Abstract

Areader of the daily press in 1987 and 1988 could easily gain the impression that the finance ministers of the Group of Seven countries think that today’s constellation of exchange rates is an equilibrium constellation, regardless of the date or the actual values of the rates. A reader of the Fund’s World Economic Outlook could easily gain the impression that the same group of people think that a shift in the fiscal mix between the United States and the rest of the Group of Seven would substitute for further depreciation of the dollar, despite the lessons they were taught many years ago by the fathers Mundell and Fleming. These views seem to be held firmly although they are contrary to most generally accepted analyses of exchange rates and fiscal policy. The fact that they are professed publicly may even hinder progress toward actual international adjustment.

Areader of the daily press in 1987 and 1988 could easily gain the impression that the finance ministers of the Group of Seven countries think that today’s constellation of exchange rates is an equilibrium constellation, regardless of the date or the actual values of the rates. A reader of the Fund’s World Economic Outlook could easily gain the impression that the same group of people think that a shift in the fiscal mix between the United States and the rest of the Group of Seven would substitute for further depreciation of the dollar, despite the lessons they were taught many years ago by the fathers Mundell and Fleming. These views seem to be held firmly although they are contrary to most generally accepted analyses of exchange rates and fiscal policy. The fact that they are professed publicly may even hinder progress toward actual international adjustment.

This paper attempts to provide a comprehensive but concise analysis of the relationship between fiscal policies and exchange rates and outlines alternative feasible macroeconomic policy options, including their implications for exchange rates. Fiscal policies are treated at the aggregate level, as if the control variable were undifferentiated government purchases. This provides one limit to the discussion, avoiding the territory already covered by Frenkel and Razin (1987). The theoretical discussion is limited to two-country examples, but the empirical simulations cover three areas, the United States, Japan, and Europe, sometimes represented by the Federal Republic of Germany.

The analysis also avoids the complications of cyclical fluctuations by assuming constant levels of output. One justification for this procedure is that adjustment policies should succeed at full employment; permanent recession or inflation would not seem to be an appropriate part of the plan.

The methodology of the paper is to proceed from the relatively simple to the relatively complex, using only as much theoretical apparatus as is needed for the issue at hand. This means moving from the long run to the short, from comparative statics to dynamics, from analysis of the real equilibrium to nominal variables, from theory to empirical results.

The next section of the paper discusses the long-run outlook for the dollar, and concludes that perhaps 15 percent more real depreciation is needed. The following section focuses on fiscal policy and the exchange rate, concluding that depreciation is the very mechanism through which a fiscal shift would restore international balance. Fiscal policy in a real “fundamentals” model (that is, a two-country version of the model in Branson (1985)) is then analyzed. The model in Genberg and Swoboda (1987) is quite similar to the model of this section, and has essentially the same results. Nominal variables and dynamics are brought into the story in the following section, in a two-country version of the model in Dornbusch (1976). Based on these models, the argument is then made for a combination of fiscal tightening in the United States and monetary ease in the Federal Republic of Germany and Japan. This would provide more short-run exchange rate stability and reduce world real interest rates, to the benefit of developing country debtors.

The final sections discuss the Haas-Masson (1986) Minimod as an empirical representation of the theoretical models of the earlier sections and analyze recent policy adjustment scenarios by the International Monetary Fund and the Organization for Economic Cooperation and Development (OECD), using the theoretical spotlight from previous sections. These reinforce the point that a shift in the fiscal mix will be accompanied by further dollar depreciation, and the view that monetary expansion would be better than fiscal expansion in the rest of the OECD.

Long-Run Equilibrium for the Dollar

Two major long-run issues of adjustment among the industrial countries, represented here by the United States, the Federal Republic of Germany, and Japan, are the effect of the change in the international position of the United States from creditor to debtor during the 1980s, and the effects of differential trends in productivity and output growth. If the output bundles of goods in the three areas are imperfect substitutes in demand, these will require adjustments in real exchange rates to maintain current account balance at a standardized level of employment in the three areas, even if they begin in balance. In this section, we begin the analysis with a simple real model of the current account that highlights these adjustments.

For any of the three areas, the current account balance can be represented as the sum of the trade surplus, X, and the surplus on investment income, rF. Here F is the net foreign investment position and r is the rate of return on F. If the country is a net debtor, F is negative. The surplus on current account is then given by

(1)CAB=X(c,Y/Y*)+rF.

Here the trade surplus X is assumed to depend on competitiveness, c (measured by weighted relative unit labor costs), and relative real GNP. Throughout the paper, a “*” represents the “foreign” variable. These should generally be interpreted as weighted averages of the relevant foreign economies. An increase in c represents an increase in competitiveness, and results in an increase in X. An increase in Y/Y* is assumed to reduce X. The long-run equilibrium is represented by the condition that CAB is constant, and for simplicity, we will assume this constant is zero. So in the long run we have

(2)CAB=X(.)+rF=0.

The competitiveness measure is relative unit labor costs. It can be written as

(3)c=EW*q/Wq*=eq/q*,

where W is the nominal wage rate, E the nominal exchange rate, q is labor productivity, and e is the real exchange rate in terms of relative wages. This way of expressing c will facilitate the analysis of differential productivity trends later. The model of equation (1) and the definition of long-run equilibrium can be used to show the consequences of the shift in the U.S. international asset position and the likely long-run trend for the equilibrium value for the dollar, in real effective terms.

U.S. Asset Position and Real Exchange Rate

During the 1980s, the United States shifted from an international net creditor to debtor position. To see the implications of this shift for the long-run equilibrium of the dollar, we can ask what this shift implies for the equilibrium trade balance. Let 1980 represent initial equilibrium, with a U.S. current balance of about zero and a trade deficit of about 1 percent of GNP, financed by investment income, rF. During the 1980s, the current account and trade balance were substantially in deficit, and the international investment position turned negative in 1985. If we assume that the United States will return to current account balance sometime in the first half of the 1990s, it will have a debt service requirement, represented by a negative rF. This, in turn, will require a trade surplus to finance the debt service for current account balance.

The eventual size of the debt service depends on when and how the adjustment to the long-run equilibrium is made. Estimates by Blanchard (1987) put it in the range of 0.5 to 2.5 percent of GNP. His best estimate would be at the lower end of the range. The U.S. Committee for Economic Development (1987) estimates the debt service to be about $55 billion in the early 1990s. This is about 1 percent of projected GNP in 1992. So an estimate of eventual debt service of 1 percent of 1990s’ GNP seems acceptable as a working hypothesis. This, in turn, implies a swing of 2 percent of GNP in the trade balance from the original equilibrium of 1980 to the eventual equilibrium of the early 1990s.

To see the implication for the equilibrium real exchange rate of the dollar, as measured by the competitiveness variable c, consider how large a real depreciation relative to 1980 would be needed to achieve a swing of 2 percent of GNP, holding relative real output Y/Y* constant. Dornbusch and Frankel (1987) present econometrics that estimate that a 13.5 percent real depreciation is needed to achieve an increase of 1 percent of GNP on the trade balance. This is consistent with the “conventional wisdom” estimate of the semi-elasticity of the trade balance reported by Marris (1985), that a 1 percent real depreciation would yield a $3 billion improvement in the trade balance. With 1985 GNP at $4.0 trillion, $3 billion is 0.075 percent, so Marris’ estimate implies that a 13.5 percent depreciation would yield 0.975 percent of GNP, which is close enough to 1.0. On these estimates, a swing of 2 percent of GNP in the trade balance would require a real depreciation of the dollar of 26 percent in effective terms relative to 1980.

Most estimates put U.S. competitiveness at the end of 1987 slightly higher than in 1980. (Remember that on our measure, up is an improvement.) For example, the OECD (1987) shows it improved by about 10 percent. This suggests that, in the absence of other important shifts in the world economy since 1980, a further real depreciation of about 15 percent, in effective terms, would be needed to move the U.S. current balance to equilibrium. If the currencies of some of the major trading partners of the United States, such as Canada, do not appreciate much against the dollar, others, such as the yen, would have to appreciate more.

Most of the changes in the world environment since 1980 that would be relevant for modifying this conclusion seem to work in the direction of increasing the estimate of the necessary further real depreciation to bring the U.S. current account back into balance at standardized levels of real output. Table 1 shows estimates of growth of real domestic demand and labor productivity in manufacturing for the United States, Japan, and the Federal Republic of Germany, for 1980–86, U.S. demand growth was stronger than that in Japan or Germany. Most estimates of income elasticities of trade show a substantially higher elasticity for U.S. imports than for U.S. exports. The combination of stronger demand growth and asymmetric income elasticities in the United States implies the need for a greater real gain in competitiveness.

Table 1.

Growth in Domestic Demand and Labor Productivity in Manufacturing, 1980–66

(Average annual growth rates, in percent)

article image
Source: Bank of Japan (1987).

Table 1 shows that growth in labor productivity in manufacturing in the United States was about the same as in Germany and a percentage point less than in Japan over the period 1980–86. Since the competitiveness variable is relative unit labor cost, slower productivity growth in the United States means that a greater real depreciation in terms of wages is needed to achieve a given gain in competitiveness. In addition, the depression in Latin America attendant on the debt crisis reduces the demand for U.S. exports relative to those of Japan or Europe. All of these factors suggest that the estimate of a required further real depreciation for the dollar in effective terms of 15 percent is on the low side.

Long-Run Equilibrium Trend

The calculations in the previous section should be interpreted as giving the needed real depreciation of the dollar that would return the current balance to equilibrium in the early 1990s. However, this does not suggest that holding the dollar at that level in real effective terms would maintain equilibrium. The estimates in Table 1, and the asymmetry of the U.S. trade income elasticities, imply that the dollar would have to depreciate in real terms continuously along a long-run trend to maintain equilibrium. In this section we briefly present the calculation of that long-run trend. Estimating its long-run value would require detailed study beyond the scope of this paper, and the parameter values will change before the dollar is back on the equilibrium path. So here we present only the qualitative results.

The definition of equilibrium as current account balance implies a constant net foreign debt position, and a constant flow of debt service, for given interest rates. This, in turn, implies a constant level of net exports, x, to finance the debt service. The net export function from equation (1), with the definition of competitiveness filled in from equation (3), is

(4)X=X(eq/q*,Y/Y*).

The rate of change of net exports is given by

(5)X^=nxc(e^+q^q^*)+nxy(Y^Y^*),

where nxc is the positive elasticity of net exports with respect to competitiveness, nxy is the negative elasticity with respect to relative growth, and a “^” over a variable denotes its growth rate.

The focus here is on the rate of real depreciation of the dollar in terms of relative wages, e, needed to set X^ at zero, given relative growth in productivity and demand. From equation (5), withX^ = 0, this is

(6)e^=(q^*q^)nxy/nxc(Y^Y^*)

The rate of real depreciation along the equilibrium path is equal to the weighted differential in productivity growth less the weighted differential in demand growth times the ratio of the negative income elasticity with respect to relative demand to the positive price elasticity with respect to competitiveness. Both factors are likely to contribute to a needed real depreciation of the dollar along the equilibrium trend. U.S. productivity growth is slower than that of its major trade competitors, its demand growth is faster, and the asymmetry of income elasticities will raise the value of n,xy.

Thus it appears that the long-run trend for the dollar that would maintain equilibrium on the current account is depreciation in real effective terms. It also appears that a further real depreciation is needed to get the dollar back on that equilibrium trend.

Fiscal Policy and the Real Exchange Rate

Before moving on to models of the determinants of exchange rates and international adjustment, it will be useful to deal at the clearest and simplest level with one specific issue regarding the relationship between fiscal policy and real exchange rates. This is because the view in policy discussions in the context of the Groups of Five and Seven seems to be that a contractionary shift in fiscal stance in the United States and an expansionary shift in Europe and Japan would substitute for real depreciation of the dollar in restoring current account balance among those three areas. The argument in the previous section says that a further real depreciation is necessary, and is therefore contradictory to this new view of the Group of Seven. So it seems best to confront this issue directly before moving to a more complex level of analysis.

The view of the Group of Seven that an international shift in the fiscal mix can substitute for a change in the real exchange rate is expressed in the October 1987 issue of the World Economic Outlook of the International Monetary Fund (p, 17).

“It is important, therefore, to consider what role policies might play in avoiding the sharp exchange rate movements … of the finance constrained scenario … A harmonized realignment of fiscal positions would tend to restrain the growth of domestic demand in the United States, while fostering it in the surplus countries. If accompanied by a moderate movement in exchange rates, this could be consistent with a gradual reduction in external imbalances ….

The problem with this view is that, in general, a balanced fiscal package with no change in world aggregate expenditure will change the composition of world expenditure toward the expanding area’s goods, away from the contracting area’s. This will require a rise in the relative price of the expanding area’s goods, that is a real appreciation, to rebalance supply and demand in both markets. This is shown by the following illustration, taken from Krugman (1987).

Consider a two-area example, with both areas producing a given amount of output, perhaps full-employment output. The home area has a marginal propensity to spend on imports out of total absorption of m, with 1-m spent on home goods. Likewise, the foreign area’s marginal propensitites are m* and 1-m*. Then total spending on the two areas’ goods is given by

(7a)d=(1m)a+m*a*;
(7b)d*=ma+(1m*)a*,

where a and a* are real absorptions and d and d* are real demands.

Suppose now that a balanced fiscal package reduces a and increases a* by equal amounts, with no change in output of either area’s goods. This means that Δa* = – Δa. Then the changes in demands for the two areas’ goods are given by

(8a)Δd=(1mm*)Δa,and
(8b)Δd*=(m+m*1)Δa.

