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2

I. Interpreting the Reagan Deficits

II.

.............. ............... 5
Thomas J. Sargent

International Financial Crises, Past and Present .........................13
Hang-Sheng Cheng

III. Oil Prices, Exchange Rates and the U.S. Economy:
An Empirical Investigation....................... ......................................... 25
Bharat Trehan
IV. Real Exchange Rates, Imperfect Information,
and Economic D istu rb an ces................ ........................... ..
.44
Reuven C lick
Editorial Committee:
Randall J. Pozdena, Carl Walsh, Michael Keeley, Frederick T. Furlong

I

3

4

Thomas J. Sargent"

This paper describes two ways ofrationalizing the large net-ofinterest
deficits experienced by the U.S. during the Reagan Administration. Both
of these rationalizations imply that U.S. government expenditures are
destined to fall relative to their pre-Reagan path.

Figures on government deficits are difficult to
interpret because the economically relevant budget
constraint is an intertemporal one. As such, it
restricts the present value of a sequence of government deficits but not the size of deficits for particular
years or even for long strings of years. For any
observed string of government deficits, there always
exists a string of prospective future surpluses that
renders the budget in balance in the present value
sense.
By alluding to prospects for future government
surpluses, anyone can therefore assert that a record
of observed deficits is consistent with maintaining
sound government credit and a stable government
currency. Several years of big deficits by themselves
therefore fail to indicate that the entire sequence of
government budgets is out of balance. This fact
opens recent deficit figures for the United States to
alternative interpretations, some hopeful, others
foretelling doom.

This paper tries to rationalize the large net-ofinterest deficits in the federal budget of the United
States that have marked the Reagan Administration.
I take for granted that the recent deficits are temporary and that they foretell future government surpluses. I spend no time discussing the view that the
deficits are simply a mistake, a failure of policy, or
the result of shortsightedness or ignorance of the
intertemporal government budget constraint. Instead I focus on alternative interpretations of recent
events that are consistent with George Stigler's
vision that all agents in a social system are rational
and purposeful. I seek to explain the fiscal and
monetary actions observed during the Reagan
administration as reflecting the optimal decisions of
government policymakers.
There will be one equation in the background of
my discussion, one whose validity is granted by all
competing theories of macroeconomics. This equation is the intertemporal government budget constraint. It states that, at any moment, the value of
interest-bearing gov~mment debt is equal to the sum
of two terms: the present value of future government
surpluses net of interest, and the present value of
future government revenues from printing currency
(seignorage revenues).

* Visiting Scholar, Federal Reserve Bank of San
Francisco, and Professor of Economics, University
of Minnesota. I received helpful comments on an
earlier draft from Randy Pozdena, Michael Keeley
and Carl Walsh.
5

stance that has been tight, especially before February 1985, and even more so before August 1982. I
take as indicators of tight monetary policy high real
rates of interest on U.S. government debt and pretax yields that exceed the growth rate of the economy. (Real rates of this magnitude imply that the
interest-bearing government debt is growing relative to the size of the economy unless the net-ofinterest government budget is in sufficient surplus.)
I take for granted that the string of net-of-interest
government deficits and tight monetary policies
(low rates of seignorage production) cannot both
continue forever, simply because they would violate
the intertemporal government budget constraint.2
I shall describe two rationalizations of recent
observations on government policy, each of which is
consistent with the government budget constraint,
under the hypothesis of "rational expectations" and
the presumption that the government as a whole is
committed to a monetary regime with low inflation
rates over the long haul. The last stipulation is
equivalent to an assumption that the present value of
seignorage in the government budget restraint is
taken for granted to be small.

Presumably, the government deficit net of interest
and the revenues from currency creation are controlled by separate and independent agencies of the
U. S. government. However, in a recurrent and strategic sense, independence is not feasible. Because
revenues from printing currency are one component
of the government budget constraint, the notion that
there can be truly independent monetary and fiscal
authorities is a myth.
Arithmetic makes the strategies of the monetary
and fiscal authorities interdependent. 1 Classic recommendations for the conduct of monetary policy,
such as Friedman's (1959) k-percent growth rule for
currency or the gold standard, are well understood
as coordination rules for monetary and fiscal policy.
For these coordination rules to be feasible, the
intertemporal government budget restraint must be
respected. Throughout this paper, I will assume that
a version of Friedman's k-percent coordination rule
(one with a small value of k) is followed.
I seek to interpret the following observations
about monetary and fiscal policy during the Reagan
years: a string oflarge annual net-of-interest government deficits accompanied by a monetary policy

I.

Barro Tax Smoothing

The first rationalization is constructed by applying the optimal tax smoothing model of Robert
Barro (1979). I assume that the monetary authorities
are committed to supplying little or no seignorage,
and that this is beyond dispute. It follows therefore
that the present value of seignorage is small.
Because of the government budget constraint, the
net-of-interest government budget must be in surplus in present value by an amount equal to the
current value of interest-bearing government debt.
How can this implication be reconciled with the
string of large net-of-interest deficits observed during the Reagan administration? Barro's model supplies a possible answer.
Barro's model of tax smoothing can be thought of
as a reinterpretation of Milton Friedman's (1956)
model of permanent income as developed by Robert
E. Hall (1978).3 The permanent income model of
consumption confronts a consumer with an
exogenous process for labor income and a constant
real rate of return on savings. The consumer has

preferences over a long horizon that can be represented as a discounted sum of a current period utility
function that depends on current consumption
alone. That is, preferences are additively time-separable, and the utility function is concave in current
consumption.
Hall shows that for a discount factor equalling the
reciprocal of the gross interest rate on assets, the
marginal utility of consumption follows a random
walk. To the extent that the marginal utility of
consumption is approximately linear in consumption, consumption itself may approximately follow
a random walk. As Hall has stressed, for any income
process, no matter how unsmooth, the model predicts that consumption is approximately a random
walk. This means that at every point in time, future
consumption is expected to be approximately constant.
Hall's model precisely represents the consumption-smoothing idea present in Friedman's ongmal
work on the consumption function. A possibly very

6

unsmooth labor income process is used to support a
consumption process whose future is expected at
each point in time to be perfectly smooth. Borrowing and lending are used to convert an unsmooth
income path into a smooth consumption path. At
any time, the mean of the consumption path is set so
that the present value of consumption equals the
present value of labor income plus initial nonhuman
assets.
Barro can be regarded as having changed the
names of the variables in Hall's model and applied
them to government. In place of the household
budget constraint, Barro uses the government budget constraint. What was the exogenous labor
income process in the Friedman model becomes an
exogenous process for government purchases. What
was consumption in the household budget constraint becomes total tax collections in Barro's
model. What were household assets become the
stock of interest-bearing government debt. The
interest rate confronting the household in Hall's
model becomes the interest rate at which the government can borrow and lend in Barro's model.
The intertemporal version of the re-interpreted
budget constraint is precisely the intertemporal government budget constraint described above, with
seignorage assumed to have a present value of zero.
In place of the preference function used by Hall,
Barro uses an additively time-separable loss function measuring distortions from taxing. The current
period loss function is convex in total tax collections.
Barro poses the problem of a government that
faces an exogenous and given stochastic process for
government purchases and that chooses a tax strategy to minimize the expected discounted value of
losses from tax distortions. In mathematical terms,
this model is equivalent to Hall's consumption
model, with the change of variables described
above. It follows that the model gives the result that
optimally, total tax collections should follow a random walk. That is, in the face of an unsmooth
government expenditure stream, tax collections
should be smoothed. In this way, distortions are
allocated over time in a way to minimize the present
value of the distortion.
We note that this result depends critically on the
feature of the loss function that the distortion at time
t is assumed to depend only on total tax collections

at t, and not on future tax collections, as would
occur in a model in which private agents are speculating about future government tax collections. In
Barro's model, expected future tax collections are
set equal to current tax collections, with current tax
collections set to satisfy the intertemporal government budget constraint.
The Barro model can be used to rationalize the
observed deficits of the Reagan Administration as
part of an optimal tax smoothing response to an
"innovation" about the present value of government
expenditures that arrived coincidentally with
Reagan's election.
Assume that the election of Reagan signalled a
downward revision in the size of the U.S. government, as measured by the expected present value of
federal expenditures. Assume further that the path
of reductions, compared to the path that could have
been expected prior to Reagan, was skewed toward
the future or "back-loaded". That is, the election of
Reagan meant reductions in the government expenditures could be expected to take place gradually
over time, with larger reductions in the future than in
the present.
Given such a change in the path of expected
government expenditures at the start of the Reagan
administration, Barro's tax smoothing model predicts that the (optimal) response of the government
would be an immediate permanent reduction of tax
collections, relative to the pre-Reagan path. The
consequence of these immediate reductions would
be a string of deficits while expenditures remained
high, to be followed by a string of net-of-interest
government surpluses after the reductions in
expected government expenditures had been realized.
According to this scenario, there is nothing
pathological about the large deficits we have
observed. Instead, they are to be interpreted as the
result of optimal tax smoothing by the federal government. Note that Barro's argument implies that
the, Reagan Administration should have tried for a
25 percent reduction in tax rates at one shot, rather
than the 5-10-10 phasing in over three years embodied in the Kemp-Roth tax legislation.
Barro's model implies that the large deficits
observed pose no inflationary threat because they
pose no danger of being monetized subsequently.
The fact that the interest-bearing U.S. government
7

investment decisions and therefore future values of
capitaL As a result, they should be used sparingly.
The assymmetry in attitude toward current and
future taxes on capital is at the heart of the time
inconsistency of the
as well as
suboptimality of tax smoothing.
In summary, by restricting the nature of the function that is assumed to measure the losses from the
distortions that taxes
Barro was able to
create a model calling for "tax-smoothing". By taxsmoothing, he meant
even if government
eXI)erldH:un~s were
to vary in the future, it
would be optimal for consumers to expect taxes to
remain unchanged. Applied to the current situation
in the U.S. (supposing that the election of Ronald
Reagan signallea that government expenditures
would fall relative to their pre-Reagan path), the
model rationalizes a string of deficits like the one we
have experienced. Not only does the model
"explain" those deficits, but it also implies that they
are not signs of a "problem". Rather, the current
deficits are simply a "signal" of future reductions in
the path of government expenditures.
This application of Barra's model is attractive
because it explains many aspects of the current
situation and supports a sanguine interpretation of
recent U.S. deficits. However, such an application
is not beyond criticism for reasons alluded to above.
In particular, the restrictions on the loss function
measuring distortions in Barro's model are very
strong ones. Indeed, the restrictions suppress any
"supply side" effects flowing from expectations
about future taxes to current decisions.
I now turn to an alternative interpretation, one
due to Neil Wallace. Wallace's interpretation hinges
on the observation that economic policymaking in
the United States is decentralized over a variety of
agencies, and that
cannot
be reduced without a struggle among those agencies. Wallace's explanation makes the deficit an
instrument in that struggle.

debt has grown under Reagan is merely a signal that
the budget will swing into surplus sometime in the
future, and that government expenditures are destined to fall relative to their pre-Reagan path.
The scenario described
on a
controversial aspect of Barro's specification of the
function measuring the current loss from distortion
in the government's objective function. In particuBarro spl~ci'ties that the current distortion at time
t depends only on current tax collections, and is not
a function of the public's expectation of future taxes
set by the government. This feature is critical in
giving rise to the random walk characterization of
taxes, which is at the heart of our interpretation of
the Reagan deficits. It is also crucial in rendering
Barro's solution of the optimal tax problem timeconsistent. 4
H()w<~ver, in models in which there is capital,
either
or human, the current distortion
from taxation at time t typically depends in part on
people's expectations about future taxes. In making
investment
look and respond to
the government's strategy for taxing in the future.
about future taxes therefore distort
decisions. 5 Such distortions would alter
Barro's loss function in a way that would make it
sul)o~)til1[lal if tax collections followed a random
walk. It would also render the solution of the optimal tax problem time-inconsistent. Various administrations
over time would therefore be
unable to carry out any solutllon.
As it turns out, when optimal tax
are
solved for systems with physical or human capital,
the
tax
usually is far from a random
walk
Usually high taxes are called for
in the
lower taxes in the
future. Since
taxes now are imposed on existand
is
inelastic
the taxes take on a lump sum character. As
such current taxes should be imposed
to minimize the
value of distortions.
future taxes, in contrast, do distort

8

Wallace's Game of Chicken
opens the way to the playing of what Neil Wallace
has characterized as a game of chicken.
In the game of chicken being played
Reagan Administration, the tax and
authorities jointly desire a reduction in the present
value of government expenditures (something they
do not control) as well as a stable price
expenditure authority is assumed to desire a larger
government in the sense of a larger expected
value of government expenditures than does the tax
authority.
To achieve its objective, suppose that the tax
authority plays the game as follows. It achieves a
once-and-for-all reduction in tax collections that
reduces the present value of tax collections relative
to its initial value. The tax authority
then encourages the central bank to adhere to a
k-percent rule for the monetary base for the indefinite future. Such a monetary policy
that the
central bank withholds seignorage revenues
the government. Given these
the President and the Federal Reserve, the only plays open to
the government expenditure authority are ones that
capitulate to the President's objective and that
reduce the present value of government eXJ)enditures by an amount commensurate with the reduction in the present value of tax collections. As
as the President and the Federal Reserve adhere to
their strategies, the stream of g01,enrlment eXJ)eulditures must be reduced because of the arithmetic of
the government budget restraint.
Congress may, however, reason as follows. It can
simply refuse to reduce the present value of government expenditures despite the tax reduction
neered by the tax authority.
as long as the
mcmetary authority refuses to monetize interestbearing government debt, the arithmetic of the
government budget constraint
that the tax
authority eventually reverse itself and raise taxes by
an amount that makes the present value of taxes
equal to the present value of
plus
whatever debt has accumulated. If the monetary
authOl:1ty and Congress both refuse to chicken out,
then the arithmetic of the budget constraint asserts
that the only feasible thing for the tax authority to do
is to raise taxes.
Of course, it is feasible that neither the tax

Wallace's interpretation assumes that the" game"
played by government policy authorities has a different structure from that assumed. by Barro. In
particular, Wallace has interpreted monetary and
fiscal policy during the Reagan Administration as
unfolding like a game of chicken among distinct
branches of government with different preferences
about the size of the U.S. federal government. 6 In
this game of chicken, reducing the present value of
gover:nnl1errt expenditures is not a
but instead
is the objective of one of the participants in the
game. This objective, in tum, is actually opposed by
another player. The players' weapons consist of their
separate authorities to set paths for government
expenditures, tax collections, and currency creation. Using Wallace's analogy, the Reagan Administration plays the game for the purpose of reducing
the present value of government expenditures - an
objective whose attainment Barro's explanation
took for h"un',-".
The game of chicken is played among
decentralized branches of government that control
separate elements of the government budget constraint. There is a tax authority, whose role I shall
assign to the Reagan Administration, and whose
responsibility is to select a stochastic process for tax
collections. There is a government expenditure
authority, here assigned to Congress, that determines the stream of government eX!Jerlditures.
Finally, there is a central bank (the Federal Reserve
System) that determines a time stream of currency
and thereby controls the present value of seignorage
that appears in the government budget constraint.
While these three players, the tax authority, the
eX!Jeuldlture authority, and the monetary authority,
must coordinate their strategies because
arithmetic of the intertemporal government budget constraint, they are not forced to do so on a day-to-day
basis by any formal legal Of constitutional mechanism. The coordination of monetary and fiscal
icy in the United States is not governed by a set of
well-understood, recurrently applied, or explicit
rules. Instead, policy actions seem to emerge from a
process that is decentralized across institutions
(Congress, President, and Federal Reserve) and
spread over time through a succession of administrations and personalities. This decentralization
9

authority nor the expenditure authority will chicken
out. In that case, the central bank would be forced to
chicken out by departing from its k-percent rule and
generating substantial seignorage. By monetizing
the debt, the central bank would permit government
expenditures to exceed tax collections in present
value terms, albeit at the cost of generating inflation.
While the authorities are playing this game of
chicken, we would observe large net-of-interest
government deficits, low rates of monetization of
government debt (low growth rates for the monetary
base), and maybe also high real interest rates on
government debt. The result of high real interest
rates on government debt and the net-of-interest
government deficit is a growing real value of the
stock of interest-bearing government debt. The rising stock of this debt would be a signal that the game
is not yet over, in the sense that there has been
insufficient capitulation. In the U.S. today, the real
stock of interest-bearing federal debt continues to
grow in relation to GNP.
The game of chicken interpretation has a number
of merits as an explanation of these events. While it
is tempting to criticize resorting to a game of
chicken as an inferior way to run a government, such
criticism ignores the extensive decentralization
across time and institutions that exists under U.S.
government. Given the limited power assigned to
the Presidency for economic policy in general and
government expenditures in particular, resorting to
the game of chicken may be the best method available for achieving the preference, reflected in

m.

Reagan's policies, for reducing the size of the U. S.
government.
Several important macroeconomic policy events
during the Reagan years bear interpretations in
terms of one party or another in our game of
chickening out. The Federal Reserve partly chickend out on two occasions, one in August 1982, and
another at the start of 1985. Each time, the Fed was
responding to outside pressures that were partly
consequences of, and which in tum fed back upon,
the original game of chicken.
In August 1982, the Fed substantially eased monetary policy, increasing the growth of narrow monetary aggregates and driving real interest rates downward. These actions were in large part responses to
the international debt crisis that coincided with the
high real interest rates associated with the game of
chicken that dominated U .S. macropolicy. The Fed
eased its monetary policy specifically in response to
the Mexican crisis and the threat it posed for U. S.
financial stability. Such concerns limit the Fed's
ability to continue to playa tight monetary policy in
the face of continued net-of-interest U.S. government budget deficits.
The second partial capitulation by the Fed was
associated with a move starting in early 1985 to
lower real interest rates in the U. S. as a device to
drive down the value of the dollar. The Fed was
responding to the increasing strength of protectionist pressures in the U.S. that were themselves
responses to the U.S. trade deficit which was, in
turn, one consequence of the string of government
deficits associated with the game of chicken.

