Front Matter

Front Matter

Editor(s):
Paul Masson, Jacob Frenkel, Ralph Bryant, David Currie, and Richard Portes
Published Date:
June 1989
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    The Brookings Institution
    Centre for Economic Policy Research
    International Monetary Fund

    © 1989 International Monetary Fund

    Cover design by the IMF Graphics Section

    Library of Congress Cataloging-in-Publication Data

    Macroeconomic policies in an interdependent world / edited by Ralph C. Bryant… [et al.].

    • p. cm.

    Papers from a conference held at the Brookings Institution in Dec. 1988, sponsored by the institution, the International Monetary Fund, and the Centre for Economic Policy Research.

    ISBN 1-55775-111-0 (Centre for Economic Policy Research)

    1. International economic relations—Congresses. 2. Economic policy—Congresses. 3. Macroeconomics—Congresses. I. Bryant, Ralph C., 1938–II. Brookings Institution. III. International Monetary Fund. IV. Centre for Economic Policy Research (Great Britain)

    HF 1352.M34

    1989

    339.5—dc20

    89-24417

    CIP

    Price: US$17.50

    Preface

    This collection of essays is a joint publication of the International Monetary Fund, The Brookings Institution, and the Centre for Economic Policy Research (CEPR). Each essay focuses on some aspect of international economic interdependence, and the book itself is the result of an international collaboration in the production and dissemination of economic research.

    During the four and a half decades since the establishment of the International Monetary Fund, its staff has been a leading contributor to the development of knowledge about the functioning of the world economy and about the effects of national economic policies. In recent years, the Fund staff has been actively cooperating with a variety of individuals and institutions in member countries to present and evaluate international macroeconomic research. Since its establishment in 1983, the Centre for Economic Policy Research has promoted the independent analysis and public discussion of open economies and the relations among them. And The Brookings Institution, as an integral part of its effort to aid in the development of sound public policies and to promote public understanding of important policy issues, has a longstanding commitment to research in international economics.

    Beginning in 1985, CEPR and Brookings launched a three-year joint research program to further the study of macroeconomic interactions and policy design in interdependent economies. Financial support for this research was generously provided by the Ford Foundation and the Alfred P. Sloan Foundation. To conclude the joint CEPR/Brookings program, policymakers and academic researchers were gathered to assess the major issues of international macroeconomic interdependence and policy design. Given the research activities of the Fund staff, the Fund was asked to join forces with Brookings and CEPR in organizing a conference to foster this assessment. These collaborations resulted in the conference on macroeconomic policies held at The Brookings Institution in December 1988. The essays and discussant comments contained in this volume are revised and edited versions of the papers and comments presented at that conference.

    The editors were jointly responsible for organizing the December 1988 conference and for overseeing the preparation of this volume. Ralph C. Bryant is a Senior Fellow in the Economic Studies program at Brookings. David Currie is Professor of Economics at the London Business School and was Co-Director of CEPR's International Macroeconomics Programme during 1985–88. Jacob A. Frenkel is the Economic Counsellor and Director of the Research Department at the International Monetary Fund. Paul R. Masson is an Advisor in the Fund's Research Department. Richard Portes is the Director of the Centre for Economic Policy Research and Professor of Economics at Birkbeck College, London.

    Numerous individuals provided crucial assistance in the organization of the conference and the preparation of this book. Special acknowledgment is due David M. Cheney of the External Relations Department of the International Monetary Fund, who ably supervised and coordinated the many tasks of editing and production. We would also like to thank Hernan Puentes, also of the IMF External Relations Department, for helping with the organization of the conference. Evelyn M. E. Taylor, Boban Mathew, and Kenneth P. Pucker provided administrative and research assistance at The Brookings Institution. Support at the Centre for Economic Policy Research was coordinated by Stephen Yeo.

