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DISTRICT ENJOYS STRONG INCOME GROWTH
Aubrey

N. Snellings

An examination of recently revised personal income data shows that in the ten-year period from
1966 to 1976, growth in economic activity in the
Fifth District outpaced that of the national economy.
Over that decade, personal income in Fifth District
states grew significantly faster than it did in the
nation as a whole, both on a total and a per capita
basis. In addition, figures on personal income by
source show significant changes in the reIative importance of particular industries in District states
and in the nation.
Personal
Income Data
Personal
income for a
particular state may be looked at in two ways: (1)
as the total personal income received by residents of
the state, or (2) as the personal income produced by
industries located in the state.
Since many people
live in one state and work in another, these two
figures are not necessarily equal for any given state.
Thus, in deriving personal income by place of residence, the Department of Commerce begins with total
labor and proprietors’
income generated by indus-

tries located in the state. This figure is adjusted by
deducting personal contributions for social insurance
by place of work and also by making an adjustment
for residence of w0rkers.l
These adjustments produce net labor and proprietors’ income by place: of
residence. To this is added dividends, interest, rlent,
and transfer payments received by residents of a
state to obtain personal income by place of residence.
Personal income by place of residence is the figure
most commonly used in discussions of state income
and it is the one that will be used here in reviewing
the growth in total and per capita income in the
Fifth District.
On the other hand, data on labor
and proprietors’ income by industry provide important information on the industrial structure of a state

1 This adjustment for residence is particularly important
in the Fifth District because so many workers in the
District of Columbia reside in Maryland and Virginia.
As a result, the District of Columbia had a ne:gative
residence adjustment in 1976 equal to more than 5’7 percent of total labor and proprietors’ income. On the other
hand, Maryland derived 15 percent of its personal income
from outside the state and Virginia about 9 percent.

Tobie I

PERSONAL

INCOME

United States and Fifth District States,

1966,

1971,

and

1976

(millions of dollars)
Percent Change
1966
District of Columbia

1971

2,839

3,842

1966.71

5,662

1971-76

36.0

1976

1966-76
--

46.6

99.4
144.7

Maryland

11,652

17,999

28,514

545

58.4

Virginia

11,814

18,867

31,908

59.7

69.1

1170.1

3,929

5,773

9,941

46.9

72.2

‘153.0

North Corolino

11,344

17,724

29,821

56.2

68.3

162.9

South Carolina

5,347

8,369

14,662

56.5

75.2

174.2

46,925

72,594

120,508

54.7

66.0

156.8

579,161

851,952

47.1

61.2

137.2

West Virginia

Fifth District
United States

Source:

2

1.373511

Il. S. Department of Commerce, Bureau of Economic Analysis.

ECONOMIC

REVIEW, MAY/JUNE

1978

or region as well as changes in that structure over
time. This type of information will be used to portray the industrial structures of Fifth District states
and to spotlight changes in those structures over the
past decade.
Growth in Personal Income The personal income
of i\mericans has grown quite rapidly in recent years.
In nominal terms, total personal income in the
United States more than doubled between 1966 and
1976, for an average annual increase of almost 14
Moreover, the rate of growth
percent (Table I).
in the second half of that period was almost a third
higher than in the first five years.” And over this
ten-year period, every state in the Fifth Federal Reserve District enjoyed a significantly higher growth
in personal income than the nation as a whole. Only
the District of Columbia, because of its peculiar industrial structure and geographical limitations, had
a smaller increase than the national rate.
Among
District states, South Carolina and Virginia recorded
the fastest growth in total personal income while
Maryland and West Virginia were at the lower end
of the scale.
As Table I shows, however, in most District
states growth in personal income did not proceed at a
uniform pace over the ten-year period. &lost District
states, as well as the nation as a whole, achieved a
much higher rate of growth in the 1971-76 period
than in the immediately preceding five years. Maryland was the only District state to show very little
pickup in the second half over the first half of that
period and, excluding the District of Columbia, was
the only District state with a growth rate in the
second half that was below the national rate.3
Both South Carolina and Virginia enjoyed strong
growth in income throughout the decade, with these
two states ranking one-two among District states in
terms of growth over the entire period.
Virginia
achieved the highest growth rate among District
states in the 1966-71 period, with South Carolina
second; South Carolina was first in the 1971-76
period, with Virginia third.
2 These

comments refer to nominal income, oi course,
and the faster growth rate in the latter period is largely a
reflection of the higher rate of inflation experienced since
1970. Real per capita disposable income (that is, total
nominal income adjusted for taxes. inflation. and the
growth in popuiatiok) increased at g faster pace in the
second half of the 1960’s than it did in the first half of
the 1970’s.

3 At the same time it should be noted that, excluding the
District of Columbia, Maryland has the highest per capita
income of any Distrxt state and is the only District state
whose per capita income exceeds the national figure.
FEDERAL RESERVE BANK

fable it
PER

CAPITA

United

PERSONAL

States

1966and

and

Fifth

INCOME
District

States,

2976
1976

1966

Pet

Capita
income

----

Percent
of u. 5.

Per
Capita
income

Percent
of U. S.

% Change

1966-1976

District of
Columbia

3,589

121.7

8,067

126.1

124.8

Maryland

3,153

106.4

6,880

107.5

118.2

Virginio

2,651

89.5

6,341

99.1

139.2

West Virginia

2213

74.7

5,460

as.3

146.7

North Carolina

2,317

78.2

5,453

85.2

135.3

South Caroline

2,122

71.6

5,147

80.4

142.6

Fifth District

2.674

90.2

6,225

97.3

132.8

United States

2,963

100.0

Source: U. S. Department of
Analysis.

6,399

100.0

Commerce, Bureau of

116.0

Economic

West Virgma : had the most dramatic turnaround
*
growth of any District state.
In the 1966-71
period, 1J7esi Virginia recorded the smallest growth
in income of any state in the District and was the
only Districr state with a growth rate below the
national average ; in 1971-76 West Virginia’s growth
was second xnong District states only to South Carolina’s, and x-as significantly higher than either the
District or the national rate. This dramatic improvement is undoubtedly attributable to the revolutionary
changes in tje world energy picture and the resulting
recovery in fYest Virginia’s coal industry.
in

Per Capita Personal Income
From 1966 to 1976,
per capita personal income in the Fifth District rose
almost 133 percent (Table II). This compares with
an increase of 116 percent for the entire nation.
Every District state and the District of Columbia
recorded a larger percentage increase over this period
than the nadoLnaI gain.
Maryland, which has the
highest per capita income among District states (excluding the District of Columbia), realized the smallest percentage increase.
West Virginia, with the
second lowest per capita income in 1966, enjoyed the
largest percentage gain, mainly because of a very
strong surge in the final five years of the period.
South Carolina, with the lowest per capita income
among Disttict states, had the second highest growth
rate, while Virginia was third.
Per capita income
OF RKHMOND

3

Table III

TOTAL

LABOR AND PROPRIETORS’

United

States

and

INCOME BY PLACE Of WORK

Fifth District States,

1966

and

1976

United States

Fifth District

Districtof Columbia

Percent of Total

Percentof Total

Percentof Total

1966
Total labor and Proprietors’ Income

1976

1966

1976

1966

1976

100.0

100.0

Percentof Total
1966

197i
-a

100.0

100.0

1.1

1.1

-

100.0

100.0

loo.0

100.0

Farm

3.5

2.4

2.9

2.1

Agricultural services, forestry,
fisheries, and other

0.3

0.4

0.3

0.3

0.5

0.7

0.3

0.3

Mining

1.1

1.5

1.4

2.0

0.0

0.0

0.2

0.1

Construction
Manufacturing
Transportation and public utilities
Wholesale and retail trade
Finance, insurance, and real estate

6.3

5.7

6.3

5.8

4.0

2.9

7.2

6.8

29.7

25.9

25.1

22.6

4.0

2.9

23.3

16.6

7.1

7.5

6.4

6.6

6.3

6.2

6.6

6.5

16.9

17.2

15.0

15.0

12.0

7.1

16.4

17.7

5.2

5.3

4.2

4.1

4.6

4.4

4.6

4.8

Services

14.3

16.4

13.6

15.2

20.0

21.2

15.0

‘IS.7

Government

15.6

17.8

24.8

26.2

48.7

54.4

25.1

‘27.3

North Carolina

South Carolino

Virginia

West Virginia

Percent of Total

Percent of Total

Percent of Total

Percent of Total

1966
Total labor

and Proprietors’ Income

1976

100.0

100.0

1966

1976

1966

loo.0

loo.0

100.0

1976
loo.0

1966

1976
.-

100.0

100.0

0.7

0.2

Farm

6.6

5.3

4.5

2.3

2.1

1.2

Agricultural services, forestry,
fisheries, and other

0.3

0.3

0.4

0.3

0.3

0.2

0.1

0.1

Mining

0.2

0.2

0.2

0.2

1.1

1.9

12.6

17.8

Construction
Manufacturing
Transportation and public utilities
Wholesale and retail trade

6.1

5.3

6.6

6.3

7.0

6.4

6.1

6.4

33.3

32.4

35.2

33.7

21.5

19.6

29.9

24.4

5.7

6.3

4.4

5.5

7.0

7.0

9.5

8.2

16.0

16.1

13.8

14.6

15.0

15.4

14.1

14.4

4.0

4.0

3.6

3.8

4.4

4.2

2.9

2.9

Services

11.8

12.9

11.0

11.7

13.2

15.1

11.2

11.8

Government

16.1

17.3

20.2

21.6

28.4

29.0

12.8

13.9

Finance, insurance, and real estate

Source:

U. S. Department of Commerce, Bureau of Economic Analysis.

growth in North Carolina exceeded the District
figure, while the increase in the District of Columbia
fell somewhat short of it.
As a result of these above average growth rates,
the level of per capita income in every District state
and in the District of Columbia improved relative to
the national level (Table II). For the District as a
whole, income per capita rose from about 90 percent
of the national figure in 1966 to about 97 percent in
1976. The District of Columbia, whose per capita
income of $8,067 in 1976 was second only to Alaska
among the nation’s states, improved its relative posi4

ECONOMIC

tion from 121 percent to 126 percent of the national
level.
Maryland, with the smallest percentage increase among District states, improved only slightly
Virginia, with the
relative to the national level.
third highest per capita income in the District, enjoyed strong growth throughout the period.
As a
result, the level of income per person rose from
almost 90 percent of the national figure in 1966 to
99 percent in 1976. West Virginia, North Carolina,
and South Carolina all enjoyed better than average
growth in per capita income and all made significant
gains toward reaching the national average.

