International Transmission of Fiscal Policies in Major Industrial Countries
Author: Mr. Paul R Masson and Mr. Malcolm D. Knight1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Publication Date:
01 Jan 1986
eISBN:
9781451972887
Language:
English
Keywords:
cost of capital; private sector; U.S. dollar; investment incentive; fiscal deficit; Real interest rates; Government debt management; Real exchange rates; Capacity utilization; Private investment; Global
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During much of the period from 1980 through 1985, three major features characterized trade and financial relations among the industrial countries and exerted a strong influence on economic growth and external adjustment in the developing world. These “stylized facts” were the sustained high level of real interest rates in international financial markets, the sharp rise in the current account deficit of the United States after mid-1982 and the increased surpluses of the Federal Republic of Germany and Japan; and the persistent appreciation in the nominal and real exchange rate of the U.S. dollar from the trough in the third quarter of 1980 to a peak in the first quarter of 1985.

Abstract

During much of the period from 1980 through 1985, three major features characterized trade and financial relations among the industrial countries and exerted a strong influence on economic growth and external adjustment in the developing world. These “stylized facts” were the sustained high level of real interest rates in international financial markets, the sharp rise in the current account deficit of the United States after mid-1982 and the increased surpluses of the Federal Republic of Germany and Japan; and the persistent appreciation in the nominal and real exchange rate of the U.S. dollar from the trough in the third quarter of 1980 to a peak in the first quarter of 1985.

During much of the period from 1980 through 1985, three major features characterized trade and financial relations among the industrial countries and exerted a strong influence on economic growth and external adjustment in the developing world. These “stylized facts” were the sustained high level of real interest rates in international financial markets, the sharp rise in the current account deficit of the United States after mid-1982 and the increased surpluses of the Federal Republic of Germany and Japan; and the persistent appreciation in the nominal and real exchange rate of the U.S. dollar from the trough in the third quarter of 1980 to a peak in the first quarter of 1985.

Table 1 summarizes these developments. It shows that from 1980 through 1985 a simple measure of the U.S. real interest rate rose by over six percentage points. During the same period the U.S. current account shifted from a balanced position to an annual deficit of over $100 billion, while those of Japan and Germany moved from substantial deficits to surpluses of $50 billion and $13 billion, respectively. Finally, the annual average level of the dollar’s real effective exchange rate was some 43 percent higher in 1985 than it had been in 1980, while the yen’s real value remained roughly unchanged and that of the deutsche mark declined by about 12 percent.

Table 1.

Selected Variables for the United States, the Federal Republic of Germany, and Japan, 1980–86

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Sources: International Monetary Fund, International Financial Statistics (Washington, various issues), and World Economic Outlook (Washington, April 1986, Tables A17 and A31).

Average values during first half of year.

Simple sum of annual fiscal impulses during 1980–85. A net expansionary impulse (discretionary increase in the fiscal deficit) is indicated by a minus, a contractionary impulse (movement toward surplus) by a plus.

Foreign currency per unit of domestic currency (index: 1980 = 100); annual averages as measured by relative normalized unit labor costs.

In billions of U.S. dollars; includes official transfers.

In percent; annual average yields on long-term government bonds, adjusted by change in gross national product (GNP) deflator.

Actual values, measured as percentage of GNP; a deficit is indicated by a minus, a surplus by a plus.

Several explanations have been offered to account for these stylized facts. They include the impact of shifts in relative degrees of monetary restraint in major industrial countries; the effects of changes in relative cyclical positions; “safe-haven” effects; and possibly even a speculative bubble. Each of these explanations does appear to have some merit in accounting for developments during a particular episode or portion of the period under review. For example, differences in the degree of monetary restraint were probably important both at the beginning of the period (1980–81), when U.S. monetary policy was relatively tight, and in 1985, when the opposite was the case (Frenkel (1985)). Similarly, in 1981–82 the dollar may have been pushed up by safe-haven effects associated with the onset of the developing country debt crisis, and in 1983–84 by the fact that U.S. output growth was more rapid than elsewhere; finally, the sharp runup of the dollar in the early months of 1985 seems to bear some of the characteristics of a speculative bubble. Nevertheless, none of these factors can be said to have exerted a consistent influence throughout the whole period 1980–85. Furthermore, since late 1985 the stylized facts have been at least partially reversed. In particular, the passage in the United States of the Gramm-Rudman-Hollings legislation to reduce the federal fiscal deficit1 coincided with a substantial decline in real short- and long-term interest rates and in the value of the dollar against other major currencies.

In this paper we examine the role of a single set of factors that may help to explain both the stylized facts of the period 1980–85 and the partial reversal that has taken place over the past year. The factors that we emphasize are fiscal developments: first, the sustained shift in the pattern of fiscal positions among the largest industrial countries during this period that resulted from the strong expansion of the U.S. fiscal deficit at a time of fiscal consolidation in Germany and Japan; second, the tax incentives for investment spending that were implemented during this period in the United States.

It is, of course, widely appreciated that these tax and spending developments strongly influenced the pattern of fiscal positions among the largest industrial economies. Table 1 presents data on the shifts from 1980 to 1985, as measured by actual fiscal positions and by cumulative fiscal impulses, which attempt to gauge the short-term discretionary thrust of fiscal policy in each country. Although there is considerable dispute about the best way of measuring the fiscal stance from the point of view of the variables that are of interest here (see International Monetary Fund (1986, Supplementary Note 1, pp. 109–23)). there can be little doubt that, over the period 1980–85 taken as a whole, the broad stance of U.S. fiscal policy was very expansionary at a time when Germany and Japan were moving vigorously toward restraint.

In addition to the major shifts in the overall stance of fiscal policies in the largest industrial economies in recent years, a closely related development in the United States has been the more favorable tax treatment of capital. In particular, there has been a substantial acceleration of depreciation allowances. As a result, real nonresidential investment has doubtless been encouraged in the United States, and increased investment may also have contributed to appreciation of the dollar and to the substantial current account deficits of the United States in recent years.

In an earlier paper (Knight and Masson (1987)) we examined the impact of shifts in fiscal policy in large countries on national saving and investment balances and performed several simulation experiments in an attempt to assess the direction and broad order of magnitude of the effects that such fiscal shifts may have had in producing the stylized facts outlined above. The present paper extends this research in two areas. First, at the theoretical level it analyzes the effects of fiscal policy shifts and compares them with those of changes in the private sector’s intended investment, whether induced by altered expectations or by changes in tax incentives. It then considers several simulation experiments designed to address these issues.

Because our purpose is to analyze the relationship between the stance of fiscal policies and the pattern of current account positions and exchange rates that can be sustained over the medium term, we abstract from short-run portfolio-allocation decisions about stocks of domestic and foreign assets—see Kouri and Porter (1974); Dornbusch (1975); Girton and Henderson (1977); Branson, Halttunen, and Masson (1977); and Knight and Mathieson (1983)—and concentrate instead on the intertemporal decisions that determine flows of domestic saving and capital accumulation.2 Although such an approach cannot provide much insight into the causes of day-to-day or month-to-month fluctuations in market exchange rates, which in any case approximate a random walk (see Frenkel (1985)), it may serve to highlight how shifts in fiscal policy in the largest industrial economies influence private saving and investment behavior both at home and abroad, leading to changes in the level of world interest rates and in the pattern of real exchange rates and current account positions that is sustainable over the medium term. Such an approach seems particularly relevant, given the developments of recent years that are summarized in Table 1.

The basic point that is emphasized by our analysis is that both the actual fiscal changes in the United States, Germany, and Japan over the past five or six years and the large prospective shifts that would occur if the Gramm-Rudman-Hollings act were fully implemented constitute major exogenous disturbances to total saving and investment flows in the largest industrial countries. Thus, we model the determinants of the overall current account not in standard terms of import demand and export supply, but in terms of intertemporal decisions about saving and investment. Such an approach has a long history in the literature, dating back to the work of Laursen and Metzler (1950) and Mundell (1963). More recent contributions include Dornbusch (1975), Dornbusch and Fischer (1980), Sachs (1981), Svensson and Razin (1983), Sachs and Wyplosz (1984), Frenkel and Razin (1984, 1985a, 1985b), Branson (1985), and Feldstein (1986).