If the sum of the two marginal propensities to import is less than one, the demand for home goods falls, and for foreign goods rises, by the same amount in this two-area case. This requires a reduction in the relative price of home goods, that is, a real depreciation of the home currency, to eliminate the excess supply of the home good and the excess demand for the foreign good. This need for a real depreciation of the home currency is caused by the fiscal shift. It is how the fiscal shift generates the adjustment. In this sense, real depreciation is a complement to the fiscal shift, rather than a substitute.

Krugman’s illustration assumes two areas, both specialized in production, so there are two goods. McKinnon (1988) produces an example with three goods. Each area produces an exportable (X), an importable (M), and a nontraded good (N). Here the terms of trade is Px/Pm. The real exchange rate is the ratio of the average price of traded goods to Pn. McKinnon points out that the effect of a fiscal shift on the terms of trade is uncertain in this setting. Tighter fiscal policy at home reduces the demand for both the exportable and the importable, for example. McKinnon takes this result as refuting Krugman’s point. But in the three-good example, the relevant variable is the real exchange rate, and the result still holds. Tighter fiscal policy at home and easier fiscal policy abroad will reduce the demand for the home nontraded good, and increase it for the foreign nontraded good. So the relative price of the home nontraded good must fall to restore equilibrium. This means the real exchange rate must rise, that is, the home currency must depreciate in real terms.

Given this analysis, it is reasonable to ask how the Group of Seven view came into existence. One possibility is that the implicit model underlying it assumes a traded versus nontraded structure. Here each country or area produces a common, perfectly substitutable, traded good, and a unique nontraded good. For each country, the real exchange rate is the ratio of the prices of the traded and nontraded goods.

In this case, or in the three-good McKinnon example, if the fiscal shifts resulted purely in a shift in the composition of demand for the traded goods, with no spillover onto the nontraded goods, there would be no need for a change in either real exchange rate. However, if the contraction in the home area and expansion abroad in the examples fell partially on the nontraded goods, the home nontraded would have to fall in price relative to the foreign nontraded to reestablish equilibrium in the two markets for nontraded goods. This requires a real appreciation in the expanding area and a depreciation in the contracting area.

Thus, the Group of Seven view could hold up if the fiscal shift affected relative demands only for a perfectly substitutable traded good. But most of government exhaustive spending is on nontraded goods, such as construction and wage and salary payments. So the Group of Seven view is unlikely to hold in this implicit framework, either. The basic conclusion is that a change in the real exchange rate is a complement to a fiscal shift, except under most unusual circumstances.

Fiscal Policy in a Fundamentals Model

Shifts in fiscal policy will have important implications for the international pattern of real interest rates, as well as real exchange rates. This section explores these, using a minimal two-country framework that focuses on the effects of shifts in real exogenous variables on real interest rates and the real exchange rate. The model is a two-country version of the “fundamentals” model presented in Branson (1985) and modified in Branson (1988). It is called a fundamentals model because it focuses on the real variables that rational markets should consider in forming their expectations. A precursor of the two-country version was presented in Krugman (1985). The model expands the previous discussion by explicitly incorporating budget positions and financial market equilibrium into an explanation of movements in real interest rates and the real exchange rate. First we set up the model briefly, and then discuss the effects of fiscal shifts.

Fundamentals Model

This subsection will present only enough detail to support the discussion of fiscal policy in the subsection on the long-run equilibrium trend. A full discussion of the model and results is in Appendix I. The model consists of the two countries’ national income equilibrium conditions and the arbitrage equation linking their financial markets. These three equations determine movements of real interest rates and the real exchange rate as dependent on relative bond stocks, and the long-run equilibrium real exchange rate from the earlier section.

The two national income equilibrium conditions are given by

(9a)D=S(r)X(ee¯),(Homecountry)
(9b)D*=S*(r*)+X(ee¯).(Foreigncountry)

These two equations say that the (real) budget deficits D and D* must equal the sum of (real) net private saving S and S* and the current balance X. With two countries, one’s X is the other’s – X. Net private saving is assumed to be an increasing function of the real interest rate. Net exports of the home country X are assumed to be an increasing function of the real exchange rate relative to its long-run equilibrium value ē. Movements in e reflect the considerations discussed in the section on the long-run equilibrium. When e = ē, the current account is in balance.

Financial market equilibrium can be summarized by the arbitrage condition across real interest rates and the expected rate of change in the real exchange rate e:

r=r*+e^+ρ(B/B*).

Here p is the risk premium on home currency, an increasing function of the home bond stock relative to the foreign. The exchange rate is expected to move toward its long-run equilibrium following the proportional adjustment process given by

e^=θ(e¯e).

Combining these two relationships gives us the arbitrage condition that is the third equation of the fundamentals model:

(10)e  e¯=(1/θ)  (r* r   +ρ(B/B*)).

This arbitrage condition says that if r is higher than r* plus the risk premium, then e must be sufficiently below its long-run equilibrium value that its expected rate of increase maintains the arbitrage equality.

Equations (9) and (10) can be used to obtain solutions for r, r*, and e as functions of D, D*, B/B*, and ē. The algebra is relegated to Appendix I. Here we move to the graphical analysis.

Equations (9a) and (9b) can be combined into one condition in the two interest rates. Summing the two equations gives us the world saving-investment balance:

(9c)D+D*=S(r)+S*(r*).

This condition is represented by the negatively sloped RR line in Chart 1. For a given total fiscal deficit D + D*, an increase in one interest rate requires a reduction in the other to maintain world saving-investment balance. An increase in either deficit shifts the RR line up, requiring a rise in real interest rates. A reduction in one deficit, matched by an increase in the other, would not move the RR line.

Chart 1.
Chart 1.

Equilibrium in the Fundamentals Model

Chart 2.

Equation (9c) introduces the point that world real interest rates will be reduced by an industrial country fiscal package that reduces the aggregate deficit, but not by one that simply rearranges its composition, as is suggested in the passage from the April 1987 World Economic Outlook cited earlier. Thus to reduce the burden of debt service on developing countries, the policy mix should reduce the aggregate deficit.

The positively sloped AA line in Chart 1 represents financial market equilibrium, as specified in equation (10). The AA line has a slope of unity. It is shifted up by an increase in the risk premium or by a decrease in e – ē. In any long-run equilibrium, e – ē = 0, and the position of the AA line is determined by the risk premium that controls the equilibrium real interest differential. The equilibrium values of r and r* at any time are determined by the intersection of RR and AA. In the background behind the position of the AA line is the equilibrium value of e – ē. How this is determined is best discussed in the context of a shift in one of the basic exogenous variables, D or D*.

Fiscal Policy

Two common medium-term scenarios in analyses by the Fund, the OECD, and the European Community of the economic outlook involve a fiscal contraction in the United States alone, or a fiscal contraction in the United States matched by a fiscal expansion in Europe and Japan. These two cases are shown in Chart 2. Consider first the case of a U.S. contraction.

The analysis proceeds in two steps. First, consider the impact of the shift in the budget position. This shifts both RR and AA. Second, consider the effect of the new path of debt accumulation; this alters the risk premium and shifts the AA curve only, leading to the final equilibrium.

A reduction in the home deficit D shifts the RR line, as shown inChart 2. What happens to the position of the AA line? To answer this question, refer back to equations (9a) and (9b). In (9b), there is no change in D*, by supposition. If the position of the AA line were unchanged, r* and S* would fall. This would require an increase in e – ē, a depreciation of the home currency, to maintain saving-investment balance in the foreign country. Less excess private saving to finance the given D* requires an increase in the current account deficit (or reduction in the surplus). In equation (9a), the increase in e – ē reduces the current account deficit, splitting the decrease in D between a fall in S and an increase in X. So the initial depreciation of the home currency maintains saving-investment balance abroad, and cushions the effect on the real interest rate at home.

The increase in e – ē accounts for the initial downward shift of the AA line in Chart 2, taking the equilibrium from point 0 to point 1. Both interest rates must fall. If AA shifted enough that r* increased, moving from 0 to 1, the previous reasoning on the movement of e – ē, based on equation (9b), would be reversed, producing an upward shift in AA, which would contradict the premise that r* increased in the first place. So the initial effect of the reduction in D is for both real interest rates to fall, r by more, and the home currency to depreciate, moving from point 0 to point 1 in Chart 2.

At this point the two economies have not yet reached the final equilibrium, because the reduction in D implies an eventual reduction in the relative debt stock B/B* and in the risk premium. This will shift the AA curve down further, bringing the two economies to a final equilibrium at point 2 in Chart 2, where r* is back at its original level, r has fallen by the decrease in the risk premium, and e = ē. In equation (9b), with D unchanged and X back to zero, r* must be the same as the original value.

The long-run equilibrium e will have decreased in the movement from point 0 to point 2 due to the reduction in debt service of the home country with a reduced ratio B/B*. So the actual value of the exchange rate rises (home currency depreciates) from point 0 to point 1, and then falls from 1 to 2. It ends up below its initial value due to the long-run effect of reduced debt service. The reduction of average interest rates in this unbalanced fiscal scenario also implies a reduction of debt service of the developing countries.

The case of an equal reduction in D and increase in D* is shown in Chart 2 by the movement from points 0 to 1’ to 2’. The balanced fiscal package leaves the RR line undisturbed. But a depreciation of the home currency is required to maintain the arbitrage condition (10) as r falls and r* rises. The depreciation shifts the AA line down, producing the movement from point 0 to point 1’. The depreciation also reduces the home country’s current account deficit, cushioning the movement in relative interest rates in the movement from 0 to 1’.

Again, at point 1’, further adjustment comes with the reduction in the risk premium implied by the fall in B/B*. This moves the economies to the final equilibrium at point 2’, with a lower r and higher r*. At 2’, ē is below its original value, and e = ē, so the path of actual e is reversed in the movement from points 0 to 1’ to 2’. The net results from the balanced fiscal package are a change in relative interest rates and the risk premium, offsetting changes in the government deficit and excess private saving in the two industrial countries, and no reduction in debt service for the developing countries.

Nominal Dynamics and Monetary Policy

The fundamentals model, due to its focus on real variables and equilibrium positions, says nothing about the dynamics of price and nominal exchange rate adjustment, expectations, and monetary policy. To introduce these elements into the discussion of policy alternatives, we turn to a modified two-country version of the Dornbusch (1976) model of exchange rate and price dynamics. This expands the fundamentals model to include the two price levels, the nominal exchange rate, and monetary policy. Price adjustment is assumed to be gradual, while the exchange rate and interest rates can jump in anticipation of future developments. Movements of. real variables between equilibria then depend on combinations of sluggish adjustment of price levels and instantaneous adjustment of asset prices. The fundamentals model gives the real equilibria; the model developed in this section gives the paths between them. In the following subsections, we first outline the model in the minimum necessary detail, and then apply it to the analysis of fiscal and monetary policies.

Two-Country DynamicsModel

This subsection presents only enough exposition to support the subsequent discussion of fiscal and monetary policy. The details of the algebra are in Appendix II. Here we add money-market relationships and dynamics to the fundamentals model. Since for analysis we will use the assumption that the two countries are symmetric to reduce the dimensionality of the model, the assumption that parameters are the same in both countries is applied from the outset.

The two money-market relationships are given by:

(11a)mαp(1α)p*(1α)E=φyλi(Home)
(11b)m*αp*(1α)p+(1α)E=φy*λi*.(Foreign)

Here all variables except the nominal interest rates i are expressed in logs, making λ the semi-elasticity of the demand for real balances with respect to the interest rate. The deflator for money balances is the consumer price index, with weights a for home goods and (1 – α) for imports. Real outputs are assumed to be exogenous. The semi-log form is used only to impose homogeneity in nominal variables. It ensures that if the ratios of money supplies and price levels, and the exchange rate, all change by the same proportion, the real equilibrium will remain undisturbed.

The arbitrage condition from the fundamentals model also applies across nominal interest rates and the expected rate of change of the nominal exchange rate. This gives the arbitrage condition linking the two money markets,

(12)i=i*+E˙+ρ,

where ρ is the risk premium, still dependent on B/B*. Since E is the log of the exchange rate, Ė is the rate of change. In the dynamics of this section, exchange rate expectations will be assumed to be formed in an unbiased manner, that is, with zero average forecast error over time. This defines expectations as rational. So Ė in equation (12) is both the expected and actual rate of change of the exchange rate.

The two domestic goods prices are assumed to adjust gradually over time to eliminate excess demand, which is X-S + D from the national income equilibrium equations (9) of the fundamentals model. The dynamic versions of equations (9) are given by

(13a)p˙=Π[X(E+p*pe¯)S(i)+D].(Home)
(13b)p˙*=Π[X(E+p*pe¯)S(i*)+D*].(Foreign)

Here the price levels adjust to excess demand with a speed given by π, The real exchange rate in the net export function is expressed in terms of its components. To avoid excessive complexity, excess private saving is written as a function of the nominal interest rate, which will be the same as the real rate in equilibrium.

Long-run equilibrium of this model can be analyzed by setting ṗ, ṗ*, and Ė equal to zero in equations (11)–(13). Then the five equations determine values for the two price levels and interest rates, and the exchange rate. This analysis is discussed in Appendix II. Here the focus is on dynamic adjustment to equilibrium. To do the dynamic analysis, we can reduce the model to two equations in the relative price level p – p* and the exchange rate E and proceed graphically.

Subtraction of equation (11b) from (11a), and substitution of Ė + ρ for i – i* from equation (12) yields the relative money-market equilibrium condition

(11c)mm*+(12α)(pp*)2(1α)E=φ(yy*)λ(E˙+ρ).

