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a t r i civiDcn/uu i uocn 199**

ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago

Demographic changes,
consumption patterns,
and the M idw est economy
Interest rate shocks
and the dollar




FEDERAL RESERVE BANK
OF CHICAGO

Contents
Demographic changes,
consumption patterns,
and the Midwest economy.......................................................................... 2
Paul D. B allew and
Robert H. Schnorbus

During the last twenty years a variety of factors have
reshaped American industries and prompted widespread
reorganization. The adjustment of the Midwest economy
is being complicated by substantial changes in the
domestic market. Specifically, a number of demographic
shifts and growing income inequality may be perma­
nently altering traditional consumption patterns, with
particular impact on the market for durable goods.

Interest rate shocks
and the dollar................................................................................................ 11
Charles L. Evans

From February through June 1994, the federal funds rate
increased 125 basis points while the dollar depreciated
10 percent against both the yen and the mark. Is it puzzling
that four tightenings in U.S. monetary policy have been
accompanied by a depreciation of the dollar? The author
assesses the empirical relationship between short-term
interest rates and the dollar.

ECONOMIC PERSPECTIVES
Editorial direction
Janice Weiss, editor
David R. Allardice, regional studies
Steven Strongin, economic policy and research
Anne Weaver, administration
Production
Nancy Ahlstrom, typesetting coordinator
Rita Molloy, Yvonne Peeples, typesetters
Kathleen Solotroff, graphics coordinator
Roger Thryselius, Thomas O’Connell,
Lynn Busby-Ward, John Dixon, graphics
Kathryn Moran, assistant editor




S e p te m b e r/O c to b e r 1994 V o lu m e X V III, Issue 5

ECONOMIC PERSPECTIVES is published by
the Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and do not necessarily reflect the views of
the management of the Federal Reserve Bank.
Single-copy subscriptions are available free of
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Articles may be reprinted provided source is
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ISSN 0164-0682

Demographic changes,
consumption patterns,
and the Midwest economy

Paul D. B a lle w and
R o b ert H. Sch n orbu s

and factors associated with the goods them­
selves such as product quality and potential
product life.3 Significant price increases for
some products relative to income gains—autos
or housing, for instance—may negatively af­
fect consumption of these items by making
them unaffordable. On the other hand, stron­
ger economic activity and income gains, differ­
ent income distribution patterns, and/or demo­
graphic age shifts may prompt mini-booms for
many industries. Product quality improvements
lengthen the life of products and therefore may
prompt delays in replacement purchases. Con­
versely, extended product life expectancy can
be offset by design enhancements or techno­
logical breakthroughs.
From the standpoint of future consumption
patterns, the most significant changes in the
U.S. macroeconomic environment are demo­
graphic shifts. Of principal concern is the
rapid proliferation of nontraditional household
units during the last two decades, coinciding
with a growing disparity in income distribu­
tion. The potential impact of these trends on
future income growth and distribution and on
consumption patterns is overwhelming; indeed,
they could either swamp or intensify other
economic, social, and product developmental
changes. Clearly, the effect may not be posi­
tive. Economic activity, and specifically con­
sumption growth, may be substantially

During the last twenty years a
variety of factors including oil
shocks, technological change,
and increased foreign compe­
tition have reshaped industries
and prompted widespread reorganization.
Within the auto, steel, and other durable goods
industries that form the core of Midwest manu­
facturing, many firms have downsized, relocat­
ed facilities, reduced wages and profits, and
suffered general economic malaise.1 As these
industries have been transformed, the Midwest
has undergone a substantial economic adjust­
ment.2
The adjustment of the Midwest economy
is far from over and in some regards has been
accelerating in recent years in response to
domestic and international pressures. More­
over, this adjustment is being complicated by
substantial changes in the domestic market.
Specifically, a number of social and economic
developments of the last few decades may be
permanently altering traditional domestic
consumption patterns, with a particular impact
on the market for durable goods. These devel­
opments include an aging population and
growing disparities in income distribution.
This article analyzes these trends and their
impact on consumption patterns and on the
Midwest economy.
A wide variety of economic and social
factors affect the consumption of durable
goods. Among the most prevalent are family
or household formation rates, income growth,
appreciation of financial and nonfinancial
assets, prices of durable and nondurable goods,

Paul D. Ballew is an economist and coordinator at
the Detroit Branch of the Federal Reserve Bank of
Chicago. Robert H. Schnorbus is a senior econo­
mist and assistant vice president at the Federal
Reserve Bank of Chicago.

2

ECONOMIC PERSPECTIVES




depressed. The question for policymakers and
industry alike is whether this scenario is only a
potential risk or a likely outcome.4
D e m o g ra p h ic sh ifts

The number of two-wage-eamer families
has increased by 65 percent over the last twen­
ty years. This has increased the proportion of
so-called wealthy households in the popula­
tion. But much more significant has been the
greatly increasing proportion of single-parent
families and single-person households. In
1970, 77 percent of all households were twoparent families; by 1990 the figure had fallen
to 55 percent.5 Over the same period, the total
number of families increased by 23 percent,
but single-parent families increased by more
than 100 percent— from 6.7 million families to
more than 14 million. As a result, by 1990,
single-parent families had become 21 percent
of all families and 15 percent of all households
in the country. The increase in single-parent
families was even greater among AfricanAmericans; by 1990, over half of all AfricanAmerican families were headed by a single
parent, usually a woman. Female-headed
single-parent families constitute 18 percent of
all families and over 43 percent of all AfricanAmerican families.
These changes in household composition
have a striking impact on income distrbution.
Between 1970 and 1990, the median income of
all households increased less than 7 percent.
Two-parent families have been the recipients
of most of this income gain, and this trend will
likely continue in the decades ahead. Overall,
the median income of two-parent families grew
13 percent from 1970 to 1990, with almost all
of the gain occurring after 1980. By 1990, the
median income of two-parent families was 135
percent of the median income of all house­
holds. This was up appreciably from 1970,
when that statistic was approximately 120
percent. Over the same period, the median
income of two-wage-eamer families—which
constitute two-thirds of all two-parent fami­
lies— increased almost 20 percent, again with
most of the gain occurring after 1980.6 This
rise parallels the rise in both personal and per
capita income in two-wage-earner families.
The popular media have asserted that the
“richer are getting richer, and the poor are
getting poorer.” This view is substantiated
by several measures of income gains and

FEDERAL RESERVE RANK OF CHICAGO




distribution (see figure 1). The Gini coeffi­
cient for the U.S. (a measurement of income
inequality) has increased substantially since the
mid-1960s, and especially since the 1970s; this
trend is likely to accelerate during the next
decade. Yet, as figure 2 indicates, much of the
increasing inequality of income distribution
appears to be due to structural changes in
U.S. households.
On average, single-parent families and
single-person households are socially and eco­
nomically worse off than other households and
are increasingly burdened with disadvantages
that hamper improvement in well-being. In
1990, the median income of single-parent fam­
ilies was only about 42 percent of the median
income of two-parent families, and only 36
percent of the median income of two-wageeamer families. Furthermore, the relative
social and economic status of single-parent
families has slipped appreciably in the last two
decades.7 In 1970, their median income was 42
percent of that of two-wage-eamer families.8
Single-parent families on average experienced
little or no income growth during the twentyyear period; in fact, their median income de­
clined, with most of the decline occuring in the
1980s. This trend was a principal factor be­
hind the anemic rise in the median income of
the overall population. As so-called nontraditional households increase in number, the me­
dian and mean incomes of the overall popula­
tion are depressed, with the median falling

FIGURE 1

U.S. income inequality: Gini coefficient

Note: A coefficient of zero would indicate absolute
equality of incom e distribution, a coefficient of
1 absolute inequality.
Source: U .S . D epartm ent of C om m erce (1 9 9 0 ).

