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Review
Vol. 69, No. 10
December 1987
,
5 Risk Aversion Efficient Markets and
the Forward Exchange Rate
14 Federal Fiscal Policy Since the
Employment Act of 1946
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Federal Reserve Bank of St. Louis
Review
Decem ber 1987
In This Issue . . .
The foreign exchange value of the dollar occupies an increasingly prominent
place in the press, policy discussions and economic analyses. In these forums,
debate has centered on whether floating exchange rates reflect the currencies'
fundamental values or inefficient speculation. The efficiency of the foreign ex
change market has been a contentious issue among economists throughout the
modem floating rate era which began in 1973. The main debate centers on
whether exchange rates contain a risk premium that reflects a currency holder’s
apprehension about the currency he purchases relative to the currency he sells. If
there is no risk premium, the variation in exchange rates must reflect inefficiency
in the market for foreign exchange.
In the first article of this Review, Kees G. Koedijk and Mack Ott review the role of
the risk premium in foreign exchange markets and its relation to interest rate
differentials between the economies involved. They then compare the results of
two empirical examinations of the risk-premium-efficiency alternative which
yield conflicting conclusions about the economic significance of the foreign
exchange rate risk premium.
*
*
*
The Employment Act of 1946 assigned to the federal government the official
responsibility of achieving and maintaining a high level of employment. Over the
past 40 years, monetary and fiscal policy have evolved into the primary tools of the
government’s stabilization policy. In the second article in this Review, Keith M.
Carlson summarizes and examines fiscal policy to determine whether the direc
tion of fiscal actions over the years generally has been consistent with the
Employment Act. Using various measures, his study concludes that, during
periods of recession and recovery, fiscal actions usually were stimulative and
consistent with the Employment Act. During periods of high demand and
inflation, however, fiscal actions tended to be inappropriately stimulative; how
ever, these were generally wartime periods.
DECEMBER 1987
FEDERAL RESERVE BANK OF ST. LOUIS
Risk Aversion, Efficient Markets
and the Forward Exchange Rate
Kees G. Koedijk and Mack Ott
13
Ji- M.ISK is a characteristic of existence. Attempts to
avoid it explain such arrangements as insurance, lim
ited liability firms and diversification of investment
portfolios. In recent years, risk aversion and the at
tendant premium for risk-bearing have been used
increasingly to explain a stubborn paradox in the
empirical exchange rate literature: the failure of the
forward exchange rate to be an unbiased predictor of
the future spot exchange rate.
In this article, we review recent economic analyses
of the risk premium’s role in foreign exchange mar
kets. The starting point is an explanation of covered
and uncovered interest parity and their relation to the
risk premium. We then turn to a discussion of empiri
cal tests of efficiency. In particular, we examine two
recent papers that demonstrate the existence of the
risk premium but differ in their conclusions about
market efficiency: Fama (1984) and Frankel and Froot
(1986).
competitive, well-informed individuals suggests that
the foreign exchange market fits Fama’s (1970) defini
tion of an efficient market: “A market in which prices
always 'fully reflect’ available information.” An analy
sis of forward exchange market efficiency and the risk
premium draws on market information as revealed by
relations between interest differentials and exchange
rates. These relations are called the covered and un
covered interest parity conditions.
Covered interest parity (CIP) relates the forward
premium (F, - S,) to the interest differential,
ill
where
i
= log of 1 plus U.S. three-month T-bill interest
rate,
i*
= log of 1 plus foreign equivalent of T-bill
rate,
F,
= log of the forward exchange rate (dollars
COVERED AND UNCOVERED
INTEREST PARITY
Currencies are exchanged, spot and forward, in
highly organized markets. The high volume of trade by
Mack Ott is a senior economist at the Federal Reserve Bank of St.
Louis. Kees G. Koedijk is an assistant professor of economics at
Erasmus University, Rotterdam, the Netherlands. James C. Poletti and
Nancy D. Juen provided research assistance.
i - i * = (F, —S,)ot
per foreign currency unit),
S,
= log of the spot exchange rate (dollars
per foreign currency unit),
a
= annualizing factor — 12 divided bv number of
months in the forward contract.
The right-hand side of (1), which is the annualized
forward premium on foreign currency, measures the
rate of return in domestic currency on a covered
5
FEDERAL RESERVE BANK OF ST. LOUIS
exchange position — that is, a spot purchase of foreign
currency offset by a forward sale. The equality with the
differential between the domestic and foreign interest
rate on the left-hand side is brought about by arbi
trage: since the bonds are assumed to be default free
in their respective currencies, a riskless excess return
would be available if CIP did not hold.'
Because the forward rate is the present contractual
dollar price of foreign currency for future deliveiy, the
assumptions of market efficiency and no risk pre
mium imply a second form of interest parity called
uncovered interest parity (UIP). An expression for UIP
can be obtained from the arbitrage condition which
equates the expected change in the spot rate plus the
premium for risk with the forward premium:
(2!
E,[Sl+k]- S , + P, = F, -S „
where
E,[Sl+k) = the expectation of the period-t + k
spot rate based on period-t informa
tion,
P, = the risk premium for bearing the uncer
tainty of unexpected currency price
changes.
Under the no-risk-premium hypothesis,
(3)
P, = 0,
then, from (II, we have the second form of interest
parity, UIP:
I4 I
i - i * = (E,[S,. J - S,)a.
Comparing equation 4 with equation 1, UIP implies
that the forward rate, F„ which is observable to the
market at time t, is equal to the market’s forecast of the
future spot exchange rate at time t + k. Note that un
covered interest parity is conditional upon the hy
pothesis of no risk premium; only if (31 holds will the
annualized rate of the expected change in spot rate be
equal to the current interest differential.
The risk premium, P,, on buying a currency in the
forward market is implicitly defined by equation 2.
That is, individuals who do not want to bear the
uncertainty of holding an open currency position buy
forward currency to hedge this risk. As shown in the
left-hand side of equation 2, the price these hedgers
pay includes the risk premium, the price of insuring
against this uncertainty. It is the difference between
1CIP has been supported in a variety of empirical investigations; see
Clinton (1987) and Isard 1987, pp. 7-8.
http://fraser.stlouisfed.org/
6 Bank of St. Louis
Federal Reserve
DECEMBER 1987
the log of the forward rate and the log of the expected,
but unobservable, future spot rate,
(5)
P, = F,-E[S,.J.
For instance, if the risk premium is positive, specula
tors sell foreign currency forward at price F, and ex
pect to be able to buy the foreign currency spot at time
t + k for Et(S,+k), profiting by doing so at rate P, (annual
rate aP,). Note that, if the risk premium is not zero, the
market actually can expect the dollar to depreciate,
even though the observed interest differential and the
forward premium indicate an appreciation of the dollar.-
Risk Premium or Market Inefficiency
Current investigations of the relationship between
the spot and forward exchange rates are premised on
a widely documented finding: the simple no-riskpremium efficiency criterion, defined jointly by equa
tions 2 and 3, has been refuted by many empirical
studies. Using a variety of assumptions, data, time
periods and estimation techniques, investigators have
established three fundamental points:3
1) The forward exchange rate is not an unbiased pre
dictor o f the future spot rate.
2) The residuals obtained in a regression of spot ex
change rates of their lagged forward rates fre
quently exhibit serial correlation.
3) There exist systems (filters) that permit profitable
speculation in foreign exchange either through the
purchase of foreign assets with offsetting forward
exchange safes or buy and hold strategies.
2An example may clarify this relation among the premium, forward
rate and expected future spot rate. Suppose the dollar-DM spot
exchange rate is $.5512/DM, the three-month forward rate is
$.5494/DM, and the expected future spot rate three months hence is
$.5556/DM. Since the risk premium is negative, the speculative
position will be against the dollar rather than against the DM. The
speculator (whose beliefs are represented by the expected future
spot rate) would expect to make a profit by selling dollars fonward
and buying DM assets. After holding the DM assets for three
months, the speculator anticipates selling the DM assets and using
the proceeds to buy dollars. The speculative rate of profit — that is,
the excess over a hedged, secure return — anticipated over the
three months is, from equation 2,1.12 percent or 4.49 percent on an
annual basis:
-P , = {[E|(S1+3)-SJ - [F,-St]}* 4
= |[ln(.5556)-ln(.5512)] - [ln(.5494)-ln(.5512)]}* 4
= .0449
3These characteristics have been widely discussed. For the biased
ness of forward rates, see Robichek and Eaker (1978), Levich
(1979), Cumby and Obstfeld (1981), Hansen and Hodrick (1980)
and Meese and Rogoff (1983). The serial correlation of errors has
been noted by Hansen and Hodrick (1980) and Cumby and Obstfeld
(1984). On the existence of profitable speculation through “ filters"
(obtained from lagged data) see Levich (1979), Bilson (1981) and
Sweeney (1986).
FEDERAL RESERVE BANK OF ST. LOUIS
Given the ample empirical evidence, most researchers
accept the rejection of the simple no-risk-premium
efficiency criterion; however, they remain divided on
whether the existence of a risk premium or market
inefficiency is responsible for this result.
Why has it been so difficult to test for the presence
of a risk premium? The answer is that while, in gen
eral, we do not have actual ex ante expectations data,
we assume that foreign exchange market participants
are rational in their decisions, including their pricing
of risk. Hence, the expectation of the future spot rate is
equal to its actual, subsequently observed value plus a
random error and, perhaps, a risk premium. Conse
quently, whenever the observable value of F,-St+k is
different from zero, there is c,x post evidence on the
existence of a risk premium or market inefficiency or
both, but no direct evidence bearing on which*
The empirical difficulties in assessing the presence
of a risk premium from simple calculations of F-S, +,
can be gathered from chart 1. In this chart, we have
plotted the so-called ex post or rational expectations
risk premium, F,-St+, (annualized), for the dollar/
deutsche mark exchange rate from January 1976
through June 1985. As is evident, it is difficult to show
that the forward rate systematically underpredicts or
overpredicts the future spot rate. When long periods
of time are considered, the average prediction error of
the forward exchange rate is close to zero. Fortunately,
however, two direct tests for the presence of a risk
premium in the foreign exchange market have em
erged from the literature.
TWO TESTS OF EFFICIENCY AND
RISK PREMIA
Recently, two studies of exchange rates have offered
tests that separate the rational expectations hypothe
sis and the existence of a risk premium. These papers
use different methods, time periods and data sets, and
they arrive at different conclusions about the relative
impoi’tance of the risk premium and expectation er
rors.
40 f course, this is conditional on expectations being rationally
formed. Even so, unforeseen events transpiring between time t and
t + k may result in F,-S,+k 4 0. Such unforeseen events, dubbed
“ news” by Frenkel (1981) explains some variation in Ft- S uk due
neither to a risk premium nor nonrational expectations; however,
news should not result in biased expectations since unforeseen
events must have an expected mean of zero.
