Full text of Economic Review (Federal Reserve Bank of San Francisco) : Summer 1980 : Responses to International Inflation

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FEDERAL RESERVE BANK
OF SAN FRANCISCO
ECONOMIC REVIEW

The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
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Responses to
International Inflation
I.

II.

Introduction and Summary

4

Managed Floating and the Independence of Interest Rates
Adrian W. Thro op

6

. . . For four major European countries (but not Canada or the U.K.),

managed floating generally has severed short-run linkages between
U.S. and foreign interest rates.

III.

Wringing Out Inflation: Japan’s Experience

24
Charles Pigott

. . . The sharp rise, and sharper fall, in Japanese inflation during the 1970’s

can be traced predominantly to variations in the nation’s money growth.

IV.

Financial Deepening in Pacific Basin Countries
Hang-Sheng Cheng
. . . The real deposit-interest rate plays a critical role in a nation’s financial-

deepening process, and hence in its economic growth.
Editorial committee for this issue:
Randall Pozdena, Rose McElhattan, John Scadding

43

pletely insulated from U.S. rates. But as
Throop notes, central banks in practice have
intervened in foreign-exchange markets about
as frequently under the new system as under
the old. Has "managed floating" then decoupled interest rates? "This depends not on the
amount of intervention per se, but rather on
the relative amount of intervention in response
to interest-rate variations under the two different systems."
For four major countries - Germany, Switzerland, France and Belgium - Throop concludes that managed floating generally has severed short-run linkages between U.S. and
foreign interest rates. This has occurred apparently because of reduced exchange-market
intervention in response to interest-rate variations, rather than larger offsetting domestic
monetary operations. Canada and the United
Kingdom were atypical, however. In both
countries, linkages to U.S. interest rates did
not change significantly between the two exchange-rate regimes, because of unique Canadian and British policies.

The international economy, like the domestic economy, has learned to cope during the
past decade or more with an environment of
high risk and high inflation. Economists thus
have increasingly focused their attention on
the responses of various national economies to
a difficult and fast-changing international environment. This issue of the Economic Review
analyzes three such patterns of response. Can
a regime of floating exchange rates provide
more monetary independence than was possible under the fixed-rate regime characteristic
of a less inflationary age? How does a nation
(specifically, Japan) overcome a major burst of
inflation, and at what cost to the nation's
growth? Can the "financial deepening" process succeed in an era of repressed finance,
where the authorities hold nominal interest
rates rigid even in the face of general price
inflation?
Adrian W Throop addresses the first question, examining the claim that flexible exchange
rates permit a greater independence of monetary policies by weakening linkages between
national interest rates. Under the former Bretton Woods system of fixed exchange rates, foreign interest rates moved sympathetically with
U.S. interest rates, and this interest-rate dependence made it difficult for foreign countries
to pursue independent monetary policies. The
system finally collapsed during the raging inflation of the early 1970's, mainly because nations were no longer willing to accept such a
lack of monetary independence.
The world's financial authorities thus replaced Bretton Woods in 1973 with a flexible
exchange-rate system. Theoretically, with perfectly "clean floating" - that is, without any
central-bank intervention in the exchange market - foreign interest rates would be com-

Charles Pigott, in a second article, analyzes
the causes of the rise and fall of Japanese inflation during the 1970's, and attempts to gauge
the costs the nation incurred in its successful
effort to reduce inflation. Consumer-price inflation decelerated from 25 percent in 1974 to
only 3 percent in 1978, and the inflation rate
remained below 5 percent in 1979. Japan's
real-growth performance was somewhat less
enviable, however. Between 1965 and 1972,
Japan's real GNP grew at a 10 1!2-percent annual rate
but since 1975, real growth has
averaged less than 6 percent.
Japan's experience confirms that the key to
containing inflation is controlling money growth,

4

unimportance of capital markets. In developed
economies, capital markets play a larger role
than in developing economIes, but financial
intermediation still predominates in the savings-investment process.
To measure and compare financial deepening, Cheng provides a cross-section view of the
degree of financial intermediation in each
country in 1978, plus a comparison of the
eleven countries' financial-growth process over
the entire 1960-78 period. Financial-intermediation ratios in 1978 were significantly higher
than average in Japan, Singapore and Taiwan,
and significantly lower than average in Australia, New Zealand and the United States. In
terms of growth over time, Malaysia, Singapore and Taiwan achieved nearly uninterrupted growth between 1960 and 1978. Most
other countries also experienced at least some
growth - except Australia and New Zealand,
which sustained net declines in their degree of
financial intermediation.
Cheng argues that the real deposit-interest
rate played a critical role in setting the pace of
each nation's financial growth. Positive real
deposit rates maintained over a number of
years invariably led to financial deepening,
while negative real deposit rates (even over
brief periods) could result in sharp financial
disintermediation against an otherwise strongly
upward trend. "Because of the importance of
financial deepening for economic growth," he
concludes, "economic policy should be aimed
at reducing inflation, which by definition lowers
the real deposit rate." He adds that where
inflation cannot be brought down quickly, interest rates should be allowed to adjust with sufficient flexibility to permit a positive real rate of
return to savings.

in Pigott's view. "Without the 1971-72 acceleration in money growth, Japan's inflation in
1973 and 1974 would have been much lower
than it actually was. Moreover, the relatively
low inflation of the late 1970's was not the result
of a fortuitous exchange-rate appreciation or
government fiscal 'discipline', but rather of a
consistent policy of containing money growth."
But substantial increases in the domestic price
level sometimes have resulted from other factors, such as the oil-price hike of 1974. In
addition, Japan's monetary authorities have
demonstrated that high budget deficits and foreign-exchange market interventions need not
inevitably destroy monetary control.
Japan's experience is perhaps most interesting for what it reveals about the costs of reducing inflation, Pigott adds. His evidence suggests that Japan's attempts to reduce inflation
through lower money growth substantially aggravated the 1974 recession. However, the evidence also suggests that the continuation of
slow money growth was not primarily responsible for the sluggishness of the recovery. Instead, real growth may have lagged because
the inflation and the ensuing recession undermined investor confidence.
Hang-Sheng Cheng, in a third paper, presents an overview of the financial-deepening
process in eleven Pacific Basin countries during
the inflationary period of the past two decades.
For any nation, "financial deepening" represents an increase in the extent of financing of
production and investment through specialized, organized markets. In developing countries, the process is identified with increases in
the activity of financial intermediaries - such
as commercial banks, savings institutions, and
insurance companies - because of the general

5

I

Rates
Adrian W. Throop*

The major industrial powers abandoned the
Bretton Woods system of fixed exchange rates
in March 1973. From a foreign point of view,
the Bretton Woods system had a major disadvantage: foreign interest rates moved sympathetically with U.S. interest rates. Studies have
indicated that a 100-basis point (one percentage point) change in U.S. short-term interest
rates caused short-term rates in industrialized
countries abroad to change by about 40 basis
points, on average, during that period of fixed
exchange rates.
This interest-rate dependence reflected a lack
of monetary-policy independence. For example, when U.S. interest rates fell as a result of
monetary expansion, investors had an incentive to purchase foreign securities. Such purchases generated a demand for foreign currency and an outflow of dollars - which foreign
central banks were obliged to purchase to
maintain a fixed exchange rate. The accumulating dollars boosted foreign reserves and,
hence, their money supplies. This tended to
push down foreign interest rates in sympathy
with U.S. rates.
As this example indicates, such interest-rate
dependence made it difficult for countries to
pursue independent monetary courses. The
Bretton Woods system collapsed mainly because nations were no longer willing to accept
a lack of monetary independence.
The world's financial authorities replaced
Bretton Woods in 1973 with a flexible exchange-

rate system, mainly because they believed that
this approach would permit a greater independence of monetary policies. Theoretically,
with perfectly "clean" floating - that is, without any intervention by central banks in the
exchange market - foreign interest rates
would be completely insulated from U.S.
rates. In practice, however, central banks have
intervened in foreign-exchange markets about
as frequently under the new system as under
the Bretton Woods system. But has "managed
floating" decoupled interest rates? This depends
not on the amount of intervention per se, but
rather on the relative amount of intervention
in response to interest-rate variations under
the two different systems.
This article examines the impact of managed
floating on the relationship between U.S.
money-market conditions and short-term interest rates in.Belgium, Germany, Switzerland,
France, Canada, and the United Kingdom.
Our conclusion is that managed floating generally has severed short-run linkages between
U.S. and foreign interest rates. The reason
apparently has been reduced exchange-market
intervention in response to variations in interest rates, rather than larger offsetting domestic-monetary operations. Canada and the
United Kingdom are exceptions to this general
pattern, however, because of policies peculiar
to those two countries.

'Senior Economist, Federal Reserve Bank of San Francisco. Deborah Anderson and Steven Kamin provided research assistance for this article.

6

I. Interest Rates, Risk, and the Exchange Rate Regime
arises because of official restrictions on the
flow of capital, either current or prospective.
Prospects of such governmental restrictions
make securities issued in different political jurisdictions imperfect substitutes in the eyes of
international investors. Due to the imperfect
substitutability of the securities, an interestrate "differential" arises between U.S. and
foreign securities, even in the absence of any
risk of a change in the exchange rate.
The magnitude of this differential depends
upon a number of factors. Obviously the differential would change with any change in
investors' perceptions of comparative economic or political risk across countries. More
importantly, however, this interest-rate differential would vary with any change in the relative supplies of various countries' securities.
If, for example, investors are asked to hold
relatively more foreign securities, the foreign
interest rate would have to rise relative to the
U.S. interest rate, leading to a new differential. The change is necessary to make investors
content with the shift in the composition of
their security portfolios.

National interest rates can be linked in the
short run through the impact of international
capital flows on national money supplies. The
tightness of this linkage depends upon the substitutability of the financial assets of different
countries, which in turn is importantly influenced by the exchange-rate regime. In a completely fixed exchange-rate regime, and with
perfect substitutability of financial assets, national interest rates would be perfectly linked.
This case provides a useful point of departure for our analysis. l Consider the impact of
a decline in U.S. interest rates on foreign interest rates. First, lower interest rates in the
U.S. would encourage investors to buy foreign, rather than American, securities. As
investors try to obtain the necessary foreign
currency to effect these purchases, the dollar
value of foreign currencies would tend to increase. However, central-bank intervention to
maintain fixed exchange rates, through purchases of dollars and sales of foreign currency,
would expand foreign money supplies until
foreign interest rates fell to equality with U.S.
rates. 2 Thus a change in the U.S. interest rate
(ius) precipitates an equivalent change in the
foreign interest rate ( if), or

Exchange-rate risk

U.S. and foreign interest rates also may differ because of exchange-rate risk. This type of
risk enters the picture because an American
investor must (I) obtain foreign currency to
purchase a foreign security and then (2) convert the foreign funds obtained at that security's maturity back to dollars. If there is a risk
that the exchange rate will change during the
maturity period, then the American investor
is not assured of a fixed dollar return on 'his
investment. The investor can "cover" himself
against this eventuality, however, by contracting to redeem his foreign currency at the currently quoted dollar price of foreign exchange
in the forward market (F), while purchasing
the needed foreign funds at the spot dollar
price of the foreign currency (S).4
Market forces will work to equalize returns
"covered" for the risk of exchange-rate
changes, except for any differential due to

(1)

Of course assets are not perfectly substitutable in practice. But the higher the degree of
substitutability, the stronger may be the linkage of interest rates between countries. The
financial assets of different countries are imperfect substitutes because of (a) economic
and political risk, and (b) exchange-rate risk.
To understand the processes which link national interest rates in practice, it is necessary
to examine the influence of these factors.
Economic and political risk

Purely economic factors, such as the probability of default, influence the riskiness of financial assets. However, for short-term securities, economic risk is quantitatively less
important than political risk. 3 Political risk

7

economic and political risk. It can be shown
that, in equilibrium

pIing of U.S. and foreign interest rates. That
is, does a change in ius now primarily lead to
changes in fp and d rather than if? Under perfectly "clean" floating, we would expect the
money-supply channel that links interest rates
to be completely severed. 6 However, this question remains open, in view of the large amount
of official intervention in exchange markets in
the post-Bretton Woods system.
Secondly, how is foreign central-bank behavior responsible for decoupling interest
rates, assuming this has actually occurred? Interest rates could be decoupled either because
foreign central banks have decreased their exchange-market intervention in response to
U.S. interest-rate changes or because they
have increased "sterilization" actions designed
to remove foreign influences from their money
supply. Thus, it would be useful to devise an
empirical means of distinguishing between
these two approaches. The distribution of the
effect of a change in ius between changes in fp
and d will provide us with the necessary clue.

ius = if + fp + d,
(2)
where fp = ((F - S)/S)(t/contract period) is the
"forward premium" at an annual rate on a
foreign-exchange contract, and d is the differential due to economic and political risk. Since
d explains the differential between the U.S.
interest rate and the "covered" return on the
foreign security, it is called the "covered interest differential."5
Thus, in a world where exchange-rate risk
exists in addition to economic and political
risk, changes in the U.S. interest rate are distributed over three factors: the foreign interest
rate, the forward premium, and the covered
interest differential. That is,
ai us = ai f + afp + ad.
The questions raised in this paper concern
how changes in U.S. interest rates have been
distributed over these factors. The first is
whether managed floating has led to a decou-

II. Foreign Impact of Changes in the U.S. Interest Rate
and depressing its interest rate. It is also important to note that the foreign central bank
generally holds these additional dollar reserves
in interest-bearing form. Typically, the central
bank uses these dollars to purchase U.S. securities, thereby exchanging non-interest-bearing reserves for interest-bearing reserves. Thus
intervention increases the demand for U.S. securities while also increasing the foreign
money supply.
If the foreign central bank wishes to avoid
having its domestic monetary policy affected
by its intervention activity, it can "sterilize"
the effects of that activity by contracting the
domestic component of reserves by exactly as
much as the intervention has increased the foreign component of reserves. The central bank
accomplishes this by selling foreign securities
in its own domestic market - what we would
call open-market operations. This sops up the
undesired liquidity and "sterilizes" the effect
of the intervention. This action, however,
tends to increase the supply of foreign securities in world markets. 7
With this background in mind, the impact of

As we have just seen, changes in the U.S.
interest rate must affect either the foreign interest rate, the forward premium, or the covered interest differential. The most significant
factors determining the outcome are (1) the
extent of official intervention in the exchange
market and (2) the degree of sterilization of
reserve-flow effects on the foreign monetary
base. Before considering some examples, we
should examine what each of these factors involves.
A foreign central bank's official intervention
in exchange markets - that is, its "support of
the exchange rate" - involves spot-market
purchases or sales of currency. For example,
if the dollar price of a foreign currency tends
to rise above the level desired, the foreign
central bank could sell its currency and buy
dollars. Such actions would tend to drive its
currency's spot dollar price back down. Just as
importantly, however, such intervention causes
the foreign central bank's dollar holdings to
rise. Since these dollars represent a form of
reserves, the foreign economy's monetary base
expands, thereby expanding its money supply
8

changes in the U.S. interest rate can be explored under alternative scenarios of foreign
central-bank behavior. The relevant cases are:
(1) no official intervention; (2) support of the
exchange rate with sterilization; (3) support of
the exchange rate without sterilization. These
cases are best analyzed through the use of the
modern theory of forward exchange. s We limit
ourselves here to a heuristic analysis. The appendix demonstrates the conclusion rigorously
for the interested reader.

exchange rate from rising. Moreover, the sterilization action insulates the foreign money
supply and the foreign interest rate from the
impact. However, as noted above, the support
operation typically causes the foreign central
bank to acquire U.S. securities, while sterilization results in an official sale of foreign securities - making U.S. securities scarce relative to foreign securities in private markets.
Even without a change in investors' risk perceptions, this will cause a reduction in the covered interest differential, which allows the
change in relative supplies of securities to be
absorbed. In addition, as U.S. investors sell
foreign currency in the forward market to
cover their investments in foreign securities,
the price of forward exchange is driven down,
and the forward premium declines despite the
support of the spot rate.
Thus, in Case 2, the reduction in the U.S.
interest rate is absorbed by both a decline in
the forward premium and a decline in the covered interest differential.

Case 1: No official intervention
Consider the impact of a decline in the U.S.
interest rate when there is no attempt by the
foreign central bank to intervene in support of
its currency. First, without intervention, there
is no reason for foreign central-bank reserves
to change. Thus, the foreign money supply and
the foreign interest rate remain unaffected.
Second, without intervention there is no
change in the supplies of U.S. and foreign securities available to private investors - and
no reason for a change in investors' perception
of political and economic risk. Therefore, the
covered interest differential will not change
either.
It follows, then, that the decline in the U.S.
interest rate must only affect the forward premium on the foreign currency. U.S. investors,
eager to buy foreign securities, must buy foreign currency in the spot market and sell it in
the forward market. This bids up the spot exchange rate and bids down the forward rate on
the foreign currency, thereby depressing the
forward premium. The forward premium will
fall until covered returns are once more equal.
In Case 1, then, the entire reduction in the
U.S. interest rate is absorbed by a decline in
the forward premium.

Case 3: Exchange-rate support with no
sterilization
In this case, the effects of a decline in the
U.S. interest rate are spread over all three
factors. The forward premium changes for the
same reasons as in Case 2. The covered differential also changes in the same fashion because, once again, the foreign central bank's
support operations typically result in an increase in demand for U.S. securities, thereby
affecting the balance of supplies available to
private portfolios. But now the lack of sterilization causes the foreign money supply to be

Table 1
Impact of Dolus

Case 2: Exchange-rate support with
sterilization
In this case, the decline in the U.S. interest
rate puts upward pressure on spot foreign currency as U.S. investors buy foreign currency
as before. But the support operation keeps the

9

Case 1:

No official intervention

Doi us = Mp

Case 2:

Exchange rate supported
with complete
sterilization abroad

Doi us

Case 3:

Exchange rate supported
without sterilization
abroad

Doi us = Mp + Dod
+ Doi f

Mp

+ Dod

because official intervention ceased to be associated with changes in the U.S. interest rate
(Case 1) or because intervention was accompanied by complete sterilization (Case 2). If
lack of intervention were the sole cause of the
decoupling (Case 1), changes in the forward
premium should absorb all of the impact of
changes in U.S. interest rates. In contrast, if
complete sterilization were the sole cause
(Case 2), the impact should be felt in both the
forward premium and the covered interest differentiaP

affected by the support operation. This causes
the foreign interest rate to fall in sympathy
with the U.S. rate.
Case 3, then, is the only one in which the
foreign interest rate is affected.

Implications for empirical analysis
The above cases are summarized in Table 1.
We see that there are two ways in which interest rates could have become decoupled after
Bretton Woods. Decoupling could occur either

III. Measured Impact of Managed Floating on linkages
Between Interest Rates
In this section, we examine empirically the
impact of managed floating on the interest-rate
linkages for six industrialized countries. Our
methodology tests for the direct linkage of interest rates, allowing for two other factors that
may impinge upon foreign interest rates. 10
The first such factor is the cyclical variation
in the demand for money, and hence interest
rates, that occurs over the business cycle. To
measure this influence, we use as a proxy the
percentage deviation of industrial production
from its trend. l l Other things equal, when the
cyclical component of industrial production is
relatively high, the demand for money, and
hence the real interest rate, also tends to be
high. A second factor to consider is the inflation-expectations premium in interest rates. A
major part of the movement in foreign interest
rates can be attributed to variations in the inflation premium. 12 Unless we allow for such variations, measured changes in monetary effects
on interest rates might be spurious and simply
due to common inflationary trends.
The following equations relate U.S. interest
rates to comparable foreign interest rates: 13
if

= <l"

where

if = foreign interest rate,
fp = forward premium on the foreign
currency,
ius = U.S. interest rate,
D = dummy variable having a value
of one for the Bretton Woods
system and zero for the period of
managed floating,
= percentage deviation of indus.
trial production from trend,
CP = rate of change of the consumerprice index,
e = error term.

o

In equation (3), the foreign interest rate (if)
depends on domestic and foreign components
of the foreign monetary base, as well as the
foreign demand for money. The exchange rate
regime influences the components of the foreign
monetary base, and therefore the foreign
money supply. Variations in the foreign demand for money (relative to supply) are explained by cyclical variatio~s in output (0) and
inflationary expectations (CP). Expected inflation is measured by a (nine quarter) fourthdegree polynomial distributed lag on current
and past quarterly changes in the consumerprice index. The sum of the coefficients on this
distributed lag is expected to be positive, but
not necessarily equal to one, as would be true
in the long run in the absence of tax effects.
Equation (3) is used to test if managed floating has decoupled interest rates. A dummy
variable (D) having a value of one during the

+ aID + a2ius + a 3Di us + a4 0 +
(3)
i=O

(4)
i=O

10

of these same variables on the forward premium, provides evidence on the reason for a
decoupling of U.S. and foreign interest rates
under managed floating - assuming this has
actually occurred. If the major factor is a lack
of market intervention in response to U.S. interest-rate changes, the forward premium
would change by as much as the U.S. interest
rate, making the value of b 2 close to one. On
the other hand, if interest-rate linkages were
severed by complete sterilization, changes in
the U.S. interest rate would affect both the
forward premium and the covered interest dif-

fixed-exchange-rate period and zero otherwise
is included, both as a multiplicative term on
the U.S. interest rate and as a shift parameter
for the constant term. 14 If a2 is not significantly
different from zero, we may conclude that ius
and if have generally not moved together during the floating-rate period. The coefficient on
a3, on the other hand, registers the additional
impact attributable to the fixed-exchange-rate
regime, so that we would expect a3 to be positive if ius and if were more closely linked during that period.
Equation (4), which accounts for the impact

Table 2
Impact of U.S. Interest Rate on Foreign Interest Rates

and Forward Premiums on Foreign Currencies
8

•

8

if = ao + a1 D + a2 i US + a3 Di us + a4 Q + ~oa5+i cPt - i

Country

Dependent
Variable

fp

Estimated Coefficients of Independent Variables
8

a o or bo
Belgium

if
fp

Germany

if
fp

Switzerland

if
fp

France

if
fp

Canada

if
fp

United
Kingdom

if
fp

•

b o + b 1D + b2iUS + b 3Di us + b 4Q + l~ob5+i CPt-I

a 1 or b 1

a 2 or b2

a 3 or b3

a 4 or b4

8

i_taS+ i or i~obs+i

S.E.

