Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : September/October 1981, Volume V, Issue 5

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Interest rates and exchange rates
under the Fed’s new operating
procedure: the uneasy marriage

3

The relationship b etw e en interest
rates and the dollar has b een m uch
m ore system atic sin ce the Fed a d o p te d
its n ew re serve s-o rien ted operating
p ro ce d u re.

The internationalization
of American agriculture

CONTENTS

The p ro sp e rity o f A m erican agricul­
ture has b eco m e increasingly d e p e n d ­
ent on the exp o rt m arket in recent
decades.

A new role for federal
crop insurance
Federal insurance against cro p
losses may play a greatly exp a n d e d
role in the future.

EC O N O M IC PERSPECTIVES
September/October 1981, Volum e V , Issue 5
Economic Perspectives is published bimonthly by the Research Department of the Federal
Reserve Bank of Chicago. The publication is produced under the direction of Harvey
Rosenblum, Vice President, and is edited by Larry R. Mote, Assistant Vice President, with the
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not necessarily reflect the views of the management of the Federal Reserve Bank of Chicago or
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Controlled circulation postage
paid at Chicago, Illinois.




14

18

Interest rates and exchange rates under
the Fed’s new operating procedure:
the uneasy marriage
William L. W ilby
M ovem ents in the trade-weighted value of
the dollar have exhibited a greatly increased
sensitivity to m ovem ents in U.S. short-term
interest rates since the adoption of the Fed­
eral R eserve’s new m onetary policy operating
p ro ced u re on O cto b er 6,1979 (see chart). On
that date, the Federal Reserve (Fed) changed
its pro ced ure to a system of so-called “ reserve
targeting’’ w h ereb y it attempts to hit a target
level of bank reserves estimated to be co n ­
sistent with the desired level of the money
sto ck.1 Previous to that date the Fed had
attem pted to keep the federal funds rate
w ithin a targeted range believed consistent
with the money stock's desired level.2
The relationship between interest rates
and the d ollar has been much more syste1It will be helpful to remember that the new operat­
ing procedure adopted on October 6 is not a reserves
operating procedure in the sense in which that term has
generally been used—i.e., a total reserves targeting
procedure. Because of lagged reserve accounting, under
which the banks’ current required reserves depend on
their deposits two weeks ago, total reserves cannot be
controlled closely in the current week. What the Fed can
control is nonborrowed reserves, forcing banks to bor­
row any difference between required reserves and non­
borrowed reserves at the Fed’s discount window and
thereby influencing the cost of reserves at the margin.
2Because the federal funds rate is the cost to a bank
(at the margin) of obtaining funds to support loans to its
customers, it influences interest rates on all other assets
in the financial system. When the Fed operates on a
federal funds rate target, it does so by supplying reserves
to the banking system when the rate starts to rise above
the target, and draining reserves from the banking sys­
tem when the rate starts to fall below the target.
Although under lagged reserve accounting there is a
two-week delay in the transmission of disturbances from
the federal funds market to conditions in the credit
markets (and vice-versa), we will assume throughout this
articlethat no such lag exists. Furthermore, we will speak
of “ the” interest rate as if such a representative rate
existed. A technically more accurate analysis would
examine the entire term structure of both interest rates
and spot and forward exchange rates.

Federal Reserve Bank o f Chicago



matic since the change in operating proce­
dure. M o reo ver, the relationship has been
decidedly positive in the short run as well as
over longer periods, w hich was not always the
case in the past. This article will argue that
there are strong reasons for believing that the
Fed’s shift to its new operating procedure can
partially explain the more consistently posi­
tive relationship between dom estic interest
rates and the U.S. cu rren cy.
W hat are these reasons, and more gener­
ally, how does the observed relationship
between interest rates and exchange rates
mesh with various theories of exchange rate
determ ination? It w ill be argued below that
m ovem ents in the exchange value of the dol­
lar respond to d ifferences in real interest rates
(that is, interest rates adjusted for expected
inflation) and that these real interest rates are
affected both by m arket perceptions of the
Fed’s operating stance and by the particular
m onetary policy operating target chosen by
the Fed. This interpretation explains the rela­
tionship between nom inal interest rates and
the exchange rate over the past five years, as
w ell as the shift in that relationship that seems
to have occurred since the Fed im plem ented
its new operating p rocedure in the fall of
1979. M o reo ve r, it w ill be argued that this
view is consistent both with the m odern asset
m arkets approach to exchange rate determ i­
nation and with the more traditional theories
of exchange rate m ovem ents.
Interest rates and exchange rates—the theo­
retical relationship
The relationship between interest rates
and exchange rates is a com plex one which
incorporates num erous behavioral parame-

3

The trade-weighted dollar versus the
U.S.-foreign interest differential, 1976-80
Nov. 1, 1978

ters. Considered in isolation, a rise in interest
rates in a given country w ould be expected to
cause a rise in the value of that country's
cu rren cy, simply because higher interest rates
should attract capital from investors in other
countries. H ow ever, when investors purchase
the cu rren cy of a foreign country to take
advantage of higher interest rates abroad,
they must also consider any losses or gains
they might incur due to fluctuations in the
value of the foreign cu rren cy prior to m atur­
ity of their investm ent. G enerally they cover
against such potential losses by contracting
for the future sale or purchase of a foreign
cu rren cy in the forward m arket for foreign
exchange so as to lock in a certain exchange
rate on repatriation of their principal and
interest.
Their actions in trying to profit from
interest rate differentials between countries
lead, in eq u ilib riu m , to the condition of socalled interest parity, in w hich any exchange
rate gains or losses incurred by engaging in a
sim ultaneous purchase and sale in the spot
(im m ediate delivery) and forward (future
delivery) markets are just offset by the inter­
est d ifferential on sim ilar assets. U nder these
co nd itions, there is no incentive for capital to
move in either d irectio n, since the effective
returns on foreign and dom estic assets have
been equalized (see box).
Interest parity can be upset by a sudden
rise in dom estic interest rates creating an
opportunity for a shrewd and swiftly reacting
investor to make a profit at little or no risk by
borrow ing m oney w h ere it is cheap (the fo r­
eign m arket) and lending it w here it is dear

4



O ct. 6 , 1979

(the dom estic m arket). This practice is known
as interest arbitrage and it is engaged in fre ­
quently by the foreign exchange traders of
large m ultinational banks and corporations.
In order to engage successfully in inter­
est arbitrage, ho w ever, an arbitrager must
accom plish four things before other traders
have had tim e to react to the higher dom estic
interest rates and reestablish equilib rium .
First, he must borrow at a low er foreign inter­
est rate. Second, he must purchase dom estic
money with his newly borrowed foreign
money in the (spot) foreign exchange market.
Th ird , he must invest the dom estic money at
the higher dom estic interest rate. Fourth, and
finally, he must contract in the forward market
for a future sale of his dom estic cu rren cy for
foreign cu rren cy at m aturity of his investment
in order to repay his loan.
As many investors simultaneously attempt
to take advantage of the opportunity for
profit occasioned by the rise in dom estic
interest rates, the interest and exchange
markets typ ically react in the follow ing m an­
ner: foreign interest rates rise as arbitragers
attempt to borrow foreign cu rre n cy; the
dom estic exchange rate rises as arbitragers
attempt to convert foreign into dom estic cu r­
rency in the spot m arket; the dom estic inter­
est rate falls (although not back to its original
level) as arbitragers invest their funds in the
dom estic credit m arket; and the forward
price of the dom estic cu rren cy falls as arb i­
tragers attempt to sell the dom estic cu rren cy
in the forw ard m arket in order to pay off the
foreign loans and retain the differen ce as
profit. These actions w ill all w ork to reestab-

Econom ic Perspectives

The interest parity condition
The interest parity condition sim ply re ­
lates interest rates and spot and forward
exchange rates so th ere is no advantage to
investing in one cu rren cy as opposed to
ano ther. It can be developed very sim ply by
com paring the returns an investor w ould
earn at hom e and abroad. Let E equal the
spot e x c h a n g e rate in d e u tsc h e m arks
(D M )/d o lla r. Also let Rf and
equal the
G erm an (foreign) and U.S. (hom e) interest
rates on 12-month certificates of deposit
(CD s) both expressed as a fraction (i.e ., .06
instead of 6 p e rce n t), and assume that a U.S.
investor has $1.00 to invest that he could put
in either G erm an or U.S. CDs.
If he places his dollar in the U.S. C D , he
w ill have 1 + R^ at the end of 12 m onths.
If he places his m oney in the Germ an
C D , he must first convert his one dollar in the
spot foreign exchange m arket. This w ill give
him E D M . He must then invest the E DM in a
G erm an C D , w h ich w ill give him E(1 + Rf)
D M at the end of 12 m onths. H o w ever, if he
wants to be certain of his return in dollars, he
must co ntract for exchange of his D M for
dollars in the fo rw ard m arket. This w ill give
him E(1 + Rp,)(1/F) dollars at m aturity.
If th ere is to be no incentive for the
investm ent in G erm an y, his dollar return on
the investm ent there must be the same as his
do llar return on the investm ent in the U n i­
ted States. Thu s, for “ p arity,”
1 + R h = E(1 + Rf)(1/F), or
1 + Rf
F/E = ------ - .

