The 1967 Devaluation of the Pound Sterling

Two recent investigations of the 1967 devaluation of the pound sterling concluded that the benefits of that devaluation were delayed in timing and were relatively small in magnitude. If confirmed, their conclusion would clearly tend to undermine the case for exchange rate changes as a means of promoting current account adjustment; it would also refute the previous consensus on the size of international trade elasticities. It is therefore of the greatest importance to scrutinize the devaluation experience of the United Kingdom more closely, so that the right lessons may be drawn from it. A further and more detailed investigation of the U. K. devaluation is presented here. Its conclusion differs sharply from that reached in the recent investigations by the National Institute of Economic and Social Research (NIESR, 1972) and the London Business School (LBS, by Ball, Burns, and Miller, 1972). It is estimated in the present study that positive benefits from the devaluation occurred relatively rapidly and were large in their magnitude.

Abstract

Two recent investigations of the 1967 devaluation of the pound sterling concluded that the benefits of that devaluation were delayed in timing and were relatively small in magnitude. If confirmed, their conclusion would clearly tend to undermine the case for exchange rate changes as a means of promoting current account adjustment; it would also refute the previous consensus on the size of international trade elasticities. It is therefore of the greatest importance to scrutinize the devaluation experience of the United Kingdom more closely, so that the right lessons may be drawn from it. A further and more detailed investigation of the U. K. devaluation is presented here. Its conclusion differs sharply from that reached in the recent investigations by the National Institute of Economic and Social Research (NIESR, 1972) and the London Business School (LBS, by Ball, Burns, and Miller, 1972). It is estimated in the present study that positive benefits from the devaluation occurred relatively rapidly and were large in their magnitude.

I. Introduction

Two recent investigations of the 1967 devaluation of the pound sterling concluded that the benefits of that devaluation were delayed in timing and were relatively small in magnitude. If confirmed, their conclusion would clearly tend to undermine the case for exchange rate changes as a means of promoting current account adjustment; it would also refute the previous consensus on the size of international trade elasticities. It is therefore of the greatest importance to scrutinize the devaluation experience of the United Kingdom more closely, so that the right lessons may be drawn from it. A further and more detailed investigation of the U. K. devaluation is presented here. Its conclusion differs sharply from that reached in the recent investigations by the National Institute of Economic and Social Research (NIESR, 1972) and the London Business School (LBS, by Ball, Burns, and Miller, 1972). It is estimated in the present study that positive benefits from the devaluation occurred relatively rapidly and were large in their magnitude.

One reason for the different results obtained in the present study lies in the methodological approach used. The study by the NIESR sought to estimate what the U. K. current balance would have been in the absence of devaluation, based on the extrapolation of trade equations estimated from data on the predevaluation period and “guesstimates” of what the movement of relative prices would have been in the absence of devaluation. The residual between the forecast thus generated and the actual outturn for the balance of payments was then defined as the devaluation effect. The shortcoming of this method is that the residual between forecast and outturn may be due not only to the effects of devaluation but also to other changes in structural relationships, or to purely “random” factors which assumed particular importance in the postdevaluation period. The method of calculation in the LBS study is based on simulation of an econometric model much larger than the one used in the present study, but the LBS model was not designed specifically for calculating the effect of a devaluation and is not quite appropriate for that purpose.1 Both the NIESR and LBS methods were found to underestimate significantly the devaluation effect—in particular, its effect on U. K. imports.

The methodology followed in the present paper is to focus the analysis on the critical economic relationships that determine the effect of a devaluation, and to estimate them whenever appropriate over a period which spans the devaluation (1960–72). The main relationships involved are: (1) the devaluation effect on import prices, (2) the effect of import price changes via the cost of living on the wage-price spiral, (3) the induced effect of wage and other cost changes on the price of U. K. traded goods, and (4) the response of domestic and foreign demand to changes of the relative price of U. K. and foreign goods. The last three relationships can be investigated for a period of years, since they are not generated only by exchange rate changes. Given the values of the coefficients, the entire model can be simulated so as to obtain an estimate of the effect of a change in the exchange rate.

Two conventions are used in the present paper. First, for expositional convenience, the U. K. devaluation refers not only to the 14.3 per cent devaluation of sterling in terms of foreign exchange announced on November 18, 1967 but to the complete set of exchange rate changes that took place in November 1967.2 The incomes policy introduced in March 1968 is also considered to be an integral part of the 1967 devaluation measure, whereas the coincidental changes in the indirect taxes and in subsidies are considered separately.3 Second, for analytical reasons, variations in the overall level of production in the U. K. economy are not ascribed to the devaluation. In other words, devaluation effects are estimated holding constant the overall level of economic activity. These estimated devaluation effects can be described as effects on the “full employment current balance.” This assumption may be justified on the grounds that government authorities generally manage aggregate demand so as to maintain gross domestic product (GDP) at a certain target level—a target level that does not depend on the exchange rate and is likely to reflect mainly a target employment rate. By use of this assumption, the analysis is focused on the devaluation effect on relative prices and on the specific goal of the devaluation: the improvement in the balance of payments, holding constant the overall level of production. However, this is not to say that an interpretation of balance of payments developments after 1967 does not need to take into account the demand management policy actually followed by U. K. authorities during that period—policy that might have reinforced the devaluation effect or might have offset it. In the final section of the paper, this demand management policy is considered in some detail in an attempt to relate current balance developments after 1967 to the estimate of the devaluation effect as defined here.

In Section II, devaluation effects on U. K. prices are traced through input-output tables, the wage-price spiral, and ultimately U. K. export prices and prices of U. K. products competing with imports. Price elasticities of demand for U. K. imports and exports are examined in Section III. Particular emphasis is given to the estimation of demand price elasticities for U. K. imports and exports of manufactures. The estimated price elasticities of demand and the calculated relative price changes are then employed in Section IV to obtain an estimate of the effects of the 1967 devaluation on the full employment current balance. The question of whether or not the management of aggregate demand over the 1967–71 period was adequate to allow devaluation to have its intended effects is considered in Section V. The partial equilibrium econometric model used to derive most of the results of this study appears in the Appendix.

II. Devaluation Effects on the Relative Price of U. K. Products

The fundamental impact effect of a devaluation is to reduce the foreign exchange price of the devaluing country’s goods relative to foreign goods. However, this impact effect triggers an adjustment process that is by no means simple. The increase in prices of imported products employed as inputs in production, the adjustment of prices of factors of production to price developments in the product markets, and the magnitude of the switch in demand at home and abroad in favor of the devaluing country’s goods and services will affect the whole structure of prices in the devaluing country. The foreign currency price of goods produced abroad may also be affected. While this adjustment process is too complex to be described fully, partial equilibrium analysis can focus attention on the main channels through which the devaluation effect has taken place. It also yields useful information on the quantitative magnitude of this effect, at least in the short run and medium run. The following partial equilibrium analysis deals sequentially with the effect of the devaluation on import prices, the inflationary effect of the wage-price spiral, and finally the adjustment of prices of U. K. products exported or competing with imports.

devaluation effect on import prices

Developments in the year following the devaluation indicate that U. K. import prices in sterling increased almost proportionately to the change in the exchange rate (taking into account simultaneous devaluations by other countries). Such a large pass-through is important because it makes imported goods less attractive to U. K. buyers; however, it also gives a strong push to the wage-price spiral. Import price changes between the third quarter of 1967 and the third quarter of 1968 are analyzed below. By the third quarter of 1968, most imported products had been ordered at contract prices agreed on after the devaluation took place.4

Percentage changes in import prices between the third quarter of 1967 and the third quarter of 1968 are presented in Table 1. As indicated in this table, once account is taken of changes in world market prices over the same period,5 most observed changes in import prices correspond quite closely to the average appreciation of foreign currencies of supplying countries in terms of sterling. Even if it is taken for granted that world market prices have themselves been lowered somewhat by the devaluation, these calculations indicate that foreign exporters of foodstuffs, raw materials, or even manufactures did not absorb a large part of the change in the exchange rate in their profit margins. The estimate of the devaluation effect presented in Table 1 takes into account a “notional” adjustment for devaluation effects on world market prices. For foodstuffs, raw materials, and manufactures, the sterling price of imports rose by about 90 per cent of the import-weighted average appreciation of currencies of supplying countries in terms of sterling. The case of crude petroleum is less clear because the same international companies are producing, shipping, and distributing it, so that the c.i.f. price at the U. K. port of entry is a somewhat arbitrary accounting price.