REVIEW, MAY/JUNE

1978

Sources of Personal Income
Data on labor and
proprietors’ income by industry provide valuable information as to the relative importance of particular
industries in our economy and, if looked at over a
period of years, they may spotlight changes in the
industrial structure of the economy. It comes as no
great surprise, oi course, that the industrial structures of Fifth District states, with the exception of
the District of Columbia, are not greatly different
from the structure of the national economy.
But
there are differences between them, just as there are
differences among the individual states of the District, and these structural differences help to explain
such things as differential rates of growth, more or
less susceptibility to business cycles, and so on.
The major structural difference between the District and the national economies lies in the difference
in relative importance of government and manufacturing (Table III).
Government is, of course, a
much more important generator of income in the
Fifth District than it is nationally.
It was the most
important source of personal income in the Fifth District in 1976, accounting for 26.2 percent of total
labor and proprietors’ income. This compares with
17.8 percent for the nation as a whole. Part of this
difference is accounted for by the location of Washington, D. C. in the Fifth District, but there are also
a number of large military installations and other
government facilities in the District that generate a
considerable amount of income. Manufacturing, on
the other hand, accounts for a much larger part of
labor and proprietors’ income nationally than it does
in the District. In 1976 it generated 25.9 percent of
total labor and proprietors’
income in the United
States, by far the most important single source, as
compared with 22.6 percent of such income in the
Fifth District.
While government and manufacturing account for
the major structural differences between the nation
and the District, there are other differences as well.
Wholesale and retail trade and the service industries, each of which contributes about one-sixth of
labor and proprietors’ income in the United States,
are both more important nationally than in the District. Finance, insurance, and real estate is a much
less important source of income than the other industries mentioned, but it is significantly more important nationally than in the District.
Changes in Sources of Income
As mentioned
earlier, changes in the relative importance of particular industries as generators of personal income

provide useful information as to the changing structure of the economy. They are by no means a perfect
indicator of structural changes, however, because increases in labor income may result simply from a
larger number of workers, drawing higher wages,
but producing the same amount of output.
Nevertheless, changes in these data over a period of years
do provide a fairly accurate picture of structural
changes in the economy.
Data for the ten-year period 1966-76 show a
continuation of trends that have been in progress
for a number of years. Generally a reflection of the
evolution toward what might be called a post-industrial (i.e., service oriented)
society, they will undoubtedly continue to affect the structure of the
The general
economy for many years to come.
picture one gets from these data is of an economy
increasingly oriented toward wholesale and retail
trade and the service industries, and in which government is an increasingly important source of personal
On the other hand, manufacturing
and
income.
farming are becoming less important as creators of
income. During the period under review, construction also declined in relative importance but construction is a highly cyclical industry, and in 1976
it had not fully recovered from the severe downturn
of 1973-75.
Changes in sources of income in the individual
states comprising the Fifth District were generally
in line with changes in the national economy. There
were differences, however, and these may help to
esplain the faster growth in personal income in District states than in the nation.
That is to say,
differences in the growth of personal income for
Fifth District states as compared with the national
growth may be explained, at least in part, by two
factors.
First, in most District states the rapidly
growing sectors are relatively more important than
they are in the national economy.
Second, growth
rates of specific components of the state’s personal
income differed from the national growth rate. In
several District states the second factor appeared to
be more important than the first.
Maryland is perhaps a case in point. Government,
one of the “growth” sectors, is the most important
source of labor and proprietors’ income in that state,
accounting for more than a quarter of the total.
Manufacturing, a relatively slower growth sector, was
second most important in 1966, the source of more
than 23 percent of the total. Between 1966 and 1976,
however, government-produced
income increased in
Maryland at almost the identical rate as in the nation,
and at a significantly lower rate than in other District

FEDERAL RESERVE BANK OF RlCHMOND

5

Table IV

TOTAL

LABOR AND PROPRIETORS’

United

States and

INCOME BY PLACE OF WORK

Fifth District States,

1966

and

1976

(millions of dollars)
United States
Total Labor and Proprietors’ Income _._____ _._._.__.. _____
_.__..
_.._

1966

-

1976

Fifth District
% Change

-

1966

-

1976

% Change
--

472,866

1,046,5 13

121.3

39,422

95,192

16,606

24,977

50.4

1,144

2,031

Agricultural services, forestry, fisheries, and other

1,587

3,840

142.0

130

292

124.6

Mining

5,099

15,256

199.2

552

1,902

244.6
1222

Farm .............._-__.._._._.___._..... ..._._.._._..._...__.__._._......
_..._
_

__.........._.._._..__ __..._._.__._ _____
_
_
__
______ __.__.._.____.._._._..

Construction -._..._..-_.._......._._._...._.____._
.
.
__.__________ _
_.___._...

77.5

60,147

102.2

2,502

5559

__ _._._.____
__..
.__.___._______..__.___.______.__
________
_._

140243

271,138

93.3

9,890

21A84

117.2

Transportation and public utilities ..._._..........._...
___._

33512

78,203

133.4

2,531

6,253

147.1

Wholesale and retail trade _.__
.__._.
_._._.__
______.
_.______
.___.

79,789

179,693

125.2

5,915

14,315

142.0

Finance, insurance, and real estate _._._._________.___.~..~

24,576

55,712

126.7

1,637

3,946

141.l

Services .-...--...._..._.. ._..._. ........._._._._. .__.._...._._
.
_
_._
__.________.

67,765

171,741

153.4

5,359

14505

170.7

Government

73,919

185,806

151.4

9,7&I

24,903

155.2

1976

% Change

1966
P

-

23,666

146.5

4533

11&l

Manufacturing

29,770

‘141.5

......~_~~.__~~__~~~.~ ___.____.__.__._ ___._
__.___.
_._._
_.__
_.._

North Carolina
1966
Total Labor and Proprietors’ Income _._
__._._.._._._.__.._.....___

939

Farm __ _._._._._._....._._..._.. ....._._-.___._._ _*.__..___
___
..._..*
__.__..___
.

South Carolina
1976

‘% Change
.152.8

629

1,259

100.2

205

259

26.3

29

Agricultural services, forestry, fisheries, and other

62

113.8

18

37

105.6

..-.........-....-...-._._..... .-.*..... ..._... ......._....._.......
__
_
_

18

54

200.0

9

20

122.2

_
_._..
__
._._.
Construction ........_...... .....__ __._._._......_.___.......~..

582

1,243

113.6

300

720

140.0

Mining

Manufacturing

3,195

7663

139.8

1,597

3,868

142.2

_ _
_____
Transportation and public utilities .._... .___.__._.___

. ..-....._._ .. ..-._.._...__.._......._.._...___...
.
_
_
_._._.

545

1,485

172.5

201

629

212.9

Wholesale and retail trade ._._._._.___._.________ ____
___
__._____

1,535

3,802

147.7

624

1,670

167.6

Finance, insurance, and real estate ____
._._._____.__..
____.