Conclusion

While they differ in a number of respects, our two
alternative rationalizations of the Reagan deficits
share the premise that, compared to the pre-Reagan
path, U.S. federal expenditures are destined to fall.
In Barro's model, the fall in the path of expenditures
occurs exogenously, and precipitates the Reagan
deficits via optimal tax smoothing. In Wallace's
view, the fall in the path of federal expenditures
relative to the pre-Reagan path is an outcome of
(or "reward to") the game of "chicken", with an
endless string of prospective budget deficits being
the stick by which the President and Federal Reserve

persuade a reluctant Congress to reduce federal
expenditures. According to both explanations, large
net-of-interest deficits are signals of prospective
surpluses to be achieved via reductions in expenditure.
Each rationalization relies on the looseness of the
intertemporal government budget constraint to
which I referred at the beginning of the paper. A
long string of large deficits is consistent with budget
balance provided that sufficient surpluses occur
later. We have rationalized the large Reagan deficits
by appealing to the idea that they are temporary and

10

bound to be replaced by surpluses long before they
damage the economy.
Some readers may find the entire endeavor of
rationalizing the large Reagan deficits to be misplaced. Perhaps it is farfetched to rationalize deficits
in the ways that we have, and better to regard them

simply as reflecting shortsighted mistakes that the
U.S. is bound to pay for in the future via more
inflation, increased financial fragility, or higher
taxes. Nevertheless, to reach the conclusion that the
deficits of the last five years were mistakes, One
must first understand the arguments that could
rationalize them.

ApPENDIX

(H4) Eo At "" M > -

We describe linear-quadratic versions of the models of Hall (1978) and Barro (1979). The exposition
is designed to highlight parallels between the two
models. For further details and implications of the
models, see Sargent (1987).

00

forallt

which rules out a strategy of larger and larger
borrowing to support bliss consumption. Subject to
H4, the solution of the difference equation H3 is the
following intertemporal version of the budget constraint:

Hall's Model
A representative consumer chooses a contingency
plan for (ctYr=o to maximize

Equation H5 states that the expected present value
of consumption equals the expected present value of
labor income plus the value of initial assets At.
where c t is consumption at t, Et is the mathematical
expectation operator conditioned on information
known to the consumer at t, and u is a one-period
utility function given by

Hall shows that a first order necessary condition
associated with the problem of maximizing HI
subject to H5 is Etu'(c t + I) = (f3R) IU'(C t). Since
we have set f3R = 1, this becomes Etu' (c t + I) =
u'(c t). With utility given by H2, this in turn implies
I; ct + I = c t, so that consumption is a random walk.

where uo, uI' U2 > O. The objective (H 1) is maximized
withrespectto(cl'At+I)~=o subject to the
sequence of budget constraints

Barro's Model
A government chooses a tax collection sequence
(Tt)r'=O to maximize

(H3) At + 1 =R[A t + Yt-Ct],t=O,I, ...
Ao given

00

(Bl) - E t:o f3t L(Tt),O < f3 < 1

where R "" 1 is the gross rate of return on savings
between periods t and t + I, At is assets (indebtedness, if negative), and Yt is noncapital or labor
income at t. We assume that Yt is a given stochastic
process, outside the agent's control. We assume that
f3R = 1. We assume that (Yt) is a stochastic process
that satisfies j ~1)1 E t f3j Yt + j = 0 for all t. We
impose upon assets the condition

where Tt are total tax revenues, and L is the loss
function

The maximization is carried out subject to the
sequence of government budget constraints

11

+

gt -

Ttl, t=O,

FOOTNOTES

1, ...

1. Sargent and Wallace (1981) describe some of the
implications of the interdepE";ndence between monetary
and fiscal policy.
2. This is Sargent and Wallace's unpleasant monetarist
3. See the Appendix for a more formal presentation and
comparison of Hall's and Barro's models.

and gl is government expenditures at t. Government expenditures are taken
to be an exogenous stochastic process that satisfies
= o for aH t.

4. See Kydland and Prescott (1977) for a discussion of the
time-inconsistency problem in macroeconomics. See
Lucas andStokey [1983J for a study of dynamic inconsistency in the context of an optimal tax smoothing model that
shares many features with Barro's model.

We impose the boundary condition
~

M < +

00

5. See Sargent's (1987) chapter on dynamic optimal taxation for an extended example exploring the time-inconsistency phenomenon created by the responsiveness of
investment to anticipations of future taxes.

forallt

6. Wallace advanced his ideas orally in March 1981 during discussions that later led to our co-authoring "Unpleasant Monetarist Arithmetic" (1981).

which rnles out a strategy of "never tax, always
borrow more." Subject to B4, the solution of the
difference
B3 is the intertemporal government budget constraint

REFERENCES
Barro, Robert J. 1979, "On the Determination of the Public
Debt," Journal of Political Economy, Vol. 87 (1979),
pp.940-951.
Friedman, Milton. A Theory of the Consumption Function.
Princeton: Princeton University Press, 1956.
Friedman, Milton. A Program For Monetary Stability. New
York: Fordham University Press, 1959.
Hall, Robert E. "Stochastic Implications of the Life Cycle Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, Vol. 86, NO.6
(1978).
Kydland, Finn E. and Edward C. Prescott. "Rules Rather
than Discretion: The Inconsistency of Optimal Plans,"
Journal of Political Economy, Vol. 85, NO.3 (1977), pp.
473-491.
Lucas, Robert E., Jr., and Nancy Stokey. "Optimal Monetary and Fiscal Policy in an Economy Without Capital,"
Journal of Monetary Economics, Vol. 12, NO.1 (1983),
pp.55-94.
Sargent, Thomas J. Macroeconomic Theory. 2nd Ed. Academic Press, 1987.
Sargent, Thomas J., and Neil Wallace. "Some UnpleClsant
Monetarist Arithmetic," Quarterly Review, Federal
Reserve Bank of Minneapolis, Fall 1981.

00

EIJ,

-jTt+J,=BI+EI

k

j=O

R-jg t+J,

Equation B5 states that the expected present value of
tax collections equals the sum of the current value of
debt plus the expected present value of government
expenditures. The government is assumed to maximize B1 subject to B5 by choosing a strategy for
setting(Tt)'f 0, taking B o and the stochastic
process for gl as given. Assume as in Hall's model
that I3R= l.
Mathematically, Barro's model is equivalent to
Simply replace ct in Hall's model with Tt in
Barro's, Yt in Han's model with gt in Barra's, At in
Hall's with B t in Barro's, (uo, Ul, uz)in Hall's model
with (0, - v J, vz) in Barra's. It immediately follows
from Hall's results that the optimal tax collection
strategy in Barro's model satisfies Et 7 t + J = 7 t, so
that tax collections are a random walk.

12

Hang-Sheng Cheng'"

Prior to the internationalfinancial crisis in 1931, the principal barrier
hindering adjustment by the international financial system to macroeconomic shocks was the fixed exchange rate system under the gold
exchange standard. The lack of international liquidity support also
contributed to the fragility of the international financial system. In
contrast, flexible exchange rates since 1973 and the international liquidity support that has developed since 1982 have helped avert an international financial crisis in the present, even though underlying problems
remain unresolved.

In recent years, as less-developed countries
encountered increasing difficulties in servicing their
debts to international banks, serious questions have
arisen on the stability of the international financial
system. In 1983 and 1984, at the peak of such
concerns, fears of widespread debt defaults conup the
of the disaster of 1931 , when a
rapidly spreading international banking panic
brought down the international financial system,
created havoc in the world economy, and lengthened
the duration and exacerbated the severity of the
Great Depression. In the last two years, the international-debt situation has
and
fears of an imminent cataclysm have subsided. The
underlying international debt problem, however, is
not resolved.

In the present calmer environment, it is useful to
compare the 1931 experience with the developments since 1982 for insight into underlying conditions and policy responses. The comparison sheds
light on the workings of the international financial
system, the conditions under which it might break
down and plunge into crisis, as well as the policies
that might be helpful for averting or arresting crises.
This comparative historical study cannot cover
the gamut of issues on the conditions and policies
for ensuring international financial stability.
Instead, it will focus on two subjects: cooperation
for
times of internationalfinancial stress, and the role of exchange rate
flexibility in the international transmission of economic stresses.
The article concludes that the lack of an international mechanism for providing liquidity support
prior to 1931 left the international financial system
virtually defenseless against systematic, pervasive
world economic stresses. In addition, the
exchange standard then prevailing significantly contributed to the international transmission of mone-

* Vice President, International Studies, Federal
Reserve Bank of San Francisco. Helpful comments
were received from Milton Friedman, Frederick
Furlong, Robert Gemmill, Richard Herring,
Charles Kindleberger, Jiirg Niehans, Henry Wallich, and Carl Walsh on earlier drafts of this paper.
13

from the constraints of the gold standard and helped
them adjust to the series of large and pervasive
shocks to the world economy in the 1970s and early
1980s. Moreover, since 1982, an international
mechanism has been developed to
the
essential international liquidity support for containing international financial crises.

tary deflation and other economic stresses, gave
impetus to destabilizing speculative capital flows,
and severely constrained the ability of monetary
authorities to support the financial institutions in
their own countries during times of stress.
In contrast, the flexible exchange rate system
since 1973 has released the major industrial nations

I.

The 1931 Crisis

The financial crisis that swept over Europe from
May to September 1931 and subsequently engulfed
the whole world was unprecedented in its severity,
scope, and speed with which it spread.

same course as had ordinary slumps of past business
cycles. 4
The surface calm, however, belied the increasing
fragility of the financial structure underneath. As
had the economic depression, the financial structure
started to crumble first in the peripheral countries.
From 1925 to 1930, bank demand deposits fell 27
percent in Australia, 16 percent in South Africa, 14
percent in Japan, 32 percent in Bolivia, 40 percent
in Chile, and 25 percent in Peru. 5 In contrast,
demand deposits either increased or were
unchanged in virtually all the industrial countries in
1930, even while they were engulfed by the Depression. A 1934 League of Nations' study attributed
this anomaly to banks' efforts to keep strapped
borrowers afloat by rolling over old loans and
extending new credits; the banks expected business
conditions to improve in the near future. In the
process, bad loans piled up and seriously reduced
the solvency of these banks. 6
The stress on banking surfaced in 1930. But only
in the United States, with its unique system of an
extraordinarily large number of independent banks
(about 25,500 in 1929), were there widespread bank
failures. Nevertheless, even in the U.S., banking
conditions appeared to be quite stable until October
1930, as the total deposits of failed banks up to then
were not significantly larger than during the preceding decade. In the next three months, however, a
rash of bank failures, starting from the Midwest,
climaxed in the failure of the $200 million Bank of
United States in December. The panic, however,
was shortlived and faded completely when the new
year arrived. 7 Moreover, it seemed only to be a
domestic financial stress with no noticeable impact
on banks abroad.
In the meantime, banking conditions in Europe

Calm Before the Crisis
As late as spring 1931, the international financial
system appeared remarkably stable, despite the
spectacular stock market crash in October 1929 and
the onset of the worldwide Depression. With declining world agricultural prices, economic depression
had begun in some far-flung countries and regions,
such as Australia and the Dutch East Indies in late
1927, and had then spread to Brazil and Finland in
1928, Argentina and Canada in the first half of
1929, and to the United States and most of the
European countries by the second half of 1929. I
Times were hard and businesses were failing, but
confidence in the soundness of the international
financial system was not weakened.
There appeared to be some grounds for continued
confidence. The outlying countries that first sustained large declines in export proceeds were able to
counteract the resultant balance-of-payments strains
through a combination of currency depreciation and
domestic deflation. Few resorted to exchange controls. 2 None - except the Soviet Union, Mexico,
Ecuador, and some local governments of Argentina,
Brazil, and of the United States - had defaulted on
their foreign bond issues. 3 International capital
flows remained largely unrestricted as an active
interbank deposit network provided international
liquidity to national banking systems bound
together on a gold exchange standard. For market
participants reared on a belief in the efficacy of the
gold standard adjustment mechanism, the unfolding
worldwide depression was merely following the

14

began to deteriorate quickly. Central banks managed to keep the worsening situation from public
view by conducting secret rescue operations of
insolvent banks through acquisitions by financially
stronger banks backed by large central bank subsidies. 8 The undercover operations succeeded in
containing imminent banking crises - but not for
long.

needed assistance was underestimated as the funds
lasted less than a week.
The rest of this story almost exactly duplicates
that of the Austrian episode. The Reichsbank asked
for more credits; negotiations again went nowhere
as the United States refused to take part if France
would not share the burden, while France insisted
on scrapping the customs union proposal and also
demanded that full war reparation payments resume
at the end of one year of moratorium; Britain, for its
part, wanted to tie the granting of credit to a final
resolution of the entire war debt and reparation issue
that had vexed the major countries since the end of
the war. In the end, nothing was resolved.
In mid-July, the closure of the nation's third
largest bank, the Darmstaedter and National Bank
(the Danat Bank), triggered a full-scale run on
German banks. When the central bank's gold and
foreign exchange reserves were nearly exhausted,
Germany proclaimed a two-day bank holiday, and
then imposed exchange controls that effectively
sealed off the nation from the rest of the international financial system.
In mid-July, the panic spread to Britain. On the
day of the Danat Bank failure in Germany, the
Committee of Finance and Industry in Britain issued
its report (the Macmillan Report) revealing that
London's short-term claims on foreigners at the end
of March had amounted to less than 40 percent of its
corresponding liabilities. The fear aroused was further aggravated by large fund withdrawals by banks
in Belgium, the Netherlands, Sweden, and Switzerland, which were caught in a liquidity squeeze by
Germany's exchange controls. In the two weeks
ending on July 29, the Bank of England lost $200
million in gold and dollars, or one-quarter of its
international reserves.
Again, foreign central banks came to the rescue.
Interestingly, as the banking crisis spread from
Austria to Germany and then to Britain, the size of
the major central banks' joint rescue package
expanded rapidly: from $14 million for Austria to
$100 million for Germany, and then to $250 million
for Britain. The last-mentioned, announced on
August 1, was shared equally by the Bank of France
and the Federal Reserve Bank of New York. Again,
the size proved inadequate. On Saturday, September
19, the Bank of England's remaining gold and

Spread of the Crisis
The deceptive calm ended abruptly with a massive run on the Credit Anstalt, the largest bank in
Austria, in May 1931. 9 The collapse of Credit
Anstalt was preceded by more than eighteen months
of worsening business conditions and mounting
loan losses in Austria. By the end of 1930, the net
worth of Credit Anstalt neared zero without the
public's knowledge. Ironically, it was the bank's
publication of an international rescue plan to write
off its loan losses and to replenish its capital that set
off a run that quickly spread to other Austrian
banks.
The central banks of major industrial countries Britain, France, and the United States - did see in
this situation a potential threat to the stability of the
international financial system, but they underestimated its seriousness. It took them three weeks of
acrimonious negotiations to come up with a paltry
$14 million credit to the Austrian National Bank
that was used up in five days. Negotiations for a
second $14 million bogged down over the French
government's insistence that Austria must agree to
abandon a proposed customs union with Germany.
After two weeks of frustration, the Bank of England
unilaterally extended the credit, but it was too late to
save Credit Anstalt. Bank runs and capital flights
quickly spread to Hungary, Czechoslovakia,
Romania, and Poland, which had special ties with
banks in Austria.
In June, the panic hit Germany. The Reichsbank,
the nation's central bank, lost nearly one-third of its
gold and foreign exchange reserves in the first
twelve days of June. When asked for help, the
central banks responded with greater alacrity. In five
days, a $100 million package was put together, with
the central banks of Britain, France, and the United
States and the Bank for International Settlements
(BIS) sharing equally. Again, the magnitude of the
15

foreign exchange reserves exceeded its total obligations under forward exchange contracts and borrowings from foreign banks by only £5 million. The
next Monday, England went off the gold standard,
suspending indefinitely the Bank of England's obligation to convert sterling into gold.
The shock of sterling's downfall was felt all over
the world. Unable to use their funds in London to
sustain the gold convertibility of their currencies,
some thirty-three countries in rapid succession left
gold within a year. Only France, Germany, the
United States, and South Africa remained on the
gold standard. In the meantime, 27 countries
imposed exchange controls, and virtually all countries raised import tariffs or imposed import
quotas. 1O Annual international debt defaults rose
from near zero in 1930 to $520 million in 1931 and
$830 million in 1932. 11 International lending virtually ceased. Total world trade in 1933 fell to only
35 percent of its average level in 1928-29. 12 With
remarkable
the international economy disintegrated along with the collapse of the international
financial system.

