The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Federal
Reserve Bankof
New York
Quarterly Review
Autumn 1989
Volume 14 No. 3
1
Trends in International Banking
in the United States and Japan
7
Evaluating Recent Trends in Capital
Formation
20
Inflation Expectations Surveys as
Predictors of Inflation and Behavior
in Financial and Labor Markets
33
Japanese Trade Balance Adjustment
to Yen Appreciation
48
The Effectiveness of Tax Amnesty
Programs in Selected Countries
54
61
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1989
May-July 1989
This Quarterly Review is published
by the Research and Statistics Group
of the Federal Reserve Bank of New
York. Remarks of E. GERALD
CORRIGAN, President of the Bank,
on trends in international banking in
the United States and Japan begin
on page 1. Among the staff members
who contributed to articles in this
issue are A. STEVEN ENGLANDER
and CHARLES STEINDEL (on
evaluating recent trends in capital
formation, page 7); A. STEVEN
ENGLANDER and GARY STONE (on
inflation expectations surveys as
predictors of inflation and behavior in
financial and labor markets, page 20);
SUSAN HICKOK (on Japanese trade
balance adjustm ent to yen
appreciation, page 33); and ELLIOT
UCHITELLE (on the effectiveness of
tax amnesty program s in selected
countries, page 48).
Two quarterly reports on Treasury
and Federal Reserve foreign
exchange operations for the periods
August through O ctober 1989 and
May through July 1989 begin on
pages 54 and 61, respectively.
Trends in International Banking
in the United States and Japan
Good afternoon, ladies and gentlemen. I am pleased to
be able to participate in this most important and timely
discussion of Japanese direct investment in the United
States with emphasis on developments in the financial
sector. Allow me to say at the outset that the views I
will express today are my own and should not be con
strued as necessarily reflecting the official point of view
of the Federal Reserve as a whole. Before turning to
the particulars of developments in the financial sector,
allow me to begin with several more general observa
tions which I believe can provide some perspective on
the discussion that will follow:
• First, patterns of direct foreign investment and
international capital flows more generally must be
viewed in the context of bilateral and global pat
terns of national savings and investment rates as
well as patterns of current account positions. That
is, for a country like the United States, which is
running large internal and external deficits, the
external deficit must be financed by some combina
tion of direct and/or portfolio investment flows from
abroad. Thus, so long as there are large imbal
ances in these macroeconomic relationships, there
will have to be — as a matter of simple arithmetic —
corresponding capital flows and swings in net for
eign investment positions among countries. The
bilateral relationship between Japan and the United
States is no exception to the inevitability of this
Remarks by E. Gerald Corrigan, President of the Federal Reserve
Bank of New York, before the A.F.I.I. and C.B.I.U.S. Conference on
Japanese Direct Investment in the United States, in Tokyo, Japan,
O ctober 12, 1989.
arithmetic. It follows, therefore, that the only way
the rise in net foreign investment in the United
States can be ameliorated is in a context in which
underlying economic imbalances are reduced over
time. As in most things, at the end of the day, the
economic fundamentals are what really count.
...The only way the rise in net foreign investment
in the United States can be ameliorated is in a
context in which underlying economic imbalances
are reduced over time. As in most things, at the
end of the day, the economic fundamentals are
what really count.
• Second, as a general matter, the free flow of capi
tal and investment across international boundaries
is a clear plus for national economies and for the
global economy as a whole. Free and efficient flows
of capital on an international scale (1) help to pro
mote more open, competitive, and efficient national
economies; (2) better allocate savings and invest
ment on a global basis; and (3) may even help to
promote greater harmony among nations. Looked
at in this light, Japan is in a unique position and
has unique responsibilities to assist in the optimal
deployment of savings, not just here in Japan, but
more generally.
• Third, direct investment, particularly de novo
investment in productive plant and equipment, can
play a particularly important role in stimulating
competition, growth, and improvements in stan
FRBNY Quarterly Review/Autumn 1989
1
dards of living. Indeed, economic history —
especially in the postwar period — provides unam
biguous evidence that foreign direct investment
works to the benefit of all.
Free and efficient flows of capital on an interna
tional scale (1) help to promote more open,
competitive, and efficient national economies;
(2) better allocate savings and investment on a
global basis; and (3) may even help to promote
greater harmony among nations.
• Fourth, all countries have some limits on the
amount or nature of foreign investment they will
accept within their national boundaries. Among the
industrialized countries, such limits often take the
form of restrictions on the extent — if any — of for
eign ownership or control of firms or industries that
are associated with the production of goods or
services that are seen to have national strategic
importance. Often, but not always, these restric
tions grow out of national security considerations.
However, while all governments respect the right of
other governments to limit or restrict foreign invest
ment on such grounds, there can be significant dif
ferences of opinion as to what constitutes
legitimate grounds for such restrictions. For exam
ple, over the years we have seen evidence in some
countries that suggests that banking — or at least
certain core components of banking — can be
viewed as falling within the range of commercial
activities having special status for these purposes.
In short, there can be an exceedingly fine line dis
tinguishing between practices and policies that are
motivated, on the one hand, by legitimate national
strategic considerations and by protectionist-like
attitudes on the other.
In order to provide a workable framework within
which individual countries and countries at large
can better manage both the politics and the eco
nomics of foreign investment, many countries —
the United States and Japan included — have come
to rely on the principle of national treatment.
• Finally, in order to provide a workable framework
within which individual countries and countries at
large can better manage both the politics and the
economics of foreign investment, many countries —
the United States and Japan included — have come
2 FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized for
to rely on the principle of national treatment. That
principle, in its simplest form, states that, subject to
limitations growing out of national strategic con
siderations, foreign firms should have the same
rights, privileges, and responsibilities as domestic
firms. In practice, however, the principle of national
treatment is subject to many ambiguities since it is
not always easy to determine whether such equal
ity of treatment prevails even in de jure terms much
less in de facto terms.
...In practice, however, the principle of national
treatment is subject to many ambiguities since it
is not always easy to determine whether such
equality of treatment prevails even in de jure
terms much less in de facto terms.
Partly for this reason, the principle of national
treatment is increasingly accompanied by an
implicit or explicit policy of reciprocity, which in
effect says that one country will be willing to pro
vide national treatment to another only so long as
the second country provides national treatment to
the first. This is the philosophy which was associ
ated with the so-called primary dealer amendment
to the omnibus trade bill enacted in the United
States in 1987. I personally, and the Federal
Reserve generally, resisted that approach, partly
on the grounds that a policy of “ reciprocal national
treatment” can all too easily put us all on the very
slippery slope of protectionism. Indeed, this epi
sode should serve as a forceful reminder that we
all have an ongoing responsibility to see to it that
policies and practices are fully consistent with
national treatment and that markets for goods and
services alike are open and free to all competitors,
foreign and domestic.
With those general observations in mind, allow me to
turn now to the financial sector in particular. What I
would like to do in this regard is to provide an overview
of the extent of Japanese presence in U.S. banking
and securities markets and contrast that with the
extent of U.S. presence in Japanese markets. That dis
cussion must clearly take place in the context of the
explosive growth of Japanese banks over the decade
of the 1980s. We all know very well that any list of the
largest banks in the world is now dominated by Japa
nese banks. We also know that the enormous growth of
Japanese banks in this decade, and especially in more
recent years, has to a very considerable extent been
driven by macroeconomic considerations, including the
high savings rate in Japan, the country’s massive
cumulative current account surpluses, and net changes
in dollar exchange rates.
What may not be as widely recognized is the extent
to which the growth of Japanese banks has occurred in
international banking markets. For example, over the
seven years ending in December 1988, assets booked
The enormous growth of Japanese banks in this
decade, and especially in more recent years, has
to a very considerable extent been driven by
macroeconomic considerations, including the high
savings rate in Japan, the country’s massive
cumulative current account surpluses, and net
changes in dollar exchange rates.
at the foreign branches (and agencies) of Japanese
banks have increased almost fivefold. Looked at some
what differently, there are now almost 100 branches
and agencies of Japanese banks in the United States
as well as a number of relatively large U.S. subsid
iaries of Japanese banks. From still another vantage
point, in the few short years between 1984 and 1988,
B.I.S. statistics suggest that the share of international
banking assets held by Japanese banks grew from
about 23 percent to almost 40 percent.
Turning more directly to comparisons of relative bilat
eral U.S. and Japanese presence in banking and secu
rities markets, the following picture emerges:
• Judging by the limited data available, it appears
that the scope — as measured by employment and
capital deployed — of Japanese securities firms’
presence in U.S. securities markets is not wildly
out of line with the scope of U.S. securities firms’
presence in Japan. However, even this qualitative
and broad-brushed judgment must be further quali
fied in that it may not fully and fairly reflect condi
tions after taking account of Japanese firm s’
acquisitions of, or minority investments in, U.S.
securities firms which have taken place over the
last few years.
• The presence of Japanese banks in U.S. markets
far exceeds the presence of U.S. banks in Japa
nese markets. To be specific, there are about
twenty U.S. banks with a presence in Japan. In the
aggregate, these banks have about $30 billion in
assets — a very small market share by any mea
sure. By contrast, there are about three dozen
Japanese banks in the United States, and their
aggregate banking assets amount to about $370
billion. More generally, and reflecting the openness
of U.S. banking markets, foreign banking institu
tions in the United States now control about onequarter of the banking assets booked in the United
States, with slightly more than half of that total in
Japanese banks. Indeed, by this measure of market
The presence of Japanese banks in U.S. markets far
exceeds the presence of U.S. banks in Japanese
markets. To be specific, there are about twenty U.S.
banks with a presence in Japan. In the aggregate,
these banks have about $30 billion in assets —a
very small market share by any measure. By con
trast, there are about three dozen Japanese banks
in the United States, and their aggregate banking
assets amount to about $370 billion.
share, Japanese banks now have about a 14 per
cent share of the banking market in the United
States. And for selected geographic and product
markets, the market share of Japanese banks is
still larger. Further, if the total banking activities in
the United States of major Japanese banks were
fully consolidated (that is, to include on one pro
forma balance sheet the assets and liabilities of the
family of subsidiary banks, branches, and agen
cies), six such Japanese banks would now appear
on the list of the thirty largest U.S. bank holding
companies and a couple would be within striking
distance of the tenth largest banking organization
in the United States. While those comparisons may
— as much as anything else — reflect the seg
mented structure of U.S. banking markets, they are
striking none the less.
Having said earlier that macroeconomic forces such
as savings rates, current account positions, and
changes in dollar exchange rates can go a long way in
...Can these same macroeconomic forces fully
explain the very sizable relative presence of
Japanese banks in U.S. markets? The answer to
that question is, in my view, negative. That is,
while macroeconomic forces are very important,
they are by no means the whole story.
explaining the overall growth of Japanese banks over
the past decade, the question that naturally arises is
can these same macroeconomic forces fully explain the
very sizable relative presence of Japanese banks in
U.S. markets? The answer to that question is, in my
FRBNY Quarterly Review/Autumn 1989
3
view, negative. That is, while macroeconomic forces
are very important, they are by no means the whole
story.
For example, one can reasonably point to a number
of historical or institutional factors that help explain this
situation. As an illustration, Japanese banks probably
developed a major strategic interest in U.S. banking
markets before U.S. banks developed similar interests
in Japanese markets. Similarly, elements of innovation,
liquidity, and diversity of financial instruments in U.S.
banking markets probably provided Japanese banks
with more opportunities and earlier opportunities to do
more things in the United States than they or U.S.
banks could do in Japan, notwithstanding the sim
ilarities between Glass Steagall and Article 65. Finally,
it is clear that for a number of years U.S. markets were
more open than were Japanese markets. Indeed, the
process of significant liberalization and deregulation of
Japanese financial and banking markets is only a few
years old.
But even these historical and institutional considera
tions, when added to the macroeconomic factors cited
earlier, do not tell the whole story regarding the com
parative scope of Japanese and U.S. banking presence
in the respective marketplaces.
A further factor that must be considered is the mar
ket valuation of the shares of major Japanese and U.S.
banks, respectively. Specifically, based on recent expe
rience, the shares of major Japanese banks on the
Tokyo Stock Exchange sell at price earnings multiples
that are often in the range of fifty or more. By contrast,
none of the major U.S. money center banks have P/E
ratios of more than ten. This pattern raises two closely
related questions: first, what accounts for the dramati
cally higher market valuation of the shares of Japanese
banks, and second, what implications, if any, does this
have for the bilateral patterns of banking presence in
the two countries?
...This pattern raises two closely related ques
tions: first, what accounts for the dramatically
higher market valuation of the shares of Japanese
banks, and second, what implications, if any, does
this have for the bilateral patterns of banking
presence in the two countries?
I am not well positioned to answer the first question
since stock market valuation matters are not an area in
which I claim any expertise, even in the United States
much less in Japan. I suspect, however, that some of
these differences can be traced to tax, accounting, and
regulatory considerations. The high internal savings
4
FRBNY Quarterly Review/Autumn 1989
rate in Japan may also be relevant in that the pool of
funds available for investment in equities is so large. It
is also widely stipulated that Japanese equity market
valuations provide a significant premium for unrealized
capital gains on real estate and equity holdings. In the
case of the Japanese banks, these unrealized capital
gains on equity investments are large in part because
some of the investments they represent were seed
money for industrial companies in the immediate post
war period that have since grown to become industrial
giants on a national and global scale. (It should be
noted that equity investment limitations governing
investments by Japanese banks in industrial com
panies are technically now quite similar to those pre
vailing in the United States.)
Whatever the precise factors accounting for the very
high P/E ratios for Japanese banks relative to U.S.
banks, the more important question in this context is
Whatever the precise factors accounting for the
very high P/E [price/earnings] ratios for Japanese
banks relative to U.S. banks, the more important
question in this context is does it matter in terms
of the competitiveness between Japanese and U.S.
banks? The answer to that question is yes, it does
matter, and it may matter a lot.
does it matter in terms of the competitiveness between
Japanese and U.S. banks? The answer to that question
is yes, it does matter, and it may matter a lot. There
are at least three reasons for this. First, even in the
face of broadly similar international bank capital stan
dards, it is obviously cheaper — and presumably easier
— for the class of banks with high P/E multiples to
raise fresh equity in the marketplace. Second, it is also
likely that this condition may provide room within which
Japanese banks may have opportunities to price indi
vidual transactions at spreads that are lower than U.S.
banks can justify — a pattern that would not be incon
sistent with the low rates of return on assets generally
observed at Japanese banks relative to U.S. banks.
Finally, these differences in market valuation of shares
also result in a situation in which it is easier for Japa
nese banks to expand in the United States by acquisi
tion while it is virtually impossible for U.S. banks to
expand in Japan by acquisition. The economics of the
price tag may therefore represent a significant barrier
to U.S. banking expansion in Japan. For this reason, it
is all the more important that no stone is left unturned
in the effort to ensure that all barriers— visible and
invisible — to expansion and openness in Japanese
banking and financial markets are eliminated.
All of this raises still another very difficult question:
namely, is there a point where the extent of foreign
banking presence in U.S. markets could give rise to
public policy concerns about such presence? In my
judgment, the candid answer to that question is yes,
such concerns could arise, particularly in the context of
The economics of the price tag may...represent a
significant barrier to U.S. banking expansion in
Japan. For this reason, it is all the more important
that no stone is left unturned in the effort to
ensure that all barriers —visible and invisible —to
expansion and openness in Japanese banking and
financial markets are eliminated.
any pattern of future behavior that might be viewed by
some as an aggressive strategy of expansion through
acquisition. I refuse to speculate whether — or under
what circumstances — such future concerns might
arise, since the initial point of friction — if it ever comes
about — is likely to be more political than economic.
However, leaving aside any such political considera
tions, there are other public policy issues which could
arise in this context.
For example, in the United States, concerns about
concentration of economic and financial power —
particularly in the credit origination process — have
been at the heart of the national debate about banking
structure for 200 years. While much of the doctrine
about concentration has centered on market shares of
In the United States, concerns about concentra
tion of economic and financial power —particularly
in the credit origination process —have been at
the heart of the national debate about banking
structure for 200 years. While much of the doc
trine about concentration has centered on market
shares of individual institutions, it is not a major
leap in intellectual terms for some to suggest that
concerns about concentration should be extended
to foreign banks or to foreign banks from a single
country.
individual institutions, it is not a major leap in intellec
tual terms for some to suggest that concerns about
concentration should be extended to foreign banks or
to foreign banks from a single country. There are also
a number of supervisory and “ safety net” issues that
arise in this context, not the least of which are those
relating to the responsibilities of the home country’s
central bank as lender of last resort should a sizable
liquidity problem arise in a foreign country. Finally,
there are also the continuing questions whether the
second country is really doing all it can in law, in regu
lation, and in practice to provide the same degree of
openness as prevails ini the first country— again, the
whole question of national treatment or reciprocal
national treatment.
Fortunately, the last several years have seen some
major progress in containing these points of concern.
The B.I.S. capital standards surely are working in the
right direction even though they cannot and do not
solve all the problems; the very significant deregulation
and liberalization of Japanese banking and financial
markets in recent years have clearly helped, even
though here too, more needs to be done; the very
close and cooperative efforts between official institu
tions in the United States and Japan are also a clear
plus even if progress does not always come as quickly
and as smoothly as both sides would hope; finally, the
recognition that both countries have a major stake in
finding mutually acceptable ways to blunt points of ten
sion has grown, but here too, that recognition is not as
widespread as it could be.
In closing, allow me to return to the point where I
started: namely, to stress the mutual benefits arising
from the free flow of capital internationally and tp
stress the importance of the economic fundamentals.
The most constructive thing we can both do to check
points of tension in the bilateral economic and financial
The most constructive thing we can both do to
check points of tension in the bilateral economic
and financial relations between our two countries
is to pursue policies aggressively that will wind
down in an orderly way the macroeconomic
imbalances I referred to earlier.
relations between our two countries is to pursue poli
cies aggressively that will wind down in an orderly way
the macroeconomic imbalances I referred to earlier. We
all lost a good friend recently with the passing of Gov
ernor Mayekawa, a man greatly respected throughout
the world for his vision and his contributions to interna
tional harmony. Not the least of his accomplishments
was the report bearing his name that was aimed at
encouraging basic structural changes in the Japanese
economy.
Looking ahead, I know others will take up this impor
tant work just as I know we will continue to make prog
ress in our efforts to better harmonize competitive
conditions in our respective countries. I am also
FRBNY Quarterly Review/Autumn 1989
5
acutely mindful of the pressing need for substantial
reform in economic policy in the United States, just as I
am sensitive to the need to achieve a still higher level
of cooperation and coordination in policies and prac
tices that relate to the structure, operation, and super
FRBNY Quarterly Review/Autumn 1989
Digitized 6for FRASER
vision of our banking and financial markets. None of
this will be easy, but the stakes for us and for the world
economy are so very large that we have no choice but
to find the will and the way that ensure success.
Evaluating Recent Ttends in
Capital Formation
Since 1984 real gross nonresidential fixed investment
by nonfarm business has grown at a 7 percent pace,
considerably faster than in earlier periods. Its share of
real nonfarm business output has averaged over 14
percent in the 1980s, well above its norm for the last
generation (Table 1, columns 1 and 2). Some analysts
have argued that this Strong investment performance
reflects an improved business climate and is likely to
provide long-term gains in productivity and com
petitiveness.1
A more sobering conclusion emerges from an anal
ysis of capital stock and depreciation data provided by
the Department of Commerce.2 The pickup in invest
ment is highly correlated with an increase in the esti
mated depreciation of the capital stock. Subtracting
investment that merely replaces aging capital leaves a
more modest level of net investment and capital forma
tion (Table 1, columns 3 and 4). This rate of net capital
formation is below the average of the postwar period.
The key factor in this rising depreciation rate is the
shifting of investment to shorter lived capital goods. A
shift towards capital that has to pay for itself over a
shorter lifetime may raise the measured short-term
contribution of capital to output but lower the contribu
tion over the longer term.
’ See, for example, John A. Tatom, “ U.S. Investment in the 1980s: The
Real Story," Federal Reserve Bank of St. Louis Review, vol. 71, no. 2
(March-April 1989), pp. 3-15.
2The most recent data are presented in John C. Musgrave, “ Fixed
Reproducible Tangible Wealth in the United States, 1985-88," Survey
of Current Business, vol. 69, no. 8 (August 1989). Historical data are
published in Department of Commerce, Bureau of Economic Analysis,
Fixed Reproducible Tangible Wealth in the United States, 1925-85
(Washington, D.C.: Government Printing Office, June 1987).
Commerce Department measures of net and gross
capital stock growth tell similar stories. These two capi
tal stock measures are alike in reflecting the scrappage
of older capital equipment but differ in the time pattern
they use to depreciate older capital. The gross capital
stock represents the cost of replacing all installed capi
tal equipment currently in use. Capital goods are sub
tracted from the gross capital stock only at the end of
their estimated service lives. The net capital stock, by
contrast, subtracts estimated depreciation from the
capital stock on an ongoing basis. Despite these differ
ences, the two capital stock measures provide a quali
tatively similar picture of the slowdown in capital
accumulation. Both the gross and net capital stock are
growing at a weaker pace than in the 1960s and 1970s
(Table 1, columns 5 and 6). Moreover, the growth in
capital per worker is quite low (Table 1, columns 7
and 8). These data do not support the view that rapid
capital accumulation is supporting output or labor pro
ductivity growth more strongly now than earlier in the
postwar period.
At first glance, the slowdown in the growth of the
gross capital stock seems at odds with the acceleration
of gross investment. However, capital that has been
scrapped at the end of its service life is subtracted
from gross investment to calculate the change in the
gross capital stock. The shift to shorter lived capital in
recent years has increased the rate of scrappage and
reduced the rate of growth of the gross capital stock.
The relationship between net investment and the
growth of the net capital stock is closer than that for
the two gross series. Essentially, net investment equals
the change in the net capital stock. Net investment has
FRBNY Quarterly Review/Autumn 1989
7
fallen off as a share of output in the 1980s, and net
capital stock growth has also weakened.
In some respects the contrasts between measures of
gross investm ent and capital stock growth are even
more striking for the manufacturing sector than for all
nonfarm business (Table 2). After falling sharply in the
early 1980s, gross investment has been growing at a
robust pace since the mid-1980s. The two capital stock
measures, however, show an anemic performance, with
growth rates well below those of earlier periods. In
part, the weak manufacturing data reflect the relative
weakness of the manufacturing sector in this expan
sion. However, the strong growth in gross investment
since the mid-1980s, even when combined with the
loss of manufacturing jobs, does not begin to restore
per capita capital formation to 1960s levels (Table 2,
columns 7 and 8). The stagnation of employment in the
sector is not being offset by an accelerated rate of cap
ital growth.
The c o n flic tin g m essages conveyed by d iffe re n t
measures raise the question: Which set of data offers
the most reliable view of the country’s economic per
formance? If one accepts the gross investment data as
indicative of the confidence in, and future prospects for,
economic growth, then an optimistic view is justified. If
one focuses instead on capital stock growth, then a
more conservative evaluation of prospects is in order.
Clearly, the answer is important for analyzing the long
term perform ance of the Am erican economy. If the
optimistic view is correct, then the economy may be
able to grow out of the external and federal govern
ment deficits without a reduction in living standards or
a loss of government services. If the pessimistic view
is correct, then the nation should, at the least, look for
policies to stimulate capital form ation.3
Although economic theory suggests focusing on cap
ital input as an indicator of capital’s contribution to out
put, using capital stock data as a measure of the flow
3See, for example, M.A. Akhtar, “Adjustm ent of U.S. External
Balances,” Federal Reserve Bank of New York 1988 Annual Report.
Table 1
indicators of Capital Formation in the Nonfarm Business Sector
3
4
5
6
7
8
Growth in
Gross
Investment
2
Gross
Investment
as Share of
Output
Depreciation
as Share of
Output
Net Investment
as Share of
Output
Growth in
Gross
Capital Stock
Growth in
Net
Capital Stock
Growth in
Gross Capital
per Worker
Growth in
Net Capital
per Worker
7.04
3.90
5.31
5.59
3.01
14.85
14.64
13.36
12.69
11.93
11.41
11.18
9.60
8.40
8.23
3.44
3.46
3.76
4.29
3.69
3.53
3.56
3.79
3.74
2.70
3.20
3.17
3.53
4.26
3.74
0.26
1.45
0.92
1.60
1.70
1
1984-88
1979-88
1973-79
1961-73
1948-61
-0 .0 6
1.06
0.66
2.11
2.72
Note: Investment, depreciation, capital stock, and output data all refer to the nonfarm business sector and are measured in constant 1982 dollars.
Sources: Department of Commerce, Bureau of Economic Analysis, for investment and capital stock data; Bureau of Labor Statistics for data on labor input.
Table 2
indicators of Capital Formation in Manufacturing
1
1984-88
1979-88
1973-79
1961-73
1948-61
3
4
5
6
7
8
Growth in
Gross
Investment
2
Gross
Investment
as Share of
Output
Depreciation
as Share of
Output
Net Investment
as Share of
Output
Growth in
Gross
Capital Stock
Growth in
Net
Capital Stock
Growth in
Gross Capital
per Worker
Growth in
Net Capital
per Worker
5.90
0.92
6.30
5.09
1.09
9.51
10.52
11.44
11.11
10.53
8.91
9.10
8.31
7.49
7.65
0.60
1.42
3.14
3.62
2.88
1.80
2.47
3.87
3.98
3.37
0.85
1.63
3.44
4.31
3.43
0.80
3.05
2.54
2.61
3.16
-0 .1 4
2.20
2.12
2.91
3.20
Note: Investment, depreciation, capital stock, and output data all refer to the manufacturing sector and are measured in constant 1982 dollars.
Sources: Department of Commerce, Bureau of Economic Analysis, for investment and capital stock data; Bureau of Labor Statistics for data on labor input.
FRBNY Quarterly Review/Autumn 1989
Digitized 8for FRASER
1
of capital services poses several problems. These diffi
culties have led some economists to recommend gross
investment as an indicator that is theoretically imper
fect but superior in practice to the commonly used
measures of the capital stock.4 For this reason, this
article considers a broad set of capital input indicators
from both a theoretical and practical viewpoint.
Mindful of the apparent contradictions in the data, we
begin by discussing the theoretical role of capital in
economic growth, the conceptual basis for measuring
the input of capital, and the strengths and weaknesses
of the various approximation techniques used to mea
sure the aggregate capital input. The potential pitfalls
of some widely used measures are illustrated in a sim
ple example. Next, we present alternative capital input
data and discuss their implications for economic
growth. Finally, we compare the ability of a number of
capital input measures to explain economic growth
over the last thirty years, arguing that if a measure cor
rectly reflects the contribution of capital to output
growth, its movements ought to be reflected in the
movement of output.
Our analysis suggests that while no single capital
input measure dominates all others, the various capital
stock measures more accurately characterize recent
and prospective economic performance than does
gross investment. The higher gross investment rate
has not raised capital input per head at a pace compa
rable to that in the 1960s. Any positive contribution to
growth made by the shortening of the average life span
of capital will wear off quickly as the composition of the
capital stock is stabilized. Any improvement in trend
labor productivity growth (especially in manufacturing)
in the 1980s is more likely due to enhanced technology,
greater competition, and a better skilled labor force
than to more rapid capital accumulation.
The data show that the contribution of capital to
overall economic growth is about the same as, or
slightly lower than, it was throughout the postwar
period. In manufacturing, however, the contribution is
markedly lower. There is little to indicate that the cur
rent pace of capital formation will propel the economy
along a higher trend output path, unless technology is
embodied in new capital to a much greater degree than
the data can capture. The analysis suggests that if
capital formation is to help accelerate growth, it will
require added domestic savings.
These conclusions are not dependent on a particular
measure of capital formation. An important message of
4See Frank de Leeuw, “ Interpreting Investm ent-to-Output Ratios,”
Bureau of Economic Analysis, Discussion Paper no. 39, March 1989;
and Maurice FitzGerald Scott, A New View of Economic Growth
(O xford University Press, 1989). Scott proposes a theoretical
justification for focusing on gross investment.
the data is the broad similarity in the movements of
many capital input measures and the rough equality of
all such measures in explaining economic perfor
mance. Economists have spent much effort refining
theoretical and empirical measures of the capital input.
The resulting estimates depend heavily on strong theo
retical assumptions and fragmentary disaggregated
data. From a policy perspective, it is reassuring to note
that straightforward, readily observed measures of the
capital input — such as the net and gross capital stocks
— move in line with more sophisticated measures
based on disaggregated data.
Measurement of the capital input5
The Commerce Department makes two estimates of
real nonresidential capital stock. The gross capital
stock is the sum, valued at reproduction cost, of all
installed plant and equipment. New capital and old
capital of the same type are valued equally. The net
capital stock deducts accumulated depreciation from
the gross stock estimate. New capital is weighed more
heavily in the net stock estimate than is old capital of
the same type, because it has accumulated less
depreciation.
The gross and net capital stock estimates do not
necessarily represent estimates of the capital input —
the contribution of capital to production. This is the
product of the quantity of capital and its marginal prod
uct. As the existence of two official measures suggests,
the quantity of capital is difficult to measure because of
the heterogeneity of the capital stock and the difficulty
of summing capital of the same type but of different
ages (“vintages” ).
The marginal product of a capital good cannot be
measured directly, just as the marginal product of labor
is often difficult to identify. The measurement practices
used reflect two different approximations. The first and
theoretically preferable approach is to treat capital
analogously to labor. Just as the marginal product of
labor can be inferred from workers’ wages, so can the
marginal product of capital be inferred from the cost of
renting capital. However, the measurement of capital’s
marginal product in this way is harder than the corre
sponding calculation for labor because rental markets
for capital are thin.
In theory, rental rates and the cost of capital can be
deduced from financial and tax data, but these calcula
tions are difficult to make and their precision is always
uncertain. Capital goods have lifetimes stretching over
several years. The contribution to output needed to
recover financing costs will depend on tax rates and
5A recent technical study of this subject is E. Bjorn, Taxation,
Technology, and the User Cost of Capital (Am sterdam : North-Holland,
1989).
