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2
in fla tio n , G row th and
Exchange Rates
I. Introduction and Summary
5
II. Inflation and Economic Growth in Pacific Basin
Developing Economies
8
Maxwell J. Fry
. . . In combination, monetary deceleration with interest-rate increases could lower
inflation and, simultaneously, raise the real rate of economic growth.
III. Money and Credit in China
19
Hang-Sheng Cheng
. . . China’s financial future largely depends on whether the authorities can forge an
effective monetary policy that does not rely primarily on direct controls.
IV. The Influence of Real Factors on Exchange Rates
37
Charles Piggott
. . . Real factors have represented a major source—in some cases the single largest
source—of exchange-rate fluctuations about trend over the last eight years.
V. Effectiveness of Exchange-Rate Changes on
the Trade Account:The Japanese Case
Kenneth Bernauer
. .. Japan’s expanding surpluses of 1980 and 1981 stemmed largely from an
improvement in Japan’s price competitiveness, leading to robust exportvolume gains.
Editorial committee for this issue:
Joseph Bisignano, Randall Pozdena and Adrian Throop
3
55
The past decade's turmoil in the international economy has provided economists with
a treasure trove of interesting research topics.
Throughout this period, the developed nations
of the Atlantic Basin have wrestled with problems of inflation, growth and exchange adjustment. Meanwhile, the developing nations generally fast-developing nations - of the
Pacific Basin have faced variations of the same
problems. This issue of the Economic Review
investigates several of these problems, and
especially their effects on Pacific Basin
economies.
Maxwell J. Fry notes that some developing
economies have exhibited a negative correlation between long-run average inflation and
real economic growth. He suggests one possible explanation - financial repression, that is,
institutional interest rates fixed below their
competitive, free-market equilibrium levels by
administrative fiat. To test that thesis, he
applies a small-scale model of inflation and
economic growth to seven Pacific Basin
developing countries that have utilized such
financial restrictions.
Fry's analysis provides an important policy
conclusion: "Flexible interest-rate policies in
financially repressed economies can be used to
counter inflationary shocks and accelerate the
real rate of economic growth." An increase in
the real deposit rate towards its competitive
equilibrium level raises real money demand,
so reducing inflationary pressures. At the same
time, the availability of credit increases in real
terms. Consequently, real economic growth
rises, which increases real money demand
some more. "Inflation drops; the virtuous circle is complete."
Fry notes the well-known policy dilemma:,
Lowering the rate of monetary expansion to
bring down inflation raises unemployment and
reduces real economic growth in the short run.
"However, financially repressed economies
can use both the money supply and nominal
interest rates as independent policy instruments." Monetary deceleration could have a
permanent inflation-reducing but temporary
depressing effect on real economic growth. But
raising nominal institutional interest rates
towards their competitive equilibrium levels
could have a temporary inflation-reducing but
permanent growth-enhancing impact. "In
combination, monetary deceleration with
interest-rate increases could lower inflation
and, simultaneously, raise the real rate of economic growth."
Hang-Sheng Cheng discusses the policy
dilemma faced by the People's Republic of
China, especially in the current environment
of inflation. "Over the years, tight controls
have strangled work incentives and caused
serious waste and inefficiency; yet under the
present institutional set-up, administrative
controls appear to be indispensable for combating inflation." Then he asks: In the long
run, do the authorities have adequate policy
instruments for fighting inflation without administrative controls? The answer to this
question will to a large extent depend on
whether China can forge an effective monetary
policy that does not rely primarily on direct
controls.
Cheng argues that money has a significantly
lesser role in the Chinese. command economy
than in the typical market economy, and that
monetary policy thus has a more restricted role
than it does elsewhere. China's monetary
policy has been circumscribed, first, by a
nearly complete reliance on administrative
controls for regulating monetary growth, and
second, by the monetary authorities' lack of
independence from both central- and localgovernment authorities with respect to credit
allocation. Other complications arise from the
5
tended to be highly persistent, suggesting
they mainly reflect real-factor influences.
"Thus, real factors have represented a major
source - in some cases the single largest
source- of exchange-rate fluctuations about
trend over the last eight years." He adds that
this conclusion, although tentative, suggests
that models of exchange-rate determination
which consider only financial-market conditionswhile ignoring fundamental commodityprice determinants will inevitably miss an
important aspect of actual exchange-rate
behavior.
Pigott warns, however, that the importance
of real factors creates difficulties for interpreting actual movements in exchange rates.
"This is particularly the case as neither real
interest rates nor the long-run factors influencing relative commodity prices are directly
observable." He notes that U.S. officials have
used foreign-exchange market conditions as a
major policy guide in recent years, partly
reflecting a belief that these markets convey
early signals of developing inflation pressures.
"But the analysis here indicates that exchangemarket signals normally are highly ambiguous,
reflecting as they do a variety of factors. Since
the appropriate response to one source of
exchange-rate variation may be inappropriate
in another case, policy-makers at the least
should be very cautious in using foreignexchange market developments as a regular
guide to policy."
Kenneth Bernauer turns to another aspect of
exchange rates - specifically, the effectiveness of exchange-rate changes on the Japanese
trade account. He notes that analysts no longer
take for granted the view that exchange-rate
movements will be completely passed forward
into export and import prices. In his analysis,
therefore, he first considers the impact of an
exchange-rate change on the prices of exports
and imports, and then considers the effects of
these price changes on the quantities
demanded of exports and imports. This twostage procedure permits him to trace out the
"J curve" measuring the effects of a yen depreciation on the Japanese trade account. The
curve is so named because the initial deteriora-
authorities' mechanical reliance on the quantity equation of money for determining
money-growth targets - and also from their
reliance on a narrow definition of money,
limited to currency, which tends to lead to an
underestimate of the inflationary pressures on
the economy.
Cheng says that monetary policy is coterminous with credit policy, given China's
exclusive reliance on administrative controls
for regulating money growth. In this regard,
official thinking continues to be guided by the
"real bills doctrine" and by the so-called "separation principle," even though theoretical
support for these principles is found wanting
even in the Chinese context. These principles,
moreover, require continued reliance on administrative controls for enforcing compliance. "Their replacement by a flexible
interest-rate policy would not only be more in
tune with the spirit of Modernization, but also
would help support the development of an
effective monetary policy, operating through
market forces rather than administrative controls. "
Charles Pigott next reviews the experience
of several major industrial countries since the
beginning of flexible exchange rates in 1973.
He asks, "To what extent have real factors factors such as tastes, productivity, and oil
costs, determining relative commodity prices
in the long-run - actually affected these
exchange rates?" He points out that nominal
exchange rates can be divided into two components - one reflecting the ratio of national
price levels as determined (mainly) by money
supplies and demands, with the other 'real' or
'terms-of-trade' component reflecting the
relative prices of individual commodities. He
notes, however, that the 'terms-of-trade' is
potentially affected not only by real factors but
also by real interest fluctuations or other influences leading to temporary changes in relative commodity prices.
Pigott shows that fluctuations in nominal
exchange rates about their trend have largely
represented terms-of-trade changes in recent
years. And for the floating-rate period as a
whole, variations in the terms of trade have
6
Hon and subsequent improvement in a depreciating country's trade account resemble
the letter J when the trade account is plotted
on the vertical axis against time on the
horizontal axis.
Bernauer measures this effect by estimating
volume and price equations for four separate
commodity categories. His results show that a
lO-percent yen depreciation would lead to
about a 3.B-percent deterioration in the terms
of trade. With no change in export and import
quantities, this terms-of-trade effect would
then lead to an initial deterioration in the trade
account. The duration of the worsening trade
balance - the duration of the first segment of
the J-curve - would depend upon the time lag
between movements in quantities and prices,
and upon the size of the price elasticities of
demand for exports and imports.
Turning to the actual trade results, Bernauer
shows that a 33.6-percent effective yen depreciation between the third quarter of 1978
and the first quarter of 1980 was followed by a
17.6-percent rise in Japanese export volume
between 1979IV and 1980IV - and by a 6.8percent decline in Japanese import volume.
Ironically, the export upsurge occurred almost
simultaneously with a 16.6-percent appreciation of the yen against the dollar and major
European currencies between 19801 and
1980IV. "From the evidence, though, the
reverse J-curve effects stemming from the
yen's appreciation made only a modest contribution to the improvement in Japan's trade
account. The expanding surpluses of 1980 and
1981 stemmed largely from an improvement
in Japan's price competitiveness, leading to
robust export-volume gains." Bernauer thus
sees little prospect of a reduction in the U.S.
bilateral-trade deficit with Japan, given the
continued erosion of U.S. price competitiveness
during 1981. The U.S.-Japanese controversy
over trade matters consequently may not subside in the foreseeable future.
7
Maxwell J. Fry·
The absence of any long-run relationship between inflation and the real rate of economic
growth in developed economies has been well
documented. The short-run positive correlation between inflation and real economic
growth holds only so long as expectations of
future inflation lag behind actual inflation
rates. In the long run, the inflation/growth
tradeoff disappears because actual inflation
becomes fully anticipated.
Several developjng economies have
exhibited a negative correlation between longrun average inflation and real economic
growth rates. One explanation may be financial
repression - institutional interest rates fixed
below their competitive, free-market
equilibrium levels by administrative fiat.
Under such circumstances, higher inflation
rates generally produce lower real (i.e., inflation-adjusted) institutional rates - deposit,
loan and bond rates of interest.
In many developing economies, commercial
banks dominate the financial sector. Hence,
institutional interest rates consist, in the main,
of deposit rates offered to lenders/savers and
loan rates charged borrowers/investors. Financial savings are held as bank deposits - a
major component of the money stock. Money
is defined throughout this paper to include
savings, time and post office deposits, as well
as sight deposits and currency in circulation. 1
Higher inflation rates typically reduce real
deposit rates of interest. And lower deposit
rates tend to contract real money demand, i.e.,
demand for money expressed in constantvalue terms. The decline in the real value of
the banking system's deposit liabilities must
be matched by a similar fall in the real value of
the banking system's assets (or by a corresponding increase in bank capital). The primary
asset of most banking systems is domestic
credit.
A fall in real money demand may affect the
price level in the same way as a rise in nominal
money supply. Provided the money market
clears, i.e., supply equals demand, inflation
can be expressed as the difference between
rates of change in nominal money supply and
real money demand. In contrast, a fall in real
money demand may not affect real economic
growth in the same way as a rise in nominal
money supply. Ceteris paribus, a decline in
real money demand reduces real credit supply,
but in the very short run, an increase in
nominal money supply has exactly the
opposite effect.
As inflation accelerates, and as real deposit
rates, real money demand and real credit supply all decline, the government may expropriate an increasing proportion of the contracting
supply of real domestic credit to finance its rising deficit. Hence, funds for both working
capital and fixed investment are doubly
pinched. The fall in real money demand produces a credit crunch which, in turn, reduces
the real rate of economic growth.
The long-run negative relationship between
inflation and real economic growth in financially repressed developing economies has
important implications for stabilization policy.
Policy-makers face the well-known dilemma:
lowering the rate of monetary expansion to
bring down inflation raises unemployment and
'Professor of Economics, University of California at
Irvine, and Visiting Economist, Federal Reserve Bank of
San Francisco, Summer 1980. Roger Fujihara, Steve
Kamin, Cole Kendall, Tom Klitgaard, David Parsley and
Benny Yu provided research assistance for this paper.
8
reduces real economic growth in the short run.
However, financially repressed economies can
use both the money supply and nominal
interest rates as independent policy instruments. While lowering the rate of monetary
expansion, they can raise nominal institutional
interest rates. The monetary deceleration has a
permanent inflation-reducing but temporary
depressing effect on real economic growth.
Raising nominal institutional interest rates
towards their competitive, free-market
equilibrium levels, however, has a temporary
inflation-reducing but permanent growthenhancing impact. In combination, monetary
deceleration with interest-rate increases could
lower inflation and, simultaneously, raise the
real rate of economic growth.
This paper tests the hypothesis that lowering
real deposit rates below competitive levels
increases inflation and, at the same time,
reduces real economic growth. Section I
examines the credit-availability mechanism.
Section II applies a small-scale model of inflation and real economic growth to seven Pacific
Basin developing countries. Section III
analyzes alternative stabilization strategies for
financially repressed developing economies.
I. Financial Repression and the Credit Availability Effect
Low interest-rate policies found in a number
of developing economies are often part of a
broader policy of financial restriction. Such a
policy encourages financial intermediaries and
financial instruments from which the government can expropriate a large seigniorage, while
discouraging other entities. For example, the
system favors money and the banking system:
reserve requirements and obligatory holdings
of government bonds can be imposed to tap
this source of saving at zero- or low-interest
cost to the public sector. However, the system
suppresses private bond and equity markets through transaction taxes, stamp duties,
special tax rates on capital income, an unconducive legal framework, etc. - because seigniorage cannot be taken so easily from private
bonds and equities. The government can
impose interest-rate ceilings and foreignexchange controls to stifle competition with
government borrowing. It can then use high
reserve requirements to increase the flow of
resources to the public sector with minimum
effects on inflation and/or borrowing costs.
Nominal interest-rate ceilings established to
reduce competition under financially restrictive policies can be disruptive in the face of an
inflationary shock. Just as U.S. deposit-rate
ceilings have caused serious disintermediation
in an environment of rising inflation and freemarket interest rates, so developing
economies' all-embracing interest-rate ceilings
on financial assets have caused violent
portfolio shifts from financial to tangible assets
(i.e., inflation hedges) in a situation of
accelerating inflation (Shaw, 1975). This type
of reaction magnifies the initial inflationary
shock. It also turns financial restriction into
financial repression, a condition in which the
financial sector contracts in real terms.
Typically, it seems, financial repression is
the unintended consequence of an inflexible
interest-rate system - established under
financial restriction, selective credit policies
and/or a bank cartel - in the face of accelerating inflation. Shaw's central proposition
(1973, pp. 3-4) is that financial repression indiscriminate "distortions of financial prices
including interest rates and foreign-exchange
rates" - reduces "the real rate of growth and
the real size of the financial system relative to
nonfinancial magnitudes. In all cases this
strategy has stopped or gravely retarded the
development process." More recently, Cheng
(1980) has analyzed the phenomenon of financial repression and the process of financial
deepening in seven Pacific Basin developing
economies.
This paper considers the effects of financial
repression on credit availability in seven
Pacific Basin developing countries: Indonesia,
Korea, Malaysia, Philippines, Singapore,
9
Taiwan and Thailand. The ratio of investment
to GNP increased in all these countries between the1960s and the 1970s. (Table O. Yet
in every case, except the Philippines, a higher
investment ratio was required just to sustain
the 19608' real economic growth rate. In other
words, incremental output/capital ratios fell.
Also, five countries (Indonesia, Korea,
Singapore, Taiwan and Thailand) showed a
negative relationship between real economic
growth and inflation. In fact, inflation accelerated in all the sample countries except
Indonesia, where lower inflation was accompanied by substantially higher real economic
growth.
Until 1975, institutional interest rates were
determined, not competitively, but rather by a
bank cartel in Singapore and by administrative
fiat in the other six countries. With the worldwide acceleration of inflation in 1974, the real
12-month time-depomt rate declined in all the
sample countries - indeed, became substantially negative in every case except Malaysia
(Table 2). Apart from Indonesia, real deposit
rates were considerably lower in the 1970s
than they had been in the 1960s. The lower
incremental output/capital ratios of the 1970s
may have been due to lower capacity utilization, due to reduced credit availability for
working-capital needs.
The traditional link between credit and output is through demand - the increase in credit
created by monetary expansion is accompanied
by an increase in demand which stimulates real
output. Within the past decade, Kapur (l976) ,
Keller (1980), Mathieson (1980), McKinnon
(1973) and Shaw (1973) have analyzed the
link between credit and real output through
the supply side. This Wicksellian view holds
that the availability of working capital determines,ceteris paribus, the volume of production which can be financed. In particular, as
Keller (1980, p. 455) argues, " ... production
expansion may depend, entirely or in part, on
credit availability and/or the cost of credit."
Evidently, this supply link between credit
availability and real economic growth springs
from the ratio of credit to output, or from the
real rather than the nominal volume of credit.
In the very short run, the real availability of
credit can be increased through an acceleration
in nominal domestic-credit expansion. Ceteris
paribus, this accelerated credit expansion is
accompanied - in fact, brought about - by
accelerated monetary expansion. Momentarily, the money market does not clear money supply exceeds money demand. The
ensuing inflation erodes the real supply of
domestic credit as well as the real money stock.
If real money demand actually falls due to
higher inflation, then the new equilibrium
will, ceteris paribus, result in a lower ratio of
credit to output. 2
Conversely, a deceleration in domestic
credit expansion decreases credit availability in
the very short run (Kapur, 1976; McKinnon,
Table 1
Investment, Growth and Inflation, 1962-81
Country
Investment
Ratio
1962-71
1972-81
Incremental
Output/Capital
Ratio
1962-71 1972-81
0.42
0.33
ILO
20.9
Indonesia
0.26
20.1
32.3
0.43
Korea
0.31
18.8
24.1
0.33
Malaysia
21.1
25.6
0.23
0.24
Philippines
24.1
34.9
0.38
0.23
Singapore
20.9
0.44
0.26
29.5
Taiwan
24.1
24.4
0.33
0.30
Thailand
Note: Growth and inflation rates are continuously compounded.
Source: World Bank, World Tables (1980), and IMF estimates.
10
Real GNP Growth
Rate
1962·71
4.6
8.7
6.1
4.8
9.0
9.1
8.0
Inflation
Rate
1972-81
1962·71
1972·81
8.3
7.5
6.2
7.9
7.7
7.2
1
15.7
0.1
6.9
L5
4.0
1.1
18.1
7.1
12.1
5.4
10.3
9.9
tion, they tend to favor price controls on the
output of nationalized industries. As inflation
increases, nationalized industries tend to post
larger losses. The gap widens between conventional tax receipts and public expenditure, and
this is financed by heavier reliance on seigniorage and the inflation tax. The government
extracts greater seigniorage by increasing the
proportion of domestic credit allocated to the
public sector, and thus reduces the ratio of private sector credit, DCp, to total domestic
credit, DC. The government levies an inflation
tax by creating more money than the public
wishes to hold at the current level of prices.
This creates a double squeeze on credit available for private-sector working capital, i.e.,
DCplPY falls due to the decline in both DCI
PY and DCp/DC.
This credit-availability mechanism can be
tested for the 1961-77 period by regressing
three ratios - domestic credit to nominal
GNP, DCIPY; private-sector domestic credit
to total domestic credit, DCp/DC; and privatesector domestic credit to nominal GNP, DCpl
PY - on the real rate of interest, dIP*, where
d is the continuously-compounded 12-month
time-deposit rate of interest and P* is the continuously-compounded expected inflation rate
(see Appendix). The ordinary least-squares
(OLS) estimates are (t values in parentheses):
1973). With the consequent disequilibrium in
the money market, the real money stock is less
than real money demand. The subsequent
decrease in inflation may raise real money
demand, and the new equilibrium will exhibit
a higher ratio of credit to output. At this point,
credit availability is greater than it was before
the initial deceleration in credit expansion.
I am not concerned with the very short run,
for which this annual model is unsuitable,
but rather with the somewhat longer-run relationship between the rate of nominal domestic
credit expansion and the ratio of credit to real
output. Faster expansion of money and
nominal credit raises the inflation rate. If the
nominal deposit rate is fixed, the ensuing
increase in expected inflation reduces the real
deposit rate of interest - and this in turn
reduces real money demand or decreases the
ratio of money to nominal GNP. The ratio of
domestic credit, DC, to nominal GNP, PY,
also falls. In this way, an acceleration in
nominal domestic credit and in money supply
reduces credit availability in real terms, i.e.,
DC/PY declines.
The Pacific Basin countries considered here
have placed little reliance on progressive
income-tax systems. This results in inflation-inelastic real tax revenue due, in large
part, to lags in tax collection. For fighting infla-
Table 2
Real Deposit Rates of Interest, 1962-81
1962-71
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981*
1972-81
Indonesia
-65.3
-10.4
-7.7
-10.5
-5.8
-3.2
-4.1
-4.7
-9.9
-9.8
-9.1
-7.5
Korea
3.6
0.2
-1.8
-4.5
-5.6
-4.6
-2.9
-2.8
-0.4
0.6
-3.0
Malaysia
5.7
Philippines
0.5
Singapore
3.9
Taiwan
6.6
Thailand
5.6
5.4
2.2
1.6
3.1
0.4
-0.8
-1.0
-1.4
-0.4
-0.6
-1.0
-3.0
-5.8
-4.1
-2.9
-1.9
0.5
2.0
1.9
1.0
1.5
-1.4
-3.0
-1.2
0.8
2.6
4.2
4.9
3.2
3.2
3.7
-3.2
-15.9
7.9
6.5
3.4
4.5
-0.3
-3.6
-1.4
0.9
-1.3
1.5
0.2
4.8
0.1
-3.0
-1.4
-0.9
-0.4
-0.1
0.1
1.7
1.1
0.2
-2.5
*Nominal deposit rates are assumed to remain at their December 1980 levels throughout 1981.
Source:
Deposit rates are from central-bank publications. Expected inflation is from polynomial distributed lags estimated
for each country in money-demand functions (Appendix).
11
oc
=
PY
-0.045 + 0.034(d-P*)
(-0.983) (2.683)
+
0.007 z + 0.972 (OC)
0.361) (35.348) PY t- 1
0)
K= 0.93
OCp
DC
=
0.095 + 0.048 (d-P*) + 0.913 (OCp)
(2.7i7) (0.542)
(34.173) DC ,-i
K= 0.91
OCp = 1.099 + 0.847 (d-P*);
OC 07.408) (2.992)
K= 0.06
OCp
PY
=
0.014 + 0.025 (d-P*) + 1.005 (OCp)
0.125) (2.399)
(52.344) PY (-i
(4)
K= 0.96
OCp = 0.227 + 0.203 (d-P*);
PY (20.825) (4.158)
K = 0.12
where z is the natural logarithm of per capita
real GNP. All of these estimates are consistent
with the credit-availability model presented in
this section. 3
(5)
II. Inflation and Real Economic Growth
The inflationary process in the sample countries can be properly understood only through
an analysis of the determinants of nominal
money supply and real money demand. The
money-supply mechanism takes different
forms in different countries, which precludes
any generalized analysis of the money-supply
process. I make one crucial assumption,
however - the feedback mechanisms from
inflation to money-supply growth occur with a
certain lag (see Aghevli and Khan's (1977)
study of Indonesia). Hence, the system is
recursive and changes in the nominal money
supply can be treated as if they were
exogenous for the purpose of estimating the
inflation function without biasing the estimate.
Real money demand, on the other hand, is
invariably determined by one or more price
(i.e., interest rate) variables and a budget constraint. Here, the price variable is the real deposit rate of interest, d-P*, and the budget con-
Inflation in the Pacific Basin developing
economies, as elsewhere, is a monetary
phenomenon. Its analysis centers on the
market for money, whose market-clearing or
equilibrium condition can be expressed as the
difference between the rates of growth in per
capita nominal money supply and in real
money demand (a dot is b..ln):
•
P
• s
M
= -- _
N
•
md
'
(6)
where P is the continuously-compounded
rate of change in the GNP deflator, Ms is the
nominal money supply, N is population, and
m d is the per capita demand for real money balances, i.e., (Md/P)!N. It seems reasonable to
expect that the market clearing or equilibrium
condition - short-run demand equal to supply
- would hold for this model because of the
preponderance of auction markets in all the
sample countries.
12
straint is per capita real permanent GNP, y*. A
standard stock-adjustment process is added.
The money-demand function then is
expressed in first-difference, semi-logarithmic
form:
d = alY* + a2.6. (d-P*) + a3mt.l·
(7)
The rate of change in per capita real permanent income, y*, and the change in the
expected inflation rate, .6.P*, were both estimated as polynomial distributed lags (see
Appendix). This procedure allows expectations regarding future changes in inflation and
income growth to be formed on the basis solely
of current and past values of the variables
themselves. Still, given the dearth of
econometric forecasting and low levels of economic education in the sample countries, this
seems reasonable. However, such expectations are "rational" only in special circumstances.
Equation (7) is substituted into equation (6)
and the coefficient of MslN is no longer constrained to one. The OLS estimate of this inflation equation, with 1961-77 pooled time series
data, is:
economic growth, g (i.e., .6.lnGNPIP) - the
dependent variable
is determined in the
short run by the ratio of the actual to the
expected price level, PIP*. If actual price
exceeds expected price, entrepreneurs
interpret the difference to reflect a real
increase in the demand for their products. In
response, they raise their rate of capacity
utilization to increase output immediately, and
also invest more to increase that capacity.
Expected inflation also affects short-run real
economic growth through the real deposit rate
of interest, d- P*. An increase in expected inflation reduces the real deposit rate in all the
sample countries, except Singapore since
1975, because of the fixing of nominal rates by
administrative decisions. In this situation,
adjustments to nominal rates invariably occur
too little and too late to prevent a decline in
real deposit rates. A fall in the real deposit rate
decreases real money demand - equation (8)
- and the resultant contraction in the real size
of the banking system reduces the real supply
of domestic credit.
Rising inflation typically enlarges public•
( M) .
