Journal Article The Use of Adaptive Expectations in Stability Analysis: Reply Get access Donald R. Hodgman Donald R. Hodgman University of Illinois Search for other works by this author on: Oxford Academic Google Scholar The Quarterly Journal of Economics, Volume 75, Issue 2, May 1961, Pages 327–329, https://doi.org/10.2307/1884207 Published: 01 May 1961

I. Approaches to credit rationing, 258. — II. The influence of credit risk on loan payoff, 259. — III. Implications for lender behavior and borrower access to credit, 267. — IV. The central bank's influence, 275.

D ESPITE the growth in importance of other financial institutions the behavior of the commercial banking system remains a principal consideration in most discussions of national monetary affairs. Explanations of the way in which the Federal Reserve System exerts its influence on the cost and availability of credit in the economy continue to rely heavily on hypotheses about the loan and investment policy of the commercial banking system. For example, the postwar doctrine of credit rationing appears to rest primarily on the observed behavior of commercial bankers in dealing with their loan customers. Less exclusively but still significantly, the effectiveness of debt management and Federal Reserve open market operations in influencing the terms of credit to private borrowers has been linked to the responsiveness of commercial bankers to changes in market prices and yields of government securities. concept of the commercial bank which undergirds the argument for the sensitivity of commercial bankers to yield differentials is basically similar to that of an individual investor concerned with the yield, risk, and liquidity of alternative financial instruments. By an appropriate development of risk considerations' and by (rather general) allusion to oligopolistic imperfections of competition within the banking industry,2 this model has been extended to cover the rationing of bank credit by nonprice means. Nevertheless, the state of our understanding of commercial bank behavior is not entirely satisfactory. If commercial bankers are sensitive to yield changes on government securities why have they moved so freely out of these securities whenever the demand for bank loans was strong? 3 If oligopolistic conditions within the banking industry occasion nonprice rationing of bank credit what is their specific nature and how do they exert their influence? purpose of this article is to contribute to our understanding of commercial bank behavior by examining some implications for bankers of the demand deposit relationship of their loan customers. Anyone who troubles to inquire of commercial bankers will discover that the deposit relationship of a loan customer is a primary consideration in determining the cost and availability of bank credit to that customer. Despite this fact, the literature of monetary economics has little or nothing to say about the deposit relationship as one of the determinants of the investment behavior of commercial banks. Rather, as I have mentioned, we have preferred to carry forward the discussion in terms of the broader analytical categories of yield, risk, and liquidity applicable to any investor. But a discussion of commercial banks which is couched in these more general terms abstracts from some of the essential features of commercial banks as specialized financial institutions. In particular it neglects the role of deposits as the principal source of an individual bank's power to lend and invest. In what follows we shall examine the significance of the deposit relationship for the individual bank and then explore its influence on such broader issues as the cost and availability of bank cred* This article is drawn from a more comprehensive study of commercial bank loan and investment policy supported by Merrill Foundation for the Advancement of Financial Knowledge, Inc. author wishes to acknowledge the helpful criticism of Professors James Duesenberry, John Lintner, Lawrence Thompson, and Dr. Parker Willis. 1 For examples see Ira 0. Scott, The Availability Doctrine: Theoretical Underpinnings, Review of Economic Studies, xxv (October I957); and my own Risk and Credit Quarterly Journal of Economics, LXXIV (May I960). 2 For examples see John H. Kareken, Lenders' Preferences, Credit Rationing, and the Effectiveness of Monetary Policy, this REVIEW, xxxix (August I957); Monetary Policy and Management of the Public Debt, Joint Committee on the Economic Report, 82d Congress, 2d Session, Statement of Paul Samuelson; and Warren L. Smith, On the Effectiveness of Monetary Policy, American Economic Review, XLVI (September I956), esp. 593-96. 'This movement is chronicled and discussed in John H. Kareken, Post-Accord Monetary Developments in the United States, Banca Nazionale del Lavoro (Rome), Quarterly Review, September I956, 588-607; and Warren L. Smith, op. cit., esp. 597.

