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FEDERAL RESERVE BANK OF DALLAS Fourth Quarter 1993  The Theory and Practice ofFree Trade David M. Gould, Roy J. Ruffin, and Graeme L. Woodbridge  Rethz'nkz'ng the IS z'n IS -LM: Adaptz'ng Keynesz'an Tools to Non-Keynesian Economz'es Part 2 Evan F. Koenig  Hz'gh Injlatz'on: Causes and Consequences John H. Rogers and Ping Wang  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 Daflas Robert D. McTeer, Jr. President and Chief Executive Officer  Tony J. Salvaggio First Vice President and Chief Operating Officer  Harvey Rosenblum Senior Vice President and Director of Research  W. Michael Cox Vice President and Economic Advisor  Gerald P. O'Driscoll, Jr. Vice President and Economic Advisor  Stephen P. A. Brown Assistant Vice President and Senior Economist  Robert W. Gilmer Research Officor. Houston Branch  Economists Zsolt Becsi Evan F. Koenig Robert T. Clair D'Ann M. Petersen John V. Duca Keith R. Phillips Kenneth M. Emery Fiona D. Sigalla Beverly J. Fox Lori L. Taylor David M. Gould Mark A. Wynne William C. Gruben Kevin J. Yeats Joseph H. Haslag Mine K. YOcel Research Associates Professor Nathan S. Balke Southern Methodist University  Professor Thomas B. Fomby Southern Methodist University Professor Gregory W. Huffman Southern Methodist University Professor Roy J. Ruffin University of Houston Professor Ping Wang Pennsylvania State University Editors Rhonda Harris Virginia M. Rogers Design Gene Autry Graphics and Typography Laura J. Bell  The Economic Review is published by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System . Subscriptions ate available free of charge. Please send requests for single-copy and multiplecopy subscriptions. back issues. and address changes to the Public Affairs Department. Federal Reserve Bank of Dallas. P.O. Box 655906. Dallas. TX 75265-5906. 12141922-5257. Articles may be reprinted on the condition that the source is credited and the Research Department is provided with a copy of the publication containing the reprinted material.  On the cover: an architectural rendering of the new Federal Reserve Bank of Dallas headquarters.  Contents Pag 1  The Theory and Practice ofFree Trade David M. Gould, Roy J. Ruffin, and Graeme L. Woodbridge  D avid M . Goul I, Roy.J. Ruffin , and Grae m L. W oodbridg argu that fre trade is support d both by co no mic principl es and vidence fro m o untri s that have fo llowed o p n nl'lrk t po licies. The autho rs d mo nstrat th at th countries w hose mark ts are th most o pen have higher re't! output and econo mic growth . The authors show that many arguments fo r prate tio n obscure th benefi ts countries drive rro m intern atio nal trad High-w age countri s not o nl y ca n compete with low-wage countries, they d minat th wo rld cono mi c st'lge. T rad defi cits or surplus s ar not inh rentl y bad or good, but rath r r fl ect a country's onsumpli on and inveSLment decisio ns over time. Mo l' ove r, ther is n vidence to suggest that imports ca use yst malic un mployment o r that exports I' ate syst matic mploym nt. T he aULho rs ex plain w hy industri al policies 'Ind prot ctio n des igned to pro mote particul ar ind ustries usuall y backfire; trade po li ci s usually ref! ct th lobbying efrorts o f th most voca l and powerful s If-interest groups.  Pag 17  Rethinking the IS in IS-LM: Adapting I(eynesian Tools to NonKeynesian Economies Parl2 Evan F. Koenig  The TS-LM diagram was develo ped as a too l ~ r analyzing Keynesian econo mies-economies w ith stick y pri c sa nd myopic ho useho lds. In Part 1 or Lhis anicl ,Eva n Ko nig showed how a gr'lphi ca l apparaLus simil ar LO Lhe Lraditio nal TS-tM diagram ca n be us d to analyze economies w ith a Fixed ca pital stock and o pLimi zing, fo rwa rd -looking ho use ho lds. Part 2 eXLends th e ea rli r analysis to an economy with ca pit't! investment. As b ro re, an expectatio ns-a ugm nted va ri 'lnl of the I S-LM mod I is round to includ a po pular rea l-busil1 sscycle model as a spe ial case. Thus, the IS-LM diagram has w id applicability as a pedagog ica l device and as a framework w ithin w hich lO discuss policy.  Contents Page 37  High Inflation: Causes and Consequences John H. Rogers and Ping Wang  Us ing evide nce from s ve n hype rinflationary pisodes in four Latin America n countries in the second half o f the 1980 , Jo hn Rogers a nd Ping Wa ng exa mine the causes a nd con eque nces of hig h infl atio n. The article emphasizes fOLir iss ues: the welfare costs of inflatio n and rea l costs of stabili zati o n, the COllU110 n featu res of the chro nica lly hig h inflations experie nced in Latin Ame rica n countri es, the ma in ca uses o f hig h inflation, and th w ide ly diffe re nt o utcomes of seve ra l stabilization programs. Rogers and Wa ng find that the w !fa re costs of e v n moderate pe riods of inflation may no t be negligibl ,whe reas the adverse macroecono mic ffects of stabili zation efforts are mostly tempora ly. The autho rs show that dle spiral-like adjustm nt of dle government bu Iget a nd mo ne ta ry g rowdl may res ult in a hig h-inflatio n trap . The ma in ca uses of chronica ll y hig h inflatio n indud continuo us fi scal-monetary extensio n , productivity slowdown, systematic underva luatio n of the dom stic curre ncy, a nd dimini shed credibility of anti-inflatio n policies. Su ccessfLIl stabilization , in essence, r suIts fro m budg ta ry adjustm nt, market libe ra li zatio n, and th ado ptio n of a no mina l anchor (such as the no mina l excha nge rate), a ll of w hich e nsur cred ibility o f the public autho rities.  David M. Gould  Roy J. Ruffin  Economist Federal Reserve Bank of Dallas  M. D. Anderson Professor of Economics University of Houston  Graeme L. Woodbridge Assistant Professor of Economics University of Melbourne  The Theory and Practice of Free Trade  S  ince the end of World War II the U.S. share of world income has fallen, while U.S. trade with the rest of the world has increased. Many believe that these two trends are not coincidental. U.S. firms that once dominated automobile, steel, and consumer electronics industries face stiff competition from Japan and increasing competition from South Korea and other industrializing countries. In response to the changing pattern of world trade, the automobile, steel, semiconductor, and other industries have requested and received increased trade protection in the form of voluntary export restraints, countervailing duties, and antidumping lawsuits. The trend toward trade liberalization, beginning with the Generalized Agreement on Tariffs and Trade (GATT) in 1947, appears to be changing as the United States and other countries escalate their use of protection to limit imports— especially imports from developing countries. The perception that liberalized trade contributes to unemployment has been a primary cause of the rise in protection. Indeed, much of the debate surrounding the North American Free Trade Agreement (NAFTA) has focused on the question of whether free trade with Mexico will take jobs away from the United States. Does free trade cause unemployment, or does it enhance economic growth? In this article, we examine the case for free trade in theory and in the light of recent experience. Fortunately, there is now a good deal of data on trade and protection from numerous countries to use in assessing the role of trade in economic performance. Despite some theoretical exceptions to arguments for free trade, the data suggest that free trade has worked best in practice. Economic Review — Fourth Quarter 1993  Comparative advantage and international trade The most fundamental argument for international trade is that it enables a country to expand the quantity of goods and services it consumes. Through imports, a country can acquire goods and services that it either cannot produce at home or can produce at home only at a cost that is greater than the cost of obtaining them indirectly by exchanging them for the exports it produces. In other words, through trade, a country can obtain goods and services with greater efficiency by specializing in those activities in which the country has a comparative advantage. For example, the United States can spend its unique talents in developing computing and communications technology while Japan devotes its efforts to consumer electronics. If Japan did not perform these tasks, the United States would have to shift resources from other activities into the production of camcorders, flat-panel displays, TV sets, and other items that the United States currently imports. David Ricardo developed the principle of comparative advantage in 1817. It says that every country, no matter how inefficient in its overall production structure, can always profitably export  Gerald P. O’Driscoll, Jr. offered extremely helpful comments as the reviewer for this article. We also benefited from the discussions and comments of William C. Gruben. All remaining errors are solely our responsibility.  1  A Simple Example of Comparative Advantage The concept of comparative advantage between countries is analogous to exchange between individuals. Suppose a lawyer can write five briefs or type two pages of text in an hour, while a secretary can write one brief or type two pages of text in an hour. Is there room for trade between the lawyer and the secretary? Although the lawyer can write more briefs and type just as fast as the secretary, it is worthwhile for the lawyer to specialize in writing briefs and the secretary to do the typing. Trade between the secretary and lawyer leads to higher output. Suppose that the lawyer and the secretary do not trade and each spends half of an eight-hour day typing and writing briefs. The lawyer would write twenty (20 = 4 × 5) briefs and type eight pages (8 = 4 × 2), while the  some goods to pay for its most desired imports. A country’s wages reflect its general productivity level and its overall standard of living, but they do not determine its competitiveness or which goods it ultimately exports. Countries with high overall productivity will have high wages, and countries with low overall productivity will have low wages. What matters for trade is that within countries different industries are more productive than others. It is unavoidable that each country has industries with both higher than average and lower than average productivities. Because a country’s high-productivity industries need only pay that country’s competitive market wage, these industries will have lower relative costs and will be able to compete in world markets. This principle is the basis for trade. For example, the United States has higher wages than Mexico, but this difference does not prevent the United States from selling products to Mexico. On the contrary, U.S. industries with higher than average productivities, 2  secretary would write four briefs (4 = 4 × 1) and type eight pages (8 = 4 × 2). Combined output for the lawyer and the secretary would be twenty-four briefs and sixteen typed pages. However, if the lawyer and secretary traded services, and the lawyer specialized in writing briefs and the secretary specialized in typing, their combined output would be forty briefs (40 = 8 × 5) and sixteen typed pages (16 = 8 × 2), which is clearly an increase in overall production. The lawyer has a comparative advantage in writing briefs, and the secretary has a comparative advantage in typing. The same basic principle applies to exchange between countries. Countries gain from trade because they obtain goods and services more cheaply by specializing in activities in which they have a comparative advantage.  such as the computer industry, can export substantial amounts to Mexico at a lower cost than Mexico can produce them. Likewise, Mexico will export goods and services from its industries with higher than average productivities because these industries will have a cost advantage in the United States. (See the box entitled, “A Simple Example of Comparative Advantage.”) Although we usually think of the benefits of international trade as limited to the exchange of goods and services, perhaps the greatest benefit of international commerce results from the transmission of ideas. Throughout history, international trade has served as the principal means by which new goods (such as the potato), services (such as the music of the Beatles), and processes (such as Japanese just-in-time manufacturing) have spread around the globe. Even rediscoveries of lost civilizations have led to new ideas about furniture, decoration, and art. Our alphabet was devised to keep international trading records on Phoenician ships without using highly trained scribes. Federal Reserve Bank of Dallas  Figure 1  Growth Per Capita and Level of Protection, 1976–85 Average yearly per capita growth 8  6  Singapore Hong Kong  4  South Korea  Sri Lanka U.S.A.  2 Tanzania 0 Ghana –2  Sierra Leone –4 Nigeria Zambia –6 0  50  100  150  200  250  300  Level of Protection  NOTE: Level of protection is defined by the real exchange rate distortion. SOURCE OF PRIMARY DATA: Dollar (1992). Summers and Heston (1991).  The effects of protection Perhaps one of the best natural tests of whether free trade works can be found in the experience of developing countries. In the 1950s and 1960s, many developing countries adopted the import substitution industrialization policy expounded by Raúl Prebisch. The idea, also known as the dependency theory, was that if poor countries wanted to develop, they would have to start producing manufactured goods rather than continue to rely on imports of these goods from developed countries in exchange for exports of primary products. The fear was that as income rose, the demand for manufactured products would increase relative to primary products, and Economic Review — Fourth Quarter 1993  this change would lead to a lower relative price for primary products in international markets. In other words, if the poor countries were ever to become rich, they would have to substitute their own domestically produced manufactured goods for manufactured imports. This policy was implemented by imposing high trade barriers on imports from developed countries. After thirty years, however, the evidence clearly points to the failure of highly protected import substitution trade regimes and the success of outward-oriented open trade regimes. Figure 1 plots the growth experience of developing countries against their level of protection as measured by the country’s real exchange rate distortion. The real exchange rate distortion is a practical 3  measure of the degree of protection.1 As the figure shows, countries that have pursued highly protectionist policies, such as Tanzania, Nigeria, and Ghana, grew much more slowly than the relatively open economies of Southeast Asia, such as Hong Kong, South Korea, and Singapore.2 The basic problem with the import substitution strategy is that it assumes development can only occur through manufacturing and that it is only possible to develop manufacturing by protecting it. To be successful, however, countries have not had to rely solely on manufactured goods production. Regardless of the economic sector— manufacturing, agriculture, or mining—countries have done best by exploiting their natural comparative advantage. In fact, after moving toward a more liberalized trading environment, most countries increase productivity and growth in agriculture as well as manufacturing. In twenty-nine episodes of trade liberalization analyzed by Michaely, Papageorgiou, and Choksi (1991), growth increased in both the manufacturing and agriculture sectors after liberalization (Table 1). Moreover, growth in most agricultural sectors increased not only after the liberalization period but also during the process of liberalization. In other words, for many countries, the benefits of liberalization have been widespread  and immediate. Evidently, market economies are sufficiently flexible in most countries to allow the liberalized sectors to expand more quickly than the once-protected sectors contract. Another flaw in the import substitution theory is the implicit assumption that international competition does not matter to a thriving and strong manufacturing sector. In countries with an inward-looking import substitution policy, firms have no incentive to innovate. The lack of competition leads to high-priced, poor-quality products and retards economic growth. For example, in 1870 Argentina had a larger per capita income level than Japan or Germany. But after more than one hundred years of intense government intervention and high protection, Argentina was at the lower end of the world distribution of income. Until the late 1980s, a 1968 Ford Falcon was one of the finest, most luxurious cars available in Buenos Aires. The lesson is that outward-oriented policies are a much stronger conduit for economic growth and advancement than protectionist import substitution policies. In highly protected regimes, resources are attracted to industries that do not reflect the comparative advantage of the country. Moreover, protected industries, because they lack the incentive to innovate, produce high-cost, inferior products. Common misperceptions  4  1  As measured by Dollar (1992). The real exchange rate distortion is a measure of the degree to which a country’s tradable goods prices are distorted by domestic trade policies. The greater the amount of domestic protection is, the larger the real exchange rate distortion. Other measures of protection, such as the effective rate of protection and its black market exchange rate premium, also show a strong negative correlation with economic growth. See Gould and Ruffin (1993) for a detailed empirical examination of the relationship between growth and trade regime.  2  Although Southeast Asian economies are relatively open to trade, this does not imply a lack of government intervention. Government protection of import-competing industries in these economies is often undone by government support of export industries. In other words, resources that would be attracted away from export sectors to the import-competing sectors because of protection are kept in the export sectors because of export subsidies. Consequently, the resource misallocation and the price distortion between exports and imports is relatively low.  Public understanding of international trade issues is often hampered by an array of misperceptions. In this section, we evaluate the logical and empirical underpinnings of several common arguments. Exports are good, imports are bad. In discussions of a country’s trade balance we often hear terms that are filled with value judgements. For example, a worsening trade balance implies that imports are growing faster than exports, while an improving trade balance implies that exports are growing faster than imports. However, by itself, a trade surplus or deficit is not inherently bad or good. Over time, a U.S. trade deficit must be followed by a U.S. trade surplus. If this were not true, then it would imply that other countries are willingly providing goods to the United States without the expectation of repayment. Federal Reserve Bank of Dallas  Table 1  Summary of Manufacturing and Agricultural Performance Before, During, and After Liberalization (Real Annual Percentage Rate of Growth) PtL  T  T+1  T+2  T+3  Manufacturing  6.7  5.3  6.9  6.9  8.0  Agriculture  2.8  2.9  5.5  2.8  3.9  PtL, average of three years up to liberalization T Year of liberalization T + 1 One year after liberalization T + 2 Two years after liberalization T + 3 Three years after liberalization SOURCE: Michaely, Papageorgiou, and Choksi (1991).  