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The Reaction

of Interest

to the Employment



The Role of Policy Anticipations
Timothy Cook and Steven Kom *

Participants in the financial markets have been
intensely interested in the monthly employment
report in recent years. Interest rates have frequently changed sharply following the report, and the
report appears to have strongly influenced market
expectations of Federal Reserve policy actions. The
employment report for November 1988, for example, indicated that nonfarm payroll employment had
risen by 463,000, which was well above the increase
expected by market participants of about 255,000.
The Wall Street Jozmai’s financial market story the
following day reported that “the Federal Reserve is
likely, in light of November’s strong employment
figures, to decide to raise short-term interest rates
at its policy meeting December 14.” Treasury bill
rates rose about 25 basis points the day of the
employment report, and the JoamaL subsequently
reported that the Fed raised its target for the federal
funds rate on December 15.
As this example suggests, many market participants
believe that Federal Reserve policy actions in recent
years have been more closely linked to the employment report than in previous years and that the
reaction of rates to the report at least partly reflects
this link. According to this view, after the Fed deemphasized the monetary aggregates in the early
1980s it began to place relatively greater emphasis
on current economic conditions. The monthly employment report provides an early, comprehensive
reading on the economic conditions of the previous
The idea that market participants’ reaction to
economic news is influenced by their expectations
Timothy Cook is an economist at the Federal Reserve
Bank of Richmond and Steven Korn is a financial analyst with
Burlington Industries. The authors benefited from comments
by Marvin Goodfriend, Thomas Hahn, Thomas Humphrey,
Tony Kuprianov, Bob LaRoche, and Roy Webb.

of the Federal Reserve’s response to the news has
been called the “policy anticipations hypothesis.“’
According to this view, the Federal Reserve makes
periodic changes in its target for the federal funds
rate in response to new information, and these
changes are highly persistent and seldom quickly
reversed. Treasury bill rates, like other longer-term
rates, are linked to current and expected levels of
the federal funds rate in accordance with the expectations theory of interest rates. Consequently, the
reaction of bill rates to economic news depends on
how market participants expect the Fed to move its
target for the funds rate in reaction to this news. This
view implies that as the economic and monetary
variables influencing the Fed’s policy decisions
change, so should the market reaction to the announcement of new information on these variables.2
In this paper we examine the reaction of interest
rates to the employment report since the mid-1980s
and find that it has been significant. We then look
at the reaction of interest rates to the employment
report over a longer period of 20 years and find that,
consistent with the policy anticipations hypothesis,
the reaction in recent years has been considerably
stronger than it used to be. In the final part of the
paper we illustrate in more detail how the employment report has influenced market expectations of
Fed policy actions.

1 This term comes from the money announcement literature,
which documented the reaction of interest rates to money
in the late 1970s and early 1980s and proposed a number of explanations for this reaction. The most
widely accepted explanation is that the reaction reflected the
effect of money announcements on market participants’ anticipations regarding subsequent Federal Reserve policy actions.
See Dwyer and Hafer (1989) and Santomero (1991).
2 Poole (1988) and Santomero (199 l), among others, emphasize
this point.




The employment report for a given month is
generally released on the first Friday of the following month. The most widely publicized and anticipated data in the report is the change in nonfarm
payroll employment. Two other elements of the
report are the unemployment rate and the revision
in the previous month’s employment, which can be
substantial.3 To examine the reaction of interest rates
to the employment report, we collected monthly data
for nonfarm payroll employment and the unemployment rate as they were in&&y reported by the Bureau
of Labor Statistics in its monthly publication, Emphyment and Eakzgs.

We would expect interest rates to react only to the
changes in employment, the unemployment rate and the revision.4 As
a proxy for the market’s expectations of the change
in nonfarm payroll employment, we use survey data
from MMS International, which are available starting in January 1985. The expectations series is the
median forecast of a large group of market specialists
surveyed by MMS International. The unexpected
component of the employment announcement is the
difference between the actual change in employment
and the survey expectation. The unexpected component of the change in the unemployment rate is
calculated in a similar way using survey expectations
for the unemployment rate, which MMS International
has collected since 1980. Survey data on expectations of the revision in employment are not available,
so in the empirical work below we are unable to
separate the expected and unexpected components
of the revision.
llnexpected part of the announced

In addition to general economic conditions, two
factors affecting the monthly changes in nonfarm
payroll employment numbers over the 1985-91
period were the number of workers on strike each
month and the number of government workers collecting data for the 1990 census. The survey data
on expectations are not adjusted for strikers and
3 The employment report also includes data on hourly wages
and the workweek. We do not include these because we do not
have expectations data for them and because they receive
relatively little emphasis in accounts of the market’s reaction to
the employment report. See Webb (1989) for a description of
the data in the employment report.
4 The reason is that if interest rates (and, hence, security prices)
reacted to the expected component of these announcements,
that would imply that market participants were ignoring an easy
way to make large profits.

census workers so, in effect, the survey participants
have to incorporate their knowledge about strikers
and census workers into their forecasts. The employment report comes out after the end of the month,
however, and it is probably reasonable to assume that
survey participants had a good idea of the number
of strikers and census workers in the month when
making their forecasts. In any case, neither the
actual employment numbers nor the survey expectations are adjusted for strikers or census workers,
so this feature of the data presents no problem in
this section of the paper.
To measure the change in interest rates following
the employment report, we use the change in the
three-month, six-month, and twelve-month Treasury
bill rates from the afternoon prior to the report to
the afternoon following the report, as provided in the
Federal Reserve Board’s H. 15 release.5 We examine
the response of interest rates to the employment
report by estimating the coefficients of the equation:
ARnt = a + bl AExpected


+ et


where ARn is the one-day change in the n-month
Treasury bill rate surrounding the employment
report, Emp is employment as initially reported, UR
is the unemployment rate as initially reported, Rev
is the revision in the previously reported monthly
employment figure,6 and e is an error term. The coefficients are estimated over the period from February
1985 through April 199 1. The starting point for the
regressions is dictated by the availability of the MMS
International survey data, but as noted above it also
corresponds roughly with the growing interest in the
employment report among market participants as
indicated by the financial press.
On three occasions in the 1985-91 period the
Federal Reserve changed the discount rate on the
s All yields are converted

to a simple interest basis,

6 We calculated the revision in employment as the difference
between the initial report of the monthly level of employment
and the next report of that level. This computation includes revisions in the changes in employment for all previous months. We
also calculated the revision as the revised change in employment
over the two most recent months. The regression results were
generally similar, although the revision calculated in the latter
way added less to their explanatory power.


ticipants put greatest weight on the payroll employment figure, they also consider other aspects of the
employment report in evaluating its likely effects on
interest rates and monetary policy.

same day as the employment report. (On March 7,
1986, the Fed lowered the discount rate by one-half
percentage point; on September 4, 1987, it raised
the discount rate by one-half percentage point; and
on February 1, 199 1, it lowered the discount rate
by one-half percentage point.) Discount rate changes
have well-documented
effects on market interest
rates. To control for these effects, we added to the
regressions a variable set equal to the change in the
discount rate.
The estimates of equation (1) are reported in
Table 1. The estimates of the coefficients of the
expected components of the changes in employment
and the unemployment
rate are not significantly
different from zero in any of the regressions. The
coefficients of the unexpected change in employment
are positive and significantly different from zero at
the 1 percent level in all three regressions. The
coefficients indicate that over this period an unexpected increase of 100,000 in nonfarm payroll
employment on average caused about a 5 to 8 basis
point increase in Treasury bill rates on the day of
the announcement.
The coefficients of the unexpected component of
the change in the unemployment rate and the revision are significant at the 5 percent level in all the
regressions, and these variables account for about
one-fourth of the explanatory power of the regressions.7 These results suggest that while market par7 This statement is made on the basis of a comparison of the
R* of the regressions in Table 1 with the RZ of unreported regressions that include as independent variables only employment
or only the unemployment rate and the revision. These regression results and others mentioned but not reported in the paper
are available from the authors, as are the data from Employment and Eurnings used in the regressions.


The coefficient of the revision in employment is
about one-third of the coefficient of the unexpected
component of employment in the most recent month.
The coefficient on the revision is smaller for two
reasons. First, market participants probably place less
weight on more lagged data in evaluating the current state of the economy and the Federal Reserve’s
likely response to it. Second, some of the revision
may be anticipated.s

While the regression results for the 1985-9 1 period
are consistent with the policy anticipations hypothesis, they are also consistent with an alternative
hypothesis called the “real activity hypothesis.“9
According to the latter hypothesis, a stronger-thanexpected employment report may be signaling only
that the economy is stronger than previously thought,
thereby leading market participants to raise their
* N&mark and Wascher (1991, p. 198) provide evidence that
some of the revision can be forecast. They find that “incorporating other labor-market information available at the time of
the release of the preliminary estimate [of nonfarm payroll
employment] into a forecast equation for the first revision leads
to a reduction of about 10 percent in the unanticipated component of the revision.”
9 This term also arose in the early literature on money announcements, when this hypothesis was proposed as an explanation for the reaction of interest rates to money announcements.
See Cornell (1983, pp. 647-48).


The Reaction of Interest Rates to Employment

___ Em

















- 12.83







- 1.49



- 20.00







- 1.81



- 20.56






Treasury bill yields and the discount rate are in basis points, employment
is in hundreds of thousands,
percentage points. Estimation period is February 1985 through April 1991. t-statistics are in parentheses.



at 5 percent

level and ** denotes


at 1 percent

and the unemployment
DW is the Durbin-Watson

rate ,is,in




expectations of the real interest rate. Thus, a
stronger-than-expected report will be associated with
an increase in Treasury bill rates. Under this
hypothesis, any change in the Fed’s funds rate target
following the report is interpreted simply as a contemporaneous reaction to the same underlying “real”
shock. Hence, monetary policy anticipations cannot
be said to have contributed to the rise in bill rates
following the report.
The obvious way to provide evidence on which
of the two hypotheses is right would be to reestimate
equation (1) for the period prior to 1985. Under the
policy anticipations hypothesis we would expect the
reaction of interest rates to the unanticipated information in the employment report to be greater in
a period when the Fed was putting greater emphasis
on the report. Hence, if the coefficient of the unexpected component of the employment report were
significantly greater in the period after the mid-1980s
than earlier, that would be evidence that policy
anticipations were affecting the market’s reaction to
the report. Unfortunately, we cannot conduct this
exercise because MMS International did not begin
to collect expectations data for nonfarm payroll
employment until the beginning of 1985. But this
fact in itself suggests that market participants became
more interested in the employment report in the
mid-1980s because they perceived it was becoming
more important in the Fed’s policy decisions.
Although expectations data on nonfarm payroll
employment are not available before 198.5, such data
on a wide variety of other macroeconomic variables
were collected prior to that time. Specifically, MMS
International collected survey data as far back as the
beginning of 1980 for industrial production, the
unemployment rate, the trade balance, the producer
price index, and the consumer price index. Dwyer
and Hafer (1989) estimate regressions from 1980
through 1987 of changes in the 3-month Treasury
bill rate and the 30-year Treasury bond rate on the
of these government
statistics. They find very little evidence of an interest
rate response.“*” In light of their finding, it seems
lo Dwyer and Hafer’s finding that the unexpected component
of the unemployment rate did not affect interest rates in the
period from 1985 through 1987 at fist appears inconsistent with
the regression results reported in Table 1. When we estimated
the regressions from 1985 through 1987, however, the coefficient of the unexpected component of the unemployment rate
was not significant.
I1 Hardouvelis (1988) examines the response of interest rates
and exchange rates to 15 macroeconomic series from October
1979 to August 1984. He finds that markets respond primarily

