Board of Governors of the Federal Reserve System

Abstract:

An increasingly popular approach to policy evaluation involves applying the parameters calibrated for a real business cycle model that does not include policy to a different model, where policy does affect private decisions. This technique, in effect, estimates a model that misspecifies how private behavior depends on policy. The calibrated parameters depend on policy behavior, but calibrators overlook this dependence when projecting policy effects. This procedure repeats the "Keynesian" errors that Lucas (1976) noted in his influential critique of (then) standard methods of econometric policy evaluation and produces predictions of policy consequences that may be no more useful than ones from traditional econometric models.

Abstract:

This paper provides a reinterpretation of seventeenth-century mercantilist trade doctrine and policy in light of recent theories of strategic trade policy. Mercantilist economic thought, like strategic export-promotion theories, emphasized the use of government policy to capture rents that arise from imperfect competition in international trade. The economic structure of the Anglo-Dutch rivalry for the East India trade provides an excellent illustration of an environment in which the profit-shifting motive for strategic trade policies exists. Using data from the seventeenth-century East India trade, I find that the scope for strategic trade policies was clearly present, although the gains from such policies were probably quite small and are highly sensitive to assumptions about demand.

Abstract:

The recent theoretical literature on strategic trade policy suggests that government intervention in international trade has the potential to be welfare-improving, thus bringing into question the traditional economic case for free trade. Economists in the nineteenth century also argued about whether theoretical justifications for tariffs compromised the case for free trade. This paper discusses two older debates somewhat related to the current focus on strategic industries and reciprocity, and concludes with an observation about how developments in economic theory affect economists' view of policy.

Abstract:

Trade of the OECD countries has grown faster than income during the postwar period. This paper tests a number of different hypotheses for the observed growth in the trade/income ratio. For small open economies, increases in real output and international reserves, as well as declines in tariff rates are associated with growth in the ratio. There are important differences in the behavior of the trade ratio across time and country size.

Abstract:

This paper focuses on price discrimination in international trade that is associated with movements in exchange rates. This phenomenon is referred to as "pricing to market." We find strong evidence of pricing to market for Japanese exports of automobiles. We find moderate evidence of such behavior for German auto exports, and very little pricing to market for U.S. auto exports. We conjecture that these sharp differences in export pricing behavior may be due to differences in the extent of overseas production by firms based in these countries. Pricing to market may be more important to firms that do not have plants in their target markets.

The patterns observed for automobiles do not hold up for total merchandise exports, where pricing to market varies by both source and destination country. These differences in measured pricing to market may reflect differences in the product mix of trade by source and destination.

Abstract:

In the context of a flexible-price monetary exchange rate model and the assumption of uncovered interest parity, we obtain a measure of the fundamental determinant of exchange rates. Daily data for the European Monetary System is then used to explore the importance of non-linearities in the relationship between the exchange rates and fundamentals. While some statistical evidence of non-linearities in conditional means of exchange rates is detected, these seem to have little economic content. A number of implications of existing "target zone" exchange rate models are tested; little support is found for existing models of limited exchange rate flexibility.

Abstract:

This paper estimates the pass-through relationship between exchange rates and import prices for the United States using recursive techniques across a variety of specifications to examine structural and coefficient stability in a systematic fashion. Results of estimations: 1) indicate that pass-through at the macroeconomic level is a complicated amalgamation of disparate industrial structures that involves more than one long-run equilibrium relationship between the variables of interest, and 2) call into question the prevailing wisdom that foreign firms changed their pricing behavior in light of the large appreciation in the exchange value of the dollar in the early 1980s.

Abstract:

This paper provides direct measures of the international mobility of long-term financial capital using interest arbitrage conditions previously applied only to short-term assets. Long-term arbitrage conditions are constructed using a now well-developed mechanism for hedging long-term currency positions, the currency swap. Asset returns are compared in the Euromarkets and in the onshore markets of Canada, Japan, Germany, Switzerland, the United Kingdom, and the United States. The evidence, discussed below, indicates that long-term financial capital is as mobile across these markets as is short-term capital. This appears to be the case both within the Euromarkets and across political jurisdictions.

