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May 25,1 984
Firm Size, ExchangeRates,and Interest Rates
This Weekly Letter inaugurates a new series,
appearing once a quarter, of digests of
articles appearing in the Federal Reserve
Bank of San Francisco's quarterly Economic
Review. These digests are intended to make
available to a wider audience the major
findings of research conducted at the San
Francisco Bank. Readers of the Weekly who
wish to obtain individual copies of a Review,
or who would like to be placed on the Review mailing list, may do so by writing the
Public Information Department, P.O. Box
7702, San Francisco 94720. In the case
where you are interested in a particular
Review, please be sure to specify its date
(e.g., Winter, 1984).
Economics of Firm Size
Four articles appear in the Winter, 1984
Economic Review, covering a wide range of
topics. In the first article, "The Economics of
Firm Size," Michael Keeley looks at the
question of why firms of widely varying sizes
coexist in many industries, a question that
has important implications for regulatory
and antitrust policy. Conventional neoclassical price theory does not shed much
light on this question because its usual
assumptions of competitive behavior and
identical production technologies lead to
the prediction that all firms will be the same
size in an industry.
Recent research on the economics of firm
size finds an explanation in differences
in managerial ability. According to this
work, even small differences in managerial'
talent can have large effects on a firm's
overall productivity because of the highly
hierarchical structure of the modern day
enterprise. Firms with superior managerial
talent therefore can become large and still
remain efficient by reason of their increased
productivity.
As Keeley notes, however, there are limits to
the size of a firm because costs of monitoring
employees' performance grow as the firm's
work force expands. Keeley argues that two
ways large firms try to keep monitoring costs
under control is to hire high-productivity
workers and to provide large amounts of
specific, on-the-job training for them. If his
argument were correct, employees in larger"
firms should be observed to earn more 00"
average than workers in smaller firms
because of their higher productivity. At the
same time, the relatively large amounts
invested in specific training by larger firms
should mean lower layoff and quit rates for
their labor force.
Keeley finds evidence for both of these
implications in a survey of households and
employers done in 1979-1980 for the federal
government's Employment Opportunity
Pilot Project. He findsthat large firms pay 10
to 15 percent more on average to their
employees, even after correcting for
demographic differences, occupation,
union status and other variables. Moreover,
data from the survey also indicates significantly lower employee turnover rates in
larger firms.
These findings bear on contemporary antitrust law and regulatory practices that
discourage large-scale firms in some industries. Keeley argues that these actions may
be counterproductive because they may
prevent firms from fully utilizing their
managerial resources to obtain maximum
efficiency. Consequently, he concludes,
" ... there may be economic lossesassociated"
with public policies that prohibit firms from
attaining their optimum size."
Money Demand
In a short policy article, "Dynamic Adjustment in Money Demand," Brian Motley
looks at two competing specifications of
how money demand behaves in the shortrun. The first, contained in conventional, or
money-adjustment, models specifies that
()pinions expressed in this new::;letter do not
necessarilv reflect the views of the management
01 the Federal Reserve Bank of San Francisco.
or (lithe Board of C;overnors of tilE' Federal
Reserve System.
the public adjusts the quantity of money it
holds with a lag to changes in desired levels.
"the evidence is not strong either way."
Motley also notes that the price-adjustment
model's poor performance for the period
after October 6, 1979 raises the question of
whether the Fed's switch to a new operating
procedure then was really the "monetarist
experiment" many claimed it to be.
The alternative explanation, which has
received increasing attention in the past few
years, is based on the idea that the central
bank can in principle determine the total
amount of money in circulation (the supply
of money) independent of the public's
demand for it in the short run. Over longer
periods oftime, the economy will adjust
interest rates, prices and income to bring the
desired quantity of money balances into line
with the existing supply.
Intervention: Japan'sease
Whether and how central banks should
intervene in foreign exchange markets to
stabilize their currencies has been a subject
of wide debate in recent years and a major
topic in the economic summits of Versailles
and Williamsburg in 1982 and 1983.
Michael Hutchison, in his article "Intervention, Deficit Finance and Real Exchange
Rates: The Case of Japan," studies the effectiYE;,IlE;;Sli
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tion in the foreign exchange markets.