•
sector deficits in developing countries due to
P = 0.930 N - 0.927y* - 0.986.6. (d-P*)-0.280m t_1 the lag in the collection of tax receipts (Tanzi,
(33.196)
(-4.~59)(-10.849)
(-4.303)
1977), to the erosion of the tax base, and to
It = 0.92
(8)
price freezes on nationalized-industry proThe coefficients of the four variables in
ducts. The government finances the larger
deficit by allocating a greater proportion of
equation (8) all agree with a priori beliefs. The
coefficient of the rate of change in the nominal
domestic credit flows to the public sector.
Indeed, the private sector is doubly conmoney supply is not significantly less than one.
The implied long-run real-income elasticity of
strained as the real supply of domestic credit
money demand is 1.286, a figure comparable
declines and as the government extracts
increased seigniorage from the money supply.
to those produced directly in most demand
This credit squeeze dries up working-capital
estimates for broad money aggregates. The
implied long-run coefficient for the real defunds and reduces the utilization of the existing capital stock. Hence., the real deposit rate
posit rate of 1.368 is also similar to coefficients
estimated in money-demand functions for
affects positively the real rate of economic
other developing economies (Fry, 1978).
growth, at least indirectly.
In the very long run, real economic growth
Finally, the coefficient of the lagged per capita
depends on the volume and productivity of
real money stock indicates that over 70 percent
of the adjustment to current expected realinvestment, both of which are related
income and interest-rate values takes place
positively to real institutional rates of interest
within the year.
in the sample countries (Fry, 1980 and 1981).
However, for this shorter-run analysis, I
The other equation of this model, equation
(9), below is a modified Phillips curve with the
assume that investment raises productive
capacity - so moving the transformation froncredit-availability effect added. The real rate of
m
13
tier outwards - smoothly over time. For
industrial countries, the time trend of real
GNP may provide a reasonable proxy for
"normal" supply, the noncyclical component
determined solely by productive capacity but for most developing countries, annual
fluctuations in agricultural output are also
important Year-to-year changes in farm-output growth determined largely by shifting
weather conditions represent exogenous
shifts in the production-possibility curve. Normal supply for this sample of developing countries thus may be defined as trend real GNP
plus the difference between actual and trend
real agricultural output
Normal real economic growth, g+, exerts a
positive effect on actual real economic growth,
g. However, above-average growth in
agricultural output may depress real growth
elsewhere because of the higher priority
accorded to the credit requirements of foodprocurement and agricultural price-support
programs, which are of course positively
related to farm-output growth. Hence, other
sectors would suffer a credit squeeze in real
terms whenever agriculture obtained a greater
share of the fixed real supply of domestic
credit
The effect of g+ on g would therefore be
expected to be positive but the coefficient of
g+ should be somewhat less than one, despite
the fact that on average g equals g+. Aboveaverage growth in agricultural output imposes
a credit squeeze on other sectors which
reduces their capacity-utilization rates and
hence their growth rates. The two-stage leastsquares (2SLS) estimate of this short-run economic-growth equation for the 1961-77 period
is: 4
•
Figure 1
Short and Long-Run
Inflation/Growth Tradeoffs
Inflation
Short-run
tradeoffs
.*constant
with P
Long-run
tradeoffs
with d constant
Growth
The short-run Phillips curves show the standard positive
relationship between inflation and growth. This is caused
by price exceeding expected price in the short run as inflation accelerates and expected inflation temporarily lags
behind. In the long run, expectations are realized. Ceteris
paribus. a higher inflation rate results in a lower real deposit rate of interest. In turn, real money demand and real
credit supply contract. The credit squeeze reduces the rate
of growth, so producing a negative relationship between
inflation and growth in the long run.
Equation (8) suggests that an acceleration in
nominal money growth raises the inflation
rate and so PIP*. This, in turn, seems to raise
growth in real GNP (equation (9», but
expected inflation meanwhile starts to rise. In
long-run equilibrium, P equals P* because
inflation is fully anticipated. In the long run,
therefore, inflation per se has no effect on real
economic growth. With d held constant,
however, the real credit-supply mechanism
leads to a negative relationship between inflation and real economic growth in a financially
repressed economy (Figure l). 5
g = 0.390g+ + 0.043 (J;-) + 0.049(d-P*).
(9.139) (11.403) P
(4.257)
(9)
It = 0.26
14
III. Stabilization Strategies for Financially Repressed Economies
Central banks of financially repressed
economies have at their disposal two independent monetary-policy instruments - the
nominal money supply and the nominal deposit rate of interest. There is, in practice, an
upper bound to the deposit-rate instrument the free-market equilibrium rate in the
absence of discriminatory taxation of financial
intermediation (Fry, 1981). Since a higher real
deposit rate appears to reduce inflation and
raise real economic growth at the same time,
an optimal monetary policy would set the
nominal deposit rate at (or allow it to increase
to) its upper bound. The obvious approach
would be to abolish all institutional interestrate ceilings and dismantle any discriminatory
taxes. However, a minimum deposit rate
might be needed to force cartelized and
oligopolistic banking systems, found in all the
sample countries except Singapore, to achieve
the ideal competitive solution.
This analysis suggests that when the
authorities accelerate money-supply growth,
they should also change nominal interest rates
to maintain an appropriate level of real interest
rates and hence prevent a real credit squeeze.
As shown above, monetary acceleration by
itself tends temporarily to enhance or sustain
growth, but this is followed by a credit squeeze
which reduces growth. The real credit squeeze
can be avoided through appropriate interestrate policy designed to prevent administered
rates from falling further below their marketequilibrium levels.
Interest-rate policy, by reducing inflation
and raising real economic growth can be a useful instrument for stabilization purposes in
financially repressed Pacific Basin developing
countries. To illustrate, I simulate three
alternative stabilization policies for a composite economy, using the model estimated in
Section II. The usual caveats apply about the
reliability of these forecasts.
The composite economy (somewhat resembling Indonesia) starts off in a steady state,
with a 20-percent continuous rate of inflation
over the past decade and with expectations
realized regarding both expected inflation and
per capita real permanent income. The real deposit rate is -10 percent, the normal real economic-growth rate is 7 percent, and the
population-growth rate is 2 percent. The lag
coefficients for expected inflation and per
capita real permanent income are: t-l, 0.4; t-2,
0.3; t-3, 0.2; t-4, 0.1. Equation (9) can then be
solved to yield an actual real economic-growth
rate of6.54 percent. and per capita real permanent income growth, y"', of 4.54 percent. The
steady-state solution of equation (8) shows a
smooth increase of money-supply growth at
30.63 percent a year.
The first stabilization strategy reduces the
growth of the nominal money supply from
30.63 percent in the base year, year 0, to 17.14
percent in year 1 and all subsequent years. This
lowers the inflation rate in the new long-run
equilibrium to 7 percent and, hence, raises the
real deposit rate from -10 to +3 percent with
no change in the nominal deposit rate. The
new long-run equilibrium real-growth rate
increases from 6.54 to 7.18 percent (Table 3).
The second stabilization strategy again reduces
nominal money growth to 17.14 percent, but
also raises the real deposit rate (through deposit indexation) to 3 percent at the outset of
the program, i.e., in year 1. The third strategy
establishes the 3-percent real deposit rate, but
sets money growth at whatever rate is required
to maintain a constant real rate of economic
growth of 7.10 percent.
The main point to note in the simulation
results (Table 3) is that the first and second
strategies both produce a recession. Per capita
real GNP growth initially declines because
actual prices fall below expected prices. To
some extent, increased credit availability
offsets this expectations-reduction in supply.
Naturally, the credit availabili ty effect is
stronger for the second strategy - real economic growth does not fall so much and picks
up faster, despite the fact that higher real
money demand actually reduces the price
level. Both economic growth and inflation
converge to their new steady-state values
15
Table 3
Simulation of Three Stabilization Strategies·
Year
Strategy 1
Strategy 3
Strategy 2
Real Per
Capita GNP
Price
Level
Real Per
Capita GNP
Price
Level
Real Per
Capita GNP
Price
Level
Money
Supply
6
7
8
9
10
4.54
4.09
4.34
4.73
5.15
5.45
5.56
5.51
5.36
5.21
5.09
20.00
7.45
2.94
Li6
1.51
3.34
6.07
8.08
9.02
8.99
8.33
4.54
4.27
4.96
5.20
5.27
5.26
5.19
5.17
5.17
5.18
5.18
20.00
-5.37
4.23
6.74
7.20
7.14
7.00
6.95
6.96
6.98
7.00
4.54
5.10
5.10
5.10
5.10
5.10
5.10
5.10
5.10
5.10
5.10
20.00
17.85
17.01
16.04
14.99
13.92
12.92
11.90
10.90
9.90
8.92
30.63
42.10
31.73
28.00
26.15
24.81
23.65
22.51
21.39
20.29
19.20
00
5.18
7.00
5.18
7.00
5.18
7.00
17.14
0
1
2
3
4
5
·Continuously compounded percentage rates of change
faster under the second than under the first
strategy. The third strategy maintains a constant per capita real growth rate somewhat
below its new steady-state level. This permits a
gradual and smooth reduction in the inflation
rate. However, because of the sharp, deflationary increase in the real deposit rate in year 1,
nominal money growth must initially accelerate. Thereafter, nominal money growth falls
gradually and smoothly in step with the declining inflation rate.
The strategies of raising the real deposit rate
are more successful than the money-growthonly strategy in achieving both higher real
growth and lower inflation. 6 However, once
the optimal real deposit rate has been fixed,
higher nominal money growth always
increases inflation as well as real economic
growth in the short run - but does not affect
the latter in the long..:run steady state. Conversely, lower monetary growth reduces inflation
and real economic growth in the short run, but
again has no long-run influence on real economic growth. Optimal policy with respect to
nominal money growth could be solved as a
dynamic control problem, given policymakers'
loss function.
The two strategies making active use of the
nominal deposit rate are clearly superior to the
strategy which relies solely on control over the
nominal money supply. And, of course, other
policy instruments are also important, such as
fiscal, price, exchange-rate and foreign-trade
policies. Indeed, fiscal policy strongly influences money-supply growth in all the sample countries, with the possible exception of
Singapore. Again, appropriate price and
exchange-rate policies are crucial for the success of any stabilization program. However,
their consideration is beyond the scope of this
paper, which was designed solely to examine
the role of monetary policy for stabilization in
financially repressed economies.
IV. Summary and Conclusions
money demand fell, compounding the inflationary forces. Declining real deposit rates also
reduced the real supply of domestic credit and
this credit squeeze lowered real rates of economic growth.
This analysis provides an important policy
conclusion: flexible interest-rate policies in
The international economic environment
over the past decade has not been conducive to
stable economic growth. The oil shocks of
1973-74 and 1979-80 were accompanied by a
worldwide acceleration in inflation. Economies
with rigid nominal interest rates experienced
declining real rates of interest. In turn, real
16
tionary pressures. At the same time, the
availability of credit increases in real terms.
Consequently, real economic growth rises,
which increases real money demand some
more. Inflation drops; the virtuous circle is
complete.
financially repressed economies can be used to
counter inflationary shocks and accelerate the
real rate of economic growth. An increase in
the real deposit rate of interest towards its
competitive, free-market equilibrium level
raises real money demand, so reducing infla-
Appendix
The lag coefficients for per capita real permanent income and expected inflation were
obtained by applying polynomial distributed
lags to the rate of change in per capita real
GNP and to the rate of change in inflation in
the following first-difference semi-logarithmic
money-demand function:
= a1y'" + a?P'" + a 3 t _1;
(A.I)
where m is per capita real money holdings.
Unconstrained first-, second- and thirdorder polynomials were applied to the coefficients of the current and (up to six) past rates
of change in inflation and real per capita
income. Choices of polynomial degrees and lag
m
lengths were based on the pattern of the lag
coefficients, a nonnegativity criterion and the
R 2S. Ceteris paribus, monotonically declining
or inverted U-shaped coefficient patterns were
preferred as being most consistent with an a
priori assumption about formation of expectations. For the same reason, sign changes were
inadmissible - the nonnegativity criterion.
"Satisfactory" results were obtained for
all the sample countries with first- or secondorder polynomials. The lag coefficient estimates used for the pooled time-series analysis
reported here are presented in Tables A.l and
A.2.
m
Table A.1
Permanent Income
Coefficients
Country
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
Order
1
1
1
1
0
0
2
t
t-1
0.597
0.652
0.300
0.338
1.000
1.000
0.594
0.403
0.348
0.247
0.662
t-2
t-3
t-4
t-5
0.193
0.140
0.086
0.033
t-6
0.247
0.159
Table A.2
Expected Inflation lag Coefficients
Country
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
Order
2
2
1
2
1
1
2
0.326
0.304
0.243
0.187
0.780
0.994
0.334
t-1
t-2
t-3
t-4
t-5
t-6
0.236
0.245
0.213
0.234
0.220
0.006
0.240
0.164
0.190
0.182
0.240
0.109
0.137
0.151
0.206
0.071
0.086
0.121
0.133
0.050
0.039
0.090
0.046
0.166
0.113
0.080
0.068
17
FOOTNOTES
1. The annual financial-stock figures used in this
paper, I.e., .the .money • stock, domestic •credit, •and
domestic credit to the private sector, are centered
monthly averages. End-of-month figures were
averaged first to provide mid-month estimates. Then
the 12 mid-month estimates were averagedJorthe
annual figures.
3.· The coefficients of the lagged dependent variables
are biased upwards, since country dummy variables
were not used (see Fry 1978,p. 4139).
4. The instrumental variable technique is used to
deal With. both simultaneous-equation bias> and
measurement error in PIP". The instruments used in
the first stage were the rate of change in per capita
real permanent GNP, the real deposit rate of interest,
income terms of trade, the ratio of foreign exchange
receipts to GNP, the lagged ratios of national saving
investment to GNP, the lagged real deposit rate of
interest, the normal growth rate, the rate ofchange in
per capita nominal. money bal.ances, exchange-rate
overvaluation as measured by the ratio afthe blackl
free market to the official exchange rate, andthe real
exchange rate.
2. With perfectly elastic international capital flows,
an increase in domestic credit would, in the main, producea decline in foreign-exchange reserves under a
fixed (including crawling peg) exchange-rate system.
Exchange-rate policy, not domestic credit policy, thus
would determine nominal money growth and inHation.
In •none .of the Pacific Basin developing countries,
with the recent exception Of Singapore, .are international capital flows perfectly elastic. Indeed, capital
controls permitted the independent interest-rate
policies pursued by all these countries until 1975.
Singapore abolished its interest rate-setting bank
cartel in 1975 and thereafter dismantled such controls. With capital-account controls at least partially
effective, an acceleration in domestic credit expansion raises the rate of growth in the nominal money
supply while reducing foreign-exchange reserves.
5. In the long run, financial repression also affects
the saving rate and the average efficiency of new
investment (Fry, 1980 and 1981).
6. How to control the money supply is a separate
issue beyond the scope of this paper. One prerequisite for monetary control in all the sample countries
is undoubtedly fiscal discipline.
REFERENCES
Aghevli, Bijan B. and Khan, Mohsin S. "Inflationary
Finance and the Dynamics of Inflation:
Indonesia, 1951-52," American Economic
Review, June 1977, pp. 390-403.
Keller, Peter M. "Implications of Credit Policies for
Output and the Balance of Payments," International Monetary Fund Staff Papers, September
1980, pp. 451-477.
Cheng, Hang-Sheng. "Financial Deepening in Pacific
Basin Countries," Federal Reserve Bank of San
Francisco Economic Review, Summer 1980, pp.
43-56.
Mathieson, Donald J. "Financial Reform and Stabilization Policy in a Developing Economy," Journal of
Development Economics, September 1980, pp.
359-395.
Fry, Maxwell J. "Money and Capital or Financial
Deepening in Economic Development?", Journal
of Money, Credit and Banking, November 1978,
pp.464-475.
McKinnon, Ronald I. Money and Capital in EConomic
Development, Washington, D.C.: Brookings,
1973.
Shaw, Edward S. Financial Deepening in Economic
Development, New York: Oxford University
Press, 1973.
_ _. "Saving, Investment, Growth and the Cost of
Financial Repression," World Development,
April 1980, pp. 317-327.
_ _, "Inflation, Finance and Capital Markets,"
Federal Reserve Bank of San Francisco Economic Review, December 1975, pp. 5-20.
_ _. "Interest Rates in Asia," University of Hawaii,
Study prepared for the Asian Department of the
International Monetary Fund, mimeo, June 1981.
TanZi, Vito. "Inflation, Lags in Collection, and the Real
Value of Tax Hevenue," International Monetary
Fund Staff Papers, March 1977, pp. 154-167.
Kapur, Basant K. "Alternative Stabilization Policies for
Less-Developed Economies," Journal of Politi·
cai Economy, August 1976, pp. 777-795.
18
Hang-Sheng Cheng'"
The purpose of this paper is twofold: to
introduce the role of money and credit in
China to those unfamiliar with the subject, and
to propose some fundamental re-thinking in
the conduct of Chinese monetary and credit
policy.
China today is in a period of transition. Dissatisfied with the economy's past performance, the authorities in recent years have
instituted a series of reform measures
designed to infuse more material incentives
and a greater use of market principles in an
otherwise rigidly controlled economy. The
essence of the reform lies in giving farmers
and enterprises greater autonomy in production and investment decisions in response to
market forces.
The future of the reform is now threatened
by inflation. To combat inflation, the government has ordered draconian cutbacks in
investment projects, thus in effect suspending
the recently instituted production and investment autonomy. This creates a policy
dilemma: over the years, tight controls have
strangled work incentives and caused serious
waste and inefficiency; yet, under the present
institutional set-up, direct administrative con-
trois appear to be indispensable for combating
inflation. In the short run, the government has
decided to fight inflation now and ease controls
later. But, in the long run, do the authorities
have adequate policy instruments for fighting
inflation without direct controls? The answer
to this question will determine whether future
spending decisions will be made by the market
according to the spirit of the reform or by the
central-planning authorities as under the old
regime.
Inflation is in essence a monetary
phenomenon. In the long run, China's ability
to "modernize" its economy without
aggravating inflationary pressures will to a
large extent depend on whether China can
forge an effective monetary policy that does
not rely primarily on direct controls.
Section I presents an overview of money and
banking in China. The rest of the paper raises a
number of policy issues, specifically (0 the
usefulness of the quantity equation of money
and the measurement of money in the Chinese
context, (in Section II) , and (2) the principles
of credit policy followed in China (in Section
UI). The findings and conclusions are summarized in Section IV.
I. Money and Banking in China
surprisingly, China under socialism operates
along vastly different lines from economies
under capitalism. In this section, we describe
the structure of the Chinese economy, the use
of economic planning (and especially financial
planning) to allocate the nation's resources,
and then some fundamentals of the banking
and monetary system. Our sketch of the real
side of the economy will be brief, limited to
what is necessary to help explain the functioning of the financial system. I And because
institutions and policies are changing rapidly,
To assess the role of money and banking in
China it is essential first to understand how the
Chinese economy functions, as, not
* Assistant Vice President and Economist, Federal
Reserve Bank of San Francisco. Research for this paper
was based in part on material collected when the author
visited China as a member of a Federal Reserve delegation in June 1980. The staff of the People's Bank of China,
especially Messrs. Shang Ming and Zhang Tuen, provided
generous assistance and cooperation. Responsibility for
errors is, however, entirely the author's, since neither Mr.
Shang nor Mr. Zhang had an opportunity to review the
manuscript prior to publication.
19
we do not try to incorporate all the recent
changes into this brief overview. The emphasis
here is rather on the fundamentals of China's
monetary and banking system, which remain
largely intact in spite of recent modifications.
reconciliation, submits the final plans to the
State Council (Cabinet) for approval. Once
approved, the plans become the blueprint of
the nation's economic activities during the
next year.
Economic Structure and Planning
The People's Republic of China was
founded in 1949, but it took the authorities
about seven years to communize what had
been a largely private-enterprise economy.
Prior to 1949, nearly all the means of production had been privately owned, aside from
state-owned infrastructure facilities such as
harbors, railroads, schools, hospitals, and public utilities. After 1949, by stages, all the
farms, mines, factories, shops, and banks
became either state-owned enterprises (i.e.,
belonging to "all people") or collectives (i.e.,
owned collectively by members). Except for a
presumably small amount of interest income,
total household income today consists of
either state-paid wages and salaries or collective distributions of funds according to earned
work points and retained earnings. 2 On the
farms, where eighty percent of the population
reside, the collective form predominates; in
industry and commerce, except handicrafts,
the state-ownership form is dominant. In
either case, everyone works directly or
indirectly for the state, and all economic
activities are, at least in theory, conducted in
accordance with state-designed economic
plans and under close state supervision.
China under communism has operated,
both in theory and in fact, as a planned economy, based on a series of five-year plans
stipulating medium-term national economic
goals. The State Planning Commission drafts
the five-year plans, and is also responsible for
drafting (a) an annual economic plan in terms
of physical input and output of goods and services, and (b) a counterpart annual financial
plan in terms of money flows. The Commission works with proposed plans of individual
government and enterprise units, which are
consolidated and approved layer by layer up
the government structure. The State Planning
Commission, after final consolidation and
Price Stability and Inflation
Implicit in the physical and financial plans
are the prices of all the products included in
the plans. In principle, the authorities set all
prices, which cannot be changed thereafter
without explicit permission. Since the early
1950s, the authorities have attempted to maintain price stability for individual commodities
as well as in the aggregate. 3 Indeed, for several
decades, government officials claimed that
China had been able to maintain prolonged
price stability in the midst of a world racked by
unstable and rising inflation. 4 They provided
no price indices in support, but most outside
scholars generally agreed with this claim. 5
However, price stability was purchased at
considerable cost. Government officials now
admit that the rigid price system, by favoring
heavy industries at the expense of agriculture,
coal mining and consumer goods, has resulted
in serious production imbalances - with
perennial shortages offood, fuel, raw materials
and consumer goods co-existing with excess
inventories of a variety of unsold goods. 6
Waste and inefficiency are rampant. The
authorities are well aware of the problem, but
they also recognize that changing the price
system would mean a redistribution of income
among industries and regions, inevitably
benefitting some and hurting others. Few prudent bureaucrats would want to open that Pandora's box in a heavily politicized economic
system.
In a system where prices do not necessarily
reflect relative scarcity, it is not always possible
to distinguish between a condition of repressed
inflation and one of sectoral maladjustment.
Long queues may be indicative of shortages of
only certain goods; even a general rise in consumer prices may represent only a correction
of a previous disparity between consumer and
producer-goods prices. Neither case provides
definitive evidence of the existence of infla20
tionary pressures.
Yet, in spite of these conceptual difficulties,
China apparently experienced brief periods of
open inflation in 1953, 1956, 1960-61 and
again in 1979-81 7 In all these episodes,
widespread price increases followed unusually
rapid increases in currency circulation brought
forth by large unplanned government budget
deficits or credit expansions. The resultant
inflationary pressure manifested itself in two
forms: first, price increases for a wide range of
consumer goods, which were sold on a "free
market" that periodically operated alongside
the official market; and second, official price
increases, which helped to mop up excess currency issues through enhanced revenues of the
state trading agencies. 8
key role in regulating currency in circulation,
and hence supporting the nation's financial
stability.
Banking System
The banking system in China today consists
of the People's Bank of China and three
special-purpose banks: the Bank of Agriculture, the Construction Bank of China, and the
Bank of China. With more than 15,000
branches and offices and 330,000 staff members at the end of 1979, the People's Bank is at
once the nation's central bank and the only
bank providing a wide range of banking services to the general public. lO In contrast, the
other three banks either perform special functions or serve specific sectors: the Bank of
Agriculture serves the agricultural sector;
the Construction Bank finances plantequipment and infrastructure projects for
enterprises and government units; and the
Bank of China handles foreign-trade financing
and foreign-exchange administration. Within
the government structure, the President of the
People's Bank is a member of the State Council with cabinet rank; the Bank of Agriculture
and the Bank of China, though reporting
directly to the State Council, come routinely
under the People's Bank supervision; while
the Construction Bank, although reporting to
the State Council, comes under Ministry of
Finance supervision.
(a) Financial supervision. As stated, each
year the banking system is responsible for
drafting a Credit Plan and a Cash Plan for submission to the State Planning Commission. In
addition, it is responsible for monitoring the
nation's financial flows to ensure that all is in
accordance to the plans. To facilitate surveillance, all government units and enterprises
must set up accounts, called "transfer balances," in one or more of the four banks
according to the designated functional divisions, and all payments among the entities
must be conducted through these bank
accounts. The entities may keep only a
minimal amount of cash on hand, sufficient for
three days' operation in localities where there
is a banking office and up to 14 days where
Financial Planning
The Chinese authorities have long maintained that inflation can arise only through
excess currency issue, which occurs only
through excess bank-credit extension for
financing business investments and government budget deficits. (Banks do not extend
credit to consumers in China.) The authorities
attempt to regulate currency issues through
deliberate financial planning. 9
The financial plan, as stated previously, is
the counterpart of the physical economic plan.