When looking at trade balances this way it is easy to see that the cost of imports are exports. When a country exports something, it gives up the products of its resources; when a country imports something, it adds to the quantity of goods it can consume. What a country can consume at home equals what it produces plus its imports minus its exports. Thus, from the standpoint what a country can consume, imports are good. The proper concept is what economists call the terms of trade, the quantity of imports a country receives in exchange for a given quantity of its exports. The larger the terms of trade, the better. This basic truth was discovered many years ago by David Hume, Adam Smith, and David Ricardo as they developed a rationale to counter the doctrine of mercantilism. Mercantilists were a group of business writers in the seventeenth and eighteenth centuries who argued that a nation was like a business. This analogy, however, suffers from the fallacy of composition: what is true for a part need not be true of the whole. The mercantalists mistakenly argued that it was better to sell more to foreigners than to buy from them. In this way, it was claimed, a country with a “favorable trade balance” would benefit the most from international trade. This language is still with us today, reminding us of a quotation from John Maynard Keynes (1936, 383): Economic Review — Fourth Quarter 1993  [T]he ideas of economists..., both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.  We often are guilty of a good deal of Orwellian doublethink when it comes to exports and imports. When trading with a friendly nation, like Japan, it is considered bad to export less to them than we import. But when we consider trade with an enemy, such as the former Soviet Union at the height of the Cold War or Saddam Hussein’s Iraq, it is considered treason export anything at all to them. For some reason, in times of war or tension, we can see through the flows of money and focus on the flows of goods. Just think of imports of food into starving Somalia. Are the Somalians worse off ? Obviously not. A trade “deficit” is perhaps best thought of as a surplus: the value of goods coming into a country exceeds the value of goods leaving the country. Trade and economic powerhouses. Another reason some observers consider trade deficits bad stems from the notion that a country with a huge trade surplus is an economic powerhouse. Some 5  International Capital Movements and the Balance of Trade The balance of trade reflects how long a country has been a borrower or lender. To understand this concept, let us examine the basic structure of a country’s balance of payments. Let X = Exports, M = Imports, T = net gifts or unilateral transfers to foreigners, ∆B = net new borrowing from abroad, B = net indebtedness to the rest of the world, and r = the rate of interest on foreign indebtedness. A country’s balance of payments must be  X + ∆B = T + M + rB. The left-hand side of the equation refers to receipts from foreigners; the right-hand side refers to payments to foreigners. These must always balance. If ∆B > 0, a country is  people consider the country with the biggest surplus to be the most competitive and efficient nation on earth. Japan is one such candidate. This concept is flawed because trade deficits or surpluses today are the consequence of a country’s current and historical position in the international flow of capital. International lending and borrowing allow countries to buy now and pay later, just as domestic lending and borrowing allow individuals to buy now and pay later. What must be true is that the imports of goods and services now must be paid for by the exports of goods and services later. There is no free lunch. For example, in 1992 the United States had a merchandise trade deficit of $96 billion and net unilateral (mostly government) transfers to foreigners of $31 billion. To finance this outflow of $127 billion, the United States received about $10 billion in net investment income from foreigners, had a $55 billion surplus in service transactions (travel, license fees, insurance, and so forth), and borrowed approximately $62 billion. The reason the United States has a trade deficit is because it earns large amounts from direct investments abroad, has a comparative advantage in selling services, and is 6  borrowing; if B > 0, a country is a net debtor. If ∆B < 0, a country is lending, and if B < 0, a country is a net creditor. A country is considered to be a relatively young, or immature, borrowing nation when its net indebtedness, B, is small compared with its net new borrowing, ∆B. In this case, imports will be greater then exports (M > X ). A country is considered to be a relatively mature borrowing nation when the interest it pays on foreign indebtedness, rB, is larger than its net new borrowing from abroad, ∆B. Here, exports are greater than imports (X > M ). The opposite is true for an immature or mature creditor country. As a consequence, trade surpluses or deficits are simple reflections of the efficient means of allocating the world’s capital.  considered by many foreigners to be a good place to invest capital. The United States does not have a trade deficit because it cannot compete in world markets. (See the box entitled, “International Capital Movements and the Balance of Trade.”) Most recent discussion of the U.S. merchandise trade deficit has focused on the United States’ billion-dollar bilateral trade deficit with Japan. To a large degree, Japan has a trade surplus because Japanese savings are relatively large compared with investment opportunities in Japan. In the same manner, the United States has a trade deficit because its savings are relatively low compared with investment opportunities in the United States. Strong prospects for growth and investment opportunities in the United States can increase the U.S. trade deficit, but this deficit is not impoverishing. Without international capital flows, U.S. rates of interest would be much higher than they actually are. Indeed, Americans who borrowed to build U.S. factories and homeowners who refinanced their homes in 1992 and 1993 at low rates of interest were beneficiaries of these international capital flows. The level playing field. We often say we believe in free trade, but we want trade to be “fair” because Federal Reserve Bank of Dallas  Table 2  Protection and Per Capita GDP Growth, 1960– 85 Countries with Effective Rates of Protection Less than 40 Percent  Countries with Effective Rates of Protection Greater than 40 Percent  Country  Country  Average Annual Growth (1960–85)  Bangladesh Burma Canada Colombia Costa Rica Hong Kong India Italy Malaysia Mexico Nepal Pakistan Peru Philippines Portugal South Africa Singapore Spain Sri Lanka Syria Thailand Uruguay United States  .6 2.6 2.4 2.0 1.8 5.5 .4 3.4 3.7 2.4 1.0 2.3 .9 1.4 4.0 1.6 5.4 3.4 1.2 4.2 3.5 .1 1.8  Algeria Angola Bolivia Burundi Cameroon Central Africa Congo Egypt Ghana Honduras Ivory Coast Liberia Mauritania Niger Nigeria Rwanda Sierra Leone Somalia Sudan Tanzania Uganda Zaire Zambia  Average  2.4  Average  Average Annual Growth (1960–85) 2.6 –1.7 1.3 .6 3.6 –.5 3.6 4.9 –.8 1.3 1.5 .02 .1 .3 –.2 1.3 .6 –.1 –.1 2.3 .6 –.2 –1.6 .9  SOURCE OF PRIMARY DATA: Summers and Heston (1991). De Long and Summers (1991).  foreigners protect or subsidize some of their producers. This argument is convincing at the political level because it appeals to the sentiment in all of us to deal with others as they deal with us, but it is a red herring. One flaw is its reliance on the misperception that we benefit from exports and lose from imports. However, the core idea is the claim that the benefits of free trade only accrue if free trade is followed in other countries. A country can still gain from free trade even if free trade is not followed elsewhere. Although protection in other countries can reduce a country’s benefit from trade, a country will continue to gain from trade because it can obtain certain goods on Economic Review — Fourth Quarter 1993  cheaper terms by importing them rather than producing them at home. It makes little difference to the free trade country why it is getting the goods on cheaper terms. If it is because another country is subsidizing those exports, the free trade country is simply being provided a gift. As Table 2 suggests, in practice, the countries of the world that grow the fastest are precisely those that have the most open markets, despite high protection elsewhere in the world. Foreign wages are too low. Perhaps the most subtle argument against free trade is that it is unfair to compete with countries paying wages that are far below domestic standards. To a textile 7  company in the United States, it may seem unfair to lose business to a Mexican company that is far less efficient. Should efficiency not be rewarded? Efficiency is rewarded, but in a different way. The U.S. comparative advantage lies in areas in which our productivity advantages outstrip the disadvantages of having higher wages. Importcompeting industries in the United States cannot meet the pace set by our most productive industries. In 1992, the United States had a trade surplus of nearly a $5 billion with Mexico, even though Mexico had higher tariffs than the United States, and the United States had wages that were about seven times higher than Mexican wages. In industries that manufacture and market machine tools, electrical machinery, and high-tech business equipment, Mexican workers have difficulty competing with highly skilled U.S. workers. Low wages are not the key to exporting; if they were, countries with low wages like Bangladesh and Haiti would be great exporting nations. The truth is exactly the opposite: Germany and the United States are the world’s largest exporting countries. American goods create American jobs. Critics of free trade often claim that protection of domestic industries saves jobs. This rationale proceeds at two levels. First, the economically sophisticated argument holds that the benefits of free trade are derived from theoretical models that assume the economy has full employment. Because there is unemployment in the economy, free trade is not necessarily optimal because unemployment might actually increase. It is true that theoretical arguments for free trade assume full employment and are taken from a simplified version of reality, but these assumptions work well in practice. In fact, absence of free trade may be more correlated to unemployment  8  3  President Hoover signed the Smoot–Hawley Act despite a petition from a rare consensus of 1,028 economists strongly warning of the dire consequences of higher tariffs.  4  See Cox and Alm (1993) for a discussion of the U.S. experience with creative destruction.  than the presence of free trade. The most important event in the history of U.S. protection was the 1930 Smoot–Hawley bill, which substantially raised tariff rates. The Smoot–Hawley tariff inspired a trade war between the United States and Europe that may have prolonged and deepened the Great Depression of the 1930s (Meltzer 1976, 460).3 Arguments for free trade, however, should not be based on jobs claims. Free trade is not about the number of jobs, but about the types of jobs and standards of living. U.S. experience shows that unemployment changes substantially over the course of business cycles but, over time, the number of jobs roughly equals the size of the working-age population. What matters in the long run is the type of future jobs that are available. If the goal of U.S. policy were to keep jobs, today we would have thriving horse-drawn carriage and blacksmith industries. By keeping the same jobs we have always had we discourage the development of new high-skill jobs that add to the stock of knowledge and generate innovation and growth. A second argument simply holds that imports of textiles, consumer electronics, and automobiles cost domestic textile workers, electronics workers, and auto workers their good jobs and force them to take bad jobs. In other words, imports supposedly displace domestic workers. The slogan, “American goods create American jobs,” has become a rallying cry, but often such sentiments are rooted in the fallacy of composition. What is true for the part is not necessarily true for the whole. It is certainly true that imports of textiles or cars can destroy American textile or automobile jobs. But it is not true that imports reduce the number of jobs in a country. A big increase in imports will inevitably cause an increase in exports or foreign investment. In other words, if Americans suddenly wanted more Japanese cars, eventually American exports would have to increase to pay for these goods. The jobs lost in one industry are replaced by jobs gained in another industry. In a capitalist society, progress entails what Joseph Schumpeter called “creative destruction.” Fundamentally, new job opportunities destroy old job opportunities. The rise of manufacturing in the twentieth century destroyed jobs in farming. Jobs in the automobile and airline industries destroyed jobs in the railroad industry.4 Imports are just another way of producing goods. As old jobs Federal Reserve Bank of Dallas  Table 3  The Correlation Between Future Unemployment Rates and Current Import Penetration or Export Performance, 1950–88  Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Luxembourg Netherlands Norway New Zealand Portugal Spain Sweden Switzerland United Kingdom United States  Import Penetration  Export Performance  .252 –.363* .830* .046 –.240 –.445* .814* .421* –.809* –.601* –.029 –.193 .363* –.575* .295 –.001 .468* –.075 .799* –.427* –.594* .340* .390*  .357* –.400* .810* .111 –.142 –.269 .829* .406* –.721* –.640* –.155 –.199 .467* –.463* .414* –.017 .467* –.101 .780* –.422* –.549* .537* .350*  *Correlation significant at 5-percent level or above. SOURCE OF PRIMARY DATA: Organization for Economic Cooperation and Development and the Centre for Economic Performance, 1950–88, Centre for Economic Performance, the London School of Economics.  disappear and new ones emerge, people and jobs are eventually matched, but periods of unemployment are inevitable as the economy continually adjusts to new ways of production and new goods. Economic theory suggests that, for the economy as a whole, more exports lead to more imports, and vice versa, so that neither imports nor exports should correlate with widespread unemployment. Jobs lost and jobs gained roughly balance. Table 3 sheds some light on the correlation between unemployment rates and import penetration (the ratio of imports to gross domestic product) or export performance (the ratio of exports to gross domestic product). Data are from the twenty-three members of the Organization for Economic Review — Fourth Quarter 1993  Economic Cooperation and Development (OECD) for 1950–88. The data suggest that there is no simple causal link between unemployment and import penetration or export performance. Correlations of import penetration with the following year’s unemployment rate vary substantially among countries, from 0.814 in France to –0.809 in Greece. There is no statistically significant correlation for eight countries, and for nearly half the countries for which there is a significant correlation, the correlation is negative. Moreover, virtually the same pattern of correlation holds for export performance. There is no instance of a significant positive or negative correlation of imports with 9  the following year’s unemployment that is not similar for exports.5 Exports and imports are more related to each other than other macroeconomic factors, as one would expect since, ultimately, exports must pay for imports. In this case, as in others, practice follows theory. A country can gain from strategic trade policy. New theories of international trade that emphasize monopolistic competition and international oligopolies have led some economists to think that free trade may be out of date (Krugman 1986). The new theories of trade have emphasized the importance of economies of scale, learning curves, and innovation. These new theories are incompatible with the assumption of perfect competition that lies behind the classical argument for free trade. Thus, in a real world environment, some have argued, a country might be able to follow an activist trade policy that promotes domestic industries at the expense of foreign competitors. Strategic trade policy is usually based on one of two key ideas. The first is that a domestic industry is part of a world industry that earns monopoly profits. Subsidizing a domestic firm can secure more of the world’s monopoly profits for a country. The second is that a particular industry, such as semiconductors, may confer spillover benefits on other domestic industries by lowering their costs and raising their rates of return. In this latter case, subsidizing the industry generating the spillover benefits may improve a country’s total real income. Proposals for the use of trade protection to benefit the domestic economy at the possible expenses of other countries have a long history. For many years, trade theorists have recognized the possibility that through a tariff a large country may be able to raise revenue by, in effect, getting smaller foreign countries to pay indirectly into the national treasury. This rationale has been called the optimum tariff argument.  10  5  This relationship also holds for the contemporaneous correlation with unemployment and import penetration or export performance.  6  Dollar and Wolff (1993).  