FRBNY Quarterly Review/Autumn 1989
9
benefits, expected capital gains, and the effect of wear and
tear on the capital good’s productivity over the years. A
further complication is the possibility that the operating
characteristics of installed capital may not be altered to
reflect changed financial and tax considerations.
Because the reliability of cost of capital calculations
is uncertain, a much simpler approximation is often
used. The marginal product of each type of capital is
assumed to be stable and the services of capital are
assumed to be in proportion to the quantity of capital
in use.
Even with this simplification, measurement of the
capital input is not entirely resolved. Determining how
the flow of services from capital changes over time
poses additional problems. A lightbulb, for example,
produces roughly the same light towards the end of its
life as at the beginning. Knowing the number of lightbulbs in operation is a good guide to the services pro
vided by the lightbulbs, irrespective of their ages. The
change in the productive stock is simply the number of
new lightbulbs installed less the number retired at the
end of their service life. An automobile, by contrast, is
likely to require some servicing and repairs as it ages,
adding expenses that would have to be subtracted from
the automobile’s product. Because of the decline in the
automobile’s net marginal product over time, it is not
sufficient to sum the number of automobiles operating
in order to estimate their contribution to production.
One would have to know the age distribution as well.
The Bureau of Economic Analysis (BEA) makes both
types of calculations. The use of the gross capital
stock as a capital input measure formally requires the
“one-hoss-shay” assumption that the productivity of a
piece of capital does not diminish over its service life.
Capital goods are assumed to provide a constant flow
of services until the end of their normal lifetime, when
they are scrapped.6 The use of the net capital stock as
a capital input measure requires the assumption that
the straight-line depreciation calculated by BEA reflects
an actual loss of productivity. Ultimately, analysts face
an empirical question: Which measure best approxi
mates the time pattern of a capital good’s productivity
over its lifetime?
Summing either the gross or net capital stocks
across types could provide exact proxies for the aggre
gate capital input if all types of capital had equal pro
ductivity or if the mix of the capital stock and the
productivity of each capital type remained unchanged.
These conditions, however, rarely exist. Short-lived
•The actual procedure is slightly more com plicated since scrappage
is assumed to follow a probab ility distribution around a mean lifetime
for each category of capital. In general, though, we have little way of
knowing w hether BEA assum ptions about the service lives of capital
and the discard patterns of businesses are accurate.
10
FRBNY Quarterly Review/Autumn 1989
capital has to recover costs over a shorter span than
long-lived capital and hence, other things equal, has to
yield a higher gross return per year. Investment in
short-lived capital goods has exceeded that in longlived goods in recent years, shifting the capital mix
towards shorter lived goods.
As neither the equal productivity or unchanged mix
assumption holds in reality, the crucial issue is the size
of the error that will result from using simple capital
aggregates, such as net or gross capital stocks, to
approximate service flows. Intuitively, the error would
emerge because high-productivity capital is downweighted relative to low-productivity capital in the sim
ple aggregates. Simple algebra, summarized in the
Appendix, indicates that the weighting error is directly
proportional to the difference in marginal productivities
and growth rates of different capital types and inverse
ly proportional to the relative sizes of the different capi
tal stocks.7 Nevertheless, one additional factor works to
mitigate the biases introduced by these effects. The
faster growing capital type may be growing faster
because its price is falling, suggesting that its marginal
productivity is also falling. The faster growth rates
could reflect the less productive uses to which the cap
ital is put.
A simple simulation illustrates some elements of the
mix problem. It presents the rationale for using gross
investment as a proxy for capital service flows and also
proposes two other capital service measures that deal
more directly with the mix shift problem. Our hypotheti
cal economy produces output using only capital. The
capital is of two types: short-lived capital with a fiveyear service life and long-lived capital with a twentyyear service life. Both types emit services at a con
stant rate throughout their lives; that is, we are assum
ing a “ one-hoss-shay” economy.® We also assume that
there is no change in the marginal productivity of either
capital type over time. In addition, both capital types
are equal in present value terms — the present value of
the services emitted by one dollar of short-lived capital
is equal to the present value of the services emitted by
one dollar of long-lived capital. We also assume that
the economy’s real interest rate is fixed at 4 percent.
Given these assumptions, the annual service flow from
a $100 investment in short-lived capital is $22.46, and
from a $100 investment in long-lived capital, $7.36.9
“T h e intuition behind the latter relationship is that if one type of
capital dom inates the capital stock, the growth of services will be
dom inated by the growth in this asset.
•S ubstituting the assumption that the flow of services falls 20 percent
per year from short-lived capital and 5 percent per year from longlived capital leads to no substantive change in the analysis.
•These service flows are calculated by assuming that the flows are
received at the end of the year and that the present discounted
By assumption, gross investment is fixed at $100. Ini
tially, 75 percent of investment is in long-lived capital.
In the initial steady state, the net capital stock amounts
to $762.50, of which $50 is short-lived capital and
$612.50 long-lived capital.10
We then alter the composition of the gross invest
ment flow permanently, placing $40 in the short-lived
form. Since short-lived capital depreciates more rapidly
than long-lived capital, the switch results in an increase
in depreciation and a decline in net investment and the
net capital stock (Chart 1). The gross capital stock also
declines, because the shift to shorter service lives
increases the fraction of the capital stock that reaches
the end of its service life in any year. In the long run,
the net and gross capital stock stabilize, depreciation
falls back to $100, and net investment is again zero.
In the short run, the flow of capital services behaves
quite differently from the net and gross capital stocks.
The increase in short-lived capital initially results in an
increase in the capital input because short-lived capital
emits services at a higher rate than long-lived capital.
Eventually, the smaller stock of capital overcomes this
effect, and the flow of capital services falls to a new
equilibrium rate below its initial level.
Neither the gross nor the net capital stock perfectly
reflects the time path of the capital input during the
transition period. Both fail to reflect the initial pickup in
capital services from the switch to shorter lived capital,
and although they give correct qualitative signals in the
long run, they greatly exaggerate the actual decline in
capital services. This problem with the aggregate capi
tal stock data has led some analysts to advocate gross
investment as a measure of the capital input. They rea
son that while gross investment does not accurately
reflect the time path of the capital input, at least it does
not make any egregious errors.11
N evertheless, confidence in this measure appears
misplaced. Our exam ple was contrived to put gross
investment in its best light as an indicator. The invest
ment mix went in sta n tly from one steady state to
another. In the real world, where investment growth can
vary markedly from one period to the next, it is implau
sible that the flow of actual capital services would be
well represented by investment.
Furthermore, better measures of the aggregate capi
tal input than gross investm ent can be readily con
structed. Depreciation is one such measure; it correctly
increases when the investm ent mix shifts to shorter
term assets. Although depreciation provides the same
m isle a d in g lo n g -te rm sig n a l as g ro ss in ve stm e n t,
returning to its previous equilibrium of $100, it captures
the dynamics of changing service flows much better.
Another alternative is to recompute the net capital
stock by assigning each type of capital a weight that is
the inverse of its mean service life, rather than assign
ing all forms of capital equal weights as is done in a
conventional calculation.12 This reweighting reflects the
12A sim ilar calculation was done for gross investment in Arnold J. Katz,
“An Analysis of Trends in the Intensity of U.S. Capital Formation and
Their Determ inants,” Journal of Policy M odeling, vol. 8 (Fall 1986),
pp. 433-70.
Chart 1
Measures of Capital Services, Capital Input,
and Investment
Indexed levels*
Capital
consumption
/
1/7
/
\ \
\ \
I/I
\
\
ijj
\
\
\
\
\
. . . . . . . ___
\
\
\
\
\
Gross
investment
V
/
s /^ n n n n r
\
\
\
\
\ -----------------------Capital services
\
\
\
Capital consumption
rate-weighted
net capital stock
\
\
\
\
\
\
Footnote 9 continued
value of the flows equals $100. A sim ilar simulation can be found in
de Leeuw, “ Interpreting Investm ent."
11See de Leeuw, “ Interpreting Investm ent." This author also
em phasizes the need to consider all physical investment (residential
and nonresidential, public and private) and investment in research
and education to explain econom ic growth.
\
K
\
10This net capital stock is calculated on the basis of straight-line
depreciation. The results show little change if we replace the
straight-line assumption by “ true econom ic depreciation," the decline
in the value of an asset as it ages.
'b
\
\
\
\
\
Gross capital
stock
stock
Ll u
i
1i
0
i
1 1 1 1 1 1 1 1 1 1 11 1 LLi 1 1 1 1 1 1 1 II II 1 1 1 11 1
5
10
15
20
25
30
Number of years after switch in investment mix
*Y e a r of switch in investment mix = 100.
FRBNY Quarterly Review/Autumn 1989
11
assumption that short-lived capital has a higher margi
nal product than longer lived capital. It may be viewed
as a simple first approximation to a full-blown user cost
calculation. In the simulation, the reweighted net capi
tal stock provides a good proxy to the capital input: it
correctly increases when the investment mix shifts, and
its lo n g -ru n e q u ilib riu m leve l is b e lo w its in itia l
equilibrium.
The conclusions we draw from the simulation are that
the criticism s of the net and gross capital stocks as
measures of the capital input can be valid, at least for
analysis of short-term movements in the capital input.
Gross investm ent may provide a m arginally b etter
index of capital services during periods of extrem e
shifts in the investment mix, but depreciation and the
rew eighted capital stock appear to provide b etter
approximations to the actual path of the capital input.
Thus, if the changing composition of investment and
capital is truly the key to understanding the flow of cap
ital services, the latter two measures are preferable to
gross investment.
In the real world, the mix problem is likely to be less
severe than in this simulation. First, the actual shift in
the mix has been somewhat less striking. In the late
1960s the service life of the installed U.S. nonresidential ca pita l stock was about tw enty-one years; the
recent figures still put the average service life at more
than seventeen years (Table 3).13 In the simulation the
service life of installed capital falls from sixteen and
one-quarter years to eleven years over a twenty-year
period, about twice as fast a rate of change as actually
occurred. Second, to the extent that the shift to shorter
lived capital in the United States was prompted by tax
motives (such as the investm ent tax credit and the
13We derived an estimate of the average service life of installed capital
by dividing gross capital stock estim ates by depreciation.
Table 3
Service Life of Installed Capital
(Years)
1988
1985
1980
1975
1970
1961
All Nonfarm Business
Manufacturing
17.5
18.2
19.0
20.2
21.0
22.3
18.5
18.8
19.2
19.9
20.2
20.4
Source: Federal Reserve Bank of New York calculations based
on Bureau of Economic Analysis data.
FRBNY Quarterly Review/Autumn 1989
Digitized 12
for FRASER
acceleration of depreciation allowances) or by relative
price changes associated with improved technology
(such as the price declines for computers and telecom
munication equipment), it would be less likely to con
tribute to an acceleration of capital service flows; longlived capital may have been replaced by short-lived
capital of comparable productivity. The shortened ser
vice lives would normally have led to an increase in the
marginal productivity of the capital stock, but the tax
advantages and relative price changes could have led
to the installation of less productive short-lived capital.
Empirical estimates of capital formation
Lacking a universally accepted capital input measure,
we consider several such measures before drawing any
firm conclusions. Table 4 computes the growth since
1961 of various measures of the capital input for all
U.S. nonfarm business, and Table 5 makes the same
ca lcu la tio n s for m anufacturing. The a lte rn a tive real
capital input measures are:
1)
2)
3)
4)
5)
Gross capital
Net capital
Depreciation
Reweighted net capital
Bureau of Labor S tatistics (BLS) index of capital
services
6) Gross investment
7) Gross investment, chain-weighted.
As noted above, the gross capital stock estim ate
does not take into account accumulated depreciation
on existing capital, while the net capital stock does.
Recall also that gross investment is not equal to the
change in the gross capital stock, because scrappage
is not deducted from gross investment.
Gross capital, net capital, depreciation, and gross
investment are all taken from BEA data. Depreciation is
included because it represents the basic flow of ser
vices a piece of capital must provide: it must pay for
itself over its lifetime. The reweighted net capital stock
is computed as in the simulation. Each component of
the net capital stock is assigned a weight equal to the
inverse of its mean service life on the assumption that
the relative productivity of different pieces of capital
should be roughly inversely related to their service life.
The BLS service flow measure is designed to capture
systematically all the effects that alter the aggregate
capital input. These effects include shifts in the mix of
capital between capital types with different produc
tivitie s, and changes in the optim al p ro d u c tiv ity of
installed capital resulting from changes in the cost of
finance and in the structure of taxes and subsidies to
capital.14 The alternative measure of real gross invest
ment, derived from chain-weighted price changes, may
be preferable to conventionally measured real gross
investm ent because it reflects the lowered marginal
productivity of capital goods, notably computers, whose
relative prices have dropped sharply over time.15 Also,
changes in implicit price deflators — and hence, growth
of real spending — can be distorted by shifts in the
com position of real spending. Price indexes derived
from changes in chain-w eighted deflators avoid this
problem.
The standard measures for the nonfarm business
capital input — gross capital, net capital, and capital
services — suggest that growth has been slower in this
expansion than over the 1961-73 period (Table 4, col14See U.S. Bureau of Labor Statistics, "Trends in Multifactor
Productivity, 1948-81,” Bulletin 2178, Washington, D.C., 1983, for
detail on the construction of this series.
15de Leeuw, "Interpreting Investm ent,” argues strongly for these chainweighted measures.
umns 1, 2, and 5). Somewhat surprisingly, growth rates
of all three measures throughout the 1980s have been
below those of the 1970s.
The measures linking capital services most closely to
service lives, the reweighted net capital stock and con
stant dollar depreciation, tell a m oderately different
story. They suggest neither a major improvement nor a
deterioration in growth during the 1980s relative to the
1970s, but find some acceleration with respect to the
1960s (Table 4, columns 3 and 4).
Of the seven measures of capital input growth, only
conventionally measured gross investm ent shows a
d e fin ite break w ith past tren ds, b e g in n in g in the
mid-1980s (Table 4, column 6). (Chain-weighted gross
investm ent also shows a sharp improvem ent in the
mid-1980s, but its current growth rate is comparable to
that in the 1960s and 1970s.) The two gross investment
measures differ from all the other measures of capital
services in being com pletely independent of capital
scrappage or depreciation.
Table 4
Measures of Capital Input Growth: All Nonfarm Business
(Percent Change at an Annual Rate)
19 84-8 8t
19 79-8 8f
1973-79
1961-73
4
1
Constant Dollar
Gross Capital
Stock
2
C onstant Dollar
Net Capital
Stock
3
Reweighted
Net Capital
Stock
Constant Dollar
Depreciation
3.53
3.56
3.79
3.74
3.20
3.17
3.53
4.26
4.93
4.47
4.90
4.20
4.84
4.76
4.78
4.32
5
6
Private
Nonfarm Business Constant Dollar
Capital Services Gross Investment
3.64
3.80
3.95
4.09
7.04
3.90
5.31
5.59
7
Chain-Weighted
Investment
6.03
3.57
5.77
6.09
Sources: Bureau of Economic Analysis, columns 1, 2, 4, and 6; Bureau of Labor Statistics, colum n 5; Federal Reserve Bank of New York
calculations based on Bureau of Economic Analysis data, colum ns 3 and 7.
f19 87 for capital services.
Table 5
Measures of Capital Input Growth: Manufacturing Industries Only
(Percent C hange at an Annual Rate)
1984-88t
1979-88t
1973-79
1961-73
.. 1
Constant Dollar
Gross Capital
Stock
2
Constant Dollar
Net Capital
Stock
3
Reweighted
Net Capital
Stock
4
5
6
7
Constant Dollar
Depreciation
Manufacturing
Capital Services
Constant Dollar
Gross Investment
Chain-W eighted
Investment
1.80
2.47
3.87
3.98
0.85
1.63
3.44
4.31
1.48
2.24
4.51
4.69
2.43
3.23
4.10
4.05
1.38
2.32
3.92
4.12
5.90
0.92
6.30
5.09
5.49
1.04
7.09
5.32
f f l& g
Sources: Bureau of Economic Analysis, colum ns 1, 2, 4, and 6; Bureau of Labor Statistics, colum n 5; Federal Reserve Bank of New York
calculations based on Bureau of Economic Analysis data, colum ns 3 and 7.
f19 87 for capital services.
FRBNY Quarterly Review/Autumn 1989
13
To make the argument that the gross investment
measures are better indicators of capital services than
the others, one might maintain either that the measures
of depreciation and scrappage are greatly overstated
or that the greater productivity of new investment rela
tive to investment being depreciated or scrapped is
significantly understated by the data. Although these
are theoretical possibilities, there is little evidence
showing that service lives are overstated or under
stated, and little presumption in the literature that these
factors are causing large distortions in the data. More
over, the argument for gross investment as an indicator
is much more commonly based on other claims —
namely, the robustness of gross investment to shifts in
the composition of investment. Nevertheless, as we
have seen, indicators that are better at reflecting mix
shifts do not show a major break with past trends.
The movement in the manufacturing measures has
been more dramatic than in all nonfarm business. The
1980s as a whole have witnessed much slower growth
in measures of the capital input, and the weakness has
been concentrated in recent years. The net manufac
turing capital stock has shown virtually no growth in
this expansion (Table 5, column 2). Overall, the first five
measures show drops ranging from one and seventenths percentage points to three percentage points in
the growth of capital input in the late 1980s relative to
the 1970s. Again, only conventional gross investment
appears moderately robust, declining only four-tenths
of a percentage point from its growth rate in the 1970s.
(Chain-weighted investment slowed by one and six-tenths
percentage points but is still strong relative to its perfor
mance in the 1960s.) Even for these investment measures,
however, growth since 1979 has been very weak.
In manufacturing, as in nonfarm business, the first
five measures tell a consistent story: capital formation
is proceeding at historically low levels. The measures
differ in the exact level of growth, but they point to a
qualitatively similar slowing. Labor input has actually
been falling through the 1980s, so that capital-to-labor
ratios have been rising, presumably aiding productivity
growth. But it is hard to argue that the capital input
data show either capital or labor making a rising contri
bution to sectoral growth.16 Technology and efficiency
may be improving at a more rapid clip, but little evi
dence supports a similar finding for capital formation.
Some of the minor differences between the mea
sures of capital input growth for nonfarm business and
manufacturing can be readily explained. For example,
16We do not focus on output growth rates in manufacturing because
critics have argued that they are im plausibly rapid, and publication
of substantially revised data is expected soon. See Frank de Leeuw,
“ Gross National Product by Industry: Comments on Recent C riticism ,"
Survey of Current Business, vol. 68 (July 1988), pp. 132-33.
14 FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized for
growth in the gross capital stock in both the total non
farm business and manufacturing sectors has slowed
less than growth in the net capital stock, while the
growth rate of depreciation has exceeded those of net
and gross capital in every subperiod since 1973. This
divergence reflects the shift of the capital stock to
short-lived assets (most notably computers), a develop
ment which has tended to increase the depreciation
rate on the overall capital stock. During the transition
period, a switch to short-lived capital will increase the
growth of depreciation and reduce the growth of the
net capital stock relative to the gross capital stock.
The gross investment data differ from all other capi
tal input measures in the impression they present, both
for all nonfarm business and for manufacturing. Con
ventionally measured gross investment has been grow
ing at very rapid rates in this expansion. The
comparison is not quite as favorable for the chainweighted series; still, this measure of investment has
been growing about as rapidly as in the 1960s. As
noted above, the virtue of gross investment as a mea
sure of capital input is that it is relatively robust to mix
changes in investment. Nevertheless, three of the first
five capital input measures in Tables 4 and 5 —
reweighted net capital stock, constant dollar deprecia
tion, and capital services — reflect these mix shifts
directly, in a manner more consistent with economic
theory. They show flat or declining trends in capital
service growth despite the mix shift. Hence the use of
a gross investment measure as an indicator of capital
input cannot be justified by its robustness to shifts in
investment composition.
Which indicator of capital services works best?
Theoretical considerations, simulations, and descriptive
statistics can only go so far. It may be helpful to con
sider whether, in a more practical context, the net and
gross capital stocks are unreliable indexes of the
aggregate U.S. capital input. Regression analysis of
U.S. economic growth can give us a partial answer. If
the net and gross capital stocks are poor measures of
the capital input, then they should yield explanations of
overall U.S. growth that are significantly poorer than
those provided by theoretically superior alternatives.
Conversely, if gross investment captures factors omit
ted in the standard capital input measures, it may be
more correlated with output movements in practice.
The table in the Box summarizes regressions
explaining the annual growth of real nonfarm business
output, using hours worked as the measure of the labor
input and various alternative measures of the capital
input. The alternative capital input measures are the
net capital stock, the gross capital stock, the BLS index
of capital services, real depreciation, the reweighted
Box: Testing the Capital Stocks in Production Relationships
Several different approaches to measuring capital and
capital services are discussed in the text. Each mea
sure requires that some strong assumptions be made
about the path of capital service flows. The rental cost
measure, preferred theoretically, is the most demanding
in term s of param eter requirem ents. Thus, there
appears to be a substantial trade-off between simplicity
and elegance. We apply a simple criterion to identify
the particular capital stock measure that outperforms
the others in practice: a capital measure performs bet
ter if its implied capital service flows are more closely
related to output or productivity than those of the other
capital measures.
Output growth can be decomposed into components
representing tabor input growth, capital input growth,
and a residual that is often termed total factor produc
tivity growth. The residual tends to be very procyclical
and can be broken down into a relatively stable compo
nent, viewed as the productivity trend, and a strongly
cyclical component. Other assumptions, such as con
stant returns to scale, can also help identify the rela
tionship. Our approach is to estimate a variety of such
production relationships and to select the capital input
measure that contributes to the best explanation of
growth.
We assume a constant returns to scale Cobb-Douglas
production function, which can be written in logarithmic
terms as
In Y = a + aln L + (1-a) In K + Xt,
Performance of Capital Service Measures in Production Relationships
Coefficients
Net
Capital
Equation
1
0.37
2
0.58
3
0 .3 5 f
4
0 .3 5 f
5
0.24
Gross
Capital
0.53
0.91
0 .3 5 t
0 .3 5 f
0.21
ChainW eighted D epreci
Investment
ation
0.00
0.00
0 .3 5 f
0 .3 5 f
- 0 .0 2
0.32
0.75
0 .3 5 t
0 .3 5 f
-0 .0 2
1
In(lprod) = ao + a,ln (caphrs) + a2 cycl +
2
dlprod
3
dlprod
4
dlprod
5
In(out)
Equation Residual Standard Errors
Capital
Services
0.33
0.56
0 .3 5 t
0 .3 5 f
0.12
2
=3
Re
w eighted
Net
Capital
Stock
-0 .1 8
-0 .1 7
0.35T
0 .3 5 f
0.03
Net
Capital
Gross
Capital
0.008
0.98
0.98
1.05
0.009
0.009
0.76
0.88
0.97
0.010
ChainWeighted D epreci
Investment
ation
0.010
1.09
3.13
4.05
0.010
0.010
0.82
0.89
1.00
0.010
Capital
S ervices
Re
w eighted
Net
Capital
Stock
0.009
0.99
0.99
1.08
0.010
0.010
1.04
1.45
1.54
0.010
aj Tj
= a0 + a, dcaphrs + a2 d cycl +
2 aj D.
j= 3
6
= a0 + .35 caphrs + a2 dcycl + 2 aj D,
j=3
6
= a0 + .35 caphrs + .4 dcycl + 2 aj D;
j= 3
= ao + .65 In(hrs) + a. In cap + a2 cycl +
where
Iprod
dlprod
caphrs
dcaphrs
cycl
=
=
=
=
=
dcycl
Tj
Dj
out
hrs
cap
=
=
=
=
=
=
7
2 aj Tj
j— 3
nonfarm business sector labor productivity
the percent change in labor productivity
the ratio of capital input to hours worked
the percent change in the capita! input-to-labor ratio
a measure of capacity utilization (the ratio of actual to potential real GNP, as calculated by the Federal Reserve
Board staff)
the change in capacity utilization
a set of tim e trends (allowing for breaks in 1952-61, 1962-68, 1969-73, 1974-79, 1980-88)
a set of (0,1) dummy variables (allowing for breaks in 1952-61, 1962-68, 1969-73, 1974-79, 1980-88)
output in the nonfarm business sector
manhours worked in the nonfarm business sector
the capital input,
flm p o se d .
FRBNY Quarterly Review/Autumn 1989
15
Box: Testing the Capital Stocks in Production Relationships (continued)
where Y, L, K, and X are respectively output, labor
input, capital input, and the rate of total factor produc
tivity growth, and a and (1-a) are elasticities of output
with respect to labor and capital. (The last two parame
ters can be shown under constant returns to scale to
equal their income shares.)
This expression can be rewritten as
(A)
In (Y/L) = a + (1-a) ln(K/L) + \t,
or in first difference form,
(B)
A(Y/L) = (1-a) Aln(K/L) + X.
The estimated equations differ in the extent to which
the coefficients are freely estimated and whether the
relationship is estimated in levels or first differences. In
the accompanying table, equations 1 and 2 assume
constant returns to scale, freely estimate the cyclical
correction, and estimate implicitly the elasticity of out
put with respect to the capital input. In theory this elas
ticity should equal capital’s share of output, which is
about 0.35. Equation 1 is estimated in levels, equation 2
in first differences.
Equation 3 imposes this theoretical response of out
put to the capital input, while equation 4 also imposes a
cyclical response of productivity to capacity utilization
of 0.4. (Both of these equations are estimated in first
differences.) The residual standard errors in 3 and 4 as
compared with 2 indicate how much explanatory power
net c a p ita l sto ck, and ch a in -w e ig h te d real gross
investment.
The list of capital input proxies allows for testing a
wide range of assumptions about the correct way to
aggregate the inputs of capital. If either gross or net
capital provides the best explanation for econom ic
growth, then the problems of the changing mix of capi
tal have not been severe (or at least have not been
better addressed by the alternatives). The comparison
of gross and net capital amounts to testing whether the
U.S. capital stock has a service flow pattern more like
that of lightbulbs or automobiles. In other words, does
depreciation occur at the end of an item ’s service life
or continually as the item ages?
Depreciation and the reweighted net capital stock are
alternative measures intended to capture any effects of
the changing se rvice life of the aggregate capital
stock. (The comparison of the two measures is analo
gous to the comparison of gross and net capital.) If the
16 FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized for
is lost by imposing the theoretical output response elas
ticities on the alternative capital input measures. Equa
tion 5, estimated in levels, drops constant returns to
scale, assumes that the output elasticity with respect to
labor is 0.65, and estimates the elasticity with respect
to capital.
Looking at the regression results, we see that in
equation 1 — the specification that uses the log of labor
productivity as the dependent variable — the net capital
stock has the closest fit, followed by the gross capital
stock and the capital services index. We expected that
the coefficient on the capital input would be in the
neighborhood of 0.35 (capital’s share of output); this
prediction roughly holds for four of the measures. In
equation 2 — the equation 1 specification in first differ
ence form — only the net capital stock and capital ser
vices have coefficients anywhere near 0.35, but the
gross capital stock and depreciation have the greatest
explanatory power.
In equation 3 we constrain capital’s marginal contribu
tion to output to be constant at 0.35. In this formulation,
gross capital and depreciation have the closest fit. The
same is true in equation 4, which imposes the addi
tional constraint on the capacity utilization response.
Finally, equation 5 constrains labor’s marginal contri
bution to output to be 0.65. The net capital stock has
the best fit, and its coefficient is closest to the hypothe
sized 0.35. The gross capital stock and capital services
fo llo w , w h ile in v e s tm e n t, d e p re c ia tio n , and the
reweighted capital stock perform poorly.
BLS capital services measure provides the best fit,
then there have been substantive changes in the
aggregate productivity of the capital stock which must
be accounted for in a rigorous fashion. Finally, if the
gross investm ent measure proves superior, it would
imply that measurement problems are so severe that
the best compromise between theory and reality is to
assume that contemporaneous capital demand should
be related to the capital input.
Because regressions relating aggregate output to
aggregate inputs lack a solid theoretical foundation and
often give aberrant results (such as negative contribu
tions to output from capital), we used five different
specifications. In the first, we assumed that the log
arithm of the ratio of output to hours (that is, the log of
labor productivity) was related to the logarithm of the
ratio of the capital input to hours, time trends, and the
c y c lic a l sta te of the econom y. In the second, we
assumed that this relationship held for the changes in
the logarithms of labor productivity (that is, the rela
tionship held for growth rates). The third specification
related the growth of labor productivity less 0.35 times
the growth in the capital-to-labor ratio to a cyclical vari
able and dummy variables for subperiods; the justifica
tion for this specification was that capital’s share of
output is roughly constant at 0.35, and this relationship
simply imposes that constraint. The fourth specification
was the same as the third but limited the coefficient of
the cyclical variab le to 0.4. The fifth sp e cifica tio n
related the log of output less 0.65 times the log of
hours to the log of the capital input. (The motivation for
the tests is presented in the Box.)
On the whole, the results suggest that no one mea
sure is clearly superior to the others, but some patterns
emerge. First, out of the five production relationships
estimated, the gross capital stock performed best in
three and the net capital stock in two. Depreciation and
capital services followed. The reweighted capital stock
perform ed poorly, and the indicator based on gross
investment showed the least explanatory power. Knowl
edge of gross investment levels or growth rates, w ith
out any kn ow led ge of the c a p ita l sto ck, provided
virtually no useful information about output.17
While the gross capital stock showed greater explan
atory power in three of five regressions, the estimated
coefficients for the net capital stock were closer to the
expected 0.35 value. In both specifications in which
this elasticity was imposed, however, the gross capital
stock produced the equation with the least residual
error in output growth.
The theoretically preferred measure of capital ser
vices that was based on estimated capital rental rates
17Conventionally measured, as opposed to chain-weighted, gross
investment also perform ed poorly when tested in similar regressions.
performed somewhat worse than net and gross capital,
but generally its perform ance was not far below that of
net and gross capital. In coefficient size and residual
error, it was a little closer to the net capital than to the
gross capital stock.