unlikely that the strong reaction of interest rates to
the unexpected component of nonfarm payroll employment since the mid-1980s results solely from the
impact of this news on the market’s perception of
the economy.
In the absence of survey expectations for nonfarm
payroll employment prior to 1985, we estimated an
autoregressive time series model and used it to
generate a series of proxy expectations. The steps
of our procedure were as follows. (1) We used final
data (i.e., the latest revised historical series) on nonfarm payroll employment to estimate an autoregressive time series model from 1955 through 1970. In
this model, the logarithm of employment is firstdifferenced and then regressed on two lags of itself. l2
(2) We generated a forecast of the change in employment for each month (month t) from January
1971 through March 1991 using the coefficients of
the time series model and the employment figures
available in the previous month (month t-l) as
(3) Prior
in&Gy reported in ~!G~~,@YLG+N
to making these forecasts, we adjusted the initial
data for strikers and 1990 census
workers by adding the former and subtracting the
latter. After making the forecasts, we subtracted
strikers and added census workers to get a prediction of the actual employment numbers. In effect,
we assumed that market participants knew the
number of strikers and census workers prior to any
month’s employment announcement.i3
As before, we subtracted forecasted from actual
employment to generate a series for the unexpected
component of the employment announcement. Then
we estimated the regression:
to monetary news, although he also finds some evidence that
markets respond to variables that reflect the state of the
I2 The estimated
AE, = .00078

coefficients of this model are (t-statistics
+ .2@?6A$-3

+ .3793A&-2


R* = .24

I3 The series for 1990 census workers is from the December
1990 issue of Emphymtzt and Earnings. The series for strikers
is from the Board of Governors. The strikers series does not
begin until 1968, so we were unable to use it to estimate the
autoregressive model. We did, however, reestimate the model
after making adjustments for the steel strikes of 1956 and 1959,
which were the two major strikes of the 19.5570 period. We
used the “Highlights” section of the Etnploytnen~ and Eumings
reports to estimate the effects of these strikes on the monthly
numbers and then used these estimates to
reestimate the autoregressive model and generate employment
forecasts. The resulting forecasts were very similar to those made
without these adjustments.


ARnt = a + bl AExpected

and stays high in the 1988-91 period.14 In the latter
two periods the coefficient is significant at the 1
percent level and is only a little lower than the
coefficient in comparable regressions using the survey
expectations data, shown at the bottom of Table 2.
These results suggest that the autoregressive time
series procedure is doing a reasonably good job of
mimicking market expectations. l5


+ b2AUnexpected


+ et,


where expected employment is the forecast of the
change in employment and unexpected employment
is the difference between announced employment
and this forecast.
Table 2 shows the estimates of equation (2) for
seven subperiods from the beginning of 197 1 through
early 1991. The coefficient of the expected component of the change in employment is not significantly different from zero in any of the regressions.
(Nor was the constant statistically significant in any
regressions, and it is not reported in the table to conserve space.) The coefficient of the unexpected component of the change in employment is not significantly different from zero in any of the three subperiods in the 1970s. The coefficient then jumps
sharply in the period from 1980 through 1982 and
is highly significant. It then falls substantially in the
1983-84 period, rises again in the 1985-87 period

t4 We also estimated equation (2) over one-year periods, and
the results were very similar to those reported in Table 2. The
coefficient of the unexpected component of the employment announcement was statistically significant at the 10 percent level
in only one year (1980) prior to 1984, but was significant at the
10 percent level in each of the years from 1984 through 1990.
The coefficient was also significant at the 5 percent level in four
of the latter years and in 1980.
I5 We did three additional exercises to check the robustness of
the results reported in Table 2. Fist, rather than estimating the
autoregressive model only once over a fixed period ending in
1970, we extended the estimation period to month t-l prior to
forecasting employment in month t. Second, we forecast employment without making the adjustments for strikers and census
workers described in the text. Third, we added another lagged
term to the autoregressive model. In each case the interest rate
regression results were not substantially different from those
reported in Table 2.



The Reaction of Interest Rates to Nonfarm Payroll Employment




















- 1.09

- 1.69





















































1988April 1991



























with Survey Data



1988April 1991

* denotes


bill yields are in basis points and employment

at 5 percent

level and


* denotes

is in hundreds

of thousands.
at 1 percent


are in parentheses.

DW is the Durbin-Watson





On balance, the regression results are consistent
with the policy expectations hypothesis. The coefficients of the unexpected component of the change
in employment in the 1985-91 period are highly
significant and much greater than those in the 1970s
which are essentially zero. The reason for the strong
reaction of interest rates to the employment announcement in the period from 1980 through 1982
is not clear.i6 These years correspond roughly to the
period from October 6, 1979, through October 9,
1982, when the Federal Reserve went on a “nonborrowed reserves” operating procedure intended to
improve its control of the money supply. Movements
in the funds rate were unusually large in this period,
and they were largely determined on a judgmental
basis by the Federal Reserve, as they had been
before.” One interpretation of the sensitivity of
interest rates to the employment announcement in
this period is that it reflected the view of market
participants that the Fed was reacting more aggressively to all information-money
growth and economic conditions-affecting
its policy decisions.
Hetzel’s (1986) description of the Fed’s behavior in
this period is consistent with this view.


As a final exercise, we use the financial market
stories of the Wall Sn-eet Journal to illustrate the link
in recent years between the employment report and
market expectations of Federal Reserve behavior.
Beginning in late 1988 the .iixmza~stories immediately
following the employment report regularly included
what can be interpreted as a consensus market
forecast of near-term Fed policy actions conditional
on the report. These forecasts are summarized in
Table 3. The table also shows (1) the market’s expectation of the change in nonfarm payroll employment as reported by the Jownal, (2) the unexpected
component of the employment announcement, and
(3) the hmafs
reports of changes in the Fed’s target
I6 We reviewed the financial market stories in the wal/ Street
Journa/ to investigate the possibility that this coefficient was picking up the effect of monetary policy events. The Jounro/reported
six policy events that were contemporaneous with employment
announcements. These included two discount rate changes, one
change in the funds rate, a speech by Chairman Volcker, the
phase-out of credit controls, and a large unexpected money announcement. We reestimated the regressions for the 1980432
period without these six observations. The coefficients of the
unexpected component of the employment announcement were
smaller in each of the regressions, but they were still significant
at the 5 percent level.
I7 For detailed evidence

on this point, see Cook (1989).

for the federal funds rate, if any, over the period
until the following employment report. (The Journal’s reports of funds rate target changes shown in
Table 3 are based on the perceptions of participants
in the financial markets. They have not been confirmed by the Federal Reserve and may not correspond precisely with the timing of actual Fed policy
Table 3 confirms that in the late 1980s and early
1990s market participants believed there was a close
‘link between the employment report and Fed policy
actions and that market participants’ forecasts of Fed
behavior were strongly influenced by the report. Late
in the period shown in Table 3, Fed policy actions
appeared to be especially closely linked to the
employment report. In December 1990, February
199 1, and March 199 1 the Jimrtza~reported that the
Fed changed its target for the funds rate later on the
same day as the employment report. And in January
199 1 the .lbuma~ reported that the Fed changed its
funds rate target on the market day following the
employment announcement.
The near-term policy forecasts recorded in Table
3 were accurate three-fourths of the time.i8 The
major forecasting error followed the weak employment reports of August and September 1990, which
led market participants to anticipate that the Fed
would lower its funds rate target. Following the
September employment report the Joumalreported
that “[i]n a rare show of unanimity, many economists,
bond strategists and big investors are predicting that
the Federal Reserve will reduce short-term interest
rates within four weeks.” Yet the Fed did not reduce
the funds rate target, and the hmzal’s story following the employment report in October found the
reason in the Fed’s probable decision to link further
decline in the funds rate to a federal deficit reduction package. After agreement on such a package was
reached on Thursday,
October 25, the Journal
reported that the Fed lowered its target for the funds
rate the following Monday.

This article has provided evidence that market
interest rates responded more strongly to the unexpected component of the employment report in the
is The policy forecasts were accurate 18 times and wrong 6 times
(in November 1989, March 1990, June 1990, July 1990, August
1990 and September 1990). In seven instances the forecast
cannot be evaluated because the Journal did not provide a
consensus forecast or because the Fed reportedly changed the
target on the same day as the report.


the finding of the money announcement literature
that monetary policy anticipations can strongly influence the way market interest rates react to
economic news. A corollary, emphasized by Goodfriend (1991) and Poole (1988), is that movements
in market interest rates cannot be used to extract
information about the economy without an understanding of how monetary policy influences interest
rate expectations.

latter half of the 1980s and the early 1990s than they
generally did in earlier years. We have also documented the perception of market participants that
the Fed’s month-to-month policy decisions over this
period were heavily influenced by the report. A
reasonable conclusion is that the strong reaction of
interest rates to the employment report in this period
largely reflects the greater impact of this report on
expectations of Fed policy. This conclusion reinforces



Reports, Policy Forecasts, and Journal Reports of Funds Rate Target Changes


































Change in
Six-Month Rate
(Basis Points)

Policy Forecast in Journal
Financial Market Story


Report of Subsequent
in Funds Rate Target


Friday’s rally...came
after government
figures indicated the economy isn’t
expanding as rapidly as many people
had thought. Money managers quickly
concluded that removed any pressure
on the Fed to tighten credit, at least
until after Election Day.

No change

+ 16

Hopes for a credit-easing
move by the
Federal Reserve have vanished. Some
analysts even predict tighter credit
after the elections, especially if the
dollar drops in the foreign-exchange


raised late November


The Federal Reserve is likely, in
light of November’s strong employment figures, to decide to raise shortterm interest rates at its policy
meeting December 14.


raised December

[not available1

No target

+ 12

credit soon
increase of



The Federal Reserve probably will
leave its credit grip unchanged for the
next few weeks. But many economists
think the central bank will raise shortterm rates again next month to combat

No target change

Many analysts expect the Federal
Reserve Board to sit tight and leave
interest rates where they are in the
wake of the report.

No target



that the Fed will tighten
grew Friday after the
released its January
report showing a robust
in payrolls.


in target



raised February
raised February





Change in
Six-Month Rate
Unexpected I (Basis Points)

Policy Forecast in Journal
Financial Market Story


Report of Subsequent
in Funds Rate Target







- 14

April’s employment
report makes it
highly unlikely that the Federal
Reserve Board will decide to push up
interest rates when its policy-making
meets here next week.

No target change






The meek growth in new jobs last
month confirmed to many economists
that the U.S. economy is on a slower
track and could lead the Federal
Reserve to ease its grip on credit this


lowered June 6
lowered July 6






Many economists expect the closely
watched federal funds rate, which fell
to 9%% Thursday, to decline %
percentage point sometime soon.


lowered July 26






It now appears that investors should
expect the federal funds rate to
remain at about 9%, according to
many economists and analysts. . . .
Before Friday, many investors were
betting that the Fed would allow the
rate to fall an additional quarter of a

No target







[not available1

No target



Speculation that the Fed will
ease credit grew Friday after a
government report painted a darker
picture of the economy than analysts
had expected. The report indicated
severe weakening in the manufacturing











+ 18

The jobs data dashed hopes for an
immediate easing of interest rates by
the Federal Reserve, and caused bond
prices to tumble.










Many economists say the latest
government’s first economic report for
the economy has
weakened to the point the Fed may
decide to cut interest rates further.
But they expect the central bank to
wait at least until its policy-making
meets next Monday
181 before taking any









[not available]

No target change





The catalyst for Friday’s retreat was
a mixed bag of employment
which economists said provided little
reason for the Federal Reserve to alter
its credit policy. That policy appears
to be holding for now.

No target change





















- 320



















Change in
Six-Month Rate
(Basis Points)

Policy Forecast in Journal
Financial Market Story


Report of Subsequent
in Funds Rate Target


Just a few weeks ago, many Wall
Street economists were holding on to
hopes that interest rates would soon
resume their downward drift and that
the Federal Reserve would cut shortterm rates once again. Now they
believe the Fed will push rates higher
sometime this spring.

