Full text of New England Economic Review : May/June 1972

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I

May/June

A

972

FEDERAL RESERVE BANK OF BOSTON

NEW
ENGLAND
ECONOMIC
REVIEW
Exchange-Rate Flexibility and the ForwardExchange Markets: Some Evidence from the
Recent Experience with the German Mark
One common objection to more flexible exchange rates is that they would
overburden the forward-exchange markets and disrupt international trade. However, the experience of 167 U.S. firms last year shows that flexibility of the markdollar exchange rate did not produce this result.

The Path to Full Employment
To attain "full employment," the U.S. economy must sustain a high rate of
growth beyond this year due to continuing rapid growth of the labor force.


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New England Economic Review

Exchange-Rate Flexibility and
the Forward-Exchange Markets:
Some Evidence from the Recent Experience
with the German Mark
by Norman S. Fieleke

IT IS WIDELY acknowledged that national
govern~ents will generally be freer to adapt
monetary and fiscal policies to domestic needs if
those policies are not constrained by a requirement to maintain fixed rates of exchange between
national currencies. Nevertheless, governments
typically undertake to fix these rates of exchange,
allowing them to vary only within narrow limits.
One reason for this rate-fixing is a fear that
international commerce would be disrupted by
exchange rates that could shift around with
relative freedom. The evidence examined in this
article suggests that this fear has little basis in fact.

The Role of the Forward-Exchange
Markets in International Trade
The contention that exchange-rate flexibility
would disrupt international trade is customarily
based on one or more of three different assumptions, none of which has been substantiated. The
first assumption is that if exchange rates were
allowed to fluctuate ( or float), they would fluctuate wildly; there is little in economic theory or
experience to support such an extravagant claim. 1
The second assumption is that in the absence of
fixed rates international traders would be unnerved by uncertainty over what future exchange
rates would be ( even if exchange rates did not
fluctuate wildly); thus, they would do much less
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business, for to avoid struggling with uncertain
exchange rates each trader would insist on consummating transactions in his own currency. This
second assumption is vulnerable on two counts.
First, over the long run, "fixed" rates are not
really certain but are adjusted by sizable amounts.
Second, in the short run, if forward-exchange
markets are working properly they can substantially diminish business uncertainty stemming
from short-run fluctuations in exchange rates.
How the forward-exchange markets are utilized
to reduce uncertainty can readily be illustrated.
Suppose that a U.S. importer signs a contract to
purchase merchandise from Germany, and that the
German supplier is to be paid in German marks
soon after the merchandise is delivered 3 months
hence. Because the rate of exchange between
dollars and marks may change over the coming
months, the U.S. importer cannot be sure what the
merchandise will cost him in terms of dollars if he
waits 3 months or more to buy the marks he has
agreed to deliver. One way he can avoid this uncertainty is to buy marks for future delivery in the
forward-exchange market. More specifically, his
bank will agree to deliver, say, 3 months from now,
1
It is true, of course, that an exchange-rate which has
been fixed by a government at a highly unrealistic level
will change radically if it is allowed to move freely; this,
however, is a different matter.

May/June 1972
the marks he will need at that time, and will tell
him today the rate of exchange ( or dollar price)
that he will have to pay for the marks at that time.
By entering this contract, that is, by purchasing
"forward cover," the importer can eliminate any
uncertainty about the dollar price that he will have
to pay for his imported merchandise. This service
is made possible by the existence of the forwardexchange market.
This leads to the third assumption underlying
the fear that exchange-rate flexibility would cripple international commerce. This assumption is
that the forward-exchange markets would be
unable to meet the demands placed upon them by
a system of flexible exchange rates. With flexible
rates, it is argued, the demand for forward cover
would rise sharply, the facilities of the forwardexchange market would be overtaxed, and international trade would suffer. · To return to the
illustration, if the importer could not buy marks
for future delivery without paying an exorbitant
commission, he would not be willing to order the
German merchandise.
Whether this third assumption is valid is a very
important question. Fortunately, the question
need not be debated in the abstract, since there is
some recent experience to draw upon. In particular, the Canadian dollar has been floating since
June 1, 1970, and nearly all the other major
currencies also were allowed to float for a while
last year after it became widely recognized that
their rates of exchange against the dollar were
being held at levels notably different from what
market forces would dictate.

Two Case Stu dies
In order to tap this experience with floating
rates; we mailed questionnaires to selected U.S.
firms which dealt with parties in Germany during
the flotation of the mark, and also to firms which
dealt with parties in Canada during the flotation of
the Canadian dollar. Follow-up interviews were
held with many of the firms that replied. The

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purpose of these two surveys was to discover
whether efficient forward-exchange market facilities were available for "covering" commercial
transactions during the recent experiments with
flexibility.
The results of the survey of firms doing
business with Canadians have been published
elsewhere. 2 Those results were very encouraging;
the flotation of the Canadian dollar apparently did
not impair the ability of the forward-exchange
market to provide forward cover for transactions
between U.S. and Canadian firms. However, because "one swallow does not make a summer," we
subsequently investigated the functioning of the
mark-dollar forward market during the flotation of
the German mark, and it is the primary purpose of
this article to report the results of that investigation.

Firms Participating in the Survey
As noted, the investigation took the form of a
questionnaire survey with follow-up interviews.
Questionnaires were mailed to nonbanking firms in
New York City which might have been expected
to transact business with parties in Germany
during the period the mark was floating (from
early May through mid-December). 3 The questionnaire, which is reproduced at the end of this
article, was designed to discover whether firms had
experienced difficulties in obtaining forward cover
during the flotation of the German mark. Completed or partially completed questionnaires were
returned by 16 7 firms.
Recognizing the possibility that some lines of
business might be troubled more than others by

2
See Canadian-United States Financial Relationships,
Conference Series No. 6, Federal Reserve Bank of Boston, available upon request.
3
Firms to which the questionnaire was mailed were
selected from Paul G. Baudler's Directory of American
Business in Germany (4th ed.; Munich, Germany: Seibt
Publications, 1971 ). Questionnaires were mailed to 890
firms.