The difficulties with all such trade policy arguments are threefold. First, such policies assume that foreign governments will not retaliate. Foreign retaliation can reverse any potential gain anticipated from domestic protection. Second, as discussed in more detail later, most arguments for protection assume that tariffs and subsidies are imposed by a benevolent dictator, rather than political parties representing special interest groups. Most trade policy decisions, however, are not determined by what is in the best interests of the whole country; usually they are the result of political lobbying. Finally, strategic trade policy conclusions are based on theoretical models, but the implementation of the policy relies heavily on empirical estimates of industry demand and supply that can vary substantially over time. Given these problems, it is unlikely that any government could, even if it had the power to do so, implement the optimal policy (Grossman 1986). The problems of industrial policy Since the 1980s, it has become increasingly popular to advocate industrial policy as a means of promoting specific domestic industries and a way to gain access to foreign markets. A common belief is that the United States is becoming deindustrialized as other nations grow at our expense. Many fear that deindustrialization is the result of supportive industrial policies of foreign governments and lackadaisical U.S. policy. However, no country, not even Japan, has clearly gained from industrial policy. Many developed countries, including the United States, have experienced a growing comparative advantage in high-technology industries that caused a natural movement away from the labor- and capital-intensive products that utilize standardized technologies. Although this transition has led to a decline in manufacturing employment in the United States and other developed countries, it has not meant the deindustrialization of the United States per se. Among the OECD countries, the U.S. share of manufacturing output has increased slightly since the early 1970s. In 1990, the U.S. share of OECD manufacturing production was 37 percent, slightly higher than the U.S. share of total OECD population.6 The relatively steady size of U.S. manufacturing proFederal Reserve Bank of Dallas  duction has been accompanied by expanded U.S. trade. Increased trade has not come at the expense of manufacturing. Much has been made of the fact that from 1973 to 1992 U.S. hourly wages in manufacturing dropped from $12.90 to $11.50 (both in 1992 dollars), while during the same period, imports as a percent of GDP increased from less than 12 percent to about 21 percent. Has trade led to a drop in manufacturing wages? Looking only at hourly wages can be misleading. Hourly wages do not measure total hourly compensation. Since 1973, employee benefits (including medical and pension benefits) have increased substantially. Generally, a dollar paid in wages is equivalent to a dollar paid in employee benefits. Figure 2 plots real hourly compensation for manufacturing workers against trade as a share of gross domestic product (GDP) over the past twenty years. Hourly compensation includes wages, benefits, as well as employer contributions toward Social Security. As the figure shows, real manufacturing compensation has continued to rise along with trade throughout the 1970s and 1980s. Although the real hourly compensation of workers in some industries undoubtedly has fallen, overall it has not declined. While U.S. manufacturing production has not fallen, is there any evidence to suggest that industrial policy and targeted protection has worked for other nations? We often hear the argument that Japan has done rather well during the postwar era in protecting and promoting certain industries. In particular, the Japanese Ministry of International Trade and Industry (MITI) has often been credited with consistently providing support to industries that could not have been competitive in world markets had they not been supported. Moreover, the phenomenal success and strength of the Japanese economy is often attributed to MITI’s farsighted approach to industry support. Has Japan been successful in promoting and protecting its industries? Japanese real per capita GDP growth has averaged a robust 6.1 percent a year since 1950. During the same period, U.S. real per capita growth averaged only 2.1 percent a year. But most of Japan’s growth would probably have occurred without MITI’s policies. First, over the past four decades, Japanese savings as a percentage of GDP was three to four times greater than that of the United States. This high level of Economic Review — Fourth Quarter 1993  Figure 2  Real Manufacturing Compensation and Trade as a Share of GDP Hourly compensation 1982 = 100  Trade  103  24 Compensation  101  22  99 20 97  Trade  95  18  93  16  91 14 89 12  87 85  10 ’70  ’72  ’74  ’76  ’78  ’80  ’82  ’84  ’86  ’88  ’90  SOURCE OF PRIMARY DATA: Bureau of Labor Statistics.  savings generated a cheap and plentiful pool of funds for most of the growth differential between Japan and the United States (Barro 1991). In addition, Japan has also had the unique advantage of being able to catch up to the level of technology of the United States. With its large pool of savings, Japan has been able to invest in the latest technology without devoting the time required to develop the new technology. The United States, however, already possessing the newest technology during the postwar period, grew at the slower pace as the frontiers of technology were being pushed forward. Evidence now suggests that productivity growth in Japan and the other major industrialized nations is beginning to slow and converge with that of the United States. While U.S. real per capita income grew at a relative steady pace of 2.1 percent per year from 1950 to 1989, Japanese per capita income grew at a rapid 8.3 percent from 1950 to 1970, but slowed to 3.4 percent from 1970 to 1989. The same sort of convergence has occurred in other developed nations during the postwar era. However, despite relatively high growth rates among developed countries, the U.S. per capita income level continues to be the highest in the world (Figure 3 ). 11  Figure 3  Real Per Capita GDP in the G-7 Log levels, 1985 international prices 10  9.5  9  U.S.A. Canada  8.5  U.K.  8  France Germany Italy  7.5 Japan 7 1950  1960  1970  1980  1988  NOTE: The figures for Germany refer to the former West Germany. SOURCE: Summers and Heston (1991).  Other developed nations are catching up to the United States’ level of technological development. Their gains reflect the international diffusion of technology and accumulation of capital after World War II. Future U.S. leadership in technology, however, cannot benefit from U.S. protection. Technological growth will ultimately be determined by the skill level of U.S. workers. Recent economic evidence suggests that education and open markets are key elements to strength in technological innovation and growth.7 Although the Japanese government has promoted saving and investment though tax laws and other measures, the benefits of MITI’s industrial policies are questionable. MITI did successfully funnel resources into the steel and semiconductor industries and promoted internationally competitive industries, but it is unlikely that the benefits of such a policy were greater than the costs. As Paul Krugman (1987) has pointed out, the relevant question is whether this particular use of Japanese  7  12  See Gould and Ruffin (1993) and Roubini and Sala-i-Martin (1991).  resources generated a higher return for the nation than would have been earned had the private market allocated the funds. Although economists have long recognized the theoretical possibility of certain industries’ generating national rates of return higher than private rates of return, in practice few industries actually fit this criterion. Moreover, even if some industries did fit the criterion, governments are ill-equipped to identify them. Some of Japan’s biggest success stories (TVs, stereos, and VCRs) were not the industries most heavily targeted by MITI. Moreover, as these products have become even more standardized, production has moved out of Japan to Korea and other Southeast Asian countries. The inability of governments to pick the winners is evidenced by MITI’s actual or likely failures: • MITI first wanted the Japanese automobile industry to produce only trucks and later wanted to limit the number of automobile companies to a few giants, in particular, attempting to keep Honda out of the car business. Of course, market forces eventually led MITI to abandon these plans, but the intervention generated costs that could have been avoided. Had MITI been successful, Japan would have paid an enormous price for this policy. • The Japanese heavily targeted an analog version of high definition television (HDTV), but it appears that digital HDTV—the product of U.S. research and development —will be the industry standard. • MITI is now investing in cold fusion, a procedure for creating nuclear power that has been debunked by most of the scientific establishment. These examples and many others indicate that even Japan has done a poor job of picking the winning industries. Similarly, the U.S. government’s commercialization programs have produced only one clear success—the National Aeronautics and Space Administration’s program for launching communications satellites from 1963 to 1973 (Cohen and Noll 1991). Government efforts to promote nuclear power and synthetic fuels have wasted billions (Cohen and Noll 1991). Even if it were possible to recognize future winning industries with high rates of return, is it Federal Reserve Bank of Dallas  possible to subsidize them successfully? While most economists recognize the possibility of industries with technological spillovers and social benefits higher than private rates of return, they also realize that the political market that generates policies does not always allocate funds in a way that maximizes their economic efficiency. Governments rarely implement policies that maximize the country’s well-being. Rather, governments maximize their political support and, in doing so, implement policies that benefit the most powerful and vocal interest groups. Indeed, there is much evidence to suggest that trade policy is primarily determined by special interest groups. The politics of protection If free trade maximizes a country’s income and allows its citizens to achieve greater average welfare, why do we continually observe governments implementing policies that inhibit flows of goods and services between nations? Although government intervention is not necessarily inconsistent with the objective of maximizing national income (for instance, in the optimal tariff case), we rarely observe trade policies implemented to meet this objective. Trade policy usually reflects the lobbying efforts of special interest groups. Economists increasingly are recognizing that trade policies are usually not designed to improve economic performance but, rather, aim to alter the distribution of income.8 This consensus is based on the observation that trade policy is an endogenous outcome of the political process. In a democratic system in which politicians must achieve or maintain political office, special interest lobbying groups exert strong influence. Lobbying, either by informing the government of the support for a policy or by directly funding the election of a particular party, can influence electoral success and, hence, trade policies. Mindful of this, special interest groups, whose economic welfare can depend on the outcome of a particular trade policy, have an incentive to lobby for legislative outcome in their own favor. Because almost every change in policy produces winners and losers, the political contest is competitive. Pro-protection forces are predominantly industry-based coalitions of capital owners and labor organized through industry associations Economic Review — Fourth Quarter 1993  and labor unions. The losers from import protection are consumers who face higher prices and the owners of factors of production employed in exporting industries that face the possibility of reduced access to foreign markets through retaliation.9 Trade policy is the outcome of the political contest between these opposing forces, which is primarily determined by the lobbying expenditures of the two groups. The gainers from trade policy tend to be highly concentrated in well-defined industry interest groups, while the losers tend to be far a more diffuse group of consumers. Consequently, while the total cost of a particular trade policy often exceeds the gains, the costs are widely dispersed over a large group of consumers who individually have little incentive to lobby against the policy. For example, in 1984 the U.S. Federal Trade Commission estimated that import quotas and tariffs on sugar benefited U.S. sugar producers by $783 million, while costing U.S. consumers $1.266 billion.10 While the losses far exceeded the gains, the loss of $5 per average consumer was hardly enough to motivate these individuals to actively resist the policy. The political contest is biased in favor of the pro-protection coalitions because the benefits of trade policy are concentrated, while the costs are diffuse. Because trade policy is typically used to alter the distribution of income rather than to increase national income, resources devoted to lobbying are wasted. Moreover, as discussed by Magee, Brock, and Young (1989) and Olson (1982), the value of resources expended on these unproductive activities can approach the size of the transfer itself. The reason is that lobbyists have an economic incentive to expend resources as long as potential benefits exceed their lobbying costs.  8  See Hillman (1989) and Quibria (1989) for surveys of this literature.  9  See Gould and Woodbridge (1993) for a discussion of the incentives of exporting industries to oppose import protection if there is a possibility that the policy will induce retaliation by a trading partner.  10  See Tarr and Morkre (1984).  13  Thus, lobbying costs can mushroom to the level of potential benefits. Olson (1982) argues that these costs have limited the economic growth of nations. These findings are of concern to those mindful of the economic costs of trade policy. The resource costs in contesting trade policies may, in fact, dwarf the costs of the protection itself.11 Conclusion It is difficult to overestimate the advantages a country derives from international trade. Every person can enjoy the technological and geographical advantages that exist any other place in the world. A villager in India may listen to local broadcasts on a Sony radio running on batteries produced in Korea. Americans and Europeans enjoy their tea times and coffee breaks, using Indian tea or South American coffee. A world without international commerce would not be a pleasant one.  11  14  The case for free trade can be made not only in terms of basic economic principles, but also in terms of the experience of countries that have followed protectionist policies. Arguments for protection are contradicted by the evidence. Highwage countries not only compete with low-wage countries, they in fact dominate world trade. Trade deficits or surpluses simply reflect consumption and investment decisions over time: they are not inherently bad or good. Moreover, there is no evidence that imports cause systematic unemployment or that exports create systematic employment. Both arguments are based on the fundamental fallacy of composition that what is good or bad for one is good or bad for all. Highly protected economies tend to grow slower than open economies, and industrial policies designed to promote particular industries usually backfire. Protectionist policies feed interest groups rather than fuel economic growth.  See Hillman (1989) for a review of the literature on the costs of rent-seeking.  Federal Reserve Bank of Dallas  References Barro, Robert (1991), “Economic Growth in a Cross-Section of Countries,” Quarterly Journal of Economics 106 (May): 407–43.  Keynes, John M. (1936), The General Theory of Employment, Interest and Money (New York: Harcourt, Brace, and Co.).  Cohen, Linda R., and Roger G. Noll (1991), The Technology Pork Barrel (Washington, D.C.: The Brookings Institution).  Krugman, Paul (1987), The New Protectionist Threat to World Welfare, Dominick Salvatore, ed. (New York: Elsevier).  Cox, W. Michael, and Richard Alm (1993), “The Churn: The Paradox of Progress,” Federal Reserve Bank of Dallas 1992 Annual Report.  ——— (1986), “Introduction: New Thinking About Trade Policy,” in Paul Krugman, ed., Strategic Trade Policy and the New International Economics (Cambridge, Mass.: MIT Press).  De Long, J. Bradford, and Lawrence H. Summers (1991), “Equipment Investment and Economic Growth,” Quarterly Journal of Economics 106 (May): 445–502. Dollar, David (1992), “Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976 –1985,” Economic Development and Cultural Change 40 (April): 523–44. ———, and Edward N. Wolff (1993), Competitiveness, Convergence, and International Specialization (Cambridge, Mass.: MIT Press). Gould, David M., and Roy J. Ruffin (1993), “Human Capital, Trade, and Economic Growth,” Federal Reserve Bank of Dallas Research Paper no. 9301, January. ———, and Graeme L. Woodbridge (1993), “Retaliation, Liberalization, and Trade Wars: The Political Economy of Nonstrategic Trade Policy,” Federal Reserve Bank of Dallas Research Paper no. 9323, July. Grossman, Gene (1986), “Strategic Export Promotion: A Critique,” in Paul Krugman, ed., Strategic Trade Policy and the New International Economics (Cambridge, Mass.: MIT Press). Hillman, Arye L. (1989), The Political Economy of Protection (Chur, Switzerland: Harwood Academic Publishers).  Economic Review — Fourth Quarter 1993  Magee, Stephen, William Brock, and Leslie Young (1989), Black Hole Tariffs and Endogenous Policy Theory: Political Economy in General Equilibrium (New York: Cambridge University Press). Meltzer, Alan (1976), “Monetary and Other Explanations of the Start of the Great Depression,” Journal of Monetary Economics 2 (November): 455–71. Michaely, Michael, Demetris Papageorgiou, and Armeane M. Choksi, eds. (1991), Liberalizing Foreign Trade: Lessons of Experience in the Developing World, vol. 7 (Cambridge, Mass.: Basil Blackwell). Olson, Mancur (1982), The Rise and Decline of Nations (New Haven, Conn.: Yale University Press). Quibria, M. A. (1989), “Neoclassical Political Economy: An Application to Trade Policies,” Journal of Economic Surveys , Issue 2, 107–36. Roubini, Nouriel, and Xavier Sala-i-Martin (1991), “Financial Development, the Trade Regime, and Economic Growth,” NBER Working Paper Series, no. 3876 (Cambridge, Mass.: National Bureau of Economic Research, October). Summers, Robert, and Alan Heston (1991), “The Penn World Table (Mark 5): An Expanded Set  15  of International Comparisons, 1950–1988,” Quarterly Journal of Economics 106 (May): 327–68. Tarr, David, and Morris Morkre (1984), Aggregate Costs to the United States of Tariffs and Quotas and Imports (Washington, D.C.: Federal Trade Commission. Wynne, Mark A. (1992), “The Comparative Growth Performance of the U.S. Economy in the Postwar Period,” Federal Reserve Bank of Dallas Economic Review, First Quarter, 1–16.  16  Federal Reserve Bank of Dallas  Evan F. Koenig Senior Economist and Policy Advisor Federal Reserve Bank of Dallas  Rethinking the IS in IS–LM: Adapting Keynesian Tools to Non-Keynesian Economies Part 2  O  nce the generally accepted framework within which to discuss macroeconomic policy and the centerpiece of every intermediate macro textbook, IS–LM analysis has become a source of controversy within the economics profession. Critics point to its ad hoc behavioral assumptions — especially its neglect of expectations — as reasons for abandoning the IS–LM framework altogether (King 1993). Simple real-business-cycle models, such as that popularized by Barro (1990), are seen as better approximations to reality. On the other hand, supporters of the IS–LM analysis stress the importance of working within a framework that does not impose continuous market clearing a priori (Tobin 1993). This article shows how forward-looking expectations can be incorporated into IS–LM analysis. Thus, the article provides a compromise alternative to existing models for those who are uncomfortable with the myopia of traditional Keynesian analysis but hesitate to impose the continuous market clearing of real-business-cycle theory. Of course, not everyone believes that forward-looking behavior is realistic. For such people, this article offers insight into which of the traditional Keynesian results flow directly from sluggish price adjustment and which involve myopia in an essential way. Similarly, for economists to whom sluggish price adjustment is anathema, this article provides a means for communicating with those who hold contrary views. This article does not pass judgment on existing macroeconomic models nor break new theoretical ground. Instead, the article tries to narrow the gap between the two macroeconomic paradigms that dominate both today’s textbooks and today’s Economic Review — Fourth Quarter 1993  policy debates by showing that a graphical framework taken from one of these paradigms is consistent with models drawn from the other. Overview Part 1 of this article shows how forwardlooking expectations can be incorporated into IS–LM analysis of an economy without capital investment.1 Practically speaking, forward-looking expectations imply that current consumption demand is a function of expected future consumption, as a proxy for permanent income, rather than a function of current income. Part 2 extends the analysis to the case in which current savings decisions have a nontrivial effect on future consumption opportunities. This extension introduces a new simultaneity into the analysis: current consumption depends on expected future consumption, which depends on current saving (the difference between current income and current consumption). The real interest rate adjusts to ensure that, in the aggregate, households’ savings decisions are consistent with their consumption expectations. Our goal here  Stephen P. A. Brown, Zsolt Becsi, Scott Freeman, and Mark A. Wynne offered valuable comments and advice. The views expressed are not necessarily those of the Federal Reserve Bank of Dallas or the Federal Reserve System. 