View original document

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

For release on delivery
(12:00 NOON E.S.T.)
FEBRUARY 26, 1985

Remarks by

Lyle E. Gramley
Member
Board of Governors of the Federal Reserve System
before
The National Association of Business Economists
Seminar on
Economic Policy In The Next Four Years
Washington, D.C.
February 26, 1985

It is a pleasure to address the distinguished members of
the National

Association

of Business

Economists

on

the

occasion

this seminar on "Economic Policy in the Next Four Years."

My remarks

today will not be tied to any particular four-year cycle —

political,

or

otherwise,

but

they

are

designed

to

cf

tie

economic,

in with

the

principal theme of the seminar.

The current recovery is now a little over two years old.
The

overall

average

for

rate

the

of

economic

comparable

Inflation, however,

expansion

period

of

has not accelerated;

has

been

earlier

well

postwar

in fact,

above

the

recoveries.

it appears to have

moderated somewhat during the course of the recovery.

Interest rates

have risen, as they typically do during a cyclical expansion, but the
percentage increases

in both short- and long-term interest rates are

not, thus far, out of line with those in earlier postwar recoveries.
While
abound,

difficulties

in

individual

sectors

and

regions

the performance of the macroeconomy during this recovery has

been more trouble free than most of us had expected.

The economy and

financial markets have been subjected to an enormous amount of fiscal

stimulus —

the increase in the structural Federal deficit since

The author gratefully acknowledges the assistance of Peter Hooper and
Peter Isard in the preparation of this talk, while taking full
responsibility for any mistakes contained herein.

early

1981

period.

has
But

been
the

of unprecedented

dire

financial

dimensions

consequences

for a peacetime

of those

deficits

that many economists and others had expected by and large have not
happened.

It
international

come.
imports

The

would

be

sector

have

exchange

have

widely
played

value

expanded

at

agreed

of

an

the

that

developments

important

dollar

an unprecedented

account deficit has widened dramatically.

has

role

in

in this

increased

the
out­

greatly;

rate,

and

the

current

These

events have had

important effects on our overall economic growth rate, on the rate
of inflation, and on interest rates.
I must confess that I know less about the interaction
between

domestic

would like.

recovery,

and

international

developments

Perhaps some of you share that feeling.

the need

to worry

acute than it is currently.

make a small contribution

area.

economic

about

the

than

I

Until this

interconnections

was

less

What I would like to . o today is to
1

to improving our understanding

in this

I warn you that I am only scratching the surface of a large

and important subject.

3

-

-

A Measure of External Restraint
From

the

fourth

quarter

of

1980

through

the

fourth

quarter of 1984, the value of the dollar in exchange markets on a

trade-weighted

basis

roughly 65 percent.
in our

using

major

foreign

currencies

rose

by

It did so despite steadily widening deficits

merchandise

consumer

against

trade

prices

and

here

current

and

abroad

accounts.

In real

as measures

of

terms,

inflation,

the increase was about 60 percent.

So large

seem to have
domestic
measuring
measures

exerted

output.
it
of

that

a change

a good

How

large

would

stimulus

or

in

the

deal

of

the

of restraint

might

permit

value

it

be?

Is

comparisons

restraint,

such

on

with

as

dollar

the

there
other

those

would

growth

of

a

of

way

familiar

employed

for

fiscal policy?
We

all

know

that

to

analyze

the

effects

of

fiscal

policy on the economy and on financial markets, the actual deficit

in the Federal budget is a potentially misleading indicator.

The

actual deficit reflects the effects of the economy on the budget,

-li­
as well as the effects of the budget on the economy.

Measures of

the high-employment deficit, also known as the structural or stan­

dardized deficit, are designed to get around this problem.

Similarly,

measures such as the current account defi­

cit, or the gap between GNP and domestic aggregate demand, reflect

lines of causation running both ways between the domestic economy
and the international sector.

A measure of external

restraint is

needed that avoids this problem.

