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A MONETARIST

MODEL OF EXC

RATE DETERMINATION
Thomas M. Humphrey

Almost four years have passed since the major
nations of the world decided to let their currencies
float., jointly or individually.
During this period
foreign exchange rates have eshibitecl sharp movements, examples being the recent precipitous fall of
the international
value of the British pound, the
Italian lira, and the Mexican peso as well as sharp
gyrations in the U. S. dollar relative to the German
deutschemark.
Among the explanations that have been advanced
to account for these movements is the monetarist
approach, which views national monetary policies as
the primary factor directly or indirectly influencing
exchange rates. -4s usually presented, the monetarist
approach emphasizes that the exchange rate is determined by demands for and supplies of national currencies; that it is subject to the same influences as
other asset prices (e.g., stock prices) ; that it is particularly sensitive to expectations about future eschange rates, expectations that are heavily conditioned by recent and current tnonetary policies; and
finally that it reflects all available information about
the two currencies and therefore alters in response to
new information about changed circumstances.
In
accord with this view, monetarists argue that one
reason for the observed volatility of exchange rates is
that monetary policies of major nations have been
variable and erratic. Policy changes, so the argument
goes, have induced asset holders to alter their espectations of future exchange rates, thereby resulting in
large movements in current exchange rates. A second
factor allegedly contributing to exchange rate movements is lack of policy coordination among nations as
manifested by divergent rates of monetary growth.
Monetarists contend that this factor produces international differential inflation rates that are a primary
source of e&?ange
rate variability.
It follows~
therefore, that the way to achieve exchange rate
stability is for countries to abandon monetary finetuning for policy rules calling for uniform constant
rates of monetary growth per unit of trend output.

If the foregoin g monetarist view sounds familiar,
it is probably because it appears so frequently in the
financial journals and the popular press.
For example, Milton Friedman regularly espouses it in his
No~~~eek column, as do the editors of the Wall
Street Journal and analysts writing in Citibank’s
Montlzly Economic Letter.
Rarely, however, do
these commentators
mention the analytical framework underlying their analysis, although that framework is a standard part of the monetarist approach.’
The purpose of this article is to present one version of this framework and to discuss its public
policy implications. The framework is represented in
the form of a simple two-country,
seven-equation
expository model of exchange rate determination.”
This model has a long history dating back at least
175 years. A rudimentary version of it was first used
by David Ricardo, John Wheatley, and other classical
economists to explain the fall of the paper pound
following Britain’s suspension of convertibility
of
notes into bullion at a fised price during the Kapoleonic wars. Later it was employed by the Swedish
economist Gustav Cnssel to explain the fall of the
German mark during World War I and afterward
in the famous hyperinflation
episode of the early
1920’s. In fact, the model in one form or another
has been at the center of monetarist policy discussion
and analysis whenever flexible exchange rates have
been in operation.3
Applied to recent experience,
the model is capable of explaining why exchange
rates have been so volatile and why espectational influences have caused them to deviate from levels suggested by underlying rates of monetary and income
growth alone.
i This framework
has been thorouahly
developed in the seholarb
if
not the ~omlar, literature. See in particular the paners cited’ in
the list of references at the end of this article.
The present article
draws heavily from these sources.
2 The model presented here is adapted from similar models developed
by Bilson t-1.21, Dornbusch
[3], F’renkel [4], Fry ES], Magee [G-J,
and Mussa [73.
“See Frenkel
[4] and Myhrman
[S], especially the latter. for a
discussion of the role of the monetarist
approach in earlier exchange
rate

FEDERAL RESERVE BANK

debates.

OF RICHMOND

3

Key Propositions
Central to the model are six
ingred’ients that should be acknowledged at the outset. These include (1) the quantity theory of money,
(2) the purchasing power parity doctrine, (3) the
interest rate parity concept, (4) the Fisher relationship (named for the economist who first formulated
it) between nominal and real interest rates, (5) a
monetarist
expectations-formation
hypothesis, and
(6) the efficient markets hypothesis.
The quantity theory states that the price level clears the
market for money balances by bringing the real
(price-deflated)
value of the nominal money stock
into equality with the real demand for it. The purchasing power parity doctrine states that the equilibrium exchange rate is such that a unit of a given
currency commands the same quantity of goods and
services abroad when converted into the other currency as it commands at home. This implies that the
buying powers of the two currencies are the same
when expressed in terms of a common unit at the
equilibrium rate of exchange.
Such purchasing
power equalization eliminates profitable opportunities
for commodity arbitrage, thereby insuring that existing stocks of national currencies will be willingly held
and that the markets for real cash balances in both
countries will clear simultaneously.
Similar reasoning underlies the interest rate parity concept, which
states that the real rate of return on capital assets
tends to be everywhere the same and independent of
the currency denomination of the asset. The Fisher
relationship states that the nominal rate of interest
equals the real rate of interest plus the expected rate
of inflation. Taken together, the Fisher relationship
and the real interest rate parity concept imply that
international
nominal interest rate differentials reflect differences in national inflationary
prospects.
The monetarist
expectations-formation
hypothesis
states that the public forms expectations of the future
rate of inflation on the basis of its perception of the
likely future course of monetary policy. Finally, the
efficient markets hypothesis states that the current
market price of an asset (e.g., foreign eschange)
reflects all available information
and adjusts instantaneously to incorporate new information.
Constituting the central analytical core of the monetarist view of exchange
rate determination,
the
foregoing propositions
are incorporated
into the
model presented below.
The Model and Its Components
The model itself
consists of seven equations containing the following
variables.
Let M be the nominal money stock (assumed to be exogenously determined by the central
bank) and m and me be the current and expected
4

ECONOMIC

future rates of growth of that stock. Furthermore,
let D be the real demand for money, i.e., the stock
of real (price-deflated)
cash balances that the public
desires to hold, Y the esogenously determined level
of real income, i and r the nominal and real rates of
interest, respectively, and -a the interest elasticity of
demand for money. Also let X be the exchange rate
(defined as the domestic currency price of a unit of
foreign currency),
P be the price level, E be the
expected future rate of inflation, and I be the set of
information upon which those expectations are based.
Asterisks are used to distinguish foreign-country
variables from home-country variables, and the subscript w refers to the entire world economy.
The foregoing variables are linked together via
the following relationships :
(1)

P = M/D and P* = M*/D*

(2)

D = Yi-” and D* = Y*i*-a

(3)

P = XP”

(4)

i = r + E and i* = r* + E*

(5)

r=r

(6)

E = E(m’)

(7)

m” = me( m, I) and me* = me* (m*, I*)

* = rW
and E* = Ed’ (me*)

The first relationship, which can also be written as
-M/P = D, is the monetary equilibrium equation. It
states that the price level in each country adjusts
instantaneously to bring the real value of the nominal
money stock into equality with the real demand for
it thereby clearin, m the market for real cash balances.
Kate that the equation also implies that, given the
real demand for money, the price level is determined
by and varies equi-proportionally
with the nominal
money supply. This latter result, of course, is the
essence of the quantity theory of money.
The second equation is the money demand function
that expresses the public’s demand for real cash
balances as the product of two variables, namely real
income and the nominal interest rate. The former
variable is a proxy for the volume of real transactions
effected with the aid of money and thus represents
By contrast:
the transactions demand for money.
the interest rate variable measures the opportunity
cost of holding money.
The parameter --a, which
appears as the exponent on the interest rate variable,
is the interest elasticity of demand for money. This
parameter measures the sensitivity or responsiveness
of money demand to changes in the interest rate and
is assumed to be a negative number indicat:ing that
desired real cash balances vary inversely .with the
cost of holding them. Kate that the numerical magni-