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New England Economic Review
difficulties in the forward-exchange market, we
asked recipients of the questionnaire to identify
the nature of their business and, in particular, to
indicate whether they had acted as purchasers or
sellers in their dealings with German residents
during the flotation of the mark. This question,
like others in the questionnaire, was not answered
by all of the 167 firms. Of the firms which did
answer the question, 35 had acted as purchasers,
54 had acted as sellers, and 31 had both bought
and sold. A variety of lines of business were
represented; 48 firms were manufacturers, 29 were
distributors, wholesalers, or retailers, 25 merely
exported or imported, 10 were publishers, and the
remainder comprised a miscellany representing
activities as diverse as mining and advertising.
It is also possible that smaller firms might not
be accommodated so readily in the forwardexchange market as larger firms, and for this
reason recipients of the questionnaire were asked
to report their total assets and sales in 1971. The
table shows how the responding firms are distributed in terms of their assets and sales; a few

gargantuan firms are included, but smaller businesses are well represented.

The Performance of the
Forward-Exchange Market
The questionnaire included two classes of questions relating to the performance of the markdollar forward-exchange market. The first class
sought information on the general adequacy of the
market, the second on specific characteristics of
the market.

The General Adequacy of the Market
The most important finding can be stated in a
single sentence. During the flotation of the mark,
not one of the responding firms decided to forgo
a transaction with a German resident because of
difficulties in the forward market, and no firm was
unable to buy or sell marks in the forward market.
This is strong testimony that forward-exchange
markets can function well during periods when
exchange rates are undergoing significant change.
One hundred twenty-five of the firms partici-

NUMBER OF RESPONDING FIRMS SPECIFYING SIZE OF
ASSETS AND SALES IN 1971, BY SIZE
Size of assets
or sales
( in millions
of dollars)

Number of
firms with
asset size
indicated

Number of
firms with
sales volume
indicated

Less than
5
5 and under
50
50 and under 200
200 and under 500
500 and under 1,000
1,000 and under 2,000
2,000 and under 5,000
5,000 and over
Total

33
16
17
9
10
13
7
4
109

23
24
18
12
15
12
6
3
113


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May /June 19 72
pating in the survey had entered into or completed
a transaction with a German resident during the
flotation of the mark. Seventy-three of these firms
had agreed to make or accept payment in German
marks in some of these transactions, and, other
things being equal, these firms were faced with a
foreign-exchange risk of the sort which confronted
the importer in our illustration. Those which had
contracted to pay marks in the future could, of
course, have dealt with this exchange-risk by buying marks forward, while those expecting to
receive marks in the future could have sold
forward the marks they expected to receive.
However, 54 of the 73 firms dealing in marks
stated that they did not buy or sell forward the
marks involved in their transactions. It was not
difficulties with the forward market which led
these 54 firms to avoid the market, but other
considerations. Eleven of the 54 thought that the
mark amounts involved were too small to worry
about, and a few others did not understand the
logic of covering their mark transactions in the
forward market. But the great majority of the 54
chose either (1) to protect themselves from
exchange-risk by means other than buying or
selling forward or (2) to gamble that they would
do well enough without protection.
The means other than buying or selling forward
which were employed by these firms to secure
"protection" are discussed in a following section
of this article. As for the "gambling" that went on,
one example should suffice. Suppose that a firm is
obligated to make a payment in German marks in
the future , but that the management believes the
rate it would have to pay for forward marks is
unrealistically high; therefore, rather than buying
the marks forward the management decides to
wait and buy them at the time the payment must
be made. In this example, the firm is "short" of
the marks it needs to meet its obligations. Actually, the gamble represented by being "short"
was not so common among the participating firms
as the reverse gamble of having claims in marks
that were greater than needed to meet the firm's

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obligations.
The evidence presented thus far suggests that
U.S. firms did not encounter any major inadequacies in the mark-dollar forward market
during the period when the mark was allowed to
float. However, it is possible that firms in Germany might not have been so fortunate; German
firms making or receiving payments in dollars
might have faced difficulties in covering their
exchange risks by buying or selling dollars forward. If so, they might have asked their U.S.
customers or suppliers to denominate the transactions in marks rather than in dollars.
The firms participating in our survey were
questioned about this matter, and 23 of them
stated that they had indeed been asked by German
firms to start making or accepting payment in
marks on transactions of a kind which previously
had been denominated in U.S. dollars. However,
none of the 23 firms indicated that it was
difficulty with the forward-exchange market that
had led the German businessmen to make this
request. The truth probably is that the German
businessmen did not want to be bothered with the
bookkeeping and other administrative burdens
associated with transactions in the forward-exchange market; if transactions were denominated
in marks, it would be the U.S. firms, not the
German firms, that would be faced with the
exchange-risk and the decision of whether to enter
the forward-exchange market. To be sure, these
German firms had been willing to deal in dollars
before the flotation of the mark; but at that time
they probably thought that the exchange-rate
would be stable enough to obviate the need for
forward cover.
Nearly all of the 23 U.S. firms agreed to begin
making or accepting payments in marks. Interviews with these firms revealed that the practice
was continuing after the flotation of the mark was
terminated. The continuation of the practice is no
doubt partly attributable to inertia; but it is
mainly attributable to a loss of confidence in
Germany about the future worth of the dollar,
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New England Economic Review

since 20 of the 23 U.S. firms reported that
German suppliers had requested payment in marks
out of fear that any dollars due them would
decline in value.
To conclude this section, we were not able to
discover any major deficiencies in the mark-dollar
forward market during the flotation of the mark.
In the next section , specific aspects of the market's performance are considered.
Specific Characteristics of the Market