No target



Interest rates are likely to remain
relatively stable in the weeks ahead
while the Federal Reserve keeps credit
policy on hold, many economists

No target



But the weakness in the report led
many analysts to predict that the
Federal Reserve will refrain from
pushing up interest rates for now.

No target




Speculation that the Fed may choose
to push rates lower began on Friday,
after the Department
of Labor released
the May employment

No target




Friday’s employment
report, coming
on top of stronger than expected auto
sales data on Thursday, has convinced
investors that interest rates won’t
fall significantly and that the Federal
Reserve will probably keep credit
policy on hold.


- 224


Speculation that the Fed will soon
ease interest rates has been swirling
for weeks, but the prospects that such
an easing will occur sooner, rather
than later, were heightened on Friday
when the government released a
bombshell July employment

No target

lowered July 13




In a rare show of unanimity,
economists, bond strategists and big
investors are predicting that the
Federal Reserve will reduce short-term
interest rates within four weeks.

No target change



Although Friday’s employment
should have provided the Fed with
an additional reason to lower rates,
many economists believe that by
linking lower interest rates to the
package, the Fed is
now paralyzed. [Deficit reduction
agreement approved on Thursday,
October 25.1


lowered October



Then last week’s batch of economic
reports pointed straight toward recession...and the Federal Reserve is expected to ease interest rates further
before year end.
















Change in
Six-Month Rate
(Basis Points)

- 14

Policy Forecast in Journal
Financial Market Story


Report of Subsequent
in Funds Rate Target

Treasury bond prices soared and
short-term interest rates fell
sharply after the government reported
grim economic news., . .
The Fed reacted to the economic news
by moving to nudge a key short-term
rate slightly lower.



same day


[not available]


lowered January

Jan-4-9 1

- 149






Prices of U.S. government bonds
soared in response to a surprisingly
weak employment
report and a
slashing of the discount rate by the
Federal Reserve.



same day

The Federal Reserve eased credit
another notch Friday . . . . The move...
came shortly after the [employment



same day

Although the Fed left interest rate
policy unchanged on Friday, many
analysts expect the central bank to
reduce the federal funds rate another
notch sometime soon.



April 30

















Cook, Timothy. “Determinants of the Federal Funds Rate:
1979- 1982.” Federal Reserve Bank of Richmond Economic
Rev&w 75 (January/February 1989): 3-19.

Hetzel, Robert L. “Monetary Policy in the Early 1980s.” Federal
Reserve Bank of Richmond Economicti
72 (March/April
1986): 20-32.

Cornell, Bradford. “The Money Supply Announcements
Puzzle: Review and Interpretation.”
Review 73 (September 1983): 644-57.

Neumark, David, and William L. Wascher. “Can We Improve
Upon Preliminary Estimates of Payroll Employment
Growth?” JoumaL of Business d Economic Starhics 9
(April 1991): 197-205.

Dwyer, Gerald P., Jr., and R. W. Hafer. “Interest Rates and
Economic Announcements.”
Federal Reserve Bank of
St. Louis Economic Review 71 (March/April 1989): 34-45.
Falk, Barry and Peter F. Orazem. “The Money Supply
Puzzle: Comment.” Am&an
Revietw 75 (June 1985): 562-64.
Goodfriend, Marvin. “Interest Rates and the Conduct of
Monetary Policy.” Carnegie-Rochester series on Public Policy
34 (Spring 1991): 7-30.
Hardouvelis, Gikas A. “Economic News, Exchange Rates and
Interest Rates.” Journal of Int~aciona~ Money and Finance
7 (March 1988): 23-35.


Poole, William. “Monetary Policy Lessons of Recent Inflation
and Disinflation.” Journal of Economic Perspectives 2
(Summer 1988): 73-100.
Santomero, Anthony M. “Money Supply Announcements:
Journal of Economics and Bushess
(February 1991): l-23.


Webb, Roy H., and William Whelpley. “Labor Market Data.”
Federal Reserve Bank of Richmond Economic Review 75
1989): 15-22.



Policy and Operating


in New Zealand
Mz’chael Dotsq *



The current structure of financial intermediation
and monetary policy in New Zealand provides an
interesting environment for examining some recent
work by Fama (1980, 1983) concerning unregulated
financial systems and price level determinacy. In New
Zealand, banks are not subject to interest rate regulations or reserve requirements. Currency is also supplied elastically, and yet monetary policy has been
able to exert control over prices and to reduce inflation substantially. These attributes of New Zealand’s
financial system seemingly are at odds with Fama’s
analysis since in the absence of currency control he
emphasizes the use of noninterest-bearing
reserves as a means of establishing a well-defined real
value of a medium of exchange.
A closer look at the operations of the Reserve Bank
of New Zealand, however, reveals an important legal
restriction governing the settlement of accounts between a bank and the Reserve Bank. This restriction, together with the operating procedures used by
the Reserve Bank, creates a well-defined demand for
an asset whose nominal supply is under the direct
control of the central bank. This asset, called exchange settlement funds or cash, pays a below-market
rate of interest. Thus the general thrust of Fama’s
work on price level determinacy holds.
It is also interesting to study the procedures of the
Reserve Bank of New Zealand from a monetarist
perspective. The Reserve Bank of New Zealand currently uses a quantity-based procedure rather than
an interest rate instrument in conducting monetary
policy. Like most central banks, however, the
Reserve Bank is averse to directly controlling the
This research was begun while I was a visiting scholar at the
Reserve Bank of New Zealand. I wish to thank members of the
Research Department and Open Market Desk at the,Reserve
Bank of New Zealand for their help. Many useful comments were
also received from Marvin Goodfriend, Arthur Grimes, Robert
Hetzel, and Robert King. The views expressed in this paper are
solely those of the author and do not necessarily represent those
of the Federal Reserve Bank of Richmond, the Federal Reserve
System, or the Reserve Bank of New Zealand.

stock of currency. Given the absence of reserve
requirements the only other remaining quantity to
target is excess reserves. The level of this target is
extremely low compared to the size of the banking
system and implies that monetary policy is implemented through its influence on a very small percentage of the monetary base. Also, as mentioned these
excess reserves or settlement funds pay interest.
Thus the operating procedures of the Reserve Bank
of New Zealand impose a very small cost on the
banking system compared to the costs imposed by
most other institutional frameworks for monetary
policy. New Zealand’s arrangements,
appear to be a relatively efficient means of anchoring the monetary system.
This paper outlines the major aspects of monetary
procedures in New Zealand and examines how these
procedures affect the price level. Section II briefly
examines the setting for Reserve Bank operating procedures. Although New Zealand does not conform
to any of the specific examples stressed by Fama that
allow for price level determinacy,
the monetary
system does meet his general requirements. Section
III presents a model of bank behavior based on a
precautionary demand for exchange settlement or
excess reserves. The model draws on past work on
the precautionary demand for money, most notably
Poole (1968). In Section IV the model’s equilibrium
and the determination of prices are discussed, while
in Section V some extensions are examined. Section
VI concludes the paper.

Issues Concerning Price Level Determinacy
In some influential work Fama (1980, 1983)
examines the behavior of economies with unregulated
financial intermediation and analyzes the conditions
under which a purely nominal commodity serves as
a numeraire. Banks in his world provide two related
services. They provide an accounting system of
exchange that keeps track of exchanges of wealth



between transactors. They also manage portfolios
transforming one form of wealth (a particular portfolio) into another. This activity is related to banks’
role in the exchange process because the recipient
of a wealth transfer may wish to hold his wealth in
a form that differs from that transferred by the
initial holder. Since deposits are heterogeneous (every
deposit may represent a claim to a different set of
underlying assets), there is no sense in which a
generic deposit can serve as a numeraire. Indeed, this
unregulated world is not a monetary economy and
has no object that resembles what is currently
referred to as money.
To introduce a nominal commodity that serves as
a medium of exchange into this abstract environment,
Fama analyzes a number of monetary arrangements.
The first relies on the introduction of a noninterestbearing currency, which enjoys a relative advantage
in certain types of transactions. The government
monopolizes the printing of currency and sells a given
quantity to banks for assets. Banks hold the currency for customers who may wish to exchange assets
for currency. To get a well-defined price level, or
real value for currency, there must be a well-defined
demand and supply of currency, and currency must
earn a below-market rate of return (see Patinkin).
Because currency is valued for its transaction services
there is a real demand for it, and the government
is able to fix its nominal supply. As Wallace (1983)
stresses, the government must prohibit privately
issued competing transactions instruments (e.g., small
denomination interest-bearing securities) for government currency to have value.‘.
Alternatively, the government
could define a
nominal unit of account through reserve requirements
on bank deposits. Requiring banks to hold some fraction of deposits as noninterest-bearing
creates a well-defined real demand for reserves. The
can control the nominal supply of
reserves and, as in the case of currency, produce a
well-defined unit of account. Under this system
nominal reserves are controlled and currency could
be issued passively (i.e., on demand).
Fama also indicates that a hybrid policy of controlling the sum of reserves and currency, but not
caring about their mix, is sufficient for defining a price
1 Wallace’s legal restrictions argument is somewhat severe.
Privately issued bearer notes would be consistent with price level
determinacy if the government auctioned off rights to print a
fiied value of notes and required a below-market yield on these

level. In New Zealand, none of the above policies
are followed. There are no reserve requirements and
currency is issued passively. What the Reserve Bank
of New Zealand does is control the quantity of the
transactions medium used to settle interbank balances
between banks in the New Zealand Bankers Association and between these banks and the Reserve Bank.
These settlement balances, referred to as cash, earn
6.5 percent of the seven-day Reserve Bank bill yield.2
The institutional structure of the interbank market
and the rules for settlement set by the Reserve Bank
generate a well-defined demand for cash. The
Reserve Bank controls the nominal quantity of cash
implying that the monetary system in New Zealand
obeys Fama’s necessary conditions for a determinate
price level. In the United States an analogous policy
would be controlling the supply of excess reserves.
The Operation of New Zealand’s
Monetary Policy
At the beginning of each new banking day the net
position of each bank from business conducted on
the previous day is calculated. Banks must then
settle among themselves and with the Reserve Bank.
There is a net flow of funds between the banking
system and the Reserve Bank because the Reserve
Bank serves as the government’s banker. Also, the
Reserve Bank does not permit overdrafts on settlement accounts. Any bank that has a net debit position must either borrow settlement cash from another
bank or rediscount Reserve Bank bills of less than
28:days to maturity. These bills are issued with a
maturity of 9 1 days and are the only instrument rediscounted by the Reserve Bank at a penalty of 150 percent above the market rate on seven-day certificates
of deposit. The discount rate penalty, therefore,
depends on the term to maturity of the bill. To avoid
these penalties, banks hold an inventory of cash as
well as an inventory of Reserve Bank bills. The rediscount feature of these bills implies that their supply
affects the liquidity of the banking system and that
their quantity, along with the quantity of exchange
settlement, directly influences the price level.
A crucial feature of the New Zealand system is the
uncertainty involving movements in the government’s
accounts. These movements must occasionally cause
the banking system as a whole to have a net debit
position with respect to the Reserve Bank. Banks
can borrow and lend cash to satisfy net interbank
* The policy of paying interest on cash would be analogous to
a policy of paying interest on excess reserves in the United States.


positions, implying that in the absence of stochastic
cash flows with the government, the banking system
as a whole need not hold cash. All settlement could
be done through credit arrangements. Negative cash
flows with the government require payment with
exchange settlement or the rediscounting of Reserve
Bank bills. Since rediscounting involves a penalty the
optimal response by the banking system is to hold
an inventory of cash for clearing purposes.
The primary instruments of monetary policy are,
therefore, the supply of cash and the supply of
Reserve Bank bills. The supply of cash is largely controlled through open market operations which are
conducted in an attempt to hit a specific cash target,
currently 30 million $NZ. Whether the end-of-day
cash balance equals the target will depend on how
well the Reserve Bank forecasts the net flow of
government transactions. The Reserve Bank cannot
afford to forecast or offset government flows too
exactly or there will never be a need for rediscounting by the banking system as a whole. Without
periodic rediscounting there would be no demand
for cash, since an inventory of cash is only held to
avoid rediscounting.
The Reserve Bank can also affect the demand for
cash through its second instrument, namely the
supply of Reserve Bank bills. These bills affect the
liquidity of the banking system. A decrease in their
supply would imply a greater likelihood that any
individual bank would not have a sufficient amount
of bills for rediscounting and would have to incur the
additional transactions costs of obtaining such bills
if the need should arise. Also, with a smaller supply
of bills, a bank caught short of cash would have to
rediscount bills of a greater average maturity, incurring a larger rediscount penalty. To avoid these added
penalties, banks increase their demand for cash. By
influencing the demand for cash the supply of
Reserve Bank bills affects the price level and serves
as an additional instrument of monetary policy.


