Abstract

In the 1980s, fiscal policies in the industrial countries have been generally more restrictive (or less expansionary) than they were during the middle and latter 1970s. Since about 1979, the governments of all the major industrial countries have been committed—at least in principle—to reducing both their fiscal deficits and the relative size of government transactions in their economies. In practice, however, these goals have proved elusive in most countries. Because of such factors as miscalculation of economic prospects, unforeseen external developments, and persistent political pressures, effective implementation of measures required to reduce deficits and to reverse the relative growth of government transactions has been widely frustrated or postponed. In some cases, and particularly in the United States, the effects on the fiscal deficit of the programs actually implemented have diverged markedly from the declared intentions of the authorities. Among the seven major industrial countries, indeed, only two have succeeded in preventing outright increases in the deficits of their general government sectors since 1979, and none of them has yet achieved a major reduction in the ratio of government expenditures to GNP.

Supplementary Note 1: Fiscal Developments in Major Industrial Countries Since 1980

In the 1980s, fiscal policies in the industrial countries have been generally more restrictive (or less expansionary) than they were during the middle and latter 1970s. Since about 1979, the governments of all the major industrial countries have been committed—at least in principle—to reducing both their fiscal deficits and the relative size of government transactions in their economies. In practice, however, these goals have proved elusive in most countries. Because of such factors as miscalculation of economic prospects, unforeseen external developments, and persistent political pressures, effective implementation of measures required to reduce deficits and to reverse the relative growth of government transactions has been widely frustrated or postponed. In some cases, and particularly in the United States, the effects on the fiscal deficit of the programs actually implemented have diverged markedly from the declared intentions of the authorities. Among the seven major industrial countries, indeed, only two have succeeded in preventing outright increases in the deficits of their general government sectors since 1979, and none of them has yet achieved a major reduction in the ratio of government expenditures to GNP.

This supplementary note reviews the principal factors contributing to the partial frustration of fiscal plans during the first half of the 1980s, describing the changes in fiscal balances and in the overall size of government transactions during 1980-85, the factors affecting government revenues, and summarizing expenditure trends and policies. Against this background, the note then deals with the current and immediately prospective impact of fiscal developments on the economies of the major industrial countries. It includes a special note on an important new law adopted by the United States in December 1985 (the Balanced Budget and Emergency Deficit Control Act of 1985—popularly known as the “Gramm-Rudman-Hollings” legislation), and a technical note on the concepts and statistical techniques underlying the “fiscal impulse” estimates used in assessing the thrust of fiscal policy.

Changes in Fiscal Balances

Judged in terms of prima facie changes in general government fiscal balances, the deviations of actual from planned fiscal outcomes appear to have been most pronounced in Italy, the United States, and Canada (Table 22).1 The deficits of these countries, expressed as percentages of GNP/GDP, rose from 1979 to 1985 by some 4-4½ percentage points. The apparent slippage was somewhat more moderate in France, amounting to about 1¾ percent of GNP. Contrasting with these results were the changes that occurred in the Federal Republic of Germany, Japan, and the United Kingdom. Over the same six years, Japan’s general government deficit was reduced by about 3 percentage points in relation to GNP and Germany’s by 1½ percentage points. The ratio of the deficit to GDP in the United Kingdom showed virtually no cumulative change over this period.

Table 22.

Major Industrial Countries: Summary of General Government Fiscal Developments, 1980-85

(Percent of GNP/GDP)

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According to the criteria described at the end of Supplementary Note 1, a constant ratio of revenue to GNP is considered cyclically neutral. Any change in that ratio may thus be considered structural, and the figures shown in row 2 may he viewed (with reversal of algebraic signs) as cumulated contributions from the revenue side of the government accounts to the fiscal impulses shown in Statistical Appendix Table A17.

Row 5 minus row 2—the difference being equivalent to a cumulation of the annual “fiscal impulses” shown in Statistical Appendix Table A17.

Both among the countries with rising deficits and among those whose deficits were reduced, the prima facie comparisons of actual outcomes just summarized convey some misleading impressions of policy-directed shifts in fiscal positions. From 1979 to 1985, the change in general economic conditions was much more adverse in the four European countries than in the two North American countries or in Japan. The degree of deterioration of fiscal positions in this period attributable to purely cyclical factors is estimated (in row 4 of Table 22)2 to have been equivalent to more than 5 percent of GNP for Italy and France to more than 3½ percent for the United Kingdom and just below 3 percent in the Federal Republic of Germany. For the United States and Canada, on the other hand, the cumulative deterioration ascribable to cyclical influences over the same period is calculated to have been equivalent to only about 1½ percent of GNP, and for Japan, it was even lower—roughly ½ of 1 percent.

Adjusting for these rather sharp contrasts in the fiscal effects of cyclical developments, one can focus on budgetary shifts of an essentially structural character (summarized in the last row of Table 22). This perspective throws a different light on some of the cumulative changes in actual deficits as listed in the first row of the same table. The contractionary impact of changes in the German budget during the 1980s, for example, is much larger (roughly 4½ percent of GNP) than that implied by the actual change in the fiscal balance, and substantial structural reductions (3-3¾ percent of GNP) in fiscal deficits are also shown for the United Kingdom and France. Even in Italy the net impact of structural changes appears to have been restrictive.

Since most of the changes in Japan’s fiscal balance during the 1980s were structural, a cyclical adjustment of the Japanese figures does not greatly alter the degree of contractionary influence implied by the cumulative reduction in that country’s general government deficit. As estimated in the last row of Table 22, this restrictive influence was broadly similar to that exerted by structural shifts in the fiscal positions of most of the large European countries. (It should be noted, however, that the Japanese deficit at the beginning of the period was considerably larger than that of any of the major European countries except Italy, and that similar changes over the period under review do not necessarily imply similar current levels of structural deficits in any absolute sense.)

On a cyclically adjusted (or structural) basis, the cumulative changes in fiscal balances of the United States and Canada stand in striking contrast to those of all the other major industrial countries. During a period in which the structural changes in the other five countries were all in the direction of lower deficits, and in most cases quite substantially so, the corresponding changes in the U.S. and Canadian deficits were strongly upward. Cumulatively over the period 1980-85, these increments amounted to about 2¼-3 percent of GNP.

Generally speaking, the major industrial countries have made less progress in reducing the overall scale of their government transactions than in the companion goal of shrinking fiscal imbalances.3 For 1980-85 as a whole, the most that can be said is that earlier upward trends in ratios of government revenues and expenditures to GNP were flattened in most cases, and that in some cases trends were tilted downward during the last two or three years of the period.

In no major industrial country was the ratio of revenue to GNP lower in 1985 than in 1979, and only in the Federal Republic of Germany was there a (fractional) decline in the ratio of expenditure to GNP (Chart 31). Although the Japanese authorities also managed to limit the relative growth of general government expenditures rather severely (to a little more than 1 percent of GNP), such growth elsewhere in this group of countries ranged from about 3¼ percent of GNP in the United Kingdom to 8½ percent in Canada and 13¾ percent in Italy. Italy was also the country with the largest increase on the revenue side of the account, as Italian general government revenues rose by about 9¼ percentage points in relation to GNP. Other revenue increases were on the order of 3½-4½ percent, except in the United States and Germany, where they were held to about ½ of 1 percentage point and l¼ percentage point, respectively.

Chart 31.
Chart 31.
Chart 31.

Major Industrial Countries: General Government Fiscal Aggregates and Balances, 1979-86

(Percent of GNP)

1 Fiscal impulse as defined in text, cumulated from 1979.

Factors Affecting Revenues

Revenue growth can be analyzed in terms of the relative contributions of “fiscal drag” and policy-determined changes in tax rates or in the tax base. The exceptionally slow growth of U.S. general government revenue from 1979 to 1985 was essentially a function of the large federal income tax reductions introduced in 1981 and implemented over a three-year period. Despite a subsequent partial reversal of some elements of the original tax-reduction legislation, the cuts were almost sufficient over the period as a whole (and more than sufficient during 1982 and 1983) to offset two major influences working to raise the ratio of revenue to GNP. One of these was the continued operation of a “fiscal drag,” reflecting the elasticity of the revenue system in response to inflation and the trend growth of real income.4 Another major factor tending to raise the U.S. revenue ratio during the 1980s has been a series of progressive increases in both the tax base and the applicable rates for social security contributions. Although the tax changes implemented under the 1981 legislation (which included provisions for indexing of personal exemptions and of the tax brackets through which progressive marginal rates are imposed) have probably reduced the longer-term income elasticity of the U.S. revenue system, a considerable element of fiscal drag is likely to remain a feature of U.S. fiscal developments. It may soon become more evident again in the absence of further reductions in U.S. income tax rates, since 1985 was the last year in which settlements of personal tax liabilities were significantly affected by the phased reductions enacted in 1981.

In relation to GNP, the rise in general government revenue in the Federal Republic of Germany during the first half of the 1980s was only slightly larger than that in the United States. With both real growth and inflation lower in Germany than in the United States, the impact of fiscal drag and cyclical influences tended to be smaller. In addition, income tax adjustments to “correct” for fiscal drag were introduced by the German authorities early in the period, and significant cuts in taxes on business incomes were provided, chiefly through credits designed to encourage investment and structural shifts in the composition of output.

Reflecting the opposing influences of the fiscal drag and the above-mentioned tax changes, direct taxes as a share of GNP remained virtually unchanged over the period. However, social security contributions as a proportion of GNP increased by 1 percentage point as a result of gradually increasing contribution rates. On the other hand, because of a fall in tax rates for specific indirect taxes in real terms, the share of indirect taxes in GNP declined by ½ percentage point, despite increases in selected consumer taxes and in the value-added tax. Thus, within a relatively stable overall tax burden, there was a shift away from indirect taxation toward a higher degree of reliance on direct taxes and social security contributions.

Japan’s major fiscal policy objective during the 1980s has been to reduce the deficit through curbing growth on the expenditure side of the budget. Revenues have risen substantially in relation to GNP because of the considerable elasticity of the tax system, increases in social security contribution rates, and some increases in corporate and indirect taxes in the early 1980s. The relative rise in taxes and social security contributions was facilitated by the fact that Japan’s general government revenues at the beginning of the period were still by far the lowest, in relation to GNP, of any major industrial country. They remain the lowest, although the spread has narrowed considerably in comparison with some of the other countries (notably, the United States and the Federal Republic of Germany).

The fiscal restraint sought by the U.K. authorities during the early 1980s was achieved chiefly by revenue increases, although strenuous efforts were also made to contain the growth of expenditures. The rise in world oil prices played a significant role in bolstering revenues. A feature of the fiscal strategy adopted by the U.K. Government in 1979 was a major shift in the tax structure from income taxation to taxes on expenditures. This shift continued in the budgets of 1982/83, 1983/84, and 1984/85, which resulted in very little cumulative change in the ratio of general government revenues to GNP. During those years, further cuts in taxes on both personal and company incomes were substantially offset by upward adjustments of excise taxes (mainly to take account of inflation), by increases in national insurance contributions, and by a significant rise in oil-related revenues. Partly because of the substantial shift in the tax structure, as well as widespread use of indexation, fiscal drag appears to have been a less important factor in revenue growth in the United Kingdom than elsewhere.

In France, where reliance on income and profits taxes is lower (about 18 percent of total revenue) than in any other major industrial country, a very substantial portion of the rather steady annual increments in the ratio of revenue to GDP ratio during the 1980s has come from successive increases in social security contributions. Measures initiated in 1979 to restore the integrity of the social security system were instrumental in launching this upward trend early in the current decade, and further increases in social security contributions were necessitated in subsequent years by the expansionary trend in social expenditures. In 1983, when a significant reorientation of fiscal policy occurred in response to pressures on the French franc, an income tax surcharge—introduced for the benefit of the family allowance fund—resulted in a relatively comfortable surplus in the social security accounts, but contributed to a further increase in the revenue to GDP ratio. This trend was finally arrested in 1985, when reductions in the personal income and business tax were introduced with a revenue impact equal to about 0.7 percent of GDP, which offset the impact of some further increases in the social security payroll tax rates, an increase in the domestic tax on petroleum products, and certain other measures.

Cumulatively, the growth of general government revenue relative to GNP in Canada during the 1980s has been similar to the average of the other major industrial countries, although somewhat more irregular. Revenue growth was very strong early in the decade, as a result of large increases in energy taxation. In 1983, however, fiscal policy was directed toward promoting recovery from the 1981-82 recession, while energy tax receipts declined somewhat as a result of both the domestic recession and the weakness in world oil prices. During 1983 and 1984, there was also a slowdown in the growth of revenue from personal income taxes. This slowdown apparently stemmed in part from a shift in the relationship between assessed income for tax purposes and total personal income, reflecting such factors as greater than expected use of exemptions, deductions, and tax credits. In addition, however, there was a decline in the ratio of tax collections to tax liabilities.

