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THE PERSISTENCE
OF INFLATION
Thomas M. Humphrey

Among the most exasperating and puzzling of recent economic phenomena is the apparent intractability of the inflation rate. Once started, an inflation
becomes difficult to subdue. It seems to develop a
momentum of its own, independent of other basic
economic conditions.
It resists or at best responds
only sluggishly to traditional restrictive policies. Its
persistence in the face of high unemployment and
excess capacity has resulted in the addition of the
term stagflation to the economist’s lexicon.
What accounts for the stickiness of the inflation
rate? Why is it so policy-resistant
and difficult to
control? Why is it so slow to decelerate even when
demand is slack? Many economists believe that the
answers lie in the mechanism through which inflationary impulses are transmitted through the economy.’
Embedded in this mechanism are certain
delays or lags that may slow the spread of inflation
over the total price structure and may also prolong
its duration.
Particular prices that lag behind general inflationary movements have to catch up later to
reestablish their relative position in the price structure. This lag/catch-up characteristic of the inflationary transmission mechanism is offered by some
as an explanation of why strong upward pressures
on prices persist long after demand slackens.
The most important
lags in the process by
which inflation is diffused through the economy are
the price-adjustment lag and the expectations-formation Zag. The first refers to the delayed response of
the rate of price increase to shifts in aggregate demand.
Demand pressure is transmitted to prices
via a complicated and circuitous channel that runs
from output to inputs to input prices to costs and
lag
finally to product prices. The price-adjustment
accounts for the time it takes for demand to affect
prices through the channel of costs. It should be
noted that many of these costs themselves adjust
slowly, partly because they are influenced by sticky
price anticipations.
These sticky anticipations are
described by the second lag, which refers to the
slowness with which expectations of future inflation
are revised when individuals realize that actual inflation has turned out to be different than was ex1 See, for example,
the studies by Cagan [l, 2, 3], and
Laidler
[5, 6].
See also the articles
by Friedman
[4]
and Selden [8]. The present article draws heavily from
Cagan and Laidler.

pected. For example, immediately following periods
of rapidly accelerating inflation, expectations about
the future behavior of prices continue to reflect the
preceding price experience even though the current
rate of inflation may be decelerating.
Some analysts
point to these lags as the reason that inflation is so
persistent and hard to subdue, even in the face of high
unemployment and excess capacity.
The purpose of this article is to examine the priceadjustment and expectations-formation
lags and to
indicate how they may affect the speed, pattern, and
duration of inflation.
The article proceeds in the
following manner.
First, it identifies the location
and describes the operation of the lags in the inflationary transmission mechanism. Second, it provides
an explanation of the existence of the lags. Third,
and most important, it analyzes the policy implications of the lags. Finally, the appendix contains a
brief description of how the lags are treated in simple
analytical models of the inflationary process.
Sketch of the Inflationary
Process
The first
objective is to describe the operation of the lags in
the inflationary mechanism. As a necessary preliminary, a brief description of the inflation process is
offered, with emphasis on the time sequence or chronological order in which key economic variables
(spending, output, costs, prices, expectations, etc.)
The hypothetical
adjust to inflationary pressures.
example presented below may not conform to all of
the inflationary episodes experienced in the U. S.
although it probably typifies most of them.
As a first approximation, the sequence of events
in a typical inflation may be described as beginning
with an increase in aggregate demand to a level in
excess of the economy’s capacity to produce.2 Such
2 In starting
with demand,
the example
does not deny
that supply shocks-crop
failures, strikes, natural disasters and the like-may
also play a role in inflation.
Given the random, transient,
and often reversible
nature
of these shocks, however,
it is unlikely that they could
produce
a continuing
(sustained)
inflation.
What they
can do is to temporarily
intensify
an inflation generated
This is the problem
of price blips
by demand
forces.
illustrated
by the transient
double-digit
episode of 1974
when supply constraints
caused inflation to deviate temporarily
from its basic trend rate determined
by excess
demand.
When the supply shocks abated, inflation
returned to its basic path.
Note also that supply shocks
can be treated as an excess demand phenomenon,
albeit
one in which the excess arises from falling supply rather
than rising demand.

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a step-up in the rate of spending might stem from
any of a variety of causes including : (1) an increase
in the government’s budgetary deficits ; (2) an episodic expansion in private spending associated, say,
with a major innovation ; and (3) an acceleration in
the rate of monetary growth either actively engineered or passively permitted by the monetary authorities. Whatever the cause, the increased rate of
spending, if it is to continue, must be supported by a
sustained higher rate of monetary growth. Without
this concomitant
monetary
growth, rising prices
would simply reduce the real value of existing cash
balances below the level that people desire to hold.
In an effort to rebuild their price-eroded real balances, cashholders would cut expenditures,
thereby
bringing the inflation to a halt. An increased rate of
spending cannot be maintained for long without the
monetary expansion necessary to finance it. Assuming such expansion occurs, however, the corresponding increased rate of spending leads to a buildup of
excess demands on the economy. Businessmen initially respond to this rising demand not by raising
prices but rather by reducing inventories and expanding output. That is, their initial adjustments are to
quantities; price adjustments come later-hence
the
so-called price-adjustment
lag.
The stimulus to final output resulting from these
quantity adjustments is transmitted back to earlier
stages of production via increases in the demand for
labor and material inputs, as well as for intermediate
(semi-finished)
products.
Demand pressure passes
downward to lower stages of production where prices
-especially
those of raw materials and other basic
commodities-are
particularly sensitive to increases
These prices begin to rise almost imin demand.
mediately as do certain competitive
(non-union)
wages whose adjustment is not delayed by long-term
union contracts or collective bargaining agreements.
Since the output of earlier stages of the productive
process constitutes the input of later stages, these
rising wages and prices pass back up through the
interindustry structure in the form of increased costs.
In short, demand pressure is transmitted downward
thus invoking cost increases that ripple upward until
they finally reach the finished product stage. Here
businessmen, operating with fixed percentage markups over costs, pass these cost increases on in the
form of higher prices. These price increases induce
workers operating under collective bargaining agreements to bargain for cost of living increases in the
next wage contract.
The resulting increases in labor
costs are passed through into still higher prices.
Such cost-induced price increases, of course, constitute the delayed price response to the prior shift in
4

ECONOMIC

REVIEW,

demand. These cost and price increases provoke further rounds of wage and price increases that add
impetus to the inflation through the channel of costs.
It should be noted that the expectations lag is in
operation throughout
the early and intermediate
stages of the inflation. Price anticipations are based
on perceived trends and so do not change quickly.
Because these trends are estimated largely from past
experience, it takes time to adjust expectations to
higher current rates of inflation.
Thus when the
actual rate of inflation begins to rise, the expected
rate is not immediately affected. Only after the actual
rate has exceeded the expected rate for a time will
the latter start to rise. But it will rise slowly at first
because it continues to reflect the lower past rates of
inflation. Eventually, however, the expected rate rises
faster and faster as people become acclimated to the
higher actual rate and adapt their expectations to it.
Once aroused, inflationary expectations
feed back
into the current rate of inflation as firms and unions
seek to raise prices and wages at the same rate as
they expect prices in general to rise. At this stage
of the inflationary process, where cost increases are
passing through into price increases and the expected
rate of inflation is rising to catch up with the actual
rate, the main impact of the inflationary
stimulus
shifts from quantities to prices. The temporary output and employment effects diminish, and purely inflationary price effects dominate.3 The lags, however,
may be long; and the price system may take several
years-years
that may even encompass a business
Particular
recession-to
complete all adjustments.

3 Note that the expectations
lag temporarily
influences
real economic
activity
by causing the nominal
and real
prices of factor inputs to move
(i.e., inflation-corrected)
Put differently,
the expected
in opposite
directions.
inflation
component
of nominal wage and interest
rates
may not adjust sufficiently
to offset actual inflation thus
causing
changes
in the corresponding
real (price deflated) values of those variables.
For example, when an
inflationary
stimulus
begins, nominal wage and interest
rates adjust upward by the amount
of the expected
inflation.
Because the expected rate of inflation lags behind
the actual rate, however,
the adjustment
is incomplete
and consequently
real wage
and interest
rates
fall.
Businessmen
take advantage
of the falling real wage and
interest
rates by hiring more labor and borrowing
from
banks in order to expand production.
These effects, together
with decreases
in the demand
for money
(and
hence rises in spending)
induced
by higher
nominal
interest
rates, result in a temporary
rise in real output
The stimulus
ends, however,
when
and employment.
expected inflation catches up with actual inflation.
When
this happens,
nominal
wage and interest
rates fully reflect the actual rate of inflation
and real wage and
interest
rates return to their initial levels.
Similar real
effects
operate
on the downside
when actual inflation
falls below expected
inflation.
In this case the expectations lag results
in a temporary
rise in real wage and
interest
rates and these rising real costs act to temporarily depress real economic activity below its equilibrium
level.

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1979

costs and prices that have lagged behind the others
will have to catch up in order to restore the equilibrium price relationships disturbed by the inflation.
Also, at the end of a serious inflation, inflationary
psychology may continue to exert upward pressure
on wages and prices even after other basic pressures
have begun to diminish. Wages and prices continue
to mount as inflationary expectations adjust to catch
up with the accelerating price movements of the
recent past. This catch-up process may extend well
into an ensuing recession, thus resulting in the
anomaly of rising prices despite slackening demand.
In the process just described, the chain of causation or pattern of adjustment runs from spending to
output to costs to prices to expectations and back
again to input and product prices. This sequential
process is represented schematically in the chart,
which also shows the location of the price-adjustment
and expectations lags. It should be emphasized, however, that an important constraint exists to the continuous operation of this process.
Specifically, the
process cannot continue unless it is constantly refueled with additional supplies of money. A determined stand by the monetary authorities to deny this
fuel will eventually bring inflation to a halt.

inflationary expectations continue to mount. But as
demand pressures
slacken throughout
successive
stages of production, the resulting weakening of costs
eventually leads to an easing of prices of final goods
and services. As the actual rate of price increase falls
and remains for a time below the expected rate, expectations of further rises are gradually revised
downward. Since the expected rate is a determinant
of the actual rate, the decrease of the former will
produce a further deceleration of the latter. But the
price-adjustment
and expectations lags draw out the
winding-down process and the actual rate of inflation
will converge on its new equilibrium level only
slowly.
Factors Retarding Price Adjustment
What characteristics of a modern economy account for the lags
described in the foregoing sections? In the case of
the price-adjustment lag, the answer is fairly straightforward.
The lag arises from institutional arrangements and behavioral practices that operate to make
many costs and prices relatively unresponsive to
short-run shifts in demand.4 For example, long-term
contracts fix some wages and prices for substantial
intervals of time.
In addition, regulated rates of

The Winding-Down
Process The lags described
in the preceding section continue to operate even
after an effective program of monetary restraint is
implemented.
Spending slackens, output falls, and
input demands decline; but prices nevertheless continue upward because recent cost increases are still
working their way through the system and because

THE INFLATIONARY

PRICE-ADJUSTMENT
A

4 Note that the rigidities or inflexibilities
described in this
section refer not to levels of particular
prices and costs
but rather to rates of change of those variables.
The
concept of rigid price levels, of course, implies the complete absence
of price change and is thus irrelevant
to
the analysis
of inflation,
which deals with continually
rising, not constant,
prices.
The problem
of sluggish
inflation
is not one of downward
inflexibility
of price
levels, but rather the resistance
of rates of price increase
to departures
from the established
trend.

