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FEDERAL RESERVE
RESERVE BANK
BANK OF
OF DALLAS
fEDERAL
Of
FEDERAL
Fourth Quarter 1992
•
•
conOllllC CVICW
eVlew
conOIlllC
ConOInlC
Do Interest
In/erest Rates
Rales Help
Predict Inflation?
Kenneth M,
M. Emery and
Evan F. Koenig
Trade
7)'ade
Policy
'l}'ade Polic)'
and Intellectual
Property
Properly Protection:
The
'l7Je North-South
Nortb--SOutb Dispute
William C
C. Gruben
Wilham
Gruben
Regional Wage
u;(tge
WClge
Divergence
and National
Divergellce andNational
Wage Inequality
Keith
R.
Kerth R.
A. Phillips
Phillips
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Economic Review
Federal Reserve Bank of Dallas
Robe" O. MeT.." Jr.
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Gt ,.ld P. O'Dtilcoll. Jr.
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S1. phtn P. A. Bro_
~ ~M_'" s..", It:cntwosI
EcollOlllists
Zsolt Becsi
Roberl T CI,m
JaMV Cuca
KennelllM E~
RotJett W Gilmer
David M Goold
WIlIIaI'II C Gruben
Joseph H Haslag
EvanfKoeI'llll
D'Ann M Peterwn
Keith R PhIllips
Fiona 0 S!gaIIa
llrll Taylor
John H Wetdl
_AWymo
Kev.n J Yeats
Mine K YOc:eI
Rn..n:h Assoc i....
l'I'ofHsor Nathan S Balte
Southllm MeUtodisr tklMniry
l'Iolessor ThomIs B Fomby
Sou/hem Methodm Unrmslfy
Professor &1ln Fraemall
Umll8fSiryof rexas
Professor Gregory W Hulfman
Soolhem M8lhotiis/ University
ProtesSCl Roy J Ruffin
I.Inrversiry of Houston
Professor PII'lQ Wang
~ Slate Unrverslty
Editon:
Rhonda Hams
VW'gIll.a M Rogers
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Contents
Page I
Do interest Rates Help
Predict Inflation?
Kenneth M. Emery and
Evan F. Koenig
Accur<l.Ie forecasts of inflation are important \0 policymakers and \ 0 individuals who must make decis ions on the
basis of expect:uions about the fut ure purchasing power of
the dollar,
Recent research on forecasting influion has shown that
interest rates, by themselves, may provide useful infonnation
about fUlUre inflation. In this article, Kenneth M. Emery and
Evan F. Koenig investigate whether interest r.!.ICS contain
infannation about future inflation beyond that fou nd in
Irddilionai inflation-forecasting models. In other words, docs
adding interest rates \0 traditional innation models e nhance
the models' forecasting ability? Emery and Koenig find that
incl ud ing imerest rates doe.'; Significantly improve the forecasting abili ty of trdditiona l models. They also find , in contrast
(0 recent research focusing on the forecasting abiliry of
interest rates in isolation , that the information content of
interest rates d id not diminis h in the 1980s.
Emery and Koenig point out thar whethe r the historical
forecasting ability of interest ra tes can be e.xploited by policymakers is problematic. Be<7dUSe interest rates reflect expectations of future monetary policy, if the Fcderdl Reserve were
to begin relying more o n interest rates as a guide to policy,
the relationship between interest mtes and inflation wou ld
likely change.
Page 19
Trade Policy
and inteilectu({I
Property Protection:
Tbe NOI'/b-Soulb Dispute
Wi!tlam C Gruben
News about foreign-made counterfeit products that range
from pharmaceuticals to tennis shoes and about processes
that have been copied without payment of royalt ies 10 patent
holders has become common place. Many of these appropriations of intellectual propelty originate in developing countries,
where intellectual propen y lawS and e nforcement have traditionally been less restrictive than in developed countries. 111ese
d ifferences between the North-the developed countries thaI
produce most intellectual property-and the South-the dcveloping countries that consume more than they producehave gener..lted much international friction.
(Col1fl nued on rbe next page)
Contents
(Continu.ed/rom the Prwious page)
'frade Policy
and In tellectllal
Property Protection:
7be NOl'tl>-Soutb Dispute
WIlliam c.Gruben
Recently, however, some developing countries have
begun to tighten these Jaws and their enforcement A few
a nalysts have been quick \0 explain wh y ~ these countries are
simply reacting to incre;lsingly tough U.S. pressu re. But lire
they? Not all cou ntries unde r the most intense U.S. pressure
have reacted to it, :t nd thcrc is a difference between those
that have a nd those Ibm have not. The d ifference turns o ut to
be these individua l countnes' own lmdc policies.
Focusing primarily on the experiences or Latin American
(nunlries, William C. Grulx-n shows how :mcl. why a nation's
own trade policy innucnces Lts intclk-clual property Jaws and
enforcement and w hy con\'~nt ional argument... about U.S.
trade pressures may be only P'lrt of the Story. Gruben shows
why developing countries that practice strong trode protectionism are mOliy.n ed toward wC'J k Inlellcctua l property
protection, but thOSt: lhat have Hbcrolized lmdc omy fi nd
strong inieUeclUa l propcny protection more attractive.
Page 31
Regional Wage
Divergence and National
~Ige Inequali(y
KeiTh R Phillips
Throughout much of the 1980s, W"Jge inequaHry incre-.lSed
in the United States. Previous rescarch has found tha! a rise in
earnings by educatio nal level and increased wage dispersion
across occupatio ns wt"rt" im portant factors in Ihe rise in wage
incqualiry. Researchers, however, have nuted Ihat much of
the risc in wage inequality was left unexplai ned by Ihe demographic and industry factors that they examined . In this study.
Keith R.. Phillips extends U1C analysis by examining the impact
on wage inequality of a divergenc.:e in regi~1 wages that
occurred during the 19BOs.
The :wlhor finds th.·lt regional shocks, such as the recessions in the o il and f:mn belts. pushed wages lower in these
below-average-wagt' area ... and incr~d.scd dcf('nsc spend ing
pushed up wages in m:IOY l.tbovc-'I\'t!rage-wase areas. Wh ile
these regiona l shocks i(lCrc;lM.'d overnll Mlge inequality.
Phillips fi nds that region:tl wage di\'e~cnce a('COunted for
onl y 2. J percent to 5 percent of the rt'iC in n:uio nal "\\'3ge
inL'quality. Other factors, such as increased w-d.ge dispersion
across eduC:lIjonal and IXCup:Hlonal groups :lOd :1 reduClJon
in the male-female wag"-' g:lp. playoo larger rok·s.
Kenneth M. Emery
Evan F. Koenig
Senior Economist
Federal Reserve Bank 01Dallas
Senior Economist and Pohcy Advisor
Federal Reserve Bank 01 Dallas
Do Interest Rates Help Predict Inflation?
ht: primary responsd)ility of a <:~ntr;J1 bank is
to prt:st:rve the va luc of its nation's currency.
In (h ~ U nit~d States. thc Federal Ikse:rve System
allc:mpls 10 mee t this rcsponsihility by pursuing
111onc:I:II)' policic:s IIlal prornOfe C:(.'( )o( )lllic gro~1 h
without fueling inllati()[l . Achieving s ustained
no ninll ;Hionary growth j.-; complic:llcd by the fact
Ihal changes in mOllet;lry policy atTel'l the economy
wilh : 1 hi}: Thus. the successful (:onduct of monetary poliq' requires rcli:lble foreGI.~ts of both
infbtion and economic activity.
A plot of Ihe threl'-month US. Treasury bill
rate and subsequent qua neriy inll:llion suggests
Ihal inlerc:!'>\ rales may tuntain infonllalion about
future inll'ltion (Fip,lIIl! I ) Indeed. rt:ccnt research
indit~ll ...s that lIloVemt'J\IS in imel1.:'st r.ltes are helpful in predicting innation (Ue rnanke 1990; Fama
T
Figure 1
Three-Month Treasury Bill Rate and CPI Inflation
Percenl
"
"
..
--
"
"
•
•
HWiRali
•
,"',....
,
~,
SOURCES OF
PRIMARY OATA
Board
01 Governors. Federal
Reserve Sys:em; U S Sureau 01
LaI:lof Slal,SUCS
Econ o mic Revie w -
)' o u nh
Qu ~ ne r
1?92
1990; Mishkin 1990a, 1990b; Frankel and Lown
1991). Interest mte movements may, therefore, pro-
vide {he Fedcral l{eSCtve with information useful
in cond ucting monel:IlY policy. In fact, some monet:uy policyma kers (johnson 1988) have :Iuvoca(ed a
strategy for conducting policy b:lscd on monitoring
scveral fin.mcial varia hies, induding interest r~Hes.
While: the studies tiled above have addressed
the question of wbetht'r interest rates, by themselves. hdp pn.:dic\ inflation, more relevant to
policymaking is tbe qllestion of whether adding
interest r..ues to tr'.Iditional models for forecasting
inflation yields any improveme nt in the models'
foreca~l inK ahility This ll nide examines whether
intert.'SI r..ues provide information about innation
beyond that containt."<.I in traditional models. For
two re:ISOIlS we focus on inflation as measured by
the consumer price index (CPO, First, existing
studies or the predictive content of interest rates
usc the consumer pricc index almost exclUSively.
Secor1d. because they al~ not distoned by transitory shifts in the composition of output, flxcdweight indexes like the consume r price index give
a more accumte picHire of ncar-te rm ch>lnges in
Ihe COSI of living Ihan do variable-weight indexes.
The first sect ion o f the :utide revicws the
economic intuition undc:rlying thl.! connection
between interest rates and inllation. Tht: second
section pre~ents evidence of the power of interest
lenes. by themselves. to pr(:ciict near-tenn inllation.
Consistent with previous studies, we find Ihal
although int... rest rates arc quite helpful in explaining movements in inll'llion during the 1960s and
WSWlSh/O/tIankJohnV Oucs. OavrdM GouId. andJoseplt
Ha~ tot hc/pIvi commcfIts and Mr.enne C Slack {Of
/1
excel/em research assIstance
Table 1
Inflation and Interest Rates
MltrglNiI Significance Level
DV
3M
3MFF
IOY3M
JOINT
DV
•
•
.000
.034
,012
.000
3
A
B.
••
C.
D.
Number of Lags
M
3M
733
.920
.059
296
3
.006
.000
.483
000
8
8
.146
.862
.671
.168
2
2
3MFF
10Y3M
R'
6
5
899
618
5
_493
265
Sample periods
A. 1959:1 - 1979;4
B_ 1980 1- 1991:2
C. 1959 1- 1979:4
o 1980 :1- 199 1:2
Definitions
DV • dependent variable 10 the regression
l't •
change ioganthm 01 the consumer price Index.
l!.n • change in l't
3M
3MFF
lOY3M
JOINT
•
•
.
.
NOTE A ll
Interest rate on three-month Treasury bills.
dltterence between 3M and Ihe lederallunds rate.
difference between the Interest rate oillell-year Treasury bonds and 3M
ma/gmal Sl{lnlhcance level from a test 01 the hypotheSIS that the coelhcleflls 01 allinlerest rale variables
are equal to zero.
.ogressoons we re canled OUI usmg tile RATS regresSion pacto.age, V elSOOfl 3 0
1 9-0~, the l..";..ptm.tH1rr pO\\l'r ot l1 H l'rl'~t r; U l'~
lll:t rkl'dlr d ..:tl'r i()r.III.."~ 11) Ihl" 1 9H()~ T lll'thini
~ect i () n of the ,tn idc '1X'(:ilk, tl':ld illfln,1 1 inll:i l ioll
fo n...--<::b tll1 g Ill{xkb ,tnd l 'X:lIll UK', \\ Ill'l l ll'r i ll('I(ld ing
in tl:re., t 1: 11..:, i n IIll'''l' lllod ,,' I, n.:'Ulh III ;l(ldil iolla l
e.x pb n:lloI"Y pOWL" f \'ill ' li nd th:lt ~ h {)rl Il Tlll i l1l l"fl"~1
1: l1 es do po.~Sl"s:, m aq,.:i n:d l-xpl:II1:llflrr j){I \\lT ill Ihl"
prl.." 19HO sa m pll" I'UI"I IIl"ril \{lr..:. this i lll'l"l":I " l 'd
e xpb nat( II"}' Ix)\\ ..: r d{x: .. I /( I! di... :tPPl":l f <h iring III ..:
19HO'... [ndel'<.l. \\'l" lind 111;11 lon).,:- tl'nll in tl"re."t r:lt e....
also hl '(;oml" ~ i ~n ili(,,;ln l d uri n).: tltl' 1')H{}o.. The
fourth .......'i..:tion of Ihl' ;trlil'll" e:<.ulli nl"" 111<' rea l-linK'
fo n':Chtin).: perfonll.I1l<:e of tIll,: r1\Il:o- t 1-l<'rll'r;11 of
o ur inll;l\ lon nl(xk-b Fo u r H'r-.;on" o f tilt ... ).,:etlL"ral
nuxld ;m: I,."on ..i<.il"n.:d -\,cr-.io,,:o- r1\o.:;m l 10 l"xpla in
tile kH-1 o f int1:uion and t he t han}.:e in lnll:u lon.
hoth \\'il h and \\ ilho\ll Ihe hl.:lp of in tl"rt--.l 1~l\e ....
\X'\! fi nd that hettl'r intlat ion rtlrt'ch l ~ :Ifl' nhl:!i nnl
from m odel .. t hat l-;.. p l:l lll Ihe cll:! n,L:'" in inlbtlo n
,
th:ln IrOIll 11Io"kb Ih:1I l" p Llln thl' k,,,,:l of mtbllt,n ,\ l o reO\lT, \\l' fi nd Ihat ,n ll'IV"l raI l'" impro\'t:'
0111' .! h ll l! ) 10 p lVdil"l IlI.',l r t,,'rrll t h:Hlge.. III inlb ..
lioll \'\ l' co nd lld e h~ in l ..'.-p n:t ing 0 111' fin di n ~.~
:l lld d"l ll~," lIl g t lwir impli{-at ioll" [u r 1){Jlicy,
The relationship hc twccn interest
rates and inflatio n
I n ,L:elll-rai. thl' l 'XIXTlt,:d real rl"t u rn on:1
loall \:qua l .. thl" n0ll1 i l\:11 rl'hlrn Il" ...... t he l'xpo.:cll 'd
r. lll' of inlbl io rl T urllln,L: Ihh n:bl ion .. hip around,
(I)
\\ Iwr\.' I, I I" th ..- r1l:trkl" i ntere .. t r; l\e ;11 tim e 1 - 1.
I~ I i .. lh..: ..:xpn ll'<.l fl'al mIen:.'" rail' at lime 1 - 1.
and 1%"; i .. 11K' l ';"P",'{·I..:d r,I1 ..' o f IIllb tion l"lCt\\t't'n
rx:ru KI 1 - I and 1"lCI'iod I. If till" n: po.:('tl'<.\ rca l
Ft'lkral Iksc:n 'c: Hank of Dallas
interest rate is constant, then movements in exIX'Cted inflation will be rCflC(1ed, one fo r one,
in movemenLS in the m:lrkct intCl\."St rate. More
gcncrdlly, as long as the expected re:11 interest
mte is not l-'orrcJ:lled with the market interest mte.
analyst.. can infer a I-percentage-point increase in
expectatiort'i of inflation from a I-percentage-point
increase in the market interest mtc. Of course,
insofar as analysts arc able to find variables Ihat
control for movements in the expcClL-d rea l interest
rate. they will be able to improve the accurdCY of
their estimates of expected inflation. Ilowever,
even exact estimates of cxpected inflation are
of lillie ust:: unless expcCled inflation is, in turn,
an act'urme indicator of realized inflation.
Simi1:Lrly, the expected challge in inflation is
( I')
" - "
=11,
- , ,I-I"
-<: ),
where Jrl-l represents the realizl.-d rate of inllation
between period t - 2 and period t - I and where
(~l ~ IH - )'f'_I) is the ex post real rate of return on
a loan made in period t - 2 that matures in period
1- I. If expected changes in the real interest rate
are not ("Orrelat(.'(.] with changes in the market
interest ratt.'-as will Ix: the case, for example, when
the real intere~t rate follows a ra ndom walkthen a l-percentage-point increase in the market
interest rdtc can be used to infer a I-percentagepoint increase in expectatio ns of the change in
inflation. Variables correlated with the expected
change in the rcal interest ("'dte will allow analysts
to control for the ch:mge in the real rate and
thereby imp rove their forecasts of the market
expect:ltion of the change in inflation. This market
expectation m:ly or may not be a good predictor
of the actual cha nge in inflation.
Before mov ing on to furthe r analysis of the
additiona l predictive content of nominal interest
r.lies. we briefly review the evidence that movements in nominal interest rates, by themselves,
Cdn help prediCt future inflation or future changes
in inflation.
Infla tio n a nd inle rest rates:
the e x isting evide n ce
A st udy by Fama (1975) first showed that
interest rolles might be useful for prediding inflation.
For the period from 1953 through 1971 , Fama
Economic Review -fourth Quarte .. l<)92
fou nd that the level of one- to six-month Treasury
hill rates provided information about future inflation beyond that contained in lagged values of
inflation Additionally, Fama 's results suggested
that all the varialion in one- to six-month nominal
Treasury bill mtes during this period was due to
variation in expcct<..'(.] inflation, rather than variatio n in ex]X.'Cted real interest rates.
Hess and Bicksler (1975) showed that Fama's
finding o f a consta nt real rate o f interest was
specific to the sam ple period he examined. However, Fama's other resuh--that market interest
rates provide information about future inflation
beyond Ihal obtained from lagged values of
inflatioo- has been confirmed by subsequent
stud ies (Failla and Gibbons 1982, 1984).
Table I demonstrates the usefulness of
interest mles in explaining inflation and changes
in inflation. Line A, for example, summarizes results
obtained when quarterly CPI-inflation data from
the first quarter of 1959 through the fourth quarter
of 1979 are regressed on three lagged values of
inflation and several interest rate measures. l The
interest rate measures arc the three-month Treasury
bill rate, six lags o f the difference be[Ween the
three-month Treasury bill rale and the fedeml
funds rate, and five lags of the difference between
the ten-year Treasury bond r'dtc and the threemonth Treasury bill mte.l If the expected real
intcrest rate were constant over the 1959-79
]X:riod (apart from white noisc) and if market
, InflatJCfl is rTl6awred as lhe /ogarilnmic difference of the
daIS series CPI-UX (U S BUleauo/Labor Slatistlcs). which
cosls on a rental·oqulvaltmee basis Two
tf18 rsgrossions 10 cap.
ture tnelfllP8Ct of ff1e Nixon Administration wage and price
tl98IS /loosing
dummy van"aoles were included in
dummy variable IS !.KIlty over the 8ClI.Jal
(1971 .~1972·4)< and ffIc second
durrmy variable is (NlItyover Ifle penod lITm8dtare/y follow..
ing the prICe conllol$ (1973. 1-1974 4)
controls Tile
~'rst
period of prICe controls
, A11lfltBfesl rates are qvartBfty averages We used Akaike·s
final predlcllOfl Bfror (FPE) cmenOl'1 fOdIoos8the apptopt"f.
ate lag qfh f« 8adl nght-hand-S<de variable The FPE
$lO/JSlte (AAaille 1969) measures a regressions ~
square prfKhc/tOfl.,or We used the FPE srafl$lic, along
...tn II methodology OIJI/lned by HsoM> (1981). fO dclermne
the orticr In \01IotCII I8g-1cngrn selecrlOflS were made A
maunum oI81ght IBgs was allowed
expccl:nions of inflation differed from realized
inflalion by only :1 white-noise error, then equa tion I would imply a coeHkient of unity on the
three-momh Treasury bill mit.: and zero cocfftdents
on all Olh~r right-h:U1d-sidt.: varbhh,-... [n fad . the
cOt!fficient on the three-month T-l1ill r.t1e is es timatt.-'d prcdsely and is within one stand:1f"(1 error
of unity, hut lagged inflation and the interest rale
spread.. also have Significant explanato ry power
for inflation ' Apparently, expos' real relUrns were
corrdatt'd with both lagged iofliltioo and lagged
interest rail' spn;:ads over the 1959-79 period,
A nu mher of studies have sllggcsted thaI
the relationship between interest r.t1es and inflation has broken down or, at ICilst. changed since
1979' This s hift in the intcrest rate-inflation relationship is illustr.lted on line 13 of Tahle 1, which
presents r~Slllt,~ from :1 regressio n of inflation on
lagged infl:lliol1 and sever.1 1 intl.!L'e.~t rate measures
over the period from the first quartl.!r of 1980
through thl.' second quarter of 1991. Note that
over this later sample pe riod , none of the inte rest
rate measures help to explain movements in
infl;lIi()n.
