Board of Governors of the Federal Reserve System

Abstract:

There have been numerous theoretical and empirical studies of the effect of exchange rate variability on the level of international trade. Most theoretical studies have concluded that under reasonable assumptions exchange rate variability ought to depress the level of trade. Empirical studies generally have not identified a significant effect of exchange rate variability on trade flows. This paper builds a theoretical model in which exchange rate variability has a negative effect on the level of trade. The model is calibrated to observed trade flows and real exchange rates. Simulation of the model demonstrates that the effect of increasing exchange rate variability on trade flows is very small. These results are not sensitive to a wide range of parameter values. Moreover, reasonable extensions of the model only serve to minimize further the effect of exchange rate variability on trade flows.

Abstract:

Capital stock variables appearing in investment and other equations are almost always constructed by the "perpetual inventory method." Successive values are related by the well-known equation:

where K(t) is the measure of the real capital stock at time t, I(t) is the real rate of investment, and the rate of depreciation. By successive backward substitutions for K(t-l), K(t) can be expressed equivalently as a weighted sum of past levels of investment plus the depreciated value of an initial real capital stock:

The initial real capital stock, K(O), that is implicitly a component of every measure of the capital stock calculated by this method can rarely be measured, however, with any degree of accuracy. As demonstrated in this paper, the measurement error can frequently lead to severe bias in the estimated coefficients of investment functions.

This paper proposes a method to bypass this source of measurement error. In important cases it is then possible to estimate unbiased and consistent coefficients.

Abstract:

This paper examines the empirical relation between nominal exchange rates and macroeconomic fundamentals for five major OECD countries. Five theoretical models of exchange rate determination are considered. Potential non-linearities are examined using a variety of parametric and non-parametric techniques. We find that the poor explanatory power of the models considered cannot be attributed to non-linearities arising from time deformation or improper functional form.

Abstract:

A state-dependent income tax is incorporated into an intertemporal production economy. Methods are developed for establishing the existence and uniqueness of an equilibrium, and for explicitly constructing this equilibrium. Some tax-policy experiments are suggested, the results of which may have important implications in quantifying the effects of various tax policies.

Abstract:

This paper examines the macroeconomic impact of tariffs. The effects of unilateral tariff changes are reviewed in a variety of theoretical models. Three different sets of data are consistent with the hypothesis that tariff rates have no significant effect on a system consisting of the real exchange rate, the real trade balance, and real output (both foreign and domestic).

Abstract:

Since the adoption of the Single European Act in 1986, doubts have been expressed about the ability of the European Monetary System as presently structured to ensure an efficient and effective monetary system for the single European market. The further adoption by the European Council (June 1989) of the Report on Economic and Monetary Union (the Delors report) moves the European Community towards even greater monetary integration.

Policy discussions have focussed on perceived problems with the current institutional and political structure of the European Monetary System and its exchange rate mechanism. Some have stressed that the current system is inherently asymmetric in the sense that it places greater burdens of adjustment on countries whose currencies are in less demand. Others have stressed that the objectives of fixed exchange rates, free capital mobility, and the autonomy of national monetary policies cannot simultaneously be achieved. Others emphasize that not only is closer monetary policy coordination required but so is greater coordination in other policies including budgetary, tax, and trade policies. This paper reviews these and other issues relating to monetary integration in Europe. While the discussion attempts to highlight important aspects and implications of these issues, and attempts to present the many points of view, it does not attempt to resolve these issues.

Abstract:

The economics literature offers competing hypotheses about the relationship between savings rates and output variability. This paper examines data for eight industrial countries to determine if there is a discernible pattern between savings rates and cyclical volatility of output. We find a striking coincidence of high gross savings rates and high output variability when real GDP gaps are estimated from a constant growth trend. But there is also strong evidence that this coincidence is an artifact. The major conclusion is that there is not a robust relationship between average gross savings rates and the variability of real GDP gaps (measured as deviations from trends) between 1960-Q1 and 1988-Q4. We also report a number of interesting features regarding estimated autoregressive processes for output in the major foreign industrial countries.

Abstract:

The rapid rise in Japanese owned assets in the United States and the substantial fall of the dollar against the yen naturally raises the question of whether there is a causal relationship between Japanese direct investment and the yen/dollar exchange rate.