3

more than the mean. Although the gap be­
tween the median and mean does reflect chang­
es in income distribution, it is not due so much
to the rich getting richer and the poor getting
poorer, but rather, to the growth in nontraditional households.
While single-parent families as a whole
tend to be less well-off than other households,
female-headed families are even worse off,
with almost half reporting annual incomes
below $15,000 a year. By 1990, the median
income of female-headed families was only
about 47 percent of the median income of all
households and 42 percent of the
median income of two-parent fami­
lies.9 These figures reflect an ero­
sion from 1970. In that year, the
median income of female-headed
families was 59 percent of the
median income of all households.
Evidence of “losing ground”
during the 1970s and 1980s is also
reflected in the number of nontraditional households below the pover­
ty line. Since 1970 the number of
married couples with children be­
low the poverty level has remained
constant, but the number of single
parents with children below the
poverty level has doubled. Single­
parent families represent over 60
percent of all households with
children below the poverty level.

4




Almost two-thirds of all children
in single-parent families are in a
household with an income below
the poverty level. Firm data
tracking these children as they
move into adulthood are only now
being collected. However, it is
expected that the data will show
them substantially lagging their
peers educationally, and not mak­
ing up the lost ground between
themselves and children in tradi­
tional family structures. With
their educational achievements
depressed, their future economic
performance is also likely to be
depressed. Given the large num­
ber of affected children, this will
be a significant erosion in human
capital. Thus, whether through
diminished consumption expendi­
tures or through negative repercussions on
human capital, these structural changes have
negative impacts on the macroeconomic envi­
ronment.
Noting that the structural changes in
households account for a large portion of the
increasing income inequality and poverty does
not remove the concern over the likely impact
on future consumption patterns. In fact, if
anything, recognizing the causal role of these
structural changes intensifies this concern
because it makes clear that the only way to
neutralize the likely effect on consumption

ECONOMIC PERSPECTIVES

patterns would be to break the
cycle of poverty—a very tall order.
If a steadily growing portion of the
population is less able to spend
because its standard of living is
stagnating or declining, the impli­
cations will be enormous for cer­
tain sectors, especially durable
goods. Because economic hardship
is reinforced by social, cultural,
and environmental factors, resolu­
tion of these problems does not
appear probable in the near future.

FIGURE 4

Annual expenditures by income quintile
percent of income

C h a n g in g c o n s u m p tio n
p attern s

Consumption patterns vary
significantly by income and house­
hold composition (see figure 3).
Not surprisingly, households with
higher incomes spend more on luxury items
relative to necessities. Lower income units
spend significant percentages of their income
on food, clothing, and housing, with very little
left over for other purchases (see figure 4). By
1990, households in the lowest income quintile
spent almost two-thirds of their total income on
food and housing. In contrast, households in
the highest quintile spent less than 30 percent
of their income on food and housing, a level
that would be even lower if it were not for a
large investment in high-quality housing and
the amount spent on food prepared outside
the home.
If present trends continue, these spending
patterns may spell trouble for the durable
goods industry. For instance, as figure 5 indi­
cates, spending both as a percentage of income
and in annual dollar amounts for one of the
principle big ticket items, autos, is positively
correlated to income level and two-parent
families. Two-wage-eamer families spend
over $3,000 a year on vehicles, two-parent
families slightly below $3,000, and single­
parent families less than $1,000 (see figure 6).
With little or no income growth in the last few
decades, the affordability of items such as
vehicles is becoming a major concern for nontraditional households. As figure 7 shows,
between 1970 and 1990, vehicle affordability
remained relatively unchanged for two-parent
families. But vehicles became substantially
less affordable for single parents, a trend that
has accelerated over the last decade.1 Conse­
0


KEDERAL RESERVE


BANK OE CHICAGO

quently, nontraditional households have be­
come less inclined to purchase vehicles in the
last few decades, and the proportion of their
income spent on durable goods as a whole is
declining. In 1960, for instance, single-parent
families spent 7.5 percent of their income on
vehicles annually; by 1990, this figure had
fallen below 6 percent.
While the growth in nontraditional house­
holds has led to a decline in the consumption
of durable goods, two-parent families have
been increasing their consumption of both
durable and nondurable goods. These house-

5

FIGURE 6

Annual expenditures on vehicles
by household structure
tho u sa n d dollars

percent

Source: U .S . Bureau of Labor Statistics (1 9 9 2 )
and Federal Reserve Bank of Chicago.

holds have traditionally spent a greater propor­
tion of their total expenditures on durable
goods, and that proportion has been rising,
albeit gradually, in recent years. Although
two-parent families are likely to maintain rela­
tively high levels of consumption of durable
goods in the future, certain factors may affect
these income and consumption trends.
It is not clear whether traditional house­
holds will be able to compensate for the spend-

ing shortfall from nontraditional households in
order to maintain spending on durable goods in
the future. First, existing debt levels may
dampen consumption if they lead to a perma­
nent restructuring of the household balance
sheet. Of course, these debt levels may be
partially offset by leasing, new financing
mechanisms, refinancing, longer contract
terms, and other financial innovations.
Furthermore, although two-parent families
received most of the income gains of the last
two decades, those gains were only modest.
Moreover, their distribution was increasingly
skewed toward college graduates. For in­
stance, the Bureau of Labor Statistics estimates
that the number of two-parent families with
one spouse earning an income below the pov­
erty line increased from 12 percent to 18 per­
cent of all two-parent families during the last
twenty years. During this period the average
wage of high school graduates with less than
five years’ experience fell by almost 30 per­
cent. The differential between annual wages
for college graduates versus high school gradu­
ates currently exceeds 155 percent. Recent
census data also indicate that two-parent fami­
lies are on average older than other households.
Consequently, if the life-cycle theory holds,
these units may be moving away from their
peak consumption years toward the saving
period of their lives." Finally, two-parent
families are an increasingly smaller proportion
of total households.
T he " c o n s u m p tio n g a p "

FIGURE 7

Weeks of family income required to
purchase average new vehicle
w ee k s

Source: Federal Reserve Bank of Chicago.


6


A complimentary concern to distributional
questions involves current and future income
growth patterns. Income trends over the last
twenty years do not bode well for domestic
consumption in the 1990s. Per capita dispos­
able income growth over the last twenty years
slipped below an annualized rate of 1.5 per­
cent, a modest level below the trend of the
postwar era. These aggregate data mask the
fact that for a large segment of the population,
income is growing very slowly or actually
declining. For instance, the real incomes and
wages of many segments of the manufacturing
sector have declined significantly during the
last twenty years. Wages for high school grad­
uates, according to some estimates, have de­
clined more than 15 percent on average over
the same period.1
2

ECONOMIC PERSPECTIVES

Although disposable income growth
lagged relative to the historical norm, con­
sumption expenditures continued to increase at
rates comparable to their pre-1970s level, with
the relationship to historical patterns somewhat
stronger in the more robust 1980s than in the
1970s (see figure 8). This level of consumer
expenditure with lower income growth resulted
in a stronger propensity to consume during the
last two decades compared to the 1950s and
1960s. This led to a proliferation of consumer
debt and reduced savings during the 1980s. In
fact, consumer debt rose both as a percentage
of GDP and as a ratio of debt service payments
to income. By the end of the decade, the debt
burden had risen significantly and payment
levels were constraining for some segments.
The total household leverage ratio exceeded 90
percent of income by 1990, up from approxi­
mately 70 percent in 1980.
Overall, the continued growth of consumer
spending in the face of slower income growth
produces what can be labeled a “consumption
gap”—the differential between annual growth
in disposable personal income and annual
growth in consumption expenditures.1 To
3
some extent, this phenomenon may be simply a
consequence of rapid household formation
rates and the aging of households. The lifecycle hypothesis suggests that debt growth in
the 1970s and 1980s may be due to “baby
boomer” households’ moving into peak con­
sumption years. If this reasoning is true, it
implies that in future decades there will be an
eventual readjustment as those households pay
off their accumulated debt and move into the
saving stage of life to prepare for retirement.
No matter what the cause, the increasing
levels of debt may constrain future consump­
tion.1 Households may restructure their bal­
4
ance sheets permanently or make ongoing
efforts to lower their debt servicing burdens.
The recent atypical recession and recovery are
at least partly due to consumers’ making these
adjustments already. Debt, or at least debt
servicing costs, have been reduced, consump­
tion expenditure growth has been modest, and
the pace of recovery has been constrained as a
result.1 O f course, recent economic behavior
5
has also been affected by pessimism due to
cyclical factors and other economic problems
such as abnormal weakness in labor markets.1
6
To the extent that this is the case, the constraint

