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This paper was presented at a conference organized by the IMF and HWWA-Institut fur Wirtschatsforschung on “National Economic Policies and Their Impact on the World Economy” held in Hamburg on May 5-7, 1988. In addition to colleagues in the Research Department, the authors are indebted to Hali Edison, Martin Feldstein, Pieter Korteweg, and Jacques Melitz for helpful comments on an earlier draft.
Evidence on the size of spillover effects from policy actions by the major industrial countries is discussed in the latter part of this section and in Table 1 of Section IV.
The conclusion that a monetary expansion under floating rates affects real output in opposite directions at home and abroad is associated with the Mundell (1971)-Fleming (1962) model. For a recent evaluation of this model, see Frenkel and Razin (1987a); a broader survey of the international transmission mechanism can be found in Frenkel and Mussa (1985). Econometric models are more divided on whether a monetary expansion under floating rates has negative transmission effects on real output abroad; see Helliwell and Padmore (1985) and Bryant and others (1988).
We regard the label as inappropriate, both because the proponents of decentralized macroeconomic policy-making--including Corden (1983), (1986), Feldstein (1987), Niehans (1988), Stein (1987), and Vaubel (1985)--are geographically quite diverse, and because some prominent German economists, such as Poehl (1987), have stressed the importance of coordination.
Corden (1986) has recently argued that there may be a case for asking large countries to slow their speed of adjustment to desired policy targets so as to dampen movements in real exchange rates that could cause difficulties for others (see Section IV).
Another constraint on regional attempts to create more of the public good is that they may divert or discourage its production outside the region; the argument here is analogous to the concepts of “trade creation” and “trade diversion” in the customs-union literature.
To reach this conclusion, it is necessary to assume that each player does not have sufficient policy instruments to achieve all its policy targets simultaneously, and that coordination alters the tradeoffs among policy targets; see Gavin (1986). Without those assumptions, the motivation for coordination would disappear.
See Goldstein (1984). This is not to say that the insulating properties of floating rates are inferior to those of alternative regimes. Indeed, it is hard to see any other exchange rate regime surviving the shocks of the 1970s without widespread controls on trade and capital.
On the possible use of commodity-price indicators in the conduct of monetary policy, see Heller (1987).
Another barrier is disagreement over forecasts for key economic variables over the medium-term; on this point, see Tanzi (1988).
See Bryant and others (1988) and Helliwell and Padmore (1985) for a comparison of open-economy multipliers from different global econometric models. Frankel and Rockett (1986) illustrate the sensitivity of welfare effects of coordination to the selection of the “right” versus the “wrong” economic model.
See Fischer (1987). Dini (1988) goes further to argue that when the incentives to coordinate differ widely among group members, there may be a tendency for bilateral bargains to take place among those who have the most to trade.
See Putnam and Bayne (1984). At the same time, the Bonn Summit is regarded in some quarters as illustrative of the pitfalls of coordinating macroeconomic policies when the economic outlook is changing rapidly.
Another example of high-frequency coordination is that among central banks of the largest countries on exchange-market intervention tactics.
For example, the Louvre Communique states that: “The United States Government will pursue policies with a view to reducing the fiscal 1988 deficit to 2.3 percent of GNP from its estimated level of 3.9 percent in fiscal 1987. For this purpose, the growth in government expenditures will be held to less than 1 percent in fiscal 1988 as part of the continuing program to reduce the share of government in GNP from its current level of 23 percent;” see International Monetary Fund (1987).
Because coordination of structural policies typically involves different policy instruments, individual country actions cannot--unlike coordination of fiscal policies--be evaluated with reference to an aggregate policy indicator that would be desirable from a global perspective.
This is not to deny the helpful role that harmonization of structural policies--ranging from adopting similar tax provisions to implementing common regulations concerning movements of goods, labor, and capital--could play in certain circumstances.
Those who hold the view that international factors have minimal influence on policy-making, sometimes also argue that countries’ policy commitments in coordination agreements represent policies that would have occurred even in the absence of such agreements. Under this view, coordination affects only the timing of policy announcements with countries delaying such announcements until coordination meetings so that they can present a dowry to the others.
As Poehl (1987, pp. 19-20) notes: “… international cooperation does not necessarily imply that all parties must agree on all details at all times. It is important that we regard it as a process of maintaining stability in our increasingly interrelated world economy… The process of international cooperation may be difficult and burdensome, even frustrating at times, but there is no alternative to it.”
It is precisely because of the risk of “collusion” among the coordinating countries that Vaubel (1985) favors decentralized decision making.
It is in this context that the problems of time-inconsistency and moral hazard often surface.
Advocates of rules also argue that once the public knows better what the authorities will do, markets will demand less of a risk-premium to hold the authorities’ financial obligations.
Kenen (1987) cites a regression of the change in the inflation rate between 1979 and 1985 on the level of the inflation rate in 1979 and a zero-one dummy variable denoting participation in the exchange rate mechanism of the EMS. The sample was comprised of 22 industrial countries. The EMS dummy variable was not statistically significant, whereas the level of the inflation rate in 1979 was. Note that this finding does not preclude a helpful role of the EMS in disinflation since participation could still have reduced the output cost of disinflation (see, for example, Giavazzi and Giovannini (1988)); but this is a different story.
As developed in Polak (1988), the need for rules to guard against the dangers of fine tuning has receded in any case since economic policy in most industrial countries is now oriented much more toward the medium-term. Fischer (1987) makes the complementary point that the state of our knowledge about the effects of monetary and fiscal policy is too rudimentary to justify policy rules. Niehans (1988) expresses doubts that rules could be relied upon to reduce international disturbances.
