International economic relations ; Economic policy

Charles Pigott

English

Research Papers in Economics

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February 15, 1980 
The Foreign Dimension 
Over the past year, the "foreign dimension" 
of u.s. economic policy has become 
increasingly prominent. In November 1978 
and again last October, the Federal Reserve 
took dramatic steps to reduce money growth 
and slow inflation, spurred in part by the 
adverse verdict rendered by the foreign-
exchange markets on u.S. economic 
policies. While safeguarding the soundness 
of  the dollar has always been a u.S. policy 
objective, recent events have made it a matter 
of more explicit and immediate concern. 
In this situation, U.S. policymakers are likely 
to give more weight to foreign economic 
policies in formulating their own. After all, 
the foreign-exchange value of  the dollar 
depends upon policies taken abroad as well 
as those pu rsued here at home. Ten-percent 
inflation in the u.s. need not mean a falling 
dollar if foreign inflation is the same-but a 
fall can scarcely be avoided if  the foreign 
inflation rate is only five percent. This 
consideration looms particularly large as 
pol icymakers attempt to deal with the latest 
round of oil price increases. The conse-
quences for the dollar of u.S. policies will 
depend critically upon how foreign govern-
ments choose to deal with that price surge-
superficially, whether they choose to fight its 
inflationary effects or whether they try to 
combat its adverse impact on real growth. 
Past record 
To a large extent, cu rrent and futu re macro-
economic policies abroad reflect the 
reverberating impact of 1974's quadrupling 
of oil prices. This increase led to a sharp rise 
in inflation rates in japan and Europe in 1974 
and ,1975, accompanied by the most severe 
recession of the post-war period. As in the 
U.S., foreign governments at first reacted to 
the increased inflation by tightening 
monetary policy, even while applying fiscal 
stimulusto raise real growth. Their fiscal 
measures were largely unsuccessful, 
however, and so they eased monetary policy 
later in 1975 in a further attempt to alleviate 
the recession. 
Thereafter, economic policies here and 
abroad diverged somewhat. In the U.s., 
money growth continued to accelerate while 
real output recovered fairly steadily from its 
1975 trough. Increased money growth in turn 
led to a fairly steady acceleration in U.s. 
inflation following its 1976 trough. In 
contrast, foreign monetary policy remained 
cautious, with money growth actlJally 
slowing in 1976 in most Europea'n countries 
and in 1977 in japan. By 1978, these policies 
had generally succeeded in reducing foreign 
inflation rates well below 1974-75 levels. 
(Indeed, in Germany and japan, consumer-
price inflation fell to 3.5 and 2.5 percent, 
respectively, in 1978.) Partly as a result of 
these policies, foreign economies remained 
relatively sluggish: after a strong but abortive 
recovery in 1976, real growth slowed 
substantially in 1977, leaving unemployment 
rates very high by pre-1973 standards., 
Road to '79 ... 
Apparently successful in lowering inflation 
but faced with continued high unemploy-
ment, foreign governments eased policy in 
late 1977 and 1978 in an attemptto stimulate 
output. All of the major foreign industrial 
nations increased their government budget 
deficits followi  ng the adoption of  tax cuts and 
other stimulus measures. In japan, for 
example, the budget deficit reached 
5 percent of GNP in 1978-this in a country 
that had not experienced any significant 
budget deficits until the early 1970's. (In 
contrast, the u.s. budget deficit in the 1970's 
generally remained under 3 percent of 
GNP-and never exceeded 4 percent.) 
Except in the U.K. and Canada, fiscal 
stimulus was accompanied in 1978 by an 
acceleration of money growth, although for 
external as well as domestic reasons. 
German, japanese and Swiss central banks in 
particu lar made heavy pu rchases of  dollars in Opinions expressed in this newsletter do not 
nc:cessariiy  r(~f!ect the views of the rnanagernent 
of the Federal Resf'::rve  Bank of  Sail  francisco, 
nor of the Board of CoverrH)r:~ of the F'edera! 
Reserve  Sy~;;lern. 
order to support the dollar's sagging value on 
the foreign exchanges. As a resu It, money 
growth in these countries in 1978 substan-
tially exceeded official targets or (Japan) 
projections. 
Whatever the reasons, the results of  these 
pol icies were largely the same.  Real growth 
averaged 3.3 percent in the ten majorforeign 
industrial countries in 1978-compared to 
2.9 percent the previous year-and appar-
ently was about the same in 1979. This 
improvement in real growth led to significant 
reductions in unemployment, but the 
accompanying easing of policy left govern-
mentdeficits bloated in several countries and 
rekindled inflationary pressures. 
In 1979, foreign industrial countries 
experienced sharply accelerating inflation, 
traceable to their previous monetary expan-
sion but also to sharp price increases for oil 
and other basic commodities. Consumer 
prices rose nearly 8.0 percent (on average) in 
the 10 major foreign industrial nations, 
compared to 1978's SA-percent average 
increase. Mindful of their earlier success in 
containing inflation, governments generally 
responded quickly and decisively to this 
acceleration by slowing money growth and 
raising domestic interest rates. For example, 
Japan raised its central-bank discount rate 
three times last year, from 3.5 percent to 
6.25 percent, while Germany raised its 
central-bank rate from 3 to 6 percent over the 
same period. Foreign money-market rates 
increased apace (see ,chart). Indeed, interest 