REVIEW, JANUARY/FEBRUARY

1977

tude of the interest elasticity ,coefficient is assumed
to be the same in both countries. Xote also that the
income elasticity of demand for money, as represented
by the exponential power to which the income variable is raised, is assumed to possess a numerical
value of unity.
The third equation of the model is the purchasing
power parity relationship showing how national price
levels are linked together via the exchange rate. As
indicated by the equation, prices in both countries
are identical when converted into a common unit at
the rate of exchange. This means that the exchange
rate equalizes such (normalized) price levels and, by
implication, the purchasing power of both moneys
expressed in terms of a common currency unit. This
condition of equalized purchasing power is of course
necessary if the two national money stocks are to be
willingly held and equilibrium is to prevail in both
money markets simultaneously.
If the purchasing
powers were unequal, people would demand more
of the high- and less of the low-purchasing power
currency on the market for foreign exchange.
The
resulting excess demand for the former and the
corresponding excess supply of the latter would cause
the exchange rate between the two currencies to
adjust until purchasing power was equalized and
both money stocks were willingly held. Sote also
that the purchasing power parity equation can be
rearranged to read X = P/P*, thus corresponding
to the monetarist interpretation of the exchange rate
as the relative price of two currencies, i.e., as the
ratio of the foreign currency’s value in terms of goods
to the domestic currency’s value in terms of goods.
Since the value of a unit of currency in terms of a
composite market basket of commodities is the inverse of the general price level l/P, it follows that
the relative price of the two moneys is simply the
ratio of the national price levels as indicated by the
equation.
The fourth and fifth equations explain the determination of the nominal and real rates of interest,
respectively.
Following Irving Fisher, the fourth
equation defines the nominal interest rate as the sum
of the real rate of interest and the espected future
rate of inflation, the latter variable being the premium
added to real yields to prevent their erosion by
inflation.
The fifth equation expresses the concept
of interest rate parity according to which real yields
on assets tend to be the same everywhere and independent of the currencies in which denominated.
Since capital is mobile internationally, i.e., foreigners
can purchase domestic securities and domestic citizens can purchase foreign securities, it follows that

real yield equalization is necessary if all asset stocks
are to be willingly held. Accordingly, the equation
states that reai interest rates in both countries are
the same and are equal to a given constant world
rate. Taken together, equations 4 and 5 imply that
international nominal interest rate differentials reflect
differences in expected future national rates of infiation. For example, if the market expects the future
rate of inflation to be 10 percent in the U. K. and 3
percent in the U. S., then the U. K. nominal interest
rate will be 7 percentage points above the corresponding U. S. interest rate.
The sixth and seventh equations together explain
how the public forms its expectations of the future
rate of inflation.
These inflationary expectations
constitute the anticipated future rates of depreciation
of money hold5gs.
As such, they enter the foreign
and domestic demand for money functions via the
nominal interes rate variables and thereby play an
important role in determining the exchange rate.
Regarding the iormation of price anticipations, equation 6 expresses the monetarist hypothesis that inflationary expecta:ions are based on what the market
believes the furare rate of monetary growth will be.
This of course means that the market must forecast
the future rate of monetary growth in order to forecast the future rate of inflation. Equation 7 explains
how money growth forecasts are formulated.
The
equation embodies the assumption that people formulate expectations rationally, using all available information in predicting future monetary growth, and
perhaps revisizg their predictions as new information
appears. Relexxnt information includes recent policy
pronouncements, imminent political changes, data on
past and current behavior of the monetary aggregates, past observations on the policymakers’ responses to changes in the economy, and the like. In
equation 7, the information input is represented by
two variables, namely the current growth rate m of
the monetary a_
cgregates and all other information I.
The model does not attempt to explain precisely how
money growth iorecasts are derived from this inforIt simply assumes that the forecasts are
mation.
somehow made> that they constitute the most accurate
predictions pol;Gble given the state of the market’s
knowledge and the availability of information, and
that they form The basis for future price anticipations.
Xote that the substitution of equation 7 into equation 6 yields the efficient market hypothesis that the
price expectations underlying the eschange rate reflect all availabie information concerning it.
Linkages
foregoing

and Causation
Taken together,
the
reiaeonships
constitute a simple seven-

FEDERAL RESERVE BANK OF RICHMOND

5

equation system that embodies the monetarist view
of exchange rate determination.
The equations imply
two unidirectional channels of influence-one
direct,
the other indirect-running
from money to prices to
the exchange rate. Regarding the former channel,
the model implies that the actual stock of money
affects prices and the exchange rate directly through
the monetary
equilibrium
and purchasing
power
parity equations.
As for the indirect channel, the
model implies that the anticipated future growth
rate of money influences prices and the exchange rate
indirectly through the price expectations component
of the nominal interest rate variable that enters the
demand for money functions.
More specifically, the
model postulates the following causal chain :
1. Current and past monetary growth rates influence predictions of future monetary growth.
2. Predictions of future monetary growth determine the expected rate of inflation.
3. Given the real rate of interest, inflationary
expectations determine the nominal rate of interest.
4. The latter variable, together with the given
level of real income, determines the demand for
money.
5. Given the demand for money, the nominal
money stock determines the price level.
6. Finally, the two price levels, foreign and domestic, together determine the exchange rate.

Clearly, in the model presented above, the linkages
run from money (actual and anticipated) to prices
to the exchange rate. Moreover, all variables affecting the exchange rate do so through monetary channels, i.e., through the demand for or supply of money.
In this sense, money demand and supply may be said
to constitute the proxhmzte determinants of the exchange rate.
The ultimate determinants, however,
are the variables that underlie and determine the
monetary factors themselves, namely income, interest
rates, price expectations,
money stocks and their
growth rates, and other exogenous information.
Determinants

of the Exchange

Rate

To show
the relationship between the exchange rate and its
ultimate determinants,
simply substitute equations
2-7 into equation 1 and solve for the exchange rate.
The resulting “reduced form” expression is
(8)

X =

[M/M*]

[Ye/Y]

[i/i*]”

or, since the nominal interest rate i is the sum of the
real interest rate r and the expected rate of inflation

6

ECONOMIC

Equation S (or S’) collects the determinants of ,the
exchange rate into three groups, namely relative
money supplies, relative real incomes, and relative
nominal interest rates comprised of a fixed real rate
component and a variable price expectations component.
Of these three groups, the first captures
purely monetary influences on the exchange rate
while the second and third capture real and expectational influences, respectively.
Regarding the first group of determinants,
the
equation implies that, all else being equal, the country with the faster monetary growth will find, its
currency depreciating on the foreign exchanges.
As
for the second group of determinants, the equation
predicts that, everything else being equal, the country
with the faster growth of real income and hence real
demand for money will experience an appreciating
exchange rate. The reason is straightforward.
Given
a constant nominal money stock, a real incomeinduced rise in the demand for it necessitates a f,all in
the price level to clear the market for money balances.
Since the required price fall is greater in the highthan in the low-growth economy, and since the exchange rate by definition is the ratio of the two price
levels, it follows that the high-growth country’s currency will be appreciating on the foreign exchanges.
Note that the monetarist conclusion that real income
growth tends to appreciate
(lower) the exchange
rate contradicts the traditional trade balance view
that income growth depreciates the exchange rate by
inducing a rise in the home demand for imports.
Finally, as regards the third group of determinants,
equation S (or S’) states that, everything else being
equal, the country with the relatively worsening inflationary prospects will have a depreciating exchange
rate. There are two explanations for this.
First,
people will desire to hold relatively less of the currency whose value is expected to fall the most.
Therefore the relative asset demand for that currency
will fall and the exchange rate will depreciate-asc:hanges
suming, of course, that no compensating
occur in relative money supplies. Second, contracts
will tend to be written in terms of the curreacy that
is expected to depreciate the least, i.e., the stronger
currency will be preferred to the weaker as an international unit of account, standard of value, and medium of exchange. The resulting fall in the relative
transactions demand for the weaker currency will
reduce its value on the foreign exchanges.
In short,
an anticipated depreciation of a currency will reduce
both the asset and transactions demand for it thereby
helping to brin g about the very depreciation that is
anticipated.
Note, however, that such anticipations