the 1920s, long-term international lending took
place largely through the national foreign bond
markets, of which the American market was by far
the most important. Among the borrowers, Germany was the largest, and the next five in declining
order were Australia, Canada, Argentina, Japan,
and India. 14 As recession spread throughout the
world, foreign issues in the United States fell from
$2.1 billion in the first half of 1928 to $900 million
in the second half and only $450 million in the
second half of 1929. 15 This abrupt decline is generany attributed to the concurrent U.S. stock market
boom, which not only reduced U.S. capital outflow
but also attracted large volumes of foreign capital
inflow into the United States, turning the U.S. into a
net importer of long-term capital by 1931. However,
the deteriorating economic conditions in outlying
countries, and their advance inward to the core
industrial countries, undoubtedly also contributed
to the sharp decline in long-term international lending.
The experience of economic contraction arising
from a compounding of export decline and the
international liquidity squeeze was common among
many countries prior to 1931. These countries
included Argentina, Australia, Brazil, Bolivia,
Chile, Venezuela, Spain, and the Eastern European
countries.
Australia's experience is illustrative. 16 That country had relied heavily on overdrafts at London banks
to finance its foreign trade. It floated long-term bond
issues to refinance short-term debts when the sums
became large. In 1927, as its export prices declined,
it began to pile up external debts and to feel the
limits of international funding. In January 1929, an
Australian issue in London was subscribed to the
extent of only 16 percent. Monetary deflation in
Australia then set in.
November, unemployment
rose to 13 percent, and sterling had to be rationed to
Australian Banks. The Australian currency began to
depreciate as a market developed outside the trading
banks. By March 1931, Australia's currency had
fallen by 30 percent against the sterling and thus
shifted the burden of adjustment to its export-competing countries.
A major cause of the gradual deterioration of the
world economy in the second half of the 1920s was
probably the malfunctioning of the fixed exchange

Although much has been written on the origin of
the Great Depression, there has been surprisingly
little systematic study on the causes of the financial
collapse of 1931 and on the policy actions that were
taken or not taken for
with the crisis. Such a
is beyond the scope of this paper, but some
comments on each of these two aspects might nevertheless be useful.
Unquestionably, a major reason for the 1931
international financial crisis was the gradual but
steady spread of the recession that began in outlying
countries in late 1927. The prolonged and worldwide scope of the recession
eroded banks'
asset and capital positions, an erosion that could not
have been avoided by any degree of banking prudence and asset diversification. Although the fragility of the international financial system should
have been evident, there is little indication that
the banking community or national
authorities fully understood the situation. 13
While deteriorating economic conditions weakened financial soundness, the resulting shrinkage in
finance in tum exacerbated the economic decline. In
16

rate
and its associated international transmISSIOn of economic shocks and constraints on
national macroeconomic policies. In the first place,
after World War I, most nations returned to the gold
standard at pre-war parities despite the high inflation that had intervened. Underpricing gold limited
the supply of gold for monetary purposes, with the
result of a general deflationary pall on the world
economy.
Misalignment of currency created additional
strains on the international economy. The overvaluation of the sterling after 1925 combined with
the undervaluation of the French franc after 1926
gave rise to a large volume of speculative international capital flows that made domestic monetary
management much more difficult. While paymentdeficit countries, such as Britain, had to adopt
restrictive monetary policies to protect their external
positions, payment-surplus countries, such as
France and the United States, were reluctant to
pursue
policies for fear of
inflation.
The universal deflationary bias was probably a
major reason for slackening world aggregate
demand. The decline in demand first hit the primary
producing countries - with low elasticities both of
demand and supply of their exports - and spread in
time to the industrial countries.
Concern over the adequacy of gold reserves acted
as a serious constraint on national authorities'
choice of appropriate policies for domestic macroeconomic stabilization. Following the sterling's
collapse in September 1931, there were heavy withdrawals of gold from the United States as foreign
central banks attempted to use the gold reserve to
defend their national currencies against speculative
capital outflows. To check the gold loss, the Federal
Reserve raised its discount rate from 1.5 percent to
3.5 percent in the two weeks ended October 16,
1931, and let banks' nonbrorrowed reserves fall
from $2.1 billion in early September to $1.3 billion
to the end of the year. From August 1931 to January
1932, the U.S. money stock fell at an unprecedented annual rate of 31 percent. I?
In contrast, freed from obligations of defending
fixed exchange rates after Britain went off gold in
September 1931, the Bank of England was able to
reverse its previous deflationary monetary policy. In

six steps over four months, it reduced its discount
rate from 6 percent in February 1932 to 2 percent.
Bank deposits responded by reversing a prolonged
decline, and rose from £1.6 billion in February to
£2.0 billion at the end of the year. StiJmulat~:d
interest rates declines - the Treasury bill rate
falling from 4.94 percent in January to 0.55
in September - housing construction began rising
in autumn and reached a level in 1933 that was 70
percent above the level two years earlier. IS
Finally, the collapse of the international nn:il.nc:lal
system in 1931 also can be attributed to the
international actions to contain the
of the
crisis after its start. The world community was illprepared for the task. The only public international
financial agency that existed in 1931 was the
which was established only the year before tofacilitate the transfer of war reparations and to prc)m1ote
international financial cooperation. With
million of capital, of which only $21 million was paid
up at the end of 1931, it lacked resources of its own
for coping with the crisis. 19
As described earlier, the major central banks'
joint actions to assist distressed national banking
systems were indecisive, distracted by extraneous
political motives, and were too little too late.
Throughout the developing crisis, the heads of the
central banks of Britain, France,
and the
United States kept in direct touch with one another
through letters, telephone
cables, and occasional meetings. Nevertheless, they lacked adequate information on the extent of international
indebtedness 20 as well as the expertise to deal with
it. In addition, there was neither an
mandate
from their respective governments nor a sense of
international solidarity that would have 0p.'U.,U
them to effective joint actions.
The international commercial
community was equally ill-prepared for the crisis. Their
stakes were high, 21 and their vast financial resources
would have been essential for supplementing the
hmit~d means at central banks' disposal to stop the
spreading panic. Yet, they dragged their feet in
negotiating standstill agreements in the Austrian
and German crises, and joined the international
rescue operations for Britain only when it was too
late. 22
In 1931, there was some recognition that without

17

tic economic policies. 23
In view of the foregoing review of the macroeconomic causes of the 1931 crisis, it is doubtful
that domestic policy adjustments and international
financial assistance could have held the international financial system together. The fundamental
problem was an international monetary order
characterized by fixed exchange rates with little
international policy coordination, that permitted
unobstructed international transmission of economic shocks while severely constraining national
macroeconomic policy choices.
Gradually, but steadily, world aggregate demand
slackened and international long-term financing
dwindled amid swelling international speculative
capital flows. National policymakers, strapped to
the gold standard, were powerless against these
increasingly corrosive forces. Eventually, the world
economy disintegrated, crumbling the foundation
of the world financial system.

forceful adjustments in domestic economic policies,
external credits alone would not be able to ward off
speculative attacks on banks. The subject, however,
was not broached with the Austrian Government.
Negotiations for rescuing the German banks also
focused only on securing financial assistance. Only in
the British ca.<;e was the need for economic policy
adjustment made an explicit condition for obtaining
credits from foreign commercial banks. Throughout
August 1931, negotiations for foreign bank loans were
thwarted by the foreign banks' insistence that the
British government adopt a budgetary reform program
for reducing its large budget deficit, and by the Labor
government's refusal to cut relief payments to the
unemployed at a time of severe recession. Only after a
new Conservative-Liberal coalition government
agreed to accept a budget cut was a foreign bank loan
assured. Throughout the negotiations, there was widespread and bitter resentment by the public toward the
pressure exerted by foreign bankers on British domes-

II.

Experience Since 1982
tionallending as a strategy to diversify their portfolios and enhance profits. The scope of the adverse
impact on international banking portfolios was reminiscent to many observers of the precarious situation faced by international banks prior to the 1931
crisis.
Also recalling the 1931 crisis was the apparent
complacency with which nations regarded deteriorating economic conditions. The U.S. recession in
1980 was generally expected to be a short one lasting perhaps one year, which was the average
duration of business cycle downturns in the United
States since 1945. Under this expectation, both
lenders and debtors believed that the proper strategy
would be to keep lending and borrowing because a
world economic recovery was "just around the
corner." Given optimistic expectations, lenders let
the quality of their assets deteriorate, while debtor
nations felt no pressure to make adjustments in
economic policies that had produced large budget
deficits, inflation, and over-valued currencies. In a
replay of the scenario prior to 1931, it was business
as usual under the common illusion that a world
economic recovery would restore the debtor nations'
ability to repay their debts.
The illusion was shattered abruptly in September

The world economy seemed to slide toward
another major international financial crisis in 1982.
Most of the elements were there for the making of
another crisis like that of 1931, and there appeared
to be several striking similarities.

Similarities
The world economy suffered a severe and prolonged recession in 1980-82. Moreover, the start of
the recession almost coincided with a change in the
direction of monetary policy in several major industrial countries. The new policy aimed at controlling
a world inflation that had raged with varying intensity in different parts of the world over the previous
fifteen years. The anti-inflationary bias in these
major industrial countries recalled the same policy
bias that preceded and prevailed during the Great
Depression. The result was unprecedentedly high
real interest rates in world financial markets.
The double shock of high real interest rates and a
severe, prolonged worldwide recession drastically
changed the world economic environment and
simultaneously eroded the debt-servicing capacity
of a large number of debtor nations. As a result,
individual investment risks became systematic risks
for those banks that had vigorously pursued interna18

Fundamental Differences
The collapse to which these similarities pointed
has not materialized. Despite widespread anxiety
over its stability, the international financial system
has continued to function wen four years after the
Mexican shock. Debts have been rescheduled many
times, but there have been no major defaults. There
have been many bank failures, but none attributable
to international lending as a primary cause. The
numerous manifestations of financial stress, instead
of growing and culminating in a crisis, have markedly lessened in recent years.
The perceived parallel between the experience of
1982 and that of 1931, even if to some extent valid,
has been misleading. The international financial
system and the world economy had changed in three
fundamental ways since the early 1930s: industrial
nations now operate under a flexible exchange rate
regime; they have a mechanism for international
cooperation to cope with developing crises; and they
have better safeguards to ensure the stability of their
banking systems.

1982, when Mexico announced that it was no longer
able to service its $86 billion external debt and
needed relief from its foreign creditors. The
announcement sent shock waves through the international banking system.
The world had not been aware of the high concentration of international debt in certain debtors
and lenders. At the end of 1982, nearly half of the
$700 billion total external debt ofthe less-developed
countries (LDCs) was owed by eight debtor nations:
Brazil,. Mexico, Argentina, Korea, Venezuela,
Indonesia, Chile, and the Philippines. The debt's
concentration in U.S. banks' portfolios was even
higher, as the same eight debtor nations accounted
for seventy percent of U.S. banks' claims on the
LDCs. Among U.S. banks, the nine largest
accounted for one-half of the total U. S. bank lending to the LDCs at the end of 1982. 24 The fear soon
became widespread that debt defaults or moratoria
by only two or three of the large debtor nations
could seriously damage the capital positions of the
world's largest banks, in general, and those in the
United States, in particular.
The 1982 Mexican debt shock was followed by a
precipitous decline in international lending. From
$27 billion in the first half of 1982, net international
bank lending to the LDCs declined to $12 billion in
the second half of that year and only $9.0 billion
during the full year of 1983. 25 This sharp decline
recalled the international liquidity squeeze suffered
by debtor nations prior to the 1931 catastrophe, and
raised the fear that it would again precipitate widespread debt defaults.
Signs of financial fragility quickly grew widespread. From an average of one a year in the late
1970s, the number of less-developed countries'
bank-debt rescheduling rose to four in 1982, fourteen in 1983, and twenty in 1984; the total amount
of rescheduled bank debt increased from an annual
average of $0.9 billion in the late 1970s to $1.7
billion in 1982, $41 billion in 1983, and $113
billion in 1984. 26 Separately, bank failures in the
United States rose from an annual average of 8
between 1977 and 1979 to 42 in 1982,48 in 1983,
and 79 in 1984. The total assets offailed banks rose
from an annual average of $453 million in 1977-79
to $11. 6 billion in 1982. They dropped to $7.0
billion in 1983 and $3.3 billion in 1984, but were
still high by historical standards. 27

Flexible Exchange Rates
Perhaps the most important difference between
the two eras has been the international monetary
setting. No longer are the world's currencies pegged
to gold at fixed exchange rates as they were before
1931. The floating of exchange rates in February
1973 came none too soon as, within a year, the
world experienced its first oil shock and widely
divergent resulting impacts on the real income and
external-payment positions of different nations.
The floating exchange rates did not insulate the
oil-import nations from the shock, but they did
provide them with a mechanism to adjust to the
drastically altered relative-price conditions in ways
that accorded with their own national aggregate
demand and supply conditions. Had the nations
attempted to maintain arbitrarily pegged exchange
rates, many payment-deficit nations would have had
to pursue deflationary macroeconomic policies to
keep their currencies in line. The 1974-75 world
recession would then have been much more severe
and prolonged. This same analysis can be applied to
the second oil shock which took place in the
1979-80 period.
Flexible exchange rates cannot completely insu-

19

host of such agencies: the International M()n<~taJry
Fund, the World Bank and its affiliates, and various
regional development banks. Each has sizable
financial resources to assist stranded debtor nations
Pt<)vidirlj:?; ITlediunil- or long-term financial assistance .as well as advice on policies needed for
reducing payment imbalances. Among these, the
pivotal role of the International Monetary Fund
cartnotbe overemphasized.
Second, and also in contrast to 1931 , the national
central banks of major industrial nations and the
BIS have, since 1982, acted jointly in a timely and
decisive manner to provide short-term bridge
credits to strapped debtor nations pending negotiations for debt rescheduling and longer term new
credits from international agencies and commercial
banks.
Third, the international rescue packages of the
1980s also contained an essential element missing
in 1931: the cooperation of major international
commercial banks. These banks were willing to
reschedule debts and extend new credits to support
the debtor nations' adjustment programs for reducing payment imbalances.
Fourth, since 1974, there has been an agreement
among major national central banks to carry out the
lender-of-Iast-resort responsibility in cases where
banking operations involving more than one
national jurisdiction are in need of assistance. 28
Since then, the central banks have kept in close
contact with one another, frequently consulting one
another on the international banking situation, and,
as stated, undertaken successful joint actions to
provide short-term bridge credits to relieve the
world debt problem.

late
from the impacts of oil price increases.
Those developing nations that were unwilling or
unable to make the needed adjustments to the price
increases and continued to rely on foreign borrowtheir domestic spending saw their
external debts rise rapidly and at higher real interest
rates. In contrast, the industrial nations underwent
severe recessions in the period 1974-75 and again in
Hw' np'nfl,1i 1980-82 to contain domestic inflation and
to the higher oil prices.
the time of the Mexican debt shock, the
industrial nations had about completed their adjustments and were ready to begin recovery from tpe
1980-82 recession. Although reducing inflation
remained a primary policy objective, they also
aimed macroeconomics policies at restoring stable
output growth. In none of these countries was there
a deflationary bias for the sake of fixed exchange
rates, as there was before 1931.
Thus, a generally strong world economy
provided a sound base for international banks to
cope with sectoral shocks. The LDC-debt problem
was a sectoral shock to international banks, just as
difficulties in agriculture, construction and energy
industries were sectoral shocks for domestic banks.
To a varying extent, many international banks have
undergone, and are still undergoing, severe stress
according to the degree of their asset concentration
in LDC, energy, real estate and farm loans.
However, there is an important distinction
between individual bank stress and systemwide
stress. Individual banks with a large proportion of
their a<;sets in problem loan areas see their capital
positions seriously eroded. But because the core
countries in the world economy had adjusted successfully to the shocks of the 1970s, the sectoral
shocks of 1980s did not destabilize the international
as a whole. As a
there have
few signs of a generalized weakening in bank
capital positions, as occurred prior to 1931.

National Safeguards
Since the 1930s, national
systems have
been made more crisis-resistant by deposit insurance, government regulation and
and
improved availability of information on banking
operations. Although these devices may have in tum
created problems of their own (such as the "moral
hazard" problem involving enhanced risk-taking by
financial institutions because external support is
available 29 ), on balance, they have strengthened
national banking systems and hence indirectly the
international financial system.