Simi!:lr results arc o btained when one substitutes the cbange in inflation for the IeI'd of inflation
in the rq:.:rcs....ion equations. DurinR the pre- l980
period , Ix)th the le ve\ of the three-month Treasury
bill rate and the spread hetw<::cn the three-month
Treasury hill r.ttc and the fooer.ll fuml.. r:lte have
significant m:lrginai explanatory power for changes
in inflation (line C). After 1979, thi.-. exp!:tnato ry
]X>wcr dis;lppears (line D).
What :tn:ounts ror Ihe changed rdalionship
betwl;:en m:lrket interest r.ttes and infl:llion since
1980? 13rooldly speaking, only tWD explanations are
• The eSIIf7l8Ie<1 cocflrcl6nf ClfI lfIe 1/lI~f1IOfllh Treasury bill
,ate IS I 115. WIth II standard errOl 01 0215
• See. 101 example. CI8Ilda and Fncdman (1 984), Hwz.nga
and MrsMlI'I ( 1986), Bemank8( /990), Fama( 1990). Mrsflktn
( 199Oa. I99OtJ). at>dJononancJMISIlIun (1991 J Thec/lange
"' ,he,elatlOflS/ljp09lWHr1l(}reresr ,alCS 8fldlll/la/lOfl1$ also
eMdenl ..... F.gute I
• AIsoseeRomcrandRomet tl989)and Ball<e and Fomby
(I991J
•
possihle Either the rdationship between :t<:tual
inflation and cxpc..'Ctcd inflation or the com:b tion
hetween movements in nominal interest r.ttcs and
movC;'lllents in real intcrest r:lIes must have Ix:cn
different during the 1980s compared with the
1970s, Evidence exi.-.ts to support eac h of these
views (which. after all. arc not mutU:llly exclusive).
TIlllS, for e xample, E";lns and Lewis (\99J) and
R:lymond and Rich ( 1<)92) have presentt:d empirical resu lts suggeSiing that inflation policy is subje<1
to discrete ~ regimc s hifts." \ During the 1970s,
according to these two studit:s, there may ha\"l;:
hcen a systematiC tendcncy for reali7.ed inflation
to exceed expectations of inn:nion. This app:trent
hias in expectations wml ld he rational if. owr Ihis
period, people had fdt that the Feder.tl Reserve
might soon adopt a ,~tro n ger anti-infl:Llion:lry
st:Lnce, Beginning in late 1979, according to ma ny
ohservers, the federal Rcscrvc did indeed launch
a campaign to bring down the r.tte of inflation.
Therefon;:, the seeming hi:l); in inOat io nary expectations likely wa); eliminated. or even reverSt.'d in
sign , afte r 1979. Thu);. :t plaus ible case can Ix'
made for a SlKklcn ... hift in [he relationship hetwl."'Cn
expeL1ed infl:llion ((he infl:l1ion incorpor.ltcd into
market interest r.ues) :lnd realized inflation (the
infl:l1ion we arc altempting to explain in o ur
regression (:qllation .. ),
The view thaI the correl:llio n betwcen
nominal interest r.ue); :md re:11 interest r.ues may
h:I\'1;: been altered has re<.:civcd indirect suppon
from t:mpirical sludics d(X'umenting a shift in the
rcl:llionship between nominal interest r.L1es a nd
real economic activity- a shift that apparently
occurred at alx mt the same time as the shift in the
rclationship between nominal interest r.L1es :Ind
infl:ltion Bernankc (19<)0) documents the cha nged
rclationship octwccn interesl r:ltes :lnd real a<:tivity
and uiscussl.!s financial innov:Llions that may have
1"lL1.:.'n respons ible for the change. Expected real
rctU!l1S, though not dirct1ly ol"'ISClvable, :Ire thought
10 he closely rel;Ltl.-o 10 movement" in real economic activity (Ch:lpman 19<)1),
In summary. exi... ting studies indi<::'lle thar over
some ,..ample periods, interl."'St r.lll.'S ~md inteTCst mte
spreads have provided informatio n useful in
explaining or predicting ,uovements in inflation .
Howe\'t'r. thcM.' l)tudies have only eX:II11int:<.1
whedler l11;LrKet intcrc... t r.ttc.."'); h:n'c explanatory or
pn.'<.Iictivc power heyond Ih:lt cvident in the history
federal Rescn 'c Bank of [)allas
of innation itM:lf." In tht, analysis that follows. we
adopt a lIIore stringl;:nt test of the u.'it-fulness of
interest r.lles in prL"{lil1ing innation. In ]Xmicular.
we ex:uninc whether markL1 interest ••lIes provide
information ahout price movement" heyond the
infonnation inc1udL-d in v:triahles tradition;llly ust.""(\
to forecast innation. &:sidcs inter!::.t r.lIe ..... Ihe
variables we consider ;In: 1llC;ISurl'S of money
gro"1h. Ihl! velocity of money, the rclativc price of
energy, productivity-adJusted w;lges. and ()utpulmarket .!.lack. Wt: first eSlim:lIe empiriell modds
that rely solely on the...;c non-inlere...t-r.lh: varlahles.
thcn IC."I whcthcr :tdding inll'rest fates 10 tlh.:
models ...,ij..:nifk:mtly implUves Iheir JX'rform:lOo.:.
Sp ec ificatio n of trad itio n al inflatio n models
r.,·lost e('Ollomists would :lj..:n:e that over tht:
long tt:1"1n. inflation b <ktt:rmined hy the rate of
Illont:y growth rcbti,,\.' 10 tht: l~lI(' of pott:ntial
output growth. Tll\.'re is t'onsidt:r:thly ks." con."t:nsus alxlUt the fa(.:tors Th:lt innut:nn' ne:lr-Ienn
movemenTS in inn:ltion. Two pamdi/-tllls. th\.'
Illonetari:-.t :Ind Phillips-CUi"l' approadles. havc
dominated the elllpiril'al Iiler.lIure on near-teml
movements in innation In th\.' mom:tarist ]Xlr.ldigm. inn:nion i:. GIUS(.-d hy money-supply growlh
in cxcess of money-dem:tnd grO\\·th-in othcr
words. by -too much moncy chasing [(X) fcw
g<XXI ... - In monctarist lll()(tcis. pa ... r mon!.:y wowth
i... Ihe prim:lry dert..'rmin:Hu of nt..'ar·t!.:rm move'
ments in innation '1111..' l'hillips-curvc p:lmdigm, in
eontr.tst. attribules !lear-term mO"ements in innation to v;lri:ltions iI' execs... dcm:lnds on Ihe bl)()r
or output !lwrkets. [n l'hillip~-(" ur\'e Illlxlels,
variablt:.~ That proxy for tht: ~ap ])ctwCl'n current
OUlput ;md the full -cmrloyment level of out put
Pl:tY;H1 impOl1ant rolt..' in determining infl ation.
~/t..' e~timate V:lri:tnts of hoth mOlletarist :Ind
Phillips-cur\'\.' mooels, :IS well as :I ~eneral model
that draws upon both par.ldigms. Estimalin~
scverJ.l inflation modds allows liS 10 dt..'ten11ine
whctllt..'r our rt..'."ull:. afe rohust wilh n.:sIX-""(;t to
model specific:llion. Testing for rohustness i."
import"nt, given the currcnI lack of consensus
ahout whkh inflation p:lradigm i.. :.upc;rior.
A monetaris t model of inflation , A typical
monetari:.t mcxlcl of inn:llion 1:lkes thc fonn
(2)
Jr,
= (I + L I"e
+ L. c,I\I", + L d
F..con o m ic Rc 'ic w -Fo unh Qua rte r 1992
i
where Jr is innation , M is money growth, E is an
em:rgy·slux:k variable, and thc lowercase letters
dl..'note parJ.mctcrs to he estimated. We use the
logarithmil' differencc of the M2 monetary aggregate as OUT Olt..'aSlIrt: of money growth and usc the
growth r..ue of tht..' producer prict! index for fuels
and energy rc!ati\'c to the overall producer price
index as our t..'nergy·shock variable.' All data are
quarterly, mnnin/-: from 1959 through the second
qU:1l1er of 1991
Beforc cquation 2 I.:an be estimated. several
tedlOil'ill issllc:' n!.:ed to be addresS(.'d . The first
I.:Onl'l'rnS :Ippropriate lag lengths for Ihc right.
ha nd-side variables in the equation Choosing:1
))1(xlt..'l with hlgs that a rc tex:) ~hort can result in
hiased ct>limates, while choosing lags that arc too
long ca n I"l'sult in inefficiency. We rclicd upon
Akaike's ( 1969) final pr<.-didion crror (FPE) criterion
to sekct the appropri:l1e lag ICI1gth for each righth;lOd· . >ide vari:lhle in our regrt..'ssions.
A .-.ccond tt..'c hnic;ll issue is the stationarity of
lhe rq.:re ...sors in L'qllation 2. If any of its righth:lI1d·side v:lriahles have nonlrivi:1 1 trends, then
misleading conclu. . ions may rt.'Sult from hypoth<.."Sis
(t..'stin/-: For this reason. Dickey-Fuller tests were
u!>Cd to en:.ure th:l\ all right· hand-side variables
enterl.-d in (2) arc sl:lIionary" These tests ~fJ.ve
amhi~uollS re~lIlts fo r the :.tationa rity of inflation.
111ercfore. (2) was eSlimiited Iwice: once with
inflation as the dependent variable and once with
thc <:hange in inflation as the dependent variable 9
• Tile exceptIOn
Is
Bemsnk6 (/990). who also mcludcs
a
I1lstOfy 01 the U 5 Commercc ();;JpSrlmenr"s Index of lead·
ing matestors
We also exsmmcd fIlOo'lEIl/lfist models
using
the 51 Louis
fIlOo'lEItllty base. ratfler than M2. and lO(Jnd flO qualitative
dIfferences in lew/IS Separalely.
we 8xamlflcd modets If!
which the CflCf"gy·SIIOCk vllrlBbio was Ihe growth ralc 01
cons(.ll7l(ll"onergycos/s rclalNe to overa" conSIXnCf prices.
rather lhan Ihcgrowthrate 01producer enetgyCOSlsre/all'lfi
we found flO quahtallW)
10 overall prodlJcer pnces Aga.n.
dlffer8f"lC6S
III
results
A /IfI'I8 serlOs random varoablc IS said to be statlOflaty jf lIS
dlstributoon does not dePMd on /me
• Orflcrencl#'lf1 II random VIII/able lhal IS IlQ'lSla11Oflaty with a
SIngle U/'IIt 1001 ensures SI/ItlOll/lfll)'
,
Table 2
Tradtflonallnflation Models
A. Monetarist Model
Marginal
Number 01 lags
L.evel
DV
E
M
DV
E
R'
.000
000
.003
3
8
.833
.000
000
.002
2
8
433
DV
,
~gniflcaoce
a. Phillips-Curve Model
Number 01 lags
Marginal Slgnllicance Level
DV
E
GAP
V2
DV
E
.000
.000
.013
.303
3
8
000
000
.00 1
.006
2
8
DV
..
•
GAP
6
V2
R'
2
.829
2
.476
C. General Encompassing Model
Marginal Significance Level
DV
..
,
Number of Lags
DV
W
E
GAP
V2
M
DV
W
E
000
.0 18
000
.093
.194
001
3
6
8
000
.251
.000
.024
114
000
2
8
GAP
V2
2
M
R'
856
.473
Sample period : 1959.1 - 19912
Definitions
~ • change In the logarithm of the relative pnce of energy In the ptoducer pnc(llnde • .
M • change In the logarithm of the M2 monetary aggregate
GAP • difference between the logariThm of GNP and the Ioga nthm of potenllal GNP
V? • logarithm 01 the velocity 01 M2.
W • change in the Iogan thm of the ratio 01 compensation per hou r to output per hour In the nonfarm business
seclor.
NOTE: For lurther e( planations. S{le Table 1
Iksu lt.., ;m.." pn.·:-.... lu .... d 111 '1';11110.: 1. p:lrl A
T ht" t"Xpl.u':tIOt)' po\\ ..:r of lIw 1ll01ll.·I;lri..,1
Il\(xkl.., I" quil l' hi~ h CIo.:;!rly. hoth Llgg l 'd m o ney
g rowth ;md l a~nll'nl'r}:.y p rill'''' hl 'lp L'"pbi n Illl )\'l"
.. Godfrey Bteusch Lagrangemull1pltet rests wef8 used
'** 1or.,,1tJI
le$l/IO
~
e..,.,..1t;r ~ n.tyHl<DOIIlIot
~.r.d«hllrF
6
/Q
w. ~ • ...".". 01 ~""'('S
1estI .... ,1S/tWN$'~oI 1980.
IIK'II I" in il1fl;uil Hl In Iwu hL'1 rq.~rL·." :-ioll i.. :-':I"i;ll corn:I:llio l1 or hL"l\·n l." kl·(b"liL"i ty 0 1 thl' l 'n'or" ;I pro h k m 1'1l11hl·n JlClll ·. tl~ td l l i ol1 .t1 , : ll·..h do nOI p .-o v id ....
l' \ id l" n cl' 0 1' ;1 "lnlt·tur. II Im .:;lk in l'it hl'r mod el .•.,
A Ph i llips · c u rve m odel of i nn' llio n . 0 11l' m oli·
\.lliOI1 for th ..: i'h illi p:- \Ilrn' [I1lb lion Ill(xld b
prl".'>l·ntL·d hr 11.t1 I111a n . I'orln . ;lI1d SIII;11I (199 1).
An ;lll I: I('li\ l' Il': ll llrL' Ilf IIW lr appn ):tl h h Ih:1 1 it
m; lkl"" l'xplici t till" 11111'11.111:111(·.... o f monq' g rowth
h lr ]l llt).Hl." l"I n In.,., l! .. In inll:H lIJ1l. \\ h ilL- :1 1II)\\mg
,,'X,
( km:ltu l for o u tp u t to in ll u .... l)("l' 11\0\"0;;:-
l.'''''
I't.··t krn l Itcsc rn ' Ha n k of Dallas
ments in infl;nio n over the ncar term.
Hallman et al. write inllation ;IS a function of
ta~L"(1 inflation and of the gap lx.'1wccn the current
price level, P, :md the long-nm equilihrium price
level, P'. II The equil ibrium price le\'eI is defined
as the price kvcl consistent with the current
outstandin~ stock of M2, the aver.Jge vdocity of
~n (V2'), and the current value of potenti:l!. or
fllll-employment. real output. u Fonnally,
(3)
p' . 1112+ 1'2' -Q',
when: Q' is polenti;11 real output and :111 variables
.m.: in logarithmic form
A("(:ording to the e'luation of exchange,
p - .~-T2 + 1'2 - Q, where 1'2 is the current vt:loclty
of M2 and Q is the current level of output. Clearly,
if the velocity of M2 te nds to revt..'r1 to 1'2' a nd if
outpllt tends to reVe!"t to Q', then Ihe price kvd
will converge to P' Ha llman. Porter, :md Sm:ll1
;Irgue th:lt this convergence is describt.'"<i hy the
equation
(4 )
.111" = -b( p - P' )
where .111" is the change in inllation and b is a
I1xed, positive p;tr:.uueter. From the equation of
exch:mge, (4) can be rewritten a:-.
M = -bI(V2 - V2") - (Q - Q')J
sions. The Akaike criterion was ust..-d to sck><.:t lag
lengths, ;lIld Dickey-Fuller tests were applied to
ensure stat iona rity of the right·hand-side variables.
Like l-IaUm:m, Poncr, and Small, we found that
both M2 velocity and the output gap a re Slation;try . Hc{erosked:lslicity and serial correlation did
nOl appear to be a problem. II Results are pn.>sentc..>O
in Table 2, p:1n B.
The explan:llory power of the inflation-level
version of the Phillips-curve model, as measured
by itsR1 , is sim ilar to Ih:lt of the corresponding
monetari~t model. '111C infl ation-change version of
the Phill ips-curve model, on the Olher hand , has
somewhat gre:lter explanatory power than does
thc corresponding monctarist model. Each righlhand-side vari:lb lc in the Phillips-curve model
makes ;1 significant contriblltion to the explanation
of the change in inflation. Every right-band-side
varia hIe except the velocity of money makes a
significant contribution to the exphlnation of the
level of inllalion.
A generaJ encompassing model of inflation.
The fin:11 inllation model we estimate includes
both monetarist and Pbillip...-curvc variables. ',he
., Stncllysoealllllg. IhcHal/mafH'orler-SmallderNalOlQOCS
/tlfoogh onlY II P IS an If7IP/iCII defla/Ol for some measure of
OUtpul As a practlC8l maller, fIowevcr. rrKNe-
/Jf1!}fegat~
If! /he C(ltI$(KTI6I" prlCelfldex are fIIgflIy COITetaled
""'th those n f/loimpllCit gross r'lBtKJ(ltl/ product deltalor and
mctlts
or, more gener.llly, as
(6)
.111" = a - &1'2 + c(Q - Q'),
gross OOmcSIIC prodUCI denator Consequently. 006 rmghl
reasonably expect Ihal the set of llaflabies thaI helps
explain movements In /he <mp!lCi/ deftators WOtJld atso flelp
explain moV6fTlCflls in me CPI
where (j is defined as /)1'2'. Equ:nions 5 and 6 art:
equivalent if c equals h.
We estimated not only :1 version of the
Phillips-curve model with the ch:mge in inflation
;tS the dependent vari'IDle, as in t..'"quation 6, but
also a version with the level of inllation as the
dependent v:lriable In hath cases, lagged v:llues
of the dependent variable werc allowed to enter
as right-hand-side variables. We used gross
national product as Ollr measure of output.
Estimattc's of potcntial output camc from the Hoard
of Governors of the FL'Cier.l1 Reserve System, As
with the monetarist models, an energy-shock
variable and dummy v;lriables for the Nixon wage
and price cont rols were included in the regresEco no mic Review - FOllr1h Quarter 1992
" Mehra (1989) advocates an altsrna/we definition of the
Iong·run equilibrium pncs 16V61 Mehra 's analysIs leads 10
an ;ntlab'on sQuatlOfl that Includos lfIe cllange
In
lTICfley's
oppotluMy cost as a riaht·hand,slae variable Because
changes in /h(!oppotlurllryCOSlof hOlding rrI(l()8y are highly
correlaled woth Cll8f1Qes In Interest rates. Iv/ehra's analysIS
provides e rallOflalc for inclVdmg interest rale measures in
1116 Klfla/KJf1 aquat.on thai 's an
sMIched earilel in /tHs af/IC1e
sttems/,ve 10 /he ratJonale
" F tests yJe/d6d strongo'l1(ienCeBgartlSl thrl slructural slabi/·
Ityof thePhdllps-ClXVefTlOd9iflS/lftlatedlll /eVeI$ formbul no
tMdencesgsrnst structural slabiittyol /he rrw;JdeI estJmaled
form Accordingly. etrnough _ present Issults
lot bolt! forms 01 /he rr'ICJ(k!J/. WIt ~ araaler emohaSlS III
our analysts on results obtarned from /he IIlflstlOfl-Changc
III chIJnges
"'."''''''''
7
Table 3
Interest Rates and the Monetarist Model
A. Inleresl Rale Variables
1959:1- 1979:4
Marginal
SlgnlUcance Level
DV
3M
3MFF I OY3M
JOINT
1980:1-1991:2
Marginal
Significance level
Number of Lags
3M
3M 3MFF IOY3M
Number of Lags
3MFF I OY3M JOINT
,
.032
.089
.1 48
.025
4
.165
.01 1
.043
.000
.dlt
.122
.032
.468
.034
4
.978
.016
.000
.000
3M 3MFF IQY3M
4
3
2
3
2
B. Non·lnlerest·Rale Variables
1959:1-1991:2
Number 01 lags
Marginal Significance level
DV
,
DV
E
M
DV
.000
.000
.001
3
.000
.000
.001
llloti\'atio n lor L·.~til11: l tlll/-:: 1 /-:t·m."r.11 lIl(xlt:1 01 thi:typL' l"(>I11C'" frolll rL~'L'nt finu inl-\:-' lh:tt 1110d l·ls
indll(Iing I)(>tll rll {l1lct ari ... t and Phillip:-'-i..:tlr.e
l" h :Ir:I(le1"i.~1 ie...... i).:nilkant I ~' o utperfo rm n;l rnl\\"l'r
modd :-. ( 11 :lslag and Ol.l11cnl 199 1; t\1chr,1 19(0).
Ik.~ idl's lagged value:-. of Ihe cle(X'ndc:nl variallk' (cilllL"r Iht.' k'\cl of intl at ion or Ihe change
i n infblion). 1ll(1)L'Y ).:rtlwt h. anclthe OUlpul gap,
\\"0,.: include faggt.·d \':tilles or t\ 12 VdCKiIY. bg).:ed
ellt.·r,!..:y-pril"e .~ hOt·k:-., ;I nd b).:gel! v: tlucs of :1
1I1t.·:I"Ure of bllor t"().~IS :IS right-hand side \':Iri:Ihlt:... I, Dumllly \ari:lhk's for Ihe )/ixon \\·: I).:C :md
prkt.· uml1"oL" l"IJillplo.:lC Ihe model. Thl.·rt.· i .~ no
e\·idl"I1t"t.· of :1 ... [rUt'tur.ll hn::ak in the ).:cncr:11
I1J( Xlt-1. re,t.:ardle... s o f \\ hl"till"r [h t.· mcxlel is fO rtllll1:l k ·d i n l enn... of I lle k' \'d of infllition or 1111.'