    Ralph C. Bryant

    David A. Currie

    Jacob A. Frenkel

    Paul R. Masson

    Richard Portes

    August 1989

    Introduction

    Ralph C. Bryant, David A. Currie, Jacob A. Frenkel, Paul R. Masson, and Richard Portes

    International macroeconomic policy coordination is high on the agenda for debate among policymakers and academic economists. Since 1985, officials of the Group of Seven industrial countries have met periodically to examine world macroeconomic developments and to coordinate their policies. Particularly marked has been the cooperation between Group of Seven central banks on exchange-market intervention. Starting with the Plaza Agreement of September 1985, followed by the Tokyo Summit of May 1986, the Louvre Accord of February 1987, and in more recent meetings, finance ministers have been increasingly concerned with developing a framework for coordination. This has led to a focus, during multilateral discussions, on a series of economic indicators that provide appropriate signals for the conduct of monetary, exchange rate, and fiscal policies. The International Monetary Fund has been actively involved in this process, both through the participation of the Managing Director of the IMF in Group of Seven meetings and through its use of indicators in bilateral and multilateral surveillance over the policies of industrial countries.

    The heightened attention paid by policymakers to international policy coordination was anticipated in large degree by the academic research community. Consequently, policymakers had a considerable body of research to draw on. The early analytical work of Koichi Hamada and Richard Cooper began the theoretical literature, and in the 1980s, this work was extended to the area of policy coordination in dynamic economic models. Empirical evidence for the need for coordination—which arises because of economic interdependence—has also been extended.

    Some major theoretical advances were presented at a conference held in 1984 by the Centre for Economic Policy Research and the National Bureau of Economic Research on the subject of International Economic Policy Coordination (published in 1985 in a book by that name, edited by Willem Buiter and Richard Marston). Further progress was made in a Centre for Economic Policy Research conference volume, Global Macroeconomics (edited by Ralph Bryant and Richard Portes, 1988). Evidence from empirical multicountry models was the topic of a conference sponsored by The Brookings Institution in 1986, whose proceedings were published as Empirical Macroeconomics for Independent Economies (edited by Ralph Bryant and others, 1988). Other research in this area has also been sponsored by Brookings and the CEPR, as well as by the IMF, which has continued to conduct research on international interdependence (including the construction of a multiregion model, MULTIMOD) and on policy coordination.

    Recent theoretical and empirical research has covered several areas. First, studies have examined the nature of spillover effects among different regions of the world economy, concentrating on linkages between the Group of Seven countries. (Linkages between the developed and less developed regions of the world economy have received far less attention.) Second, there have been evaluations of different economic policies (whether coordinated or not) in the context of empirical models that take account of the interdependencies among different regions of the global economy. An important aspect of this research has been concerned with the performance of different exchange rate regimes. Third, there has been a growing literature on the welfare implications of policy coordination and on the difficulties involved in coordinating macroeconomic policies, resulting from imperfect information and incomplete credibility. Attention has also been directed to the practical and institutional problems of policy coordination, including the experience of exchange rate systems such as the European Monetary System (EMS), and the role that international institutions could play in the implementation and surveillance of policy coordination.

    Against this background, the International Monetary Fund joined forces with The Brookings Institution and the Centre for Economic Policy Research to organize an international conference among policymakers and academic researchers to assess where we stand on questions of international macroeconomic interdependence and policy. The conference on “Macroeconomic Policies in an Interdependent World” was held at The Brookings Institution, Washington, D.C., on December 12–13, 1988.

    The papers in this volume cover a range of issues concerned with macroeconomic interdependence and policymaking. The volume begins with two broad surveys: the first gives an overview of the issues involved in international coordination of economic policies and considers the benefits to be gained from coordination; the second surveys empirical evidence on macroeconomic interactions in the world economy. These are followed by a group of papers that evaluate alternative rules or regimes for the international macroeconomy, using empirical multicountry macromodels. The volume then turns to studies concerned with more specific policy issues: the target zone proposal; the European Monetary System as a possible example for the international economy; and plans for a European central bank. A subsequent paper examines more general institutional questions concerned with policy coordination and the role of international organizations in the process. And the final paper takes up a neglected but important issue: macroeconomic interdependence between industrial and developing countries, and the implications of these interactions for international policy coordination.

    In the paragraphs that follow, we briefly identify some main points made in each of the papers and indicate some reactions contained in the discussants' comments.