If α the share of home goods in consumption, is between 0.5 and 1.0, the coefficient of (p – p*) is negative and the coefficient of E is positive. To obtain the equation for the inflation differential ṗ – ṗ*, we assume that the saving functions are linear (so one can be easily subtracted from the other) and subtract (13a) from (13b) with the same substitution for i – i*. This yields

(13c)p˙p˙*=Π[2X(E+p*pe¯)S(E˙+ρ)+DD*].

The two equations (11c) and (13c) are a dynamic system in the relative price level p – p and the exchange rate E. The dynamics can be analyzed readily using a variant of the diagram introduced by Dornbusch (1976).

Setting Ė = 0 in equation (11c) yields the negatively sloped line in Chart 3. This is the locus of points along which the money markets are in equilibrium with zero expected change in the exchange rate. An increase in the exchange rate requires a reduction in the domestic price relative to the foreign if neither consumer price index is to change, and therefore neither money market equilibrium disturbed. The dynamics of the exchange rate relative to the Ė = 0 line can be understood by considering a point above it, such as point A in Chart 3. At point A, the home price relative to the foreign, p–p*, is higher than would be consistent with expected Ė = 0. A higher home price level means lower real balances and a higher interest rate than the foreign, that is i – i*>0. If i is greater than i*, then from the arbitrage condition (12), expected Ė must be positive for point A to be consistent with money-market equilibrium. With rational expectations, this means that at point A, E must be rising. In a sense, only an expectation of a further increase can justify an already high exchange rate. This line of analysis yields the direction of the horizontal arrows in Chart 3. Above the Ė = 0 line, E rises; below it, E falls. The Ė = 0 line provides the unstable element of the dynamics.

Chart 3.

Setting ṗ – ṗ* = 0 in equation (13c) yields the positively sloped line that is so labeled in Chart 3. This is the locus of points along which the goods market is in equilibrium. (To derive the expression for the slope of ṗ – ṗ* = 0, one must substitute from equation (11c) for (Ė+ρ) in (13c); see Appendix II.) Below this line, for example at point A, the relative price of home goods is too low to be consistent with equilibrium. There is excess demand for home goods and excess supply of foreign, so p–p* rises. This reasoning yields the direction of the vertical arrows in Chart 3. The ṗ – ṗ* = 0 line provides the stable element of the dynamics.

The intersection of the Ė=0 and ṗ – ṗ* = 0 lines in Chart 3 is the long-run equilibrium of the system, given the two money stocks, the two deficits, and the risk premium. It will be useful to notice that the equilibrium real exchange rate is given by the slope of the ray from the origin to the equilibrium. This is P/EP*, the inverse of the real exchange rate. So any disturbance that moves the equilibrium to a flatter ray raises the real exchange rate, that is, depreciates the home currency.

With one stable and one unstable element in the dynamics, there is one unique stable path to the equilibrium in Chart 3. This is the path labeled ss; in the technical literature it is called the “saddle path.” It has two essential properties: (a) it leads to the equilibrium, and (b) along it, expectations of changes in the exchange rate are realized. As suggested by the arrows moving away from the ss path in Chart 3, all other paths are unstable; they are “speculative bubbles.” Along them, expectations are realized from one period to the next, but they do not lead to the equilibrium. The market abhors these bubble paths, and searches for the ss path that does lead to the equilibrium.

After a disturbance, the relative price p–p* cannot adjust instantaneously, by assumption, but the exchange rate can jump onto the new ss path that leads to the new equilibrium. So following a disturbance that will lead to future relative price adjustment, the market attempts to find the value for the exchange rate that lies on the ss path, so expectations could be expected to be realized if the economy were to proceed to the equilibrium with no further disturbances.

Monetary Policy

A brief discussion of the case of an unanticipated shift in monetary policy will provide a clear example of dynamic adjustment and set the stage for the subsequent analysis of policy options. The effects of a relative easing of monetary policy abroad are illustrated in Chart 4. The original equilibrium is at point zero. A reduction of m – m* shifts both the ṗ – ṗ=0 and Ė=0 and ṗ – ṗ* = 0 lines proportionately toward the origin. The long-run equilibrium moves down the ray from the origin to point 2 in Chart 4. Eventually the relative price level and the exchange rate will change by the same proportion as the relative money supply.

Chart 4.
Chart 4.

Relative Monetary Expansion Abroad

A new stable ss path leads to the new long-run equilibrium at point 2. For the initially given value of p – p*, the exchange rate jumps to the ss path at point 1. In anticipation of the future fall in the relative price level, the home currency appreciates immediately. The relative price level, p – p*, and the exchange rate then move gradually along the ss path to point 2. This illustrates the well-known “overshooting” result in response to monetary disturbances.

The initial jump downward of the exchange rate to point 1 has to be consistent with the expectation that it will rise gradually to point 2. With no initial change in relative prices, initially the interest rate at home rises relative to that abroad, consistent with the expectation that the exchange rate will rise. As the adjustment then proceeds from point 1 to point 2, the interest differential closes as the home price level rises relative to the foreign.

Fiscal Policy

The results of a relative fiscal contraction in the home country are shown in Chart 5. The fiscal variables do not appear in equation (11c) for Ė=0, so a fiscal contraction in the home country shifts the ṗ – ṗ* = 0 line down along the original Ė=0 line. The new long-run equilibrium point 2 is on a flatter ray from the origin, reflecting a real depreciation of the home currency. The new ss path runs into the long-run equilibrium. The exchange rate jumps onto the ss path at point 1 in Chart 5 and then the relative price level and the exchange rate move gradually toward point 2. This is an example of undershooting in response to a real disturbance.

Chart 5.
Chart 5.

Relative Fiscal Contraction at Home

The path of the exchange rate in Chart 5 breaks the movement from point 0 to point 2 into two pieces. The real depreciation from 0 to 2 is determined by the fundamentals model. The additional result here is the prediction of an initial jump as the market anticipates the subsequent further real depreciation of the home currency.

Policy Scenario: U.S. Fiscal Contraction with Exchange Rate Stability

In anticipation of the later discussion of empirical policy scenarios, it may be useful at this point to use the dynamics model to illustrate a scenario that could provide short-run exchange rate stability with an international shift in fiscal policy. This scenario would combine a tightening of fiscal policy in the home country, the United States, and easing of monetary policy abroad, the Federal Republic of Germany and Japan. The scenario is partially suggested by the evident desire of the Group of Seven to avoid any further sudden movements in exchange rates. It has the additional benefit that by increasing world saving it would reduce real interest rates and developing country debt service. The scenario essentially combines Charts 4 and 5.

Let us begin by interpreting Chart 5 as illustrating the result of a U.S. fiscal contraction. In the absence of any additional policy action, the dollar would show a jump depreciation in nominal and real terms, and then a further gradual depreciation. This is the theoretical result in Chart 5, and it is the empirical result in the Fund’s Multimod model and scenarios to be reviewed below. It is shown as the movement from points 0 to 1 to 2 in Chart 6, which reproduces Chart 5 to this point.

Chart 6.
Chart 6.

Policy Scenario: fiscal Contraction in the U.S.; Monetary Expansion Abroad

Let us now assume that the initial jump in the exchange rate from 0 to 1 is undesirable. How can policy prevent it? By altering monetary policy so that the original equilibrium point 0 lies on the new s’s’ path. The shift in the U.S. fiscal position establishes a new equilibrium real exchange rate given by the fundamentals model, and shown in Chart 6 by the ray through point 2. But an expansionary monetary policy in Germany and Japan can shift the new equilibrium in along this ray until the new s’s’ path goes through point 0. This combination of fiscal tightening in the United States and monetary expansion in Germany and Japan would result in a gradual depreciation of the dollar from point 0 to point 3 with no initial jump.

The gain in exchange rate stability here comes at the cost of additional adjustment of relative price levels and nominal dollar depreciation between points 2 and 3 in Chart 6. This tradeoff could be evaluated in quantitative terms using the Fund’s Multimod. This scenario has the additional benefits of lower world real interest rate and a stimulus to demand in Germany and Japan to offset any potential contraction in the United States.

Empirical Representation: Minimod

The theoretical models discussed in the previous sections have a close empirical representation in Minimod, a two-country model developed at the Fund. The model is presented in detail in Haas and Masson (1986). It includes empirical specifications of equations (11)–(13), and options for adaptive or rational expectations solutions. Haas and Masson present simulation results that correspond closely to the policy experiments described analytically in Charts 2, 4., and 5., plus the result of an increase in the risk premium, which is described in Appendix Charts 10 (Panel 4) and 11 (Panel 6).

In the simulations, the authors first solve the model forward from the first quarter of 1985, using the baseline assumptions on policy provided by the Brookings Institution model project (see Haas and Masson, footnote 13). They then change the path of a policy or other exogenous variable by a specified amount, and re-solve the model under the two alternative expectations assumptions. For each endogenous variable, the difference from the baseline path, in percentage terms, is the effect of the policy change. The simulations of policy effects over time should correspond to the analytical experiments of the earlier sections of this paper. They do, fairly closely.

The effects of an unanticipated, permanent reduction of real government purchases by 1 percent of GNP in the United States, beginning in the first quarter of 1985, on the dollar exchange rate and the U.S. and foreign absorption deflators are shown in Chart 7. This corresponds to the experiment analyzed in Charts 2 and 5 earlier. Charts 7 shows percentage deviations from baseline, beginning in 1985. The heavy line in each figure shows the rational expectations result, and the light line shows the adaptive expectations result. Note that in the Haas-Masson model, as in the analytical models of the earlier sections, an increase of the exchange rate is a depreciation.

Chart 7.
Chart 7.

Minimod Simulation: Reduction in U.S. Government Purchases

Source: Haas and Masson (1986), Chart 1.1Increase indicates dollar depreciation.

The top panel of Chart 7 shows a jump depreciation of the dollar by 4 percent following the fiscal action. This is followed by a slight further depreciation, and then a slow path of appreciation. The depreciation comes as the initial response to the fiscal contraction for a given debt ratio B/B*. Then gradually the debt ratio falls relative to baseline. This reduces the risk premium and leads to a gradual appreciation. Eventually, the argument of the above section says the dollar would appreciate, due to lower debt service relative to the baseline. This reversal is also noted by Haas and Masson (p. 735), although it occurs past the horizon of their illustrations.

The bottom panels of Chart 7 show the fall in the U.S. price level relative to the foreign as is also shown in Chart 5. The initial jump in the price levels in the Minimod is due to the direct effect of the exchange rate on the absorption deflator. The price levels in Chart 5 are prices of home and foreign output, while Minimod works with absorption.

The effects of a foreign monetary expansion in the Minimod are shown in Chart 8, which corresponds to the earlier Chart 4.. The foreign money supply is increased permanently by 4 percent, with the increase spread evenly over the first four quarters of the simulation. The top panel of Chart 8 shows an initial appreciation of the dollar by 7 percent, followed by a gradual depreciation, as is also shown in Chart 4.. The bottom panels of Chart 8 show the fall of the U.S. relative price, mainly from an increase in the foreign price level. Again, the initial jump down in the U.S. price and up in the foreign price comes from the direct effect of the exchange rate on the absorption deflators.

Chart 8.
Chart 8.

Minimod Simulation: Non-U.S. Monetary Expansion

Source: Haas and Masson (1986), Chart 4.1Increase indicates dollar depreciation.

We can see how the policy scenario of the previous section could be implemented, at least as estimated by the 1986 Minimod, by comparing the top panels of Charts 7 and 8. Chart 7 shows a 1 percent of GNP fiscal contraction in the United States producing a 4 percent depreciation, while Chart 8 shows a 4 percent increase in the foreign money supply producing a 7 percent appreciation. So scaling the fiscal contraction up to 1.75 percent of GNP, and combining it with a 4 percent increase in the foreign money supply (in the Federal Republic of Germany and Japan) would leave the exchange rate approximately unchanged, as illustrated in Chart 6. Subsequently, the dollar would gradually depreciate, as also shown in Chart 6. This can be seen in the flatter path of the exchange rate in Chart 7 compared with Chart 8. Thus the policy scenario of the previous section seems quite feasible in the context of the Minimod simulations.

The effects of the addition of a constant 1 percentage point to the risk premium on dollar assets in the Minimod, beginning in 1985, are shown in Chart 9. This corresponds to Appendix Chart 10, Panel 4 and Chart 11, Panel 6. The top panel of Chart 9 shows an initial depreciation of about 7 percent in the rational expectations case, and a gradual depreciation with adaptive expectations. In the case of an increase in the risk premium, the latter might be the more appropriate assumption. Rather than following on a policy announcement, as in the two previous cases, the increase in the risk premium may come about more gradually as the market comes to understand the long-run consequences of current policies, if they were to continue indefinitely. This upward movement is shown most clearly in Chart 11, Panel 6. Whether it takes the form of a jump depends on expectations.

Chart 9.
Chart 9.

Minimod Simulation: Increase in Risk Premium on U.S. Dollar Assets

Source: Haas and Masson (1986), Chart 5.1Increase indicates dollar depreciation.

The bottom panels of Chart 9 show the initial effects on the two absorption deflators from the jump in the exchange rate in the rational expectations case. With adaptive expectations, the U.S. relative price rises slowly. This fits the ambiguity of the relative price movement with an increase in the risk premium in Chart 12, Panel 6 and Table 4.

Alternative Policy Scenarios and the Dollar

The theoretical structure of the earlier sections is reflected to differing degrees in the simulation models used by the international organizations. The Fund’s Multimod, or multi-region econometric model, is an expanded version of Minimod. It includes endogenous determination of exchange rates and arbitrage equations with terms for risk premia. So policy simulations with Multimod produce endogenous variations in exchange rates. In addition, simulations can be performed with exogenous variations in risk premia and endogenous variation in exchange rates. The OECD Interlink model takes nominal exchange rates as exogenous. This results in small variations in real exchange rates in the policy simulations. To simulate the effects of market-determined variations in exchange rates, Interlink must be given exogenous input.