Toward the end of 1984 and in early 1985, Canadian fiscal policy was redirected onto a path of restraint by a new government. Although this was done predominantly through measures to curb spending, tax increases were also instituted. Sales tax rates were raised by 1 percentage point, and the base of the tax was broadened; tax brackets and exemptions were partially deindexed; and a temporary surcharge was levied on both individual and corporate incomes. The result was a reversal of the 1983 drop in the ratio of Canadian general government revenues to GNP, partly through restoration of an element of fiscal drag that had been suppressed by indexation.

In Italy, the persistently high rate of inflation and the steep progressivity of personal income tax rates combined to produce an unusually large degree of fiscal drag during the early 1980s, despite periodic steps to reduce its effects. In addition, upward adjustment of various tax rates, particularly for indirect taxes, plus fiscal amnesties and a shortening of lags in revenue collections contributed to a series of marked annual increases in the ratio of revenue to GNP ratio from 1980 through 1983. The fact that the growth of government spending during that period was even more rapid prevented major steps to reduce the rapid rise in the tax burden. Revenue increases were especially large in 1982 and 1983, reflecting various temporary measures to boost receipts. Subsequently, the expiration of those temporary measures, coupled with a reduction of fiscal drag (undertaken in conjunction with an agreed reduction of wage indexation), led to an abrupt leveling off of the ratio of revenue to GNP ratio in 1984 and 1985. The current medium-term strategy of the Italian authorities appears to be geared broadly toward maintenance of the tax burden at its recent level. Within this overall objective, some redistribution of incidence from wage to non-wage income is being sought, along with an increase in the share of indirect taxes. Improved enforcement and measures to reduce the erosion of the tax base (especially for the value-added tax and for income from unincorporated businesses) are prominent among the means through which these aims are being pursued.

Expenditure Trends and Policies

Government expenditure trends in all of the major industrial countries have been strongly affected during the 1980s by two pervasive influences: the difficulty in arresting the rapid growth of spending under various social welfare programs; and the dramatic increase in interest payments generated by large increments in government debt and high interest rates. Both demographic changes and the impact of the prolonged international recession tended to generate automatic or quasi-automatic increases in payments to beneficiaries whose “entitlements” had been established under earlier policy decisions. Although many of the relevant entitlement programs had been introduced at times when prevailing conditions were quite different from those characterizing the 1980s, social and political pressures against curtailment of benefits were almost universal.

Debt service payments were, of course, even more intractable. With the scale of such payments sharply higher in relation to GNP during the early 1980s, containment of the overall ratio of government expenditures to GNP could not be accomplished by any of the major industrial countries except through outright reduction in the relative magnitude of noninterest outlays. The degree to which the national authorities of the seven nations have succeeded in reaching or approaching that target has varied even more widely from country to country than their respective results on the revenue side of the fiscal accounts.

At one extreme is the record of the Federal Republic of Germany, where the rise in total general government expenditures, expressed as a percentage of GNP, was limited to about ½ of 1 percentage point per annum from 1979 through 1982 and then rolled back to a level in 1985 fractionally below that of 1979. Since interest payments increased over those six years by the equivalent of 1¼ percent of GNP (Table 23), the decline in the relative magnitude of other outlays was appreciable. Moreover, inasmuch as those other outlays in 1985 included much larger unemployment insurance benefits, as well as other components pushed upward by cyclical influences, the compression of cyclically adjusted expenditures was substantial. As measured according to the concepts of the cyclically neutral budget analysis, it amounted to about 3¼ percentage points in relation to GNP over the period 1980-85 (Table 22). The restraint was distributed fairly evenly between government purchases of goods and services and transfer payments. It was also applied gradually, through a succession of relatively small steps in the annual budgets of recent years, rather than through any major fiscal reform. Contributory steps have included, for example, reductions of unemployment benefits, a temporary (nine-month) freeze on civil service wages, changes in the calculation of pension payments, and measures to limit the cost of health insurance.

Table 23.

Major Industrial Countries: General Government Expenditures and Selected Components, 1979-861

(Percent of nominal GDP/GNP)

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The fiscal data used in computing the ratios shown in this table are on a national accounts basis.

Japan’s fiscal restraint program, although applied under somewhat different economic circumstances, has also been characterized by gradualism and effectiveness. Given the revenue increases produced by the greater buoyancy of the Japanese economy in recent years and the relatively high elasticity of the Japanese tax system, the Japanese authorities have been able to lower the general government deficit substantially without a major cutback in the overall ratio of government expenditure to GNP, which rose moderately from 1979 to 1983, then fell back slightly during the past two calendar years. However, a considerable restructuring of expenditures was carried out.

The authorities’ main objective has been to reduce the deficit in the general account of the central government so as to eliminate by fiscal year 1990/91 the issuance of bonds to cover current spending. A reduction in the deficit is believed to be needed both to prevent the further erosion of fiscal flexibility and to place the government in a better position to accommodate the increased social welfare expenditure that will inevitably accompany the rapid aging of the population in the next two decades.

Given the heavy upward pressure on expenditure arising from social security outlays caused by the aging of Japan’s population and the maturing of its social security schemes, as well as the rise in interest payments on government debt, the burden of expenditure restraint has fallen heavily on other categories of expenditure. Whereas the ratios of transfer payments and of interest payments to GNP rose by 1.1 percentage points and 2.0 percentage points, respectively, between 1979 and 1985, the ratio of other expenditures was reduced by nearly 2 percentage points. Initially, the expenditure restraint was achieved mainly by across-the-board cuts of nonpriority, discretionary expenditures. However, room for reductions in these areas has become smaller and, in recent years, the authorities have undertaken an important reform of social security programs.

In both the United Kingdom and the United States, the growth of general government expenditures in relation to GNP during the period 1980-85 was close to the average for all seven major industrial countries. However, a considerably larger share of the rise in the expenditure ratio can be attributed to cyclical factors in the United Kingdom than is the case in the United States. Indeed, the “cyclically neutral budget” analysis would impute the entire rise since 1979 in U.K. general government expenditure (as a percentage of GDP) to such factors, whereas the corresponding share in the United States was only about one third (Table 22).

The composition of the respective increases in these two countries also differed. Interest payments and expenditures for national defense were the predominant expansionary elements in the United States, while a rise (relative to GNP) in transfers and subsidies accounted for more than half of the cumulative growth in total expenditures of the general government sector in the United Kingdom. Government interest payments in the United Kingdom, which were already relatively high in 1979, rose less (as a percentage of GDP) over the following six years than in any other major industrial country. In both the United Kingdom and the United States, transfers and subsidies rose more sharply in relative importance during the first several years of the period, but have fallen back somewhat (relative to GNP) since 1983, especially in the United States.

Another change of considerable significance in the United States was an appreciable reduction in the relative importance of transfers to state and local governments. Partly because of this development, which did not affect spending programs of the state and local governments commensurately, the latter units have been much more disposed toward revenue increases than the federal government. Accordingly, their share of U.S. general government receipts has risen, in relation to GNP, by about ½ of 1 percentage point during the first half of the current decade.

In France, the cumulative rise in general government expenditure during 1980-85 was appreciably larger than the average for all major industrial countries, and was more heavily concentrated on social welfare transfers and subsidies. This increase, together with a virtual doubling of the ratio of government interest payments to GNP, accounted for more than 85 percent of the cumulative growth of total French government spending. Most of the increment occurred during 1981 and 1982, as a consequence of the highly stimulative (but short-lived) fiscal policy introduced to cushion the 1980-81 recession and hasten recovery. However, a major reorientation of French fiscal policy occurred in early 1983, when measures of restraint adopted to help defend the franc included steps to reduce public sector spending. Since then, the French authorities have arrested the increase in the ratio of expenditure to GDP and, despite the continued relatively slow growth of GDP, managed to reduce it slightly in 1985.

The course of general government spending during the 1980s in Canada has been broadly similar to that of France, except that the main surge occurred a year later (1982) and the cumulative rise in relation to GNP was moderately larger (8½ percentage points). Half of the cumulative increase occurred in 1982, reflecting countercyclical efforts of that year, including a large increase in the relative magnitude of unemployment insurance benefits. However, the ratio of government expenditures to GNP did not recede during 1983 and 1984, as might have been expected on cyclical grounds. On the contrary, the ratio rose in each of those years, and did not begin to recede until 1985.

One reason for difficulty in slowing the increase in the expenditure ratio in Canada has been an exceptionally persistent escalation of interest payments. Although the Canadian central government’s debt ratio is not particularly high (relative to other countries), Canadian provinces and municipalities have quite large amounts of debt outstanding. With the relatively high level of Canadian interest rates, increases in general government interest payments outpaced the growth of nominal GNP in 1984-85 by a wider margin than in any of the other major industrial countries except Italy.

Throughout much of the period since 1980, the Italian authorities have been unable to obtain the expenditure cuts or revenue increases (beyond those resulting from fiscal drag) that would have been required to meet their established goal of containing the government deficit. General government expenditures rose faster than nominal GDP in every year—and by a strikingly wide margin from 1981 through 1983. Cyclical conditions explain part of the expansion during those years, but the rise in government spending also reflects improvements in social welfare benefits, sizable wage increases in the public sector, larger transfers to troubled enterprises, and rapid growth of debt service costs. Government interest payments in Italy, expressed as a percentage of GDP, increased from less than 6 percent in 1979 to a little over 9 percent in 1983—easily the highest such ratio among the major industrial countries (Table 23). Further increases since 1983 have been considerably slower, in broad conformity with the general trend in most of the other major industrial countries toward a leveling off of this relationship. Further deceleration sufficient to permit the growth of revenues to be applied to reduction of the deficits may depend crucially on the future evolution of real interest rates.

Recent and Prospective Fiscal Influences on Economic Activity

This section, after recapitulating the most recent changes in fiscal balances reviews the prospects for 1986 and 1987, focusing on the restrictive or stimulative effects likely to be imparted to economic activity in the major industrial countries, using an analytical approach that measures the direction and strength of policy-induced changes in underlying fiscal positions. The particular concept utilized here is that of the “fiscal impulse” (expansionary or contractionary) calculated in terms of the “cyclically neutral budget” technique described below. The main provisions are summarized of what might prove to be the most important single fiscal measure of recent years—the “Balanced Budget and Emergency Deficit Control Act of 1985” enacted by the U.S. Congress and approved by the President toward the end of 1985. Although the results likely to flow eventually from this legislation are highly uncertain at the present time, some of the potential consequences are of far-reaching importance, not only for the United States, but for the world economy generally.

Fiscal Developments in 1985

The combined fiscal deficit of the major industrial countries increased marginally in relation to GNP in 1985 at the central government level and was stable at the level of general government (Statistical Appendix Tables A16 and A17). The virtual stability of the combined fiscal balance, however, resulted from contrasting movements in the balances of individual countries. The deterioration in the budgetary position of the United States in 1985 was more than large enough to offset a small decline in the composite fiscal deficit of the other six countries. For the entire group, with account taken of cyclical changes in the respective economies, the underlying fiscal impulse was expansionary at the central government level, but broadly neutral at the general government level.

The difference between the expansionary thrust of U.S. fiscal policy and the generally restrictive impulse in the other major industrial countries, taken together, was somewhat greater in 1985 than in 1984. At the general government level, the U.S. fiscal impulse was again equal to about ½ of 1 percent of GNP, while the composite for the other countries shifted appreciably toward restraint. In the United States, the expansionary impulse stemmed from the expenditure side of the fiscal account, being fueled primarily by the defense buildup and secondarily by expansion of state and local government spending. Part of the expenditure impulse, however, was offset by revenue growth associated with the built-in elasticity of the tax system.

Outside the United States, the moderate composite swing toward restraint in 1985 was largely due to developments in Japan and the Federal Republic of Germany. In each of these countries, the general government deficit was reduced by approximately 1 percentage point in relation to GNP. Occurring in a context of little or no change in cyclical influences, these reductions imparted restrictive impulses of broadly similar size. In Japan, the degree of restraint was smaller at the central government level than for the general government sector, while in Germany it was about that same at either level. Moreover, the sources of the restrictive impulses differed in other ways. In Japan, the negative impulse came to a considerable extent from the revenue side of the account, reflecting mainly the built-in elasticity of the tax system, whereas in the Federal Republic of Germany the decline in the fiscal deficit was due mainly to a fall in public investment outlays and restrained growth of social transfers. Although these categories of expenditure were also strongly restrained in Japan, the total withdrawal of stimulus from the expenditure side of the Japanese account was limited by built-in increases in social security outlays and the rise in interest payments.

In France, the thrust of fiscal policy was contractionary in 1985, particularly at the general government level, where the unadjusted deficit is estimated to have declined from 2.8 percent of GDP in 1984 to 2.5 percent in 1985. The central government deficit is estimated to have been marginally reduced from 3.4 percent to 3.3 percent of GDP, and thus to have slightly overshot the target of 3.0 percent of GDP. This withdrawal of stimulus was attributable to a slowing of expenditure growth. The decline in government expenditures as a percentage of GDP was attributable to restraints on increases in both employment and real wages in the government sector, and to deceleration in the growth of social security transfers and subsidies.

