IFDP 1985-272
Expected Fiscal Policy and the Recession of 1982

William H. Branson, Arminio Fraga, and Robert A. Johnson

IFDP 1985-271
Elections and Macroeconomic Policy Cycles

Kenneth Rogoff and Anne Sibert


There is an extensive empirical literature on political business cycles, but its theoretical foundations are grounded in pre-rational expectations macroeconomic theory. Here we show that electoral cycle in taxes, government spending and money growth can be modeled as an equilibrium signaling process. The cycle is driven by temporary information asymmetries which can arise if, for example, the government has more current information on its performance in providing for national defense. Incumbents cheat least when their private information is either extremely favorable or extremely unfavorable. An exogenous increase in the incumbent party's popularity does not necessarily imply a damped policy cycle.

IFDP 1985-270
Assertion without Empirical Basis: An Econometric Appraisal of Monetary Trends in ... The United Kingdom

David F. Hendry and Neil R. Ericsson


This paper critically re-evaluates some of the fundamental empirical claims about monetary behavior in the United Kingdom made by Milton Friedman and Anna J. Schwartz in their 1982 book Monetary Trends in the United States and the United Kingdom. We focus on six aspects of their analysis: the exogeneity of money; their claims of the constancy and correct specification of their money-demand equation; their interpretation of a dummy variable in that equation as capturing a "shift in liquidity preference" for 1921-55; their treatment of the interdependence of money, income, prices, and interest rates; and their use of phase-average data. They fail to support many of their empirical assertions with valid econometric evidence: in particular, they leave untested many conditions necessary to sustain their inferences. However, those conditions either are in part directly testable from their data or have testable implications: we test many of those hypotheses and reject virtually all of them. We reject basic claims made for their empirical model of money demand, e.g., those of parameter constancy, price homogeneity, and normality of the disturbances. En route, we show that their model of velocity as a constant performs poorly relative to the "will-o'-the-wisp" model of velocity as a random walk. As constructive evidence against their models, we develop a money-demand model superior to either model of velocity, and which has an unexplained residual variance less than one tenth that of their money-demand equation. This paper, however, is not an "anti-monetarist" critique; rather, it is a pro-econometrics tract which highlights the practical dangers of seeking to analyze complex stochastic processes while eschewing modern econometric methods.

IFDP 1985-269
Canadian Financial Markets: The Government's Proposal for Reform

Garry J. Schinasi


This paper discusses Canada's financial sector, recent institutional changes, and the Government's recent (April 1985) proposal for financial market reform and its likely impact. Canada's financial markets have been dominated by traditional financial institutions known as the "four pillars". Although traditions and regulations have contributed to the evolution of Canadian financial markets, economic conditions and customer-provided incentives have recently created the major impetus for change. Structural changes have occurred along three separate but related tracks: product and service innovation by banks and near-banks; less market segmentation; and conglomeration. Political pressures have led the federal and provincial governments involved to accommodate the changes that occurred and to encourage changes that were clearly inevitable. The Government of Canada is currently proposing sweeping regulatory reform of financial institutions to encourage more competition for the dominant chartered banks, to establish more effective safeguards to protect consumers, to ban self-dealing, and to insure the stability of the financial system. If implemented, the proposal may alter the traditional roles of financial institutions and their relationship with the federal government.

IFDP 1985-268
Was it Real? The Exchange Rate-Interest Differential Relation, 1973-1984

Richard Meese and Kenneth Rogoff


The main result of Meese and Rogoff [1983 a,b] is that small structural exchange rate models forecast major dollar exchange rates no better than a naive random walk model. This result obtains even when the model forecasts are based on actual realized values of the explanatory variables. Here we improve our methodology by implementing a new test of out-of-sample fit; the test is valid even for overlapping long-horizon forecasts. We find that the dollar exchange rate models perform somewhat less badly over the recent Reagan regime period than over the episodes studied previously. The methodology is also applied to the mark/yen and mark/pound exchange rates, and to real exchange rates. Finally, we test to see if real exchange rates and real interest differentials can be represented as a cointegrated process. The evidence suggests that there is no single common influence inducing nonstationarity in both real exchange rates and real interest differentials.

IFDP 1985-267
The U.K. Sector of the Federal Reserve's Multicountry Model: The Effects of Monetary and Fiscal Policies

Hali J. Edison


The purpose of this paper is to describe and to analyze in some detail the U.K. sector of the Federal Reserve's Multicountry Model (MCM). The analysis focuses on the effects of shifts in U.K. monetary and fiscal policies at three levels: 1) within the unlinked U.K. sector, 2) within the linked MCM framework, and 3) within the linked MCM under the assumption that U.K. policy shifts are coordinated with those in other countries. In comparing the unlinked MCM U.K. sector with other U.K. models such as the LBS and National Institute it is found that all the models have similar government expenditure multipliers but the components of GNP respond quite differently. The contrast between linked and unlinked simulation illustrates the importance of international feedback effects.

