Full text of Economic Review (Federal Reserve Bank of San Francisco) : Spring 1979 : Money, Prices, and Exchange Rates

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FEDERAL RESERVE BANK
OF SAN FRANCISCO

ECONOMIC
REVIEW

SPRING 1979

The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
Bank’s Research and Public Information Department under the supervision of Michael W. Reran,
Senior Vice President. The publication is edited by William Burke, with the assistance of Karen
Rusk (editorial) and William Rosenthal (graphics).
For free copies of this and other Federal Reserve publications, write or phone the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco,
California 94120. Phone (415) 544-2184.

Money, Prices
and Exchange Rates
I.

Introd uctio n and Sum m ary

5

II.

Estim ating the U nderlying Inflation Rate
John L. S cadding

7

...S o m e tim e w ill be required to reduce the rate of im bedded
in fla tio n — abo u t 7 p e rce n t— to the level of the early 1960’s.

III. Money and Exchange Rates— 1974-79
M ichael W. Keran

19

...A m ajor share of recent U.S. exchange-rate m ovem ents can be
explained by the divergence of U.S. m onetary policies from those
of G erm any, Japan and Sw itzerland.

IV. Has a Strong U.S. Econom y Meant a Weak Dollar?
M ichael Bazdarich
...R e c e n t U.S. evidence does not su p p o rt the view that strong
eco n o m ic g ro w th necessarily weakens exchange rates.
E ditorial com m ittee fo r th is issue:
John Judd, Charles P igott, Rose M cE lhattan

35

The newspapers and academic journals are full
of theories (sometimes contradictory theories)
which attempt to explain each striking new
development occuring in this era of rapidly rising
prices and wildly fluctuating exchange rates.
Consider, for example, several important policyoriented questions which have arisen during the
past year or two. What is the basic underlying
rate of inflation? Do speculative influences explain the steep drop in the dollar's value during
the 1977-78 period? Or has the very strength of
the U.S. economy led to the decline in the value
of the nation's currency? The task of analysis, as
the following articles indicate, is to apply sophisticated tests to the available statistical evidence,
as a means of devising correct answers to these
questions-and therefore correct policy solutions to the nation's problems.
In analyzing the recent inflation, John Scadding says, "Only the systematic changes in prices
are of any use in forecasting future prices; by
definition, the unsystematic, transitory changes
contain no information about the future course
of prices." He then presents a model of how
individuals might rationally extract information
about the underlying inflation rate from observed price changes, and then use that information to forecast future prices.
Scadding argues that successively higher levels
of inflation have become imbedded in the economy since 1960. The underlying inflation rate
fluctuated around 1.7 percent until the late
1960's, averaged about 4.8 percent in the 1971-73
period, and hovered around 7.0 percent in the
expansion of the late 1970's. "Neither the
1969-70 nor the 1973-75 recession made a sizable dent in the underlying rate; the most they
seemed capable of doing was to stabilize the
inflation rate until some new disturbance carried
it to a higher plateau."
The ingrained rate of inflation currently perceived by the market is very high by historical

standards, and has stubbornly remained at this
level throughout the current expansion. "This
persistence of a high perceived underlying inflation rate doubtless has given inflation an important momentum of its own as market participants, in an effort to protect themselves against
future inflation, build this perception into their
wage and price demands."
This point leads Scadding to a second important conclusion-"Even if aggregate demand
growth could be moderated, pressure for price
and wage increases would continue to emanate
from the cost side for a considerable time." The
implication for the real economy is not reassuring, since output and employment may have to
remain below normal levels for a fairly protracted time if any significant progress is to be made
against inflation.
Michael Keran, in his contribution, analyzes
the reasons for the decline in the international
value of the dollar over the 1977-78 period. He
quickly dismisses the popular impression that
the dollar was driven down by speculators with a
vested interest in an undervalued dollar, noting
that speculation tends to drive the value of a
currency towards a long-run equilibrium value
determined by economic fundamentals. Those
speculators who most clearly perceive the underlying fundamentals and accordingly take a position in the exchange market will generally make
the most profits, while those speculators who go
against the fundamentals will generally lose
money. Because of this self-selection process, the
observed value of the dollar should not deviate
significantly from the level consistent with economic fundamentals for more than a short period
of time.
Keran concentrates on explaining movements
in the exchange value of the dollar against the
currencies of seven other major industrial countries in the 1974-79 period of flexible exchange
rates. He first summarizes the apparent
5

monetary-policy considerations which shaped
monetary developments during this period. Then
he shows that actual changes in the "excess
money supply"-nominal money supply less real
money demand-led to changes in prices and
exchange rates in a way consistent with economic theory and empirical statistical tests. He bases
his analysis on two propositions: I) the exchange
rate between two domestic currencies will adjust
to reflect changes in the relative domestic purchasing power of the currencies; and 2) domestic
monetary developments are a major determinant
of domestic inflation rates, and thus of the
domestic purchasing power of a given currency.
Keran estimates his equations with two alternative measures-money, and money plus quasimoney. The former is the narrow definition of
money including currency and demand deposits.
This primarily satisfies the means-of-payment
motive for holding money. The latter is the
broader definition which includes currency, demand deposits and quasi-monetary deposits of
commercial banks. This measure includes a
substantial store-of-value motive for holding
money. Both definitions provided statistically
significant results, although the broader measure
gave generally superior results. "Given the dollar's role as both an international means of
payment and store of value, the superiority of the
broader measure of money is not surprising."
Keran concludes that an important share of
the exchange-rate movements since 1975 can be
explained by monetary factors, rather than by
speculation or changes in such real factors as the
terms of trade. His study also implies that
foreign-exchange markets adjust much more
quickly than domestic commodity markets to
changes in domestic monetary conditions. Because these exchange rate changes can affect the

dollar price of internationally traded goods, the
emergence of flexible exchange rates can shorten
the lag between money and prices.
Michael Bazdarich raises the question of
whether the recent strength in the U.S. economy
has led to the weakness of the dollar. According
to the theory in question, fast economic growth
in a country causes an acceleration in its imports
and therefore a deterioration in its trade balance.
This ultimately would lead to a depreciation of
the domestic currency.
Bazdarich questions this approach, arguing
instead that true economic growth, as evidenced
by rapid growth in productive capacity, or potential GNP, typically strengthens the domestic
currency. "Growth of this type implies improving supply and wealth conditions, which can
more than offset the effects of rising demand on
the trade balance. Sharp cyclical increases in
GNP, on the other hand, can weaken the domestic currency. These movements typically involve
an increase in demand with no change in productive capacity, and so do not generate any offsetting effects to the rise in imports."
Bazdarich argues that the popular analysis has
missed this important distinction. His statistical
tests indicate no support for the argument that
truly strong growth in an economy will necessarily tend to weaken exchange rates. "Indeed,
recent. U.S. evidence suggests that the opposite
has been the case. The 'strong economy, weak
currency'explanation of the dollar's decline thus
does not appear to have any hard theoretical or
empirical evidence to support it." Bazdarich's
findings-which parallel Keran's-suggest that
recent GNP increases have been mostly cyclical,
caused perhaps by an overly expansionary policy, and for that reason have been associated with
a falling dollar.

6

John L. Scadding*
It is widely recognized that every wiggle in the
consumer price index or in the GNP implicit
price deflator does not signify a change in what
we typically mean by inflation. Inflation is usually defined as an on-going, systematic rise in
prices, while many of the influences which operate to produce month-to-month or even quarterto-quarter changes in prices-like strikes, crop
failures, temporary dislocations due to inclement
weather and the like-do not persist. Indeed,
their effects are unsystematic and ephemeral.
Only the systematic changes in prices are of
any use in forecasting future prices; by definition, the unsystematic, transitory changes contain no information about the future course of
prices. The persistence of relatively high and
variable rates of inflation in recent years has
measurably increased the marketplace's stake in
efficiently forecasting prices. One would expect
therefore that the marketplace makes some attempt to discriminate between the systematic
forces operating on prices-the things that determine the underlying inflation rate-and the
short run, transitory and unsystematic part of
price changes. I
This paper presents a model of how individuals might rationally extract information about
the underlying inflation rate from observed price
changes, and how they might use that information to forecast future prices. The model is then
estimated by assuming that people use these
forecasts, among other things, to determine how
much to spend on consumption.
Traditionally, economists have assumed that
economic agents form their expectations about
future· events adaptively, i.e., the forecast for
next period is formed by adjusting this period's
forecast by some fraction of this period's forecast
error. Price expectations are commonly mod-

elled this way, although the adaptive model is in
fact ill-suited for this purpose because it leads to
chronic underprediction of prices if prices are
growing. The reason is fairly obvious. The adaptive model implies that forecast prices are a
weighted average of current and past prices,
which will always be less than the current level
when prices are growing. The forecasting model
developed in this paper represents a generalization of the adaptive model that allows for systematic growth in prices and therefore avoids the
problem of chronic underprediction. The model
has the added attraction of being derived from
optimizing behavior, rather than adduced on an
ad hoc basis as is typically done.
Information about the market's perception of
the underlying inflation rate is valuable to the
policy maker for at least two reasons. In the first
place, such information should provide relatively efficient estimates of ingrained inflation,
which presumably is what policy makers are
interested in. Almost by definition it is the
problem-the inflation that won't go away.
Certainly the agonizing that goes on in Washington every month over what the price indices are
telling us suggests that the chief preoccupation of
policy makers is with the underlying inflation
rate. This is understandable, of course, because
that underlying rate is probably the appropriate
target for the conventional macroeconomic remedies for inflation: tight money and stringent
government budgets. These traditional policy
tools are too cumbersome, inflexible or blunt in
their impact to be used to counteract every
vagary of the price indices.
The second reason why the policy maker
should be interested in how the market estimates
the underlying inflation rate has to do with the
putative trade-off between employment and
inflation summarized in the now-familiar Phillips Curve. One popular explanation for the
trade-off is that it is caused by temporary diver-

* Associate Professor of Economics, Scarborough College, University of Toronto, and Visiting Scholar, Federal Reserve Bank of San Francisco, Summer 1978.

7

gences between the perceived or anticipated rate
of inflation on the one hand, and the actual rate
of inflation on the other. According to this view,
a decline in the actual rate of inflation, for
example, produces a (temporary) increase in
unemployment and corresponding decline in
output as perceptions about the course of inflation lag behind events. Obviously the longer it
takes perceptions about inflation to adjust, the
longer will be the adjustment period during
which employment and output are below their
full-employment levels. It follows, therefore,
that the costs in terms oflost output and employment of a successful anti-inflation policy depend,
among other things, on the speed with which
perceptions adjust. Knowledge about how the
market estimates the underlying inflation ratewhich presumably comes close to the theoretical
notion of the perceived rate of inflation-can
provide the policy maker with one estimate of
this critical parameter.
The estimates of the underlying inflation rate
yielded by the model suggest several important
conclusions. First, perceptions of the ingrained
inflation are currently quite high (about seven
percent) and have been so during all of the
current expansion. Second, these perceptions

appear to respond very sluggishly to changes in
the actual inflation rate, which suggests that a
successful assault on inflation will entail a protracted adjustment period (and possibly one that
involves significant losses in output and employment). Finally, this sluggishness in perceptions
may be attributable to a high variance in the
unsystematic part of price changes, which makes
it difficult for individuals to distinguish changes
in underlying inflation from random movement
in the indices. A certain amount of evidence
suggests that this problem has become worse
since 1970.
Section I of our paper develops our basic
theory-a standard model of consumption behavior and a sketch of how people might rationally forecast prices. Section II expands on the
latter point with a technical discussion of the
theory of optimal prediction. The reader who is
not interested in the details may skip this section
and proceed directly to Section III, which discusses the empirical results and presents estimates of the underlying inflation rate. Section IV
concludes the paper with a summary and touches
briefly on one important policy implication of
the empirical findings.

I. Basic Theory
Prices and Consumption
Almost all modern theories of consumption
start from two fundamental propositions. First,
people are free from any significant money
illusion, i.e., what matters is the amount of goods
and services that the dollars allocated to consumption will buy. The second proposition is
that the decision about the amount to spend on
consumption today is part of a broader plan
which encompasses decisions about how much
to spend over a significant and indefinite period
in the future. The first proposition is typically
incorporated in empirical work by measuring
consumption in real terms, i.e., as consumption
spending deflated by some appropriate price
index. The second proposition is handled by
making consumption a function not of current
income alone, but rather of people's longer-term
income position as measured by their wealth or
permanent income. A familiar and widely-

accepted hypothesis about consumption
behavior-the permanent-income hypothesisembodies these two points in the following
simple formulation:
Ct

PI

= Boyt

(1.1)

Here C is nominal, or current-dollar consumption; P is some price index; l is permanent real
income; and Bo is the marginal (and average)
propensity to consume. 2 Note that (1.1) assumes
that all relations are contemporaneous-that
today's (time t's) consumption depends on today's prices and permanent income. If the time
period used as the unit of observation is long
enough, this assumption of strict contemporaneity is probably not too far-fetched. A year, for
example, is probably enough time for people to
make consumption plans and to adjust those
plans as they receive new information about
8

These unpredictable influences on consumption
we model as an additive random-error term in
the logarithms of the variables. 3 Thus we complete (1.3), after writing it in logarithms, as

prices and income. However, the assumption is
doubtless strained for quarterly data such as we
use, and for that reason quarterly consumption
models typically assume that consumption adjusts with a lag to changes in prices and income.
As is well known, such models are indistinguishable from specifications which make consumption a function of expected, or forecast, prices
and income where the forecasts of a particular
variable are based on its past values. Hence we
can turn (1.1) into a quarterly model by replacing
actual prices and permanent income with their
forecast values. We assume that consumption
plans are revised each quarter, and the relevant
forecasts therefore are one-period-ahead forecasts, i.e., forecasts for next quarter. Thus consumption plans for the next quarter (time t+ 1)
are made today on the basis of today's forecasts
(denoted by bars over the variables) of next
quarter's permanent income and prices:

In

Ut+l,

-

(In

Pt+1 -

In

PHI)

(I.4)

where In Ut+1 is a random variable which has
mean zero and which is uncorrelated with the
other right-hand variables.
We shall derive estimates of forecast prices by
estimating equation (I.4) on quarterly, U.S.
postwar data. To do so, however, we must be able
to distinguish the consumption effects of the
forecast errors in prices from all of the unpredictable influences captured in In Ut+l. To do
that, we next turn to a discussion of how prices
are forecast.
Forecasting Prices
Again, the problem in forecasting prices is to
separate the systematic, sustained rise in prices
from the random and transient. We can visualize
this distinction by thinking of the systematic
influences as operating to push prices along a
path, while the unsystematic forces temporarily
displace prices away from that path. By definition, only the systematic part of the price change
is predictable, and the problem of forecasting
prices therefore comes down to one of extrapolating the systematic, underlying path. Two types
of uncertainty intrude to make this a difficult
problem. First, the underlying inflationary process is not fully understood, so that the systematic path of prices cannot be precisely inferred from. one's model of inflation. For
example, suppose for the sake of argument that
monetary growth is the main cause of inflation.
Our understanding of the links between money
and prices is still too imprecise to permit complete certainty about how prices will behave
given the behavior of money. For this reason, we
should look at the current behavior of prices
themselves as another indicator of the underlying rate of inflation. However, that introduces
the second source of uncertainty: the prices we
actually observe can deviate in an unpredictable
way from the underlying inflation path. These

Equation (1.2) implies that nominal consumption deflated by expected prices should be more
stable than nominal consumption deflated by
actual prices, which is the usual measure of real
consumption. Or to put the point in a slightly
different way, part of the observed variation in
the conventional measure of real consumption is
spurious in the sense that it reflects the unintended effect of errors in forecasting prices. To
see this, let Ct+1 = C t+l/Pt +l be the conventional
measure of real consumption. Then we have

= (C t+l/Pt+J) (Pt+I/Pt+l)
= BoY 1+1 (Pt+l/Pt+l)

= InB o + In Y1+1
+ In

(1.2)

Ct+1

Ct+1

(1.3)