" The labor-cOSl measure IS dchncd as lhe growth rale 01
Cc:mpensal.on per hour rstalNfl 10 OUtput per hOur Hl rile
nQIl/atm /)(JSIIICSS SCCIC)( Mehta (1m} and Has /ag and
O;!m(JIl/ ( I991} JI'Idude SIfflIIar I8bor-CCSI ~es <fI1hett
ilnalyses
•
2
E
•
•
R'
.876
.564
cha nge in inlblion TIII.: rt: ,... ;Ibo no c\ i(knn' of
.....·rbl corrd:ll ion o r IIL·II.·ro"kt.·t!a"'lll"Il\". Ik... u1!s ;tfl.'
prl.·... t.·lll1..." in T:lhk 2. pari C.
Ikco rdi n ~ to thl! la hl~. Ihe gener.l l IIIc x\t.'1
cxpl:tirb :1 ...o llli:\\·h:u hi,t.:her propor1io ll of 11ll.·
v:lri:ttic III in tilt.' kvcl of infl:lIion Ihan do the Jl)onetari."1 :lnd I'hillips CII I"\'\'! IIIcxkls. /\ 10:'>1 of Ihi"
innt.·mi:n t:l l e., \pJan:ttory power C()!l1l"S from
pnKll lctil·ily-adju:-.lt"d W:l).:CS Th t.: illflaliclrl-ch:ln,t.:t.'
\·LT:-.iOI1 of Iht: ).:t: n t: l~ d modd pLTfonns 110 hi:ttLT
1h:1l1 dOi:... Ill ..· corrl.·:-.ponding l'hiltip:'>·l."l IlY..· model.
110\\ 1.'\'t..1". money ;.l!"O\\·t h hl"lps :-.igllific:l lllly in
l"xpt:tining \':lrialion<; in hoth tht.' !t.-I·d of infbtion
:Ind Ihi: I.·hangt: In inflation. :md Iht.· \d ocil )" \:lri:thli: i.~ no\\' in:-.ignifiGlnl in Ihe c\!al)g..·... rt.·,t.:ri: ....~ion
In tlli: cllangl":O; rt.'~1"e'"ion. t tnlik t: l ilt." inflalion·
!t-\'d fc,t.:rl.·:-..... ion. \\ ;lge gro,,·th I.·o nlrihult.,... l ink·
l.·xpl:l n:I\{)1)· pO\\l"r.
Additional inrorm:ltion content
of the interest rate v.ariab les
To l"x:l1nine tile marginal mf0I"111:1I101l t"C1rl1t.·1lI
o f inl,,·rl.':-.I [";1Il"... fo r fuwrt.." inlbllon . wt.· :Iddi:d
laggt:d valut..:s of Ih1"(:t..: intert:sl ralt: measurt..:s 10
the right-hand .~idt..:s of our innalion modds
Thest..: nW:lSurcs wert..: the level of the lhrecmonth Treasury hill ratt..: (3M). lhe spread
Ix:twet:n thl' Ihrl'l'-l11onth Treasury bill ralt: :lOd
the ft:der:d funds rale (3MN'"), and Ihe spre:ld
hetween Ihe tL'n-YL':lr Treasury bond rale :lIld Ihe
thret:-monlh Trt..:asury hill rale (IOY3M). The
three-month fatL' was included Ix:cause economic
theory suggests Ih:]( the r:l!e incorporales markL'\
expectations of inn:llion O\'er the coming qual1er
(comp;lft: wi1h equ;l1ion I). The spread between
the ten-ye:tr bond r:lle and the three-month bill
rate was indudL'd heclll.~e previous rese:lTch
indicates th:1I thi.~ spread is dosely rebted to
rutun: growth in n:al econol11ic :Ictivity and.
hence. might conlrol for movements in expectt:d
re;11 interest r.Hes (Bernanke 1990: Estrella :lIld
Hardouvdis 1991). The spread Ix:tween the
three-monTh Tn:asury hill rate and the fedl'r.ll
funds r.lIe was included p:ully for compldt:nl'SS
and p;lrtly hec;lust' tIll' fede ral funds rale is the
intcrt..:st rate that is most nt:ady under the conlrol
of Ihe mont'tary authority.
In e:Kh n:gression t..:quation, both the constant IeI'm :md tht..: coefficients on the interest r:llo.;:
variahles wen: alluwt:'d to differ between the prt,;1980 and po~t-1979 s:ltnplc Ix:riods.'~ This split
W:1S introduced ht'GIU.'>C formal F tests indicaTl'd
that thl.' codlkients on some interest r.:lle vari·
abIes in lhe monL'larist :lIld Phillips-curve models
s hifted Ix.'~inning in 1980. A split WllS :llJowed
even in tIll.' genl'r.11 l11odel. w hich shO\ved no
evidence of a structural .~hift. because w<;.· wanted
to examine w hether interesl rates played :1 less
import:ml rok in explaining movements in innation during th .... 19HOs than during the 1%0.~ and
1970s. (lkcall thai in regressions involving only
interest r.lles and Ihl..' bgged level of infl:llion or
ch:m~e in inll:ition. we found evidence thai the
m:lr~inal explan:ltory power of interest I~Hes
d..:dines alkr 1979.) Coefficients on non-iml.'Tl,'slr:lle varbhll.'.~ Weft· nmstr.lined 10 be ..:qu:1I across
the entire 19'59-91 1wriod.
Wt: found that in the pre-1980 period. thL'
short t..:nd of the intereST r.lle yield olive has substantial marginal e.'<pbn:ltory pO\ver for [xltli Ihe
level of intlation :lnd Ille change in innation.
\\'hile the long end of the yield curve does not. In
the IXlst-1979 period. holh short-term and longEconomic Rcvtew -
Fou nh Quane r
1 ~2
tl:nn interest rates help to l'Xphlin movements in
inflalion. Our general encomp:lssing model with
inten:st r.Hes apparently domiml\es the intereslr.lte-all~mented monetar i.~t and Phillips-curve
modds. nOI only in terms of ilS stmctur.d stability
hut also in tenns of irs ability 10 explain innation.
In the gcner.J1 modd, ;1 yield c urve that is steep
at its long end lends to signal low, and declining,
near-term inflation.
Impact of interest rates on the monetarist
model, According to Table 3, adding interest rdtcs
to lhe monel;lrlst model of the kvd of innation
l~lise:-; the J?! of Ihe regression L'qU:llion 10 0 88.
Over the pre-1980 period. the three interest rale
me:lsure." arc jointly significant at well under the
,>-percent lcveL Ovcr Ihe post-1979 period, the
Joint .~ignilka nce lev\.'! f:111.'> 10 0.02 percent, indicating that the marginal explanalory power of
interest rales increased during the 1980s. Most of
th .... m~l rginal explanatory pow.... r of interest mtes
over the elldy sample period is au:ounted for by
Ihe level of Ihe three-monlh interest rate, though
Ihe spread Ix:tween Ihe three-month rdte and the
feJer.tI funds rate is alsO significant at the 10pt!rcent level. The spread Ix:twt;'en the ten-yea r
and Ihree-month interest r.:nes-representi ng the
slo lX: of Ihe long end of the yidd CUlvc---doeS
not contribute Significant marginal explanatory
power until the 1980s. l~
.. Lags on the norHn/crcst-rate va"abJcs were held fixed at
lenglhs determmed by Akaike's FPE criterIOn 8S app/Jed 10
the monctilnst. f'hill,ps·curve. and general modets withoul
m/crest rales The Akaikc cflterlOn was applied separately
/0 /he prc- l980 and post·/919 Interest rato vllriables to
determine the opllmal number ol/ags of these variables 10
be mcluded m lhe regression equal'ons
.. One explanalron 101 th,srcsu/I - llnd 5JfTIIlar results reported
later m the arllcle-can be prOVIded Wlthm the context 01 a
model (such as /hat of Mehra 1989. 1990) m which /he
opportum!y cost of hoIdmf} monoy IS ono determmant of
Inflation During the 19605 and 19105. when deposit ralO
ceilings wcre generally bmding. /he opportunity cost of
holdmg monoy prmcipally vaned wi/h snort·term interest
rales Once deposit rate ceilings were abolished, banks
wero tree to change depoSl/ rales m rcsponse 10 move.
ments in loan fates- whICh arc relalTVCIy Iong-Ierm- and
the OpporlUMy cost of hoJding moncy became a funcl10rl of
/he sproad between IDrIg·lerm and shott-term market mles
9
Table 4
Interest Rates and the Phillips-Curve Model
A. Intern' Rete Variables
1959:1- 1979:4
Marginal
S/gnHtclirtce Level
DV
411
3M
3MFF
1980:1-1991 :2
Marginal
5'gnlflcance Level
Number 01 Lags
lOY3M JOINT
.020
.018
.31 4
.011
.542
422
.774
413
3M 3MFF lOY3M
3
3M
Number 01 Lags
3MFF lOY3M JOINT
4
.082
.778
.012
.011
2
.589
.026
.001
.00'
3M 3MFF IOY3M
2
3
B. Non-Inlerest-Rate Variables
1959:1 - 1991 :2
Marginal Significance Level
DV
DV
•
GAP
E
Number 01 Lags
DV
V2
.00'
.000
.766
.055
3
8
000
000
.019
004
2
•
",
GAP
E
6
V2
R'
2
.856
2
567
Table 5
Interest Rates and the General Encompassing Model :
Split-Sample Interest Rate Coefficients
A. Interesl Rate Variables
1980 :1- 1991 :2
1959:1- 1979 :4
Marginai
Significance Level
DV
,
'"
3M 3MFF IOY3M
Marginal
Significance Level
Number 01 Lags
3M 3MFF I OY3M
JOINT
.015
051
990
007
3
596
037
.700
093
4
3M 3MFF tOY3M
.049
677
.002
013
Number 01 Lags
JOINT
.097
.00'
3M 3MFF lOY3M
000
3
2
00'
3
2
AI
R'
B. Non-interest-Rat. Variables
1959:1- 1991 :2
Marginal Significance Level
DV
DV
W
E
GAP
V2
AI
DV
W
E
.,
5B6
012
.000
628
.022
003
3
6
8
.000
286
000
00'
2
,
10
Number 01 Lags
62'
75'
8
GAP
V2
2
.895
56'
1't.-dc l"3l Rese,,·., Il:i nk o f DaUas
\I;'hl'n intcn..':-t r.Ul.... arc addl'd 10 monelanst
' ";Iriahles in an :lI1Clllpt tn explain cbal/p,es in
inllation. the R! of thl' Illono.:tarist equation riS(:.~
frolll O. I,) to 0,6 Colll,t'th·L'iy. tht' inh::rest rate
IIlI.:a,un,:..; hdp :..i~nitk:lIll ly in t"xpl:li ning (.'li:l n).,:•.:s
III mtl:uion durin).,: hoth the l:;lrly and the Jatl' .~lIllple
period, A, in thl' inll:ltion-h.:\'d n:gre:-:-Ion, thl'
hulk of interl' .. t r:lle ... · l1larginal explan:ll0l)' PO'\'l'r
during the t'arly S:1I11plc period t:ome..; from thl~
., lIon end of the yield nllYC During the 19HOs. the.:
long l'nd o f the yield n1l"\'c ;]1.'><1 1ll:lkcs :1 significant (.'ontrihuti()ll
Impact of interest rates on the Phillips-curve
model. Ik'sllil:- for the Phi ll ip:-'l'ur..-e model
('1'(//)/" 4) :Ire qu:dit:lllvdy ~illl j br to those for the
Illondari:">t modd Illduding interest rates in I h<:
I'hillip."-('tI!'\'e equation for tht: Ien:1 of intlation
r:lisl'S thl:' I:'qu:ltion's R:' fl'Orll O.H3 to 086 and
lai,l:'s thl:' Rl of till' Phillip:-'('ul'\'l' equation for tile
cll;lIlJ.,:e in mtl:l1ion from 0 -tH 10 0 57. In thl:' lewis
regre:-sion, o nly :-hort-tenll interl'~t r:llt'S h:lve
:..ignifiGlIlt m:trHinal expl:m:lt()I)' power in 111<..' carty
~lIliple (X'riod, while it I." prindpally tht' :-Iopt: of
the long l'nd of the yidd 1'1lI'\'t' th:1I hdp.~ expl:lin
rnon:rnenls in intlation du rinJ.: the 1980s In tht,
rt:gn.':.... ion for tht, ('h:tnge in inflation, none of thl'
intl're:-ol r.lIe Illl'a:-olire' :tre st:lli:-otic:.ll1y signifil':tnt
during Ihl' c:lrly :..:t111ple period. hut the slope:- of
hoth the short end and thl' long end of the yidd
nu'\'e ha\'e suhstantial expt:lIlalol)' power during
the 19HOs.
Impact of inter-est rates on the general cncompassing model. Induding interest r.tte .... in
I I!I:' general cncomp:t..;~i\lg l1l(xld of intlation
r:li:">t'S th<..· Rl of tlte le\·d.. rewession from 0.1-16
to 0 H9 and raise:.. Ihe /{! of the l'h:mges regression frolll 0.47 to 0 ;6. (Compare Table 5 with
T:dlle 2.) [n bOlh the pre-19HO :l1ld the posl- 1979
segments of Ihe 1959-91 .~;lInplt- period, measure... of short-term intere't r.Hes help subst:m,
li:ll1y in explaining movements in the levt'l of
intl:lIion :md the change in intlation. In contra...;!.
tile slope o f the long ..:nd of the yk'id clIrn: is of
lillie help in explaining movements in the level
of inll:llion or the change in intlalion u nti l afler
1979 Tahle 6 shows th:1I when the cocfficie.:nts
of tht, intl'f('St rate variahles arc constr.linC'd to
I'll..' ('()\lst:lnt o\'l;:r Ihe .~am plc period. all three
intt're:-t r.IIC me:l:>llres 1Il:lk..: a st:llistical1y signifiemt l'ontriblltion to hoth thl! level-or-inflation
Eco nomi c Rt.'Vlcw _ Fo urth Q u a rte r 1992
and the chan).,:l!-in-inll;lIion regressions
Induding i nter..:'t r:lles among the riJ.:hth:tnd-siclc variahles in the regression equ:Hions for
the geller.tl en(·ompa:-sinJ.: model h:l.s import:1I11
eff<..octs on Ihl' expl:matOlY power of hoth the
o utput g:lp :lnd tlK' vdt)(:ilY of money. The expbnatory powl'r of the output gap for the level of
inflat ion is wt':lken(:d hy the inclusion of interest
r:lIe" ",hilt- tlt:\1 of \'eI(l("ity i:"> markedly strenWhened 1- (Comparl:' T:lhle:-., and 6 with T:lhle 2)
In the inflation-dlan~e "ersion of Ihe gl'ner:11
ent:omp:t~:-in~ model. adding interest r.l«..-'S mark<"-'<.11), redu('es the explan:uOI)' power :lHrihulah1c
to the Olltplll Hap. The vclocity vuiahle remains
insignifkant
Inflation aud the slope of t he yield cu rve_ Is a
.~!e q) yield curve ;1 •..;ignal of high infl:ltion or of
low infl:1!ion~ 1:- a :..Icep yield cUI,\,e:t Signal of
rising inlbt ion or of f:tlling infl:llion? One l':ln
determinc the lonJ.:-flm dTet:t of:l change in the
Met:pness of the yield ( 'U TVe on predicted intlation. or on the predit'ted change in infllllion. hy
using tlte ~Ul1l of thl! t:()effici<..'nts attached {O
lagged v;llue:.. of the intert:st r.ue spre:ld. In our
estim:lIe o f thl! I('ids version of the gener.tl
encompa....... ing tn{)(lcl, this sum of cOt:fficients is
0.891 (with sland:lrd ermr 0,346) for the sprl'ad
het\\'l.--cn the three-!llonth r.Ue and the feder.. 1
funds r.Jte :lnd is -0.403 (With standard error
0,175) fo r ,he sprelld Ix:tween the ten-year rate
:Ind the thn..-'C-Illotllh r.IIl', Thus, a thrl.-'C-Illonth
intercst 1~ltl! {1t:1I is hi~h relath'c to the feder.1 1
funds nile siHn:lb a bi}!.b ncar-term nlll' of inflation. whiil' :1 ten-yl'a r intt:reM r.ue {hat is high
relative to lite tllft:e-mOf}lh r.1It: Signals a/oIl'
near,tenn r.lH: of inflation.
One: interpretation of theSe results is thaI
hond ma rket p:tn i c:ipanl .~ eXptXI the Fedenl l
Ikserve to r.l i .~c the federal funds r.ue qUickly
when near-term in!lation thre:ltens to he high
Bel':lusc Ibe thn:e'!llonth ra((: is mo re responsive
10 cxpected ncar'tenn movements in (h..: fede ral
funds rate Ihan is tht: ten-ycar rate, the prospc(1
o f an increase in Ihe fedenll funds rare mises the
" This 5181emenl 81so 8pphBS 10 me PhdIiPS-i;r,KVe model
(Comparo 18b1o <t. p81t B, wrlh Table 2, part B)
11
Table 6
Interest Rates and the General Encompassing Model :
Unj,jed·Sample Interest Rale Coefficients, 1959:1-1991:2
A. Intern l Rate Variab les
Marginal Significance level
DV
,
3M
3MFF
IOY3M
JOINT
3M
3MFF
.011
.004
.000
5
,
10Y3M
001
_0 17
.011
.002
001
2
2
2
,
B. Non·lnt...... t·Ral. Variables
Number of Lags
Marginal Slgnlflcanc. Level
DV
w
E
GAP
V2
M
.02 1
.000
.000
.289
.002
.000
,
.000
.196
000
.518
.134
000
2
DV
,
Ilm...1..· lllomh r;th:
1"...·blln.:
!O h0111 til ...· ntrrL"1li fund ...
inflal ion I cn d ... !o 1'1 ....... llllliV ... Iowly tn 11ll"
l ·... li l1 u ' ~·( l l·l)dfici t'n '"
:lu;R'hl'd to Lt.!.!,~l"ll \ .I h ll· ... o f Ih...· ... ptva d h":I\\"t:'t:'1l
[ t:"n-~l': l r :lnd 111I'L"l"111onlh m 1crl· ... 1 1.11l'''' I'" ...(1.5().".
\I
6
8
GAP
V2
M
2
R'
.891
'48
8
ThL' f(JIiII\\U1).,: "'clli(1Il .lll.lh/t: ... lh..' f(ln:c.I ... l lng
·11 1..: . I n.II ~'''' I''' comp ,l rL" ~hl' 1( 1!\."<.,I"'llIlg p.:lf,ml1:l1ln:
or lllod..:l ... wilh tn ll·r..·... 1 r.t1l·" \\ rlh Ih l · 1(II\."CI'>I II1;':
f ulllr..:. Illl' :-.t...1..·lx·f h !ht: IOllg l'nd o f th..: ~ n.:ld
Ii [111.:
E
or
in lit..: rq.:n.· ....... on ":X p IaUlUl).: (h(/I//.':I ·~ in
('UrIl' T im.... III ...· MIIII
W
Ix-rl(ll1l1:mcl'
lit ..: ~..' rK·r:,ll·rKomp .l ...... in.~ 1Il()lkh
or Illl ' lL'\ l ·1 0 1 nllbl ioll ~md thL' lh~Hlg ...· III mil,ll ion .
r:tl..: .tnt! Ill ...· ll·n·\ ..... u· r.lh.: :IIltbUO Il .