rates in Germany and Japan have increased 
more in real terms (relative to inflation) than 
they have in the U.S. Largely as a result, 
money growth abroad has slowed over the 
last year, while some foreign governments 
also have moved to tighten fiscal policy. 
...  and 1980 
Until the latest round of  oil price hikes, last 
year's policy tightening promised some 
reduction in 1980 inflation-but at the cost 
of lower real growth. According to the 
December 1979 Economic Outlook of the 
2 
Organization for Economic Cooperation and 
Development (OECD), real GNP in 1980 was 
expected to grow by 2.25 percent in 
Germany and by 4.75 percent in Japan 
(considerably below their 1979 performance 
of 4.25 and 6.00 percent, respectively), and 
was expected to fall by about one percent in 
'the U.S. Even those unfavorable forecasts 
assumed thatoil prices would rise by no more 
than 10 percent over those prevai ling at the 
end of 1979. 
This expected slowdown could halt, and in 
some cases partially reverse, the recent prog-
ress in lowering unemployment and excess 
capacity. Nonetheless, foreign governments 
seem unlikely to relent from their stance of 
restraining inflation t~rough  tighter monetary 
and fiscal policies. As in the U.s., their con-
centration on fighting inflation appears to 
reflect a public consensus that inflation is the 
number-one economic problem. 
To what extent are these prospects now 
altered by the oil price increases of the past 
several months? With oil prices rising this 
year, not by 10 perce.nt, but by nearly 30 per-
cent, the outcome is likely to be even lower 
growth and higher inflation than previously 
anticipated. Whether governments now ease 
policy is likely to depend crucially upon how 
those price increases affect real growth 
throughout the industrial world. 
According to recent OECD estimates, the 
latest oil-price hikes could reduce real GNP 
in the industrial countries by an average of 
about one percent in 1980. This could mean 
stagnation or worse, especially in view of the 
fact that real GNP was already expected to 
grow very little in most foreign countries. Still, 
any downturn would probably not beas 
sharp as that occurring in 1974 and 1975, 
when real output fell sharply in most major 
industrial countries. Furthermore, estimates 
of  the growth effects of  these oil-price 
increases may be overstated, because they 
are based on past reactions of industrial 
economies to such shocks. In light of the 
experience gained by the oil-'importing nations over the past six years, the disruptive 
effects of further price increases may be 
smaller and less protracted now than in the 
past. On balance, then, it seems I  ikely that 
unemployment abroad will remain at painful 
but probably not intolerable levels during 
1980. If so-and in view of the inflation 
impact of the latest oil-price increases-
policies abroad may continue to be directed 
toward containment of inflation. 
This prognosis, if correct, has important 
implications for u.s. policy. In the last fifteen 
months, the u.s. has twice succeeded in 
relieving pressure on the dollar by taking 
steps to restrain money growth-and hence 
Percent 
ultimately to reduce inflation. Given the 
move toward more restrictive policies 
abroad, and given the lower average levels of 
foreign inflation rates, continued stability of 
the dollar is likely to depend upon a public 
perception that u.s. policy remains on its 
announced course of checking inflation. In 
other words, America's room to "accom-
modate" the oil price increases will be 
constrai ned by pol icy decisions made abroad 
if  further pressure on the dollar is to be 
avoided. The foreign dimension of u.s. 
policy thus seems likely to remain prominent 
for some time to come. 
Charles Pigott 
15  Money Market Rates 
12 
9 
6 
3 
U.K. 
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Germany 
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BANKING DATA-TWELfTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and liabilities 
large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.S. Treasury securities* 
Other securities* 
Demand deposits - total# 
Demand deposits  adjusted 
Savings deposits  total 
Time deposits  total # 
Individuals, part. & corp. 
(Large negotiable CD's) 
Amount 
Outstanding 
1/30/80 
.137,161 
114,423 
32,765 
44,145 
24,700 
1,303 
7,199 
15,539 
43,346 
32,111 
28,130 
59,100 
50,272 
21,323 
Change 
from 
1/23/80 
+  151 
+  101 
+  92 
+  129 
+  121 
- 68 
+  32 
+  18 
+  352 
+  520 
248 
223 
- 188 
- 319 
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Change from 
year ago 
Dollar  Percent 
+  16,637  +  13.80 
+  16,043  +  16.30 
+  3,965  +  13.80 
+  8,648  +  24.40 
+  4,206  +  20.50 
304  - 18.90 
- 391  5.20 
+  985  +  6.80 
+  2,872  +  7.10 
+  2,573  +  8.70 
- 1,670  - 5.60 
+  7,970  +  15.60 
+  8,814  +  21.30 
+  2,344  +  12.40 
Weekly Averages  Weekended  Weekended  Comparable 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (  + )/Deficiency (  - ) 
Borrowings 
Net free reserves (  + )/Net borrowed( - ) 
Federal Funds - Seven large Banks 
Net interbank transactions 
[Purchases (+)/Sales (-)] 
Net, U.S. Securities dealer transactions 
[Loans (+  )/Borrowings (-)] 
* Excludes trading account securities. 
#  Includes items not shown separately. 
1/30/80 
5 
336 
- 341 
+ 1,526 
- 436 
1/23/80  year-ago period 
0  77 
69  56 
69  21 
+1,139  +1,363 
- 306  +  616 
Editorial comments may be addressed to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

The foreign dimension

http://www.frbsf.org/publications/economics/letter/1980/el80-07.pdf

The foreign dimension

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Research Papers in Economics