1  See “Rethinking the IS in IS–LM: Adapting Keynesian Tools to Non-Keynesian Economies,” pt. 1, Federal Reserve Bank of Dallas Economic Review, Third Quarter 1993.  17  is to capture, in a simple set of graphs, the forces that determine consumption and interest rates. The analysis begins with a discussion of consumption and interest rate determination in a simple, Barro-style market-clearing economy. Because investment demand is interest-sensitive, the level of consumption that is consistent with the clearing of labor and output markets is not independent of the real return on bonds. Even in a market-clearing economy, consequently, the IS schedule—which represents combinations of output and the real rate of return that clear the credit market—plays an essential role in determining the equilibrium level of consumption. Because the position of the IS schedule depends on household expectations, so too does equilibrium consumption. The article demonstrates how, in a marketclearing economy, capital investment allows households as a group to smooth consumption through time. No longer is the impact of a temporary increase in government spending entirely absorbed through reductions in contemporaneous leisure and contemporaneous consumption. Instead, the impact of temporarily increased government purchases is absorbed partly through reductions in future leisure and future consumption and— insofar as the increased government spending is anticipated—partly through reductions in past leisure and past consumption. That is, investment in the periods preceding the heightened government spending is increased, and investment in the periods of the heightened government spending is reduced. Next, the possibility that price adjustment is less than immediate is considered. As in Part 1 of the article, we assume that prices take (at most) one period to respond to economic shocks. Thus, regardless of whether or not prices adjust fully in the current period, people expect all markets to clear next period, absent new disturbances. The optimality conditions that determine the levels of output and interest rates in the period during which price adjustment is incomplete are a subset of the conditions that determine equilibrium in a market-clearing economy. They can be summarized, graphically, as IS and LM schedules. We find that the chief effect of introducing capital investment is a flattening of the IS schedule, so that changes in monetary policy have a larger impact on current 18  output and consumption than before while anticipated future supply shocks have a smaller impact than before. It remains the case that current supply shocks—including shocks to current government purchases—have no effects at all on current consumption, current investment, or the real interest rate. Possible modifications and extensions of the analysis are discussed in the final section of the article. Investment in a market-clearing economy Before analyzing a simple two-period model with investment, we review equilibrium consumption and interest rate determination in an economy with a fixed capital stock. In an economy with a fixed capital stock, the level of consumption that is consistent with clearing of the labor and output markets is completely independent of the real interest rate. This independence breaks down once capital investment is introduced into the economy. Intuitively, an increase in the real interest rate reduces investment demand, raising the amount of output available to consumers at any given quantity of leisure. A review of the no-investment case. The marketclearing model developed in Part 1 of this article is characterized by four optimality conditions and three identities: (1)  MRSl c = w;  (2)  MPn = w;  (3)  n = L – l;  (4)  y = c + g;  (5)  MRScc僓 = r ;  (6)  MRSm c = (R – 1)/R ;  (7)  R = rP僓/P.  Equation 1 is the optimality condition that determines the supply of labor. It says that in equilibrium the marginal rate of substitution between leisure and consumption (MRSl c , where l and c denote leisure and consumption, respectively) Federal Reserve Bank of Dallas  equals the real wage rate (w). Equation 2 is the optimality condition that determines the demand for labor. It says that in equilibrium the marginal product of labor (MPn , where n denotes hours of labor) equals the real wage. Equation 3 says that hours worked by the representative household equal total hours (L ) less hours of leisure. Equation 4 says that output (y) is divided between consumption and government purchases (g). Government purchases, financed with lump-sum (nondistortionary) taxes, are assumed to have no direct effect on household preferences for consumption, leisure, or real money balances and, also, to have no direct effect on the production technology. Equation 5 is an intertemporal optimality condition. It says that in equilibrium the marginal rate of substitution between current consumption and future consumption (MRScc僓 , where c僓 denotes future consumption) equals the gross real rate of return on bonds (r ). Equation 6 is the optimality condition that determines the demand for money. It says that in equilibrium the marginal rate of substitution between real money balances and consumption (MRSmc , where m denotes real money balances) equals the real opportunity cost of holding money, which is the nominal interest rate (R – 1) divided by the gross nominal rate of return on bonds (R). Equation 7 is the identity that relates the nominal return on bonds to the real rate of return, next period’s price level (P僓 ), and the current price level (P). In addition, in Part 1 of this article, we assume that output and employment are related to one another by a production function of the form  Figure 1  Market-Clearing Equilibrium in an Economy Without Capital Investment Consumption  Slope = –w e  L ge  le  Leisure  from equations 3 and 4 into equation 8, yielding a leisure–consumption opportunity locus that has equation c = θf (L – l ) – g. Equilibrium occurs at the point where the indifference curve is tangent to the opportunity locus. Note that none of the equations that determine the equilibrium level of consumption depend on the real rate of return on bonds in any way.2 Making investment endogenous. How is the analysis above affected by the introduction of capital investment? First, equation 4 is replaced by (4′ )  (8)  E  ce  y = c + i + g,  y = θf (n),  where θ is a multiplicative technology shock. Equations 1, 2, 3, 4, and 8 are, by themselves, sufficient to determine the equilibrium levels of output, consumption, employment, leisure, and the real wage, given current government purchases and the current value of the technology parameter, θ. A graphical representation of the economy’s equilibrium is given in Figure 4 of Part 1 of this article and is reproduced as Figure 1 here. The convex curve in the middle of the figure is an indifference curve of the representative household, while the concave curve in the lower left corner of the figure is obtained by substituting Economic Review — Fourth Quarter 1993  where i is the amount of investment undertaken in the current period. Second, equation 8 is replaced by y = θf (n) + σh (k),  (8′ )  2  The implicit assumption here is that the marginal rate of substitution between leisure and consumption is independent of both real money balances and future consumption.  19  where k is the current-period capital stock and where changes in σ represent shocks to the productivity of capital.3 We also have k僓 = (1 – δ )k + i,  (9)  where k僓 denotes the amount of capital that will be available next period and where δ denotes the rate at which capital depreciates. The representative firm will find it profitable to invest as long as the rate of return available on investment projects exceeds the cost of financing the projects. Formally, the profit-maximizing condition is MPk僓 + 1 – δ = r,  (10)  where MPk僓 denotes the marginal product of next period’s capital stock. Intuitively, the marginal unit of capital investment is expected to produce MPk僓 units of additional output next period and has a scrap value equal to 1 – δ. Thus, the left-hand side of equation 10 represents the expected marginal return to new capital investment. The right-hand side of the equation represents the return that firms must offer households to attract financing for capital investment. Assuming that the marginal product of capital is decreasing in the quantity of capital, equation 10 implies that the quantity of capital demanded is decreasing in the real rate of return on bonds. In Figure 2, an increase in the real rate of return from r to r ′ causes the quantity of capital to fall from k僓 to k僓 ′. Of course, the lower is the amount of capital demanded, the lower is current investment for any given current stock of capital (equation 9). A decline in current investment affects the currentperiod leisure–consumption opportunity locus of  20  3  The function h(•) is assumed to have a positive first derivative and a nonpositive second derivative. The assumption that the production function is additively separable between labor and capital, while not essential, substantially simplifies graphical analysis of the economy.  4  Formally, the equation of the leisure–consumption opportunity locus is now c = θf(L – l) + σ h(k) – i – g.  Figure 2  The Demand for Capital  The demand for capital is decreasing in the real rate of return on bonds. Rate of return MPk + 1 – δ  r′  r  k′  k  Future capital  the representative household in exactly the same way as a decline in government purchases: it shifts the opportunity locus upward, over its entire length, by a constant amount.4 Provided leisure and consumption are normal goods, the representative household will want more of both. In Figure 3, a decline in investment from i to i′ moves the economy from E to E′, raising both equilibrium consumption and equilibrium leisure. Because the representative household is less willing to work than before, the real wage must rise. Because hours of work decline, so does output: consumption rises by less than investment falls. In summary, an increase in the real rate of return on bonds tends to reduce investment, freeing resources for current use. The representative household responds by increasing consumption. This positive relationship between the real rate of return on bonds and current consumption is plotted in Figure 4 and labeled “CS.” The less sensitive is investment demand to changes in the real rate of return on bonds, the steeper is the CS schedule. In the absence of capital investment, the CS schedule is vertical. Increases in the current productivity of labor and capital (increases in θ and σ ) tend to raise the amount of consumption consistent with the clearFederal Reserve Bank of Dallas  ing of the labor and output markets, shifting the CS schedule to the right. A decrease in current government purchases also results in a rightward shift in the CS schedule.5 On the other hand, an anticipated increase in the future productivity of capital (an increase in σ 僓 ) will tend to raise current investment, reducing the amount of consumption consistent with the clearing of the labor and output markets and shifting the CS schedule to the left.6 Changes in future government purchases and in the future productivity of labor have no effect on the CS schedule. In summary, we have seen that the quantity of goods available to households for current consumption is an increasing function of the real rate of return on bonds, the current productivity of labor, and the current productivity of capital. It is a decreasing function of current government purchases and the expected future productivity of capital. Formally,  Figure 4  The CS Schedule  In a market-clearing economy, the amount of output available to consumers is increasing in the real rate of return. Rate of return  CS  Consumption  c = c (r, θ, σ, g, σ 僓 ). + + + – – S  (11)  Deriving the IS curve. We have seen that an increase in the real return on bonds, because it induces a decline in investment, tends to free  Figure 3  Effects of Decreased Investment  Leisure and consumption both increase in response to a decline in current investment. Consumption  resources for current consumption while reducing the amount of output available for consumption in the future. At the same time, according to equation 5, an increase in the real return on bonds tends to raise households’ incentive to save—that is, to defer consumption. Full market-clearing equilibrium requires that the real return on bonds adjust until these two opposing tendencies balance. The tendency for current consumption to rise with increases in r we have captured in the CS schedule. The tendency for current consumption to fall with increases in r can be captured in a schedule that is the natural counterpart, in an economy with forward-looking households, to the Keynesian IS  i – i′  E′ 5  Because a decrease in government purchases will also lead to an increase in leisure (leisure being a normal good), the rightward shift in the CS schedule must be smaller than the decrease in g.  6  Because the impact of the higher investment will be absorbed partly through a decrease in leisure, the leftward shift in the CS schedule will be smaller than the increase in i.  E  Leisure  Economic Review — Fourth Quarter 1993  21  curve. Figure 5 illustrates the construction of this expectations-augmented IS curve in an economy with capital investment. The upper left quadrant of Figure 5 displays three MRScc僓 schedules, each corresponding to a different level of future consumption. (For convenience, the diagram assumes that the marginal rate of substitution depends only on the ratio of future consumption to current consumption. When current consumption and future consumption are equal, the marginal rate of substitution is ρ.) In an economy without capital investment, it is a marginal-rate-of-substitution schedule like one of those displayed in this quadrant that serves as the IS curve. With capital investment, however, the level of consumption next period is not independent of the real rate of return on bonds, complicating the construction of the IS curve. The three remaining quadrants of Figure 5 capture the links between future consumption and the real rate of return. The upper right quadrant of Figure 5, replicating Figure 2, contains a plot of the marginal return on capital, net of depreciation, as a function of next period’s capital stock. From equation 10, we know that for any given real rate of return on bonds, the schedule for the net marginal product of capital gives the optimal level of capital. The real return r0 corresponds to a capital stock of k僓 0, the real return r1 corresponds to a capital stock of k僓 1, and so on. For each future capital stock, the lower right quadrant of Figure 5 gives the corresponding level of future consumption. From the perspective of next period, an increase in 僓 k represents an unambiguous increase in household wealth.7 As such, a higher k僓 tends to raise the level of consumption  7  8  22  A one-unit increase in k僓 shifts next period’s leisure–consumption opportunity locus upward, along its entire length, by the amount MPk僓 + 1 – δ. Some empirical estimates suggest that the timing of consumption (as measured by the ratio of future consumption to current consumption) is largely insensitive to changes in the real interest rate (Hall 1988). However, to the extent that investment responds to interest rate changes, the analysis here demonstrates that current consumption demand may, nevertheless, have a significant interest elasticity.  next period, c僓. We will call the plot of this positive relationship the KC schedule. Finally, the lower left quadrant of Figure 5 contains a 45-degree line. According to Figure 5, at real rate of return r0 (< ρ), firms desire capital stock k僓 0, which is associated with future consumption c僓0. But if consumption next period is expected to be c僓0 and the real rate of return on bonds is r0, then households will demand c0 (> c僓0 ) units of consumption today. Similarly, at real rate of return r1 (= ρ), consumption next period will be c僓1, and households will demand c1 (= c僓1) units of consumption today. At rate of return r2 (> ρ), consumption next period will be c僓2, and households will demand c2 (< c僓2 ) units of consumption today. In general, corresponding to each real rate of return is a unique level of current consumption that is consistent with the optimal intertemporal allocation of output. As the real rate of return rises, the optimal level of current consumption falls. The locus of all these points constitutes the IS curve. That the IS curve is now flatter than any of the MRScc僓 schedules reflects that in an economy with capital investment, future consumption falls as the real rate of return on bonds rises. That the introduction of investment into an economy tends to flatten the IS schedule is a standard result in Keynesian macroeconomic theory. The usual story is that a given reduction in the real return on bonds now stimulates both an increase in consumption demand and an increase in investment demand, rather than an increase in consumption demand alone. However, the IS curve in Figure 5 is a plot in c × r space, not y × r space; so, finding that the IS schedule in this figure is flatter than before means that introducing investment has increased not just the interest sensitivity of the demand for output but also the interest sensitivity of the demand for consumption.8 Changes in current-period government purchases have no effect whatever on the schedules plotted in Figure 5. Consequently, these changes have no effect on the IS schedule. On the other hand, an anticipated decline in next period’s government purchases will raise the amount of consumption available next period at each level of k僓 . In Figure 5, the KC schedule plotted in the lower right quadrant will shift upward, forcing the IS schedule to shift to the right. See Figure 6. Federal Reserve Bank of Dallas  Figure 5  Construction of the IS Curve in an Economy with Capital Investment r  r  r2  r1 = ρ  IS MRS ⏐c2  MRS ⏐c1  r0  c2  MRS ⏐c0  c1  MPk + 1 – δ  c0  k2  k1  k0  c c  k c  KC c0  c1  c2  45° c  Because the effect next period of the lower government spending will be absorbed partly through an increase in leisure (much as, in Figure 3, the impact of reduced current investment is absorbed partly through an increase in current leisure), c僓 rises less than one for one in response to the decrease in g僓. It follows that the IS schedule shifts to the right by an amount that is smaller than the decrease in g僓. Like changes in current government purchases, current-period technology shocks have absolutely no effect on Figure 5 and, hence, no effect on the Economic Review — Fourth Quarter 1993  k  position of the IS curve. Anticipated changes in future technology are a different matter altogether. Anticipated increases in the future productivity of labor (anticipated increases in 僓 θ ) raise the level of future consumption available at each level of k僓 and, so, shift the IS schedule to the right. (Again, see Figure 6.) In the case of a positive shock to the future productivity of capital (an increase in σ僓 ), the rightward shift in the IS schedule is reinforced by an upward shift in the marginal-productivityof-investment schedule (Figure 7 ). 