The rest of the paper is organized as follows. Section I describes a simple theoretical model of the international transmission of fiscal policies. Section II briefly sets out the specification and estimates of a more complete empirical model that shares the basic features of the model of the preceding section but also allows for a number of crucial, real-world complications: the effects of shifts in the general level of economic activity on private saving and investment, and the consequences of the gradual accumulation of productive capital and wealth for the behavior of the major world variables in which we are interested—interest rates, exchange rates, and current account positions—in both the short and the long run. Section III describes four sets of simulation experiments designed to analyze the effects of several exogenous shocks, including shifts in fiscal deficits of the broad order of magnitude experienced in the three largest industrial countries in 1982–85 and the investment incentives introduced in the United States during that period. Finally, Section IV summarizes the main conclusions.

I. A Simple Model of International Transmission of Fiscal Policies

Our earlier paper (Knight and Masson (1987)) sets out a “classical” model that emphasizes capital transfers and the saving-investment balance and is consistent with all three of the stylized facts of the international economy that were noted in the introduction to this paper. The model proves to be quite simple indeed. In particular, it starts from the proposition that if there is an autonomous rise in a country’s fiscal deficit or in intended private investment, that country will have to rely more heavily on saving from abroad (or on a reduction in the amount of domestic saving it provides to the rest of the world). For the increased saving from abroad to enter through the capital account, the current account must be pushed into deficit via an appreciation of the real effective exchange rate and a loss of international competitiveness. In addition, if the home country is large enough to affect the aggregate demand for savings in the world market, the general level of real interest rates in international credit markets may be expected to rise.3

This process can be described by a model that does not depend on an elaborate specification of the effects of fiscal policy on the level of real income4 and that avoids the complex issue of the effect of international interest rate differentials on exchange rates and capital flows. Consider a world of two large countries: the home country and the rest of the world, ROW (with variables for the rest of the world indicated by an asterisk). All variables, including the exchange rate and the interest rate, are defined in real terms, taking units of domestic output as the numeraire. The notation of the model is

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where for any function F(x), Fx = ∂F/∂x.

Because we are here taking simplicity to be a virtue, we initially make a number of highly restrictive assumptions. In particular, we suppose that there is perfect flexibility of goods prices (thus allowing us to ignore the effects of changes in money stocks on real magnitudes). Both private investment and government spending are financed by the issue of one-period bonds, and all bonds, wherever issued, are viewed as perfect substitutes for one another. Finally, we suppose that market participants expect the real exchange rate to persist at its current level in the future. The assumptions about substitutability and expectations ensure that there is a fully integrated world credit market with a single world interest rate. These assumptions are all made so that we can highlight the implications of the model with the greatest possible clarity; the assumptions will be relaxed when we proceed to the empirical analysis of Section III.

Ex ante saving and investment are both assumed to depend on the real interest rate. Because of adjustment costs, real private net investment exhibits lagged adjustment to an optimal capital stock, which in turn depends on the user cost of capital (Gould (1968)). At a given level of the real interest rate R, changes in the tax treatment of investment will also affect firms’ incentives to undertake fixed-capital formation. We specify a simple investment function of the form

I=I⁡(R),(1)

where I() is also affected (in a way to be specified later) by changes in tax legislation.

Private saving is taken as the outcome of individuals’ intertemporal optimization of the utility from consumption (Mussa (1976)). For a given rate of time preference and expected future wage income, higher real interest rates will decrease consumption. A rise in the real interest rate, however, may either raise or lower real private saving, since current income is increased for households holding positive net claims; hence the sign of the partial derivative of saving with respect to R is ambiguous. Here we impose the weaker restriction that if intended saving declines when the interest rate rises, such saving falls by less than intended investment.

Because private sector saving decisions are likely to depend on the perceived level of household net wealth, any analysis of the international transmission of fiscal policies must confront the issue of debt neutrality (Barro (1974)). The Barro-Ricardo hypothesis of debt neutrality asserts that if individuals and firms expect that the government will raise taxes in the future to finance the debt service on the bonds, and that they or their descendants will have to pay those taxes eventually, then there may be little difference between financing government spending through tax increases or through bond issues (Barro (1974) and Carmichael (1982)). Under the extreme assumptions that individuals are fully rational, can borrow and lend in perfect capital markets, and value their descendants’ consumption as highly as their own, bonds issued by the home government are not properly treated as a component of the private sector’s net wealth, which will consist only of the capital stock and net claims on foreign residents. In this case a rise in the fiscal deficit (that is, an increase in public sector dissaving) would be exactly offset by a higher flow of saving by the private sector. Holdings of bonds issued by foreign governments would still be part of wealth because the taxes to service them are levied on foreign residents.5

Although most economists would now concede that changes in public sector saving are likely to be offset at least partially by alterations in private saving behavior, there are several reasons for expecting that, in practice, households would not make a full offset of any change in their holdings of bonds to take account of future taxes. In particular, they face significant capital market imperfections, and they may not value their descendants’ welfare equally with their own (Buiter and Tobin (1979)).

If taxes and real interest rates are expected to remain constant in the future, then a simple model of aggregate consumption behavior implies that the proportion of government bond holdings that is considered net wealth by the private sector will be unity minus the ratio of the government’s discount rate to that of the private sector (Blanchard (1985), Knight and Masson (1987)). We will call this proportion ϕ; it should lie between zero and unity. A value of ϕ that is less than unity implies that the private sector treats only a corresponding fraction of government debt as part of its net worth, with the rest reflecting the present discounted value of future tax liabilities.

Measured private saving equals the private sector’s total net asset accumulation, including its acquisition of government debt. Thus, total private saving S equals the change in private net wealth plus (1 - ϕ) times the government deficit D (that is, the increase in the outstanding stock of government debt):

S=S⁡(R)+(1−φ)D,(2)

where S(R) is the component of private saving that corresponds to net wealth accumulation and (1 - ϕ)D is the “Barro-Ricardo component” reflecting the private sector’s induced response to public sector dissaving.

Because net exports of goods and services N (the current account surplus) respond to the price of the home good relative to the foreign good, we assume that the home country’s real current account in terms of domestic output tends toward deficit when its currency appreciates in real terms (that is, ε falls), and vice versa when the home currency depreciates.6

Macroeconomic equilibrium in the home country occurs when ex ante private saving minus private domestic investment and the government’s fiscal deficit equals the current account surplus:

S−I(R)−D=N(ε).(3)

Substituting equation (2) into equation (3) yields the following modification of the equilibrium condition:

S⁡(R)−I⁡(R)−φD=N(ε).(4)

The restrictions on the partial derivatives of the behavioral functions of equation (4) are

Nε > 0, IR < 0, (SR - IR) > 0, 1 ≥ ϕ ≥ 0.

The analogous saving-investment equilibrium for the rest of the world is

S*(R)−I*(R)−φ*D*=N*(ε),(5)

with the restrictions

IR*<0,(SR*−IR*)>0,1≥φ*≥0.

Equations (4) and (5) do not constitute two independent conditions for macroeconomic equilibrium because, in a two-country world, the home country’s current account surplus must equal the deficit of the rest of the world:

N*(ε)=−N(ε).(6)

This identity serves to emphasize the fact that the partial derivative Nε embodies the effects of expenditure switching by both home and foreign residents: a fall in the relative price of home-country output (an improvement in international competitiveness) leads to higher demand for home goods by both domestic residents and foreigners. Finally, assuming a “pure” float, real private capital transfers from the rest of the world to the home country (that is, the use of foreign saving by the home country) must always equal N*.

The model of equations (4)-(6) determines three endogenous variables: the world real interest rate, R; the real exchange rate, ε; and the current account balance, N = - N*, prevailing between the home country and the rest of the world. The exogenous variables are the public sector fiscal deficits at home and abroad, D and D*, and the (unspecified) factors that may shift saving, investment, and net export schedules.

The total differential of the system represented by equations (4)-(6) is

[(SR−IR)−Nε(SR*−IR*)Nε][dRdε]=[φdDφ*dD*].(7)

The determinant of the coefficient matrix, Λ, is

Λ=Nε(SR−IR)+Nε(SR*−IR*),(8)

which, given our assumptions about the partial derivatives, is unambiguously positive.