F - E= Rf * h
E

1 + Rh •

Since 1 + R^ is not very d ifferent from
o n e , w e can app ro xim ate this condition as
fo llo w s:

Ills'R,-Rh.
In ad dition , w e w ould expect that the
forw ard rate (F) should be a reflection of the
m arket’s expectations about the spot e x­
change rate one year from now . If this w ere
not the case, speculators w ould move the
rate until it did reflect accurately their expectationso f th e fu tu re . For exam ple, if an inves­
tor thought that the 12-month forw ard rate
on D M w ere belo w what he was fairly sure
w ould be the actual spot exchange rate 12
m onths from n ow , he could earn a profit by
contracting in the forw ard m arket for p u r­
chase of D M . T h e n , after 12 m onths, he
could exercise his contract by purchasing
D M at the p revio usly agreed upon forw ard
rate, and im m ediately sell them at the c u r­
rent (higher) spot rate for a profit. If many
speculators w ere attem pting sim ilar actions,
this w ould drive up the forw ard rate until it
accurately reflected m arket expectations. To
the extent that the forw ard rate is a reflection
of m arket expectations, the interest parity
condition may be w ritten as fo llo w s:
Expected ( E ) - E g R | _ R| nr

i + Rfi

This can be sim p lified further by sub ­
tracting one from both sides of the equation
1 = E/E

i + *h
1 + Rh '

so that

1 + Rf

F/E - E/E = ------ 1 + Rh

1 + Rh

or

1 + Rh

Federal Reserve Bank o f Chicago




expected % A E = R^ - R^ .

This is also know n as the condition for
u ncovered interest parity since an investor
w ould expect the same earnings even if he
did not contract for sale in the forw ard
m arket at m aturity of his investm ent w hich
should be the case in e q u ilib riu m .

5

lish interest parity and elim inate the oppor­
tunity for profit. Because exchange and money
markets are connected by sophisticated tele­
phone, telex, and com puter hook-ups, the
reestablishm ent of interest parity takes only a
matter of minutes.
W hen the arbitraging has been com ­
pleted, the ultim ate results of the initial rise in
dom estic interest rates w ill be: higher dom es­
tic and foreign interest rates, a higher dom es­
tic exchange rate, and a lo w er foreign ex­
change rate.3 In other w o rd s, even though
increases in the hom e co u n try’s interest rate
are associated with appreciation in its cu r­
rency, increases in the foreign country's
interest rate may be sim ultaneously associated
with a depreciation in its cu rren cy.
Although this result may seem paradoxi­
cal at first, it is a necessary consequence of the
nature of world capital m arkets today. The
so-called Eurocurrency m arkets, w here much
of such arbitrage takes place, ensure that all
of the w o rld ’s money m arkets are highly inte­
grated. W ith free m ovem ents of international
capital, pressures are generated for fairly syn­
chronous m ovem ents in interest rates. Under
these circum stances a positive relationship
between dom estic interest rates and the price
of the dom estic cu rren cy necessarily im plies
an inverse relationship between the foreign
co u n try’s interest rate and the price of its
cu rren cy. Thus, if the deutsche m ark/dollar
exchange rate is appreciating with rising U.S.
interest rates, the d ollar/d eu tsch e mark ex­
change rate is depreciating by d efin itio n,
even though Germ an interest rates are rising
as they are pulled up to some degree by U.S.
rates.
O n the other hand, the relationship be­
tween the interest d ifferen tia l and exchange
rates should be consistent. That is, if the
3
Whether this scenario is played exactly according to
script depends critically on the various elasticities of
supply and demand in the spot and forward exchange
marketsand in the national money markets. Elasticities in
the exchange market will depend largely upon the
demand of exporters and importers for forward cover,
the availability of funds for speculative purposes, and the
certainty with which expectations are held, as expressed
by the variance of market participants' subjective proba­
bility distributions.

6




interest differential favo ringthe United States
(the U.S. rate minus the foreign rate on similar
assets) is increasing, w e should expect an
appreciation of the dollar and a depreciation
of the foreign cu rre n cy.4
5
H ow ever, m ovem ents of interest rate d if­
ferentials and exchange rates have not always
displayed such consistency (see chart). As can
be seen, the trade-w eighted value of the d o l­
lar declined from mid-1976 to late 1978 even
though the interest d iffe re n tia l favoring the
U nited States rose continuously throughout
this period. Th en , in 1979, after the change in
F e d e ra l R e s e r v e o p e r a tin g p r o c e d u r e s , th is

relationship reversed and the interest d iffer­
ential and the trade-weighted dollar rose and
fell together.
A theory of the determ ination of n o m i­
nal interest rates and exchange rates capable
of resolving this seem ing anom aly must in ­
clude two essential elem ents. The first is a
description of the m echanism by w hich e x­
pectations, especially of future inflation rates,
influence the determ ination of nom inal inter­
est rates and exchange rates. The second is an
explanation of the role of the Fed's operating
target in the form ation of these expectations.
To understand these two keys to the process
by w hich interest rates and exchange rates are
determ ined, it is useful to begin by exam ining
the leading alternative theories of exchange
rate determ ination.
Theories of exchange rate determination
In addition to the sim ple interest parity
theory, it is possible to identify four other
4
This analysis assumes that movements in U.S. rates
determine the movement of the U.S.-foreign interest
differential. There are two primary reasons why this is a
plausible assumption. First, the large size of the U.S.
capital market makes it more impervious to forces from
outside. Second, the prevalence of the dollar in interna­
tional trade and in the Eurocurrency markets makes U.S.
monetary conditions the prime force internationally.
5
The interest differential is the difference between
the U.S. rate on 90-day certificates of deposit and a
weighted average of foreign interest rates on similar 90day money market instruments. The countries entering
into the weighted average are the same as those used in
computing the trade-weighted value of the dollar (the
Group of 10 countries plus Switzerland).

Econom ic Perspectives

m ajor theories of exchange rate determ ina­
tio n : (1) the purchasing power parity theory,
(2) the balance of paym ents theory, (3) the
m onetary approach to exchange rate deter­
m ination, and (4) the asset markets or portfo­
lio balance approach. Although, when consi­
dered in isolation, each may project a different
course for exchange rates, each sheds some
light on the relationship between interest
rates and exchange rates and provides some
in sig h ts in to th e fo rm a tio n of m arket
expectations.
Purchasing power parity
The theory of purchasing power parity in
its sim plest form says that the exchange rate
must change so as to equate the prices of
goods in both countries in terms of a single
cu rren cy. Thus, if the prices of Germ an goods
rose relative to the prices of U.S. goods, the
G erm an mark should depreciate (cost few er
dollars) to keep the dollar prices of goods in
G erm any the same as the dollar prices of
identical goods in the United States. O th e r­
w ise, arbitragers w ould have an incentive to
purchase goods in the United States and sell
them in G erm any until these prices w ere
again equalized.
Th ere are some obvious weaknesses of
the purchasing pow er parity doctrine. First, it
assumes that goods are identical across co u n ­
tries and are easily transported for arbitrage
purposes. This is obviously not the case, for
some goods such as houses are not traded at
all. In addition, in order to com pare the prices
of dissim ilar goods we have to rely on price
indices, and it then becom es a question of
w hich index is most reflective of goods traded
betw een the two co untries. H ow ever, the
main im plication of the purchasing power
parity theory is quite useful, and rem ains at
least approxim ately valid over the long run : If
a country's dom estic rate of inflation remains
higher than that of its trading partners for a
long period of tim e, that country's currency
w ill tend to d epreciate so that it does not
price itself out of export m arkets. The pur­
chasing pow er parity d octrine is not, how ­

Federal Reserve Bank o f Chicago




ever, a good predicto r of short-run exchange
rate movem ents.
The balance of payments approach
The balance of payments approach to
exchange rate determ ination is quite straight­
forw ard. It says that if country A is buying
m ore goods and services from country B than
it is selling to co untry B, then residents of A
w ill be attem pting to obtain m ore of B's cu r­
rency than residents of B are attempting to
obtain of A ’s cu rren cy. This w ill cause an
excess supply of A ’s cu rren cy relative to B's
and a declin e in its relative price. Thus, the
balance of payments theory would predict
exchange rate depreciation for countries with
deficits in their international transactions and
appreciation for those with surpluses.
The major problem with the balance of
payments theory is that it is difficult to define
unam biguously what constitutes balance in a
co u n try’s internatio nal paym ents. C onse­
qu en tly, countries have resorted to classifica­
tions of their international transactions into
the trade account (w hich encompasses trade
in goods o n ly), the current account (which
includes goods and services and interest pay­
m ents), and various arbitrary breakdowns of
the capital account (which encompasses trade
in financial assets).6 None of these accounts
by itself can explain m ovem ents in the e x­
change rate, but it is generally accepted that
the current account balance will influence
the exchange rate directly over the long run,
and through its im pact on expectations in the
short run.
The monetary approach
The m onetary approach emphasizes the
role of the dem and for and supply of money
6
The controversy over balance of payments account­
ing seems to stem more from the inability to define
money than from the inability to define the balance of
payments. If international transactions could be defined
on an actual "payments” basis, the balance of payments
approach becomes simply the flow counterpart of the
monetary approach which focuses on the stock of a par­
ticular asset, i.e., money.