TRANSMISSION

MECHANISM

LAG

EXPECTATIONS

LAG

The inflation process is set in motion by a rise in aggregate
demand or spending to a level
in excess of the economy’s long-run capacity to produce.
Businessmen initially respond to the excess demand by drawing down inventories and stepping up production.
Output expands and the demand for
resource inputs increases.
The resulting upward pressure on resource pricer pusher up unit production costs upon which product prices are bared.
Pricer therefore rise.
There price increases induce resource owners to bargain
for cost-of-living
pay increaser to restore real earnings eroded by
inflation.
This feedback of product prices into resource costs generates additional
rounds of inflation.
The price-adjustment
log is the time it takes
for demand pressure to affect product prices through the complicated channel of factor costs.
If the inflation
persists, it eventually induces upward
revisions of expected future rates of inflation,
which feed back into wages and prices to add further momentum to inflation.
Slow to build up and
hard to reverse, price expectations may keep wages and prices increasing long after demand slackens.
The expectations lag accounts for the slow
adjustment of the expected future rate of inflation to changes in the actual current rate.

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public utilities can be changed only after lengthy
administrative and judicial proceedings.
Moreover,
there exists a variety of legal restrictions on wage and
price flexibility, including minimum wage laws, rent
controls, oil price ceilings, interest-rate ceilings, and
the like.
There are also numerous governmentsanctioned’ trade-restriction
and price-fixing arrangements, such as production and marketing quotas for
certain agricultural products, import quotas, licensing
and other restrictions to entry of professions, and
resale price maintenance agreements.
All these contribute to the stickiness of the prices affected.
An important factor retarding price adjustment is
the inflexibility of many wages. Owing to long-term
labor contracts, delays in the adjustment of price
expectations, and perhaps also workers’ money illusion (i.e., failure to distinguish between nominal
and real wage increases), some wages tend to lag
behind inflation during certain phases of the business
cycle. When inflation accelerates in the upswing,
these wages are often slow to respond.
In later
stages of a sharp inflation, however, wage increases
may outstrip price increases. Wages may then tend
to rise ahead of prices to restore real earnings eroded
by past price increases and to protect real earnings
from anticipated future price increases. But the lag
becomes noticeable again when inflation is subsiding
as the rate of wage increase shows little tendency to
decelerate even though the rate of rise of other prices
is diminishing.
Another important
factor contributing
to price
rigidity is the price-setting behavior of large-scale
firms operating in manufacturing industries.
In the
typical imperfectly
competitive
market, the price
mechanism works in the long run as prices adjust to
clear the market. In the short run, however, prices
are relatively inflexible. Firms do not typically alter
their prices in response to short-run shifts in demand.
At least three explanations
of this behavior have
been offered.
According to the first, firms have difficulty distinguishing between real demand shifts specific to a
particular industry and shifts in nominal aggregate
demand for the output of all industries.
Because
they alter only the composition and not the overall
level of aggregate demand, specific demand shifts
may occur without inducing a corresponding rise in
input prices. By contrast, an economy-wide demand
increase leads to an equiproportional
bidding-up of
input prices. In the former case, industry cost and
supply curves remain unchanged.
In the latter case,
however, cost and supply curves
shift sharply upward, just matching the rise in demand. The rational
entrepreneurial
reaction to the former is a change in
6

ECONOMIC

REVIEW,

some quantity whereas the rational reaction to the
latter is a change in prices.
But when aggregate
demand alters there is a good likelihood that each
producer will tend to regard the shift in demand for
his product as special to him and so adjust quantity
Only later, when cost changes
rather than price.
become widespread, will producers correctly perceive
the demand shift as an economy-wide phenomenon.
Then and only then will they start to change their
prices.
A second explanation stresses the administrative inconvenience and costs of frequent price
changes-for
example, the expense of printing and
disseminating new price lists-as
a reason for sticky
oligopolistic prices.
Still a third explanation of price inflexibility in
imperfectly competitive markets begins with the observation that in the complex and dynamic modern
industrial economy there is always much uncertainty
about the equilibrium or market-clearing price. Firms
operating in this kind of environment try to avoid
the market disruption, confusion, and perhaps even
outright price warfare that could result if each sought
individually to determine the equilibrium price. In
order to prevent such confusion from developing,
firms seek ways to coordinate price changes.
Such
coordination,
if successful, will assure that firms
raise prices in unison and that price changes will not
occur when demand shifts are thought to be temporary and reversible.
Firms have devised several
techniques to facilitate price coordination.
Infrequent
price changes are perhaps the simplest of these. Price
leadership constitutes another such technique.
In
this case, one firm-often
the largest in the industry
-initiates
price changes, and the rest more or less
automatically follow that price change. Perhaps the
most widely used mechanism for coordinating price
behavior, however, is to base selling prices on unit
labor and material costs that are the same for all
firms in the industry. This practice is accomplished
by the use of so-called unit cost or mark-up pricing
formulas.
Unit-cost pricing is thought to be characteristic of
many of the large oligopolistic firms that operate in
American industry. The mark-up technique of pricing involves setting prices on the basis of a constant
percentage markup applied to production costs per
unit of output at some standard level of plant operation or capacity utilization. The chief cost components are unit labor and unit material costs. Included
in the markup is the firm’s profit margin per unit of
output. This profit margin is usually set to provide a
fixed target rate of return on equity. Since percentage markups or profit margins are treated as fixed
constants in unit-cost pricing formulas, it follows
SEPTEMBER/OCTOBER

1979

that formula-based price changes are strictly costdetermined, that is, they result solely from changes in
unit labor and material costs. Prices respond to costs,
not to demand. Moreover, since standard unit labor
and material costs are roughly the same for all
firms in the industry, unit-cost formulas insure that
price changes will be uniform throughout the industry, thereby minimizing the risks of competitive
price undercutting.
Thus unit-cost pricing is consistent with the slow response of prices to shifts in
demand, the dependence of prices on costs, and the
coordination of prices in concentrated industries.
A Source of Confusion
The long delay in the
adjustment of many prices to demand pressure makes
it difficult to distinguish cause from effect in the
inflationary sequence and contributes to confusion in
popular understanding
of the source of inflation.
The sequence of cost-price responses observed in concentrated industries, for example, may suggest that
inflation is initiated by autonomous increases in costs.
The use in such industries of mark-up or unit-cost
pricing formulas, and the resulting dependence of
prices on costs, means that firms do not raise prices
unless there occurs a prior increase in costs. This
cost-price sequence, with costs rising first and prices
later, makes it appear that inflation is caused by
rising costs when in fact excess demand is usually the
culprit.
For, as pointed out earlier, both the cost
increase and the ability of firms to pass on this increase are due to a prior expansion in aggregate demand for final goods and services.
Similarly, the long lag in the response of oligopolistic prices to prior inflationary pressures may
make it appear that large firms in concentrated industries play an important independent role in generating inflation.
Due to the price-adjustment
lag,
catch-up price increases in such industries are often
delayed until well after restrictive
policies start
to turn the inflation process around.
The apparent
perverse behavior of prices when markets are slack
and unemployment
is rising fosters the notion of
giant firms arbitrarily exercising monopoly power by
effecting autonomous increases in prices totally independent of economic conditions.5
But it should be
5 This simplistic

cost-push
view is implausible
and at odds
with the orthodox
theory of monopoly
behavior.
According to the latter view, a monopolist
sets a relative price
for his product that maximize;
profits in real term; and
maintains
that real price by adjusting
his nominal price
to allow for inflation.
The logical implication
is that
given the degree of monopoly
power monopolists
would
have no incentive
to raise prices other than to keep pace
or catch up with inflation.
With
real prices already
established
at profit-maximizing
levels, any further
upward adjustment
would reduce profits.
On the other
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noted that the price increases in such situations can
be interpreted as constituting a delayed reaction to
prior economic conditions of expanding demand and
demand-induced
cost increases and a near perfect
example of the price-adjustment
lag. They might
well be interpreted as a delayed manifestation of the
effects of a general inflation rather than of inflationinitiating price behavior.
From this interpretation
it follows that big firms
are not inflation starters.
Nevertheless they may
play an important role in the working out of the
inflationary process. Specifically, they may be inflation prolongers.
It follows logically from the mere
existence of the price-adjustment
lag that administered prices do not usually initiate inflation. Instead
they tend to slow it down. By doing so, however,
they extend the duration of inflation and protract
the period necessary for its reversal.
Administered
prices are a problem because they act to prolong inflation once it gets started and because they delay
the success and exacerbate the adverse side effects of
anti-inflationary
stabilization policy. Just as in an
upward price spiral sticky administered prices retard
the spread of inflation, so when the spiral is unwinding they delay its deceleration and impede the return
to price stability.
The Expectations-Formation
Lag
As noted
earlier, the complicating effects of the so-called priceadjustment lag are reinforced by a comparable lag in
price expectations, which tend to adjust slowly to
the actual rate of inflation. Why does this expectations lag occur and what determines its length?
The expectations lag occurs because people have
imperfect foresight and cannot predict the future with
certainty.
If the future were known with absolute
certainty, there would be no forecasting errors and
no expectations lag. Anticipations would adapt themselves instantaneously to realized outcomes, and the
expected rate of inflation would always be the one
that actually occurred.
Although the future is emphatically uncertain, people nevertheless try to make
informed guesses about it, often on the basis of analyses of the past. Thus one longstanding explanation
of the lag holds that price predictions are based on
perceived trends as estimated from past price experience perhaps modified by current information.
hand, if prices are being raised to exploit hitherto
unexploited monopoly
potential,
the question
arises as to why
In either case,
those gains were foregone
in the past.
rising real prices imply non-rational
behavior.
It is true
that rising real prices would be consistent
with profitmaximizing
behavior
if the degree of monopoly
power
were increasing.
But there is little empirical
evidence
that monopoly
power is on the rise.
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Because they reflect the past, these trends and the
predictions derived from them change slowly over
time.
Transitory
deviations from the trend have
little impact on expectations.
Thus if the current
rate of inflation departs from the recent trend, the
expected rate will remain unchanged for a time. It
requires the cumulative influence of a sustained
change, or at least a very large change, in the actual
rate to produce a change in the expected rate. And
even then the adjustment will not be instantaneous
or complete. The expected rate will continue to lag
behind the current rate. As time passes, however,
and the new rate persists, it will eventually begin to
dominate the trend. The price experience of the more
distant past gradually will be forgotten and the expected rate will finally converge on the actual rate.
The length of time required for this convergence
cannot be specified with any degree of precision.
It
depends on what interval or intervals of the past
people consider in formulating their expectations and,
in particular, on what relative weight they assign to
the price experience of the more distant past.
In
general, the greater the weight assigned to the distant
past, the longer will be the lag. The lag may indeed
be quite long because people, in formulating their
expectations, may look not merely at a chronological
succession of prior years but rather at the relevant
phases of a succession of past inflation-recession
cycles and at the public policy response to these episodes. Looking back at a succession of what might
be regarded as stop-go policies, for example, people
may expect the recession phase to be brief and to be
followed immediately by an expansionary phase that
experience suggests may bring new inflationary pressures. To use a popular expression, they may “look
across the valley.”
A second factor that may affect the length of the
expectations lag is the variability of the rate of inflation about the trend. The greater the variability
of the actual rate of inflation the greater is the financial incentive to forecast it more accurately, i.e., to
predict the variations, not just the trend.
Accordingly, forecasts of the inflation rate will be revised
more frequently and will rely more heavily on current
and recent information.
The whole time frame employed in observing past price behavior and past
forecasting errors will contract and shift toward the
present.
Correspondingly,
the expectations lag will
shorten.
Time Lags and Demand Management
Policies
This article has focused on the role of time lags in
the inflationary transmission mechanism. These lags
raise several potential problems for demand manage8

