View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FEDERAL RESERVE BANK
OF ST. LOUIS
DECEMBER 1976

jg B B S i

sssss
Wmm
fgs- :. t

CONTENTS
Economic Pause — Some Perspective
and Interpretation .....................

Eh
LITTLE R O C K




Vol. 5 8 , No. 12

U.S. International Trade and
Financial Developments in 1976 .........
REVIEW Index ....................................

n

Economic Pause —
Some Perspective and Interpretation
N EIL A. STEVEN S and JAM ES E. TU RLEY

T H E economy began a recovery in the second
quarter of 1975 and made significant advances in its
first year. In the last two quarters, however, the pace
of economic activity has been less robust. The econ­
omy’s performance in this most recent period has
triggered a great deal of concern over the sustain­
ability of the recovery. These fears have probably
been intensified by a number of considerations, in­
clu din g the fac t that the unem ploym ent rate has

risen recently — a development not generally ob­
served at this point in a recovery. In addition, con­
cern over the economy was no doubt heightened by
the political campaigns conducted in this election
year where the release of any economic news, whether
good or bad, sparked considerable public discussion.
Analysts have offered a whole host of explanations
for the current economic lull. Some seem more credi­
ble than others, but when recent developments are
placed in perspective, a less pessimistic economic
picture is painted.

MEASURING THE DIMENSIONS
OF THE SLOWDOWN
The term “pause” has been employed by analysts
to describe the current state of economic activity.
Although popular, use of the term is a bit misleading
since it implies some degree of stagnation or inactivity.
While developments of the last two quarters have
not been favorably regarded by some analysts, the

Page 2


economy has not been inactive or stagnant. Its up­
ward momentum, however, has moderated since the
spring of 1976 and it is this period of slower growth
to which the term “pause” refers.
Measures of aggregate output are often cited as
evidence of this slowing. For example, real GNP ex­
panded by more than 7 percent during the first year
of the recovery from the 1973-75 recession. In the
past two quarters this measure of aggregate output
has slowed to about a 4 percent rate of growth. In­
dustrial production, another measure of the nation’s
output, posted a substantial gain of about 15 percent
during the first 12 months of the recovery which be­
gan in early 1975. Since March, however, this meas­
ure of real output has slowed to about a 5 percent
pace.
The unemployment rate, after peaking at 8.9 per­
cent in May 1975, responded to the forces of recov­
ery and began a descent which carried it to 7.3 per­
cent in June 1976. Since then, however, this rate has
tended to rise and stood at 8.1 percent in November.
Personal income, which registered an 11.1 percent
advance in the first year of the recovery, has since
exhibited a more modest 8.6 percent rate of growth.
Along with this slowdown in income, consumption
expenditures have also displayed some signs of slug­
gishness. For instance, from first quarter 1975 to first
quarter 1976, personal consumption expenditures rose
by almost 12 percent, somewhat more robust than

FEDERAL RESERVE BANK OF ST. LOUIS

the nearly 9 percent growth rate registered since the
first quarter of this year. Growth of consumption ex­
penditures adjusted for price changes fell from about
6 to 4 percent over the same time periods.
Retail sales have likewise mirrored the pattern of
overall activity. During the first 12 months of the most
recent recovery, retail sales grew by more than 16
percent. Since March of this year, retail sales have
slowed to about a 6.4 percent rate of advance.

DECEMBER 1976

A less stimulative fiscal policy however, is evident
from recent trends in actual Government expendi­
tures. Over the past three quarters of this year, Fed­
eral expenditures have increased at a 5.4 percent
rate, compared to a 12.8 percent rate in calendar
1975. To the extent that Government spending has
an impact on economic activity independent of mone­
tary actions, this measure of fiscal policy does imply
a slowing in the pace of economic activity. But the
extent of the implied slowing is less than that asso­
ciated with the so-called “shortfall” argument above.

EXPLANATIONS FOR THE PAUSE

Monetary and Fiscal Policies
Both monetary and fiscal policies have been offered
by various analysts as factors contributing to the
pause.1 Some monetary analysts have pointed to the
relatively slow monetary growth in late 1975 and
early 1976 as a causal factor. Money ( Mi ) grew at
only a 2.5 percent rate in this period, after a rapid
7.4 percent rate in the previous two quarters. Studies
have been conducted which show that marked and
sustained fluctuations in money growth have impor­
tant effects on variations in output growth, and it
cannot be ruled out that some restrictive influence on
the economy resulted from this period of slower
money growth.
Another popular explanation for the current lull in
economic activity is associated with fiscal policy —
in particular, Federal Government spending. In the
first three quarters of the year, the Government spent
less than the amount budgeted. Estimates of the
amount of this “shortfall” range from $4 billion to
$17 billion. Proponents of this “underspending” view­
point argue that the deviation of actual expenditures
from planned or budgeted expenditures has acted to
restrain activity and, in fact, is one of the key factors
affecting the current economic slowdown.2 This type
of argument, however, is somewhat suspect. The con­
census has usually been that economic activity is in­
fluenced by the “spent” government dollar. Now it
appears as if economic activity is sensitive to the “un­
spent” government dollar as well.3
1“A Longer Pause Than Expected,” Business Week, 18 Octo­
ber 1976, p. 36. Also, “ Sagging 76 — Slowdown Surprises
Most Analysts; Some Expect It To Persist,” Wall Street Jour­
nal, 6 October 1976.
2See The Federal Budget: Its Impact on the Economy, The
Conference Board, October 27, 1976.
3To the extent that economic forecasts are based on planned
expenditures, the shortfall in expenditures can serve as an ex­
planation of why forecasts of economic activity differ from
actual performance. But this is quite a different argument
from the one advanced above.




Business Confidence
Lack of business confidence is also said to have
played some part in the current hesitation in eco­
nomic growth, although this explanation is difficult
to demonstrate.4 Uncertainty about future economic
policies always exists, but it is especially great in
election years. Expectations of future government
actions, such as tax policies regarding business, can
greatly influence investment decisions made in the cur­
rent period. One such consideration is the investment
tax credit. Since current discussion suggests the possi­
bility of increasing the amount of the credit, business­
men may be taking a wait-and-see attitude with regard
to capital expansion programs, thus contributing to
the more modest rate of economic expansion.