23  Figure 6  Anticipated Future Supply Shocks and the IS Schedule  A decline in future government purchases or an increase in the future productivity of labor shifts the IS schedule to the right. r  r IS  IS′  ρ  MPk + 1 – δ  c c  k c  KC′  KC  45°  c  In summary, the quantity of goods that households wish to purchase today is a decreasing function of the real rate of return on bonds and of expected future government purchases and is an increasing function of the expected future productivities of labor and capital. Formally, (12)  24  c = c D (r, g僓, θ 僓, σ僓 ). – – + +  k  Comparative statics. Equilibrium is achieved where the IS and CS curves intersect (point E in Figure 8). It is at this point—and only at this point—that the labor, output, and bond markets simultaneously clear. Shocks to the economy fall into three broad categories: monetary shocks, current supply shocks, and anticipated future supply shocks. Monetary shocks include changes in the current money Federal Reserve Bank of Dallas  Figure 7  Anticipated Future Capital-Productivity Shocks and the IS Schedule  An increase in the future productivity of capital shifts the IS schedule to the right. r  r IS′ IS  ρ  MP′k + 1 – δ  MPk + 1 – δ  c c  k c  KC′  KC  45°  c  supply (M ) and changes in the future price level (P僓 ).9 Current supply shocks include current-period shifts in the productivity of capital and labor (changes in σ and θ ). From the perspective of households, changes in current government purchases (g ) are supply shocks too: an increase in government purchases shifts the leisure–consumption opportunity set of the representative household downward by the amount of the increase in g.10 Anticipated Economic Review — Fourth Quarter 1993  k  9  Here, as in Part 1, the long-run price level is treated as a policy variable selected by the monetary authority.  10  See Abel and Blanchard (1983) for further discussion of the equivalence between fiscal-policy shocks and supply-side shocks.  25  Figure 8  Market-Clearing Equilibrium in an Economy with Capital Investment Rate of return  CS  re  E  IS c  e  Consumption  future supply shocks include anticipated changes in the future productivity of labor (changes in θ 僓) and anticipated changes in future government spending (g僓 ). Anticipated changes in the productivity of capital (changes in σ僓 ) act as both current and future supply shocks. A rise in the future productivity of capital increases the amount of output available for consumption next period but also tends to stimulate current investment, reducing the amount of output available for consumption today. Monetary shocks have no effect on the CS and IS schedules and, hence, no effect on the equilibrium levels of consumption, the real rate of return on bonds, output, hours of work, or the real wage. By equations 6 and 7, monetary shocks affect only the nominal rate of return on bonds and the current price level. Current supply shocks affect the CS schedule but not the IS schedule. Positive shocks to the current productivity of capital and labor and declines in current government purchases all tend to raise the amount of output available for current consumption, shifting the CS schedule to the right. Consequently, the real rate of return on bonds falls, and consumption rises. (In Figure 9, the equilibrium moves from point E to point E′.) The decline in the real return on bonds leads to an increase in investment. Thus, society transfers 26  some of the increase in its current-period real opportunities into the future. Anticipated future supply shocks affect the IS schedule but not the CS schedule. Anticipated positive shocks to the future productivity of labor and anticipated declines in future government purchases tend to increase future consumption at every given future capital stock, shifting the IS schedule to the right. The resultant increase in the real rate of return on bonds lowers current investment, freeing output for current consumption. (In Figure 10, the equilibrium moves from point E to point E′.) Thus, society transfers some of the increase in its future real opportunities into the present. Because current leisure is a normal good, it responds positively to the increase in household wealth. Consequently, current output must fall. Like any other future supply shock, an anticipated increase in the future productivity of capital shifts the IS schedule to the right. Unlike other future supply shocks, an anticipated increase in the future productivity of capital has a direct positive impact on current investment demand and, so, has a direct negative impact on the amount of  Figure 9  Effects of a Positive Current Supply Shock in a Market-Clearing Economy  Positive current supply shocks shift the CS curve to the right, increasing equilibrium consumption and lowering the equilibrium real rate of return. Rate of return CS CS′  E  E′  IS  Consumption  Federal Reserve Bank of Dallas  Figure 10  Effects of a Positive Anticipated Future Supply Shock in a Market-Clearing Economy  A decline in future government purchases or an increase in the future productivity of labor raises equilibrium consumption and the real rate of return. Rate of return  CS  E′  E  IS′ IS Consumption  tion with a one-period lag. As is traditional in Keynesian analysis, we assume that output is demand-determined over the interval during which the output market fails to clear. The interest rate adjusts instantaneously to maintain equilibrium in the markets for credit and money. Graphically, equilibrium is achieved at the intersection of the IS and LM curves. Results are little different from those obtained for an economy without investment. An exception is that positive anticipated future supply shocks may easily have a contractionary short-run effect in an economy with investment. Also, the fact that the IS curve is more elastic in an economy with investment than in an economy without investment means that monetary shocks have a larger short-run impact on consumption than before, while anticipated future supply shocks have a smaller short-run impact on consumption than before. The LM curve. As in Part 1 of this article, the LM curve is obtained by combining equations 6 and 7 to obtain (6′ )  current output available to consumers. In this respect, an anticipated increase in the future productivity of capital acts like an adverse current supply shock, shifting the CS schedule to the left. The leftward shift in the CS schedule combines with the rightward shift in the IS schedule to drive the real return on bonds sharply higher. (See Figure 11.) The net impact on current consumption—and, hence, current investment as well—is ambiguous. Current consumption tends to rise because the increase in the real return on bonds moves firms back along their investment demand schedules, putting downward pressure on current investment. Current consumption tends to fall because firms’ investment demand schedules shift upward in direct response to the productivity shock, tending to stimulate current investment. Current leisure moves in the same direction as current consumption. Current output moves opposite to current leisure.  MRSmc = 1 – P/(rP僓 ).  Figure 11  Effects of an Anticipated Rise in the Productivity of Capital in a Market-Clearing Economy  An increase in the future productivity of capital raises the equilibrium real rate of return and has an ambiguous effect on consumption. Rate of return  CS′  E′  CS  E  IS′  Investment and expectations-augmented IS –LM analysis We turn now to a thought experiment in which the price level responds to new informaEconomic Review — Fourth Quarter 1993  IS Consumption  27  Because the marginal rate of substitution between real money balances and consumption is decreasing in real balances and increasing in consumption, equation 6′ implies that there is a positive relationship between consumption and the real return on bonds for given values of the current money supply, the current price level, and the monetary authority’s long-run price level target. This positive relationship is the LM schedule. Comparative statics. Much as in an economy without investment, increases in the current money supply or in the monetary authority’s long-run price level target shift the LM curve to the right, driving down the real rate of return on bonds and stimulating consumer demand. However, consumption now rises not only because the fall in the real rate of return induces households to increase current consumption relative to future consumption but also because a lower real rate of return on bonds leads to higher investment and, hence, higher future consumption. Figure 12 compares the impact of expansionary monetary policy on an economy with lagged price adjustment with the impact of expansionary monetary policy on an otherwise identical economy in which price adjustment is instantaneous. In the latter economy, the current price level rises—instantaneously—by enough to keep the LM curve in its original position, so that the IS–LM and IS–CS intersections remain coincident at point E. In the former economy, equilibrium moves from E to E″ in response to the policy shift. The real rate of return falls, and consumption rises. Thus, to the extent that short-run price adjustment is incomplete, the economy is overly responsive to changes in monetary policy. In contrast, an economy with incomplete short-run price adjustment is insufficiently responsive to current-period supply shocks. In Figure 13, when the price level is fixed, neither the IS curve nor the LM curve moves in response to a cut in current-period government spending, an increase in the current-period productivity of capital, or an  11  28  To avoid undue complexity, this shift in the LM schedule is not illustrated in Figure 13.  Figure 12  Comparative Effects of Expansionary Monetary Policy  If the price level fails to adjust fully, expansionary monetary policy will increase consumption relative to its market-clearing level and will lower the real rate of return relative to its marketclearing level. Rate of return  CS LM LM′  E′ = E  E′′  IS  Consumption  increase in the current-period productivity of labor. Thus, the economy remains at its initial equilibrium, point E, after any of these shocks. The market-clearing equilibrium shifts to E′, however, at the intersection of the IS schedule and the new CS schedule. At E′, consumption is higher than originally, and the return on bonds is lower than originally. To eliminate what would otherwise be an excess demand for real money balances, the price level will fall (instantaneously), shifting the LM curve to the right until it intersects the IS curve at E′.11 Whether an economy with incomplete shortrun price adjustment is overly sensitive or insufficiently sensitive to anticipated future shocks to the productivity of labor and anticipated future changes in government purchases depends on whether the LM curve is flatter or steeper than the CS curve. Whether the LM curve is flatter or steeper than the CS curve depends, in turn, on the relative interest sensitivities of the demand for money and the demand for capital. Both an anticipated cut in future government purchases and an anticipated increase in the future productivity of labor shift Federal Reserve Bank of Dallas  the IS schedule to the right, without affecting the LM and CS schedules. If the LM and CS schedules happen to have the same slope, no price adjustment is required for the economy to remain in full market-clearing equilibrium. The new marketclearing equilibrium, point E′, and the new stickyprice equilibrium, point E″, coincide. On the other hand, if the LM schedule is flatter than the CS schedule—as will certainly be the case in an economy without investment—then some increase in the price level is required if consumption is not to overshoot its market-clearing equilibrium level. Figure 14 illustrates both the case in which the LM schedule is flatter than the CS schedule and the case in which the LM schedule is steeper than the CS schedule. Two additional observations are appropriate before we consider the impact of prospective shocks to the productivity of capital. First, recall that the IS schedule is flatter in an economy with investment than in an economy without investment. It follows that anticipated changes in the future productivity of labor and in the future level  Figure 14  Comparative Effects of a Positive Anticipated Future Supply Shock  Depending on the steepness of the LM curve relative to the CS curve, consumption and the real rate of return may be insufficiently responsive to future supply shocks or overly sensitive to future supply shocks when the price level is sticky. Rate of return  LMsteep  CS  LMflat  E′′ E′ E′′ E  IS′ IS Consumption  Figure 13  Comparative Effects of a Positive Current Supply Shock  If the price level fails to adjust fully, a positive current-period supply shock will leave consumption below its new market-clearing level and will leave the real rate of return above its new market-clearing level. Rate of return  CS  LM CS′  E′′ = E  E′  IS  Consumption  Economic Review — Fourth Quarter 1993  of government purchases will have a smaller effect on equilibrium consumption in a sticky-price economy with investment than in a sticky-price economy without investment. Second, note that in a sticky-price economy with investment, unlike in one without investment, there is the possibility that a prospective positive supply shock will actually be contractionary in the short run. Although current-period consumption unambiguously rises in response to a prospective positive supply shock, so too does the real return on bonds. If the LM curve is sufficiently steep, the increase in the real return on bonds may have such a large negative impact on investment that the overall demand for output declines. Thus, an announcement of, say, military spending cuts may have an adverse impact on today’s economy, even if the cuts are not scheduled to occur for some time. Consider, finally, the effects of an anticipated future increase in the productivity of capital. In a market-clearing economy, we know that the IS curve shifts to the right, but the CS curve shifts 29  to the left (Figure 11 ). If the price of output fails to adjust in the short run, the same rightward shift takes place in the IS schedule, but the LM curve remains fixed. One cannot say, in general, whether the new equilibrium level of consumption in the sticky-price economy will be above or below the equilibrium level of consumption in the marketclearing economy. Clearly, though, consumption in the sticky-price economy is more likely to be overly sensitive to an anticipated future increase in the productivity of capital than to anticipated future shocks to government purchases or the productivity of labor. Figure 15 illustrates the special case in which the LM and CS schedules have the same slope. Equilibrium moves from E to E′ in the market-clearing economy and from E to E″ in the sticky-price economy.  Figure 15  Comparative Effects of an Anticipated Rise in the Productivity of Capital  Unless the LM curve is steeper than the CS curve, an increase in the future productivity of capital will have too large an effect on consumption and too small an effect on the real rate of return when the price level is sticky. Rate of return  CS′  CS, LM  E′  E′′  E  Summary and conclusion IS′  There is nothing in IS–LM analysis that an individual enamored of real-business-cycle theory ought to find objectionable in principle. The IS curve is simply the locus of points where the credit market clears. The LM curve is the locus of points where the demand for money equals the supply of money. As long as the credit and money markets clear, therefore, the equilibrium of the economy must correspond to an IS–LM intersection. Real-business-cycle models require, additionally, that the wage rate and price level adjust instantaneously to clear the markets for labor and output. (Graphically, the price level adjusts to ensure that the LM schedule crosses the IS schedule at the point where the IS and CS schedules intersect.) Thus, the real-business-cycle model can be thought of as a special case of the IS–LM model, obtained by imposing additional restrictions. If there is a problem with IS–LM analysis from a real-business-cycle perspective, it is the way in which IS–LM analysis has traditionally been implemented. Thus, in deriving the IS curve, macroeconomic textbooks have typically assumed that household consumption decisions are made according to myopic rules of thumb. In addition, in deriving the economy’s “long-run aggregate supply schedule,” traditional Keynesian analyses have ignored the effects of changes in wealth on the supply of labor. Both Part 1 and Part 2 of this article have worked through a version of IS–LM 30  IS Consumption  analysis in which the determinants of consumption and the supply of labor are consistent with real-business-cycle theory. The more fully prices adjust in this version of IS–LM analysis, the more closely its predictions conform to those of a standard real-business-cycle model. Even if prices adjust instantaneously to clear all markets, the optimality conditions that define the IS and LM schedules are no mere sideshow. This statement applies especially to an economy with capital investment, for in such an economy, the equilibrium level of output cannot be determined independently of the IS equation. Even in an economy without investment, the LM equation is needed to determine the price level, and the IS equation is needed to determine the real return on bonds. In comparing the predictions of our expectations-augmented IS–LM analysis with those of traditional IS–LM analysis, several broad similarities are evident. For example, both models yield substantially similar predictions regarding the impact of an increase in the money supply: insofar as prices fail to rise, interest rates will fall, stimulating Federal Reserve Bank of Dallas  consumption and investment. Both models also yield substantially similar predictions regarding the impact of current-period supply shocks: such shocks have no impact on real variables except to the extent that the shocks are accompanied by changes in the price of output. The traditional and expectations-augmented IS–LM analyses differ most substantially in their predictions regarding the impact of anticipated future supply shocks. Traditional analysis pays scant attention to such shocks, except future shocks to the marginal product of capital. In the traditional analysis, a positive shock to the marginal product of capital stimulates investment, drives output above its market-clearing level, and has an ambiguous effect on current consumption. According to the expectations-augmented IS–LM model developed here, on the other hand, it is the response of investment to a capital productivity shock that is ambiguous, and it is the response of consumption that is clearly positive. Furthermore, output need not be driven above its market-clearing level. More generally, any shock that tends to increase expected future consumption also has a positive impact on current consumption in the expectations-augmented IS–LM model. The simple version of the consumption-based capital asset pricing model (CCAPM) that is the basis for the IS curve in expectations-augmented IS–LM analysis is rejected in most empirical tests. However, relatively minor modifications to the CCAPM are sufficient to achieve congruence with the data. One approach is to relax the assumption that consumption and real money balances are additively separable in the household utility function (Koenig 1990b). Another approach is to assume that some fraction, λ, of households consume myopically (Campbell and Mankiw 1989).  