ECONOMIC

REVIEW,

ment (i.e., monetary and fiscal) policy. First, if the
lags are variable and hard to predict, policymakers
may experience difficulty in accurately forecasting
when their policy actions will take effect on the rate
of inflation. In this case discretionary policymaking
becomes a potentially risky undertaking.
That is,
unpredictability
of the lag effects of policy may
render the latter destabilizing rather than stabilizing.
For this reason, some analysts have advocated the
abandonment of discretionary policy in favor of fixed
policy rules. Other observers, however, argue that
the lags are not so variable and unpredictable as to
defeat effective policy forecasting and control. Actually, little is known about the variability of the lags.
The evidence is simply not sufficient to settle the
issues.
Whether rules would be superior to discretion in the conduct of stabilization policy remains
an open question.
Additional policy problems arise from the length
rather than the variability and unpredictability of the
lags. As previously mentioned, the price-adjustment
and expectations lags extend the time it takes for a
policy-induced change in spending to work its way
through to the rate of inflation. Moreover, they influence the pattern of response of quantities and
prices to inflationary stimuli. Specifically, they cause
the quantity response to precede the price response.
When spending changes, output and employment
adjust first, prices only later. What are the policy
implications of such consequences?
First, owing to the slow response of inflation to a
spending change, anti-inflationary
monetary-fiscal
policy can be expected to produce observed results
only after a corresponding
lag.
Quick monetary
remedies for inflation are not likely to be found.
Moreover, since the initial impact of a change in
spending is on output and employment rather than
on prices, a move to monetary restraint would almost
surely entail a recession or at least a marked retardation in the rate of expansion of the economy.
In
short, a temporary but protracted period of unemployment, idle capacity, and sluggish growth might
have to be endured if restrictive policy were to ‘be
successful in permanently lowering the rate of inflation.
Second, due to the difference in timing of the response of output and prices to a spending change,
anti-inflationary
policy may appear impotent or even
Because inflationary movements tend to
perverse.
subside so slowly, prices may continue to rise long
after output and employment have turned down.
Thus inflation can persist even in slack markets, a
condition variously known as inflationary recession,
stagflation, or slumpflation.
During such periods,
SEPTEMBER/OCTOBER

1979

monetary restraint may be wrongly blamed for causing both the slump and the accompanying inflation.
At such times, monetary authorities,
anxious to
achieve quick and relatively painless results, may be
tempted to abandon the policy of restraint as ineffective at best and harmful at worst.
Third, the same asymmetrical pattern of response
-output
first, prices only much later-may
create
the dangerous illusion that expansionary policy in the
upswing can achieve permanent gains in output and
employment at the cost of little additional inflation.
If inflation proceeds as described in the foregoing
sections, this view may have unfortunate
consequences. For it is virtually impossible to peg output
and employment above their natural or equilibrium
levels without continuously accelerating the rate of
inflation. In any case, time lags may well compound
the problem of curbing inflation by leading to the
undue prolongation of expansionary policy, thus increasing the momentum behind inflation when it
finally occurs.
Indeed, these time lags, together with society’s
commitment to full employment, may bias monetaryfiscal policy toward inflation over the entire policy
cycle. The lags cause output and employment to
adjust before prices. Consequently, on the upside the
desired output results of demand expansion occur
before the undesired inflationary results thus encouraging the prolongation of policy stimulus.
On
the downside, however, the painful effects come first
as restrictive policy produces undesired and costly
rises in unemployment with little initial effect on the
rate of inflation. Not surprisingly, the appearance of
painful rather than desired results leads to impatience
with restrictive policies and often to their premature
reversal.
The policies are abandoned before they
have a chance to eliminate the inflation generated in
The net result is that rethe preceding upswing.
strictive policies reduce the inflation rate less than
expansionary policies raise it and inflation ratchets
upwards.
Direct Controls
If orthodox
demand-management policies cannot curb inflation without causing
painful rises in unemployment, then what other means
can be utilized? One suggestion is to reimpose direct
Several arguments have been
wage-price controls.
advanced in behalf of controls.
The most naive is
that controls can constrain the rate of inflation while
the authorities
pursue demand-expansion
policies
necessary to insure full employment. This argument
assumes that the rate of inflation can be permanently
pegged in the face of persistent excess demand. In
fact, however, the rate of inflation tends to gravitate

to an equilibrium level where excess demand is zero.
Controls can delay the adjustment to that level but
they cannot stop it. The equilibrium rate of inflation
will inevitably be reached either via evasion, i.e.,
through black markets, or after the controls are
lifted.
In the final analysis, controls will have no
effect on the equilibrium rate of inflation, which is
determined by aggregate demand.
It logically follows. therefore, that a decrease in aggregate demand,
not the application of controls, is the sine qua non
for the reduction of the inflation rate.
Controls and the Expectations
Lag A more
sophisticated argument for controls calls for using
them as a supplement to monetary and fiscal policy.
The prescription
here calls for first employing a
monetary-fiscal policy sufficient to eliminate excess
aggregate demand and then using controls to speed
the actual rate of inflation to its new equilibrium
level. In this view, a controls program properly coordinated with restrictive demand policy could help
short-circuit the painful process of winding-down a
stubborn inflation.
The foregoing argument rests on the belief that
controls can exert an independent influence on otherwise sticky price expectations.
Eradication of inflationary expectations is of course a prerequisite to the
elimination of inflation, since the former is a determinant of the latter. The problem is how to dampen
The orthodox method is to create
expectations.
slack (excess supply) in the economy, thus causing
the actual rate of inflation to fall below the expected
rate, inducing a downward revision of the latter.
Owing to the expectations lag, however, this adjustment may be a slow process and a prime example of
how sluggish price anticipations can impede the return to price stability.
Direct controls are viewed
as a means of speeding the expectations adjustment
and thus reducing the duration and severity of the
economic slowdown necessary to bring inflation to
its equilibrium level determined by aggregate demand.
How could controls influence expectations ? Two
mechanisms have been suggested.
First, the mere
announcement of controls might alter expectations in
the desired direction.
Second, by freezing prices or
at least severely constraining their rate of rise, controls would cause the gap between the expected and
actual rates of inflation to be greater than it would
otherwise be. Assuming that the rate at which expectations are revised varies directly with the size
of the gap, controls would thus accelerate the downward revision of expectations.

FEDERAL RESERVE BANK OF RICHMOND

9

This view, however, probably overestimates
the
influence of controls. To have anything more than a
temporary impact on price expectations, the controls
must convince the public that the trend of prices
when controls are in force is a reliable indicator of
the likely future trend of prices after they are lifted.
The public may be hard to convince, especially if the
controls have failed to stop inflation in the past.
Aside from this point, it is hard to understand why
controls should have a stronger impact on expectations than, say, an announced policy of a permanent
reduction in the growth rate of the money stock.
What counts is not the means by which the government announces its determination
to permanently
reduce inflation but that those intentions be believed.
Controls
and the Price-Adjustment
Lag
It
should be noted, moreover, that even if controls
could reduce the expectations lag, they would tend to
lengthen the price-adjustment
lag, and this would
impede the return to equilibrium. The attainment of
economic equilibrium requires that two conditions be
satisfied.
First, inflation must be correctly anticipated, i.e., the expected rate of inflation must equal
the actual rate. Second, the equilibrium structure of
relative prices must be restored. Lagging prices and
costs must be allowed to catch up to and reestablish
their equilibrium relationships with other prices that
have already adjusted to inflation.
Controls interrupt this catch-up process by arbitrarily freezing all
prices and costs. As a result, catch-up adjustments
are postponed until the controls are lifted and account
for the observed tendency for prices to rise sharply
when controls are terminated.
Note that this problem would not arise if controls could distinguish between legitimate catch-up and unwarranted anticipatory price increases.
In practice, however, the two
are virtually indistinguishable
and controls prohibit
both. By forcing the postponement of catch-up price
increases, controls probably protract the inflationary
process and lengthen the interval required for the
rate of inflation to reach its equilibrium level. In
the interim, the controls-distorted
price structure
generates inefficiency, resource misallocation, and income redistribution.
Clearly, in the context of the
explanation presented here, controls offer no solution
to the problem of persistent inflation.
Other Proposed
Solutions
One of the more
promising, and yet untried, solutions to the lag
problem is indexation,
i.e., the inclusion of purWith all
chasing power clauses in all contracts.
contractual prices tied to automatic cost of living
escalators,
inflation would be transmitted
more
10

ECONOMIC

REVIEW,

quickly and evenly throughout all markets, thereby
permitting faster restoration of relative price equilibrium. On the downside, indexation could help reduce
expectations more quickly, thus shortening the time
required to remove inflation.
Critics argue that
indexation would intensify inflation. This criticism
confuses the level of inflation with the speed with
which inflationary impulses are propagated through
the economy. There is no reason to believe that escalator clauses by themselves would have any effect
on the rate of inflation. The speed of inflation would
be increased, to be sure, but the level of inflation
would not necessarily be any higher. Another partial
solution to the lag problem would be to shorten the
length of contracts. For example, trade-union collective bargaining agreements could be renegotiated
more frequently as could long-term contracts for raw
materials and energy supplies.
A distinction should be made here between reforms
designed to increase the speed of response of inflation
to changes in aggregate demand and reforms aimed
at reducing the equilibrium rate of unemployment,
i.e., the unemployment rate that, given the inevitable
frictions, rigidities, and imperfections in the economy,
is just consistent with zero excess demand and stable
(nonaccelerating,
nondecelerating)
rates of inflation.
Indexation falls in the former category while socalled structural reforms fall in the latter. Structural
reforms refer to microeconomic policies directed at
improving the efficiency of labor and product markets. True, these policies may increase the responsiveness of inflation by eradicating market imperfections that inhibit price flexibility.
But their chief
purpose is to reduce the equilibrium rate of unemployment at which the demand for and supply of labor
are in balance and at which any stable rate of inflation (including a zero rate) is possible. By so doing,
structural policies may make it easier in at least two
ways to bring inflation under control. First, they may
render the equilibrium rate of unemployment
and
the corresponding zero or other desired steady-state
rate of inflation a more acceptable policy option. By
bringing equilibrium unemployment down to a socially tolerable level, structural policies reduce the risk
that political pressure will be put on the authorities to
peg unemployment at even lower levels that can only
be maintained by a constantly accelerating rate of
inflation.
Second, they reduce the severity of the
recession necessary to achieve price stability. Since a
dampening of inflation requires a temporary rise in
unemployment above its equilibrium level, it follows
that any policy that reduces the latter also reduces
the transitional level of unemployment.
SEPTEMBER/OCTOBER