Inventories
The behavior of business inventories over the cur­
rent recovery offers another explanation for the re­
cent pause.5 Movements in inventories in the current
recession/recovery period have been very large by
historical standards. Real inventory swings were quite
severe in early 1975 with a $21 billion annual rate of
decumulation in the second quarter. From the fourth
quarter of last year to the first quarter of this year,
inventories exhibited a large swing, from a run-off at
a $5.5 billion annual rate to a $10.4 billion annual
rate of accumulation. This sharp rebuilding of inven­
tories boosted GNP growth in the first quarter to an
unsustainable 9.2 percent rate. In the subsequent two
quarters, inventories were accumulated at about the
same rate as in the first quarter, thus providing no
further impetus to GNP growth rates.6
^Statement by Arthur F. Bums, Chairman, Board of Governors
of the Federal Reserve System, before the U.S. Senate, Com­
mittee on Banking, Housing and Urban Affairs, November 11,
1976.
5Burton G. Malkiel, Council of Economic Advisers, “ U.S. E co­
nomic Outlook” ( Speech delivered before the 1977 U.S. Out­
look Conference, November 15-18, 1976).
6The arithmetic of how inventories affect the level of GNP in
a given period and the change in GNP between periods is
Page 3

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1976

Table I

The Pattern o f E cono m ic G ro w th in Recoveries
REAL G N P

11/1954

REAL FIN A L SALES

M O N E Y SUPPLY

Com pounded A nn u al
Rates of C hange
Recession
Trough

C H A N G E IN REAL
IN V EN T O R Y IN V ESTM EN T
Billions
of Dollars

Compounded Annual
Rates of Change

Com pounded A nnual
Rates of Change

First
Year of
Expansion

Second
Year of
Expansion

First
Year of
Expansion

7 .5 %

2 .6 %

+ $12.1

First
Year of
Expansion

-$

2.5

Second
Year of
Expansion

First
Year of
Expansion

5 .4 %

Second
Year of
Expansion

3 .0 %

3 .8 %

Second
Year of
Expansion
1 .2 %

11/1958

8.7

1.7

+ $19 .2

-$

8.1

5.8

2.9

4.5

— 0.7

1/1961

7.0

3.2

+ $14 .4

-$

3.0

5.0

3.7

3.0

1.7

+ $ 0.4

+ $ 7.1

4.6

6.7

6.7

8.4

5.2

4.1

4.5

2.7

4.6

4 .2 *

5.0

6 .4 *

IV / 1 97 0

4.6

7.3

A verage

7.0

3.7

1/1975

7.3

4.1 *

+ $3 0 .9

-$

0 .2 *

*Measured from 1/1976 to III/1976.

INVENTORIES AND THE
PATTERN OF RECOVERY
All of the factors mentioned in the explanations
above may have had some influence on the current
period of slowing. Upon further investigation, how­
ever, the inventory pattern appears to have been the
most influential factor.
In the first place, a moderation in the pace of eco­
nomic activity is not an unusual development at this
stage of the business cycle, as three out of the last four
recoveries have displayed such a slowing. In general,
the pattern of real GNP growth is one of acceleration
in the early stages of recovery, followed by a period of
deceleration and more moderate growth.
This pattern is depicted in Table I where the
growth in real GNP during the first year of each of
the last five expansions is contrasted with that in the
second year of expansion. Except for the recovery
which commenced in the fourth quarter of 1970,
economic growth in the second year has been notice­
ably less rapid than in the .first. On average, real GNP
in the last four recoveries has increased at a 7.0 per­
cent rate in the first year, followed by a 3.7 percent
rate in the second year; this is very similar to the
respective 7.3 and 4.1 percent rates of advance re­
sometimes confusing. This confusion stems from the fact that
the change in the stock of inventories in a period adds to the
level of GNP in that period. Perhaps more confusing is that
the difference of the change in inventory levels from one pe­
riod to another affects the change in GNP from one period to
another. Thus a change in inventories levels of $10 billion in
each of two quarters implies no change in GNP between the
two quarters, given everything else equal.


Page 4


corded in the recovery to date. The tendency for
recoveries to exhibit some slowing at this stage sug­
gests the possibility of a common set of factors which
influence the pattern of economic recovery.
The acceleration of real output growth in the early
stages of recoveries is influenced to a great extent by
the pattern of inventory investment. As shown in
Table I, changes in real inventory investment in the
first year of most recoveries have provided a sub­
stantial boost to GNP growth in that year; by the
second year, inventory stimulus to aggregate demand
growth has generally disappeared. Table I suggests,
however, that the influence of inventories on recent
real GNP growth has been even greater than in other
recoveries. The $31 billion swing in inventory invest­
ment in the first year of the current recovery is by far
the largest of the postwar period. The magnitude of
this swing largely reflects the sharp inventory decum­
ulation which occurred in 1974. The stage was set for
this decumulation in 1972 and 1973 when shortages,
price controls, and accelerating inflation resulted in
a speculative buildup of inventories. Therefore, at
least a portion of current movements in inventory in­
vestment is a response to these excesses and is inde­
pendent of more fundamental determinants, such as
the stance of aggregate demand policies.
Additional evidence of the impact of inventories
in the current period can be gleaned from an exam­
ination of real final sales, which is real GNP minus
changes in real inventories. In the recoveries which
began in 1954, 1958, and 1961, growth of real final
sales decelerated in the second year of economic ex­
pansion, as did real GNP. This indicates that the eco­

FEDERAL RESERVE BANK OF ST. LOUIS

nomic slowing extended beyond inventories and that
more fundamental factors were impacting on the econ­
omy. Probably the most important factor operating
during these periods was monetary growth. Table I
shows that the slowing in real final sales in the second
year of these expansions was accompanied by a les­
sening of the stimulus provided by monetary ex­
pansion. Only a very slight slowing in real final sales,
however, is detectable in the current recovery. This
suggests that aggregate demand policies have not
played a dominant role in the current period of
slower economic growth.