Table 1.

Effects of the 1967 Devaluations on U. K. Import Prices

(In per cent)

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This is the weighted average appreciation of foreign currencies of supplying countries in terms of sterling; the weights are the shares of the supplying countries in 1967 in the U. K. imports of the commodity considered.

For food, beverages, and tobacco and for raw materials, data were obtained from the world export price indices of the United Nations by commodity classes. The change in the price of fuels was obtained by averaging the import unit value indices for fuels for major European countries, excluding the United Kingdom. Changes in prices of semifinished manufactures and finished manufactures were obtained by averaging the export unit value indices for these product groups for France, the Federal Republic of Germany, Japan, and the United States.

Percentage change in U. K. import prices in sterling deflated by world market prices in foreign exchange.

the wage-price spiral

The case for a devaluation rests to a large extent on the hypothesis that hourly labor earnings in money terms will be adjusted significantly less than by the full amount of the change in the exchange rate. This will place domestic entrepreneurs in a better position relative to their foreign competitors. The validity of this hypothesis rests crucially on the assumption that the wage-price spiral triggered by the increase in import prices is dampened by the existence of “sticky” prices and incomes.

In the following analysis, a model of the wage-price relationship is specified and econometric techniques are used to estimate the effect of the 1967 devaluation on hourly labor earnings and the cost of living. Results indicate that the U. K. experience is consistent with the hypothesis that labor earnings are not necessarily pushed to the full extent of the increase in the price of foreign exchange, at least in the short term or medium term (3 to 4 years). The rise in hourly labor earnings caused by the devaluation was slow to appear and was significantly smaller than the increase in the price of foreign exchange. This was not so much the result of any “money illusion” on the part of employees as of the fact that the food,6 rent, and public services components of the cost of living index were not sharply increased by the devaluation. Furthermore, the incomes policy adopted in March 1968 played a useful role in delaying the adjustment of labor earnings to the cost of living.

In the most general terms, the wage-price determination may be represented by the following three-equation model:

w˙=f(p˙e,x),[ηw˙/p˙e1.0](1)
p˙e=g(p˙,y),[ηpe˙/p˙1.0](2)
p˙=h(w˙,m˙,p˙f,z),[ηp˙/w˙1.0](3)

where

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x, y, z = vectors of additional predetermined variables, and ηi/j indicates the elasticity of variable i with respect to variable j.

The exchange rate (e), in units of local currency per unit of foreign exchange, influences both nonfood import prices (m) and food prices (pf). Solving the system of equations for the elasticity of hourly labor earnings with respect to the exchange rate yields:7

ηu˙/e˙=ηw˙/p˙eηp˙e/p˙(ηp˙/m˙ηm˙/e˙+ηp˙/p˙fηp˙f/e˙)/(1ηp˙/w˙ηw˙/p˙eηp˙e/p˙).(4)

A set of equations similar to equations (1) through (3) is part of the econometric model presented in the Appendix. Parameters were estimated from observations over the period 1956-72, with w referring to average hourly earnings of manual workers (men, 21 years and over) in manufacturing, adjusted for overtime,8 and p referring to the retail price index. Point estimates of the parameters are:

ηw˙/p˙e.ηp˙e/p˙= 1.05(0.67,0.29,0.10),ηp˙/w˙=0.38(0.12,0.10,0.17),ηp˙/m˙=0.08(0.04,0.03),andηp˙/p˙f=0.439

where partial elasticities for simultaneous and lagged values of right-hand side variables by half-year periods are shown in parentheses. Results indicate that hourly labor earnings in manufacturing do adjust rapidly to increases in retail prices. However, the sum of elasticities of retail prices with respect to hourly labor costs, nonfood import prices, and food prices is less than unity (ηṗ/ẇ + ηṗ/ṁ + ηṗ/ṗf = 0.89). One reason for this result is that components of the retail price index, such as rent and charges for public services, do not adjust rapidly to changes in hourly earnings. Another reason might be that gross profit margins (in proportionate terms) in the nonfood sector are reduced whenever production costs rise rapidly.

The major dampening factor on the wage-price spiral was found to be the relatively small effect of the devaluation on food prices. Such effects are difficult to identify precisely because of the large tax element in the retail price of alcoholic beverages and tobacco, direct governmental controls on certain food products, subsidies to farmers, and various import controls—and particularly, variations in agricultural prices caused by crop variance. Nevertheless, a rough estimate of exchange rate effects can be obtained by decomposing changes in food prices before and after the devaluation into variations attributable to changes in world food prices, devaluation effects on import prices, import levies, indirect taxes, and other factors (see Table 2).10 The category “other factors” covers variations in the gross income of farmers, food processors, and distributors per unit of output. This item, which accounted for increases of 2.5 percentage points in food prices per year on average over the period 1962–67, played a less important role in the year and a half after the devaluation. This suggests that gross incomes of farmers, food processors, and distributors may have acted as a buffer, absorbing some of the initial effects of the rise in import prices.11 Furthermore, even including some catch-up effects in 1969–71, exchange rate effects on food prices do not seem to have exceeded the 4.4 percentage points directly attributable to effects taking place through import prices.12 Given that the average appreciation of the currencies of countries exporting food to the United Kingdom was only 10.4 per cent in terms of sterling (that is, ė = 10.4), a value of 0.40 (0.10, 0.10, 0.05, 0.05, 0.05, and 0.05) seems a fair estimate, possibly on the high side, for the elasticity of food prices with respect to the exchange rate (ηṗf/ė) as far as the 1967 devaluation is concerned.

Table 2.

Semiannual Increase in U. K. Food Prices, at Annual Rate, 1962–71

(In per cent)

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Food includes food, alcoholic beverages, tobacco, and meals bought and consumed outside the home.

See footnote 10 in the text.

See footnote 12 in the text.

Effects of the gradual shift from subsidies to farmers toward import levies on the retail price of foodstuffs is difficult to estimate precisely. Estimates presented here indicate only the order of magnitude of these effects.

Based on the preceding results and on the elasticity of nonfood import prices with respect to the exchange rate calculated in Section II (ηṁ/ė = 0.9), equation (4) yields an estimate of 0.42 for the elasticity of hourly labor earnings in manufacturing with respect to the exchange rate (ηẇ/ė). Thus, labor earnings in money terms would not normally be adjusted by anything like the full amount of the devaluation. In the case of the 1967 devaluation, the initial impact on wages and prices was limited because of the relatively low increase in the import price of foodstuffs (resulting from concomitant devaluations by supplying countries), and the wage-price spiral was dampened by certain measures to restrain hourly labor earnings during 1968–69.13 Estimates presented in the Appendix indicate that measures to restrain hourly labor earnings cut their rate of increase by 1.2 percentage points in each half-year period in 1968 and 1969. However, abolition of these measures at the end of 1969 resulted in a catch-up effect that added 3.9 percentage points to the rate of increase of hourly labor earnings in the first half of 1970 and 1.9 percentage points in the second half of 1970.14 The net effect of these measures was somewhat perverse (a 1 percentage point increase in hourly earnings); however, they did slow down sharply the speed at which hourly earnings were adjusted to devaluation-induced increases in consumer prices.

A simulation of the effects of the 1967 devaluation and wage restraint measures is presented in Table 3. The results indicate that it was not until 1970, when the period of wage restraint ended, that the devaluation effect on hourly labor earnings was allowed to take place. By the end of the adjustment period, hourly earnings and consumer prices had been raised by 6.8 and 5.6 per cent, respectively, as a result of the devaluation and of measures to restrain hourly earnings. As explained in the Appendix, such results must be regarded as quite tentative. Economic theory and econometric methods have been notoriously unsuccessful in explaining changes in the money wage rate, particularly in the United Kingdom. The better fit of more recent wage equations, including the one employed here, results from a search process for an equation that fits the data rather than from a better understanding of the wage determination process. Further, the stability of any wage equations can be questioned on both a priori and empirical grounds.15 Nevertheless, the main conclusion of the present study cannot be doubted.

Table 3.

Cumulative Exchange Rate Effects on Hourly Labor Earnings in Manufacturing and on Consumer Prices1

(In per cent)

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The model presented in the Appendix was employed to simulate economic developments after 1967 under alternative assumptions as to the exchange rate. Results indicated here refer to the difference between values of the variables in the simulation assuming away the November 1967 changes in exchange rates with accompanying measures of wage restraint (that is, the control solution) and those in the simulations assuming the actual exchange rate changes that took place in November 1967 with accompanying measures of wage restraint. Differences are expressed in percentages of values taken by the variables in the control solution.

