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FEDERAL RESERVE RESERVE BANK BANK OF OF DALLAS DALLAS FEDERAL November November 1990 1990 • • cononnc CVICW ~cononuc Tbe Trade Ti"ade Balance and The tbe Real Rea! Exchange Excbange Rate Rale the John K K. Hill Reduced Defense D~fense Purcbasing· Anticipating the tbe Purchasing: Impact on Slate State and Industry Employment Lori L. Taylor Lori This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) Economic Review Federal Re.~e!ve Bank of Dallas -_.... Robert H. Boykin •,. William H. Waillee ""'1oWI!1'tr/.JdInt.., , HI,", Ro:Jenblum Gerald P. O"Dri.coll, Jr. W. Michlll v ,t~ '_M eo. 'f'd Slephen P. A. Brown A" rV«i'I,,< , _ .h Economists National and Inter/liwonal John ~ HIli Evan F KoenIg Robert T Clal! Jnseph H Has~ Kenneth M Emery Da~ld M. Gould MarlA Wynllfl Kevin J Veal~ Reg-ooa/ i1tld ETJefg¥ WII<amC Gr!tlen Robert W G.lmer MIne K Vue&1 Ketlh A PhilliPS lOl! l 1ayIor FIona 0 Sirlaita EdilO~ Rhonda Hams Diana W Palmer VirgInIa M Rogers Tile fCOOOfl1lC f/e.tPW publl"led try :1Ie Federal Reserve Sank 01 ~U;tS It.. ......... , ex prtSled .. ~ II'Iose oj !hi Jumort rid 00 nol oecessar'iy refl(!(\ rile po$l!!(WIS ot thII FedI'ill Rese<w 8ri at DaIIIS or tile FedI<al ReseM '."" Subsc"pt CIR$ lie ...lII¥JIe fret rI ~ Please SInd 'eqUllll for S"'lIle-copy ~od mul~l)Ie-etIP!' $.Qer!ptlom ,*, ~ n .oi'ns ctwvn tQ ,tie f>IJ~~ AI""I :>et>.wltnef'1. fedllralllestrYe Bank oIlbtt.1 St.t'GII K o.tlJ'l Tr.." 75222.I2I.t651-62M Ar\Jdes ....,. tie rtphIIIeO Gr1 tflt a.od IIDI' that dlII $OLIlte '$ tfecl,!~ ."" tile Resurt: til • top'f of .". DUliIa~on tonta<WlO thl repnn\IMI malefWl Departml!l"! " P'(Iy,ded ... Contents Page I The Ti-ade Balance and the Real Exchange Rate John K. Hill John K. Hill o.:xamincs how tht: tr:ldl' haJ:met,' and tht.: fc;11 \.:xc h ;ln~c ra!\:.' inlo...-ract :I ftcr an \:t:onomit: dislurhano: Hill cXI"Jlains how. for distu rlxl nCl:S lik<.:iy to havl,' a significant dfLoct on tilL' tradl;.· b;llancr.:. real cxch:mgc ratl: movements arc lllore the result of :1 shift in the tr:l{k habnce than the calise of it Th ... impetus for chang!.: in tht: trade h:lhlnu: is llll' disturhance itself. Exchan)-:c r:Hc mOVL'l1wnts are accommoda tive :md. hy tlll:!l1sdvcs, :Hxount for o nly p:ln of the total change in Ihe trade halanCl: Hill conclude.'s that 10 ask "How fa r must till' dollar bll \0 halann: thL' trade account?" is to serioLlsly O\'cn:stimah: thl.! CX!l:nt of nccdcd dollar ucprL"ci<ltion. Page 17 Reduced Defense Purchasing: Anticipating the Impact on State and Industry Employment Lori L. Taylor Despitc Iraq·.... invasion of Ku\\·ail. hudw:tary pressures in thc I lnited States m;IKC significant cuts in defense purch~ls ing :--CL"rll inevitahle Lori L. Taylor an,ilYl.es the employment consequL·ncc.. of clIning hill ion.... of dollars in defense purchasing ShL" finds that whi1c certain industries and areas wou ld L"xrK.:riL·nct" SOIllC cconomic difficulties. joh losscs would IX:." nL"gligihk' nali<mwiLie T ;tylor L"stimales Ihe ncar-term and ]OI1,1.:-lef m effects of a lO-pL"rCenl cut in I"ca! ddL"nse pu rchasing. Using input-oulput analysi.... SilL" delcrrnines which induslries afC defense depend cnl ;l1ld idL"nlifies thL" irnp:KI on employment in each industry Sill" finds Iha\ all induslric:-- would l().~c .~omc cmployment. bul 111:11 job losscs in cCltain ddt"n.~l"-(kpendenl industries could rC;1l"h 7 ') percent Taylof L"stilllalL".~ that ovcr timc. hOWt"Vt"r. bhnr displ:K"l"d hy defense CLitS would Ix' reahsorbed hy olhcr industrks ShL" aho finds thai all .~Ialt"s would lose al lea:--! :1 fl"w johs in IIlL" m"ar tl"l"I11. hut that no SI:lle would lose mort" Ih:m () ') pl"fn:nt of its employment if fe:ti defense purchasing decl ined hy ]() peH."ent. T:l ylor estim:ltes that no :--latL' would g:lin lllorl' Ihan 0;"1') [x'Kcnl of it.... employment nor lOSt' morl' than () 2') I1L'I"("L'nl of irs t.:lllploYl11ent in the long It"nn John K. Hili Senior EconomISt and PoHcy Advisor Federal Reserve Bank 01 Dallas The Trade Balance and the Real Exchange Rate hat role did the n;;li e xchange r:.lle play in Ihe (ktcrior;lIion of the U.S. trade halancl' W during Ihe 19HOs!- The s!ancbrd V il'W during the fir~1 half of thl;.' dl,!('adc-a vicw oth:n asslx;i;lled wilh ~ la nin Fl,k blCin-\\ as th;l\ till: federal budget dt. ficit (';lll~Nllhc trade deficit hut that it did so Ihroll!-:h an arrreci:ltion of the dollar. To repeat the well-known c hain of logic, the hudget deficit r.li:-.cd 11 S interest rates. which ('au:>l..'d the dolbr to appreciate. which drO"c the (r.lde anUlln! inlO deficit. During the second half o f the decade. after an cnonnou:> dcprl.!ci:l1ion of the dollar bik'd to eliminate the trade deficit, the U.S. tr.ldc prohleJll GUlli.: to he \ ie\\'cd incn.:::... ingly a:-;;J U ,S s:l\' in~" prohlem , '111e Ir.. dc deficit wa:-; a dirt:d con:-;e- qllcncc of a 3 1x.'ndin~ hinge l.illll: llleniion i:-; made of Iht" exchange rale Indeed, i n Ihe vil,.'\\· 01 Ronald MI.:Kinnon :lnd OIher global monel:lrb,ls. thL' exdl:lI1ge r.ue is un im porta nl 10 tr:l(k hab nn: deK'nnin;lI ion. I The di.'lxlrit y in views o n tht: t:volutioll of the U.S tr.lde deficit points to ;J need for :1 hetlo.;r lInde r,~tanding of the rcl<llionsh ip ht:t ween a na tion's track h;llance and ils f<.'a l l:xcil:mgl: raW. Till' theory o f how the tmele halanct" and the n:al e x c h an~e 1~ l\ e an,' joint ly dt:wnmnt:d under condil ion~ o f o[X'n Gl p il al Illarkets \\,;IS worked O UI and p uhli:-.hed in profeSSio nal journab during the t'arl y 19OOs. Th:n thL'Ory b, not c:..~ily accL':-...~ihlt:. howl"·Cf. 11K' purpo~ of this :lrticlc is tn prOVide a :-.illlplifil;.'(\ exposition of tht: thL'OI")' and 10 usc it to ~1lL'd light un rL,<:cnt and pruSPL"ClivL' l" 'cnt:-. in U.S. tr.ldt: hi:-;mry. The ct:ntr.11 fe:lIufc of the n"l<xlern tllL'OlY of tr:td\:., b;lbnn~ dt:lt:rminatiun is :111 t:xplicit rL'Cogn ilion of Ihc inlcncmporal choi(·c, thaI llnderlil" a F.conomic Rt.'v l ...",,· - No... ~mbC'r t 9')o trade imhalance. \"('ith open capital markets. aggre}::lte -"pending in all economy may deviatc fro m aggrt:gatl;.' income, and it may do so by a .~ ignilk:ln( ~H110UIll for <l Significant period of rimc. The ,~t:paration of srending from incomt: is the es.~ential mC:lI1 ing of:1 tl';ldc imbalance, To illlcrpn-t tr..de imbabnces properly, therefore_ we net:d to undel"3tand w hy a mit io n wou ld choo:'>C to s~nd beyond (Of sho n 01) it~ current incollll'. So, \\"e come 10 vicw tht:" tmele balance a3 :l fl'nl;."L'tion of illlcncmpor.. 1 choice In the illlcnempomi approach, disturbances with the gre:uesl polenli:11 for gencrating large :lnd persi:-Iellt tr.tde imbabnces are those im'olving a shift in the time dbtriblltion of domestic tiL-rll;md or :-.urr1 y. Exarnph:s include a shifl in prcfcrences for consumption over time or a change in Ihe world interest r.LlC. In COIllr.LSt. disIlIrh;mCl.'-" tll: tt produce a pcnn<l llellt change in income and :.pt:nd ing h:I\'c o nly small cfftX'IS o n till: trade h;ll:!nce. Thus, a long-term dcdint: in:1 nalion 's cxtL-rnal terms of tr..d e-due, for example. 10 tcc ilnologica l adva ncement in olht:r cou ntri e.~ OJ" l he imposition of foreign tr:ldc bar" rier:-;-is not hkdy 10 :lffect the tr_Idc bal:\I1Cl: signifiGllll ly, A.~ commo nly defined. tile real t:xchange r.llt: i;-. the r.llio of :Iggregate p ricc Ie\"ds in two COUlllriet> exprc:..,t:d in a single L-liITCIlC},. The fL'a1 See McKRlOrIandOhno( t986} MundcII(t987}expresses SII7IIIar O'ICWS Paul Krvgman was the first /0 nollCe the WJde dlsparotyHl wows oolhe n'/POfl8flCfI oIlhe exchange rale 10 IhedelflfnvnatlOl'loilhelraoooslllflCfI SecKrugman(J987} and Krugman aod Ba/awm (tOO7) exchangc ratc i:-. mon.: lllL":mingfully thought of. however. :I.S a t'olllpo:"itc of two types of rdatin: prices: a r:.IlC of L"Xdl:lngl;.· hetwee n tradeable J!O<xis in world m:lrkcts :md :1 ra te of exchange IxtwCt!n trldcablc and nontradcable goods in locII ll1;1fkct:> In thi-i anklc. 1 deal exclusively wit h tilt! rekition.. hip hctwecn the tr~lde halance :tntl the dOl11c1>ti(' rdati\'c price of nOnlraded goods 'nl i~ com pklllcnts :111 anide in the September 1989 iSSllc of Ihe /;"(:(IIlOlIIic Rel'iell". in which EYan Koenig eX:II11i n(..'d the inter.Klion betwccn the lrade b:liant'e a nd Ihe terms of Ir.H.ie. Theory (·ontinw,;'.s to providc a role for the real e xchangc mtc in Inldc h;\I:lno.: dctc rmin:ltion An appreciation of thc n: al cxch:lnge r,lIe, as rcnt."<.· ted in a fall in pri<.:t.:s of goods thaT aTe tr;t(kd relative to those tilat arc 11()t , reduces the tl~ldc balance by encouraging a movt!mcnt of resour(·t.:S out of production of l ra(k.'d go(xb and by inducing hou.s chold s to .. uhstiHIlt.: loward tf3ded good.s in con:>umption Theory al:-.o m:lkcS ("lear, however. that real cxch:mge r.ltt.: movt.:ments a re often simply :Kcommoda tin'-mofC the n.:sult of a shift in the tr.Jde h:liance tha n the causc of iT A nation wbhing 10 abM.lrh go(xis :11 :l r.lle that eX('ct:ds its ability 10 product.' them int .... m:llly would gener.tlly likt' to nm tr.ldl:: ddkit,.; ~I("rm..., a hroad spt.""Ctnllll of <..·ornmCKlilit.":-. Rd ativ<..' prices of nOlllraded goods rise to ensure that ;lny excess of dem:md o\"er supply i:" rcnt:cwd only in tf3dcable goods '11lese price :ld jU1>tmenh .'>t: T\'C the:: economic function of ..,igna1in~ pt:ople in the horrowing country to produce Ie:"s (nmsume more) of what can IX' obtained and mo re (lc1>s) o f wh:lt canno t be oblained from the le nding ('Ollrltry There :Ire hasic rl':I.SOns, the n. to believe that the forces clu:"ing a nation to run a trade deficit will also induce a re:III;.'xdlangc r:.He appn:ciation and th:1\ the appfcc i:lI ioll ilsdf wi ll affect the sizc of the defi cit l low 111llch of The tOlal changc in Ihe tr.ldc b:llance Gin he explained by rC:11 exch:mge rate movclll(..'ntst For disturh:mces that CUI evenly aCfOSS coml1lO(l ities Inlt unevenly across time, the fl";.l("lion of the cha nge in the tr.l(le ha lance that is induct.'(1 h y a n accommodat ing adjustme nt in thl;.' real exdlange r:ue is somewhat It's." than the ~ha fl: of nontr.tdt..'d goods in national p({Xiu(lion In the UniTI;.' (1 Siale." nontr.lded g{)(xj... aCCOunl fo r alXlllt 60 perc.·en! of gro1>S natio n:11 prodUll (GNP) 11 1i .~ lea\"(,:'s us ne:lr the middle of , the two extreme positions take n hy Feldstein and McKinnon. Pe rha ps one-h:llf of tile US. tr.lde dcfk it can be thoughT of as thc rcsull of movements in the rt:.':d exchange r.t1e. But the funda ment:tI caliS<! o f the deficit ha:-. heen an auto nomous shift in dorne~tic spending, :md the other half of the tmd(' deficit is a difl.'(·t mn"l.