The following model attempts to capture the
major aspects of monetary operations in New Zealand
and examines how these operations affect the price
level. The most important aspect is the precautionary
nature of the banking system’s demand for cash and
the role that unanticipated flows in the Crown’s
accounts have in generating that demand. Throughout it is assumed that there exists a perfectly competitive interbank market. In this respect the model

is similar to that of Poole (1968) and also is related
to much of the literature on the precautionary demand for money.
The major characteristic of the model is the
simple and direct way it relates nominal magnitudes
to Reserve Bank policy. The coSt of doing this requires the assumption that the real and monetary
sectors of the economy are exogenous. But this
assumption is to some extent justified by treating
New Zealand as a small open economy with perfectly
flexible prices and a flexible exchange rate. Under
such treatment, the real rate of interest and the real
exchange rate are taken parametrically and are
unaffected by domestic monetary policy. Also, for
simplicity, currency, being elastically supplied and
so having no essential effects on any other variables,
is omitted from the model. Adding a currency demand function would only serve to determine the
nominal supply of currency without affecting the main
channels through which monetary policy affects
nominal magnitudes.
The Real Economy
The real rate of interest, Pt, and the real exchange
rate, et (expressed as the number of world goods per
New Zealand good), are taken as given. Thus,

it = (1 +af)(l+Pt)


where it is the nominal rate of interest, ?rFis expected
inflation, et is the nominal exchange rate (the number
of New Zealand dollars per unit of world currency),
P; is the rest of the world’s price level, and Pt is the
price level in New Zealand.
The banking system is assumed to be competitive
and provides transactions accounts called demand
deposits to individuals. Funds flow between banks
for two reasons. One is that individuals transact
among themselves creating interbank flows. The net
of these flows for the banking system as a whole is
zero, and it is assumed that an interbank credit
market exists to handle short-term imbalances.
Individuals also transact with the government,
creating a net flow of funds between the banking
system and the Reserve Bank of New Zealand. The
Reserve Bank does not permit overdrafts requiring



banks to maintain a nonnegative balance of settlement funds at the end of the day. A bank that has
a net negative position with the Reserve Bank is required to pay a penalty by rediscounting Reserve
Bank bills at a penalty rate, rp. These bills are auctioned regularly by the Reserve Bank and constitute
the only rediscountable security it accepts. The
absence of overdraft privileges, plus the penalty on
rediscounting, creates a precautionary motive for
holding a settlement account at the Reserve Bank
and a corresponding motive for holding Reserve Bank
bills. In the presence of an interbank market it is the
net expenditure flows with the government, as well
as the rediscounting policy of the Reserve Bank, that
creates a well-defined precautionary demand for
exchange settlement funds or cash.
A simplified representation of a bank’s balance
sheet is depicted in Figure 1.




A representative bank supplies demand deposits D
at a constant marginal cost (Y and pays a nominal
interest rate of rD on the account. Banks hold at the
Reserve Bank cash or clearin balances C which yield
a below-market rate of r r!. They also purchase
Reserve Bank bills, RB, that yield a rate r and make
loans, L, that earn a risk-adjusted nominal interest
rate of i. A further assumption is that if a bank does
not have the necessary amount of Reserve Bank bills
for rediscounting, it must buy some in the market
and incur a proportional transactions cost of 4.
Further, since rediscounting is at a penalty rate, it
is easiest to think of each dollar of Reserve Bank bills
rediscounted as incurring a net proportional cost of
6. Because Reserve Bank bills have the added feature
of being rediscountable they will never trade at a rate
greater than i in equilibrium.
Before describing the simple model that depicts
the major features of a bank’s decision in this environment, it may be useful to highlight some of the
operating characteristics of the interbank model. In
doing so I focus on movements in the overnight
interbank interest rate that occur under various
realizations of stochastic cash flows between the
banking system and the government. First, when

cash is plentiful and all banks’ exchange settlement
accounts have a positive balance at the end of the
day, the interbank rate should equal the rate paid
on cash. If the interbank rate fell below the rate paid
on cash, a bank would find it profitable to borrow
cash and deposit it at the Reserve Bank. Also, from
the standpoint of the lending bank it would be
better to deposit the money at the Reserve Bank than
lend the cash at a lower rate. If the banking system
on the whole is short of cash, then the interbank rate
should rise to the level of the penalty rate on the
shortest available maturing Reserve Bank bil1.j If
the rate were to exceed the penalty rate, banks
could earn profits by rediscounting
a bill and
lending the cash. The interbank rate will, therefore,
be bounded by the rate paid on cash and the
penalty rate for rediscounting.
Given the Reserve Bank’s operating procedures,
banks will decide on an optimal level of both C and
RB. These levels will be based on the penalties
associated with rediscounting, the opportunity cost
of holding cash and Reserve Bank bills, transaction
costs, and the stochastic processes governing flows
between each bank and the government. I will discuss
in detail the simplest case in which there are no
interbank flows and where each bank realizes the
same stochastic cash flow with the government. In
this case a representative
bank can serve as a
stand-in for the banking system as a whole. I make
this simplifying assumption to concentrate on aggregate disturbances to the cash position of the banking system as a whole. It is these disturbances and
the resulting precautionary demand for cash that are
crucial for understanding nominal determinacy in
New_Zealand. In particular, let deposits held at a bank
be D = D +pg, where D is expected deposits,
p is the price level, and g is a mean zero random
variable with a density function f(g) that takes on
positive values over the interval [ -g, g]. Deposits
are decomposed into these two components because
banks in this model are only able to choose an
ex ante expected level of deposits. Actual deposits
will equal expected deposits plus any stochastic
deposit flows. A representative bank maximizes its
expected profits, Q, subject to the balance sheet constraint C +RB +L = D. Formally, a bank solves the
optimization problem seen in the accompanying box.
J Note the yield on Reserve Bank bills should not change
significantly for temporary cash shortages since their yield is
governed by intertemporal considerations. That is, their demand
is a function of expected future cash shortages as well.




(3) cm;;#L = (i+d+&
9 T,


-z p


(C +RB+pgN(gWg - 6 -6 p

(C +pg)f(g)dg



5 -C

(C +pgWdg

+ r

+ iL - (rD+cu)

(RB + C + pg)fWg




_ g (D + pg)f(&k

= D.

The first two terms in (3) represent the case where
there is a large transfer of funds to the government.
For such a large negative value of g the bank is short
of Reserve Bank bills. It must borrow and pay a
brokerage fee to obtain the bills and then rediscount
them at a proportional loss of 6.4 The expression
inside the first integral is, therefore, negative and
represents a cost. Furthermore, in this case the bank
must rediscount its entire stock of bills and this cost
is given by the second integral. When g is not so
negative as to force all of the bank’s bills to be rediscounted, the bank rediscounts a portion at a cost
6 (the third term) and earns r on the rest (the fourth
term). When the outflow of funds to the government
is not less than the bank’s inventory of cash (i.e.,
g > -C/P), the bank earns rc on its cash balances
and r on all its bills. This realization is given by the
fifth and sixth terms in (3). Finally, banks earn i on
loans and incur a cost of rD +a on each dollar
The first-order conditions
maximization are:




subject to C +RB +L


+ r


+ rc




+F( -“p

RB) + r[l-F(

= i[l-F(





(4 - dF( -’ pRB) + (r +6 -r’)F($$
+ rc = ill-F(

(4c) rD+c2 = i
Since banks produce deposits at a constant
marginal cost the equilibrium value of deposits will
be demand determined. The bank’s balance sheet
constraint can be used to calculate L once p, i, rD,
C, and RB are determined. Given i, rD is obtained
from (4~). Using (l), (4a), (4b), and the equilibrium

C = Cs,



for the bank’s profit

4 It is easiest to think of rediscounting as a collateralized loan
at the rate rp. In the area of the distribution where g <
( -C - RB)/P, the bank essentially must swap a loan or Treasury
bill for a Reserve Bank bill at a cost of 4 per dollar of transaction and then take out the equivalent of a penalty loan from
the Reserve Bank. The bank must also use its stock of Reserve
Bank bills to secure a penalty loan at a net cost of rp -r. Alternatively one could look upon rediscounting as involving a
proportional loss of 6 per dollar of bills rediscounted (i.e., 6 =
rp - r). In the case where a bank is out of cash and must borrow
Reserve Bank bills, the bank must first borrow the money (sell
off a loan at rate i) to get a Reserve Bank bill that earns r, pay
a proportional transactions cost $‘, and rediscount at rp earning
a proportional loss of 6. Thus 6 +i +$’ = rp +d~ in the paper.

where Cs and RBS are cash and Reserve Bank bills
supplied, one can calculate i, p, C, RB, and r.

The simple model of Section III is now used
to analyze the equilibrium determination of prices
and interest rates. One case involves the situation
where the supply of Reserve Bank bills is such
that, in equilibrium, (C +RB)/p 2 g. In this case
equation (4a) implies that r =i and (4b) implies



that (6 + r - r’)F($

) = i - rc. Here the supply of

Reserve Bank bills is so abundant that the marginal
bill supplies no liquidity services and hence the yield
on bills is driven to i. When that happens the price
level is directly proportional to C because a proportional change in cash and the price level still solves
equation (4b). Also if 4 = 0 then (4a) once again
implies r = i, and (4b) yields a solution in which prices
are proportional to cash. With no transaction costs
in acquiring Reserve Bank bills, Reserve Bank bills
and loans become perfect substitutes from an individual bank’s standpoint and hence bills provide no
added liquidity benefits. In these cases, marginal
changes in Reserve Bank bills have no effect on the
real demand for settlement cash. Hence the price
level is proportional to the supply of cash.
Since Reserve Bank bills typically yield less than
other financial instruments (i.e., r < i), one must
conclude that (C +RB)/p < g. For the simple model
with independently distributed flows among banks
this implies that at times banks may not have enough
Reserve Bank bills for rediscounting. The transaction cost $J could then be interpreted as an additional
penalty imposed by the Reserve Bank. In these
circumstances the price level would no longer be
directly proportional to cash since equations (4a) and
(4b) would no longer be satisfied if cash and the price
level were changed proportionately from their equilibrium values. These equations would still be
satisfied, however, if cash, Reserve Bank bills, and
prices changed proportionately. Hence the price level
is sensitive to the supply of Reserve Bank bills even
though these bills pay a competitive rate of interest.
The sensitivity of the price level to a financial
instrument paying a competitive rate occurs because
in this case the supply of Reserve Bank bills influences the real demand for settlement cash. With the
possibility that a bank may incur an additional cost
of 4, the real demand for cash decreases as the supply
of Reserve Bank bills is increased.
In reality, each bank does not hold enough cash
and Reserve Bank bills to cover all stochastic realizations of flows with the government. Yet the banking system as a whole does. This happens because
the flow of funds between banks and the government
is not independent across banks. Although removing the assumption of independence and analyzing
idiosyncratic as well as aggregate movements in cash
greatly complicates the analytics of the model, it
should not change the basic result that the price level
is a function of both the supply of cash and Reserve
Bank bills. Neglecting independence, one could think

of each bank receiving a stochastic cash flow composed of a common term g and an idiosyncratic term
u, where the sum of the idiosyncratic terms across
banks is zero and these terms take on values over
the interval [ -a, a]. Hence, any one bank could be
in the position of g < (C +RB)/p < g +u, in which
case the banking system as a whole would have
enough Reserve Bank bills but the individual bank
experiencing the large cash drain would have to purchase bills and incur the transaction cost 4. If the
penalty for being unable to cover stochastic outflows
through rediscounting were severe enough (say
closing the bank), then the first-order conditions
would guarantee that each bank would hold enough
liquid assets (C +RB) so that in equilibrium the
banking system would not be short of Reserve Bank
For example, with a banking system composed of
two identical banks A and B, bank A would invoke
the penalty of being closed down if