Table 2 summarizes recent alternative policy scenarios produced using the Multimod and Interlink. The baseline scenarios (not shown) assume generally unchanged policy and roughly constant real exchange rates. The alternative scenarios add to the most recent baseline the effects of assumed changes in policy or in the economic environment. Three of these are summarized in Table 2. These are the cases of market-determined dollar depreciation with no change in policy, a shift toward fiscal restraint in the United States, and a combination of a shift in the international fiscal mix and market-determined dollar depreciation. Details of the simulation assumptions are given in the notes to the table.

Table 2.

Alternative Policy Scenarios

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Notes: (A) Percentage growth rates, except as otherwise marked. (B) For GNP, deflator and exchange rate, percentage deviations from reference scenario; for current account balance, absolute deviations. Figures under (A) have been obtained applying deviations from baseline derived from simulations carried out by the Fund in August 1987 with the reference scenario. For scenario 2, figures under (A) have been obtained applying deviations from baseline derived from simulations carried out by the OECD in August 1987 with the reference scenario.Source: Bank of Italy estimates.

Let us focus on the behavior of exchange rates and the U.S. current account in Table 2. Consider first the Fund’s Multimod scenarios in the top bank of figures. The case of pure dollar depreciation reflects an exogenous increase in the risk premium. This is shown in the movement of the real exchange rates of the yen and DM against the dollar. The yen appreciates by 7.1 percent against the dollar in 1989 and 2.7 percent in 1992, relative to the baseline. The corresponding numbers for the DM are 8.0 and 4.2. These follow the path of sudden depreciation of the dollar with rational expectations shown in Chart 9. The consequence is a reduction in the U.S. current account deficit of $86.1 billion by 1992, the largest reduction of all the alternatives in Table 2.

Table 3.

Key Assumptions for Scenarios

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Simulation carried out in August 1987 for Multimod and in February 1988 for Interlink.

Simulation carried out in August 1987 for Multimod and in April 1987 for Interlink.

Simulation carried out in August 1987 for Multimod and in February 1988 for Interlink.

The Multimod scenario of fiscal restriction in the United States illustrates one of the main points of this paper. In this scenario the dollar depreciates in real terms against the yen by 2.8 percent in 1989 and 6.6. percent in 1992, and against the DM by 4.3 percent in 1989 and 11.1 percent in 1992. In the scenario with fiscal expansion in Germany and Japan as well as fiscal contraction in the United States, the depreciation against the yen is much greater; against the DM it is a bit smaller. The point here is that the fiscal scenarios all include further depreciation of the dollar. This raises the question: why do the Group of Seven finance ministers and some of their central banks profess the illusion that fiscal action can eliminate the need for further dollar depreciation? This undermines their own credibility.

The OECD Interlink model takes nominal exchange rates as exogenous, so the simulations in the bottom bank of figures in Table 1 are quite different from Multimod’s in the behavior of exchange rates. In the first simulation, the dollar is devalued against the yen by 15.9 percent and against the DM by 11.4 percent in real terms and held at that level. Oddly, the effect on the U.S. current account is less than half of that in the corresponding Multimod simulation, which has less than half the dollar depreciation. In the Interlink simulation of fiscal restriction in the United States, the real exchange rate hardly moves. This does not support the Group of Seven view, of course; it is due to an inconsistent assumption.

The simulations, as well as theory, show that a degree of restoration of fiscal balance in the United States, with its concomitant dollar depreciation, would contribute to the restoration of international balance. The curious point remains the idea of the need for fiscal expansion outside the United States. If the secondary objective is to stabilize the dollar in the short run, fiscal expansion is counterproductive. Monetary expansion in Japan and Europe could do the job. It would also support demand and ward off fears of a world recession as the United States rights its fiscal balance. And, by increasing world saving, this package would reduce real interest rates and the debt service of the developing countries.

Appendix I Two-Country Fundamentals Model

This Appendix sets out the algebra of the two-country version of the “fundamentals” model presented in Branson (1985 and 1988). The model analyzes the effects of changes in real variables such as the deficit or risk premium on other real variables, namely real interest rates and the real exchange rate. It abstracts from cyclical effects by holding output constant.

The model delivers the comparative statics of real disturbances for real endogenous variables. It does not analyze their dynamic paths, which are composed of changes in nominal variables, some of which are sticky (goods prices), and some free to jump (asset prices). The dynamics of nominal adjustment are discussed in Appendix II, which has the same real comparative static properties as the fundamentals model here. So it may be useful to view this model as giving a concise description of the movement of equilibrium position in real terms, and the dynamic model as describing the nominal paths between equilibria.

Model

The model is three equations, describing national income equilibrium in each country, and the real arbitrage condition linking the two countries’ financial markets. The national income equilibrium conditions are

(14)D=S(r)X(ee¯,α),(Homecountry)
(15)D*=S*(r*)+X(ee¯,α)(Foreigncountry).

These say that the budget deficits (D,D*) must equal the sum of net private saving (S,S*), and the current account surplus (X>0) or deficit (X><0). Net saving is assumed to depend on the domestic interest rate with S´, S*´>0. Net exports of the home country depend on the real exchange rate and a shift parameter to reflect changes in demand patterns, with Xe>0 and Xa>0. When e = ē, the current account is in balance.

Financial equilibrium is characterized by the arbitrage condition on real interest rates developed in Branson (1988):

r=r*+e^+ρ(B/B*),

where ê is the expected rate of change of the real exchange rate and ρ is a risk premium that depends on the relative supplies of government debt, assumed to be denominated in home currency. We add the perhaps reasonable assumption that the exchange rate is expected to move toward the long-run equilibrium:

e^=θ(e¯e).

Combining these two relationships yields the arbitrage condition that is the third equation of the fundamentals model:

(16)e=e¯+1θ[r*r+ρ(B/B*)].

Equations (14)–(16) serve to determine the real interest rates rand r* and the real exchange rate e, as functions of the real budget deficits D and D*, the shift parameter α, the relative real debt stock B/B*, and the underlying long-run equilibrium real rate ē.

Comparative Statics

The total differential of the model can be written in matrix form as equation (17):

(14)(15)(16)AB[s0xe0s*xe11θ][drdr*de]=[10xα0xe01xα0xe000ρθ][dDdD*dαdBB*de¯]

The determinant |A|=S[θS*+Xe]+S*Xe>0.

The comparative statics results can be obtained by substituting columns of the B matrix into the A matrix following Cramer’s Rule. These results are given in Table 4. Since total differentiation linearizes the model, effects of combinations of changes in D and D* can be obtained by summing or differencing the entries in the dD and dD* rows. For example, a reduction in D and an increase in D* by the same amount would reduce r and increase r* by

Table 4.

Comparative Statics Results of Fundamentals Model

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dr=Sθ|A|dD*;dr*=S*|A|dD*.

The effect on e would be an increase (depreciation) by

de=S*+SAdD*.

The effects of policies on the interest differential r–r* can be obtained by the difference of the entries in the relevant row. For example, an increase in D will raise the interest differential r – r* by

d(rr*)=S*|A|dD,

holding the existing relative debt stocks B/B* constant.

Graphical Analysis

The two-country model has three endogenous variables, r, r*, e. For a graphical analysis in r, r* space, we can collapse the model into two equations as follows. The total differentials of the two national income equations (14) and (15) can be summed to yield

(18)dD+dD*=Sdr+S*dr*.

In the r, r* space of Chart 10, Panel 1, this is the RR line with a negative slope dr/dr* = –S*´/S´. An increase in either D or D* shifts RR out, tending to increase both interest rates. The arbitrage condition (16) is the AA line in this panel, which has a slope of unity. Its position is conditional on (e – ē) (which is endogenous) and B/B*. An increase in (e – ē) shifts the AA line down; an increase in ρ(B/B*) shifts it up.

We can now describe the results of Table 4 graphically. An increase in either D or D* shifts RR out, as in Chart 10, Panel 2. If the increase is in D, the real exchange rate e falls (home currency appreciates), and the AA line shifts up, moving the equilibrium to point 1 from point 0. The home interest rate rises more than the foreign rate. If the increase is in D*, the AA curve shifts down or e rises, and the equilibrium moves to point 2 from point 0. In both cases, both interest rates rise because world saving is reduced; this is clear from Panel 1.

A shift in demand from foreign to home goods, reflected in an increase in α, causes the real exchange rate to fall (home currency appreciates), shifting the AA line up along RR, raising r and reducing r*. This is shown in Panel 3. Similarly, an increase in the risk premium ρ(B/B*) shifts the AA curve up.

The text analysis of the effects of an increase in D, such as occurred in the 1980s in the United States, is illustrated in Chart 10, Panel 4. The initial increase in the deficit carries the system from point 0 to point 1, with an increase in r, r*, and r – r*, and a fall in e (appreciation). This generates a current account deficit (X < 0). As dollar debt accumulates, B/B* rises, shifting the AA curve up further. During this phase the exchange rate is rising (depreciation). This can be seen from de/d(B/B*)>0 in Table 4. This process continues until the current account deficit is closed at a point like 2. There r has risen enough, and r* fallen enough, to raise S and reduce S* enough to make room for debt service in the current account X. This would be represented in Table 4 by an increase in ē.

Chart 10.
Chart 10.

Comparative Statics Results of Fundamentals Model

Appendix II Nominal Dynamics in Two-Country Dornbusch Model

This Appendix sets out the algebra of the two-country version of the dynamic exchange rate model presented first in Dornbusch (1976). The model can be used to analyze the effects of changes in monetary and fiscal policies on the price level and the nominal exchange rate. In the version presented here, real output is held constant to avoid the complications of cyclical effects.

This model delivers the comparative statics of nominal disturbances for nominal variables, and the dynamic paths of adjustment of these variables. After setting out the model, we will first present the long-run comparative statics, and then the dynamics. This model contains the fundamentals model of Appendix I as the determinant of real variables, but adds the dynamics of nominal adjustment. Here we focus on the latter.

Model

Here we add money-market relationships and nominal variables to the fundamentals model, and then reduce the model by assuming symmetry to focus on relative price levels and the nominal exchange rate. So as the model is introduced, we assume the parameters are the same in both countries.

The two money-market equilibrium conditions are

(19)mαp(1α)p*+(1α)E=φyλi(Home)
(20)m*αP*(1α)p+(1α)E=φy*λi*(Foreign).

All variables except the nominal interest rates i and i* are in logs, so λ is the semi-elasticity of money demand. The deflator for nominal money balances in each case is the consumer price index, with a home goods share α and an import share (1 – α). We assume α > 0.5. The exchange rate enters both equations through the import content of consumer prices. E is the log of the nominal exchange rate.

The nominal arbitrage condition is given by

(21)i=i*+E˙ + ρ,

where ρ is the risk premium. In the dynamic analysis we will assume exchange rate expectations are formed rationally.

Gradual adjustment of prices to excess demand in the goods markets is assumed. The two price-adjustment equations are

(22)p˙=π[X(E+p*pe¯)S(i)+D](Home)
(23)p˙*=π[X(E+p*pe¯)S(i*)+D*](Foreign).

Here prices adjust gradually to the excess of demand, given by X—S + D, The components of demand are the same as in the fundamentals model. Since in the long-run equilibrium inflation is zero, in the long run i = r and i* = r*.

Long-run equilibrium of the model can be analyzed by setting p, p*, and Ė equal to zero in equations (19)–(23). In that case, the five equations serve to determine long-run equilibrium movements in the two price levels, the two interest rates, and the nominal exchange rate, in response to changes in the money supplies m and m*, the fiscal deficits D and D*, and the risk premium ρ Total differentiation of (19)–(23) with ṗ= ṗ*= Ė = 0 yields the 5x5 matrix equation (24):

(19)(20)(21)(22)(23)[α(1α)0XeXe(1α)α0XeXe(1α)(1α)0XeXeλ01s00λ10s]A[dpdp*dEdidi*]=I[dmdm*dρdDdD*]

where I is the unit diagonal matrix.

Rather than analyzing the entire 5x5 system, we simplify it into two parts. The fundamentals model of Appendix I combines p, p*, and E into one variable e and focuses on the real part of the system. The A matrix in equation (17) is the bottom right-hand 3x3 matrix in A in (24), with ө in place of 0 in the diagonal. Here we focus on nominal adjustment and dynamics by eliminating i and i* and reducing the system to two equations in p–p* and E. Here the assumption of symmetry is important.

If we subtract equation (20) from (19) and substitute from (21) Ė+ρ for i–i*, we obtain

(25)mm*+(12α)(pp*)2(1α)E=θ(yy*)λ(E˙+ρ).

The assmption that α > 0.5 makes the coefficient of (p–p*) negative. To obtain the equation for the inflation differential ṗ – ṗ*, we assume the savings functions are linear and subtract (23) from (22) with the same substitution for i – i*. This yields

(26)p˙p˙*=π[2X(E+p*pe¯)S(E˙ +ρ)+DD*].

The two equations (25) and (26) can be used to analyze the comparative statics and dynamics of the relative price level p – p* and the exchange rate E.

Long-Run Comparative Statics

Long-run equilibrium can be analyzed by setting ṗ= ṗ* = E=0 in equations (25) and (26). The total differentials of the resulting equilibrium system are given by the 2x2 matrix equation (27):

AB(25)(26)[(12α)2(1α)2Xe2Xe][d(pp*)dE]=[1λ000S11][d(mm*)dpdDdD*]

The determinant of the |A| matrix is 2Xe>0.

