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FEDERALR
ESERVEBANK
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ALLAS
FEDERAL
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DALLAS
QUARTER1995
SECONDQUARTER
SECOND

Mellco's Crisis:
Mexico's
Looking
looking Back to Assess
The Future
DavidM.
David M. Gould

Energy Prices and State
Economic Performance
Stephen
SIIlphen P
P. A. Brown
Braum and Mine K Yiicel
Yum

Optimal Monetary Policy
Pollc,
In an EconolllJ
Economy with Sticky
Nominal Wages
Evan
evan F Koenig

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

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Contents
Mexico's Crisis:
Looking Back
To Assess the Future

Mo.:xko·s mOSt recent e<:onomic crisis look many in the international
husinC$s <:ommunily by surprise. In carly D ecemher 1994, the Blue Chip
consensus foreclsl for 1995 Mexican rcal GO!' growth was 3.8 pen:cnt. A few

weeks laler, o n 11t.'Ccmlkr 20, the devalmuion of the Mexican peso rocked
international fin:mcial markets Wh:JI first appearL>ti 10 be a minor coITCction
in Mcxico·.~ naminl! exchange !".lIe quicklydcvdopcd into a broader financial
!.'fllnch fell in and outside M,."xi<:o Tho.: Mcxic-.m government now expects the

David M. Gould
Page 2

Energy Prices and State
Economic Performance
Stephen P. A. Brown and Mine K. Vucel
Page 13

Optimal Monetary Policy
In an Economy with
StiCky Nominal Wages
Evan F. Koenig

Page 24

co~mtry's

real GDP to fall about 3 percent in 1995; some private economists

sug,gest ;m even ~rc;I(Cf decline

What caused Mexico's recent economic crisis, and how long will it take
Mexico to reco\'cr' Were Mexico's economic refonns reality or illusion?
In thi~ aMide, David M, Gould argues that to assess Mexico's future, one
mllst look ~It J\'kxico's past. Guuld finds that, unlike the period prior to
Mcxico's 1982 Jcllt crbis, the recent trend in Mexico's economic poliCies has
been toward grea te r economic integr:.nion in the world econoillY and less
reliance on the ~overnment Although Mexico IIlay need seveml years to
rcgain the invcstor confidence it lost during the rL'Cem economk crisis, the
trend in ,\Iexico ',~ poliCies is more consistent with future low innation and
higher j;lfOwth than tho.: cotmtry's previous closed-market policies.

Changes in enl'rgy prices have had si~,;Ible hut differing effects on
economic activity a crus~ the United States n1e composition of each state's
c(;onomy largdy dctermines how its employment responds to <:hangcs in
l:nergy prices In this anicle, Stephen Hrown ;md l\line Ylicel usc simulations
hased on input-oUlplH J.nllysis to as;;css the long-term consequences of
changing oil pri('CS on employment in each state in 1982, 1992, and 2000,
Brown and Ylicd find that because state economics are becoming more
s imilar in their composition, the variation across states in the response to
lh:.mging oi! prices is narrowing n1C authors' findings suggest that the
grounds for regional djvi~ions in the debate over n:ltional tncrgy policy have
J,.·sse ned since the e arl y 19HO,~ and ,,,,ill <:ontinue to do so throughout the
fCmainder of the 1990,~

In Ihis article, Evan Koenig deri\'es [he optimal monetary policy rule
for an el'Onomy with contl".l(;tuaJ wage' agreemcnts, The optim:ll rule has the
monel:lry authority target a weighted average of aggregate output and the
price level In a realislk ~pC(:i al case, the optimal rule calls for the monetary
authority to target aggn:gale nominal spending The optimal rule is quite
general in form, cncompassin~ policy proposals made by such prominent
t:t.onOlllbts a,~ Rulx:rt Hal! and John Taylor
Koenig points out that if the monetary authority responds optimal!y
to economic shocks, it willlx: difficult to distingubh the effects of monetary
policy from the effects of the shock.~ themselves . .so, the important contribUTion thaI monetary policy makes to tht! economy may easily he overlooked Paraduxkal!y, only insofar as monetary policy is implemented with
e rro r will i[ be apparent that monetary policy matttrs.

In early December 1994, the Organization
for Economic Cooperation and Development
(OECD) and many private economists were predicting that Mexico’s real gross domestic product
(GDP) would grow by at least 3.8 percent in
1995.1 Mexico appeared to be on the fast track to
economic growth and stability. For the first time
in many years, its annual inflation rate was down
to less than 10 percent, the public-sector budget
was nearly balanced, and exports were growing
at an annual rate in excess of 22 percent. Moreover, Mexico’s entry into the North American Free
Trade Agreement (NAFTA) and its recent uneventful presidential elections suggested a continuity in the country’s economic reform policies.
A few weeks later, however, on December
20, 1994, international financial markets were
rocked by the devaluation of the Mexican peso.
Then, what first appeared to be a minor correction
in Mexico’s nominal exchange rate quickly developed into a broader financial crunch felt in and
outside Mexico. By March 1995, the peso had
fallen more than 50 percent against the dollar, and
monthly inflation was growing at an annual rate
in excess of 60 percent. Despite a $50 billion financial assistance package arranged in late January
by the international community to help shore-up
liquidity problems in Mexican dollar-denominated debt, interest rates on this debt remained
twice as high as they were before the devaluation. The Mexican government now expects the
country’s real GDP to fall about 3 percent in 1995.
It may take several years for Mexico to fully
regain the investor confidence lost during this
recent economic crisis. However, the speed with
which Mexico recovers will be fundamentally
determined by the economic policies it chooses

Mexico’s Crisis:
Looking Back
To Assess the Future
David M. Gould
Senior Economist
Federal Reserve Bank of Dallas

t may take several years for
Mexico to fully regain the

investor confidence lost during
this recent economic crisis.
However, the speed with which
Mexico recovers will be fundamentally determined by the
economic policies it chooses to
follow. The more Mexico relies on
open markets and stable macroeconomic policies, and the less it

Figure 1

withdraws within itself, the faster

Annual Growth Rate of Mexican Real Gross
Domestic Product per Capita, 1954–94

the country will recover.

Percent
10
8
6
4
2
0
–2
–4
–6
–8
–10
’54

’58

’62

’66

’70

’74

’78

’82

’86

’90

SOURCES: Penn World Table, Version 5.6, 1995; International
Monetary Fund.

’94

Table 1

Mexican Economic Indicators,
1954 –72 and 1973–76

to follow. The more Mexico relies on open markets and stable macroeconomic policies, and the
less it withdraws within itself, the faster the
country will recover.
The purpose of this article is to put Mexico’s
most recent economic crisis into broad historical
context in order to assess the future trend in
Mexico’s economic policies. Like many developing countries during the 1980s, Mexico’s economic paradigm shifted from a closed market,
inward-looking development strategy to an open
market, outward-oriented development strategy.
Unlike the period leading up to the 1982 debt
crisis, the period before the latest crisis was one
in which markets were becoming more open,
inflation was low, and the public-sector budget
was nearly balanced. Although there are forces in
Mexico pulling away from market reforms as well
as toward them, the trend in Mexico’s policies has
been toward greater openness. These economic
reform policies have made future openness a
more credible policy.
The first section of this article examines the
history leading up to Mexico’s recent economic policies. Next, the article discusses Mexico’s
economic reform policies and how they have
changed since the economic crisis began. The
following section examines the factors that influence the credibility of Mexico’s open market
policies. The final section summarizes the likely
trend in Mexico’s policies.

per capita grew
at an average
annual rate of
about 3.7 perReal GDP per capita growth
cent from 1954
Inflation
Public deficit /GDP
to 1972 (Figure
Current account deficit /GDP
1 ). Mexico did
not grow as
quickly as some
other developing countries that followed more outwardoriented policies, such as Korea and Taiwan, but
growth was stable and living standards were
rising.4 This period of Mexico’s development
has been referred to as stabilizing development.
During the early 1970s, Mexico’s inwardlooking policies generated economic inefficiencies, but increased government spending during
the period may have made these costs less
apparent.5 While per capita real GDP grew 3.7
percent from 1954 to 1972, it grew only slightly
less, 3.1 percent, from 1973 to 1976. The microeconomic costs of price controls, a growing
government sector, and inward-based industrialization policies were beginning to increase
(Bazdresch and Levy 1991). Moreover, resources
that might have otherwise been devoted to education and other productive investments were
spent on subsidizing a growing number of the
state-owned enterprises.6 The world recession
and the spike in oil prices that hit in 1973 only
made matters worse for Mexico, which at the time
was a net importer of oil (Lustig 1992).
In attempting to offset a slowdown in growth,
Mexico pursed expansionary fiscal and monetary
policies. However, as Table 1 and Figure 2 show,

The historical context
The years of inward orientation. The economic reform policies that Mexico undertook in
the mid-1980s were a shift away from policies that
began shortly after World War II. Like many
developing countries in the early 1950s, Mexico
pursued an import-substitution industrialization
policy. 2 The government kept Mexican markets
relatively closed to foreign competition, restricted
foreign direct investment, and tightly regulated
domestic financial markets.
The original impetus for closed market
policies was the dependency theory, the idea that
if poor countries want to grow, they have to break
away from developed countries. Poor countries
would have to start producing manufactured
goods for themselves rather than continue to
import these goods from developed countries in
exchange for exports of primary goods. The fear
was that poor countries would never catch up to
the rich countries without major government
intervention to manage international competition
and support domestic industry.3
Despite the inherent problems of a closed,
highly regulated economy, Mexico’s real GDP

FEDERAL RESERVE BANK OF DALLAS

Figure 2

Mexico’s Inflation Rate and
Fiscal Deficit, 1960 – 82
Inflation
(Percent)

Fiscal deficit
(As a percentage of GDP)

100

14
12

10
55
8
40
6
Inflation

4
Deficit

–5

0
’60

’62

’64

’66

’68

’70

’72

’74

’76

NOTE: Deficit data not available before 1966.
SOURCE: International Monetary Fund.

ECONOMIC REVIEW SECOND QUARTER 1995

’78

’80

’82

1954–72
(Percent)

1973–76
(Percent)

3.7
3.5
1.8
–1.5

3.1
20.1
4.3
–2.9

Table 2

Overview of Mexican Finances, 1954–94

Year

Population
(In thousands)

1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994*

31,419
32,348
33,483
34,617
35,757
36,891
38,227
39,472
40,754
42,074
43,446
44,337
46,337
47,868
49,451
51,081
52,770
51,982
53,690
55,429
57,165
58,876
60,560
62,211
63,836
65,445
67,046
68,637
70,225
71,791
73,309
74,766
76,178
77,562
78,933
80,312
81,724
83,306
84,967
86,557
88,054

Real GDP
per capita
(In U.S. dollars)

Real GDP
per capita
growth rate
(Percent)

Inflation
(Percent)

Nominal
exchange rate
(New pesos)

2,397
2,514
2,590
2,711
2,751
2,726
2,836
2,864
2,897
3,019
3,258
3,351
3,467
3,582
3,766
3,846
3,987
4,213
4,404
4,609
4,782
4,928
4,973
4,900
5,208
5,621
6,054
6,467
5,942
5,401
5,524
5,621
5,283
5,262
5,349
5,566
5,827
6,018
6,253
6,167
6,244

7.15
4.88
3.02
4.67
1.48
–.91
4.04
.99
1.15
4.21
7.92
2.85
3.46
3.32
5.14
2.12
3.67
5.67
4.53
4.65
3.75
3.05
.91
–1.47
6.29
7.93
7.70
6.82
–8.12
–9.10
2.28
1.76
–6.01
–.40
1.65
4.06
4.69
3.28
3.90
–1.38
1.25

4.85
15.99
4.85
5.10
8.17
0
7.59
–2.03
2.15
–.11
3.55
4.50
3.77
3.05
1.76
2.60
7.06
4.95
5.66
21.35
20.60
11.31
27.20
20.67
16.17
20.04
29.78
28.68
98.87
80.77
59.17
63.74
105.75
159.16
51.66
19.70
29.93
18.80
11.94
8.01
7.00

.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0125
.0200
.0227
.0227
.0228
.0233
.0262
.0965
.1439
.1926
.3717
.9235
2.2097
2.2810
2.6410
2.9454
3.0710
3.1154
3.1059
5.0800

International
reserves minus gold
(Millions of U.S. dollars)
147.08
298.50
344.50
295.50
247.50
316.00
306.00
301.00
333.00
409.00
418.00
379.50
454.99
420.00
491.92
493.39
568.10
752.09
975.88
1,160.21
1,237.63
1,383.46
1,188.00
1,648.90
1,841.51
2,071.71
2,959.89
4,074.36
833.89
3,912.92
7,272.04
4,906.40
5,669.82
12,464.08
5,278.68
6,329.10
9,862.90
17,725.52
18,941.96
25,109.61
6,148.00

*Estimate.
NOTE: Data are for the end of the period. Real GDP is shown in terms of 1985 U.S. dollars and is adjusted for differences in purchasing power
(using an equivalent basket of goods) between the United States and Mexico.
SOURCES: International Monetary Fund International Financial Statistics; Penn World Table, Version 5.6, 1995; Banco de México.

expansionary policies without real fundamental
economic change simply generated inflation and
large fiscal and current account deficits. In 1976,
a balance of payments crisis erupted and led to a
60-percent devaluation in the peso, which had
been fixed at 12.50 old pesos per dollar since 1954
(Table 2 ).

If macroeconomic policies had been as
stable as they were in the 1950s and 1960s, Mexico
might have been able to avoid the balance of
payments crisis in 1976, even without structural
change. But Mexico’s increasing economic inefficiencies would have necessitated, at some point,
fundamental change.

