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H i Econom i c
frfli Review
FEDERAL RESERVE BANK OF ATLANTA
MAY/JUNE 1991
Investigating U.S. Government and
Trade Deficits
Some Evidence on the
Impact of Quasi-Fixed Inputs on
Bank Scale Economy Estimates
FYI: The Interest Rate
Sensitivity of Stock Prices
Book Review
International Trade and Finance
Reference Sources
Economic
Review
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VOLUME 76, NO. 3, MAY/JUNE 1991, ECONOMIC REVIEW
J
Investigating U.S. Government and
Trade Deficits
Ellis W. Tallman and Jeffrey A. Rosensweig
*1 2
Some Evidence on the
Impact of Quasi-Fixed Inputs on
Bank Scale Estimates
William C. Hunter and Stephen G. Timme
2 2
F.Y.I.
The authors look at models and evidence concerning the link between the U.S. government
and trade deficits and discuss their own research,
which is consistent with a "twin deficits" notion.
Taking into account the quasi-fixed nature of
some bank inputs could improve the statistical
accuracy of bank cost function estimates, the
authors find.
The Interest Rate Sensitivity of Stock Prices
David W. Stowe
Book Review
J e r r y J . Donovan
International Trade and
Reference
Sources
Finance
Investigating U.S. Government and
Trade Deficits
Ellis W. Tallman and Jeffrey A. Rosensweig
During much of the past decade both the U.S. government and trade deficits grew dramatically, prompting empirical studies to determine whether there is a relationship between the two. Tallman and Rosensweig review casual evidence and economic models supporting the "twin deficits" notion and introduce alternative models that
cast doubt on a causal link. Noting that the way researchers have used deficit data in their empirical work
influences results, Tallman and Rosensweig conduct statistical tests to determine the appropriate
form—either
levels or variables measured as changes from the previous period—for representing the data. Using a technique
that accounts for dynamic interaction among variables, the authors examine deficit data in levels form, as ratios ofGNP. Their findings suggest a causal relationship between government debt and the trade deficit, indicating that fiscal policy could play an important role in balancing U.S. trade accounts.
he 1980s witnessed record-sized deficits
of more than $150 billion on both the
U.S. government and trade accounts. The
development of these deficits during approximately the same time span prompted frequent
allusions to them in business, policy-making, and
academic circles as "twin deficits."
T
For much of the decade, trade imbalances and
government budget deficits were major news topics
in the business press (see John Greenwald 1984,
Mike McNamee et al. 1988, and "Some of My Best
Friends Are Deficits" 1990). The media put forward
an image of the United States as a debtor nation,
borrowing domestically and internationally to support extravagant spending behavior by the government as well as the private economy. Meanwhile,
the issue of growing debt, both the government's
and the nation's as a whole, also became central in
policy debates as numerous analysts questioned the
long-term viability of economic progress with a
growing external debt. With the change in status of
the United States from net foreign creditor to debtor
nation, policymakers and economists face the challenge of dealing with a possible decline in living
standards.
By 1983 a casual explanation directly linking
the two mushrooming deficits—the twin deficits
story—was gaining wide exposure. 1 The notion
suggests that the two series' large movements in
the same direction occurred because of an underlying interrelationship. A combination of existing
theory on international economics and what appeared to be compelling empirical facts observed
FEDERAI. RESERVE BANK O F ATLANTA
primarily in the United States during the 1980s
gave rise to the idea. The validity of the hypothesized relationship between these two deficits is a
crucial issue as the United States faces ongoing
massive fiscal deficits into the 1990s and the foreseeable future.
Following a presentation of some of the visual evidence that prompted the twin deficits explanation,
this article includes a more rigorous examination of
existing theory and of scholarly investigation into the
linkages between government and trade deficits. It
concludes with a discussion of how the authors'
original research contributes to this academic and
policy debate.
Origins of the Twin Deficits Idea
Briefly, the twin deficit story as it pertains to a
flexible exchange rate regime (it will be treated more
fully in a later section) claims that an increased government deficit places incipient upward pressure on
real, or inflation-adjusted, interest rates, attracting
foreign capital in search of these higher returns. This
increased flow of capital into the United States
prompts the real exchange rate to appreciate, raising
The authors are, respectively, an economist in the macropolicy section of the Atlanta Fed's research department and
an assistant professor at the Emory Business School at
Emory University.
1
the dollar's foreign exchange value. In turn, the
higher exchange rate inhibits exporting by making
U.S. products costlier abroad. A higher-valued dollar
also results in relatively less expensive—and therefore more attractive—imported goods. Falling exports and rising imports eventually move the trade
balance toward deficit. 2
hypothesized relationship between them. The two
data series—net foreign investment balance and total
government budget balance—both moved dramatically into deficit during the 1980s; the government
balance turned radically into unprecedented deficits
(in nominal magnitudes) prior to similar movements
in the trade measure. 3
The striking aspect of Chart 1 is the apparently extreme magnitude of both deficit measures during the
1980s. However, because these deficits are measured
in level terms in current face-value or nominal dollars, observed associations between these deficit
magnitudes may not be based on a structural interrelationship between the data series.
The twin deficits hypothesis is one possible explanation of the comovements portrayed in data
such as that shown in Charts 1 and 2. However,
such an informal method of inference does not provide sufficient evidence of a fundamental underlying
relationship. Further cursory analysis, performing
straightforward statistical analysis (standard correlation techniques) on these two deficit series to explore basic relationships among the data, reveals that
the two series have positive correlation contemporaneously, with correlation coefficients of approximately 0.7 in level terms and 0 . 3 4 in ratios to
nominal GNP (see Table 1). These findings suggest
that the variables move together to some extent over
time, consistent with the comovement displayed in
Charts 1 and 2.
Many macroeconomic series tend to grow over
time b e c a u s e of inflation as well as e c o n o m i c
growth. Therefore, economists often scale or normalize nominal dollar totals by dividing them by a
nation's nominal gross national product (GNP).
Taking each deficit series as a ratio to nominal GNP
accounts for economic growth and removes any inflationary bias from using nominal magnitudes, allowing clear focus on the s p e c i f i c relationship
between the deficits. Most of the study uses deficit
measures scaled as a ratio to GNP.
Chart 1 shows the gross facts regarding the two
deficits, facts that underlie the initial appeal of the
Billions of Dollars
Chart 1
Total Government Budget Balance and Net Foreign Investment
in Current Dollars
Net Foreign Investment
-120
Nominal Government Budget Balance
-150 -
-180
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
Source: All charts and tables were calculated by the authors using data from the National Income and Produce Accounts
(NIPA), U.S. Department of Commerce, Bureau of Economic Analysis.
2
ECONOMIC REVIEW, MAY/JUNE 1991
Does the apparent relationship of the two deficits
remain after adjusting them for GNP? Chart 2 plots
the two measures as ratios to GNP; the fiscal and
trade deficits still appear to be related, although the
similarities in movement are less striking. What is
noteworthy, however, is the lengthy duration of substantial deficit in the 1980s that the two series have
in common. 4
Consistent with Chart 1, Chart 2 shows that the
government budget balance ratio to GNP turns
sharply into deficit immediately before the similar
downturn in the trade balance ratio (to GNP) during
the early 1980s. This empirical observation likely enhanced the popularity of the twin deficit explanation
for the conjunction of record-sized deficits. The explanation not only refers to a relationship between
the deficits but suggests a causal impact running
from the government to the trade deficit.
To investigate the possibility of lead-lag relationships, cross-correlation techniques, which measure
the linkage of one variable's movement with that of
another a number of periods before or after observation of the initial variable, have been used. Table 1
presents the cross-correlations for various quarterly
lags and leads spanning twelve periods in either di-
rection. The table indicates large positive correlations
of movements in trade and those in the government
budget deficit several quarters earlier the largest correlations exist roughly at the point when the government deficit measure is lagged seven quarters relative
to the trade deficit: 0.87 for deficits measured as
nominal levels and 0.72 for deficits as ratios to nominal GNP. To compare movements in the government
balance with succeeding movements in trade, Chart 3
shows the government deficit ratio lagged seven
quarters in relation to the trade deficit ratio.
As expected, given the pattern found in the crosscorrelations, Chart 3 shows an even stronger relationship between the two deficit series than Charts 1
and 2 indicate. However, like the visual and statistical evidence presented earlier, this information is still
only casual evidence that increased government
deficits may lead to larger trade deficits.
Theoretical Support
In addition to the suggestive casual evidence, there
are theoretical frameworks that support the existence
Chart 2
Total Government Budget Balance and Net Foreign Investment
Relative to Nominal G N P
Percent
2
Foreign Investment/GNP
1
0
-1
- 2
-3
-4
-5
Government Budget Balance/GNP
- 6
-7
1970
1972
1974
Digitized FEDERAI.
for FRASER
RESERVE BANK O F ATLANTA
1976
1978
1980
1982
I
l
1984
1986
1988
1990
3
Sp+Sg=I+NFI,
Table 1
Correlations and Cross-Correlations of
U.S. Government Deficits
and Trade Deficits
where Sp is private savings, S is government savings
(total government budget balance), / is private domestic investment, and AfFJ is the nation's net foreign
investment. The additive inverse of NFI is net foreign
borrowing, which in this research is considered a
theoretically pleasing broad measure of the trade
deficit. Thus, net foreign borrowing (-NFI) is used
as the trade deficit measure, TDEF. Employing the
additive inverse of government savings
) as the
government deficit ( G D E F ) , the following relationship suggests the twin deficits relationship:
Cross-Correlations of Trade Deficits
with Quarterly Leads (-) and Lags of Government
Deficits*
Lead/Lag
Levels
Ratios
-12
-11
-10
-9
-8
-7
-6
-5
-4.
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
11
12
.161
.202
.255
.313
.346
.375
.424
.488
.529
.558
.611
.662
.698
.707
.756
.815
.832
.837
.854
.867
.844
.813
.794
.776
.731
.067
.079
.083
.093
.092
.092
.109
.168
.210
.245
.270
.306
.339
.389
.458
.559
.608
.662
.685
.724
.709
.690
.660
.648
.582
* Cross-correlations
relations.
at 0 are contemporaneous
TDEF = GDEF + (I-Sp).
A model of international economics proposed by
Robert Mundell and J. Marcus Fleming in the early
1960s provides one theoretical perspective that may
help justify the twin deficits notion. In a world of
capital mobility and flexible e x c h a n g e rates, the
Mundell-Fleming model predicts that increased government budget deficits put incipient upward pressure on domestic interest rates, inducing capital
inflows that lift the foreign exchange value of the
dollar. After a time lag, the higher value o f the dollar
retards exports and stimulates imports.
cor-
(1)
This identity can be disaggregated into a familiar
form:
4
(3)
The identity above provides a useful framework for
analyzing the proposed twin deficits relationship.
While the framework does not indicate any behavioral or temporal relationships, it predicts that any
government deficit increase not offset by changes in
the private-sector savings/investment balance will
affect the trade deficit. The trade deficit may not respond if private savings changes to offset government deficit movements. T h e crucial question is
whether or not government deficit changes are fully
offset by private savings responses.
of a twin deficits relationship. Combined, these two
factors have provided ample motivation for further
inquiry into the validity of a twin deficit notion,
which has been the focus of recent academic research.
The frequently hypothesized relationship between
the two deficits is often buttressed by the presence
of both deficits in a variant of the core savings/investment identity from the National Income and
Product Accounts (NIPA):
Gross National Savings =
Gross Investment by the Nation.
(2)
According to the Mundell-Fleming model, a positive relationship exists between government deficits
and trade deficits because, it is assumed, people implicitly perceive government bonds issued to finance
deficit expenditures as increasing their net wealth.
Thus, they do not see a need to increase their current private savings to cover future tax liabilities arising from the deficit financing.
Recent theoretical work concerning government
fiscal policy suggests that private savings behavior
may change in the presence of increased budget
deficits. Robert J. Barro (1974) reintroduced a concept, referred to as Ricardian equivalence (in ack n o w l e d g e m e n t of the c o n t r i b u t i o n by David
Ricardo), suggesting that people recognize that financing tax cuts by bonds merely alters the time
profile of taxation. In this view, rational people re-
ECONOMIC REVIEW, MAY/JIJNE 1991
alize that a tax cut financed by bonds does not increase their net wealth: while current taxes are reduced, future tax liabilities, in "present value"
terms, increase by the same amount. As a result, a
tax cut resulting in a government budget deficit
may induce rational individuals to save an additional portion of their income. 5 The Ricardian equivalence proposition suggests that the net private
savings term in the savings/investment identity increases to offset government deficit movements. If
Ricardian equivalence holds, then private savings
rather than the trade deficit (net foreign borrowing)
finances the increased government deficit. There is
no anticipation of a twin deficits linkage in this
framework. 6
The implications of the Mundell-Fleming approach contrast clearly with those of Ricardian
equivalence in regard to the relevance and validity
of a twin deficits relationship. Among the numerous
theoretical approaches to open-economy macroeconomics, these two were selected as frameworks for
interpreting the empirical analysis because of their
prominence in the discipline and their sharply contrasting conclusions.
Research Findings
Recent economic research has produced a substantial body of empirical literature employing rigorous econometric estimation techniques to test the
validity of the twin deficits hypothesis. Nonetheless,
the current body of evidence does not yield a consensus on the relationship between government and
trade deficits. Some studies using a Mundell-Fleming
framework indicate that the twin deficit notion is
consistent with the data. In contrast, other studies,
finding no underlying relationship between government and trade deficits, are consistent with the predictions of Ricardian equivalence.
How did the empirical work lead to such diametrically opposed conclusions? The following summaries of selected, representative empirical studies
include some possible explanations for such varying
results and implications. Clearly, certain issues are of
primary importance—for example, the choice of appropriate data series and data samples (periods) for
examination. These and other important issues are
emphasized in the following discussion of existing
Chart 3
Government Budget Balance (with Seven Lags) and Net Foreign Investment
Relative to Nominal G N P
Percent
2
Net Foreign Investment/GNP
Budget Balance/GNP
-7
1970
1972
1974
FEDERAI. RESERVE BANK O F ATLANTA
1976
1978
1980
1982
1984
1986
1988
1990
5
empirical research into whether the twin deficits notion fits the evidence.
Stephen M. Miller and Frank S. Russek's (1989)
empirical work is concentrated on two subperiods of
post-World War II U.S. data—one subsample associated with the fixed exchange rate period (1946:Q1 to
1971 :Q2) and the other generated during years of
flexible exchange rates (1971 :Q3 to 1987:Q2). The
researchers use measures of the trade and government deficits in nominal levels as well as in ratios to
nominal GNP. Only in the flexible exchange rate period do their results support the twin deficit notion
for both deficit levels and deficit ratios. Thus, Miller
and Russek present evidence suggesting a causal impact of government deficits on trade deficits during
the floating rate era.
Despite rigor and attention to detail in their study,
Miller and Russek, using bivariate analysis of two
deficit measures, do not address the interrelationships between government and trade deficits and
other relevant explanatory variables. The observed
relationship between the two deficit measures does
not necessarily reflect an underlying twin deficits
structure because one or more other variables may
explain the apparent comovements in both series. 8
Research into the twin deficits story requires explicit
examination of the entire set of variables that may
relate meaningfully to trade and government deficits
behavior. A number of other studies estimate relationships between a selection of additional variables
that appear relevant for the twin deficits story.
