Full text of Economic Review (Federal Reserve Bank of San Francisco) : Fall 1985, Number 4

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2

I.

R evision s in the “F lash” E stim ates o f G N P G rowth:
M easurem ent Error or Forecast E r r o r ? ............................... 5

Carl E. Walsh
II.

D ev elo p m en ts in B ritish Banking:
L esson s for R egu lation and S u p e r v is io n .......................... .14

Randall J. Pozdena and Kristin L. Hotti
III.

U . S. B u d get D eficits and the
R eal Value o f the D o l l a r ........................................................... 26

Michael M. Hutchison and Adrian W Throop

Editorial Committee:
Bharat Trehan, John Judd, Jack Beebe, Michael Keeley, Frederick Frulong and Ramon Moreno.

3

Carl E. Walsh*

This paper examines the Department of Commerce's "flash" estimate of real GNP growth. Differences between the flash and the
final real GNP figures are often large, but the flash is shown to
provide an unbiased forecast of the final GNP figure. Other preliminary estimates of GNP are also released by the Department of
Commerce, and these are shown to provide unbiased, but inefficient, forecasts of the final real GNP growth rate.

differed from the final growth rate by 3 percentage points or more in five of the thirty-two
quarters.
At times, the flash has even incorrectly signalled the direction of GNP growth. For example, the flash estimate of real GNP growth
in the first quarter of 1978 was a negative 1.3
percent, in contrast to the final figure of a positive 3.4 percent. This represented the second
largest difference between the GNP flash and
the final figure during the 1976-1983 period.
There are two alternative ways to view the
revisions shown in the chart. One approach is
to think of the flash estimate as equal to the
true, but as yet unobserved, growth rate, plus
some measurement error. This measurement
error could be due, for example, to the limited
data available at the time the flash estimates
were made. If, in a particular quarter, the measurement error were positive, then the flash figure would overstate the actual growth rate and
land above the final figure. If the error were
negative, the flash would be too low and fall
below the final. In other words, the flash estimates would be positively correlated with the
measurement error.
The second approach views the flash estimates as forecasts, as opposed to measures, of
the final figures. In such a case, the errors plotted in the chart are forecasting errors, rather

Fifteen days before the end of each quarter,
the Department of Commerce releases its
"flash" estimate of that quarter's economic activity, including the real GNP growth rate. 1
Even though these flash estimates are prepared
before the quarter is over, they are widely used
as early indicators of the current state of the
economy. The flash estimates are also used to
update and revise forecasts of future real GNP
growth and price inflation, although they are
frequently subject to large revisions. This paper
looks at whether the revisions to flash GNP
growth estimates are due to forecast or measurement error, since the type of error bears
directly on the usefulness of the flash for forecasting or policy analysis. 2
The differences between the actual growth
rate of real GNp3 and the flash estimate are
plotted in the chart for the period from the first
quarter of 1976 through the fourth quarter of
1983. While the average revision in the growth
rate was less than 1 percentage point, in comparison with the average actual GNP growth
rate of '2.9 percent over the period, the flash

*Senior Economist, Federal Reserve Bank of
San Francisco. I would like to thank Jean Bursan for research assistance.

5

than measurement errors, with properties that
distinguish them from measurement errors.
If a forecast has been based on all the relevant information available at the time it was
made, any forecast errors would arise only because of unpredictable events or developments
that were not incorporated into the forecast because they were, by definition, unpredictable.
Forecast errors therefore should have no systematic correlation with the forecast. If they
did, the forecast could have been improved by
taking the correlation into account. Forecasts
that are uncorrelated with their forecast errors
are called rational forecasts. If the flash estimate of GNP growth is a rational forecast, then
there should be no correlation between the
flash and subsequent revisions.
Interpreting revisions to flash estimates as
measurement errors or forecasting errors has
different implications for how the flash can best
be used in forecasting or policy analysis. For
example, suppose the flash estimate of the current quarter's GNP growth were used to help
forecast next quarter's GNP growth. The subsequent forecast error would depend, in part,
on the revision to the flash. If revisions are best
viewed as necessitated by measurement error,

the forecast error in predicting the next quarter's GNP growth will be correlated with the current flash since the flash is correlated with the
measurement error. This means that using the
flash produces forecasts that are systematically
in error and that do not use information efficiently; the forecasts will not be rational.
If, in contrast, the revisions to the flash estimates are themselves rational forecast errors,
this problem does not arise. Errors in predicting future real growth will still be affected by
revisions to the current flash, but because the
revisions are not correlated with the flash, no
systematic bias is introduced. Thus, if flash estimates are to be used to measure current economic activity, to forecast future prices or
output, or to forecast future Federal Reserve
policy actions, it is important to determine
which view of the errors is most appropriate.
This paper sets forth some recently proposed
tests for distinguishing between measurement
error and forecast error and applies these tests
to the flash estimate of real GNP growth. 4 Subsequent estimates of GNP, such as the preliminary, first revised, and second revised figures
are also released before the final figures are
published, and these data also are analyzed.

Chart 1
Difference Between Flash and Final
Growth Rate of Real GNP
Percentage Points

5
4
3

2
1

at--+-1

-2
-3 -1976
- -1977
- -1978
-................-1983
-..
1979
1980
1981
1982

6

The remainder of this paper provides a technical development of these points. In the first
section, the test for distinguishing between the
measurement error and rational forecast error
views is discussed. This test was originally proposed by Mankiw, Runkle, and Shapiro who
applied it to preliminary data on the money
stock and found that the differences between
final and preliminary money stock numbers are
best viewed as due to measurement error. Test
results using data on real GNP growth are presented in Section II.

The test results clearly support the view that
revisions to the flash, preliminary, and revised
real GNP growth estimates are forecast errors
and not measurement errors. They imply that
usi I1g the flash, and other preliminary estimates
of real GNP growth, for forecasting purposes
will not lead to the biases that would occur if
measurement error accounted for the revisions.
HQwever, some evidence is found that the revised real GNP growth estimates are inefficient
forecasts of final GNP growth in the sense that
they do not incorporate readily available information.

I. Analytical Framework
This section discusses the method that will be
used to test whether the revisions between final
and flash data are better characterized as measurement error in a classical errors-in-variables
model (EVM) or as forecast error in a rational
forecast model (RFM). The implications of using the flash data in forecasting applications are
briefly considered and shown to depend on
whether EVM or RFM is the true model.
To understand why it is important to distinguish between alternative interpretations of the
flash estimates, consider the use of flash estimates as an input into a forecast of future real
GNP growth. In general terms, suppose Xt is
the true value of some random variable (i.e.,
the growth rate of real GNP), and let x~ denote
a preliminary estimate of Xt. Suppose that one
wishes to forecast Xt +1using a model, estimated
from historical data, of the form

From equations 1 and 2, the error in forecasting
Xt + 1 can be written as
Xt +l - Xi+l = b(xt - xf) + lOt
(3)
Equation 3 shows how the error in forecasting Xt + 1 depends on the difference between Xt
and x~. The properties of the errors in the forecast of Xl + 1 will thus depend crucially on the
properties of Xt - x~. As demonstrated below,
the errors-in-variables model and the rational
forecast model make different predictions
about the potential presence of systematic bias
in the forecast error Xt +1 x~ +I'
Errors in Variables Model
Cast within the classical errors-in-variables
model (EVM)5, xP is viewed as equal to the true
value of X plus a measurement error, u, with
mean zero:

xi

(1)
xt + 1 = a + bX t + c Zt + lOt
where Zt is a vector of additional variables with
coefficient vector c, and lO is a random disturbance term. For the purposes of this illustration, the variables in Zt are assumed to be
known and uncorrelated with both xP and lO.
Since Xt is not yet known, suppose x~ is used in
its place in forecasting Xt + I. Letting x~ + 1 denote the forecast of Xt +1,
xi+ 1 = a + bxf + c Zt.
(2)

Xt + u t .

(4)

In this formulation, u and X are taken to be
uncorrelated. Consequently, xP and u will be
positively correlated. Thus, in equation 3, xt + 1
X~ +1 = - bUt + lOt and the covariance of
(Xt+1
X~+l) and x~ is - b(J~ =1= 0, where (J~ is
the variance of u. Using xP to forecast Xt+1
leads to forecast errors that are systematically
related to xp. This implies that x~ + 1 will be an
inefficient, and biased, forecast of Xt +I. 6 If x~

7

sence of such systematic errors. Hence, if xP is
a rational forecast, xP and v will be uncorrelated. Equation 3 shows that using xP to foreproduces
an
error
of
cast
Xt + 1
bV t + lOt that is uncorrelated with x~. In this
case, x~ is not systematically related to the error
in estimating Xt. A high x~ is just as likely to
underestimate as overestimate Xt. Consequently, no systematic error is introduced into
the forecast of Xt + 1.
Just as was done with equation 4, equation 5
can be viewed as a regression equation in which
the intercept is zero and the slope coefficient is
one. A more general version of equation 5 is

is high, it will tend to be so in part because of
a measurement error that is positive. Since x~
overestimates Xl>
+ I will also overestimate
Xt + 1. (This assumes b is positive.) The errors
in x P produce systematic errors in forecasting

xi

Xt +l'

Equation 4 can be viewed as a regression
equation in which the intercept term is equal to
zero and the slope coefficient on Xt is equal to
one. That is, we can write a more general version of equation 4 in the form

°

xf

=

a

+ bXt +

Ut

(4a)

where a = and b = 1 if equation 4 is the true
model. Under the null hypothesis that EVM is
the true model, x and u are uncorrelated. Thus,
we can estimate equation 4a by OLSO and test
the restrictions a = 0, b = 1.

Xt = a + bxf + Vt.
(5a)
Under RFM, a =
and b = 1. Since xP and v
are uncorrelated under RFM, equation 5a can
be estimated by OLSO and the restrictions on
a and b can be tested.
Mankiw, Runkle and Shapiro propose estimating both equations 4a and 5a and testing the
null hypothesis that the intercept is equal to
zero and the slope coefficient is equal to one in
each equation. For the money stock, they find
that the null hypothesis could be rejected for
5a but not for 4a. The preliminary money stock
appears, therefore, to be an example of classical errors-in-variables. In the next section, we
report the results of estimating 4a and 5a for
real GNP growth.

°

Rational Forecast Model
As an alternative to the errors-in-variables
model, suppose xP is a forecast of x. In the rational forecast model (RFM) , the difference between x and x P is a forecasting error that is
uncorrelated with the forecast xp . Thus, we can
write
(5)
where Vt is the forecast error. Any correlation
between v and xP would imply forecast errors
that are systematically related to the forecast,
and one property of rational forecasts is the ab-

II. Test Results
In this section, EVM and RFM are tested by
estimating equations 4a and 5a. Recall that under the errors-in-variables model (EVM), the
intercept should be zero and the slope coefficient one in a regression of a preliminary estimate on the final value. Under the rational
forecast model (RFM), the intercept should be
zero and the slope coefficient one in the reverse
regression of the final value on each preliminary estimate.
This test can be applied to the flash estimate
of real growth, and to subsequent estimates released by the Department of Commerce. In

fact, there are at least three subsequent estimates of GNP growth before the final values
are established, and the tests outlined above
can be applied to each.
The variables analyzed in this paper are defined in Table 1: y denotes the final real GNP
growth rate, while y(t) denotes an earlier estimate of y released t days after the end of the
quarter. Four estimates of the annual percentage growth rates of real quarterly GNP plus the
final figures are used, and the data are from
1976:01 to 1983:04. 7 The data are given in the
Appendix.

8

TABLE

1

Definitions
Yt( -15)

flash estimate of the percentage growth rate of real GNP from quarter t - 1 to
quarter t, expressed at an annual rate. This figure is released 15 days before the end
of
quarter t.
preliminary estimate, released 15 days after the end of quarter t.

Yt(45)

first revised estimate, released 45 days after end of quarter.

Yt(75)

second revised estimate, released 75 days after end of quarter.

Y,

final value of growth rate during quarter t, taken as the value reported as of July
1985.

TABLE

2

Tests of the Two Models 1
Errors-in-Variables Model
y(t)

a

+ by, where t = - 15, 15, 45, and 75
Test: a

0, b = 1

Intercept

Dependent Variables

y

F

M.S.2

1.

y( -15)

-0.030
( 0.37)3

0.735
(0.07)

11.00

.0003

2.

y(15)

-0.036
( 0.39)

0.815
(0.07)

4.79

.016

3.

y(45)

-0.052
( 0.33)

0.874
(0.06)

3.26

.052

4.

y(75)

0.255
( 0.32)

0.875
(0.06)

2.35

.113

Rational Forecast Model
y= a + by(t) , t = -15, 15, 45, and 75
0, b = 1
Test: a
Intercept
5.

0.634
(0.43)

6.

0.602
(0.42)

7.

0.431
(0.34)

8.

0.095
(0.34)

y( -15)

y(45)

y(15)

y(75)

1.081
(0.10)
0.990
(0.09)
0.996
(0.07)
1.006
(0.07)

F

M.S.

2.69

0.085

1.29

0.289

1.02

0.371

0.082

0.921

1. Sample period is 1976:01-1983:04.
2. The Marginal Significance level is the probability of observing an F-statistic greater than or equal to the reported
value.
3. Numbers in parentheses are standard errors.