The larger is this fraction, the more the economy behaves as predicted by the traditional IS–LM model. (See the Appendix to Part 1 of this article.) Most empirical estimates indicate that a substantial fraction of households are forward-looking (Hall and Mishkin 1982; Jappelli 1990). An interesting extension of the current model is a version in which price adjustment occurs gradually, over several periods, rather than all at once. If, in an otherwise conventional IS–LM model, households have forward-looking inflation expectations, increased price flexibility is potentially destabilizing (De Long and Summers 1986) —a result that is very much in the Keynesian tradition (Tobin 1993). However, Koenig (1990a) has shown that the potentially destabilizing effects of price flexibility are unlikely to be a concern if households are forward-looking when making their consumption decisions. Another interesting extension of the current model would allow capital investment to become productive before the price of output has a chance to adjust fully to its market-clearing level. In such a model, the demand for capital is driven, partly, by expectations of future sales. This “accelerator” model of investment can have bizarre implications if combined with forward-looking consumption behavior (Koenig 1989; King 1993). To say that the expectations-augmented IS– LM model includes a standard real-business-cycle model as a special case is certainly not to claim that the augmented IS–LM model encompasses all—or even the most promising—alternatives to Keynesian orthodoxy.12 Nevertheless, insofar as expectations-augmented IS–LM analysis helps close the gap that currently separates the Keynesian and real-business-cycle paradigms, it provides a valuable service.  12  Economic Review — Fourth Quarter 1993  For an overview of some of the new alternatives to the Keynesian and real-business-cycle paradigms, see Romer (1993).  31  Appendix Derivation of the Comparative Statics Results for a Market-Clearing Economy Exogenous investment  Next, we differentiate equations 4′ and 8′:  Suppose that the household utility function is additively separable across time and, also, between real money balances and other household utility arguments. Then equations 1, 2, 3, 4′, and 8′ can be solved for the marketclearing level of consumption (as well as the market-clearing levels of output, employment, leisure, and the real wage) as a function of government purchases, investment, the initial capital stock, and the technology-shift parameters, θ and σ. We begin with the labor market. Combine equations 1 and 3, then differentiate, to obtain a linearized labor supply schedule:  (A.1)  dw = f ′dθ + θf ′′dn,  where f ′ > 0 and f ″ < 0. Solving A.1 and A.2 for equilibrium hours of work, we obtain  (A.3)  dn = (f ′dθ − µc dc ) /(−θf ′′ − µ l ).  In words, equilibrium hours of work are increasing in the labor-productivity-shift parameter, θ, and decreasing in equilibrium consumption, which proxies for wealth.  32  dy = dc + d ( g + i )  and  (A.5) dy = fdθ + hdσ + θf ′dn + σh ′dk . Finally, substitute from A.3 into A.5, and then solve A.4 and A.5 for equilibrium consumption: (A.6)  dw = µc dc − µl dn,  where µc ≡ ∂MRSlc /∂c > 0 and µl ≡ ∂MRSlc /∂l < 0. Similarly, equations 2 and 8′ yield a labor demand schedule:  (A.2)  (A.4)  ⎡ θ (f ′ )2 − f (θf ′′ + µl ) ⎤ dc = ⎢ ⎥d θ D ⎣ ⎦ θ f + µ ⎛ ′′ l⎞ [hdσ + σh ′dk − ⎝ D ⎠ − d (g + i )],  where D ≡ θf ′µc – (θf ″ + µl ) > 0. Thus,  (A.7)  c = ψ (θ, σ ,k, g + i ),  where ψθ > 0, ψσ > 0, ψk > 0, and –1 < ψg +i < 0. Similarly,  (A.7 ′)  c = ψ (θ ,σ ,k ,g + i ),  where a bar over a variable indicates that it is evaluated in period 2. In Part 1 of this article, we assume that dσ = dk = di = d σ 僓 = dk僓 僓 = d i = 0. (Continued on the next page)  Federal Reserve Bank of Dallas  Appendix Derivation of the Comparative Statics Results for a Market-Clearing Economy— Continued Endogenous investment: the CS and IS schedules By using equations 8′, 9, and 10, the demand for capital and the demand for investment can be written as decreasing functions of the productivity-adjusted cost of capital:  (A.8)  k = ξ⎛ ⎝  r + δ − 1⎞ σ ⎠  and (A.9)  i = ξ⎛ ⎝  r + δ −1⎞ − (1− δ )k , ⎠ σ  where ξ(•) is the inverse of h′(•), so that ξ ′(•) < 0. The CS schedule is obtained by substituting from A.9 into A.7: ⎡ ⎤ ⎛ r + δ − 1⎞ − (1− (A.10) c = ψ ⎢θ , σ,k ,g + ξ δ )k⎥ . ⎝ ⎠ σ ⎣ ⎦  It follows that the CS schedule is upward sloping when plotted in c × r space. The schedule shifts to the right in response to increases in θ, σ, and k, and it shifts to the left in response to increases in σ 僓 and g. In a two-period economy, i僓 = –(1 – δ )k僓. More generally, i僓 = ι(k僓 ), with ι′(•) < 0. Hence, c僓 = ψ [θ僓,σ 僓,k僓,g僓 + ι(k僓)] or, using A.8 to elimi僓 nate k ,  Economic Review — Fourth Quarter 1993  (A.11)  ⎧ r + δ − 1⎞ c = ψ ⎨θ , σ , ξ ⎛ ,g ⎝ σ ⎠ ⎩ ⎡ r + δ −1⎞⎤⎫ + ι ⎢ξ ⎛ ⎥ ⎬. ⎣ ⎝ σ ⎠⎦⎭  It follows that c僓 is decreasing in the real rate of return on bonds, r. If household preferences are homothetic in current and future consumption, equation 5 can be written in the form c = c僓φ (r ), where φ ′(•) < 0. Then, by using A.11 to eliminate c僓, the equation of the IS curve is (A.12)  ⎧ r + δ − 1⎞ c = φ (r )ψ ⎨θ , σ , ξ ⎛ ,g ⎝ ⎠ σ ⎩ ⎡ r + δ −1⎞⎤⎫ + ι ⎢ξ ⎛ ⎥ ⎬. ⎣ ⎝ σ ⎠⎦⎭  The demand for current consumption is decreasing in the real rate of return, not only because an increase in the rate of return induces substitution away from current consumption toward future consumption but also because an increase in the rate of return depresses capital accumulation, leading to a decline in future consumption. The IS schedule shifts to the right in response to increases (Continued on the next page)  33  Appendix Derivation of the Comparative Statics Results for a Market-Clearing Economy— Continued in θ僓 and σ 僓 and to the left in response to increases in g僓.  equating A.10 and A.12. This calculation yields  (A.15)  dr = (∆IS − ∆CS )/( ΣCS − ΣIS )  Comparative statics and The horizontal shift in the CS schedule, which will be denoted ∆CS, is found by differentiating equation A.10:  where  (A.13) ∆CS = ψθ dθ + ψσ dσ + [ψk − (1− δ )ψg + i ]dk + ψg + i dg − ψg + i  ⎛ r + δ − 1⎞ ⎛ ξ′ ⎞ dσ. ⎝ ⎠ ⎝σ⎠ σ  This shift can be interpreted as a current僓 shift period supply shock. Even changes in σ the CS schedule only insofar as they affect the quantity of output drawn away from consumption into investment. The horizontal shift in the IS schedule, which will be denoted ∆IS, is found by differentiating equation A.12: (A.14)  (A.17)  (A.18) ΣIS = c φ ′ +  (A.19)  This shift can be interpreted as the change in household demand for current consumption in response to anticipated future supply shocks. The IS schedule shifts only insofar as households expect a change in future consumption. Finally, equilibrium consumption and the equilibrium real rate of return are found by  dr ⎧⎛ r + δ − 1⎞ ⎡⎛ ξ ′ ⎞ =⎨ ψ d σ ⎩⎝ σ ⎠ ⎢⎣⎝ σ ⎠ g + i ξ′ c ⎤ − ⎛ ⎞ ⎛ ⎞ ⎛⎝ψk + ι ′ ψ g + i⎛⎝⎥ ⎝ ⎠ ⎝σ ⎠ c ⎦  ]  ]  ⎛ c ⎞ ⎛ξ′⎞ ⎛ ψ + ι′ ψg + i⎛⎝ < 0 ⎝ c ⎠⎝σ ⎠ ⎝ k  are the slopes of the CS schedule and IS schedule, respectively. In particular,  ξ′ ⎛c ⎞⎧ ψ −⎛ ⎞ ψ ⎝ c ⎠ ⎨⎩ σ ⎝ σ ⎠ k  r + δ − 1⎞ ⎫ + ι ′ψ g + i ⎛ dσ . ⎝ σ ⎠ ⎬⎭  ΣCS = ψg + i ξ ′/ σ > 0  and  c ∆IS = ⎛ ⎞ ⎛⎝ψθ dθ + ψg + i dg ⎛⎝ ⎝c ⎠ +  34  (A.16) dc = ( ΣCS ∆IS − ΣIS ∆CS )/( ΣCS − ΣIS ),  +  ⎞ 1 ⎛ c ⎞ ψ ⎫⎛ > 0, ⎝ c ⎠ σ ⎬⎭⎜⎝ ΣCS − ΣIS ⎟⎠  and  (A.20)  dc ⎛ 1 =⎜ d σ ⎝ ΣCS − ΣIS + φ ′c ⎛ ⎝  ⎞ ⎛ ξ ′ ⎞ ⎡⎛ c ⎞ ⎟ ⎝ ⎠ ⎢⎝ ⎠ ψσ ⎠ σ ⎣ c  r + δ − 1⎞ ⎤ ψ . σ ⎠ ⎥⎦ g + i  The latter expression is of ambiguous sign.  Federal Reserve Bank of Dallas  References Abel, Andrew B., and Olivier J. Blanchard (1983), “An Intertemporal Model of Saving and Investment,” Econometrica 51 (May): 675–92.  Journal of Economic Perspectives 7 (Winter): 67–82.  Barro, Robert J. (1990), Macroeconomics, 3d ed. (New York: John Wiley and Sons).  Koenig, Evan F. (1993), “Rethinking the IS in IS –LM: Adapting Keynesian Tools to Non-Keynesian Economies,” pt. 1, Federal Reserve Bank of Dallas Economic Review, Third Quarter, 33– 49.  Campbell, John Y., and N. Gregory Mankiw (1989), “Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence,” in NBER Macroeconomics Annual 1989, ed. Olivier Jean Blanchard and Stanley Fischer (Cambridge, Mass.: MIT Press), 185–216.  ——— (1990a), “Is Increased Price Flexibility Stabilizing? The Role of the Permanent Income Hypothesis,” Federal Reserve Bank of Dallas Research Paper no. 9011 (Dallas, November).  De Long, J. Bradford, and Lawrence H. Summers (1986), “Is Increased Price Flexibility Stabilizing?” American Economic Review 76 (December): 1031– 44. Hall, Robert E. (1988), “Intertemporal Substitution in Consumption,” Journal of Political Economy 96 (April): 339 –57.  ——— (1990b), “Real Money Balances and the Timing of Consumption: An Empirical Investigation,” Quarterly Journal of Economics 105 (May): 399– 425. ——— (1989), “Are the Permanent-Income Model of Consumption and the Accelerator Model of Investment Compatible?” Federal Reserve Bank of Dallas Research Paper no. 8915 (Dallas, December).  ———, and Frederic S. Mishkin (1982), “The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households,” Econometrica 50 (March): 461–81.  Romer, David (1993), “The New Keynesian Synthesis,” Journal of Economic Perspectives 7 (Winter): 5–22.  Jappelli, Tullio (1990), “Who Is Credit Constrained in the U.S. Economy?” Quarterly Journal of Economics 105 (February): 219–34.  Tobin, James (1993), “Price Flexibility and Output Stability: An Old Keynesian View,” Journal of Economic Perspectives 7 (Winter): 45–65.  King, Robert G. (1993), “Will the New Keynesian Macroeconomics Resurrect the IS –LM Model?”  Economic Review — Fourth Quarter 1993  35  John H. Rogers  Ping Wang  Assistant Professor of Economics Pennsylvania State University  Visiting Senior Economist Federal Reserve Bank of Dallas and Assistant Professor of Economics Pennsylvania State University  High Inflation: Causes and Consequences  A  lthough cases of very high inflation and hyperinflation may at first seem like unusual events, in recent years these economic scourges have been all too common. Using the conventional definition of hyperinflation as a monthly inflation rate of more than 50 percent, there were no hyperinflations in the world between 1950 and 1983 but seven in the second half of the 1980s. Furthermore, the 1980s brought approximately twenty episodes of high inflation (rates exceeding 100 percent in a twelve-month period), originating in nine Latin American countries. In this article, we try to answer a series of questions that can at least offer some guidance for understanding the economics of high inflation. First, what are the costs of inflation compared with the costs of lowering inflation? Second, why is inflation chronically high in most Latin American countries? The fact that Latin American countries have suffered high and chronic inflation throughout most of the past three decades may suggest some commonality in the processes that determine inflation. Third, what are the main causes of these inflationary episodes? Finally, why have some countries successfully lowered inflation while others have not? Successful stabilization by some governments but not others probably reflects the perception that the costs of inflation have become unacceptable to those societies that stabilized. We try to understand what creates such a change in perception. In Table 1, we summarize the inflationary experiences of four Latin American countries— Argentina, Bolivia, Brazil, and Mexico—beginning in the mid-1980s. All four experienced high inflation, with periods of hyperinflation in Argentina during 1989, in Bolivia during 1985, and in Brazil during 1990. Success in stabilizing inflation in the Economic Review — Fourth Quarter 1993  four countries has been mixed, as Table 1 indicates. Argentina made several unsuccessful attempts at stabilization before initiating its April 1991 program, which still endures; Bolivia enjoyed an immediate and lasting end to inflation in mid-1985; and Mexico experienced a gradual and lasting end to inflation, while Brazil has yet to control inflation for any substantial length of time. Table 1 also provides figures on the changes in real economic activity taking place around each of the inflationary episodes. Each successful stabilization, regardless of whether it came about in a gradual or a shortlived fashion, has been accompanied by no worse than a temporary drop in output. Economists generally accept the view that inflation is ultimately a monetary phenomenon. Nevertheless, there are rather divergent opinions on the short- and long-run interactions between the monetary and the real sectors. So far, there has been no theoretical consensus on the macroeconomic trade-offs, if any, between inflation and output. Moreover, it is difficult to discriminate empirically between alternative views on inflation– output trade-offs. For a simple example, consider the “child’s game” in Figure 1, in which we plot inflation and  We thank Mike Cox, Greg Huffman, Eric Leeper, John Welch, Mark Wynne, and, especially, Evan Koenig and Ellis Tallman for very helpful comments on earlier drafts of this article, as well as Steven Prue for excellent research assistance and Rhonda Harris and Monica Reeves for careful editorial review. Any remaining errors are our own responsibility.  37  Table 1  Summary of High-Inflation Episodes Country Argentina Peak inflation rates (per episode): 31 percent (June 1985), 190 percent (1989:3) Success in stabilizing: very temporary (before April 1991)  Bolivia Peak inflation rate: 66 percent (June 1985)  Success in stabilizing: yes, immediate Brazil Peak inflation rates (per episode): 20 percent (February 1986), 24 percent (June 1987) 33 percent (January 1989), 59 percent (March 1990) Success in stabilizing: only temporarily Mexico Peak inflation rates (per episode): 11 percent (August 1982), 15 percent (December 1987) Success in stabilizing: very temporary (before December 1989)  Inflation rate (Percent) 434 688 387 82 175 388 4,145 1,629 923 22  (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990) (1991) (1991:2–1992:2)  276 1,281 8,175 14.6 16.0 15.2 16.5 17.4 16.2  (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990) (1991)  178 197 227 145 225 1,038 1,759 1,658 494 1,147  (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990) (1991) (1992)  29 99 81 59 64 106 159 45 20 24 19 12  (1981) (1982) (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990) (1991) (1992)  Output Growth Around Stabilization (Percent) –.67 –5.39 13.5 4.1 –5.2 –4.1 –4.5 .4  33.3 –25.7 15.2 –2.9 2.1 3.0 3.2  (1985:2) (1985:3) (1985:4) (1987) (1988) (1989:3) (1989) (1990)  (1985:2) (1985:3) (1985:4) (1986) (1987) (1988) (average 1989–1991)  –2.5 5.7 8.3 7.6 3.6 –.01 3.3 –4.1  (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990)  –.6 –4.2 3.6 2.6 –3.7 1.6 1.4 2.9 4.9 3.9  (1982) (1983) (1984) (1985) (1986) (1987) (1988) (1989) (1990) (1991)  NOTES: Any rate quoted for a given month is a monthly rate, for a quarter is a quarterly rate, and for a year is an annual rate. Attempted stabilization occurred on the date following each peak inflation noted in the table. The sources of the data are as follows, where IFS denotes that the data are from various issues of the International Monetary Fund’s International Financial Statistics. Argentina (IFS): consumer price inflation, line 64; and real GDP in 1978 prices, line 99bp. Bolivia (Bulletin of the Central Bank of Bolivia ): consumer price inflation; and real GDP in 1980 prices. Brazil (IFS and Boletin Mensal do Banco Central do Brasil ): consumer price inflation, line 64; and general industrial production index, 3/86=100. Mexico (IFS and the Central Bank of Mexico’s Economic Indicators ): consumer price inflation, line 64; and industrial production, base year = 1980.  38  Federal Reserve Bank of Dallas  Figure 1 Inflation–Output Trade-Offs: A Child’s Game Below are plots for real inflation and output for four different countries over a ten-year period. The game is to match each country’s inflation series with its output series. Inflation  Output  AP  AY  BP  BY  CP  CY  DP  DY  Economic Review — Fourth Quarter 1993  39  output series for four countries over a period of thirty quarters. The inflation series are plotted in a random order in the left panels and are labeled AP, BP, CP, and DP; the output series are plotted in a different order in the right panels and are labeled AY, BY, CY, and DY. The object of the game is to select pairs (say, for example, AP and BY) that correctly match each country’s inflation series with its output series. (Answers are given in the concluding section.) As the reader may find, ocular inspection offers no clues to the correct answers, which indicates that even in the short run, there have been no apparent gains in output growth as a result of increased inflation. Explaining why different societies end up with different inflation rates is a difficult task that has largely been left unaccomplished by economists. To glean the similarities and differences between inflation experiences, we briefly review the experiences of Argentina, Bolivia, Brazil, and Mexico. The inflationary processes and the failed attempts at stabilization reflect three common features: 1. no apparent gains in output growth as a result of increases in inflation, 2. high fiscal deficits, and 3. public skepticism about the government’s commitment to fighting inflation. Successful stabilization, on the other hand, combined fiscal adjustment with some set of policies that enhanced the credibility of the government: 1. outward commitments to fixed exchange rates, 2. increased independence of the central bank, or 3. “social pacts” that spread the burden of adjustment across sectors and imposed commitment on the government’s actions. Finally, we give theoretical content to these conclusions. Specifically, we look at the relationship between money printed to finance government deficits and inflation. We find that more than one outcome is possible. Typically, one outcome involves high inflation and the other involves low inflation. A successful move from the high inflation outcome to the low inflation outcome involves not only reducing government deficits and money creation but also convincing the public that the government is strongly committed to lower inflation. 