As equation (1.3) makes clear, real consumption
depends not only on forecast permanent income,
but also inversely on the relative error in forecasting prices, (P t +II Pt).
To complete the specification of the determinants of real consumption, we need to recognize
that there are accidental, unforeseen influences
which cause consumption to deviate temporarily
from its planned levels-things like illness, sudden trips, unannounced sales, discoveries of new
products and new places to shop, and so on.
9

random deviations act like measurement error—
they cause observed prices to differ from the
underlying prices which we are interested in.
The next section develops an explicit model of
how consumers would rationally forecast prices
in the context of these two types of uncertainty.
Because the non-technical reader may wish to
skip that section, we may summarize the main
points here and in Chart 1. The essence of the
optimal forecasting scheme is that forecasts are
revised each period as new information about
prices is received. This new information is used in
two ways: (1) to locate the current position of the
underlying inflation path (point B) and (2) to
determine its slope (line AB), i.e., to determine
how fast prices are growing along the underlying
path. This latter variable, of course, is what we
mean by the underlying inflation rate. The two
variables then are used to extrapolate the under­
lying path, and that extrapolation is used as the
forecast of next period’s prices (C).
It is clear from these remarks that the forecast
of prices is an estimate of where the underlying
path will be tomorrow. When tomorrow comes,
however, actual prices in general will differ from
this estimate, and the question then is how much
of the forecast error to attribute to a mistake in
estimating underlying prices, and how much to
ascribe to the random deviations of observed
Chart 1
Price Paths Over Time

prices from the underlying path. The former of
course should be used to revise one’s estimate of
where the underlying path (B) is; the latter is
merely “noise” and should be disregarded. The
theory of optimal prediction provides the follow­
ing solution to this problem: add to last period’s
forecast (E) a fraction (EB) of the forecast error,
and use that result as the best estimate of the
current position of the underlying path. This
fraction, which we denote by K, is a number
between 0 and 1. Its value is determined by the
amount of random variation found in observed
prices. If this measurement error is negligible, so
that observed prices stay close to the underlying
path, K will be 1, because the estimates of
underlying prices should always be adjusted to
equal observed prices. At the opposite extreme,
where observed prices contain no information
about the underlying path, one should disregard
the entire forecast error and hence K will be 0.
The new information about prices allows us
not only to estimate the current position of the
underlying path, but also to re-estimate its posi­
tion last period. The idea involved here is a
familiar one in navigation: a navigator’s current
readings allow him both to estimate his current
position and to revise his estimate of where he
was previously. This approach provides an upto-date estimate of a second point on the under­
lying path, which means that the slope of the
path can be estimated and hence an estimate of
the underlying rate can be calculated. The theory
of optimal prediction indicates that the revision
in the estimate of last period’s position (DA)
should be proportional to the revision in the
estimate of the current position (EB). The factor
of proportionality, which we denote by D, must
lie between 0 and a number less than 1. Its
particular value depends upon the amount of
knowledge market participants have about the
inflationary process. Where knowledge is fairly
complete—where one can be reasonably confi­
dent about his estimate of the underlying infla­
tion rate—D should be close to 1, so that the
revisions in the estimates of today’s and last
period’s positions leave the slope of the path
unchanged. By the same token, where one has
only a vague idea about what causes inflation
and therefore must rely heavily on observed price
changes as an indicator, D should be close to 0.

10

This will mean that any forecast error leads to a
relatively large revision in the estimate of the
current location of the path, to relatively little
revision in the estimate of where the path was
yesterday, and consequently to a relatively large
revision in the rate of growth between the two
points.
As noted earlier, Chart 1 illustrates the sequence of steps involved in forecasting prices.
Logarithms of prices are used here because the
empirical results in Section III are expressed in
those terms. This representation also has the
advantage that slopes of straight-line segments
can be interpreted as rates of change-as rates of
inflation, in other words.
Clearly, the estimate of the underlying inflation rate-the slope of the line segment AB-is a
function of how much estimates of the current
and previous locations of the underlying path are
revised, given the forecast errors. Thus the estimate of underlying inflation depends on K and
D. It is also clear that the forecast for period t + 1
depends on the same factors. These two observations suggest the possibility of obtaining esti-

mates of the underlying inflation rate by using
data on price forecasts to infer the values of D
and K. Of course, we do not have direct observations on forecast prices. But we do have indirect
evidence because real consumption is a function,
among other things, of the price-forecast error.
However, to deduce the forecast error from
observed movements in real consumption, we
must be able to isolate its effects from all of the
other influences on consumption. In order to do
that, we need to introduce the final result from
Section II-that the forecast error depends on
the sequence of current and past accelerations in
prices, i.e., on how fast the rate of inflation has
been changing. Hence our methodology consists
of substituting a distributed lag in price
accelerations for the forecast error in the consumption function (equation 1.4), estimating the
distributed-lag co-efficients, calculating estimates of K and D from these distributed-lag
estimates, and, finally, using the estimates of K
and D to calculate estimates of the market's
perception of the underlying inflation rate.

II. Optimal Prediction
The problem of forecasting prices can be
formally characterized as one of forecasting a
variable with incomplete knowledge of the
causes of its movements and with errors involved
in its observations. The model sketched here is
summarized by equations (2.1a) and (2.1 b). The
first describes the path of prices generated by the
underlying inflationary process; the asterisks are
used to distinguish these prices-which are not
directly observed-from actual or observed
prices, P. The variable ¢ summarizes all of the
available information about how fast prices are
growing along the underlying path. Thus ¢ is
what we mean by the underlying inflation rate.

what causes inflation is essentially a question
about the determinants of ¢. This, of course, is
an important issue, but one which we need not
address here.
Uncertainty about the inflationary process is
represented by the random variable, w. Since by
definition this uncertainty provides no information about prices, we require that it have zero
mean and be uncorrelated with its past (and
therefore with past P*s). A common name for
random variables with these properties is white
noise. Equation (2.1 b) expresses the point that
prices are measured with error. Thus observed
prices (P) differ from underlying prices (P*) by a
random term, v. Again, since v is uninformative
about inflation, we require that it be white noise,
and also that it be uncorrelated with w.
Consider now the problem of forecasting
prices in the context of equations (2.1a) and
(2.1 b). Before proceeding, we should note that
while the following discussion provides only a
heuristic justification for our final forecasting
equations, it is easy enough to show that these

(2.1a)
(2.1 b)

Note that this representation of the inflationary
process is completely general. It can as easily
accommodate a pure monetary explanation of
inflation as a cost-push one. The question of
11

equations generate minimum mean-square error
forecasts and therefore are optimal in that sense. 4
As we noted in the previous section, the problem
of forecasting is viewed as a problem in extrapolating the underlying inflationary path. Formally
this can be divided into two parts: (1) determining the current position of the underlying path,
i.e., determining what Pi is, to serve as a starting
point; and (2) determining the rate of change of
p* so that the path can be extrapolated. Let the
estimate of the current location of the path be P~
and the estimated rate of change, (f)t+l. Then
equation (2.la) suggests that our best forecast of
tomorrow's prices, Pt+l, is given by

sponds to Ks close to I, while the opposite
ranking of uncertainties produces Ks close to 0. 5
We assume that people identify the underlying
inflation rate with the speed at which p* is
currently changing. In order to determine that
velocity, it is necessary to know not only what p*
currently is, but also what it was last period. Let
Pi-lit denote the latter. The t-l subscript denotes that this is an estimate of where the underlying path was yesterday; the t subscript indicates
that is a retrospective estimate, i.e., one made
today. In general, people's perceptions today of
where the underlying path was yesterday will
differ from where they thought it was at the time.
The latter is obviously last period's analogue of
Pi, which we denote by Pi-I' The theory of
optimal prediction indicates that people revise
their estimate of the last period's position by a
fraction, D,6 of the revision in their estimate of
the current position:

(2.2)
The estimate Pi is based on two sources of
information: all prior information which is incorporated in last period's forecast, Pt, and new
information received in the form of today's
prices. However, the latter is not fully informative about inflation, which suggests that only a
fraction of the new information should be incorporated in estimating Pi:

(2.3a)
First-order approximations to equations (2.2)
and (2.3) yield the following relationship in the
logarithms of forecast prices:

(2.3)
In Pt+I - In P t == 4>t+l - (I-K) (In P t - P t)
(2.5)

The factor K is essentially the ratio of the
uncertainty about underlying prices to uncertainty about the amount of error in observed
prices. The latter is measured by the variance of
v, while the uncertainty in underlying prices is a
function both of this uncertainty and uncertainty
about the underlying inflationary process .as
measured by the variance of w. .If we let a~ be the
variance of v, aJ, the variance of w, and a*2 the
uncertainty in underlying prices, we have

It is clear from this expression that our forecast-

ing scheme is a mixed extrapolative-regressive
one of the sort first proposed by deLeeuw (1965)
and subsequently used by Modigliani and Sutch
(I966), among others, in their work on forecasting interest rates. The extrapolative element is
<Pt+ I-the rate at which prices are forecast to
grow in the future. The regressive element in the
forecast is represented by the second term onthe
right-hand side of the expression. It indicates
that, ceteris paribus, prices are forecast to revert
partially to their present level. The smaller is K,
the larger is the influence of this regressive
element. The estimate of the underlying inflation
rate is given by

(2.4a)
a*2 ==

"--

~

t

(2.4b)

_

Clearly K lies on the closed interval [0, I]. Relatively low measurement uncertainty or high
process uncertainty (low a~ or high a~) corre-

<Pt+I

...

== (Pi -

A

A*

Pi-l/t)/ P Hit,

which to a first-order approximation is
12

(2.6a)

(f;t+l~ (l-K) (InP t - InPt-l) + K(InP t

as a distributed lag in current and past accelerations in prices:

-lnP t-l) - DK(lnP t - InPt)
(2.6b)

-

_ 00

2

1n P t+l - Pt+1 -k aj Ll In P t+l-j
j=0

Equations (2.5) and (2.6b) together yield the
following relationship in the logarithms of forecast prices:

(2.9)

Since (2.9) is a particular solution of (2.8), the
distributed-lag coefficients, aj, must be functions
of K and D. In particular, we must have

In P t+l - In P t = (I-K) (In P t - InP t-l)
+K(In P t In Pt-I) + (I-D)K(In P t - In Pt)
(2.7)
If the last term were missing, (2.1) would imply
that the growth rate of forecast prices is an
exponentially declining weighted average of
current and past rates of price change-the
familiar adaptive-expectations result. For forecasting the level of prices, this is clearly suboptimal if a change occurs in the average rate of
growth of prices. Consider, for example, what
would happen if the inflation rate permanently
increased. The growth rate of forecast prices
would follow with a lag, and approach as a limit
the new, higher inflation rate. But it would never
exceed the actual inflation rate, and consequently the level of forecast prices would always fall
short of the level of actual prices. For this reason,
(2.7) has a term in the forecast error, InPt-lnPt,
which is designed to adjust the growth of forecast
prices to remove any systematic discrepancy
between actual and forecast prices.
Finally, (2.7) is easily recast in terms offorecast errors to produce

lim aj+ 1

=0

(2.10)

j-oo

It is clear from equation (2.9) that a constant
inflation rate, i.e., Ll 21nPt+j = 0 for current and
all past periods, produces a zero forecast error.
In other words, when prices are growing at a
steady rate, the actual and forecast levels of
prices are the same. A permanent change in the
inflation rate, on the other hand, produces a
transitory (though by no means short-lived)
divergence of actual from forecast prices. The
distributed-lag coefficients trace out the path of
the forecast error during the transition. Thus the
requirement that ao = I indicates that a onepercentage-point increase in the rate of inflation
initially raises actual prices above forecast prices
by exactly the same amount. Thereafter, the gap
between actual and forecast prices may continue
to widen for awhile, or may begin to close; the
particular path followed depends on the values
of D and K, which determine the speed with
which forecasts are revised. Ultimately, however,
as the last condition on the aj indicates, the gap
must close and in the limit go to zero. Thus in the
new steady-state equilibrium, forecast and actual
prices again grow along the same path.

(In Pt+l -In P t + l ) =[2(l-K) + DK](ln P t -In
Pt) - [l-K] (In P t-l - In P t-]) + Ll 2 In Pt+l,
(2.8)
where Ll 2 In P t+l, the second difference in the
logarithm of prices, measures price accelerations, i.e., changes in the rate of growth of prices.
Repeated lagging of (2.8) and substitution back
into itself yields a solution for the forecast error

III. Empirical Results
Estimating the Consumption Function
Our consumption function, after substituting
a distributed lag in price accelerations (denoted
by Ll21nPt+l_j) for the forecast error, is

InCt+l

=

InBo + In(yf+I) - k ajLl 2
J=O

InPt+l-j + InUt+l
13

(3.1)

For the purpose of estimation, consumption is
defined to exclude expenditure on new consumer durables, which is more properly treated as a
form of savings. 7 Forecast permanent income,
Yl+ 1, is computed recursively from the formula
H+l

sample period of 24 years. Next, consider the
second restriction. Recall that the permanentincome variable in (3.1) is forecast permanent
income. If this variable were correlated with the
forecast error in prices, people could use this
association to improve their forecasts of permanent income. It would pay them to do so until the
association disappeared, i.e., until permanent
income and the forecast error in prices became
uncorrelated.
The two restrictions are easily imposed by
estimating (3.1) in two stages. First, real consumption is regressed on a constant and permanent income. The residuals from this estimation
are then regressed on the distributed ·lag in
accelerations in prices to obtain estimates of the
aj. The latter will be unbiased provided the
restrictions are true.
Equation (3.2) reports the results of the firststage regression. The sample period is 1953:31977:4, and both consumption and permanent
income are in per capita terms. The adjusted
mUltiple R 2, standard error of estimate, Durbin
Watson statistic and estimated first-order serial
correlation in the error term (p) are shown
below. The standard errors of the estimated
coefficients are shown in parentheses beneath
their respective estimates.

= (I + .0048) (O.IYt + 0.9yn,

where y is measured per capita real income, .0048
is the quarterly trend rate of growth of y for the
period 1947:1-1977:4, and the weights 0.1 and
0.9 are taken from Darby (1972).
Measured income is defined as the sum of
disposable personal income plus undistributed
corporate profits. On theoretical grounds alone
the latter should be included, since permanent
income is viewed as the flow of income generated
by a broadly defined concept of wealth that
includes corporate wealth. Moreover, empirical
evidence suggests that households treat changes
in the value of their equity holdings as part of
their income. (See, for example, David and
Scadding [1975].) The implicit price deflator for
GNP, rather than the consumer-price index or
consumption-spending deflator, is used to measure P. This is done because a "true" cost-ofliving index-i.e., one that corresponds to the
notion of permanent income-should include
the prices of both current and future consumption. No existing index approaches this ideal, of
course, but a broad-based index like the GNP
deflator presumably comes closest, because it
implicitly includes the prices of future consumption through its inclusion of producers'goods
pnces.
Two restrictions are imposed in estimating
(3.1): (I) the forecast errors are assumed to
average out to zero over the sample period; and
(2) the forecast errors and permanent income are
assumed to be uncorrelated. Both are imposed
on the grounds that people make efficient forecasts, i.e., that roughly speaking, they· use all
available information. Consider the firstrestriction. If, for example, the forecast error were
systematically positive, people would ultimately
recognize their chronic underforecasting and
would adjust their forecasts upwards to remove
the discrepancy. This recognition might take
some time, but not to the extent that errors
would systematically cumulate over our entire

InCt+l

= -.2820 + 1.0015

In(yf+d

(.0752) (.0573)

(3.2)

iP= .9986 D.W. = 1.7458
S.E.

= .0057 P= .9434

The appropriateness of the restnctlOns imposed in estimating (3.1) can be roughly gauged
by comparing the coefficient estimates in (3.2)
with comparable estimates from otherconsumption studies. Such a comparison indicates no
significant bias in the estimates, which suggests
that the restrictions may not be unreasonable.
Thus the point estimate of the coefficient on yf+ 1,
which measures the permanent-income elasticity
of consumption, is effectively unity. Thisagrees
completely with the permanent-income specification of the consumption function, and it is
supported by a large body of other evidence}
The estimated constant in (3.2) implies a marginal propensity to consume ofapproximately.75.
14

This is somewhat low-most estimates cluster
its relatively high standard error, it is surely compatible with other
estimates.