383

956

149.6

162

438

170.4

1,133

3,044

168.7

500

1341

168.2

10549

4,098

164.6

917

2,478

170.2

Services ..._._._... ._.__...._._..._..._....
_____
__
.___._...._.____._____
________
Government

__..._..._._____._._.~...........~............~~~.~.~
_____
______

* Less than $5DD,DOO.

source:

0. S. Department of Commerce, Bureau of Economic Analysis.

states (Table IV). At the same time, income from
manufacturing in Maryland increased only 64.4 percent over that decade, as compared with an increase
of 93.3 percent nationally.
For the entire District,
manufacturing income rose 117.2 percent, and figures
for the other states ranged from 91.9 percent for
West Virginia to 142.2 percent in South Carolina.
Income from the trade and service industries grew
significantly faster in Maryland than in the nation.
Thus, the smaller growth in the relative position
of income from government,
and the more rapid
decline in the relative importance of manufacturing
income was only partially offset by the robust ex6

ECONOMIC

pansion in trade- and service-produced
income, so
that the increase in tota personal income in Maryland
was the smallest among District states. It was still
significantly above the national figure, however.
The pattern in North Carolina also differs from
the national pattern and the patterns in other District
states. Manufacturing is by far the most important
source of personal income in North Carolina, accounting for almost a third of labor and proprietors’
in North
income. But income from manufacturing
Carolina grew almost 140 percent from 1966 to 1976,
compared with 93.3 percent growth for the nation.
At the same time, income from trade an.d service

REVIEW, MAY/JUNE

1978

Maryland

District of Columbia
1966
-

1976
_I-

4,405

9,465

66

*

3

114.9

200.0
-

1966

1976
--

8,557

19,807

131.5

97
22

% Change

222

128.9

28

62

121.4

21

29

38.1
121.2

-

% Change

174

279

60.3

612

1,354

174

278

59.8

1,998

3,284

64.4

278

590

112.2

562

1,293

130.1

529

676

27.8

1,404

204

416

103.9

396

943

138.1

879

2,011

128.8

1,287

3,707

188.0

2,144

5,146

140.0

2,152

5,402

151.0

Virainia

3311

150.1

West Virainia

1966

1976

% Change

1966

1976

9,097

23,188

154.9

3,231

7,605

135.4

189

276

46.0

24

15

- 37.5

29

56

93.1

4

9

125.0

1,354

232.7
146.4

96Change

97

442

355.7

407

638

1,480

132.0

196

483

1,960

4,537

131.5

966

1,854

91.9

639

1,632

155.4

306

624

103.9

1,367

3,563

160.6

A56

1,093

139.7

397

971

144.6

95

222

133.7

1,198

3,507

192.7

362

895

147.2

2,584

6,723

160.2

414

1,056

155.1

industries also grew SignificantIy faster than in the
nation.
Government-produced
income in Xorth
Carolina also outpaced the nation, but government is
less important as a source of income in North Carolina than it is in Maryland, Virginia, and South
Carolina.
South Carolina enjoyed the highest rate of growth
of personal income among District states, recording
an increase of 174.2 percent as compared with 156.5
percent for the District and 137.2 percent for the
nation.
This robust expansion is reflected in the
growth rates of the various categories of income,
with most of them exceeding the comparable national

rates. Nevertheless, there were changes in the relative importance of particular industries.
Manufacturing, for example, fell from 35.2 percent to 33.7
percent of total labor and proprietors’ income, but at
the same time income from this source rose 142.2
percent over the ten-year period. Trade and service
industries are relatively Iess important as a source
of income than they are nationally, but income from
these industries rose substantially faster in South
Carolina than nationwide.
Virginia had the second highest growth rate of
personal income for District states and this may be
one instance where the industrial structure was favorable to growth.
Government
is by far the most
important source of income in Virginia, accounting
for almost 30 percent of labor and proprietors’ income in recent years, and income from this source
grew much more rapidly in Virginia than in the
Other high growth sectors, the trade and
nation.
service industries, also enjoyed considerably faster
expansion in T’irginia than across the nation. At the
same time, income from the slow-growth manufacturing sector surged 131.5 percent in Virginia, as
compared with 93.3 percent nationwide.
Construction, mining, and the finance industries all recorded
above average growth.
The behavior of personal income in West Virginia
over the past decade reflects the differences between
the economic structure of that state and the structures of other District states as well as that of the
Altho-dgh manufacturing accounted for alnation.
most a quarter of total labor and proprietors’ income
in West Virginia, mining was in second place in
1976, accounting for 17.8 percent of the total. Wholesale and retail trade was the third most important
source, and government fourth.
Services, with only
11.S percent of the total, was far below the comparable figure for the District and for the United States.
The strong surge in income from mining in the
last five years dominates the economic picture of
West Virginia. From 1966 to 1971, personal income
in West Virginia recorded a gain of 46.9 percent,
the lowest among District states.
Mining declined
in relative importance as a source of income, shoxing
a gain of only 30 percent over the five-year period.
h!Ianufacturing fell in relative importance from 29.9
percent to 25.9 percent of labor and proprietors’
income and showed a five-year gain of only 21.6
percent (compared with 39.7 percent for the District
and 27.1 percent nationally).
The largest gains
during this period were in construction and government.
But the change in the worldwide energy

FEDERAt RESERVE BANK Of RICHMOND

7

supply situation in the early 1970’s brought dramatic
changes in the West Virginia economy. The loss of
population that had characterized
the 1960’s was
reversed and personal income jumped 72.2 percent
from 1971 to 1976. This growth was second among
District states during that period only to South
And there is no doubt that the large
Carolina.
growth in personal income came from the coal mines.
Income from mining grew 156.0 percent over this
five-year period and by 1976 mining accounted for
17.8 percent of labor and proprietors’ income, up
from 11.7 percent in 1971. There were some spillover effects, with the service and trade industries
showing above average increases in income.
Income from government grew at a faster pace than in
the preceding five years, and considerably above both
the District and the national rate.
It is not very meaningful to compare the District
of Columbia with the states in the District or with

8

ECONOMIC

the national economy because growth in personal
income in the District of Columbia is largely determined by the government sector. In 1976, government was the source of 54.4 percent of total labor
and proprietors’ income, a figure that had grown
from 48.7 percent in 1966. The service sector was
second with 21.2 percent of the total, while wholesa.le
and retail trade produced 7.1 percent of the total.
In sharp contrast to developments throughout
the
Fifth District and the nation, trade has declined
sharply in relative importance
in the District of
Columbia.
In the ten-year period ending in 1976,
income produced in the trade industries grew only
27.8 percent. This compares with 142.0 percent for
the Fifth District and 125.2 percent for the nati.on.
The decline in the relative importance of trade: in
the District of Columbia can be attributed to the
rapid development of shopping centers in the Maryland and Virginia suburbs of the Washington area.

REVIEW, MAY/JUNE

1978

Sada L. Chrke

The winter of 1977-78 may well be remembered as
Many of the
the winter of farmers’ discontent.
nation’s farmers, faced with rising production costs,
low prices, depressed incomes, and heavy indebtedness, banded together to seek better prices for their
products.
With many producers in financial difficulty, a wave of rural unrest swept across the country. Farmers’ sign-draped tractor and truck caravans
parading through Washington and other major cities
to protest low farm prices, their threatened “strike,”
their battle cry of 100 percent of parity prices-all
in an attempt to increase their incomes-were
evidences of farmers’ angry mood.
History records that farm prices have never been
While it is
supported at 100 percent of parity.
doubtful that all farmers know just what fuI1 parity
Few
really means, they apparently are not alone.
people probably understand parity or realize what
full parity would actually cost.
Today’s farmers may, or may not, understand
parity.l
But what they do understand is that farm
prices slumped in 1977 on the heels of progressively
low prices since 1974, while the costs of farm inputs
kept rising. Moreover, it is quite clear to them that
they’ve netted less money almost every year since
the record level in 1973. Meanwhile, farmers have
continued to increase their debts, which limits their
ability to repay loans. They know, too, that it takes a
lot more corn, wheat, and/or soybeans to buy items
for farm production and family living, or to pay off
a $1,000 debt, than it did a few years ago.
Grain Producers
Hit Hardest
Of course, the
buying ability of all farm products has not declined
equally, nor -have all costs risen equally.
Farmers
1 The parity price of a farm commodity is the price (calculated by a complex formula) that will give a unit of
that commodity the same purchasing power, in terms of
goods and services bought by farmers, as that farm product had in a selected base period (1910-14). during which
the price relationships were considered to have been reasonably well balanced.
To illustrate: Whenever a commodity, such as corn, is selling at parity, a farmer can
seff a bushel and buy, say, as much food as he could with
a bushel of corn during the period 1910-14.
When the
price is below parity, the farmer can buy less; when it is
above, he can buy more.

hurt most are the grain producers, followed by cattlemen who are now finally beginning to recover from a
3- to 4-year slump in cattle prices.
Nor are all
farmers in debt. Well over one-third of the nation’s
farmers were estimated to be debt free at the beginning of 1977. Evidence indicates that operators of
large farms were much more heavily indebted than
were the small farm operators.
More Refinancing
Because of the poor cash-flow
position of many farmers brought on by the slump
in farm prices, many farm borrowers had loan repayment difficulties last year and many had to request
loan renewals or extensions.
?vloreover, many operators found it necessary to convert their short- and
intermediate-term
loans into loans secured by farmland. This restructuring
of debt not onIy enables
farmers to spread out their payments and takes the
pressure off their cash flow but also provides lenders
with more security.
No Farm Credit Crunch- ?Vhile farmers’ demand
for credit continued strong in 1977, supplies of loanable funds from traditional lenders were generally
Furthermore,
the
adequate to meet the demand.
SBA and FmHA provided additional loan fund
Generally,
assistance to farmers in disaster areas.
bankers’ regular farm customers did not find it difficult to get needed credit.
Most lenders, it seems,
have been willing to assist borrowers who have run
into repayment problems.
Overall, lenders say that
only a few borrowers-about
5 percent-have
become unsatisfactory credit risks.
District Versus Nation
This picture of the national farm financial and credit situation mirrors
conditions in the District pretty well. The one exception would seem to be the likelihood that the proportion of District farmers with cash-flow problems may
he a shade larger than in the nation as a whole.
The Situation
in Perspective
To put current
farm financial conditions in perspective, it is helpful
to study the key financial relationships shown in the

FEDERAL RESERVE BANK OF RICHMOND

9

10

ECONOMK

REVIEW, MAY/JUNE

1978

accompanying charts2 This longer term perspective
showing the changing fortunes of farming reveals
that the current situation is both highly unusual and
potentially troublesome.