1979

Conclusion
The policy implications
stemming
from the preceding analysis are straightforward.
Admit that there are no quick and easy solutions to
the inflation problem. Realize that any serious antiinflation program faces the formidable obstacles of
entrenched
inflationary
expectations
and eroded
public confidence in the government’s ability and
determination
to fight inflation and to tolerate the
resulting economic slack. Comprehend that, obstacles
notwithstanding, the costs of removing inflation may
be far less than the costs of accepting it as a permanent way of life.6 On
the basis of this cost-benefit
analysis establish a permanent target rate of inflation.
Rely on demand-management
(i.e., monetary and
fiscal) policies to bring inflation down to the desired
target level. Assuming that level is zero, reduce the
rate of monetary expansion and trim budget deficits
until the growth rate of total spending (aggregate
demand) is equal to the long-term trend growth rate

of real output (aggregate supply). Eschew controls.
Recognize that a reduction of inflation necessitates a
transitional rise in unemployment above its equilibrium level with the extent and duration of the rise
depending upon the speed with which inflation is to
be removed.
In other words, recognize that quick
eradication of inflation requires high excess unemployment for a relatively short period whereas slower
eradication requires a lower level of excess unemployment for a prolonged period. Choose the desired
path to price stability always realizing that the choice
is between higher excess unemployment for a short
time or lower excess unemployment for a long time.
Acknowledge also that the severity and duration of
the recession necessary to eliminate inflation depends
upon the responsiveness of wages and prices to deflationary pressure and upon the adjustment speed of
price expectations.
Use indexation, if possible, to
increase the downward flexibility of wages and prices.
Similarly, seek to influence expectations by preannouncing the inflation target and by adhering to a
path consistent with achieving it. Once inflation is
removed, maintain price stability by avoiding expansionary policies that generate excess demand. Balance the budget each year and maintain a money
stock growth rate roughly equal to the long-term
growth rate of real output. If society is unwilling to
tolerate the equilibrium unemployment rate associated
with price stability, design structural policies to lower
that rate by improving the efficiency of labor and
product markets. If society is still unwilling to accept
that rate, face up to the fact that price stability may
be impossible to achieve.

6 A policy of accommodating

permanent
inflation is likely
to lead to a pattern
of accelerating
and highly erratic
(variable)
inflation.
Such inflation, by virtue of its variability and unpredictability,
imposes substantial
costs on
the economy.
Not only will there be repeated
falls in
output and employment
whenever
the inflation rate drops,
but the very unpredictability
of volatile
inflation
increases
business
uncertainty,
makes capital
investment
decisions riskier. diverts energies and skills from industry
and production
into speculative
activities designed to beat
the inflation,
and reduces
the information
content
of
market
prices thereby
making
the price system
a less
efficient mechanism
for coordinating
economic
activity.
All this makes for a wasteful
and inefficient
use of resources that results in a lower level of output than the
economy is capable of producing.
The costs of inflation
can be measured
in terms of this lost output.
Similarly,
the benefits
of removing
inflation
can be reckoned
in
terms of the increased
output that would result.

APPENDIX
THE TREATMENT
OF THE

OF LAGS IN SIMPLE ANALYTICAL

INFLATIONARY

TRANSMISSION

The inflationary
mechanism and its constituent
lags can be summarized in the form of simple analytical models.1
Economists have long used such
models to study how lags affect the speed and duration of inflation.
More recently, such models have
been employed to estimate the impact of lags on the
effectiveness
of anti-inflationary
policy.
These
1 For a thorough
review
of inflation
models
see the
article by Laidler
and Parkin
[7] especially
pp. 774-81
that describe models similar to the one presented
in this
appendix.
FEDERAL RESERVE BANK

MODELS

MECHANISM

models specify the chief determinants of the current
They also
and expected future rates of inflation.
specify the lags linking the variables and determining
the pattern of their interaction over time. Comprising these models are a price-adjustment equation and
The pricean expectations-formation equation.2
adjustment equation explains how the current rate of
inflation responds to inflationary expectations and to
2 Some models of the inflationary
process contain
equation
that explains
how inflation-generating
aggregate
demand is determined.
OF RICHMOND

a third
excess

11

lagged excess demand-the
lag on the latter variable
representing the price-adjustment
delay. The expectations-formation
equation explains how price anticipations are generated and revised in the light of past
price experience.
As shown below, the latter equation expresses the expected future rate of inflation as
an exponentially-declining
weighted average of past
rates of inflation.
A crude version of this two-equation model is
presented in the following paragraphs.3 It should be
strongly emphasized, however, that the model constitutes a severe oversimplification
of a complex
process and thus should be interpreted with some
skepticism.
Presented solely as an illustration, the
model purposely omits many of the variables and
behavioral relationships that a more complex, sophisticated, and realistic model would contain.
The Price-Adjustment
Equation
Most models
of the inflationary mechanism contain an equation
that explains how the current rate of inflation is
determined, i.e., the rate at which businessmen mark
up their
prices. One such equation shows the rate of
price inflation p varying directly with lagged excess
demand x-1 and with the expected rate of price increase pe. The equation is written as follows:
(1)

p = ax-l

+

pe-1

where p is the current rate of inflation (expressed
as a percentage rate), x-1 is excess demand lagged
one period, pe-1 is the present period’s expected rate
of inflation forecast at the end of the preceding
period, and a is a coefficient specifying how much
each unit of lagged excess demand contributes to the
rate of price increase.
The excess demand variable
x is measured in terms of real output since businessmen initially respond to changes in demand by altering quantity produced.
More specifically, excess
demand x is represented by the difference between
actual and capacity real output.
Actual output can
exceed capacity output because the latter is defined
not as the absolute physical limit or maximum ceiling
level of output but rather as the output associated
with the economy’s normal or standard level of operation.
Equation (1) states that if aggregate demand and
supply are equal so that there exists no excess de-

mand (x = zero), then actual price inflation p will
just equal expected inflation pe-1, i.e., businessmen
will be raising their prices at the rate at which they
expect other businessmen to be raising theirs.
If,
however, an expansion in demand raises x above
zero, businessmen will eventually react to the excess
demand by raising prices at a rate in excess of
the expected rate of inflation.
This price response,
however, is not instantaneous.
For a while, quantities rather than prices tend to absorb the impact of
excess demand as businessmen temporarily expand
output and perhaps allow their inventories to be
depleted. These quantity changes affect demands for
and prices of factor resources and ultimately invoke
cost increases that signal the desirability of raising
the rate at which prices are marked up. Later, therefore, businessmen respond to the excess demand by
raising prices. The same price-adjustment
lag operates on the downside.
Thus if a subsequent slackening of spending causes excess demand x to become
negative (i.e., a situation of excess supply) the actual
rate of price increase p will eventually fall below the
expected rate pe-1. The key word here is eventually
because the lag prevents prices from responding
immediately to shifts in demand.
The Price-Response
Lag The one-period
delay
on the excess demand variable symbolizes the tendency for price adjustments to lag behind shifts in
demand.4 This price-adjustment lag is
meant to
account or the time it takes for demand pressure to
work backward through the interindustry
structure
and for costs to work forward.
To summarize, the
association of the price-adjustment
lag with the excess demand variable x implies that the impact of a
shift in demand is initially registered on x. That
impact is not immediately transmitted to prices, however. Instead it is transmitted first to quantities and
subsequently to costs. Prices do not respond until
rising costs induce them to do so.
The Expectations-Formation
Equation
The second equation of the model is the expectations-formation equation. It is written as follows:
(2)
or, alternatively,
(2a)

3 The model presented
here is adapted from similar
models developed by Phillip Cagan and David Laidler.
See Cagan [2; pp. 94-6] and Laidler [5, 6]. For an
elementary description of Laidler’s model, together with
a diagrammatic
illustration
of its dynamic properties see
Laidler and Parkin [7; pp. 776-8].

12

ECONOMIC

REVIEW,

pe = bp + (l-b)pe-1
as
pe - pe-1

= b(p-pe-1).

4 More sophisticated models would express the delayed
price adjustment
as a distributed lag, i.e., a lag spread
over a number of time periods.
SEPTEMBER/OCTOBER

1979

Equation (2a) states that the change in the expected
rate of inflation pe-pe-1
is proportional
to the
amount by which the period’s actual inflation p deviated from expected inflation as forecast at the end
of the preceding period pe-1 with the factor of proportionality b having a value between zero and unity.
Embodied in the equation is a particular theorythe so-called adaptive-expectations
or error-learning
hypothesis-of
how inflationary
expectations
are
formed. According to the error-learning
hypothesis,
people formulate expectations
about the inflation
rate, observe the discrepancy between the actual and
anticipated rates, and then revise the anticipated rate
by some fraction of the error between the actual and
anticipated rates. Expectations are revised in proportion to the error associated with the previous
level of expectations.
It can also be shown that the adaptive-expectations
hypothesis is equivalent to the theory that people
formulate price expectations from prior price experience by looking at a geometrically-weighted
average
of past rates of inflation with the weights diminishing
exponentially as time recedes. This alternative interpretation of the adaptive expectations hypothesis is
written as follows :

the speed of adjustment of expectations.
A steep
slope represents a short weighting scheme, implying
swift adjustment, and conversely for a relatively flat
slope. The slope itself is determined by the magnitude of the fraction (1-b).
A value of (1-b)
close
to zero implies that the weights decline rapidly as
time recedes, and so future price expectations depend
primarily on recent experience.
On the other hand,
if (l-b)
is closer to 1 in value, rates of inflation
from the more distant past enter the equation with
higher weights, and recent price information is discounted more heavily.
Econometricians
who have
attempted to fit equation (2b) to the statistical data
have found the fraction (l-b)
to be both significantly greater than zero and less than 1. These
findings imply that while people generally assign
higher weights to more recent phenomena, these
weights do not dominate the cumulative weight of all
past price experience.
In short, price anticipations
continue to reflect past price experience, which explains why the expected future rate of inflation does
not adjust instantaneously to the current rate.
To summarize, equation (2b) states that the expected future rate of change of prices is based on a
geometrically
declining weighted average of past
rates of change of prices.
The equation therefore
constitutes a precise specification of the commonsense notion that expectations are based on past
experience with more emphasis given to recent, rather
than distant, experience.

Here
is the summation
operator indicating the
mathematical operation of adding a succession or
series of terms, in this case the weighted past rates of
inflation.
The summation index i
represents each
past time period starting with the most recent (i=O)
and extending backward to the most distant (i = ).
The variables p-i are the past rates of inflation, one
for each of the i periods stretching backward into
time. Attached to each past rate of inflation p-i is a
corresponding
weight that measures the degree of
influence that each p-i has on the formation of price
expectations
pe. The weights are expressed
as
(l-b)i,
one for each of the i time periods.
Since,
as mentioned previously, the coefficient of expectations b is a fraction whose magnitude lies between
zero and one, it follows that the term (l-b)
will
also be a fraction. And since any given fraction raised
to progressively higher integral powers yields successively smaller numbers, it follows that the weights
(l-b)i
must decrease as the exponent i increases,
i.e., the weights must diminish the further back in
time one looks.

the equation collapses to pe = p, i.e., anticipated and
actual inflation are always identical.