DECEMBER 1987
The first paper is Fama’s (1984) article, which as
sesses the relative variability of the risk premium and
forecast errors during 1973-82. Fama concludes that
the risk premium explains more of the variance than
the forecast error does. Furthermore, he also finds that
the risk premium and the expected (but unobserved)
future spot rates are negatively correlated.
The second paper, Frankel and Froot (1986), uses
the median response from survey data of foreign ex
change traders’ expectations of future spot rates.5
Their study, primarily covering 1981-85, finds a risk
premium varying between 3 percent and 10 percent
depending on the currency observed. Thus, they are
able to test directly the rational expectations hypothe
sis and to estimate the proportion of the forward rate
error that can be ascribed to forecast error and to risk
premia.
Their findings concur with Fama’s in two respects
— the risk premium is significant and negatively cor
related with the expected future spot rate — but
diverge in terms of the relative variances of forecast
errors and risk premia;
In all three surveys, the errors exhibit unconditional
bias of a sign opposite to estimates of the risk premium
from the survey data. The premia are large in absolute
value, and are statistically different from zero. We can
reject the hypothesis that systematic unconditional
mistakes made by the forward rate in predicting the
future spot rate are due entirely to a failure o f rational
expectations. But at the other extreme, the hypothesis
that the forward rate prediction errors can be ex
plained by the risk premium alone is also rejected.
Expected depreciation is more variable than both the
forward discount and the risk premium. The first find
ing corroborates Fama's (1984) conjecture that ex
pected depreciation and the risk premium are nega
tively correlated. The second finding rejects the
hypothesis that the variance o f expected depreciation
is less than the variance of risk premium . . . .*
5Frankel and Froot used three different surveys: Money Market
Services (MMS), Inc., biweekly January 1983-October 1984,
weekly 1984-86, polled an average of 30 currency traders or
economists at major international banks; The Economist Financial
Report every six weeks June 1981-December 1985 conducted
telephone interviews with currency traders at 14 leading interna
tional banks; finally, Amex Bank Review 1976-85 annually sur
veyed 250-300 central and private bankers, corporate officers and
economists. In each case, respondents were asked for exchange
rate forecasts at various horizons for the pound, mark, Swiss franc,
yen and (except for MMS) French franc. Details of these surveys
can be found in the data appendix of Frankel and Froot (1987), p.
151.
6Frankel and Froot (1986), p. 29. Originally, this negative correlation
was presented by Fama (1984) as a puzzle; however, as shown in
Hodrick and Srivastava (1986), it is perfectly consistent with the
intertemporal asset pricing model of forward exchange markets.
7
J3
>
Chart 1
RESERVE
The E x Post R isk P re m iu m ^
Dollars per Deutsche Mark
150
Percent
150
Mo nt hl y Data
BANK OF ST. LOUIS
P e rc en t
100
50
-50
■100
77
78
79
80
81
82
83
84
1985
The a n n u a l i z e d di f f erence b e t w e e n the log of the f o r w a r d rate a n d the log of a one - mo nt h l e a d of the
o b s e r v e d spot rate.
-150
DECEMBER
1976
FEDERAL RESERVE BANK OF ST. LOUIS
Assessing the Divergent Findings
o f Fama and Frankel-Froot
The two papers, which use very different methodo
logies, concur in the statistical significance of a risk
premium, but are in dispute about its economic
significance. On the one hand, Fama’s paper, as well as
others whose research has followed his lead, asserts
that the risk premium accounts for most of the for
ward rate error.7An implication is that the efficiency of
forward exchange markets is not refuted. A corollary of
this implication is that, since foreign exchange trading
is not subject to biased forecasts, policy intervention
in foreign exchange markets cannot be justified on the
existence of destabilizing and misguided speculation.
In contrast, the findings of Frankel and Froot assert
that, although the risk premium is statistically signi
ficant, it is smaller (in absolute value and variability)
than the forward rate forecast errors made by the
surveyed traders, economists and corporate officers of
international banks. Moreover, they find that the ex
pectations of these surveyed traders are systemati
cally biased, that their speculative activity is excessive
and that the risk premium is without economic
significance:
The data continue to reject statistically the hypothesis
of rational expectations ... in favor o f the alternative of
excessive speculation... Put differently, even after al
lowing for measurement error, it is still not possible to
reject the hypothesis that
all the bias consists o f re
peated espectational errors made bv survey respon
dents, and that no positive portion o f the bias can be
attributed to the survey risk premium.''
These disparate findings require some resolution.
Besides the different statistical methodologies used,
there are two fundamental differences between their
analyses. First, the two papers use different data sets
for their empirical tests: Fama’s study covers data
observed at four-week intervals from August 1973
through December 1982, while Frankel-Froot’s data
are of varying frequency over primarily 1981-85." Fa
ma’s sample covers nine exchange rates, including the
six that Frankel-Froot examine. Second, the FrankelFroot study uses survey data rather than the e* post
market observations for the expectation proxy. This
7For example, see Hodrick and Srivastava (1986), Frenkel (1986)
and Boothe and Longworth (1986).
DECEMBER 1987
creates some problems of interpretation, as FrankelFroot recognize.10While the measurement errors can
be statistically addressed, there are three economic
differences between survey opinion and market
actions that warrant consideration in weighing the
conflicting results of Fama and Frankel and Froot.
Survey responses may deviate from market expecta
tions first because a single observation rather than a
weighted average forms the datum. That is, FrankelFroot use the median response to represent the typi
cal market agent. In contrast, when expectations are
deduced from market actions (actual portfolio posi
tions or changes in position), the expectations of every
active agent are included in a composite average with
the weights being asset holdings or changes in asset
holdings. This population-weighted, distributionbased expectation may differ considerably from the
median proxy, especially if the tails of the expectation
distribution contain the beliefs of the agents making
the largest purchases. If differences of opinions as well
as changes in information move markets, then median
survey responses will offer incomplete guides to mar
ket expectations.
A related, but slightly different aspect of the differ
ence between survey and market data is that the latter
is substantiated by action. Surveys are frequently mis
leading in that agents are not disciplined in their
responses by having to take positions that risk wealth.
Put differently, actions speak louder than words, or
talk is cheap.
Finally, the survey responses may not be expected
values but rather modal values — the most likely
values — or, perhaps, risk-adjusted expectations. For
example, Frankel-Froot (198G) describe each of their
three data sets in about the same form as the Money
Market Services (MMS) survey:
Every two weeks from January 1983 to October 1984,
MMS spoke by phone with an average of 30 currency
traders or currency-room economists at major inter
national banks. Respondents were asked for their ex
pectations of the value of the pound, mark, Swiss franc
and yen against the dollar in two weeks and three
months time. From October 1984 to February 1986,
MMS conducted its suivey every week, asking for ex
pectations one week and one month into the future
(p. 4).
For normally distributed future spot rates, such ambi
guity would not matter since mode and mean are
equal; if the distributions are asymmetric, however,
'Frankel and Froot (1986), p. 28, emphasis added.
9Frankel-Froot do report some earlier data (1976-78), but the bulk of
their tests are on data from the 1980s.
10Frankel-Froot (1986), p. 4.
9
FEDERAL RESERVE BANK OF ST. LOUIS
mode and mean are unequal." Consequently, the re
spondents’ interpretations become important, and
changes in the median respondent, the identity of the
responding institutions or their spokesman makes the
interpretation of survey expectations even more prob
lematic.
Since these are unavoidable properties of survey
data, they cloud the interpretation of survey-based
findings. The other two possible sources of the dispar
ity between the findings — different data and different
time periods — can be tested. For Fama's study, reestimation of the model will determine whether, over the
latter period on the same data, his results still diverge
from those of Frankel and Froot. Thus, in the next
section, we reestimate Fama’s model over a period
including the 1981-85 period and use the same data
source as Frankel and Froot.12
FAMA’S TEST FOR A VARIABLE RISK
PREMIUM, AN EXTENSION
Fama’s (1984) test for a variable risk premium de
composes the forward premium (F—S,) into its two
components: the expected change in the spot rate
[E(S,+1-St)] and the risk premium [PJ as shown in equa
tion 2. Fama then considers two regressions using the
forward premium as the explanatory variable and
each of the two components of the forward premium
— the forward rate error, F —S,., and the actual change
in the spot rate, St. ,-S, — as dependent variables:
(6)
DECEMBER 1987
and
(7)
S,+1-S, = a2 + b2(F,-S,) + eZ,.
In these regression equations, b2 estimates the accu
racy of the forward premium in predicting the actual
change in the spot rate, whereas b l reveals the risk
premium component of the forward premium. Since
the premium and forward rate errors may have non
zero covariance, the coefficients in (6) and (7) cannot
be used directly to measure the proportion of varia
tion due to risk and forecast errors, but the difference
between them does provide some information.13
The difference between the two estimated coef
ficients, (bl —b2), provides statistical evidence on the
proportional importance of variation in the risk pre
mium vs. variation in the rational future spot rate
forecast error as sources of variation in the forward
premium. Specifically, if b l —b2 is positive and statisti
cally significant, most of the variation in forward pre
mium is due to variation in the risk premium.14Con
versely, if b l —b2 is negative and statistically
significant, most of the variation is due to variation in
the expected change in the exchange rate. Finally, if
b l —b2 is not significant, it is not possible to draw any
conclusions about the source of variation.
,3As shown in Fama (1984), p. 21, by assumption of rational expecta
tions,
b1 = c o v (F ,-S ,,, F, - S.)
F,-S,., = a l + bl(F,-S,) + el,,
«*(F, - S,)
= <r*(P,) + cov(P„ E,(S, . , - S , ) )
<t2(F ,-S ,)
” That is, when distributions are not symmetric, the different statistics
that survey respondents might interpret as “ expectations” will be
widely divergent. When distributions of future spot exchange rates
are symmetric, the mean and mode (most likely future exchange
rate) are the same. Also, the odd moments of a symmetric distribu
tion are zero, so that skewness could not influence a survey respon
dent’s answer. If distributions are asymmetric, however, the mean
and mode will diverge and nonzero skewness (the third moment of
the distribution) influence the risk premium and, hence, the survey
response. For example, consider two alternative distributions for the
DM one month in the future:
I. Symmetric Distribution (likelihood)
$.667 (10%), $.606 (80%), $.545 (10%).
II. Asymmetric Distribution (likelihood)
$.667 (20%), $.606 (80%)
In each distribution, the mode is $.606, which is also the mean of I
but, the mean of II is $.618. Thus, the statistic that respondents
report as their expected value matters for distribution II, but does not
matter for distribution I.