(CA+RBA)/P< Zg - " 'pRBB.
If the penalty of being closed is sufficiently negative, then the first-order conditions for bank A would
not be met unless the preceding inequality were
reversed. Since each bank is identical; the system
as a whole could meet its liquidity needs. However,
a solution with (CA +RBA)/~ < g +n is entirely
possible and r would be less than i as long as there
is a transaction cost for purchasing additional Reserve
Bank bills. Also, the price level would be sensitive
to the supply of bills.
One should also note that the first-order conditions
(4a) and (4b) depend on the form of the distribution
function F. The distribution of net cash flows between the Reserve Bank and the banking system is
also under the control of the Reserve Bank. Specifically, the Reserve Bank can to some extent control the variability of these flows and thus influence
the demand for cash. Hence different choices of F
can lead to different equilibrium outcomes. The
Reserve Bank can also choose rc and 6, and can
achieve the same equilibrium for a variety of choices
regarding F, rc, and 6. Different combinations of
these instruments will generally alter the overall tax
on the banking system associated with the Reserve
Bank’s monetary policy. For example, making cash
flows less variable would require costly additional
monitoring of government transactions. There are,
therefore, tradeoffs between costs to the banking
system and costs to the Reserve Bank in obtaining


any equilibrium price level (or price level path).
A quantitative assessment of these costs would be

While extending the model to incorporate some
stochastic dependence among banks may not qualitatively affect price level determination, it would provide a framework for examining fluctuations in the
interbank interest rate. Interbank lending is an ex
post decision with respect to cash flows and this rate
would be a function of given realizations of g. In a
setting where profits from cash management do not
affect economic activity, and where the price level
and other market rates are not influenced by these
unexpected flows, the interbank rate will vary with
realizations of g. When all banks are flush with cash,
the interbank rate, under a quantity target, should
fall to the rate paid on cash. When, on the other hand,
banks are rediscounting, the interbank rate should
rise to the rediscount rate. One could then investigate
how various institutional changes (e.g., with respect
to rediscounting) would affect the volatility of the
interbank interest rate.
One could also extend the analysis to consider a
banking system under imperfect competition. Comparing operating procedures that use an interest rate
instrument as opposed to a quantity target would have
different implications for bank behavior.

of efficiency loss. One part of the efficiency loss
arises because the monetary instrument must by
necessity earn less than the market determined
nominal rate. Holding this instrument, therefore,
incurs an opportunity cost [for a more detailed discussion of efficiency losses see Wallace (1983)].
While all central banks prohibit interest on currency, New Zealand’s system seems to impose a
smaller tax on its banking system than most other
monetary systems. There are no reserve requirements. Moreover, excess reserves, which constitute
a small fraction of bank assets, do earn some interest.
The full cost borne by New Zealand banks also
involves any interest differential between Treasury
bills and Reserve Bank bills as well as any costs
incurred through rediscounting. These costs still
appear relatively small so it may well be that New
Zealand’s monetary policy will be a precursor for
other central banks.

Fama, Eugene. “Banking in the Theory of Finance.” Journal of
Monetary Economics 6 uanuary 1980): 38-58.
“Financial Intermediation
and Price Level
Control.” Journal of Monetary Economics 12 (July 1983):
Frost, Peter A. “Banks’ Demand for Excess Reserves.”
Journal of Political Economy 79 (hrly/August 197 1): 805-25.
Grimes, Arthur. “Monetary Policy with Unregulated
Unpublished manuscript.


This article provides an analytical framework for
investigating the nominal implications of targeting
interbank balances in New Zealand. The institutional
structure of the interbank market is such that banks
demand clearing balances for precautionary reasons.
The Reserve Bank through its supply -of cash and
Reserve Bank bills is able to affect the price level
and nominal interest rates. Of particular interest is
the result that the supply of Reserve Bank bills influences the price level even though these bills pay
a competitive rate of interest. These bills do so
because they provide an additional form of liquidity
and, therefore, affect the demand for exchange
settlement funds.
Further, one observes that the Reserve Bank of
New Zealand conducts monetary policy through a
reserve instrument, namely exchange settlement
funds. Except in the case of an optimal deflation, the
operation of any monetary system that produces
nominal determinacy must do so through some sort


Patinkin, Don. “Financial Intermediaries
and the Logical
Structure of Monetary Theory.” American Economic Reviti
51 (March 1961): 95116.
Poole, William. “Commercial Bank Reserve Management in a
Stochastic Model: Implications for Monetary Policy.”
Journal of Finance 23 (Dec. 1968): 769-9 1.
Reserve Bank of New Zealand. The Basics of Liquidity Management.” Reseme Bank Bulletin 50 (1987): 197-202.
Sprenkle, C. M., and M. H. Miller. “The Precautionary
Demand for Narrow and Broad Money.” Economica 47
(Nov. 1980): 407-21.
Tsiang, S. C. “The Precautionary Demand for Money: An
Inventory Theoretical Analysis.” Jound of Pohicaibtmmy
77 Uan./Feb. 1969): 99-117.
Wallace, Neil. “A Legal Restriction Theory of the Demand
for ‘Money’ and the Role of Monetary Policy.” Federal
Reserve Bank of Minneapolis Quarterl Rewim (Winter
1983): l-7.
Whalen, Edward. “A Rationalization of the Precautionary
Demand for Cash.” Quartedy Journal of Economics
80 (May
1966): 314-24.





and Payments


An Introduction
Robert F. Graboyes

This articr’e is part of a series published by this Bank in the second edition of
Data: A User’s Guide. The book, schdu~edforpubCication in th
jkst quarter of 1992, contains intrvductions to important series of macroeconomic data,
inchding prices, employment, pmduction, and money. Th articles in the book are
desiped to he& the reader accuratetj interpret economic data and thwby
a&w the numbers to be usefii ana&ical took


International trade and payments statistics are
constantly discussed by journalists, businessmen,
unions, politicians, and academicians. Nationalism
has often made these data a source of emotion and
politics. A primary goal of Adam Smith and other
founders of modern economics, for example, was to
subdue’the ancient belief that a nation’s economic
strength could be measured solely by its volume of
gold imports.
Terms like trade deficit, protection, quotas, and
tariffs can raise red flags. The severity of the
Great Depression has been blamed on the SmootHawley tariff and retaliatory
greatly reduced world trade.’ Some historians view
tariffs passed by Northern states as a proximate
cause of the American Civil War. In our own time,
concerns about trade with Japan, Mexico, Europe,
and other countries rankbigh on the U.S. political
agenda. At the center of each controversy is the
interpretation or misinterpretation
of a set of trade
It is important to know that, by themselves, trade
data have no meaning-they
cannot speak for
themselves. Depending on what question is being
asked, the same trade deficit, for example, can be
viewed correctly by different observers as good, bad,
neutral, understated, overstated, or illusory. Imports
are frequently a source of policy concern. Sometimes these concerns are well reasoned: one can
rightfully be concerned about luxury good imports1 Barry Eichengreen [Th Pohical Economy of the &mot-Hawley
Tarif, NBER Working Paper Series #ZOO1 (1986)] examines
the literature on Smoot-Hawley and argues against the view that
the tariff was central to the depth of the Depression.


financed by debt to foreigners-which
arise because
of tax distortions. Sometimes these concerns are less
well-reasoned, as in the case where debt-financed
imports do not indicate economic weakness, but
rather indicate investment in a growing economy.
International transactions are controversial, and
they are crucial to the world economy. It is’impossible to understand an economy without understanding its relationship with the world around it,
and it is impossible to understand that relationship
without a knowledge of international financial data.
This article lists many weaknesses in international
data and offers many reasons to be skeptical of
analyses using them. These weaknesses are not
presented to warn the user away from international
data, but rather to suggest that the data be used with
eyes open to their frailties. A simple reading of
numbers often results in simplistic conclusions.
Used with care and understanding,
financial data are indispensable. The purpose of this
article is to give the reader a modicum of that
and to suggest further areas of
The article is organized



as follows:

Basic Definitions
Components of the Balance of Payments
Trade: Bilateral vs. Total and
Gross vs. Net
and Measuring
Problems in Defining Aggregates
Measurement Problems
Interpreting Trade Data.
Sources of Data and Other Information




Components of the Balance of Payments
The balance of payments accounts-of which trade
accounts are a part-are a compilation of international
transactions. Included in a country’s balance of
payments are, in principle, all movement of resources
across borders. Balance of payments accounts are
related to the National Income and Product Accounts
(NIPA),Z the system by which we calculate Gross
National Product (GNP) and other measures of
national productivity. Net exports, plus domestically earned income, yield GNP, for example.
The types of transactions that appear in the NIPA
do differ from the types that appear in the balance
of payments accounts. Notably, trade in second-hand
goods is excluded from the NIPA but not from the
balance of payments. A used car sold by a Virginian
to a North Carolinian does not appear in the NIPA
(though the commission on the sale would be included). The NIPA measure economic transactions
resulting in the addition of new final products to the
economy. Domestic transactions in the NIPA are
those which create things of economic value; the
value of a car is added to the accounts at the time
it is first sold. At the time of subsequent resale, the
only addition of value to the economy (new final
product) is the service provided by the car dealer and
represented by his commission. Balance of payments
accounts, in contrast, measure the movement of value
across borders rather than the m?ation of value. Thus,
if an American sells a used car to a Canadian, that
sale will appear in the balance of payments.
Merchandise trade, goods and services trade, the
current account, and the overall balance3 are all
aggregate measures of trade in resources, but their
definitions and interpretations are very different.
Table 1 shows some of the major accounts that comprise the balance of payments and shows how they
are aggregated into the current account and the capital
accounts which finance the current account.

2 For an introduction to these accounts, see Roy H. Webb, “The
National Income and Product Accounts” in Roy H. Webb, ed.,
Macmtmmmic Data: A User’s Guide, Richmond: Federal Reserve
Bank of Richmond, 1990. This article also appeared in the Richmond Fed’s Economic R&m
(May/June 1986).
3 For some purposes, the International Monetary Fund separates
international monetary flows from other capital flows. These
monetary flows are defined to consist mainly of movements of
central bank reserves and related habilities. The overall balance
is the sum of the current and capital accounts minus these
monetary flows.