    Issues of Interdependence and Coordination

    The first paper of the volume is “The Theory and Practice of International Policy Coordination: Does Coordination Pay?”, by David A. Currie, Gerald Holtham, and Andrew Hughes Hallett. It provides a broad overview of the issues pertinent to policy coordination, many of which are considered in more detail later in the volume. The authors' account of the recent historical experience of policy coordination distinguishes between absolute and relative policy coordination. The former is directed toward the overall stance of policy in all the main industrial countries; it would try to counteract shocks to the world economy as a whole. Relative policy coordination, in contrast, is concerned with the interactions between countries and tends to focus on exchange rates and balances of payments. Messrs. Currie, Holtham, and Hughes Hallett argue that relative coordination was the chief concern during the Bretton Woods era, except insofar as the adequacy of aggregate world liquidity was addressed. Furthermore, the recent resurgence in policymakers' interest in policy coordination appears to have been motivated by a perceived need for relative coordination following the U.S. fiscal expansion in the early 1980s and the large current account imbalances that resulted.

    Currie, Holtham, and Hughes Hallett describe the conclusions of economic analysis on the potential payoffs from coordination. They outline a number of possible levels of intergovernmental cooperation, ranging from information exchange to full policy coordination across all policy targets and instruments. The gains to be achieved depend on the degree of cooperation adopted; they accrue from a number of different sources and not solely from coordination proper. Even limited cooperation in terms of information exchanges may bring substantial gains in terms of more efficient “noncooperative” policies. Additional gains may derive from the use of “shared targets,” such as the exchange rate or other intermediate targets, and of common simple policy rules. Such gains may not be realized, however, if cooperative policies encounter problems of unsustainability, lack of credibility, imperfect information, and uncertainty over objectives and the functioning of the economy. Three of the authors' conclusions merit special attention. First, information exchange is an important part of the process of intergovernmental cooperation insofar as it improves the quality of “noncooperative” outcomes (outcomes reached without coordination proper). Second, the adoption of a rule-based system of coordination may lead to benefits in terms of credibility and reputation, especially if it is based on simple and robust rules. Third, exchange rate agreements may be an important vehicle for policy cooperation because they may prevent inappropriate monetary and fiscal policies.

    Vito Tanzi's discussion points out that the gap between the rhetoric and practice of policy coordination may have been narrowed because officials have aimed at the less demanding goal of “relative” coordination. Global demand management, in Tanzi's view, is not a realistic aim. Tanzi does not believe that reneging on agreements is a problem. Sustainability is more likely to be impaired by policymakers' inability to achieve total control over their policy targets and by a lack of political continuity. He sees precommitment to fiscal policy as more difficult than agreements on monetary policy and intervention in exchange markets. Tanzi points out that coordination is impaired by the unreliability of forecasts, especially if policies take a long time to implement.

    Jeffrey Frankel's comments stress uncertainty as the main obstacle to coordination. Each country considering participation in a coordination agreement must believe that it stands to gain, ex post, in most states of the world. Commitment to an intermediate target may be bad, ex post, because of the different shocks impinging on the system. But in Frankel's view, adopting an intermediate target may be advantageous for policymakers in helping them gain reputation. A policy rule involving an intermediate target should be robust across a whole range of possible shocks, and Frankel disagrees with the authors' contention that the exchange rate is a good target, arguing instead that the main candidate should be nominal gross domestic product.

    The second paper of the volume, entitled “Domestic and Cross-Border Consequences of U.S. Macroeconomic Policies,” by Ralph C. Bryant, John F. Helliwell, and Peter Hooper, provides an overview of the available empirical evidence about macroeconomic interactions between the United States and the rest of the world. The authors present evidence from simulations generated by a number of global macroeconometric models to yield evidence on the effects of changes in fiscal and monetary policy in the United States. They calculate averages and standard deviations of the effects obtained with the various models. Though the effects predicted by different models for particular U.S. fiscal and monetary actions differ considerably, the authors argue that careful use of the model-average effects and their standard deviations can prove useful as guides to policy. They reach a number of conclusions. First, an unanticipated cut in U.S. government expenditure would have a substantial negative impact on U.S. output, prices, interest rates, and the exchange value of the dollar; such a cut would also reduce the U.S. trade deficit, over a six-year horizon (although output would be recovering by the end of this six-year period). Second, if it were judged desirable, a temporary expansion in U.S. monetary policy could offset some of the negative effect on U.S. output caused by the fiscal contraction; U.S. monetary expansion, however, would not offset any negative impact on foreign output. Third, if a U.S. fiscal contraction were anticipated and credible, it could bring forward the decline in interest rates and the U.S. dollar, offsetting some of the output reduction that would occur from an unanticipated fiscal contraction. Fourth, alternative types of fiscal actions that have equivalent effects on the fiscal deficit have different effects on major macroeconomic variables, depending on the specific fiscal action chosen: for example, increases in excise and corporate taxes could have a more damaging long-run effect on output than increases of equivalent size in personal taxes or comparable reductions in transfers. In their policy conclusions, the authors favor the announcement of a gradual and credible U.S. fiscal retrenchment incorporating personal tax increases or transfer decreases.