REVIEW, JANUARY/FEBRUARY

1977

are not independent of recent and current monetary
policies (represented by the \:ariables m and 111%
in
equation S’) but arc strongly conditioned by them.
Within the contest of the model, at least, a history of
unrestrained monetary expansion will produce expectations oi more of the same thereby contributing to
the weakness of the currency on the foreign exchanges.
Similarly, ;L history of monetary stab+
will help create the favorable espectations that contribute to a currency’s strength.
The preceding discussion gives some inclication oi
the importance that monetarists attach to the role of
expectations in determining exchange rates. Corrcsponding to this emphasis on expectations, equation
S’ specifies divergent inflationary prospects as the
reason why exchange rates often deviate from levels
suggested by relative money stocks and real incomes
alone. According to the equation, the exchange rate
will conform to the level suggested by the underlying fundamentals only when inflationary expectations are the same in both countries.
In this special
case, expected future rates of return on both currency
holdings are identical and cancel out, and the eschange rate is determined solely by the fundamentals.
In all other cases? however, differential expected
inflation rates influence the eschange rate and cause
it to diverge from the Ievel predicted by the fundamentals, i.e., relative money stocks and real incomes.
Equation 5’ would be of little interest to analysts
and policymakers
were it incapable of esplaining
another characteristic of recent floating rate experience, namely exchange rate Volatility. Fortunately.
however, the equation can account for suc11 behavior
and does so by identifying two main sources of
exchange rate movements.
The first is shifts in
relative money supplies (M/M*)
owing to monetary
policies that are variable and divergent as between
For esample, oscillatory movements in
countries.
the exchange rate could be produced by two countries
engaging in discretionary
countercyclical monetary
policy but always in opposite directions, A’s money
stock expanding when I3>s contracts, and vice versa.
The second source of eschange rate volatility identified by equation s’ is expectational shifts occasioned
by the appearance of new information-e.g.,
announced changes in policy targets-about
the future
prospects for various currencies.
The new information leads the market to revise its opinion about the
future costs and returns from holding the different
currencies.
Reflecting these espectational shifts, exchange rates change until the existing stocks of the
various currencies are again willingly held. Sote
that exchange rates are no different than stock prices
in this respect. Just as the price of a firm’s stock at

any moment reflects all avaiIable information about
the future profitability of the firm, so also does an
exchange rate embody all hcown information about
the future values of two currencies. New information
that alters the market’s perception of these future
values will result in sudden changes in exchange
rates just as new information about future firm
profitability causes sharp shifts in a stocli’s price.
Both are special cases of the general rule that, gixzen
new information about changed circumstances, the
market price of any asset -whether
equity share or
unit of foreign currency or whatever-must
change
until the outstanding stock of the asset is willingly
held.
A third possible source of exchange rate instability
is variations in the ratio of real incomes (Y*/Y).
This factor, however, is deemphasized by monetarisrs
who believe it to be dominated by shifts in relative
money stocks and relative inflationary expectations.
Policy Implications
of the Model
This article
has presented a monetarist
model that specifies
money stocks and inflationary expectations as ke;\l
determinants of the exchange rate and that stresses
the role of monetary policy in influencing these determinants.
Specifically, the model postulates that
money stocks are exogenously controlled by national
central banks and that the public’s expecrations about
the future purchasing power of various currencies
are strongly shaped by current policy actions and
announcements.
Several implications follow from
the model. It is well to remember, however, that
these implications reflect the particular assumptions
underlying the model and that some of these assumptions are disputable.
This is especially true of the
assumptions of purchasing power parity, real interest
rate parity, and exogeneity of real income.
While
these conditions may hold in long-run equilibrium,.
empirical evidence suggests that they may not hold
over any realistic short-run policy horizon nor over
the transitional adjustment period following economic
sllocks.
Recognition of this fact would probably
modify any policy prescriptions based on the model.
Subject to these caveats, the policy implications of the
model are summarized below.
The first implication is that, given the rate of
ioreign monetary growth, the most effective means
of halting and reversing a depreciation of the eschange rate is a preannounced permanent reduction
in the rate of domestic monetary expansion. As new
information, the announcement itself will of course
have an immediate impact on the exchange rate
through the price expectations channel.
For this
impact to be anything more than temporary, however,

FEDERAL RESERVE BANK OF RICHMOND

7

the pub1ic must be convinced that the announced
policy target is a reliable indicator of the future
growth rate of the money stock. To convince the
public of this, the authorities must bring the actual
rate of monetary growth into conformity with the
announced target rate since the public forms its expectations of future monetary growth at least partly
on the basis of the observed current growth rate. Assuming this is done and the stable money growth rate
target is thereafter permanently adhered to, the exchange rate will continue to be strengthened through
the money stock and price anticipation channels.
A second policy implication is that exchange rate
movements are going to occur when domestic monetary policies are divergent and inconsistent as between countries.
This can be demonstrated by rewriting equation 8 as X = (M/Y) (Y*/M*) (i/i*)“.
As written, this expression shows the relationship
between the exchange rate, its underlying national
money/output
ratios, and of course the interest rate
Dissimilar monetary policies (i.e., internaratio.
tional differences in rates of monetary growth per
unit of real output) cause the money/output
ratios
to diverge. When this happens relative inflationary
expectations
are also affected, thereby producing
These changes
changes in the interest rate ratio.
augment and reinforce the impact of the divergent
money/output
ratios on the exchange rate. Because
of these influences, the exchange rate is going to
vary when monetary policies differ as between countries.
The exchange rate will be stable only if both
countries agree to keep their money/output
ratios
constant or at least growing at the same rate. This
in turn requires that both countries abandon divergent policies for a uniform rule tying the money
growth rate to the growth rate of real income. Note
in particular that within the context of the model
it is impossible for a single country to stabilize the
exchange rate by adhering to a monetary rule if the
other country persists in monetary fine-tuning.
In
short, exchange rate stability is virtually impossible
when countries pursue incompatible monetary policies.
A third policy implication, therefore, is that policy
coordination or harmonization is the key to eschange
If two countries agree to adopt the
rate stability.
same monetary expansion rule-e.g.,
a rule tailing
for a constant rate of domestic monetary growth
fixed in relation to the trend growth rate of domestic
output-then
both will enjoy the same long-run
stable domestic inflation rate, and the floating exchange rate between their currencies will be virtually
as constant as an institutionally fised rate. In this
8

ECUNOMIC

REVIEW,

case, policy coordination would allow the countries
to enjoy the advantages of a fixed exchange rate
while retaining some degree of national monetary
autonomy.
The preceding discussion raises several questions.
Why is exchange rate constancy so important 7 Is
the type of exchange rate regime per se cruciaI to
the attainment of that objective? Regarding the first
question, it can be stated unequivocally that eschange
rate constancy is a prerequisite
for an efficiently
This is
operating international
monetary system.
because money, in its role as a social device for
economizing on the use of scarce resources in the
generation and transmission of economic information,
is most effective when its value across countries is
stable, certain, and predictable.
These qualities of
course are lacking when exchange rates fluctuate and
money therefore functions poorly as a resourceIn such situations, traders themselves
economizer.
must forecast shifts in the value of currencies, bear
the risks of such shifts, or hire someone else to bear
the risks. Either way, real resources-effort,
time,
knowledge-are
diverted from productive pursuits
into forecasting and risk-taking activities that would
be totally unnecessary if exchange rates were constant.
It follows that the international
economic
system is not going to be operating at peak effic.iency
as long as exchange rates continue to fluctuate.
On
efficiency grounds alone, therefore, exchange rate
constancy is a desirable objective.
As for the question of whether a specific exchange
rate regime-fixed
or floating-is
crucial to the
attainment of that objective, the answer appears to be
The preceding analysis suggests
in the negative.
that the key to achieving exchange rate constancy
lies less in the way the foreign exchange market is
organized than in finding a means of coordinating
national monetary policies. As previously mentioned,
policy coordination in the form of the adopt:ion of
uniform rules is required if exchange rates are going
to be constant in a floating rate regime.
Similarly,
some sort of coordination is necessary in a fixed rate
regime, otherwise countries might inflate their domestic money stocks at different rates forcing a
breakdown of the system.
To summarize, policy
coordination, not the exchange rate regime, is the
sine qua non for exchange rate stability.
Summary
This article has presented
a simple
expository model of exchange rate determination that
incorporates key elements of the monetarist approach.
These elements lead to the conclusion that the exchange rate is determined by relative money stocks,
relative real incomes, and relative inflationary especJANUARY/FEBRUARY

1977

tations, with the last variable

being strongly conditioned b>: observed rates of monetary growth.
The
model is helpful in esplaining exchange rate volatility

or under-valcec
ior long periods. Finally, the mode1
provides a use&i framework for specifying the conditions necessaq for the attainment of exchange rate

and the tendency for some currencies

stahilitg.

to remain over-

References
BiIson, John F. 0. “The Monetary Approach to the
Exchange Rate: Some Empirical Evidence.”
Unpublished manuscript, Northwestern University,
October 1976.
. “Rational Expectations and the Exchange Rate.”
Unpublished manuscript, Korthwestern University, August 1976.
Dornbusch, Rudiger. “The Theory of Flexible Exchange Rate Regimes and Macroeconomic Policy.”