The comparative static results are given in Table 5. The symmetry of the model is obvious. An increase in the relative money supply (m – m*) raises (p–p*) and E proportionately. An increase in the home deficit D reduces E (appreciation) and an increase in the foreign deficit increases it. An increase in the risk premium raises E but has an ambiguous effect on (p – p*).

Table 5.

Comparative Statics in Two-Country Dornbusch Model

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The effect here of a change in either deficit or in the risk premium on the real exchange rate e (= E + p*–p) can be obtained by subtracting the entry for (p – p*) from the entry for E in Table 5. The results are given by

dEd(pp*)dD=dEd(pp*)dD*=12Xe<0
dEd(pp*)dρ=S2Xe>0.

As in the fundamentals model, an increase in the home budget deficit or reduction in the foreign budget deficit generates an appreciation of the real exchange rate, and an increase in the risk premium, a depreciation.

Dynamics

We can study dynamics in the (p – p*), E space by sketching the locuses for Ė=0 from equation (25) and (ṗ – ṗ*) = 0 from equation (26). Setting Ė=0 in (25) gives the downward-sloping locus in Chart 11, Panel 1, with a slope given by

Chart 11.
Chart 11.
Chart 11.

Comparative Statics in Two-Country Dornbusch Model

d(pp*)dE|E˙=0=2(1α)12α<0ifα>0.5.

The dynamics of E relative to the Ė= 0 locus under rational expectations are given by the horizontal arrows in Panel 1. For a value of the exchange rate above the Ė= 0 locus to be consistent with money-market equilibrium, the exchange rate must be expected to rise. An increase in the exchange rate reduces relative real balances and increases i – i*, requiring from the arbitrage condition a positive Ė. Below the Ė=0 locus, the exchange rate must be expected to fall. With rational expectations, the actual movement is the same as the expected.

The slope of the locus where ṗ – ṗ* = 0 can be obtained as follows. Totally differentiate equation (25) allowing (p – p*), E, and Ė to change, and solve for de. Then totally differentiate equation (26) with ṗ– ṗ* = 0, and substitute the expression from (25) for the term in dĖ. This yields for the ṗ– ṗ* = 0 locus in Chart 11, Panel 2, a slope of

0<d(pp*)dE|p˙p˙*=0=2XeSλ2(1α)2XeSλ(12α)<1.

The slope of the ṗ – ṗ* = 0 locus is flatter than unity due to the Ė term in equation (26). As (p – p*) rises, Ė increases because i–i* rises, so saving increases and the depreciation needed to maintain goods market equilibrium is less than the original increase in (p–p*). The vertical arrows in Panel 2 show the direction of price adjustment toward the ṗ – ṗ* = 0 locus.

Dynamic adjustment to the long-run equilibrium where both ṗ – ṗ* and Ė=0 is shown in Panel 3. As usual in a model with expectations dynamics, there is a unique stable saddle path into the equilibrium, labeled SS. (This is the QQ path in Dornbusch (1976)). Other paths diverge to an asymptote normal to the SS path. Following a disturbance, the market searches for a level of the exchange rate in the SS path, which has two essential properties: (a) it leads to equilibrium, and (b) along it, expectations of Ė are realized.

Dynamic adjustment can now be analyzed as follows. First, the movement of the equilibrium point is given by the multipliers of Table 5. This locates the new SS path. Then the exchange rate jumps to the new SS path at the pre-existing value of p – p*. Finally both E and p – p* were along SS to the new equilibrium.

The effect of an unanticipated increase in (m – m*) is shown in Panel 4. The long-run equilibrium moves out proportionately from point 0 to point 2, with both locuses shifting up. The exchange rate jumps from point 0 to point 1 on the new SS path, and then E and p–p* move gradually to point 2. This is the famous overshooting result in the two-country model.

The effect of an increase in D–D*, the relative fiscal stance, is shown in Panel 5. Here only the ṗ – ṗ* = 0 locus shifts, since D – D* is not in the Ė=0 equation. The long-run equilibrium moves from point 0 to point 2 as the ṗ – ṗ* = 0 locus (not shown) shifts up. The exchange rate jumps (appreciation) to point 1 on the new SS path, and then both E and p–p* adjust gradually to point 2. The model exhibits “undershooting” with respect to the (real) fiscal disturbance. A decrease in D – D* would move the equilibrium down the Ė = 0 locus in Panel 5, with the exchange rate depreciating. This would be the consequence of a tightening in the U.S. fiscal position and an easing of fiscal policy in Germany and Japan.

The effect of an increase in the risk premium is shown in Panel 6. From Table 5, we see E rises but the sign of the effect on p – p* is unclear. If the latter were zero, then the equilibrium would move from point 0 to point 2, with both locuses shifting right. The exchange rate would follow the shift with no effect on p–p*. If the new equilibrium is above point 2, that is, p–p* rises, then the exchange rate would overshoot. If it is below point 2, the exchange rate would undershoot. Thus we can expect an erratic path of depreciation in response to an increase in the risk premium.

The movement of the U.S. dollar since 1980 can be roughly replicated in this model if we assume first an increase in D – D* as the U.S. fiscal position shifted, and later in 1985 an increase in the risk premium as the market came to understand the implications of the increase in the stock of dollar debt. This is shown in Panel 7. The initial budget shift yielded a jump appreciation of the dollar across 1981 as the market came to understand the implications for the deficit. The dollar continued to appreciate along an erratic path to early 1985, as the market continued to digest new information on the size and duration of the deficit. The turnaround in 1985 can be interpreted as resulting from a gradual rise in the risk premium as the market contemplates the eventual size of the stock of dollar debt. The final equilibrium position in 199? will have to be below the ray from the origin to the initial 1980 point, since the equilibrium real exchange rate ē will have risen. This is necessary to provide the trade surplus to finance debt service at eventual current account balance.

REFERENCES

  • Bank of Japan, “U.S. Competitiveness in Manufacturing,” Special Paper No. 153, September 1987.

  • Blanchard, O.J., “Reaganomics,” Economic Policy Review (Cambridge), No. 5, (October 1987), pp. 1556.

  • Branson, William H., “Causes of Appreciation and Volatility of the Dollar,” in Federal Reserve Bank of Kansas City, The U.S. Dollar—Recent Developments, Outlook, and Policy (Kansas, 1985).

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  • Branson, William H., “Sources of Misalignment in the 1980s,” in R.C. Marston, ed., Exchange Rate Misalignment (Chicago: University of Chicago Press, forthcoming, 1988).

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  • Committee for Economic Development, “Report on U.S. Debt,” cited in International Herald Tribune, February 20–21, 1988.

  • Dornbusch, Rudiger D., “Exchange Rate Dynamics,” Journal of Political Economy (Chicago), Vol. 84 (December 1976), pp. 116176.

  • Dornbusch, Rudiger D., and Jeffrey A. Frankel, “Macroeconomics and the Dollar,” in R.M. Stern, ed., U.S. Trade Policies in a Changing World Economy (New York: MIT Press, 1987), pp. 77130.

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  • Frenkel, Jacob A. and Assaf Razin, Fiscal Policies and the World Economy (Cambridge, Mass.: MIT PRess, 1987).

  • Genberg, Hans and Alexander Swoboda, “Current Account and Policy Mix Under Flexible Exchange Rates,” International Monetary Fund Working Paper WP/87/70, October 1987.

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  • Haas, Richard, and Paul R. Masson, “Minimod: Specification and Simulation Results,” Staff Papers, International Monetary Fund (Washington), Vol. 33 (December 1986), pp. 72267.

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  • International Monetary Fund, World Economic Outlook (Washington: IMF, 1987).

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  • Krugman, Paul R., “Fiscal Policy, Interest Rates, and Exchange Rates: Some Simple Analytics,” Mimeograph, M.I.T., August 1985.

  • Marris, Stephen N., “The Decline and Fall of the Dollar: Some Policy Issues,” Brookings Papers on Economic Activity: 1 (1985), The Brookings Institution (Washington), pp. 2374.

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Comment

Niels Thygesen

William Branson identifies three policy illusions in the analysis by the International Monetary Fund and the Group of Seven Finance Ministers of the issue of international policy coordination. Taking the Fund’s recent World Economic Outlook and Group of Seven communiqués announcing the so-called Louvre Accord of February 1987 and the follow-up in December 1987 as representative expressions of the official view, Branson is highly critical of three conclusions:

  • (1) that “today’s constellation of exchange rates is an equilibrium constellation”;

  • (2) that “a shift in the fiscal mix between the United States and the rest of the Group of Seven would substitute for further depreciation of the dollar”; and

  • (3) that there should be fiscal expansion in the surplus countries in the OECD area to match fiscal contraction in the United States.

Branson disagrees on all three points and provides a cogent empirical and theoretical analysis in support of his alternative views: a further depreciation of the dollar of at least 15 percent in effective real terms is required to eliminate the U.S. current account deficit; fiscal policy adjustments cannot substitute for depreciation, as both expenditure reduction and expenditure-switching measures have to be set in motion in the U.S. economy; while, finally, monetary expansion outside the United States would be preferable to fiscal expansion to smooth exchange rate changes. My comments take issue with all three of Branson’s points. While there are good reasons for believing that the officially expressed views contain elements of wishful thinking and of inconsistent assumptions, Branson’s conclusions seem to me too severe. Without endorsing the official view, which Branson identifies on the basis of a mixture of explicit statements and implicit assumptions, my own interpretation of it is more sympathetic. Let me take the three in turn.

Equilibrium Exchange Rate for the Dollar

Branson’s reasoning is loyal to the bulk of the empirical analysis on the determinants of the U.S. current account deficit which has become available in recent years. The official institutions (the Fund and the OECD) and the large econometric models surveyed in the long-term research program on macroeconomic interactions and policy design in interdependent economies, jointly sponsored by the Brookings Institution and the Centre for Economic Policy Research (see notably Bryant, and Holtham and Hooper (1988)), invariably reach pessimistic conclusions about the course of the U.S. current account deficit over the next three to four years. After a small correction in 1986–88, the deficits widen again from 1989 on the basis of the assumptions of unchanged policies and exchange rates. Branson’s estimate of the real exchange rate depreciation it would take to bring the U.S. current account into approximate balance by the early 1990s is not only in line with the results of the authors he quotes—Dornbusch and Frankel and Marris—but also with most of the large models. Had the paper been written in mid-1988 rather than early 1988, Branson would have been justified in increasing from 15–20 percent the required real depreciation, since the dollar has been allowed to rise by approximately 5 percent in nominal effective rate terms in recent months—which is surprising in view of the general recognition that the dollar was not undervalued when it reached its temporary low in early 1988. Branson adds that even 15 (or 20) percent real depreciation—which would correspond to at least 25–30 percent nominal depreciation of the effective rate and more vis-à-vis the major industrial competitors, implying a dollar rate of less than 100 yen and less than DM 1.25 by 1991—would not be the end of exchange rate adjustment. Because of the weaker trend performance in output per manhour in the United States than in some of its competitors, and because of the asymmetry between the income elasticities in U.S. import demand and in the demand in the rest of the world for U.S. exports, the dollar will require further gradual downward adjustment, though at a much slower rate, after the major depreciation of the near future which Branson sees as necessary to restore external balance for the United States.

I have two critical comments to these calculations and their implications, while accepting Branson’s analysis as a good reflection of mainstream macroeconomic analysis. The first relates to his choice of external objective for the United States, while the second raises a more basic doubt about the elasticity pessimism which is reflected in the calculated effects of past changes in the U.S. dollar.

As regards the former point, setting the objective for the U.S. current account at zero by the early 1990s appears unnecessarily ambitious. There is nothing compelling in such a scenario. The financial constraint on the United States in the sense of keeping the risk premium on dollar-denominated assets constant, is likely to be looser. For example, as long as U.S. net indebtedness is growing no faster than international financial portfolios, there should be no relative upward pressure on U.S. interest rates. Furthermore, foreign investors in dollar assets are likely to put more emphasis on the direction of change in the U.S. current account than on the level. Tentatively, but clearly as arbitrarily as for full elimination, one might argue that aiming for a gradual reduction of the current account deficit toward a level of 1 percent of GNP by the early 1990s would be sufficient to assume smooth financing through private net inflows. If such a course were to be firmly set, foreign central banks would also find the task of sustaining the dollar more manageable during brief periods of doubt in private markets, if such action were to be required. If the objective is “only” to swing the current account toward a deficit of 1 percent of GNP, the required real depreciation is cut by 8–10 percentage points according to Branson’s own calculations (after taking into account the additional interest service, because U.S. net indebtedness will be higher in such a scenario).

As regards the second point, it seems reasonable to question whether the collective wisdom accumulated in the econometric models has moved toward excessive pessimism with respect to the price sensitivities of trade flows. The estimates based on these models are dominated by the experience of the 1970s and 1980s with their short-run volatility and medium-term cycles. This experience is reflected partly in a slower pass-through of exchange rate changes into prices—a phenomenon which is taken into account in well-specified models—and partly in greater reluctance to engage in international trade and investment. A detailed justification for inertia and a wait-and-see attitude has been provided (in recent work by Krugman (1987)).

At the present time, a lengthening of the lags with which firms producing internationally traded goods respond to relative price changes may offer an important part of the explanation of the apparent conflict between the massive improvement in U.S. competitiveness over the period since 1985 (confirmed in surveys of U.S. manufacturing industry by the Conference Board and others as largely sufficient to make U.S. products fully competitive with those of its main industrial competitors in the OECD area), and the slowness with which these changes show up in the trade flows (even in constant dollars). U.S. exporters are hesitating to engage in major efforts in foreign markets, and those U.S. producers who have been squeezed hard by foreign competition have delayed their decision to hit back aggressively while awaiting a clearer message as to how far and how fast the dollar was to be brought back to a sustainable level.