It is composed of the Government Budget, the
Credit Plan, and the Cash Plan. The Budget
needs no explanation. The Credit Plan sets out
the expected sources and uses of banking
funds. The Cash Plan specifies the planned
change in currency in circulation as a net result
of cash transactions between the government
sector (including enterprises) and households
(including the farm sector). The Ministry of
Finance is responsible for the Budget, and the
People's Bank of China for the Credit Plan and
the Cash Plan. All three plans are
simultaneously constrained by a national f1owof-funds identity, so that increases in currency
in circulation must equal the increases in
banks' net lendings (i.e., net of increases in
deposits) to the government and enterprises,
minus increases in households' time and savings deposits. Thus, the banking system plays a
21
there is none. Only banks may extend credit,
since supplier's credits are prohibited, and
they must ensure that credits are extended
only as planned and used only for specified
purposes. Thus, the banking system serves as
the "controller" of the government and
enterprise sectors, exercising financial control
over all their economic activities.
In fact, however, banks must function
within the bureaucracy of which they are a
part. Deviations from plans can and do occur,
depending on the relative political clout of the
banks versus other entities within the power
structure. According to Vice Premier Yao Yilin, in 1980 the financial plan called for the
banking system to issue 3.0 billion yuan in currency; the actual currency issue that year
amounted to 7.6 billion. lI That excess currency issue provides a good barometer of the
political pressure operating on the banking
system.
(b) Financial intermediation. In advanced
industrial countries, many types of financial
institutions - e.g., banks, savings institutions,
pension funds, insurance companies, mutual
funds - perform a financial intermediation
role by channeling household and business
savings into investments. In China, only the
banking system carries out that role. 12 By
prohibiting government agencies and
enterprises to hold more than a bare minimum
of cash on hand, the law funnels all their financial surpluses through the banking system.
Households may hold their surplus funds in
any form, but their only real choice is between
currency and bank savings and time deposits.
Banks do not offer checking deposits. Savings and time deposits are available only to
households. Individuals may withdraw savings
deposits at any time without penalty, but must
pay an interest penalty when withdrawing time
deposits prior to maturity (ranging from six
months up to five years) . Banks pay interest on
the transfer balances - restricted checking
accounts - held by enterprises, but not on
those held by government agencies.
China has built up a vast organization for
financial intermediation. This organization
includes 15,000 branches and offices of the
People's Bank in cities throughout the nation,
and more than 20,000 branches and offices of
the Agriculture Bank in smaller cities and
townships, in addition to 59,000 agriculturalcredit cooperatives scattered throughout rural
areas.
(c) Allocation of capital. China has adopted
the Soviet model of finance in distinguishing
between a "fiscal channel" and a "credit channel" of fund allocation. This has given rise to
the so-called "separation principle," which is
based on the idea that all the means of production belong to the people, so that financial
surpluses arising from their labor should be
used for capital formation without interest and
repayment obligation. However, government
agencies, enterprises and households sometimes have idle funds on hand, while others
have temporary needs for funds. Banks must
attract these idle funds and redirect the funds
to those that have temporary need for them.
The theory asserts that, corresponding to the
two sources of funds: fiscal and banking, the
uses of these funds must also be separated.
Bank credit should be limited to temporary
financial needs, such as fluctuations in inventories, agricultural credit between planting and
harvest, goods in transit, gaps between receipt
and payment, etc. Banks must charge interest
on the use of such funds so that they can pay
the depositors. In contrast, funds needed for
fixed capital formation and working capital
(e.g., wages, investories) should be provided
through government budget appropriations
and disbursed through banks without interest
and repayment obligations. 13
The authorities claim that this separation
principle is not only compatible with a communist philosophy of social organization, but
also constitutes prudent banking and a
safeguard against inflation. It is prudent banking, because it does not tie up "temporarily
idle funds" taken from depositors in "permanent capital needs" of the fund-users. It
safeguards against inflation, because credits
are extended on the basis of idle funds
mobilized by banks, not through issuance of
currency. The validity of these arguments will
be discussed in the next section.
22
posits, 5.40 percent on one-year time deposits,
1.80 percent on enterprise deposits (transfer
balances), 5.04 percent on industrial and commercialloans, and 4.32 percent on agricultural
loans. 14
The authorities until recently have not used
interest rates as a conscious tool of credit
policy. Since 1953 they have raised commercial and industrial loan rates only in 1959 and
1971. They changed the savings-deposit rate in
1959 and again in 1979 and 1980, raising the
rate in the latter two cases in an apparent
attempt to fight inflation by attracting a larger
volume of savings.
Role of Money
Monetary policy in China, as in the United
States, is concerned primarily with control
over the growth of the quantity of money. Yet
paradoxically, what constitutes money is still
an unsettled question in both countries. In
China's case, some insight into that question
may be obtained by considering the payment
system in China - specifically, the difference
between the "transfer balance circuit" and the
"currency circuit." The former corresponds
broadly to the production sector, and the latter
to households and farm communes.
Government agencies and enterprises constitute one economic decision-making unit,
with all production and distribution activities
guided by the nation's economic and financial
plans. Within that sphere, all entities must
keep "transfer balances" at designated banks
and make payments to one another only
through credits and debits to those balances.
These transfer balances, unlike our familiar
demand deposits, are not checkable in the normal sense; that is, depositors cannot draw
upon them for making payments to third parties. Rather, each transfer is subject to explicit
approval by the bank holding the balance, to
ensure that the payment has received prior
authorization by the proper authorities (an
industrial bureau or a ministry), and that all
papers relating to the transaction are in order.
In a sense, these payment flows are not unlike
intra-company transfers within a giant corporation: in both cases, transfers are subject to the
case-by-case scrutiny by accounting personnel.
According to officials interviewed in 1980,
the two channels of financing differ in importance according to the type of economic
activity involved. On the whole, about 70 percent of industry's capital needs are met
through fiscal appropriations, while 30 percent
are provided through bank credit - and conversely for commercial financing. Agricultural
financing is nearly all through bank credit,
except for relief and capital construction (e.g.
roads, irrigation facilities). For the nation as a
whole, fiscal funds financed 73 percent of total
capital formation, banking funds only 13 percent, and other sources (mainly capital-depreciation allowances) another 14 percent.
A related, but somewhat different, principle
states that bank credit should be limited to
short-term financing of production and distribution of goods and services. Whereas the
separation principle emphasizes the distinction
between permanent and transitory needs of
capital, this bank-credit principle draws the
line between credit extension that enhances
current production and that which does not.
The distinction is important because, according to this principle, credit extensions that
enhance current production and distribution
are necessarily non-inflationary, since any
consequent increase in currency circulation
would be matched by an equivalent expansion
of output. Moreover, upon the final sale of
goods and repayment of credit, a return flow of
currency is generated from consumers through
enterprises back to the banks. In contrast,
bank credits to finance government deficits,
consumer expenditures, stock speculation,
etc., do not add to the flow of goods and services and hence are inherently inflationary.
This is, of course, the "real bills doctrine"
familiar to students of monetary economics of
an older generation in market economies. We
will consider its validity in a Chinese context in
the next section.
(d) Interest rate policy. As stated, banks in
China pay interest on deposits and charge
interest on bank loans. According to People's
Bank data, interest rates were relatively low, in
view of the six percent annual inflation rate
in 1980: 2..88 percent a year on savings de-
23
In contrast to check payments in a market
economy, which represent an unconditional
transfer of funds, transfer balances in China
are good only for payments to government
entities and enterprise within the production
sector. Cash is required for payments to other
entities, such as households and farm communes. In such cases, the payor would have to
apply to the relevant bank for approval in order
to convert transfer balances into currency.
The "currency circuit," on the other hand,
consists of payment flows between households
and farm communes on the one hand and
government agencies and enterprises on the
other. In addition, farm produce and handicraft products can be sold on the "free
market" to consumers for cash. ("Free
market" prices are in fact subject to some official supervision and control, though to a much
lesser degree than official market prices,)
Unlike transfer balances, currency is freely
transferable and can be used to purchase anything on the market - subject only to the
availability of goods or services, and occasionally to ration restrictions for certain
"essential goods" (e.g., rice, flour, cooking
oil, cloth).
There is little for money to buy except consumer goods, and these have been in perennial
shortage. Since all means of production belong
to the people, there are no common stocks or
land to buy. Until 1981, because of continual
government-budget surpluses, there were no
bonds or any other kinds of securities to
purchase. IS Houses and gold can be privately
owned, but can be sold only to the state;
foreign currencies cannot be held privately. In
short, money in China has far fewer uses than
it does in market economies. For households,
the only meaningful alternatives to holding
currency are bank savings and time deposits
and limited amounts of consumer goods.
regulated by explicit financial planning, i.e.,
through the Budget, the Credit Plan, and the
Cash Plan. However, the Cash Plan shows the
growth in currency circulation as the
difference between household wage incomes
and consumption minus increases in household time and saving deposits (see Appendix) .16 Banks presumably could regulate deposits by adjusting deposit interest rates, but
they cannot regulate any of the other items in
the Cash Plan. Despite the considerable
amount of manpower devoted to the monitoring of currency flows - volume and composition by industry, by region, by season, etc. banks can do little to affect currency flows
directly.
But, of course, there is the Credit Plan.
Since currency growth is also equal to banks'
net lending (i.e., loans minus deposit
increases), in principle the currency-growth
rate could be determined by targeting a creditgrowth rate and a deposit-growth rate. In fact,
however, banks cannot always control their
own loan volume. In 1980, for instance, the
currency issue exceeded its target by 4.6 billion yuan, largely because of a 4. I-billion yuan
central government budget overrun,17 which
the People's Bank was obligated to fund.
Clearly, monetary policy is not independent of
fiscal policy, in that the People's Bank must
accommodate any budget surplus or deficit
that should ari~e.
However, even a perfectly accommodative
policy does not necessarily imply that the
monetary authorities lack control over the
nation's money supply. In theory, they could
contract credits to enterprises sufficiently to
offset any amount of fiscal-deficit accommodation. But the actual practice in 1980 was quite
different. The banking system's credit to
enterprises in all sectors, including agriculture,
increased by 37.5 billion yuan, or 18 percent.
Although we have no information on whether,
and the extent to which, the increase exceeded
the planned amount, official data suggest that
these loans contributed at least as much to the
excess currency issue in 1980 as the banking
system's financing of government budget
deficit. 18 Clearly, credit policy was not con-
Monetary Policy
There are no bank reserve requirements, no
security markets, and no discount windows in
China, so that all the traditional central-bank
policy instruments have no relevance in the
Chinese setting. Instead, monetary growth is
24
ducted with a view towards offsetting the
impact of fiscal accommodation on the currency issue that year.
Little direct evidence is available of the political pressures on the banking system to
expand credit to local governments and
enterprises. Some inkling can be found,
however, in a major policy directive issued by
the State Council in February 1981: "No one
is allowed to force banks to make loans, refrain
banks and credit cooperatives from recalling
matured loans, declare forgiveness of debts, or
make unauthorized use of credit cooperatives'
funds." 19
II. Current Issues: The Quantity Equation and Money Management
Chinese economic Iiterature 21 and in official
discussions is invariably: the quantity equation.
Quantity Equation
The quantity equation, MV=PQ, is a
familiar concept in the economic literature of
both socialist and market economies. It associates the price level (P) with the quantity of
money in circulation (M), the velocity of
money circulation (V), and the quantity of
goods being traded (Q). In Western economic
literature, the equation has been used in two
different ways for analyzing the effects of
money-supply changes on the national output
and the price level.
One approach, generally identified as the
"transactions approach" and attributed to Irving Fisher,22 analyzes the large number offactors that influence P through the three "proximate causes": M, V, and Q. Popular thinking
generally has regarded V and even Q as constants, so that P would change proportionately
with M, but the leading proponents of the
theory - such as Irving Fisher and Edwin W.
Kemmerer 23 - explicitly rejected this
simplistic interpretation. They maintained that
the quantity equation states a condition for
market equilibrium, and that proportionality
between money and price changes holds only
in the long-run equilibrium. The central task
of monetary theory, in their view, consists of
analyzing the effects of a change in M on all
three factors (V, Q, and P) during what Fisher
called the "transition period. "24 In the short
run, which is what counts most in monetary
analysis, the effects are anything but deterministic and mechanical.
China's modernization program seeks to
correct the errors of an excessively rigid
Soviet-type planned economy by providing
greater material incentives to workers and
more autonomy to enterprises (including farm
communes), and by substituting at least some
market forces for administrative decrees in the
economic decision-making process. Money
will inevitably play an expanding role in the
economy, but whether money will be a bane or
a boon will depend crucially on how it is managed. As the economic structure shifts away
from the Soviet model, the premises underlying the nation's Soviet-style monetary
system 20 should also require re-examination.
Few observers expect a complete restructuring of the nation's monetary and banking
system. A more realistic approach might be to
consider what adjustments in monetary and
credit policy could be made within the present
economic-planning framework, to strengthen
ways of achieving macroeconomic stabilization
and of improving the efficiency of capital
allocation. This calls for a discussion of the
usefulness of the quantity equation as a guide
to monetary policy and the measurement of
money (discussed in this section), and of
China's credit-allocation policy (discussed in
the following section).
China's monetary authorities have followed
the Soviet model for a quarter-century in
explicitly planning for monetary growth foreshadowing the policy of money targeting
adopted by the major industrial countries just
within the past decade. What criteria do the
monetary authorities follow in setting moneygrowth targets? The answer given in the
25
Another approach, commonly identified as
the "asset approach" or the "Cambridge
approach,"25 also views the quantity equation
as a market-equilibrium condition - not for
the goods market, as in the Fisherian
approach, but for the money market. In other
words, it views PQN as the market demand
for money and M as the supply of money, and
studies the adjustments in the public's spending behavior and asset portfolios following a
change in the underlying conditions. Thus, the
approach calls for an explicit specification of
the process of money creation, of the factors
determining money demand, and of the process of adjustment towards money-market
equilibrium following, say, an increase in the
money supply.26 Again, in this approach,
neither V nor Q is considered as fixed in
analyzing the process of adjustment towards
market equilibrium.
In the Chinese economic Iiterature,27 the
quantity equation also serves as a starting point
of monetary analysis. But Chinese economists,
unlike Western economists, do not ask how P
and Q would be affected by a change in M.
Instead, they consider P as given by the
targeted price level and Q as given by the
planned volume of national output, and then
ask about the amount of money circulation,
M, that would be consistent with stated price
and output objectives, given the velocity of circulation, V. This line of thinking evidently
underlies the annual Cash Plan in the nationalplanning process. Each year, bank officials at
local levels must compile a "Resident Currency Receipts and Expenditures Balance
Table," estimating the wage incomes, consumption expenditures, savings and time deposits, cash on hand, etc., of different types of
residents, and this procedure helps determine
the velocity of circulation and the "required"
amount of currency for the residents of each
city and province. The People's Bank of China
aggregates these local financial data together with data for targeted output, wage
rates, and employment - and adjusts them for
"financial balance" to determine the planned
amount of growth in currency circulation. 28
In a formal sense, the Chinese approach
seems to resemble the Western monetary
approach, since both take off from the same
quantity equation of money. However, a common starting point means little, since the
quantity equation itself is no more than an
identity, and as an identity, it can be consistent
with widely divergent analytical approaches.
Again, both the Fisherian and the Cambridge
approaches use the quantity equation only as a
market-equilibrium condition; the analysis in
each case focuses on the market adjustment
after a change in the underlying conditions.
Moreover, in the adjustment process, neither
V nor Q is considered as fixed. In contrast, in
Chinese monetary analysis, adjustments
toward market equilibrium are precluded by
officially fixed prices and interest rates. With
P, Q, and V determined, the analysis never
really departs from the quantity equation as an
identity. The Chinese approach, unlike its
Western counterparts, thus sheds no light on
market behavior, and its analytical results cannot be subject to empirical testing.
Nevertheless, Chinese monetary analysis
uses the quantity equation only for determining the optimal quantity of money for achieving given price and output objectives. Hence,
the only relevant question is how useful the
equation is for accomplishing that limited purpose.
To answer that question, let us consider a
hypothetical case - which is, incidentally, not
far removed from recent reality. Suppose that
prices and output are both fixed according to
plan, so that one side of the quantity equation,
PQ, is a constant. Now, the authorities raise
wage rates for a significant portion of the work
force and at the same time embark on an
ambitious investment program, financing both
through bank-credit extensions. As a result,
households hold more currency but can buy no
more consumer goods; similarly, enterprises
have larger transfer balances but can obtain no
more producer goods. Obviously, inflation
pressure has increased. But since prices are officially fixed, inflation is repressed, and there
are disequilibria in both the money and goods
markets.
Under such circumstances, does the quan-
26
both cases, the authorities could mistakenly
conclude that a credit expansion has had no
impact on currency circulation, or that it has
produced an enhanced desire to hold currency
(i.e., a decline in velocity) exactly offsetting
any increase in currency circulation. Thus, the
quantity equation, combined with a narrow
- definition of money~ provides little indication
of the repressed-inflation pressure in the
system.
The failure of this approach can be partly
attributed to an inadequate measure of money
and partly to a misinterpretation of the velocity
of circulation. The narrow definition of money
makes a clear distinction between a) cash held
for transaction purposes and b) other types of
financial assets held in consideration of some
returns. The amount of cash the public is willing to hold depends in part on its alternative
cost in terms of the interest return foregone by
holding cash, and in part on the volume of
transactions the holding of cash is intended to
facilitate. 3o This assumes that the public is free
to choose among consumer goods, cash and
other types of financial assets in holding its
wealth - which means that the definition
makes sense in a market economy. But in a
planned economy such as China's, with officially fixed prices and rampant shortages of
consumer goods, this narrow definition of
money could be seriously misleading. In our
illustrative case, a substantial portion of the
public's increased holdings of cash and time
and saving deposits might be involuntary,
because of a mismatch between enhanced
money income and limited consumer-goods
output. Increased money balances might
represent consumer frustration rather than
increased confidence in the value of the currency. Since bank deposits can be liquidated at
any time with no, or only minor, interest
penalties, depositors may regard their funds as
a temporary reservoir of purchasing power to
be used at any time goods become available.
Under these circumstances, the more
meaningful definition would include both currency and (at least) savings deposits.
However, this broader definition of money
still would not encompass a condition of
tity equation provide a reliable reflection of the
repressed inflation pressure? On the surface,
the answer might appear obvious. Since, by
assumption, PQ remains fixed, any increase in
M at given V must mean inflation pressure,
whether repressed or open. 29 But the answer is
not quite so simple: It depends very much on
ho\v money is measured.
Measurement of Money
The official measurement of money includes
only currency in circulation, for two reasons.
First, the authorities are concerned only with
the stability of consumer prices, which have to
do with people's livelihood, and not with producer prices, which are merely accounting
devices for effecting transfers within the state
sector. Hence, they do not worry about
increases in transfer balances held by
enterprises, especially since enterprises must
obtain official approval for the use of these balances. Second, aside from questions of
availability of supplies, consumer inflation
pressure can arise only from increased currency holdings, because currency is the only
means of payment for the purchase of consumer goods. As stated, enterprises cannot use
their transfer balances for purchasing consumer goods, and households cannot have
checking accounts in banks. Hence, the monetary authorities believe that they need only to
control the growth of currency circulation in
order to check inflation pressures.
This approach may be examined in terms of
the illustrative case presented above. Consider
first the consumer sector. As a result of the
postulated credit expansion, households
now hold more currency, but can buy no more
consumer goods, than before. Under the circumstances, households can either hold the
extra currency in the form of interest-earning
bank deposits, or hold part in deposits and part
in idle cash for consumer-goods purchases. In
the former case, all the extra cash flows back
into the banking system as increased time and
savings deposits, with no net increase in currency circulation and no change in velocity; in
the latter case, since PQ is a constant, V must
decline in proportion to the increase in M. In
27
repressed inflation. Because prices and output
presumably are both fixed according to plan,
the increase in money supply (by the broader
definition) would be offset by a proportionate
decline in the velocity of circulation. Here
also, the concept of velocity implies a public
demand for money, which is meaningful in a
market but not in a planned economy. In a
market economy, a decline in velocity means a
rise in the public's demand for money holdings, say, on account of lower interest rates. It
implies a re-ordering of asset-holders'
portfolio choices among goods, cash and other
financial assets. In a planned economy, with its
widespread shortages, a decline in velocity (in
the absence of interest-rate changes), often
means simply an increase in consumer frustration.
This velocity phenomenon, combined with a
broadened definition of money, suggests a
potentially useful way of measuring repressed
inflation in an economy such as China's. In
our illustrative case, since there is no change
in prices, output, and interest rates, the entire
decline in velocity accompanying the moneysupply increase may be considered involuntary, resulting from insufficient supplies of
goods at prevailing prices. Then, the decline in
velocity multiplied by the increase in money
supply should measure the increase in
repressed inflation pressure. 31
This measure could be operationally useful
in policy-making. The authorities could select
abase year with few symptoms of repressed
inflation (e.g., ration coupons, queues in front
ofstores, bare store shelves). Subsequent declines in velocity multiplied by current year
money supply (i.e., currency plus savings deposits) might indicate the amount of repressed
inflation occurring since the base year. Given a
policy of monetary restraint for reducing inflation, the authorities might attempt to achieve a
below-target rate of monetary growth until
velocity rises to its base year level - proper
adjustments being made to take account of
possible changes in velocity attributable to factors such as interest-rate changes and financial
innovations.
Finally, enterprises' transfer balances might
properly be included in an even broader
measure of the money supply.32 The reasons
cited above for their exclusion may have some
validity under a rigidly enforced planning
regime,33 but not in a regime where policymakers introduce more price adjustments into
both the producer and consumer sectors and
give more financial autonomy to enterprises.
In any case, a rise in transfer balances held by
enterprises might be as much a symptom of
repressed inflation as increases in savings deposits involuntarily held by households.
Moreover, as enterprises gain more autonomy
in the use of their bank accounts, the "moneyness" of these balances will rise, increasing
the need to include them in the measurement
of the nation's money supply.
III. Current Issues: Credit Policy
As described earlier, China's bank-credit
policy theoretically is guided by two basic principles: the "real bills doctrine" and the "separation principle." In practice the doctrines
have not always been followed, and this conflict has given rise to considerable dispute in
Chinese economic literature on banking
policy,34 We shall consider these two doctrines
in turn in the context of the Chinese economy.
real-bills doctrine is a special feature of
socialist finance, in contrast to the bank
financing of non-productive, speculative
activities common in capitalist economies. 35 In
their view, adherence to the doctrine accounts
for the Communist success in stablizing prices,
while departures from it are a basic cause of
inflation.
Conceptually, however, the real-bills
doctrine is inconsistent with the quantity
theory of money. The latter holds that the
quantity of money is a key determinant of eco-
Real-Bills Doctrine
Chinese economists like to stress that the
28
nomic activities, especially the price level;
hence, the monetary authorities must actively
control the growth of· the money supply in
order to maintain price stability. But according
to the real-bills doctrine, so long as bank credits finance •only current production and distribution of· goods. and services, there can
never be an over-issue or under-issue of
money. Therefore, an active monetary policy
that sets and adjusts the rate of money-supply
growth according to the quantity equation (or
any other approach) would be superfluous and
probably also destabilizing, as the moneygrowth rate, however determined, would only
by chance be identical to the rate required by
the real needs of commerce.
The doctrine has had a long history in
Western economic thought, dating back at
least to Adam Smith in 1776. 36 It suffices to say
that as early as 1802 Henry Thornton 37 pointed
out that the doctrine is neither necessary nor
sufficient for insuring non-inflationary bank
finance. It is not necessary because, so long as
a credit expansion is offset by savings somewhere in the economy (e.g., fiscal surplus),
there is no inflation. It is not sufficient because
a credit expansion, even though secured by
increased commodity output, gives rise to an
expansion in money income - which in turn
stimulates demand for more commodities,
thus justifying further bank credits to finance
production. Thus, a cumulative process could
be generated, leading to precisely the type of
boom-and-bust conditions the real-bills
doctrine is meant to avoid.
However, can this cumulative process occur
in a Communist system? Some say not. One
Western monetary economist wrote:
"We must not be too hasty to judge the
Communist credit policy on the basis of
modern Western monetary theory. In this
case, important differences in institutions
must be taken into account. .. The real bills
doctrine does not work in a capitalist economy mainly for two reasons. First, ... the
increase in credit may bid up prices and bid
away resources from elsewhere. Second, ... the investment multiplier, or the
velocity of circulation of money, .,. could
easily be larger than the gross productivity
of the working capital that actually get created. Both these reasons, however, probably do not apply to a Socialist command
economy provided it is properly managed.
There, as the grant ofcredit is presumably
based .·uponthe planned availability of
materials and labor for the investment in
working capital at controlled prices, the first
reason obviously does not apply. Furthermore, the velocity of circulation of bank
balances of enterprises in a Communist
country is strictly under control, so that an
increase in credit would not necessarily
cause aggregate demand to outstrip supply. "39
This analysis, however, pertains only to the
producer sector. In contrast, the cumulative
process following a credit expansion also raises
household money income, which then creates
additional demand for goods and services.
Even though material and labor prices can be
held fixed in a planned economy, each round
of credit expansion would still give rise to a
further rise in household money income and
hence to increased demand pressure on
resources. In the process, enterprises' transfer
balances will grow; controlling their use simply
means repressing inflation. Restrictive
measures, like price and wage controls in
market economies, only suppress the
symptoms of inflation, and do not abate its
latent pressures.