The literature on “speculative attacks” deals with just this phenomenon; see, for example, Flood and Garber (1980).
See Frenkel and Goldstein (1986). This missing link between exchange rate movements and fiscal policy under target zones is being increasingly recognized. Whereas first-generation target zone proposals spoke only of monetary policy, second-generation proposals have added a policy rule or guideline for fiscal policy; contrast Williamson (1985) with Williamson and Miller (1987).
The list of indicators noted in the Communique of the Tokyo Economic Summit included growth rates of gross national product, interest rates, inflation rates, unemployment rates, ratios of fiscal deficits to GNP, current account and trade balances, money growth rates, international reserve holdings, and exchange rates.
There is also the question of the proper assignment of policy instruments to policy targets. This issue is touched on in the next section.
This characterization is not universally shared. Williamson and Miller (1987), for example, regard the gold standard and Bretton Woods as more symmetric systems.
In practice, high-inflation countries have sometimes resorted to capital controls during exchange rate crises so as to avoid the choice of having to give up either monetary independence or the exchange rate target.
To the extent that the EMS produces greater stability and predictability of exchange rates, all members also share any efficiency gains associated with moving closer to a single currency.
See Dornbusch (1988).
Holtham and others (1987). See the proposals on the EMS put forward to the European Community Monetary Committee last Fall by Minister Balladur of France as prefacing such a symmetric development of the EMS.
See Schultze (1987) and Bryant and others (1988). As an example of the difficulties associated with identifying the “counterfactual” contrasst Feldstein’s (1987) appraisal of the likely evaluation of exchange rates in the absence of the Plaza Agreement with that of Lamfalussy (1987).
Another recent paper, Taylor (1986), considers different exchange rate arrangements in a rational expectations model; however, only completely fixed and freely floating exchange rates are compared, and the model is limited to the seven major industrial countries.
The model simulations do not, however, allow for two other ways in which private sector behavior may be affected by changes in policy regimes. First, the variance of output, prices, or exchange rates may be different, leading to different degrees of substitutability among goods or assets. For example, it has been argued that the greater variability of exchange rates has led to a lower level of international trade than would have prevailed under fixed rates. Second, expectations may contain “speculative bubbles” in some circumstances, and hence may not solely reflect economic fundamentals. For example, the rise of the U.S. dollar early in 1985 despite declining interest rate differentials in favor of dollar-denominated assets is hard to explain.
In contrast to the industrial countries, developing countries are not assumed to face perfect capital markets. Instead, the availability of financing reflects their ability to service debt, as measured by a ratio of their inflation-adjusted interest payments to the value of their exports. It is assumed that there is an upper limit to this ratio, beyond which the risk of nonrepayment becomes high, and consequently creditors would refuse to grant further new lending. As a result of the financing constraint, imports by developing countries are also constrained, tending to reduce both consumption and investment. The constraint on financing is, however, not solely based on current developments, but also reflects an assessment of future export prospects of developing countries; expected future exports are made to be consistent with the model’s solution for those future exports.
This is a feature that will be relaxed in future work--in particular, by imposing shocks to residuals in successive periods.
Labor markets do not appear explicitly in the model, but features of wage bargaining, such as those due to overlapping multiperiod contracts, are reflected in the equation estimated for inflation.
One strong implication of this empirical regularity is that any “assignment rule” that assigns monetary policy to the current account--for example, Williamson and Miller’s (1987) Blueprint--is going to face problems; on this point, see Genberg and Swoboda (1987) and Boughton (1988).
It is assumed here that fiscal expansion is not accommodated by an increase in money growth. Current account effects also reflect the impact of interest rate changes on net investment income.
Niehans (1988, p. 215) also stresses the importance of steady policies: “The first, and most promising, step to reducing international disturbances must surely be the avoidance of the policy shifts that produce them. Especially for the dominant economy, the United States, the most important part of cooperation is steadiness.”
The measure of real effective exchange rate is the country’s manufactured export price, divided by a weighted average export price of its competitors, including developing countries. Thus, an increase indicates appreciation.
Corden (1986, p. 431) recognizes this to some extent: “[Coordination] means, incidentally, that if private investment in a country declines there should be some compensating increase in its fiscal deficit to modify the current account effect. It does not necessarily mean that a fiscal policy stance should be stable.”
The role of this variable is to give a nominal anchor to the system. The inclusion of this term is also consistent with the intent of the blueprint proposal to make the level of interest rates depend (in an unspecified fashion) on the growth of aggregate GNP.
In implementing the rule, the value given by Edison and others (1987) to n, 10 percent, was initially tried, but the model either would not solve or gave negative nominal interest rates. Consequently a higher value, 20 percent, was used, implying a lower feedback of exchange rate misalignments on interest rates.
Again, we adopt Williamson’s (1985) estimates of target or equilibrium real effective exchange rates merely to stay as close as possible to the original proposals. There should be no implication that we agree or disagree with those estimates.
It should also be noted that MULTIMOD’s definition of real effective exchange rates is wider than most measures, since it allows for competition from manufactures produced in developing countries.
It is also the case in Edison and others (1987), that real exchange rates under a target zone regime differ little from their historical values.
Suppose there are three time periods, and that interest parity relates interest rates and exchange rates. Suppose also that the exchange rate is unchanged in the third period. In each period, the interest rate differential is equal to the appreciation that is expected (and actually occurs) next period. Thus, in terms of deviations from baseline, dt = et+1 - et, where e3 = 0. Then in the second period, the interest differential will have to be equal to the desired change in the exchange rate; if it is overvalued by 5 percent, interest rates will have to be 5 percentage points lower. If in the first period the exchange rate is undervalued by 5 percent, then interest rates will have to be not 5, but 10 percentage points, higher.