This paper contributes in two ways to the analysis of the direct investment-exchange rate link. First, it presents a hybrid model of direct investment which incorporates insights from both portfolio balance models and industrial-organization-based models of direct investment. Second, it tests and compares these three models of direct investment using data for Japanese direct investment in 12 U.S. manufacturing sectors.

The results suggest that familiar I-0 determinants of industry profitability attract Japanese direct investment into U.S. manufacturing. Lower raw material costs, more profitable investment opportunities (as measured particularly by growing markets, presence of valuable patents, and more highly concentrated production structure), as well as trade barriers all significantly increase Japanese direct investment in U.S. manufacturing industries.

Portfolio balance factors also affect the demand for U.S. assets. Greater Japanese internal and external savings and reduced profitability of alternative assets (including ownership stakes in Japanese domestic industries) lead to significant increases in direct investment transactions in U. S. industries.

There is no evidence that the exchange rate alone is a significant determinant of Japanese direct investment in U.S. manufacturing.

Abstract:

In addition to dominating the list of the world's largest banks, Japanese banks currently account for about two-fifths of measured international banking assets of all banks. Between year-end 1984 and year-end 1988 Japanese banks accounted for slightly over one-half of the measured growth of total international banking activity. A large proportion of their international assets are at their branches in the United Kingdom and their agency and branch offices in the United States.

This paper analyzes the U.S. and U.K. activities of Japanese banks. The paper integrates the activities of the Japanese banks in these two markets with the regulatory environment for banks in Japan, with Japan's overall external financial position, as well as with business opportunities in the two host country markets. The paper concludes that the domestic regulatory environment in Japan, including restraints on interest rates, and possible quantitative restraints, has had an important impact on the activities of Japanese banks in these two foreign markets.

Japanese banks appear to have adjusted to their domestic regulatory environment by using their London branches as a flexible funding source, and their branches and agencies in the United States as substitutes for their head offices in extending commercial and industrial loans to Japan-based companies as well as a substitute location for large interbank trading activities. In both markets Japanese banking offices are large net borrowers from unrelated banks because of the constraints on raising funds in their home market.

Abstract:

According to conventional wisdom, if deficits are inflationary then current deficits should predict subsequent movements in money growth. This paper USES a general equilibrium model fit to data to: (1) explore the policy behavior underlying this accepted viewpoint; (2) examine alternative equi­librium deficit policies ranging from an exclusive reliance on direct lump-sum taxes to a mix of direct and inflation taxes; and (3) evaluate the empirical trade-offs implied by the various financing schemes. The results suggest that reduced-form analyses of whether "deficits matter" can lead to seriously misleading conclusions by mistakenly attributing fiscal effects to monetary policy.

I demonstrate that simple monetary and tax policy rules and plausible assumptions about when private agents learn of fiscal actions can produce a classical economy whose nominal equilibrium depends on the process for lump­sum taxes and whose time series contradict the view that monetized deficits predict inflation. I assess the fit of versions of the model to U.S. data and reinterpret existing reduced-form studies in light of the results.

Abstract:

This is paper discusses the theoretical structure and empirical properties of MX3, a multicountry macroeconometric model with rational expectations. MX3 is a medium-sized quarterly model of the United States, Japan, and West Germany. The primary objective of the model is to analyze the effect of fiscal and monetary rules on national economies in an international context. By incorporating rational expectations into almost all of the model's behavioral equations, MX3 takes a large step toward addressing the "Lucas critique" of model-based policy analysis.

Abstract:

In the 1980s, the United States developed a large and persistent current account deficit, financed by borrowing from abroad. The purpose of this paper is to explore the sustainability of these large deficits from one of several possible perspectives. Simulations of a model of the U.S. current account are used to examine the future servicing burden implied by the accumulating U.S. indebtedness to foreigners (or more precisely by the negative net international investment position).

Abstract:

This paper discusses the problems of international debt from the point of the of the evolution of U.S. policy. The first section presents a brief historical review of the international debt problems of the 1980s. The next section examines the situation as of early 1989: progress as well as continuing concerns are discussed. In the final section, some thoughts on the prospects for the debt problems are presented.

Abstract:

This paper examines the role of exchange rate changes in the international economic adjustment and policy process. The pre-1973 academic literature on flexible exchange rates is examined in light of the experience since 1973. Some thoughts on the efficacy and appropriate role of exchange rate changes in the international economy are then presented.