    Haruhiko Kuroda argues in his comment that a U.S. fiscal deflation might, by reducing the U.S. current account deficit and increasing confidence in the U.S. economy, actually lead to an appreciation of the dollar by attracting foreign capital. He also constructs, using the model-average estimates presented by Bryant and others, a U.S. fiscal package composed of expenditure cuts and increases in transfers that, taken literally, could reduce the U.S. budget and current account deficits without any output loss—in fact, he argues, U.S. output would be higher! Kuroda's use of the illustrative estimates in the paper underlines the need for caution in translating such estimates directly into policy prescriptions.

    David Begg points out that the authors do not deal with issues of policy coordination, but only with specific U.S. policies. Ignoring policy interactions among countries, he argues, may bias the results. Begg also notes that the horizon over which the models were simulated (five to six years) was longer than the typical political horizon, which might be inconsistent with the importance of credibility in the analysis. Finally, Begg suggests that, in evaluating the output effects of different taxation policies, policymakers may be just as interested in the composition of output as in the total.

    Evaluating Alternative Policy Rules and Regimes

    The next three papers use a specific international macromodel to evaluate alternative rules or regimes for the international economy.

    “Policy Analysis with a Multicountry Model,” by John B. Taylor, examines the properties of alternative monetary policy rules under different exchange rate regimes. Using the estimated multicountry model that he has constructed, Taylor assesses alternative choices of targets for simple feedback interest rate rules. He assumes nominal wages to be sticky and to adjust according to a standard contracts model. Output in each region converges in the long run to the exogenous level of potential output; fiscal policy is also exogenous, so monetary policy is the only effective instrument of stabilization policy. The model features time-varying risk premia in both the uncovered interest parity condition and the long-short interest rate differential, with forward-looking behavior in many behavioral relationships.

    Taylor conducts his policy evaluations in the light of the actual shocks to the world economy during 1972–86. Given the statistical properties of the shocks experienced in the past, he uses stochastic simulation techniques to examine the possible behavior of future outcomes under similar patterns for the shocks. Taylor concludes that a flexible exchange rate system performs better than a fixed exchange rate system in terms of stabilizing domestic price and output levels in the Group of Three countries. This result holds even with the imposition of Taylor's assumption that a fixed exchange rate regime will have beneficial effects in eliminating the risk premia in the model's exchange rate equations. The simulations also suggest that a “mixed” price-real output rule for monetary policy is generally more effective in stabilizing Group of Three prices and output than a “pure” rule based on either price or nominal gross national product (GNP).

    Manfred Neumann's comment expresses concern that Taylor's conclusions depend initially on his working analytical assumption that future exogenous shocks to the world economy will follow the same statistical distribution as in the turbulent period of the 1970s and early 1980s. Furthermore, suggests Neumann, the export and import functions, which were estimated over a period of flexible exchange rates, might be different under a fixed rate regime. In the discussion that followed his presentation, Taylor acknowledged the problem of assessing the performance of fixed exchange rates using data from a period of flexible exchange rates. On the other hand, Taylor pointed out that the distribution of shocks and the degree of economic integration via trade would be unlikely to change immediately upon the adoption of a fixed rate system; his result that macroeconomic performance would deteriorate in the short run, he believes, is thus still plausible. Ralph Tryon, in his comment, suggests that data from earlier periods of fixed rates may be used to assess the significance of this problem. He points out that Taylor's results seem to conflict with those of other researchers, who do not so clearly find flexible rates to be superior to fixed rates. Taylor's conclusions, suggests Tryon, may be very sensitive to the properties of his trade equations.

