V ol . 7 1 , N o.

1 Ja n u a r y / F e b r u a r y 1989

3 P a y m e n ts S y s te m R i s k : W h a t Is It
an d W h a t W ill H a p p e n If W e T ry
To R e d u c e It?

1 8 F e d e ra l B u d g e t T re n d s a n d th e
1981 R e ag an E co n o m ic Plan

32 A n I n tro d u c ti o n to N o n - T a ri f f
B a r r i e r s to T r a d e

47 C an a C e n tra l B a n k In f lu e n ce Its
C u r r e n c y ’s R e a l V a l u e ?
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F e d e ra l R e s e rv e B an k o f S t. L o u i s

R evi ew
Ja n u a r y / F e b r u a r y 1989

I n T h i s Is s u e . . .
B o th c o m m e r c i a l b a n k s a n d th e F e d e r a l R e s e r v e a s s u m e r is k b y p a r­
ti c i p a ti n g in th e p a y m e n ts s y s te m . In r e c e n t y e a r s , t h e F e d e r a l R e s e r v e
h a s ta k e n a c tio n s to lim it s u c h r is k , a n d f u r th e r a c tio n s a r e u n d e r c o n ­
s i d e r a ti o n . In th e f i r s t a r ti c l e in th i s Review, " P a y m e n ts S y s te m R is k :
W h a t Is I t a n d W h a t W ill H a p p e n If W e T r y to R e d u c e It ? ” R . A l to n
G ilb e r t u s e s s im p le b a l a n c e s h e e t e n tr i e s to d e s c r ib e h o w p a y m e n ts a f ­
f e c t r i s k . H e a ls o e x a m i n e s t h e li k e ly e f f e c t s o f p o s s i b l e a c t i o n s to
r e d u c e p a y m e n ts s y s te m ris k . A m o n g th e a c tio n s c o n s id e r e d a re c h a rg ­
in g f e e s o n th e d a y lig h t o v e r d r a f ts o f b a n k s ’ r e s e r v e a c c o u n ts a t F e d e r a l
R e se rv e b an k s an d r e q u ir in g b a n k s th a t o v e r d r a w th e ir r e s e r v e a c ­
c o u n ts to h o ld a d d itio n a l r e s e r v e b a l a n c e s . T h e illu s tr a tio n s a ls o c o n ­
s i d e r t h e o p e r a t i o n o f C H IP S — t h e p r i v a t e s y s t e m f o r e le c tr o n ic
p a y m e n ts — u n d e r a p r o c e d u r e th a t e n s u r e s th e e x e c u tio n o f p a y m e n ts
m e s s a g e s p r o c e s s e d b y t h a t s y s te m .

* * *

In th e s e c o n d a r tic le in th is Review, " F e d e r a l B u d g e t T r e n d s a n d th e

1981 R e a g a n E c o n o m ic P la n ,” K e ith M . C a rls o n a s s e s s e s th e s u c c e s s a n d
f a ilu r e o f f e d e r a l b u d g e t p o lic y d u r in g th e e ig h t- y e a r R e a g a n a d m in is tr a ­
tio n . T h e a r tic le c o m p a r e s th e 1981 R e a g a n b u d g e t p l a n , a l o n g w i t h i ts
e c o n o m ic a s s u m p tio n s , w ith th e a c tu a l p e r f o r m a n c e o f th e s e b u d g e t
f ig u r e s o v e r th e 1 9 8 1 - 8 8 p e rio d .

C a r ls o n c o n c lu d e s th a t th e R e a g a n b u d g e t p o lic y w a s s u c c e s s f u l in
s e v e r a l r e s p e c ts , n a m e ly , in c r e a s in g n a tio n a l d e f e n s e s p e n d in g , r e d u c in g
th e g r o w th o f th e n o n in te r e s t p o r tio n o f n o n d e f e n s e s p e n d in g a n d
r e d u c i n g t h e o v e r a l l t a x b u r d e n . T h e m a jo r e x c e p t i o n t o th e R e a g a n
b u d g e t p la n w a s th e r is e in n e t in te r e s t p r o d u c e d by a f a i l u r e to
f o r e c a s t th e 1 9 8 1 - 8 2 r e c e s s io n , w h ic h , in tu r n , h a d a c o m p o u n d in g in ­
t e r e s t e f f e c t o n o u tla y s .

* * *

R e s tr ic tio n s o n in te r n a tio n a l tr a d e , p r im a r ily n o n - ta r if f b a r r ie r s , h a v e

m u ltip lie d r a p id ly in th e 1 9 8 0 s . In th e th i r d a r ti c l e in th is Review, "A n
In tr o d u c tio n to N o n - T a r if f B a r r i e r s to T r a d e ,” C le tu s C . C o u g h lin a n d
G e o ffre y E. W o o d p r o v id e a p r im e r o n th e s e b a r r i e r s . T h e a u th o r s
b e g in b y id e n tif y in g n u m e r o u s n o n - ta r if f b a r r i e r s a n d d o c u m e n t th e ir
p r o lif e r a tio n . T h e g e n e r a l e f f e c ts o f n o n - ta r if f b a r r i e r s , lik e th o s e o f
ta r i f f b a r r i e r s , a r e to in c r e a s e th e d o m e s tic p r i c e s o f th e p r o te c te d
g o o d s a n d to im p e d e tr a d e to b e n e f i t s e le c te d p r o d u c e r s a t th e e x p e n s e
o f d o m e s tic p r o d u c e r s . N u m e r o u s r e a s o n s f o r th e in c r e a s in g u s e o f n o n -
t a r i f f in s te a d o f ta r if f b a r r i e r s a r e p ro v id e d . A m o n g th e r e a s o n s a r e
th e i r m o r e c e r ta i n p r o te c tiv e e f f e c ts , th e p o s s ib ility th a t s o m e b e n e f i ts
c a n b e c a p tu r e d by f o r e ig n p ro d u c e r s a n d d o m e s tic p o litic ia n s a n d th e
f a c t th a t th e ir a d v e r s e e f f e c ts a r e g e n e r a lly le s s o b v io u s to c o n su m e rs.

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Federal Reserve Bank of St. Louis
 2

To d a te , a tte m p ts th r o u g h th e G e n e r a l A g r e e m e n t o n T a r i f f s a n d T ra d e
(G A T T ) to c o u n te r a c t th e e x p a n s io n o f n o n - ta r if f b a r r i e r s h a v e m e t w ith
little s u c c e s s . A b r i e f h is to r y o f th e s e a tte m p ts c o m p le te s th e p a p e r .

***

T h e la r g e f lu c tu a tio n s in e x c h a n g e r a te s o b s e r v e d in th e 1 9 8 0 s h a v e
p r o m p te d m a n y c e n tr a l b a n k s o f in d u s tr ia liz e d n a ti o n s to d is c u s s e x ­
c h a n g e m a r k e t in te r v e n tio n . T h e s e d is c u s s io n s h a v e e x p lo r e d w h e th e r it
is a p p r o p r ia te to u s e m o n e ta r y a c tio n s to in f lu e n c e e x c h a n g e r a te s a n d ,
if so , h o w s u c c e s s f u l s u c h e f f o r ts m ig h t b e . In th e f in a l a r t i c l e in th is
is s u e , “ C a n a C e n tr a l B a n k In f l u e n c e Its C u r r e n c y ’s R e a l V a lu e ? T h e
S w is s C a s e ," M ic h a e l T . B e lo n g ia a n d W e r n e r H e r m a n n a n a ly z e th e
d is tin c t e x p e r ie n c e o f o n e c e n tr a l b a n k p u r s u in g a n e x c h a n g e - r a te
o b je c t i v e .

In th e f i r s t p a r t o f t h e i r a r ti c l e , B e lo n g ia a n d H e rm a n n r e v ie w th e
e c o n o m ic th e o r y th a t r e la te s m o n e ta r y a c tio n s to m o v e m e n ts in th e r e a l
e x c h a n g e r a te . A f te r c o n c lu d in g th a t th e e f f e c ts , i f a n y , w ill b e s h o r t­
liv e d , th e y in v e s ti g a te h o w a c tio n s b y th e S w is s N a tio n a l B a n k , r e l a ti v e
b o th to th e F e d e r a l R e s e r v e a n d G e rm a n B u n d e s b a n k , h a v e a f f e c te d th e
S w is s f r a n c / d o lla r a n d S w is s fra n c / D M r e a l e x c h a n g e r a te s . T h e ir r e s u lts
in d ic a te th a t a c e n tr a l b a n k c a n in f l u e n c e r e a l e x c h a n g e r a te s o n ly fo r a
p e rio d o f m o n th s ; m o r e o v e r , a predictable r e s p o n s e w ill o c c u r o n ly w ith
re g a rd to th e o n e b ila te r a l r a te th a t r e c e iv e s h ig h e s t p r io r ity a s a p o lic y
o b je c t i v e .

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Federal ReserveF EBank
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 3

R. Alton Gilbert

R . A lto n G ilb e rt is a n a s s is ta n t v ic e p r e s id e n t a t th e F e d e ra l
R e s e rv e B a n k o f S t. L o u is . D a w n M . P e te rs o n p r o v id e d re s e a r c h
a s s is ta n c e .

P a y m e n ts S y s te m R isk : W h at I s It
a n d W h at W ill H ap p e n If W e T ry
T o R e d u ce I t?

O
O T H c o m m e r c ia l b a n k s a n d th e F e d e ra l R e ­ s i g n e d to li m it th e r is k a s s u m e d b y R e s e r v e R a n k s
s e rv e a s s u m e a c e r ta in a m o u n t o f ris k in p a r tic i­ a s w e ll a s c o m m e r c i a l b a n k s w h o p a r tic ip a te in
p a tin g in th e p a y m e n ts s y s te m . T h is p a p e r p r o ­ p r i v a te s y s t e m s f o r t h e i r e l e c t r o n i c p a y m e n t s . ( S e e
v id e s a n in tr o d u c ti o n to p a y m e n ts s y s te m ris k a n d a p p e n d i x 1 f o r a d e s c r i p t i o n o f t h a t p o l i c y .)
th e p u b li c p o li c y is s u e s in v o lv e d in lim itin g th e
r i s k . U s i n g s i m p l e b a l a n c e s h e e t e n t r i e s to i l l u s ­
Federal Reserve Daylight Overdraft
tr a t e , t h e p a p e r w i l l e x a m i n e h o w p o l i c i e s i n ­ Risk and the Operation o f Fedwire
t e n d e d to r e d u c e p a y m e n t s s y s t e m ris k w o u ld
W h ile v a r io u s ty p e s o f tr a n s a c tio n s a f f e c t th e
a f f e c t b a n k s a n d b a n k c u s to m e r s .
r e s e r v e b a l a n c e s o f b a n k s , d a y lig h t o v e r d r a f ts g e n ­
e r a lly r e f le c t la r g e tr a n s a c tio n s th r o u g h F e d w ir e ,
PA Y M EN T S S Y S T E M R I S K : W H A T IS th e w ir e tr a n s f e r s y s te m o p e r a te d b y th e F e d e r a l
R e s e r v e S y s te m . In s ti tu ti o n s w ith r e s e r v e o r c l e a r ­
IT ?
in g a c c o u n t s a t a R e s e r v e B a n k m a y tr a n s f e r th e i r
M a n y b a n k s o v e rd ra w th e ir re s e rv e a c c o u n ts a t r e s e r v e b a l a n c e s to o t h e r i n s t i t u t i o n s th a t h a v e
th e F e d e r a l R e s e r v e d u r in g p a r t o f e a c h b u s i n e s s s im ila r a c c o u n ts . T h e s e tr a n s f e r s , w h ic h a v e ra g e d
d a y a s th e y p r o c e s s p a y m e n ts w ith in th e p a y ­ $ 6 0 5 b illio n p e r b u s in e s s d a y in 1 9 8 7 , a re
m e n ts s y s te m . T h e F e d e r a l R e s e r v e is c o n c e r n e d p r o c e s s e d e l e c tr o n ic a lly th r o u g h F e d w ir e .
a b o u t th e e x te n t o f th is in tr a d a y c r e d it f o r s e v e ra l
F e d e r a l R e s e r v e B a n k s t r a n s f e r r e s e r v e s to r e ­
r e a s o n s . F i r s t o f a l l , s i n c e it d o e s n o t c h a r g e i n t e r ­
c e iv in g b a n k s e v e n if th e r e s e r v e b a l a n c e o f th e
e s t o n th e in tr a d a y c r e d it it e x te n d s , it is p ro v id in g
s e n d i n g b a n k is i n s u f f i c i e n t to c o v e r t h e tr a n s f e r s .
th i s o v e r d r a f t f a c i lity a t n o c o s t to b a n k s a n d , th u s ,
T ra n s f e r s o v e r F e d w ire a re “ f in a l” w h e n th e r e c e iv ­
m a y b e o v e ru s e d b y b a n k s . S e c o n d , a n d m o re im ­
in g b a n k s a r e n o tif ie d o f th e tr a n s f e r s . T h u s , if a
p o r t a n t , it i s p o s s i b l e , t h o u g h u n l i k e l y , t h a t a b a n k
s e n d i n g b a n k s h o u l d f a il w h ile its r e s e r v e a c c o u n t
c o u l d f a il w h il e its r e s e r v e a c c o u n t is o v e r d r a w n .
w a s o v e rd ra w n , th e F e d e r a l R e s e rv e w o u ld h a v e
I n t h i s e v e n t, t h e F e d e r a l R e s e r v e w o u l d b e c o m e a
n o c la im o n b a n k s th a t r e c e iv e d r e s e r v e s f ro m th e
g e n e r a l c r e d ito r o f th e f a ile d b a n k . F in a lly , th e F e d
f a ile d b a n k o v e r F e d w ire .
is c o n c e r n e d w ith th e ris k th a t b a n k s a s s u m e
th r o u g h th e i r p a r ti c i p a ti o n in p r iv a te w ir e tr a n s f e r U .S . T r e a s u r y a n d a g e n c y s e c u r i t i e s a l s o a r e
s y s te m s . C u r r e n t F e d e r a l R e s e r v e p o li c y is d e ­ tr a n s f e r r e d a m o n g b a n k s o v e r F e d w ir e . O w n e r s h ip