While different capital input measures “ fit” best in
different specifications, in no case did gross investment
outperform these other measures.18 To the extent that
methods based on production functions are valid, there
was no evidence that gross investment flows provided
an ade qu ate a p p ro x im a tio n to the flow of c a p ita l
services.
Such exercises are suggestive but hardly conclusive.
The validity of the test is highly dependent on a cor
rectly sp ecified production relatio n ship. S ubstantial
quality shifts in labor input, the absence of constant
returns to scale, the existence of a more complicated
production relationship than is assumed in our regres
sion equation (for example, translog as opposed to
Cobb-Douglas), or the unstable evolution of total factor
productivity could undermine the usefulness of the test.
Despite these concerns, the test does determine how
well the various capital measures fit into a commonly
used production framework. Moreover, it provides some
guidance in determining which capital input measure
pro vid e s the m ost in fo rm a tio n a bo ut tren d o u tp u t
growth and whether or not the mix shift has had a dis
cernible effect on productivity and output growth.
Nevertheless, it is fairly astonishing to find that gross
and net capital do so well in the regressions relative to
measures designed to reflect the changing mix of the
capital stock. Although the change in the mix has been
less rapid than in the simulation, short-lived capital has
18Beginning the regressions in 1973 did not alter the relative
perform ance of investment and the alternative capital input variables.
Table 6
Growth of Gross Capital Stock Types: All Nonfarm Business
(Percent per Year)
Short-Lived Capital
(Service Life of
Eleven Years or Less)
1984-88
1979-88
1973-79
1961-73
Medium-Lived Capital
(Service Life of
Twelve to Twenty-Four Years)
Long-Lived Capital
(Service Life of
Twenty-Five Years or More)
Change in
Real Stock
Price
Change
Change in
Real Stock
Price
Change
Change in
Real Stock
Price
Change
8.47
6.74
7.19
5.74
- 5 27
0.02
7.56
1.85
2.90
3.88
4.32
4.00
3.54
5.54
8.95
3.48
2.27
2.40
2.75
3.26
3.05
5.41
9.05
3.69
Source: Federal Reserve Bank of New York calculations based on Bureau of Economic Analysis data.
Note: Price changes based on im plicit deflators.
FRBNY Quarterly Review/Autumn 1989
17
grown substantially as a share of the total capital stock
over the last generation, and the difference in growth
rates has increased (Table 6). Why is it so hard to
detect the influence of the changing mix?
The most plausible answer is that the shift of the
capital stock did not necessarily imply a shift to assets
with greater immediate productivity. One reason, men
tioned above, is the possible role of taxes in spurring
the shift; a change in asset mixes due solely to tax
considerations does not necessarily imply that either
mix is more productive (as opposed to profitable).
More important perhaps, the shift in the relative
prices of capital goods has also had implications for
relative productivities. Primarily because of the sharp
decline in the price of computers, the cost of short
lived capital has plunged, both in absolute terms and
relative to long-lived capital (Table 6). The effect of
prices on user costs is very similar to the effect of tax
incentives: low-priced capital goods are purchased to
the point that the last, or marginal, unit is placed in a
low-productivity setting. Thus, changes in the relative
price of capital goods affect the marginal productivity
of capital types.
The sharp drop in the relative price of short-lived
capital goods makes it plausible to argue that the
recent switch to short-lived capital has not markedly
changed the overall productivity of the existing capital
stock. Thus, the net and gross capital stocks can be
plausible approximations to the capital input. (The
Appendix presents a more technical discussion of the
approximation error involved in using simple sum
aggregates of the capital stock.)
during this expansion. It has been argued that in
periods of rapid shifts in the capital mix, gross invest
ment may give some clues to the growth of the capital
input — better clues, at least, than those provided by
the gross and net capital stock measures. Thus, a con
flict emerges: if we follow the capital stock data, we
would conclude that growth in the capital input has not
improved in recent years; if we follow the gross invest
ment data, we would conclude that the capital input
may be growing more rapidly than in the past.
The recent divergence in growth between the capital
stock measures and other indicators designed to cap
ture the effects of a changing mix has not been as
marked as the divergence between the capital stock
measures and gross investment. In empirical relation
ships linking nonfarm business inputs to output, the
simple net and gross capital stock measures did as
well as, or better than, the alternative capital input
measures, and gross investment did worse than any of
the other measures.
The evidence for the entire nonfarm business sector
suggests that the growth in the aggregate capital input
has not accelerated in this expansion. Applying these
results to manufacturing gives a stronger verdict: the
growth of all the alternative measures of the capital
input, except for gross investment, has been decidedly
weak. A reversal of this trend would strengthen the
growth of U.S. industrial capacity and aid the U.S.
external adjustment process by augmenting the poten
tial output available to meet the growth of foreign and
domestic demand.19
Conclusion
A wide variety of capital input measures for the non
farm economy — including the Commerce Department’s
estimates of the gross and net capital stocks and alter
native measures designed to capture the output effects
of a changing capital mix — suggest that in recent years
there has been a continuation of 1970s growth rates at
best, or an outright decline in growth. In sharp con
trast, the growth of gross investment has accelerated
A. Steven Englander
Charles Steindel
18
FRBNY Quarterly Review/Autumn 1989
19The relationship between industrial capacity growth and the
adjustm ent process is de scribed in Akhtar, “Adjustm ent of U.S.
External Balances"; and in R. Spence Hilton, "C apacity Constraints
and the Prospects for External A djustm ent and Economic Growth:
1989-90," Federal Reserve Bank of New York Quarterly Review,
vol. 13, no. 4/vol. 14, no.1 (W inter-Spring 1989), pp. 52-68.
Appendix: Approxim ating the Error from Simple Sum Aggregates of the Capital Stock
Assume that three types of capital are in service.
Type 1 capital is short-lived, type 2 has a medium life,
and type 3 is long-lived. They emit services at the rates
ix1; |x2, and |x3, respectively. The total input of capital
services, KS, is then
(1) KS = |i,1K1+ (i2K2 -i-(A3K3.
Suppose we want to approximate the growth of KS by
the growth of the simple sum of the physical capital
stocks, KG = K1+ K2 + K3. The approximation error, AE,
will be determined by
(2) AE = ( f W m - m-2)(K1- K2) + K1K3(Pl1- ^ 3)(K1- K3)
+ K 2 K 3 ( f i 2 — fi>3){K2 — K 3 ) + ( 1 ^ K 1
+ (12K2 + M-3K3)/(KG*KS),
where the dot over the variable indicates a growth rate.
Note that if the rate of service emission is unchanged
over time, and either the emission rates are equal
across types or the growth rates of the capital types are
equal, there will be no error.
In reality, we observe the growth rates of capital
stocks, not the services they emit. But with some sim
plifying assumptions we can estimate the approximation
errors that result from treating the growth of the U.S.
gross capital stock as the growth of the capital input.
To simplify, we divide the capital stock into short-lived
(service life, zero to eleven years), m edium -lived
(twelve to twenty-four years) and long-lived (twenty-five
or more years) goods. The average service life is calcu
lated for each of these goods. In general this composite
average service life will vary from year to year as the
mix of capital types within each category changes. For
simplicity we ignore tax effects and assume that the
real interest rate is constant at 4 percent. The “ onehoss-shay” assumption is made, so each capital good
is assumed capable of producing the same physical
product from installation to the end of its service life.
Apart from differing service lives, the major factor
affecting the relative productivity of the different types
of capital is their cost and the rate of change in relative
prices. Consider an investor buying a computer at time t
versus time t + 1. Because the real price of the same
computer will fall between t and t + 1, the computer’s
contribution to output has to be high enough in period t
to offset the gain that would be realized by the investor
who waited another period before purchasing a cheaper
computer. Each period, however, the same machine
gets cheaper and cheaper, implying that the value of its
marginal product is falling. For example, if the real price
of computers falls by 50 percent over five years, a com
puter bought today has to be only half as productive on
the margin as an identical computer purchased five
years earlier. That is, computers will be used less and
less productively.
This last consideration is very important. If investors
are purchasing many short-lived capital goods because
they have become relatively cheap, the diminished
value of their marginal product may substantially offset
the effect of shorter service lives on the growth of capi
tal services.
The exact formula used to estimate the value of the
marginal products of capital types with varying service
lives is
h = Pj( 1 - V j)/(Vj<sLi+ D),
where
(Xj = the value of the marginal product of the j ’th
capital type
Pj = the price of the j ’th capital type relative to over
all capital goods prices,
Vj = (PyPt‘5j)/1.04, the rate of relative price appre
ciation (averaged over five years) divided by
the assumed real interest rate, and
SLj = the average service life of the j’th capital type.
The time superscript is suppressed in all cases except
in the calculation of Vj.t
The table shows the approximation errors that arise
when the gross capital stock is used to calculate the
capital input. We see that in the 1960s the gross capital
stock grew at virtually the same rate as the hypothetical
capital input. In the 1970s the capital input grew more
rapidly, but in the current expansion the gross capital
stock has grown more rapidly than the approximate
capital input.
Average Approximation Error
(Growth of Hypothetical Capital Input Less Growth of
Gross Capital Stock, Percent per Year)
1984-88
1979-88
1973-79
1961-73
-o .3 3
-0.11
0.57
0.17
mui
In general these approximation errors are small, less
than 15 percent of the average capital stock growth
rate. Moreover, when converted to a contribution to
labor productivity or overall growth (multiplying by an
average capital share of 0.35), the error is extremely
small and unlikely to be significant in any policy debate.
fT h e price changes are calculated over five-year periods to
smooth out short-term price fluctuations, which probably do
not greatly affect decision makers.
FRBNY Quarterly Review/Autumn 1989
19
Inflation Expectations Surveys
as Predictors of Inflation and
Behavior in Financial and Labor
Markets
Inflation expectations underlie many important deci
sions made in product, labor, and financial markets.
They contribute to the determination of nominal com
pensation gains and interest rates, and they even influ
ence the future course of inflation itself. Among the
surveys that report inflation expectations are the Uni
versity of Michigan Institute for Social Research Survey
(MICH), the Decision Makers Poll (DMP), and the Blue
Chip Consensus (BCC). The surveys differ in their ori
entation: MICH focuses on the expectations held by
households, DMP attempts to capture the expectations
of individuals active in financial markets, and BCC can
vasses professional economists and industry-based
forecasters as well as financial market participants.
This article examines whether these differing groups
hold the same expectations and whether their inflation
expectations, as reported in the surveys, are more
closely related to future trends in inflation than is the
recent behavior of actual inflation.
We conclude that over the last decade inflation sur
veys have on the whole conveyed useful information
about subsequent inflation developments. Specifically,
during this time period the inflation surveys possess a
statistically significant forward-looking element and are
more reliable than past inflation in predicting future
inflation trends. We also find, however, that although
the surveys have performed well for the decade as a
whole, their record since 1982 has been quite poor. All
three surveys overpredict consumer price inflation sub
stantially, and this bias remains present, although to a
smaller degree, even when the effects of fluctuations in
food and energy prices are removed.
The similarity in the forecasting performances of the
FRBNY Quarterly Review/Autumn 1989.
Digitized 20
for FRASER
inflation surveys in recent years reflects the strong cor
relations of the surveys with each other and with past
inflation rates. Despite these correlations, however, the
forecasts produced by the different surveys are by no
means identical. At various times in recent years the
surveys have given different indications of the level and
the direction of inflation.
Such differences might be interpreted as random
variations without any economic significance, except
that households and financial market participants
appear to act on their different expectations. More spe
cifically, household inflation expectations, as revealed
in MICH, appear to feed into future compensation
growth, while financial market inflation forecasts, re
vealed in DMP, appear to feed into interest rate de
velopments. The household inflation forecasts contain
little information useful for interest rate determination;
the financial market forecasts contribute relatively little
to the explanation of nominal compensation growth.
These results have several important implications.
First, inflation expectations can be consistently wrong
for several years. Partial explanations can be found for
the errors, but ex post real interest rates can differ sig
nificantly and persistently from their ex ante expecta
tions. Given the continuing pattern of errors in recent
years, high nominal interest rates caused by pessimis
tic financial market inflation expectations are likely to
have produced unexpectedly higher real rates on an ex
post basis. To the extent that households viewed infla
tion prospects more optimistically, they would have
viewed the higher nominal rates as higher real interest
rates on an ex ante basis, and hence the higher rates
would have been contractionary.
Erroneous inflation forecasts also may affect the effi
ciency of capital accumulation and savings. If financial*
markets and households have different inflation expec
tations, they may perceive different real returns to sav
ings and costs of funds, with consequent effects on
savings and investment decisions.
Although not common, divergent inflation expecta
tions appear to have contributed to movements in nom
inal interest rates on several occasions in recent years.
The first and most im portant instance began in
mid-1983 and extended through the first eight months
of 1984. The financial market expectation of inflation
exceeded that of households by a percentage point or
more through much of this period and was considera
bly higher than realized inflation as well. In another
notable instance, during the first three quarters of
1987, financial market inflation expectations and inter
est rates rose sharply in anticipation of inflationary
pressures which did not emerge, while household infla
tion expectations moved less pessimistically. In recent
months, inflation expectations have declined sharply in
a number of published surveys. Both future economic
performance and the appropriate stance of monetary
policy depend on whether interest rate movements in
response to such changing expectations are best inter
preted as real interest rate movements or neutral nomi
nal rate changes that on average correctly reflect
future inflation rate trends.
Our findings also possess some academic interest.
First, they represent yet another in a long line of empir
ical rejections of the rational expectations hypothesis.1
More important, they suggest that inflation expecta
tions in specific markets can affect the relative prices
determined within these markets. Such heterogenous
expectations may have a significant impact on eco
1C onsiderable effort has been devoted to determ ining whether survey
expectations are rational. The working paper version of this paper,
A. Steven Englander and Gary Stone, “ Inflation Expectations Surveys
as Predictors of Inflation and Behavior in Financial and Labor
Markets,” Federal Reserve Bank of New York, Research Paper no.
8918, D ecem ber 1989, cites many of the relevant sources. A recent
article treating the question is Adrian Throop, “An Evaluation of
Alternative Measures of Expected Inflation," Federal Reserve Bank of
San Francisco Economic Review, no. 3 (Summer 1988), pp. 27-43.
Throop also analyzes the perform ance of surveys in relationships
where inflation expectations are thought to be im portant. His results
differ from ours in that he finds in general that autoregressive or
augm ented autoregressive expectations outperform surveys in
regression equations estim ating such relationships. Our approach
differs in that we use only data that would have been available at the
time of the forecast and we consider surveys that are relevant in
specific markets. For these reasons, Throop's procedure may be
biased towards finding that surveys contain little information beyond
what is available in autoregressions. By contrast, a recent paper by
Michael P. Keane and David E. Runkle, “ Testing the Rationality of
Price Forecasts: New Evidence from Panel D ata," Federal Reserve
Bank of Minneapolis, Mimeo, November 1988, examines the
perform ance of individual professional forecasters in the ASA-NBER
survey and concludes that their forecasts are indeed rational.
nomic activity because there is no immediate mecha
nism by which such expectations differences can be
arbitraged away.
The survey data
Three surveys of expected inflation over a one-year
time horizon are examined. The surveys evaluate the
expectations of individuals who may interpret economic
conditions and data differently. DMP focuses on finan
cial market expectations; the vast majority of respon
dents are equity or bond portfolio managers, chief
investment officers, and financial officers. MICH, by
contrast, canvasses the inflation expectations of ran
domly selected households. Although BCC overlaps to
some extent in its coverage with the DMP, it is much
more heavily weighted to economists, economic con
sultants, forecasters, and nonfinancial corporations,
and probably reflects the views of professional fore
casters to a greater degree than DMP. These groups
are clearly unlike in their perspectives and knowledge
of economics. Their differences may cause them to
react to information and events differently and to hold
diverse beliefs.
Since February 1982, Richard Hoey, Chief Economist
at Drexel Burnham Lambert, has published DMP on a
regular basis. The response group comprises any
where from 190 to 400 institutional investment portfolio
managers, economists, and executives in financial and
investment institutions. Respondents are not asked to
forecast any specific inflation rate, but the pollers
regard the consensus forecast as the sample’s expec
tation of the one-year change in the consumer price
index (CPI). Publication is rapid, so an expectation
published in January 1983 is the expected change in
the inflation rate from January 1983 to January 1984.
DMP is issued every two or three months. In order to
have as many data points as possible for our statistical
analysis, we linearly interpolate the missing values,
using the data points on either side of the missing
value.2
MICH is a monthly survey of over 1,000 randomly
chosen households. The households are asked their
prediction of the change in the prices of the goods that
they buy.3 The survey has changed over the years;
prior to 1966, respondents were asked for only a quali2Lagging the DMP to elim inate any possible effect from the
interpolation procedure does not produce substantially different
results, nor does removing the interpolated months.
3For a more detailed discussion of the Michigan survey and a
com parison with a survey of professional econom ists (Livingston
Survey), see Edward M. Gramlich, "M odels of Inflation Expectations
Formulation, A Comparison of Household and Economist Forecasts,"
The Journal of Money, Credit and Banking, vol. 15, no. 2 (May 1983),
pp. 155-73.
FRBNY Quarterly Review/Autumn 1989
21
Chart 1
Comparisons of Inflation and Inflation Expectations
Percent
Percent
Percent
_ _ _ _ --------------------------1............. 1......-........ ............. r — —......
..................i-----------------------------------C) Forecast Errors of Surveys: D ifference between Survey and A ctual, 1978-83
Positive values are overpredictions and negative values are underpredictions
I
Blue Chip Consensus
i fA\ \ I
I l l I I l I II
1978
l i I
l l I l l I I I I I l
1979
I I
Decision-Makers Poll
\
JX/ J
II I II I II
1980
I
Michigan Survey
I I I I I I I I I J I
1981
I I I I I I I I I I L
1982
I I
II I II I II I I
1983
Sources: Eggert Economic Enterprises, Blue Chip Economics Indicators; Drexel Burnham Lambert, Decision-Makers Poll; and Institute for
Social Research, University of Michigan, Survey of Consumers.
* The consumer price index (CPI) and the personal consumption expenditures (PCE) deflator are the actual inflation rates over the survey horizon.
FRBNY Quarterly Review/Autumn 1989
Digitized22
for FRASER
Percent
A)
--------------------- _
CPI and PCE Infl ation over Survey Horiz on, 1984-89
,
Personal consumption
expenditures deflator*
>
r
\
\
-------------
■V
/
/
/
I I i I l I I i I I I I
1984
t
i l l
n
i l
i 1 iV
1985
/
Cons umer price index *
/
J/
I l I l i I l l I l l
II
1986
I I I I I I I I I
1987
11111111111
111111111
1988
* i j
1989
Percent
Percent
C)
Forecast Errors >f Surveys:
D ifference betw een Survey and A ctual, 1984-89
U lS fa r
V!
r>
Decision-Makers Poll
//
/J
\
.......................
Michigan Survey
Bl
1 1 1 11 1 1 1 I 1 1
1984
i 11 111111M
1985
i i 1 i i 1 iJn 1 n W i i l l
1986
i i 1i I 1i i i i i
1987
l ii
1i i 1 i i
1988
je Chip Consensus
,
i i 1I i 1I I 1I i 1
1989
FRBNY Quarterly Review/Autumn 1989
23
tative measure, but after 1966 they were asked for a
quantitative measure on a quarterly basis. In the anal
ysis below, we use data on MICH beginning in January
1978, when the survey switched to a monthly format.
The publication schedule of MICH is such that the
reported number is actually the previous month’s
expectation of inflation over the following twelve
months. We align the expectations so that they corre
spond to the month in which they were taken, not the
month of publication. Thus, the expectation reported in
February 1978 is the expectation of the change in infla
tion from January 1978 to January 1979, and we treat it
accordingly.
In March 1980, Robert J. Eggert introduced the BCC,
a survey reporting the forecasts of CPI growth made
by banks, econometric forecasting companies, financial
markets firms, and large nonfinancial companies. The
forecasts are made at the beginning of the month in
which the survey is published or at the end of the pre
vious month.
The one-year-ahead expected inflation rate is con
structed by taking the average of four consecutive
annualized quarterly forecasts, beginning with the fore
cast following the current quarter. Although respon
dents are not asked to forecast inflation over a twelve
month horizon, as they are in the other surveys, the
time profile of the quarterly forecasts is extremely flat,
suggesting that respondents are providing their general
sense of future inflation rather than period-dependent
forecasts. Because only the BCC makes a specific ref
erence to the CPI, the forecasting performance of all
three surveys is compared to growth in both the CPI
and the personal consumption expenditures (PCE)
deflator. CPI and PCE deflator growth rates are similar
in trends, although substantial differences appear in
the magnitude of the changes in the inflation rate
(Chart 1, panel A). The PCE neither increases nor falls
as rapidly as the CPI. This reflects differences between
a fixed-weighted index (CPI) and an implicit deflator
(PCE), as well as the compositional differences in the
two consumer price indicators.
Comparison of the survey forecasts
The broad movements in the survey forecasts are simi
lar, but during some periods their predictions differ
markedly. For example, the BCC forecast exceeded the
MICH forecast from the beginning of 1980 until early
1982 (Chart 1, panel B). Subsequently, for extended
portions of 1982, 1983, and 1984, the DMP forecast
was substantially higher than those of either BCC or
MICH. At intermittent periods since 1984, the MICH
inflation forecast was above those of the other surveys
(parts of 1985 and much of 1988), and the DMP fore
cast was higher than those of the other surveys (parts
FRBNY Quarterly Review/Autumn 1989
Digitized24
for FRASER
of 1987 and 1989). Since 1982, BCC generally has fore
cast lower inflation than the other surveys or taken an
intermediate position between them.
A more formal statistical analysis reveals both sim
ilarities and differences among the surveys. As might
be expected, the surveys are highly correlated with
each other, although the association is greater between
DMP and BCC than between MICH and the other two
surveys. The adjusted R2 from a regression of the DMP
forecast on the BCC forecast is 0.88, as against about
0.61 for the regression of MICH on either BCC or DMP.
To some extent the correlations among the surveys
reflect the correlation that each of the surveys has with
past inflation. A distributed lag on past inflation can
account for somewhat more than half of the variation in
the surveys, ranging from 0.53 for BCC to 0.59 for
MICH to 0.61 for DMP.4 These are higher correlations
than exist in fact between future and past inflation,
suggesting that survey respondents may be backward
looking to a substantial degree.
Although the surveys show a fair degree of correla
tion with one another and with past inflation, some dis
similarities emerge when one looks a little deeper. If
only those components of the surveys not related to
past inflation are considered, the correlation between
MICH and the other two surveys weakens considerably.
Only about a quarter of the variation in MICH that is
independent of past inflation can be explained by the
other two surveys. By contrast, even after the effects of
past inflation are removed, BCC and DMP can explain
more than 80 percent of the residual variation in each
other. This suggests that BCC and DMP are correlated
w ell beyond th e ir common b a ckw a rd -lo o k in g
components.
inflation-forecasting performance
The forecast performance of MICH is quite respectable
over the 1978-88 period. It is virtually unbiased with
respect to the CPI, has a moderate upward bias with
respect to the PCE, and its root mean-squared errors
(RMSEs, which measure the typical size of error irre
spective of sign) are only about half the standard devi
ation of CPI and PCE inflation (Table 1, column 12).
The performance is also strong relative to the naive
forecast that just projects next year’s inflation as equal
ing that of the past year. The RMSEs of MICH are quite
a bit lower than those of the naive forecasts, although
the upward prediction bias of MICH is slightly higher
with respect to the PCE (Table 1, column 13).
The RMSE falls substantially when MICH is viewed
as forecasting consumer price inflation excluding food
4The adjusted R2 from such regressions changes with the sample
period. The standard errors remain relatively stable in the 0.45 to
0.65 range throughout the available sample.
points for DMP with respect to the CPI to eight-tenths
of a percentage point for MICH with respect to the PCE
deflator. The errors have also been persistent, with
only a few small instances of underprediction (Chart 1,
panel C).
A comparison of forecast RMSEs with the standard
deviation of actual inflation also illustrates the limited
predictive success of the surveys in the mid and late
1980s. The standard deviations of inflation since 1982
are less than half their post-1980 levels (Table 1, memo
item). By contrast, the forecast RMSEs are virtually the
same for MICH and only slightly lower for BCC across
the two periods, despite the stability of inflation.
Much of the bias in the forecasts can be explained
by variations in food and energy prices. For example,
the average overpredictions of MICH and BCC fall from
about one percentage point to about three-tenths of a
percentage point if the surveys are viewed as project
ing growth in the CPI excluding food and energy. The
bias in DMP falls as well, but remains high compared
to the bias in the other two surveys.
and energy. Households appear to forecast the core
component of consumer price growth better than they
forecast food and energy price fluctuations.
The perform ance since February 1980 (when BCC
becomes available) is similar. MICH remains better
than the naive forecast, and its RMSEs are a good deal
lower than the standard deviations of actual inflation
(Table 1, columns 9 and 10). The performance of BCC
in forecasting inflation as measured by growth in the
overall CPI and the CPI excluding food and energy is
much better than that of the naive forecast and slightly
worse than that of MICH. (Recall that BCC respondents
are asked specifically to forecast CPI inflation.)
When we evaluate the perform ance of all three sur
veys beginning in 1982, the year DMP became avail
able on a regular basis, we find that the forecasting
perform ance falls apart. None of the surveys provides
very good unconditional forecasts of one-year-ahead
inflation over the period from February 1982 to August
1988 (Table 1, columns 1-3). The average overpredic
tion ranges from one and th re e -te n th s percentage
Table 1
Performance of Surveys in Forecasting Inflation
February 1982-August 1988
e x p e c ta tio n s
m e asure d b y :
(1)
DMP
February 1980-August
1988
January 1984-August 1988
January 1978August 1988
(2)
MICH
(3)
BCC
(4)
Naive
(5)
DMP
(6)
MICH
(7)
BCC
(8)
Naive
(9)
MICH
(10)
BCC
(11)
Naive
(12)
MICH
(13)
Naive
1.04
1.65
1.05
1.63
0.16
1.86
0.99
1.66
0.90
1.52
0.82
1.45
- 0 .0 8
1.59
0.79
1.61
1.10
1.72
1.00
2.50
0.06
2.01
0.27
2.67
Personal consum ption expenditures
B ia s f
1.12
0.84
0.85
RMSE
1.77
1.43
1.46
0.16
1.34
0.78
1.65
0.69
1.44
0.61
1.42
- 0 .1 2
1.43
0.81
1.42
1.12
1.70
0.75
1.83
0.53
1.38
0.27
1.84
CPI excluding food, energy
B ia s f
0.56
0.28
RMSE
1.21
0.92
0.29
0.92
0.37
1.59
0.23
0.76
0.15
0.59
0.06
0.58
0.11
0.48
0.04
1.13
0.35
1.11
0.91
2.07
- 0 .2 9
1.31
0.25
2.19
PCE excluding food, energy
B ia s f
0.68
0.41
RMSE
1.34
1.02
0.42
1,05
0.36
0.99
0.39
1.28
0.30
1.08
0.22
1.08
-0 .0 1
0.81
- 0 .2 5
1.23
0.70
1.28
0.63
1.24
0.52
1.12
0.25
1.30
P e rfo rm a n ce in p re d ic tin g
tw e lv e -m o n th g ro w th in:
Consumer price index
BiasT
1.31
RMSE
1 .9 t
Memo: standard deviation of
twelve-month growth in:
CPI
1.04
1.13
2.37
3.80
PCE
0.83
0.95
1.88
2.78
CPI excluding food, energy
0.48
0.26
2.14
3.05
PCE excluding food, energy
0.58
0.53
1.64
2.04
Note: Naive forecast assumes that inflation over the following twelve months will be the same as inflation over the previous twelve months.
tB ia s defined as average value of actual inflation less forecasted inflation. A minus sign indicates that the survey underpredicted on
average; a negative sign, that it overpredicted.
FRBNY Quarterly Review/Autumn 1989
25
The perform ance of the surveys improves over the
period from January 1984 to August 1988, after the ini
tial stages of the deceleration in inflation had ended.
This was a period of very stable inflation, however, and
all three surveys are outperform ed on the whole by the
naive forecast, with RMSEs substantially higher than
the standard deviation of actual inflation (Table 1, col
umns 5-8). Among the surveys, the DMP p erform s
unam biguously the worst both in term s of bias and
RMSE.
Regression analysis generally supports the conclu
sions reached above. For the 1982-88 period, when
inflation rates were very stable except for food and
energy price fluctuations, no meaningful inform ation
about future inflation is contained in any of the surveys
or in past inflation itself (Table 2, columns 1-4). When
the sam ple is extended back to 1980, the picture
reverses. Both MICH and BCC contain significant infor
mation about future inflation and more information than
a distributed lag on past inflation. That is, on average,
changes in MICH or BCC are better guides to future
inflation trends than the past patterns of actual price
inflation (Table 2, columns 5-7).5 The significance of
the surveys in explaining future inflation remains even
when they are entered sim u ltan e ou sly w ith lagged
values on past inflation (Table 2, columns 8 and 9). If
we go back to 1978, when only MICH is available, the
margin by which that survey outperform s a distributed
lag on past inflation increases substantially.
sAs m ight be expected with forecast horizons of twelve months, the
errors possess a strong moving average com ponent. Although the
moving average errors do not affect the consistency of the estimates,
they do affect the consistency of the standard errors estim ated by
ordinary least squares regressions. For discussions of this problem
and proposed corrections see H albert White, “A H eteroskedasticityC onsistent Covariance Matrix Estimator and Direct Test for
H eteroskedasticity,” Econometrica, vol. 48 (1980), pp. 817-38; and
Lars P. Hansen and Kenneth J. Singleton, “ Generalized Instrumental
Variables Estimation of Non-Linear Rational Expectations M odels,”
Econometrica, vol. 50 (1982), pp. 1269-86. The method proposed by
Whitney K. Newey and Kenneth D. West, “A Simple Positive SemiDefinite H eteroskedasticity and Autocorrelation Consistent Covariance
M atrix," Econometrica, vol. 55 (1987), pp. 703-8, was used to correct
the estim ated standard errors of the coefficients for eleventh-order
moving average errors and heteroskedasticity.