Graphically, the weights are distributed along an
exponentially
declining curve whose slope reflects

On the other hand, the lag will be longer the
closer b is to zero. In the extreme case where b

FEDERAL RESERVE BANK

The Expectations Lag The preceding discussion
clearly implies that the length of the expectations lag
can be defined in terms of the coefficient of expectations b. The coefficient b itself measures the speed of
adjustment of expectations to experience, i.e., the
quickness of response of pe to realized actual rates
of inflation p.
The average length of the expectations lag is the
counterpart of the speed of adjustment.
This lag is
expressed as (l-b)/b.
The closer b is to 1, the
shorter the lag. In the extreme case where b equals
1, the lag is nonexistent, and the expected rate of
inflation adjusts instantaneously to the current rate.
Thus when b is set equal to 1 in the expectationsformation equation
(2)

OF RICHMOND

pe = bp + (1-b)pe-1

13

equals zero, the lag is infinitely long, i.e., the expected rate of inflation never changes. This result
can be demonstrated by setting b at zero in equation
(2), which yields pe = pe-l, showing that the expected rate of inflation always remains unaltered
from the preceding period.
In short, if b is zero,
the lag is of infinite length and expectations never
change regardless of what is happening to the actual
rate of inflation.
One possible shortcoming of the adaptive expectations or error-learning
model is that it regards the
speed of adjustment or coefficient of expectations b
as a fixed constant.
And since b determines both
the length of the expectations lag and the slope of the
weighting pattern used to distribute the lag, it follows
that the model, by implication, also treats these
phenomena as given constants.
This treatment is
surely too restrictive.
Some analysts think, contrary
to the model, that the coefficient b is capable of being
influenced by outside information and by the behavior
of the rate of inflation itself. For example, it has
been suggested that the sensitivity of price anticipations is greater and the corresponding adjustment lag
shorter for high and volatile rates of inflation than
for low and steady rates.
Finally, some observers
believe that the expectations coefficient can be influenced by government policy. In fact, this idea constitutes one rationale for direct wage and price
controls.5
The Complete
System
Taken
together,
the
price-adjustment
and expectations-formation
equations summarize the operation of the inflationary
transmission mechanism.
These two equations explain the mutual determination of actual and expected
rates of price increase. They also indicate the iterative interaction process whereby the expected inflation rate influences the actual current rate, which in
turn becomes a determinant
of next period’s expected rate, which feeds back into next period’s
actual rate, etc. Moreover, the model demonstrates
how inflationary expectations operate to lengthen the
lagged adjustment of prices to short-run shifts in
demand. This latter result is obtained by substituting
the expectations-formation
equation into the price-

5 The argument
here is that, by directly altering the expectations
coefficient,
controls could speed the downward
adjustment
of price expectations
necessary
for the removal of inflation.
Of course controls
might also speed
the adjustment
process simply by constraining
the actual
rate of inflation
below the level that would otherwise
occur at a given level of unemployment.
In the latter
case, controls would take the expectations
coefficient
as a
given constant.

14

ECONOMIC

REVIEW,

adjustment equation and then solving recursively for
p. The resulting “reduced form” expression is:

where the second term on the right-hand side of the
equation represents
the delayed price impact of
excess demand attributable to the operation of the
expectations lag.
Equation
(3) states that once
price anticipations enter into price-setting behavior,
they tend to prolong the inflationary process. They
cause current prices to respond not only to last
period’s excess demand but also to excess demand in
the more distant past.
Finally, the model identifies excess demand as the
proximate source of inflation. Specifically, the model
implies the following causal chain.
(1)

Inflation is determined by excess demand and
inflationary expectations.

(2)

Inflationary
expectations
are generated by
previous inflationary experience and hence by
previous excess demand.

(3)

Therefore, excess demand-past
and present
-is the proximate cause of inflation.

The inflation-generating
role of excess demand is
made explicit in the reduced-form
equation (3)
where past levels of x constitute
the sole independent
variables.
The model does not explain how excess
demand itself is generated.
Such an explanation
would require an additional equation expressing the
relation between excess demand and the independent
variables that determine it. At a very minimum, the
list of independent variables would include the money
stock since excess demand cannot be long sustained
without the monetary growth necessary to support it.
Note, however, that there is at least one situation in
which excess demand would properly be treated as
an independent variable and the money stock as a
dependent variable.
Such would be the case if society were committed to a
full-employment objective
in excess of the natural or equilibrium level of employment. Here the policymakers would be expected
to pursue the target employment rate (or level of
excess demand),
passively permitting
the money
stock and the rate of inflation to adjust so as not to
inhibit attainment of the full-employment
goal. In
this case the level of excess demand would enter the
system as a datum to determine the size of the money
stock.
Thus, depending upon the policy regime,
excess demand may appear either as an endogenous
or an exogenous variable.
SEPTEMBER/OCTOBER

1979

EXCHANGE RATE POLICY AND THE
DUAL ROLE OF EXCHANGE RATE MOVEMENTS
IN INTERNATIONAL ADJUSTMENT
Marvin Goodfriend

I.INTRODUCTION

1. The Problem of International Adjustment and
Its Relevance
Over the past few years, the foreign exchange value of the dollar has gradually
emerged as a primary concern of United States monetary authorities.
This growing concern is well illustrated by a sampling of Wall Street Journal headlines. For example, on January 10, 1978, a headline
read “Federal Reserve Moves to Tighten Credit in
Escalating Effort to Bolster U. S. Dollar.”
By November 1 of that year, the dollar had depreciated 35 percent against the Swiss franc, with
most of the depreciation occurring after midyear.
Other major exchange rates also moved substantially
against the dollar with the result that U. S. officials
came under heavy pressure to intervene in the foreign
exchange market to prevent a further decline in the
value of the dollar. On November 1, U. S. authorities publicly announced their intention to support
the dollar with appropriate monetary policies, including direct intervention in the foreign exchange
market.
This policy was reported on November 1
in the headline “Dollar Dilemma-Bold
Currency
Support Announced by the U. S. Raises Recession
Risks.” Although there was no official commitment
to a particular rate, the decision represented a significant change of policy. Never since World War II
had the U. S. publicly committed itself to intervene
directly in the foreign exchange market on such a
large scale to stabilize the exchange rate.
While exchange rates fluctuated considerably in
the months following November 1, on the whole, the
policy action succeeded in arresting the dollar depreciation. In July, however, the renewed depreciation
of the dollar began to concern U. S. officials. This
time the Federal Reserve responded directly to events
on the foreign exchange market by raising the Federal funds rate. This action was reported in a July 7
headline reading “Tighter
Credit Policy of Fed
Facing Test on the Foreign Exchange Market.”
16

ECONOMIC

REVIEW,

What is the reason for this “dollar dilemma” as it
was called in the November 1 headline? Why should
a sudden large exchange rate movement concern
policymakers?
And even if there are valid reasons
for concern, what prevents the monetary authority
from pegging the exchange rate if it so desires?
These are the questions the article seeks to address.
The sources of this policy dilemma stem from the
operation of the international adjustment mechanism.
This mechanism refers to the manner in which interaction among world goods markets and the foreign
exchange market produces terms of trade, trade balance, and exchange rate responses to economic disturbances.
It must be emphasized that the word
response here refers not only to the immediate effects
of disturbances but also to any persistence of the
effects that may be produced by the adjustment mechanism itself.
An important issue related to persistence concerns
how long it takes for adjustment to occur, and
whether that adjustment is, in fact, stable. If noninterference in the foreign exchange market is to be
an acceptable policy alternative, then the exchange
rate must automatically converge to a stable equilibOtherwise, the exrium following a disturbance.
change rate may in fact require official management.
This article is partly concerned with examining
potential adverse effects of allowing exchange rate
Consemovements to play a role in adjustment.
quently, the body of this article is devoted to
investigating the function of exchange rate movements in the adjustment process. It turns out that
the source of the dilemma involved in holding the
exchange rate fixed is easily recognized once the
role of exchange rate movements in equilibrating the
foreign exchange market is made clear.
Exchange rate movements are shown to function
in two ways in the adjustment mechanism: first, by
changing the relative price of domestic and foreign
produced goods in international trade, and second, by
revaluing stocks of domestic relative to foreign assets
in portfolios. Analysis of the terms of trade effect of
SEPTEMBER/OCTOBER

1979

exchange rate changes is contained in Part II, in a
general discussion of the effect of exchange rate
The revaluchange on goods market equilibrium.
ation effect of exchange rate change is developed in
Part III, where the focus is shifted to portfolio balance and foreign exchange market equilibrium.

offset by reduced expenditure on other goods, total
national expenditure need not be affected. In other
words, an increase in oil imports, if it is simply a
consequence
of individuals switching expenditure
from food or clothes to gasoline, is not necessarily
associated with an increase in total expenditure or a
trade deficit.

The partial equilibrium results of Parts II and III
may be condensed into two graphical relationships
called the GM and FX curves, respectively.
In Part
IV, these two curves are brought together to show
how the exchange rate and trade balance are determined in general equilibrium.
The two roles of the
exchange rate are thereby synthesized in a simple
graphical framework which is then used to investigate some features of the adjustment mechanism as a
whole. In particular, the free exchange rate mechanism is shown to automatically restore international
economic equilibrium after a disturbance. The article
concludes with a discussion of the sources of the
policy dilemma faced by central banks operating
under a flexible exchange rate.
II.

THE GOODS

3. Tradable Goods Prices and the Terms of
Trade
Sections 3 and 4 are devoted to establishing a relationship between the trade balance and
the exchange rate that must hold in the context of
goods market equilibrium.
The relationship to be
derived is represented graphically by the GM curve
in Figure 1, where the U. S. trade balance is measured on the vertical axis and the dollar/pound exchange rate is measured on the horizontal axis.