,There are other ways to divide up the balance of
payments accounts. Sometimes the capital account
.is divided into short- and long-term
Sometimes the monetary portion of the capital account is itself divided into flows of gold, central bank
reserves, Special Drawing Rights (SDRs), and other
accounts. In general, the United States maintains its
balance of payments accounts in accord with the
International Monetary Fund’s procedures.
Trade: Bilateral vs. Total and Gross vs. Net
In discussing international trade and payments,
failure to distinguish among different definitions can
cause confusion and misunderstanding. Particularly
troublesome can be the distinctions between (1) bilateral vs. total accounts and (2) gross vs. net accounts. In most data sources, merchandise, service,
and income trade accounts are compiled on both
gross and net bases. In some data sources, unrequited
transfers and capital accounts are available only on
a net basis. While the discussion here uses the word
“trade,” the concepts are equally applicable to other
payments accounts.
Bilateral trade refers to trade between two regions
(a region can be an individual country or a group of
countries). Total trade refers to a country’s trade with
the rest of the world combined. Gross exports or imports constitute the quantity of resources flowing in
between two regions, while net exports
one &zchm
equal gross exports minus gross imports.
Gross BilateralExports and Imports: Table 2
shows the gross bilateral’ trade between three
United States, Japan, and Other Countries (all countries except the U.S. and Japan).
In Table 2, rows 1, 2, and 3 give each country’s
gross imports, and columns a, b, and c give gross
exports. For instance, the U.S. exported $45 billion
worth of goods to Japan while importing $97 billion
in goods from Japan.
Gross Total Exports and Imports: In Table 2,
adding columns a, b, and c gives each region’s total
imports (column d), while adding rows 1, 2, and 3
gives each region’s total exports (row 4). If there are
no data or measurement errors, total world exports
will always equal total world imports, since any goods
leaving one country will enter some other country.
As later sections will indicate, though, there are
always measurement problems.
Total Net Exports: Total net exports are
defined as the total gross exports minus total gross





Balance of Payments Components
United States, 1989

of dollars)

- 114.87


Merchandise (goods): manufactures,



Services: insurance,



Income: interest,

- 95.28







Goods, Services 81 Income


Private Transfers: private

- 13.43


Official Transfers: unrequited government

- 14.76




Portfolio Investment: asset purchase
(e.g., bonds)

- 16.79


Other Capital: investments


firm) where


aid payments

not classified

Reserve and Other Monetary


‘where little managerial


gains substantial

is gained

as direct or portfolio

Errors & Omissions: balancing item to reconcile
current and capital accounts



Current Account Balance
Direct Investment: asset (e.g.,
managerial control


gifts, wage remittances,

Unrequited Transfers





- 1.33

- 110.04


the overall balance

and the sum of


Capital Account Balance

* Reserve and other monetary flows appear in IMF statistics as the Overall Balance. In published statistics, the sign is reversed-in
this case, the Overall Balance
would appear as + 16.79 instead of - 16.79. An explanation is that the sign here indicates an “import”
of money; 16.79 in net monetary reserves are flowing
into the United States. We do not normally think, however, of importing or exporting money. We think of importing and exporting current items and capital,
using money as the payment medium. Thus, by convention, the Overall Balance is listed as + 16.79 to indicate that the U.S. was a net exporter of total current
items and capital.
July 1991. This table is described in the adjacent text. Note that the figure for net exports (- 114.87)
inconsistent with the net exports in Table 2 (- 130). The principal reawn for this discrepancy is that Directions
of Trade Statistics values,imports
on a c.i.f.
basis, while International
Financial Statistics values imports on an f.o.b. basis. (See discussion of f.o.b. and c.i.f. below.)

impqrts. Table 2, row 6 shows total net exports for
each region. If a country’s net exports are positive,
then that country is exporting more than it is importing. Negative net exports means that the coun.
try 1s importing more than it is exporting. Assuming
no measurement errors, the sum of all regions’ net
exports will equal zero.
Bilateral Net Exports: Finally, bilateral net
kxports can be calculated from the data in Table 2.
For example, Japa&s net exports to thi: United States
would equal $52 billion ($97 billion -4845 billion),
and U.S. net exports to Japan would equal -$52

Table 1 defines a numbei of international accounts
which together comprise the balance of payments.
At first glance, the divisions, between different

classes of cross-border transactions seem self-evident.
Exporting a piece of fruit is merchandise trade.
Buying legal advice from an overseas firm is a service import. Investing in foreign bonds is portfolio
investment. The lines, though, are not as clear as
these examples would suggest.
We can define two broad classes of problems in
compiling statistics. First, even with complete information on each and every transaction, simply defining the lines between different aggregates would
be a chore. Second, complete information on every
transaction does not exist, so there are errors,
sometimes large, in measurement. In the text that
follows, a set of hypothetical
aggregated into balance of payments statistics, as
shown in Table 3.
For example, in the first row of the top portion
of Table 3, an exporter in the U.S. sends wheat to
a purchaser in some other country and, in exchange,



Gross Bilateral

Table 3


of U.S.







Other Countries



(see adjacent
















Gross Total Exports





Gross Total Imports






Gross Net Total Exports







row 4=row


row 5=column
row 6=row



illegal drugs

U.S. Balance of Payments Accounts


from transactions



1989 data adapted from the IMF’s Directions
of Trade Statistics
yearbook. This table is described in the adjacent text and is used
to illuminate
the mathematical
between the gross
accounts. In order to make exports equal imports (for illustrative
purposes), the numbers here ignore measurement
errors present in
the actual data.

the importer issues to the exporter a liability whose
value is equal to that of the wheat. Importantly, the
rows represent transactions between disparate individuals, firms, and governments, with the paper trails
(if any) widely dispersed. In the bottom portion of
Table 3, the sale of wheat shows up in U.S. merchandise exports and the corresponding trade credit
shows up in other capital.


1 private transfer
1 h 1 bonds issued by factory
1 j 1 tin
1 I 1 gold ingots
1 n 1 property rental
1 p 1 automobiles
1 r 1 cash

1 steel ingots




1 trade credit


1 automobiles
1 stock issued by factory

Mathematical Relationships


hotel room

[g 1 bank deposits



Rest of the World to U.S.

[ e 1 wages remitted
[ i



to Rest of World

[al wheat
1 c 1 tourist’s


Balance of Payments Transactions




& Total Trade Accounts



[al through [rl above





Private Transfers








Other Capital





Goods and Services


Goods, Services & Income


Current Account Balance
Capital Account Balance

(a + i + o + q-j - p1+ c - n - f

Overall Balance


It is expensive to collect and sort data, so resources
should be spent on the most useful information.
Collecting enough information to sort merchandise
trade by color, for instance, would cost a great deal
and would not seem a sensible use of resources-it
is difficult to think of anyone who would find this
information useful. Thus this information is not collected. There are potentially useful distinctions which
are not collected, though, because the usefulness is
still not viewed as worth the costs. In deciding what
data will be collected, it must also be remembered
that the mere act of collecting and classifying data
implies that the classification is economically meaningful. It is easy, for instance, to take for granted
that the distinction between current and capital
transactions is clear and economically significant; for
some purposes, that is an overstatement.

The top portion of this table lists hypothetical individual transactions, each
consisting of two movements
of resources of equal value. The bottom
portion shows the resulting balance of payments accounts. In the adjacent
text, this table is used to illustrate measurement and classification problems.
As explained in Table 1, the sign is reversed for the Overall Balance.

A current account deficit is viewed by some as
collective profligacy,4 while a current account surplus
is taken to mean saving for a rainy day (Section III
explains why this view may be erroneous). On the
basis of such views, governments sometimes enact
policies, such as trade or capital controls, to influence
4 For an article taking this view, see Benjamin M. Friedman,
“Implications of the U.S. Net Capital Inflow,” in R.W. Hafer,
ed., How @en Is the U.S. Economy?, Lexington, Massachusetts:
Lexington Books, 1986.



the current and capital accounts. A current account
deficit, though, may be illusory-resulting
less from
economic realities than from the means of defining
and measuring current and capital transactions.

lower monetary receipts, even if everyone involved
had considered the gold to be money. (It should be
noted that since 1973, gold has for the most part
ceased being a means of international settlement.)

Problems in Defining Aggregates

Defining Countries: International
data are
critically dependent on where national boundaries are
drawn. Changes in the amount of trade over time
will be affected by changes in boundaries. For instance, the trade statistics for the Federal Republic
of Germany might be expected to drop because of
that country’s recent reunification. The reason is that
transactions between West Germany and East Germany used to count as international trade, but are
now counted as domestic transactions. Similarly, the
independence of the Baltic States should increase
measured international trade; transactions between
the Baltics and other Soviet republics were previously considered domestic transactions, but now
enter world trade statistics. The changes, though,
do not necessarily represent any changes in any
individual’s economic activity or well-being.

This section gives some conceptual problems
encountered in classifying international transactions.
In the paragraphs below, the transactions found in
the top portion of Table 3 are aggregated into the
balance of payments accounts in the lower portion
of the table.
Consumption vs. Investment: Distinguishing
between consumption and investment purchases is
difficult in international trade, as it is in all national
income accounting. Consider automobiles and tin in
[i] and fi]. Both are treated here as merchandise trade
(current account transactions), thus implying that they
are consumption goods. Autos, however, are co~~mer
or-producer durabh,
meaning they are part capital
good, yielding services over time. A company which
imports an automobile for business use over the next
five years is investing as surely as is the purchaser
of the factory stock in [k] . Similarly, tin is a storable
commodity and can be purchased either to use next
week (consumption) or to store for the next ten years
(investment). Classifying durable goods as current
account items can thus imply a lower rate of investment than is true in an economically meaningful
sense, since the capital portion of the good never
shows up in the capital account.
Merchandise vs. Money-Gold
and Silver:
The gold ingots sold to the U.S. in Table 3 (11
appear in the capital accounts as reserve flows,
implying that gold is money. Gold, though, can also
be a form of nonmonetary capital or a merchandise
good (say, for a jeweler). The United Nations classification system distinguishes between monetary and
nonmonetary gold. It assumes that gold received by
a central bank is money, and gold received by anyone
else-even commercial banks-is not money. While
this is an imperfect way to divide the data, the U.N.
system views this as closer to the truth than classifying all gold as money or all as merchandise. This
convention also implies that a more accurate classification system is viewed as not worth the expense.
In Table 3, the fact that gold appears as a monetary
flow indicates that it was received by the central bank
of the U.S.-the Federal Reserve. Had the gold been
received by a commercial bank, the U.S. accounts
would have shown higher merchandise imports and

Customs unions can cause world trade to be
These organizations are -collections
of countries which have eliminated or limited their
trade barriers with each other-the
Community is an example. Sometimes, customs
unions will cease collecting statistics on trade between member countries and only report trade between the union and countries outside the union.
When this happens, measured international trade
drops because the customs union hides the intraunion trade. Note that Table 1 understates the
amount of world trade by hiding all trade between
“Other Countries.”
Goods Destined for Embassies or Military
Bases: The wheat shipped in transaction [a] is a
merchandise export because the shipment of grain
reduces the material resources found in the U.S. If,
however, the grain were sent to a U.S. embassy
abroad, then this line would not appear in the trade
statistics. Thus, a shipment to an American in a hotel
in Paris would appear as an export, while a shipment
to an American at the U.S. embassy down the street
is treated as a domestic sale. In principle, shipments of military resources across borders should be
included in balance of payments statistics, but they
are sometimes omitted for security reasons.
Ships and Aircraft: In transaction b], tin, a
material resource, is transported to the United States
in the hold of a ship, which is also a material resource.
The movement of the ship itself is not counted as


an export to the U.S. because the ship will only reside
temporarily in the U.S., and we do not wish temporary resource movements to be counted as trade.
Ships and airplanes move frequently between countries in this manner, but sometimes they do move
permanently from one country to another, or they
change their national ownership or flag of registration. By convention, the sale of a new ship or airplane
across national boundaries is counted as merchandise trade. The sale of old vessels is omitted from
some trade data (e.g., United Nations data), even
though such a sale might constitute a real (and enormous) movement of resources. This is because the
ownership of ships and airplanes is highly complex,
and it is difficult to define and measure international
trade of such vessels. IMF statistics include such
sales, though there are serious measurement problems involved.
Pass-Through Trade: Suppose that in transaction [p], a U.S. importer buys cars from Germany
and then plans to sell them next week to a buyer
in Mexico. Then, [p] would generally not be considered an import, but rather would be counted
as a temporary import destined for re-export and
dropped from U.S. trade figures. If this were not so,
then the automobile transaction would be counted
twice, thus overstating the volume of world trade.
Some de facto temporary imports are counted as if
they were permanent due to the form of their legal
Tourist Effects: Suppose the tourist in transaction [c] takes his car on his trip. If he goes for a
week and then brings the car back, then the car will
not appear in the trade statistics because this relocation is, again, regarded as temporary. If the car were
to remain abroad for ten years, that would constitute
a merchandise export, offset by a private transfer.
A line between permanent and temporary must be
drawn, usually at one year, but that line is arbitrary.
Ownership vs. Location: In general, concerns
about imports revolve around the question “Are we
buying too much from foreigners?” The way international trade is measured makes it difficult to
even know how much a country buys from foreigners.
Until recent decades, capital mobility was quite
limited by today’s standards. By and large, factories
in Germany were owned by Germans, firms in the
U.S. were owned by Americans, and so forth. Today, capital is highly fluid, but our trade statistics can
obscure that fact. Suppose Acme-USA buys equipment from American-owned Apex-Germany or from
Acme’s wholly-owned subsidiary Acme-Germany.