Thus, the real-bills doctrine does not appear
to be an effective anti-inflationary bank-credit
policy, even in a planned-economy context. By
adhering to it, the authorities may ignore the
need for controlling the money-growth rate or
the national savings-investment balance - the
essence of macroeconomic policy. Moreover,
the doctrine unnecessarily restricts banking
operations, and is in practice both preached
and breached. Banks in market economies
have long abandoned that principle and
engaged in all types of financing, ranging from
consumer, equipment, real estate, to government financing - without necessarily giving
rise to inflation. Banks in China have also gone
beyond commercial-bill financing into
29
medium-term project financing. Banking
theory in this case thus lags behind and sometimes serves as a drag on banking practice.
deposit withdrawals, and prudence thus
requires that bank assets be limited to shortterm<and self-liquidating loans and investIllents. The falsity of the argument has long
been demonstrated by banking experience all
oYer. the world.· To meet unexpected withdrawals, only a small fraction of a bank's total
assets needs to be held in liquid form. The
larger the bank's ready access to borrowing
facilities, the smaller needs to be the fraction.
For a banking system such as China's, with
onlyfour banks in the entire nation, all under
government control, deposit withdrawals
should be the least of problems.
The anti-inflation argument for the separation principle has more substance. According
to this argument, through national financial
planning the state allocates funds for investment, wage payments, etc., in a manner
designed for achieving macroeconomic balance. If enterprises are allowed to tap bank
credit for unplanned investment and other
types of spending, this extra-plan spending will
lead to a breakdown of the macrobalance and
thus to inflation. 39
The argument assumes, however, that
aggregate balance between savings and investment had already been attained in national
economic planning; then, additional credit
expansion for financing investment would
certainly be inflationary. But that is tautology.
It is an argument against excessive credit
expansion, when any credit expansion beyond
that set out in the Plan could be considered
"excessive." It is not an argument for the separation principle itself.
What is important for stabilization policy is
not so much the distinction between sources of
funds as the total volume of investment relative to national savings. The separation principle, by providing free funds for more than 70
percent of enterprise investment funds
through· the fiscal channel, enlarges capital
delllandand encourages waste and inefficiency
in its use. Thus, the intended investment is
larger, and the resultant increase in output
smaller, when credit is allocated under the separation principle than it would otherwise be.
Within the existing socialist framework of
"Separation Principle"
The "separation principle" is another cardinal rule of socialistic banking which China
adopted from the Soviet model in the 1950s.
As explained earlier, China makes a crucial
distinction between "fiscal funds" and "banking funds." Banks distribute fiscal funds to
enterprises, with no interest and repayment
obligations, for financing fixed-capital investments and regular ("quota") working-capital
needs. In contrast, they lend banking funds to
enterprises for meeting transitory, revolving
working-capital needs, with definite interest
and repayment obligations.
Banks are responsible for watching over the
two channels and guarding against the mixing
of funds in a manner that would sabotage the
separation principle. However, in practice,
since funds are notoriously fungible, the two
channels are constantly merging. The banks'
task is further complicated by the fact that fiscal funds are free, and therefore difficult to
obtain. Often, enterprises' capital-investment
projects are approved in the state economic
plan, but without sufficient appropriations.
Thus, to complete certain projects, enterprises
must obtain bank loans under the subterfuge
of "above quota" working-capital needs, and
surreptitiously employ the proceeds for fixedcapital investments, wage and tax payments,
and other purposes for which banking funds
are ineligible. Banks are aware of their responsibility to stop such practices, even though
they know that the enterprises are basically
sound and actually need the funds to carryon
business. Banks are thus caught in the unenviable position of either ignoring the problem
or constantly and fruitlessly complaining about
the condition.
As stated, the Chinese advocate the use of
this principle for two reasons: banking prudence and non-inflationary credit extension.
The banking-prudence argument for the separation principle can be dismissed quickly.
According to this argument, banks must meet
30
the economy, there are various alternative
ways of allocating capital. One would be a
variation of the present practice: collect all
enterprise savings into the state treasury, deposit the funds at banks, and let banks lend out
the funds to enterprises. Another would be for
the .enterprises to decide how much of their
retained earnings to plough back into their
own projects and how much to channel
through the banks for investment elsewhere.
In the former case, a sufficiently high loan rate
would have to be charged to insure efficient
use of capital; in the latter case, a sufficiently
high deposit interest rate would have to be set
to attract funds away from self-financed investments and household consumption to investments with higher returns. Either approach
would mean the abandoning of the separation
principle and increased reliance on interest
rates for attracting savings and for capital
allocation.
Already, some movement away from the
separation principle towards greater reliance
on the market mechanism is discernible. In
August 1979, the State Council ordered the
Construction Bank to experiment with
medium- to long-term loans of five to fifteen
years· to enterprises on approved capital-construction projects. The interest rate, however,
was set at only three percent a year, considerably below the five-percent rate charged by the
People's Bank on short-term loans· to all
industrial and commercial borrowers. 4o In
addition, the People's Bank itself has started to
make short- to medium-term loans to textiles
and other light industries for renovating,
uPlrading, or enlarging existing facilities. 41
There was no follow-up, however, to these
tentative steps away from the strict Soviet
model of credit allocation. Indeed, as inflationary pressures mounted during 1980, the
authorities fell back on the old, familiar banking principles to control inflation. In the
February 1981 State Council decision on
national credit policy, Article 2 declares:
"Restatement of the principle of separation
of fiscal capital and bank-credit capital; strict
prohibition of any shifting of bank-credit funds
for use on fiscal-type expenditures. "42
IV. Summary and Conclusions
First, the Chinese economy today - including its monetary and banking system - is a
socialist planned economy largely patterned
after the Soviet model. The "monobank" network supplemented by a few special-purpose
banks, the Credit Plan and the Cash Plan, the
"transfer balance" and the currency circuits of
money circulation - all are Soviet inventions
of the early 1930s.
Second, money has a significantly lesser role
in this command economy than in a market
economy, especially since it provides little
purchasing power when goods are unavailable.
By the same token, monetary policy has a
much more restricted role in national
macroeconomic policy than it does elsewhere.
China's monetary policy has been circumscribed by: (a) the nearly complete
reliance on administrative controls for regulating monetary growth, and (b) the monetary
authorities' lack of independence from both
central- and local-government authorities with
respect to credit allocation. Because of these
two factors, policy has necessarily been accommodative. The money-growth rate thus has
largely reflected fiscal policy, with monetary
stability resulting from a budget balance (or
surplus) and inflation resulting from a deficit.
Monetary policy in this context has been
incapable of making much difference to
stabilization efforts.
Third, effective monetary policy means
effective control over money-supply growth.
Monetary analysis in China has relied on the
quantity equation of money for determining
the targeted non-inflationary rate of monetary
growth. However, a mechanical reliance on the
equation - one assuming a given velocity of
circulation - appears inappropriate for a situation of rigid prices and pronounced market dis31
bills doctrine" and the so-called "separation
principle," although banking practice has
begun to move away from these guidelines.
The theoretical support for these banking principles, however, is found wanting even in the
Chinese cOl1text, so .that the tension between
official thinking· and •banking practice· is •. both
unnecessary and distractive from real issues of
economic stabilization and banking prudence.
These principles,moreover, require continued reliance on administrative controls for
enforcing compliance. Their replacement by a
flexible interest-rate policy would not only be
more in tune with the spirit of Modernization,
but also would help support the development
of an effective monetary policy, operating
through market forces rather than quantitative
controls.
equilibria. An alternative approach - still relying on the quantity equation, but using
changes in velocity as a measure of the extent
of repressed inflation - could provide a
workable policy guide for China.
Fourth, we may question the rationale for
the official use of the narrow definition of
money supply, limited to currency circulation
only. In China's institutional environment,
the narrow definition could result in a serious
underestimate of latent inflationary pressures
in the .economy. Alternative measures to
remedy that underestimate might include
household savings and time deposits, as well as
"transfer balances" of enterprises and government agencies (excluding the state treasury).
Fifth, in the area of credit policy, official
thinking continues to be guided by the "real
Appendix: A National-Accounts Model of China's Financial
Plan
This appendix presents a scQ.ematic framework of the structure of China's Financial Plan
in terms of sectoral accounts and inter-sectoral
financial flows. As explained in the text, the
Financial Plan consists of (a) the Government
Budget, (b) the Credit Plan, and (c) the Cash
Plan. The three parts are interrelated such
that, given any two, the third is determined.
From the point of view of monetary policy, the
Cash Plan is of primary importance, as it determines the money-growth rate. It is constructed
on the basis of data on household income and
Uses of Fund
Sector
Sources of Fund
Government
Enterprises
Banking
Households
T+B G
C H + C G+ I G+ BE
D G + DE + S H + CD
where T
designates taxes and profits
paid into the state treasury;
borrowings from banks;
output of, or expenditure on,
consumer goods and services;
B,
C,
WG+W E
expenditure, and it must also be consistent
with planned financial flows of the Government and Banking sectors. That is why China's
financial planners place so much emphasis on
reconciliation of the various parts of the plan.
And that is why monetary policy, as presently
constituted, is largely determined by decisions
made outside the central bank's jurisdiction.
The national economy may be divided into
four sectors, and the sectoral financial transactions during the plan period may be summarized as follows:
=C G+ WG+ I G+ D G
=WE+T+D E
= BG + BE
=C H + SH+ CD
W,
32
(1)
(2)
(3)
(4)
wages and salaries, bonuses,
payments in kind, and government subsidies to workers
(e.g., housing, health care);
I,
investments in plant, equipment, inventories, and land
improvement;
D,
increase in transaction balances
in banks;
S,
increase in bank savings and
tirnedeposits;
CU, increase in currency circulation.
All items are stated in nominal values, and the
subscriptsG,E, H designate the Government,
Enterprise, and Households sectors respectively.
Equation (0 shows the Government
Budget. BG and D G are financing items, reflecting the government's position vis-a-vis the
banking system. A positive BG indicates net
government borrowing, and a negative BG net
government repayment of bank debt. A positive D G indicates a net increase in government
deposit balances at banks, and a negative D G a
netdec:rease in such balances. I G is enterprise
capital formation financed by the government,
which also appears as a source of funds for the
Enterpr!sessector in equation (2).
Equation (2) shows the sources and uses of
fundsQf the Enterprises sector vis-a-vis the
other s.ectors on a consolidated basis. Both
sides of the equation are equal to the sectoral
net output. The left-hand side of the equation
shows that the net output consists of sales to
the Households sector (C H) and to the
Government sector (C G) , "fixed-capital
investment plus quota inventory accumulation" financed by the government (IJ, and
"above-quota inventory accumulation"
financed by bank credit (B rJ .
Equations (3) and (4) are straightforward
sQurce-lmd. use-of-fund equations for the
Banking and Households sectors, respectively.
The rnodel abstracts from the real world in
order to show the essence of China's financial
planning. Omitted are foreign.trade flows,
changes in foreign assets, retained earnings,
and capital-depreciation allowances. These
could be added at will, without changing the
essence of the analysis.
The model contains all three compQnent~ of
the Financial Plan. The Government Budget,
as stated, is equation .(1). The Credit Plan is
sh~wn in equation (3). The Cash Plan can be
derived from equation (4). by showing. an
increase in currency circulation (CU) as the
difference between Households' incomes (Wo
+ WrJ on the one hand and Households'cQnsumption .plus increase in Househ.olds' time
and savings deposits (C H +. S ~ on the other
hand. In reality, of course, agricultural communes are included in the Households sector
insofar as the Cash Plan is concerned.
From equations (0 and (3), it can be shown
that
(CU + S~ = (BE-DP) + (BG-D G).
(5)
In other words, an increase in the sum of currency circulation and household time and savings deposits must arise from banks' net lendings to enterprises and the government. Since
banks' net lending to the government is the
mirror-image of the deficit (or surplus) of the
Government Budget, since banks' lending to
enterprises embodies the net outcome of the
Credit Plan, and since the growth in currency
and household time and savings deposits
reflects the outcome of the Cash Plan, equation (5) summarizes the interrelationship
among all three components of the Financial
Plan.
Moreover, equation (5) provides flexibility
in the choice of measurement of money. As
discussed in the text, the official measurement
includes only currency circulation. One can
show the sources of its increase by moving SH
to the right-hand side of equation (5). Alternatively, if one wishes to include household
time and savings deposits, S H should remain
on the left-hand side of equation (5). An even
broader definition of money would include the
"transfer balances", in which case DE would
be moved to the left-hand side of equation (5).
33
FOOTNOTES
8. Describing the 1960-61 inflation, a key economic
advisor said: "However, beginning in 1959,
agricultural. output deClined, currency circulation
increased 1.4 times from 1957 to 1961, free-market
prices ros~ sharply, and the prices of those commoditi~s which were hard for the state to control also
climbed. In order to insure people's livelihood, the
stateresolutely held stable the prices of 18 categories of major consumer goods, but had to raise the
priceS of a number of high-priced commodities in
ordertocontractcurrency circulation." See Xue Muquiao,op. cit., p. 170. Nearly all the references to
priqe .increases involve consumer goods. However,
there is evidence that the prices of some producer
goods also rose in the 1979-80 inflation. See Renmln
Rlba~(E3eijing Daily), June 23, 1981, p. 1, in reference
to steel price increases.
1. The interested reader is referred to Jan S. Prybyla,
The Chinese Economy, Columbia, South Carolina:
University of South Carolina Press, 1978; Audrey
Donnithorne, China's Economic System, New York:
Praeger, 1967.
2. Typically, a worker employed by a collective earns
less than one employed by the state. In 1980, for instance, the average income of collective workers
amounted to 803 yuan, and that of state workers only
624 yuan - a yuan being equivalent to about 68 U.S.
cents in 1980. See The State Statistical Bureau,
"Communique on Fulfillment of China's 1980 National
Economic Plan," Beijing Review, No. 19, May 11,
1981,p.20.
3. Why the authorities wish to achieve stability in
both aggregate price level and individual prices is not
clear. One possible explanation is that rigid prices are
needed so as not to complicate the already immensely complex task of planning the input and output of
an entire national economy. One top economic
advisor to the planning authority wrote recently:
"There are hundreds of thousands, or even more than
a million, prices to deai with. For each product, the
calculation of production cost would be a very complicated task. The producer and the buyer would each
proceed from different angles and engage in interminable arguments. Hence, no price authority,
however brilliant and competent, could possibly solve
this complex problem through subjective planning."
See Xue Mu-quiao, "On Price Adjustments and
Reform of the Price Administration System" in his
Certain Problems in Our National Economy Today On
Chinese), Beijing: People's Publishing Co., 1980, p.
177.
9. For an authoritative study of China's financial
system and monetary policy, see Katherine H. Hsiao,
op. cit. Although the data refer to years prior to 1961 ,
the description and analysis remain largely valid
today.
10. information in this and the following paragraphs
on China's banking system is based on interviews
with officials in mid-1980 and on Financial Overview
of the People's Republic of China On Chinese), PlanningBureau, The People's Bank of China, June 1980.
(This is also available in English in a special translation by Foreign Broadcast Information Service, Washington, D.C.) See also Katherine H. Hsiao, op. cit., and
Liu Hong-zu, Issues of Money and Banking Under
Socialism On Chinese) Beijing: China Financial and
Economic Publishing Co., 1980; Dick Wilson, "How
Banks Work in China," The Banker, January 1980,
pp. 19-27; Audrey Donnithorne, op. cit., pp.402-433.
4. See, for instance, Wang Ping, "No Inflation in
China: Long-term Stability of Renminbi," Peking
Review, No. 11, May 23, 1975; and Yang Pei-hsin,
"Why China Has No Inflation," China Reconstructs
(Peking), April, 1975, pp. 4-9.
11. See "Report on the Readjustment of the 1981
National Economic Plan and State Revenue and
Expenditure," Beiling Review, March 16, 1981, p. 15.
12. There is also the People's Insurance Corporation
of China. However, organizationally it appears to be a
mere appendage of the People's Bank.
5. For a painstakingly thorough study on the subject,
see Tong-eng Wang, Economic Policies and Price
Stability In China, Center for Chinese Studies, China
Research Monograph No. 16, University of California,
Berkeley, 1980. See also Dwight H. Perkins, Market
Control and Planning In Communist China,
Cambridge: Harvard University Press, 1966, pp. 155159; Audrey Donnithorne, "The Control of Inflation in
China," Current Scene, April-May, 1978, pp. 1-12.
13. A clear and full exposition of this theory is presented in Uu Hong-zu, op. cit., pp. 201-211.
14. All interest rates were annual rates compounded
from monthly rates. See People's Bank of China, PlanningBureau,op. cit., pp. 23-24.
15. In March 1981, the Government announced
plans for the sale of up to five billion yuan in treasury
bonds - the first bond issue in China since the
1950s - following government budget deficits of 17
billion yuan in 1979 and 12 billion yuan in 1980. The
bonds were denominated from 10 yuan to one million
Ylian,carrying an annual interest rate of 4 percent
and repayment in installments over the 1987-90
period. Since the terms of the bonds were not particularly favorable in view of the high inflation rate, the
government made subscriptions mandatory for
selected state enterprises, local governments, army
units, and wealthy communes. See report in The New
York Times, March 8, 1981.
6. See, for instance, Xue Mu-quiao, op. cit., pp. 164179.
7. For an analysis of the 1953 and 1956 inflations,
see Katherine Huang Hsiao, Money and Monetary
Policy In Communist China, New York: Columbia
University Press, 1971, pp. 234-253. For an account
of the 1960-61 episode, see Xue Mu-quiao, op. cit., p.
1 70. For that of the 1979-80 episode, see Vice Premier Yao Yi-lin's report to the Standing Committee of
the National People's Congress reported in Beijing
Review, March 16,1981, p.15.
34
16. For a fuller list, see Sho-Chleh Tslang, "Money
and Banking In Communist China," in An Economic
Profile of Mainland China,. studies· prepared for the
Joint Economic Committee, U.S. Congress, Washington: Government Printing Office, 1967, Vol. I, p.336;
and Katherine Hsiao, op. cit., p. 170.
History of Economic Analysis, New York: Oxford
University Press, 1954, pp. 1095-1106.
25. Following the writings of Professor Alfred
Marshall, Cambridge Unlverl)lty. See Alfred Marshall,
Money, Credit and Commerce, London: Macmillan,
1923.
17. See Vice Premier Yao YI-lin'l) report, Beijing
Review, March 16, 1981, p. 15.
26. See Milton Friedman, "The Quantity Theory of
Money: ARestatement," in M.Friedman, ed., Studies
in the Quantity Theory of Money (C hlcago: University
of Chiago Press, 1956). For a more recent survey, see
David E. W. Laidler, The Demand for Money, (New
York: Dun-Donnelley, 2nd edition, 1977).
18. Information in this paragraph is based on
Chinese monetary statistics released for the first time
and published In People's Daily (in Chinese), July 4,
1981, p. 2. The data Indicate that the currency Issue
increased by 7.8 billion yuan, or 29.3 percent, in
1980, which, coupled with the data cited in the preceding footnote, implies an increase 142 percent
larger than the planned amount. The data also indicate that In 1980 the banking system increased its
credit to the Government by 8.0 billion yuan, while the
Government's deposits in the banks rose by 1.3 billion yuan. Thus, the currency issue attributable to
budget deficit amounted to 6.7 billion yuan. During the
same year, the banking system's loans to enterprises
rose by 37.5 billion yuan, which was offset by 30.5
billion yuan Increase In deposits held by all nonGovernment sectors, thus contributing 7.0 billion
yuan to the currency expansion that year. The two
sources together accounted for more than the 7.8 billion yuan increase In the currency issue in 1980 the difference being attributable to a 2.9 billion yuan
decrease in foreign-exchange reserves, a 2.7 billion
yuan Increase in the banking system's capital and
surplus, and 0.1 billion yuan to unspecified others.
27. See references cited in note 21 above.
28. See a handbook prepared by the People's Bank
for Its staff, Certain Problems in Research Work on
Currency Circulation (in Chinese), Publications
Bureau, People's Bank of China, Beijing: Finance
Publishing Co., 1957, esp. pp. 14-18 and 35-76; and
Currency and Credit (in Chinese), Textbook Editorial
Commission, People's Bank of China, Beijing: China
Financial and Economic Publishing Co., 1964, esp.
pp. 115-26.
29. See Katherine H. Hsiao, op. cit., pp. 234-251, for
an empirical study of the extent of open and
repressed inflation In China during the 1952-57
period.
30. See William J. Baumol, "The Transactions
Demand for Cash: An Inventory Theoretical
Approach," Quarterly Journal of Economics, November 1952, pp.545-56.
31. I am indebted to this issue's editorial committee
for suggesting this point.
19. See "State Council's Decision on Strengthening
Credit Administration and Strictly Controlling Currency Issue," China Finance (in Chinese), April 1981 ,
p.2.
32. The suggestion was also made by a number of
Chinese economists in the early 1960s and more
recently In 1980. See Huang Da, "Bank Credit and
Currency Circulation," in Lin Qi-keng, ed., op. cit., pp.
40-55, and other articles in the same volume; also Liu
Hong-zu,op. cit., pp. 162-67.
20. For authoritative studies of the Soviet monetary
system, see George Garvy, Money, Banking, and
Credit in Eastern Europe, Federal Reserve Bank of
New York, 1966; and his Money, Financial Flows, and
Credit in the Soviet Union, Cambridge, Mass.:
Ballinger, 1977.
33. See Lin Qi-keng, "On the Role of Monetary-Circulation Principles Under Socialism," Economic
Research (in Chinese), February 1963, reprinted in
Lin QI-keng, op. cit., pp. 56-71.
21. See, for instance, Liu Hong-zu, op. cit., pp. 159162. Also, Xlan Yu-tai, "On the Inter-relation Between
Capital Flows and Money Circulation" in Lin Qi-keng,
ed., Issues of Currency Circulation Under the
Socialist System (in Chinese), Beijing: China Financial and Economic Publishing Co., 1964, PP. 97 -99,
and other authors in the same volume: Yu Zueh-xlan,
pp. 104-109; Zhou Quin, pp. 122-132; Zhao Zhemlng, pp. 142-53; Lin Qi-keng, pp. 154-169.
34. See, for Instance, articles in China Finance (in
Chinese), April 1981, pp. 28-29.
35. Thus, a prominent chinese economist wrote: "In
capitalist economy, banks frequently require commodity pledge as a security for insuring repayment of
a loan. However, in the course of capitalist economic
growth, banks have engaged In security transactions
(such as common stocks, bonds, etc.) in large
volumes by extension of loans on such securities or
Investing in these securities for speculation. Thus,
capitalist bank credit has become more and more
separated from commodity flows. In our socialist
countries, things are different. Bank credit. .. applies
primarily to the production and distribution of commodities, and loans must be secured by commodities.
We require the complete matching of credit flow and
commodity." See Liu Hong-zu, op. cit., p. 215.
22. See Irving Fisher, The Purchasing Power of
Money, New York: Macmillan, 1911.
23. See Edwin W. Kemmerer, Money and Credit
Instruments in their Relation to General Prices, New
York: Holt, Rinehart and Winston, 1907.
24. See Irving Fisher, op. cit., Chapters 5 and 6.
Kemmerer stressed that the velocity of circulation
varies with business conditions. See Edwin W. Kemmerer, op. cit., p. 20. See also Joseph A. Schumpeter,
35
36. See LloydW. Mints,A· History >of Banking
Theory, Chicago: University of Chicago Press, 1945,
pp. 25-27. For the c:levelopment of the doctrine since
Ac:la.lTlSmith,see L.loydW.Mints,QP.clt.;and Jacob
Viner, .Studlesln the Theory of International Trade,
New York: Harper, 1937, pp. 148-54 and 234-43.
39. For a lucid statement of this argument, see Wang
L.anand Uu Hong~zu, Issues.ofSoclailstBank
(:redlt,(in Chinese) Beijing: China Financial and Economic Publishing CO.,+964,pp. 49~52.
40. See Liu Hong-zu, op. cit., p. 247.
37. See Joseph A. Schumpeter, op. cit., pp. 721-4.
41 .• l5ee People's Bank of China, Planning Bureau,
op.clt., (in Chinese), p. 13.
38. See Sho"Chieh Tsiang,op. cit., pp. 334-335.
42. See China Finance (in Chinese), April 1981, p. 2.
36
Charles Pigott*
One of the oldest controversies in international economics concerns the extent to which
real factors affect exchange rates. Real factors
are influences, such as tastes and technology,
which affect the supply and demand for commodities and thereby their relative price in a
persistent way. The present dispute is not over
whether such changes in relative prices
actually occur (the most casual observation
confirms that they do) but, rather, whether in
recent years they have significantly affected
the value of one nation's currency in terms of
another's.
The doctrine of "purchasing power parity"
(PPP) reflects a widely held and traditional
view of this issue. This asserts that the foreign
exchange value of a nation's currency is determined by the level of its domestic prices relative to the level of prices abroad - that is, by
the PPP value of the domestic currency. Since
the level of a country's prices is (mainly)
determined by the level of its money stock,
relative to the demand for it, the PPP doctrine
implies that exchange-rate changes largely
reflect monetary, rather than real, factors. This
theory traditionally concerns long-run currency values, but it has recently been incorporated in short-run exchange-rate models which
allow for temporary departures from PPP due
to interest-rate fluctuations.