In
associated

with

constructed.
exchange

principle,
a

Take

change
an

such
in

a
the

assumed,

rate and multiply

of

exchange

or

external

rate

observed,

can

change

restraint
be

in

readily
the

real

it by estimated price elasticities of

demand for imports and exports.
change

measure

The resulting estimates of volume

for imports and exports are then multiplied by the prices

of imports and exports expected in the absence of a change in the

exchange rate.

The

course,

an

source of a change

important

issue

to

in

which

the

I

exchange

will

rate

return

is,

of

shortly.

Setting

that

described

issue

(or

its

aside

for

equivalent

the

moment,

performed

with

the
the

exercise

just

assistance

of a

model of the current account) yields an estimate of the impact of

the change

evaluated

Thus,

in the

at

exchange

rate

predetermined

on the current account

prices,

without

feedback

deficit,

effects.

it measures the first-round effect on demands for goods and

services produced in the domestic economy.

Such

a

measure

of

external

restraint

(or

ease)

is

analogous in all respects save one to the effects on the economy,
and on

financial

budget deficit.

markets,

of a change

In one very important

in the structural Federal
respect,

however,

the two

concepts differ.

A

change

in

direct effect on prices,

the

structural

Federal

deficit

has

no

so that its influence on interest rates,

ignoring expectational effects,

results from its impact on aggre­

gate demand for goods and services.

An exchange rate change, how­

ever, directly affects both prices and aggregate demand.

There is

therefore a direct effect on real money balances that is absent in

the case of a change

in the structural

budget deficit.

Thus,

a

rise in the exchange rate reduces real GNP through its effect on

relative

prices

of

imports

effect" of the appreciation.

lowers

the

average

level

and

exports.

This

is

the

"fiscal

However, since the appreciation also

of

prices,

other

things

equal,

it

increases real money balances and through that channel has a stim­

ulative effect on the economy.

We may say,

therefore,

that

the

measure of external restraint I have described has fiscal effects
on markets for goods and services,

and also on financial markets,

analogous to those of a change in the structural Federal deficit.
But exchange rate changes also have monetary effects that need to
be carefully considered.
Estimation

exchange

rate

restraint is subject to a particularly wide margin of error.

This

is

true

imports

because

and

of

calculated

exports

periods during which

such

a

price

measure

of

elasticities

necessarily

are

based

the dollar's

exchange

on

of

demand

historical

for

time

value changed consid­

erably less than it has in the past four years.

-

With
Board

staff's

percent

that caveat

model

of

appreciation

four years

has

7-

in mind,

the

of

produced

current

the

dollar

an

impact

estimates generated

account

in

suggest

real

terms

that

over

by the
the

the

effect on the current

60

past

account

deficit (at predetermined prices and without feedbacks) of approx­

imately
trade

$175

flows,

domestic

b i l l ion. V

adjustment

of

not all of this impact effect has yet been felt

in

markets.

The

Because

part

that

of

lags

has

in

already

the

been

felt,

around

$140 billion, is approximately equal to the increase in the struc­
tural Federal budget deficit over the same period.

If one took these estimates of external
face

value

mean

that

rise had
Federal

(and
the

I do

fiscal

largely
deficit

not

effects

offset
on

suggest

the

economic

that

associated
effects

of

activity,

anyone
with
the
and

restraint

should),
the

also

it would

exchange

increased

at

rate

structural

on

financial

markets.

Taking into account the fiscal effects of the exchange

rate

change

TTThTs

alone,

however,

would

be misleading.

The

monetary

figure may appear unusually large.
However, It reflects
estimates of price elasticities of demand of close to unity for
both imports and exports, although only about half of a change in
the exchange rate is reflected in changes in average import
Drices,

-

effects are substantial.

exchange rate

quarter

of

The

that occurred

1984

would

8

65

-

percent

increase

in the

nominal

in the four years ended in the fourth

ultimately

reduce

the

level

of

prices

by

roughly 5 to 7 percent, according to Board staff estimates.