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 4

r e c o r d s o f th e s e s e c u r itie s a re m a in ta in e d in e a c h f o r e i g n b a n k s . M e m b e r s o f C H IP S s e n d a n d r e c e i v e
F e d e r a l R e s e r v e B a n k ’s c o m p u te r s y s te m . B a n k s p a y m e n t m e s s a g e s d u r in g th e d a y ; n o f u n d s a re
c a n t r a n s f e r s e c u r i t i e s h e l d i n t h e i r n a m e s to o t h e r a c t u a l l y t r a n s f e r r e d to c o v e r t h e s e p a y m e n t m e s ­
in s titu tio n s th r o u g h th e s e c o m p u te r s , a s y s te m s a g e s , h o w e v e r, u n til th e e n d o f th e d a y . N e t o b li­
c a lle d “ b o o k - e n tr y .” A tr a n s f e r o f s e c u r itie s in g a t i o n s a r e s e t t l e d a t d a y ’s e n d t h r o u g h F e d w i r e
b o o k - e n tr y f o rm c a n b e a rr a n g e d e ith e r in c o n ­ t r a n s f e r s i n t h e r e s e r v e a c c o u n t s o f C H IP S p a r t i c i ­
ju n c t i o n w i t h a t r a n s f e r o f r e s e r v e s o f e q u a l v a l u e p a n t s . B a n k s i n n e t d e b i t p o s i t i o n s o n C H IP S a t
o r a s a s e p a r a te tr a n s a c tio n . S u c h s e c u r itie s tr a n s ­ t h e e n d o f t h e d a y ( v a lu e o f p a y m e n t m e s s a g e s
a c t i o n s c o n t r i b u t e t o d a y l i g h t o v e r d r a f ts , s i n c e s e n t e x c e e d s th e v a lu e o f p a y m e n t m e s s a g e s r e ­
ty p i c a l ly th e r e s e r v e a c c o u n t s o f b a n k s a r e d e b i te d c e iv e d ) tr a n s f e r f u n d s f r o m th e i r a c c o u n t s a t R e ­
w h e n th e ir b o o k - e n tr y s e c u r itie s a c c o u n ts a re s e r v e B a n k s to a r e s e r v e a c c o u n t m a i n t a i n e d b y
c r e d ite d . T r a n s f e r s o f b o o k - e n tiy s e c u r itie s o v e r th e c le a r in g h o u s e a t th e F e d e r a l R e s e r v e B a n k o f
F e d w ire a v e ra g e d $ 3 1 2 b illio n p e r d a y in 1 9 8 7 . N e w Y o rk , w h ile b a n k s in n e t c r e d it p o s i tio n s r e ­
c e iv e r e s e r v e tr a n s f e r s f r o m th a t a c c o u n t. T h e
T h e F e d e r a l R e s e r v e m e a s u r e s i t s e x p o s u r e to
v a l u e o f p a y m e n t m e s s a g e s p r o c e s s e d b y C H IP S
p a y m e n ts s y s te m r is k b y s im p ly s u m m in g th e
a v e ra g e d $ 5 5 5 b illio n p e r d a y in 1 9 8 7 .
m a x i m u m d a y l i g h t o v e r d r a f t e a c h d a y a c r o s s a ll
b a n k s . I n 1 9 8 7 , t h e F e d ’s e x p o s u r e t o d a y l i g h t S y s t e m i c r i s k r e f e r s to t h e r i s k t h a t t h e f a i l u r e o f
o v e r d r a f ts a v e r a g e d $ 1 1 2 b i l l i o n , a p p r o x i m a t e l y 5 3 o n e b a n k w i l l c a u s e o n e o r m o r e o t h e r b a n k s to
p e r c e n t o f w h i c h c a n b e a tt r i b u t e d to tr a n s a c t i o n s f a il. O n e w a y th a t th i s c o u l d h a p p e n is th r o u g h
in v o lv in g b o o k - e n tr y g o v e r n m e n t s e c u r i t i e s .1 S o m e p a r t i c i p a t i o n i n C H IP S . I f a b a n k f a i l s w h i l e i n a n e t
s p e c i f i c f e a tu r e s o f th is ris k m e a s u r e s h o u ld b e d e b i t p o s i t i o n o n C H IP S , o t h e r C H IP S p a r t i c i p a n t s
n o te d . F ir s t, u n l ik e c o n v e n ti o n a l r is k m e a s u r e s , c o u ld s u f f e r l o s s e s a s w e ll, d e p e n d in g o n th e p r o ­
t h e F e d e r a l R e s e r v e ’s m e a s u r e d o e s n o t i n c o r p o ­ c e d u r e s i n f o r c e f o r d e a l i n g w ith s u c h a d e f a u l t.
r a te th e p r o b a b ility th a t a b a n k w ill f a il w h ile in a n P a y m e n ts o v e r F e d w ir e , in c o n t r a s t, in v o lv e n o
o v e rd ra f t p o s i ti o n o r th e p r o b a b ility o f F e d lo s s e s s y s te m ic ris k . T h e F e d e r a l R e s e r v e w o u ld a b s o r b
in s u c h s itu a tio n s .2 S in c e th e F e d e r a l R e s e rv e h a s a n y lo s s e s r e s u ltin g f ro m f a ilu r e s b y b a n k s w ith
n e v e r i n c u r r e d a l o s s o n d a y l i g h t o v e r d r a f ts , t h e o v e rd ra w n re se rv e a c c o u n ts .
p r o b a b ility o f l o s s e s in th e f u tu r e a r e q u ite lo w .
T h e F e d e r a l R e s e rv e m e a s u r e s th e p a y m e n ts
S e c o n d , it e x c e e d s th e a c tu a l s u m o f r e s e r v e s y s t e m r i s k a s s u m e d b y C H IP S p a r t i c i p a n t s a s t h e
a c c o u n t o v e r d r a f ts a t a n y p o i n t d u r in g th e d a y ; s u m o f th e ir m ax imu m n e t d e b it p o s itio n s d u r in g
th e m a x i m u m o v e r d r a f ts o f in d i v id u a l b a n k s ty p i ­ t h e d a y o n C H IP S . T h i s m e a s u r e a v e r a g e d $ 4 3 . 7
c a lly o c c u r a t d if f e r e n t tim e s d u r in g th e d a y . b illio n in 1 9 8 7 .
T h ir d , it r e p r e s e n ts th e lo s s th a t th e F e d e r a l R e ­
T o r e la te th is m e a s u r e to s y s te m ic r is k is d if ­
s e r v e w o u ld i n c u r o n a g iv e n d a y if a ll b a n k s w ith
f i c u l t , h o w e v e r ; u n d e r c u r r e n t C H IP S r u l e s , p a y ­
o v e rd ra w n re s e r v e a c c o u n ts f a ile d w h e n th e ir
m e n t m e s s a g e s d o n o t r e f le c t in tr a d a y e x te n s io n s
o v e r d r a f ts w e r e a t m a x i m u m le v e ls a n d t h e F e d ­
o f c r e d it a m o n g b a n k s b u t p ro v is io n a l p a y m e n ts
e r a l R e s e r v e r e c o v e r e d n o th in g .
w h ic h m a y b e u n w o u n d a t th e e n d o f th e d a y . If a
Systemic Risk and the Operation o f b a n k c o u ld n o t c o v e r its n e t d e b it p o s i tio n o n
C H IP S a t t h e e n d o f t h e d a y , a l l p a y m e n t m e s s a g e s
CHIPS
to a n d f r o m t h a t b a n k w o u l d b e c a n c e l e d ; n e w n e t
T h e C le a r in g H o u s e In te r b a n k P a y m e n ts S y s te m d e b it a n d c r e d it p o s itio n s w o u ld th e n b e c a l c u ­
( C H IP S) i s a n e l e c t r o n i c p a y m e n t s y s t e m o p e r a t e d l a t e d f o r t h e r e m a i n i n g C H IP S p a r t i c i p a n t s , a n d
b y t h e N e w Y o r k C l e a r i n g H o u s e . It c u r r e n t l y i s t h e p a y m e n ts w o u l d b e m a d e to c o v e r t h e s e r e v is e d
o n l y p r i v a te e l e c t r o n i c p a y m e n t s y s t e m i n o p e r a ­ p o s i t i o n s . U n w i n d i n g C H IP S p a y m e n t s b e c a u s e o f
t i o n i n t h e U n i t e d S t a t e s . C H IP S h a s a b o u t 1 4 0 a d e f a u l ti n g b a n k , h o w e v e r , c o u l d e x p o s e th e r e ­
m e m b e r s , w h i c h i n c l u d e U .S .- c h a r te r e d b a n k s a n d m a i n i n g C H IP S p a r t i c i p a n t s t o l o s s e s i f t h e i r d e -

1D a ylig h t ov e rd ra fts a ttrib u te d to tra n sa ctio n s in b o o k-e n try 2ln co nv e n tio n a l d e fin itio n s, risk is s p ecifie d in te rm s o f the
s e cu ritie s are c a lcu la te d a s fo llo w s. A b a n k is in a net c re dit p ro b ab ility d istrib u tio n o f re tu rns o n an inv estm e nt. U n d er one
p o sitio n on b oo k -e n try se c u ritie s tra n s fe rs if th e va lu e o f s e c u ri­ d e fin itio n , risk m a y be m e as ure d as th e v a ria n c e o f th e d is trib u ­
tie s tra n s fe rre d to th e b a n k ’s b oo k-e n try s e cu ritie s a cc ou nt tion o f returns. S ee R o ths ch ild a nd S tig litz (1970).
e x ce ed s th e va lu e o f s e cu ritie s tra n sfe rre d o u t o f th a t a cco un t
to o th e r banks. T h e b oo k -e n try o v e rd ra ft o f a b a nk fo r e a ch d a y
e q u a ls its la rg e st net cre d it p o sitio n on s e cu ritie s tra n s fe rs th a t
o c cu rs w h ile th e rese rve a cc o u n t o f th e b a n k is o v erd ra w n .