7

in determ ining the exchange rate. The ex­
change rate is considered to be the relative
price of national m onies, and m ovem ents in
exchange rates w ill be such as to make the
stocks of national m onies w illing ly held. Thus,
if there is an excess supply of m oney in co u n ­
try A , part of that excess supply w ill be forced
upon the exchange markets as individuals in
country A co llectively attempt to rid them ­
selves of their unwanted m oney holdings.
This w ill cause a dep reciation in country A ’s
cu rren cy. C o n seq u en tly, an excessive rate of
growth of a co u n try’s m oney supply relative
to growth in its demand for money (which is
based in part on its growth in real output)
should manifest itself in currency depreciation.
In practice, the dem and for money is an
unob servab le quantity w h ich is strongly
influenced by expectations. Thus, even though
we may know what is happening to the
m oney supply, unless we are equally sure of
what is happening to m oney dem and, it is
difficult to predict accurately the direction of
exchange rate changes.
The asset markets approach
The final approach, the asset markets or
portfolio balance approach, em phasizes the
fact that national currencies are one among
an entire spectrum of real and financial assets
that eco nom ic agents may desire to hold.
Each asset, including national currencies,offers
a com bination of risk and expected return
that is based partly upon anticipations about
the future as w ell as on current econom ic
conditions. Shifts in these perceived risks and
returns induce financial agents to reallocate
their portfolios betw een assets denom inated
in different cu rren cies and, thus, bring about
changes in the exchange rate.
The exchange rate is seen as being jointly
determ ined with other eco nom ic variables
such as national output, the trade balance,
and the p rice of other goods. M o reo ve r, it is
prim arily through the m edium of expecta­
tions that exchange rates are affected, and
other variables such as the current account
balance or the rate of m onetary growth in flu ­

8



ence the exchange rate p rim arily to the
extent that they affect expectations. O ver the
long run, these factors w ill affect the exchange
rate directly, but the effect of expectations
w ill usually dom inate at any given tim e. The
asset markets approach is consistent with the
actual behavior of the financial markets and
with the interest parity relationship discussed
earlie r. In fact, most eco nom ic m odels of
exchange m arket behavior w hich follow this
approach take the interest parity condition as
their point of departure.
Real interest rates and expectations
The same factors that are adduced in the
above theories of exchange rate determ ina­
tion also enter into the determ ination of
dom estic interest rates. That is, dom estic rates
of inflation, rates of m onetary grow th, inter­
national m onetary flows (the balance of pay­
m ents), risk, and real return all affect interest
rates as w ell as the dom estic exchange rate.
There is a fundam ental reason why this should
be so. The interest rate is the p rice of m oney
services over a certain period of tim e, or the
price of cred it. O n the other hand, the
exchange rate is the relative price of two
national money sto cks at a given point in
tim e. In a free m arket, the relative prices of
any two stocks of assets autom atically include
inform ation on the im plicit flows of services
from those assets. For exam p le, if the ratio of
the prices of two autom obiles is 2 to 1, this
im plies that the m arket has determ ined the
present value of expected services from one
autom obile to be tw ice that from the other. If
the interest rate is determ ined in a free
m arket, we w ould expect it to incorporate all
inform ation relevant to the expected flow of
services from a given national cu rren cy. If
exchange rates are similarly freely determ ined,
we w ould expect that same inform ation to be
incorporated in th em .7
*
7lf information were perfect and there were no
intervention in either market, one could argue that the
relationship between interest rates and exchange rates
should be exact. Any explanation of deviations from this
relationship must therefore be sought in either govern­
mental policies or informational deficiencies.

Econom ic Perspectives

The problem is that exchange rates and
interest rates are not always market d eter­
m ined. H o w ever, when some outside inter­
feren ce prevents nom inal interest rates from
adjusting to all of the relevant risk/return
inform ation p ertinent to the holding of a
given asset, the adjustm ent to that new infor­
mation is absorbed by an adjustm ent of the
m arket's assessment of the real rate of return
on that asset. This can be m ore clearly u n d er­
stood if w e exam ine the com ponents of the
nom inal interest rate.
Economists have long accepted the hypo­
thesis that nom inal interest rates include both
a real rate o f return and an inflation prem ium
to com pensate lenders for the expected loss
of value of th eir p rin cip al. This can be ex­
pressed as:
R = r + le
w here R is the nom inal rate of interest, r is the
real rate of interest, and le is the expected
rate of inflation . Thus, a change in nom inal
interest rates may arise from either of two
so u rces: a change in the real interest rate or a
change in the expected rate of inflatio n .8
Likew ise, if the nom inal rate is fixed, a change
in inflationary expectations implies a change
in the real return on the asset concerned.
The im portance of these ideas for the
determ ination of the exchange rate can be
seen by exam ining the interest parity co nd i­
tion in m ore detail. The sim ple (uncovered)
interest parity condition suggests that the rate
of change of the exchange rate equals the
nom inal interest d ifferential (see box for an
exp lanation):
expected (% A E) = Rf - R^
w here E is the foreign currency price of the
hom e cu rre n cy, and the subscripts f and h
^Technically, the nominal interest rate should incor­
porate a risk premium as w ell’ so that R = r + le + Z,
where Z is a composite risk premium (one could argue
that the variance of le should also be included in Z). Thus,
any change in perceptions of Z due to political events or
other occurrences should also be reflected in changes in
either R or r or both depending on the authorities’ wil­
lingness to let R adjust to market forces.

Federal Reserve Bank o f Chicago



denote foreign and hom e, respectively. Using
the above relationship between nominal and
real interest rates, interest parity may be
rew ritten:
expected (% A E) = (r^ + 1^ - (r^ + 1^) or,
)
expected (% A E) = (rf - rh ) + (lf - l£ ).
e
This says that changes in the exchange rate
should be the sum of d ifferences in the real
rates of interest and differences in expected
inflation rates. In long-run equ ilib riu m , real
rates of interest are equalized by interna­
tional capital flow s, r^ - r^ = 0, and we have
simply that
expected ( %AE ) = 1^- 1^
w hich is nothing m ore than the purchasing
power parity theory of exchange rates.
Taking this one step fu rth er, if one incor­
porates into the analysis a monetarist assump­
tion about the determ inants of inflation, the
m onetary approach to exchange rate deter­
m ination also falls out of the interest parity
co ndition. For exam ple, if the rate of price
increase is assumed to equal the excess of the
rate of m onetary growth over the rate of
g r o w t h of m o n e y d e m a n d
(Ie =
% A MS - % A M D ),9then the parity condition
is
expected (% A E) = (% A MSf - % A MDf)
- (% A M S h - % A M D h).
This relationship expresses the monetary
approach to exchange rate determ ination in
its most rudim entary form and illustrates the
fact that both this theory and the theory of
purchasing pow er parity a reth eo ries of long9
This is a simple monetarist proposition based on the
quantity equation. If MS-V = PV where P is the price level
and V is velocity, taking logarithms and differentiating
both sides gives: MS + V = P + Y, where the dot signifies
percentage rates of change. If V = 0 (constant velocity)
and the real income elasticity of demand for money were
one (MD = Y), then P = MS - MD.

9

run eq u ilib riu m (based on the assumption
that rf = rh).
The balance of payments approach to
exchange rate d eterm ination is based on the
fact that excess dem ands for and supplies of
foreign goods create dem ands for and sup­
plies of foreign curren cies. H ow ever, this ap­
proach has been criticized for focusing nar­
rowly on international transactions in goods
and services and overloo king the interna­
tional transactions in financial assets included
in the capital account. If the balance of pay­
ments w ere properly defined to reflect the
actual m onetary flows through the foreign
exchange m arket, this approach would be
very sim ilar to the m onetary approach, since a
balance of paym ents surplus or d eficit, co n ­
ceptually, is a m onetary flo w . Any supply of a
currency to the foreign exchange market
w hich influences the exchange rate should
also affect interest rates since that money is
no longer available for dom estic lending.
All of these ideas are synthesized in the
asset markets approach to exchange rate
determ ination. The asset approach incorpo­
rates relative rates of price increase (purchas­
ing power parity), relative rates of m onetary
growth (the m onetary app roach), and bal­
ance of payments phenom ena into the ex­
change rate determ ination process through
their impact on anticipated risks and returns
to various financial assets.
M oreover, by em phasizing the jointly
determ ined nature of interest and exchange
rates and the role of expectations in in flu e n c­
ing both, the asset m arket approach focuses
much m ore on the short run and rein tro d u ­
ces the role of real interest d ifferentials, since
these real returns are residuals that incorpo­
rate both relative risks and relative nominal
returns (see footnote 8). If nom inal interest
differentials adjust to changes in the p er­
ceived real d ifferentials, then changes in rela­
tive nom inal rates should cause exchange
rate m ovem ents consistent with the asset
markets approach. Any inconsistencies in this
relationship should result either from im per­
fect inform ation or from governm ent inter­
vention into one or the other of the various