MARKETS

2. A Macroeconomic Framework for Analysis of
the Trade Balance The national balance of trade
is defined as the value of national exports (of goods
and services) minus the value of national imports.
The trade balance is also the excess of the value of
national production in a given period over the value
To see this, note that (1)
of national expenditure.
expenditure by domestic residents consists of purchases of domestically produced goods plus imports
and (2) domestic output consists of goods sold to
domestic residents plus exports. Therefore the difference between domestic output and expenditure
is
exports minus imports or the trade balance.
All goods produced provide owners of factor resources (land, labor, and capital) with income in
wages, rent, and profit equal to the value of the
output produced. Since the value of national output
equals the value of national income, the trade balance
can also be thought of as the difference between national income and national expenditure, which, of
course, may be positive, negative, or zero.
This last relation has an important implication for
analysis of the trade balance. A complete explanation
of movements in the trade balance must be given in
terms of factors affecting total national income or
total national expenditure.
For example, it is not
sufficient to explain a movement of the trade balance
into deficit by pointing to the fact that oil price rises
have led to an increase in the value of oil imports.
To the extent that the increased expenditure on oil is

As shown in the graph, the GM curve will turn
out to be upward sloping. The curve may be interpreted as follows. Let an exchange rate change occur
for reasons outside the goods markets, e.g., due to
The
speculation in the foreign exchange market.
maintenance of goods market equilibrium implies
that an exchange rate rise (fall) is associated with a
movement of the U. S. trade balance toward surplus
(deficit).
It bears emphasizing that the determinants of the
slope of the GM curve are entirely unrelated to the
foreign exchange market.
Since the GM curve involves only the goods markets, it may be called a
partial equilibrium relationship,
It is incomplete in
the sense that it can only determine the trade balance
for a given exchange rate. If the exchange rate is to
be determined also, another curve needs to be provided.
This second FX curve comes out of the

FEDERAL RESERVE BANK

OF RICHMOND

17

partial equilibrium discussion of the foreign exchange market undertaken in Sections 5 and 6. In
Section 8 the two curves are superimposed on the
same graph and the simultaneous determination of
the trade balance and exchange rate is discussed in
what is called general equilibrium, i.e., equilibrium
analysis involving both foreign exchange and goods
markets.
Proceeding with the analysis at hand, suppose the
world consists of two countries, the U. S. and U. K.
Residents in the U. S. produce corn and U. K. residents produce wool. Both goods are traded.
The
price of corn in dollars is denoted by $Pc and the
price of wool in pounds is expressed as £Pw. Further, let

be the exchange

rate between the two

currencies in dollars per pound.
Suppose the trade balance were in equilibrium at
the initial prices.
But now suppose the exchange
rate rises due to foreign exchange speculation.
At
initial goods prices $Pc and £Pw, the higher exchange rate raises the so-called commodity terms of
trade, i.e., the relative price of wool in terms of corn.
The terms of trade is the number of bushels of corn
it takes to buy one bale of wool, i.e., bushels of corn
given up to obtain one bale of wool, or simply
bushels of corn
The terms of trade can be written
bale of wool
using the three basic prices as

Note that the dollar and pound units cancel in the
foregoing expression, verifying that it does yield the
commodity terms of trade.
Because the relative cost of wool compared to corn
is increased, world residents are induced to switch
expenditure
from wool to corn, and an incipient
excess demand for corn and excess supply of wool
develops at initial goods prices. Therefore, domestic
currency goods prices must adjust to eliminate these
incipient excess demands and supplies so as to maintain goods market equilibrium.

In particular,

(i.e., the ratio of the pound price of wool to the
dollar price of corn) must fall to eliminate the incipient excess supply and demand at the higher exchange rate. But how are these price changes going
18

ECONOMIC

REVIEW,

to affect national income, national expenditure, and
the trade balance? This question is addressed next.
4. Goods Prices and the Trade Balance
Suppose increased demand for domestic output raises
domestic currency output prices. National expenditure depends on the level of national assets. If the
domestic currency value of national assets rises proportionally with domestic output prices, then expenditure rises proportionally
with income. However,
one component of assets is domestic money which by
definition has a fixed domestic currency unit value.
Therefore,
even if the domestic currency value of
other components of wealth rises proportionally with
output prices, the value of total assets rises less than
proportionally
with output prices. Consequently, a
rise in the price of output raises national income more
than national expenditure, and induces a trade surplus. Analogously, a price fall induces a trade deficit:.
In the two-country model analyzed here, the U. S.
trade surplus (deficit) must be associated with a
U. K. trade deficit (surplus)
of equal magnitude.
This means that when $Pc and £Pw adjust in response to an exchange rate rise, they must do so by
moving in opposite directions, since only in this way
can the associated trade imbalances remain equal and
opposite in sign as required. This requirement, taken
together

with the requirement

that must

fall,

implies that $Pc must rise and £Pw fall to maintain
goods market equilibrium following an exchange rate
rise. It also follows that the U. S. trade account,
consistent with goods market equilibrium at the
higher exchange rate, moves into surplus matched by
an identical movement of the U. K. trade balance
into deficit.
Does the terms of trade return to its initial level
after the exchange rate rise? Not if the residents of
each country spend the predominant share of their
income on goods produced domestically. Because the
U. K. is now importing more than it exports, its
residents now account for a larger share of world
expenditure
on goods than formerly.
Therefore,
world demand is shifted toward wool and away from
corn. Since the quantities of these goods produced
have not changed, the goods markets must have been
brought into equilibrium by a rise in the relative
price of wool in terms of corn. The terms of
trade may be said to have moved in favor of U. K.
residents and against U. S. residents as a result of
the exchange rate rise, since the number of bushels
of corn (U. S. product) that can be obtained in trade
for a bale of wool (U. K. product) increases, and the
number of bales of wool that can be obtained with a
SEPTEMBER/OCTOBER

1979

bushel of corn decreases.
at least, U. S. residents
living as a result of the
and U. K. residents enjoy

In this sense, temporarily
suffer a lower standard of
depreciation of the dollar
a higher standard of living.

U. S. residents traveling in Germany and Switzerland in summer 1973 or fall 1978 noted how the
depreciation of the dollar against the D-mark and
Swiss-franc produced an especially large and rapid
deterioration in the foreign purchasing power of the
dollar. But it is because their dollar incomes did not
increase at home that the tourists rightly felt that
they were less able to afford foreign goods and services. In other words, these U. S. tourists suffered a
large adverse movement in the terms of trade brought
about by a sudden depreciation of the dollar on the
foreign exchange market.
Because U. S. residents suffer a reduced ability to
consume foreign goods, they might pressure U. S.
monetary authorities to forestall such a sudden dollar
depreciation in an effort to prevent an adverse movement of the terms of trade.
Yet, as will be made
more clear in Section 5 and later in Section 8, such
pegging of the exchange rate requires the monetary
authority to give up control of the money supply.
To the extent that money growth becomes inconsistent with domestic policy objectives, the monetary
authority gets caught on the horns of a dilemma.
III.

THE FOREIGN

EXCHANGE

MARKET

5. Financing a Trade Surplus or Deficit with a
Fixed Exchange
Rate
The determinants
of
national
expenditure
and national
income are
necessary but not sufficient to explain the trade balance. For example, the existence of a U. S. trade
surplus means that the value of goods and services
being purchased by U. K. residents from U. S. residents exceeds the value of goods and services being
sold by U. K. residents to U. S. residents. In order
to pay for, or finance, this trade imbalance, U. K.
residents must be willing and able to run down their
money balances and U. S. residents must be willing
to accept corresponding increases in their money balances. That is, at the end of any period of time in
which there is a U. S. trade surplus, a value of money
wealth equal to the value of the trade surplus must
flow from U. K. to U. S. residents.
Put another
way, a trade surplus (deficit) is necessarily associated with an inflow (outflow) of money. But U. S.
residents generally choose to hold their money wealth
predominantly in U. S. dollars while U. K. residents
largely hold their wealth in pounds. Since the wealth
transfer increases the relative share of world money
wealth in the hands of U. S. residents, it raises the
FEDERAL RESERVE BANK

demand for dollars relative to pounds and thereby
creates an incipient excess supply of pounds and
corresponding excess demand for dollars. It follows
that in order to provide a complete explanation of
the trade balance, the mechanism that eliminates these
associated incipient excess supplies and demands for
pounds and dollars must be explained.
In other
words, the mechanism by which the foreign exchange
market clears must be explained.
The wealth transfer from U. K. to U. S. residents,
by creating a net demand to trade pounds for dollars
at the given exchange rate, puts downward pressure
on this rate. If the monetary authorities of the U. S.
and the U. K. desire to prevent the exchange rate
from moving, then they can enter the foreign exchange market to accommodate the net desire to trade
pounds for dollars.
Under the fixed exchange rate regime, the central
banks are committed to passively supply dollars for
pounds or pounds for dollars as required to prevent
exchange rate movements.
Suppose, for example,
that the Bank of England desires to hold the exchange rate fixed. To the extent that the U. K. trade
deficit (U. S. surplus) creates an excess pound demand for dollars, the Bank of England would passively accept the unwanted pounds and pay out
dollars as required to prevent an exchange rate
change. By providing the foreign exchange market
(and ultimately U. S. residents) with the dollars
desired in payment for the U. K. trade deficit, the
Bank of England in effect finances the trade deficit.
In this case the U. S. trade surplus is said to be
financed by foreign official transactions.
By passively accepting unwanted pounds in exchange for
dollars, the Bank of England gives up control of the
pound money supply, i.e., allowing it to fall because
of conditions on the foreign exchange market.
The reduced rate of growth of the pound money
supply necessary to stabilize the exchange rate may
not be consistent with domestic goals of U. K. monetary policy such as price stability and stable real
output growth. When this is the case, the Bank of
England is caught on the horns of a dilemma in the
following sense. If there is downward pressure on
the dollar/pound exchange rate, in order to hold the
exchange rate fixed, U. K. authorities will have to
reduce the rate of growth of the pound money supply.
A sharp sustained reduction in pound money growth
could reduce real output growth. On the other hand,
allowing the dollar/pound rate to fall, i.e., letting the
pound suddenly depreciate, would cause an immediate worsening of the terms of trade for U. K. residents.
OF RICHMOND

19

6. The Role of Exchange Rate Movements in
Equilibrating
the Foreign Exchange Market In
the absence of a commitment to fix exchange rates,
central banks need not participate in the foreign exchange market. When this is the case, the exchange
rate is said to be free. How does the foreign exchange market clear in this case? What eliminates
the excess pound demand for dollars on the foreign
exchange market associated with a U. S. trade surplus ?
This section is devoted to establishing a relationship between the trade balance and the exchange rate
that must hold in the context of foreign exchange
market equilibrium in the absence of central bank
intervention.
The relationship to be derived is represented graphically as the FX curve in Figure 2.
As shown in the graph, the FX curve is downward
sloping. The curve may be interpreted as follows.
Let the U. S. trade balance be disturbed due to events
in the goods markets, for example, a switch of consumer tastes from U. S. to U. K. cars. The maintenance of foreign exchange market equilibrium implies that a U. S. trade balance movement toward
deficit (surplus) is associated with an exchange rate
rise (fall).
It bears emphasizing that the determinants of the
slope of the FX curve are entirely unrelated to the
goods markets. Since the FX curve involves only the
foreign exchange market, it is only a partial equilibIt is incomplete in the sense that
rium relationship.
it can only determine the exchange rate for a given
trade balance. If the trade balance
is to be determined also, the GM and FX curves must be brought
together. This is done in Section 8 where the simultaneous determination
of the trade balance and exchange rate is discussed in general equilibrium.
Economic agents holding portfolios of both foreign
and domestic money carefully regulate the relative
shares of different monies that they hold. The agents
may be importers, exporters, multinational corporations, or individuals living on international borders.
The desired portfolio shares vary according to individual circumstances.
As discussed in Section 8,
shares may also vary over time with the anticipated
rate of depreciation,
or appreciation,
of domestic
relative to foreign money.
However, to avoid unnecessary complication, desired portfolio shares are
here assumed fixed and agents are assumed to hold
predominantly
national money in portfolio.
To monitor his portfolio share, an individual must
first calculate the total value of his money balances.
20