Chart 1 makes it quite obvious that increases in hourly earnings in manufacturing, adjusted for overtime, were abnormally low in 1968–69, given the relatively large increases in retail prices and the moderately tight labor market.16 For two years, the rate of increase in hourly earnings, adjusted for overtime and in, real terms, was kept below the rate of increase in the standard output per man-hour (about 5 per cent a year at the end of the 1960s); however, real earnings more than caught up in 1970.

Chart 1.
Chart 1.

Semiannual Rate of Change of Hourly Earnings in Manufacturing (Manual Workers—Men, 21 Years and Over)

(Seasonally adjusted, at an annual rate)

Citation: IMF Staff Papers 1975, 003; 10.5089/9781451969382.024.A001

effect on domestic and export prices of u. k. products

Given a set of demand elasticities, an accommodating aggregate demand policy, and a certain change in prices of foreign goods in foreign exchange, the extent of the switch in demand away from foreign toward U. K. traded goods is uniquely determined by variations in prices of U. K. products. Difficulty arises however, in tracing the exchange rate effect on prices of U. K. products. The following analysis considers mainly the effect on prices of U. K. manufactures competing with imported products and on export prices of U. K. manufactures. These are the crucial prices, because U. K. exports of nonmanufactures are not large (less than 15 per cent of total exports in 1967), and elasticities of demand for U.K. imports and exports of manufactures are far higher than elasticities of demand for U. K. imports of nonmanufactures.

A study of the pricing behavior of entrepreneurs in the manufacturing sector is presented in Artus (1974); only a brief summary of the approach employed in that study is presented here, with a more detailed explanation in the Appendix. Desired long-run supply prices of U. K. manufactures in export markets (Px*) or competing with imports (Ph*) are specified as a function of the standard level of hourly labor cost (w),17 prices of intermediate inputs (pi), and the standard output per man-hour (yxloryhl), with all prices expressed in sterling:

Px*=f(w,yx1,pi)
Ph*=g(w,yh1,pi).

However, in the short run, factors such as product prices in the preceding period, px (–1) and ph (–1), the level of unused capacity in the U.K. manufacturing sector (cu) and changes in sterling prices of competing products (Δpcx for products competing with U.K. exports and Δpch for U.K. products competing with imported goods) temporarily influence the pricing behavior of entrepreneurs. Price equations explaining actual prices (px and ph) also include the exchange rate (e) and are specified as:

Px=h(Px*,Px(1),cu,Δpcx,e)(7)

and

Ph=i(Ph*,Ph(1),cu,Δpch,e).(8)

In the Appendix, price equations derived from the model above are estimated for semifinished manufactures and finished manufactures, separately, from observations on the period 1960–72. The exchange rate effect on px and ph can take place directly or indirectly through the effect of the exchange rate on: (1) sterling prices of competing products, Δpcx and Δpch; (2) standard rate of hourly labor cost, w; (3) prices of intermediate inputs, pi; (4) standard output per man-hour, ylx or ylh; and (5) capacity utilization, cu.18 The effect on the sterling price of competing products is assumed to be somewhat less than proportionate to the change in the exchange rate; the foreign exchange price of competing products was assumed to be cut so as to compensate for about 10 per cent of the change in the exchange rate. The exchange rate effect on hourly labor earnings was estimated above.19 The effect on prices of intermediate inputs was estimated by taking into account the change in the price of imported products and in the price of intermediate products supplied by U.K. industries. Effects on output per man-hour and capacity utilization are not taken into account in the partial equilibrium analysis presented here.20

The effect of the 1967 devaluation and accompanying measures of wage restraint on prices of U. K. manufactures was estimated by employing the model presented in the Appendix under the set of hypotheses listed above. The results are given in Table 4. Feedbacks of the 1967 devaluation on export prices of U. K. manufactures were large. By 1971, they accounted for an increase in export prices of U. K. semifinished and finished manufactures of 6.5 and 9 percentage points, respectively.21 The effect on export prices of semifinished manufactures took place quite rapidly, while the effect on export prices of finished manufactures stayed below or at about 6 percentage points up to the second half of 1970, when hourly labor earnings started to rise sharply and were passed through in the form of higher prices. Devaluation feedbacks on the prices of U. K. finished manufactures competing with imports accounted for an increase of about 1 percentage point or less up to the first half of 1970 and then rose sharply because of higher labor earnings to reach 5.9 percentage points in 1971. On the other hand, domestic prices of semifinished manufactures competing with imports adjusted rapidly by nearly the full extent of the change in the exchange rate. This last result is not surprising. Because the domestic supply of some basic metals, paper, textile yarns, and similar products is small, domestic prices are determined to a large extent by world market prices.

Table 4.

Cumulative Exchange Rate Effects on Import Prices and on Prices of U. K. Products1

(In per cent)

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See Table 3, footnote 1.

Totals are obtained by weighting the various items by their respective weights in 1971.

Feedback effects of devaluations by foreign countries on their wage-price levels in local currencies are not taken into account.

Percentage change in the ratio of export and import prices.

The effect of the 1967 devaluation on export prices of products other than manufactures was estimated on a somewhat ad hoc basis by taking into account the effect from increases in labor costs and by making allowance for the adjustment of the price of certain products to world market prices. The effect on export prices of foodstuffs amounted to 2 percentage points up to 1970 and then increased gradually (by half a percentage point each half year) to reach 4 percentage points in the second half of 1971. The effect on export prices of raw materials and fuels amounted to 9 percentage points over the entire period. The effect on prices of foreign travel services was assumed to be identical to the effect on consumer prices (see Table 4). For other private services, the devaluation effect was estimated to raise sterling prices by 10 percentage points over the period.

Except in the case of manufactures, prices of products competing with imports played an important role only as far as foreign travel and foodstuffs are concerned. Prices of U. K. travel services can be assumed to be the same whether exported (bought by foreign travelers) or purchased by U. K. residents who spend their vacation in the United Kingdom rather than abroad. Prices of U. K. food products competing with imports were assumed to behave as U. K. export prices for foodstuffs. The devaluation effect on import prices of goods has already been discussed. The devaluation effect on import prices of private services was calculated by making a rough estimate of the share of these services having a price denominated in foreign exchange.

III. Price Elasticities of Demand for U. K. Imports and Exports

A devaluation has a twofold effect on demand in the devaluing country: first, it switches demand away from foreign traded goods and services toward domestic traded goods and services; and second, it switches demand away from traded goods and services toward nontraded goods and services. The effect on demand in the rest of the world works in the opposite direction. The intensity of the switching effect in the devaluing country and in the rest of the world depends on the size of the effective changes in relative prices induced by the devaluation and on the magnitude of the price elasticities of demand for the goods and services. Price elasticities of demand are considered in the present section. Such elasticities play a crucial role in the adjustment process. High price elasticities of demand make it more likely that a devaluation will succeed because the large initial switch in demand that follows the devaluation will start the adjustment process on the right path; and ultimately, smaller effective changes in relative prices and in the terms of trade will be needed to obtain a given transfer of resources to the external sector.

The price elasticities of demand that play the crucial role in a devaluation are those for imports and exports of goods and services. They reflect the influence of relative prices on the choice between the devaluing country’s goods and services and similar goods and services of foreign origin.22 Other price elasticities to be considered are those between different types of consumer goods—say, foodstuffs and housing. The various elasticities are difficult to estimate; and the diversity of econometric results obtained from often careless studies of U. K. foreign and domestic trade flows has greatly contributed to the controversy on the magnitude of the effects of a devaluation of the pound sterling—a controversy that started before the 1967 devaluation and was stimulated rather than settled by postdevalua-tion developments. The dominant view before the devaluation was that the price elasticity of demand for U. K. imports of goods was between – 0.5 and – 1.0, and that for U. K. exports of goods it was about—2.O.23 No firm views were held as to the price elasticities for services. The sharp rise in the volume of U. K. imports of nearly all kinds of products in 1968–69 and the poor U. K. export performance in 1968 led many observers to reject previous optimistic views on price elasticities and to conclude rather that these elasticities were nil or quite small. It is argued here that the empirical evidence does not warrant such a conclusion; in contrast, it tends to support the predevaluation assumptions. In this section the following price elasticities of demand are considered sequentially: (1) elasticities for U.K. imports of goods, (2) cross price elasticities between various kinds of consumer goods and services in the U. K. market,24 (3) elasticities for U. K. exports of goods, and (4) elasticities for U. K. imports and exports of services.