9

Rows 1-4 in Table 2 present the results of
testing the EVM for preliminary real GNP
growth estimates. For the flash, y( -15), and
the preliminary, y(15), the hypothesis that a =
0, b = 1 can be rejected at the 5 percent significance level. The hypothesis that a
0, b =
1 for the first revision, y(45), can be rejected at
the 6 percent level. For the second revision,
y(75), however, the F value is 2.35 with a marginal significance level of 11.3 percent. Except
for y(75), the data clearly reject the errors-invariables interpretation of early estimates of
the growth rate of real GNP. The failure to reject EVM for y(75) is perhaps explained by the
fact that revisions between y(75) and yare
small, which suggests that the power of the test
may be low.
Rows 5-8 of Table 2 present the tests of
RFM. In striking contrast to the results for
EVM, the hypothesis that the preliminary announcements of GNP growth are rational (unbiased) forecasts cannot be rejected at the 5
percent level of significance for any of the GNP
estimates. Unlike the results for preliminary
money stock numbers reported by Mankiw,
Runkle and Shapiro, the preliminary real GNP
numbers seem to be rational forecasts of the
final rate of growth in GNP.
In addition to being viewed as an estimate of
the final growth rate of real GNP, the flash is
also viewed as an estimate of subsequent estimates of GNP growth. Thus, we investigated
whether the flash is better represented as a rational forecast of subsequent revised estimates
or as equal to future estimates plus some measurement error. The EVM regressions of
y( - 15) on each subsequent revised estimate of
yare given in the top half of Table 3. The null
hypothesis under EVM can be rejected in each
case. The lower half of Table 4 presents the test
statistics under the RFM. At the 5 percent significance level, the hypothesis that y( -15) is a
rational forecast of y(15) and y(45) cannot be
rejected. It can be rejected, however, for y(75).

inary GNP growth rate estimates. These results, however, do not shed much light on the
efficiency of the preliminary estimates as forecasts of the final growth rate (a forecast is efficient if it correctly incorporates all relevant
information). If x~ is an efficient estimate of Xl'
then the prediction error Xl - x~ should be uncorrelated with any information available at the
time x~ is formed. In a regression of Xl - x~ on
known information, all the coefficients should
be zero.
The hypothesis that preliminary announcements of real GNP growth are efficient forecasts implies, at a minimum, that the prediction
error of each estimate should be uncorrelated
with earlier revisions in the estimate. For example, y
y(75) should be uncorrelated with
y(75) - y(45), y(45) - y(15), and y(15) y( - 15). Similarly, y - y(45) should be uncorrelated with y( 45)
y(l5) and y(15) y( -15), while y - y(15) should be uncorrelated with y(15) - y( 15). These hypotheses
are tested in Table 4.
The hypothesis that y - y(15) is uncorrelated
with y(15)
y( -15) clearly cannot be rejected. However, the hypotheses that y - y(45)
and y - y(75) are uncorrelated with earlier revisions is rejected by the data. Rows 2 and 3 of
Table 4 show that y
y(45) and y - y(75) are
related to the difference between both the first
revised and the preliminary estimates, y(45)
y(15), and the preliminary and flash estimates,
y(15)
y( -15). If the first revision, y(45),
shows one percentage point more estimated
GNP growth than did the preliminary estimate,
y(15), i.e., y(45) - y(15)
1 in rows 2 and 3,
then both the first and second revised estimates, y(45) and y(75), will tend to underestimate the final growth rate, y, by 1.1 percentage
points. This evidence of inefficiency is consistent with the earlier results which showed both
y(45) and y(75) to be rational forecasts of y.
Table 2, for example, shows that the unconditional expectation of y - yet) is zero for t =
45, 75. Table 4, however, shows that the expectation of y yet), conditional on y(45) - y(15)
and y(15)
y (-15), is not zero. Hence, these
estimates do not use all prior information as
efficiently as possible.

Efficiency of Forecasts

The bulk of the evidence from Tables 2 and
3 favors the RFM interpretation of the prelim10

numbers provide unbiased forecasts of the final
figures. Although the revisions that are subsequently made to the flash are often quite large,
the problems that would occur if these revisions
were due to measurement error do not apply.

The results reported in this paper support the
view that the flash, and other early estimates of
real GNP growth, are rational forecasts of actual GNP growth. Generally similar conclusions apply to estimates of the percentage
change in the GNP Price Deflator. 8 The flash

3

TABLE

The Flash and Subsequent Estimates*
Errors-in-Variables Model
15) = a + by(t), t = 15,45,75
Test: a = 0, b = 1

y(
Intercept
1.

0.033
( 0.16 )

2.

0.003
( 0.22 )

3.

-0.246
( 0.25 )

y(45)

y(15)

y(75)

0.889
(0.03)
0.845
(0.05)
0.841
(0.05)

F

M.S.

6.42

.005

7.99

.0023

10.53

.0003

Rational Forecast Model
y(t) = a + by( -15), t = 15, 45, 75
Test: a = 0, b = 1
Dependent
Variable

Intercept

y( -15)

F

M.S.

4.

y(15)

0.067
(0.18)

1.076
(0.04)

2.69

.084

5.

y(45)

0.192
(0.25)

1.090
(0.06)

2.82

.075

6.

y(75)

0.535
(0.27)

1.075
(0.06)

4.98

.014

* See notes to Table 2

TABLE

4

Tests of Efficiency*
Test that all coefficients are zero
Dependent
Variable

Intercept

1.

Y

y(15)

0.646
(0.37)

2.

Y - y(45)

0.390
(0.27)

3.

y - y(75)

0.098
(0.30)

y(75) - y(45)

F

M.S.

-0.297
(0040)

0.559

.461

1.082**
(0.39)

-0.601 **
(0.29)

4.972

.014

1.114**
(0.38)

-0.622**
(0.28)

3.89

.019

y(45) -y(15)

-0.056
(0048)

* See notes to Table 2.

** Significantly different from zero at the 5% level.

11

y(15)

y(

15)

APPENDIX
TABLE A.1

Estimates of Percenta.ge Change
in Real GNP (Annua.l Rates)*
y( -15)
1976:1
1976:2
1976:3
1976:4
1977:1
1977:2
1977:3
1977:4
1978:1
1978:2
1978:3
1978:4
1979:1
1979:2
1979:3
1979:4
1980:1
1980:2
1980:3
1980:4
1981:1
1981:2
1981 :3
1981:4
1982:1
1982:2
1982:3
1982:4
1983:1
1983:2
1983:3
1983:4

5.0
3.6
3.8
3.2
4.4
6.4
5.2
3.5
-0.3
6.0
4.2
5.8
1.4
1.9
2.5
1.7
2.3
-9.2
-0.5
3.7
5.5
0.0
0.5
-5.4
-4.4
0.6
1.5
-2.2
4.0
6.6
7.0
4.5

y(15)

y(45)

6.4
5.0
3.9
2.9
5.5
6.3
3.9
3.9
0.5
6.3
4.3
6.9
0.8
-2.7
3.5
1.6
1.5
-9.8
0.5
5.0
6.5
1.9
-0.6
-5.2
3.9
1.7
0.8
2.5
3.1
8.7
7.9
4.5

7.3
4.9
3.7
2.3
6.5
6.0
4.9
3.6
0.6
6.9
4.3
7.2
0.4
-1.8
4.5
2.3
1.0
-9.8
0.3
4.0
8.4
-2.4
0.6
-4.7
-4.3
1.3
0.0
1.9
2.5
9.2
7.7
4.8

y(75)
7.5
5.1
3.8
2.5
7.1
6.0
5.2
3.5
1.0
7.6
3.5
7.7
0.8
-1.8
4.1
2.2
1.6
-10.3
2.4
3.8
8.6
-1.6
1.4
-4.5
-3.7
2.1
0.7
-1.0
2.6
9.7
7.6
5.0

Y
9.1
2.7
2.3
3.7
8.9
6.7
6.8
0.8
3.4
11.0
3.3
5.5
1.1
-0.9
4.8
0.7
1.9
-9.0
0.8
3.8
10.0
-0.5
2.8
-5.4
-4.7
-0.8
-0.9
0.5
3.3
9.4
6.8
5.9

'Variables are defined in Table 1 of the text. Source: Department of Commerce, Bureau of Economic Analysis.

FOOTNOTES
1. The second revised estimate of GNP growth in the previous quarter is released at the same time.

(a~ + a5) is equal to the coefficient b corrected for the ratio
of the variance of x to the variance of xp •

2. For a somewhat skeptical view of the usefulness of the
flash, see "A Flash in the Pan," Morgan Economic Quarterly, September 1985.

7. The flash estimates have been prepared by the Bureau
of Economic Analysis, Department of Commerce, since the
mid-1960s. Prior to 1976, the data as originally released is
not consistent with the current definition of GNP because
of the re-benchmarking of the National Income and Product
Accounts in January 1976.

3. "Final" or "actual," refers here to the values reported
as of July 1985.
4. Similar tests were carried out for the GNP Price Deflator
and the results are described in footnote 8.

8. Results for the percentage change in the GNP Price
Deflator were similar to those for real GNP growth. EVM
could not be rejected at the 5% level only for the first revised estimates. However, no evidence of inefficiency was
found for the inflation estimates.

5. For a general discussion of the errors-in-variables
model, see E. Maiinvaud,Statistical Methods of Econometrics (North Holland, 1970), chap. 10.
6. The unbiased forecast of xt + 1 , conditional on x~ and
metrics (North Holland, 1970), chap. 10.

Zt'

12

TABLE A.2
Estimates of Percentage Change
in GNP Price Oeflator (Annual Rate)**
p( -15)
4.0
4.4
5.0
6.4
5.7
6.5
5.4
6.6
7.5
8.4
7.4
8.9
9.1
9.8
8.2
8.6
10.2
9.7
10.1
12.1
8.3
6.2
9.3
8.3
4.5
5.0
6.6
4.4
4.5
4.3
3.5
4.2

1976:1
1976:2
1976:3
1976:4
1977:1
1977:2
1977:3
1977:4
1978:1
1978:2
1978:3
1978:4
1979:1
1979:2
1979:3
1979:4
1980:1
1980:2
1980:3
1980:4
1981:1
1981:2
1981:3
1981:4
1982:1
1982:2
1982:3
1982:4
1983:1
1983:2
1983:3
1983:4

p(15)

p(45)

p(75)

3.7
5.0
4.4
6.5
5.6
7.1
5.3
6.6
6.8
10.7
7.4
8.6
8.6
9.1
7.9
8.3
9.4
9.3
9.7
11.7
8.4
5.9
9.4
7.9
3.5
5.4
5.4
4.2
6.0
4.8
3.7
4.1

3.6
5.4
4.2
6.0
5.5
7.5
5.1
6.6
6.8
11.5
7.5
8.6
8.8
8.6
7.7
8.2
9.2
9.5
10.5
11.2
10.9
6.5
9.6
8.9
3.4
4.9
4.7
3.6
5.8
3.8
3.5
4.4

3.7
5.5
4.5
6.0
5.7
7.6
5.1
6.3
6.8
11.8
7.2
8.7
8.9
8.7
8.3
7.9
9.4
9.5
9.4
11.1
10.6
6.3
10.0
9.1
3.7
4.7
5.1
3.6
5.7
3.6
3.9
4.1

P
3.9
3.8
5.1
6.7
5.9
7.1
6.3
6.5
5.5
12.0
9.0
9.7
8.7
8.4
8.8
7.4
9.8
9.9
8.9
11.7
12.1
6.5
10.3
7.9
4.4
5.5
3.4
3.4
5.2
2.9
3.3
4.7

**Variables are defined analogously to those in Table A.l (i.e., p( -15) is the flash estimate of p). The percentage
change in the GNP Price Deflator was obtained by subtracting the change in Constant Dollar GNP from the change in
Current Dollar GNP.

REFERENCES
Malinvaud, E. Statistical Methods of Econometrics. North
Holland, 1970.
Mankiw, N. Gregory, David E. Runkle, and Matthew D.
Shapiro. "Are Preliminary Announcements of the
Money Stock Rational Forecasts?" Journal of MonetaryEconomics, 14(1) (July 1984).
Trevor, Robert G. Rational Expectations and Economic
Modeling: Four Essays in Macroeconomics and International Finance. Unpublished Ph.D. dissertation,
Princeton University, 1985.

13

Randall J. Pozdena and Kristin L. Hotti*
The British banking system has experienced significant stress in
the last decade or so. In this paper, the authors examine the sources
of this stress and study the reaction of British banking policy to
these changes. Like their American counterparts, the British are
striving to maintain a stable banking environment in the face of
increasing competitive pressures.
The purpose of this paper is to examine the
recent changes in banking policy that have occurred in the kindred financial system of the
United Kingdom. Despite many similarities,
British and American banking policy differ significantly in the ways they achieve financial stability as well as in their impacts on the efficiency
of their respective banking systems. In particular, British policymakers historically have relied more heavily on "self-regulation" by the
banking industry, and have tolerated pricing
cartels and restrictions on entry. The high levels
of concentration in the British banking sector
also facilitated a supervisory approach that,
while more informal than that practiced in the
United States, was also more intimate. Furthermore, the British approach involved banks
more directly in national economic policy initiatives.
By the 1970s, British policy had stimulated
the growth of nonbank competition that was
undiversified and entirely unsupervised by any
regulatory authority. The failure of these fringe
institutions precipitated a crisis of confidence
that threatened the entire British banking system.
The British experience illustrates the
strength of natural competitive forces, particu-

During the last two decades, the economic
and technological environment in which financial institutions operate has undergone important changes. Improved communications,
electronic data processing and a volatile economic environment have combined to challenge the extant structure of the financial
industry and its supervision and regulation by
banking authorities. In the United States, these
developments have resulted in the creation of
new nonbank competitors, essential elimination of deposit rate regulation, and weakened
prohibitions against interstate banking activity.
They have also contributed to serious strains
on and loss of confidence in portions of our
financial system.

*Senior Economist and Research Associate, respectively, Federal Reserve Bank of San Francisco. The authors wish to thank the Editorial
Committee for its assistance and extend a special thanks to Mr. David Germany and Emeritus Professor J. S. G. Wilson for their helpful
comments. Any errors of fact or interpretation
are the authors' responsibility. We also wish to
thank the staff of the Bank of England and the
British Information Service.

14

larly in an environment where implicit central
bank protection is provided asymmetrically to
various financial institutions and bank restrictions on entry and portfolio composition exist.
This interpretation is supported by recent
changes in British banking policy that would
appear to be moving Britain toward a system
with relatively free entry, but also one with

more intensive supervision and examination of
financial institutions.
We turn now to a brief review of the evolution of the British banking structure. This discussion is followed by an analysis of current
efforts to reform banking policy. The paper
concludes with a brief summary and interpretation of recent events in British banking.