Rho

Ow.

5.32
(1.64)*
-6.84
( -1.77)*

-1.92
( .662)
4.76
(1.67)*

.255
(1.15)
.973
(3.32)***

.178
.211
(2.27)**
(.545)
.550
.271
(-1.80)** ( -2.84)***

.348
(1.63)*
- .488
(- 2.72)***

1.56***
.657
(6.22)***
1.82***
1.452

-.973
( .150)
3.23
(1.05)

-6.71
( -1.60)*
-2.49
(- .760)

.181
(.960)
.748
(2.86)***

.508
(1.57)*
- .0734
(- .157)

.935
(1.53)*
1.58
( -3.44)***

9.14

1.79
(1.40)*
-1.10
(- .405)

-1.77
( -1.26)
4.50
(1.49)*

- .0385
(- .324)
1.01
(4.03)***

.456
.0801
(2.66)*** (2.02)**
-.924
.141
(-2.51)*** (-1.72)**

.465
(6.64)***
- .712
( -4.47)***

1. 78***
.560
(4.82)***
1.82***
1.112 .610
(5.50)***

12.5
-7.61
(4.44)*** (-2.85)**'
-12.0
8.81
(- 3.68)*'* (2.82)***

- .196
( 1.27)
1.21
(6.43)**'

.843
.0678
(3.10)*** (2.17)**
- .863
.0578
(-2.58)*** (-14.5)'

- .192
(- .820)
.158
(.588)

1.55***
.886
(13.1)***
1.34***
.884* .815
(9.66)*'*

.894
(.865)
-1.26
( -1.15)

.314
(- .160)
.368
(.178)

.652
(6.05)***
.480
(3.45)***

.0833
(.326)
- .188
(- .655)

.0297
(.427)
.00152
( .0178)

.390
(3.02)***
.346
( -2.51)***

.588

9.72
(2.07)*'
-10.7
( -1.51)*

-3.49
( .736)
8.42
(1.19)

.195
(.670)
.730
(1.53)*

.0501
(.108)
.713
(- .970

- .0741
(- .492)
.183
(.726)

-.0509
( .251)
.166
(.574)

.192
(2.16)**
-.211
( 1.67)*

.978

1.12**
.982
(36.8)***
1.74***
1.470 .548
(4.67)***
.533

.716

.770

1.54***
.712
(7.24)***
.549
1.82*'*
(4.69)*'*

2.14***
1.265 .884
(13.5)***
2.08***
2.013 .742
(7.92)***

t-statistics are in parentheses .
•• * indicates a coefficient that is significantly different from zero at the one-percent level on the basis of a single-tailed test.
•• indicates significance at the 5-percent level; and * signifies a lO-percent level of significance.
With respect to the Durbin-Watson statistic (D.W.), the absence of significant positive serial correlation in the residuals is
denoted by •• * at the 5-percent level and •• at the 2.5-percent level.

11

ferential, resulting in a value of b2 significantly
below one. IS
The coefficients on the "control" variables,
b 4 and b s in equation (4), are expected to be
nearly equal in absolute value to a4 and as in
equation (3), but opposite in sign. Changes in
the foreign de~and for money-as measured
by the Q and CP variables-would affect the
foreign interest rate, and this in turn would
produce opposite changes in the forward premium. The U.S. interest rate would not be
affected by such variations, because the U.S.
dollar was a reserve currency throughout the
periods of both fixed and floating exchange
rates.

lesser degree of foreign interest-rate dependence on U.S. rates does not depend on the
amount of intervention per se. Rather, it depends on the relative amount of intervention
under the two regimes, in response to variations in U.S. interest rates and associated incipient capital flows. Because the forward premium is seen to have changed, on average, by
just about the full amount of the change in the
U.S. interest rate (with hardly any change in
the implied covered interest-rate differential),
we infer that official intervention has ceased to
be associated with interest-sensitive movements of capital.
Interest-rate independence might also occur
if foreign central banks intervened to support
the exchange rate but fully sterilized the impact on foreign money supplies (Case 2). However, in that case the impact of the change in
the U.S. interest rate would be split between
a change in the forward premium and a change
in the covered differential between interest
rates. Under managed floating, the forward pre-

Belgium, Germany, Switzerland, and France
Estimates of these equations for a sample of
six industrialized countries, using ordinary
least squares and a first-degree Cochrane-Orcutt adjustment for serial correlation, are
shown in Table 2. The a z coefficient is not
significantly different from zero for Belgium,
Germany, Switzerland and France - which
suggests that under managed floating there was
no transmission of U.S. interest rates to those
countries' interest rates through direct monetary effects. Also, the b 2 coefficient is not significantly different from one, indicating that
with managed floating a change in the U.S. interest rate resulted in nearly an equal movement in the forward premium on the foreign
currency.
On average in these four countries, a 100basis-point change in the U.S. interest rate is
estimated to have produced a 99-basis-point
change in the forward premium on the foreign
currency, but only a 5-basis-point change in
the foreign interest rate, and also hardly any
change in the (implied) covered interest differential. This result corresponds most closely
to Case 1, in which there is no official intervention in the foreign-exchange market in response to incipient capital flows induced by differences in interest rates.
The overall magnitude of central-bank intervention has been about as large for these
four countries under managed floating as under
the Bretton Woods regime (Table 3).16 But
whether managed floating has brought about a

Table 3
Average of Absolute Values of Quarterly
Percent Changes in Official Reserves·
Bretton Woods Managed Floating

Belgium

2.50

4.05

Germany

8.35

3.62

Switzerland

3.32

5.00

France

5.17

6.83

Canada

4.39

6.37

United Kingdom

4.40

12.97

'Reserves are denominated in SDR's as tabulated in International Financial Statistics. Since world reserves have
been growing over time, this in itself would result in an
observed "use" of reserves. To correct for this trend effect,
percentage changes in world reserves were subtracted from
corresponding country figures. The formula used to measure the average absolute percentage change in quarterly
values of reserves is:
T

p:
i=l

/T)xlOO

The periods of fixed and managed floating correspond to
those used in estimating the interest-rate and forward-premium equations, as described in footnote 14. For a discussion of this and various alternative measures of intervention, see Suss (1976).

12

mium is estimated to have responded by approximately the full amount of a change in the
U.S. interest rate. Thus a lack of exchangemarket intervention in response to interest
rate variations, rather than sterilization, apparently accounted for most of the interestrate insulation for those countries under the
floating-rate regime. 17
In contrast, their insulation from the U.S.
interest rate was far less complete in the period
of fixed exchange rates. The estimated value
of a 3, the coefficient on the multiplicative
dummy variable in the interest-rate equation,
is positive in all cases, and significantly so in
all cases but one. Thus, the U.S. interest rate
significantly affected interest rates in these
countries during the Bretton Woods years. The
estimated value of b3, the coefficient on the
multiplicative dummy in the equations explaining the forward premium, is negative for all
these countries, and significantly so in all but
one case. Thus, the impact of U.S. interest
rates on the forward premium of these countries' currencies was significantly less during
the fixed exchange-rate period, as would be
expected in the case of stronger intervention
in response to interest-induced capital flows.
The four countries' results for the fixed-rate
period correspond most closely to Case 3. Our
estimated responses of foreign interest rates to
the U.S. interest rate, equal to the sums of the
a2 and a3 coefficients, are consistent with those
obtained by Herring and Marston (1977). On
average, we find that a 100-basis-point change
in the U.S. rate produced a 55-basis-point
change in the foreign interest rate. In Case 3,
the difference between the changes in U.S.
and foreign interest rates is split between
changes in the forward premium and the covered interest differential. We find the average
estimated response of the forward premium
for the fixed-rate period, equal to the sum of
the b 2 and b3 coefficients, to be 38 basis points.
The implied change in the covered interest
differential, obtained by subtracting the sum
of the above two values from one, is significantly smaller at 7 basis points.
The variables influencing the demand for
money have highly significant effects on for-

eign interest rates for these four countries,
which suggests the need to consider those variables when testing for the effect of managed
floating on the short-run interdependence of interest rates. In all four cases, the cyclical component of output has significantly positive effects on the foreign interest rate and significantly
negative impacts on the forward premium.
Similarly, except for France, the measure of
expected inflation significantly and equally affects the foreign interest rate and the forward
premium, but with opposite signs. The sum of
the coefficients on past inflation is generally less
than one, as would be anticipated in the shortrun when output and employment are variable.
Canada and the United Kingdom
Canada is an exception to this general pattern of money-market insulation from U.S. interest rates under the managed-float regime.
The estimated a2 coefficient indicates that a
change of 100 basis points in the U.S. shortterm interest rate affected the Canadian short
rate by about 65 basis points even during managed floating. The insignificance of the a3 coefficient indicates further that the impact of U.S.
on Canadian interest rates was not very different under a fixed exchange-rate system. Similarly, the impact on the forward premium is
estimated to have been about the same under
fixed and floating exchange rates.
Although the Canadian dollar was ostensibly freed to float on the foreign-exchange market in May 1970, the Bank of Canada continued to make the U.S.-Canadian dollar
exchange rate an important policy target, and
it viewed domestic monetary and fiscal policies
as primary instruments for achieving the desired exchange rate .18 However, the target
range for the Canadian dollar turned out to be
a relatively static one, which did not allow for
any significant movement in the exchange
rate. 19 After floating in 1970, the Canadian dollar appreciated immediately against the U.S.
dollar by about 10 percent, and then remained
in that range throughout most of the decade.
To maintain this exchange rate, Canadian authorities keyed nominal interest rates quite

13

closely to U.S. interest rates, continuing the
traditional interest differential in favor of Canada.
Another unique case is the United Kingdom, where interest rates apparently were
fully inslilated from U.S. interest rates during
both the fixed-rate and floating-rate regimes.
The estimated value of the a2 coefficient, measuring the impact of the U.S. interest rate on
the U.K. rate during the managed float, is not
significantly different from zero; and neither
is the value of the a3 coefficient that registers
the difference made by the fixed-exchange-rate
regime. 20
The absence of any observable transmission
may be explained by the existence in the
United Kingdom, as in the United States, of

a highly developed short-term market for
credit, which allows the authorities easily to
sterilize the impact of reserve flows on the
money supply and interest rates. Indeed, sterilization occurs almost automatically as a consequence of the normal operation of the British Government's Exchange Equalization
Account. When this Account purchases foreign exchange to support the exchange rate, it
obtains the necessary sterling by issuing Treasury bills to the public, thereby preventing a
new injection of bank reserves and deposits
into the monetary system. Similarly, when it
sells foreign exchange it uses the sterling proceeds to purchase a like amount of Treasury
bills from the market, thereby preventing a
contraction of bank reserves and a tightening
of credit-market conditions. 21

IV. Summary and Conclusions
Advocates of a system of flexible exchange
rates, such as the managed floating adopted in
1973, claim that it permits a greater independence of monetary policies by weakening linkages between national interest rates. Variations in U. S. interest rates affect international
capital flows, which in turn put pressure on exchange rates. When exchange rates are supported by central-bank intervention, as under
the Bretton Woods system, foreign money supplies are affected. Such changes in foreign
money supplies, unless they can be sterilized
by offsetting central-bank action, in turn impact on foreign interest rates.
Quantitatively, central-bank intervention in
exchange markets has been about as large under managed floating as under the Bretton
Woods system. Whether managed floating has
actually weakened interest-rate linkages therefore depends upon whether intervention now
offsets the effects on exchange rates induced
by interest-rate differentials to a lesser extent.
It also depends on the extent of utilization of
sterilization policies. This study has analyzed
the question by comparing the linkages between U.S. and foreign interest rates in six
industrialized countries under the two exchange-rate regimes.

Canada and the United Kingdom were atypical. In both countries, linkages to U.S. interest rates did not change significantly during the
two exchange-rate regimes, although for different reasons. In Canada, interest rates continued to be pegged to U.S. interest rates after
the shift to managed floating, simply as a matter
of policy. In contrast, the Bank of England was
both willing and able to prevent any linkage
between U.S. and U.K. interest rates by sterilization operations under both exchange-rate
regimes.
The more typical pattern was exhibited by
Belgium, Germany, Switzerland, and France.
For all four of these countries, U.S. interest
rates exerted a strong impact on foreign interest rates under the Bretton Woods system of
fixed exchange rates. A lOO-basis-point (one
percentage point) change in the U.S. shortterm interest rate, on average, produced a 55basis-point change in the comparable foreign
interest rate. The results for this period, thus,
conform most closely to Case 3 of our theoretical analysis, in which the exchange rate is
supported by central-bank intervention with
little or no sterilization. Case 3 is the only one
in which the foreign interest rate is affected.
In it the difference between the changes in
14

U.S. and foreign interest rates is split between
a change in the forward premium on the foreign currency and a change in the covered
interest differential.
Under the Bretton Woods system, a lOO-basis-point change in the U.S. interest rate produced, on average in these countries, a 38basis-point change in the forward premium required by the market to provide the forward
cover needed by investors. The average
change in the covered interest differential
needed to induce investors to move their capital internationally was much smaller, at only
7 basis points. These results indicate that: (1)
In the absence of exchange-rate risk, securities
in different national markets are fairly close
but not perfect substitutes for one another, and
(2) the elasticity of supply of forward cover to
investors was not very high even in the Bretton
Woods period, suggesting that the market required a significant risk premium for bearing
the risk of change in the exchange rate. 22
In contrast to the Bretton Woods years, during the period of managed floating a 100-basispoint change in the U.S. short-term interest
rate produced a 99-basis-point average change
for the four countries in the forward premium

on the foreign currency, but no significant
change in either the foreign interest rate or the
covered interest differential. These results for
the period of managed floating correspond to
Case 1 of our theoretical analysis, where monetary independence flows from an absence of
foreign-exchange market intervention by foreign central banks in response to a change in
the U.S. interest rate. Without such exchangemarket intervention, there can be no impact
on foreign money supplies and foreign interest
rates.
In the theoretical Case 2, the exchange rate
is supported in response to a change in the
U.S. interest rate, but monetary independence
flows from sterilization of the impact of international reserve flows on the foreign money
supply. In Case 2, both the covered interest
differential and the forward premium change
in response to a change in the U.S. interest
rate, while in Case 1 only the forward premium
is affected. The general absence of a significant
response of the covered interest differential to
the U.S. interest rate in the period of managed
floating suggests that sterilization policies were
not the main cause of the observed monetary
independence under this regime.

APPENDIX
Interest Arbitrage in the Modern Theory of Forward Exchange
The modern theory of forward exchange
recognizes that both covered-interest arbitragers and speculators are important forces in
determining the response of the foreign interest rate, the forward premium, and the covered interest differential to a change in the
U.S. rate of interest. As discussed in footnote
4, uncovered interest arbitrage can be decomposed into covered-interest arbitrage and speculative activity in the forward market, and
therefore does not have to be treated separately.
We abstract from growth and therefore focus
on short-run equilibrium at a point in time, in
which the total stock of private wealth and
supplies of U.S. and foreign securities are
given. Conditions of portfolio balance determine interest rates and the spot and forward

exchange rates. Figures 1 through 3 show the
supply and demand for the stock of forward
commitments in a foreign currency. The vertical axis measures the price of forward exchange, and the horizontal axis indicates the
stock of forward exchange either supplied or
demanded at a point in time. The spot price
of foreign exchange is initially equal to S in
the diagram. To simplify the analysis, we assume initially that the U.S. interest rate and
foreign interest rate are equal. We also assume
that, given this condition, tastes and portfolio
sizes are such that at a forward rate equal to
the spot rate, there is initially no supply of or
demand for forward exchange by investors
hedging against the risk of exchange-rate
changes.

15

exporters) constitute the other side of the forward market. For simplicity, we initially assume that the value of the future spot rate
expected by traders and speculators, ES, is
equal to the current spot rate, S. Unlike arbitragers, speculators and traders take positions with respect to exchange-rate risk ~
speculators outright and traders by not covering commercial commitments. When the forward rate rises above the expected future spot
rate, ES, speculators and traders will supply
foreign currency forward. Since both are to
some extent averse to risk, a higher forward
price of foreign currency, and hence a larger
risk premium, will be required to draw forth
a larger supply. Conversely, when the forward
rate falls below the expected future spot rate,
speculators and traders demand foreign currency forward. Thus, the amount of forward
exchange made available by speculators and
traders (S & T) is an increasing function of
price.

Arbitragers, who cover their investments
against exchange risk with contracts in the forward market, constitute one side of the market
for forward exchange. If the forward price of
foreign currency declines, given the current
spot rate, covered rates of return on U.S.-dollar-denominated securities exceed those on
foreign-currency-denominated securities; and
arbitragers demand foreign currency forward
to cover additional holdings of dollar-denominated assets. Conversely, if the price of forward exchange rises, assets denominated in
foreign currencies now become more attractive; and to achieve portfolio equilibrium arbitragers supply foreign currency forward.
Thus, the amount of forward exchange that
arbitragers wish to hold is a downward-sloping
schedule (AA). It is less than infinitely elastic,
because financial assets in different national
markets are imperfect substitutes even when
covered against exchange-rate risk.
Speculators and traders (i.e., importers and

Case 1: No Official Intervention

Figure 1

Figure 1 shows the effect of a change in the
U.S. interest rate with no official intervention
in the spot market. Under the conditions specified, the initial equilibrium price of forward
exchange is equal to the current spot rate, S.
Now suppose the U.S. interest rate falls because of either an increase in supply or a decrease in demand for money in the United
States. With the spot price of foreign exchange
initially at S, the arbitrage schedule shifts
down to A' by an amount equal to the decline
in the U.S. interest rate. This occurs because,
with a given demand by arbitragers for forward
exchange, the price of forward exchange must
fall by an amount equal to the decline in the
U.S. interest rate, leaving covered returns on
U.S. and foreign-currency-denominated assets
as before. At the intersection of the S&T and
A' schedules, arbitragers desire to shift Q10
assets from the United States to foreign financial markets. But this incipient capital outflow
puts upward pressure on the spot price of foreign exchange, which operates to shift the arbitrage schedule back up.

Transmission of U.S. Monetary Policy
with No Official Intervention
Price of Forward Exchange

S+T
_S'I

-S& ES
A & A"

A'

Q, 0

Supply of Forward
Foreign Currency
from Arbitragers and
Demand by
Speculators and
Traders

16

Demand for Forward
Foreign Currency by
Arbitragers and
Supply from
Speculators and
Traders

terms of the basic equation in the text. ~ius
impacts only on Mp (equals POP I ), and not at
all on ~d or ~if'
More realistically, if the future spot rate is
expected to rise, but by less than the change
in the current spot rate, the S&T schedule then
shifts up as well. However, the new equilibriuminvolving higher S&T and A schedules
would still intersect on the vertical axis and
generate the same discount on forward exchange as shown in Figure 1, but simply at
higher levels of spot and forward rates. Once
again, ~ius does not impact on ~d or ~if.23

For simplicity, we may assume that exchange-rate expectations are perfectly inelastic, so that speculators and traders expect an
unchanged spot rate to prevail in the future.
In that case, pressure in the spot market
pushes the spot exchange rate to S" until the
A' schedule returns to its old position. The
spot rate rises by an amount equal to the decline in the U.S. interest rate. The net result
is that, under a fully flexible exchange rate, the
discount on forward exchange becomes sufficiently large to offset the difference in interest
rates, preventing an actual capital outflow. In

Case 2: Exchange Rate Support With Complete Sterilization
Figure 2 shows the impact on the forwardexchange market of a decline in the U.S. interest rate when the exchange rate is supported, and when the foreign central bank
sterilizes the effects of international reserve
flows on its monetary base by offsetting operations. The decline in the U.S. interest rate
shifts the A schedule down to A' as before.
But now, because of central-bank support operations in the spot market for foreign exchange, the incipient capital outflow, 0 10, becomes an actuality. The upward pressure on
the spot price induces foreign central banks to
sell foreign exchange in order to maintain the
exchange rate. In addition, when the foreign
central bank sterilizes the effects of this operation on the foreign money supply, say, by
sales of securities in the foreign money market,
it prevents the foreign interest rate from faIling.
The net result for the foreign central bank
is an exchange of foreign securities for U.S.
securities. 010 of private capital can flow
abroad even in the short run, with the total
stock of wealth given, because an equal
amount of foreign official capital flows in the
opposite direction. The result in the forward
exchange market is an allocation of the impact
of ~ius on Mp (equals PoP I) and ~d (equals
P I P 2 ), depending upon the degree of substitutability of financial assets and the degree of
exchange-rate certainty. The greater the substitutability of financial assets in the absence
of exchange-rate risk, the greater is the elas-

ticity of the A schedule; and the greater the
certainty about future exchange rates, the
more elastic is the S&T schedule. If the A
schedule is elastic relative to the S&T schedule, as drawn, then ~ius mostly affects Mp, with
relatively little impact on ~d. The empirical
results in the text suggest that these relative

Figure 2
Transmission of U.S. Monetary Policy
with Supported Exchange Rate
and Complete Sterilization
Price of Forward Exchange

S+T

S & ES

A
A'

0,0

Supply of Forward
Foreign Currency
from Arbitragers and
Demand by
Speculators and
Traders
17

Demand for Forward
Foreign Currency by
Arbitragers and
Supply from
Speculators and
Traders

elasticities are indeed a realistic configuration.
But in any case, the forward premium changes
by less than the change in the U.S. interest

rate, which creates a change in the covered
interest differential, ad, inducing investors to
substitute foreign assets for U.S. assets.