,2Frankel and Froot (1986) use spot and forward exchange rate data
from DRI, while Fama (1984) uses data from Harris Trust National
Bank of Chicago. In the results reported in tables 1 and 2, we use
DRI data.
http://fraser.stlouisfed.org/
10
Federal Reserve Bank of St. Louis
and
_ C0V(S, ■i —St, F, —S()
<r2(Fi - S,)
= <r2(E,(S,, i - S ,)) + cov (P„ E,(S,,, - S ,))
<f2(F, - S,)
Since the covariance term appears in the b1 and b2 regression
coefficients, neither b1 nor b2 can be used by itself to assess the
relative contribution of risk or forecast error to the forward premium;
however, since they have a common denominator, <r2(F,-St), the
difference between b1 and b2, which does not contain this term in
the numerator, can be used to provide evidence about the propor
tional contribution or risk and forecast error,
b 1 -b 2 -
<r^ P |^ ~ (T^ E |^S |* 1 ~ S |) )
a2 (F, - St)
14The standard error of b1 - b2 is twice the common standard error of
b1 and b2: Since (6) and (7) imply that b, + b2 = 1, by definition of
the variance of b, - b2
< r(b ,-b 2) = [E(b, —b, - (b2- b 2) )2] 1/2
= [E(b, - b, - (1 ~ b ,) + (1 —b,) )2] 1/2
= 2a(b1).
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Table 1
Tests of Stability of Regression Estimates of Fama’s Equations
During Subperiods 1976.01-85.06
F-Statistics for Tests of Subperiod Breaks
All Subperiods
Pairs of Subperiods
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
Switzerland
United Kingdom
B,D,S
B + D.S
B + S,D
B,D + S
B.D
B,S
D,S
4.11*
0.67
2.52v'
5.07”
0.11
0.09
0.04
2.46v
0.26
0.95
2 .7 V
0.56
4.60*
3.04v
0.46
2.10
1.98
1.84
0.27
0.56
0.37
0.07
3.14*
0.51
1.74
1.85
1.45
0.05
0.41
1.33
2.60v
3.97*
0.49
2.75v
2 .5 4 /
2.20
0.18
0.65
0.86
1.05
1.14
0.23
0.47
3.21*
0.61
1.01
2 .9 5 /
1.14
5.20**
0.91
0.19
0.65
2.95v
0.87
1.12
2.81 v
0.16
2.80v
2.4 V
1.15
3.36’
1.46
5.56**
NOTE: Subperiods are denoted by Before (B), During (D), and Since (S) the 1979.10-82.09 subperiod
of U.S. monetary aggregate targeting. Subperiods tested are separated by commas; plus
indicates inclusion. Significance levels are indicated by ** for 1 percent, * for 5 percent, / for 10
percent.
Fama’s Specification Estimated by
Subperiods, 1976—85
One possible reason that different sample periods
(Fama, 1973-82; Frankel-Froot, 1981-85) yield different
results is that the structure of markets may have
changed during or between these periods. Econo
mists have argued that the so-called peso problem
makes the 1973-76 period difficult to interpret.'3 Oth
ers have argued that the development of foreign ex
change markets, learning curve behavior of agents and
the evolution of floating exchange rate policy are other
reasons why subperiods may differ in structure."* In
particular, several authors have presented evidence
that a change in the monetary regime in the United
States during the last quarter of 1979 may have caused
a structural change.17 Consequently, we have esti
mated Fama’s model, equations 6 and 7, over all com
binations of the three subperiods of 1976.01-1985.06:
,5The peso problem refers to the devaluation of the Mexican peso
which was anticipated throughout the 1973-76 period and which
occurred in early 1976. More generally, it refers to any anticipated
exogenous event that does not occur within the sample period. See
Krasker (1979) and Isard (1987).
16See Isard (1987).
,7For example, see Ott and Veugelers (1986) and Frenkel (1986).
before (B), during (D) and since (S) the interval of
monetaiy aggregate targeting, 1979.10-1982.09.'"
F-statistics for tests of these structural breaks over
the 1976-85 period against the null hypothesis of no
breaks are reported in table 1. These Chow tests are
used to determine the proper estimation subperiods
to be reported in table 2. As the first column of table 1
indicates, Canada, France, Italy, Japan and Switzer
land do not reject the full-period structural stability
hypothesis, and their regression estimates in table 2
are for the undivided full period, indicated by
B + D + S. Belgium, Germany, the Netherlands and the
United Kingdom reject the null hypothesis at the 5
percent level or better, and their regression estimates
are reported by the appropriate subperiods.'"
Table 2 reports the regression estimates of (6) and (7)
for the nine currencies whose structures were exam
ined in table 1. Overall, the b l —b2 test reported in the
18The later starting date also avoids the peso problem; see Krasker
(1979).
I9lntecestingly, the data for none of the countries supported the
alternative hypothesis that the Before and Since subperiods were
the same. Germany and Belgium provided evidence that all three
periods were dissimilar, while the Netherlands and the United King
dom indicated that the Before and During subperiods were similar
but jointly different from the Since subperiod.
11
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1967
Table 2
Estimation Results for Fama’s Tests: Significance of Variable Risk Premium in
Forward Rate Errors_________________________________________________________
Regression Coefficients and Standard Errors
Country
Subperiod1
Belgium
B
D
S
B+ D+ S
B+ D+ S
B
D
S
B+ D+ S
B+ D+ S
B+ D
S
B+ D+ S
B+ D
S
Canada
France
Germany
Italy
Japan
Netherlands
Switzerland
United Kingdom
a1
-0.01
0.02
0.01
0.00
0.01
-0.01
0.01
-0.05
0.01
-0.01
-0.01
-0.04
-0.02
0.00
0.01
b1
0.80
1.34
3.06
2.20
1.38
2.18
0.81
15.47
1.64
3.41
3.78
15.28
4.19
2.26
11.92
a2
0.01
-0.02
-0.01
-0.00
-0.01
0.01
-0.01
0.05
-0.01
0.01
0.01
0.04
0.02
-0.00
-0.01
Summary Statistics
Risk Premium Test2
b2
s(a)
s(b)
R?
R§
DW
t(b1-b2
0.19
-0.34
-2.06
-1.20
-0.38
-1.18
0.19
-14.47
-0.64
-2.41
-2.78
-14.28
-3.19
-1.26
-10.92
0.01
0.01
0.01
0.00
0.00
0.01
0.01
0.02
0.00
0.00
0.00
0.02
0.01
0.01
0.01
1.25
1.40
3.72
0.87
0.74
2.50
2.62
5.52
0.47
1.01
1.14
4.71
1.39
0.95
3.30
.01
.03
.02
.05
.03
.02
.00
.20
.10
.09
.12
.25
.08
.07
.30
.00
.00
.01
.02
.00
.01
.00
.18
.02
.05
.07
.23
.04
.02
.26
2.76
1.74
2.01
2.33
2.22
2.82
1.81
2.44
2.01
1.97
2.33
2.54
2.02
1.94
2.49
0.24
0.60
0.69
1.95/
1.20
0.67
0.12
2.71*
2.40*
2.88**
2 .8 9 "
3.14**
2.66**
1.85/
3.46**
NOTE: ** indicates significance at 1 percent level; * indicates significance at 5 percent level; / indicates significance at 10 percent level.
’Subperiods are as follows: B, 1976.01-1979.09; D, 1979.10-1982.09; S, 1982.10-1985.06.
2Standard error of difference between b1 and b2.
last column reasserts the relative importance of the
risk premium that Fama found in his original tests.
This result holds both for currencies that revealed
structurally differentiated subperiods and for curren
cies that did not, that is, Canada, Italy, Japan and
Switzerland. Of the nine currencies, only the Belgian
franc and the French franc failed to support the statis
tically greater importance of the risk premium over the
expected change in the exchange rate.20 The other
results reported in table 2 indicate that the results are
quantitatively similar to those reported by Fama for
the same currencies over a shorter sample and differ
ent data set.
CONCLUSION
Markets for foreign exchange are well-organized,
high-volume interactions that encompass the trading
activities of many competitive profit-seeking agents.
That is, they appear similar in many functional as
“ But even for Belgium and France, the difference b1 - b2 was posi
tive so that forecast error variance was not greater than risk premia
variance for any currency.
http://fraser.stlouisfed.org/
12 Bank of St. Louis
Federal Reserve
pects to other (domestic) financial markets so that the
hypothesis of efficiency is plausible. Empirical tests,
however, have rejected the joint hypothesis of market
efficiency and no risk premium in the foreign ex
change market. That is, while CIP holds, UIP does not.
Consequently, the role of the risk premium in for
eign exchange markets often was not distinguishable
from market inefficiency until Fama’s (1984) analysis
provided a test of its importance in the foreign ex
change market. Frankel and Froot (1986) have pro
vided survey-based evidence that also supports the
existence of a risk premium but conflicts with Fama’s
assessment of the risk premium’s economic impor
tance. We have replicated Fama’s study for an ex
tended sample period and, although the results varied
substantially by subperiods, found results that in gen
eral corroborate Fama's findings. What this impasse
suggests is that the economic significance of the risk
premium will not be resolved by tests of its existence,
but may require direct modelling of the portfolio
choice problem from which it arises.2'
21For an application of portfolio choice theory to this problem, see
Bomhoff and Koedijk (1987).
FEDERAL RESERVE BANK OF ST. LOUIS
REFERENCES
Bilson, John F. O. “The ‘Speculative Efficiency’ Hypothesis," Jour
nal of Business (July 1981), pp. 435-51.
Bomhoff, Eduard J., and Kees G. Koedijk. "Bilateral Exchange
Rates and Risk Premia," Journal of International Money and Fi
nance, forthcoming.
Boothe, Paul, and David Longworth. “ Foreign Exchange Market
Efficiency Tests: Implications of Recent Empirical Findings,” Jour
nal of International Money and Finance (June 1986), pp. 135-52.
Clinton, Kevin. “Transactions Cost and Covered Interest Arbitrage:
Theory and Evidence,” mimeo (Bank of Canada, April 1987).
Cumby, Robert E., and Maurice Obstfeld. “A Note on Exchange-Rate
Expectations and Nominal Interest Differentials: A Test of the
Fisher Hypothesis,” Journal of Finance (June 1981), pp. 697-703.
________ . “ International Interest Rate and Price Level Linkages
under Flexible Exchange Rates: A Review of Recent Evidence,” in
John F. O. Bilson and Richard C. Marston, eds., Exchange Rate
Theory and Practice (University of Chicago Press, 1984), pp. 121-
SI.