Abstract:

National treatment, which precludes the use of rules that discriminate between foreign and domestic firms, seeks to ensure equality of competitive opportunity for foreign firms entering or operating in a host country. National treatment is a generally accepted principle for international trade in financial services. It is the basis for commitments by the twenty-four countries belonging to the Organization for Economic Cooperation and Development (OECD) and for the current negotiations on trade in services in the Uruguay Round of the General Agreement on Tariffs and Trade (GATT). This paper provides an analysis of national treatment and alternative principles in the context of the banking sector, with the U.S. experience as an example.

The first section of the paper presents a conceptual analysis of national treatment and of principles that go beyond national treatment that have been used or proposed to govern domestic market access for foreign firms. The second section discusses the development and application of the U.S. policy of national treatment in the context of the conflicting demands created by the internationalization of banking and a host-country regulatory structure that differs significantly from that of other major industrial countries. The treatment of nonbanking activities and interstate activities of foreign banks that operate banking offices in the United States are used as examples of the U.S. approach. The final section presents the conclusions.

Abstract:

This paper develops dual, geometric techniques for two popular three-factor general equilibrium models: the specific-factor model and the Krueger model of economic development. Several comparative static exercises from international trade theory illustrate how these models easily lend themselves to geometric exposition.

Abstract:

Despite the importance of well-specified empirical money-demand functions for inference, forecasting, and policy, problems in modeling have arisen concerning the economic theories of money demand, the data, institutional frameworks, financial innovation, and econometric implementation. By developing constant, data-coherent M1 demand equations for the UK and the US, we investigate these issues and explain such puzzles as "missing money", the great velocity decline, and the recent explosion in M1. The endogeneity of money, the Lucas critique, and the non-invertibility of our M1 models are also discussed.

Keywords: Conditional models, encompassing, error-correction, exogeneity, feedback, feed-forward, invariance, Lucas critique, money demand, predictive failure

Abstract:

This paper investigates term premia behavior in U.S., German, and Japanese markets. Onshore returns are evaluated in order to focus on the co-movement of the term premia across a set of potentially heterogeneous markets. The paper extends the work of Campbell and Clarida [1987], who find that the term premia within the Euromarket appear to move together. In keeping with their approach, Hansen and Hodrick's [1983] latent variable model is used. The model constrains expected returns, conditional on an information set, to be proportional to one another. These restrictions are not rejected for the markets examined here, implying that the term premia behave as if in a single market.

Abstract:

An important challenge to economists is to explain how financial contracts and institutions affect economic growth while simultaneously explaining how economic development elicits the creation and modification of an economy's financial structure. This paper addresses one side of this inherently two-sided issue. The paper shows how risk, transactions costs, and economies of scale in information gathering and resource coordination create incentives for the emergence of commonly observed financial institutions and contracts and how the resulting financial structure influences the steady state growth rate of per capita output. Policy can affect growth directly by altering investment incentives and indirectly by changing the incentives underlying the creation of financial structures.

Abstract:

This paper is an annotated bibliography of recent research on foreign exchange market intervention. Most of the paper is devoted to empirical studies of the effectiveness of intervention.

The paper describes the analytical framework within which most of this research has been conducted. Researchers have identified two principal channels through which sterilized intervention has its effects: the portfolio balance channel and the expectations or signalling channel. The great bulk of formal statistical tests of the effectiveness of sterilized intervention operating through the portfolio balance channel (influencing the relative supplies of bonds denominated in different currencies) have not found a quantitatively significant effect for sterilized intervention. In all of the much smaller number of studies of the expectations channel (influencing the expected future exchange rate), intervention has been found to have at least some statistically significant effect; most of these studies do not assess the quantitative significance of the effects that researchers found.

Abstract:

This paper uses a multi-country econometric model to assess the global impact of rapid economic integration of the two Germanys. The fundamental assumptions are that East Germany brings relatively more labor than capital to the union than does West Germany, and that the economic structure of a united Germany is essentially identical to that of pre-unification West Germany. In all of the simulations economic union leads to an acceleration of growth and investment in Germany, a real appreciation of the Deutsche­mark, and a reduction in Germany's current account surplus. The impact of German economic unification on other countries is relatively modest, as the additional investment demand is not large relative to global investment and a disproportionate share of that investment demand is met by domestic German savings.

