INTERNATIONAL MONETARY FUND STAFF PAPERS CONTENTS Inflationary Expectations, Taxes, and the Demand for Money in the United States VITO TANZI • 155 Macroeconomic Performance and Adjustment Under Fund-Supported Programs: The Experienc of the Seventies DONAL J. DONOVAN • 171 Effects of Inflation Control Programs on Expected Real Interest Rates JOHN H. MAKIN • 204 An Analysis of Exchange Market Intervention of Industrial and Developing Countries MICHAEL DOOLEY • 233 Interest Rate Differentials and Exchange Risk: Recent Argentine Experience MARIO I. BLEJER • 270 The International Monetary Fund, 1980-1981: A Selected Bibliography ANNE C.M. SALDA • 281 Summaries • 352 Resumes • 355 Resumenes • 359 VOL. 29 No. 2 JUNE 1982 ©International Monetary Fund. Not for Redistribution STAFF PAPERS NORMAN K. HUMPHREYS, Editor MARY ELLEN LUCAS, JENNIE LEE CARTER, and PAUL GLEASON Assistant Editors Editorial Committee Norman K. Humphreys, Chairman Adalbert Knobl Jacques R. Artus Anthony Lanyi Sterie T. Beza M. Ranji P. Salgado Eduard H. Brau Stephen A. Silard Deena R. Khatkhate Alan A. Tait From the Foreword to the first issue: "Among the responsibilities of the International Monetary Fund, as set forth in the Articles of Agreement, is the obligation to 'act as a center for the collection and exchange of information on monetary and financial problems,' and thereby to facilitate 4the preparation of studies designed to assist members in developing policies which fur- ther the purposes of the Fund.9 The publications of the Fund are one way in which this responsibility is discharged. "Through the publication of Staff Papers, the Fund is making available some of the work of members of its staff. The Fund believes that these papers will be found helpful by government officials, by pro- fessional economists, and by others concerned with monetary and financial problems. Much of what is now presented is quite provisional. On some international monetary problems, final and definitive views are scarcely to be expected in the near future, and several alternative, or even conflicting, approaches may profitably be explored. The views presented in these papers are not, therefore, to be interpreted as nec- essarily indicating the position of the Executive Board or of the offi- cials of the Fund." The authors of the papers in this issue have received considerable assistance from their colleagues on the staff of the Fund. This general statement of indebtedness may be accepted in place of a detailed list of acknowledgments. Subscription: US$9.00 a volume or the approximate equivalent in the currencies of most countries. Four numbers constitute a volume. Single copies may be purchased at $3.00. Special rate to university libraries, faculty members, and students: $4.00 a volume; $1.00 a single copy. Subscriptions and orders should be sent to: Publications Unit International Monetary Fund Washington, D.C. 20431 U.S.A. ©International Monetary Fund. Not for Redistribution INTERNATIONAL MONETARY FUND STAFF PAPE RS Vol. 29 No. 2 ©International Monetary Fund. Not for RedistributionJUNE 1982 EDITOR'S NOTE The Editor invites from contributors outside the Fund brief comments (not more than 1,000 words) on pub- lished articles in Staff Papers. These comments should be addressed to the Editor, who will forward them to the author of the original article for reply. Both the com- ments and the reply will be published in the same issue of Staff Papers. International Standard Serial Number: ISSN 0020-8027 ©International Monetary Fund. Not for Redistribution Inflationary Expectations, Taxes, and the Demand for Money in the United States VITO TANZI* N HIS EXCELLENT ARTICLE on the demand for money, Goldfeld i cited Harry Johnson to the effect that the lack of "American evidence that the expected rate of change of prices enters the demand for money ... [was] something of a puzzle" (Goldfeld (1973), p. 608). Goldfeld described his own empirical results as "a mixed bag" (ibid., p. 613) and concluded that "even at the the- oretical level," the question of "whether inflationary expectations have an independent role to play in the demand-for-money func- tion" is controversial (ibid., p. 607). Studies dealing with devel- oping economies, however, have generally found that inflationary expectations possess more explanatory power than institutionally rigid nominal interest rates in basic money demand functions. Furthermore, some recent studies for the United States have used both inflationary expectations and the rate of interest in the demand-for-money equation. These studies have not provided sufficient theoretical justification for doing so. This paper deals with the role of inflationary expectations from a theoretical and empirical point of view. It contains four sections. Section I presents a theoretical justification for introducing infla- tionary expectations as an independent variable in the demand- for-money function. The