FEDERAL RESERVE



BANK OF CHICAGO

FIGURE 8

Consumer expenditures relative
to disposable income
index, 1 9 7 0 = 1 0 0

on economic recovery may be merely transito­
ry, due in large measure to the restructuring of
consumer debt in the last few years and the
delay in purchasing many big-ticket items.
A related issue is the question of product
affordability. Especially because of income
declines, many consumer items have become
less affordable over the last twenty years, in­
cluding housing, medical care, and education.
Price increases for these items have exceeded
the consumer price index by more than 40
percent since the mid-1980s. Given the con­
sumption gap, the prospect of slower growth in
net worth (especially housing values), and
declines in affordability, permanent shifts in
consumption patterns seem very likely.1
7
D e c lin in g co n s u m p tio n o f
d u rable g o o d s

Because the number of nontraditional
households is continuing to grow relative to
other households, the impact of these spending
patterns can be particularly great within specif­
ic industries. For instance, holding family
composition constant as a share of total house­
holds allows one to project the potential level
of annual expenditures relative to the actual
level. The difference is in excess of $22 bil­
lion, or $22 billion less spent annually on vehi­
cles because of shifts in family composition.
Looked at differently, if all households spent
the same percentage of their annual income on
new vehicles and parts as did two-parent fami­
lies, it would increase the spending on new

7

vehicles and parts by approximately $10 bil­
lion annually, or 5 percent.1
8
These trends cause more than just a drag
on overall consumption; they also motivate
shifts in product composition in the market­
place. For example, by 1990 nontraditional
households accounted for over 25 percent of
the total annual expenditures for vehicles, up
from less than 15 percent in 1970. This shift,
and future market shifts, will likely continue to
prompt adjustments by manufacturers to meet
the special demands of this segment of the
population. Among other changes are poten­
tially increased demand for economy vehicles
and used vehicles. Major adjustments in prod­
uct lines are also likely in the next decade in
response to the aging of the U.S. population.
For single-parent families and even twoparent non-college-graduate families, the ex­
tended economic outlook is not bright. Intense
competition in the marketplace continues to
depress wages, and state and local budget diffi­
culties will take their toll on aid payments.
Given these trends, the future could bring a
period of sales stagnation for the country’s
producers of expensive durable goods.1
9

of these competitive pressures was partially
muted. When demand is flat, it is much
more difficult for producers to compete, as
market share becomes the primary goal.
2) Given the demographic trends, nontradi­
tional development approaches become
important. Of necessity, Midwest producers
have attempted to diversify during the last
few decades. These efforts have been
somewhat successful and have contributed
to the region’s above-average growth in the
last few years. The region has also benefit­
ed from a more competitive, revitalized
domestic manufacturing base. While this
renewed competitiveness has lessened the
pain of a weak market, it cannot fully offset
that weakness; a revitalized manufacturing
base will still struggle if the sales environ­
ment remains weak. Given a flat market,
economic development agencies must work
harder and more inventively to encourage
growth and change in the region.
3)

Exports may become an important element
in this strategy. Exports made important
contributions to the economic activity in
the nation and the region in the late 1980s.
In a domestic market not experiencing
sales growth and facing substantial pres­
sure to restructure and downsize, exports
take on renewed importance as a source of
regional growth.

4)

Export growth requires alternative devel­
opment strategies. In formulating a com­
prehensive export strategy, policymakers
must address a variety of factors such as
trade barriers or agreements, factor mobili­
ty, general locational concerns, and a high­
ly competitive environment—relatively
new developments that must be taken into
account in the formulation of future gov­
ernment policies. Perhaps of greatest con­
cern for policymakers, the same elements
depressing domestic consumption may also
be large hurdles to developing a successful
export-oriented strategy.

Im p lica tio n s fo r M id w e s t p ro d u ce rs

Projecting trends and their impacts is risky
activity, especially when those trends involve
changes in individual behavior. Yet it seems
clear that the demographic changes sketched
above have set in motion a substantial alter­
ation of the U.S. social and economic fabric.
Sales of durable goods over the next few de­
cades will be weak to modest at best.
Although diversification has been dis­
cussed extensively in the Midwest since the
1970s, durable goods still account for a signifi­
cant proportion of the employment and income
in the region. If the domestic sales environ­
ment slumps during the next few decades, the
implications for the region will continue to be
profound. Even with a best-case scenario of
modest sales growth, the challenges for these
industries and the Midwest are numerous:
1) Competitive pressures will continue to
intensify. The U.S. marketplace has be­
come significantly more competitive during
the last few decades as domestic operations
have streamlined and foreign firms have
penetrated the market. As long as the do­
mestic market was expanding, the impact

8



The dynamics of sweeping structural
changes have significantly altered past patterns
of market activity and the Midwest’s economy.
Demographic shifts, the prevalence of structur­
al dislocation, and the heightened importance
of global competitiveness have transformed the

ECONOMIC PERSPECTIVES

economic setting for all individuals and institu
tions. Public and private policy that fails to
recognize these underlying shifts may yield

disappointing results. These changes are particu­
larly important to the Midwest because of the
major impact on the region’s core industries.

NOTES
'Traditional analyses o f durable goods sales assume that
short-term sales are disproportionately affected by cycli­
cal factors, including income, employment growth, and
consumer sentiment. Long-term sales trends are linked to
a variety o f demographic factors such as long-term in­
come growth and household formation rates, as well as
technological factors.
3While often stressful, this transition has also had positive
effects on these industries and on the region. In fact, the
restructuring o f the last twenty years may prove invalu­
able as the econom y adjusts to potentially slow domestic
growth and fast-paced external growth.
’Analysts increasingly use households rather than families
as their unit o f observation because o f the proliferation o f
nontraditional family units. We do the same in this
article.
■
’Immigration growth and an increase in birth rates have
partially offset the limited population growth in the last
few decades. However, the effects o f these changes did
not entirely offset the aging o f the population, at least not
initially.
5See U.S. Department o f Commerce, Bureau o f the Cen­
sus, Current Population Reports.
6 Ibid.
7 The principal causes o f this anemic income growth are
complex. On average, the heads o f single-parent families
have lower educational attainment and other barriers to
well-paid external employment. Additionally, a dispropor­
tionate number o f single-parent families receive govern­
ment assistance. The level o f assistance has been declin­
ing in relation both to income growth and to the officially
defined poverty level. In Michigan, for instance, maxi­
mum AFDC payments fell throughout the 1980s to 75
percent o f the federal poverty threshold, a trend also
occurring in other states. Average monthly AFDC pay­
ments during this period went up by only 6 percent, while
the CPI increased by almost 30 percent.
8Further complicating any analysis o f household income
trends is the fact that single-parent families have an
income distribution diametrically opposite that o f tradi­
tional households. Alm ost 30 percent o f single-parent
families have annual incomes below $10,000 and almost
45 percent below $15,000. Female-headed families are
even worse off, with a median annual income o f only
$17,000 and almost 40 percent o f these families below the
official poverty line. Two-parent families reflect the
opposite concentration, with over 30 percent earning more
than $50,000 per year and over half earning more than
$35,000.