Scandinavian

Jownal

(1976)) 255-75.

of

Economics,

78,

No.

2

5. Fry, MaxweX J. “A Monetary Approach to Afghanistan’s Flexible Exchange Rate.” Journal of
Money, Credit and Banking, 8 (May 1976), 219-25.
6. Magee, Stephen P.
“The Empirical Evidence on
the Monetav Approach to the Balance of Payments and Exchange Rates.” American Economic
$TT$J:
Papers and Proceedings,
66 (May 1976),
- .
Mussa, Xichael. “The Exchange Rate, the Balance
of Payments, and Monetary and Fiscal Policy Under
a Regime of Controlled Floating.”
Scandinavian
Journal

Frenkel, Jacob A. “A Monetary Approach to the
Exchange Rate: Doctrinal Aspects and Empirical
Evidence.” ScandirLavialz Journal of Economics, ‘i8,

No. 2 (1976), 200-24.

FEDERAL RESERVE BANK

of Economics,

78, No. 2 (1976),

229-48.

8. Xtyhrman, J&an.
“Experiences of Flexible Exchange Rates in Earlier Periods: Theories, Evidence
and a New l’iew.” Scandinavian Journal of Economics, 78, So. 2 (1976), 169-96.

OF RICHMOND

9

FORECASTS 1977
A PERSISTENT

BUT GRADUAL EXPANSION

William E. C&son

The views and opinions set forth in this article
are those of the various forecasters.
No agreement or endorsement by this Bank is implied.

The economy will continue to expand in 1977, and
“the pause” will pause, at least for the year. That,
at least, is the general conclusion reached by leading
business and academic economists who have published forecasts for the 1977 economy.
Each year the Federal Reserve Bank of Richmond
compiles various forecasts of the economy’s performance for the coming year. This year many of the
forecasters based their’ forecasts on the following
assumptions :
1. Higher

oil prices ;

2. Good harvests
prices ;

resulting

3. Continued availability
financing ;
4. An “accomodative”

in

lower

of money

monetary

grain

for home

policy.

Many also assumed that any fiscal stimulus that may
be introduced by the Carter administration would not
be felt in 1977. On the basis of these assumptions,
the forecasters expect approximately
a 5.0 percent
rate of real growth for GNP. This slightly lower rate
is expected to be accompanied by a 5.4 percent increase in prices and a 7.1 percent unemployment
rate.
Last year the consensus prediction was remarkably
close to the target for the year as a whole.
The
consensus was in error, however, on the path of the
expansion during the course of the year. Last year’s
forecasters did not anticipate the so-called “pause”
or “lull” in the economy’s growth. This lull, which
many observers believe began in June, persisted,
some think, through October.
There is some question about the dating of the pause, since different
indicators suggest different dates. For example, the
10

ECONOMIC

REVIEW,

unemployment rate, which reached a low of 7.3 percent in May and began to move up sharply until July
and slowly thereafter, suggests that the economy
could still be in the growth pause. The reliability of
the unemployment rate as an economic indicator has
been questioned, however, because of the estraordinarily large increase in the civilian labor force in
1976. Employment increased at a good pace until
June, and after a pause, apparently resumed its longterm normal growth path in November. The index of
industrial production increased until August, when it
began a decline that lasted until October. In November, however, the index turned up again.
This year the forecasters expect steady, though
moderate, expansion.
Although the growth in 1977
is expected to be balanced with no sectors declining,
the outlook appears to be brightest for residential
construction, and especially for single-family dwellings, where conditions are expected to be much improved.
Even for multi-family dwellings the seers
expect considerable improvement.
This article attempts to convey the general tone
and pattern of some 40 forecasts received by the
Research Department of this Bank. Not all of these
forecasts are comprehensive, and some incorporate
estimates of future behavior of only a few key economic indicators. The consensus of the annual forecasts may differ from the consensus drawn from the
quarterly forecasts, since different forecasters were
applying their skills. Also, since there were varying
assumptions in the individual forecasts regarding
events in 1977, the general tone and pattern may not
necessarily be based upon the more realistic assumptions but only those most prevalent.
the booklet Business
of representative business forecasts with names and details of the
various estimates. No summary article can ever be
as informative as the actual forecasts themselves.
Serious readers are urged to look at the individual
forecasts in more detail in Business Forecasts 1977.
This

Bank

Forecasts

JANUARY/FEBRUARY

also publishes

1977, which is a compilation

1977

1976

FORECASTS

IN PERSPECTIVE

Commerce indicate that GNP in 1976 actually increased 11.6 percent. Prices, however, increased at a
somewhat slower rate than anticipated, so preliminary estimates put the increase in real GNP around
6 percent-quite
close to the amount of increase predicted by the consensus of last year’s forecasters.
The forecasters expected the unemployment
rate
to average 7.8 percent for the year. At present, preliminary estimates indicate an average of 7.7 percent.
As with the aggregate figure, the forecasters also
predicted the components of GNP more accurately
than in past years. Personal consumption spending
was forecast to increase 11.0 percent, very close to
the actual 10.S percent rate of increase.

The consensus forecast for 1976 GNP, published
in last year’s January/February
Economic Review,
predicted an increase of 12 percent over 1975. The
rates of increase forecast ranged from 9.0 percent to
13.4 percent. Using the revised 1975 GNP total of
$1,516.3 billion, the consensus forecast for 1976 GNP
would have been $1,698.3 billion and the range from
$1,652.8 billion to $1,719.5 billion. Increasing prices
were expected to account for 5.6 percent of the gain
in GNP, so GNP measured in constant dollars, or
real GNP, was expected to rise 6 percent.
Current

estimates

by the U. S. Department

RESULTS

of

FOR 1976 AND TYPICAL FORECAST FOR 1977
Perirn-iege
Unit or
Base

PrellLm$ary Forecast
*
1977**

‘p97756/ ‘p977p7/
--

1692.4

1880.2

11.6

1078.6

1192.2

10s

10.5

Durables ________________________________________-------------------$ billions
156.3
_______ -__-______
________._______.__.______________
$ billions
440.3
Nondurables

175.4
4i9.9

18.7
7.6

12.2
9.0

______
- ________________________________________---------$ billions
482.0

536.9

241.2

281.5

11.5
31.3

11.4
16.7

160.0

183.7

S.8

14.8

67.S

82.5

13.4

15.3

32.4
-

21.7
-

________________________________________
$ billions
365-S

399.s

7.9

9.3

Gross national product ________________
- ______
- _________________
$ billions
Personal

consumption

Services

expenditures

______________._
$ billions

Gross private domestic investment ___________________
$ billions
Business fixed ___________________________________
- _____________
$ billions
Residential

structures

_____________________________________
$ billions

Change in business inventories

______________________
$ billions

Government

purchases

Net exports

__.___________________________I_________---------------$ billions

6.9

6.7

1265.0

1328.3

6.2

5.0

121.2”

137.2

7.5

13.2

profits before taxes ____-__________________________
$ billions

148.0’

167.2

29.3

13.0

housing starts ___________
- ______________________________
millions

1.6

1,s

34.5

16.9

8.6

9.1

16.6

6.0

7.7

7.1

-

-

Gross national product
Plant and equipment
Corporate
Private

11.1

Automobile

(1972 dollars)

expenditures

sales (domestic)

________________
$ billions

_________ - $ billions
- _____

___________ ___________
- _____
millions

_______ - _______________________
- ______
percent

Rate of unemployment
Industrial

production

index __________________________________
1967= 100

129.8

138.2

10.2

6.5

Wholesale

price index __________________________________I_____-- 182.9
1967= 100

192.2

4.6

5.1

Consumer

price index __.____________
- ___________________________
1967= 100

lSO.6

5.s

5.9

141.0

5.1

5.4

170.5

Implicit price deflator ________________________________________-----1972= 100
133s
+Data available
**Figures

as of January

are constructed

24, 1977.

from the typical percentage

change forecast for 1977.

eEstimated.