DECEMBER 1976

The Pattern of E co n o m i c G r o w t h
in R ecent R e c o v e r i e s
( T w o - Q u a r t e r A n n u a l R a t e s of C h a n g e )
S e a s o n a lly A d ju s te d
Percent

To sum up, the inventory pattern seems to have
masked the underlying growth pattern of the recov­
ery, as revealed by a fairly stable growth of final sales.
In retrospect, the strength of real GNP growth ex­
perienced in the first year of recovery was based
largely on the strong inventory rebuilding. The “pause”
in the past two quarters, on the other hand, largely
reflects the lack of further stimulus to GNP growth
from inventory investment rather than lack of stimu­
lus provided by stabilization policies.

This recent upward movement in the unemploy­
ment rate is especially curious on two counts — it is
contrary to historical patterns and it occurred despite
relatively strong employment gains. The unemploy­
ment rate historically has registered its largest de­
clines during the first year of recovery. In the second
year this measure of labor market conditions has
tended to stabilize or fall somewhat further. In ad­
dition, total employment has risen rapidly in the
past two quarters when compared to the average
growth in the second year of several other recoveries
(see Table II). This suggests that the demand for
labor has not been the primary factor affecting the rise
in the unemployment rate.

10

Real Final S a le s

UNEMPLOYMENT RATE PATTERN —
A DISTINCT FEATURE OF
THE CURRENT RECOVERY
The high and recently rising unemployment rate
is a feature of the current recovery which has been
most disconcerting. The unemployment rate fell from
a high of 8.7 percent in the second quarter of 1975
to 7.6 percent in the first quarter of 1976. With the
period of slower real GNP growth this year, the un­
employment rate has reversed its downward course,
averaging 7.8 percent in the third quarter.

Pe r c en t

Real GNP

1 0 ,----------

Q U A R TERS TO A N D FR O M TRO U G H S
L atest d a t a p lo t te d :3 rd q u a r t e r

referring to Table II, the labor force has expanded at
an unusually rapid rate in this recovery, especially in
the past two quarters. In the first year of recovery,
the labor force increased 1.9 percent — significantly
greater than the 0.9 percent average rate observed in
the first year of other recoveries. In the last two quarTable

II

L a b o r M a r k e t D e v e lo p m e n ts in Recoveries
C IV IL IA N E M P L O Y M E N T
GROW TH

C IV IL IA N LABO R FORCE
GROW TH

Com pounded A nnual
Rales of Change

Com pounded Annual
Rates of Change
First
Year of
Expansion

Second
Year of
Expansion

First
Year of
Expansion

Second
Year of
Expansion

11/1954

2 .8 %

3 .4 %

1 .3 %

3 .2 %

11/1958

3.2

2.0

0.8

2.1

Recession
Trough




1.0

1.2

— 0.3

1.3

1.7

3.2

1.7

2.7

Average

2.2

2.5

0.9

2.3

1/1975

The recent rise in the unemployment rate appears
to reflect atypical labor supply developments. Again,

1/1961
IV / 1 9 7 0

2.5

3.5 *

1.9

3.9*

^Measured from 1/1976 to III/1976.

Page 5

FEDERAL RESERVE BANK OF ST. LOUIS

ters, labor force growth accelerated to a 3.9 percent
rate — noticeably higher than the 2.3 percent average
in the second year of previous recoveries. This unu­
sual growth of the labor force reflects both demo­
graphic factors which have worked to increase the
number of teenagers of working age and the increased
participation of those of working age, particularly
among teenagers and women.
The impact on the unemployment rate from the
increased supply of labor is magnified by the compo­
sition of this supply. Women and teenagers who are
entering the labor force in greater numbers tend to
have had a higher degree of unemployment among
their ranks. Chronic unemployment for these groups
is, in part, the result of a number of structural barriers
including minimum wage laws, discrimination, and
the lack of suitable work skills. As a result, demandoriented policies, unless accompanied by appropriate
structural reforms, are not likely to reduce unemploy­
ment to levels attained in other expansions without
accelerating inflation.

OUTLOOK
Although some degree of moderation has set in, the
expansion has not run its course. Some recent indi­
cators of economic activity suggest that GNP growth
in the fourth quarter of 1976 may be somewhat less
than the growth recorded in the third quarter. But
fundamental forces affecting demand and supply sug­
gest that such growth should be interpreted as chiefly
a random fluctuation and not indicative of the likely
future direction of economic activity.

Demand Forces
Monetary developments are a particularly important
determinant of fluctuations in economic activity, as
was discussed above. Table I showed that the three
recoveries which slowed in the second year were ac­
companied by slower monetary growth. In the recov­
ery beginning in early 1971, economic growth accel­
erated in the second year, apparently reflecting the
acceleration in money growth.
The current stance of monetary policy appears to
be moderately expansive. In the past nine months,
Ml has increased at a 6 percent annual rate, above
the 4.9 percent growth observed in the first year of
economic expansion. While this growth of money, if
sustained over the long-term, is too rapid to make
progress in reducing inflation, such growth increases

Page 6


DECEMBER

1976

the likelihood of some acceleration in the pace of
economic advances in 1977 from currently prevailing
rates.

Supply Conditions
While growth of aggregate demand is likely to ac­
celerate in 1977, a fundamental consideration is the
ability of the economy to translate these demands
into real goods and services. Measures of the utiliza­
tion of manufacturing capacity give some indication
of this capability.
A recent major revision of the Federal Reserve
Boards’ capacity utilization rate in manufacturing
has reduced substantially the amount of excess ca­
pacity which was previously thought to exist. Accord­
ing to the revised figures, manufacturing capacity
utilization is estimated to be at about 81 percent in
the third quarter, not significantly different from the
utilization rate achieved after six quarters in the pre­
vious three recoveries.
The comparability of utilization rates in both the
current and previous expansion periods is noteworthy,
since at the depths of the 1973-75 recession, manu­
facturing capacity utilization was less than in any
previous postwar recession. The recent 10 percentage
point gain in this utilization rate, however, was the
result of a slower-than-average increase in manufac­
turing capacity, rather than a greater-than-average
increase in output. This slower growth in capacity is
quite disconcerting since it has an effect on the ability
of the economy to quickly absorb all of the unem­
ployed labor resources at prevailing prices and wages
and to sustain the increases in real income achieved
over the past 30 years.
Utilization rates in recent peacetime expansions
have peaked at rates which have ranged from the
middle to the upper 80’s. Thus the excess capacity
implied from the current operating rate of 81 per­
cent should allow the economy in 1977 to generate
increases in output at rates greater than the long-run
trend rate. But the extent of this excess capacity may
be less than is implied by a comparison of the cur­
rently reported operating rate with previous peak
rates. In particular, analysts have noted that events
of the last few years, such as the quadrupling of oil
prices, have reduced the economy’s potential output.
Given the uncertainty of whether or not such events
have been fully captured by the recently revised ca­
pacity data, the economy may be closer to an effec­