Models which explain international patterns
of trade and industrial specialization provide a
rather different perspective on exchange-rate
determinants. These models commonly imply
that factors which cause changes in the relative
prices of commodities can lead to changes in
exchange rates. For example, a decline in
demand for a country's traded goods - one
leading to a fall in their prices relative to those
abroad - might result in a depreciation of the
home country's currency. Thus, in contrast to
PPP theories, these models imply that real factors affect exchange rates.
Clearly, the influence of real factors on
exchange rates is of interest to those concerned with explaining and predicting the
value of the dollar and other currencies. But
real factors can also be critically important for a
number of policy issues. For example, should
the authorities reduce domestic money growth
if a nation's currency falls suddenly and
sharply on the foreign exchanges, as some
academics have proposed (McKinnan, 1980)
- and as happened in the U.S. in November
1978 and October 1979? Such a policy can be
appropriate if the currency decline reflects
domestic inflationary pressures; in this case,
the reduction in money growth helps stabilize
exchange rates and domestic prices. But suppose the currency decline reflects real factors
which will ultimately lower the relative prices
of domestic versus foreign goods. If the
authorities now prevent the exchange rate
from declining - say by reducing domestic
money growth - this fall in relative homeforeign commodity prices can only be
accomplished through a decline in the
domestic price level. Thus, a policy of stabilizing the exchange rate in the face of "real"
disturbances may actually lead to more
instability in domestic prices than would occur
under a policy of fluctuating exchange rates. l
Similarly, the proposal by several European
economists (OPTICA, 1976) for using
foreign-exchange intervention to keep
exchange rates within a band about their PPP
values may be appropriate if long-run mone-
'Economist, Federal Reserve Bank of San Francisco.
David Parsley provided research assistance for this article.
37
tary factors mainly determine currency values.
But if real factors are important, such a policy
of "enforcing" PPP may reduce efficiency in
trade and production by delaying needed
changes in relative prices.
This paper presents evidence on the influence of real factors on the exchange value of
the U.S. dollar since 1973, the beginning of the
floating exchange-rate regime. As explained in
Section I, nominal exchange rates can be
divided into two components, one of which
reflects the ratio of national price levels, while
the other reflects "real" or "terms-of-trade"
(TOT) influences. (The latter is simply a
weighted average of the relative prices of
individual commodities.) Real factors alter
relative commodity prices in the long-run, and
hence affect the long-run value of the TOT
component of the nominal exchange rate. But
other factors, such as fluctuations in real
interest rates, also may produce temporary
variations in this component. Hence, the post1973 influence of real factors on exchange
rates should be reflected in variations in the
long-run TOT, more so than in fluctuations in
the observed TOT. As we will see in Section II,
the evidence indeed suggests that real factors
have played a very substantial role in
exchange-rate variations in recent years.
I. Real Factors and Exchange Rates
Real factors normally refer to conditions
affecting the supply and demand for commodities and services, and thus their relative
prices. In principle, these could include purely
temporary influences on relative product
prices, arising, say, from strikes or bad harvests, as well as more "fundamental" factors
determining relative prices in the long-run.
However, because we are concerned mainly
with the ultimate influence of relative price
changes on exchange rates, we identify real
factors only with "fundamental" conditions.
That is, real factors are those which persistently affect product demands and supplies,
and so determine their long-run relative
prices.
The most obvious real factors are (real) factor-input costs, productivity levels, tastes, and
other direct commodity supply-demand determinants. But real factors could include conditions which, while not originating in commodity markets, nonetheless permanently
affect their relative prices. For example, a
monetary policy shift that reduced domestic
investment by adding to uncertainty about
future inflation would qualify as a real factor
(because it lowers domestic commodity supplies) even though its source is in financial,
rather than product, markets. Thus, evidence
that real factors have substantially affected the
dollar would very strongly suggest -although
not conclusively prove - that we must look
beyond variations in financial-asset supplies
and demands in explaining exchange rates. 2
How, then, can real factors affect exchange
rates, which are the prices at which different
national monies are bought and sold for one
another? The answer lies in the fact that
exchange rates influence the supplies of and
demands for commodities and services. For
example, the greater the dollar cost of foreign
currency, the more costly are foreign imports
to Americans and the less of those imports
they are likely to buy. Thus, exchange rates
must attain levels in the long-run that are consistent with supply-demand equilibrium in
product markets - and, for that reason, factors causing commodity supplies or demands
to change can alter "equilibrium" exchange
rates. 3
This section explains how and through what
channels real factors can influence exchange
rates, as well as how their impact may be
measured. As explained below, any exchange
rate contains a real component, which reflects
the value of domestic goods and services in
terms of their foreign components. Real factors are those which alter the long-run value of
the real component, and hence affect
exchange rates generally. However, as we will
38
produced goods versus the prices of foreign
products in their own currencies also affects
the exchange value of the dollar. If the dollar
prices of U.S.-produced goods rise by 10 percent, individuals who are now just willing to
purchase American products will switch to
foreign imports unless their price in dollars
also rises by 10 percent. But, given the foreigncurrency price of imports, this means that the
dollar price of foreign currency must rise by 10
percent. Likewise, if (foreign currency) prices
abroad fall by 10 percent, the cost to Americans of purchasing foreign currency will have
to rise by the same amount if the dollar prices
of U.S. imports (relative to those of competing
domestic goods) are to remain the same as
before.
More formally, let "e" stand for the
logarithm of the price of foreign currency, "p"
and "pr" for the log of the U.S. and foreign
price levels, respectively, and "x" for the log
of the "price" at which foreign products can
be exchanged for U.S. goods and services.
Then, the above example shows, we can
decompose the nominal exchange rate into
two components,
see, temporary changes in this component can
arise from (real) interest rate fluctuations or
(possibly) other transient factors. For this
reason, the task of measuring the impact of
real factors on exchange rates primarily
involves separating the persistent and transient portion of their real components.
Real Components of Exchange Rates
Real factors can affect exchange rates
because the price at which individuals will
exchange one money for another depends in
part upon the amount they will pay for foreign
versus domestic commodities and services. As
an example, consider a car buyer choosing between two cars of equal quality - a compact
American car selling for $5,000 versus a German Volkswagen costing 10,000 marks (OM),
including U.S. delivery. Then, the purchaser
will buy the American car if a OM costs more
than 50 cents, but will buy the German car if
one mark sells for less than 50 cents. Now,
suppose the German dealer offers an "extra"
at no additional cost (in OM) that enhances
the attractiveness of a VW relative to its
American competitor. Plainly, all other factors
the same, the buyer will now be willing to pay
more than 50 cents per OM to purchase the
German car.
As this example suggests, the price of
foreign currency is affected by the amount
individuals are willing to pay for foreign versus
domestic goods and services. This amount depends, of course, upon individuals' tastes and
their perceptions about quality, dependability
and other determinants of product attractiveness. However, it depends as well upon factors
determining the relative supplies of U.S. and
foreign goods. For example, if productivity
falls in the German auto industry, German
workers will produce fewer Volkswagens and
prospective buyers of now scarcer VWs will
find them more expensive relative to their
American competitors. But in either case, the
more individuals are willing to pay for foreign
versus domestic goods, the more costly (all
other factors the same) will be foreign currency.
Equally plainly, the cost in dollars of U.S.-
e= x
+ (p -
p~
(1)
The first, or "real," component of the
exchange rate, x, represents the "terms-oftrade" (TOT) because it denotes the proportion in which individuals, in effect, give up
foreign for domestic goods. 4 The second compotent, (p - Pr), is commonly known as
"purchasing power parity" (PPP) because it is
the exchange-rate level corresponding to a
fixed relative price, or "parity," among
foreign versus domestic goods.
In practice, the amount individuals will pay
for foreign currency depends upon their
choices among many foreign and domestic
goods and services. For this reason, the
"prices," p and Ph composing the PPP component, as well as the TOT, should be viewed
as averages of the prices of many individual
commodities. In particular, the TOT, x, represents the rate at which "baskets" of foreign
and domestic goods exchange for one another
- that is, a weighted average of many relative
39
commodity prices. 5 Generally, also, the products used to define these components should
include non-traded as well as traded goods and
services. Non-traded goods can affect the
amount individuals will pay for foreign currency by influencing the supplies of and
demands for traded goods (and, thus, their
relative prices) as well as their prices in
domestic and foreign currency. (The more
exact rationale for including non-traded products - which derives from the monetary
theory of price-level determination - will
become apparent shortly.)
Plainly, since real factors - by definition affect relative commodity prices, their influence will, in a sense, be reflected in the
TOT. As the chart shows, the TOT component
of the dollar has varied nearly as much as the
dollar itself since 1973 - reflecting,
apparently, the very great influence of real factors.
In fact, however, two additional questions
must be answered before firm conclusions can
be drawn from the observed behavior of the
TOT. Recall that real factors alter long-run
relative prices so that, strictly speaking, only
the TOT; now the long-run TOT would unambiguously reflect their influence. This suggests
distinguishing between the long-run TOT, x*,
and the "transient" TOT, x', in the original
decomposition:
e = x*
+ x' + (p
Pr); x' = x - x*
The distinction is illustrated in figure (i). At
any given time, the TOT can be viewed as
approaching a long-run path; x* is the TOT's
current value if it were on this long-run path,
while x' is the difference between the actual
TOT and its long-run value.
Thus, in measuring the importance of real
factors, we must consider what determines the
transient TOT, as well as how it can be dis-
Chart 1
Trade-Weighted Dollar and its TOT Component
(in log terms)
Index (in logs)
4.85
4.80
4.75
4.70
4.65
4.60
4.55
4.50 1970
1972
(2)
1976
1974
40
1978
1980 1981
tinguished from its long-run counterpart, x*.
But first, we must answer a more fundamental
question about the transmission ofreal factors.
To date, we have only established the link between real factors and one component of the
nominal exchange rate, the TOT; now we
must also ask how they affect national price
levels, and hence the PPP component. As we
will see, the monetary theory of price-levels
determination (and inflation) supplies the precise answer to the earlier question, "How can
various changes in relative commodity prices
affect the relative prices of national monies?"
Impact of Real Factors
To understand the importance of real factors, consider an increase in the quality of
foreign-produced goods that makes them more
attractive to Americans and foreigners alike.
The result is likely to be a rise in demand for
foreign goods at the expense of home-produced goods, and consequently a rise in the
relative prices of foreign versus V.S. products.
But this increase in the TOT component could
be accomplished in several different ways. The
shift in demand could lower the prices of V.S.
goods and raise those of foreign goods in an
offsetting manner, so that the exchange rate
itself remains unchanged. This, of course,
would lower the V.S. price level and raise the
foreign price level, with the resulting fall in the
PPP component exactly offsetting the rise in
the TOT component. Or the price of foreign
currency could rise just enough to obviate any
change in the dollar prices of V.S. goods, leaving the V.S. price level (and hence the PPP
component) unaffected; in terms of relation
(l), this means that the exchange rate would
bear the entire adjustment to the altered TOT.
Or this shift might be accomplished by adjustments in price levels and in the exchange rate.
Which of these cases is most likely to occur
depends critically upon the determinants of
domestic and foreign price levels. According to
the increasingly accepted monetary theory of
inflation, the price level is determined by the
supply of money available in relation to the
"real" demand for that money, which is
simply the value in terms of goods and services
of the money individuals and businesses want
to hold. Thus, if the supply of money rises with
no change in demand, its value in terms of
goods or services must fall, which means that
the price level must rise. 6
Moreover, the real demand for money depends, first, on real income and real wealth,
which determine how much (in real terms)
individuals and businesses collectively want to
spend on goods and services; and second, on
institutional factors, such as the average lag
between payments and receipts, which determine the rate at which money "turns over" in
the process of carrying out transactions. 7
Together, these determine the amount of
money (in real terms) individuals and businesses need to carry out their desired expenditures.
This suggests that changes in relative commodity prices will normally have little or no
impact upon the demand for money. That is, a
rise in the price of one domestic good relative
to that of another may raise the real incomes of
some, but it will lower the real incomes of
others; aggregate real income should be little
affected. Likewise, the rate at which money
"circulates" in transactions probably would
not be affected perceptibly. In short, a shift in
relative prices should not significantly influence the aggregate level of transactions carried out by individuals, and the amount of
money needed to undertake them - and
hence should not affect the real demand for
money.8 Relative price shifts, with a given
money supply, thus should leave unaffected
the average level of prices at which these transactions are carried out. Note however that this
proposition applies only to price-level
measures that are representative of transactions carried out by the country as a whole;
such indices almost certainly will include nontraded as well as traded goods.
These arguments imply that, with given
domestic and foreign money "paths," shifts in
relative commodity prices will have little or no
impact on the PPP components of exchange
rates corresponding to these price-aggregates.
In the context of relation (2), this suggests
that when exchange rates vary freely, real factors will affect the dollar precisely to the extent
41
prices to changes in the supply or demand for
money or other financial assets, since commodity prices are often constrained in the
short-run by contracts (both implicit and
explicit) and other institutional rigidities. Consider, for example, the effects of a rise in
domestic money growth that is expected to
persist. For the reason cited, domestic commodity prices would need time to adjust in proportion to the increased money growth. There
are no impediments to the immediate adjustment of exchange rates, however. Because
holders of the domestic currency know that its
value must ultimately fall to reflect higher
domestic prices - that is, its purchasingpower-parity value must decline - they have
an incentive to sell it now, to avoid a capital
loss. Thus, exchange rates tend to fall
immediately following a rise in domestic
money growth, while domestic prices lag
behind for some time. As a result, the relative
price of domestic versus foreign goods
(expressed in the same currency) falls - that
is, the TOT declines initially. Then, as
domestic prices respond, the TOT tends back
to its original value as the nominal exchange
rate and its purchasing-power-parity value
converge in the long-run. II
Transient variations in the TOT also can
arise out of fluctuations in credit demand leading to temporary changes in real interest rates
- that is, nominal interest rates relative to
anticipated inflation. For example, an increase
in U.S. real interest rates due to a surge in
credit demand will attract capital to our shores
because investments in dollars will then pay a
higher return, after inflation, compared to
investments abroad. As a result, the dollar will
tend to rise on the foreign exchanges along
with its (transient) TOT component. But
generally, these effects will be only temporary,
in part because such transient credit imbalances normally have little impact on domestic
prices, but also because real interest rates and
the TOT will fall back to their original values as
capital flows into the U.S. to ease the financial
imbalance. 12
Thus, the substantial variability in the actual
TOT exhibited by the chart does not
that they affect the long-run TOT component
(again, as defined in terms of the above pricelevel measures). If so, variations in the longrun TOT, x*, should provide a fairly accurate
indication of the ultimate impact of real factors
on exchange rates under a floating-rate
regime. 9
It should now be clear why the PPP and TOT
components encompass a wide variety of
traded and non-traded goods and services, and
in particular why prices of non- traded products
can easily affect exchange rates. According to
the monetary theory, the level of domestic
money effectively constrains the average level
of prices at which agents' purchases - of
traded and non-traded products - are carried
out. For this reason, changes in the prices of
non-tradeables will generally lead to variations
in tradeables' prices - and so to changes in
exchange rates. To illustrate, suppose demand
for U.S. housing services increases, ultimately
increasing their price relative to those of other
U.S. products, but with no impact upon relative domestic/foreign traded-goods prices. If
the U.S. money stock remains constant, U.S.
housing prices can rise only with a fall in prices
of other domestic goods, including tradeables.
But this means that the dollar must appreciate
to keep the relative costs of (U.S. versus
foreign) traded goods fixed. More generally,
the impact of a given relative price change on
the dollar depends upon its importance in
domestic and foreign money transactions; and
the structure of these transactions largely
determines how real factors influence (freely
floating) exchange rates. 10
Transient Influences on the TOT
While variations in the long-run TOT tend
to reflect the influence of real factors on
exchange rates, the same cannot be said of
variations in the actual, or observed, TOT. As
has become increasingly evident, this is
because conditions in money and financial
markets can temporarily affect relative commodity prices, and thus the transient TOT,
even though their long-run impact is generally
negligible.
In part this is because exchange rates tend to
react much more quickly than commodity
42
hinge primarily upon the substitutability of
foreign and domestic traded products. As we
have seen, variations in the relative prices of
non-traded goods could lead to substantial
exchange-rate variations even if tradeables'
relative prices were fixed. 16
More generally, the relative importance of
various exchange-rate components is likely to
be less a function of the structure (e.g.,
elasticities) of the relevant supply and demand
relations, than of the size, duration, and frequency of the disturbances causing shifts in
these relations. For example, it would hardly
be surprising if, during hyperinflations,
exchange-rate movements arose mainly from
changes in PPP. Hyperinflations are, after all,
periods of exceptionally high and variable
inflation. But the last decade has witnessed
unusually sharp variations in the relative
prices of certain basic commodities, with oil
being the most obvious, but certainly not the
only, example. Surely, real factors may have
played a prominent role in exchange-rate
determination over this period. 17
These observations suggest that, normally, a
wide variety of factors - reflected in variations in all three components - will affect
exchange rates. Moreover, the relative importance of various influences can be expected to
vary over time and across countries, with
alterations in policies and other aspects of the
economic environment. In this sense, the
following empirical examination is an "historical" analysis, in that the results in large part
reflect the economic conditions prevailing during the period in question. As with history,
certain general lessons can be drawn, but we
should not expect current patterns to be replicated exactly in other periods or for other
countries.
necessarily indicate any substantial impact of
real factors on exchange rates. How, then, can
the transient and long-run components of the
TOT be distinguished to obtain an appropriate
gauge of the importance of real factors? The
persistence of the variations in the observed
TOT provides one indication of the relative
importance of variations in its long-run component. Again, the association between fluctuations in real interest rates and the transient
TOT provides another indication. Indeed, it
can be shown that the long-term U.S.-foreign
real-interest differential provides at least an
approximate measure of the transient TOT as
it is perceived by investors. 12 As we will see,
this relation provides an alternative way of
measuring the importance of real factors.
Importance of Different Factors
Our analysis has identified three sets of factors affecting nominal exchange rates:
differential inflation rates causing movements
in PPP; real interest rates or (possibly) other
influences on the transient TOT; and real factors that lead to variations in the long-run
TOT. Most models of exchange-rate determination emphasize either the first or second
explanations (or both). For example, simple
monetarist models attribute exchange-rate
fluctuations mainly to variations in PPP levels.
Other models have focused on variations in
supplies of interest-bearing assets, which can
affect the transient TOT by causing real
interest rates to fluctuate. 14 The present
analysis is largely concerned with whether the
comparative neglect of real factors in most
models is justified. 15
What, then, determines the relative importance of the various influences affecting
exchange rates? Clearly, the answer does not
II. Evidence on the Influence of Real Factors
The above arguments suggest that measuring the impact of real factors on exchange rates
involves answering two empirical questions.
First, what has been the relative importance of
variations in the PPP and TOT components of
actual exchange rates? And second, to what
extent have actual changes in the TOT been
transient, that is, offset in the long-run? The
earlier discussion implies that the influence of
real factors will be greater, the larger are the
fluctuations in the TOT versus the PPP components, and the more persistent are the fluc43
tuations in the TOT component.
This section discusses evidence on these
questions for the floating-rate period beginning with May 1973 and ending with August
1980. 18 These tests are carried out with the use
of consumer-price indices to measure the PPP
and TOT components. Such indices are more
reflective of the entire range of money transactions carried out here and abroad, than are
indices of traded-goods prices alone, or even
wholesale price indices. Thus, the CPI-based
measures are more likely than alternatives to
capture the real factors affecting exchange
rates. 19 In addition, both the text and the
Appendix (Table A-3) present evidence (supporting the theoretical argument advanced earlier) suggesting that long-run TOT changes
have mainly affected nominal exchange rates,
with little or no impact on national price levels,
and hence their PPP components. 20
Trends and Deviations
In interpreting the evidence, it is important
to distinguish between trends in exchange
rates (and their components) and deviations
from those trends. In terms of Figure (I), the
trend in an economic variable simply refers to
the slope of its long-run path, that is, to the
average rate at which it changes over time.
Movements in e( ) at a greater or faster rate
than the trend represent variations in the
deviation from trend. These deviations may be
either permanent - that is, reflect movements
in the level of the long-run exchange-rate path
(i.e., shifts in e* ()) - or transient (changes in
investments. The reason is that, over a short
interval, the deviations are likely to account
for considerably more of the exchange rate's
movement than is the trend. But the biggest
risk of exchange loss on long-term investments is likely to arise from the risk of a
change in trend, because the trend - unlike
the deviations - produces continuous,
systematic changes in the exchange rate in the
same direction over many periods.
Furthermore, real factors may influence
trend movements and deviations in differing
degrees. In fact, considerable evidence indicates that variations in the exchange-rate trend
across countries and over time result mainly
from differences in the PPP trend. This does
not mean that real factors have no influence at
all on the exchange-rate trend - a glance at
Table 1 suggests otherwise - but rather suggests that they are not the major source of
shifts in this trend. 21
For this reason, and because the determinants of the exchange-rate trend have been
extensively analyzed in the literature, the
Figure 1
Permanent and Transitory
Components of
the Terms of Trade (TOT)
Value of TOT
e').
We distinguish between trend and deviations in the exchange rate (and its components) because their relative importance to
international traders and investors, as well as
policy-makers, will vary with the types of
activities they are engaged in, and particularly
with their time horizon. Consider an investor
who takes an open position in foreign currency, thereby risking loss if the future
exchange rate should differ from that now
expected. Although neither the trend nor the
deviation component of future exchange-rate
changes can be predicted perfectly, the latter is
likely to pose the greatest risk to short-term
Long~run
TOT
...
(x')
Transient portion of TOT (x')
Actual
TOT ...
(X)
Time
44
tions of the TOT (percentage) changes are
remarkably high in absolute terms - they substantially exceed the average monthly, or
trend, change - but they are also far greater
than those of the corresponding changes in
PPP levels (see Table 1). Moreover, the correlation between changes in nominal
exchanges rates and changes in relative
national price levels is very low and, indeed,
statistically insignificant in all cases. The main
point, however, is that fluctuations in nominal
exchange-rate changes about their trend are
dominated by variations in the TOT; indeed,
the standard deviations of the real and nominal
changes are virtually the same. Thus, explaining nominal exchange-rate fluctuations essentially means explaining variations in TOT.
There are at least two possible explanations
of the results. First, disturbances in financial
markets, reflected in real interest rates, could
be responsible for the relatively high
variability of the TOT, and consequently for
the low correlation of the nominal rate and its
contemporaneous PPP component. Alternatively, the volatility of the TOT component
could simply reflect high variability in real factors. Either explanation can thus account for
the basic features of Table I. But the first also
following analysis focuses on the impact of real
factors on the deviations of exchange-rate
changes. This is in no sense only a minor
aspect of the matter. As Table 1 indicates, the
average magnitude of these deviations is considerably greater, on a monthly basis, than the
trend rate of change of the exchange rate.
Furthermore, much of the policy controversy
about exchange rates centers about the deviations, in large part because these are generally
the least predictable and least understood components of exchange-rate variations.
VariabiUty of Exchange Rates
The post-1973 floating exchange-rate
regime has been marked - remarkably, and
certainly unexpectedly - by a very high
variability of nominal exchange rates in relat(on to fluctuations in relative national price
levels. Also remarkably, there has been a
relatively low correlation between monthly or
quarterly changes in exchange rates and the
contemporaneous change in their PPP components. These empirical observations have
stimulated the formulation of some new theories of exchange-rate determination in recent
years. 22
In the 1973-80 period, the standard devia-
Table 1
Variance of Nominal Exchange Rates and Their Components
(May 1913-August 1980)
1) Nominal exchange rate}
Average change (%)2
Standard deviations 2
Canada
France
Germany
Japan
U.K.
Italy
-.17
1.34
.10
3.14
.53
3.52
.18
3.09
-.07
2.78
-.42
2.84
.01
.33
-.14
.33
.33
.36
-.06
.83
.42
.75
-.55
.56
-.18
1.42
.25
3.18
.20
3.57
.24
3.07
-.49
2.86
.14
2.83
-.11
-.34
-.07
-.17
-.07
-.17
.15
-.12
.02
-.24
.12
-.08
2) PPP component}
Average change (%)2
Standard deviation 2
3) TOT component}
Average change (%)2
Standard deviation 2
Memo:
a) Correlation of (l) and (2)
b) Correlation of (2) and (3)
I Nominal
exchange rates are the dollar values of foreign currency; the PPP component is the ratio of the (seasonally
adjusted) U.S. to foreign CPI: the TOT component is the exchange rate divided by the PPP component.
2Both the average changes and standard deviations are calculated from monthly changes in the logarithm of the variable
in question, expressed in percentages.
45
Figure 2
implies that the fluctuations in the TOT are
largely transient, while the second requires
that they persist in the long run. To decide between these two explanations, we must determine the extent to which actual variations in
the TOT represent changes in its transient (x')
versus its long-run (x*) element. (Although
the foHowing analysis is unavoidably technical,
a non-technical summary of the final results
and· their implications is given at the end of
this section.)
Path of Terms of Trade (TOT)
Value of TOT
I
,
c
Transient or Permanent?
By definition, a transient fluctuation in the
level of the TOT is one which disappears over
time. This .can be seen from Figure (2), which
shows a long-run path for the TOT - the slope
or trend is taken to be zero. Suppose the level
of this path remains constant over time, so that
there are no changes in the long-run TOT, x*.