Abstract:

This paper investigates two issues related to international trade in computers: measurement and prediction. Because of the rapid technological advancement in the computer industry, the Bureau of Economic Analysis (BEA) measures computer prices using techniques that adjust for quality change. The constructed hedonic index is essentially a domestic price measure, but the BEA uses it for the deflation of international sales and purchases of computers. This paper begins with a review of the theory behind hedonic price indexes, and then proceeds to discuss the concerns that arise when a domestic index is used to deflate international transactions.

If the computer industry is sufficiently different from other industries, separate treatment of computers in empirical models of international trade may be necessary to capture historical developments and predict future outcomes. This paper examines the simulation performance of a conventional aggregate trade model, a modified aggregate trade model, and a model that disaggregates computers. The model with computers disaggregated is shown to out-perform the other models.

Abstract:

This paper evaluates the distributional properties of forecasts from six econometric models of the U.S. trade account. Using stochastic (Monte Carlo) simulation, we derive confidence intervals and forecast-based test statistics which account for uncertainty from future disturbances and from coefficient estimation. Empirically, the confidence intervals of the trade-account forecasts are very wide, and are generally (but not necessarily) increasing with the forecast horizon. Even with such a large degree of uncertainty, some models exhibit "predictive failure" when tested. To evaluate forecasts across models, we generalize Chong and Hendry's (1986) forecast-encompassing test statistic to allow for model nonlinearity and to account for uncertainty arising from estimation. All models are rejected by this test, i.e., the data are highly informative. Although both the calculated forecast uncertainty and the test failures temper the role of these models in formulating policy, the failures imply the potential for improved model specification with narrower confidence bands.

A robust, competitive manufactured goods sector is also key. A growing manufactured goods sector increase the flexibility of the economy to respond to external and internal shocks and is associated with higher per capita income growth. World trade in manufactures is growing faster and at relatively better and less votatile terms of trade than trade in commodities. Criteria such as labor productivity in agriculture and manufacturing, population growth rates, and changes in the share of production and exports of manufactured goods provide evidence of which countries of the new generation can take advantage of the manufacturing dynamic.

Abstract:

In the 1970s, the Newly Industrializing Economies (NIEs) emerged from the pack of developing countries by exporting manufactured goods. Some succeeded and some did not. In this decade, another set of developing countries are poised to become the next generation of NIEs. Which have the prerequisites of stable macroeconomic policies and the foundation for further manufacturing development? A review of the Latin and Asian NIEs' experiences suggests criteria against which we can measure countries of the next generation.

Macroeconomic criteria include: the savings-investment imbalance, but also their levels; fiscal deficit and the sectoral allocation of government spending; the magnitude and change in domestic and external exposure to interest payments on debt; the variability, degree, and duration of misalignment of the real exchange rate. But macroeconomic stability, while necessary, is not sufficient for sustained growth and development.

A robust, competitive manufactured goods sector is also key. A growing manufactured goods sector increase the flexibility of the economy to respond to external and internal shocks and is associated with higher per capita income growth. World trade in manufactures is growing faster and at relatively better and less votatile terms of trade than trade in commodities. Criteria such as labor productivity in agriculture and manufacturing, population growth rates, and changes in the share of production and exports of manufactured goods provide evidence of which countries of the new generation can take advantage of the manufacturing dynamic.

Abstract:

A simple stochastic equilibrium structure is used to study the implications of monetary and fiscal policy interactions for government intertemporal budget balance. Existence and uniqueness of monetary equilibria are shown to depend on parameters of policy rules. The paper derives closed form solutions for equilibrium inflation and real debt as functions of policy parameters and policy shocks and obtains conditions under which the usual tests that deficits Granger-cause money creation will successfully uncover evidence of monetized deficits. In addition, equilibria are studied in which private agents today know tomorrow's taxes exactly. Coupling this informational assumption with a monetary policy that pegs the nominal interest rate reverses the usual Granger-causal ordering between deficits and monetization, so that money growth (or inflation) may predict higher deficits. This implies that empirical work designed to detect that deficits have been monetized by testing whether deficits Granger-cause money creation, may fail to uncover the monetization.