Abstract:

This paper evaluates an empirical model of UK money demand developed by Friedman and Schwartz in Monetary Trends... .Testing reveals mis-specification and hence the potential for an improved model. Using recursive procedures on their annual data, we obtain a better-fitting, constant, dynamic error-correction (cointegration) model. Results on exogeneity and encompassing imply that our money-demand model is interpretable as a model of money but not of prices since its constancy holds only conditional on contemporaneous prices.

Abstract:

Even though pieces of empirical evidence individually may corroborate an economic theory, their joint existence may refute that same theory. We discuss examples concerning testing for omitted variables, simultaneity, and rational expectations in the context of general-to-simple versus simple-to-general modeling. The proposition in the first sentence strongly favors the building of empirical models which are consistent with all available evidence.

Abstract:

According to data published by the Department of Commerce, the U.S. net international investment position (roughly the net external debt position with its sign reversed) at the end of 1987 was a negative $368 billion. This sum represents a deterioration of about $100 billion from the end-1986 level. The sharp downward plunge in the United States' net international investment position in recent years is, of course, a reflection of the large current account deficits recorded during most of the 1980s. In this paper, the U.S. net external debt position is examined and compared with the experience of other countries. The paper then proceeds to analyze the dynamic process of external debt accumulation. Concepts of external debt "stability" and "sustainable" external deficits are discussed. Next, a simulation model is developed with which various illustrative scenarios--involving alternative assumptions about exchange rates and demand growth--for the U.S. external accounts are generated and compared. Using these scenarios as background, the U.S. external adjustment process is discussed. Policy implications are then addressed, including the usefulness of focusing on the trade balance, rather than the current account, as the key indicator of external adjustment.

Abstract:

This paper examines the question of how the path of real GDP in four important Latin American countries, Argentina, Brazil, Chile and Mexico, might have differed if the sharp run-up in borrowing during the late 1970s and early 1980s had not occurred. Specifically, we ask whether these countries are better off or worse off for having borrowed heavily prior to the debt crisis, and we attempt to gauge the extent to which they would have received greater benefits if policies that improve economic efficiency had been followed. A simple macroeconomic mode is developed, and the simulation results are compared to the historical outcomes.

Abstract:

This paper presents an algorithm to solve recursive systems, formulated in discrete or continuous time, which have an endogenous state variable. The basis of the algorithm is a fixed point equation in the function from the state variables to the control variables.

Abstract:

In 1988, the United States recorded a current account deficit of about $135 billion. The consensus forecast seems to be for little change in the current account in the near term. In this paper, the implications of the U.S. current account deficit and of the consequent buildup in U.S. external debt are examined. The analytical framework for thinking about the U.S. current account is first surveyed, and the results from the empirical literature on the causes of the deficits in the 1980s are then reported. The sustainability of the U.S. external position is discussed next. It is concluded that, at some point, the U.S. trade deficit has to be closed, but that it is conceivable that the U.S. current account balance could remain substantially negative. How the trade gap might be closed is addressed in the final section of the paper.

Abstract:

The EC program to complete the internal market is designed to allow the free movement of goods, persons, services, and capital within the Community by the target date of December 31, 1992. This paper provides a comprehensive description and analysis of the EC program for the financial sector, with emphasis on the relationship of this program to overall issues regarding international trade in financial services.

The first section of the paper presents a brief historical survey of the origins of the internal market program. The second section provides an overview of the EC program for creation of a "European Financial Area," a term used by the EC Commission to refer to both the removal of barriers to capital movements and the establishment of a framework for a Community-wide market for financial services. The third section, which is the main focus of the paper, is a conceptual analysis of the internal and external dimensions of the EC program for financial services and markets; the section analyzes the EC approach of mutual recognition as a means of achieving integration of the Community's financial sector and also sets forth a general framework for considering approaches to market access for third-country firms. The fourth section presents the conclusions. A series of appendices provide detailed explanations of the EC programs for banking, investment services, securities markets, and insurance.