Table 2
The Inflation Surveys as Forecasts of Future Inflation: Regression Results!
Dependent Variable: Growth rate in consumer price index over the next twelve months.
February 1982-August 1988
(1)
Inflation expectations
measured by:
DMP
(2)
(3)
MICH
BCC
February 1980-August 1988
(4)
Lagged
Inflation
(5)
(6)
MICH
BCC
4.22*
-1 .4 3
-0 .5 5
January 1978-August 1988
(7)
Lagged
Inflation
(8)
(9)
(10)
MICH
BCC
MICH
1.76*
-0 .5 2
-0 .6 4
-2 .8 6 *
<12)t
(11)
Lagged
Inflation
MICH
1.94*
-0 .8 9
C oefficients:
Intercept
Inflation survey
3.61**
-0 .0 0
3.92**
-0 .0 7
3.14***
0.10
Distributed lag
on inflation
1.12*
0.00
0.09
0.58
0.00
0.00
0.19
0.12
0.25
0.17
0.55
0.13
0.56
1.40
1.32
1.49
1.39
1.34
1.72
2.37
1.27
0.65
0.69
0.60
0.66
0.68
0.79
0.61
0.79
0.00
0.00
0.05
0.10
0.10
0.10
0.39
1.04
1.04
1.03
-0 .01
0.01
-0 .0 1
1.06'
0.16
0.00
-0 .0 1
1.45*
0.00
0.00
0.99
ADJ. R**2
0.95*
0.20***
DW
1.05
0.75*
0.56*
-0 .1 9
Significance level
of rationality test
[a = 0,
b( + c) = 1]
SEE
0.90*
-0 .0 3
0.81
Notes: Standard errors are corrected for eleventh-order moving average errors and heteroskedasticity. See Newey and West,
“A Simple Positive Semi-Definite Heteroskedasticity and Autocorrelation Consistent Covariance Matrix."
tEquation: CPI12F = a + b • inflation expectation ( + c • lagged inflation), where CPI12F is the growth rate in the consumer price index over the next
twelve months, and the fagged inflation term is an eighteen-month polynomial distributed lag on one-month annualized growth in the consumer price
index with degree two and an endpoint constraint.
^Dependent variable is the growth rate in the personal consumption expenditures deflator over the next twelve months.
’ Significant at 1 percent.
"S ignificant at 5 percent.
“ 'Significant at 10 percent.
26
FRBNY Quarterly Review/Autumn 1989
It is difficult to determine whether BCC or MICH con
tains the more significant information. Regression anal
ysis indicates that BCC is marginally superior to MICH
in general. When the two surveys are entered simul
taneously, they both contribute sig n ifica n tly to
explaining one-year-ahead inflation, although the coeffi
cient size and statistical significance are greater for
BCC. The existence of significant information on future
inflation in both surveys indicates that the differences
between the surveys are not random noise. Their fore
casts are different but informative.
We can partially reconcile the poor performance of
the surveys during 1982-88 with the much stronger per
formance when the sample period is extended back
wards even a few years if we examine the sources of
inflation fluctuations in the two periods. The surveys do
poorly in periods when the primary sources of variation
in inflation are food and energy prices, factors which
are volatile and difficult to anticipate. By contrast, the
surveys do better when the variation in inflation is
largely due to fundamental labor market and business
cycle pressures. The inflationary cycles caused by
such forces extend over longer periods, and survey
respondents may be able to assimilate them to a
greater degree than the shorter lasting fluctuations
caused by food and energy prices. Extending the sam
ple backwards to 1980 introduces additional cyclical
fluctuation and may account for the superior forecast
ing performance of the survey in the longer samples.
Since 1982, the standard deviation of the CPI excluding
food and energy has been less than half that of the
overall CPI; for the post-1980 period as a whole, this
share jumps to more than 90 percent (Table 1, memo
item).
Although the longer term forecasting performance of
the surveys is good, the survey forecasts are not
clearly “ rational” in the economists’ sense of efficiently
incorporating all available information. The standard
form of this rationality test is provided at the bottom of
Table 2. Over the shorter period the data strongly
reject rationality, a result which is not surprising since
all the surveys were strongly biased with respect to
actual inflation. Over the longer periods the tests are
close to accepting the hypothesis of rationality; indeed,
over the 1978-88 period the tests on the coefficients
easily accept the hypothesis that MICH rationally pre
dicts PCE inflation. However, the persistence of overand underpredictions for lengthy periods suggests that
the surveys do not incorporate all available information
(Chart 1, panel C).6 Thus, the surveys are somewhat
•M ore formally, because the surveys are forecasting twelve months
ahead, the autocorrelations of the errors should disap pear after a lag
of eleven months. In fact, they persist at a level of around 0.2,
forward looking and may be useful in forecasting infla
tion, but the pattern of prediction errors suggests that
the surveys do not correspond to economists’ concep
tion of rationality.7
Inflation expectations and compensation growth
The poor record of surveys in predicting inflation in
recent years does not necessarily mean that they con
tain no information about future economic develop
ments. Inflation expectations enter importantly into
many economic decisions. The key question is whether
individuals act on their expressed beliefs when they
make these decisions.
To explore this question, we consider the relationship
between inflation expectations and nominal compensa
tion growth. In theory, nominal compensation growth
ought to be strongly influenced by expectations of
future inflation, with workers factoring an inflation
markup into their real wage bargains. In practice, most
econometric models assume that the expectations pro
cess can be modeled reasonably well by a distributed
lag on past inflation rates, or alternatively, that this dis
tributed lag reflects workers’ willingness to “catch up”
with past inflationary movements rather than base their
wages on a forecast of future inflation. This section
examines whether the putative inflation expectations
component of nominal compensation growth is entirely re
lated to past inflation, or whether the survey inflation fore
casts contain a discernible forward-looking component.
The underlying model which we use is very simple.
Workers contract for the year ahead on the basis of
current labor market conditions and their expectations
of future inflation. For each time period, the surveys
are entered first individually, then in pairs, and finally in
combination with distributed lags on past CPI and PCE
inflation as candidate representations of inflation
expectations.8 Each inflation expectations proxy is
Footnote 6 continued
indicating that not all available information is used in the surveys
since a better forecast could be made using the forecast error of
twelve months earlier. The persistence of the autocorrelation alone
warrants rejection of the rationality hypothesis.
7Prior researchers have reached varied conclusions on the rationality
of the M ichigan survey. For example, James S. Fackler and Brian
Stanhouse in “ Rationality of the M ichigan Price Expectations Data,"
Journal of Money, Credit and Banking, vol. 9 (November 1977),
pp. 662-66, argue on the basis of their coefficient estimates that
MICH is rational, but they do not discuss autocorrelation in errors.
Edward M. Gram lich in “ Models of Inflation Expectations” rejects the
rationality hypothesis.
“ For example, in the 1982-89 period, thirteen proxies for inflation
expectations are entered: (1) DMP, (2) MICH, (3) BCC, (4) CPI,
(5) PCE. (6) MICH, CPI, (7) MICH, PCE, (8) BCC, CPI, (9) BCC, PCE,
(10) MICH, DMP, (11) BCC, DMP, (12) DMP, CPI, (13) DMP, PCE. In
the above listing PCE and CPI represent an eight-quarter secondorder polynomial distributed lag on past PCE or CPI inflation with an
endpoint constraint.
FRBNY Quarterly Review/Autumn 1989
27
evaluated according to its ability to contribute to the
prediction of com pensation growth over a one- and
four-period-ahead horizon. We use two models of nom
inal compensation determination — a basic model relat
ing co m p e n sa tio n gro w th to the prim e age m ale
unemployment rate and to inflation expectations, and a
more elaborate model (E-L) that has been found to fit
well and have stable parameters over long periods of
time.9
Because there are three time periods, two forecast
horizons, and two compensation models, twelve “ horse
races” are being run. In all, we estimate 108 regression
equations to determine which combination of surveys
and distributed lags on past inflation best explains
future compensation growth.
The results point in a common direction. Equations
with MICH or a combination of MICH and a distributed
lag on either PCE or CPI inflation have the highest
explanatory power (as measured by adjusted R2) in ten
of the twelve “ horse races” (Table 3). In the other two
instances, a distributed lag on past CPI inflation proves
superior, although the margin is small over MICH.
In all instances MICH contributes to explaining com
pensation growth over a four-period horizon, but it is
outperform ed by a distributed lag on CPI inflation in
two instances of forecasting compensation growth over
a one-quarter horizon. This finding is of interest be
cause our regressions suggest that the four-quarter
horizon provides more reliable results. The standard
errors for the four-quarter-ahead equations are much
less than one-half the size of the standard errors of the
one-quarter-ahead equations, indicating that some of
the one-quarter-ahead error is offset within a year.
(W here com pensation grow th rates are annualized,
errors that are random on a quarter-by-quarter basis
should produce standard errors in the four-quarterahead com pensation equation that are one-half the
size of those fo r the one -q ua rter-a h ea d equation.)
Thus, the survey in all cases contributes to explaining
m ore s ta b le m ed iu m -te rm tre n d s, even th ou gh it
misses some near-term fluctuations.
In the period since 1982, MICH has done particularly
well relative to both the other surveys. In no case did
including DMP or BCC improve the fit of an equation
9The model and its properties are discussed in A. Steven Englander
and Cornelis A. Los, “ The Stability of the Phillips Curve and Its
Im plications for the 1980s," Federal Reserve Bank of New York,
Research Paper no. 8303, February 1983. The model includes as
explanatory variables not only inflation expectations and the primeage male unemployment rate, but also the growth in the civilian labor
force, the share of unemployment benefits paid under extended
benefits programs, and the positive change in the prime age male
unemploym ent rate.
Table 3
Inflation Expectations Proxies Showing the Best Fit over Alternative Time Periods, Specifications,
and Forecast Horizons
Time
Period
1982-11 to 1988-111
1982-11 to 1988-111
1982-11 to 1989-11
1982-11 to 1989-11
1980-11 to 1988-111
1980-1! to 1988-111
1980-11 to 1989-11
1980-11 to 1989-11
1978-1 to 1988-111
1978-1 to 1988-111
1978-1 to 1989-11
1978-1 to 1989-11
Specification
E-L
Basic
E-L
Basic
E-L
Basic
E-L
Basic
E-L
Basic
E-L
Basic
Forecast
Horizon
Four
Four
One
One
Four
Four
One
One
Four
Four
One
One
quarters
quarters
quarter
quarter
quarters
quarters
quarter
quarter
quarters
quarters
quarter
quarter
Coefficients of Best Fitting
Inflation Expectations Proxy
)
)
)
)
)
)
)
)
)
)
)
)
MICH
MICH
MICH
CPI
MICH
MICH
MICH
CPI
MICH
MICH
MICH
MICH
=
=
=
=
=
=
=
=
=
=
=
=
0.50**
0.45*
0.73*
0.57*f
0.55*
0.56*
1.16*
0.52*f
0.52*
0.58*
0.34***
0.35***
ii) CPI = 0.33*t
ii) PCE = 0.23**f
it) PCE = 0.21‘ f
ii)
ii)
ii)
ii)
PCE
PCE
CPI
CPI
=
=
=
=
0.23*t
0.23*t
0.36*t
0.40*f
Equation
Adjusted R2
Equation
Standard Error
0.59
0.54
0.14
0.19
0.90
0.90
0.66
0.65
0.95
0.94
0.78
0.76
0.48
0.51
1.41
1.37
0.56
0.54
1.39
1.41
0.59
0.61
1.34
1.39
Note: The basic specification includes the prime age male unemployment and inflation expectations as explanatory variables for compensation
growth. The E-L specification is discussed in Englander and Los, “The Stability of the Phillips Curve and Its Implications for the 1980s.” The
significance levels of the inflation expectations coefficients in equations with a four-quarter horizon are based on Chi-squared tests after the
standard errors are corrected for a fourth-order moving average process and heteroskedasticity. See Newey and West, “A Simple Positive SemiDefinite Heteroskedasticity and Autocorrelation Consistent Covariance Matrix."
tS um of coefficients in an eight-month polynomial distributed lag on one-month growth in either the consumer price index or the personal
consumption expenditures deflator with degree two and an endpoint constraint.
'Significant at 1 percent.
“ Significant at 5 percent.
•“ Significant at 10 percent.
28
FRBNY Quarterly Review/Autumn 1989
containing MICH. Indeed, in all cases the adjusted R2s
fell and the standard errors rose. At least since 1982,
MICH has been the survey most useful for forecasting
compensation growth.
When the sample is extended back to 1978, the
results again suggest that MICH embodies a substan
tial portion of inflation expectations. The estimated
effect of MICH is always of the same magnitude as, or
greater than, the estimated effects of past inflation,
although the significance level is sometimes relatively
low. Taken as a whole, the data suggest that the infla
tion expectations process relevant to compensation
growth can be well represented by MICH alone or by a
combination of MICH and a distributed lag on past
inflation. None of the other surveys, whether by itself or
in combination with past inflation or another survey,
provides any additional information beyond what is
embedded in MICH and past inflation.
Finally, it is informative to make a comparison
between the compensation-forecasting and inflationforecasting equations, although the four-quarter hori
zon of the former differs slightly from the twelve-month
horizon of the latter. The standard errors of the fourquarter-ahead compensation equation range from
about five-tenths to six-tenths of a percentage point.
By contrast, the standard errors of the inflationforecasting equations in Table 2 varied from about one
percentage point to two and four-tenths percentage
points depending on the time period and dependent
variable. The much greater precision of the one-yearahead compensation projection relative to that of infla
tion indicates that shocks to prices over the forecast
horizon are not likely to be complemented by shocks to
compensation growth.10 Otherwise the magnitude of
the forecast errors would be similar, given that inflation
expectations affect compensation growth on close to a
one-to-one basis. The large difference in precision sug
gests that surprise inflation or disinflation mainly
affects real compensation as opposed to nominal com
pensation. That is, nominal compensation growth does
not seem to change fast enough in response to infla
tion shocks to maintain real wage growth at expected
levels.
In sum, the significance of MICH in compensation
determination and the tight fit of the relationship are
reasons to take the household survey seriously, at
10To test these conjectures formally, we would have to convert the
twelve-month-ahead inflation forecasting equations of Table 2 into
four-quarter-ahead forecasting equations and correlate the residuals
across equations. For the reasons mentioned in the text and the fact
that the residuals in the inflation-forecasting equations are much more
autocorrelated than in the com pensation equations (Durbin-W atson
statistics of about 0.1 to 0.5 as against 1.2 for the com pensation
equations), unexpected inflation does not appear to have similar
effects on inflation and com pensation within a given year.
least as a partial indicator of underlying inflation
expectations. Even when the survey provides a rela
tively poor guide to future inflation, as in the mid-1980s,
it appears to represent the beliefs on which households
act.
Inflation surveys and interest rates
This section analyzes the relationship of the inflation
surveys and interest rates to determine which survey, if
any, represents the inflation expectation underlying
interest rate movements. The approach parallels that of
the previous section in that the surveys alone and in
combination with distributed lags on past inflation are
entered into nominal interest rate equations. The infla
tion proxy that best explains contemporaneous interest
rate movements — as before, in terms of highest
adjusted R2 and minimum standard errors — is judged
the best representation of the underlying inflation
expectation. (The question whether causation runs
from the inflation expectations surveys to interest rates
or the reverse is addressed in the next section.)
The result also parallels that of the previous section
in that one inflation survey is found to be better related
than the others to the variable in question. In this case,
the best fitting survey is the DMP, by a moderate but
consistent margin. Movements in the DMP inflation
forecast are more closely aligned with movements in
interest rates than are those of either BCC or MICH.
More important in light of the results on compensation
growth, MICH is poorly related to interest rates, with a
coefficient that is often small and insignificant.
Our model of interest rate determination relates nom
inal interest rates to expected inflation and to past data
on inflation and interest rates.11 It can be written as
Rt = a + b nte + c Rt_.| + d n ® ,
where R is the nominal one-year Treasury bill rate, ne
is the expectation of inflation, and t and t-1 are time
subscripts. With specific restrictions on the coefficients,
the equation can be made consistent with a variety of
interest rate models: a simple Fisher equation, b = 1,
c = d = 0; a rational expectations cum Fisher equation,
b = c = -d, a = 0; a modified Fisher equation in which
real rates deviating from the equilibrium level gradually
adjust back to that level, b = 1, c = d<1, a = (1-c) • r,
where r is the equilibrium real rate of interest; real
interest rates that follow a random walk, b = 1, a = 0,
11The model is a variant of a model estim ated by James D. Hamilton in
“ Uncovering Financial Market Expectations of Inflation,” Journal of
Political Economy, vol. 93, no. 6 (1985), pp. 1224-41, and others. We
do not make the assumptions on the error structure that Hamilton
uses to identify his model.
FRBNY Quarterly Review/Autumn 1989
29
c = d = 1; partial adjustment of nominal rates to inflation
expectations, d = 0, b + c = 1 or b + c + d = 1; or more
general sets of coefficient estimates. To explore the
possibility that survey inflation expectations do not
adequately refle ct the expe ctatio n s co n trib u tin g to
interest rate determination, lagged values of past infla
tion are included in some of the estimated equations.
Such a loose specification has the advantage of being
based only on observable nominal inflation and interest
rates rather than conjectured real interest rates, while
allowing for patterns of coefficient estimates consistent
with a wide variety of models.
The regression results support three conclusions.
First, the equations in which DMP is entered have
lower standard error and higher adjusted R2 than do
similar equations with MICH and BCC (Table 4, col
umn 1 as compared with columns 2 and 3, column 5 as
compared with columns 6 and 7). The DMP coefficient
is generally larger and more significant than the coeffi
cients of MICH or BCC. Second, even when the sample
is extended back to 1978, the significance level of the
coefficient on MICH remains low as compared to the
levels observed for the other surveys over a shorter
time period (Table 4, columns 9-12). Third, including a
variety of lagged inflation terms does not greatly alter
the significance or size of the DMP coefficient (Table 4,
column 1 as com pared with column 4, column 5 as
com pared with column 8). Nor does introducing the
other surveys sim ultaneously with DMP significantly
improve the fit of the equation or reduce the level and
significance of the DMP coefficient.12 Finally, introduc
ing a second lag of the dependent variable or correct
ing for autocorrelation to eliminate the moderate but
12AII of the results discussed in this paragraph and the next are
presented in greater detail in the working paper version of this
article.
Table 4
Inflation Expectations and Interest Ratesf
Dependent Variable: Yield on actively traded one-year Treasury issues adjusted to constant maturities.
March 1982-August 1989
February 1978-August 1989
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
MICH
BCC
DMP
DMP
MICH
BCC
DMP
MICH
MICH
MICH
MICH
-0 .3 1
( - 1 29)
0.08
(0.23)
-0 .4 5
(-1 .4 1 )
-0 .4 3
(- 1 .8 4 )
-0 .1 3
(- 0 .5 4 )
0.27
(0.77)
-0 .4 7
(- 1 .4 7 )
-0 .4 1
(- 1 .7 1 )
-0 .1 5
(- 0 .4 3 )
0.12
(0.35)
0.18
(0.69)
0.21
(0.6G)
0.46
(5.13)
0.15
(1.66)
0.43
(3.77)
0.53
(5,67)
0.58
(3.55)
0.19
(1.84)
0.18
(0.91)
0.56
(3.52)
0.11
(1.82)
0.16
(2.60)
0.21
(2.62)
0,21
(2.63)
0.82
(22.41)
0.92
(27.32)
0.84
(21.35)
0.83
(20.07)
0.83
(19.98)
0.92
(30.45)
0.80
(19.69)
0.83
(19.05)
0.92
(27.85)
0.90
(25.90)
0.93
(34.66)
0.90
(25.91)
-0 .1 1
(- 2 .2 1 )
-0 .0 4
( -0 .6 5 )
-0 .0 5
(-1 .0 8 )
0.21
(1.99)
-0 .0 6
(- 0 .1 4 )
0.05
(0,33)
-0 .1 2
(- 1 .5 0 )
(1)
Inflation expectations
m easured by:
DMP
C oefficients:
Intercept(a)
Inflation
survey(b)
Lagged
interest
rate(c)
Lagged
inflation(d)
Lagged
survey(d’)
-0 .2 5
(-1 .4 1 )
Distributed lag
on past
inflation(e)t
DW
-0 .1 1
(- 1 .0 1 )
0.29
(1.35)
1.29
1.47
1.60
-0 .0 9
( -0 .9 9 )
-0 .1 9
(-3 .2 1 )
-0 .4 0
(-3 .4 0 )
1.39
-0 .4 6
( - 0 .2 5 )
0.08
(0.42)
0.00
(0.02)
1.34
1.30
1.29
1.52
1.30
1.32
1.35
0.41
0.38
0.76
0.75
0.76
0.75
0.96
0.95
0.92
0.92
0.92
0.92
SEE
0.39
0.44
0.42
0.37
0.40
0.44
ADJ. R**2
0.96
0.95
0.96
0.97
0.96
0.95
0.93
Note: T-statistics in parentheses.
tEquations: Rt = a + b • survey + c • Rf_ , + d • CPI12t _ 1 + e • lagged inflation, and R, = a + b • survey + c • Rt _ 1 + d' • surveyt _ ,
+ e • lagged inflation, where CPI12 is the twelve-month growth in the consumer price index and the lagged inflation term is the eighteen-month
polynomial distributed lag on one-month annualized growth in the consumer price index with degree two and an endpoint constraint.
30
FRBNY Quarterly Review/Autumn 1989
persistent autocorrelation indicated by the low DurbinWatson statistics barely alters the results. Taken
together, these results support the view that the DMP
and, possibly to a lesser extent, BCC inflation forecasts
contribute to the inflation expectations underlying inter
est rates.
Variations on the basic regression equations produce
essentially the same results. In estimating the same
relationships for interest rates with maturities of three
and six months, one finds that both the size of the
coefficients and their significance increase as the
maturities lengthen. The fact that the surveys uniformly
contain more information for one-year Treasury bill
rates than for shorter maturities suggests that respon
dents are correctly identifying their inflation rate expec
tation over that time and not just responding to short
term fluctuations. Also, if one estimates equations for
the change in interest rates (by constraining the coeffi
cient of the lagged interest rate variable to equal one),
the qualitative results do not change.
The form of rational expectations embodied in the
Fisher equation would demand that the effects of
higher inflation be passed through to interest rates on
a one-for-one basis. This hypothesis is examined either
directly or indirectly in most tests of rationality relating
interest rates to inflation expectations. The regression
results show plausible estimates of the various coeffi
cients but reject the coefficient of one on inflation
expectations. Such tests implicitly assume that taxinduced distortions in the cost of borrowing or return to
lending are insignificant or exactly offset each other, or
that marginal borrowers and lenders are nontaxable.
As neither theoretical nor empirical analysis seems to
support these hypotheses, it is not appropriate to make
the hypothesis of rationality depend critically on a coef
ficient of uncertain theoretical magnitude.13
Do financial market participants base their fore
casts on interest rates?
Thus far we have assumed that financial market
respondents hold independent views of inflation, which
they then translate into interest rates. An alternative
assumption is that financial market participants, when
questioned about inflation, take their cues from current
interest rates. When they observe a rise in rates, they
may be inclined to attribute it to a rise in inflation
expectations, whether or not expectations have in fact
risen. In this case, the interpretation of the empirical
results would have to be substantially revised, because
the causality would be reversed. The reported inflation
13See, for example, Lawrence H. Summers, "The Nonadjustment of
Nominal Interest Rates: A Study of the Fisher E ffect," in James Tobin,
ed., Macroeconomics, Prices and Quantities (Washington, D.C.:
Brookings Institution, 1983).
expectations would not determine interest rates.
Rather, survey respondents would be formulating their
stated expectations largely in response to current inter
est rates. If this interpretation were correct, it would not
be possible to base any inferences on the estimated
relationships that use the inflation surveys. While such
a possibility seems very unlikely in the case of the
household survey, it is more plausible in the case of
DMP and, to a lesser extent, BCC. The composition of
the response groups suggests that all of the partici
pants in DMP and many in BCC would pay careful
attention to interest rates.14
Several factors, however, support the interpretation
that the surveys reflect actual inflation expectations.
First, the survey forecasts are highly correlated with
past inflation, and the financial market forecasts are
more highly correlated with past inflation than is the
household forecast. It may not be a good forecasting
methodology for financial market participants to base
their inflation forecasts on past inflation to this degree,
but it is a plausible one.
Second, the correlation of the inflation expectations
survey and inflation is actually higher between the cur
rent survey and future (two-months-ahead) interest
rates than between the current survey and current
interest rates. This relationship is true of BCC as
well.15 More formally, DMP appears to Granger cause
one-year Treasury bill rates (significance level 0.02),
while Treasury bill rates do not Granger cause DMP
(significance level 0.35).16 If anything, interest rates
appear to react to inflation expectations with a short
lag.
Finally, the characteristics of the survey forecasts
match those of inflation much more closely than those
of interest rates. The variances of the inflation fore
casts are quite close to the variance of inflation over
the forecast horizon and much lower than the variance
of interest rates. If survey inflation expectations were
derived by subtracting a relatively stable expected real
interest rate from observed nominal interest rates, the
variances of survey inflation expectations would more
closely match the variance of interest rates. Hence, our
findings support the view that the inflation expectations
14ln the earlier sections, the issue of causality was not central because
the surveys were being used to predict future com pensation growth
and inflation.
15Over the sam ple available for all of the surveys, the correlation of the
current one-year Treasury bill rate with DMP is 0.87; with BCC, 0.86;
and with the M ichigan survey, 0.66. For DMP and BCC the interest
rate correlation is m axim ized with a two-month lead on interest rates,
at 0.90 and 0.89, respectively. The correlation between the Michigan
survey and future interest rates is scarcely changed.
16Four lags of each variable are included. Even with DMP lagged two
months, it still Granger causes one-year Treasury bill rates.
FRBNY Quarterly Review/Autumn 1989
31
surveys contain information independent of contem
poraneously observed interest rates.
Assessing the differences in inflation expectations
The regression results indicate strongly that MICH is
the inflation expectation relevant to future compensa
tion growth, while DMP is the inflation expectation most
relevant to interest rates. In theory, such differences of
opinion should not exist — households and financial
market participants have access to much the same
economic data from which to form a view of future
inflation trends. Nevertheless, it is inherently plausible
that the survey of households would be most corre
lated with labor market developments and the survey of
financial market participants most correlated with inter
est rates movements. By small but persistent margins,
expectations in labor and financial markets are shown
to be most relevant to the determination of relative
prices in these markets.
To be sure, recognition of the existence and signifi
cance of such differences in expectations should not
lead to an overstatement of their ongoing importance.
The mean difference between the MICH and DMP sur
veys since 1982 is about three-tenths of a percentage
point and the root mean squared difference about
seven-tenths of one percentage point. Since the early
1980s, the range of forecasts has narrowed in line with
the stabilization of actual inflation rates, as Chart 1
demonstrated. Consequently, in recent years differ
ences in household and financial market inflations
expectations have led to different perceptions of real
interest rates and real compensation growth only for
limited periods. The gaps are likely to return to eco
nomically significant levels consistently only if the infla
tion outlook becomes more uncertain.
Conclusions
Surveys of inflation expectations contain useful infor
mation about future inflation on average, but they have
proved to be unreliable in recent years. Even if the
respondents’ expectations are not realized, however,
the surveys contain important information. Correct or
incorrect, the survey expectations appear to reflect the
respondents’ underlying beliefs about inflation, beliefs
which contribute to nominal compensation growth and
interest rate determination. In other words, individuals
appear to act on their stated beliefs, even when those
beliefs are wrong.
One of our major findings is that different groups act
on different inflation expectations. The household sur
vey contains significantly more information on future
compensation developments than does the survey of
financial market participants. The financial markets sur
vey, by contrast, reveals much more about interest
rates than does the household survey.
The differences in inflation expectations at particular
times suggest that financial markets and households
may have divergent views of the tightness of monetary
policy and the real costs and returns to borrowing and
saving. Differing perceptions of inflation premia may
affect the behavior of both savers and investors. To the
extent that incorrect forecasts of accelerating or
decelerating inflation affect interest rates and compen
sation growth, these forecasts may contribute unfore
seen contractionary or expansionary impulses to the
economy. Somewhat paradoxically, the inflation surveys
ought to be regarded as reliable indicators of the
underlying beliefs of respondents but should be used
cautiously as a guide to future inflationary trends.
A. Steven Englander
Gary Stone
32
FRBNY Quarterly Review/Autumn 1989
Japanese Trade Balance
Adjustment to Yen Appreciation
Beween 1985 and 1988 the Japanese yen appreciated
47 percent on a nominal trade-weighted basis. During
this same period the Japanese trade surplus increased
by $39 billion. This trade performance contrasts
sharply with the U.S. experience from 1980 to 1985,
when nominal dollar appreciation of about the same
magnitude resulted in a U.S. trade balance deteriora
tion of $95 billion. Although in real, or volume, terms
the difference in the trade performance of the two
countries is somewhat smaller, it is also striking. This
article investigates why the Japanese trade perform
ance remained so strong in the face of Japan’s large
nominal exchange rate appreciation.
The article finds that three factors were important in
explaining Japan’s trade strength measured in both
nominal and real terms. These factors also acounted
for most of the difference in Japanese and U.S. trade
performance. The first factor was simply a starting
base effect. Because Japanese exports were substan
tially larger than Japanese imports in 1985, Japanese
imports would have had to grow significantly faster
than exports just to keep Japan’s trade surplus from
rising. Japan’s trade performance was also aided by its
commodity composition. Raw materials accounted for
over half of Japanese imports in 1985 but represented
a negligible proportion of Japanese exports. This trade
composition made Japan’s trade balance less respon
sive to the relative price and demand conditions that
were working to push it down. The third factor support
ing Japan’s trade balance was the much smaller real
appreciation of the yen, especially when measured in
terms of relative export prices, compared with its nomi
nal rise. Falling Japanese prices in yen terms enabled
Japan to maintain a much better price competitiveness
position than the nominal rise in the yen alone would
have suggested. These falling yen prices reflected a
sharp drop in imported raw material input prices as
well as significant profit cutting by Japanese export
industries. Japan’s nominal trade balance was further
bolstered by the sharply falling world price of oil.