In the United Kingdom, government revenue declined in relation to GDP in 1985, reflecting the impact of lower oil prices and certain tax changes introduced in the March 1985 budget. Notwithstanding this relative decline in revenues, the government deficit also decreased moderately as a result of a sharper deceleration in the growth of government spending. In a year of relatively strong expansion of economic activity, however, much of the decline in the ratio of expenditure to GDP was due to cyclical developments. With allowance for those, the moderate change in the actual deficit must be interpreted as essentially neutral in terms of the implied fiscal impulse.

Italy was the only major European country in which the fiscal deficit widened substantially in 1985. The increase amounted to about ½ of 1 percentage point in relation to GDP, whether measured at the general government level or for the central government alone. In either case, about one third of the change could be attributed to cyclical influences in a year of rather weak GDP growth, but the greater part represented growth in the structural deficit. Slower growth of nontax revenue, increased outlays associated with social security benefit payments and other transfers to households, and termination of discretionary measures of restraint in effect during the previous year were the principal factors underlying Italy’s reversion to a more stimulative fiscal stance in 1985.

In Canada, a relatively high rate of economic growth and the implementation of a number of deficit-reducing measures adopted in the context of the May 1985 budget resulted in little change in the fiscal deficit, after three consecutive years of large and growing imbalances. The revenue measures in the budget included an increase in the sales tax, a partial de-indexation of personal income tax brackets, and temporary corporate and personal income tax surcharges. Partly because of lags in collection of the newly increased taxes and partly because government spending declined less in relation to GNP than might ordinarily have been expected in a year of rather buoyant economic activity, the thrust of central government fiscal policy in 1985 was moderately expansionary. In the broader general government accounts, because of the weight of provincial and municipal government transactions not directly affected by the shift in federal government policy, the fiscal impulse calculated for 1985 was also somewhat expansionary, although less than in the preceding two years.

The Outlook for 1986 and 1987

The projections for 1986 presented in Tables A16 and A17 of the Statistical Appendix are generally based on proposed and, in some cases, adopted budgets and medium-term fiscal plans. For the seven countries as a group they indicate a moderately contractionary thrust at the general government level and a somewhat more contractionary thrust at the central government level. On the basis of staff estimates consistent with the general assumption of “present policies,” a further contractionary impulse is indicated for 1987 at both the central and general government levels.

For the United States, the projections are based on the authorities’ “current services” estimates.5 Their estimates of the deficit on this basis have been revised downward substantially from those presented in the fiscal 1986 budget. Current services estimates for expenditures have been lowered, reflecting sizable reductions in estimates of defense spending and the first-year spending reductions required under the Gramm-Rudman-Hollings Act (described below). In deriving the projections for 1986, the staff has adjusted the U.S. authorities’ current services estimate for differing assumptions regarding economic growth, employment, inflation, and interest rate developments. According to the staff projections, the federal government deficit (on a “unified budget” basis) would decline by about 1 percentage point to 4¾ percent of GNP in 1986. With little change in the U.S. cyclical position, the thrust of fiscal policy would thus turn contractionary for the first time since 1979. This prospective shift is mostly attributable to cuts in spending and to a reduction in interest rates. Revenue is also projected to increase at a marginally faster rate than GNP, and thus, to impart some contractionary impulse. This essentially reflects the elasticity of the tax system, rather than new discretionary measures.

The overall fiscal deficit at the general government level is expected to remain unchanged in 1986 at about 3½ percent of GNP. An expansionary impulse emanating from the state and local government sector would offset the withdrawal of stimulus by the central government. (Part of the difference between the two “impulse” estimates is also due to differences in coverage between the “unified budget” and the national income accounts, as well as to timing differences between cash transactions and accruals in the federal government account.)

For the other six countries as a group, the 1986 projections indicate little change in the composite fiscal stance. In Japan, the projections for 1986, which are based on the authorities’ budget proposals (with some adjustment) and estimates made by the staff, reflect the expectation of continued efforts to reduce the budget deficit and a further withdrawal of stimulus equivalent to ½ of 1 percent of GNP at either level of government. The Japanese authorities continue to stress the containment of expenditures in a situation featuring strong growth of “entitlement” spending. Social security transfers, in particular, are growing rapidly in response to demographic factors and increasingly wide eligibility of the elderly for pensions. Against this background, containing total expenditures implies that growth in discretionary outlays will have to be especially firmly restrained. Implementation of such an expenditure policy would mean that the steady rise in revenue, which is expected to add about¼ of 1 percentage point to the revenue-GNP ratio, would produce an equivalent withdrawal of stimulus. For the most part, this prospect reflects the elasticity of the tax system, rather than any significant new discretionary measures.

In the Federal Republic of Germany, the 1986 budget has been formulated in line with the authorities’ commitment to medium-term fiscal consolidation. The overall budget deficit is projected to decline by about ¼ of 1 percent of GNP at both levels of government, notwithstanding a larger relative decline in revenue (½ of 1 percent in relation to GNP) due to implementation of previously announced measures of personal income tax relief. The strengthening of the financial position is to be effected by restricting the growth in general government expenditure so as to lower the total by about 1 percent in relation to GNP. This result would reflect above-trend growth in GNP, as well as some futher decline in the underlying share of government expenditure in total output. After allowance for cyclical factors, the withdrawal of stimulus from the expenditure side does not appear to be quite enough to offset the expansionary thrust originating from the revenue side. Accordingly, the overall fiscal impulse is expected to be slightly expansionary, both at the central government level and for the entire general government sector.

In France, the principal objective of the central government’s financial policy in 1986 will again be to limit the budget deficit to 3 percent of GDP. This objective is to be achieved through absolute reductions in some types of outlays and by reducing the real growth rates of other categories of discretionary expenditure. This expenditure restraint would more than offset the effects of a decline in the ratio of revenue to GDP, reflecting, inter alia, an income tax reduction. The net effect at the central government level is expected to be marginally contractionary after cyclical adjustment. At the general government level, the appreciably lower rate of inflation now in prospect will help to lower the rate of increase in social security transfers. The contractionary impulse from the expenditure side will be offset by a fall in the ratio of revenue to GDP stemming from income tax reduction and less rapid growth of social security revenues, and both the stance of fiscal policy and the deficit will be unchanged.

The projections for the United Kingdom are based on the 1986/87 budget made public on March 18, 1986. In 1986, the budget deficit (national income accounts basis) at the central government level is projected to decline slightly as a percentage of GDP. Central government receipts are forecast to fall by almost 1½ percentage points of GDP, with oil revenues dropping sharply and non-oil revenues rising by slightly less than the forecast growth in GDP. Overall, central government outlays are projected to decline by a somewhat greater amount, with the growth in real expenditure held to about 1½ percent. On balance, the contractionary effect of the expenditure restraint would not be large enough to offset the stimulus from slower revenue growth, and the overall thrust of fiscal policy at the central government level would be slightly expansionary in 1986 (equivalent to about¼ of 1 percent of GDP). In the 1985/86 budget, the authorities had penciled in a “fiscal adjustment” for 1986/87, amounting to about 1 percent of GDP in terms of possible reductions in personal income taxes. In the event, the steep drop in oil prices absorbed most of the scope for such reductions, and the actual budgeted cut—a 1 percentage point drop in the basic rate of income taxation—is less than one third of the originally envisaged amount. The staff forecast for 1987 assumes further steps along these lines. A broadly similar picture to that sketched above emerges by focusing on the transactions of the general government.

For Italy, the projections are based on the authorities’ “current trends” estimates, with adjustments for the deficit-reducing measures included in the proposed budget, for the effects of income tax reform, and for expected delays in budget implementation. The central government deficit in 1986 is expected to decline to about 15 percent of GDP, from 16 percent of GDP in the preceding year, which would be about 1 percentage point above the authorities’ target. The ratio of revenue to GDP is expected to grow by ½ of 1 percentage point, more than offsetting the structural growth of expenditure. A relatively contractionary impulse is thus implied, and is expected to be reflected also at the general government level. The projected increase in the relative magnitude of government revenue is partly attributable to tax measures proposed in the budget, including those to increase social security contributions and local taxes.

The 1986 projections for Canada are based on the authorities’ latest estimates as announced in the federal budget of February 1986, with adjustments for differing staff assumptions with respect to growth, inflation, and interest rates. The fiscal deficit is expected to decline by about 1½ percentage points in relation to GNP at the central government level and by almost 2 percent at the general government level. The declines reflect a modest increase in taxes, as announced in the budget of February 1986, and the full-year effects of expenditure restraints and revenue measures contained in the May 1985 budget that will greatly exceed the part-year effects reflected in the 1985 outturn. Deceleration of expenditure growth will result mainly from cuts in federal government employment. In relation to GNP, however, part of the decline in expenditure is expected to stem from a sizable drop in unemployment insurance benefits and other cyclical influences. With allowance for these factors, the overall contractionary impulse imparted to the Canadian economy is projected to be about 1¼ percent of GNP at both the central and general government levels.

For 1987, highly tentative staff projections of the central government fiscal balances of major industrial countries indicate a contractionary composite fiscal thrust equivalent to about¾ of 1 percent of GNP. This would include significant moves toward restraint in the United States, Japan, Italy, and Canada, while fiscal impulses in the Federal Republic of Germany, France, and the United Kingdom are projected to be moderately contractionary or expansionary. The projections for the United States are based on the working assumption that significant cuts in expenditure would be made in relation to the staff’s estimate of the current services deficit for 1987; however, the projections assume that less than half of the potentially very large spending cuts implied by the recently adopted “Gramm-Rudman-Hollings” legislation, described in the following subsection, will be implemented. The full implementation of the cuts provided for under this legislation would imply a further significant reduction of the federal budget deficit in 1987. The contractionary impulse in the United States would be 0.6 percentage points greater than indicated in Statistical Appendix Table A16, and the combined contractionary impulse for all seven major industrial countries would be greater by about¼ of 1 percentage point. The 1987 projections at the general government level (Statistical Appendix Table A17) broadly parallel those for the central government in all countries.

The “Gramm-Rudman-Hollings” Legislation in the United States

On December 12, 1985, the President signed legislation—the Balanced Budget and Emergency Deficit Control Act of 1985 (widely known as the “Gramm-Rudman-Holiings” Legislation)—stipulating that the federal budget deficit, which reached $210 billion in fiscal year 1985, must be reduced in each fiscal year from fiscal year 1986 to fiscal year 1991 to attain a balanced budget in the latter year. The maximum deficit amounts specified in the Act are shown in the following tabulation:

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The Act provides that automatic spending cuts would be triggered if the Administration and Congress are unable to reach agreement on measures that would achieve these targets. With the exceptions of fiscal years 1986 and 1991, the deficit may exceed the target by up to $10 billion without triggering the mandatory spending cuts; once triggered, however, those cuts must be sufficient to bring the deficit down to the target for that year. For fiscal year 1986, the reduction in outlays is limited by the Legislation to a maximum of $11.7 billion regardless of the amount by which the projected deficit for that year exceeds the maximum; no leeway is allowed for fiscal year 1991.

The first step in the process of expenditure reduction will involve the presentation of a joint report, on August 20 of each year, by the Office of Management and Budget and the Congressional Budget Office to the Comptroller General, who is head of the General Accounting Office. The reports are required to provide:

  • (1) estimates of the amount by which the projected deficit exceeds the maximum deficit for the fiscal year covered by the report;

  • (2) a set of economic assumptions, including the estimated rate of real economic growth in the fiscal year covered by the report; and

  • (3) calculations of the percentages and amounts by which various budget categories must be reduced to eliminate any difference between the projected deficit and the maximum deficit.

The Comptroller General will then review the joint report and issue his own report on August 25 to the President and to the Congress; this report should either confirm or modify the estimates provided by the Office of Management and Budget and the Congressional Budget Office. An order by the President implementing the spending cuts specified by the Comptroller General must be issued on September 1, 1986. Unless Congress acts—and the President agrees—to modify the spending reductions in the Comptroller General’s report by adopting an alternative deficit reduction plan (which could include tax increases as well as alternative spending cuts), the expenditure reductions will take effect on October 1. Any Congressional action taken during September to reduce the gap between the estimates and the maximum allowable deficit will be reflected in a final Presidential order to be issued on October 15, 1986.

Special procedures are to be followed in the event of a recession. Specifically, the Director of the Congressional Budget Office must notify Congress at any time:

  • (1) if during the current and preceding quarter, and with respect also to the four quarters following the notification, the Congressional Budget Office or the Office of Management and Budget has projected real economic growth to be less than zero in two consecutive quarters within this six-quarter period; or

  • (2) if the Department of Commerce reports that actual real economic growth for the most recent and immediately preceding quarter is less than 1 percent.

Upon receiving such notification, both Houses of Congress will suspend the obligation to achieve the maximum deficit target for the current fiscal year and the next fiscal year, as it applied to Congressional budget resolutions and the President’s budget submissions.

Certain federal programs and activities are exempt from mandatory cuts under the Act. These include social security benefits, veterans’ compensation and pensions, regular state unemployment insurance benefits, medicaid, aid to families with dependent children, food stamps, supplemental security income, and interest on the federal debt. Certain other programs, while not exempt, are subject to special rules limiting the extent of the cuts. For example, programs such as medicare and veterans’ medical care cannot be cut by more than 1 percent in fiscal year 1986 and 2 percent in subsequent fiscal years. Programs with provisions for annual cost of living adjustments, such as pensions, can be cut by no more than the total cost of living adjustment in any one year.