FEDERAL RESERVE BANK OF CHICAGO




9From the perspective o f net worth, distribution o f wealth
appears similar to that o f income. O f two-parent families,
almost 55 percent have a net worth in excess o f $50,000,
over 33 percent in excess o f $100,000. O f single-parent
families, almost half have a net worth o f less than $10,000
and over 40 percent have a net worth o f less than $5,000.
‘"Single-parent families are the only household classifica­
tion in which annual consumer expenditures exceed the
median income level. (On average, it is said that these
units are currently “dissaving.”) These families spend
almost two-thirds o f their income for food and shelter.
"The effects o f an aging population will be even more
pronounced in the first two decades o f the next century.
For example, given current expenditure levels, by the
year 2010 people over 45 years old will account for 53
percent o f all vehicle expenditures, compared with the
current level o f approximately 44 percent. The impact
on product mix as well as the overall market is likely to
be significant.
"Office o f Technological Assessm ent estimates (1992).
"Note that aggregate data for households is being used in
an attempt to explain broader consumer behavior. Specif­
ic household segments diverged substantially during this
period in terms o f both spending activity and income
growth. Given this divergence, the “consumption gap” is
probably even greater than the aggregate data suggest,
and the potential adjustment in consumption patterns is
likely also to be that much greater.
"The economic recovery in 1991-92 was significantly
affected by limited consumer spending growth because o f
financial restructuring, structural unemployment, and the
weight o f existing debt. Without the consumer leading
the recovery, economic growth has been tepid.
"There has been much debate about how much debt
restructuring has occurred. For instance, when one in­
cludes the switch toward home equity debt and leasing o f
autos, there seems to have been only minimal reduction o f
consumer debt. Unfortunately, current statistics in this
area are sparse; see Eugeni (1993).
l6The changes in the labor markets may be not only short­
term but long-term as well. For instance, the amount o f
structural unemployment, the movement from highpaying industries (such as defense, aerospace, and autos),
and other developments will have profound implications
for the economy over the next few decades.
"One interesting recent area o f analysis is an attempt to
gauge how consumers and business respond to past
periods o f economic uncertainty and hardship. In today’s

9

rapidly changing marketplace, the potential for uncertain­
ty over employment, revenue, and other factors is great.
Eventually individuals may accept this as normal, but
such a conclusion may come slow ly and only after some
painful adjustment.

I9A related concern is the fact that on average, nontraditional families are younger than two-parent families and
have more children. In addition, almost one-third o f all
children born in 1990 were bom to single women. These
characteristics will affect the macroenvironment signifi­
cantly in the decades ahead.

l8Based on 1990 data.

REFERENCES

Congressional Budget Office, “Measuring the
distribution of income gains,” Washington,
DC: CBO, March 1992.
Eugeni, Francesca, “Consumer debt and home
equity borrowing,” Economic Perspectives,
Federal Reserve Bank of Chicago, Vol. 17,
No. 2, March/April 1993, pp. 2-14.
Fuhrer, Jeffrey C., “Do consumers behave as
the life-cycle/permanent-income theory of
consumption predicts?” New England Econom­
ic Review, Federal Reserve Bank of Boston,
September/October 1992, pp. 3-14.
Haslag, Joseph H., and Lori L. Taylor, “A
look at long-term developments in the distribu­
tion of income,” Economic Review, Federal
Reserve Bank of Dallas, First Quarter 1993,
pp. 19-30.

to 1989: Evidence from the Survey o f Consum­
er Finances,” Federal Reserve Bulletin, Board
of Governors of the Federal Reserve System,
January 1992, pp. 1-18.
Modigliani, Franco, “The life cycle of sav­
ings—twenty years later,” Contemporary>Is­
sues in Economics (Manchester University
Press), Vol. 10, 1975, pp. 99-124.
Office of Technological Assessment, “U.S.Mexican trade, pulling together or pulling
apart?” Washington, DC, No. ITE-545, Octo­
ber 1992.
U.S. Bureau of Economic Analysis, National
Income and Product Accounts o f the U.S.,
Washington, DC, various years.
_______________ , Survey o f Current Busi­
ness, Washington, DC, various years.

Hayashi, Funio, “The permanent-income
hypothesis: Estimation and testing by instru­
ment variables,” Journal o f Political Economy,
Vol. 90, 1982, pp. 895-916.

U.S. Department of Commerce, Bureau of
the Census, Current Population Reports: Pov­
erty in the U.S., Washington, DC, 1992.

Kennickell, Arthur, and Janice Shack-Marquez, “Changes in family finances from 1983

_______________ , Census o f Population and
Housing, Washington, DC, 1990.

10



ECONOMIC PERSPECTIVES

Interest rate shocks
and the dollar

C h arles L. Evans

From February through June
1994, the dollar depreciated
j 9.9 percent against the Geri man mark and 10.2 percent
■
against the Japanese yen. This
depreciation has occurred during a period when
(1) the Federal Open Market Committee
(FOMC) announced a tightening of reserve
positions on four occasions, which resulted in
an increase in the federal funds rate of 125
basis points; (2) the Bundesbank lowered its
discount and Lombard rates by 50 basis points
in May; and (3) the prime minister of Japan
resigned. Instead of the yen weakening, the
dollar hit a then postwar low against the yen at
the end of June.
Episodes like this are harsh reminders that
exchange rate movements are virtually impos­
sible to forecast over short horizons. Since the
mid-1980s, international economists have often
reminded us that sophisticated models for
forecasting exchange rate fluctuations cannot
outguess a simple forecast of no change.
Meese and Rogoff (1983), for example, argued
this point exhaustively for forecasting horizons
under two years.
However, there is increasing evidence that
exchange rate movements are in fact pre­
dictable at longer horizons. Eichenbaum and
Evans (1992) find evidence that unexpected
increases in the federal funds rate lead to an
eventual appreciation of the dollar against the
German mark, French franc, Italian lira, Japa­
nese yen, and British pound, but it often takes
over two years for this effect to take noticeable
hold.1 Indeed, Evans (1994) finds that a large

FEDERAL RESERVE BANK OF CHICAGO




part of the dollar’s recent depreciation against
the mark and the yen may be due to the unusu­
ally low federal funds rate during the period
following the recent U.S. recession—over two
years ago. Similarly, Mark (1993) finds that
changes in exchange rates over a four-year
period have a predictable component, but not
for time periods shorter than this. Specifically,
taking account of relative monetary policies
and the state of real income in Germany and
the United States helps predict four-year move­
ments in the German mark against the dollar.
This article examines the relationship
between shocks to short-term interest rates in
the United States, Germany, and Japan and
movements in the yen/dollar and mark/dollar
exchange rates since 1979. The evidence indi­
cates that much of the dollar’s recent deprecia­
tion against the yen is consistent with the be­
havior of the U.S. federal funds rate and short­
term interest rates in Japan since 1991.
A ran dom w a lk th ro u g h the
c u rre n c y m arke ts?

Since the Bretton Woods era ended in
1973, most major currencies have floated
against the U.S. dollar. One rationale behind
this change was that it would allow countries
to pursue alternative monetary policies inde­
pendent of U.S. policies. Countries that pursue
higher inflation rate policies will simply allow
their currencies to depreciate against the cur­
rencies of countries with lower inflation. ConCharles L. Evans is a senior economist and assis­
tant vice president at the Federal Reserve Bank
of Chicago.

11

sequently, knowing a country’s monetary poli­
cy, the state of its real economy, relative infla­
tion, and interest rate differential should help
one forecast future movements in the exchange
rate between its currency and the dollar.
An influential study by economists Rich­
ard Meese and Kenneth Rogoff (1983) con­
cluded that sophisticated models of exchange
rate determination make poor forecasts. In
fact, the forecasts produced by these models
were not consistently better than the simple
random walk forecast of no change. Meese
and Rogoff s findings are especially sobering
today. Imagine trying to forecast the future
path of the dollar following Chairman
Greenspan’s February 4 announcement that the
FOMC had decided to increase slightly the
degree of pressure on reserve positions. From
that date through June, the federal funds rate
has increased by 125 basis points, so it would
have been tempting to forecast a dollar appre­
ciation— and even more tempting with the
additional knowledge that the Bundesbank
would lower its discount and Lombard rates in
May. Yet over this period, the dollar has
depreciated from 1.752 to 1.58 German marks
and from 109.0 to 98.6 yen.
In this period, forecasting no change
would have been more accurate than forecast­
ing an appreciation of the dollar. Apparently,
over relatively short forecasting horizons such
as these, exchange rate fluctuations are largely
composed of random movements that can push
the dollar up or down, in spite of the current
state of monetary policies or the real conditions
of the relevant countries’ economies.
R ecen t e v id e n ce on U .S . m on e ta ry
p o lic y s h o c k s and th e d o lla r