Case 3: Exchange Rate Support Without Sterilization
Figure 3 shows the impact of a decline in
the U.S. interest rate when the exchange rate
is supported, but the foreign central bank does
not offset the effects of exchange-market intervention on its own money supply. The decline in the U.S. interest rate once again shifts
the A schedule down to A resulting in an
incipient capital outflow equal to 0 10. As arbitragers increase their (covered) investment
abroad, however, the foreign interest rate declines because of the increase in the foreign
money supply. The foreign central bank supports the exchange rate by purchasing an excess supply of dollars in the spot market and
investing these dollars in U.S. securities. The
arbitragers use the foreign currency that they
purchase from the foreign central bank to bid
up the price of foreign securities and reduce
the yield, until the original holders of the securities are willing to exchange them for the
newly created foreign money. But the decrease
in the foreign interest rate shifts the arbitrage
schedule to A" and consequently reduces the
size of the actual capital outflow to 0 20.
The outflow of private capital can occur even
in the short run, with the total stock of private
wealth given, because an equal amount of foreign official capital (the exchange of foreign
money for U. S. securities) flows in the opposite
direction. The relative impacts on afp (P OP 1)
and ad (P 1P2 ) depend upon the relative elasticities of the A and S&T schedules, with the
impact on Mp (POP 1) being greater if the A
schedule is relatively elastic, as drawn. Empirical results in the text for the Bretton Woods
period correspond most closely to this case.
They indicate the existence of a relatively inelastic schedule for the net forward commitments of speculators and traders, implying that
speculators and traders require a relatively
large risk premium in order to bear the risk of
exchange-rate changes. 24

Because national financial assets are not perfect substitutes, even in the absence of exchange-rate risk, the foreign interest rate does
not decline by as much as the U.S. interest
rate. Thus the arbitrage schedule does not shift
all the way from A'to A, but rather to an
intermediate position A" where a positive
covered interest differential, P1PZ , induces arbitragers to increase their holdings of foreign
assets. Because the increase in the covered
differential is less than in the case where the
monetary effects on the foreign economy are
sterilized, the size of the capital outflow, 0 2 0,
is less also.

I,

Figure 3
Transmission of U.S. Monetary Policy
with Supported Exchange Rate
But No Sterilization
Price of Forward Exchange

S+T

A
An

A'

0,020

Supply of Forward
Foreign Currency
from Arbitragers and
Demand by
Speculators and
Traders

18

Demand for Forward
Foreign Currency by
Arbitragers and
Supply from
Speculators and
Traders

FOOTNOTES
and foreign investors combined can be analyzed in terms
of the net amount of covered interest arbitrage and the
net size of the speculative positions undertaken by both.

1. This is an instance of perfect capital mobility internationally. The pioneering treatment of the effects of perfect
capital mobility under different exchange-rate regimes is
contained in a series of papers by Mundell (1968). More
recently, the assumption of perfect capital mobility has
become an important ingredient of the "global monetarist"
approach to international adjustment. See Whitman

We can easily demonstrate the equivalence of holding
foreign securities without the exchange risk being covered
in the forward market to the combination of holding foreign
securities with the exchange risk covered and a simultaneous and equal speculative holding of a forward contract.
Suppose an American investor has $1 to invest in foreign
securities of one year's maturity. Let Sl be the current
price of foreign exchange in the spot market, and S2 be
the price when the foreign security matures. Also let if be
the foreign interest rate and F equal the current price of
foreign exchange in the forward market. If the investor
does not cover his exchange risk by a transaction in the
forward market, the value of his investment in dollars at
maturity equals

(1975).

2. Since the U.S. dollar is a reserve currency, international capital flows normally have no impact on the U.S.
money supply. Dollar reserves purchased by foreign central banks in exchange-rate support operations are returned to circulation when they are invested in U.S.
money-market instruments. But in the case of adjustment
between two nonreserve-currency countries, reserve
flows woUld reduce the money supply and increase interest
rates in the home country (where interest rates had originally fallen) and produce opposite reactions abroad, until
interest levels at home and abroad were equalized.
Moreover, it would be impossible for foreign central banks
to sterilize the impact of capital flows on their money supplies and interest rates through offsetting policies when
financial assets are perfectly substitutable. If foreign central banks decrease the domestic component of their monetary bases by sales of securities in the open market, or
by other means, all that would occur is a one-for-one
substitution of the international reserve component for the
domestic component of the monetary base, as new capital
outflows from the United States were stimulated.

Alternatively, the American investor can hedge his investment against exchange risk by entering into a forward
contract to sell foreign currency to be received at maturity.
The value of his investment in dollars at maturity is

If at the same time he speculates in the forward market
by buying forward

3. Aliber (1973) has shown that securities issued in the

same political jurisdiction-such as Eurodollar and Euromark deposits in London-show nearly equal returns covered for exchange-rate risk. In contrast, covered returns
on securities originating in different countries differ from
one another to a larger extent, and also exhibit less covariation.

1
Sl

(1

+ if)

of foreign currency, he will make an additional gain or
loss. The gain or loss is equal to the dollar value in the
spot market of this amount of foreign currency, which he
gets by selling the proceeds from the forward contract,
less the dollar cost of buying this amount of foreign currency in the forward market.

Results similar to those of Aliber (1973) have been obtained by Frankel and Levich (1975) and Minot (1974).
Studies showing less than perfect integration among national capital markets, even on securities covered for exchange-rate risk, include those of Grubel (1966), Stoll
(1965), and Stein (1965).

The investor's gain or loss on his speculative activity is
therefore equal to:

4. The alternative-holding foreign securities without the
exchange risk being covered in the forward market-is
completely equivalent to holding foreign securities with
the exchange risk covered combined with a simultaneous
and equal speculative holding of a forward contract. Speculation in the forward market involves the acquisition of
contracts to bUy (sell) foreign exchange at some future
date in the hope that the future spot rate will be higher
(lower) than the current forward rate. When the contract
becomes due, the speculator sells (buys) foreign currency
in the spot market to discharge (obtain) the foreign exchange obtained (necessitated) by his forward contract.

1

Sl

(1

+ if)F

The total value in dollars of the covered interest-arbitrage
transaction plus the speculative transaction at the maturity
of the security is therefore:

This return is precisely the same as for the uncovered
interest-arbitrage transaction. Thus, uncovered interest
arbitrage can be decomposed into covered interest arbitrage and a simultaneous speculative position in the forward market; and there is therefore no need to treat it
separately.

Because of this equivalence, the portfolio equilibrium of
American investors can be analyzed completely in terms
of holdings of domestic securities, holdings of foreign securities with exchange risk covered in the foreign market,
and holdings of speculative positions in the market for
forward exchange. A similar analysis also holds for foreign
investors. Therefore, the portfolio position for American

5. The total covered return is actually only approximately
equal to if + fp. For example, the yield, at an annual rate,

19

exchange rates lies outside the scope of this study. However, for some partial evidence on this question, see Howard (1979).

from covered interest arbitrage on the 90-day securities
used in this study is:

7. A useful analysis of sterilization policies and their tendency to short-circuit the transmission mechanism is
found in Herring and Marson (1977, Ch. 2). Empirical work
in the Same volume, however, shows that sterilization was
not complete under Bretton Woods, leading to some interdependence between U.S. and foreign interest rates.
For more recent work on sterilization policies, see Hickman and Schleicher (1978) and Laney (1980).

The forward premium (fp), or percent gain (or loss if a
discount) on the spot and forward market transactions, at
an annual rate, is:

(F~S)X4

8. Expositions of the modern theory of forward exchange
include Argy and Hodjera (1973), especially section III;
Grubel(1966); and Stoll (1965).

Therefore, by substitution, the yield on covered interest
arbitrage reduces to:
fp+

9. The shift to managed floating could also affect the distribution Of effects between Mp and ~d under conditions of
exchange-rate support. But this effect is probably not
large. The split between ~fp and M when the exchange
rate is supported depends upon the substitutability between U.S. and foreign securities relative to the elasticity
of the supply of forward cover from speculators. The willingness of speculators to supply forward cover to interest
arbitragers depends importantly upon the degree of uncertainty about exchange rates. Even under the Bretton
Woods system, there was a substantial amount of exchange-rate risk. The spot rate was allowed to fluctuate by
± 1 percent around the official parity, and official parities
were sometimes changed. Indeed, a recent study by Farber, Roll, and Solnick (1977) concludes that exchange
rates were neither more nor less certain in the Bretton
Woods period. Although exchange-rate changes have occurred with greater frequency under the managed float,
such changes were larger and more unpredictable under
Bretton Woods. Thus, the elasticity of the speculator supply of forward cover may have been made neither more
nor less elastic by the shift to managed floating.

F .

S

If

But this is approximately the same as fp + if' since
normally has a value close to one.

F
S

6. As has been emphasized by Mundell (1968), even
under a perfectly clean float it is theoretically possible for
interest rates to be linked through money-demand effects,
rather than money-supply effects, if capital continues to
be highly mobile internationally. For example, with a decline in U.S. interest rates, capital tends to flow abroad and
produce an appreciation in the dollar values of foreign
currencies. This appreciation eventually reduces foreign
net exports (and strengthens U.S. net exports), contributing to a decline in aggregate demand and interest rates
abroad (and to opposite effects in the United States). In
the extreme case of perfect capital mobility, where capital
flows are infinitely sensitive to differences in nominal interest rates (despite the presence of exchange-rate risk),
these movements would continue until interest rates in the
United States and abroad were equalized.

Governmental controls over capital movements have been
the most important factor affecting substitutability between
domestic and foreign securities. Such controls have been
used under managed floating to help stabilize the exchange
rate and under the Bretton Woods system to affect reserves. It is not clear that either the incidence or threat of
capital controls has generally been any less under managed floating than before. Moreover, in neither case were
capital controls highly effective. So substitutability between domestic and foreign securities may not have been
importantly affected by the exchange rate-regime either.

However, Mundell's mechanism for the linking of nominal
interest rates under floating exchange rates is not likely to
be important in practice. First, in the short-run the trade
balance tends to respond perversely to changes in the
exchange rate. (For a summary of the evidence on this
point, see Goldstein and Young (1979).) This "J curve"
effect tends to drive interest rates apart initially, rather
than together, leading to further capital flows and exchange-rate movements until investors begin to take into
account an expected future reversal of exchange-rate
movements. Therefore, the response of foreign interest
rates to U.S. rates is not unidirectional. Secondly, over a
longer period differing inflation rates between the United
States and foreign countries produce differential inflation
premiums in interest rates, as well as exchange-rate
movements that tend to maintain approximate purchasingpower parity between currencies. Thus, expected changes
in exchange rates-corresponding to inflation differentials-tend to offset differences in nominal interest rates
attributable to inflation premiums, severing any systematic
response of capital flows to differences between nominal
interest rates. The mechanism that is supposed to drive
nominal interest rates together is therefore effectively destroyed. In other words, Mundell's argument has more
applicability to real rates of interest than to nominal ones.
The question of whether national real rates of interest
continue to be closely related under managed floating of

10. Previous empirical work on this question generally
has not allowed for the influence of such other factors. For
example, Logue, Salant, and Sweeney (1976) use factor
analysis to measure the degree of covariation in interest
rates among industrialized countries during the fixed exchange-rate period. They find that a single factor explains
a fairly high proportion of the covariation in interest rates
across countries. However, factor analysis sheds no light
on the causes of this common variation. It could be due
to events that have impinged more or less simultaneously
on all financial markets, such as common business-cycle
and inflation trends; or it may be the result of the transmission of interest-rate changes from one country to another
through money-supply channels.
White and Woodbury (1980) extend this type of analysis
to the floating-rate period, and find a significant reduction

20

in the covariation of interest rates associated with the shift
to managed floating. (The main body of their paper compares the covariation in covered interest rates between
the two periods, finding little change. But in footnote 10,
the analysis is applied to uncovered yields on a set of
financial assets in a manner similar to that used by Logue,
Salant, and Sweeney (1976). The result is a significant
reduction in the covariation of interest rates in the period
of managed floating). Since inflation differentials have widened and become more variable during the period of managed floating, and since nominal interest rates incorporate
inflationary premiums, such a result is not unexpected. But
this result does not necessarily imply a reduction in the
degree of short-run interdependence of interest rates operating directly through money-supply effects. It could be
caused merely by more variable inflation differentials, a
weaker degree of synchronization of national business
cycles, or a combination of the two.

revaluation during the fixed-rate period. Only in the case
of the U.K. did such a speculative dummy variable register
a significant effect, and then only for the quarter of the
1967 devaluation. Rather than entering a dummy variable
to help explain behavior for this one quarter, that observation was simply dropped from the U.K. sample.
15. It might be objected that with an infinite elasticity of
interest arbitrage with respect to the covered interest differential, Ad would equal zero; and Afp, and therefore b2 ,
would equal one in this case also. But to anticipate the
empirical results, the evidence for the Bretton Woods period indicates that Ad is smaller than Mp when exchange
rates are supported, but that it is still large enough to
distinguish between the two hypotheses. If it could be
assumed that the Bretton Woods period constituted a pure
combination of Cases 2 and 3, then the evidence from the
period would suggest that if interest rates had been completely decoupled under managed floating solely because
of complete sterilization (Case 2), Afp, and hence b2, would
equal only .84 on average. But, since the Bretton Woods
period contains an admixture of Case 1, due to floating of
the exchange rate between intervention points, this estimate of .84 is really only an upper bound; and we would
expect the observed value of b 2 to be lower than that if
there were complete sterilization.

11. The trend level of industrial production was calculated
recursively by multiplying last quarter's trend level by the
actual rate of growth over the previous 20 quarters. Thus,
the trend in period t of industrial production is:

P,

=

PH (1 + R,) where R, = '\! P,IP'n 20 -1,

and

P,

=

P,

16. Since exchange-rate variability has indeed increased
very significantly under managed floating, this may at first
seem surprising. But shocks to the system, particularly
those associated with the oil crisis, may well have been
larger in the period of managed floating. In addition, the
view that there is necessarily a trade-off between exchange-rate changes and reserve changes rests on assumptions that 1) speculative behavior in the foreign-exchange market is independent of the exchange-rate
regime, and 2) the exchange market is stable in the shortto medium-run. Neither assumption is necessarily tenable.
For stability to occur, the excess demand for foreign exchange must fall (rise) as the exchange rate rises (falls).
But "J curve" effects on the current account assure that
this will not be true in the short run unless speculation is
stabilizing within the relevant range. With a locally unstable market, movements in the exchange rate increase the
size of any gap between the demand and supply for foreign currency, increasing the use of reserves for authorities who intervene in order to resist such exchange-rate
fluctuations. For a detailed treatment of these points, see
Williamson (1976).

for the first observation. The source of the quarterly data
on industrial production was the IMF's International Financial Statistics.
12. Recent work in this area suggests that, in the postWorld War II period, inflationary expectations generally
have adjusted relatively rapidly to inflation actually experienced. In the United States, for example, inflation expected
by money-market participants appears to be mainly a
function of actual inflation over the previous eight quarters.
A similar formulation is used here to account for the variation in expected inflation, and hence inflation premiums, in
foreign interest rates. A representative study for the United
States is Yohe and Karnosky (1969). The consumer-price
index was used as the measure of inflation, and the source
of quarterly changes in this index was the IMF's International Financial Statistics.
13. The interest rates used are 3-month representative
money-market rates for all countries except Switzerland,
where the bank time-deposit rate is used instead. Quarterly averages were calculated from end-of-month data.
The data source is Morgan Guaranty Trust's World Financial Markets. The 3-month forward premium was calculated on an annual-rate basis as a quarterly average
from end-of-month data on spot and forward rates, as
compiled by the International Monetary Fund. The data
were obtained from the Chase Econometrics data bank
covering various issues of the IMF's International Financial Statistics.

17. Thus, a 100 basis-point change in the U.S. interest
rate, on average, actually produced a 99 basis-point
change in the forward premium on the foreign currency
under managed floating, compared to the less than 84
basis-point change that likely would have resulted from
the Case 2 model of complete sterilization (see footnote
15). These point estimates strongly suggest that the insulation of these foreign interest rates under managed
floating was mainly due to an absence of exchange-market
intervention in response to changes in the U.S. interest
rate. However, the standard errors of the estimated coefficients are not low enough to allow one to reject with a
high degree of certainty the alternative hypothesis of complete sterilization.

14. For all countries in the sample except Canada, the
fixed exchange-rate period is 1966-1 through 1971-1, and
the period covering the managed float is 1973-111 through
1978-1V. Canada floated earlier, and its respective periods
are 1966-1 through 1970-1 and 1970-111 through 1978-1V.
We experimented with additional dummy variables to account for variations in the forward premium and foreign
interest rates caused by expectations of devaluation or

18. The Annual Report of the Bank of Canada (1970, p.
9) clearly states this orientation:

21

that might affect the expected future spot rate, ES. But
since a major part of the movement in U.S. interest rates
during the period examined can be attributed to variations
in inflationary premiums, we should consider the case of a
decline in the nominal U.S. interest rate that is due to
lower inflationary expectations. However, the distribution of
this impact of ~ius on Mp, ~d, and ~if when there is no
official spot-market intervention turns out to be the same
as when the change in the U.S. interest rate is due to a
change in the real rate.

The exchange rate is a very important price in
a country that trades with the outside world on
the scale that Canada does.... It is not therefore possible to ignore it, even when it floats.
Public financial management must continue to
be concerned that the exchange rate is broadly
suitable to the development of Canada's international trade, and compatible with the desired
structure of our balance of payments, in particular the size of the balance on current account.
It is therefore still necessary to seek a mix of
fiscal and monetary policy which encourages
levels of interest rates in Canada that are consistent with the exchange rate staying within a
suitable range.

If the U.S. interest rate declines because of lower inflationary expectations, in a situation (such as managed
floating) where there are no official parities for the spot
rate, speculators and traders might expect the future spot
rate to fall according to the well known principle of purchasing-power parity. In Figure 1, the initial downward
shift in the A schedule would be accompanied by an equal
downward shift in the S + T schedule (due to the change
in the expected spot rate, ES). The new equilibrium would
occur at the same quantity as initially (at 0); and ~fp would
be equal to ~ius' leaving no impact on ~d or ~if - as is
also true in the case of a "real" rate decline.

19. For more extended treatments of this point, see Pesandra and Smith (1973) and Courchene (1976). Toward
the end of 1975, the Bank of Canada announced an apparently radical change in monetary policy. Instead of interest rates, the focus of policy henceforth would be the
behavior of a monetary aggregate; and policy would be
geared to a gradual lowering of the inflation rate. But in
practice, interest rates were chosen as the policy instrument for controlling money, and on certain occasions were
explicitly used to defend the exchange rate. The econometric results presented here suggest that actual policy
remained much the same, despite the change in rhetoric.
See also Howitt and Laidler (1980).

However, two differences can be cited. When the U.S.
interest rate declines purely because of lower inflationary
expectations, the decline in the forward premium is produced solely by a decline in the forward rate, with the spot
rate given. Whereas when that decline is a "real" change,
the reduction in the forward premium tends to be produced
by an increase in the spot rate. Secondly, when the decline
in the U.S. interest rate is only nominal, arbitragers have
no incentive to move their capital abroad. But with a "real"
decline in the U.S. interest rate, there is an incipient capital
outflow, which then turns the forward premium against arbitragers. Nevertheless, no matter which kind of change
occurs in the U.S. interest rate, an equal change in the
forward premium indicates a lack of official intervention in
the spot market.

20. In contrast, the estimated coefficient on the multiplicative dummy variable, b3 , though not significantly different from zero, is about equal in magnitude but opposite
in sign to the estimated response, b2, of the forward premium to the U.S. interest rate in the period of managed
floating. This suggests a smaller impact on the forward
premium under fixed exchange rates. However, the reason in this case is different than it is for the other four
countries. The explanation apparently is the heavy intervention in the forward exchange market undertaken by
the Bank of England early in the fixed exchange-rate period, rather than an increased response of the U.K. interest
rate to the U.S. interest rate. The fact that the forward rate
was supported by the Bank of England over only a portion
of our fixed exchange-rate period (up until the 1967 devaluation) likely accounts for the lack of statistical significance in the observed shift in the impact of the U.S.
interest rate on the forward premium. Chalmers (1971)
provides a collection of papers detailing this period of
forward-exchange intervention by the Bank of England.

24. If the decline in the U.S. interest rate were due to
lower inflationary expectations, the S + T schedule might
shift downward as described in footnote 23, to reflect a
decline in the expected future spot rate based on purchasing-power parity. Then the relative impacts on ~fp and
M would no longer be determined soley by the relative
elasticities of the A and S + T schedules.. However, this
probably did not occur to any significant extent in the
Bretton Woods period.
To be sure, changes in the U.S. interest rate were partly
only nominal, and not "real". But it is unlikely that changes
in the inflation premium in U.S. interest rates were significantly associated with concurrent changes in expected
future spot rates under the Bretton Woods system. For in
that system, anticipations of speculators and traders were
conditioned more by the likelihood of imminent changes
in official parities, which in turn depended on such things
as the size of international reserve holdings and political
factors, than by current changes in purchasing-power parity. Consequently, the relative impacts on ~fp and~d estimated for the Bretton Woods period would appear to be
indicative of the actual relative elasticities of the A and
S + T schedules.