70



m arkets. It is the latter w hich explains the
changes in the nature of the nom inal interest/exchange rate relationship since the Fed
im plem ented its new operating procedure.
The role of the Fed in the formation of
expectations
From the above discussion it should be
clear that expectations about the future course
of eco nom ic policy play a critical role in the
determ ination of both interest rates and ex­
change rates. Through its ability to influence
interest rates, the Fed plays a key role in the
form ation of these expectations, and the
reactions of both the money and foreign
exchange markets w ill be quite different
dep endingo n h o w th e financial markets view
the Fed’s actions. For purposes of exposition,
let us identify the two extrem e types of Fed­
eral Reserve policy stances as perceived by
the financial m arkets: an "a ctiv e ” policy of
intervening in the m oney and/or foreign
exchange markets to impose a prescribed
growth path on the econom y and a "p assive”
policy of accom m odating demands em anat­
ing from the private sector. W hen the market
perceives Fed policy as active, m ovem ents in
the money supply figures or the current
account balance may generate a totally d if­
ferent set of expectations than would result
under perceptions of a passive policy.
Likew ise, the extent to w hich interest
rates them selves incorporate these expecta­
tions and thus reflect cu rren t inform ation
depends on the extent to w hich interest rates
are m arket d e te rm in e d as opposed to
governm ent adm inistered. This w ill in turn
depend on the interm ediate target of Federal
Reserve policy.
Thus, when the operating target of m one­
tary policy is the federal funds rate, any influ ­
ence of expectations on nom inal interest
rates may be attenuated by actions of the Fed
to keep the funds rate w ithin a specified
range. O n the other hand, if the Fed w ere to
set a level of bank reserves and let the funds
rate find its m arket-determ ined level, changes
in expectations should be fully reflected in

Econom ic Perspectives

movem ents of this key interest rate.1
0
In order to clarify these ideas, and isolate
various effects on the financial m arkets, Fed
policy is characterized in the accom panying
table according to market perceptions both
of its basic stance and of its actual operating
target. If new inform ation becom es available
that suggests w orsening inflation — e.g ., an
unexpected increase in the rate of monetary
growth (% A M S)— the reactions should be as
depicted. Although there are other possible
positions in betw een the ones show n, focus­
ing on extrem e cases makes clearer the forces
generated by policy shifts.
In the extrem e, market perceptions of a
truly active policy im ply no change in infla­
tionary expectations (% A MS = > A le = 0) even
when there is news of developm ents that
otherw ise w ould be inflationary. In other
w ords, the news leads the public to anticipate
strong Fed counterm easures rather than w o r­
sening inflation. In contrast, when the Fed is
perceived as passive, new inflationary infor­
mation becom es fully incorporated into infla­
tionary expectations. (% A MS => A le ^ 0)
Let us fu rth er consider two types of
operating targets: a federal funds rate target
and a reserves operating target. U nder a fed ­
eral funds rate target, the Fed modulates
movem ents in the rate by adding reserves to
or draining reserves from the banking system.
The p o la r case of such an operating p ro ce­
dure w ould be to fix the federal funds rate at
some constant, predeterm ined level ( A R = 0).
U nder a reserves operating target, the
Fed tries to hold the growth of bank reserves
to a p rescribed growth path and allows the
federal funds rate to fluctuate according to
m arket dem and for reserves. U nder this pro­
cedure nom inal interest rates would react to
incorpo rate any new inform ation relevant to
determ ining future risks and returns (A R
market determ ined).
O n e additional matter needs to be cla ri­
fied. An active policy using a federal funds
10Under the current system of “ lagged reserve
accounting” this is not actually the case, since demand in
the market for federal funds is established by conditions
two weeks in the past.

Federal Reserve Bank o f Chicago




Possible responses to information on
increased monetary growth (given R = r = le)
Perceived policy stance
O perating
target

Active

Federal funds rate
ambiguous
responses

Reserves

le
R
r
E

-

no change
increase
increase
appreciate

Passive

le
R
r
E

-

increase
no change
decrease
depreciate

ambiguous
responses

rate target is som ewhat ambiguous. If the pol­
icy is truly active it w ill require moving the
federal funds rate to a new (higher, in the
exam ple above) target when new inform a­
tion becomes available, thus raising the real
return on assets and yielding results sim ilar, if
not identical, to those resulting from an active
policy with a reserves target. O n the other
hand, if credit dem ands in the econom y are
stronger than exp ected , the Fed may fail to
raise the rate su fficien tly to prevent engend­
ering more inflationary expectations. The
m ovem ent in the real rate w ill depend on the
magnitude of the policy action relative to
changes in credit demands.
Thus, market perceptions of the Fed’s
policy stance, by influencing the response of
inflationary expectations to new inform ation,
and the Fed’s operating target, by influencing
the im m ediate response of nominal interest
rates to new inform ation, should jointly in­
fluence real interest differentials and the
exchange rate. M o reo ver, because these fac­
tors determ ine w hether real and nominal
interest rates vary directly or inversely with
one ano th er, they should also determ ine the
relationship between nominal interest rates
and the exchange rate.
Interest rates and exchange rates, 1976-80
W hat light does the above fram ework
shed on m ovem ents in interest rates and
exchange rates in recent years? First, two dis-

11

tinct shifts in Fed behavior conveniently divide
the period since 1976 into three distinct sub­
periods. The first im portant shift in Fed
behavior occurred on N ovem ber 1, 1978,
when the Carter adm inistration adopted a
policy of active dollar support. Because this
was w idely view ed by the m oney m arkets as a
shift to a more active m onetary p olicy, the
Fed’s perceived policy stance prior to that
date can be characterized as “ passive” and
subsequent to that date as “ active.”
The second m ajor behavioral shift o c­
curred on O cto b er 6, 1979, w hen the Fed
moved from a federal funds rate operating
target to a nonborrow ed reserves target. The
three subperiods between January 1976 and
D ecem ber 1980 may thus be characterized as
follow s:
Period
1/76 - 10/78
11/78 - 9/79
10/79 - 12/80

Policy stance

Operating target

Passive
Active
Active

Federal funds rate
Federal funds rate
Nonborrow ed reserves

The entire period has been one of almost
continuously increasing m onetary growth and
inflationary expectations, m arked by sharp
movements in interest rates. Using the rela­
tionships in the table on page 11, the co rrela­
tion between nom inal and real interest rate
differentials can be classified as fo llo w s:*1
1

Period

Correlation between movements
in real and nominal interest
rate differentials

1/76 - 10/78
11/78 - 9/79
10/79 - 12/80

Negative
Ambiguous
Positive

1 This relationship has been tested empirically for
1
the presence of structural shifts. When estimated in first
difference form with slope dummy variables, the esti­
mated relations for the three periods are:
Period I: ATW D = -.703AUSFID
(-2.27)
Period II: ATWD = .261 AUSFID
(2.04)
Period III: ATW D = .632AUSFID
(1.07)
R2 = .14

12



DW = 1.75

In the first p eriod, the trade-weighted
dollar declined almost continuously. A cco rd ­
ing to our theory, this should have been
caused by a declining real interest d ifferen ­
tial. M oreo ver, based on our characterization
of Fed policy during this period, we would
expect an inverse relationship between real
and nom inal interest rates in the U .S., thus
im plying a rising nom inal interest differential.
This was in fact the case, and the tradeweighted dollar moved inversely with the
nom inal interest differen tial. M ovem ents in
the value of the dollar and in the nom inal
interest differential diverged because the Fed
prevented nom inal interest rates from inco r­
porating fu lly the rising inflationary expecta­
tions, thereby low ering the m arket’s evalua­
tion of the real return on U .S. financial assets.
M ovem ents in nom inal U.S. interest rates
and the trade-weighted dollar showed a
som ewhat different pattern in the period
between N ovem ber 1978 and O ctob er 6,
1979. In the first half of this p eriod, both the
nom inal interest d ifferential and the tradeweighted dollar rem ained relatively flat, and
manifested a slight inverse relationship to
one another. The two variables declined
together from June to August 1979, and then,
in August and Septem ber, the interest d iffer­
ential rose w h ile the dollar fell slightly. These
m ovem ents are also consistent w ith the
interpretation given above. As was argued in
the previous section, the active m onetary pol­
icy with a federal funds rate target that char­
acterized this period could result in either a
positive or negative relationship between
real and nom inal rates depending on the
appropriateness of the federal funds rate
where A ’s signify first differences of the variables and
TWD and USFID are the trade-weighted dollar and the
U.S.-foreign interest differential, respectively. The
numbers in parentheses are t-statistics. The t-statistics for
periods II and III test the statistical significance of the
point estimates of incremental slope changes in each of
those periods. The low t-statistic for period III can be
explained by the theoretical equivalence of periods II
and III if the Fed were choosing the “ right” funds rate.
See William L. Wilby, “ Federal Reserve Policy and the
Interest-Exchange Rate Relationship: 1976-1980,” un­
published manuscript, July 1981.