Suppose that, starting from a balanced current account position, either the government of the home country increases its fiscal deficit by some amount dD or the foreign country raises its fiscal deficit by dD*. The system of equation (7) gives the following effects on the endogenous variables:

dRdD=φNεΛ>0dεdD=φ(IR*−SR*)Λ<0dNdD=φNε(IR*−SR*)Λ<0dRdD*=φ*NεΛ>0dεdD*=φ*(SR−IR)Λ>0dNdD*=φ*Nε(SR−IR)Λ>0.(9)

Consider first the case of fiscal expansion in the home country. If the private sector treats some fraction (0 < ϕ < 1) of domestic government bonds as a component of its net worth, an increase in the home country’s fiscal deficit, dD, will raise the world interest rate, cause the domestic currency to appreciate in real terms, and induce a deterioration of the home country’s current account balance that will be financed by a transfer of capital from the rest of the world. These results have a simple intuitive rationale. When an increase in the home country’s public sector fiscal deficit disturbs the domestic saving-investment balance, the excess demand for saving must be financed by an inflow of capital from the rest of the world. For this capital transfer to be effected, the home country’s current account must move into deficit, and this movement is accomplished by a real appreciation of the domestic currency in the foreign exchange market. However, other things being equal, an increase in public sector dissaving by the home country creates an imbalance between global saving and investment, necessitating a rise in the world real interest rate to restore equilibrium.7 Finally, the results in equations (9) make it clear that the deterioration in both the home country’s international competitiveness and its current account position will be greater the larger is the interest sensitivity of private investment minus private saving in the foreign country.

Analogous results hold for the case of an increase of the public sector fiscal deficit, dD*, in the rest of the world: provided that ϕ* > 0, a more expansionary fiscal policy in the rest of the world will also raise the world interest rate but will cause the home currency to depreciate and will induce a current account movement in the opposite direction to that referred to above.8

Note once more that these results hold for deficit shifts in each country only if the relevant value of ϕ does not equal zero, implying that full Barro-Ricardo equivalence does not hold. In general, the value of ϕ depends, among other things, on the life expectancies of households (Blanchard (1985)) and on private sector expectations about the specific types of future tax and spending measures that the government will introduce to achieve its desired stance of fiscal policy. Thus the values of ϕ may differ significantly, not only among countries but over time, as views change about likely future fiscal policies.

It would also be possible to calculate the comparative static effects of autonomous changes in private investment expenditure or in private saving behavior, although this is not done formally here. An autonomous increase in private investment spending, for instance, would have the same effects on the world real interest rate, the home country’s real exchange rate, and the current account position as a rise in the fiscal deficit, except that in this case the comparative static effects (analogous to equations (9) above) would not be premultiplied by ϕ and ϕ*. Because both parameters lie between zero and unity, it is obvious that the effects of a given increase in private investment on interest rates, the current account, and the exchange rate are always larger than those of a rise of the same size in the fiscal deficit. Put simply, unless domestic households regard all increases in the outstanding stock of government debt as a full addition to their wealth, a dollar of investment spending will always yield more “bang per buck” than a dollar rise in the fiscal deficit, in terms of the variables discussed here. The reason for this difference is also intuitively apparent: unlike current government spending, net investment always represents an addition to the stock of private sector productive capital; hence it is an increment to private sector wealth.

To summarize, an autonomous increase in private investment in the home country will tend to raise interest rates at home and abroad and to appreciate the home currency by more than an equal increase in the fiscal deficit. Higher interest rates will tend to reduce investment in the foreign economy, which did not experience the initial autonomous investment shift. Analogous results hold for the case of an increase in investment in the rest of the world.

The implications of the preceding analysis for the world real interest rate and the real exchange rate between the two countries are illustrated in Figure 1. In the figure, the vertical axis is the real exchange rate (ε)—the relative price of the rest of the world’s output in terms of home output—and the horizontal axis is the world real interest rate (R). The SI curve is the locus of combinations of the interest rate and the real exchange rate that, for given public sector fiscal positions, equates the ex ante home-country private saving-investment balance with the ex ante current account balance. This curve slopes upward because of our assumption that a rise in the interest rate causes desired investment to fall relative to intended saving, leading to an improvement in the home country’s current account balance in real terms. Such an improvement requires a depreciation of the home currency (a rise in ε) to equate the ex ante current account balance to the new desired pattern of saving and investment. For analogous reasons, the rest of the world’s saving-investment balance curve, SI*, slopes downward in ε - R space. The nature of the interest rate and exchange rate movements that result from an autonomous shift in one country’s fiscal position or in ex ante investment will obviously depend on the responsiveness of the real interest rate and exchange rate to a disturbance in the world market for saving or to a disequilibrium in the world goods market.

Figure 1.
Figure 1.

Determination of Rent Exchange Rate (ε) and World Interest Rate (R)

Citation: IMF Staff Papers 1986, 003; 10.5089/9781451972887.024.A001

We can now use the graphical apparatus to render more specific the model’s conclusions about the effects of changes in fiscal policy and in investment incentives such as those described in the introduction to the paper. We will therefore refer to the home country as “the US” and the foreign country as “the ROW.” Suppose that the US experiences an expansionary fiscal policy, an autonomous increase in the private sector’s desire to invest, or some combination of the two. The effects of these shocks are illustrated in Figure 1 by a shift of the SI curve from its starting position at A to SI´. The rightward shift of the SI curve occurs because at the initial exchange rate and current account the increased demand for private saving can only be brought about through a rise in the real interest rate that “crowds out” private investment relative to desired saving. The new equilibrium, B, will involve a real appreciation of the US currency to ε1, a higher world interest rate R1, and hence (directly from equation (6)) a larger US current account deficit. Fiscal restraint or a weakening of private investment spending in the ROW would shift the SI* locus to the left, thereby magnifying the exchange rate and current account effects just described, but moderating the upward pressure on the world interest rate. By contrast, a credible fiscal deficit reduction package in the US would involve an inward shift of the SI curve to a position such as SI″. Compared with the equilibrium at B, the new short-run equilibrium at C would involve a lower value of the US currency, ε2, a smaller US current account deficit, and a decline in the world interest rate to R2.

It is important to emphasize, however, that this simple model does not capture some of the long-run international transmission effects of fiscal policies and investment (or saving) shifts. Whereas the effects on the world interest rate may be expected to endure, those on exchange rates and current accounts may be altered substantially over time as the processes of asset and wealth accumulation influence saving and investment behavior and induce changes in the factor service flows of the balance of payments. These longer-run aspects of the international transmission mechanism are considered in detail in Section III.

The conclusions of the simple model of this section support the view that, provided certain assumptions hold, shifts in fiscal deficits and in private investment in the three largest industrial economies over the first half of the 1980s were consistent with the stylized facts of the period 1980–85. In addition, assuming that the Gramm-Rudman-Hollings legislative package was regarded as “credible” by market participants at the time it was enacted,9 the analysis of the model is also consistent with the partial reversal of these developments that occurred in late 1985 and the first half of 1986. The assumptions required for these conclusions are those relating to the partial derivatives of the behavioral functions. Most important among these is the assumption that full Barro-Ricardo neutrality does not hold. In this case the standard model yields results that are, in qualitative terms, consistent with experience.

The empirical work in Knight and Masson (1987), which is briefly summarized in the next section of this paper, provides preliminary estimates of the values of the interest elasticities of private saving and investment and of the Barro-Ricardo parameter that are consistent with these conclusions. Nevertheless, some important empirical questions remain unanswered. First, how large are the exchange rate and interest rate effects of a change either in the public sector fiscal deficit or in private investment, taken in isolation; and how large might these effects be when combined? In particular, would their combined impact be strong enough to account for a large proportion of the net movement that actually occurred over the 1980–85 period? Do these simple conclusions hold in the long run, when the effects of saving on wealth and of investment on the stock of productive capital are fully accounted for? To address these questions, even in a rudimentary way, we need a dynamic empirical model. Such a model is considered in the next section.

II. Empirical Analysis for the United States, Germany, and Japan

This section briefly describes the specification and estimation of the empirical model that is used to perform the simulations discussed later, in Section III. In the spirit of the theoretical model of the preceding section, the empirical model includes equations for private saving, private investment, and non-oil merchandise exports and imports. The two-country theoretical framework, however, is now extended to include the three largest industrial economics: the United States. Germany, and Japan. The rest of the world is also captured in a rudimentary way by using an aggregate function that explains total ROW saving minus investment. The effects of cyclical variations in output (relative to its capacity level) on private saving and investment behavior in each of the included countries are taken into account in estimation, although these “gap” variables are held constant in the simulation experiments reported in Section III.

To catch long-run as well as impact effects, the empirical model also goes beyond the comparative static analysis by explicitly allowing for the accumulation of assets that are the counterpart of the flows of saving, of investment, and of the net receipts from or payments to foreigners associated with current surpluses and deficits. Thus, for each of the three included countries there are equations that link fiscal deficits to the increase in outstanding government debt, net investment to the change in the real capital stock, and imports and exports (via an identity equating the current balance to net merchandise exports plus the balance on services) to the change in claims on foreigners. These processes of accumulation are specified such that the outstanding stock of each type of asset settles down to some stable proportion of output in the steady state.