FEDERAL RESERVE BANK OF ST. LOUIS

tive capacity constraint than is indicated by reported
data.7

CONCLUSION
Fluctuations in inventory investment have been an
important influence on the recovery pattern to date.
Upon reflection the “pause” seems to be little more
than the economy’s reaction to the lack of further
inventory stimulus in the past two quarters, not a
7For further articulation of this view, see Denis S. Karnosky,
“ The Link Between Money and Prices — 1971-76,” this R e­
view (June 1976), pp. 17-23. Whether the recent capacity
revision reflects this type of analysis is unclear. The revision
does not directly incorporate any adjustment factor for the
effects of the oil price change on economic capacity, but it
may indirectly reflect such events through the incorporation
of a recent McGraw-Hill survey of capacity utilization rates.




DECEMBER 1976

reflection of insufficient stimulus to aggregate de­
mand. Existing demand and supply conditions now
seem set for further economic expansion next year.
The relatively high unemployment rate continues
bothersome. This high rate, however, largely reflects
labor supply factors and is not necessarily indicative
of weak aggregate demand. Part of the unemploy­
ment is of a chronic nature which can only be solved
by structural reforms in the labor markets. As such,
adopting demand policies designed to reduce the un­
employment rate to levels achieved in other recov­
eries is likely to be frustrated by accelerating infla­
tion. Instead, policies designed to promote a favorable
environment for much needed capital investment
seem in order.

Page 7

U.S. International Trade and
Financial Developments in 1976
DONALD S. KEMP

HE purpose of this article is to review U.S. inter­
national trade and financial developments for the
year 1976. However, because much of the data re­
lating to these developments are not available beyond
the second quarter of 1976, the review is limited in
this respect. Since this same limitation was encoun­
tered in the Review article which examined inter­
national transactions for the year 1975, the events of
the last half of 1975 will be briefly recounted here.1
Of particular importance is the pattern of interna­
tional transactions, their impact on the U.S. economy,
and consideration of the movement of exchange rates
between the U.S. dollar and other major currencies.
In this regard attention will be devoted to the Italian
lira, the British pound, and the Mexican peso.

Merchandise imports increased during each quar­
ter from III/75 to 11/76. During both the first and
second quarter of 1976 the major part of the increase
occurred in the industrial supplies and materials com­
ponent. While petroleum imports increased in both
quarters, the second quarter increase in these im­
ports was particularly large, accounting for nearly
all of the increase in merchandise imports in that
period.

U.S. INTERNATIONAL
TRANSACTIONS IN 1976

The flow of direct investment between the United
States and the rest of the world changed significantly
between 11/75 and 11/76. Over this four quarter
period, U.S. direct investment abroad increased in
two quarters ($924 million in IV /75 and $63 million
in 1/76) and decreased in two quarters ($1.6 billion
in III/75 and $2.2 billion in 11/76) relative to the
levels recorded in the respective preceding quarter.
Direct investment in the United States also decreased
during two quarters ($828 million in III/75 and $2
billion in 1/76) and increased in two quarters (about
$1.3 billion during IV /75 and 11/76) relative to
their respective levels in the preceding quarter. In
fact, during 111/75 and 1/76 foreign direct invest­
ment in the United States was actually negative. The
$728 million disinvestment recorded in 1/76 was a
record decrease for the post-war period. However,
during 11/76 the flow of direct investment into the
United States increased to record a net inflow of $547
million. At the same time, U.S. direct investment
abroad decreased relative to its first quarter rate, to
register a net decline of $463 million. This was the
first quarter since at least the early 1960’s during
which there was a net U.S. direct disinvestment
abroad. Thus, during the first half of 1976 there was
a significant shift in direct international investment
from a net U.S. outflow in the first quarter to a net
U.S. inflow in the second quarter.

What Happened?
Reference to the figures presented in Table I indi­
cates that merchandise exports increased during the
third and fourth quarters of 1975 by $711 million and
$1.1 billion, respectively.2 However, during the first
quarter of 1976 merchandise exports declined by $821
million. This decline was evenly divided between
agricultural and non-agricultural goods. A decrease
in capital goods exports, led by a decrease in the
export of civilian aircraft, accounted for most of the
decline in non-agricultural exports. However, mer­
chandise exports registered a significant turnaround
during the second quarter of 1976, increasing by $1.6
billion. While both agricultural and non-agricultural
exports increased during this quarter, the latter cate­
gory accounted for about two-thirds of the total in­
crease. This was primarily the result of a large
increase in capital goods exports, led again by civilian
aircraft.
iSee Hans H. Helbling, “ Foreign Trade and Exchange Rate
Movements in 1975,” this Review (January 1976), pp. 9-14.
-’For a description of the various categories of international
transactions discussed in this article, see any issue of U.S.
International Transactions and Currency Review, published
quarterly by this Bank.


Page 8


Preliminary data indicate that both merchandise
exports and imports increased during the third quar­
ter of 1976, with the latter increasing substantially
more than exports. Indications are that these increases
were broadly based across virtually all categories of
imports and exports.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1976

Table I

U.S. IN T E R N A T IO N A L T R A N S A C T I O N S 1
S e a s o n a lly A d ju ste d
(M illio n s of Dollars)
1975

1 97 6

1

II

III

IV
—

1
"