Fama, Eugene F. “ Efficient Capital Markets: A Review of Theory
and Empirical Work," Journal of Finance (May 1970), pp. 383-417.
_________ "Forward and Spot Exchange Rates,” Journal of Mone
tary Economics (November 1984), pp. 319-38.
Frankel, Jeffrey A., and Kenneth A. Froot. “ Interpreting Tests of
Forward Discount Bias Using Survey Data on Exchange Rate
Expectations,” National Bureau of Economic Research Working
Paper No. 1963 (June 1986).
_________ “ Using Survey Data to Test Standard Propositions Re
garding Exchange Rate Expectations,” American Economic Re
view (March 1987), pp. 133-53.
Frankel, Jeffrey A., and Richard Meese. “Are Exchange Rates
Excessively Variable?” National Bureau of Economic Research
Working Paper No. 2249 (May 1987).
Frenkel, Jacob A.
“ Flexible Exchange Rates, Prices and the Role of
DECEMBER 1987
‘News’: Lessons from the 1970s,” Journal of Political Economy
(August 1981), pp. 665-705.
________ . “ Comments on Hodrick-Srivastava,” Journal of Interna
tional Money and Finance, Supplement, Vol. 5 (March 1986), pp.
523-30.
Hansen, Lars Peter, and Robert J. Hodrick. “ Forward Exchange
Rates as Optimal Predictors of Future Spot Rates: An Econometric
Analysis, Journal of Political Economy (October 1980), pp. 829-53.
Hodrick, Robert J., and Sanjay Srivastava. "The Covariation of Risk
Premiums and Expected Future Spot Exchange Rates,” Journal of
International Money and Finance, Supplement, Vol. 5 (March
1986), pp. 5-21.
Isard, Peter. “ Lessons from Empirical Models of Exchange Rates,”
IMF Staff Papers (March 1987), pp. 1-28.
Krasker, William S. “The ‘Peso Problem’ in Testing the Efficiency of
Forward Exchange Markets,” Journal of Monetary Economics
(April 1980), pp. 269-76.
Levich, Richard M. “ On the Efficiency of Markets for Foreign Ex
change,” Rudiger Dornbusch and Jacob A. Frenkel, eds., Interna
tional Economic Policy — Theory and Evidence (John Hopkins
University Press, 1979), pp. 246-67.
________ _ “ Empirical Studies of Exchange Rates: Price Behavior,
Rate Determination and Market Efficiency,” in Ronald W. Jones
and Peter B. Kenen, eds., Handbook of International Economics,
Vol. 2 (Elsevier: North Holland, 1985), pp. 979-1040.
Meese, Richard A., and Kenneth Rogoff. “ Empirical Exchange Rate
Models of the Seventies: Do They Fit out of Sample?” Journal of
International Economics (February 1983), pp. 3-24.
Ott, Mack, and Paul T. W. M. Veugelers. “ Forward Exchange Rates
in Efficient Markets: The Effects of News and Changes in Monetary
Policy Regimes,” this Review (June/July 1986), pp. 5-15.
Robichek, Alexander A., and Mark R. Eaker. “ Foreign Exchange
Hedging and The Capital Asset Pricing Model,” Journal o f Finance
(June 1978), pp. 1011-18.
Sweeney, Richard J. “ Beating the Foreign Exchange Market,” Jour
nal of Finance (March 1986), pp. 163-82.
13
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Federal Fiscal Policy Since the
Employment Act of 1946
Keith M. Carlson
T
JL HE Employment Act of 1946 assigned to the
federal government the official responsibility to
achieve and maintain a high level of employment.1
According to the act:
The Congress hereby declares that it is the continuing
policy and responsibility of the Federal Government to
use all practicable means ... to promote maximum
employment, production, and purchasing power.’
While the act does not specify how to achieve these
goals, monetary and fiscal policy over the past 40 years
have evolved into the primary tools of stabilization
policy.
The general purpose of this article is to summarize
fiscal policy since the Employment Act of 1946. The
meaning and significance of fiscal policy are dis
cussed, including some measurement problems asso
ciated with fiscal actions. Different measures of fiscal
action during periods when the pace of economic
activity was significantly above or below trend are
examined to determine whether the direction of fiscal
actions generally has been consistent with the Em
ployment Act.
THE MEANING OF FISCAL POLICY
Fiscal policy is the use of federal expenditures and
taxes to stabilize the economy. Two aspects of this
definition require clarification. First, for the most part,
the government does not control directly the dollar
amount of expenditures or taxes: instead it controls
specific programs and the structure of tax rates. Sec
ond, to evaluate fiscal policy, a more specific definition
of “economic stabilization” is required.
Defining Fiscal Action
Though Congress is originally responsible for estab
lishing various expenditure programs — indeed, it
must appropriate funds each year to keep a program
in place — the dollar cost of implementing and main
taining such programs depends on economic condi
tions, including movements in the general level of
prices. Similarly, though Congress legislates tax rates,
the performance of the economy in conjunction with
these rates determines the dollar amount of tax re
ceipts. Once a tax structure is established, receipts are
forthcoming in a particular year without any further
action by the government.
The 1962 Economic Report of the President summa
rized the government’s control problem diagrammatically.' In figure 1, panel A, an expenditure program is
shown as a downward-sloping time, E,„ reflecting pri
marily the decline in unemployment benefits as real
GNP increases. In combination with a given structure
of tax rates (the line TJ, the surplus or deficit (S„) is also
drawn as a function of the level of GNP in the bottom
portion of panel A. A fiscal action, in this case an
increase in spending programs, is shown as a shift of
Keith M. Carlson is an assistant vice president at the Federal Resen/e
Bank of St. Louis. James C. Po/etti provided research assistance.
’ For discussion of the evolution of the Employment Act along with its
updated version, The Full Employment and Balanced Growth Act of
1978, see Santoni (1986).
2From Public Law 304, quoted in Norton (1985), pp. 79-80.
http://fraser.stlouisfed.org/
14 Bank of St. Louis
Federal Reserve
3Council of Economic Advisers (1962), pp. 77-84. Using real GNP on
the horizontal axis implies that the expenditure and tax lines are
drawn for a given price level. To avoid complicating the analysis,
price level problems are not considered explicitly here. For detailed
discussion of such problems, see Carlson (1983).
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Figure 1
An Illustration of Fiscal Actions
(A )
(B)
Expenditure increase
T a x in crease
*♦
the expenditure line to E„ which also shifts the sur
plus/deficit line. But because the new level of expendi
tures is now greater for each level of GNP, the surplus
is less (or the deficit is more) at each GNP level.
Similarly, the affects of a tax action are shown in
panel B of figure 1. A given structure of tax rates is
shown as an upward-sloping line, T„, indicating that
taxes increase with the level of GNP. An increase in tax
rates will shift the surplus/deficit line upward, to S,.
This shift represents the effect of legislated or admin
istered fiscal actions.
Defining Economic Stabilization
The second clarification concerns the meaning of
the term “stabilizing the economy.” While the wording
of the Employment Act can serve as a guide, it is not
very specific. In particular, the word ‘'maximum” is
subject to a variety of interpretations. A working inter
pretation has evolved over the years, since one was
never clearly delineated in the late 1940s and 1950s. A
considerable amount of controversy revolves around
the specific goals associated with economic stability.
In theory, the objective of fiscal policy can be
defined quite clearly. If the economy is subject to
fluctuations, fiscal policy should be used to dampen
those fluctuations. To illustrate, see figure 2. The solid
line summarizes a cyclical pattern for GNP around an
upward trend. A policy of economic stabilization, as
shown by the dashed line, dampens the fluctuations.
Generally, this would be achieved by taking restrictive
action when GNP is above trend and stimulative action
when it is below. Doing this at the right time and in the
right dosage is, of course, difficult in practice. None15
DECEMBER 1987
FEDERAL RESERVE BANK OF ST. LOUIS
bined with the administrative budget, producing the
consolidated cash budget.5
F igu re 2
The M eaning of Economic Stabilization
Currently, the unified budget, which succeeded the
consolidated cash budget, serves as the primaiy
budget measure used by the government in its fiscal
planning. The federal sector of the national income
and product accounts, sometimes called the national
income accounts budget, is considered a more useful
measure for economic analysis, however (see insert).
Full-Employment Budget Concept
theless, this concept does provide a framework for
assessing the success or failure of past actions, which,
in turn, might be useful as a guide to formulating
future actions.
THE MEASUREMENT OF FISCAL
ACTIONS
There has been continuing controversy over the
proper role, if any, for fiscal policy in the U.S. economy
since the Employment Act of 1946 was passed. Many
issues remain unsettled. Accompanying the debate
about the theory of fiscal policy have been significant
changes in the way fiscal actions are measured.
Evolution o f Budget Data
When the Employment Act of 1946 was passed,
about the only data readily available on the federal
budget were the figures released in the budget docu
ment itself. These figures were for fiscal years for the
administrative budget and excluded the transactions
of trust funds, for example, social security. The devel
opment of the national income accounts budget in the
1950s resulted in the availability of quarterly data.
Later, the transactions of the trust funds were com
One of the most important innovations in measur
ing fiscal actions occurred in the 1960s when the full
employment budget was developed as a part of the
E con om ic R eport o f the President.6 The fullemployment budget is not really a budget at all: it is an
analytical measure that adjusts federal expenditures
and receipts in the national income accounts to ac
count for the feedback effects of economic activity.
One of its main features is to draw the distinction
between active and passive deficits (or surpluses).
Active deficits (surpluses) result from policy actions,
that is, they reflect legislated or administered changes
in expenditures or tax rates. Passive deficits (sur
pluses) reflect the influence of economic activity on
the deficit, given the spending programs and the tax
structure in place. This distinction is shown in figure
3, which reproduces panel A in figure 1 except that the
full-employment level of GNP is now a dashed vertical
line. An active deficit (in this case, a smaller surplus) is
shown as a movement from A to B. A movement from A
to C can be described as a passive deficit (again a
smaller surplus).
The full-employment budget was renamed the
high-employment budget in the late 1960s and later
changed to the cyclically adjusted budget in 1983.7
Despite these changes, its purpose is unchanged: to
adjust actual expenditures and receipts for the in
fluence of changing economic conditions.
Other Measures
In recent years, other measures of fiscal action have
been introduced; most of them are refinements of
existing measures. For example, with the recent
growth in the importance of interest cost, and its role
in eventually eradicating deficits, James Tobin has
President’s Commission on Budget Concepts (1967).
4For an exhaustive survey of the theory of fiscal policy, see Brunner
(1986).
http://fraser.stlouisfed.org/
16 Bank of St. Louis
Federal Reserve
6Council of Economic Advisers (1962), and Carlson (1967).
7de Leeuw and Holloway (1983).