International Cooperation
Complare:d to 1931, international cooperation has
been
strengthened for ensuring the
stability of the international financial system. There
are several facets to this development. First, in
contrast to 1931, when the newly established and
endowed BIS was the only public international financial agency in existence, there are now a

20

IU. Conclusion
the world, stresses often develop in the interrlation;al
monetary system that require countries with. a
cit in their international
to restrain domestic aggregate dernarld
countries in surplus to expand it.
deflationary pressure the world economy is
erbated if, in addition, the center country \a};alJll'"
whose currency other nations peg their ex€:h,mg:e
rates) itself follows a deflationary policy in
combat inflation or to m'lintain
national currency. Where
and wages are
perfectly flexible, a worldwide deflation will result
and lead to worldwide declines in aggregate
demand, with widespread business failures and
unemployment. As economic conditions worsen,
the basis of the international financial system crumbles.
This sequence of events, in essence, appears to
have caused the 1931 crisis. But, the world has
learned much from that disaster. Flexible exchange
rates have enabled the world economy to weather
several major shocks since 1973. As a result, the
international financial system in 1982 was in a much
sounder condition than in 1931 , and thus was able to
absorb major disturbances such as the Mexican-debt
shock. In addition, the world community also has
learned to formulate and carry out a coordinated
international strategy to contain the LDC-debt problem in a timely and decisive manner. Thus far, the
strategy appears to have worked with considerable
success.
Nevertheless, keeping the LDC-debt problem in
check does not mean the problem has been solved.
A number of debtor nations continue to have difficulty servicing their external debts. Capital flights
from these nations as well as the virtual cessation of
voluntary international private lending have put
these nations in a crushing liquidity squeeze. More
recently, the precipitous decline of oil prices, while
providing a welcome relief to most debtor nations,
has meant a sharp setback to the debt-servicing
capacity of oil exporting nations. More difficult debt
negotiations can be expected to lie ahead, and
innovative initiatives are needed to help resolve
international debt problem that continues to
threaten the long-run stability of the interr,ation,al
financial system. 30

An analogy with the functioning of a national
economy can help bring out the lessons of past
international financial crises. National economic
integration binds together the various regions of a
nation economically and financially through unimpeded flows of goods, services and capital. While
benefits accrue to the nation through greater efficiency in resource utilization, the various regions
are exposed to risks of economic and financial
shocks that originate from other parts of the national
economy - especially since one national currency
ties the regional economies together.
This does not mean, however, that nationwide
banking operations are necessarily riskier. On the
contrary, since not all adverse shocks are likely to
affect the various regions of the nation at the same
time, national asset diversification can reduce the
total risk for such banks.
One type of risk, however, cannot be diversified
in this manner: credit risk related to unexpectedly
prolonged and severe nationwide recessions. Under
these circumstances, a general deterioration in the
quality of banking assets and in banks' capital
positions is hard to avoid. These risks are systematic, macroeconomic risks that individual banks cannot minimize through nationwide portfolio diversification. Nor can governments contain such risk
through tighter bank supervision and higher bank
capital requirements. Instead, stability in the
national financial system requires national
authorities to conduct macroeconomic .policies to
minimize macroeconomic instability and to provide
liquidity support to banks when macroeconomic
instability results in severe financial stress.
In the global context, international banks can
reduce. asset risks through intemational· portfolio
diversification. Portfolio diversification, however, is
not sufficient against systematic, worldwide
instability that adversely affects asset quality everywhere. The likelihood of such instability is
enhanced under fixed exchange rates, which tie all
national economies together like regions in one
nation with one national currency - but without the
benefit of a single authority to ensure worldwide
macroeconomic stability.
When national authorities pursue domestic objectives with little regard to their effects on the rest of
21

It would be short-sighted to regard the LDC-debt
problem as the only threat to the stability of the
present international financial system. Numerous
innovations in telecommunication technology have
Illade wOrld capital markets more highly integrated
than ever before. Also unprecedented is the domination of exchange rate changes by international capital flows. In the meantime, large international payments imbalances continue despite wide swings in
exchange rates. As a result, national governments
have been concerned about the volatility of
exchange rates and the lack of policy coordination
among major industrial countries. Uncertainty

hangs over what these might mean for the stability
of the world economy since flexible exchange rates
cannot' be a panacea against all world economic
shocks.
In. short,. during the. half-century between. 1931
and 1982, the world has made significant progress
in buttressing the international financial system to
keep problems such as LDC debt in check. By
comparing the experience of the 1930s and the
current international debt situation, this study helps
identify the key elements of this progress on which
the solutions to future international financial problems can build.

FOOTNOTES
1. League of Nations, World Economic Survey, 1931-32
(Geneva, 1932), chart inset between pp. 64 and 65.

9. The Credit-Anstalt case, the spread of international
financial crisis throughout Europe, and the collapse of the
international financial system are described in a large
number of sources, notably, Yeager, op. cit., pp. 339-49;
League of Nations, Commercial Banks, 1925-1933, cited
above; Charles P. Kindleberger, The World in Depression,
1929-1939 (University of California Press, 1973); Stephen
V.O. Clarke, Central Bank Cooperation, 1924-31 (Federal
Reserve Bank of New York, 1967).

2. Except Spain, Iran, and Turkey. Leland B. Yeager,
International Monetary Relations: Theory, History and Policy (Harper and Row, 1976), pp. 338-39
3. Ninety-eight percent of the £1.7 billion total debt
defaults outstanding at the end of 1930 was attributable to
the Soviet Union alone, according to the Council of the
Corporation of Foreign Bondholders, The Problem of International Investment, a report by a Study Group of the Royal
Institute of International Affairs (Oxford University Press,
1937), p. 299.

10. League of Nations, World Economic Survey, 1931-32
(Geneva, 1932), pp. 319-22.
11 .. The Problem of International Investment, op. cit, p.
325.

4. "Until the late spring of 1931, ... the gold standard was
still intact in Western Europe and the United States. Steadiness or slight increases in seasonally adjusted figures of
industrial production in Germany and the United States
even offered sorne hope during the first few months of the
year. In Great Britain and most other countries, however,
economic activity kept on sinking." Yeager, op. cit., p. 339.

12. U.S. Department of Commerce, World Economic
Review, 1933 (Washington, D.C., 1934), p. 278.
13. However, not all bankers and central bankers were
oblivious to the precariousness of situation. In January
1931, a U.S. investment banker told the U.S. Ambassador
in Berlin that "short loans to Germany were now in such
volume that they could not be called or renewals refused
without great danger to the financial situation in the United
States." A month later, the President of the Reichsbank
sent to the U.S. Ambassador a memo detailing the weakness of Germany's short-term financial position and suggesting, among other things, a long-term loan of $350-475
million to refund Germany's short-term liabilities. The
Ambassador duly passed the information and the proposal
to Washington, but solicited no response. Clarke, op. cit.,
pp.177-78.

5. Based on data in League of Nations, Commercial
Banks, 1925-1933, Geneva, 1934, Appendix I, pp. 48-49.
For Chile and Peru, the changes were from 1926.
6. The League of Nations study cites actual cases of major
banks in Berlin, Vienna, Italy, and Hungary extending large
new credits to industrial concerns or on agricultural bills for
the sake of assisting customers in distress. League of
Nations, op. cit., pp. 16-17.
7. Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton University Press, 1963), pp. 308-15.

14. The Problem of International Investment, op. cit., p.
223.

8. The Bank of England's secret rescue of the failing
William Deacon's Bank in Lancashire in 1928-30, costing
the Bank of England £3.2 million, is described in R. S.
Sayers, The Bank of England, 1891-1944 (Cambridge
University Press, 1976), pp. 253-59. The Bank of Italy and
the Bank of England's joint rescue of the Banca ItaloBritannica of Milan in 1929-30 is discussed in Sayers, op.
cit., pp. 259-63.

15. Lester V. Chandler, America's Greatest Depression,
1929-41 (Harper and Row, 1970), p. 98.
16. Kindleberger, op. cit., pp. 97-100.
17. Yeager, op. cit., pp. 346-47.
18. Kindleberger, op. cit., pp. 180-181.
19. Clarke, op. cit., p. 147.

22

20. For instance, the Federal Reserve Bank of New York
did not know the extent of the foreign liabilities of banks in
Austria, Germany and Britain until these countries were in
crisis. Clarke, op. cit., p. 185.

23. Clarke, op. cit., p. 210 and p. 263, especially note 97.
24. The LDC-debt data are from Morgan Guaranty Trust
Company, World Financial Markets, February 1983, p. 5;
the World Bank, World Debt Tables, 1984-85, Washington,
D.C., 1985, p. ix. U.S. bank lending data are from Federal
Financial Institutions Examination Council, Statistical
Release E16, June 1, 1983; and Federal Reserve Chairman Paul Volcker's statement before the Hou~e Foreign
Affairs Committee, August 8,1984, Appendix Table 3.

21. For instance, it was estimated that foreign commercial
banks held44 percent of the total deposits of the big Berlin
banks in 1929. League of Nations, op. cit., pp. 110-111.
22. In the Austrian crisis, the three-week delay in securing
the first $14 million credit to the Austrian National Bank was
due mainly to the difficulty in negotiating a standstill agreement among the Credit-Anstalt's principal creditors in
Berlin, London, New York, and Paris. The foreign creditors
formed an Austrian Creditanstalt International Committee
to negotiate with the Austrian Government. While negotiations were going on, large fund withdrawals continued. A
standstill agreement was not reached until the end of
August, after the Government had already instituted
exchange controls, so that the agreement achieved no
more than the institution of an orderly procedure for liquidating the blocked foreign balances. The German case
was similar in that a standstill agreement was not reached
until August 1931, also after exchange controls had
already been put in place. League of Nations, op. cit., p.
58.

25. Maxwell Watson, Peter Keller, and Donald Mathieson,
International Capital Markets: Developments and Prospects, 1984, International Monetary Fund Occasional
Paper No. 31, Washington, D.C., 1984, p. 5.
26. The World Bank, op. cit., pp. xvi-xvii.
27. Federal Deposit Insurance Corporation, Annual
Report, 1984 (Washington, D.C., 1985).
28. Federal Reserve Governor Henry Wallich's testimony
before the Permanent Subcommittee on Investigations,
Senate Committee of Government Operations, Federal
Reserve Bulletin, November 1974, pp. 760-62.
29. Michael C. Keeley and Frederick T. Furlong, "Bank
Regulation and the Public Interest", Economic Review,
Federal Reserve Bank of San Francisco, Spring 1986, pp.
55-71.

It appears that only in the British crisis did the large
i(lternational banks agree to extend credit to a besieged
foreign central bank. In that case, a $200 million loan by a
group of New York banks headed by J.P. Morgan & Co.
was extended to the Bank of England on August 28,1931,
and another $200 million was raised in Paris. The loans,
however, proved inadequate for meeting the final assault
on sterling. Clarke, op. cit., 209-213.

30. In this regard, the Baker Plan for aiding the debtor
nations in making structural adjustments for improving
their economic conditions is a significant step in the right
direction. See Hang-Sheng Cheng, "The Baker Plan",
Federal Reserve Bank of San Francisco, Weekly Letter,
November 22, 1985.

23

Oil Prices, Exchange Rates and
the U.S. Economy:
An Empirical Investigation
Bharat Trehan*

Tn general, research on the impact ()j6ilprice shocks on the U.S.
economy has assumed that oil price changes are exogenous - determined almost exclusively by the actions ofOPEC. This paper uses vector
autoregressions to demonstrate that the foreign exchange value of the
dollar has a substantial impact on the price of oil. Thus, the practice of
using changes in the dollar price of oil as a measure of the underlying
supply shocks is likely to exaggerate the effects of exogenous oil price
changes.
Research on the effects of oil supply shocks on
the United States' economy has assumed that
changes in the price of oil are exogenous, determined largely by the actions of OPEC. Significant
historical episodes seem to support this assumption.
For instance, oil prices. approximately tripled in
both 1973 and 1979 as a result of OPEC's decision
to curtail the supply of oil. This assumption of
exogeneity is critical, because it permits researchers
to associate changes in the price of oil with shocks
to its supply. Researchers can then determine the
effects of a shock to the supply of oil simply by
looking at the response of the economy to a change
inthe price of oil.
In this paper, we demonstrate that it is incorrect to
treat all changes in the dollar price of oil as
exogenous. More specifically, we show that the
foreign exchange value of the dollar has a substantial impact on the dollar price of oil. This result has
important implications. First, exclusion of the
exchange rate in any study of the impact of oil
supply shocks will lead to incorrect estimates of the
effect of oil price changes on the economy since
some of the effects of exchange rate changes will be
attributed to oil price changes. Second, the existence of exchange rate effects implies that changes

in the price of oil cannot always be associated with
exogenous supply shocks but must be recognized as
the result of a mix of factors. Thus, changes in the
price of oil should not be used as a measure of
supply shocks.
We examine these issues using a statistical technique known as vector autoregressions (VARs). This
approach is "atheoretical" in the sense that it does
not use economic theory to impose any restrictions
upon how different variables should interact with
one another. In addition, it treats all variables as
determined within the system itself - a feature
whose importance will be evident below. This technique is well-suited for the issues at hand because
shocks to oil supply affect the economy through
several channels (see the discussion in Section II).
Because of the multiplicity of channels and the lack
of prior knowledge about their relative importance,
the more conventional technique of placing specific
restrictions upon the ways that a supply shock will
affect the economy is likely to distort the empirical
results.
A number of previous empirical studies have
examined the relationship between oil price changes
and the U. S. economy using VARs but none of them
take the exchange rate into account. 1 For instance,
Hamilton (1983) showed that the price of oil has
predictive power for real GNP, the GNPdeftator,
and a host of other variables, butthatthe oil price is

* Economist, Federal Reserve Bank of San Francisco.
25

not affected by them. His results suggest that oil
price changes are determined by considerations
external to the U.S. economy, and that oil price
increases have contributed significantly to business
cycles in the U. S. in the post World War II
period. 2 ,3 Burbidge and Harrison (1984) also present evidence supporting the view that oil prices
have had a significant impact upon both industrial
production and the consumer price index in the U.S .
Below, we present some empirical evidence on
this issue. Section I focuses on the relationship
between the exchange rate and the price of oil. It

contains a discussion of why changes in the value of
the dollar will have an effect on the price of oil, as
well as some empirical tests of this relationship,
Section II then demonstrates how the measured
impact ofoil price changes on the U, S. economy is
sensitive to the inclusion of exchange rates. In that
section, we first discuss what economic theory tells
us about the impact of oil price shocks on the
economy and what the historical experience has
been in terms of both oil supply shocks and
exchange rate changes. Empirical results follow.
Section III contains the conclusions.

I. The Dollar and Oil Prices
Crude oil traded in world markets is priced in
dollars, This fact has important implications for the
relationship between the value of the dollar and the
price of oil because oil importers who do not use the
dollar as currency must, in effect, obtain dollars to
purchase oil. Thus, if the value of the dollar
changes, the price they pay in terms of their own
currencies will change. For similar reasons, oil
exporters will also not be indifferent to fluctuations
in the value of the dollar.
To understand the way in which a change in the
value of the dollar affects the price of oil, consider
the figure below. Assume that the curve labeled Do
represents the demand for oil by the oil importers
and the curve labeled So represents oil supply. The
world market for oil is then at equilibrium when the
price of oil is $Po per barrel.
Now suppose that the dollar falls in value against
the currencies of other oil-importing nations and
against the currencies of the oil exporters. If the
dollar price of oil remains unchanged, the other oilimporting countries will find that the price of oil in
terms of their own currencies has declined. Consequently, their consumption of oil will go up. In terms
of the diagram, the demand curve for oil will
shift to the right. It is worth pointing out that this
increase in demand at an unchanged dollar price
occurs only because oil is priced in dollars. If oil
were priced in yen, for instance, a decrease in the
value of the dollar would actually lead to a decrease
in the U.S. demand for oil. The demand for oil by
other oil-importing countries would not be affected.
A change in the value of the dollar affects the
supply of oil as well. If the dollar falls, oil exporters

The Effect of a
Decline in the Value of the
Dollar on the Price of Oil
Price

0 .....- - - - - - -........- - Quantity

will discover that the price of oil in terms of their
own currencies has declined. Consequently there
will be a contraction in the quantity of oil supplied at
the prevailing dollar price. 4 In the diagram above,
this is shown as a leftward shift in the supply curve
for oil. To equate demand and supply, the dollar
price of oil will then increase from Po to Pl' In the
same way, increases in the value of the dollar would
setinto motion declines in the dollar price of oil.
There are, of course, other factors that determine
the price of oil. The ability of the members of OPEC
to act in concert was the primary reason that oil
prices approximately tripled in both 1973 and in
26

1979. The preceding discussion i~ not meant to deny
a role to OPEC, but to point out a role for the dollar.
For instance, it is difficult to believe that OPEC does
not take the value of the dollar into account when
setting the dollar price of oil.
The discussion above has shown how changes in
the value of the dollar affect the price of oil. While
we have not discussed what factors influence the
value of the dollar itself, this should not be taken to
imply that the dollar is immune to developments in
the U. S. and the rest of the world. In fact, the dollar
reacts to factors such as differences in the rate of
inflation between the U.S. and the rest of the world,
interest rate differentials, and shocks to productivity. For example, many economists contend that an
important reason for the depreciation of the dollar
during the two periods 1971-72 and 1978-79 was
the relatively loose monetary policy being followed
by the U.S. during those years.

We use the multilateral trade-weighted nominal
exchange rate constructed by the Federal Reserve
Board as our proxy for the value of the dollar. 5 This
is not the precise empirical counterpart to the
exchange rate in the discussion above. The
exchange rate relevant to world oil demand would
perhaps be one that used oil imports as weights.
However, the data necessary to construct such an
index is not readily available. Moreover, our results
may notbe very sensitive to the choice of index. 6
Consequently, the trade-weighted exchange rate is
used here.
The measure of the oil price is the crude
petroleum component of the producer price index.
This measure is probably the most relevant to both
real activity and inflation in the U. S. Both the
exchange rate and the oil price measures have also
been widely used in previous research on the U.S.
economy.
Before examining the statistical relationship
between oil prices and exchange rates, it seems
useful to look at how the two variables have behaved
over our sample period. Chart 1 shows the relation-

The Empirical Relationship
We now present some empirical evidence on the
relationship between the dollar and the price of oil.

Chart 1
Quarterly Growth Rates* of the Nominal
Exchange Rate of the Price of Oil
Percent

16

12

Oil Price ...

8
4

-4
- 8 5657

59 61

63 6567 69 71

73 75 77 79 81

*3-quarter moving averages of the first difference of logs.