Like the simple theoretical model, the system of this section retains the assumption of a single integrated international capital market with perfect substitutability among assets held by residents of the three countries. Thus it implicitly determines the level of the real effective exchange rate of each of the three countries as the rate that makes the supply of private saving, minus the demands for saving from net private domestic investment and the government deficit, equal to net exports plus net foreign investment income. (The real effective exchange rate of the remaining countries as a group is residually determined, as are their net exports.) The world real interest rate, expressed in terms of U.S. output as numeraire, adjusts to ensure equilibrium in the world market for saving. However, we relax the assumption that real exchange rates are expected to remain unchanged in the future. In the empirical model, real interest rates in Germany and Japan will be lower (higher) than the rate in the United States by an amount equal to the expected rate of dollar depreciation (appreciation).

Specification

The structural equations of the model (equations (10)—(24)) are summarized in Table 2, and the symbols used are identified in Table 3. In Table 2 and in the discussion that follows, the subscript i is incremented over the three included countries (the United States, Germany, and Japan) unless otherwise noted. The derivation of the equations in Table 2 will only be summarized here; a fuller discussion is contained in Knight and Masson (1987).

Table 2.

Equations of the Empirical Model

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Note: In the private saving equation (10), b3i = [ni/(1 +ni) - ai], where ni is the growth rate of capacity output; b0i, b1i, and b2i depend on the Ŵ function as well as on the speed of adjustment ai. In the private investment equation (11), f3i=[ni/(1 +ni) - ci].
Table 3.

Key to Symbols of the Empirical Model

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Note: All variables are in real terms—that is, in constant (1980) units of domestic currency. For more detailed definitions, see the Appendix.

Following Metzler (1951) and Dornbusch (1975), the empirical model assumes that the private sector adjusts its flow of saving so as to close the gap between its desired stock of wealth and its actual holdings at the beginning of each period. Desired wealth is a function of the domestic real interest rate and permanent income (here proxied by the current level of income). Because all structural equations of the model, including those for real private saving and wealth, are deflated by a measure of capacity output (see the Appendix for sources of data), the income variable appears in each equation in the form of a gap between actual and capacity output.

Because the assumptions that are required for autonomous shifts in public sector saving to be offset fully by induced movements in private saving are so stringent, our empirical model assumes that the private sector’s perceived net wealth may include any proportion ϕ of government debt, with ϕ to be dictated by the data. Thus we can test whether Barro-Ricardo equivalence of government debt and taxes is consistent with the data for our sample.

The equation for private saving in each country, i, embodies the hypothesis that the change in private sector real wealth, as a proportion of capacity output, YCi, is equal to a fraction of the gap between the private sector’s end-of-period target real wealth, Ŵi, and lagged wealth,

Δ(Wi/YCi)=ai[Ŵi/YCi-Wi(-1)/YCi(-1)],

where Ŵi = Ŵi(Yi, Ri); that is, target wealth is a function of domestic real income and the domestic real interest rate. Wealth is defined in identity (12) of Table 2 as the real net capital stock, Ki, plus some proportion, ϕi, of the real stock of government debt, Bi, plus real net claims on foreigners, Fi.10

The real interest rate on (private and government) bonds valued in units of U.S. output is RUS. Because we no longer impose the assumption of static expectations of the future real exchange rate, however, expected changes in the real value of the U.S. dollar in terms of the other two currencies over the holding period can drive a wedge between the interest rates prevailing in the three countries. Thus real interest rates in Germany and Japan. Ri(i = GE, JA), satisfy equation (21) in Table 2. where ERDOTi is the market’s anticipated rate of appreciation in the real exchange rate of currency i with respect to the U.S. dollar.11

In the national accounts, private saving is defined to equal the difference between after-tax disposable income and consumption; that is, the private sector’s acquisition of assets including government debt. On the basis of the arguments of Section I above, we therefore define private saving as the change in net wealth plus (1 - ϕ) times the real government deficit (D, equal to ΔB):

Si=ΔWi+(1 - ϕi) Di,

where, again, the first term is the “wealth-accumulation component” of private sector saving, and the second is the “Barro-Ricardo component.” This specification of the flow of private saving is therefore consistent with the definition of the stock of private sector wealth given by identity (12). Combining this identity with the wealth adjustment equation given above, we obtain

Si/YCi = ai[Ŵi/YCi-Wi(-1)/YCi(-1)] + (1-ϕi)Di/YCi+[ni/(1+ni)]Wi(-1)/YCi(-1),

where n is the growth rate of capacity output. After substituting for Ŵ and grouping terms, the final form of the structural equation is given in equation (10) of Table 2.

The current account balance, which is the difference between total national saving (Si - Di) and private investment, is given by

Ni ≡ Si - Ii - Di.

If Barro-Ricardo equivalence (ϕ ≡ 0) holds, induced private saving increases one-for-one with the government deficit, and total (public plus private) net national saving does not depend on the government deficit. In this case the current account balance would also be unaffected, and changes in fiscal deficits (if unaccompanied by output changes) would not be transmitted internationally. In the other polar case, ϕ ≡ 1, all of the increased government debt would be considered part of private net wealth, so that there would be no automatic increase in private saving to allow for future tax liabilities. Here the current account balance would change by an amount that would depend on endogenous movements in interest rates and exchange rates. Of course, our model also admits intermediate cases (0 < ϕ < 1) in which there would be a partial response of private saving to increases in government deficits.

The investment equation assumes lagged adjustment of the real (net) capital stock divided by capacity output, where the desired capital stock depends on expected output and the domestic real interest rate, and expected output is assumed to be equal to actual output:

Δ(Ki/YCi)=ci[K^i/YCi−Ki(−1)/YCi(−1)],

where K^i=K^i(Yi,Ri). The interest rate affects the desired stock through the user cost of capital, which also depends on tax considerations, discussed more fully below. The investment equation has the familiar accelerator property: an increase in output, relative to capacity output, tends to increase investment. We assume that the K^ function is homogeneous in Y, and we write the investment equation in terms of the output gap. After grouping terms, the structural equation takes the form of equation (11) in Table 2.

The merchandise trade equations closely follow those of the International Monetary Fund’s World Trade Model (see Spencer (1984)). Non-oil merchandise export volumes, XV, are assumed to depend on foreign demand, here proxied by the foreign output gap, GAPF = (YF/YCF) - 1, and on the real effective exchange rate, REEX. In addition, the ratio of exports to the home country’s capacity output, YC, may vary with a time trend, T—for instance, as a result of a gradual expansion of trade flows, relative to output, over the period since World War II. Non-oil merchandise import volumes, MV, are assumed to depend on the country’s output gap and its real effective exchange rate and, again, may exhibit a time trend when divided by capacity output. In addition, we allow for slow adjustment of volumes to activity and exchange rate changes. The resultant structural equations for export and import volume are given in equations (13) and (14), respectively, of Table 2. Note that because—in contrast to the theoretical model—the real effective exchange rate REEX is now defined as the ratio of normalized unit labor costs in the home country to those in foreign countries (that is, the inverse of ε in Section I), an increase in REEX indicates a real appreciation. Thus the a priori restrictions on the price elasticities of equations (13) and (14) are g3i < 0 and h3i > 0.

The last estimated equation of the model is equation (22), which determines the aggregate level of saving (minus investment) of the rest of the world. In the absence of data on the fiscal positions and wealth stocks of those countries, we simply make this net saving variable (also equal to the current account position of the rest of the world, NROW) a function of their real interest rate (RROW), proxied by an average of rates prevailing in the United States. Germany, and Japan (equation (23)).

The remaining equations in Table 2 are relations that close the system. First, we include an identity (16) that equates the overall current account balance Ni to non-oil merchandise exports minus non-oil merchandise imports, plus investment income (which we proxy by the real interest rate multiplied by the stock of real net foreign assets), plus an exogenous residual (RESi) that consists of other net exports of goods and services (oil trade, other services, and unilateral transfers). For each country i, the model solves implicitly for the values of the real interest rate, and of the real effective exchange rate, REEXi, that make this definition consistent with the other way of expressing the current balance identity—that is, private saving minus private investment minus the government fiscal deficit (equation (17)), Although the model is simultaneous, it is useful to think of the role of the real exchange rate as that of making these two definitions equal, given real interest rates and output gaps in each of the countries.