Difficulties in estimating price elasticities of demand in international trade arise mainly because the appropriate price term in an aggregate trade equation is complex and difficult to construct.25 The use of a simple ratio between the total import (export) price index and the wholesale price index for domestic (foreign) goods would introduce a substantial bias into the estimates. In particular for U. K. imports, historical variations in aggregate price series are dominated by movements in commodity prices for which the price elasticities of demand are likely to be quite small. Any estimated aggregate price elasticity based on such data is likely to be biased downward and has no relevance to the study of effects of relative price changes caused by the devaluation.

In the econometric model presented in the Appendix, price elasticities for semifinished manufactures and finished manufactures were estimated from observations on the 1960–72 period. In this study aggregate price series for U. K. goods competing with imports were reweighted by the shares of the various products in U. K. imports to the extent that data made this reweighting possible. The estimated long-run price elasticities are—3.4 (0.7)26 for semifinished manufactures and—1.0 (0.3) for finished manufactures. These relatively high price elasticities reflect the attempt made in the present study to compare import prices to prices of comparable domestic products. When this is done, relative price changes—in particular, for metals, textile fibers, and basic chemicals—are found to be quite small with proportionately large effects on demand, as could be expected on a priori grounds for relatively homogeneous products. No significant differences were found between price elasticities in the predevaluation period (1960–67) and the postdevaluation period (1968–72).27 As regards timing, all of the relative price effects took place within a year for finished manufactures and within two years for semifinished manufactures. It is likely that further effects did occur later, although they are too spread out over time to be identifiable.

All available empirical studies have concluded that price elasticities of demand for U. K. imports of foodstuffs, raw materials, and fuels are relatively low. For a large number of these products, imports provide the only source of supply, at least over the medium term and for the range of price variations considered here. However, there are also various imported products, such as alcoholic beverages, beef, temperate vegetables and fruits, and cheese, that do compete directly with domestic products, so that the demand for these categories should not be considered as completely price inelastic. The estimates obtained by Barker (1970) for the Cambridge Growth Project that are presented in Table 5 will be taken here as indicative of the magnitude of the price elasticities for these categories; although somewhat dated, since Barker’s study covers only the 1949–66 period, these estimates remain the most comprehensive available.

Table 5.

Price Elasticities of Demand for U. K. Imports of Goods

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The commodity classification is based on the Revised Standard International Trade Classification (SITC). The SITC categories are indicated in parentheses.

See Terence S. Barker, “Aggregation Error and Estimates of the U. K. Import Demand Function,” in The Econometric Study of the United Kingdom, edited by Kenneth Hilton and David F. Heathfield (London, 1970), pp. 115-45.

Excludes precious stones (667) and silver bullion (681.1).

These estimates are not used in the present study. Differences between the estimates here and the estimates obtained by the Cambridge Growth Project are likely to reflect mainly the attempt made in the present study to compare prices of imported manufactures to prices of comparable domestic products.

Excludes military aircraft (part of 734).

The import price elasticities considered here do not represent all the effects of changes in import prices on the distribution of aggregate demand. Changes in the average prices of different kinds of products may cause a switch in total demand away from certain types of products toward others—say, away from foodstuffs toward houses. The modern theory of exchange rate effects has put much emphasis on the substitution away from traded goods toward nontraded goods in final demand (see Pearce, 1961). In a largely open economy, the foreign exchange prices of traded goods, whether domestic or imported, should be influenced mainly by world market forces, with exchange rates having little effect on them. Exchange rate variations would only affect the price of nontraded goods relative to prices of traded goods. Price elasticities between different types of products are difficult to estimate directly without constraints, and methods have been designed to solve the difficulty by making use of a priori considerations in the estimation procedure. The Frisch method was employed here to derive the matrix of price elasticities between foodstuffs, fuels, finished manufactures, and nontraded goods and services for final consumption.28 The results are presented in Table 6. These price elasticities are quite small by comparison with those between domestic and imported products of the same kind. As indicated in Section II, changes in relative prices of various kinds of consumer goods induced by the devaluation were also small, so that the quantitative importance of this aspect of exchange rate effects seems limited, at least in the case of the 1967 U. K. devaluation. These effects are ignored in the rest of the present paper.

Table 6.

Income-Compensated Price Elasticities of Demand Between Various Kinds of Consumer Goods in the U. K. Market

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Price elasticities of demand for U. K. exports are also difficult to estimate, partly because numerous strikes of industrial workers, dockwork-ers, and seamen distort trade figures even more than they are distorted on the imports side. Price elasticities of demand for U. K. exports of semifinished manufactures and finished manufactures were estimated from observations on the period 1960–72 as part of the econometric model presented in the Appendix. These estimates, presented in Table 7, are based on aggregate price series for foreign products competing with U. K. exports obtained by weighting disaggregated foreign price series by the shares of the exporting countries in the world market and by the shares of the products in U. K. exports. The estimated long-run price elasticities are–2.5 (0.6) for semifinished manufactures and –1.4 (0.1) for finished manufactures. Price elasticities of demand for U. K. exports of food, raw materials, and fuels were obtained from the study prepared by Winters (1974) for the Cambridge Growth Project.29 These elasticities are reported in Table 7.

Table 7.

Price Elasticities of Demand for U. K. Exports of Goods

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The commodity classification is based on the Revised Standard International Trade Classification (SITC). The SITC categories are indicated in parentheses.

These estimates were obtained by the author from the more detailed results (covering 16 groups of products) presented by L. A. Winters, “Regressions for U. K. Export Volumes” (mimeographed, 1974). The aggregation was made by using 1967 trade weights.

Excludes precious stones (667).

See Table 5, footnote 4.

Price elasticities of demand for U. K. imports and exports of private services are even more difficult to estimate because of a lack of reliable data on relevant prices. Empirical studies have dealt mainly with foreign travel and transportation services, with all other private services aggregated together in a residual category (for example, see Phillips, 1974). The demands for foreign travel services by U. K. residents and for U. K. travel services by foreigners have been shown to be quite price elastic. Estimates employed in the present study (–2.20 for U. K. imports and –1.66 for U. K. exports) 30 were obtained from Artus (1972).31 The demand for transportation services is to a large extent a complementary demand and is influenced by relative prices of U. K. goods and foreign travel services. International air fares and freight rates are to a large extent fixed by international conferences, so that the demand for transportation services supplied by ships or planes under a given flag is not influenced by relative prices among competing countries. However, the U. K. demand for foreign transportation services is influenced by the volume of imports of goods and foreign travel services. Phillips’ (1974) estimate of 0.5 for the elasticity of U. K. imports of shipping services with respect to imports of goods and for the elasticity of U. K. imports of civil aviation services with respect to imports of foreign travel services is used here. Similarly, U. K. exports of civil aviation services are influenced by U. K. exports of foreign travel services; the elasticity of 0.3 estimated by Phillips is also used here.32 U. K. exports of shipping services correspond mainly to freight revenues from cross trades, charter receipts, and disbursements by overseas operators in the United Kingdom and will be assumed to be determined by factors not directly influenced by relative prices of U. K. goods and foreign travel services. Demand for U. K. imports and exports of other private services—financial services, transactions between associated companies for services rendered, commissions on trade transactions, and so on—will also be considered to be price inelastic in volume terms; however, their sterling values will change as indicated in Section II.

Price elasticities considered here refer only to direct effects of relative price changes. Substitution in demand between two products will have secondary effects through the maze of input/output relationships. For example, a switch in demand in favor of U. K. finished manufactures at home or abroad may imply an increase in imports of the semifinished manufactures or raw materials needed to produce those additional finished manufactures. However, the direct import content of U. K. manufactures was only about 22 per cent in 1968, so that these secondary effects cannot compensate for direct price effects to any large extent (see Section IV).

Clearly, price elasticities of demand are parameters that cannot at present be estimated with precision, in view of the inadequate import and export price series available. Nevertheless, the empirical evidence obtained from disaggregated studies taking into account postdevaluation developments is all in favor of the price elasticity optimists. This evidence is also consistent with results of disaggregated studies for other countries.33 The mysterious curse that is supposed to make everyone insensitive to relative prices whenever the choice is made between a U. K. product and another product is a myth that feeds on aggregation bias.