FEDERAL RESERVE BANK

OF RICHMOND

11

The components of consumption spending, however, were predicted less accurately.
Consumer purchases of durable goods, estimated to increase 15
percent, actually rose IS.7 percent.
In contrast to
the underestimate of consumer durables, purchases of
nondurables were overestimated, the actual rate of
increase, 7.6 percent, being 3.1 percentage points
below the forecast rate of increase.
Consumption
spending for services was forecast to increase only
10.1 percent, so its actual 11.5 percent increase combined with the underestimate
of durable purchases
acted to offset the overestimate of nondurable expenditures. As a result of these offsetting errors, the
11 percent expected increase in aggregate consumption turned out to be, quite fortuitously, close to the
actual 1O.S percent figure.
The forecasters expected a large increase in gross
private domestic investment from its depressed 1975
level, but not as large as the 31.3 percent rise that
Their major error was in
actually materialized.
underestimating
business inventory investment by
S5.S billion. By contrast, residential construction and
business fixed investment spending were predicted
Residential construction, predicted
fairly accurately.
to increase 33.3 percent, actually rose 32.4 percent:
and business fixed investment, projected to rise 10.3
percent, actually rose 8.5 percent. When combined,
those figures resulted in a predicted 28.4 percent
increase in aggregate gross private domestic investment, and that prediction, as noted earlier, was well
below the figure realized.
Net exports, which the forecasters always iind
difficult to estimate accurately, was underestimated
by only $1.9 biIlion last year. Bv historical standards,
that is a relatively small error. As for the last major
component of GNP, namely government purchases of
goods and services, the forecasts centered around a
rate of increase of S.7 percent.
Actual government
spending is no\y thought to have risen 7.9 percent.
-411in all, the last year’s forecasters did remarkably
well in predicting average levels and rates of change
on key economic variables for the year. They anticipated the recovery quite well, and their numbers for
the year as a whole were closer to the mark than they
have been in any previous year since this Bank has
been gathering these data,
The consensus of the quarter-by-quarter
forecasts
for 19% had current dollar GXP rising s4l.S billion
in the first quarter, $46.7 billion in the second quarter, $46.0 billion in the third quarter, and $50.5
billion in the fourth. The realized quarterly increases
\vere $4S.O billion, $39.0 billion, $34.6 billion, and
$38.7 billion. For real GKP, the consensus forecast
called for quarterly increases of $16.3 billion, $18.2
12

ECONOMK

billion, SM.1 hifliont and $1.9.7 billion. The realized
numbers for the first three quarters, respectively:
were $27.1 billion, $13.7 billion, and $12.2 billion,
while the preliminary number for the fourth quarter
is now placed at $9.3 billion.
The forecasters, then, exhibited considerably less
prescience about the quarterly path of the economy
than they did about average figures for the year as
a whole. They espected relativeIy constant growth
in 1976, with the largest increase in GKP coming
in the fourth quarter.
Instead, the economy experienced its largest growth in the first quarter, with the
rate tapering off in the second, third, and fourth
quarters.
In defense of the forecasters: however, it
should be noted that the large growth of GNP in
the first quarter stemmed from hard-to-forecast
inventory stimulus with real inventory investment. increasing $15.9 billion. Likewise, much of the s’iowdowns in real GI\TP in the second and fourth quarters
came from inventory adjustments.
Excluding these
unespected and hard-to-predict
inventory swings, the
forecasters came much closer to anticipating actuai
developments.
The limits of forecasting prescience were equally
apparent in the discrepancy between actual and predicted quarter-by-quarter
behavior of the unemployment rate. The unemployment rate was espected to
decline gradually throughout the bicentennial year,
averaging 7.4 percent in the fourth quarter. In:jtead,
the unemployment rate surprised almost everyone by
dropping sharply in the first quarter-from
S.5 percent in the fourth quarter of 1975 to 7.6 percent:
continuing its fall, as expected, to 7.4 percent in the
second quarter ; but rising sharply to 7.8 percent in
*
the third quarter ) and continuing that rise into the
fourth, when it averaged close to S percent.
Thus, although those who forecast the quarter-byquarter performance
of the economy expected the
unemployment rate to average 7.75 percent for the
year (close to the actual 7.7 percent average rate),
they thought that the end-of-the-year
unemployment
figures would be substantially better than the!; actually were.
Regarding profits and production, the forecasts for
1976 underestimated the recovery of both. Before-tax
corporate‘profits
were predicted to rise 22.5 percent ;
most observers now think they increased about 30
percent. The index of industrial production rose 10.2
percent against a predicted increase of 9.3 percent.
As with the implicit price deflator, the forecasters
overestimated the rise in the consumer price index.
Consumer prices were expected to rise 6.5 .percent,.
but current figures indicate a rise of 5.S percent.

REVIEW, JANUARY/FEBRUARY

1977

1977

FORECASTS

IN BRIEF

Gross National Product
Forecasts
for 1977 current dollar GNP center around $l,SSO.2 billion.
This consensus forecast indicates an approximate
11.1 percent yearly gain, about the same as the 11.6
percent increase apparently registered in 1976. Prices
are expected to increase only 5.4 percent.
GNP
measured in constant dollars, or real GNP, is projected to rise 5 percent in 1977, considerably less
than the 6.2 percent increase registered in 1976.
Estimates for increases in current dollar GNP range
from 6.S percent to 12 percent, but the great majority
lie between 11.0 percent and 11.5 percent. The concensus of quarterly estimates indicates an expansion
of an essentially constant rate throughout the year.
It calls for increases of $45.3 billion in the first
quarter of 1977, $50.9 billion in the second, $52.1
billion in the third, and $54.0 billion in the fourth.
Personal consumption expenditures are expected
to total $1,192.2 billion for 1977, up 10.5 percent
from 1976. The estimates for consumption spending
range from an increase of 8.S percent to an increase
Forecasters estimate that expendiof 11.0 percent.
tures for durable goods will rise 12.2 percent for the
year, while expenditures for nondurables and services
are projected to advance 9.0 percent and 11.4 perThe expansion in durable goods
cent, respectively.
expenditures
is expected to stem primarily from
sales of appliances, furniture, and automobiles as a
result of generally improving consumer confidence,
a continued housing recovery, relatively strong demand for automobiles, and rising real disposable
incomes.
Government purchases of goods and services are
projected to total $399.S billion. This estimate represents a 9.3 percent increase over 1976, somewhat
larger than the 7.9 percent gain of the previous year.
The 1977 forecasts for government purchases range
from increases of S.2 percent to 11.0 percent.
Gross private domestic investment is expected to
rise by 16.7 percent in 1977, following a 31.3 percent
increase in 1976. Inventory rebuilding is expected
to continue at about the 1976 level, although without
the large quarter-by-quarter
fluctuations that characterized 1976. Residential construction, however,
will be the leading sector if the projectors are correct.
It is expected to increase by 21.7 percent in 1977.
Business fixed investment spending will be another
source of strength. That sector is expected to register a 14.S percent gain. The array of forecasts this
year, as is usually the case, diverge more from the
consensus in the investment area than in any other.
Expectations
for residential construction
increases
FEDERAL RESERVE BANK

TYPICAL*

QUARTERLY

FORECASTS

Quarter-by-Quarter
Changes in Billions
Unless Otherwise Noted

FOR 1977
of Dollars

II

III

IV

Product

I
---45.3

50.9

52.1

54.0

Personal Consumption
Expenditures

Gross National

27.0

31.2

31.0

30.1

Gross Private Domestic
Investment

9.s

10.7

12.0

11.7

Net Exports-t

4.5

4.0

3.2

3.0

7.7

5.4

9.4

1l.S

17.0

18.7

5.2

5.6

5.6

6.4

7.7

7.4

7.2

6.9

Government

Purchases

Gross National Product
(1972 Dollars)
Implicit

Price

Deflator$

Rate of Unemployment(o/o)f

18.0 18.0

“Median.
$Actual estimate.
$Percentage

changes at annual rates.