27

83 85

28

29

ship between the growth rate of the oil price and the
exchange rate using quarterly data from the second
quarter of 1956 to the fourth quarter of 1985. Threequarter moving averages have been used in the chart
to smooth out fluctuations.
The chart shows that the price of oil was much
more stable in the fixed exchange rate period than in
the floating exchange rate period. Growth rates of
both the exchange rate and the price of oil were close

to zero prior to 1970 but have been much more
volatile since then. In addition, both periods of
extended drops in the dollar (approximately the
periods 1970-73 and 1977-79 in the chart) were
followed by substantial increases in the price of oil
- the two oil price" shocks" - while the appreciation of the dollar in the first half of the eighties has
been accompanied by falling oil prices. This pattern
of co-movement between these two variables is

30

example of such a disturbance would be the IranIraq war. The disturbances actually used in Chart 2
have been set equal to the standard deviation of the
disturbances in each variable over the sample
period. Thus, the plots represent the dynamic
responses of each of the two variables to an "average" disturbance in the other variable.
The charts reveal that an unpredicted increase in
the value of the dollar leads to a decline in the price
of oil with a lag of approximately two quarters. The
price of oil remains low for about three years after
the shock, after which the response damps out. By
contrast, the response of the exchange rate to a
shock to the price of oil is relatively weak, although
the dollar does show some evidence of appreciation. 8
The evidence in Table lA and Chart 2 demonstrates that changes in the dollar's value have a
statistically significant impact on the dollar price of
oil, and that an increase in the value of the dollar
leads to a decline in the dollar price of oil. However,
the results do not rule out the possibility that
exchange-rate-induced changes in the price of oil
constitute only a small proportion of the total varia-

what the analysis above would suggest.
The increase in the volatility of oil prices in the
floating rate era is one piece of evidence supporting
our hypothesis. Stronger confirmation is provided
by· the fact that periods of dollar depreciation have
bee.u followed by increases in the dollar price of oil,
while an appreciation of the dollar has been followed by decreases in the dollar price of oil.

Results from VARs
We now employ VARs to present some formal
evidence for our hypothesis.? The results of the
estimation are in Table lAo They reveal that the
exchange rate has predictive power for the price of
oil, while the oil price is not very useful in predicting exchange rates. Approximately half of the variation in oil prices is unpredictable on the basis of past
values of the exchange rate and the price of oil.
Chart 2 transforms the VARs in Table lA and
shows how exchange rates and oil prices react over
time to a disturbance that could not have been
predicted on the basis of their past values. The right
hand panel, for instance, shows how the exchange
rate reacts to a disturbance in the price of oil. One

Chart 2
Dynamic Responses
(Obtained from VARs in Table 1)
B. Response of the Exchange
Rate to an Increase in the
Price of Oil

A. Response of Oil Price
to an Increase in the
Value of the Dollar

Percent

Percent

24
12

40
30

o

20
10

-12
-24

o

36
- 60 0....&...&........8.........a...&....1..1o..&...&...24

-10
- 20 ......................,L",I,........I..I..IU

Quarters

Quarters

-48

o

16

31

8

16

24

prices and the fitted values obtained fromestimating
the equation over 1959Q2-1985Q4. The equation
tracks changes in the growth rate of oiL prices
reasonably well. It reveals that oil prices would have
been expected to increase over the periods(1973-74
and 1978-81 on the basis of the relationship between
oil prices and exchange rates alone. Needless to say,
the equation does not explain the entire increase in
oil prices during those periods. The equation also
suggests that oil prices should have deCliriedbver
the period 1981-1985.
A common criticism of exercises of this. sort is
that the estimated equation has simply correlated
changes in the two variables. Consequently, while
such an equation provides a reasonable fit over the
sample period, it is not likely to perform very well in
explaining events beyond the period over which it
was estimated. To test this proposition, the same
equation was estimated from 1959Q2 to 1978Q4,
that is, up to the year before the second "oil
shock".11 The coefficients from this equation and
the actual values of the exchange rate from 1979Ql

tion inthepriceof oil over the sample period. To
eXamine this issue, consider the results in Table 1B.
Disturbances .to •the exchange rate account for a
progressively greater proportion of the variance of
theerfoririforecastirigtheprice of oil. At the
twenty-quarter horizon, for instance, exchange rate
disturbances account for 42 percent of the forecast
errpr "arian~~?f?ilprice~.9 These results imply that
shock.s to the exchange rate have been an important
sourceof'variationsin the price of oil over the
sample period.
Sin.ceexchange rate changes account for a substantial proportion of the changes in oil prices over
the period sampled, it is natural to wonder about the
role played by exchange rate changes during particular episodes within the period. More specifically, how much of the two oil price shocks of the
1970s can be predicted on the basis of past changes
in exchange rates alone?
To answer this question, the growth rate of oil
prices was regressed on past growth rates of the
exchange rate. 10 Chart 3 shows the growth rate of oil

Chart 3
Actual and Fitted* Values of the Growth
Rate of the Price of Oil
Percent

40
30
Actual--

20
10

73

75

77 79

81

Fitted values obtained by regressing oil price on lags
of exchange rate only.
See footnote 10 for details.

32

83 85

onwards were used to "predict" the price of oil
through the second quarter of 1986.
Chart 4A shows the results of this exercise; The
equation predicts increases in the price of oil
through the end of 1981, and decreases in the price
of oil through the first quarter of 1986. This pattern

is· consistent with the actual changes in oil prices
over this period, although the equation does underpredict the increases inthepre--1982 period (most
noticeably in the first quarter of 1981) and predicts
sharper decreases irlthe price of oil than actually
occurred in the three years afterward. The equation

Chart 4

Actual and Predicted* Values of the Price of Oil
A. Quarterly Growth Rates

Percent

30
~

Actual

10

__,...iIIII:-I~

OI-------I~~-J'I!Sn-..,..~-

-10

-30

-50

1979

1982

1984

1986

1982

1984

1986

B. levels
level of Oil Price Index

900
800
700
600
500
400
300
200

1979

33

also misses the large fall in oil prices in the second
quarter of 1986, when it predicts a small increase.
Chart 4B transforms these results to express them
in terms of the level of oil prices. The predicted
va.llles track the actual price of oil quite closely until
the fourth quarter of 1980, but miss the large
increase that took place in the first quarter of 1981.
It is perhaps significant that the Iran-Iraq war began
in September 1980. The equation correctly predicts
declining oil prices from the third quarter of 1981
onwards, but a faster pace of decline than what
actually occurred. The large drop in oil prices that

took place over the first half of this year actually
brings oil prices back into line with those predicted
by the equation.
While these results should not be interpreted to
implythat the exchange rate is the only variable that
matters for the price of oil, they do offer strong
evidence that the exchange rate is an important
determinant of oil prices. Since it is well-known that
the exchange rate itself is influenced by a host of
developments both in the V. S. and abroad, the
results imply that oil price changes cannot always be
regarded as exogenous to economic developments.

II. Oil Prices and Economic Activity
also redistributes income between the V .S. and the
rest of the world because the V. S. is a net importer
of oil. Within industry, profits are redistributed from
oil-consuming to oil-producing firms.
The last effect reveals an aspect that is potentially
important when trying to determine the net impact
of oil supply shocks on economy-wide output. Just
as oil consuming industries react to an exogenous
increase in the price of oil by reducing output,
industries involved in the production of oil will react
by increasing output. They do so because the higher
price of oil makes it profitable to engage in both
exploration and drilling for oil in locations where it
was previously unprofitable to do so. An increase in
the level of activity by firms directly engaged in the
production of oil leads, in tum, to increased production in industries that supply these firms with inputs.
Similarly, an exogenous decrease in the price of oil
will force a contraction in the output of industries
involved in producing oil.
Thus, the overall effects of any exogenous change
in the price of oil on real output will depend upon
the relative magnitude of the effects on the oilconsuming and oil-producing sectors. While previous research has focused upon the impact of
exogenous oil price changes on oil-consuming sectors of the economy, recent evidence suggests that
the impact upon the oil-producing sector may be
substantial as well. In particular, experience over
the short period since the oil price decline in early
1986 suggests that the immediate impact on oil
producers may be large enough to outweigh the
impilct on oil consumers.

The results demonstrating that changes in the
exchange rate have a substantial effect on the price
of oil have, in tum, important implications for
studies that attempt to estimate the impact of oil
supply shocks on the V.S. economy. They imply,
first, that studies that omit exchange rates will
mismeasure the impact that oil supply shocks have
on the economy since some of the impact of
exchange rate changes will be attributed to oil price
changes. Second, they imply that it is incorrect to
use changes in the price of oil as a measure of the
underlying supply shock because some of these
price changes are caused by other factors. Thus,
studies that attempt to analyze the effects of oil
supply shocks must first isolate the component of oil
price changes that is not due to these factors. Before
proceeding to an empirical examination of these
issues, we review the channels through which a
shock to the supply of oil will affect the economy.
Effects of Oil Supply Shocks
Along with labor and capital, energy is an input
to the production process. Oil in tum is an important
component of total energy sources. An increase in
the price of oil due to an OPEC shock to supply will
force business firms to economize on the use of oil.
Since close substitutes for oil are not readily available, this will lead to a reduction in energy input and
a consequent decline in aggregate supply.
There will be other effects as well. Analysts have
often likened exogenous increases in the price of oil
to a tax increase for consumers that leads to a
reduction in demand. An increase in the price of oil

34

These considerations imply that using theory
alone to predict the exact response of aggregate
output to an exogenous change in the supply of oil
would lead to a somewhat ambiguous answer. In
contrast, the effect on the •price .level. is •unambiguous. An exogenous reduction in the oil supply
leads to an increase in the priceaf oil and in the
aggregate price level. (It is this increase in the price
ofail that causes domestic oil producers to increase
their output.)
We have contended that the omission of exchange
rates will bias the measured impact that oil price
changes have on the economy. To see what the
precise effects will be, it is necessary to examine
what economic theory tells us about the impact of
exchange rate changes on the economy. Recall,
first, that the sample period of this study includes
two episodes of sharp increases in the price of oil.
Oil prices almost tripled in 1973 and then again over
the 1979-81 period. As Chart 1 indicates, both
episodes were preceded by declines in the value of
the dollar. The proximity of these dollar declines
suggests that omitting the effects of the exchange
rate changes would exaggerate the effect of oil price
shocks.
For instance, theory tells us that an increase in the
value of the dollar will lead to lower inflation. A
higher dollar implies that the price of U. S. imports
declines and that domestic producers must lower
prices on goods sold in the U.S. In addition, if
domestic producers are to remain competitive in
world markets, they must reduce export prices as
well. Similarly, when the dollar falls, the price of
imports goes up. In addition to the direct impact on
the price level, a decline in the dollar's value also
allows domestic producers to raise prices on products that compete with imports. For our purposes,
this implies that ignoring exchange rate effects will
lead one to attribute the inflation that followed the
dollar's depreciation in both the early and late 1970s
largely to the oil price increases. 12

relationship between real GNP and the price of oil
alone and indicates that the price of oil is extremely
significantin predicting real GNP. The reverse is
true as well, that is, real GNP predicts the price of
oil..Similarly, in the systemconsisting ofoil prices
and the GNP deflator, both variables "cause"·each
other.· These conclusions hold up in the three-variable system as well, although in not as strong a
form ..The results reported in· these VARson the
effect of oil prices on both real GNP and the price
level are essentially similar to what has been
reported in earlier studies.
To test our major hypothesis, we added the
exchange rate to the VAR. The result of this addition
is that the price of oil is no longer significant at
conventional statistical levels in predicting real output. This finding is consistent with our discussion
above since it demonstrates that the significance of
the measured impact of oil price changes on real
output depends on whether exchange. rates are
included in the VAR. While oil prices are still
significant in .predicting the GNP .det1ator, the
dynamic response functions show that their impact
is considerably smaller once exchange rates are
included. These results are discussed below. Table 2
also reveals that both real GNP and the exchange
rate provide information about future values of the
price of oil.
A problem in interpreting the results above is that
the dollar is a financial asset. Since financial markets react to new information much more rapidly
than goods markets, results from causality tests
often show that financial market variables have
considerable predictive power for other variables in
the model. (See Sims, 1982, for a discussion of this
issue and an example.) Thus, it is possible. that the
exchange rate is significant in the ;)hove equations
b¢cause it is "picking up" information about the
future course of events in the economy.
In Section I, we showed that changes in the value
of the dollar predict a reasonable p¢rcentageof the
oil price increases in both 1973 and 1979. •This
result suggests that the relationship between the
dollar and oilprices is not due to the anticipation by
ass.et markets ofincreases in the price ofoil because
it is generally agreed that the dollar's depreciation
prior to both these. episodes was due to factors such
as the difference between.the policy stance of the

Empirical.Results
We now tum to a discussion of the formal empirical tests. InTable 2,we examine whether changes in
the price of oil help predict changes in real output.
To isolate the role played by different variables, we
present a series of VARs. The first VAR looks at the

35

reduce its predictive power. Table 2 reveals that the
addition of the S&P index does not materially alter
the significance of the exchange rate. 14 Together,
the results from these tests suggest it is unlikely that
the exchange rate is significant in the VAR simply
because it is acting as a proxy for developments in
the financial market.
The different VARs reported above appear to
represent robust results. Slope dummies were used
in order to test for stability. For each variable on the
right-hand side of a given equation, another variable
was created that takes the value of that particular
variable up to 1973Q1 and zero after that. These
new variables were then included in all equations in
addition to the original variables.

United States and other industrialized countries.
As a formal test of whether the exchange rate is
falsely significant in the above equations, we
replaced the exchange rate by the Standard and
Poor's 500 stock price index in the VAR. The
change does not alter the significance of the oil price
variable in the real GNP equation at all (that is, it
remains the same as in the three-variable VAR). Nor
does the stock price index predict changes in the
price of oil. 13
As a final check, the last system shown in Table 2
adds the Standard and Poor 500 stock index to the
VAR that also contains the exchange rate. If the
exchange rate were significant only because the
dollar is a financial asset, this experiment should

36

If the relationships under study changed between
the periods 1959Q2-1973Q1 and 1973Q2-1985Q4,
then including these variables would significantly
alter the pattern of unpredicted changes in the variables (such as real GNP and oil prices) whose
behavior is being explained. The tests show that
there is no significant difference between the two
periods for either the five-variable system or the
four-variable system (which contains real GNP, the
GNP deflator, the exchange rate, and the oil price).
However, when the exchange rate is dropped from
the VAR, the test reveals a significant difference
between the two periods. A second test involving an
examination of the individual equations shows that
the source of this difference lies in the oil price
equation. This finding implies that there is a significant difference in unpredictable oil price changes
between the two periods if exchange rates are
excluded from the oil price equation but not when
they are included.!S
We now examine the responses of output and the
price level to an oil price shock. Chart 5 shows how
the responses of both these variables change when
the exchange rate is included in the system. In the

left-hand panel, we show that the effect of an
increase in the price of oil on the GNP deflator
becomes noticeably smaller once the exchange rate
is included in. the VAR. In particular, including the
exchange rate •. reduces both. the magnitude of the
initial impact and the duration of the effect. The
response of real GNP to an oil price shock changes
in a similar manner. That is, including the exchange
rate in theVAR reduces both the size as well as the
duration of the real GNP response to an oil price
shock. (Notice also that in the system excluding the
exchange rate, an oil price shock leads to a contemporaneous increase in real GNP. This anomaly is
removed when the exchange rate is added to the
system.)
It is interesting to examine the implications of
these results for specific episodes such as the
1973-1975 period of oil price increases. Using two
of the VARs shown in Table 2, we examine the
impact on real GNP.
Chart 6A shows the forecasts we would have
made using the three-variable system containing
real GNP, the GNP deflator, and the price of oil with
the model used to generate these forecasts estimated

Chart 5
Dynamic Effects of an Increase in the Price of Oil
(Obtained from VARs in Table 2)
A. Response of the GNP Deflator
Percent Change

B. Response of Real GNP
Percent Change

50

10

40

o

30

20

-10

10

-20

O....--~---,.