FEDERAL RESERVE BANK OF ST. LOUIS
The Budget and Federal
Sector of the National
Income and Product
Accounts
The federal budget summarizes the finances of
the government and records transactions on a cash
basis. The federal sector of the national income and
product accounts (sometimes referred to as the NIA
budget) is considered a more appropriate measure
of budget’s effect on economic activity because it is
conceptually consistent with the national income
and product accounts which measure current in
come and production. The NIA budget excludes
financial transactions and measures taxes when
the liability is incurred. Defense procurement is
recorded when the goods are delivered to the gov
ernment; work in progress is a part of private busi
ness inventories. The accompanying table shows
the relationship of the budget to the NIA budget.1
DECEMBER 1987
Relationship of Budgets for Fiscal 1986
(billions of dollars)
Receipts
Total budget receipts
Government contributions for employee retirement
Other netting and grossing
Timing adjustments
Geographic exclusions
Other
$ 769.1
33.8
12.3
0.8
-1 .4
—
NIA receipts
$ 814.7
Expenditures
Total budget outlays
Lending and financial transactions
Government contributions for employee retirement
Other netting and grossing
Defense timing adjustment
Bonuses on outer continental shelf land leases
Geographic exclusions
Other
$ 989.8
-1 2 .5
33.8
12.3
3.2
2.0
-5 .4
2.0
NIA expenditures
$1,025.4
'For further discussion, see Budget of the United States Govern
ment for Fiscal Year 1988, Special Analysis B.
developed the notion of primary surplus or deficit.8
This measure is simply the surplus or deficit minus
interest payments to the public and Federal Reserve
payments to the Treasury. This measure can be calcu
lated on a cyclically adjusted basis as well.
actions in light of the Employment Act’s objectives.
This approach attempts to measure the active deficit
directly; thus, it represents one measure of "discre
tionary” fiscal action. Several other variants of the
cyclically adjusted budget also are examined.
Another measure receiving recent publicity has
been developed by Robert Eisner." His measure, which
can be derived for a variety of budget measures, is
adjusted for inflation. This means adjusting the deficit
for changes in the value of government debt outstand
ing due to inflation.
To assess fiscal policy actions, one must discuss
and analyze them in an economic context."’ The back
ground for this assessment is shown in chart 1, which
summarizes economic and budget data with refer
ence to the ratio of GNP to its trend value." The vertical
ECONOMIC PERFORMANCE AND
FISCAL POLICY: AN OVERVIEW
While several fiscal policy measures have been de
veloped over the years, the cyclically adjusted budget
approach is used here to assess the direction of fiscal
,0For detailed summaries of fiscal policy, see Holmans (1962), Lewis
(1962), Stein (1969), Eisner (1986) and Pechman (1987).
"T he trend value is calculated following procedures outlined in de
Leeuw and Holloway (1983). Since the Department of Commerce
does not attempt to cyclically adjust the price level, the ratio could be
interpreted in terms of nominal GNP. That is,
actual real GNP
actual real GNP x P
trend real GNP
trend real GNP x P
"Tobin (1984).
actual nominal GNP
9Eisner (1986).
trend nominal GNP
17
FEDERAL RESERVE BANK OF ST. LOUIS
Figure 3
Full-Employment Budget
DECEMBER 1987
quite volatile, reflecting, in part, the influence of wars
and their aftermath. During the second half of the
1950s and the early 1960s, economic performance
fluctuated relatively close to trend. The second half of
the 1960s again reflected wartime conditions. Finally,
economic performance in the 1970s and 1980s
showed considerable fluctuation around trend, even
though there were no major wars.
The bottom tier of the chart summarizes fiscal
actions as measured by the surplus or deficit in the
cyclically adjusted budget. To adjust the level of the
surplus or deficit for the size of the economy, we
divide by the trend value of GNP in current dollars.
The resulting measure is quite volatile on a quarterly
basis.
This measure of fiscal action was well in surplus in
the late 1940s. The sharp movement from surplus to
deficit in the early 1950s followed by the movements
back to surplus reflected the Korean War and its
aftermath. During the mid-1950s, this budget measure
stayed in surplus until 1958 before dipping temporar
ily into deficit; it bounced back into surplus in 1960.
The period from 1960 to 1968 was one of consider
able volatility around a downward trend. Except for
one quarter in 1963, this budget was in deficit, increas
ingly so toward the end of the period when defense
spending accelerated during the Vietnam War. By late
1968, however, there was a sharp movement toward a
smaller deficit, after a belated tax increase to finance
the war. The smaller deficit persisted for the most part
until 1975, reflecting mainly the phasing out of the
Vietnam War.13
lines represent periods when GNP was persistently
above or below trend, or when it was moving along
trend. The choice of periods using trend GNP as a
point of reference follows the interpretation of figure 2
and differs from procedures followed by the National
Bureau of Economic Research where reference points
are based on whether economic activity is rising or
falling.12
The top tier of chart 1 summarizes U.S. economic
performance as measured by the ratio of GNP to its
trend value from 1947 through 1986. U.S. economic
performance in the late 1940s and early 1950s was
,2Note that the focus is on real GNP movements, thus deemphasizing
the problems of inflation. Generally, periods when GNP is above
trend are also periods of inflation. The “ stagflation" case is not
addressed explicitly; the assumption is made that the Employment
Act places priority on real economic performance during such times.
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18 Bank of St. Louis
Federal Reserve
The second half of the 1970s showed a shift toward a
larger deficit, highlighted by an anti-recession tax cut
in 1975. Following this tax cut, the deficit remained at
about 2 percent of trend GNP through 1981. After 1981,
however, the deficit showed a sharp downward move
ment that generally persisted through 1986. This drop
was associated with accelerated expenditure growth
and the Economic Recovery Tax Act of 1981, which cut
individual income taxes by 25 percent and accelerated
depreciation allowances for corporations. Despite
some rescinding of these provisions by the Tax Equity
and Fiscal Responsibility Act of 1982, the cyclically
adjusted deficit fell below 5 percent of trend GNP by
1985-86.
13For a review of the sources of change in the federal deficit, see
Holloway and Wakefield (1985).
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
C h art 1
G N P an d F ederal Fiscal Actions Relative to
Trend G N P
Ratio
AN ANALYSIS OF FISCAL ACTIONS:
1947-86
To analyze whether fiscal policy has been con
ducted in a manner consistent with the Employment
Act, the last 40 years was divided into 18 periods, as
Ratio
shown in chart 1. In the presumed spirit of the Em
ployment Act, assessments of whether “easier” or
“tighter” fiscal actions were called for were made as
follows: periods when GNP was persistently below
trend were viewed as calling for easier fiscal actions;
periods when GNP was above trend were judged to
19
FEDERAL RESERVE BANK OF ST. LOUIS
call for tighter fiscal actions. A growth of GNP along
trend suggests that fiscal actions were satisfactory.
The subperiods are summarized on the left side of
tables 1-3; the “description" column in these tables
summarizes the relation of GNP to trend during these
periods. “Required policy” follows from our analysis
above. In some cases, because GNP was coming off
such a high level, the early stages of recession were
sometimes lumped in with “expansion above trend”
(see 1/1951—IV/1953 and II/1959-II/1960). Two other re
cessions were not noted separately: 1969-70 and 1980;
the 1969-70 recession appears mild in retrospect and
the 1980 recession was so short, as was the ensuing
recovery, that it was not treated separately. In some
periods, where it is not obvious what the “required
policy” was, such cases are labeled “unknown.”
Tax policy and expenditure policy are examined
separately. The tax system is, in a sense, self perpetu
ating. Once a tax structure is put in place, the eco
nomic system will generate a stream of tax receipts
without further “discretionary action.” Expenditure
policy, on the other hand, is not as automatic. For the
most part, to implement new programs or continue
existing ones, some congressional action is required.
After examining the tax and expenditure policies sep
arately, the two are combined to assess overall fiscal
policy.
Federal Tax Policy
Table 1 summarizes tax policy over the 1947-86
period with the annual rate of change of cyclically
adjusted receipts. This change is termed “restrictive"
or "stimulative,” depending on whether its growth
rate was larger or smaller than that of trend GNP in
current dollars. Using cyclically adjusted receipts as a
measure of discretionaiy action implies that they were
moving as the policymakers wanted them to. For ex
ample, if such receipts were growing significantly
faster than trend GNP, we assume that policymakers
were content with that outcome.'4
According to table 1, over the entire 40-year period,
tax policy was restrictive in 12 of the 18 periods,
although in some cases marginally so (as shown with
14The Commerce Department also calculates another measure,
which purports to be a measure of discretionary tax action. It is
derived from total cyclically adjusted receipts by subtracting an
estimate of the automatic effect of inflation on such receipts (See
Holloway (1984)). The Commerce Department calls this residual
“ receipts change due to discretionary and other factors.” Use of this
alternative measure did not alter the conclusions.
http://fraser.stlouisfed.org/
20 Bank of St. Louis
Federal Reserve
DECEMBER 1987
question marks in table 1). This apparently reflected
the progressive nature of the tax system and the con
tinuing increases in social security taxes, even with
the multitude of tax actions legislated throughout the
periods (see appendix).
To determine the tax policy response to economic
conditions, we focus on those periods when GNP was
persistently above or below trend. For the nine peri
ods in which GNP was below trend — mainly reces
sions and recoveries — tax policy was appropriately
stimulative only three times: II/1960-IV/1961,
11/1974—1/1978 and III/1981-I/1984.
GNP was persistently above trend in only four peri
ods, two of these during wartime. The table shows that
tax policy was restrictive in three of the four cases. The
two wartime periods however, require special men
tion. During the Korean War, corporate, individual
and excise taxes were raised very quickly after the
outbreak of hostilities. As a result, most of the revenue
effect occurred in the IV/1948-I/1951 period while the
economy was still recovering from the 1948-49 reces
sion. In the I/1951-IV/1953 period, on the other hand,
revenues declined in the latter part of the period
because some wartime taxes were allowed to expire.
The Vietnam War was handled much differently. In
the early part of IV/1963-IV/1969, most tax actions were
stimulative rather than restrictive. Not until 1968 and
1969, long after the war had accelerated, were taxes
increased. Because of the 10 percent surcharge on
corporate and individual income taxes in 1968, tax
policy during the IV/1963-IV/1969 period is shown as
restrictive, even though it was stimulative during the
early part of this period.
In summary, tax policy often has not been con
ducted in a manner consistent with the Employment
Act. Tax actions that were taken were usually over
whelmed by other considerations, namely, financing
wars and the social security system. The record has
improved, however, in the 1970s and 1980s. Major tax
cuts were implemented during the 1973-75 recession
and before the 1981-82 recession; during the 1972-74
and 1978-80 periods of excess demand, taxes in
creased faster than GNP.