I. The Structure and Evolution of the British Banking System
their subsidiaries. 4 It was not until relatively recently that British banking policy addressed the
problems stemming from this market structure.
Historically, the Bank of England only gradually assumed the supervisory and regulatory
functions of a modern central bank. The concentrated nature of the clearing bank industry
fostered the development of a supervisory system that was informal and therefore flexible.
Moreover, within this system, the Bank of England may have benefitted from according the
clearing banks a privileged competitive position
in exchange for their cooperation in carrying
out the Bank's monetary and other policy objectives. 5
The concentrated character of the clearing
bank industry is due to a history of legislative
barriers to entry imposed to a significant degree
by the Bank of England. As a result of these
barriers, very few new banks formed after the
mid-19th century.6 Instead, there was a period
of extensive amalgamation of smaller banks.
Protected from competition from new banks,
competition between existing banks took the
form of rapid branching.
Through the first half of this century, the
Bank of England essentially ignored the effects
of the clearing bank cartel's collusive pricing
and monopoly of the clearing mechanism on
the British banking industry, including the possibility that the clearing banks enjoyed supranormal profits. 7 The quid pro quo of this
arrangement was that the banks would comply
with the Bank of England's "requests" regarding monetary and other policy objectives without requiring explicit, formal regulation. 8
Supervision of the clearing banks was likewise simplified due to the concentration of the

Examining the evolution of British banking
institutions in the context of changing economic
policy illustrates how regulation, market structure, and the performance of the banking system interacted in a way that resulted in
considerable instability. The following discussion does not attempt to encompass the range
of institutions making up the British banking
system, but rather, focuses on those banking
entities salient to the main issues of this paper.
These entities include the "clearing banks"
(roughly analogous to U.S. commercial banks),
the "building societies" (resembling mutual
savings banks in the U.S.), and, finally, the
fringe group of bank-like financial organizations known as the "secondary banks." Together, these three groups account for over 75
percent of total deposits in the U. K., although
they do face some competition from various
other British banking institutions. 1
The London Clearing Banks

Before the early 1960s, clearing banks were
overwhelmingly the most important providers
of demand deposits in the British banking system. They continue to control about 35 percent
of total U.K. deposits, and are active in both
commercial and consumer lending. 2 The group
derives its name from its exclusive ownership
and control of the nation's major funds transfer
and check clearing system. 3 This privilege has
restrained competition from other institutions
for checkable deposits, or "current accounts"
as they are known in the U.K.
The clearing bank industry historically has
been highly concentrated. Indeed, today, only
4 major London banking groups own or effectively control almost all the clearing banks and

15

to new industrial centers. They were then, and
remain today, "mutual societies" in that most
of their liabilities take the form of "shares."
This arrangement leaves management authority, at least in concept, in the hands of depositors. 11 Since their formation, they have been
viewed by British policymakers as a mechanism
for promoting and financing home ownership
in the United Kingdom. Their assets have consisted, therefore, primarily of mortgage loans.
Competition within the building society industry has been more vigorous than that among
clearing banks throughout the societies' history.
A cartel was formed in the 1930s to stabilize
the industry, but after some 50 years of operation, the maverick behavior of members disabled its effectiveness; the cartel was
dismantled in 1984. 12 However, the number of
building societies in the U.K. has fallen sharply
since the turn of the century and market share
has become increasingly concentrated in a few
firms from a five-firm concentration ratio of 39
percent in 1930 to 55 percent in 1983. The larg~
est society now has over 20 percent of total industry assets. However, unlike the case of the
clearing banks, the building society sector did
not face significant barriers to entry. Consequently, some 210 institutions exist today with
extensive branch networks throughout the
United Kingdom.
Overall, the building societies played a relatively minor role in the British financial industry until the 1950s and 1960s when reform of
the tax treatment of owner-occupied housing
increased the demand for residential mortgages. The combined effect of increased residential mortgage demand, tax advantages, and
an ability to compete for deposits at competitive rates then stimulated rapid growth in building societies. Their share of total deposits
relative to the clearing banks rose from less
than 30 percent in 1955 to almost 90 percent in
1985.
Unlike their American analogs in the thrift
industry, British building societies were not
subject to Regulation Q-type deposit rate ceilings. They were thus able to pay shareholders
and depositors returns consistent with those enjoyed elsewhere in the marketplace. The clear-

industry. No explicit legislation regarding bank
supervision was perceived to be necessary given
the overall stability of the industry. Instead, the
Bank generally relied on "moral suasion" to influence the clearing banks, as well as the implicit threat of refusing to maintain a bank's
account. Consequently, supervisory efforts consisted of relatively informal discussions with
senior management about the nature and quality of its business, including its management,
and an annual review of the banks' accounts. 9
Before 1979, Britain lacked an equivalent to
U.S. deposit insurance. However, clearing
bank control of the nation's funds transfer and
clearing mechanism, the general intimacy between the Bank of England and the clearing
banks, and several historical precedents contributed to the general perception that, in the
event of a major financial crisis, the Bank
would step in to uphold the continued operation of the clearing banks.
Until the early 1960s, the British banking system was highly concentrated and dominated by
a cartel of clearing banks enjoying oligopolistic
benefits. This situation resulted in a banking
industry that, for many years, was stable and
easy to control from the point of view of the
Bank of England. 10 However, during the 1960s
and 1970s, a number of interrelated factors upset the status quo and jeopardized the stability
of the system. In the postwar era, restrictions
on the dearing banks, including lending and
interest rate ceilings and portfolio restrictions,
in combination with rising interest rates and a
higher standard of living resulted in the emergence of lucrative banking opportunities for
other institutions. Consequently, despite the
relatively protected status of the clearing
banks, competition emerged from several quarters.
Building Societies
At present, building societies comprise important competition for the clearing banks,
controlling some 33 percent of total deposit liabilities. They were formed during the industrial revolution to provide a mechanism for
financing the home purchases of workers drawn
16

lending to individuals or to property interests,
hoping thereby to channel investment into the
industrial sector. Meanwhile, post-war personal
income was rising and generating more demand
for consumer goods. The secondary banks
emerged during this time to exploit the new
lending markets. In general, they engaged in
activities such as the finance of auto and household goods purchases and equipment leasing to
businesses. They freely obtained deposits from
the newly developing wholesale money markets. And generally higher market interest rates
combined with interest ceilings on clearing
bank deposit accounts induced depositors to
seek higher yielding deposit alternatives from
them.
By the 1960s, as lending and other restrictions continued to handicap the clearing banks,
the secondary banking sector presented increasingly strong competition. However, the
rapid development of this fringe banking sector, generated by restraints elsewhere in the industry, introduced elements of risk that
threatened the traditional stability of the British banking system.
First, these institutions were largely undiversified, lending only to the narrow sectors to
which they had access. Consequently, these
banks were left with more risky activities and
engaged in more speculative ventures than the
clearing banks had been wont to do. Whereas
the clearing banks had traditionally eschewed
investment in equity shares of other companies,
the new financiers participated actively in holding and dealing in shares, takeover activities
and investment management.
A second element of risk stemmed from the
complete lack of supervision of these institutions. Growth in this new banking sector occurred so rapidly that the supervisory scope of
the Bank of England was not expanded to incorporate it. Neither were codified standards of
prudential management proposed. 13 Finally,
unlike the clearing banks, there was no entity
to function as a lender of last resort to the secondary banks; the money placed through the
wholesale markets was (and is) entirely unsecured.

ing banks had tied rates of interest paid on noncheckable deposits to the Bank rate, which was
frequently lower than rates paid elsewhere.
The building societies also received more favorable tax treatment than the clearing banks
in that depositors received their interest on an
after-tax basis. The tax on interest earnings was
paid at a so-called "composite" rate by the
building society, thus no further tax obligation
was incurred by resident depositors. Since the
composite rate, historically, has been lower
than the very high marginal personal tax rates
in the U.K., building societies were very attractive to retail depositors. In addition, the societies have been insulated somewhat better
from interest rate and credit risk than their
American counterparts because of their policy
of making adjustable rate mortgage loans and
government policies which provide funds for
mortgage payments to the unemployed. Building societies are supervised by the "Chief Registrar of Friendly Societies."
Despite relative advantages such as the ability to pay market rates of interest and preferential tax treatment, the extent to which the
building societies were able to compete with the
clearing banks has been restrained. Restrictions
on the composition of building society assets
did not permit deposit account overdrafts-a
major mechanism in the British system for
making loans-and thereby precluded societies
from offering "checkable" current accounts. In
addition, the clearing banks' monopoly of the
clearing and settlement mechanism has also
impeded building societies from offering effective competition.
The Secondary Banking Sector
The fringe financial institutions in the British
banking system, frequently referred to as "the
secondary banks", did not become important
until the post-war period when restrictions on
clearing banks induced the development of
other institutions to take advantage of new and
unexploited banking opportunities in the then
generally favorable economic climate.
During the 1950s and early 1960s, the Bank
of England discouraged clearing banks from

17

tighter monetary policy that raised interest
rates.
The resulting fear of the effects of higher interest rates on asset valuations of property companies and their creditors, as well as fear of a
rent freeze and a new development tax, generated considerable uncertainty in the property
market. In late 1973, a sizeable finance company collapsed and sparked a crisis in confidencein the secondary banking sector. The
incident initiated a flight of funds from the unprotected fringe to what was perceived as the
"safe haven" of the clearing banks. 16
The Bank of England recognized the need to
prevent the secondary bank crisis from affecting the banking system proper and stepped in
to initiate a rescue operatiorl named "the Lifeboat".17 The Bank backed a group of clearillg
banks in essentially "recycling" deposits (originally withdrawn from the secondary banks)
back to illiquid fringe institutions. By 1974, the
number of troubled institutions had multiplied
as a result of the collapse of property values.
As the security (property) behind their lending
melted away, these institutions' debts mounted,
often at increasing interest rates. Consequently,
the overall cost of the lifeboat operation to the
Bank of England and the clearers was considerable. 18

The Crisis

In 1971, the Competition and Credit Control
policy was introduced that loosened many of
the lending restrictions on clearing banks. This
act encouraged the clearing banks to compete
with other financial institutions as well as
among themselves in previously restricted markets at competitive interest rates. The Bank of
England had expected the number of fringe financial institutions to contract under this increased competition and thereby free more
investment credit for industrial uses. Overall
lending did skyrocket as a result, but the clearing banks also began to compete with the secondary banks for lucrative property
development and other lending markets. By
mid-1972, the clearing banks were once again
restricted from lending in the property market.
Their competition, however, had forced the unsupervised fringe banks to extend themselves
even farther into property markets and other
more speculative dealings. 14
When the ensuing monetary boom began to
manifest itself in rising inflation rates in 1973,
the Bank of England abandoned the Competition and Credit Control policy, re-imposed interest rate ceilings, and introduced a form of
noninterest-bearing reserve requirement on the
clearing banks. IS The Bank also pursued a

II. Directions of Change in British Banking
Events in the early 1970s, including the secondary banking crisis, revealed two basic flaws
in this strategy. First, the lack of complete coverage of portfolio and entry restrictions and supervisory authority resulted in an inability to
protect the clearing banks from competition
from building societies and other non-bank deposit takers ("the secondary banks").2o Second,
as a consequence, the hoped-for protection of
the banking system from the destabilizing effects of excessive risk-taking on the part ()f individual financial institutions was not realized.
Indeed, the coexistence of an implicitly protected clearing bank sector and an unprotected
secondary banking sector actually may have exaggerated the flight of deposits from the sec-

We have discussed how a history of policy
decisions contributed to the concentrated and
segmented nature of the British banking industry. British policy makers, like their American
counterparts, have attempted to achieve a
workable balance between soundness and vigorous competition within the banking industry,
assuming that vigorous competition alone
would lead to socially excessive levels of risktaking. 19 The British historically have maintained this balance by restricting entry into
commercial banking, permitting coordinated
pricing and by tolerating the high concentration
of banking activity in a relatively few institutions with which the Bank of England had a
productive, albeit informal, relationship.

18

dustry had expressed much interest in deposit
insurance. They relied instead on credit controls and rate-setting cartels in the building society and banking sectors to control potentially
destabilizing risk-taking.
However, as discipline in the building society
cartel deteriorated, the Building Societies Association independently devised a Voluntary
Depositor Protection Scheme to protect the industry from associations with individual societies weakened by excessive risk-taking. The
voluntary depositor protection scheme covers
100 percent of all deposits and 90 percent of all
shares in participating institutions. As of 1984,
over 80 percent of all building societies were
participating in the deposit insurance scheme,
with the result that over 95 percent of all shares
and deposits in the building society industry enjoyed protection. 22
The Banking Act had specified that banks
and other licensed deposit-takers be subject to
a compulsory deposit insurance plan. This plan,
which took effect in 1983, has features similar
to the programs administered by the Federal
Deposit Insurance Corporation (FDIC) and the
Federal Savings and Loan Insurance Corporation (FSLIC) in the United States. 23 It differs,
however, in several important respects. First,
the Compulsory Depositor Protection Scheme
insures only 75 percent of a depositor's funds
up to a maximum of 10,000 pounds sterling.
Thus, unlike its American counterparts, the
scheme is designed to provide protection only
for small depositors and, even then, to provide
them with an incentive to maintain active personal surveillance of financial institutions, since
less than 100 percent of their deposits will be
recovered in the event of failure.
Second, the depositor protection scheme is
designed to function only as a first line of defense against capricious runs initiated by unsophisticated investors. The Bank of England
and the clearing banks remain de facto, if not
de jure, the main sources of emergency liquidity
in the British banking system. Indeed, the
clearing banks opposed the creation of the
Compulsory Depositor Protection Scheme precisely on the grounds that it afforded them no
relief from their responsibilities but required

ondary banks to the clearing banks that
necessitated the "lifeboat" operation in 1973.
In this section, we examine the modifications
in policy that have been used to redefine the
balance between soundness and competition in
British banking markets.
Changes in Supervisory Policy

After the initial responses to the secondary
banking crisis-abandoning Competition and
Credit Control policy and imposing other restrictive policies-British policymakers sought
legislation to extend the supervisory authority
of the Bank of England to cover the previously
unregulated, secondary banking sector. They
achieved the extension with the passage of the
Banking Act of 1979. The Act extended the
supervisory authority of the Bank of England
to all deposit-taking institutions, with the exception of Building Societies, which remained
under the aegis of the Registrar of Friendly Societies. All depository institutions thus were required to meet minimum managerial and
financial requirements and to file periodic statementsof condition with the Bank of England.
This change represented a significant increase
in the· extent and formality of bank supervision
by the Bank of England, although by American
standards, supervision remains relatively
tnild. 21
The Banking Act of 1979 also sought to reemphasize the distinction between clearing
banks and other banking sectors by creating a
new category of institutions called "Licensed
Deposit Takers." This classification embraced
most of what we have referred to above as secondary banking institutions. The rationale for
re-emphasizing this distinction was that, in the
public's mind, a true "bank" had come to be
regarded as an institution that enjoyed a special
and protected relationship with the Bank of
England. Indeed, given the historical exclusivity enjoyed by clearing banks, such perceptions
were probably not unrealistic.
In reaction to the events of the 1970s, British
policymakers also increased pressures to institute deposit insurance as a bulwark against runs
on deposit-taking institutions. Prior to the
1970s, neither government nor the financial in19

them nevertheless to be major contributors to
the insurance fund. 24 In recent policy papers on
the Building Society industry, it has been recommended that the Compulsory Depositor
Protection Scheme currently in place be extended to the building society sector to replace
its current voluntary plan.
In summary, the debut of deposit insurance
and the extension of the Bank of England's supervisory authority represent a move toward
less reliance on self-regulation and competitive
restraint as the means of bringing stability to
the U.K. banking system. Supervisory mechanisms remain pro forma, however, in comparison with the procedures followed in the United
States. In addition, the features of the Depositor Protection Scheme (the low insured maximum and investor co-insurance) suggest that
British authorities still regard industry self-regulation, investor prudence and a strong clearing
bank sector as the main lines of defense against
financial instability.