Chart 2
Distributed Lag Estimates

around.80~but given

Lag Coefficients

4.0

Estimates of Forecasting Parameters
The results· of estimating the second-stage
regression, in which the residuals from estirriat~
ing the consumption function (3.2) are regressed
on the distributed lag in price accelerations,are
summarized in Chart 2 and Table 1. Chart 2
graphs the estimated lag coefficients on current
and past accelerations in prices, while Tablel
reports the implied estimates of K and D and the
summary statistics of the regressions. lo Separate
results are given for the whole sample period,
1954: 1-1977:4, and for two subperiods,
1954:1-1970:4 and 1971:1-1977:4.
The familiar Almon polynomial distributedlag estimator (with the Cochrane~Orcutt correction for serial correlation) was used to estimate
the coefficients. Experiments with different lag
shapes and lengths led to the choice ofathirddegree polynomial with a 20~quarter lag. In all
cases, the far end of the distributed lag was
constrained to be zero in order to incorporate the
requirement that the steady-state (long-run)
forecast error be zero.
In several instances the results square remarkably with our theory. All of the estimates of the
coefficient on the contemporaneous price acceleration are within two standard errors of their a
priori value, 1. Similarly, all of the point estimates of K lie within the a priori bounds, [0,1].
The point estimates of D are ostensibly an
exception-they are greater than 1 while our
theory predicts just the opposite. Nevertheless,
the difference is probably not statistically signifi-

3.0

Estimates of
K and D

Lags (Quarters)

cant. The estimate of D is calculated from a ratip
of distributed-lag estimates, and such ratio esti-'
mators typically have large standard errors. The
numerical differences from unity of about 12 to
16 percent are probably well within two standard
errors of estimate.
As noted earlier, people are assumed to revise
their estimate of the underlying inflation path
when prices turn out differently from what was
forecast. Roughly speaking, the revision in the
estimated level of the path varies directly with the
size of K, while the revision in the estimated slope
of the path varies inversely with the size of D.
The relatively low values ofK and relatively high
values of D indicate that people's perceptions of
underlying prices and the underlying inflation
rate are slow to respond to changes in the actual
inflation rate. Consequently, forecast prices can
deviate substantially from actual prices, and the
discrepancy can persist for a long period oftime.
The. distributed-lag coefficients (Chart 2) can be
interpreted as tracing out the sequence offorecast errors after a permanent one-percentagepoint increase in the inflation rate. They indicate
that forecast prices can differby as much as three
percent or morefrom actual prices for every onepercentage-point increase in inflation, and that it
takes about five years for the difference to
disappear altogether. On the face of it,a lag of
five years between actual and forecast prices may
seem rather long, but it is in fact relatively short

Summary Statistics
R2
S.E. Rho D.W.

1954.1-1977.4 .1471 1.1248.9302 .0044 .9528 1.8939
1954.1·1970.4 .1528 1.1591 .9367 .0044 .9607 2.1394
1971.1-1977.4.0881 1.1177 .9128 .0040 .6194 1.4414
21

The equation estimatedisz t+1

~

2.0

Table 1
Estimates of K and D
Sample
Period

1971.1-1977.4

2
= j::;:O
~ a j C1 1nP t+l_ j • where Z

is the (raw) residual from the regression InCt+1 = InR. +
Inytr l . The UjS were constrained to lie along a thirddegree polynominal with aZI = O.

15

by comparison with typical results obtained
from studies of the relationship between prices
and interest rates. Some observers have rejected
these long lags as being implausible, givellour
knowledge of how prices are formed. I I However,
once errors of measurement are allowed, they
may not be so implausible: where one is unsure
about the amount of information contained in
price movements, it is not irrational to ignore
them unless they continue for a long time.
The low values of K and high values of D also
suggest that most of the uncertainty in forecasting prices stems from measurement error in
prices, i.e., from the fact that a significant partof
the observed variation in prices represents random shocks which are unrelated to systematic
inflation. The decline in the value of K for the
later subperiod suggests as well that prices have
become more unpredictable since 1970. This
point has been made elsewhere on the basis of
different evidence, 12 and agrees with one's casual
impression that the price level in the Seventies
has been subject to more frequent and severe
shocks than was the case in prior decades.

Estimates of Underlying Inflation Rate
_ Estimates of the underlying inflation rate,
4>t+1 , along with the actual quarterly inflation
rates, are shown in Chart 3. Clearly, the estimates of the underlying inflation rate have the
sort of properties one would expect of such a
series: a much greater quarter-to-quarter stability than the actual inflation rate, and an ability to
track faithfully the longer-run movements in the
actual inflation rate. However, the underlying
inflation rate can differ from the actual rate for
substantial periods of time, reflecting the long
adjustment lags.
It is also clear that successively higher levels of
inflation have become embedded in the economy
since 1960. Thus the underlying inflation rate
fluctuated around l. 7 percent until the late
Sixties, averaged about 4.8 percent from 1971 to
1973, and in the current expansion has hovered
around 7 percent. Apparently, neither the
1969-70 nor the 1973-75 recession made a sizable dent in the underlying rate; at most, they
seemed capable only of stabilizing the inflation

Chart 3
Actual and Underlying Inflation Rates
Annual Rate (%)

12
11

10
9

8
7

6.

5
4
3

2

oHf-------,j----,j--1 =-~~~-":=~""":_:

1954

1956

1958

1962

1964

1966

16

1968

lying inflation rate was 4.8 percent in the first
period, and 4.9 percent in the secondeffectively unchanged, in other words.
Much of the spectacular run-up in inflation
rates in late 1973 and in 1974 appears to have
been treated by economic participants as transitory, and thus was not viewed as symptomatic of
a deterioration in the underlying rate (though
that did happen). This perception was borne out
by the subsequent sharp decline in inflation rates
after 1974. By the same token, the underlying
rate did not follow the actual rate down as the
latter fell from its 1974 highs. Again, this perception appears to have been borne out by the
bounce-back in inflation rates after mid-1976.

rate until some new disturbance carried it off to a
higher plateau.
There is no evidence that the 1971 priceand
wage controls had any noticeable effect on people's perceptions about the underlying inflation
rate. The decline in the underlying inflation rate
after the second quarter of J 971 was negligible
compared to the fall in the actual rate, and it did
not last as long. Some numbers make this point
more forcefully. In the four quarters ending in
1971 :2, the inflation rate, measured by the
growth in the GNP implicit price deflator, averaged 5.2 percent. In the four subsequent quarters, inflation declined by nearly 1Yz percentage
points to 3.8 percent. By comparison, the under-

IV. Summary and Conclusions
Obviously, the estimates of the underlying
inflation rate calculated here should not be
accepted uncritically. Nevertheless, the congruence of our estimation results with the predictions of theory, and their conformance with
historical experience, are too striking to be
ignored. This congruence lends our estimates a
high degree of plausibility.
Two points seem worth repeating because they
bear on the important question of what a successful assault on inflation is likely to cost in
terms of lost output and employment. First, the
ingrained rate of inflation currently perceived by
the market is dismally high by historical
standards-around 7 percent at an annual rateand has stubbornly remained at this level
throughout the current expansion. This persistence of a high perceived underlying inflation
rate doubtless has given inflation an important
momentum oUts own, because market participants, in an effort to protect themselves against
future iI1 flation, have built this perception into
their wage and price demands.

Secondly, even if aggregate-demand growth
could be moderated, pressure for price and wage
increases would continue to emanate from the
cost side for a considerable time. The implication
of this for output and employment is not reassuring. If pressures from inflationary expectations
do not abate after growth in aggregate demand
slows down, the difference presumably has to
come out of real income growth. This is essentially the modern explanation for the observed
trade-off between unemployment and inflation
described by the Phillips Curve. This explanation of course stresses the temporary nature of
the trade-off. Once expectations of inflation
have fully caught up with the actual rate, output
and employment are assumed to return to their
normal levels. But our finding about the length
of the adjustment period-about five yearssuggests that temporary can still be a long time.
Hence, output and employment may have to
remain below normal levels for a fairly protracted time if any significant progress is to be made
against inflation.

FOOTNOTES
1. For some evidence that the market discounts spurious evidence of inflation in the consumer price index
see, E. Fama, "Interest Rates and Inflation: The
Message in the Entrails,"American Economic Review,
67 (June 1977), pp. 487-96.

the estimation, but the empirical results were so consistent with it that I have written (1.1) in the traditional
form.
3. The variable u, which can be interpreted to be the
ratio of actual to planned consumption, has a lognormal distribution if we assume, in the usual way, that 1n u
is normally distributed. Hence the assumption that the
mean of 1n u is zero corresponds to assuming that the

2. Some controversy surrounds the proposition implicit in (1.1) that consumption is strictly proportional to
permanent income. This restriction was not imposed in

17

ics: A Survey," Journal of Economic Literature 11
(December 1973), esp. pp. 1307-08. Estimating (3.1) in
two stages does not appear to have affected the estimates except trivially. When (3.1 J is estimated in one
step, the estimate of the marginal propensity to consume is .78 rather than .75, while the estimated income
elasticity is .98 rather than 1-differences which are
without statistical or economic significance. The
distributed-lag estimates are even less affected: they
are virtually indistinguishable from the estimates
graphed in Chart 2.

median ratio of actual to planned consumption is unity,
and it is in this sense that actual and desired consumption are "on average" the same.
4. A good account of the theory involved can be found
in A. Bryson and Y. Ho, Applied Optimal Control (Waltham, Mass.: Blaisdell, 1969J
5. K has a steady-state solution for constant<t>.AIthough obviously we do not wantto assume the latter,
we shall assume that the relative variation in <t> is so
small that K is approximately constant. There .is ample
precedent in the literature for doing· so, presumably
because without such a simplification the forecasting
problem has no closed-form solution,

10. The estimates of K and D are obtained by substituting the estimated aj into the restrictions aj+l = (2(1-KJ +
DK) aj - (1-KJ aj-l = 0 and solving for K and D. The
choice of which aj to use is arbitrary: any four consecutive ones will do, and I chose a2 through a5. See G. Box
and G. Jenkins, Time Series Analysis (San Francisco:
Holden Day, 1970), page 383.

6. The expression for D is

D=
O*~ (1+<t>I) 2+ o~

11. See for example, T. Sargent, "Interest Rates and
Prices in the Long Run," Journal of Money, Credit and
Banking 5(February 1973, Part 11), pp. 384-449.

where, as before, 0*2 measures the uncertainty in
underlying prices and o~ stands for the uncertainty
about the underlying inflationary process. Clearly D is
bounded from above by a number less than 1, while it
cannot be less than zero.

12. B. Klein, "Our New Monetary Standard: The Measurement and Effects of Price Uncertainty,1880-1973,"
Economic Inquiry 13 (December 1975), pp. 462-84,
argues that the shift from a monetary constitution
based on the gold standard to a managed fiduciary
standard increased uncertainty about future prices. He
places the watershed in the mid-Sixties, at the latest.
However, my experiments with different subperiods
produced clear evidence for a break around 1970. My
conjecture is that it took the monetary laxity of the late
Sixties to convince the public that monetary arrangements had fundamentally changed-a perception that
was soon borne out by the collapse of the Bretton
Woods System.

7. To be totally consistent, we should add to consumption the imputed service flow from the existing stock of
consumer durables. We did not do this simply because
quarterly estimates are not readily available; it is doubtful that the omission has any practical significance.
8. For a more thorough discussion of this point,see A.
Alchian and B. Klein, "On a Correct Measure of Inflation," Journal of Money, Credit and Banking 5 (February 1973, Part Ill, pp. 173-91.
9. For an up-to-date survey of evidence on the consumption function, see R. Ferber,"Consumer Econom-

REFERENCES
the United States, Chicago: Rand McNally, 1965,
Chapter 13.
Fama, Eugene. "Interest Rates and Inflation: The
Message in the Entralls."American Economic Review 67 (June 1977), pp. 487-96.
Ferber, Robert. "Consumer Economics: A Survey,"
Journal of Economic Literature 11 (December
1973), pp. 1303-43.
Klein, Benjamin. "Our New Monetary Standard: The
Measurement and Effects of Price Uncertainty,
1880-1973," Economic Inquiry 13 (December
1975), pp. 461-84.
Modigliani, Franco, and Sutch, Richard. "Innovations in
Interest Rate Policy," American Economic Review
65 (May 1966), pp. 178-97.
Sargent, Thomas. "Interest Rates and Prices in the
Long Run," Journai of Money, Credit and Banking
5 (February 1973, Part II), pp. 385-449.

Alchian, Armen and Klein, Benjamin. "On a Correct
Measure of Inflation," Journal of Money, Credit and
Banking 5 (February 1973, Part 1), pp, 173-91.
Box, George, and Jenkins, Gwilym. Time Series Analysis, San Francisco: Holden Day, 1970.
Bryson, Arthur, and Ho, Yu-Chi. Applied Optimal Control, Waltham, Mass.: Blaisdell, 1969.
Darby, Michael. "The Allocation of Transitory Income
Among Consumer's Assets," American Economic
Review 62 (December 1972), pp. 928-41.
David, Paul, and Scadding, John .. "Private Savings:
Ultrarationality, Aggregation and 'Denison's LaIN',"
Journal of Political Economy 82 (March"Aprll
1974), pp. 225-50.
de Leeuw, Frank. "A Model of Financial Behavior," in J.
Duesenberry, G. Fromm, L. Klein and E. Kuh, eds.,
The Brookings Quarterly Econometric Model of

18

Michael W. Keran*
exchange rate-real factors and monetary factors. The real factors have to do with the relative
attractiveness of any two countries' goods, i.e.,
how many bushels of U.S. wheat are exchanged
for one Japanese color T. V. set. This is called the
terms of trade. The monetary factors have to do
with the purchasing power of a currency. If
inflation reduces the domestic purchasing power
of the dollar, a parallel decline in the dollar's
foreign purchasing power will be achieved by an
exchange-rate adjustment. This is called purchasing power parity.
The purpose of this article is to explain movements in the exchange value of the dollar against
the currencies of seven other major countries
(Canada, France, Germany, Japan, Italy, Switzerland and the U,K,), during the period of
flexible exchange rates running from roughly
1974 or 1975 through March 1979. The analysis
focuses on whether monetary factors can explain
a significant share of the movements of the dollar
against these seven major currencies. Section I
discusses the role of monetary factors in influencing prices in general. Section II discusses the
monetary and real determinants of exchange
rates, with the aid of a model which permits the
empirical estimation of the monetary factors
affecting the exchange rate. In Section III, comparative monetary developments in the U.S. and
other industrial countries are analyzed and
shown to be in close alignment with observed
movements of exchange rates. F orillal statistical
analyses confirm that a significant share of the
variation in exchange rates between the dollar
and seven other currencies can be explained by
monetary factors. That section provides forecasts of exchange rates based on actual monetary
developments in 1978 and forecasts of monetary
developments in 1979. Section IV gives a summary and conclusion.

Why has the international value of the dollar
declined over the past year and a half? There is a
popular impression (sometimes reinforced by the
rhetoric of government officials) that the dollar
has been driven down by speculators who have a
vested interest in seeing an undervalued dollar.
According to this view, the magnitude of the
decline is unrelated to economic fundamentals
and represents the irrational behavior of speculators.
Most economists have difficulty with this
explanation. A considerable body of evidence
shows that speculation tends to drive the value of
a currency towards the long-run equilibrium
value; i.e., value determined by economic fundamentals. Those who misjudge fundamentals
and attempt to drive the dollar away from its
long-run equilibrium value will tend to lose
money. On the average they will buy when the
market value is high and sell when the market
value is low. Those speculators who most clearly
perceive the underlying fundamentals and accordingly take a position in the exchange market
will, on average, make the most profits.
What this means is that stabilizing speculation
will tend to be profitable and destabilizing speculation to be unprofitable. 2 The self-selection
process of unsuccessful speculators leaving the
market to the successful speculators has important implications for the exchange markets. In
particular, the observed value of the dollar
would not deviate significantly from the level
consistent with economic fundamentals for more
than a short period of time.
Two types of economic factors affect the
* Senior Vice President and Director of Research,
Federal Reserve Bank of San Francisco. Research
assistance for this article was provided by Stephen
Zeldes.

