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Research Papers in Economics

The past decade's turmoil in the interna-
tional economy has provided economists with
a treasure trove of interesting research topics.
Throughout this period, the developed nations
of the Atlantic Basin have wrestled with prob-
lems ofinflation, growth and exchange adjust-
ment. Meanwhile, the developing nations -
generally fast-developing nations - of the
Pacific Basin have faced variations ofthe same
problems. This issue ofthe Economic Review
investigates several of these problems, and
especially their effects on Pacific Basin
economies.
Maxwell J. Fry notes that some developing
economies have exhibited a negative correla-
tion between long-run average inflation and
real economic growth. He suggests one possi-
ble explanation - financial repression, that is,
institutional interest rates fixed below their
competitive, free-market equilibrium levels by
administrative fiat. To test that thesis, he
applies a small-scale model of inflation and
economic growth to seven Pacific Basin
developing countries that have utilized such
financial restrictions.
Fry's analysis provides an important policy
conclusion: "Flexible interest-rate policies in
financially repressed economies can be used to
counter inflationary shocks and accelerate the
real rate ofeconomic growth." An increase in
the real deposit rate towards its competitive
equilibrium level raises real money demand,
so reducing inflationary pressures. At the same
time, the availability ofcredit increases in real
terms. Consequently, real economic growth
rises, which increases real money demand
some more. "Inflation drops; the virtuous cir-
cle is complete."
Fry notes the well-known policy dilemma:,
Lowering the rate of monetary expansion to
bring down inflation raises unemployment and
reduces real economic growth in the short run.
5
"However, financially repressed economies
can use both the money supply and nominal
interest rates as independent policy instru-
ments." Monetary deceleration could have a
permanent inflation-reducing but temporary
depressing effect on real economic growth. But
raising nominal institutional interest rates
towards their competitive equilibrium levels
could have a temporary inflation-reducing but
permanent growth-enhancing impact. "In
combination, monetary deceleration with
interest-rate increases could lower inflation
and, simultaneously, raise the real rate ofeco-
nomic growth."
Hang-Sheng Cheng discusses the policy
dilemma faced by the People's Republic of
China, especially in the current environment
of inflation. "Over the years, tight controls
have strangled work incentives and caused
serious waste and inefficiency; yet under the
present institutional set-up, administrative
controls appear to be indispensable for com-
bating inflation." Then he asks: In the long
run, do the authorities have adequate policy
instruments for fighting inflation without ad-
ministrative controls? The answer to this
question will to a large extent depend on
whether China can forge an effective monetary
policy that does not rely primarily on direct
controls.
Cheng argues that money has a significantly
lesser role in the Chinese. command economy
than in the typical market economy, and that
monetary policy thus has a more restricted role
than it does elsewhere. China's monetary
policy has been circumscribed, first, by a
nearly complete reliance on administrative
controls for regulating monetary growth, and
second, by the monetary authorities' lack of
independence from both central- and local-
government authorities with respect to credit
allocation. Other complications arise from theauthorities' mechanical reliance on the quan-
tity equation of money for determining
money-growth targets - and also from their
reliance on a narrow definition of money,
limited to currency, which tends to lead to an
underestimate ofthe inflationary pressures on
the economy.
Cheng says that monetary policy is coter-
minous with credit policy, given China's
exclusive reliance on administrative controls
for regulating money growth. In this regard,
official thinking continues to be guided by the
"realbills doctrine" and by the so-called "sep-
aration principle," even though theoretical
support for these principles is found wanting
even in the Chinese context. These principles,
moreover, require continued reliance on ad-
ministrative controls for enforcing com-
pliance. "Their replacement by a flexible
interest-rate policy would not only be more in
tune with the spirit ofModernization, but also
would help support the development of an
effective monetary policy, operating through
market forces rather than administrative con-
trols."
Charles Pigott next reviews the experience
ofseveral major industrial countries since the
beginning of flexible exchange rates in 1973.
He asks, "To what extent have real factors -
factors such as tastes, productivity, and oil
costs, determining relative commodity prices
in the long-run - actually affected these