    The next paper, on “Implications of Policy Rules for the World Economy: Results from the MSG2 Model,” is by Warwick McKibbin and Jeffrey Sachs. Using their MSG2 econometric model of the world economy, the authors investigate what policies could solve the current trade imbalances in the world economy, and what policy rules could be adopted to avoid the recurrence of such problems. One of the features of their model is that fiscal and current account imbalances affect asset stocks, so full stock equilibrium is required in the long run. The model also incorporates rational expectations in asset markets and (partially) in the behavior of households and firms. It has “Keynesian” short-run properties, however, because it assumes slow adjustment in nominal wages in most regions; in keeping with existing empirical evidence, the degree of stickiness varies considerably among regions.

    The analysis by McKibbin and Sachs suggests that a reduction in the U.S. fiscal deficit might not be as deflationary as some observers predict, since it would be offset by lower long-term interest rates in the United States and elsewhere after the announcement of fiscal contraction. But a small cut in the fiscal deficit may not by itself be sufficient to close the U.S. trade deficit by 1993. The authors also examine the properties of a number of different policy “regimes”—sets of rules governing the domestic monetary and fiscal policies of the Group of Three countries. They find some instability associated with the “blueprint” proposal advanced by Williamson and Miller (targeting real exchange rates using monetary policy, with fiscal policy used to target domestic demand). This instability may arise from fixing the target real exchange rate once and for all in the model simulation, and from the fact that the MSG2 model allows for debt accumulation, which would tend to change the real exchange rate, ceteris paribus.

    In his comment, Patrick Minford points out that, although the model relies on intertemporal maximization for much of its structure, this seems difficult to reconcile with the assumptions of a high degree of wage stickiness in some regions and the presence of hysteresis effects. Minford also doubts the result that the recessionary effects of U.S. fiscal contraction could be easily offset by monetary expansion in the Group of Three countries; he questions the positive transmission effects for monetary policy in McKibbin and Sachs' model, which occur even when fully anticipated by the private sector. David Currie suggests that the instability properties of the blueprint proposal as implemented in the MSG2 model may result from trying to hit targets too precisely (fine-tuning), and that the McKibbin-Sachs implementation differs from that advocated by Williamson and Miller, who argue for the use of policy in a “coarse-tuning” way. Currie also points out that one cannot fix the real exchange rate once and for all if asset stocks change.

    The final paper in the group of model-based evaluations of rules or regimes is by Jacob A. Frenkel, Morris Goldstein, and Paul R. Masson, entitled “Simulating the Effects of Some Simple Coordinated Versus Uncoordinated Policy Rules.” The authors evaluate how different simple monetary and fiscal rules perform in the International Monetary Fund's MULTIMOD. This model includes forward-looking expectations and is a fully closed model of the world economy, in contrast to many other multicountry models. The authors consider both uncoordinated policies—which include policy rules under which each country independently targets monetary policy on either the monetary base or nominal GNP—and “coordinated policies,” in which monetary policy is targeted to real or nominal exchange rates, or where monetary and fiscal policy target both real exchange rates (or the current account) and nominal domestic demand. Rather than running historical simulations with different policy rules, Frenkel and others simulate the model for a future period by applying to the baseline of the model shocks drawn from the actual historical distribution of disturbances. They then examine how successful each rule is at minimizing the deviations of the target variables from the baseline. This procedure, which is similar to the stochastic simulation techniques used in Taylor's paper, allows multiple simulations to be carried out by selecting a new set of shocks from the distribution of past shocks. In contrast to the Taylor paper, Frenkel and others do not find a clear ranking of different policy rules. For instance, the choice is not clear cut among the two uncoordinated rules (money supply and nominal GNP targets, each of which entails flexible exchange rates) and a fixed exchange rate rule. Second, although the Williamson-Miller blueprint proposal tends to work well in stabilizing key target variables, the authors are skeptical about the flexible use of fiscal policy that it implies. Third, pursuing target zones by using monetary policy alone—or making the response of fiscal policy less flexible—tends to produce instability, probably because of the relatively weaker effect of systematic monetary policy in affecting real magnitudes, compared with fiscal policy, in the model.