Last, but not not least, international investment in the United States and the repatriation of some U.S.-owned production facilities abroad have been delayed by the uncertainty surrounding the prospects of the dollar and by the many verdicts by economists that it was bound to fall significantly further. It is my contention that we are some distance from having observed the full effects of the downward adjustment of the dollar that had taken place up to early 1988—provided that adjustment had been regarded as permanent and definitive.

Turning to the shorter-term outlook, it adds to the uncertainty about the nature of the medium-term cycle of the dollar against the other main currencies that the dollar has been allowed to rise in recent months. One may disagree, as I do, with respect to the degree of overvaluation relative to a longer-term sustainable equilibrium estimated by Branson, but there could hardly be any disagreement about the medium-term required change, which—for the two reasons mentioned above—I would put at less than half the figure estimated by Branson.

Can Fiscal Policy Substitute for Depreciation?

It is correct and important to point out that fiscal adjustment in the United States, possibly combined with similar measures in the opposite direction abroad, cannot by themselves achieve both internal and external balance. A package of fiscal changes designed to bring the current accounts of the major countries into sustainable equilibrium—not necessarily zero—while pegging exchange rates in real (or, even more so, in nominal) terms could well lead to an overall deficiency in demand. Some exchange rate adjustment will be required, unless rather stringent assumptions are met, as mentioned by Branson, if departures from internal balance are to be contained. This is orthodox transfer theory and has been well absorbed into the textbook version of international adjustment following the contributions of Meade, Johnson, Fleming, and Mundell. It is only the juxtaposition with the recent official view that makes it look controversial. It is a virtue of Branson’s paper that this conflict is put in the open. I believe it to be more apparent than real for essentially three reasons.

The first, briefly recognized by Branson, is that he adopts a too aggregative and Keynesian view of fiscal policy which is taken to be synonymous with short-term changes in public expenditure. Fiscal policy is not easily reducible to this one dimension, as, for example, the work of Frenkel and Razin (1987) on temporary versus permanent fiscal changes and on different fiscal instruments has shown. A more differentiated approach is required, even for assessing the broad macroeconomic issues raised by Branson. The international institutions are already taking this into account in their policy recommendations, though the implications are to make advice less qualitative and more difficult.

The second point is, as was the first, more a counsel of perfection than an objection which can easily be quantified. By focusing in his discussion of fiscal policy on public expenditure changes, Branson gives maximum weight to the departure from the assumptions under which fiscal policy could be sufficient for bringing about external adjustment between two countries while preserving internal balance in both. These assumptions are, as Branson fairly notes, either that one abstracts from bringing nontraded goods into the analysis, or that the sum of the marginal propensities to import in the two areas is one. Neither of these justifications is likely to hold if we think of opposite changes in public expenditures in the two countries. They would be less unrealistic if one thought of tax changes impinging largely on consumer spending or on corporate investment.

My third point in partial justification of the view attributed by Branson to the officials of Group of Seven starts from the observation that, in the perspective of most non-U.S, officials and of an increasing number of U.S. officials, the U.S. economy is in an overheated state, in which both internal and external considerations suggest a need for fiscal tightening. Without it the risk of accelerating inflation and a collapse of the dollar is seen as considerable. This line of thinking is illuminated in Chart 1.

Chart 1.
Chart 1.

Internal and External Balance and Dollar Devaluation

Source: After the Louvre: Promoting Exchange Rate Stability (Report of the Croham Committee, Public Policy Centre, London, 1988).

The chart, which takes policy outside the United States as given, shows in the traditional way combinations of the real exchange rate and the stance of fiscal policy (possibly measured by the structural budget deficit) at which the U.S. economy is in external and internal balance. As the fiscal deficit grows, the dollar has to appreciate in real terms to provide internal balance; this is approximately what happened during the later stages of the U.S. expansion and appreciation of 1983–85. A growing fiscal deficit requires real depreciation to pursue current account equilibrium; hence the external balance line has a negative slope.

The story starts at point A, marked Plaza. (One could have started it from the peak of the dollar in February 1985 above the internal balance line with a combination of even greater overvaluation of the dollar in an external sense and some unutilized resources.) On that occasion the Group of Five Finance Ministers argued that further depreciaton of the dollar should be encouraged. At their Louvre meeting 17 months later, with the dollar nearing what would be a sustainable level of the U.S. currency, provided a U.S. fiscal contraction, possibly combined with fiscal expansion abroad, was launched, the Group of Five chose to put the main emphasis on the fiscal prerequisites, while encouraging their central bankers to sustain the dollar where it was. One may see interventions and the supporting monetary policies essentially as a means of affecting the speed with which the dollar moves along the vertical trajectory in the absence of other policy changes. The dollar had to fall further after the stock market crash in October had prompted the U.S. monetary authorities into a relative easing of policy which was incompatible with the Louvre Accord. But in December 1987 the Group of Five reiterated in a statement their view that the dollar had fallen enough. To be fair, the U.S. fiscal stance has been tightened slightly in late 1987 but it is near enough to being unchanged to justify the crude illustration in the diagram.

The strategy of the Group of Five would appear to be to say to the financial markets: we believe that relying on further dollar depreciation without an important fiscal contraction would be counter-productive. The further distance from C to D in the chart may not be very long in real terms—say, at most 10 percent from mid-1988 levels, or about half of Branson’s figure—but in nominal terms it could be dramatic, because the depreciation would feed quickly into domestic costs and prices. It could also force a drastic adjustment of U.S. monetary policy. In these circumstances it is in the joint interest of the United States and other countries to try to constrain the adjustment path as closely as possible to CE, rather than to follow CDE (or a more unfavorable path with the dollar falling temporarily further than required by external balance, possibly interpreted as it was above in the sense of a small, but sustainable deficit). Recognizing that fiscal contraction on any major scale is unlikely in 1988, the Group of Five have effectively chosen to try to stay near or just above C for the time being.

This reasoning may be tactically motivated and risky, but it is not as inconsistent as Branson’s criticism implies. The strategy is designed to avoid an inferior outcome of rapid dollar depreciation and the need for brutal correction rather than a full blueprint for how adjustment to both internal and external balance could be achieved. The illustration fails to take explicitly into account that the external balance line, representing the sustainable flow equilibrium of the current account will itself shift gradually downward to the extent that the net external indebtedness of the United States grows and the risk premium required to encourage investors into dollar assets increases. But these effects are, within the range of policy options considered, sufficiently small to leave the basic message of the official view coherent enough to warrant serious attention, despite their apparent conflict with received theory.

Symmetric Adjustment Outside the United States?

In accordance with the traditional view that the responsibility for correcting balance of payments imbalances should not fall solely on the deficit countries, most official statements over the past few years have stressed that the surplus countries have to facilitate adjustment by fiscal or other means to keep the growth of their domestic demand well above the growth of output. This prescription seems particularly appropriate in countries where the growth of output has in recent years been insufficient to prevent substantial underutilization of resources, resulting in high unemployment. The problem raised by Branson is whether this responsibility of the surplus countries should be exercised through fiscal or monetary expansion.

Branson is surely right in saying that fully compensating fiscal expansion outside the United States to offset contraction there would be inappropriate. His main reasons for saying so are that such a package would keep interest rates too high and accentuate downward pressures on the dollar which official opinion proclaims to wish to avoid. Instead, he argues, as always with good and discriminating use of economic theory, that the contribution of the surplus countries should take the form of additional monetary ease to contain an otherwise likely jump downwards of the dollar.

The former part of the argument seems to me more convincing than the latter. It would be desirable to have some net tightening of fiscal policy in the OECD area both because fiscal contraction in the United States seems an urgent problem and because the fiscal position in the aggregate outside the United States is not initially such as to suggest any major room for expansion. Japan has already acted significantly, but may have to do more; the Federal Republic of Germany could do more, though the growth of domestic demand there too is running well ahead of output growth. Germany’s expansion may, however, have to be offset to some extent by fiscal tightening in other parts of Europe, where high deficits and/or high debt/GNP ratios severely constrain investment. The need to minimize the risk of pushing interest rates higher, hence reducing investment and making the debt-servicing problems of the international debtor countries more difficult, must encourage the industrial countries to collectively reduce their public deficits, making the U.S. contraction larger than the fiscal expansion abroad.

Branson’s argument that a symmetrical adjustment would be a recipe for exchange market instability and undershooting of the dollar seems more questionable to me. The scenario underlying Branson’s Charts 5 and 6 implies that a fiscal contraction in the United States would prompt a decline in U.S. interest rates and a downward jump of the dollar. This jump would become larger if fiscal expansion outside the United States was to be announced simultaneously because relative interest rates would then move further in favor of nondollar-denominated assets. While logically correct within the framework of the Dornbusch overshooting model, this reasoning is in conflict with the dynamics of exchange rates as seen by market participants and intended by officials.

An announced fiscal tightening of some significance in the United States would be likely to reduce U.S. interest rates, but the impact on the dollar is uncertain, because the fall in internal rates would largely reflect lower inflationary expectations. And it is certainly arguable that the initial effect on the dollar of the anouncement of a program for reducing the U.S. deficit gradually over three to four years would initially push the dollar up; only gradually, as the new policy showed up in lower borrowing, would there be a lower dollar to accompany the lower interest rates. Similarly, outside the United States, it is not obvious that an increase in interest rates prompted by larger government borrowing in Germany or other European currencies would strengthen the respective currencies. Early empirical work by Oudiz and Sachs (1984) on policy coordination did not find such effects outside the United States, and on the whole the transmission through interest rates to exchange rates of fiscal changes are not well explained in the models.

My conclusion is that Branson has taken the overshooting model of exchange rates too literally. The arguments he finds in that model against a partly symmetrical fiscal response in the United States and elsewhere constitute no serious impediment to the adoption of such a program.

Branson recommends expansionary monetary policy in Europe and Japan to smooth the course of the dollar. His policy prescription may already be said to have been followed in Japan and Germany over the past couple of years, during which money growth has run well ahead of what the authorities expected or intended, partly as a result of dollar interventions. A similar remark could be made about the United Kingdom. In this situation, where domestic liquidity is already considered ample and as posing some inflationary risks, for the monetary authorities of the United Kingdom, Japan, Germany and possibly others to announce a step up in the rate of money creation would be hazardous. But the authorities of these countries may continue to follow, quietly and without announcing that as their contribution to international policy coordination, a course of intervening occasionally to sustain the dollar while minimizing in their domestic markets the liquidity effects of these interventions.

Jacques Polak said in his perceptive paper in this volume on national policies that a good deal of loving tender care had to be applied to fiscal policy to keep it in good shape for future and more difficult tasks, A similar observation may be made about monetary policy outside the United States; by permitting the rate of money creation to be stepped up significantly from already high rates, these countries would find themselves with serious difficulties of monetary management—as they have done in past periods where a weak dollar has left them with excessive liquidity. Branson’s prescription would push the policy mix outside the United States still further in a direction in which it is already lopsided.

REFERENCES

  • Bryant, R.C., G. Holtham, and P. Hooper, eds, External Deficits and the Dollar: The Pit and the Pendulum (Washington: The Brookings Institution, 1988).

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  • Croham, Lord et al., After the Louvre: Promoting Exchange Rate Stability, Report of an International Committee chaired by Lord Croham, Public Policy Centre (London, 1988).

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  • Frenkel, Jacob A., and Assaf Razin, Fiscal Policies in the World Economy (Cambridge, Massachusetts: MIT Press, 1987).

  • Krugman, P.R., “Exchange Rates and International Adjustment,” The Centre for Japan-US Business and Economic Studies Working Paper No. 39 (New York: New York University, 1987).

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  • Oudiz, Gilles, and Jeffrey D. Sachs, “Macroeconomic Policy Coordination Among the Industrial Economies,” Brookings Papers on Economic Activity, 1 (1984), The Brookings Institution (Washington), pp. 175.

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Comment

Alexander K. Swoboda

William Branson’s paper, together with most popular discussions of contemporary international adjustment problems, focuses on the need to achieve a reduction in the large current account deficit of the United States. Branson pays particular attention to the role of the dollar in the adjustment process as well as to the impact of fiscal and monetary policies. His argument proceeds in piecewise fashion. He begins with a simple model of the long-run equilibrium real value of the dollar consistent with a given target value of the current account and goes on to derive the implications of fiscal policy for the real exchange rate from a version of the classical transfer criterion. Branson then presents a “fundamentals” two-country model which determines both real interest rates and real exchange rates from the requirements of saving-investment balance and the fulfillment of an arbitrage condition that includes a risk premium related to relative bond stocks. He then investigates monetary policy and “nominal dynamics” with the help of a two-country variant of the Dornbusch single-country model. These analytical exercises are supplemented by preliminary empirical investigations with the help of the Fund’s Mini-mod and lead, in conclusion, to a fairly specific policy recommendation: fiscal tightening in the United States and monetary ease in the Federal Republic of Germany and Japan.

This is clearly a rich paper that covers a vast territory and does so well and efficiently. Individual analytical points are made simply, clearly, and forcefully. I have few qualms with the various models that are presented as long as their explicit (and implicit) assumptions are clearly kept in mind1 Yet I do have serious reservations about some of the conclusions.

Branson’s main conclusions are conveniently summarized in the introduction to his paper. The first is that, as far as the long-run outlook for the dollar is concerned, “perhaps 15 percent more real depreciation is needed.” The second is that “depreciation is the very mechanism through which a fiscal shift would restore international balance.” Third, the proposed combination of fiscal tightening in the United States and monetary ease in Germany and Japan would “provide more short-run exchange rate stability and reduce world real interest rates, to the benefit of developing country debtors.”