The transition years. In late 1982, Mexico’s
newly elected president, Miguel De la Madrid
Hurtado, inherited perhaps the worst economic
crisis in the country’s history. During the early
years of De la Madrid’s administration, the first
important stages of reform began, but it was only
toward the end of his administration that structural reform policies genuinely moved in the
direction of a more market-based economy.
From 1982 to 1985, Mexico’s annual rate
of inflation slowed from around 100 percent
to about 65 percent in response to government spending cuts and tighter monetary policy.
Real GDP per capita declined about 13 percent over these years as the economy adjusted to
lower government spending and large foreign
debt payments. Due to the high debt payments,
Mexico’s net transfers to the rest of the world
totaled nearly 6 percent of GDP from 1982 to 1985
(Aspe 1993, 35).
Although the De la Madrid administration
began reducing the public-sector deficit, it was
not eliminating other fundamental causes of
macroeconomic instability. Anti-inflation policies
were not credible because the government still
relied heavily on excessive money growth to earn
inflation tax revenues. The inflation tax as a share
of GDP was 8 percent in 1983 and 5.5 percent
in 1985 (Figure 3 ).7 The need for inflation tax
revenues was due to debt payments, financial
support of state-owned enterprises, and a weak
tax system. Inflation began to accelerate in 1985,
and by 1986, it was back up to more than 100
percent a year.
Although the economy was opening to
trade, it was still relatively closed and the private
sector was uncertain about the government’s true

Mexico was ready for structural change in
1976, but huge oil discoveries appeared to lift
fiscal and foreign exchange constraints, at least
for the foreseeable future. Rather than implement
the needed but difficult structural reforms, the
new administration of President José López Portillo, expecting uninterrupted oil revenues, set out
on a massive fiscal expansion. Without tight
budgetary constraints, the state devoted more and
more resources to purchasing private-sector firms
that were no longer economically viable, with the
hope of maintaining employment (Bazdresch
and Levy 1991, 249). From 1950 to 1970, the
number of para-statal firms in Mexico remained
below 300; twelve years later, state-owned firms
numbered 1,155. In 1983, state-owned firms
accounted for 18.5 percent of GDP and employed
more than 10 percent of the population (Aspe
1993, 181). Firms owned by the government
included businesses such as the national oil
company (PEMEX), the airlines (Aeromexico and
Mexicana), the national telephone company
(TELMEX), sugar refineries, and hotels.
Mexico’s economic boom turn to bust when
oil prices began to fall and U.S. real interest rates
began to rise in mid-1981. The fixed exchange rate
became extremely overvalued as the economic
fundamentals changed. Investors’ fear of another
balance of payments crisis and devaluation led to
capital flight. The government tried to maintain
the exchange rate as long as it could, but foreign
reserves were dwindling rapidly. In 1982, the
government devalued the currency by more than
260 percent, declared a temporary moratorium on
debt payments, and forced the conversion of
dollar-denominated bank deposits into pesos at
an unfavorable, below-market exchange rate.
As the crisis worsened, the government
responded by tightening its grip on the economy.
Toward late 1982, all trade became regulated, full
exchange controls on capital were adopted, and
the Mexican banking system was nationalized.
But more government intervention spooked the
financial markets and only made matters worse.
With the Mexican financial markets in disarray, a
government fiscal crisis, and inflation pushing an
annual rate of 100 percent, real per capita GDP declined 8.1 percent in 1982 and 9.1 percent in 1983.
Hindsight is always better than foresight. By
1982, it was obvious that Mexico should have
pursued more market-based policies and limited
foreign borrowing. However, with the price of
oil increasing quite rapidly during the late 1970s,
and expectations of further price increases (expectations that other countries shared as well),
the pressing need for change was not apparent
(Lustig 1992, 21).

FEDERAL RESERVE BANK OF DALLAS

Figure 3

Mexico’s Inflation Rate and
Inflation Tax, 1982–94
Inflation
(Percent)

Inflation tax
(As a percentage of GDP)

180

12
11

160

10
140

Inflation tax
Inflation

120

9
8
7

100

6
80

4
3

2
20

1
0

0
’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94

SOURCE OF PRIMARY DATA: International Monetary Fund.

ECONOMIC REVIEW SECOND QUARTER 1995

commitment to open markets. Thirty-five percent
of imports had to be licensed, and quotas covered
83 percent of the value of imports (Aspe 1993,
156). The export sector was being held back because resources were kept in import-competing
sectors. Foreign investment was also weak because investors were suspicious of Mexico’s commitment to open markets; laws still limited foreign
ownership of business, and the government controlled the banking sector. The macroeconomic
environment continued to worsen. After an earthquake in 1985, another oil shock in 1986, and a
stock market crash in 1987, Mexico was ready for
rapid and far-reaching reforms. The next package
of reforms began to address some of Mexico’s
worst structural problems.

Solidarity, which was followed by the Pact for
Stability and Economic Growth under the newly
elected administration of President Salinas de
Gortari. These two measures, now jointly referred
to as the Pacto, were designed to combine
orthodox fiscal and monetary restraint with structural reforms and an incomes policy (controls on
wages and prices).
The Pacto has gone through 15 phases (or
renegotiations, as they have been called) since its
implementation in 1987.8 The Pacto phases began
as very short-term commitments, lasting about
two months; they then grew to longer term, oneyear commitments.9 During the first phases, a
strong emphasis was placed on price and wage
controls, fiscal and macroeconomic adjustment,
and debt renegotiation; later stages focused on
deregulation and privatization to promote economic efficiency and on trade and financial liberalization to enhance competition and reduce
production costs (Schwartz 1994).
Incomes policy. The incomes policy, or
price and wage controls, has been and remains
the most controversial part of the Pacto. Wage
controls included programs that simply limited
nominal wage increases, as well as more complicated schemes of linking nominal wage increases
to productivity growth. Price controls were not
uniform across the economy; the intention was
to focus the controls on the leading sectors. Some
have contended that the incomes policy was
necessary to break the cycle of increasing inflation resulting from the practice of indexing
wages and prices to past inflation (Lustig 1992,
52). Others, however, have argued that the incomes policy was unnecessary because, without
fiscal and monetary austerity, the lifting of price
controls would simply result in a return to high
inflation.
Fiscal and monetary austerity are sufficient
to stop inflation, but some have claimed that a
benefit of the incomes policy was that it served to
announce the government’s intentions to all concerned parties. An explicit statement of the
government’s goals may have informed individuals what the inflation targets were, which could
have decreased the costs of adjustment. However,
price and wage controls, by themselves, can be
costly because they tend to distort relative prices
in an economy. The exact cost or benefit of
Mexico’s incomes policy has yet to be quantified.
The incomes policy was the most hotly
debated during the first few months of the Pacto,
when prices and wages were adjusted on a
monthly basis according to changes in expected
inflation. As inflation subsided, price and wage
controls became a less contentious policy. High

The move to open market-based policies
During the early 1980s, Mexico’s drop in
real per capita income was almost as large as that
which occurred during the Great Depression. As
Figure 4 shows, in 1982 real per capita GDP fell
8.1 percent, while inflation rose to an annual rate
of 98.9 percent. The experience convinced many
people in and outside the government that Mexican policies were not working and they had to
find an alternative (Aspe 1993, 14). Certainly,
there were those, mainly in the protected and
state-owned sectors, who resisted changes in
policy. But as the economy continued to contract,
their political clout waned. The country embarked on a new policy direction.
In December 1987, President De la Madrid
and representatives of the labor, farming, and
business sectors signed the Pact for Economic

Figure 4

Real GDP Growth per Capita and Mexican
Inflation, 1980–94
Inflation
(Percent)

Real GDP growth per capita
(Percent)

180

160

140

120

2
GDP

100
80

–2

60
40

–4
Inflation

–6
–8

–10
’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94

SOURCES: Penn World Table, Version 5.6, 1995; International
Monetary Fund.

inflation expectations were no longer automatically built into wage contracts, and the strength of
labor unions to negotiate large wage increases
declined. Although the December 1994 exchange
rate devaluation was followed by higher inflation
and attempts to impose more stringent price and
wage controls, the government subsequently
abandoned further attempts to impose controls.10
Public finance. An important element of the
Pacto has been public finance policy. In addition
to fiscal austerity, there has been a realignment of
public-sector goods prices to reflect costs, the
divestiture of state-run enterprises, and changes
in the tax structure. An often observed difficulty
with plans to reduce fiscal deficits, not just in
Mexico but also in other countries undergoing
economic reforms, is their structural inconsistency with other objectives. In other words, a
government may state that the fiscal budget will
be balanced and inflation will be reduced, but
without a functioning tax system, inflation may be
the only way to finance public expenditure.
Although Mexico still has fiscal problems, changes
in the public sector have made fiscal prudence a
more feasible policy than during the early 1980s.
Of the 1,155 enterprises held by the public
sector in 1982, 940 were either sold to the private
sector, liquidated, or merged by 1994. Stateowned enterprise expenditures fell from around
18 percent of GDP in 1983 to 9.6 percent of GDP
in 1994. The recent economic stabilization plan
for Mexico calls for further privatization of ports,
public utilities, and some petrochemical plants.
However, some of these proposed privatizations
are being contested, and PEMEX, the national oil
company and the largest state-run business, is not
currently being considered for privatization.
Since 1989, the tax system has been simplified, and tax rates are down to levels similar to
those in the United States. The corporate tax rate
was reduced from 42 percent to 35 percent, and
the highest income tax rate paid by individuals fell
from 50 percent to 35 percent. By simplifying the
tax structure, lowering tax rates, and increasing enforcement, tax evasion has fallen and tax
revenue has increased. In the early 1990s, tax
revenues increased nearly 30 percent, mostly as a
result of Mexico’s expanding tax base (Aspe 1993,
108). The overall fiscal deficit as a percentage of
GDP fell from 16 percent in 1987 to 0.3 percent
in 1994.11 During the same period, total government spending fell from 43.7 percent of GDP to
26.3 percent of GDP, and inflation fell from 160
percent a year to 7 percent a year.
Mexico’s stabilization plan of March 9, 1995,
calls for increases in the prices of fuel, electricity,
natural gas, and other goods and services pro-

FEDERAL RESERVE BANK OF DALLAS

vided by the public sector to reflect international
prices and increase revenues. There are also plans
to raise the value-added tax from 10 to 15 percent,
reduce public-sector employment, and limit the
growth of public-sector real wages.
Financial liberalization. An important element of Mexico’s new reform policies has been
financial liberalization. Financial liberalization took
a major step forward after 1988 with the elimination of compulsory bank reserve requirements
and forced credit to public-sector enterprises. The
elimination of these measures allowed greater
financing for private-sector enterprises. Other
changes have been the authorization of universal
banking and other financial entities. In 1991–92,
the government privatized all the banks and lifted
capital controls imposed after the 1982 crisis.
Mexico is now increasing access to foreign
banks and brokerage houses. In October 1994,
Mexico authorized virtually all the foreign
banks, brokerages, and insurance companies
that sought entry into the market. The finance
ministry issued fifty-two licenses to eighteen
commercial banks, sixteen securities firms, twelve
insurance companies, five financial groups, and
a leasing company.
Because of the recent economic crisis and
stress on the banking system, the government has
pledged to speed up implementation of provisions that would allow greater foreign ownership
of existing financial institutions. Foreigners will
be able to hold majority interests in all but the
three largest banks. Before the recent economic
crisis, foreign ownership of existing banks was
severely limited, although the banking sector still
faced increased competition in the market. In
1991, Mexico’s three largest banks—Banamex,
Bancomer, and Serfin—accounted for about 62
percent of total Mexican banking assets; in late
1994, they accounted for less than 50 percent.
Since the December 1994 devaluation, there
has also been an easing of the rules keeping
financial institutions from using the futures market to hedge uncertainty. Prior to the devaluation,
the development of a futures market to hedge
peso and equity volatility was suppressed. But
although the government felt that these markets
would add to unwanted speculation against the
currency, the markets may have led to greater
flows of trade and investment. The rules now
allow for Mexican institutions to hedge movements in the peso and the stock market.
Trade liberalization. On the trade side, Mexico
started to gradually liberalize in mid-1985, but the
process was solidified in 1988 when the number
of goods covered by import licenses fell dramatically and the tariff structure was simplified. In

ECONOMIC REVIEW SECOND QUARTER 1995

Some have argued that keeping the exchange rate closely tied to the dollar, especially
during the early stages of Mexico’s economic
reforms, kept exchange rate volatility low and
allowed investors a simple means of monitoring
Mexico’s monetary policy. For example, if expected inflation was higher in Mexico than in the
United States or prospects for growth in Mexico
weakened relative to those in the United States,
dollars would leave Mexico seeking better returns
in the United States. This would lead to upward
pressure on the exchange rate (increase the
number of pesos per dollar) as people who hold
pesos buy U.S. dollars. If the exchange rate was
to be kept within the band, Mexico would need
to tighten monetary policy and increase interest
rates to attract dollars back into Mexico. As long
as the exchange rate policy was maintained and
was credible, it was argued, anyone who watched
the movement of foreign reserves would know
what would happen to monetary policy.
Of course, exchange rate policy does not
make low inflation credible. Low inflation is made
credible only through sustainable fiscal balances
and low and stable monetary growth. Over the
long run, it is these policies that keep exchange
rate policy credible, not the other way around. If
monetary policy is too loose and is inconsistent
with maintaining the exchange rate, foreign reserves leave the country. Without any foreign
reserves to defend the exchange rate, the exchange rate policy has to be abandoned.
From 1987 to the end of 1993, Mexico’s
monetary policy was consistent with low inflation
and maintaining its exchange rate targets. Inflation fell from a high of nearly 160 percent in 1987
to around 7 percent in 1994. During 1994, however, political uncertainty in Mexico and rising

Figure 5

Annual Growth Rate of Trade (Exports
Plus Imports) Between the United States
And Mexico, 1982–94
Percent
30
25
20
15
10
5
0
–5
–10
–15
’82

’83

’84

’85

’86

’87

’88

’89

’90

’91

’92

’93

’94

NOTE: 1994 data annualized from first- and second-quarter data
SOURCE: International Monetary Fund.