    Jeffrey Shafer suggests that the authors found it difficult to discriminate among the performances of different rules because they all performed reasonably well. In actual practice, policies do not work quite as well, however, so perhaps the authors' methods of assessing different rules may be optimistic. Shafer also proposes considering the effects of model uncertainty on the results. Stanley Fischer, in commenting on the paper, suggests that one way of overcoming instrument instability is by setting a loss function that penalizes extreme policy settings. He also points out that the paper concentrates on policy rules for the interest rate, even though monetary policy appears less effective than fiscal policy in influencing real variables such as output and net exports.

    Target Zone Proposal

    The next paper in the volume, “The Stabilizing Properties of Target Zones,” by Marcus Miller, Paul Weller, and John Williamson, considers a specific blueprint for policy coordination, namely the target zone proposal. The authors examine how target zones might cope with shocks originating from the private sector in exchange markets in the presence of two types of inefficiencies: Blanchard “bubbles” and currency “fads.” In an analytical model in which the authorities choose the target zone to encompass the equilibrium exchange rate, the authors show that target zones can have a deterrent effect where bubbles are present. In the presence of “fads,” the adoption of a target zone may encourage smart money to play a stabilizing role in exchange markets. The authors question whether the simulations of empirical multicountry models in the papers by Taylor, McKibbin-Sachs, and Frenkel-Goldstein-Masson—even though the simulations remove noise in exchange markets when simulating fixed exchange rates—do justice to the target zone proposal.

    Michael Mussa argues that if the authors see target zones as a deterrent for Blanchard bubbles, there is no reason to propose a narrow target zone, as any announced limit on exchange rate fluctuations will do. Furthermore, Mussa doubts whether the presence of fads could explain the behavior of the dollar during the early 1980s, as the authors suggest; in the authors' model, a high dollar would have had to coincide with a high interest rate and with an economy in recession; yet this did not occur in practice. As a result, the model yielded some rather perverse policy prescriptions. James M. Boughton points out that the policymaker would have to distinguish to what extent currency fluctuations owed to fundamentals and to what extent “bandwagon effects” were important. Boughton also questions the assignment of monetary policy to external balance; one would expect that fiscal policy would be more effective in hitting current account targets.

    Policy Coordination and Integration in Europe

    Some argue that developments in Europe offer a possible model for more general moves toward policy coordination at the world level. “The Exchange Rate Question in Europe,” by Francesco Giavazzi, examines the possible evolution of the European Monetary System beyond its present form of fixed but adjustable parities. Many believe that the abolition of capital controls will put pressure on the EMS that will force it back toward greater exchange rate flexibility or toward permanently fixed parities (European Monetary Union, or EMU). Giavazzi examines the arguments for and against such monetary unification. Permanently fixed rates would eliminate the incentive to use “beggar-thy-neighbor” policies, but it may be desirable to retain the ability to realign EMS parities even when all countries face common shocks but retain structural asymmetries. Moreover, in a fixed rate system, if monetary policy is set by one of the countries—presumably the least inflation-prone member of the group—other countries tend to lose monetary sovereignty. This may pose problems for countries whose fiscal structures involve a large ratio of money financing to tax revenues.

    William H. Branson emphasizes that a move toward permanently fixed rates would require detecting the appropriate rates on which to fix. This is particularly important in the European context, with the present large and growing German current account surplus. Branson also highlights the difficulty of instituting fiscal transfers among regions in the absence of a fully integrated European fiscal system. Moreover, the development of an integrated financial system will have important implications for small firms in each region, which do not have access to centralized bond markets for finance. Mario Draghi argues that the current system would survive under perfect capital mobility, so long as individual regions did not attempt to carry out independent monetary policies. He points out that problems may arise during periods of increased competition in financial services—as envisaged in the move to a single European market in 1992—if countries' banking systems continue to have different reserve requirements; those with higher required reserves would be placed at a competitive disadvantage.