P

Chart 1 The sharp gains in total net income of
farm operators that occurred during the concluding
years of the World War II-Korean War boom were
followed by a cost-price squeeze on net income during
the remainder of the 1950’s. Net income shifted to a
slow uptrend in the 1960’s. Farm prices and income
in the early 1970’s were driven up significantly by a
combination of circumstances-shortfalls
in world
grain production, the drawdown in stocks of the
major grain-exporting
countries, the massive grain
sale to Russia, the disappearance of anchovies off
the Peruvian coast, and other causes. The peak in
farm operators’ total net farm income came in 1973,
and farm prices peaked in 1974. But better world
crops, especially in the last two years, have reversed
By 1977, total net farm income had
the situation.
dropped 36 percent from its 1973 level. Moreover, its
purchasing power in constant (1967) dollars had
fallen 55 percent and, with the exception of 1976,
was at its lowest level since 1964. On a per farm
basis, operators’ total net income from farming in
constant
dollars was about $4,19O--down
from
around $8,800 in 1973 and, except for 1976, the
lowest since 1968.
Chart 2 Although
outstanding
farm debt has
been trending upward since the mid-1940’s, farm debt
(extruding CCC loans) increased by a record $14
billion or 14 percent in 1977, following a gain of $11
billion or 12 percent in 1976. Both real estate and
non-real-estate debt contributed to the rise. Historically, net increases in farm debt of the magnitude of
14 percent in a single year tend to occur in boom
years for farm income and investment, such as 195051 and 1973, rather than in years like 1977 when
farm income was relatively depressed and had few
prospects for significant near-term improvement.
Chart 3 The value of farm assets rose gradually
through the 1950’s and 1960’s and then literally
shot upward in the early 1970’s, exceeding $700
billion by January
1, 1978. Rapidly accelerating
farm real estate values were the chief cause, for
3 The analyses accompanying Charts 3-6 rely heavily on a
Xelichar,
Division of Research and
Statistics,
Board of Governors of the Federal Reserve
System.
See Emanuel Xelichar,
“Agricultural
Finance
Commentary,”
Board of Governors of the Federal Reserve System, Vl’ashington,
November
1977, pp. l-15
(Mimeographed.)

report by Emanuel

farmland accounts for from two-thirds
to threefourths of the value of all farm assets. By raising
the value 0:’ assets and thus also the equity of
farm proprietors,
the advance in farmland prices
in the 1950’s helped to push the annual return from
production down to around 3 percent of equity as
shown in Panel B.
Continued increases in land
prices during the 1960’s and early 1970’s kept the
return at ro;lghly this same level. Favorable farm
income triggered a land price explosion in 1972-73,
and returns ro farm proprietors’ equity in production assets moved up to some 10 percent.
Since
19i3, however, farmland prices have continued to
rise in the face of declining net income.
Returns

FEDERAL RESERVE BANK OF RICHMOND

11

through 1974 and 1975, on the average, continued
high enough to support the gains in land prices.
But by 1977, the combination of depressed income
and high prices of farmland reduced returns to equity
to around 2 percent-only
one-fifth the record rate
in 1973. With farm income settling near the floor
provided by government programs, a key support
for further land price gains is now missing.
Chart 4 Favorable
farm income, as pointed out
earlier, triggered the recent explosion in land prices.
By the late 1960’s, however, land market participants
and analysts had noted the steady capital gains that
appeared to be providing a significant supplement
to net farm income and were discussing the concept
of “total returns” to farm investment.
However,
those who add capital gains to income to calculate a
“total return” to the farming sector should also note
that only the amount by which the price appreciation

Nominal Capital Gains

of farm assets exceeds general price inflation represents a gain in real terms to owners of farm assets.
Comparison of real net income and real capital gains
in Panel B reveals that, in real terms, capital gains
over the last five years average slightly less than
income, rather than eclipsing income as one might
suppose after viewing nominal gains only. Also, in
constant dollars the recent levels of income and capital gains are revealed as somewhat more modest
relative to past levels.
Real income, in fact, has
dropped below its pre-1972 level. Also note that real
capital gains disappeared in 1968-70, demonstrating
that if farm income is relatively depressed, farm
assets may not continue to appreciate faster than ,the
rate of inflation.
Chart 5 With farm income relatively
depressed
and with the continuation
of real capital gains
in some doubt, should there be cause for concern about further large increases
in farm debt
such as that which occurred last year? Many analysts
examine this question in terms of relationships shown
in Chart 5. These analyses reflect the optimism
derived from ( 1) the recent large absolute increase
in equity and (2) the low overall debt-to-asset ratio.
They note, for example, that the farming sector’s
debt-to-asset ratio is just under 16 percent and conclude that the sector can greatly increase its borrowings. The financial cushion implied by this sort of
an analysis, however, is in part an illusion.
For
instance: High equity in farm real estate is no guarantee of sufficient cash flows necessary to meet consumption needs and to repay debt.3 The debt-to-asset
ratio was not reduced significantly during the recent
years of farm prosperity, and thus the farming sector
has entered a period of financial strain with the
ratio near its post-World War II high. More importantly, the average return on farm production
assets is now about 3 percent, while the interest
charge on new farm loans averages around 8.5 percent. Given this relationship, further borrowing by
the farming sector would tend to reduce its net income. In other words, increased borrowing cannot be
sustained for long in the absence of income adequate
to service the additional debt.
Chart 6 A look at debt financing of capital. formation provides another approach in evaluating ,the relative usefulness and safety of ongoing increases in
farm debt. The inherent productivity
of increased
3 David
Lins, “Credit and Finance
Outlook”
(Speech
presented at the 1978 Food and Agricultural
Outlook
Conference, Washington,
November 16, 1977), p. 8.

12

ECONOMIC REVIEW, MAY/JUNE

1978

percentage
percent.”

of farm capital

formation

averaged

76

Chart 7 Farmers have relied increasingly
on the
use of borrowed funds in recent years. Because the
importance of debt capital has risen substantially, the
growth in farm debt outstanding has been spectacular.
The rapid increases in outstanding farm debt, in
fact, are far outside the previous bounds of their
4 Alvin S. Tostlebe, Capital in A&culture:
Its Forrnation and Financing since 1870, A Study by the Nationa!
Bureau of Economic Research (Princeton, N. J.: Princeton University Press, 1957), p. 136.

debt financing, for example, can be assessed in part by
examining whether it is financing increased capital
formation or simply replacing internal financing of
this capital flow. Panel .+ shows that increases in
debt have recently been rising faster than capital formation. I3y 1976-77, debt financing had replaced internal financing to a highly unusual degree.
Debt
financing, as indicated in Panel B, in fact, averaged
86 percent of farm capital formation in 1976 and 95
percent in 1977. In this century, a comparably high
ratio of debt financing to farm capital formation has
previously occurred only once-during
the ill-fated
speculative boom of World War I. In this latter
period, accordin g to Tostlebe, debt financing as a
FEDERAL RESERVE BANK OF RICHMOND

13

relationship to total net farm income and to total
net cash income from farm and nonfarm sources.
(See Panel A.)
There is growing concern, therefore, as to whether
the income of farm operators can support this debt
load. Ratios of farm debt outstanding to total net
farm income, or to total net cash income from farm
and nonfarm sources, allow one to measure the relative burden of debt against income. (See Panel B.)
Both ratios indicate that the relative burden of debt

has risen significantly since 1973. Farm debt (excluding CCC loans) in 1977, for example, was 4.07
times as large as total net farm income and 1.56

times as great as total net cash income from farm and
nonfarm sources. Such increases indicate that farmers are incurring debt commitments at an accelerate13
rate relative to their income flows from which debt
must be serviced. Moreover, they make it clear that
the farmer whose income comes solely from farming
generally has a much higher relative burden of debt
than the farm operator whose income derives from
both farm and off-farm sources.
His capacity to
repay debt and his credit rating with lenders is thus
often poorer than those of the farm operator who also
has income from an off-farm job.
Summary

Some

potential

for

future

financial

problems appears to be indicated by these aggregate
farm finance trends. To what extent problems materialize remains to be seen, however.