DV
il il ...!.l m!.lr... 1 l 'rnlr n . I ';:-l , '\ ).:. 1111 .. 1 I)( ....... il)k inll'r-
IX'rf()n1lan c ..· I)" Ill..: 1.-"rr"'·" IXl1ld l l1~ 1111 11.1...'1 ... \\"il I1I )ll \
illk·I"l·... \ 1":'11..: ... \\ 'l ' l o n finl' our ~lIt t:nt ion 10 ilk'
gl·lk'r:11 mo(k·l ... Iwell hl' Ihl'Y ""Ill"o m p~ I """ Ilk'
Ilhllll'\;lri"'l ;ll1(1 f' l lllllp", ntl"\l' r1 ll xtd, .lmllx·cIU'('
prt:I:1I1( 1) I ... 111.11 Il ll' F...·dt'r.t1I ~l· ...l·l"\l· I:-.Iilougill to
,IlL' Ul'L"ttkil'nt ... I ll) till' in ll'r\' ''1 I~IIL' \,lri.ll lII: .. In I hL'
hI: morl: I tI'l'ly to d l'in.: dow n IH-; 11 1('rl11 tnleres!
rates II hL'1l infbtiun:II)' pn.·...:-.ltrL\... :11"(' II :tning th:tn
st:llIl...· :1("1"0 ... :-. th..: l.·nli."I..' "':l ll1plt'
\\'111:11
.\!'L· tl L·I~ 1 1 1110(k ·h -un lit.. ...· I h\· o t l1l ·r ll1o<!l'h-
a .....'
inlbtiol1 :lI"}, prcsslIl"l·s an: hllilding
O ut-o r-sa mple fo reca.!ots
rile olll 01 ',Hl1plL' lor .......·; .... ! ir)).: l ·\\·ITI .......... \1 ...·
{"(I1UlllU a rL'
0111..'
qll.ll"tl-'r·.lhl"ld "'I;l\i\ fl .aT;:I "'\'- Ill'
m llt lioll .1' gl·lll ·r.lll'd h~ till' gl,tll:'I: l ll'mornp:l,... in~
St!f> /tIcM..~('969
33} AIICm. ltlV<'Iy, .1 1..1,geSPfead ~
tW('CIlk/l>(l-/(,lm and shor/-lerm lI1/('tL'S/ ta'es may S.gnat.l
low <1I't'f"I\WI'ly COSt 01 hOId,f'IQ IJU'kOY ....(1 f>8nCe a lOw
""".-'/~' oIlJ1<)rlt"y A Iowveloc.lyColfl1(lf«'y lend$IO.o7lJ)I~,l
It ... eq., Ur'(jm
(r~~r'''q
pr.ce
Ie. .. ,
'or anv
do.',,·'.>.lrd t)t~$SU'e .In "
j}<"i·4,.... "If!
:"'$
~ ' IJ'a"d ' ;;w-r
<}
.j'
II /·"rr
"'n
'ftOt"'Cy WP lJty
1.-_"" 1f:'_aroOf'
~eJcX,lr
"1("',,,Io--,j ," iI St1O.-1rare ''91,', '1i1",1 IIP,I<' ~<" . ,b
01-11 '""I.on II"(.I'(l'$SI(It'I
1l
Tt>e
s ;;.reiJc,
(>;n tI>e
ie>.-ei
mudd ... TtK' tI)rl"l.l"''''' .I f l' rt.,; t!·linll' in II\\..' ...L'n .. ..:
11 1.11 IIll'Y .If": g l 'llI.."l:Ikd u .. m).! only info rt ll:lt loll
.I\ ;tibhk ;tll h .... I lIlll' o f ,Ill· IO!"l·C;t"'I'" FIII11ll'1'11l0rl·.
Ih\ · P;U: ul1":(I.·r l·... tim.II ...... o f Ill ...· 111111.1...-1, .m: lIPd;lIl"<.1 \·:tC11 Ix·rit>lI,I ...
111..'\\ 1111<11111 : 111401)
1l<.:nmll·...
.1\ ~lIl.thk· IIO\\l·\·l·r. tlt l · b)-.t -.t.nll"lllfl·... nllllt.· Illul.k l ...
\\I.·fl· ......·k(·I ..'(1 h~ 1I'1Il)-.t d.II.1 hum thl' l.·nllI"l· '>;l lllpk-.
( "'f X·(· ificlll~. t h ... I.I).:' ll"'l.·d In Ilk' fll ......I'. I ...ling
Table 7
Forecasting Performance of the General Encompassing Model
WIthout Interest Rates
With Interest Rates
,
Mean eHor
-.278
-.255
- 235
-.130
Mean absolule efTor
1.445
1.175
1.303
1.211
Root·mean·square error
1.836
1465
1.697
1.574
NOTE: Based 01'1 one·penod·ahead forecaSIS from 1980:1 lhrough 1991:2
Ali $til1l$I,CS are mulllphed by 100~ for example. a mean error of -0 255 represents an erfor 0/ -0.255 percentage po,nt
illOl.kl" ;Ir..: lil..: .".11110.: ;1." I Il()."": in TI IlI .... ())
T;lhk - pn...., ... nl .; for"'Cht .....:-;llll." I'<)r Ihe k\d
o f ;111d lhl' d1;111).:V III inlblloll o h t;lint:d from til ..'
~"'IWr:11 ..·'ln ullll.1" .... II).: 111< I{I"'I" \\ it 11 :llld \\ ilh(),ll
int,,·rc ..' 1~ 111.:'> Inl·\,.:I)" Cl"': . Ih ..· I'ol....et ... t lX'nod
fun ... fWIII IIIl' fir... t q \l;lrtn of 19HO throtl).:h t ill'
.....·u "ul qU;lnl'r i >f 1')1) I '\c Int: of Ill..· llll';m l'1Tor~
;m : "'LlII"'Il(,;III~ difk,.... nt f nun 1t:1"0. indk;lIill,g Ih:11
IIK· lill"lx.l ... t~ .In•.' tlllhLt.'>I..'d l~cK)H ll,,·an -"qtl:lfI.: l'rn>l~
. 1"'" I/)\\l'r for 1I".... ("; I ... t ... lu .....>t.1 Oil n'gn.:~~ io ll '" in thl'
dl:m.l..:l· 111 rrlll,lIion 111;111 lor lorl'C hh h:I"'l'd on
rq.:f..·...... ion ... in I lIl' k\ ..: 1 C If inll:uioll. ,.,
T:l hk l{ pn...... o.:llh I lw I"l· ... IIIl ... of lofl11al o.:n ·
C0t11p:I ...... I11,e. 11.: ...1 ... \ 1"01' :111 l·,pl:lnati(11l of fon.:C''<1
,.:I1«(Utlll,I ....... Ill,e.ll'''' .... ~L·t: 111l ·1){>x litkd ·· I ·'JI'I."GI ... 1
FI1(( ullp.l ...." in,g. p.I,g1..' l'i ) ' lllo.:"L· I..:... " ("( mfinn tll:H
11ll' inn:11 i( m·d 1:' 11).(1..' \ ·L'r... ic In ... (If 11K' ),:I..'I1L·l~1 1 Ill ( )(k l
~ idd ... i).:l1 i ri clIll I ~ 1110rl..' ;1,'('111';111..' forl..',·:I " l.'; of in lb·
[i(m 111.111 d(l II I" , I UTC",p(Uldi n ),: intbli{)I1-k l 'd
1000r.... ("I ... Thu .... h>f\:cl ... t ...'ITIH" ... ()f t h ..· inlb,iol1L·II:I!1).!l' (11(JlkL... IIdp l'xpb m tl1\.' 1"0rn:I.... 1 l ...ror.... of
Ih ..· mn:l1ioll-k\ d (11odd~ h ilt I1 CIt 1 i("..' \ l·r.;a
(T:lh1<.- 1'1. lirK"~ \ :md 1\) COIll P:II"IIl),: lilL' ill11:lIiOIl("11:111),:"" 111(){k·I ... . tiK' rnoc.kl \\ itll im"''!"I..'''t r:III..''''
...'nullllp.l .......I..' ... tIl ...· 11lI)(ld \\jllulut r:lll· .... 11111 IIII..'
1I11){ld \\ ithollt r: IIL· ... l:iih 10 l·lll·1l1l1r:t" ... IhL' lllod,,1
\\illi r:IIL· ... IT,th k H. linL' C) CO lb ... <tUl·nll~. th..:
forl>t. .l'ling jll.:l'lnnH:IIK... o f th ...· l110 dd \\ Ilh illll..'r...·...1
r:lll·'" i" unal11hiJ,.:lIou ... ly "'''p•.: riof tn tll:11 of lIlt.'
Illll{kl \1 nilolll inl ...r ...·"t 1: lIl'''' In p:mi("ub r. iOl("I"I.· ... t
1: 11 ..'" {{>nUII1 rllt"rln;UrOIi u ......l"ul III pn.·dicllng
nl..'.l r-ll'1"l11 rn(I\\'llll'nl~ 111 inlblioll
fu:onnrnk
R~vi<:w -
Fou nh Quano:r 1992
Discussion
I'r",\·jo\l'"
of th"
1".. •... l,;lI"(,'h
11:1:-0 :-ohml n Illat 1110.: :-;lopl..'
illIL·n:..'~11~ lll· ~il·ld clln ...· can
."'0.:,,0.:
;I....
;t
u ...dlll pn,:dit'llll" (> f h mJ,.:-t ... nn changes in intl:.il i(lll.
AlIL·mpt.... to I,;'XI I': I("1 in fonn:llion alxl\l1 11('(II~\('rl11
111()\L'111L'nt'> ill 111(bll(1Il fl"(1111 1I1II..'r......1 1~lte~ h:l\\..'
prc.)\ ...·11 1(1 Ix: k~~ ""ICI.·c" ... ful-l..·"Ix:<."i:l l ly tilr Ih...
19HO~ FI jlrimi. 011 ... l11i1!hl h.I \'L· ... Xp ...'CIl·c,I [he
m:l l",gin:l1 in fo1"m:Hiol1 (·0111 ...·111 (>1' int ... rl..' ... l r:l!I..'S to
..,hrink ,I'" ;I(I<lili(1I1.1 1 L·xpbrl.llory \·afi;l hk.; \\"1.'1"...
indulinl Oil lill' ri,e.1l1 hand ... ilk of Iho.: inlblion
rq.;r ..·....'01( III API); l rt·IlII~. 111 1\\ \'\ ... r. Ihl' \,:lrbhl t'~
Ih:ll migllt 11:1\ ...· lx'i..'l1 L'xfX'{'lnl 10 Ix: lllo:-o1 (:0111lWl ili\l' \\jlh 1ll;lrkL·III1tt.-.....·...II':ltl'.; :KI ll:llly help ti ll..'
:11l:lh ... 1 10 c..:onl rol for u n o h :-<"'1"\:lhle IllO\'L'1l1t:nt.... in
<:'xlX....ll'd real inIL·rt:...1 r.IlL' ...., T l1u ..;. :-;Upp k111l"n ti ng
i lllnl·." 1 1~ 1 1 t'.'; \\ it h 1I:1(l itiol1:11 inl1ujol1-pro.:d iI..1 i ng
\ :Iri:lhk ... 1ll:l kl· ... it ...·:lSil·r I(l <.'"I "let 11K' inf()rm al h ltl
:lhoul I1I.·ar t<.:rm inlblion tllal i" ilid(kn in tht:
\'i dd \.lll"\·(·.
By wayol eotr!pafISOf) McNees (1992}rcporIS rhe mflarlOl1·
forecaSI<ng perlIYmanceol1!ll ononyn'OU$ 'prOtTldlen/ loreC<lSfe('1ot lire perIOd /(om 11>8 flTSt qU.1f/Cf oIl980lt>rcvgJl
the f"51 QUilIrcr 01 1992 nte mean efl(x. mean absolure
em;x 8fl(1 fOOl.meat1-SOIJ<I(e emx lot /hJs flYccasler were
01 12 ,ma I 7percooifIgfJpotrIIS fCSpeclJveIy(McNees
1992 r,lt)/e 2!
"
Table 8
Encompassing Tests
Independent Variable
A.
(K - ~) -
Dependent Valiable
,-
(Oil-OK)
..
Oil -olt'
B.
C.
(K - 1'I") - (OK-OJt")
(01[ - &Il') - (4K - oJt")
,-
..
f Statistic
2.710'
.192
5.146"
01[ -or<!
.696
OIt-oK
2.685"
4 1t -or<!
.458
Definitions
It - It' • forecast error from the level-ol -inflalion model wi lhout interest rates.
0.1[ - on' • forecast error from the change·in-inflalion modet without interest rales.
I[ -'II! • forecast error from the level-of·inttatlon model with interest rates.
41l - oil! • forecast error from the change-in-inflatioo model with interest rales.
- S!grMllcanl al the '-percer., level.
In Ille (: xi'>linJ.l Ii\(:r.HUl"e. a . . ICcr yickl curvc
siJ.ln:.ls rbin}: inn:!lion. I h: fl.', howc\'l.'r. short -h.:rIn
r..IL·S Ihal :' n.' low reblh '\..· 10 IOIlI-:-I\..'rm rail.''> af'l' a
.... i).:o;ll of !alllllg innalion on.·r Ih\..' nca f Il'nn
Bond-m :.rkl.'l Ir.ll k·"" po ........ ihl) Ix·l ,l.'\'\..' I h.,1 policym:.ker--. are mor\..· inl'linl.'d \0 driH .' down short wrm intcn.:.... \ r:UI" .... ......Ieepclllll).: I Ile YII.: ld (·Ul'\'l.'.
w hl"n till.' ne:lr-h.:nn outlook lor infb l ion i.... fa\,or:.hlc
lil:1I1 \\'h ...·n Ihl' Ill"ar-Il"nn o Ullook for infl:tlion is
unf;,v( )rahlc. 'l 'hi... inlC rprl't:l l illll I )f IHII" l'mpi rica l
rl'."uli s woul d im pl y t ll:11 :1 shift in Iho..: motH;lary
aUlho rit y's I"espon," e to chan).:es in 11ll' nl'ar-lI..'rm
1I111:.l lon outlook would 1c:.d [0 : 1 ,..hift in ollr
p:I1":II11I"I\..·r \..·....[i1ll:11\..·. . In p: lrtil.~ llbT , if I hI..' F...·tk ·r.1I
IkSl'lY\..' wen.: t o hc ).:in to n: ly m o l'\..' heavily on t he
.... Iop\..· of thc yidd ('lIIYl' :I.... a g uide for mo nelary
policy. Ix )liq'makl.'l"S mighl find that tile t:.~li11latt"d
rel:uion.... hip hetwCf..:n tht: :-.Iope of t ile yield n ll'\·t.'
:lml n\..';lf -ll'nn innal ilJll wou ld ("hangt: \Vhi k
JIlll.'rt..'.~t r:llt:.... hiswrit":.lly have ("olll:linl'd informalion helpful in pr\..'lhn ing nc:u··ll.'l'm innat ion, Ih is
histo ric:,1 n.:1:lI ion:-.i1 ip h no g uara ntec l ilal 1ll0Vl'ml'llf.~ in 111:.rkt:1 i nle r!: ... t r:ll cs Gi ll Ix: Llsed SLI("cL·..:-.fu lly to ).:ui(k poliq'
f cdc ..." Rese rve' fbnk o r D" lbs
Forecast Encompassing
The idea underlying the Chong and
Hendry (1986) forecast encompassing test
is not complicated. Let y denote the variable
being forecast, and let y : and y~ denote
forecasts generated by two competing models. Consider the regression equation
(B. 1)
Y = cry: + (1- cr)y~ H ,
where E is a random error term . If cr does not
contains useful informaequal zero , then
tion lor forecasting y that is not contained in
y ~ , and model 1 is said to "encompass" model
2. 11 a does not equal 1, then Y~ contains
useful information for forecasting ythat is not
and model 2 encompasses
contained in
model 1. If model 1 encompasses model 2 but
model 2 does not encompass model 1 (that is,
if cr equals 1), then model ! is clearly superior
for forecasting purposes. II model 1 is encompassed bul is not encompassing (lhat is, if a
equals zero) , then it is model 2 that has clear
superiority.
An easy way to test for forecast encom ·
passing is to estimate each of two rearrange·
ments of equallOn B.l :
y;
y:,
18.1') y - y: =ll -alllY- y:H y - y;)) . .
and
(B. 1")
y - y~= cr((y - y~ ) - (y - y : )]+E.
(1 - cr) is significantly diHerent from zero, then
a is significantly diNerent from unity , and
model 2 encompasses model 1. Similarly , if
the estimated value of a in equation B.l "
differs significantly from zero, then model 1
encompasses model 2. If (1 - a) is significantly diHerent from zero but cr is not, then
model 2 contains information about y beyond
that contained in modell , while model 1
contains no information about y beyond that
contained in model 2. In this case, model2 is
clearly superior for forecasting purposes.
Similarly, if a is significantly different from
zero while (1 - cr) is not, then model 1 is
clearly superior.
In Table 8, we first test whether fore·
casts of inflation derived from models of the
change in inflation encompass forecasts of
inflation obtained trom models of the level of
inflation. (ImpliCit in any one-period-ahead
forecast of the change in inflation is a oneperiod·ahead forecast of the level of inflation. )
The t statistics reported on lines A and B of
Table 8 confirm that forecasts of inflation
derived from the change-in ·inflation regressions are superior to forecasts obtained from
the level·ol-inflation regressions . Finally, the
t statistics reported on line C of Table 8
indicate that in predicting inflation , forecasts
derived from change· in· inflation regressions
with interest rates are superior to forecasts
derived from change·in ·inflation regreSSions
without interest rates.
In equation B.l ', if the estimated value of
"
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Economlc Rcvie w -Fou nh Quane r 19'92
17
William C, Gruben
Senior Economist and Policy Advisor
Federal Reserve Bank 01Dallas
Trade Policy and Intellectual Property Protection:
The North-South Dispute
ill\'l:nIOr~ h:l\'l: a righl 10 profil from Ihl:ir
invl:rllil)lb? Thl.: i11lplicalion~ (If Ihi:-; que:-;li{lIl
h;lvl' l'\'okcd c(lntrnvcr~)' in r(!n~ nt ye:lr~. :md IlllKh
of I Ill' di~pulc h:l." oCCllrnxl hClwl:l:'n devdoping
and lkvehll1l"d countri(:!:-; Thl:' maj(lr pl'(ldllCl~rs
01' inldkClu;l1 rroPerly. Ih .... dcvdoped 11:l1ions.
I}'picdly \\anl ~lrong int ..:llectual properly protl'Clion Ik\'doping n;l1ions. which Iradilion:rll y
('Ol1.'lUlH: more rntl'llcCl ua l properly th:lIl they
prodllCl·. pRofl'r nOI 10 p:ry for it They oftl'l1 \\'a nt
\\ l"akl'r pruil'ctron (See lile hox titkd - What Is
Intl'lknual ProJX"rly~" )
Hl"n.·ntly. 110\\ L'\
-;()lIll' dC\'doping luuntri\.·s
h:l\ l' IX'gun to tiglllen Ihl'ir proIL'l'lion of imd1cctll,ll propl'11)' Thi.' :111i('[t' di'>Cu~~'~ lilt, moti\'l'S
hehind IhL'X' ('OllOlriL'S' recent ch:l11ge!'> :md 1'0.:':1.1.>;('.,
o n lllL' l"rx:rrl'Ill'l' of Latin AmeriC:1I1 COlllllries in
Ihi' pr{)l'I':~' In larl-te p :1I1. the h:l!'>c'" for IhL·~·
(·h:lngl.':-; il1\OI\L' tradl.· policy.
I arWle Ihal t\\'o types of linklgl.'s hl.'I\\'l·I.·1l
11~ ldl' poliq' and inlellectual propt.'ny exist Fil};l. :IS
11:1' ofl .... n Ix~t.' n nOled, we:tk inll'lkCIlI:ri propt.'rly
Ia\\ ., in devl.·loping Olunlries 11:1\'1:.' kd d;"vdoped
('ountril's to n.::ta liall' with sdectivl' barriers 10
Third WOI'ld exports. Some do.:\'eloping ('ountries
ha\'I.' hegun to re ... pond by tight .... ning tho.:ir intdIl-du;11 p1'OPl:'rt}' I;l\\ .~ Uut therl' is l!!llCh that tl1i:-;
., l:lndard ;l rgll111 .... t11 (';Innot l'xpblll. i\ol all counIril·... lIndl'r tire highl's! pf(.'~.'lIft' 10 ch:mgl' Tlll'ir
I :I\\'~ ha\ L' l·hangt.'d tht.'1ll Thl: dilkrl'l1c .... ho.:t\\'l:en
~·olln tn~'.'" tllat han;, not ch:rngl.'d and thoSt., that
11:1\ l' app..:ar, to rl'nl.,(·t ;1 SI.'Cond typl.: of linkagl'
TIll' ........~:()nd type;, of linklge i!l\'o!\·I.-'S :r spt.·cific
rdallOtl., h ip Ix·t\\'(;'en :1 l'ollmr)"~ tr.ldl.' polky and
\\ hat it Ina~ pern.'i\·e :1... its Optilllulll imdlt.x·llI;tl
pro]lI.·r1y n.:gilllL' When:l coun try Ifil.·s to lkvdop
a r.l11ge of hOIllt., indu<;tries hy pro(I.'l1mg thC!ll from
fOfl.'lgn l'omrx'tition, :t loo~ intdll:'l'lu:rl propt.·ny
D
(J
L"..
t:':on o m ic R..,v it:w _ Fo unh Qua n c r 1991
rq..:illll' m:.y ~ee111 rational. A ... I will expl:lin. getting
tlrl' late...1 technology in :,o uch a country may not
he ca ... y. Will1mll foreign comp ....liTioll , howl:'\'l:'r.
industries 111:1Y not need the latesl tl:'chnology;
wilhout intellectual property prolection 10 himil'r
them. th~'y ca n get older lechnologil:'s for nothing.
But many developing countries are shifting
fro111 .' trong 1I';lde protectioni.~11l to more lilx:r.ll
tr..dl.· and foreign investment poli cie~ and 10 an
inl'fl';hing foclLs o n m:mufaclUring exp0rls For
IIlt.'ir p roduci s 10 cornpl: te more intl'nsl'ly in IXlth
d0111l·... tic and world market!'>. dt.:\'doping nations
mllsl h:t'e their pro(illCl.:. on 11ll' latt.:...ltL'l·hnology.