B. Douglas Bernheim (1988), using annual data
from the Organisation for Economic Cooperation and
Development for the United States and several of its
major trading partners, investigates the possibility that
fiscal deficits lead to trade deficits.9 The data sample
spans the period from I960 to 1984, and the estimations employ broad measures of the deficits relative
to the relevant nominal gross domestic product
(GDP) measures for each country. Bernheim explicitly estimates a regression in which the government
deficit affects the trade deficit, but not the reverse, an
assumption that restricts his specification.
The effect of budget deficits on trade deficits is
likely to be less in the presence of unemployed resources, according to Bernheim. 10 He argues that in
weakened economic conditions it is possible for additional government expenditures or a tax cut—both
of which may increase the fiscal deficit—to increase
private income and private savings, thereby minimizing the effects of the increased government deficit
on the trade deficit. To account for business-cycle effects, Bernheim uses the current as well as last period's growth rate in GDP. The estimation results for
the United States suggest that the fiscal deficit does
6
significantly affect the trade deficit. Evidence for the
trading partners—except for Japan, where no relationship appears to exist—is also consistent with the
twin deficits story.
While it provides some evidence for the existence
of a twin deficits relationship across nations, the
Bernheim study is limited by the absence of additional potentially important variables, namely the real
exchange rate and the real interest rate. Because
they are not included as explanatory variables in
Bernheim's estimations, some aspects of a twin
deficit investigation remain unresolved.
Another criticism of earlier studies, aside from excluding important variables from the estimations, is
that there is no explicit theoretical structure generating the empirical models for estimation. Rather,
those previous studies are centered on a proposed
relationship suggested by the Mundell-Fleming
framework. The lack of a formal structure as a foundation for the empirical work leaves researchers with
few hypotheses that can be rejected.
Recent research by Paul Evans (1989) uses an abstract model economy in which people (agents)
make decisions rationally and over a lifetime horizon; his model and theoretical framework provide a
more rigorous structure for empirical estimation than
has been seen in prior research. Primarily, the model
generates a testable hypothesis about the relationship between fiscal deficits and trade deficits—
specifically, that in a world incorporating a Ricardian •
view of taxes and deficits no clear relationship between the deficits should be observed.
Evans (1989) estimates an empirical model that is
specified in first-difference form (variables measured
as changes from the previous period) and that includes a real (inflation-adjusted) interest rate, real
government spending, and real government debt as
explanatory variables. 11 The empirical results using
data from Canada, France, West Germany, Italy,
Japan, the United Kingdom, and the United States
suggest that Ricardian equivalence is a reasonable
abstraction in the real world.
While Evans's study is more rigorous than earlier
work, it is open to criticism on certain empirical
grounds that may hinder interpreting the results. For
the purposes of this discussion the most relevant
criticisms are that there is no variable to account for
the effect of real exchange rate variability and that
the estimations employ data measures in first difference form. Evans estimates the model in first differences because his theoretical model specifies data in
that form. Recently, much empirical literature has focused on testing statistically to determine whether
data are more appropriately modeled in levels than
in first differences. The issue becomes most relevant
ECONOMIC REVIEW, MAY/JIJNE 1991
when results achieved by using first-differenced data
have implications different from those of tests involving data specified in levels. In Evans's case the use
of first-differenced data is simply intrinsic to the
model, but, as discussed below, the question of
whether it is more appropriate to model in levels or
in differences can be addressed explicitly and prior
to estimation of an empirical model, as in Jeffrey A.
Rosensweig and Ellis W. Tallman (1991). The topic is
addressed more fully in the next section.
Walter Enders and Bong-Soo Lee (1990) follow
Evans in modeling more rigorously the economic behavior underlying the observed relationship between
the trade and government deficits. 12 Using quarterly
data on the United States from 1947:Q3 to 1987:Q1
for real consumption, real government spending, real
public debt, real interest rates, the external current
account, and the exchange rate, the researchers apply an estimation methodology known as vector autoregression (VAR). Through techniques that account
for dynamic interaction a m o n g variables, the
methodology allows estimation of relationships without imposing very restrictive assumptions on the
specification. Essentially, a VAR specifies that each
variable in a system or model is determined by its
own lagged values (an autoregression) and the
lagged values of all other variables in the system.
Despite what appears to be an important effect of
the changes in the real public debt on the current
account, the model suggests no direct relationship.
An explicit test of the Ricardian equivalence proposition with the data cannot reject the hypothesis that
budget deficits do not affect the current account.
The criticism of Enders and Lee's (1990) research
is similar to that lodged against Evans (1989). First,
the estimates are performed on data specified in first
differences. The specification in first differences is
only a criticism if statistics suggest that such a transformation is inappropriate for the data. However,
Enders and Lee do not provide statistical evidence to
support the first difference transformation. An additional shortcoming is that, although the nominal exchange rate is among the explanatory variables
included in Enders and Lee's work, their measure of
this variable exhibits no movement for the fixed exchange rate period from 1947:Q3 until 1973.
The Appropriateness of FirstDifferenced Data
One vein of recent empirical literature focuses on
statistical tests that examine whether data are more
appropriate for model estimation in first differences
FEDERAI. RESERVE BANK O F ATLANTA
or in level form. Statistical techniques are used to determine whether data are stationary in levels—that is,
whether the data series' statistical properties, such as
means and variances, do not change over time. That
quality is an important one to identify because nonstationary data employed in estimation techniques
produce statistics that should not be analyzed in the
same way as those generated from stationary data. In
many cases, estimations using nonstationary data series produce results that lead to incorrect statistical
inferences.
Clearly, the answer to the question of whether data used in an examination of twin deficits should be
in levels or in first differences is more pertinent if estimation results using first-differenced data lead to
inferences that are different from those drawn from
data in level form. Among the empirical studies surveyed above, those that support the twin deficits notion tend to have either deficit levels or deficit ratios
to GNP as the main variables under study. On the
other hand, researchers who found no twin deficits
relationship were more often investigating data transformed into first differences. 13 These patterns suggest that the particular data transformation does
significantly color the results of inquiry into the twin
deficits phenomenon; the choice of data transformation influences whether evidence supports or contradicts the twin deficits story.
T h e research discussed b e l o w , detailed in
Rosensweig and Tallman (1991), explicitly considers
which is the appropriate form (levels or differences)
for representing the data in estimation. Statistical
tests guide the choice of data transformation.
Additional Evidence
Rosensweig and Tallman (1991) examine the empirical relationship between the U.S. government
and trade deficits using a data set that includes a real
interest rate measure as well as a real exchange rate
measure. The additional variables capture common
movements in trade and government deficits that
result from these two variables. Like Enders and
Lee (1990) and John D. Abell (1990), Rosensweig
and Tallman employ vector autoregression methodo l o g y . 1 4 Additional evidence presented b e l o w
concerning support for the twin deficits story corroborates the results in Rosensweig and Tallman.
The research focuses on the idea that movements in
the government deficit have a causal impact on the
trade deficit.
The data set employed consists of quarterly observations on the variable measures listed above from
7
the period of flexible exchange rates, 1971 to 19B9The trade and government deficit variables are measured as ratios to GNP to account for growth and
inflation, as discussed above.
Despite contrasting evidence from typical DickeyFuller tests for stationarity, the Rosensweig and Tallman ( 1 9 9 1 ) study shows that there is statistical
support for estimating the VAR in level form rather
than as differences. 15 Hence, in the research reported here, levels of the four variables (with the deficit
series as ratios to GNP) in a VAR with eight lagged
quarterly values of each series have been used. 1 6
Each part of the investigation takes place within the
paradigm of VAR, employing the set of four variables described above.
According to the twin deficits notion, movements
in the government deficit precede similar changes in
the trade deficit, implying that past government
deficits would explain a substantial portion of the
movements in subsequent trade deficits. This assertion is tested using VAR, which is well suited for
such inquiries, by determining whether the statistical evidence supports the hypothesis that the other
variables are unaffected by past movements in the
government deficit.1 If the statistics suggest that the
movements in other variables are not affected by
past movements in the government deficit, the implication would be that the government deficit
movements do not precede the movements in the
other variables.
T h e estimated statistics imply rejection of the
proposed hypothesis at conventional significance
levels, as shown in Table 2, indicating that the government deficit has an important explanatory role
and appears to precede statistically the movements
in the trade deficit. The implications of these statistics are consistent with evidence from the simpler
single-equation estimations also presented in Table 2,
where the F-statistics show that GDEF is important
for explaining TDEF movements.
For completeness, the importance of lagged values of TDEF on the remaining system of variables is
examined by testing statistically for whether the
model's other variables respond to trade deficit (as
ratio to GNP) movements. The twin deficits story
suggests that past movements of the trade deficit
should show no impact upon subsequent movements of the other variables.
If the statistical evidence suggests that past trade
deficits do have substantial effects on the other variables' subsequent values, then the inferences from
the finding that government deficit movements precede trade deficit changes is weakened. Instead, the
indication would be that the trade and government
deficit variables each affect the other. In formal
8
Table 2
Block-Exogeneity Tests and
Single-Equation Block F-Tests
Tests of the Multivariate Hypothesis
GDEF (ratio to GNP) lags are unimportant
to the VAR system
X2 (24) = 41.75
Critical Value 36.415 at 5 percent significance level.
Reject the null hypothesis. GDEF lags are important
to the VAR system.
TDEF (ratio to GNP) lags are unimportant
to the VAR system
X2 (24) = 27.94
Critical Value 36.415 at 5 percent significance level.
Cannot reject the null hypothesis that TDEF lags are
unimportant for the VAR system.
Single-Equation Block F-Tests*
Variable
F-Statistic on 8 lags
Significance
Level
Dependent Variable - GDEF
GDEF
REALI
REALEX
TDEF
8.34
.66
1.32
.84
.00
.72
.26
.57
t
Dependent Variable - REALI
GDEF
REALI
REALEX
TDEF
2.08
4.71
.42
1.98
.07
, .00
.90
.08
Dependent Variable - REALEX
GDEF
REALI
REALEX
TDEF
1.73
2.22
15.77
1.70
.13
.05
.00
.13
Dependent Variable - TDEF
GDEF
REALI
REALEX
TDEF
3.06
1.07
.97
4.98
.01
.40
.47
.00
* REALI indicates real interest rates; REALEX
cates real exchange rates.
indi-
ECONOMIC REVIEW, MAY/JIJNE 1991
frameworks that lend theoretical underpinnings to the
notion. However, other frameworks, stemming from
a Barro-Ricardian theory, are less supportive of the
possibility that there is a truly causal linkage between
the deficits. The crucial nature of large and persistent
deficits in the U.S. government budget and external
accounts, the seemingly compelling evidence of their
coincidence during the 1980s, and the uncertainty
arising from theoretical alternatives about their potential causal linkage have stimulated intensive empirical
scrutiny of the twin deficit notion's validity.
terms, if the statistics imply rejection of the hypothesis that lagged values of the trade deficit have no impact on the other variables, then the statistics would
suggest bidirectional causality.
The statistics generated from the test on the trade
deficit measure suggest that past trade deficits do not
affect subsequent movements in other variables. 18
Results from tests of the single-equation restrictions
(tested by F-statistics and presented in Table 2) coincide with those of the multivariate test. Overall, the
evidence suggests that trade deficits have little effect
on the subsequent behavior of the system's variables. Both the statistical evidence presented above
and the findings of Rosensweig and Tallman's (1991)
empirical work point toward the existence of a twin
deficit relationship in U.S. data. 19
Conclusion
The movement of both the U.S. fiscal and external trade accounts into substantial, persistent coinciding deficits has b e c o m e an often noted or
bemoaned phenomenon. This joint, precipitous
slide into deficits during the 1980s, combined with
an apparent temporal relationship whereby fiscal
changes precede trade balance movements, led to
the development of a popular "twin deficits" story.
This explanation has relied on casual evidence to assert a fausal influence of the government deficit on
subsequent trade deficits.
The notable gross facts of dual deficit expansion
underlying the widely popular twin deficit hypothesis
has been further backed up by certain economic
The evidence from a range of detailed studies has
been mixed or inconclusive. Those starting from a
Ricardian framework (such as Evans 1989 and Enders and Lee 1990) find Ricardian results; that is,
they find little support for a clear link between the
two deficits. However, many of these studies that fail
to support the twin deficits idea use particular data
transformations (first differences). In contrast, other
studies (for example, Bernheim 1988 and Miller and
Russek 1989) present evidence in favor of a twin
deficit explanation.
The original research reported here was based on
an extensive data set and a relatively unrestricted
vector autoregression methodology. Further, the
deficits data were examined in levels form (as ratios
of GNP). This crucial choice of data transformation—
versus first differences—was motivated by tests for
stationarity of the data. The results provide clear evidence favoring the validity of a twin deficits notion. 20
Clearly, if, as the evidence suggests, government
deficits lead or influence subsequent trade deficits,
then fiscal policy could well have an important role
to play in any attempt to bring the U.S. trade accounts toward balance.
Notes
1. See, for example, Feldstein (1983), Laney (1986), and
Volcker (1984).
2. Feldstein (1983), Laney (1986), and Volcker (1984) are
useful references for the story.
3. The two data series are net foreign borrowing (additive
inverse of net foreign investment), a broad measure of
the trade deficit, denoted as TDEF. and the total government deficit (additive inverse of government balance) as the government deficit series, denoted as
GDEF. These series are examined on a quarterly basis
for the period 1971 :Q1 to 1989:Q4, from essentially the
beginning of the flexible exchange rate regime under
which the large trade and government deficits of the
1980s developed.
4. In ratio form, the government deficit reached 6 percent
of nominal GNP in 1975 during the deep recession in
1974-75. in 1982 the deficit-to-GNP ratio approached 5
FEDERAI. RESERVE BANK O F ATLANTA
percent again during a recessionary period, then remained in the 3 percent to 4 percent range throughout
the recovery and expansion years as well. Government
budget deficits are likely during recessions because, as
incomes shrink, tax revenues decline and government
outlays for unemployment compensation and the like
rise. These "automatic stabilizers" increase the government deficit in ways that may have little to do with the
trade deficit and its movements. This recessionary phenomenon is likely to appear again during 1991.
5. In a simple economic model, the Ricardian equivalence
proposition predicts that agents will save the tax cut so
that the interest proceeds will cover increased tax liabilities in the future.
6. The Ricardian view does not imply that a twin deficit
phenomenon cannot be observed in data. The proposition suggests, though, that there are no behavioral or
9
structural underpinnings to the observation of twin
deficits. The main empirical difficulty in distinguishing
between Mundell-Fleming and Ricardian implications is
that if government deficit movements are correlated
with changes in government spending behavior, the
twin deficits may appear to be consistent with MundellFleming and also to behave consistently with a Ricardian view. This situation, referred to as observational
equivalence, may arise because of the Ricardian view
that government spending behavior affects private consumption decisions by reducing the amount of output
available for private consumption. Government choice
of financing method—debt versus taxes—does not alter the amount of output available for private consumption and therefore does not affect perceived
wealth.
7. The researchers present empirical evidence about
whether the government deficit "Granger causes" the
trade deficit. Granger causality is a statistical notion
that innovations in one variable precede innovations in
another variable. The inferences drawn from Granger
causality tests can be controversial. However, the statistical evidence is consistent with the theoretical implications presented in the Miller and Russek article.