The Act requires that 50 percent of the mandatory cuts come from domestic programs and 50 percent from the defense budget. For fiscal year 1986 only, the Act gives the President authority to exempt all or part of military personnel from cuts; he has chosen to use this authority, and has exempted 93 percent of the fiscal year 1986 appropriations in this area from cuts. The Act also permits the President (for fiscal year 1986 only) to adjust to a limited extent the percentage reductions for particular programs within a given category of defense spending. Except for these special provisions applying to fiscal year 1986, and subject to the exemptions and limitations described above, all programs must be cut on a uniform percentage basis, computed separately for defense and nondefense programs.

For fiscal year 1986, the average of the deficits recently estimated by the Office of Management and Budget and the Congressional Budget Office is $220.5 billion. As indicated above, the Act limits spending reductions to $11.7 billion for the current fiscal year. This figure reflects the fact that the Act restricts deficit reduction measures to a maximum of $20 billion at an annual rate for fiscal year 1986; as the reductions will not take effect until March 1, 1986, the maximum deficit reduction is seven twelfths of $20 billion. The President’s order specifying these cuts was issued February 1, 1986.

On February 7, 1986, a federal court ruled that a crucial provision of the Balanced Budget and Emergency Deficit Control Act of 1985 (the “Gramm-Rudman-Hollings” law) was unconstitutional because it violated the separation of powers among the three branches of government. The court stated that powers conferred by the law on the Comptroller General as part of the provision for the automatic spending reductions were executive powers that could not be exercised by an official who is removable by Congress. The court stayed the effect of its order pending the outcome of an appeal to the Supreme Court.

Calculation of Fiscal Impulse and Fiscal Data Base

This section provides a brief description of how the “fiscal impulse” measure is derived from the “cyclically neutral budget” model, and of the fiscal data used in the analysis undertaken earlier in this Note. The “cyclically neutral budget” technique involves a distinction with respect to government revenues and expenditures between changes considered to be associated with cyclical fluctuations in the output of an economy and other changes, which may be viewed as imparting expansionary or contractionary impulses to the economy independently of the more or less automatic responsiveness of government transactions to cyclical developments. Revenue is regarded as cyclically neutral when it grows in proportion to actual GNP at current prices, and is contractionary (expansionary) when it increases faster (more slowly) than actual GNP. Expenditure other than unemployment insurance benefits is regarded as cyclically neutral if it parallels the movement of potential GNP at current prices, and is expansionary (contractionary) when it increases faster (more slowly) than potential GNP. Year-to-year variations in unemployment insurance benefits are viewed as cyclically neutral—that is, merely reflecting cyclical developments in the economy.6 The net “impulse” from changes in revenue and expenditure (that part of any net change in the fiscal balance that cannot be attributed to “cyclically neutral” changes in revenue or expenditure) may be interpreted as a cyclically adjusted indicator (according to the criteria just specified) of stimulative or restrictive shifts in government fiscal operations.7 Such changes may be viewed as policy determined either (1) by the introduction of new measures or (2) by the operation of previously existing measures that automatically result in revenue (expenditure) changing disproportionately to the change in GNP (potential GNP) by which “neutrality” is judged.

The fiscal impulse measure, as defined above, differs from the measure of “discretionary changes” in budget items employed by the Organization for Economic Cooperation and Development in its Economic Outlook reports. The latter measure is calculated by deducting from the change in the fiscal balance the estimated effect on the budget of the operation of automatic stabilizers. The deduction is based on structural estimates of the automatic responsiveness of revenue and expenditure to cyclical fluctuations in real output, rather than on equiproportionate revenue and expenditure rules.

The fiscal impulse measure also has not taken account of the potentially different aggregate demand effects associated with increases in noninterest expenditure or decreases in revenue as opposed to increases in expenditure due to the effects of inflation on interest payments. In a situation of increasing inflation, nominal interest rates may rise sharply, leading to a significant increase in interest payments and a deterioration in the fiscal position. It has been argued that the implicit amortization component of these interest payments (reflecting the erosion of outstanding debt, in real terms, through inflation) has a much weaker impact on aggregate demand than other types of expenditure or revenue measures. The appropriate adjustment of the fiscal balance for the effects of inflation is itself a matter of controversy, but the effects of such adjustments on the measure of fiscal impulse are likely to be important only in periods when the inflation rate accelerates or decelerates rather sharply. If movements in the expected inflation rate could be assumed to closely parallel movements in the actual inflation rate, then adjustment of the fiscal impulse measure for the effects of inflation would impute a more expansionary (contractionary) character to fiscal policy in a period of declining (increasing) inflation than would be implied by the unadjusted fiscal impulse measure.

The data on central government fiscal balances shown in Statistical Appendix Table A16 generally conform to the standards used in the Fund’s Government Finance Statistics Yearbook, which call for the recording of government transactions on a cash basis and the classification of net government lending (loan disbursements less repayments) with expenditures rather than with financing. For the United Kingdom and Canada, however, and for Japan (in large part), the data are on a national income accounts basis; for the Federal Republic of Germany and France, the data are on an administrative basis and do not incorporate social security transactions in the latter case; and for Italy, the data cover the transactions of the state budget as well as those of several government-owned enterprises but, instead of including the gross revenue and expenditure transactions of social security institutions, include only net transfers from the central government to these institutions. The data on general government fiscal balances, in Statistical Appendix Table A17, cover the consolidated balances of central, regional, and local government units engaged in performing governmental functions but exclude government-owned industrial and commercial enterprises. These data are on a national income accounts basis, and thus exclude net government lending from expenditure. The data in Statistical Appendix Tables A16 and A17 are derived from national sources and Fund staff estimates. The base year for the calculation of the fiscal impulse is 1978. In general, definitions and statistical sources used are the same as in the April 1985 World Economic Outlook exercise except for the Federal Republic of Germany and the United Kingdom. The central government data on Germany have been shifted from a cash to an “administrative” basis in order to remain in agreement with government practice, which first introduced the shift. In addition, the data on growth of potential output in Germany have been revised to take account of new estimates reported by the Bundesbank. The figures related to the Central Government of the United Kingdom have been changed from a cash to a national accounts basis; this shift has been introduced to facilitate the interpretation and forecasting of central government finances in view of recently observed wide and erratic fluctuations in central government net lending to other entities within the public sector. In addition, several other fiscal data series for both central and general government and some of the GNP series have been revised since the publication of the World Economic Outlook, April 1985.

Supplementary Note 2 Monetary Developments in Major Industrial Countries

During the past decade, a number of major industrial countries specified target ranges for the growth of key monetary aggregates as part of a medium-term policy framework that gave special emphasis to controlling inflation. These monetary targets have played an important role in establishing the credibility of the authorities’ commitment to anti-inflation policy and have thereby increased the policy’s effectiveness. Partly as a result of this policy, the average rate of inflation (as measured by the GNP deflators) in the major industrial countries has declined from over 9 percent in 1980 to 3.6 percent in 1985. This represents the lowest average rate of inflation in these industrial countries since 1967.

While the period since 1980 has witnessed a decline in inflation in all major countries, the implementation of policies involving monetary aggregates targeting has faced a number of difficulties. The substantial changes in exchange rates, nominal and real interest rates, and financial market structures that occurred in the early 1980s made it difficult for the authorities in some countries to control and to interpret movements in monetary aggregates. These developments also complicated the operational problems associated with the conduct of monetary policy by introducing increased variability into the relationships between the growth rates of monetary aggregates and the expansion of nominal income. The extent and nature of this variability has differed across countries. The velocities of some key monetary aggregates (such as M2 in the United States) have oscillated over a wider range than previously experienced while showing no clear trend, whereas the velocities of certain other key aggregates (such as sterling M3 (£M3) in the United Kingdom) have shifted trend in a reversal of previous behavior.

In some cases, central banks have specified their targets without being able to predict the sharp movements in velocity that would occur during the target year, especially when market innovations or changes in regulations led to the creation of new types of financial instruments. Changes in financial market regulations generally tended to increase the velocity of narrow monetary aggregates, which usually include a relatively high proportion of assets with controlled interest rates; whereas the velocity of more broadly defined aggregates did not change as substantially.1 To a considerable extent, the pressures that gave rise to financial deregulation resulted from the rapid growth of new forms of financial instruments with market-related yields, which in turn reflected the strong incentives for the public to reduce its holdings of instruments with fixed or controlled yields in a period of high market interest rates.

The uncertainties surrounding the nature and stability of the linkages between the monetary authorities’ policy instruments, their intermediate monetary targets, and their overall macroeconomic objectives have affected both the priority given to achieving monetary targets and the range of economic and financial variables used by the authorities in evaluating monetary conditions. As a result of these uncertainties, the growth rates of monetary aggregates have in a number of cases been allowed to move outside their target ranges. In some cases, target ranges have been modified prior to the end of the original target period and, in certain countries, the new bases that have been set for the monetary targets have incorporated the overshooting of the target ranges in the previous period. Several countries have established target ranges for more than one aggregate simultaneously, and in some cases the targeting of particular monetary aggregates has been de-emphasized or abandoned.

Of course, the monetary authorities in the major industrial countries have for some time examined a broad range of indicators of economic activity and financial market developments in evaluating monetary conditions. Nevertheless, the general decline in inflation and the instability of the linkages between money and income in some countries have led some authorities to give relatively more weight than previously to movements in such variables as the exchange rate, interest rates, and nominal or real income. The behavior of monetary aggregates relative to their targets nonetheless remains an important consideration in the formulation of policy in most major countries. However, the renewed focus on short-term movements in exchange rates, interest rates, output, and employment raises issues concerning the extent to which the authorities can pursue these objectives through monetary policy without jeopardizing the credibility of their long-term commitment to an anti-inflation policy.

Recent monetary policy in the major industrial countries is examined in the next section. The first part of that section considers developments in these countries as a group while the second contains notes on individual countries’ experiences. The final part of that section of the note examines prospects for 1986.

Recent Monetary Policy Developments

While the average rate of growth of both narrow and broad money in the group of major industrial countries was lower in 1984 than in 1983, the average rate of monetary growth accelerated during 1985 (Tables 24 and 25). The slower monetary growth in 1984 reflected both reductions in the target growth rate ranges for key monetary aggregates and greater success in keeping actual rates of monetary growth within the target ranges (Chart 32). As a result, the average rate of growth of narrow money in the major countries declined from 8.6 percent in 1983 to 6.9 percent in 1984, while the average growth rate of broad money fell from 10.1 percent to 7.9 percent. In 1985, by contrast, the rate of growth of broad money rose to 8.9 percent, while narrow money growth accelerated to 10.1 percent—the highest rate of expansion for this aggregate since the late 1970s. The acceleration of monetary growth reflected both overshooting of target growth rate ranges and modifications of the target ranges during the original target period. Even in those countries where the rates of monetary expansion fell within the target ranges, they were generally near the upper bounds of those ranges.

Table 24.

Major Industrial Countries: Selected Composite Data on Monetary Aggregates and Other Variables, 1978-851

(Annual percentage changes, except as noted)

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All of the data shown are weighted averages for the seven major industrial countries (with weights for each year’s calculation proportionate to U.S. dollar values of the respective GNPs in the preceding three years).

Changes from year-end to year-end.

Constructed by dividing nominal monetary aggregates by GNP deflators.

Based on average stock of money during the year.

Annual average.

Average of quarterly data calculated by adjusting the nominal rates by the effect of expected changes in prices. The expected change in prices is calculated from a weighted average of the rate of inflation in the current quarter and the next two quarters, with the deflator of private final domestic demand being used as the price variable.

Table 25.

Major Industrial Countries: Changes in Stocks of Narrow Money and Broad Money, 1978-85

(Percentage changes from year-end to year-end)

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These composites are averages of individual country rates, weighted for each year in proportion to the U.S. dollar values of the respective GNPs in the preceding three years.

M2 for Canada, the United States, and Italy; M2 + CDs for Japan; M2R for France; M3 for Germany; and £M3 for the United Kingdom.

Chart 32.
Chart 32.
Chart 32.

Six Major Industrial Countries: Target Ranges and Growth of Targeted Aggregates, 1981-861

1 As reported at end of policy period. Target ranges project from base at beginning of policy period, and as bands for the United Kingdom beginning in 1985.

Despite this more rapid monetary expansion, the weighted average growth of nominal GNP of the major industrial countries slowed sharply from 9.1 percent in 1984 to 6.4 percent in 1985 as the income velocities of both narrow and broad money declined. While the slower expansion of nominal GNP was accompanied by a slight reduction in inflation (the GNP deflator slowed from 3.9 percent in 1984 to 3.6 percent in 1985), real output growth also declined from 5.0 percent in 1984 to 2.8 percent in 1985.