21. Hodgman (1974, p. 173) describes the operation of
the Exchange Equalization account.
22. Another recent attempt at measuring risk premiums
in the forward exchange market is Stockman (1978). His
findings suggest that significant risk premiums exist for
those taking open positions, but that they are probably not
constant. This result is consistent with both the modern
theory of forward exchange outlined in the appendix and
our empirical results. See also Froewiss (1977).
23. The above analysis assumes that the decline in the
U.S. interest rate is a change in the "real" rate, and is
unaccompanied by a change in inflationary expectations

22

REFERENCES
Aliber, Robert Z. "The Interest Parity Theorem: A Reinter·
pretation," Journal of Political Economy, Novem·
ber/December 1973, pp. 1451-1459.

Laney, Leroy O. "More Flexible Exchange Rates: Have
They Insulated National Monetary Policy?" Voice of
the Federal Reserve Bank of Dallas, February

Argy, Victor and Hodjera, Zoran. "Financial Integration
and Interest Rate linkages in Industrial Countries,
1958-71," International Monetary Fund Staff Papers, March 1973, pp. 1-77.

1980, pp. 6-18.
Logue, Dennis E.; Salant, Michael A.; and Sweeney, Rich·
ard James. "International Integration of Financial
Markets: Survey, Synthesis, and Results," in Carl H.
Stem, John J. Makin, and Dennis E. Logue, Eurocurrencies and the International Monetary System, Washington: American Enterprise Institute for
Public Policy Research, 1976, pp. 91-138.

Bank of Canada, Annual Report, 1970.
Chalmers, E. B. (ed.). Forward Exchange Intervention,
London: Hutchison Educational, 1971.
Courchene, Thomas J. Money, Inflation, and the Bank of
Canada: An Analysis of Canadian Monetary Policy from 1970 to Early 1975, Montreal: C.D. Howe
Research Institute, 1976.
Farber, Andre L.; Roll, Richard; and Solnik, Bruno. "An
Empirical StUdy of Exchange Risk Under Fixed and
Flexible Exchange Rates," Operations Financieres,
Documents, Brussels, 1977, pp. 63-96.
Frenkel, Jacob A. and Levich, Richard M. "Covered Interest Arbitrage: Unexploited Profits?" Journal of
Political Economy, April 1975, pp. 325-338.
Froewiss, Kenneth. "Risk Premiums in the International
Securities Markets: The Canadian·U.S. Experience,"
Federal Reserve Bank of San Francisco Economic
Review (Summer 1977).

Minot, Winthrop G. "Tests for Integration Between Major
Western European Capital Markets," Oxford Economic Papers, November 1974, pp. 424-439.
Mundell, Robert A. International Economics, New York:
The Macmillian Co., 1968.
Pesandro, James E. and Smith, Lawrence B. "Monetary
Policy in Canada," in Karel Holbrik (ed.), Monetary
Policy in lINelve Industrial Countries, Federal Reserve Bank of Boston, 1973.
Stein, Jerome. "The Forward Rate and Interest Parity,"
Review of Economic Studies, April 1965, pp. 113126.
Stockman, Alan C. "Risk, Information, and Forward Exchange Rates," in Jacob A. Frenkel and Harry G.
Johnson (eds.), The Economics of Exchange
Rates: Selected Studies, Reading, Mass.: AddisonWesley Publishing Co., 1978.

Goldstein, Morris and Young, John H. "Exchange Rate
Policy: Some Current Issues," Finance and Development, March 1979, pp. 7-10.

Stoll, Hans R. "An Empirical Study of the Forward Exchange Market Under Fixed and Flexible Rate Systems," Canadian Journal of Economics, April
1965, pp. 55-78.

Grubel, Herbert G. Forward Exchange, Speculation and
the International Flow of Capital, Stanford: Stan·
ford University Press, 1966.
Herring, Richard J. and Marston, Richard C. National
Monetary Policies and International Financial
Markets, Amsterdam: North Holland Publishing Co.,
1977.

Suss, Esther C. "A Note on Reserve Use Under Alternative Exchange Rate Regimes," International Monetary Fund Staff Papers, July 1976, pp. 387-394.
White, Betsy Buttrell and WoodbUry, III, John R. "Ex·
change Rate Systems and International Capital Market Integration," Journal of Money, Credit, and
Banking (forthcoming, 1980).

Hickman, Bert G. and Schleicher, Stefan. "The Interdependence of National Economics and the Synchro·
nization of Economic Fluctuations: Evidence from the
LINK Project," Weltwirtschaftliches Archiv, Voli.
114, Heft 4, 1978, pp. 642-708.

Whitman, Marina V.N. "Global Monetarism and the Mon·
etary Approach to the Balance of Payments," Brookings Papers on Economic Activity, 1975, No.3,
pp. 491-555.

Hodgman, Donald R. National Monetary Policies and
International Monetary Cooperation, Boston: lit·
tie, Brown and Co., 1974.

Williamson, John. "Exchange Rate Flexibility and Reserve
Use," Scandinavian Journal of Economics, Vol.
78, No.2, 1976, pp.327-339.

Howard, David H. "The Real Rate of Interest in International Financial Markets," International Finance Discussion Paper, No. 136, Board of Governors of the
Federal Reserve System, April 1979.

Yohe, William P. and Karnosky, Dennis S. "Interest Rates
and Price Level Changes," Federal Reserve Bank of
St. Louis Review, December 1969, pp. 19-36.'

Howitt, Peter and Laidler, David. "Recent Canadian Monetary Policy: A Critique," in Measuring Monetary
Aggregates, A Compendium of Views Prepared by
the Subcommittee on Domestic Monetary Policy of
the Committee on Banking, Finance, and Urban Affairs, House of Representatives, 96th Congress,
Second Session, 1980, pp. 174-203.

23

Charles Pigott*
Over the last five years, Japan has succeeded
in reducing her inflation rate to a degree that,
from an American perspective, can only seem
enviable. In 1974, Japanese consumer prices
rose by nearly 25 percent. By 1978, CPI inflation had declined to 3 percent, and, despite
sharp oil price increases, remained below 5
percent for 1979 as a whole. Japan's success in
reducing inflation is all the more remarkable in
view of its experience with two factors widely
blamed for U.S. inflation: oil price increases
and government budget deficits. Japan is substantially more dependent upon foreign oil
than is the U. S., and so should have suffered
more inflation from OPEC price increases.
Moreover, Japan's budget deficit as a fraction
of its GNP has been nearly twice the U.S. ratio
since 1976.
Japan's real growth and unemployment performance over the last five years has been far
less enviable than her inflation experience. Between 1965 and 1972, Japan's real GNP grew
at a lOYz-percent annual rate. After 1975, real
growth averaged less than 6 percent, and in no
year has it substantially exceeded that figure.
Japan's unemployment rate-always remarkably low compared to other industrial countries-rose to nearly twice the 1965-72 average
in the second half of the 1970's.
This paper reviews Japan's experience in reducing inflation, and examines several issues
raised by it that are potentially applicable to
other countries. Section I considers the factors
accounting for the rise and fall of Japanese
inflation over the 1973-78 period. We found that
the 1973-74 surge in import prices, and in particular the 1974 oil price hike, was a major but

not the most important factor behind the upsurge in inflation. Instead, variations in Japan's
money growth were the single most important
factor in the 1973-74 rise in inflation, and in its
subsequent abatement over the next four
years.
Japan's experience is perhaps most interesting for what it reveals about the costs of reducing inflation. According to a common view,
lowering inflation necessarily entails a very substantial and prolonged cost in terms of reduced
real growth and higher unemployment. Japan's performance would at first seem to confirm that this cost is indeed very high and protracted, judging from both the severity of the
1974 recession and the exceptionally sluggish
recovery that followed. The evidence cited in
Section II suggests that Japan's attempts to
reduce inflation through reduced money growth
substantially aggravated the 1974 recession.
However, it also suggests that the continuation
of slow money growth may not have been primarily responsible for the sluggishness of the
recovery. Instead, real growth may have
lagged largely because of the undermining of
investor confidence by the previous inflation and
the ensuing recession. If this is so, the cost of
reducing Japan's inflation, while high, was not
as great as simple comparisons of its actual
and pre-1973 performances might suggest.
Taken as a whole, Japan's experience thus
suggests two lessons relevant for the U.S. and
other industrial countries. First, lowering
money growth can bring inflation down within
several years' time. Second, other factors besides reduced money growth may produce periods of reduced real GNP growth, such as
Japan experienced after 1973; the cost, that is,
of reducing inflation in Japan was high, but not

*Economist, Federal Reserve Bank of San Francisco.
David Parsley provided research assistance for this article.

24

also have wider significance. Further analysis
of Japan's experience thus may define additional lessons of use to other industrial economies.

so high as might appear at first. Other aspects
of Japan's experience noted below-such as
her ability to reduce money growth in the face
of very large government budget deficits-may

I. Rise and Fall of Inflation
rising at double-digit levels in that and the
following year. Over that two-year period, the
GNP price deflator increased by nearly 40 percent, compared with the II-percent increase
experienced over a typical two-year period
during the 1960's. Increases in consumer and
wholesale prices were even more dramatic, reflecting sharp increases in the prices of Japanese
imports relative to non-traded goods and services.
Then, following Japan's first decline in real
GNP in nearly twenty years, inflation abated
nearly as fast as it had arisen. By 1975, inflation measured by the GNP deflator was virtually
back to the 1960's average, although consumer
price inflation remained high by historical standards through 1976. Inflation decelerated further during 1977 and 1978, with wholesale
prices actually falling over that period. Thus
the lessons drawn from Japan's inflation performance of the 1973-78 period are likely to be
very important for other countries: no other
major industrial country experienced a sharper
surge in inflation during 1973-74, and none was
as successful as Japan in reducing inflation
thereafter. I What then accounted for the rise
and fall of Japan's inflation?
Inflation, both in Japan and elsewhere, is
often attributed to a variety of factors. The
most prominent "candidates" include high
government-expenditure levels and budget
deficits, wage increases in excess of productivity gains, exchange-rate depreciations and/or
import-price increases, and money-supply
growth. As it happens, the list of factors substantially affecting Japan's inflation can be easily narrowed to the latter two.
Neither the government budget deficit nor
accelerating government expenditures can
plausibly be blamed for Japan's 1973-74 inflation surge. During the late 1960's, Japan's
budget deficits were relatively modest, averaging about one percent of her GNP. The def-

Economists generally agree that variations
in average long-run inflation are nearly always
caused by changes in domestic money growth.
There are disagreements, however, about the
impact of money growth on medium-term fluctuations in inflation, over periods of several
years or so. According to one view, other factors-such as government budget deficits or
imported-goods price changes-cannot have
more than a small and temporary effect upon
the level of domestic prices unless they are
'accommodated' by changes in the domestic
money stock .....J\.ccording to an alternative vie\v,

such 'non-monetary' factors can independently
and significantly affect inflation for a considerable time-although, because they tend to be
sporadic and reversible, their influence diminishes with the lengthening of the time horizon.
The first view implies that a policy of steady
money growth will alleviate all but relatively
small fluctuations in inflation; the second suggests
that substantial variability in inflation may remain even after money growth is stabilized.
During the last seven years, prices in Japan
(as in other countries) have been buffeted to
an unusual degree by external shocks largely
unrelated to her domestic money growth.
These included the commodity-price increases
of 1973-74, as well as the sharp exchange-rate
fluctuations (appreciation and then depreciation) of the 1977-79 period. For this reason,
it is worthwhile examining the sources of Japanese inflation to find an indication of the extent
to which factors other than domestic money
growth can affect inflation. As explained below,
money was in fact the main factor accounting
for the rise and fall of Japanese inflation, but
traded goods' prices played a significant role
as well.
Waxing & Waning of Inflation

Beginning in 1973, Japan experienced its
worst inflation since the early 1950's, with prices

25

declining. Japan in 1977 and 1978 managed to
keep inflation at or below the 1960's average,
while incurring a budget deficit whose size (relative to GNP) was easily the largest of any
major industrial country. Government fiscal
policy, therefore, was probably not a major
factor in Japan's inflation over this period. 2
Likewise, it is very doubtful that 'excessive'
wage increases led to the 1973-74 inflation.

icits then increased in 1972 and 1973 to about
1V2 percent of GNP, but were still quite comparable to those in the U.S., where inflation
was only about half as great as in Japan. Meanwhile, government expenditures as a fraction
of GNP also remained relatively stable during
the early 1970's. Indeed, Japan's budget deficit
and government expenditures did not rise substantially until after 1975, when inflation was

Table 1
Basic Data Sheet for Japan 1
1962-70
Average

1971

1972

1973

1974

1975

1976

1977

1978

1979

GNP Growth Rate (%)
Nominal GNP
Real GNP

17.2
11.4

8.0
4.3

17.6
11.9

23.2
6.2

18.0
-1.5

8.4
3.4

10.9
5.0

11.2
5.8

9.8
6.1

7.0
6.0

Inflation Rate (%)
Consumer
Wholesale
GNP Deflator
Wage Rate

5.8
1.7
5.2
12.1

5.5
1.0
3.7
13.9

4.6
4.0
5.7
16.5

16.5
24.0
15.5
19.5

24.5
23.3
18.3
26.1

8.5
0.7
5.0
13.4

9.4
6.1
5.9
11.3

6.2
-1.0
5.4
9.3

3.1
3.2
3.7
5.3

4.9
16:0
1.0
6.0

Money Supply Growth (%)
M P
M-25

17.1
17.4

29.9
24.4

25.0
24.8

17.1
16.8

11.8
11.5

11.1
14.4

12.5
13.6

8.2
11.1

13.4
13.1

3.0
8.4

Change in Exchange Rate (%)
Dollar Exchange Rate
Trade-Weighted Rate'
Real Exchange Rate 6

0
na
na

13.6
na
3.7

4.2
11.8
6.6

7.8
7.6
10.8

-7.0
1.4
-6.4
3.2
2.3 -12.0

4.2
3.6
3.8

22.0
10.6
3.4

23.3
24.2
11.6

18.9
6.7
11.6

Government Deficit/GNP (%)

1.3

0.2

1.6

1.6

1.3

4.4

2.0

6.1

6.5

5.3

Foreign Exchange Reserves
($ billion)

1.8

13.8

16.5

10.2

11.3

10.6

13.9

20.1

28.91

Change in Unit Labor Costs (%)

1.7

10.7

2.6

6.0

41.0

9.1

-4.2

4.1

-4.9

Unemployment Rate (%)

1.3

1.2

1.4

1.3

1.4

1.9

2.0

2.0

2.2

2.1

Average Output G ap3 (%)

1.2

3.0

5.8

0.1

-8.4

24.5

19.2 -19.9

18.6

15.4

3.02

JAil growth rates are computed fourth-quarter-over-fourth-quarter unless otherwise indicated.
2Figure refers to 1979.3/1978.3.
3The output gap is defined as the percentage difference between actual and potential industrial output. Data are taken
directly from Artus (1978) for 1960-77, and then estimated using his potential-output figures and industrial-production
series from International Financial Statistics for 1978-79.
'The trade-weighted exchange rate is an average of the value of the dollar against foreign currencies taken from
International Financial Statistics; the 'real' exchange rate is a trade-weighted average of the dollar-denominated
wholesale prices of Japan relative to those of her competitors (Source: IFS).
Sfigures are year-end over year-end; for 1979, considerable distortion exists due to year-end window dressing or some
other factor. The average M-l level in December 1979 was about 9 percent higher than the average of December 1978.
6'fhe 'real' exchange rate is a trade-weighted average of the dollar-denominated wholesale prices of Japan relative to
those of her competitors (Source: IFS). The figures in the table are percentage changes in yearly averages. For 1977,
1978, and 1979, the fourth-quarter over fourth-quarter percentage changes are 8.1%, 9.6%, and -22.0% respectively.

26

yen did not change appreciably over the period
as a whole. Instead, the general rise in Japan's
traded-goods prices can be traced to conditions
prevailing in world markets--eonditions which
were largely external to Japan's economy.
Probably the most important of these was a
general acceleration in money growth in the
industrial countries, which led to a sharp rise
in world aggregate demand. In addition, supply shortages, low inventory levels, and other
'special' factors led to severe rises in prices of
key raw materials, the most spectacular of
which was the early-1974 four-fold increase in
the price of oil. 4 These increases accounted for
a nearly 30-percent decline in Japan's termsof-trade (the price of her exports relative to
her imports), and represented a substantial
loss of real income to her citizens.
There was, however, another potential cause
of the price upsurge-the 1971-72 acceleration
in money growth. Over that two-year period
as a whole, M-1 rose by 62 percent and M-2
by 55 percent. (M-1 includes currency plus
commercial-bank demand deposits, and M-2
includes the same plus time deposits.) These
increases were at least half again as large as
the average increases of the 1960's. Most of
the acceleration stemmed from Japan's massive purchases of dollars, undertaken in an
effort to stabilize the foreign-exchange value
of the yen, which accompanied the December
1971 devaluation of the dollar. These purchases swelled domestic bank reserves, allowing the subsequent sharp increase in bank deposits. Despite this, the increase in money
growth cannot meaningfully be termed 'imported.' After 1971, Japan was subject to no
international obligation to maintain the pre1971 foreign-exchange value of the yen. Moreover, this rise in money growth in response to
dollar purchases can be traced largely to a
deliberate policy choice of the authorities; six
years later, equally massive purchases of dollars did not lead to any significant acceleration
in money growth. s
Despite the unusually rapid growth in
money during 1971 and 1972, Japan's prices
did not begin to accelerate until 1973. This
delay in money's impact is not unusual; be-

During the 1960's, Japanese wages typically
increased at more than twice the general inflation rate. This pattern reflected rapid advances
in productivity, as the increase in unit labor
costs was very modest. Unit labor costs accelerated in 1971 in line with that year's cyclical
downturn, but then decelerated again in 1972.
Thus the 1973-74 surge in prices was not preceded by wage increases large enough to account for the ensuing inflation. And the sharp
1973-74 increases in wage rates are, for reasons cited below, most plausibly regarded as
symptoms ofinflationary pressures generated by
other factors.
In fact, only money growth and sharp import-price increases were large enough to have
led to an acceleration in inflation of the magnitude observed. And, aside from money
growth, only the yen's sharp 1977-78 appreciation could have contributed substantially to
the ebbing of inflation after 1974. The question
now is, what was the relative importance of
each of these in Japan's inflation?
Was Inflation Imported?
The obvious interdependence among national economies revealed by the events of the
1970's has led to increased concern that a
country may 'import' price increases from
abroad to the detriment of its anti-inflationary
policies at home. Much of this concern originates in the 1973-74 period, when a sharp runup in world commodity prices was associated
with an inflation surge in all industrial countries,
not simply in Japan. These extraordinary commodity price rises accounted for perhaps as
much as half of the acceleration in U.S. inflation in that period. 3 Since Japan is even more
dependent than the U.S. upon international
trade, it is reasonable to ask if her 1973-74
inflation was largely imported.
Certainly, the increase in prices of Japan's
traded goods was spectacular. During that twoyear period, the average price of Japan's imports of goods and services rose by 87 percent,
while her export prices increased by roughly
45 percent. Exchange-rate movements had
very little influence on these increases, and indeed the average foreign currency value of the

27

cause of contracts and other impediments to
commodity-price changes, the effects of
money-growth variations usually take at least
a year to become manifest, and often considerably longer. In addition, the impact upon
inflation could have been even further delayed
because the surge in money growth was unusually severe and prolonged. 6
Which factor, then, money growth or increases in traded-goods prices, was mainly responsible for Japan's 1973-74 inflation? A recent study by Spitaeller (1978) suggests that
the extra inflation was attributable principally
to the increase in import prices. He found that
Japan's wholesale-price index tended to rise
by nearly 30 percent of any increase in import
prices. This would suggest roughly a 30-percent rise in 1973-74, resulting from the doubling of import prices-or almost two-thirds of
the actual increase in wholesale price inflation
over that period. However, this and similar
findings reveal primarily the association between import- and domestic-price increases
over the estimation period, and thus reflect in
part the monetary policies followed by the authorities. For this reason, such estimates can
provide a very misleading indication of the
independent contribution of traded-goods
prices to domestic inflation-that is, of their
impact with a given path of domestic money.7
In fact, a simple calculation-which effectively treats the terms-of-trade deterioration as
a tax-shows that traded goods' price hikes at
most could have had only a quite modest impact on the price level in the long-run. This
approach involves calculating the extra amount
Japan's residents paid to foreigners, versus the
additional amount received, as a result of the
1973-74 increases in traded-goods prices. Specifically, Japan's imports in 1972 amounted to
10 percent of her GNP, so that the 88-percent
increase in import prices over the following
two years required an additional payment for
the same volume equal to 8.8 percent of annual
GNP; likewise, the increase in export prices
transferred additional income to Japan equal
to 4.5 percent of annual GNP (10 percent of
the 45-percent increase). The total effect upon
income available to residents was the differ-

ence between the additional payments and receipts, or about 4 percent of GNP. This provides a rough estimate of the reduction in
Japan's purchasing power that resulted from
the external price increases.
Assuming proportionality between real
money demand and real income (as was generally the case prior to 1973), Japan experienced about a 4-percent reduction in the demand for money. This reduction, given the
level of the money stock, would have required
a 4-percent increase in Japan's price level to
bring real money demand and supply into balance. 8 An ultimate price effect of this magnitude is clearly significant, but it plainly is very
modest compared to the actual acceleration in
inflation observed during 1973 and 1974. In contrast, since an increase in money tends to lead
eventually to a proportionate rise in domestic
prices, the 1971-72 money growth had a much
larger ultimate impact upon prices.
Normally, however, the long-run impact of
external price increases, which may take several years to be completed, will be smaller
than the short-run effects. A rise in import
prices raises the domestic price level directly
and fairly immediately. The resulting fall in
real money balances (given an unchanged path
for the nominal money stock) later depresses
the prices of other domestic goods, although
this process can be quite protracted. Hence
the impact of external price increases upon the
1973-74 inflation could have been substantially
greater than the above calculation would suggest. For this reason, it may be useful to compare the price effects of two alternative
money-growth scenarios-one assuming the
historical growth rate, and the other assuming
the actual 1971-72 growth path of the money
stock. (In each case, we assume that the external price increases of 1973-74 had not occurred.) The difference implied by these two
hypothetical scenarios provides a crude but
nonetheless revealing indication of the extent
to which the 1971-72 acceleration in money
growth contributed to the 1973-74 inflation.
To begin, assume that both real income and
the M-2 money stock had grown at their historical averages during the 1971-72 period-