1983, the share of imports covered by import
permits was close to 100 percent; by 1992, the
share had fallen to less than 2 percent (Banco de
México 1993). Mexico joined the General Agreement on Tariffs and Trade (GATT) in 1986 and
cemented its open trade stance with the United
States and Canada through NAFTA in 1993. NAFTA
has generated a large increase in trade and joint
business ventures between U.S. and Mexican
firms. For example, total trade flows between the
United States and Mexico (exports plus imports)
grew by around 17 percent in 1994, compared
with a 7-percent annual rate in 1993. These trade
flows have averaged about 15-percent growth
since 1988 (Figure 5 ). Mexico is now vying with
Japan to be our second largest trading partner
behind Canada.
Monetary and exchange rate policy. When
Mexico began its economic reform, the key element of its monetary policy was the use of the
exchange rate as a nominal anchor—that is,
domestic prices were tethered to international
prices by targeting the nominal exchange rate.
During the initial stages of the Pacto, the exchange rate was fixed to the dollar; then it was
held to a preannounced daily depreciation. In
1991, the exchange rate was allowed to float
within a widening band. At first, the top of the
band rose 20 centavos (0.0002 new pesos) per
dollar a day; then it was increased to 40 centavos
(0.0004 new pesos) per dollar a day (Figure 6 ).
On December 20, 1994, however, under pressure
from foreign exchange markets and dwindling
foreign exchange reserves, Mexico abandoned its
exchange rate band. The peso was devalued and
then allowed to float freely against the dollar.

Figure 6

Peso–Dollar Exchange Rate
Pesos per dollar
6
Oct. 20, 1992
5.5

4.5

3.5

Dec. 20, 1994

Top edge of band
(0.0002 daily increase)

Top edge of band
(0.0004 daily increase)
Bottom edge of band

3
Nov. ’91

May ’92

Nov. ’92

SOURCE: Banco de México.

May ’93

Nov. ’93

May 94

Nov. ’94

interest rates in the United States began to drain
Mexican foreign reserves. Investors were not
being fully compensated for the greater perceived risks in the Mexican market so they took
their money elsewhere. Money left the country
because interest rates did not rise sufficiently. A
contributing factor could have also been that
peso risks were difficult to hedge against. The
central bank was suppressing the peso futures
market because it feared the market would
allow for inordinate speculation against the currency. Foreign reserves fell from around $25
billion at the end of 1993 to about $16 billion in
July 1994 (Figure 7 ).
The election of Ernesto Zedillo in August
1994 brought new confidence in Mexico’s policies and temporarily boosted foreign reserves
and the peso. Following the elections, however, because of higher U.S. interest rates and
increased investor uncertainty, money began
flowing out of Mexico again. Without dramatically higher interest rates, foreign reserves continued to leave the country. Eventually, foreign
reserves dwindled to such a point that the exchange rate band had to be loosened and then
completely abandoned after continued pressure
on the peso.
If interest rates had been kept higher after
the 1994 presidential elections, perhaps the costs
of abandoning the exchange rate, in terms of lost
credibility and higher short-run inflation, could
have been avoided. In hindsight, this may have
been a better option than the one chosen, although dramatically higher interest rates could
have also sparked an economic crisis. Perhaps a
better option would have been to let the exchange rate float when foreign reserves were
coming into the country, such as in late 1993.
A floating exchange rate allows a country to
weather domestic and international economic
shocks without necessitating dramatic changes
in domestic monetary policy and without calling
into question the credibility of basic policies.
Now that Mexico is floating its exchange rate,
economic ups and downs will not generate speculation against a particular exchange rate policy.
If monetary restraint continues, inflation—over
the long run—will remain moderate.

Figure 7

Mexico’s Stock of International
Reserves Less Gold, 1994
Billions of U.S. dollars, monthly average
30

0
Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.

SOURCE: International Monetary Fund.

For example, Peru’s trade liberalization attempt
during the early 1980s was abandoned shortly
after it was implemented. Will Mexico’s economic
reforms continue?
A common element of unsuccessful liberalizations seems to be the failure to create a credible
economic policy. An example would be a
government’s pursuit of low inflation without
addressing far-reaching structural problems, such
as an inadequate tax system and a large budget
deficit. In this case, pursuit of low inflation is
inconsistent with the budget deficit and an inability to tax except through inflation.
Another credibility problem occurs when a
government’s policies are time-inconsistent. A
time-inconsistent policy is one in which the
government, at some later date, has an incentive
to break it’s promise. For example, the government, for political reasons, may have an incentive
to redistribute income from the rich to the poor.13
Under this objective, a free trade policy may not
be credible because the government has an
incentive to provide more protection than expected to import-competing firms whenever the
relative price of imports decreases. When the
price of imports falls, the import-competing sector becomes relatively poor; consequently, the
government has an incentive to renege on its free
trade promise and redistribute income through
protection to these sectors. Free trade, then, is not
a credible policy because the private sector understands the government incentive structure.
Creating a credible policy that is timeconsistent can be problematic because it depends
on the government’s ability to precommit to a
particular policy. In trade reform, for example, if
a government cannot precommit to free trade, it
may have to pursue a time-consistent but second-

Assessing Mexico’s policy credibility
What determines credibility. Perhaps economic liberalization never comes without a crisis.
This has certainly been the case in Mexico. What
becomes evident from looking across a broad
spectrum of countries that have embarked on
economic reform is that some have achieved great
success, while others have failed miserably.12

FEDERAL RESERVE BANK OF DALLAS

ECONOMIC REVIEW SECOND QUARTER 1995

best policy of partial tariff protection. In other
words, the government may never be able to
create a credible policy committed to complete
free trade; it may, however, be able to create a
credible policy with less protection.
Consequently, to evaluate the credibility of
any particular economic policy two questions
have to be addressed: (1) Is the policy consistent
with other objectives being pursued at the same
time? and (2) Is the policy time-consistent? In
other words, does the government have an incentive to renege on the policy commitment? In
the political economy context, the second question can be thought of addressing whether the
political forces that determine a particular policy
are likely to change.
Almost universally, no policy—whether in
a developed country like the United States or
developing country like Mexico—is completely
credible. The lack of information about the
government’s incentives and uncertainty about
future economic shocks makes complete credibility impossible. However, the degree of policy
credibility can be subjectively assessed by examining factors such as the government’s behavior
over time, the country’s institutions, and the
consistency of policies.
Assessing the credibility of Mexico’s economic liberalization. Since the December 1994
devaluation, Mexico’s economic growth has stalled,
and a growing number of people have become
disenchanted with the current economic situation.14 High interest rates have made it difficult
for people to service their debts and have caused
a decline in spending. While the economic crisis
could generate a political stimulus for greater
economic liberalization and macroeconomic
stability, it could also cause the abandonment of
policies that enhance long-run growth in order
to ease the short-run pains of adjustment. So far,
the policies that have been adopted since the
crisis began have favored greater economic
liberalization and long-run macroeconomic stability, but their credibility over time will be
determined by their consistency with other objectives and the strength of the constituency groups
that favor such policies.
Because of Mexico’s recent exchange rate
devaluation, the credibility of another fixed exchange rate policy in Mexico is obviously very
low. Mexico’s past monetary policy, although it
generated a relatively low rate of inflation, was
not consistent with its rigid exchange rate band.
Its current floating exchange rate regime, however, is more credible because it does not require
any specific commitment to tie Mexico’s monetary policy to that of the United States. In addition,

while a floating exchange rate may be more
volatile on a day-to-day basis, it is unlikely to
experience the kind of large discrete jump that is
often seen in managed exchange rate regimes.
Compared with the period after the 1982
crisis and devaluation, however, Mexico may
have a more credible low inflation policy. Although inflation has dramatically increased since
the December 1994 devaluation, over the longer
run Mexico may be in a better position to avoid
high inflation. Unlike the situation during the
1982 economic crisis, the Mexican economy
now has fewer government-owned enterprises
that are taking funds from the public sector; many
of these businesses have been privatized or
liquidated. Moreover, the government budget is
not in a large deficit, and because of a better
tax system, the government does not have to rely
solely on the inflation tax (printing money to pay
for government expenses) to collect revenues
(Figures 3 and 8 ).
Government incentives to maintain a more
stable macroeconomic environment may also be
higher today than in the past. Unlike the early
1980s, economic interdependence is much more
important in Mexico today. Trade as a share of
GDP increased from 8.7 percent in 1982 to 22.1
percent in 1993. The benefits of foreign investment and its sensitivity to bad policy choices have
also become more obvious over the last decade.
Countries that are more open and outward
oriented—such as Chile, Hong Kong, Korea,
Singapore, and Taiwan—have achieved much
higher sustained economic growth than more
closed, inward-oriented economies.15

Figure 8

Mexico’s Inflation Rate and
Fiscal Deficit, 1987–94
Inflation
(Percent)

Fiscal deficit
(As a percentage of GDP)

180

160

140

14
12

120

10
100

Deficit*
8

80
6
60

Inflation
20

–2
’87

’88

’89

’90

’91

’92

’93

’94

* Public-sector borrowing requirements.
SOURCES: Banco de México (1994); International Monetary Fund.

Conclusion

The importance of market-based policies is
apparent in Mexico’s own experience. As discussed earlier, import-substitution industrialization policies were very costly for Mexico in terms
of diminished economic efficiency and long-run
growth. Moreover, while Mexico’s 1982 crisis
certainly hurt the country terribly, the poor policy
response afterward, such as the nationalization of
the banking industry, turned a bad situation
worse by creating a massive capital flight for
which Mexico paid a tremendous price. Despite
the recent exchange rate crisis, Mexico has yet to
reverse its open market stance.
Institutional arrangements can also increase the credibility of a policy. Although
Mexico unilaterally reduced trade barriers in
several areas before joining NAFTA and GATT,
these multilateral agreements may be a much
stronger commitment to future open markets,
and not just because they are international
agreements.
Free trade agreements create domestic
coalitions against increases in domestic protection because of the threat of retaliatory response and possible collapse of the entire
agreement. The greater the move to free trade,
the more at stake and the greater the strength
of these free trade coalitions. Usually, it does
not pay for any one group to lobby against a
single protective policy if the costs of such a
policy to that group are relatively small. However, with NAFTA, a Mexican exporter has
much more of an incentive to lobby actively
against increases in Mexican protection because an increase in protection could induce a
retaliatory response against its own products
from the United States or Canada. The Mexican
consumer also has a stake in seeing that the
free trade agreement is kept because of the
potentially large increase in the price of consumer goods if NAFTA is abandoned.16
Even though there may be coalitions in
favor of sustaining open markets, in some sectors
there is likely to be backsliding. Like the United
States, Mexico is now using antidumping and
countervailing duties against imports much more
than in the past. Despite the fact that average tariff
rates fell from around 34 percent in 1985 to 4
percent in 1992, the coverage of nontariff barriers
went from 12.7 percent of imports in 1985–87 to
20 percent of imports in 1991–92 (Edwards 1993).
The devaluation of the peso, however, may
weaken the demand for nontariff barriers in
Mexico. As the real value of the peso (adjusted
for Mexican and U.S. inflation rates) has fallen
against the dollar, the price pressure on importcompeting firms in Mexico has decreased.

FEDERAL RESERVE BANK OF DALLAS

While continued economic reforms are
not guaranteed in Mexico, they are more likely
than is often believed. During the 1980s, Mexico’s economic paradigm shifted from a closed
market, inward-looking development strategy
to an open market, outward-oriented development strategy. Unlike the period prior to Mexico’s
1982 debt crisis, the trend in Mexico’s economic
policies has been toward greater economic integration in the world economy and a reduced
reliance on the government sector. This trend
in Mexico’s policies, although not immune to
shocks, is more consistent with future low inflation and greater economic growth than the
country’s previous inward-oriented policies.

Notes

Catherine Mansell Carstens, Ken Emery, Steve Kamin,
Moisés Schwartz, Sidney Weintraub, and Carlos
Zarazaga offered many helpful comments for this
article. All remaining errors are solely my responsibility.
In December 1994, the Blue Chip consensus forecast
for 1995 Mexican real GDP growth was 3.8 percent.
The OECD was predicting 4-percent growth for 1995
and 4.3-percent growth for 1996.
One of the main architects of this policy was Raúl
Prebisch. For an insightful analysis of Prebisch’s views,
see Love (1980).
The underpinnings of this theory was the idea that as
world income rose, the demand for manufactured
products would increase relative to primary products,
and this change would lead to a lower relative price for
primary products in international markets. As a result,
if developing countries did nothing to change the
structure of their output, their terms of trade would
always move against them.
Over the same period, Taiwan and Korea both experienced around 4.6-percent real GDP growth per capita.
Although Prebisch was one of the main architects of
the import-substitution industrialization policy, he
realized the problems of protectionism as early as
1963. Hirschman (1968) quotes a very interesting
passage from Prebisch (1963, 71): “As is well known,
the proliferation of industries of every kind in a closed
market has deprived the Latin American countries of
the advantages of specialization and economies of
scale, and owing to the protection afforded by excessive tariff duties and restrictions, a healthy form of
internal competition has failed to develop, to the
detriment of efficient production.”
Gil Díaz (1984). As price controls were imposed to limit
inflation, the profit margins of some private firms were
squeezed. Those firms that could no longer produce
profitably at the given prices were then purchased by
the government. This was the case, for example, with
sugar mills.

ECONOMIC REVIEW SECOND QUARTER 1995

15
16

Macroeconomics of Populism in Latin America, ed.
Rudiger Dornbusch and Sebastian Edwards (Chicago:
University of Chicago Press), 223 – 62.

The real output that a government obtains by printing
money and spending it is called the inflation tax or
seigniorage. Money creation that leads to inflation
erodes the real value of nominal money holdings. The
formula used here to calculate the inflation tax as a
share of GDP is: INFTAX = (M/GDP ) * π/(π + 1), where
M is monetary base, GDP is nominal gross domestic
product, and π is the annual inflation rate.