The key ‘un-

certainty is whether the level of farm income in the
post-boom period will prove sufficient to maintain
the past appreciation of farm assets and to support
further increases in farm debt. At current incI,me
levels, the financial ratios examined here are not very
encouraging.
References

3-J

/q]

Farm Debt Outstanding/Net Farm Income

_______m v-e-------.
I

*m-e

c

Farm Deb Outstanding/Net &% Income
from Farm and Nonfarm Sources

AllenAFPFr$ T., et al. Agricultural Finance Outlook,
USDA, Economic Research Service.
Wa&n&on,
November 1977.
Bickers, Jack. “NO Crunch on Farm Credit.” Progressixiz5Farmer, Vol. 93, No. 2, February 1978, pp.
- .
Clarke, Sada L. “A Replay of . . . Farm Financial and
Credit Conditions.”
Economic Review, Vo’l. 64,
No. 2 (March/April 1978), pp. 21-23.
Evans, Carson D., et al. Balance Sheet of the Farm&g
Agriculture Information Bulletin
~octo~~I1977.
USDA, Economic Research Service.
W&hi&on,
October 1977.
Lins, David. “Credit and Finance Outlook.” Speech
presented at the 1978 Food and Agricultural Outlook Conference, Washington, November 16, 1977.
Melichar, Emanuel. “Agricultural Finance Commentary.” Board of Governors of the Federal Reserve
(N(imeoSystem, Washington, November 1977.
graphed.)
and Sayre, Marian.
Agricultural Finance
Da&book, Annual Series, Outlook C0nferenc.e Issue.
Board of Governors of the Federal Reserve System.
Washington, November 1977.
Tostlebe, Alvin S. Capital in Agriculture: Its Formation and Financing since 1870. A Study by the
National Bureau of Economic Research. Princeton,
N. J.: Princeton University Press, 1957.
USDA, Economic Research Service. “Farm Financial
Ledger: Mixed Returns for 1977.” Farm Index.
Vol. XVII, No. 1 (January 1978), pp. 6-7.
Farm Income Statistics. Statistical Bulletin
No. 576. Washington, July 1977.
Major Statistical Series of the U. S. Departmen; of Agriculture:

How They Are Constructed

and Used. Vol. 1, “Agricultural Prices and Parity.”
Agricultural Handbook No. 365. Washington, October 1970.
14

ECONOMIC

REVIEW, MAY/JUNE

1978

THE CAUSE OF THE DOLLAR DEPRECIATION
Robert

L. Hetzel and Thomas

An index of the value of the dollar against the
currencies of other major industrialized countries fell
from an average value of 89.7 in 1976 to a value of
84.0 in January .197&l The depreciation of the dollar
is often attributed to a surplus of dollars on the foreign exchange market caused by an excess of imports
over exports for the United States as measured either
by the trade balance or the current account balance.2
(See Chart 1.) These payments imbalances are, in
turn, attributed to two particular factors-the
demand for oil imports and the faster economic reThese
covery in the United States than abroad.
factors have caused the demand for United States
This
imports to increase faster than its exports.
article presents evidence suggesting that the depreciation of the dollar, rather than being primarily a real
phenomenon as just suggested, is primarily a moneBefore this evidence is examined,
tary phenomenon.
however, several popular views concerning the current account deficit and the depreciation of the dollar
are discussed critically.

A. Lawler

Direct foreign corporate investment
in 1977 by
United States residents exceeded by $3.5 billion similar investment by foreigners in the United States.
This amount, however, was undoubtedly outweighed
by the investment by the oil-producing states of the
Persian Gulf in dollar-denominated
assets. The current oil revenues of these countries exceed the value
of their merchandise imports and the surplus is invested mainly in dollar-denominated
assets.
The net supply of dollars generated by a current
account deficit may also be matched by a demand for
dollars by foreign central banks motivated by a desire
to maintain existing exchange rates.
The current
account deficit for the United States in 1977 was
$20.2 billion. The dollar holdings of foreign central
banks, however, increased by $37.4 billion in 1977.
(In 1976 their dollar holdings increased by $18 bil-

The Current Account and the Exchange Rate
Imports produce a supply of dollars and exports
produce a demand for dollars on the foreign exchange
market. It seems reasonable, therefore, to associate a
current account deficit (an excess of imports over
exports) with an excess suppiy of dollars on the
foreign exchange market and consequently with a fall
in the value of the dollar. A current account deficit
need not, however, imply the existence of an excess
supply of dollars on the foreign exchange market.
The net supply of dollars coming onto the foreign
exchange market because of a current account deficit
can be offset by a net demand for dollars if foreigners
desire to invest more in the United States than residents of the United States desire to invest abroad.
1 The index referred to is the Federal Reserve Index of
Currency Values.
In this index? changes in the value of
the U. S. dollar since May 1970 m terms of the currencies
of 10 countries are weighted by each foreign country’s
1972 worldwide exports plus imports relative to the 1972
worldwide exports pIus imports of all 10 foreign countries. The countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands,
Sweden, Switzerland, and the United Kingdom.

‘.

_ ,$ Billions
~10.00
1 ,,

Value of Dollar

Balance of Payments
-

i

\

_.

’
:

2 The former measure is the difference between merchandise exports and imports. The latter measure is the more
inclusive and includes net military transactions,
net investment income, net travel and transportation,
net other
services, and net unilateral transfers.
FEDERAL RESERVE BANK OF RICHMOND

15

lion.) 3 A comparison of the respective magnitudes of
the current account deficit and the demand for dollars
by foreign investors and foreign central banks renders
implausible the simple statement that the current
account deficit of the United States produced an
excess supply of dollars on the foreign exchange
market that, in turn, caused the dollar to depreciate.
The Foreign Exchange Market and the Exchange
Rate
It also appears reasonable
that a depreciation in the value of a country’s currency indicates
that there is an excess supply of its currency on the
foreign exchange
market.
Exchange
rates may
change, however? without excess supplies or demands
ever appearing on the foreign exchange market.
If
the rate of growth of the money supply in the United
States produces a seven percent rate of inflation here,
and the rate of growth of the money supply in Germany produces a three percent rate of inflation there,
then the dollar must depreciate by four percent each
year in order to keep constant the real terms of trade
between the t’nited States and Germany.
For esample, if one unit of a United States commodity costs
one dollar, one unit of a German commodity costs
two marks, and one dollar exchanges for two marks,
the rate of exchange between the commodities is one
for one. If the dollar price of the United States commodity rises, the mark price of the dollar must fall
proportionally
in order to preserve the original rate
of exchange between the commodities.
It is important to note that changes in exchange rates occurring in order to compensate for differing rates of
inflation across countries can take place without any
balance of payments disequilibria or without any
excess demands or supplies on foreign exchange
markets. All that is necessary is that the inflation be
anticipated.
Exchange
Rate Changes and Invalid Association
Simple association between a present current account
deficit (surplus) and a depreciation
(appreciation)
of the dollar does not necessarily imply that the
payments imbalance is causing the change in the
value of the dollar.
Consider a country with balanced international
accounts.
Market participants
come to believe that the price level wiil rise more
rapidly than previously anticipated for one of its
trading partners than for the home country, and as a
result they begin to trade the home country’s currency at an appreciated value. The home country’s
central bank uses domestic currency to buy foreign
3 The figures
merce.

16

are from

the U. S. Department

of Com-

ECONOMIC

currency in order to resist the appreciation.
The
overall balance of payments is an accounting identity
that must equal zero ; total imports must equal tota
exports.
If the home country imports foreign currency as a consequence of the purchases of foreign
eschange by the central bank, it must be a net exporter of securities, goods, and services.
The central bank may buy the foreign currency at
the old rate. This intervention in the foreign eschange market increases the domestic money supply.
The increase in the domestic money supply, if not
offset, will raise the domestic price level and vaI!idate
the old exchange rate.
Market participants may,
however, believe that the central bank will be ur.willing to place its exchange rate objective above its
domestic price level objective.
They may conclude
then that the central bank is only temporarily keeping
the value of the home currency below its longer-run
value and will willingly supply the central bank with
foreign currency in return for the home country’s
currency.
The acquired home currency will be held
in liquid securities in anticipation of a windfall gain
to be derived from the eventual appreciation of the
home currency.
Alternatively, the market may anticipate that the
efforts of the central bank to control the value of its
currency will be useless and the exchange rate may
move immediately to the Ievel that the market views
as the equilibrium level. There will be no advantage
to placing the honle currency received from thl: intervention of the central bank in the foreign exchange
market into liquid securities because the exchange
rate is viewed as having appreciated to its equi,librium
value. The acquired home currency will be used to
purchase not only securities, but also the goods and
In this case, home
services of the home country.
country imports of foreign currency resulting from
intervention by its central bank produce a surplus in
its current account accompanied by an appreciation’
of its currency.
The foreign country necessarily experiences a deficit in its current account accompanied
by a depreciation of its currency.
This example suggests the following possibility.
The recent depreciation of the dollar resulted from a
belief by market participants that monetary phenomena would lower the equilibrium valtte of the dollar.
Fruitless attempts by foreign central banks to resist
the appreciation of their currencies put their currencies into the hands of United States residents who
used them to purchase foreign goods and services.
The depreciation of the dollar is in this sense a cause
of the present United States current account deficit,
not a consequence of the deficit. The fac.t that the