--quence of Ihat di ... wrh:mcc. The model Two ingredients arc essential TO :1 model of how the Tr:.tde balance :1I1d the re:ll exchange r.lIe :Ire jointly dCTt.:nllined : (1) a fr.Llllt.:WOfk of intertemporal optimization that provides Ihe basic motiwtion for Ir.tde imhalanccs and (2) an explicit Tt.:cogniTio n of IWO types of goods-those with high tr..lI1sport costs and thosc with low tr:.II1Sport costs--whose i"l;:lativt: price:" constitute tht.: re:ll cxchange rdlC. The model I now develop is the minimal-sized model wilh these fe:lIures. It is a :"implified versio n of a model analyzed by Ra zin ( 1984) and Greenwood ( 191i4). The model is defined by the following :t:-.sumptlOns L Theft! are two goods--one that can be c()~tle:-.sly shipped between countries and another that Glnnot be tr.Jded. The two goods arc consum ption goods. and they arc pcrbbahle. 2. Consu mers pbn with perfect foresight O\it:f :1 two-period horizon. The do mestic ca pital 111:lrket is perfect and is fully inteRrJ.ted with Ihe world (':lpilal market. The home country is small in world markets. so world interest r.ltes :lre not :lfft'cted by domestic di~tLlrhan("e.~. 3. Domestic productio n possihilities are fixed within each period There is no capital investmt:nt. :lnd reSOllf("CS are always fu lly employed. 4 Household prefere nces arc separable and hOl11olheti(" :\Cross time, and they arc identical and hOl1lotheti(" across gcxxls consumed within a JX."fiod. 5. The no.::t inTt:rn:lIional ~1 1>.sct pOSition of the home ('ollnt ry is initi:llly zero. The model n:cogniz('s only one t~'pe of intcrtemporal deci~ion houMCl1old :l lloGlI ion of con,.;umpt ion over timo.::. There is no iO\'<':1>tl11enl. Thus. the :-.ig n of the trade halance:: b determined solely hy the sign o f n;lIional x lving. TIle capital market i~ a mark.:t fOf consumption loans. Two indi\'idu:l1 intere:-.t r.Jtes c:tn Ix: dcfinl;.'(i--one for I',:dent Rescn 'c Bank of Dallas loans involvin).: thl.' u.ltkd good, "1' :md ,mothl.'r for lo;m s of the nontr::ltktl good, ,:,. Arhilragc bctwcl.'n cOllntril.'s I...'qllatcs rr wilh the world interc:.t r::lle on tr.ld ...-d go(xls. r:;.. intcmation;11 arhilr::l).:e is nonexistent in Ihl.' nontr::tded good, ho\\'e\"l,.'r. so there is nothing to foro.: '"., to l.,<\u:11 I~. As a n:sult. th..: <loI11L':.lit· int..:re:.t rale on :tggrcgatc conswnplion 1ll:IY he inOuencoo by conditions in local l11arkl:ls T Ill: a..su1l1ptions made :tbout household prt-fl.:.'r..:nn.'s ht'lp to ~implify the :malysis When pr..:ft·rence.~ arc tempor.llly scpar::lble. the dl..'cision concerning what tOlal tonsumption expenditures should he in :1 period (that is, the savings decision) can IX" separated from the (It;:cisioll ahoUI how thost: expenditures should ht: dividl;.'d among individu:tl t"(l1nmoditics. Thl;.' assU!nption of h(ll110theticity in preferences for goods t"(lIls11med within a period enSlLres the I;.'xistencl;.' o f a cost -of· livin).: index. P. that Gi n he used to conVt'n norni· Ilal expenditures into units of aggreg:llt: consumption in the analy:.is, I express :,11 nominal value,~ in units of tht: tr::L<k·d good. As a n:sult. Pis uniqut'ly tk-tt'rmint:d by the relative price of th ...· nonll~ltlt-d good . I will usc the term p to den()(e the rd:nivt' pnce of tht· nontrad...·d good Since p is the only Ol1llpOnent of the rC:l1 ('xchange mlc rcco).:nized in tht: 1Il0del. i will also refer to p:LoS tllc real cx· dlange r.Lle. (Sec the accompanying IXJX for a mon: oJmplch.' disClLssion of Ihe mC:lning of the realexch:lI1ge l~lte.) Chart 1 ,~ h()ws Ihe conditions for intertempor::d cquilihrium A representllli\'t.' consumer st"cks the highc,~t lifetime indifference curve hy choosin).: a ("(1111hination of present and futlln: agweKate consumption that is financially feasihle. Bec:tu.sl..' of OUT assumption that net foreign asscts are initi:tlly zero. the intcrtempor::tl hudKct linc passes through thc aggrcg:Lle production point V Aggreg:ltt' pnKluClion in period i is defined hy takin).: tht' va l uc of nalion:t! product in peri(xi i and den:lting it hy the cost-of·living index P<PI)' The slope of the budget line represents tht: op· Ix)rtunity COSt of present consumption and is ).:iven h}' thl;.' following: l composite goods. r Th:1I r::l te is ;1 produCI of both the world intcrest r.HC on loans of tradeahl~ g(xxls and a term renecling any expected change in the domestic cost o f living ikcause of the nonImdt'd good. openness of the dOIllt'stic capital m:trket is insufficient to cause an t-qualization of domestic and foreign aggregate interest r;lIeS. f)omcstic di~turbances that produce an expected dl:mge in the local price of the nontr::lded go<xl will 1>1..' rcncctcd in domestic inten:st r.ttes h ut necd not haxc an effecl on r.iles in world markets. Optimal aggregatt: consumption is determined by finding the poinr on the hudget l ine that yidds the highest lifetime uti lity The solution occurs :It point C, where lhe indiffcrence curve labeled IV is tangent to the budget line. In Chart 1, d omestic consumers collect ively choose an agxrqpte consumption point that lies to the ."oLLlheast of the domes1ic prod uti ion point. 'Illis l11e:1I1S that consumers :Ire harrowing on thei r future incomes 10 extend pr('sent consumption l>I..'yond wl1:tt is provided by domestit' pn:xluction _ National dissaving in the first period is given hy (e, - .1',). Because of the budget constr.lin t. conMlmcrs must s:tve next period in an amount :->ufficicnt to p:ty interest plus retire prindpaL Charts 2 and 3 show the condit io ns for within-period equilibrium. The utility curves ]a. het...·d VI and Vl represent different comhinations of tr.ldt:,d and nOnTr.lded gCKXls that yidd given :Hnounts of aggregate consumption. T he lines Ihat :Ire dr::lwn concave to rhe origin are pnxluction· possihilil ies scht-'dult's. Combinations o f g<xxis that provide a constant val lie of total expenditure or tOlal p roduct :Lre represented hy strJ.ight lines with a slopl;.' equal to the rebtiVt: price of the nontr.lded go(xI Equilihrium requires that any excess aggregate demand or Sllpply be reflected soldy in Ir.lded goods. Chans 2 and 3 depict this GiSt: I EQualJOn 1 can 06 derl'l6d by askIng flOw much additJOnal future co'npoS<lC CQflsvmplJOn IS made avaIlable by lhe sacrifice 01 one [Jf\It 01 preS6flt composite consumplJC¥l A UflJt 01 present CO'lsanpl.(lfl costs Pfp ,J IJ(I!IS 01 the traded good A loan oI/hrs /lI'JlOUOlal the~lIllercstr8IC, ';. will Y'flId (I ... r;)p(p,) ooIlS 011'" /T8dea0l6 good in lhe ne)(/ period Deflalcd by (18)(1 pMIOd'SCOSHJf.livlng IIldex.1his IS squntsfcnlto (I ... ';)P(p,Wfp" UflI/S oIlufure composslC Equation (It'fines the domestic interc::st rate on Economic Rt:\·\(:w_ Nm,.,mbcr 1990 -~ What Is the Real Exchange Rate? Ascommonlydefined , the real exchange rate is the ratio of aggregate price levels in two countries expressed in a single currency. As commonly interpreted, the real exchange rate is an implicit rate of exchange between the market baskets of goods produced in the two countries. The real exchange rate is more accurately thought of, however, as a composite of two types of relative prices : a rate of exchange between tradeable goods in world markets and a rate of exchange between tradeable goods and nontradeable goods in local markets. To make things concrete, suppose that two countries-the home country and the foreign country---each produce three goods: goods X and M, which are traded in world markets, and good N, which is not traded internationally because of high transportation costs . Let E denote the foreign exchange value of the home country's currency, e the real exchange rate, and PI and p. the owncurrency price of good j in the ho~e country and in the foreign country, respectively . To keep the algebra simple, assume that price indexes are constructed using simple geometric averages of individual prices. Then, if all variables are expressed in logarithms, the real exchange rate can be written as (8 .1) e=E+[aP. +(1-a)P, [ -[a"P";+ ( I - a*)P; ], where and In the above expressions , a and a* represent the shares of the nontraded good in aggregate domestic production , and band b* are the shares of good X in total tradeable goods • production . The relationships in equation B. t can be further simplified if we assume that international trade in goods X and M is frictionless. Cross-country arbitrage will then ensure that the common-currency prices of goods X and M are equalized across countries. Using this result, we have (8.2) • • a(p.- P,) - aO ( p~ - P;) +(b_bO)(P;_P;,) . Equation B.2 reveals that the real exchange rate is a composite of three relative prices : the relative price of the nontraded good in the home country , the relative price of the nontraded good in the foreign country, and the rate of exchange between the two tradeable goods in world markets . Each price has a clear economic function. The internal terms of trade equilibrate local markets for nontraded goods; the external terms of trade equilibrate the world market for traded goods. To speak meaningfully about the real exchange rate, we must be specific as to which of its individual components we are referring . The above remarks point out a basic difficulty with the theory of ~purchasing power parity." According to this view, the real exchange rate tends toward a constant value over the long run , making it possible to assess the degree of overvaluation or undervaluation in a given exchange rate . It is clear from equation B.2, however, that to assume constancy in the real exchange rate is tantamount to denying the need for relative price adjustment in the face of changes in world economic conditions. As a practical matter, the real exchange rate may revert to a mean value over long periods of time. But this would be an empirical regularity , not a theoretical necessity . For a recent survey of the empirical literature on the long-run behavior of real exchange rates, see Coughlin and Koedijk (1990) . Intertemporal and Within-Period Equilibrium Chart 1 Gi\'l.·11 rd: l li\'\~ prin::s. Ihe I,:h ....apcsl way of relchin}! utility l~\'cl l ~ i.~ to (."on...ullll.":u point C: . T he IIIO.-.t profitable comhination of produ<..1 outputs (XTUr.- at point } ~. Points and ) ; i nvolw idemiGIl qU:l1llities of Ihl." nontr:.ld .... d good :l1ld , therefore. :tre feasible. 11' ........ xccs.. dom....... tic dem and for tr.I(.I ...-ahle ~ood... in the l1r.-.t period is s.uisfied hy mnning :1 tr:l(le deficit In th .... st..-cond peri od. there is :m ~xce~,> domestic .-.upply of tlte traded good Thb is t h ~ fll ture tr:.lde ...urplus that pays fo r th ..... inlcrnation:l lloan nxeiw'd in the first period A j:!..... n~r:l l equilibrium rl."<luires that all the infOl'III:ltion in Ch:lr1S I through .3 IX! mutually l,"on....istl."nt. Th .... :1,gW.... g:lI .... l'OnSUll1ptio n point C in Ch:l rt I lIlust :Iwee Illathematically with points C, :lI1d C. in Charts 2 and .3. Lik .... wisl·, the aggregate production point }' in Chart I 1l11I.