19

I. Money and Prices
The monetary source of exchange-rate
changes is based on two propositions:
I) The exchange rate between two domestic
currencies will adjust to reflect changes in the
relative domestic purchasing power of the currencies (i.e., purchasing power parity); and
2) Domestic monetary developments are a
major determinant of domestic inflation rates,
and thus the domestic purchasing power of a
given currency.
The second of these propositions is the monetary theory of inflation-too much money chasing too few goods. In its simplest form, this
theory can be stated as follows:
%

~P

= % ~MS - % ~md

ways of stating this relation is via the familiar
Fisher Equation of Exchange.
MV= PT

(2)

The stock of money (M) times the velocity of
money (V) equals the physical volume oftransactions (T) times price level (P).
This is true by definition, analogous to the
national-income definition: National Income
Household Consumption plus Business Investment plus Government Spending. Just as the
national-income definition can be translated into
a statement of economic behavior by making
assumptions about consumption and investment
behavior, so the Fisher equation of exchange can
be by making assumptions about the factors that
determine the demand for money, i.e., velocity
and transactions.
One can make equation 2 into a behavioral
relationship by introducing the demand for real
money balances. If we rearrange terms in equation 2, we obtain:

(I)

In the long run, the inflation rate (% D.P) is
determined by the difference between the growth
of the nominal money supply (% ~MS) and the
real money demand (% ~md). The nominal
money supply is determined by the government
through its monetary authority. The real demand for money is determined by the private
sector of the economy. The primary motives
behind the demand for money are as a means of
payment and as a store of value. The means-ofpayment desire for money is dependent on the
volume of transactions, which in turn is related
to the level of a country's real income. A rise in
real income leads to a rise in the real demand for
money.3
The store-of-value desire for money depends
upon the following factors:
I) The sophistication of the financial system,
and the type and convenience of non-monetary
financial assets available to the public;
2) The real interest rate. The higher the real
rate paid on monetary assets (e.g., time deposits),
the higher the money demand; the higher the real
rate paid on non-monetary assets, the lower the
real demand for money.
3) Inflation expectations. The higher the expected inflation rate, the greater the expected
decline in the value of monetary assets and thus
the lower the real demand for money.
There are a number of ways of translating
these general principles into an empirically
testable proposition. Perhaps one of the oldest

M/P=T/V

(3)

In long-run equilibrium, demand for real
money balances must be equal to actual real
balances (M/ P). Thus, using equation (3), we
identify the long-run equilibrium value of M/ P
with (md) and the long-run values of T and V
with the determinants of money demand. Thus:
md

= T/V

(4)

In this expression, where the bars refer to longrun equilibrium values, Trepresents the long-run
means of payment function of money, while V
represents the long-run store of value function.
We next substitute this long-run behavioral
description of money demand back into the
equation of exchange to obtain:

P = M/md = M/(T/V) = ME

(5)

This relationship states that, in long-run equilibrium, prices (P) will be equal to the ratio of
money supply to the long-run real demand for
20

money balances. This ratio is defined as excess
money balances (ME). An expression similar to
equation (1) can, of course, be obtained by
taking the time rate of change of all variables in
(5) to obtain:
% ~P = % ~M - % ~(T/V) = % ~ME (Sa)

This expression summarizes the main point of
the monetary theory of inflation-that ultimately inflation is determined by excess money
growth (%~ ME). This excess money supply is
the key element in the monetary factors which
determine the exchange rate.

II. Detennination of Exchange Rates
The exchange rate between the currencies of
any two countries will be determined by two
factors, one monetary and one "real." These
separate influences can be summarized in the
following way:
Ex

= (Pr / Pus) . t

currency (for reasons already discussed), so they
also influence the international exchange value
of that currency.
Purchasing-power parity can be explained in a
number of interrelated ways. Theoretically, the
most general explanation is related to the neutrality of money. If the money supply is doubled,
all prices will double-or the purchasing power
of money will be reduced by half. For this
proposition to hold for all goods, both domestic
and foreign, the exchange value of the domestic
currency must fall by one-half relative to foreign
currency (assuming there is no change in the
excess supply of money abroad). In this way, the
domestic and international purchasing power of
the domestic currency are equal, and the neutrality of money is preserved. If the foreign money
supply is doubled at the same time as the domestic money supply, the exchange rate will be
unchanged, because foreign prices will go up as
much as domestic prices.
The market mechanism by which the adjustment process operates is sometimes called the
law of one price. This is based on the proposition
that the same goods will have the same price in all
markets. For example, the dollar price of wheat
in Kansas City will be the same as the yen price in
Tokyo, given the dollar/yen exchange rate. If the
price of wheat were higher in Tokyo than in
Kansas City by more than transportation, tariffs
and other costs, then sufficient wheat will be
shipped to Japan to drive its price toward equality with the U.S. price.

(6)

Where Ex is the exchange rate between the U.S.
dollar and some foreign currency (t). Pus is the
long-run equilibrium price level in the U.S.; Pr is
the long-run equilibrium price level in the foreign
country; t is the equilibrium terms of trade. The
monetary effects are measured by the relative
price (Pr{Pus), while the real effects are measured by the terms of trade (t).
I. Real effects: The terms of trade measure the
value of one country's goods in terms of the value
of another country's goods, e.g., how many
bushels of U.S. wheat it takes to "purchase" one
Japanese T. V. set. A change in the terms of trade
could be caused by a change in technology, the
discovery of new sources of raw material, or a
substantial change in relative prices of important
commodities, such as a rise in the price of oil.
2. Monetary effects: Exchange rates fluctuate
to maintain equality between the domestic and
foreign purchasing power of a currency, according to the theory of purchasing-power parity (or
PPP). A rise in U.S. prices will reduce the
domestic purchasing power of the dollar. This
will increase the demand for lower-priced foreign
goods and assets, which will depreciate the dollar
relative to the foreign currency. The incentive to
increase demand for foreign goods will subside
only when the dollar has depreciated by an
amount equal to the decline in its domestic
purchasing power, assuming foreign-currency
prices are unchanged. Because monetary factors
determine the domestic purchasing power of a

Short vs. Long Run Considerations
In Section I, we emphasized that the relation
between money and prices was a long-run proposition. Equilibrium in the market for goods
takes some time to achieve, because households
must change their consumption habits and firms
21

must change their production patterns. It is
costly for households to speculate on inflation by
purchasing goods in excess of consumption
needs, because the cost of holding "inventories"
is high. While anticipatory purchases in a period
of rising prices will occur, the amount is severely
limited. Thus goods prices will adjust only slowly
to a rise in excess money supply.
In contrast, the market for assets seems to
adjust relatively quickly to changes in supply and
demand, because "inventory" adjustments in
assets can be achieved at low cost. One can
rearrange his portfolio of assets by "instantaneous" buy-and-sell decisions at relatively low
transactions cost, and generally zero carrying
cost. In general, we assume that goods prices in
"flow" markets take longer to adjust to shifts in
supply and demand than assets prices in "stock"
markets.
This distinction has important implications
with respect to the monetary determinants of
exchange rates. The exchange rate-the international price of the dollar-can be affected by
shifts in the international supply and demand for
dollars, which in turn depend upon international
trade in goods, services, and financial assets.
Trade in goods and services changes relatively
slowly in response to changes in income and
prices, as is typical of all "flow" markets. But
trade in financial assets can change quickly, as is
typical of all "stock" markets.

measure of long-term PPP than are current
goods prices. Second, because prices of traded
goods increase with a decline in the exchange
value of the dollar, and because traded goods are
a significant component of the general price
index, the time lag between money and prices
may be shortened when a country moves from
fixed to flexible exchange rates.
The Model
This discussion can be formalized and an
equation specified for empirical testing. Given
initial condition values for the exchange rate and
excess money, and substituting equation 5 into
equation 6, we get:

Ex

= (M & /

M Bus) . t

(7)

Taking the logs of both sides and making the
simplifying assumption that the terms of tradj::
are constant, we can empirically estimate the
equation as follows:
Log Ex

= a o + al

log (MEr / MEus )

(8)

Where aa is a measure of an unchanged terms-oftrade effect on the exchange rate, and al is a
measure of the monetary influence on the exchange rate. Its value is expected to be positive
and equal to one. Alternatively, we can express
equation 7 in terms of changes:

The exchange rate, in the short run, thus is
determined by the capital account of the balance
of payments. A change in the excess money
supply (once recognized) could translate immediately into a change in the exchange rate. The
monetary effect on the exchange rate would be
the same in magnitude as that on the domestic
inflation rate. The only difference would be in
terms of timing: the effect on the exchange rate
would occur quickly, while the effect on the price
of domestically produced goods would be
delayed.
This analysis has several important implications. First, the exchange rate between the dollar
and any foreign currency will measure the equilibrium purchasing power parity of the two
currencies. If the exchange rate adjusts quickly
and prices adjust slowly to the same excess
money supply, the exchange rate may be a better

% ilEx = % il(ME r / ME us ) + % ilt

(9)

Assuming that the real factors which affect
exchange rates-i.e., the terms of trade (%
ilt)-change at a constant rate, we obtain the
empirically testable equation:

The changes in the exchange rate are equal to a
constant term (a o ') which measures the changes
in the real factors, plus a coefficient (al') which
measures the impact on exchange rates of the
change in the ratio ofthe excess money growth in
the U.S. and in the foreign country. This is
hypothesized to equal unity. The time lag in
equations 8 and 10 reflects the length of time
needed by market participants to recognize that

22

the relative excess supplies of money had
changed. This might well vary between countries, depending upon the country's past mone4
tary policy and inflation experience. Introducing time lags into equations 8 and 10
produces the basic estimating equations which
will be considered in the next section.
n
log EXt = a o + raj log (MEr! MEus)t-n
(II)

~log EXt

n

= ao' + Iaj' ~log(MEriMEuS>t-n
(12)

n

Where I refers to the sum of months in which
changes in excess money will have their complete
effect on the exchange rate.

UI. Testing the Monetary Approach
We present evidence here to support the proposition that monetary factors explain a significant share of the recent movements in the exchange value of the dollar against seven other
currencies. First, we present a summary of the
apparent monetary-policy considerations which
shaped monetary developments in the 1975-78
period. Then we show that the actual changes in
the excess money supply led to changes in prices
and. exchange rates in a way consistent with
economic theory. Finally, we present formal
statistical tests of the relationship between money and exchange rates which confirm and quantify the empirical relations.

1978 which was above its historical average, but
the reverse was true for Germany, Japan and
Switzerland. Over the longer run, these divergent
monetary policies led to divergent inflation rates.
From 1976 to 1978 the inflation rate in the U.S.
accelerated, while the inflation rates in Germany,
Japan and Switzerland decelerated. Finally, the
policy divergence between the U.S. and Germany, Japan and Switzerland led to a decline in
the exchange value of the dollar with regard to
the Deutschemark, yen and Swiss franc.

Marshalling the Evidence
In broad outline, we assert that divergent
monetary policies have been the key factor
behind the divergent economic developments
and exchange-rate movements of the past several
years. The evidence in support of this scenario is
provided in Charts I and 2.5 Chart I shows that
from 1975 to 1978, the money supply in the U.S.
grew at about the same rate as in Switzerland,
and more slowly than in Germany and Japan.
However, as discussed in the theoretical section,
the relevant measure is not the growth in the
nominal money supply, but rather the growth in
the excess money supply, which is nominal
money less real money demand, as is shown in
Chart 2.
In estimating real money demand, the means
of payment (i.e., transactions) motive was measured by the trend in industrial production, and
the store of value motive for holding money was
measured by the trend in velocity. Sixty-month
trends of these factors were utilized, to reflectthe
assumption that reversible cyclical shifts in the
components of real money demand would have
no effect on the long-term equilibrium price level

Monetary Policy 1975-78
In the summer of 1975, all eight countries in
this study faced a common set of economic
problems-two or more years of double-digit
inflation and the recent emergence of a business
recession which, for most countries, was the
worst in the post-World War II period. Different
governments (and their monetary authorities)
responded to these twin problems in different
ways.
In the U.S., the primary goal apparently was
to deal with the historically high unemployment
rate by following a monetary policy which permitted a substantial acceleration in aggregate
demand from 1975 through 1978. Other countries such as Germany, Japan and Switzerland,
responding to the historically high inflation rate,
apparently followed a monetary policy which
permitted only a moderate acceleration in aggregate demand.
As a result of this divergence in monetary
policies, short-run rates of real growth also
diverged. The U.S. grew at a rate from 1975 to

23

the last four years (close to 7 percent)—
substantially higher than that observed in
Germany (4 percent) and Switzerland (2 per­
cent). In the period 1977.3-1978.3, however,
Japan’s inflation rate had decelerated to 4
percent, and the German and Swiss rates have
also decelerated, while the U.S. rate has
accelerated to almost 8 percent. As a result, the
spread in the consumer inflation rates between
the U.S. and the other three countries has
widened recently in line with the differences in
their excess money growth.
The same basic pattern emerges with respect to
wholesale prices, but with an even wider spread
since 1977.3. For one reason, there is a larger
weight of traded goods in the wholesale index
than in the consumer index. Thus, changes in the
exchange rate which directly affect inter­
nationally-traded goods prices will have a larger
and more immediate impact on the WPI than on
the CPI. This may be the genesis of the vicious vs.
virtuous cycle argument. Countries whose mone­
tary policies tend to decelerate inflation experi­
ence an immediate favorable impact on the
exchange rate which reduces the inflation rate
promptly; while countries whose monetary poli­
cies tend to accelerate inflation suffer an immedi­
ate unfavorable effect on the exchange rate
which promptly adds to domestic inflation. This
vicious/ virtuous cycle should be considered a

Chart 1
Nominal Money Supply
1975=100

(P), and thus no effect on the exchange rate.6
Calculated on that basis, excess money growth in
the U.S. was higher in the 1975-78 period than in
Germany, Japan and Switzerland (Chart 2).
Domestic Results. The relationship between
excess money growth and real output growth is a
short-run phenomenon. Thus, we would expect
that those countries with the highest excess
money growth would, in the short run, exhibit
the most rapid growth in real output. The results
in Table 1 and Chart 2 confirm that result. The
U.S., where growth in excess money has been
fastest among the four countries since 1975, has
also had the fastest rate of real growth. Germany,
with the slowest growth of excess money, has had
the slowest real growth, and Japan and Switzer­
land have fallen in between.7
The relationship between excess money
growth and prices is a long-run phenomenon.
Thus, excess money-growth patterns would not
necessarily be completely reflected in the ob­
served price patterns for consumer and whole­
sale prices to date. (Tables 2 and 3). For all four
countries and for both price indexes, the
inflation rate has dropped substantially since
1974. The U.S. and Japan recorded almost the
same average consumer-price inflation rate in