In contrast to the above literature focusing
on short-run exchange rate forecasts, recent
studies have found a stronger, more predictable
relationship between monetary policy actions
and movements in exchange rates at longer
horizons. Eichenbaum and Evans (1992)
investigated monthly movements in bilateral
exchange rates between the U.S. and Japan,
Germany, France, Italy, and the United King­
dom. The analysis focused on the post-Bretton
Woods era (1974 to 1990), when these coun­
tries’ currencies floated against the dollar. A
controversial aspect of this research is the
necessity of characterizing U.S. and foreign
monetary policy actions. We addressed this

12




concern by considering several measures of
U.S. monetary policy variables: exogenous
shocks either to the federal funds rate or to the
ratio of nonborrowed reserves to total reserves,
and movements in the Romer and Romer index
of monetary policy contractions.2 A robust
finding across these monetary policy measures
was that an expansionary U.S. monetary policy
shock leads to a reduction in short-term U.S.
interest rates and a statistically significant de­
preciation of the dollar against these five major
currencies. This depreciation, however, occurs
slowly over the course of two to three years,
and the maximum impact is estimated to take
effect after two years. An implication of these
estimates is that predictions of movements in
the dollar based upon perceived shifts in U.S.
monetary policy are likely to be reliable only at
long forecast horizons.
Clarida and Gali (1994) identified mone­
tary policy shocks in an alternative way. Using
a structural vector autoregression (VAR) mod­
eling strategy and quarterly data, these econo­
mists econometrically identified monetary
policy shocks by assuming that they have no
long-run effects on real variables. This is an
appealing assumption to most economists who
believe that the long-run Phillips curve is verti­
cal and that the natural rate of unemployment is
unaffected by monetary policy.3 Like Eichen­
baum and Evans, Clarida and Gali found that
expansionary U.S. monetary policy actions led
to a depreciation of the dollar against most
major currencies. Because the latter’s model
considered only a small number of variables,
their measures of monetary policy could be
capturing additional nonmonetary shocks that
have only transitory effects on real variables.4
Nevertheless, using two alternative identifica­
tion strategies, the Clarida-Gali and Eichenbaum-Evans results produced a similar picture
of the effects of monetary policy shocks on
the dollar.
Analyzing monthly data, Eichenbaum and
Evans were able to control for a variety of
nonmonetary variables that are likely to affect
monetary policy and exchange rates. These
control variables are not generally available in
weekly data. Nevertheless, in weekly data
covering 1985-90, Lewis (1993) found comple­
mentary evidence that the dollar depreciates
against the mark following reductions in the
federal funds rate, increases in M 1, or increases

ECONOMIC PERSPECTIVES

in nonborrowed reserves. This indicates that
the effects of monetary policy on exchange
rates are robust across different time periods.
G e rm a n y and J a p a n , 1979-94

To investigate these relationships further
for Germany and Japan, I considered a threevariable VAR for each country. For Japan the
data are the yen/dollar exchange rate (ex­
pressed in yen per dollar), the federal funds
rate, and a two-day call money rate in Japan.
I used analogous data for Germany. The data
are weekly, covering the period March 2, 1979,
through June 24, 1994. All observations are
from Friday of the given week unless one mar­
ket was closed on that day, in which case the
observations are from Thursday. I transformed
the data so that the three variables in the
VAR are:
1) the federal funds rate (FF);
2) the difference between the foreign interest
rate and the federal funds rate (RGER-FF
and RJAP-FF, respectively, at annualized
percentage rates); and
3) 100 times the logarithm of the exchange
rate (mark/dollar and yen/dollar,
respectively).
Each equation in the VAR contains 26
weekly lags of the three variables plus a
constant.
Three shocks are identified as transforma­
tions of the three error terms in the VAR, one
from each autoregression. A positive shock to
the federal funds rate (FF shock) is defined as
an unforecast increase in the federal funds rate
that induces contemporaneous movements in
the foreign interest rate and the exchange rate.
Under certain sets of assumptions, a shock
such as this can be interpreted as contraction­
ary U.S. monetary policy. Specifically, sup­
pose that the federal funds rate were the instru­
ment of monetary policy. The Federal Reserve
considers myriad types of data before deciding
on the final setting of this policy instrument.
To the extent that the Fed’s policy setting devi­
ates from the value dictated by this information
set and the reaction function, a positive devia­
tion of the federal funds rate can be interpreted
as a contractionary U.S. monetary policy
shock. The weekly data in the three-variable
VARs do not contain as much information as
the data employed in the Fed’s reaction func­

FEDERAL RESERVE BANK OF CHICAGO




tion. However, to the extent that much of the
important variation in the economy’s funda­
mentals is captured by variation in these three
variables, the measured FF shock may have
many of the same attributes as a U.S. monetary
policy shock.5
A positive RGER-FF (or RJAP-FF) shock
is an unforecast increase in RGER-FF (RJAPFF); it induces a contemporaneous movement
in the exchange rate but no contemporaneous
movement in the federal funds rate (by as­
sumption). Under a similar set of assumptions
as above, the RGER-FF shock can be interpret­
ed as a contractionary German monetary
policy shock.
A positive MARK (or YEN) shock is an
unforecast increase in the mark/dollar ex­
change rate (or yen/dollar rate) that induces no
contemporaneous movement in the federal
funds rate or the German interest rate spread
(RGER-FF).6 This is a catch-all shock, captur­
ing contemporaneous variation in the exchange
rate that cannot be accounted for by the two
interest rate shocks. A few possible causes of
these exchange rate shocks are increasing fears
of a trade war, the collapse of a government’s
ruling party, or a coup attempt.
An interesting question that these VAR
estimates can address is, how do average-size
shocks affect the federal funds rate, the Ger­
man and Japanese interest rate spreads, and the
exchange rate over time? For Japan, figure l
plots the estimated effects of the three shocks
on each of the three variables for three years of
weekly data. The red lines are one-standarderror bands around the estimated impulse re­
sponse functions.7 Figure 2 plots the analo­
gous effects for Germany. As Lewis’ (1993)
empirical analysis suggested, the weekly data
results presented here are broadly consistent
with the analysis of monthly data by Eichenbaum and Evans (1992). A positive FF shock
(interpreted as a contractionary U.S. monetary
policy shock) leads to a persistent increase in
the federal funds rate. In both cases, the initial
one-standard-deviation FF shock induces an
increase in the federal funds rate of about 50
basis points. Since many movements in the
federal funds rate over time are on the order of
25 basis points, this estimate may be somewhat
high for a one-standard-deviation shock. A
possible explanation for this large estimate is
that the sample period is dominated by the

13

FIGURE 1

Effects of FF, RJAP-FF, and YEN shocks
Effect of FF on federal funds rate

Effect of RJAP-FF on federal funds rate

Effect of YEN on federal funds rate

basis points

basis points

basis points

ECONOMIC PERSPECTIVES

Effect of FF on RJAP-FF

Effect of RJAP-FF on RJAP-FF

basis points

basis points

basis points

Effect of FF on yen/dollar

Effect of RJAP-FF on yen/dollar

Effect of YEN on yen/dollar

percentage appreciaton of dollar

percentage appreciation of dollar

percentage appreciation of dollar




Note: Impulse response functions estimated from three-variable vector autoregression of federal funds rate, Japanese call money rate,
and yen/dollar exchange rate. Data cover March 1979 through June 1994. The red lines represent one-standard-error bands.

FEDERAL RESERVE BANK OF CHICAGO

FIG UR E 2

Effects of FF, RGER-FF, and MARK shocks
Effect of FF on federal funds rate

Effect of RGER-FF on federal funds rate

Effect of MARK on federal funds rate

basis points

basis points

basis points

Effect of FF on RGER-FF

Effect of RGER-FF on RGER-FF

Effect of MARK on RGER-FF

basis points

basis points

basis points

Effect of FF on mark/dollar

Effect of RGER-FF on mark/dollar

Effect of MARK on mark/dollar

percentage appreciation of dollar

percentage appreciation of dollar

percentage appreciation of dollar

Note: Impulse response functions estimated from three-variable vector autoregression of federal funds rate, German call money rate,
and mark/dollar exchange rate. Data cover March 1979 through June 1994. The red lines represent one-standard-error bands.

