Iowa State University Capstones, Theses and Retrospective Theses and Dissertations Dissertations 1985 The impacts of monetary policies on US agriculture S. Devadoss Iowa State University Follow this and additional works at: https://lib.dr.iastate.edu/rtd Part of the Economics Commons Recommended Citation Devadoss, S., "The impacts of monetary policies on US agriculture " (1985). Retrospective Theses and Dissertations. 7838. https://lib.dr.iastate.edu/rtd/7838 This Dissertation is brought to you for free and open access by the Iowa State University Capstones, Theses and Dissertations at Iowa State University Digital Repository. It has been accepted for inclusion in Retrospective Theses and Dissertations by an authorized administrator of Iowa State University Digital Repository. For more information, please contact [email protected]. INFORMATION TO USERS Tliis reproduction was made from a copy of a document sent to us for microfilming. 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THE IMPACTS OF MONETARY POLICIES ON U.S. AGRICULTURE Iowa State University PH.D. 1985 University Microfilms Intsrricltionsl 300 N. zeeb Road, Ann Arbor, Ml48106 The impacts of monetary policies on U.S. agriculture by S. Devadoss A Dissertation Submitted to the Graduate Faculty in Partial Fulfillment of the Requirements for the Degree of DOCTOR OF PHILOSOPHY Major: Economics Approved : Signature was redacted for privacy. In Charge of Major Work Signature was redacted for privacy. For the Major Department Signature was redacted for privacy. For the Graduate College Iowa State University Ames, Iowa 1985 ii TABLE OF CONTENTS Page CHAPTER I. INTRODUCTION 1 The Problem 1 Objectives of the Study 3 CHAPTER II. REVIEW OF THE LITERATURE 5 Exchange Rates and Agricultural Commodity Trade 5 Interest Rates and U.S. Agriculture 9 Inflation and U.S. Agriculture 10 Monetary Policies and the U.S. Farm Sector 11 Previous Farm Sector Models 13 First generation models 14 Second generation models 14 Third generation models 15 CHAPTER III. TRANSMISSION MECHANISMS BETWEEN AGRICULTURE AND MACROECONOMY 17 Exchange Rate Effects (Trade Effects) 17 Interest Rate Effects (Stock and Cost Effects) 18 Inflation Effects (Cost Effects) 19 Income Effects 19 CHAPTER IV. METHODOLOGY 23 Graphical Representation 23 Mathematical Representation 28 The agricultural sector 28 General economy 36 CHAPTER V. EMPIRICAL ANALYSIS AND MODEL VALIDATION 49 Page Estimation -^9 Farm Sector 67 General Economy 71 Validation of the Model 75 Root Mean Square Error (RMSE) 77 Root Mean Square Percentage Error (RMSPE) 77 Theil's inequality coefficient (U) 77 Turning point method 79 Results of the model validation 79 CHAPTER VI. DYNAMIC POLICY ANALYSIS 111 CHAPTER VII. SUMMARY AND CONCLUSIONS 128 Conclusions and Implications 129 Directions for Further Research 132 BIBLIOGRAPHY 135 ACKNOWLEDGEMENTS 143 1 CHAPTER I. INTRODUCTION The Problem . A representation of the agricultural sector was a major component of the early macroeconometric models developed by Klein and Goldberger in the 1950s. Since that time, accepted macroeconomic theory and the theory of the macroeconomics of agriculture have followed separate paths of development. Schuh (1974) has called attention to this dual evolution by noting that the sectoral emphasis in agriculture has resulted in the neglect of the linkages of agriculture with the rest of the economy. Schuh (1979) further indicated that the agricultural commodity markets can no longer be understood in isolation from the capital market and other monetary factors either domestically or internationally. The need for improved econometric models to capture the possible interactions between the macroeconomy and agriculture was suggested by Fox (1973). These two economists' suggestions and the recent effects of the macrovariables, such as the exchange rate, on the farm sector have led to an increasing awareness among economists of the importance of the performance of the agricultural sector in relation to the macroeconomy, and conversely, of the effects of macroeconomic performance on agricul­ ture (see for example. King, 1975; Popkin, 1975; Roop and Zeitner, 1977; Johnson, 1977; Just, 1977; Chambers, 1981; Penson and Hughes, 1979; Van Duyne, 1979; Gardner, 1981; Starleaf, 1982; and McCalla, 1982). Despite the fact that a number of agricultural sector models have been developed specifically for inclusion within a large macromodel 2 (e.g., Cromarty, 1959), these models are not entirely satisfactory because the linkages between the macroeconomy and agriculture are either missing or specified inadequately. Furthermore, macromodel builders include agriculture as a satellite model in the macromodels. The agricultural sector in these stand-alone models is influenced by relatively few macroeconomic variables, such as disposable income and the implicit price deflator. Thus, in these models, the transmission mechanisms between the farm and nonfarm sectors through the macrovariables are not properly recognized. The increased integration of the U.S. farm sector with the nonfarm sector during the past decade, both domestically and internationally, led to significant implications for farm product prices, input costs, and farm income from developments in international and/or domestic economies. This is true, especially in light of the effects of exchange rates, interest rates, and inflation, all of which are influenced by macroeconomic policies and capital markets, on the farm sector. Schuh (1983) argues that the value of the dollar in terms of other currencies is very crucial for agricultural trade. For example, an expansionary monetary policy will reduce the value of the dollar, providing stimulus for dollar exports, and thus increasing aggregate demand for farm commodities. Like the exchange rate, the interest rate is another macrovariable which has a significant influence on the farm income through the cost structure of the farm sector. Chambers (1984) emphasized the importance of interest rates on agricultural production. To date, however, no 3 empirical work has been done to address the impact of interest rates on agricultural production and inventory storage (Schuh, Hodges, and Orden, 1980). Inflation—a rise in the general price level—is another important macrovariable which has a significant effect on the farming sector. Inflation has led to higher prices of both farm inputs and outputs, and, thus, has influenced production decisions. Finally, an increase in the real income of the economy means higher spending for the output of the economy. The effect of this increased spending on the farm sector is a higher domestic demand for the farm products. From macrotheory, we know that these four macrovariables—exchange rates, interest rates, inflation, and real income—are influenced by macropolicies, particularly by monetary policies of the Federal Reserve. Thus, changes in monetary policy are likely to have significant impacts on the prices and incomes of the agricultural economy. Objectives of the Study Given the statement of the problem, the objectives of this research are: 1. To develop a general equilibrium econometric model of the U.S. to investigate the relationships between the macrosector and agriculture through exchange rates, interest rates, inflation, and income 1inkages. 4 2. To examine, through these four linkages, the effects of changes in U.S. monetary policy on the U.S. farm sector, particularly on crop prices, livestock product prices, crop production and demand, exports, inventories, livestock production and demand, and farm incomes. 3. To evaluate and draw policy implications from the empirical findings. The