Whldl Ill..:)' C;ln :lCquire morl' e;l~ily wh..:n tht::}'
proll.'l'I intdlecillal pmpt.'rty 1r1 ~UI1l. IwO of m y
pnndpal a r~lIllle nts ;lrC thar Ir.l(it.' proll."CIioI1~,m
r:ttion a1izl:'.' loo.'tt: intdlectu:11 propt·rty bW!i ;Ind
that tl';lde 1iI)t'r.lli.' m r;lIion:lli/.;.·~ light laws.
Why has Latin America
preferred weak protection?
During Ih..: first IWO dl.·C;ldes itftcr World War
II. Mexico. Br:lzil. Argentina. and mo...t other
COll111ril.·s in i.:rtin America followed trade lxllicies
!(It.'llsl.'d on illl/XH1 slIbslill//iOIl. a policy thato.:n1:1ik:d
the protection of local m:rrkt·t~ wilh hi.gh barril'rs
to import!'> Most of these cOllntrie... ('(mlinUl:'d their
:ldhl'rl'nC(' to import substitution polidl's in The
1')60.... hut h y the 1970s. Ihl.' dbtnbution of tr.rde
ano Da.-.d AI Goold offered many
heJpfui cormtefIIS as
oIlhts attJClc I also oen·
81,led fromd'$ctI$SIOOS .... ,thAh$l;tnButler. Ed\IwIF E~sre<n.
Joe W Prtts III. IJfId Rober' AI Sherwood Any errors tY
Stephen P A Brown
0f'1lISSIClflS are
,_s
my own
t.
What Is Intellectual Property?
Intellectual property has two anributes.
First , it is a tangible product of the intellectan invention, an idea, a product, or a process.
Second , a nation's laws say that intellectual
property can be owned; it may not be used by
others without the owner's permission.
In the most general sense , laws concerning intellectual property address fou r types :
trade secrets, patents, trademarks, and copyrights. I Even though each of these four types is
different, the lines separating what they protect
are often blurred , In the United States, for
example , a computer program may be protected either by copyright or palent , Despite
these ambiguities, an understanding of the
broad distinctions between such laws is useful,
Among the alternatives in protecting in tellectual property , the patent is the most
powerful, The patent is a temporary right to
exclude others from using an invention. Patent
laws grant this right for only a certain number
of years, and it is not unusual for inventors to
complain that a patent's duration is not long
enoug h,
The copyright is also a temporary right .
It is the right to keep others from sell ing copies
of one's creative expression . Pirating copies
of copyrighted material-such as films, books,
and computer programs-may be among the
pol i<.:ies ;1I110Ilg till::."":: CO llntri<.:.~ had hegun to widen
A fe w beg;m dr()n ~ to d evdop SOI11l' 1l1;l1lufau ll ring for l'xport. ' But for the 111()st p;1I1, l'\'l'n thl':--l'
nat io ns pe rsi:-;tl'd wi th their impnr1 s l1h.~ti t u ti ()n
polidl':-- It i:-. no coinckk nn .: [h:II , thro ugh this
l'nti rl' pl'rtod ;Ind into Ihl' 19HO:--. Ihl'sl' count ril's
a lso o lle rt;'d rl'bt in ::ly \\'l':lk :md ~poltr intclll,(·tua l
pn )[ll'rt y pro tection.
most publicized class of violations of intellectual property rights.
A trade secret consists of otherwise
legally unprotected confidential information
that, in a firm's opinion , gives the firm a competitive edge , The trade secret, although possibly not covered or even subject to coverage
by patent or copyright law , has demonstrable
value ; a firm could legitimately claim damage
if a departing employee left with the secret
and transmitted it to a competitor.
Last is the trademark. The trademark is
a word or mark that identifies the sou rce of a
good or service , The sale of clothing and
ath letic shoes that display unauthorized trademarks isanotherofthe more publicizedclasses
of intellectual property rights violations , In the
United States , protection of trademarks and
trade secrets lies principally with the states ,
as contrasted with the federal protection that
dominates for copyrights and patents.
, While tnese loul classes o! intellectual propeny law are the
!OOl;l llnponant, there are orhers SheIWOOd ( r 990) adds a lilth
etass laws tllal prOlect computer mask works: or chip de·
soons [115 po$S<bIe 10 protect mask works b-,. patent. copynghl ,
o. t.ade socrel law, bullncrea$II'lQ fy. a separate body 01 law IS
developrng 10. them lesser 11990) also Clles a t>tlh class'
special laws that offer palenl · ~ke protec1lOO 10 cover bred plant
vaflel>es l e sser does not Include mask wooIIs as a separata
category
IInl)ort s ubstitutio n rind i nte llectual lll"opCrty.
l ~ lIin i\ml: ric I!1 ('mmtril-s co mmonly bast;:c\ im port
... uh~[ i tution ;md intd lt'ctua l p ro pl'l1y IX)lit:il's o n th~
:l rgu ml'l1I s (If Ibut I'reb isch ( 19')0 and 1959), who
m :lint;lilll"(i that lilt, tCrlll:-- o f Irad !:: Wl.'rl' turninl-\
;Ig;tilh l na tio n .. w ho:--\:' c hic f e xports \\l' rl' raw
m; lt c rb l~, :nld Hl f:I\'or of e xpo rte rs of m:mufactures
J> rc h i ~('h ("o un ..dt'd co nti nlled export.~ of
r:I \\ n1:Itl.·ri:rl:-. to gl'l hl·r w ith thl.' dc \'\,"lo pm .... n t o f
til.· m;t lllifacturing l'Ol pa("it)' ta rgct\:'d 1(m::rrd
[tw ho me m:l rkc l Th i.. :--tr:llq-l), wou ld not o nl y
10:--[('( d L'\ d o p m l'lll. hut ;t1sn .__ ;1\ e fo rt'i AIl exl h:rngL' FI)II,)\\ in).: p ~bi'o(· h . .\lexi("( ), Ur:r zil,
i\ 1}~L'nti ll ;t. am i "'()lIll' "'lI1;tlkr coumril's p ro tl'ClL'd
d,,,,,,: .
Amotlg me most OOloeeaO/e such coon/TIes ...,ere BtaZtl and
KQlea
20
t'l'tkr.1i Rl."SCl"n: llank or Oall:1S
manufacturcn; with high tariffs and mher barriers.
The protection of their markets gave moS!
manuf:lCturcr::. in ,hese countries lillie incemive to
hu y the btt-'St technology because trade harriers
barred many of the foreign producers who h:ld il
from competing in the developing countries'
markets :myway.' Prebisch and his followers
counsdl!d weak intellectua l property protection,
so that the local developing countlY producers
<..·ould avail them.selves of technology without the
discomfort of paying for it. ~ i'res::.ure:-. against
.~t ronK intellectual property protection were not
only high :md widespread in these countries, hut
also efft:·ctivc. Local manufacturers might not have
heen ahle 10 get ehe vcry btest technology hut,
for what they ("Ollid g~t, the price was righ!.
Ahhou~h Latin American and other developing COLlrltril.:s have traditionally offered weak intd!l!<.."il1al property protection , they h;Lve offered
some. The difference between the motivations of
nm . . uming countries and the moriv:llions of producing countries has m;lt!e developing-country
protection spony. A country can v;uy it" degree of
intelle(1llal pro]X'rf)' protection among individual
pnxluJ.:ts ;Ind processes Developing COUniricS'
pro{IXtion lIlay have fr.ldit ionally heen Spolly in
order to encour;lge innovations the country otherwise could not get; spD(ty protection enahled Ihe
J.:ount!)' to avoid paying for innovations that
would occur ;lIlyway.
For ~x:ltnple, where an intelk-'Ctu:tl-proJX·rtyI.:onsuming country's distribution of demand.. for
innovations differs from the producing country's
di:-ot ribution of demands for innovations, the consuming J.:oulll ry is motivated to protect (Diwan
and H(xlrik 1991). Suppose the consuming country
ch:m;mds innovations that arc: very differ~nr from
innovations the producing country demand..,. The
producing country may still innovate pmdu("!s the
con:-oulTIing country W:lOtS. but only if Ihe consuming country protects intelleCtual propt'rty. If the
consuming country has a polio epid~mic and tht;.·
producing country does nO{, the pnx lucing country
1ll;IY still invenl a ('ure for polio. if the consuming
country protcrts the CU fe '
SUPIX>SC a polio epidemic hits both countrit-"'S.
In this C ISC. tile prodllcing country and consuming
count!)' have identic.1I preference:-, so the consuming COUlllry has Ie ....... incentive to pmlcCI. The
producing country may still inno"~lIe whm the
Eco nomic Kl"Vlc."·w -
Fo unh Quaner 1992
consuming country wants hcC'.llIse firms in the
producing country can at least benefit from
innovating when they sell the product at home.
Other arguments for weak inteUectu.al property protection. The case for weak intelleaual
property protl.:aion does not rely solely o n the
;Ihility 10 acqu irc innovations without paying for
them. Strong intellcctual property protection may
:Ilso pt!nllit monopolislic abu.sc,:.;. Under some condition... , :1 monopolist may accumulate patents to
preserve tht: monopoly a nd Ihen allow the patents
to "slt:e p ~ so as to deter e ntry inlo an induslry
(GilI)t;'rt and Newbcry 1982). Chin and Grossman
(1990) cite cases in which, for innovation-consuming countries like the developing nations, the cost
of monopolization morc than offsets the contribution that stronger intellcc."iua l propeny protection
can make in stimulating cost-sa ving inn ova l ions. ~
, This roiarlOfl$hlp borween /fade prolCCt/Oll'sm and the de-
mand for oow/ec1lllOlogy has perSlSIcd UsIng oata /rom a
1981 SUt'VCyoi moto than3.tlXlBrazilialllirms. Braga and
Wlltnore (199/' /ou(l(J thatlirms' ~ oIredlnol-
OW IhlOtJ9h rc5fNJfCII and deveIopmcn/ and IIieII likelihood
01 pl.lfc:haSlflg fore.gn /echnology were both negalrve/y
rela/ed /0 rhe degrco /0 which lhil<r IfIdustfl6S were protec/cd Ircm /oI6ffJfI compe/ll/OII
J
FrY discllSSlOflS 01 /lie early ar~ts 01 Prcblsc/1 and hts
/oNowefs. sco$hMwood (1900. 173-74)and Gad/:lawar>c/
Rldlards (1988,21) ShcIwoodno/8S thaI Preblsch. not ICn(}
belOfQhls death on 1966. re/fICtcd these earl/Cf arguments
Otxong the perIOd I 8fII cIIscussong. howellllf. /he conSlS-
/ency of weak mtellectual property laws With impofr subsliIv/lOll was perceived as high When Preblsch f;nal/ydld rum
af}ams/ tho notJOfl of weak intellectual property protection.
he aloo lumed against the /<ica 01 Import svbs/itutlOf)
• /I 's mtcrestmg /0 nota that Fusch/ok, m a paper that oIfers
a plan 101 t'9ntcnmg Btu,'"
In/ellectual properly policies.
Sl.lQges/s changes //leI arecomp/ele/yconsistent With these
arguments -The onlroducflOll 01 full (prodUCI and process,
patent protccl/Oll ITIIQ/lt lead /0 market dJSFUpllOfl and.
po$Slbly. IfICrBascs IT) ckug prICeS Wllhool clear benefits A
poSSJOIe t/SfISIIJOfIaI step
might be /tie development 01 a
new cktJgs would be
"posI"ve hst' 01 c/sslJaSeS for which
palentBOIe, such as t/opIC8I dlseascs highly prevs/enl '"
8uwJ (C/lagas dISease. schtS/OSOmaSls. maJarra. elc
r
(Fosch/8/< 1990. 64,
• Hefe. tho def}t1N! 10 which /lie COflSUfTWIg country is moll·
va/ed not 10 ptOlecl IS. IT) parr. Inversely re/alcd 10 lhe
(elatlve SIlt! olliS market
"
From the pc~pcctive of net innovationconsuming countries that want to e nco llr.lge inno\·;\tion at ho me . an additional a rgument as'... inst
sHong intclicctu:11 propeny prott:ct ion involves the
instilutional ..fnlcturcs in which such property is
produce<.! and dislribult."d. Vessuri (1990) notes
that Imnsnatio ll:J1 compule r corpor3lio ns in Br.lzil
were not intcrc:.te<J in developing or :1 bsorb in~
kr.ll technological efforts bcc'.lllM~ of the centr.llized nature of their own rese'.lrch and developmenl
So, instt..'ad of protet1ing this intel1t,:ctual propeny
strongly, 8mzil tried to foster local innovat io n by
reserving a portio n o f tht: market fo r minicomputers, microcomputers, and their peripherals for
domestic pr<xlucers.
For Latin Ame rican and othe r consuming
countril.'s, anothef afgume nt ,lgainst strong intellectual property laws is that enforcement eosts can
be very high ( Primo Br.IEP 1990h). Whe n the bulk
of protection is for foreign innovations. these
enforccmc=nt co... ts lead to increas(.'(i royalty gains
for foreigners and gre;lter roY;llty expenses for
nationa l s.~ Foreigners do, in fact, hold the b ulk of
palents that a~ ~gisten.."XI in developing countrit:'s.
Not only might foreigners benefit disproportionately from lio:n..;ing and myaltit.'S, blll also from
cost advantages. '111t:' introduction and enforcement of tougher intellectual property laws would
inCrL'a.se prodm·tio n COSts for domeslic producers
who had not ht.-cn p:lying fo r the intellC("tual
property that they wcre using. These domestic
producers might he s upphmted by the foreign
finns that had origin:ltly produced the imellcctllal
property on whil.:h the domestic firms' production
processes were hased. Pir.Hes who continued to
sel l products of the intellect, or use them in production proccsscs , withOlll paying thl,; producers
would in ;lny Cl.~c= be run Olll of hus inc:.:ss.
The changing role of Ihe Unilcd Siaies
in intcrnalional trade liberalization
In the 19HOs, new pressures Illolivated some
developing COUnlrit:'s to cha nge bot h their tr.l.de
• Accordll1{1 fa the OrganualJOflIot ECOfIOfflIC Cooperall(l(l
SfId Dovclopmenl (GECD 1989). fJarlOfl8ls 01 dcve/aplag
CCUlIne$ hcldorly I {NIfCMlfclClt15/ong paTents" Iheworlt:1
policies and their intellectu;11 pro(X!rty regimes.
Some of the pressures involve events in the
United States.
From the end o f \'('orld War 11 until the late
1970s, the Unitc:.'<.i State~ adopted a relatively
lihc.:.·r.lltr.lde regime based o n the idea of I1IlIlt;lateralism. Ihe idea th:l! trade agret:ments :lTnong
m:my nations at the .same time work lx:st. The
United States expressed this commitment through
il<; support ~md use of the most /{//I()ret/ /latio/l
d:llIse of the GenC!"'.JI Agreement on Tariffs and
Tmde (GAlT). By this clause, any reciprocal tafiff
re<.!ll(.1 ion negotiated between the United S\;Ites
and :my of its trading partners applies to all U.S.
tr.lding p:lrtne rs.
However, under the GArr. the Cniled Staws
also offered speci:ll tr.ldc privileges for developing
countries through the Gcncr.dized System of
Prefere nces (GS P). Through the GSP, the United
States and other developed cmllltrie."; may waive
duties on se lected imports from .selechx l developing I:oumrit:'s. Curre ntly, :1 number of products of
the Mexican in-bond pbnts ( maqlli/culoms) flow
ha<.·k to the Unite<.! States under the GSP.
lly the 1980s, the Unit(.-d Sta tes had begun
10 hack well aW3y from tr.lde liber.J lis lll and had
startt.'<.ito use GSP prOvisions :IS wC;lpons. Fruslmted with what it viewed as the con\;lmination
of Illultil:ller.l.lism, the United States markedly
inl:rcast.'<.i its use of cOl l11ten/ai/il18 actio/IS, suc h
as r.lising tr.lde barriers it had lowcn..'<.i anti inI:reasing its filings of dumping c h:lrgcs \Vhatevcr
else these a ction~ meant, they signak.'<..I a rise in
U.S. protectionism . Beginning in 1984, tht.· mte o f
:I<.u::ler.ltion lX!came more acute. One rOllte Ihe
United Slates chose fo r th is escalation is p,lrticularly relevant to intellectual property protect ion in
developing countries
The U" ited States provides itsel f retaliatory
n.:mcdies for "u nfair trade~ through Sect ion 30 1 of
the US Tr...de Act of 1974 and Section 337 of Ihe
Tariff Act of 1930. Seclio n 337 prolects U.S. firms
from "unfair" t."Ompctition from impons. Se<:tion
301 offers more ]c:.-eway; it allows the United States
to ael as'... insl inadt.""quatc prott.'Ction of its intdlectual property in other countries, even if Ihe vio latio ns do not involve products imponed into the
United St~l tes .
In 1984, the U.S. Congress passt:'d a Tr.lde
:Jnd Tariff A(.1 that strengthened oplions under
Fc:d e.,.,1 R~,","4e Bank of Dallas
S~ct ion
301. Th~ 1984 act ex plicitly desiRnates
wt'ak intdlectual property protection in a country
;IS grounds for withdrawing trade concessions
extended to that country under the Generalized
System of Prderences. Next, Congrt..'ss pa.'i.sed [he
Omnihus Trade and Competitiveness Act of 19HB.
Thi.~ act requires Ihe United States Trade Repfesentative 10 specify timetables for investigation of
actions and 10 identify countries that have inadequate intellectual property regimes.
In sum. tlH:se me;lsun:s exp;mded options
the Unitt:d St;l1es could use to pressu re countries
to ch:mge their intdlectual property protection
Congress adck.--d provisions to signal to U.s. officials
thai they had hetler use these new tools. Mody
(1990.219), commenting on Ihe 1984 Trade and
TarilT ALt, notes that '"four cOllmries, Korea, i'I "It::xico,
BrJzil, and Thai land, have been affected by this
legislation."' With tIll' 1988 act, the list lengthened
consider:.lhly.
Foreign debt, trade Hberalization,
and intellectual property reform
l';tr1. :I!though not all. of the increase in U.S
protectionism constituted retaliation for inc rease.~
in Third World protectionism during the 19HOs.During the 1970s. sewral Third World countries
had chosen to t:'xpand their development progr:.lms
by resorting to foreign loans. These cOllntries
borrowed under the assumption that the prices of
their exp()rt.~, \vhich had been high during much
of lhe 1970s, would remain high enough to allow
repayment. \Vhen [he prices of many developing
countries' princip:l! exports fe ll hard in the early
1980s. a world debt crisis ensued
To revive their s:lgging terms of tr:.lCle a nd to
earn ha rd currency to pay their external obligations.
some developing countries commenced the saml'
beggar-thy-neighIXlf policies that the developed
countries h;1(1 used during rhe Great Deprl'ssion.
Th;1\ is. they increased protectionism .
In the face of m:lssive trade retali:l\ion from
the Unitl.--d St:nes. however, some countries changL'<.1
cours(:: and ope ned their own economies. If Mexico's economy, or Korea's, became more open,
how could the United Stmes, with its ongOing
dedar.nions of commitment to free trade, remain
closed to thell1~ Of [en developing nations in the
Western Hemisphere evaluated by Wil!i:lmson
Eco no m k Revtew _ Founh Quancr 1992
0990.26), "only Peru and BrJzil remain locked in
the old protectionist mode "
By themselves, Ihese tr:.tde liberalizations
offered a good deal of motivation for the increased
intellectual property protection that occurred in
Latin America in the late 19HOs a nd early 199Os.
Tnlde liberalization , after all, means that foreign
products incorpor,lIing and pr<xluced by the kllest
and most inexpensive technology will now he
competing at home with domestically made goods
a nd services.
If developing-country producers wish to
replicate this latest technology, they will often
have to pay for it. The latest technology is often
harder to acquire by subterfuge than afe p rocesses
that ha ve been longer in the market in some fonn.
Moreover, the policies of a nonprotecti ng consuming country can affect its businesspersons'
ability \0 purchase such technology, even if they
:.tre willing to p:l.y for it. When dealing w ith firms
in such countries, fo reign producers of technology
are caLllious about selling it because the prospective buyers may violate purchasing agreements
w ith impunity. Sherwood (1990) dtes anecdotal
evidence in which a Brazi li;tn finn's employees
h:.tve approached companies abroad to gain costeffective tedmology. However, the firm's negotiations with the foreign source often came to an
a brupt end when the source learned o f Brazil"s
we;lk protcction for many innov'ltions.