argument is based upon the necessity of explicitly taking into account the effect of taxation on the rate of return, an effect that has been ignored by previous studies. Sec- *Mr. Tanzi, Director of the Fiscal Affairs Department, holds a doctorate in economics from Harvard University. He was formerly a professor and Chairman of the Economic©Internationals Departmen Monetaryt at America Fund.n University Not .for Redistribution 155 156 VITO TANZI tion II presents some simple empirical tests.1 Section III outlines an alternative model, subjects it to testing, and presents the new empirical results. Section IV draws some conclusions. I. Theory Assume that an economy is growing at a steady pace and that the price level is not expected to change. For such an economy, it is widely agreed that the demand for money, m, can be repre- sented by the function where r and y denote, respectively, the interest rate and the income level. As the price level is constant, r and y, as well as m, represent both nominal and real values. In this case, the rate of interest reflects fully the opportunity cost of holding money. Next, assume that although the economy is still growing at a steady pace, the price level is no longer stable but instead is increasing (and is expected to continue increasing) at an annual rate TT. Does this require a modification of equation (1)? Or should TT be included among the independent variables that affect ml The basic arguments against this inclusion would seem to be two: (1) the Fisherian hypothesis about the behavior of nominal interest rates during inflationary situations, and (2) the Keynesian assumption that money as an asset is substituted only for financial assets ("bonds") and not for real assets. If R denotes the nominal interest rate and r the real rate, Fisher's hypothesis states that or, in a stricter version, which implies that r is constant and that changes in 11 are fully reflected in R. When the strict version of the Fisherian hypothesis holds, the nominal rate of interest incorporates fully the expected rate of inflation. Furthermore, if interest income is not taxed, an individual who lends money at a nominal rate R receives a real ll shall stay within the established demand-for-money literature in order to test more accurately the main innovations in this paper. Areas of disagreement and current research effort are well surveyed in Laidler (1980). ©International Monetary Fund. Not for Redistribution INFLATION, TAXES, AND DEMAND FOR MONEY 157 return equal to the real rate r, which, under the assumed condi- tions, will always be positive and constant.2 This implies that R always exceeds IT by the amount of the real rate. Therefore, financial assets that pay a nominal return equal to R will be preferred over assets that pay an implicit nominal return equal to TT. The latter can be called consumption goods and would also include durables and non-income-yielding real assets such as works of art and jewelry. In such a situation, the real rate of return on equity will, at the margin, tend to be equal to the expected real rate of interest (r = R - TT); consequently, there will not be any preference for real assets over financial assets. The demand for money will be limited to the amount needed for current trans- actions; temporary excesses over that amount would lead to the purchase of interest-bearing financial assets (bonds) or income- yielding real assets (equity) and not to increases in the holdings of "consumption goods." The reason for this is that the purchase of the latter would be associated with an opportunity cost equal to the expected real rate of interest. Furthermore, if one still fol- lowed the traditional Keynesian assumption, even the substitution between money and income-yielding real assets (equity) would not take place, so that only financial assets would be purchased. The next step toward realism requires that the existence of income taxes be recognized.3 In today's world, an individual who buys a financial asset bearing an interest rate equal to R does not retain the total interest income derived from the asset but only the portion of it that is left after paying income taxes. Assuming that an individual's marginal tax rate, expressed as a fraction, is T, his after-tax interest rate will be reduced to R r, where If the Fisherian relationship is still assumed to hold, equa- tion (3) can be rewritten as Obviously, the higher is 71, the lower R T will be compared with R. Consider the rate of return that an individual gets, ceteris part- bus, if, instead of buying a financial asset, he buys, first, an equity, and, second, consumption goods. As unrealized capital gains are not taxed, if this individual buys an equity for which nominal value 2However, the real rate may not, in fact, be constant (see Tanzi (1980)). 3The role that income taxes may play in the demand for money has been largely ignored (see Tanzi (1979)).