has operated successfully for a specified period
oftime , subject to approval by the Bank of
England.. (The British operations of a foreign
bank automatically are eligible for retail bank
status if they belong to a bona fide bank in their
home country.) This time provision represents
a relaxation of former barriers to entry into the
demand deposit-taking, retail banking sector.
Current statistics of the Bank of England identify 140 institutions in the retail banking sector,
including in addition to former nonbanks, the
clearing· banks and subsidiaries of foreign
banks. 25
A second, and perhaps more important,
concession to clearing bank competitors is the
granting of access to the Bankers' Clearing
House to entities other than the handful of original clearing banks. A bank may gain access to
the Clearing House if it can demonstrate that
it handles one percent or more of total daily
payment volumes (that is, checks and electronic
funds activity). Access to the clearing house is
particularly important for institutions wishing
to compete economically with the clearing
banks for demand deposit ("current account")
and credit card customers. The U.K. representatives of large foreign banks have been the first
to seek access to clearing facilities. Lack of such
access-as well as the difficulty of establishing
de novo a branch system to rival the extensive
networks of the clearing banks-may explain
the difficulty foreign banks have had in competing with clearing banks, despite their perception of the market as a profitable one and
the availability of considerable resources from
their overseas parents.
The third major area of reform involves the
role of the building societies. Building societies
have been, and are likely to remain, the main
source of increased competition for clearing
banks. Unlike foreign banks and secondary
banks, the building societies have long-established and extensiv~ branch networks throughout the United Kingdom. The largest building
society has nearly 1,000 branches, and the
roughly 200 societies in existence have roughly
7,000 branches in total throughout the U.K.
This long reach provides the building societies

Addressing the Competitive Balance

The new supervisory and insurance measures
signal a recognition on the part of British policymakers that the forces of competition frequently regarded as potentially destabilizing in
banking markets are difficult to suppress. In
some ways, the clearing banks' loss of market
share to building societies and the secondary
banking sector in the 1960s and 1970s and the
Secondary Banking Crisis were to British policymakers what the cycles of disintermediation
and growth of money market mutual funds and
other "nonbanks" were to U.S. policymakers
in the same time period. Both sets of events
alerted policymakers to the strength of the
forces of financial innovation and the weakness
of extant regulatory devices. In the U. K., this
change in policy perception is manifested in a
number of significant changes in the competitive "playing field" of British banking.
First, the Banking Act of 1979 provides a
mechanism by which a nonbanking institution
may formally enter the retail banking business.
The institution may become a retail bank, and
use the word "bank" in its corporate title, if it

20

a geographically diversified clientele, familiarity with local credit needs and conditions, and
name. recognition not enjoyed by clearing
banks' other potential competitors. 26
Public policy toward building societies is
moving rapidly toward giving them the same
treatment as banks. In 1983, for example, legislation was passed giving building societies
greatly improved access to wholesale deposit
markets. In addition, a variety of proposals
made by the Chancellor of the Exchequer to
the Parliament in 1984 would give building societies certain powers now only enjoyed by
banks. Under the proposals, expected to become law in 1987, building societies would, for
example, be able to invest up to 10 percent of
their assets in commercialloans. 27
In addition, most of the current restrictions
on the provision of money transmission services
by the building societies would be removed, allowing them to offer, for example, point-of-sale
electronic debit services, automated funds
transfer on behalf of customers between institutions, check guarantee cards, and other services. Relieving them from these restrictions
would substantially eliminate the competitive
disadvantage building societies have faced by
being unable to offer true demand deposit services. 28 In addition, it has been proposed that
building societies be permitted to sell insurance
products and offer real estate brokerage services in addition to their traditional product
lines.
While giving societies certain bank powers,
public policy also is eliminating the preferential
tax treatment building societies have enjoyed.
The preferential treatment of building societies

under corporate tax law, for example, in essence will have been eliminated by this year. 29
The asymmetric treatment of interest paid to
depositors at building societies versus banks,
which many argued worked to the competitive
advantage of the building societies, also was
phased out this year. 30
Building societies and banks already are responding to the existing and pending changes
in their competitive environment. Building societies formally abolished their interest-rate
cartel in 1984,andare now competing more
vigorously among themselves and with the
banking sector for deposits and mortgage assets. 31 The building societies also have begun
to explore the use of a shared automated teller
machine (ATM) network that could be expanded to allow depositors to pay bills or transfer funds. Some of the clearing banks also have
hastened to establish correspondent relationships with the building societies. Through
"sweep" -type arrangements with clearing
banks, the building societies can provide checking services to their customers.
The clearing banks, for their part, also are
reacting to the actual and potential increase in
competition by altering their price and service
strategies. In a sharp break with tradition, few
of the clearing banks are offering interest, for
example, on current account deposits. Some
also have extended banking hours, expanded
their customers' access to credit, and taken
steps to improve the efficiency of their internal
operations. 32 Others are experimenting with
home electronic banking, point-of-sale debit
systems, and expanding their ATM networks
rapidly.

IU. Conclusions and Implications for U.S. Banking Policy
The attitude of British policymakers toward
their banking system has changed significantly
since the late 1960s. Generally speaking, they
have allowed and encouraged the British banking system to evolve toward one that permits
greater competition albeit with a deeper overlay of government supervision, insurance and
oversight. The previously informal nature of

banking regulation-facilitated by the existence of interest rate cartels, restricted entry,
and fraternal relationships with the central
bank-appears to have been codified and formalized, although policymakers indicate a preference to retain some elements of "selfregulation." In sum, relationships between the
banking community and the British central

21

bank are becoming increasingly more formal as
the competition for domestic markets has
grown more vigorous.
Whether the new regime will increase the
long-term efficiency of the British banking sector depends largely on whether the greater efficiency brought about by competition is offset
by greater public expenditures on supervising
and examining financial institutions. The latter
is needed to maintain the stability that has characterized the British financial system throughout most of this century. All that can be said at
this time is that the economic environment and
the pace of financial innovation have made it
impossible to ignore the role of competitive
forces in the U.K.
The British banking experience may inform
U.S. banking policy in a number of ways. First,
the British have learned that although it is possible to affect the structure of the financial industry through credit controls, portfolio
restrictions, and tax policy, competitive forces
run counter to attempts to manage credit flows.
For example, both rapid growth in the building
society industry and the existence of the secondary banking sector are, to a considerable
extent, the results of restrictions on clearing
bank activity and other credit allocation policies. 33
Second, the U.K. has learned that banking
activities cannot remain segmented without the
appropriate economic conditions and stable
regulatory policy. When British policymakers
relaxed some of the controls on clearing banks
in 1971, the market found it difficult to adjust.
The change contributed to weakness in the secondary banking sector and eventually led to a
crisis of confidence in the entire payments
mechanism. It was not until nearly a decade

later that deregulation in the British financial
system could safely resume.
Third, the British experience illustrates the
hazards of asymmetric treatment of like institutions concerning receipt of "protection" from
the centralbank or benefitting from deposit insurance mechanisms. The coexistence of a
"protected" clearing bank sector and an "unprotected" secondary banking sector that also
accepted deposits may have exacerbated· the
problems experienced by the secondary bankingsector in 1971-1973 as depositors sought a
safe haven for their funds in the clearing banks.
British policymakers reacted, probably not inappropriately, by extending supervision and depositor protection mechanisms to virtually· all
depository institutions. The same problem may
arise in the United States given the presence of
unprotected or only privately insured depository institutions in a few markets. Indeed, U.S.
policymakers appear to be reacting to these
cases by trying to extend insurance and supervisory coverage to those institutions as well.
Finally, American observers of the British
banking system often cite its structure as an indication of how U.S. banking might appear in
the absence of geographic branching restrictions and deposit rate regulation. In fact, as we
have pointed out, the structure and high levels
of concentration observed in the British banking industry are at least partly the result of British banking and antitrust policy. While it is true
that British banking has developed without certain restrictive regulations imposed upon its
American counterpart, its structure also is
partly the consequence of attitudes toward
managing a perceived trade-off between competition and payments system stability.

22

FOOTNOTES
1. These other institutions include wholesale banks such
as merchant banks, foreign and consortia banks, and discount houses. In addition, the British system includes several deposit-taking institutions serving primarily small
indiVidual • $av~n3 .••• These·•• jncltJdethe.Trustee.Savings
Banks, the National Savings Bank, and the National Girobank. For a comprehensive explanation of these institutionssee Cooper, The Management and Regulation of
Banks.

below. For many years, the cartel made the interest rate
paid on noncheckable deposits two percentage points below Bank Rate, or the Bank of England's lending rate
(somewhat like the Federal Reserve Bank's discount rate).
LikeWise,borrbWerspaidaset. rateabol(eBar"lkRafe.
8. For example, during the post-war period, on the Bank
of England's recommendation, the. clearing banks channeled their lending into the rebuilding of the industrial sector-a policy that was to affect the entire banking system
considerably, as discussed below.

2.Sinceacol1siderable portion of their deposit base is
made up of liquid retail deposits, the generally conservative
clearing banks have preferred to lend by overdraft, recallable at very short notice.

9. This process was facilitated by the social homogeneity
of both clearing bankers and the Directors of the Bank of
England. They belonged to the same class, attended the
same schools, or met at the same clubs.

3. The Committee of London Clearing Bankers (CLCB) operatesmost of the nation's cash distribution and money
transmission activities primarily through the Bankers'
Clearing House or the Automated Clearing Services, both
of which are owned by the London clearing banks.

10. Cartels in the financial industry may have functioned
as an alternative to regulation in that they have attempted
to regulate interest rates to achieve a lower risk, lower
return equilibrium in loan portfolios. (See "Building Societies: A New Framework, p. 27).

4. These four major banks are: Barclays Bank, L10yds
Bank, Midland Bank and National Westminster Bank. Besides these, there· are two other London clearing banks
(Coutts & Co. and Williams and Glyns Bank), three Scottish
clearing banks and four Irish clearing banks. The four major
London clearers own outright or have very substantial interests in nine of the other clearing banks. Two of the Irish
clearing banks are independent. The Committee of London
Clearing Bankers will be supplanted in the near future by
an enlarged trade group to be known as the Committee of
London and Scotland bankers. This new group initially will
have seven members, all of whom were members of the
London or Scottish Committees of clearing banks.

11. Building societies are analogous, in this sense, to mutual. savings banks in the United States.
12. In the 1970s, in an environment of high interest rates,
a few very large building societies broke away from the
cartel, threatening its risk-optimizing function. Discipline
continued to erode until, in 1984, the interest rate cartel
officially was abandoned although the BUilding Societies
Association continues to publish recommended deposit
and mortgage rates.
13 Many of the secondary banks possessed certificates,
issued by the Board of Trade, stating that they engaged in
bona fide banking busine$s for the narrow purpose of exempting these institutions from the Money Lenders Act of
1900. This certification created the illusion that the companies were recognized by a responsible government department.
14. MK Lewis and B. Chiplin, De-Regulation and Competitive PressUres upon British Banks.

By way of comparison, even U.S. state-level 4-firm concentration ratios are nowhere near this high. In 1984, for
example, California-which permits statewide branching
and comprises a large economy itself-had over 450 banks
and a 4-firm concentration ratio oUess than 64 percent.
The5-firm, 55 percent concentration ratio observed among
building societies in Great Britain, however, more closely
matches U.S. experience. In California, for example, there
are approximately 200 savings and loan associations (and
no other mortgage lenders such as mutual savings banks),
and the 5-firm concentration ratio is 40 percent.

15. In September 1973, the Bank of England imposed a
ceiling of 9.5 percent per annum on interest thatcould be
paid on bank deposits of less than £10,000. This ceiling
was withdrawn in February 1975. The Supplementary Special Deposits Scheme, or the "corset", put up to 50 percent
of deposit increases into noninterest bearing reserves and
constituted an important tool of British monetary policy during that period.

5. In the past, this cooperation has frequently taken the
form of clearing bank compliance with directives by Bank
of England on such issues as the volume and direction of
bank lending am:! the composition of balance sheets.
6. The Bank Act of 1844, introduced by the Bank of England and repealed in less than 15 years, temporarily restricted entry to the British banking industry. Alreadyexisting banks-many the forebears of the main contemporary clearing banks-were consequently sheltered from
competition for a period of time. This period of relative freedom, enhanced by the advantages of acceptance into the
Committee of London Clearing Bankers in 1854, allowed
those banks to entrench themselves in the banking sector
at the expense of any competitors. William T. McCaffrey,
English and American Banking Systems Compared, pp.
28-29.

16. See Margaret Reid, The Secondary Banking Crisis,
1973-75.
17. "While the U.K. clearing banks appeared secure from
the domestic effects of any run, their international exposure
was such that the risk to external confidence was a matter
of concern for themselves as well as for the Bank." (Bank
of England, ''The Secondary Banking Crisis...")
18. The recycled deposits were "loaned" at a market rate
of interest plus a premium for the perceived riskiness of
the loan. The Bank of England agreed to assume responsibility for financing 10 percent of the amounts outstanding.
Although no precise data are available, it has been estimated that the total financing of the Lifeboat amounted to
about £3 billion. Losses from the operation could have

7. One example of such collusive pricing behavior was
later to become a competitive disadvantage, as discussed

23

been as much as £50 million for the clearing banks and
£100 million for the Bank of England. Reid, op. cit., pp.
190-92.
19. This notion rests on the view that runs on essentially
sound institutions can occur as the result of the failure of
similar institutions. Risk-taking that is rational from an individualinstitution'spointof view may impose costs •in the
form of increased risk of failure on other institutions.

clearing banks to rise from approximately 50 percent in
1965 to 90 percent in 1975.