We also include a simple production function relationship (equation (20)) that relates capacity output to the capital stock. The labor force is not explicitly included; rather, there is a trend term that captures both population growth and technical progress. On the basis of sample averages for the growth of the capital stock and output, we impose a plausible number for this growth rate, 3 percent per year, and make it common to all countries so that we can compare steady-state solutions of the model. We also arbitrarily impose a common Cobb-Douglas production function (differing, however, by a scale factor), with a share of capital equal to one third.

In the theoretical model of Section I, the world rate of interest brings about equality of world saving and world investment; the distribution of saving and investment between countries helps determine the real exchange rate between their currencies. The equality of world saving and investment is equivalent to the condition that current account balances sum to zero globally, and in the simulation model we add the equation, equation (24) of Table 2, that enforces this condition for the United States. Germany, Japan, and the remaining countries taken as a group. In the data this condition also holds because we have calculated residually the rest-of-world current balance, expressed in real U.S. dollars; e80GE and e80JA are merely base-period (1980) dollar exchange rates of the deutsche mark and the yen.

Data sources are described in the Appendix, but it is useful here to mention briefly how our data on government debt and deficits were obtained. For our estimate of the real value of government debt, a correction has been made to fiscal deficits for the portion of nominal interest payments that corresponds to compensation for inflation (see Jump (1980)). The calculation was performed in the following fashion: nominal deficits were cumulated from a benchmark stock for government debt, and this series was divided by the gross domestic product (GDP) deflator to get the real debt stock. The adjusted real fiscal deficit was then calculated as the first difference of this stock.

Estimation

The structural equations were estimated in two separate blocks on annual data by using nonlinear three-stage least squares. Joint estimation by blocks allowed appropriate restrictions, discussed below, to be imposed across equations. It also permitted gains in efficiency by allowing for correlation among the shocks affecting the same sectors in different countries. Because real interest rates, real exchange rates, and output gaps are endogenous to the full model, they were not treated as being predetermined in each block; instruments used included the lagged asset stocks, government deficits, and capacity output. In the first block, saving and investment equations were estimated jointly for the three countries, along with the net saving function for the rest of the world, over the period 1966–83. Estimates are presented in Table 4. The second block of jointly estimated equations consisted of the import and export functions for the three countries estimated over the period 1961–83; results are reported in Table 5. Joint estimation of all the equations together was not feasible because of data and computer limitations.

Table 4.

Coefficient Estimates for investment and Saving Equations, Three-Stage Least Squares, 1966–83

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Note: For the form of the equations, see equations (10), (11), and (22), respectively, of Table 2. All variables are expressed as decimal fractions or as ratios to capacity output, and t-ratios appear in parentheses beneath the coefficient estimates. For the system as a whole, the log-likelihood is 412.6; the coefficient of determination (R2) is .969; and the weighted standard error of estimate (SEE) is .0102. Variables are as defined in Table 3.

Constrained to the same value for all three countries.

Table 5.

Coefficient Estimates for Export and import Volume Equations, Three-Stage Least Squares, 1961–83

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Note: For the form of the equations, see equations (13) and (14), respectively, of Table 2. All variables are expressed as decimal fractions or as ratios to capacity output except time T, which is incremented by one each year, and the real effective exchange rate REEX, which is an index number (1980 = 1); t-ratios appear in parentheses beneath the coefficient estimates. For the system as a whole, the log-likelihood is 520.9; the R2 is .989; and the SEE is .0055. Variables are as defined in Table 3.

Long-run elasticity is constrained to equal the average of the export price elasticities cited for Germany in Helliwell and Padmore (1985, p. 1148).

Long-run elasticity is constrained to equal the average of the import price elasticities cited for Germany in Goldstein and Khan (1985, p. 1079).

The saving equation for each country embodies a nonlinear restriction on the coefficients, since ϕ appears in both the definition of wealth and the coefficient applied to the budget deficit. We initially estimated ϕ separately for each country. On the basis of the arguments of the preceding section, one would expect the value of ϕ to vary both among countries and over time.12 Nevertheless, for this preliminary estimation and simulation work we chose to employ the strong simplifying assumption that ϕ has the same value in all three countries. This restriction is accepted by the data, on the basis of a likelihood-ratio test, at the 2.5 percent level of significance. The estimated common value of ϕ is significantly different from both zero and unity. The value of 0.43 yielded by our sample implies that neither Barro-Ricardo debt neutrality nor the full inclusion of government bonds in private net wealth is warranted on the basis of the data; this result is consistent with earlier estimates based on consumption functions (see Kochin (1974), Tanner (1979), Buiter and Tobin (1979), and Seater (1982)).

Because of the well-known difficulties in isolating a statistically robust effect of the real interest rate on saving, our second simplification was to constrain this coefficient to be the same for the three countries. Our estimate implies a small negative response of saving to an increase in the interest rate, a result that accords with recent empirical research in the United States by Bernheim and Shoven (1985). The equations for net investment are similar in the three countries; in all cases, investment responds positively to the output gap and negatively to the real interest rate. Coefficient f3 implies a similar, rather slow, speed of adjustment to the desired capital stock in all three countries. The effect of the real interest rate on investment is larger than that on saving; consequently, saving minus investment in each of these countries responds positively to the interest rate. Saving minus investment in the rest of the world also responds positively to an increase in the real interest rate, proxied here as a weighted average of real rates in the United States, Germany, and Japan.

As regards the trade volume equations, for the three largest industrial countries there is a positive and statistically significant trend effect in the ratios of both (non-oil) import and export volumes to capacity output that is attributable to the secular trend toward greater openness associated with trade liberalization and specialization. There are also significant cyclical effects, as measured by foreign and domestic gap variables in export and import equations, respectively. For Germany, we had difficulty in isolating the price elasticities of non-oil imports and exports on the basis of annual data. Because the values of these parameters are well established from empirical work using quarterly data, however, we imposed a long-run elasticity of imports equal to 0.28 (at sample means), which is an average of estimates for Germany presented in Helliwell and Padmore (1985, p. 1148); and a long-run elasticity of exports equal to 0.79, the average of estimates for German total exports (Goldstein and Khan (1985, p. 1079)).13 For the United States and Japan, as expected, export volumes respond negatively and imports positively to an appreciation of the home country’s real effective exchange rate (an increase in REEX). For both exports and imports, lags in adjustment to changes in relative prices and activity seem to be present in all three countries. Finally, it should be noted that the parameter estimates reported in this section are consistent with the a priori restrictions that are needed for the simple theoretical model of Section I to yield the three stylized facts summarized in the introduction.

III. International Transmission of Fiscal Policies: Simulation Experiments

This section describes four simulation experiments designed to highlight the international transmission of fiscal policies in major industrial countries: (1) a benchmark simulation involving a reduction in the fiscal deficit of 1 percent of GNP in each country taken in isolation; (2) year-by-year shifts in the pattern of fiscal deficits of the order of magnitude that actually occurred in the United States, Germany, and Japan over the period 1982–85; (3) tax incentives for private investment in the United States starting in 1982; and (4) combined effects of simultaneous changes in both fiscal deficits and investment incentives.

Although the empirical model just described incorporates several real-world complications that were neglected in the very simple model of Section I, it is not intended to provide a comprehensive description of all the macroeconomic processes at work in the international economy. In particular, it intentionally neglects the well-known Keynesian adjustment mechanism, whereby shifts in saving and investment induce changes in output. Specifically, the GAP variable, which is exogenous to the model, is held constant in the simulations; thus the results of the simulation experiments implicitly relate to a time period long enough for actual output to return to its normal (or cyclically adjusted) relation to capacity output. This medium-term focus also provides the rationale for our neglect of the influence of monetary factors on real interest rates and real exchange rates. As already noted, under floating exchange rates perfect substitutability between domestic and foreign assets does not require that real interest rates be equal at home and abroad: the two real rates will differ by the expected rate of change of the real exchange rate, which we call ERDOT. The simulation model includes the equations that relate real interest rates in Germany and Japan to the U.S. real interest rate and to the expected real appreciation or depreciation of the deutsche mark or the yen relative to the dollar. In the simulations reported below, however, these expected rates of change, ERDOTi, are treated as exogenous.

The simulation model consists of the equations in Table 2 of the preceding section, together with the estimated numerical values for the structural parameters set out in Tables 4 and 5. To begin the simulations, a baseline was created with residuals added back to the equations so that the model replicated historical data through 1983. For convenience it was further assumed that from 1983 onward the values of variables were consistent with a steady state for the economy: in the baseline, ratios of real flows and stocks divided by capacity output are constant, as are real interest rates and real exchange rates. The baseline thus embodies the simplifying assumption that the secular growth in the relative importance of international trade comes to an end, so that there is no trend growth in exports and imports relative to capacity output. However, capacity output itself does grow in the baseline solution, by 3 percent a year, as do other stock and flow variables.