8. Darrat (1988) finds bidirectional Granger causality between the government deficit and the trade deficit in
estimates that use an assortment of additional explanatory variables. Also, he estimates the relationship using
one data sample that mixes data generated during both
the fixed and flexible exchange rate regimes.
9- The countries he studies are Canada, Japan, Mexico,
West Germany, the United Kingdom, and the United
States.
10. This point relates to the argument above that businesscycle downturns affect the government budget deficit
in ways that probably do not influence the trade
deficit.
11. The model includes the real government spending variable because the theory suggests that government
spending rather than the method of financing government spending affects private consumption decisions
(see note 5). Also, Evans (1989) discusses measurement
error in the existing current account data that fails to
account for the increased market value of U.S. investment abroad. For more detail on this issue see Dewald
and Ulan (1990).
12. Abell (1990) estimates a VAR system with several relevant explanatory variables. Using first-differenced data,
he finds little support for the government deficit as a
primary explanatory variable for the trade deficit measure. The results suggest the absence of the causal underpinnings of the twin deficit story. It is notable that
the data sample—monthly observations from 1979 to
1985—presents only a limited picture of the historical
behavior of the two deficits and the related variables.
13- It is also important to note that Evans (1989) and Enders and Lee (1990) employ government spending variables and measures of the real public debt rather than
only measures of the fiscal deficit, as in the previous
studies. The model implications suggest the relevance
of the government spending measures for the estimates.
14. Runkle (1987) criticizes the use of VAR techniques
without providing some mechanism to infer statistical
significance of the results. Rosensweig and Tallman
(1991) provide confidence intervals for the relevant statistical output.
15. Rosensweig and Tallman (1991) employ Monte Carlo
integration techniques to estimate a Bayesian posterior
probability for the stationarity of the data in level form.
Results suggest that the model should be specified in
levels.
16. A VAR with six lags produced statistics with the same
inferences as those presented in the text.
17. A block exogeneity test, a multivariate test that examines whether the regressions for all the remaining
variables are (statistically) significantly changed by removing the lagged values of the government deficit (to
GNP) ratio from all regressions, is used. The chi-square
statistic with 24 degrees of freedom of 40.9 suggests rejection of the null hypothesis that GDEF lags are unimportant at the 5 percent significance level.
18. The chi-square statistic for 24 degrees of freedom of
27.94 does not allow rejection of the null hypothesis at
the 5 percent significance level.
19- See Rosensweig and Tallman (1991) for more detailed attention to issues like the percentage of variance explained,
the direct impact on particular variables of shocks to other
variables, and the dynamic effects of shocks.
20. These findings do not contradict Ricardian equivalence
because the specification does not allow a direct test of
Ricardian hypotheses.
References
Abell, John D. "Twin Deficits during the 1980s: An Empirical Investigation." Journal of Macroeconomics 12, no. 1
(1990): 81-96.
Barro, Robert J. "Are Government Bonds Net Wealth?"
Journal of Political Economy 82 (November/December
1974): 1095-1117.
Bernheim, B. Douglas. "Budget Deficits and the Balance of
Trade." In Tax Policy and the Economy, edited by
Lawrence H. Summers. Cambridge, Mass.: MIT Press,
1988.
10
Darrat, Ali F. "Have Large Budget Deficits Caused Rising
Trade Deficits?" Southern Economic Journal 54 (April
1988): 879-87.
Dewald, William G., and Michael Ulan. "The Twin-Deficit
Illusion." CatoJournal 9 (Winter 1990): 689-707.
Enders, Walter, and Bong-Soo Lee. "Current Account and
Budget Deficits: Twins or Distant Cousins?" Review of
Economics and Statistics 12, no. 3 (1990): 373-81.
Evans, Paul. "Do Budget Deficits Affect the Current Account?" Ohio State University Working Paper, July 1989-
ECONOMIC REVIEW, MAY/JIJNE 1991
Feldstein, Martin. "Domestic Saving and International Capital Market Movements in the Long and Short Run." European Economic Review 21 (1983): 129-51.
Greenwald, John. "Smooth Waters Now, But Rapids
Ahead: Budget and Trade Deficits Trouble the SecondTerm Outlook." Time, November 19, 1984, 96-98.
Laney, Leroy. "Twin Deficits in the 1980s: What Are the
Linkages?" Business Economics 21 (April 1986): 40-45McNamee, Mike, Paul Magnusson, Catherine Yang, Tim
Smart, and Howard Gleckman. "The Economic Drama:
New Cast, Old Script; Can Bush and Congress Make
Headway against the Daunting Deficits They Inherit?"
Business Week, December 26, 1988, 94-97.
Miller, Stephen M., and Frank S. Russek. "Are the Deficits
Really Related?" Contemporary Policy Issues 7, no. 4
(1989): 91-115.
FEDERAI. RESERVE BANK O F ATLANTA
Rosensweig, Jeffrey A., and Ellis W. Tallman. "Fiscal Policy
and Trade Adjustment: Are the Deficits Really Twins?"
Federal Reserve Bank of Atlanta Working Paper 91-2,
March 1991.
Runkle, David E. "Vector Autoregressions and Reality."
Journal of Business and Economic Statistics 5, no. 4
(1987): 437-42.
"Some of My Best Friends Are Deficits; America's Twin
Deficits have so far failed to trigger the long predicted
economic crunch." The Economist, January 20, 1990, 73.
Volcker, Paul A. "Facing Up to the Twin Deficits." Challenge 27 (March/April 1984): 4-9-
11
Some Evidence on the
Impact of Quasi-Fixed Inputs on
Bank Scale Economy Estimates
William C. Hunter and Stephen G. Timme
Studies of bank production and costs have increased understanding of the production process in financial institutions and influenced public opinion about banking consolidation. However, the robustness of these studies'
conclusions has not been established with models that account for the quasi-fixed nature of some bank inputs.
Hunter and Timme report on their own analysis comparing bank production function estimates using variable
inputs with those that allow some inputs to change only after a time lag. Including quasi-fixed inputs in specifications, the authors conclude, enhances the statistical accuracy of bank cost function analysis but does not
substantially alter policy conclusions that arose from earlier studies. As the banking industry evolves, empirical
enhancements like those the authors discuss may help policymakers target prescriptions more effectively.
ublic policy concerning commercial bank
product deregulation, geographic expansion, and consolidation relies heavily on
empirical analyses of bank production
and cost functions. Policy questions involving bank
expansion and consolidation generally center on
whether or not larger banks, merely because of their
size, are more efficient than smaller banks, while the
crux of product deregulation issues is whether banks
that are allowed to offer a wide variety of financial
services under one corporate banner enjoy lower
costs because of certain economies resulting from
multiproduct production. Because the absence or
presence of these economies is essentially an empirical question, it is easy to understand the policy significance of empirical literature examining bank
production and costs.
P
The seminal studies by Stuart Greenbaum (1967)
and Fredrick Bell and Neil Murphy (1968), and,
more recently, the papers by George Benston, Gerald Hanweck, and David Humphrey (1982), Jeffrey
Clark (1984), Thomas Gilligan and Michael Smirlock
(1984), Allen Berger, Hanweck, and Humphrey
12
(1987), William C. Hunter and Stephen G. Timme
( 1 9 8 6 , 1991), Douglas Evanoff ( 1 9 8 8 ) , Colin
Lawrence (1989), and Hunter, Timme, and Won Keun Yang (1990), among others too numerous to
mention, have all provided valuable empirical evidence related to these efficiency questions. 1 Despite their sometimes seemingly conflicting results,
these studies have increased understanding of the
production process in financial firms. In addition,
this voluminous empirical literature has been influential in solidifying public opinion about banking
expansion and consolidation and, as a result, is
likely to influence the evolution of the U.S. banking
industry.
Public policy prescriptions emanating from the
empirical production and cost function literature
have been generally consistent. For example, the
consensus of the most rigorous studies is that there
are indeed significant scale economies at small
banks (total assets of $50 million to $100 million)
and small but significant diseconomies at the largest
banks (total assets exceeding about $25 billion).
The results imply that banks having total assets
ECONOMIC REVIEW, MAY/JIJNE 1991
within the $50 million to $25 billion range incur
roughly similar average costs of producing basic
banking products or services. In economic terms, a
relatively flat industry long-run average cost curve
prevails over a wide range of asset sizes. An obvious policy implication of this pattern is that consolidations involving very small banks (less than $50
million in assets) that create postmerger firms within this $50 million to $25 billion asset range should
be encouraged because significant scale economies
can be realized. Consolidations of banks already
within this range that produce postconsolidation organizations remaining in the same size range would
appear to be innocuous except when excessive
market concentration results. Even in the latter
case, significant diversification, customer convenience, and product and cost innovation benefits
and advantages quite possibly will offset any potentially negative effects. 2
Although the above conclusions have been found
to be robust across studies employing different statistical methodologies, data definitions, output measures, periods, and number of products (outputs)
examined, this robustness has not been explicitly established with respect to models that recognize the
quasi-fixed nature of many bank inputs.
The purpose of this article is to report on the authors' basic research examining the robustness of
bank scale economy estimates derived from a specification or model that explicitly recognizes the quasifixed nature of some inputs into the bank production
function. 3 The analysis directly compares estimates
of bank cost functions that assume completely variable inputs with those that take into account the
quasi-fixed nature of core deposits and bank branches for the period from 1984 through 1987.
If the short-run fixity of bank inputs truly affects
the efficiency of bank production, then policy recommendations made on the basis of results obtained
from models that ignore these fixities could be called
into question. On the other hand, if the research
findings prove to be robust when quasi-fixed inputs
are recognized, then the conclusions found in the
bank scale economies literature summarized earlier
are further strengthened.
The Nature of Fixed or
Quasi-Fixed Inputs
The production characteristics of a firm can be
summarized by its short-run or long-run production
or cost functions. In economic theory the short run
is defined as the period in the production process
FEDERAI. RESERVE BANK O F ATLANTA
during which certain factor inputs (that is, the fixed
or quasi-fixed inputs) cannot be changed. The long
run is the period during which all factor inputs can
be varied. While a production function simply depicts the relationship between the output of a good
and the inputs (factors of production such as labor,
physical capital, and the like) required to make that
good, the cost function depicts the relationship between the total production cost and the prices of the
inputs required to produce a good (that is, the factor
prices). The long-run and short-run modifiers simply
establish the degree to which a firm can change the
amounts of inputs employed as it attempts to meet
profit objectives.
In analyzing a firm's short-run optimizing behavior—profit maximization or cost minimization—it is
assumed that some factor inputs cannot be varied.
On the other hand, the underlying assumption of
long-run analysis is that all factors of production are
completely variable and thus can be employed at
their long-run equilibrium (cost effective or profit
maximizing) levels. Depending on the firm being described, production functions can be of a single- or
multiproduct nature.
The short-run fixity of some inputs such as physical capital (for example, buildings, branches, and
computer systems) has long been acknowledged in
economic theory. Despite this fact, extant studies of
bank scale economies assume all inputs to be completely variable, adjusting instantaneously to their
long-run equilibrium levels. 4 Furthermore, there
are reasons to believe that short-run fixities extend
beyond pure physical capital to include factors related to transactions and information costs. For example, the notions of "core deposits" (interest-rate
insensitive retail deposits) and the "bank-customer
relationship" exhibit characteristics traceable to fixity
of bank factor inputs and transactions and information costs.
Core Deposits, Customer Relationships,
and Branches
As noted above, core or retail deposits are an example of a bank input with quasi-fixed characteristics.
William C. Hunter is vice president and senior financial
economist responsible for basic research in the Atlanta
Fed's research department. Stephen G. Timme is an associate professor of finance at Georgia State University. The authors are grateful to Loretta Mester, Allen Berger, and
Stephen Smith for helpful comments.
13
Mark Flannery (1982) has argued that such deposits should be considered quasi-fixed inputs because both the bank and its customers incur set-up
costs or transaction-specific investment costs when
opening new accounts. Flannery has shown that
because of these investments a bank is less likely
to reduce retail deposits during times when, at the
margin, these deposits are not needed but are expected to be needed in the future. As a result, the
rate paid on interest-bearing retail deposits during
these periods may exceed that paid on purchased
funds (for example, negotiable certificates of deposits).
Elsewhere in the literature (see, for example,
Gary Becker 1962, Walter Oi 1962, and Donald Parsons 1972) it has been noted that when trading partners incur significant set-up costs, these common
expenses provide strong incentives for the parties to
continue the relationship, although it may not be
profit maximizing in a particular period. Bank customers are less likely to switch banks to avoid incurring further set-up costs and having to become
familiar with a new bank's service delivery mechanism. On the lending side, banks' costs associated
with learning about customer payment and borrowing habits can also be considered switching or setup costs. Given that such information is durable,
banks find it cheaper to service customers over time
and can offer these familiar customers preferred
rates (equivalent to repeat business discounts like
the points given for consumer charge-card purchases and the frequent-flyer benefits offered by most
major airlines).
As noted above, bank physical capital is an obvious quasi-fixed input into the production function.
Investment in home and branch offices generally
varies little in the short run, primarily because severe
costs are associated with quickly building or disposing of these facilities. However, factors other than
adjustment costs can make an input quasi-fixed in
the short run. Regulation is one such factor. For example, it has been suggested that the Community
Reinvestment Act of 1977 has prompted many banks
to continue operating branches in certain community
areas when it is not cost effective to do so. In the
case of branch banking, state restrictions can prevent
banking offices from reaching their long-run equilibrium level; although banks may be expected to find
alternative means for expanding deposits, such
means may not be efficient. This kind of nonequilibrium situation could occur, for example, when a
banking organization is forced to expand geographically by way of holding company acquisitions or
chain banking as opposed to simply opening newbranches.
14
Total-Cost versus Variable-Cost
Functions
In the authors' research, tests of bank-scale economy estimates' robustness in the presence of quasifixed inputs were carried out by analyzing two
models or specifications of a bank's cost function—
the total-cost and the variable-cost specification.
Applied to bank production, the total-cost model
corresponds to a long-run bank cost function that
considers all inputs as variable. Thus, it is assumed
that a bank can adjust all factor inputs appropriately
to minimize its costs (maximize its profits). In contrast, the variable-cost model essentially assumes that
the bank is in equilibrium with respect to a set of
variable inputs conditional on the observed levels of
the quasi-fixed inputs. The bank's optimizing behavior is carried out subject to certain inputs' being
fixed during the period of analysis.
Under the total-cost specification, the bank's total
cost—that is, the sum of the quantities of inputs employed multiplied by their factor prices—is expressed
as a function of the quantities of outputs produced
and all input factor prices. Under the variable-cost
specification—because the bank minimizes the cost
of a subset of its inputs, conditional on the level of
the quasi-fixed inputs (for example, physical capital,
core deposits, and so forth)—the relevant costs to be
minimized are variable costs (the sum of the quantities of the variable inputs multiplied by their factor
prices). Thus, for the variable-cost function total variable costs are expressed as a function of products
(outputs produced), the factor prices of the variable
inputs employed, and the quantities of the quasifixed inputs used in producing the outputs.