Edwards, Sebastian (1993), “Trade Policy, Exchange
Rates and Growth,” NBER Working Paper Series, no.
4511 (Cambridge, Mass.: National Bureau of Economic
Research, October).

If one includes the two stabilization plans announced
on January 2, 1995, and March 9, 1995, as new Pacto
phases, then there have been seventeen phases.
See Schwartz (1994) for the dates of Pacto announcements and phase durations.
The Mexican government’s first stabilization plan,
announced on January 2, 1995, allowed for a 7-percent
increase in overall wages. On March 9, a revised plan
included an additional 10-percent increase in the
minimum wage, but those earning more than the
minimum wage were free to negotiate their own wages.
The overall fiscal balance referred to here is the
public-sector borrowing requirement, which measures
the difference between total revenue and expenditure,
which includes debt amortization in the interest
component. The primary balance, which excludes all
of the interest component in expenditures, has been
in surplus since 1985.
See Michaely, Papageorgiou, and Choksi (1991) for an
overview of the liberalization experience in several
developing countries.
This is a case analyzed by Staiger and Tabellini
(1987). In formal economic terms, the government’s
objective is to redistribute income from individuals with
a low marginal utility of income to those with a high
marginal utility of income.
Recent election results suggest such disenchantment.
For the first time in its sixty-five year history, the ruling
Institutional Revolutionary Party (PRI) lost the governorship in the state of Jalisco, which includes Mexico’s
second largest city, Guadalajara. The victory went to
the National Action Party (PAN), which received 55
percent of the vote.
See Gould and Ruffin (forthcoming).
See Gould (1992) for a more in-depth discussion of
this topic.

Gil Díaz, Francisco (1984), “Mexico’s Path from Stability
to Inflation,” in World Economic Growth: Case Studies

of Developed and Developing Nations, ed. Arnold C.
Harberger (San Francisco: Institute for Contemporary
Studies Press), 333 –76.
Gould, David M. (1992), “Free Trade Agreements and the
Credibility of Trade Reforms,” Federal Reserve Bank of
Dallas Economic Review, First Quarter, 17–27.
_____________ , and Roy Ruffin (forthcoming), “Human
Capital, Trade and Economic Growth,” Weltwirtschaftliches Archiv.
Hirschman, A. O. (1968), “The Political Economy of
Import-Substituting Industrialization in Latin America,”
Quarterly Journal of Economics 82 (February): 1– 32.
Love, Joseph L. (1980), “Raúl Prebisch and the Origins of
the Doctrines of Unequal Exchange,” in Latin America’s
Economic Development: Institutionalist and Structuralist
Perspectives, ed. James L. Dietz and James H. Street
(Boulder, Colo.: Lynne Rienner Publishers).
Lustig, Nora (1992), Mexico: The Remaking of an
Economy (Washington, D.C.: The Brookings Institution).
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).
Prebisch, Raúl (1963), Towards a Dynamic Development
Policy for Latin America (New York: United Nations).
Schwartz, Moisés J. (1994), “Exchange Rate Bands and
Monetary Policy: The Case of Mexico” (Paper presented
at XII Latin American Meetings of the Econometric
Society, Caracas, Venezuela, August 2).

References
Aspe, Pedro (1993), Economic Transformation the Mexican Way (Boston: MIT Press).
Banco de México (1994), Indicadores Economicos
(Mexico City: Banco de México, August).

Staiger, Robert, and Guido Tabellini (1987), “Discretionary
Trade Policy and Excessive Protection,” American
Economic Review 77 (December): 823 – 37.

——— (1993), The Mexican Economy 1993 (Mexico City:
Banco de México).

Summers, Robert, and Alan Heston (1991), “The Penn
World Table (Mark 5): An Expanded Set of International
Comparisons, 1950 –1988,” Quarterly Journal of Economics 106 (May): 327– 68.

Bazdresch, Carlos, and Santiago Levy (1991), “Populism
and Economic Policy in Mexico, 1970 –1982,” in The

Energy Prices and
State Economic
Performance

Over the past two decades, interregional
divisiveness has been an integral part of the debate over U.S. energy policy. Energy-producing
regions have tended to favor policies that would
boost domestic energy prices, while energyconsuming regions have tended to favor policies
that would lower domestic energy prices.
In fact, fluctuations in energy prices have
been frequently cited as a major reason for
differences in regional economic performance
during the late 1970s and early 1980s. Rising oil
prices stimulated economic growth in energyexporting states and retarded economic growth
in energy-importing states. Falling oil prices
retarded economic growth in energy-exporting
states and stimulated economic growth in energyimporting states.
In the past decade, however, economic fluctuations have become increasingly correlated across
states, and fluctuating energy prices have played
a smaller role in the differences in economic performance across states (Sherwood-Call 1988). Increased homogeneity in the composition of state
economies likely accounts for much of the increasing similarity in economic fluctuations across
regions (Barro and Sala-I-Martin 1991, Carlino and
Mills 1993). By our estimates, however, shrinkage of the industries most sensitive to energy
prices has also contributed to the declining role
of energy price fluctuations in the differences in
economic performance across states. This trend
is likely to continue throughout the 1990s.
In this article, we use simulations based on
input–output analysis to examine how declines in
the prominence of the industries most sensitive to
oil prices have affected and are likely to affect the
response of state economies to changes in oil
prices. We find that the decreased prominence of
these industries in nearly every state’s economy
has reduced the differences in the states’ responses to changes in oil prices. Given forecasts
that the industries most sensitive to oil prices will
further decline in prominence during the 1990s,
we expect the differences in the states’ responses
to oil price changes to decline further throughout
the decade.
These findings have important implications
for economic activity and national energy policy.
The role of energy price fluctuations in the
variation in economic activity across states should
continue to diminish, as it has done in the past
decade. In addition, the regional flavor of national
debates over energy policy should diminish.

Stephen P.A. Brown
Assistant Vice President and Senior Economist
Federal Reserve Bank of Dallas
Mine K. Yücel
Senior Economist and Policy Advisor
Federal Reserve Bank of Dallas

n this article, we use simula-

tions based on input –output
analysis to examine how declines
in the prominence of the
industries most sensitive to oil
prices have affected and are
likely to affect the response
of state economies to
changes in oil prices.

Diversification of state economies
Since 1982, state economies have diversified away from both energy-intensive industries

FEDERAL RESERVE BANK OF DALLAS

ECONOMIC REVIEW SECOND QUARTER 1995

cultural employment at 0.79 percent (Figure 1 ),
followed by petrochemicals with an employment share of 0.40 percent and coal mining with
a 0.26 percent share. Refining accounted for 0.18
percent employment, and oil field machinery
accounted for 0.13 percent.
The decade from 1982 to 1992 brought wild
swings in oil prices and a severe downsizing in
the oil and gas industry. Oil prices were at an alltime high in the first quarter of 1981 at $36 per
barrel. They remained relatively high in 1982 but
began a slow decline that continued until July
1986, when they collapsed to $11 per barrel.
Lower oil prices brought about a drastic
downsizing in oil and gas extraction and related
service industries. Coal prices also fell, and coal
mining was reduced. Falling consumption of
refined products and petrochemicals —a lagged
response to the higher prices in the late 1970s and
early 1980s —also led to a decline of the refining
and petrochemical industries.
From 1982 to 1992, employment in the five
key energy industries declined a total of 39
percent, while total U.S. nonagricultural employment increased by 23 percent. By 1992, the five
industries accounted for only 1 million jobs (0.9
percent of total U.S. nonagricultural employment). Oil and gas extraction accounted for 0.32
percent of total nonagricultural employment.
Petrochemicals claimed an employment share of
0.30 percent, coal mining 0.12 percent, refining
0.11 percent, and oil field machinery 0.04 percent.

Figure 1

U.S. Energy-Related Employment
(Thousands)
800
1982

700

1992

600

2000

500
400
300
200
100
0
Coal mining

Oil and gas
extraction

Oil field
equipment

Refining

Petrochemicals

SOURCES: Bureau of Labor Statistics, U.S. Department of Labor;
U.S. Department of Energy.

and energy-producing industries. Projections made
by the U.S. Department of Energy (DOE) and
DRI/McGraw–Hill (DRI) indicate this trend will
continue through 2000, albeit at a slower rate.
A shrinking energy industry. In 1982, the five
industries most sensitive to oil prices—coal mining, oil and gas extraction, oil field machinery,
petroleum refining, and petrochemicals —
accounted for 1.6 million jobs (1.8 percent of total
U.S. nonagricultural employment). Of these five
key energy industries, oil and gas extraction
accounted for the largest share of total nonagriFigure 2

Energy-Related Employment for Select States
(Percentage of nonagricultural employment)
16

Delaware

Louisiana

Oklahoma

Texas

West Virginia

Wyoming

13.7

12.8
12

11.8
10.3

10
9.1
8.0

7.4

7.3

7.2

6.8
5.8

4.9

4.8
4.0

3.6

3.4
2.7

2.5

0
1982

1992

2000

1982

Coal mining

1992

2000

1982

1992

Oil and gas extraction

2000

1982

1992

Oil field equipment

2000

1982

Refining

1992

2000

1982

1992

2000

Petrochemicals

SOURCES: Bureau of Labor Statistics, U.S. Department of Labor; U.S. Department of Energy; Independent Petroleum Association of America.

Table 1

Employment-Weighted Variances
In Energy-Industry Employment Across States

The DOE/DRI projections suggest an employment decline of 11 percent in the five key
energy industries between 1992 and 2000, while
total U.S. nonagricultural employment increases
by 15 percent. In oil and gas extraction, resource
depletion and productivity gains are projected to
reduce employment. In oil field machinery, productivity gains and a declining domestic market
are projected to lead to reduced employment. In
coal, refining, and petrochemicals, productivity
gains and growth slower than that of the national
economy are projected to translate into slight
employment losses from 1992 to 2000.
By 2000, the five key energy industries are
projected to account for 0.9 million jobs (0.7
percent of total U.S. nonagricultural employment). Oil and gas extraction is projected to
account for 0.23 percent of total nonagricultural
employment, petrochemicals 0.25 percent, coal
mining 0.10 percent, refining 0.09 percent, and oil
field machinery 0.02 percent.
Increasing diversification of state economies.
At the same time that energy industries have
been shrinking, individual state economies have
increasingly diversified away from energyintensive and energy-producing industries. Since
the early 1980s, nearly every state has become
less dependent on the five key energy industries. This trend is likely to continue throughout
the remainder of the 1990s.
For example, in 1982 the five key energy
industries accounted for 7.3 percent to 13.7 percent of nonagricultural employment in the six
states with the highest concentrations of energyindustry employment —Delaware, Louisiana,
Oklahoma, Texas, West Virginia, and Wyoming
(Figure 2 ). By 1992, the same five industries
accounted for 3.6 percent to 9.1 percent of
nonagricultural employment in the six states. The
most dramatic effects occurred in the oil- and gasproducing states. By 1992, the combined employment shares of oil and gas extraction and oil field
machinery in Louisiana, Oklahoma, Texas, and
Wyoming were less than 50 percent of the 1982
levels. Data for all 50 states and the District of
Columbia indicate that declines in the size of the
energy industry reduced the variance of employment in the five key energy industries across the
states from 1982 to 1992 (Table 1 ).1
From 1992 to 2000, the energy industry is
likely to continue to lose prominence in individual state economies, but less dramatically than
during the 1980s. Our reading of the DOE/DRI
projections indicates that the five industries will
account for 2.5 percent to 7.4 percent of nonagricultural employment in the six states with the
highest concentrations of energy-industry em-

FEDERAL RESERVE BANK OF DALLAS

1982
1992
2000

Coal
mining

Oil and gas
extraction

Oil field
machinery

Refining

Petrochemicals

Sum
energy

.8646
.1548
.1091

2.9653
.5405
.2700

.0973
.0110
.0022

.0390
.0180
.0111

.5302
.3188
.2250

6.6927
1.6354
.9251

Employment-Weighted Coefficients of Variation
In Energy-Industry Employment Across States

1982
1992
2000

Coal
mining

Oil and gas
extraction

Oil field
machinery

Refining

Petrochemicals

Sum
energy

354.10
346.89
343.28

221.25
227.02
222.82

247.97
272.62
267.90

108.43
122.86
121.52

184.79
191.13
188.06

148.44
145.27
140.19

ployment. Continued declines in the size of the
energy industry will further reduce the variance
of employment in the five key energy industries
across states from 1992 to 2000.