Finally, the conversion of Japan’s nominal trade bal
ance from yen into depreciated dollars entailed a sig
nificant currency translation effect, raising the dollar
value of Japan’s nominal trade balance.
These conclusions about the sources of Japan’s
trade strength are important for what they exclude as
well as for what they include. The analysis suggests
that some factors often mentioned as lying behind
Japan’s robust trade performance — superior Japanese
business ability, a world investment boom, and the
expansion of Japanese export trade to a growing
number of Japanese foreign subsidiaries — appear to
have played a minor or no role in that performance to
date. Falling Japanese profit rates, moreover, were
important in explaining Japan’s real trade balance
strength but they were considerably less important in
explaining developments in Japan’s nominal trade
balance.
The primary focus of this article is Japan’s real trade
balance. The article begins with an accounting of the
starting base, demand growth, and relative price fac
tors that helped shape Japan’s real trade balance evo
lution. Subsequent sections treat the influence of both
Japan’s distinctive commodity composition and domes
tic and foreign demand growth on Japan’s trade per
formance. Also examined in some detail is the change
FRBNY Quarterly Review/Autumn 1989
33
in Japan’s relative price position, broken down into its
com ponents — nominal appreciation, unit labor cost,
profit margins, and raw material input prices. Through
o ut the d is c u s s io n , the J a p a n e se e x p e rie n c e in
responding to yen appreciation is compared with the
U.S. experience under dollar appreciation in order to
identify those developments offering unique support to
Japan’s trade balance adjustm ent. The a nalysis of
Japan’s real trade balance culminates in conclusions
about what did and did not contribute to Japan’s strong
performance. Following a brief accounting of develop
ments in Japan’s nominal trade balance, the country’s
trade behavior in 1989 is discussed. A final section
examines the implications of the analysis for Japan’s
future trade balance evolution.
Major factors underlying Japan’s real trade balance
performance
In real term s, based on 1985 prices, the Japanese
trade surplus fell from $56 billion in 1985 to $16 billion
in 1988 (Chart 1). This fall was the consequence of a 4
percent rise in the volume of Japanese exports and a
41 percent rise in the volume of Japanese imports.
Corresponding figures for the United States provide a
benchmark for comparison: the real U.S. trade balance,
based on 1980 prices, fell from a deficit of $26 billion in
1980 to a deficit of $171 billion in 1985. During these
two periods the yen and dollar appreciated 47 percent
and 46 percent, respectively, on a nom inal tradeweighted basis (Chart 2).1
J a p a n ’s s tro n g e r tra d e b alan ce p e rfo rm a n c e re
flected both significantly faster export volume growth
and slightly more moderate import volume growth than
that achieved by the United States. However, it is
im p o rta n t to co nside r Japan’s trade volum e growth
rates in combination with the starting bases to which
these growth rates were applied.2 The volume of Japa
nese exports in 1985 was about one and a hahf times
as large as the volum e of Japanese im ports. This
export-to-im port ratio meant that imports had to grow
roughly 50 percent faster than exports just to keep
Japan’s trade surplus from rising.
The quantitative significance of Japan’s starting trade
surplus in keeping Japan’s ending surplus relatively
high can be gauged by applying actual Japanese
export and import volume growth rates to a hypotheti
cal Japanese starting position of balanced trade. If
Japanese imports and exports in 1985 were set equal
to a level halfway between their actual levels and then
1Effective exchange rate movements and export and import volume
changes are provided by the International Monetary Fund,
International Financial Statistics, various issues. Exchange rate
changes are calculated relative to the exchange rates of seventeen
industrial countries. Real trade balance changes are com puted
based on export and import volume growth rates applied to nominal
base year trade levels for Japan and the United States. The volume
growth rates are calculated based on unit value price indexes;
consequently, they are little affected by changes in base years.
However, applying these volume growth rates to nominal base year
exports and im ports during each cou ntry’s appreciation period
means that the real trade balance change reported for Japan is
based on 1985 prices whereas the real trade balance change
reported for the United States is based on 1980 prices. To the extent
prices changed between 1980 and 1985, the calculated real trade
balance changes for the two countries are not strictly com parable.
However, deviations from purchasing power parity exchange rates
and differences in com m odity com position make any cross-country
com parison of real trade balance changes measured in constant
dollar term s problem atic. Since the quantitatively estim ated effects of
the factors lying behind Japanese and U.S. real trade balance
adjustm ent presented in the text are also based on volume growth
applied to 1985 nominal export and im port levels for Japan and 1980
nominal export and import levels for the United States, they
accurately account for the difference in the two countries’ real trade
balance adjustm ent measured from these respective base year
starting points.
2The starting trade balance measured in real terms depends upon the
choice of base year prices used to convert nominal exports and
im ports into volume levels. Since Japan currently reports its trade
volume growth from a 1985 basis, 1985 base year prices are used in
the above analysis.
34
FRBNY Quarterly Review/Autumn 1989
both grew at their actual rates through 1988, the Japa
nese real trade balance would have fallen $15 billion
more than it actually did between 1985 and 1988.
Several developm ents co ntribu te d to the growth
rates observed fo r Japanese expo rts and im ports.
Japan’s 4 percent export volume growth was promoted
by a cumulative 11 percent growth in demand in other
industrial countries during the 1985-88 period.3 This
foreign demand growth more than offset the negative
impact on export volume from the rise in Japanese
export prices relative to foreign prices attributable to
yen a p p re c ia tio n . F oreign dem and gro w th had a
greater impact partly because the actual increase in
Japanese export prices relative to foreign prices was
3Demand growth is defined as growth in GNP plus imports minus
exports. It measures growth in a cou ntry’s demand for all dom estic
and im ported goods and services. Throughout this article, industrial
country demand and price changes are used as a proxy for
unavailable world data. This substitution may skew some of the
results. However, applying the trade elasticities discussed in the text
to industrial country data appears to explain Japanese export and
import growth reasonably well.
Chart 2
Nominal Yen Appreciation
Foreign Currency/Yen, Year Average Levels*
Index 1985=100
150 -----------------
only 9 percent despite the 47 percent nominal appre
ciation of the yen.4
This surprisingly small Japanese relative export price
rise was prim arily due to a 23 percent fall in the yen
p rice of Ja pa ne se e x p o rts .5 Som e rise in fo re ig n
wholesale prices during the period also helped support
Japan’s price competitiveness. The 23 percent fall in
Japanese yen export prices reflected two major factors.
The firs t was a sharp drop in Japanese dom estic
wholesale prices; these prices fell 8 percent between
1985 and 1988.6 The second factor was substantial
price reductions through dramatic cutting of profit mar
gins in Japan’s export sector. In fact, Japanese export
prices fell fifteen percentage points more than Japa
nese domestic wholesale prices in almost every indus
try during this period (Table 1).
The quantitative impact that world demand growth
and relative price changes had on Japanese export
volume can be roughly gauged by applying econometrically estim ated export volume elasticities to these
changes. The Japanese export volume elasticity with
respect to foreign demand is about 1.8; the Japanese
export volume elasticity with respect to relative price
changes is about -1 .1 .7 On the basis of these export
4International Financial Statistics.
5Japan’s 23 percent yen price decline offset all but thirteen
percentage points of the yen’s forty-seven percentage point nominal
appreciation. Mathematically, the yen change in export prices times
yen appreciation equals (1— 0.23) x 1.47 = 1.13.
6Domestic wholesale prices and dom estic wholesale prices for
manufactured goods only both fell 8 percent during this period.
7Export and import volume elasticities measure the percentage
changes in exports and imports that result from a 1 percent change
in foreign and dom estic demand growth or a 1 percent change in
relative prices. Volume elasticity estimates vary significantly. The
above export elasticities are the average of elasticities estim ated by
Robert Corker, “ External Adjustm ent and the Strong Yen: Recent
Table 1
Japanese Export Prices Compared with
Japanese Domestic Prices
(Cumulative Percent Change, 1985-88)
Export Prices
Source: International Monetary Fund, International
Financial Statistics.
All com m odities
Textiles
Chem icals
General machinery
Electrical machinery
Transport equipm ent
Precision instruments
- 2 1 .2
- 1 9 .0
- 3 2 .5
- 1 5 .7
- 2 9 .2
-1 5 .1
- 1 2 .3
Domestic Manufactured
Goods Prices
-8 .1
-7 .6
-1 0 .1
-2 .7
-1 5 .1
-3 .3
-1 .0
* Nominal effective exchange rate weighted by manufactured goods
trade with seventeen industrial countries.
FRBNY Quarterly Review/Autumn 1989
35
elasticities, the 11 percent rise in foreign demand sup
plied about a 20 percent boost to Japanese export vol
ume. The small 9 percent rise in Japanese prices
relative to foreign prices cut Japanese export volume
by only about 10 percent. These two factors combined
explain fairly well the continued strength of Japanese
export volume between 1985 and 1988.
The 41 percent increase in Japanese import volume
also reflected the effects of demand growth — in this
case Japanese demand — and relative price changes.
These two developments both promoted growth in
Japanese import volume. Relative price changes were
more important for imports than for exports because
they were much larger. The price of Japanese imports
fell 45 percent in yen terms between 1985 and 1988,
with about two-thirds of this fall due to the rise in the
nominal effective value of the yen.8 An approximately
40 percent fall in the dollar price of Japanese petro
leum imports also contributed significantly to the
decline in Japanese import prices. Moderate foreign
inflation did put some mild upward pressure on these
prices.
Relative to Japanese domestic prices, Japanese
import prices fell roughly 40 percent. This decline
reflects the 8 percent drop in Japanese wholesale
prices in 1985-88 that was noted earlier.9 On the import
side, foreign prices fell much more relative to Japanese
prices than was the case for the Japanese export sec
tor primarily because of the oil price factor and the
absence of significant Japanese profit cutting for
Footnote 7 continued
Japanese E xperience," IMF Staff Papers, June 1989, and William
Helkie, cited in Realignment of the Yen — Dollar Exchange Rate:
Aspects of the Adjustment Process in Japan, by Bonnie E. Loopesko
and Robert A. Johnson, International Finance Discussion Paper no.
311, Board of Governors, Federal Reserve System, August 1987. The
elasticities from these two sources were chosen because they were
relatively up-to-date. Average Japanese export volume elasticities
estim ated during the 1960s and 1970s were 2.6 with respect to
foreign dem and and — 1.4 with respect to relative price, according to
Morris Goldstein and Mohsin Khan, “ Income and Price Effects in
Foreign Trade," Handbook on International Economics, vol. 2
(Amsterdam: North Holland, 1985). Using these earlier elasticities
suggests that the com bined im pact of foreign demand growth and
relative price changes would have led to about a 15 percent growth
in Japanese export volume over the 1985-88 period. This figure is
somewhat larger than the 10 percent export volume growth
suggested by the elasticities used in the text and significantly larger
than the 5 percent actual Japanese export volume growth.
•A 47 percent increase in the value of the yen translates into about a
30 percent fall in yen import prices. Mathem atically the yen value of
im port prices now equals 1/1.47 = 0.68 of its previous value.
•That is, (1— 0.45)/(1— 0.08) = 0.60. Japanese im port prices are
com pared with Japanese wholesale prices in the text despite a
substantial difference in com m odity com position. This com parison is
made because the elasticity estim ates used in the text are based on
this relative price ratio. Japanese m anufactured goods im port prices
fell roughly 20 percent relative to Japanese dom estic m anufactured
goods prices.
36
FRBNY Quarterly Review/Autumn 1989
import-competing products.10
Elasticity analysis can again be used to evaluate the
importance of demand growth and relative price
changes in promoting imports. The Japanese import
volume elasticity with respect to Japanese demand
growth is about 1.3; the Japanese import volume elas
ticity with respect to relative price changes is about
-0 .4 .11 Japanese demand grew a cumulative 18 per
cent between 1985 and 1988. The elasticity analysis
suggests that this demand growth raised Japanese
import volume by about 25 percent. It also suggests
that the 40 percent relative fall in Japanese import
prices boosted Japanese import volume by about
15 percent.
These calculations imply that foreign demand growth
was the major force accounting for change in Japanese
export volume because the sharply falling yen price of
Japanese exports meant there was not much move
ment in relative prices despite substantial yen appre
ciation during this period. Japanese demand growth
and relative price changes both provided support to
import volume growth because, on the import side, for
eign prices did fall significantly relative to Japanese
prices. The next sections look at Japanese trade com
position, relative rates of demand growth, and the fac
tors underlying relative price changes to clarify why
this picture emerges. They also compare developments
in the determinants of U.S. and Japanese real trade
balance adjustment during appreciation to identify the
factors that enabled Japan to cope exceptionally well
with the yen’s rise.
Japanese trade composition and trade elasticities
Japanese trade composition is distinctly different from
that of most other industrialized countries, including the
United States. Japanese exports are almost entirely
10The absence of dom estic profit cutting may have helped to provide
financial support to Japanese producers who were cutting profits on
export sales.
11These elasticities are calculated by weighting the subcom ponent
elasticities for food, fuel, other raw materials, and m anufactured
goods estim ated by Corker and Helkie by their 1985 trade shares. As
presented in Goldstein and Khan, elasticities estim ated during the
1960s and 1970s averaged 1.2 with respect to Japanese demand
growth and — 1.0 with respect to relative price changes. The earlier
price elasticity estim ates were higher than the more recent ones in
part because the im port subcom ponent of fuel, which has a low
price elasticity, was a much smaller share of Japanese im ports in the
1960s and 1970s. See, for example, M.A. A khtar ("M anufacturing
Import Functions for Canada, Japan and the United States,"
Hitotsubashi Journal of Economics, vol. 22, no. 1 [June 1981]). The
average im port elasticities provided by Goldstein and Khan would
suggest that Japanese im port volume increased almost 60 percent
because of changes in dem and and relative prices. This result is
very sim ilar to the outcom e of the calculations in the next section of
this article that com pute how much faster Japanese im port volume
would have grown if Japan had had a less fuel-intensive import
com position.
manufactured goods while only about three-quarters of
industrialized country exports on average are manufac
tured products. In contrast, Japanese imports are much
more c o n c e n tra te d in raw m a te ria ls than are the
imports of other industrialized countries. Of Japanese
imports in 1985, 44 percent were fuel, 14 percent food,
15 percent other raw materials, and only 27 percent
manufactured goods. The United States may be used
as a benchmark for comparison. U.S. imports in 1985
were about 15 percent fuel, 7 percent food, 5 percent
other raw m aterials, and 73 percent m anufactured
goods.12
Japan’s unusual trade composition had a significant
impact on aggregate Japanese import prices. Because
the world price of petroleum dropped sharply in the
mid-1980s, the fall in Japan’s petroleum import price
measured in yen terms was significantly greater than
the yen price fall for other Japanese import subcompo
nents (Table 2). The unusually large share of petroleum
in Japanese imports meant that this petroleum price
fall had an inordinately large impact on overall Japa
nese import prices. In fact, if the yen price declines in
Japan’s im p ort su bcom ponents were rew eighted to
refle ct the shares of these subcom ponents in the
import composition of the United States, Japan’s import
prices would have declined only about 30 percent dur
ing 1985-88. This result contrasts significantly with the
actual 45 percent decline in Japanese import prices.13
Although Japan’s trade com position helped push
down import prices and thereby promoted a deteriora
tion in Japan’s real trade balance, its impact on Japan’s
trade elasticities more than offset this negative trade
12International Financial Statistics, Supplement on Trade Statistics,
1988. The average import com position of industrial countries in 1985
was 18 percent fuel, 10 percent food, 7 percent other raw materials,
and 65 percent manufactured goods.
13Reweighting the price subcom ponents to reflect a more normal trade
com position on Japan’s export side is difficult because Japanese
export price data for nonmanufactured goods do not exist. However,
reweighting on the export side is less im portant because Japan’s
difference in export trade com position from the industrial country
average is not that great.
Table 2
balance factor. Raw m aterial sales, p articularly fuel
sales, are generally less responsive to exchange rate
changes than are manufactured goods sales.14 Conse
quently, Japanese im port volume, heavily skewed to
raw m a te ria ls, had a s ig n ific a n tly low er e la s tic ity
response with respect to exchange rate movements
than did the import volumes of other industrial coun
tries. Japan’s export volume, in contrast, had a slightly
higher than average elasticity response to exchange
rate movements. Raw material sales are also some
what less responsive to demand growth than are man
ufactured goods sales. Therefore, Japanese im ports
again had a somewhat lower elasticity response to
Japanese demand growth than might be expected on
the basis of other countries’ experiences while Japa
nese exports had a slightly higher than average elastic
ity response.
Japanese import elasticities are significantly different
from U.S. import elasticities (Table 3).15 This difference
is explained in large part by the difference in trade
composition. The composition effect can be seen by
taking Japanese trade elasticities that have been esti
mated for the subcomponents of im p o rts — fuel, food,
other raw m aterials, and m anufactured goods — and
w eighting them according to the hypothetical im port
share they would have had if Japanese imports had
had the same composition pattern as U.S. imports. The
resulting hypothetical Japanese im port elasticities of
2.0 with respect to Japanese demand and - 0 . 7 with
respect to relative price changes are s ig n ifica n tly
closer to the U.S. import elasticities of 2.0 and -1 .1 ,
respectively, than are the actual Japanese elasticities
of 1.3 and - 0 .4 .
On the export side, a similar exercise is more difficult
because the alm ost total concentration of Japanese
exports in manufactured goods means that Japanese
subcom ponent e la sticity estim ates are not available.
The export composition of the two countries, however,
is much more alike than their import composition. Con
sequently, although the composition effect on Japan’s
export elasticities helped keep Japanese exports stron
ger than they otherwise would have been (because of
a stronger response to foreign growth), the effect was
smaller than that estimated for Japanese imports.
By co ntrast, the com position e ffe ct on Japanese
Yen Import Price Change
(Cum ulative Percent Change, 1985-88)
All imports
Energy products
Food
Other raw materials
Manufactured goods
-4 5
-6 3
-3 3
-2 5
-2 5
14Manufactured goods are more sensitive to exchange rate changes
because the country in question can generally increase its own
m anufactured goods supply more easily.
15The U.S. im p o rfvo lu m e elasticities in this table are obtained from a
regression that includes U.S. supply factors. Omitting supply factors
may raise the U.S. im port volume elasticity with respect to demand.
Nevertheless, a reweighting of the Japanese elasticities to reflect a
more average import com position would still move them closer to the
U.S. elasticities.
FRBNY Quarterly Review/Autumn 1989
37
import prices and import elasticities had a substantial
impact on Japanese trade. Applying the hypothetical
import elasticities estimated for Japan on the basis of
the U.S. import composition to Japan’s rate of demand
gro w th and to the h y p o th e tic a l Ja pa ne se re la tiv e
import price change, again based on U.S. import com
position, implies that Japanese im port volume would
have grown about fifteen percentage points faster if
Japan had not had such an unusual import com posi
tion. This hypothetical Japanese import volume growth
rate suggests that Japan’s import volume (measured in
1985 prices) would have been about $20 billion greater
than the level a c tu a lly reco rd ed in 1988. C learly,
Japan’s unusual import composition was an important
factor affecting how Japan adjusted to currency appre
c ia tio n , p a rtic u la rly in c o m p a ris o n w ith the U.S.
experience.
Demand growth
As noted above, demand growth was relatively brisk in
Japan and other industrial countries during the 1985-88
period. Japanese demand growth averaged over 51A>
p e rc e n t a n n u a lly d u rin g th is period w hile fo re ig n
dem and grow th averaged 31/2 percent. The strong
Table 3
Import Elasticity Comparison
E lasticity with
Respect to
Demand Growth
Elasticity with
Respect to
Relative Price
Changes
Actual Japanese
elasticities
1.3
-0 .4
Japanese subcom ponent
elasticities:
Fuel
Food
Other raw materials
M anufactured goods
1.0
0.5
1.1
2.4
- 0 .1
-0 .6
-0 .4
-0 .9
U.S. elasticities
2.Of
- 1 .1
H ypothetical Japanese
elasticities based
on U.S. trade
com position
2.0
-0 .7
growth in Japanese demand boosted Japanese imports
by about 25 percent w hile foreign dem and growth
raised Japanese exports by around 20 percent. This
growth differential favoring imports arose even though
Japanese e x p o rts w ere m ore s e n s itiv e to fo re ig n
dem and grow th, m easured in e la s tic ity term s, than
Japanese imports were to Japanese demand growth.
Demand growth conditions for Japanese trade during
1985-88 may be compared to demand growth condi
tions for U.S. trade during 1980-85 to see if growth
conditions unique to Japan helped support its trade
surplus. This comparison is important because a coun
try whose currency is appreciating will frequently raise
its rate of domestic demand to maintain employment
levels.16 T herefore, rapid Japanese dem and growth
does not necessarily mean that demand growth factors
were unim portant in explaining Japan’s muted trade
balance response to appreciation.
Japan did face a relatively vibrant world trade envi
ronm ent in the m id-1980s that helped to keep its
exports growing. Real foreign demand growth was on
average much stronger in the mid-1980s than in the
early 1980s. However, Japanese demand growth in the
mid-1980s was also on average considerably stronger
than early 1980s demand growth in the United States.
Cum ulative demand growth rates both at home and
abroad over the entire respective appreciation periods
for Japan and the United States were remarkably sim i
lar. (The yearly pattern of growth rates was different,
but the United States achieved the same cumulative
growth as Japan because U.S. demand grew rapidly
late in the 1980-85 period follow ing a steep early
recession.) Cumulative growth in Japanese demand in
the mid-1980s equaled 18 percent, while cum ulative
growth in U.S. demand in the early 1980s equaled 19
percent. As to foreign demand, Japan faced cumulative
foreign growth of 11 percent during 1985-88; the United
States faced cum ulative foreign growth of 9 percent
d urin g 1980-85. T hese co m p a ris o n s su g g e s t th a t
demand conditions did not leave Japan in a special
position to adjust to currency appreciation.
Relative price changes
Sources: Japanese import elasticities are averages of
estim ates in Corker, “ External A djustm ent," and Helkie, cited
in Loopesko and Johnson, Realignment. U.S. elasticities are
the w eighted com bination of oil and non-oil im port elasticities
given in William L. Helkie and Peter Hooper, “An Empirical
Analysis of the External Deficit, 1980-86,” in Ralph C. Bryant,
Gerald Holtham, and Peter Hooper, eds., External Deficits and
the Dollar (Washington, D.C.: Brookings Institution, 1988),
pp. 10-56.
fE la s tic ity with respect to U.S. income growth.
FRBNY Quarterly Review/Autumn 1989
Digitized for38
FRASER
Price changes have four basic components — nominal
exchange rate movements, changes in unit labor costs,
a djustm ents to p ro fit m argins, and changes in raw
16A country with an appreciating currency may use expansionary fiscal
policy to maintain econom ic growth. An expansionary fiscal policy is
at times an im portant element in realigning a country's savings/
investment gap. Because a cou ntry’s trade balance equals its
savings/investment gap, this realignm ent is necessary for the trade
balance to adjust. Expansionary fiscal policy, through its im pact on
demand growth, played an im portant role in bringing down Japan's
nominal and real yen trade balance.
material input prices.17 The 47 percent rise in the nom
inal effective value of the yen would have had a very
significant impact on Japan’s real trade balance had
the other three price fa cto rs rem ained unchanged.
Specifically, given the Japanese trade elasticities, the
yen’s nominal appreciation could have been expected
to lower Japanese export volume by over 50 percent
while increasing Japanese im p ort volum e by over
10 percent.
Changes in the other three price factors measured in
yen term s, however, sig n ific a n tly im proved Japan’s
price competitiveness position, notably on the export
side. In fact, because of these three price factors, the
yen rose only 9 percent on a real trade-weighted basis
calculated from changes in the export prices of Japa
nese and other industrial country manufactured goods.
A comparison of Japanese import prices with Japanese
domestic prices suggests that, as noted earlier, relative
prices on the import side changed much more sharply.
The most significant factor holding down Japanese
export prices was substantial profit cutting on Japa
nese e x p o rt s a le s . S a le s of J a p a n e s e im p o rtcompeting goods were not subject to significant profit
cutting; for manufacturing sales in general, Japanese
17Because exchange rate changes are treated separately, changes in
unit labor costs, profit margins, and raw material input prices refer to
changes measured in yen terms.
Chart 3
Japanese Manufacturing Profit Margins
Percent
6
-------------------------------------------------------C urrent Profits/S ales
1985
Source:
Note:
1986
1987
1988
Bank of Japan, Tankan, May 1989.
Data are for Japanese fiscal years, which begin in April.
profit margins in the mid-1980s stayed near their pre
appreciation levels (Chart 3).18 Export prices, however,
differed sharply from domestic sales prices. Japanese
export prices fell on average fifteen percentage points
more than Japanese dom estic wholesale prices for
manufactured goods from 1985-88. This large d iffe r
ence, which was observable in almost every industry,
may be attributed to massive cuts in export profit mar
gins. Indeed, since profits account for only a portion of
overall export price, profit margins must have been
slashed deeply to bring overall export prices down fif
teen percentage points relative to domestic prices.
In addition to export profit cutting, a decline in the
price of raw material inputs helped to lower the price of
Japanese exports and im port-com peting goods sub
stantially. Japan imports a high proportion of its raw
material inputs. When the yen appreciated, the price of
these inputs fell in yen terms. A 40 percent fall in the
world price of petroleum during 1985-88 brought Japa
nese raw material input prices down significantly fur
ther. In sum, between 1985 and 1988 Japanese raw
m aterial prices fell 40 percent, contributing substan
tially to an 8 percent fall in Japanese domestic whole
sale prices.
Changes in unit labor costs also helped to reduce
Japanese prices. Japanese unit labor costs in manu
facturing declined 4 percent between 1985 and 1988.
This fall was due to strong Japanese p ro d u ctivity
growth, which continued at the average annual 51/2 per
cent rate that it had achieved in the early 1980s. Japa
nese labor compensation actually grew at a relatively
robust rate from 1985 to 1988, averaging 4.2 percent
annually during this period. This rate was just modestly
lower than the 4.6 annual rate Japan experienced in
the 1980-85 period. Japan’s relatively strong growth in
labor compensation was important because it helped
support the rapid growth in Japanese demand d is
cussed in the previous section.
To evaluate Japan’s price competitiveness during the
years 1980-85, changes in Japanese prices must be
considered in relation to changes in foreign prices.
Unfortunately, studies comparing changes in Japanese
profit rates, the single most im portant factor holding
Japanese expo rt prices down, with changes in the
profit rates of Japan’s trade partners are not available.
However, an assessm ent of the change in Japan’s
v a lu e -a d d e d d e fla to r in m a n u fa c tu rin g re la tiv e to
changes in foreign value-added deflators is available.19
18Bank of Japan, Tankan: Short-term Economic Survey of Enterprises in
Japan, May 1989.
19Comparisons of relative changes in unit labor costs, value-added
deflators, wholesale prices, and export prices in manufacturing may
be derived from the real effective exchange rate series provided in
International Financial Statistics, various issues.
FRBNY Quarterly Review/Autumn 1989
39
Value-added deflators combine labor costs and profit
rates. A comparison of changes in unit labor costs
alone is also available. Consequently, the importance
of ch'anges in relative profit rates may be inferred from
the data after the impact of changes in relative unit
labor costs is assessed. Similarly, it is difficult to find a
comprehensive comparison of changes in Japanese
raw material prices, the second most important factor
holding Japanese overall prices down, with changes in
the raw material prices of Japan’s trade partners. But a
comparison of changes in Japanese and foreign whole
sale prices in manufacturing is available.20 Wholesale
prices are a combination of labor costs, profit rates,
and raw material prices. Consequently, after the rela
tive changes in labor costs and profit rates are
analyzed, the relative changes in raw material costs
may be inferred from the wholesale price data. The
wholesale price data analysis also* indicates how
important changes in raw material costs are to overall
manufactured goods price changes.
As noted, Japanese unit labor costs in manufacturing
fell 4 percent between 1985 and 1988. During this
period, manufacturing unit labor costs in other indus
trial countries, measured on a Japanese tradeweighted basis, rose 2 percent.21 As a result, Japan
gained 6 percent in relative labor cost competitiveness.
Now, to assess the impact of relative profit changes,
consider the change in the value-added deflators.
Japan’s value-added deflator fell 9 percent relative to
the trade-weighted value-added deflators of its major
competitors. Since Japan’s unit labor costs fell 6 per
cent relative to foreign unit labor costs, a fall in Japa
nese profit rates relative to those abroad may be taken
as responsible for the additional three percentage point
fall in Japan’s value-added deflator relative to foreign
deflators.
This value-added deflator comparison implies that
Japanese profit rates fell significantly more than 9 per
cent relative to foreign profit rates. That is, since
Japan’s labor costs fell only 6 percent relative to for
eign labor costs, Japan’s profit rates must have fallen
substantially more than 9 percent relative to rates
abroad in order for the combined impact of changes in
relative labor costs and profit rates to equal 9 percent.
Moreover, since Japanese profit rates fell only for
exports, not for domestic sales, and exports only
“ Wholesale price indexes for m anufactured goods are apt to differ
less in com position across countries than are wholesale price
indexes for raw materials.
21 Bureau of Labor Statistics, International Comparisons of
Manufacturing Productivity and Labor Cost Trends, 1988, News
Release. Other industrial countries include Canada, Denmark,
France, Germany, Italy, the Netherlands, Sweden, the United
Kingdom, and the United States.