Estimating Bank Scale Economies
The notion of scale economies, or, more properly, returns to scale, refers to the rate at which output
changes as all input quantities are varied. If, for example, a firm doubles the quantity of its inputs and
its output doubles, then its production technology is
said to exhibit constant returns to scale. If output increases by less than 100 percent, decreasing returns
to scale or diseconomies of scale prevail, and if by
more than 100 percent, increasing returns to scale or
simply economies of scale prevail. In the above definitions, the term scale serves as a reminder that all
inputs are being varied. The concept is a long-run
equilibrium concept, and the presence of economies
of scale means that the average cost of producing a
ECONOMIC REVIEW, MAY/JIJNE 1991
product, in the long run, declines as more of the
product is produced. If, because of the presence of
quasi-fixed inputs, banks are not in long-run equilibrium with respect to the quantities of their inputs,
scale economy measures derived from cost functions that assume all inputs are variable may be misleading.
For the analysis of bank scale economies presented below, the first step involved specifying and estimating a functional form for each of the cost
functions. Once these forms were estimated or fitted
to sample data, scale economy measures could be
computed and compared. In addition, other economic properties of the two cost function specifications could be examined to determine if one clearly
dominates the other in describing bank costs.
Second-order transcendental logarithmic (translog)
approximations were used to statistically fit the totalcost and variable-cost specifications. The translog
functional form, a generalized or flexible mathematical model capable of approximating many different
production technologies, includes most popular
specifications as special cases and is able to capture complex patterns of input substitution.^ These
features have gained it wide acceptance in the empirical literature examining production and cost relationships in financial intermediaries.
Variable Definitions
Outputs. The criterion of value added employed
by Berger, Hanweck, and Humphrey (1987) was
used in the research reported on here to determine
the composition of the various output categories examined. In both cost function specifications, output
includes wholesale loans, represented by the dollar
volume of all commercial and industrial and security
loans; consumer loans, comprising the dollar volume
of credit cards and other personal loans except for
loans secured by real estate; and real estate and other
loans, including those secured by real estate, agricultural loans, and others in the wholesale or consumer
categories. In addition, an output category is defined
to capture the off-balance-sheet activities of the sample banks. These include such items as loan sales,
letters of credit, securitization, swaps, and clearing
activities, all of which are becoming increasingly important at U.S. commercial banks. This proxy output
variable is defined as total noninterest income, including service charges received on transaction and
nontransaction deposit accounts. Securities are excluded from the definition of output because banks
add only negligible, if any, value to these assets.
FEDERAI. RESERVE BANK O F ATLANTA
Inputs and Input Prices. The inputs into the
bank production function are taken to be labor,
physical capital (plant and equipment), deposits, and
other miscellaneous inputs (for example, director
services and advertising). Thus, the cost functions include the following input or factor prices: the price
of labor (the total salaries and benefits divided by
the number of full-time employees), the price of
physical capital (the ratio of occupancy and fixedasset expense to net bank premises), the price of deposits (the interest rate paid on all deposits divided
by the sum of all interest-bearing deposits outstanding), and a proxy price for miscellaneous inputs
(pretax noninterest expenses less labor and capital
expenses divided by total assets).
Quasi-Fixed Inputs. Core deposits and a measure of physical capital are treated as the quasi-fixed
inputs in variable-cost specification. Core deposits
are defined as each sample bank's previous year's
dollar volume of demand deposits, negotiable orders
of withdrawal (NOW accounts), and other interestbearing checking accounts, savings accounts, and
small time deposits. Purchased funds are excluded
from the definition of core deposits.
Quasi-fixed capital for a given year is defined as
the number of branches the bank operated in the
previous year. Branches are chosen as a proxy for
quasi-fixed capital inputs because, for planning purposes, they are typically considered fixed in the
short run. In addition, branching networks represent
a substantial proportion of most banks' investment in
physical capital.
Total and Variable Costs. Total costs are defined as total noninterest costs plus allocated interest expense (the product of the ratio of total loans
to earning assets times total interest expense). The
allocation of interest expense is necessary because
securities are not specified as an output and many
banks incur a substantial proportion of their interest
costs to finance their securities portfolio. The output/
cost specification used in this study is consistent
with the intermediation approach to examining
bank costs discussed in Humphrey (1985).
Variable costs are defined as total costs less the
previous year's expenses for premises and fixed assets and interest allocated to core deposits. The interest price of core deposits is defined as the current
year's total interest on all d e p o s i t s less than
S 100,000 (for example, NOW accounts, saving and
time, IRAs, and Keoghs) excluding all interest on
purchased funds (Fed funds, retail repurchase
agreements, and jumbo CDs) divided by the sum
of all noninterest-bearing demand deposits plus all
interest-bearing deposits less than §100,000, excluding any purchased funds. Total allocated interest
15
equals the interest price of core deposits times the
amount of core deposits.
The Data
The data used to estimate the cost functions were
taken primarily from the Federal Reserve end-of-year
Reports of Condition and Income filed by banks for
1984 through 1987. This period of analysis was chosen for several reasons. First, significant changes in
bank regulation and markets occurred in the early
1980s. Hence, combining more recent data with earlier data could have produced misleading results.
Second, during the period from 1984 through 1987,
retail CDs exhibited characteristics associated with
quasi-fixed inputs. That is, for some periods the effective cost of retail deposits exceeded the cost of
purchased funds. Data from this period should
therefore be particularly useful in examining the impact of quasi-fixed inputs on bank scale economy
measures.
Data for all banks having at least SI billion in total assets as of year's end 1987 and complete data
for the entire 1984-87 period were collected. Although these banks represented a small percentage
of the total number of U.S. banks operating in 1987,
they held approximately 60 percent of all banking
assets. Banks in states with unit banking laws were
d r o p p e d from the s a m p l e b e c a u s e analysis o f
nonunit banking banks is expected to provide more
useful insight into issues currently confronting bank
regulators. The final sample included 254 banks.
The sample banks were found to vary both with
regard to their scales of outputs and their product
mixes. As a result, the sample banks were divided
into seven subgroups based on total assets as of the
year ending 1987. Table 1 presents summary statistics for each of the seven subgroups.
Table 1
Summary Statistics for Sample Banks for 19871
(means and standard deviations in parentheses)
Output
Quasi-Fixed Inputs
Number
of Banks
Wholesale
Loans
Consumer
Loans
Real Estate
and Other
Loans
$1.0-1.5
69
$ .21
(.09)
$ .20
(.12)
$ .35
(.12)
$ .02
(.11)
$ .63
(.15)
33.5
(23.9)
$1.5-2.0
36
.32
(.12)
.26
(.14)
.53
(.15)
.03
(.03)
.92
(.28)
44.5
(25.1)
$2.0-3.0
32
.52
(.22)
.32
(-14)
.79
(.24)
.03
(.01)
1.22
(.27)
49.8
(20.9)
$3.0-5.0
50
.76
(.25)
.52
(.27)
1.21
(.39)
.05
(.03)
1.74
(.45)
83.9
(53.7)
$5.0-10.0
36
1.58
(1.50)
.91
(.45)
2.02
(.66)
.09
(.05)
3.26
(1.08)
118.3
(65.7)
$10.0-25.0
21
4.07
(2.19)
1.48
(.99)
4.35
(1.45)
.20
(.11)
5.88
(2.41)
188.6
(95.5)
$25.0 plus
10
16.51
(7.18)
4.41
(4.07)
20.90
(11.19)
1.04
(.80)
20.57
(10.90)
375.3
(332.2)
Asset
Size
1
Other
Outputs
Core
Deposits
Number
of Branches
A// dollar amounts are in billions of dollars for the year ending 1987.
Source: Calculated by the authors from data in Consolidated Reports of Condition for Insured Commercial Banks and
Consolidated Reports of Income for Insured Commercial Banks filed with the Federal Reserve System.
16
ECONOMIC REVIEW, MAY/JIJNE 1991
Results of the Tests
Both the total-cost and variable-cost specifications were statistically fitted using data for the
overall sample. However, scale economy estimates
are reported for each subgroup identified in Table 1
to account for differences in the subgroups' scale
and product mix. Because the cost functions are
multiproduct cost functions, the scale e c o n o m y
measures or indices reported below are ray scale
economy indices, which are the multiproduct firm
equivalent of the traditional scale economy index
used in analyzing the single-product firm. In simple terms, a ray scale economy index measures the
change in total (or variable) costs as the firm's
scale is increased, holding product mix constant.
As presented in this article, if a ray scale economy
index (RSCE) equals 1.0, constant returns to scale
prevail, and if the index is less or greater than 1.0,
decreasing or increasing returns to scale, respectively, prevail.
Using pooled data for the years 1985-87, the statistical technique of full information maximization
likelihood was used to estimate the two cost specifications' parameters. Including time-dependent
dummy or indicator variables accounted for possible structural shifts in the sample banks' production functions during the sample period.
Table 2 reports the estimated ray scale economy
indices for the total-cost specification (RSCE-TC)
and the variable-cost specification (RSCE-VC) for
e a c h o f the seven s a m p l e b a n k s u b g r o u p s for
1985, 1986, and 1987. For the total-cost model the
estimated ray scale economy indices for 1985 indicate significantly increasing returns to scale (RSCETC > 1.0) for banks with total assets of $5 billion
or less. Banks with $5 billion to $10 billion in total
assets exhibit approximately constant returns to
scale, whereas banks with total assets in excess of
Table 2
Ray Scale Economy Estimates of the Total-Cost and Variable-Cost Models
(standard errors in parentheses)
Asset
Size 1
1985
RSCE-TC 2
1986
RSCE-VC '
1987
RSCE-TC
RSCE-VC
RSCE-TC
RSCE-VC
$1.0-1.5
1.042**
(.015)
1.038**
(.015)
1.056**
(.017)
1.028
(.017)
1.074**
(.015)
1.052**
(.018)
$1.5-2.0
1.033**
(.013)
1.031*
(.013)
1.053**
(.015)
1.030*
(.015)
1.064**
(.013)
1.039**
(.014)
$2.0-3.0
1.020
(.016)
1.025*
(.011)
1.031**
(.010)
1.024
(.013)
1.045**
(.011)
1.025*
(.012)
$3.0-5.0
1.009
(.019)
1.009
(.010)
1.023*
(.010)
.998
(.011)
1.054**
(.013)
1.011
(.011)
$5.0-10.0
.999
(.019)
1.004
(.010)
1.011
(.009)
.997
(.010)
1.030**
(.010)
1.010
(.011)
$10.0-25.0
.980
(.013)
.986
(.010)
.996
(.011)
.987*
(.011)
1.008
(.016)
1.004
(.012)
$25.0 plus
.940**
(.016)
.962**
(.013)
.959*
(.017)
.956**
(.014)
.978
(.01 7)
1
2
Assets are given in billions of dollars for the year ending 1987.
"RSCE-TC" denotes the ray scale economies index from the total-cost model; "RSCE-VC"
economies index from the variable-cost model.
.966**
(.013)
denotes the ray scale
* Significant at the .05 level.
** Significant at the .01 level.
Source: Calculated by the authors from data in Consolidated Reports of Condition for Insured Commercial Banks and
Consolidated Reports of Income for Insured Commercial Banks filed with the Federal Reserve System.
FEDERAI. RESERVE BANK O F ATLANTA
17
$10 billion exhibit moderate to large decreasing returns to scale (RSCE-TC < 1.0). The results for
1987, relative to those for 1985, indicate more pronounced increasing returns to scale and more muted decreasing returns to scale. The 1987 estimates
suggest that only the largest banks—with assets in
excess of S25 billion—exhibit decreasing returns to
scale.
A number of factors could account for the apparent change in the sample banks' efficiency between 1985 and 1987. First, because it ignores the
presence of quasi-fixed inputs, the total-cost specification may be inappropriate. This possibility will
be discussed in detail below when the results obtained under the variable-cost specification are examined.
A second possible explanation for the apparent
change is that product mixes of the sample banks
may have varied significantly during the period covered. The validity of this explanation was explored
by reestimating the ray scale economy indices using
the fitted parameter values of the total-cost specification for the year 1987 and the mean output data taken from 1985. The indices obtained under this
procedure for 1987 were essentially the same as
those reported in Table 2. This analysis, along with
other comparisons, suggests that changes in the
quantity and mix of outputs among the sample
banks did not contribute significantly to the changes
observed in the ray scale economy indices using the
total-cost specification.
New technology is another factor that could explain the c h a n g e s o b s e r v e d . If t e c h n o l o g i c a l
change during this period was scale-biased—that
is, if it worked to increase the threshold of efficiency in terms of asset size—then, assuming all other
factors were constant, banks should have exhibited
higher (lower) increasing (decreasing) returns to
scale over time. Tests for the presence of scale-biased
technological change during the 1985-87 period
did reveal the presence of statistically significant
s c a l e - b i a s e d t e c h n o l o g i c a l c h a n g e . Thus, the
changes in the ray scale economy indices derived
from the total-cost specification can be explained,
in part, by a technology-induced shift in the total
cost function. 6
Ray scale economy indices derived from the
variable-cost specification are also given in Table 2
for each of the bank subgroups. For 1985 the RSCEVC indices indicate either increasing or constant returns to scale for banks with total assets in amounts
up to S10 billion. Banks with total assets in excess
of $10 billion exhibit modest to substantial decreasing returns to scale. Although these results are very
similar to those obtained using the total-cost specifi-
18
cation, the estimated RSCE-VC indices are relatively
stable for the 1985-87 period, indicating a slight but
statistically insignificant increase (decrease) in ray
scale economies (diseconomies). The lack of timedependent scale economy indices contrasts sharply
to the pattern exhibited by the indices derived from
the total-cost specification.
Further testing of the differences between the
two cost specifications involved a statistical test to
determine which model best fits the sample data.
Because the variable-cost specification contains all
of the total-cost specification's estimated parameters and total costs differ from variable costs by the
amount of fixed costs, the parameters of the totalcost specification are a subset of those used to fit
the variable-cost model. Thus, by reestimating the
variable-cost specification with total rather than
variable costs as the quantity to be explained, a
statistical test of the best-fitting model could be
conducted. The results of the test indicated that
the two specifications are not identical. The more
general variable-cost specification was found to
provide a more accurate description of the sample
data.
Although the variable-cost specification better
fits the data, the results in Table 2 show that the
ray scale economy indices for both specifications
are virtually identical for 1985, and the largest discrepancies appear in 1987, as discussed above. Using the standard errors of the estimates reported in
Table 2 for 1987, tests were conducted to see if the
differences in the ray scale economy indices are
statistically different. These test results indicate that
only the indices for the subgroups in the $5 billion-$10 billion and $3 billion-$5 billion total assets categories are statistically different.
Additional insight into the significance of the
observed differences can be obtained from an
analysis of the projected increases in costs resulting from increases in scale under each specification. This comparison was performed using the
statistical results obtained for 1987. For both cost
specifications, changes in total and variable costs
were computed for each bank subgroup using observed costs, ray scale e c o n o m i e s estimates in
Table 2, and an assumed 5 percent increase in all
outputs. In all cases, the differences in the projected
cost increases derived from the two specifications
were found to be minor. These comparisons suggest
that over the time period examined managerial policy decisions would be fairly similar regardless of
which specification was used in the production
planning process, even though the variable-cost
specification appears to provide a better statistical
fit. 7
ECONOMIC REVIEW, MAY/JIJNE 1991
Implications and Conclusions
The results of the empirical analyses show that
the variable-cost specification better fits the sample
data when compared with a total-cost specification.
Thus, it would appear that explicitly recognizing the
short-run fixity of some bank inputs is required in
bank cost function analysis if statistical accuracy is
the guiding criterion.