Even though the mark-dollar forward market
seems to have been generally adequate during the
mark's flotation , there might have been discontent
with particular features of the market's performance. Consequently, our questionnaire included a
few questions designed to reveal any such discontent.
As noted near the beginning of this article , it is
conceivable that large firms with large forward
transactions would be given much better service by
the banks than small firms with small transactions.
However, the questionnaire responses contained
no evidence or allegations of discrimination against
small firms or small transactions. In fact , in
response to a question on the subject, three small
firms each claimed to have entered the forward
market during the flotation for a transaction of
only 10,000 marks (the equivalent of about
$3 ,000). While such small transactions are hardly
typical, it is encouraging that they did take place.
To obtain additional evidence on the treatment
of small transactions, we asked the participating
firms whether the forward-exchange rates quoted
by banks are generally less favorable for small
transactions than for large transactions. There
were three affirmative and 10 negative responses.
While the participating firms are therefore generally content with the treatment accorded their
smaller transactions, it still is probably true that
very small transactions are accommodated at rates
less favorable to the firm ; as one firm noted, "if
the transaction were quite small the rate would be
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less favorable to cope with the nuisance value."
Another important feature of the market is
whether it can accommodate long-term contracts.
To illustrate, a U.S. firm might agree to buy from
a German firm a specialized machine which will
require, say, 2 years to produce. If payment is
to be made in marks, the U.S. firm might enter the
forward market, seeking a contract to have the
marks delivered 2 years hence at a price agreed
upon today. It is sometimes alleged that such
long-term contracts are very difficult to obtain,
and that firms which could not obtain them would
be discouraged from trading internationally if
exchange rates became more flexible.
The evidence of the questionnaire survey is
clear on this matter. No participating firm was
unable to obtain forward-exchange contracts of
the duration desired. However, the longest term to
maturity that any firm contracted for was 1 year
and 10 months, indicating that long-term contracts
were not in great demand.
Finally, the questionnaire sought a little information on the nature of competition among
banks active in the forward market, since it is
sometimes argued that the banks follow monopolistic practices. The firms receiving the questionnaire were asked if they generally shopped around
among the banks for the most favorable exchange
rate when buying or selling marks forward. Those
which did not shop around were asked why they
did not, and those which did shop around were
asked whether they encountered variations in the
rates quoted by the banks.
Of the 24 firms answering this question, 12
customarily shopped around, and they reported
minor variations in quoted rates. As for the 12
non-shoppers, the great majority either expressed
confidence that their banks would not overcharge
them or declared that the amounts involved in
their transactions were too small to warrant the
effort of shopping around. No firm complained of
monopolistic behavior by U.S. banks.
The questionnaire also asked for suggestions on
how to improve the mark-dollar forward market.

May /June 19 72
The only response relating to the functioning of
the market was a suggestion that up-to-the-minute
information on exchange rates should be obtainable without having to "bother the foreignexchange traders all day." Twenty-five firms explicitly stated their satisfaction with the market.
In sum, the evidence examined in this section
reinforces the conclusion that the mark-dollar
forward market did not malfunction so as to
disrupt international trade during the flotation of
the mark.

Commercial Hedging Practices
In the illustration given near the beginning of
this article, it was noted that the importer could
eliminate his exchange risk by purchasing marks
forward. In fact, entering the forward-exchange
market is only one of several methods by which a
firm can cope with exchange risk. The purpose of
this section is to describe the various methods that
were employed by the firms which participated in
the questionnaire survey.

Measurement of Gain or Loss from
Exchange-Rate Changes
Once his merchandise had arrived, the importer
in our illustration would have a debt to pay in
marks, even though he had no marks on hand and
none coming due him; he would then be "short"
on marks. By contrast, an exporter to Germany
might be entitled to receive payment in marks,
even though he had no mark debts; he would be
"long" on marks. Suppose that, before these
payments were made, the dollar price of the mark
went up in the foreign-exchange market, as happened last year. Then the exporter could obtain
more dollars when he received and sold the marks
than he could have obtained if the exchange-rate
had remained stable; the importer, on the other
hand, would have to spend more dollars to acquire
the needed marks. Consequently, under the customary concepts the importer or other firm which
had been short on marks would experience a loss

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in terms of dollars, while a firm which had been
long on marks would experience a gain in terms of
dollars. If the dollar price of marks had fallen, the
firm which had been long would have suffered a
loss, while the other firm would have experienced
a gain.
Measuring a firm's long or short position and
the associated gain or loss from exchange-rate
changes becomes more complicated if the firm has
a number of different kinds of assets and liabilities
denominated in the foreign currency, as firms
commonly do if they have subsidiaries abroad.
Knowing how firms measure their long or short
position is necessary for understanding how they
"hedge," or protect themselves, against avoidable
losses from exchange-rate changes.
The accounting profession sanctions two general approaches, each with its variants, for measuring a firm's foreign-exchange position: the net
financial assets approach and the net current assets
approach. Under the net financial assets approach,
the firm compares its financial assets (including
cash and accounts receivable) which are denominated in a foreign currency with its financial
liabilities (including both short- and long-term
debt) which are denominated in that currency.
Unless these foreign-currency assets and liabilities
are of equal magnitude, the firm is considered to
have a foreign-exchange position and to be exposed to the risk of loss from movements in the
exchange rate. Physical assets, such as inventory
and equipment, are excluded from the computation on the following grounds: (1) unlike cash and
other financial assets, physical assets do not
represent a fixed number of foreign currency
units; (2) if a country's currency is losing value in
the foreign-exchange markets, it is generally because of relative inflation in that country; and the
price of physical assets in such a country generally
rises with inflation, offsetting the depreciation of
the country's currency and obviating any foreignexchange loss on the physical assets.
Under the net current assets approach, the firm
compares its current foreign assets (more pre7

New England Economic Review

cisely, its current financial assets denominated in
the foreign currency plus inventories held in the
foreign country) with its current foreign liabilities
(short-term debt payable in the foreign currency).
Again, unless these assets and liabilities are of
equal size, the firm is deemed to have a foreignexchange position. The logic underlying this approach is not clear.
In response to our questionnaire, 75 firms
indicated the approaches they used in determining
whether they had a foreign-exchange position.
Thirty-three firms used one of the traditional
accounting approaches which have just been described, or used some minor variant of these
approaches; more specifically, 16 relied upon the
net current assets approach, six relied upon the net
financial assets approach, and the remaining 11
employed variants or hybrids of these approaches.
All but 7 of these 33 firms apparently had subsidiaries in Germany.
The remaining 3 2 firms made no reference to a
traditional accounting approach, and only one of
these firms had a German subsidiary. In other
words, as might be expected, firms tend to ignore
the traditional accounting concepts if they do not
have German subsidiaries and are not faced with
the task of periodically translating a complete set
of German mark accounts into dollars. Nevertheless, these firms showed awareness that changes in
the mark-dollar rate made a difference in the
profitability of their dealings with parties in
Germany; exporters to Germany knew that last
year's rise in the dollar value of the mark would
tend to raise their dollar revenues, while importers
from Germany could hardly ignore the accompanying increase in the dollar cost of their
imports.