Increased competition from foreign technologies may also convince a ch;ve1oping country to
seck domestic innovations as well, ;lIld there is
much evidence to suggest that weak intellectual
propCrty protection discourages innovation. In a
Brazilian survey, 80 percent of 377 finns said
they would invest more in internal research and
would improve tra ining for their employees if
better legal proteaion were ava il:lble (Sherwood
1990). While Brazi lian survey evide nce suggests
that the lack of protection discourages innovation, U.S. survey evidence (Ma nsfield 1986)
suggests that protection stimulates innovation.
ProtectlCJ(l,sm in the Unotcd States had been nsmg during
the 19lOs as well. belOte/he dcveJopmg COUfl/nes began /0
ra,se theHS
And, at le;L~t in the United Statcs, there also appc:.--ars
to be a high social r:ile of retum to innovatio n,
considembly higher th;tn the r::IIC of return 10 the
innovator (fo.bnsficld ct al. 1977)
Latin America's widening
technological gap in the 1980s
Whi lt: their trade liherdlii'..ations alone might
well have motival",'d L.uin American countries to
tighten their intc!lL,<:t u;l1 property protection , the
pressures for slI(.:h pro(ect.ion increased in the
1900s as the h"'chnological gap betwet!n L:ltin
America and thl! developed cOlL ruries widened .
One reason this technological gap wident---d
so much in the 19HOs is hec:lUse terms of 1'~lde
shocks and <.Ie])! probkllls forced :I slump in Ullin
American investment that lasted nlllch of tht!
decade. New clpital goods wcr" not replaci ng 01<.1
and , as the :lver::lge age o f Latin American plants
and eqUipment [-o..,e, the region's ca pital stock
heGlnle in crea si n ~l y obsole te.
111e technological gap widened further
ix.--causc, while investmem was plunging in LLtin
Ame rica, the de\'c!opcd countries were e ntering a
period of partil:lliarly r;lpid technological advance
(B:l\:~ r 19(3). During this period. spending on
research a nd de\'c!opment was growing m uch
more rapi<.lly than gl'O:"" national pnxlU~1 in all
major OECD coumries, and prodllct life cydes
were hecoming shorter. Mon.-'()ver, while the
productivity of knowledge was increasing relative
to other input..;, the cost of gener:Hing it was also
rising. Accordingly, knowledge became increasingly pri vatizl;'d (Mody 1990). In light of these
ch:mgt:s, frischtak 0990, 62) nOles, "The tr;Jde-off
ht:tween encourJging the d iffusion of existing
technology thrOllgh unlicensed imitation and
stimu];lting the cre:ltion of new technology
becomes steeper over time·
This la~t argument became particularly compclling in a Latin Ame ricm context during the
19HOs Latin American cou ntries' Mscvere loss of
compctitiveness· was worsened hy their M
inCOI_
padt)' to carl)' out the Str\lcturJI mtXiifications of
an institutional char-Jcter that would h:lvt' e na hled
them to develop sources from which they could
c~ate :lnd disseminate new tedmologit!s· (Barherd
1990.92).
In sum, at the smIle ti me that foreign debt
problems had led m:tny devcloping countries to
seek new avenues 10 ~arn foreign exchange, these
I.:ollntries were suffering from incre:lsing technological backwardness. Moreover, it had become
ohvious Ihat m:lny o f these n:u ions' dcteriol'dting
competitivene:.s resulted , in part , from institutional
problems that imped ed the development and
trJnsft:r of technology In the new :nmosphcre of
f;dling Latin AmeriC'J.n trade ha rrit:rs. with its
rt:suhing increases in local compet itio n from
imports. the incentives for technologically competitive domestic products lind forrm of production ha<.l riscn In any CISe, Ihe debt problem and
techno logica l back\\':lrdne~ were important
faclor:. tbat affected L<ttin America's ahility to
rc."fX>nd to foreign compet ition, and they may
also ha\'e been importa nt in changing developing
nations' responsiveness to U.S, initiatives concerning Third World intellectual property protection.
Has U.S, policy caused the l .."uin
American move toward stronger
inteUectual property prou..'Ction?
• Gadbaw (/968. 284) nole$ 1/181 'In 1986 and 1987. Ihe
RepuI:Jhc 01 Korea (Korea/ (){)Xtcd II1to law a scncs 01
reVISlOflS /0 ,IS Intellectual ptopflft)' regmt] /hal pt()Vlde a
dramallc ellamp/e 01 U 5 success in fXon'IObI'I9l1llellfJcrual
ptOptUty reform tnrough the COI'I'IbItl«J use 01 negoi181JOfl
end the /hIeal 01 trade lelalla/1Oft - 1h8 U 5 ~I
malll/alflS 1/181 Cflforcemenl remaons a problem. however
(East As an ExcciJ~ve Reports 1990) In 1990. MexIco
pUJposed sweepmg rclorm$ 0111$ ifllcIJcctua/ property laws
1/18/ CCr'Is/'/u/8d -I) vrrue/laundry /lSI oIlhe present law·s
majorlnad6Qu8clCs-(Elfl$lem 1991, 134} In June 01 199/.
MaIoco passed IfIOSB relom'ls 11110 law
Consid ering th:lt the United 5t:llc,.; has not
only empowered itself to inflict trdde retaliations
upon countries that do not fully proh.:.'<:t intell~c
llIal pro perly. hut also 10 impose sch...-dules hy
which tbe U.s. Trade Repre~ntati\'e is sllppo..;cd
({) inflict the m. increased Third World compliance
m i~ht be expected.
Moreover. a prcponder:mce of Third World
ch;ln~es in intellectual propeny protection h:l.';
occum:d since the pa.ssing of the United States'
1984 TrJde ;lIld Ta riff Act and of the Omnibus
Fede ral Rcsc l"\le Ibnk of Dallas
Trade and Competitiveness Act of 1988 Gadbaw
and Richards (1988, 21) offer the mgument. writh.:n
unck-r thc heading of "Tl.lde Pressure," that "only
when the potenti:J1 loss of other economic benefits
i.~ introduced into the <'-'<I.u:lIion have government....
of the nations studied concluded that il is in their
interest to refoml their intellectual property
protection regimes.~
\\' hile the putcntialloss of economic benefit.s
surely motivates countries to strengthen their
intellectual property Jaws. the perception of
potential loss appears to I~ a more complicated
phenomenon than Gadb:l\v and Richards' chara<.·terization of it. If U.S. t"lde pressure is the diret:t
ancl preponderant reason developing countries
have strengthened their intelleCTual property Jaw.
what expbins the laggards! As an example, consider the four countries t-.kxly notes :IS :lffected by
the 1984 Tl.lde and Tariff Act. By the end of 1990.
Mexico and Korea had both greatly liberaliZl.'d
their trade regimes (see above) ;tnd had takt.'n
steps to markedly strengthen their intellectual
property laws.~ while B"lzil :md Thailand had
donL' neither. ~
The recalcitrance o f Brazil and Thailand'"
does not mean U.s. trade pressures arc ineffective
any more than the continuation of speeding in tht:
United States means thm traffic laws are ineffective. But this recalcitrance docs suggest that other
fa<.'{ ors are invoh'ed Here. a hro;ldcr definition of
"rotential loss" than what G:ldbaw a nd Richards
sel~m to he using is in order That is. cou ntries
that impose b;lrriers to foreign competition may
more fully serve themselves by making backw;ITd
technology c hea r than hy allOWing the most
modern technology 10 be expensive, But when
«l.~ in the case of 1'.'lexico) they c hoose to open
their economies to foreign competition, it is the
loose intellectu;tl propelty regime that becomes
more expensIve
Thus, w hile U.S. policy encou rages countries
to tighten their intellectual property regimes. the
policy may be most effective with countries th;lt
have chosen to open their economies to trade
After all. these countries bave the strongest predisposition to tighte n their intellectu;tl property
regllnes. 111 :Iny case.
This argument has significant implications for
the process by which U.S. policy actually affects
other nation's intdlectu;ll property 1;1\\/s. This arguEl:onontic Revkw -
Fourth Quarter 1992
menl suggests th:lt the dirC(."( ('ffeet of U.s. trade
policic.:s ll lxm Third World intellectual property
bws may not be as strong as the indillc"Ct effect, in
which the u.s tl.lde policies simply influ ence other
nation'S trade policies. That is, to lhe extent that
U.S. trade policy motivates Third World countries
\0 lower their Irade ba rrio.:rs, then U.S. policy indirectly motivates Third World cou ntries to tighten
their inlt;.'lIectual property regimes. If trade libeml-
• Although Braz,/ d id adopt copyright protection for softwale
m 1987 and enforcfXi it (Sherwood 1990. 196). until very
reccmly there have been lew Other cl1anges to Bmzii's
intelleelual property regime since the ellrly 19705 In addition. -the BIOlZlban judicial sy~lem does nol appear to
proVl(ic an ellectlVe dotetrentlO violations of intelieclUal
propertyrights · (Frischlak /990. 13) In 1991 , theofliceof
the U S Trade RepresentatIVe placed Brlll'il on its prlOfity
walch list of areas "where the U S faces '5eflOUS problems'
WIth mrcllec/ual prOperty protectlOfl or market access (Truell and Lachica 1991. A 16) However. Brazil has very
iatelybegun to libera/ue moteol its lIade policieS. including
those on some hlf}h·technology ,mports As oIli1SI Feb!U·
al)'. Brazil began to allow Ihe flee mporl 01 hard and floppy
disk dflves and digital II()Icemail eqUipment Addlhonal
products '.11,11 be subje<;tto llberalizahon as 0/ October 29,
1992 Meanwhile. some tlghtemng 01 re/auxt intellectual
properly protection has a/so begun 10 occur In June 1992.
Brazil announced thaI if would begin 10 protect -{ranchlse
agreemenls - that may mclude a combmatlOfl 0/ trademark
usage. teehmcal serVICe assistance. and other types of
lechnology lIans/or included m the agreemenlS With re·
gard 10 Thailand, Schumann (/990. 164) no/es that -In·
frmgement of intellectual property fights seems to be an
ongomg ISSue despite efforts by some ASian countries to
suppress It In 1988. the ASia-Pacific CounCIl 01 American
Chambers of Commerce VlCW Thailand as lhe worSt offfHlder • She adds thlll -tho United Slams Trade Represen/alive (USTR) leporl Of) 'Special 3D!' 01 May 25. 1989.
aerermmed Thailand and India as being leaders of 115
'priority watch list' •
'" This recalCitrance has had liS costs As a result 01 noncom·
pbance WIth US requirements. Thailand /osl GSP prlVl'
leges, lesultmg m a 5'percentlo 100perCfHli imporl duly
IncreaS90f) $165 mi/11Ofl of Thai exports The United States
also imposed 1000percent dUlleS on $39 millKXI of Brazilian
exports. even though these exports were net related to
prodUCIS or services on which intellectual propertyin/ringe·
mfHlt was alleged Moreover. the umrfXi Stales proposed
but did nol implement punitive tariffS on $105 mil//Oll of
Brazilian cxportS as a sanction against &azilian computer
pOlicy ThiS lasl measure was withdrawn with the passage
of the Brazilian sofrware copyflght law mentioned in the
previolls !oomo/(:: As!or the other penel/(es, ·exporters in
Thailand and BraZil have said they can Jove With the
InCreased duties • (Mody 1990.224)
iSl11 I11I)ti":ltl.:" intdkctual P(\)PI..:1'ty C\Jlberva!islll.
thcn prc:-.... urel'> for trad~' lihe rali.~m ;lR' pre:-....urel'>
fc)r light intellectual prc l peny pro!ec:tion . II
[n this l 'onteXI , howe"er. it il'> impor1ant to
rememher thaI !he event.. of the 19HOs in the Th ird
Wortd ll1oti\';u~xl intdk'CllIal propcny protection
in any G1Sl..', brin ,\meriel 'l'> inc: reasing tl.x·hnologil'al h;Jckw;m.lm::~~';,lllS~xl h~' a l 'omhin;ltioll of
c.k-dining in\'e . . tmt:nl thl're. ;ll'l'der.ning techno[OgiGII advance .. . in the First World, and Latin
AmeriGI 's ()\\'n inno"alion-c.liS(.:our.lging in..titutional
..t11.tl1Ul't' -shOll ld he a !'>trong mOli\':Jtor when
nation.. . in the region Inu!'>t f( K'ul'> on manubcturcl'>
eXfXlr1!-i to p:ly tlwir fort:ign dehts,
It h, of l'ourl'>c . diffic.·ult to kno w if thl.'St'
prcl'>sure!'> alone would ha\'t: Ix.ocll l'>ufficienl to
motivate Third Wortd l'ountries to amend their
intdk..:tu:d proJX'n y [aWl'>, But it i!-i unllsu:ll(o find
1'00lOtr1t."!'i th:ll h:l\'t.' lighlt.'nt.'(llhest.' laws when
trade lihc..'r.lliz:ll ion had nOI O(:culTed as wdl
" W'hIIe IfI(1lfT!p(XfaflCe 01 who'll / ClalfT! 10 /)e Inc connecllCt'l
ocrween trado pobcJes and Ifltctlcdual property reglfflCS
seems not /Q be fully apprecJa/oo. " C9rla/llly has oecn
f8COpfll, OO Pnmo Staga (19900) notes /hal ' /116 fofergn
deb! CflS'S oocreaSlOg pfllla:e capItal flows 10 oeve oping
coonl.oes.
t>ega1M1 eJlpsnences WI/h /he regul8rury approach. ourward-or18l1100 aeve.opmenl strateglCS. and me
ongorrrg /ecNrOIOt}ICSI feV'OluIIOt'!' are $O"TW 01 fne poSS!OIe
cJlp/Bt1abons fa( /he mote ht:>etal post(lfC adopIed by many
doIrcIopIng counmes or! ItIlallcctual prCJPf!rfY- /empllaSlS
_I
Fcden.i
Rcse",'~
Rank of Dallas
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Regional Wage Divergence
and National Wage Inequality
n n:~~m year,... COIlCt'1ll ahout ri .. ing wagl.: :md
in(:01111: inequality in the UnilL'd St:l\es has he~:n
expressed in Ix)\h til ..: l11a ..... media and the aCldemic
I
1iteratun,;' Tht: rm:cii;1 :0.101"1(:." han: stressed \hl'
um:vo.:ll nalllre of Iht: ).!:lin.. in w;lgcs and inC0111l'S
during Ihe 19HO'.... wilh rq)orls Ih:1I the gains have
heen cOllcent rated al the l OP of the distrihution
:ll1d Ihal 1110:-.1 Atncrkan.. have :>ccn linlt:, if :my,
mcrease in eit her wagl.:' or irKomc,'
The acadc mit' lill'r.l1url' on Ihe SUhje<.1 h:l.o;
IWl'n fo(.'u5(..,<1 on tht, po...:--ihl!.' Cilises of the riSl':
:H;('ountcd for on ly 2. 1 pcrc~m 10 5 percent of the
ri.~~ in nalional wage int.'(!u:llity The regional dfe('(
is similar in lI1agni\lldt: 10 f:Ktors rebling to the
industrial structure but is rdativcly small in ('omp:lrison with r:Klof," n,:lating to education, occupation, gender, and agt:, Givt:n this result, tile regional
('OI1\'('rgena: that will likely t:lkc pbcc in the 1990s
is unlikely 10 h:t\'e :1 significan t imp:lct on (}\'I:r.lll
wage inequality in tht: United Stales,
National wage inequality
b hor-Mlppl)' fa clor:'-sudl as ch:mges in tht:
l'dllcalion. :I).!C, :tnd j.Cl'mk·r of the work forn.:·:Ind lahor-demand f:I('lor.-.-such ;1:' changes in the
industry :ll1d (Kl"Ilpati<)Jl IllIX , Although sc"er:.11
ret'ellt ,~t lldi\!,~ !la"e IXllr1lt.'d to :-0111(' pos:-ibk
ca u,'>t.',~ ror the rise in inl'qualit}" much of Ihe riSt.'
remain~ unexplained ~
In tllb :'llIdy, I '>I,:ek to :Idd to [he liter:.nun,:
by addre!'>Sing ,h\.' qlle:-lion of how much of Ihe ri,~
in LS, \\';lgc inequality during the: 1980s can Ix:
explained by :1 divt.'l',gl.'llt'l.' in \"a~es acms,~ rt;'~ions.
SI.'\'er:.d ,~tudit.'s h:l\'e :-hO\\'1l Ihat :Iftcr II long pl.'li(xt
oj" t'olH'ergcllce, fl.'gion:1l W:lgl'S diver~l.::d during
thl.' 1980s, Thest.' ,"audie:- also indicale Ih;1t Ihl.'
din:rgencl~ was likely tt.'rnpor:.lry :Inel th:n \vages
an..' likely to ft:llIm tOl'onvcrgl:llce. [I' a siro ng link
exbb helween the regional divergence ;lnd Ihe
n:-.c in U.S, w:lge iIK'qualit}', thl'Tl a r('tum 10 ~gional
t'oll\'ergl.'ncc in I he 19lXls ('ould put signifk:ml
dowl\w:ud pre!>,Mlre on \\ aw: ineqllalilY,
t flnd th:n th\.' r<.'),':lon:11 ~h<Kks that (Kt'llrfl,..d
during th\.' 198(), pn x hlt'l'd a p:Hlem of w:lge
d in:rgl:.'ncc th:\! t'orn.:I:ltt'(l do!>dy with the p:utcrn
of nation:ll wage int.,<[uality In a mathem:ltic:'ll
dl'l'omposition of n:uional wage ine<[uality , howe\'er. I find Ihal Ihe di\'er).,:t.'Ilt'e of regional w;lg~s
Economic Rc.'it·w -
founh
Quan~r
1992
In a ~\'il'w or t he liter.lture on wage in(.'quality, Loveman and Tilly (988) find that most
fC!>carchers agrL't' 11t:lt the inequality of boor earnings has inCfC:.lsl.'d !>inCt: the l;lte 19705, TIle ('auses
or thl: increa~ , h()wt:\'er, are not well undersl(xxI
A\.'cording to Lo\'el11:m and Tilly, rat'ton; such as
dmnge.~ in gender c()mpc:)!>it io n , age diSlrihution,
and industri:11 :lnd ()('('up:Hiona l mix explain only
:I sma ll part of the risc.: in c:lrnings inequality
I WIsh to lhank.)0s8ph H HasJ8!J. ZsoIf BeeS!, STephen P A
Brown. aM Lor, L Taylor for helpfu/cammenls and James
L lledges for exccJlcnl fCSlN3ft:h aSSlslance
For example SH S'Dfh ( 1992) snd StCl(l (/992)
• ..w.te Sludles have Iovnd e fiSC in both II>C'OfTIC and wage
1tlfICIU8h1y. the 1100 nlCil$(NCS 8re quite d,ffcrM Income is
a//cc/oo by NWeS/menilflCOfl'lC 8fKJ /lans/ers Household
tnCOfT/8l$afl«/ooby 18ITIIIys,zesndSlfuclure In""s study.
1100/0; solely 8/ pie/ax w8l1CS. 8fId, thus. my focus 's OIl me
s/ruclureollabet.ncome Labet .irJcom6d09sllOl fellee/trle
lOUIl n:omt or /he (]YfJfal/ wctfare oIlf1dMduals
31
In more a mor!.! r!.!c!.!nt study, Gmhb and
Wilson (1992) find th:1t fa<.1ofS n:lating to t.'(lucation
and occu patio n played important roles in :1 rise in
wage im:.--<Iuality in the 1980s, while workt.'r agf...'
and industry had relali\'dy small imp:lCts. Gmhh
and Wilson find, howcver, that much of the ri..<;/.."
in inl.'quality in the 1980s W:IS unexplaint.:d. 'nley
concill(.k thai Ihe ~pre:ld o f wl_ges anos... l.-xJul'ation groups is likely to cont inue to in<:n:asc in the
future. causing further upward pres~ure on W:lg!.!
inL"'quality The authors Gluti(m that furtht'r :m:llysis
is needed to find a mo rf...' complt'te expl:mation for
tht! rise in w:lge inequality
Bound and Johnson (1992) Iligh ligiit three
major w ag!.! structure devdopI11e1lls in Iht' 1900s:
an increase in wage di ffcrcnti:ll.~ hy t'd ucation, a
decreast' in the gemk:r w:Ig!.! gap , and- l(lr workt.·rs
without a college degree-:m increase in the
aver.lge wage of older workers rda ti ve to younge r
workers. Uound :md Johnson concludl..' thai the
principal reason for the incr!.!;I.<;/.." in wage differential by t..'(lucalion :Lnd the (k."<:rl';i!'>l.' in the gendt'r
differl'nti;!1 was a skillt'd-1al>or-hiaSl'd te(:hIllJI(lgica l changl..'. The :Iuthors found Hull' to explain the
rela tive-wage dl.>crl..'ase of younl-( workers with
low t.'duc:lIional all:li nment TIlt' authors indiGLlr.:
that wage differentia ls hy l.-due.ltion :I~ likdy to
continue to increase, putting: further upward
pre~ure on w:lge inequality
Regional wage divergence
One possible factor in risins:: national wage
inequality that has received rdatively lillie :lttention is a divergence in wagr.:s :lCross fl'l-(io!ls.