20. Indeed, the Competition and Credit Control policy that
some feel precipitated the secondary banking crisis was
im,tituted partly to redress the diminishing dominance of
the clearing banks. (See Lewis and Chiplin's account of
this policy.)
21. The Bank of England, for example, does not conduct
on-site or surprise examinations as do the supervisory authorities in the United States. It relies instead on a rather
arms-length review of the submitted reports of condition.
In recent months, these have been argued to be insufficient. (See "A Juicy Summer Scandal is Rocking the City
of London," Business Week, August 19,1985, page 44.)

29. Building society corporations traditionally faced a 40
percent tax rate on corporate profits, whereas banks faced
a 52percEmtta~ rate.. However, banks were able to.reduce
their corporate tax liability through leasing activities not allowed building societies. In 1984, pOlicymakers considerably reduced the tax advantages enjoyed by leasing
operations and began a progressive reduction of the corporate tax rate to 35 percent-applied uniformly to banks
and building societies. In addition, the building societies'
ability to count income from the sale of certain .types of
securities as capital gains rather than ordinary income was
eliminated in 1984.

22. The Depositor Protection Scheme employed by the
building societies was enabled by permissive language in
the 1962 Building Societies Act. The Scheme is run by the
Building Societies Association (BSA), although participation is not reserved to BSA members or participants in the
BSA cartel.
23. The Depositor Protection Scheme in Britain is funded
by a fee based. upon the level of short-term deposits at
each institution, with stipulations for a minimum and maximum contribution. It is administered by a special commission composed of representatives from the Bank of
England and affected sectors of the financial industry.

30. Prior to 1985, building societies paid interest to investors net of a composite tax rate, which was slightly lower
than the. basic income tax rate. Interest payments by clearing banks, in contrast, were paid gross of tax, subjecting
the taxpayer to the basic rate and, thus, a lower after-tax
rate ofretum, ceteris paribus.

27.• Currently, approximately 80 percent of building society
assets are in mortgage loans; the. remainder is invested in
liquid and other securities.
28. Some building societies employ "sweep"-type arrangementswithclearing banks to provide their customers
with checking-like services.

31. Clearing banks traditionally had not involved themselves in the residential mortgage market. As recently as
1980, their loan portfolios contained essentially no mortgage assets. Since BSA policy frequently kept mortgages
issued by building societies in short supply, the absence
of clearing banks from the mortgage market must not have
been a matter of choice but the result of credit restrictions
imposed on clearing banks by the Bank of England. Today,
the clearing banks hold approximately 5 percent of their
assets in the form of mortgages.

24. The clearing banks recalled the burden imposed upon
them by the "lifeboat" operation begun in 1973. Their feeling was that, should a major banking panic occur, they once
again would be called upon to shoulder a large portion of
the burden of re-establishing stability in the banking system. The proposals for reforming the building societies are
presented in a so-called "Green Paper" titled "Building Societies: A New Framework," presented to Parliament by the
Chancellor of the Exchequer, July 1984.
25. No statistics are available on the size of the licensed
deposit-taker institutions that have not achieved retail bank
status. Conversations with experts on British Banking suggest, however, that the conversion of licensed deposit-takers to retail banks has not been rapid.
26. These factors, combined with preferential tax treatment of interest earned at building societies, caused the
share of building society deposits relative to deposits at

32. The Clearing House Automated Payment System
(CHAPS), for example, will facilitate the interbank transfer
of sterling funds.
33. in terms of deposits, building societies and clearing
banks in Britain today are virtually identical in size. By comparison, savings and loan associations, an American coun"
terpart to the building society, have deposits equal to only
about one-third of the deposits of commercial banks. Thus,
a much greater share of total deposits in Great Britain resides with highly undiversified, mortgage-oriented financial
institutions. Some argue that this places the British financial system in greater jeopardy should some systemic problem affect the quality of mortgage loan assets.

24

REFERENCES
Hawtrey, R. G. The Art of Central Banking. London: Frank
Cass & Co., Ltd., 1962.

Bank of England. ''The$econdary Banking Crisis and the
Bank of England's Support Operations," Bank of England Quarterly Bulletin, April 1978.
Bank of England, ''The Future of Building Societies: ACen,
tral Banker's View," Bank of England Quarterly Bulletin, Vol. 23 No.2 (June 1983).

Inter-Bank Research Organisation. Prudential Regulation
of Banks in the European Economic Community,
United Kingdom, London: British Bankers' Association, 1975.

Bank of England, "Changes in the Structure of Financial
Markets: a View from London," Bank of England Quarterly Bulletin, March ·1985.

Lewis, M.K. and B. Chiplin, "De-Regulation and Competitive Pressures upon British Banks," University of Nottingham,mimeo, 1985.

Bolea, Mark, "Building Societies and Housing Finance in
Britain," Federal Home Loan Bank Board Journal, Vol.
16, No.5, (May/June 1983).

MCCaffrey, William T. English and American Banking Systems Compared, Kingsport, Tenn: Kingsport Press,
Inc., 1938.

Central Office of Information, Reference Division. British
Banking and Other Financial Institutions. Reference
pamphlet 123. London: Her Majesty's Stationary
Office.

Peat, Marwick, Mitchell & Co. Banking in the United Kingdom. London: Peat, Marwick, Mitchell & Co., 1984.
Pringle, Robin. A Guide to Banking in Britain. London:
Charles Knight, 1973.

Chancellor 01 the Exchequer, "Building Societies: A New
Framework", London, July 1984.

Reid, Margaret. The Secondary Banking Crisis 1973-75.
London: Macmillan Press Ltd., 1982.

Cooper, John. The Management and Regulation of Banks.
New York: St. Martin's Press, 1984.

Sayers, R. S. Modern Banking. Oxford: Clarendon Press,
1967.

Department of Trade and Industry. Financial Services in
the United Kingdom. London: Her Majesty's Stationary
Office, January 1985.

Walden, Herbert. "How Building Societies See Their Role
in the Financial Services Revolution," The Banker,
March 1984.

Florde, J. S. "Competition, Innovation and Regulation in
British Banking," Bank of England Quarterly Bulletin,
September 1983.

Wilson, J.S.G. The London Money Markets. Tilberg, The
Netherlands: Societe Universitaire Europeenne de Recherches Financieres, 1976.

25

Michael M. Hutchison* and Adrian W. Throop**

As a direct result of U. S. fiscal expansion, the real value of the
dollar has remained much stronger than can be explained solely by
differentials between real interest rates in the U.S. and those abroad.
Forecasts of the dollar's value based on a longer run, general equilibrium model have much smaller errors than those from a shortrun, partial equilibrium model relying on interest rate differentials
alone. Thus, the real value of the dollar is likely to remain high by
pre-1980 standards for the foreseeable future unless and until U.S.
or foreign countries change their fiscal policies.
By the summer of 1985, the real tradeweighted value of the dollar stood at nearly 35
percent above its 1980 value (see Chart 1). In
September, the United States together with
West Germany, Japan, the United Kingdom
and France announced that they were prepared
to undertake coordinated intervention in currency markets to drive the dollar down and
make it better reflect fundamental economic
conditions. However, there is considerable disagreement among policymakers, academics,
and market participants alike over the fundamental forces causing the phenomenal strength
of the dollar. Moreover, a strong argument can
be made that the dollar is not fundamentally
overvalued.
Among the factors most often cited for generating a strong dollar are the present stance
and future outlook of U.S. budget policy. According to this view, the exchange value of the
dollar has closely followed the course of U.S.

budget policy relative to budget policies
abroad.
Casual evidence seems to support this linkage as Chart 2 indicates. Measured on a cyclically adjusted basis, the U.S. general
government fiscal balance has fallen from a
fairly large surplus position in 1980 (0.7 percent
of potential GNP) to a large deficit position (1.9
percent of potential GNP) in 1985. Moreover,
the generally expansionary fiscal policy in the
U.S. has not been matched, and in fact has
been counteracted, by restrictive fiscal policies
followed by most other major nations in recent
years. West Germany, for example, reversed a
2.4 percent budget deficit (cyclically adjusted)
in 1980 into a 1.1 percent surplus in 1985. Similarly, Japan's large 4.0 percent deficit in 1980
was cut to 1.0 percent by 1985.
However, even among the group of economists that are convinced of strong causal links
between fiscal policy and real exchange rates,
there is considerable controversy. At least two
views may be distinguished. One view, expressed for example by former Chairman of the
Council of Economic Advisers Martin Feldstein
(see Box), states that the influence ofthe recent
U.S. fiscal stimulus on the dollar works primarily through interest rate differentials and
portfolio adjustments. High and rising U.S.
real interest rates associated with domestic

*Assistant Professor of Economics at the University of California, Santa Cruz and Visiting
Scholar, Federal Reserve Bank of San Francisco. **Research Officer, Federal Reserve
Bank of San Francisco. Research assistance by
Hamid-Reza Davoodi, Kelly Main, and Roger
Weatherford is gratefully acknowledged.

26

27

in spending on U.S. goods). Excess demand
for goods in the U.S. and abroad causes an
increase in the general level of world interest rates, while the relative excess demand for
U.S. goods associated with the fiscal stimulus is
eliminated by a real dollar exchange rate appreciation.
This view assumes that U.S. and foreign
goods are imperfect substitutes, and that their
relative price (the real exchange rate) will
change over time in response to shifts in fiscal
policy. No expectation of a subsequent fall in
the value of the dollar back to its original level
is therefore required. Moreover, a high degree
of substitutability between U.S. and foreign financial assets limits the extent to which U.S.
real interest rates can diverge from foreign real
interest rates in the long-run.
This paper develops a simple theoretical
model that incorporates both the short-run,
partial equilibrium portfolio balance and the
longer run general equilibrium views of the way
exchange rates are influenced by a fiscal stimulus. The portfolio balance view is presented in
Section I, and the general equilibrium view is
explained more fully in Section II. The methodology employed for empirical implementation of the completed model is presented in
Section III. Empirical tests are performed in
Section IV to estimate the relative importance
of the various factors in influencing the tradeweighted real value of the dollar over the 19741985 floating rate period. The out-of-sample
forecasting performance of the two models, as
well as the performance of a simple random
walk forecast are examined. The final section
draws some conclusions for policy.

budget deficits, in this view, have created an
interest rate differential that has attracted a foreign capital inflow. This inflow has, in turn,
caused a temporary appreciation of the dollar
exchange rate above its long-run equilibrium
value.
The causality described represents a short
fUn and partial equilibrium portfolio balance
perspective. In that perspective, the real value
of the dollar should gradually fall back to its
former level, either because interest rates will
eventually fall or because investors will become
reluctant to invest an increasingly large share
oftheir portfolios in dollar-denominated securities. A number of major published forecasts
apparently have based their predictions of a
gradually falling dollar on this type of reasoning. One problem with the simple portfolio balance view is that the dollar continued to
strengthen after 1983 even though the real interest rate differential in favor of the U.S. diminished sharply, as shown in Chart 1.
An alternative view, expressed for example
in the quotations from Dornbusch (see Box),
does not necessarily question the short-run
links between fiscal policy and exchange rates
working through interest rate differentials and
portfolio preferences. But, it stresses the longrun effects on goods markets and interest rates
in a world of high capital mobility. This second
link may be characterized as a goods market
channel of transmission.
Basically, this longer run, general equilibrium view argues that the U.S. fiscal expansion
has increased both the aggregate demand for
goods worldwide and the relative demand for
U.S. goods (because the fiscal expansion in
the U.S. has led to relatively larger increases

I. Interest Rate, Risk and the Exchange Rate:
Portfolio Balance View
tion in this framework may be derived initially
from the uncovered interest parity condition.
This is an arbitrage condition that states that
the expected percentage change in the exchange rate over any period is equal to the difference between the nominal returns on
securities at home and equally risky securities

To show the linkages between the real exchange rate and real interest rate, we used an
approach that is basically a simplification of
Hooper and Morton's (1982) extension of the
sticky-price monetary model of exchange rate
determination developed by Dornbusch (1976)
and Frankel (1979). The exchange rate equa-

28

abroad, with maturities for that same period:
Ins

lnse=n(i-i*)

exchange rate risk or other factors, the expected yield differential would be positively associated with the supply of domestic debt
relative to debt abroad.
It is convenient to think of the current spot
exchange rate as linked to the future expected
exchange rate through the interest differential.
Equation 3 illustrates this relationship: A given
risk-adjusted interest differential (that is, including <j:>e) is consistent with any given spot
exchange rate level, and only indicates the expected change in the (log) level of the exchange
rate over the maturity of the bonds in question.
Once expectations about the future spot rate
are identified, however, the spot rate is determined. The link between the current price of a
currency and its expected future price is hence
quite strong, as it is in the case of any asset
price.
Equation 3 also holds in real (or price-adjusted) terms. 1 Thus,

(1)

where i= U.S. interest rate on security with
n years to maturity;
i* = foreign interest rate on a similar security;
s = foreign currency price of the dollar;
se foreign currency price of the dollar
expected to prevail n periods in the
future.
Equation 1 holds when financial capital is
freely mobile across national boundaries and
investors are willing to accept equivalent yields
on U.S. and foreign securities regardless of the
currency of denomination. In this case, any deviation from uncovered interest parity would
cause investor arbitrage to bid the exchange
rate back to that point where equation 1 would
again hold.
Under circumstances where U.S. and foreign
assets are less than perfect substitutes, however, equation 1 will not strictly hold as an equilibrium condition; and U.S. and foreign
expected yields generally will differ. This case
is represented by augmenting equation 1 with
an expected equilibrium yield differential, or
"risk premium", <j:>e:
In s