Measures Taken to Avoid Loss

The 75 firms which explicitly recognized that
exchange-rate variations affected their businesses
generally took steps either to protect themselves

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or to profit from last year's appreciation of the
mark. In particular, 25 of the 33 firms which
employed a traditional accounting concept, or
some variant thereof, managed to avoid having net
liabilities, or to avoid being "short," under that
concept. As for the 32 firms which did not espouse
a traditional concept, the great majority of these
also took steps to protect themselves. In fact, only
eight firms explicitly declared themselves to be
without protection, and all of them were importers.
The firms which took protective or profit-seeking measures named a variety of devices. Fourteen
of them purchased marks forward; six purchased
marks with borrowed dollars; 10 requested payment in marks for German goods they were
reselling or for U.S. goods they were selling to
German purchasers, while one started paying a
German supplier in dollars instead of marks; two
made estimates of how the exchange rate would
change and planned their purchases from Germany
on the basis of those estimates; two employed
"currency clauses" in their contracts with German
suppliers, under the terms of which their mark
payments to the German suppliers were to be
adjusted downward to offset any increase in the
dollar price of the mark; and 11 engaged in
"leading" or "lagging," which consists of changing
the timing of foreign-exchange transactions in
order to take advantage of anticipated changes in
the exchange rate.
Leading and lagging, which was an important
protective device, was accomplished in the following ways: deferral of dividends from German
subsidiaries; delay in payment by German subsidiaries to non-German creditors; prepayment of
German creditors; early placement of orders for
German goods; and delay in repatriating export
proceeds collected in Germany. In general, such
activities allowed firms to delay the conversion of
marks into dollars and to accelerate the conversion
of dollars into marks, so that the firms would
experience greater profits, or smaller losses, from
the rise in value of the mark.

May/June 1972

Conclusion
The purpose of this article was to present
additional evidence on the question of whether
exchange-rate flexibility disrupts international
trade by overtaxing the forward-exchange markets.
The conclusion from the evidence now in hand is
unambiguous. The 167 firms participating in our
survey made no major, and virtually no minor,
complaints about the functioning of the markdollar forward market during the flotation of the
mark. This finding is all the more impressive in
view of (1) the radical change in the mark-dollar
exchange rate during the flotation and (2) the
prolonged uncertainty over what the new fixed
rate would be. Moreoever, it is a finding which is
very similar to that obtained from our earlier
survey of experience under the flotation of the
Canadian dollar. In brief, the claim that flexibility
would overburden the forward markets is a bogeyman, whose exorcism is now in order, if not long
overdue.
Of course, it is true that some forwardexchange markets did not perform well during the
period of exchange-rate revisions last year; the

forward market for the Japanese yen is a case in
point. However, the failings of such markets were
caused by government restrictions over the
institutions which serve the markets, not by basic
inadequacies in the institutions themselves. These
restrictions operated to reduce the degree of
exchange-rate flexibility, but this reduction in
flexibility impaired, rather than strengthened, the
markets where it occurred.
Another important discovery from our survey is
that a significant proportion of importers have
started paying their German suppliers in marks
instead of dollars. Foreign-exchange traders report
that other continental West European currencies
have similarly replaced the dollar to a significant
degree in U.S. transactions with the countries
concerned. This diminished role of the dollar as a
transactions currency may have adverse implications for the U.S. balance of payments. In particular, if U.S. importers or other firms augment the
foreign currency balances and reduce the dollar
balances which they hold for transactions purposes, there will tend to be an excess supply of
dollars in the foreign-exchange markets.

QUESTIONS FOR FIRMS TRANSACTING
BUSINESS WITH GERMAN RESIDENTS
Note: For purposes of this questionnaire, "German
resident" means any party in Germany, including
individuals or firms or other organizations. "The
flotation" refers to the period from May 10 through
December 17, 1971.

2. Did you enter into or complete a commercial or
financial transaction with a German resident at any
time during the flotation? _ _ . If so, please proceed
to the next question. If not, please return this
questionnaire without answering any of the remaining
questions except numbers 12 through 18.

1. During the flotation of the German mark, did you at

any time decide against entering into a transaction
with a German resident on the grounds that it would
be too expensive or difficult to buy or sell German
marks forward (for future delivery)? _ _ . If so,
please explain.

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3. What was the general nature of your business with
German residents during the flotation? (In your
answer, please note whether you acted as a purchaser
or seller, or both, and what general classes of items
were involved.)

9

New England Economic Review
4. a. During the flotation were you asked by a resident
of Germany to make or accept payment in marks
on transactions of a kind which previously had
been executed in U.S. dollars?___ . If so, can
you explain why?
b. If you did not agree to a request to make or accept
payment in marks, would you explain why?

10. a. Do you generally shop around among the banks for
the most favorable exchange rate when buying or
selling marks forward? _ _ . If not, why not?
b. If you do shop around, do you frequently encounter variations in the forward exchange rates
quoted by different banks? _ _ . Could you
illustrate the variation encountered?

5. During the flotation did you enter into or complete
transactions with German residents involving your
payment or your receipt of German marks? _ _ . If
so, please proceed to the next question. If not, please
return this questionnaire without answering any additional questions except numbers 12 through I 8.

11. Are the forward exchange rates quoted by banks
generally less favorable for small transactions than for
large transactions? _ _ . If so, could you illustrate?

6. Did you generally try to sell or buy forward the marks
involved in the transactions mentioned in question
5 ?_ _ . If not, why not?

13. How would you go about computing the total loss or
gain that your firm might have experienced as a result
of the rise in the dollar value of the mark last year?