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Federal Reserve F EBank
D E R Aof
L St.
RES Louis
E R V E B A N K O F ST. LO U IS
 5

p o s i to r s h a d w i th d r a w n b a l a n c e s c r e d i t e d to t h e i r tr a n s f e r s c a n c a u s e th e b o r r o w in g b a n k s to o v e r­
a c c o u n ts d u r in g th e d a y b a s e d o n p a y m e n t m e s ­ d ra w th e ir re s e r v e b a l a n c e s d u r in g th e d a y .
s a g e s f r o m th e d e f a u l ti n g b a n k . T h e s e b a n k s in
T h e b a l a n c e s h e e t e n tr i e s in ta b le 1 il lu s tr a te
tu r n m a y b e u n a b le to r e c o v e r th e f u n d s w ith ­
h o w f e d e r a l f u n d s tr a n s a c tio n s a f f e c t th e ris k
d r a w n b y t h e i r d e p o s i t o r s d u r i n g t h e d a y .3
b o r n e b y th e F e d e r a l R e s e rv e . E a c h b a n k b e g in s

Federal Reserve Policy on Payments th e d a y w ith d e p o s its o f $ 1 0 0 a n d r e s e r v e s o f $ 1 0 .

W ith a 1 0 p e r c e n t r e s e r v e ra tio , e x c e s s r e s e r v e s a r e
System Risk z e r o . D u rin g th e p re v io u s b u s in e s s d ay , B a n k A

In r e c e n t y e a r s , th e F e d e r a l R e s e r v e B o a r d h a s b o r r o w e d $ 2 5 f r o m B a n k B th r o u g h th e f e d e r a l

ta k e n a c ti o n s to li m it its o w n r is k a n d th e s y s te m i c f u n d s m a r k e t. B e f o r e th e e n d o f b u s i n e s s o n th e

r i s k i n v o l v e d i n C H IP S . T h e F e d e r a l R e s e r v e i n ­ p r e v io u s d a y , B a n k B tr a n s f e r r e d $ 2 5 o v e r F e d w ir e

d u c e d C H IP S to r e q u i r e e a c h b a n k i n i t s s y s t e m to f r o m its r e s e r v e a c c o u n t to th e a c c o u n t o f B a n k A .

e s ta b li s h b i la te r a l n e t d e b it lim its w ith e a c h o th e r T h is tr a n s a c tio n c r e a te d a lia b ility f o r B a n k A ( f e d ­

C H IP S p a r t i c i p a n t , b e g i n n i n g i n 1 9 8 4 . U n d e r a n ­ e r a l f u n d s p u r c h a s e d ) a n d s h if te d $ 2 5 o f th e a s s e ts

o th e r p r o g r a m th a t w e n t in to e f f e c t in M a r c h 1 9 8 6 , o f B a n k B f r o m r e s e r v e b a l a n c e s to f e d e r a l f u n d s

th e F e d e r a l R e s e r v e r e q u i r e s b a n k s to s e t l i m i ts o n s o ld .

t h e i r d a y l i g h t o v e r d r a f ts a c r o s s F e d w i r e a n d
T h e f irs t tr a n s a c tio n b y B a n k A in th e c u r r e n t
C H IP S . ( S e e a p p e n d i x 1 f o r d e t a i l s o f t h e s e p o l i ­
d a y i s a t r a n s f e r o f $ 2 5 f r o m i t s r e s e r v e a c c o u n t to
c i e s . ) T h e F e d i s c u r r e n t l y s t u d y i n g p r o p o s a l s to
th e r e s e r v e a c c o u n t o f B a n k B, r e tu r n in g th e f u n d s
e s ta b lis h a n e x p lic it o r im p lic it p r ic e f o r d a y lig h t
it h a d b o r r o w e d o v e r n i g h t; th i s e l i m i n a te s th e
o v e r d r a f ts o f r e s e r v e a c c o u n t s .
lia b ility o f f e d e r a l f u n d s p u r c h a s e d b y B a n k A .
S in c e th e b a la n c e in th e re s e r v e a c c o u n t o f B a n k A

H O W PA Y M EN T S A F F E C T R I S K w a s o n ly $ 1 0 a t th e s ta r t o f th e d a y , th e tr a n s f e r o f
$ 2 5 m a k e s its r e s e r v e a c c o u n t o v e r d r a w n b y $ 1 5 .
T h is s e c tio n u s e s s im p le b a la n c e s h e e ts o f h y ­ T h is p r e s e n ts n o p ro b le m f o r B a n k A , h o w e v e r,

p o t h e t i c a l b a n k s to i l l u s tr a te h o w t r a n s a c t i o n s s i n c e it p l a n s to b o r r o w $ 2 5 th r o u g h th e f e d e r a l

th r o u g h th e p a y m e n ts s y s te m a f f e c t th e e x p o s u r e f u n d s m a r k e t l a t e r i n t h e d a y to e l i m i n a t e i t s r e ­

o f t h e F e d e r a l R e s e r v e a n d c o m m e r c i a l b a n k s to s e r v e o v e rd ra f t a n d m e e t its r e s e r v e r e q u i r e m e n t

p o te n ti a l l o s s e s . T h e i l l u s tr a ti o n s in v o lv e f e d e r a l o f $10.

f u n d s t r a n s a c t i o n s a n d t r a n s a c t i o n s a m o n g C H IP S
If B a n k A b o r r o w s th e $ 2 5 in th e f e d e r a l f u n d s
p a r tic ip a n ts . A p p e n d ix 2 illu s tr a te s h o w th e p a y ­
m a r k e t, th e le n d in g b a n k ( s ) w ill tr a n s f e r th e r e ­
m e n t p r a c ti c e s o f b a n k s th a t s e r v e g o v e r n m e n t
s e r v e s to th e a c c o u n t o f B a n k A in th e a f te r n o o n .
s e c u r itie s d e a le r s a n d th o s e th a t is s u e a n d r e d e e m
G iv e n th e ti m e g a p b e tw e e n th e tr a n s f e r o f f u n d s
c o m m e r c i a l p a p e r a f f e c t t h e i r r e s e r v e o v e r d r a f ts .
to l e n d i n g b a n k s i n th e m o r n i n g a n d th e tr a n s f e r

Federal Funds Transactions o f r e s e r v e s to B a n k A i n th e a f te r n o o n , th e F e d e r a l

R e s e r v e e f f e c ti v e l y l e n d s $ 1 5 to B a n k A d u r i n g p a r t
B a n k s th a t b o r r o w f e d e r a l f u n d s o v e rn ig h t a re o f th e b u s in e s s d a y b y p e r m ittin g th e re s e rv e
c o n c e r n e d p rim a rily a b o u t th e ir re s e rv e b a la n c e s o v e r d r a f t.
a s o f th e e n d o f th e d a y , r a th e r th a n d u r in g th e
T h e F e d is a g e n e r a l c r e d i t o r o f B a n k A w h il e its
d a y , f o r tw o r e a s o n s . F i r s t , t h e F e d e r a l R e s e r v e is
r e s e r v e a c c o u n t is o v e r d r a w n . T o illu s tr a te th e r is k
m o r e to l e r a n t o f d a y lig h t o v e r d r a f ts o f r e s e r v e
it a s s u m e s i n p e r m i t t i n g d a y l i g h t o v e r d r a f t s , s u p ­
a c c o u n t s t h a n o f n e g a tiv e r e s e r v e b a l a n c e s a t th e
p o s e th a t p a r tic ip a n ts in th e f e d e r a l f u n d s m a r k e t
c lo s e o f b u s in e s s . S e c o n d , th e in tr a d a y re s e r v e
f in d o u t th a t th e v a lu e o f B a n k A s a s s e ts h a v e d e ­
b a l a n c e s d o n o t c o u n t to w a r d m e e ti n g r e s e r v e
c l i n e d b y $ 1 5 ju s t a f t e r B a n k A t r a n s f e r s $ 2 5 t o
r e q u ir e m e n ts ; o n ly th o s e b a la n c e s h e ld a t th e e n d
B a n k B . A f te r t h i s i n f o r m a t i o n b e c o m e s k n o w n ,
o f th e b u s in e s s d a y d o .
B a n k A w ill b e u n a b le to b o r r o w r e s e r v e s in th e
B a n k s th a t b o r r o w o v e r n ig h t f e d e r a l f u n d s ty p i­ f e d e r a l f u n d s m a r k e t a t p re v a ilin g m a r k e t r a te s .
c a lly re c e iv e re s e rv e s f ro m th e le n d in g b a n k s o v e r T h e a g e n c y th a t c h a r te r e d B a n k A m u s t d e c id e
F e d w ir e la te in th e d a y ; th e y r e tu r n th e r e q u is ite w h e t h e r it is s o lv e n t. If B a n k A is d e c l a r e d s o lv e n t
re s e rv e b a l a n c e s th e f o llo w in g m o r n in g . S u c h a n d h a s a s s e t s to p l e d g e a s c o l l a t e r a l , it c o u l d

3T h e legal s ta tu s o f c la im s b y th e b a n k s a g a in st th e ir d e p os ito rs
in su ch s itu a tio n s is c u rre n tly uncle ar. S ee M e n g le (1989).

Digitized for FRASER

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Federal Reserve Bank of St. Louis i a kii i a n v / c c o n i ■a r»v/ a n o n
 6

T a b le 1
R isk C reated by th e Tra nsfer of R eserve B alances in O vernight Federal Funds
Transactions
B alance sh ee ts a t sta rt of day:

B ank A B a nk B

R e se rve s $10 D e p o sits $100 R e se rve s $ 10 D e p o sits $100

O th e r F e d e ra l fu n d s Fe d e ra l fun d s N et
a sse ts 125 p urc ha se d 25 sold 25 w o rth 10

Net O th e r
w o rth 10 a s se ts 75

B a nk A se nd s $2 5 o f its re se rve balan ce s to B a nk B o v e r Fedw ire:

B a nk A B a nk B

R e se rve s - $ 15 D e p o sits $100 R e se rve s $35 D e p o sits $ 10 0

O th e r F e d era l fu n d s F e d e ra l fun d s N et
a ss ets 125 p urch a s ed 0 sold 0 w orth 10

N et O th e r
w orth 10 a sse ts 75

V a lu e o f o th e r a s se ts at B ank A re duced b y $15:

B a nk A B a nk B

R ese rve s -$ 1 5 D e p o s its $ 100 R e se rve s $35 D e p o sits $100

O th e r F e d e ra l fun d s F e d e ra l fu n ds N et
a ss ets 110 p u rc ha se d 0 sold 0 w o rth 10