IV. Devaluation Effect on the Full Employment Current Balance

The price elasticities of demand and changes in relative prices calculated in the preceding sections determine the relative price effect of the devaluation on the full employment current balance. As explained above, this effect must be interpreted as caused by the devaluation, with the proviso that the exchange rate effect on total final demand is compensated for by an accommodating cut in domestic final demand so as to keep real GDP constant (at its full employment level). While overall supply and demand remain constant, the exchange rate effect on demand and the effect of the policy-induced cut in domestic demand may not compensate for each other at the sector level. The exchange rate effect on the composition of demand and production will result in expenditure effects on imports. Relative price and expenditure effects of the 1967 devaluation on the structure of production and the current balance are estimated below. These results are then compared with estimates obtained from simulations of the LBS and NIESR models.

The relative price effect of the 1967 devaluation on U. K. trade flows in volume terms is presented in Table 8. Calculation of this effect from price elasticities of demand and relative price changes estimated above is straightforward. The cumulative effect on exports of goods increased gradually from a 2.9 percentage point rise in the first half of 1968 to a 12.7 percentage point rise in 1971. The final effect, after the wage-price adjustment mechanism had worked itself out, amounted to only a 6.8 percentage point rise in the export volume of goods. Exports of foreign travel services were sharply increased by the devaluation, by 16–18 percentage points during the whole of the 1968–71 period and by nearly 13 percentage points at the end of the adjustment period. On the import side, the effect was smaller but still quite significant. Further, the import effect occurred more rapidly. By the second half of 1968, imports of goods had been lowered by nearly 3½ percentage points and imports of private services by about 4¼ percentage points. However, the effect on imports also started to decrease sooner, with a peak effect of 4.8 percentage points for goods and 4.7 percentage points for private services in the second half of 1969. The final effect still amounted to 3.7 percentage points for imports of goods and 2.8 percentage points for imports of private services. Most of the exchange rate effect on the import side is accounted for by the effect on imports of manufactures and foreign travel services.

Table 8.

Cumulative Relative Price Effects of the 1967 Devaluation of Sterling on the Volume of U. K. Foreign Trade Flows1

(In per cent)

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See Table 3, footnote 1.

Totals are obtained by weighting the various items by their respective weights in 1971.

Excludes precious stones.

Excludes military aircraft.

The effect of this switch in domestic and foreign demand in favor of U. K. traded goods is large, relative to U. K. productive capacities; and if the overall level of production is to be maintained, this switch in demand needs to be accompanied by a cut in real domestic demand. Real domestic final demand needs to be cut by an amount that increases gradually from 1.2 percentage points in the first half of 1968 to 2.9 percentage points by the 1970–71 period. The effect of this cut in domestic demand on various sectors of the U. K. economy, and ultimately on imports, obviously depends both on the nature of the economic measures chosen to obtain it and on expenditure elasticities of demand. Subsequent calculations assume that current expenditures by consumers and public authorities and gross domestic capital formation are all cut by the same proportion. The cut in current expenditure by consumers and public authorities is allocated among the goods and services in relation to expenditure elasticities.34 All goods and services going into gross domestic capital formation are cut by the same proportion. Estimated cuts in real domestic demand for goods are presented in Table 9.

Table 9.

Cumulative Expenditure Effects of the 1967 Devaluation of Sterling, Assuming an Accommodating Cut in Domestic Final Demand1

(In per cent)

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See Table 3, footnote 1. The accommodating cut in domestic demand considered here is defined as the cut necessary to keep the overall level of gross domestic product (GDP) unaffected by the devaluation.

Totals are obtained by weighting the various sectors by their relative contribution to GDP in 1968.

Combined effects of relative price changes and cuts in domestic demand on the structure of U. K. production are calculated by taking into account the input-output relationships (by employing the 1968 input-output tables). These results are also presented in Table 9. Traded goods sectors—mainly sectors producing semifinished manufactures, which have to expand not only because of the substitution of U. K. semifinished products for foreign products but also to supply more products to other expanding U. K. manufacturing sectors—grow to the detriment of sectors producing other goods and services. By 1971, production of foodstuffs and finished manufactures increased by about 2 percentage points. The production of semifinished manufactures was raised by nearly 6 percentage points, and the production of other goods and services was lowered by about 2 percentage points. These estimates are based on the assumption that, over the time span considered, factors of production are sufficiently mobile to allow the transfer of resources to take place without undue friction. This assumption does not seem unrealistic in a growing economy, where the adjustment can take place by allocating new resources to expanding sectors rather than by a transfer of resources as such. Nevertheless, as the U. K. economy is slow growing, the shifts described just above imply pressures on some types of capacity and labor or on labor in particular locations.

Net expenditure effects of changes in the composition of aggregate demand and production on the volume of imports of goods and services are also calculated by employing the 1968 input-output tables. Results are presented in Table 9. Expenditure effects result in a relatively small cut in imports of goods and private services—less than 1 percentage point—with most of the decrease in imports of products for final domestic demand (mainly finished manufactures and foreign travel services) compensated for by a rise in imports of semifinished manufactures.

The effect of the 1967 devaluation on the U. K. full employment current balance is presented in Table 10. Estimates are obtained by combining the price changes calculated in Section II with the volume changes caused by relative price changes or expenditure effects calculated above. The effect on the trade balance in pounds sterling was perverse during the first half of 1968 by the relatively small amount of £134 million at an annual rate. However, it became favorable in the second half of the year by a similar amount. By the first half of 1969, the favorable effect on the trade balance became quite significant, amounting to about £350 million at an annual rate. It reached more than £700 million in 1970 and nearly £950 million in 1971 before starting to decline. At the scale of flows in 1971, the final effect is estimated at about £700 million. The effect on private services was also quite favorable and occurred more rapidly, without an initial perverse effect. By 1970–71, the effect on private services amounted to about £250 million. The effect on other invisibles (government payments and private transfers) is not estimated in the present study; the estimates presented in Table 11 are an average of estimates calculated by the LBS and the NIESR studies. The net effect on the current balance is always positive; small in the first half of 1968 (£77 million), it increased rapidly and averaged about £700 million in 1969, £1,000 million in 1970, and nearly £ 1,300 million in 1971. The effect on the current balance in U. S. dollars was significantly favorable earlier, because the immediate effect of the devaluation was to scale down the size of the existing deficit expressed in U. S. dollars.

Table 10.

Cumulative Effects of the 1967 Devaluation of Sterling on the U. K. Current Balance, at Annual Rate

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Table 11.

Comparison of Estimates of Balance of Payments Effects of the 1967 Devaluation

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Source: Estimates by the London Business School and the National Institute of Economic and Social Research are presented in the National Institute Economic Review, No. 61 (August 1972), p. 19.

Original estimates take into account a 3 per cent rise in gross national product (GNP) by 1970 attributed to the devaluation (with a 2½ per cent increase in the volume of imports of goods and an improvement in the private services balance of £162 million). These are adjusted by the author to the same conceptual basis as estimates of NIESR and estimates of the present study. Adjustments are calculated by simulating a 3 percent rise in GNP in the LBS model. No adjustment is made to estimates for 1968 that reflect an unknown devaluation effect on GNP.

Table 11 compares the estimates obtained in the present study with those of the LBS and NIESR. The principal differences in the three sets of estimates are to be found in imports of goods. By 1970, the effect on the value of imports of goods in pounds sterling is assumed to amount to an increase of 16½ per cent by the NIESR (that is, it is postulated that import value remains constant in terms of U. S. dollars).35 This estimate seems rather questionable, considering that the average effective change in the exchange rate (foreign currencies per pound sterling) relative to supplying countries was less than 14 per cent. Even if one assumes that the fall in the foreign currency prices of imported goods was quite small, such an estimate would imply an increase in the volume of imports because of the devaluation.36 The estimates made by the LBS seem more reasonable. The volume of imports of goods is not cut, but at least it does not rise. However, as was noted in Section III, the empirical evidence clearly suggests that demand price elasticities for U. K. imports of goods are not nil, and the results presented in Table 11 indicate that even a relatively small underestimation of these elasticities may lead to a quite misleading estimate of the magnitude of the devaluation effects on the trade balance.