Federal Expenditure Policy
Table 2 summarizes federal expenditure policy for
the same periods as described in table 1. The measure
of expenditure policy is total cyclically adjusted ex
penditures; the reason underlying the use of this as a
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Table 1
Federal Tax Actions
Rate of
change of
cyclically
adjusted
receipts
Rate of
change of
trend GNP
in current
dollars
Tax
policy
direction
Correct
policy
direction?
11.6%
Stimulative
—
Period
No.
of
quarters
I/47-IV/48
7
Expansion along
trend
IV/48—1/51
9
Recession and
recovery
Stimulative
19.5
7.8
Restrictive
No
1/51 —IV/53
11
Expansion above
trend including
early recession
Restrictive
to
Unknown
- 0 .8
4.5
Stimulative
No
IV/53—1/55
5
Recession and
recovery
Stimulative
7.0
6.4
Restrictive?
No
1/55-111/57
10
Unknown
7.5
6.3
Restrictive?
---
111/57-11/59
7
Recession and
recovery
Stimulative
5.4
4.7
Restrictive?
No
11/59-11/60
4
Expansion along
trend including
early recession
Unknown
to
Stimulative
7.4
4.8
Restrictive
No
11/60—IV/61
6
Mild recession
and recovery
Stimulative
3.9
4.5
Stimulative?
Yes
IV/61 —IV/63
8
Expansion along
trend
Unknown
6.0
5.6
Restrictive?
-
IV/63—IV/69
24
Expansion above
trend
Restrictive
8.9
7.7
Restrictive
Yes
IV/69—1/71
5
Expansion along
trend
Unknown
2.2
9.5
Stimulative
—
1/71—III/72
6
Expansion below
trend
Stimulative
10.7
8.9
Restrictive
No
III/72—II/74
7
Expansion above
trend
Restrictive
13.1
10.3
Restrictive
Yes
Recession and
recovery
Stimulative
9.5
10.4
Stimulative?
Yes
Description
Expansion along
trend
Required
policy
Unknown
0.5%
II/74-I/78
15
I/78—1/80
8
Expansion above
trend
Restrictive
13.6
11.5
Restrictive
Yes
I/80—111/81
6
Short recession
and recovery
followed by
expansion along
trend
Stimulative
to
Unknown
16.4
12.3
Restrictive
No
111/81—1/84
10
Recession and
recovery
Stimulative
3.8
7.1
Stimulative
Yes
I/84-IV/86
11
Expansion along
trend
Unknown
5.7
5.1
Restrictive?
21
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Table 2
Federal Expenditure Actions
Rate of
change of
cyclically
adjusted
expenditures
Rate of
change of
trend GNP
in current
dollars
Expenditure
policy
direction
Correct
policy
direction?
11.6%
Stimulative
—
Period
No.
of
quarters
I/47-IV/48
7
Expansion along
trend
IV/48—1/51
9
Recession and
recovery
Stimulative
9.3
7.8
Stimulative
Yes
1/51—IV/53
11
Expansion above
trend including
early recession
Restrictive
to
Unknown
19.1
4.5
Stimulative
No
IV/53—1/55
5
Recession and
recovery
Stimulative
-1 0 .2
6.4
Restrictive?
No
1/55—111/57
10
Unknown
7.1
6.3
Stimulative?
---
111/57-11/59
7
Recession and
recovery
Stimulative
7.0
4.7
Stimulative
Yes
11/59-11/60
4
Expansion along
trend including
early recession
Unknown
to
Stimulative
2.9
4.8
Restrictive
No
11/60—IV/61
6
Mild recession
and recovery
Stimulative
8.1
4.5
Stimulative
Yes
IV/61—IV/63
8
Expansion along
trend
Unknown
6.2
5.6
Stimulative?
-
IV/63—IV/69
24
Expansion above
trend
Restrictive
9.1
7.7
Stimulative
No
IV/69—1/71
5
Expansion along
trend
Unknown
7.0
9.5
Restrictive
—
1/71-III/72
6
Expansion below
trend
Stimulative
7.8
8.9
Restrictive
No
III/72—II/74
7
Expansion above
trend
Restrictive
13.6
10.3
Stimulative
No
II/74—1/78
15
Recession and
recovery
Stimulative
11.6
10.4
Stimulative
Yes
I/78—1/80
8
Expansion above
trend
Restrictive
12.7
11.5
Stimulative
No
I/80—111/81
6
Short recession
and recovery
followed by
expansion along
trend
Stimulative
to
Unknown
14.8
12.3
Stimulative
Yes
111/81—1/84
10
Recession and
recovery
Stimulative
7.9
7.1
Stimulative?
Yes
I/84-IV/86
11
Expansion along
trend
Unknown
7.0
5.1
Stimulative
http://fraser.stlouisfed.org/
22
Federal Reserve Bank of St. Louis
Description
Expansion along
trend
Required
policy
Unknown
17.1%
FEDERAL RESERVE BANK OF ST. LOUIS
discretionary variable parallels that for cyclically ad
justed receipts.15
To determine whether expenditures were stimula
tive or restrictive, we compare them with trend GNP.
Like cyclically adjusted receipts in table 1, we compare
total expenditures with trend GNP in current dollars.
According to this measure, expenditure actions were
stimulative in fourteen of the eighteen periods. The
overall 40-year period provides a mixed assessment of
expenditure policy. There were nine periods when
economic conditions called for stimulative policy. Ex
penditure policy was stimulative in six of those peri
ods. As noted earlier, total expenditures grew faster
than trend GNP throughout the entire period. Thus, it
is not surprising that expenditure policy just happens
to have moved in the appropriate direction more often
than not when economic conditions called for policy
in a stimulative direction. To refer to such results as an
example of success perhaps overrates them.
There were four periods of high demand, when a
restrictive policy would have been appropriate; in
each case, however, expenditure policy was stimula
tive. Two of these periods encompassed the buildup
for the Korean and Vietnam wars.
On net, like tax policy, federal expenditure policy
has not been consistent generally with the Employ
ment Act. During periods of recession and recovery, it
was stimulative only two-thirds of the time. During
periods of excess demand, it was always stimulative;
two of these periods, however, were associated with
wars.
Total Fiscal Policy
As a final step in assessing whether fiscal policy has
been conducted consistent with the spirit of the Em
ployment Act, we examine measures of total fiscal
policy. An overall measure is derived from tables 1 and
2 and summarized in table 3. It is the dollar change in
expenditures minus the dollar change in receipts,
converted to an annual rate, and divided by the aver
age of trend GNP (in current dollars) over the relevant
subperiod. If this ratio was positive, policy on net was
stimulative over the period. If it was negative, policy
was restrictive.
15The Commerce Department also calculates a direct measure of
discretionary expenditure. Reflecting the effect of cost-of-living es
calator clauses, it is obtained by subtracting an automatic inflation
effect on federal programs from cyclically adjusted expenditures.
Use of this measure did not alter the overall conclusions about
expenditure policy.
DECEMBER 1987
In only four of the 12 nonneutral cases did the
measure of total fiscal policy move in the right direc
tion. These were recession and recovery periods after
1955. When GNP was above trend, the quantitative
measures indicated stimulus in each case, although
the size of the net stimulus usually was very small.
Analysis of this summary measure suggests that fiscal
actions generally have moved in a direction opposite
to that which would be consistent with the Employ
ment Act.
SUMMARY
The Employment Act of 1946 designated a role for
the federal government in stabilizing the level of eco
nomic activity. Economists, in general, interpret this
to mean that monetary and fiscal actions should be
used for that purpose. This article summarizes the
general movement of fiscal policy since the 1946 act.
After reviewing the meaning and measurement of
fiscal policy, fiscal actions were summarized over the
1947-86 period. This was done by dividing the 40-year
period into subperiods depending on the relation of
GNP to its trend value. Various measures of fiscal
action then were examined to determine if such
actions were consistent with the spirit of the Employ
ment Act, focusing on the direction of fiscal response
to economic conditions, not on the impact of fiscal
actions on the economy.
Although various measures of fiscal actions occa
sionally offered different conclusions, some tentative
general conclusions emerged. Fiscal actions during
periods of recession and recovery were usually stimu
lative, although this assertion is somewhat sensitive to
the measure of fiscal action chosen. During periods of
high demand and inflation, fiscal actions tended to be
inappropriate mainly because these were wartime
periods.
Overall, it is impossible to determine accurately
whether the Employment Act has succeeded or failed
in stabilizing the economy. To do so requires an as
sessment of other policies, and perhaps the inherent
stability of private actions, as contributors to the eco
nomic stability and progress of the United States over
the past 40 years.
REFERENCES
Brunner, Karl. “ Fiscal Policy in Macro Theory: A Survey and Evalu
ation,” in R. W. Hafer, ed., The Monetary versus Fiscal Policy
Debate (Rowman and Allenheld, 1986), pp. 33-116.
23
DECEMBER 1987
FEDERAL RESERVE BANK OF ST. LOUIS
Table 3
Federal Fiscal Policy: Summary Indicators (dollar amounts in billions)
Required
policy
Annualized
change of
cyclically
adjusted
expenditures
Annualized
change of
cyclically
adjusted
receipts
Unknown
$ 5.4
$ 0.2
Change in
expenditure
minus change
in receipts
-r trend GNP in
current dollars
Policy
direction
Correct
policy
direction?
Stimulative
—
Period
No.
of
quarters
I/47-IV/48
7
Expansion along
trend
IV/48—1/51
9
Recession and
recovery
Stimulative
3.9
9.6
-2 .1
Restrictive
No
1/51—IV/53
11
Expansion above
trend including
early recession
Restrictive
to
Unknown
10.8
- 0 .5
3.2
Stimulative
No
IV/53—1/55
5
Recession and
recovery
Stimulative
- 7 .8
4.5
- 3 .3
Restrictive
No
I/55—III/57
10
Unknown
5.1
5.4
-0 .1
Restrictive?
---
III/57—II/59
7
Recession and
recovery
Stimulative
5.8
4.6
0.2
Stimulative
Yes
II/59—II/60
4
Expansion along
trend including
early recession
Unknown
to
Stimulative
2.6
6.8
- 0 .8
Restrictive
No
II/60—IV/61
6
Mild recession
and recovery
Stimulative
7.7
3.9
0.7
Stimulative
Yes
IV/61 —IV/63
8
Expansion along
trend
Unknown
6.7
6.5
0.0
Stimulative?