Benchmark Simulations: Deficit Reduction in a Single Country

The analysis of Section II suggests that, other things being equal, an increase in the fiscal deficit in a major industrial country will raise the real interest rate, appreciate its real exchange rate, and cause its current account to move into deficit. An exogenous reduction in the fiscal deficit should exert opposite effects. As a starting point for the new simulations that will be discussed later in this paper, we reproduce the first simulation from Knight and Masson (1987). In the present discussion, however, we stress the international transmission of such a policy shift. Each experiment represents a discretionary reduction in the home country’s fiscal deficit equal to 1 percent of capacity output, with the stance of fiscal policy in both of the other countries held constant. We calculate the effects of these hypothetical changes on the steady state of the model, as well as on the dynamic path of the endogenous variables. Stock and flow variables are scaled by capacity output so that induced changes in them can be compared directly with the autonomous shock to the fiscal deficit, and also so that the simulation results are comparable across countries.14

Table 6 gives the simulation results for the United States, whereas Tables 7 and 8 present separate simulation results for isolated deficit reduction programs in Germany and Japan, respectively. The paths of real interest and exchange rates are presented in Chart 1; those of current account and investment ratios are shown in Chart 2.

Table 6.

Simulation of a U.S. Fiscal Deficit Reduction, Equal to 1 Percent of Capacity Output, Starting in 1985

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline. Variables are as defined in Table 3.
Table 7.

Simulation of a German Fiscal Deficit Reduction, Equal to 1 Percent of Capacity Output, Starting in 1985

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline. Variables are as defined in Table 3.
Table 8.

Simulation of a Japanese Fiscal Deficit Reduction, Equal to 1 Percent of Capacity Output, Starting in 1985

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline. Variables are as defined in Table 3.
Chart 1.
Chart 1.

Simulated Changes in Real Exchange Rates and Real Interest Rates in Response to a Fiscal Deficit Reduction, Starring in 1985, Equal to 1 Percent of Capacity Output

(Deviations From baseline)

Citation: IMF Staff Papers 1986, 003; 10.5089/9781451972887.024.A001

Source: Tables 6-8.
Chart 2.
Chart 2.

Simulated Changes in Current Balances and Private Investment in Response to a Fiscal Deficit Reduction, Starting in 1985, Equal to 1 Percent of Capacity Output

(Deviations from baseline)

Citation: IMF Staff Papers 1986, 003; 10.5089/9781451972887.024.A001

Source: Tables 6-8.

First consider the simulated first-round effects of this policy on the United States economy (Table 6). Given the estimated value of ϕ. a fiscal program that permanently reduces public sector dissaving will be only partially offset by an induced decline in private saving. S. The first column of Table 6 shows that a permanent reduction in the fiscal deficit equal to 1 percent of capacity output will be associated with a decline of only about 0.48 percent in the U.S. private sector’s propensity to save (both on impact and in the long run). Thus there is a permanent increase in total public plus private saving (not shown in Table 6) of just over 0.5 percent of capacity output. The rise in national saving exerts downward pressure on the U.S. real interest rate, R, so that private domestic investment, I, increases strongly, by about 0.25 percent of capacity output on impact (and by some 0.13 percent in the long run). This expansion in investment, however, is less than the rise in total national saving in the United States, so that there is an ex ante current account surplus. The mechanism by which this surplus appears involves a rather large (nearly 6 percent) initial depreciation of the dollar (REEX) that improves U.S. competitiveness and increases non-oil merchandise exports relative to imports. As a result, the U.S. current account moves into a surplus that is initially 0.28 percent of capacity output (third column of Table 6) and continues to rise gradually thereafter.

The way in which these effects are transmitted internationally is also very interesting. Because interest parity holds for real interest rates in the model and expected real exchange rate changes are assumed to be exogenous, interest rates in Germany and Japan (not reported in Table 6) decline by the same amount as in the United States—1.4 percentage points on impact, and 2.7 percentage points in the long run. Hence private investment also rises strongly in Germany and Japan. Because there has been no autonomous increase in national saving in these countries, however, their current accounts move into deficit by means of an appreciation of their currencies that is the counterpart of the move already noted for the United States. To summarize the first-round international effects of implementing the policy, the simulation results in Table 6 suggest that a U.S. fiscal deficit reduction program would lower the general level of world interest rates, depreciate the dollar, and stimulate private investment in all three countries of the model.

The effects that occur on impact are modified over time as productive capital is accumulated and the net claims on foreigners held by residents of each country rise or fall in response to current account flows. The U.S. current account surplus gradually rises to 0.4 percent of baseline capacity output, and claims of U.S. residents on foreigners eventually increase by 13 percent of capacity output. As U.S. private claims on foreigners rise, the investment income account also improves, requiring less of a surplus in non-oil merchandise trade to maintain the overall current account position that is sustainable, given the new saving-investment balance. As this happens, and as lags in the response of import and export volumes work themselves out, the dollar gradually reverses its depreciation. Given the parameters of the model, the new steady-state value of the dollar is actually slightly above the initial level (see Table 6 and the broken line in Chart 1), since total national saving has been permanently increased relative to U.S. private investment. Because the simulation experiment shows that the steady-state change in the real exchange rate may actually be in a direction opposite to the initial effects given by the simple model of the preceding section, it illustrates the importance of taking into account the consequences of alternative policies for the rates of wealth and capital accumulation. Furthermore, it shows that real exchange rate overshooting can occur not only because of monetary shocks in economies with sticky goods prices (Dornbusch (1976)), but also as a consequence of real shocks in a system where there is slow adjustment of trade flows and where the accumulation of claims on foreigners is explicitly taken into account (Dornbusch and Fischer (1980), Frenkel and Rodriguez (1982)).

In long-run equilibrium the net wealth of the U.S. private sector is higher than it would have been in the absence of the fiscal shift, owing to the accumulation of both productive capital at home and net claims on foreigners. More surprisingly, because of the fall in world interest rates, the accumulation of capital in both Germany and Japan is greater than the rise in their net foreign liabilities, so that their wealth is higher as well. Other things being equal, the larger equilibrium levels of national capital stocks imply that the paths of per capita income would be higher in all three countries in the long run. It should again be noted that our model, being classical in nature, neglects any short-run effect of fiscal consolidation on activity levels.

The simulation results for an isolated fiscal deficit reduction of 1 percent of capacity output in either Germany or Japan, with fiscal policy in the other two countries held constant, are presented in Tables 7 and 8, respectively. Because the model assumes the same value of ϕ in all three countries, the simulated effects of these programs of fiscal restraint in Germany and Japan are qualitatively the same as those already described for the United States. Effects on domestic (and world) interest rates, however, are smaller in response to a fiscal deficit reduction equivalent to 1 percent of capacity output, and the current account effects in the country reducing its deficit are considerably larger in relation to its GNP. These results are due not only to the obvious fact that the levels of total output in Germany and Japan are smaller than those in the United States, but also because a given program of fiscal restraint provides less of a stimulus to private investment in these two countries. It is also interesting to note that for Germany and Japan, as well as for the United States, the long-run effect on the real exchange rate is opposite to its short-run effect. In the long run the real exchange rate appreciates in response to a shift to fiscal restraint because the resultant increase in the net foreign claims position improves the services account sufficiently that the trade balance must be pushed into deficit by an appreciation, in order for net foreign claims to settle down to a constant proportion of capacity output (or of wealth). It need not necessarily be the case, however, that appreciation is the long-run outcome. For a given positive net claim position, the services account surplus will decrease as interest rates decline. Thus it is possible that the services balance will deteriorate, and the real exchange rate depreciate, in the long run. The sign of this long-run effect obviously is dependent on several parameters, including investment and saving elasticities, the net creditor or debtor position of the country, and the country’s “economic size” (see Sachs and Wyplosz (1984)).

With this set of benchmark simulations in mind, we may now assess the implications of our model for the effects of the fiscal shifts that actually occurred in the largest industrial countries over the period 1982–85. This is done in three stages, as described in the three subsections that follow. First, actual changes in overall fiscal deficits in the United States, Germany, and Japan are simulated. Next, the effects of shifts in investment resulting from changes in tax incentives in the United States are calculated by the model. Finally, the combined effects of deficit changes in the three major industrial countries and of investment incentives in the United States are simulated.