U
1




years 1979 to 1984, when interest rate move­
ments were quite large. The smaller estimated
effects for the 1987-94 period (reported below)
are consistent with this possibility.
The spread between short-term foreign
interest rates and the federal funds rate is nega­
tive following a positive FF shock. The point
estimates indicate that initially the foreign
interest rates do not respond strongly to the
increase in the federal funds rate. After about
one year, the estimated spread is about 15 basis
points rather than the initial 50 basis points. If
the German and Japanese monetary authorities
use these short-term interest rates as the instru­
ments of their monetary policies, then the im­
pulse response functions indicate that the for­
eign authorities tighten a bit following a U.S.
tightening. But the foreign response is not
one-for-one with the U.S. contraction.
A positive FF shock leads to a persistent
appreciation of the dollar against both the mark
and the yen.8 Notice that the effect of the FF
shock on both the mark and the yen is delayed,
in both cases reaching its maximal effect after
at least two years. The initial effect is ex­
tremely small compared with the estimated
effect after three years. This finding turns
out to be quite consistent with the short-hori­
zon forecasting results documented by Meese
and Rogoff. Thus a shock to the federal funds
rate does not imply a substantial revision to
the forecast for the near-term path of the ex­
change rate.
The foreign interest rate shocks are mea­
sured by the RGER-FF and RJAP-FF shocks.
According to the identifying restrictions, a
positive shock to RGER-FF induces no con­
temporaneous change in the federal funds rate.
Consequently, a shock to RGER-FF (RJAPFF) represents a shock to the German interest
rate, RGER (or the Japanese interest rate,
RJAP). The shocks induce smaller effects than
the FF shock on the federal funds rate, the
foreign interest rate spreads, and the exchange
rate. In the German system, the federal funds
rate is not significantly altered by an RGER-FF
shock. In the Japanese system, an increase in
Japanese short-term interest rates leads to a
modest reduction in the federal funds rate. For
both countries, however, a persistent positive
spread opens up between the foreign interest
rate and the federal funds rate that is estimated
to be about twice as large for Japan as for

Germany after six months. Interestingly, the
dollar is estimated to depreciate against both
the mark and the yen, but the larger and more
significant effects are again with the latter.
After one year, a one-standard-deviation shock
to Japanese interest rates (about 20 basis
points) leads to a 0.75 percent depreciation of
the dollar against the yen.
Finally, the exchange rate shocks have a
large, persistent, and significant effect on the
mark/dollar and yen/dollar exchange rates
(MARK and YEN, respectively). In the early
phases of a positive exchange rate shock, the
dollar appreciates by a little over 1.5 percent
for both currencies. One year later, the dollar
continues to be about 1.25 percent higher than
before the shock. These shocks seem to damp­
en out after about two to three years, at least in
terms of statistical significance. That is, there
seems to be little evidence against the hypothe­
sis that the dollar’s initial appreciation has
been completely unwound three years later. In
response to these exchange rate shocks, the
evidence suggests that the dollar’s time path
exhibits reversion to the mean over a long
horizon. Interestingly, there is somewhat less
evidence of this type of mean reversion in
response to an FF shock at the three-year hori­
zon. Much as a one-time shock to monetary
policy would be expected to have a permanent
effect on prices, an FF shock seems to have a
long-lasting effect on the level of the dollar
against the mark and the yen.
Another way of measuring the long-hori­
zon predicability of exchange rates is by exam­
ining the variance of particular forecast errors.
Specifically, suppose we were forecasting the
mark/dollar exchange rate for 52 weeks from
now. At the end of 52 weeks, we would know
how far wrong the forecast was. We would
like to know what events had occurred during
those 52 weeks to cause the forecast to be
wrong, and we would like to quantify the im­
pact of those events on the forecast’s error.
Suppose the forecast was very wrong, say by 5
percent. Since the average MARK shock has a
relatively large effect on the mark/dollar ex­
change rate, the impulse response functions
indicate that a small number of these shocks
could lead to a 5 percent shift in the exchange
rate after only 52 weeks. However, the aver­
age FF and RGER-FF shocks have a smaller
impact effect on the mark/dollar; so a larger

16

ECONOMIC PERSPECTIVES




(and less probable) number of these shocks
would be required for this to happen. Conse­
quently, at short horizons, we would expect
most of the forecast error variance to be ex­
plained by exchange rate shocks. At longer
horizons, however, the FF shocks are likely to
have more explanatory power. The effect of
the FF shocks is delayed and builds over time,
while the exchange rate shocks dampen.
Table l reports this decomposition of fore­
cast error variances for Germany and Japan.
Two observations are in order. First, at ex­
tremely short forecast horizons, virtually all of
the forecast errors are due to the realization of
exchange rate shocks. Since these shocks are
not easily or readily identified with real-world
events, this large percentage demonstrates our
inability to explain exchange rate movements.
This finding is consistent with Meese and
Rogoff s finding that sophisticated models of
exchange rate determination cannot outperform
a random walk forecast at short horizons. Sec­
ond, at longer horizons the explanatory power
of these exchange rate shocks is smaller. This
seems to be due to the mean reversion in these
unknown shocks. This is an indication as to
why long-horizon movements in exchange rates
have a forecastable component.
H isto rica l d e c o m p o s itio n o f e x ch an g e
rates, 1979-94

The statistical analysis assumes that varia­
tions in YEN and MARK are due to the three
shocks discussed above. An interesting ques­
tion that this statistical model can address is,
how much of the dollar’s depreciation against
the yen since 1991 is due to shocks to the fed­
eral funds rate? A historical decomposition can
provide an answer.
The VAR estimates imply that the ex­
change rate can be expressed as a moving aver­
age of current and past FF shocks, foreign
interest rate shocks, and exchange rate shocks,
plus a constant term. How much of the ex­
change rate’s fluctuations over a particular time
period are accounted for by the FF shock? One
way to answer this question is simply to as­
sume that the historical values of the foreign
interest rate and exchange rate shocks are
identical to zero for each time period, and then
to plot the fitted exchange rate autoregression
using the FF shocks as the only nonzero ex­
planatory variables. If all of the variation in
exchange rates were accounted for by the FF

FEDERAL RESERVE



BANK OF CHICAGO

TABLE 1

Percentage of yen/dollar forecast error
variance explained by:
Forecast
horizon

FF
shocks

RJAP-FF
shocks

YEN
shocks

1 week
6 weeks

0.8

0.0

2.5

0.0

97.5

13 weeks

3.3

0.3

96.4

26 weeks

1 year
2 years
3 years

99.2

4.9

1.8

93.3

16.2

7.2

33.1
45.4

11.7

76.6
55.2

10.6

44.0

Percentage of mark/dollar forecast
error variance explained by:
Forecast
horizon

FF
shocks

1 week
6 weeks

1.0
2.8

13 weeks

5.0

26 weeks
1 year

5.1
9.7

RGER-FF
shocks

MARK
shocks

0.4

98.6

0.1
1.0

97.1

2.4

92.5

2 years

21.0

4.3
4.2

3 years

33.2

4.0

94.0

86.0
74.8
62.8

Note: FF shocks rep resent an un forecasted m o v e ­
m en t in the fed e ra l fun ds rate. RJAP-FF shocks
(RGER-FF shocks) rep resent an unforecasted
m o v em e n t in the fo re ig n in terest rate spread.
YEN shocks (M A R K shocks) rep resent an u n fo re ­
casted m o v e m e n t in the e xch an ge rate.

shocks, the fitted values would be identical to
the actual exchange rate series. If the FF
shocks were statistically independent of the
exchange rate, and consequently explained
none of its fluctuations, then the fitted values
would be a smooth path relative to the volatile
exchange rate path. Obviously, this analysis
can be done for each of the shocks. The three
resulting paths for the exchange rate represent
a historical decomposition of the exchange rate
fluctuations that are explained by the FF, for­
eign interest rate, and exchange rate shocks.
Initial conditions at the beginning of the
data present an additional difficulty to any
interpretation. For example, imagine that for
some unexplained reason, the dollar were over­
valued at the beginning of the sample period,
say March 1979. If no other shocks were to hit
these economies, then the dollar would be
expected eventually to depreciate to eliminate