28

that is, 38 percent for M-2 and about 24 percent for real GNP (and thus real money demand). This growth of nominal money relative
to real money demand would, in turn, have
resulted ultimately in an ll-percent increase in
the GNP deflator (Table 2). On the other hand,
Me2 actually grew by 55 percent, which would
suggest a 25-percent increase in the deflator
given the same growth in real GNP. In either
case, virtually ail of the price increase resulting
from the 1971-72 money growth probably
would have occurred in 1973-74 because, as
indicated earlier, virtually no effect of the earlier money expansion was in fact evident until
1973. (For the same reason, the 1973-74
money and output growth is ignored for this
calculation.) Thus, this reasoning suggests, inflation during 1973-74 would have been nearly
14 percentage points higher than the historical
rate as a result of the 1971-72 acceleration in
money growth alone. This accounts for more
than half of the actual 1973-74 acceleration in
the deflator. And this estimate may be conservative, because when M-l is used for the calculation, two-thirds of the additional inflation
appears attributable to money.
It would also be misleading to attribute all
the remaining inflation not accounted for by this
calculation to the 1973-74 external price increases. The reason is that real output, and
thus real money demand, grew by six percent-

age points less than the historical average over
the 1971-72 period. This reduction in real
money demand could have added a further six
percentage points to the deflator over the 197374 period.9
On balance, then, the 1971-72 acceleration
in money growth probably accounted for more
than half the surge in Japan's GNP deflator over
the subsequent two years, and possibly for as
much as two-thirds. This would certainly be
true if we include the effect of 1971's slower
real growth, which may itself have resulted
from the 1969-70 mild reduction in money
growth. Japan, that is, would have had doubledigit inflation in 1973-74 even without the increase in external prices. However, variations
in money growth probably had considerably
less impact on consumer and wholesale prices
than they did on the deflator, because tradedgoods prices have substantially more weight in
those two indices than in the deflator. 1O
Our analysis thus shows that the 1973-74
increase in traded-goods prices accounted for
less than half, and quite possibly no more than
one-third, of Japan's inflation increase. This
conclusion is fairly consistent with the experience of other industrial countries. For example, a study for the Joint Economic Committee
of the U.S. Congress (1975) estimated that
import-price increases raised U.S. consumer
prices about 5 percent annually between the

Table 2
Contribution of Money Growth to 1973-1974 Inflation 1
M-1

Total Money Growth, 1971-1972 (%)
Less: Secular Real Output Growth during 1971-1972 (%)
Equals: 3 Predicted rise in GNP Deflator, 1973-1974 (%)
Less: Secular Inflation implied by historical average Money Growth (%)
Equals: Additional Inflation due to higher 1971-1972 Money Growth (%)
Plus: Additional Inflati0n from lower Real Output Growth in 197]2
Equals: Additional Inflation from aeeelerated Money and lower Real Output Growth,
1971-1972 (%)
MEMO:

M-2

62

55
24

31

25
11 4

20
6

14
6

26

20

Actual total rise in GNP deflator in 1973-74: 37 percent (26 percent above the secular rate).

lBased on the assumption that priee increases resulting from the growth of nominal money relative to demand (excess
money) in 1971-72 occurred in 1973-74, whereas the impact of excess money growth in 1973-74 was evident after 1974.
2Real output growth over 1971-72 totaled 18 percent, and thus real money demand at the end of 1972 was roughly six
pereent below the level implied by the historical trend.
3Figures are not precisely equal to the arithmetic difference between money and real output growth because of compounding.
4This is the figure implied by the historical pattern for M-2 and inflation; for M-I, the implied secular inflation rate is 10
percent.

29

both the GNP deflator and wage rates were
increasing at or even below the average pace
of the 1960's, although comparable deceleration was not evident in the CPI until 1977. 13
Inflation fell still further in 1978, to well below
the historical rate. In no other major industrial
country, except possibly Germany, was the reduction in inflation so substantial and steady.
As the previous discussion suggests, Japan's
money growth was the key to her success in
lowering inflation. Money growth began t9 fall
sharply in 1973 (Chart 1), and continued to
decelerate in 1974. Thus the delay betweentl1e
deceleration of money and the decline in inflation (roughly two years) was consistent with
the lag observed during the previous upsurge.
This again demonstrates that money growth
takes a considerable time to affect domestic
prices. After 1974, both M-l and M-2 grew at
average rates of 12-13 percent annually, nearly
one-third less than during the 1960's. While
the abatement of import price increases after

end of 1972 and mid-1974- about one-quarter
of the actual increase. The effect upon Japan's
CPI might be expected to be substantially
greater__Japan's ratio of imports to GNP was
about 40 percent higher than the U.S. ratio in
1972, and her relative dependence upon oil
imports was even greater. However, the estimate given earlier does not seem substantially
out-of-line with that suggested by America's
experience. II It is also worth noting that no
othermajorindustrial country (except Italy)
experienced nearly as sharp an increase in
money growth during this period, and none
experienced nearly as sharp an acceleration in
inflation. 12
Waning of Inflation, 1973-78

The fall in Japanese inflation from 1975 to
1978 was nearly as spectacular as the previous
increase. The CPI began to decelerate steadily
during the last half of 1974, and by 1975 inflation was back to single-digit levels. By 1975,

Chart 1
Growth Rates of Japanese Money and Prices
Change (%)

22
20
24

18
16
14
12
10
8

12

6
4
2
1977

30

1979

0

mid-1974 almost surely speeded the initial decline in inflation, the later continuation of that
trend may plausibly be attributed to the reduction in money growth.
The other factor often credited with helping
to reduce Japan's inflation in 1977 and 1978--the nearly 40-percent appreciation in the average foreign-currency value of the yen-was
itself probably a result rather than a cause of
Japan's lowered money growth. The yen's appreciation far outstripped the contemporaneous gap between Japanese and foreign inflation, so much so that Japan's wholesale-price
level, in dollar terms, rose almost 20 percent
more than her trading partners' average price
level during this period. This increase in the
real value of the yen led many observers to
conclude that Japan's 1976-78 current-account
surpluses were causing the currency appreciation, and depressing Japan's inflation rate in the
process. However, as Keran (1979) has argued,
most of Japan's surplus was the result of her
incomplete recovery from the 1974 recession.
Normally, business cycle variations in trade
balances do not have such substantial effects
upon exchange rates. 14
Also, as Keran has shown, the yen's 197778 appreciation may plausibly be attributed to
the differential growth of Japan's money supply relative to other nations. In 1973, money
growth slowed in Japan, but so did that of
most other industrial countries. By late 1976,
however, Japan's money (adjusted for demand) was growing substantially more slowly
than abroad-especially in comparison with
the U.S. acceleration-and the yen's appreciation followed soon after. The yen's ability to
far out-strip contemporary inflation trends can
be explained by the tendency of exchange rates
to respond more quickly than prices to money
changes, because exchange-rate adjustments
(unlike price adjustments) are not constrained
by contracts and other institutional impediments. Thus there is a 'monetary' explanation
of the rise in the real, as well as the nominal,
value of the yen. 1S

Deficits, Intervention, and Money Slowdown
Japan's reduction in money growth was particularly remarkable in view of two factors that
have often considerably complicated moneysupply control-government budget deficits
and foreign-exchange market intervention. No
other major industrial country ran budget deficits as large in relation to GNP as Japan did
during this period; none engaged in heavier
foreign-exchange market intervention. Yet
these factors, which are often asserted to make
money-supply control virtually impossible, did
not prevent money growth from remaining relatively low during this period.
The sharp expansion of Japan's budget deficit, beginning in 1975, resulted primarily from
an expansion of public-works expenditures
aimed largely at stimulating the private economy. In effect, the Japanese authorities decided to maintain money growth at a level
thought to be compatible with reducing inflation, while using fiscal policy to stimulate the
economy. By 1978, this endeavor had brought
the government budget deficit to over six percent of GNP-well above the rate in any other
major industrial nation. Indeed, in that year,
government borrowings amounted to nearly
one-third of total expenditures. According to
a widely held view, substantial deficits make it
nearly impossible for the authorities to avoid
excessive money expansion. In this view, containment of money growth in the face of expanding deficits tends to "squeeze out" smaller
borrowers in politically powerful sectors, such
as agriculture and housing. However, Japan's
experience demonstrates clearly that there is
no inexorable link between expanding budget
deficits and money growth.
Similarly, Japan showed during 1977 and
1978 that heavy foreign-exchange market intervention can be sterilized-that it need not
necessarily lead to an acceleration in money
growth. In that period, Japan's foreign-exchange reserves more than doubled, from less
than $14 billion to nearly $29 billion. (That
increase was nearly as great as the 1971-72
rise.) These purchases of dollars resulted from
the authorities' efforts to slow the sharp ap-

31

change intervention by reducing Bank of Japan
lending to the banking sector. As a result, average money growth was no higher during
1977-78 than during the previous two years. 16

preciation of the yen. But during 1977 and
1978-and in sharp contrast to 1971-72-Japan's authorities largely offset the increase in
bank reserves resulting from their foreign-ex-

II. Cost of Reducing Japan's Inflation
Japan's success in reducing inflation was accompanied by a reduction in real growth and
a rise in unemployment. The 1974--75 recession was easily Japan's most severe of the postwar era, with real GNP falling for the first time
in over twenty years. Moreover, the subsequent recovery was exceptionally sluggish by
Japanese standards, so much so that unemployment and underutilized capacity still remain historically high.
According to a widely held view, Japan's
reduced real growth over the 1974--79 period
was the natural consequence of her policies to
reduce inflation. In this view, a substantial lowering of inflation necessarily entails reduced real
growth and increased unemployment for several, possibly many, years. 17 This interpretation of Japan's experience is not likely to be
encouraging to U.S. policymakers, because it
suggests that only by tolerating high inflation
was it possible to substantially reduce unemployment here after 1974--and that bringing
inflation back down is a very painful and protracted task.
An alternative view of Japan's experience,
however, implies that its sluggish growth after
the recession was more the consequence of the
1973-74 surge in inflation and oil-price increase,
than of subsequent anti-inflationary policies.
This view attributes the continued sluggishness
primarily to the depressing effect on spending,
particularly private investment, of the uncertainty engendered by the previous inflation and
"oil-shock." This suggests that real growth
would have remained slow after 1974 even if
the government had not continued to restrain
money growth.

the second and third quarters of 1973, following the deceleration of money growth by
roughly one-quarter. Indeed, had real growth
recovered after the fourth quarter, Japan
would have recorded a "growth recession"
comparable in both magnitude and timing with
those experienced earlier. It seems clear that
the oil embargo and subsequent oil-price hikes
were mainly responsible for transforming a
fairly ordinary downturn into the debacle of
1974. 18 Output declined nearly 2'12 percent between the fourth quarter of 1973 and the recession trough in the first quarter of 1975-an
impressive decline for a nation whose average
annual real growth had previously exceeded 10
percent.
The sluggish recovery following the recession trough was as troubling as the downturn
itself, and rather less understandable (Chart
2). Real output growth rebounded sharply in
the last three quarters of 1975, but unlike previous recoveries, it remained below the secular
average. The recovery then effectively petered
out, with growth falling back somewhat in 1976
and settling at slightly below a six-percent annual rate over the next two years. By the end
of 1978, Japan's unemployment rate was actually higher than at the recession trough.
Also, the gap between actual and potential
industrial output, while narrowing, remained
near 15 percent. Even this narrowing cannot
have comforted the authorities, as it reflected
mainly a decline in capacity growth resulting
from the depressed state of investment. 19
Historically, Japan's real growth has been
led by her private-investment sector, and this
sector played an equally prominent role in the
sluggish recovery after the 1973-75 recession.
In fact, private investment was largely moribund after the recession, with no real signs of
recovery evident until 1978. Indeed, private
non-residential investment did not attain the

Severe Downturn, Anemic Recovery
As with the inflation surge, Japan's worst
post-war recession began before the oil crisis
of late 1973. Real growth slowed markedly in

32

to discourage investment. First, because capital goods are generally complementary to energy inputs in the short-run, the return to investment in the near-term may have been
reduced by the oil-price increase. Moreover,
uncertainty about the future price of oil (and
security of supply) created doubts about the
payoff to investment in particular productive
techniques, because of the possibility that they
might later be rendered obsolete. In any case,
signs of the discouraging investment climate
were evident from a high rate of corporate
bankruptcies and a high level of pessimism
recorded in business surveys.21 Indeed, the
poor investment climate was substantially responsible for the view, then widely held in
Japan, that real growth in the medium-term
was likely to be well below the pre-1974 average, in fact probably no higher than six percent. 22
These factors would suggest a longer-thanusual recovery in investment spending after
1974. But can such factors explain the continued sluggishness of private investment nearly
three years after the recession trough? This
raises the question whether Japan's monetary
policy substantially delayed the recovery.

real level of 1973 until the end of 1978, while
residential investment in the latter year remained below the 1973 peak. It is hard to resist
the conclusion that private investment substantially retarded the recovery in Japan 2°-and
perhaps in other industrial nations.
The unusually severe recession, combined
with the increase in oil costs, depressed corporate profits to an unprecedented degree, discouraging investment expenditures that in any
case were made less pressing by the extraordinarily high levels of excess capacity. Perhaps
even more important were the uncertainties
about the future engendered by the previous
inflation and oil-price increases, events which
seemed to many to mark a "watershed" in
Japan's economic "miracle." The violent fluctuations of money growth and inflation in the
1971-75 period were a marked departure from
the 1950's and 1960's, \vhen variations in inflation were fairly modest and fluctuations in
money growth were comparably predictable
and understandable. Consequently, substantial
uncertainty about future government policies
and inflation probably could have been expected
to prevail for some time.
The increase in the price of oil also tended

Chart 2

Growth Rates of Japanese Money and Real GNP
Change (%)

Change (%)

26

16

24

14

22

12

20

10

18

8

16

6

14

4

12

2

10

o

8 ~J.LLL1LI~ulL~wJ.~I.U.LLI.LIJ.LL~~uJ.I~w.I~I.LU~~.LLLl~ - 2

33

Monetary Policy Influence
Most economists agree that reducing inflation entails significant costs in terms of lowered
real growth, but they disagree about their magnitude and duration. Japan's pre-1973 experience certainly suggests that reduced money
growth helped slow inflation, but was also responsible, at least in part, for reduced real
growth thereafter. Prior to 1973, policy-induced fluctuations in Japan's money growth
were followed fairly regularly by cyclical variations in real output growth; indeed, variations
in money growth were probably the most important influence on income fluctuations during
this period. Typically, balance-of-payments
deficits developed during cyclical upturns leading the authorities to reduce money growth
below the secular average. The resulting
squeeze on corporate liquidity, manifested by
a deceleration in real-money balances (Chart
4) and rising real interest rates, generally led
within several quarters to a decline in real
Chart

growth. Then, once the balance of payments
returned to equilibrium, the growth of the
money stock (and of real balances) accelerated
once again. Real output then recovered, growing for a time at above the long-run average,
and this reduced the excess capacity developed
during the previous slowdown. 23
This pattern suggests a monetary interpretation of Japan's recession and recovery; specificaiiy, it suggests that the 1973 reduction in
money growth caused the recession, while the
continuation of slow money growth prevented
real GNP from recovering fully thereafter. But
as indicated above, other important factorsincluding the oil embargo and OPEC price
increases-also influenced output during this
period. In assessing the cost of Japan's antiinflation efforts, we should ask how much of the
reduced real growth in the 1974-78 period was
due to slower money growth, rather than to
these other factors.
The 1973 slowing of money growth clearly
3

Simulated Growth Rate of Japanese Real GNP
Change (%j

14
Real GNP
(Simulation with _
secular M-2 growth
after 1974)

12

10

~

Real GNP
(Simulation with
actual M-2 growth)

8

6

1973

1974

1975

1976

1977

1978

7

L\q(t)=a+2:b(j)L\m(t-j)+ c l L\q(t-1) + czL\q(t-2)
pol)
where q(t) is the logarithm of real GNP and m( ) is the log of M2. Data are quarterly and seasonally adjusted. In
estimating the b( ), a third degree polynomial with 'far' constraint was used, with lags from 0-7 quarters.
Notes: The plots are based upon the following regression:

.16 (-.44) Adjusted R 2 : .16

a: .025 (1.33)

h(j):

cj :

c,: .36 (2.31)

.11 (- .64)

j=0.

Period: 1962.1-1972.4

•

ObservatIOns: 44

Both simulations depicted are dynamic after 1972. The black line gives the predicted effect on real income growth of
actual M2 growth over the period 1971-1978; the colored line simulates the impact of a return to the average rate of M2
growth prevailing before 1971, starting in 1975. For comparability with the previous charts, the quarterly growth rates
predicted in the simulations were converted to year-aver-year changes for the plots.

34

was at least partly responsible for the subsequent recession. Money growth began decelerating, both in real and nominal terms, early
in 1973, while output growth slowed shortly
afterward. By the third quarter of 1973--even
before the oil embargo--a fairly typical Japanese "growth recession" was already evident.
In its early stages, this recession resembled the
1965 recession, which was preceded by an almost comparable slowing of money growth.
This similarity can be seen from the relation
between money and real-output growth over
the 1962-72 period, as summarized in the
notes to Chart 3. 24 Dynamic simulation of this
relation after 1972 (i.e., with simulated values
substituted for the lagged values of real GNP
growth) suggests that the reduction in money
growth would itself have resulted in a deceleration of output growth quite comparable to
the 1965 decline. The greater severity of the
1974 recession is an indication of the substantial effect of the oil shock in depressing real

output. In other words, both money growth
and oil contributed to the unprecedented slowdown of 1974-75.
The primary controversy about Japan's
monetary policy during this period centers
about its role during the recovery, instead of
during the recession. This concerns the extent
to which the traditional relation between
money and real-output growth could have
been "exploited" by the authorities after 1974.
According to one "historical" view, the failure
of money growth to return to its historical average after the recession trough restrained the
recovery. In this view, had money growth been
maintained at a higher rate, real growth would
have been higher-although perhaps at some
cost in additional inflation. 25
But according to an alternative interpretation, the post-1974 recovery was not primarily
a manifestation of the earlier relation between
money and output, so that higher money
growth primarily would have contributed to

Chart 4
Japanese Real Interest Rates and Real Money Growth
Change (%)

20

15

8
10

6
4

2

5

o
o

2
4

-6

5

*Current quarter's call rate deflated by GNP deflator (average of preceding three quarters).
**Year-over-year growth in nominal M-2, deflated by GNP deflator.