During 1985 and the first few months of 1986, there was a widespread decline in interest rates, whether measured on a nominal or a real basis, for both short-term and longer-term maturities (Chart 33). The average of short-term nominal interest rates fell from 9.7 percent in 1984 to 8.4 percent in 1985; long-term nominal rates declined from 11.1 percent to 9.9 percent. With inflation stable, or declining only slightly, real interest rates are estimated to have fallen in both short-term and long-term markets. However, the declines in interest rates were not uniform across the major industrial countries. In the United States, downward pressures on interest rates were particularly pronounced in the 18 months prior to the end of 1985. Although interest rates also fell in most other countries, the extent of these declines often differed from that in the United States. As a result, there were sizable changes in the pattern of interest rate differentials. In addition, with the exception of the Federal Republic of Germany and Japan, the long-term interest rate differentials in the past two years have been considerably smaller than the short-term yield differentials. In part, this could reflect the fact that short-term rates have been more strongly affected by the operations of the monetary authorities.

Chart 33.
Chart 33.
Chart 33.

Seven Major Industrial Countries: Short-Term and Long-Term Interest Rates and Underlying Inflation, 1981-861

(In percent)

1 Underlying inflation is measured by a weighted average of the rate of inflation in the current quarter and the next two quarters, with the deflator of private final demand being used as the price variable.

While nominal interest rate differentials have shown a somewhat diverse pattern, real interest rate differentials have shown greater convergence, especially in the period since mid-1984. For each of the major industrial countries except Canada, the real long-term interest rate differential with the United States has declined from the 4 to 5 percent range to less than 2.5 percent.

On average, the income velocities of both narrow and broad money declined in 1985, in contrast to the previous year (Table 24 and Chart 34). These swings in velocity continued a pattern of variability that has been apparent since the late 1970s. Over this period, the behavior of inflation rates and nominal and real interest rates has combined to produce substantial movements in the velocities of the key monetary aggregates. The reduction in the level and variability of inflation and the emergence and persistence of high real interest rates have tended to increase the general attractiveness of financial assets relative to that of real assets. During 1982 and 1983, the average velocity of both narrow and broad money declined sharply as inflation slowed and nominal interest rates fell from the peak levels seen in 1981. After mid-1983, however, the decline in inflation slowed and nominal interest rates either stabilized or edged up; reflecting this, in 1984, the velocities of broad and narrow money both changed at rates roughly comparable to the trend rates of increase evident in the period prior to the high inflation era of the late 1970s. In 1985, stable inflation and a renewed decline in interest rates were accompanied by declines in the velocities of both broad and narrow money.

Chart 34.
Chart 34.
Chart 34.

Seven Major Industrial Countries: Velocities of Broad and Narrow Money, 1970-85

(Quarterly GNP al annual rates/average stock of money during quarter)

Despite the pronounced variability of velocity for the major industrial countries as a group, certain industrial countries have had relatively stable velocities for their key monetary aggregates. Since the mid-1970s, in particular, the income velocities of central bank money in the Federal Republic of Germany and M2 + CDs in Japan have shown relatively modest variability around a downward trend (Chart 34). In contrast, the velocities for the key monetary aggregates in other major industrial countries have at times shown reversals of trend (such as £M3 in the United Kingdom) or increased variability around an unchanged trend (such as M2 in the United States). While the lower variability of velocity in Germany and Japan has reflected the more stable evolution of inflation and interest rates in those countries, it may also be due in part to the fact that financial markets in the Federal Republic of Germany and Japan have until recently not experienced as extensive a series of institutional changes as financial markets in some other countries.

Country Notes

United States—The monetary growth ranges set at the beginning of 1985 were kept substantially the same as in 1984, and were judged to be consistent with “further sustainable economic growth and progress toward reasonable price stability over time.”2 At the time it was formulating its 1985 objectives, the Federal Open Market Committee projected that both real GNP and the GNP deflator would increase by 3½ percent to 4 percent during 1985, and it was also assumed that the monetary aggregates would not be appreciably influenced by any new statutory or regulatory developments. In setting a target range of 4-7 percent growth for M1, account was taken of the behavior of M1 velocity during 1984, together with other evidence, which suggested that “the factors responsible for the highly unusual velocity behavior over 1982 and early 1983 have receded.”3 Moreover, in setting growth targets of 6-9 percent for M2 and 6-9.5 percent for M3, it was recognized that a large continuing net capital inflow from abroad might tend to slow the growth of certain components of M2 and M3, thereby restraining the growth of these aggregates in relation to bank credit and credit generally.4

As shown in Chart 32, at the time that the Federal Reserve submitted its Monetary Policy Report to the Congress in February 1985, all three monetary aggregates were above the upper bands of their target ranges, as traditionally indicated by growth cones projected from the base-period levels that prevailed in the fourth quarter of 1984. “As a matter of economics and policy, rather than graphics,” however, the Federal Open Market Committee was “not disturbed” by that development; Chairman Volcker indicated to Congress that the aggregates remained within “parallel lines drawn back from the outer bounds of the specified fourth quarter (1985) target ranges to the base period,” and that the Committee contemplated that “as the year progresses, growth will slow consistent with the target ranges.”5 At mid-year, however, only M2 and M3 had been brought back within their cones. By that time, interest rates had drifted lower as industrial output remained little stronger than a year earlier, and the Federal Open Market Committee had lowered by roughly 1 percentage point its projections for both real and nominal GNP growth during 1985. In re-examining its targets in July, the Committee expected that the sharp decline in M1 velocity during the first half of the year would be neither extended nor substantially reversed in the second half; however, the high degree of uncertainty surrounding the behavior of M1 velocity was explicitly recognized. Reflecting these various considerations, the base for the target range for M1 was shifted forward to the second quarter of 1985, and the range itself was widened to 3-8 percent for the second half of the year.

Over the next several months, however, M1 continued to grow rapidly. At the October meeting of the Federal Open Market Committee it was suggested that “the recent strength in M1 could not be explained fully by such factors as institutional changes and financial innovations” but should be judged “in the context of the performance of the economy and the relatively moderate growth in the broader aggregates.”6 Accordingly, it was decided not to react aggressively to M1 growth above the upper bound of the rebased target range.

For 1985 as a whole, M1 in the United States expanded by nearly 12 percent (fourth quarter 1984 to fourth quarter 1985), while the growth rates of M2 and M3 were held within their target ranges. Nominal interest rates continued to decline in 1985 and early 1986, most markedly for long-term maturities, and the Federal Reserve lowered its discount rate by ½ of 1 percentage point in May 1985 and by another ½ point in early March 1986. The monetary targets for 1986, as adopted in February, have retained the 6-9 percent range for M2 growth while narrowing the M3 range slightly, also to 6-9 percent. The range for M1 was set at 3-8 percent, the same as the revised range that the Federal Open Market Committee adopted last July for the second half of 1985.

Federal Republic of Germany—In 1985, monetary developments in the Federal Republic of Germany were consistent with the plans established by the authorities at the end of 1984. For the period from the fourth quarter of 1984 to the fourth quarter of 1985, the Central Bank Council had indicated a target range of 3-5 percent for the growth of central bank money. This range was based on projections that both potential output and prices would increase about 2 percent. No allowance for a change in the velocity of circulation was included. During the target period, central bank money expanded at a seasonally adjusted annual rate of about 4½ percent, toward the top end of the target corridor (Chart 32) and much the same as the rate experienced in 1984.

Both short-term and long-term interest rates declined steadily from March until August-September 1985 (Chart 33). These declines reflected a number of factors, including the continued slowing of domestic inflation and strong foreign demand for deutsche-mark-denominated financial assets. Although German interest rates declined by somewhat less than comparable U.S. dollar interest rates during this period, the reduction in market interest rates had created a situation by mid-August in which the Bundesbank was able to lower both its discount and Lombard interest rates by ½ of 1 percentage point to 4 percent and 5.5 percent, respectively. German interest rates increased somewhat in the fourth quarter of 1985, but began to decline again in 1986. In early March 1986, the Bundesbank reduced its discount rate by another ½ of 1 percentage point to 3.5 percent.

In December 1985, the Deutsche Bundesbank set a new target range of 3.5-5.5 percent for the growth of central bank money for the period from the fourth quarter of 1985 to the fourth quarter of 1986. This target range is based on an estimated potential real output growth of 2.5 percent in 1986 and a projection of around 2 percent for underlying price inflation. The target range does not make any allowance for changes in the income velocity of central bank money.

During 1985, the monetary authorities also took measures to increase the competitiveness of the German financial markets. In May, for example, the range of assets available on German markets was expanded with the admission of various new financial instruments (such as floating rate notes, zero-coupon bonds, dual-currency bonds, and bonds linked to currency and interest rate swaps), which had previously been excluded. Moreover, in December, the Central Bank Council recommended a reduction and restructuring of reserve ratios, having the effect of reducing the reserves credit institutions are required to hold by about DM 8 billion. As part of these changes, liabilities in foreign currencies to non-residents will largely be freed from the minimum reserve requirement, but certain newly issued bank bonds with an original maturity of less than two years will be subjected to minimum reserve requirements. In addition, the Bundesbank indicated that it would not object if credit institutions domiciled in the Federal Republic of Germany issued deutsche-mark-denominated paper having the character of certificates of deposit.

Japan—In recent years, monetary policy in Japan has attempted to influence interest rates and the growth of money and credit through intervention in the money markets and through variations in the discount rate. While credit ceilings are still a potential instrument of monetary control, they have not been used for several years. The change in the implementation of monetary policy reflects the evolution of the Japanese financial market that has occurred in response to a gradual process of financial deregulation. In the past two years, this has included the liberalization of the foreign exchange market (for example, by increasing the scope of transactions that could be undertaken by foreign exchange banks and currency brokers), the introduction of new financial instruments (such as bankers’ acceptances, bond futures, and money market certificates), expansion of the Euroyen bond market, and allowing foreign financial institutions improved access to Japanese markets. As a result, market forces have played an increasingly important role in the determination of domestic interest rates, and the linkages between Japanese and international financial markets have been strengthened.

The Japanese authorities have regarded movements in the broad money stock (M2 + CDs) and interest rates as the primary indicators of monetary conditions. The demand for M2 +CDs is regarded as more stable than that for narrower aggregates, while data for even broader aggregates are available only with longer reporting lags.7 Although there is no formal targeting of monetary aggregates, the Bank of Japan announces in the first month of each quarter a projection, with a loosely specified range, for the year-on-year growth of M2 + CDs measured from the same quarter of the previous year. The Bank of Japan’s projection for the first quarter of 1986 was 9.0 percent. In general, actual growth rates have been in line with official forecasts (Chart 32).

M2 + CDs expanded by 9 percent during 1985 in contrast to an average of approximately 7½ percent during the previous three years (Table 25). During much of last year, however, the primary focus of monetary policy was on exchange rate objectives. The sharpest change in monetary conditions during the year occurred following the September 22 Group of Five meeting, at which the five largest countries expressed themselves in favor of an orderly appreciation of non-dollar currencies (including the Japanese yen). The Bank of Japan decided not to sterilize the shortage of funds in the interbank market that resulted from its intervention in foreign exchange markets, and also decided not to accommodate the seasonal increase in the demands for funds in the domestic money market. As a result, short-term interest rates increased by 1-1½ percentage points by the end of October, effectively eliminating the short-term differential between nominal interest rates on Japanese and U.S. assets. This rise in short-term interest rates, however, was more than reversed by early 1986 as the yen strengthened further and the Bank of Japan reduced its discount rate by ½ percentage point in order to support domestic demand. The discount rate was reduced ½ of 1 percentage point further in early March.

United Kingdom—Since fiscal year 1980/81, monetary policy in the United Kingdom has been formulated in the context of a medium-term financial strategy designed to achieve lower rates of inflation through a progressive lowering in the growth rates of the targeted monetary aggregates. The specific set of targeted aggregates has varied with changes in their perceived usefulness as indicators of monetary conditions during a period of extensive financial liberalization. In addition, various supplementary indicators, including the exchange rate, have been taken into account in interpreting financial conditions and in determining interest rate policy. The budgets for fiscal years 1985/86 and 1986/87 reaffirmed the Government’s commitment to the medium-term financial strategy and to maintaining monetary conditions consistent with declining growth of nominal GDP and inflation, with short-term interest rates to be set at levels needed to achieve this objective.

For fiscal year 1984/85, the authorities had adopted £M3 as the sole broad money target, while the wide monetary base MO was introduced as the target for narrow money.8 In accordance with the medium-term financial strategy, the target ranges for 1984/85 were set at 4-8 percent annual growth for MO and 6-10 percent for £M3, and it was projected that by fiscal year 1988/89 these target ranges would decline to 0-4 percent annual growth for MO and to 2-6 percent annual growth for £M3. In the 14 months to April 1985, MO grew within its target range at an annual rate of 5.7 percent, while £M3 grew somewhat above its target range at an annual rate of 11.9 percent (Chart 32).9 In the new budget year, the growth rates of the two aggregates began to diverge more strikingly: MO grew at an annual rate of 3.5 percent in the 12 months to February 1986 (compared with its 1985/86 target range of 3-7 percent), while £M3 grew by 14.8 percent (compared with its target range of 5-9 percent).