N et O th e r
w orth -5 a s se ts 75

r e c e i v e a l o a n f r o m t h e F e d e r a l R e s e r v e to c o v e r its to c o v e r a n y l o s s e s . T h e l o s s o f $ 5 w o u l d b e b o r n e
r e s e r v e o v e r d r a f t. I f t h e s u p e r v i s o r y a g e n c y d e ­ b y u n in s u r e d d e p o s ito r s o r th e F e d e r a l D e p o s it
c l a r e s B a n k A in s o lv e n t, it w ill b e c l o s e d . If B a n k A I n s u r a n c e C o r p o r a t i o n ( F D IC ) . T h u s , r e q u i r i n g
is c l o s e d a n d liq u id a te d , th e d e p o s i to r s g e t f ir s t c o l l a t e r a l a g a i n s t r e s e r v e o v e r d r a f ts d o e s n o t n e c ­
c l a im o n th e $ 1 1 0 o f “ o th e r a s s e t s . ” In th i s c a s e , e s s a r ily p r o t e c t th e p u b li c s e c to r ; it m a y s im p ly
th e F e d e r a l R e s e r v e w ill r e c e iv e $ 1 0 a g a in s t th e $ 1 5 s h i f t t h e l o s s f r o m t h e F e d e r a l R e s e r v e t o t h e F D IC .
o v e r d r a f t o f th e r e s e r v e a c c o u n t a n d , th u s , w ill
lo s e $5. Transactions Among CHIPS
Participants
If th e F e d e r a l R e s e r v e h a d k n o w n th a t B a n k A
In th e c a s e il lu s tr a te d in ta b le 1, th e F e d e r a l
w a s in p o o r f in a n c ia l c o n d itio n , it w o u ld h a v e
R e s e r v e a s s u m e s th e ris k . B a n k s a ls o a s s u m e ris k
r e q u i r e d t h e b a n k to p l e d g e c o l l a t e r a l a g a i n s t its
b y p a r t i c i p a t i n g i n C H IP S . T h e i n t e r b a n k r i s k e x p o ­
o v e r d r a f ts . 4 B y r e q u i r i n g c o l l a t e r a l , t h e F e d s h i f t s
s u r e s c r e a te d th r o u g h th e p r o c e s s i n g o f p a y m e n t
th e ris k to o th e r p a r tie s . S u p p o s e , in th is c a s e , th a t
m e s s a g e s t h r o u g h C H IP S a r e i l l u s t r a t e d i n t a b l e 2 .
B a n k A h a d p le d g e d $ 1 5 o f its r is k le s s a s s e ts to th e
F e d e r a l R e s e r v e to c o v e r its o v e r d r a f ts . W h e n th e In th e f ir s t tr a n s a c ti o n o f th e d a y , a d e p o s i to r o f
b a n k f a ils , th e F e d w o u ld h o ld th e $ 1 5 in c o lla te r a l B a n k A s e n d s $ 2 5 to a d e p o s i to r o f B a n k B in th e

"T a s k F o rce (1988), pp. 6 5 -6 9 .

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Federal Reserve Bank of St. Louis
 7

T a b le 2
R isk C reated by the Transfer o f Funds over C H IP S
B a lanc e s h ee ts a t sta rt o f day:

B a nk A BankB

R ese rve s $10 D e p o sits $100 R e s erve s $10 D ep o s its $100

O th e r N et O the r N et
a sse ts 100 w orth 10 a ss ets 100 w orth 10

D e pos itor at B a nk A tra ns fers $ 25 to d e p os ito r of B a nk B, tra ns ac tio n o v e r C H IP S :

B a nk A BankB

R e se rve s $10 D e p o sits $75 R e s erve s $10 D e p o sits $125

O the r R e se rve s R e se rve s N et

a ss ets 100 p aya ble 25 re c eiva b le 25 w o rth 10

N et O th e r
w o rth 10 a ss ets 100

D epo sitor at B ank B tra ns fe rs $ 2 5 to d e p os ito r o f B a nk C, o v e r C H IP S :

BankB BankC

R e se rve s $ 10 D e p o sits $100 R e se rve s $10 D e p o s its $ 12 5

R e se rve s R e s erve s R e s erve s N et

re c eiva ble 25 p a ya ble 25 re ce iva b le 25 w o rth 10

O th e r N et O th e r
a ss ets 100 w o rth 10 a sse ts 100

f o r m o f a w i r e t r a n s f e r o v e r C H IP S . B a n k A d e b i t s S u p p o s e th a t, b e f o r e th e e n d o f th e d a y , a d v e r s e
th e d e p o s it a c c o u n t o f th a t c u s to m e r f o r $ 2 5 . B e ­ p u b lic ity p r e v e n ts B a n k A f ro m b o r r o w in g $ 2 5 in
c a u s e b a n k s d o n o t re p o rt th e ir b a la n c e s h e e ts o n th e f e d e r a l f u n d s m a r k e t. T h i s s i tu a tio n c o u ld
a n in tr a d a y b a s is , th e r e is n o o f f ic ia l te r m f o r th e c r e a te a liq u id ity p r o b le m f o r B a n k B. If B a n k A
o f f s e ttin g lia b ility e n tr y in th i s tr a n s a c t i o n . In th is c a n n o t o b ta i n s u f f ic ie n t r e s e r v e s to c o v e r its n e t
c a s e , w e w i l l c a l l i t " r e s e r v e s p a y a b l e . ” F o r B a n k B, d e b i t p o s i t i o n o n C H IP S , c u r r e n t r u l e s c a l l f o r
d e p o s it lia b ilitie s a n d a n a s s e t ite m c a lle d " r e ­ u n w in d in g a ll tr a n s a c ti o n s in v o lv in g B a n k A a n d
se rv e s re c e iv a b le " e a c h in c re a s e b y $25. s e ttl in g th e tr a n s a c ti o n s a m o n g th e r e m a in in g
C H IP S p a r t i c i p a n t s . T h i s s e t t l e m e n t w o u l d in v o l v e
In th e n e x t t r a n s a c t i o n , a d e p o s i to r o f B a n k B
a tr a n s f e r o f $ 2 5 i n r e s e r v e s f r o m B a n k B to B a n k C .
d ir e c ts it to s e n d $ 2 5 to a c u s to m e r o f B a n k C .
S u c h a n e t s e t t l e m e n t c a n n o t ta k e p l a c e , h o w e v e r ,
A f te r t h e s e c o n d t r a n s a c t i o n , B a n k B i s e v e n w i t h
b e c a u s e B a n k B h a s o n l y $ 1 0 i n i ts r e s e r v e a c ­
C H IP S . I f t h e r e w e r e n o m o r e t r a n s a c t i o n s o v e r
c o u n t. T h u s , u n le s s th e F e d e r a l R e s e r v e le n d s $ 2 5
C H IP S t h a t d a y i n v o l v i n g B a n k B , t h e s e t t l e m e n t
t o B a n k A o r B a n k B , a l l C H IP S t r a n s a c t i o n s f o r t h e
f o r C H IP S t r a n s a c t i o n s w o u l d h a v e a z e r o i m p a c t
d a y w o u ld b e c a n c e le d .
o n th e re s e r v e a c c o u n t o f B a n k B . B a n k A , in c o n ­
tr a s t, w o u l d h a v e its r e s e r v e a c c o u n t d e b i te d f o r S i m u la tio n e x e r c i s e s in d i c a te th a t th e u n w i n d ­
$ 2 5 , w h ile B a n k C w o u ld h a v e its a c c o u n t c r e d ite d i n g o f t r a n s a c t i o n s w i t h o n e l a r g e C H IP S p a r t i c i ­
b y $ 2 5 . B a n k A w o u ld h a v e to i n c r e a s e its r e s e r v e p a n t th a t c a n n o t m e e t its p a y m e n t o b lig a tio n s
b a l a n c e b e f o r e t h e t i m e f o r s e t t l e m e n t o f C H IP S w o u ld m a k e a h ig h p e r c e n ta g e o f o th e r p a r tic i­
p a y m e n t s to f a c i l i t a t e s e t t l e m e n t . p a n ts u n a b le to m e e t th e ir c o m m i tm e n ts o n

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 8

C H IP S w i t h o u t a d d i t i o n a l r e s e r v e s . 5 I n t h e s e e x e r ­ T H E E FFE C T S O F PO S S IB L E
c i s e s , s o m e b a n k s th a t b e c o m e illiq u id h a v e n o
C H A N G ES IN P O L I C Y
d ir e c t tr a n s a c ti o n s w ith th e d e f a u ltin g b a n k . T h u s ,
a s illu s tr a te d in ta b le 2, a d e f a u lt b y B a n k A k e e p s C h a n g e s in p o lic y o n p a y m e n ts s y s te m r is k a r e
B a n k C f r o m r e c e i v i n g i t s p a y m e n t s o v e r C H IP S , b e in g d is c u s s e d w ith in th e F e d e r a l R e s e rv e Sy s ­
b e c a u s e th e d e f a u lt b y B a n k A m a k e s B a n k B te m a n d th e p r iv a te s e c to r . T h i s s e c ti o n i l l u s tr a te s
illiq u id . t h e e f f e c ts o f tw o p o s s i b l e p o l i c y c h a n g e s : e x p l i c i t
f e e s o n r e s e r v e a c c o u n t o v e r d r a f ts a n d i n te r e s t-
A s th e c e n tr a l b a n k , th e F e d e r a l R e s e rv e is r e ­ e a r n in g r e s e rv e b a la n c e s r e q u ir e d to c o v e r p a r t o r

s p o n s i b l e f o r p r e v e n tin g s u c h a li q u id ity c r i s i s . In a ll o f d a y lig h t o v e r d r a f ts .7

o u r e x a m p l e , t h e F e d c o u l d l e n d r e s e r v e s e i t h e r to
F e d e r a l R e s e rv e p o lic y m a k e rs h a v e in d ic a te d
B a n k A o r B a n k B . If it c o n s i d e r s B a n k A to b e s o l ­
th a t s u c h c h a n g e s w o u l d b e a d o p te d o n ly a f te r
v e n t, it c o u l d le n d th e $ 2 5 a n d ta k e c o l l a te r a l . T h e
C H IP S h a s d e v e l o p e d a r r a n g e m e n t s f o r e n s u r i n g
$ 2 5 a d d e d to th e r e s e r v e a c c o u n t o f B a n k A f a c ili­
th e e x e c u ti o n o f p a y m e n ts o n th a t s y s te m th a t
t a t e s t h e n e t s e t t l e m e n t o n C H IP S . I f B a n k A t u r n s
th e y c o n s i d e r a c c e p ta b le .8 T h is s e c ti o n a ls o illu s ­
o u t to b e in s o lv e n t, th e c o lla te r a l p r o te c ts th e F e d ­
tr a te s th e im p lic a tio n s o f s u c h a n a r r a n g e m e n t f o r
e r a l R e s e r v e f r o m lo s s , tr a n s f e r r in g it i n s te a d to th e
b an k s.
g e n e r a l c r e d i t o r s a n d t h e F D IC .