FRBNY Quarterly Review/Autumn 1989
Digitized for40
FRASER
accounted for about 10 percent of Japanese manufac
turing output,22 the comparison on the export side is
even more dramatic. Profit cutting pulled down Japa
nese export prices about fifteen percentage points
more than falling unit labor costs alone did, as the 15
percent difference between the change in Japan’s
export prices and the change in Japan’s wholesale
prices attests. In other words, export profit rates had to
have fallen much more than 15 percent to explain the
difference between Japanese export and domestic
price levels.
Evaluating changes in relative raw material prices is
complicated by the lack of raw material price indexes
for all of Japan’s major trade partners. Nevertheless, a
Japanese trade-weighted average of the indexes for
those countries that do report raw material prices fell
10 percent between 1985 and 1988.23 In contrast,
Japanese raw material prices fell 40 percent during
this period, in large part because yen appreciation
reduced the price of raw material imports. Japan
clearly gained substantial price competitiveness from
these relative movements in raw material prices.
A more comprehensive comparison of raw material
price changes in Japan and other industrial countries
may be inferred from a comparison of changes in over
all manufacturing wholesale price indexes. Japanese
domestic wholesale prices fell 8 percent between 1985
and 1988, while the trade-weighted average of whole
sale prices for Japan’s trade partners rose 6 percent.24
The resulting fourteen percentage point difference in
wholesale price movements suggests that Japanese
raw material prices had to have fallen more than 14
percent relative to prices abroad. That is, because the
combined relative change in Japan’s labor costs, profit
margins, and raw material prices equaled 14 percent
and the combined impact of relative changes in Japan’s
labor costs and profit rates alone equaled only 9 per
cent, the fall in relative raw material prices had to be
greater than 14 percent. Alternatively viewed, sharply
falling raw material prices contributed five percentage
points to Japan’s fourteen percentage point fall in rela“ Statistics Bureau, Management and Coordination Agency, Monthly
Statistics of Japan, Japanese input/output price table.
^C o u n trie s reporting raw m aterial wholesale prices include Belgium,
Germany, Japan, the Netherlands, Switzerland, the United Kingdom,
and the United States. Other countries included in the more
com prehensive industrial country data used in this article are Austria,
Australia, Canada, Denmark, Finland, France, Iceland, Ireland, Italy,
New Zealand, Norway, Spain, and Sweden.
^D iffe re n c e s in wholesale price movements across countries may
reflect differences in the com position of wholesale price indexes.
However, petroleum products, which showed the largest price
movement in this period, had a w eight in the Japanese price index
that was about equal (under 10 percent) to its w eight in the U.S.
price index. The United States is Japan’s major trade partner.
tive wholesale prices.
Combined, the domestic price factors of profit cut
ting, declining raw material input prices, and falling unit
labor costs were im portant in keeping Japan pricecompetitive in the face of the large nominal apprecia
tion of the yen. On the e xpo rt side, these factors
explain why Japanese prices rose only 9 percent rela
tive to foreign prices despite the 47 percent nominal
rise in the yen. Given Japan’s export elasticity of -1 .1
with respect to price, the thirty-eight percentage point
difference in these two m easures boosted Japanese
export volume more than 40 percent, or $70 billion
(based on 1985 prices), beyond w hat it otherw ise
would have been. On the import side, falling raw mate
rial input prices and unit labor costs boosted the price
competitiveness of Japanese import-competing manu
factured goods by about 9 percent, offsetting some of
the increase in import volume resulting from the sharp
fall in import prices. Given Japan’s import volume elas
ticity of - 0 . 4 with respect to price, these two factors
cut Japanese import volume more than 5 percent, or
about $10 billion, from what it otherwise would have
been.
Since all countries try to hold domestic costs down
as their currencies appreciate, it is instructive to com
pare the price developments in Japan and the United
States during yen and dollar appreciation, respectively.
Such an analysis helps identify which price factors
gave Japan an exceptional ability to maintain a strong
trade performance. Although profit cutting, falling raw
material prices, and declining unit labor costs were all
im portant in explaining the evolution of Japan’s real
trade balance during the period of yen appreciation, a
comparison with the earlier U.S. appreciation experi
ence suggests that Japan’s falling raw material prices
were the most important determinant of the difference
in the two countries’ trade performances. In fact, Japan
and the United States experienced remarkably similar
changes in relative unit labor costs and profit cutting
during their respective episodes of currency apprecia
tion while raw material price developments were very
different.
Consider profit developments first. U.S. export prices
fell about ten percentage points relative to U.S. whole
sale prices during the 1980-85 period (Table 4). This
price fall was not spread as evenly across sectors as
the Japanese e xpo rt price fall relative to dom estic
prices of fifteen percentage points. In particular, in the
automobile sector, where U.S. exports are prim arily
intra-firm trade across the Canadian border, export
prices actually rose relative to domestic prices. Nev
ertheless, on average, profit cutting in the U.S. export
sector appears to have been significant.
Moreover, for U.S. m anufacturing in general, profit
rates were significantly lower in 1985 than they had
been in 1980 (C hart 4). The recession in the early
1980s initially brought U.S. profit rates down, but even
when the U.S. economy was growing at a brisk pace in
1984 and 1985, trade pressure arising from dollar
appreciation held profit rates to a relatively low level.
Indeed, since the United States started its appreciation
period with imports larger than exports, the fact that
U.S. profit rates were down in both export and domes
tic import-com peting industries meant that profit cutting
may have had an even bigger impact on the U.S. trade
balance than it did on the Japanese trade balance. The
Chart 4
U.S. Manufacturing Profit Margins
Percent
6 ------------------------------------------------Pretax P rofits/M anufacturing Shipm ents
Table 4
U.S. Export Prices Compared with
U.S. Domestic Prices
(Cumulative Percent Change, 1980-85)
All com m odities
Food, feed, beverages
Industrial supplies
Capital goods
Autom obiles and parts
Consumer goods
Export
P ricesf
Domestic
Producers’ Prices
5
-1 2
-4
14
34
5
15
-9
14
25
28
19
3 -
2-
1
-
tF ixed -w eight export price indexes from the U.S. National
Income and Product Accounts.
1980
1981
1982
1983
1984
1985
FRBNY Quarterly Review/Autumn 1989
41
greater fall in the U.S. relative value-added deflator for
m anufacturing relative to the fall in the Japanese
value-added deflator shows the importance of acrossthe-board profit cutting for the U.S. trade balance.
Before drawing profit implications from the change in
the U.S. value-added deflator, however, it is necessary
to examine changes in unit labor costs. U.S. unit labor
costs fell 6 percent relative to the U.S. trade-weighted
average of foreign unit labor costs during 1980-85.25
This fall is actually identical to the fall in Japanese rel
ative unit labor costs during 1985-88. Consequently,
differences in relative unit labor cost developments do
not explain why the Japanese and U.S. real trade bal
ances moved so differently in response to appreciation
nor why the Japanese and U.S. relative value-added
deflators fell to a different extent.
The U.S. value-added deflator in manufacturing fell
11 percent relative to the deflators of U.S. trade part
ners during 1980-85. This fall was greater than the
9 p ercen t relative fall in the Japanese value-added
deflator. Since Japanese and U.S. unit labor costs
moved similarly, the greater fall in the U.S. relative
25Bureau of Labor Statistics.
Chart 5
Cumulative Change in Raw Material
Input Prices
Percent
value-added deflator implies more extensive U.S. profit
cutting during dollar appreciation than Japanese profit
cutting during yen appreciation. Consequently, profit
cutting does not appear to explain the large difference
in Japanese and U.S. trade balance changes.
In contrast, relative changes in raw material prices
do emerge as an important determinant of the differ
ence in trade balance adjustm ent. A com parison of
Japanese and U.S. relative raw material price move
ments reveals a significant difference in price changes
in the two countries. Evidence from co u n trie s that
rep ort raw m aterial w holesale prices suggests that
while Japanese raw material prices were down 30 per
cent relative to those of Japan’s trade partners during
yen appreciation, U.S. raw material prices were only
down about 15 percent relative to those of U.S. trade
partners during dollar appreciation (C hart 5).26 This
substantial discrepancy may be traced to the fact that
the United States is a large raw m aterials producer
while Japan is not. Since U.S. raw m aterial prices
reflect to a large degree U.S. domestic prices, they did
not change very much in dollar terms during the period
of dollar appreciation. Because Japan imports a large pro
portion of its raw materials, its raw material prices primarily
reflect import prices. Therefore, when the yen rose, Japa
nese raw material prices fell sharply in yen terms.
The impact of differences in relative raw material
price changes can be seen by comparing changes in
Japanese and U.S. relative wholesale prices. As noted,
Japanese wholesale prices fell 14 percent relative to
the wholesale prices of Japan’s trade partners during
yen appreciation. U.S. wholesale prices fell only 7 per
cent relative to the wholesale prices of U.S. trade part
ners during dollar depreciation. Since unit labor cost
developments were the same for both countries and
U.S. profit rates actually fell more than Japanese profit
rates, the greater fall in Japanese wholesale prices is
directly attributable to the much sharper fall in Japa
nese raw m aterial input prices. M ovem ents in raw
material input prices thus gave Japan a unique advan
tage in adjusting to currency appreciation.
Other p ote ntial fa cto rs a ffecting Japanese real
trade balance adjustment
Three other possible factors have received consider
able attention as sources of Japan’s strong trade per
formance. Some observers have attributed this strong
perform ance to an exceptionally competitive Japanese
business ability. Others have pointed to a world investJapan
1985-88
42
Japanese
trade
partners
1985-88
United States U.S.
1980-85
trade
partners
1980-85
FRBNY Quarterly Review/Autumn 1989
26Canada is a major U.S. trade partner that does not report raw
material wholesale prices. Since Canadian prices move relatively
closely with U.S. prices, however, the measured fall in U.S. raw
material prices relative to those abroad would have been smaller if
Canadian prices were included in the comparison.
ment boom that has supported Japanese capital goods
exports, and still others to an upsurge in demand for
Japanese exports to service rapidly growing Japanese
overseas direct investment. The analysis in this article
suggests that none of these factors was of major signif
icance in keeping Japan’s trade surplus high.
The foregoing analysis of factors underlying differ
ences in Japanese and U.S. trade balance adjustment
implies that business ability distinctions do not explain
the variation in the Japanese and U.S. experiences.
Abstracting from the starting balance effect, the prime
e con om ic fa c to rs behind the ve ry large d is p a rity
between Japanese and U.S. adjustm ent to currency
appreciation appear to be differences in the two coun
tries’ import elasticities and the trade balance boost
Japan received from fa llin g im ported raw m aterial
prices. The import elasticity differences also reflect the
distinctive role raw materials played in Japanese trade.
Adding the effect of different starting trade balances to
the estimated quantitative impact of these raw material
factors more than accounts for the difference in the
response of the Japanese and U.S. trade balances to
currency appreciation, as Table 5 reveals.
For this table, the impact of different starting trade
balances is calculated by measuring how the disparity
between the real Japanese and the real U.S. trade bal
ance adjustments differs from the disparity that would
have arisen if the c o u n trie s ’ respective e xpo rt and
import volumes had grown at actual rates but from a
balanced trade position. In this balanced position,
exports and imports are set equal to the numeric aver
age of actual 1985 Japanese exports and im ports.27
The e la sticity e ffe ct listed in the table shows the
change that would have occurred in Japanese trade if
Japanese import volume had responded in the manner
suggested by a combination of Japan’s import subcom
ponent elasticities, weighted to reflect the composition
of U.S. trad e. T his c a lc u la tio n also in vo lve s the
reweighting of Japanese import prices to reflect how
they would have moved in aggregate if Japan’s import
composition equaled that of the United States. The raw
material price effect in the table is derived by comput
ing how the actual growth in Japanese export and
import volumes differs from the growth that would have
taken place (based on Japan’s export and import vol
ume e la sticitie s) had fa llin g Japanese raw m aterial
input prices had the same limited impact on Japanese
relative wholesale prices as more m oderately falling
U.S. raw m aterial input prices had on U.S. relative
wholesale prices. These hypothetical Japanese export
and im p o r t c h a n g e s a re n e tte d to g e th e r . T he
27By starting the exercise with identical export and import levels, this
analysis also adjusts for the difference in the two countries’ overall
trade size.
importance of these calculations attributing the differ
ence in Japanese and U.S. trade balance adjustment
solely to the effects of different starting balances and
raw materials trade lies in what they exclude. Specifi
cally, the calculations suggest that the trade balance
adjustm ent disparity between Japan and the United
States had relatively little to do with different business
strategies or abilities to compete.28
As for the arguments concerning a world investment
boom and Japanese overseas direct investm ent, the
earlier analysis explains Japanese export growth rea
sonably well as the outcome of other factors already
discussed, namely, foreign demand growth and relative
price changes. In fact, actual Japanese export growth
was slightly slower than a com bination of the lastnamed factors suggested. Consequently, there does
not appear to be strong evidence that a major world
investment boom led to a tem porary surge in Japan’s
28This conclusion does not mean that Japanese and U.S. producers
followed identical business practices. Nevertheless, Japanese
practices generally cited as having a positive effect on Japanese
com petitiveness (such as strict attention to quality control) appear to
have offset practices generally viewed as having a negative effect on
Japanese com petitiveness (such as relatively inflexible supply
relationships) to the same extent positive practices offset negative
practices in the United States.
Table 5
Comparison of Japanese and U.S. Real
Trade Balance Adjustment to Currency
Appreciation
(Billions of Dollars)
Japanese real trade balance change, 1985-88
U.S. real trade balance change, 198 0 -8 5
Difference between Japanese and U.S.
real trade balance changes
Difference due to:
Starting base effect
Trade com position effect on
im port prices and elasticities
Net raw material price effect on exports and imports
Residual
-4 0
-1 4 5
+ 105
+ 70
+ 20
+ 25
-1 0
Note: These numbers are based on calculations de scribed in
the text. The numbers have been rounded to the nearest
$5 billion since it is im possible to estimate them exactly. In
particular, the last four numbers listed depend on estimated
Japanese trade elasticities. C hanges in these elasticities
could significantly affect the results. Moreover, the last four
numbers depend on a com parison of price indexes across
countries. Differences in index com position or method of
calculation could affect the results. Japan's real trade balance
change is com puted by applying export and im port volume
growth rates to Japan’s nominal 1985 trade levels. The U.S.
change is com puted by applying volume growth rates to
nominal 1980 trade levels. Footnote 1 of the text considers the
im plications of this methodology.
FRBNY Quarterly Review/Autumn 1989
43
capital goods exports. Nor does it appear that Japan’s
exports were substantially increased by sales to Japa
nese subsidiaries abroad.
This reasoning is not meant to imply that world and
overseas Japanese investm ent were unim portant for
Japanese exports. Rather, it suggests that these two
factors did not play exceptional roles that could explain
Japan’s strong trade performance. Foreign investment
does not appear to have offered Japan a unique export
environment in the mid-1980s. Cumulative gross fixed
nonresidential investment in industrial countries other
than Japan grew about the same between 1985 and
1988 as did cum ulative gross fixed nonre side ntia l
investment in industrial countries other than the United
States between 1980 and 1985. Like Japan, the United
States was a major capital goods exporter that bene
fited from this earlier foreign investment growth. That
overseas investment does not emerge as a unique ele
ment in Japanese export growth between 1985 and
1988 may be due to the fact that this investm ent
became really large only at the end of this period
(Table 6). Consequently, the impact of this investment
on Japanese exports is likely to be more fully felt in
1989 and beyond.
Adjustment of the Japanese nominal trade balance
Between 1985 and 1988, the nominal Japanese trade
balance rose $39 billion, from a surplus of $56 billion
to a surplus of $95 billion. This rise reflects a dollar
translation effect, a starting base effect, and price
movements applied to the export and import volume
growth rates already discussed.
The dollar translation effect is the dollar rise that
results when Japan’s nominal trade balance measured
in yen is converted into depreciated dollars.29 When
measured in yen, the Japanese trade surplus did not
grow between 1985 and 1988; it actually shrank by
¥ 974 billion (or $8 billion converted at the 1988 dollar/
yen exchange rate). But because the dollar value of the
yen increased by 86 percent, the measured dollar level
of Japan’s surplus rose despite this fall in yen terms.
The starting base effect for Japan’s nominal trade
b alan ce is a n a lo g o u s to the s ta rtin g base e ffe c t
already examined for Japan’s real trade balance. The
nominal starting base effect can be measured jointly
with the dollar translation effect just discussed. This
c a lc u la tio n co m p ares the actual d o lla r -change in
29lt is im portant to distinguish how Japan's nominal trade balance
moved in yen terms from how it moved in dollar terms. The yen
change reflects a more fundam ental adjustm ent for Japan because
Japanese labor must be paid in yen and Japanese profits are
gauged dom estically in yen terms. Moreover, Japanese savings and
investment, and the gap between savings and investment that
constitutes Japan's current account deficit, are econom ically
determ ined in Japan's yen-based economy.
44 forFRBNY
Digitized
FRASER Quarterly Review/Autumn 1989
Japan’s trade surplus with the change that would have
occurred if Japan had started with balanced trade and
if the nominal dollar levels of exports and imports had
grown at their actual nominal yen growth rates. The
hypothetical starting base used for this procedure is
again derived by setting Japanese exports and imports
equal to the average of their 1985 actual levels. This
exercise suggests that Japan’s large trade surplus at
the start of its appreciation period, combined with the
effect of translating the Japanese surplus into depreci
ated dollars, raised Japan’s nominal 1988 trade bal
ance by $33 billion above what it otherwise would have
been.
These dollar translation and starting base effects are
thus clearly very important in explaining Japan’s nomi
nal trade strength. Even after these effects are taken
into account, however, Japan’s nominal trade balance
would still have remained very high during the 1985-88
period despite the 47 percent nominal effective appre
ciation of the yen. To determine what lay behind this
underlying nominal trade strength, it is instructive to
consider each of the factors already discussed in the
real trade balance analysis.
The first factor is trade composition and its impact on
im port price and im port elasticities. Japan’s unusual
trade composition has been estimated to have reduced
Japanese import volume by about 15 percent. To this
volume effect must now be added the com position
effect on im port price in order to calculate the overall
effect of import composition on Japan’s nominal trade
balance. As already estimated, the composition effect
lowered Japanese import prices by about fifteen per
centage points from what they would have been if
Japan had had a more normal import composition. The
combined 30 percent price and volume reduction in
imports attributable to Japan’s unusual import com po
sition cut Japanese nominal import payments (or raised
the Japanese nominal trade balance) by about $35
Table 6
Japanese Foreign Direct Investment
in Manufacturing
(Billions of Dollars)
1985
1986
1987
1988 estimate
2
4
8
15
Source: Bank of Japan, Balance of Payments Adjustm ent in
Japan: Recent Developments and P rospects, Special Paper
no. 178, May 1989. The estim ate for 1988 is based on the
number for the first half of 1988 listed in the source. Data are
for Japanese fiscal years, which begin in April.
billion.30
Profit cutting also had a major impact on Japan’s real
trade balance, specifically on the export side. Its
impact on Japan’s nominal trade balance, however,
appears to have been significantly smaller. Profit cut
ting reduced the yen payment received on each export
sale. This payment reduction per sales unit offset a sig
nificant proportion of the export volume gain attributa
ble to profit cutting. Indeed, the export volume
elasticity with respect to relative price changes of -1.1
discussed earlier implies that almost all of the volume
gain was offset by the yen price fall attributable to
profit cutting, leaving only a small positive impact on
Japan’s nominal export level.31
Unit labor cost developments also boosted Japan’s
real trade balance. Again, however, the impact on
Japan’s nominal trade balance was relatively small. On
the export side, Japan translated its falling unit labor
costs into a reduction in the yen price of its products.
While the volume of exports rose because of this price
reduction, the yen payment per unit exported fell. This
fall in per unit payment offset most of the volume gain,
just as it did in the case of profit cutting. The nominal
level of Japanese exports increased only modestly. On
the import side, in contrast, Japanese unit labor cost
developments had no direct impact on Japanese import
prices. Therefore, the reduction in import volume
resulting from falling Japanese unit labor costs relative
to those abroad was not offset by any import price
changes. However, the reduction in import volume from
falling relative unit labor costs was actually only on the
order of $5 billion. The decrease was small because
Japanese import demand is quite unresponsive to rela
tive price changes. (It has only an estimated -0 .4
im port volume e la s ticity with respect to these
changes.) Consequently, falling Japanese unit labor
costs do not appear to explain a substantial part of
Japan’s strong nominal trade performance.
Falling raw material input prices were the third price
factor providing support to Japan’s real trade balance
performance. The impact of this factor on Japan’s nom
inal trade balance was also substantial. Its significance
is in distinct contrast to the small nominal impact of
Japanese profit cutting and declining Japanese unit
labor costs. Falling raw material prices did lower Japa
nese export prices, as did profit cutting and declining
labor costs. But falling raw material prices also
reflected falling Japanese import prices whereas the
other two factors did not. In fact, because the
appreciation-induced fall in the yen price of imported
raw materials accounted for the overall fall in Japanese
raw material costs relative to those of foreign competi
tors, the negative effect of falling export prices on
Japan’s nominal trade balance was just about matched
by the positive effect of falling import prices. Conse
quently, with a positive export volume effect and offset
ting export and import price effects, Japan’s nominal
trade balance clearly benefited from falling raw mate
rial prices.32 On the basis of the magnitude of the raw
material price fall and Japan’s trade elasticities, this
benefit equaled about $20 billion in 1988 prices.
Falling raw material prices had one other important
effect on Japan’s nominal import level aside from the
gain in the price competitiveness of Japan’s manufac
tured goods. The sharply falling price of petroleum
imports lowered the cost of Japanese home heating oil
and gasoline as well as the cost of petroleum used as
a manufacturing input. Japanese petroleum import
prices declined about forty percentage points more
than other Japanese import prices because of the fal
ling world price of petroleum during 1985-88. Japanese
petroleum imports not going into manufacturing pro
duction were roughly $35 billion in 1985.33 A 40 per
cent savings on this import level would equal about $15
billion. This import savings from the world petroleum
price fall was separate from, but simultaneous with, the
adjustment that occurred in Japan’s nominal trade bal
ance in response to yen appreciation. Japan’s large
petroleum savings, therefore, contributed significantly
to the strong performance of Japan’s nominal trade
balance.
Demand growth, a world investment boom, and Japa
nese overseas direct investment did not have an
unusual effect on Japan’s real trade balance. This con
clusion holds for Japan’s nominal trade balance as
well, and the reasons are the same as those cited in
the real balance analysis. To determine if Japanese
business acumen played a role, the factors underlying
Japanese nominal trade adjustment can be compared
with those underlying U.S. nominal trade adjustment,
just as the factors determining the real trade perform
ances of the two countries were compared. The results
^ T h is calculation and those that follow in this section abstract from
the dollar translation im pact to avoid double counting. In other
words, the $35 billion estim ate measures the m agnitude of the trade
com position im pact in the absence of any dollar translation effect.
32This argum ent is a more general version of the case in which an
entrepot economy im ports products solely for the purpose of re
exporting them. The entrepot econom y’s trade balance is relatively
immune to changes in its exchange rate.
31Japanese export volume elasticities with respect to relative price
estimated in the 1960s and 1970s averaged — 1.4. These elasticities
would suggest that the negative price effect of profit cutting offset
about 70 percent of the positive volume effect of profit cutting.
“ Bank of Japan, Economics Statistical Annual 1988, Japanese input/
output table. Because Japanese petroleum import volume is very
unresponsive to changes in price, the $15 billion savings calculated
above did not show up in the earlier real trade balance analysis.
FRBNY Quarterly Review/Autumn 1989
45
of the nominal comparison are shown in Table 7. For
this table, the dollar translation and starting base effect
are calculated by computing how the nominal Japanese
and U.S. trade balances would have adjusted if they
had both started with identical balanced export and
import levels and each country had followed its actual
domestic currency nominal export and import growth
rates. The difference between the actual trade balance
results and these hypothetical results accounts for $75
billion of the difference in Japanese and U.S. nominal
trade balance adjustment. The trade composition effect
is calculated as described above. The raw material
price effect is based on the difference that would have
occurred in Japan’s nominal trade balance if Japanese
relative raw material prices had moved the same as
U.S. relative raw material prices. The heating oil and
gasoline price effect equals $10 billion rather than the
$15 billion Japanese savings calculated above because
U.S. petroleum im port prices also fell somewhat during
1980-85.34 The negative residual in this table suggests
that the factors listed more than account for the differ
ence in Japanese and U.S. nom inal trade balance
adjustment to currency appreciation. Consequently, as
the analysis of the real trade balance suggested ear
lier, differences in business ability or business strate34There is some double accounting of the oil price effect with the
trade com position effect. The trade com position effect includes the
im pact of o il’s large im port share. If the oil share were not so large,
the falling oil price effect would be less.
Table 7
Comparison of Japanese and U.S. Nominal
Trade Balance Adjustment to Currency
Appreciation
(Billions of Dollars)
Japanese nominal trade balance change, 1985-88
U.S. nominal trade balance change, 1980-85
D ifference between Japanese and U.S.
nominal trade balance changes
D ifference due to:
Dollar translation and starting base effects
Trade com position effect on
im port prices and elasticities
Net raw material price effect on exports and im ports
Decline in price of heating oil and gasoline
Residua)
+39
-9 6
+135
+75
+35
+20
+10
- 5
Note: These numbers are based on calculations described in
the text. The numbers have been rounded to the nearest
$5 billion since it is im possible to estim ate them exactly. In
particular, several of the num bers listed depend on estim ated
Japanese trade elasticities. Changes in these elasticities
could significantly affect the results. Similarly, some numbers
depend on a com parison of price indexes across countries.
Differences in index com position or method of calculation
could affect the results.
46for FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized
gies do not explain Japan’s nom inal trade balance
strength.
Recent Japanese trade behavior
Japan’s trade surplus fell significantly in the middle of
1989 after rising sharply early in the year. Japan’s
second-quarter and third-quarter 1989 annualized sur
pluses, averaging $72 billion, were substantially lower
than its 1988 trade surplus of $95 billion. Exchange
rate c h a n g e s , raw m a te ria ls p ric e s , and re la tiv e
demand growth explain these recent developments in
Japan’s trade balance fairly well.
There were some notable exchange rate and oil price
changes in the spring of 1989. The yen depreciated
3 percent in the second quarter from its 1988 average
level and 5 percent from its first-quarter 1989 level. It
fell another 3 percent in the third quarter. Although the
gain in price competitiveness from depreciation should
raise Japan’s trade surplus over time, the initial impact
of the 1989 depreciation was to lower the dollar value
of Japan’s trade surplus through the dollar translation
effect (which in this case worked in reverse). Dollar
petroleum prices also rose about 15 percent in the
spring of 1989 from their average 1988 and first-quarter
1989 le v e ls , fu rth e r lo w e rin g J a p a n ’s 1989 tra d e
surplus.
Another im portant factor behind the recent turndown
in Japan’s trade surplus was Japan’s relatively rapid
demand growth during 1989. Japanese demand grew at
an average annual rate of over 5 percent in the first
half of 1989 (growth was concentrated in the first quar
ter but demand growth had some lagged effect on
im ports) while demand in other industrial countries
grew at only about half that rate. Japan’s export and
import trade volume elasticities with respect to demand
growth suggest that this divergent demand growth per
formance by itself led to Japanese import growth about
50 percent faster than Japanese export growth. Since
Ja p a n e s e im p o rts w ere 64 p e rc e n t of J a p a n e s e
exports in 1988, a 50 percent growth differential was
necessary to keep the Japanese trade surplus from ris
ing. Demand grow th that was much more rapid in
Japan than in other countries achieved this result and
thereby allowed the 1989 price changes to actually
push the Japanese trade balance down.
Conclusion
This analysis of Japan’s trade balance adjustment to
yen appreciation suggests that the rise in Japan’s trade
surplus from 1985 to 1988, measured in either real or
nominal dollar terms, can be explained in a relatively
s tra ig h tfo rw a rd manner. A su bsta ntia l s ta rtin g base
trade surplus in 1985 accounts for a significant part of
the rise in Japan’s trade balance. In addition, the com
modity structure of Japan’s trade, with imports domi
nated by raw materials and exports consisting almost
exclusively of manufactured goods, had a substantial
favorable effect on Japan’s trade balance. Japan’s real
trade balance was further supported by the profit cut
ting measures of Japan’s export industries, although
profit cutting had a much smaller effect on Japan’s
nominal trade balance. The statistical effect from trans
lating a yen balance into depreciated dollars, combined
with substantial import savings from the falling world
price of petroleum during 1985-88, boosted Japan’s
nominal trade balance but had little effect on Japan’s
real trade balance. Apart from these factors, Japanese
exports and imports appear to have responded fairly
conventionally to changes in relative price and demand
growth at home and abroad.
A corollary of these findings is that the impressive
strength of Japan’s trade surplus in the mid-1980s does
not appear to stem from any unique Japanese business
strategy or ability to compete. Nor does it appear to be
directly related to temporary factors such as a world
investment boom or Japanese sales to overseas sub
sidiaries. Consequently, measures taken to address
these other factors, although they may influence
Japan’s trade balance, are not likely to affect the mac
roeconomic conditions behind Japan’s trade strength.
Looking to the future, although longer term factors
such as shifting international supply conditions,
changes in trade policies, and shifts in demand prefer
ences may affect Japan’s trade position, they probably
will not by themselves be enough to offset the trade
gains Japan realized from declining imported' raw
material prices over the past few years. Consequently,
if its trade surplus is to decline substantially, Japan will
likely have to continue to grow much more rapidly than
its trade partners, or relative prices may have to
change further to reduce the competitiveness of Japa
nese goods.
One encouraging development is that Japan’s trade
balance will probably respond more strongly now to
both Japanese demand growth and changes in the
value of the yen than was the case in 1985. After the
sharp profit cutting of the last two years, Japanese
manufacturers currently have considerably less room to
cut profit margins on export sales. Even more impor
tant perhaps, Japanese imports are a higher percent
age of exports in 1989 than they were on average
between 1985 and 1988. Therefore, every percentage
point increase in the growth rate of imports relative to
exports will have a larger effect on Japan’s trade bal
ance now than it did over the past few years. Moreover,
manufactured goods imports are a higher percentage
of total imports than was the case in the past. Conse
quently, import growth should now be more responsive
to changes in demand and relative prices.