F = 21.94

Econom ic Perspectives

chosen by the Fed. The am biguous relation­
ship between m ovem ents in the interest d if­
ferential and the dollar reflected this am bi­
guity, as exchange rates responded to differing
m arket perceptions of both policy and the
outlook for inflation.
Fin ally, in the period from O ctob er 1979
to D ecem ber 1980, there was a decided shift
in the n atu re o f the relationship between U.S.
and foreign nom inal interest rates and the
trade-w eighted dollar. M ovem ents in both
becam e more vo latile, and the relationship
between them was distinctly positive. During
this period Fed policy was essentially active,
and the Fed's operating target shifted from
the federal funds rate to nonborrowed re­
serves. C o n seq u en tly, real interest d ifferen ­
tials moved in the same direction as nom inal
interest d ifferen tials, and the latter moved in
the same d irection as the exchange rate. This
positive relationship, in tu rn , resulted from
the fact that nom inal interest rates were
allow ed to reflect more efficiently market
inform ation with respect to both real rates of
return and inflationary expectations, the most
im portant variables affecting exchange rates.
Conclusion and outlook
The exchange rate norm ally moves in
response to real interest differentials. The
nature of the relationship between nom inal
interest differen tials and the exchange rate
depends on the correspondence between
real and nom inal interest rates. This co rres­
pondence depends critically on Fed policy.
M arket perceptions of the Fed's m one­

Federal Reserve Bank o f Chicago



tary policy stance, in conjunction with its
operating target, determ ine movements in
real interest rates and, consequently, the rela­
tionship between nom inal interest rates and
the exchange rate. The active policy stance
and nonborrow ed reserves operating target
in effect since O ctob er 6, 1979, have tight­
ened considerably the relationship between
the nom inal interest differential and the
exchange rate.
Do these observations shed any light on
the future direction of the relationship be­
tween U.S. nom inal interest rates and the
exchange rate of the dollar? To the extent
that the Fed m odifies its targeted reserve path
to cushion any declin e in the federal funds
rate, it w ill have im plicitly retreated in the
direction of a funds rate target. If this occurs,
the positive relationship between the dollar
and interest rates might be upset again de­
pending on w hether the actual rate is above
or below the rate consistent with the Fed's
m onetary goals. M o reo ver, to the extent that
other central banks modify their own interest
rate policies in an attempt to move the real
rates of return on their dom estic assets, the
positive relationship might be distorted, since
the analysis above assumes that the actions of
foreign central banks are dom inated by the
Fed. This seems to have occurred in early 1981
as the G erm an Bundesbank intervened sub­
stantially in support of the mark.
Thus,w hether the recent close correspon­
dence betw een U .S. interest rates and the
dollar proves to be a sum m er rom ance or an
en du rin g m arriage depends critically on the
fu tu re actions of the w orld's central banks,
and in particular the Fed.

13

The internationalization
of U.S. agriculture
Jack L. H ervey
Agricultural trade is a m ajor com ponent in
the international trade account of the United
States. The agricultural com m unity can take
pride in the im portant contribution of A m er­
ican farms and ranches tow ard feeding the
peoples of the w o rld . Assisted by its natural
attributes of abundant and rich farm land and
a generally tem perate clim ate in com bination
with unsurpassed w arehousing facilities, this
country serves as the w o rld ’s food store­
house. The U nited States isth e prim ary supp­
lier of num erous agricultural com m odities to
many co un tries, and it is also a m ajor but
marginal supplier to many others, including a
num ber of the w o rld ’s leading im porters.
Foreign buyers are heavily dependent on the
reliability of supplies from the United States.
An equally im portant fact that often goes
unrecognized is the profound dependence
of Am erican ag riculture on its freedom of
access to foreign m arkets. The internationali­
zation of A m erican ag riculture has been a
major co ntributo r to the eco n o m ic health of
the industry. But, it has also opened the
industry to the vagaries of international polit­
ical gam esm anship and trade protectionist
sentim ent. The potential rewards of interna­
tionalization are consid erab le, but the asso­
ciated risks of greater d ependence on foreign
markets have also increased.

one-half the export rate, increasing threefold
from $5.8 billion to $17.4 billion in 1980. The
agricultural trade surplus rose from $1.9 b il­
lion in 1971 to $23.9 billion in 1980. As a result,
agricultural trade has contributed in an in ­
creasing and positive m anner to the overall
m erchandise trade balance.
A g ricu ltu re has not always been a net
positive contributor to the U.S. trade balance.
Prior to W orld W ar II, agricultural imports
typically surpassed the value of farm com ­
modity exp orts.1 During the war and the folMndeed, until fairly recently agricultural commodi­
ties dominated the value of total U.S. imports. In 1940
more than one-half of U.S. imports were agricultural.
During the period 1945-54 agricultural imports accounted
for an average of more than two-fifths of the value of all
imports. By 1970 the share had dropped to 15 percent and
in 1980 it was 7 percent.

Agricultural exports under govern­
ment financed programs decline
billion dollars

percent
45

Agriculture and the U.S. trade balance
Trade in agricultural com m odities has
been one of the few continuously bright
spots in the U .S. m erchandise trade account
during the past decade. The dollar value of
dom estically produced agricultural exports
increased nearly sixfold from $7.7 billion in
calendar 1971 to $41.2 billion in 1980 and is
expected to total about $45 billion in 1981.
Imports of agricultural com m odities also grew
substantially during the decade but at only

14



•Includes exports under PL 480, the Mutual Security Act, and
the Agency for International Development. Not included are
shipments financed through Commodity Credit Corporation
credits, Eximbank loans or guarantees, or the sale of governmentowned inventories at less than domestic market prices.

Econom ic Perspectives

Rapid growth in U.S. agricultural
trade—a recent phenomenon
billion dollars
60

1930 '35

'40

Percent
60

'45

'50

'55

'60

'65

70

'75 '80

lowing recon stru ction , to w hich U.S. agricul­
ture was a significant contributor through
governm ent grants and concessional sales of
farm com m odities to foreigners, exports in ­
creased dram atically and exceeded imports
through 1949. D uring the 1950s, how ever, the
governm ent's dom estic agricultural policy
supported the dom estic prices of major agri­
cultural com m odities at levels well above
m arket clearing prices on the w orld m arket.
This contributed to a stagnation in shipments
of U.S. farm com m odities. O n ly an expansion
in governm ent-supported export programs
such as export subsidies and sales to foreign
co u n trie s on co n cessio n al term s— as, for
exam p le, under the term s of the Agricultural
Trade D evelopm ent and Assistance Act of
1954 (com m only known as PL 480)— m ain­
tained agricultural exports at the levels of the
late 1940s.
M e a n w h ile , ag ricu ltu ral im ports co n ­
tinued to rise with the result that deficits in
agricultural trade w ere recorded in all but
two years from 1950 through 1959. A g ricu l­
tural trade grew m oderately in the 1960s, with
exports typically exceeding imports by $1 b il­
lion to $2 billion each year.
New markets in the 1970s
In the 1970s U.S. agricultural exports v ir­
tually exp lo d ed — in value as well as in quan­

Federal Reserve Bank o f Chicago



tity. At least th ree m ajor factors contributed
to this p h en o m en o n : increasingly marketoriented prices for farm com m odities, which
made U.S. com m odities m ore com petitive in
the world m arket; the opening of the Soviet
and C h in ese m arkets as political tensions
eased during the decade; and rapidly increas­
ing incom es abroad, w hich contributed to a
shift in consum ption patterns and a marked
increase in the dietary demand for meats and
high protein foods. The last factor in particu­
lar contributed to a large increase in foreign
dem and for U.S. feed grains, especially co m ,
and soybeans as foreigners increased their
livestock production in order to im prove the
protein content of their diets.
Japan co ntinued as the largest single­
country foreign market for U.S. farm pro­
ducts in 1980, as it was throughout the 1970s
and much of the 1960s. Its dom inance as a U.S.
export m arket is m aintained on the strength
of its dem and for feed grains, soybeans, and
w heat. In 1980 Japan took $2.1 billion of U.S.
feed grains, m ore than double the value of
such shipm ents to any other country. Japan
im ported $1.1 billion of U.S. soybeans and
$596 m illion of w heat. In total, U.S. agricultu­
ral shipm ents to Japan were valued at $6.3
billion in 1980, 15 percent of all U.S. farm
com m odity exports.
The nine-m em ber European Common
M arket (E C )2 was the largest consolidated
market for U.S. farm com m odities—account­
ing for $9.3 b illio n , or 22 percent of the total.
Four of the 12 leading foreign markets are
contained w ithin the borders of the EC—the
N etherlands, West G erm an y, Italy, and the
United Kingdom . These four countries ac­
counted for 80 percent of the value of U.S.
shipm ents to the EC. Agricultural shipments
to the EC have been heavily in the animal feed
category. Feed grains and oilseeds and oil2
Greece became the tenth member on January 1,
1981. In 1980 the United States exported $307 million in
agricultural products to Greece. Among EC members
only Denmark and Ireland are smaller markets (Belgium
and Luxembourg are considered as a single market). The
other nine EC members are: Belgium, Denmark, France,
West Germany, Ireland, Italy, Luxembourg, the Nether­
lands, and the United Kingdom.

