Journal Issue

United States

International Monetary Fund
Published Date:
October 1995
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I. Introduction 1/

Since the beginning of the year, economic growth has slowed from the unsustainable pace set during 1994, partly in response to the tightening of monetary policy that began in February of last year. The impetus for a reduction in the fiscal deficit also seems to have grown; since the beginning of the year both the Congress and the Administration have presented budget proposals that envisage achievement of a balanced budget over a seven to ten-year horizon.

Other developments, however, give rise to continued concern that the policy environment may not be adequate to achieve a satisfactory macroeconomic outcome. The U.S. current account deficit is expected to remain large; inflation increased in the first half of the year; and the dollar continued to weaken against the currencies of the major industrial countries. Building on the previous work by the staff (Table I-1), this report addresses a number of these issues, with an emphasis on the relationship between fiscal policy and the exchange rate, monetary policy and the inflation-output tradeoff, and the effects of tax policy on private saving.

Table I-1.United States: Additional Background Material
United States - Background Papers (SM/94/223)
Chapter III.Indicators of Economic Slack
Chapter IV.Changes in the Relationship Between the Long-Term Interest Rate and its Determinants
Chapter VI.A U.S. Value Added Tax--Issues for Consideration
Chapter VII.An Examination of U.S. Saving Performance
Chapter VIII.Postwar Investment and Productivity Trends
Chapter IX.Welfare Reform in the United States
Chapter X.Health Care Cost Containments
Chapter XI.Wage Dispersion and Job Growth
United States - Recent Economic Developments (SM/93/183)
Chapter III.Inflation and the Business Cycle
Chapter V.Fiscal Deficit Reduction and Interest Rate Spreads
Chapter VI.Investment Incentives in the United States
Chapter VII.U.S. Health Care Reform
Chapter VIII.An Overview of Income Distribution in the United States
United States - Recent Economic Developments (SM/92/168)
Appendix I.The Output Gap: A Brief Exploration
Appendix II.The Recent Instability of M2
Appendix IV.State and Local Government Finances in the Current Cycle
The United States Economy: Performance and Issues
(International Monetary Fund, Washington, D.C., 1992)
Chapter 2.National and Personal Saving: Measurement and Analysis of Recent Trends
Chapter 3.Tax Policy and National Saving
Chapter 4.National Saving Targets for the Federal Budget Balance
Chapter 9.Tax policy and Business Investment: Evidence from the 1980s
Chapter 10.A Systems Approach to Estimating the Natural Rate of Unemployment and Potential Output for the United States.
Chapter 16.Structural Models of the Dollar
Chapter 17.The U.S. Health Care Industry: Performance and Issues

Chapter II examines the effect of fiscal deficit reduction in the context of the Fund’s multicountry simulation model, with a particular focus on the effect of deficit reduction on the current account and the real exchange rate. The simulations suggest that, other things being equal, fiscal consolidation will tend to cause the real exchange rate to depreciate in the short term, which would help to reduce the current account deficit. However, a tight monetary policy or a significant shift in portfolio preferences toward dollar-denominated assets could alter this result. In the longer run, deficit reduction and the improvement in national saving would imply a lower level of net foreign indebtedness and a lower current account deficit than otherwise. The dollar would rise above its baseline level in the longer term.

Chapter III examines this prediction by estimating a long-run relationship between the real effective exchange rate for the U.S. dollar and a number of variables including the U.S. fiscal deficit relative to that of its major trading partners. The results suggest that the relative fiscal stance has affected the equilibrium level of the real effective exchange rate, but that the principal avenue through which fiscal policy affects the real exchange rate is through its impact on the level of net foreign liabilities.

Exchange market pressures on the U.S. dollar is often attributed to the persistence of a large U.S. current account deficit. However, two other factors are often mentioned as contributing to the dollar’s weakness: the erosion of the U.S. dollar’s role as a key reserve currency and the movement of cross-border capital flows. Chapter IV discusses the principal factors that help promote a currency’s role as a reserve currency and examines a number of indicators of the dollar’s role in the international monetary system. The data suggest that while the dollar’s status appears to have diminished somewhat in the foreign exchange and eurodollar deposit markets, the share of dollar-denominated international syndicated bank loans and official reserves has rebounded in recent years.

Chapter V examines developments in the U.S. capital account and the extent to which these developments may have affected exchange rate volatility. The analysis suggests that a growing volatility of net capital flows has been correlated with the increased volatility of the dollar’s exchange rate during the past decade.

A notable feature of monetary policy developments during the past year has been the fact that monetary conditions were tightened in advance of clear signs that inflation pressures were mounting. Chapter VI examines the hypothesis that the short-run tradeoff between inflation and output--the Phillips curve--is asymmetric. In particular, it presents evidence that the upward response of inflation to excess demand is greater than the decline in inflation that occurs in periods of excess supply. Simulations are used to show that, when the Phillips curve is asymmetric, delaying the monetary policy response to an excess demand shock will require a more severe economic downturn than would otherwise be needed to keep inflation from rising.

An important factor underlying the weakness in U.S. saving performance and the large current account deficit during the 1990s has been the low level of private saving. This has contributed to recent proposals for tax policies to promote saving, through either an expansion of federal tax assistance for retirement saving or a comprehensive reform of the income tax system. Chapter VII reviews some of the major proposals for simplifying the personal and corporate income tax systems and converting them to a consumption tax. In particular, the “flat tax” proposal would set a fixed marginal tax rate that would be applied to the business sector’s value-added tax and the household sector’s labor income. The chapter notes that estimates of the gain in economic efficiency that could result from these types of tax reform proposals are as high as 5-6 percent of GDP. However, such a reform would raise important distributional and transition issues.

Chapter VIII describes recent proposals for an expansion of existing tax preferences for retirement saving and examines whether these preferences have had a significant effect on household saving in the past. The results of the econometric investigation do not suggest that these tax preferences boosted overall saving, but instead have encouraged a shift in households’ asset allocation toward tax sheltered saving vehicles.

Chapter IX reviews recent U.S. trade policy developments, and Chapter X discusses U.S. overseas development assistance.

I. Aquino (staff assistant), Y. Li (research assistant), S. Solares (staff assistant), and A. Stevens (administrative assistant) participated in the preparation of this document. The report was edited by C. Towe.

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