Susan Hickok
FRBNY Quarterly Review/Autumn 1989
47
The Effectiveness of Tax
Amnesty Programs in Selected
Countries
Tax evasion presents a serious problem for a variety of
countries. Every year, governments lose large amounts
of potential revenue because many citizens, in some
manner, avoid paying taxes, in Italy, for example, some
estimates place tax evasion as high as 20 percent of
gross domestic product each year.1 Estimates of the
amount of unpaid taxes in the United States range as
high as $100 billion yearly.2 The problem of tax evasion
is especially serious in less developed countries
(LDCs), where large percentages of the population fail
to pay taxes fully.
To address the problem of tax evasion, many coun
tries have implemented tax amnesty programs over the
years. In this decade alone, Argentina, Australia, Bel
gium, Colombia, Ecuador, France, Honduras, India, Ire
land, Italy, Panama, the Philippines, and the United
States have all implemented some form of tax
amnesty.3 In addition, Denmark, Mexico, the Nether
lands, Norway, Peru, Sweden, and West Germany
have, or have had at one time in the 1980s, standing
tax amnesty programs reducing or abolishing penalties
1John Wyles, “ The Taxing Problem Italy Faces,” Financial Times,
August 7, 1989, p. 15.
2Herman Leonard and Richard Zeckhauser, “Amnesty, Enforcement
and Tax Policy," National Bureau of Economic Research, Working
Paper Series, no. 2096, 1986, p. 2.
3The United States has never had a federal tax amnesty program , but
the following states have im plem ented tax amnesties: Alabama,
Arizona, California, Colorado, Idaho, Illinois, Kansas, Louisiana,
Massachusetts, Minnesota, Missouri, New Mexico, New York, North
Dakota, Oklahoma, South Carolina, Texas, and Wisconsin. See U.S.
Departm ent of the Treasury, Internal Revenue Service, “ Study of Tax
Amnesty Programs,” August 1987.
48 forFRBNY
Digitized
FRASERQuarterly Review/Autumn 1989
for delinquent taxpayers who voluntarily disclose past
errors or omissions. The specific provisions of the pro
grams have differed greatly; the length of time the
amnesties are effective, the types of taxes eligible for
the amnesty, and the types of penalties absolved vary
across countries. Nevertheless, most amnesty pro
grams share a common feature — a grace period during
which delinquent taxpayers can correct prior infractions
of the tax law without incurring penalties normally
associated with tax delinquency.
Governments implement tax amnesties to raise reve
nues from three main sources. The first source is the
large amount of revenue in the domestic economy that
goes unreported because it is circulating in the under
ground economy. Tax amnesties are designed not only
to increase current tax revenue but also to reduce per
manently the amount of economic activity occurring in
the underground economy, thereby increasing future
tax revenues as well. The second source of potential
revenue is flight capital. Governments use amnesties
as an inducement for citizens to repatriate sums of
money, often very large, that have been illegally trans
ported abroad. A substantial amount of potential tax
revenue is lost yearly, especially in LDCs, because of
flight capital. According to one set of estimates, for
example, the compounded value of flight capital assets
held abroad from 1977 to 1987 amounted to $84 billion
for Mexico, $58 billion for Venezuela, $46 billion for
Argentina, and $31 billion for Brazil.4 The third and final
source of potential revenue is the payment of back
4"LDC Debt Reduction: A C ritical A p p ra isa l,” World Financial Markets,
Morgan Guaranty Trust Company, D ecem ber 30, 1988, p. 9.
taxes by those who inadvertently underpaid taxes but
never reported this mistake because of the penalties
associated with tax evasion. Tax amnesties encourage
full repayment by eliminating or lessening such penalties.
This article examines the benefits and costs of tax
amnesty programs. It analyzes programs enacted in six
countries in the 1980s, giving particular consideration
to those features that appear to have contributed most
to program success. The analysis suggests that tax
amnesties are successful only if they are perceived as
onetime opportunities to redress tax violations. In addi
tion, the evidence gathered here shows that the effec
tiveness of the programs is enhanced if they are
accompanied by stricter tax enforcement or changes in
tax rates.
Benefits
A number of benefits may be derived from tax amnesty
programs. The most evident potential benefit is a wind
fall revenue gain that accrues to the government from
the collection of past debts. Some governments have
collected substantial sums of back taxes that have
helped reduce the treasury’s borrowing requirements.
Programs have also proved successful in collecting
money from both the underground domestic economy
and capital held abroad.
A further benefit is that amnesty programs can
increase the tax base and thereby improve future tax
collections. Governments implement the programs hop
ing both to enlarge the base of registered taxpayers
and to increase the amount of reported economic activ
ity. A well-regulated tax amnesty program can ensure
that those individuals who utilize the amnesty are not
only added to the list of taxpayers but also carefully
audited in the future. Amnesties can therefore de
crease the need to raise taxes in the future because of
the expanded tax base. Consequently, regular tax
payers can also benefit from tax amnesties as non
payers are brought into the fold.
An additional advantage of these programs is that
they can ease the transition to a new tax enforcement
regime. A government that desires to strengthen its tax
collection mechanism can couple this enhanced enforce
ment with a tax amnesty. This coupling allows those
taxpayers who were unwilling to acknowledge past
underpayments to come forward without fear of penal
ties before the new collection regime is introduced.
Costs
The benefits of tax amnesty programs must be
weighed against a number of potential costs. First, the
programs can have undesirable incentive effects if they
are implemented frequently. Citizens may come to
expect their governments to offer periodic tax amnes
ties. These expectations can decrease the incentive to
pay taxes routinely and lead eventually to an increase
in the number of tax evaders. Moreover, if amnesties
make evasion seem forgivable, they may reduce volun
tary compliance over the long run, causing serious
financial consequences for the governments.
Amnesties may also have the effect of penalizing
regular taxpayers. Some of the amnesties have offered
better returns on assets to those who have evaded
taxes than to those who have routinely paid. Most
amnesties, however, seem simply to have rewarded
errant taxpayers by absolving them of penalties on
unpaid taxes.
A further cost of a tax amnesty is that it can be inter
preted as a sign of the government’s inability to
enforce its tax laws. Consequently, an amnesty carries
the potential of reducing the credibility of the govern
ment instituting the amnesty.
By providing a windfall gain in revenue, tax amnes
ties may also enable governments to ignore structural
problems in the economy. For example, a government
receiving such a windfall may be less inclined to reex
amine burdensome regulations and poor economic pol
icies that often are the root causes of the tax evasion.
Were governments to concentrate on correcting these
structural inefficiencies, they would encourage more
activity to take place in the legal economy, thereby
increasing the overall tax base.
Requirements for a successful program
The performance of the programs examined in this
study strongly suggests that a tax amnesty can be suc
cessful only if it is perceived as a unique event. Many
countries offering tax amnesties on a repeated basis
have met with little or no success after the initial pro
gram. The reason is fairly simple. If the citizens of a
country expect there to be more than one amnesty,
they have little or no incentive to report or redress an
offense immediately. In fact, because they expect a
future amnesty, they have an incentive not to pay cur
rent taxes. Only if individuals see the amnesty as their
single opportunity to redress past offenses is the pro
gram likely to be effective. Thus, in deciding whether to
participate in the amnesty, these individuals are likely
to be guided by the government’s announcements
about future policy. Repeated tax amnesties not only
remove the incentive for reporting overdue taxes, but
also in many cases increase the frequency of tax
evasion.
Evidence to date also suggests that amnesties, to be
successful, require adjustments in other areas of the
tax system. Most notably, the effectiveness of an
amnesty program is likely to improve markedly if the
existing enforcement mechanisms are strengthened.
FRBNY Quarterly Review/Autumn 1989
49
An amnesty alone may not be sufficient to induce
delinquent taxpayers to declare heretofore unreported
income. They may come forward, however, if the
amnesty is accompanied by the increased likelihood of
detection. The public must therefore be convinced that
tax evasion successfully practiced before the amnesty
will no longer be possible once the amnesty is in place.
The enhanced enforcement mechanisms may not only
increase participation in the amnesty but also reassure
regular taxpayers of the government’s resolve to appre
hend future tax offenders.5
Because tax evasion is often the result of high tax
rates and poor economic policies, amnesties have also
proved more successful when they have been part of
an overall package of tax changes. For example, Col
ombia reduced its tax rates at the same time as it
announced a tax amnesty, while the Philippines
increased allowable exemptions. In the long run, how
ever, the success of tax amnesties depends impor
tantly upon the government’s willingness to undertake
structural changes. The experience of countries that
have implemented tax amnesties to date indicates that
an amnesty can lead to revenue gains, but the country
must address the more fundamental economic prob
lems of the economy that may have encouraged tax
evasion in the first place.
Finally, the effectiveness of a tax amnesty program
may be influenced by the type of government in power
or likely to take power. Tax amnesties often fail not on
the merits of the program but as a result of political
factors. For example, citizens may refrain from partici
pating in an amnesty program if they believe that the
current government or one likely to be elected will not
abide by the amnesty or will adopt economic measures
greatly reducing the value of the newly reported
income. In fact, some amnesty programs have become
highly politicized. For example, the socialist parties in
France in 1986 and Belgium in 1985 repudiated
recently passed tax amnesties in their election plat
forms because they were convinced that the amnesties
would almost solely benefit the wealthy.
The following sections examine tax amnesty pro
grams enacted by six countries in the 1980s. The dis
cussion underscores the variation in program design
and explores the reasons for the programs’ differing
success rates.
Ireland
By most accounts, the Irish government has carried out
the most successful tax amnesty program to date. In
the January 1988 budget, the Irish government intro
duced a comprehensive proposal that gave delinquent
5Peter Stella, “An Economic Analysis of Tax Amnesties,” IMF Working
Paper, WP/89/42, May 1989, p. 13.
50
FRBNY Quarterly Review/Autumn 1989
taxpayers ten months to pay overdue taxes without
incurring any interest or penalty charges. The govern
ment also promised not to prosecute any of these
delinquent taxpayers.
In addition to granting the amnesty, the government
simultaneously implemented a series of supporting
measures. It increased the number of “ tax sheriffs”
responsible for enforcing tax collection. It began pub
lishing in the national newspapers lists of the names of
people who were delinquent in their tax payments. At
the end of the ten-month amnesty, it introduced a new
tax system. Further, the government increased interest
and penalty payments on delinquent taxes and gave
added power to the revenue commissioners. The addi
tional powers included the right to seize stock and
other assets and to freeze bank accounts belonging to
convicted tax evaders.
According to the Central Bank of Ireland, the tax
amnesty raised approximately $750 million. This wind
fall gain helped reduce the treasury’s total borrowing
requirement to approximately 3.4 percent of GDP in
1988, compared with 10 percent in 1987.6 The amount
of revenue raised from the amnesty far exceeded
expectations when the amnesty was first proposed.
The government had anticipated raising only about $50
million; the final amount of $750 million clearly repre
sented a success. The one remaining question is
whether Ireland’s tax amnesty will lead to a larger per
manent tax base or whether the gains will have been
achieved on a onetime basis only.
Although the experience of most programs to date
suggests that tax amnesties are not likely to widen the
tax base, Ireland may prove to be the exception
because of its emphasis on greater tax enforcement.
Still, much of the success of the Irish program appears
to be due to the laxity in collecting taxes before the
amnesty. Substantial sums were available for the
amnesty because a large percentage of Irish wage
earners had successfully underpaid for many years.
More important, Ireland’s program probably benefited
from the fact that the government had never previously
attempted a tax amnesty. In implementing the 1988
program, the governm ent emphasized that this
amnesty was the first and last opportunity for delin
quent taxpayers to be forgiven. A large percentage of
the $750 million was raised in the last few months of
the program because Irish citizens seemed to realize
that this was a onetime opportunity.
One factor that may undercut the success of Ire
land’s amnesty in increasing future tax revenues is that
the government did not reduce its tax rates or increase
exemptions as part of the package. The widespread
6Central Bank of Ireland, Q u a rte rly B u lle tin , Winter 1988, p. 11.
evasion of taxes in Ireland was probably in large part a
response to the country’s tax rates, which are among
the highest in Europe. Therefore, while the strength
ened enforcement measures should help sustain the
widened tax base, the maintenance of high tax rates
may well increase the incentive for tax evasion.
India
In February 1981, the Indian government introduced a
unique form of tax amnesty. For a period of about three
months, the government sold special bearer bonds that
were designed specifically to tap untaxed income. Any
one holding black market funds was allowed to use
these funds to purchase the bonds with no questions
asked about the source of the income. The bonds,
which mature in 1991, carry only a nominal annual
interest rate of 2 percent. But the money invested in
the bonds was exempted from the wealth tax imposed
on other bank deposits and from an income tax on
principal and interest at the time of maturity. Some
estimates suggest that a tax evader who bought the
bonds with black market money would have up to 60
percent more money in ten years than would a citizen
who bought the same amount of regularly issued
bonds with money held in a savings account.7 The
Indian government was reportedly able to attract over
$1 billion from the issuance of these bonds.8
Although the money collected was fairly substantial,
the government did not raise as much money from the
amnesty as it had anticipated, nor did it succeed in
widening the overall tax base. The government had
hoped to widen the tax base by adding taxpayers to
the rolls and carefully auditing in the future those who
participated in the program. Yet the issuance of the
bonds was not accompanied by any strengthening of
the tax laws or any structural changes in the tax sys
tem. Because the enforcement mechanisms remained
the same, delinquent taxpayers had no reason to
believe that penalties would be more likely in the
future.
In addition, this amnesty, while different in form, was
the fifth in a series of amnesty programs offered by the
government over a period of twelve years. Many citi
zens may have assumed that the government would
offer other, possibly more attractive, amnesties in the
future. Consequently, they had little incentive to partici
pate in the 1981 program.
The Indian program illustrates the way in which
amnesties can penalize regular taxpayers. In this case,
regular taxpayers were unable to purchase the more
lucrative special bearer bonds.
7l‘ lndia’s Amnesty for Tax Evaders," New York Times, February 3, 1981.
BReserve Bank of India Bulletin, vol. 35, no. 6 (June 1981), p. 462.
Argentina
Another type of amnesty program exempts from taxes
all previously unreported income that is used for
investment purposes. Argentina attempted this form of
tax amnesty to stimulate the return of flight capital as
part of its 1987 debt-to-equity program. The 1987 debtto-equity program was open to both foreign and local
investors. It stipulated that, for every dollar of debt
converted, the investor had to contribute an additional
dollar in fresh funds. Together with the matching funds,
the converted debt had to be used to purchase new
equipment, build new plants, or increase the physical
capacity of existing facilities. Under the amnesty, the
government permitted the return of the matching funds
free of any taxes owed. It also promised not to investi
gate the origins of these funds or prosecute delinquent
taxpayers.9
For a number of reasons, the program failed. Inves
tors viewed the matching funds requirement as overly
stringent. The one-to-one rule, even with the lifting of
taxes, largely undercut the benefit from participating in
the debt-to-equity program. In addition, the attraction of
not paying taxes on the matching funds was in some
ways inconsequential because tax evasion in Argentina
is widespread in any case. Finally, the potential impact
of the program was undermined by the frequency with
which the Argentine government had offered tax
amnesties. In 1988, the government adopted a new
debt-to-equity program that partially removed the
matching funds requirement and annulled the tax amnesty.
The case of Argentina supports the argument that a
modest tax amnesty unsupported by structural adjust
ments is likely to fail. Argentina has for years lost large
amounts of potential tax revenue to flight capital and
the underground economy. Although tax amnesties
have been introduced under various regimes, there has
been little effort to address the sources of the tax eva
sion problem. The underground economy remains
large, in part because of the highly regulated nature of
the economy, while capital flight" has recurred because
of uncertainty concerning economic policies. Conse
quently, the tax amnesties in Argentina have failed to
produce their intended results.
Belgium
In 1984, the Belgian government enacted a tax
amnesty whose purpose was to attract flight capital
and bring black market funds into the open economy.10
The law exempted from taxes any capital invested by
9John Whitelaw, “Argentina Plans D ebt Cut, Investment Spur," The
Christian Science Monitor, Septem ber 5, 1986.
10U.S. D epartm ent of the Treasury, Internal Revenue Service, "Study of
Tax Amnesty Programs.”
FRBNY Quarterly Review/Autumn 1989
51
Belgian residents in em ploym ent-creating a ctivitie s
before the end of the year. It also excused these resi
dents from any obligation to report the origin of the
funds. One-eleventh, or 9 percent, of the amount in
question, however, had to be invested in five-year noninterest-bearing treasury certificates. Ultimately, the
center-right coalition government, confronted with a num
ber of political problems in 1985, annulled the legislation.
Colombia
The Colombian government implemented a successful
amnesty program in 1987. The program stipulated that
taxpayers who had previously failed to report assets or
who had declared nonexistent liabilities would be able
to rectify their reports without incurring sanctions or
being subject to investigation or reappraisal. The law
further stated that to be eligible for the amnesty the
income declared could not be less than the income
declared in the previous year. Finally, the amnesty was
not made available to anyone already under investiga
tion by the tax authorities.11
11Central Bank of Colombia, Revista del Banco de la Republica,
vol. 59 (D ecem ber 1986), p. 58.
Table 1
Effectiveness of Tax Amnesties
Country
Estimated
Amount
Year
Raised
Program
(In Millions
Implemented of Dollars)
1987
1984
1987
1986
1981
1988
Argentina
Belgium
Colombia
France
India
Ireland
—
—
93
1610
1000
750
Amount as
Percentage
of GDP
Amount as
Percentage
of Central
Government
Deficit
-
—
—
0.3
0.22
0.54
2.55
—
54
8
10
158
At the same time the Colombian government insti
tuted the amnesty, it unified the corporate income tax
rate, lowered personal income tax rates, eliminated the
double taxation of dividends, and raised income tax
w ithholding rates. The governm ent estim ates that its
tax amnesty yielded about $94 million, or the equiva
lent of 0.3 percent of GDP in 1987.12
In Colombia’s case, it appears that the tax amnesty
in conjunction with these other changes may have
improved overall tax collection. The expansion of the
revenue base that began with the 1987 amnesty contin
ued in 1988. N evertheless, revenue c o lle ctio n s w ill
have to be measured for a few more years to assess
fully how these changes have affected the tax base.
France
France in 1986 enacted a tax amnesty geared solely
toward recouping income illegally transferred abroad.
Under the amnesty, the government reduced the tax
rate on repatriated capital to 10 percent, a rate much
lower than that normally imposed on income. The gov
ernment also abolished the wealth tax and allowed the
holdings of gold to be anonymous.
The government adopted these additional measures
to m ake th is a m n esty m ore s u c c e s s fu l than one
adopted in 1982. The 1982 law was also designed to
encourage French citizens to repatriate capital illegally
held abroad. That program failed in part because of the
high wealth tax in existence in France at that time.
The exact amount of the revenue raised from the
1986 amnesty is unknown, but nonbank private capital
inflows grew about 400 percent in 1986. Much of the
increase, according to the central bank, was the result
of this fiscal amnesty.13 France’s experience supports
the view that a successful tax amnesty depends impor12Central Bank of Colombia, Revista del Banco de la Republica,
vol. 60 (D ecem ber 1987), p. xi.
13“ La Balance des Paiements de la France,” Bank of France Annual
Report, 1986, p. 88.
Table 2
Characteristics of Tax Amnesties
Country
Argentina
Belgium
Colombia
France
India
Ireland
.•
Accom panied by
Enhanced
Enforcement
Implemented
for First
Time
Designed
to A ttract
Flight Capital
Geared to
Domestic
Capital
Accom panied by
Tax Rate
Adjustments
No
No
Yes
No
No
Yes
No
No
Yes
No
No
Yes
Yes
Yes
No
Yes
Yes
No
No
Yes
Yes
No
Yes
Yes
No
No
Yes
Yes
No
No
FRBNY Quarterly Review/Autumn 1989
Digitized52
for FRASER
tantly upon the government’s willingness to adopt
simultaneously other structural changes. An amnesty
alone was unable to attract the return of flight capital in
1982; the government had to address some of the
causes of flight capital before it could achieve its
purpose.
Conclusion
Tables 1 and 2 summarize the quantitative and qualita
tive characteristics of the programs examined in this
article. As Table 1 indicates, tax amnesty programs
have had varied success. Most of the programs have
not led to a widening of the overall tax base, and many
have failed to produce even very large onetime reve
nue gains. In the case of programs that combine tax
amnesty with rate adjustments and more rigorous
enforcement, it is difficult to distinguish revenue gains
attributable to tax amnesty from the gains attributable
to enhanced tax enforcement or changes in tax laws.
On the one hand, if enhanced enforcement or other
structural changes would have raised the same amount
of revenue without the introduction of an amnesty, then
the amnesty could have resulted in a loss of money to
the state because of the forgone interest or penalty
charges. On the other hand, if the amnesty accelerated
the repayment of taxes, the state would have gained
the advantage of collecting the money sooner, a benefit
not available to governments making only structural
changes.
Most programs seem to have failed because the
countries implementing the amnesties did not possess
the means or desire to enforce tax collection after the
amnesty. As a result, the programs often led to one
time revenue gains but appear to have had no lasting
effects.
For these reasons, it seems likely that developing
countries in particular will gain little by implementing a
tax amnesty until they improve their overall systems of
tax collection. In addition, many developing countries
have already enacted several tax amnesties, thereby
diminishing their chances of implementing truly suc
cessful programs in the immediate future. Neverthe
less, a w e ll-d e s ig n e d ta x am nesty program ,
accompanied by structural and tax reforms, has the
potential to lead to beneficial results in both developed
and developing countries.
Elliot Uchitelle
FRBNY Quarterly Review/Autumn 1989
53
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1989
During the first half of the August-October reporting
period, the dollar came under renewed upward pres
sure in the face of strong investment inflows. In
response, the U.S. monetary authorities intervened to
sell dollars in keeping with Group of Seven (G-7) policy
commitments to foster exchange rate stability. The dol
lar reached its highs of the period in mid-September. It
then moved sharply lower after the G-7 statement of
September 23 expressed concern over the dollar’s
rise and persistent coordinated intervention operations
followed. Toward the end of the period, the dollar
traded in a relatively narrow range. Demand for dollars
moderated as a result of a narrowing of interest rate
differentials favoring dollar assets and of concerns over
volatility in U.S. equity markets. However, investment
interest continued to provide some support at lower
levels.
The dollar ended the August-October reporting
period V2 percent higher on a trade-weighted basis in
terms of other Group of Ten (G-10) currencies as mea
sured by the staff of the Federal Reserve Board of
Governors. Against individual currencies, however, the
dollar’s performance varied considerably. On balance,
the dollar declined VU percent against the German
mark and V2 percent against the Canadian dollar while
rising 474 percent against the Japanese yen and 51/2
percent against the British pound.
During the three-month period, the U.S. monetary
authorities sold a total of $5,871 million between
A report presented by Sam Y. Cross, Executive Vice President in charge
of the Foreign Group at the Federal Reserve Bank of New York and
Manager of Foreign Operations for the System Open Market Account.
George G. Bentley was primarily responsible for preparation of the report.
54for FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized
August and early October, of which $3,289 million was
against Japanese yen and $2,582 million was against
German marks. These operations were conducted in
coordination with foreign central banks.
The d o llar’s rise from early August to midSeptember
As the period opened, market participants were still
apprehensive that the U.S. economy might be slipping
into recession. In the final days of July, evidence was
widespread that the Federal Reserve had responded to
a slackening of economic growth and price pressures
by easing monetary policy, and the dollar declined. On
August 1, Chairman Greenspan confirmed in Senate
testimony that the Federal Reserve had modestly
eased its stance the previous week. On the same day,
several leading banks cut their prime lending rates.
The perception thereby strengthened in the market that
U.S. interest rates were steadily declining and favor
able dollar interest rate differentials would continue to
narrow. The dollar then moved to its lows for the month
of August of DM 1.8430 and ¥ 135.50 on August 2.
The dollar’s softer tone was short-lived. Economic
data released in early August alleviated the market’s
earlier concerns regarding the severity of an economic
slowdown. The prospects of another imminent easing
by the Federal Reserve appeared to fade after employ
ment data released on August 4 showed a sharp
upward revision in June nonfarm payrolls and contin
ued employment growth for July. The release of figures
on August 11 showing buoyant retail sales in July made
the possibility of an easing appear even less likely. In
addition, the monthly U.S. trade reports released in
both August and September suggested that the U.S.
trade perform ance was continuing to improve.
In this environm ent, com m ercial and investm ent
demand for dollars revived, and the dollar was buoyant
through m id-September. On Septem ber 15, following
the announcement that the July U.S. trade deficit had
narrowed une xpe cte dly to $7.58 billion, the d ollar
surged briefly to its highs of the three-month period of
DM 2.0032 and ¥ 148.98, up roughly 71/2 percent and
83/4 percent, respectively, from the closing rates of the
previous reporting period. At these levels, the dollar
was trading near the highs reached earlier in the year.
Later that same day, when it appeared that the dollar
would not move any higher, dealers began to take
profits on lo n g -d o lla r positions, trig g e rin g stop-loss
orders, and a sudden decline in the dollar ensued.
Chart 1
After rising early in the reporting period, the dollar trended lower after mid-September . . .
Percentage points *
-2
August
September
1989
October
and closed the period below its highs of earlier in the year.
Percentage points *
15
J
J
1988
* The top chart shows the percent change of weekly average rates for the dollar from August 4, 1989. The bottom chart shows the
percent change of monthly average rates for the dollar from February 1987. All figures are calculated from New York noon quotations.
FRBNY Quarterly Review/Autumn 1989
55
Although sentiment toward the dollar remained positive
for quite a while afterwards, the episode revealed a
vulnerability for the dollar at these higher levels.
D uring much of S eptem ber, the U.S. m on e ta ry
authorities again intervened in coordination with those
of several other countries to resist upward pressure on
the dollar. A fter m id-September, moreover, with the
approaching G-7 meeting in Washington on September
23, the market became increasingly wary that more
aggressive official action might be introduced to curb
the d o lla r’s strength, e ithe r through interven tion or
through monetary policy adjustments. The dollar then
drifted down to close at DM 1.9520 and ¥ 146.00 on
Septem ber 22, the Friday before the weekend G-7
meeting.
Accordingly, between August 1 and September 22,
the U.S. monetary authorities sold a total of $1,452 mil
lion against marks and $1,699 million against yen. The
operations became more frequent as upward pressure
on the dollar intensified. During the first ten days of
August, the U.S. authorities intervened only once, sell
ing $70 million against yen. During the remainder of
August, the U.S. monetary authorities sold dollars on
six days for a total of $425 million against marks and
$525 million against yen. The authorities entered the
market more frequently after the beginning of Septem-
ber, intervening on eleven of the fifteen business days
leading up to the G-7 meeting to sell a total of $1,027
million against marks and $1,104 million against yen.
Dollar demand moderates after the late September
G-7 meeting
After their meeting on Saturday, September 23, the G-7
finance m inisters and governors issued a statem ent
concluding, among other things, that the dollar’s rise in
recent months was inconsistent with longer run eco
nomic fundamentals and that a further rise of the dollar
above then current levels or an excessive decline could
adversely affect prospects for the world economy. The
ministers and governors also expressed their intention
to cooperate closely in exchange markets.
On the strength of the G-7 statem ent and official
interven tion to reinforce that statem ent, the d ollar
moved lower in Asian trading on Monday, September
25. The fact that the U.S. monetary authorities, along
with others, were selling dollars in the Tokyo market
sent a signal of the firmness of the G-7 resolve. In the
days im m e diately follow ing the statem ent, the G-7
monetary authorities persisted with their intervention.
By October 2, the dollar had declined to DM 1.8650
and ¥ 138.60, about 5 percent lower than its closing
levels on September 22. For the next eight business
days, the dollar was again well bid, showing a tendency
to recover from its October 2 levels. Subsequently, as
Chart 2
Short-term interest rate differentials favoring
the dollar continued to narrow as interest
rates declined in the United States and
increased abroad.
Percentage points
Table 1
Federal Reserve Reciprocal Currency
Arrangements
In Millions of Dollars
Amount of Facility
Institution
1 L l j . j, I i - i i 1 i i i i I i i i 1 i i i 1 i i i i I i i i I
Jan
Feb
Mar
Apr
1989
May
Jun
Jul
The chart shows w eekly average interest rate differentials
between three-m onth Eurodollar rates and three-m onth
Euromarket deposit rates for marks and yen.
Digitized
FRASER Quarterly Review/Autumn 1989
56for FRBNY
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
O ctober 31, 1989
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
the authorities continued to intervene to resist the dol
lar’s rise, market participants appeared more recon
ciled to the possibility that the dollar’s uptrend might
finally have been broken. In total, from September 25
through October 12, the U.S. monetary authorities sold
$1,130 million against marks and $1,590 million against
yen, operating on most days in that period.
The latter half of October
As mid-October approached, upward pressure on the
dollar lessened. For the balance of the three-m onth
period, the dollar remained below the mid-September
highs.
One factor contributing to the easing of upward pres
sure was that interest rate differentials favoring the dol
lar narrowed further in October as a result of interest
rate increases abroad. German market interest rates
had begun edging higher in late September as dealers
anticipated possible increases in the Bundesbank’s offi
cial rates. On October 5, the Bundesbank announced a
full one percentage point increase in both its discount
and Lombard rates, surprising the market with the mag
nitude of the increase. The British, French, Swiss, Bel
gian, Dutch, Danish, Irish, and A ustrian m onetary
authorities followed by raising their official rates. The
following week, the Bank of Japan surprised the market
by raising its discount rate by one-half percentage
point on October 11, and short-term market interest
rates in Japan increased by approxim ately 75 basis
points within the span of a week.