Analytical framework
To analyze how the composition of each
state’s economy affects its response to changing
oil prices, we use a computational model developed by Brown and Hill (1988). In this model,
differences in state concentrations of energyproducing and energy-consuming industries are
the principal factors accounting for the variation
across states of the employment response to
changing oil prices. The model also allows for
differences in multiplier effects across states while
remaining computationally tractable.
In this framework, employment in each
state is decomposed into two parts. One part
captures the abundance or scarcity of key energyproducing and energy-consuming industries
in the state relative to the nation. The other
part, which contains both key and non-key industries, has the same composition of employment
as the national economy.2 For the former part,
the effects of changing oil prices are modeled as
a combination of the direct effects on key industries and indirect multiplier effects. For the latter
part, the effect of changing oil prices is modeled
as identical to those occurring at the national
level. The total effect of changing oil prices on
state employment is the sum of the effects on the
two parts.
In the model, let E*ij denote the margin
by which employment in industry i is overrepresented (+) or underrepresented (–) in state
j. Estimates of the E*ij are developed by hypothetically withdrawing workers from, or adding
workers to, a set of key energy-producing and

ECONOMIC REVIEW SECOND QUARTER 1995

energy-consuming industries —and the nonkey workers they support through multiplier
effects—until the remaining industry composition of each state is identical to that of the nation.
Formally, E*ij is represented by the expression
(1)

(5)

E*ij = Eij – si •(Nj – N*j )

N* j =

∑m

Key industries. Although the procedure
allows the use of any number of key industries,
we follow Brown and Hill and limit the key
industries to five. These include oil and gas
extraction (Standard Industrial Classification
code 13), coal extraction (code 12), oil field
machinery (code 3533), petroleum refining
(code 2911), and petrochemicals (codes 282 and
286). Employment in the remaining, non-key
industries is assumed to respond uniformly to a
change in oil prices.
The list of key industries does not include a
number of industries that are directly affected by
changing oil prices. Some of those ignored—
such as pulp and paper; stone, clay, and glass;
food processing; primary metals; electric utilities;
and transportation—are important energy-using
industries. Nevertheless, the list of key industries
should be sufficiently complete to provide a good
estimate of the effects that changing oil prices
have on state employment. Empirically, the omitted industries are substantially less sensitive to oil
prices than the included industries. In addition,
many of the omitted industries are distributed
more evenly across the states than are the key
industries.
Employment data. We use the employment
and earnings series produced by the Bureau of
Labor Statistics, U.S. Department of Labor, as the
basic data source for 1982 and 1992. Where this
series lacks sufficient detail for the analysis, we
supplement it with the annual employment and
wages series produced by the Bureau of Labor
Statistics and data obtained from the Independent Petroleum Association of America.
Employment data for 2000 are based on a
DOE/DRI forecast.3 We chose the DOE/DRI
forecast because it provides sufficient detail for
our analysis, is generally consistent with the
consensus outlook for energy markets, and is
often taken as a standard reference for analysis.
The forecast shows U.S. employment increasing
by almost 15 percent from 1992 to 2000, while
employment in the key industries declines.
We follow the DOE forecast and allow for
differences in employment growth across the

where summation is over i, and mij is the multiplier effect from key industry i into the non-key
industries but not other key industries. The mij
accounts for the intermediate demands that
each key industry makes on the non-key industries and the indirect effects operating through
personal income.
With some manipulation, equations 1 and 2
can be combined to obtain a computable expression for the E*i j as follows:
(3)

E* ij = Eij − si •N j

Eij
Nj

1 − ∑ mij si

By construction, all the E*ij are zero if Eij /Nj = si
for all i in state j. Such a case would arise if
employment in the key industries represented the
same proportions in the state as the nation.
Otherwise, the E*i j will tend to be positive when
Eij /Nj > si and negative when Eij /Nj < si .
Once the nonrepresentative portions of
the state economy are defined, the remaining
state employment, T *j , is identical in composition to the national economy at some degree of
aggregation:
(4)

(

)

Data and parameter values

E* ij ,

1 − ∑ mij

(

∆T
∆Ei
+ ∑ E* ij 1 + mij
,
T
Ei

where summation is over i, ∆T/T represents the
percentage change in total national employment resulting from a change in oil prices, and
∆Ei /Ei the percentage change in national employment in key industry i resulting from a change
in oil prices.

for every key industry i. In equation 1, Eij represents actual employment in key industry i for
state j, Nj actual state employment in non-key
industries, si the ratio of national employment
in industry i to national employment in nonkey industries, and N*j the employment in
non-key industries in state j that can be attributed to multiplier effects associated with the
overrepresentation or underrepresentation of
the key industries, E*i j .
Formally, N*j can be expressed as
(2)

∆T j = T * j

)

T * j = N j − N* j + ∑ Eij − E* ij .

With each state’s economy divided into two
parts, the total response of each state’s employment to a change in oil prices, ∆Tj , can be
represented as a combination of the national
response, the responses of key industries, and
multiplier effects as follows:

Table 2

Projected Employment Growth by Census Region, 1992–2000
(Percent)

nine U.S. census regions (as shown in Table 2 ).
The DOE projects that three regions —Mountain,
South Atlantic, and West South Central—will
grow more rapidly than the nation between 1992
and 2000. For the same time period, the DOE also
projects, the Pacific region will grow at the same
rate as the nation, and five regions —West North
Central, East South Central, East North Central,
New England, and Mid-Atlantic, will grow more
slowly than the nation.

United States

14.64

New England

10.08

(Connecticut, Maine, Massachusetts,
New Hampshire, Rhode Island, Vermont)

Mid-Atlantic
East North Central
West North Central

14.33

(Iowa, Kansas, Minnesota, Missouri,
Nebraska, North Dakota, South Dakota)

Brown and Hill estimated the long-run oilprice elasticities of employment in each key
industry. They found elasticities of +1.01 for oil
and gas extraction, +1.23 for oil field machinery,
+0.45 for coal extraction, –0.56 for petroleum
refining, and –0.32 for petrochemicals. We use
these estimates to calculate the effects of changing oil prices on employment in the key industries
nationwide.
Employment multipliers. The multipliers used
in evaluating the employment effects are nonstandard. The multiplier for each key industry
expresses the effect of a unit change in employment in the key industry on state employment in
non-key industries while holding the output of
other key industries constant. These multipliers
allow us to treat the output from each of the key
industries as exogenous while avoiding a doublecounting of purchases that key industries make
from each other.
We adapted the work of Brown and Hill to
develop the requisite employment multipliers for
each of the five key industries in each state (and
the District of Columbia) for each of the three
analysis years.5 They used a special inversion of
a 1979 Texas input–output table to obtain special
private output multipliers as described in Appendix A. They converted these multipliers to special
private employment multipliers for Texas by
using the associated employment coefficients.
Following Brown and Hill, we develop total
special employment multipliers for each state and
the District of Columbia for each of the analysis
years by adjusting the special private employment
multipliers Brown and Hill developed for Texas.
To do so, we use information on 1982 state input–
output multipliers supplied by the Bureau of
Economic Analysis (BEA) (1986) and employment in state and local government as follows:6

South Atlantic

17.96

(Delaware, District of Columbia, Florida,
Georgia, Maryland, North Carolina,
South Carolina, Virginia, West Virginia)

East South Central

11.14

(Alabama, Kentucky, Mississippi, Tennessee)

West South Central

17.32

(Arkansas, Louisiana, Oklahoma, Texas)

Mountain

20.44

(Arizona, Colorado, Idaho, Montana, Nevada,
New Mexico, Utah, Wyoming)

Pacific
(Alaska, California, Hawaii, Oregon, Washington)
SOURCE: U.S. Department of Energy.

dustry i into the non-key industries but not other
key industries in state j, Mi is the special private
employment multiplier for Texas, rij is the BEA’s
private employment multiplier for industry i in
state j, ritx is the BEA’s private employment multiplier for industry i in Texas, and gj is the share of
total employment in state j accounted for by state
and local government in the analysis year.
National employment response. Brown and
Hill surveyed the major forecasting services to
obtain a consensus estimate of the response of
national employment to changing energy prices.
They concluded that a drop in the price of oil from
$26.50 to $21.50 per barrel would increase national employment by 0.4 percent. They implemented this relationship through a point elasticity
between oil prices and national employment
equal to –0.0193.
We adopt Brown and Hill’s estimate of the
oil price elasticity of national employment for
1982. Since that year, however, both energy
prices and the energy-to-GDP ratio have declined. The likely consequence is that the U.S.
economy has become somewhat less sensitive
to changes in energy prices. Although we are
unaware of any formal research that shows how

⎛
⎞ 1
⎛r ⎞
mij = ⎜(M i − 1) ⎜ ij ⎟ + 1⎟
− 1,
⎜
⎟ 1− g
⎝ ritx ⎠
j
⎝
⎠

where mij is the multiplier effect from key in-

FEDERAL RESERVE BANK OF DALLAS

10.98

(Illinois, Indiana, Michigan, Ohio, Wisconsin)

Response of key industries

(6)

10.08

(New Jersey, New York, Pennsylvania)

ECONOMIC REVIEW SECOND QUARTER 1995

14.64

the oil price sensitivity of the U.S. economy may
have varied over time, discussions with a number
of experts supports the view that U.S. economy
has become less sensitive to oil price changes.
In the absence of formal estimates, we use
a CES production function with parameter values
drawn from the economics literature and information about energy prices and the energy-toGDP ratio to calculate oil price elasticities of
national employment for 1992 and 2000. We
calibrated the function to reproduce the Brown –
Hill estimate for 1982. We then input new prices
and energy-to-GDP ratios to obtain estimates for
1992 and 2000. For 1992, we estimate the oil
price elasticity of national employment to equal
–0.0125. For 2000, the DOE/DRI forecast we have
adopted yields an estimated oil price elasticity of
national employment equal to –0.0120.7
Using the elasticities described above, we
estimate that a permanent 10-percent increase in
real oil prices would have resulted in a nation-

wide net employment loss of 165,000 jobs (0.18
percent) in 1982 and 129,000 jobs (0.12 percent) in 1992. In 2000, a permanent 10-percent
increase in real oil prices is projected to result
in a nationwide net employment loss of 142,000
jobs (0.11 percent).8

Oil prices shocks and state employment
We use the model and parameters described above to assess how diversification away
from the key energy industries has and will affect
each state’s response to a change in oil prices. To
do so, we simulate the employment consequences
of a hypothetical 10-percent increase in oil prices
in each of three years: 1982, 1992, and 2000.9 Our
simulations show that since 1982 the variance
across states in the response of economic activity
to oil price changes has declined. Our simulations further show that the narrowing is likely to
continue through the end of the decade but at a
slower rate.
State employment effects, 1982. In 1982, oil
prices were $48.40 per barrel (in 1992 dollars). In
that year, a 10-percent increase in the price of oil
would have amounted to $4.84 per barrel. Such
an increase would have led to employment losses
of 165,000 nationwide (0.18 percent). Nonetheless, thirteen states would have gained employment for a combined total of 166,000 jobs
(Table 3 ). The remaining thirty-seven states and
the District of Columbia would have lost a combined employment of 331,000 jobs.
The estimated effects of higher oil prices
vary considerably for 1982. The states most adversely affected by higher oil prices have high
concentrations of employment in refining or
petrochemicals (industries hurt by rising oil
prices) and low concentrations of employment
in coal, oil and gas extraction, and oil field
machinery (industries helped by rising oil
prices). The states helped by rising oil prices
have high concentrations of employment in oil
and gas extraction and oil field machinery. Many
of these states also have relatively high concentrations of refining and petrochemicals, which
partially offset the effects operating through the
oil and gas extraction sector.
Coal mining is less important in driving the
estimates because coal is not as sensitive to oil
price changes as oil and gas extraction or oil
field machinery and has smaller multipliers than
refining or petrochemicals. Nonetheless, the
extremely high concentrations of coal mining
lead to estimated employment gains in West
Virginia. Relatively high concentrations of coal
mining also contribute to estimated employment gains in Wyoming.

Table 3

Estimated Effects of a 10-Percent Increase in Oil Prices
On 1982 Nonagricultural Employment
(Percent)
United States
Delaware
South Carolina
New Jersey
Tennessee
North Carolina

–.18
– 2.51
–.85
–.73
–.67
–.61

South Dakota
Connecticut
Arizona
Ohio
Maine

–.38
–.38
–.38
–.37
–.36

Missouri
Virginia
New Hampshire
Hawaii
Massachusetts

–.53
–.50
–.49
–.47
–.45

Alabama
Maryland
Nevada
California
Nebraska

–.35
–.34
–.33
–.33
–.32

New York
Pennsylvania
Minnesota
Washington
Wisconsin

–.44
–.43
–.43
–.43
–.42

District of Columbia
Arkansas
Kentucky
Utah
Mississippi

–.31
–.23
–.07
.02
.03

Iowa
Indiana
Oregon
Rhode Island
Illinois

–.42
–.42
–.42
–.42
–.41

Kansas
North Dakota
West Virginia
Montana
Colorado

.16
.30
.31
.32
.44

Michigan
Florida
Idaho
Georgia
Vermont

–.40
–.39
–.39
–.39
–.39

Alaska
New Mexico
Louisiana
Texas
Oklahoma
Wyoming

.56
.83
1.35
1.37
2.91
3.03

Table 4

Estimated Effects of a 10-Percent Increase in Oil Prices
On 1992 Nonagricultural Employment

States between the extremes tend to have
more balanced concentrations of all industries.
Those states in which the five key industries have
smaller shares than the national average but
appear in the same proportions to each other as
they do in the nation are hurt more by rising oil
prices than the nation as a whole. Conversely,
those states in which the five key industries have
larger shares than the national average but appear
in the same proportions to each other as they do
in the nation are hurt less by rising oil prices than
the nation as a whole.
State employment effects, 1992. In 1992, oil
prices were $18.20 per barrel (in 1992 dollars). In
that year, a 10-percent increase in the price of oil
would have amounted to $1.82 per barrel. Such
an increase would have led to employment losses
of 129,000 nationwide (0.12 percent). Nine states
would have gained 68,000 jobs (Table 4 ).10 The
remaining forty-one states and the District of
Columbia would have lost a combined employment of 197,000 jobs.
By 1992, Montana, Utah, Mississippi, and
West Virginia would no longer have gained
employment from higher oil prices. Between
1982 and 1992, employment in coal mining, oil
and gas extraction, and oil field machinery
declined enough in these states such that the
prospective gains in these industries resulting
from higher oil prices could no longer offset the
losses in other sectors of the states’ economies.
A comparison of estimates for 1982 and
1992 indicates that states became increasingly
similar in the response to a change in oil prices.
At the extremes, 10-percent higher oil prices
would have reduced employment by 2.51 percent in Delaware and increased employment by
2.91 percent in Oklahoma and 3.03 percent in
Wyoming in 1982. In 1992, the same increase
would have yielded extremes of –1.86 percent in
Delaware, 0.95 percent in Oklahoma, and 1.40
percent in Wyoming. We find the employmentweighted variance of the response across states
to be 0.4598 in 1982 and 0.0749 in 1992.11
Alaska is one state that countered the pattern of convergence. Higher oil prices would
have meant a 0.56-percent increase in employment during 1982 and a 0.66-percent increase in
1992. With new finds in Alaska in the 1980s,
Alaskan oil production peaked in 1988, and the
oil industry continued to thrive in the 1980s
despite lower oil prices.
State employment effects, 2000. For 2000,
DOE projects oil prices will be $20.70 per barrel
(in 1992 dollars). In 2000, a 10-percent increase
in the price of oil would amount to $2.07 per
barrel. Such an increase would lead to employ-