IFDP 1985-266
Optimal Currency Basket in a World of Generalized Floating an Application to the Nordic Countries

Hali J. Edison and Erling Vardal


The purpose of this paper is to derive optimal weights for a currency basket taking into consideration the objective of the policymaker. We carefully distinguish between the two terms: effective exchange rate index and currency basket, which are often used interchangeably in the literature. In general, our analysis is an extension of the work of Branson-Katseli and Lipschitz-Sundararajan and then applied to the Nordic countries. We use the policy objective of minimizing fluctuation in export production and illustrate our results using Norway, Sweden and Finland. The weights we derive create optimal currency baskets which are different from the ones used in the countries.

IFDP 1985-265
Money Demand in Open Economies: A Currency Substitution Model for Venezuela

Jaime Marquez


This paper investigates the extent to which domestic money balances in Venezuela are influenced by foreign exchange considerations. To this end, individuals are assumed to choose the levels of foreign and domestic money that minimize the borrowing costs associated with a given level of monetary services. The solution to this optimization problem yields a closed form domestic money demand function. This specification is estimated and the results point to an elasticity of currency substitution in excess of one. Conditioned on these estimates, the paper presents estimates of the out-of-sample exchange-rate risk for the period 1981-1982, prior to the collapse of the fixed exchange rate system in 1983.

IFDP 1985-264
Comparing Costs of Note Issuance Facilities and Eurocredits

Rodney H. Mills


Since early 1984, note issuance facilities (NIFs) have in considerable degree replaced syndicated Eurocurrency bank credits in international credit markets, especially for borrowers in industrial countries, because borrowers have found it cheaper to bypass bank syndications and obtain funds more directly by issuing Euronotes. Factors behind this include an increasing awareness of borrowing possibilities, more freedom for Japanese investors to buy foreign securities, a drop in the relative popularity of bank obligations with investors, and banks' desire to slow asset growth to improve capital ratios.

Measurement of the cost savings to borrowers on NIFs as compared with Eurocredits is difficult because of limited comparison possibilities. Most NIFs arranged so far have not been drawn on through issuance of notes, and few of the actual issuers have arranged LIBOR-priced Eurocredits recently. In the 12 cases, as of mid-1985, where meaningful comparisons could be made, it appears that the cost savings to the borrowers ranged from about 10 to around 50 basis points. All of the savings were in the interest spread, where the NIFs appear to have been about 15 to 55 basis points cheaper. Fee costs were slightly higher on NIFs than on Eurocredits; although front-end fees are lower, the total fee costs for NIFs are higher because of the annual facility fee paid to banks that underwrite the NIF.

IFDP 1985-263
Some Implications of the President's Tax Proposals for U.S. Banks with Claims on Developing Countries

Allen B. Frankel


This paper examines some implications of the President's 1985 tax reform plan for U.S. banks with claims on developing countries. An assessment is presented of how the plan would modify, or eliminate, a variety of mechanisms by which banks shelter income from taxation. A particular focus of the paper is an analysis of the consequences for large U.S. banks of the proposed change in the computation of the U.S. tax credit for taxes paid to foreign countries.

IFDP 1985-262
Monetary Stabilization Policy in an Open Economy

Marcus H. Miller


This paper investigates optimal stabilization policy in a small open economy using a continuous time model in which inflation depends on future monetary policy as well as past inflation. The impact of monetary policy is assumed to operate via real interest rates and the real exchange rate and the setting of real interest rates is chosen so as to minimize quadratic costs of fluctuations in output and inflation, subject to varying expectations in the foreign exchange market. Analytical expressions and simulation results are presented for "time inconsistent" optimal policy, the "dynamic programming" solution, for policy which ignores the exchange rate effects when setting real interest rates, and for the "optimal linear feedback" rule.

IFDP 1985-261
Anticipatory Capital Flows and the Behavior of the Dollar

Arnold S. Kling


In this paper, I argue that the value of the dollar is influenced by the "state of long-term expectation" and that market expectations do not appear to embody a return to steady state. I suggest that the recent strength of investment in the United States reflects "animal spirits" and those investors appear to expect the investment boom to he sustained indefinitely. Finally, I show how an adverse shift in perceptions concerning the profitability of investment, by altering this state of expectations and thereby affecting international capital flows, conceivably could put upward pressure on interest rates that would outweigh the downward pressure coming from the actual slowdown in investment.