7. During the flotation were any of your requests to buy
or sell marks forward denied by a bank? _ _ . If so,
why?

14. Would you describe what measures, if any, you took
to avoid suffering a loss from the widely anticipated
appreciation of the mark last year?

12. What improvements, if any, would you like to see
made in the market for forward German marks?

15. Please add here any other comments you may care to
make.
Note: If you have never bought or sold marks forward,
please return this questionnaire without answering any
additional questions except numbers 12 through 18.

16. The following questions (16a and 16b) are asked
merely for the purpose of classifying responses to this

questionnaire. Your answers will be held in strict
confidence.
8. During the flotation what is the smallest volume of
marks which you bought or sold forward in a single
transaction? ___ . (An approximate figure will do.)
9. In buying or selling marks forward during the flotation, what is the longest term to maturity that you
contracted for? ___ . Did you find it impossible to
obtain desired maturities? _ _ . If so, please explain.

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a. What is the nature of your business?
b. What were your total assets in 1971 ?_ _ .
Total sales? _ _ .
17. Would you please state the name of your firm:
18. Date you completed this questionnaire: _ _ _ .

May/June 1972

THE PATH TO FULL EMPLOYMENT
by Stephen K. McNees

AFTER 2 YEARS of no growth, civilian
employment began to rise in mid-1971. Since then
employment, as measured by the household survey, has been expanding at the rate of 2.5 million
new jobs a year. 1 Despite· these impressive employment gains, the unemployment rate has been
virtually stationary. Some observers, apparently
seeking a single statistic to serve as the "true"
indicator of labor market trends, have viewed
these facts as a paradox. Others have "explained"
the matter by suggesting that there has been a
temporary, abnormally rapid rate of labor force
growth. 2 There is some danger that the long-run
implications of these recent events will be misinterpreted. While recent employment gains have
been encouraging, returning to the full employment range is likely to be a nagging problem a
year, or even 2 years, from now, unless an
extremely high rate of output growth can be
sustained.

I. Definitional Framework
It may be helpful to present the definitional
framework which will identify the relevant factors.
Since output is the product of productivity,
average man-hours, and employment, it grows as
rapidly as those three factors, taken together,
grow. For example, the "official" estimate of the
rate of growth of potential output is 4.3 percent.
The 4.3 percent is composed of a 1. 7 percent

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annual rate of growth in employment, a 0.2
percent rate of decline in the average workweek,
and a 2.8 percent growth in output per man-hour,
or productivity. 3
Employment can be defined as the product of
the working age population ( aged 16 years and
over), the participation rate ( the proportion of the
population in the labor force), and the rate of
employment (the proportion of the labor force
employed). The unemployment rate depends upon
all of these factors: output, productivity, hours
worked, participation rate, and the working age
population. 4 This article will focus on alternative
future time paths of employment and output and
their implications for achieving full employment.

1
This excludes the 301 thousand increase in
household employment, registered in January, which is
solely attributable to population revisions based on the
1970 census.
2
See, for example, Business Week, April 15, 1972,
p. 44.
3
The figures cited are those adopted by the Council of
Economic Advisers. The Bureau of Labor Statistics also
projects a 4.3 percent rate of growth of potential output
but with a 0.1 percent annual decline in the workweek, a
3 percent rate of growth in productivity, and a 1. 7
percent rate of growth in employment. See "The U. S.
Economy in 1970: A Preview of BLS Projections,"
Monthly Labor Review, April, 1970, pp. 3-34.
4
Output and employment are defined algebraically by
(l) and (2) respectively. Combining (1) and (2), it is clear
that the unemployment rate, (3), is negatively related to
the level of output alone and, for a given amount of
output, positively related to productivity, man-hours, the

11

New England Economic Review

II. Population Growth and Participation
Rates
Between 1948 and 1959 the working age
population (the noninstitutional population 16
years or older) grew at an annual rate of only 1.1
percent, because new entrants were born during
the Great Depression when birth rates were quite
low. Due to the post-World War II baby boom, the
working age population growth accelerated in the
early 1960's, reaching an annual rate of 1. 7
percent between 1962 and 1971. The working age
population is relatively easy to predict for at least
16 years, since all the new entrants have already
been born and since death and immigration rates
are relatively stable. Thus, it is now clear that the
working age population will continue to grow at
the high 1. 7 percent pace through the decade of
the l 970's because birth rates did not peak until
the late l 950's. After 1980, the rate of growth of
the working age population is bound to drop off,
due to the decline in the birth rate which occurred
in the mid-1960's.
On the basis of these relatively certain projections of population, there will be some important
shifts in the future composition of the labor force.
The baby boom which drove up the proportion of
teenagers in the labor force in the 1960's has
reached its peak. The proportion of the labor force
under 25 will decline slightly over the next few
years, and the proportion of prime-age workers
will rise steadily through du t the 1970s. All of the
rise between now and 1975 stems from a strong
upward surge in the proportion of the labor force
between 25 and 34. The proportion between 35
and 44 will continue to decline until 1975 but
then will rise in the last half of the decade , as the
baby boom population starts moving up the age
structure.
Projections of participation rates, the percentage of the various age-sex groups who hold a job or
are looking for work, are not so certain, however.
The Bureau of Labor Statistics has projected
participation rates through 1985. 5 The projections
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hinge on four broad assumptions: (I) The
participation rate for prime-age men, 25-54, will
hold constant at the 1964-1968 level. (2) The
labor force participation by men 55 and over,
which has been declining since 1950, will continue
to decline but at only half the rate of recent years.
(3) The participation rate of students, which is
lower than that of non-students but which has
been rising, will continue to rise while the
non-students' participation rate will hold at its
1965-1967 level. (4) Finally, for adult women,
classified by age, marital status, and age of
children, the participation rates which have held
constant will continue to do so, while the
participation rates which have been rising will
continue to rise but at only half their former rate
of increase.
While each of these assumptions appears reasonable enough, together they lead to a rather
peculiar result: 94 percent of the labor force
growth in the 1970s will come from population
growth and only 6 percent from higher labor force
participation. This would mark a sharp departure
from the 1960s, when 26 percent of labor force
growth resulted from the net increases in participation rates. With no changes in participation rates
between 1960 and 1970, the labor force would
have grown at only a 1.3 percent annual rate

participation rate, and the working age population:
(1) Q = P • MH · E
(2) E = ER • PR • Pop
(3) UR
1 - ER= 1 - _ _ _ _
O_ __
P MH • PR • Pop
Output
Productivity, or output per employee
MH
Average man-hours
ER
The proportion of the labor force which
is employed.
PR
The proportion of the working-age
population which is employed or is
seeking employment.
Pop
Noninstitutional population I 6 years
or older.
5
Sophia C. Travis, "The U. S. Labor Force:
Projections to 1985," Monthly Labor Review, May, 1970,
pp. 3-10.
Where

