1966 issue of Business Week is a $48 4.1 per cent growth for the same period in 1966. This billion or 6.3 per cent increase in nominal GNP from forecast of 1967 growth in real GNP is below the the fourth quarter of 1966 to the fourth quarter of growth in capacity, which is generally estimated at 1967. A Michigan University econometric model, also about 4 per cent. This implies some increase in un- based on the income-expenditure theory (the publish- employment in 1967. Milton Friedman, a major ex- ed results of which are only available on a calendar ponent of the quantity theory approach, has predicted year basis), gives similar results. (Newsweek, October 17, 1966 and January 9, 1967) that the U.S. economy would suffer a recession in 1967 These alternative forecasts can be presented graph- on the basis of the decline in the money supply in the ically. In Chart 3 they are represented as projected last half of 1966. movements in the level of real and nominal GNP. Forecasting 1967 GNP on the basis of the income- The preliminary value of nominal GNP for the fourth expenditure theory requires a projection of autono- quarter of 1966 is $759 billion. The quantity theory mous spending through most of 1967. This is because would forecast GNP to grow to the level of $787 the best statistical relation between changes in auton- billion by the fourth quarter of 1967. The income- omous spending (iSA) and GNP (~Y) is with a one- expenditure theory would forecast growth to a level of quarter time lag. To predict the course of GNP during about $805 billion. Similar projections are shown for 1967 with only a one-quarter forecasting horizon real GNP in 1958 prices. In Chart 4 the alternative requires estimates of (~A)through the third quarter forecasts are presented as projections of per cent of 1967. Autonomous spending consists mainly of business investment and Government spending. This laIn the January 10, 1967 State of the Union Message the is why many forecasters emphasize the need to esti- President proposed a 6 per cent surtax on personal and cor- mate these variables before any projection of GNP can porate income effective July 1, 1967. Even if adopted as proposed, the effect on CNP estimates for 1967 as a whole 0 be attempted. If these estimates are unreliable, the would probably be small.

Page 12 Cttorta ments in GNP Nominal and Real GNP

. ouarterfylotafs otannuclkoses 1 It should be kept in mind, however, that there is B thhto ns of Dollars SeosonoffyAdfusred B’ lhto n $ 0 Do liars I 850 850 also a trend towards synthesizing these two theoretical views. A large middle group of professional economic opinion holds that both financial and auton- 800 omous real factors play a role in jointly determining GNP. When changes in money (S M) and autonomous spending (SA) are simultaneously used in an 750 equation to determine quarterly changes in GNP SY), the results are as follows: 700 3. SY, = 4.00 ±2.52 (SM),a + .670 (SA),., (.80) (.241) r’= .658 650 According to equation 3, quarterly changes in GNP (S Y) will equal $4.0 billion (at an annual rate) plus 600 $2.5 billion for every $1.0 billion increase in money three quarters previously plus $0.7 billion for every increase of $1.0 billion in autonomous spending one 550 quarter previously. The values of the coefficient for (SM) and (S A) are both significant in a statistical L. 0 sense and the equation explains 66 per cent of the 1962 1963 1964 1965 1966 1967 variance in (SY). It should be noted that equation changes in real and nominal GNP. As these forecasts 3 explains a greater per cent of the variance in GNP are on a fourth quarter-to-fourth quarter basis, the (S Y) than either the quantity theory or the income- projection into 1967 must be viewed as an average expenditure theory separately. Proponents of the syn- value during the year rather than as a specific estimate of growth in the fourth quarter of 1967. thesis view might argue that this is because it reflects the real-world situation more accurately.’4

The year 1967 will provide an interesting testing Per Cent Chart4 ground for the predictability of the quantity theory Changes in Nominal and Real GNP as against the income-expenditure theory. These two OuarterfyOata atAnnuafRates Per Cent views of the determination of CMI’ have been consist- 20 Seasonaffv Adiusted • fecome Espetsditure Forecast ent with each other during the present business cycle. •Ouontify l’hebrv Foresust Each has predicted about the same movement in GNP. However, with the recent decline in the stock 15 of money, the quantity theory predicts a substantial decline in the growth of GNP and the emergence of some unemployment. The income-expenditure theory, 10 on the other hand, predicts only a moderate lessening in inflationary pressures, with real output grow- ing at roughly the same rate as capacity. Depending 5 upon the actual course of events in 1967, one theoretical view or the other will be given substantial empirical support. 0