---
IV/63-IV/69
24
Expansion above
trend
Restrictive
13.5
13.0
0.1
Stimulative
No
IV/69—1/71
5
Expansion along
trend
Unknown
14.1
4.3
1.0
Stimulative
—
1/71-111/72
6
Expansion below
trend
Stimulative
17.1
22.0
- 0 .4
Restrictive
No
111/72-11/74
7
Expansion above
trend
Restrictive
34.5
32.1
0.2
Stimulative
No
11/74—1/78
15
Recession and
recovery
Stimulative
41.0
31.2
0.6
Stimulative
Yes
1/78-1/80
8
Expansion above
trend
Restrictive
61.9
59.1
0.1
Stimulative
No
I/80-111/81
6
Short recession
and recovery
followed by
expansion along
trend
Stimulative
to
Unknown
89.3
89.2
0.0
Unknown
III/81-I/84
10
Recession and
recovery
Stimulative
60.1
25.8
1.0
Stimulative
Yes
I/84—IV/86
11
Expansion along
trend
Unknown
64.1
43.1
0.5
Stimulative
---
http://fraser.stlouisfed.org/
24
Federal Reserve Bank of St. Louis
Description
Expansion along
trend
2.1%
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Carlson, Keith M. “ Estimates of the High-Employment Budget:
1947-67,” this Review (June 1967), pp. 6-14.
Change in the Federal Government Deficit, 1970-86,” Survey of
Current Business (May 1985), pp. 25-32.
_________ “ The Critical Role of Economic Assumptions in the
Evaluation of Federal Budget Programs,” this Review (October
1983), pp. 5-14.
Lewis, Wilfred Jr. Federal Fiscal Policy in the Postwar Recessions
(The Brookings Institution, 1962).
Council of Economic Advisers. Economic Report of the President
(U.S. Government Printing Office, 1962).
de Leeuw, Frank, and Thomas M. Holloway. “ Cyclical Adjustment
of the Federal Budget and Federal Debt,” Survey of Current Busi
ness (December 1983), pp. 25—40.
Eisner, Robert.
1986).
How Real is the Federal Deficit? (The Free Press,
Holmans, A. E. United States Fiscal Policy: 1945-59 (Oxford Univer
sity Press, 1962).
Holloway, Thomas M. “ The Economy and the Federal Budget:
Guides to the Automatic Effects,” Survey of Current Business (July
1984), pp. 102-05.
Holloway, Thomas M., and Joseph C. Wakefield.
“ Sources of
Norton, Hugh S. The Quest for Economic Stability: Roosevelt to
Reagan (University of South Carolina Press, 1985).
Pechman, Joseph A.
Institution, 1987).
Federal Tax Policy, 5th ed. (The Brookings
President’s Commission on Budget Concepts. Staff Papers and
Other Materials Revised by the President's Commission (GPO,
October 1967).
Santoni, G. J. “The Employment Act of 1946: Some History Notes,"
this Review (November 1986), pp. 5-16.
Stein, Herbert.
1969).
The Fiscal Revolution (University of Chicago Press,
Tobin, James. “ Budget Deficits, Federal Debt, and Inflation," in
Albert T. Sommers, ed., Reconstructing the Federal Budget
(Praeger Publishers, 1984), pp. 130-49.
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Appendix
Chronology of Major Federal Tax Actions: 1948—86
Listed below are the major tax actions affecting
federal receipts from 1948 through 1986. The list is not
exhaustive but does include the major tax actions. For
greater detail, see the following:
The Annual Report of the Secretary of Treasury,
Budget of the United States Government,
Survey of Current Business,
Joseph A. Pechman, Federal Tap. Policv, 5th ed., The
Brookings Institution, 1987,
Congress and the Nation (Congressional Quarterly,
Inc.I.
1948
1950
Revenue Act of 1948 (enacted 4-2-48 over presi
dent’s veto): individual income tax rates re
duced, standard deduction increased, exemp
tions raised and income splitting allowed;
effective for calendar 1948 with reduced with
holding beginning 5-1-48.
OASDI tax rate raised from 2.0 percent to 3.0
percent.
Revenue Act of 1950 (enacted 9-23-50): individ
ual income tax rates increased, with increased
withholding effective 10-1-50; corporate tax
rates increased, applicable to profits in calen
dar 1950; excise tax rate on gambling devices
raised, 10 percent tax extended to television
sets and deep-freeze units.
1951
Excise Tax Reduction Act of 1954 (enacted 331-54): excise tax rates reduced on jewelry,
some admissions, telephone service and trans
portation of persons.
Internal Revenue Code of 1954 (enacted 8-1654): provided for general reform, with liberal
ized depreciation allowances one of the most
important provisions.
1955
OASDI wage base raised from $3600 to $4200.
1956
Federal-Aid Highway Act of 1956 (enacted 6-2956): excise tax rates increased on gasoline, tires,
etc.
1957
OASDI tax rate raised from 4.0 percent to 4.5
percent.
1958
Excise tax on transportation of property re
pealed.
1959
OASDI tax rate raised from 4.5 percent to 5.0
percent, and wage base raised from $4200 to
$4800.
Excise tax rate raised on gasoline.
1960
Excess Profits Tax Act of 1950 (enacted 1-3-51):
effective 1st quarter 1951 but retroactive to
7-1-50.
OASDI wage base raised from $3000 to $3600.
Revenue Act of 1951 (enacted 10-20-51): individ
ual income tax rates increased, with increased
withholding effective |11-1-51; corporate tax
rate increased (applicable to profits for 3-31-51)
and excess profits credit reduced; excise tax
rates raised on distilled spirits, beer, cigarettes,
gasoline and automobiles, and a new tax en
acted on wagers.
1954
OASDI tax rate raised from 3.0 percent to 4.0
percent.
Expiration of Revenue Act of 1951: individual
income tax rates reduced.
Excess profits tax allowed to expire.
http://fraser.stlouisfed.org/
26 Bank of St. Louis
Federal Reserve
OASDI tax rate raised from 5.0 percent to 6.0
percent.
Excise tax rate raised on tires, tubes and heavy
trucks.
1961
Unemployment insurance tax rate raised from
3.0 percent to 3.1 percent.
1962
OASDI tax rate raised from 6.0 percent to 6.25
percent.
Unemployment insurance tax rate raised from
3.1 percent to 3.5 percent.
Revenue Act of 1962 (enacted 10-16-62): tax
credit for investment in equipment allowed.
Depreciation guidelines and rules revised.
1963
OASDI tax rate raised from 6.25 percent to 7.25
percent.
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
Unemployment insurance tax rate reduced
from 3.5 percent to 3.35 percent.
1964
Excise Tax Reduction Act of 1965 (enacted 621-65): excise tax rates reduced on automobiles
and air conditioners (retroactive to 5-15-65).
to $650 in 1971, to $700 in 1972 and to $750 in
1973; standard deduction increased from 10 to
15 percent over a three-year period beginning
in 1971; maximum marginal rate introduced of
50 percent on earned income (maximum rate
on unearned income remained at 70 percent);
surcharge extended to 6-30-70 at a 5 percent
rate; scheduled reductions in excise tax rates
on automobiles and telephone services post
poned until 1-1-71; investment tax credit gen
erally repealed for corporations for property
constructed, reconstructed or acquired after
4-18-69.
Second stage of Excise Tax Reduction Act of
1965.
Unemployment insurance tax rate raised from
3.1 percent to 3.2 percent.
Unemployment insurance tax rate reduced
from 3.35 percent to 3.1 percent.
Revenue Act of 1964 (enacted 2-26-64): individ
ual and corporate tax rates reduced, with re
duced withholding effective 3-1-64.
1965
1966
Second stage of Revenue Act of 1964.
OASDI tax rate raised from 7.25 percent to 8.4
percent, and wage base raised from $4800 to
$6600.
Tax Adjustment Act of 1966 (enacted 3-15-66):
graduated withholding of individual income
taxes introduced, effective 5-1-66, and corpo
rate income taxes accelerated (the act did not
alter tax liabilities).
1970
Excise, Estate and Gift Tax Adjustment Act of
1970: repeal of excise tax rates on automobiles
and telephone services extended to 1-1-72; col
lection of estate and gift taxes accelerated.
1971
OASDI tax rate raised from 8.4 percent to 8.8
percent.
Investment tax credit restored, effective 3-9-67
(enacted 6-13-67).
1968
Job development tax credit effective 8-15-71.
OASDI wage base raised from $6600 to $7800.
Import tax surcharge effective 8-15-71.
Revenue and Expenditure Control Act of 1968
(enacted 6-28-68): 10 percent individual in
come tax surcharge imposed, with withhold
ing effective 7-1-68 but retroactive to 4-1-68
(scheduled to expire 6-30-69): 10 percent cor
porate tax surcharge imposed, applicable to
profits in calendar 1968 (scheduled to expire 630-69); scheduled 4-1-68 reduction in the 7 and
10 percent excise tax rates on automobiles and
telephone services postponed until January
1970.
1969
OASDI tax rate raised from 8.8 percent to 9.6
percent.
Revenue Act of 1971 (enacted 12-10-71): sched
uled increases in personal exemptions and the
standard deduction accelerated by one year
(see Tax Reform Act of 1969); 7 percent excise
tax on automobiles repealed retroactive to 815-71 and excise tax on small trucks and transit
buses repealed retroactive to 9-22-71; 7 percent
investment tax credit reinstated.
Elimination of import tax surcharge effective
12-20-71.
1972
OASDI wage base raised from $7800 to $9000.
Covered wages for unemployment insurance
tax raised from $3000 to $4200.
The 10 percent surcharge, previously sched
uled to expire 6-30-69, extended to 12-31-69.
Tax Reform Act of 1969 (enacted 12-30-69 but
generally effective beginning in 1970): personal
exemption increased from $600 to $625 in 1970,
OASDI tax rate raised from 9.6 percent to 10.4
percent.
Treasury's asset depreciation guidelines (is
sued in June 1971) gave firms the option of
raising or lowering the “guideline lives” of de
preciable assets by up to 20 percent, effective
for calendar 1970. (This administrative action
was, for the most part, incorporated into legis
lation as part of the Revenue Act of 1971).
Investment Credit Suspension Act of 1966 ef
fective 10-10-66.
1967
Surcharge expired on 7-1-70.
1973
OASDI tax rate raised from 10.4 percent to 11.7
percent, and wage base raised from $9,000 to
$10,800.
27
FEDERAL RESERVE BANK OF ST. LOUIS
1974
DECEMBER 1987
Unemployment insurance tax rate raised from
3.2 percent to 3.28 percent.
Unemployment insurance tax raised from 3.2
percent to 3.4 percent.
OASDI wage base raised from $10,800 to
$13,200.
Excise tax on telephone service reduced.
Tax Reduction and Simplification Act (enacted
5-23-77); effective 6-1-77, standard deduction
modified, reducing withholding; jobs tax
credit for corporations enacted.