Chart 2

24

reflection of the timing of the monetary impact
on prices, rather than as a new destabilizing
phenomenon. This subject is discussed further in
Section IV.
Exchange Rate Results. These domestic results are broadly consistent with the assumptions
of relatively easy monetary policy in the U.S. and
relatively tight monetary policies in Germany,
Japan and Switzerland. To measure the impact
of these assumed divergent policies on exchange
rates, we have computed a "monetary index"the ratio of the excess money supply in the U.S.
to the excess supply in each of the other countries. Each monetary index is scaled to the
corresponding exchange rate by the coefficients
estimated in the equation in the appendix of this
article. As indicated in Chart 3, this monetary
index shows a high degree of correspondence
with the movement in the bilateral exchange rate

between the dollar and each of these three currencies. In each case, the monetary index declined in 1974, rose slightly in 1975 and early
1976, and then declined substantially through
the end of 1978. This movement in the monetary
index is paralleled by a similar movement in the
exchange rate. The major decline in the exchange
value of the dollar was accompanied by a major
expansion in the excess money supply in the U.S.
relative to the other three countries.
In general, adjustments of exchange rates to
changes in the monetary index appeared to occur
quickly-within a quarter of a year or so. And
the magnitudes of these exchange-rate adjustments were approximately the same across countries for any given change in the monetary index.
This observation is consistent with the hypothesis developed in Section II, that the exchange
rate in the short run is dominated by the capital
account of the balance of payments, and that it
thus responds quickly-in a way analogous to
any domestic-asset market response to changes
in supply and demand.
The same broad relationship of monetary
indexes and bilateral exchange rates holds for
Canada, France, Italy and the U.K .. The results
for France and Italy are detailed in Chart 4. With
these four countries, however, the lags between
changes in the monetary index and the exchange
rate seem to be longer and the degree of relationship weaker, than in the case with Germany,
Japan and Switzerland for a number of reasons.
First, Germany and Japan are leading economic
powers in their own right, so that their currencies
are potential replacements for the dollar as an
international currency. Also, the Swiss franc has
a unique role as an international store of value,
and the Swiss monetary authorities have
followed a more restrictive monetary policy than
most of the countries studied.
Second, excess money-supply growth has been
even greater in Canada, Italy and the U.K. than
in the U.S. over the 1974-78 period. (French
growth has been slightly less expansionary). As a
consequence, the dollar generally strengthened
against these currencies before weakening in the
second half of 1977. The recent weakness of the
dollar may in part reflect a spill-over of the appreciation of the Swiss franc and especially the
D.M. onto other European currencies. This

Table 1
Industrial Production
(Annual Rate ,of Change)

Germany
Japan
Switzerland
United States

1963-73

1973-75

1975.1-1978.3

5.1
12.3
4.6
5.4

-4.3
-7.5
-6.7
-4.7

2.1
6.7
3.0
7.8

Table 2
Consumer Price Index
(Annual Rate of Change)

Germany
Japan
Switzerland
United States

1973.41974.4

1974.41978.3

1977.31978.3

6.5
24.4
8.7
12.1

4.0
7.3
2.0
6.8

2.5
4.0
1.0
7.9

Table 3
Wholesale Price Index
(Annual Rate of Change)
1977.31978.3

1973.41974.4

1974.41978.3

Germany

13.4

2.5

1.2

Japan

23.5

0.9

-3.3

Switzerland

12.7

-2.4

-4.0

United States

22.2

5.6

8.3

25

would occur among the European currencies if a
common set of "real" exchange rate influences
operated. (The dollar's relative strength against
the Canadian dollar supports this conjecture.)
Third, in the case of the U.K., a special real
factor may explain the relative weakness ofthe
dollar. That factor is the recent favorable effect
of North Sea oil on the British balance of payments.
The evidence presented above tends to support
a monetary interpretation of much of the recent
movements in the exchange value of the dollar,

especially against the D.M., the yen and the
Swiss franc-and substantially with respect to
the Canadian dollar, the Italian lira, the French
franc and the British pound. The next step is to
present evidence in a more formal econometric
setting. This will help show whether the relationship between the monetary index and the exchange rate is significant and stable within a
rigorous statistical testing procedure. Those
readers who are not interested in this necessarily
technical discussion should proceed to the section on forecasting exchange rates on page 30.

Chart 3
Money' and Exchange Rates
Switzerland

3.4

Francs/$

Monetary Index

108

Germany

2.8

Monetary Index

106
340
104

2.7

Yen/$

r'J

Monetary Index

320
102

2.6

300
100

2.5

2.4

280

\

102

-.:/"\

.

ff'\\\

106

30

104

100

2.8

\\
",

102

\

-.\)
2.6

i\»-

\}\

100

"

,

'~

98
260

\

-0lil(

96

2.3

\\

2.2

\\

\~

2.1

2.0

1.9 1974

3.2
Japan

DM/$

1976

\,....

~

240

98

2.4

96

2.2

94

220

2.0

92

200

18

90

1978 88

180

90

\

98

96

94

1.6

90

160
1974

1976

'Monetary Index=Ratio of excess money supplyih foreigh
country to excess U.S. money supply.

26

1978 88

1.4 1974

1976

1978 88

money plus quasi-money. The formeris the
narrow definition of money including currency
and demand deposits. This primarily statisfies
the means-of-payment motive for holdingmoney. The latter is the broader definition which
includes currency, demand deposits and quasimonetary· deposits of commercial banks. This
measure includes a substantialstore-of-value
motive for holding money.
While statistically significant results were obtained with both definitions of money, the
broader measure gave results which weregener-

Formal Statistical Tests

The exchange rates to be tested are the bilater"
al rates between the U.S. dollar and the seven
foreign currencies discussed above. The countries were selected on the basis of data availabilityand importance in international trade and
finance.· All regressions were estimated with
ordinary least~squares (OLS) using a thirddegree (or less) polynomial distributed lag
(PDL). The equations were estimated with two
alternative measures of money published in
International Financial Statistics-money, and

Chart 4
Money' and Exchange Rates
Italy
Monetary Index
1000

I

Lira/$

I

I

950

1.i

L

900

850

135

130

125
France
120

Monetary Index 106
52

J
/

5.1

4.9

110

4.6
4.5

750
100

4.4
4.3

95

4.2
4.1

104

!

4.8
105

i\

/

5.0

800

700

Francs/$

.)
\

V

4.0

90
650

3.9
3.8
1978 85

'Monetary Index=Ratio of excess money supply in foreign
country to excess U.S. money supply.

27

L19':'::7:-:4..L--L179:::-76~-.11':":9:-=7-:o'8 92

constant term. In the level equation, we assume
that the real factors are unchanged over time, but
in the difference equation, we assume that they
change at a constant rate over time. However, as
the constant term is both large and statistically
significant only for Italy in the difference form,
there is only weak general evidence for a strong
real factor affecting the exchange rate. 9 This
suggests that either form of the equation would
represent the underlying structure without major
systematic bias. The remainder of the discussion
will be in terms of the rate-of-change equations
except where otherwise stated.
The monetary effect is measured by the sum
coefficient value (Ial')' It is a sum because it
measures the combined effect of the current and
lagged values of the monetary influence on the
exchange rate. The coefficient values are statistically significant in all cases. The lags between the
monetary influence and the exchange rate measure the total number of months needed for the
monetary effect to operate. The lag periods were
selected on the basis of the minimum standard

ally superior. Given the dollar's role as both an
international means of payment and store of
value, the superiority of the broader measure of
money is not surprising.
The equations for the seven bilateral exchange
rates were estimated monthly from January 1974
(or Jan uary 1975) to December 1977 in both level
and rate-of-change form, i.e., matching equations II and 12. The level results are presented in
the appendix, and the rate-of-change (difference)
results are presented in Table 4. The percent of
variation explained (R2) is much higher in the
level form than in the difference form, because
the unsystematic variance is necessarily greater
in the latter. However, a better measure of
goodness of fit is provided by the standard error,
which measures the percentage error in explaining the exchange rate. The standard errors are
about the same for both forms of estimation. s
The major conceptual difference between the
level and difference form is the implicit treatment
of real factors which affect the exchange rate. In
both forms, the real factor is captured by the

Table 4
Monetary Factors and Exchange Rates: Difference Form
n
Lllog EXt == a,,' + Ial' Lllog(ME r/ MEus)t-n
Estimation
Period

lags

Degrees of
Freedom

Canada*

1974.01-1977.12

6-18

44

-.003506
(-1.21)

France

1975.01-1977.12

12

32

Country

Germany

1975.01-1977.12

9

32

Corrected
S.E.

1.076
(2.16)

.096

.0097

1.83

-.000053
(-.17)

1.761

.168

.0168

1.70

-.000023

2.565

.137

.0177

1.45

.332

.0193

(.07)
Italy
Japan

1974.01-1977.12
1975.01-1977.12

9
6

44
32

l'

R'

ao

".03392
(-1.80)
-.004021
(-1.75)

~a

RHO

D.W.

( 1.95)
(2.69)
5.487
(2.27)
2.887

.42

1.85

(3.17)
.205

.0132

1.73

2.649
(2.96)

.135

.0227

1.54

3.060

.352

.0170

(3.17)

Switzerland

1974.01-1977.12

2

45

-.002440
(-.62)

U.K.**

1975.01-1977.12

15

32

-.015769
(-1.29)

t -statistics in parentheses
* Includes only lags t-6 to t-18
** Uses log of deviation of Ml UK from trend
M 1 US

28

(2.01)

.44
(2.90)

1.61

In the theoretical discussion (Section II), we
hypothesized that the expected value of the
monetary influence on exchange rates would be
positive and equal in value to 1.0. This results
from the method of calculating the monetary
influence-the ratio of excess money in the U.S.
to excess money in each of the other countries.
Excess money is, in turn, defined as the difference between the change in nominal money
supply and the change in real money demand. If
money is homogeneous of the degree one in
prices, i.e., if neutrality conditions hold, a permanent I-percent increase in excess money will lead
to a I-percent increase in the long-run equilibrium price level and, thus, to a I-percent decrease
in the exchange value of the dollar, assuming no
change in excess money in other countries.
The estimated coefficient values are positive
for all of the countries considered in this study.
However, only in the case of Canada and France
are the coefficient values close to one. In the case
of Germany, Japan, Switzerland and the U.K.,
the coefficient values fall within a narrow range
of 2.5 to 3.1. Italy, on the other hand, falls
significantly outside the range, with a coefficient
value of 5.5. 10
One factor which can explain the divergence
between the expected theoretical value and the
actual measured value of the monetary influence

error of estimate. In general, the lags varied
sUbstantially between countries. They were the
shortest for Switzerland (2 months), and Japan
(6 months)-the countries with the shortest lags
between the monetary index and the exchange
rate (Chart 3). The lags were longest for Canada
(18 months), the U.K. (15 months), France (12
months), and Italy (9 months). Germany
provided the only exception to the general
parallelism of the formal statistical results and
the informal results in Charts 3 and 4, with its
relatively long (9 months) lag compared to those
of Japan and Switzerland.

Chart 5
Exchange Rate Estimates
DM/$

Estimation Period

2.70

Dynamic Forecast

Chart 5 (cont.)
Francs/$

Estimation Period

3.40

Forecast

320
Yen/$

Estimation Period

320

Dynamic Forecast

300

300

2.80

280

260

260

2.40

240

220

220

200

200

180

180

1.60

160

1975

1976

1977

1978

1.40

1979

29

1974

1975

1976

1977

1978

1979

is measurement error with respect to the public's
real demand for money. Errors of this type can
occur when there is a permanent shift in the
demand for money which is not captured by the
60-month trend procedure. As discussed in Section I, inflation can have an importanteffecton
real demand for money. In countries which have
been more successful than the U.S. in reducing
inflation (such as Germany, Japan and Switzerland) the real demand for money may be higher
than our measured demand for money.. Conversely, in countries which have been less successful than the U.S. in reducing inflation (such
as Italy and the U.K.), the real demand for money
may be less than measured demand. Assuming
that the real demand for money is accurately
measured in the U.S., the errors. in the other
countries could bias the monetary index. In all
cases the bias would tend to make the observed
index move in a narrower range than the true
monetary index, with a smaller decline forthose
countries with a lower inflation rate than the
U.S., and a smaller increase for those countries
with a less successful recOfd than the U.S. in
controlling inflation. In each case, the measured
monetary index would have a greater coefficient
value than would the true monetary index. This
analysis is broadly consistent with the observed
coefficient values. Those countries with coefficient values close to one (Canada and France)
experienced roughly the same amount of inflation as the U.S., while those countries with
coefficient values substantially greater than one
recorded inflation rates which were significantly
above or below the U.S. inflation rate. II

1) An estimation period (1974-1977 for
Switzerland, and 1975-77 for Germany and
Japan) where the fitted values of the exchange
rate (Chart 5) are compared with the actual
values of the exchange rate. For all three
countries, the equations accurately tracked the
monthly movement in the exchange rate. 12
2) A forecast period (January 1978 to December 1979), with actual money-supply growth
used through November or December 1978, and
with money assumed to grow thereafter at the
same rate as it had grown over the previous 12
months (Table 5).
Table 5
Forecasts of Money Growth Rates for 1979
Percent
Canada
France
Germany
Italy
Japan
Switzerland
U.K.13
U.S.

16.0
11.0
10.0
22.5
13.0
9.0
15.0
8.75/6.5

To demonstrate the effects of U.S. monetary
policy on exchange rates, two different sets of
forecasts were performed. The first assumes U.S.
money growth over 1979 to be equal to the actual
rate of growth over 1978: 8.75 percent. The
second set of forecasts assumes a lower moneygrowth rate of 6.5 percent. These two forecasts
are indicated by the two dotted lines in Chart
5. No adjustment is made for past forecast
errors (i.e., the simulations are dynamic), so that
the errors cumulate from the initial condition
month (December 1977) to the month being
forecast. As Chart 5 indicates, the forecast
money-based exchange rate tracks the actual
exchange rate with reasonable accuracy. The
following table shows the actual and forecast
change in the exchange rate from December 1977
to March 1979.

Forecasting the Exchange Rate
The results presented above, although tentative, provide a reasonable basis for making short
term forecasts of exchange rates. Such forecasts
would be useful because our equations· Were
estimated with data only through December
1977 (Table 4), while some of the largest declines
in the dollar's value occurred in 1978 and were
only partially reversed by the dramatic dollarrescue operations announced on November I,
1978. We can estimate the degree of monetary
influence on the exchange rate in 1978 by conducting dynamic simulations of our equations.
The results are presented for two time periods:

The forecasts of the DM/ $ and ¥ / $ exchange
rates were quite close to the actual decline in
value through March 1979. In the case of the
Swiss franc (SF /$) rate, the forecast was reasonably accurate through mid-1978 and picked
30

Table 6
Exchange Rate Changes
(December 1977-March 1979)

grows at the rates indicated in Table 5, then
between March and December 1979 the dollar
will appreciate against the Swiss franc, be stable
against the Japanese yen, and decline slightly
against the German D.M.

Actual Forecast
Error
(Percent) (Percent) (Percent)
Germany (DMI $)
Japan (¥ 1$)
Switzerland (SF1$)

-13.6
-14.6
-19.1

-14.0
-12.0

-8.6

Very good results were obtained when the
same forecast experiment was conducted with
respect to the dollar and the French franc. In
France's case, the error was only .6 percent over
the forecast period. However, the forecast errors
were in excess of 10 percent for Canada, Italy,
and the U.K. In two cases (Italy and the U.K.),
the actual dollar value was below the forecast
value, while in one case (Canada), it was above
the forecast value. In all three cases, significant
non-monetary factors apparently influenced
these exchange rates.