-10 0

8

24

- 30 .......L;"L.I....................................
o
8
16
24

Quarters

Quarters

16

37

Chart 6
Actual and Forecast Real GNP Growth*
Growth Rate* (Percent)

Growth Rate* (Percent)

‘ Growth Rates are measured quarter over quarter.
38

using data up to 1985Q4. The line labeled "Pure
Forecast" is the real GNP we would have predicted
before any data for 1973 becameavailable. The line
labeled "Pure Forecast Plus Oil" adds the effects of
the oil price shocks.. We see that including the oil
price shocks improves the forecast, .1ll0st noticeably during the fourth quarter of 1974 and the first
quarter of 1975 when real GNP was contracting.
Chart 6Bshows the results from a similar exercise
using the four-variable system consisting of real
GNP, the GNP deflator, the price of oil, and the
exchange rate. The line labeled "Pure Forecast Plus
Oil" shows what we would have predicted at the end
of 1972 had we known the behavior of oil prices
over the next two years. The continuous line is
reproduced from Chart 6A for comparison. Comparing the two lines reveals that the effect of the oil
price shock on real GNP growth is smaller in the
four-variable system, most noticeably in the first
quarter of 1975. The smaller impact is due to
unpredictable exchange rate changes, captured in
the line labeled "Pure Forecast Plus Exchange
Rate." This outcome supports our contention that

omitting the exchange rate will cause the. effect of
exchange rate changes to be attributed to changes in
the price of oil.
To obtain an idea of how much of the total
variation in.both real GNP and the price level over
the.entire sample period is due to oil price sho(':ks,
consider the results shown in Tables 3 and 4.Table 3
shows the results for real GNP. Once again, we first
consider a system consisting.of only real GNP. and
the price of oil and successively add the GNP
deflator and the exchange rate.
While disturbances to the price of oil have a
relatively large impact on real GNP when only these
two variables are included in the VAR, the addition
of other variables noticeably reduces their explanatory power. The results for the GNP deflator in Table
4 tell a similar story. Oil price disturbances do
account for a relatively large percentage of the
variance of the error made in predicting the GNP
deflator in the first two systems. However, adding
the exchange rate lowers their relative importance.
The results reported here maximize the role
played by oil price shocks because only oil price

39

shocks are allowed to affect everything else in the
VAR contemporaneously. Removing the restriction
on other variables noticeably reduces the response
of both real GNP and the deflator to oil priceshocks,
especially when the exchange rate is included in the
VAR. The effects of an oil price shock are also
susceptible to an increase in the lag length used in
the VAR. For instance, an increase in the number of
lags in the VAR from 4 to 8 causes the real GNP
response to an oil price shock to become even

smaller (while the real GNP response to an
exchange rate shock becomes somewhat larger). 16
Finally, while the results are not shown, disturbances. to the. exchange rate account fora relatively
large proportion of the variance of the oil price
forecast error in the larger systems as well. For
example, in the four-variable system, the percentage
of. the oil price forecast error variance due to
exchange rate disturbances is 38 at the ten-quarter
horizon and 40 at the twenty-quarter horizon. 17

40

m. Interpretation and Conclusions
The empirical results in Section I above demonstrate that changes in the value of the dollar have a
substantial impact upon the dollar price of oil.
However, we must emphasize that the estimated
equations do not explain all the variation in oil
prices over the period studied. The results do not
imply that OPEC was unable to increase oil prices
above what they otherwise would have been. They
do suggest that the dollar price of oil would have
risen in the 1970s as the dollar depreciated and
would have fallen in the 1980s as the dollar appreciated even without the existence of OPEC. This
contradicts the common view that changes in the
price of oil are generally exogenous. Such a view
may have resulted from an excessive focus on the
role of OPEC in setting oil prices and the belief that
OPEC's decisions are made independently of economic developments.
The analysis suggests that a considerable proportion of the changes in the price of oil during the socalled oil price shocks were simply discontinuous
price adjustments to changes in the economic
environment. This discontinuity is probably the
result of the cartel's mode of operation, which has
been one of making large adjustments in output
while adhering to a pre-announced dollar price.
Of particular interest in this context was the steep
fall in oil prices in early 1986. While disagreements
within the cartel were the proximate cause of the
large decline in prices, it is likely that the appreciation of the dollar until early 1985 played an important part. The appreciating dollar tended to reduce
non-U.S. demand for oil while increasing supply
from countries other than OPEC. Since OPEC was
trying to maintain a constant dollar price of oil, it
was forced to make large reductions in output.
Disagreements about how these reductions in output
were to be allocated led to a collapse in OPEC's
agreements. In all likelihood, the output reductions
forced upon the cartel would have been smaller in
the absence of the dollar's appreciation.
Viewed differently, the evidence (especially
Chart 4) suggests that, during the early 1980s, the
cartel succeeded in keeping prices above what the
historical relationship between exchange rates and

oil prices would suggest. However, pressures that
arose from doing so led to abreakdown of the cartel.
The large oil price decline in early 1986 then
brought prices back to more "normal" levels.
While our analysis ignores other factors that may
affect the price of oil, our interpretation is consistent
with the behavior of other commodity prices. In
general, commodity prices have been declining
since the dollar began to appreciate. Were it not for
the cartel, oil prices probably would have declined
significantly more prior to 1986.
The relationship between oil prices and the value
of the dollar is the basis for questioning studies that
purportedly measure the impact of oil price shocks
on the economy while ignoring either the impact of
the exchange rate on the price of oil or the impact of
the exchange rate on the economy. In Section II, we
demonstrated that once the exchange rate is taken
into account, changes in the price of oil no longer
have a significant impact on real GNP. An examination of the 1973 "oil shock" episode also reveals
that omitting the exchange rate exaggerates the
contraction in real GNP following the oil price
increase. Furthermore, the results in Table 3 suggest
that output variations induced by oil price changes
have not constituted a large proportion of the total
variation in real output over the sample period as a
whole. Taken together, this evidence suggests that
the large decline in oil prices in the beginning of
1986 is not likely to provide as big a boost to real
GNP as would be predicted on the basis of previous
studies.
Finally, the results in Section II also show that
inclusion of the exchange rate in the VAR reduces
the impact of changes in the oil price on the GNP
deflator. Most noticeable is the reduction in the
length of time for which oil price changes continue
to have an effect on the price level. Apparently, the
effect of oil price changes is concentrated in the first
few quarters following an oil price shock. This
finding reinforces our point that omitting the
exchange rate causes the oil price variable to pick up
the inflation that may actually have been due to the
dollar's depreciation.

41

FOOTNOTES
8. The moving average representations and the variance
decompositions shown here - and in the rest of the paper
- have all been obtained by placing oil prices first and
exchange rates last in the ordering imposed upon the error
terms. In other words, it is assumed that any shock common to oil prices and other variables in the VAR is due
entirely to a change in oil prices. This ordering will, in
general, maximize the role played by oil price shocks and
minimize that of exchange rate shocks.

1. Structural models that take the exchange rate into
account when studying the effects of oil shocks on the
economy assume that the price of oil is determined
exogenously (which is halfway between including and
excluding exchange rates in the corresponding VAR). An
exception is Hooper and Lowrey (1979), which studies the
impact of exchange rate changes under two alternative
assumptions: first, that exchange rate changes have no
impact on the price of oil, and second, that half of the oil
price increase in 1979 was due to the fall in the value of the
dollar.

9. Placing exchange rates first in the ordering substantially increases the effect of exchange rate disturbances.
Exchange rate shocks account for 33 percent of the forecast error variance of oil prices at the 5-quarter horizon, 51
percent althe 1O-quarter horizon, and 54 percent althe 20quarter horizon. The effect of oil price shocks becomes
correspondingly and noticeably smaller. Oil prices shocks
account for 5 percent of the forecast error variance of
exchange rates at the 5-quarter horizon, 11 percent at the
1O-quarter horizon, and 11 percent at the 20-quarter horizon.

2. In view of the results to follow, it is interesting that he
found that the price of imports (which reflects the value of
the dollar) had a significant impact on the price of oil and
yet dismissed the finding as inconsequential.
3. Gisser and Goodwin (1986) build upon the
"exogeneity" results of Hamilton, and use the price of oil in
a reduced form, St. Louis-type equation to show that the
price of oil affects output, inflation, etc.
4. Oil exporters will be indifferent to changes in the value
of the dollar only if the entire proceeds from the sale of oil
are used to purchase dollar-denominated products
a
condition that is hardly likely to be satisfied in practice.

10. The first difference of the log of the price of oil is
regressed on 12 lags of the first difference of the log of the
exchange rate. The equation also contains a constant and
a time trend. The R2 for the equation is .48, the adjusted R2
is .41. The Standard Error is .041, and the Durbin-Watson
statistic is 1.66.
11. The R2 from this exercise is .47, the adjusted R2 is .37.
The Standard Error of the equation is .034 and the OW.
statistic is 1.86.

5. An exchange rate index for the dollar measures the
value of the dollar against a weighted average of a basket
of currencies. A multilateral trade-weighted index uses the
ratio of a country's total trade (exports plus imports) to the
total trade of all countries in the basket as weights.
6. It appears that alternative dollar indices will move
together as long as changes in these indices originate from
changes in the value of the dollar. However, the indices will
move differently if non-dollar currency realignments tend
to be larger or more common. For our purposes, it is
probably sufficient that the dollar depreciation during the
early, as well as late 1970s, was not accompanied by large
changes in the value of nondollar currencies against each
other.

12. Theory also tells us that a fall in the value of the dollar
will lead to an increase in output. However, the empirical
results indicate that this increase is only temporary and
that it is followed by a contraction in real output.
While this result is counterintuitive, it has been reported by
other researchers as well. Simulations with the Board of
Governors MPS model suggest that a fall in the value of the
dollar first raises real output but then reduces it, so that two
years later, the level of real GNP is below its initial level. An
important assumption in their simulation is that monetary
policy remains unchanged. In our analysis, the results are
not significantly altered when the money supply is included
in the VAR.

See Brown and Phillips (1986) for a study that uses oil
consumption weights to construct an index for the dollar.
They show that an increase in the value of the dollar leads
to a decline in the dollar price of Saudi Arabian oil.
7. Sample size and data frequency were dictated by the
availability of exchange rate data. Data on the Federal
Reserve Board's trade-weighted exchange rate is available in quarterly average form starting in 1956.

13. When the S&P 500 is included (and the exchange rate
dropped from the VAR), the oil price has a marginal
significance level (M.S.L.) of .06 in the real GNP equation,
which is the same as when the VAR contains only real GNP,
the real GNP deflator, and the price of oil. The S&P 500 has
a M.S.L. of .11 in the oil price equation, .81 in the GNP
deflator equation, and .02 in the real GNP equation. In the
variance decompositions, the S&P 500 accounts for no
more than (a) 7 percent of the forecast error variance of the
oil price; (b) 4 percent of the forecast error variance of the
GNP deflator, and (c) 10 percent of the variance of real
GNP, at forecast horizons up to 20 quarters.

All variables are included as the first difference of logs. All
VARs include a constant and a time trend. Lag lengths
were chosen as follows. I started with a specification of 12
lags. A likelihood ratio test was then used to compare this
with lag lengths of 4, 8 and 16 lags. (The test used is
discussed in Sims 1980, and includes a correction for the
number of explanatory variables in each equation.) For the
VAR containing the price of oil and the exchange rate, the
tests reveal that the 12-lag specification is different from
the 4- and 8-lag specifications at the 1 percent level, but is
no different from the 16-lag specification. The lag of 12
quarters implies that estimation begins from 195902. To
keep the results comparable, all other VARs are estimated
over the same period, even though each of them contains
only four lags o/each variable.

14. The variance decompositions reveal that the share of
forecast error variances explained by the S&P 500 is no
more than 4 percent for oil prices, 4 percent for the GNP
deflator, and 9 percent for real GNP at any forecast horizon. Inclusion of either the 1O-year or the 20-year Treasury
bond rate also does not alter the significance levels of the

42

REFERENCES

exchange rate in the VAR, although the long rates do
explain a considerable proportion of the GNP deflator's
forecast error variance, Finally, the nature of the results is
unaffected by the inclusion of M1 in the VAR.

Brayton, F, and E, Mauskopf. "The MPS Model of the
United States Economy," Board of Governors of the
Federal Reserve System, February 1985,
Brown, S,PA and K,R. Phillips, "Exchange Rates and
World Oil Prices," Economic Review, Federal Reserve
Bank of Dallas, March 1986,
Burbidge, J, and A Harrison, "Testing for the Effects of OilPrice Rises Using Vector Autoregressions," International Economic Review, June 1984, pp, 459-484,
Cooley, T.F, and SF LeRoy, "Atheoretical Macroeconometrics: A Critique," Journal of Monetary Economics,
November 1985, pp, 283-308,
Gisser, M, and T,H, Goodwin, "Crude Oil and the Macroeconomy: Tests of Some Popular Notions," Journal
of Money, Credit and Banking, February 1986, pp,
95-103,
Hamilton, JD, "Oil and the Macroeconomy Since World
War II," Journal of Political Economy, April 1983, pp,
228-48,
Hooper, P, and B,R, Lowrey, "Impact of the Dollar
Depreciation on the U,S, Price Level: An Analytical
Survey of Empirical Estimates," Staff Studies 103,
Washington: Board of Governors of the Federal
Reserve System, 1979,
Sargent, T,J, and CA Sims, "Business Cycle Modeling
Without Pretending to Have Too Much A Priori Theory," in CA Sims, ed" New Methods of Business
Cycle Research: Proceedings from a Conference,
Federal Reserve Bank of Minneapolis 1977,
Sims, CA "Econometrics and Reality," Econometrica,
1980, pp, 1-48,
Sims, CA "Policy Analysis With Econometric Models,"
Brookings Papers on Economic Activity, 1: 1982,

15, For the system stability tests, a likelihood ratio test,
discussed in Sims (1980), was used, F,testswere carried
out on the individual equations, For the 5,variable system
in Table 2, the Chi,square statistic - calculated under the
null hypothesis of no change between the two periods had a marginal significance level of ,85, For the 4-variable
system, the computed Chi-square has a marginal significance level of A 1, Finally, for the 3-variable system, the
test statistic has a marginal significance level of ,02, In this
system, the oil price equation has a F(12,81) statistic of 2,5,
which is significant at 5 percent
16, The effect of increasing the lag length is especially
noticeable in an examination of the 1973 "oil shock" episode, While the impact of the change in oil prices in the
3-variable VAR is more or less the same in both the 4 and 8
lag versions, it becomes much smaller once the exchange
rate is included, Specifically, knowledge of the oil price
shocks does not appear to be useful in "predicting" much
of the decline in real GNP over 197403-197501,
17, To test the robustness of this result with respect to
other output and inflation measures, a system containing
industrial production and the producer price index was
also estimated, While the oil price is significant at less than
one percent in the industrial production equation when
only oil prices and industrial production are included, its
marginal significance level increases to, 76 when both the
producer price index and the exchange rate are added to
the system,
In the variance decompositions, the oil price variable
accounts for a maximum of 6 percent of the forecast error
variance of industrial production even when it is placed
first (in a four-variable VAR which included the exchange
rate), With oil prices placed last, this number falls to 4
percent In the same system, oil prices (when placed first)
account for 13 percent of the variance of the error in
predicting producer prices in the contemporaneous quarter. This falls to 8 percent at the ten-quarter horizon, When
oil prices are placed last, they account for more than 5
percent of the forecast error variance of the PPI only once,

43

Reuven Glick*
This paper provides theoretical and empirical explanations for shortterm fluctuations in the real value ofthe dollar. ltformulates a model in
which the imperfect information of economic agents about disturbances
causes the real exchange rate to respond to monetary as well as real
shocks. Empirical evidence from vector autoregressions support the
hypothesis that increases in the U.S. money supply induce declines in the
real value of the dollar, while increases in real demand in the U.S.
generate rises in the dollar's value. Foreign disturbances were also found
in some instances to influence the value of the dollar.
nations were first freed from the constraint of pegging exchange rates by coordinating their monetary
policies, great variations in money supply growth
emerged. Oil-related price shocks also occurred in
that decade. In the 1980s, differences in real aggregate demand among countries, in part related to
differences in fiscal policy stimuli, have been apparent.
This paper seeks to explain movements in real
exchange rates in terms of these underlying determinants. In particular, it provides both a theoretical
and empirical analysis of the role of monetary and
real disturbances in explaining the direction and
magnitude of exchange rate changes. Real exchange
rate fluctuations, because of their implications for
the international competitiveness of countries, have
important resource and output effects. A real dollar
appreciation, for example, raises the relative international cost of U.S. goods and thereby dampens
the demand for U. S. output. Understanding the
magnitude and origin of causes of real exchange rate
changes is thus important for formulating effective
policies to reduce exchange rate variability.
Section I contains the formulation of a model of
real exchange rate determination based on the
assumption that economic agents possess impelrte(~t
information about disturbances such as changes in
money supply growth or in real demand and supply

Since 1973 the relative values of the currencies of
major industrial countries have been determined
primarily by free-market forces in a floating
exchange rate system. Fluctuations in nominal
exchange rates over this period have been substantial. Real exchange rates - nominal exchange rates
adjusted for differences in national price levels have been almost as volatile, since nominal
exchange rate movements have exceeded those of
national price levels. I
The chart graphs an index of the real dollar value
of the yen and German mark, defined as the dollar
"value" of the foreign wholesale price index
divided by the u.S. wholesale price index. A rise in
this index represents an increase in the dollar price
of foreign goods relative to the price of U. S. goods
and hence a real dollar depreciation. The chart
shows substantial fluctuations of the dollar in real
terms over the entire floating rate period.
Variation in underlying economic conditions has
undoubtedly contributed directly to exchange rate
fluctuations. Indeed, the floating exchange rate
period has been characterized by frequent and varied economic disturbances. In the 1970s, when

* Economist, Federal Reserve Bank of San Francisco. Research assistance from Laura Shoe is
greatly appreciated.
44

conditions. 2 The resulting confusion among agents
about the relative magnitudes of monetary and real
disturbances implies that the real exchange rate will
be influenced by monetary as well as real disturbances. The model provides indications of both the
direction and magnitude of response of the real
exchange rate to such disturbances. 3
Section II examines several hypotheses suggested
by the theoretical framework using the technique of

vector autoregressions. Real depreciations of the
dollar are found to be associated with U.S. money
supply increases, and appreciations of the dollar
with fluctuations in expansionary U. S. real
demand. The section also provides estimates of the
relative amounts of exchange rate variability that
can be attributed to various disturbances. Conclusions are presented in the final section.

Real Dollar Value of Foreign Exchange
1980

100

140

120

$/Yen

100

;.

80
60

40

1973

1975

1977

1979

1981

1983

1985

Note: An increase in the real $/Yen(deutschemark) rate
represents a decrease in the real value of the dollar in terms of
the Yen(mark).