Around this time, market participants also began to
expect favorable interest rate differentials to diminish
further because of an easing of monetary policy in the
U nited S tates. M any o b s e rv e rs view ed e con om ic
reports, p articularly the Septem ber U.S. employm ent
data released on October 6, as a sign that U.S. eco
nomic activity was sluggish enough to warrant a new
move to lower U.S. interest rates. During the second
week of October, the federal funds rate moved lower,
and by mid-month, market participants concluded that
the Federal Reserve had indeed eased.
Although interest rate differentials favoring the dollar
had been narrowing throughout most of 1989 without
any apparent negative effect on dollar exchange rates,
the moves that occurred in October were sufficient to
induce a moderation in capital inflows to the United
States. By this time, interest rates in Germany had
risen to levels that were almost as high as those in the
United States. At the same time, as asset prices both
in the United States and in foreign markets continued
to adjust to the changing interest rate and economic
assessm ents, questions arose about the continued
Table 2
Drawings and Repayments by Foreign Central Banks under Reciprocal Currency Arrangements
with the Federal Reserve System
In Millions of Dollars; Drawings ( + ) or Repayments ( — )
Central Bank Drawing on the
Federal Reserve System
Bank of M e xico f
Amount
of Facility
O utstanding as of
July 31, 1989
August
Septem ber
O ctober
O utstanding as of
O ctober 31, 1989
700.0
0
-
+ 700.0
-
+ 700.0
Data are on a value-date basis.
fD ra w n as a part of the $2,000 million near-term cre dit facility established on Septem ber 21, 1989.
Table 3
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangements
with the Federal Reserve System
In Millions of Dollars; Drawings ( + ) or Repayments { — )
Central Bank Drawing
on the U.S. Treasury
Bank of M e xico f
Amount
of Facility
Outstanding as of
July 31, 1989
August
Septem ber
O ctober
Outstanding as of
O ctober 31, 1989
125.0
0
-
+ 84.1
-
+ 84.1
Data are on a value-date basis.
fD ra w n as a part of the $2,000 million near-term cre dit facility established on Septem ber 21, 1989.
FRBNY Quarterly Review/Autumn 1989
57
strength of certain capital markets — markets that had
attracted investors either because of high yields or the
prospect of sharp capital gains. Against this back
ground, the sharp d ecline in U.S. equity prices on
October 13 revived concerns that heavy foreign invest
ment in the United States might be discouraged and
that the Federal Reserve might ease even more quickly
or aggressively than previously supposed.
The October 17 release of data showing a sharp
deterioration in the U.S. trade position in August also
served to reduce upward pressure on the dollar, as it
Chart 3
Real GNP growth figures for the third quarter of
1989 indicated a continued moderation in the pace
of economic growth.
Percentage change
5-----------------------------------------------------------------------------------------------------------------------------------
4
3-
2
-
1
-
I
II
III
IV
I
1988
II
1989
III*
The chart shows the annualized change in U.S. real gross national
product.
*T h e change in real gross national product for third-quarter 1989,
originally reported at 2.5 percent on October 26, was later revised to
2.7 percent after the close of the reporting period.
highlighted the dangers of a further rise in the U.S.
currency and reminded the market of the continuing
need to correct the current account imbalances.
Although the dollar’s overall tone remained consid
erably softer late in the period, the dollar continued to
receive some support from investment demand, partic
ularly by Japanese entities, through the end of the
three-m onth period. The dollar closed the quarterly
period at DM1.8415 against the mark and ¥ 142.85
against the yen.
With the dollar generally trading more narrowly in the
latter part of the reporting period, markets tended to
focus more on developments abroad, and the dollar’s
performance against individual currencies varied con
siderably. The d o lla r’s decline against the mark was
particularly pronounced, as the German currency bene
fited not only from the rise in German interest rates but
more broadly from a growing sense of confidence in
G e rm a n y ’s e co n o m ic p e rfo rm a n c e and p ro sp e cts.
Buoyant demand, high levels of capacity utilization, and
rep orts of high wage dem ands from G erm an labor
unions seemed to indicate that interest rates would
remain firm and economic growth strong. The process
of reform just beginning to unfold in Eastern Europe
and the inflow of East German immigrants were seen
to promise longer term benefits for the West German
economy, although there was considerable uncertainty
about the short run.
Against the yen, conversely, the dollar showed a
somewhat greater tendency to rise as actual and antici
pated Japanese capital outflow s kept the yen under
downward pressure against most other major curren
cies. Japanese investor demand for dollars, which had
helped support the dollar throughout 1989, reflected a
high Japanese domestic savings rate, ample domestic
liquidity, and a perception that domestic assets were
relatively expensive. The United States was seen as
having a good long-term investment environment and
Table 4
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangements
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( — )
Central Bank Drawing
on the U.S. Treasury
Bank of M e xico t
Central Bank of B olivia t
Amount
of Facility
O utstanding as of
July 31, 1989
425.0
100.0
0
100.0
August
Septem ber
—
—
Data are on a value-date basis.
tR ep resen ts the ESF portion of $2,000 million near-term cre dit facility.
•£The facility, which was established on July 11, 1989, was renewed on Septem ber 15, 1989.
FRBNY Quarterly Review/Autumn 1989
Digitized58
for FRASER
+ 384.1
- 1 0 0 .0
+ 75.0
O ctober
—
Outstanding as of
O ctober 31, 1989
+ 384.1
—
—
—
+
75.0
as providing sufficient opportunities to absorb a large
pool of Japanese savings.
Against sterling, the dollar traded relatively firm ly
throughout most of the three-month period as market
participants became increasingly concerned about the
outlook for the U.K. economy. Despite the fact that high
British interest rates were raising w orries about a
recession, many analysts felt that the progress in curb
ing inflation and redressing external imbalances had
been too slow. Market uncertainty regarding the future
direction of U.K. economic policy was compounded by
the perception that the U.K. authorities were divided on
basic issues.
For the three months as a whole, the U.S. monetary
a uth orities sold $5,871 m illion. The U.S. T re a sury’s
Exchange Stabilization Fund (ESF) and the Federal
Reserve System participated equally in these opera
tions. To finance a portion of its share, the ESF “ ware
housed” $3,000 million equivalent of foreign currencies
with the Federal Reserve, bringing the total of ware
housed funds to $7,000 million equivalent.
In other operations, on September 21, the Federal
Reserve System and the ESF, together with the Bank
for International Settlements (acting for certain central
banks) and the Bank of Spain, agreed to provide a
short-term credit facility totaling $2,000 million to the
Bank of Mexico. The Federal Reserve’s share in the
facility was $825 million, of which the first $700 million
was to be provided under the existing reciprocal swap
line with Mexico and the remaining $125 million under
a separate swap agreem ent. The ESF’s share was
$425 million, provided under a special swap arrange
ment. On September 25, Mexico drew $784.1 million
from the Federal Reserve’s portion and $384.1 million
from the ESF’s portion of the facility.
Also during the period, Bolivia repaid in full on Sep
tember 15 its $100 million outstanding commitment on
the short-term financing fa cility established with the
ESF. Subsequently, the Treasury agreed to provide a
new $100 million facility, and on September 22, Bolivia
drew $75 million.
As of end October, cumulative bookkeeping or valua
tion gains on outstanding foreign currency balances
were $1,366.5 m illion fo r the Federal R eserve and
$870.3 million for the ESF (the second figure includes
valuation gains on warehoused funds). These valuation
Chart 4
After narrowing in June and July, the U.S. trade
deficit widened sharply in August.
Billions of dollars
Trade de fic it
Table 5
Net Profits ( + ) or Losses ( — ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
In Millions of Dollars
Federal
Reserve
U.S. Treasury
Exchange
Stabilization
Fund
May 1, 1989 to
July 31, 1989:
Realized
Valuation profits and losses
on outstanding assets and
liabilities, July 31, 1989
0.0
+ 1,045.5
+
77.3
+ 724.2 f
August 1, 1989 to
O ctober 31, 1989:
Realized
Valuation profits and losses
on outstanding assets and
liabilities, O ctober 31, 1989
0.0
+ 119.6
+ 1,366.5
+ 870.3
Data are on a value-date basis.
The chart shows the monthly and three-month moving average
U.S. merchandise trade deficit, seasonally adjusted and
reported on a customs basis. The trade figures for June, July,
and August were released on August 17, September 15, and
October 17, respectively.
*T h e deficit for August, originally reported at $10.8 billion, was
later revised to $10.1 billion.
fT h is figure takes into account warehoused funds as of July 31,
1989. Data as originally reported in Table 3 of the foreign
exchange report in the summer 1989 issue of the Quarterly
Review excluded valuation profit on warehoused funds. The
amount, of valuation profits including warehoused funds as of
July 31, 1989, was $724.2 million.
FRBNY Quarterly Review/Autumn 1989
59
gains represent the increase in the dollar value of out
standing currency assets valued at end-of-period
exchange rates, compared with the rates prevailing at
the time the foreign currencies were acquired.
The Federal Reserve and the ESF regularly invest
their foreign currency balances in a variety of instru
ments that yield market-related rates of return and that
FRBNY Quarterly Review/Autumn 1989
Digitized 60
for FRASER
have a high degree of quality and liquidity. A portion of
the balances is invested in securities issued by foreign
governments. As of end October, holdings of such
securities by the Federal Reserve amounted to
$6,746.5 million equivalent, and holdings by the Trea
sury amounted to the equivalent of $7,475.7 million.
Treasury and Federal Reserve
Foreign Exchange Operations
May-July 1989
The dollar was under upward pressure in the first half
of the period under review, continuing a tendency that
had begun toward the end of the previous reporting
period. The dollar was supported by strong investment
demand until late May. In early June, after a brief
period of relative market calm, the dollar came under
renewed upward pressure amid large capital flows pre
cipitated by escalating tensions in China. These two
waves of upward pressure were met with heavy and
sustained intervention.
After mid-June the dollar retreated and, on balance,
ended the three-month period 1/4 percent lower on a
trade-weighted basis as measured by the staff of the
Federal Reserve Board of Governors. This reversal in
the dollar’s direction coincided with changes in the
market’s assessment of the U.S. economic outlook — in
particular, emerging indications of a softening of eco
nomic growth and somewhat lessened price pressures
led to market expectations of an easier U.S. monetary
policy stance and lower short-term interest rates. Eco
nomic and political developments abroad also influ
enced movements in dollar exchange rates over the
course of the three-month period.
Against individual currencies, the dollar’s net move
ments varied considerably. The dollar closed the period
approximately 3 percent higher against the Japanese
yen and Vk percent higher against the British pound,
while it was about 3A percent lower against the German
A report presented by Sam Y. Cross, Executive Vice President in
charge of the Foreign Group at the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open Market
Account. Cathy W eintraub was prim arily responsible for preparation
of the report.
mark and 1A» percent lower against the Canadian dollar.
Intervention sales of dollars by the U.S. authorities
between May and the end of July totaled $11,917 mil
lion, of which $7,237.5 million was sold against Japa
nese yen and $4,679.5 million against German marks
— the largest U.S. intervention for any three-month
reporting period. The bulk of these dollar sales
occurred in May and early June when the U.S. mone
tary authorities were intervening vigorously, in keeping
with the Group of Seven (G-7) policy commitments to
foster exchange rate stability. At the same time, a
White House statement expressed concern about the
dollar’s appreciation and indicated that, if sustained or
extended, it could undermine international efforts to
reduce global trade imbalances. For the balance of the
period, intervention sales of dollars were modest as
upward pressures on the dollar subsided.
The dollar firms in May
During May, as in earlier months of 1989, the dollar
was buoyed by investment and commercial demand. At
the opening of the three-month period, investors and
commercial interests were gaining confidence about
increasing the share of dollar assets in their overall
portfolios and reducing the hedged proportion of their
dollar assets. The relatively stable performance of the
dollar during the previous year had led many to con
clude that it was no longer necessary to maintain
costly hedges to protect their dollar exposures against
exchange rate loss. Actions to unwind these hedge
positions continued to exert powerful upward pressure
on the dollar, while adjustments in commercial leads
and lags also contributed to the dollar’s upward
FRBNY Quarterly Review/Autumn 1989
61
m om entum . M eanw hile, in ve sto rs co n tin u e d to be
attracted to the relatively high interest rates available
on dollar-denominated instruments, even though inter
est rate differentials favoring the dollar had already
narrowed considerably from levels of last fall and win
ter. Also, market sources reported the widespread view
that the prospect for capital gains on long-term fixed
income dollar securities seemed attractive given the
growing perception that the U.S. economic expansion
was slowing and that interest rates in the United States
were likely to continue to decline.
With sentiment toward the dollar decidedly positive
during early May, the dollar advanced smartly. To coun
ter the upward pressure, the U.S. monetary authorities
sold a total of $550 million against marks and $400
million against yen between May 1 and May 8, fo l
lowing through on operations begun at the end of April.
The upward pressures intensified after the May 12
report of a smaller than expected rise in U.S. producer
prices during April buoyed both the U.S. bond and
exchange markets. By May 15 the dollar broke through
the s ig n ifica n t te ch n ica l and psychological level of
DM 1.9250 against the mark. Attitudes toward the dollar
became even more bullish following the May 17 release
of prelim inary U.S. trade data for March indicating a
Chart 1
sharp improvement in U.S. external performance. On
May 22, the dollar pierced the DM 2.00 level against
the mark and ¥ 140 against the yen. By May 24, the
dollar reached DM 2.0150 and ¥ 142.85, up roughly
71/4 percent against the mark and yen, respectively,
from the end of April.
As the dollar moved to levels not seen since the Feb
ruary 1987 Louvre Accord, market participants increas
ingly came to question the will of the G-7 monetary
authorities to halt the dollar’s rise. Under these circum
stances, official warnings about the negative conse
quences of dollar appreciation went unheeded. Instead,
market participants gave more credence to statements
by some U.S. and foreign officials that seemed to re
inforce the idea that G-7 m onetary authorities were
prepared to tolerate the recent higher levels for the
dollar. Upward pressure continued to mount as market
participants bid for dollars amid fears that the currency
would go even higher.
In this environment, the U.S. authorities intensified
their intervention operations to resist the dollar’s rise.
They sold a total of $5,785 million between May 12 and
May 31, reflecting sales of $3,000 million against marks
and $2,785 million against yen. Of these amounts, a
total of $2 billion was sold on May 18 and May 19
alone.
By late May, upward pressure on the dollar abated
and a more cautious atmosphere returned to the for
The dollar continued to rise early in the
period, then declined after mid-June.
Table 1
Federal Reserve Reciprocal Currency
Arrangements
In Millions of Dollars
Amount of Facility
Institution
.loi.lllllllllllllllllllllllllllllllllllllllllllllllllll
A
S
O
N
D
J
F
M
A
M
J
J
1988
1989
The chart shows the percent change of weekly average
rates for the dollar from August 5, 1988. All figures are
calculated from New York noon quotations.
62 FRASER
FRBNY Quarterly Review/Autumn 1989
Digitized for
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
April 28, 1989
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
eign exchange market. A confluence of factors contrib
uted to the d o lla r’s retracem ent at the end of the
month: The cumulative effect of sizable and persistent
central bank intervention operations came to weigh
upon the currency and these operations were viewed
as a strong signal that U.S. and foreign officials were
seriously committed to fostering exchange rate stability
and were determined to resist the dollar’s rise. Official
interest rate increases in Japan, Britain, Switzerland,
and elsewhere in Europe late in the month, though
prompted by domestic considerations, were also seen
as contributing to a more stable exchange rate environ
Chart2
Short-term interest rate differentials favoring the
dollar continued to narrow, primarily because of
interest rate increases abroad.
Percentage points
6 -----------------------------------------------------------------
ment. Moreover, indications of a m oderation in the
pace of U.S. economic growth began to accumulate,
reinforcing e xpe ctatio n s that U.S. m onetary policy
might soon be eased and, therefore, that favorable
interest rate differentials would continue to narrow.
The financial markets took special note of the June 2
release of U.S. nonfarm payroll figures for May that
showed slower employment growth than the markets
had previously anticipated. These data were seen as
increasing the likeliho od that the Federal Reserve
w ould soon ease its m o n e ta ry sta nce . The d o lla r
moved sharply lower, declining about 2 percent against
the mark and 13A percent against the yen over the
course of the day. The dollar closed on June 2 at
DM 1.9420 and at ¥ 140.45, 31/2 percent lower against
the m ark and 13A p e rc e n t low er a g a in st the yen,
respectively, from the levels reached on May 24, but
31/4 percent and 51/2 percent higher, respectively, from
the opening of the reporting period.
Renewed upward pressure in early to mid-June
p ll I I I I II I I I II I II I I I II I I I I I I I II I I I I I I I I I I I I I I
J
F
M
A
M
J
J
A
S
O
1989
The chart shows weekly average interest rate differentials between
three-month Eurodollar rates and three-month Euromarket deposit rates
for marks and yen.
On June 5, however, the dollar moved abruptly higher
amid heightened market sensitivity to political insta
bility. In particular, market attention shifted to news
com m entary on the Chinese governm ent’s efforts to
suppress a student demonstration that reflected grow
ing pressures for dem ocratic reform in China. The
escalating tensions in China led many market partici
pants to anticipate capital outflows from East Asia for
safe-haven considerations stemming from a reassess
ment of the prospects for economic and political stabil
ity in the region. A sharp decline in the Hong Kong
stock index added to the uncertainty of the time. The
d ollar’s rise was particularly pronounced against the
yen as the Japanese currency remained vulnerable to
selling pressures, in part because of the additional
uncertainties associated with Japan’s political situation.
The dollar was bid up strongly, notwithstanding reduc
Table 2
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangements
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Central Bank of Venezuela
Central Bank of Bolivia
Amount
of Facility
O utstanding as of
April 30, 1989
450. Of
100.0*
0
—
Outstanding as of
July 31, 1989
May
June
—
—
—
_
—
—
+ 100.0
+ 100.0
July
Data are on a value date-basis.
fT h e facility expired on May 15, 1989.
fT h e facility was established on July 11, 1989.
FRBNY Quarterly Review/Autumn 1989
63
tions in the prime lending rate at several U.S. banks on
June 5 and an easing of the federal funds rate on the
following day.
The bullish sentiment toward the dollar continued to
build in advance of the June 15 release of U.S. trade
data, which were expected to show a greatly reduced
trade gap for April. The dollar moved higher im m e
diately following the prelim inary report of a narrowing
of the trade deficit to $8.26 billion, from a revised $9.55
billion deficit in March. By midmorning in New York
tra d in g th a t day, th e d o lla r w as p u s h e d up to
D M 2.0470 against the mark and ¥ 151.90 against the
yen, its highest levels in more than two years. At these
levels, the dollar was 83A percent higher against the
mark and 141A percent higher against the yen from end
April and was trading roughly 31 percent and 26 per
cent higher, respectively, from the record lows reached
on January 4, 1988.
Chart 3
The declining trend in the U.S. trade
deficit since the beginning of the year
provided support to the dollar throughout
the three-month period. In mid-June
market participants reacted quite favorably
to the news of a sharp narrowing in the
trade d e ficit reported for April.
B illio n s o f d o lla rs
The dollar declined in late June
As impressive as the dollar’s upsurge had been, mar
ket participants noted that the dollar failed to move
above the key technical levels of DM 2.05 against the
mark and ¥ 152 against the yen on June 15, and profit
taking began to move the dollar lower. Selling momen
tum quickly built as market participants scrambled to
unwind long-dollar positions. The dollar plunged in vol
atile trading, and many participants started to question
w h e th e r th is d e c lin e was the b e g in n in g of a sea
change in the dollar’s direction. The dollar closed on
June 15 at DM 1.9820 a g a in s t th e m ark and at
¥ 145.30 against the yen, down 31A p ercen t and
41/4 percent, respectively, from the highs reached only
hours earlier.
At the same time, the dollar was perceived as vulner
able to central bank intervention operations. Consistent
and heavy intervention sales of dollars by the U.S.
authorities, undertaken in coordination with other cen
tral banks, continued after the dollar moved down from
its peak and helped convince market participants that
the G-7 m onetary authorities were firmly comm itted to
resisting the d o lla r’s rise and m aintaining exchange
rate stability. By mid-June, m arket participants had
become more aware of the scale of intervention. Inter
vention sales of dollars by the U.S. authorities between
June 6 and June 30 totaled $4,952 million, including
$3,822.5 million sold against yen and $1,129.5 million
sold against marks.
By late June, market attention had shifted back to
the outlook for the U.S. economy and m onetary policy.
Indications of a softening in economic activity contin
ued to appear, highlighted by the June 23 report of a
sharp drop in durable goods orders in May. Further,
emerging signs pointed to some lessening of price
Table 3
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
In Millions of Dollars
May 1, 1989 to
July 31, 1989
1988
1989
The c h a rt s h o w s the m onthly and th re e -m o n th m oving
a v e ra g e U.S. m e rc h a n d is e tra d e d e fic it, s e a s o n a lly
ad ju s te d and re p o rte d on a c u s to m s ba sis. The tra d e
fig u re s fo r M a rc h , A pril, and M ay w e re re le a s e d on
May 17, June 15, and J u ly 18, re s p e c tiv e ly .
FRBNY Quarterly Review/Autumn 1989
Digitized 64
for FRASER
Realized
Valuation profits and losses on
outstanding assets and
liabilities as of July 31, 1989
Data are on a value-date basis.
United States
Treasury
Exchange
Stabilization
Federal Reserve
Fund
0
+ 77.3
+ 1,045.5
+ 502.8
C hart 4
Data released during the period indicating
some decline in the monthly rate of
price increases . . .
P e rce n t
0 . 7 -------0.6
-
0.5 0.4 0.3 0.2
0.1
-
J
A
S
O
1988
N
D
J
F
M
A
1989
M
J
and a slowdown in the pace of economic
growth . . .
P e rce n t
4 . 5 ------4.0 3.5 -
pressures and to an underlying trend in inflation that
was less severe than markets had previously feared.
M arket participants noted the easing in the federal
funds rate that had already taken place earlier in the
month and expected further declines. The dollar moved
lower as market participants anticipated that favorable
interest rate differentials would narrow further, thereby
d im in is h in g th e re la tiv e a ttra c tiv e n e s s of d o lla rdenominated instruments.
An undertone of caution set in as the perceptions of
downside risk associated with holding dollar assets
increa se d. By late June, p o rtfo lio a d ju s tm e n ts to
reduce hedging ratios appeared to taper off. Capital
flows from East Asia also appeared to diminish. Fur
thermore, corporations reportedly refrained from buy
ing dollars as the currency continued to decline. Under
these circum stances, the dollar experienced only a
brief bout of upward pressure in the afterm ath of a
June 25 upper house by-election in Japan.
The dollar subsequently resumed its decline as mar
ket attention again centered on the prospects for fur
ther narrowing of favorable interest rate differentials.
Accumulating signs of slowing U.S. economic growth
were seen by market participants as increasing the
likelihood that the Federal Reserve would again ease
its monetary stance. At the same time, economic statis
tics were suggesting buoyant growth and increasing
inflationary pressures abroad. In these circumstances,
the monetary authorities in Germany and several other
continental countries announced increases of one-half
3.0 2.5 2.0
-
1.5 1.0
-
0.5 -
0L
IV
1988
I
II
1989
suggested that the balance of risks in the
U.S. economy may have shifted away from
greater inflation.
The to p c h a rt sho w s the m o nth-to-m onth change in the
U.S. con sum er p rice index. The bottom c h a rt shows the
annualized change in U.S. real g ro ss n a tio nal p ro d u c t.
♦ T h e cha nge in real g ro s s national p ro d u c t fo r second
q u arte r 1989, o rig in a lly re p o rte d at +1.7 p e rc e n t on
July 27, was later re v is e d to +2.7 p e rc e n t a fte r the
close o f the re p o rtin g pe riod.
During the three-month period, the Federal Reserve
warehoused foreign currencies for the Exchange Stabi
lization Fund (ESF) of the Treasury. Such warehousing
operations have been carried out from time to time
since 1963. In carrying out such an operation, the Fed
eral Reserve buys the foreign currency in a spot pur
chase from the Treasury and simultaneously sells it
back to the Treasury at the same exchange rate for a
future maturity date. A key aspect of this type of trans
action is that, since both the Federal Reserve and the
Treasury agree to pay and to receive the same amount
of foreign currency, as specified by the use of the same
exchange rate, n e ith e r p a rty incurs any fo re ig n
exchange rate risk by virtue of this transaction. The
ESF may realize a profit or loss at the time the ware
housing transaction is undertaken and remains exposed
to valuation gains or losses on the foreign currencies
being warehoused (see Table 3). A warehousing trans
action is reversed when the Treasury repays dollars and
the Federal Reserve repays the foreign currency it has
acquired from the Treasury.
FRBNY Quarterly Review/Autumn 1989
65
to one full percentage point in their official interest
rates on June 29. On July 6, the dollar traded as low
as ¥ 137.85 against the yen, down 53A percent from
the June 9 close.
During the second week in July, however, sentiment
toward the dollar turned temporarily more positive. A
series of economic reports released on July 14 was
viewed in the exchange market as favoring the dollar.
These reports confirmed economic activity was settling
into a sustainable rate, while price data suggested the
Federal Reserve might not have as much leeway to
lower interest rates as previously supposed. But then,
in his congressional testimony on July 20, Chairman
Greenspan stated that the balance of risks in the U.S.
economy had shifted away from greater inflation and
that monetary policy had been adjusted accordingly.
The testimony temporarily revived expectations that
U.S. interest rates would continue to move lower, and
dollar rates subsequently drifted irregularly lower
through the balance of the month.
During July, at times when there appeared to be
upward pressure building toward the dollar, the U.S.
authorities entered the market to contain the pressure.
These operations, however, were modest and intermit
tent. In fact, the Desk operated on only three days dur
ing July, selling a total of $230 million dollars against
yen between July 11 and July 21. On July 31, the dollar
closed the three-month reporting period at DM 1.8648
against the mark and at ¥ 136.90 against the yen.
The total intervention sales of $11,917 million during
the three-month reporting period were shared equally
by the U.S. Treasury, through the Exchange Stabiliza
FRBNY Quarterly Review/Autumn 1989
Digitized 66
for FRASER
tion Fund (ESF), and the Federal Reserve System. To
finance a portion of these operations, the ESF “ware
housed” $4,000 million equivalent of foreign currencies
with the Federal Reserve (see Box).
In other operations, the ESF acquired $198.0 million
equivalent of Japanese yen through sales of Special
Drawing Rights and repayments under the Supplemen
tary Financing Facility of the International Monetary
Fund. Also during the period, Bolivia drew the full $100
million from a short-term financing facility established
on July 11 by the U.S. Treasury through the ESF. The
ESF short-term facility with Venezuela, established on
March 10, expired in May. There was no activity in the
facility during the period.
As of end July, cumulative bookkeeping or valuation
gains on outstanding foreign currency balances were
$1,045.5 million for the Federal Reserve and $502.8
million for the ESF. These valuation gains represent the
increase in the dollar value of outstanding currency
assets valued at end-of-period exchange rates, com
pared with the rates prevailing at the time the foreign
currencies were acquired.
The Federal Reserve and the ESF regularly invest
their foreign currency balances in a variety of instru
ments that yield market-related rates of return and that
have a high degree of quality and liquidity. A portion of
the balances is invested in securities issued by foreign
governments. As of end July, holdings of such securi
ties by the Federal Reserve amounted to $5,113.6 mil
lion equivalent, and holdings by the Treasury amounted
to the equivalent of $5,856.9 million.
Recent FRBNY Unpublished Research Papersf
8913. McCauley, R obert N., and Steven A. Zimmer.
“ Explaining International Differences in the Cost
of Capital: The United States and United King
dom versus Japan and Germany.” August 1989
8914. Fons, Jerome S. “ The High-Yield Market Struc
tu re and the Im pact of S e c u rity S u p p lie s .”
August 1989.
8915. De Kock, Gabriel S. P. “ Endogenous Exchange
Rate and Regime Sw itches.” Septem ber 1989.
With Vittorio U. Grilli.
8916. Brauer, David A. “ Does C entralized C ollective
Bargaining Lead to Wage Restraint? The Case
of Israel.” October 1989.
8917. Korobow, Leon, and David P. Stuhr. “A New Look
at U.S. Banking Strategy and Structure in the
1980s.” November 1989.
8918. Englander, A. Steven, and Gary Stone. “ Inflation
Expectations Surveys as Predictors of Inflation
and Behavior in Financial and Labor Markets.”
December 1989.
8919. Kambhu, John. “ Concealment of Risk and Regu
lation of Bank Risk Taking.” December 1989.
fS in g le copies of these papers are available upon
re q u e s t. W rite to R ese a rch P apers, Room 901,
A Research Function, Federal Reserve Bank of New
York, 33 Liberty Street, New York, N.Y. 10045.
FRBNY Quarterly Review/Autumn 1989
Single-copy subscriptions to the Quarterly Review (ISSN 0147-6580) are free. Mul
tiple copies are available for an annual cost of $12 for each additional subscription.
Checks should be made payable in U.S. dollars to the Federal Reserve Bank of
New York and sent to the Public Information Department, 33 Liberty Street, New
York, N.Y. 10045 (212-720-6134). Single and multiple copies for U.S. and for other
Western Hemisphere subscribers are sent via third- and fourth-class mail, respec
tively. All copies for Eastern Hemisphere subscribers are airlifted to Amsterdam
and then forwarded via surface mail. Multiple-copy subscriptions are packaged in
envelopes containing no more than ten copies each.
Quarterly Review subscribers also receive the Bank’s Annual Report.
Quarterly Review articles may be reproduced for educational or training purposes,
providing they are reprinted in full and include credit to the author, the publication,
and the Bank.
Library of Congress Catalog Card Number: 77-646559
FRBNY Quarterly Review/Autumn 1989
5T
co
CD
O
c
03
—
s
CD
D
CD
CD
Q.
Federal Reserve Bank of New York
3
13
O
GO
33 Liberty Street
New York, N.Y. 10045
J3
CD
C
—i
@FedFRASER