40  Historical experiences with high inflation Argentina. Significant changes took place in the Argentine economy after 1975. Until 1991, inflation never fell below an annual rate of 100 percent, while the liberalization policies of 1977– 80 brought increased indebtedness and capital flight. In the ten years before the 1985 Austral Plan, real gross domestic product (GDP) rose at an average annual rate of 0.5 percent, inflation was 11 percent per month, the fiscal deficit never fell below 5 percent of GDP, and external debt rose by $42 billion. In 1983, a combination of events led to an upward adjustment in wages and acceleration of inflation to an annual rate beyond 400 percent. The Austral Plan, announced in April 1985, was a “heterodox shock” program, in which the government took actions to contract aggregate demand and directly control wages and prices. Realigning relative prices was required if the program was to reduce inflation without severe shortages. Thus, it was announced that between April and June, controls on many industrial prices would be removed, utility rates and beef prices would rise, and there would be a real devaluation. During the stabilization, prices were to be frozen at levels prevailing on a specified date in June. An agreement was signed with the International Monetary Fund, and Argentina pledged to stop issuing money to finance the fiscal deficit, which would be financed entirely with external credit. The budget deficit was reduced through an increase in revenues, in part due to increased real activity following the freeze and reduced income tax postponement with lower inflation. The effects on inflation were felt immediately. The wholesale price index, which rose 42.3 percent in June 1985, fell by 0.9 percent in the following month. These figures are testimony to the success in eliminating the inertial component of inflation. However, fundamental imbalances persisted and eventually drove inflation higher. In particular, relative prices fluctuated significantly, mostly as a result of higher prices for foodstuffs and services, which were initially frozen at levels well below equilibrium. The price freeze lasted nine months. An attempt in March 1986 to alter relative prices and save the plan failed within three months. Inflation continued to grow in the late 1980s, until Argentina once again faced hyperinflation in Federal Reserve Bank of Dallas  1989. Monthly inflation reached 196 percent for July 1989 under the new president, Carlos Menem, and gave rise to the Bunge–Born stabilization program. The attempted stabilization consisted of exchange rate stabilization, price “agreements” between producers, partial trade liberalization, and promised fiscal adjustment. Lack of true fiscal adjustment led to the collapse of the stabilization program in December 1989 and a return to hyperinflation. A subsequent program to refinance the government debt, dubbed the Bonex Plan, amounted to a forced confiscation of liquidity in the financial system. This caused real interest rates to rise dramatically, and depressed economic growth, but did not bring inflation down to a desirable level. In late 1990, a run on the currency moved Argentina back to hyperinflation. In April 1991, a new stabilization package was put in place under the auspices of Economy Minister Domingo Cavallo. This plan included the elimination of the budget deficit, monetary stringency, privatization, and the introduction of a new currency—the peso—whose value would be rigidly fixed against the U.S. dollar. The plan achieved a dramatic reduction in inflation and has enjoyed continued success for two full years. Bolivia. Unlike many of its neighbors, Bolivia did not suffer chronic inflation before 1982. However, by the end of 1981, Bolivia had an overvalued currency, a large fiscal deficit, and external debt. Consumption levels were maintained by recourse to new and expensive short-term loans. An abrupt reversal of the earlier net foreign resource inflows occurred in 1982 and set Bolivia on the path to hyperinflation. The first of several stabilization programs was announced soon after the inauguration of the civilian president, Hernan Siles-Zuazo, in October 1982. The plan contained some standard measures designed to correct relative price imbalances, while other measures—such as price ceilings for essential goods and interest rates, a fixed exchange rate with exchange controls, and wage indexation —were heterodox. The plan failed almost immediately. By February 1983, the premium in the black market for foreign exchange was 100 percent. After March, inflation accelerated. Consequently, the price controls created excess demand and a thriving black market for basic items. Furthermore, the fiscal sector was adversely affected because Economic Review — Fourth Quarter 1993  prices for publicly provided goods lagged behind inflation, because the overvalued currency impaired public enterprises producing for export, and because of the large deficit resulting from the administrative lag of tax collection. Central bank policies resulted in rapid money creation, and there was a buildup of arrears on the external and internal public debt. Several other attempts at stabilization failed to prevent hyperinflation. Average monthly inflation between March 1984 and August 1985 was 43 percent; in February 1985, it was 182 percent. General economic decline accompanied the rise in inflation; real GDP growth was negative in 1983, 1984, and 1985 (and again in 1986), and the rate of investment (to GDP) sank to a record low of 6.5 percent in 1985. Economic deterioration was so severe that by August 1985 Bolivia seemed ripe for stabilization. A new, center-right government led by Victor Paz Estenssoro ruled with the support of business. In addition, the real value of the money base was low, long-term peso contracts had virtually disappeared, wage indexation schemes were discredited (as were the unions), the economy was extremely dollarized, and there was strong social demand for stabilization, even for shock treatment. Supreme Decree 21060, the New Economic Policy (NEP), was declared on August 29, 1985. The NEP featured a fiscal package, market liberalization, exchange rate unification, a new currency, and the establishment of an anchor for inflation. A fiscal stabilization package, including several dramatic measures on both the revenue and spending sides, was instituted along with market liberalization. There were sharp increases in the price of gasoline and other petroleum products produced by state-owned enterprises. Public-sector wages were frozen. Many state enterprises either were privatized or had drastic cuts in employment (23,000 of 30,000 miners were discharged, for example). In addition, public-sector investment and foreign debt servicing were temporarily frozen. Liberalization took the form of eliminating many price ceilings, opening the financial sector, reforming the labor market, and eliminating barriers to international and domestic trade. The plan resulted in a dramatic drop in inflation. Except for first-quarter 1986, quarterly inflation remained below 8.1 percent. Output 41  declines accompanied the drop in inflation; in 1986, real GDP fell more than 3 percent, unemployment rose to 20 percent, and investment was near an all-time low. Exacerbating matters were adverse external shocks, such as the collapse of the tin market and the drop in natural gas sales, which contributed to unfavorable terms of trade in 1986. Although Bolivia achieved positive real growth in 1987 and 1988, real GDP at the end of 1988 was still below the 1983 level (especially in per capita terms). While the official numbers exclude illegal and underground activities, the failure to achieve positive growth of real per capita GDP is surely the most disappointing feature of the NEP. But continued success in curtailing the fiscal deficit has allowed Bolivia to renew foreign sources of finance and moderately expand money growth, and is viewed as the key to sustaining the success of the plan. Inflation has remained under 20 percent at an annual rate, and GDP has grown modestly. Brazil. Annual inflation in Brazil was approximately 30 to 40 percent for most of the 1970s. In 1978, imprudent policy measures, including more rapid adjustments in nominal wages from twelve to six months, contributed to an acceleration of inflation. Between 1980 and 1982, inflation was stable at around 100 percent, but a reacceleration took place in 1983 and 1984. Following a short-lived reform package that accompanied a civilian government’s passage into power in March 1985, three stabilization plans were attempted. The first and most famous of these, the Cruzado Plan, was implemented in February 1986. This plan was heterodox (like Argentina’s and Israel’s 1985 stabilization packages), calling for a price and wage freeze and imposing formulas for adjusting wages, rents, and mortgages. Notably, policymakers believed there was no need for fiscal adjustment, as the budget deficit amounted to only 0.5 percent of GDP. The plan was implemented in the midst of favorable external developments: Brazil had registered large trade surpluses in the previous two years, world oil prices and interest rates were falling, and the dollar was depreciating against major currencies. The initial results of the Cruzado Plan were favorable, as inflation was stopped in its tracks without a recession. The euphoria that greeted the plan led to the ill-advised maintenance of the price freeze. However, prices were frozen at levels prevailing on a 42  given day (in this case, February 27, 1986), when there was no reason to believe that relative prices were in equilibrium. This policy ultimately created shortages and spurred black market activity. In mid-1986, demand was clearly overheated by the real wage increases and the budget deficit, which was nearly 5 percent of GDP by late 1986. The failure of the original Cruzado Plan led to CruzadoII, which was announced on July 24, 1986. This attempt at fiscal reform was no more successful than its predecessor, nor were the Bresser Plan of June 1987 and the Summer Plan of January 1989. A radical stabilization package, introduced by President Fernando Collor in March 1990, froze 80 percent of the financial liabilities of the financial system, putting them into an account at the central bank. Real interest rates rose dramatically due to a combination of liquidity confiscation and lack of government credibility in honoring its debts. Inflation fell, but never to acceptable levels. Meanwhile, the economy moved into its worst recession in history, largely because liquidity confiscation froze most of producers’ working capital. Absent any real deficit reduction, inflationary pressures eventually mounted toward the end of 1990. Another income-based stabilization plan, Collor-II, was announced in January 1991, but lack of fiscal adjustment destroyed the program by March 1991. The situation in Brazil, on the brink of hyperinflation, contrasts sharply with that of Bolivia recently. Inflation in Brazil has averaged well over 1,000 percent each year from 1988 through mid1993. Although the government continues to struggle toward fiscal control, Brazil seems to be moving toward a more open trade regime and a deregulated business environment. In response, the stock market has boomed, but income inequality and inflation remain serious problems. Mexico. With the discovery of vast oil reserves, the performance of the Mexican economy between 1978 and 1981 was impressive: annual GDP growth was never less than 8 percent, while the inflation rate stayed in the range of 20 percent. However, Mexico’s return to statist policies became apparent. For example, public-sector expenditure increased in real terms by 97.7 percent from 1977 to 1981, for a jump from 29.5 to 41.3 percent of GDP. The budget deficit grew from 6.7 to 14.7 percent of GDP during this period, because failure to maintain public-sector prices in real terms prevented a Federal Reserve Bank of Dallas  significant rise in tax revenue. The exchange rate, which was ostensibly flexible, rose at an average annual rate of only 3.6 percent during these years. The budget deficit and real appreciation led to a 128-percent rise in the volume of imported intermediate inputs. This increase coincided with higher output and employment and, eventually, problematic inflation rates, balance of payments deficits, and a burdensome foreign debt. Failed attempts at adjustment in late 1981 and early 1982, amid several signs of serious economic problems, reflected the weakness of President José López Portillo’s economic policy-making. A 67percent devaluation in February 1982, new external loans, planned cuts in public spending, and increases in public-sector prices were not enough to stop the flight out of peso-denominated assets and Mexdollars. The economic crisis unfolded in August 1982 with a devaluation of nearly 100 percent, the introduction of a dual exchange rate system, price hikes on staples, and a forced conversion of Mexdollars into pesos. These were followed by the nationalization of the banks that September and a moratorium on foreign debt payments until a rescheduling agreement was reached in December 1982. In 1982 annual inflation reached 100 percent, while the real GDP growth rate was negative for the first time in 50 years. President Miguel de la Madrid’s administration began in 1983 with a wide-ranging program of stabilization and reform, along with negotiations over the foreign debt. Fiscal austerity, lower money growth rates, and improvement on the external accounts were prominent goals of the program, just as in 1976. During this time, Mexico achieved much success in meeting its targets. From 1982 to 1983, the public-sector deficit was halved (to 8.9 percent of GDP), money growth rates declined in both real and nominal terms, and the current account balance went from a $6 billion deficit to a $5 billion surplus, in large part due to tight controls on imports. Success in meeting the targets initially was accompanied by a deep recession—real GDP growth was –5.3 percent in 1983—with only a slight drop in inflation to 80 percent. Furthermore, the effects of import compression—squeezing imports to reverse the current account deficit— and deep cuts in capital expenditures on longterm growth prospects were disconcerting. In Economic Review — Fourth Quarter 1993  1984 and early 1985, real GDP growth improved modestly, inflation fell into the 60-percent range, and the current account remained in surplus. At the same time, the budget deficit began to rise slightly, and plans for a fiscal correction were announced in March 1985. Money growth was strictly controlled despite the fiscal deficits, which were financed by sales of government bonds (CETES) to the banking system and public. In the second half of 1985, the economy slipped back into recession, as world oil prices fell, a huge earthquake hit Mexico City, and monetary policy was tight. Oil prices continued to fall in 1986, and the public-sector deficit rose to 16.3 percent of GDP, despite measures to cut spending and increase taxes. Monetary and fiscal contraction continued, and an increase in the rate of peso depreciation was implemented to cushion the blow falling oil prices could cause to the balance of payments. At the time, Mexico faced stagflation: real GDP growth was –3.8 percent, and the rate of inflation reached 106 percent in 1986. The economy’s performance in 1987 was no better: although real GDP growth was positive, inflation rose to 160 percent. The Pacto de Solidaridad Economica program was undertaken in late 1987 under the de la Madrid administration. The peso was frozen at 2,281 per dollar for most of 1988 immediately after a severe devaluation in late 1987. In late 1989, President Carlos Salinas de Gortari renewed the program as the Pacto para Estabilizacion e Crecimiento Economico by incorporating tax reform combined with exchange rate devaluation guidance. The administration’s continuation of trade liberalization and normalization of relations with creditors produced benefits. Mexico became the first country to participate in the Brady Plan for debt restructuring and began negotiating the North American Free Trade Agreement with the United States and Canada. After 1989, inflation fell sharply, accompanied by a gradual appreciation of the peso. In 1990, capital started to flow to Mexico, and by 1992, the Mexican government had accrued a budget surplus of about 0.5 percent of GDP. Summary. Historical experiences of four highinflation Latin American countries suggest some common features of their inflationary processes and failed attempts at stabilization: no apparent gains in output growth as a result of increases in 43  inflation, high fiscal deficits, and public skepticism about government’s commitment to fighting inflation. Conversely, successful stabilization in Bolivia in 1985 and, to a lesser degree, in Argentina in 1991 and Mexico in 1989 involved combined fiscal adjustment with credibility-enhancing policies through outward commitments to fixed exchange rates, increasing independence of central banks, or social pacts that negotiated the burden of adjustment across sectors and imposed commitment on the correspondent government actions.1 Costs of inflation and stabilization Since Milton Friedman and Walter Heller debated the welfare consequences of monetary policy, the real cost of inflation has become a central macroeconomic issue. Sargent’s (1986) study of four episodes of hyperinflation, which indicates that real costs of stabilization are present but not large, has added to the controversy.2 In this section, we investigate the welfare costs of inflation and discuss the real costs of stabilization. We draw empirical evidence from the high-inflation experiences of Argentina, Bolivia, Brazil, and Mexico. Costs of inflation. Generally, four types of costs are associated with inflation created from monetary expansion. First, higher inflation raises money holding costs, thus encouraging more frequent  44  1  For a more detailed historical review and statistical displays, the reader is referred to Bruno, Di Tella, Dornbusch, and Fischer (1987), Bruno et al. (1991), Welch (1991), McLeod and Welch (1991), Rogers (1992), and Rogers and Wang (1992).  2  See Garber (1982) and Wicker (1986).  3  See Saving (1971) and Drazen (1979).  4  See Sheshinski and Weiss (1977), Rotemberg (1983), and Rotemberg and Summers (1990).  5  See Cukierman (1980) and Ball and Cecchetti (1991).  6  See Garber (1982), Rogers and Wang (1993), and Wang and Yip (1992), respectively.  