17

the overvaluation. Depending on
FIGURE 3
the reasons for the overvalued
Exchange rate movements explained by FF shocks
dollar and the structures of the U.S.
Japanese yen
and foreign economies, this transi­
yen/dollar
tion might take two weeks, two
years, or two decades. In the his­
torical decompositions, no matter
which path the FF shocks take over
the period 1979-94, the effects of
this depreciation will be superim­
posed on the path explained by the
FF shocks. To continue with a
hypothetical example, suppose that
the initial realizations of the FF
shocks implied that U.S. monetary
policy shocks were extremely con­
tractionary. Monetary theories of
exchange rate determination predict
that the dollar should appreciate
German mark
mark/dollar
relative to currencies with more
expansionary monetary policies.
Since the underlying tendency for
the dollar in this example was to
depreciate prior to the FF shock
realizations, the actual path of the
exchange rate will depend on the
relative strengths of these two
competing effects.
Figure 3 displays the weekly
time paths of YEN and MARK
from March 1979 through June
1994. The line labeled baseline
projection in each panel displays
Notes: Calculations based on three-variable vector autoregression.
the effects of the initial conditions
Shaded areas indicate recessions.
on the projected exchange rate
path. For the mark, initial condi­
has no well-defined mean over the longer sam­
tions in 1979 projected the dollar would ap­
ple period. Apparently, the estimates are,fit­
preciate from around 1.80 marks to above 2
ting a unit root with negative drift; this means
marks in 1982, then settle down to an average
that the fitted values for YEN will trend down­
level of about 1.85 marks by the end of the
ward in the absence of any shocks. It also
sample period in 1994. Essentially, the VAR
implies that the end points of the projected
is estimating MARK to be a stationary process
path will fit the data’s end points very closely,
with a well-defined mean value of about
irrespective of the paths of monetary policy.
1.85 marks.
Figures 3, 4, and 5 display the projected
For the yen, on the other hand, initial con­
path of the exchange rate that is due to realiza­
ditions project a continual depreciation of the
tions of the FF shock, the foreign interest rate
dollar from 1979 through 1994. This phenom­
shock (RJAP-FF and RGER-FF), and the ex­
enon seems to be due less to the initial condi­
change rate shock (YEN and MARK shocks),
tions in 1979 and more to the nonstationary
respectively. Recall from the impulse response
behavior of YEN over this sample period.
functions in figures 1 and 2 that the FF shocks
From 1979 through 1985, the dollar traded
accounted for mainly long-horizon movements
between 200 and 280 yen; from 1988 through
in the dollar, specifically, the one to three-year
June 1994, the dollar was between 100 and 160
yen. The VAR estimates indicate that YEN

18



ECONOMIC PERSPECTIVES

horizons. Figure 3 indicates that
FIGURE 4
for both the yen and mark, FF
Exchange rate movements explained by RJAP-FF and
shocks account for long, slow
RGER-FF shocks
movements in the exchange rate.
Relative to the projected path from
Japanese yen
yen/dollar
the initial conditions, the FF shocks
account for higher levels of the
dollar over the period 1980-85.
One interpretation of this path is
that contractionary monetary policy
shocks led the dollar to appreciate
through 1982, and the subsequent
depreciation represents either a
reversion to the mean for the mark
or a resumption of the negative
drift for the yen.
In figure 4, the foreign interest
rate shocks account for relatively
small deviations of the exchange
rate from the initial projected path.
German mark
For the yen, RJAP-FF shocks do
mark/dollar
account for part of the dollar’s
depreciation from the peak of the
last business cycle in 1990 through
1992, but their total explanatory
power remains small over the full
sample period. The RGER-FF
shock has virtually no explanatory
power for the mark.
As the impulse response func­
tions indicated, most of the short­
term variation in these two ex­
change rates is due to the unex­
plained YEN and MARK shocks,
and this is evident in figure 5. Spe­
Notes: Calculations based on three-variable vector autoregression.
Shaded areas indicate recessions.
cifically, the projected path from
these shocks reflects the jaggedness
YEN does not change much for 12 months, so
of the actual exchange rates. This occurs even
forecasting no change will not be far wrong.
though the overall level of the exchange rate is
Second, FF shocks seem to explain longer-run
not well captured by the shocks, especially for
movements in exchange rates. The informa­
the yen. For example, from 1980 through
tion content in short-term interest rates is more
1985, the average value of the dollar was
likely to improve exchange rate forecasts at the
around 240 yen, but the YEN shocks projected
two-year horizon and beyond.
it to be around 180 yen.
One caveat in the analysis of Japan is the
Two conclusions seem to follow. First,
estimated negative drift in YEN over the entire
accurately forecasting exchange rate move­
1979-94 period. This drift term implies that
ments over short time horizons (under one
the out-of-sample forecasts will be for the
year) requires knowledge and an understanding
dollar to continue depreciating indefinitely, but
of unexplained YEN and MARK shocks. Con­
that seems implausible despite the recent de­
sidering the persistence of these shocks, as
preciation. The likely source of this nonstadisplayed in the impulse response functions, it
tionarity is the behavior of YEN in 1985 and
is not surprising that a random walk forecast of
1986. From 1987 to the present, this exchange
exchange rate movements does reasonably well
by comparison. That is, after a YEN shock,


FEDERAL RESERVE


RANK OF CHICAGO

19

rate has traded in a narrower band. So it is an
interesting robustness check to see how the
exchange rate analysis changes for this period.
J a p a n , 1987-94

Figure 6 displays estimated impulse re­
sponse functions for Japan from a VAR based
on weekly data from July 1987 through June
1994. While the qualitative effects are similar,
there are some interesting differences between
these responses and their full-sample counter­
parts in figure 1. First, because the period
1979 to 1984 was excluded, average changes in
the federal funds rate were smaller. Conse­
quently, the estimated one-standard-deviation
FF shock is smaller, about 18 basis points

20



versus 50 basis points for the
1979-94 period. This means that
a 25-basis-point FF scale was less
likely in the 1987-94 period than
in the 1979-94 period. However,
the effect of this shock on the
federal funds rate is more persis­
tent over the first year. Second,
the initial effect of the 18-basispoint FF shock on the dollar is
small and uncertain for the first
nine months; that is, the standard
errors are large relative to the
estimated effect. Over the second
year, however, the dollar has
appreciated on the order of 0.5
percent. Taking into account the
smaller size of the FF shock over
the 1987-94 period, a 50-basispoint shock is estimated to trans­
late into an approximately 1.5
percent appreciation of the dollar
in the second year; this is compa­
rable to the estimates reported in
figure 1 for the 1979-94 period.
Third, the RJAP-FF shock is
estimated to have a more delayed
effect on the federal funds rate
and the dollar. At the end of the
second year, an initial 15-basispoint increase in the short-term
Japanese interest rate is estimated
to reduce the federal funds rate by
about 10 basis points. Since the
spread RJAP-FF is estimated to
be less than 10 basis points at this
time, the Japanese interest rate
has declined on net from its initial increase.
The statistical analysis here is too simple to
allow an evaluation of the underlying causes of
these interest rate changes, but the results are
suggestive. For instance, the response pattern
could be consistent with a monetary contrac­
tion in Japan that reduces economic activity in
both Japan and the United States; the U.S.
monetary response might be to reduce U.S.
short-term interest rates somewhat to accom­
modate the reduction in activity. To assess that
possibility would require a statistical analysis
that examines economic activity simultaneous­
ly with interest rate shocks. Another possibili­
ty is that the RJAP-FF shock represents an
attempt by Japanese monetary authorities to

ECONOMIC PERSPECTIVES

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FIGURE 6

Effects of FF, RJAP-FF, and YEN shocks
Effect of FF on federal funds rate

Effect of RJAP-FF on federal funds rate

Effect of YEN on federal funds rate

basis points

basis points

basis points

Effect of FF on RJAP-FF

Effect of RJAP-FF on RJAP-FF

Effect of YEN on RJAP-FF

basis points

basis points

basis points

Effect of FF on yen/dollar

Effect RJAP-FF on yen dollar

Effect of YEN on yen/dollar

percentage appreciation of dollar

percentage appreciation of dollar

percentage appreciation of dollar

Note: Impulse response functions estimated from three-variable vector autoregression of federal funds rate, Japanese call money rate,
and yen/dollar exchange rate. Data cover June 1987 through June 1994. Red lines represent one-standard-error bands.