Changes in Fiscal Deficits, 1982–85

It was emphasized in the introduction that during the early 1980s there were important changes in the pattern of overall fiscal positions in the United States. Germany, and Japan. Our second simulation experiment attempts to gauge the direction and rough order of magnitude of the international transmission of these fiscal shifts. This experiment is similar to that contained in Knight and Masson (1987), except that, since that paper emphasizes how wealth and expectations effects influence the time path of adjustment, it makes use of the extreme simplifying assumption that the entire net shift in fiscal positions from 1981 through 1985 took place in the first year. In the present experiment we relax this assumption slightly and use the year-by-year shifts in fiscal stance that took place during this period. Column 1 of Table 9 gives figures for each year’s fiscal deficit, measured as the difference between the initial (1981) deficit and the actual inflation-corrected general government deficit, Di, in each subsequent year. These figures, of course, indicate a large move to fiscal expansion in the United States in 1982, and to fiscal contraction in Germany and (starting in 1984) in Japan.

Table 9.

Simulation of Deficit Changes in the United States, Germany, and Japan for the Period 1982–85

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline.

As can be seen from Table 9, the simulation results for the model suggest that these fiscal changes would have rapidly led to an appreciation of the U.S. dollar that would have been sustained throughout the period, to a comparable depreciation of the deutsche mark, and to a modest (and delayed) depreciation of the yen. The model simulation also implies a substantial deterioration of the U.S. current account—by some 1 percent of U.S. capacity output—and large increases (measured in percentage of capacity output) in the surplus positions of Germany and Japan. Furthermore, this pattern of changes in fiscal deficits is simulated to produce a rise in world interest rates of 4 percentage points in 1982, a further rise in 1983, and a net decline in 1984–85.

The path of interest rates and exchange rates depends on the form that expectations of exchange rates and interest rates take, and on whether movements in those variables, by affecting the current valuation of wealth, are allowed to influence saving behavior. The model as it stands assumes that exchange rate expectations are exogenous; hence, given the convenient assumptions of perfect asset substitutability and flexible prices, real interest rate movements are equalized internationally. The model also values asset stocks in such a way that relative price changes are not allowed to affect the real value of wealth.

In our other paper (Knight and Masson (1987)), however, we have shown that relaxing these assumptions does not make a great difference in either the qualitative or quantitative results of simulating the model’s response to the fiscal deficit shocks that are imposed there. A version of the model in which expectations of exchange rates and interest rates are formed “rationally” (that is, in which they are consistent with the model’s predictions)—with beginning-of-period stocks of real government debt revalued as a function of changes in the real interest rate, and with real net foreign claims revalued as a function of changes in the real effective exchange rate—gives quite similar results for most variables (including exchange rates), at least when the fiscal changes occur all at once and at the beginning of the simulation period. The main difference in that version is that interest rates in the three countries are uncoupled, so that a country implementing a fiscal expansion has real interest rates that are higher than elsewhere, with the converse obtaining for countries implementing fiscal contraction. With a path of deficit changes that grows over time, rational expectations of financial variables would likely bring forward the effects on exchange rates and interest rates but, on the basis of our previous results, would be unlikely to change greatly the magnitudes of these effects.

Tax Incentives for Private Investment

The two preceding simulations have analyzed the effects of changes in overall fiscal deficits, but they have not incorporated the impact of tax changes on investment incentives. Such an analysis is important for explaining the behavior of interest rates and the U.S. dollar over the period we are considering. In 1981 and 1982 the United States implemented substantial changes in the tax treatment of depreciation that tended to lower the user cost of capital for nonresidential investment; at the same time a reduction in personal income tax rates increased the cost of capital for residential investment. These changes are embodied in the Economic Recovery Tax Act of 1981 (ERTA) and in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Hooper (1984) cites estimates that the cost of capital relevant to investment in producers’ durable equipment and structures fell by 1 percentage point and 3 percentage points, respectively, as a result of these changes (see also Brayton and Clark (1985)). In contrast, the cost of capital for rental housing increased by an estimated ½ percentage point, and by 1 percentage point for owner-occupied housing (Hooper (1984, p. 14)). Averaged together using shares in 1983 investment as weights, these changes yield a decrease in the cost of capital relevant to total investment of about 1¼ percentage points.

For the estimates cited above, the user cost of capital was calculated in the following way (see Brayton and Clark (1985, p. 5)):

C=[(1−t)Rn+δ−π]Δ,(25)

where

  • t = the tax rate (corporate or personal)

  • Rn = the nominal interest rate

  • δ = the rate of economic depreciation

  • π = the rate of change of the price of the investment good

  • Δ = a factor that depends on the tax treatment of depreciation and investment tax credits (for housing, Δ is equal to unity).

ERTA and TEFRA lowered the value of Δ for business investment and lowered the value of t for individuals. To simulate the effects of these measures on investment, we first calculate the changes in the interest rate, for given rates of inflation, that would have produced the same change in the user cost of capital. From equation (25) above, these changes are approximately

dRn=1Δ(1−t)dC,

where t = .46 for corporations and t = .19 for individuals.15 If we average these implied changes in the real interest rate using investment shares, the same effect as the tax changes would have been produced through a decrease of 2 percentage points in the real interest rate. Table 10 presents the result of simulating the model in such a way that this change is embodied in the equation for U.S. investment; in particular, the constant term in that equation is decreased by 0.02 times the coefficient of the interest rate (with the sign reversed). However, effects on government revenue are ignored here; the deficit is assumed to remain unchanged in this simulation.

Table 10.

Simulation of U.S. Tax Changes Affecting the Cost of Capital, Starting in 1982

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline. Variables are as defined in Table 3.

As would be expected, the simulation indicates that the decline in the user cost of capital stimulates investment in the United States and leads to a current account deficit there. In long-run equilibrium, both the U.S. capital stock and external indebtedness are permanently higher. The dynamics of adjustment produce an initial substantial rise in the real exchange rate of the dollar and an increase in world real interest rates in excess of 1 percentage point. In long-run equilibrium, real interest rates are higher than in the baseline, but the exchange value of the dollar is close to its initial equilibrium. Higher interest rates discourage capital formation in the other countries, which are assumed not to benefit from greater investment incentives. Despite increased claims on the United States, wealth in Germany and Japan is lower than in the baseline.

Combined Effects of Fiscal Deficits and Investment Incentives

In Table 11 we combine the effects of the decrease in the user cost of capital in the United States with the pattern of changes in overall fiscal deficits that was simulated in Table 9. The results indicate substantial movements in exchange rates relative to the baseline among the three countries and a rise in interest rates that reaches 6 percentage points in 1983. This increase more than offsets the effect of investment incentives in the United States, and U.S. investment declines relative to baseline.

Table 11.

Simulation of Deficit Changes in the United States, Germany, and Japan, for the Period 1982–85, and of U.S. Tax Changes Affecting the Cost of Capital, Starting in 1982

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Note: All variables are deviations from baseline (expressed as percentages of baseline capacity output) except REEX, which is given as percentage deviation from baseline, and R, which is given as percentage-point deviation from baseline.

The issue of how much of the dollar’s strength can be attributed to shifts in fiscal policy—and of the extent to which such fiscal changes also explain high real interest rates in the United States and elsewhere—has been addressed in several recent papers. Blanchard and Summers (1984, p. 302) have concluded that “on balance,… we find no evidence that fiscal policy in the OECD [Organization for Economic Cooperation and Development] as a whole is responsible, through its effect on saving, for high long real rates.” By contrast, simulations of a small global macro-economic model by Sachs (1985) tend to support the view that the U.S. monetary-fiscal policy mix—even accompanied by fiscal contraction in the rest of the OECD—goes a long way toward explaining developments in financial and exchange markets in the past few years.

Our results imply effects on the exchange rate of the dollar and on real interest rates that are similar to those of Sachs, although somewhat smaller in magnitude. When inflation-adjusted deficit changes are simulated in the three countries in combination with tax-induced changes in the user cost of capital in the United States, the peak dollar appreciation relative to the baseline yielded by our model is 21 percent in real effective terms, and the peak real interest rate increase is 6 percentage points. Because we do not take account of the tightening of U.S. monetary policy in 1980–81, we do not expect to account fully for the rise in interest rates and in the value of the dollar that was observed in the first half of the 1980s. Our model does, however, seem to explain a substantial portion of observed movements. From its trough in 1980 to the peak of early 1985, the dollar appreciated by 57 percent, of which 37 percent was from the end of 1981; at their peak, real short-term interest rates were about 4 percentage points higher, and long-term rates about 8 percentage points higher, than in 1980 (International Monetary Fund (1985, pp. 8 and 18)). To summarize, if one accepts the size of the fiscal shifts assumed in the simulation, then the view that changes in fiscal policy help to explain the direction and rough order of magnitude of the net movements in real interest rates and real exchange rates of the three largest industrial countries during the 1980s receives strong support.

