Board of Governors of the Federal Reserve System

Abstract:

This paper presents the services account sector of a model of U.S. international transactions (the USIT model) that is maintained in the Division of International Finance of the Federal Reserve Board. Part I present the models for payments and receipts on direct investment, other investment income, and non-investment services. Part II reports on simulations that indicate the sensitivity of the model's forecast to changes in its predetermined variables such as interest rates and exchange rates. In particular, we explore the implications of large current account deficits and the resulting accumulation of net claims by foreigners on the United States for the services balance.

Abstract:

If forecasts of economic activity are to rely on preliminary data, the predictable component of the data revisions should be taken into account. This paper applies the Kalman filter to improve the forecast accuracy of published preliminary estimates of retail sales. Successive estimates of retail sales are modeled jointly as a vector autoregressive process, incorporating panel rotation and calendar effects. Estimates of retail sales based on this model are then combined with the raw Census estimates via the Kalman filter. This technique, which may be applied to other bodies of data, yields a significant improvement in the efficiency of the raw Census data, reducing the mean-squared error by about 1/3.

Abstract:

Using recently developed Monte Carlo methodology, this paper investigates the effect of dynamics and simultaneity on the finite sample properties of maximum likelihood and instrumental variables statistics for testing both nested and non-nested hypotheses. Numerical-analytical approximations (response surfaces) to the unknown finite sample size and power functions of those statistics are obtained for dynamic one-and two-equation models. The results illustrate the value of asymptotic theory in interpreting finite sample properties and certain limitations for doing so. Two practical finite sample results arise: the F form of the Wald statistic is strongly favored over its chi-squared form; and the effects of "large-sigma" and a small effective sample size are particularly pronounced for Sargan's (1958) instrumental variables statistic and Ericsson's (1983) Cox-type instrumental variables statistic. Re-examining Pesaran and Deaton's (1978) empirical example illustrates the additional information gained from the instrumental variables statistics.

Abstract:

This paper presents an empirical analysis of the macroeconomic and microeconomic factors underlying the causes and persistence of the U.S. external deficit in the 1980s. The paper begins with a review of the extensive literature on this subject, and then outlines an analytical framework that synthesizes several different approaches taken in previous studies. The proximate causes of the deficit are assessed using a partial-equilibrium model of the U.S. current account. We find that the decline in U.S. price competitiveness associated with the appreciation of the dollar over the first half of the decade was the dominant factor, while the excess of U.S. growth over growth abroad also contributed significantly. At a more fundamental level, drawing on average policy multipliers from a group of international macro models, the rise in the dollar and the growth gap that led to the deficit can be explained by the combination of a relatively restrictive U.S. monetary policy and expansive U.S. fiscal policy, along with fiscal contraction abroad. While the initial widening of the deficit can be adequately explained by macroeconomic factors, the deficit has adjusted substantially more slowly (particularly in real terms) to the fall in the dollar since early 1985 than conventional macro trade equations would predict. Analysis of the pricing behavior of foreign exporters, both in the aggregate and for a number of narrowly defined commodities, suggests that foreign profit margins have been squeezed more in response to the fall in the dollar than previously. Moreover, some foreign producers have benefited from significant reductions in production costs. Finally, quantitative restraints on U.S. trade appear to have slowed the adjustment of the trade balance to the decline in the dollar.

Abstract:

This paper is a general discussion of debt conversions in heavily indebted developing countries. The paper first describes the three different types of transactions that are commonly called debt conversions. Next the paper discusses programs that have been established in Chile, Brazil, Mexico, Argentina, and the Philippines to facilitate these transactions. Then the different ways in which commercial banks can participate in these transactions and the volume of these transactions to date are discussed. The paper concludes with a discussion of a broad range of economic issues raised by these transactions, including: the effect of debt conversions on the structure of debtor countries' external liabilities, the incentives debt conversion programs provide for net new capital inflows, the macroeconomic effects of these transactions, and the new role for debt swaps programs in the so-called "menu-of-options" approach to restructuring developing countries' bank debts.

Abstract:

Argentina's Austral Plan is used as a point of departure for the investigation of the role of exchange rate policy in a macroeconomic stabilization program for a developing country. A model of a country like Argentina is developed and the relationship between the exchange rate and macroeconomic policy is derived. The paper next explores the implementing of alternative macroeconomic policy strategies involving exchange rates. The framework provides a rough way of quantifying and making operational what is meant by "appropriate" fiscal and monetary policy in the context of a stabilization program. Finally, some practical aspects of implementing an exchange-rate-oriented macroeconomic stabilization program are discussed.