Abstract:

In a model that emphasizes technological progress and human capital creator as essential features of economic development, this paper establishes a theoretical link between the financial system and per capita output growth. More specifically, it demonstrates that stock markets--by facilitating the ability to trade ownership of firms without disrupting the productive processes occurring within firms--naturally encourage technological innovation and economic growth. Along with recent studies of the role played by financial institutions other than stock markets in promoting growth, this paper contributes to a theoretical foundation upon which financial policy recommendations may more confidently rest.

The paper finds that direct and indirect taxes associated with stock market transactions slow real per capita output growth. Thus, given different policies toward financial markets, this paper helps to explain simultaneously the observed differences in growth rates across countries, the inability of measured factor inputs to explain these differences, and the close empirical association between the size of financial markets and the rate of economic growth.

Abstract:

This paper assesses prospects for sustained improvement in the U.S. external balance drawing on both model-based macro analysis and examination of disaggregated data. Most model projections of the future path of U.S. external balance show the recent improvement petering out by the end 1989 or so. Key structural factors leading to the expected future worsening of U. S. external balance are two asymmetries--the "income asymmetry" and the "pass-through asymmetry". That is, asymmetries in the pricing behavior of U.S. exporters and foreign suppliers and asymmetries in the elasticities of U.S. demand for imports and foreign demand for U.S. exports with respect to economic activity.

However, could projections based on historical relationships be misleading? Have these models ignored important changes in the international environment? Changes in trading partners and composition of trade, in income responsiveness, exchange rate movements and price competitiveness, the net debt position, trade protection, long-term supply response, and model uncertainty are considered.

Plausible (or sometimes implausible) changes in the historical relationships do not materially change the medium-term outlook for a future deterioration in U.S. external balance. However, model uncertainty suggests that confidence intervals around the point estimates of key parameters are sufficiently large that periods of improvement in U.S. external balance are within the realm of statistical probability; nevertheless, the outlook for sustained improvement remains problematical.

This suggests that outcomes for growth and the exchange rate different from those assumed in the projections, and which would probably stem from a different configuration of fiscal and monetary policies here and abroad, are likely necessary to put U.S. external balance on a sustainable path.

Abstract:

This paper analyzes movements in the U.S. external imbalance over the 1980s from the perspective of the capital account. It considers the empirical evidence on two competing hypotheses about the causes of the large and persistent net capital inflow during the decade: one that the capital inflow was induced by a substantial increase in the expected rate of return on real fixed investment in the United States relative to other countries, and the other that strong U.S. fiscal stimulus and a declining private savings rate boosted demand for credit in the United States.

The empirical evidence that we review on this score include the pattern and composition of capital inflows, trends in the components of U.S. domestic saving and investment, and movements in U.S. relative to foreign rates of return across different types of real and financial assets. The evidence strongly supports the view that the net capital inflow resulted from an increase in demand for credit, and not to any significant degree from an increase in the relative rate of return on real fixed investment in the United States.

We also consider the sustainability of the U.S. external imbalance. Available empirical evidence on this score suggests that over the short to medium term at least, continued large U.S. external deficits could be absorbed manageably into foreign portfolios. Nevertheless, if those deficits continue to finance U.S. government and private consumption rather than the increased rate of domestic investment that would be needed eventually to service the associated external debt, they are not sustainable in the long run.

Abstract:

Over the past century, the ratio of international trade to GDP has not grown substantially for most major OECD economies. We conjecture that growth in intra-industry trade has been offset by a decline in intra-industry trade. Inter-industry trade may have declined either because of biased growth in factor inputs so that factor proportions have become more similar, or because preferences have become more similar with rising per capita income.

Abstract:

Analyses of the possible contractionary effects of exchange rate devaluation typically assume the foreign exchange market to be unified, thereby ignoring the large fraction of transactions taking place in the black market for foreign exchange that exist in many developing countries. This paper explores how the existence of these black markets may alter the impact of an official devaluation on aggregate output. It is argued that devaluations will be followed by less immediate contraction in a black­market economy than in a unified-market economy, both because the black market exchange rate will depreciate by less than the official rate, and because many of the devaluation's contractionary effects will occur in anticipation of the official devaluation itself. These propositions are tested using a simple numerical simulation model.