II
—

III

Merchandise Exports

27,018

25,851

26,562

2 7 ,6 5 7

26,8 3 6

28 ,450

29.678P

Agricultural G oods

6,0 53

4,8 8 6

5,563

5,740

5,321

Foods, Feed and Beverages

5.876P

5,268

4,109

4,836

4,984

4,5 4 3

4,9 8 9 P

20,965

20,9 6 5

2 0 ,999

21,9 1 7

21,515

22.574P

8,096

7,589

7,488

7,624

7,655

8,003P

245

25 7

24 7

255

24 9

243P

Capital G oods, except Automotive

8,580

8,880

8,9 8 7

9,3 9 4

9,1 1 6

9.583P

Automotive Vehicles, Parts, and Engines

2,249

2,682

2,803

2,897

2,828

3,046P
1.969P

Nonagricultural G oods
Industrial Supplies and Materials
Petroleum and Products

Consumer G oods (n o n foo d ).
except Automotive

1,562

1,527

1,651

1,802

1,91 8

Merchandise Imports

2 5 ,570

22,568

24,483

2 5 ,4 3 7

2 8 ,510

29,735

Agricultural G oods

2,306

2,276

2,491

2,445

2,625

2,736P

2,306
23,264

2,312

2,585

2,475

2,671

2,827P

20,292

21,992

22,992

25,8 8 5

26.999 P

13,796

12,232

12,710

12,636

14,116

15,924P

6,552

6,338

7,183

6,945

7,399

8,539P

Capital G oods, except Automotive

2,442

2,358

2,543

Automotive Vehicles, Parts, and Engines

2,594

2,343
2,684

3,233

3,3 3 7

2,587
3,982

2,637P
4,074P

Foods, Feed and Beverages
Nonagricultural G oods
Industrial Supplies and Materials
Petroleum and Products

Consumer G oods (n o n foo d ),
except Automotive

3,409

3,204

3,386

3,736

4,2 1 0

4,427P

Service Exports

9,925

9,9 1 9

10,488

10,945

1 1,748

1 1,78 IP

Service Imports

8,765

8,118

8,302

8,808

9,0 1 6

8,922P

Unilateral Transfers A broad (net)

1,976

2,348

1,100

1,428

1,168

9 67 P

Direct Investment A broad

1,510

2,334

770

1,694

1,757

32 ,553 P

-4 6 3 P

Direct Investment in U.S.

476

780

-4 8

1,229

-7 2 8

1,928

979

9 38

2,361

2,525

1,448

2.808P

34 4

38 5

73 8

1,038

1,030

160

78P

Deposits A broa d (dem and, time)

-4 3 3

-2 8 9

450

44 5

45 2

72 0

Deposits in U.S.2 (dem and, time)

40

-387

1,423

-1 ,3 5 7

1,715

-711

M onetary Base Effect

42

-12

141

12

580

Portfolio Investment A broad
Portfolio Investment in U.S.

547P

560

—381 P

P — P r e lim in a r y

1The signs in this table do not indicate whether a p articular transaction is an inflow or outflow, as is the case in standard balance-of-paym ents
tables. In this table a negative sign indicates that there was a reduction in the stock o f a particular class o f assets during a particular time
period. F or an explanation o f some o f the term s used see any issue o f U.S. International Transactions and C urrency R eview , published by this
Bank.
2Deposits in U.S. only available fo r deposits payable in dollars.
Sources: Board o f Governors o f the Federal Reserve System, U.S. D epartm ent o f Commerce, U.S. T reasury Departm ent

U.S. portfolio investment abroad followed the same
general pattern as U.S. direct investment, rising
during IV /75 and 1/76 and declining during 111/75
and 11/76. However, unlike U.S. direct investment
abroad, there was still a net increase in portfolio
investment abroad of about $1.4 billion in the second
quarter. On the other hand, foreign portfolio invest­
ment in the United States slowed during the first
three quarters of 1976 after increasing during the
last two quarters of 1975. However, as was the case
with portfolio investment abroad, there was a net
increase in portfolio investment in the United States
during all three quarters of 1976.



United States ownership of bank deposits abroad
increased during each quarter after the second quar­
ter of 1975. However, while foreign owned bank de­
posits in the United States increased significantly
during 111/75 and 1/76, there was a decline in these
deposits during IV /75 and 11/76.

What Does It All Mean?
In spite of many attempts to do so in the past, it
is almost impossible to glean an overall picture of the
impact of international transactions on the U.S. econ­
omy from the data discussed in the preceding section.
Page 9

FEDERAL RESERVE BANK OF ST. LOUIS

The data are partial in coverage and are, therefore,
a very incomplete guide to an assessment of the over­
all impact of international transactions on economic
activity. However, the data can be very useful in an
assessment of international investment trends and a
more specific breakdown of the merchandise trade
accounts could be useful for specific industry studies.
In order to assess the overall impact of international
transactions on the U.S. economy, it is necessary to
compute the net impact of these transactions on the
U.S. money stock. Under a system of “managed” ex­
change rates, the primary channel by which inter­
national trade and capital transactions can have an
impact on aggregate economic activity is via inter­
national reserve flows and their subsequent impact
on the money supply.3 However, one is unable to
gauge the magnitude of this impact by looking at
either the trade or the capital account separately.
For example, the effects on aggregate economic
activity of a deficit in the merchandise trade account
alone could be partially or fully neutralized by a
surplus in one of the capital accounts. If such a
situation arose, the negative aggregate demand (for
domestic output) effects resulting from an increase
in imports of goods would be partially or fully offset
by an inflow of capital and a resulting increase in
investment demand. If the two effects fully offset
each other, there would be no gain or loss of inter­
national reserves and the money supply would not
be affected by the international trade and capital
transactions.
Of all international transactions, the only ones that
affect the money stock are those that affect some
component of the monetary base. Official U.S. hold­
ings of gold and foreign currency balances (primary
reserve assets) and foreign deposits at Federal Re­
serve Banks are the only components of the mone­
tary base that are affected by international transac­
tions. Thus, the entire impact of these transactions
on the money stock can be captured by observing
changes in these items.4
The computations described above have been per­
formed and the results are presented in Table I
3A system of “managed” exchange rates is one in which ex­
change rates are managed through limited official market
intervention rather than rigidly pegged or left alone to float
completely free in response to nongovernmental market in­
fluences. This type of arrangement is descriptive of the ap­
proach taken by the United States since March, 1973.
4For a more thorough exposition of this view, see Donald S.
Kemp, “ A Monetary View of the Balance of Payments,” this
Review (April 1975), p. 16 and “ Balance-of-Payments Con­
cepts— What D o They Really Mean?” this Review (July
1975), p. 16.