Abstract:

This paper examines how Taiwan, China, has used monetary policy to deal with the impact of the two oil shocks since 1973, as well as with the recent problem of a very large rise in foreign exchange holdings. In dealing with the inflationary pressures brought on by the two oil shocks, the central bank relied primarily on changes in its rediscount rate to reduce inflationary pressures. However, the changes were initially too small and too late to prevent a large rise in consumer prices in 1974 and 1980. Since 1985, the large gains in foreign exchange reserves, due to a rising trade surplus and capital inflows have sharply expanded the money supply. The burden of containing this inflationary threat has fallen on monetary policy, and the government has not been able to offset the build-up in reserves by prepayment of external debt since the amount of outstanding debt is relatively small. In addition, use by the central bank of its rediscount policy or changes in reserve requirements has not been appropriate as domestic credit expansion has been low and not a basic cause of the large rise in liquidity. Instead, the central bank has relied almost exclusively on open market operations. It has engaged in a massive sterilization operation, selling primarily central bank certificates of deposit to neutralize the potentially inflationary impact from the large rise in the money supply. So far the central bank has been successful in holding the inflation rate to a low level, but it is not yet clear whether the present strategy will continue to be successful. Some suggestions of new basic measures for restoring a sustainable equilibrium between the external and domestic sectors are discussed.

Abstract:

This paper addresses the question: do risk premia account for the observed time-varying discrepancies between forward and corresponding future spot exchange rates? A simple theoretical framework is used to derive testable restrictions on the parameters of a multivariate regression model. Using various econometric procedures and different estimation periods, the data reject the restrictions. In contrast to past investigations, the empirical results are inconsistent with a world in which time-varying risk premia are the sole determinants of observed deviations from the unbiased expectations hypothesis. Anticipated real exchange rate movements may explain the rejection.

Abstract:

The paper first surveys recent estimates of the appropriate yen dollar exchange rate that have been proposed in the literature. Most of the more careful estimates suggest that the yen was substantially undervalued against the dollar in early 1985 when it began its steep ascent and some of the estimates suggest that further appreciation from today's strong level is warranted.

We then turn to the adjustment process. First, we present evidence that a narrowing of Japan's record trade surplus has already started to occur, particularly in real terms. Next, we show that external adjustment has been slower than would have been predicted by a simple econometric model, if Japanese trade. We then explore several possible explanations for this predictive failure in the recent period, including the slower pass-through of exchange rate changes to Japanese export prices than in the past, and the slow pass-through of terms-of-trade gains to consumer prices. Evidence is also presented that Japanese exporters adjust prices asymmetrically in response to yen depreciations and appreciations.

Next, we use a simple model to analyze the oft-stated claim that too much yen appreciation in a short period of time may actually be counter-productive. The model shows that this outcome is possible, but we argue that for an economy with Japan's structure it is unlikely.

Finally, we analyze what role fiscal policy can play in the adjustment process. MCM simulation results suggest that a Japanese fiscal expansion would be much less effective in fostering a reduction in both the U.S. and Japanese trade imbalances than would a U.S. fiscal contraction. However, a Japanese fiscal expansion could have an important impact on domestic demand in Japan and on trade with the developing countries.

Abstract:

This paper attempts to capture the portfolio incentives for central bank participation in a multilateral trade clearinghouse and to discuss the relation of those incentives to the volume of trade. Clearing­houses for the netting of multilateral intra-regional trade have existed since the 1950s, but no work to date has attempted to explore the incentive effects of such arrangements. Instead previous work, primarily empirical, has focused on the tendency of preferential arrangements (clearing as well as favorable protectionist policies) between nations to encourage trade flows between them. This paper advances the notion that the effects of clearing arrangements must be modelled as a portfolio choice problem, in order to ascertain the precise influence of clearing alone.

The model developed here describes the choice of the central bank between holding reserve balances and investing in productive assets. For a given distribution of net export receipts and a given cash management policy of the central bank, expected daily demand for international reserves is derived. This demand is re-derived to illustrate the effects of a clearing­house; in addition, reserve demand is augmented to account for debt payments to external creditors.

Regardless of whether the central bank makes external debt pay­ments, the clearing arrangement reduces the demand for reserves to finance trade. It is possible, were the "freed" reserves invested in development of the export industry, that the clearing arrangement could translate into an increased volume of trade. If the country is burdened with external debt payments however, it is possible that the "freed" reserves would simply be used to increase payments to external creditors.