Browne (989) notes Ih:1\ "aftl'r three dr.:cades of
J
In /hIS SllJdy. wages afC fflCasured as annual wages and
sal8fIflS 01 people 16 yeafsoI8(}eex older who worl<ed yearloooeJ. 1u1l-11fTIe ('(AFT). OF. more (XlJCJse/y. peopic who
worked lilly "1)Cks ex mora durlllfllhc year and /hJIty·!we Of
more hovfs durJT19 the week The dala afe laken from lhe
Mafc;hCvrrem Popu/aIIOfl$urveys (CPS)oI me U S Bureau
01 /he Census 0uwIg me sl'UCfy perJOd. VAFT worl<ers
Icplesenled 54 percenllO 6lJ percent 01 all sampled wor/o:.
ers. and /he sal'1¥'ie SlZC 01 YRFT workers ranged from
41.T5()0fI 19711050.434"" 1989 AlfflOuQhavefage/Joorty
wages recerwxJ durmr; /he yeaf !ex all workers afe (Xc-terred. rtus J(JtormallOfl is not avadabUJ Of) the CPS tapes
gentle con\'ergem:e. re~ional per capil:1 incomes
diverged sharply in the 19HOs ~ Sbe finds that
ch:tnges in rdative wages Wl're the primary
SOUTCC of c hange!'> in re~ional per (<Ipita income.
If regional sh()ck.~, ~uch as the recessions in
the oil and ran11 bell.. , caused wage," in low-wagl'
afl..."..lS of tht' country to dedinc n:l:Ilivl' to the
\\'e:rlthier :ue:I.... then this change could C..luse
national wage inl.·qu:llity to increase. And if these
shocks wl..'re tempor:.uy. then a rl'turn to regional
nlllvergl'nce in the 1990.. (':outd put downward
Pfl.'SSllfl' on wage inequality.
Elx,rts ( 19H9) finds th:1I a d ivergence in
rt'gional wagl's in the 19HOs likely was causcd hy
n:gion-spt't'ific f:lt'tors, sll('h :IS the oil :1I1d fanll
crisis, :lIld W:I ... not l11erdy thl.: uneven regional
impact of changing n:tlion:ll p:ltll.:rtlS. For eX:Hllple.
if thl.'re was a region:llconccntf:ltion of highly
t.:duGIIl'd workt'rs, then the national rise in wages
rt.:sulting frolll l'duGltional attainment cou ld h;lve
re.'>llhed in rq.,:ional wagt.: divergence. EI)(;!rts
shows that the rise in region:d w:lgc in(.'qu:llity
gener-Illy "":IS not ('';IU:-.t.'(1 hy differences in regional
shares of denl0W~lphic and industry factors.
Clrlino ( 1992) u ......-:-. a liml'-serit.'s :Ippro::lch to
delenllinc whether the n:gion:11 e:tmings divergence
in the 19HOs W:IS c~u!'ol.!d b}' ()(;!rll1:1nent or tempor..lry shocks. He concludes that the divergence was
most Hkdy (::Ju~ctl h y telllpor..lry ~ho(.'k~. such as
the energy and agricullllr.ll shocks, and that the
divergence docs not repn:sent :1 reversa l of the
long-term trend in regional convergence. Given
thl..' results of Eherts' and C;lrlino's studies , the
region:tl wage divergl.:nce in the 1980s was likely
tempor:rry and independer1t of naT ional demogr:.rphic :Iml indust!), f:lClOrs. T hese results indicate
that if rel-(ional divergence in the 19ROs had:l
strong impact on national W:lge i nequality, then
a return to regional w.Ige convergence in the
1990s could pllt ~ igni lk.rnt clownw:lrd pressure
on wage inl."'quality
Describing U.s_ wage inequality
and regional shocks
As shown in Figure I . wage int-quality in the
United States in<:n:ased throughout much of the
19HOs.' The ll1ea~llfe of wage int.'quality shown in
Figun: 1 is the population-weighted 111eil statistic.
(For more information ahout the C'..liculalion and
Figure 1
Theil Measure of Wage Inequal ity
'"
'"
'"
".
'"
,..
""
,.,
'"
,'"
'"
""
'~ ~~~~~~'--r~--r-~'--r-'
..
1977 1978 li79 1\180 11111 lN2 1933 1934
1 ge~
cr.lsht:d and rc:.1 estate markets tumbled.
In contr:.lst with the oil :md farm a reas of the
t:ollnlty. the defense dependent regions grew at a
hC'.lhh)' pace during the 19ROs (FiRIIIT! 3).~ Between 1900 and 1987, nalional dt.'fcnse outlays, in
nlll~tant dollars. increased :11 an :mnual r:.IIC of 5.3
pcrt:t'nl, and total defense employment incfC'Jsed
:11 an annual r.lte of 4.2 percent. 'l1,e military
buildup was centered in privale-st.-'(:tor companies
thai proolLce military equipmcnl. Private-sector
dt:fcnst: employment grcw 7.8 JX'rccnt annually,
whilt: public-scctor mil itary personnel grew only
1.4 percent annu:lliy.9 The slrong surge in defense
1986 198 7 19M 1989
NOTE: This mea syre IS defined Irl aq yallon 21n lhe bo x
Karoly (992) SllOl'l$ thaI len d,lIarem measures of wage
SOU RCe OF PRIMARY DATA US Depal1ment of Commerce,
SlJreay of ltle Census, Cu rrenl
Populallon SlJrvey, March lapes,
mCQIJIJ"'Y all increosoo durmg the 1980s
For example. Blank (1985) finds 11101 -the income distribul.on narrows m I!rnes of gfowtll, pnmari/y because 01
large clasl,e'l,es of labor market mcome among POOr
profX'rtit':-' of thi:-. mea ... urc of im.""qualiry, SI..'C the Ix)x
titb.! '·lJ..;in~ till' Popul:nion-WeighKxI '1l1t:il 1\1t.-:I.->UTt,.'
of Im:qllalit}',-) A:-. s hown in Figure I. wage int.-quality inaea ......d from 1978 10 1%7 and th~n
dt."t'liru.."tl l1H! ri-.c in wage inequality ~hown here is
consi.... tent with other me:ISUR-"S of wagt' int.·-quality.'
TIll,,' rise i:-. wage int.'"qll:lliry in the early 19H(b
i... at le:IM panly explained b}' the two rtx~ssions
that o<:<:urrcd hetween 1980 al,d 19R2. I'rt.'vious
work has shown Iha( w:lge inequ:llity (~tpically
increascs durin).\ t:yd it::d downturns and dt:cr~ases
during expan.~ions , ~ 'Il,e increase in inequality
during the long expansion from 1983 to 19l'0 is
more diffinllt to expbin The rise in waW': int."tluality. ho\\,evt:r, matches dosely w ith the economit: ch.:dine in the fann and oil st:ltes and (hc
t:Ol'l'cspondin~ rise in the defense st:lles.
As shown in Figl1l't: 2, employment in the
f:trm :11,d oil ,..t'ltt:S gt:ner.dly grew faster (h:1I1 the
national a\'cr:.lge during Ihe 1970s." But durinl-{ tht.,
19HOs. tilc"c regions we:lkened sh:lrply High debt
Ic"":!.", com hi ned \\ ith rising interest rates and
railing farm cxpons. pushed thc f:tm, el'onomy
into;1 n..'Cc~si()n Ih:lI persbtoo until 19H7: The
I..'nl..'r~y :-.talc:- also t:ntcred a recession following a
!X'ak in oil prices in t::Ir1y 1981. FollowinS-! some
impro\'c1lll'r1t in 1984 ;lOd 1985, till' t:n~rgy slatcs
s111Tcrt.'tI:l sharp hlow in 1986, when oil priccs
F"cono m i<: Mevicw -
Fo ur1h QUilncr 1992
heads 01 housc/lOld for whom both wages and hours
mcrease during 8COi'IO'llOC upturns • Also, Bluestone and
HamS()(> ( 1988) lind Ihal tne proporhOn 01 year-found fut/·
Illne workers who Cllfned low wages IlaS
a
stiwsllCal/y
Slgmflcant neQB!I'I(Irc/IJtronsfllP Willi cycllCalmovemcnls
III
gfOSS nal","l1/ p'00uc1
The farm Slates we dclrned es delMrlf} a/least 5 2 perccr>/
01 lherr gross Slate prodvct If) 1977 from famwng (The
nai/OfllllsVCtBge was 2 6 pefCOflt ) These Slates afe Ar/o:an$/IS, Idaflo, Iowa. KlfllSas. ~1InncSOla, MISSISSIPPI. Monlana, Neblaslt.lf. Nonll Dakota, South Dakota. and WISCOf)ssn TIle energy slates are d61ined as t/lose Illal W(1(Jld s11ffer
CfIlPIOyrnenl Iosscs from If decline 10 energy prICes, as
sflowrJ If) 8rown and 1/1/1 (1988) Tile energy slales afe
Aillska. CoIorado,l OUtS/ana. NewMexlCO. OKlahoma. Texas,
West Virginia. and WyomIng (Kansas and Norm Dakota
/lISO sul/crC(! emp/QymCn1 losses 'rom an energy-prICe
dcelme but wero not Incl!ld9(j Mre because mey were
cons,dared pnmarrly agncullyral states)
For a d,scussson of/he reasons for the larm recessiOO "., the
early 1980s and ,IS sybscqucnt recovery lhat began III
1987. see Dr/lbcf1SlOIland Baf~ema (1990)
T1ltt def_ Slales ware defrned as SlillCS (plus tnc DlstllCl
01 CoII¥nbta) /flat rn 1991 /lad ailaaSl3 percentol t/lerrworlc
force employed If) tile pnvale defense Ifl(1uStry The defcnsttSlal8S arc ArIZOna, CabforfWII. CcnnccIJCt.Jl. MatyIand,
MassachusetIS. V'lfgonia, find WBS/IIflgtcn
• FIfJIIICS lot defense spend""f) and employment were /aken
ffom
pages 61, 229. and 230 01 U S
Calgress_ Office
T8ChrIoIogy Assasstnenl (1992)
"
01
Figure 2
Economic Performance of Energy
and Farm States
Figure 3
Relative Economic Performance
of Defense States
p""",,
Percent
,
,
,•
,
,
._..
o +---~----~~-----¥~----
-,
-,
"
~
..
~
NOTE: The lines are eql,lal to the year -Qver·vear percentage growth
employment In the larm an(! energv stales mlnl,lS lhe year·
over·year percenlage 01 growth In U S employmenl
In
NOTE· The ~ne <5 equat to the year·over ·year percenlage growth in
employment in the doefense stales mll'lus Ihe year·over·year
parcenlage of growth in U S employment
SOURCE: Bureau 01 Labor SlahslJCS. ESlabhhrnenr Survey
SOURCE : Bureau of labor SlallsloCS. Eslabl<shment Survey
spending boostl...'d employment and wagL's in
;treas of the country when: dL'f•.:nsc <'·OI\1 I);II1II:'S
were located.
The weak pe:rro rmance of the Emn and
energy n:gions reduced their rt:btive W~I ~L'.s. whilL'
the relative wages of the dcfen...;e :-o(ales roSe. ,\ ...;
shown in Figure 4. from 19MI to 19H7 febtivL'
wages in the energy states do.::dint.'d from 102.H
percent of the national average to 97.7 percent,
~lncl relative wages in the farm ~ta l o.::s declined
from 94.3 percent of the nation:ll ;lVer.lge 10 H9.3
percent. In contrast, wages in the defense slalt:s
grew from 105.6 percenT of the n:nional average
in 198110 lJ03 percent in 19l:S7
During the bte I980s. deh..'nse spending
began to dedine. The end of the defense buildup
had a detrimental eff\;.'(:l on employment growth
and relati\'e wages in the ddt·nse states. as shown
in Figures 3 and 4 During this period , a ~r.jdu;JI
n.."Covery was occurring in the fann and oil regions
of the country, :lIld cmployment growth impron."'<.I
in these areas. As shown in Figure 5, the dispersion o f ;lver;lge wages acrns:. rt:gions increased
sharply betw(.'Cn 1978 and 1987, and suhsequcntly
fd l from 191-17 to 19K9 The di\'t:r~ence in regional
wagL"S from 1971'110 191:17, ;In<.l the ... uhseqllcnt
com·ergem·e, i:. con:.is!ent w ith first the increase,
and tlll:n the <b:l ine:, in n:Hionai w:lge inequality
in the 1i)HI)...;.
34
A decomposition of the rise
in wage inequality
While the timing of changes in region:11 w .. gc
dispersion sugge.~ts a link to n:nion:ll wage ine4u:llity, a decomposition of national wage inequality shows that region:iI w;lge divergence had only
:I .~mall direct imp:rct on the rise in nalional wage
inequality. Although Iht: dispersion in average
waJ.lCs :KroSS the four economic re:gions increased
...;harply hctwccn 1978 and 1987, :lIld from 1982 to
191-17 ( FtRlfre 5"), the effect of Ihe increased dispersion on national wage in\;.'quality \'"'3S s mall in
IXlIh periods.
The Thdi mt:asure of inequality <.0111 be
decompoSl..-"(1 into fWO main effects: inequality
Gluscd by inequ;ililY in avcmge wages :leros.'>
groups and ine:qualit~, caused hy wage inequality
ft.xk:ral Rt.'SCrvc Ban k o r Dallall
within groups. Ooth of these effects (·an then he
divided into a prim:lry cffct:1 and the cffeCI of
changing shares. For example. inequalily thaI
rc~ults from inequalilY of aver:lge wages across
group:. (·ould inerease ('ven if Ihe eslim;Ilt.'<.I mean
wage of each f,lroup remained consl:1.nt. This
increase would occur if the employment shares
shift such thaI the weight givcn to a high- or loww:lge Woup increast.'S and the weight given to an
aver:.tge-wage group decre:lses. Similarly, O\'erall
inequality could incrca'iC if wage incqualilY was
constant within each group hut the employment
s h:m: r()~e for :L high-inequality region :lIld
(k'dinec! for:L low-inequ:ility region.
The Theil me;lsure of inequality increased
from 0 177 to 0 225 from 197H to 1987, from 0.199
100225 from 19H2 to 1987. and then ueercascd 10
o 199 in 1989. T:Lbie I shows the decomposition
of these change.s in Ihe Theil into the Iwo main
effc("\.s ;md then. within the.se m:tin efft.·cls, thaI
pall that results frorn ch:mging employment
shares. A... shown in the top half of Table I.
between 197~ and 1987 the n:ltional 1'11<.:il incfCaseu by 004HI. ,lIld the change in the dispers ion of a\'er.lge wage~ aero....... region... only
a(·(·ounlt."(1 for 0.00 1 (or 2.1 percent) of Ill\..'
in(Tt.:a:.e. Almost ;lllthis ch:mge was hroughl on
hy W;lgt.: ch:tnge~. not by changing employmem
Figure 4
RelatIve Regional Wages
(Regional Wage Divided by U.S. Wage)
'"
'"
,,.
,,.
".
...
..
,~
,
~
..........
..... ..... .. ..... ".
---
..............
"
......
.......
"u~~~~~~~~~~~~·~···
~_s-.
' lin ,1178 ,lin ,9110 '911, ,9112 1983 ''''' l!i8S 1_ 19$1 1988 1989
SOURCE OF PRi MARV DATA Bureau o1labof Sta\lSbcs.
Es,atJloshment St.>rYey
Economic Rl'VieW _ founh Quancr 1992
Figure 5
Dispersion of Wages Ac ross Economic Regions
-..... .
"
......"
.....".
ro"
....""
.."
"" 1---,
""
w,,+-~~~~~~-~~~-~~~
1916 1979 11180 1981 11112 1983 HI84 ,985 1986 1987 1988 1989
NOTE : The meaSlire 01 dIsperSIon show he re is defined In equation 5
on !he box
SOURCE OF PRIMARV DATA Bureau of Labor StaMt]cs .
Establishment Su rvey
share:-:. Excluding the rccessionary periods of the
late 1970:. and early 198Os, increases in thl:
variation of ;lv(.'r.lgl.' wages anoss e(.'onomic
rl:gions :.Iill accounts only for 2.7 percent of the
increase in national wage di~pcrsion.
1\·lost of the risc: in wage in''qualiIY is left
unexplained by the divergence in average wages
acros.... re}!ion.". Incrclls(.'d wlIge dispersion was
moslly a result of inneased wage dis]Xrsion
within regions. The increase within regions gives
little information ahout the causcs of the risc in
wage inequality. As shown in T:lble 2, wage
ineqwt lity, as llH::asllred by tht' regional Theil
statistic, rose in all four regions from 1978 to 1987
and from 1982 to 1987. During the period from
1982 10 1987. inequality in the farm a nd oil states
increased at a significantly fa ster p:lce than in the
defense slates and al .1 moder:ltely faster pace
tha n in the renl<lining states.
While Ibe shocks 10 Ihe fMm. oil, and
uefense regions likely played ;l major role in the
diver~cncc of regional wages, olher factors likely
also played a role. To account for other faclors , I
also look at the efft.'"C1 o n n:ilional wage inequalilY
of the wage divcrgence acros... all fifty states and
the DiMricl of Columbia. As shown in the hellom
half of Tahle 1, the ovcrdll Cfft.'<..1 does nOI in-
"
Table 1
Decomposition of Theil' Measure of National Wage Inequalily
Decomposition b y Eco nomic Regi ons'
1978-87
1982-87
1987~
.048'
,0260
- 0256
Change in inequalily 01
wages across regIOns
(Equals A + 8)
_0010
.0007
-0003
A Due to change in weight
given to each region
.00005
00003
.00000
B. Due 10 change in wages
00098
00069
- ,00030
.0471
,0253
- .0254
-.00005
- ,00040
,00002
.04709
02572
-.02539
1978-87
1982-87
1987-a9
.048'
0260
-0256
Change In Inequality of
wages across states
(EqualS A + B)
.0016
.0013
A Due to change In weight
given to each state
.00005
.00009
.000<l0
B. Due to change in wages
.00158
00121
-.00040
.0464
.0247
-.0252
C. Due to change in weight
given to each slate
.00 122
.00002
- .00008
o Due to change In state
,04522
02474
- .02513
Change In Theil
(Equals 1 + 2)
2. Change in inequality within regions
(Equals C + 0)
C. Due to change in weight
given to each reg'on
0, Due to change In regional
Inequality measures
Decomposition by Siaies'
Change In Theil
(Equals 1 + 2)
2. Change in Inequality within states
(Equals C + 0)
Inequality measures
The Thetl SIaIISIOC Increased 21,' pe'ce<"I! "om 1978 to 1981, I/rom 0,1n to 0 225) 13 I pe'09flt t,om 1982 to 1987I"om 0 199 10
o 225). and declined II ,5 percent from 1987 to 1989 (trom 0 225 to 0 199) For m(ue ,nfOfmillllon on the ca~lallon and 0ec0rnp0s.11Ofl
of the The' l. see the box
, The lour ec»oomoc r&9'O'1S are the energy Slates. the farm stales. the defense states. and all other stales (including the Orstnct of
Columboa) For more Inlo,ma~lon on the slates Included in each regoon. _footnotes 6 and 7 IllIIM1 text
ft-"'dcr:1I Rt-"S4.' n ,c Ij:lllk "r ();lII:o"
Table 2
Average Wages and Wage Inequality' Within Regions
'98'
1978
Regions
Wages
Energy
14,287
13,424
15,625
14,475
Farm
Defense
0100'
'987
Theil
Wetgnt
Wages
Theil
Weight
Wages
Theil
Weight
.'98
11.9
22,4
55.7
24,785
22,655
27,993
24.807
12,0
.176
,215
.208
.205
,189
.250
9.9
20.200
18.962
22.020
19,724
13,2
'91
,242
.221
.215
24.1
169
, Data a re lor year· rouod , lurf,t,me worllers. The Ttl(!!r measure of rnequahty
9'
23.4
... 0
9.3
"' 5
IS described 10 the bO_
SOURCE OF PRIMA RY DATA U 5 Depanment of Commerce . Bureau ot the Census, Currenl PopulatIOn Survey , MiliCh tapes
{ f\',I"\' .. i~ n ilk;l nll~ \\ illl 111\' I. l r).,:"' f h rL,:II, do\\ n.