Page 10


DECEMBER 1976

under the heading “Monetary Base Effect”. These
figures indicate that the net impact of international
transactions during each quarter from 111/75 to 11/76
was to exert upward pressure on the monetary base
and, therefore, on the money stock. During the third
quarter of 1976 these transactions exerted downward
pressure on the monetary base on the order of $381
million. However, when these figures are compared
with the overall changes in the monetary base over
these periods, their significance is brought into better
perspective. In the four quarters from 111/75 to 11/76,
the monetary base effect amounted to 6.6, 0.6, 34.6,
and 21.4 percent, respectively, of the total increase
in the monetary base. In the third quarter of 1976, the
negative impact on the base amounted to 19.4 percent
of the total change.

EXCHANGE RATE MOVEMENTS IN 1976
The year 1976 has been a watershed in the annals
of international monetary reforms. The events of 1976
represent a de facto as well as a de jure defeat for
the advocates of artificially pegged exchange rates.
For those who have long recognized the futility and
folly of such policies, the events of 1976 were evi­
dence of an ideological triumph.
The de facto defeat of the advocates of fixed ex­
change rates is represented by the precipitous decline
in the international value of the Italian lira, the British
pound, and the Mexican peso. These events are a grim
testimony to the unacceptability of fixed exchange
rates between countries which pursue differing do­
mestic economic policies. This unacceptability was
further demonstrated during 1976 by the recurrence
of exchange market crises that plagued efforts to hold
together the European Currency Snake. The de jure
defeat of the fixed rate advocates came in the form
of a proposed amendment to Article IV of the Articles
of Agreement of the International Monetary Fund
( IMF) . The proposed amendment to Article IV not
only legalizes floating exchange rates, but also requires
that IMF members avoid manipulating exchange
rates.5
The depreciation of the pound, the peso, and the
lira can be explained in terms of relative rates of
5By allowing exchange rates to float, most IM F members have
been acting in violation of Article IV for some time. In its
current form, Article IV prohibits the current international
monetary arrangement of managed floating. However, the
amended Article IV, which allows floating, is more represent­
ative of the sentiments of most IMF members and will prob­
ably, therefore, be ratified in the near future.

FEDERAL RESERVE BANK OF ST. LOUIS

inflation.6 In other words, movements in exchange
rate can be thought of as a means of adjusting price
levels for the effects of differing actual or expected
rates of inflation between two countries. As one
country inflates faster than another, the value of that
country’s currency falls (depreciates) relative to the
value of the low inflation country’s currency. Under
a system of freely floating or loosely managed ex­
change rates, necessary adjustments to differing rates
of inflation are permitted to occur gradually. How.ever, when exchange rates are narrowly fixed ( as
was the case with the Mexican peso prior to Septem­
ber 1976) or tightly managed (as has been the case
with the Italian lira and the British pound since
March 1973) exchange market pressures are not re­
lieved in a slow and orderly fashion. However, once
market participants sense the presence of pent-up
market forces which favor realignment, exchange mar­
ket pressures surge and result in “currency crises”
and sudden large jolts in exchange rates. Thus, while
the relationship between exchange rates and relative
rates of inflation may not be strong in the short run,
the longer the time frame, the stronger this relation­
ship becomes.

The Lira
The exchange rate between the Italian lira and the
U.S. dollar provides a good example of the affects of
differing rates of inflation among trading partners.
Chart I attempts to illustrate this point graphically.
Using March 1973 as a base, an index of the level
of wholesale prices is plotted for the United States
(labeled U.S. W PI) and for Italy (labeled Italy
W P I). The divergence of these two lines over time
indicates that inflation has been greater in Italy (105
percent) than in the United States (44 percent) since
March 1973. If the lira/dollar exchange rate were to
change enough to compensate for these differing rates
of inflation, the result would be a depreciation of the
lira vis-a-vis the U.S. dollar by an amount equal to
the spread between the two wholesale price lines
(about 61 percentage points).7
To see if this has been true, the following computa­
tions were performed. First an index of the exchange
6For a more complete specification of the relative inflation rate
explanation of exchange rate changes, see Donald S. Kemp,
“ The U.S. Dollar in International Markets: Mid-1970 to Mia1976,” this Review (August 1976), p. 12.
7Such a depreciation of the lira would mean that the purchas­
ing power of the lira was the same in both the United States
and Italy. If the lira did not depreciate in the face of the
higher Italian inflation, then the purchasing power of the lira
would be higher in the United States than it would be in Italy.




DECEMBER 1976

C h a ri I

Price L e v e ls a n d th e A d ju s t m e n t
fo r D iff e r in g R a te s o f In fla tio n
(U nited St a t e s and It aly)

rate (expressed as lira per dollar) was constructed
using March 1973 as a base. The U.S. wholesale price
index was then multiplied by the exchange rate index
in each month through November 1976. The resulting
product series was then plotted on Chart I (labeled
U.S. WPI X lira per $). If exchange rates changed to
compensate for differing rates of inflation, then this
line (henceforth referred to as the product line)
should trace along the Italy W PI line. On the other
hand, if the exchange rate did not change at all, the
product line would trace along the U.S. WPI line.
Chart I indicates that over the long run the product
line has traced the path of the Italy WPI line. As men­
tioned previously, this relationship should not be ex­
pected to hold up in the short run. Inflationary pres­
sures become established only in the long run and the
full impact of differing inflation rates can be resisted
by governments in the short run. However, with iso­
lated incidents acting as catalysts to precipitate shortrun surges in exchange rates, inflation rate differen­
tials will exert themselves in the long run.8
In the case of Italy, the product line traces the rise
in the Italy W PI line fairly closely, with the most
8Many of the specific events mentioned as affecting exchange
rate movements during the period of interest are discussed
at length in a series of reports titled, “Treasury and Federal
Reserve Foreign Exchange Operations.” These reports are pub­
lished in the March, June, September, and December issues
of the Federal Reserve Bulletin.
Page 11