15

U.S. agricultural exports by
destination
billion dollars

NOTE: There is no figure for China for 1971.

seed products accounted for over 60 percent
of U.S. agricultural exports to the EC in 1980.
Apart from the continuing im portance of
the EC, Japan, and Canada— Canada has tradi­
tionally been a large market for U.S.-produced
anim als, fruits, and vegetables— the relative
im portance of other foreign markets has var­
ied substantially over the years. To some
degree this reflects the fact that the United
States is a marginal supplier of agricultural
com m odities on the world m arket. Its large
productive capacity and typically substantial
stocks, made possible by a large storage
capacity for grains, have made it a ready
source to fill gaps in supplies resulting from
poor crops elsew here.
In 1971, for exam ple, the USSR purchased
only $45 m illion of U.S. farm com m odities.
But in 1973, follow ing the Soviet crop disaster
of 1972, U.S. agricultural exports to the USSR
surged to $1 b illio n . By 1979 the figure had
reached $4 b illio n , m aking the USSR the
second largest single-country foreign market
for U.S. farm com m odities. The rapid d evel­
opm ent of the USSR as a m arket for U.S. grain
was cut short follow ing the Soviet invasion of
Afghanistan in D ecem ber 1979 and the sub­

76



sequent partial embargo imposed by the U n i­
ted States on exports to the USSR. U .S. agri­
cultural exports to the USSR declined to $1.1
billion in 1980. N onetheless, the USSR still
ranked as the tenth largest foreign market for
U.S. agricultural products, ahead of such tradi­
tional major markets as the United Kingdom
and Taiwan.
M exico and China provide other exam ­
ples of how the market has changed during
the past decade. A gricultural exports to M e x­
ico in 1971 w ere $128 m illio n , less than 2 p er­
cent of the U.S. foreign m arket. By 1980 they
had risen to $2.5 b illio n , or more than 6 p er­
cent of U.S. exports, making M exico the third
largest single-country market for U.S. farm
products. China im ported no U.S. agricultu­
ral com m odities in 1971, but as political rela­
tions between the two countries im proved in
the mid-1970s so did the volum e of trad e.3 By
1980 China was the fourth largest foreign
market for U.S. agricultural products, account­
ing for $2.3 billion or 5.5 percent of the value
of U.S. exports of agricultural products.
In an attempt to stabilize fluctuations in
demand for U.S. products, the U.S. govern3Some observers have suggested that in fact the cau­
sal relationship may have been reversed; that is, China’s
need for U.S. grains initially helped contribute to a relax­
ation in political tensions. The same phenomenon may
have contributed to the opening of the Soviet market.

U.S. agricultural trade by
commodity, 1980
Exports; $41,255
million

fruits, vegetables
& preparations 6%
wheat
wheat products 16% _
animals &
animal products 9% _
cotton 7 % __

Imports: $17,366
million

L dairy products 3%
___rubber 5%
------oilseeds & products 3%
fruits, vegetables
-------& preparations 11%
-------meat & meat products 13%

soybeans &
soybean products 17% —

Econom ic Perspectives

ment in recent years has entered into bilateral
trade agreem ents with the countries that co n ­
stitute the m ajor nontraditional m arkets— the
U SSR, C h in a , and M exico . The intent of these
agreem ents has been to guarantee sim ul­
taneously that U.S. exporters as marginal sup­
pliers w ill b e a b le to s e ll asp ecified m inim um
quantity of agricultural products in these fo r­
eign m arkets and that foreign buyers w ill be
able to buy a specified m inim um quantity
from the U nited States.4
In some cases, these agreem ents may be
used to set a ceiling on the volum e of U.S.
com m odities that may be purchased by the
foreign parties to the agreements in a given
year. Such restrictions w ould be imposed to
m aintain “ accep tab le” sup p ly/p rice relation­
ships in the U.S. dom estic m arket, as well as in
the traditional foreign m arkets, in the event
of a short U .S. crop or exceptional demand
from the foreign markets.
Impact on U.S. agriculture
A gricultural exports have had a dram atic
impact on U.S. agriculture. Am erican farm ers,
especially those in the prim ary grain and soy­
bean growing areas, have becom e progres­
sively m ore dependent on foreign markets
for their livelih oo d . In 1950, the value of total
ag ricultural exports was about 10 percent of
farm ers’ cash receipts from sales of farm com ­
m odities. D uring the next 20 years, exports
as a proportion of cash receipts increased
gradually, reaching 15 percent by 1971.
A m arked acceleration in the d epend­
ence of U .S. farm ers on foreign markets
occu rred during the 1970s, and by 1979 agri­
cultural exports accounted for 24 percent of
cash receipts from com m odity m arketings. In
4ln the U.S.-USSR grain agreement, for example, the
USSR agreed to purchase 6 million metric tons of grain
annually (roughly equal proportions of wheat and corn)
and the United States agreed to supply up to 8 million
tons annually without special authorization. Purchases in
excessof 8 million tons required U.S. government appro­
val. The original agreement with the USSR went into
effect in 1976 and expired this year. With the lifting of the
embargo in late April, discussions between representa­
tives of the U.S. and USSR began in August and con­
cluded with an agreement to extend the provisions of the
original accord for one year—through September 30,
1982.

Federal Reserve Bank o f Chicago



the agricultural heartland of the corn belt and
lake states, the shift was even more dram atic,
with exports increasing from 16 percent of
cash receipts in 1971 to 30 percent in 1979.5
Today, though it is not w idely recog­
n ized , A m erican agriculture relies on the
export m arket for its vitality to a greater
degree than any other major industry group.
A sa result, the m aintenance of a strong world
eco nom y, am icable and stable political rela­
tionships, and steadfast resistance to pres­
sures for trade restrictions that could adver­
sely in flu en ce its foreign m arkets, are of vital
im portance to the prosperity of the industry.
As A m e rican a g ricu ltu re has becom e an
in te rn a tio n al in d u stry, its vu ln e ra b ility to
the vagaries of international econom ic and
p o lit ic a l d e v e lo p m e n t s has in c re a s e d
correspondingly.
The internatio nalization of the industry
has clearly affected the structure of the indus­
try. D uring a tim e w hen technological devel­
opm ents have contributed to a sharp reduc­
tion in the num b er, and a significant increase
in the average size of U.S. farm s, the increased
foreign demand for agricultural products may
have helped keep afloat some farm ing opera­
tions that w ould otherw ise have disappeared.
It may also have kept other farms operating at
a higher level of capacity utilization than
would otherw ise be the case. Co n cu rren tly,
the increased production associated with
supplying rapidly expanding foreign markets
has heightened co ncern w ithin the industry
over the impact of recent changes in cultural
practices on the industry’s long-term productivity.
Biological scientists, in particular, have
pointed out that these rapid increases in pro­
duction have contributed to an intensifica­
tion in cultural practices that has accelerated
soil erosion and the depletion of this nonre­
new able reso urce. Thus, w h ile the interna­
tionalization of A m erican agriculture has con­
tributed greatly to the industry's growth and
short-run p ro sp erity, it has not occurred
w ithout cost. The m agnitude of that cost has
yet to be determ ined.
5
These eight states are: Illinois, Indiana, Iowa, Mich­
igan, Minnesota, Missouri, Ohio, and Wisconsin.

17

A new role for federal crop insurance
J e f f r e y L. M i l l e r

The federal crop insurance program has been
revised under provisions of the Federal Crop
Insurance Act that was signed in September
1980. The revisions represent an im portant
change in policy and are intended toestablish
the Federal C ro p In su ra n ce C o rp o ra tio n
(FC IC ) as the prim ary institution offering
farmers protection against low crop yields.
The partially subsidized F C IC program is
designed to replace the fully subsidized disas­
ter payment programs that have been the
federal governm ent's predom inate form of
disaster protection for producers of grains
and cottons since the mid-1970s. The new
legislation directs the FC IC to extend the crop
insurance coverage to all agricultural co u n ­
ties and to consider underw riting insurance
on additional agricultural com m odities.
If the FC IC program expands as expected,
agricultural lending may be affected in the
process. Lenders may require farm ers to p ur­
chase the insurance in order to reduce the
risks associated with crop production and to
make sure that farm ers have funds available
to repay operating loans in the event of low
yields.
History of crop insurance programs
Federal crop insurance started in 1938.1
The first act created the F C IC as a govern­
m ent-owned agency w ithin the U.S. D epart­
ment of A g ricu ltu re (U SDA) and authorized
insurance programs for unavoidable crop
losses due to adverse w eath er, insect infesta­
tions, plant diseases, w ild life , and other risks.
Losses due to neglect, poor farm ing practices,
theft, or low prices w ere not included. O per’Prior to the legislation most of the available crop
insurance covered only fire and hail damage. Private
companies, cooperatives, and even some state govern­
ments provided the insurance. Multiple peril or all-risk
crop insurance was for the most part not available from
private insurance firms.

18




ating and adm inistrative costs w ere covered
by governm ent appropriations, w h ile pre­
miums w ere designed to cover claim s for
losses and to build reserves. Payments for
claims w ere limited to a portion of the value
of the crop loss rather than the full value.
The first program was lim ited to w heat,
although cotton was added after the second
year. Heavy losses to wheat crops resulting in
large indem nity (claim ) payments in the first
four years of the program prom pted the
Congress to suspend the program in 1943.
New legislation in 1944 tem porarily revived
the insurance program for several crops, but
the program was scaled back to an e xp e ri­
mental basis follow ing large cotton losses in
1945 and 1946.
Percent of FC IC indemnities paid
by type of loss, 1939 to 1978
Drought
Freeze
Flood
W ind
Disease
Hail
Insects
Excess m oisture
O ther
Total

41.5
13.9
2.2
6.7
2.8
10.8
4.6
15.9
1.6
100.0

Federal crop insurance was restored in
1948 and since that tim e has been gradually
expanded. Subsequent legislative changes
have increased the num ber of insurable com ­
modities from seven in 1948 to 28. The num ber
of counties eligible for some coverage has
expanded from about 400 in 1948 to 1,700.2

2
The number of different crops that are insurable in
individual counties varies. In 1980 there were 4,629 crop
programs, covering an average of about three different
crops per county in over 1,600 counties.