REVIEW, MAY/JUNE

7978

dollar holdings of foreign central banks increased by
$37.4 billion in 1977 means this view must be considered seriously.
Expectations
and Exchange Rates Investors can,
other things equal, increase the rate of return on their
portfolios by movin g into a currency before it appreciates and by moving out of it after the appreciation has occurred and, of course, by reversing the
process in the case of a depreciation.
They will try
to anticipate changes in exchange rates and alter their
portfolios accordingly.
If a widespread change in
anticipations occurs, the resulting portfolio adjustments will cause the exchange rate to move independently of excess supplies or demands in the foreign
exchange market. This idea and the assertion that
forces exist that motivate the market to form its
anticipations in such a way that the exchange rate is
moved in the direction of its longer-run equilibrium
The
value are discussed in the following section.
reader with an interest in economic theory should
Others may skip to the section
read this section.
entitled “Examination of the Data.”
Theoretical
Section
The basic ideas of this section are introduced initially by analogy in a discussion of the market for long-term bonds. At a given
point in time, there is a given stock of bonds outstanding (stock supply) and a given demand for
these bonds (stock demand) that depends on their
price. At a given price, the difference between the
stock demand for bonds and the stock supply of
bonds is called the stock excess demand for bonds,
and this difference is defined as of a given point in
time. There is also a new issue market for bonds.
Over an interval of time, the difference between new
issues and maturations of old issues give the net flow
of stocks (flow supply) for investors to absorb into
their portfolios.
Over the same interval investors
will want to change their bond holdings by an amount
(flow demand) that depends on the price of bonds.
At a given price, the difference between the flow
demand and flow supply is called the flow excess
demand for bonds, and this difference is defined
over an interval of time.
Assume that at time tl market participants come
to anticipate that at time tz the rate of inflation will
increase by some discrete amount. Holders of longterm bonds will now demand an inflation premium to
compensate for the expected decrease in the future
purchasing power of the dollars with which coupons
are redeemed and principal is paid. Issuers of bonds
will be willing to pay this premium because they will
need to surrender fewer real resources in order to

obtain dollars in the future.
The price of bonds
drops immediately.
If the price had remained at its
old level, there would be a stock excess supply of
bonds. No one will buy the old bonds at the old
price when new ones can be obtained for less. The
price of bonds changed without a flow excess supply
ever having developed, that is, without bond houses
first having to accumulate undesired inventories at
the old price.
The exchange rate, similarly with the price of
bonds, must equilibrate two kinds of markets, those
characterized
by stock excess demands and those
The first
characterized
by flow excess demands.
kind of market includes the market for the stock of
assets denominated
in domestic currency and the
market for the stock of assets denominated in foreign
currency.
Such assets include cash balances, securities of all maturities, stocks and real estate.
The
second kind of market is the market for foreign exchange, that is, the supply and demand for dollars
arising over time as a consequence of international
transactions.
It will be argued in this section that the dollar may
depreciate as a consequence of a change in the expectations of asset holders.
This depreciation
is
necessary in order to maintain equilibrium in the
markets characterized by stock excess demands.
A
depreciation of the dollar is not necessarily a sign
of an excess supply of dollars on the foreign exchange
market. Consequently the depreciation cannot necessarily be halted by measures conceived of solely as
“mopping up” excess supplies of dollars on the foreign exchange market, for example, by central bank
intervention.
The rate of return to holding assets denominated
in a foreign unit of account, calculated using the domestic unit of account, is affected by changes in the
exchange rate. If one believes that foreign currency
will appreciate, he will, other things equal, want to
hold more assets denominated in the foreign currency
and less in the domestic currency.
Everyone cannot
do so, however, because at a particular point in time
the stocks of domestically-denominated
and foreigndenominated
assets are fixed and exactly these
amounts must be held. Given the level of the exchange rate expected to prevail in the future, the
current exchange rate will have to adjust in order
that the difference between the current and future
rate is such that asset holders are willing to hold these
fixed stocks.
The current exchange rate must be
such that there is no advantage anticipated from
shifting between foreign- and domestically-denominated assets.

FEDERAL RESERVE BANK OF RICHMOND

17

The anticipated value of the future exchange rate
determines the current rate. Given this anticipated
value, the level of the current rate must be such that
asset holders are willing to hold the given stocks of
foreign- and domestically-denominated
assets.
Expectations do not, however, constitute a bootstraps
theory of exchange rate determination.
The current
exchange rate must equilibrate over time the flow
demands and supplies in the foreign exchange market. If it fails to do so, the asset holders of the country with the payments surplus will accumulate an
excess stock of liquid foreign-denominated
assets.
When they try to dispose of these assets, the foreign
currency will depreciate and inflict capital losses on
these asset holders. Asset holders will be unwilling
to accumulate the assets that buffer short-lived discrepancies in exports and imports unless they believe
the current exchange rate over time will produce
overall payments balance. The determinants of the
exchange rate anticipated by market participants to
prevail in the future must, as a consequence, be those
factors, real and monetary, that determine the future
value of the exchange rate necessary to achieve over
time fiow equilibrium in the foreign exchange market.
The following example is provided in order to
illustrate how the exchange rate is determined as a
consequence of the need to maintain equilibrium in
the market for the stock of assets and in the market
for the flow of foreign exchange.
Assume that in
the home country the recent rate of growth of the
money supply has been above its trend value, but that,
because of past experience, the public expects an
offsetting period during which the rate of growth of
the money supply will be below trend.
Something
then occurs that causes the public to believe that the
higher rate of growth of the money supply will conThe public then revises upward
tinue indefinitely.
by a discrete amount the domestic price level anticipated to prevail in the future.
Alternatively,
the
public at some point comes to realize that a natural
resource important in that country’s exports and in
its domestic consumption will be depleted at some
future time. For expositional simplicity, these assumptions are summarized by saying that at time ti
the public comes to anticipate the occurrence of a
phenomenon at time t> that will cause the eschange
rate that equilibrates the flow demand and supply of
foreign exchange to fall by some discrete amount.
Figure 1 depicts the demand schedule for home
currency arising from the home country’s exports of
goods and securities and the supply schedule of home
currency arising from its imports of foreign goods
and securities. A fall in the foreign exchange vaIue
IS

ECONOMIC

Figure 1

EXPORT AND

IMPORT

DEMAND

SCHEDULES

Exchange
Rate

Home Currency/Unit

of Time

of the home currency makes exports less expensive
abroad and increases the demand for home currency.
It makes imports more expensive and, it is assumed,
causes less home currency to be offered on the foreign
exchange market. The schedules do not include the
flow of liquid assets that buffer short-lived discrepancies between the flow of exports and imports. At
time ti these schedules are represented by the solid
lines. At time t?; they shift to the position indicated
by the dashed lines. Figure 2 shows the behavior
over time of the exchange rate and the bala.nce of

Figure 2

Exchange
Rate

I

Balance of
Payments

REVIEW, MAY/JUNE

Surplus

Deficit

1978

payments apart from international
flows of liquid
assets. Initially, the behavior of the exchange rate
over time is described, then the rationale behind this
behavior is provided.
At time tr the public comes to anticipate the occurrence of a phenomenon at time t2 that will cause
the exchange rate that equilibrates the flow demand
and supply of foreign exchange to fall. At the old
exchange rate EO, there is now an excess stock supply
of domestically-denominated
assets and an excess
stock demand for foreign-denominated
assets because
asset holders anticipate a windfall gain from holding
assets denominated in the foreign currency. The exchange rate must fall immediately (Er).
The foreign exchange market is characterized at tl by the
solid lines shown in Figure 1 and the home country’s
balance of payments moves into a position of surplus.
The surplus will be financed by an accumulation by
residents of the home country of liquid assets denominated in the foreign currency.
At time tg the
export and import demand schedules shift to the
position shown by the dashed lines in Figure 1 as
At the exchange rate existing at t2
anticipated.
(El), the home country develops a balance of payments deficit.
The exchange rate then depreciates
over time until it reaches its long-run equilibrium
value. As shown in Figure 2, the deficit is eliminated
by this further depreciation,
but it persists long
enough in order to offset the previous surplus. The
initial accumulation
of foreign-denominated
liquid
assets is matched by a corresponding reduction.
What keeps the exchange rate on the path shown
in Figure 2?
Between time tr and t2, the home
country experiences a trade surplus and between
time t2 and the time when the final rate of exchange
is attained, a trade deficit. The home country first
accumulates foreign-denominated
securities and then
reduces them as a result of the deficit. This accumulation represents no risk of capital loss from changes
in exchange rates because the foreign-denominated
assets will subsequently be used to pay for foreign
goods.
If, however, the initial depreciation is too
small, eventually it will become evident that the exchange rate will fall further than anticipated.
Domestic holders of foreign assets could have increased
the rate of return on their portfolios by holding more
foreign-denominated
assets. Their attempt to do so
will drive the exchange rate down. If, on the other
hand, the initial depreciation is too large, over time it
will become evident that when the exchange rate
reaches its long-run equilibrium value, asset holders
will still be left with foreign-denominated
assets. The

deficit following the surplus in the balance of payments is smaller than anticipated.
Domestic holders
of foreign assets will experience a capital loss because the exchange rate will appreciate when they
unload their foreign-denominated
assets. Their attempt to decrease their holdings of foreign-denominated assets will drive the exchange rate up. Between time tz and ts, the exchange rate is prevented
from falling immediately to its long-run level because
home residents are unloading foreign-denominated
securities, but it must fall. Otherwise, a discrete
appreciation of the foreign currency would occur in
the future. This possibility increases the demand for
foreign-denominated
assets and forces the exchange
rate downward.
If the event anticipated to occur at tz does not
occur, the domestic currency will appreciate above its
former level while domestic residents run down the
foreign-denominated
assets accumulated because of
the surplus, and then it will return to its old level.
Holders of foreign-denominated
assets incur a loss.
If the event at tc causes a greater deficit at the existing exchange rate than anticipated, the domestic
currency will depreciate further. Holders of foreigndenominated assets forego gains that could have been
earned by holding even more of these assets.
The anticipated future exchange rate is a major
determinant of the current exchange rate, but the
former will be the rate that the market anticipates
will equate over time the flow demands and supplies
for foreign eschange arising out of international
transactions.
In general, if the exchange rate is set
at a lower (higher)
level, the payments surplus
(deficit) will h ave to be financed by accumulations
(reductions)
of foreign-denominated
assets. These
portfolio shifts lower the rate of return earned by
holders of these assets when the exchange rate moves
to its equilibricm value. (The exchange rate must at
some point move to its equilibrium value because
individuals cannot accumulate or reduce assets to
offset a payments imbalance indefinitely.)
The selfinterest of market participants
motivates them to
form expectations of the exchange rate that will
assure over time equilibrium in the foreign exchange
market.
Note finally, once more, that expectations
can cause changes in exchange rates even without
imbalances in the foreign exchange market.
Examination
of the Data It has been the depreciation of the dollar against the German mark, the
Japanese yen, and the British pound that has aroused
the most concern.
Evidence is presented in this