How

balances

policy.

years

would

large

an

depend,

effect

of

this

course,

would

on

the

have

on

response

real

of

money

monetary

What monetary policy might have been during the past four

had

the

dollar's

foreign

exchange

value

remained

unchanged

is, I submit, unknowable.
If one

given,

however,

takes

the

the

growth

of

anti-inflationary

nominal

effect

of

money

the

balances

rise

in

as

the

exchange rate, through its impact on real money balances, has had a
significant stimulative effect on domestic aggregate demand.

Esti­

mates derived from the Board staff's multi-country model (MCM) sug­

gest that the monetary effects of the four-year rise in the dollar

on growth of the U.S.

economy have thus far offset roughly half of

the fiscal effects in markets for goods and services.

In financial

markets,

on the other hand,

the fiscal and monetary effects of the

appreciation are not offsetting;

they are additive.

Both act to

reduce nominal interest rates.

If the estimate of the fiscal

appreciation

cited

earlier

esting conclusions follow.

is

effects of the dollar’s

approximately

correct,

some

inter­

First, the effect on economic growth of

the rise in the structural Federal deficit was not fully offset by

the

combined

change.

fiscal

Second,

and

monetary

effects

the impact on interest

of

the

rates of

exchange

the

rate

increase

in

the structural Federal budget deficit, on the other hand, has been

more than fully offset by the combined fiscal and monetary effects
of the exchange rate change.
There

may

be

some

of

you

who

hold

to

the

view

that

large and rising structural budget deficits do not affect interest
rates,

and

disastrous

that

that

results

is why

widely

such

deficits

forecast

uncomfortable with that hypothesis,

have

earlier.

not

To

produced

those

I offer you another

who

—

and

the

are

in

my view intellectually more satisfying -- explanation to consider.

-

10

-

Why Did the Exchange Rate Rise?

Let

me

turn

next

to

increase in the exchange rate.

the

question

of what

There are two principal

one is that a widening differential between U.S.

interest

rates has been a major

variety of possible reasons,

ferences

toward

factor;

the other

claims

at

the

theories:

and foreign real

is that,

there has been a shift

dollar-denominated

rate differentials.

caused

given

for a

in asset pre­

real

interest

There is merit in both hypotheses.

Supporting the asset-preference shift hypothesis is the
fact

that

foreign

dramatically
crisis.

in

lending

recent

Moreover,

by U.S.

years,

commercial

reflecting

the

banks

has

declined

international

debt

a number of Latin American countries have expe­

rienced larger capital outflows since 1981 from which the U.S. pro­
bably

benefitted.

There

have

been

some

regulatory

changes

that

might have increased the net demand for dollar-denominated assets.

The Japanese, for example, have relaxed restraints on their capital

markets

and

on

Japanese

investors.

Additionally, many money

11

-

-

market observers believe that the recent expansion

of the U.S.

vailing

in

economy contrasts

Western

Europe

so

that

starkly with

it

has

the

attracted

stagnation

sizable

pre­

flows of

funds to our shores.

If such sources of capital inflow helped to account for

a rising dollar exchange rate in the face of burgeoning trade defi­

cits, foreign investors evidently held expectations that the U.S. is
an attractive

country

likely to remain

in which

strong

tudes and expectations,
real

interest

rates

to invest,

for the near

however,

on U.S.

and

that

the

future at least.

would also suggest

financial

assets

dollar

is

Such atti­

that a rise in

in relation

to those

abroad would also be a powerful magnet attracting inflows of funds.
Estimates

derived

from

the

MCM,

in which

the

exchange

rate is determined endogenously,£/ suggest that both hypotheses have

27 The dollar *s exchange valued measured against a basket of major
foreign currencies is proximately determined in the model as a func­
tion of U.S. & foreign price levels, inflation rates and interest
rates.

a

role

to

play.

Real

interest

rate

differentials

in

the

model

explain a little over one-half of the rise in the real exchange rate

over the past four years,

although the confidence

estimate

remainder

reflect

is wide.3/

shifts

in

The

asset

band around

is unexplained,

preferences

at

existing

that

and might

thus

interest

rate

differentials.