35

inflation without substantially increasing real
growth. 26 In this view, various factors discouraging investment led to an autonomous decline
in the demand for investment goods corresponding to given levels of current and expected future output, interest rates, and other
traditional investment determinants (i.e., the
investment schedule shifted downward). Thus,
investment during this period would have been
relatively unresponsive to traditional measures
of monetary ease. Because of the importance
of investment in Japan's total output, then, a
prolonged sluggish recovery was likely even if
money growth had been substantially greater.
If this account is correct, then the authorities' 1975-78 reduction in money growth was
an appropriate policy response, because of the
likelihood that real output growth (and thus
real money-demand growth) would remain
substantially below the historical average for
a considerable period of time. If they had followed the historical trend of money growth,
they would simply have kept inflation high; because inflation-created uncertainties can discourage investment, such a policy could have
been counterproductive.
This interpretation is not as inconsistent
with Japan's past record as might at first appear. During previous cycles, investment and
output growth generally recovered only after
an adjustment period of several quarters following the easing of money growth; thus, in
the case at hand, this period was greatly prolonged by the severity of the recession and by
the uncertainties engendered by the previous
inflation and oil-price increase. Still, this interpretation does not absolve pre-1974 monetary
policy of some responsibility for the sluggish
recovery; indeed, to the extent that the post1974 investment weakness was the result of the
severity of the downturn, prior monetary policy was partly responsible for that protracted
recovery.
It is difficult to determine which of these
explanations is most correct, considering that
their differences center around the hypothetical consequences of different monetary-growth
paths. Conceptually, the issue in dispute is one
of cause and effect: the first view asserts that

slow money growth impeded the recovery,
whereas the second implies that slow money
growth was necessary to contain inflation because demand. growth was autonomously depressed by other factors. Traditional measures
of monetary ease or tightness, such as interest
rates, provide ambiguous evidence, because
they are influenced both by policy and by the
actual level of aggregate demand. Nevertheless, the post-1974 recovery apparently differed in several important respects from the
pattern observed during previous business
cycles. In particular, the interactions between
money and output growth implied by the pre1973 historical record suggest that slow money
growth should not have depressed real growth
for as long as actually was the case. This evidence, at the least, raises doubts about the
first interpretation.
The behavior of both interest rates and real
balances tended to refute the argument that
monetary policy restrained an otherwise robust recovery. At the least, their post-1975 behavior was not characteristic of previous periods of monetary restraint during cyclical
upswings. In Japan, the (interbank) callmoney rate has traditionally been free to vary
with market forces, while the central-bank discount rate and the private-bank loan rate
(which is partially tied to the discount rate)
have usually been set below market-clearing
levels. Typically, as money growth slowed during cyclical upswings, all interest rates increased, although the call-money rate rose relative to the loan rate-and in addition, the
growth of real money balances decelerated
sharply. Moreover, these trends normally
tended to precede the slowing of real growth,
especially prior to the 1965 and 1973 slowdowns. In addition, the call-money rate has
often risen in real terms, that is relative to the
recent inflation trend, during periods of monetary restraint- with the exception of the sharp
inflation-related decline of 1973.
The 1974 recession and early recovery also
conformed, roughly, to the historical pattern,
although the same cannot be said of subsequent developments. The call-money rate,
both relative to the loan rate as well as in real
36

terms, fell sharply during the downturn and
then recovered substantially for several quarters following the early-1975 recession trough;
this pattern was fairly typical of previous
cycles, although more pronounced. But during
most of the 1976-78 period, both indicators
remained relatively low by historical standards; in fact, their levels were more characteristic of previous downturns than of recoveries. Indeed, Japan's real interest rate was
actually lower during most of this period than
during 1971-72, when monetary policy was
"easy" by any normal standard.
Moreover, real-balance growth recovered
sharply from the 1975 recession trough-although never again reaching the level attained
in previous recoveries-and then fell back in
1976. However, the 1976 decline coincided
with a fall-off in real GNP growth; indeed, a
sustained decline in nominal M-2 growth was
not really evident until the end of 1976. This
timing suggests that the decline in the growth
of real balances was the result of the deceleration in growth of real money demand induced
by the fall in output growth. Such a pattern is
more consistent with the second interpretation
than the first. These patterns together tend to
refute the idea that strong investment demand
was "choked-off" by credit rationing in response to a stringent monetary policy. However the evidence may also be consistent with
the first explanation, because the prospect of
lower money growth quite possibly discouraged investment demand during this period.
More persuasive, perhaps, is the implication
of the pre-1973 historical record, which suggests that slow money growth should not have
depressed real growth after 1974 for nearly as
long as it actually did. The apparent reason is
the lack of a permanent 'trade-off' between
money and real output growth-in Japan as
well as elsewhere. That is, despite the influence of money-growth fluctuations on cyclical
variations in real output, permanent increases
or decreases in money growth tend to affect
only inflation, and not real growth, in the long
run. This conclusion is supported by the

regression summarized in Chart 3 as well as
other statistical evidence reported elsewhere.27
Consequently, even permanent changes in
money growth cannot cause output growth to
deviate from the secular average indefinitely.
The question then is, how much and for how
long did the post-1973 reduction in money
growth depress Japan's real growth?
The evidence (Chart 3) suggests that reduced money growth had a substantial but relatively short-lived impact on real output
growth. As the solid line indicates, even with
relatively slow money growth, real-output
growth should have returned to the secular
rate by mid-1976 if the historical relation had
continued to prevail. With this simulation also,
the fall-off in money growth beginning in late
1976 would have led to a sharp but fairly short
decline in output growth-but output growth
would have remained above the level actually
recorded over these years. Finally, raising
money growth beginning in 1975 back to its
historical rate would have speeded the recovery somewhat, but not by a great deal (compare the dotted and broken lines of the
chart).28
The evidence, although far from conclusive,
on the whole raises considerable doubts about
contentions that Japan's sluggish recovery was
due mainly to slow money growth. We should
not rule out the possibility that a sufficient
expansion in money growth would have raised
growth if the authorities had been prepared to
accept a renewal of double-digit inflation. But
the behavior of real balances and interest rates
during the recovery suggests that monetary
policy was not at all "tight" by historical standards. And the historical relation between output and money growth suggests that the recovery should have been substantially more robust
than it was-and that the effects of reduced
money growth should not have been nearly as
long-lasting as the first explanation suggests
they were. At the least, the evidence marks
the post-1974 recovery as peculiar in several
respects, and suggests a basis for the fear that
a significant increase in money growth would
mainly have raised the inflation rate. 29

37

III. Summary and Conclusions
Over the last ten years, inflation and recession have been the dominant economic problems of the major industrial economies. Their
policy responses to these difficulties have often
been quite similar, yet also different in important respects. But the uniqueness of each country's experience makes it difficult for policy
makers to draw clear lessons from their own
nation's record alone-always there is the
question of "what if." Yet in principle, the
paths taken by other industrial countries can
provide a clue to "what might have been."
The present article has surveyed Japan's experience with inflation and recession over the
1973-78 period. We have attempted to determine the main causes of the rise and fall of
Japanese inflation and to gauge, in a rough fashion, the costs it incurred in its successful effort
to reduce inflation. This effort has yielded some
tentative conclusions, and it has also raised
some interesting questions.
Japan's experience confirms that the key to
containing inflation is controlling money growth.
Without the 1971-72 acceleration in money
growth, Japan's inflation in 1973 and 1974
would have been much lower than it actually
was. The relatively low inflation of the late
1970's was not the result of a fortuitous exchange-rate appreciation or government fiscal
"discipline," but rather of a consistent policy
of containing money growth. At the same
time, Japan's record shows that substantial increases in the domestic price level sometimes
reflect more than domestic money growth. Japan probably imported a significant amount of
inflation in 1973 and 1974. In addition, Japan's
monetary authorities have demonstrated
graphically that high budget deficits and foreign-exchange market interventions need not
inevitably destroy monetary control.

Japan's experience also confirms that inflation reduction can be both protracted and
painful. Inflation fell back to the historical average only after two years in which money
growth fell considerably below the pre-1973
rate. The reduction in inflation was associated
with very heavy costs in terms of lowered real
growth, excess capacity, and unemployment.
A very substantial portion of these costs can
almost certainly be attributed to anti-inflation
measures. Also, monetary pOlicy was probably
primarily responsible for the fact that the
downturn was more severe in Japan than in
other major industrial countries. And the
1973-74 monetary restraint probably helped
retard the recovery by aggravating the recession. It is much less clear, however, that monetary policy thereafter could have raised output growth substantially above that which
actually occurred. At the least, such a policy
entailed substantial risks of rekindling inflation.
Finally, there remain intriguing unanswered
questions about Japan's experience. Why, for
example, were Japanese authorities able to restrain money growth over the 1976-78 period?
Were they simply willing to bear the political
and social costs which frequently force monetary accommodation in the face of large deficits, or were these costs simply not important
to Japan? And while it can be argued that the
post-1974 reduction in money growth was not
primarily responsible for the sluggish recovery,
the question remains as to what factors precisely were responsible. As further research
sheds light on these questions, policy makers
in other industrial nations are likely to draw
additional lessons from Japan's experience.

38

FOOTNOTES
1. Italy's average CPI inflation over 1973-1974 was nearly
the same as Japan's; in other major industrial countries,
average inflation during this period was between one-half
and two-thirds of the Japanese rate. In all major industrial
countries except Germany and Japan, inflation rates have
remained well above the 1960's average since 1976. Germany's performance is somewhat unusual, however, beClluse average money growth since 1976 has actually
been above the average of 1964-72. One reason may be
an increase in international demand for the OM resulting
(say) from decreased demand for the dollar. If so, Germany is perhaps the only major industrial nation to have
benefi.ted from a .true "virtuous circle" induced by currency
appreciation.

necessarily inconsistent with the fact that relative prices
changed greatly in 1973-74, because certain basic commodity prices are often considerably more sensitive to
variations in world aggregate demand than are traded
goods in general. However, the OECO study also shows
that the actual increase in metals and food relative prices,
relative to the increased world (real) demand, was still
much sharper than during previous cycles (see p. 28).
5. Precisely why the money supply was allowed to expand so sharply in 1971-72 is not entirely clear. It has
been suggested that the authorities were worried about
the allegedly deflationary effects of the yen's revaluation.
Moreover, growth had already slowed in 1971, and traditionally money growth had been allowed to accelerate
during recoveries. But the magnitude and duration of the
money-growth expansion of 1971-72 were substantially
greater than the norms characteristic of the 1950's and
1960's.

2. The growth of Japanese government nominal expenditureaveraged about 12 percent during the 1960's, compared to 15 percent over 1971-72 and 14 percent over
1971-74 (figures are taken from International Financial
StatistiCs). If the effects of government spending upon
the domestic price level for Japan are at all comparable
to those of other countries, these increases should have
had a negligible impact on Japanese inflation. For example,
William Dewald and Maurice Marchon (1979) found (longrun) elasticities of total nominal GNP with respect to government expenditures ranging from .05 for Germany and
.28 for France (see Table 3). These suggest that only
extraordinary accelerations in government spending have
a substantial impact upon domestic inflation; in contrast,
the elasticities of nominal income with respect to money
are generally much higher than those for government
spending.

6. The only comparable prior surge was that of 1962-63,
when M-2 increased at an annual rate of 22 percent,
compared to 25 percent in 1971-72. I have argued (see
Charles Pigott, "Expectations, Money, and the Forecasting
of Inflation" in the Spring 1980 issue of this Review) that
pricing decisions are likely to be based upon individuals'
forecasts of money, and that prices will tend to respond
more to money changes that are perceived as persistent
than to those viewed as transient. Prior to 1971, decelerations of Japan's money growth normally followed accelerations in a fairly regular and comprehensible pattern.
Hence the 1971-72 money changes may at first have
been regarded as largely transient, delaying the price
response.

3. Cagan (1980, p. 4) briefly reviews other results for the
U.S. He notes that regression studies generally suggest
a larger impact of import prices on domestic inflation than
do direct computations of the effect upon domestic costs
of external price hikes; as argued below, this is not surprising since regression results tend to reflect the monetary
policy pursued in response. Cagan's own estimates suggest that about 40 percent of the increase in the prices of
U.S. manufactures during this period (or about 16 percentage points) can be attributed to external price increases. His estimate is somewhat higher than would be
suggested by Berner et al (1975), who calculated that
about 25 percent of the increase in the personal-consumption deflator between mid-1973 and mid-1974 was
due to external price hikes. The difference can be traced
to the fact that Cagan also allowed for the impact of
increases in export prices, whereas Berner et al did notand to the fact that the latter estimates refer to consumer
prices, which are less heavily weighted with traded goods
than are wholesale prices of manufactures (see Cagan,
p.8).

7. Bijan Aghevli and Carlos Rodriguez (1979) find that
about 18 percent of an increase in (commodity) import
prices is reflected in the GNP deflator. Since the unit value
of imports rose by nearly 100 percent over 1973-74, this
suggests a total increase in the deflator of 18 percentage
points as a result; this again is about two-thirds the actual
rise above historical rates in this index. However, as is
argued in Pigott, Rutledge, and Willett (1980), such
regression estimates tend to reflect the extent to which
external price increases are accommodated by money
expansion. This contention is supported by the results of
Dewald and Marchon (1979), whose findings suggest that
the impact of import prices on the domestic price level is
substantially lower for Canada than for Germany and the
U.K.-despite the similarity of all three countries' ratios of
imports to GNP. Indeed, most regression studies find that
domestic prices rise more in the long-run than in the
short-run in response to a rise in import prices. Because
increases in import prices tend, with a given money stock,
to lower real balances, the opposite pattern is more likely
in the absence of monetary accommodation.

4. Richard Cooper and Robert Lawrence (1975) discuss
various factors in the 1973-75 commodity price fluctuations; see also "Aspects of World Inflation," OECO Economic Outlook, JUly 1974, pp. 25-37. Supply factors, as
well as a surge in aggregate demand, seem to have influenced the surge in basic commodity prices. Michael Keran
and Michael Riordan, "Stabilization Policy in a World Context," Fall 1976 issue of this Review, attributed these
increases largely to a synchronized expansion of money
supplies in major industrial countries. This view is not

8. This calculation-which is intended to provide an upper bound on the ultimate effect-is based upon a procedure very similar to that used by the World Bank in
computing "income attributable to changes in terms-oftrade," and which is included in the Bank's definition of
"gross domestic income"; see, for example, their World
Tables 1976, p.7. This income element has been used to
explain fluctuations in consumption for LOC's, as well as

39

for other purposes. Its theoretical basis lies in the SlutskyHicks notion of compensated demand. In particular, in a
two-good economy in which tastes are identical and homothetic, this calculation approximates the amount of income required to keep an individual's welfare (I.e. the
level of his indifference curve) constant when the price of
the good he sells (net) falls relative to that which he
"imports."

because it includes goods at different stages of processing, tends to "double-count" price increases of raw materials. The distortion in the WPI arising from this can be
quite substantial, as William Nordhaus and John Shoven
have shown ("Inflation 1973: The Year of Infamy," Challenge, May/June 1974, pp. 14-22).
11. Consider another "back-of-the-envelope" calculation.
Suppose that half of total U.S. inflation recorded over
1973-74 was attributable to external price increases; this
is at the upper bound of estimates in the literature, and
implies that substantially more than half the additional
increase in the U.S. CPI was due to commodity-price
hikes. In any case, this implies that the U.S. CPI was
raised by 9.5 percentage points as a result. Since the ratio
of imports (and exports) to GNP is about 40 percent higher
for Japan than for the U.S., it is reasonable to suppose
that Japan imported somewhat more inflation. Suppose
that commodity price hikes increased the Japanese CPI
by 15 percentage points (nearly 60 percent more than for
the U.S.). Since the actual increase in Japan's CPI-45
percent-was more than 30 percentage points greater
than during a "typical" two-year interval during the 1960's,
this suggests that at most half of Japan's CPI acceleration
could have been due to external price increases. The
fraction for the deflator, v'Yhich is less heavily 'y'veighted vvith
imported goods, was almost surely smaller; indeed, the
deflator rose by nearly 8 percentage points less than the
CPI during this period.

Almost surely, however, the estimate in the text is somewhat larger than the true final effect. Implicit in the calculation is the assumption that the demand for money
depends upon permanent real wealth or rea! income,
which declines as the terms-of-trade fall. However, money
is to a large extent desired for transactions purposes, and
it is much less clear that a change in the terms-of-trade
will lower transactions demand, or indeed even change it
at alL In fact, Pierce and Enzler (1974), in assessing the
effects of the oil price shock on the U.S. economy, relate
money demand to a transactions index equal to GNP plus
imports; the increase in the price of imported oil actually
raises the transactions demand for money under this formulation, and hence ultimately leads to a fall in the domestic price level.
9. It should be emphasized that this calculation assumes
that money, nominal income, and the price level vary
roughly proportionately in the long-run. Although money
and nominal income grew at virtually the same rate over
1962-70, a mild fall in velocity at a roughly 1-percent
annual rate was observed for the 1960's as a whole.
Allowing for such a trend would not substantially affect the
estimate of the inflation due to the 1973-74 external price
increase, provided the trend were the same under either
money path.

12. German CPI inflation averaged only 6.75 percent over
1973-74, despite money growth somewhat above the historical average in 1971-72. In fact, in all other major
industrial countries except Italy, average annual CPI inflation in 1973-74 was below 12 percent (usually below 10
percent)-Iess than two-thirds the rate suffered by Japan.
Several of these countries are substantially more dependent on trade than Japan is.

In regression relations between Japanese inflation and
money growth for the pre-1971 period, the adjusted Rsquare is generally found to be quite low, and the longrun impact of money on the price level is well below unity.
I have argued-see Pigott (1980)-that this may reflect the
tendency of money-growth accelerations to be offset by
subsequent decelerations, so that money changes above
or below the secular average may have been viewed as
transient. It might then be expected that prices would not
respond fully to actual money changes. This may also
explain why the sharp acceleration in money growth over
1962-63 did not lead to nearly as sharp an increase in
inflation. Indeed, average M-2 growth over these years was
22 percent, compared to 25 percent in 1971-72. However,
inflation did not substantially change over 1964-65, in
sharp contrast to the surge in the second episode. Keran
(1970) points out that during the earlier period, the government had a well-established policy of tightening monetary policy soon after balance-of-payments deficits developed. It is quite possible, then, that even the money
expansion of 1962-63 was expected to be reversed later,
so that prices did not respond. By 1973, however, this
pattern had disappeared, because Japanese international
reserves had been substantially augmented, while the
fixed exchange-rate system had broken down. Individuals
may then have come to believe that the 1971-72 money
expansion would not be subsequently offset, or at least
not as much as in the past; hence prices may have responded more than in the previous period.

13. One possible reason why the CPI rate remained
above the historical average was a delay in price increases in government-regulated sectors. The WPI movements were also probably somewhat distorted by the
sharp fall in basic commodity prices during late 1974 and
1975. However, neither factor can account satisfactorily
for the SUbstantially higher rate of increase of the CPI
compared to the GNP deflator during this period.
14. The yen's appreciation in real terms, in fact, exceeded
the fall in the real value of the U.S. dollar after the December 1970 devaluation. Between 1970 and 1972, in
fact, the dollar value of U.S. wholesale prices fell relative
to those of her trading partners by about 12 percent; as
noted in the text, the dollar value of Japan's wholesale
prices rose relative to abroad by substantially more than
12 percent. However in 1970, the U.S. was clearly in a
chronically imbalanced position in its current account;
moreover, by 1973, the volume of both our exports and
imports had responded quite sharply to the previous devaluation. In addition, most estimates of the price elasticities of demand for traded goods suggest that even a
secular surplus of the size of Japan's would have required
a far smaller change in relative prices than actually occurred over 1977-78. See Keran (1979) for further arguments that the Japanese surplus was largely a businesscycle imbalance. He also shows that the expansion of the
surplus in 1978 was due entirely to price changes.

10. This indeed is why the increases were greater for the
CPI and WPI than for the deflator. In addition, the WPI,

40

15. See Keran (1979), pp. 228-238 and especially Figure
2.

sharply in 1975, after remaining high in 1974-a pattern
fairly typical of an unexpectedly severe downturn. Finally,
while real private consumption certainly slowed compared
to the 1960's, its behavior suggests a fairly passive adjustment to the slower growth of total output. Private and
total savings rates actually fell after 1974, although this
again is not surprising in view of the sharp downturn.

16. This performance is more impressive than might at
first appear. Both Germany and Switzerland substantially
overshot money-growth targets in 1978, in large part because of heavy dollar purchases.
17. The most pessimistic views are based upon a fixed
relation between excess capacity and changes in inflation.
These imply that reducing inflation requires maintaining
unemployment well above its natural rate for many years.
See, for example, Nigel Duck, Michael Parkin, David
Rose, and George Zis, "The Determination of the Rate of
Change of Wages and Prices in The Fixed Exchange Rate
World Economy, 1956-1971," in Michael Parkin and
George Zis (eds.), Inflation in The World Economy, 1977,
especially pp. 134-136.

21. See Economic Survey of Japan, fiscal 1976/77, pp.

8D-98.
22. There has, in fact, been considerable controversy
about the future level of Japan's long-run secular growth
rate. Projections of a 6-percent growth rate are to a large
extent based upon the relatively sluggish investment of
1976-1978; in view of the continued very high savings
rate, this seems unduly pessimistic. There is a consensus
that Japan's future growth will be slower than in the pre1973 period, because of a slowing of productivity increases. How much lower depends crucially upon the
contribution to growth of capital and labor vis-a-vis that of
technical progress. See M. Nishimizu and Charles Hulten,
"The Sources of Japanese Economic Growth; 19551971," Research Memo #200 (June 1976) of the Econometric Research Program of Princeton University. On balance, it seems likely that Japan's secular growth rate is
above 6 percent. Thus growth during 1975-78 has probably been below the secular average-and certainly has
not been substantially above it as occurred during previous recoveries.

18. This conclusion is supported by the study by James
Pierce and Jared Enzler (1974) of the effects of the oilprice increase on the U.S. economy. They found that real
output was substantially depressed and unemployment
raised as a result (see pp. 36-41). The effect on Japan
was almost certainly larger, because of its much greater
dependence on oil imports.

19. According to the potentia!·output series computed by
Artus (1978), Japan's actual output was below potential
by nearly 25 percent at the recession trough in 1975. The
output gap for other major industrial countries was only
about half as large. His figures also suggest that the gap
remained very wide in all major industrial countries except
the U.S. through 1978. In Japan, for example, the gap
was almost certainly above 15 percent by the end of 1978.
These statements are based upon extensions of his series
using industrial-production data from International Financial Statistics (although the series are not strictly comparable). Artus' figures also show a slowing of potentialoutput growth to about 5 percent over 1976-78, compared
to nearly 12 percent prior to 1973.

23. See Keran (1970) and Pigott (1978) for further discussion of this policy and its effects.
24. The procedure used here departs from my previous
analysis of the relation between Japanese money and
output-see Pigott (1978)-in that money growth is not
decomposed into anticipated and unanticipated components in the regression. In the previous study, I considered
mainly the effect of money growth on Japan's industrial
production. The findings, in the sense that the long-run
impact of an increase in money on Japan's industrial production was virtually zero, are consistent with those reported here. The relation summarized in Chart 3 is in fact,
more "traditionaL" It can be viewed as a reduced form of
a system in which money influences nominal income and
prices, as well as real income. Although the relation used
here allows only current and past money (up to seven
quarters) to affect output growth directly, the effective lag
from money growth to output is potentially much longer
because of the inclusion of lagged output growth as regressors. These latter terms can, if large, allow a change
in money growth to affect output for a considerably longer
time than the lag on money alone would suggest. In fact,
however, the coefficients of the lagged dependent variables were relatively small, and this largely accounts for
the fact that output growth seems to "rebound" quickly
even when money growth is substantially permanently
reduced. This finding is also fairly similar to that reported
in the earlier study. I experimented with alternative lag
lengths for money, but found that allOWing for a twelvequarter lag length (compared to the eight for the regression reported) substantially reduced the adjusted Rsquare.