FEDERAL RESERVE BANK OF RICHMOND

19

section concerning the value of the dollar measured in
marks, yen, and pounds. The first question examined
is whether the balance of payments on current account has been a major determinant of exchange rate
movements.
Current Account
Imbalance
The solid line in
Chart 2 shows for each of the three countries the ratio
at which its currency exchanges for one dollar, so that
declines represent a depreciation of the dollar. The
broken lines measure the bilateral balance of payments of the United States with each country measured on a trade account basis (quarterly observations) and on a current account basis (annual oblservations) .4 The United States has consistently had a
bilateral current account deficit with Japan and (Germany since 1974 ; yet, from 1974 I to 1976 IV for
Japan and from 1974 II to 1976 III for Germany,
the dollar failed to depreciate against the currency
of either country.
It may be objected of course that
countries need only to balance their internat.ional
payments across all their trading partners, not bilaterally with each, in order to maintain equilibrium
in the foreign exchange market.
Chart 1 plots the balance on current account for
the United States and an index of the weightedaverage exchange value of the dollar against the currencies of other major industrialized countrie.;.
In
only slightly more than half the quarters shown is
either a surplus associated with a significant appreciation of the dollar, a deficit associated with a significant depreciation of the dollar, or approximate balance in the current account associated with no change
in the value of the dollar. It has been argued, however, that even if these associations were :present
uniformly it is not necessarily valid to assume that
the then-existing
trade imbalance was caus:ing the
change in the exchange rate because central banks
were trying to offset the change by intervention in
the foreign exchange market.
Differential
Movements
in Real Income
It is
possible to test the belief that differential rates of
growth in real income between the United States and
Germany, Japan, and the United Kingdom have produced a depreciation of the dollar by causing the
demand for imports into the United States to increase

4 The bilateral trade surpIr?s or deficit figures refer to
the value of exports of U. S. merchandise plus reexports
of foreign merchandise, minus imports of that count&s
merchandise into the U. S. customs area.

20

ECONOMIC

REVIEW, MAY/JUNE

1978

faster than the demand for exports from the United
States.s
A test of this belief is also a test of the more particular belief that oil imports are a cause of the
depreciation of the dollar .6 The argument is that the
United States is recovering from the trough of the
recession faster than other countries.
This fact is
causing its oil imports to rise faster than other counIf the OPEC countries were
tries’ oil imports.
willing to invest the receipts from their exports to
the United States in United States securities or to
import exclusively from the United States, then the
dollar need not depreciate against any currency.
OPEC countries, however, are using part of the
receipts to buy goods from other countries. In order
to achieve overall balance in international payments,
the United States will, therefore, have to run surpluses in its trade account with other non-OPEC
countries. Its currency will have to depreciate vis-avis these other currencies in order to generate such
surpluses.
Charts 3 and 4 present evidence bearing on the
hypothesis that higher rates of growth in real income
in the United States than abroad have caused the
dollar to depreciate. In Chart 3, the solid line is the
percentage change in industrial production in the
United States over the twelve-month interval ending
in the month shown on the horizontal-axis minus the
percentage change in industrial production in the
foreign country over the same interval. The dashed
line measures the depreciation (positive height) or
appreciation (negative height) of the dollar over the
same twelve-month interval. The hypothesis requires
that these lines rise and fall sympathetically.
This
behavior is not as a general rule visible in the graphs.
It fails to hold for any of the countries for the twelvemonth intervals ending in 1976. In 1977, economic
activity increased more strongly in the United States
than in Germany, Japan, and the United Kingdom.

United Kingdom

5 It should be noted that the assumed relationship must
refer to behavior over a business cycle, not secular behavior. If a country is growing faster secularly than its
trading partners, so will its demand for money.
For
given rates of growth in the nominal money supply, the
faster growing country will experience relatively slower
growth in its domestic price level. This effect works to
increase the foreign-exchange
value of the country’s
currency.
s Oil imports in themselves do not explain a depreciation
of the dollar, however.
The rise in the price of oil
increased the cost to all countries of importing oil
Because the United States is relatively self-sufficient in the
production of energy relative to Germany and Japan the
increase in the cost of importing oil cannot explain a
depreciation of the dollar against the mark and the yen.
Furthermore, the OPEC surpluses are invested mainly in
dollar-denominated
assets.
This fact would indicate an
appreciation of the dollar.
FEDERAL RESERVE BANK OF RICHMOND

21

For Germany, there was little corresponding increase
in the rate at which the mark was appreciating.
For
Japan, the yen did b egin to appreciate at an accelerated pace. For the United Kingdom, the pound depreciated less rapidly and then appreciated against
the dollar. In these two cases, however, the upward
movement in the line representing percentage changes
in the eschange rate preceded the upward movement
in the line representing differences in economic activity.
Chart 4 extends the period of observation and empioys the more general measure of real incomereal gross national product.
Observations represent
percentage changes over four-quarter
intervals ending in the third quarter of the year indicated.r
The
horizontal distance represents the percentage change
of real gross national product in the United States
minus the percentage change of real gross national
product in the foreign country.8
The vertical distance measures the depreciation (positive height) or
appreciation
(negative height) of the dollar.
The
hypothesis requires that these points fall aIong an
upward sloping line. When the 1974 observation is
ignored in the case of Japan and the United Kingdom, lines passing through the observations would
be upward sloping. Ignoring 1974 may be justifiable
because the effects of the oil embargo, the rise in
the price of oil, and uncertainty over national policies
toward energy unquestionably introduced large movements into exchange rates unrelated to differences in
real income growth across countries.
Chart 4 offers
some evidence to support the hypothesis that the
foreign exchange value of the dollar is determined by
differential rates of growth of real income, but Chart
3 indicates that the evidence is not strong.

1976

Differential
Rates of Inflation
Chart 5 is useful
‘for deciding whether movements in the foreign exchange value of the dolIar are explainable by reference to divergent behavior in the rate of inflation in
the United States and abroad.
It is constructed in
the same way as Chart 3 except that the solid line
represents percentage changes in the consumer price
‘index in the United States over twelve-month intervals minus percentage changes in the consumer price
index in the foreign country over the same twelvemonth intervals.
The dashed line, as before, is the
percentage change in the exchange rate over twelveOnly third quarter 1977 data were available
countries at the time this article was written.

7

for

all

s For the _ United Kingdom,‘> the horizontal distance of
..each point is the percentage changes of real gross national product in the U. S. minus the percentage changes
of real gross domestic product in the II. H.

22

ECONOMlC

REVIEW, MAY/JUNE

1978

l

month intervals. The two lines do not exhibit similar
contemporaneous
movements.
It is, however, possible that exchange rate movements reflected anticipations of future differential rates of inflation.
If
the line plotting percentage changes over twelvemonth intervals in the exchange rate is a predictor of
differential
rates of inflation over future twelvemonth intervals, its predictive power may be tested
by moving it rightward and comparing it with the
line plotting differential rates of inflation. A rightward movement of the line representing the exchange
rate does increase the similarity in movement between
the two lines. In particular, the troughs of the lines
can be made to coincide by this rightward movement.
Given the difficulty of predicting future rates of
inflation, it is, however, probably unreasonable to
expect that movements in exchange rates should
predict any better than is indicated by Chart 5.
The rate of growth of the money supply offers
information about future rates of inflation. Chart 6
is useful in examining whether differential rates of
growth in the money supply between the United
States and foreign countries are a determinant of
movements in the foreign exchange value of the
dollar. It is constructed in the same way as Charts 3
and 5 except that the solid line represents percentage
changes in the money supply in the United States
over
twelve-month
intervals
minus
percentage
changes in the money supply in the foreign country
over the same twelve-month intervals9
The dashed
line, as before, is the percentage change in the exchange rate over twelve-month intervals.
Shifts in United States-German and United StatesJapanese money growth rate differentials lead to
changes in the percentage changes of the foreign exchange value of the dollar as predicted.
The exception is the end of 1977. During this time, Germany
and Japan were using their currencies to buy dollars
in an effort to resist the appreciation of their currencies. This intervention has the effect of raising the
rate of growth of the money supply in Germany and
Japan relative to the United States, causing a downturn of the solid line in Chart 6. An explanation for
the failure of the mark and the yen to appreciate less
rapidly or to depreciate against the dollar as a result
of this downturn is that market participants believe
that the upsurge in the rates of growth of the money
supply in Germany and Japan will be reversed
9 The money supply used for all countries is MI, or currency plus demand deposits. U. S. money growth rates

are based on monthly averages of daily MI figures,
German and Japanese money growth rates are calculated
using end-of-month
figures, and U. K. money growth
rates are based on MI figures for the third Wednesday of
each month.
FEDERAL RUERVE BANK OF RICHMOND