.4
- 2.6
-10.5

the turnaround in late 1978, but it erred in
forecasting the level of the exchange rate. The
reason behind this forecast error waS the sharp
acceleration in Swiss money growth in the second half of 1978, which seems to have been
ignored by the market until now. The model
presented here suggests that if the money supply

IV. Conclusion and Implications
The major conclusion of this article is that an
important share of the exchange-rate movements of the dollar against key foreign currencies
can be explained by monetary factors, rather
than by speculation or changes in such real
factors as the terms of trade. In addition, the
study suggests two major implications:
I) Foreign-exchange markets adjust much
more quickly than domestic commodity markets
to changes in domestic monetary conditions.
2) The emergence of flexible exchange rates
can shorten the lag between money and prices.
One of the most generally accepted propositions in economics is that money affects goods
markets and, therefore, the inflation rate with a
relatively long lag. On the other hand, it affects
asset markets and, therefore, interest rates with
a relatively short lag. The reason for the difference in response is that costs of adjustment are
much higher in goods markets than in asset
markets. It is difficult for a household to speculate on a rise in the price of bread by buying more
bread than it can currently consume. The storage
costs are high, and the depreciation on the value
of the good is substantial. As a result, household
expectations of higher prices, even when strongly
held, will not necessarily be translated immediately into higher actual prices. Now consider the
case of an asset market, such as that for Treasury
bills. If the price of T-bills is expected to rise in

the future, it will be instantaneously translated
into a higher price of Treasury bills today. For
one reason, the transactions cost involved in
shifting from one type of asset to another is
relatively low, and for another, the storage costs
for holding Treasury bills are virtually nil. Thus,
we can expect nearly instantaneous adjustment
in asset markets to shifts in underlying supply
and demand.
This article extends asset-market analysis to
the exchange rate. We assert that the exchange
rate is, in the short run, determined by the same
factors which determine the price of any asset.
Thus, a monetary disturbance can be translated
relatively quickly into a change in the exchange
rate, even though the change in the underlying
inflation rate may be delayed. This suggests that
the short-run deviation of the exchange rate
from purchasing power parity may be substantial, even when the underlying cause of the
exchange-rate change is a monetary rather than a
real disturbance. Supporting evidence is provided by the relatively short lags observed in the
monetary index-the relation between U.S. and
foreign excess money-supply growth rates -,- and
in the resulting changes in the bilateral exchange
rates of the dollar against foreign currencies. Full
lag adjustments for some countries were as short
as two to three months, and. were never longer
than eighteen months. The average lags were

31

shorter still. On the other hand, most empirical
evidence relating money to inflation suggests an
average lag of about two years, and full-effect
lags of three to four years.
A second implication of this study concerns
the shortened link betweenmoney and prices as a
result of the introduction of flexible exchange
rates. A rise in excess money supply in the U.S.
would, with a relatively short lag, lead to a
decline in the exchange value of the dollar
against its major trading partners. For reasons
discussed above, this would tend to raise the
price not only of imported goods, but of all
internationally-traded goods, in dollar terms.
American exporters would not sell in the U.S.
market for a lower price than they could get for
the same product in a foreign market, standardizing for transportation costs.· The rise in
tradeable-goods prices would increase the average inflation rate in the U.S. by an amount equal
to the weight of tradeable goods in overall price
indexes. The weights would vary •between
indexes-high for the wholesale-price index
(which includes only goods), but lower for the
consumer-price index (which includes services)
and for the GNP price deflator (which incfudes

the cost of government).
Direct evidence of a shortening of the lag
between money and prices would have to come
from econometric tests of the lag structure. It is
difficult to acquire such evidence because ofthe
relatively short period in which flexible exchange
rates have operated. However, a certain amount
of indirect evidence supports this proposition. To
the extent that inflation operates through the
exchange rate rather than through standard
domestic markets, the price of goods (which are
internationally traded) may rise relative to the
price of services (which are not generally traded
internationally) in the short run. This reverses
the traditional ordering of the effects of money
on prices. Generally, wholesale-price indexes
tend to exhibit a lower average inflation rate
than consumer-price indexes, as a reflection of
the higher productivity of goods industries than
services industries. However, since the March
1973 introduction of flexible exchange rates, the
rate of inflation in the goods-dominated (wholesale) index has been higher than the rate of
inflation in the services-denominated (consumer) index. This is consistent with an international
explanation of much of the recent inflation.

Appendix
Monetary Factors and Exchange Rates: level Form
n

log EXt

= aa + kal

Estimation
Period

lags

Degrees of
Freedom

Canada*

1974.01-1977.12

6-12

44

France

1975.01-1977.12

12

32

Germany

1975.01-1977.12

6

32

Country

Italy

1974.01-1977.12

3

44

Japan

1975.01-1977.12

2

33

Switzerland

1974.01-1977.12

U.K.**

1974.01-1977.12

12

44

log (MEr/MEus)t-n
Corrected
ao

la1

R2

S.E.

RHO

D.W.

-.076
(-1.67)
1.297
(49.40)
1.131
(22.73)
6.611
(147.98)
6.450
(21.43)

.826
(3.00)
2.682
(9.82)
2.018
(5.17)
1.163
(3.81)
2.138
(3.04)

.935

.0095

1.82

.962

.0132

.93
(17.59)
.58
(4.28)

.892

.0168

.77

1.49

1.097
(15.97)
-.687
(-17.30)

2.701
(3.33)
1.148
(4.33)

t-statistics in parentheses
* Includes only lags t-6 to t-12
** Uses log of deviation of MI UK from trend
MI US
32

.976

.0223

.941

.0145

.945

.0222

.980

.0193

(7.22)
.92
(15.74)
.95
(18.99)
.90
(14.07)
.92
(15.78)

I. 71

.95
1.48
1.56
1.04

FOOTNOTES
6. More explicitly, log ME=log (M/\'f/iiJ), where f is the
trend level in industrial production, and ii is the trend
level in velocity. Velocity equals industrial production
divided by the real money stock. Real money is the
nominal money stock (money plus quasi-money) deflated by the wholesale-price index. The trend level
estimates are calculated recurSively by multiplying
last period's trend level estimate by the rate of growth of
the actual variable over the past 60 months. F6rexampie:

1. The intellectual foundation behind this article is the
monetary theory of the balance of payments. One Of the
original papers by Harry Johnson was published in
1972 in the Journal of Financial and Quantitative Analysis. A surveyor recent works is presented in J.A.
Frenkel and H.G. Johnson (EdsJ The Monetary Approach to the Balance of Payments, 1976. Important
recent contributions have been made by R. Dornbusch,
for example, "The Theory of Flexible Exchange .Rate
Regimes and Macroeconomic Policy," Scandinavian
Journal of Economics (1977>'

Veo = Veo
Rt = ( Vt - Vt-eo ) /60
Vt-eo
Vi = Vi-1 x (1 + Rt) For all t >60
This procedure was followed for all countries with the
exception of the U.K., for which there was no monthly
data for quasi-money, and for which there was insufficient monthly money data to calculate the trends. In the
U.K. case, money alone was used, instead of money
plus quasi-money, and the trend in real money demand
was estimated by extrapolating the average 1963-1973
nominal money growth rates in the U.K. and the U.S.
7. Other factors which could have explained these
differential growth rates, such as the size of the previous business-cycle downturn or the trend growth in the
economy, do not appear to have been significant. The
U.S. growth rate in the last three and a half years-7.8
percent-was significantly above its 1963-73 trend
growth of 5.4 percent. On the other hand, Germany's,
Japan's and Switzerland's recent growth rates were
significantly below their trend growth rates in the
decade ending in 1973. The size of the previous
business-cycle downturn also does not explain the
recent strength in the U.S. growth rate. Both Switzerland and Japan had a more severe downturn in their
economy in the 1973-75 period than the U.S., while
Germany had a downturn equal tothat of the U.S. Thus,
it appears that differences in monetary stimulation have
been a key factor in differences of real growth rates of
these four countries in the most recent business-cycle
expansion. The movement in the unemployment rate
was consistent with the pattern of growth rates in
industrial production. In the U.S., unemployment declined significantly by 1978 from its 1975 peak rate. In
Germany, Japan and Switzerland, however, unemployment rates were equal to or above 1975 rates. This
suggests that real growth in those three countries had
been insufficient to absorb the natural growth in their
labor force and productivity, and thus suggests that
their growth had been below potential.

2. There may be short-run situations when destabilizing speculation is also profitable. This occurs when the
"greater.fool" theory operates. An intelligent speculator
may believe that a currency is undervalued and still sell
it because he perceives that other speculators believe it
is still overvalued. One can make money in the short run
by speculating about the actions of other speculators
rather than about the economic fundamentals which
determine a currency's long-run value. But this "greater
fool" approach can be profitable only for a limited
period of time.
3. Other important factors which influence the demand
for money as a means of payment are various institutional arrangements, such as the frequency with which
wages and salaries are paid. However, these factors will
change only slowly over time, and are not usually an
important source of a change in the demand for money.
4. Government intervention can also affect the exchange rate, but we ignore these effects for several
reasons. Government intervention can fall under three
headings: 1) actions to counter disorderly markets; 2)
central-bank purchases and sales of foreign exchange
for own account; and 3) Treasury purchases or sales of
foreign exchange through sale or redemption of debt
denominated in foreign-currency values. The first type
of intervention (countering disorderly markets) is by
definition transitory and reversible. Thus it has no
permanent effect on the exchange rate, the balance
sheet of the central bank, or the position of the Treasury. The second type of intervention affects the balance
sheet of the central bank. Sustained intervention in the
foreign-exchange market will either increase or decrease central-bank holdings of foreign assets, and thus
change the domestic money supply. This type of intervention is considered directly by the way the equation is
estimated-through the excess money supply. The
third type of intervention (sale of foreign-denominated
government securities) affects the composition but not
the level of Government debt. Its effect on exchange
rates is not captured by our empirical estimation procedures. However, this type of intervention is insignificant
because of the recency and small scale of such operations. The U.S. Treasury issued its first OM security in
January 1979 and its first Swiss franc security in February 1979. The total amount authorized by the Treasury
is $10 billion, and the amount actually sold is $3 billion.

8. All of the level equations were estimated with Cochrane/Orcutt adjustment for the first-order serial correlation of the error term.
9. In the case of Japan, the constant term is statistically
significant but quantitatively small. In the case of the
U.K., the constant term is quantitatively large, but not
significant statistically.
10. Italy is the only country in which the constant term
has a large and statistically significant value. This
suggests that there were important real factors operating on the Italian exchange rate as well as the money
factors modeled in the equation.

5. This broad definition of money includes currency,
transactions deposits and quasi-money deposits of
commercial banks. A fuller discussion of the monetary
measures is given in the following section on statistical
tests.

33

11. A related source of measurement error is associa~
ted with market expectations. Market participants may
view current nominal money growth as aprecursorof
future growth in the nominal money supply. These
expectations could affect the exchange rate. ForexaTTlpie, when market participants observe the steady decet.eration over the last four years in Switzerland's nominal
money growth, they might reasonably. expect. that
pattern to continue and, thus,. would forecast alower
long-run equilibrium price and lower exchange value of
the dollar relative to the Swiss franc than is implicitin
the actual trend of nominal money growth. These
expectational influences could bias the coefficient
values either above or below one~above one if the
market extrapolated current monetary developments,
and below one if the market expected the monetary
authorities to revert to some trend value in the face of an
observed deviation in money.

To the extent that expectations have been important
in affecting coefficient values, these values may remain
unstable over long periods of time. Indeed, if all monetary authorities followed constant money-growth rules,
this expectation factor would no longer influence market participants and the coefficient values would move
toward unity.
12. The equations in Table 1 were estimated in difference form, while the charts were displayed in level form
for convenience in interpretation. This transformation
was achieved by conducting a static simulation of the
equations over the estimation period.
13. See footnote 6 for an explanation of why the narrower aggregate (money) is used for the UK, as opposed to
the broader aggregate (money plus quasi-money)
which is used for the other countries. The corresponding growth rate for US money is 6 percent.

34

Michael Bazdarich*
The popular analysis has not fully recognized
this distinction. It has described U.S. economic
performance in generally favorable terms, but
then blamed it for part of the dollar's weakness.
Yet sharp increases in U.S. GNP could have
triggered the decline in the dollar only if these
were primarily unsustainable cyclical movements, with little increase in potential output.
Such behavior hardly constitutes strong growth.
The rest of this paper will present these arguments in greater detail. Section I provides a
number of examples expounding the "strong
economy ... weak currency" theme. Section II
argues against this approach by distinguishing
between secular and cyclical increases in GNP,
and by analyzing their different effects within a
general framework of exchange-rate determination. Section HI then presents recent statistical
evidence on these issues. The concluding Section
IV briefly considers whether recent GNP
"growth" in the U.S. has in fact been mostly
secular or cyclical.

Over the last eighteen months, a number of
explanations have emerged for the dollar's decline in the foreign-exchange markets. One particularly prominent theory attributes thedollar's
weakness largely to the relatively rapid growth of
the American economy. The analysts proposing
this theory argue that fast economic growth in a
country causes an acceleration in its imports and
therefore a deterioration in its trade balance,
ultimately leading to a depreciation of the domesticcurrency.
This paper questions the validity of that approach. It argues instead that true economic
growth, as evidenced by rapid growth in productive capacity, or potential GNP, typically
strengthens the domestic currency. Growth of
this type implies improving supply and wealth
conditions which can more than offset the effects
of rising demand on the trade balance. Sharp
cyclical increases in GNP, on the other hand, can
weaken the domestic currency. These movements typically involve an increase in demand
with no change in productive capacity, and so do
not generate any offsetting effects to the rise in
imports.

I. Income Growth And Exchange Rates In Recent Economic Commentary
Again, many analysts have attributed the
dollar's fall in part to the "strong economic
performance" of the U.S. economy. Perhaps the
most direct such statement is in Solomon
(l978b):1

healthy expansion. I know many people
believe it odd or paradoxical that a nation
with a strong economy should have a weak
currency and vice versa. But this is pure and
simple economics. It happens again and
again.

The major influence on the dollar is that the
rate of growth of the German and Japanese
economies has been very, very slack while
the American economy has enjoyed a

Similar analysis can be found in Coldwell (1978),
Burns (1978), Business Week (1978 a,b), Lewis
(1978), Bell (1978), and others.
Some of these remarks, though expounding
the high growth/ weak currency theme, do make
some mention of special cyclical factors as being

*Economist, Federal Reserve Bank of San Francisco.
Kirk McAllister provided research assistance for this
paper. Michael Wachter and Jeffrey Perloff provided
potential GN P data.

35

determined by the underlying structure of the
world economy. The elasticities mentioned
above apply to a period when the world's economic structure also caused the U. S. to grow more
slowly than its major trading partners. Yet if this
structure indeed has changed so as to imply a
faster relative rate of growth for the U.S., then it
is only reasonable to presume that these structural changes will also alter the underlying income-elasticities. Therefore, it does not follow
that a sustainable increase in the U.S. growth
rate relative to abroad will necessarily lead to a
steady deterioration in the balance of payments.
A final example can be found in the technical
economics literature. In a series of articles,
Mundell (1968), Wein (1974), and Kuska (1978)
all consider whether growth causes a deterioration in the balance of payments and, ultimately, domestic-currency exchange rates. Though
their conclusions vary, all treat growth as merely
an increase in GNP, without any consideration
of changes in productive capacity or supply
conditions. These studies make no explicit distinction between cyclical GNP expansion due to
increases in demand alone, and real economic
growth with increases in both aggregate demand
and supply.
In view of this failure by many analysts to
distinguish between cyclical and secular increases in GNP, it's clear that these issues deserve
future study.

behind the growth rates. Yet there is still no real
distinction between true growth and cyclical
expansion, or consideration whether their respective exchange-rate implications might be
different. What's more, the Solomon statement
flatly declares a weak currency to be one result of
strong growth. Even if one were to argue that his
claims are based on perverse exchange-rate expectations, it remains to be seen whether this has
indeed been the case historically.
Another strand of thought on these issues is
given in Business Week (l978c):
The only way to strengthen the dollar is thus
the hard way. [Studies] overwhelmingly
show that the foreign balance is highly
income-elastic-that when the dollar value
of the gross national product is growing
faster in the U.S. than in other industrial
countries, net U.S. exports fall more than
proportionately.
Similarly, Business Week (1978d) cites Houthakker and Magee (1969) in a more detailed version
of this argument, claiming that these incomeelasticities require the U.S. to grow more slowly
than foreign countries if the dollar is to remain
stable.
In interpreting the Houthakker-Magee results, these arguments overlook the fact that
growth rates and income elasticities are both