Abstract:

Both future disturbances and estimated coefficients contribute to the uncertainty in model-based ex ante forecasts, but only the first source is usually taken into account when calculating confidence intervals for practical applications. Schmidt (1974) and Baillie (1979) provide an easily computable second-order approximation to the mean-square forecast error (MSFE) for linear dynamic systems which recognizes both sources of uncertainty. To assess the accuracy of their approximation, and thus its usefulness, we compare it with three sets of estimates of the exact MSFE for the univariate AR(l) process: Monte Carlo estimates for OLS, analytically based values for OLS, and Monte Carlo estimates for maximum likelihood. We find that the Schmidt-Baillie formula is a good approximation to the exact MSFE, and that it helps explain why the exact MSFE can decrease as the forecast horizon increases. In fact, for dynamics typical to econometric models, the MSFE often has a maximum at a forecast horizon of one to twelve periods, i.e., at horizons that are of principal concern to forecasters and policy makers.

Abstract:

This paper presents an empirical analysis of the relationships among the U.S. external balance, exchange rates, macroeconomic policies, and longer-term trends in relative labor productivity. Movements in the U.S. external balance over the past two decades have been determined to a substantial degree by shifts in U.S. international price and cost competitiveness. Movements in price and cost competitiveness, in turn, have been dominated by swings in nominal exchange rates, which can be explained to a large extent by shifts in fiscal and monetary policies at home and abroad. A longer-term downward trend in the dollar may have been associated with secular decline in U.S. relative to foreign productivity in manufacturing. The downtrend in relative productivity has leveled off in recent years, however. The likelihood of a resumption of the downtrend in relative productivity may be reduced, at current level of exchange rates, by a shift in manufacturing investment towards.

Abstract:

The objective of this paper attempts to reconcile PPP-based views are model-based views about prospects for V.S. external adjustment in the medium term. Projections based on conventional models of the current account do not fully capture ongoing adjustments to exchange rate changes that are implicit in long-run PPP theory. In particular, the model-based projections fail to capture longer-run shifts in relative output capacity in response to sustained cost differentials (or deviations from absolute purchasing power parity) across countries. Such supply-side adjustments appear to have been quantitatively important in the past. With V.S. labor costs in manufacturing now noticeably below those in some other major industrial countries, these supply-side adjustments are potentially important in the period ahead. Nevertheless, when the model extrapolations are revised to factor in such longer-run adjustments, the projected deficit remains sizable.

Abstract:

This paper presents an empirical analysis of the progress in U.S. external adjustment through 1988 and prospects for continued adjustment over the years ahead. Our analysis, based in part on a partial-equilibrium model of the U.S. current account, suggests that adjustment was slower than "expected" during 1986-87, and faster than expected during the first half of 1988. The model was about "on track" in the second quarter of 1988, but did not anticipate the drop off in the trade balance in the second half of the year. We consider various model extrapolations of the U.S. external balance with exchange rates and income growth rates held unchanged. Our model, as well as those of other researchers, indicate that the U.S. external balance will narrow somewhat further during 1989, but will begin to widen again thereafter. This view may be overly pessimistic, due to some limitations of the models. In order to assess the credibility of these projections, we consider the issue of model uncertainty and construct error bands around the model projections using stochastic simulation techniques.

Abstract:

This paper reviews empirical evidence about the effects of changes in U.S. monetary policy and fiscal policy that has been accumulated during recent years in a series of collaborative research projects involving a variety of global macroeconometric models. The paper also considers, in particular, the consequences over the next five to six years for key U.S. and foreign economic variables of a significant U.S. fiscal contraction. The quantitative implications of both alternative fiscal spending and tax actions, and alternative treatments of expectations (adaptive versus rational) are analyzed.

The results suggest that a phased-in fiscal contraction could reduce the level of output for up to several years, as well as the levels of interest rates, the dollar and the U.S. external deficit. The decline in the external deficit would be significantly smaller than the decline in the budget deficit, however. The negative effects on output would be mitigated to the extent that the phased-in contraction were anticipated (i.e., announced credibly in advance), to the extent that monetary policy were eased, or to the extent that the fiscal package emphasized spending cuts and personal taxes rather than corporate and excise taxes.

Abstract:

In this paper I address some of the issues associated with measuring the profits and losses from intervention and show that U.S intervention since the beginning of generalized floating in 1973 has earned positive economic profits for the U.S. monetary authorities. Profitability has been largest during episodes of intervention that have generated large foreign-exchange exposures. Fundamental explanations for the profitability of intervention are difficult to isolate, but I discuss possibilities that are consistent with the data. Finally I consider the effects profitable intervention may have on macroeconomic activity through its effect on the government budget constraint.