~t he consis tent with points YI :md Y: in Ch;lI1s 2 and 3 And the fL':l] t:xchange rates given by tlK' sl(Jpt,~ of the :-. t r:li ~ht l in ....s i n Charts 2 :Ind 3 lllust eomhine with r;, throu~h equation I , to pl"(xlu("e the slope of tlK' hud).!t:t li ne in Cha rt I r.; Con'Iposite good in penod 2 " w " Composite good in pElrlod I 0. Chart 2 Traded good In period I AJgeb ...."ic solution of the model ,,, u, SIopIt., - p , C~, Nontraded good • V.. , in penod 1 Chart 3 Traded good in penod 2 ,. u, CJQ • Nonlfaded good V... In F..c.:ono mic Revie .... -Novemocr 1990 penod 2 The dia~r:.lln:-. an: u ....... ful in defining the l.·quilibrium condition ... of the model and in shO\vin,g the fiN -round .... 0(,..(: 1... of a ,given di~tllrhance. Ik....:.u:-.e the d iagrams arl' inH:rrd:llt.'d. howevcr. tlll'y are in:.dt.·qu:lI<.> a,... :1 g...:n .... ral tool of analysis. For a more rigorous analY"'ls, w .... mliSI represent thL' l'qllilihriulll condi tions hy mathematical equations and solv.... th...: t:C[u;Ltions ... itlluit:lncollsly. T he p:l rlic ul:lr solutio n 1Ul.·thod I use highlights the two-way rela tionship hctwCtl1 the tr:.l(k h~l lano: and Ihe n:al .... xdl:lng.... rat e In one set of l'quilibriull"l .... qu:nio ns, 1 tak .... till' real exchange rat...:s ;IS givtn and us.... the conditiol)s for p roducer and con.... ulller optimalit y to solv .... for the desired tr.lcll.· h:l lancc:-. In a .~ .... cond ,....... t o f L.·<.[u il ihrium l.'(llI;ltions, I lake tilL' trad .... halanc....s :I,~ g iven and (ktermine whll the real L'x('hange r:ltes mUSl he if 10GII rn~trkcls for nontr:.lc1ed good:-. arc to clear T hl." two :-.et:-. of ....qu:ttions can h .... soh'ed togethcr to find the g .... n .... ral equilibrilllll. (So,.. t' the Appendix for additional lIlatl.·rial rcl:mng to tltt.· algehr:.l ic :>olution of tlte 1110d(:1.) How the real exchange rate affects the trade balance. If v;lllll.·:-' for thL' I"l.:;,l l exchange r:.ue arc gh'cn. e:ldl pel'i(xt'.-. tr:.lde h:tl:tnce ca n be , deterl11lnt'd from the conditions for producer and con:.umer optim:llity The fc)llowing equations de,'.,(:ribe th L" rd:llionship betwccn the trade balance :Ind the real cxch:mge r.lle: (2H 3) '"' Y,,<P,) - c l ,IP" C,(P I 'P!)1, fori -!.:! The tr.lde b:llanc(', f" is definl..'(l :I.~ thl..' difference hctwl..'t;n domestic supply of tr.l(le:lbl(' goods. Y T ,. :md domestic dem:lnd for Ir.lde:lbk goods. c r,' Givt.!n the rdative pric(' of nonlr.ldcd goods, Y n is determined by maximizing thl..' v:llul..' of national pr(xlw.:t along the produclion-pos-"ib ilities frontier. Knowing PI and PI' w e can al...o definl..' each peri(xl's cost of living :lIld , thCl't.."fore, the domestic in terest 1'<1\(;. Aggregate dcmar\d, 'I' i.,> found hy maximizing lifetime utility :l long the intcl'tcmporal budget linl..' With c, determined, a (,:orrespo nding indifference cuJ'\'c shows ;l ltefnativc comhinations of tr.lded and nontr.lded ,!!;c)(xls th;1I yield that particular quantity of aggregate consumption. Optimal demand for the tr.l(kd ).!ood, en' is determined b )' finding the che.:ape:.t way of obtaining c, at prc:vailing prices, Equations 2 :lnd 3 are.: sim ilar to equations typiGllly uS\..'<i in economel ric studil..'s of the t['".Ide halan<:c. The c ru cial difference is Ih:n, in these equations, the intertempor.l] nature of the aggregate spending decision l'i explicitly recognized. In the tmditional approach, CllTrent :;pending is exprc:.sl..-'<i as a fu nction of current income. In the inlertcmpor..t l approach, cum:nt ."pending depends on 111(; imcreSI r..lle and perrllimenl incomc. To anal},!',c movements i n the tr~ ld e balance. il is useful to t.!xpress cquation .~ 2 :Ind 3 in pcrcenta~e changes To keep thl..' algdml simple , I will assume th;lI , in the initi:11 equilihrium, tr.lde halances arc zero ;tnd cb stidth:s :Ind budget shan~s :In:.' tXlllal across lime. (4) %Ill r - %6. 1 ~·· - (U;(%Ilpr ) - lIy(%Ilp l ) + (I - v)a ja (%tlp,) (')J - (/(%Ilp~ )J. %111'; - lI£(%llp!) - tly(%Ilp) + "<1la(%I1P!) - {/(%IlPI)} Equation...; 4 :lnd ; dcserihl..' :my ('!lange in the tr.lde hal:mee (wriu t.!11 as :1 I".'rl'l.:nt:lgt: of initi3] 6 .~lIpply of the traded ,gI)()(l) either as the direct ["t'suh of ,Ill c:<ogenoll~ disturb;tnce or :IS :I re." JXlIlSC to movements in the real exch:lngc rolle. TIle term %6f7' rcpfl.':..(.'nt:. the direct effect of tltt.' di:'lllrhance. That is. %Ilf:' is the change in lht" tr.lde balance that ()("t.· lIr~ inder)l,~ndenlly of mO\l(;menl" in the real exchan).!c r.lle. Exchange r.lte dTI..~1S ()("cur through threc ch:mnels FiN, the change in relative prices implied by a real exehan).!e roltC mOVemcnt alters dOIllt;'stic production of tr.lded goods. '1111.: size of this dfect depends on the share of nontr.lded gc~ xls in the dome:.tic economy, t.I, and the elasti<.:ily of substitution ;Iround lht.! production-possibilities frontier. e Second,:l ch:tngc in relative prit"es alters the demand for traded goods by shiftinJ.: tht! commodity composition of domestic .~rl..·nding. The size of thi." eff(;;.:t depends on thc relative impo nancc of nontr.lded goods and tht: ela..-ticity o f commodity ."ubst itlrtion in consump' tion. y. The first two price t:ffe;.:(s reil\forc~ one another :Ind contrihute to ;In inverse rebtionship betwee.:n the real t:xch:m).!e r.:11t: and the tr.lde balance. An apprl..ociation of the Tell exchcange r.1(t: reduces the tr.lde balan;.:c Ix)(h by encour.lging a movement o f rCM)un.:cs out of production of tr.ldl..-O goods and hy inducing households to substitute toward tr.lded g()(x\s in conslllTIp'ion. T ilt.! final price effl.."'{'( il\ equ:l1ions <'I and 5 is k:..~ bmiliar. It repr(;~nts the effi_'C t of exchange r.ll e movements 01\ :L~reg,l\e spending An inn(;;t~c in the fir~t -pcriod real exchange rate r.l ises th e.: cost of li\'i ng in the amount of a(%!J.P I ). If this changc is thought to he tcmper.lf)'. the d omestic inten.:.~t r.lle will rbe Consuillers will s.\\'(' more in the first period and redu;.:e their demand for hoth tr.lded and nontmded ).!oo(ls. The st],ength of this dTe(·t (k'pends on the share of present consumptioll in total (discounted) lifetime <:onsumption, v, and the dasticity o f int(;rtempor.:il substitution, 0'. Note that (he third price clTect disagrees in sign with (he first (wo. By r.l ising the domestic int<:rt..':-.t ml(;, an appre<:i:ltion of the re:iI exchange r.lle di.,;.:ourages currl..'nt spending and therehy implVl'('S tht: (['".Ide ha1:ln;.:t.'. Fo r thi .. effect to be .~i).!nificllll. ho\\c\'cr. the cXl:hange r.lte movement 1lI11!';t he temper.lTy. If it were permanent , so that %tJ.fJL t.'Glml(;d %ll.pl , (hen the domestiC interest r.lle would nol I:hanjole. :lnd there would he no I..'ffl..oct on aggregate.: :.pcndin).! Feder.. 1 Kcse n :c 8.:ank of Dalla.. How the trade balance affects the real exchange rate. The real exchange r.He is not an exogenou:i \·:lriahk· In my :malysis, the real exclwnge rate adiLLsts to ciL-:lr the loca l rn:lrkd for nontl:lded gO()(,b. This <:ondition <::111 he cxpn.·ssl.'d in equation form ;l .~ As indil:ak'd in Ihe e<..ju:uions. the value of the real eXl:h:lnge rate th,lI clears ilx'al marke\.<; depends on the tl";ldc haJant:e This relationship ca n he cxpl:lined with reference to Charts 2 and 3. The total .~u rply of goods 10 Ix: alloclIed among domest i<: consumers consis\." of goods produl"Ixl intL'rn:dly plus the net quantity of good." ohtained from othL'r countries through intern:uional borrowing and lending Tn Ihe ch:lrts. thl: point of tala I domL"stiL supply is found by locating tht., domestic product ion point and then moving venically lip or down hy the amount of the trade bal ance. Consumer demaml is foun d by maximizing utility along the expenditllre line that passes through Ihe point of total domesric sllpply The equilihrium real exchange r:lte is the relative price ensuring that domestic rn:lrkets de:lr. The trade halance affects the real eXl.:hange ..tit." hy alteri ng the relative :lVailabiJity or goods in the L'conomy Trade deficits contribute to :1 rdatin: shortage of nontr:1ded goods Thl: real exchange I";lte lllllst then rise to encourage gn:ater production :mel lower consumption of nontr;lded gocx.ls. Trade surpl uses. on the olher ha nd. creale a domestic surplus of nontraded g<xxls and put d01;\'nward pres,<;llre on the re:1I exchange r.lle. A fonm11 statement of how changes in the tmde bal:uKe afTet·t the real ext'h:tnge mte is provided in tht· follOWing ('"<.Iuations: (RH9) %t!.p, - -I(%t!.s~" )+ (l - I I( I - (/)(()/\I6 t)J (/)(E + y)l, for 1-1.2 Tht.: reciprocal of the denominator in equations 8 :l nd 9 indiC:lICS tbe amount of cha nge in p, net.:ded to eliminate an t:xces,'i supply of nontr.ldt::lbles in the amount of 1 percent of initial supply. The required price adjustment is brgt:r the more imponant the nontraded good is to the Ec onomic R•.:view - Novembcr 1990 economy :lnd the smaller are the elasticities of substitution in production and consumption The term in hrackets in the numerator of the equations sh()\'vs thl: c hange in excess supply of nontraded gOOtlS expressed as :1 percentage of initial supply Exogenous shifts in eXces.~ supply are denoted Ms':" The otht.:r source of change in eXl:es.s supply i~ the tmele balance A ri.-;e in the t"lde b:llance in Ihe amount o/,08t, lowers n:ltional expenditures by (I - aXMt) and the demand for nontradeables hy an eq ual percentage Shifts in thl: tr.lde halance then (.";Iuse a ch:lIlge in the re.ll exchangl' r;lIe that is opposite in .~ ign to the change in the tr::lde b:ll:tnce. Equations 4. 5, H, and 9 prOVide a general framework for analyzing movements in the tr.lde habnce and the real exchange ratc. As is clear from the equations, hoth the trade balance and the real exchange mte ,Ire endogenous to the domestic economy. Neither can change withollt an initiating di.';turbance o r shock. In the analy.~is to follow, I will classify disturbances into two types: illlenem/XJral shocks-those that d irectly :lffect tht: trade balance but ha\'e no direct effect on tbe re;ll exchange rate-;md commodi~JI .,·hocks-those that directly affect the real exchange r:lIe ,lnt! mayor may not affect the trJ.de balancc. Analysis of intertemporal shocks Inlertemporal ..;hocks are distLlfbances that aiter the tr::lde hai;tncc without direct ly affecting rdative prices within a period. Examples include a shift in intcrlcmporal preferences, a change in the world interest r:lle, or a change in domestic production possibilities that is even across commod iTies but uneven across time. In algebmic terms, a n intertemporal .';hock is defined by the fo llOWing conditions: MI'I" :F- 0, o/\I6 t ~' :F- 0, o/\I6s ~"'''' O. and °Al.!ls~x - 0 with v(~t';') + (I - vX~ t ~"') - o. - Charts 4 through 6 illustrate the effects of a fall in the world interest mte. To kcep things simple, I :t.