O nl~ :t.~ IK 'I'\'l 'nl (If Ill ... net lIH f\ ·:t .. V III n'lti o n ;l1
invqll,lhl~ IWI\\\'l'11 I<)- /'i .Intl I ')I'C (';111 h •.: dirL'dl\
al1nl ltlll'd 11) .In In, r\·,I"l·(1 dl~IK'r" I ')11 In .1\ L'1:lgL'
\\:Igl'" ,Inl)''':-- "1.11 \'" Excl u d i ng t ill' \'{·'l·.... i(lI1.try
r'll.:rilllt.. ( If Illl' I.l1l· I ()- C):-' ;Intl L':ld~ 1')H(h. IIl l f l :. I:-"
... 6 p "'H"l'nt 0 1 till' irllTl.';i"l' A H'(h l('l ioll in lilt:
·"
I,..
in lhl' \ .lri,1I10n "f \\ ,Igl" ,II n
"1.lll'" .. Ii ll onl~
,llUllIIlI" for:; r'll.:r".:1l1 (If ll1l' int'rl':I"l' III 11,111011;1 1
\\:I.l:L' d l"rM,:r,ulIl ()n(l' ,1).:.11 11 . IIlL' IIKn.::I:--\'d \\ :tgl'
dl'JX'l'-lOIl \\:1' !llo" h .1 rl" lI ft 01 incn.:;r-.\ ·d \\ :I).:l'
dl"JX'1'-1I11l \\ullin ,UI\'.. T he ri'l' in \\,1).:,: inl'qu:rl ·
il~ \\ ilhill ,LUl " \\.1'- \\ idl:"pr\·,rd. \\ 1111 \\ ,Igl'
)l ll'l lll , l lil~ n .. inJ.: in fo rt y-Iollr ..I;IIL" 1'1'0 111 J') - K to
II)S- ,In ri i ll lh ll1\,wH:n "1;11\ '" 1'1'0 111 f')Xl1 0 191';'1h ..· dl\ \ 'rg..'I1('\' 0 1 \\ .lgl·" ,Kro,," ..1.11 ..',
pl.l~ cd a "Ill,tlkr rok in Il,Hional \\':lgc Ir lL'q llalil~
Ih;ll1 d id "l'I \'r;1I ( 1IItt 'f f;l\'lo l'''. :--lIch ;b ;1 rbt: i n !Ill'
\ ;lri; II)('t: (,f \\ : I g~' .. :I<TI J:--." g n IlIp.. d:l...... int:d hy
c , iJ l( ;ll i"Il , (In up:u II 111 :lI1d ,f .~(· Thl' c OcCI of
,!.!t:nri('1' LK lnr .. \\, I ~ ;l1 ..() "lnl n~l' l' lll; m the 1t:).ti,)Jl: tf
1:1l'1(11''', IlUI in 11 1(' "]lP().. il l· d il'\ 'l'I j(l[) A rl'dul'ti(lll
in t ill' \\.I l!t: j.l: lp IX'l wl't'n 11I1'1\ :lnd \\[lll1l'n act ed
II I Il'du( t, \\.Igl· l! lL'qualil~. ~'I 1'1l 1\'h ilL' IIt<-' .. ha rl '
0 / \\tl l11l.' 11 in .IIL' \\(lr k fOrt'l' grt:\\ 1'11\' rl'gional
1:.'11..-l l \\,(' ' II n iLlr Dilly 10 IIt;! 1 of l it.,: dl:l!\).tln g
in dlh tri.rl " l n ll IUrl: o f t ill' \lor\.. force
\ ~ ~ ho\\ n III T.lhk- :\. "'dIlCliioll .11lL! on:up.ltlorul i.r('lor'" "\'l'lll 10 h,11 l' pl.ly ..-<I the b rg(' ''( rol l'
III 11lL' li'-4,.' rn \\ agl' In ..:q u;ll ll \ ,. hUIlI 1,,,,,110 19:-1-.
:rn Il1In,':I",,' ill I ll\' d i"pcr-it)1l of 1\,lgl" ,I("n),..;
\'dUl.llI0Il,rl group.. \\;1" rl'''J'l0n .. ib k- lor 115 p ..: r
ll'nl (1f til\' 1lL'1 inul·:l"I.' in Iltl' Tlll'il. ,rn IIKr,:;I",'
F...·o
n .. "' ....
Rc" k w -
" .. urlh Qu:orll'r 19'91
.I efl ).... ' 1<"(·I IP:lIIIIII.11 g1'(Jup:-- \\ , 1" rl: ..;ptm .. lll!L- fo r
1- - lX'I'l'l' n t of tire imTr.:a:--l: : ;1Il HlU..·;t ,,_· ;I('I'OSS
;tgl' gn 'lll'~ \\ .1" lv,p<m .. ihk- 1,)1' X K IX 'l'n'n l: and
an ilu r\';I'\.' ,1('1'0 .... Illdu:--lril::-- \\ .1" fl ' ''lx lIl .. ih k' for
di" Ix,.... ion o f \\,'gl '" ,Kro:-.... ),:t:nlk'r group :-- n:dlleed
Ihl' 1lL'1 1\l( 1'l';l'-l' ttl 11ll' T bl,.1 h\ I ~ H pl'rc<-'nl
.\ .... IUl\\ n in 111L' th ird l"olurlln' of'l':lhl\-..
:l nd 5. 11.lg<-' in('ljU,l ll lr d,:dinnl q uilt: .. Iurply
frolll II)S- 10 Ii)SI) The ('o n n 'r),:clll't:' in \\ :Igl '."
;I('H'......1;lll'" l h :1 1 occu rred f f( )1Il 1<)1{- 10 JI)I->'<)
:\C('()unll'd for o n l~ I (l pt.· ..l t:llI o f Iht: (k'din ..: in
Il:u io ll:rl \\,:Il-tl: inl.'qu;t l ity dUl'ltll-t I llat p.,:n o d ThL'
1110 :--1 impo lI;l nt f;I\'!Of :l fft:'l'ling I Ill: d~d inl' in
\\ :tgl' In ...qu,l lity \\,1." , f conli nui ng dcdi nl' in t ill;'
1l1,lk'-fcm,d c \\";t.l:e g ap 1\ Ikd ll1l: in l it..: r..:l:l1in :
w;lg\'" (II Ill:I1l:lgl,.-b l . prol-..: ..... i(ln:r l . Ic d tnictl , <l nd
' ';lk.. \\'Ol'ktTS rl'dllc<-'d lilt: OCl't lp:rli()n:tI w ;lgc
," prl':ld . 1\ hieh :11.. \ I Ic(1 1( 1 k'''~ ()\'cl: 111 1\ age
inl'qu ;l li l ~ Til \,' d i .. pl:r.. io n " I' \\ agcs :tnn.....
l:d llCallo n:lf !-(roup:-- wa s l':-....l·r111;tll y ul1cll;l11gl'd
Irolll I ')X7 10 J I)S()
Tfle docol>l/JOS'lJOnS ptOH(J(J-:J 111 Tables I an-:J 3 SJmPly
plr:NrOO clUes as 10 wfJJcn
('C.(}I'I(lIThC
and demogtapll.c
/ac/(XS may n.we Dlilyed ;J10/6lnrlSJfJ9 II-age rnequahly
The
deCom,:)O$llO'lIQflO£eS""P"'lanr .nle fllC rIOfIS bct~n (dC'
lors sucn as 0CCtI031f(}fl and edvcallOf' and 'I IS /TlUS
'!ilpptOO<..J'e 10 lora/the percent e~fJliJ<ned by a 8 factors
"
Table 3
Decomposition of Theil Measure of National Wage Inequality
By Demographic and Industry Demand Factors'
Education
1978--87
1982-a7
1987-39
.0481
02<0
-.0256
.0131
.0058
-.0001
- .00018
- .00156
- .00049
.01331
,00732
.00035
0349
,0203
C Due to change In wel(lht
given \0 each group
-. 00016
-. 00022
.00009
0 , Due to change In group
Inequality measures
,03510
.02051
- 02543
1978--87
1982-87
1987-89
0481
0260
-. 0256
Change In Inequality 01
wages across age groups
(Equals A ~ B)
,00.)4
.0023
-. 0023
A Due \0 change m weight
given \0 each group
- .00325
-. 00085
- .00070
B. Due to change in wages
,00663
.00313
-, 00 156
.0447
.0238
-, 0234
- .00056
-. 00021
.00075
04525
.02397
- 02413
Change tf1 Theil
(Equals 1 + 2)
Change in inequality of
wages across educational groups
(Equals A + B)
A
Due to change in weight
given to each group
B. Due to change
In wages
2. Change
In inequality within groups
(Equals C + D)
-.0255
Age
Change In Theil
(Equals 1 + 2)
2. Change in inequality
within age groups
(Equals C .. 0)
C. Due to change m weight
given to each group
o Due to change m group
mequality measures
, For <Seton-hOM ot demogr.;tphoc and IfIduslry groups. see Ihe Appeod,x Dala are lor year·round,
lul~me W{)rI<~
SOURCE OF PRIMARY DATA, U 5 Depanmeru 01 CommerCE!. Bureau Of the Census. Current Populatoon Survey. March tapes
(Contmued on lhe rlfI.K1 page)
Table
J-Continued
Decomposition of Theil Measure of National Wage Inequality
By Demographic and Industry Demand Factors
Gender
Change in Theil
(Equals 1 + 2)
I, Change in inequality of
wages across gender
(Equals A + B)
1978-87
1982-87
1987-a9
.0481
.0260
-.0256
-.0077
- .0049
-0040
A. Due to change in weight
given 10 each group
00147
00040
-_00000
B. Due 10 change in wages
- .00921
- .00528
- .00460
.0558
.0309
-.0210
-.00211
-.00064
-.00001
.05792
.03156
-.02102
1978-87
1982-87
1987--89
.0481
0260
-.0256
Change In inequahty 01
wages across occupations
(Equals A • B)
.0078
0046
-.0033
A. Due to change in weight
given to each group
- .00147
-.00033
,00014
B. Due to change in wages
.00926
.00428
-.00340
.0403
.0214
-.0224
C. Due to change In weight
given to each group
.00864
.00144
.00154
D Due to change in group
mequality measures
03164
.02000
-.02393
2. Change in inequality
w thin gender groups
(Equals C + OJ
C, Due to change in weight
given to each group
o
Due to change in group
Inequality measures
Occupat ion
Change 10 Theil
(Equals 1 + 2)
2 Change in Inequality
Within occupations
(Equals C + OJ
(Continued on the next page)
r: .....nnmic
Rt" ';t'W- fou rth Q U""t' r I'.N!
"
Table 3-Continued
Decomposition of Theil Measure of National Wage Inequality
By Demographic and Industry Demand Factors
Industry
1978-87
1982~7
1987~9
Change In Theil
(Equals 1 + 2)
.0481
.0""'
-.0256
1. Change in Inequality of
wages across industries
(Equals A + B)
.0020
.0012
-.0022
.00064
.00029
.00022
.00136
.00089
-.00242
.0461
0249
-.0234
C. Due to change In weight
given to each group
.00539
.00188
.00124
D. Due to change In group
Inequality measures
.04071
.02298
-.02469
A. Due to change in weight
given to each group
B. Due to change in wages
2. Change in inequality
within industry groups
(Equals C l' 0)
Summary a nd implicatio ns
Thro u~ hOlI[ much o f lh ...' 19HOs. w:lge
inequality ill(:rt:!:l.....:d i ll 11K' Un ited St:llt'S Prn-ioll:-'
n :.'iL'arch h:l:-. fOlmd tllal ;1 ri:-.l..' i n 1.::lrnings h y
...·(itIGllion:ll it.:\'d ;Ind iIKrl':I"",'" wago.: dispersion
anoss occupations \\,,,,'re lI11pOnant factOI':' in til('
1'i...C in \\'ag ...~ inl'qu:di' y Ik.....·ardter:-.. I1O\\'e\cr.
11;1\'l' no1t:d 111:11 much of t ill' riM: i n \\,:I~e inequ:l lily \\';I ,~ left uno:pbinl,:d hr the dL'lIIographic :Uld
indu!'>try f:K'tor:-. tll:1I tl1l'}1 L'x:lI11 ined In thi,.. ,.. tudy.
I Itavt: fll rtlll: rni till' :111:IIY,"I .. hy l'xamining tht:
i ntpact on waRt: inl'qll:llil)' of:l di,'t:rgt:no: in
rq.:ion al wa~t:~ that ()('l'um,:d d urinj.! the 19HO:-.
I find that rq~lo n:d .. hc)(:k.... !'> uc h a.s tin:
n.:n:!'> .. ions i n tilL' oil and farlll hd t ... pushcd wagc!'>
IO\\'l:'r in Iht;.·M:' 1'll:low-:I\·\:r:lgo.:-\\,:Ij.!1.' :Irca!'>. and
increased dcfcn ..<.· .. po.: ndin).: ptl .. hl:'d lip \\ agOO'!'> in
alx)\ c-;t"t:r:I~l'- \\ :I).:l· ,lfl":I!'> \,\'h l k' ill(.'''l' rl.:"gional
.. h(X'k:-; innea ..ed o\'l.'r;l1l \\ a).:<.· int:qu:dity. I find
l 11al fCRion:l l \\age d i\'erj.!...·!ll·...• acnlll l1l<.·d fo r o nly
2 I pcrn'nt to :; perl'cnt of tiK' n .....· in n:lliollal
W:I).:l· inc qua lity Ot hl;'1' f:I(:l or... "lKh ;1:-. inneasl;'d
\\'a).:c dl"rx:I':'IOn ann..!'> I.'dul·alional ;Ind OCCUp:ltiona I group~ and:1 rl.'dul'lion i n llll' ma1c-fcmalt:
\\a).:1.' g;lp. phl}l'd 1:l f gl'f ro1c!'>
Altl l()llgll ren:nt "Illdil.''' .. uggL'... 1 , 11:11 regional
\\:Iges arL' likely 10 return IOl·O!1\l'fg...·IK"L·. re:-'lI!ts
of thb swdr ,"\lgge.'~1 Ihal Ih ..., l'Ol1\o.:rgl.'lKe \\ ill
li l\cl y h;I\·1.' only:1 :-111:111 iI11P:KI on 11;llion:11 wage
in ...·qu:dily Tllt: flJlufl' dir..."ction of \\ :Igl' inl.'qu:I l ily
i .. lI!K 1c:I!'. A )(I"owin),: demand I'm high-sk i lkd
\\ork<.'r!'> (Without ;l klfgl' i ncrca!'>l.' in till' ,..tlppl y of
"ki lll,d worker!'» would PUI upw:ml pre..... urt: on
\\,:I).:l' lIleqll;ll iIY. whik a ('Olllinu<''l1 dedinl:' in the
III:II<.'-fcmale wa!-,!t: gap \\ould pUi downward
Pfl''':-ll rl' o n w:lgt;.· inl'qll:llity To !-,!L'I :1 ho.,:II<.·r ide::!
of Ihe flltllr<." di ....:.'l't ion of n:llion:11 \\ ag<.· inc::qllalit)'.
f1ll1 11 ...·r \\orl.: need.. III ho.: don\.' 10 fu ll) llmk"r:.tand
till' faclor.. :llTecti nR \\ .1)..:...· 1Il"''lIU:lliIY
FC<k r.1i RCSC ...·l· 6:l nk of Dalla:>
Using the Population-Weighted Theil Measure of Inequality
If the wages of each person were multiplied by some positive constant, the degree of inequality would remain the same_
In this paper, I use a measure of inequality due to Theil (1967, 126-27)_ As shown in
Horrigan (1991 ), this measure can be written
simply as
(1)
T=
Ips,li ps,),
,
' \ IS,
where ps, is the population share of the ith
person , iSI is the income share of the i th
person , and P is the number of people in the
sample. Thus, the greater is the difference
between individual 's income share and their
population share , the greater is the Theil
statistic.
As brought out by Haslag, Russell, and
Slottje (1989), no single inequality measure
has been proved superior to the others . As
described in Shorrocks (1980), however, the
population -weighted Theil is one of a limited
number of additively decomposable inequality measures that satisfy three important properties :
A transfer of earnings from a richer to a
poorer individual reduces the value of
the measure ;
Shorrocks finds that among the limited number of additively decomposable inequality
measures that fit these criteria, the population-weighted Theil is the most satisfactory
because its decomposition is unambiguous.
In calculating the Theil with CPS data,
several problems must be addressed . The
first is that each observation is not weighted
equally. I address this problem by adjusting
the Theil measure to account for unequal
weights. As shown in Horrigan (1991) , the
adjusted Theil is calculated as
"
I~ln
( Z, )
(2)
T = ln,u
N
where
" ' Z,
I~
(3)
,u = '
N
, and
(4)
If there are r groups with n individuals
and each group has an identical distribution , then aggregating the groups would
result in an inequality measure that would
be equal to the measure for each of the
individual groups; and
F~"nomk
K.,.,icw _ I'oun h Quancr
1 9~~
~ is equal to the CPS sampling weight for
individual i, and Z, is the wage and salary
earnings of individual i.
(Continued on the next page)
.,
Using the Population-Weighted Theil Measure of Inequality-Continued
The second problem in using the CPS
data is that wages that exceed a set level are
not given in the sample . Although the truncated part is usually only between 0.5 percent
and 1.5 percent of the sample, it nonetheless
can represent an important downward bias in
the Theil. To account for these high-wage
earners , a Pareto distribution was estimated
by state, excluding the lowest-paid 60 percent
of the work force. I An average top-coded
wage for each state was calculated by using
the estimated distribution of the top-coded
individuals , and each top-coded person was
then assigned the average wage.
Once a wage was estimated for each of
the top·coded individuals and a nalional Theil
statistic was calculated using the C PS weights,
then the Theil was decomposed first into the
contribution of wage differences between
subgroups :
(5)
1
N
Jl
G
8 =- "L,N log - ,
g
g
J1. g
where Nand jJ are defined in equations 3 and
4. The contribution due to inequality within
each subgroup 9 '" 1,... , G is then defined as
(6)
where T is the Theil for each group. The
aggregate Theil measure is then equal to
(7)
Pasl research on 11>8 d.su.b\Jtlons 01 wages and .rocome has
Iouod that lhe P8fe1O d.su,b\Jbon Ms _~ al ll>8 ~ppef 81ld 01 the
OtslflbutlOl'l For .~ample. see Sll19 h and Maddala (1976) and
Crarner (1971)
Appendix
Group Definitions
1. Age
A. 16-19
B. 20-29
C. 30-39
D. 4Q-64
E. 65+
2. Education,
A. 0-8
B. 9-11
C. 12
D. 13-15
E. 16
F. 17+
Years Completed
Elementary School or Less
Some High School
High School Graduate
Some College
College Graduate
Post·Coliege Graduate
3. Gender
A. Female
B. Male
4. Industry
A. Agriculture, Forestry, and Fisheries
B. Mining
C. Construction
D. Durable Goods Manufacturing
E. Nondurable Goods Manufacturing
F. Transportation , Communication, and
Public Utilities
I~ no mic
Hl""icw -
f .. unh Qlla n \' r 19')2
G. Trade
H. Finance, Insurance, and Real Estate
I. Business and Repair Services
J. Personal Services
K. Entertainment and Recreational
Services
l. Professional Services
M. Public Administration
5. Occupation
A. Executive, Administrative, and
Managerial
8 . Professional
C. Technicians and Related Support
O. Sales Occupations
E. Administrative Support
F. Private Household
G. Protective Service
H. Farming, Forestry, and Fishing
I. Precision Production, Craft , and
Repair
J . Machine Operators, Assemblers, and
Inspectors
K. Transportation and Material Moving
L. Handlers, Equipment Cleaners,
Helpers, and Laborers
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Horrigan, Michael (991), "The Effect of Truncation
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States: 1967- 1986," Review of EcOllOmics and
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Loveman , Gary W., and Chris Tilly (988), "Good
Jobs or Bad j obs: What Docs the Evidence
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4&-Q5
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Carl ino, Ger-.dd A. (1992), "Arc Regional Per Capita
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f ebruary.
Federal Reserve Bank of Dallas
1992 Index
Economic Review
First Quarter
n\~
C:lM' of the Missmg M2
job" V. Dum
Monetary Policy in
;t
Small Opcn Economy: The Case of Singapore
101m I I Wood
RegionJI Effc(:1s of LihcrJlizcd Agricul tural Tr.lde
Fiolltl D. Siga l/a
Second Quarter
The Compar,l(ivc,' Growth Performance of the U.S. Economy in Iht! PoStwar Period
Mark A, Wymle
Free Tr.HJc Ag~mcnt:. and the Credibility of Trade RefomlS
IJtlt'id M . Gould
Quantifying Management's Role m tiank Survival
"/00"'0$ F. Siems
Third Quarter
Money and Output: Corre];ulon or Causality?
Scott Frr!f!moll
1.0::10 Grow1h and Loon Quality: Some Preliminary Evidence from Texas Banks
Raben T. Clair
When WiJllhe United States Grow Out of tL'i Foreign Debt.?
jolm K. Hili
l;ourth Quarter
Do Interest Rates Help Predict infl:J.t ion?
KelllJet/J AI Emely lInti E/Xm F. Kocnig
Tmde Policy and [nldlectu:l] Prvpcny PfO{cnion: TIle
W'iII/am C Gnlwn
~orth-Soulh
Dispute
Regional W:Igt.! Divergence and "'a!ional Wage Inequ:lltly
Keirh R Phillips
I'as l IS-,UC" uf Ihe £Collomic Reule/w are available free of chlrge hy wrillng to the Puhlic Affairs Depart-
ment. Fc.."dcr.ll Reserve &mk of Dallas. SbliOn K.. Dalla.<:. TX 75222. o r by calling (214) 922-5257.
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