Explicit Pricing o f Daylight Overdrafts

A l te r n a ti v e l y , t h e F e d e r a l R e s e r v e c o u l d p r e v e n t o f Reserve Accounts
a liq u id ity c r is is b y le n d in g $ 2 5 to B a n k B , a llo w in g
B a n k B t o m e e t i t s r e q u i r e d r e s e r v e s a n d C H IP S O n e w a y to r e d u c e F e d e r a l R e s e r v e r i s k w o u l d
o b lig a tio n to B a n k C . E v e n i f th e F e d p r e v e n ts a b e to c h a r g e a f e e o n d a y lig h t o v e r d r a f ts . I f th e f e e
liq u id ity c r is i s b y le n d in g $ 2 5 to B a n k B, th e d e ­ w e r e h ig h e n o u g h , b a n k s w o u ld r e d u c e th e s iz e o f
f a u lt o f B a n k A c o u ld m a k e B a n k B in s o lv e n t. T h is th e i r o v e r d r a f ts b y c h a n g i n g t h e i r p r a c ti c e s f o r
is a n e x a m p l e o f s y s te m ic r is k in v o lv e d in th e o p ­ m a k in g p a y m e n ts .
e r a ti o n o f th e p a y m e n ts s y s te m . S u p p o s e th a t th e R espon ses o f Banks to Pricing D aylight O ver­
tr a n s f e r o f $ 2 5 f r o m B a n k B to B a n k C is i n i ti a te d drafts — P e r h a p s t h e e a s i e s t a n d l e a s t e x p e n s i v e
b y th e d e p o s ito r o f B a n k B w h o r e c e iv e d $ 2 5 f ro m c h a n g e f o r m o s t o f th e r e la tiv e ly la r g e b a n k s w o u l d
B a n k A . B a n k B m a k e s th is tr a n s f e r b e f o r e d is c o v ­ in v o l v e r o u t i n g m o r e o f t h e i r w i r e t r a n s f e r s o f
e r in g th e d e f a u l t b y B a n k A . A t th i s ti m e , it is n o t f u n d s t h r o u g h C H IP S r a t h e r t h a n F e d w i r e . T h e r e
c l e a r w h e t h e r t h e c o u r t s w o u l d p e r m i t B a n k B to a r e o th e r w a y s f o r b a n k s to r e d u c e th e i r r e s e r v e
r e g a i n t h e s e f u n d s f r o m i t s d e p o s i t o r . 6 I f B a n k B ’s a c c o u n t o v e r d r a f ts . T h e y c o u l d p u r c h a s e m o r e o f
lo s s e x c e e d s $ 1 0 , it is b a n k r u p t. th e ir f e d e r a l f u n d s a s te r m f e d e r a l f u n d s o r u n d e r
r o llo v e r a r r a n g e m e n ts th a t in v o lv e p a y in g a d a ily
S u p p o s e , in s te a d , th a t th is d e p o s i to r o f B a n k B r a te b u t e lim in a tin g th e d a ily tr a n s f e r o f r e s e r v e
h o ld s th e e x tr a $ 2 5 in its d e m a n d d e p o s it a c c o u n t b a l a n c e s . P r i c i n g to ta l d a y l ig h t o v e r d r a f ts o f r e ­
a t B a n k B u n til th e e n d o f th e d a y . T h e tr a n s f e r o f s e r v e b a l a n c e s ( i n c l u d i n g b o o k - e n t r y o v e r d r a f ts )
r e s e r v e s f r o m B a n k B to B a n k C w a s in i ti a te d b y a w o u ld im p o s e c o s ts o n th e c le a r in g b a n k s , w h ic h
d i f f e r e n t d e p o s i t o r o f B a n k B . W h e n B a n k A ’s d e ­ th e y w o u l d p a s s o n to th e g o v e r n m e n t s e c u r i t i e s
f a u lt is d is c o v e r e d , B a n k B c o u l d c a n c e l th e $ 2 5 in d e a le r s th e y s e rv e . T h e d e a le r s c o u ld r e d u c e b o o k -
r e s e r v e s r e c e i v a b l e a n d r e v e r s e t h e $ 2 5 c r e d i t t o i ts e n tr y d a y lig h t o v e r d r a f ts b y b u il d i n g s m a l l e r i n ­
d e m a n d d e p o s i t li a b il itie s . In th i s c a s e , th e u n ­ v e n to r ie s o f s e c u r itie s d u r in g th e d a y o r h o ld in g
w i n d i n g o f t h e C H IP S t r a n s a c t i o n h a s n o a d v e r s e la r g e r in v e n to r ie s o v e r n ig h t. B a n k s th a t a c t a s
e f f e c t o n t h e n e t w o r t h o f B a n k B. a g e n ts in i s s u i n g c o m m e r c i a l p a p e r c o u ld c h a r g e

5H u m p hre y (1986). th e A n g e ll p ro p o sa l, th e F e d e ra l R e s erve w o u ld p ro h ib it d a y ­

lig h t o ve rd ra fts. T ra n sfe rs o f re se rv es th a t w o u ld m a ke the
6M engle (1989).
res erve b a la nc e o f a b an k n eg a tiv e w o uld be fu n d e d a s d is ­
7F or d is c u s sio n s o f th e s e p o s sib le c h a n g e s fro m F e d e ra l R e ­ c o u n t w in d o w loans. T o p ro vid e b a n ks in c e n tiv e s to hold
s e rve s o u rc es , s e e B e lto n , e t al. (1987), C o rrig a n (1987), e n ou g h re se rv es to p re v e n t o v e rd ra fts , th e F e d e ra l R e se rve
J oh n s o n (1988), T a s k F o rce (1988) and M e n g le , e t al. (1987). w o u ld p a y in te re s t on e x c es s re s erve s , b u t a t a rate b e lo w the
F or d is cu s sio n s o f th es e issu es b y tho se in th e p riva te sector, d is c o u n t rate. S e e V a n H o o s e (1988).
se e F la n n e ry (1987), F a u lha b e r, e t al. (1989) a nd La rg e D o llar
8J oh n s o n (1988), p. 15.
P aym e n ts S yste m A d v is o ry G ro u p (1988). G o ve rn o r W a yn e D.
A ng e ll o f th e F e d e ra l R e se rve B o a rd h a s p ro p ose d a no th e r
a p p ro a ch to revising p o licy on p a y m e nts sy ste m risk. U n d e r

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Federal Reserve FEDERAL
Bank of St.RESERVE
Louis BANK OF ST. LOUIS
 9

i s s u e r s f o r t h e f e e s o n o v e r d r a f ts o r d e l a y p a y ­ t h a t o v e r d r a w t h e i r r e s e r v e a c c o u n t s to h o l d s u p ­
m e n t s to i s s u e r s u n t i l th e y r e c e i v e p a y m e n t s f r o m p le m e n ta l re s e r v e b a la n c e s . T h e s e r e q u ir e m e n ts
p u rc h ase rs. w o u l d b e s e t to c o v e r p a r t o r a l l o f t h e i r d a y l i g h t
o v e r d r a f ts . T h e s u g g e s t e d i n t e r e s t r a t e t o b e p a i d
Effects in Financial M arkets — P r ic in g d a y lig h t
o n th e s u p p l e m e n ta l b a l a n c e s w o u l d b e s lig h tly
o v e r d r a f ts c o u l d h a v e a v a r i e t y o f i n d i r e c t e f f e c t s i n
b e lo w th e f e d e r a l f u n d s r a te , th u s c r e a ti n g a n o p ­
th e f in a n c ia l m a r k e ts . B a n k s th a t le n d in th e o v e r­
p o r tu n ity c o s t o f h o ld in g s u p p le m e n ta l r e s e r v e s .
n ig h t f e d e r a l f u n d s m a r k e t c o u ld f in d th a t th e ir
T h is c o s t w o u ld h a v e th e s a m e im p lic a tio n s f o r
re s e r v e s a re b e in g r e tu r n e d la te r th e f o llo w in g d a y .
b a n k b e h a v io r a n d f in a n c ia l m a r k e ts a s a n e q u a l
T h e t i m e v a l u e o f i n t r a d a y r e s e r v e s m i g h t l e a d to
e x p l i c i t f e e o n d a y lig h t o v e r d r a f ts .
th e d e v e lo p m e n t o f a n in tr a d a y f e d e r a l f u n d s m a r ­
k e t, w i th l e n d e r s m a k in g r e s e r v e b a l a n c e s a v a ila b le T h e im p lic a tio n s o f a s u p p le m e n ta l re s e rv e r e ­
to b o r r o w e r s f o r o n ly p a r t o f th e b u s i n e s s d a y . q u i r e m e n t c a n b e e x a m i n e d b y a d ju s t i n g t h e b a l ­
S o m e a n a l y s ts th i n k th i s c o u l d le a d to g r e a t e r a n c e s h e e t e n tr ie s in ta b le 1 . In th is c a s e , B a n k A
v a r ia b ility in a n o v e r n ig h t f e d e r a l f u n d s r a te a n d w o u ld b e r e q u i r e d to i n c r e a s e its a v e r a g e e n d - o f -

o th e r in te r e s t r a te s .9 d ay re se rv e b a la n c e b y $15. A re se rv e b a la n c e o f
$ 2 5 a t th e s ta r t o f th e d a y w o u ld e lim in a te th e ris k
B a n k s c o u ld lim it th e s iz e o f th e ir d a y lig h t o v e r­
o f F e d e r a l R e s e r v e l o s s b e c a u s e B a n k A ’s r e s e r v e
d r a f ts b y d e l a y i n g w i r e t r a n s f e r s o f f u n d s f o r d e ­
b a l a n c e w o u ld n o t f a ll b e l o w z e r o a f te r th e $ 2 5
p o s i to r s th a t d o n o t d e m a n d im m e d ia te d e liv e ry
tr a n s f e r .
o f f u n d s ; o r , t h e y m i g h t c h a r g e a n e x t r a f e e to d e ­
p o s ito r s th a t d e m a n d im m e d ia te d e liv e ry . T h e m e th o d b y w h ic h B a n k A r a is e s th e $ 1 5
s u p p le m e n ta l b a la n c e a f f e c ts th e d is tr ib u tio n o f
C le a r in g b a n k s w o u ld c h a r g e g o v e r n m e n t s e c u ­
p o te n tia l lo s s e s a m o n g p a r tic ip a n ts in th e b a n k in g
r i ti e s d e a l e r s f o r th e c o s t o f th e f e e o n d a y lig h t
in d u s tr y . S u p p o s e , f o r e x a m p l e , B a n k A s o ld s o m e
o v e r d r a f ts . G o v e r n m e n t s e c u r i t i e s d e a l e r s , i n t u r n ,
a s s e t s to o b ta i n th e $ 1 5 in a d d i ti o n a l r e s e r v e s . T h i s
w o u ld in c r e a s e th e tr a n s a c tio n c o s ts o f b u y in g
r e s p o n s e w o u l d r a i s e t h e r i s k - a d ju s t e d c a p i t a l
a n d s e llin g g o v e r n m e n t s e c u r itie s . In te r e s t r a te s
r a t i o o f B a n k A , u n l e s s it s h i f t e d t h e r e m a i n i n g
o n g o v e rn m e n t s e c u r itie s w o u ld ris e s o m e w h a t
$ 1 1 0 o f o th e r a s s e ts in to c a te g o r ie s w ith h ig h e r
r e la tiv e to y i e l d s o n a lte r n a tiv e i n v e s tm e n ts , i n ­
r i s k w e i g h t s . A r i s e i n B a n k A ’s r i s k - a d ju s t e d c a p i ­
c r e a s i n g th e T r e a s u r y ’s c o s t o f s e r v ic in g th e n a ­
t a l r a t i o w o u l d r e d u c e t h e F D I C ’s p o t e n t i a l
ti o n a l d e b t.
lo s s e s ."
H o w b a n k s r e a c t to d a y l i g h t o v e r d r a f t f e e s c o u l d
a f fe c t m a rk e t y ie ld s o n o th e r f in a n c ia l in s tr u ­ S u p p o s e , i n s t e a d , t h a t B a n k A r a i s e s t h e $ 1 5 in

m e n t s . F o r i n s t a n c e , t h e f e e o n o v e r d r a f ts w o u l d s u p p le m e n ta l re s e rv e s b y in c r e a s in g f e d e ra lly

i n c r e a s e t h e c o s t s to b a n k s a c t i n g a s a g e n ts f o r in s u r e d d e p o s its f r o m $ 1 0 0 to $ 1 1 5 . T h is r e s p o n s e

f ir m s th a t is s u e c o m m e r c i a l p a p e r . T h e r e s p o n s e s w o u ld in c r e a s e th e p o te n tia l lo s s e s f a c e d b y th e

b y th e a g e n t b a n k s c o u l d i n c r e a s e t h e c o s t s to F D IC . 12

f irm s o f r a is in g f u n d s b y is s u in g c o m m e r c ia l B a n k A a ls o c o u ld r a is e th e a d d itio n a l $ 1 5 in th e
p a p e r . 10 te r m f e d e r a l f u n d s m a r k e t. T h e c l a im s o f th o s e
s e llin g te r m f e d e r a l f u n d s to B a n k A w o u ld b e
Supplemental Balance Requirement s u b o r d i n a t e t o t h e c l a i m s o f B a n k A ’s d e p o s i t o r s .
T h e F e d e ra l R e s e rv e c o u ld im p o s e a n im p lic it T h u s , th e s u p p le m e n ta l b a la n c e re q u ir e m e n t
p r i c e o n d a y lig h t o v e r d r a f ts b y r e q u i r in g th e b a n k s w o u l d s h i f t r i s k to t h o s e b a n k s s u p p l y i n g t h e t e r m