Motley compares the performance of a
variant of this supply-determined modelone in which prices adjust to bring money
demandandsupply into balance--,-with the
money-adjustment specification in the
Federal ReserveBank of San Francisco's
money-market model. (As Motley notes in
his introduction, the San Francisco specificCltion,with its emphasis on the important
"buffer stock" role money plays, falls
somewhere between the conventional and
alternative specifications.) Using monthly
data for the period 1976-1 983, Motley concludes thatthere is some evidence in favor of
the money-adjustment model, although
Sterilized intervention means that any
effects of intervention on the domestic
money stock are offset. Sterilized intervention therefore affects the exchange rate
only through its impacton the mix of foreign
and domestic bonds in private portfolios.
Different portfolio compositions in principle
affect the relative yields on domestic and
foreign bonds, which in turn causes
exchange rates to adjust. However, as
Hutchison argues, government deficits also
alter the mix of foreign and domestic securities as new domestic bonds are issued, and
therefore may offset the effect of exchange
rate intervention.
Hutchison's examination of the JapaneseU.S. exchange rate during the period
1973-82 suggeststhat sterilized intervention
2
u.s.
by the Bank of Japan has "had only a small
influence on the yen-dollar real exchange
rate" and that this influence has been
swamped by the impact of government
deficits. Moreover, Hutchison concludes,
"it appears likely that sterilized intervention
will become an even less potent pol icy
instrument as the Japanesefinancial system
becomes more closely integrated with its
western counterparts."
an observed rise in both
nominal rates
and the real exchange rate would indicate
that real u.S.rates had risen. On the other
hand, concurrent movements in nominal
interest rates and forward exchange ratesan indicator of expected inflation -would
be evidence that inflation expectations
had changed.
Pigott applies this methodology to the
behavior of the dollar-German mark
exchange rate and U.S. and German longer
term interest rates over the period 19761983 in a search for clues about what
happened to real interest rates and inflation
expectations in the U.S. during thattime. His
findings corroborate impressions from other
sources that there was "a substantial decline
in .expected.. .inflation over\qeJastse.veral
years" but that at the same time "real interest rates have remained very high in
comparison to their level prior to 1 979."
Indicators of RealInterestRates
Modern economic theory emphasizes that
nominal, or market, rates of interest have
two components: an inflation premium to
protect lenders against expected future
inflation, and a real, or inflation-adjusted,
component that measuresthe true cost to the
borrower. As Charles Pigott points out in his
article, "Indicators of Long-Term Real
Interest Rates," each of these components is
of concern to the policy-maker, but unfortunately, neither can be observed directly.
This makes it particularly difficult to
interpret movements in longer term rates.
Despite some practical difficulties in implementing his methodology, Pigott concludes
that it offers a potentially fruitful way of extracting information from foreign exchange
and other financial markets to understand
the likely sources and potential impacts of
variations in domestic interest rates.
Pigott's strategy for determining which
component is changing when market rates
move is to look at some economic indicators
that are affected either by real interest rates,
or by expected inflation-but not by both.
One of the real rate indicators Pigott uses is
the real exchange rate-the nominal exchange rate deflated by the ratio of the
foreign to the
price level. A rise in the
real exchange rate is caused, among other
things, by a rise in
longer term real
rates. Thus, all other things being equal,
u.s.
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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4 .
Total Non-Transaction Balances6
Money Market Deposit
Time Deposits in Amounts of
$lQO,OOO
or more
Other Liabilities for Borrowed Moneys.
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)
Amount
Outstanding
5/9/84
179,691
159,987
48,421
59,720
27,906
5,013
12,106
7,598
185,545
43,257
29,173
12,296
129,992
Change from 12/28/83
Percent
Dollar
Annualized
Change
from
5/2/84
- 375
- 393
320
29
- 34
13
36
18
- 2,311
-2,969
63
99
559
-
-
3,666
4,632
2,458
821
1,255
50
401
565
5,452
5,980
2,158 '
479
1,007
-
-
-
-
5.6
8.1
14.6
3.8
12.8
2.7
8.7
18.9
7.8
33.2
18.8
10.2
2.1
39,370
62
-
277
-
1.5
38,773
21,192
292
660
-
608
815
-
4.3
9.6
Weekended
Weekended
5/7/84
4/23/84
356
120
236
68
102
33
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, N OW, Super N OW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPsand other sources
6 Includes items not shown separately
Editorial comlJ1entsmay be addressedto the editor (Gregory Tong)or to the author .... Freecopies of
Federal Reservepublications can be obtained from the Public InfQrmation Section, Federal Reserve
Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246.
1
2
@FedFRASER