7  The following welfare cost measures have been computed on U.S. data.  banking and exchanges. As a consequence, there will be larger transactions costs, including shoeleather or wheelbarrow (transportation) costs for banking or making exchanges, information costs for conducting future trading, and time costs for traveling.3 Second, with higher inflation, sellers need to change menus and advertising, as well as their decisions about employment and investment, more frequently, adding to adjustment costs.4 Third, increased uncertainty about future trading will result from higher inflation and lead to larger risk premiums in various financial market returns.5 Finally, different opportunity costs associated with higher inflation and the different responses that result will lead to a misallocation of production inputs, goods outputs, and time devoted to various economic activities.6 In a traditional partial-equilibrium, monetaryexchange setup, the welfare costs of inflation can be measured by approximating the area under the money demand function (that is, the Harberger triangle).7 Fischer (1981) and Lucas (1981) apply this method to obtain estimates of the welfare cost of inflation to be between 0.3 and 0.45 percent of gross national product (GNP). Using a generalequilibrium cash-in-advance model that assumes cash is required prior to goods purchases, Cooley and Hansen (1989) find similar estimates. However, if distortionary taxes such as taxes on labor and capital income are considered, as in Cooley and Hansen (1991), inflation distortions combine with tax distortions, doubling the welfare loss. Wang and Yip (1993), on the other hand, allow monetary growth to affect the engine of economic growth by retarding the accumulation of human capital, and find a much higher welfare cost of about 3.6 percent of GNP, a number that is not negligible. Without doubt, overexpansion of money supply leads to welfare reductions in the long run. Moreover, the Latin American experience suggests the absence of a short-run Phillips curve, implying that even the short-run gain of expansionary monetary policy may not be present. With this in mind, we consider the potential costs associated with ending inflation. Costs of Stabilization. Efforts to end inflation almost always seem to be associated with recession. The lost output associated with inflation reduction is what is referred to as the “costs” of stabilization. Table 1 implies that this association, although Federal Reserve Bank of Dallas  temporary, is prevalent in these high-inflation countries and was reinforced by casual empiricism of the low-inflation, developed countries in the 1980s. Stabilization, or disinflation, may be costly for several reasons. For simplicity, we break these explanations into the two camps discussed below. First, New Keynesians emphasize costs arising from contractionary aggregate demand policies in the presence of nominal rigidities, or inertia in wages and prices, which arise because of staggered or backward-looking contracts and/ or menu costs. Intuitively, with staggered pricesetting behavior, some firms set prices before the announcement of a fully credible stabilization program. With these prices set for periods lasting beyond the program itself, prices are too high. A potentially long-lasting recession ensues because no cohort of price-setters desires to be the first to cut prices. This analysis is based upon the work of Taylor (1979) and Blanchard (1983). These results suggest that stabilization programs should be implemented gradually. As applied to high-inflation episodes, this school recommends that incomes policies—in other words, some type of wage and price controls—be implemented. Stabilization programs that have followed such policies have come to be known as heterodox. Bruno, Di Tella, Dornbusch, and Fischer (1987) provide an excellent discussion of heterodox stabilization programs. They show that in Argentina, Brazil, and Peru, three heterodox programs failed, while in Israel (in mid-1985) and Mexico (in late 1989), heterodox methods were used with more success. Second, the New Classical school emphasizes the problems in making a promised stabilization credible. The credibility problem is made more difficult, it is argued, by the implementation of policies. Instead, inflation may be reduced without much of a cost in terms of lost output if the government pursues an ambitious plan of attack centered on tightening domestic credit and eliminating the budget deficit. This is the so-called shock-treatment approach to stabilization. Without the frictions of the New Keynesian models, New Classical analysis asserts that only orthodox measures, such as fiscal and monetary discipline, are necessary to end inflation, as long as the program achieves credibility. Sargent (1986) presents evidence that the ends of four major episodes of inflation were associated Economic Review — Fourth Quarter 1993  with real costs, though not nearly as large as was predicted by the believers of the inflation– output trade-offs. Sargent elaborates on the inflation– output trade-offs by concluding that in the Austrian case, the “cost in increased unemployment and foregone output was minor compared with the $220 billion GNP that some current analysts estimate would be lost in the U.S. per one percentage point inflation reduction.” For the much-discussed German episode, Sargent states the reasons to expect real effects from stabilization: “There is little doubt that the ‘irrational’ structure of capital characterizing Germany after stabilization led to subsequent problems of adjustment in labor and other markets.” Garber (1982) and Rogers and Wang (1993) examine this by-product of stabilization. More recently, Bolivia in 1985 eliminated a much higher inflation than had Israel or Mexico, and did so without employing any heterodox elements. In fact, the Bolivians actually deregulated almost all prices at the start of the stabilization program. What is common among each of these successful stabilization programs and the ongoing Argentine stabilization is strong budgetary adjustment. Historical experience has shown that drastically reducing or eliminating the budget deficit to ensure credibility for the tight-money policy is absolutely essential for successful stabilization, as the Brazilians have unfortunately discovered from the other side of the fence. Finally, in several high-inflation episodes, governments delayed for some time before launching a coherent stabilization program. Examples of recent literature on the timing of stabilization policies include Sargent and Wallace (1986), Drazen and Helpman (1987, 1990), and Alesina and Drazen (1991). Given the need for credibility, there is widespread belief that the longer the government waits to attack inflation, the more damage to the economy, and hence, the more costly will be the policies needed to stabilize the economy. Why, then, do governments delay stabilization? One answer may be that policymakers are irrational, but this conclusion is less than satisfactory because it might explain any behavior. For Alesina and Drazen (1991), the problem is distributional. In their model, the costs of stabilization are borne by heterogeneous groups that are not necessarily affected to the same degree. Because these groups are in competition to shift the burden 45  of stabilization onto others, stabilization is delayed by a “war of attrition.” Alesina and Drazen (1991) illustrate how the expected date of stabilization is affected by various characteristics of the economy, such as income inequality, political cohesion, and the extent of monetization of the budget deficit. Historical experience that shows extremely diverse stabilization outcomes lends support to the predictions of this line of research. Summary. These considerations lead to four main conclusions. First, the short-run welfare or output gain of expansionary monetary policy may not be present. Second, by taking into account the plausible adverse growth effect of inflation through resources misallocation, the welfare costs of even moderate inflation may be very significant (perhaps as high as 3.6 percent of GNP). Third, though there were real costs associated with stabilization in several high-inflation episodes, such adverse macroeconomic effects have been mostly temporary. Finally, ensuring credibility is not only essential to controlling inflation but important in minimizing the corresponding real costs of stabilization.  Money market equilibrium condition (MM). We begin by considering a modified Cagan (1956) money demand model. This type of model has been broadly used in studies of high inflation or hyperinflation. Specifically, money demand (m d ) can be thought of as a decreasing function of the expected rate of inflation (π e ), since higher expected inflation reduces the real value of money. Unlike Cagan (1956), who restricted economic individuals to reliance on past information only, we assume that individuals have rational expectations and thus utilize all information available and form predictions with no systematic errors. Thus, letting expected inflation be primarily driven by the preannounced rate of money growth ( µ), we can express money demand function as an exponential function of µ:  Causes of inflation  (2)  Inflation is a long-term, persistent increase in the price level. From the quantity theory identity that money stock times velocity is equal to the price level multiplied by real output, one can specify the rate of inflation as monetary growth + rate of change in velocity – output growth. In an open economy, both domestic and foreign structural changes and policy alterations can affect inflation. For demonstration purposes, this article considers three types of policy instruments —fiscal, monetary (domestic credit), and external (nominal exchange rate) —in addition to structural output (domestic net of foreign) disturbances. To study how these disturbances affect the rate of inflation, we construct a modified model of an inflation trap.8 Following the view that inflation in the long run is a monetary phenomenon, we focus primarily on the money market and its dynamic adjustment process.  This relationship indicates that in money market equilibrium, money growth and real money balances are negatively related. After normalizing population and exogenous technological growth as zero, the actual inflation rate in the short run may deviate from the preannounced rate of money growth:  8  46  Our model is a modification of that used by Bruno and Fischer (1990).  (1)  m d = exp(−απ e ) = exp(−αµ ).  Money market equilibrium requires money demand be equal to (real) money supply, m d = m, which implies  (3 )  µ = − [ln(m )] /α .  π = µ + θ = − [ln(m )] /α + θ ,  where θ denotes the deviation of inflation from the (preannounced) money growth rate. This deviation measure may depend on disturbances to productivity, the nominal exchange rate, government size, central bank credibility, and/or any other shifters, such as exogenous foreign shocks, oil-price shocks, and policy shocks that involve price and wage controls (fiats) during high-inflation episodes. Later, we shall refer to this negative relationship between inflation and real money balances, equation 3, as an MM (money market equilibrium) locus in (m,π)-space. Steady-state equilibrium condition (SS). So far, we have not discussed how the dynamics of the inflationary process may reach a steady state. To Federal Reserve Bank of Dallas  complete this analysis, we introduce a standard steady-state equilibrium condition, which requires the rate of change of real money balances to be zero—that is, m˙ /m = 0. To account for inflationary finance, we follow Sargent and Wallace (1973) by incorporating the real government deficit, d, into the analytical framework. Rather than treating d as given, we specify it as (4 )  d = D (π ) + η,  where D represents the ex ante real government deficit, η can be thought of as deviation of actual from ex ante real government deficit, and dD/d π > 0. An increase in the inflation rate reduces the real value of income tax revenue given the time lags involved in tax collections, thus enlarging the government budget deficit through an increase in D. This is usually referred to as the Olivera (1967) – Tanzi (1977) effect. For simplicity, we assume that the Olivera–Tanzi effect is not strong enough to alter the structure of the dynamic system. More specifically, we require that the inflation elasticity of government deficit (⑀ ), which is, for analytic convenience, assumed to be constant, is strictly less than unity; for an alternative case, the reader is referred to Bruno and Fischer (1990). The deviation of actual from ex ante real government deficit, on the other hand, may respond to changes in productivity and the size of government. Since income or sales taxes have been considered in the above relationship, the deficit must be financed ex ante by the inflation tax in the short run—that is, d = µm, where the rate of nominal money supply growth, µ, can be thought as the ex ante rate of the inflation tax, and real money balances, m, can be reinterpreted as the inflation tax base. Therefore, the government will adjust money supply according to the following equation that specifies the evolution of real money balances as the difference between the nominal money supply growth rate and the inflation rate: (5)  πm = D (π ) + η .  (6 )  Given the deviation term, η, inflation and real money balances are negatively related, provided that the Olivera–Tanzi effect is not too strong. This relationship, equation 6, will later be referred to as the SS (steady-state equilibrium) locus in (m,π)-space. Notably, this SS curve approaches the horizontal and vertical axes asymptotically. Determination of the full dynamic equilibrium. We are now prepared to illustrate the full dynamic equilibrium using the MM and SS loci, equations 3 and 6, in Figure 2. Recall that the SS curve approaches the two axes asymptotically. To ensure the existence of a full dynamic equilibrium, we assume that the government deficit is not too large. Then the MM curve must intersect the SS curve at least once, and a full dynamic equilibrium therefore exists. The next question is whether the full dynamic equilibrium is unique. To proceed, we need to assume that even when the rate of inflation approaches zero, there is an upper bound on real money holdings, m max, which is finite. Furthermore, we assume that as inflation becomes uncontrollable, real money holdings approach zero faster than inflation—that is, πm approaches zero as π goes to infinity. Under these two assumptions, we are able to express the ex post Laffer curve of the inflationary tax in Figure 3, which plots the ex post government deficit, d = πm d, against the ex post  Figure 2  Full Dynamic Equilibrium π D E  B  m˙ /m = µ − π = d /m − π .  Substituting the government deficit specification, equation 4, into the real money balances adjustment equation, equation 5, we obtain the following steady-state equilibrium condition: Economic Review — Fourth Quarter 1993  A SS C  MM m  47  inflation tax rate, π. As the reader can see, for a given level of deficit, d 0, there are two corresponding rates of inflation, π1 and π2. In fact, the same conclusion can be reached by depicting the inflation rate, π, against logged real money balances, ln(m). One can easily show that the relationship described in equation 3 is now a straight line with a negative slope and positive intercepts, while the relationship displayed in equation 6 is a downward-sloping curve, convex toward the origin. Provided that the government deficit is not too large, the presence of two full dynamic equilibria can again be verified. Thus, examining Figure 2 in the (m,π)-space, we learn that the MM and SS curves in this case must intersect twice such that one deficit level can correspond to two different rates of inflation (see points A and E, for example). We now turn to studying the local stability property of the model. We assume that in transition to a steady state, the money market is always in equilibrium. Thus, dynamic movements after any perturbation must be along the MM curve. Consider an initial position at point B, which lies above the SS curve. For a given level of inflation, real money balances are higher than the steadystate level and from equation 5, m˙ /m must be negative. This implies that the dynamic adjustment must be to reduce m and hence to move toward point E. By contrast, if the economy starts from an initial point below the SS curve, say C (or D), then the dynamic adjustment process must be to increase m and hence to move away from A (or toward E). The discussion above indicates that point A, which is associated with a lower inflation rate, is unstable—that is, any disturbance will lead the dynamics away from A. On the contrary, point E, which exhibits higher inflation, turns out to be a stable full dynamic equilibrium. In other words, a country in this circumstance may end up in an “inflation trap” (point E) in which inflation is persistently high. This may explain why the four Latin American countries have experienced chronically high inflation. By affecting the two deviation terms, θ and η,  9  48  See Chen (1973) and Rogers (1992) for further elaboration on currency substitution and its macroeconomic consequences.  a policy that either tightens money supply growth with enhanced credibility, or retains the foreign exchange value of the currency,9 or imposes fiats (price control or wage freeze) may shift the two curves such that the MM curve intersects the SS curve only once, and from below. The possibility of a unique intersection can be readily seen using Figure 3. With a credible tight-money policy, it may set an upper bound for the rate of inflation, say πmax < πs , which ensures a one-to-one relationship between d and , corresponding to the upwardsloping portion of the ex post Laffer curve. In this case, one can avoid the inflation trap and free the economy from a sustained high rate of inflation. In Figure 4, we illustrate this sort of successful tight-money policy by examining the paths of logged nominal money stock and logged price level. The slope of the logged nominal money stock measures the (nominal) money growth rate, while the slope of the logged price level measures the (actual) inflation rate. In the long run, these two paths are parallel to each other, as indicated by equation 3 with θ = 0. The vertical difference then measures logged real money balances. Given ensured credibility, a tight-money policy imposed at time T makes the path of nominal money flatter. As a consequence, real money demand, m, increases because of the reduction in anticipated inflation, as indicated in equation 1, leading to an instantaneous drop in the price level. Upon accomplishment of this successful anti-inflation policy, the economy will thereafter face a permanently lower inflation Figure 3  Ex Post Laffer Curve πm  d0  π1  πmax  πs  π2  π  Federal Reserve Bank of Dallas  Figure 4  Stopping High Inflation  ln(M)  ln(m)  ln(P)  T  Time  rate, as reflected by the flatter path of the price level. Summary. These considerations lead to two main conclusions. First, a country may end up in a high-inflation trap, thus lending theoretical support to the chronically high-inflation experiences faced by the four Latin American countries for some periods. Second, some stabilization policies may not break up the inflation-trap structure, as in Argentina (before April 1991), Brazil (even into 1993), and Mexico (by late 1989), where the success of their stabilization programs, if any, was at best temporary; conversely, a successful stabilization that ensures credibility and restores market mechanism may move an economy quickly out of the inflation trap, as witnessed in Bolivia after its 1985 hyperinflation. In summary, our model explains the rather diverse stabilization outcomes reflected in Table 1 and demonstrates that a country without a properly specified, well-executed stabilization program may never be able to control inflation for a substantial length of time. Conclusions Recalling Figure 1, we provide the reader with the answers to the child’s game: Argentina (AP and DY), Bolivia (BP and CY), Brazil (CP and BY), Mexico (DP and AY). As the reader can see, there is no clear-cut trade-off between inflation and output, even in the short run, except on some occasions after stabilization. We began this article by posing four quesEconomic Review — Fourth Quarter 1993  tions, and our discussion has led to their answers. First, why is inflation an issue worth considering? We answer this question by examining the real costs of inflation and stabilization. We point out that by taking into account the plausible adverse growth effect of inflation through resource misallocation, the welfare costs of even moderate inflations may not be negligible. We also recognize the real costs associated with stabilization in several high-inflation episodes but find these adverse macroeconomic effects to be mostly temporary. Our second question was, Why has inflation been so chronically high for several Latin American countries? We found the answer by constructing a model to show that the spiral-like adjustment of the government budget deficit and monetary expansion may result in an inflation trap, which represents a dynamically stable equilibrium with persistently high inflation. The third question asked was, What are the main causes of those inflationary episodes? For the answer, we hypothesize that the main causes of chronically high inflation include continuous fiscal and monetary expansion, a productivity slowdown, a systematic undervaluation of the domestic currency, and diminished credibility. Finally, in attempting to answer the last question—why some of these countries have been able to stabilize inflation successfully, while others have not—we note that stabilization succeeded in ending the hyperinflationary episode of Bolivia in 1985, essentially because of a tight-money policy that was made possible by a budgetary adjustment and market liberalization program that ensured credibility, and by a proper anchor for inflation that used the (unified) nominal exchange rate. In terms of our model, this stabilization program fundamentally changed the equilibrium money market relationship, thus enabling the Bolivian economy to jump out of the inflation trap. A similar stabilization story emerged to a certain degree over the past two years in Argentina. 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