In se = n (i

i*) - n<j:>e

(2)

n<j:>e + In se

(3)

lnq = n(r-r*) - n<j:>e + lnqe

where q = real value of the dollar;
qe = real value of the dollar expected n
years hence;
r= U.S. real interest rate;
r* = foreign real interest rate.
The difference between the current real exchange rate and its expected future value-that
is, the expected change in the real value of the
currency-is thus proportional to the expected
(risk-adjusted) real interest rate differential,
r
r*
<j:>e. For example, a one-percent rise
in the U.S. one-year real (risk-adjusted) interest rate above the equivalent foreign rate would
appreciate the real value of the dollar by one
percent above the spot value expected one year
hence. This sets up the expectation of a onepercent dollar depreciation over the course of
the year, which, in turn, equalizes expected
risk-adjusted yields on the underlying foreign
and domestic securities. Thus, the dynamics of
exchange rate changes are implicit in the relative yield differential across currencies. This
process is illustrated in Diagram 1. An important point to note, however, is that the effect

Rearranging gives:
In s = n (i - i*)

(4)

Equation 2 is a condition that will hold in
internationally integrated financial markets
when investors behave rationally. It simply
states that the market expectation of domestic
currency depreciation over a given period will
be equal to the difference in nominal returns
between securities at home and those abroad
over a similar holding period, less any expected
yield differential. Portfolio balance models suggest that the expected yield differential (risk
premium, <j:>e) will depend on both investors'
preferences and the relative supply of domestic
and foreign securities. If investors view these
securities as imperfect substitutes because of

29

roughly constant. Budget deficits, whether of a
transitory or more permanent nature, do not
alter the expected long-run real value of the
dollar in this framework. The assumption of a
fixed long-run relative price between domestic
and foreign goods provides a convenient anchor
on which expectations of the future real exchange rate can be based. Furthermore, the dynamics of exchange rate adjustment to interest
rate shocks can also be derived from this assumption.
The real interest rate/real exchange rate link
may be thought of as a portfolio balance channel through which budget deficits influence the
real exchange rate. A rise in the U.S. budget
deficit, to the extent that it causes U.S. real
interest rates to rise above world levels, attracts
a foreign capital inflow that temporarily appreciates the real value of the dollar, q, above its
expected long-run equilibrium value, qe. The
dollar appreciates to the point where an expected future depreciation is set up that (in order to maintain internationally comparable
yields on dollar and foreign investments) just
offsets the extra interest rate return on dollar
assets compared with foreign currency denominated assets. In other words, the dollar appreciates until an offsetting expected capital loss is
created. In this view, the influence of budget
deficits on exchange rates through the interest
rate channel is transitory.
The pattern of initial exchange rate appreciation followed by gradual depreciation will occur
in this framework regardless of whether budget
deficits are perceived as temporary or longer
lasting. In the former case, both interest rates
and the exchange rate would rise and gradually
fall back to their initial levels as financial market pressures associated with transitory budget
imbalances subside. In the case of longer lasting
budget deficits, however, interest rates would
rise and stay above their initial values for as
long as private aggregate demand is "crowded
out" by the fiscal stimulus. This would not preclude a subsequent gradual exchange rate depreciation-as expressed in the quotation by
Feldstein-if the expected return differential
(<j>e) gradually rises over time in response to the
accumulation of government debt associated

Diagram 1
Real Exchange Rate Response
to Rise in the Domestic
Real Intererst Rate Differential
log of real
exchange rate

The real exchange rate is price of the dollar in units of
foreign currency (price adjusted). The risk adjusted real
interest differential (r
r*
<pe) rises at point t l ,
causing an appreciation in the dollar exchange rate from
qo to ql)' Over the maturity of the interest rate in
question (from t l to t 2 ), the exchange rate gradually
depreciates and causes a capital loss on domestic
securities which exactly offsets the explicit additional
interest rate return. At time t2 the exchange rate returns
to its original equilibrium value.

of interest rate variations on exchange rates is
temporary, Over the maturity of the particular
rate in question, the spot real exchange rate is
expected to return to a fixed equilibrium value.
A central aspect of this theory is its emphasis
on term structure effects. For example, if the
I-year U.S. real interest rate goes up by 1 percentage point, but future I-year interest rates
are not expected to change, then the real value
of the dollar will go up only 1 percentage point.
However, if the same increase in the U. S. 1year rate is expected to last for 5 years, then
the 5-year bond rate will immediately rise by 1
percentage point and the real exchange value
of the dollar will rise by 5 percentage points.
Thus, the long-term real interest differential
controls movements in the real exchange rate.
The expected long-run real value of the exchange rate, or the relative value of a representative bundle of domestic goods in comparison
to their foreign counterparts, is assumed to be
30

with the longer lasting government deficit. In
both cases-temporary or longer lasting budget
deficits-the portfolio balance view predicts
that the real exchange rate gradually depre-

ciates and returns to its original level (qe).
However, both cases exemplify a partial equilibrium model because qe is either assumed constant or determined outside the model.

II. Goods Markets, Interest Rates and the Exchange Rate:
General Equilibrium View
The longer run, general equilibrium view of
the budget deficit/real exchange rate link abstracts from the dynamics of expected changes
in the exchange rate. The analysis is static and
longer run so that expected and actual exchange
rates do not differ. It focuses on the potential
for budget policy to alter the real exchange rate
in the long-run, and therefore to cause shifts in
the expected equilibrium real exchange rate
(qe) that enters into the shorter run portfolio
balance approach.
While the portfolio balance view allows for
assets denominated in different currencies to be
imperfect substitutes (4)e 4= 0), it in effect assumes that domestic and foreign goods are perfect substitutes, making their expected
equilibrium relative price (qe) constant. The
general equilibrium model, in contrast, allows
goods produced in different countries to be imperfect substitutes and allows their equilibrium
relative price to change in response to shifts in
the supply and demand for domestically produced versus foreign goods. The real exchange
rate in this framework is a key factor helping
to maintain a balance in domestic and foreign
goods markets.
For example, a domestic fiscal stimulus-effected through either an increase in expenditures or a reduction in taxes-will increase the
demand for both domestic and foreign goods,
but is likely to raise the demand for domestic
goods more. This relative rise in domestic demand, in turn, will put upward pressure on the
domestic real interest rate relative to the foreign real interest rate. But since, in a world of
high capital mobility, interest rates at home and
abroad can differ by only a relatively small risk
premium, the resulting inflow of capital will be
sufficient to raise the domestic real exchange
rate enough to offset most, if not all, of the

effects of the fiscal stimulus. An appreciation
of the real exchange rate accomplishes this both
by lowering the private demand for domestically produced goods (exports and import-competing goods), and by raising that component
of domestic demand directed towards imports. 2
To put this argument in more formal terms,
consider the equilibrium conditions for domestic and foreign goods markets, assuming a complete adjustment to full employment in both the
U.S. and the rest of the world:
y

y*
where y (y*)
A (A*)

=

NX(NX*)

and

A(r)

+ NX(q)

A *(r*)

+ NX*(q)

(5)
(6)

Yo (y;)), fixed domestic
(foreign) output
domestic (foreign) absorption of
goods and services, i.e. both
home production and imports
(A = C + I + G)
domestic (foreign) country net
exports

aA
aA*
~-- <0 . - - < 0 .
ar
' ar*
'
aNX
aNX*
---~<O·
>0'
aq
'aq
,

We have three unknowns (r, r*, and q) but only
two equations. However, r can be solved as
equal to r* in the case where U.S. and foreign
assets are perfect substitutes, or equal to r* + 4>
in the risk premium case. This reduces the system to two equations and two unknowns. 3
Diagram 2 provides a graphical representation of this system. 4 The downward sloping (q,
r US ) locus, or GHs , is the U.S. (domestic country) goods market clearing condition, that represents equation 5. It is downward sloping
because, for any given level of output, a fall in

31

for any given real exchange rate, higher U.S.
real interest rates are necessary to offset the
rise in absorption and to restore equilibrium.
Similarly, to the extent that the rise in U.S.
government expenditures falls on foreign
goods, the demand for rest-of-world net exports
rises· (at an unchanged real exchange rate) and
Gbowshifts upward to Glow. The rise in aggregate demand in both countries thus causes U.S.
and rest-of-world interest rates to rise.
Most of the rise in aggregate demand falls on
U.S. output, however. As long as U.S. and restof-world securities are perfect substituteswhich implies equal real rates of return in static
equilibrium (rys = rlOW)-the incipient real interest differential in favor of the U.S. appreciates the dollar real exchange rate to divert
private demand away from U.S.-produced
goods towards foreign-produced goods. A general equilibrium is restored at point b, where
the higher level of world interest rates dampens
excess world aggregate demand (U.S. plus restof-world) pushed up by the U.S. fiscal stimulus,
while dollar appreciation (from qo to ql) dampens the relative excess demand for U.S.-produced goods. 5 Unlike the short-run portfolio
balance model, the dollar appreciates without
any increase in the equilibrium real interest
rate differential.
The possibility of a risk premium (<!>
0),
or real yield differential, is easily incorporated
into this framework. As noted earlier, a risk
premium could arise if, over time, investors become reluctant to absorb an increasingly large
share of U.S. debt into their portfolios. As
shown in Diagram 3, a gradual rise in the risk
premium (from an assumed initial value of
zero) associated with cumulative U.S. budget
deficits would allow a gap in the static equilibrium real interest differential.
In the case of a U.S. debt-financed fiscal
stimulus, the U.S. real interest rate would rise
above the rest-of-world interest rate (rYs >
rlOW ), and the difference would be reflected in
the gap between the GYs and GloW loci at an
equilibrium real exchange rate to the left of
point b (points c, c1 for example). The result is
that both the rest-of-world interest rate (rlOW )

Diagram 2
Effects of U.S. Fiscal Expansion
when U.S. and Foreign Assets
are Perfect Substitutes
Rest-at-World
Real Interest Rate

u.s. Real Interest Rate

qo q1
Real Value of Dollar, q
..... Depreciation

Appreciation,...

q (depreciation of the real value of the dollar)
stimulates net exports and must be offset by
lower U.S. absorption brought about by an increase in the U.S. real interest rate. Gbow , the
rest-of-world (foreign) goods market equilibrium locus (q, rrOW), is upward sloping for analogous reasons. In this case, however, a fall in
q represents an appreciation of the foreign currency, and hence a contraction of rest-of-world
net exports to the U.S. This is offset by a fall
in rest-of-world interest rates and a corresponding rise in Arow (rest-of-world absorption) to
maintain equilibrium in the rest-of-world goods
market.
In the no risk premium case, the initial steady
state equilibrium is found at the intersection of
the goods market equilibrium schedules for the
U.S. and the rest of the world, or point a,
where r~s = rbow . Depending on the state of domestic aggregate demand and output relative to
demand and output abroad, the U.S. has either
positive or negative net exports.
Consider the comparative statics of a U.S.
fiscal expansion. As U.S. fiscal expansion increases the demand for U.S. goods and services, domestic absorption (A llS ) rises
correspondingly. This shifts the U. S. goods
market locus upward from G~s to Gys because,

*'

32

and the value of the U.S. dollar (ql) rise less
than in the no risk premium case. Once again,
the result differs from the portfolio balance
view in that, in the goods market view, the dollar normally appreciates following a fiscal stimulus in the U.S. even though there is no change
in the risk-adjusted differential between real interest rates.
However, in the extreme case in which the
risk premium grows so large that it leaves the
real exchange rate and the rest of the world's
interest rate unchanged, the end result is the
same as that characterized by the portfolio balance view. That is, over the longer run the U.S.
interest rate would rise enough to cause a fall
in domestic interest-sensitive expenditures that
entirely offsets the fiscal expansion's impact.
The introductory quotation by Feldstein expresses this view of how the economy adjusts
to ongoing fiscal deficits. 6

Diagram 3
Effects of· U.S. Fiscal Expansion
when U.S. and Foreign Assets
are Imperfect Substitutes
Rest-of-World
Real Interest Rate

U.S. Real Interest Rate

qo q1
Real Value of Dollar, q
..... Depreciation

Appreciation

m.

~

Estimation Methodology

In the short-run, partial equilibrium portfolio balance approach, the real value of the exchange rate is expected to return to a constant
expected long-run real value. In contrast, in the
general equilibrium analysis, persistent budget
deficits change the long-run equilibrium value
of the real exchange rate. Because exchange
market participants have a time horizon of at
least several years, a combination of both approaches is required for explaining the actual
behavior of exchange rates.
In a static long-run equilibrium, interest rates
can diverge by only the amount of the risk premium. In the short-run, larger disparities in interest rates can temporarily occur, but they are
counterbalanced by expected changes in the exchange rate. A useful synthesis of the two views
therefore embeds a rational expectation of
longer run equilibrium into the short-run dynamics of the portfolio balance approach.
In the general equilibrium model, the real
exchange rate may depart from its original
value even over extended periods of time. It
can be altered by changes in tastes, technology,
or supplies of productive factors. It can also be
affected by imbalances between private saving

and investment caused by budget deficits, or by
changes in the risk premium. In our empirical
estimation, we abstract from factors other than
fiscal deficits that might cause changes in the
equilibrium real exchange rate. Thus, the log
of the real exchange rate expected in the future
is assumed equal to some constant plus a function of the expected U.S. budget balance (B)
and the rest of the world's budget balance (B*):
In qe

=

ao - al Be + a2 B*e

(7)

Substituting equation 7 into equation 4 yields
the synthesis of the two views to be estimated:
In q

=

ao + n(r - r*) - n<l>e
- a1Be + a2 B *e

(8)

To empirically estimate this model, we use
Morgan Guaranty's real trade-weighted value
of the dollar for q. We also calculated tradeweighted measures of real interest rates and expected budget balances. Because of data limitations, variables for the rest of the world were
limited to the six largest OEeD countries. 7
As pointed out earlier, the real interest differential dominating movements in the real exchange rate is the long-term one. Rather than