However, the analysis also demonstrates that efficiency measures of the type typically used in public
policy debates concerning bank product deregulation, geographic expansion, and consolidation—
measures that have traditionally been computed
from models ignoring these short-run fixities—will
not necessarily produce erroneous policy prescriptions. In the case examined in this article, it is clear
that ray scale economy measures produced under
the two different cost specifications are essentially
identical. It follows that public policy prescriptions
based solely on these estimated ray scale economy
indices should not be affected by the particular cost
specification employed. These results provide strong
support for the notion that policy prescriptions emanating from the empirical bank production and cost
function literature are in fact robust.
On the other hand, these findings do not imply
that the two cost specifications will never produce
significantly different public policy prescriptions. Instead, they make it clear that as banks and banking
markets continue to evolve, policy-oriented studies
of bank production and cost functions should establish the robustness of policy prescriptions to specification changes if the prescriptions are to be seriously
considered in policy debates.
Notes
1. Comprehensive reviews of this literature can be found
in Clark (1988) and Humphrey (1990).
2. See Hunter and Timme (1991) for an examination of the
relationship between concentration and innovation in
banking markets.
3. For a more detailed and technical discussion of the research reported in this article see Hunter and Timme
(1990).
4. The one exception in the published literature is the paper by Noulas, Ray, and Miller (1990). However, the authors fail to compare the estimates of bank cost
characteristics they derive from a quasi-fixed specification with those derivable from a traditional specification
assuming instantaneous adjustment. In addition, their
study examines only one quasi-fixed input (core deposits), and therefore the importance of quasi-fixed
physical inputs cannot be ascertained. Finally, because
Noulas, Ray, and Miller have examined bank cost data
for only one year, their study provides no insight into
the dynamic aspects of quasi-fixed inputs in bank production.
5. The review article by Clark (1988) contains an excellent
technical discussion and overview of the properties of
the translog cost function.
6. Fmpirical evidence on technology-induced shifts in
bank production and cost functions is reported in
Hunter and Timme (1991).
7. Neither does consistency with economic theory make
one specification preferable over the other. It should be
noted that both the variable-cost and the total-cost specifications were found to produce results consistent with
most of the dictates of economic theory.
References
Becker, Gary S. "Investment in Human Capital: A Theoretical Analysis." Journal of Political Economy 70 (October
1962, Supplement): 9-49Bell, Fredrick, and Neil Murphy. Costs in Commercial
Banking: A Quantitative Analysis of Bank Behavior
and Its Relationship to Bank Regulation. Federal Reserve Bank of Boston, Research Report No. 41, 1968.
Benston, George J., Gerald A. Hanweck, and David B.
Humphrey. "Scale Economies in Banking: A Restructuring and Reassessment." Journal of Money, Credit and
Banking 14 (November 1982): 435-56.
Berger, Allen N., Gerald A. Hanweck, and David B.
Humphrey. "Competitive Viability in Banking: Scale,
Scope and Product Mix Economies." Journal of Monetary Economics 20 (December 1987): 501-20.
Clark, Jeffrey A. "Estimation of Economies of Scale in Banking Using a Generalized Functional Form." Journal of
Money, Credit and Banking 16 (February 1984): 53-68.
FEDERAI. RESERVE BANK O F ATLANTA
. "Economies of Scale and Scope at Depository Financial Institutions: A Review of the Literature." Federal
Reserve Bank of Kansas City Economic Review 73
(September/October 1988): 16-33Evanoff, Douglas. "Branch Banking and Service Accessibility." Journal of Money, Credit and Banking 20 (May
1988): 191-202.
Flannery, Mark J. "Retail Deposits as Quasi-Fixed Factors
of Production." American Economic Review 72 ( J u n e
1982): 527-36.
Gilligan, Thomas, and Michael Smirlock. "An Empirical
Study of the Joint Production and Scale Economies in
Commercial Banking." Journal of Banking and Finance
8 (March 1984): 67-76.
Greenbaum, Stuart I. "A Study of Banking Costs." National
Banking Journal 4 (June 1967): 415-34.
Humphrey, David B. "Cost and Scale Economies in Bank
Intermediation." In Handbook for Bank Strategy, edited
19
by R. Aspinwall and R. Eisenbeis. New York: Wiley
and Sons, 1985.
. "Why Do Estimates of Bank Scale Economies Differ?" Federal Reserve Bank of Richmond Economic Review 76 (September/October 1990): 38-50.
Hunter, William C., and Stephen G. Timme. "Technical
Change, Organizational Form, and the Structure of
Bank Production." Journal of Money, Credit and Banking 18 (May 1986): 152-66.
. "Quasi-Fixed Inputs in the Estimation of Bank
Scale Economies." Federal Reserve Bank of Atlanta
Working Paper 90-8, October 1990.
. "Technological Change in Large U.S. Commercial
Banks." Journal of Business 64 (July 1991): 206-45.
Hunter, William C., Stephen G. Timme, and Won Keun
Yang. "An Examination of Cost Subadditivity and Multi-
20
product Production in Large U.S. Commercial Banks."
Journal of Money, Credit and Banking 22 (November
1990): 504-25.
Lawrence, Colin. "Banking Costs, Generalized Functional
Forms, and Estimation of Economies of Scale and
Scope." Journal of Money, Credit and Banking 21 (August 1989): 368-79.
Noulas, Athanasios, Subhash C. Ray, and Stephen M.
Miller. "Returns to Scale and Input Substitution for
Large U.S. Banks." Journal of Money, Credit and Banking 22 (February 1990): 94-108.
Oi, Walter Y. "Labor as a Quasi-Fixed Factor." Journal of
Political Economy 70 (December 1962): 538-55.
Parsons, Donald O. "Specific Human Capital: An Application to Quit Rates and Layoff Rates ."Journal of Political
Economy SO (December 1972): 1120-43-
ECONOMIC REVIEW, MAY/JIJNE 1991
FYI: The Interest Rate Sensitivity of
Stock Prices
David W. Stowe
hanges in interest rates affect all financial
securities, simple or complex, to some
degree. Thus, it is important to assess
any financial asset's interest rate risk—
the potential for fluctuations in the general level of
interest rates to cause movements in the value of a
security. Traditionally incorporated in fixed-income
security analysis, interest rate risk should be a consideration in equity security analysis as well.
C
The relationship between interest rates and the
price of a risk-free bond (such as a Treasury note) is
straightforward; the bond's value is inversely related
to its yield to maturity.1 However, the relationship
among stock prices and interest rates is less direct.
The common myth that a decline in interest rates
leads to a subsequent rise in stock prices is not always accurate. For one thing, the interest rate is only
one factor affecting a stock's value. Assuming a predictable cause-and-effect relationship between interest rates and stock prices fails to consider interaction
among interest rates and other economic variables
that can determine a stock's value. For example, in
the case of a share of common stock, its price is a
function of interest rates, its correlation with other
assets in the market, and the projected cash flows
from the security arising from corporate earnings. In
short, while a basic fixed-income security's value is
directly related to interest rates, an equity security's
value has only an indirect relationship.
The objective of this article is to provide some basic insight into the complex relationship among interest rates and stock prices as well as to explore
FEDERAI. RESERVE BANK O F ATLANTA
methods of measuring a stock's interest rate sensitivity. The interest rate sensitivity, or elasticity, of a financial security is its duration, which measures the
direct interest rate sensitivity of a financial asset but
does not account for the correlations among interest
rates and other economic variables. For fixed-income
securities, duration is the only measure needed.
However, because other factors are correlated to
some degree with interest rates to determine an equity security's value, duration has limitations as a
tool for quantifying these securities' interest rate elasticity. This article explores ways to adjust the standard duration model so that it will incorporate the
interactive effects of interest rates and other variables
on a stock's value. In doing so, its findings should
contribute to a better understanding of the ways in
which interest rates influence a stock's price. 2
Measuring Interest Rate Risk:
A Note on Duration
The concept of duration was proposed separately
by two economists in the 1930s. Frederick Macaulay
([19381 1980) introduced it as a measure of the "longness" of a loan—the average number of years until a
The author is a financial analyst in the macropolicy section
of the Atlanta Fed's research department. He thanks Stephen
D. Smith and William C. Hunterfor helpful comments.
21
lender would r e c o v e r a loan's present value.
Macaulay's approach contrasted with the traditional
loan-maturity concept, which measures only the time
of receipt of the last payment. His specification of
duration is calculated by weighing the time to receipt, t, of each loan payment by the payment's present value as a proportion of the current value of the
loan or bond.
changes in the discount factor, or yield. Given a
small relative change in the yield, the percentage
change in the security's price, %AP, can be estimated using Macaulay's duration value, D, as follows
(the relative change in the yield, %Ar, is the increase or decrease in the yield level, Ar, divided by
one plus the initial yield, 1 + r): 3
%AP/%A r = - / > A r/( 1 + r).
Duration=
Ct
7 «
Ü (1 + r,)
—
P
(1)
t
= the time to receipt of a security's cash flow.
As an example, for a security with a ten-year
maturity providing annual payments t would
begin at year one and end at year ten.
Ct = the payment, or cash flow, to be received at
time t. This could be a coupon payment for
years one through ten and a repayment of
principal at the end of year ten.
rt = the rate at which the cash flow is discounted
to the present from time t. This is the
market-determined yield for the bond.
Macaulay simplifies the calculation by assuming the yield curve is flat—that is, rt is
the same for all periods. Furthermore, he assumed that the yield curve shifts in a parallel fashion when interest rates change (the
yield curve always remains flat).
P = the current price of the security (for example, the present value of the bond).
In long-hand form, the duration equation is the following:
Duration
L 1 + Tj
+
'
a
(2)"
(1 + r 2 ) 2
C'rt-1
—r(w-l) + ———(n)l
n l
(1 + r„)
J
O + Vi) ~
'
(2)
/price,
where n is the time of receipt of a security's last cash
payment.
An interpretation of duration more useful for the
purposes of this discussion is that of John R. Hicks
(1939). Hicks introduced the idea of the average
period of a stream of payments, a concept essentially the same as Macaulay's notion of duration.
Hicks also demonstrated that this measure was
equal to the elasticity of the present value of the
stream of payments with respect to the discount
factor (1 + r(). In other words, duration measures
the sensitivity of the financial asset's value to
22
(3)
The percentage change in the price of a security
given a percentage change in its yield equals the
negative of Macaulay's duration multiplied by the
change in the yield over one plus the initial yield
level.
For this article, the concern is with the concept of
duration as a measure of the elasticity of a security's
price with respect to interest rates.' Chart 1 illustrates
the inverse, or negative, relationship between a security's price and its yield. It should be noted that
the relative price change is not the same for every
yield level; that is, the relationship is nonlinear. The
security's price rises at a comparatively faster rate
when the yield falls than it would decline if the yield
rose by an equal amount. The security's price graph
is convex.
Duration measures the slope of the security's
price graph at a particular yield level. Clearly, duration changes as a security's yield changes. The
slopes of each of the straight lines adjacent, or tangent, to the price graph in Chart 1 represent the security's duration at the two different yield levels.
The duration measure accurately approximates the
security's actual price change for a very small
range of yields near the point where the duration
line is tangent to the security's price curve. If the
duration value (B) were employed in estimating
the relative price change from a large increase in
the yield level—for instance, from 5.0 percent to
8.0 percent—accuracy would be considerably reduced. The size of the error equals the vertical distance between the duration line at the 8.0 percent
yield level and the actual price curve, represented
by the shaded area.
A generic duration index such as that shown in
Table 1 is simple; it measures the direct interest
rate sensitivity of a security. For example, the duration index of a Treasury note weights the time to
receipt of each of the security's cash flows (for example, the coupon payments and principal) by the
present value of that cash flow as a proportion of
the note's market price as in equation (1). For a
Treasury security, whose risk of default is considered to be remote, the cash flows, time to receipt
of each cash flow, and maturity are all known in
ECONOMIC REVIEW, MAY/JIJNE 1991
Chart 1
Duration versus a Security's True Price Function
Security's Actual Price
Duration at a 2 % Yield
Duration at a 5 % Yield
•
'
1.0
'
2.0
I
I
3.0
1
1
4.0
L
J
L
6.0
5.0
Estimation Error
•
7.0
•
'
8.0
I
I
9.0
I
L
10.0
% Yield
advance (ex ante) with certainty. Changes in the
interest rate, or the note's yield to maturity, affect
neither the amount nor timing of cash payments.
Only the rate at which these cash flows ape discounted to their present value is changed. From
the duration measure in Table 1, the interest rate
elasticity of the T-note's price for a 1 basis point,
or .01 percentage point, increase in the yield level
would be calculated using equation ( 3 ) as follows:
Percent change in price =
-4.27 • .0001/(1 + .0761) = -.04%.
Thus far the discussion of duration has been targeted toward bonds, specifically a simple Treasury
note, to illustrate the application of the duration
concept. The duration of an equity security is more
complex. For one thing, rather than being synonymous with interest rate sensitivity as in the example above, with regard to stocks duration is an
input in an interest rate sensitivity model. The duration measure from equation (1) requires inputs
for the security's price, expected cash payments,
and timing of each payment. With stocks, none of
these variables are known in advance but must be
projected.
Deriving a stock's price is not an exact science;
many models can be employed. For the sake of simplicity, most researchers studying the topic of equity
securities' duration have assumed that a stock's
FEDERAI. RESERVE BANK O F ATLANTA
price is based on one available model—the dividend discount model."'
Valuing an Equity Security
The dividend discount model (DDM) is a relatively simple model frequently employed in calculating
the intrinsic value of a common stock 6 The model
bases the value of a share of stock on the present
value of all the future dividends, or cash flows, it is
expected to provide in perpetuity. Thus, use of this
model requires forecasting the stock's dividend
stream.
The simplest dividend discount model is the constant growth model, which assumes that future divid e n d s will i n c r e a s e or g r o w from the current
dividend at a constant rate. Because the common
stockholder is a residual owner of a company and is
entitled to dividends (a prorated share of the company's net earnings) only after all other obligations
have been met, the receipt of the projected dividends is not guaranteed. Allowing for the uncertainty involved, the estimated cash flows are discounted
by a risk-adjusted required rate of return (discount
rate). This rate of return is assumed to be a combination of a risk-free interest rate (for example, the Tbill rate) and a unique risk premium. The constant
growth dividend discount model determines the
stock price as follows:
23
Table 1
Macaulay's Duration Index for a Five-Year Treasury Note
Annual Coupon Rate: 7.50%
Date of Maturity: 1996
(1)
(2)
Semiannual
Period
Cash
Payment
1
2
3
4
5
6
7
8
9
10
$ 37.5
37.5
37.5
37.5
37.5
37.5
37.5
37.5
37.5
37.5
and
1,000
Stock
a+k)
, , , ,
a+k)
2
Annual Yield to Maturity: 7.61 %
Current Price: $995.3
(3)
Present
Value of
Payment
Weight:
(3) - Price
(5)
Weighted
Time Period:
(4) • (1 )
$ 36.13
34.80
33.53
32.30
31.11
29.97
28.87
27.82
26.80
714.58
.0364
.0351
.0338
.0326
.0314
.0302
.0291
.0280
.0270
.7202
.0364
.0702
.1014
.1303
.1569
.1813
.2038
.2244
.2432
7.2015
(4)
8.55
Duration in years:
4.27
= time of receipt of each cash payment. Theoretically, a stock has an infinite maturity. 7
Dpd+g)'
D0 = current dividend per share.
g = the growth rate of dividends, assumed constant.
k = the risk-adjusted discount rate (investors' required rate of return for holding a specific
stock), defined as the risk-free interest rate
plus a risk premium. This discount rate is
assumed constant. The risk premium is defined as the security's beta, which is its correlation with the market portfolio of all
assets, multiplied by the market risk premium, which is the difference between the
risk-free rate and the rate of return for the
market for all assets. That is, the risk premium equals fifRM - Rp).