range from 13.6 percent to 27.5 percent. For business fixed inveszment, estimated increases range between 11.9 percent and 16.7 percent. Forecasts for
investment in business inventories, for which the
consensus was SC.3 billion, range from $14.0 billion to $21.0 billion.
Industrial
Production
The typical forecast for
the Federal Reserve index of industrial production
(196i = 1OOj in 1977 is 13S.2, an increase of 6.5
percent.
This prediction calls for more moderate
espansion than in 1976, when the index increased
10.2 percent. From a longer-term viewpoint, even if
the projected increase for 1977 is realized, the index
will still be onl:: 6.5 percent above its 1993 level.
Housing
The construction
industry is expected
to continue its recovery from the very low levels of
1974 and 1975. Activity in this sector, however, is
still espected to be below the 1971-1973 pace. Private
housing starts-which
totaled over 2 million in 1971,
1972, and 1973 : 1.3 million in 19i4 ; 1.2 million in
1975 ; and 1.6 million in 19X-are
expected to total
l.S million units in 1977. According to preliminary
estimates, however, housing starts closed 1976 at an
average annual rate of 1.S million in November
and December, so the predicted number for 1977
represents no improvement over the year-end 1976
rate. Forecasters expect the recovery to be limited
mainly to single-iamily dwellings. Home financing is
expected to be available, and the inventory of unsold
houses on hand has been reduced during 1976. High
OF RICHMOND

13

cm-rent prices for new homes, however, continue to
limit sales, and some builders have not yet recovered
from past difficulties.
Corporate
Profits
All the forecasters
expect a
better pretax profit figure than was realized last year.
The most pessimistic forecaster expects a 9.6 percent
profit increase ; the most optimistic a 19.5 percent
rise. The consensus forecast calls for an increase in
pretax profits of about 13 percent, to 5166.S billion.
This would follow a gain of approsimately 29 percent
in 1976. Hence, corporate profits are expected to
continue their rebound from their generally poor
performance in 1974 and 1975.
Unemployment
Most forecasters
are predicting a
decline in the rate of unemployment
during 197i.
The typical forecast for the year’s average is around
7.1 percent. This will be only 0.G percentage points
below the 1976 average, but considering that the
unemployment
rate at year-end 1976 stood around
8.0 percent., a 7.1 percent average for 1977 indicates
the seers expect employment growth finally to outpace labor force expansion and reduce the unemployment rate.
Prices
This year the forecast indicates that rhe
rate of price increase will level out at about last
year’s rate. The implicit GNP deflator, which rose
10.0 percent in 1974; an estimated 9.3 percent in
1975; and an estimated 5.1 percent in 1976; is apetted to increase only 5.4 percent in 1977. The
consumer price index is expected to average lS0.6.
5.9 percent higher than the 1976 average.
The
wholesale price index is expected to increase at a
lower rate than the other indexes, 5.1 percent, but
moderately faster than the 4.6 percent rate of advance
registered in 1976. Current expectations are for a
far better year, of course, than 1975, which had a

BUSINESS

9.2 percent increase, and 1974j when wholesale prices
rose 18.9 percent.
Net Exports
The nation’s trade position, measured on a National Income Accounts basis, was
approximately $6.9 billion in surplus in 1976 and is
expected to stay at approximately the same level in
1977. The forecasters espect imports to continue to
increase as consumer spending picks up, but they aSso
foresee an increase in exports, since they expect recovery abroad. The estimates for net exports varied
between --$1.6 billion and -j-$10.0 billion.
Quarter-by-Quarter
Forecasts
Fifteen forecasters made quarter-by-quarter
forecasts for 1977. As
indicated by the accompanying table, the forecasters
generally expect growth of $lf-$19 billion (measured
in 1972 dollars) per quarter throughout the year.
Translated into percentages and annualized, the espetted median growth rates are 5.4 percent, 5.9 percent, 5.6 percent, and 5.5 percent for the four quarters, respectively.
These rates are median forecasts, however, and
there is considerable variation among the forecasters.
The forecasts for increases in real GSP in the first
quarter range from $12.5 billion to $19.5 billion;
second quarter expectations range from increases of
S14.S billion to $21.5 billion; third quarter from
$16.0 billion to $26.4 billion; and the fourth from
$13.9 billion to $21.0 billion.
If the median forecasts are realized, the 6.9 percent unemployment rate for the fourth quarter will
be a considerable improvement over the present unemployment rate.
It is, however, above the announced policy target of the new administration.
There was considerable difference of opinion among
the forecasters about the fourth quarter unemployment rate, however, and the estimates ranged from
G.5 percent to 7.1 percent.

FORECASTS

1977

The Federal Reserve Bank of Richmond is pleased to announce the publication
of Blfsincss I:orec-asts 2977, a conlpilation of representative business forecasts with
names and details of estimates for the coming year. Publication is scheduled for
February 16: 1977. Due to the energy crisis: howe\-er, there may be some delay.
Requests for the booklet will be filled as soon as it becomes available. It may be
obtained free of charge by writing to Bank and PulJlic Relations, Federal Reserve
Bank of Richmond, P. 0. 130s 27622, Richmond, Virginia 23261.

14

ECONOMIC

REVIEW,

JANUARY/FEBRUARY

1977

Cautiously Optimistic . . .

THE OUTLOOK

FOR AGRICULTURE

IN 1977

Sada L. Clarke
Leading economists of the U. S. Department of Agriculture presented their views of prospects for the
nation’s agriculture in 1977 at the National Agricultural Outlook Conference in mid-November.
The following is a capsule review of the outlook as they see it.

Modest gains in gross farm income and a slight
rise in farm production expenses leave prospects for
realized net income in 1977 about the same as the
relatively favorable level of 1976. Moreover, only
modest increases in retail food prices are indicated.
Expectations
point to large supplies of crops and
But strong donear-record
livestock production.
mestic and foreign demand are expected to bolster
farm prices and incomes despite the large supplies.
While the outlook for agriculture in 1977 currently
appears favorable, major uncertainties exist which
could have a significant impact on the general prosperity of the nation’s farmers.
These uncertainties
include the expansion in domestic markets, upcoming
farm legislation, growing stocks of food grains, the
impact of the downswing in the cattle cycle on
supplies and prices of meats, and the usual weather
uncertainties here and abroad.
Farm Income and Production Expenses
Farmers’
net earnings in 1977 are expected to hold close to
the average of recent years. Realized net income may
range in the neighborhood of $23 to $25 billion if
growing conditions are average and if there are no
big surprises in world markets.
Earnings from farm marketings during the latter
part of the year will probably be better than returns
in the last half of 1976 and the early months of 1977.
Should crop output be maintained at about the level
of the last two years and if livestock numbers decline
as anticipated, livestock producers will likely be in a
stronger income position compared to last year and
relative to crop farmers.
Supplies of crops-except
for soybeans, cotton,
and some fruits and vegetables-will
continue large
relative to demand during the current marketing
year.
Livestock output will also be large but will
likely taper off and decline later in the year if cattle
numbers fall and beef production is cut back as
expected.
Of course, crop prospects for 1977 are
uncertain at this time. But unless there are unexFEDERAL RESERVE BANK

pected weather developments during the growing and
harvesting seasons, crop output should be large again.
Some shifts in the acreage of major crops are likely.
Moreover, there are no set-aside program restraints
for the major crops, and large supplies of fertilizer
and other inputs are available.
Farm price changes during the year will probably
be mixed.
But for calendar 1977, both crop and
livestock prices may average about the same as in
1976. The indicated changes in farm marketings and
prices point to further gains in gross farm income in
1977. Livestock producers are likely to benefit most
from any increases that may be realized.
With lower prices for fertilizer and seed and relatively small increases for chemicals and feed, the
rise in farm production expenses slowed to around
5 or 6 percent last year.
The slower rise in the
cost of farm inputs is expected to continue in 1977.
Steady to slightly lower prices are indicated for
fertilizer and chemical supplies, while outlays for
purchased feed and livestock may change little. But
with the expected increases in the costs of farm machinery, fuel, hired labor, and taxes, farm production
expenses in 1977 will rise further, probably about as
rapidly as in 1976.
Foreign Demand for Farm Products
The agricultural trade outlook for fiscal 1977 points to another year of near-record exports. Expectations are
that U. S. farm exports will total $22.8 billion, equaling last year’s record. Export volume may be below
the tonnage shipped last season, but the decline in
volume is expected to be offset by higher prices for
soybeans, oilseed products, and cotton.
With generally improved world grain production
in 1976-77 and world grain carryover stocks espected
to increase considerably-probably
by about 20 percent-foreign
demand for U. S. grain has slackened
from last year’s record level. U. S. grain exports
during the current marketing year will probably be
OF RICHMOND