The authorities attributed the strong growth of £M3 to a permanent shift in the demand for broad money, reflecting developments in financial markets arising from decontrol of the banking system and the restoration of positive real interest rates during the early 1980s. The associated downturn in velocity had not been sufficiently factored into the fiscal year 1985/86 target range for £M3, and with financial liberalization having altered the usefulness of the broad aggregates as indicators of financial conditions, the authorities downgraded the role of £M3 and upgraded that of the exchange rate. This development was foreshadowed in January 1985 by the abandonment of the “decoupling policy,” which had focused interest rate policy almost exclusively on domestic indicators and objectives. At that time, the authorities allowed short-term interest rates to rise by 4½ percentage points to 14 percent in order to halt the depreciation of the pound relative to the U.S. dollar. Subsequently, as the pound strengthened, interest rates were allowed to decline by 2½ percentage points, despite the overshooting of the £M3 target.

In January 1986, amid falling oil prices, renewed downward pressure on the pound and the continued buoyancy of bank lending prompted the authorities to let base interest rates rise by 1 percentage point. Despite further easing of the exchange rate and upward pressure on interest rates, a further increase was resisted. While the authorities are paying close attention to the exchange rate as an indicator of monetary conditions, they do not have an exchange rate target. Indeed, they appear willing to countenance declines in the effective value of sterling associated with falling oil prices to the extent that the effects of the two factors on the inflation rate are broadly offsetting.

In mid-March 1986 the authorities released their budget for 1986/87, including new monetary target ranges. The target ranges for fiscal year 1986/87 were set as annualized growth rates of 2-6 percent for MO and 11-15 percent for £M3. The day after the budget was released, base interest rates were reduced by 1 percentage point.

France—In 1985, inflation and interest rates in France continued the declines that began several years earlier. Measured by the consumer price index, inflation has fallen continuously from over 13 percent in 1981 to less than 5 percent from fourth-quarter 1984 through fourth-quarter 1985. Since 1981, both short-term and long-term nominal interest rates have been reduced by more than 5 percentage points. Because inflation and nominal interest rates have moved together in the period since mid-1983, however, real interest rates have generally remained within the range of 4-6 percent.

In 1984, the French authorities began to formulate their monetary target in terms of M2R (M2 held by residents), rather than total M2.10 In that year, M2R growth somewhat exceeded the upper bound of the target range of 5.5 to 6.5 percent (Chart 32). For 1985, monetary policy was again formulated in terms of M2R and the target growth rate range was set at 4-6 percent. During the first half of 1985, the expansion of M2R generally exceeded the upper bound, and this led the authorities to take measures in June designed to restrict the extension of credit by banks and to restrain capital inflows through the balance of payments. These measures included a lowering of the limits on bank lending not subject to penalty rates, holding down new foreign borrowing, and encouraging the private sector to repay foreign debt in advance of maturity.

In order to reflect recent financial innovations and institutional changes in the banking system, such as the introduction of instruments similar to claims on money markets funds, the authorities have chosen to change their definitions of the monetary aggregates from a classification based on institutional criteria to a new system based on the nature and the substitutability of the financial assets involved. The authorities have adopted the redefined concept of M3 as the target aggregate for 1986.11 The 1986 target range has been set at 3-5 percent, 1 percentage point lower than the 1985 target range for M2R, to indicate the continuing commitment of the authorities to reduce inflation.12 The authorities have also reiterated their intention to move away from the present system of credit controls toward a system based on the control of interest rates, in order to give market forces more influence on the allocation of credit.

Canada—From 1975 until late 1982, the Canadian monetary authorities set a specific target range for the growth of M1 as a policy guide in their attempts to achieve sustained economic expansion and long-term price stability. In November 1982, however, the Bank of Canada abandoned the practice of monetary targeting. It was felt that the relationship between the monetary aggregates (particularly M1), nominal income, and interest rates had become unstable as a result of financial innovations (such as the introduction of interest-bearing checkable accounts and the wide spread availability of cash management facilities for businesses). These innovations in the financial sector led to a shift of funds from accounts classified as part of M1 (currency and non-interest-bearing demand deposits) into deposits bearing market-related interest rates.13 As a result of the inflows into these types of deposits, there was a sharp divergence between the rates of growth of M1 and M1A (which includes interest bearing checking accounts). While M1 increased at an annual average rate of 3.3 percent during 1981-84 (Table 25), the average rate of growth for M1A was 12.0 percent. Consequently, after mid-1981 the income velocity of M1 increased, while that of M1 A declined. Since its decision to abandon monetary targeting, the Bank of Canada has implemented its monetary policy with reference to a variety of economic and financial indicators, including in particular the exchange rate between the Canadian dollar and the U.S. dollar.

During 1985, the sharp divergence between the growth rates of M1 and M1A continued, but the growth of both aggregates accelerated substantially relative to their earlier pace. M1 and MIA expanded by 9.4 percent and 38.3 percent, respectively, in 1985, having grown by 0.3 and 21.7 percent, respectively, in 1984. The authorities attributed the acceleration of the growth of M1A to an ongoing substitution of interest bearing checking accounts for other types of deposits. In addition, the more rapid growth of M1 since mid-1985 has been associated in part with changes in the amount of bank float (that is, changes in the amount of checks and other items that have been deposited or cashed but not yet debited from the accounts on which they were drawn).

Under current conditions, one aim of monetary policy has been to try to reduce interest rates so as to promote economic expansion, provided these interest rate movements do not conflict with the objectives of maintaining a reasonably stable exchange rate and low inflation. Thus, when confronted with the downward pressure on the Canadian dollar that resulted from an increase in U.S. interest rates in the first half of 1984, the Canadian authorities allowed domestic interest rates to increase. Similarly, in early 1985, Canadian interest rates, especially short-term rates, were allowed to rise as U.S. interest rates firmed and the U.S. dollar strengthened relative to the Canadian dollar. However, the subsequent decline in U.S. interest rates permitted reductions to take place in Canadian rates also. As a result, average interest rates (both nominal and real) in Canada were about 2 percentage points lower in 1985 than in 1984.

In September 1985, two bank failures occurred (the first in Canada in more than sixty years). One of the banks involved had received considerable support in the form of an infusion of funds from federal and provincial governments and other Canadian banks. These failures led to liquidity problems in certain small Canadian banks as a result of large deposit withdrawals. However, the authorities felt that this episode did not threaten the financial position of the banking system as a whole and did not raise major problems for the implementation of monetary policy.

Italy—Although the Italian authorities do not announce targets for monetary aggregates in their management of monetary affairs, overall economic policy is based on plans that include projections for a broad range of monetary and credit aggregates, including total domestic credit and its components and the financial assets held by the private sector. Since the beginning of 1984, the authorities have sought to influence financial conditions through their policies regarding the monetary base and interest rates, rather than through direct controls over the availability of domestic credit.14 For 1985, the authorities’ plans included a continued deceleration in rates of monetary and credit growth. This was viewed as consistent with both a further reduction in inflation and some expansion of real output. However, the planned deceleration was achieved only for credit to the private sector, which is estimated to have grown by 12.6 percent in 1985 (15.6 percent in 1984).15 Credit to the state sector expanded by an estimated 21.7 percent in 1985 (22.8 percent in 1984), which was more than 2.5 percentage points above the projected increase of 19.0 percent. M2 is estimated to have increased by about 11.2 percent (the central projection was 10 percent), as the sharp loss in foreign reserves registered in the fourth quarter led to a marked slowdown of the monetary aggregates. The monetary base adjusted for the automatic increase in reserve requirements is projected to have grown by 14.6 percent, 4.6 percentage points above the initial target.

The major source of liquidity growth was the public sector deficit. As in several recent years, it was originally planned to keep the fiscal deficit unchanged in nominal terms. However, the state sector borrowing requirement is estimated to have been approximately 13 percent higher in 1985 than originally planned, and the deficit therefore rose to 16.0 percent of GNP instead of the originally projected 14.4 percent. Similar difficulties in controlling the size of the public sector deficit have been experienced during most of the 1980s.

Although the central bank no longer has a legal obligation to underwrite the public sector deficit, it was felt that financing the larger than anticipated deficit through the issuance of nonmonetary obligations would require increases in interest rates that were not warranted in the face of an already weak demand for credit by the private sector. In 1985, 26 percent of the public sector deficit was financed by credit extended by the Bank of Italy, against 11 percent in 1984. As a result, in 1985 central bank credit to the Treasury accounted for approximately 145 percent of the increase in the monetary base, against about 72 percent in 1984.

On average, both short-term and long-term interest rates in Italy were lower during 1985 than during 1984 (Chart 33). Short-term rates fell from slightly more than 17 percent in 1984 to about 15 percent in 1985, and long-term rates fell from 15 percent to around 13 percent during the same period. Given the concomitant reduction in inflation, however, real interest rates showed a much smaller decline, and began to rise again after the middle of 1985.

The authorities’ plans for 1986 envisage a 9.5 percent increase in credit to the private sector,16 along with a 9 percent increase in the stock of M2. Partly because of the recent decline in the cost of oil imports, it is envisaged that these growth rates for money and credit would support a 10.5 percent rise in nominal GNP. The deficit of the state sector is projected to increase somewhat in nominal terms but to decline to about 14½ percent as a share of GNP.

Review of 1985 and Outlook for 1986

Table 26 summarizes the sharp contrasts in the “velocity puzzles” that different central banks encountered in pursuing their 1985 monetary growth targets. In the Federal Republic of Germany and Japan, the changes in velocity during 1985 were similar to the 1984 experiences. In France, the apparent decline in M2R velocity during 1985 (based on incomplete data) more closely resembled the average 1970-85 experience than the experiences of 1983 and 1984, and it appears that the 1985 monetary growth target was exceeded (Chart 32). For each of the targeted aggregates in the United States, and for sterling M3 in the United Kingdom, the sharp declines in velocity contrasted strongly with both the 1984 experiences and the average annual changes over the period since 1970. To some extent, the velocity declines in the United States may have reflected the lower level of interest rates. In any case, however, the rapid growth of money demand relative to nominal GNP led the authorities during the course of the year to stop aiming at the M1 target in the United States and the sterling M3 target in the United Kingdom.

Table 26.

Five Major Industrial Countries: Recent and Implied Changes in Annual Velocities of Targeted Aggregates, 1970-851

(In percent per annum)

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The definitions of monetary aggregates used in this table are those employed by the monetary authorities of the individual countries. Velocity changes represent changes from year to year in the ratios of average annual money stocks to annual GNP levels; such changes do not correspond to velocity changes during policy periods.

Percentage changes between implied velocity levels for the indicated year and actual velocity levels for the previous year. Implied velocity levels are based on the nominal GNP projections adopted in the World Economic Outlook and the average money stocks that would prevail during the year if money growth coincided with the upper or lower bounds of the target ranges. The actual changes in velocity may fall outside these bounds if the monetary aggregates do not grow in their target ranges or if the GNP projections are incorrect.

1976-85.

There is no formal targeting of monetary aggregates by the Bank of Japan. This calculation assumes that the projected rate of growth of M2 + CDs for the first quarter of 1986 is maintained throughout 1986.

Based on incomplete data for 1985.

Columns (5) and (6) of Table 26 provide an alternative perspective of the contrasting velocity puzzles and macroeconomic conditions that different central banks encountered in 1985. These columns indicate the ranges for velocity that were implied a year ago by the monetary growth targets that had then been announced, in combination with the nominal GNP forecasts adopted in the World Economic Outlook, April 1985. The sharp declines in velocity that occurred during 1985 in the United States and for sterling M3 in the United Kingdom were substantially outside the ranges implicitly expected a year ago, as was the decline in M2R velocity in France. By contrast, the velocity change for MO in the United Kingdom exceeded the range of expectations held a year ago, while the velocity changes for central bank money in Germany and M2 + CDs in Japan were close to last year’s expectations.

Columns (7) and (8) of Table 26 project the velocity changes implied by combining the monetary target ranges that have been announced for 1986 with the staffs nominal GNP forecasts. It should be emphasized that the projections for GNP growth that are used in the construction of these columns are not those of the authorities, and that the year-over-year changes do not correspond to policy periods in any country. It is noteworthy, however, that the 1986 target ranges for the United States suggest that the velocities of all three targeted aggregates most likely will continue to decline, although at more gradual rates than during 1985, while the monetary targets for the United Kingdom imply a continuing sharp divergence of MO and M3 velocities. It may also be noted that for Japan, growth of M2 + CDs at the recent projection of 9.0 percent would (under WEO output projections) imply an unusually sharp decline in velocity, which has had a remarkably stable downward trend since the mid-1970s.

The variability of velocity in recent years, particularly in the United States, the United Kingdom, and Canada, and the decisions to de-emphasize or abandon certain monetary targets in those countries, has rekindled the debate over the appropriate conduct of monetary policy. The average inflation rate in the major industrial countries has now been reduced to little more than half of its level in the decade through 1976. With unemployment high and the global economy strained by a widespread need to grow out of severe debt burdens, it has been argued that the formulation of monetary policy in some countries should devote relatively higher priority to sustaining output and employment than could be done when inflation was the major short-run danger. Regardless of the extent of agreement on the desirability of promoting growth, however, there is disagreement both about the inherent ability of monetary policy to achieve this objective, and about the possible long-run inflationary consequences of attempting to do so.