In the next part of my comment I question the contention that the dollar will or should depreciate by some 15 percent in real terms by the early 1990s. In the following part I argue, and here I do not think Branson would sharply disagree, that depreciation or appreciation is only one of the mechanisms through which international balance is restored in response to fiscal shifts. I then introduce some general considerations on the role of monetary and fiscal policy under fixed and flexible exchange rates which shed some light on the appropriate policy package to deal with current international imbalances.

Long-Run Outlook for the Dollar

There are three main steps in Branson’s argument that perhaps 15 percent more real depreciation of the dollar is needed. The first step is to identify 1980 as an initial current account equilibrium where income on net foreign assets represented about 1 percent of GNP and was matched by an equivalent trade deficit. Since by the mid-1990s income on the foreign asset position of the United States is forecast to have turned negative to the tune of roughly minus 1 percent of GNP, re-equilibrating the current account will require a change of the trade balance from a 1 percent deficit to a 1 percent surplus (of GNP), or a total turnaround of some 2 percent of GNP. The second step is to refer to “standard estimates” of the elasticity of the trade balance with respect to the real exchange rate which indicate that the dollar must depreciate by 26 percent in real terms from its 1980 level to achieve such a 2 percent turnaround. Since roughly 10 percent real depreciation has already occurred, some 15 percent remains. The third step is to note that these calculations are valid only “in the absence of important shifts in the world economy since 1980.” Branson argues that such shifts, mainly changes in productivity, would, if anything, call for even more dollar depreciation.

There are at least two questions that one can address to Branson’s argument. First, how credible, or reliable, is his conclusion as a forecast of what will actually happen to the dollar? Second, what are the policy implications of the statement that the dollar must (will?) decline by another 15 percent or so in real terms?

With respect to the first question, there are three requirements for the forecast to be credible. First, the initial equilibrium (here 1980) must pertain not only to the current account but also to other endogenous variables, notably the real exchange rate. Second, one must identify the sources of the disturbance to the initial equilibrium, that is, one must know or forecast the paths of important exogenous (monetary, fiscal, or foreign) variables and trace their implications for the endogenous variables of interest (here the current account and the real exchange rate) with the help of a model, however simple, which includes the path of other important endogenous variables, such as interest rates, saving, and investment. Finally, one must have credible statistical estimates of the relationship among the main variables of interest.

The 15 percent depreciation forecast seems to me not to meet the above three criteria. Take them in reverse order. The “standard estimates” of the Marris type are based on a simple regression of the trade balance on the real exchange rate over a specific sample period. They are not a properly derived reduced-form estimate from an appropriately specified economic model. Thev completely ignore that the real exchange rate and the trade account are jointly determined endogenous variables. Second, and related, it is clear from all reasonable general equilibrium models, however simple, that the path of the real exchange rate associated with any given improvement of the current account will depend both on the source of the initial disequilibrium and on the adjustment policies being pursued. Therefore naive “trade balance elasticity” estimates only capture the relationship between the trade balance and a relative price variable yielded by a particular constellation of shocks.

As an example, compare an improvement in the U.S. trade balance brought about by an “exogenous” increase in the risk premium on dollar assets (such as a tax on capital movements) on the one hand, and by a decrease in government spending on the other. Theoretical and empirical considerations suggest that both the path and the eventual change in the real exchange value of the dollar (as well as in other variables) will differ substantially in these two cases. For instance, a Minimod-based simulation of these two cases undertaken by my colleague Hans Genberg in Geneva suggests that the real depreciation of the dollar eventually brought about by an increase in the risk premium is substantially larger than that associated with a decrease in government spending; moreover, while the first of these “policies” results in an increase in real interest rates in the United States, the second produces a fall in real U.S. interest rates; potential output as well as other macroeconomic variables are affected differently in the two regions.

Finally, there is the important question of the nature of the initial equilibrium. If 1980 was a year of current account equilibrium, what of the real exchange rate, real interest rates, output, absorption, and so forth? And how much of the adjustment in these other variables has already taken place today? The answer to these questions bears crucially on whether one would expect the dollar to have to depreciate, or for that matter appreciate, further. To illustrate, consider Chart 1, which represents the path of the dollar real exchange rate in response to a one-period fiscal deficit of 3 percent of GNP simulated from the estimated version of a fairly complete but simple model (due to Dirk Morris) which corresponds rather closely to Branson’s “fundamentals” model.2 In the model, the current account goes into deficit and remains in deficit for some seven years; it eventually returns to equilibrium. Note that the real depreciation from peak to trough is over 25 percent, while from initial to final equilibrium it is roughly 5 percent. Now backdate the fiscal shock to 1981 and reckon that, as Morris suggests, the fiscal shock in Chart 1 should be multiplied by (slightly less than) three “to get close to the actual size of US debt financing over the mid-1980’s.”3 Then the eventual real depreciation of the dollar would be of the order of 15 percent and not 26 percent, and perhaps we have already reached the trough and should expect the dollar to appreciate rather than depreciate in real terms in the future.

Chart 1.
Chart 1.

Response of Real U.S. Dollar Exchange Rate to One-Period Fiscal Deficit of 3 Percent of CNP

Source: Reproduced from Morris (1988), p. 3.

The upshot of this discussion is simply that, as a forecast, the statement that “15 percent more real depreciation of the dollar is needed” is, to say the least, unreliable. I would argue, furthermore, that such a statement is devoid of policy implications beyond suggesting that policy should not seek to resist trend changes in real exchange rates, a proposition that can be justified on general analytical grounds independently of any specific forecast of the future value of the real exchange rate. As the real exchange rate is an endogenous variable under both fixed and flexible exchange rates, one should not want to make it a fixed target of policy although one may want to smooth its path. The statement that the dollar must depreciate in real terms does imply that prices in the United States must decline relative to those in the rest of the world, but that can occur either through nominal depreciation, or through movements in price levels, or through a combination of both. It thus tells us little per se about the inherent merits or demerits of stabilizing nominal exchange rates.

Arguing that the dollar must depreciate by x percent in order to improve the balance trade is fraught with danger if one does not have much confidence in the accuracy of that forecast, or in the realization of the circumstances upon which it is conditional. It distracts attention from the actual policies needed to restore balance and risks recourse to protectionism as a “last resort” if depreciation is not associated with an improvement in the trade balance (cf. 1985–87).

Fiscal Shifts, Exchange Rate, and International Balance

In the third section of his paper, Branson appeals to the classical transfer problem criterion for a change in the terms of trade to argue that “depreciation is the very mechanism through which a fiscal shift would restore international balance.” If the words “one of the possible mechanisms” were substituted for “the very mechanism” in this statement, one could have no qualms about it.

Although it is true that a change in the real exchange rate (or the terms of trade) will have to occur if the sum of the marginal propensities to import is different from unity, that change is only one of several mechanisms that concur to restore trade or current account balance. These include the direct expenditure effects of the fiscal shift, possible changes in saving behavior, expectations, and output changes if economies do not continuously stay at full employment. They also include those mechanisms so correctly emphasized in Branson’s “fundamentals” model, that is, the asset accumulation process and its relationship to risk premia and real interest rates.

If, among these, one wants to emphasize “the principal mechanism” of trade balance adjustment one might as well take, as Branson does in other parts of the paper, a saving-investment (or absorption) approach to the current account. Take, for instance, the first equation (9a) of Branson’s “fundamentals”model. Assuming the exchange rate to be equal to its long-run equilibrium value we have: X = S(r) – D. The most direct determinants of the trade account are the budget deficit and net private saving; the crucial adjusting variable is the real interest rate; though this is not in the equation, there could also possibly be a direct terms-of-trade, Laursen-Metzler, effect on net saving. Such an absorption approach may prove useful if one were to ask what policies should be undertaken to adjust the current account or to speed up its adjustment to some target long-run value. It is to this issue that I turn next.

Role of Monetary and Fiscal Policy

In what follows I assume that current accounts are targets of policy without questioning the wisdom of such targeting. I also assume that there is agreement on what value of the current account represents “equilibrium.”4 Rather than asking by how much the real exchange rate will or should change to bring the current account back into equilibrium after some initial fiscal or other disturbance, I want to ask what policies are best assigned to the trade or current account, what policies to other objectives. To do so, I will draw on some recent work carried out with Hans Genberg (see Genberg and Swoboda (1987a)).

To keep things simple, take the long-run case analyzed by Branson where output is given at full employment and consider a two-country model with perfect capital mobility. This last assumption allows one to concentrate on the world rate of interest and ignore risk premia and interest-rate differentials; incorporating the latter would not make a major difference for present purposes.5 Table 1 shows the assignments of instruments to targets that suggest themselves under fixed and flexible rates (the latter being the case analyzed by Genberg and Swoboda).

Table 1.

Long-Run Assignments

article image
Note: G = government spending; M= money stock; P = price level; E = nominal exchange rate; CA = current account; and rw = world interest rate.An asterisk identifies foreign variables, the subscript w identifies world variables; and the real exchange rate, e = EP*/P is endogenous under both exchange rate regimes.

Four policy instruments are considered: monetary and fiscal policy at home (unstarred) and abroad (starred). Four targets can be reached with these four instruments. The targets differ under fixed and flexible exchange rates. A fixed exchange rate ties national price levels together and endogenizes the distribution of the world money stock among the two countries (national monetary policy loses its autonomy and must be devoted to keeping the nominal exchange rate, E, fixed). The nominal targets under fixed rates are therefore the world price level and the nominal exchange rate to which the sum of the national money stocks (the world money stock, Mw) and their difference (the distribution of Mw) must respectively be assigned. The real targets are the current account and the world rate of interest to which the difference and the sum of government spending in the two countries (given taxes) must respectively be assigned.

The same assignment of instruments to real targets obtains under flexible exchange rates. Here, however, the nominal exchange rate is no longer a target of policy but an endogenous variable; national monetary policy regains its autonomy and should be assigned to the national price level (or rate of inflation). Note that under both exchange rate regimes, the real exchange rate is an endogenous variable, the exchange rate regime impinging on whether the real exchange rate adjusts through inflation differentials, through nominal exchange rate changes, or both.

Three broad conclusions emerge from this simple long-run framework.6 First, as far as policy toward the current account is concerned, the focus should be on fiscal policy, more specifically on the difference in fiscal stances—and the real exchange rate should be left free to adapt under both exchange rate regimes. As, in addition, the world fiscal stance plays an important role in determining the world level of real interest rates, coordination of fiscal policies is required if the real variables are targets of policy. Second, under fixed exchange rates some agreement on the desirable evolution of the world money stock and some means for achieving it are required to achieve the target world price level or rate of inflation.

Finally, the fact that, under both exchange rate regimes, the real exchange rate is an endogenous variable which presumably adjusts to changes in tastes, technology, and endowments (and relative asset positions), suggests that targeting that variable as in some “target zone” proposals is likely to be destabilizing. There are two main reasons why this should be so. First, unless the target value of the real exchange rate happens to correspond to that which would represent an equilibrium given all policy and behavior parameters, disequilibrium will build up in other variables of the system. Second, target zone proposals typically propose that the target real exchange rate be reached by means of monetary policy. The assignment of monetary policy to the current account via that policy’s effect on the real exchange rate is clearly inappropriate if Table 1 is to be believed. It is interesting to note, in this context, that the paper by Frenkel, Goldstein, and Masson (1988) presented at this conference (see Chapter 4 in this volume) provides some empirical evidence which confirms the potentially destabilizing character of the typical assignment proposed by advocates of the target zone system.

Dealing with Current International Imbalances

The general principles outlined in the preceding section do have some implications for the proper policy packages to deal with current international imbalances. The design of such packages requires first that current imbalances be identified, second that there be some agreement on the goals to be reached, and third that there be some agreement on the way the world economy functions, that is, on a minimal model of the world economy.

I will illustrate with a very simple model of the world economy under floating exchange rates that corresponds to the general principles of the previous section and does not differ sharply from Branson’s “fundamentals” model. The model, drawn from Genberg and Swoboda (1987a), will allow us to appraise Branson’s policy proposals and to compare them with some alternatives.

Chart 2.
Chart 2.

Three Paths Toward Current Account Equilibrium

Three paths away from B and toward current account equilibrium:(1) B to C (Croup of Sewn view?)(2) B to A (Branson view?)(3) B to C to A (cautiuus view?)

The model is pictured in Chart 2 G stands for government expenditure in the United States or, if you prefer, the stance of U.S. fiscal policy, while G* stands for fiscal policy in the rest of the world, Europe and Japan if you wish. The line CA represents the combinations of fiscal policies in the two regions which given current values of all other exogenous and pre-determined variables would yield current account equilibrium (or an agreed target value of the current account). Similarly, the rwo line represents those combinations of the two fiscal policies that would yield an appropriate, or target level of real interest rates in the world.7 Assume that there is general agreement that rwo and current account equilibrium are legitimate and desirable goals of policy in the long run.

The remaining questions are: where are we today and how do we get from wherever we are to the target real interest rate and to current account equilibrium? Answers to the first question differ. Nevertheless, there is probably fairly general agreement that the U.S. current account deficit is too large, that is, that we are below and to the right of the CA line in Chart 2, and that current levels of real interest rates are too high—that is, that we are above and to the right of the rwo line. This, in turn, implies that U.S. government expenditure is too high; it is above G0, say at G1. There is less agreement as to where European fiscal spending is. Suppose for simplicity that it is G0* so that we are currently at B in Chart 2. The combinations of the two countries’ government expenditures which would maintain real interest rates at their current (high) level is given by the dotted line labelled rw1.