It is difficult, if not impossible, to compare the actual balance of payments developments in the postdevaluation period with the estimate of the devaluation effect presented here, because many factors other than the 1967 devaluation have affected these developments. Nevertheless, the reconciliation between the estimated devaluation effect and actual current balance developments presented in Table 12 is useful as a rough check that the estimate of the devaluation effect is realistic. In Table 12, the factors behind the change in the current balance from its average level in 1965–67 have been decomposed into devaluation effects (obtained from Table 10), effects of other policy measures, cyclical effects, and “residuals.” Effects of other policy measures take into account the abolition of the import surcharge, the increase in indirect taxes, the abolition of the export rebates, the reduction in the Selective Employment Tax, the Kennedy Round of tariff reductions, payments for U. S. military aircraft, and the Import Deposit Scheme. The estimate of the effect of these various policy measures is obtained from simulation of the model presented in the Appendix; it takes into account only the effect of these policies on U. K. imports and exports of manufactures. The estimate of the effect of cyclical variations in the overall levels of economic activity in the United Kingdom and abroad on the U. K. trade balance is obtained from simulation of a separate cyclical adjustment model.37 The large residual component in the second half of 1967 reflects mainly the dock strikes in September and October 1967. The persistence of negative residuals through 1970 could indicate that the exchange rate effect had not taken place as rapidly as is estimated in the present study. However, an alternative and more likely explanation is that by the time the devaluation took place in November 1967, the U. K. competitive position was worse than it was on average over the 1965–67 period (the period taken here as indicative of the predevaluation position).

Table 12.

Reconciliation Between the Estimated Devaluation Effect and Actual Current Balance Developments

(In millions of pounds sterling at annual rate, seasonally adjusted)

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V. Management of Aggregate Demand

The simulation of the devaluation effect in Section IV indicates that, given existing price elasticities and direct devaluation feedbacks on the domestic wage-price level, shifts in demand caused by relative price changes were such that by 1971 the devaluation accounted for an improvement of the U. K. full employment current balance by about <£ 1,300 million (US$3,100 million) as shown in Table 10. Of course, other policy measures, such as the increase in indirect taxes, the reduction in aids to exporters, and the Kennedy Round of tariff reductions did compensate to some extent for the devaluation effects, while other measures such as the Import Deposit Scheme reinforced its effects. However, the net effect of the devaluation and these other measures on the U. K. current balance should still be highly favorable; a rough calculation based on the model presented in the Appendix put the net current balance improvement caused by the devaluation and these other measures at about £900 million (US$2,150 million) by 1971.

Such calculations assume that a sufficient resource transfer into the balance of payments can take place without additional inflation, since real domestic absorption of goods and services is cut by an amount corresponding to the improvement in the current balance (in real terms) plus the terms of trade effects—that is, about 3.0 per cent of GNP in 1971, if the estimate of £1,300 million is considered (see Table 9). Actual balance of payments developments depend on whether or not this cut in domestic demand takes place. Theoretical analyses of exchange rate effects have focused attention on the extent to which the devaluation alone would reduce real domestic absorption. Finding few if any direct devaluation effects on real domestic absorption, most researchers have concluded that devaluation alone would not improve the balance of payments (see especially Alexander, 1959, and Johnson, 1972). Such a conclusion is quite unwarranted; relatively efficient fiscal and monetary policy tools are available to reduce domestic demand so that it is not so important whether or not devaluation alone cuts real domestic absorption. What is important is that appropriate policy measures be taken. A review of demand management in the United Kingdom before and after the devaluation shows that appropriate measures were taken, but only after a rather lengthy interval.

By mid-1967, there was increasing evidence that the strategy followed by the authorities since 1964 had failed. Incomes policy and “structural” changes, the two instruments of this strategy, had not been successful in improving the U. K. balance of payments. The current balance was still “in the red” (with a seasonally adjusted deficit of £280 million at an annual rate in the second quarter of 1967), in spite of a stagnation of economic activity and an unemployment rate above 2 per cent.38 Unit labor costs and export prices for manufactures were still rising faster in the United Kingdom than in most other industrial countries. Foreign exchange reserves were low (US$2.8 billion at the end of June 1967); the “true” reserve position was even worse but was concealed by the use of swap arrangements and by the intervention of the Bank of England in the forward market. Not surprisingly, a new speculative attack against sterling started in May 1967 and became stronger during that summer.

Viewed ex post, it can readily be seen that the underlying external position of the United Kingdom was such that only a devaluation could have achieved the right mixture of domestic stimulus and improvement in the payments situation. However, government authorities chose a policy of expansion based on an increase in domestic demand rather than on foreign demand (devaluation).39 The exchange rate of sterling was kept unchanged. Severe restraints on prices and wages were eliminated in July 1967; in June and again in August, expansionary fiscal measures were taken. Bank lending to public authorities and to the private sector was allowed to expand rapidly (see Table 13). Such a policy made a balance of payments crisis unavoidable. Closure of the Suez Canal, the Arab boycott after the Middle East conflict in June, and dock strikes in London and Liverpool in September and October accelerated the worsening trade situation, and ultimately the Government devalued the pound under duress in November (with heavy losses to speculators).

Table 13.

Fiscal and Monetary Statistics, 1964–71

(In millions of pounds sterling, at annual rate, seasonally adjusted)

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Source: U. K. Central Statistical Office, Financial Statistics (June 1972 and previous issues).

Series seasonally adjusted by the author.

Includes overseas lending to public sector.

Includes bank lending in sterling to nonresidents less bank lending in foreign currencies to residents for investment abroad.

Consumer expenditure had already started to rise rapidly by the time the devaluation took place. The lack of measures to restrict domestic demand at the time of the devaluation and the announcement that such measures would come with the April 1968 budget led to a boom in consumer expenditure.40

Consumer demand for durable goods in real terms, seasonally adjusted, rose at an annual rate of about 50 per cent in the last quarter of 1967 and 60 per cent in the first quarter of 1968. Such a rapid expansion led to a sharp rise in imports. The volume of imports, seasonally adjusted, rose by 37 per cent at an annual rate in the first half of 1968. Even when the buying spree abated somewhat in the latter part of the year, imports were kept at a high level to replenish stocks. When added to the initial perverse J-curve effect on the trade balance arising from the devaluation, this boom in consumer expenditure made for a record deficit in the trade balance—nearly £800 million at an annual rate in the first half of 1968. Speculative attacks against sterling started afresh in May–June 1968.

The actual consequences of the stimulation of domestic demand in the second half of 1967 and in 1968 were not so serious as to prevent real devaluation effects; unused capacity was available in most export industries, in particular, in the machinery and steel industries, because private domestic investment was at a low level. Thus the transfer of resources into the balance of payments was not markedly delayed by high consumer expenditure. Foreign orders for engineering products and, after a lag, exports of those products rose sharply, partly because of exchange rate effects and partly because of a rapidly expanding world demand.

Contractionary fiscal and monetary measures that were implemented in several steps from April to November 1968 ultimately caused sharp cuts in the public sector deficit and in bank lending to the private sector.41 The fiscal and monetary statistics in Table 13 show that the public sector borrowing requirement decreased from £1,961 million in the first half of 1968 to £654 million in the second half of 1968 and that the public sector’s financial position moved into surplus in the first half of 1969, at £900 million measured at annual rates, seasonally adjusted. Bank lending to the private sector decreased from £ 1,132 million in the first half of 1968 to £296 million in the second half of 1968 and £338 million in the first half of 1969 on the same basis. The result was a near standstill of domestic demand in real terms that extended to mid-1971. Thus resources were freed from domestic use by employing fiscal and monetary policy to reduce domestic demand.

A comparison of the allocation of GDP for the United Kingdom at factor cost among components of final demand in 1965–67 and 1968–71 gives some further indication of how the U. K. economy adjusted to devaluation. Data in Table 14 indicate that about 1.8 per cent of GDP at factor cost (£ 1 billion) was transferred into the balance of payments between the 1965–67 period (when net exports of goods and services accounted on average for—1.3 per cent of GDP) and 1971 (when net exports of goods and services accounted for 0.6 per cent of GDP). In terms of real resources, the transfer amounts to only about 1.6 percentage points, because about 0.2 percentage point reflects a 1 per cent improvement in the terms of trade.42 The data also indicate that most of the resource transfer into the balance of payments was made possible by the cut in resources employed to satisfy consumer expenditure. Government authorities were not successful over that period in their avowed goal of increasing the proportion of GDP allocated to investment in plant and machinery, but at least this proportion was not cut in the process of improving the balance of payments.

Table 14.