9T a s k F orce (1988), pp. 1 0 3 -1 4 . m a tio n s to re la tive risk. R e se rve s have a w e ig h t o f z ero. S e e

“ P ro p o sa ls fo r In te rn a tion a l C o n v e rg e n c e ” (1988).
10T o illu stra te th e p o ten tial e ffe c ts on th e c o s t of issu ing c o m m e r­
cial paper, su pp o se th e F e d e ra l R e se n /e c h a rg e s 100 ba sis l2A s su m e th a t th e s e a d d itio n a l fe d e ra lly in su re d d e p o s its h a ve a
p o in ts a t an a n n u a l rate on th e m a xim u m d a y lig h t o v e rd ra ft of z e ro re s erve re q u ire m e nt. T o illu stra te th e im p lic a tio ns fo r
each bank. S e e M engle, e t al. (1987) fo r th e b a sis fo r su ch a F D IC risk, s up p o se th a t a fte r B a nk A tra n s fe rs $ 25 to B ank B,
rate. If an a g e nt b a n k co n tin u e s th e tim in g o f p a ym e n ts d e ­ th e re is a p ub lic a n n o u n c e m e n t o f e v e n ts th a t re d uce th e va lu e
scrib e d in a p p e n d ix 2 in issu ing and re d ee m in g co m m e rcia l o f th e a sse ts o f B a n k A by $15. B a nk A fa ils and th e FD IC
paper, th e o v e rd ra fts fe e w o u ld c o st $ 5 4.7 9 p e r $1 m illion of b eco m e s th e re ce ive r. A s rece ive r, th e F D IC o bta in s a sse ts
c o m m e rcia l p a p e r issu e d and red e e m ed . If th e b an ks p ass th is w orth $ 1 1 0 and a s s um e s lia b ilitie s o f $1 15, fo r a n e t loss o f $5.
c os t on to th e issu e rs, th e a n n u a l c o s t o f raising fu n d s by In th is c ase , th e re fo re , th e su pp le m e n ta l b ala n c e re q u ire m e nt
is su in g c o m m e rc ia l p a pe r e v e ry 30 d a ys w o uld rise b y 7 basis s h ifts risk fro m th e F e d e ra l R e se rve to th e FD IC .
points.
" A risk -b a se d c a p ita l ratio is c a lcu la te d a s a m e asu re o f ca p ita l
divid e d by w e ig hte d a sse ts, w ith w e ig h ts a s sig n e d a s ap p ro xi-

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Federal Reserve Bank of St. Louis
 10

f e d e r a l f u n d s , in c r e a s in g th e s y s te m ic ris k in th e i l l u s t r a t i o n , C H IP S i s p r e s u m e d to h a v e f o r m e d a
b a n k in g s y s te m . b a n k e r s ' b a n k , w h ic h is a c o o p e r a tiv e v e n tu r e th a t
p e r f o r m s b a n k i n g s e r v i c e s f o r C H IP S m e m b e r s .
O f c o u r s e , s u p p le m e n ta l b a l a n c e r e q u ir e m e n ts
T h is in s titu tio n p r o c e s s e s p a y m e n t m e s s a g e s f o r
a l s o w o u l d g iv e b a n k s a n i n c e n t i v e t o r e d u c e t h e
its m e m b e r s a s d e b it a n d c r e d it e n tr i e s to th e i r
s iz e o f th e in tr a d a y m o v e m e n ts in th e i r re s e r v e
d e m a n d d e p o s i t a c c o u n t s a t t h e b a n k e r s ’ b a n k . 14
b a la n c e s , s in c e th e in te r e s t r a te p a id o n th e b a l­
T h e illu s tr a tio n is b a s e d o n s o m e g e n e r a l p r i n c i­
a n c e s w o u ld b e b e lo w th e m a r g in a l r e tu r n o n
p l e s o f s e ttl e m e n t f in a lity a r r a n g e m e n ts th a t h a v e
o th e r a s s e ts a n d b e lo w th e in te r e s t r a te o n f e d e r a l
b e e n c o n s i d e r e d f o r s e v e r a l y e a r s . 15
f u n d s . T h e s u p p le m e n ta l b a la n c e r e q u ire m e n t
w o u l d b e r e d u c e d to t h e e x t e n t t h a t a b a n k k e p t T h e h y p o th e tic a l a rra n g e m e n t re q u ire s m e m ­
its r e s e r v e b a l a n c e p o s itiv e th r o u g h o u t th e b u s i ­ b e r s o f C H IP S a s a g r o u p t o p l e d g e e n o u g h c o l l a t ­
n e s s d a y . S u p p o s e , f o r in s ta n c e , th a t B a n k A e r a l w i t h t h e i r b a n k e r s ’ b a n k to c o v e r t h e l a r g e s t
c h a n g e s i t s i n t r a d a y p a t t e r n o f p a y m e n t s s o th a t , n e t d e b i t p o s i t i o n o f a n y o n e p a r t i c i p a n t . T h i s is
w i t h t h e s u p p l e m e n t a l r e q u i r e m e n t o f $ 1 5 , i ts b a s e d o n th e id e a th a t a d e f a u lt b y o n e la rg e p a r ­
re s e rv e b a la n c e n e v e r f a lls b e lo w $ 5 . T h e F e d e r a l t i c i p a n t w o u l d d i s r u p t t h e o p e r a t i o n o f C H IP S .
R e s e r v e m ig h t r e d u c e its s u p p le m e n ta l b a la n c e S i n c e t h e r e h a s n e v e r b e e n a d e f a u l t b y a C H IP S
r e q u i r e m e n t to $ 1 0 , th u s r e d u c i n g t h e o p p o r t u n i ty p a r tic ip a n t, h o w e v e r, a d e f a u lt b y o n e la rg e p a r tic ­
co st o f Ban k A. i p a n t is a n u n l i k e l y e v e n t . C o l l a t e r a l r e q u i r e m e n t s
f o r C H IP S p a r t i c i p a n t s i n e x c e s s o f t h e l a r g e s t n e t
Provisions fo r Settlement Finality o f d e b i t o f a n i n d i v i d u a l C H IP S p a r t i c i p a n t c o u l d b e
Payments over CHIPS in te r p r e te d a s a n e x c e s s iv e d e g r e e o f p r e c a u tio n .

S e ttl e m e n t f in a l ity w o u l d in v o lv e p r o c e d u r e s f o r In ta b l e 2 , th e la r g e s t n e t d e b i t p o s i ti o n is $ 2 5 .
e n s u r i n g th e e x e c u ti o n o f p a y m e n ts ( a v o id u n ­ T o c o v e r th i s p o s i ti o n ( a n d to a ll o w s o m e m a r g in
w in d i n g p a y m e n ts in v o lv in g a d e f a u ltin g b a n k ) f o r e r r o r ) , C H IP S r e q u i r e s e a c h o f t h e t h r e e b a n k s
a n d th e a llo c a tio n o f lo s s e s in th e e v e n t o f a d e ­ to p le d g e $ 1 0 o f th e i r in te r e s t- e a r n i n g a s s e ts w ith
f a u l t b y a C H IP S p a r t i c i p a n t . 13 I f l o s s e s a r e s p r e a d C H IP S i n t h e f o r m o f T r e a s u r y s e c u r i t i e s .
w i d e l y a m o n g C H IP S p a r t i c i p a n t s , t h e f a i l u r e o f a
S u p p o s e t h a t a f t e r C H IP S p r o c e s s e s t h e t r a n s a c ­
C H IP S p a r t i c i p a n t to m e e t i t s p a y m e n t o b l i g a t i o n
ti o n s d e s c r ib e d in ta b le 2 , a n a n n o u n c e m e n t i n d i ­
w o u l d p r o b a b l y n o t c a u s e o t h e r b a n k s t o f a il .
c a t e s a $ 1 5 l o s s in th e v a lu e o f B a n k A ’s a s s e ts .
T h e i m p l i c a ti o n s o f s e ttl e m e n t f in a lity a r r a n g e ­ U n d e r t h e s e t t l e m e n t f i n a l i t y a r r a n g e m e n t , C H IP S
m e n ts f o r p a y m e n ts s y s te m r is k a r e illu s tr a te d w o u ld u s e th e c o lla te r a l p o s te d b y its p a r tic ip a n ts
u s in g th e b a l a n c e s h e e t e n tr ie s in ta b le 2 . In th is to r a i s e $ 2 5 , e i t h e r b y s e l l i n g p a r t o f t h e c o l l a t e r a l

13D is cu s sio n s o f th e fin a lity o f p a ym e n ts o n p riva te w ire tra n s fe r c a n ce o f th e d is tin ctio n b etw e en g ro s s a nd net ob lig atio ns,
s y ste m s m e n tio n th re e a sp e cts o f fin a lity. S e n d e r fin ality su pp o se a b a nk fa ils w h ile it is in a net cre d it p o s itio n on
m a ke s e ach m e s sa ge o v e r th e p a y m e nts sy ste m fin a l w h en C H IP S p a ym e nts. If C H IP S o b lig a tio n s a re tre a te d le g a lly as
sent. P a y m e nt m e ss ag e s c a n n o t be c a n ce le d la ter in th e day. n et o b lig atio ns, C H IP S p a rticip a n ts w o u ld m a k e a p a y m e n t to
T h e rule s fo r p a ym e n t m e s sa g e s on C H IP S in clu d e s e n d e r th e re c e iv e r o f th e fa ile d b a n k fo r th e a m o u n t o f th e n e t d e bit
fin a lity. p osition. T h e re c e ive r o f th e fa ile d b an k m ig h t s u e C H IP S
S e ttle m e n t fin a lity re fers to p ro ce du re s th a t w o uld e n s u re th e p a rticip a n ts b ase d on g ro s s o b lig a tio n s. U n d er a su cce ss fu l
s e ttle m e n t o f p a ym e nts if a p a rtic ip a nt d e fa u lts on its net de b it s u it by th e re ce ive r, th o se th a t had s e n t p a ym e nt m e s sa ge s to
a t th e e nd o f th e d ay. C H IP S d o e s n o t h a ve s ettle m e n t fin a lity th e fa ile d b a n k w o u ld h ave to p a y th e g ro s s a m o u n t o f th o se
p ro ce d u re s in pla ce a t th is tim e . U n d er c u rre n t p ro ce du re s , p a ym e n ts, and th o s e w h o re ce ive d p a ym e n t m e ss ag e s fro m
C H IP S w o uld ca n ce l all p a y m e nts b y th e b a n k th a t d efa u lts, as th e fa iled b a n k w o u ld b e co m e its g e n era l c re d ito rs fo r th e
w e ll a s all p a y m e nts to th a t bank, and c a lcu la te n e w n e t d e bit a m o u nt o f th e g ro s s tra n s fe rs fro m th e fa ile d b ank. T h is tre a t­
o r c re dit p o s itio n s fo r th e rem a inin g p a rtic ip an ts . T h is se ction m e n t o f C H IP S p a rtic ip a n ts w o uld in c re a se th e re co ve ry ra te o f
illu s tra te s th e im p lic a tio n s o f a do p tin g a fo rm o f s e ttle m e n t th e fa iled b a n k ’s o th e r g e ne ra l c re d ito rs. T h ere h a ve b een no
fin a lity. su ch ca se s to in d ica te w h e th e r th e c o u rts w o u ld u p hold p a y ­
U n d er re c e iv e r fin a lity , c re d its to th e d e p o s it a c c o u n ts o f the m e n ts to th e re c e ive r based on g ro s s p a y m e n ts.
c u sto m e rs o f C H IP S p a rtic ip a nts w o uld be fin a l w h en th e S u p po s e, in c on tra s t, th a t C H IP S p a y m e n ts are p ro ce s se d
re c eivin g b a n ks re ce iv e p a ym e n ts m e ss ag e s o v e r C H IP S . If a th ro u gh d e m a n d d e p o s it a c co u nts a t th e b a n k e rs ’ b a n k fo r
s e n d in g b a n k d e fa u lts, th e re ce ivin g b a n k w o uld h ave no C H IP S . U n d er th a t a rra n ge m e nt, th e o n ly c la im o f th e re c e ive r
re co urse to its d e p o sito rs . C H IP S rules d o n o t in c lu de re ce ive r o f th e fa ile d b a n k w o uld be fo r th e p o s itiv e b a la n ce o f th e fa iled
fin ality . F or ad d itio n al d iscu ss io n o f th e se a sp e cts o f th e fin a lity b a n k in its d e m a n d d e p o s it a c co u n t a t th e b a n k e rs ’ bank.
o f p a ym e nts, se e H u m p h re y (1986) and B elton, e t al. (1987).
15M e n g le (1989).
t4C H IP S h as co n sid e re d d e ve lo p in g a b a n k e rs ’ b a n k to e nsu re
th a t p a y m e n t o b lig a tio n s o v e r C H IP S w o u ld be tre a te d as net
ra th e r th a n g ro s s o b lig a tio n s in th e c a s e o f a d e fa u lt by a
C H IP S p artic ip a n t. S e e K a ntro w (1 9 8 8 ). T o illu s tra te th e sig n ifi-
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Federal Reserve Bank of St. Louis
 11