The trade accounts treat these transactions as imports, even though no foreigners are involved.
Similarly, if Acme-Germany
sells widgets to a
German distributor, this is treated (in the merchandise trade accounts) as a wholly German transaction,
despite the fact that Germans are buying goods from
It should be noted that this last transaction
would not be a problem in the current account, as
opposed to the merchandise trade account. AcmeGermany’s profit on the sale to a German distributor
would either be paid to the American parent company as a dividend or would be kept on AcmeGermany’s books as retained earnings. Either way,
the income would show up as a credit item in the
income account of America’s balance of payments.
Our accounting conventions record trade on the
basis of place of origin, rather than nationality of
ownership. In the past, the two were usually the
same, so the distinction made little difference.
Nowadays, the country of production is a poor guide
to nationality of ownership. An alternative accounting system would define trade by owner&> rather
than by location. Under such a system, a shipment
to an American factory overseas would be treated as
a domestic transaction, just as shipments to embassies
are already treated. According to Th Economist
(“Tricks of the trade,” 3/3 l/9 1, p. 6 l), this change
in accounting procedures would change America’s
1986 merchandise trade balance from a $144 billion
deficit into a $57 billion surplus. If the question
being asked is how much American firms are selling
to foreigners, then trade ought to be defined by
ownership. If, alternatively, the question is where
jobs will be found, then perhaps trade ought to be
defined by location, since Acme-Germany is likely
to be staffed by German workers instead of American
Measurement Problems
Even if all conceptual problems in defining trade
data could be resolved, measuring the data would
still be difficult. Unlike the hypothetical example in
Table 3, there is in actuality no complete record of
individual transactions. Much information is confidential or simply not recorded, so aggregate estimates
must be made; there are statistical sampling problems; some data are intentionally distorted by those
involved; price, quantity, and exchange rate data
often come from different sources, and reconciling
them is a challenge. In other words, trade data are
developed by splicing together bits and pieces of
inaccurate, incomplete, inconsistent information. Any



such aggregation requires judgment and any such
judgment will, at times, cause problems. Again
using Table 3, some problems can be illustrated.
Timing of Prices, Exchange Rates, and
Quantities: A major problem in measuring the
value of trade is that our information on quantities
and prices often comes from separate sources. In
blending these different data sources, timing is
often critically important. Suppose we are estimating
the dollar value of tin purchases represented in
Table 3, transaction b]. Estimating this figure
may require that the numbers and calculations in
Table 4 be used. Here, a foreign exporter sells tin
to the U.S. for a foreign currency (here called francs),
and we wish to know the dollar value of those sales.

from customs forms which list both quantity and price
information. Such indexation problems, though,
become much more severe in services and capital
accounts, where data collection relies on surveys and,
to a large extent, voluntary compliance. The sort of
problem shown in Table 4 is also more common in
poorer countries, where data collection is less
complete, where the collection process is poorly
financed, and where documentation is less reliable.

Exchange rate data are readily available on a daily
or even more frequent basis, and the same is true
for prices of many goods-especially
Information on physical quantities of goods sold,
though, is often reported only for longer periods of
time. In Table 4, it is assumed that quantity information is available on a quarterly basis, while price
and exchange rate information are available on a
monthly basis. As is explained in the table, the result
is that the hypothetical country’s export earnings are
greatly overestimated.

Other Timing Differences: In Table 3, item
[o] is the sale of steel ingots. This sale, though,
could show up in a number of different time periods,
depending on the methods of accounting and data
collection. The movement of ingots could end up
being counted when the sale was made, when the
steel was loaded onto a ship in the U.S., when
the steel was unloaded overseas, when the steel
reached the buyer, when the customs documents
reached the data collection agency, when the data
collection agency sifted through its in-box, and so
forth. A change in procedures, for example, could
result in items [o] and [pj-which are the two sides
of the same transaction-showing
up in different
years, thus distorting the merchandise trade balance
and capital account. Timing problems’may wash out
in the long run, but for some purposes, the data may
remain permanently distorted.

This sort of indexation problem is less severe for
merchandise trade in a country like the U.S., where
statistical collection procedures have been developed
and refined over time. Trade data are mostly gathered

Index Number Problems: Aggregating data
lets us make more important observations. Trade
data begins as millions of individual bits of data on
narrow ranges of transactions, and the usefulness of

Table 4


Quarterly Tin Exports










10 (total)





40 (total)





Tin Price (in francs)

(in francs)


Rate (francs/$)

(in dollars)


10 = 40/4

3 Months


8 (average)




10 (total)

40 =8x10/2

In this table, a hypothetical
country exports tin,, priced in francs, and paid for in dollars. Price information
is available on a monthly basis, but quantity
IS only available on a quarterly basrs. In this three-month
period, total trade is actually 40 francs, or 10 dollars. However, the data only say
that 10 units of the tin were sold, and it is not specified whether the tin was sold in January, February, or March. In this situation, total value of sales
could be estimated
by multiplying
the average quarterly price (8 francs) by the total units sold (10 umts). Using this method, total sales appear to be
80 francs-twice
the actual amount.
When the world moved to floating exchange rates in the early 1970s
a further complication
was added. Here, the exchange rate moved from 1 franc per
dollar to 4 francs per dollar. To estimate the dollar value of tin sold, divide the estimated total franc value (80 francs) by the period average exchange rate
(2 dollars per franc), yielding estimated total dollars sales of 40 dollars-four
times the actual amount.



these individual data is limited. Data on aggregate
merchandise trade is more important than data on
trade in Swiss cheese or vacation packages (unless
you deal in Swiss cheese or vacation packages).
Aggregating data, though, introduces judgment and
ambiguity into measurement.
In the case of a single good-say,
a standard gold
can unambiguously separate changes in
price from changes in quantity. Suppose in one year,
10 coins are sold at $100 apiece ($1,000 in total),
and in the second year, 15 are sold at $80 apiece
($1,200 in total). S everal unambiguous observations
can be made: The trade value went up by $200; the
trade volume went up by 5 coins; and the trade price
went down by $20.
Suppose, though, that data on two goods-say,
melons and grapes-are
being aggregated, with the
intention of calculating the change in trade volume
and trade price. First of all, measuring change in
aggregate volume requires that statistical weights be
applied to the separate volumes of melons and grapes.
Individual fruits could serve as the unit: then, a
decrease of one melon and an increase of two grapes
would be considered an increase in fruit trade. For
most purposes, this choice of weights seems unsatisfactory. Statistical weights could be based on physical
weight or on physical volume so that the one-melon
decrease would outweigh the two-grape increase;
these weights might also yield unsatisfactory results,
Usually statistical weights are based on the WZLWS
of the goods in some base year; to measure changes
in aggregate trade volume, ask how the aggregate
value of goods would change if the prices of all
goods remained the same but quantities changed.
Similarly, changes in price per unit of aggregate trade
is measured by asking how much aggregate value
would change if quantities purchased of each good
remained the same but prices changed. The problem
is that by choosing different base years, the same data
can indicate falling or rising volumes and pricesthere is no means of aggregating dissimilar data that
precisely answers every possible question.5
Accounting Methods and Valuation: The
value of cross-border flows is generally assumed to
5 See Roy H. Webb, Macn~~onomicData: A User’s GurZe, Federal
Reserve Bank of Richmond, 1990, p. 5 (Introduction) for a
discussion of indexing problems. Fuller explanations of indexation problems can be found in any elementary textbook under
Laspeyres Index or Paasche Index or a variety of other indexes.

be the price paid when the title to the resource
changes. Some items, though, have no readily
verifiable market price-services
and capital are
especially vulnerable to these problems. In highly
developed market economies, merchandise trade data
are of good quality, and price and quantity data come
from the same source. In other countries, though,
records may be less complete or consistent. Some
data will report the value of an item-say,
stock in
a factory-according
to its historical price-the price
originally paid for it. Another method would value
the factory according to its current replacement cost.
Often, these valuation methods will differ greatly from
the market value-the
price that would actually be
paid in a current transaction for that item. Such
valuation problems become especially acute in the
case of barter (counter-trade), such as in Table 3,
items [o] and [p], where no monetary price is expressed on either side of the transaction.
Trade barriers (e.g., quotas and tariffs) can make
the value of trade ambiguous. Suppose an importer
pays $1,000 for an item, but the exporter only
receives $500, with the rest going to tariffs. The
value of merchandise trade might appear in one
account at one price and in another account at the
other price. This is because the inclusion or exclusion of taxes from the recorded price is in some
cases a matter of discretion. In principle, the accounting treatment of taxes should be consistent in
all countries. In practice, however, different countries apply different rules so that equivalent transactions will appear differently in the statistics.
Lightly Monitored Borders: Cross-border
trade is not uniformly monitored. Some countries
have free-trade zones whose attraction to business
is that international trade through the zone is
monitored lightly or not at all. Some countries
are lax in monitoring cross-border trade in certain
geographic areas or in specific industries. For
example, customs officials may choose not to monitor
livestock movements across inland borders, either
because monitoring would be too expensive or
because de facto immunity from customs laws may
be a political favor to those involved in the trade.
Services: Sale of services across borders is
particularly difficult to estimate, since there are no
customs agents monitoring them. Tracking, say,
banking and legal services between countries
demands cooperation by those involved. Much
information is derived from surveys, which are
subject to a variety of statistical problems such as
sampling error.



False Invoicingin Response to Taxes: Taxes
and customs on international transactions provide
an incentive to overstate or understate various
transactions. Referring again to Table 3, suppose
that the United States were to place a high tax
on the purchase of foreign bonds [h] while not
taxing the rental of foreign property [n]. In response,
a U.S. entity might purchase bonds and rent property
from the same overseas entity, and then understate
the sale price of the bonds and overstate the cost
of the property rental. The effect would be to
overstate the current account and understate the
capital account.
Illegal Trade: Individuals do not routinely
report illegal activities to their governments, so the
sale of illegal drugs [q] will not likely show up as a
merchandise import or as part of current account
debit items. The likely result is that the illegal drugs
will be mistakenly included in “Other Capital” or in
“Errors and Omissions,” the balancing item used to
reconcile discrepancies between the accounts.6
Foreign Exchange Black Market: In Table 4,
the dollar value of purchases was miscalculated
because the quarterly average exchange rate was not
equal to the actual exchange rate used in the transaction. Similarly, the dollar value of a transaction can
be misjudged when foreign currency is purchased not
at the official (or legal) exchange rate, but rather at
an illegal black market rate.
Inconsistentand InadequateAccounting: In
Table 1, U.S. exports to Japan were said to total
around $45 billion, based on U.S. estimates. In the
same data source, Japan reported importing over $48
billion from the U.S. in 1989. Such discrepancies
in reporting are the norm. Sometimes the discrepancies can be huge relative to total trade. When such
conflicts arise, the user of data is forced to rely
on judgment in deciding which numbers to use.
Finally, measurement of trade between countries can
be difficult because different countries use different
accounting systems. Some are lax in accounting.
Some lack the resources to measure trade adequately.
Some, for political or other reasons, do not wish to
measure trade accurately.
6 A great deal of unrecorded transactions can be explained not
by smuggling of goods, but rather by illegal or unseen capital
flows. According to the Wall Strze~ Journal (“U.S. Statistics on
‘90 Capital Inflow Are Off to the Tune of $73 Billion,” S/24/9 1,
p. AZ), unrecorded capital inflows into the U.S. appear to be
the largest factor in the statistical discrepancies in the balance
of payments accounts.

