This paper is an attempt to assess empirically the role of monetary factors in the process of short-run determination of output growth, inflation, and the trade balance for Japan during the period extending from the first quarter of 1965 to the fourth quarter of 1976. The theoretical framework is highly aggregated and focuses on the explanation of the behavior of the key economic variables. Despite its apparent simplicity, however, the model tracks the short-run movements of output, prices, and the trade balance well. The framework is essentially monetarist, in that the excess supply of real cash balances plays the leading role in the short-run adjustment process of the economy. As a first theoretical approximation, we envision a money-goods economy in which an excess supply of money, opposed by an excess demand for goods, results in higher output, higher prices, or deterioration of the trade balance. The adjustment of output, prices, and the trade balance is assumed to depend on the excess supply of money, the degree of openness of the economy, and the existing level of excess capacity.
The idea that an excess supply of money affects output and prices has received considerable attention in the literature, notably by Milton Friedman (1970). Friedman views the excess supply of money as one of the major factors determining changes in nominal spending, which, in turn, are divided between output and price changes, depending on the state of inflationary expectations and the current deviations of real output from its full-employment level. Friedman’s model, however, assumes a closed economy and therefore does not allow for the possible inflationary effects of foreign price changes or for the excess demand for goods to be partially channeled abroad through a balance of trade deficit. This last mechanism is the focus of the “monetary approach to the balance of payments,” 1 which views the trade balance as one of the main endogenous channels through which the public adjusts its actual cash balances in an open economy. 2 To date, however, most empirical works on the monetary approach have been conducted under the “full-employment” and “small country” 3 assumptions, which imply that output and prices are exogenously given and thus independent of domestic monetary developments. In this paper, we drop the full-employment assumption and recognize that at least some prices in the economy may not be immediately responsive to world prices. An excess supply of money thus has three “escape valves”—namely, raising domestic prices, increasing output, and diminishing the trade balance. Since monetary factors alone cannot explain the long-run real growth of an economy, we incorporate the concept of potential output, which is assumed to be independent of monetary factors, and concern ourselves with explaining the short-run behavior of the gap between actual and potential output.
The structure of the paper is as follows: Section I presents the basic structure of the model and estimating equations; Section II presents and discusses the results; Section III contains simulations under alternative assumptions regarding the conduct of monetary policy; and Section IV provides some concluding remarks.
All data used in this study were taken from various issues of the Fund’s monthly publication, International Financial Statistics (IFS). Variables and the corresponding line numbers in IFS, which refer to data on the pages of that publication that cover Japan, are as follows:
M = total liquidity = Line 31n + Line 32
y = output (GNP, 1970 prices) = Line 99a.r
p = GNP deflator (1970 = 100) = Line 99a divided by Line 99a.r
= value of exports = Line 70 = value of imports = Line 71
pm = unit value of imports (1970 = 100) = Line 75
B = trade balance in real terms = (
All variables are seasonally adjusted, and all “real” variables are deflated by the GNP price deflator. Potential output y* was constructed based on the indices of actual industrial output I and potential industrial output I* provided by Artus (1977). Assuming that aggregate output is a log-linear function of I and the ratio of (I/I*), the following regression was carried out for the period extending from the first quarter of 1965 to the fourth quarter of 1976:
The second term in the regression indicates that aggregate output reacts to the movements of industrial output in a nonlinear fashion. Thus, a fall in industrial output will have relatively less impact on aggregate output when there are higher levels of excess capacity in the manufacturing sector. Using the relationship (10), potential output y* can be constructed by substituting I* for I,
Aghevli, Bijan B., and Mohsin S. Khan, “Credit Policy and the Balance of Payments in Developing Countries”, paper presented at the SSRC-Ford Foundation Conference on “Macroeconomic Policy and Adjustment in Open Economies,” at Ware, England, April 28-May 1, 1976 (unpublished, International Monetary Fund, December 27, 1976).