IFDP 1985-260
Simulating Exchange Rate Shocks in the MPS and MCM Models: An Evaluation

Arnold S. Kling


In 1983 and 1984, the United States economy staged a vigorous economic recovery at a time when the value of the dollar was high and rising, leading to a steady deterioration of the trade balance. The strength of both the economy and the dollar exceeded most forecasts. This raises a question: are there expansionary effects from a currency appreciation that are overlooked when we focus solely on the trade balance?

The purpose of this paper is to try and resolve the issue of whether or not an appreciation of the dollar is expansionary. To do so, I evaluate the simulation properties of the MPS and MCM models. As part of this evaluation, I develop a "back-of-the-envelope" model to serve as a third alternative against which to compare the two large econometric models.

IFDP 1985-259
Trade Policy for the Multiple Product Declining Industry

Catherine L. Mann


Increasing returns to scale and scope in production technology combined with product substitutability in demand yields an environment where free trade may not maximize domestic country welfare. If not, there is an optimal tax on imports that depends on the cross-elasticity of demand between the products in the spectrum and on the degree of economies of scale and scope in technology. However, even if protection may be warranted in the short run, the long run solution is consistent with the theory of comparative advantage.

IFDP 1985-258
Long Memory Models of Interest Rates, The Term Structure, and Variance Bounds Tests

Gary S. Shea


Variance bounds tests of the rational expectations hypothesis of the interest rate term structure are sensitive to the stochastic characterization of short-term interest rates used. When a long memory or fractional difference nonstationary time series model is used in preference to a mean stationary model, the rational expectations hypothesis is not rejected. Long memory models of interest rates are estimated and tested against alternatives. Their forecasting properties are also examined. Hypothesis tests are based upon bootstrapping (Monte Carlo) methodologies.

IFDP 1985-257
Currency Substitution and the New Divisia Monetary Aggregates: The U.S. Case

Jaime Marquez


The purpose of this paper is to examine the extent to which the behavior of aggregate money holdings is influenced by foreign exchange considerations, an influence that has been labeled as currency substitution. Knowledge of the extent to which monies of different countries can substitute for each other is important for the design and implementation of monetary policy. However, existing empirical analyses of currency substitutions rest on official estimates of money holdings which imply an infinite elasticity of substitution between different monetary assets. Analyses of economic monetary aggregates do not impose the assumption of infinite elasticity of substitution, but no foreign exchange considerations are allowed. This paper combines both approaches into a unified explanation of money demand behavior.

IFDP 1985-256
The International Transmission of Oil Price Effects and OPEC's Pricing Policy

Jaime Marquez


Analysis of oil-price effects generally maintain the assumption that oil-importers can be treated as small economies, which allows oil-price changes to be treated as exogenously set by OPEC. Analyses of oil-price determination rely on the assumption that the demand for oil is a stable function, which implies that real income of oil importers is unaffected by oil-price changes. Our analysis treats oil prices and economic activity as jointly determined. The effects of exogenous oil-price changes are studied in a simple theoretical world model. Hotelling's analysis is generalized to allow for both oil-price feedback effects and stabilization policies.

IFDP 1985-255
U.S. Banks' Lending to Developing Countries: A Longer-Term View

Henry S. Terrell and Rodney H. Mills


There was very little net new lending by U.S. banks to developing countries in 1983-84, following the heavy lending of preceding years. When non-spontaneous lending to Brazil, Mexico and some other Latin American countries is deducted, there was an absolute decline in U.S. banks' claims on these countries. However, estimates of net new lending based on charges in outstanding claims understate the amount of net new lending to these countries in 1983-84 by an amount on the order of $3-1/2 billion. This is because outstanding claims were reduced by a number of factors other than repayments; such factors included loan charge-offs, sales of claims to non-bank investors, the exercise of official guarantees, and the statistical effects of exchange rate charges. Other aspects of U.S. bank lending to develop countries in 1983-84 were an increased concentration of the outstanding claims at the largest banks, and an increased concentration of the claims towards the public sector of the borrowing countries.

IFDP 1985-254
Conditional Econometric Modelling: An Application to New House Prices in the United Kingdom

Neil R. Ericsson and David F. Hendry


The statistical formulation of the econometric model is viewed as a sequence of marginalizing and conditioning operations which reduce the parameterization to manageable dimensions. Such operations entail that the "error" is a derived rather than an autonomous process, suggesting designing the model to satisfy data-based and theory criteria. The relevant concepts are explained and applied to data modelling of UK new house prices in the framework of an economic theory-model of house builders. The econometric model is compared with univariate time-series models and tested against a range of alternatives.

IFDP 1985-253
Loan Pushing: Doctrine and Theory

William Darity, Jr.

Back to Top
Last Update: August 13, 2021