O
P

May/June 1972
rather than the actual 1. 75. Since the participation
rate for men actually declined over the last decade,
clearly the main stimulus came from women. The
number of women in the labor force would have
grown at a 1.5 percent annual rate if the 1960
participation rates for women had prevailed in
1970, but, in fact, the number of women in the
labor force grew more than twice as rapidly.
Not only do the BLS estimates contrast sharply
with the changes which occurred in the 1960s, but
they also appear too conservative when compared
to the participation rate levels in the early 1970's.
Table 1 gives the age-sex breakdown in participa-

tion rates both historically and as projected by the
BLS. With only the single exception of women
between the ages of 55 and 64, participation rates
in the sluggish 1970-71 period exceed the rates
projected for 1975. One would expect those
participation rates which normally rise to increase
more rapidly, or at least not decline, and those
rates which typically fall to decline less rapidly, as
the current economic recovery gains momentum.
Thus, the conclusion seems inescapable that for
the next few years participation rates, and therefore the labor force, will be higher than the BLS
has projected them to be.

Table 1
PARTICIPATION RATES
(Total Labor Force as a Percentage of
Total Noninstitutional Population)
1960

1970

1971

1975*

Total

59.2

61.3

61.0

60.1

Male

82.4

80.6

80.0

79.1

16-19
20-24
25-54
55-64
65+

58.6
88.9
95.8
85.2
32.2

58.4
86.6
96.0
83.0
26.8

58.0
85.7
95.6
82.2
25.5

56.8
83.4
95.4
81.1
23.1

Female

37.1

43.4

43.4

42.5

16-19
20-24
25-54
55-64
65+

39.1
46.1
42.6
36.7
10.5

44.0
57.8
50.1
43.0
9.7

43.5
57.8
50.3
42.9
9.5

41.2
56.9
49.3
44.3
8.8

*Bureau of Labor Statistics estimate. See Monthly Labor Review, May, 1970, Table I, p. 4.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics, Employment and Earnings.


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13

New England Economic Review

Table 2
EMPLOYMENT GAINS NECESSARY TO ACHIEVE "FULL EMPLOYMENT":
LOW GROWTH ASSUMPTION
Date Target is Reached
Unemployment

4.0
4.5
5.0

Annual Growth Rate From 1971:4 To
1974:4
1972:4
1973:4
3.3
3.0
2.7

4.3
3.7
3.2

2.9
2.7
2.6

Annual Increase (Thousands)
4.0
4.5
5.0

3422
2987
2553

2654
2432
2210

2401
2250
2098

SOURCE: T. Aldrich Finegan, "Labor Force Growth and the Return to Full Employment," Monthly Labor
Review, February, 1972, pp. 29-39.

III. Employment Growth
The question then becomes how much higher
they will be. Professor Finegan has recently
projected labor force growth using a fairly simple
set of assumptions based on the growth of
participation rates in the period 1965 to 1969. 6
For the groups which raised their participation
rate, primarily women under 65 and teenage men,
Finegan assumes that future growth will be at one
half of the rate which prevailed between 1965 and
1969. For groups whose participation rate
dropped, primarily men 55 and over, Finegan
extrapolates the full rate of decline. These assumptions, which fared fairly well in predicting actual
figures in 1970 and 1971 , imply that the labor
force will grow at a 2.2 percent annual rate
between 1969 and 1974 - 2.2 percent is about 30
percent higher than the BIS estimate of 1. 7. 7
The Finegan results have two important, related
implications: first, the 4.3 percent rate of growth
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of potential output used by the Council of
Economic Advisers, the Bureau of Labor Statistics,
and other official agencies is distinctly too low
(unless, of course, there is an offsetting error in
the estimates of productivity growth or workhour
changes); and, second, the employment gains
required to reach a full employment target will be
significantly higher than the gains implied by the
BIS estimate.
Table 2 updates Finegan's approach to include
6
This section relies heavily upon T. Aldrich Finegan's
"Labor Force Growth and the Return to Full Employment," Monthly Labor Review, February, 1972,
pp. 29-39.
7
Strictly speaking 1970 and 1971 do not provide a
test of Finegan's projections since he projected the
"full-employment civilian labor force," the labor force
which would occur if the economy were operating at an
unemployment rate of 4.5 percent. Tables 2 and 3 are
based on the assumption that the economy is operating at
an unemployment rate of between 4 and 5 percent so that
Finegan's projections are taken as estimates of what the
actual, measured labor force would be.