<;Sumc thaI the tf'J.de account is bal;mced initially. A decline in r; affects the domestic cconomy by lowcring the domestic interest r::lte. The intertemporal budget line in Ch,ln 4 rotates counterclockwise through the aggregate produc· tion point. Optimal consumption moves from point C to point C'. Households decide to con· 7 <;ql~ JU 'tU'CH 3.U.M;)lI IIIJ~J "111 IUtUJ 01t1 , ... 1.I1: ... ltO!I)IJI JO "'1:1 .11[1 tI! .,:ill l:lp"., l':.Iolhu,)U,'llI! JO >: ...:ncud "111 .1\llIUIl:.~.II'" 01 d[.llj WIll "'11I.,uII ... nlpl' ;l.,ull ., 1111'1" ,1 1.1.")lp.l .'11:1 .1:iIU·lj) -"., P:"J .")IP 1Il "'lll.'!U.' 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Ilow much of Ihc changl: in the trade b:llann.' em hI.:' ;lIlributl.."(l to exchan~e rate mon:m..:nlsf '111e :mswer b ~i\'cn helow Ih:1I1 (£ + y}-so th;1I tIll' effect in cqu:ltion 4 is relaliwly small--<..'xc.:hangc r:.llc dfccts will he reinron.:in~, moving the tl'ldt· h:l1ance in Ihe sanK' dire::ct ion :IS Ihe initi:.l distllrhance did. How brge is the right side of equation 10 likdy to he~ Empiric. l e:.timatl's ineliC:He Ihat a is Vt'ry low, near zero. Suppose we use a va llie of 0.2 for cr. The par:lIlleters £ and yare not well est imated . hut IIll'Y ;m.! thought 10 Ix: sollll:what larger than cr, especially the elasticity of tr:msform:llion in pro.. ductiOll For the sake of c:l1ndation. assume that (£ + y ) I:qu;!ls 1 The fin;!1 par:lllll:ter. (I. is tht.' :.il:lrt· of nontrad<,"d good" in n:llion:l1 production. For the Unitl.."(l St:Ilt!S. a i:. d(l~ to 0 6.·l When: docs thi.~ lea\"e Lt.,,? The answer i:-.. alxllIt 0.5. Roughly ont! .. half of thc mOVement in the trade h;. iance l'an Ill.' anribUlcd to movcments in rC:11 exdl:m~e r:Ltt.·s. I'rovid..:d Ihat (J b Ie:>.'; aj..(J.tn.:~ah.: sp(" nd in~ Analysis of commodity shocks Commod ifY shocks arc di:.t urha nc('s w ith a dire{'[ effect on relative prices within ;J period. In the COOlexl of my model. commodity shocks in .. volve an exogenous shift in eXl"e:.s suppl y of lhe nontraded good [n some GISeS, thl:rc m:ly also be an eXo~t!nous shift in the trade halance. In genl:ral. we may h;l\"c %8t~·· -:f:. O. ~t~' :F- O. %.6.s;·'· -:f:. 0, ;.lIld 'X.a.~';' -:f:. 0 ' - Ch;1I1S 7 and 8 i1lu~Ir:llc Ihe effects of an exo~cn()u.~ drop in pnxllKlion of tr:.uleahk g(xx.ls Ihat (X"l'Urs :11 the samc mlC in the two pcri(x.l'i. [n Chan 7. aggregate production mo\'cs from point }' to point }". Optimal l·onsum plion. which begins at point }'. cnds lip at point r' All tht"' decline in nalional output i:-. ahsonx. d hy consumption: S;IV.. in~ rem:lin:. con:.tant (;1t zero) \'(,Ie em use Ch:m H 10 l"Cason through the effc("i of the disturh:IIll"\.' Econ o m ic Rev lew_ NO\'~ mbc: r 1?90 on tile rl::11 ("xl"ha n~c r.lle At const:ml prices. production mO"eS from )~ to )':. Commodity dem;mds shift from C ; to IJ, . There is an exces,o; supply of nontradt!d good:-. ,mel an excess demand for IrJ.tied go<xL... 11ms, the rdati\'c price o f nonIr..ltied good.. must f:11I in each period. 'Illt! diagr:.llns ~t1gge~t the fo\1owing conclu .. sion: A perm:IIlt!llt drop in tradeable g<xxls production lowers the re:.1 exchange r..lte but h:ls no cffect on the tr:ldc halancc. How is Ihis (X)ssiblc? The key is th:1I thc di:.tunlance has :I diR"'(:t df(.·ct on the Ir:Jde halanee At constanl prices, the tr.. ele balance f:l lis hy ad pt!rcent, whe re dis Ihe ralt:' of decli ne in output of traded goods The shock also lowers the rdalive price of nonlraded goods by d /( £ + y) pt'rceni in c;!ch period These price changes improve the tr:lde bai:u)Ce hy encouraging gre:lter production and lowe r consumplion of traded goods. Uut tile price effects. which are rt!prescnted hy the second :lIld third terms o n the right side of equ:uions 4 and 5, simply comhine to offset the d in.."Ct d(I:<.1 of the dbtllrbance. In general. commodity shocks that a re even acro~s lime have strong implications for the real exchange r.lle Inll little or no effect on the tr..lde • The shale 01 nonlladeables III domestIC economoc actIVIty 'solrcn measured by /tic Iractonolgross domestJC prodvcl (GOP) 8UOUfIlcd {Of by conStrlJCIIOfI. transporto/JOll and ptJOIIC vt,lItlCS. wfIoksalc and rCllla /fllde. Manc,al serVICes. bvsmess SI/fVIC8S. soc,atand commvrnly ~rvices. lind governmenl /n the Un,led Stales. these OIJdvslroes cons/ltule rOUQhly 70 perC(!(11 01 GDP I adJUst/h,s number downward somewhat to account!Of the mcreasmg trad~ ability of some SClViccs • These terms may. 01 course. not be independent Ttlcy shoold be speclI,ed 'rom a more ptifnilive descllpl'on of Ihe d,stv'Dance ConSIder. torexample.thccaseofexogenous CCOo'lOffllC Qrowlh LeI Q denotc lhe exogenous rale of in· crease III ptoducllOfl 01 good I IT! perIOd I Then. ,,'" _. SAy IQ. p aJg • babncl.·. Con."U!l1t.·r:-. do no!. horrow in Illl: f:Kc.: of a penllanc.:nl (k·d int.· in inco!l1e beGlu:-oc Ihey he- Effects of a Decline in the Production of Tradeable Goods Ileve tIK·II1:-od\,l.·:-' I() he t.·qually poorer in :III pe:ri- 00:-0. If the de:d i ne: in income: i.., expected 10 Ill: tc.:mpor.II)', ho\\ t.·\"e:r, l ·on:-Olllllcr:-. witl bom)w to mainl:lln Iheir prl·"l·1lI nlll:-.umption. In thl:-O C:I:-.e.:. Ihe.: trade.: h;ll:Ino.: \\ ill WOf'ot;'ll An import:lnl cb ....... of comillodit)" :-ohocb b th:u de.:fint.·d hy :1 Ch :lll~l.· i n :t COl lnlry·s externa l 1l.·nl1.... of 11':lde.: En.:m:-o Ih:lI affecl :In eco nomy hy altt.·ring ils ICTIlh of Ir:ldl.· mdmJe the illlpo1-oilion of fo reign 1r;1(1c h;l rri CI"S. :. (Il,-'d ine i n intt.'rn:lI ional comlX' tit ivene:-.. . due 10 fore ig n economic gn:)\\·,h . and o i l price .. hol.:k". From :m an:l lytical viewpOi nt, the.: cffecI:-. of a til-d ine in the tenns of tl:Kk: arc an;lIo~olls tu the c1fet"l.~ of an exugenous drop in dOllle.:.~tk production of tradeablc good:-o ~ Thus. o ur prc.:viou:-o l.·xen:ise has a :-.uqx isi llgly hma d r .•nge of appl icat io n . Consider th t.' l":IM': of foreign tradc.: harrit.·r; Whl."liler tht.·y arc in tht.· lorlll of impOI1I:lriffs. quola:-., or re"triclivc.: inlt.·rn:ti m:lrke:li ng agrc.:c- Ad{N.onaI SSS!¥I1PlIOtl5 sr. rflQUlled 10 tn/Ike Ihls analogy ptt1CrS6 Doe approach 1$ 10 asStme /hal pte lerences for CCl'lsumplJOrl "r/tlln .. perIOd are $Cp8raole If) /laded and fIOfIlradetJ goods and lhal me subuMty fvnctlM over 1fIdt, ",dual uar;Jet1 rJOOd$lS hcmothellC The tneJ,ffcrencc map in Cnar/s 2 and 3 Iflerl writ show /Iouseno;d pte1erences for e<mpOSrle COflsumptlM 01 /faded goods and COflSlM'I1PIIOfI oImeflOfllrlfdcdgood 11>6 -ptodrJctlOfl-(JOS5JbdJI<es sdIed ukJ WIll s/IO"N comblflallOflS althe IWD CompDSlli.J goodS the country can COflSume " II IS allowC(j 10 I/ade wrth Olher The schedule Will nailOflS Wlthltl a perIOd bur not over tltTl(f depend not Otlly Otl l/Ie SISle oIlochnoiogy and domeS/IC Chart? Composrle good on penod 2 w CompoSIte good in period I Chart 8 Traded good ,n perIOd 1 (2) ,, ,, " "" " . , I " , " B. ~ y u, Nontraded good ,nperiod 1 (2) resource supply bill also on Ihe exlernal terms ol llfldB II me lerms o f Irade d ewrlOfOIO. leS5 Y, IS available lor anygrven Y, For IJ (JlYleralllnlllysls of the effecls of Cflanges /(Ilile lerms of If/Ide on /fle Iracht b8!;lr1ce see Svensson and ROJz;,,(I983) Th,S Iltle 01 argument IS precisely thaI usee by Sachs ( 198 1J c.~plal" the lack 01 a petSlswm COfreld /1(I(l bfitWf!()fi relal.ve at! d..~ an<1 me sIZe oI/he Irdde defICll1tl to rrn1Mouai CClU"lI/.eS after lhe 1973011 ptoee rt,~e InvnedIal/!/y OJiler the poce lnCfea5e many OIllITIpOiters rncludtng the Unrled Staws. saw the,! traOfJ acCOVnlS deieraa'e Grven perCepllOfl/agS and /he costs of adjUslrng CMSUfflP. not SlJfpi'Sin9 Durll'lfl /fie 1975 78 perIOd. 1110 defICitS 01 1n.tny001.unporlrng I13tlMS returned to ptewous levels In the end oil depeflt:Jence deterfTWlCd /J1e e~lent 01 a 11311011"5 rilal.ncome loss wt not /he sIZe of t>Ofl. /illS fl!lC/IS nowe-er ,ts trM/8 deflCrl " Ilwnt.... fon.:ign tl~I J I.! b:. rrit.·r:-. rl.!dun· dCIll:llld for product... e." portl.!d hy ollk'r Ilal ion:-. ;ll1d. COI1."I.."qucllil y. lo\\'t.:r Ihd,. p,.ice Is there rV:I." oll 10 Ihin k Ih:ll ;I llallon f:l(."I:.'d \\·ith :J (kl c.:riO I~l tioll III ils It.·flil" of lI~l(k \\ i ll rl.·:-lx)Ild hr nlllllin~ :1 If:ldt.· dd"icil ! HqX" .l tl n~ (llir p rt;:\·ioll" ('()nd ll~il.lIl. f()rt.·i~1l tr.l(k h:II"I"I<..· r ... \\'111 e IlN.:' lI: l(k' dt:hc lh i n ,.:"porll1l~ 11:1 l ion .. onlr if thl.! h:lrril'r... arl:.· tt·mpor:ll")· It Iht.·y :I rc nlll"ide:n.:d fll.:nn:lne.:nl . Ir.ltie harrlt.· ..... \\ 111 11;1\C liuk clTl't: ! o n t l~lde h:da ncc ... EXpOI1 ......... :11"1': , of ("t)Il,....,·. nOI Indiffl.-rcnl to f()r.... i~n tr.l(k ft.· ...I I";linl:-O. T ht.·ir fl.';11 in('Oilll.· ... \\i1IllI..·]o\\l'r ;1." ;1 H ':-'1I11 But til<.' rt.· ... ]")(I11......· 10 :1 Ix·nnallt.·nt fall in innl1lK' .... to rl'{hlCI.." nlll"'"lllption . nul to n.Ul :1 1r:.l(k· deficil h f l.'dc-r.-I R('t>t.· ..w Hank of Dallas Understanding the 1980s '·.S Thl' Ix:hanor of th~ tr;td~ halance chanAed rathca lly during th~ I<)HOs (Chan 9). In the prl'\·iou ... d",'cadl'. trade imh:dan<:t':- were rebti\'dy ...mall (within I percent of GNP). ::U)cJ they were.: te.:Jl1 poral)' Then, the 1I.s Ir.LcJl' accounl ... te<Ldily dl'lt'rior.u<,,"d from a IXlsilion of approxi111:lte habnn' in 19BO to a ddkit of more than .3 pe ....:l'n[ of G,P by 198-. T hl: 1r.llk h::tlance has imprn\ l'd sOI11l'\\'hal since Iha\ lillll'. hUI it rem:l!ns IX·t\\l·i.: n - I percent :md -1 percent of GN P What GLn :K"count for Ihc growth in thl: [ralk dl'ndt~ A:- we h;l\'l' secI). the disturb:LlKl'S with till' }!,rl'atest potential for Al'nl' l~L ting large :I nd pl:rsbtl'nt shift s in the Iradl' \);I[;II1Ce :trl' intertl'lllpor:d shocks-those w ilh a direct effecl on tht: time distrihution of (1<-'111:111(1 or supply l)is(:u ...sl.:d helow a re tim::" intl'I1l:mpor::tl shocks fn:qm'ntly cited a:- <..' ontrihuting to till' US. trac\(: deficit. Eal'h h:: ..... the effel't of l'nl'ouf:lging fO fl'ign indehtl·dne.....". \\ hich j<; manlfl'... t in a tl':.I(lc dl'fidt Growth in the U.s, federaJ budget deficiL Uudgt·t dl.:fidh f:li.'>C aggr~g:lI ..... ... pending whl'n the implit'(l futuro.: t:IX tiabilitit·" :lre not fully n..'CogniZt."'(1 hy hou:-dlOlds, In ~ffl'l·1. lkfidt spending hri ngs ahout a suh:-titutio n of prt'sent (.' onSlLmption for futuR' t·on:-umption. This p rocess could Ix.' rcpn: ...ented in Ch,1n I hy a ., hirt in intertempor.11 prl.ferences toward gTe:lh:r l'urrent con'lIl11ptil)l). Decontrol of capitaJ Oows. As d iscussed in FI~H1kel ( 19H<)1. a liber~l liz:l1ion of controls on clpital olittlO\\' hy j:lp;m and olhl'r major COllntrie." during Ihe [;t1C 1970s and carly 1980... \Vas al.