FEDERAL RESERVE BANK OF DALLAS

(Percent)
United States
Delaware
South Carolina
Tennessee
New Jersey
North Carolina

–.12
–1.86
–.47
–.37
–.36
–.28

Florida
Oregon
Idaho
Nevada
Alabama

–.16
–.16
–.15
–.15
–.14

Virginia
Pennsylvania
Illinois
Ohio
Missouri

–.24
–.22
–.22
–.22
–.22

Wisconsin
Arizona
South Dakota
Maine
Maryland

–.14
–.14
–.14
–.13
–.12

Hawaii
Minnesota
Rhode Island
New Hampshire
Indiana

–.22
–.21
–.21
–.19
–.19

Kentucky
Nebraska
Mississippi
Montana
West Virginia

–.12
–.11
–.10
–.06
–.06

Massachusetts
Michigan
New York
Washington
Connecticut

–.19
–.19
–.18
–.18
–.17

Arkansas
Utah
Kansas
Colorado
North Dakota

–.05
–.05
.03
.09
.14

Vermont
Georgia
California
Iowa
District of Columbia

–.17
–.16
–.16
–.16
–.16

New Mexico
Louisiana
Texas
Alaska
Oklahoma
Wyoming

.44
.53
.53
.72
.95
1.40

ment losses of 142,000 nationwide (0.11 percent).
Eight states would gain 46,000 jobs (Table 5 ).12
The remaining forty-two states and the District of
Columbia would lose a combined employment
of 197,000 jobs.
The pattern of diminished oil price effects
and variance across states is repeated in 2000.
In 1992, 10-percent higher oil prices would have
reduced employment by 1.86 percent in Delaware and increased employment by 0.95 percent in Oklahoma and 1.40 percent in Wyoming.
By 2000, the same increase is projected to yield
extremes of –1.54 percent in Delaware, 0.58
percent in Oklahoma, and 0.94 percent in Wyoming. We find the employment-weighted variance of the response across states to be 0.0749
in 1992 and 0.0360 in 2000.13
Converging state employment effects, 1982 to
2000. Although the variance in the response to oil
prices across states is projected to diminish from
1992 and 2000, the rate of convergence is less
than that from 1982 to 1992. In 1982, oil prices
were near record highs and the domestic oil
and gas industry was at its peak. In the early
1980s, the energy-consuming states diversified
away from energy-intensive industries and

ECONOMIC REVIEW SECOND QUARTER 1995

Table 5

Estimated Effects of a 10-Percent Increase in Oil Prices
On 2000 Nonagricultural Employment

energy-producing industries in nearly every state’s
economy. The consequence was reduced sensitivity to oil price changes and less variation across
states in the response to changing oil prices.
Without further impetus from volatile oil prices,
industries sensitive to oil prices are likely to
become only slightly less prominent during the
remainder of the 1990s. Therefore, the rate at
which states are becoming similar in their response to oil price changes is likely to moderate.
Nonetheless, the variance of energysensitive industries across states is projected to
continue falling in the 1990s. This continuing
convergence is likely to further reduce the differences in states’ response to changing energy
prices. In doing so, it could also further lessen the
interregional divisiveness that has characterized
past debate on national energy policy.

(Percent)
United States
Delaware
South Carolina
New Jersey
Tennessee
North Carolina

–.11
–1.54
–.39
–.32
–.31
–.23

Florida
Nevada
Oregon
Idaho
Alabama

–.13
–.13
–.12
–.12
–.12

Virginia
Pennsylvania
Ohio
Illinois
Missouri

–.20
–.19
–.19
–.19
–.18

Wisconsin
Arizona
South Dakota
Maryland
Maine

–.12
–.11
–.11
–.10
–.10

Hawaii
Rhode Island
Minnesota
Michigan
Massachusetts

–.18
–.17
–.17
–.16
–.16

Mississippi
Kentucky
Nebraska
West Virginia
Montana

–.10
–.09
–.09
–.08
–.07

Indiana
New Hampshire
New York
Washington
Connecticut

–.16
–.16
–.16
–.16
–.15

Arkansas
Utah
Kansas
Colorado
North Dakota

–.06
–.06
–.00
.04
.08

California
Vermont
District of Columbia
Georgia
Iowa

–.14
–.14
–.14
–.13
–.13

New Mexico
Louisiana
Texas
Alaska
Oklahoma
Wyoming

.27
.28
.30
.49
.58
.94

Notes

learned to conserve. As consumption fell, oil
prices slipped and then crashed. Falling oil
prices encouraged the energy-producing states
to diversify away from energy industries. By
1992, the variance across states in response to
changing oil prices had narrowed substantially.
For the 1990s, DOE projects less dramatic
price changes than occurred in the 1980s. The
implied impetus for diversification away from
energy-related industries is thus weaker. It follows that the projected convergence will be less
in the 1990s than it was in the 1980s.

4
5

Summary and conclusions
Changes in energy prices have had sizable
but different effects on economic activity across
states. The industrial composition of a state’s
economy determines the employment response
to a change in energy prices. Our simulations
show that as the states diversify away from
energy-intensive and energy-producing industries, the variation across states in the response
of economic activity to oil price changes is
lessening.
During the 1980s, volatile oil prices helped
erode the prominence of energy-intensive and

The authors thank Kent Hill, Hill Huntington, David
Montgomery, Don Norman, Mark Rodekohr, Laura
Rubin, Lori Taylor, and Chuck Trozzo for helpful
comments and discussions but retain responsibility for
any remaining errors or shortcomings in the analysis.
For all but one of the industries, the decline in variance
is a size effect. Only the data for coal mining show a
decline in the coefficient of variation from 1982 to
1992. Of these measures, variance more closely
represents the range of influence across states.
The composition of the state’s economy is identical to
that of the nation at a degree of aggregation that is
inversely related to the number of key industries.
See Energy Information Administration (1994a and
1994b) and DRI/McGraw–Hill (1994).
See Energy Information Administration (1994b).
Multiplier effects arise because industries purchase
inputs from one another and consumers use their
income to purchase goods and services. States with
less diverse economies generally have lower multiplier
effects because subsequent purchases quickly leak
out to other states. Use of state-specific multipliers
accounts for the differences in leakages across states
but does not account for the corresponding injections
that the exporting states enjoy. The exporting states
are likely to be substantially larger than the nondiverse
states; therefore, a total accounting may not be crucial
to the analysis.
A 1986 input–output table is available for Texas. We
use a 1979 input–output table for Texas because it is
most consistent with the 1982 input–output multipliers
provided by the BEA.
Because this procedure to estimate elasticities is ad
hoc, we also consider cases in which the oil price
elasticity of U.S. employment remains constant at
–0.0193. We find that the assumed value of the
national elasticity affects the level of each state’s

response to oil prices but does not substantially alter
the variance across states. See Appendix B.
Under the assumption that the oil price elasticity of
U.S. employment is maintained at –0.0193 for 1992
and 2000, we estimate a 10-percent increase in real oil
prices would have resulted in a nationwide employment loss of 200,000 jobs in 1992 and would result in a
nationwide employment loss of 228,000 jobs in 2000.

Bureau of Economic Analysis, U.S. Department of Commerce (1986), Regional Multipliers: A User Handbook for
the Regional Input–Output Modeling System (Washington, D.C.: U.S. Government Printing Office), May.
Carlino, Gerald A., and Leonard O. Mills (1993), “Are U.S.
Regional Incomes Converging? A Time Series Approach,”

Journal of Monetary Economics 32 (November): 335 – 46.

Because the model operates on constant price
elasticities, a constant percentage increase in prices
maintains comparability across years.
Only eight states would benefit from higher oil prices if
we assume that the national economy remained as
sensitive to oil prices in 1992 as it was in 1982. See
Appendix B.
The variation across states is not simply a size effect.
The coefficients of variation for 1982 and 1992 are
–378.04 and –241.95, respectively.
Only seven states would benefit from higher oil prices
if we assume that the national economy remains as
sensitive to oil prices in 2000 as it was in 1982. See
Appendix B.
The coefficients of variation are –241.95 for 1992 and
–172.27 for 2000.

DRI/McGraw–Hill (1994), Review of the U.S. Economy,
Winter 1993 – 94.
Energy Information Agency, U.S. Department of Energy
(1994a), Annual Energy Outlook 1994 (Washington, D.C.:
U.S. Government Printing Office).
——— (1994b), Supplement to the Annual Energy
Outlook 1994 (Washington, D.C.: U.S. Government
Printing Office).
Sherwood-Call, Carolyn (1988), “Exploring the Relationships Between National and Regional Economic Fluctuations,” Federal Reserve Bank of San Francisco Economic
Review, Summer, 15 – 25.

References

Yücel, Mine K., and Shengyi Guo (1994), “Fuel Taxes and
Cointegration of Energy Prices,” Contemporary Economic
Policy 12 (July): 33 – 41.

Barro, Robert, and Xavier Sala-I-Martin (1991), “Convergence Across States and Regions,” Brookings Papers on
Economic Activity , Issue 1, 107– 82.
Brown, Stephen P. A., and John K. Hill (1988), “Lower Oil
Prices and State Employment,” Contemporary Policy
Issues 6 (July): 60 – 68.

FEDERAL RESERVE BANK OF DALLAS

ECONOMIC REVIEW SECOND QUARTER 1995

Appendix A

Developing Special Output Multipliers
The analysis presented in the body of the article requires
special output multipliers. Each special multiplier represents the
effect of a unit change in the output of a key energy industry on the
output in non-key industries while holding the output of other key
energy industries constant. These multipliers allow us to treat the
output from each of the key industries as exogenous while avoiding
the double-counting of purchases that key industries make from
each other.
Each industry i must produce enough output to satisfy both
final demand and meet the input requirements of all industries as
follows:
n

x i = d i + ∑ aij x j

(A.1)

i = 1, 2,…, n.

j =1

In the above equation, xi is the output of industry i, di is the final
demand for goods produced in industry i, aij indicates how much of
industry i ’s output is used to produce each unit of industry j ’s output,
and n is the number of industries.
If we treat the first g industries as the key energy industries
for which output is exogenous, the equations described in A.1 can
be divided into two groups by placing all endogenous variables on
the left-hand side and all exogenous variables on the right-hand side
of each equation as follows:
(A.2)

− di −

∑ aij x j

xi −

∑ aij x j

j = g +1

(A.3)

j = g +1

= x i + ∑ aij x j
j =1
g

= d i + ∑ aij x j
j =1

i = 1, 2,…, g, and
i = g + 1,…, n.

In matrix notation, equations A.2 and A.3 are rewritten as

[

]

(A.4)

−Dg − Ag ,n − g X n − g = − I g − Ag X g , and

(A.5)

n −g

]

− An − g X n − g = Dn − g + An − g ,g X g .

In the above equations, Dg and Dn – g are vectors of the final demands
for output from the key energy industries and non-key industries
respectively, Ag , n – g and An – g are arrays of input coefficients relating
the outputs of the non-key industries to the inputs required from the
key industries and the non-key industries, respectively, Xg and Xn – g
are vectors of the output from the key and non-key industries, respectively, Ig and In – g are identity matrices, and Ag and An – g , g are
arrays of input coefficients relating the output of key industries to the
inputs required from the key industries and the non-key industries,
respectively.

Combining A.4 and A.5 yields:

(A.6)

− Ag ,n − g ⎤
⎡−I g
⎢
⎥
0
I
⎢⎣ n − g ,g n − g − An − g ⎥⎦

⎡Dg ⎤ ⎡−I g + Ag 0g ,n − g ⎤
⎢
⎥=⎢
⎥
⎢⎣X n − g ⎥⎦ ⎢⎣ An − g ,g I n − g ⎥⎦

⎡ Xg ⎤
⎢
⎥.
⎢⎣Dn − g ⎥⎦

In the equation A.6, 0n – g , g and 0g , n – g are arrays of zeros.
Equation A.6 can be rewritten to express the endogenous
variables as a function of the exogenous variables and the input
coefficients as follows:

(A.7)

− Ag ,n − g ⎤
⎡ Dg ⎤ ⎡−I g
⎢
⎥=⎢
⎥
⎢⎣X n − g ⎥⎦ ⎢⎣0n − g ,g I n − g − An − g ⎥⎦

−1

⎡−I g + Ag 0g ,n − g ⎤
⎢
⎥
I n − g ⎥⎦
⎢⎣An − g ,g

⎡ Xg ⎤
⎢
⎥.
⎢⎣Dn − g ⎥⎦

An alternative approach is to recognize that equation A.5
shows the output vector of non-key industries, Xn – g , strictly as a
function of exogenous variables and parameters. Equation A.5 can
be rewritten to express the output of the non-key industries as a
function of the exogenous variables and the input coefficients as
follows:

[

X n − g = I n − g − An − g

(A.8)

] [D
−1

n −g

]

+ An − g ,g X g .

Combining equations A.8 and A.4 yields the following
expression for the final demand for output from the key energy
industries:

[

]

[

(A.9) Dg = I g − Ag X g − Ag ,n − g ⎡⎢ I n − g − An − g
⎣

] [D
−1

n −g

]

+ An − g ,g X g ⎤⎥ .
⎦

The special output multipliers associated with each key
energy industry (i =1, 2,..., g ) can be obtained from A.7 or A.8. Take
total derivatives of either expression with respect to xi and combine
as follows:
Mi = 1+

(A.10)

∑ ∂x j / ∂x i

j = g +1

i = 2,…, g.

Throughout the analysis, g determines the number of key
industries—those for which output is treated as exogenous. For all
values of g, output multipliers for each of the key energy industries
include purchases from non-key industries but exclude purchases
from other key industries. For g =1, the procedures outlined above
yield a standard output multiplier that includes purchases from all
other industries.