24
t
Duration in semiannual periods:
(1 + k)'
for g < k.
(4)
Equity Duration Based on the Dividend
Discount Model
The concepts provided by Macaulay and the dividend discount model can be used to formulate a duration equation for equities. The following equation
is a combination of the dividend discount model,
equation (4), and Macaulay's duration, equation ( l ) : 8
Equity DurationDDM
=
i f (i+*/)Stock
Price
.
O)
The equation equals the weighted average time to
receipt of each dividend payment a stock provides.
The numerator is the product of each dividend's
ECONOMIC REVIEW, MAY/JIJNE 1991
present value and its respective time of receipt, t. The
denominator represents the present value of a common stock as based on the dividend discount model.
Equation (5) reduces to the following basic equation:
Equity Duration
=
DDM
(1 + k)/(k-
g),
(6)
which assumes that a firm has a constant growth rate
over the long run and pays a dividend at discrete intervals in perpetuity.
Because the concern in this research is with approximating an equity security's interest rate sensitivity, or elasticity, it must be assumed that the cash
flows are paid out continuously rather than at discrete intervals, as in the following equation:
Dddm
= equity duration
= l/(k-
g),
(7)
and
Percentage
~dddm
change
• AMI
in the price of a stock =
(8)
+
Equation (7) is a simple approximate of a stock's direct sensitivity to interest rates. It is the reciprocal of
the difference between a stock's required rate of return, k, and its dividend growth rate, g. In equation
(8), the duration value, DDDM, is multiplied by the
change in the stock's required rate of return, k, as in
equation (3); the calculation produces the percentage change in a stock's price given a change in the
security's required rate of return.
The dividend yield of a stock, or its dividend relative to its price (Dividend/Price), can be derived from
the stock pricing equation (4) and is equal to the difference between the required rate of return, k, and
the dividend growth rate, g. Acknowledging this fact
and knowing that a stock's duration equals the inverse of the difference between the required rate of
return and growth rate, the duration for a stock with
constant dividend growth is equal to the reciprocal of
the security's dividend yield. (Both of these variables
can be observed in the stock quote pages of news
periodicals.) Thus,
Dnnxf
= equity duration
=
Price/Dividend.
(9)
Limitations of Equity Duration Based on
the Dividend Discount Model
While the measure DDDM is easy to compute and
apply, caution must be exercised in its application as
a measure of a stock's interest rate sensitivity. To be-
FEDERAI. RESERVE BANK O F ATLANTA
gin with, the assumptions underlying the dividend
discount model (for example, employing a constant
dividend growth rate) may be unrealistic when applied to valuing the stock of a given company. Because duration depends on the security's price, and
a stock's market price can be different from that the
dividend discount model suggests, the duration
measure based on the model may not give a reliable
quantitative value for a stock's duration. A fixedincome security's duration value is a more reliable
measure because the parameters of a fixed-income
security (for example, cash flows and price) are
more easily determined.
Moreover, duration measures the direct relationship between a security and interest rates. As such,
applied to stocks it is a measure of an equity security's sensitivity to changes in its discount rate, k.
Therefore, equity duration based on the dividend
discount model is best used as an analytical tool
for measuring a stock's price sensitivity to changes
in the security's discount rate, k, or required rate of
return.
As discussed earlier, interest rates indirectly affect
a stock's value because of the correlations between
interest rates and other stock price variables. The
basic duration model fails to account for this fact,
but these correlations must be incorporated to
gauge interest rates fluctuations' potential impact on
a stock's price.
How Interest Rates Affect a Stock's Value
Clearly, variability in interest rates influences the
present value of a financial asset's future cash flows.
With stocks, however, the nominal value of these
payments to the shareholder may be affected also.
Because a common stock's expected cash flows are
not fixed, interest rate movements can shape both
the cash flows (the numerator) and the discount rate
(the denominator) of the basic stock pricing model.
For example, an increase in interest rates will precipitate a rise in the risk-adjusted rate of return, k, (the
discount rate), for a stock. Considering that all other
variables remained constant, the rate at which the
stock's future dividends are discounted to the present value would then rise. Hence, the stock price
should decline. In addition, a change in interest rates
may influence the growth rate of the stock's expected dividends through its impact on a firm's earnings
growth. For example, high interest rates could slow
e c o n o m i c activity and thereby adversely affect a
company's earnings. All else being equal, if an increase in the general level of interest rates would
25
precipitate a decline in a firm's dividend growth rate,
the stock price should decline.
Furthermore, fluctuations in the nominal interest
rate can have a different effect on a stock's growth
rate than on the discount rate. The nominal, or quoted, interest rate consists of two variables—the real
interest rate and expected inflation—and the reaction
of a stock price depends on which of these two
variables is changing. For instance, companies in
relatively price-inelastic industries, where demand
for the product or service is not sensitive to price
changes, may be able to pass cost increases arising
from higher inflation to their customers. The nominal
interest rate and the stock's discount rate would rise
in conjunction with expectations of increased inflation. However, because the firm's earnings may not
be affected, the dividend growth rate would not
change, all else being equal. Stocks of firms whose
customers absorb the inflation would be less sensitive to changes in the nominal interest rate caused
by a change in inflation expectations.
On the other hand, most stock prices would be
adversely affected by a rise in the real interest rate.
In a simple case, a higher real rate could lead to
higher costs for capital for companies, in turn dampening expansion and therefore earnings growth projections. Furthermore, rising real interest rates tend
to restrain general economic activity, further inhibiting a firm's earnings growth. In sum, rising real interest rates would likely lower a company's earnings
growth rate and raise the discount rate for the stock,
leading to a declining stock price.
The correlation of interest rates and other economic variables that may influence an equity security's price complicates any clear connection between
stock prices and interest rates. For this reason, the
simple equity duration equation must be modified.
One such model has been proposed by Martin Leibowitz and others (1989).
A Differential Approach to
Equity Duration
In the traditional equity duration model, the
growth rate, g, of the payment stream is assumed to
be unrelated to changes in the discount rate, k. In
the differential approach Leibowitz and his coauthors
used, the dividend discount model-based duration,
DDDW, is an input. This duration value is then modified for the different effects of a change in either the
real interest rate or inflation, or both. T h e researchers developed equation (10) to extend the dividend discount model duration:
26
Percentage
change
-DDDM\{(\
- y + 8b/8r)8r]
d
ddm
/
r
g
h
y
A
8b/8r
8h/8l
in price =
(10)
- [(1 - A +
8h/8l)8l}\.
!/(*-«>.
= the inflation component of the nominal
interest rate.
= the real interest rate component of the
nominal interest rate.
= constant growth parameter.
= equity market risk premium. Recall that
the discount rate, k, is a function of the
nominal interest rate, i, plus an equity
market risk premium, h, which is assumed to be equal to fifR v/ - Rf).
= the growth rate's sensitivity to changes
in real interest rates.
= the inflation flow-through, ranging from
0 to 1.
= a change in the stock's risk premium
given a change in the real interest rate.
= a change in the stock's risk premium
given a change in inflation expectations.
Equation (10) states that the interest rate sensitivity of a stock is directly related to the dividend discount model-based duration plus two terms that
account for the price effects of changes in both the
real interest rate and inflation.
This equation makes it possible to isolate the significance of a change in inflation expectations for
the value of a firm's equity. T h e inflation flowthrough in higher profits is accounted for by A,
which approaches 1 for complete flow-through. The
more inflation a firm can pass on—the higher the
inflation flow-through—the lower the interest rate
sensitivity of its stock price, all else equal, assuming
the change in interest rates was caused solely by a
change in inflation expectations. If the equity risk
premium, h, is unaffected by a change in inflation
(8h/8l = 0), the interest rate sensitivity of a stock can
be estimated using equation (11):
Percentage
change
in price = -DDDAf
l - A)A I. (11)
In addition, one can isolate the stock's sensitivity
to changes in the real interest rate:
Percentage
change
in price = -DDDA£1
- y)A r. (12)
The calculations by Leibowitz and others (1989)
produce much shorter duration values—results that
differ greatly from the traditional equity duration based
on the dividend discount model. This discrepancy
ECONOMIC REVIEW, MAY/JIJNE 1991
results from the fact that the two models measure different things. Leibowitz and his coauthors attempt to
measure a stock price's total interest rate sensitivity,
while the dividend discount model-based duration
measures the stock's sensitivity to its discount rate.
How the Factors Determining an
Equity's Value Affect Its Duration
Research examining the interest rate sensitivity of
stock prices and its relation to factors like dividends
and earnings growth that compose a stock's value
has provided results consistent with those of equity
duration. Duration provides an analytical tool for estimating how stocks of companies in different types
of industries (for example, growing or mature) or
different risk classes may be affected by interest rate
volatility. When analyzing the various stock-pricing
factors below and how they influence equity duration, Macaulay's duration index, equation (1), should
be kept in mind.
The duration measure, or a security's interest rate
sensitivity, is negatively related to the size of a security's cash flows, the frequency of the cash payments, and the level of a security's yield. In other
words, when any one of these variables rise while
all other variables are constant, the duration measure
for that security will decline—that is, its interest rate
sensitivity will decrease. On the other hand, duration
is positively related to the maturity of a security, all
else equal. With regard to equities, the sensitivity of
the duration measure to factors influencing a stock's
price is outlined below.
• Duration is inversely related to the size of a
stock's periodic dividend, or its dividend yield.
A stock that pays higher dividends will be less
sensitive to changes in interest rates, if all other
variables are equal, than a low dividend stock.
With higher dividends, more weight is applied
to the closer time periods, t. Thus the investor
will recoup the present value of an investment
in fewer years and the security will have less interest rate sensitivity.
• Duration is positively related to the growth rate,
g, of a security's cash flows, all other variables
equal. High-growth stocks are more sensitive
to changes in interest rates than low-growth
stocks. A higher growth rate increases the more
distant cash flows' contribution to the present
value of the security and thus assigns greater
weight to the distant time periods, resulting in a
longer duration. Furthermore, duration is posi-
FEDERAI. RESERVE BANK O F ATLANTA
tively related to the term of the expected growth
(for example, the length of time the firm's earnings are expected to grow at rate g).
• Duration is negatively related to the level of a
security's discount rate, k, all other variables
equal. The higher the required rate of return on
a stock, the lower its duration, all else equal.
This factor has the opposite effect of the growth
rate on the stock's duration. A higher discount
rate would lower the present value of the more
distant payments and thus the weight applied to
the distant time periods, reducing the duration.
• The discount rate is a combination of the level
of the risk-free interest rate and a risk premium.
Holding the risk premium constant, the discount
rate, k, will rise with the general level of the
risk-free interest rate. Therefore, the higher the
general level of interest rates in the market, disregarding a security's risk premium, the lower a
stock's sensitivity to changes in the level of interest rates will be, all other variables equal.
• Alternatively, holding the risk-free rate constant,
the required rate of return, k, will increase with
a rise in the stock's risk premium, P f R M - R F )Therefore, a security with a higher risk premium
will be relatively less sensitive to changes in the
level of interest rates than a less risky security,
all else equal.
• The risk premium is partly influenced by a
stock's beta, or its correlation with the market.
Thus, the duration of an equity security is negatively related to its beta,
all other variables
equal. Low beta stocks are more sensitive to
changes in interest rates than high beta stocks,
all else equal. This was found to be a partial inverse relationship.9
Conclusion
In contrast to a bond price's inverse relationship
to interest rates, the relationship between interest
rates and stock prices is indirect and complex. For
example, if interest rates were to decline, stock
prices may or may not rise. Although the present
value of a stock's expected dividends will rise, the
nominal value of these cash flows may be affected
by a correlation of interest rates and other economic
variables that could offset the favorable effect on a
stock's price.
While a bond's price variability can be fully explained by interest rate fluctuations, employing
Macaulay's duration, a stock price's sensitivity to
changes in interest rates can be adequately gauged
27
only by incorporating the correlations between interest rates and other economic variables affecting a
stock's price with duration. Moreover, the effects of
a change in the nominal interest rate based on a
change in the real interest rate or in inflation expectations must be specified as illustrated by Leibowitz
and others' ( 1 9 8 9 ) equity interest rate sensitivity
model.
Because many interactive factors may influence
stock prices, there can be no simple assumptions
about their behavior. For instance, if interest rates
are expected to fall, stock prices do not necessarily
rise. A recent example occurred in early 1991 when
the slow domestic economy was pushing interest
rates down and at the same time indirectly pressuring stock prices downward partly because lower corporate earnings were being projected. Even though
it is possible to successfully account for the direct
and indirect effects of interest rates on a stock's value, doing so explains only a portion of the security's
variability.
Notes
1. For risk-free bonds the yield is derived from the price
based on the assumption that the cash flows (for example, coupon payments) are reinvested as received at the
yield during a bond's life.
2. It should be kept in mind that even if the duration model is successfully modified to account for the indirect influences of interest rates, it will generally explain only
the portion of the stock price's variability that can be attributed solely to movements in interest rates.
3. It is common to see this calculation as -FT • A r, where
FT is D/(l + r), or modified duration.
4. Duration is the derivative of the security's price with respect to its yield, 8P/8y. This derivative approximates
the rate of change in the security's price when the
change in its yield is very' small. The smaller the change
in y, the closer the approximation is to the true value of
AP/Ay. Thus, duration is a linear approximation to a
nonlinear relationship. Duration is the second term in
a Taylor series expansion of a security's price func-
tion. The third term, convexity, is the second derivative
of the security's price function with respect to its yield,
8 2 P/8y 2 . It is a measure of the curvature of the priceyield graph, the change in duration. Adding convexity to
the duration value more closely estimates a security's
price change.
5. See, for example, Boquist, Racette, and Schlarbaum
(1975), Malkiel (1963), Casabona, Fabozzi, and Francis
(1984), Ben-Horim and Callen (1989), and Reilly and
Sidhu (1980).
6. For a more extensive review of the dividend discount
model concept, see Brealey and Meyers (1988).
7. Fquation (4) reduces to D/(k- g), where D = D 0 (l + g).
8. The approach to computing Macaulay's duration for a
common stock based on employing the traditional dividend discount model is taken from the research of Boquist, Racette, and Schlarbaum (1975).
9. See, for example, Casabona, Fabozzi, and Francis
(1984).
Bibliography
Ben-Horim, Moshe, and Jeffrey L Callen. "The Cost of
Capital, Macaulay's Duration, and Tobin's q." The Journal of Financial Research 12 (Summer 1989): 143-56.
Bierwag, G.O., George G. Kaufman, and Alden Toevs.
"Duration: Its Development and Use in Bond Portfolio
Management." Financial Analysts Journal 39 (July/August 1983): 15-35.
Boquist, John A., George C. Racette, and Gary G. Schlarbaum, "Duration and Risk Assessment for Bonds and
Common Stocks." Journal of Finance 30 (December
1975): 1360-65.
Brealey, Richard A., and Stewart C. Meyers. Principles of
Corporate Finance. 3d ed. New York: McGraw-Hill,
1988.