May/June 1972
actual data from 1971 and extends it to the end of
1974. Table 2 shows the gains in employment
necessary to meet various unemployment rate
targets by the end of 1972, 1973, and 1974. For
example, to achieve an unemployment rate of 4.5
percent by the end of 1973, employment would
have to grow at an annual rate of 3 percent
throughout this year and next. The economy
would have to add about 2.5 million jobs in each
of those years. The President's Council of Economic Advisers has predicted that the unemployment rate will be in "the neighborhood of 5
percent" by the end of this year. Unless the
neighborhood is fairly large, this would require
more than 2.5 million jobs to be created this year,
a growth in employment of 3.2 percent. The first
quarter of 1972 was an admirable start in this
direction - payroll employment grew by 4 percent
and employment measured on the basis of the
household survey grew by nearly 3 percent.
However, despite this strong performance over
the last several months, there are some grounds for

pessumsm. Most important, a high growth rate
would have to be sustained for several more
quarters in order to reach full employment.
Moreover, the participation rate assumptions in
Table 3 may well be too conservative. Table 2 is
based upon what Finegan calls his "low growth"
assumptions. Along with them, he presents some
"high growth" assumptions. The pair are intended
to bracket the actual outcome. The implications of
the high growth assumptions are shown in Table 3.
The high growth assumptions, a simple extrapolation of growth rates from 1967 to 1969, imply a
2.5 - 2.6 percent annual rate of growth in the
labor force, so that even more employment gains
would be needed to meet the unemployment rate
targets. Under the high growth assumptions, the
1972 first quarter results will have to be improved
in order to reach a 5 percent unemployment rate
by the fourth quarter of 1974.
Table 4 gives some historical perspective on
how difficult it will be to sustain an expansion of
employment at an annual rate of 3 percent. Rates

Table 3

EMPLOYMENT GAINS NECESSARY TO ACHIEVE "FULL EMPLOYMENT":
HIGH GROWTH ASSUMPTION
Date Target is Reached
Unemployment
Rate Target
(%)

1972:4

1973:4

1974:4

4.0
4.5
5.0

5.5
5.0
4.4

4.0
3.7
3.5

3.5
3.3
3.2

4.0
4.5
5.0

4410
3970
3510

Annual Increase (Thousands)
3280
3055
2830

2911
2757
2603

Annual Growth Rate From 1971:4 To

SOURCE: Finegan, op. cit.


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15

New England Economic Review

exceeding 3 percent were achieved early in the first
two post-World War II economic expansions, but
these rapid rates lasted only about a year. Exceptionally high rates of real economic growth were
necessary to achieve them. In the long, gradual
expansion of the early 1960's, perhaps the most
analogous to the present situation, employment
grew at less than 2 percent per year. Even under
the low growth assumptions, this rate would not
reduce unemployment below 5 percent in the
fourth quarter of 1974.

IV. Output Growth
Up to this point, the approach has been to
concentrate on how rapidly employment must
grow to reach various unemployment rate goals.

The same problem can also be approached by
asking a different, but closely related question:
How fast must aggregate real output rise in order
to reach the unemployment rate target? Historical
data, as shown in Table 4, provide little insight
into this question since the amount of real growth,
in relation to employment growth, has varied
widely - from a low of less than twice as great in
the mid-l 950's to a high of more than seven times
in the early part of the 1960's.
It is obvious that a 1 percent increase in the
employment of a given labor force could be
achieved with about a 1 percent increase in real
output if everything else remained unchanged. But
of course things do change: employment gains are
associated with increases in the size of the labor
force , in average hours worked, and in produc-

Table 4
ANNUAL RATES OF GROWTH DURING POSTWAR EXPANSIONS

Expansion Period

1949:IV to 1951:1
1954:III to 1955:IV
1958:11 to 1959:III
1961:1 to 1962:11
1970:IV to 1972:1

1949:IV to 1952:11
1954:III to 1957:1
1961:1 to 1963:III

Rea/GNP

Civilian
Employment

Civilian
Labor Force

Average Annual
Output
Change in
PerManhour Unemployment
(Private Nonfarm)
Rate

12.6
8.6
6.4
7.4
5.1

First 5 Quarters
3.0
0.1
4.5
3.0
2.7
0.9
1.0
-0.0
1.9
2.0

4.8
2.8
2.9
5.3
4.0

-2.8
-1.4
-0.8
-1.0
0.0

7.7
4.4
5.7

First 10 Quarters*
1.6
0
2.7
1.9
1.4
0.8

3.3
1.9
4.5

-1.6
-0.8
-0.5

*The expansion starting in 19 5 8 did not last 10 quarters.
SOURCE: Original data from U.S. Department of Commerce, Bureau of the Census and U.S. Department of
Labor, Bureau of Labor Statistics.


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May/June 1972

Table 5

REAL GROWTH RATES NECESSARY TO ACHIEVE "FULL EMPLOYMENT"
Date Target is Reached
Annual Rate of Growth of Output From 1971:4 To:
A. Estimates Based on Original Version of "Okun's Law":
Unemployment Target
1972:4
1973:4
1974:4
4.0
10. 7
7.4
6.3
4.5
9.0
6.5
5. 7
5.0
7.2
5.6
5.1
B. Estimates Based on Gap Version of "Okun's Law":
4.0
11.5
4.5
9.8
5.0
8.2

7.8
7.0
6.2

6.8
6.3
5.7

SOURCE: The gap version of "Okun's Law" is taken from the Data Resources, Inc. econometric model of the U.S.
economy.

tivity. Expansion not only means the employed
work longer hours and are more productive, but it
also means more people seek employment. George
Perry has estimated that a 1 percentage point drop
in the unemployment rate brings 500,000 persons
into the labor force. 13 The basic question of how
much real growth reduces the unemployment rate
is, in short, an exceedingly complex one to which
several different approaches have been taken.
A decade ago, Arthur Okun provided a useful,
simple rule of thumb, known as " Okun's Law," to
answer this complex question. His approach is
straightforward - he used historical data to relate
changes in the unemployment rate to the rate of
growth of real output. The relationship he
developed implies that real GNP must grow at an
annual rate of more than 4 percent to hold the
unemployment rate constant; for each additional
percentage point real GNP grows at annual rates,
the unemployment rate will drop by about 0.3
percentage points per year. 9 The top part of Table
5 gives the answer to the question based upon the

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original version of Okun's Law. For example, a 7.2
percent real growth rate would be required to
reach a 5 percent unemployment rate by the end
of the year.
Some have suggested that Okun's Law may
overstate the output growth requirements in the
1970's. Most of the reasons center upon a predicted decline in the rate of growth of productivity due, for example, to the constraint of energy
supplies or to the rise in the proportion of services
(with presumably sub-normal productivity) in
total output. A substantial decline in the workweek would also lower the output growth requirements for employment gains. On the other hand,
there are several reasons why Okun's Law is likely
to understate the growth requirements in the

8
George Perry, "Labor Force Structure, Potential
Output, and Productivity," Brookings Papers on
Economic Activity (3:1971), pp. 533-565.
9
Arthur Okun, The Political Economy of Prosperity,
Norton, 1970, pp. 135-137.