Appendix B

Estimated Effects of Oil Price Increases with a Constant National Response
Tables B1 and B2 present alternate estimates of the effects of a 10-percent increase in oil prices for 1992
and 2000. These estimates are made under the assumption that the national employment response remains at the
1982 value of 0.18 percent.

Table B1

Estimated Effects of a 10-Percent Increase in Oil Prices
On 1992 Nonagricultural Employment
(Percent)
United States
Delaware
South Carolina
Tennessee
New Jersey
North Carolina
Virginia
Pennsylvania
Illinois
Ohio
Missouri
Hawaii
Minnesota
Rhode Island
New Hampshire
Indiana
Massachusetts
Michigan

–.18
–1.89
–.53
–.43
–.43
–.35
–.30
–.29
–.29
–.29
–.28
–.28
–.28
–.27
–.26
–.26
–.26
–.25

New York
Washington
Connecticut
Vermont
Georgia
California
Iowa
Oregon
Florida
District of Columbia
Idaho
Nevada
Wisconsin
Alabama
Arizona
South Dakota
Maine

–.25
–.25
–.24
–.24
–.23
–.23
–.23
–.22
–.22
–.22
–.22
–.22
–.21
–.21
–.21
–.20
–.20

Maryland
Nebraska
Kentucky
Mississippi
Montana
Arkansas
Utah
West Virginia
Kansas
Colorado
North Dakota
New Mexico
Louisiana
Texas
Alaska
Oklahoma
Wyoming

–.19
–.18
–.18
–.17
–.12
–.12
–.12
–.11
–.04
.02
.07
.38
.47
.48
.66
.90
1.34

Maryland
Mississippi
Nebraska
Kentucky
Montana
West Virginia
Arkansas
Utah
Kansas
Colorado
North Dakota
New Mexico
Louisiana
Texas
Alaska
Oklahoma
Wyoming

–.18
–.17
–.17
–.16
–.14
–.14
–.13
–.13
–.07
–.03
.01
.20
.22
.24
.43
.52
.88

Table B2

Estimated Effects of a 10-Percent Increase in Oil Prices
On 2000 Nonagricultural Employment
(Percent)
United States
Delaware
South Carolina
New Jersey
Tennessee
North Carolina
Virginia
Pennsylvania
Ohio
Illinois
Missouri
Hawaii
Rhode Island
Minnesota
Michigan
Massachusetts
New Hampshire
Indiana

–.18
–1.57
–.45
–.39
–.38
–.30
–.26
–.26
–.26
–.26
–.25
–.25
–.24
–.24
–.23
–.23
–.23
–.23

Washington
New York
Connecticut
California
Vermont
District of Columbia
Georgia
Iowa
Florida
Nevada
Oregon
Idaho
Alabama
Wisconsin
Arizona
South Dakota
Maine

FEDERAL RESERVE BANK OF DALLAS

–.23
–.23
–.22
–.21
–.22
–.21
–.21
–.20
–.20
–.20
–.20
–.20
–.19
–.19
–.18
–.18
–.18

ECONOMIC REVIEW SECOND QUARTER 1995

Optimal Monetary
Policy in an
Economy with Sticky
Nominal Wages

More than thirty-five years ago, Milton
Friedman initiated an intense “rules versus
discretion” debate by calling for the Federal
Reserve to maintain constant growth of the
money supply (Friedman 1959). The focus of
this early debate was on whether an active
monetary policy or a passive monetary policy
is more successful at stabilizing output. Over
the years, the debate has continued, but its
terms have shifted.
First, large swings in the velocities of
the monetary aggregates have led many economists to turn away from Friedman’s constantmoney-growth prescription, toward policy rules
that are more directly concerned with output
and prices.
Second, in a very real sense the debate is no
longer over “rules versus discretion” but “which
rule?” It’s now taken for granted that the monetary
authority follows a rule of some kind—albeit a
rule that may not be clearly articulated and that
may shift in response to changes in the composition of the authority’s councils or changes in
policymakers’ understanding of how the economy
operates. The behaviors of private agents are
conditioned on how they expect the monetary
authority to react to future shocks to the economy
(Lucas 1976). Consequently, future policy choices
cannot be treated as exogenous.
Finally, there is increased recognition that in
monetary affairs—as in so many other areas of
life—expedient policies are rarely the best policies. Moreover, to obtain a socially optimal
outcome today may require that policymakers
find a way to convince the private sector that
shortsighted policies will not be pursued in the
future (Barro and Gordon 1983, Kydland and
Prescott 1977). In particular, the experience of
the 1970s has led to a consensus that the private sector must never be given grounds for
doubting the Federal Reserve’s commitment to
long-run price stability.
While there is a consensus that monetary
policy must be conducted within a framework in
which people are confident of a low long-run
inflation rate, there is little agreement on how the
Federal Reserve ought to allow prices to respond
to shocks over the near term. This article attempts
to shed light on the short-run stabilization issue
within the context of an economy subject to
productivity shocks, with sticky nominal wages.
The article shows that the optimal monetary
policy rule in such an economy has the Federal
Reserve target a geometric weighted average of
output and the price level. In a realistic special
case, the monetary authority should target nominal spending.

Evan F. Koenig
Research Officer
Federal Reserve Bank of Dallas

hile there is a consensus

that monetary policy must be
conducted within a framework
in which people are confident of
a low long-run inflation rate,
there is little agreement on how
the Federal Reserve ought to
allow prices to respond to shocks
over the near term. This article
shows that the optimal monetary policy rule has the Federal
Reserve target a geometric
weighted average of output
and the price level.

The analysis is subject to a number of
limitations. The model economy is not subject to
any disturbances other than aggregate productivity shocks. There is no attempt to explicitly
model the adverse effects of inflation. Nor does
the article model how the Federal Reserve would
actually go about implementing alternative
policy rules. In the real world, some rules may
have fewer informational requirements than
others or may imply less extreme movements
in policy instruments. Implementation errors
are likely to be smaller for such rules, enhancing
their performance.
This article has implications that extend
beyond the short-run stabilization issue. Thus,
this article illustrates that real-business-cycle
models may accurately describe the historical
behavior of an economy and yet be a poor
guide to policy. That a large fraction of the
business cycle can be attributed to supply
shocks may mean not that monetary policy is
ineffective but that the Federal Reserve has been
doing its job. More generally, neither monetary
policy nor private contracts should be analyzed
in isolation. Policies optimal under one system
of private contracts may perform poorly under
a different system. Conversely, the performance
of a given system of private contracts may be
sensitive to the policy rule adopted by the monetary authority.

competitive firm will hire labor up to the point
where the marginal product of labor equals the
real wage:
(1)

where N denotes hours of work. Suppose, in
particular, that output is produced according to
the function
(2)

Y = ΘN 1–β/(1 – β ),

where Y is output, 0 < β < 1 is a fixed parameter,
and Θ is a random productivity shock. Equation
1 is then equivalent to
(1′ )

θ – βn = w – p ,

where lowercase letters represent logarithms of
their uppercase counterparts. The demand for
labor is an increasing function of the productivity shock and a decreasing function of the real
wage. For any given level of hours, a doubling of
Θ doubles the marginal product of labor and,
so, doubles the real wage.
Utility maximization implies that the representative household will supply labor up to the
point where the marginal rate of substitution
between leisure and consumption equals the
real wage. Equivalently, each household will
supply labor up to the point where minus the
marginal rate of substitution between labor and
consumption equals the real wage:

A simple model of aggregate supply
This section analyzes output determination and optimal monetary policy in a competitive economy subject to aggregate productivity
shocks.1 Initially, all prices are assumed to be
perfectly flexible, so that markets clear instantaneously from period to period. In such an
economy, monetary policy is irrelevant to shortrun output determination. The monetary authority is, therefore, free to focus exclusively on
maintaining price stability. Next, the money wage
rate is assumed to be set one period in advance,
introducing the possibility that output may deviate from its market-clearing level in response to
unexpected shifts in the production function.
Since the money wage rate fails to react to supply
shocks in this economy, the burden of doing so
falls on the monetary authority. The optimal
policy rule has the monetary authority target a
geometric weighted average of output and the
price level. Insofar as the monetary authority is
successful in implementing the optimal rule, the
real economy will behave as if the money wage
rate is perfectly flexible.
Aggregate supply with flexible prices. Profit
maximization implies that the representative

FEDERAL RESERVE BANK OF DALLAS

MPN = W/P,

(3)

–MRSN,C = W/P.

If the representative household’s utility function
takes the form
U (C,N ) = (C 1– α – 1)/(1 – α ) – N 1+λ/(1 + λ),
where C is consumption and α > 0 and λ > 0
are fixed parameters, then equation 3 is equivalent to
(3′ )

λn + α c = w – p.

The supply of labor is increasing in the real
wage and decreasing in consumption.
To close the model, take logarithms of
equation 2:
(2′ )

y = (1 – β )n + θ – ln(1 – β ),

and assume that all output is consumed, so that y
can be substituted for c in equation 3′.
The market-clearing values of output, the
real wage, and labor are obtained by simul-

ECONOMIC REVIEW SECOND QUARTER 1995

taneously solving equations 1′, 2′, and 3′:

[

]

(4)

y * = A (1 + λ )θ − (β + λ ) ln(1 − β ) ,

(5)

(w − p )* = A (α + λ )θ − αβ ln(1 − β ) ,

[

Since there is no short-run trade-off between
output stability and price stability, the monetary
authority can concentrate its efforts on achieving
the latter.
Aggregate supply with a predetermined money
wage. Predetermined nominal wages are an
oft-studied source of monetary nonneutrality.2
Moreover, the existence of meaningful nominal
wage rigidities is consistent with several recent
empirical studies (Card 1990, Cho 1993, Cho
and Cooley 1992, McLaughlin 1994). Accordingly, the remainder of this article assumes that
the money wage rate is set, one period in advance, at its expected market-clearing level and
that firms have discretionary control over hours
of work at the preset wage.3 From equation 5,
the money wage will equal

]

and
(6)

[

]

n * = A (1 − α )θ + α ln(1 − β ) ,

where A ≡ [α + β (1 – α) + λ ] –1. Equations 4 and
5 say that a positive productivity shock (an increase in θ ) raises equilibrium output and the
equilibrium real wage. The impact on equilibrium hours of work is ambiguous. The higher
real wage that accompanies an increase in productivity tends to increase the supply of labor.
This substitution effect is opposed, however,
by a negative wealth effect: as output becomes
more readily available, people are less willing
to work at any given wage. In the real world,
hours of work per person have changed relatively little despite large productivity gains. This
observation suggests that α ≈ 1. If α = 1, the
substitution and wealth effects of an increase in
productivity cancel. Equilibrium output and the
equilibrium real wage rise one-for-one with θ,
while equilibrium hours are constant.
Regardless of the value of α , in a marketclearing economy the evolution of output is
independent of the evolution of the price level.

(7)

(8)

n = n* +

1
β

[( p − p ) + (α + λ)A(θ − θ )].
e

Substituting into the production function (equation 2′), one obtains a formula for output:

[(

)]

⎡1 − β ⎤
e
e
(9) y = y * + ⎢
⎥ p − p + α + λ A θ −θ .
⎢⎣ β ⎥⎦

Aggregate Supply in Sticky-Wage and
Flexible-Wage Economies

) (

)(

Output and employment deviate from their
market-clearing levels to the extent that the output price or productivity deviates from values
expected at the time the wage rate was set.
The intuition behind these results is straightforward. Consider, first, an unexpected increase
in the price of output. For any given productivity
realization, a surprise price increase lowers the
real wage. Firms move down along their labor
demand schedules, hiring more labor (and expanding production) as the real wage falls.4
Similarly, an increase in productivity causes
firms’ labor demand schedules to shift upward. In
a market-clearing economy, the positive impact
that this upward shift would otherwise have
had on equilibrium hours is partially offset by
an increase in the wage rate as households move
out along their labor supply schedules. When the
money wage is predetermined, this offset can
occur only insofar as the productivity increase
was expected. (Compare equation 5, which ap-

The aggregate supply curve is vertical when the
money wage is flexible and upward sloping when
the money wage is predetermined.
ASflexible wage

assticky wage

y*(θe)

]

where an e superscript indicates an expected
value conditioned on information available in the
immediately preceding period.
With the money wage set as above, the
representative firm’s profit maximization condition (equation 1′) implies that hours of work
are given by

Figure 1

[

w = p e + A (α + λ )θ e − αβ ln(1 − β ) ,

θ = θ ″ > θ e. The corresponding market-clearing
output levels are denoted y *(θ ′ ), y *(θ e), and
y *(θ ″ ), respectively. The monetary authority
would like the economy to end up at point A ≡
[y *(θ ′ ), p′ ] in the first case, point B ≡ [y *(θ e), p e ]
in the second case, and point C ≡ [y *(θ ″ ), p″]
in the third case. More generally, the monetary
authority would like to restrict the economy to
the line passing through points A, B, and C.
Everywhere along this line, y = y *.
From equation 4, as θ rises from θ e to θ ″,
the market-clearing output level rises by

Figure 2

The Response of Aggregate Supply
To Productivity Shocks
Holding the price level fixed at its expected value,
the sticky-wage aggregate supply curve shifts
farther in response to productivity shocks than
does the flexible-wage aggregate supply curve.
p

AS (θe)

AS (θ′)

AS (θ″)

as (θ′)

as (θe)

y * (θ ′′ ) − y * (θ e ) = (1 + λ )A (θ ′′ − θ e ).
From equation 9, the price level changes by

as (θ″)
pe

p ′′ − p e = − (α + λ )A (θ ′′ − θ e ).
Therefore, the line connecting points B and C
has a slope of – (α + λ)/(1 + λ), and the equation
of the line passing through points A, B, and C can
be written
y* (θe)