IV. Conclusions

In periods when international economic developments are strongly influenced by large autonomous changes in national saving and investment balances—particularly those induced by shifts in public sector fiscal positions in the largest industrial countries—such disturbances may be expected to exert an overriding influence on the pattern of real exchange rates and current account positions. The developments analyzed in this paper are clearly not the only factors that have been at work over the past few years. In particular, as the data in Table 1 suggest, the sharp appreciation of the U.S. dollar in 1980–81 cannot be explained by shifts in actual fiscal deficits in these two years. Plausible explanations are the move toward monetary restraint in the United States during this period (Frenkel (1985)) or anticipations of future shifts in fiscal policy (Branson (1985)). Nevertheless, the analysis of this paper suggests that a careful examination of national saving and investment balances, and of the shifts in fiscal positions and tax laws that influence them, may be expected to yield useful insights into the behavior of exchange rates and payments balances among the industrial countries, at least over the medium term.

More specifically, the work of the preceding sections suggests several conclusions. First, under plausible assumptions, a very simple and standard classical model will yield the result that fiscal shifts such as those that have taken place among the largest industrial countries in recent years are indeed consistent with all three of the stylized facts mentioned in the introduction to this paper: the persistently high level of real interest rates in international financial markets, shifts to a large current account deficit in the United States and to surpluses in Germany and Japan, and persistent appreciation of the U.S. dollar. Second, preliminary estimation results suggest that the assumptions needed for the model to yield these effects are themselves consistent with the data for the period. Third, although the timing of exchange rate movements depends on many factors, the effects of fiscal shifts on real interest rates and exchange rates are clearly important. In terms of direction and order of magnitude, the simulation experiments support the view that the shifts in the pattern of fiscal positions that took place among the three largest industrial economies over approximately the period 1982–85—combined with changes in U.S. tax incentives for investment—were responsible for a substantial proportion of the net changes in interest rates and exchange rates that actually occurred in the United States, Germany, and Japan during the first half of the 1980s. A corollary of this conclusion is that movements up to mid-1986 have also been broadly consistent with predictions of the model, provided that the Gramm-Rudman-Hollings fiscal deficit-reduction package was regarded as credible when it was enacted in the United States in late 1985.

These specific conclusions concerning the medium-term determinants of current account positions, exchange rates, and interest rates naturally lead to the crucial issue of policy interactions among the industrial countries, and to the related problem of how to develop an analytical framework for assessing economic policies and performance over the medium term. The Economic Declaration issued by the leaders of the seven major industrial countries after the Tokyo Summit of May 4–6, 1986, reflected agreement to engage in “close and continuous coordination” of their national policies and suggested that in their meetings the finance ministers should make use of quantitative indicators of economic policies and performance “with a particular view to examining their mutual compatibility” (IMF Survey, Vol. 15, No. 1, May 19, 1986, p. 145). The analysis of this paper suggests that, since trade and capital flows are the principal channels by which national policies are transmitted internationally, it is important to try to determine a pattern of current account balances and real exchange rates that would be sustainable in the medium term (Artus and Knight (1984)). The results also suggest that inferences about the sustainable current account position can usefully be drawn from a theoretical framework that emphasizes the medium-term stance of fiscal policy and its implications for the domestic saving-investment balance. Thus, it seems clear that a careful assessment of each country’s fiscal position and saving-investment balance may help to shed light on the general issue of policy interactions among the industrial countries. It is also clear that other factors not captured by the present model—such as cyclical effects, uncertainty about the future stance of fiscal policy, safe havens, and monetary policy effects—are part of a more complete explanation. Nevertheless, the fiscal effects we have studied here appear to be a most important factor.

APPENDIX Data Sources and Definitions

Except where otherwise noted, all flow data were taken from the national accounts of the country concerned. Sources were Data Resources. Inc. (DRI) for the United States and the OECD’s National Accounts (Paris, the issues for 1960–77 and 1971–83) for Germany and Japan. Real flows and stocks were valued at 1980 local currency prices.

Variables for the United States, Germany, and Japan (i = US, GE, JA)

Bi is the real government net debt, calculated by cumulating general government fiscal deficits from benchmark figures, based on ratios of debt to GDP in 1982 (Muller and Price (1984)): 23.6 percent for the United States, 23.4 percent for Japan, and 19.8 percent for Germany. The net debt series was then divided by the GDP deflator.

Di represents the real general government deficit corrected for inflation, calculated as Bi - Bi(-1).

Fi is the real net foreign asset position, calculated by cumulating Ni. Benchmark figures for the Fi were obtained by dividing nominal net claims on foreigners valued in local currency at the end of 1982 by the 1982 GDP deflator. For the United States, net claims on foreigners at the end of 1982 were US$149.5 billion (U.S. Department of Commerce, Survey of Current Business (Washington, June 1984, p. 75)); for Germany. DM 66.5 billion (Monthly Report of the Deutsche Bundesbank (Bonn, October 1984. p. 35)): and for Japan. US$24.7 billion (Bank of Japan. Economic Statistics Annual (Tokyo, 1983, p. 248)).

GAPi stands for the output gap, as a ratio to capacity output: the gap equals actual GDP divided by capacity output (YCi,) minus one. Given the way in which YCi is calculated, GAPi is the same as the output gap in manufacturing (see Artus (1977)).

GAPFi is the foreign output gap; that is, actual GDP for nine industrial countries (excluding the country concerned) divided by the corresponding potential output, minus one. The set of ten countries comprises the United States, Japan, Germany, the United Kingdom, France, Italy, Canada, Belgium, the Netherlands, and Sweden.

Ii represents real private net investment, residential plus nonresidential.

Ki is the real private net capital stock. For the United States it was calculated as the sum of the nonresidential and residential real stocks, minus the government residential stock (source: DRI). For Germany and Japan, Ki was calculated by cumulating Ii, using a benchmark figure. This figure for Germany was the 1970 total net capital stock minus the 1970 government capital stock (OECD, Flows and Stocks of Fixed Capital (Paris, the issue for 1955–80)). For Japan, where a figure for the real net capital stock was not available, preliminary estimation of an investment equation chose the value of the 1960 ratio of capital to GDP (3.18) that maximized the fit of the equation.

MVi stands for the volume of non-oil merchandise imports in real local currency terms; figures were obtained from International Monetary Fund data files.

Ni is the national accounts net exports of goods and services divided by the GDP deflator.

Ri represents the real long-term interest rate, calculated as the nominal long-term government bond rate (source: International Monetary Fund, International Financial Statistics, or IFS (Washington, various issues)) minus the percentage change in the GDP deflator. The result was divided by 100 to get an interest rate expressed as a decimal fraction.

REEXi is the real effective exchange rate index (1980 = 1; an increase indicates appreciation), calculated as the country’s normalized unit labor costs (NULC) relative to a weighted average of its competitors’ NULC, in a common currency (source: IFS).

RESi is a residual current account item that includes the oil trade balance, the balance on services excluding investment income, and unilateral transfers. It is calculated as Ni - XVi +MVi-RiF(-1).

Si represents real net private saving, calculated as Ni +Ii + Di.

Wi is real private sector net wealth, calculated as ϕBi + Ki + Fi.

XVi stands for the volume of non-oil merchandise exports in real local currency terms (source: International Monetary Fund data files).

YCi is capacity GDP, calculated by applying the gap between actual and potential manufacturing output (Artus (1977)) to actual GDP.

Variables for Germany and Japan

ERDOTi represents the expected rate of change of the bilateral real exchange rate against the U.S. dollar (with a positive value indicating depreciation), calculated as RUS - Ri.

Variables for the Rest of the World (ROW)

NROW is a proxy for the ROW real current balance, calculated as - (NUS + NGE/1.815 + NJA/225.82); denominators contain 1980 bilateral rates of the deutsche mark and the yen against the dollar.

RROW represents the real interest rate, calculated as a GDP-weighted average of RUS, RGE, and RJA.

YCROW is capacity output in 1980 U.S. dollars, calculated by aggregating the remaining seven of our sample of ten industrial countries.

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