FEDERAL RESERVE BANK OF ST. LOUIS

notable exception occurring between November 1974
and June 1975. This temporary divergence is prima­
rily attributed to a rise in the dollar value of the lira
during this period in light of encouraging economic
news. In particular, during this period there were
three significant developments in Italy: a slowing of
the rate of inflation (as evidenced by the flattening
out of the Italy WPI line), a decline in the balance-oftrade deficit, and an increase in capital inflows.
However, the situation changed during the last half
of 1975 and into 1976. Renewed downward pressure
on the lira mounted throughout this period as a result
of increased uncertainty about Italy’s political and eco­
nomic outlook. There were signs that inflation was
intensifying, merchandise imports began to rise, and
the country was unable to induce any capital inflows.
On top of this, the coalition government appeared
increasingly fragile and was forced to resign on Janu­
ary 7, 1976. In the face of all of these events, the lira
was supported in foreign exchange markets via mas­
sive official intervention by the Bank of Italy. How­
ever, the Italian government was unable to sustain
its intervention measures beyond January 21 and on
that date the lira was set free to float on the open
market.
Uncertainty over Italy’s economic and political out­
look was continually nourished through April by an
outpouring of bleak economic and political news.
This situation is reflected in Chart I by the steep rise
in the product line which began after mid-1975.
However, in early May 1976 the Italian government
imposed sweeping exchange restrictions — including
a 50 percent deposit scheme on nearly all purchases
of foreign currency. The lira appreciated somewhat
relative to the dollar as a result of these moves and
the product line moved back into alignment with the
Italy WPI line. By the beginning of September the
effects of the import deposit scheme had begun to
dissipate and, in the absence of any further policy
initiative by the government, the lira began to move
again in a direction consistent with its relatively high
rate of inflation; that is, it depreciated against the
dollar. As a result, the product line in Chart I began
to rise again along a path similar to that traced by
the Italy WPI line.

The Pound
The same three series that were plotted for Italy in
Chart I are plotted for the United Kingdom in Chart
II. The product line (labeled U.S. W PI X •£ per $)
follows the same general pattern as the product line

Page 12


DECEMBER

1976

C h art II

Price L e v e ls a n d the A d ju s t m e n t
fo r D iff e r in g R a t e s o f In fla tio n
(United
March 1 9 7 3 = 1 0 0

St a t e s and

United K in g d o m )
M arch 197 3 = 1 0 0

for Italy prior to 1976. That is, it traces the rise in
the United Kingdom wholesale price line fairly
closely, with the major deviation occurring between
November 1974 and March 1975. This divergence re­
flects a relatively stable pound-dollar exchange rate
in the face of a slowdown in the rate of inflation in
the United States and unabated inflation in the
United Kingdom. The steadiness of the pound vis-avis the dollar during this period is primarily attribu­
table to the poor performance of the U.S. economy,
the anticipation of an accelerated decline in U.S.
interest rates, and an improvement in Britain’s trade
account in early 1975.
However, the pound began to depreciate vis-a-vis
the dollar during April 1975. This was the result of
new evidence of continued high rates of inflation in
the face of continually rising unemployment in the
United Kingdom. Moreover, concern mounted that a
continuing trend of lower British interest rates would
generate large capital outflows. The result of this re­
newed depreciation was a closing of the gap between
the product line and the U. K. W PI line.
The pound stabilized in late 1975 and showed little
change in early 1976. The voluntary wage restraint
program was having its desired effect and hence was
helping to curb the reported rate of inflation. During
this period an apparent shift in priorities within the
government began to emerge. That is, the government
began to talk more about bolstering productivity and

FEDERAL RESERVE BANK OF ST. LOUIS

less about broad social welfare programs. In addition,
during this period large interest rate differentials stim­
ulated significant inflows of capital. The resulting sta­
bility of the pound during this period can be seen in
Chart II as a flattening of the product line and its
subsequent divergence from the U. K. WPI line.

DECEMBER 1976

C h a r t III

Price L e v e ls a n d the A d ju s tm e n t
fo r D iffe r in g R a te s o f In fla tio n
( U n i t e d S t a t e s a nd M e x i c o )
1954=100

However, developments in late February 1976 pre­
cipitated new doubts about the future of the pound.
Economic indicators showed little evidence of a re­
covery and indicated a likelihood of continuing infla­
tion and still rising unemployment. In addition, in­
terest rates began to decline and thus the differential
favoring investments in the United Kingdom began to
erode. Given the already uncertain economic and po­
litical environment, these factors resulted in renewed
depreciation of the pound in early March 1976. As a
result, the product line in Chart II surged upward to
reach a point considerably above the U. K. W PI line
by June.
The economic news coming out of the United King­
dom began to improve in early July. There were
indications that both exports and real output were
increasing at a faster than anticipated rate and that
wholesale price increases were slowing. In addition,
there were reports that the government was formulat­
ing plans for substantial public expenditure cuts. These
factors combined to stabilize the pound-dollar ex­
change rate during July and August and thus the
product line flattened out during that period.
However, a number of factors came to light in late
August which precipitated a return of the pound to
its downward trend. The release of figures showing
increased unemployment during July led to fears that
the government’s commitment to reduce public spend­
ing might be abandoned. In addition, a sharp increase
in the U. K. money supply in July was announced. In
the face of these developments, the United Kingdom
was beginning to feel the effects of the severe summer
drought, and the possibility of further employment
and production cutbacks increased as a result. The
resulting depreciation of the pound caused the prod­
uct line to move upward again to a level significantly
above the U. K. WPI line.

The Peso
The data series presented in Chart III are similar
to those presented in Charts I and II. One difference,
however, is that the indices presented in Chart III are
on a 1954 base rather than a March 1973 base. An­
other difference between Chart III and Charts I and
II is that it has two different horizontal scales. The



P e r $) w e re ide n tical. This reflects the fa ct that o v e r this time p e rio d the e x c h a n g e
rate b etw e e n the d o lla r a n d the p e s o w a s rig id ly fixed . H o w e v e r, in S e p te m b e r 1 976
the se lin e s d iv e rg e d , re fle cting the fact that the e x c h a n g e rate b etw e e n the d o lla r
a n d the p e s o w a s a llo w e d to c han ge .
L ate st d a t a p lotted: M e x ic o W P I-S e p te m b e r; O t h e rs- N o v e m b e r

left hand portion of the chart is made up of annual
observations (1954 -1975) while the right hand por­
tion plots monthly observations (January 1976-N o ­
vember 1976). The absence of a product line in the
left side (annual data side) of Chart III reflects the
fact that the peso/dollar exchange rate was not al­
lowed to change between 1954 and August 31, 1976.
The performance of the Mexican peso in the past
few months is a grim testimony to the effects of at­
tempts by a government to peg the external value of
its currency in the face of an inflation rate which dif­
fers significantly from that of a major trading partner.
The peso/dollar exchange rate was rigidly pegged at
12.5 pesos/dollar between 1954 and September 1976.
However, as indicated by Chart III, the overall
amount of inflation experienced by Mexico between
1954 and 1975 far exceeded that experienced by the
United States during this period.
Between 1964 and 1969 the gap between the two
WPI lines in Chart III stabilized, indicating that the
inflation rate was about the same in the United States
as in Mexico during this period. However, since 1973
Mexico’s rate of inflation has greatly exceeded that
experienced in the United States. As a result, import
growth began to far outstrip export growth during
the early 1970’s and Mexican debt to foreigners began
to rise alarmingly. It has been estimated that interest
Page 13