Abstract:

An examination of the macroeconomic, political, and institutional environment of the 1930s and the 1980s suggests a set of stylized facts associated with periods of trade tension and incidents of trade retaliation. Periods of macroeconomic stress precipitate changes in the conduct of and implementation of U.S. trade policy, which then can lead to escalating trade tension, protectionist measures, and perhaps retaliation. Macroeconomic stress, especially when linked to external events, decreases the political benefits of following a liberal trade policy and changes the economic consequences of following a particular trade strategy. As a result, it may be difficult for trading partners to predict the conduct of U.S. trade policy. Moreover, in reexamining its commitment to free trade, the United States may change its response to policies abroad. Finally, the United States may not only deviate from its established behavioral norms, but may also stray from the consensual international code of trade conduct.

These stylized relationships between macroeconomic environment and political and institutional pressures are applied to a simple game-theory paradigm. Changes in the environment and balance of political power change the elements of a payoff matrix. The policy implications of the model are that the United States should, subject to the constraints of a democracy, make clear both the direction of its trade policy and the magnitudes of any penalties. Much of the tit-for-tat trade retaliation observed in recent months may represent just such a communications effort.

Abstract:

This paper analyzes the effects of a tariff on price-setting duopolists who cannot segment geographically distinct markets; hence, commercial policy has effects in domestic and foreign markets. Although each firm's payoff function is discontinuous, there is a unique equilibrium for an arbitrary tariff. We find that a tariff serves to increase the profits of both the domestic and foreign producer. Moreover, the profits of both firms rise monotonically with the tariff.

Abstract:

The paper develops a simple simulation model of international bank lending to test the extent to which targeting of fixed shares in the stock of total bank claims on a borrower can make lending flows unstable. The model is based on three distinct types of lending strategies: potentially volatile lending by one group of banks with limited long-term commitment to international lending; the targeting of a given share of the total lending market; and lending based on an assessment of the borrower's creditworthiness.

The results of the model's simulations suggest that lending flows can become quite unstable if more than one-half of international bank lending is predicated on the maintenance of market share. The model also indicates an ambiguous role for market information in preserving stability. To the extent that improved public information about the lending activities of banks causes more banks to target market share, such information can result in market instability. However, under a rational expectation version of the model, if the increased information about bank lending behavior is used by some banks to improve their forecasts of the reactions of other banks it can serve to stabilize the system.

Abstract:

Recent attention has focused on measures of the dollar's effective exchange rate amid disappointment by some observers with the response of the U.S. trade balance to the depreciation of the dollar since February 1985. In particular, these observers suggest that the traditional indexes, which include only currencies of industrial countries, overstate the dollar's decline because it has depreciated much less against the currencies of some key newly industrialized trading partners.

This paper begins with a description of the uses of effective exchange-rate indexes and describes theoretically the choice of an index, which varies with the application. Although the inclusion of currencies of developing countries in an index may be useful for analyzing trade developments, it is not appropriate for some other purposes, such as providing information for monetary conditions. The latter part of the paper focuses on measures of exchange rates suitable for analyzing trade flows and domestic inflation and compares their performance in the context of the equations used by the Federal Reserve Board staff to forecast trade components and price deflators for exports and imports. The results suggest that the addition of the currencies of important developing-country trading partners in an index of exchange rates improves its performance in forecasting export volume and import prices but makes little difference for the forecasts of export prices.

Abstract:

During the early 1980s, many less developed countries (LDCs) experienced a phenomenon which is not readily explicable using conventional macroeconomic theory: accelerating inflation coupled with output contraction. Moreover, arguments based on supply shocks do not adequately explain the performance of the LOCs over this period. In explaining the apparent anomaly of accelerating inflation coupled with output contraction, the model developed here assigns an important role to the availability of bank credit.

In many LDCs, the government fixes interest rates on bank deposits and loans. If rates on loanable funds are set below market clearing levels, this leads to credit rationing. Generally, firms must pay wages to workers in advance of the receipts from sales. Bank credit is needed to finance the hiring of labor when there are few alternative sources of finance. Loan availability can thus have a crucial impact on the supply of output. The credit constraint is exacerbated when the government's fiscal deficit instigates inflationary pressure. In response, households reduce deposit holdings leading to a contraction in loan availability and recession.

Initially, the fiscal deficit and the money supply are assumed to be exogenously determined. Later, the analysis examines a feedback effect of inflation leading to increases in the fiscal deficit and further inflationary pressure. As inflation accelerates, individuals try to shift out of money balances and into inflation hedges contracting the real money supply, real loan availability, and output. Thus the model suggests an explanation for the vicious circle of accelerating inflation and declining output which is observed in many LDCs.