Supplementary Note 3 Non-Fuel Primary Commodity Prices: Developments and Prospects

This note reviews developments in prices of the major non-fuel primary commodities (hereafter generally referred to as “commodity prices”) entering international trade. The first section describes recent price movements and examines the main determinants of those movements. The second section assesses the short- and medium-term outlook for commodity prices. The final section contains brief discussions of the implications of changes in commodity prices for the terms of trade of the non-fuel exporting developing countries and of the use of the Fund’s special facilities.

Recent Developments

The weakness in world commodity markets that has been in evidence in recent years continued and became more pronounced in 1985. Following a moderate improvement in 1983-84, the overall index of commodity prices, measured in current U.S. dollar terms, fell in 1985 to its lowest average level since 1976, 12½ percent below the average in 1984 (Table 27).1 The downturn began in the third quarter of 1984 and proceeded through five consecutive quarters during which the dollar price index dropped by more than 20 percent. The final quarter of 1985, however, witnessed a slight recovery in the index primarily because of the special circumstances affecting coffee prices (discussed below). In real terms (deflated by the export price index for manufactures),2 the overall index dropped by nearly 13 percent in 1985, erasing most of the improvement that had occurred in the two preceding years.

Table 27.

Indices of Non-Fuel Primary Commodity Prices, 1970-851

(1980 = 100)

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Weights are based on 1979-81 average world export earnings from commodities.

Based on the United Nations index of the unit values of manufactures exported by industrial countries.

Including forestry products.

The recent decline in commodity prices was both steep and broad-based, encompassing all the major commodity groups included in the index (Table 27 and Chart 35). The most pronounced declines since mid-1984 were recorded for food items and agricultural raw materials. The index for beverages also declined sharply through the third quarter of 1985 before recovering markedly in the final quarter of the year, when the prolonged drought in key coffee growing areas of Brazil began to exert a strong influence on coffee prices. The average price of metals exhibited the smallest decline of the major commodity groups after mid-1984, but this decline occurred from an already relatively low level, as metal prices largely had failed to share in the general upturn in commodity prices that occurred during the 18 months following the 1981-82 recession. In contrast to the other major commodity groups, prices of metals weakened further in the last quarter of 1985, largely as a result of the sharp downward adjustment of the price of tin, following the suspension in October of buffer stock operations under the Sixth International Tin Agreement. Over the five-year period from 1980 to 1985, prices of metals fell more (by 30 percent) than the overall index of commodity prices (24 percent). The index for beverages, on the other hand, recorded the smallest decline (12 percent) in the period, due in part to the recovery in the fourth quarter of 1985. The five-year movements in the indices for food items and agricultural raw materials were broadly similar to those of the overall index. The separate indices of prices for primary commodities exported by developing countries and by industrial countries closely paralleled each other in the past two years (Chart 35). In some earlier years (such as 1977 and 1981-83), however, those indices had moved apart, reflecting divergent movements of the particular primary commodities exported by the two groups of countries.

Chart 35.
Chart 35.

Dollar Commodity Price Indices, 1980-85

(1980=100)

1 Weights are based oil 1979-81 average world export earnings.2 Weights are based on 1979-81 average export earnings of the respective country groups.

Because of the large changes in the exchange rates of major currencies in recent years, movements in commodity prices denominated in currencies other than the U.S. dollar have, of course, diverged markedly from the changes in the dollar price indices shown in Table 27 (Chart 36). With the large appreciation of the U.S. dollar from 1980 through the first quarter of 1985, commodity prices denominated in terms of the French franc and the pound sterling stood in the latter period some 86 percent and 65 percent, respectively, above their levels in 1980, while the overall U.S. dollar index declined by 21 percent; the index measured in terms of the Japanese yen was in the first quarter of 1985 some 10 percent below the 1980 level. Mainly as a result of the depreciation of the U.S. dollar in the last three quarters of 1985, the differences between the commodity price indices denominated in various currencies have narrowed substantially or have been reversed. Thus, while the overall dollar price index fell by 6 percent between the first and the fourth quarters of 1985, the reductions in terms of other major currencies ranged from 26 percent to 29 percent. Whereas the indices for the French franc, the pound sterling, and the deutsche mark were still considerably above the U.S. dollar price index in late 1985 (on a base of 1980=100), the index of commodity prices denominated in the Japanese yen was, in fact, about 9 percent below the dollar price index. The index of commodity prices, measured in terms of the SDR, was in the final quarter of 1985 some 20 percent above the dollar price index.

Chart 36.
Chart 36.

Commodity Price Indices in Terms of SDRs and Five Major Currencies, 1980-85

(1980= 100)1

1 Weights are based on 1979-81 average world export earnings

Changes in real commodity prices have been more important—at least from the perspective of the commodity exporting countries—than the changes in nominal prices discussed above. Real changes are measured here by changes in nominal commodity prices relative to changes in the unit values of manufactured exports from the industrial countries. With the general slowdown of world inflation during the past few years, and reflecting the impact of the appreciation of the U.S. dollar over the 1980-85 period, real commodity prices declined less from 1980 through 1984 than the index measured in nominal U.S. dollar terms would indicate (Table 27 and Chart 37). However, given the dollar’s depreciation during 1985, by the end of the year the level of the real and nominal indices was nearly equivalent.

Chart 37.
Chart 37.

Real and Nominal Commodity Price Indices, and Unit Value of Manufactures, 1980-85

(1980= 100) 1

1 Weights are based on 1979-81 average export earnings of developing countries.2 Dollar commodity price index deflated by unit value of manufactures’ exports.

Commodity prices in real terms were quite weak throughout this five-year period, particularly when viewed against a longer time perspective. After declining considerably during the 1981-82 recession, and then recovering in 1983 and 1984 to a point slightly above the 1980 level, real commodity prices fell by about 13 percent in 1985. Despite the small rise in nominal dollar commodity prices in the final quarter of 1985, the average real price in the second half of 1985 was about 20 percent below the level of 1980. Moreover, real commodity prices so far in the 1980s have averaged about 16 percent below the average for the 1970s and in 1985 were some 20 percent below the average for 1960-80.

While annual fluctuations in commodity prices have resulted mainly from various specific influences operating on the demand and the supply sides of the various markets (discussed later in this section), the general weakness of commodity prices during the past five years can be attributed in large measure to the slower economic growth experienced in the industrial world—the major market for primary commodities—than during the 1970s. The sluggishness of economic activity in Western Europe since 1980 is of particular significance as this region accounts for half of total world imports of primary commodities. However, the prolonged weakness of the markets for primary commodities may also, to some extent, have been the result of more deep-seated and fundamental changes in the world economy. One of these factors may well be the structural changes that are taking the economies of the industrial countries away from basic and heavy industries toward lighter manufacturing (particularly in electronics) and services industries. While such changes were already under way in the 1970s, they were given additional impetus by the sharp rise in energy prices during 1979-81. Structural changes, reflected in lower intensity of commodity use, may have been a particularly important influence on prices of metals, which, as noted earlier, have shown the most pronounced decline since 1980. These changes may also have contributed to the weak state of the market for agricultural raw materials. At the same time, technological progress and the spread of new technology to developing countries may have contributed to an outward shift in the supply curve for some commodities. As a result of the increased use of higher-yielding varieties of foodgrains, for example, several developing countries have managed to achieve self-sufficiency in food production and, in some cases, to develop export surpluses. As drought-related declines in food production generally have affected regions with relatively small populations and markets, such as sub-Saharan Africa, the net increase in supply may be one factor underlying the persistent weakness of food prices during the past five years.

The sharp declines in commodity prices that were recorded in 1985, following the recovery in the two preceding years, must, of course, be attributed primarily to short-term influences, in particular changes in economic activity in the industrial countries and to specific factors operating on the supply side. That such factors have recently played an important role is indicated by the fact that over the last thirty years, a decline in commodity prices of the magnitude experienced in 1985 occurred only in the 1975 and 1981-82 recessions.

On a year-to-year basis, the rate of growth in real GNP in the industrial world fell from 4¾ percent in 1984 to 2¾ percent in 1985, while growth in industrial output slowed from about 8 percent to 3 percent (Table 28). The deceleration in industrial output was even more pronounced on a half-yearly basis, as the rate of growth declined continuously from a peak of 11 percent in the second half of 1983 to only 2½ percent in the second half of 1985. This marked slowdown in world demand was partly responsible for the emergence of excess supply of commodities on world markets in 1985.

Table 28.

Non-Fuel Commodity Prices and Major Underlying Factors, 1981-85

(Annual percentage changes)

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Real average GNP for all industrial countries.

Index for seven major industrial countries.

Index of consumer prices in seven major industrial countries.

Positive figures indicate appreciation of the effective exchange rate of the U.S. dollar.

Using same weights as in commodity price index, adjusted to exclude commodities for which no production data are available. Data for 1985 are estimates.

Nevertheless, while the severity of the commodity price decline in 1985 resembled those of the major postwar recession periods in the sense that it was both large and shared by virtually all commodities, the major factor depressing commodity prices appears to have been the large worldwide buildup in supplies of primary commodities that occurred during 1984-85. This buildup had the effect of depressing commodity prices even further during a period of continuing, albeit decelerating, world economic growth. The total supply of primary commodities, defined as current production plus beginning stocks, increased by a cumulative 7½ percent during 1984-85 (Table 29), the largest two-year increase since 1960, the first year for which the supply index was calculated. The effect of this expansion in supply availability on the overall level of commodity prices was reinforced by its concentration in commodities for which supply factors are relatively more important in the determination of prices.

Table 29.

World Supply of Commodities, 1980-85

(Annual percentage changes)

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The largest cumulative increases in commodity output during 1984-85 were recorded for food and beverages, which together expanded by about 11 percent in the two-year period. With allowance for the impact of stock changes, the total supply of food items increased by about 9 percent and that of beverages by about 8 percent in the period. In addition to relatively favorable weather conditions, these increases appear to have resulted mainly from an expansion in productive capacity (including technological improvements), which in turn reflected mainly the lagged response to earlier changes in real prices. As the gestation lags are estimated to be relatively long (an average of about four years for food items and about seven years for beverages),3 the 1984-85 production increases can be traced in part to the high levels of food prices in 1980-81 and to the high prices of beverages in 1977-79. As, in addition, the utilization of productive capacity in food and beverage production is responsive to the previous year’s real prices, the increased output of these commodities in 1984-85 may also have been attributable partly to the rise in prices of these items from late 1982 through mid-1984.

Other factors that may have contributed to the increase in agricultural production in 1984-85 may be related to price support policies pursued by major producing countries and pressures on debtor countries to maximize their foreign exchange earnings. Agricultural price support policies are widely applied in the major industrial countries. Although it is not clear that these policies intensified during 1984-85, the maintenance of support policies by these countries at a time when world production was increasing had the effect of inhibiting adjustment in output, thereby exacerbating pressures on prices of the commodities concerned. The lack of response to price signals was particularly evident in 1985 when production of most agricultural commodities continued to rise despite substantial declines in market prices beginning in the middle of 1984.

Total supplies of agricultural raw materials and metals also increased during 1984-85, but these increases were much less pronounced than in the case of the two commodity groups discussed above. While production of agricultural raw materials and metals increased in 1984 by about 7½ percent and 5 percent, respectively, small contractions of output were recorded for both these groups of commodities in 1985. For agricultural raw materials, these developments were accompanied by lower-than-expected increases in consumption and a consequent sharp rise in stocks, which tended to depress price expectations. Supply factors had a particularly depressing influence on prices of cotton and, to a lesser extent, rubber and wool. In the case of metals, an important factor was the existence of large unutilized production capacity that continued to depress prices despite the fact that consumption growth outpaced production growth in 1984-85. This is particularly noteworthy as metal stocks declined significantly in the period. In addition, some of the major metal producers achieved substantial reductions in costs of production.

The differential rates of growth in supplies of the various commodity groups, discussed above, had a significant impact on the overall movement of commodity prices in 1985, since changes in production of food commodities and beverages are much more important determinants of short-term price developments than is the case for agricultural raw materials and metals; for the two latter groups changes in economic activity have been shown to be the more important factor.4 Demand for food and beverages is more stable than demand for industrial raw materials. In addition, the production of food crops and beverages cannot easily respond to short-term demand changes (such as those during a crop year), whereas output of most industrial raw materials, particularly metals, can usually adjust somewhat more quickly.5

The relatively large increases in output of food items and beverages in 1984-85, therefore, had a strong depressing impact on prices of these commodities as well as on the overall level of commodity prices. With the large supply increases in 1984, prices began to fall sharply in the second half of the year in response to the actual supplies themselves and to lower price expectations, and these price reductions continued in 1985 when output increased further. The impact on prices of the large rise in output of these commodities in 1984-85 can be illustrated by examining a hypothetical scenario of alternative output developments. It is estimated that if food production had recovered in 1984 only to the 1982 level and then remained unchanged in 1985, and if output of beverages had remained at the 1983 level, the prices of these commodities in 1985 would have been some 15 percent higher than the levels actually attained. This would have resulted in the overall index of commodity prices being 8 percent higher than the level actually experienced. While the rise in output of food items and beverages had a particularly important impact on prices, specific supply factors also tended to depress prices of certain agricultural raw materials and metals, as noted earlier.