FEDERAL. RESERVE BANK OF ST. LOUIS

costs on this debt amount to at least $1.8 billion per
year, while total Mexican merchandise export earnings
in 1975 were only $2.9 billion (versus an import bill
totaling $6.6 billion). Thus, the ability of Mexico to
service any increased foreign debt came into question
and their access to international financial markets was
restricted accordingly.
The distressing economic outlook described above,
coupled with the political uncertainties surrounding
the impending change of governments on December 1,
precipitated ever increasing downward pressure on
the peso. As a result, on September 1, 1976 the Mexi­
can government decided that it had no choice but to
allow the peso to float freely on the open market.
The immediate response of the peso was a precipi­
tous decline from 12.5 pesos/dollar to about 20 pesos/
dollar. This decline is indicated by the sharp rise
in the product line (labeled U.S. WPI X peso per $)
in the right hand section of Chart III. The Bank of
Mexico began to intervene in the peso market to peg
it at 19.7 pesos/dollar on September 13, 1976. How­
ever, continued uncertainty over the political and eco­
nomic outlook in Mexico resulted in an intensification
of capital outflows and downward pressure on the
peso. As these pressures mounted, the intervention
activities of the Bank of Mexico led to a significant
loss of official reserves.
With Mexico’s application for a medium-term IMF
loan still under negotiation, the authorities decided
to allow the peso to float freely again on October 27.
The immediate response was a further depreciation
of the peso to about 26 pesos/dollar. This second de­
cline in the value of the peso is indicated by a further
rise in the product line in Chart III to a level con­
siderably above the Mexico W PI line.
Throughout November the Bank of Mexico inter­
vened frequently in an attempt to stabilize the peso/$
exchange rate. However, a series of events, ranging
from government expropriation of private land to
rumors of a military coup, fueled political uncertainty
during this period. Because of reserve losses, and the
prospect for even greater losses in the near future,
the Bank of Mexico decided to cease all intervention


Page 14


DECEMBER 1976

activities as of November 22. At the same time, tem­
porary regulations which strictly limited commercial
bank dealings in foreign exchange were enacted. In
the weeks immediately following these actions, the
peso reversed its downward trend and rose in value
relative to the dollar. However, considerable political
and economic uncertainty remains and the market
continues to speculate about the course of the Mex­
ican economy under the administration which came
into office on December l.9

CONCLUSION
This article has sought to review U.S. international
trade and financial developments over the last year
or so. In taking such an overview, there is one com­
mon theme that continually surfaces. That theme re­
lates to the desirability of fixed versus floating ex­
change rates in the world today.
It is shown in the article that efforts to artificially
support a particular exchange rate were doomed to
failure. The shocks that resulted from the inevitable
large changes in exchange rates were greater than
those that would have resulted if exchange rates
would have been allowed to change gradually as
market pressure developed. On the other hand, the
United States policy of maintaining a relatively free
market for the dollar insulated this nation from the
kind of shocks experienced by Italy, the United King­
dom, and Mexico.1 While there was considerable vari­
0
ation in U.S. trade and capital flows during the last
year or so, the United States was spared the kind of
exchange market crises that were continually plaguing
these other countries and that plagued the United
States itself from the late 1960’s until March 1973.
1At the close of trading on December 15 the peso was being
1
quoted at 20 peso/dollar. Thus, it had risen back up to the
level it attained after the first float in September. Although
Chart III does not cover the events of December, this recent
appreciation would imply a decline of the product line back to
about the 340 level.
10In this regard, of a total of $16 billion worth of foreign ex­
change market intervention conducted by governments around
the world between August and October 1976, the Federal
Reserve was responsible for only $63.4 million. Statement by
Scott E. Pardee, New York Times, 2 December 1976, p. 80.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1976

REVIEW INDEX - 1976
Issue

Jan.

Title

1975— Year of Economic Turnaround
Foreign Trade and Exchange Rate Movements
in 1975
Food Production and Prices — Perspective and
Outlook

Issue

Title

July

Bank Financing of the Recovery
An Explanation of Movements in Short-Term
Interest Rates

Aug.

Income and Expenses of Eighth District Mem­
ber Banks: 1975
The U.S. Dollar in International Markets:
Mid-1970 to Mid-1976
Housing: A Cyclical Industry on the Upswing

Feb.

Operations of the Federal Reserve Bank of St.
Louis — 1975
Outlook for Agriculture

Mar.

Recent Changes in Reserve Requirements: An
Example of Contradictory Regulation
The FOMC in 1975: Announcing Monetary
Targets

Sept.

The Unemployment Rate as an Economic
Indicator
Development of Electronic Funds Transfer
Systems

Apr.

The 1976 Economic Report and the Federal
Budget: Toward a Long-Run Perspective
A Mortgage Futures Market: Its Development,
Uses, Benefits, and Costs

Oct.

Large Federal Budget Deficits: Perspectives and
Prospects
Economic Activity in Ten Major Industrial
Countries: Late 1973 through Mid-1976

May

Food and Population: A Long View
Preferred Habitat vs. Efficient Market: A Test
of Alternative Hypotheses

Nov.

Derivation of the Monetary Base
The Welfare Cost of Inflation

Dec.

J e
un

Inflation and the Economic Recovery
Automobile Sales in Perspective
The Link Between Money and Prices — 1971-76

Economic Pause — Some Perspective and
Interpretation
U.S. International Trade and Financial Devel­
opments in 1976




Page 15