33

attempting to construct direct measures of longterm inflation expectations for each country, we
used an indirect approach based upon the theory of the term structure of interest rates. Our
model of the real long-term bond rate is based
on the "preferred habitat" theory of the term
structure of interest rates developed by Modigliani and others. This approach synthesizes the
market segmentation and expectational theories of the term structure.
In this approach, the long-term interest rate
is equal to the average of expected short-term
rates, modified by a risk premium that reflects
preferences of the two sides of the market for
long versus short securities. In the original
statement by Modigliani and Sutch (1966), the
past history of nominal short-term rates is used
to forecast expected future nominal rates.
Therefore, the long-term bond rate is explained
by the past history of short rates and a risk
premium represented by a constant term. Analogously, in an inflationary world, one can
model the real long-term bond rate as a function of the past history of real short-term rates
(proxying for expected real short-term rates)
plus a constant term to represent the risk premium.
For the real short-term interest rate in the
U.S., we used the 6-month commercial paper
rate. We forecasted inflation on the basis of past
changes in Ml and past inflation. 8 Foreign interest rates are 90-day interbank rates, or the
nearest equivalent. Expected inflation abroad
was measured by the rate of change in consumer prices over the previous four quarters. 9
The empirical results are not particularly sensitive to various alternative measures of expected inflation.
In earlier work, it was found that the U.S.
real bond rate can be satisfactorily explained
by an l1-quarter distributed lag on the real
short-term interest rate. lO Consequently, we
have modeled the real long-term interest rate
differential, r - r*, by an II-quarter distributed lag on the difference between the real 6month commercial paper rate and the tradeweighted value of real short-term interest rates
abroad. ll The estimated coefficient on this syn-

thetic real long-term rate differential equals n,
or the relevant time horizon of investors in
the market, times the sum of the weights in the
distributed lag on short rates. But since the latter should theoretically sum to a value close to
one, the sum of these estimated coefficients
should approximate n.
To measure anticipated budget surpluses or
deficits (expected values of Band B*), a moving average of the actual high employment, or
structural, budget balance for one year ahead
was used. Structural budget balances are preferable to actual (non-cyclically adjusted) deficits because they better capture the goods
market pressures associated with fiscal policy
shifts. The one-year ahead measure was found
to give more satisfactory results than a moving
average over longer time horizons. Budget balances more than one year ahead cannot be
known with any high degree of certainty because they can always be altered by policy
changes. And even though the relevant time
horizon of participants in the foreign exchange
market is likely longer than one year, the structural budget balance for one-year ahead appears to be as good as any other indicator of
the expected value of future structural budget
balances.
We tried both inflation-adjusted and unadjusted structural budget balances, measured as
a percent of potential GNP, in empirical estimates of the model. The inflation-adjusted
measures treat the amount of the inflationary
erosion in the real value of outstanding government debt as a receipt. Their appropriateness
for this analysis depends upon the behavior of
the private sector. To the extent that changes
in real wealth affect household consumption,
the inflation-adjusted indicator may be a more
accurate gauge of fiscal impact on the economy
than the unadjusted one. But if the inflation
premium embedded in the interest rate were
treated as disposable income, the nominal component of interest rates would affect consumption and the "inflation tax" would not. The
unadjusted structural budget balance would
then be the more appropriate one. 12

34

The final variable requiring explanation is the
expected risk premium, <pc. This yield differential is determined by. tIle interaction of demand and supply for assets in both the home
and foreign countries. Following the large body
of literature on the topic (e.g., Dornbusch,
1980; Frankel, 1982; Hutchison, 1984), we focus on the relative supplies and demands for
government debt ("outside" assets). This approach assumes that exchange risk on privately
issued "inside" assets is eliminated by portfolio
diversification. 13
An increase in the supply of domestic government debt, other things equal, causes a rise
in the risk premium. In contrast, a rise in the
proportion of domestic financial wealth in total
world wealth, assuming domestic investors prefer the home country habitat, would cause a
rise in the demand for domestic government

debt and therefore lower the risk premium.
The excess of domestic financial wealth over the
domestic supply is represented by the cumulative domestic current account surplus. The domestic current account surplus represents the
surplus of domestic national saving over private
investment.
The risk premium can therefore be expressed
as:

<

ao -- 0; a1

>

> 0;

a2

< O.

where D s represents the supply of U.S. government debt, W w represents the total supply of
government debt (both foreign and domestic),
and 2:CA represents the cumulative U.S. current account surplus. 14

IV. Empirical Results and Forecasts
shorter sample period was estimated to evaluate the stability of the estimated model coefficients and to perform out-of-sample forecasts
that can be compared with actual movements
in the dollar exchange rate. The shorter sample
ends at the time when U.S. budget deficits were
beginning to rise sharply relative to GNP and
foreign deficits had begun to decline. Out-ofsample forecasts of recent experience therefore
provide a useful test of the importance of U.S.
and foreign budget balances, relative to the importance of real interest rate differentials, in
affecting the real value of the dollar.
The three real exchange equations estimated
represent the model containing only real interest differentials (columns 1 and 4), the model
containing both real interest differentials and
U.S. and foreign budget balances (columns 2
and 5), and the full model which includes real
interest differentials, budget balances and the
risk premium determinants (columns 3 and 6).
In Table 1, which contains the inflation-adjusted budgets, the estimates· of the coefficients
on the risk premium variables are statistically
insignificant. However, lack of statistically significant risk premium variables is consistent
with previous research (e.g., Frankel, 1982;

Tables 1 and 2 present empirical estimates of
three formulations of the real exchange rate
model. The tables use structural budget balances adjusted for inflation and ordinary structural budget balances, respectively. As shown
in Chart 2, the inflation-adjusted budget is always in larger surplus than the ordinary budget
balance as long as inflation is positive because
the adjustment for inflation treats the erosion
in the real value of government debt as a tax.
The inflation-adjustment can be relatively
large-as much as 2 percent of GNP for the
United States and somewhat larger for other
major OECD countries. But the pattern of variation over time has been fairly similar for both
budget concepts. In the United States, the largest difference between them occurs from 1978
to 1981 when inflation first rose quite sharply
and then dropped even more abruptly. This
caused the inflation-adjusted budget first to
shift more sharply into surplus and then to fall
more rapidly into deficit.
Columns 1-3 in both tables show estimates
of three real exchange rate models for the
1974:03 through 1981:04 sample period, and
columns 4-6 show estimates for the 1974:03
through 1984:03 full sample period. The

35

TABLE

1

Real Exchange Value·of the Dollar:
Regression Estimates With Inflation-Adjusted •Structural BUdget Surpluses1
Sample:
(1)
Constant
11

2: (rs

r:)

-

i=O

1974:03 - 1981 :04
(2)

1

4.47
(171.9)
4.24
(8.91)
-2.83
(- 5.44)
1.00
(1.13)
-2.87
( -1.02)
-0.02
( -0.01)

4.82
(27.6)
4.16
(3.42)

4.61
(191.4)
3.46
(4.49)
-4.48
( -7.60)
3.22
(3.12)

.84
.019

.88
.017
.59
(3.96)
2.00

.92
.013
-.21
( -1.19)
2.22

.95
.022
.98
(33.4)
1.65

.97
.018
.62
(5.03)
1.84

2:CAfWw

.71
(5.44)
1.68

D.W.

(6)

4.49
(151.2)
3.50
( 7.20)
-4.11
( -7.00)
1.94
(2.29)
7.76
(0.55)
-8.93
( -0.82)

DS/Ww

P

(5)

4.59
(85.4)
3.40
(3.70)
-4.30
(- 3.05)
2.96
(2.11)

B*e

SER

1974:03 - 1984:03

(4)

4.44
(179.1)
4.78
(4.58)

Be

R2

Sample:

(3)

.98
.015
.16
(1.02)
1.88

See text for definitions of variables and data sources. All equations were estimated using ordinary least squares and
the Cochrane-Orcutt procedure to adjust for first-order serial correlation. The t-ratios are in parentheses.

TABLE

2

Real Exchange Value of the Dollar:
Regression Estimates With Ordinary Structural Budget Surpluses 1
Sample:

(1 )
Constant
11

2:(rs

i=O

-

r s *)

4.44
(179.1)
4.78
(4.58)

Be
B*e

1974:03 - 1981 :04
(2)
4.54
(55.9)
3.70
(3.02)
-4.19
( -2.19)
1.90
(0.91)

DS/Ww

2:CAfWw

R2
SER

P
D.W.
1

.84
.019
.70
(5.44)
1.69

.86
.018
.72

(5.76)
2.00

Sample:

1974:03 - 1984:03

(3)

(4)

(5)

4.37
(91.9)
4.07
(7.25)

4.82
(27.6)
4.16
(3.42)

4.62
(94.4)
3.22
(3.38)

4.40
(77.6)
4.61
(8.27)

-5.86
( -4.82)
3.77
(2.49)

3.35
(- 4.42)
0.12
(0.07)
-3.09
( -1.00)
-0.63
( -0.24)

-4.28
( -4.49)
-0.22
( -0.14)
5.25
(0.33)
-7.91
( -0.64)
.90
.016
-.03
( -0.19)
2.01

.95
.022
.98
(33.9)
1.65

See Table 1 notes.

36

.97
.018
.73
(6.86)
1.91

(6)

.97
.016
.17
(1.13)
1.93

Danker, et.aI., 1984; and others), indicating
that risk premia on internationally traded assets
are small, vary with time, and are difficult to
associate systematically with structural variables.
In contrast, the model estimates in Table 1
give statistically significant coefficients on the
real interest differential (r - r*), the expected
U.S. structural budget balance (Be), and the
expected foreign structural budget balance
(B*e) of the theoretically predicted signs. Also,
there is a high degree of stability between the
estimates from the shorter and longer sample
periods.
An increase of 1 percentage point in the real
long-term interest rate differential in favor of
the U.S. is estimated to have raised the real
trade-weighted value of the U.S. dollar by 3.5
percent in the 1974:03-1984:03 sample period (column 5). This estimate is consistent with
the view that investors in the market have a
time horizon of roughly 3-4 years. A rise in the
U.S. budget surplus by 1 percent of GNP is
estimated to reduce the real trade-weighted
value of the dollar by 4.5 percent. And a similar

movement in the budget balances of our major
trading partners is estimated to raise the real
value of the dollar by 3.2 percent.
The estimates using ordinary structural
budget balances (not inflation-adjusted).shown
in· Table 2 provide similar but somewhat less
robust results. The estimated real interest differential and budget balance coefficients are
again of the predicted signs and highlysignificant in the full sample, whereas the risk premium variables are statistically insignificant.
-2
The goodness of fit (R ), standard error, and
other summary statistics are also very similar.
However, the coefficient on the foreign budget
balance is statistically insignificant in the
shorter sample. Moreover, the coefficient estimates using ordinary budget balances are less
stable across the two samples. Since these results suggest that the behavior of the private
sector is affected, at least to some extent, by
the wealth changes included in the inflation-adjusted measure of the budget balance, further
discussion of the empirical results and forecasts
is limited to those using this measure.

Chart 1

Percentage Points

Real Trade-Weighted Value
of U.S. Dollar and Real Long-Term
Interest Rate Differential*

1980-1982 avg.
= 100

130

4
Real Long-Term
Interest Rate Differential

3

~

120

.....

110
2

100
1

~

Real Trade-Weighted
Value of Dollar

90

.....

0 ................._ ...........- - 1 _................1................._

..........

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
'U.S. real rate minus trade-weighted foreign real rate

37

80

Estimates derived from the shorter sample
period (1974:Q3-1981:Q4) shed further light
on this explanation of the current strength of
the dollar (Table 1, columns 1 and 2) and also
provide an indication of the stability of the ex­
change rate model. These equations were used
to make out-of-sample forecasts of the real
value of the dollar through the second quarter
of 1985. The results are shown in Chart 3. As
expected, the exchange rate model containing
only the real interest rate differential forecasts
a steadily declining real value for the dollar
after 1982. In contrast, the exchange rate model
that also includes budget balances forecasts the
extraordinary strength of the dollar out-of-sample rather well. Its forecast is almost exactly on
track through the end of 1984, but misses the
spike in the value of the dollar early in 1985.
A recent study by Meese and Rogoff (1983)
has tested the out-of-sample forecasting prop­
erties of the most widely employed empirical
exchange rate models. Their conclusion was
that a random walk model, which uses the cur­
rent exchange rate to predict future rates, gen­
erally had smaller out-of-sample forecasting
error variance than any of the structural models

The results thus far presented provide con­
siderable support for the general equilibrium
model and suggest that the omission of ex­
pected structural budget balances from the
portfolio balance model is a serious error. They
also indicate that the U.S. fiscal stimulus has
had significant impact on the dollar and that its
influence has worked through goods market
pressures and interest rate differentials, but not
through a risk premium.
Chart 1 shows the movement in the real long­
term interest differential between the U.S. and
other major OECD countries implied by our
estimated model from 1974 through the second
quarter of 1985.15 The real long-term interest
rate differential in favor of the U.S. peaked in
1982 at around 4 percent and has since dropped
sharply to around 1 percent in the second
quarter of 1985. At the same time, the real
value of the dollar continued to rise until early
1985. The shift of the U.S. budget into deficit
and an accompanying movement of foreign
budget balances towards surplus, shown in
Chart 2, helps to explain the otherwise puzzling
opposite movement between the real exchange
rate and the real interest rate differential.

Chart 2
U.S. and Foreign Structural Budget Balances
Percent of Potential GNP

38

Out-of-sample fit is an important criterion to
consider when evaluating any econometric
model. This seems particularly true for exchange rate models, which appear to be subject
to more than the usual degree of instability.
Our out-of-sample forecasts suggest that a
model stressing the importance of direct fiscal
effects on the real value of the dollar, and not
limited to indirect effects operating through interest rate differentials or risk premium determinants alone, gets a distinctly better rating
than do most other models of exchange rate
determination. The direct effect of fiscal policy
on the longer run equilibrium value of the dollar is a largely neglected theoretical point, but
one that appears to be highly important in practice.

examined. Interest rate differentials are an important element in a number of the models
tested by Meese and Rogoff, but none of these
models contains domestic or foreign budget balances.
In the post-1981 period, the random walk
model has a smaller root mean square error
(equal to 14.7) in forecasting the real value of
the dollar than doe~ the model containing only
the real interest differential (equal to 18.1).
This result comes as no surprise since it parallels the earlier findings of Meese and Rogoff.
It is noteworthy, however, that the root mean
square error of the out-of-sample forecast from
the exchange rate model that includes U.S. and
foreign budget balances as well as the real interest differential is much smaller (at 5.39) than
that for either alternative forecast.

v.

Conclusion

This paper has presented two alternative
views on the way fiscal policy influences real
exchange rates. Each leads to substantially different conclusions about the future course of
the dollar in the foreign exchange market. The
first view, based on a short-run, partial equilibrium portfolio balance model of exchange rate
determination, predicts that the dollar will con-

tinue to depreciate either because of a declining
real interest rate differential or because of
investors' reluctance to continue to absorb U.S.
dollar-denominated debt into their portfolios.
The second view, based on a longer run, general equilibrium model, predicts that the dollar
is likely to remain strong by the standards of
the late 1970s. In particular, this view suggests

Chart 3
Real Trade-Weighted Dollar
1980-82 avg.