ECONOMIC

REVIEW,

This requires that he choose a unit of account in
which to measure his money wealth. It is important
to emphasize that choice of this measure has no
economic significance; it is equivalent to choosing
between yards and meters to measure distance. Let
the dollar be the unit of account. Suppose the individual has $M dollars and £M pounds in his portfolio. If the current market clearing exchange rate is
,then the portfolio

has a total dollar value of

$M + p • £M,which is the combined sum of dollars
and pounds in portfolio valued in the dollar unit of
account. It follows that the share of pounds in portwhich is the fraction

folio is

portfolio value held in pounds.
fall (rise)

in the exchange

rate

of total

It also follows that a
lowers (raises)

the share of pounds in total money wealth. An exchange rate fall reduces the value of pounds in portfolios throughout the world, thereby lowering the
average share of pounds in world portfolios.
Now that the notion of portfolio share has been
formally defined, it is easy to explain why asset
holders care about portfolio shares. The above discussion abstracts from income earning assets, but,
To the
in general, individuals hold such assets.
extent that individuals are risk averse, they maintain
a diversified portfolio to minimize the overall risk
for any acceptable average return on their portfolios.
That is, they dislike “holding all their eggs in one
basket.” A rise in the current exchange rate raises
the share of wealth in the “pound basket” so to speak.
Therefore, when the exchange rate rises (the arguSEPTEMBER/OCTOBER

1979

ment works in reverse for a fall) asset holders have
incentive to sell off some pound assets for dollar
assets to bring their portfolios back into balance.
The mechanism by which a free exchange rate
equilibrates the foreign exchange market in a period
of U. S. trade surplus works as follows. The wealth
transfer from U. K. to U. S. residents lowers the
average desired share of pounds in world portfolios.
Therefore, to achieve foreign exchange market equilibrium, the average actual share of pounds in world
portfolios must be reduced. But the argument above
has demonstrated that an exchange rate fall does in
fact reduce the average actual share of pounds in
world portfolios.
An exchange rate fall is said to
clear the foreign exchange market when it brings the
net excess pound demand for dollars to zero; in other
words, when it leaves world residents just satisfied
to hold the existing stocks of dollars and pounds.
In a period of U. S. trade surplus, a free exchange
rate will be driven down until the foreign exchange
market clears. It is important to emphasize that the
exchange rate fall equilibrates the market by revaluing pounds in terms of dollars, thereby adjusting
the relative value of pound and dollar money stocks
until they are compatible with (1) the current distribution of money wealth between countries and (2)
the average desired share of pounds and dollars in
world portfolios.
Under a flexible exchange rate, a trade surplus or
deficit is not necessarily financed as it is under a fixed
rate. That is, no agent, private or official, need enter
the market to voluntarily exchange pounds for dollars
to clear the market.
However, this does not mean
that from time to time central banks or private agents
do not choose to enter the market to stabilize the
exchange rate. It has been a characteristic feature
of the current experience with flexible exchange rates
that central banks have frequently chosen to buy or
sell foreign money to prevent or retard exchange
rate movements in order to forestall sudden changes
in the terms of trade that could produce hardship
for domestic residents. Likewise, private agents may
choose to vary the share of foreign and domestic
money in portfolio to protect themselves against anticipated future exchange rate movements. Exchange
rates have been influenced considerably by this type
of official and private portfolio management.
But
the important point is that the fundamental free exchange rate equilibrating mechanism requires neither
private speculation nor official intervention.
It operates basically through the revaluation effect of exchange rate changes.

IV.

AN ANALYSIS
TRADE BALANCE

OF THE EXCHANGE
IN GENERAL

RATE AND

EQUILIBRIUM

7. The Simultaneous
Determination
of the Exchange Rate and Trade Balance
As should be
apparent by now, the exchange rate plays a dual
role in the adjustment process.
In Section 3, exchange rate movements were shown to affect the
terms of trade (relative prices of traded goods),
domestic currency goods prices, national income and
expenditure, and the trade balance. In Section 6,
for a given trade balance, it was shown how an exchange rate movement equilibrates the foreign exchange market by revaluing pound relative to dollar
assets in portfolios. In one role, exchange rate movements function in the adjustment mechanism through
their effects on relative goods prices. In the other
role, the exchange rate functions through its effects
on the relative value of foreign and domestic assets.
In this section, both roles of exchange rate movements are brought together in one graphical framework to investigate the operation of the adjustment
mechanism as a whole. This analysis extends that of
previous sections by considering all three marketsU. S. goods, U. K. goods, and the foreign exchange
market-simultaneously.
Therefore,
the analysis
contained in this section is called general equilibrium,
in contrast to the partial equilibrium analysis of
earlier sections.
The basic result of Section 4 is that an exchange
rate rise is associated with movement of the U. S.
trade balance toward surplus under conditions of
goods market equilibrium. This result is represented
graphically in Figure 3 as the goods market clearing
(GM) curve. The GM curve shows all trade bal-

FEDERAL RESERVE BANK

U.S.
Trade

Balance

Figure

OF RICHMOND

3

21

ante-exchange
rate combinations
consistent
with
equilibrium in the goods markets. The curve slopes
upward indicating a direct relationship between the
trade balance and the exchange rate. The curve says
that a rise in the exchange rate must be accompanied
by a rise in the trade balance to keep goods markets
in equilibrium.
This is so because, as outlined in
more detail in Section 4, the exchange rate rise disturbs the terms of trade. Changes in the dollar price
of corn and pound price of wool are then required to
But these domaintain goods market equilibrium.
mestic currency price changes raise U. S. income and
lower U. K. income relative to expenditure,
and
thereby move the U. S. trade balance into surplus.
The basic result of Section 6 is that an exchange
rate fall is associated with movement of the U. S.
trade balance toward surplus under conditions of
foreign exchange market equilibrium.
This result is
represented graphically in Figure 3 as the foreign
exchange market clearing (FX) curve, which shows
all trade balance-exchange
rate combinations consistent with equilibrium in the foreign exchange
market. The downward slope of the curve indicates
the inverse relationship between the trade balance
and the exchange rate. For example, the curve says
that a movement of the U. S. trade balance toward
deficit must be accompanied by an exchange rate rise
to maintain foreign exchange market equilibrium.
This is so because, by analogy to the discussion in
Section 5, the U. S. trade deficit implies a wealth
transfer to U. K. residents which raises the demand
for pounds relative to dollars in world portfolios.
Given existing asset stocks, the increased demand for
pounds relative to dollars in portfolio must be satisfied by an increase in the value of pound relative to
dollar assets, i.e., an exchange rate rise.
The intersection
of these curves (at point A)
represents the trade balance and exchange rate that
are consistent with both goods and foreign exchange
market equilibrium in the current period. The intersection of GM and FX curves may be called short
run or period equilibrium.
Short run equilibrium
does not require a zero trade balance. But Figure 3
is drawn so that the trade balance is indeed zero.
When this is the case, no wealth is being transferred
between U. S. and U. K. residents since the value of
U. S. exports (U. K. imports) equals the value of
U. S. imports (U. K. exports).
Consequently, the
exchange rate need not move.
In the absence of
further disturbances, this short run equilibrium can
sustain itself indefinitely and so it is called a steady
state or full long run equilibrium. Because no wealth
changes hands, world residents are implicitly satis22

ECONOMIC

REVIEW,

fied holding their stocks of money wealth. In this
sense the long run equilibrium is also known as stock
monetary equilibrium.
Now suppose the GM and FX curves intersect at
point B in Figure 4, so that the U. S. trade balance
is in deficit. How do the exchange rate and trade:
balance adjust to long run equilibrium?
First, the
short run equilibrium trade balance and exchange
rate at point B cannot be self-sustaining because
such a situation involves a transfer of money wealth
from U. S. to U. K. residents. This wealth transfer
causes the GM locus to shift up each period in which
the U. S. trade balance is in deficit. To see this,
remember that for a fixed exchange rate a transfer
of money wealth from U. S. to U. K. residents raises
U. K. resident assets relative to those of U. S. residents. This in turn raises U. K. national expenditure
relative to income, and lowers U. S. national expenditure relative to income, thus tending to reduce the
U. S. trade deficit gradually each period.
Suppose
the trade deficit is reduced by half each period. This
is represented graphically by a vertical shift of the
GM curve equal to half the distance between point B
and the horizontal axis.

U.S.
Trade

Balance

Figure

4

By how much does the FX curve shift? To answer
this question, suppose the exchange rate were to
remain unchanged.
Now ask what trade balance
would be consistent with foreign exchange market
equilibrium. Any trade imbalance and wealth transfer would create an incipient excess pound supply
So if the exchange rate
(or demand) for dollars.
were to remain unchanged, the trade balance would
have to be zero for the foreign exchange market to
Therefore the FX curve
remain in equilibrium.
SEPTEMBER/OCTOBER

1979

shifts vertically each period by the full amount of the
distance between point B and the horizontal axis.
Putting the two shifts together shows that next
period’s short run equilibrium is established at point
C in Figure 4. It follows by similar reasoning that
the sequence of trade balance-exchange
rate short
run equilibrium points during the adjustment process
lies on a positively sloped path cutting through B
and C. It also follows that the trade balance converges gradually to zero as the exchange rate converges gradually to its long run level.
In Section 1, it was pointed out that feasibility of a
free exchange rate policy requires that adjustment
to a stable equilibrium be achieved automatically
following disturbances.
It is now possible to comment on this issue. The analysis outlined here suggests that, if the trade balance is not zero, wealth
transfers associated with trade imbalance provide a
force tending to bring the trade balance back to zero.
That is, the system tends to return to long run stock
monetary equilibrium after a disturbance. Therefore,
the government can rely on the tendency of the free
market adjustment mechanism to move toward a
stable equilibrium.
In other words, management of
the exchange rate need not concern policy makers out
of fear of instability of the free exchange rate.
8. Two Illustrations
of the Adjustment Mechanism
The graphical
apparatus
constructed
in
the previous section can be used to analyze two types
of hypothetical disturbances to long run equilibrium
characteristic
of those that occur in international
markets. The first of these originates in goods markets and, in terms of the model developed here, may
be occasioned by, say, a shift of U. S. resident tastes
from large domestic automobiles to smaller U. K.
(foreign) cars. The second originates in foreign exchange or asset markets and involves, say, a shift of
asset preferences from dollar assets to those denominated in pounds (foreign currencies).
Disturbance l-An
Expenditure
Shift
If U. S.
resident preferences for goods shift toward U. K.
output, an incipient excess supply of U. S. output
and corresponding excess demand for U. K. output
develops at the initial goods prices and exchange
rate. At the initial exchange rate, U. K. prices rise
and U. S. prices fall. This lowers U. S. income
relative to expenditure
and raises U. K. income
relative to expenditure so that the goods markets
come into equilibrium, with a U. S. trade deficit
In other words, the GM
(U. K. trade surplus).
curve shifts down as shown in Figure 5.