Then all observed TOT changes will follow a
pattern (a-b-c-d in the Figure 2) whereby a
movement away from the path is subsequently
offset by movements in the opposite direction
that bring the TOT back on path. Hence, if all
fluctuations are transient, changes in the TOT
about trend will tend to be fully offset in the
future. On the other hand, if all TOT variations
represent shifts in the long-run value - that
is, real factors - a current change will not, on
average, be offset at all in the future.
More generally, the importance of real factors can be measured by the fraction of
changes in the actual TOT which, on average,
tends to persist. This fraction in turn can be
measured by analyzing the pattern of changes
in the series itself (that is, without introducing
explicitly any additional explanatory variables). Specifically, we assume that the TOT in
a given period is affected by a collection of
(unobserved) real and financial disturbances,
which then may set off further responses over
time. A general model of this form can be written as,
Time
This is an essentially equivalent, but more
convenient, form of the regression,
.e:.x(t)
= c + ej.e:.x(t-I) + e 2.e:.x(t-2)
+ ... +
z(t)
(3')
and can be estimated in an analogous way. 23 In
either case, z() represents the collective
impact of all (unobserved) financial and real
disturbances initially causing the TOT to vary.
Subsequent changes can then be calculated
from past changes using either of the above.
Now, the change in the long-run TOT
resulting from a disturbance z( ) is equal to the
cumulative changes it sets off in the actual
TOT. Let "g" refer to the cumulative change
set off by a disturbance equal to one percent,
which is simply the fraction of the disturbance
persisting in the long-run. This fraction then
can be written in terms of the coefficients of
(3) as,
g = (ao + a l
+ .. a,)
I (I - b j - b 2 -
.•
bJ
(4)
It follows that the standard deviation of
changes in the long-run TOT, S(.e:.x*), is equal
to this fraction times the standard deviation of
the disturbance, S(z),
.e:.x(t) = c + aoZ(t) + aIz(t-I)
+ ... a"z(t-n)
+ b I.e:. x(t-I)
+ b~x(t-2) + ..
Hypothetical path when
long-run TOT is fixed
b
brrAx(t-m) (3)
S(.e:. x*)
46
=
gS (z)
(5)
actual real interest rates, the estimates derived
from. (6) may be seriously biased. Bias could
also arise jf the authorities were to vary real
interest rates in response to changes in real
exchange rates. (Then 6. r() would be
endogenous relative to 6. x.) 28 Moreover, both
methods fail to analyze explicitly the sources
of the real influences on the TOT. Such a procedure is necessary for our study, because the
sources of real influences on the exchange rate
may be highly varied and hence difficult to
identify. But as a consequence, we can obtain
only indirect evidence on the impact of real
factors. And the evidence must, in any case, be
regarded as tentative.
Estimation
Table 2 summarizes the results of estimating relations (3) and (6) and the Appendix
provides further details. In estimating the
univariate models (3), lags of 1-6 and 12
months were allowed for the "exogenous"
disturbances (z), plus 1 and 2 months lag for
the TOT changes (Le., the lagged dependent
variable). The real interest rate proxies used
for the second (regression) model (6) were
obtained by subtracting a proxy for anticipated
inflation over a 3-month perio_d from the 3month Eurocurrency interest rate observed at
the beginning of the period. The expectedinflation measure was derived by regressing
actual CPI inflation on its lagged values; thus,
anticipations of inflation presumably are at
least approximated by an average of observed
past inflation (see Appendix for further
details). To avoid estimating excessive numbers of parameters, lagged-error (moving
average) terms were confined to 1-4 and 12 in
this second case, along with the current and
three-lagged values of the changes in the real
interest differential (and the two lags for the
dependent variable) . 29
Taken as a whole, the Table 2 evidence suggests that real factors have been a major influence - in some cases the dominant influence - on variations in the TOT, and hence
the nominal exchange rate, under a regime of
floating exchange rates. And in the majority of
cases, at least half, and generally more, of a
"typical" disturbance to the TOT persists in
Estimates of these can be obtained from the
estimates of (3).
This procedure, though simple, fails to
account explicitly for the various influences on
the TOT. This could lead to instability in the
estimated model ifthetime pattern ofvariation in these influences changes .over time. 24
Alternatively, then, we could attempt to
account, at least partially, for transient TOT
variations by .introducing. proxies for changes
in the foreign-U.S. real interest differential
into (3). (Recall that such differentials should
reflect transient TOT changes to the extent
they are perceived by investors.)
6.x(t)
=
c + dcAr(t) + dj6.r(t-l)
+ .. d~r(t-k) + bj6.x(t-l)
+ .. bnAx(t-m) + z(t)
+ajz(t-l)+ .. anz(t-n)
(6)
Here, 6. r() is the estimated change in the 3month foreign-U.S. real interest differential,
derived from estimates of anticipated U.S. and
foreign inflation. 25 This short-term real
differential is used as a proxy for the long-term
real interest differential. 26 As before z() is the
regression residual, or portion of 6.x(t) that
cannot be "explained" by changes in the real
interest differential or by past changes in real
exchange rates. Now however, z stands for all
real influences on the TOT as well as any other
(temporary) influences not reflected in the
real interest differential. (Of course, z is not
directly observable but is estimated along with
the regression parameters.) As before, the
trend or average change in the TOT will be
assumed fixed, which implies that the average
real interest differential is also constant over
time. This implies further that interest fluctuations about the mean do not affect the longrun TOT, so its variability can still be
measured with the use of relations (4) and
(5).21
This second model - unlike the first - can
help account explicitly for at least some of the
influences on the TOT. It has a practical
drawback, however: since no direct observations of real interest rates are available, admittedly imperfect proxies must be used. Unfortunately, if these proxies are poor measures of
47
tions may be more reliable, particularly for
France where this seems to fit the data better
than does the univariate relation. If so, real
factors also appear to have dominated fluctuations in the TOT (and the exchange rate) in
the case of France, although the results for
Germany remain inconclusive. It is also worth
recalling that there is no a priori reason to
expect that real factors will affect exchange
rates to the same degree for all countries. For
example, the (apparently) relatively greater
importance of transient variations in the TOT
for Germany could simply reflect a relatively
high variability of German real interest rates or
other temporary influences on the TOT.
Thus, while sampling variability inevitably
makes the exact estimates somewhat
imprecise, the general conclusion remains that
real factors have played a substantial, and
perhaps central, role under floating exchange
rates. In particular, the substantial variability
of the TOT does not appear, as some theories
have assumed, to be mainly the temporary
result of financial-market imbalances. Rather,
these fluctuations seem mainly the consequence of real-factor induced shifts in long-
the long-run. Moreover, the estimated
variability of the long-run TOT (S(l::..x*» is
generally at least half the standard deviation of
the actual TOT changes and of changes in the
nominal exchange rates. These conclusions
seem firmest for Japan and the U.K., where
either model suggests that virtually all TOT
changes ultimately persist. 30 Also, the results
for Canada and Italy imply that less than half of
a TOT change is subsequently offset. Thus, in
these four cases, TOT changes appear to
reflect primarily the influence of real factors,
which points to real factors as the major source
of exchange-rate fluctuations since 1973.
The results for France and Germany are
more questionable, as the two models yield
contradictory results, with the univariate
model suggesting that TOT variations are
mainly transient, while the regression model
suggests they largely persist. Indeed, the
univariate models in these cases tend to be
quite sensitive to the exact specification and
sample period, indicating the results are not
very robusPl Because the regression model
attempts to account explicitly for some of the
potential factors affecting the TOT, its implica-
Table 2
Summary Evidence on the Persistence of TOT Changes
Regression Model 1
"Univariate" Model 1
F2
S(~)
-------Canada
France
Germany
Japan
U.K.
Italy
1.43
3.10
3.36
3.12
2.88
2.85
F2
R2
S(~*)
(unadjusted) S(z)
4.3*
2.9*
2.2*
2.6*
3.9*
2.2*
.34
.25
.21
.23
.32
.21
1.23
2.83
3.16
2.89
2.52
2.68
72%
36%
0%
113%
120%
83%
.89
1.02
.00
3.26
3.02
2.22
R2
(unadjusted) S(z)
3.7*
3.2*
2.2*
2.5*
3.4*
1.7
.38
.30
.24
.32
.33
.23
1.21
2.77
3.13
2.91
2.52
2.68
g
62%
98%
64%
142%
96%
60%
S(~*)
.75
2.71
2.00
4.13
2.42
1.61
I. The effective period for the univariate and regression models is July 1973-August 1980, except for Japan, where the
starting point is July 1974 for the regression model.
2. Test of the hypothesis is that all the estimated parameters (except the 'constant) are zero. An asterisk (*) indicates
that the hypothesis (based on an asymptotic "F" distribution for the test statistic) can be rejected at a 5 percent (or better) significance level.
N
3. The percentage of the residual (z) persisting in the long-run is computed as ~a'/(I-fjl-fj2) where a and b refer to the
estimates (see relations 3 and 6).
0 J
4. S(z) is estimated standard error of the disturbance; g is percentage of z persisting in the long-run;S (,6, *) is the estimated standard deviation of changes in the long-run TOT; S (,6, x) is standard deviation of ,6, x.
48
run, suggesting the strong influence of real
factors. Except in the cases of Germany, and
perhaps France, it is difficult to avoid concluding that real factors dominate fluctuations in
the TOT.
3) The nominal exchange rate, and not the
level of prices, generally adjusts to relative
price changes induced by real factors. This and
the other findings suggest that for Japan, the
U.K., Italy, and Canada (and possibly France),
real factors have been the major source of fluctuations in exchange rates about their trend.
Partial evidence suggests that real factors may
have substantially affected the German
exchange rate as well.
These conclusions are highly tentative, particularly as they are based on indirect evidence. More precise measures of the impact of
real factors will require explicit identification
of their various sources. Moreover, the results
certainly do not rule out the possibility of
monetary and other financial influences on
relative commodity prices, and hence on the
TOT component. 31 But at the least, the evidence cited here suggests that a better understanding of exchange-rate fluctuations depends upon a better understanding of the real
sector of the foreign and domestic economies.
run relative commodity prices. Given the high
variability of TOT changes in recent years, this
suggests that real factors may have been the
single largest source of nominal exchange-rate
variations about trend for several major countries. These conclusions are supported by the
finding, summarized in Table A-3 of the
appendix, that shifts in the long-run TOT
apparently had little or no impact on PPP
levels, but instead led to nearly proportionate
changes in the nominal exchange rate.
Implications of Results
Taken as a whole, our results strongly suggest that real factors have strongly affected
nominal exchange rates during the current
regime of floating exchange rates. This conclusion follows from the following findings:
1) Most of the fluctuations in nominal
exchange rates about their trend are attributable to variations in the TOT component. The
variability of this component substantially
exceeds the trend rate of change of the
exchange rate, indicating that changes in the
TOT about its trend are an important source of
cumulative exchange-rate movements over
periods of a year and perhaps longer.
2) In the majority of cases, fluctuations in
the TOT appear largely to persist in the long-
fl!.
Summary and Conclusions
Over the last several years, analysts have
become aware that exchange rates resemble
asset prices more than commodity prices. Like
stock and bond prices, exchange rates are free
to vary immediately as new information
becomes available about inflation and other
relevant developments. In contrast, commodity prices often must "wait" for existing
contractual agreements to expire before they
respond to new information. However, the fact
that asset prices are determined in financial
markets does not mean that they are
unaffected by real factors originating in commodity markets. Indeed, the stock market provides an obvious illustration of a financial
market in which real factors, such as technical
innovation and demand, profoundly influence
prices.
Our analysis suggests strongly that real factors critically affect exchange rates as well. As
we have seen, fluctuations in nominal
exchange rates about their trend largely represent variations in TOT. And, for the floatingrate period as a whole, variations in TOT, in
most cases, have largely reflected real-factor
influences. Thus, real factors have represented
a major source - in some cases the single
largest source - of exchange-rate fluctuations
over the last eight years.
This conclusion, although tentative, suggests that models of exchange-rate determination which consider only financial-market conditions will inevitably miss an important aspect
of actual exchange-rate behavior. Interpretations and policies based upon such models may
then be seriously inadequate. For this reason,
49
further research into the determinants of longis
run real components Qf exchange
needed for a better understanding of •. the
causes and effects of nominal exchange-rate
changes. One question, not addressed here, is
what types ofrelative.price changes
of
traded goods, or of traded relative to nontraded goods - show up in variations in real
exchange rates. Identification of various types
of relative pricecllanges causing
shifts
could provide useful clues as to the ultimate
sources of real factors affecting exchange rates.
Finally, the importance of real factors makes
the task of interpreting actual exchange-rate
movements very difficult indeed. This is particularly the case as neither real interest rates
nor the long-run factors influencing relative
commodity prices are directly observable. This
suggests an important policy lesson.
Increasingly in recent years, U.S. officials have
used. foreign-exchange market conditions as a
major policy gui<ie. Tll.eiractions have largely
reflected a belief that these markets convey
early signals of developing inflation pressures,
wllileprovidinganindicatorof investorconfidetlce in U.S. <policies;. theexperienl,;es of
November 1978 and October 1979, when a
sharp fan in the dollar convinced U.S. officials
to do more. to contain inflation,
seemed to confirm this belief. But our analysis
indicates that exchange-markeLsignals nQrmany are highly ambiguous, reflecting as they
do a variety of factors. Since the appropriate
response to one source of exchange-rate variation may be inappropriate in another case,
policy-makers at the least should be very
cautious in using foreign-exchange market
developments as a regular guide to policy.
Table A-1
Parameter Estimates from Univariate Model
Variable
.6. x (t-1)
.6. x (t-2)
z(t-1)
z(t-2)
z(t-3)
z(t-4)
z(t-5)
z(t-6)
z(t-12)
Standard error
Q-orig 2
Canada
France
Germany
Japan
U.K.
Italy
.29(.I2)
-.64(.12)
.44(.15)
-.64(.15)
-.16(,13)
.11 (.13)
-.18(.12)
.06(.I0)
.40(.09)
.87 (.I 5)
-.29(.I3)
1.13(.16)
-.66(.23)
.13(.18)
-.15(,17)
.04(.18)
.31(.12)
.05(,08)
1.1 4(.I 6)
-1.34(.27)
.64(.27)
-1.43(.30)
-.78(.38)
-.22(.20)
-.42(.21)
-.38(.22)
-.05(.15)
-.10(,06)
.43(,02)
-.94(,03)
.52(.10)
-1.16(.12)
.15(.17)
.02(.17)
-.26(.I2)
.12(.11)
-.21 (,06)
-.64(,05)
-.91 (,05)
-.56(.13)
-.93(.14)
.11(.15)
.11(.16)
.05(.14)
.08(.12)
.02(,08)
1.23
16.7
-.58(.I4)
1.42(.19)
-.92(.25)
.30(.21)
-.08(.21)
.16(.19)
-.04(.12)
.16(,06)
2.82
8.7
3.16
10.1
2.89
5.3
2.53
15.0
2.68
3.0
1. The m: ( ) are the autoregressive terms; the z are the moving average elements. Asymptotic standard-error estimates are in parentheses.
2. Q-orig. is the (Box-Pierce) test statistic for the first 12 autocorrelations of the original series (the 5 percent critical
value is 21.0).
3. The coefficients of the moving average terms correspond to -at, -a2, etc. as defined in expression (3) of the text
(ao=l)·
50
Table .0.-2
Param.eter Estimates of the
Variable 2
Germany
.6.r(t)
.6.,(t-I)
.6.r(t-2)
.6.r(t-3)
.6.x (t-I)
.6.x (t-2)
z(t-I)
z (t-2)
z(t-3)
z (t-4)
z(t-12)
.11(5)
.28(6)
-.08(7)
.29(.17)
.21(.17)
-.44(.13)
.34(.16)
-.38(5)
-.18(.12)
.0(.1 I)
.46(.10)
1.21
Regression standard error
-.15(.15)
.23(.15)
-.05(.16)
-.01(.16)
.04(.22)
-.65(.12)
.25(.16)
-.82(.16)
.15(.12)
-.20(.1 1)
.05(.09)
2.77
.83(2)
-1.60(.15)
1.35(.24)
-.24(.20)
1.29(.08)
-.77(.08)
1.62 (.08)
-1.30(0)
.32(.13)
.04(.09)
.01 (.04)
13.3
Model
U.K.
Japan
Italy
-.22(.20)
.23(.28)
.42(.30)
.57 (.22)
-.89(.08)
-.70(.09)
-1.09(.04)
-1.03 (.07)
-.24(.1 I)
-.04(.10)
-.26(.07)
2.91
-.02(.06)
.02 (.06)
.08(.07)
.00(.07)
.45 (.12)
-.55 (.1 5)
.56(.14)
-.68(.16)
.14(2)
.04(.12)
.26(0)
2.68
-.12(.12)
.14(.13)
-.07(4)
.06(.14)
.38(.07)
-.85 (.04)
.38(.12)
-1.03(.04)
.28(.1 I)
.00(.06)
-.07(.04)
2.52
1. Period is July 1973-August 1980 except for Japan, where the starting point is October 1974. 6. r( ) is change in the estimated 3-month foreign-U .S. real-interest differential; z() is moving-average term; 6. x( ) is change in the log of the real
exchange rate.
2. The moving-average coefficients correspond to -aj, -a2' etc. as defined in relation (6) in the text (ao
are asymptotic standard error estimates.
I). Figures in ( )
Table .0.-3
Estimated long-Run Impact of TOT Residulas 1
Impact on U.S./Foreign CPI
R2
(unadjusted)
long-run2
Canada
.05
.01
France
Germany
.04
Japan
.14
U.K.
.12
Italy
-.06
tThe regressions from which these were taken were of the form,
.35
.07
.17
.18
.20
.20
Impact on Nominal Exchange Rate
long-run2
.84
.92
.67
1.07
.91
.91
R2
(unadjusted)
.74
.92
.76
.72
.88
.92
3
.6. vet) =c+H.z(t-i) +gj.6. vet-I) +g2.6.v(t-2)
,-0
where v( ) refers either to the PPP component (first column above) or to the nominal exchange rate, e (second column).
The z are the estimated residuals from the regression relation (6). Details of the estimates will be supplied upon request.
3
2Calculated as ~ fj
,-0
/
(I - gj - g2)
FOOTNOTES
1. This is simply the "international" analogue of the
well-known proposition that stabilizing interest rates
in the face of "real" shocks is destabilizing for
nominal income and the price level. See also Darby
(1981).
3. This statement is not inconsistent with the
"modern" view that exchange rates vary to maintain
continuous short-run equilibrium in asset markets.
Conditions in commodity markets affect demands for
and supplies of financiai assets, and so asset
markets cannot be in long-run equilibrium until goods
markets are. In this sense, the "asset" view of
exchangecrate behavior. does. not alter traditional
views about their long-run determinants.
2. For a. more formal illustration Of how financial
policies can have real implications, see Sweeney
(1978). A practical reason for excluding temporary
influences on relative prices is that is easier toseparate the transient and persistent components of the
TOT than to identify their sources. In addition, persistent changes in relative prices generally have
different implications for policy than do transient
changes.
4. In international-trade literature, the TOT has a
narrower meaning, referring to the rate at which one
country's traded goods exchange for another's. Here
x refers to the amount an individual could obtain by
"selling" a "typical" bundle of home goods for home
51
currency, and then trading that currency for foreign
currency to purchase a "typical" bundle of foreign
goods
where these bundles may include nontraded goods. We use the term "terms-of-trade"
(admittedly a bit loosely) because it is intuitively more
informative than the more common name given to x,
the "real" exchange rate.
5. More
precisely ' letP=~wpandpf=~wfpf(~w=
f
f
I I
I
I
I
~w; = 1) where Pi (Pi) are the logarithms of prices of
the individual commodities, "i." Then we can write,
10. Suppose, instead, that the TOT & PPP components were defined using the price of a single traded
good - say, wheat ~ the dollar price of which is the
samein all countries (that is, the "law of one price"
applied). Since the TOT component would be fixed in
this case, real influences on the exchange rate would
be reflected in movements in the dollar versus the
foreign currency price of wheat. As we will see, this is
an inconvenient waY to measure real influences.
11. Dornbusch (1976) provides an excellent
description of how variations in money growth can
influence real interest rates and cause the TOT to
deviate from its long-run value.
x = ~w:(p:+ e - Pi) + ~(w:- Wi) (Pi - p)
That is, x is a weighted average of the relative prices
of foreign versus domestic commodities expressed in
a common currency plus an average of the relative
prices of domestic goods; the latter term disappears
if the weights in the two price indices are the same.
Generally, then, Virtually any change in relative commodity prices can cause the TOT to vary, even if the
relative prices of foreign versus domestic commodities are fixed.
12. See Keran and Pigott (1980).
13. This follows from two assumptions: that the longrun nominal interest differential (id) is equal to the
(percentage) difference between the spot exchange
rate, e, and its long-term foward value, f; and that the
forward value is equal to the value of the exchange
rate currently anticipated to prevail in the long-run, e*.
The first of these conditions holds very closely in the
Eurocurrency markets; while there is some evidence
that the second is not strictly correct, it may be a
reasonable approximation. Let y refer to the current
PPP value and y* to the value expected in the longrun. Then, by assumption,
6. Of course, this heuristic argument is essentially
true by definition. The theory underlying the monetary
approach involves the demand for money, as is explained in the text.
7. In addition, the availability of money substitutes
and the level of interest rates - which affect
individuals' Willingness to hold money - influence the
rate at which money circulates. Since we are concerned with long-run effects, we ignore factors leading to business cycle fluctuations in money demand.
The discussion in the text largely ignores long-run
impacts of interest rates on the demand for money,
partly because changes in long-run rates mainly
reflect inflation, and partly because studies suggest
that the impact (elasticity) is fairly small.
id(t) = e(t) - e*(t)
But the real interest differential ir(t), is defined as,
ir(t)
==
id(t) - (y*(t) - y(t))
Since the latter term is the amount of inflation anticiplated between now and the long-run it follows
immediately that,
ir(t) = (e(t) + y(t))
(e*(t) + y*(t)
which is simply (minus) the expected change in the
TOT component, x(t) - x*(t).
8. This argument does not strictly apply to relative
price shifts that alter real income or wealth for the
country as a whole. For example, a rise in oil prices
represents a real income loss for the U.S. and could,
for this reason, lower real money demand and raise
the price level, even with a fixed money stock. In this
case, relative price changes have an impact on
exchange rates in addition to any impact on price
levels.
14. See Dornbusch (1976) and Bransen, Haltunnen
and Mason (1977).
15. Important exceptions are the work of Stevens, et.
al. (1979), and Hooper and Morton (1980). However,
even these approaches generally use proxies (e.g.,
the current account) for the TOT, or ignore variations
in the prices of non-traded to traded goods.
9. The "ceteris paribus" conditions assumed for this
argument cannot be overemphasized. In particular,
the arguments do not rule out correlations of changes
in the TOT and PPP components that could arise if the
authorities varied domestic money in response to
exchange-rate developments. Also, where monetary
policies affect long-run relative prices, we might
expect some correlation of price levels and relative
prices. Indeed, it is largely because of these potential
complications that we have attempted to estimate the
relations between PPP components and shifts in the
TOT. These results, which are reported in the Appendix, suggest that TOT changes have lillie if any longrun impact on PPP levels - that it is reasonable to
measure the impact of real factors on exchange rates
from TOT variations alone.
16. This proposition is often mistakenly referred to
as the 'law of one price'; the law in fact asserts only
that the dollar prices of identical goods will be the
same aller transport costs are taken into account. But
it sho\.ildbe apparent that either proposition is nearly
irrelevant to the theoretical impact of real factors on
exchange rates.
17. In particular, some evidence suggests that the
revision in Federal Reserve operating procedures
initiated in October 1979 has been associated (at the
least) with greater variability in real interest rates
than before. If so, the relative importance of real factOrs versus real interest rates as a source of
exchange-rate fluctuations may have changed. See
Keran & Pigott (1980) for a further discussion of this
possibility, as well as Truman, et. al. (1981).
52
18. The possibility that the relative importance of
real factors has changed since October 1979 is discussed in another paper; we focus here on the period
as a whole.
related with the real interest proxy (or lagged
changes in the actual real exchange rate).
26.. Thus we use an estimate of the short-term
differential asa proxy for the long-term real interest
differential. This could be justified if expectations
about future short-term rates were based on current
and past rates, because the long-term real interest
rate is (approximately) an average of current and anticipated future Short rates. The relation between the
long-rate and current and past short-rates is then
implicit in the lag-structure of relation (6).
19. GNP deflators might be preferable to CPls,but
they are available on a quarterly basis only. Darby
(198Q) has carried out time-series tests similar to the
univariate estimates presented here using WPls,
CPls, and deflators, with fairly compatible implications that are quite similar to those discussed in the
text.
27. Apermanen( change in the real interest differential would correspond to a shift in the slope of the
long-run path for the TOT. that is. to a shift in its trend.
We ignore such shifts here, and so assume that any
observed change in the real interest differential will
be offset by future changes in the opposite direction.
its impact on the TOT "washing out" in the long-run.
In effect. we attempt to measure variations in the level
of the long-run TOT path.