Casabona, Patrick A., Frank J. Fabozzi, and Jack C. Francis.
"How to Apply Duration to Equity Analysis." Journal of
Portfolio Management 10 (Winter 1984): 52-58.
Durand, David. "Growth Stocks and the Petersburg Paradox.",Journal of Finance 12 (September 1957): 348-63.
28
Farrel, James L., Jr. "The Dividend Discount Model: A
Primer." Financial Analysts Journal 41 (November/December 1985): 16-25.
Haugen, Robert A., and Dean W. Wichern. "The Elasticity
of Financial Assets." Journal of Finance 29 (September
1974): 1229-40.
Hicks, John R. Value and Capital. London: Oxford University Press, 1939.
Johnson, Lewis D. "Equity Duration: Another Look." Financial Analysts Journal 45 (March/April 1989): 7375.
Lanston, Ronald, and William F. Sharpe. "Duration and Security Risk." Journal of Financial and
Quantitative
Analysis 13 (November 1978): 653-70.
Leibowitz, Martin L. "Total Portfolio Duration: A New Perspective on Asset Allocation." Financial Analysts Journal A2 (September/October 1986): 18-29.
Leibowitz, Martin L., Eric H. Sorensen, Robert D. Arnott,
and H. Nicholas Hanson. "A Total Differential Approach
ECONOMIC REVIEW, MAY/JIJNE 1991
to Equity Duration." Financial Analysts Journal 45
(September/October 1989): 30-37.
Macaulay, Frederick R. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and
Stock Prices in the United States since 1856. 1938.
Reprint. New York: Arno Press, 1980.
FEDERAI. RESERVE BANK O F ATLANTA
Malkiel, Burton G. "Equity Yields, Growth, and the Structure of Share Prices." American Economic Review 53
(December 1963): 1004-31.
Reilly, Frank K., and Rupinder S. Sidhu. "The Many Uses
of Bond Duration." Financial Analysts Journal 36 (July/August 1980): 58-72.
29
Book Review
International Trade and Finance
Reference Sources
Jerry J. Donovan
This review of international trade and finance reference sources includes information on classic
worldwide directories of administrative, geographical, and political units as well as worldwide statistical compendiums.
These publications have demonstrated their usefulness over many years. A
selection ofperiodicals
dealing with international trade and finance, ranging from popular to
academic, will be discussed in the fuly/August issue of Economic Review. The forthcoming
review
will place more emphasis on principal identifiable trade and finance areas of the world such as
the Pacific Rim, the European Community, and Latin America.
he imminent attainment of a single European Market ("Europe 1992"), scheduled
to become operational January 1, 1993,
indicates that global economic integration is becoming a reality. 1 Such a development,
along with the spread of regional trade agreements,
in turn draws attention to the increased need for systematic access to data and information on international trade and finance. Fortunately, a wide
selection of publications tracks the levels and composition of this international activity and provides
timely analysis that can be useful not only to
economists, statisticians, and academicians but also
to business people, bankers, and staff in government
agencies.
T
A selection of these sources is reviewed here. All
the titles considered are serials, whose format allows
continuous updating of data, categories, names, and
regimes important in world markets and their finance.
The publications described here are, for the most
part, classics with proven track records, forming the
nucleus for an international trade and finance reference book shelf. (One, first published in 1864, is in
its 127th edition.) They range in subject matter from
commercial publications like directories of administrative, geographical, and political units to statistical
compendiums and outlook discussions by international agencies. The first section of this review will
30
cover worldwide directories, and the second will
present worldwide statistical compendiums.
Worldwide Directories: Administrative,
Geographical, and Political Units
The Europa World Year Book 1990. London: Europa
Publications Ltd., 1990. $265.00/set (two-volume index). ISSN 0956-2273.
The Europa World Year Book, a well-known encyclopedia that began in 1926, provides reliable, detailed information on political, e c o n o m i c , and
commercial institutions of Europe and the world.
The yearbook is published in a two-volume set.
Volume 1 is in two parts, the first giving exhaustive overviews of international organizations. Part 1
begins with a description of the structure of the
United Nations with its components: Regional Commissions (for example, the Economic Commission
for Africa), Other Bodies (such as the World Food
Council), and Specialized Agencies within the UN
System (such as the International Labor Organisation). Listings for more than fifty additional international bodies follow, ranging from the African
Development Bank and the Andean Group to the
World Federation of Trade Unions. Volume 1, part 2,
ECONOMIC REVIEW, MAY/JIJNE 1991
begins the alphabetical coverage of nations with
Afghanistan through Jordan and concludes with an
index to international organizations. Volume 2 continues the alphabetical treatment of nations from
Kenya through Zimbabwe; at the end of the volume
is an index of the entire list of nations.
Accounts of countries in The Europa World Year
Book are always elaborately detailed. Each description begins with a survey of the nation's geographical location, climate, history, and socioeconomicconditions, a c c o m p a n i e d by statistical surveys
drawn from official publications. Each territorial entry also provides information about government
structure (including the constitution, where applicable), political parties, diplomatic representation, the
population's religious affiliations, press, publishers,
radio and television, finance, trade and industry,
transport and tourism, and atomic energy. The
names of important government officials are furnished, making the book a virtual international
who's who.
The Europa World Year Book's extensive coverage
of the European Community (EC) encompasses topics such as a list of members; addresses and phone
numbers of permanent representatives; a summary
of the 1958 Treaty of Rome, establishing the European "Common Market"; community institutions (for
example, the Commission of the European Communities); community activities (such as the European
Monetary System); and publications, including the
address and phone number for the Office for Official
Publications.
Both volumes have complete lists of the numerous and often obscure abbreviations used by international organizations, like ECOSOC, the United
Nations Economic and Social Council. These lists
eliminate the need to switch back and forth between
volumes to identify crucial abbrevations.
The Europa World Year Book is admittedly cumbersome because of its extensive coverage and comprehensive detail. However, it is a keystone for a
collection of books and periodicals on foreign nations and international organizations.
The Statesman's Year-Book 1990-91: Statistical
and
Historical Annual of the States of the World, edited
by John Paxton. New York: St. Martin's Press, 1990.
$55.00. ISBN 0-312-04614-6.
While the two-volume Europa World Year Book
consumes five inches or more of shelf space, The
Statesman's Year-Book, offers adequate detail in the
same subject areas in a handy, less expensive format that can be tossed in a desk drawer. The States-
FEDERAI. RESERVE BANK O F ATLANTA
man's Year-Book.: Statistical and Historical
Annual
of the States of the World, which dates back to 1864,
ranks very high on any list of concise and dependable reference manuals about countries of the world
and international organizations. It is a major compendium, mostly discursive, but also packed with
useful statistics.
The yearbook's (one-volume) arrangement
roughly parallels that of The Europa World Year
Book, with discussions of "International Organizations" (part 1) followed by "Countries of the World
A-Z" (part 2). In the 1990-91 edition, special features
like tables listing world foodstuffs are worked in before the formal beginning of part 1. There is also a
chronology of world events for the year preceding
the imprint date. Special indexes covering international organizations, products, names, and places facilitate quick reference. "Further Reading" lists of
available official publications and corollary articles
and books conclude each topical section. The Statesman's Year-Book gives fundamental facts for every
country through concise summaries on the nation's
geography, history, politics and government, education, economics, agriculture, commerce, banking
and credit, religion, and social welfare. The yearbook also provides comparable details at the individual state, province, and territory levels. This
technique proves useful because many large states
or provinces like California or Quebec clearly exceed the economic or political importance of small
sovereignties.
'Ihe World Factbook. 1990, U.S. Central Intelligence
Agency. Washington: U.S. Government Printing Office, n.d. S 19.00. (Available on CD-ROM at $99-00.)
The Central Intelligence Agency's World Factbook
is produced annually for use by U.S. government officials, although it is available to the public. Its terse
style, format, coverage, and content are designed to
meet government requirements. Less detailed than
The Europa World Year Book or The
Statesman's
Year-Book, the compactly organized World Factbook
is devoted almost entirely to coverage of individual
nations.
Lengthy "Notes, Definitions, and Abbreviations"
open the work. Information on international organizations is presented in diagrams and tables in the
appendixes, which consist of a diagram of the United Nation's components, followed by tables for the
'Ihe reviewer is the research librarian in the Atlanta Fed's
research library.
31
international organizations and their member nations; t a b l e s o f w e i g h t s and m e a s u r e s ; and a
cross-reference list of geographic areas, which indicates where various names, including alternate and
former versions, and political or geographical entities
can be found in the book. Ihe World Factbook also
contains extensive maps of world regions corresponding roughly to the continents, as well as a
"World Guide to Regional Maps" and a breakout of
"Standard Time Zones of the World."
The incisive design of this Central Intelligence
Agency production makes it an "executive summary"
of material that the other two world yearbooks treat
more diffusely and in more detail. The alphabetical
arrangement of the country studies obviates an index, but the table of contents provides convenient
and quick access.
A conspicuous shortcoming of the book is the
perfunctory treatment of the Common Market and
the European Communities, which are given only
passing mentions in the table of Country Membership in International Organizations. The realization
of Europe 1992 will warrant more extensive attention
in a future World Factbook. Nevertheless, for users
who wish to go straight to unembellished fact, sometimes relying on the design of the printed page to
point up inherent relationships, the CIA publication
is the definitive choice. Given its low price as well,
the book is a sound value.
Encyclopedia
of Associations—International
Organizations, 1991, 25th ed., edited by Linda Irvin. Detroit: Gale Research, 1991. S285.00. ISBN 0-81037406-4 (Parts 1-2).
The Encyclopedia
of
Associations—International
Organizations
is one of three components of the Encyclopedia of Organizations "family" whose combined texts present entries for more than 78,000
organizations. It is available in hard copy and CDROM. Sibling to the Encyclopedia
of
Associations—
National
Organizations
of the U.S. and the
Encyclopedia
of Associations—Regional,
State,
and
Local Organizations,
International
Organizations
(in
a two-volume set) rounds out worldwide coverage
of associations and organizations. International
Organizations
covers "nonprofit organizations that are
international in scope, membership, or interest . . .
including multinational and binational groups, and
national organizations headquartered outside the
U.S."
An example of a typical trade and development
association entry in International
Organizations
illustrates the publication's potential usefulness (see
32
Figure 1
• 2 9 5 * TURKISH INDUSTRIALISTS' AND BUSINESSMEN'S
ASSOCIATION (TIBA)
(Turk Sanayicileri ve Isadamlari Dernegi - TUSIAD)
Cumhuriyet Caddesi 233/9-10
Harbiye
Phone: 1 462412
TR-80230 Istanbul, Turkey
E. Ihsan Ozol, Sec.Gen.
Founded: 1971. Members: 297. Staff: 19 Budget: TL 4,000,000,000.
Languages: French, Turkish; corresponds in English. National. Bankers,
companies, contractors, industrialists, and other business professionals.
Aims to contribute to the success of Turkey's industrial development and
assist in attaining welfare standards enjoyed in the industrialized world.
Promotes public weltare through private enterprise by bringing together
the views, experience, and support of those engaged in industry and
business. Conducts research in economic prospects and trends, fiscal and
monetary developments, marketing, industrial performance, the world
economy, and public affairs. Maintains 3000 volume business library.
Computerized Services: Accounting services; data base; electronic
publishing; mailing list. Telecommunications Services: Fax, 1 470082;
telex, 22318 TSAD-TR. Committees: Turkey-EC Rela tions; Turkish
Tourism. Divisions: Economic Research; Press. Affiliated With: Union of
Industrial and Employers' Confederations of Europe.
Publications:
State of the Turkish Economy (in Turkish), annual.
• Turkish Economy (in English), annual. • TUSIAD Members' Company
Profiles (in English), periodic. Directory. • Also publishes economic reports and studies.
Convention/Meeting: annual symposium.
Source: Encyclopedia of Associations—International
Organizations,, 1991, 25th e<±, Linda Irvin, ed. (Detroit:
Gale Research, 1991), 34.
Figure 1). The entry for the Turkish Industrialists'
and Businessmen's Association provides information
essential for communication with this organization—not only the name of the person in charge
and the address, telephone, and FAX numbers but
also the crucial fact that the group is prepared to
converse only in French and Turkish, although it
will correspond in English. The particular areas of
economic development the Turkish Industrialists'
and B u s i n e s s m e n ' s A s s o c i a t i o n p r o m o t e s are
spelled out along with the fact that they maintain a
sizable library, conduct research, and are affiliated
with the Union of Industrial and Employers' Confederations of Europe (an organization also included in this directory).
The Encyclopedia
of
Associations—International
Organization^s
deep indexing makes it quite easy
to use. To find one's way around part 1 of the set,
which is organized by item number, it is necessary
to employ one of the four indexes that make up
part 2: geographic, executive, organization name,
and keyword. Introductory material explains the organization of entries and the fifteen broad subject
categories; provides a keyword list to relate the us-
ECONOMIC REVIEW, MAY/JIJNE 1991
er's "natural" vocabulary to these categories; gives
worldwide abbreviations for geographical entities;
and lists the currencies of the world nations. The
Encyclopedia
of Associations—International
Organizations, whether in hard copy or online, is a basic
tool for access to trade associations and professional
groups around the world.
1988-1989
World Currency Yearbook, by Philip P.
Cowitt. Brooklyn, N.Y.: International Currency Analysis, Inc., 1991- $250.00. ISBN 0-917645-03-0.
A working knowledge of foreign currencies is
crucial to importing and exporting in world markets, searching out new markets, or protecting investments abroad. The World Currency
Yearbook
provides practical historical and current information about social, political, fiscal, and monetary
policies, as well as factors such as political corruption, all of which potentially influence the e x c h a n g e r a t e s o f c u r r e n c i e s . In a d d i t i o n , t h e
publication gives measures (estimates) of flight
capital and includes such facts as how much national currency a traveler can bring in or take out
of a country. It also provides information on world
currencies, including official and "black market"
exchange rates.
The World Currency Yearbook is a formidable single source of practical information about money. The
current volume provides complete descriptions of
147 world currencies as well as a monetary glossary;
a list of abbreviations; currency, trade, and other organizational areas (of the world); monetary "spheres
of influence" (like Franc-Zone and OPEC); currency
control categories (such as, free, liberal, or strict control); gold restrictions; and international black market
positions.
Representative of the topics addressed in this yearbook and its thoroughness is the CFA franc presentation. CFA stands for the Communauté Financière
Africaine, an area comprising the Central African
Currency Union and the West African Currency
Union. The yearbook's discussion encompasses an
exhaustive protocol of factors necessary to understanding the CFA franc, including the history and
transferability of the currency; developments in each
country within the CFA (at length—twenty-five
pages); currency varieties and administration (see
Figure 2); the names of the governors of each central bank; statistical information on all countries in
the CFA; a ten-year c u r r e n c y record; the total
amount of currency in circulation and per capita;
and parallel market rates of U.S. dollars or unlicensed transfers abroad.