23

shortly. The increase in the rate of growth of their
money supplies would, if not reversed, frustrate the
desire of the German and Japanese central banks to
maintain low rates of inflation.
If a movement in
the line representing
differential
rates of money
growth is expected to be reversed shortly after it
occurs, it will have no effect on the exchange rate.
Such a movement will not affect differential rates of
inflation. Furthermore, if the exchange rate were to
follow any such predictable pattern, speculative activity would soon eliminate the pattern.
For the United Kingdom, the slowdown in the
rate of growth of its money supply relative to the rate
of growth in the United States money supply that
lasted until early 1977 is reflected by a slowdown in
the rate at which the pound was depreciating against
the dollar. Over most of 1977, however, the rate of
growth of the money supply in the United Kingdom
rose in relation to the rate of growth of the money
supply in the United States while the pound continued to depreciate more slowIy and finally appreciated vis-a-vis the dollar.
The explanation for the
similar discrepancy in the cases of Germany and
Japan may also apply here.
Also, in the United
Kingdom, the rate of growth of the money supply is
closely related to the size of the government deficit.
The opening of the North Sea oil wells may have
been espected to reduce or eliminate this deficit and
to slow the rate of growth of the money supjply in
the United Kingdom.
The current behavior of the
dollar-pound exchange rate may be dominated by
expectations of slower future growth rates ,in the
British money supply.
The evidence presented in Charts 3 through 6
suggests that both real and monetary phenomena have
influenced the value of the dollar in the last three
years. A comparison of Charts 3 and 6 suggests that
monetary phenomena have been relatively more important than real phenomena in determining
the
value of the dollar.
Expectations Because of a lack of a direct measure of expectations, it is difficult to say whe?her the
espectations market participants form about the exchange rate necessary to equilibrate the market for
foreign exchange over future intervals of time. explain
the depreciation of the dollar. Chart 7 plots the rate
of change of the money supply from the fourth
quarter of the preceding year to the fourth quarter
of the year shown. These annual growth rates decrease and then increase for the United States. For
the United Kingdom, they exhibit an upward trend,
although as mentioned above, there are reasons that
may be causing asset holders to anticipate a fall in
24

ECONOMIC

REVIEW, MAY/JUNE

1978

this series in the future.
The series for Germany
appears trendless.
The series for Japan exhibits a
downward trend. Only for Japan does a comparison
of these series across countries strongly support the
hypothesis that the dollar has depreciated because
asset holders expect monetary policy to be more
inflationary in the future in the United States than
abroad.
Asset holders are undoubtedly concerned
more about future than past rates of growth of the
money supply, however, and historical growth rates
of the money supply probably offer less information
on this question than a complex of nonquantifiable
domestic considerations.

Japan

United States

Concluding Comments There is evidence to support the view that the depreciation of the dollar is
primarily a monetary phenomenon.
Acceptance of
this view has several implications. First, the depreciation of the dollar is not necessarily a self-limiting
process. Although a discrete change in the expectations of asset holders may cause a large one-time
depreciation of the dollar, a continual depreciation of
smaller magnitude can continue indefinitely, if necessary, in order to compensate for a faster rate of
inflation domestically than abroad.
Second, the depreciation of the dollar cannot be dealt with using
policy tools designed to deal with real phenomena,
that is, phenomena pertaining to particular markets
in the real sector of the economy.
For example, a
tariff or quota on imports might strengthen the dollar
temporarily
by reducing the demand for imports,
but the effect would only- be temporary.
Furthermore, intervention by foreign central banks in the
foreign exchange market that puts foreign currencies
into the hands of United States citizens will, if these
currencies are used to purchase foreign goods, produce a current account deficit for the United States.
A depreciation of the dollar need not indicate h
current flow excess supply of dollars in the foreign
exchange market. It may rather be a result of anticipations by the market that at the old exchange rate a
flow excess supply of dollars would develop in the
future.
Many of the current proposals for ending
the depreciation of the dollar concentrate entirely on
the presumed current flow excess supply of dollars in
the foreign exchange market.
For example, one proposal is for the United States
Treasury to float a mark-denominated
bond and to
use the proceeds to buy dollars. Deposits of German
banks decrease when the bonds are purchased, but
increase to their original level when the Treasury
uses the marks it has obtained to purchase dollars.
The purchase of marks with dollars decreases the
FEDERAL RESERVE BANK OF RICHMOND

25

deposits of United States banks. The operations of
the Federal Reserve necessary to preserve its Federal funds rate target will! however, bring these deposits back to their original level. If the Treasury
uses the dollars it obtains in this operation in order
to retire debt, asset holders end up with fewer dollardenominated securities and more mark-denominated
securities. They may be willing simply to accept this
alteration in the relative shares of their portfolios
denominated in marks versus dollars in order to
profit from an anticipated appreciation of the mark.
The operation has no effect on the equilibrium value
of the eschange rate.
Intervention
in the foreign exchange market in

itself need have no effect on the value of the dollar.
It is necessary for this intervention to change the
expectations
of asset holders about the foreignexchange value of the dollar that wiI1 equilibrate the
market for foreign exchange not only over the current
time interval, but also over future time intervals.
For example, what will be of concern to market participants will be how intervention affects the longrun
behavior of the money supply domestically
and
abroad. Intervention in the market for foreign exchange in order to affect the eschange value of the
dollar cannot be viewed in isolation, but muzt be
viewed as an integral part of a more comprehensive
set of policies.

The Eco~o~rc
REVIEW is produced by the Research Department of the Federal Reserve Bank of
Richmond. Subscriptions are available to the pub& without charge. Address inquiries to Bank and
Public Relatiolzs, Federal Reserve Bank of Richmond, P. 0. Box 27622, Richmond, Viq@a
23262. Articles way be reprodnxed if source is given. Please provide the Ba.nk’s Research Department with a copy of any @bEcation in which an article is used. Also note that microfilnz copies of
the ECONOXIC REVIEW are available for purchase f~ona University 34ic~of&vzs, Ann Arbor, .Michigan 48106. The iden$ificatz’on nawber is 5080.

26

ECONOMK

REVIEW,

MAY/JUNE

1978

13. Rottenberg, I.
“Inventories and the Inventory
Valuation Adjustment.” Quarterly GNP Estimates
Revisited

in a Double-Digit

Inflationary

17. Stevenson, J. Methods of Inventory

Valuation and
Their Effect
on Balance Sheets and Operating
Statements,
Submitted to the Graduate School of

Economy,

Banking conducted by the American Bankers Association, Rutgers University, June 1952.

BEA Staff Paper No. 25, U. S. Department of
Commerce, Bureau of Economic Analysis, October 2, 1974, pp. 29-33.
14.

18. Tatom, J. “Inventory Investment in the Recent
Recession and Recovery.” Review, Federal Reserve
Bank of St. Louis, (April 1977), pp. 2-9.

; M. Foss; and G. Fromm. “Improving
the Measurement of Business Inventories.” American Statistical
Association Proceedings,
1977, pp.

19. Touche Ross and Co.

Current Value Accounting,
Economic Reality
in Financial Reporting, A Program for Experimentation,
1975.

15. Shoven, J., and Bulow, J. “Inflation Accounting
and Nonfinancial Corporate Profits : Physical
Assets,” Brookings Papers on Economic Activity,
(3: 1975), pp. 557-611.
16.

. “Inflation Accounting and Nonfinancial Corporate Profits: Financial Assets and Liabilities.” Brookings Papers on Economic Activity,
(1: 1976), pp. 15-66.

20. van Furstenberg, G. “Corporate Taxes and Financing Under Continuing Inflation.”
Contemporary
Economic Problems. Edited by W. Fellner. American Enterprise Institute for Public Policy Research,
1976, pp. 225-54.
21.

, and Malkiel, B. “Financial Analysis
in an Inflationary Environment.” The Journal of
Finance, (May 1977), pp. 575-92.

The ECONOMIC REVIEW is produced by the Research Department of the Federal Reserve Bank of
Richmond. Subscriptions are available
to the public without charge. Address
inquiries to Bank and
Public Relations, Federal Reserve Bank of Richmond, P. O. Box 27622, Richmond,
Virginia
23261. Articles may be reproduced if source is given. Please provide the Bank’s Research Department with a copy of any publication in which an article is used. Also note that microfilm copies of
the ECONOMIC REVIEW are available for purchase from University Microfilms, Ann Arbor, Michigan 48106.
The identification number is 5080.

FEDERAL RESERVE BANK

OF RICHMOND

27

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