17

New England Economic Review

l 970's. The most important ones have already
been mentioned - the working-age population and
labor force participation rates will grow more
rapidly than they did in the period Okun studied.
Re-estimating Okun's equation, using more current
data, indicates that unemployment has been
slightly less responsive to output growth over the
last decade. The difference, however, is not significant so that the numbers in Part A of Table 5
should perhaps be taken as only slight underestimates. 1 0
Most estimates of the relationship between real
growth and the unemployment rate have been
based on "Okun's Law." For example, the econometric model of the U.S. economy developed by
Data Resources, Inc. modifies Okun's approach to
take account of the proportion of the working-age
population who are teenagers, since teenagers
suffer such high unemployment rates. The proportion of teenagers in the labor force rose
dramatically during the 1960's. Part B of Table 5
shows the real growth rates which will be required
to attain specified employment targets, based on
the Data Resources approach. This estimate is
clearly more pessimistic than the original Okun
version since at least an additional half of 1
percent of real growth is required to reach each of
the unemployment targets. Considerable support
for these estimates of the high real growth rates
necessary to reduce unemployment comes from
the fact that they are very similar to those Perry
arrives at in his more sophisticated, disaggregated
analysis. 11
Finally, it is useful to consider an approach to
the output-unemployment rate relation which is
not based on Okun's Law. The Fair forecasting
model arrives at an estimate of the unemployment
rate by producing separate explanations of employment and of the labor force. There are two
important innovations in the Fair approach: (1)
wages rates are used to help explain labor force
participation rates, 12 and (2) employment
depends not only on changes in real (non-farm)
output but also on the amount of "excess labor"
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in the economy. 13
In the Fair model, separate participation rates
are determined for primary workers (males aged
25 to 54) and all other workers. The participation
rate for primary workers is taken as simply a
function of time. For secondary workers, participation depends not only on a time trend but also
positively upon the total employment rate and
the money wage rate, and negatively upon the
price level. While participation is related to current
employment conditions, wages and prices enter
with a seven quarter distributed lag. It is interesting to note that when employment conditions
including wage rates are taken into account, the
relationship explains the rise in the participation
rate of secondary workers without relying upon a
positive time trend. Other things held unchanged,
the passage of time results in a gradual decline in
the participation of secondary workers in Fair's
equation.
"Excess labor" is an important determinant of
changes in employment in Fair's approach. Excess
labor can be looked upon either as the difference
between the standard number of hours of work
per worker and the actual number of hours
worked per worker or as the difference between

10
In Okun's original version, a 1 percentage point
increase in the quarterly rate of growth of real output
lowers the unemployment rate by 0.3 percent each
quarter. Virtually the same responsiveness is found when
the 45 quarterly observations through 1972: 1 are added
to the sample. A regression based upon quarterly data for
the period 1961 :1 thru 1972:1, however, gives the result
that each percentage point increase in real output lowers
the unemployment rate by .24 percent per quarter. The
difference is not significant, however, on the basis of the
Chow test for a structural shift in the coefficients:
F(2, 92) = 0.4.
1 1
Perry, op. cit., p. 561.
1 2
Ray C. Fair, "Labor Force Participation, Wage
Rates, and Money Illusion," Review of Economics and
Statistics, May, 1971, pp. 164-68.
1 3
Ray C. Fair, A Short-Run Forecasting Model of the
United States Economy, Lexington: D. C. Heath and
Company, 1971, chapter 9; and The Short-Run Demand
for Workers and Hours, Amsterdam: North Holland
Publishing Company, 1969, passim.

May/June 1972
the number of workers employed and the desired
number of workers to be employed in any given
period. The desired level of employment is obtained by dividing total man-hour requirements, as
determined from a production function for each
level of output, by an estimate of the standard
number of hours per worker. When the actual
number of man-hours exceeds man-hour requiremen ts, firms can decrease either employment or
hours per worker or both. When the man-hour
requirements exceed actual man-hours in the last
period of time, requirements are met both by
increasing employment and by paying for more
costly overtime hours.
The real growth requirements necessary to
achieve full employment in the employment sector
of the Fair model differ significantly depending on
the time horizon in which the target unemployment rate is met. The prospects for this year are
exceedingly bleak, given the amount of "excess
labor" which has built up in the economy during
the recent years of sluggish growth. A real growth
rate of over 9 percent would be necessary to reach
an unemployment rate of 5 percent in the fourth
quarter. However, in 1973, the impact of a
sustained high growth rate would erode the
amount of excess labor, enabling the unemployment rate to drop more rapidly. An unemployment rate of 4.0 percent by the end of next year is
consistent with an average annual real growth rate
of 6.6 percent sustained throughout 1972 and
1973. This result is, of course, considerably more
optimistic than either version of Okun's Law.


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V. Conclusion
The task of reaching full employment is clearly
both an important and demanding one. Each of
the analyses presented suggests that full employment, even when defined as only 95 percent of the
labor force, is not likely to be achieved this year.
The outlook for attaining full employment in
future years is, of course, less certain. If the rise in
participation rates should prove to be transitory,
an updated version of Okun's Law should provide
a workable estimate of the necessary growth
requirements. In that event a real growth rate of
between 6 and 7 percent would bring the economy
to full employment range by the end of next year.
At the other extreme, if labor participation rates
were to behave the way Finegan suggests they
might, the official estimate of the rate of growth
of potential output is about 0.5 percent too low.
Unless there is an offsetting reduction in the
growth of productivity or speedup in the decline
of the workweek, real growth requirements to
reach full employment at the end of 1973 could
be as high as 6½ to 8¼ percent. Only if the target
date were extended to the end of 1974 would an
unemployment rate much below 5 percent be
attainable if current ( first quarter 1972) real
growth rates are sustained. Whichever target date
and whichever full employment target one selects,
the implication is clear - rapid rates of real
economic growth must be sustained over an
extended period of time in order to reach society's
full employment objective.

19


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*