RESERVE BANK O F ATLANTA
Digitized FEDERAI.
for FRASER
Figure 2
CURRENCY VARIETIES
In CFA Francs per U.S. Dollar (At December 30,1988)
Official
A. CFA Franc (Theoretically Defined At 3.2 Milligrams Of Fine Gold), Or 0.02 French Francs . . 230.207
B. Effective CFA Franc; Controlled Floating Rate,
Applicable To All Transactions
302.95
C. Nonresident CFA Franc Accounts (Comptes
Etrangers); Resulting From Conversion Of
Foreign Currencies, Current Payments And
Authorized Capital Transfers. Freely Transferable Abroad
302.95
Unofficial
D. Parallel Market CFA Franc; Resulting From
Unauthorized Dealings Of Foreign Currency
Banknotes And/Or Unlicensed Transfers
Abroad
310.00
CURRENCY ADMINISTRATION
The Banque des Etats de l'Afrique Centrale (BEAC) is the
Central Bank for the Central African Currency Union, while
the Banque Centrale des Etats de l'Afrique de l'Ouest
(BCEAO) is the monetary authority for the West African Currency Union. Both institutions hold their exchange reserves
in French Francs in an Operations Account (Compte
d'Opérations) with the French Treasury, except for the BEAC
maintaining 20% and the BCEAO 35%, respectively, of their
reserves in foreign currencies. In the individual states,
exchange and trade licensing controls are usually handled
by the Directorate of Economic Controls and External
Finance attached to the Ministry of Finance, in cooperation
with or under the supervision of the appropriate Central
Bank. Trade licensing or controls is usually under the jurisdiction of the Ministry of Commerce and Industry or the
Ministry of Finance. The CFA group is in the Franc-Zone,
has an associated status with the Common Market, and
belongs to the International Bank and International Monetary Fund in Washington.
Source: 1988-1989 World Currency Yearbook, Philip P.
Cowitt. (Brooklyn, N.Y.: International Currency
Analysis, Inc., 1991), 63.
Concluding the 1988-1989
World Currency
Yearbook. are a discussion of the Eurocurrency market; an
appendix for currency circulation per capita (with an
accompanying table giving descending national rank,
as of 1987, at Free Rate of U.S. Dollar—that is, converted into U.S. dollars at the free or black market
values of the currencies as compiled by the staff of
the publisher, and listed according to U.S. dollar
amount); money supply per capita (ranked as per
capita currency in circulation); a directory of countries' central bank officials, listed alphabetically from
Afghanistan to Zimbabwe; and the index.
T h e World Currency
Yearbook
has been published annually since 1984. Its predecessor, Pick's
33
Currency Yearbook, dates back to 1955. Volumes
from 1955 to 1984 are available on microfilm.
Annual Report on Exchange Arrangements and Exchange Restrictions, 1990, the International Monetary
Fund. Washington: IMF, 1990. $39.95. ISSN 02507366 (English only).
The International Monetary Fund's Annual Report
on Exchange Arrangements and Exchange Restrictions,
dating from 1950, provides detailed country-by-country
descriptions of the exchange and trade systems of
the 152 individual IMF member countries, as well as
Hong Kong (for which the United Kingdom has accepted the IMF's Articles of Agreement), Aruba and
the Netherlands Antilles (for which the Kingdom of
the Netherlands has accepted the IMF's Articles of
Agreement), and Switzerland (which does not belong to the IMF).
The information in this publication is current for
both the year indicated by the title as well as for the
first quarter of the year after the one cited in the title. Despite some format changes in the reports for
1989 and 1990, this directory remains critical to coverage of factors affecting world trade and finance. 2
The annual report is actually a manual that provides standardized coverage of a broad range of topics for e a c h country: e x c h a n g e arrangements,
including the official exchange rate as of December
31 (unless otherwise noted); the authorities responsible for financial policy (for example, central bank or
the ministry of finance); the selection of currency
and method of settlement for transactions with other
countries; facilities and limitations attached to accountholders not regarded as resident in the country;
import-licensing requirements; payments for invisibles (such as travel expense, transfers of salaries and
wages). Other topics detailed include exports and
export proceeds, including detailed explanations of
expressions such as "exchange receipts must be surrendered," indicating the disposition of export proceeds as to kind of currency and rate of exchange
and authorized banks or dealers who may participate; limitations on the import of foreign and domestic bank notes; special arrangements or limitations
attached to international capital movements; and, finally, a summary of the principal regulations governing holding, negotiating, importing, or exporting
gold coin or gold in other forms.
Country coverage of principal nations ends with a
calendar of significant changes during the past year
in each of the categories listed above. A table summarizing features and a list of abbreviations concludes the volume. There is no index.
34
For the practitioner whose interests in world trade
and finance are limited to IMF countries, the Annual
Report on Exchange Arrangements and Exchange Restrictions, at about $40, may be a better value than
the more expensive World Currency Yearbook. The
Annual Report, in fact, offers more detailed coverage
of places like Chad, Grenada, or St. Kitts and Nevis
than does the World Currency Yearbook, whose brief
references are embedded within the coverage for
"CFA Franc" (for Chad) and the "East Caribbean Dollar" (for Grenada and St. Kitts and Nevis).
Worldwide Statistical Compendiums
Historical statistics quantify and record the past,
but at the same time they present data which,
through empirical analysis, can be helpful in predicting the future. Thus, statistical series form a basic
part of any core collection on international finance
and trade. The statistical compendiums described
here, which complement each other, present a world
view of international trade and finance.
The International Monetary Fund (IMF) and the
Organisation for Economic Cooperation and Development (OECD) are probably the two most comprehensive sources of up-to-date worldwide statistical
data. A comparison of the purposes and objectives
of the two organizations (as spelled out in The
Statesman's Year-Book, 1990-91, pages 19 and 35, respectively) helps in choosing between thetfe two
agencies as the principal sources for international
trade and finance data.
The International Monetary Fund. The International Monetary Fund, with more than 150 member
nations, was established as an independent international organization in 1945 and began operation in
1947. The purpose of the IMF, as stated in The
Statesman's Year-Book., is "to promote international
monetary co-operation, the expansion of international trade and exchange rate stability; to assist in the
removal of exchange restrictions and the establishment of a multilateral system of payments; and to alleviate any serious disequilibrium in members'
international system of payments by making the financial resources of the Fund available to them, usually subject to conditions to ensure the revolving
nature of Fund resources."
Although many of the titles in the long list of
IMF publications are distinguished and attract a variety of informed users, only four statistical compendiums stand out as germane to this discussion:
International
Financial
Statistics Yearbook,
Balance of Payments Statistics Yearbook, Direction
of
ECONOMIC REVIEW, MAY/JIJNE 1991
Trade Statistics Yearbook, and Government
Finance
Statistics Yearbook. These titles are published principally in English, French, and Spanish, although
sometimes in German and Portuguese. The yearbooks summarize the annual activity of their respective monthly publications and give historical series.
All four of the statistical publications of the International Monetary Fund are available on magnetic
tape. Statistical information is entered into the IMF
Economic Information System (EIS), a computer system for storing, maintaining, and manipulating data,
as well as assembling tables for hard copy publications. Researchers interested in finding EIS information in a hard copy format can consult recent
yearbooks, which contain a table displaying the EIS
code, the line number, and a title (in English,
French, and Spanish) for each line of the yearbooks'
statistical tables.
International Financial Statistics, International Monetary Fund. $148.00 (twelve monthly issues and a
yearbook). ISSN 0250-7463.
International
Financial
Statistics is a standard
source of statistics on all aspects of international and
domestic finance. Although the yearbook includes illustrative international charts while the monthly issues do not, both feature the same basic design: a
section of world tables and a section of country tables. The yearbook provides comparative data, by
country, for thirty years. For each country, the tables
include exchange rates, international liquidity, money and banking, international transactions, prices,
production, government finance, interest rates, and
other items. The International
Financial
Statistics
Yearbook is published simultaneously in English,
French, and Spanish.
Direction of Trade Statistics, International Monetary
Fund. Washington: IMF. $52.00 (twelve monthly issues and yearbook). ISSN 0252-3019.
Direction of Trade Statistics functions as a supplement to International Financial Statistics. The 1990
yearbook, the twenty-fifth in the series, presents figures on the value of merchandise exports and imports by trade partners for the 1983-89 period for
161 countries. The beginning tables are area and
world aggregates showing trade, denominated in
dollars, between major world areas. The composition of these areas, along with area codes, is printed
inside the back cover. Introductory material is provided in English, French, and Spanish.
FEDERAI. RESERVE BANK O F ATLANTA
Data on exports and imports by trading partners
vary in terms of frequency and timeliness. Approximately forty countries, comprising virtually all of
the industrialized economies and about twenty developing nations, report their figures monthly. In
recent years, these forty countries have represented about 80 percent of the value of recorded
world exports and imports. The fact that much of
the data is bilateral makes it possible to include estimates for current periods not only for countries
less current in their reporting but also for countries
for which data are not o b t a i n a b l e from other
sources.
Since publication of the 1989 yearbook, the estimation procedure has been modified and enhanced:
now the entire DOTS computerized data base is
continuously supplemented with estimates based on
total exports and total imports reported independently and published in International
Financial
Statistics. The methodology for presenting benchmark data is thoroughly discussed in the introduction.
For the seven years of data presented in each Direction of Trade Statistics yearbook, usually published in July, statistics are divided into two sets of
world and area summaries, as well as by individual
country. World and area trade information can be
gleaned from data from reporting countries and
their partner countries in those transactions.
Balance of Payments Statistics, International Monetary Fund. Washington: IMF, 1990. $63.00 (two-part
yearbook). ISSN 0252-3035.
Balance of Payments Statistics reports balance of
payments data sent to the International Monetary
Fund by member countries. The publication contains
monthly, quarterly, and yearly balance of trade
statistics for about 140 countries, compiled in accordance with the IMF's Balance of Payments
Manual
(4th ed., 1977). Until recently, the publication consisted of twelve monthly issues with a two-part yearbook. The monthly issues ceased publication,
however, with the April 1991 issue. Monthly data
will still be available on subscription magnetic tapes.
The yearbook will continue to be published and will
contain the same information as in the past.
Part 1 of the yearbook includes two tables that
show aggregate as well as detailed transactions data
for eight years and explanatory notes. Available data
on external assets and liabilities are shown in a third
table. Part 2 of the yearbook provides fifty-five tables
of data on area and world totals for balance of payments components and aggregates.
35
Government Finance Statistics Yearbook, International Monetary Fund. Washington: IMF, 1990. $48.00
(published annually). ISSN 0250-7374.
The Government Finance Statistics Yearbook for
1990 provides annual financial statistics for up to a
ten-year period on the 122 member country governments in detailed tables on central government revenue, expenditure, lending, financing, and debt. The
publication also presents, in somewhat less detail,
data on subnational government levels (states,
provinces, municipalities). The inside back cover displays a guide to statistical and institutional tables that
indicates the years for which data are given for
countries in the yearbook.
Introductions and main headings are printed in
English, French, and Spanish. Detailed headings for
French-speaking, Portuguese-speaking, and Spanishspeaking countries are usually given in English and
in the national language.
The Organisation for E c o n o m i c Cooperation
and Development. Encompassing essentially only
the world's industrialized nations, the Organisation
for Economic Cooperation and Development (OECD)
has more limited membership than the IMF. The
OECD succeeded its predecessor, the Organisation
for European Economic Cooperation (OEEC), in
September 1961. The change in title marked the organization's altered status: inclusion of Canada and
the United States meant the organization was no
longer purely European. The revamped organization
also added development aid to the list of its other
activities. The membership at the present time consists of twenty-four nations: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Greece, Iceland, Ireland, Italy, Japan, Luxembourg,
the Netherlands, New Zealand, Norway, Portugal,
Spain, Sweden, Switzerland, Turkey, the United
Kingdom, and the United States. Yugoslavia participates in the organization's activities with special status.
The objectives of the Organisation for Economic
Cooperation and Development are "to promote
economic and social welfare throughout the OECD
area by assisting its member governments in the formulation of policies designed to this end and by coordinating these policies; and to stimulate and
harmonize its members' efforts in favor of developing countries." The IMF statistical sources provide
data on a wider range of countries than do those
from the OECD, but OECD statistical publications offer a wider array of subjects than do those of the
IMF, which tend to focus solely on international and
national financial data.
36
Through its Economics and Statistics Department
(ESD), the OECD publishes statistics on factors influencing economic development in publications
such as Quarterly National.Accounts
and National
Accounts (two volumes, annual), Monthly Statistics
of Foreign Trade and Foreign Trade by Commodities:
Series C (annual), Quarterly Labour Force Statistics
and Labour Force Statistics (annual), Main Economic
Indicators (monthly), and Indicators of
Industrial
Activity (quarterly). Hard copy editions, magnetic
tapes, and diskettes are available; statistics on foreign trade by commodity can also be obtained on
microfiche.
Main Economic Indicators
provides at-a-glance
information on the most recent changes in the
economies of the OECD countries and a collection
of statistics on economic developments affecting
OECD areas during the past few years. This comprehensive publication covers national accounts, industrial production, deliveries, stocks and orders,
construction, internal trade, labor, wages, prices, domestic and foreign finance, interest rates, international trade, and payments.
Although the OECD Economic
Outlook is not,
strictly speaking, a statistical publication, this semiannual review contains important numerical data based
on an analysis of each country. Practitioners specializing in forecasting will find the Outlook particularly
useful because it provides the OECD's projections
for output, employment, prices, and current balances
over the next two years, based on an OECD review
of each member country and the feedback affect of
international developments on each of them. Specific
attention is paid to the policies governments are
adopting to solve present economic problems. Summary statistics and projections are included for the
external accounts of OPEC and non-oil developing
countries.
Supplementary Sources. Although the IMF and
OECD data sources reviewed above are thorough
enough for most needs, they do not represent total
closure on available data. Some important publications from several international organizations that
have not been included here may need to be taken
into account to achieve an exhaustive overview of
the international finance and trade literature. For example, the pertinent source for U.S. trade data disaggregated by sector or commodity is the Survey of
Current Business (U.S. Department of Commerce,
Bureau of Economic Analysis). Comprehensive, albeit delayed, coverage of national accounts is provided by the United Nations' National
Accounts
Statistics: Main Aggregates and Detailed Tables. To
find specific information on particular imports and
exports, rather than summary figures, one would
ECONOMIC REVIEW, MAY/JIJNE 1991
have to consult at least one of three alternative statistical sources: World Debt Tables 1990-1991;
External
Debt of Developing Countries (The International Bank
for Reconstruction and Finance/The World Bank);
International
Banking and Financial Markets Developments (Bank for International Settlements [BIS]);
and Handbook
of International
Trade and
Develop-
ment Statistics (United Nations Conference on Trade
and Development).
With this caveat in mind, a researcher can use
the collection of statistical compendiums discussed
in this review to construct a solid historical base
for analyzing domestic and overseas finance and
trade activity.
Notes
1. For a full discussion of the Europe 1992 program and its
agenda, see the forthcoming article by Janice L. Boucher, "Europe 1992: A Closer Look," scheduled for the
July/August issue of Economic Review.
2. A section called "Developments in the International Exchange Rate and Restrictive Systems," which for years
formed part 1 of the two-part report, has been omitted
from the 1989 and the 1990 reports. The IMF has scheduled separate publication of this assessment of develop-
FEDERAI. RESERVE BANK O F ATLANTA
ments for the 1989 report as a forthcoming component
of its series World Economic and Financial Surveys. It
will be titled "Developments in the International Exchange Rate and Restrictive Systems." At this writing,
the IMF has no plans for separate publication of assessment of developments for the 1990 report. With the
publication of the 1991 report, however, the former
two-part format will be resumed, including the assessment of developments.
37
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