    The second paper on European issues, “The European Monetary Union: An Agnostic Evaluation,” by Daniel Cohen and Charles Wyplosz, also assesses arguments for and against the EMU. “Nonstrategic” considerations include the need for seigniorage by countries with inefficient tax systems, the desire of countries with large public debts to use surprise inflation to erode the public debt, and the possibility that the European currency unit (ECU) would become an important asset held in official international reserves. Cohen and Wyplosz conclude that these considerations do not yield a decisive verdict on the EMU. They then examine the strategic issues underlying the arguments for fixed rates. Although an inflation externality points toward the efficiency of the EMU, the authors argue that in the presence of other externalities—for example, the collective determination of the zone's balance of trade—the EMU might yield a suboptimal outcome.

    Massimo Russo points out that the EMU should be considered in part as the result of political moves. Furthermore, seigniorage should be viewed as a second-order effect, as the reduction of exchange rate risk would probably compensate high-debt countries for their loss of seigniorage. Alberto Giovannini agrees that seigniorage is probably a second-order issue but he emphasizes that convergence to a common inflation rate in the 1980s has produced interest rate increases and cyclical falls in taxation revenues, thus worsening the fiscal problem for some countries. He also stresses serious identification problems in Cohen and Wyplosz's empirical analysis of symmetric and asymmetric shocks.

    Institutional Issues

    The next paper, on “The Role of International Institutions in Surveillance and Policy Coordination,” by Andrew Crockett, turns to more institutional considerations of policy coordination. The usual arguments in favor of coordination are that it eliminates the externality caused by spillover effects and supplies the public good of worldwide economic stability. Against the background of these arguments, Crockett describes the development of efforts to underpin international economic cooperation. Under the Bretton Woods system, Working Party 3 of the Organization for Economic Cooperation and Development (OECD) established procedures whereby countries exchanged information on balance of payments aims and forecasts. A Working Party 3 report proposed the use of indicators to diagnose the emergence of imbalances and a set of guidelines for appropriate policy reactions.

    Crockett examines the working of policy cooperation under the initial years of floating exchange rates in the 1970s and early 1980s. The “rules of the game” seemed imprecise, partly because of the difficulty in making clear prescriptions in a floating rate regime, and partly because of the demise of the “Keynesian consensus” on the operation of macroeconomic policy. Thus, a greater weight was placed on surveillance, another component of cooperation. This failed to prevent the emergence of the debt crisis in 1982 and the excessive dollar appreciation up to 1985. The period after 1985 has seen the strengthening of cooperation, partly through the regular meetings of the Group of Seven and the undertaking to strengthen surveillance in conjunction with the Fund. Finally, Crockett analyzes steps that could be taken to make the policy coordination process systematic rather than episodic and argues that the role of the Fund will probably have to remain central.

    Sylvia Ostry suggests that Crockett's analysis of the process of coordination is optimistic. She stresses that there may be sharp differences in individual countries' views of the underlying model and the appropriate policy targets. Such differences can only be resolved through political processes. Ostry points out that Crockett's account omits a discussion of trade issues and the General Agreement on Tariffs and Trade, despite their importance: it is arguable that the moves in 1985 by the major countries toward coordination were triggered by fears of increased protectionism. In his comment, Jacques Polak points out that there are limits to the feasible number of parties in the management of exchange rates, which is probably best conducted within the confines of the Group of Five or Group of Seven. There are other aspects to policy coordination, however, since exchange rate management has to be underpinned by fiscal and monetary policies. Furthermore, Polak argues that countries should recognize the danger of any coordinated approach: it can lead to a struggle to determine each country's share of the burden of adjustment.

    North-South Interdependence

    The final paper in the volume addresses an issue that is largely neglected in earlier papers, but may well be of great importance, the interdependence between industrial countries (the “North”) and developing countries (the “South”). In their paper on “Macroeconomic Interactions Between the North and South,” David Vines and Anton Muscatelli argue that spillover effects between North and South should be taken into account when discussing Northern policy proposals. Muscatelli and Vines analyze the main channels of North-South economic interdependence using a theory-based simulation model. They emphasize the linkages that relate to the demand-side effects of Northern policies, which may feed back on commodity prices and affect the North's own supply sector. Furthermore, any effect of Northern policies on Southern capital accumulation will have a long-run effect on commodity prices. The authors emphasize that the determinants of investment in the South and the determinants of financing flows from the North to the South warrant specific empirical investigation. They argue for a coordinated policy package that would involve maintenance of a satisfactory policy environment in the Group of Seven countries; implementation of satisfactory adjustment policies in the South—including increased investment expenditure—and resumption of new financing flows to the South.