20. Again, the main reaSon for empiricallY examining
the relation between the TOT and PPP is to evaluate
the empirical importance of correlations induced by
money "reactions" to exchange rates, or long-run
relative price variations resulting from monetary
policies. The results imply that shifts in the long-run
TOT are associated with little, if any, change in the
long-run PPP components. This suggests that the
impact of real factors is, as hypothesized, mainly confined to the long-run TOT.
28. To obtain the expected inflation proxy, we
regressed CPI inflation over a 3-month period on its
values over the past 3-21 months (i.e. lagged 3-month
inflation over the past 3-18 months) for 1973-80.
Details of these estimates will be supplied upon
request. We ignore the possibility that there may be
"feedback" from TOT variations to real interest rates.
that is, that the latter are endogenous with respect to
the TOT. The results do not appear to be greatly
affected if only lagged interest rates are included.
however.
21. For a review of evidence on this issue, see Pigott
and Sweeney (1980).
22. As illustrated by any recent review of exchangerate models; see Dornbusch (1980).
23. More precisely, (3) is an autoregressive representation. Strictly speaking, the latter exists only if
there are some variations in the long-run TOT, that is.
if the level of the actual TOT is non-stationary in the
sense that it has a time-varying (unconditional) mean.
The evidence from Darby (1981) and Pigott and
Sweeney (1980) so strongly support this argument
that we have not tested forstalionarity here. The
models (3) and (6) are estimated using standard maximum-likelihood techniques with the University of
Wisconsin's multi-variate ARMA software package.
29. In the case of Japan as well as Italy. the autocorrelations of the changes in TOT, as well as the results.
suggest fairly strongly that TOT changes are essentially random. The same result for Japan is reported in
Darby's (1980) univariate estimates for the 1971-78
period.
24. This is because the "dynamic" responses of the
TOT to transient factors generally will not be the
same as the response to real factors. Thus, a shift in
the relative importance of transient and real influences is likely to change the serial correlation pattern of changes in x. and hence the univariate model
30. This is also true to some extent of the univariate
models for the other countries. This may be due in
part to the fact that relatively large numbers of
parameters are estimated. We have estimated a fairly
general model - at the obvious risk of "over-fitting"
- in order to avoid "losing" small effects that might
not show up as statistically significant. When we
follow the more usual procedure of allowing lags only
where the corresponding autocorrelations are
relatively significant, half or more of TOT changes
appear to persist in the long-run in virtually all cases.
On the whole, the general conclusion regarding the
importance of real factors is reasonably robust
except for Germany and France.
(3).
25. The argument in the text shows that we can write.
L:J.x(t) = b.r(t) + b.x·(t)
here b. x·(t) is the change in the long-run real
exchange rate as it is perceived by investors, and r(t}
is the long-run real interest differential. Rewriting.
b.x(t) =b.f(t)
+ b.x·W + (b.r(t) - b.f(t))
31 However, if financial factors causing inflation
were substantially responsible for long-run TOT
variations, we would expect to find a strong association between the PPP and long-run TOT components. The results given in Table A-III of the appendix
suggest this is not the case. providing indirect evidence that financial factors are not primarily responsible for relative price changes.
where b.f(t) is the proxy for the change in the real
interest differential actually used in the estimation.
and the last term is the error in measuring it. This
measurement error will be correlated with b. f(t) and
so constitutes one potential source of bias in the estimates. A second bias would arise if the perceived
change in the long-run real exchange rate were cor-
53
REFERENCES
Bransen, William, H. Haltunnen,and P. Mason.
"Exchange Rates in the. Short-Run: The DollarOM Case," European Economic Review, 1977.
Monetary Approach", Scandinavian Journal of
Economics, Vol. 78,No.2, 1976.
McKinnon, Ronald. "Currency Substitution. and
Instability in. the World DoliarStandard,"ProCl:ledings.,of th•• 'Nl:lstC,oast Acadl:lrnic/Federal
Reserve Economic,ReselirchSemil1ar, the
Federal Heserve8ank of San Francisco, November 1980.
Darby, Michael. "Does Purchasing Power Parity
Work?" NBERworkingpaper No. eO?, December1980.
Dornbusch, Audiger. "Expectations· and Exchange
Rate Dynamics," Journal of Political Economy,
Vol. 84 (1976), No.6.
Optica Committee. Inflation and Exchange Rates:
Evidence<andPolicyGuidelines for the Europl:lan Comm",nity, 1976.
_ _."ExchangeAateEconomics: Where Do We
Stand?" Brookings Papers on Economic
Activity, 1980:1.
Pigott, Charles<and Richard J. Sweeney. "Exchange
Rate· Dynamics in Several Popular Models,"
unpublished, 1981.
Hooper, Peter, and John Morton. "Fluctuations in the
Dollar: A Model of Nominal and Real Exchange
Rate Df;ltermination," International Finance Discussion Paper 1'40.168, Board of Governors of
the Federal Reserve System, 1980.
_ _. "purchasing Power Parity and Exchange Rate
Dynamics," unpublished, 1980.
Stevens, Guy, Richard Berner, Peter Clark, Ernesto
Hernandez-Cata, Peter Hooper, Howard Howe,
Sung Kwack and Ralph Tryon. "Modeling
Bilateral Exchange Rates in a Multi-Country
Model," Proceedings of the Fourth Pacific Basin
Central Bank Econometric Modeling Conference, November 1979.
Isard, Peter. "How Far Can We Push the 'Law of One
Price," American Economic Review, 1978.
_ _. "Factors Determining Exchange Rates: The
Roles of Relative Price Levels, Balances of Payments, Interest Rates, and Risk", International
Finance Division 0 iscussion Paper No. 171,
Board of Governors of the Federal Reserve
System, December 1980.
Sweeney, Richard J. "Risk, Inflation and Exchange
Rates," Proceedings of the West Coast
Academic/Federal Reserve Economic Research
Seminar, Federal Reserve Bank of San Francisco, November 1978.
Keran, Michael and Charles Pigott. "Interest Rates
and Exchange Rates," Federal Reserve Bank of
San Francisco Weekly Letter (September 12
and 19, 1980).
Truman, EdWin, et al. "The New Federal Reserve
Operating Procedure: An External Perspective",
in New Monetary Control Procedures, Volume II,
Federal Reserve Staff Study, February 1981.
Kouri, PenH!. "The Exchange Rate and the Balance of
Payments in the Short-Run and the Long-Run: A
54
Kenneth Bernauer*
Many economists have criticized adherents
of flexible exchange rates for overestimating
the effectiveness of exchange-rate changes on
redressing external imbalances. The critics
argue that, since the advent of generalized
floating in May 1973, large and persistent
trade-account imbalances have occurred
despite substantial swings in exchange rates.
The issue, however, is not a new one among
international economists.
According to traditional theory, an
exchange-rate depreciation will improve the
trade account of a devaluing country by
increasing its price competitiveness in world
markets. For example, a dollar depreciation
can correct a trade deficit because it lowers the
price of U.S. exports in terms of foreign currencies and raises the dollar price of imports in
the U.S. market. Because U.S. goods become
relatively cheaper to foreigners and imported
goods more expensive to Americans, a dollar
depreciation will improve the price competitiveness of U.S. export industries and
likewise import-competing industries. The
improved price competitiveness will boost
U.S. export sales while reducing foreign sales
in the U.S., leading to an improvement in the
trade account.
In the past, many economists and policy
makers doubted that these exchange-rate
effects would be great enough to eliminate
payment shortfalls. In their view, the volume
effects of a dollar depreciation might not be
large enough to produce an improvement in
the U.S. trade balance. For analyzing this question, economists estimate price elasticities,
which measure the degree of responsiveness of
the quantity demanded to changes in its price.
Numerically, a price elasticity of demand for
exports (imports) of -2.0 indicates that a I-percent rise in export (import) prices will lead to a
2-percent drop in the quantity demanded of
exports (imports). A devaluation will improve
the trade account in both domestic and foreign
currency if the sum of the demand elasticities
for exports and imports after reversing signs
exceeds unity (the Marshall-Lerner condition). This assumes that an exchange-rate depreciation will lead to a proportional decline in
the foreign-currency price of exports and a
proportional rise in the home price of imports
- and that the trade account will initially be in
balance.
Many studies during the 1940s argued that
the measured price elasticities were substantially less than one, so that a devaluing country
would experience a worsening of its trade
account. Such elasticity pessimism consequently led policymakers to consider policies
other than relative-price changes to correct
trade imbalances. However, the state of the art
for empirical research improved considerably
in the 1950s and 1960s. This, in turn, led to
higher estimated price elasticities of demand,
and contributed to renewed optimism about
the success of a devaluation. In this view, the
volume effects (higher exports, lower
imports) would offset the adverse movement
in the terms of trade and thus would lead to an
improvement in the trade account.
The focus of the debate has subsequently
shifted. While many critics do not dispute that
a currency depreciation will eventually
improve the trade account, they argue that the
long time lags between changes in prices and
*Economist, Federal Reserve Bank of San Francisco.
David Parsley provided research assistance for this article.
55
the controversy over the Japanese-U.S. automobile trade. That particular conflict has been
resolved temporarily through the imposition
of "yoluntary" quotas on Japanese cars. But
Japan has been running a persistently high
s1.ltplus not only with the U.S. but also with the
European community, and this has brought
forth protectionist pressures against Japanese
products.
This paper is designed to investigate the
effectiveness of exchange-rate changes on the
Japanese trade account. The view that
exchange-rate movements will be completely
passed forward into export and import prices
can no longer be taken for granted. Thus the
first stage of our analysis considers the impact
of an exchange-rate change on the prices of
exports and imports, and the second stage considers the effects of these price changes on the
quantities demanded of exports and imports. 1
This two-stage procedure allows us to trace out
the J-curve measuring the effects of a yen depreciation on the Japanese trade account.
Sections I and II provide the theoretical and
empirical framework for measuring the effects
of exchange-rate changes on export and
import prices. Section III discusses the responsiveness of trade volumes to changes in relative prices, and Section IV describes the
derivation of the J-curve. The paper concludes
with a discussion of the policy implications.
changes in quantities diminish its usefulness as
an instrument of adjustment. That is, it takes
time for buyers and sellers to recognize
changes in competitive situations and act
accordingly. In the case of a dollar devaluation,
Americans in the meantime will be spending
more dollars on imported goods and foreigners
will be spending less of their own currency on
U.S. goods. An exchange-rate change thus is
likely to lead to an initial deterioration (and a
subsequent improvement), in the trade
account of the country with a depreciating currency, and to an improvement in the trade balvt 1vl~ance of the country with an appreciating cur\,\IJ,) v
rency. The initial deterioration and subsequent
improvement in the depreciating country's
trade account resemble the letter J when the
trade account is plotted on the vertical axis
against time on the horizontal axis.
Some critics also have argued that the pricing behavior of exporters has changed with the
adoption of flexible exchange rates, with
exporters changing their profit margins rather
,than their prices in order to maintain sales.
Hence, a depreciation simply tends to increase
the home-currency price of exports and to
lower the foreign-currency price of imports,
leaving the devaluing country's competitive
position unchanged.
The contentious debate about the ability of a
freely floating exchange rate to restore price
competitiveness has surfaced most recently in
I. Determination of Export and Import Prices
In the traditional view of trade adjustment,
an exchange-rate depreciation will lead to a
proportional decline in the foreign-currency
price of exports and a proportional rise in the
domestic-currency price of imports. The effectiveness of a devaluation thus will depend
upon whether or not the absolute value of the
sum of the price elasticities of demand is
greater than one.
To illustrate, consider the impact of a yen
depreciation on the Japanese trade account
(Chart 0. Suppose a yen depreciation of 10
percent vis-a-vis the dollar leads to a proportional rise in the yen price of U.S. goods in the
Japanese market. (In this example, the
average price of an American good rises from
100 yen to 110 yen.) The rise in price makes
American goods less attractive to Japanese
buyers. Assume a demand elasticity of -1.6.
The 10-percent price increase prompts a 16percent fall in the quantity demanded of U.S.
goods by Japanese importers. This is illustrated diagrammatically by a shift in the supply
schedule from ss to Sf Sf. The quantity
demanded of U.S. goods falls from 200 million
to 168 million units. The lower volume of
American goods demanded more than offsets
the price increase, so that the value of
56
Japanese imports in yen falls in response to a
yen depreciation. In this example, the yen
value of Japanese imports (price x quantity)
declines from 20 billion yen to 18.48 billion
yen. With the dollar price unchanged, the
value of Japanese imports in dollars falls by the
percentage change in the quantity demanded
(16 percent) .
Conversely, on the export side, a 10-percent
yen depreciation produces a fall in the dollar
price of Japanese exports, improving the price
competitiveness of Japanese goods in the U.S.
market. The greater demand stemming from
the price decline is illustrated by a rightward
shift in the demand schedule from DD to
D'D'. Again, assume a demand elasticity of
-1.6. The fall in the dollar price of Japanese
exports boosts the quantity demanded by
Americans of Japanese goods by 16 percent.
With the yen price unchanged, the yen value
of Japanese exports rises in direct proportion
to the percentage increase in the quantity
demanded. In dollars, the higher volume of
Japanese exports more than compensates for
the price decline, so that the dollar value of
Japanese exports rises following a yen depreciation.
Chart 1
Impact of 10-Percent Yen Depreciation
on the Japanese Trade Account
Japanese Imports
Japanese Exports
Exchange
Rate (V/$)
150
Exchange
Rate (V/$)
D
275
110 I--~_---"""
100 I--"'-';"'-';~--- 200 1------.;
50
s
125
168
200
100
Quantity
116
Quantity
Impact of a 10-Percent Yen Depreciation on Japanese Trade Account
(quantities in millions of currency units)
Pre-10% yen depreciation·
Yen
Trade balance
millions)
Exports On millions)
Imports On millions)
Export price
Import Price
Export quantity On millions)
Import quantity On millions)
Exchange rate
Dollars
o
o
20,000
20,000
200
100
100
200
200
100
100
1.0
0.5
100
200
0.005
*$1 = ¥- 200, or ¥-1 = 0.50 cents
t $1 = ¥- 220, or ¥-1 = 0.455 cents
57
Post-10% yen depreciationt
Yen
Dollars
4720
23,200
18,480
200
110
116
168
220
21.5
105.5
84.0
0.91
0.50
168
168
0.00455
On balance, the value of Japanese exports
rises in both yen and dollars following a yen
depreciation, while import value falls in both
currencies. This is, however, predicated on the
assumptions that the demand elasticities are
greater than unity, and that import and export
prices both adjust to the full extent of
exchange depreciation.
In the short run, export and import quantities tend to be unresponsive to price changes.
That is, buyers and sellers need time to recognize changes in competitive positions and act
accordingly. In fact, an exchange-rate change
initially is likely to lead to a deterioration in the
trade account of the country with a depreciating currency.
We may assume, as above, that the long-run
price elasticities of demand are -1.6 for both
exports and imports - and that their
responses are uniform over time, so that
export and import volume each decline 0.2
percent per quarter for eight quarters following
a yen depreciation. In this case, the MarshallLerner condition is met only in the third
quarter following the exchange-rate change.
This movement in the trade account is depicted graphically in Chart 2, illustrating the
so-called J-curve phenomenon.
Separately, various observers have argued
that exchange-rate changes are totally ineffective in eliminating trade imbalances, because
exporters will absorb those changes into higher
or lower profit margins so as to maintain sales.
For example, a yen depreciation (appreciation) will prompt Japanese exporters to raise
(lower) their yen prices by the same percentage amount. This implies that Japanese
exporters set their prices on the basis of
foreign-competitor prices measured in yen,
and not on the basis of domestic cost considerations.
Export prices in yen would rise by the full
amount of the depreciation only when supply
is fixed or the demand schedule is perfectly
horizontaL The former condition may be relevant for a country which is operating at full
capacity and has a large export sector relative
to total output. In the one case, the full utilization of resources would not permit export
firms to increase supply. In the second case,
their ability to increase supply would depend
upon bidding away resources from the nontradeable goods sector, and this capacity would
be limited if the export sector is large relative
Chart 2
J-Curve Effects of Yen Depreciation
Trade Balance
+
o h:----~...,....'"--":!'-'--4--~5--~6-~7~-~8
Lag Quarter
58
to the total economy.
Japanese firms meanwhile would face a
horizontal demand schedule only if their product cannot be differentiated from foreign products and their supply represents a small part
of total world production. In the case of
undifferentiated products - such as silver, tin
and copper, but not motor vehicles - buyers
are indifferent to the country from which they
purchase. Thus, the law of one price holds and
no one exporter can sell at a different price. At
the same time, if the quantity supplied by the
firm or country is small relative to total world
supply, then its own output will have little
effect on price. Under these two conditions,
the export price is given exogenously and the
quantity of exports is determined in the longrun via a supply curve.
In the Japanese case, its exports represent a
small proportion of total domestic production
but loom large relative to European and Amer-
ican exports of manufactured goods. Consequently, the supply of Japanese exports should
be highly sensitive to prices and should
strongly influence international prices in turn.
Moreover, Japanese producers should have a
certain amount of control over price, because
their exports are composed largely of finished
goods with a high degree of product differentiation. With this information, one would
expect Japanese export prices to be jointly
determined by cost conditions and foreign
competitor prices.
In contrast, Japanese imports are heavily
weighted with basic commodities (primary raw
materials) which are noted for a high degree of
homogeneity. As a consequence, Japan should
largely be a price taker on the import side; that
is, a yen depreciation should lead to a proportional rise in Japanese import prices in yen.
This proposition will be tested below.
II. Specification of Export and Import Price Equations
The rise in export prices in response to an
exchange-rate change may be tested
empirically. Here we specify a chain of causation running from exchange rates to prices to
export quantities. 2 For clarity of exposition, we
assume that export quantities do not adjust to
prices immediately, 3 since the literature indicates that long lags are involved.
In measuring the pass-through effect, we
consider four export commodity groupings:
machinery and equipment, metal products,
chemicals, and textiles. Recent empirical
research (e.g., Spitaller, 1980) has attributed
no significance to domestic-cost variables in
the setting of export prices. The result may
simply reflect aggregation bias, and not the
determination of domestic prices by international prices. Separate equations thus may be
estimated for each price series, which in turn
permits us to determine the responsiveness
(and time lag) of export prices to exchangerate changes.
Within individual product categories, the
extent of the pass-through depends upon the
nature of the product and the cost charac-
teristics of the industry. As a proxy for
domestic costs, researchers have generally
relied upon unit labor costs. However, this
measure fails to account for the dramatic
recent rise in raw material prices, which suggests the need to utilize a more comprehensive
measure, such as the wholesale-price index.
Another consideration is the tendency for a
higher level of capacity utilization to limit the
supply response of exporters, causing them to
allocate output by raising prices instead. 4
We hypothesize, then, that Japanese exporters set prices on the basis of 1) the yen
exchange rate, 2) the prices of foreign competitor goods expressed in local currency, 3)
the level of capacity utilization, and 4) labor
and other input costs (proxied by wholesale
prices). The general form of the specification
can be written as:
XP = f(WP, EX, CP, CU)
where XP = export prices,
WP = wholesale prices,
CP = foreign competitive prices,
CU = capacity utilization,
EX = exchange rate.
59
In contrast, Japanese imports (as noted) are
heavily weighted with basic commodities with
a high degree of homogeneity. The "law of
one price" thus should hold, so that a depreciation of the dollar leads to a proportional
fall in imported commodity prices in yen
terms. For example, the 36-percent depreciation of the dollar against the yen between the
first quarter of 1976 and the fourth quarter of
1978 paralleled a 32-percent decline in the yen
price of oil over that period. The prices of
Japanese imports in yen terms will be related
to the yen/$ exchange rate and to the world
commodity-price index denominated in dollars 5• A coefficient value of one attached to the
yen/$ exchange rate would be consistent with
complete pass-through. This proposition will
be tested with respect to food, fuels, raw
materials, and metals - categories accounting
for 75 percent of all imports.
The next step after estimating price equations is to determine the effects of changes in
the terms of trade (export prices over import
prices) on the quantities of exports and
imports. That is, having established the extent
and duration of the price response to an
exchange-rate change, we must next relate
export and import quantities to their respective prices. By substituting the price equations
into the respective volume equations, the estimated time path between an exchange-rate depreciation and its impact on export and import
quantities can thereby be derived.
III. Determination of Export and Import Quantities
The same reasoning applies to exports. A
higher level of income abroad will increase the
demand for a country's exports. An increase in
the price of the export good relative to foreign
competitors' goods will diminish the demand
for it. Moreover, an increase in demand for a
good may not bring forth a supply response
due to production bottlenecks. An exporter
faced with supply constraints thus may decide
to allocate his output by slowing delivery times
instead of raising prices. The waiting time
imposes a cost on the buyer which is not incorporated into the price of the product. In the
general form, we can write the export-volume
equation 7 as follows:
XV = fey, PXIWPX, CU)
where XV = export volume,
Y
= real GNP abroad,
PX = price of exports,
WPX = foreign competitor prices (in
yen),
CU = capacity utilization in Japan.
The theory of consumer demand provides a
basis for analyzing the demand for exports and
imports. As for imports, the quantity of a good
that a consumer wants to purchase depends
upon his income and the price of competing
substitutes. A higher level of income increases
the consumer's ability to purchase more
goods. The allocation of his income among
foreign and domestic goods depends upon
their prices and their degree of substitutability.
At the national level, a rise in real income
translates into increased demand for domestic
and foreign goods. The allocation of income
among domestic and foreign goods depends
upon the prices of foreign goods relative to
import-competing substitutes. The demand for
imports can therefore be written as a function
of domestic real income 6 and the prices of
imported goods relative to domestic goods.
The general model is:
MV= fey, PMIWP)
where MV = import volume,
Y = Japanese industrial production
PM = import prices,
WP = wholesale prices.
60
IV. Empirical Results
Chart 3
J-Curve Effects with
10-Percent Yen Depreciation
(domestic currency units)
Our results (Table 1) indicate that only
about 38 percent of an exchange-rate change is
passed forward into export prices expressed in
foreign currency. 8 That is, Japanese exporters
respond to a 10-percent depreciation
(appreciation) of the yen by raising (lowering)
their yen prices by about 6 percent. They respond slightly more to changes in foreign competitor prices expressed in foreign currency,
matching on average about 66 percent of competitors' price increases.
Contrary to some earlier empirical evidence,
domestic cost variables have played a role in
setting Japanese export prices, for three of the
four commodity categories. These variables
proved insignificant only in the case of machinery and equipment, which suggests that
further disaggregation was necessary. Overall,
export prices of Japanese manufacturers were
jointly determined by domestic cost considerations and foreign competitor prices.
Estimated price equations for different
import categories tend to confirm that Japan is
a price taker on the import side (see Table 2).
That is, an exchange-rate appreciation (depreciation) will lead to a proportional fall (rise)
in the domestic currency price of Japanese
imports. This result, combined with the estimated pass-through on the export side, suggests that a IO-percent yen depreciation will
lead to about a 3.8-percentage-point deterioration in the terms of trade. With no change in
export and import quantities, this terms-oftrade effect will lead to an initial deterioration
in the trade account. The duration of the worsening trade balance - the duration of the first
segment of the J-curve - will depend upon
the time lag between movements in quantities
and prices, and upon the size of the export and
import elasticities.
The long-run price elasticities of demand
were estimated at -0.35 for imports and at -2.5
for exports (Table 3). The price responsiveness of Japanese imports extended over a fourquarter period, whereas on the export side, the
price effect was fully absorbed within five
quarters.
Exports
Imports
110
100 ~-~"';"""""'--4-"'5--
90
Lag Quarter
On the basis of both volume and price equations, a depreciation of the yen will worsen the
trade balance during the first half year (see
Chart 3). Between the second and third quarters, the trade balance will show an improvement in both domestic and foreign currency
units, and the maximum improvement will
occur during the fifth quarter following the depreciation. At the maximum point, the value
of Japanese exports and imports in yen 9 would
have risen by 15.9 percent and 6.5 percent,
respectively. The time lag between an
exchange-rate change and a trade-account
improvement would be considerably less than
the four to five years generally suggested in the
literature.
Simulation, 1980-1981
Using the parameter estimates obtained
from the model, we performed several experiments to measure the impact of exchange-rate
movements on Japan's trade account in 1980
and 1981. In this connection, we cannot ignore
the effects of oil-price hikes on Japan's recent
trade performance. From the fourth quarter of
1978 through the fourth quarter of 1979,
Japan's trade balance shifted from a surplus of
¥-842 billion to a deficit of¥-916 billion. The
marked deterioration largely reflected the concurrent run-up in oil prices from $12.80 to
$24.28 a barrel, which was then followed by a
further rise to $33.81 a barrel in the fourth
quarter of 1980. Moreover, economic growth
during 1980 increased at a 3.6-percent rate in
61
Table 1
Effects of Movements in the Exchange Rate,
Foreign Competitive Prices, and Wholesale Prices on
Export Unit Values of Japanese Manufactured Goods
Percentage Change in Japanese Export Prices from One-Percent Change in
-------------=------==Commodity
Category
Value of Yen
(depreciation)
Machinery and equipment I
Metal Products
Chemicals
Textiles
All Manufactured Goods 5
0.46**'
1.11
0.58**
I. 22***
(0.62)2
*.
Foreign Competive Prices
(in foreign
(in domestic
currency)
4
Domestic Wholesale Prices
0.48***
1.32***
0.58**
0.89***
(0.66) 2
0.50***
1.64***
0.58**
0.53
(0.72) 2
0.00
1.02*
1.57***
1.06***
(0.34) 2
*Signifies coefficient is significantly different from zero at an alpha level of 0.10;** for alpha level of 0.05;*** for alpha level
of 0.01.
