FEDERAL RESERVE BANK OF SAN FRANCISCO ECONOMIC REVIEW

SPRING 1979 The newspapers and academicjournals are full standards, and has stubbornly remained at this of theories (sometimes contradictory theories) level throughout the current expansion. "This which attempt to explain each striking new persistence of a high perceived underlying infla­ development occuring in this era ofrapidly rising tion rate doubtless has given inflation an import­ prices and wildly fluctuating exchange rates. ant momentum of its own as market partici­ Consider, for example, severalimportant policy­ pants, in an effort to protect themselves against oriented questions which have arisen during the future inflation, build this perception into their past year or two. What is the basic underlying wage and price demands." rate of inflation? Do speculative influences ex­ This point leads Scadding to a second import­ plain the steep drop in the dollar's value during ant conclusion-"Even if aggregate demand the 1977-78 period? Or has the very strength of growth could be moderated, pressure for price the U.S. economy led to the decline in the value and wage increases would continue to emanate of the nation's currency? The task ofanalysis, as from the cost side for a considerable time." The the following articles indicate, is to apply sophis­ implication for the real economy is not reassur­ ticated tests to the available statistical evidence, ing, since output and employment may have to as a means of devising correct answers to these remain below normal levels for a fairly protract­ questions-and therefore correct policy solu­ ed time if any significant progress is to be made tions to the nation's problems. against inflation. In analyzing the recent inflation, John Scad­ Michael Keran, in his contribution, analyzes ding says, "Only the systematic changes in prices the reasons for the decline in the international are of any use in forecasting future prices; by value of the dollar over the 1977-78 period. He definition, the unsystematic, transitory changes quickly dismisses the popular impression that contain no information about the future course the dollar was driven down by speculators with a of prices." He then presents a model of how vested interest in an undervalued dollar, noting individuals might rationally extract information that speculation tends to drive the value of a about the underlying inflation rate from ob­ currency towards a long-run equilibrium value served price changes, and then use that informa­ determined by economic fundamentals. Those tion to forecast future prices. speculators who most clearly perceive the under­ Scadding argues that successively higher levels lying fundamentals and accordingly take a posi­ of inflation have become imbedded in the econo­ tion in the exchange market will generally make my since 1960. The underlying inflation rate the most profits, while those speculators who go fluctuated around 1.7 percent until the late against the fundamentals will generally lose 1960's, averaged about 4.8 percent in the 1971-73 money. Because ofthis self-selection process, the period, and hovered around 7.0 percent in the observed value of the dollar should not deviate expansion of the late 1970's. "Neither the significantly from the level consistent with econ­ 1969-70 nor the 1973-75 recession made a siz­ omic fundamentals for more than a short period able dent in the underlying rate; the most they of time. seemed capable of doing was to stabilize the Keran concentrates on explaining movements inflation rate until some new disturbance carried in the exchange value of the dollar against the it to a higher plateau." currencies of seven other major industrial coun­ The ingrained rate of inflation currently per­ tries in the 1974-79 period of flexible exchange ceived by the market is very high by historical rates. He first summarizes the apparent

5 monetary-policy considerations which shaped dollar price of internationally traded goods, the monetary developments during this period. Then emergence offlexible exchange rates can shorten he shows that actual changes in the "excess the lag between money and prices. money supply"-nominal money supply less real Michael Bazdarich raises the question of money demand-led to changes in prices and whether the recent strength in the U.S. economy exchange rates in a way consistent with econom­ has led to the weakness ofthe dollar. According ic theory and empirical statistical tests. He bases to the theory in question, fast economic growth his analysis on two propositions: I) the exchange in a country causes an acceleration in its imports rate between two domestic currencies will adjust and therefore a deterioration in its trade balance. to reflect changes in the relative domestic pur­ This ultimately would lead to a depreciation of chasing power ofthe currencies; and 2) domestic the domestic currency. monetary developments are a major determinant Bazdarich questions this approach, arguing of domestic inflation rates, and thus of the instead that true economic growth, as evidenced domestic purchasing power of a given currency. by rapid growth in productive capacity, or po­ Keran estimates his equations with two alter­ tential GNP, typically strengthens the domestic native measures-money, and money plus quasi­ currency. "Growth of this type implies improv­ money. The former is the narrow definition of ing supply and wealth conditions, which can money including currency and demand deposits. more than offset the effects of rising demand on This primarily satisfies the means-of-payment the trade balance. Sharp cyclical increases in motive for holding money. The latter is the GNP, on the other hand, can weaken the domes­ broader definition which includes currency, de­ tic currency. These movements typically involve mand deposits and quasi-monetary deposits of an increase in demand with no change in produc­ commercial banks. This measure includes a tive capacity, and so do not generate any offset­ substantial store-of-value motive for holding ting effects to the rise in imports." money. Both definitions provided statistically Bazdarich argues that the popular analysis has significant results, although the broader measure missed this important distinction. His statistical gave generally superior results. "Given the dol­ tests indicate no support for the argument that lar's role as both an international means of truly strong growth in aneconomy will necessari­ payment and store ofvalue, the superiority ofthe ly tend to weaken exchange rates. "Indeed, broader measure of money is not surprising." recent. U.S. evidence suggests that the opposite Keran concludes that an important share of has been the case. The 'strong economy, weak the exchange-rate movements since 1975 can be currency'explanation ofthe dollar's decline thus explained by monetary factors, rather than by does not appear to have any hard theoretical or speculation or changes in such real factors as the empirical evidence to support it." Bazdarich's terms of trade. His study also implies that findings-which parallel Keran's-suggest that foreign-exchange markets adjust much more recent GNP increases have been mostly cyclical, quickly than domestic commodity markets to caused perhaps by an overly expansionary poli­ changes in domestic monetary conditions. Be­ cy, and for that reason have been associated with cause these exchange rate changes can affect the a falling dollar.

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