=

100

130
120
110
100
90
80 L.....L......L.-L--J._........L..-L................Il...-........................
1974 1975 1976 1977 1978 1979 1980

39

that as long as U.S. structural budget deficits
relative to those abroad, the real
value of the dollar should remain substantially
above its pre-1980 level.
Empirical estimates and out-of-sample forecasts based on the two alternative views largely
support the "strong dollar" prediction of the
general equilibrium model. Recent dollar declines appear mainly to be related to a narrowing r~alinterest rate differential between the
U.S. and abroad, and not to investors' reluctance to continue to absorb increasingly large
amounts of U.S. debt into their portfolios.
There is very little evidence that a significant
exchange risk premium on dollar assets exists,
or will soon develop.
In the absence of substantialifurther declines
in U.S. real interest rates (or increases in foreign rates), our results suggest that aggregate
demand pressures associated with U.S. budget
deficits could well keep the dollar strong in the
intermediate term. This conclusion contrasts
with what appears to be the majority opinion
of economists and forecasters. Although we accept the theoretical possibility of the consensus
view that the dollar is likely to continue to fall
in the near term, our evidence and that of other
studies provides little empirical support for it.
A large number of analysts apparently hold
to the opinion that the dollar must ultimately
fallback to its pre-1980 level because a persistent
y high dollar value would continue to generate, in their view, unsustainably large U.S.
current account deficits. This conclusion is
based on the assumption that foreigners will not
be willing to finance U.S. current account deficits at their present magnitude indefinitely.
The rising stock of U.S. external debt, it is usually argued, will eventually generate large risk
premia on U.S. assets. A rising risk pn:mllUnl,
in turn, would cause U.S. interest rates to rise
and the real value of the dollar to fall.
One recent projection (Krugman, 1985) indicates that if the dollar only gradually depreciated from its present high level, the U.S.
foreign-debt-to-GNP ratio would continue to
climb for the next 23 years, stabilizing at
roughly 46 percent. If this were considered an
unsustainably high ratio, then the implication
is that the equilibrium value of the dollar must
be considerably less than its present value.

Admittedly, our theoretical and empirical
analysis does not purport to deal with a time
horizon of a quarter of a century and a full
long-run steady state stock equilibrium. But, as
shown in Hutchison and Pigott (1985), our
basic model's predictions appear to be reasonable even in the context of very long-run
growth. 16 Moreover, we believe that time homost market participants are relatively
short. Our empirical estimates suggest horizons
of roughly three to four years, and an informal
of actual participants in the foreign exchange market suggests even shorter time horizons.
Even if market expectations are formed on a
time horizon as long as a steady state analysis
implicitly entails, there is some question as to
whether a 46 percent foreign debt-to-GNP ratio
for the U.S. is implausibly large. A number of
countries less politically stable than the U.S.
have external debts considerably larger than
half of their GNP. And, given the status of the
U.S. dollar as the premier investment, reserve
and international transactions currency, world
demand for U.S. assets is presumably (proportionally) larger than that for most other nations.
In conclusion, our results suggest that the
real value of the dollar could well remain high
by pre-1980 standards for the foreseeable future. Its strength is caused by aggregate demand pressures associated with greater fiscal
expansion in the U.S. than abroad, combined
with the general willingness of foreign lenders
to finance U.S. current account deficits. Moreover, there is little evidence to suggest that the
dollar's underlying strength is a speculative
bubble that could easily be punctured by further official exchange market intervention. In
early 1985, the dollar was indeed stronger than
could be explained by fundamental factors. But
by the third quarter a subsequent depreciation
had moved the dollar back into line with the value
predicted by our model. 17 At the present time,
coordinated policies designed to reduce fiscal
imbalances between the United States and
abroad would likely be the most effective approach to bringing about a significant and longlasting decline in the real exchange value of
the dollar in a non-inflationary environment.
40

FOOTNOTES
1. To show that (3) holds in real (price-adjusted) as well
as nominal terms, we define the real exchange rate (q) and
the future real exchange rate (qe)expected to prevail n periods hence as:

s

ysis. This is that the former, the aggregate demand for
goods worldwide is increased by a larger budget deficit (at
the initial level of interest rates), while in the latter aggregate demand rises in the country receiving the transfer
payment but falls in the paying country as the amount of
the transfer payment is collected. In the classical case of
no change in worldwide aggregate demand, the transfer of
rea! resources can be carried out through a change in the
trade balance without any alteration in the real exchange
rate so long as the marginal propensities of the two countries to import sum to one. See Caves and Johnson (1968,
pp. 115-171) and Mundell (1960). However, in the case of
a fiscal expansion in only one of the countries, for there to
be no change in the real exchange rate, it is necessary
that fiscal expansion increase the demand for foreign
goods as much as the demand for home goods.

P*

=

q P

qe P*(1

+ p*)n
+ p)n

~~"'-"""'''~~'~'~~~-

P (1
where
=
P
P*
p
=
p*

U.S. price level;
foreign price level;
expected U.S. inflation rate (annualized);
expected foreign inflation rate (annualized).

Taking logarithms of these two equations and substituting
into equation 3, one gets:
In q
n [(i - p)
(i* - p*)]
n<j>e
or In q = n (r - r*) - n<j>e + In qe
where

4. This diagram comes from Dornbusch (1983) and Blanchard and Dornbusch (1984).
5. The difference between the classical transfer problem
and the general equilibrium view of the effect of a budget
deficit on the exchange rate can be illustrated with Diagram
2. The shift of Ggs to G¥s and GSow to GlOW could just
as well be produced by the effect on U.S. income of a
transfer payment to the U.S. from the rest of the world. As
the diagram is drawn, the propensity of the U.S. to spend
the transfer on U.S. goods is greater than the propensity
to import, so GUs shifts by more than Grow.

+ In qe

r = i
r* =

j*

p*

2. This is a description of the adjustment to a fiscal stimulus in a world of flexible exchange rates and relatively
unchanged price levels. The logic of the argument can be
applied equally well to a world of fixed exchange rates and
flexible price levels. As before, the fiscal stimulus is assumed to produce more of an increase in the demand for
domestic goods than in the demand for foreign goods. In
a world of fixed exchange rates, the result would be an
increase in domestic prices relative to foreign prices. With
a given nominal exchange rate, this relative change in
prices implies an appreciation in the domestic real exchange rate.

However, unlike the case of pure fiscal expansion in the
U.S., in the classical transfer analysis the collection of the
transfer abroad through taxation has income effects that
reduce the demand for home goods and imports there. If
the sum of the marginal propensities to import in the two
countries were equal to one, the relatively large propensity
of the U.S. to spend on domestic goods would be matched
by an equally large propensity by the rest of the world to
import. Adding the income effects for the rest of the world
from the transfer to the diagram, the G¥s schedule would
therefore shift back exactly to Ggs and, similarly, GioW
would shift back to GboW As a result, when the sum of the
import propensities equals one, a pure transfer payment
from the rest of the world to the U.S. would effect the required movement in real resources through a deterioration
in the U.S. trade balance without any change in either the
real exchange rate or the world interest rate.

3. This model is essentially a classical, or full employment,
version of the Mundell-Fleming model of fiscal policy in a
world of perfect capital mobility. See Mundell (1963) and
Fleming (1962). However, the assumption about the relative impact of fiscal policy on spending in the two countries
is also crucial to the outcome for the real exchange rate.
If fiscal expansion increased the demand for foreign goods
as much as the demand for home goods, there could be
no impact on the exchange rate.

6. This view has been widely expressed. Another example
is Branson (1985). Moreover, in the analysis of Branson
and others, the exchange rate will eventually deprl;'lciate
below its initial level. This is because a zero balance current account is assumed to be a necessary equilil;Jrium
condition in the no-growth context of their models. Because
the initial exchange rate appreciation causes a fall in net
exports and an associated foreign capital inflow, the U.S.
external debt rises. To generate a trade balance surplus
that equals the net foreign debt interest payments (keeping
a balanced current account), the exchange rate will fall
below its initial level (see Rodriquez, 1979).

This part of the analysis is similar to the classical transfer
problem. The literature on the classical transfer problem
deals with the question of how a financial transfer of purchasing power between two countries-for example
through gifts, reparations payments, or capital flows-effects a corresponding transfer of real resources. A question
of particular importance in this literature is whether a
change in the real exchange rate is required to effect the
transfer. The answer turns on the income effects of the
transfer on spending in the two countries. A famous early
discussion of the transfer problem was between J.M.
Keynes and Berti! Ohlin with regard to German reparations
payments. See Ellis and Metzler (1950, pp. 161-179).

7. These are Japan, West Germany, France, the United
Kingdom, Italy, and Canada.

There is an important difference, however, between the
effect of a fiscal expansion and the classical transfer anal-

8. The estimated equation for forecasting U.S. inflation
over the maturity of the 6 month commercial paper rate is:

41

16

Pi~2=

10

serve. Ww equals Os plus central government debt net of
central bank holdings in the six foreign countries. LCA is
the value of U.S. net external assets in 1970 plus the U.S.
current account surplus cumulated quarterly from 1971 :01
on. The source of data for central government debt and
the U.S. current account is the International Monetary
Fund, International Financial Statistics. U.S. liabilities to
official institutions is taken from U.S. Treasury Department,
Treasury Bulletin. Since the supply of U.S. debt is measured net of U.S. liabilities to official institutions, the cumulative current account is also measured net of changes
in these liabilities.

.141 +.4632:tiA1 i + .552 2: P-i
1=0

( - .486)
R2 = .812

(3.11)

i=O

(4.24)

S.E. = 1.26 DW. = 1.09

Equations based on monetary growth overpredict inflation
in 1982 and 1983 by a substantial margin because of an
unusual decline in M1 velocity. However, the demand for
M1 was stable, so the decline in M1 velocity can be explained statistically by the decline in inflation and nominal
interest rates that occurred in the period. If M1 growth is
adjusted for this effect, it continues to predict the growth
of nominal income and inflation reasonably well. Consequently, for this period, an adjusted M1 growth was used
in the inflation forecasting equation instead of actual M1
growth. The adjustment factors that were used are described in Judd and McElhattan (1983). For an analysis of
the effect of the decline in velocity on inflation and why it
occurred, see Throop (1984a, b).

*
The domestic (Dd) and rest of world (Dd)
demand functions
for U.S. government debt may be expressed as proportions
of total government bond holdings (both foreign and domestic), Wand W*, of residents in each country. (The proportions of this wealth invested in the rest of the world's
government debt equal one minus the percentages invested in U.S. debt.)

Dd = (b d + bo<l>e)w
Dd = (bd + bo<l>e)w*

9. The source of the interest rate data is the Board of
Governors' macrodata library. The data on consumer
prices is from the International Monetary Fund, International Financial Statistics.

This formulation assumes that domestic and foreign demand for U.S. government bonds differ only by a constant
term, which is higher in the U.S. because domestic investors prefer the home country habitat. Setting the supply of
U.S. government debt, Os, equal to the total demand,
Dd + Dd' we have:
Os = (bd + bo<l>e)w + (bd + bo<l>e)w.
Letting W + W* = Ww,
Ds = bdW + bd (Ww - W) + bo<l>eww

10. See Throop (1984,c).
11. The trade-weights used are those described in "Index
of the Weighted-Average Value of the U.S. Dollar: Revision," Federal Reserve Bulletin. August 1978, p. 700.
12. If changes in real wealth affect consumption so that
the inflation-adjusted measure of the budget balance is the
correct one, then the theoretical model in Section II should
be amended to include wealth as an argument in the absorption of goods and services in both countries.

Then solving for <l>e,

Useful discussions of the concept of the inflation-adjusted
budget balance include Eisner and Peiper (1984), Jump
(1980), and Siegel (1979). The budgetary data used are
the combined federal, state, and local balances compiled
by the OECD. Trade-weights are clearly appropriate for
combining the rest of the world's real interest rates. However, in the case of the structural budgets, the relative size
of the country is a further consideration. The impact of a 1
percentage point change in a country's structural budget
on the bilateral rea~~*change rate with the U.S. should be
greater the larger is the size of that country's economy.
Given the influence of relative GNP on the bilateral real
rate, the impact on the real trade-weighted value of the
dollar then depends upon the trade-weight of that country.
Therefore, the weight for the foreign budget balances that
we used is the trade-weight times the relative GNP-weight.
Since GNP-weights and trade-weights are highly correlated, this weighting scheme is not, in fact, very different
from pure trade weights.

Os
<l>e

boWw

bd - bd W
---bo
Ww

bd
bo

Thus, the risk premium is a function of the ratio of the
supply of U.S. government debt, Os, to the total supply of
government debt (both foreign and domestic), Ww, and also
the ratio to total U.S. holdings of government bonds (both
foreign and domestic), W, to total government debt. We
measure W by adding to total U.S. government debt an
amount that is some fraction of the cumulative current account surplus since only a portion of net private investment
abroad goes into government bonds. This gives the values
of <l>e to be substituted into equation 8 for the real exchange
rate.
bd

- bd + bd D

Since the relative effects of Band B* on the real exchange
rate depends upon the relative size of the U.S. versus the
rest of the world, there is no reason in principle why the
coefficients on the two budget balances should be constrained to be of equal absolute value, as is the case with
U.S. and foreign interest rates.

or <l>e

~

Ww

bd - b; 2:CA
-

0'

--- -

bo

Ww

bd
-

bo

15. Since the estimated coefficient on each of the lagged
differentials in short rates equals n times the weights in the
distributed lag of an ordinary term structure relationship,
and the sum of the estimated coefficients should be approximately equal to n, the original weights in the term
structure can be obtained by dividing each estimated coefficient on the lagged differential in short rates by n. The

13. This point is rigorously demonstrated in Frankel
(1979).
14. Os is calculated as U.S. federal government debt less
liabilities to foreign official institutions and the Federal Re-

42

synthetic real long-term interest differential is then obtained
by applying these derived weights to the current and past
differentials in real short-term rates.

tions include a low risk premium and both modest output
responses and small world interest rate increases in response to the fiscal stimulus.

16. Hutchison and Pigott show that a permanent real exchange rate appreciation following a fiscal stimulus is likely
under a wide range of plausible conditions. These condi-

17. When equation 2 in Table 1 is estimated through
1985:02, its predicted value for 1985:03 is almost exactly
equal to the actual value of the real exchange rate.

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43