20. This statement is based, in part, on the extraordinary
fall-off in private investment expenditures over 1974-77.
Real private non-residential investment grew nearly 50
percent faster than real output over 1965-73, while it grew
more slowly than output during 1974-77. Because this
sector accounts for nearly one-fifth of total GNP, its slowing was bound to substantially retard the recovery. The
depressed state of investment and reasons for it are extensively discussed in the Economic Survey of Japan
for fiscal 1975/76 and 1976/77. See especially pages 3746 of the 1975/76 issue and pp. 84-98 of 1976/77. These
present an interesting contrast indicative of the uncertainties about the course of the economy: the earlier issue
reflects the beginnings of an investment recovery in 1976;
the subsequent issue focuses on why investment remains
sluggish, reflecting the stalling of the recovery. These issues also indicate considerable divergence in conditions
in various industries and among various-sized firms- a
divergence that may have led to additional uncertainty
about relative prices and demands. Other sectors also
influenced the recovery as well, of course. Until 1978, real
export growth exceeded that of imports, so the external
sector contributed to Japan's growth. In 1978 this pattern
was reversed, and indeed real GNP growth that year
would have been well above 6 percent had real export
and import growth been equal. Inventory investment fell

25. The U.S. experience appears to confirm this: U.S.
inflation accelerated along with money growth after 1976,
while U.S. output growth returned to the secular rate.

41

more appropriate here, although space prevents its presentation. However, the pattern is essentially the same,
except that income growth falls lower during 1974 than
under the dynamic simulation. The difference between the
simulations with actual money growth versus the average
rate of the 1960's is virtually the same in either case.

However, as is discussed later, this pattern is not nearly
as clear when the industrial countries as a whole are
examined.
26. This view is certainly consistent with the actions of
the Japanese authorities, and it seems to have been held
by some. As will become clearer below, it was obvious by
1976 that the recovery was already rather different from
previous episodes. The Economic Survey of Japan issues at the time placed considerable emphasis on structural shifts needed in response to higher oil prices and
other factors-which further suggests that this was not an
ordinary recovery, and hence may not have been as malleable (via monetary expansion) as those in the past.

29. Again, the record of other industrial countries is
suggestive, although far from conclusive. Output gaps in
all major European countries apparently remained substantial through 1978 (based upon my extension of Artus'
actual output figures and his estimates of potential output).
None of these countries, however, succeeded in reducing
money growth (or, except in the case of Germany, inflation) back to the pre-1973 average. In France, for example, inflation remained nearly twice as high in 1975-78 as
in 1964-72, while her output gap averaged over 10 percent. This evidence may be suspect, however, because
real wages apparently rose in excess of productivity after
1973 in many European countries, which may have helped
to retard the recovery and keep unemployment high.

27. See Pigott (1978). The results there also imply that
there is no permanent effect of money growth on realoutput growth.
28. A static regression, using the actual values of real
GNP growth during 1973-74 (at least) might have been

REFERENCES
Keran, Michael W. "Monetary Policy and the Business
Cycle in Postwar Japan," in David Meiselman (ed),
Varieties of Monetary Experience, 1970, pp. 163248.

Aghevli, Bijan B. and Rodriguez, Carlos A. "Trade, Prices
and Output in Japan: A Simple Monetary Model,"
IMF Staff Papers, March 1979, pp. 38-54.
Artus, Jacques. "Measures of Potential Output in Manufacturing for Ten Industrial Countries, 1955-1980,"
DM/78/41 of the International Monetary Fund, May
12, 1978.

- - . "Japan's Trade Surplus and the Value of the Yen;"
in Tariffs, Quotas and Trade: The Politics of Protectionism, 1979, Institute for Contemporary Studies, pp. 221-246.

Berner, Richard; Clark, Peter; Enzler, Jared; and Lowrey,
Barbara. International Sources of Domestic Inflation, Paper No.3 of Studies in Price Stability and
Economic Growth, Joint Economic Committee of
U.S. Congress (94th Congress, 1st session), August
1975.

Pierce, James and Enzler, Jared. "The Effects of External
Inflationary Shocks," Brookings Papers on Economic Activity, 1974:1, pp. 13-61.
Pigott, Charles. "Expectations, Money, and the Forecasting of Inflation," Federal Reserve Bank of San Francisco Economic Review, Spring 1980.

Cagan, Phillip. "Imported Inflation, 1973-1974, and the
Accommodation Issue," Journal of Money, Credit
and Banking, February 1980, pp. 1-16.

- - . "Rational Expectations and Counter-Cyclical
Monetary Policy: the Japanese Experience," Federal
Reserve Bank of San Francisco Economic Review,
Summer 1978.

Cooper, Richard and Lawrence, Robert. "The 1972-1975
Commodity Boom," Brookings Papers on Economic Activity, 1975:1, pp. 671-715.

- - , Rutledge, John; and Willett, Thomas D. "Some
Evidence on the Instability of Estimates of the Inflationary Impact of Exchange Rate Changes," 1980,
processed.

Dewald, William and Marchon, Maurice. "A Common
Specification of Price, Output, and Unemployment
Rate Responses to Demand Pressure and Import
Prices in Six Industrial Countries," WeltwirtschaftIiches Archiv, 1979, Heft 1, pp. 1-19.

Spitaeller, Erich. "A Model of Inflation and its Performance
in the Seven Main Industrial Countries, 1958-1976,"
IMF Staff Papers, June 1978, pp. 254-277.

42

I
Hang-Sheng Cheng*
This paper presents an overview of the financial-deepening process in eleven Pacific
Basin countries during the past two decades.
For any nation, financial deepening represents
an increased amount of financing of production
and investment through specialized, organized
markets. The economic literature has expanded its coverage of this subject in the last
twenty-five years,l stressing financial deepening as an important factor in determining the
course of a nation's economic growth 2 and welfare. This review of Pacific Basin experience
should help us see what generalizations (if any)
can be made about the factors promoting or
retarding the financial-deepening process.
Economists traditionally examine this process within the context of developing, rather
than developed economies. In developing
economies, financial deepening is associated
with increases in the activity of financial intermediaries-such as commercial banks, savings
institutions, insurance companies and the
like-because direct placement or capital markets generally are unimportant. In developed
economies, financial intermediation is less predominant as capital markets develop. While
this paper maintains the focus on financial intermediation characteristic of developing nations, it also examines the experience of the
developed Pacific Basin countries. We include
them in the analysis in order to highlight the
changing role of financial intermediaries in the
development process and also to highlight
those processes that are common to both types
of economies.

Section I presents a simple conceptual
framework for analyzing the role of financial
markets in economic growth. Drawing on the
existing literature, it distinguishes between
various modes of finance in relation to economic growth. In addition, it analyzes the effects on economic growth of "repressed finance"-that is, a policy of rigid nominal
interest rates in the face of general price inflation. This section may be skipped by those
who are familiar with the economic principles
underlying this study.
Section II presents a comparative study of
the experiences of eleven Pacific Basin countries-Australia, Indonesia, Japan, Korea,
Malaysia, New Zealand, the Philippines, Singapore, Taiwan, Thailand, and the United
States. The observation period varies from
country to country depending on data availability, but generally covers the 1960-78 period.
In this analysis, we use the degree of financial
intermediation as a proxy for overall financial
development. We present two views of financial deepening-first, a cross-section view of
the degree of financial intermediation in each
country in 1978, and second, a comparison of
the eleven countries' financial-growth processes over the entire observation period.
Relative to per capita income, Japan, Singapore, and Taiwan had the highest financialintermediation ratios of all eleven countries in
1978. This finding does not imply that Japan,
Singapore, and Taiwan have achieved a higher
degree of financial development than such
fully-developed countries as the United States,
but merely shows that they have given a
greater role to financial intermediaries in their
activities.
The study identifies the real deposit-interest
rate-i.e., the nominal deposit rate deflated by

•Assistant Vice President and Economist, Federal Reserve
Bank of San Francisco. Benny Yu provided research assistance for this paper.

43

indirectly detrimental to economic growthassuming a positive relationship between financial intermediation and growth. It also suggests that, where inflation cannot be brought
quickly under control, interest rates ought to
be left flexible enough to cover more than the
inflation premium, and thus allow a positive
return which would encourage saving through
financial intermediaries.

a consumer-price inflation rate-as a critical factor in setting the pace of each nation's financial
growth over time. Positive real deposit rates
maintained over a number of years invariably
lead to financial deepening, and negative real
deposit rates even for a year or two tend to
result in sharp financial disintermediation
against a strongly upward trend. The finding
reinforces the view that inflation is directly and

I. Financial Deepening and Economic Growth
Economic growth depends on capital formation; capital formation requires financing.
The functioning of a financial system to generate savings and allocate savings among different types of productive activities is obviously relevant to a nation's economic
growth. Broadly speaking, a nation can choose
among three alternative ways of channeling
national savings to investment (Figure 1):3 (1)
self-finance by entities undertaking the investment, (2) external finance through capital markets (direct finance), and (3) external finance
through financial intermediation (indirect finance).
Self-finance by entities undertaking the investment may occur in either of two formsgovernment investment in economic infrastructure (such as roads, harbors, schools, or
irrigation facilities) through government-budget
appropriations, or capital formation by private
or government enterprises through retained
earnings. Self-finance is widely used in both
developed and less-developed countries. However, in countries with well-developed financial
markets and institutions, both government and
private enterprises may finance either through
their own resources or by borrowing from the
market, whereas in countries with under-developed financial markets, investing entities
must accumulate savings from within.
This difference is important for two reasons.
First, when self-finance is the only available
approach, a highly productive investment project may have to be postponed or scrapped
because of its size relative to the investing entity's internal financial resources. This limitation applies whenever economies of scale are

important, or whenever the adoption of modern technology requires substantial initial investment in human and physical capital. 4
This difference is also important because an
efficiently functioning financial market signals
to each investing entity the opportunity cost of
self-finance, thus helping to weed out investment projects which promise lower returns
than the market cost of capital. For instance,
an enterprise in a country with limited financial markets often has little choice but to plow
back its earnings regardless of potentialities
elsewhere. In contrast, an enterprise in a country with well-developed financial markets has
other alternatives-debt retirement, repurchase of its own stock, or investment in securities of other enterprises-and cyan choose
among the various alternatives depending on
the risks and the relative returns of the alternative uses of funds. A well-developed financial market heips insure that the funds generated from within each firm are channeled to
the most efficient uses from the viewpoint of
society. Thus, self-finance itself is not necessarily inefficient finance-but when self-finance is coupled with an absence of market
discipline, the result may be arbitrary and
wasteful allocation of capital.
The second channel, direct finance, may
take the form of the issuance of stocks, bonds,
notes, commercial paper, or other types of debentures by investing entities on open, organized capital markets under various degrees of
government supervision and regulation. Alternatively, as in many less-developed countries,
it may take the form of advances of seeds,
fertilizers, food, or money by landlords or

44

merchants to peasants; or direct personal loans
from friends, relatives, and the general public
to business firms; or the discounting and trading of business firms' post-dated checks among
the public outside regulated markets. The
form may vary, but the essence is the same:
Direct finance consists of the ultimate borrower issuing a liability against itself, and selling it either directly to the ultimate lender or
through dealers and brokers.
Direct finance is characterized by (a) the
separation of saving and investment, and (b)
the bearing of the lending risk by the saver.
Typically, the saver is not himself a professional lender, and has neither the time nor the
expertise for the continued monitoring of the
borrower's financial soundness. With direct finance, therefore, the government and well-established large enterprises have a distinct advantage in raising funds from the market;
others must pay a higher cost of capital to
compensate for the higher risk arising out of
lenders' lack of knowledge about borrowers'
financial capacity. In this environment, innovation-generating venture capital is especially
liable to suffer because of the public's lack of
expertise in risk assessment.
Moreover, borrowers typically prefer longterm, and lenders short-term, financing. Without a secondary market of considerable

"depth, breadth and resilience," borrowers
have to pay higher costs for capital in order to
overcome lenders' liquidity preferences. However, a well-developed secondary market presupposes a high degree of financial sophistication, based on generally accepted accounting
standards, knowledgeable investment-advisory
services, efficient communication networks,
and reasonable regulatory authorities to enforce the rules of the game. Generally speaking, such preconditions do not exist in developing nations. Not surprisingly then, developing
nations strive mightily-but usually in vainto develop a domestic capital market, in their
eagerness to mobilize national savings for economic growth. In many instances, it is a policy
of chasing the will' -0' -the-wisp.
The third channel of investment finance, financial intermediation, is characterized by a
flow of funds through financial institutions,
which specialize in intermediating between ultimate savers on the one hand and ultimate
users of funds on the other. These institutions
conduct their business by issuing liabilities
against themselves, and directly or indirectly
investing the proceeds in the financial instruments of ultimate fund users. In general, the
more financially sophisticated a national economy, the wider is the variety of its financial
institutions-central banks,5 commercial

Figure 1
Channels of Savings-Investment Flows

L
45

(checking-deposit) banks, investment (merchant, development) banks, savings institutions, insurance companies, mutual funds,
pension funds, finance companies, and so on.
Also, the more sophisticated the economy, the
more varied is the menu of financial instruments offered by these institutions-with diverse maturity, liquidity, riskiness, and auxiliary services (such as insurance, investment
counseling, and data processing) taiiored to
the preferences of ultimate savers.
Financial intermediation enhances economic
growth through the promotion of savings and
investment. By borrowing short and lending
long, financial intermediaries cater to the liquidity preferences of both borrowers and savers. By specializing in the provision of financial
services, they reduce the riskiness of each individualloan through their expertise in assessing the creditworthiness of each borrower. By
pooling savings and diversifying lending, they
diminish the aggregate risk of investment for
the nation as a whole. And by realizing economies of scale in financing, they reduce the
cost of capital to ultimate borrowers and
thereby encourage capital formation. 6
Compared to self-finance, financial intermediation also facilitates capital formation by
enlarging the scope of financing, thereby making it possible for enterprises to adopt modern
technology and realize economies of scale.
Moreover, it enhances the productivity of capital, by developing investment expertise and
instilling market discipline in the allocation of
capital. Compared to direct finance, financial
intermediation promotes saving, by more
closely satisfying savers' liquidity preferences,
by reducing risks of investment, and by packaging auxiliary services desired by savers. The
consequent increase in savings and enhancement of productivity of capital combine to
raise the nation's rate of economic growth.7
Nonetheless, despite these advantages, indirect finance is not always superior to selffinance and direct finance, regardless of the
extent of each mode of finance. On the contrary, countries with a full complement of financial markets, both direct and indirect, are
more likely to provide superior financial ser-

vices than countries that rely on indirect finance alone. Moreover, financial intermediation is not costless. Investment in human
capital in finance represents a drain on society's scarce resources which have high alternative costs. Buildings, furnishings, and extensive communication facilities also involve a
significant social-overhead investment. These
costs are reflected in the spread between the
deposit interest rates paid to savers and the
loan interest rates charged to borrowers. A
large spread reflects a high cost of operationsor a high degree of monopoly profit-for financial institutions.
The benefits and costs of financial intermediation may be shown graphically (Figure 2),
by relating the volume of national savings or
investment at various real interest rates. The
curve I DF is a demand-for-capital curve under
conditions of direct financing. It is based on
the economy's aggregate production function,
and depicts the marginal productivity of capital
for the economy as a whole in the absence of
financial intermediation. 9 The curve I F1 stands

Figure 2
Benefit and Cost of
Financial Intermediation
Real Interest
Rate

o

A

B
Savings. Investment

46

for the economy's demand for capital under
conditions of financial intermediation. It lies
above the I OF curve to reflect the higher return
to capital under financial intermediation. 10 The
curve I~! lies below the curve IF! by the real
factor costs of financial intermediation per unit
of capital.
The curve SDF depicts the amount of savings
forthcoming at various real interest rates when
savings must be placed directly by savers with
ultimate borrowers. It includes the desired retained earnings of business firms for their selffinance of investment, as well as direct purchases by savers of the securities of ultimate
fund users. The curve SF! stands for the economy's total savings when there is financial intermediation, which increases national savings
at given real interest rates.
The equilbrium amount of savings under
conditions of self-finance and direct placement
is shown as OA, and that under financial intermediation is shown as OB. At OB, the real
loan-interest rate charged by financial intermediaries is r L, and the real deposit-interest
rate paid by them is r D , the difference being
the real financing cost plus the institutions'
profit.
Free competition in financial markets is
shown in Figure 2, where the deposit rate (r D)
and the loan rate (rJ are both determined by
market demand-and-supply forces. In most
Pacific Basin countries, however, interest rates
are set by the monetary authorities at levels
below market-clearing levels, in the belief that
low interest rates help stimulate investment
and hence promote economic development. In
order to insure financial institutions' profitability, deposit rates are set even lower. The
situation is depicted in Figure 3, which reproduces the curves I F[, I~[, and SF[ from Figure
2, and adds the assumption that the authorities
set a ceiling deposit rate at rD' The amount of
savings provided to the financial system would
be OA. Given the limited amount of savings,
enterprises would be willing to pay at least a
loan rate of r l . Subtracting the cost of financial
intermediation, financial institutions could
then earn at least a profit of rDr) per unit of
capital.

But since interest-rate ceilings have been imposed in order to lower the cost of borrowing
to business firms, financial intermediaries
probably would not be allowed to charge the
market interest rate. Instead, they would be
limited to a loan rate which would allow just
enough margin to cover their operating costs.
The ceiling loan rate will be r L (r Or L=r 2r l ), at
which there will be an unsatisfied excess demand for funds of EF ( AB). Instead of financial institutions enjoying an excess profit of
roDHr2' borrowers would receive an excess
profit of rLEKr l (= rDDHr2)'
Because of the unsatisfied demand for capital, an unorganized (black) market could
arise. Since the lenders in this market would
tend to be small lenders operating under unfavorable conditions, their costs of operation
would normally be higher than those of financial institutions operating in the organized
market. The higher cost of black-market operations is shown as DG (>DE), and that market's supply curve is shown as SBM' The intersection of hI and SBM determines the total

Figure 3
Financial Repression
Real Interest
Rate

o

47

A

C

B
Savings, Investment

long as they are able to pay the loan rate of
r L • This is depicted by the dots in Figure 3 in
the box r L EKr].13 Paradoxically, under this condition, bribery of bank officials for favorable
consideration of loan applications, though a
social evil, could be an economic virtue. In
other words, bribery might supplement a price
mechanism thwarted by official repression,
and thus help ensure the allocation of capital
to the most efficient users.
The condition of "repressed finance" arises
from a real deposit rate below market-clearing
levels. The low real interest rate may be the
result of a nominal rate deliberately set low in
order to encourage investment, or a failure to
adjust the nominal rate in keeping with rising
inflation. In either case, the volume of capital
formation is limited by the volume of savings
forthcoming at the given real deposit rate. The
lower the real deposit rate, the lower would
be the degree of the economy's financial intermediation. But interest-rate liberalization, by
allowing nominal interest rates to be determined by market forces, would free financial
institutions to offer positive real deposit rates
and thereby stimulate the growth of the financial-intermediation sector.

amount of financing effected through both regulated and unregulated markets. Total savings
and investment will be OC, of which OA is
channeled through the organized market and
AC through the unorganized (black) market. ll
Under the conditions of "financial repression" depicted in Figure 3, the size of the financial-intermediary sector will be smaller
than in Figure 2, the difference depending on
the vigor with which the unorganized market
is suppressed by the monetary authorities. In
the extreme case where the unorganized market is openly tolerated by the authoritieswhere the costs of the unorganized market are
not significantly higher than those of the organized market-there might be little difference between OA and 00 2 • However, we
must consider not only the impact on the volume of savings and investment, but also the
efficiency of investment. IF! in Figure 3 is
drawn on the assumption that savings OA will
be allocated by financial institutions to the
most efficient borrowers in the market, although there is no assurance that this will indeed be the case. Under arbitrary allocative
rules, financial institutions may distribute
funds to enterprises which are less efficient, so

II. Financial Deepening in Pacific Basin Countries
We turn now to compare the financial-deepening experiences of eleven Pacific Basin countries during the 1960-78 period. Although it
would be preferable to use the broadest possible measures of financial-market development, it is difficult with existing data bases l4 to
devise comparable measures in a cross-country
sample. Thus, this analysis focuses only on
financial intermediation, since comparable
data are available only on that basis. As our
earlier discussion suggests, direct finance markets (despite their obvious uses) are unlikely
to be important in developing economies.
Our survey has been designed to see what
generalizations (if any) can be derived about
the factors promoting or retarding financial
deepening in countries at different stages of
economic development. In terms of per capita
income, the eleven countries range from less

than $400 in Indonesia to more than $9,700 in
the United States (1978 data). Overall, during
the past two decades, this region has grown
faster than any other region in the world.
However, individual growth rates have varied
from an average of about 3V2 percent per year
in the United States and New Zealand to more
than 9 percent per year in Korea and Singapore. In terms of inflation, the range has also
been considerable, from an annual-average
rate of a little over 3 percent in Malaysia and
Singapore to about 14 percent in Korea and 30
percent in Indonesia. IS •
The eleven countries also exhibit a variety
of banking structures. Banks in Indonesia, Korea, and Taiwan are predominantly owned by
the government. Malaysia, New Zealand, the
Philippines, and Thailand each has a mixed
banking system, with one or two large state-