The Middle Ground .5 The two theories discussed above represent extreme 1962 1963 1964 1965 1966 1967 statements about the determinants of GNP. One says that GNP is determined in the short run only by ~An alternative explanation is that (L~M)t.,determines (AA)t.s and (L~Y)~.Therefore, including (AA) as one of the de- financial factors (money). The other states that 15 terminants of (u~sY) t is an indirect way of counting (tiM ) t., GNP is determined only by autonomous real factors. twice, This possibility is supported by the results of another statistical test. The partial correlation coefficient between These strongly divergent views reflect a real division (tiM)t. and (AY)t holding (AA)r., constant is 0.769. The of opinion in the economics profession as to the fun- partial correlation coefficient between (tiA )t, and (AY) holding (tiM)t., constant is 0.486. Thus, the independent damental forces which determine short-term move- confribution of (LxA)u, to (tiY)t is relatively small.

Page 13 This synthesis would not view either monetary or credit availability, and interest rates would not be fiscal policy as the dominant tool of Government sufficient to induce new investment and consump- action to the exclusion of the other. Rather, it would tion. In this case, the income-expenditure theory 5 consider that there is a possible mix of monetary and would seem to provide a superior explanation of fiscal policies which can simultaneously achieve de- short-term movements in CNP. On the other hand, sired levels of income, at other periods when business expectations of the future are buoyant, as the last five years, the major The most likely reason for the existence of the restriction on new investment and consumption is the divergent theories described above is that one theo- availability of money and credit, which would make retical approach or the other may do a superior jOl) the quantity theory a superior explanation. At still of explaining short-term movements in GNP depend- other times, business expectations may be between ing upon factors which are not explicitly considered these two extremes, in which case a mix or synthesis in either theory. For example, during the 1930s of the two theories may provide the best explanation business expectations of the future were so badly of short-term movements of GNP. impaired by the depression experience that even large changes in financial variables like money, bank MIcHAEL W. KEIIAN

APPENDIX

The method of testing the respective theories of income Each theory is presented as a single-equation model, determination used here is similar to one originally devised while the true structure of the economy, and thus the struc- by Milton Friedman and David Meiselman in an article ture of any model which attempts to explain the economy, published in 1963 as “Research Study Two: The Relative is considerably more complicated. However, the use of a 0 Stability of Monetary Velocity and the Investment Mul- single-equation model of each theory may be justified for tiplier in the United States, 1897-1958” in Stabilization several reasons. (1) At the theoretical level these single- one of a series of research studies prepared for the equation models can he thought of as representing ic- Commission on Money and Credit. The purpose of that duced forms of a more complex structural model of the study was to test empirically the stability of the fundamen- economy. The intermediate links between the fundamen- tal behavioral assumptions undetlying each theory. To do tal causal factors (money or autonomous spending) and this, they selected definitions of GNP (Y), autonomous GNP are netted out. (2) The causal differences between spending (A), consumption (C), and money (M) which each theory as presented here are sufficiently large (one seemed to them most appropriate to that task. Since pub- emphasizing financial factors and the other real factors) lication of that study there has been much controversy that as a first approximation a very crude single-equation within the economics professio& regarding the appropri- model may distinguish between them, (3) As a practical ateness of using a single-equation model to test competing matter, an economic model used just for forecasting future theories and also regarding the appropriate definitions of income can he simpler than a model designed to explain major variables. The purpose of this article is not to test the structure and interrelationships of the economy. these theories but only to consider their use as forecasting tools. We have used the definitions of (Y), (A), (C), and The measure of aggregate economic activity used here (M) which are most widely recognized by the general as a forecasting target is GNP. The use of gross national public although they differ in important respects from the product rather than net national product, national income, definitions used by Friedman and Meiselman, or disposable income can he criticized for a variety of theoretical and statistical reasons. The major justification 1 See American Economic Review, September 1965, “The Rela- for using CNP is that it is the most publicly recognized tive Stability of Monetary Velocity and the Investment Mul- aggregate measure of economic activity. It is also the most tiplier,” by Albert Ando and Franco Modigliani; “Test of the Relative ltnportance of Autonomous Expenditures and Money,” widely forecast value of aggregate economic behavior, and by Michael DePrano and Thomas Mayer; “Reply to Ando and results obtained here can be compared with other forecasts. Modigliani and to DePrano and Mayer,u~by Milton Friedman If this article were designed to test the theoretical and and David Meiselman. Also see Review of Economics and Statistics, November 1964, “Keynes and The Quantity Theory: empirical “correctness” of these tsvo theories (which, it a Comment on the Friednian-Meiselman CMC Paper,” by should be noted, is not the case), then some measure other Donald D. Hester, and “Reply to Donald Hester,” by Friedman 0 and Meiselman. than GNP might have been superior.