Allocation of U. K. Gross Domestic Product at Factor Cost, 1965–67 to 1971 1

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Sources: U. K. Central Statistical Office, National Income and Expenditure, 1973 (Her Majesty’s Stationery Office, London, 1973) for national account data; Jim Taylor, Unemployment and Wage Inflation with Special Reference to Britain and the U.S.A. (Harlow, England, 1974) for data on unused labor force.

GDP valued at current prices.

The components of gross domestic fixed capital formation are valued at market prices, so that their sum exceeds the estimate of total gross domestic fixed capital formation (at factor cost).

VI. Conclusion

The favorable effect of the 1967 devaluation of the pound sterling on the U. K. current balance has been seriously underestimated by the LBS and to an even greater extent by the NIESR, mainly because they assumed, on the basis of econometric work at a very aggregative level, that U. K. imports were not affected by relative price changes. Estimates of import price elasticities obtained in the present study and by others also working at a relatively disaggregated level do not support the contention that relative prices do not matter, and they cast a new light on the effect of the 1967 devaluation.

Results obtained here indicate that the devaluation effect accounted for an improvement of about £1,300 million (US$3,100 million) in the U. K. current balance by 1971; £940 million (US$2,501 million) in the trade balance; and £331 million (US$614 million) in invisibles. Nearly 3 per cent of GDP was transferred into the balance of payments as a result of the devaluation. Estimates refer to effects on the full employment current balance of the U. K. devaluation per se, accompanying measures of wage restraint, and concomitant devaluations by certain other countries. Effects of accompanying restrictive monetary and fiscal measures are included in those estimates to the extent that they were necessary to compensate for the direct devaluation effect on the total (domestic and foreign) demand for U. K. goods and services. Such estimates are subject to a relatively large margin of error; however, results do not leave much doubt that devaluation effects were favorable and large.

Devaluation effects occurred relatively rapidly, but they were initially masked by the consequences of an expansionary domestic policy. Perverse effects on the trade balance did occur in the first half of 1968, but they were more than compensated for by favorable effects on private services and other invisibles. By the first half of 1969, favorable effects on the current balance were reaching nearly £600 million (US$1,600 million) at an annual rate. They reached more than £1,000 million (US$2,600 million) in 1970.

The volume of exports of semifinished manufactures and finished manufactures expanded rapidly under the impetus of the devaluation. By 1971, the devaluation effect accounted for an 18 per cent increase in the export volume of semifinished manufactures and a 10 per cent increase in the export volume of finished manufactures. The volume of imports of finished manufactures was also substantially reduced by the devaluation—by about 10½ per cent by 1971, when both relative price and expenditure effects are considered. The other major effect of the devaluation was to improve the foreign travel balance. Other current account items played a less important role.

The cost of the devaluation in terms of inflationary pressures and welfare losses was also high. By 1971, both consumer prices and hourly labor earnings were about 5 percentage points higher because of the devaluation. The devaluation worsened the terms of trade by about 4½ per cent for goods—with export prices in sterling up by 7.8 per cent and import prices up by 13 per cent—and by 1 per cent for private services.

During the period 1968–71, the devaluation effect on the U. K. current balance was offset to some extent by other factors, such as a cut in export subsidies, higher indirect taxes, lower tariffs on the imports of manufactures, and so on. Nevertheless, the actual current balance was turned from a £316 million deficit in 1967 to a £1,093 million surplus in 1971.43 Wage restraints in 1968–69 and a restrictive fiscal and monetary policy dating from the second half of 1968—after a year and a half of expansionary demand management—were probably the major factors behind the success of the devaluation.

APPENDIX: A Partial Equilibrium Econometric Model

Most of the key relationships that determine short-term and medium-term exchange rate effects in the United Kingdom have been investigated at length by econometricians (see, for example, Hilton and Heathfield, 1970). However, some dissatisfaction with methods employed in available studies and the need to have a complete, coherent model of key relationships estimated from observations covering a period that included the years following the 1967 devaluation of the pound sterling led to the specification and estimation of the model used in the present study.

introductory remarks

The model deals only with trade in manufactures and the wage-price adjustment mechanism. Its coverage is further restricted in two respects:

(1) Partial use is made of the small country assumption. Import prices in foreign exchange and the level of foreign demand are exogenous. Domestic prices of raw materials, fuels, and foodstuffs, in foreign exchange, are also exogenous. However, domestic and export prices of domestically produced manufactures are not constrained to be identical, and both sets of prices are endogenously determined in the model.

(2) Variables related to the level of economic activity or production capacity are predetermined in the model. In particular, the standard (or cyclically adjusted) level of productivity in the manufacturing sector and the part of the overall labor force unemployed or “hoarded” by firms are considered as given.

In specifying the model, relatively new approaches were adopted to deal with frustrating problems raised by the estimation of price elasticities of demand in foreign trade, the specification of price equations, and the unraveling of interdependent effects between money wages and consumer prices. These three topics are at the center of any empirical analysis of exchange rate effects; they have also been the subject of endless controversies.

In the estimation of price elasticities of demand in foreign trade, particular attention was paid to aggregation problems (see Learner and Stern, 1970). First, manufactured products were grouped so as to have similar demand elasticities within each group. This removes the need to weight component price series by unknown direct demand elasticities. Second, domestic price indices in the import equations and price indices for competing products in the export equations reflect a reweight-ing of disaggregated price series by the shares of the various products in U. K. imports and exports. Manufactured products are divided into two groups: semifinished manufactures and finished manufactures. The import demand for finished manufactures, being more subject to taste, quality, and delivery delays, is expected to be less price elastic than the import demand for the relatively homogeneous semifinished products. Components of the U. K. wholesale price index corresponding to semifinished products were reweighted by the shares of the various products in U. K. imports of semifinished manufactures to obtain the price index for products competing with these imports. Similarly, on the export side, a price index for foreign products competing with U. K. exports of semifinished manufactures was calculated by weighting the relevant components of foreign countries’ export unit value indices in relation to the shares of each country in the world market for the various products and to the shares of these products in U. K. exports.44 For finished manufactures, no reweighting of the price indices could be made because of the lack of disaggregated price series.45

The model distinguishes between four price series for U. K. manufactures: the export price and the price of domestic products competing with imports, for both semifinished and finished manufactures. The specification of the price equations is similar to the one derived in Artus (1974). Briefly, the price model assumes that entrepreneurs adjust prices of their products gradually in response to variations in costs. However, this is not a mechanical adjustment; in the short run, other factors such as competitors’ prices or the level of unused capacity may push actual prices away from cost-determined long-run equilibrium values. In the long run, variations in costs are assumed to be fully reflected in prices, except for the effects of a secular trend in the profit rate. A change in the exchange rate may also have a once-and-for-all effect on the profit rate.46

The price model is composed of two sets of relationships.47 First, actual prices (P) are determined as follows:

ln(P/P1)=K+Φln(P*/P1)+πln(PC/PC1)+γln(E)+ξln(CU)+θt

where

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K, Φ, π, γ, ξ;, θ = parameters.

Second, long-run desired supply prices (P*) are obtained from normal neoclassical profit maximizing conditions,

In(P*)=A+υIn(W)υ/σIn(YL¯)+rt+(1υ)In(PQ)

where

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The parameters u are estimated from input-output data, and the elasticity of substitution between labor and capital is assumed to be –0.8.

Estimation of the interdependent relationships between wage rates and consumer prices is probably one of the more intractable problems met by econometricians. First, the number of factors that may affect the wage rate is large, and variations in the wage rate are, to some extent, caused by factors such as the strength of labor unions that can neither be easily measured nor explained by economic forces. Second, it is often difficult to distinguish between the effects of variations in consumer prices on wage rates, on the one hand, and the feedback effects from wage rates to consumer prices, on the other hand, because of the simultaneity of the two effects and the lack of a sufficiently powerful exogenous and identifiable source of variations in either wage rates or consumer prices.