Since the disturbance does not initially affect the
underlying determinants of the FX curve, that curve
does not shift initially.
Therefore immediately following the disturbance, the short run equilibrium
point shifts from A to B, the exchange rate depreciates, and the U. S. trade balance moves into deficit.
The movement down the initially fixed FX curve
depicts a rise in the dollar value of pounds necessary
to accommodate the increased relative demand for
pound assets brought about by the wealth transfer
from U. S. to U. K. residents through the U. S.
trade deficit. With no further disturbances, the adjustment to long run equilibrium occurs along the
positively sloped path between B and C. The adjustment path is positively sloped because throughout
the adjustment process wealth is being transferred
from U. S. to U. K. residents.
Therefore the exchange rate must continually rise to accommodate the
rising relative demand for pound assets.
The adjustment process terminates at point C,
when the trade balance comes back into equilibrium.
At that time, the dollar will have depreciated relative
to the pound, and wealth will have been transferred
from U. S. to U. K. residents through the series of
U. S. trade deficits. The wealth transfer means U. S.
money expenditure will have fallen and U. K. money
expenditure will have risen. Trade balance equilibrium means national expenditure equals national income, which further implies that U. S. money income
will have fallen and U. K. money income will have
risen in the new long run equilibrium. Note that the
terms of trade moves in favor of U. K. residents between points A and B when demand initially shifts
toward U. K. goods. Then, as equilibrium moves

FEDERAL RESERVE BANK

OF RICHMOND

23

from B to C and the relative share of U. K. residents
in world expenditure rises, the terms of trade moves
further in favor of U. K. residents.
It should be emphasized that even though goods
prices as well as the exchange rate have been assumed
to be perfectly flexible, the adjustment to new long
run equilibrium is not achieved by price movements
This would be possible only if individuals
alone.
held no foreign assets. Then the FX curve would
be horizontal at trade account equilibrium because
an exchange rate rise would not put portfolios out of
balance. In fact without diversification into foreign
assets there would be no portfolio balance problem.
In such a case, the new long run equilibrium would
occur immediately on the shifted GM curve at trade
account equilibrium. Since the trade account remains
in equilibrium, no wealth transfer would take place.
Therefore, national money expenditure and income
would remain unchanged as would domestic currency
goods prices. The exchange rate rise would be just
sufficient to raise the terms of trade, i.e., the price of
U. K. goods in terms of U. S. goods, to maintain
goods market equilibrium.
On the other hand, when individuals do hold foreign assets, even though the disturbance originates
in the goods markets, it is transmitted
to the asset
markets through the revaluation effect of the exchange rate change.
In this case, as the exchange
rate increase raises the price of U. K. goods relative
to U. S. goods, it also moves portfolios out of balance
by raising the dollar price of pounds. Hence, a U. S.
trade deficit is required to maintain foreign exchange
market equilibrium.
The deficit initiates wealth
transfers that take time to run their course. In short,
because of the dual role of the exchange rate (i.e.,
changing terms of trade and revaluing assets) the
disturbance in the goods markets produces wealthtransfer effects which prolong the adjustment process
even though goods prices as well as the exchange
rate are assumed perfectly flexible.
Disturbance
2 -Revised
Anticipations and
the
Policy Dilemma
As a second disturbance, suppose

world residents receive information that the foreign
exchange value of the dollar is likely to fall in the
future. The anticipated future fall in the value of the
dollar could be due to an anticipated future shift of
world demand away from U. S. toward U. K. goods;
or it could be due to a number of other possible disturbances to the equilibrium value of the dollar. But
for the sake of the present discussion, the actual
cause of the future fall in the equilibrium value of the
24

ECONOMIC

REVIEW,

dollar does not matter.
What matters is that this
future fall in the equilibrium value is anticipated.1
It must be emphasized that this type of disturbance, operating as it does through anticipations, can
be a predominant source of short run exchange rate
movements for the following reason.
Individuals
holding both pounds and dollars in portfolio of course
wish to protect themselves against a future fall in
the value of one currency relative to another. Consequently, resources are expended in gathering information on likely future disturbances to the foreign
exchange rate. Because the market uses this information efficiently, it tends to react to anticipated
future disturbances to the exchange rate before they
take place. To the extent that disturbances can be
anticipated, short run exchange rate movements are
likely to be predominantly
influenced by shifts in
portfolio preference induced by anticipated changes
in the future equilibrium foreign exchange rate.
How does the market react to an anticipated fall
in the foreign exchange value of the dollar? In order
to avoid holding an asset which is likely to lose value,
individuals try to sell dollars for pounds immediately.
That is, individuals reduce the share of dollars in
portfolio in advance of the anticipated fall in the value
of the dollar. Therefore, at the initial exchange rate,
an excess dollar demand for pounds develops on the
foreign exchange market.
At the initial trade balance, the excess dollar demand for pounds must be accommodated by an exchange rate rise. This follows because, for given
asset supplies, the desire to hold a greater share of
wealth in pound assets must be satisfied by an increase in the value of existing pound assets relative
to dollar assets. Consequently the FX curve moves
right with a shift in portfolio preference toward
pounds, as shown in Figure 6.
Now since the disturbance does not initially affect
the underlying determinants of the GM curve, that
curve does not shift. Therefore, when the disturbance occurs, the short run equilibrium point moves
from A to B in Figure 6, i.e., the exchange rate rises
and the U. S. trade balance moves into surplus. The
movement along the initially fixed GM curve depicts
the emergence of a U. S. trade surplus associated
with an exchange rate rise. The reasons for this
relation are discussed in detail in Section 3. In
general terms, it is shown there that following an
exchange rate rise, domestic currency goods price
adjustments are required to restore consistency of

1 Goodfriend
[2] contains
ment to various anticipated
SEPTEMBER/OCTOBER

1979

analyses
of complete
future disturbances.

adjust-

authorities insist on pegging the exchange rate, they
must reduce the dollar money supply growth rate.
U. S. monetary policy is thereby made subordinate
to events in the foreign exchange market. The policy
dilemma arises because the monetary policy necessary
to stabilize the foreign exchange rate may not be
consistent with domestic monetary policy goals.

U.S.
Trade

Balance

Figure

The events of fall 1978 dramatically illustrate this
policy dilemma. In the months prior to November,
both U. S. money supply and the dollar price of foreign exchange had been rising at an increasingly
rapid rate. Then after November 1, the U. S. monetary authorities, coming under intense pressure, announced a commitment to stabilize the foreign exchange rate. For the following five months the U. S.
money supply grew much more slowly than before,
thereby helping to precipitate the reduction in real
economic growth that occurred in the second quarter
of 1979.

6

the terms of trade with goods market equilibrium.
These goods price movements are in turn shown to
have disproportionate
effects on national income and
expenditure.
Because of these income and expenditure effects, goods price movements that bring the
goods markets into equilibrium also move the U. S.
trade balance into surplus.

V.

This article has outlined important features of
international adjustment under a flexible exchange
rate. Exchange rate movements have been shown to
function in two distinct roles in the adjustment process. In the
goods markets, exchange rate movements have been shown to affect relative goods prices
(the terms of trade) and national income relative to
national expenditure.
In the asset or foreign exchange market, exchange rate movements have been
shown to function by changing the relative value of
foreign and domestic assets. These two functions of
exchange rate movements have been synthesized in a
simple graphical framework which displays the simultaneous determination of the trade balance and exchange rate. The framework has been used to investigate some characteristics
of the international
adjustment process as a whole.

Furthermore,
the discussion in Section 3 shows
that the exchange rate rise is associated with a rise
in the relative price of U. K. output in terms of U. S.
output units.
In other words, the terms of trade
move against U. S. residents and in favor of U. K.
residents.
It is also shown in Section 3 that this
“speculatively”
induced rise in the exchange rate
tends to push U. S. goods prices up.
These last two consequences of the induced rise in
the exchange rate bear directly on the policy dilemma
faced by- the world’s central banks operating in a
flexible exchange rate environment.
Because of the
dual role played by the exchange rate in the adjustment process-i.e.,
relative goods price and asset
revaluation roles-the
exchange rate rise required to
clear the foreign exchange market affects goods markets and acts on the GM curve as well. As mentioned
above, from the U. S. resident point of view the
depreciation of the dollar is accompanied by a worsening of both the terms of trade and domestic inflation. Consequently, the U. S. monetary authorities
in this case may come under pressure to stabilize the
exchange rate to prevent its depreciation relative to
the pound.
But stabilizing the dollar requires that
the U. S. authorities passively supply pounds for
dollars to satisfy the excess demand for pounds that
exists at the pegged exchange rate.
If the U.
S.

CONCLUSION

The fundamental dynamic feature of the adjustment process has been shown to be the wealth transfer associated with trade account disequilibrium,
which in general implies that the exchange rate and
trade balance adjust gradually to a new long run
equilibrium after a disturbance.
Wealth transfer has
also been identified as providing an automatic mechanism for exchange rate and trade balance adjustment to new long run equilibrium.
The article concludes with a discussion of the effect
of anticipated future disturbances on the current exchange rate, trade balance, and terms of trade.
It
has been argued that short run exchange rate movements are likely to be dominated by disturbances

FEDERAL RESERVE BANK

OF RICHMOND

25

Therefore,
the
operating
through
anticipations.
short run policy dilemma faced by world central
banks operating under a flexible exchange rate has
been discussed in the context of this type of disturbance.
The policy choice involves the extent to which exchange rate movements should be allowed to play a
role in short run international adjustment.
The dilemma arises because the monetary authorities must

give up control of money growth in order to prevent
exchange rate movements.
If the exchange rate is
pegged, then money growth may become inconsistent
with domestic policy objectives. But if the exchange
rate is allowed to function in the adjustment process,
the consequent terms of trade change and goods price
movements could prove equally inconsistent with domestic policy objectives such as price stability and
steady real economic growth.

Selected References
1. Dornbusch, Rudiger.
“Currency
Depreciation,
Hoarding, and Relative Prices.” Journal of Political Economy 81, No. 4 (July/August
1973) :
893-915. Discusses the effect of a devaluation of
the exchange rate (in a fixed rate context) on the
terms of trade and trade balance. A useful reference for the relationships underlying the GM
curve.
2. Goodfriend, Marvin.

Money, the Terms of Trade
and Balance of Payments
Adjustment
with a
Flexible Exchange Rate: A Theoretical and Empirical Study of the International
Adjustment
Mechanism.
Brown University Ph.D. thesis in

progress.
Contains development and thorough
analysis of the complete model from which the
framework employed in this article is derived.

3. Johnson, Harry G.
Theory,

Money, Balance of
Payments
and the International Monetary Problem.

Essays in International Finance No. 124. Prince-

26

ECONOMIC

REVIEW,

ton: Princeton University Press, 1977. Contains
a particularly good discussion of the implications
of the monetary approach to the balance of payments theory for the stability of the adjustment
process in the fixed rate context. Useful background for the discussion of the stabilizing effect
of wealth transfer. Contains the argument that
fixing the exchange rate implies loss of control
over the money supply. Useful discussion of the
exchange rate policy dilemma in the fixed rate
context.
4. Kouri, Pentti J.K. “The Exchange Rate and the
Balance of Payments in the Short Run and in the
Long Run:
A Monetary Approach. Scandinavian Journal of Economics
78, No. 2 (June
1976) : 280-304. A sample of the literature emphasizing the role of asset markets in exchange
rate determination. Contains a useful analysis of
the effect of wealth transfers on exchange rate
movements. Useful background material for the
relationships underlying the FX curve.

SEPTEMBER/OCTOBER

1979