II. Secular Growth, Cyclical Movements, And Exchange Rates
Exchange Rate Determination2
A discussion of the effects of income growth
on exchange rates must first describe how exchange rates are determined in general. An
exchange rate is the price of one currency in
terms of another, and indeed the exchange markets are markets where one currency is traded for
another, or, equivalently, where assets denomimated in one currency are traded for assets
denominated in another currency.
It follows that exchange rates are affected by
changes in the demand for or supply of the
monies in question. For example, in the DollarDeutschemark market, factors which increase
the demand for dollars will, other things being

equal, cause the price of the dollar in terms of
marks to rise; that is, they will cause the dollar to
appreciate relative to the mark. Factors which
increase the supply of, or decrease the demand
for, dollars will tend to cause the dollar to
depreciate in terms of marks.
Thus the exchange-rate impact of, say, a U.S.
balance of payments deficit can be determined by
considering how it affects the demand and supply of dollars relative to other currencies. A
balance-of-payments deficit means that the restof-the-world's receipts of dollars exceed U.S.
receipts of foreign currencies; in other words, the
supply of dollars to the rest of the world is
increasing. Other things equal, this would lead to
36

supply, that is, the supply of goods and services
at a given price level and factor-utilization rate. 7
Economic growth is also associated with an
increase in ex-ante aggregate demand, the demand for goods and services at a given price
level.
Sustainable (or true) economic growth occurs
when ex-ante demand and supply increase together. Ex-ante demand increases as the population grows and as wealth increases due to past
saving and investment behavior. But precisely
the same factors cause the increases in the work
force and stock of physical capital associated
with ex-ante supply. Thus population growth
and saving-investment behavior fundamentally
determine an economy's sustainable long-run
rate of growth, through their influence on both
supply and demand.
Cyclical changes in GNP, however, are the
result of short-run disparities in the responses of
demand and supply to these fundamental determinants. When ex-ante aggregate demand
shifts relative to supply, the economy responds
by shifting factor-utilization rates and! or goods
prices. Because these shifts are likely to be
reversed when the business cycle turns (i.e. when
supply catches up with demand or vice versa), the
attendant movements in GNP are also likely to
be temporary. The shift in ex-ante demand
causes a movement "along the aggregate supply
curve," to higher price and output levels. 8 These
shifts allow supply and demand to be equal expost.

a dollar depreciation, but often other things are
not equal.
For example, in view of the dollar's role as a
reserve currency, the rest of the world might
desire to increase its holdings of dollar reserves.
The only way this could happen is if the rest-ofthe-world's dollar revenues exceed its dollar
payments, that is, if the U.S. has a balance-ofpayments deficit. In this case, the attendant
increase in the international supply of dollars
would actually have been caused by a prior
increase in the demand fQr dollars. The dollar in
that case would tend to appreciate, if anything,
so that aU .S. payments deficit could conceivably
be associated with an appreciating dollar. 3
As another example, consider a U.S. deficit
that was only temporary, and was sure to be
reversed in the following period. 4 Though the
deficit means a higher supply of dollars now, this
increased supply will disappear in the following
period when the deficit turns to surplus. Therefore, an intelligent speculator would willingly
purchase the excess dollars now, since he knows
he can sell them next period when they will be
more scarce. In other words, the increased supply caused by the deficit is likely to be matched
by an increased speculative demand, and so the
dollar's price need not change very much if at
all. s
These examples illustrate the fact that exchange rates are affected by many different but
interrelated elements. Neglect of particular elements can lead to an incorrect conclusion, as in
the above examples, where an analysis limit~d to
the balance of payments would lead one to
expect, incorrectly, a dollar depreciation.

Economic Growth and Exchange Rates
Consider an economy that is growing at its
long-run rate. Demand increases because of the
increased wealth represented by new workers,
skills and equipment, and so imports will likely
increase. But it then follows that some of the
increased supply is available for increased exports or for use in domestic investment by
foreigners. In order to maintain current growth
rates, this available supply will indeed have to be
utilized to generate such exports or capital inflows. In that case, therefore, increased imports
will have to be matched by increased receipts
from abroad, resulting in a balanced international-payments account.

Economic Growth vs. Cyclical Movements
Real GNP or total income6 in an economy can
increase when new laborers and capital (including new productive techniques) start producing,
or when existing capital and labor are used more
intensively, either through currently employed
factors working overtime or through unemployed factors being pressed into service. The former
type of increase is associated with economic
growth, because it is the expansion in productive
capacity (or potential GNP) that allows actual
GNP to continue to increase. This, in turn, is
equivalent to an increase in ex-ante aggregate
37

This balance must occur ex-post, after necessary changes in capacity utilization, price levels,
terms of trade, and exchange rates. have occurred. But ex-ante demand and supply have
both increased. The main balance-of-payments
question is whether there will be sufficient foreign demand to absorb the domestic productive
capacity made available when some domestic
demand is spent abroad. We argue that this
demand will indeed tend to exist-that true
growth need not lead to an ex-ante decline inthe
balance of payments.

home would imply chronic capacity shortages
abroad.
While growth will not necessarily lead to a
chronic imbalance in international payments,
growth presumably will increase domestic demand for the domestic currency. As increases
occur in personal wealth and in the number of
wage-earners, the demand for money to finance
higher consumption levels and to act as a store of
wealth will also increase. Alternatively, economic growth means a lower rate of inflation for .~.
given rate of money-supply growth, and this will
increase the attractiveness of the domestic currency.9 This growing domestic demand for money implies that the domestic currency will appreciate as the economy grows, since there is no
presumption that trade developments will offset
these tendencies. Thus it can be argued that true
economic growth will tend to strengthen the
domestic currency over time.
These arguments need to be amended only
slightly when considering a shift to a higher
sustainable growth rate. Such a shift can only
occur due to increases in population and/ or
saving-investment behavior. These changes in
turn cause an acceleration in growth of aggregate
supply and money demand, described above.
Also if a shift is caused by changes in saving
behavior, then there necessarily will be reverse
shifts in consumption bel).avior-including import behavior. That is, the marginal propensity
to save increases only if other propensities decrease. These various effects, in net terms, need
not cause a continuous deterioration in the
balance of payments.
In sum, we have no reason to believe that
growth will weaken the domestic currency, and
much reason to believe it won't. At root the
growth process is one of wealth accumulation.
This strongly suggests a desire to accumulate
money balances, and thus a tendency to an
appreciating currency.

First, rational investors will typically invest in
industries where they expect profits to be made,
where equipment and labor can be utilized to
produce a good that is demanded by consumers.
Some of these goods might compete with imported products, and others might be attractive to
foreign consumers as well. Butineither case, the
increased capacity, when utilized in production,
can serve to balance spending flows, either by
absorbing a greater share of domestic spending
or by generating spending from abroad. The
increased capacity would fail to serve this purpose only if left unutilized, in which case it would
hardly be a good investment.
The terms of trade might be expected to
change over time; that is, the relative price of
domestic export goods in terms of imports might
decline, but this too should be foreseen by
domestic investors and discounted into their
investment decisions. There is quite a difference
between a decrease in the terms of trade due to
overinvestment and oversupply in the export
industry, and one due to improving technology
and falling costs in that industry. The latter can
be a natural development of growth, and thus
does not imply a weakening in the internationalpayments position. The former does imply some
weakening, but it is more likely the result of bad
investment decisions and/ or unforeseen developments, rather than an intrinsic part of the
growth process.

Cyclical Movements and Exchange Rates
While true economic-growth necessarily includes factors which tend to reverse the
exchange-rate implications of higher demand,
this is not the case when GNP increases due to
cyclical factors. When aggregate demand shifts
relative to supply, say due to expansionary

More importantly, an increase in imports
utilizes foreign capacity, or supply. Therefore,
some foreign demand. will be left over, since the
rest of the world is also presumably growing atits
normal rate over the extended period of time in
question. Otherwise, chronic excess capacity at

38

government policy, imports will increase, but no
new productive factors will become available
with which to increase exports of capital inflows.
Rather, any increase in domestic output that
occurs is a result of the initial rise in demand.
Therefore, the balance of payments can deteriorate cyclically.
The extent to which this cyclical deterioration
leads to a depreciation in the domestic currency,
however, depends on the nature of the business
cycle itself, primarily on the predictability of its
ups and downs. The cyclical part of GNP can be
estimated by subtracting potential from actual
GNP. Typically, this cyclical component series
fluctuates around zero, staying positive or negative for long periods of time (Chart I).
One way to represent this behavior is through
a predictable cycle in which if income is above
potential now, it can be expected to fall below
potential at some definite time in the future, say
eight quarters from now (Chart 2a). In such a
case, a country which balanced its payments
accounts over the course of the cycle would still
experience cyclical fluctuations in the balance of

payments (Chart 2b). The deficit would be unusually large when the cyclical-income component
was positive, and conversely.
However, this does not mean that exchange
rates would predictably follow this type of pattern. As we noted above, profit-minded speculators would prevent predictable variations in
domestic-currency supply (i.e., in the balance of
payments) from affecting rates, and so exchange
rates need show little if any cyclical variation in
this case.
Still, in the United States, GNP has not
predictably behaved in the manner described.
Just because GNP is now above potential does
not imply that it will be below potential x
quarters in the future. 10 To see this, consider the
following time-series equation estimated for the
1957-77 period:
dt

= 1.37 dt- I

.48 dt-2

-

+ ej,

where d t is cyclical GNP (as defined above) at
quarter t, and et is a random-disturbance term. A
Chart 2

Chart 1
Behavior of Cyclical Component of GNP
Cyclical GNP/ Total GNP
Percent

PrACllic:t"tllp. behavior
this ..

4.0
30

o

4

8

20

12

16

20

w d lead to predictable behavior

Trade balance

of the trade balance
like this ..

1.0

+ 0
1.0
20
3.0

o

4

8

12

16

4.0
Home-currency exchange rates.

5.0
6.0
7.0

1958 1960

but not necessarily any
movement in exchange rates.
1965

1970

75

1978

o

4

8

12

16

20
Quarters

39

positive shock to this equation will cause d to
tend to be positive over a certain period of time
(Chart 3a). However, d t will not become negative
until et becomes negative, and such future shocks
by definition cannot be predicted. 11
In such an economy, a positive disturbance to
cyclical GNP will presumably cause a cyclical
increase in the payments deficit (Chart 3b). Since
there is no presumption that the balance of
payments will be in surplus at any specific point
in the future, the market has no reason to smooth
out all effects on the exchange rate. However,
since the persistence of the cyclical variations in
GNP and the balance of payments deficit are
predictable, they should have no subsequent
effect on exchange rates. Speculators generally
will be able to foresee the future effects of current
disturbances, and these future effects will be
discounted into today's exchange rates. Rates
might then behave as in Chart 3c.
This discussion has so far ignored the direct
effects of cyclical GNP movements on domesticcurrency demand. These largely mirror the payments effects. Since the cyclical impulse to GNP
is temporary, -it will not exert much change on
the transactions demand for cash or on the
demand for money as a store of wealth. In
addition, GNP can increase above potential only
through more intensive utilization of existing
factors, which translates into inflationary pressures. 12 Therefore, cyclical increases in GNP are
likely to be associated with inflation, which
decreases home-currency demand and reinforces
the trade effects in depreciating exchange rates.
While sustainable growth arises out of accu-

mulative behavior, cyclical upswings arise from
increased spending behavior. As the two have
opposite implications for domestic wealth, inflation, and asset demand, they naturally have
different effects on exchange rates, even though
both are commonly grouped together under
"growth" in GNP.
Chart 3
Cyclical component of GNP

A positive disturbance
to the cyclical component
of GNP will cause predictable
behavior of GNP like this ..

5

15

10

and predictable behavior
of the trade deficit like this.

o

5

10

15

Home-currency exchange rates

but correct speculation
will yield exchange rate
behavior like this

o

5

10

15

Quarters After Disturbance

III. Empirical Evidence on GNP and Exchange Rates
A high long-run growth rate consequently
need not weaken a country's exchange rate, as
has been shown by the world's postwar experience. Both Germany and Japan have grown very
fast relative to other countries. While each has
had cyclical balance-of-payments problems,
these have not been chronic, and both countries'
currencies have appreciated relative to the dollar. The United Kingdom, on the other hand, has
had a very low rate of growth, and a chronically
weak currency, over the last twenty years.

Countries with high rates of growth indeed
have tended to have appreciating currencies over
the past quarter-century (Table 1)13. These results give preliminary support to our conclusions
about the differential impact of true growth and
14
cyclical movements. A more substantive test
would determine whether these hypotheses hold
systematically for a particular country over time.
The following analysis examines the systematic
statistical relation among growth, cyclical movements, the trade balance, and exchange rates for
recent U.S. data.

40

Table 1
Average Annual Growth Rates and
Exchange Rate Changes (1953-77)
Real GNP
Growth Rate

Appreciation (+) or
Depreciation (-)
Against the Dollar

Percent (Rank) Percent

Japan
France
Germany
Canada
United States
United Kingdom

8.44
4.88
4.77
4.76
3.24
2.52

(1)
(2)
(3)
(4)
(5)
(6)

the American economy. The Perloff-Wachter
study assumes that full-capacity utilization of
factors is a utilization rate that can be sustained
without generating inflationary or deflationary
pressures. This representation of potential GNP
as a level which can be maintained with stable
prices is thus compatible with the previous sec­
tion’s distinction between cyclical and potential
GNP, and its association of cyclical movements
with inflationary pressure.
With the Perloff-Wachter series (PW) used as
a measure of potential GNP, the cyclical compo­
nent of GNP (CYC) can be obtained by subtract­
ing potential from actual GNP. The behavior of
CYC over time is shown in Chart 1, and the
growth rate of PW over time in Chart 4.
As discussed above, movements in the CYC
variable should lead to opposite movements in
the balance-of-payments accounts, although the
analysis gives no indication of the sign of the
effect of increases in PW on the balance of
payments. With real GNP net exports used as a

+1.22
-1.42
+2.43
-0.33
0
-2.01

(Rank)

(2)
(5)
(D
(4)
(3)
(6)

Rank Correlation between series: .49
Source: International Financial Statistics, International
Monetary Fund.

True growth is represented here by an increase
in the quarterly potential GNP series developed
in Perloff and Wachter (1978). This series esti­
mates the effects of changes in the capital stock
and work force on the productive capability of

Chart 4
Behavior of Potential GNP Over Time
Percent

41

period of the 1970's, appear to verify our hypotheses (Table 2).17 Over both sample periods,
the cyclical GNP variable has a significant negative effect on the trade balance. The PW potential GNP variable has an effect which is positive,
but not significantly different from zero. Moreover, the results for exports and imports separately also support the above analysis. Cyclical
increases in GNP increase both imports and
exports, but appear to have a stronger effect on
imports. The PW variable apparently has about
a zero net effect on imports, but a small positive
effect on exports-although, as with the net
export equation, the signs of the net effects are
not significantly different from zero. Based on
this evidence, changes in the underlying U.S.
growth rate (i.e. in DPW) apparently have not
tended to weaken the U.S. trade balance in
recent history.
As for the exchange-rate relations, our earlier
analysis suggests estimating an equation of form:

measure of the balance of payments, these
conclusions can be tested by estimating an equation of form: 15
DDEFt

= a + bo

• DCYCt + bl
... + bn . DCYQ-n

. DCYCt-1

+ Co • DPWt + CI • DPWt- 1 +
... + Cn . DPWt- n + er,

+

(1)

where DDEF t is the difference between GNP net
exports in quarter t and that in t~ 1; DCYQ isthe
change in CYC; DPWt is the change inPW; the
two variables band care coefficients to be
estimated; and et is a random-disturbance termi 6
Our previous analysis suggests that the bcoefficients in equation (1) should generally be
negative, while the c-coefficients can be of any
sign. Of course, the exact form ofthe lag structure in (1) will depend on the data.
The results of estimating this equation, for
both a twenty-year sample period and the shorter

Table 2
Estimates Of Equation (1)
Response of Trade Deficit to Changes in GNP
Dependent
Variable

Sample
Period

Auto Correlation Effect of Cyclical Effect of Pw Potential
Component Vari·
Coefficient on
GNP Variable ""
At Lag...
Residual at Lag:".". able"" at Lag...
One
Two
Two
One
One

Change in Real
GNP Net Export
Variable**

1958.1
To
1977.4

0.133
(1.0)

Rate of Change
Of Real GNP
Imports

1958.1
To
1977.4

Rate of Change
Of Real GNP
Exports

R'

S.E.

D.W.