exchange rates?" He points out that nominal
exchange rates can be divided into two compo-
nents - one reflecting the ratio of national
price levels as determined (mainly) by money
supplies and demands, with the other 'real' or
'terms-of-trade' component reflecting the
relative prices of individual commodities. He
notes, however, that the 'terms-of-trade' is
potentially affected not only by real factors but
also by real interest fluctuations or other in-
fluences leading to temporary changes in rela-
tive commodity prices.
Pigott shows that fluctuations in nominal
exchange rates about their trend have largely
represented terms-of-trade changes in recent
years. And for the floating-rate period as a
whole, variations in the terms of trade have
6
tended to be highly persistent, suggesting
they mainly reflect real-factor influences.
"Thus, real factors have represented a major
source - in some cases the single largest
source- of exchange-rate fluctuations about
trend over the last eight years." He adds that
this conclusion, although tentative, suggests
that models of exchange-rate determination
which consider only financial-market condi-
tionswhile ignoring fundamental commodity-
price determinants will inevitably miss an
important aspect of actual exchange-rate
behavior.
Pigott warns, however, that the importance
ofreal factors creates difficulties for interpret-
ing actual movements in exchange rates.
"This is particularly the case as neither real
interestrates nor the long-run factors influenc-
ing relative commodity prices are directly
observable." He notes that U.S. officials have
used foreign-exchange market conditions as a
major policy guide in recent years, partly
reflecting a belief that these markets convey
early signals ofdeveloping inflation pressures.
"Butthe analysis here indicates thatexchange-
market signals normally are highly ambiguous,
reflecting as they do a variety offactors. Since
the appropriate response to one source of
exchange-rate variation may be inappropriate
in another case, policy-makers at the least
should be very cautious in using foreign-
exchange market developments as a regular
guide to policy."
Kenneth Bernauer turns to another aspect of
exchange rates - specifically, the effective-
ness ofexchange-rate changes on the Japanese
trade account. He notes that analysts no longer
take for granted the view that exchange-rate
movements will be completely passed forward
into export and import prices. In his analysis,
therefore, he first considers the impact of an
exchange-rate change on the prices of exports
and imports, and then considers the effects of
these price changes on the quantities
demanded of exports and imports. This two-
stage procedure permits him to trace out the
"J curve" measuring the effects of a yen de-
preciation on the Japanese trade account. The
curve is so named because the initial deteriora-Hon and subsequent improvement in a de-
preciating country's trade account resemble
the letter J when the trade account is plotted
on the vertical axis against time on the
horizontal axis.
Bernauer measures this effect by estimating
volume and price equations for four separate
commodity categories. His results show that a
lO-percent yen depreciation would lead to
about a 3.B-percent deterioration in the terms
oftrade. With no change in export and import
quantities, this terms-of-trade effect would
then lead to an initial deterioration in the trade
account. The duration of the worsening trade
balance - the duration ofthe first segment of
the J-curve - would depend upon the time lag
between movements in quantities and prices,
and upon the size of the price elasticities of
demand for exports and imports.
Turning to the actual trade results, Bernauer
shows that a 33.6-percent effective yen de-
preciation between the third quarter of 1978
7
and the first quarter of1980 was followed by a
17.6-percent rise in Japanese export volume
between 1979IV and 1980IV - and by a 6.8-
percent decline in Japanese import volume.
Ironically, the export upsurge occurred almost
simultaneously with a 16.6-percent apprecia-
tion of the yen against the dollar and major
European currencies between 19801 and
1980IV. "From the evidence, though, the
reverse J-curve effects stemming from the
yen's appreciation made only a modest con-
tribution to the improvement in Japan's trade
account. The expanding surpluses of1980 and
1981 stemmed largely from an improvement
in Japan's price competitiveness, leading to
robust export-volume gains." Bernauer thus
sees little prospect of a reduction in the U.S.
bilateral-trade deficit with Japan, given the
continued erosion ofU.S. price competitiveness
during 1981. The U.S.-Japanese controversy
over trade matters consequently may not sub-
side in the foreseeable future.

Inflation, growth and exchange rates

http://www.frbsf.org/publications/economics/review/1981/81-4_5-7.pdf

Inflation, growth and exchange rates

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Research Papers in Economics