Looking at the United Kingdom, the first problem is particularly difficult to solve because of the importance of labor unions in wage negotiations and because of the high degree of public intervention through an incomes policy, the forms of which change from year to year. On the other hand, the degree of openness of the economy is such that variations in foreign prices, to a large extent exogenous to the U. K. economy, should provide a sufficient source of exogenous movements in wage rates and consumer prices to allow an unraveling of the causal relationships. An average of prices of foreign products competing with U. K. exports of finished manufactures and prices of imported finished manufactures was taken as a proxy for external pressures on the rate of profit of U. K. entrepreneurs and their ability to pass on wage increases to customers in the form of price increases. The food component of the consumer price index was assumed to be exogenous because of the degree of government control on certain food prices, the high proportion of imported foodstuffs, and the agricultural policy followed in the United Kingdom during the period considered. (The agricultural policy was based on subsidies to farmers with certain product prices relatively free to adjust to world market prices.) Prices of imported products, other than foodstuffs, were also included as an exogenous variable in the consumer prices equation. The wage-price part of the model was estimated by using the two-stage least-squares method.

variables (frequency: semiannual)

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The subscripts are: s, semifinished manufactures (excluding pearls and precious stones and silver bullion) and f, finished manufactures (excluding military aircraft from imports and all ships and aircraft from exports).

The signs above the variables are: dots to indicate that variables are used in rate of change form, bars to indicate that the trend values of the variables are considered, and circumflexes to indicate that observed values have been replaced by estimated values. Parentheses enclose standard errors of coefficients.

All variables are seasonally adjusted.

EQUATIONS 48

Trade flows, 1960–72
ln(Xs)=1.700(0.951)+0.958(0.018)ln(FD¯s)+0.576(0.244)ln(FDs/FD¯s)2.488(0.614)[0.62(0.22),0.26(0.16),0.17(0.17),0.24(0.15),0.37(0.15),0.45(0.17),0.36(0.14)]ln(PXs/PCs)R¯2=0.999;SE=0.038;DW=1.97;ρ=0.183
In(Xf)=3.348(0.708)+0.416(0.014)In(FD¯f)+0.226(0.184)In(FDf/FD¯f)1.408(0.145)[0.20,(0.17)0.35,(0.13)0.38,(0.11)0.30,(0.12)0.17(0.15)]In(PXf/PCf)R¯2=0.999;SE=0.021;DW=1.88;ρ=0.669
ln(Ms)=3.352(2.328)+1.674(0.065)ln(Y¯f)+1.753(0.532)ln(Yf/Y¯f)1.242(0.429)ln(IS)3.415(0.744)[0.08,(0.71)0.86,(0.59)0.32,(0.43)1.14,(0.57)]In(PMsTMs/PHs)R¯2=0.999;SE=0.043;DW=1.94;ρ=0.345
ln(Mf)=3.235(1.754)+3.637(0.097)ln(A¯f)+1.587(0.403)ln(Af/A¯f)1.345(0.280)ln(IS)1.009(0.322)ln(PMfTMf/PHf)R¯2=0.999;SE=0.031;DW=1.71;ρ=0.390
In[PXs/(PXs)1]=1.925(0.588)+0.098(0.068)In[(P*sTXs)/(PXs)1]+0.251(0.072)In[PCs/PCs)1]+0.333(0.097)In(CU)1+0.00003(0.00195)t0.190(0.070)In(E)R¯2=0.541;SE=0.012;DW=1.88;ρ=0.121
In[PXf/(PXf)1]=2.545(0.831)+0.263(0.094)In[(P*fTXf)/(PXf)1]+0.082(0.093)In[PCf/PCf)1]+0.00340(0.00086)t0.299(0.060)[0.201,(0.080)0.098,(0.084)]In(E)R¯2=0.709;SE=0.012;DW=1.53;ρ=0.419
In[PHs/(PHs)1]=0.401(0.419)+0.875(0.071)In[(PMsTMsIS)/(PMsTMsIS)1]+0.134(0.090In(CU)+0.00061(0.00041)tR¯2=0.836;SE=0.017;DW=1.81;ρ=0.581
In[PHf/(PHf)1]=2.983(0.513)+0.609(0.094)In[(P*f/(PHf)1]+0.019(0.057)In[(PMfTMfIS)/(PMfTMfIS)1]+0.00200(0.00022)tR¯2=0.732;SE=0.008;DW=1.99;ρ=0.192
In(P*s)=0.74In(WLT)0.94In(YL¯s)+0.26In(PIs)In(P*f)=0.70In(WLT)0.88In(YL¯f)+0.07In(PIf)+0.10In(PMsTMs)+0.13In(PHs)
W˙=2.9190.6310.254(0.100)LH+[1.052(0.035)0.668(0.151),0.288(0.124),0.095(0.155)]C˙P^1.176(0.470)IP1+3.903(0.136)IP2+0.081(0.062)(0.7PC˙f+0.3PMfTM)R¯2=0.868;SE=0.721;DW=2.40;ρ=0.130
Wages and Consumer Prices, 1956–72
CP˙=0.399(0.222)+KP˙F+0.075(0.028)[0.042(0.018),0.033(0.018)]PM˙A+0.383(0.035)[0.118(0.053),0.100(0.053),0.165(0.055)](W^LT/YL)˙R¯2=0.975;SE=0.346;DW=2.04;ρ=0.581

empirical results

In general, the empirical results support those obtained in previous studies. However, on a number of points—important for the analysis of exchange rate effects—they differ significantly from earlier findings. Results of equations on trade flow and equations on wages and consumer prices are considered in sequence.

(1)Results for trade flow. Relative prices have large and statistically significant effects on the volume of U. K. exports and imports of manufactures. Most price effects take place within two to three years. These are the most noticeable results. In addition, there are two reasons to believe that estimates of the demand elasticities may be somewhat biased toward minus one—that is, actual demand elasticities could be even higher than estimated values. First, while the aggregation procedure employed is a significant improvement over procedures used in most previous studies, it still remains rather crude because of a lack of highly disaggregated price series. Second, foreign trade unit values are highly unreliable.49 Both factors tend to introduce large observation errors into the price and volume series.50

Results on cyclical elasticities of U. K. exports with respect to foreign demand and U. K. imports with respect to domestic demand confirm results obtained in previous studies. U. K. exports of either finished manufactures or semifinished manufactures respond only partially to a cyclical variation in foreign demand. To express it differently, the market share of the U. K. exporters contracts relatively faster in a period of rapid world trade expansion than in a period of slow growth. Cyclical elasticities of imports with respect to domestic demand are rather high, close to 1½ for both semifinished and finished manufactures. Import elasticities with respect to trend rates of growth of relevant domestic demand aggregates are quite high—that is, over the 1960–72 period imports were growing much faster than domestic demand and this is not explained by relative price variations alone.

The estimated price equations indicate that U. K. entrepreneurs do not significantly adjust their prices for finished manufactures to variations in the prices set by their foreign competitors. Thus, even in the short run, prices of U. K. finished manufactures are mainly determined by cost. On the other hand, U. K. prices for semifinished manufactures, either exported or competing with imports, are strongly influenced in the short run by variations in foreign prices for similar products. The short-run direct effect of a 10 per cent increase in foreign prices is a 2.5 per cent increase in U. K. export prices and an 8.8 per cent increase in prices of U. K. products competing with imports in case of semifinished manufactures. This result is not surprising, given the higher degree of homogeneity of most semifinished manufactures. An attempt to include a capacity utilization variable in the price equations had only limited success. It is only in the equation for the export price of semifinished manufactures that a statistically significant effect was found.

(2) Results for wages and consumer prices. The good statistical results for the wage equation should be viewed with reservation. The number of different equations that have been estimated in previous studies to explain the behavior of U. K. wages (equations that the author could not ignore) is so large that such an intensive “digging” work could not fail to yield a “good” equation in the sense that it fitted past data well.

Subject to the above reservations, the empirical results strongly suggest that during the 1960s workers in the United Kingdom did not suffer from money illusion and were normally successful in protecting the real purchasing power of their earnings. Hourly earnings in the manufacturing sector (corrected for overtime) were adjusted fully, or even more than fully, to variations in consumer prices within a short period of time—a year or less in periods without legal wage restraints. During periods of wage restraints, including the 1968–69 postdevaluation period, the adjustment of money earnings to increases in the cost of living was temporarily held back. However, the wage explosion in 1970 after the removal of controls more than compensated for favorable effects of restraints during the previous two years. The percentage of labor force unused was found to have a relatively small but statistically significant effect on variations in hourly earnings.51 Variations in prices of foreign manufactures also seem to have some direct effect, probably because they influence the willingness of U. K. entrepreneurs to accept wage increases; however, this effect is not statistically significant.

Not surprisingly, the equation for consumer prices indicates that import prices (foodstuffs excluded) and hourly earnings have certain effects on nonfood consumer prices that broadly correspond to their input-output weights.

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