~o :111 illlpnrt:1I11 factor hl'hind lhe now of fund s to th ...· li n ill'd States Tht, d...·rt·gul:L tion o f fo reign Glpit:d !low., I"\.·cluced US. interl' ....' rates from \\"h:11 Ihey othl'rwi.......· wou ld h;I\'t' IX'l'n This f;1(.'1 lllay l'xpl:t in wh~' the llla ....... ive U.S hudget deficit.-; faik'd 10 product.' :l notice:Lhk ri:-e in U.S intere."t r.lIl·.... Cyclical move ments in Investment, A!'o no\\.·d h~' Koenig (1%9 ) and Otl1l'TS. :-ome of Ih ...· mO\'Cll1l'nt in the US tr.tdt, h:tbnn' dllring the fir.-t half of the 1980:- ('.'an 1>1.: :1IInhutcd to cyclical :-,\\inA'" in l ' S imt::-tlUent <.klUand h)\'cslm~nt "'1")Coding \\a'" weak during th ..... II)HI-H2 n::cl·:-.,ion II then ... ho\\,...'([ unus ual :-trcnglh in 1%3-&1 Econ o m ic Revie.... -No\'ember 1990 Chart 9 U.S. Current Account and Relative Price of Tradeable Goods Price indel rabO {1982_ 1001 Currllfll account PercentotGNP 3 115 (Four.quarter rIlOVIOg .Yefages) 2 tl0 '" -, " -, go " SOURces OF PRIMARY DATA ' tnle<nat>Onal Monetary Fund, US Btoreau 01 Labof Statistics. (panly in rl'sfXm' ..... to \Clll l>Of:ITY \:IX incentives) hefore rct\lrnin~ to lllore nonu:!1 !t·\,e!s. In OUf 1U(Xld, il1\·e:-tm..... nt em be Ihought of as an activity thai :-iphon:- Te:-ourl'es from the pnx[uction of om... umplion g()(xis. A lempo~I)' sur~e in im'estlUenf nxlllCt·S tht· nation 's opacity to produce nmsumption good:- ill the p rt'Sl'nl pcri(xl and thereby enCOUf:lges intern::ltional IXlrrowing. Concurrent with fhe lIedint: in the U.S Irddc h abno,: \\,:IS a fall in the doml·:-til' rclativt' price of lr.Ldcd goods (Ch:tn 9). This pri!..'c 11100't'ment con· lrihuted to the Irad ..... dcfi cit h y :-qlleezing domestic nJ;! nufact ur i n~ indu.,t rics :Ind e ncouragi ng household s to ConSUl11l' more forei~ n products. [n isola tion, thesc effects sel'm arbitral)' and capricious. This perceplion. I S\,lSPCCt. is the source of much puhlic confusion f""garding Iht' o rigin of the trade deficit-for example. att ribut ing the deficit to un- rhls ana/y$ls leaves un8J<I)Ialfl6d why Kllhe pu~se;lCe 01 Darners 10 caplal outflow KlICfCSI rates would be lower Kl Japan and other 00CJfI1f1eS Ihao ., /he l.IrulOO SlaleS As I have shown elscwhcfC (H.tI 1990). /fI6 re/arlv6lyhlgh JcvcI 01 U 5 .mc<esl fales can be ploo.cllKl $II7¥lIY on /he baSIS 01 dIfferences Kl /flo ago dlSffllJUllOfIS of /he poputa/lOtlS 01 100 mBJOr industrl8lUcd COUftInc5 " faif fo reign fr.I<.it: pr.Kticcs or a loss of international COI1lI~lil i vt!ncss If the shocks Ih:1\ produced thl.! U.s. tr:1dc deficit were prim:lnly intent::mpor.tl in nature. however. the f:dl in tb;.· rdative price of tr.tded go<xb was more the n:sliit of the tr.lde deficit than the COllise of it. And Ihe dom<;:.<;tic :Idjustments in production and ct)n~UTllplion c:mscd hy this price change were. in Ihem sel\'e~. desir:lble. If you arc going 10 run a tr.ldl.! defidl. it is preferable that you produce less :Ind consume mort' of wh;tt you can get from thl' other party. If there is any problem with the whole proceSS. it is with tile root cause-the shock itself. TillIS. on(' may reasonably object to the loss of futurl' consumption that is implied by :1 govcrnmcnt hudget deficit. Bur trying to block tltt:: micfoeconomic adjuslmt!nts without reducing the hudget deficit w ill only t!xacerbate the welfare los.<;. Conclusion In this artide I have tried to provide a simple exposition of the Ih;.'ory of how the tr::ldt: balance and the rea l excha ngt! r.lle a fC determined in a cmmtry with an open ca pila! market. TIIC thL'Ory offers some important gener-II principles that Gin help us interprt!t P:L...t :tnd future developments in the intt:rn:lIional .'>CL1or of the economy. Of the numerous prindples revealed in the theory, two arl.! e-"pecia lly noteworthy First, both the trade IXllance and the n::d cxchange rate arc elldogenous 10 the dome .... tic L'"Conorny. Neither can change without :111 iniTiating disturbance in domestic prderenccs. domestic production possibilities, or prices in world markets. Since the disturbance itself is likely to have d irect effects. movements in eithef the trade h:l lancc Of the t!x<:hangc rate generally cmnot lx' explained solely as a response to Illovemt::nts in the o lher. A second important principle is that the relationship lx:twet!n the trade halance and the real t'xcha nge r,ue is hidin.'Criol/a l. Too much emph:tsis is often plact:d on the cau":llity that nlns from the exchange fate to tht: tr.lde halanct! and not enough on the caus:Llity Ih:1I nms the other way Indeed , for dislurhall1.."'t.'s Ihat primarily involvt' a shifl in the intertempor.11 u i... tribution of dema nd or sllpply- ·d bturhances thai are mo ....t 12 clpablt' of explaining 1:lrgt: and pt:: rsi.~tent shifts in the trade hala nce-tht: more primitivt! direction of c:llIsaliTY is the one th;l! n.ms from Ihe trade balance: to the rt:al exchangt: r.lle. Intt:rtempor.11 disturhance,,'s h:I\'e a uire<.1 effect on Ihe tr.lde balance hut no direL1 effecl u n the rcal exchange r:.lle. Movements in the exchanRe:! r..IIe accommodate shift... in the Ir.ldc b:llance TheSe:! b:lsic principlt!... must he well appreciated if \ve arc to anticip:ue correctly futu re developments in the !.-"Conomy. For ex:uuplc. the factors h:\\'ing the greate:-.t potential to rt:verse the US. Ir.lde:! ddicit- includi ng reduL·tions in Ihe fe der:.11 hudget deficit. 1111 agi ng of Iht: popul:ilion , Of a n llolT in foreign lending-arc all inten empor.d distu rbances. Accordingly, tht: initial impetus for d c-fieit fl'du ction will come from lht: disturbances tht:m ...dves A decline in the tr:.lCk deficit is likely to Ix: accornpa nit!d by a depredation of the rea l dolb r. Uut tllat depreciation itself will ;.'xplain only p:lrt of the ultim:llc improvt::rnent in the deficit. Studies that :Isk "How far IlIllSt (he dollar fall to balance tht! tr.ldt! :lCcount?~ art:: likely to overl.'sTimatt: seriously the extent of nt:eded dollar dt:prt.·(." iation Fcder.ll Resen 'e Ban k of Dallas Appendix Derivat ion of the Algebraic Solut ion Techn ique This Appendix demonstrates how the algebraic solution technique used in the text can be derived from a basic set of equilibrium conditions. The basic conditions are given below, together with comments about the nature and meaning of the conditions. Within-period consumer optimality (A,8HA.9) C, ' u(c.,c,,), lor i. 1,2, [Periodic utility function] (A,IO)-(A.11) UMlUn,p" lori.I,2, Intertemporal consumer optimality (A.l) [Marginal rate of commodity substitution equated to p,J MRS(cl 'Cz)=1 +f. {Marginal rate of intertemporal substitution equated to (1 + r)] Market-clearing conditions (A. 12)-(A.13) (A.2) 1 + r"" (1 + rr)P(pl)/P(pz). cM""YN" lori= I ,2. Definition of trade balance (Equation 1 in text] (A,14HA.IS) (A.3) (1 .. r)c l + Cz = (1 + f)Y l + Yz' where [Intertemporal budget constraint] With in-period producer optimality (A.4)-(A.S) G,(YM,Y,,)' 0, lor i. 1,2. [Production-possibilities frontier] (A.6)-(A.?) GN/GT, "" P" for i "" 1,2. [Marginal rate of transformation equated to p.J b :'''10'''';'· R""k\\, - '...."n·mh., ,. 19<)0 1, 'Yn-C", lori . I,2, Equations A.l-A.15 constitute a set of 15 equations in as many unknowns. To solve the model, I reduce the complete system to a set 01 four equations in the four unknowns 11' f;" PI' and pz. These equations are represented in the text by equations 2-3 and 6-? To obtain equations 2-3, I ignore the requirement that domestic markets for nontraded goods must clear and use the conditions for consumer and producer optimality to express the desired trade balances in terms of given values for the real exchange rate. This process can be accomplished through the following steps. First , use equations A.4-A.? to express optimal product supplies in terms of the real exchange rates. We then (Continued on the next page) Appendix-Continued have the first half of the expression for the trade balance , as defined in equations A.14-A.15. Second, combine the product supply functions with equations A.l-A.3 to fInd optimal aggregate consumption . Then use this result , together with equations A.8-A .l1 , to define demand for the traded good . These calculations provide the second hall of the trade balance equation. Equations 6- 7 in the text, in effect, express each period's real exchange rate in terms of given values !orthe trade balance. In deriving these equations, local markets for nontraded goods are required to clear, and consumers and producers are assumed to have optimally allocated resources within a period. But it is not necessary that wealth be optimally allocated between consumption in diHerent time periods. In equations 6-7, ex- " pressions for the supply of nontraded goods again come from equationsA .4-A .7. Expressions for the demand for nontraded goods are derived by combining the supply functions with equations A.lo--A.1S. This problem is equivalent to one of maximizing periodic utilities subject to the following budget constraints: (A.16)-(A.17) c" + P,c• • r ,,(p,) - t, + P,YNI(P') , fori",1,2. By formulating the problem in this way, we see that trade imbalances aHect the market for nontraded goods by altering the general level of expenditures and, therefore, the demand for nontraded goods. References Coughlin. Cil'IlI .~ C, and Kt't::-. K()(.'(lijk (1990). "\,\Ihal ])0 We Know ahoUT tht: Long-Run Rc:Ll Exdlanj..:l.' Rale?" Fl.x lcr.1l Iksl'I""\'t: Bank of SI LOll is Rel'iell", January/ Fl"hru;lry, 36-48 Fr.Ulkd, Jclrn..:}" A ( 19A9), " Qll:mtif}'in~ Internalion:Ll C:lpital Mobilit)' in th ..: 19HOs- (Unpuhlish ....d papt'r, IIal"\';I«.1 ( Ini\'t.:r:-.ity. janu;u·yl. Grcl'nwood . )l'ft!nlY (1984), -Non-Iraded Good.... 'ht, Tradt' B:Ll:I!1Ce, and the Babnce of Paymenl.";. " Ctll/aditlll JOIlr/wl oj Economics [ 7 (Novemher): R06-2j. Hill. John K (1990), "Deillowaphics :lIld the Foreign Inddltedncss of thl' Unitt.:d States,- Ft.:der.tI Ik";l'l""\'t' Bank of I)a l b .~ Ht.:St.:;lfCh P;lpcr no 9002 (Dallas, January). McKinno n , ROI1:lld I . ;md Kenichi Ohno (1986), ~G etting tht' Exdlange R:HC Right: Insular versus Opcn E(.'onom ies- (Papt!r presented at the Ni nety-ninth Annu:II Meeting o f Ihe Amcric:m E{'o/lomic Ass(xi:nion , Nl:W Orleans, December 2H-30). Mundell. Rolx-rt A. (I9R7), - A New De;ll on Exchange Rates" <Paper presented al (he jap:ln-Unill:d States Symposium on Exchange Rates and l\.-\acroeconomics, Tokyo, Jap:m , January 29-.3(l). R;lzin , Assaf ( 19H4). "C:lpital MOvements, Intersector.11 RCSOUf("l.' Shifts. and the Tr.l(lc Bala nce; ' EIlI"O/X,(fll Hco l/o mie Revielf' 26 (O(."(o/x·r/ November ): U ;.-52 (J9~J) , -The Current Account and Macroeconomic Adjustment in the 1970s." Brookil/!-!-~ Ptlpers 011 t eol/o lllie ACtilli~)I, no \. Sachs. Jeffrey D. Kocnij..:. Evan F ( 1989). - Rccl'nt Tr.u.k: and Exchanj..:l.' R;ue Movelllent..;: Possihle E..xplan:ltions: Federal Rt.:sel""\·t! Bank of Dallas Enlll(!