o r u s in g th e s e c u r itie s a s c o lla te r a l f o r a lo a n at b e r s o f p r iv a te w ir e tr a n s f e r s y s te m s r e s u l ti n g f r o m
t h e F e d e r a l R e s e r v e d i s c o u n t w i n d o w . C H IP S th e d a y lig h t c r e d it e x p o s u r e s . T h e F e d e r a l R e ­
w o u ld th e n tr a n s f e r th e $ 2 5 to th e r e s e r v e a c c o u n t s e rv e , h o w e v e r, h a s a d o p te d a p o lic y o n p a y m e n ts
o f B a n k B , f a c i l i ta ti n g t h e p a y m e n t f r o m B a n k B to s y s te m ris k w h i c h i n c l u d e s lim its o n th e d a y lig h t
B a n k C . I n t u r n , t h e b a n k e r s ’ b a n k o f C H IP S w o u l d o v e r d r a f ts o f in d i v id u a l b a n k s .
h o ld th e $ 1 0 in c o lla te r a l p o s te d b y B a n k A a n d
T h e F e d h a s b e e n c o n s id e r in g p o s s ib le c h a n g e s
h a v e a $ 1 5 c la im a g a in s t B a n k A a s a g e n e r a l c r e d i­
in its p o lic y to r e d u c e its o w n ris k a n d p ro v id e
to r . L o s s e s o n t h e $ 1 5 c l a i m a g a i n s t B a n k A w o u l d
i n c e n tiv e s f o r b a n k s to c h a n g e th e p a y m e n t p r a c ­
th u s b e s p r e a d b e tw e e n B a n k B a n d B a n k C . N e i­
ti c e s th a t te n d to c r e a te th e in tr a d a y ris k e x p o ­
th e r b a n k w o u ld b e f o r c e d in to b a n k r u p tc y b y a
s u r e s . O n e p r o p o s e d a p p r o a c h in v o lv e s a f e e o n
c o m p le te lo s s o n th e $ 1 5 c la im .
d a y l i g h t o v e r d r a f ts o f r e s e r v e a c c o u n t s . A s e c o n d
F r o m th e F e d e r a l R e s e r v e ’s p e r s p e c ti v e , th i s a p p r o a c h , w h i c h in v o lv e s a n im p li c i t p r i c e o n
s e ttl e m e n t f in a lity a r r a n g e m e n t is b e t te r th a n th e d a y lig h t o v e r d r a f ts , r e q u i r e s a d d i t i o n a l r e s e r v e
p r o c e d u r e t h a t c u r r e n t l y w o u l d b e u s e d to d e a l b a la n c e s a t th e b a n k s w h ic h re g u la rly o v e rd ra w
w i t h a d e f a u l t b y a C H IP S p a r t i c i p a n t — u n w in d ­ th e ir re s e r v e a c c o u n ts d u r in g th e d a y . T h e F e d e r a l
in g p a y m e n ts in v o lv in g th e b a n k . I f th is s e ttl e m e n t R e s e rv e w o u ld p a y in te r e s t o n th e s e s u p p le m e n ta l
f in a lity a r r a n g e m e n t w e r e in p l a c e , th e u n w i n d i n g r e s e r v e b a l a n c e s a t a r a t e ju s t b e l o w t h e f e d e r a l
o f p a y m e n ts , w h ic h w o u ld d is r u p t th e f lo w o f f u n d s r a t e . U n d e r e i t h e r a p p r o a c h , C H IP S w o u l d
p a y m e n ts in th e e c o n o m y , c o u ld b e a v o id e d . If a b e r e q u i r e d to w o r k o u t a n a r r a n g e m e n t t h a t is
d i s c o u n t w i n d o w l o a n w a s n e c e s s a r y to a v o id a s a t i s f a c t o r y to t h e F e d e r a l R e s e r v e to e n s u r e th e
li q u id ity c r i s i s in th e b a n k in g s y s te m , th e c o l l a t­ f in a lity o f its p a y m e n ts .
e r a l w o u l d b e a v a i l a b l e t h r o u g h t h e C H IP S o r g a n i ­
T h e o b je c t i v e o f c h a n g i n g t h e p o l i c y o n p a y ­
z a t i o n . T h e F e d e r a l R e s e r v e w o u l d n o t h a v e to
m e n ts s y s te m r is k is to r e d u c e th e r is k o f th e F e d ­
d e c id e w h ic h b a n k s s h o u ld re c e iv e d is c o u n t w in ­
e r a l R e s e rv e w ith o u t c r e a tin g a la r g e in c r e a s e in
d o w lo a n s .
s y s te m ic ris k — th e ris k th a t th e f a ilu re o f o n e
B y m a k i n g t h e r i s k t o C H IP S p a r t i c i p a n t s m o r e b a n k w ill c a u s e th e f a ilu r e o f o th e r b a n k s , th u s
e x p l i c i t , t h e a r r a n g e m e n t w o u l d g iv e C H IP S p a r t i c ­ d is r u p tin g th e o p e r a ti o n o f th e p a y m e n t s s y s te m .
ip a n ts s tr o n g e r i n c e n tiv e s to e x c lu d e b a n k s in T h e ty p e o f s e ttl e m e n t f in a lity a r r a n g e m e n t d e ­
re la tiv e ly p o o r f i n a n c i a l c o n d i ti o n f r o m t h e i r s y s ­ s ir e d b y th e F e d e r a l R e s e rv e w o u ld e n s u r e th e
te m . B a n k s th a t a r e e x c lu d e d w o u ld r o u te th e ir e x e c u t i o n o f p a y m e n t s o v e r C H IP S i n t h e e v e n t o f
w ir e tr a n s f e r s th r o u g h F e d w ir e , th u s r e d u c i n g a d e f a u l t b y a C H IP S p a r t i c i p a n t a n d s p r e a d a n y
s y s te m ic ris k . F in a lly , th e s p r e a d in g o f p o te n ti a l l o s s e s s o w i d e l y a m o n g o t h e r C H IP S p a r t i c i p a n t s
lo s s e s w o u ld lim it th e c h a n c e s o f th e f a ilu re o f o n e t h a t o n e b a n k f a i l u r e i s u n l i k e l y t o l e a d to t h e f a i l ­
b a n k c a u s i n g o t h e r s t o f a i l . It i s n o t p o s s i b l e to u r e o f o t h e r C H IP S p a r t i c i p a n t s .
d e te r m in e w h e th e r th e ris k o f b a n k f a ilu r e is lo w e r
u n d e r c u r r e n t C H IP S p r o c e d u r e s o r u n d e r t h i s
R E FE R E N C E S
p r o p o s e d p r o c e d u r e f o r s e t t l e m e n t f i n a l i ty . S u c h a
c o m p a r is o n d e p e n d s o n th e e x te n t to w h i c h d e ­ A ss o cia tio n o f R e s erve C ity B a n ke rs. R e p o rt o f th e W o rk in g
p o s i t o r s o f C H IP S p a r t i c i p a n t s d r a w d o w n t h e G ro u p o f th e A s s o c ia tio n o f R e s e rv e C ity B a n k e rs o n B o o k -
E n try D a y lig h t O v e rd ra fts (Ju ne 1986).
i n tr a d a y c r e d i t s to t h e i r d e m a n d d e p o s i t a c c o u n t s
B elton, T e rre n ce M., e t al. “ D a yligh t O v e rd ra fts and P a ym e n ts
a n d th e s u c c e s s th a t b a n k s w o u ld h a v e in c o l le c t­
S ys te m R is k ,” F e d e r a l R e s e rv e B u lle tin (N o ve m b e r 1987), pp.
in g f ro m th o s e d e p o s ito r s in c a s e o f a d e f a u lt b y a 8 3 9 -5 2 .
C H IP S p a r t i c i p a n t . C o rrig a n , E. G erald. F in a n c ia l M a r k e t S tru c tu re : A L o n g e r V ie w
(F e d e ra l R e se rve B a n k of N ew Y o rk, J a n u a ry 1987).

F au lha b e r, G e rald R., A lm a rin P hillips, and A n th o n y M. S anto-

m ero. “ P a ym e nt R isk, N e tw o rk R isk and th e R ole o f th e
C O N C LU S IO N S F e d ,” in D avid B. H u m p h re y, ed., U .S . P a y m e n t S y s te m :
E ffic ie n c y , R is k a n d th e R o le o f th e F e d e r a l R e s e rv e S y s te m
A ll b a n k s a s s u m e s o m e r i s k b y p a r t i c i p a t i n g i n (K lu w e r, 1989).
th e p a y m e n ts s y s te m . T h e p a y m e n t p r a c ti c e s th a t F lan n e ry, M ark J. “ P a y m e nts S ys te m R isk and P u b lic P o lic y,”
g e n e r a te th is ris k w e r e d e v e lo p e d in a n e n v ir o n ­ M im e o , U n ive rsity o f N orth C a ro lin a a t C h ap el H ill, N o v em b er
3 0 ,1 9 8 7 .
m e n t in w h ic h th e r e w a s n o in te r e s t c h a r g e o n
in tr a d a y c r e d it a n d , u n til r e c e n tly , n o c o n s tr a in ts H u m p h re y , D a vid B. “ P a ym e nts F in ality a n d R isk o f S e ttlem e nt
F a ilu re ,” in A n th o n y S a u n d e rs and L a w re n ce J. W h ite , ed.,
o n th e m a g n itu d e o f in tr a d a y c r e d it. T h e r e h a v e
T e c h n o lo g y a n d th e R e g u la tio n o f F in a n c ia l M a r k e ts (L e xin g ­
b e e n n o l o s s e s to th e F e d e r a l R e s e r v e o r to m e m ­ ton B ooks, 1986).