Econom ic Perspectives

Experience with crop insurance
O n balance, FC IC indem nity payments
have exceeded prem ium s. For the entire
period 1948-80, indem nities have been about
$1.6 b illio n , or 9 percent more than prem i­
ums. Ten of the 28 crops— including soy­
beans— had favorable overall indem nity-toprem ium ratios during the period, w hile for
18 other crops, payments exceeded p rem i­
ums. Th ere has been a persistent tendency for
indem nities to exceed prem ium s on cotton,
c itru s , p o ta to es, and fo rag e se ed in g . In
1980— a year of large crop losses due to
w idespread drought—the indem nity-to-premium ratio was 2.2, the highest since 1945.
D espite the expanding coverage pro­
vided by the F C IC , farm er participation in the
program has been low. The proportion of
e lig ib le acreage actually insured by the FC IC
has averaged about 9 percent since 1948. The
most acreage in any one year, 26.6 m illion
acres, was insured in 1980. H ow ever, this
represented only 12 percent of the 221.8 m il­
lion insurable acres and only 7 percent of all
the cropland in the United States.
Contributing to farm ers' aversion to make
greater use of the insurance have been the
lim ited scope of the program , the low crop
yield protection level, and, in recent years,
the availability of com peting disaster protec­
tion plans. Before 1980 federal crop insurance
was offered on one or m ore of 27 different
insurable crops in 1,526 counties. The rem ain­
ing half of the agricultural counties in the
U nited States and most of over 300 crops p ro­
duced in the country w ere ineligible for FC IC
insurance. W h ile past legislation allowed ex­
pansion, lim its on appropriations kept the
expansion below the authorization. In addi­
tio n , only one yield protection level, typically
60 p ercen t, was allow ed for a given crop. For
many farm ers this coverage was inadequate
to cover the out-of-pocket expenses of pro­
ducing a crop. The prem ium s, based on actuar­
ial needs to meet losses and build reserves,
w ere considered too high for the level of pro­
tection offered . D uring the last seven years,
other disaster paym ent programs have been

Federal Reserve Bank o f Chicago




made available to producers of major crops.
The disaster paym ent provisions in the
g o v e rn m e n t's pro gram s fo r w h e a t, feed
grains, rice, and cotton have provided the
bulk of the protection against low crop yields
since 1973. These provisions partially com ­
pensate farm ers w ho suffer losses due to
inability to plant, or subnorm al yields result­
ing from floo d, drought, or natural disaster.
To be eligible for paym ents, farm ers have to
set aside land— if such requirem ents are im ­
posed—and operate w ithin their normal crop
acreage base. The payments are made to par­
ticipants whose yields drop below 60 percent
of the participant's average yield. The pay­
ment rate per bushel is tied to a "target price''
determ ined by the Secretary of Agriculture.
Total disaster payments from federal monies
for the years 1974-80 w ere over $3.4 billion.
About one-fourth of thetotal payments made
under the program , over $900 m illion, was
distributed in 1980.
A nother program that has played a sub­
stantial role in providing assistance to farmers
who suffer losses is the Emergency (Disaster)
Loan Program of the Farmers Home A dm inis­
tration. U nder this program loans are made in
counties designated as disaster counties to
farm ers who suffer a loss of 20 percent or
m ore in a major farm com m odity enterprise.
(In late spring the requirem ents w ere changed
such that a loss of 30 percent or m ore in cer­
tain sp ecified en te rp rise categories is re ­
quired for elig ib ility.) Interest rates as low as
5 percent are available to borrowers who do
not qualify for credit from com m ercial lend­
ers. Such disaster declarations are often w ide­
spread. O ver 2,300 counties w ere eligible in
1980.

The new FCIC program
Last year's legislation is designed to ex­
pand the coverage of the federal crop insur­
ance program to all 2,740 agricultural coun­
ties. The num ber of crops eligible for coverage
w ill also be increased as sufficient actuarial
data—the history of losses in an area— are
established. It was the intent of the legislation

19

that the FC IC 's program would becom e the
prim ary form of protection against produc­
tion risks for farm ers. Unless extended in
some form by the Congress, the disaster pay­
ments provisions for grains and cotton will
expire this year. The Fm HA em ergency loan
program will rem ain in operation unless alter­
ed by budgetary cutbacks or changes made in
the major farm legislation this year.
The new insurance act incorporates sev­
eral major provisions. Participants can elect
one of three levels of yield protection and

one of three levels of price protection. The
options on yield protection are 50, 65, or 75
percent of the historical average yield in the
participant’s county or risk area within a
county. The options on price protection are
determ ined annually by the FC IC and apply
to all areas. The highest price option is at least
90 percent of the annual price projected by
the FCIC, based on trends, forward contracts, and
judgm ental factors. For 1981, price options
are $1.70, $2.00, and $2.70 for corn and $4.50,
$6.00, and $7.00 for soybeans. O ptions for the

Ratio of indem nities to prem iums by crop, 1948-80

Program

W heal

1948

1949

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

1960

1961

1962

..........................................58

1.43

.52

1.06

.85

1.25

1.42

1.26

1.09

.60

.16

.68

.23

1.09

.38

C o t t o n ...........................................43

1.97

2.81

.82

.44

1.05

.56

.84

.67

.54

.25

.45

.52

1.38

1.24

Com bined c r o p ......................... 06

.16

.94

1.65

2.33

.91

1.50

1.42

1.28

.83

.36

1.70

.27

1.23

.76

T o b a c c o .........................................43

.66

.61

.49

.79

1.90

.89

.40

.28

.34

.19

.38

.35

.29

.79
1.52

C o r n ............................................... 17

.16

1.26

2.38

.25

.17

.56

1.47

3.35

.46

.56

.87

1.45

.23

F l a x ..................................................51

.62

.42

.49

.79

.95

.77

.77

.54

2.46

.45

1.64

.47

1.27

.65

B e a n ............................................... 29

.64

1.84

3.14

.55

.62

1.60

.66

.96

1.(fe

.32

.91

.59

.54

2.03

0

0

Citrus** ..........................

0

.04

.03

.22

7.25

.15

.24

2.11

2.36

9.25

.73

.74

.65

.36

.44

.56

.54

.67

.39

.35

.39

1.08

.69

1.53

.81

.50

.77

1.13

.76

.63

1.81

Crain s o rg h u m .............

.27

.28

.70

.39

Oat ...................................

.99

.65

Soybean ..........................
Barley ..............................
Peach ..............................

Rice

.................................

.58

Raisin ...............................

1.26
1.03
.01

.47
.64
0

Pea ...................................

3.08

Peanut ............................

.35

Apple ...............
Tomato

...........

Sugar beet
C r a p e ...............
Sugarcane
Sunflower
Sweet corn

...

Forage seeding
P o ta to ..............................
Forage

2.17

............................

Rye ...................................
All Programs*

.53

in

.91

1.12

.97

1.15

1.24

1.14

1.26

.69

.26

.77

.58

.89

1.10

•Includes cherry and safflower programs discontinued after the 1966 crop year and tung nuts discontinued after the 1970 crop year.
The 1980 crop year ratios are based on preliminary estimates.
S O U R C E : Federal C ro p Insurance Corporation.

20




Econom ic Perspectives

yield coverage. Participants who purchase
hail and fire coverage from a private insu­
rance firm w ill low er their FC IC premium
costs by up to 30 percent. The act also permits
a state governm ent or an agency of the state
to pay other prem ium subsidies so as to
reduce further the farm er’s share.
The F C IC , to the m axim um extent feasi­
ble, is to use the d elivery system of the private
insurance industry to m arket and service fed­
eral crop insurance. Farmers may apply for
policies at designated local insurance agen-

1982 wheat crop are $2.50, $3.50, and $4.50.
The prem ium paid by a participant will
depend on the com bination of yield and
price protection (coverage) that is selected.
The prem ium sched ule is based on the loss
exp erien ce in the p articip ant’s county or risk
area. A prem ium subsidy of 30 percent is
available for those who select the 50 percent
or 65 percent yield coverage. The subsidy for
those selecting the 75 percent yield coverage
has a m axim um lim it equal to 30 percent of
the prem ium applicable to the 65 percent