/IIit.; Hel'iel/". St:pteml x:r. 13-28 20 1--68. S\'(.:: n ~n. Krugman, Paul (1987), "Adjllstl11l:nt in the \'(lorld Enmomy,- N BER \X1orkinj..: P:llx'r Stories. no 2'124 (Ca mbridge. !--1:i:-.~ : N:Llion:11 Burcau of El'()fl()l1li{' Iksearch, O("\()Ix-r) l.:In. E.O .. :md Assaf R:lzin (983). -The Terms of Tr.ldl: :md the Cllrro.::nt Account: The Harberger-I..aur.«:n- Metzler Eff,,:ct ,~ jOllmal oj Poli(ictlll:"<;o llollly9 1 (FebnLary): 97- 125. - - - . :111<1 l{idl;lf(1 E B:lld win (19H7). -111t! Per.~i:-"L·nct· or Ihe U.S. TI~lde Ddlcil.- JjnXJ~'ill!-!s I'lI/X"S (III ECfJllo mic 11I..' ,i";'I'. 110 I : 1-4.3. " Lori L. Taylor Economist Federal Reserve Bank 01 Dallas Reduced Defense Purchasing: Anticipating the Impact on State and Industry Employment Ill' rrosrx.'CI of cUlli n).! (!tft.'nse ru rd la~in g h y T h ill ions of dollars h : I .~ ."0111": pcork: conccrn ..·d aholll .~ ignilk;lllt joh los."l's naliol1\\·id\..· Such con ('crns on.:r.. t:tI\..' Ille rol~ (.1' defens~ purch:l.~ing in 11ll' US economy Although lilt: U.s Dl·I1;lnlll..:nt of IK:fe ll~ .. pend .. nearly":; 1')() hill ion :\ year on dcfcn.....• ('tllllr.K I". theSt· l·xpcndit ure.. rcprl'sent k~:.. than 3 Ix'rcel1l of gros.. nalion:11 product (G'>:P) Therefore ....ome workers and firms may ex r",:ri\,,·nC\..· ('('n.. id~,:r.lhl~ dink-ullY adjusl in).! HI Ihe nl'\\ \..·l.,.'onomk· l·m·ironment. Inll suhsl amial nlls 10 lk·fen.-..c purl'll:t:-.ing \\Oll ld :Iffect the n:ll ion's ('(ullom}, only marginally. !)cfen." l· purcha:.ing may play only a minor !lIk in the n:l1ion:d l·(·unom),. hut il plaY":1 m:ljor rok- in some industril's and :..t:lle." In Ihi:- ,!nick. I u-.e inpul-oulPW analysi.s 10 l'~lim:llt:' hy indu.''fl)' thl' 11\..':lr-len11 dfl'CI on employment of :\ uniforn, nil in dl'fen." l' pur('hasing l '~in~ tht:' indusl/)' result .. :md d:lI;1 ahout (';Kh .. Iate·s indu:..lri;l l mix. I abo \..'stim:lI l ' Ihl' ne;l r-lcrm dfeci o n em ployml'nt 0 1 dd,,'n:,c plIITh;l,.. ing ClII.__ Oil ;1 sl al c·!Jy-sl:llt' In" is. I lind that if rl':l l defl'l)se pllrdl:l.~ing fcll by JO perc~:nl. lkknsc-dependent industries . sllch :I.~ aiR' I~ l fi or o r(\n:lIln.: manllfal'Il.lring. could lose lip 10 7. '; l~l'('('nl 1)1' Iheir elllpll ')'mcnt, hlll no .. laIC wOllld 10* IllOf,,' Ib:1I1 0.; lX'IT!,:nl of it:-. employl11enl in tht: IK'ar lerlll On.'r li llle. Ihe l'l'onolll), will find Ik'\\' lIses fo r Ihe lahor di .. placed by Cllt .. in defe., ..e purl'h;lslIlg I ,he a modified inpul- oUl put lllo( ld 10 ....:..t irnate the lon).:-Il·n n re:lh...o rpli on of b hor hy indll ..tri ....s and fi nd Ih;11 M11l1l' indu:'l rk-~ . .sudl :1."; \yhOiL-:-':lic and retaillr.\(k . will ahsorh mort· lahor in till' Ion).: term Ihan tht:y 10 .....· in the ncar tcnn. 1 l·.. li1llall· Ih:1\ re:l hsorpl iun \\ ill :Ilso 1lll':111 .. mallcr E<''Oliomic K." ,lcw - Noycmbc r 19'90 emploYllll'nl losse .... in Ihe long 11:1'111 Ih:111 in Ihe n~ar term in all Slall"" Some ...Ial .... s. like some i nd ustriL's, will :Ih...o!'h 1110re bhor in the long Il'rm th;1I1 lhl'}' In..e in thl' ne:lr w rm Extrapobling from each .sl ale 's hi ... tory o f joh n e:ltio n , I estimate thai no ~1: l tt;' wi ll ).:ain iliOn: thall 0 ..35 pcrc\..·tl( or lose mOTl' th:1I1 0 2'; percent of il:.. employnk'nl in Ihe long term The economk impact of a decrease in consumer demand A ('ut in defense pur<:haM:~ of a pnxllll'l , .. uch as ain..'mft. would h:I\'c the ...aml;: qU:llil:lti\'e eITel'ls a~ an}' Sllb~I;Hl li ;1 1 de<:rea~l' in ci\'ilian dem:rnd for Ihe p nxlul·1. Finn ... thai p nxlm.'c airnafr or their component pan .. by oil' p;tn o f thdr work force. ,\ brgi n:11 firm~ in Ih~ indu~try go out of husinl' ...... Sales decline for nnn~ Ih:n suppl y thl' indusl!)' ]ll'ople \\'ho lo:..e work in aircr:lfl -rclatl'd indu:..lrie:.. rl '<!uc\,,' thL'it ..pendi!)).: :lIld st:l n looki ng fo r other \Vork. therehy pUlling down\V;)rd pres.~ u rt' on wagl' ~. retail ." :Ik's. :1I)d hOll:,ing pricl·s. Meanwh ile. as t:l xahle incomes :Ind propcny vallies de('feas~, displal'ed workers demand morl' ~odal sen'lce:... :.\.,Id, ;I ... blll ily coun.-..cling o r unemploYllll'nl a:.:.ist:lI\('e ikcall.">(.· tile .,>(>Ufl'(·S o f rl·\·t:nue fall :11 the ~:11ll\..· time thai dl'lll:lI1d for RO\'ernml'rll ~n' in:.. incre;l.'>Cs. hml~elary pres- IwoukIl<kc tolhafll< Slcpnen P A Blown. IVrHiamC Grut:Jcn. and GtHald P O'Onscolllot /hcIf CO'M>C<11S and suggestlO(l5 A llf6r7'la1flJl1g Cfl'0t'S arcmy fCSfXXlS'blhty I would also like /0 /hank P~uI DaIOe<lh and Edi/tl Adams lot lfICIf fcsoafCI! aSSIstance 17 sUfes may inc:.:n::ase for local governments. Over time, however, the economy finds new uses for the lalXJr displaced by purchasing cuts. Some workers migr.lh: in sear('h of wo rk, while others find local jobs in a different industry. Migr.ltion and fL"t:mployment reduce demand for local soci;.l services and pllf upward pressure: o n local wages. HOllsing and fCt:liling recover. Firms learn to pnxluce goods for new customers. :Ind stalC t:<.:onomies divePiify The only lasting impact of the cut in purcha:-;ing is the redistrihution of capital and laoor among industries and ;lCroS." Slales. The near-term effects on industry Ikcause dcfen ...e budgeting is a highly poliTicod ;lnd protr.ICtcd process, m;1ny defense contr:.K- tors can antic:ip:lte Cllts well in advance and e m adjust their purch:I.'>Cs of inputs accordingly. Defense contractors m:!}' cancel purchases of r::.w materials o r com ponent parts in a nticipation of ellIS Oefe nse e mployees who anticipate layoffs may stan saving for a period of unemployment, causing retail sales to fa ll Thus. the advanced warning disnlpt... the usual timing of direct effects followed by indin.:.'Ct (or mulliplit'r) effects. Therefore, I will treat the ne;lf-tenn effe("\s on industries and states jointly r.lther than separ.lting them into direct and multiplier effects The most rccenl input-output model of the United States identifies industries thaI sell final goods and services to the U.S. De partment of Defense. I The mod..:! :.\S() dl::'scrihcs lht;' histo rical relationships among industries that produce de- , FoIa more de/a,led desclip/H}(! 01 inpuHX1 /Pul analysis. set! />'ppcndix A , Th,s example uses numOcIS from the 1911mput-<JUlpul mcxJc/ of lhe U S economy • I eSSI.lI7NIlhat cuts m defense purchasmg will be um/ol"m In Be/uahly. ConQ,ess wiN cuI same progriNTIS c1tamahcally anc1lcavc other programs VlflualJy untOUChBd If me cuts '" any PfogtanJ 810 SUOSlan/lal1y Ql'ester /flan IOpercenl /flen lheltldvstr,es IfIVO/vedlnlflat PfOQfBm WOtJIdJoscmoro /1lan /he csumaled r'IIImt.1cr r:N JOO$ s.m.Iarly 'f the cuts ate subs/enMity lower /fJaJl 10 porUfI/. men the JOb losses vlOlJ/d be 06/0", the 6Slmale CfIanges WI I(}(jl.lStry CSIKnaICS would. 01 courso. t'lJfIsJalO ""0 new esl<males lot" Slale JOb . ""~ fen.'>\.! goods and services. industries that produce component parts, and industries that produce consumer goods ;tnd services for the employtc'Cs of the OIher two l..<Itegorics The model indical('S, for example. that every S 100 the RO\'ernment spends direc tly on airplanes initially gener3tes S4 worth of imlirc(1 business in the elt:<:tTOnics indu:;try ;lIld S6 worth of indirect busine....... in whole:;ale ;tnd ft'lai l iradc. Funhcr, through mulliplier efre<.1..... the S4 in thl::' electronics industry leads to 2 cents worth of husiness in the elL,(·tric,11 supplies industry and an additional 3; cent.. worth of business in wholesale and retail tr..de ! Ik'ca use the input--output mod",l descrihes thr.: interrelationships in the economy, I lise it to calcubte the clTect of :t uniform , IO-perccnt reduction in real defense purc haSing on the output of each industry, compounded hy the changes in output of every othl::f industry \ J u.~ employment data fo r ellc h ind u ~try to tr::lns late tho.<;e outpul Io.....-;e~ into job los...es. Not surprisingly, the indu~tries that would he most affecwd hy a cut in defense purchaSing produce arms and ammun ition. '111C o rdnance induslry would lo.'>\.! ;.Imost 7.5 ~ r('ent of its employment if dcfen.:>C purc hases wcre cut by a unifornl 10 peret'nt The aircraft manufacturing industry would lose slight ly more than :; percent of its employment Other strongly affected i nd u~ trics manufacture C\ lmmunicatioll equ ipmcnt. electronic components. s hips, and tanks. In [he nC:lr te nn. tht, per<:cntage of joh los.'>Cs in these industries would he more than ten times the averagl' losses in all other industries Ch;tn I ilIu sr rat~s the percell1age of job losses for selected industries. Cuts in aircraft manufacturing would havl' the greatest effl'l"t on the national economy. Although the orcin;mce industry would lose a greater percentage of jobs than the aircr~lft industry, the aircraft indll~try is a t least eight times larger than the ordnance industry. If re:ll defense purchas ing \Ve rt' cut by ~l uniform 10 perccnt. no industry would lose more jobs than aircraft manufa cturing. Job lo~ ...~:~ in Iht' airc r.tft industry would :tn'ount for :. llllo~t 13 percent of total job losses in the country. Industries th;1I ~ltp ply the mo~t-affect cd industries would experience mocit'r.ile job losses. Manuf:lcturers of I:ngines and lurhincs-suppliL-rs Fedrral R~rv(" Bank of Dallas Chart 1 Employment Losses from a 1a-Percent Cut in Defense Purchases for Selected Industries ","""",' A.. crall Commut;cationl equipment Electrtrie CQlT1XWlllf1t& O\tlef trllllPOftatioll eq;.ipment" :===:~ t~inea Engnas and Primary I'IOI'IlerroUl metala manulactlri'lg Metala miOOg _ Sciefltillc nstnl'l'llflt. _ Busine. . .erviCes _ Crucle petrolct.om .nd nat\.fal gas _ Petrole~ relir'irlg • ElectriC.l.nd wring equipment ._.ge • Motor vehicles • Natioll.1 • F.brics, 'P9arel, .... d telltie. , I 0 2 ' , , , 6 8 '0 Percent , Onlnance incUdes alms, ammunition , tanks, gUided miSSileS, and space veNcIes, •• Boats. shops, railroad 8qU'pm8I'1t, motorcydes and bikes, travel \failers, and mobile homes. to the aircraft, ship, and tank industries-would lose 1.6 percent of their employment. Steel and iron manufacturers wou ld lose 0.86 ~rcent of thei r employment, while the manufacturers of otltt:r metals-such as alum inum-would lose 1.34 percent of their employment. Manufacturers of electrical and wiring equipment stand to lose 046 percent of their employment if defense purchasing faJis by a uniform 10 percent. Even industries that sell little to the u.s. Department of Defense or its suppliers would lose jobs through multiplier effects. Demand for consumer g<XXIs and services would fa ll slightly while the former employees of defense-related industries look for new work. For example, rewil and wholesale tiJde stands to lose 0.17 percent of its employment in the nColr term if real defense pur· chases decrease hy 10 percent. Across industries. a suhstantial cut in defense purdmsing would lead to :I sm;I II , near-ll."IlTI reduction in tOial employment nationwide A 10-percent Economic Revlew _Noye mber 1990 cut in real defense purchasing would d isplace approximately 300,000 employees, or less than 0.28 percent of total employment . Since 1985, national employment has increased by an average of 300,000 jobs every six weeks. The n ear·te rm effects on states The regional impact of defense purchasing cuts depends on the distribution of affected industries. States with high concentrations of o rdnance or aircraft ma nufacturi ng would experience much greater employment losses than states without such concent rations. Data on gross stale products (GSP) identify e""..Jch slate's industrial composition. I use these d:lt:l to translate neat-tenn industry effects into state effects hy assigning each state a share o f industry employment according to its share of ind ustry output. By assumption, if Alabama produces 10 percent of the country's shoes, 10 per- " Chart 2 The Near-Term Employment Impact of Uniform Defense Purchasing Cuts cen! of Ihe country's shot;' manufacturing jobs art;' in Alab:mla. ' In the near term, ddense purchasing cuts would cause relatively large p<..!Tcentage-rate employment declines in Conm:cliclLl and Alaska. The rate of e mployment los.