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)| false “ Aghevli, Bijan B., and Mohsin S. Khan, Credit Policy and the Balance of Payments in Developing Countries”, paper presented at the SSRC-Ford Foundation Conference on “Macroeconomic Policy and Adjustment in Open Economies,” at Ware, England, April 28-May 1, 1976( unpublished, International Monetary Fund, December 27, 1976).
Artus, Jacques R., “Measures of Potential Output in Manufacturing for Eight Industrial Countries, 1955–78,” Staff Papers, Vol. 24 (March 1977), pp. 1–35.
Blejer, M.I., “The Short-run Dynamics of Prices and the Balance of Payments,” American Economic Review, Vol. 67 (June 1977), pp. 419–28.
Friedman, Milton, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy, Vol. 78 (March/April 1970), pp. 193–238.
Mathieson, Donald J., “The Effects of Eliminating Capital Controls on Japanese Monetary Policy” (unpublished, International Monetary Fund, July 1, 1977).
Sargent, T.J., “A Classical Macroeconometric Model for the United States,” Journal of Political Economy, Vol. 84 (April 1976), pp. 207–37.
Mr. Aghevli, Senior Economist in the Asian Department, received his doctorate from Brown University.
Mr. Rodriguez, Associate Professor at Columbia University, was on leave as a visiting scholar in the Asian Department of the Fund when this paper was prepared. He received his doctorate from the University of Chicago.
The authors are grateful to Larry Sjaastad for comments and suggestions and to Sharon Foley for efficient research assistance.
Some of the recent works in this area are collected in Frenkel and Johnson’s The Monetary Approach to the Balance of Payments (1976) and the Fund’s The Monetary Approach to the Balance of Payments (1977). See also Borts and Hanson (1977).
The other channel in this approach is the capital account of the balance of payments; throughout this paper, however, we are only concerned with explaining the trade balance. In a more general framework, one might also wish to explain the flow of international capital. In the case of Japan, however, there were strict controls on such flows of capital during our sample period (See Mathieson (1977).).
For an empirical evaluation of the impact of monetary policy on the trade balance in the developing countries, see Aghevli and Khan (1976).
While these assumptions do not strictly hold for every commodity, they have been utilized to keep the framework simple and manageable.
It should be noted that ln gt corresponds to the excess of actual over potential output in percentage terms.
For an alternative view of the determination of the output gap that utilizes the rational expectations framework, see Sargent (1976). See also Stein (1978) for an empirical test of Keynesian versus monetarist determination of inflation and output in the context of a closed economy.
This transformation is used in order to eliminate the output term, which is the endogenous variable from the right-hand side of the equation.
Since the trade balance often becomes negative, we could not use the log-linear formulation. The use of a linear term for output in equation (9) implies that we are constraining the income elasticity of money demand to be unity; such a constraint is warranted, however, since our results from the other two estimated equations strongly indicate an income elasticity not different from unity.
It should be noted that, in this context, a deterioration in the terms of trade is likely to reduce the volume of imports as well as that of exports, because the exportable surplus will be smaller. Moreover, the value of imports is likely to rise, at least in the short run (J-curve effect).
The first two equations are log-linear in variables, while the last equation is linear. There are some nonlinear estimation techniques available, but the statistical properties of the nonlinear estimators remain largely unknown.
The only exception is the coefficient of the output gap in the inflation equation, which is significant at the 0.05 level.
Correcting the equations for inflation and the trade balance for second-order autocorrelation gives the following results:
In order to determine whether the coefficient a is significantly different from β, the following expression, which is distributed as a t, is constructed:
It should be noted that since the trade balance equation is linear, the coefficient γ1 is not an elasticity and cannot, therefore, be compared directly to the coefficients α1 and α2, which are elasticities.
Additional simulations involving the assumption of 7 per cent growth in potential output and constant nominal import prices were also conducted, and no qualitative changes in the time paths of the variables were found. Quantitatively, however, the results are sensitive to alternative assumptions, and we emphasize that these simulations should not be interpreted as “forecasts” for the Japanese economy.
The financial developments that took place in 1972, when the authorities were not fully successful in controlling and neutralizing short-term speculative capital inflows, were an exception.