3/ By one measure, the difference between U.S. and average foreign
long term real interest rates had risen by nearly 7 percentage
points from its low point in 1979 to its peak in mid-1984.
In
recent months U.S. real rates have declined about 2 percentage
points relative to rates abroad, but the differential remains 5 per­
centage points above its 1979 trough.

13-

-

Effects of Endogenous Exchange Rate Changes
For

rise

in

rates

the

in

ease

of

exchange

the

reference,

rate

United

due

States

let

to

the

the

us

call

that

increase

’endogenous"
’

in

part

real

part.

of the

interest

Endogenous

exchange rate changes are likely to be a characteristic

feature of

future business cycles,

and they will have a bearing on the cycli­

cal

significant

movements

bles.

When

cyclical

of

the

changes

abroad,

cyclical

dampened.

The

some

dollar's
in

exchange

relative

movements

dampening

of

economic

value

levels
in

of

prices

interest

and

financial

responds
interest
and

rate

sensitively
rates

interest

swings

varia­

here
rates

also

to
and
are

implies

a

moderation of cyclical changes in money velocity.

Assuming a given

growth

smaller

rate of the money

stock,

that

also

means

cyclical

swings in nominal GNP.
The more difficult

effects

on

nonfinancial

questions

variables.

to answer pertain

Obviously,

smaller

to the

cyclical

swings in interest rates mean less cyclicality in housing and other

credit-sensitive sectors of the economy.

expansion

phase of the recovery

partly

"Crowding out" during the

takes

the

form

of reduced

net exports, as has been the case during the current recovery.

-1 4 What is not so cleat-, however,

tude of crowding out is affectecu

increase

less during

the exchange

rate,

a recovery

Thus,

because

is how the total magni­

although nominal GNP will

of an

endogenous

prices will also rise less,

rise

in

so that the effect

on real GNP is indeterminate.
Simulations

this

question.

period

of

They

several

done with

suggest

years

the MCM provide some

that

coming

the

from,

rise

say,

in

real

an increase

insight on

GNP

over

a

in private

spending propensities is reduced if the exchange rate is driven up
by

rising

fact

that

effects

of

U.S.

real

over

a

interest

period

dollar

of

rates.

That

result

several

years,

the

appreciation

outweigh

the

stems

from

negative

positive

The principal

of an

however,

rise

in the exchange

rate,

fiscal

monetary

effects in markets for goods and se rv ic esV
endogenous

the

effect

is to alter

the form of crowding out, rather than its overall magnitude.
¥7 This conclusion would not necessarily hold for all models, or
even for a particular model over different time periods.
For
example, in the Board staff's MPS model, the interest elasticities
of investment are much higher than in the MCM model.
As a result
the monetary effects of an exchange rate change dominate the fiscal
effects in goods markets even over very short time periods.
In the
MCM, moreover, the monetary effects increase gradually over time
and eventually become as large as the fiscal effects.

-

15-

Looking to the Future
Let me turn now to what the line of analysis I have pur­

sued might suggest for the course of the economy and economic policy

in the years ahead.
The

around

$100

current

billion.

account

Most

deficit

in

projections

1984

apparently

anticipate

current account deficits in 1985 and 1986.

still

was

larger

In subsequent years,

it

is possible that changes in relative economic growth rates here and

abroad might help to reduce those deficits somewhat.

however,

it

seems

unlikely

that

external

lished at any time in the foreseeable

Realistically,

balance

can

future without

be

reestab­

a substantial

decline in the real value of the dollar in exchange markets.
Current
tudes

would

nonresident

imply
net

foreign wealth.

some

point

resisted

by

or

account

deficits

substantial

claims

on

Portfolio

remaining

increases

the

during

years

magni­

ahead

in

foreign

GNP

balance considerations

suggest

that,

at

holdings

will

be

future

investors

unless

relative

the

current

to

other,

U.S.

near

increases

real

further relative to those abroad.

in

interest

such

rates

in the U.S.