15

at a high level, however, second only to the 83 million
metric tons exported in 1975-76.
I-?. S. cotton is likely to be the star performer in
fiscal 1977 as far as agricultural exports are concerned. With an export value of $1.6 billion, some
60 percent above last year, cotton exports are expected to show the Iargest percentage gain of all
U. S. farm exports.
Soybeans and oilseed products
with an anticipated export value of $6.1 billion-up
30 percent over last fiscal year-will
also be a major
performer on U. S. export markets in 1976-77.
Japan will continue as the largest single-country
market for U. S. farm exports, with exports in fiscal
1977 expected to reach an all-time 1Zmonth high of
$3.6 billion, up some 6 percent from the previous
year.
Because last summer’s European
drought
caused severe crop damage, Western Europe will be
the top regional export market for U. S. farm products this season, edging out Asia by some $200
million.
The continuing high level of U. S. agricultural
exports in 1976-77 can be attributed to a number of
factors.
Prominent among these are:
Supplies of grain, potatoes, and forage in
Europe were sharply reduced by last summer’s
drought, thus many countries need to rebuild their
small carryover stocks.
l

B Demand for livestock and poultry products is
increasing in major industrialized countries, particularly the European Community and Japan, and hog
and poultry numbers are expanding, encouraging the
use of more grain and high-protein meals in livestock
rations.
e Economic recovery is continuing in both the
developed and developing nations, boosting the demand for food as well as the demand for feed for
livestock production.
6 Continuation of large exports of corn, wheat,
and soybeans to the Soviet Union under the longterm Grain Supply Agreement between the U. S.
and Russia.
Farm Financial
Outlook
-4
value of farm assets: continued
farm loans, fairly stable interest
loan funds highlight the farm
1977 as seen by analysts of the
culture.

further rise in the
strong demand for
rates, and adequate
financial outlook for
Department of Agri-

On balance, the financial situation of the nation’s
farmers as they began the New Year looked favorable. Farmers’ net income last year, despite some
major exceptions, averaged about the same as in
16

ECONOMIC

REVIEW,

1975, and no major change is forecast for 1977. The
value of total farm assets as of January 1, 19’7
reached $634 billion, an increase of $49 billion or 8
percent over a year earlier. Although last year’s gain
in asset values was below the rise of $65 billion in
1975, it far exceeded net farm income in 1976. A
somewhat slower advance in farm asset values--in
the neighborhood of about 7 percent-appears
likely
in 1977.
Farmers, of course, frequently use increases in asset values to obtain additional financing.
Nationally, the value of farm real estate, a major
component of farm assets, rose around 9 percent
during the year ended February 1, 1977, significantly
below the 14 percent increase during the previous
year. Farmland values are expected to rise at a little
:But
slower rate-about
7 percent-during
1977.
as is always the case, the rates of increase across the
country will vary substantially.
Farm debt outstanding totaled an estimated $102
billion at the beginning of 1977, some $11 billion or
12 percent above a year earlier.
Both real es,tate
and non-real-estate
farm debt advanced more rapidly
last year than in 1975. Despite the rise in debt,
farmers’ equities in their farm assets-asset
values
minus debt-continued
to increase, climbing $38
billion during the year. A further gain in farmers’
equities, at a slightly slower rate than in 1975, is
forecast for 1977.
Demand for farm loans is expected to continue
strong in 1977, with increases anticipated for most
kinds of operating loans and for farm real estate
loans. Farm machinery loans are also likely to increase, as are cattle feeding loans.
Farm lenders are expected to have ample loan
funds to meet the enlarged loan demands.
Interest
rates, which eased a little in 1976, will likely hold
near the late 1976 levels. Lenders generally believe
that the risks of farm lending are increasing.
Still,,
with steady gains in the value of farm assets providing additional security to offset the risks, many
lenders continue to look upon good farm loans as
desirable investments.
Food Price Increases Moderate
Since consumers
have felt the brunt of sharply rising food costs in
recent years, they no doubt breathed a sigh oE relief
at the relative stability of average retail food prices
in 1976 and will find the outlook for another year of
only moderately rising food prices in 1977 good news
indeed. With iood supplies outpacing demand last
year, the gain in food prices was held to around 3
percent in sharp contrast to the rapid advances during the three preceding years and the lowest annual
rate of increase since 1971.
JANUARY/FEBRUARY

1977

Domestic food supplies will be large again in 1977
and will tend to dampen the rise in retail food prices
during the first half of the year. But at the same
time, strong consumer demand and rising marketing
costs will probably cause food prices to increase
moderately.
On balance, retail food prices may run
from 2 to 4 percent above a year ago during the
first half of the year. Small increases of from 2 to 3
percent are expected this winter, led mainly by
rising prices for coffee and fresh vegetables and
higher marketing costs and away-from-home
eating.
By spring, food prices may advance a little more
rapidly-probably
averaging 3 or 4 percent above
last spring-if
domestic demand increases and beef
output declines as anticipated.
Most food price increases this spring will reflect higher prices for meat,
poultry, and fresh produce. Since Florida’s fruit and
winter vegetable crops suffered extensive freeze damage in January, supplies of citrus fruit and fresh
vegetables have been sharply reduced and prices seem
certain to increase more than was expected at the
time of the Outlook Conference.
Highlights
of the DepartCommodity
Review
ment of Agriculture’s
forecasts for the principal
money-making commodities produced b>l Fifth District farmers are summarized below.
Tobaixo : Larger supplies of tobacco, both in the
United States and overseas, highlight the outlook
for 1977. Domestic cigarette consumption is expected to rise from last year’s record high. But U. S.
leaf exports will do well to hold near the high levels
of recent years. Rising tobacco output overseas, the
high prices of U. S. leaf, and slower growth in world
cigarette output will hold down exports again even
though the preference for light cigarettes containing
flue-cured and burley tobaccos continues worldwide.
The basic flue-cured tobacco marketing quota for
1977 has been cut 12 percent on the heels of a 15
percent reduction last year. Both cuts were made in
an attempt to keep supplies in line with demand.
When the basic quota for flue-cured is adjusted for
last year’s marketings above and below quota, the
effective quota for 1977 is 15 percent under last
season’s level. The basic quota for burley may be
about the same as in 1976, however. Under the legal
formula used to determine price supports for eligible
tobaccos, the 1977 loan level will increase about 7
or 8 percent over 1976.
The tight supplies and relatively strong
demand that characterize the cotton outlook for the
1976-77 season are pushing cotton prices well above
manmade fiber prices. Both domestic mill use and
Cotton:

FEDERAL RESERVE BANK

exports are holding up rather well in view of current
prices, however.
This season’s beginning
carryover
was down
sharply from a year ago, so supplies are only slightly
above the 1973-76 level and the second smallest in
53 years despite the significantly larger 1976 crop.
,Xeanwhile, mill consumption and exports combined
are expected to show a moderate increase over last
season’s level. As a result, cotton stocks may be
pulled down, probably to about 3.1 million bales by
August 1, 1977. the smallest since 1952. A carryover
of this size wodd equal approximately a four months’
supply for expected mill use and exports.
Domestic mill consumption for the entire 1976-77
season may be down moderately from a year earlier.
Demand for coaon by domestic mills has remained
relatively strong durin g the marketing year thus far,
but it is believed that later in the season when mills
are confronted with the 1976 cotton crop-priced
nearly one-third higher than the 1975 crop-they
will
increase the use of manmade fibers at the expense of
cotton.
Mill-delivered
cotton prices are currently
around 50 percent higher than manmade fiber staple.
Moreover, record cotton textile imports will compete
with U. S. mill consumption of cotton.
Export demand for U. S. cotton is expected to be
strong, more than offsetting the moderate decline in
mill use. Shipments may total about 4.6 million bales,
about two-fifths above last season’s 3.3 million. With
modest recover!- in foreign textile activity continuing
and with limited competitive supplies abroad, the
U. S. share oi world cotton trade is likely to rise
sharply, probably climbing to around one-fourth
versus IS percent last season.
Soybeans

and Pennuts:

Greatly reduced supplies,
strong demand, higher prices, and a sharp drawdown
in stocks dominate the outlook for soybeans.
Reduced acreage and lower yields combined to produce
an 18 percent smaller crop of soybeans in 1976.
When the larger beginning carryover is added to the
sharply lower production, soybean supplies for 197677 are down more than a tenth from last year’s
record level.
Soybean demand is expected to continue strong
despite the smaller supplies and resultant higher
prices. Total disappearance will probably drop some
5 percent below last season but will be about 160
million bushels above 1976 production.
Both domestic crushings and exports will probably share in
the decline. Carryover stocks September 1 will likeI>
be down to minimum operating levels, or less than
one month’s requirement for crush and exports.
Soybean crushings this season are estimated to be
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about 9 percent below the record 1975-76 crush. The
smaller crush reflects prospective lower domestic requirements for soybean meal and oil as well as the
increased avaiIabiIities of competitive fats, oils, and
protein feeds.
Soybean exports are also expected to drop, but
the decline is not likely to be as great as that projected for domestic use. Exports, like crushings, will
be limited largely by the tight supply situation. Wth
the U. S. guarantee to Japan of at least 110 million
bushels of soybeans this seasonl and the contract
with the Soviet Union for 55 million bushels of the
1976 crop, there will be fewer U. S. soybeans available for other markets. Any slack in ‘LT.S. soybean
exports in 1976-77 will most likely be taken up by
Brazil, which is continuing its rapid rise as a major
producer-exporter
of soybeans.
Soybean prices were relatively favorable to producers last fall, averaging $1.15 above a year ago.
Prices for the season are expected to average higher
than the early fall level and well above the $5 per
bushel received last year.
The price strength for
soybeans in the second half could moderate, however,
if Brazilian soybean plantings in November
and
December expand sharply and if there is a sizable
increase in U. S. soybean acreage in 1977 as is
expected.
Peanut supplies are down slightly from last year’s
record level as the result of both lower carryover
stocks and a little smaller production. And the use of
peanuts in edible products may rise some 4 percent
to about 9.0 pounds per capita compared with 8.7
pounds last season.
Even so, peanut supplies are
well in excess of edible and farm requirements, and
about one-fourth of the 1976 crop will be acquired by
the Commodity Credit Corporation under the price
support program.
Peanut acreage allotments for
1977 have again been set at the minimum level permitted by law.
Daily Pro&&s:
Dairymen may well find that the
situation they enjoyed in 1976 will be a hard act to
follow. Milk production rose sharply following three
years of virtually unchanged output, but sales of
dairy products espanded dramatically and milk prices
wcsc strong* averaging about $1 per hundred pounds
higher than in 1975. Market conditions have wenkened, however, and the potential for surplus conditions in 1977 is large.
Klk

production early in 1977 is expected to reabove year-earlier
levels, although probably
rising at a slower rate than in 1976. Strong gains
in output per cow will likely continue, more than
main

IS

ECONOMIC

REVIEW,

offsetting a small decline in cow numbers. There is
considerable uncertainty concerning the level of milk
output later in the year, however. Whether production will continue to post strong gains or whether it
will drop to year-earlier levels by the latter part of
the year will depend not only on the prices of milk,
but also on the prices of cull cows and feed and on
developments in the general economy.
Considering
all factors involved, it now appears that total milk
output in 1977 may rise by 1 or 2 percent.
‘\Vith milk production increasing and commercial
dairy stocks rebuilt and on the verge of being burdensome, supplies of milk are expected to be heavy and
may well outstrip demand.
Government purchases
of dairy products are likely to be heavy early in the
year.
Under this set of circumstances, farm milk
prices in 1977 could average below a year ago even
if demand for dairy products stays strong.
Poultr? and Eggs:
Most egg producers had a
good year in 1976. Broiler and turkey producers,
however, lived up to their reputation as boom and
bust industries, their profits early in the year turning
into losses later. Moreover, prospects for egg producers, unlike broiler and turkey producers, look
favorable for 1977.

Egg production during the first half of 1977 will
Iikely average from 1 to 2 percent above a year ago
as both layer numbers and the rate of lay rise slightly.
The outlook for the second half also looks favorable
for egg producers unless they overespand.
The level
of output will depend on producers’ profit margins
in the first half and on prospects for 1977 feed grain
and soybean crops.
Expectations are that production will continue to expand and may average around
2 percent above a year earlier.
Relatively strong demand and smaller market
supplies have resulted in higher than year-earlier egg
prices since last winter. Prices are likely to remain
comparatively strong through this winter and decline
seasonally in the spring.
Egg prices in the second
half of 1977 are expected to average below a year
earlier if production
expands in the first half as
anticipated.
Many broiler and turkey producers have been
losing n2oney since late last summer and are currently operating in the red. Furthermore,
prospects
for the first half of this year are not very favorable.
Poultry prices are wea!<, and feed costs will likely
be above a year ago. Poultry output continues to be
relatively large, and there has been a sharp buildup
in cold storage stocks of turkey meat. Both broilers
and turkeys wilI continue to face increased competiJANUARY/FEBRUARY

1977

tion from red meats. While beef supplies are expected to be moderately lower and prices higher, pork
output will be sharply higher with much lower prices.
Supplies of red meat, in fact, are likely to esert
stronger downward price pressure on poultry meat
through mid-1977 than in the first half of last year.
There are signs that the espansion in broiler and
turkey output is winding down. But prices of both
broilers and turkeys are expected to remain weak
during the first half of the year.
Movement of
broiler and turkey meat into export channels rose
substantially last year, and further increases are likely
in 1977.
Meat Aninuzls:
The sharp upturn in livestock
feeding that began in the closing months of 1975 has
led to sharply larger supplies of livestock products.
The gains have been rapid enough to weaken livestock prices in spite of the expanding domestic market. While some encouraging signs are beginning
to appear for cattlemen, hog producers can look
forward to another year of larger supplies.

Continued growth in pork production through 1977
is indicated by the actual and planned increases in the
number of sows farrowing last sunmer and fall.
Sharp gains in pork output at a rate about a fifth
above a year ago are espected to continue through

mid-1977. Slower increases in production are likely
in the second half.
Hog prices dropped sharply last fall, reflecting
the big increase in pork output as well as the large
supplies of chicken and beef. The lower hog prices
continue to make hog feeding unprofitable
even
though grain prices softened during harvest.
A slowdown in beef production appears to be in
the offing. Beef output continued to expand throughout 19i6, but losses by cattle feeders during muc11 of
the year led to reduced placemen:s of cattle on feed
This development, along with the
last suinn~er.
downphase of the cattle cycle, is expected to lead to
less beef output in 1977 and strengthening
cattle
Production will probably dip below yenrprices.
earlier levels by early 1977. Higher cattle prices.
along with moderating feeding costs, could lead to a
more favorable beef-corn ratio early in the year.
The outlook for beef cattle has been clouded, ho\vever. by the sudden 10 percent jump in placements of
Should this apcattle on feed during November.
parent renewed interest in cattle feeding result in a
larger s~~pply of fed cattle hy early spring than hat1
been anticipated, then the espectecl firming in cattle
prices may well not materialize. The upshot of suc11 ;t
de\-elopment could be the postponement of the intlicated rise in the price of beef to the consumer.

FEDERAL RESERVE BANK

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102