Abstract:

This paper examines the issue of the U.S. external deficit in a global context. First, the paper considers certain aspects of the current economic situation that have contributed to the U.S. deficit and the progress that has been made to date in laying the basis for its narrowing. Second, the paper raises some questions about the international economic implications of a substantial reduction in the U.S. fiscal deficit, about the need for additional impetus to bring about further adjustment in the U.S. current account deficit, and about the preparedness of other industrial countries to absorb the elimination of the U.S. external deficit. Finally, the paper sketches a few scenarios for the U. S. external adjustment process and comments briefly on them as alternatives.

Abstract:

This paper attempts to provide some structure to the analysis and measurement of "net resource transfers." We go about achieving this objective in two steps. First, we use standard measures of portfolio changes and balance of payments statistics to evaluate the real resource transfers associated with financial transactions. Second, we sketch ways in which this analytical framework can be used to address the economic concerns associated with the term "net resource transfers," e.g., questions regarding the "burdens" of international debt obligations and the effects of these obligations on domestic capital formation and debt servicing.

Abstract:

In this paper, we discuss a new interpretation of what might be meant by the "coordination" of policies; in this interpretation, the policymakers are selecting a noncooperative solution rather than a cooperative solution. The new interpretation is suggested by the fact that games typically have a large number of Nash solutions, and players are not indifferent as to which occurs. The multiplicity of solutions may be due to information sharing and surveillance, the choice of policy instruments, or the adoption of reputational strategies in repeated versions of the game. The "coordination" problem: results from policymakers' desire to coordinate on a good Nash equilibrium. In section I, we use the simulations of the MCM and the DECO model that were prepared for the May 1988 FRB Monetary Conference to derive reduced forms for inflation and output, and we simulate a one-shot game. We calculate an uncoordinated Nash solution, a Nash solution coordinated on the low deficit assumption, two more Nash solutions coordinated on instruments as well as the low deficit assumption, and finally a cooperative solution. By comparing them, we hope to assess the empirical relevance of the new interpretation of the coordination problem. The Nash solutions based on the low deficit assumptions are to be viewed as approximations to coordinated Nash solutions based on information sharing and surveillance, always overstating their case.

In section II, we provide new simulations from the MCM to illustrate the dynamic paths of four possible outcomes under coordination and to look for indicators. The simulations consider the two scenarios for U.S. government purchases--low and high. Given these two scenarios, two sets of possible responses are considered. The first set of responses correspond to when the policymakers are correct in predicting the path of the U.S. deficit. The second set of responses occur when the policymakers are wrong. The simulations show how much better off each country is when the policymakers get the shock right; they also suggest which indicator variables might be used as early warnings of mistaken assumptions.

In section III, we study a game that centers on instrument selection instead of information sharing and surveillance. Policymakers in the United States, Germany and Japan inherit inflation problems and full employment. We begin by calculating a Nash solution in which the United States is using the interest rate, while Japan and Germany are using money supply. Then we see how the outcome changes if the United States switches to the money supply or if the policymakers decide to cooperate.

We find, measuring importance by the percentage decrease in losses, that coordination on instruments is about ten times as important as cooperation, and we find that coordination on information and surveillance is about ten times as important as coordination on instruments. The results from our one-shot games are reinforced by the simulation exercise. Furthermore, the simulations suggest that interest rates or exchange rates would be good early warning indicators of mistaken assumptions about the size of the U.S. deficit; the current account would not, since it adjusts very slowly.

Abstract:

This paper analyzes the exchange rates and consumer price indices of the six largest countries of the European Monetary System (EMS). The analysis covers the entire period of floating exchange rates. This paper shows that many of the implied real exchange rates have unit roots, even when one allows for the possibility of a structural break occurring at the time of the formation of the EMS. Further, prices and exchange rates are not co-integrated during the EMS period. There is strong evidence that there is a quadratic time trend in these price indices and weak evidence that Exchange rates and prices were more highly co-integrated before the advent of the EMS. The data suggest that the eleven realignments of the EMS between 1979 and 1988 have not served fully to offset the member countries' inflation differentials.