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Mr. Artus, Assistant Chief of the Special Studies Division of the Research Department, holds degrees from the Faculty of Law and Economics in Paris and from the University of California at Berkeley.
More precisely, Π = R/100 − [S(1 + RF/100)/FSe − 1]—a formula that can be simplified into equation (1) by assuming that the exchange rate gain on the interest payment (i.e., the term RF(S − FSe)/FSe) is negligible.
Here Δ indicates increments in variables; Δ% indicates that increments are expressed in per cent. Formula (2) is a numerical approximation for Δ%S = (R − RF) (FSe/S−1) − (R−1 −RF−1) (FSe−1 − S−1) + 100 (FSe − FSe−1)/S−1. The approximation is based on the assumption that the scalars FSe/S−1 and FSe−1/S−1 are relatively close to one.
Some signs that such an effect was at work in 1973–74 have been noted by various authors; see Kindleberger (1974, pp. 12–13) on the decline in Euro-bond lending and McKinnon (1975) on the lack of speculative flows. However, most authors, including Kindleberger, have been rather skeptical about this danger.
See “Structure and Results of the Econometric Model of the Deutsche Bundesbank,” Deutsche Bundesbank, Monthly Report, Vol. 27 (May 1975), pp. 26–32.
Descriptions of that country’s monetary policy can be found in the Deutsche Bundesbank’s Monthly Report, “Redefinition of Banks’ ‘Free Liquid Reserves,’” Vol. 25 (June 1973), pp. 43-44, and in “Central Bank Money Stock and Banks’ Free Liquid Reserves—Notes on the Bundesbanks Liquidity Calculation,” Vol. 26 (July 1974), pp. 14-23.
Banks’ free liquid reserves include banks’ excess balances, open market paper that the Deutsche Bundesbank has promised to purchase, unused rediscount quotas, and—up to May 1973—scope for raising Lombard loans. Banks’ free liquid reserves play the role of a buffer stock, or cushion, between the quantitative measures of the Bundesbank and their effects on the central bank money stock. Whenever this cushion is relatively thin, as it was over the period considered here, the Bundesbank enjoys nearly direct control over the creation of central bank money. However, if banks’ free liquid reserves are extremely large, quantitative measures by the Bundesbank become ineffective.
No series are available on NDAD, as defined here. Series on NDAD were calculated by subtracting NFAD from MS.
A dummy variable of the zero-one type was initially introduced to take into account the change in the rate of growth of foreign liquid wealth resulting from the increase in oil prices at the end of 1973. However, it was excluded later because its estimated coefficient was small, not statistically significant, and had the wrong sign.
Both NFAD and NFAS are valued here at constant exchange rate parity.
See Argy and Kouri (1974) and Hodjera (1975) for a discussion of the estimation biases introduced in any model of international capital flows by the assumptions that the change in the net domestic assets of the central banks is an exogenous variable.
During the period under consideration, the currencies of the countries participating in the joint float were the Belgian franc, the Danish krone, the Netherlands guilder, the Norwegian krone, and the Swedish krona, as well as the deutsche mark. France temporarily withdrew from the European joint float on January 21, 1974, and rejoined it on July 10, 1975.
A certain element of arbitrariness is necessarily involved in the choice of such a dummy variable. In the present case, the net effect of the dummy variable is constrained to be nil, not because the oil shortage had no net effects but because ultimately whatever net effects it had should take place through other variables that were already included. Further, the beginning and end of the period of the oil shortage were assumed to be more important in the present case than the timing of the oil price increases (October and December 1973).
The existence of capital controls, mainly the controls on capital inflows into the Federal Republic of Germany in 1973, may have led to a downward bias in the estimated value of certain coefficients, such as c1.
The Lombard rate is an independent instrument of monetary policy only from a short-term point of view. It is used “to stabilize” the money market on a month-to-month basis. In the long run, the level of the Lombard rate reflects mainly the inflation rate.
It still explains about 75 per cent of the variations in the exchange rate when one excludes the six observations that are explained with the help of the two dummy variables.
The multiplier is equal to 1/(1−0.296), or 1.420.
Averages of relative prices over preceding periods of three and six months were also introduced in the equation without any success.
A similar conclusion was reached by Aliber (1975 b) from a comparison of the amplitude of changes in exchange rates and interest rate differentials.
Most other studies have also found it difficult to capture monetary policy targets in a simple mechanical formula. For example, see Argy and Kouri (1974).
Differences in the definition of the relevant variables may account for part of the differences in the results of those various studies. In particular, NDAD is defined in the present study as the difference between the sum of the central bank money stock and banks’ free liquid reserves (i.e., MD + FLR) and the (net) demand by the central bank for foreign assets (NFAD), rather than as the amount of net domestic assets of the central bank, as in the studies by Willms (1971) and by Argy and Kouri (1974). The variable NDAD, as defined in the present study, is under the direct control of the Bundesbank, so that it is not surprising to find that it varies so as to sterilize unwanted effects of the intervention of the Bundesbank in the exchange market on the supply of base money.
Implicitly, this simulation exercise assumes that banks’ free liquid reserves were not abundant before the increase in NDAD. As indicated in footnote 12, once free liquid reserves are reaching a high level, further increases may have smaller and smaller effects on the interest rate in the money market.