N




Beginning in 1989, the FF and RJAP-FF shocks
reduce the value of the dollar, and these
efforts are accommodated by the U.S. In
account for a substantial part of the dollar’s apprecia­
fact, the dollar does decline by 0.5 per­
tion relative to the path projected from the initial
cent after three years following an RJAPconditions in 1987. The dollar’s appreciation begin­
ning in February 1990 and its subsequent deprecia­
FF shock; this estimated effect is more
tion through September 1990 are not explained by
delayed than over the full-sample period
(figure 1).
the interest rate shocks. Credit this volatile period to
YEN shock again, and note again that the unex­
Fourth, the initial effects of the unex­
plained exchange rate shock continue to
plained YEN shock is capturing some portion of the
be large. Interestingly, the shocks only
effects of the Iraqi invasion of Kuwait on the dollar.
From 1991 to the present, the interest rate
persist for about six months, after which
their estimated effect on the dollar is
shocks account for virtually all of the long-horizon
variation in the dollar. The FF and RJAP-FF shocks
about zero. This reduced persistence
account for the initial dollar level in the spring of
relative to the full-sample period means
1991. In March 1991, the dollar was at 134.55 yen
that a smaller percentage of the longhorizon forecast error variance can be
and the interest rate shocks accounted for a level of
explained by YEN shock. For
example, at the two-year forecast
FIGURE 7
horizon, YEN shock explains 42
percent of the forecast error vari­
Exchange rate movements explained by interest
rate and YEN shocks
ance in YEN versus 55 percent
Japanese yen
over the entire 1979-94 period. At
yen/dollar
the three-year forecast horizon,
YEN shock explains only 27 per­
cent versus 44 percent. At this
horizon, the FF shock now explains
54 percent versus 45 percent previ­
ously, and RJAP-FF shock ac­
counts for 19 percent versus 11
percent.
Finally, figure 7 displays the
historical decomposition of YEN
movements over the 1987-94 peri­
od from the estimated VAR. The
projected paths explained by the FF
and RJAP shocks have been com­
bined in the top panel of figure 7.
Japanese yen
yen/dollar
Individually, these shocks account
for a substantial portion of the
YEN movements; combining these
explanations leads to a clearer
depiction of the role of interest rate
shocks over the period. Notice that
the projected path from the initial
conditions in 1987 oscillates gently
around a better-defined average
value in the range of 120 to 130
yen. From 1987 through 1988, the
unexplained YEN shock accounts
for most of the dollar’s fluctuations
against the yen; in other words, the
Notes: Calculations based on three-variable vector autoregression.
interest rate shocks explain virtual­
Data cover January 1987 through June 1994. Shaded area indicates recession.
ly none of these movements.

22




ECONOMIC PERSPECTIVES

138.34. By the end of May 1994, the dollar
was at 104.3 yen and the interest rate shocks
projected a level of 108.0. This implies that
the dollar’s 25 percent decline during this
period is consistent with the interest rate
shocks that occurred in the United States and
Japan during the most recent recesssion and the
subsequent recovery. O f course, there have
been many large short-term swings in the ex­
change rate that are not explained by the inter­
est rate shocks; these are accounted for by the
YEN shock.
C o n c lu s io n

The dollar’s recent depreciation against
both the mark and the yen has been dramatic.
Accurately forecasting short-term changes in

exchange rates is a nearly impossible task.
However, at longer forecast horizons, the evi­
dence indicates that the stance of monetary
policy, as measured by unexpected movements
in short-term interest rates, affects the dollar
significantly. The vector autoregression analy­
sis indicates that interest rate shocks account
for a substantial part of the dollar’s deprecia­
tion against the yen from 1991 through June
1994. Apparently, the relatively low federal
funds rate over this period has contributed to
the dollar’s decline. The statistical analysis
implies that the recent 125-basis-point increase
in the federal funds rate should ultimately lead
to a stronger dollar, but those effects will likely
go unnoticed for some time.

NOTES
‘Meese and R ogoff (1984) also documented evidence that
long-horizon exchange rate movements are substantially
easier to forecast than short-horizon changes.
2In the vector autoregression analysis, monetary policy
actions are identified with orthogonalized innovations in
either the funds rate or the ratio o f nonborrowed reserves
to total reserves. Bemanke and Blinder (1992) and Sims
(1992) identify monetary policy shocks with orthogonal­
ized innovations in short-term interest rates; Christiano
and Eichenbaum (1992) and Strongin (1992) identify
these shocks with orthogonalized innovations in nonbor­
rowed reserves and the ratio o f nonborrowed reserves to
total reserves, respectively. The Romer index is taken to
be exogenous, as assumed by Romer and Romer (1989).
3See Campbell and Rissman (1994) for a recent discussion
o f the Phillips curve.
4The statistical analysis in this article is also unable to
control for a variety o f nonmonetary phenomena, such as
the condition o f labor markets or changes in relative
prices that may be reflected in commodity price m ove­
ments.

equation. In one case, we allowed the policy instrument
to respond systematically to U.S. industrial production,
foreign industrial production, the U.S. price level, the
ratio o f nonborrowed reserves to total reserves, the federal
funds rate, the foreign interest rate, and the exchange rate.
Clearly, this set o f variables can capture a greater amount
o f variation in the econom y’s underlying nonmonetary
fundamentals than simply interest rates and the exchange
rate. Still, many o f the results are comparable to the
weekly estimates here. For an elaboration, see Eichen­
baum and Evans (1992) and Christiano, Eichenbaum, and
Evans (1994).
6In technical terms, the shocks are identified as orthogo­
nalized innovations from the VAR, where the order o f the
Wold causal chain is the federal funds rate, the foreign
interest rate spread, and the exchange rate.
T h e standard errors were computed using Monte Carlo
methods described in Eichenbaum and Evans (1992). The
number o f Monte Carlo draws in this study was 200.
8See Eichenbaum and Evans (1992) for a more detailed
analysis o f the statistical significance o f these types o f
impulse response functions.

5 Eichenbaum and Evans (1992) considered a much larger
set o f conditioning variables for the federal funds rate

REFERENCES

Bernanke, Ben, and Alan Blinder, “The
federal funds rate and the channels of monetary
transmission,” American Economic Review,
Vol. 82, No. 4, 1992, pp. 901-921
Campbell, Jeffrey R., and Ellen R. Rissman,
“Long-run labor market dynamics and short-

FEDERAL RESERVE



RANK OF CHICAGO

run inflation,” Economic Perspectives, Vol. 18,
No. 2, March/April 1994, pp. 15-27.
Christiano, Lawrence J., and Martin
Eichenbaum, “Liquidity effects, monetary
policy, and the business cycle”, NBER, work­
ing paper, No. 4129, 1992.

23

Christiano, Lawrence J., Martin Eichenbaum, and Charles Evans, “The effects of
monetary policy shocks: Some evidence from
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Chicago, working paper, No. WP-94-2, 1994.

Meese, Richard A., and Kenneth Rogoff,
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Clarida, R., and J. Gali, “Sources of real
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_______________ , “The out-of-sample failure
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Eichenbaum, Martin, and Charles Evans,
“Some empirical evidence of the effects of
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Federal Reserve Bank of Chicago, working
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Evans, Charles, “The dollar and the federal
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Lewis, Karen, “Are foreign exchange interven­
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really matter?” National Bureau of Economic
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1993.
Mark, N., “Long-horizon predictability of
exchange rates,” Ohio State University, manu­
script, 1993.

24



Romer, Christina D., and David H. Romer,
“Does monetary policy matter? A new test
in the spirit of Friedman and Schwartz,” in
NBER Macroeconomics Annual 1989, Olivier
J. Blanchard and Stanley Fischer (eds.), Cam­
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Sims, Christopher A., “Interpreting the mac­
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Strongin, Steve, “The identification of mone­
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ity puzzle,” Federal Reserve Bank of Chicago,
working paper, No. WP-92-27, 1992.

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