Abstract:

This paper presents an empirical analysis of the factors that contributed to the unprecedented widening of the U.S. external deficit between 1980 and 1986. The paper presents an empirical model of the U.S. current account that is used to assess the relative importance of changes in U.S. price competitiveness and changes in U.S. and foreign growth as determinants of the deficit. We find that while both factors were significant, the decline in U.S. competitiveness associated with the appreciation of the dollar was the dominant factor. The analysis is also pursued at a more fundamental level, using the results of various multicountry model simulations. We find that shifts in U.S. and foreign fiscal policy could account for over half of the widening of the deficit, but only part of the rise in the dollar. Given the importance of the dollar's appreciation to the widening of the deficit, we ask, finally, why the deficit (particularly in real terms) has been so slow to respond to the dollar's decline since early 1985. Several possible explanations are considered and we conclude that the delay can be attributed largely to normal lags in the response of trade prices and volumes to exchange rate changes. Moreover, the real net export deficit would have widened substantially further in the absence of the depreciation.

Abstract:

This paper considers the statistical and econometric effect that fixed n-period phase-averaging has on time series generated by some simple dynamic processes. We focus on the variance and autocorrelation of the data series and of the disturbance term for levels and difference equations involving the phase-average data. Further, we examine the effect of phase-averaging on the erogeneity of variables in those equations and the implications phase-averaging has for conducting statistical inference.

To illustrate our analytical results, we investigate claims by Friedman and Schwartz in their 1982 book Monetary Trends in the United States and the United Kingdom about what the properties of phase-average data and the relationships between those data ought to be. We present certain features of the observed series on velocity, examine how well our analytical model captures them, and contrast them with Friedman and Schwartz's predictions. While our model is an extremely simplified characterization of the phase-averaging adopted by Friedman and Schwartz, it does offer several insights into the likely consequences of their approach.

Abstract:

Exchange rate pass-through is the phenomenon whereby changes in the value of foreign exchange are reflected in changes in import prices. This paper presents a model in which firms are price setters who anticipate exchange rate changes. In equilibrium, firms' strategies incorporate expectations about the exchange rate consistently and are best responses to the strategies of all others in the world market. It is shown that exchange rate changes give rise to import price changes, but the degree of exchange rate pass-through depends upon domestic and foreign market structures and the exchange rate regime. In general, exchange rate pass-through is higher if the home market is monopolistic or if the foreign market is competitive. The paper concludes with an examination of disaggregated Japanese manufacturing price indices, and it shows that the degree of exchange rate pass-through was indeed correlated with industry concentration during the most recent period of the yen's depreciation against the dollar.

Abstract:

This study examines the out-of-sample forecasting performance of models of exchange rate determination without imposing the restriction that coefficients are fixed over time. Both fixed and variable coefficient versions of conventional structural models are considered, with and without a lagged dependent variable. While our results on fixed coefficient models support most of the Meese and Rogoff conclusions, we find that when coefficients are allowed to change, an important subset of conventional models of the dollar-pound, the dollar-deutsche mark, and the dollar-yen exchange rates can outperform forecasts of a random walk model. The structural models considered are the flexible-price (Frenkel-Bilson) and sticky-price (Dornbusch-Frankel) monetary models, and a sticky-price model which includes the current account (Hooper-Morton). We also find that the variable coefficient version of the Dornbusch-Frankel model with a lagged dependent variable generally predicts better than the other models considered including the random walk model.

Abstract:

Under current law, domestic deposits of federally insured banks are subject to a 1/12th of one percent per annum insurance assessment, while foreign deposits are not. This paper examines the arguments for and against extending this assessment to foreign branch deposits of insured banks, which in the aggregate amount to more than $200 billion. These arguments are based on real or imagined effects on FDIC revenues, the competitive position of various types of U.S. banks, international lending, bank capital format ion, the functioning of the international interbank markets, the general efficiency of resource allocation, and the "fairness" of assessment allocations. These arguments depend critically on assumptions about the incidence of an extension of the FDIC assessment.

The arguments are individually evaluated under assumptions about likely incidence effects on loan and deposit customers in a three sector--money center banks, foreign banks, and regional and smaller banks--collar banking system. In general, assuming all loan and deposit schedules are somewhat but not perfectly elastic in the neighborhood of equilibrium, the likely effects of an extension of the FDIC assessment can be summarized as follows: (1) slight increase in domestic deposit rates and volumes of U.S. and foreign-chartered banks; (2) slight decline in foreign branch deposit rates and volumes of U.S.-chartered and insured banks; (3) slight increase in deposit rates and volumes at foreign offices of foreign-chartered banks; (4) slight increase in interbank rates; and (5) slight increases in loan rates and a slight decline in the aggregate loan volume of the dollar banking system. The distribution of the decline in aggregate volume would depend on the elasticities of various Loan demand functions. It is also likely that the total deposits of the dollar banking system would decline slightly. The sectoral distribution of this effect would again depend on the elasticities of demand schedules.