.053

0.0020

1.92

-0.049
H·9)*

0.080
(1.2)

-0.305
(-2.7)*

2.214
(5.7)*

2.245
(1.82)

-2.155
(-1.80)

.206

0.0374

2.15

1958.1
To
1977.4

-0.351
(-3.2)*

1.154
(2.9)*

3.873
(3.0)*

-2.721
(-2.1)*

.128

0.0399

2.01

Change in Real
GNP Net Export
Variable**

1970.4
To
1977.4

0.274
( 1.1)

.112

0.0024

1.68

Rate of Change
Of Real GNP
Imports

1970.4
To
1977.4

-0.327
(-1.4)

2.763
(4.7)*

0.795
(0.4)

.328

0.0403

2.18

Rate of Change
of Real GNP
Exports

1970.4
To
1977.4

-0.476
(-2.1)*

1.405
(3.2)*

2.587
( 1.6)

.108

0.0332

1.68

0.161
(1.3)

-0.075
(-I. 7)

* Significant at 5% level
** For an explanation, see footnote 17.

42

0.154
( 1.1)
-1.545
(-0.8)

DXRt

= a + boo DCYC + b!DCYCH +..
bl

.

Co
Cn

•

The existence of lagged cyclical variables in
the. exchange. rates·· can be consistent with our
previous discussion of speculation, given some
kind of information lag for agents. OUr analysis
suggested that cyclical movements should affect
exchange rates immediately, and without much
prolonged effect.. Yet it· might not be clear until
the GNP data are released after<each quarter
whether or how much real GNP had actually
increased in that quarter, and some additional
time might pass before it becomes clear to participants how much ofthe increase could beimpllted
to •cyclical and growth factors, respectively.
These lags might then explain the lagged, but
apparently once and for all, effect of cyclical
movements on exchange rates. In this respect,
the cbfltenrporaneous PW term also represents
the· effects of previous investment· and similar
shocks,and so also involves some implicit lag
from investment developments to exchange-rate
effects.
In any case,· the results generally support our
earlier analysis. Periods of relatively fast growth
in U.S. potential GNP typically have been periods of strong performance by the dollar, other
things being equal. Increases in real GNP typically have weakened the dollar only when these
reflected primarily cyclical developments}O

DCYCt - n
DPWt + c!·DPWt-I+ ... +
DPWt - n + et>
(2)

where DXRt is the . change in .the. foreigncurrency value of the dollar, and other variables
are as defined above. Our earlier analysis suggests that the b coefficients should be negative,
while the c coefficients should be positive. As was
the case with equation (1), the exact lag structure
for equation (2) will depend on the data. DXRt
was represented as a trade-weighted average of
the rates of change in the exchange rates for the
dollar relative to eleven major currencies. 18
Equation (2) was estimated over the entire
1970.4-1977.4 period, despite the fact that the
generalized floating period did 110t begin until
1973, because substantial exchange-rate movements also occurred from late 1970 . through
1972. 19
Table 3 shows several estimated forms of
equation (2). In each of these forms, the PW
potential GNP series enters with a significantly
positive contemporaneous effect. Lagged values
of PW did not significantly affect exchange rates
in either direction. Finally, cyclical movements
in GNP had significant negative effects at the
second lag, with some sign of negative effects at
other lags.

Table 3
Estimates of Equation (2)
Response of Exchange Rates to Changes in GNP
Effect of
Contemporaneous
Potential GNP
Variable

Effect of Cyclical
GNP Variable at lag...

S.E.
One

2.161
(2.3)*

-0.148

2.395
(2.4)*
2.133
(2.3)*

-0.391
(-l.5)*

(~0.5)

-0.566
(-2.1)*

-0.629
(-2.6)*

Dependent Variable: trade weighted percentage change in dollar exchange rates.
Sample period: 1970.4 to 1977.4

* Significant at

D.W.

Two

5% level.

43

.352

1.47

1.81

.240

1.56

1.99

.344

1.45

1.80

IV. Summary and Conclusions
If true growth does not weaken the domestic
currency, what can be said about therecentU.S.
expansion? Has it encompassed rapid increases
in potential GNP, so that it remains unrelated to
the dollar's decline-or has it represented mainly
a cyclical expansion, related to the dollar's fall,
but not for the reasons generally given? A thorough analysis of this question awaits further
research, but at least some anecdotal evidence
can be presented here.
The last four years have been a time of sharp
upturn in the cyclical portion of GNP, and of
large increases in GNP itself (Chart I). However,
potential GNP has not increased particularly
rapidly, and its rate of growth has actually shown
some decline (Chart 4). This is reflected in the
lack of an upturn, and some sign of a decline, in
saving and investment behavior over this period
(Table 4). In fact, the Council of Econ()mic
Advisers has acknowledged these trends, as well
as a perhaps related slowing in productivity
growth, by lowering its estimate of the growth
rate in potential GNP to 3.0 percent}l In other
words, the rapid increase in real GNP in the last
few years appears to have been largely a cyclical
phenomenon, with (if anything) unusually slow
true growth.
Moreover, the PW series may overstate the
level of potential GNP in the economy, and
therefore understate the level of the cyclical GNP
variable. This is because the PW series was
constructed using a full-capacity utilizatiohrate
of 87 percent for capital, although McElhattan
(1978) ancl other studies have suggested that a
rate of 82 percent might be more appropriate.
Using this rate in estimating potential GNP
would lower PW but raise CYC throughout the
1970-77 sample period. Since this change would
not affect the rates ofchange of these variables, it
would not alter our statistical results. However,

Table 4
Recent U.S. Saving and Investment Data
(Values in billions of 1975 dollars)
Real Gross Real NonPersonal
Private
Saving
Private
Residential
Saving
Domestic
Fixed
asPercenl asPercenl
of GNP
Investment- Investment- of GNP
1972
1973
1974
1975
1976
1977
1978

188.3
207.2
183.6
142.6
173.4
196.3
210.1

116.8
131.0
130.6
113.6
118.9
129.8
139.9

15.4
16.1
14.9
17.0
16.0
15.4
15.3

4.2
5.4
5.1
5.5
4.0
3.6
3.7

Source: Survey of Current Business, Department of
Commerce.

it would suggest that the economy was close to
full-capacity by mid-1977.
Very plausibly, then, continued rapid increases
in GNP, large government deficits, and fast
money-supply growth at a period of nearly fullcapacity utilization could have triggered large
trade deficits and rapid inflation, and so have
contributed to the decline in the dollar. We might
conclude that the economy's performance was
related to exchange-market developments, but
not for the reasons discussed earlier. Rather than
a strong economy, the root problem for the
dollar would be an expansionary domestic policy
leading to accelerating inflation.
Again, these last conclusions are preliminary.
What has been shown more substantively is that
there is no analytical case for the argument that
truly strong growth in an economy will necessarily tend to weaken exchange rates. Indeed, recent
U.S. evidence suggests that the opposite has been
the case. The "strong economy, weak currency"
explanation of the dollar's decline thus does not
appear to have any hard theoretical or empirical
evidence to support it.

FOOTNOTES

i.

Italics added.

represent the equilibrating counterpart to structural or
'autonomous' capital inflows or outflows."

2. Readers who are familiar with the elementary
concepts of exchange-rate determination may skip this
section.

4. This might be the case if there were a dock strike
abroad in which U.S. goods could not be unloaded at
foreign ports. This would make U.S. exports low at
present, and so make the U.S. balance of payments
deficit high, but the deficit would then be reversed when

3. This possibility is acknowledged in the Councilof
Economic Advisors (1979), p. 149; to wit: " ... In fact,
deficits or surpluses on current account may well

44

the strike was over and back shipments were unloaded.
Similarly, seasonal patterns might cause large U.S.
imports, say, at Christmastime, and then large U.S.
exports in the summer. This could imply perfectly
predictable seasonal patterns in the balance of payments.
5. For another discussion of this type of speculation,
see Heller (1974, pp. 48ff).
6. These discussions will use the terms "total output," "income," and "GNP" interchangeably.

13. The meaning of the results in Table 1 is not at all
altered by the fact that the change in the dollar relative
to itself is by definition zero. It will still be the case that
currencies that appreciated relative to the dollar will be
higher ranked than the dollar in COlUmns (2) ofTable1,
and vice versa forcurrencies which depreciated relative
to the dollar. The zero for the U.S. in Column 2 has no
implications for the rankingsof currencies in Coluhln2.
For example, if Column 2were expressed as the behavior of each currency with respect to gold or SDR's, the
number in Column 2 would be the sum of each
currency's performance relative to the dollar and the
dollar's performance relative to gold or SDR's. The
latter would be the same for each country, andso such a
tabulation will have the same ranking as that in Column
2 of Table 1.

7. "Ante" means before, andin the present context,
an increase in ex-ante aggregate supply means an
increase in the supply of goods and services for a given
level of prices, wage rates, exchange rates, etc. When
any of these factors change, the resultant change in
demand occurs ex post, after prices or wages change
first. Thus, ex-ante changes in supply refer to changes
in underlying supply conditions. Ex-post changes in
supply occur as prices and wages, etc., respond to
changes elsewhere in the economy. In terms of a supply
curve, ex·ante would refer to the position of the curve in
the price, quantity plane. Ex~post changes in supply
would mean a movement along the supply curve with
no change in the curve's position.

14. The Spearman rank-correlation coefficient for
Table 1 is +0.49. This statistic indicates that the higher a
country's ranking in terms of growth rates, the higher its
ranking in terms of exchange-rate performance, with
significance at the 18 percent level.
15. The reader may question the absence offoreignincome variables in equation (1) and in sUb~equent
results, but these are not neces~ary for an estimation of
the effects of d.omestic variables alone. The theoretical
analysis considered domestic growth and cyclical developments, other things held constant. To the extent
that domestic growth and cyclical developments are
synchronized with those abroad, the foreign variables
are redundant and need not be included. To the extent
that domestic and foreign developments are unrelated,
foreign variables are not needed at all in measuring the
effects of domestic factors. In neither case should the
omission of foreign variables cause serious specification error in estimating the effects of domestic GNP
factors on the balance ()f payments and the exchange
rate. This reasoning, together with the ambiguity involved in aggregating foreign data into a rest-of-theworld series, as well as the unavailability of foreign
quarterly potentiai--GNP data, all suggesttheexclusion
offoreign data from the statistical work that follows.

8. If both ex-ante demand and supply increase, but
demand increases more, there will be some real growth,
since both have increased-but some cyclicalincrease
as well, since demand has increased more than supply,
and thus increased relative to supply.
9. This lower inflation can be viewed as due either to
a higher level of output with a given money supply, orto
the higher money demand relative to a given supply. It
is therefore really a restatement of the increase in
money demand, rather than a separate effect. Also, it
should be noted that the present discussion focuses on
the effects of GNP growth on exchange rates, and
abstracts from other effects such as shifts in the rate of
money·supply growth. Specifically, we're considering
movement along a given GNP growth path-orto a new
growth path-for a given rate of money-supply growth,
tariff structure, etc. These latter phenomena clearly
have important, but separate, exchange-rate effects
from those of economic growth.

16. GNP net exports include international factor payments and trade in services as well as merchandise
trade, and so is a wider measure than the merchandisetrade balance. It was used here since our initial argument pertains to the balance of payments, to which
GNP net exports are a closer approximation than the
merchandise-trade balance. Also, GNP net exports
were available in constant dollar (or real) terms, which
are perhaps more appropriate for relations involving
real GNP. In any case, equation (1) was also estimated
using the merchandise-trade balance and nominalGNP net exports for the DDEF t terms, and the results
were virtually identical to those in Table 2.

10. The distinction is analogous to tossing a coin. In
the long-run, half of the tosses will show heads, and half
will show tails. Moreover, we know that sooner or later a
toss will show up heads. However, this does not imply
that if the first toss is tails then the second (or thirteenth) will be heads.
11. Actually, the equation implies that given an initial
positive shock of unit size (e t = dt = 1). d t will become
negative in 20 quarters, attaining a maximum negative
value of -0.00006 (d 20 = -0.00006). Such oscillation is so
damped and insignificant that it can be safely neglected
in any analysis of observed business cycles. For another discussion of the non-osci Ilatory behavior of the U.S.
business cycle, see Sargent (1976, p. 43-45).

17. To provide an estimation form forequation (1), the
following data transformations were performed: The
trade-deficit data were divided by actual GNP. The
cyclical-component variable was also divided by GNP.
The PW potential-GNP series was used in percentagechange form. These transformations were used to
induce statistical stationarity (i.e. to detrend) in the
various time series. Percentage changes were not used
in the trade deficit and cyclical GNP variables, since
these variables fluctuate between positive and negative
values. Also, the two sample periods shown were used

12. Even an increase in demand when output is below
potential could trigger price increases. If current GNP
is below potential for legitimate reasons-say,
temporary labor-market rigidities or shifts of factors
into new industries-increasing demand will not alleviate these problems and output can increase only with
accompanying inflationary pressure.

45

to test the relations over a. long sample period
(1957-77), as well as that over which theexchange~rClte
equations were estimated (1970-77). Finally,< inthe
initial estimates •. of these equations, . first-and
second-order autocorrelation was found in the residuals for net exports. This would suggest that the Cochrane-Orcutt procedure for taking account of residUal
correlation would be. inappropriate. here... Therefore,
Durbin's two-step procedure was used in obtaining
Table 1's estimate. This procedure. is discussed in
Johnston (1972, p. 263ff.).

19. Percentage changes were used in the exchangerate series, and the same transformations described in
footnote 17 were performed on the cycl ical- and potential-GNP variables.
20. Though not presented in the text, regressions
were also run to include the effects of movements in the
trade deficit on the change in the exchange rate.
Real- and nominal-GNP net exports and the merchandise-trade balance in turn were all included in the
estimation of equation (2), and in regressions of exchange rates on deficits alone, without any sign of a
significant effect of the trade balance on exchange
rates.

18. These currencies are: the British pound sterling,
Canadian dollar, German mark, French frane, SWiss
franc, Japanese yen, Dutch guilder, Belgian franc,
Italian lira, Australian dollar, and Swedish krona. Trade
weights were based on bilateral 1976 trade data for the
U.S. and these countries.

21. For a discussion of these conclusions, see Council
of Economic Advisors (1979, p. 72ff.).

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Kuska, Edward A. 1978. "Growth and the Balance of
Payments: The Mundell and Wein Theorems." Economic Journal. December, 1978. p. 830.
Lewis, Paul. 1978. "Experts Optimistic that Worst of
Dollar's Troubles May Be Over for Awhile," New
York Times. April 21, 1978. p. 01.
McElhattan, Rose. 1978. "Estimating a Stable-Inflation
Capacity Utilization Rate," Economic Review (Fall
1978). Federal Reserve Bank of San Francisco.
Mundell, Robert A. 1968. International Economics,
Chapter 9. New York: Macmillan.
Perloff, Jeffrey and Michael Wachter. 1978. "A Production Function-Nonaccelerating Inflation Approach
to Potential Output: Is Measured Potential Output
Too High?" Discussion Paper #20. Center for Study
of Organizational Innovation. University of Pennsylvania.
Sargent, Thomas. 1976. "Notes on Stochastic Equations." Working Paper #66. Federal Reserve Bank
of Minneapolis.
Solomon, Robert. 1978a. "Intricacies of Money Supply
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_ _ _ _. 1978b. "Enact an Energy Bill," U.S. News
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Wein, James. 1974. "Growth and the Balance of Payments: A Comment on Mundell," Economic Journal. September 1974. p. 621.

Bell, Geoffrey. 1978. "Future of Dollars," New York
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Business Week. 1978a. "The Fed's Dangerous Game."
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_ _ _ _ 1978b. "A Stubborn Germany is No Help for
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_ _ _ _ 1978c. "The Only Way to Save the Dollar."
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_ _ _ _ 1978d. "Why 1979's Trade Balance Should
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Coldwell, Phillip E. 1978. "The Situation of the Dollar
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Council of Economic Advisors. 1979. Economic Report
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Heller, H. Robert. 1974. International Monetary Economics. Prentice-Hall: Englewood Cliffs, New Jersey.
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46