~t;'s in Connecticut \vmtld he almO$t twice the nationa l average. Connecticllt would lose 0.44 percent o f its employment, or almost 7.500 johs, if Con~rt..'ss cut real defen.~c purchasing by 10 pcrcc..'nt . In COnlrolst , states in the: Upper Great Plains fechn>ca /ly. 18SSI.mO /ha l /tie producll()f) lunc/I()f) lot any f}OOd is lfIdependettt 01 the state in IWIJch the faclOty IS ,. located o SigliIicanlly I\bove-_age job bsa • Above_age job lou o BeIow-average iOb lou • SigliIicantly beIow-averaga job loss and tht;' Mid-Atlantic ft:gion havt;' relatively small shares of :Iffected industries and should lose few jobs from purchasing nits Chan 2 ilI ustr.tles the relative impacts of I..h:<:rcast:d defense purchasing on .~tates Connecliclll would have:: the gre:nest percent:Ige of job IO$ses beGlllSe Finns that manufacture military transpon:ltion t..'(juipment and elcctTOnks pby dominant roles in the state'$ economy. On Iht: other h:md, South D:lkota would have the smallest pen:entage of joh losses from purchasing cUI!'. heC'"oIuse it produ<"es few ddcn.sc-related products :lnd supplies few ddcnS(:: contractors. Soulh DakOla would loS(: only 0. 12 percent of ils c mploymem. or Ics.~ th;tn 400 iohs , if Congress cut rcal defensc purch:l.~inR hy 10 pcrcenl. F~ral Reserve Bank of Dallas In all hut t\\·o of the st alt·~ with ahove-avera).!!.: t.:mployrnt·nt losst.:s, Iht· tr.mspon;nion equipl11ent in<.lu .~lries would lose Ihe most jobs from dt.:fen.'>C purchasing cu ts In Alaska . the mining industry would lose the mo~t jobs. while in r-.-1assadlll.'>CHS the d{:clronics industry would lose the mosl jobs. J\'l u hiplier effects push O hio, Indiana , ;md Alasb into the c~tego ry of st:lICS wi th aho\'<:aver.lge employmen t losses In Ohio, for examplL-. tOla l joh los~s in primary metal s manufacturi ng should exceed l o~ses in electronics or comTllunical ions equipmt.:nt. In Indiana, total lossl:s in prirn:lfy melals manufacturing should excl:l:d lossl:s in ordnance manufacturing. Ikclu .....· (Ill: lL-\·...·1 of din.:ct dl:fI..·n."!.: spending inclu(h: .. lllili(;IIY p : I ~To ll and docs 1101 account for .~ uhcOnlra(.:t illg ;1I\d l11ultiplier drecls. it is ;1 poor indiGltor of joh losses from pu rchasi ng (:uts. Direct defense spending accou nts for rough ly 1') percen t of Virginia 's GSP. but mo.~t of those dolla rs go 10 milit ary payroll. A IO-percent Clil in ft.·al ddeme pllfch:lsing would reduce Vi rgini;I's emp loYllH..·nt h y kss th:111 01 percent.' In ("(mtr.!..;t. Ohio's ;md l ndian:I's s h:lr('.~ of dirt.'Ct dden:--e :-'(knding in GSP are well hdow the n;lI ioO;11 ;I\'t.'ra).!e. yet nlultiplil:r effects wou ld lead to alxwl:a\'erage emplo),ment losses in tho:-.e :-.tates Ahhough ;I\'erage job los:-.t:;, would he negl igible III 1ll.111Y st:lles. sped fi c com m unitit.·s will1i n those :-.tates might still cX(krience :-.ignifkanl joh lo...se..; Analysis:1I the sta te level hlurs signi fi cant employment c h;1t1gt.:.~ :11 the local levl'l . Some com11luni ti e.~ w ould experience joh losst.·s signifi cantly greate1" than Ihdr st:i\e's avel~lge. Other cOlllmunitit.'.~ 1ll;IY lose no job..; at ;ill. The statl' cmploynlt.'nt dllxts arc he!!er e.~t imat t.:s of 10c:II employm ent effects whe!l :ill parts of the st;lIt.' ;If(.' integr:ltl'd into a single cconomy In states wit h Ill:!ny n:'gion:11 economies, such as C~liro rn i: 1 or T t.:xas. local I;;conoll1 ic efkcts may <.Iirkf <.Ir::1I11:lIic;lll y from tht.: state a\"cr.lge The long-tenn effects on industries Lllx)r IS :t \'ery versatile input. O\"t~r tinK·. the economy will find new lJ.-.c:-. for the bhor dbpbo:d hy dden!'tt' nils. ;md tht.: n;l[ion;11 ~'t 'o n omy wi ll ft.·turn to flill employmt.'nt In tht.' prot."t::-.... the dbtrihutio n of indu... tries wil l dlangt.' Eco n o m ic Kl....·j":w - fliovc m bc: r 1990 slightly. Odt.'nse-dc(kndent industries, sLich as ordnance and aircr.l ft manufacturi n~ , wi ll play s111;lIler rol es i n the natiollal economy. Industries th;n ahsorh sign ifi L"'<lnt quantities of displaced blx)f wi ll play somewhat larger ro les Two facto rs will min imize the redistribu tional effects o f defcnse purchasing ClItS on industries. First , the 1:II>or displaced by defense purcha:--ing cuL~ represents only a sm:1I1 fraction of the natio nal lallo r sllpply. Second, mllny industri es will fCabsorh laOOr in the long tcrm . diffUSing the i mpact of any cuts. Because a relat ively small quantity o f lahor will be distribul ed over a wide v;\rieIY of in du st rii!.~ in tht! long \t!nn. no industry'S employment wou ld incrC;lse by more than 0.33 p...:rt."en t of ils initial employment following a uniform lO-pl:rn:!nt Clil in fca l defense purchases. TI ll' l o n~-It!r!\\ employment cha nge by industry l:qu;\ls the re;lhsorlx."'(i boor llIinus labor l o.~.o;cs in the ncar tt!rm. I estimate Ihe industry ahs01"plion of labor hy indllstry shares in tOlal employml:'nt 'a~surne that e:lCh industry will ah:..orh labor in proportion to its sh:tre in national employmcnt. ;Iftl..'r the ne:tr-tcnn .. diu ~t ments. For eX:lInpk: . if shoe m:mufactllrers employ J percent of tht· t.·conomy·s bhor ant:r defen~ [lurchasing nits :tnd tht.· mult ipl ier effects, then shoe manufacturing will ahsorb , percent of the displaced lalxlr. The whole;,ale and r('tailtrad e industry. which employs more workers than any ot her indu;,t"" should ah.~orb the most labo r in the long t..... rm. T wenty-one pt!rccnt of the new jobs after r...:di.~trihution sho uld he in tr.l cie. During the <JdjllsllUenl. w ho lesale ;lIl ci re tail trade will recover the 0.1 7 pcrn:nt of thc employment it lost in the nl:ar tl:rrn. ;l!1d it w i ll :1(ld ,Ill additional 0. 16 r ern .' nt to its work force in the long tt!r1l1. Even defellsc-rd:ned industrics should reab sorb ..omc lahor in the long tenn The aircraft indu:..t!), shOl.ild re('over 6 percent of its ncar-tCI"ffi losses through rt.'ah.~orp ti on The ordn;\ncc ;md t,'t)1ll1l1llniC;ltions equipmenl industries shou ld recover 4 pern'nt :lnd 11 percent of Iheir nc aftt.'r111 lo...;sc:--. rt.·:-.pt.·cti vcly Clearly. curs ... mhtary perst;JfIfItJ/ slatlOned If! /he state would SIgfII"canlly inctfNlSfJ the job losses ... VIf/}'fll8 " Industries thai scll rd~lIi\'ely litt le to the U.S. of Dt.:fense or its sllppliers an.· most likely to ahsorh more 1;lhor in the lonR term than they lose in the m..ar tt.:rm. In gener:1 1. suppl ie.:rs of agriculturJI products would add johs in tlK" long tefill. Othef industrit...s poisl."(1 to gain worke.:rs are l"Ummmt'f scrvice indw;trit:s. SllCh as slipplilo'TS of entertainment or he:llth scrvi<:es; puhlic entt."rprist:s, such as publi<: utilities or tr.Jnsport;u io n .. gt:ncit:s: leather ~oods indu...;tries, sllch as shoe manuf;I<..·\lll"(:.:rs and t;m ncrs; and manufal"lurers of hOllsehold durablcs. sllch as furniture alld fixtures ~'partment The long,term effects on stat·e s Tht: long-term effect ..; of ddt:nse cuts on states equal the reah..;orbed b hor minus Ihe llearterm employment 10.'M::s (sec Appendix Bl. Some states should ;Lh.->orh more i;llxlr in the long term than they loSt: in the ne:lr term Other statt.:s will absorb too little: lahor to compensate for near-term losses. Each st:ut:·s :Ih:..o rption of blxlr depemls on its p;lIIefll of job CTt'ation. St-vcml st:lle ch;lr.lt.:le ristics influcnct.: joh crt!ation .. nd t'mploymt.:nt growth (see W:lsylt'nko and McGuire 1985, Whe:lt 19R6, :lnd C;lrlino :lnd Mills 19B7). High w;lges or high r.Hes of union ;Ictivity <.·har..lclI:rize many slow-growth st:ltes. Other ch:mlcteristics of slow growth include high t.. xes, high e ne rgy usage, and <.·001 dimates Characte ristics Ihat t:ncour..lge growth includt: wealthy populations, good tr.msportation fadlitie ...;. and high L-duc;ltional ex: penditurl;:s (as a sharI;: of incoml;:). Eadl stat~'s growth r;ltt: depends o n its combination of characteristics Tht: state with the nation's lowest growth r..lte over the past thiny years-New York---<:omhines high energy lise, high taxes, ,lnd low educational expenditures (as a share of income ) to more than COltnt~r the sl ight advantage o f a wealthy population and averdgc wages (Wasylenko and McGuire 1985). In Pe nn- • 01 course. if Slat6 characterl$tICs changed dramatICally III ~ ncar term. the pal/em 01 resource reabsctption wouJd 'Iso~ Howovcr. lJcclitlsethe~pted/ClSgener· ally IfISl9nificatlf emp\:Iym6nl chanpes s/ale Cl"lSrSCtefl$l!CS " III should rcmiWI slable the nell( term. sylv;Lni;L. low educ:lli(lI1:LI expcnditures. high wa).!es. :md hi).!h cne.:rgy usc swamp the positive growth effet·t..; of low taxes and a wC:lltily population. Florida benefits from p:lnicuiarly low wages. wann weat her. and low taxes that dominatc tht' statc·s poor edut·.. tional spcndin).! :lnd ah(weaVf.::r..lge ellt'rgy U.'L'. In Alaska. very strong cdllcation;11 expcnditufl.'s and a wt'althy popuiation all"e<.