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There has been relatively little contmversy among pro- To the extent that rates are unchanged, taxes are de- fessional economists about the procedures for testing the pendent upon changes in income, and their effectis thereby significance of the quantity theory, with the possible ex- reflected in consumption (C). However, changes in tax P ception of discussion of the appropriate definition of money rates are an important discretionary tool of fiscal policy, (see footnotes 6 and 10 in the text). However, with respect Therefore some measure of their effect on consumption to the income-expenditure theory, a major problem is the (C) should be included in autonomous spending (A). As method of specifying what is autonomous spending and a practical matter, there is no simple, clear-cut way to what is induced spending. It is difficult, if not impossible, separate these two components of taxes. To the extent that to distinguish statistically which components of income arc important changes in tax structure take place, the measure induced and which coTnponents are autonomous. Some of (A) is weakened, at least in the time periods during, elements in personal consumption, like durable goods, are and just after, the change in the tax structure. There was only weakly related to current income. On the other hand, an important change in the tax structure in 1964 which some part of business investment is induced by changes in makes the observed relation between (A) and (Y) or (C) current income. In this article all consumption is consid- weaker than was really the case, l-Iowever, no major ered induced and all investment is considered autonomous, change in the tax structure is likely for 1967 so the use of (A) in forecasting 1967 will not be seriously impaired. A related problem is the treatment of imports and taxes in the analysis. Although neither of these items appears Another important issue with respect to the income- explicitly, both are included implicitly and their inclusion expenditure theory has to do with the fact that (A) is not complicates the distinction between autonomous and in- only the theoretical determinant of (Y) but also an account- duced spending. ing component of (Y). That is:

The value of GNP in the national income accounts does 4. Y = I + A [Accounting definitionl not include taxes directly. Imports, however, are netted Or against exports. That is, GNP is defined as 4a. AY = AT + AA And 1. Y = C + Ig + G + (X — Im) 5. Ay = a + b(AA) [Theoretical assumptionl Y = GNP Any statistical test of the theoretical relation between (AA) C = Consumption and (AY) would give a much closer link between the two Ig = Cross business investment variables than would actually be the case, because in an C = Government spending accounting sense (AA) is included in (AY). This problem X = Exports has been handled by relating (AA) to (AY) with a one-

Im = Imports quarter time lag which breaks the link with the accounting definition. An alternative and perhaps conceptually supe- It is necessary to define induced and antonomous spending rior method would be to compare (AA) only with those in such a way that their sum will equal GNP (Y). Consider- components of (AY) which are not included in (A A). ing these problems, induced spending (I) and autonomous Because (AY AA = AT) this would mean comparing spending (A) have been defined as follows: (IsA) with (Al). If

2. I = C 2 6. Al = c + d(AY) [Because induced spending (I) 3. A = Ig + C + (X — Im) depends upon current income This problem of adjusting the values of (I) and (A) to (Y).l make them consistent with (Y) will arise no matter what definition of income is used. Because this adjusting process Then AJ = c + d(AI) + d(AA) [Because(Y)canbe is rather arbitrary, reasonable men could disagree with the specific adjustments used. The rationale for the adjust- written as (I + A).l

ments made here are givenin the two following paragraphs. Al (1 ~—d) = c + d(AA) [Collecting all (I) terms Imports are already included in the recorded value of on the left-hand side.l consumption, investment, and government spending. c d [Dividing both sides Thus, the major behavioral role of imports broken down 7. Al = + —~-(AA) by (1-d).l according to its induced and autonomous components is 1 already included in other values. The value of (I) is not Thus, (Al) depends upon (IsA). biased by excluding imports. However, by netting all im- When this relation is tested statistically, the results are ports against (A) we are introducing some element of induced spending which makes this measure of (A) less as follows: 2 accurate than would be ideal, although its quantitative 7a. AJ = 3.42 + .550 (AA)t r .372 5 importance is not likely to be large. (.133) 2 These results are statistically significant and almost as good Some very minor additional items which are part of CNP are included in A. as equation 2a in the text which relates (A) to (Y)

Page 15 It is interesting to note that when changes in money arc Friedman and Meiselman observed this superior relation c mpared with changes in induced spending only the in their study and attributed it to the fact that money should results are actually superior to money related to CNP. he related to permanent (rather than observed) income 0

8. LIt 3~ 4 2]3 (AM) t. r~- 5J1 and that consumption or induced spending is superior to .:3~) (1) as a proxy for permanent incori IC.

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