I. Tests of significance in the machinery-and-equipment equation should be viewed warily, because of first-order autocorrelation in the residuals.
2. The elasticity of export prices with respect to the exchange rate, foreign competitive prices and wholesale prices was calculated as a weighted average of the elasticities for each commodity category, with weights proportional to the share of each
commodity in total manufacturing exports. The weights are 0.698 for machinery and equipment, 0.184 for metal products,
0.058 for chemicals and 0.054 for textiles. These calculated elasticities are shown without parentheses.
3. The elasticity of export prices with respect to foreign competitive prices, measured in domestic currency units, was calculated as a weighted average of the elasticities of export prices with respect to the exchange rate and foreign competitive
prices, denominated in foreign currency units. The weights were proportional to the standard errors of the coefficients.
4. The tests for significance refer to F-tests for the joint influence of the exchange rate and foreign competitive prices. The
null and alternative hypotheses were:
Ho: BI = B2 = 0
HA : BI = B2 = 0
where &
=
0.05. this was the case for machinery and equipment, metal products and textiles.
5. In 1980, manufacturing exports constituted 90 percent of all exports.
Table 2
Effects of Movements in the Dollar/Yen Rate
on the Prices of Imported Commodities 3
Import Prices
in Yen for
Food
Fuels
Raw Materials
Metals 2
Exchange Rate
Constant
-0.24
-3.81 **
-5.00**
-5.00
0.736*
0.979*
1.045*
0919*
Export Prices
R2
D.W.
0.294
0.849*
0.960*
1.168*
0.56
0.96
0.83
0.69
0.47
1.21
0.74
1.28
*Denotes significance to 0.05 level. However, because of first-order autocorrelations in the residuals, tests of significance
should be viewed warily due to biased standard errors of coefficients.
1. The coefficient attached to the exchange rate for each commodity category was insignificantly different from one.
2. The metals equation was corrected for first-order correlation.
3. The four commodity categories constituted over 75 percent of all imports.
Table 3
Distributed Lag of Relative Prices on Japanese Export and Import Volumes
Dependent
Variable
XV
MV
Current
Quarter
0.79
0.03
t-2
t-1
-0.10
-0.07
-0.68
-0.11
62
Volumes
t-3
t-4
-0.97
-0.95
-0.12
-0.08
t-5
-0.62
Sum
-2.53
-0.35
relatively modest contribution to the trade
account. The reverse J-curve effects stemming
from the 1980 yen appreciation contributed
about ¥-350 billion to that year's trade surplus.
The improvement in trade volumes was more
important to this turnaround. Movements in
exchange rates, particularly the 33.6-percent
effective yen depreciation between the third
quarter of 1978 and the first quarter of 1980,
can more than account for the 16.3-percent
growth in export volume and 6.8-percent drop
in import volume. On balance, the outside
sample estimates indicate that movements in
effective exchange rates made a positive contribution to the Japanese trade account of
¥-3100 billion between 1979IV and 1980IV more than offsetting the oil-price rise and the
activity effect (higher economic growth in
Japan than abroad).
In 1981, the effective exchange rate of the
yen remained fairly stable. However, much to
the consternation of Japan's trading partners,
the trade surplus continued to expand - to a
¥400-billion quarterly surplus in the first three
quarters of 1981, compared with a ¥-900 billion deficit in the corresponding 1980 period.
For one reason, the terms of trade have
improved due to a fall in import prices, reflecting weakness in world commodity prices. On
the other hand, export volume has increased
while import volume has fallen. In the first
nine months ofl981, export volume rose 12.8
percent above the corresponding 1980 figure.
While less robust than the 1980 gains, these
export increases are nonetheless substantial,
reflecting as they do the relative price changes
of the preceding year. From the model's outside-sample estimates, about two-thirds of the
1981 export-volume increase can be attributed
to movements in the yen's effective exchange
rate, which in 1980 produced a 6A-percent
improvement in Japan's price competitiveness
as measured by relative export prices of
manufactures. In fact, the 29-percent rise in
Japanese export volume since 1979 can,
according to the model's results, be attributed
to exchange-rate movements. (The est,imated
contribution was 31 percent.) In particular,
movements in the yen's exchange rate more
Japan while stagnating in the U.S. and major
European countries. The growth differential in
Japan's favor should have stimulated faster
growth in Japanese imports relative to exports.
When combined with the oil-price rise, a substantial widening of the trade deficit thus
should have been realized in 1980. On the contrary, the Japanese trade account showed a ¥216-billion surplus in the fourth quarter of
1980, a turnaround of¥-1132 billion over the
year. The explanation for this paradoxical
turnaround may be found in a review of our
regression equations.
We noted earlier that a yen depreciation will
tend to raise the yen prices of Japanese exports
and imports, while a yen appreciation will have
the opposite effect. The yen's trade-weighted
exchange rate (the effective exchange rate)
depreciated by 29 percent during 1979, but
then appreciated by 14 percent during 1980
(fourth quarter to fourth quarter). Largely
reflecting these movements, Japanese exporters raised their yen prices by 22 percent during 1979 but by little more than zero in 1980.
With an estimated offset coefficient of 0.62,
exchange-rate movements contributed 18 percentage points to the 1979 price rise (0.62
times effective yen depreciation of 29 percent)
but reduced the 1980 price rise by almost 9
percentage points (0.62 times effective yen
appreciation of 14 percent) . The marked
deceleration in export prices during 1980 thus
was consistent with the evidence presented in
the text.
On the import side, the 1979 yen depreciation should have inflated the yen prices of
imports while the subsequent appreciation of
1980 should have had the opposite effect.
Reflecting the oil-price hikes, Japanese import
prices in yen actually rose by 70 percent during
1979 and by 8112 percent during 1980. According to the regression model, exchange-rate
movements contributed almost 26 percentage
points to import prices in 1979 while lowering
import prices by almost 12 percentage points
in 1980. As before, recent data thus bear out
the empirical evidence in the text.
Overall, movements in the terms of trade
attributable to exchange-rate changes made a
63
than accounted for the 13.5-percent fall between ·1978 and 1980 in the relative prices of
Japanese manufactured-goods exports.
Moreover, foreign activity contributed little if
any impetus to export volume growth, reflecting the virtual stagnation in U.S. and European
economic activity in the 1980-81 period.
On the import side, exchange-rate move-
ments would have predicted a 1.0 percent fall
in import volume over the last two years. This
compares with an 8.8-percent actual decline in
the first three quarters of 1981 compared to
the corresponding period of 1979. Energy conservation, .stemming from the oil-price rise,
apparently made the major contribution to fallingimport quantities over this period.
V. Policy Implications
The size of the Japanese trade surplus with
the U.S. and the European Economic Community (E.E.C,) has seriously impaired trade
relations among the three major trading
partners. The E.E.C. trade deficit with Japan is
estimated at roughly $10 billion for 1981, and
the U.S. bilateral trade deficit is expected to
approach $15 billion. E.E.C. policymakers thus
are calling on Japan to take appropriate
measures to redress the imbalance - just as
U.S. policymakers did when pressing for
Japanese curbs on auto exports. Without
voluntary restraint, the Brussels Commission
has said that it would consider curbing
Japanese access to E.E.C. markets for motor
vehicles, TV sets and machine tools over the
next five years.
The Japanese Government has announced
certain short-term measures to reduce the
trade deficit, such as increasing Government
stockpiles of crude oil and possibly increasing
imports of nickel, cobalt, and other metals. But
these moves are unlikely to placate Americans
and Europeans, since their deficits vis-a-vis
Japan are mainly concentrated in manufactured-goods trade.
The empirical estimates in the text suggest
that Japan's expanding surplus vis-a-vis the
U.S. and Europe could have been expected in
light of recent exchange-rate movements. The
yen depreciated by 33.6 percent against the
U.S. dollar and major European currencies between 1978III and 19801, apparently prompted
by the concurrent run-up in oil prices. With oil
representing 40 percent of Japanese imports,
the sharp rise in oil prices greatly enlarged
Japan's import bill, requiring additional
financing to erase the shortfall through higher
export growth. As a result, the yen exchange
rate depreciated, improving the price competitiveness of Japanese goods and thereby
creating the foreign demand for a higher level
of Japanese exports. The increased exports
found their way into the U.S. and E.E.C.
markets, raising Japan's market share during a
period of widespread recession and unemployment.
The empirical results show that Japanese
exporters offset about 62 percent of a yen depreciation (appreciation) by raising (lowering)
their yen prices. Despite less than 40-percent
pass-through into export prices, the yen's
effective exchange rate declined substantially,
producing a 13.6-percent decline in the relative prices of Japanese manufactured-goods
exports between 1978 and 1980. With an estimated price elasticity of demand of -2.52, the
fall in the yen rate and the related improvement in price competitiveness can more than
account for a 29-percent growth in Japanese
export volume between 1979 and 1981 (first
three quarters). Further contributing to the
improvement in the Japanese trade account
was a fall-off in import volume. But because of
the small price elasticity of demand of -0.35,
the. resulting reduction in import quantities
was modest by comparison. Overall, the
empirical results indicate that movements in
the yen's effective exchange rate contributed
substantially to Japan's trade performance in
the 1980-81 period.
According to the empirical findings, the
growing controversy between Japan and its
major trading partners does not stem from the
64
ineffectiveness of exchange-rate changes to
produce adjustments in the trade account. On
the contrary, the yen depreciation fonowing
the oil-price hikes may have gone too far.
Japan's 1981 trade surplus more than offset its
traditional deficit on services and transfers,
placing the current account in surplus.
The signs are particularly ominous for the
U.S. While the effective exchange rate
remained fairly stable during most of 1981, the
yen depreciated by 9 percent against the dollar
over the first three quarters of the year - and
by 22 percent since 1978IV. Japan's price competitiveness vis-a-vis the U.S. also increased
because of higher U.S. inflation, as U.S. export
prices in 1981 rosean estimated 3.4 percentage
points more than Japanese export prices
measured in local currency. Given the U.S.
inflation and given the donar's appreciation
against the yen, the U.S. thus has suffered a
marked erosion of its competitive position visa-vis Japan. This portends an expanding
bilateral trade deficit in 1982. This situation,
coupled with rising U.S. unemployment,
almost insures continued tensions in the trade
relations of these two countries in the
foreseeable future.
Appendix A
Data Series and Sources
The data come from numerous sources,
including various issues of the Bank of Japan's
Economic Statistics Monthly, the Monthly
Statistics of Japan published by the Statistics
Bureau, The National Institute of Economic
and Social Research Review, IMF International Financial Statistics and the UN Bulletin
of Statistics. Estimation period extends from
Ql, 1974 to Q4, 1979.
1) Exchange Rate - The exchange-rate
variable was defined in yen per foreign currency units, and included the currencies of the
U.S., Germany, Britain, France and Italy. In
cQnstructing the index, we weighted each
exchange rate by that country's share in total
manufactured-goods exports. 10 In the index,
1975 = 100.
2) Foreign Competitor Prices - Unit-value
indices of manufactured-goods exports were
used as a proxy for foreign competitor prices in
each of the four product categories. An index
was calculated with 1975 as the base period.
The countries involved and the weights are
identical to those employed for the exchangerate index.
3) World Export Prices for Basic Commodities - We used a weighted average of
commodity-price indices, expressed in dollars,
taken from various UN publications. The base
period was 1975, and weights were calculated
on the basis of shares in Japanese imports for
each product category.
4) Foreign Real Income - We used a
weighted average of real GNP for the same
countries used in calculating the exchange-rate
and foreign-competitor price indices. The base
period was 1975, and the weights present
world-trade shares.
Appendix B: Export Price Equations
Machinery and Equipment
Ln(PX) = -0.31 + 0.464Ln(EX)
(0.22) (2.23)
R2= 0.54
Se= 0.04
D.W.= 0.95
+ 0.505 Ln(CP) t + e t
0.97)
65
Textiles
Ln(PX)
=
-2.03
(4.8)
+
1.06 Ln(WP) + (4.22)Ln(EX)
(4.10
+ 0.53 (CP) , + 0.44 (CU), + e,
0.10
(4.80)
R2=0.79
Se = 0.029
D.W. = 2.0
Q(22) = 6.9
Chemicals
Ln(PX) = -2.34 + 1.57 (WP) , + 0.58 Ln(EX),
(-3.66) (4.11)
(1.74)
0.58 Ln(CP), + 0.42 Ln(CU), + 0.07 Ln(CU), + e,
(1.74)
(3.03)
(0.43)
R2 = 0.86
Se = 0.036
D.W. = 1.81
Q(22) = 6.9
Metals
Ln(PX)
=
-0.05 + 1.05 Ln(WP), + 1.11 Ln(EX) ,
(2.58)
(-2.19) 0.34)
+ 1.64 Ln(CP),-O.l34 Ln(PX)IWP) ,.1
(2.50
(-1.82)
+ e,
R2 = 0.84
Se = 0.029
D.W. = 2.01
where t-statistics are in brackets below the
estimated parameters.
Variable Names:
PX = export prices (machinery and equipment, textiles, chemicals, metals, and
manufactured goods).
EX = trade-weighted exchange rate (yen per
foreign currency unit)
CP = trade-weighted competitor prices
CU = capacity utilization (textiles and chemicals)
WP = wholesale prices (textiles, chemicals,
and metals).
Notes on Export Price Equations
Machinery and Equipment
1) Wholesale prices and capacity utilization
for machinery and equipment proved to be
insignificant and were dropped from the equation. Thus, pricing decisions of machinery and
equipment manufacturers were almost entirely
influenced by external factors rather than
domestic cost considerations. However, these
results may be tentative, since further disaggregation may be required to pick up the
effects of domestic costs on export prices.
2) Across export product categories, only
the machinery and equipment equation
exhibited first-order autocorrelation. This
result is consistent with the actual behavior of
the export-price series of machinery and
equipment, which was also identified as a firstorder autoregressive process.
Textiles
1) The equations for textiles, metal products, and chemicals were estimated in firstdifference form, although either levels or first
differences would be theoretically sound.
2) Of all the variables, only foreign competitor prices proved to be insignificant. But this
may simply reflect the downward bias associ-
66
ated with errors in variables stemming from
the much broader coverage of the competitorprice series.
3) A one-percent depreciation of the yen
will lead to a 1.22-percent increase in domestic
currency prices of Japanese exports. This
implies more than complete passthrough.
However, the coefficient on the exchange-rate
term is not significantly different from one. As
a consequence, it would be better to say that
Japanese exporters raise (lower) their prices
by the same percentage amount as the
exchange rate.
the capacity utilization rate was dropped
because of its insignificance. As a result, the
change in metal-product export prices is a
function of changes in metal wholesale prices,
the exchange-rate index, and foreign-competitor prices denominated in foreign currency.
Moreover, disequilibrium effects were incorporated into the specification, as exemplified
by lagged ratios of export prices to foreign
competitors' prices and to wholesale prices.
Estimation of the model with either one or
both of the ratio variables yielded a significant
value only for the variable with wholesale
prices in the denominator. The model has the
long-run property that export prices are determined by domestic cost considerations (See
Davidson, 1978).
Manufactured Goods
We estimated a separate equation relating
the prices of all manufactured goods to the
exchange rate (EX) and foreign competitor
prices measured in foreign currency (CP). The
specification was the same as for the machinery-and-equipment equation. The results
are not reported here because of the equation's
low explanatory power (R2=0.16) and the
insignificance of the exchange-rate term (EX).
Moreoever, wholesale prices and capacity
utilization proved to be insignificant when
added to the model. These results justify the
disaggregated approach adopted here. In fact,
the insignificance of domestic cost variables
and the autocorrelation in the residuals suggest that further disaggregation should have
been undertaken for machinery and equipment.
Chemicals
1) The coefficient values on Ln(EX) and
Ln(CP) and their respective t-statistics are the
same, reflecting the merging of Ln(EX) and
Ln(CP) into a single variable, referred to as
foreign-competitor prices expressed in yen.
This composite variable was used because of
the strong correlation among the independent
variables in the estimating equation, yielding
inconclusive results. The hypothesis of
equality between the coefficients on the
exchange-rate variable (EX) and the foreigncompetitor price term (CP) could not be
rejected at the 0.5 level of significance. For the
purposes of measuring pass-through, a coefficient value of 0.58 is used for the exchange
rate. With this result, only 42 percent of an
exchange-rate change is passed forward into
foreign currency prices of Japanese chemical
exports.
Metals
The specification for metal products is similar to the equations for chemicals and textiles,
but with several modifications. In particular,
Appendix C: Export and Import Volume Equations
Variable Names:
XV = export volume
DI, D2, D3 = seasonal dummies
WGNP = world GNP
CD = capacity utilization
PX = price of exports
CP = competitor prices
EX =
MV =
IP =
PM =
WPI =
67
exchange rate
import volume
Japanese industrial production
import prices
Japanese wholesale prices
Export Volume Equation
LN(xv)
27.5 - 0.19 Dl - 0.17 D2 -0.39 D3 + 1.85 LN (WGNP) (-8.66 LN (CU)
(-1.20
(-1.83)
(2.08)
(1.79)(-1.52)
(2.43)
(=
(C:~X)
-2.52 LN
(.k + e t
(-2.29)
Coefficient on
Lag(k)
t-statistic
I PX \
LN \CP'EX)(.k
o
0.79
1.11
1
-0.10
-0.52
2
-0.68
-2.14
3
-0.97
-1.89
4
-0.95
-1.79
5
-0.62
-1. 75
Sum
-2.52
-2.29
IV;"" 0.67,Se= 0.148,D.W. = 1.74
Q(l8) = 11.4, n = 19
Import Volume Equation
LN(MV)
1.80 + O.OlDl + 0.01 D2+20.03 D3+ 0.61LNOP) (- 0.35 LN
(3.80 (1.00)
(0.70
(3.13)
(6.00
(-3.74)
(=
Coefficient on
J
(~~I )
(.k
+ e(
tion oflagged terms until they turned insignificant.
t-statistic
The long-run price elasticities of demand
Lag(k)
LN (
were. estimated at -2.52 for exports and -0.35
1.25
o
0.03
for imports, both of which appear reasonable.
-3.21
1
-0.07
Almost all Japanese exports are manufactured
-3.88
2
-0.11
goods, while imports are mainly basic com-3.79
3
-0.12
modities. Low price elasticities are generally
-3.71
4
-0.08
associated with goods with few available
-3.74
Sum
-0.35
substitutes. In natural-resource starved Japan,
a rise in prices of imported commodities will
1.53,
Q(l9)=
9.9
R2 = 0.98, Se = 0.169, D.W.
bring little reduction in demand due to the
n = 20
unavailability of domestic substitutes. By comparison, manufactured goods should have a
Notes on Trade Equation
The price elasticities of demand for exports
l11\,lchlarger price elasticity. For example, a
and imports were estimated by the Almon lag
higher price for Sony stereos should lead U.S.
consumers to buy domestic substitutes or
technique, to offset the limited sample size
comparable European models instead.
and strong correlation between lagged indeThe contemporaneous price effect on export
pendent variables. The relative price terms
and import volumes apparently has a perverse
Ln(PX/CP EX) and Ln(PM/WPI) were
sign. But this result could be expected, since
entered as second-degree polynomials constrained at the far endpoint. The number of
others have also found a positive price
lags were determined sequentially by the addielasticity in the short run (see, for example,
~~I }.k
68
Wilson and Takacs). This reflects the fact that
trade volumes depend not only upon actual
prices but also onexp~cted prices. For exampIe, a Japanese petroleum importer who
expected oil prices to rise would accelerate his
purchases to avoid later. price increases... The
central question concernS how expectations
are formed. If, for. example, buyers expected
price one quarter ahead is equal to the current
price (PJ plus a positive fraction of the price
change from the preceding quarter (P t . P t) ,
then a direct relationship· between prices· and
trade volumes should be observed contemporaneously. A rise in price will generate
expectations of higher prices in the future,
leading buyers to speed up their purchases
from supplying countries.
Thereal·ineome variable in the exportvolume equation is a weighted average of real
GNP for the countries used in constructing the
indices of foreign competitor prices and
exchange rates. Several· weighting·· schemes
were tried, inchlding shares of a country's
imports from Japan as a. proportion of total
Japanese exports, shares ofa country's
imports of manufactured goods as a proportion
ofworld manufacturing trade, and. shares of a
cQuntry's net exports of manufactured goods
in relation to the total trade in manufactures.
All weighting schemes were normalized to
sunl to one. These real-income. series proved
to be highly correlated with lagged values of
the relative price term, yielding insignificant
values for both variables. The only weighting
schemes that did not produce high correlation
between the activity and relative-price effects
were the export-share weights used in the
exchange-rate and foreign-competitor price
series; Our· export·volume·equation·estimates
incorporate the real GNP variable with these
export-share weights.
FOOTNOTES
3. The time interval before export quantities start
adjusting can be subdivided, according to Magee, into
currency contract and pass-through periods. The discussion so far has emphasized the latter. The former
stems from statistical deficiencies inherent in using
unit-value indices. That is, unit-value indices refer to
prices at the time of delivery and not at the time of
contract negotiation. Because of time lags between
orders and deliveries, the pricing behavior of exporters and importers immediately following a devaluation
may not be contemporaneously incorporated into the
in<:tex. However, this does not necessarily mean that
unit-value indices will fail to reflect contemporaneous
movements in exchange rates. For example, suppose
that 50 percent of Japanese exports are invoiced in
do.llars; a ten-percent appreciation of the yen vis-avis the dollar then will translate, everything else held
constant, into a five-percent decline in Japanese
export prices. Moreover, suppose that Japan sells 30
percent onts exports to Germany and that 50 percent
of these contracts are invoiced in marks; then, a tenpercent appreciation of yen relative to the OM will
lower export prices by 1.5 percent. The higher the
proportion of contracts invoiced in foreign currency,
the greater will be the effect of an exchange-rate
change on the unit-value index measured in domestic
currency.
1. The induced price and income effects resulting
from exchange-rate changes will largely be ignored
here. For example, a yen depreciation, by increasing
the price competitiveness of Japanese export and
import-competing industries, will produce a shift in
demand towards Japanese products. The higher level
of production will generate increased demands for
imported goods. At the same time, the exchange-rate
depreciation will raise the cost of imported goods
which serve as intermediate goods in the production
of exports. This, in turn, will put upward pressure on
export prices, partially offsetting the effects of
exchange-rate changes. Moreover, imported goods
are part of the consumption bundle whose price forms
the basis for union wage demands. Higher import
prices stemming from currency depreciation will
require higher nominal wage settlements to maintain
the same pattern of real wage gains. The increase in
labor costs would produce a deterioration in price
competitiveness. Since these secondary effects wiil
tend to offset (partly or fully) the impact of an
exchange-rate depreciation on the trade account, the
estimates presented here represent upper-bound
estimates of its effectiveness in reducing trade imbalances.
2. Thecause-and-effect relationship, as specified in
the basic model, runs from wholesale prices,
exchange rate and foreign competitor prices to export
prices. This chain of causation is necessary for
estimating the price equations, even though (according to purchasing-power parity) the predicated
cause-and-effect relationship runs from prices to the
exchange rate in a period of freely fluctuating rates.
4. Any general effects of capacity utilization on the
price •level should already be incorporated in the
Wholesale-price index. The use. of capacity utilization
in conjunction with wholesale· prices simply
measures Whether export prices respond differently
to the former than to the latter.
69
5.thecomposilion of Japanese imports within each
commodity category will differ from the product mix in
the International price index for that commodity.
Otherwise,the relationship would be an identity and
no coefficient estimates would be obtainable.
9. Exports-import movements are virtually the same
in fweign.currency as in yen. The trade balance in
forEligncurrency Improves following an exchangerat~changebetween the second and third quarters.
The <maximum improvement occurs during the fifth
quarter, where the rise In export value in foreign currency would be 5.8 percent, compared with a 3.2-percent decline in imPort value.
6. Since basic commodities account for most
Japanese Iroports, indlJstrial production would be a
mOre appropriate argument for import demand than
real GNP.A higher level of industrial output will
require .larger Inputs of raw materials, leading to
increased demand for imported commodities.
to. The Index is weighted by world export shares
instead of bilateral trade values. This reflects the
geographical distribution of Japanese trade. That is,
a~()lJt50percent of Japan's exports. go to the Far
East lind QPEC, as compared with a 4-percent share
taken by Germany. However, Japan faces considerablYrnOrecompetition from Germany in third markets
than dO other suppliers. As a consequence, the use of
bilateral-trade weights may seriously understate the
importance of exchange-rate movements between
two cOlJntries that specialize in the same goods but
do little trade with each other, such as Germany and
Japan. World-trade weights thus seem most appropriate for Japan.
7. In 1980, manufactured goods accounted for 90
percent of Japanese exports. As a reasonable
approximation, the estimated coefficient measuring
the effect$>of exchange-rate changes on manufactured-goods prices will be used to measure the passthrough of an exchange-rate change on aggregate
export prices.
8. The estimated pass-through of an exchange-rate
change into export prices was obtained by weighting
each one of the pass-through coefficients for
differel1!cofTlroogi!y . grolJp ings by their respective
share in Japanese exports.
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