Other Definitional Ambiguities
Below are some additional ambiguities found in
trade definitions. Comparisons
can be severely
distorted if inconsistently formulated data are used
F.O.B. vs. C.I.F.:
Merchandise imports and
exports are defined either f.o.b. (free on board) or
c.i.f. (cost, insurance, and freight) terms. Trade on
f.o.b. basis equals the value of the goods only. Trade
on c.i.f. basis includes the value of the goods plus
the cost of transporting the goods from the country
of export to the country of import. Exports are almost
always measured f.o.b. Imports are usually measured
c.i.f., but some countries measure them f.o.b. In the
latter case, the shipping costs appear as service trade
instead of goods trade.
Services vs. Services & Income: Some data
sources group services and income together as sergoods being
vices or “invisibles” (merchandise
“visibles”). The International Monetary Fund and the
U.S. Department
of Commerce
have recently
adopted the convention of separating services and
Current Account and Official Transfers:
Some sources consider official transfers to be part
of the capital account rather than part of the current
Terms of Trade: A country’s terms of trade is
the ratio of a price index of the country’s exports to
a price index of its imports. The measured terms of
trade, though, can differ greatly, depending on which
goods are included in the measure, on the means of
aggregating the prices of those goods, and on the base
year chosen. (See the discussion above of index
number problems.)



The above sections have suggested that an
observer must use great care in interpreting trade
data, which are highly susceptible to problems of
definition, measurement, and aggregation. They do
not give us a perfect picture of resource movements,
and the economic significance of resource movements
themselves can be highly subjective. Following are
a few examples of how data are frequently interpreted
and problems with those interpretations.
Total Merchandise Trade: Properly measured, a U.S. merchandise trade deficit means that


in terms of value, more goods are leaving the U.S.
than are arriving. For a shipping company planning
its routing, that may be a meaningful piece of information. For public policymakers, however, a deficit
may be less significant than is often assumed.
Deficits on merchandise trade are often presented
as boding ill for a national economy.’ To be sure,
a trade deficit might well be a sign of faltering
commodity or manufactured goods sector. Alternatively, the deficit may just as easily indicate that a
large share of the country’s individuals have found
it more advantageous to produce services than goods.
The mercantilist idea that a merchandise trade deficit
is bad per se is akin to the argument that it is
inherently better for an individual to work in farming or manufacturing than in banking, sales, or
Bilateral Merchandise Trade: The same
arguments described above for total merchandise
trade hold here, but with an added caveat. Even if
one has reason to believe that a total trade deficit
is bad, there is no reason to believe that bilateral trade
accounts should be balanced. It is possible for Country A to run a $100 million deficit with Country B,
Country B to run a $100 million deficit with Country C, and Country C to run a $100 million deficit
with Country A. All three countries have balanced
total trade, despite their bilateral deficits and
For a better understanding of the patterns of world
trade, the reader can look in any macroeconomics
or international trade textbook for explanations of the
economic principles of comparative advantage and
gains from specialization. These principles are
generally thought to explain much of the flow of
7 Benjamin Friedman, op. cit., for instance, describes growing
U.S. merchandise trade and current account deficits as “deterioration” (p. 138) and describes the international imbalance as “the
outstanding failing of U.S. macroeconomic performance in the
1980s” (p. 137).
In contrast, Th Economist (“For whom
813 1191, p. 16) warns that

the gloom tolls,”

commentators should . . . mind their tongues when it comes
to trade. America’s trade balance is said to “improve” as
its deficit shrinks, Germany’s to “deteriorate” as its surplus
disappears. Yet a trade surplus is a misleading measure of a
country’s economic strength, or a deficit of its weakness.
Barring further information, it is neutral . . . . The idea that
surpluses are good and deficits bad comes from the nasty
mercaniilist view that exports are good and imports are

bad: yet the only reason to export is to enable your consumers to buy luwerly imports.

Current Account: A current account deficit
equals the domestic investment minus domestic
savings. This allows a country to spend more today
than it is earning today by borrowing from abroad.
For this reason, overseas borrowing is often taken
to mean “living beyond one’s means.” There are
many reasons, though, that a country might reasonably run a current account deficit. A current account
deficit may mean that, collectively, the country is
borrowing abroad to finance productive investment,
with presumed gains for the country and its trading
partners in the end. This is analogous to starting a
business with borrowed capital, and paying back the
loan in later years to the advantage of both the
businessman and the bank. It often makes sense for
a developing country to borrow in this way, though
the borrowing must finance productive investments
and not, say, luxury consumption goods. Some would
argue that the U.S. was justified in running large
current account deficits during the 1980s; the
Economic Report of the Prm’dmt (1989, p. 106) said
the following:
Trade and current account deficits represent important channels through which an economy can acquire
the resources needed to take advantage of profitable
investment opportunities. They can also represent
consumption out of previous saving. Trade deficits
can arise when an economy’s households and fiims
react to distorted incentives to consume today by
borrowing from abroad at the expense of future
generations. Whether the trade deficits of the 1980s
signal promise or trouble for the current and future
well-being of the United States is an important and
difficult question.

Valuation of Overseas Investments: Thus
far, this article has discussed flows of resources between countries-the
balance of payments. In all of
the above examples, some good or service or claim
on future income has been shifted from an entity in
one country to an entity in another. This section
introduces stock adjustments-changes
in one country’s claims (net overseas investment position) on

that arise not because

any resource

or claim

has moved across borders, but rather because the
price of some cross-border obligation has changed.
Purchase of overseas assets by domestic residents
(a capital account debit item) minus the purchase of
domestic assets by foreign residents (a capital account
credit item) is often assumed
to be a measure of

changes in a country’s overseas investments.


is a poor measure



of a country’s

only at transactions



ignores the

changes in values of investments. An individual would
not properly evaluate his personal wealth by adding
together what he has paid over the years for stocks
and bonds. Rather, he ought to sum up the current
market value of those investments. Ideally, a country ought to value its overseas investment position
according to the current market values of those
investments. Practically, though, such valuation is
often difficult.
If the value of an American-owned company in
Spain doubles, the American owner’s claim on
Spanish resources doubles, though no change of
title has occurred. An American who owns bonds of
a failed Australian company has lost his future claims
on Australian resources, even though the American
still holds a piece of paper promising future payment.
In other words, the balance of payments is like a corporate income statement, while the net investment
position is like a corporate balance sheet.
of capital gains in the balance of
payments and net investment accounts deserves
mention. First is the treatment of unrealized gains
resulting from exchange rate changes. For example,
suppose an American buys a German bond worth
1,000 marks, and the mark then strengthens against
the dollar (so a mark buys more dollars than before).
Now, the American has a paper gain, since the
1,OOO-mark bond is worth more in dollars, but until
the bond is sold, it is only a paper (or unrealized)
gain-the German bond issuer has notpaidanything
to the American bondholder.
Previously, such
unrealized gains were counted in the balance of
payments as income. Now, however, unrealized gains
are excluded from the balance of payments and
only appear as valuation changes in the investment
On the other hand, the treatment is different for
retained earnings of foreign subsidiaries. If a French
subsidiary earns a profit and pays its American parent
a dividend, that clearly appears as an income credit
item in the balance of payments. If the subsidiary
earns the profits and then retains those earnings (i.e.,
pays no dividend to the parent), convention still treats
that as an income credit.
The statement that the United States has become
the “world’s largest debtor” has gained frequency.*
This assertion may, in fact, be attributable to a
systematic undervaluation of U.S. assets abroad and
8 BenjaminFriedman, op. cit. argues this case.

overvaluation (or smaller undervaluation) of foreign
assets in the U.S., particularly with regards to direct
investment. An account of the U.S. Commerce
Department’s attempt to remedy these valuation problems can be found in SZHV~ of Current Business (May
1991, p. 40). Another piece of evidence indicates
that the value of U.S. investment abroad continues
to exceed the value of foreign investment in the U.S.:
according to Znterzationai financial Statistics (August
1991, p. 554), U.S. income on foreign assets has
exceeded foreign income on U.S. assets in every year
over the period 1984-90 (all the years covered in that


Numerous organizations provide data on international transactions. Below are some of the major
providers of data and analytical publications on
international trade and finance. Included are the
names of some specific publications, with subject
matter in parentheses. Many of these agencies also
sell data in electronic form.
International Monetary Fund: Publications
include Znt,,tionaiFStatihcs
(all aspects of
international and domestic finance) plus yearbooks
and topical supplements, Ba/ume of PaF&s Stititi,
Direction of Trade Statistics (distribution by partner
countries and by areas of countries’ exports and imports). The Balance of Payments Manual explains in
great detail the methodologies for measuring and interpreting international transactions. In addition, the
IMF publishes numerous studies and documents on
special topics. Articles in Finance and Development
include, information on developing country data.
World Bank (International Bank for
Reconstruction and Development): The World
Bank publishes firld Debt Tables (external debt of
developing countries, aggregate net resource flows
and net transfers) and many topical reports.
Organization for Economic Cooperation and
Development: OECD provides numerous printed,
microfiche, and electronic data publications. Among
these are Monthly Statistics of Foreign Trade, Foreign
Trade by Cornmod&, Financial Market TGVU& OECD
Financial Statistics, Main Science and Technology Zndicatorx (trade in technology),
and Qaaflerrly 02
Statistics and Energy BaLances.


United Nations:
U.N. publications include
the Intemationa~ Trade Stat&h Yearbook, Szat&caZ
Yearbook&r ASM and tke Pa@,
&r Latin America and tke Caribbean, Agrinccture,
Emma1 Tra& and International Cooperation, Fom&
Trade Stat&tics of Asia and tire Pa@,
Handbook of
IntematimaI Tra& and Devehpnmt Stat&is, and the
UNCTAD Commodiry Yearbook.



For the United



Federal Reseme Bu’letin includes data on U.S. inter-

national transactions, U.S. foreign trade, and assets
and liabilities of Americans to foreigners and
foreigners to Americans. Central bank publications
in other countries provide similar data.
National Fiscal Agencies:
The U.S. Tmasury
includes data on international financial
holdings, capital movements, and foreign currency.
Other countries’ treasuries or finance ministries
release similar data.

and Foreign
monitors U.S. foreign trade. The Department’s
Bureau of Economic Analysis publishes the &rvey
of Cumnt Bushss, which includes data on U.S. international trade and finance. Other countries’ foreign
trade ministries publish similar documents. The
Bureau has recently published a book--Tire Balance
of Payments of tke United State: Gnmpts, Data Soums,
and Estimating Prvcedums-detailing
the Bureau’s
For a better understanding of international trade data, textbooks can be indispensable.
One such book is Leland B. Yeager’s Intemationa/
Monetary ReMons: Thq,
Hhtvry, and Pohiy (Harper
& Row).