    Michael Dooley points out that Muscatelli and Vines assume that additional finance is readily available to the South at an interest rate that incorporates a risk premium, while in MULTIMOD no more finance is available to countries that do not satisfy a solvency criterion. Dooley finds the MULTIMOD approach more realistic; in actual practice, the flow of new finance to the South seems to have dried up, and as a result the large market discounts on the debt of some developing countries probably do not affect the level of Southern investment. Pierre Defraigne agrees with the authors that the South is an important “missing link” in the modeling of economic interdependence, but proposes adding two features to the model. First, he argues that the authors should recognize that the share of manufactures in Southern exports had risen to 52 percent by 1982; the authors neglect the possible erection of trade barriers on these exports in their discussion of policy cooperation. Second, in empirical work, the building of a multiregional model should recognize the strong bilateral links between particular Northern and Southern regions (for example, between Japan and the Asian newly industrialized economies, or NIEs).

    Directions for Further Research

    The papers in this volume are evidence of the advances in economic knowledge that have been made in recent years and of the renewed interest in economic interdependence and international policy coordination. The volume, however, should not be viewed as a definitive study, but rather as a signpost for future research. It is important to push forward in our attempts to understand and model the intricacies of the policy coordination process. The themes taken up in this book will undoubtedly be pursued in subsequent research, and indeed represent a major research agenda.

    In this book, we have focused on issues of coordination between the policymakers of different countries. But the issue of coordination has further dimensions: the various arms of government need to be coordinated within a country (for example, the central bank and the finance ministry); while coordination between countries may first take the form of coordination within regional groups (such as the European Community group) and then among these regional groups. These issues of internal and hierarchical coordination are touched upon in the book, but they deserve more thorough study. Moreover, coordination need not, and indeed cannot, be complete: coordination in practice will be partial, taking the form of agreement over some aspects of policy, while leaving other dimensions of policy free to be determined by countries individually. Which aspects of policy are most in need of coordination is a key unresolved question.

    These aspects of the coordination process can be illuminated by studying the most obvious example of coordination in practice, namely, the European Monetary System. The dominant interpretation of the evidence is that the EMS operates in an asymmetrical manner, with German monetary policy providing an absolute inflation anchor, while the monetary policy of other member countries is directed toward an exchange rate target relative to the deutsche mark. Moves in the direction of a European central bank may be interpreted as introducing greater symmetry in the process of macroeconomic coordination, with potential benefits and costs that need to be assessed, along with their distribution across countries. The Delors Committee report on the European Monetary System has also highlighted the issue of whether greater monetary integration requires greater fiscal coordination; the answer depends partly on how financial markets will treat borrowing by countries joined in a monetary union.

    At the global level, research is needed to help establish how macroeconomic indicators of developments in the world economy can be used to guide the conduct of policy, so as to achieve what has been termed “absolute coordination.” There is also the question of how best to conduct policy to adjust, and subsequently avoid, undue imbalances between the major Group of Seven countries. We still have unanswered questions about the role of the exchange rate as a “pivot” for policy coordination and, to the extent that this is judged desirable, how exchange rates should best be managed.

    Underlying all these questions is the issue of how to establish and maintain credibility of policy. Modern techniques of policy design allow us to investigate these questions in powerful ways, using ideas of sustainability and incentive compatibility. But the manner in which a hierarchical structure of policymaking, partial coordination, or complexity of policy design affects questions of credibility has not yet been properly investigated. This represents an important and potentially fruitful area of research.

    These and other issues need a better grounding in empirical research. The areas mapped out by the papers in this volume should be further explored. Macroeconomic models can be used to evaluate a wider range of policy rules, and to attempt to discover simple but robust frameworks for coordination. Moreover, these models should be extended and refined. A major need in this regard is the development of better methods of modeling North-South interactions through commodity prices, financing flows, and other channels.

    The list of relevant research topics is long. Though the research agenda is daunting, it should not detract from the substantial contributions made by the papers in this volume to our knowledge in the important area of economic policymaking.

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