Unemployment insurance tax rate reduced
from 3.28 percent to 3.2 percent.
1975
OASDI wage base raised from $13,200 to
$14,100.
1978
Import fees on petroleum products increased
$1 per barrel on 2-1-75.
Covered wages for unemployment insurance
tax raised from $4,200 to $6,000.
Tax Reduction Act of 1975 (enacted 3-29-75):
generally effective retroactive to 1-1-75; individ
ual income taxes reduced including a $8.1 bil
lion rebate on 1974 income and with lower
withholding rates effective 5-1-75 reflecting in
creases in the minimum and standard deduc
tions and a $30 credit against taxes paid on
1975 income; investment tax credit increased
from 7 percent (4 percent for utilities) to 10
percent for property acquired between 1-21-75
and 1-1-77; corporate surtax exemption in
creased from $25,000 to $50,000 and rate on
first $25,000 reduced from 22 to 20 percent; oil
depletion allowance repealed and limits
placed on corporate use of foreign tax credits
and deferral.
Excise tax on telephone service reduced.
Revenue Act of 1978 (enacted 11-6-78): effective
1-1-79; personal exemption increased from
$750 to $1,000, replacing the temporary general
tax credit; tax brackets indexed, tax rates cut
and zero bracket amount increased; earned
income credit increased and deductions for
state and local fuel taxes repealed; corporate
tax rates reduced; broadened and made per
manent the investment tax credit at 10 percent;
jobs tax credit modified.
Energy Tax Act of 1978 (enacted 11-9-78): tax
credits allowed for energy-conserving expend
itures retroactive to 4-20-77.
Import fees increased $1 per barrel on petro
leum products on 6-1-75.
Revenue Adjustment Act of 1975; ongoing pro
visions of the Tax Reduction Act of 1975 essen
tially extended, except for the tax rebate.
1976
1977
Foreign Earned Income Act of 1978 (enacted
10-15-78): tax laws liberalized for U.S. citizens
living abroad.
1979
OASDI wage base raised from $14,100 to
$15,300.
Tax Reform Act of 1976 (enacted 10-4-76): indi
vidual income provisions of the Revenue Ad
justment Act of 1975 essentially extended in
cluding extending the per capita tax credit and
the refundable earned income credit, making
permanent the standard deduction of $2,400
for single returns and $12,800 for joint returns;
estate tax exemption raised; the corporate in
come provisions of the Revenue Adjustment
Act of 1975 extended, including reduction in
corporate tax rates extension of surtax exemp
tion of $50,000 through 1977 and extension of
the investment tax credit through 1980.
OASDI wage base raised from $15,300 to
$16,500.
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28 Bank of St. Louis
Federal Reserve
OASDI tax rate raised from 11.7 percent to 12.1
percent and wage base raised from $16,500 to
$17,700.
OASDI tax rate raised from 12.1 percent to 12.26
percent and wage base raised from $17,700 to
$22,900.
Excise tax on telephone service reduced.
1980
OASDI wage base raised from $22,900 to
$25,900.
Crude Oil Windfall Profit Tax Act of 1980 (en
acted 4-2-80); retroactive to 3-1-80; corporate
tax reduced because of deductibility of wind
fall profits tax which is an excise tax; excise tax
on telephone service reduced; temporary fee of
$4.62 per barrel placed on imported crude oil
effective 3-15-80.
Omnibus Reconciliation Act of 1980: effective 11-81; use of tax-exempt mortgage subsidy
bonds restricted for individuals and corpora
tions.
FEDERAL RESERVE BANK OF ST. LOUIS
1981
DECEMBER 1987
OASDI tax rate raised from 12.26 percent to 13.3
percent and wage base raised from $25,900 to
$29,700.
increase in 1984 reduced by 0.3 percentagepoint; self-employed tax rate increased; cover
age of new federal civilian employees and em
ployees of nonprofit organizations made
mandatory; taxation of social security benefits
required when income exceeds certain levels.
Economic Recovery Tax Act of 1981 (enacted 813-81): cost recovery system accelerated for
corporations, applicable to 1981 income; credit
for the windfall profits tax increased for corpo
rations; individual income tax rates reduced 25
percent over 33 months with the first stage a 5
percent cut on 10-1-81.
1982
OASDI tax rate raised from 13.3 percent to 13.4
percent and wage base raised from $29,700 to
$32,400.
Economic Recovery Tax Act of 1981: third stage
of tax reduction, 10 percent on 7-1-83.
Railroad Retirement Revenue Act of 1983 (en
acted August 1983): changes similar to Social
Security Amendments introduced.
1984
Economic Recovery Tax Act: tax rates reduced
on income not subject to withholding and ex
clusion from gross income of interest and divi
dends repealed; estate and gift taxes reduced.
Tax Equity and Fiscal Responsibility Act of
1982 (enacted 9-3-82): modified coinsurance
transactions repealed effective 1-1-82; various
modifications and restrictions for leasing en
acted, generally effective 7-1-82; airport and
airway taxes increased effective 9-1-82.
Deficit Reduction Act of 1984 (enacted 7-18-84):
tax-exempt entity leasing restricted; deprecia
tion period for real property lengthened; tax
ation of life insurance companies modified;
interest exclusion as allowed for under Eco
nomic Recovery Tax Act of 1981 repealed; in
come averaging modified.
1985
Economic Recovery Tax Act of 1981: second
stage of tax reduction, 10 percent on 7-1-82.
1983
Economic Recovery Tax Act of 1981: indexing
of individual income tax began.
Unemployment insurance tax raised from 3.4
to 3.5 percent, and covered wages raised from
$6,000 to $7,000.
Highway Revenue Act of 1982 (enacted 1-5-831:
tax on gasoline and diesel fuel increased from
4 to 9 cents per gallon effective 4-1-83; general
taxes repealed on tires, lubricating oil, and
retail sales of lightweight trucks and trailers;
taxes increased on heavy-duty trucks and
trailers.
Social Security Amendments of 1983 (enacted
April 1983): previously scheduled tax rate in
crease accelerated; employee share of the rate
OASDI tax rate raised from 14.0 percent to 14.1
percent, and wage base raised from $37,800 to
$39,600.
Unemployment insurance tax raised from 3.5
to 6.2 percent.
OASDI wage base raised from $32,400 to
$35,700.
Tax Equity and Fiscal Responsibility Act of
1982: compliance provisions of individual in
come tax strengthened and casualty and medi
cal expense deductions modified; basis for in
vestment tax credit for corporations adjusted
and contract method of accounting modified;
cigarette tax doubled to 16 cents per pack on 11-83 and excise tax increased on telephone
service from 1 percent to 3 percent.
OASDI tax rate raised from 13.4 percent to 14.0
percent, and wage base raised from $35,700 to
$37,800.
Tax Equity and Fiscal Responsibility Act of
1982: accelerated depreciation schedules for
1985 to 1986 under the Economic Recovery Tax
Act of 1981 repealed.
Deficit Reduction Act of 1984: alcohol tax in
creased from $10.50 to $12.50 per proof gallon
effective 10-1-85.
1986
OASDI wage base raised from $39,600 to
$42,000.
Consolidated Omnibus Budget Reconciliation
Act of 1985 (enacted 4-7-86): excise tax on coal
production increased; medicare coverage ex
tended to new state and local employees.
Tax Reform Act of 1986 (enacted 10-22-86): fed
eral tax system overhauled by broadening the
individual and corporate tax bases and lower
ing individual and corporate tax rates; gener
ally effective 1-1-87 except for repeal of invest
ment tax credit effective 1-1-86 and transition
to modified depreciation schedules effective
for property placed in service after 7-31-86.
FEDERAL RESERVE BANK OF ST. LOUIS
DECEMBER 1987
FEDERAL RESERVE BANK OF ST. LOUIS
REVIEW INDEX 1987
JANUARY
JUNE/JULY
Richard G. Sheehan, “ Does U.S. Money Growth Deter
mine Money Growth in Other Nations?”
Mack Ott, “The Growing Share of Services in the U.S.
Economy — Degeneration or Evolution?”
Steven M. Fazzari, “Tax Reform and Investment: How
Big an Impact?”
Steven M. Fazzari, “Tax Reform and Investment: Bless
ing or Curse?”
FEBRUARY
John A. Tatom, “The Macroeconomic Effects of the
Recent Fall in Oil Prices”
Mack Ott, “The Dollar’s Effective Exchange Rate: As
sessing the Impact of Alternative Weighting Schemes”
Philip A. Nuetzel, “The FOMC in 1986: Flexible Policy for
Uncertain Times”
MARCH
Beryl IM. Sprinkel, “Confronting Monetary Policy Dilem
mas: The Legacy of Homer Jones”
Michael T. Belongia, “ Predicting Interest Rates: A Com
parison of Professional and Market-Based Forecasts”
G. J. Santoni, “ Changes in Wealth and the Velocity of
Money”
APRIL
Kenneth C. Carraro, “A Review of the Eighth District’s
Agricultural Economy in 1986”
AUGUST/SEPTEMBER
Courtenay C. Stone and Daniel L. Thornton, “ Solving the
1980s’ Velocity Puzzle: A Progress Report”
R. Alton Gilbert, “ A Revision in the Monetary Base”
OCTOBER
Thomas Gale Moore, “ Farm Policy: Justifications, Fail
ures and the Need for Reform”
C. B. Baker, “ Changes in Financial Markets and Their
Effects on Agriculture”
Geoff Edwards, “ U.S. Farm Policy: An Australian Per
spective”
Lynn M. Barry, “ A Review of the Eighth District’s Bank
ing Economy in 1986”
NOVEMBER
Thomas B. Mandelbaum, “A Review of the Eighth Dis
trict’s Business Economy in 1986”
Thomas B. Mandelbaum, “ Is Eighth District Manufactur
ing Endangered?”
MAY
G. J. Santoni, “ The Great Bull Markets 1924-29 and
1982-87: Speculative Bubbles or Economic Fundamen
tals?”
Dallas S. Batten and Michael T. Belongia, “ Do the New
Exchange Rate Indexes Offer Better Answers to Old
Questions?”
G. J. Santoni, “ Has Programmed Trading Made Stock
Prices More Volatile?”
Michael T. Belongia and R. Alton Gilbert, “Agricultural
Banks: Causes of Failures and the Condition of Survi
vors”
http://fraser.stlouisfed.org/
30 Bank of St. Louis
Federal Reserve
DECEMBER
Kees G. Koedijk and M ack Ott, “ Risk Aversion, Efficient
Markets and the Forward Exchange Rate”
Keith M. Carlson, “ Federal Fiscal Policy Since the Em
ployment Act of 1946”
@FedFRASER