48

owned banks competing with a large number
of private banks. Banks in Australia, Japan,
Singapore, and the United States are all privately-owned, with the government owning
and operating only development and exportcredit institutions.
Finally, all of these countries have experimented with a variety of interest-rate policies.
Most of them, including the United States,
have maintained rigid controls on bank deposit-interest rates for small savers. However,
New Zealand since March 1976 and Singapore
since July 1975 have lifted such interest-rate
ceilings. Some countries, because of regulated
interest rates and inflation, have exhibited negative real deposit-interest rates-but others
have shown very high positive rates. We will
later examine how these variations have affected financial growth in these countries.
The degree of financial intermediation of a
nation might be measured by the proportion
of national wealth held through financial intermediaries. Lacking adequate data on national wealth, we may assume that national
output is proportionate to national wealth, so
that financial intermediation can be measured
instead by the ratio of the consolidated assets
of each nation's financial intermediaries to national output.
We may distinguish three types of financial
intermediaries: the monetary authorities, the
deposit-money banks, and non-bank financial
institutions (savings institutions, credit unions,
insurance companies, etc.). Banks are differentiated by their ability to accept demand (i.e.,
checkable) deposits and thus to expand the
money supply by creating demand deposits
against themselves, whereas non-bank financial institutions must discharge their liabilities
by drawing on their demand deposits at banks.
In measuring the magnitude of a nation's
financial sector, what is relevant is the total
claims of financial intermediaries on non-financial sectors: government, business, households, and the rest of the world. Claims of
financial institutions on each other thus should
be netted out. This means not only inter-bank
claims, but also the monetary authorities'
claims on banks and non-bank financial insti-

tutions, bank reserves held at the central bank,
and cash reserves of banks and non-bank financial institutions.
Financial Intermediation, 1978
The degree of financial intermediation is
shown by the total consolidated assets of each
country's financial sector and their distribution
between foreign and domestic assets-all expressed as ratios to national output (Table 1).
In each category, the eleven countries are
ranked according to the magnitude of the ratio
into four groups: (I) High, (II) Medium-High,
(III) Medium-Low, and (IV) Low, degrees of
financial intermediation.
Most (but not all) of these countries showed
about the same rankings in terms of total assets
(TA/Y) as in terms of domestic assets (DA/Y).
By both criteria, Japan, Singapore, Taiwan,
and the United States exhibited the highest
degree of financial intermediation in 1978.
New Zealand stood by itself in a second group;
then followed Australia, Korea, Malaysia, the
Philippines, and Thailand; and lastly, Indonesia fell far behind the others in financial intermediation.
It is tempting to seek some explanations for
these rankings. For example, one might hypothesize that financial development is a "luxury" good in the process of economic developmenL16 This would suggest that income
levels can explain observed differences in financial intermediation. However, the extent of
financial intermediation is itself a determinant
of income levels through its effect on growth.
Thus, to isolate the effects of income on financial development would require a simultaneous-equation model describing growth processes and their two-way relationship to
financial development-a difficult task given
the notorious difficulty of modelling growth
processes.
More importantly, however, there are hazards in constructing a practical, cross-country
measure of the extent of financial development
even if the income/financial-deepening relationship is well understood. It may surprise
some, for example, to see that Japan, Singapore, and Taiwan had higher financial-inter-

49

More importantly, the financial-intermediation ratios, TAIY or DAlY, describe only the
indirect-finance portion of a nation's financial
activities. As we have seen, despite the many
advantages of indirect finance, a financial system dominated by such a system may reflect
stunted growth in capital markets. There is a
great deal of complementarity among self-finance, direct finance, and indirect finance, so
that a well-developed financial system may
combine aspects from each of these modes of
finance. Just because one country boasts a
higher financial-intermediation ratio than another does not mean that it has a more advanced financial system than the other country.

mediation ratios in 1978 than the United States
(Column 1 of Table 1). Generally we assume
that the United States has the world's bestdeveloped and most innovative financial markets, and that New Zealand and Australia are
also well advanced. In contrast, financial markets and institutions in Japan, Singapore, and
Taiwan are considered to be much less developed and shackled by official restrictions.
How can the observed financial-intermediation ratios square with this general impression?
Part of the answer may lie in the composition
of financial assets. In 1978, foreign assets as a
ratio to national output were several times
larger in Singapore and Taiwan than in the
United States (Column 3). This reflects the fact
that financial institutions in these highly open
economies engage in international financial intermediation-i.e., borrowing and lending
abroad-to a much larger relative extent than
do U.S. institutions. This is particularly true
for Singapore, where international assets accounted for nearly one-half of the total assets
of financial institutions in 1978. But when we
exclude foreign assets, the degree of domestic
financial intermediation in 1978 was higher in
the United States than in either Singapore or
Taiwan.

Financial Deepening, 1960-78
While international comparisons of financial-intermediation ratios might be misleading
indicators of financial development, we may
gain much useful information from an intertemporal study of the growth of the appropriate ratios within each nation (Table 2). In
terms of growth of total-asset ratios, Indonesia
and Taiwan ranked at the top in the 1960-78
period, with very high annual growth rates, 9.4
and 7.0 percent respectively. These ratios reflected in part their low degree of financial in-

Table 1

Assets/Output Ratios, 1978
(percent)
Total Assets/Output (TAIY)
(I)

Japan
United States
Singapore
Taiwan

188
101
96
86

(II) New Zealand

78

67
67
65
63

(III) Australia
Korea
Malaysia
Thailand
Philippines

56
55
55

4]

(IV) Indonesia

29

Japan
Singapore
Taiwan
United States

194
189
121
108

(II) New Zealand
Malaysia

82

(III) Korea
Thailand
Australia
Philippines
(IV) Indonesia
Y
TA
DA
FA

Domestic Assets/Output (DAlY)
(I)

79
61

47

Foreign Assets/Output (FA/Y)
(I)

Singapore

(II) Taiwan
Malaysia

35
24

(Ill) Philippines
Thailand
Indonesia
Korea

15
12

(IV) Japan
United States
Australia
New Zealand

Gross national (or domestic) product.
Total consolidated assets of the financial sector ( DA + FA).
Consolidated domestic assets of the financial sector .
Foreign assets of the financial sector.

Source: Based on data in International Monetary Fund. International Financial Statistics, various issues.

50

93

11

10
6
6
4
4

termediation at the beginning of the 1960-78
period. Next came Malaysia, Singapore, the
Philippines, Korea, Thailand, and Japan, with
financial-growth rates ranging from 2.6 percent
to 4.7 percent. Most of these countries, except
Japan and Singapore, started out with relatively low financial-intermediation ratios. The
United States stood alone in the third rank
with a modest financial growth rate of only 0.7
percent per year. Lastly, both New Zealand
and Australia sustained net declines in financial intermediation during the 1960-78 period,
with average annual declines of 0.3 and 0.5
percent respectively.
We see then that the rate of financial deepening tends to be negatively related to the
initial value of the total-asset ratio. One may
assume that, as a rule, opportunities of financial growth abound at an early stage of financial development, and then diminish as the
market becomes saturated with financial institutions. In order to isolate the effects of the
initial ratio, we can fit a downward-sloping
logarithmic curve to the financial-growth rates
and the initial total-asset ratios in Chart 1.J7
By this standard, which measures growth in
relation to each country's initial total-asset ratio, Singapore and Taiwan stood out with the
most rapid financial growth, and Australia and
New Zealand with the slowest growth. In between, Japan and Malaysia had above-average
growth, while Thailand and the United States
had below-average growth.
Table 2

Chart 1
Financial Growth Rates
and Initial FinancialIntermediation Ratios
TA/Y Ratio
Annual Growth Rate (Percent)

10
9

• Indonesia

8
• Taiwan

7
6
5

• Malaysia

.

Singapore

4

.

3

.Japan

Thailand

2
United States

o

~

• New Zealand

Australia.

1 .....- -......_ ......................._ ...._"'o .2 .4 .6 .8 10 1.2 1.4
Initial TA/Y Ratio

Financial Deepening: Growth of Total Assets/Output Ratio (TAlY)
Country

Initial
Year

Initial
Ratio

Ratio
in 1978

Average Annual
Growth (%)

(I)

Indonesia
Taiwan

1966
1961

0.14
0.38

0.41
1.21

9.4
7.0

(II)

Malaysia
Singapore
Philippines
Korea
Thailand
Japan

1969
1968
1963
1962
1961
1960

0.53
1.26
0.37
0.39
0.40
1.21

0.79
1.89
0.63
0.67
0.67
1.94

4.7
4.1
3.6
3.5
3.0
2.6

(III)

United States

1960

0.95

1.08

0.7

(IV)

New Zealand
Australia

1960
1960

0.86
0.70

0.82
0.65

-0.3
-0.5

Source: Based on data in International Monetary Fund, International Financial Statistics,
various issues.

51

tween, Japan and Malaysia had above-average
growth, while Thailand and the United States
had below-average growth.
Average financial-growth rates indicate the
long-run trend of financial deepening. But it
may also be of interest to examine how financial deepening evolved over time in each country (Chart 2). Three countries-Malaysia, Singapore and Taiwan-showed nearly
uninterrupted growth in the TAIY ratio (Panel
a). Two countries-Australia and New Zealand-both attained a high l~el of financial
intermediation by the 1960's but sustained

sharp declines in the TNY ratio in the following decade (Panel b). The other six countries
all achieved net financial growth, but their
growth was marked by prolonged periods (two
years or more) of zero growth or declines in
the TAIY ratio (Panels c and d).
To help explain these diverse patterns, we
should seek to determine what might account
for the broad changes in the trend of financial
growth in the various countries. For public policy, short-term fluctuations in the financial-intermediation ratio are hardly of interest. On
the other hand, it would be desirable to find

Chart 2
Growth of Financial Intermediation Ratios (TAIY),
1960-78
TAN

TAN

2.0

.90

1.8

.85

1.6

.80

1.4

.75

1.2

.70

1.0

.65

0.8

.60
1960

0.6

1966

1970

1974

1978

1974

1978

TAN

2.0
0.4
1.8
0.2
1960

1966

1970

1974

1978

1.6

TAN

0.7

1.4

0.6

1.2

0.5

1.0

0.4

0.8

0.3

0.6

0.2

0.4

0.1
1960

United States

0.2
1966

1970

1974

1978

1960

52

1966

1970

out if changes in financial-growth trends are
subject to any systematic influences under policy control.
This can be done by examining the movement of the financial-intermediation ratio in 27
different episodes, comparing it with the corresponding average real-deposit rate, i.e. the
nominal deposit rate minus the consumer-price
inflation rate (Table 3). According to our theoretical analysis, the real deposit rate plays a
key role in determining the extent of financial
intermediation, especially under conditions of
"repressed finance." The condition describes
well the financial markets in most of the countries studied, with the nominal deposit rate

fixed inflexibly in the face of consumer price
inflation.
All the episodes with falling financial-intermediation ratios were associated with negative
real deposit rates, some as large as minus 34
percent in Taiwan in 1974 and minus 19 percent
in Indonesia in 1972-74. All of these episodes
reflected attempts to maintain stable nominal
deposit rates in the face of high domestic inflation rates. On the other hand, all the episodes
with rising financial-intermediation ratios were
associated with positive real deposit rates-or,
if negative (Indonesia in 1974-78, Japan in
1974-78, and Korea in 1976-78), with a significant increase in the real deposit rate from the

Table 3
Relationship Between Financial Deepening and Real Deposit Rate
Period

Total Assets/Output (TA/Y)

1960-64
1964--69
1969-78

Rising (from 0.70 to 0.76)
Flat (from 0.76 to 0.75)
Falling (from 0.75 to 0.65)

1968-72
1972-74
1974--78

Rising (from 0.13 to 0.28)
Falling (from 0.28 to 0.26)
Rising (from 0.26 to 0,41)

~

1960-72
1972-74
1974--78

Rising (from 1.21 to 1.76)
Falling (from 1.76 to 1.64)
Rising (from 1.64 to 1.94)

~

Korea

1962-64
1964--72
1972-76
1976-78

Falling (from 0.39 to 0.25)
Rising (from 0.25 to 0.61)
Flat (from 0.61 to 0.62)
Rising (from 0.62 to 0.67)

Malaysia

1969-78

Rising (from 0.53 to 0.79) except for
dip in 1974

New Zealand

1960-67
1967-76
1976-78

Rising (from 0.86 to 0.90)
Falling (from 0.90 to 0.77)
Rising (from 0.77 to 0.82)

Philippines

1963-78

Rising (from 0.37 to 0.63) except flat
in 1973-75

2.83: except

Singapore

1968-78

Rising (from 1.26 to 1.89) except for
dip in 1974

4.3: except

Taiwan

1961-78

Rising (from 0.38 to 1.21) except for
dip in 1974

Thailand

1961-72
1972-74
1974--78

Rising (from 0,40 to 0.60)
Falling (from 0.60 to 0.55)
Rising (from 0.55 to 0.67)

5.6
8.5
3.1

United States

1960-72
1972-78

Rising (from 0.95 to 1.(7)
Flat (from 1.07 to 1.(8)

~2.0

Australia

Indonesia

Japan

53

Real Deposit Rate (%)
3.10
1.37
~2.94

14.2
18.8
1.9
0.14
11.08

~2.69

11.03
10.75
-7.17
~ 1.99

~

3.87: except

~5.5

in 1973-74

0.30
~3.81

0.79
8.7 in 1970-74

~

16.2 in 1973-74

6.67: except -34.0 in 1974

1.2

preceding period. The only exception was Japan during 1960-72, when a substantial rise in
the TA/Y ratio took place in spite of a small
negative real deposit rate. This case may have
reflected a very strong propensity to save
through financial institutions, coupled with a
vigorously growing national economy. However, Japan's TA/Y ratio fell sharply in 197274, when the real deposit rate dropped to a
negative 11 percent.
Sustained positive real deposit rates have
meant rising financial intermediation in all
cases except one: Australia in 1964--69, when
the TA/Y ratio remained virtually unchanged
instead of rising. But Malaysia, Singapore, and
Taiwan, the only countries with nearly uninterrupted financial growth, were also the only
countries that consistently maintained high
real deposit rates. In all three cases, the only
decline in the financial-intermediation ratio
occurred in 1973-74, when high inflation rates
turned their real deposit rates briefly negative.
The Philippines also showed steady financial
growth, except for a two-year period (1973-

75) when the TAlY ratio remained flat, in line
with a sharp decline in the real deposit rate.
In sum, the real deposit rate appears to play
a significant role in financial deepening. A positive rate sustained over a number of years all
but assured financial growth, whereas a sustained negative real deposit rate nearly always
brought about financial stagnation or decline.
There were some exceptions to this rule, but
in each case, financial growth accompanied a
significant rise in the real deposit rate, even
when the rate itself remained negative.
We do not claim that the real deposit rate
was the only factor determining the financial
growth rate. Rapid economic growth and a
high savings propensity helped offset the effects of a negative real deposit rate during
several periods of vigorous financial growthIndonesia during 1974--78, Japan during 196072, and Korea during 1976-78. Yet despite
these exceptions, the real deposit rate consistently played a key role in stimulating financial
growth in most of the episodes analyzed here.

III. Summary and Conclusions
The economic literature suggests that organized financial markets, and financial intermediation in particular, possess certain advantages over self-finance in terms of promoting
savings and efficiency of investment. The analysis in this paper focusses on financial intermediation for reasons of data consistency, but
it is important to remember that direct finance
also plays a major development role in countries with fully developed financial markets.
Financial intermediation ratios in 1978 were
significantly higher in Japan, Singapore, and
Taiwan than in Australia, New Zealand, and
the United States. The explanation lies partly
in Singapore and Taiwan's high degree of international intermediation, and partly in Japan, Singapore and Taiwan's relative lack of
alternative channels of financing, compared
with the other developed economies.
In terms of growth over time, Malaysia,
Singapore, and Taiwan achieved nearly uninterrupted financial growth during the data pe-

riod. In contrast, Australia and New Zealand
sustained net declines in their degree of financial intermediation. The other six nations all
recorded growth in financial intermediation,
but with varying periods of stagnation or setback.
The real deposit interest rate played a critical role in setting the pace of each nation's
financial growth. Positive real deposit rates
maintained over a number of years invariably
led to financial deepening, while negative real
deposit rates (even over brief periods) could
result in sharp financial disintermediation
against an otherwise strongly upward trend.
Other factors, such as a vigorously growing
economy with a high propensity to save, occasionally offset the adverse effects of a negative real deposit rate-for instance, in Japan
during 1960-72. However, such reversals were
relatively rare, and failed to contradict the hypothesis that a negative real deposit rate is
detrimental to financial deepening.

54

inflation cannot be brought down quickly, interest rates should be allowed to adjust with sufficient flexibility to permit a positive real rate of
return to savings.

Because of the importance of financial deepening for economic growth, economic policy
should be aimed at reducing inflation, which by
definition lowers the real deposit rate. Where

FOOTNOTES
1. See for instance, John G. Gurley and Edward S. Shaw,
"Financial Intermediaries and the Savings-Investment
Process," Journal of FInance, May 1956, pp. 257-77.
Hugh T. Patrick, "Financial Development and Economic
Growth in Underdeveloped Countries," Economic Development and Cultural Change, January 1966, pp.
174-89; Edward S. Shaw, Financial Deepening in EconomIc Development, Oxford, 1973; Ronald I. McKinnon,
Money and Capital in Economic Development, Brookings, 1973; Ronald I. McKinnon, ed., Money and Finance
In EconomIc Growth and Development, Marcel Dekker,
1976; Donald J. Mathieson, "Financial Reform and Capital
Flows in a Developing Economy," International Monetary Fund Staff Papers, September 1979, pp. 450-489.

capital stock, real savings, and a measure of the nation's
degree of financial intermediation. Differentiate (1) with
respect to time to obtain
(3)

where YK and YF are partial derivatives of Y with respect
to K and F, and a dot over a variable indicates its rate of
change over time. Now, assume that the savings function
is homogeneous of first degree with respect to Y, such
that (2) may be rewritten as
S

=

S(F)Y

(2')

Then, by equating savings with net investment,

2. By economic growth is meant an increase in per capita
real income over time. The relevant economic literature
generally regards increases in the savings rate resulting
from financial deepening as growth enhancing in the short
run. It does not deal with the long-run question of whether
the growth-enhancing effect would eventually be offset by
declining marginal productivity of capital as capital accumulates, so that in the "steady-state" the growth rate is
independent of the savings rate. This paper follows the
tradition of the financial-deepening literature by considering only the short-run effects on economic growth, excluding the "steady state" considerations.

S

=

K

=

S(F)Y

(4)

and substituting (4) into (3) we obtain

Y=

YKS(F)Y

+

YFF

(5)

Now, by definition, economic-growth rate
g == YIY

(6)

Substitute (5) into (6) to obtain

3. No consideration is given in this paper to financing by
foreign capitai. However, as a rule, foreign capital is attracted by the nation's growth prospects, which in turn
depend critically on how well the nation is able to mobilize
and utilize its own national savings. Thus, ultimately, national capital formation must depend on the efficiency of
its financial system.

(7)

Equation (7) states that the degree of financial intermediation affects a nation's economic growth rate through its
impacts on the marginal productivity of capital (YK) and
the savings rate (S); moreover, financial growth (F) directly enhances economic growth in proportion to the marginal productivity of financial intermediation relative to the
national product (YFIY).

4. See McKinnon, Money and Capital in Economic Development, Brookings, 1973, ch. 2, pp. 5--21, for an analysis of this point.

5. Central banks are also financial intermediaries, be-

Note that this analysis excludes considerations of the
"steady state" growth path (see note 2 above).

cause their currency creation channels a portion of the
nation's private savings to the Government. Also, central
banks often lend directly to the Government and businesses.

8. Including the cost of government regulation, such as
that which arises from requiring financial intermediaries to
hold interest-free reserves against either assets or deposits. McKinnon shows that the real reserve cost rises geometrically with the rate of inflation in the economy. See
Ronald I. McKinnon, "Financial Repression and the liberalization Problem within Less-Developed Countries" in
The Past and Prospects for World Economic Order,
edited by A. Lindbeck and E. Lundberg (forthcoming).

6. For a succinct statement of the economic benefits of
financial intermediation, see James C. Van Horne, Function and Analysis of Capital Market Rates, PrenticeHall, 1970, pp. 6-7.
7. These propositions can be built into a simple HarrodDomar model of economic growth:

Y

Y(K, F)

(1)

S = S(Y, F)

(2)

=

9. The benefits and costs of financial intermediation give
rise to the question of the optimal size of a nation's financial sector. For an analysis of the problem, see U Tun Wai,
"The Optimal Size and Ideal Structure of Financial Markets in Developing Countries," International Monetary
Fund, DM/78/74, August 1978.

and

where Y, K, and F designate real national output, real

55

10. For a more formal analysis of the role of financial
intermediation in economic growth, see Lewis J. Spellman, "Economic Growth and Financial Intermediation," in
Money and Finance in Economic Growth and Development, edited by Ronald I. McKinnon, 1976, pp. 11-22.

14. The only available source of internationally comparable data is the International Financial Statistics (IFS)
database. The financial intermediation measure developed here is the broadest indicator of financial-market
development calculable with that data.

11. The addition of the unorganized market to the diagrammatic analysis is due to Sho-Chieh Tsiang, "Fashions
and Misconceptions in Monetary Theory and Their Influences on Financial and Banking Policies," Zeitschrift fur
die Gesamte Staatswissenschaft, December 1979, pp.
584-604.

15. For Indonesia, the data refer to the period from 1966
to 1978.

12. This factor partially accounts for the frequent failure
to find significant effects of real interest rates in empirical
studies of national savings. See Vincente Galbis, 'Theoretical Aspects of Interest Rate Policies in Less Developed
Countries," International Monetary Fund, DM/79/7, February 1979.

16. Goldsmith found that the income elasticity of demand
for financial assets was greater than unity for both developed and less-developed countries. See Raymond W.
Goldsmith, Financial Structure and Development, Yale,
1969, Table 4-11, p. 204.
17. The regression equation is rFG
1.52 - 3.22
1n(TAIY)a, R2=0.44, where rFG is the average annual rate
of growth of the TAN ratio, and (TAIY)a is the initial ratio
of total assets to national output.

13. This form of diagrammatic presentation is due to Maxwell Fry, "Money and Capital or Financial Deepening in
Economic Development?" Journal of Money, Credit, and
Banking, November 1978, pp. 464-475.

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