Market intervention operations through supply control measures, such as export quotas and buffer stocks, under international commodity agreements were in effect in respect of three commodities in 1985: coffee, natural rubber, and tin.6 Reductions in December 1984 and July 1985 in the export quotas for coffee exporting countries established under the International Coffee Agreement served to contain the downward tendency in coffee prices in the first three quarters of 1985. However, increases in quotas in the final quarter failed to contain the sharp upward movement in coffee prices beginning in October 1985 as a result of adverse weather in Brazil. Large-scale intervention by the buffer stock manager of the International Rubber Agreement during 1985 was required to keep prices from falling below the agreed floor level. The semiautomatic downward revision of the price range of 3 percent was triggered in August 1985 after buffer stock purchases reached 300,000 tons. In contrast to the relative success during the year of operations under the Rubber Agreement, it was necessary to end market intervention operations under the International Tin Agreement on October 24, 1985, as a result of the exhaustion of financial resources in the face of continued downward price pressures in an already depressed tin market. Until that date, the price of tin had been kept within the agreed range only through large-scale intervention by the buffer stock manager of the Tin Agreement. Trading in tin on the London Metal Exchange was suspended and the market remained closed through March of 1986. It is unlikely that price stabilization operations will resume in the period immediately ahead.

In addition to the supply and demand influences discussed above, changes in worldwide inflation and in the exchange rate for the U.S. dollar have, of course, continued to have a significant impact on commodity prices in 1985. The further moderate deceleration of inflation in the industrial countries continued to constrain current commodity prices through its influence on the prices of substitutes, through pressures to reduce costs in commodity-using industries, and by reducing speculative demand for stocks. Moreover, the decline in the price of petroleum, which, apart from its widespread effects on production costs, is a raw material for many synthetic substitutes for primary commodities, also acted to depress commodity prices.

The impact of the changes in the U.S. dollar on commodity prices in 1985 is more difficult to ascertain. Although the U.S. dollar depreciated significantly after the first quarter of 1985, its average value in 1985 was about 4.5 percent above the 1984 level, a factor that probably contributed to the lower average level of commodity prices in U.S. dollar terms in 1985. The significant fall in the value of the U.S. dollar during the last three quarters of the year would, by itself, have tended to push up commodity prices in dollar terms during the year. However, it provided only a partial offset to the depressive impact of other factors, and dollar-denominated commodity prices continued to fall until the final quarter of the year. At that time, the dollar index, as noted earlier, recovered slightly under the influence of the sharp rise in coffee prices.

In summary, the major factor affecting the markets for primary commodities in 1985 was the large expansion in supplies, particularly of food items and beverages, that took place during 1984-85 and which was the largest two-year increase recorded since 1960. When combined with the worldwide deceleration of economic activity, and in an environment of continued low inflation in the industrial countries, the rise in output resulted in a broad decline in commodity prices in both nominal and real terms.

Outlook for Commodity Prices

Movements in the overall index of commodity prices in the near future will be affected in an important way by changes in coffee prices, which are discussed separately below. The markets for most other primary commodities are expected to remain weak in 1986 and 1987, reflecting the large overhang of supplies in combination with only a moderate increase in demand. The marked expansion of agricultural output in the past two years is expected to continue to depress prices of most food items, at least until the next harvest season begins to influence prices around the middle of 1986. Some response of agricultural production to the low prices prevailing in 1985 may lead to reduced output and a strengthening of prices in the latter part of 1986. This lower output is projected to result in price increases in 1987 broadly in line with the rate of inflation. Metal prices are also projected to remain weak in 1986 and to recover only moderately in 1987 because of a combination of rather slow growth in demand and ample supplies.

While supply-side factors are generally expected to continue to be the more important short-term determinants of commodity prices, prospective macroeconomic developments in the major markets for primary commodities also suggest that 1986 and 1987 will witness continued depressed prices for most commodities. Real economic growth in the industrial countries is projected to increase slightly from the subdued pace (2¾ percent) recorded in 1985.

In conjunction with a further moderate fall in the rate of inflation in the industrial countries, as well as the large drop in petroleum prices, and on the assumption that the pattern of exchange rates prevailing in early March 1986 will remain unchanged—implying a 15 percent year-on-year depreciation of the U.S. dollar from 1985 to 1986—these prospective developments on the supply and demand sides are expected to result in an increase of about 4 percent in the nominal dollar price index for all primary commodities excluding coffee in 1986. In real terms, the average price of these commodities is expected to decline further, by about 10 percent, to a level significantly below the long-term trend. In 1987, non-coffee commodity prices are expected to rise by about 7 percent in nominal U.S. dollar terms and by about 3 percent in real terms.

Changes in the overall index of commodity prices in 1986 and 1987 will, as noted earlier, differ markedly from those discussed above because of the special situation affecting the price of coffee, which has a relatively large weight in the index. As a result of the anticipated effects of adverse weather conditions on Brazil’s current coffee crop (to be harvested in 1986), coffee prices rose by more than 70 percent during the final quarter of 1985 to their highest levels since before quotas under the International Coffee Agreement were re-introduced in October 1980. While coffee prices were still lower on average in 1985 than in the previous year, prices in 1986 are projected to average about 50 percent above the level in 1985. On the assumptions that Brazil’s coffee crop will recover partially in 1987 and that other countries will draw down their stocks, coffee prices are projected to decline by 15 percent in 1987.7 Because of these developments affecting coffee prices, the overall index of commodity prices in nominal U.S. dollars is projected to increase by about 9 percent in 1986 and by about 4 percent in 1987. In real terms, overall commodity prices would therefore decline by about 5 percent in 1986 and by about 1 percent in 1987. As coffee is exported only by developing countries, the prospective changes in coffee prices discussed above will have a considerably larger impact on the overall index of primary commodities exported by these countries. The latter index is projected to rise by 12 percent in nominal U.S. dollars in 1986 and by 1 percent in 1987. In real terms, the average price of all primary commodities exported by developing countries would decline by 2 percent in 1986 and by about 4 percent in 1987.

Some of the longer-term factors that have tended to depress commodity prices in recent years are expected to continue to influence prices over the medium term. In particular, further structural changes in the economies of the industrial countries are likely to continue to adversely affect the demand for primary commodities, while technological progress may contribute to further expansion of supplies. Nevertheless, on the assumptions that these factors will exert a diminishing influence on commodity prices over time and that aggregate output in the industrial countries will increase at a moderately higher average rate in the 1988-91 period (3 percent per annum)8 than during the first half of the 1980s, real commodity prices are projected to remain virtually unchanged during the four years after 1987. Under the influence of continued low inflation (assumed to average 3.3 percent a year for the industrial countries), and with the assumed depreciation of the U.S. dollar at an average annual rate of 2.3 percent, commodity prices in nominal U.S. dollar terms are projected to rise at an average annual rate of 4.2 percent in the 1988-91 period, slightly below the 4.5 percent rate of increase assumed for prices of manufactured exports and for petroleum.

Terms of Trade and Use of Special Facilities of the Fund

The weakness in world commodity markets in recent years has been reflected in a significant deterioration in the terms of trade of the non-fuel exporting developing countries. During the six-year period from 1979 to 1985 the terms of trade of these countries declined cumulatively by almost 13 percent. Following a temporary small improvement during the recovery of commodity prices in 1983-84, the terms of trade of these countries declined again in 1985, virtually erasing the small gains recorded in the two preceding years. The fact that the terms of trade of the non-fuel exporting developing countries did not improve over the past three years is particularly significant in view of the decline in the price of petroleum, which accounts for a relatively large portion of the total import bill of these countries. The overall terms of trade of the countries under review are expected to increase by almost 4 percent in 1986, with the coffee-exporting countries benefiting relatively more than most other developing countries.

Total purchases under the Fund’s compensatory financing facility in 1985 amounted to SDR 929 million, compared with SDR 816 million purchased in 1984. Purchases during 1984 and 1985 represented a substantial decline from the SDR 2.7 billion in average purchases made in 1982-83. Of the 13 compensatory financing purchases made during 1985, four were at least partly with respect to excesses in the cost of cereal imports, and financing of these excesses accounted for 20 percent (SDR 189 million) of total compensatory financing purchases made in 1985. Repurchases during the year, in respect of previous purchases, were larger than current purchases, so that total outstanding purchases under the facility declined from SDR 7.5 billion at the beginning of 1985 to SDR 7.0 billion at the end of the year. Use of the facility may increase in 1986 as a result of the marked decline in commodity prices and the related fall in export earnings of many developing countries in 1985. Net use of the facility, however, is likely again to be negative as repurchases of SDR 2.3 billion, partly with respect to the large purchases made in 1982, become due.

No purchases were made in 1985 under the Fund’s buffer stock financing facility. Outstanding purchases with respect to previous purchases made in connection with members’ contributions to the operations of the buffer stocks of the natural rubber and tin agreements amounted to SDR 179 million at the beginning of 1986. Repurchases of SDR 153 million were made in 1985, of which SDR 95 million was made in connection with operations under the International Sugar Agreement, which expired at the end of 1984.

Supplementary Note 4 World Oil Situation

Developments in the world oil market in early 1986, when the price of both crude oil and refined products fell precipitously, were conditioned by two main factors. In essence, they reflected the culmination of the tendency of the past few years for the price of oil to become more closely related to short-term market forces and the simultaneous substantial relaxation, or de facto abandonment, of the policy of concerted output restraint that had been followed by the members of OPEC since early 1983.1 While the timing of the price drop was also influenced by other factors, it was the latter development that paved the way for the steep price decline.

Although the international oil market has clearly moved into a new phase, it is uncertain how long lasting the recent changes will prove to be. While the shift from the previous system of fixed official selling prices to market-oriented pricing may be a permanent feature of the oil market, output restraint could be restored at any time. As world demand for oil is expected to rise only moderately in the next few years, the level of oil prices will be determined primarily by factors operating on the supply side of the market. For the immediate future, the interplay of political and economic factors suggests that the oil market may remain weak, and the possibility of continued downward pressure on prices cannot be ruled out. However, in the event that some form of concerted output restraint is re-established, a partial reversal of the sharp fall in oil prices could take place.

The following section of this note reviews recent developments in the world oil market, with particular emphasis on prices. The subsequent section describes recent developments in consumption, production, and world trade in oil. The final section assesses the prospects for the oil market, focusing both on the short-term outlook and medium-term prospects.

Recent Developments in the Oil Market and Prices

In order to provide a fuller background to the present oil market situation, it may be useful first to review briefly underlying developments in a longer time perspective. During the 1963-73 decade, total production of the members of OPEC rose sharply from about 12 to 31 million barrels a day because of a combination of rapid growth in world demand and limited additions to productive capacity in other countries. These developments, which reflected mainly the low price of oil prevailing during the period and the comparatively high rate of growth in the world economy, set the stage for the first round of major oil price increases in 1973-74 when the price approximately quadrupled (in current U.S. dollars) to more than $10 a barrel. Important new oil discoveries were made in the early 1970s (in the North Sea, Mexico, and Alaska) and, with the enhanced price incentives, exploration for oil and additions to productive capacity began to rise substantially in these and other non-OPEC areas. However, because of the long lead times, the new capacity had only begun to come on stream in the latter part of the 1970s. As world oil consumption had also continued to rise, although at a much reduced rate, OPEC production in 1979 was about the same as in 1973 (Table 30). In the meantime, the members of OPEC had gained virtually full control over the determination of both prices and production from the leading international oil companies.

Table 30.

World Oil Balances, 1973-861

(In millions of barrels a day)

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For the classification of countries in groups shown here, see the Introduction to the Statistical Appendix and footnotes 5-8 below.

Includes crude oil production and output of condensates and natural gas liquids (wherever data are available).

Data for industrial countries include use of oil in refineries and bunker fuel. Data for several other countries are derived from statistics on production and trade in oil and group totals should be regarded as orders of magnitude only.

Includes changes in inventories, processing gains (in industrial countries), bunker sales (in some cases), and statistical discrepancies.

Norway and the United Kingdom.

The 12 countries classified as oil exporting countries according to former analytical criteria—Algeria, Indonesia, Islamic Republic of Iran, Iraq, Kuwait, Libyan Arab Jamahiriya, Nigeria, Oman, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. The aggregate data for these countries shown here are virtually identical with those of the members of OPEC.

Bahrain, Bolivia, Cameroon, China, Congo, Ecuador, Egypt, Gabon, Malaysia, Mexico, Peru, Syria, Trinidad and Tobago, and Tunisia.

Includes the U.S.S.R., non-member countries in Eastern Europe, Democratic People’s Republic of Korea, Cuba, Angola, and Brunei.

In addition to statistical discrepancies, reflects changes in stocks afloat (not included in normal transit lag), inclusion of bunkers in export data for some countries, and transit losses.