and

rise

-

16

-

Based on that line of reasoning,

forecasts of an immi­

nent fall in the value of the dollar have been common for at least

two and a half years.
evidently

because

Those forecasts have been decisively wrong,

there

has

been a large and continuing

shift

in

preferences for dollar-denominated assets, relative to assets deno­
minated

in

foreign

currencies,

at

given

interest

rate

differentials.
I have no idea how long it will

our

external

exchange

debt

rate.

to

But

begin

when

States may have already

exerting

downward

I contemplate

become a net

take

the

for the rise of

pressure

fact

that

international

on

the

the United

debtor,5/ that

our country is borrowing abroad at a rate of $100 billion a year or
more

—

which

debt

to

$1

in

ten

trillion

years
or

would

more

—

increase
I wonder

our
if we

net
may

international
not

soon

be

approaching a day of reckoning.
5/ Official measures of our international assets and liabilities
suggest that, at the end of 1984, the United States was still a net
international creditor.
However, to the extent that statistical
discrepancies in balance of payments accounts during recent years
may largely reflect unrecorded net capital inflows, the United
States may already have become a net international debtor.

-

Imagine,
of

balance

in

our

17-

if you will, what it would mean if restoration
external

real value of the dollar

accounts

to

its

required

level

four

a

reduction

years

ago.

in

the

We would

then be facing a source of external stimulus whose fiscal effects

in markets for goods and services, and in financial markets,

be larger

than

years

the

in

those stemming

structural

from the increase

Federal

budget

might

in the past four

deficit.

The

monetary

effects of a decline in the dollar would offset the fiscal effects

in goods markets,

markets.

but would add to the fiscal effects in financial

That is because prices would be driven up by the fall in

the exchange rate,

real money balances would decline,

rate pressures would
and

intensify.

credit-sensitive

sectors

and interest

Net exports would be crowded in,

of

the

domestic

economy

would

be

crowded out.

If the structural deficit in the Federal budget were

still

when

rising

the

dollar

began

to

fall,

the

impact

economy, and financial markets, would be that much larger.

on

the

18

-

-

I do not hold to an apocalyptic

spects for the years ahead.

view of economic

pro­

A significant decline in the dollar is

probably necessary and desirable to help restore external

balance,

and to ease the strains on agriculture and other sectors suffering

from

strong

price

competition

from

foreign

producers.

But

an

abrupt decline may be avoidable if the U.S. follows sensible macro-

economic

policies.

complacency.

In

this

Reduction

respect,

in the

there

structural

is

little

deficit

room

in the

for

federal

budget is badly needed for reasons unrelated to potential develop­
ments

in the

dollar

international

could

fall

sector.

substantially

But the possibility
over

the

next

few

that the

years

adds

urgency to the discussions of deficit reduction presently underway

in Washington.
Possible

sector

policy.

have

One

future

implications

sometimes

developments

for

hears

more room to be expansive now,

monetary

statements

in

policy

the

as

international

well

that monetary

since inflation

as

fiscal

policy

is under good

has

con­

trol, or that monetary policy should be easier because the exchange

-

rate is so high.

19-

There is a germ of truth to such arguments,

but

danger lies ahead if they are taken too literally.

Let us remember that weakness

stemming

from a rising exchange

in the domestic

rate tends

economy

by itself to create a

more expansive monetary policy, by reducing prices and raising the

the stock of real money balances.

anti-inflationary

rise

over

the

benefits

past

four

Let us remember

that we have enjoyed

years may

prove

to be

also

that

the

from the dollar's

transitory

to the

extent that reestablishment of external balance requires a decline
in the international value of the dollar.

Progress against inflation over the past five years has

required

problem

a

is

achieved,

tough

not

battle.

yet

behind

and developments

The

costs

have

us;

price

stability

in the international

years ahead seem likely to create

inflation under control.

been

very

has

high.

not

yet

The

been

sector during the

renewed difficulties

in keeping

We in the Federal Reserve would be well

advised to keep that in mind in our current decisions on monetary

policy.
//*#################