Suppose first that there is no change in fiscal stances, that is that G remains at G1 and G* remains at Go*. What would happen? Presumably current account equilibrium would eventually be re-established by the mechanisms described in Branson’s “fundamentals” model. Increasing indebtedness of the United States would lead to a risk premium on the dollar, real interest rates would rise in the United States and fall in the rest of the world. Net private saving would rise in the United States, fall abroad, and the CA curve would gradually shift to the right until it intersected the rWI curve (now to be interpreted as a given average real interest-rate line) at B. The dollar would probably, though not necessarily, depreciate in real terms in the process. But the target real interest rate would not be reached.

Alternatively, fiscal policy could be used to speed convergence to policy targets. Branson’s suggestion would seem to amount to moving directly from B to A, leaving it to expansionary monetary policy in Germany and Japan both to cushion the possible recessionary impact of a reduction in U.S. government spending in the short run and to avoid too sharp a short-run nominal depreciation of the dollar. The view of the Group of Seven, as characterized by Branson, would seem to call for a movement from B to C, where the matching of the decrease in U.S. government spending with an increase in government spending abroad would result in a return to current account equilibrium at the currently high level of real interest rates. The increase in fiscal spending abroad that the latter strategy implies could again be justified by fear of the recessionary impact of the reduction in G coupled with a fear of the inflationary consequences of monetary expansion in the surplus countries (as well as with disbelief in the effectiveness of monetary expansion). A third possibility would be to combine the U.S. budget cut with a temporary fiscal stimulus (if possible of the supply-side variety) abroad; this would amount to moving from B to C and then to A as the temporary stimulus is withdrawn.

Note that the basic element in all these policy packages is fiscal policy, particularly a reduction in the U.S. budget deficit. Little has been said about what would happen to the real exchange rate. Presumably the dollar would depreciate in real terms on impact, then appreciate in real terms. But this implies very little about what policy toward the nominal value of the dollar should be.

REFERENCES

  • Frenkel, Jacob A., Morris Goldstein, and Paul R. Masson, “International Coordination of Economic Policies: Scope, Methods, and Effects,” this volume (1988).

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  • Genberg, Hans, and Alexander K. Swoboda (1987a), “The Current Account and the Policy Mix under Flexible Exchange Rates,” International Monetary Fund Working Paper WP/87/70 (Washington).

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  • Genberg, Hans, and Alexander K. Swoboda (1987b), “Policy and Current Account Determination under Floating Exchange Rates,” International Monetary Fund Working Paper WP/87/69 (Washington).

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  • Morris, Dirk, “International Policy Coordination: Popular Misconceptions,” Swiss Bank Corporation, Economic and Financial Prospects, No. 1 (February/March 1988).

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Comment

Hans-Eckart Scharrer

In his stimulating paper, William Branson addresses two important issues. The first issue concerns the long-run equilibrium level and path of the dollar, the second the potential contribution of fiscal restriction in the United States, and fiscal or monetary expansion in Europe and Japan, to the restoration of international balance. In this connection, Branson raises the question whether fiscal action can eliminate the need for further dollar depreciation. I have been assigned the task of focusing on aspects of trade policies, a topic not addressed in Branson’s paper, and I should like to raise the question: Can trade policy action eliminate—or reduce—the need for further real dollar depreciation?

Before turning to that question, let me make a few remarks on the notion of long-run equilibrium. Branson defines long-run equilibrium by the condition that the U.S. current account balance is constant, “and for simplicity, we will assume this constant is zero.” I have no problems in accepting a zero balance “for simplicity.” Since Branson draws important analytical (and normative) conclusions from this assumption, it is necessary however, to emphasize that a scenario where a U.S. deficit on investment income is matched by a U.S. surplus on trade account, so that the sum equals zero, is by no means the only conceivable, sustainable current account position. Quite the contrary: current account equilibrium in that sense has been the exception rather than the rule during the entire postwar period, and many economies (including the United States, Japan, and the Federal Republic of Germany) have even been in “fundamental” surplus or deficit—although it is true that earlier balances were generally smaller, as a percentage of GNP, than those experienced since the mid-1980s. The fact that in 1987 private agents have not been willing to finance a U.S. current account deficit of $161 billion, or 3.6 percent of GNP, at the given exchange rate and interest rate differentials, is therefore not at variance with the possibility that they might well be prepared to finance a current account deficit of, say, 1 percent of GNP—equal to the projected debt service payments—on a lasting basis in the 1990s. As long as the United States continues to grow faster than other major high-income regions, an assumption underlying Branson’s deduction of the long-run equilibrium trend of the dollar, the expected real rate of return on U.S. investment is likelv to be higher—or at least not lower—than in alternative locations. It is then not unreasonable to assume that investors will reinvest their earnings in the United States, and that the country will even be able to attract fresh money from abroad, so that the “investment income” portion of the current account (rF) will easily be financed. If that happened, which also implies that the U.S. internal investment/savings gap will not be closed fully, the swing in the trade account from the 1980 level would need to be only 1 percent rather than 2 percent of GNP, and the warranted one-time shift in the real exchange rate will be, accordingly, smaller.

This should not imply that such an outcome is absolutely more plausible than Branson’s. It needs to be stressed, however, that economies can well live with current account deficits and rising net external indebtedness for quite some time, and that the preferences of analysts or policymakers for a balanced current account are not necessarily also the preferences of the market players.

With that in mind, let me turn to the relationship between the stance of trade policy, especially in Europe, and the percentage change in exchange rates required to reduce the U.S. deficit to a sustainable level (however defined). Branson has cited a number of estimates on the elasticity of the trade balance to changes in the real exchange rate. These estimates are based upon the trade regime prevailing in the 1970s and early 1980s. As a first observation it can be stated that the effect on trade flows of any given exchange rate change will be the greater, the more exposed to exchange rate movements the international sectors of the surplus countries are. In other words: if a major portion of the tradable goods sector of an economy is shielded from the impact of exchange rate changes by import restrictions, production subsidies or export subsidies, the trade effect of any given fall of the dollar will be smaller than without such protective devices, and the dollar will have to fall more to bring about the desired trade adjustment. Since the burden of that adjustment has to be fully borne by the exposed (and basically competitive) industries which will be subjected to an excessive profit squeeze, the allocative distortions—a byproduct of any policy of trade protection—are compounded.

These considerations are far from being irrelevant in practice. Twenty-five to 30 percent of world trade is estimated to be subject to nontariff barriers of one kind or another. In Europe, including the Federal Republic of Germany, major portions of the tradable goods sector are shielded from international competition. Protection is offered to agriculture, coal mining, steel, telecommunications equipment, consumer electronics, textiles and cloth, shipbuilding, the Airbus, railroad equipment, in certain countries also the car industry—to mention just the most conspicuous examples. In some of these products the United States is competitive, in others newly industrializing countries or traditional agricultural producers have a comparative advantage which they are, however, often unable to exploit: not only is the European market shielded but European producers are able, with the support of their national governments or the European Community, to engage in subsidized competition on third markets. As a result, redressment of bilateral and multilateral trade flows is obstructed, and an overshooting of real exchange rates is provoked.

The message is therefore clear: in a more competitive international trade regime, a redressment of the U.S. current account could be achieved at a lesser cost in terms of dollar depreciation and resource misallocation, whereas another sequel of protectionist moves would increase the “warranted” dollar variability. It is equally clear, however, that dismantling trade barriers in Europe is politically difficult to accomplish during a period of dollar weakness, high and protracted unemployment, and slow growth. It can succeed only in a climate of international trade liberalization backed by the United States, Japan, and the more advanced newly industrializing countries and with a major policy contribution of my own country which, as a principal exporter and importer of manufactures, has a foremost interest in an open world economy and steadiness in the dollar-deutsche-mark rate.

Under present conditions, a fair U.S. contribution would be to resist domestic pressures for new protectionist legislation or administrative action, and to promote actively the Uruguay Round of the GATT. As far as Japan and the newly industrializing countries are concerned, further opening of their markets for foreign commodities and a shift of their growth strategies toward more domestically led expansion would not only serve their own medium-term and long-term interests and the interest of the United States in a reduction of bilateral trade imbalances. It is also a necessary quid pro quo for increased access of their products to the European market. An important element of an enhanced growth and trade strategy of the major newly industrializing countries would be a reassessment of their exchange rate policies with a view to allowing stronger appreciation of their currencies against the dollar, in line with market forces. It is then up to U.S. firms to make use for the improved export opportunities and to recover domestic market shares.

Since the overall surplus of the European Community on current account of (roughly) $40 billion is mainly due to the German surplus of $44 billion, and most other Community countries are in deficit, the future stance of Community trade policy will crucially depend upon the German ability and readiness to offer “compensation” for a renunciation of existing as well as new trade barriers vis-à-vis the outside world. This is all the more true since the creation of a single European market by 1992 does not only offer macroeconomic efficiency gains estimated by the Cecchini Commission at $260 billion (or 5 percent of Community GNP) but will also bring about regional and micro-economic adjustment costs (plant closures or lay-offs). Various member countries appear little prepared to compound these costs by opening their markets for more competition from abroad—even though the macroeconomic benefits should be no different from the ones expected from the move for deepened integration.

What form could German compensation take? It is useful to start from the observation that of the toal German trade surplus of DM 118 billion in 1987, about one half—namely DM 62 billion—was generated with other Community countries, adn that this surplus has actually increased by 20 percent over 1986. For the current account surplus has actually increased by 20 percent over 1986. For the current account surplus of DM 80 billion, the same is true with respect to both proportion and trend. Support to other Community countries could be given either through a revaluation of the deutsche mark in the European Monetary System (EMS) or by a German growth initiative, or by both.

Present exchange rate management in the EMS is narrowly linked to cost and price inflation differentials with a further tendency of repressing realignments in order to discourage inflationary expectations. In view of the large disparities of current account positions among member countries, deficit countries have to accept real interest rates of 1—1½ percentage points above German rates in order to defend their currencies’ bilateral parities against the deutsche mark. A shift to a wider concept of exchange rate policy, giving due weight to the variance in trade and current accounts and using real exchange rate changes in the EMS deliberately as a tool of internal and external adjustment, would allow member countries to grow faster, to absorb more imports from outside the Community—including the United States—rather than from Germany, and to lessen the adjustment costs.

Yet, in view of the low price elasticities of imports cited in Branson’s paper, more could be gained by deliberate growth efforts in Germany. In addition to fostering coherence in Europe and enabling Germany as well as its European partners to adjust better to international competition, this would have a direct impact on German imports from the United States and the dollar area at large. But how can more growth be generated?

Branson has ruled out fiscal expansion, and I share his conclusion, though partly for reasons different from those put forward in his paper. Monetary policy in German policy has already been rather relaxed, as is witnessed by a rate of growth of the central bank money stock of 8 percent against a growth rate of nominal GNP of 3.8 percent, and by the low level of short-term interest rates (the only rates which the Bundesbank can directly influence). The steep yield curve suggests that monetary policy is caught in a liquidity trap, so that little could be gained from additional monetary stimulation.

However, there is wide scope for action on structural policies in the broadest sense, that is:

  • policies to overcome the rigidities in the labor markets which discourage regional and sectoral mobility;

  • policies to reduce barriers to access and activity in the services sector which stand in the way of a speedy restructuring of the German economy in favor of the production of more home—rather than export—goods;

  • policies to stimulate competition in the transport and telecommunications industries and in government procurement;

  • policies to effectively cut back production subsidies, which, besides giving wrong signals to market participants are a burden to the economically sound sectors of the economy; and

  • policies to encourage investment and thus to absorb a greater portion of savings domestically.

With these policy prescriptions we pass, of course, the frontiers of the Mundell-Fleming world, but that is inevitable given the limitations of the model. Quite in the spirit of Branson’s paper, though, trade and economic policy adjustment in Europe should not be regarded as a substitute for but as a complement to restoration of fiscal balance in the United States which, because of its impact on the investment-savings gap, is a necessary condition for a return to a sustainable international current account and exchange rate pattern.

1

This paper was written while the author was resident at the Banca d’ltalia. He thanks the Research Department for providing technical support and an excellent research environment. Special thanks to Grazia Marchese for preparing the empirical analysis in the paper.

1

Branson’s reader should be aware (and beware) that the assumptions underlying the various models used in the paper differ. For instance, the real exchange rate is sometimes endogenous, and sometimes exogenous; in some parts the effects of foreign bond accumulation are at the heart of the analysis, while in others they are assumed away (as, for example, in the monetary dynamics model); sometimes the relevant exchange rate variable is the nominal rate, and at other times it is the real rate. The ratio of domestic to foreign output is kept fixed through much but not all of the analysis; furthermore fixity of that ratio sometimes but not always implies fixity of the ratio of domestic to foreign absorption—and savings is assumed to be simply proportional to output.

3

lbid., p. 3.

4

The legitimacy of current-account targeting is briefly discussed in Genberg and Swoboda (1987a). Note two problems with current-account targeting. First, the case for adopting a current account target frequently rests, in practice, on the existence of (policy-induced) distortions in other sectors of the economy and the first-best intervention would be to remove these distortions directly. Second, it is difficult to estimate what is a sustainable, or appropriate, path for the current account in view of the complicated path that variable would follow in accordance to a “stages of the balance of payments” cycle or in response to various real shocks.

5

Such risk premia could be incorporated in Chart 2 and further in the text to provide a better match with Branson’s model, but at the cost of some complication. See also Genberg and Swoboda (1987b) for an analysis of the effects of foreign asset accumulation.

6

For additional, especially short-run, implications under floating rates, see Genberg and Swoboda (1987a).

7

With symmetry of behavior parameters and perfect capital mobility, the rwlines would be 45° lines; that is, the world rate of interest would depend only on the sum of government spending in the two regions.

Proceedings of an International Seminar held in Hamburg
Author: Wilfried Guth