If monetary policy works exclusively through the cost of borrowing and many borrowers are insensitive to higher rates of interest, how is a debacle in the government securities market to be avoided in the process of restraining a boom? This problem had its genesis in the union of the Keynesian stress on the interest rate as the sole channel for monetary policy with the phenomenon of the apparent indifference of business borrowers to interest charges reported in the Oxford surveys of 1938 and I940. The growth of government debt during the war, followed by strong inflationary pressures, has made this the central issue for postwar monetary policy. While the monetary authorities have been feeling their way gingerly forward on the practical level, the availability doctrine has been evolving to rationalize their experience (and perhaps hopes) on the theoretical level. It is important to realize that the dilemma which the availability doctrine seeks to solve arises because the relative insensitivity of borrowers to rate increases on private securities is assumed to extend above pursuit levels available to government yields as limited by considerations of government debt policy. Presumably no one denies the power of the monetary authority to check an inflationary boom if it wishes to force the general level of interest rates high enough. But can monetary policy be made effective without raising yields on government securities to levels which are excessive in terms of the burden of interest charges on the national debt and of reasonable stability in the market for government securities? It is within this more restricted elbow room left to monetary policy by the assumptions of inelastic demand from private borrowers and ceiling yields on government securities that the availability doctrine advances its solution. It is not surprising, therefore, that the availability doctrine should stress lenders' behavior on the one hand and variables other than the interest rate on the other. The availability doctrine or, more broadly, the new theory of credit is subjected to a trenchant restatement and critique in formal terms by Professor John H. Kareken in the August I957 issue of this REvIEW.1 Kareken finds small comfort for monetary policy in the availability doctrine. If credit rationing is absent and the doctrine strictly interpreted, monetary policy will be either ineffective or too effective, depending on the interest elasticity of lenders' supply in the private market (assuming quite inelastic demand). On the other hand, if lenders do ration credit, the availability doctrine suffers from internal inconsistencies and requires modifications in ways which Kareken is unwilling or unable to suggest. In either instance little encouragement is offered to monetary policy. My purpose is to defend the availability doctrine against these views and to argue for the effectiveness of monetary policy. To contribute to the control of inflation, monetary policy must be able to restrict the flow of funds to private borrowers. Whether borrowers are deterred from borrowing by the high interest costs incurred or fail to receive accommodation from lenders at any interest rate because of non-price rationing is a matter of indifference to monetary policy so long as the desired restraint is effective. It is a matter of indifference, that is, unless important side effects attend either the price or nonprice rationing of funds. The availability doctrine has been fashioned to meet a specific objection to the use of rate increases to restrain borrowing,

THE rate of economic development of the Soviet Union is a subject of considerable interest to western economists. To date, the most important single measure of this development has been the official Russian index of the physical volume of production of Russian industry published in various Soviet sources for the I920's and I930's. In the past few years, there have been several articles by western economists devoted to a discussion of the defects of this index.2 The main criticisms are these. First, the index represents gross value of industrial output rather than value-added. Second, the index is subject to an inflationary bias on two main counts: (i) prices of the baseweight year I926-27 were unduly high for many newly produced industrial goods which continued to be valued at these inflated prices even after more efficient production methods ha:d brought their prices more in line with the overall price structure of the economy; had a later year been used as a base-weight year the resulting index would have revealed a smaller rise than the existing index does; (2) the so-called constant prices of I926-27 include an increasing number of prices for later years so that, under conditions of rising prices, an artificial inflation of the index results. Soviet economic authorities themselves have long voiced dissatisfaction with the official index expressed in prices of I926-27, and in I948 it was decided to abandon the I926-27 based index in favor of an index expressed in current wholesale prices and corrected for price changes by means of a wholesale price index.3 It is not known whether the new method is in actual use, whether the old official index will be recalculated by the new method or, if this is done, whether the results will be made public. Despite these reasons for dissatisfaction with the old official index, western economists have made no attempt to date to construct independently a more satisfactory index of Soviet industrial output.4 Although Societ statistical sources contain an adequate number of series for output in physical units (i.e., tons, square meters, etc.), a means for combining these in a single index of industrial output has been lacking. This is due to the deliberate suppression by Soviet authorities of the necessary price data. No systematic presentation of price data has been made for any year, and such scattered prices as are available are largely for years prior to I930. No price index has been published for the years after I93I. Value of output is never expressed in the prices of the current year but always in the so-called constant prices of I926-