·t employment growth morc strongly than the st;uc·s high wagt' co:-.ts :Ind energy requirements. If tilt' geo).!r..lphit" d i."trihution of characteristics that signific.tntly innuencl.' Siale employment growth remains slahle, therl the st:rtes Ihal ha\·e crcalt'd thl;: most johs in the past arl;: thl;: most likely 10 creale jobs in the fut ure." Thus. state-s \vith the highl;:..;t hi..;toric;1 1 growt h r:HI;:S for c mploymo.:nt ,Ippear to he the st:III;:S most likdy to reabsorb tht: lalx)!' d isplat'ed hy dde-nse purchasing cuts Historically. Nt:vad.. , Alaska. Arizon;l. :Ind Florid;L tTcatcd jobs Ltste-r than other st:ltes. Over the pa:-.t thirty ye:lrs. employment in each of these states gR'W at ;1 rate more.: than douhle the natio nal aver..lge o f 2.4 percent ;mnually. These states s hould ah...orb relatively more lahor th.. n other st:ltes in Ihe long mn On the othe-r hand. employment growth r.ttes havt' het'n lowest in Nt'w York. Pennsylvania. and Illinois. Employment in thes~ states grew at .. r.1t~ less than one-half the national aver.lge during Ihe same- period C{) n~quently , they should :Ihsorh a sm;lller ..;hare of the lalx)r displ~lCt:d hy nils in defL'nst: purt· h:l sin~. Using Ihe relat ive growth rale."; of l'ach statt: to estimate the re:lbsorpt ion of displ,LCCd labor rei nforces historical popu lation Ir~nds. Statl's in the Sun Bdt, and 10 a lesser ext~nt the Great Plains, ahsorb more [alx)!' in the long term than they lose in the shon term, t he r~by ga ining jobs. States in the Midwest and New England lose jobs. Chan 3 ili llstr;lles the- long-term cffl'cl o n l'mployment of a cut in ddense purc hasing Long-It'nn re.. bsorp!:ion cannot completely offsct ncar-term job losses in most states with alx>ve-aver.lge ncar-term losses Alaska, ont' of the- fastest -growing st.. tes. is the exception . BarrillR signifi cant cha nges in the state·!'i growth chardcleristics. Alaska should gain :I negligible number of jobs in the long tenTl O n the other h.. nd. California and Washington would lose a fedenl Reserve Bank of Dalla... Chart 3 The Long-Term Employment Impact of Uniform Defense Purchasing Cuts negl igible numher of i()h.~ in the long ternl dl;'spitl,.' 3b()ve-:I \'tT:l~'" r...:lhsorptiOll 1)Cc;ulst." tlwir job losse:-. in thl,.' n ...:lr Il,.'nn would be dispr0[X>rtion:Itdy larg... AlthoLl).!h sl,.'vcr:d " t:ltc.~ wou ld lose ioh.~ even aftt'r ft'absorption. Io.'~es wou ld bc negligih le in I;'\'el), .~ t a l c l,.·xn.:pt C(lIllleCl iclII Connt:<:linu's indust rial 1111X I... ad.~ 10 Iht: gre31est proportional job lossl,.'s in the ncar Icnn, :md the slale's t:1H~ ployment )'!l"Owth r:lte historit.'ally has heen low Connl,.'(.'ticut would lo.'>C 0 2.. percent of it... employment , or roughly 4.000 jobs. in the long term if d ..:fe n~1;' p Uf('hasing wt:re <.:1II by 10 pcn.:ent Thn:l' ~I:ne:--Ncv:td:t, Ari"ona, and Florid:l-sho\l ld g:li n "'Ignifk-;lnlly more johs Ih:m all olh,,:r ~1:lIc~ in th ... long Il;'rm Nevada shou ld g;lin the 11l(ht johs. profXlI1ionally ~e\"ada\ employ":COllo m i" R~\'ie"' _ No"" mbcr 1990 o ModBrale lOb lou • ~joblo$.l o ~ejobgu1 C Moderate lOb ~ llll'llt should increase by 0.35 perct:nt, or roughly 2.000 jobs. :lftCf reabsorpti on Employment should increase in Ari l.on:L b y 0.29 p ... rcelll and in Florida by 028 lx:rCe nt These staws .~hol1 l d g:lin jobs in the long 1erm because ,hei r joh losses w ou ld be I)t:low ave~lge in the nt:af term and beca use they h;IVC Jcm o n~tr..lted :Ihovc·avcfagc hisforical growth The long-tcnn rC:Ll lo<.::lIio n of rcsources in<.:rea~e~ employment in Wille SI:lles and reduces Ihe impad of defense cut ... in adv\:.'"rscly ;Iffectcd : Irt~as . Although ConnC(tit'lll would n: main the most ad vc~ly alTcclC(1 statl::, realkK<lIio n \....ould cut the SlltlC '~ employmen t Ios.~e ... almost in half. In the long term . no state would lose mo rl;' than ont:-follnh of 1 percent of its t:mployment due to defenSe..' pllrchasing <.:uls Conclusions Because defense purchasing represents less than 3 percent of GNP, even s uhstantial ClIl"i would have a negligible effect on the national economy. A uniform la-percent cut in defense purchasing would n:duce employment nationally by less than 0.3 percent in the near lenn. Although all induslries would lo...;e at least sollle jobs in the near lenn, only fivt: industrit:sordnance, aircr.lfl, communic.llion t:quipment, electronic compont:nts, and other transportation f..'quipmcnt-sland to lose mort: th:m 2 percent of their total industry employment. Of thest: industries, most of the jobs lost would be in airer-Ift. State economies would experience a variety of job losses from pu rchasing cutS in the ncar term. States in the Great Plains would lose fewer jobs tha n the nat ional :Ivcrage, while states with signifiGLnt dt:ft:nse-related industries would lose more job...; than the nalional :Iverage. In all states. however, the average impact s hou ld Ix! small In Connecticut- the stale most affected by defense purchasing cuts---employment should fall by less than 0.5 pcrcem in the ncar term . In the long term, a cut in defense purchasing would force the national economy to redistribute lahor slightly. The n:Hion would return to fu ll employmt:nt , hut the industrial mix of the economy would have changed. I..-lhor migration Ix!cause of the nils will have accelerated changes in demographics. States in the Great Plains and Sun Belt would gain some jobs :J.t the expense of states in New Englund and the Midwest, but even the Slate with the largest job losses-Connecticut-would In.'it: less than 0.25 percent of its e111ploymt:nt in the long term. federa l Re!len'C Bank or Dallas Appendi x A Input-Output Analysis: A Simple Description by Linda C. Hunter1 The purpose of input-output analysis is to properly estimate the total amount of a commodity that should be produced by an economy . Because goods are used as inputs in the production of other goods , the total output of one commodity will depend on the input requirements of th is commodity by other industries. Because industries are interdependent , input-output analysis requires solving a system of simultaneousequations. An input table is a matrix that describes the interdependence of industry inputs and outputs .2 Define a as the amount of good j used in the produclion 01 good j. The production of commodity j will require ai/ amount 01 good 1, a2) amount of good 2,... , and a amount 01 good n, assuming that there are commodities in the economy . The symbol a is called the input coefficient. The analysi~ assumes that the input coefficients are fixed numbers. The input-oulput matrix A is made up of the elements of a,: n of the good pertaining to that column . In other words, the second column of A defines the amounts of commodities 1 through n required to produce one unit of good 2. The second row of the matrix defines the amount of good 2 required in the production of one unit 01 commodities 1 through n. In addition to the n industries , an open input-oulput model contains a household sector that exogenously determines a final demand for the product. This household sector supplies a primary input not produced by the n industries. In an open model, the sum of the input coeHicients is less than one. (A.2) t c\ < 1, for i '" 1..... n, "' The amount of the primary input needed to r'Qt1II(,.e one unit of commodity J equals " La,). The total amount"' of commodity (1 - 1 reo quired by an economy is defined by the following equation : (A.1) where d , is the final demand of good 1. Equation A.3 can be rewritten as: (A4) Each column of A specifies the amount of each commodity required in the production 1:0.'"""",,,, lit-' ;\.\\ - ;"\Ii"""lnh"r 19')0 (1 -al1 )x1 -~-~ - ... -a,,,xn '" d,. (Continued on the next page) " Input-Output Analysis : A Simple Description-Continued Equation A,4 is generalized for the entire system on n equations using the following matrix notation : (I -an) - a21 -a'2 (1 - ~ ) The matrix {f - AJ is called the technofogy matrix. The total amount of all commodities that should be produced in the economy is determined by (A.7) X: (1- AI-' D. (A.5) (1 - a.,) Xo do' I.rnda C Hurltet .• 1crmtIr 1iICOI'lOI'IIoS,., the F~ ReeIrn'B BBf'Ik 01 DaJIu.... ~ ~., SarI Otego _'an( SI8le Umvers1ty or, more si mply , , For e more (/0/8118(/ descriptIOn 01 irlpul aulP"I.1nelys's. see (A.6) (I - AI X : D. C/)J8ng (1974 12330) Appendix B Calculating the Long-Term Effects of Defense Cuts The long -term redistribution of labor requires separate analysis for industries and for states. Caution should be used , therefore. when interpreting the impact on specific industries in specific stales . Calculating state effects I use historical patterns of employment growth to estimate geographic reabsorption . Using data from the U.S. Bureau of Labor Statistics, I calculate a constant annual rate of employment growth (fJ) for each state during the period 1956-88, where In(employment) :: a + {j . (time). Labor displaced in the near term is then assigned to states to preserve the relative rates of employment growth . 26 R'E, e, l: (P, • E,) where L,is the number of workers absorbed in state i, ilL is the total number of workers displaced in the near term, {Ji is the annual rate of growth in employment for state i, and Ej is the total employment in state i in the year corresponding to the most recent input-output table of the United States (1983). Therefore , the long-term percentage change in state employment will be long-Term Change:: (~ - ill ,l / E" where t1L,is the number of jobs lost in the state in the near term. f c:tkr.. l RC'S(: n'~ Hank of Oa ll"s References Carlino, GerJ.ld A., :md Edwin S. Mills (987), ~Thc Determinants of County Growth, ~ journal of Regional Scie/l ce 27 (February): 39-54. Chiang, Alpha C. (974), Fundamental Methods of Mathematical Economics (New York: McGr.lw- Hill Book Company). Homer, Edith R. , ed. (1990), Almanac oftbe 50 States (Palo Aha, Calif. : Information Publications). Hunter, Linda C. (990) , "US. Trade Protectio n: Effects o n the Industria l and Region:d Composition of E mployment , ~ federJ. I Reserve Bank of Dallas Ecol/omic I?evietll, January, 1-13. Interindustry Economics Division (1989), "Annual Input-Output Accounts of the U.S. Economy, 1983 ," Survey ofC/./mmt Business 69 (February): 21- 36. - - - (984 ), ~Th e Input-Output Structure of the U.S. Bureau of the Census (1989), Statistical Abslmct of the Uuiled Staws. 1989, 109th Ed. (Washington, D.C. : Go vernment Printing Office) . - - - (1985), Statistical Abstmct of the Uniled States, /986, 106th Ed. (Washington, D.C: Government Printing Office). u.S. Department of Labor, Bureau of Labor Statis- tics (985), Employmelll and \Vages: Annual Averagl.'"S 1981 Bulletin 2249 (Washington, D.C.: Government Printi ng Office, November). Wasylenko, Michael, and Therese McG uire (1985), "Jobs and Taxes: The Effect of Business Climate on States' Employment Growth Rates, " Nalional Ta,xjoun/a/ 38 (December): 497-512. Wheat, l eonard f . (986), "The Determinants of 1963-77 Regional M:mufacturing Growth : Why the South ;md West Grow ,~ jOlin/a/ of Regional Science 26 (November); 63S-59. U.S. Economy, 1977: SurveyofCurrfmt Busi/less 64 (May): 42--84 . Eco oo mk Re yle w _ Nove m ber 1990 Z7
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