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1948-80

.95

.57

1.24

.54

1.14

1.01

.74

.46

.42

.42

.83

.97

.51

.94

1.47

.48

.98

2.70

1.04

.70

.46

.84

2.29

3.85

1.92

2.61

1.33

1.67

.97

.46

2.24

3.22

3.57

.47

1.13

1.48

1.62

1.55

.45

.45

.07

.41

2.12

.10

06

.21

.14

.29

1.02

1.06

.61

.46

1.06

.08

.07

5.81

1.16

.62

.31

.53

.59

.38

.54

1.06

.58

.39

.36

.67

.29

1.06

.91

2.98

.42

1.11

2.53

1.04
1.12

.41

1.67

2.04

.45

.94

.66

.57

1.17

.37

.25

.25

2.30

1.16

2.40

1.86

.20

.15

1.58

.79

1.41

.40

.96

.79

.36

.27

.93

.69

.70

1.24

1.94

98

2.53

1.44

.65

.53

1.81

.89

.61

1.58

2.29

1.03

.64

1.35

.82

1.18

.67

.52

.91

.13

.82

.68

1.01

.90

.34

1.02

.96

.03

.45

1.11

.29

2.75

2.21

1.75

3.11

.63

1.23

.44

.42

.37

2.66

.28

1.01

.50

1.18

1.35

1.02

.95

.58

1.27

.78

.89

.59

.72

.79

.31

1.01

.39

1.11

.39

.35

.38

1.78

.84

1.05

.53

.24

.42

.62

.43

.31

.66

.30

.61

.86

1.53

1.07

1.31

.99

.40

.56

2.29

.93

1.03

3.50

.53

.95

2.29

.24

.41

1.19

1.77

2.18

2.41

1.14

1.42

46

.50

2.17

.15

.61

1.25

.75

1.03

.50

.42

.76

1.01

.41

.96

.58

.87

.23

1.63

.52

.91

.47

1.47

.62

2.80

1.04

.60

.69

.22

.60

.48

.39

.43

.47

.25

1.23

1.03

1.05

.53

2.99

.56

.53

.60

2.48

.85

0

.68

.43

.34

.31

.77

.44

.07

.51

.57

.63

.41

.23

.54

.72

.76

1.58

3.36

1.22

3.64

.02

.07

.07

.06

.03

.30

0

0

.01

.02

0

.20

11.66

.02

12.13

0

0

1.03

.53

2.64

.87

2.69

.76

2.77

.72

.98

.59

.52

1.54

.78

.83

.80

2.93

.84

.63

.58

1.28

.77

1.31

.26

.25

.55

.53

.63

.22

2.16

.53

.21

.32

.32

.49

.57

.28

.67

8.91

1.42

.35

.92

.37

1.91

.91

3.33

.24

1.65

1.06

3.25

1.31

1.48

.18

1.38

1.93

1.07

.80

.67

1.25

.41

.25

.27

1.81

.64

.97

1.79

.30

.40

.84

.97

2.38

1.93

.19

.79

.29

1.44

.29

.76

.29

.58

.60

.64

1.82

1.32

.56

1.01

.77

1.13

1.90

.59

.33

.20

.39

.72

.78

1.02

1.25

2.59

.77

0

4.10

1.55

.11

.10

.25

3.85

.20

.22

.27

1.01

.07

.20

.08

.22

.89

.94

2.79

.50

.46

.64

.84

1.57

.70

1.49

.88

.35

.12

.12

.43

1.51

.87

.57

.54

.62

.57

2.39

4.57

5.87

4.60

0

.14

0

2.06

.68

3.41

1.99

.98

2.21

3.98

1.08

2.27

1.05

1.38

1.54

1.90
.77

.90

113

.68

1.27

1.05

1.09

Federal Reserve Bank o f Chicago



.94

.60

.60

.60

1.17

.86

1.57

1.46

.50

.65

1.90

2.20

1.09

21

Federal crop insurance availability
on 1981 crops in District states

How federal crop insurance works

Number of county programs*
IL
IN
IO
Ml
Wl
Crop
Corn
Grain sorghum
Oats
Soybeans
Wheat
Tobacco
Barley
Beans
Sugar beets
S w e e t c o rn

Peas
Forage production
Forage seeding

101
5

87

6

101
72

87
82

99

38

57

97
99

13
25
30

56
18

8

11

1
10

1
6
20
25

1
1

cies, FC IC offices, or other governm ent agen­
cies. Private insurance com panies may even
provide an all-risk crop insurance plan to
farm ers and, if the plan meets certain stand­
ards, reinsure it with the FC IC .
In the event prem ium s and reserves avail­
able to the F C IC are inadequate to meet
in d e m n itie s, em erg en cy fu n d in g may be
sought. Com m odity Credit Corporation funds
may be used for up to one year to supplem ent
payments to farm ers, or monies may be bor­
row ed, if auth o rized , from the U.S. Treasury
at prevailing interest rates.
These provisions of the new act differ
somewhat from earlier acts and may o ver­
com e some of the difficulties experienced
historically with crop insurance. In order to
make the insurance coverage more attractive,
protection levels in excess of the 50 to 68
percent level previously available on a crop
are now offered for all crops. Also, an ind i­
vidual yield coverage plan, w hereby ind ivid ­
ual farm yields are used in place of co unty­
wide or risk area yields, is available to pro­
ducers of the six com m odity program crops
and soybeans if the participants can prove
their yields are higher than the established
yields for the area. In addition, the prem ium
is now subsidized to reduce the cost of insu-




50 percent or 20 bushels per acre;
65 percent or 26 bushels per acre;
75 percent or 30 bushels per acre.

17

•Illin o is has 102 c o u n t ie s ; In d ia n a . 92; Io w a, 99; M ic h ig a n ,
83; and W isc o n sin , 72.

22

A farm er wants to insure 100 acres of
soybeans in Farm er C o u n ty, USA. The FC IC
has determ ined the average county soybean
yield to be 40 bushels per acre. The farm er
can choose one of three yield coverages:

He can also choose one of the three
price level coverages offered by the F C IC :
$4.50, $6.00, or $7.00 per bushel.
If he selects the 65 percent yield co ve r­
age and the $7.00 price protectio n , the pre­
m ium according to a schedule of rates w ould
am ount to $4.70 per acre. H o w ever, since the
F C IC w ill subsidize 30 percent, his net p re­
m ium is $3.30 per acre for m ultiple risk crop
insurance.
If drought co nditio ns red uce his yield to
10 bushels per acre on the 100 acres, he
w ould be elig ib le for an $11,200 paym ent (16
bushels loss per acre x $7.00 x 100 acres. His
cost for this protectio n was $330 ($3.30 x 100
acres).

ranee to farm ers and to encourage greater
participation. This also functions to allow the
federal governm ent a m echanism for co n ­
tinued subsidization of disaster payments
sim ilar to that w hich has prevailed under the
com m odity programs.
The provision to market the insurance
through private insurance firms is a conces­
sion to the insurance industry because of its
expressed concern over the role of govern­
ment in the insurance business. As a result,
farm ers are offered a much larger service
netw ork than was possible under the FC IC
organization. The FC IC also gains a more sub­
stantial sales force for prom oting the p ro­
gram. The provision for em ergency funding
provides a safeguard against deficits that is a
prerequisite for duplication of the w id e­
spread coverage of land area that was pro­

Econom ic Perspectives

vided under the com m odity program . In 1980
the six crops that w ere included in the com ­
m odity programs accounted for about half of
the cropland harvested.
The future of crop insurance programs
The program may be broadened in the
future as a result of research and pilot p ro­
grams perm itted by the act. Insurance on
rangeland, livestock, bees, nuts, vegetables,
a q u a cu ltu re sp ecies, forest pro d ucts, and
other com m odities could be added.
Expansion into the new com m odities
may com e about slow ly, though, since about
four years are needed to study and test a
program in an area. It is also u n certain
w h eth er or not insurance would be made
available on a com m odity that is not a major
source of agricultural incom e in an area. For
now , priority w ill be given first to duplicating
coverage on the six major crops— corn, wheat,
barley, rice, sorghum , and cotton—that were
part of the com m odity programs and then to
other principal crops— especially soybeans.
Implications of the new program
Participation by farm ers may not increase
significantly until 1982 w hen the FC IC pro­
gram is scheduled to take over as the prim ary
form of protection against low crop yields.
P relim inary estimates indicate that sales of
crop insurance in 1981 have doubled from

Federal Reserve Bank o f Chicago



1980’s level. W hether the program ultimately
assumes its anticipated new role, how ever,
w ill not be resolved until the Congress com ­
pletes action on major farm legislation this
year. O th er existing forms of crop disaster
protection may be continued and new forms
may be enacted. If that occurs, then federal
crop insurance may retain the m inor role in
protecting farm ers against low crop yields
that it has played in the past. If other pro­
grams are d rop p ed, then participation in the
federal crop insurance program may clim b as
farm ers choose, in response to the more lib­
eral provisions of the new program , to accept
a small additional exp ense, the insurance
p rem ium , in place of the possibility of large
crop losses. As a result, the governm ent's cost
of providing disaster relief to farm ers suffer­
ing low crop yields could dim inish. Outlays
by the governm ent w ill be necessary, but the
am ount could declin e substantially b elow the
levels necessary to run fu lly subsidized,
duplicate programs.
Higher farm er participation could benefit
agricultural lenders, since farm ers have the
option of assigning FC IC claim payments to
lenders. This w ould reduce the risks of lend­
ing, since repaym ent is protected by the assu­
rance that cash inflows continue when there
is a major loss. Lenders may serve as catalysts
to the prom otion of federal crop insurance as
they seek to protect the funds they lend to a
farm ing industry plagued by wide variability
in production.

23

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