⎡α + λ ⎤
e
( p − pe ) = − ⎢
⎥ (y − y )
⎢⎣ 1 + λ ⎥⎦

plies to the market-clearing case, with equation
7.) Consequently, surprise increases in productivity have a larger positive impact on employment and output than do anticipated increases.
Graphically, the aggregate supply curve
in a flexible-wage economy is vertical at y *.
In contrast, the aggregate supply curve in an
economy with predetermined wages is upward sloping. Figure 1 depicts the case where
θ = θ e.
Although both aggregate supply curves shift
to the right in response to a positive unanticipated productivity shock, the sticky-wage aggregate supply schedule shifts more. Similarly, a
negative unanticipated productivity shock causes
a larger leftward shift in the sticky-wage aggregate
supply curve than in the flexible-wage aggregate
supply curve (Figure 2 ).
Optimal policy. Competitive allocations are
efficient. Consequently, policymakers will want
to keep the sticky-wage economy as close to the
market-clearing allocation as possible. However,
the market-clearing levels of output and hours are
not, in general, directly observable. Fortunately,
this problem can be circumvented.
Consider a graphical representation of the
monetary authority’s problem. Figure 3, like Figure 2, plots three aggregate supply curves, one
for the case in which θ = θ ′ < θ e, one for the case
in which θ = θ e, and one for the case in which

FEDERAL RESERVE BANK OF DALLAS

or, equivalently,

(10)

⎡α + λ ⎤ e
⎡α + λ ⎤
e
p+⎢
⎥y .
⎥y = p +⎢
⎢⎣ 1 + λ ⎥⎦
⎢⎣ 1 + λ ⎥⎦

Figure 3

Optimal Monetary Policy
In a sticky-wage economy, optimal monetary policy
calls for the price level to fall as output rises.
p

AS (θe)

AS (θ′)

AS (θ″)

as (θ′)

p′

as (θe)

as (θ″)
pe

p″

y* (θ′)

y* (θe)

y* (θ″)

ECONOMIC REVIEW SECOND QUARTER 1995

Thus, for the monetary authority to guarantee that
period-t output is optimal regardless of the value
of θt , it is necessary and sufficient that the
authority adjust its policy instruments so as to set

Note that the optimal policy rule does not require
that the monetary authority observe the realized
values of productivity disturbances.
Insofar as the monetary authority is successful in implementing a policy rule of the form
given in equation 11, it will appear that businesscycle fluctuations can be entirely attributed to
aggregate productivity shocks—and this will,
indeed, be the case.6 However, it would be incorrect to use this observation as a basis for
concluding that monetary policy is ineffective or
unimportant.
The analysis presented above also illustrates a more general point: monetary policy and
private contracting arrangements should be
analyzed as a package. Clearly, optimal monetary policy depends upon private contracting
arrangements. In the example above, the policy
rule given in equation 11 would not be optimal
(or even feasible) in an economy where it was
the price level rather than the wage rate that was
sticky.7 Perhaps less obviously, private agents
may rely upon the monetary authority to pursue
policies that make complicated contingent contracts unnecessary.

⎡α + λ ⎤
pt + ⎢
⎥ y t = st ,
⎢⎣ 1 + λ ⎥⎦

(11)

where st is an arbitrary preannounced target. In
the special case where the market-clearing level
of employment is invariant with respect to productivity shocks (α = 1), equation 11 reduces to
a nominal spending target:5
(11′)

pt + yt = st .

Imperfect Implementation of Optimal Policy
There is only a loose connection between variables that are directly affected
by Federal Reserve actions (bank reserves and the federal funds rate) and the
variables that enter the optimal policy rule: aggregate output and the aggregate price
level. Consequently, the Federal Reserve cannot be expected to maintain the
relationship displayed in equation 11 exactly. The unanticipated component of the
error that the Federal Reserve makes in trying to implement equation 11 plays the
role of an aggregate demand shock in the model economy.
To see this, let δ denote the current-period policy implementation error. That
is, suppose that equation 11 is replaced by

Alternative versions
of the optimal policy rule
We have seen that the optimal policy rule
in a sticky-wage economy has the general form
pt + ayt = st (compare equation 11). No restrictions are placed on the price–output target,
st , except for the requirement that it be announced one period in advance.8 This section
shows that a number of prominent proposed
policy rules also have this general form. Some
of these rules are nevertheless suboptimal,
because they put too little weight on output.
Other rules are optimal only under certain conditions.
Price-level and inflation targeting. Under a
price-level target, st is a constant (or, more
generally, a deterministic function of time), and
a is set equal to 0. Under an inflation target, a
is again set equal to 0, but st is defined to equal
pt –1 (or pt –1 plus a constant).
Although the price-level and inflation targeting rules have the same general form as the
optimal policy rule, they are not themselves
optimal because they put zero weight on shortrun output stabilization. In Figure 3, the pricelevel and inflation targeting rules would confine
the economy to a horizontal line through point B,
rather than the downward sloping line through
points A and C. Consequently, output fluctuates
too much in response to productivity shocks
under these rules.

⎡α + λ ⎤
p+⎢
⎥ y = s + δ,
⎣ 1+ λ ⎦
where, as before, s is a preannounced target. This equation can be solved for p and
substituted back into equations 8 and 9, yielding (after a little manipulation)

⎡
⎤
1
e
e
n − ne = ⎢
⎥ (1+ λ ) (δ − δ ) + (1− α ) (θ − θ )
+
−
+
1
α
β
(
α
)
λ
⎣
⎦

[

]

⎡
⎤
1+ λ
e
e
y − ye = ⎢
⎥ (1 − β ) (δ − δ ) + (θ − θ ) .
⎣ α + β(1 − α ) + λ ⎦

[

]

Hours respond positively to unanticipated policy implementation errors and ambiguously to productivity shocks.1 Output responds positively to both unanticipated
implementation errors and productivity surprises. Hence, the presence of implementation errors increases the chances that hours of work will vary procyclically. This
effect is most obvious in the case where α = 1 and is especially likely in the case
where unanticipated implementation errors (δ – δ e ) are positively correlated with
aggregate productivity shocks (θ – θ e ).
Substitute from the output equation back into the policy rule to obtain
⎡
⎤
1
e
e
p − pe = ⎢
⎥ β(1 + λ ) (δ − δ ) − (α + λ ) (θ − θ ) .
⎣ α + β(1− α ) + λ ⎦

[

]

Thus, the price level responds responds positively to unanticipated implementation
errors and negatively to aggregate productivity shocks. The real wage, of course,
moves exactly opposite to the price level.
1

As a technical matter, the anticipated component of the implementation error can always be folded into the
preannounced target, s. That is, one can — without loss of generality — assume δ e ≡ 0.

More formally, if strictly adhered to, the
price-level and inflation targeting rules imply that
there are no price surprises: pt = pte. But equation
9 tells us that in a sticky-wage economy, price
surprises must partially offset productivity surprises if the economy is to achieve the marketclearing allocation.
The Hall and Taylor output-gap rules. Robert
Hall (1984) and John Taylor (1985) have proposed that the Federal Reserve adopt a policy rule
of the form

definitions yield a nominal GDP level rule and a
nominal GDP growth rule, respectively.
Discussion. How is it that so many seemingly very different rules can all be optimal? What
matters for short-run stabilization purposes is
only the relationship between unexpected price
and output changes. Equation 11, which defines
the optimal policy rule, leaves entirely open how
this period’s expected price level should depend
upon past realizations of output and prices.
Differences between rules along this dimension
may have important implications for the distribution of wealth, particularly if debt contracts
are specified in nominal terms. Additionally,
some versions of the optimal rule may be easier
than others for the monetary authority to implement. Such considerations are outside the scope
of this article.

(pt – p Tt ) + a (yt – y Tt ) = 0,
where p Tt and y Tt are a target price level and target
output level, respectively, and where a > 0. Rearranging terms to obtain
(12)

pt + ayt = p Tt + ay Tt ,

Summary and concluding remarks
Output and employment tend to be too
responsive to aggregate productivity shocks in
sticky-wage economies. Monetary policy can
offset this tendency by allowing the price level to
fall when output is high and allowing the price
level to rise when output is low. Under optimal
monetary policy, the economy responds to productivity shocks exactly as it would in a flexiblewage economy. Thus, despite a preset money
wage, there are no $20 bills lying on the sidewalk:
there is no loss of economic efficiency.
The optimal policy is sufficiently general
in form to encompass several well-known
policy proposals, including those of Robert Hall
and John Taylor. In the realistic special case in
which the market-clearing level of employment is independent of productivity, it is optimal
for the monetary authority to target nominal
spending.
It is, of course, possible that private contracts would adapt if the monetary authority
insisted upon pursuing some policy other than
that optimal in a sticky-wage economy.9 The
process of adaptation would likely take some
time, however, and might never be complete. To
minimize transition costs, a monetary authority
choosing to implement some policy other than
that optimal under current contracting arrangements would need to announce its intentions
well in advance.
The particular modeling framework used
in this article is unrealistic in its simplicity, and
the details of the optimal policy rule derived here
are sensitive to changes in model specification. However, minor changes in the model are
unlikely to affect the article’s principal conclusions:

we see that the Hall and Taylor rules will have
the same form as the optimal rule derived here
provided that p Tt and y Tt are known one period
in advance. Full optimality also requires that a =
(α + λ)/(1 + λ).
In Hall’s analysis, the price target is a
constant. In Taylor’s analysis, p Tt = pt –1. In either
case, the price target is known as of period t – 1.
Both analyses assume that the output gap, (yt –
y Tt ), is stationary. Therefore, target output and
actual output must have a common permanent
component. If yt is stationary about a deterministic trend, it is natural to set target output equal
to trend output. The right-hand side of equation 12 will be known as of period t – 1. Consequently, the Hall and Taylor rules will have the
optimal form. If output’s permanent component
is a random walk with drift, the situation is a
little more complicated. It will not do to set y Tt
equal to current-period permanent income, because period-t permanent income is stochastic
from the perspective of period t – 1. However, it
would be consistent with optimality to set y Tt
equal to the previous period’s permanent income plus a constant equal to the drift in permanent income.
Nominal income level and nominal income
growth rules. The simplest versions of the optimal
policy rule set st equal to a deterministic function of time or equal to (pt –1 + ayt –1) plus a
constant. In particular, if output growth varies
about a well-defined long-run mean, E (∆y), then
setting st equal to aE (∆y)t + s0 or equal to aE (∆y)
+ (pt –1 + ayt –1) —where a = (α + λ)/(1 + λ) —will
yield a policy rule that is optimal and that yields
a zero long-run average rate of inflation. In the
special case where α = 1 (so that also a = 1), these

FEDERAL RESERVE BANK OF DALLAS

ECONOMIC REVIEW SECOND QUARTER 1995

1. In a sticky-wage economy, the Federal
Reserve has a short-run output stabilization role to play.
2. Several variants of a given rule may have
identical short-term stabilization properties. Consequently, in choosing between
variants, distributional considerations
and differences in ease of implementation will likely prove decisive.
3. The fraction of output variation that can
be attributed to aggregate productivity
shocks conveys little useful information
about the importance or effectiveness of
monetary policy.
4. The performance of a given system of
private contracts is sensitive to the policy
rule adopted by the monetary authority.
Conversely, policies optimal under one
system of private contracts may perform
poorly under a different system. Thus,
neither monetary policy nor private contracts should be analyzed in isolation.

run control of hours. In general, a nominal spending
target is optimal only if n * is independent of productivity shocks. Because Bean uses an ad hoc labor supply
function that lacks a wealth effect, the only way that he
can make n* independent of θ is by making the supply
of labor independent of the real wage. In the model
developed here, in contrast, n * is independent of θ
6

Notes

Finn Kydland and Mark Wynne offered helpful comments for this article.
The analysis extends Bean (1983) to the case where
labor supply is derived explicitly from utility maximization—an extension that has important implications for
the circumstances under which targeting nominal
spending is optimal.
See, for example, Fischer (1977), Gray (1978), and
Taylor (1980).
Perhaps relocation costs are negligible if workers
switch jobs one period in advance and prohibitive
otherwise. Then the labor market will be competitive ex
ante and monopsonistic ex post. Workers will insist
that some of the terms of their employment be spelled
out in advance. Presetting the nominal wage, while
giving firms control of hours, is an approach that is
often observed in practice (Card 1990). The assumption that the wage is set equal to its expected marketclearing level is standard in the literature. In the model
developed here, this assumption implies no loss of
efficiency.
If monetary-policy-induced price surprises were the
primary driving force behind macroeconomic fluctuations, it would follow that the real wage ought to be
countercyclical. Since the real wage is not, in fact,
countercyclical, economists with strong priors that
monetary policy drives the macroeconomy have in
recent years tended to favor models of price stickiness
over models of wage stickiness. See, for example, Ball
and Mankiw (1994).
In contrast, Bean (1983) finds that a nominal spending
target is optimal only if labor is inelastically supplied —
a problematic assumption when firms are given short-

whenever α = 1 (compare equation 6).
The box entitled “Imperfect Implementation of Optimal
Policy” discusses the behavior of the economy when
the optimal policy is implemented with error.
For discussion of optimal policy in an economy with
sticky output prices, see Ireland (1994).
More precisely, the target must be announced early
enough that all labor contracts will be renegotiated
before the target becomes binding. The real-world
counterpart to “one period” is, thus, probably one to
three years.
This point is not new. According to Fischer (1977,
204), “An attempt by the monetary authority to exploit
the existing structure of contracts to produce behavior
far different from that envisaged when contracts were
signed would likely lead to the reopening of the contracts and, if the new behavior of the monetary authority
were persisted in, a new structure of contracts.”

References
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on Public Policy 41 (December): 127–51.
Barro, Robert J., and David Gordon (1983), “A Positive
Theory of Monetary Policy in a Natural Rate Model,”
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Bean, Charles R. (1983), “Targeting Nominal Income: An
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Card, David (1990), “Unexpected Inflation, Real Wages,
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———, and Thomas F. Cooley (1992), “The Business
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McLaughlin, Kenneth J. (1994), “Rigid Wages?” Journal
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Ireland, Peter N. (1994), “Monetary Policy with Nominal
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——— (1985), “What Would Nominal GDP Targeting Do
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