45

I. A Model of Exchange Rates and Disturbances
As mentioned, real exchange rate fluctuations
may be viewed as reflections of variations in underlying economic conditions. This section formulates
a small-country model of the equilibrium response
of the real exchange rate to domestic real demand,
real cost, and nominal money supply disturbances.
The small-country assumption is employed for convenience to simplify the structure of the model
formulated. How the results can be generalized to
include foreign disturbances a~ well is discussed
briefly at the end of this section.
The key feature of the model is its treatment of
information among economic agents. Within the
model, economic agents are aware that different
disturbances to the economy occur each period but
cannot observe them directly and are unable to
determine their magnitudes. Agents are assumed to
form rational expectations of each period's disturbances on the basis of available past information and
current "signals" obtained by observing current
goods and asset market prices and conditions. These
signals enable agents to infer information about the
under!ying disturbances.
In the model, observation of market prices and
conditions provides partial, but not perfect, information about the current magnitudes of disturbances. Thus, for example, observation of domestic
interest rate and money market conditions may
indicate the presence of an excess supply of money
but not reveal the extent to which the excess is due to
a positive money supply disturbance or a negative
real demand disturbance that has dampened money
demand. Within this framework, we show how the
real exchange rate is affected by both monetary and
real disturbances.
The formal model is constructed by first specifying relationships for aggregate supply and demand
in the domestic goods market, a domestic money
market equilibrium condition, and an international
interest rate relation linking domestic and foreign
interest rates. All variables are defined in log terms
(except for interest rates). These relationships are
then used to obtain an expression relating the real
exchange rate to the disturbances as well as to
expectations of the future exchange rate. We complete the theoretical analysis by showing how
expectations of the future exchange rate in turn

depend on expectations of disturbances, and then
deriving an expression indicating how the equilibrium real exchange rate responds to each individual disturbance.
The Goods Market
The supply of domestic output, Yt, is assumed to
depend positively on the real domestic interest rate,
rt, and negatively on a random supply cost disturbance, c t:
(1)

(2)
(3)

The specification of supply (equation 1) as a function of the real interest rate reflects the intertemporal
decision of producers concerning how much of their
product to supply in the current period and how
much to supply in the future. The real interest rate,
given by equation 2, is defined as the difference
between the domestic nominal interest rate, it, and
the expected change in the overall domestic price
level, PP where E t denotes expectations formed at
time t. The real rate may be interpreted as the price
of current goods relative to the discounted price of
future goods. An increase in r represents a rise in the
price of current goods relative to the discounted
return to selling in the future and, as implied by
equation 1, induces producers to supply more current output. 4
The supply cost disturbance at time t, described
by equation 3, consists of two components: a
serially correlated term, PeCt _ l ' linking the current
disturbance to lagged shocks, and a current (whitenoise) shock term, Eet . This disturbance can be
associated with exogenous factor cost increases or
adverse productivity movements.
The overall domestic price level, Pt, is expressed
by equation 4 as a weighted average of the domestic
currency price of domestic goods and foreign
goods:
Pt = ap?

46

+

(l - a) (pt

+

St),

(4)

is the domestic currency
of domestic
is the
currency
of
goods, St is the nominal exchange rate defined as the
domestic currency price of foreign currency, and a is
the share
constant) of domestic goods in
domestic
Note that a rise in s represents an increase in the amount of domestic currency necessary to buy a unit of foreign currency
and hence a nominal depreciation in domestic currency value.
The real
rate, qt, is defined by equation
5 as the nominal
rate plus the difference
between the foreign
level of foreign goods and
the domestic
level of domestic goods:

We assume that m!' the nominal money supply, is
determined
as the sum of a 0"''''''''''_
correlated term and a white-noise term, Emt :
(9)

A more general formulation would allow the money
supply to be determined in part by considerations of
domestic or international policy targets. Such a
formulation would include the addition of terms
related to current deviations from, for example,
output or
rate
to the right-hand
side of equation 9.
Assuming risk neutrality on the part of agents and
perfect capital mobility, equilibrium in the international bond market requires that the domestic nominal interest rate, it, equal the foreign nominal interest rate, if, plus the expected depreciation of the
domestic currency:

(5)

A rise in q
an increase in the relative
domestic currency price of foreign goods and hence
a real domestic de,pn?ci"zti'1n.
Aggre:gate real demand for the domestic good
(equatIOn 6)
on the real interest
on the real exchange rate, qt,
rate, r!' and
and a random demand disturbance term, dt:5

Yt

=

(6)

dt

=

(7)

(10)

This condition implies that the returns, in terms of
domestic currency, to holding domestic and foreign
assets become equal. An exogenous risk-premium
term could be introduced without affecting the
analysis.
For the remainder of this analysis, we will use the
small-country assumption, and treat the foreign
country variables pf and if as exogenous, constant,
and, for convenience, equal to zero.

A

real interest rate induces reduced current
mvestment) and hence current
delllaJld, while a rise in the real
rate, that
a real
of the domestic currency,
induces greater demand for domestic output. The
demand disturbance term, as described by equation
7, is serially correlated with a (white-noise) shock
term, Edt. It may be interpreted as representing the
effects on domestic demand of autonomous private
and
or of domestic fiscal eXjJenditures.

Eqluilibrilum Conditions
We are now in position to address the implications of the equilibrium conditions in the goods and
asset markets for the determination of the real
exchange rate and for the response of the real
ex(;hajt1ge rate to the various lagged disturbances dt - I, ct - I , and mt-I - and current shocks
Edt'
Eet , and E mt . Note that the term "shock" is used to
refer to the random, unserially correlated component of each disturbance occurring in a given
period. In the absence of any shocks prior to the
previous period, any lagged disturbances can be
associated entirely with lagged shocks, since in that
case, for eXaJ11ple, dt - I = Edt _. I'
Observe first that equations 4 and 5 imply the
following relationship between the nominal and real

Asset Market
market
requires the domestic
real money
to balance domestic real money
where the latter depends positively on
domestic output and negatively on the domestic
nominal interest rate:
(8)

47

ex(~h~m,e:e rates

and the overall domestic

where e 1
a + co(b1a - b2 ) > 0 by assumlption.
The current nominal
rate
PO~,ltjvely on the current real
rate, the
expected future nominal exchange rate, and
and
money
negatively on current and lagged real demand
shocks.
Intuitively, a rise in the expected future nominal
a
domestic interest
mc,biliity of international
consequently, a dampening of real money
demand. A
current
rate is then
necessary to raise the domestic
of
and the overall domestic
a decline in the real money
Current
or lagged money supply shocks induce an excess
supply of money and hence a rise in s" that
a
nominal depreciation ofthe domestic currency. Current or lagged demand shocks in the goods market
correspondillgly raise money demand, induce
excess money demand, and cause a fall in St.

level

(assurnil1:g pi =

C0l1lseql11ently e(~uations 2,
real domestic interest rate is Dositivelv
in the real exc:hallge

The domestic
market
condition
upon substitution of
3 and
in ,and
7 and I in 6, and simultaneous solution for qt:

+

ao-

+
1

+

!

+

Edt

+

+
The current real
rate, qt,
negaon
current and
real demand
and cost
and
on the eXI)ected
future real
rate.
an increase in
domestic demand or costs creates excess demand
pressure the domestic
market. This induces
a lower real
rate, that a
domestic
currency, to shift demand away from domestic outand to maintain
market
A
hlQ:her e)(pe:ct,,:d future real
rate, that
an
of the domestic currency,
a
domestic real interest rate due to
the international
of
(see equation
This creates excess
pressure by mducing
current
and lower current demand for
domestic
a
current
real
rate, that
a current domestic currency
is necessary to stimulate current

EXlpec:tatiorls and

The money market eqililibrilllm eXTlres,sion
tion 8)
the
for the
nominal
rate upon substitution of equations 6,7,9,
11 and 12 for
YP mp ip PP and

(15)

where q is the long-run average real
rate
and the B coefficients indicating the sensitivity of
the exchange rate to current and lagged disturbances
depend on the parameters of the structural relationin the model

f t,

+

+1

+

'-()~I-'rl'"t --I

pmm t -

+

I

Solution

Equal:iOlls 13 and 14 describe how the current real
and nominal exchange rates each
on current
and lagged shocks and on expectations of the future
exchange rate.
the overall eqililibrilllm
response of the current real exchange rate to these
shocks thus requires specifying how the shocks in
turn affect expectations of the future
rate.
It should be apparent that only current and
shocks should have any influence on future eXI)ectations through the serial-correlated disturbance component because any further shocks occurring in the
future are assumed to be random
and
therefore unforeseeable. This implies that the
librium real exchange rate depends
on current
and
in turn,
that
eqlnhbrium real exchange rate may be
as
a function of these shocks in the
way:

(14)

Edt)

48

least partially useful information to agents about
underlying conditions.
The content of the signals provided to an agent at
any time t may be determined from inspection ofthe
and asset market
expressions,
equations 13 and 14, both of which are known to
agents. Given the knowledge of lagged disturbances
and market prices by agents, each expression
implies knowledge of a residual term related to the
underlying current shocks. Specifically, knowledge
of c t _ 1, d t _ ], q!' and Etqt + 1 in equation 13 reveals
to agents the term ZG == Edt + Eet , a composite signal
of the current real demand and cost shocks.
While agents cannot observe the demand and cost
shocks individually, the knowledge of Zp obtained
from observing market conditions provides a signal
of excess domestic demand that reflects their net
effect in the goods market. For example, observation of a high value ofZp by agents provides a signal
of excess demand in the goods market, information
which is of value to agents even though it is not
sufficient to reveal precisely how much of the excess
demand is due to a demand shock boosting demand
as opposed to a cost shock reducing supply.
Analogously, the condition in equation 14 reveals
to agents the composite signal Z¥ == Emt - COEdt.
may be interpreted as a signal of excess money
supply reflecting the net effect of money supply
shocks and disturbances to money demand caused
by real demand and income shocks. 9
Agents are able to form expectations of each of
the current shocks conditional on the information
set including these signals. In the appendix, we
show how these expectations take the following
form:

Equation 15 implies that the equilibrium current
real
rate win differ from its long-run
average level only with the occurrence of current
and lagged shocks. To ascertain the direction of
change of the equilibrium exchange rate to each of
these
it is necessary to determine the signs
of the B coefficients. 8
We proceed to determining the signs of the B
coefficients by first discussing the formation of
expectations. According to the assumption of
rational expectations, current expectations of the
future exchange rate should be consistent with the
equilibrium exchange rate prevailing in the next
period. In particular, expectations in period t of the
forward-dated equivalent of equation 15 for period
t + I are given by

or, after substituting equations 7, 3, and 9 for d t, c t,
and m!' respectively,
1= q + Et(PdBddt -]

+ PcBcCt-1 + PmBmmt -])
+ Et(BEdEdt + BEeEct + BEmE mt)

Note that expectations formed in period t of the
white-noise shocks in period t + 1 - Edt + I' Eet + ],
and Emt +] - are zero.
To proceed further, it is necessary to discuss the
information sets of agents at the time their expectations are formed in any given period t. For simplicity, agents are assumed to have fuU information
about the magnitudes of the lagged disturbances I' c t _ ], and m t _ 1 .. While they cannot directly
observe current shocks at time t, they may infer
partial knowledge of these shocks by extracting
information from "signals" provided by observable
market conditions and prices, including q!' the real
exchange rate; St, the nominal exchange rate; it, the
domestic interest rate; and Pt, the price level. We
also assume that their information sets include the
parameters of aU structural equations and the
moments of aU random variables. Neither current
output quantities nor the money supply are treated
as observable. This distinction between observable
and unobservable market variables is intended to
capture the property that market prices convey at

(17)
.(18)
(19)

where the C coefficients are positive parameters
indicating the extent to which the expectations of
each current shock are attributed by agents to the
goods and money market signals that they observe.
Intuitively, the stronger the signal of excess

49

current excess demand signal to a current demand
shock. This implies that the coefficient CdG will be
of greater magnitude than C eG .

demand in the goods market (the higher is ZP) the
stronger the perception of both positive real demand
and cost shocks. A stronger excess money supply
signal (higher Zf"l) leads to the inference of a more
positive money supply shock, but also to the
inference that a more negative real demand shock
may have occurred and dampened money demand.
Correspondingly, the excess money market signal
implies expectation of a more positive cost shock. A
stronger goods market signal leads to the expectation of larger money supply shock, since, to the
extent that it is attributed to a positive real demand
shock, a signal of a stronger goods market lessens
the extent to which an excess money supply signal is
perceived to have resulted from a negative real
demand shock.
The extent to which the signals influence expectations of the current shocks is reflected in the magnitude of the C coefficients. To understand this, it is
helpful to view equations 17-19 as the result of
regressing historical observations of realizations of
each of the individual shocks (which are known
with a lag) on the goods and money market signals.
The magnitudes of the C coefficients obtained from
these regressions depend on the relative variability
of the different disturbances. Thus, for example, if
demand shocks have been relatively more prevalent
historically than cost and money supply shocks,
then agents will attribute relatively more of any

EqlJilit)rium Resl:llon~se of the
Real Exchange Rate
We are now in a position to determine the equilibrium response of the real exchange rate to individual shocks. The
describes in detail how
this is done by deriving the explicit values of the B
coefficients in equation 15, denoting the sensitivity
of the exchange rate to individual shocks. Table 1
indicates the signs of these coefficients under the
conditions of imperfect information, positively correlated disturbances (Pd' Pc, Pm> 0), and demand
disturbances that persist more strongly than cost
disturbances (Pd > Pc)·
A current positive real demand or cost shock
induces real appreciation of the domestic currency,
that is, a fall in q (BEd' B Ec < 0). Intuitively, either
shock creates an excess demand for domestic output
the former by boosting demand and the latter by
dampening production. Excess demand then
induces an increase in the real value of domestic
currency to shift demand away from the domestic
market. Lagged demand or cost disturbances, when
they are positively correlated over time, induce a
real appreciation (B d , B c < 0) as well.

50

In the case of imperfect information, current
money supply shocks also influence the real
exchange rate (since Bern :/= 0). The reason is that
without the ability to distinguish perfectly among
individual shocks,agents confuse money and
real disturbances. If, for example, a positive
money supply has occurred, agents will attribute the
resulting excess money signal observed in part to
negative real demand shocks. The perception of a
demand shock, even if none has actually occurred,
implies that the money supply shock will have real
effects. 10 More particularly, the perception of lower
current real demand arising from a positive money
supply shock causes the domestic currency to
depreciate to stimulate domestic demand (Bern > 0).
Note that in this model, lagged money disturbances have no effect on the exchange rate
(B rn = 0). The reason is related to the assumption
that agents know all past disturbances with a one

II.

period lag. That assumption implies that lagged
money is not a source of confusion when agents
attempt to infer the magnitudes of current shocks to
the real exchange rate.
The analysis above yields implications aboutthe
effect of domestic real and money supplydisturbances on the exchange rate within a small-country
framework. It is fairly straightforward to incorporate the effects of foreign real and money supply
disturbances into a two-country framework. By
intuition, these disturbances should have effects
opposite those of the domestic disturba.nces
described in Table 1. In particular, positive real
shocks creating an excess demand for foreign output
should lead to a real appreciation of the foreign
currency and hence a depreciation of the domestic
currency. Under imperfect information, positive foreign money supply shocks should lead to a domestic
appreciation.

Vector Autoregression Analysis

The model formulated in Section I suggests how
fluctuations of real exchange rates can be attributed
to fluctuations in various underlying disturbances,
both monetary and real. In this section, empirical
evidence is provided concerning the extent to which
monthly bilateral real exchange rate movements of
the dollar against the yen and German mark can be
related to changes in monetary and real conditions
in the United States and abroad.

Applying the VAR technique involves transforming all data into first differences of natural logs
(equivalent to forming percentage changes). and
individually regressing each variable in the system
(the vector) on lagged values of itself and of the
other variables in the system (the autoregression)
and on a common set of other terms including a
constant, linear and quadratic time trends, and
seasonal dummies. 12 A common lag length is
imposed on all endogenous variables. 13
The resulting estimates provide several useful
insights. First, they indicate whether past values of
other endogenous variable have a significant effect
on a given variable throughGranger-causality statistical tests on the values of lagged coefficients. If
past values of, say, money supply changes have. a
significant effect on the real exchange rate, then the
money supply is said to "Granger cause" the
exchange rate. 14
Secondly, since the autoregressive equations
extract the effects of past movements of variables,
the residuals from each of these equations provide
measures of unanticipated movements of variables
in the system and thus act as proxies for shocks.
Correlations ofthese residuals may be interpreted as
measures of the association of unanticipated vari-

Description of the VAR Method
To analyze the interrelationship of the real
exchange rate with changing economic conditions,
we employed the technique of vector autoregressions (VAR). The VAR technique imposes no
restrictions on the relationships between different
variables and treats them all as potentially endogenous. VARs are best thought of as a convenient
way. of summarizing empirical regularities and suggesting the predominant channels through which
relations work. l l While several other studies (for
example, Branson, 1984; Kuszczak and Murray,
1986) •have used the VAR approach to <malyze
exchange rate movements, they focus on nominal
rather than real changes and effective rather than
bilateral rates.
51

variance of any variable in the
is attributable
to itself and other variables in the
16 These
so-caned "variance decompositions" can be used to
infer the relative effect of money and real disturbances on exchange rate fluctuations. 17

able movements. Thus, for example, a posItive
correlation between the U.S. money supply and the
real dollar exchange rate residuals, or a negative
correlation between U. S. demand disturbances and
the real dollar exchange rate residuals, provide
suggestive evidence for the theoretical prediction
that the current real dollar should depreciate in
response to a current domestic money shock and
appreciate in response to a current domestic demand
shock. 15
Lastly, the VAR estimates may be transformed in
a manner to yield estimates of how much of the

Results
Two VAR systems were estimated with mcmtilly
data, each containing six variables. The first consisted of the real dollar/yen rate, the real
and money supplies and industrial pn)dllctiton

52

53

both the United States and
The second consisted of the donar/Gennan mark rate, the real price
of oil, and money supplies and industrial production
for the United States and Gennany.18 Difficulties in
monthJlyfrequency
inclusion of other possibly relevant variables, such
as government spending.
Note that the real exchange rate was defined as the
real dollar price of foreign exchange, with an
increase in the real exchange rate indicating a real
depreciation of the dollar. To provide an adequate
time period for adjustment to the system of floating
exchange rates, the observation period began in
November 1973 and ended with October 1985.
Concern about degrees of freedom limitations precluded the examination of results for subperiods.
The results of the VAR equation estimates for the
U.S.-Japan and U.S.-Gennany systems are presented in Tables 2 and 3, respectively. Observe in
the last column of each table that the real dollar/yen
and dollar/mark rates were not
influenced (Granger-caused) by lagged values of any of
the variables in the system (the marginal significance levels were .17 or much
For the other
equations, lagged values of particular sets of variables are occasionally seen to influence (Grangercause) either themselves or other variables, using a
ten percent marginal significance standard.
The bottom panels of Tables 2 and 3 present the
correlations of the residuals from the estimated VAR
equation. Of primary interest are the correlations of
the real exchange rate with those of other variables
of the system, reported in the last column. Here we
find some suggestive evidence for the association of
real exchange rate movements and money and real
shocks that accords with the theoretical implications of the model in Section I.
Observe first that U.S. money supply residuals
are positively and significantly correlated with
residuals in both the real dollar/yen and dollar/mark
rates, while Gennan money supply residuals are
negatively correlated with the dollar/mark rate. The
industrial production residuals may be interpreted as
business-cycle demand shocks
through the

VAR
they have been
of the
effects of money changes and
such as oil price changes, as well as of trend effects.
Observe that U.S. industrial
residuals
are negathrely correlated
exchange rate, while
industrial prc>dwctiC!ll
residuals are positively correlated with
yen rate, as expected. 19
Table 3 presents results from
of variances. 20 Observe first that
money and
industrial production innovations account for relatively more of the variance of the
rate
(16 percent + 14
= 30
while
U.S. money and industrial
innovations
account for relatively more of that of the donar/mark
(17 percent + 15 percent = 32 percent). In other
words, foreign disturbances appear to have
a
greater role in influencing movements of the dollar/
yen rate; U.S. disturbances were more significant
for dollar/mark fluctuations.
Note second
for the
rate, U. S. and
Japanese monetary disturbances account for
(II percent + 16 percent =) 27
and U.S.
and Japanese demand disturbances
(12
+ 14 percent =) 26
of the exchange rate
variance. For the dollar/mark rate, money and
demand disturbances account for 26
and 23
percent, respectively, of the
rate variance.
Thus, for both bilateral rates, money and real shocks
appear separately to account for a
comparable proportion of the exchange rate variance.
Observe
that the variance
and dollar/mark rates
by themselves are
rather large (38 and 43
These
figures represent the
of the
rate
that cannot be forecast by the other variables in the
analysis and which reflects the
of
eluded variables and pure innovations in the
exchange rate itself. Their
that a
sizeable
of real
rate fluctuastill remains to be
other variables
and better proxies for
and demand conditions.

54

IU.

Conclusions

This paper has provided both a theoretical and
empirical framework for analyzing the response of
the realexchange rate to monetary andrealdisturbances. The sensitivity of the real exchange rate to
these disturbances was shown to depend on the
degree of information possessed by economic
agents. When. agents have imperfect. information
and are confused about the relative magnitudes of
monetary and real disturbances, the real exchange
rate depends on monetary as well as real disturbances.
The empirical analysis indicates that movements
in the real value of the dollar can indeed be associated with real and monetary disturbances. In particular, support was found for hypotheses suggested
by the theory that U.S. money supply increases
induce falls in the real value of the dollar while real
demand expansions generate rises in real dollar
value. Foreign shocks were also seen in some

instances to influence the value of the doUar. They
were found to play a greater role in influencing
fluctuations in .the real dollar/yen rate than in the
dollar/mark rate.
Our analysis suggests that governments can and
do influence the real exchange rate through policies
affecting money and goods marketconditions.We
conclude that policies designed to reduce money
and real market disturbances should also reduce the
variability of the real exchange rate. Our findings
also suggest an alternative means of achieving such
a goal of stability, namely, increasing the extent of
knowledge in the economy about underlying economic conditions. In particular, policies that result
in less confusion and more information about the
relative magnitudes of money and real disturbances
may decrease the sensitivity of the real exchange
rate to existing money shocks.

ApPENDIX

(A.2) EtE ct = [«J;(J~

This appendix describes the derivation of expressions for the rational expectations of current disturbances from existing market signals, and also of the
equilibrium real exchange rate response coefficients.
The general expression for rational expectations
of any given disturbance Ekt , k =d,c,m, formed
conditionally on an information set containing the
signals Z? and Z~ is given by (see Sargent, 1979,
pp. 208-209)
Et[Ektl Zp,

Z~]

Et[(Ekt - Et[Ektl

= Et[EktIZy]
Z9])I(Z~

-

c6(J~(JD/Jl]Zf

+ (co(JZ(JJ/Jl)Z~

where Jl = (J~(J~ + (J~(JZ + c5(J~(JZ; and (J~, (JZ'
and (J~ are the absolute variances of the demand,
cost, and money shocks, respectively. The coefficients in these expressions represent the explicit
formulas for the C coefficients in equations 17-19 in
the text. Substitution by Zy = Edt + Ect and
Z~ = E mt - COEdt and rearrangement gives:

+
Et[Z~1

+

ZyJ)]

where for any variable X and Y

and Cov and Var represent the covariance and
variance operators. Evaluation of this expression for
k=d,c,m implies

where 3d =

(JZ(J~/Jl,

tic =

(Ja(J~/Ll,

em = co(J~(J;/Ll; 0 ~tld' tic' em ~ 1.

55

money supply shocks since the confusion about
demand disturbances (e d) then diminishes.
Equation A.4 also says that, with imperfect information, expectations of real demand shocks win
on money
shocks. More
cally, positive money shocks result in lower expectations of demand shocks. The effect of a given money
shock on perceptions of real demand disturbances is
magnified the
are the relative variances of
real disturbances (the greater is em)' Expectations of
cost and money shocks may be interpreted similarly.
To solve explicitly for the B coefficients whose
signs are given in Table I in the text, note that at
time t, dt _ I' c t _ I' and mt _ I are assumed to be
known. Substitution of Equations A.4-A.6 in Equation 16 subsequently implies

Equations A.4-A.6 relate the conditional expectations of current disturbances to their actual levels .
The parameters ed' ec, and em represent the relative
variances of demand, cost, money shocks, respecreflect the noisiness of market conditions and hence the degree of confusion by agents
about the shocks that they cannot directly observe.
Thus, for example, ed measures the degree of confusion about demand conditions. The definition of
ed indicates that such confusion is high when the
variances of cost and money shocks ((J'~, (J'~) are
relatively large since, in that case, market conditions
primarily reflect fluctuations due to cost and money
disturbances, and reveal relatively little about
demand conditions.
In the absence of any confusion about current
shocks, ed' ec, and em equal zero, and equations
A.4-A.6 imply that agents will fully perceive all
shocks. In general, however, confusion will exist
and agents will misperceive shocks. Equation A.4,
for example, describes how agents misperceive
demand shocks. The extent of the misperception
diminishes the smaller are the variances of cost and

Etqt+ I =

TABLE

q + PdBddt - 1 + PeBcCt-1 + PmBmmt-1
+ BEd[Edt - (edEdt - 6cEct + 6mEmt )]
+ BEe[Eet + (edEdt - eeEet + 6mEmt)]
+ BEm[E mt - CO(edEdt - ecEet + emE mt )]

A

Real Exchange Rate Response Coefficients

~

0 as Pd ~ 0

< 0 if Pd' Pc > 0
~

as Pc ~ 0

< 0 if Pd'

where

a2 = eO/(b2 + eo) < 1

+ eo(l- Pd»
Dc = l/(b2 + eo(l-pc»
ad = O'~O'?r/il, o~ ad ~ 1
Dd = l/(b2

am = coO'~O'~/il, 0 ~ 6m ~ 1
il = O'~(J';;'

+

O'~O';;'

+

c~O'~O'~

56

Pc

> 0

Substituting the above expression in turn into Equation 13 yields, upon rearrangement:

qlb 2 + eo)

= ao -

6m in the coefficients are equal to zero. In this
instance, the real exchange rate depends only on real
demand and cost shocks, and not on current or
lagged money shocks (B m = Bern = 0). In the case
of. itnperfect infonnation, current money. supply
shocks will influence the real exchange rate (since
Bem=l= 0). If demand disturbances persist more
strongly than cost disturbances (Pd > Pc > 0) then a
positive money supply shock causes a real depreciation (Bern > 0). The larger is 6 m and the degree of
confusion about money disturbances, the greater is
the response of the real exchange rate. Finally, note
that the response of q to current demand and cost
shocks differs from the full information response
and also depends on the degree of confusion about
these shocks (6 d, 6e) and on the serial correlation
parameters (Pd' Pc)'

bo + eoq

+ Pd(eoB d - l)~-l
Bee + coB~rn)] -1}Edt

+ {eoEB ed - 6d(B ed + Pe(eoB e -1)Ct-l +
{eo[B ee + 6e(B ed - Bee + coBern)] - I}Eet
+ PrneoBmmt- 1 +
[eo(B em - 6m(B ed - Bee + coBern)]Emt

Dividing through by b2 + eo, equating coefficients
term-by-term with Equation 15, and solving for the
B coefficients gives the expressions in Table A.
The perfect information case is characterized
when the relative confusion parameters 6d, 60' and

FOOTNOTES
1. The variability of real exchange rates over the floating
rate period has been well documented. See, for example,
Frenkel (1981) and Cumby and Obstfeld (1984). For discussion of the welfare effects of exchange rate variability,
see Obstfeld (1985) and Frankel (1985, pp. 23-32).

emphasizes the role of anticipated price changes in supply decisions, differs from the Lucas-type supply function
which depends on Pt
Et _ 1Pt and emphasizes the role of
unanticipated price changes.
5. Note that, in addition to the effect of the real exchange
rate on demand by foreigners for domestic output, the
constant b o and the disturbance term d t may also be
interpreted as including foreign influences.

2. The assumption that agents have imperfect information
because they are unable to observe directly or to infer from
market conditions the magnitude of current disturbances
to the economy is characteristic of so-called "island"
models first developed by Phelps (1970) and Lucas (1972,
1975) to analyze domestic macroeconomic adjustment.
More recently, this approach has been employed in international macroeconomic models as well, for example,
Bhandari (1982), Kimbrough (1983, 1984), Flood and
Hodrick (1985a, 1985b), and Glick and Wihlborg (1986).
These models, however, have generally focused on issues
other than real exchange rate behavior.

6. With pI = 0, equation 4 implies that Pt = a(pp - St) +
St and equation 5 that qt = St - pp. Substitution of the latter
expression in the former and rearrangement gives equation 11 in the text.
7. Substituting equation 10 in equation 2 and assuming
il = 0 gives rt = Et{St+1
Pt+1) - (St - P,), Use of
equation 11 gives equation 12 in the text. The parameter a,
the share of domestic goods in consumption, appears in
equation 12 since the real domestic interest rate is defined
in terms of the expected inflation rate in the overall domestic price level, while the real exchange rate is defined in
terms of the price of domestic goods alone.

3. Other explanations exist for real exchange fluctuations
in response to both monetary and real disturbances. For
example, in so-called "sticky-price" models, it is assumed
that domestic and foreign goods prices adjust more slowly
than the exchange rate to disturbances because of labor
and/or goods market rigidities, such as fixed wage
contracts (see Dornbusch, 1976; Obstfeld, 1985). When
domestic and foreign prices are relatively rigid in the short
run, real as well as nominal exchange rates will be affected
by disturbances. This paper does not attempt to distinguish among competing hypotheses.

8. Equation 15 may be interpreted as a "guess" about the
general form of the equilibrium expression for the real
exchange rate. The technique of "guessing" the general
form of the equilibrium solution and then determining the
values of the coefficients in this equilibrium explicitly is
standardly employed in linear stochastic difference models of the type formulated in this paper. See, for example,
Bhandari (1982) Flood and Hodrick (1985a, 1985b), Glick
and Wihlborg (1986), and Kimbrough (1983, 1984). A
similar procedure could also have been applied to the
determination of the equilibrium nominal exchange rate.

4. This particular specification emphasizes the role of
expected price changes in current supply decisions. If the
price level in natural units is denoted by P"~ then the
relevant price ratio is PJ[E'pt+ 1/(1 + ill. The logarithmic
analogue to this price ratio is Pt + In(1 + i) - Etpt+ 1, or,
noting that In(1 + i)=i, by i - (Etpt+ 1 P,), which is the
definition of the real interest rate. Work employing this
specification includes Barra (1980), Bhandari (1982), and
Kimbrough (1984). Note that this specification, which

9. Note that the model contains two signals and three
disturbances. This implies that agents cannot perfectly
infer the magnitudes of the individual disturbances merely
from observing market conditions. See Glick and Wihlborg
(1986) for a model of exchange rates which illustrates how

57

under these circumstances a demand for information purchase can arise.

15. Note that, to the extent government monetary policy is
determined by a reaction to undesired exchange rate
changes, the positive correlation between money shocks
and the exchange rate will be dampened.

It should also be pointed out that if in any period t agents
lack full information l:\bout the disturbances in periods t-1
or earlier, then lagged disturbances will pose an additional
source of confusion for agElnts whEln thElY atlemptto infer
the magnitude of current shocks and to form expectations
about the future exchange rate. In such cases, the signals
obtained in period t will reflect not only current shocks but
also unobservable lagged shocks. Correspondingly, the
equilibriumexchange rate will depend on the.samela(l(led
shocks as well as whatever disturbances in the past are
observable and useful for· inferring the magnitudes of
subsequent shocks.

16. The transformation involves obtaining the moving
average representation of the VARsystem whereby each
of the variables in the system is expressed as a moving
average function of the residuals.
17. One potential problem in interpreting the variance
decomposition results is that the use of lagged encjogenous variables only in each equation of the VAR system
forces all contemporaneous shocks that affect the endogenous variables to feed through the residuals of each
equation. While this poses no problem in the e.stimation
stage of the analysis, if the estimated residuals have high
contemporaneous correlations, the order in which the
variables are entered in the system could cause certain
variables to take on exaggerated importance in the variance decompositions, while other, perhaps more significant, variables take on little or no weight.

10.. That monetary disturbances affect real variables
under imperfect information is a feature of the closedeconomy macro models of Lucas (1972, 1975) and the
open-economy macro models of Bhandari (1982), Flood
and Hodrick (1985a, 1985b), Glick and Wihlborg (1986)
and Kimbrough (1983, 1984).

This problem arises because the Choleski decomposition
(see Hakkio and Morris, 1984) used to convert the VAR
model into its moving average form attributes all of the
contemporaneous correlation between any two variables
to the one ordered first. To minimize this problem, the order
of any variables that were highly correlated was switched
to check the sensitivity of results. No major problems
resulted.

11. The VAR technique presumes that the variables in the
system are covariance stationary and that any relationships among them are linear. The procedure of transforming variables into percentage changes, described below,
is the standard means of achieving covariance stationarity.
Discussions of the VAR technique may be found in Sims
(1980) and Hakkio and Morris (1984).
12. An alternative approach is to use pre-whitened data in
the VAR system by, in addition to taking first differences of
logs, further filtering the data to remove all trend and
seasonality before performing the regressions. A difficulty
with this procedure is that the detrending and deseasonalization may remove evidence of the interrelationships
among variables that one is seeking.

18. The money supply figures were derived from end-ofmonth M1 stock data for the United States and Japan and
monetary base data for Germany. The real value of the
dollar was defined as the U.S. producer price of oil divided
by the U.S. wholesale price. The real valueofthe dollar was
defined as the monthly foreign wholesale price times the
end-of-month dollar price of foreign exchange divided by
the U.S. wholesale price. All data came from the IMF
International Financial Statistics.

13. The assumption of a common lag length is necessary
for the VARs to provide consistent estimates. There are
several tests available for determining the proper lag
length, but alternative tests often provide different results.
In addition, degrees of freedom must be considered. Thus,
ultimately, the choice of lag length is a SUbjective matter. A
12"month lag specification is employed in this paper.

19. The correlation levels corresponding to margincii significance levels (with the 46 degrees of freedom in the VAR
estimates) of .2, .1 and .05 are given by .12, .18, and .24,
respectively. Thus, for example, there is a less than twenty
percent probability of observing a correlation larger than
.12 if the null hypothesis that no correlation exists were
true.

14. There are a number of difficulties with interpreting
Granger causality tests. First, the test may indicate a
causal relation when in fact each variable is reacting to a
common third variable but with a different lag, or anticipating a common third variable but with a different lead.
Second, the tests cannot detect contemporaneous relations among variables.

20. Technically, the figures given are the percentage of
variance of the 48-month ahead forecast errors in predicting the exchange rate attributable to individual variables.
The errors over this long a horizon, it can be shown,
approximate the variance of the predicted variable.

58

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