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
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J oh n so n , M anuel H. “ C h a llen ge s to th e F ederal R e se rve in th e M e n g le , D a vid L., D avid B. H u m p hre y , and B ru ce J. S u m ­

P aym e n ts M e c h a n is m ,” Is s u e s in B a n k R e g u la tio n (S u m m e r m ers. “ In tra d ay C re d it: R isk, V a lu e a n d P ricin g ,” F ederal
1988), pp. 1 3 -1 6 . R e se rve B ank o f R ich m o nd E c o n o m ic R e v ie w (Ja n u a ry/
F eb ru ary 1987), pp. 3 -1 4 .
K antrow , Y ve tte D. “ B ig N Y B anks M a y S pin O ff C h ip s N e t­ “ P ro po sa ls fo r In te rn a tion a l C o n ve rg e n c e o f C a p ita l M e asu re ­
w o rk ,” A m e ric a n B a n k e r (June 27, 1988), pp. 1, 23. m e nt a nd C a p ita l S ta n d a rd s .” Is s u e s in B a n k R e g u la tio n
(W in te r 1988), pp. 3 -1 2 .
L a rg e -D o lla r P aym e n ts S ys te m A d viso ry G rou p . A S tra te g ic
R o th sch ild, M ichael, and Jo s e p h E. S tig litz. “ Increa s in g R isk: I.
P la n fo r M a n a g in g R is k in th e P a y m e n ts S y s te m , R ep o rt to th e
A D e fin itio n ,” J o u rn a l o f E c o n o m ic T h e o ry (S e p te m b e r 1970),
P aym e n ts S y stem P o lic y C om m itte e o f th e F e d e ra l R e se rve
pp. 2 2 5 -4 3 .
S yste m , B o a rd o f G o ve rn o rs o f th e F e d e ra l R e se rve S ystem ,
A u g us t 1988. T a s k F o rce on C o n tro llin g P ay m e n ts S y stem R isk. C o n tro llin g
R is k in th e P a y m e n ts S y s te m , R ep o rt to th e P a ym e n ts S yste m
P o licy C o m m itte e o f th e F e d e ra l R e se rve S yste m , B o a rd of
M engle, D avid L. “ Legal and R e g ula to ry R e fo rm in E lec tro n ic
G o v e rn o rs o f th e F ederal R e se rv e S y ste m , A u g u s t 1988.
P a y m e nts: A n E va lua tio n o f F ina lity o f P a ym e nt R u le s,” in
D avid B. H u m p h re y, ed., U .S . P a y m e n t S y s te m : E ffic ie n c y , V a n H o os e, D avid. “ T he A ng e ll P ro p osa l: A n O v e rv ie w ,” s ta ff
R is k a n d th e R o le o f th e F e d e ra l R e s e rv e S y s te m (K luw er, paper, B oard o f G o v e rn o rs o f th e F e d e ra l R e s erve S yste m
1989). (Ju ne 1988).

A p p e n d ix 1
C u rre n t F e d e ra l R e s e rv e P o l i c y o n P a y m e n ts
S y s te m R i s k

C u r r e n tly , th e F e d e r a l R e s e r v e u s e s s p e c i f i c p a n t w ith a ll o th e r p a r tic ip a n ts o n th e s y s te m ;

l i m i ts o n d a y l ig h t o v e r d r a f ts o f r e s e r v e a c c o u n t s C H IP S s e t s t h i s l i m i t f o r e a c h p a r t i c i p a n t a t 5 p e r ­
a n d n e t d e b i t p o s i t i o n s o n p r iv a te w ir e t r a n s f e r c e n t o f th e s u m o f a ll b i l a te r a l c r e d i t li m its f o r th a t
s y s te m s to r e d u c e p a y m e n ts s y s te m ris k . T h e lim ­ p a r t i c i p a n t e x t e n d e d b y a l l o t h e r C H IP S p a r t i c i ­
its o n n e t d e b i t p o s i t i o n s a p p l y to a n y p r i v a te w ir e p a n t s . 2 C H IP S e s t a b l i s h e d t h e s e s e n d e r n e t d e b i t
t r a n s f e r s y s t e m t h a t s e t t l e s t h e n e t p o s i t i o n s o f i ts c a p s in O c to b e r 1 9 8 5 .
p a r tic ip a n ts th r o u g h tr a n s f e r s o f b a l a n c e s in r e ­
se rv e o r c le a rin g a c c o u n ts a t R e se rv e B a n k s . S in c e
C H IP S i s t h e o n l y s u c h s y s t e m i n o p e r a t i o n , t h e Cross-System Caps
f o l l o w i n g d e s c r i p t i o n r e f e r s o n l y t o it, b u t w o u l d
E a c h b a n k th a t o c c a s io n a lly h a s d a y lig h t re s e rv e
a p p l y to a n y s u c h s y s te m d e v e lo p e d in th e f u tu r e .1
o v e r d r a f ts i s r e q u i r e d to a d o p t a c a p o n i t s c r o s s ­
Bilateral Net Credit Limits on CHIPS s y s te m d a y lig h t o v e r d r a f t. C r o s s - s y s te m r e f e r s to
th e d a y lig h t o v e rd ra f t p o s itio n o n F e d w ire a n d
T h e F e d e ra l R e se rv e re q u ire s e a c h p a r tic ip a n t
C H IP S . T h e r e l e v a n t o v e r d r a f t p o s i t i o n f o r t h i s c a p
o n C H IP S t o s e t a l i m i t o n i t s n e t c r e d i t p o s i t i o n o n
is th e s u m o f a b a n k ’s f u n d s - r e l a te d o v e r d r a f t o f its
m e s s a g e tr a n s f e r s w ith e a c h o f th e o th e r p a r tic i­
re s e r v e a c c o u n t a n d its n e t d e b it p o s i ti o n o n
p a n ts in th e s y s te m . F u n d s tr a n s f e r m e s s a g e s th a t
C H IP S a t e a c h m o m e n t d u r i n g t h e d a y . E a c h b a n k
v i o l a t e t h e s e b i l a t e r a l n e t c r e d i t l i m i t s a r e r e je c t e d
s e ts its c a p b y p la c in g its e l f in o n e o f th e p o s s ib le
b y th e c o m p u te r s y s te m th a t p r o c e s s e s p a y m e n t
c a te g o r ie s in d ic a te d in ta b le A l ; b a n k s a r e d ir e c te d
m e s s a g e s . C H IP S p a r t i c i p a n t s h a v e h a d b i l a t e r a l
to c o n s i d e r t h e i r c r e d i t w o r t h i n e s s , c r e d i t p o l i c i e s
c r e d it lim its s in c e O c to b e r 1 9 8 4 .
a n d o p e r a tio n a l c o n tr o l a n d p r o c e d u r e s . E a c h
p o s s ib le r a tin g h a s c o r r e s p o n d in g c a p s f o r b o th
Sender Net Debit Caps on CHIPS
th e o n e d a y a n d tw o - w e e k a v e r a g e m a x im u m d a y ­
T h e F e d e r a l R e s e r v e r e q u i r e s C H IP S to e s t a b l i s h l i g h t o v e r d r a f t, e a c h a s a p e r c e n t a g e o f p r i m a r y
lim its o n th e n e t d e b it p o s itio n s o f e a c h p a r tic i­ a d ju s t e d c a p i t a l . T h e s e p e r c e n t a g e s h a v e b e e n

'F o r an a n alysis o f th e e ffe cts o f th e s e c re d it lim its on d a y lig h t 2T h e re a re a d d itio n a l d e ta ils inv olve d in d e te rm in in g th e s e lim its,
o v e rd ra fts a nd th e o p e ra tion o f th e p a y m e nts sy ste m , s ee B el- S e e B elton, e t al. (1987).
ton, e t al. (1987).

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve Bank of St.
FEDERAL Louis BANK OF ST. LOUIS
RESERVE
 13

T a b le A1
C aps on D aylight O verdrafts A cross P aym ents S ystem s
(m ultiples o f adjusted prim ary capital)
P eriod ca ps in effec t
Self- C ap
as se ss m e n t applied M arch 2 7 ,1 9 8 6 to J an u ary 1 4 ,1 9 8 8 M ay 1 9 ,1 9 8 8
ca teg ory to Ja n u a ry 1 3 ,1 9 8 8 to M ay 1 8 ,1 9 8 8 to pres ent

H igh T w o -w e e k
a ve ra g e 2 .0 00 1 .700 1.500

S in gle d a y 3 .0 00 2 .5 50 2 .2 5 0

A bove T w o -w e e k
a ve ra g e a ve ra ge 1 .500 1.275 1.125

S in g le da y 2 .5 00 2 .1 25 1.875

A ve ra g e T w o -w e e k
a ve ra ge 1.000 0 .8 50 0 .7 5 0

S in g le d a y 1.500 1.275 1 .125

L im ited T w o -w e e k
a ve ra g e 0 .5 0 0 0 .4 2 5 0 .3 7 5

S in g le d a y 0 .5 0 0 0 .4 2 5 0 .3 7 5

N O T E : A d ju s te d p rim a ry c a p ita l fo r U .S .-ch artere d b a n ks is th e su m o f p rim a ry c ap ital less all inta n gib le
a s se ts and d efe rre d n e t lo s se s on loa n s and o th e r a s se ts sold.
S O U R C E : F e d e ra l R e se rve B u lle tin (N o ve m b e r 1987), p. 843.

r e d u c e d o v e r t i m e t o m a k e t h e m m o r e e f f e c ti v e i n o u t th e v a l u e o f b o o k - e n t i y s e c u r i t i e s c r e d i t e d to
c o n s t r a i n i n g o v e r d r a f ts . th e a c c o u n t o f th e b a n k . T h is s te p e x e m p ts d a y ­
lig h t o v e r d r a f ts g e n e r a te d th r o u g h s e c u r i ti e s

Book-Entry Securities Transfers tr a n s a c tio n s f ro m th e lim its im p o s e d b y th e c a p s .

T h e F e d e r a l R e s e r v e h a s a llo w e d th is d is tin c tio n
In c a l c u l a t i n g t h e r e le v a n t m e a s u r e o f o v e r d r a f ts t o a v o i d d i s r u p t i n g t h e m a r k e t f o r U .S. g o v e r n m e n t
f o r th e c r o s s - s y s te m c a p s , th e F e d e r a l R e se rv e n e ts s e c u r itie s .

A p p e n d ix 2
A d d i ti o n a l I l l u s tra ti o n s o f P a y m e n ts a n d R i s k

Transfers fo r Depositors Over $ 2 5 to a d e p o s i t o r o f B a n k B i n t h e f o r m o f a w i r e

tr a n s f e r . S i n c e th e in i ti a l r e s e r v e b a l a n c e is o n ly
Fedwire
$ 1 0 , th e $ 2 5 tr a n s f e r m a k e s th e re s e r v e a c c o u n t o f
B a n k A o v e r d r a w n b y $ 1 5 . A s i n t a b l e 1 i n t h e t e x t,
W ir e tr a n s f e r s o f f u n d s f o r d e p o s i to r s m a y c a u s e a n a n n o u n c e m e n t o f a $ 1 5 d e c lin e in th e v a lu e o f
b a n k s to o v e r d r a w t h e i r r e s e r v e a c c o u n t s , a s ta b l e th e a s s e ts o f B a n k A w o u ld f o r c e th e F e d e r a l R e ­
A 2 i l l u s t r a t e s . A d e p o s i t o r i n s t r u c t s B a n k A to p a y s e r v e to a b s o r b a $ 5 lo s s .

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis JA N U A R Y /F E B R U A R Y 1989
 14

T a b le A 2
Risk C reated by Transferring D ep osito r’s Funds over Fedw ire
B a lanc e sh ee ts at start of day:

B a nk A B ank B

R e se rve s $10 D e p o sits $100 R e se rve s $10 D e p o s its $100

O th e r N et O th e r N et
a sse ts 100 w o rth 10 a sse ts 100 w o rth 10

B ank A se nd s $25 o f d e p os ito r’s m o n ey to B a nk B o v e r Fedwire:

B a nk A B ank B

R e s erve s -$ 1 5 D e p o sits $ 75 R e se rve s $35 D e p o s its $125

O th e r N et O th e r N et
a sse ts 100 w orth 10 a sse ts 100 w orth 10

V a lu e o f o th e r as se ts at B a nk A re duced by $15:

B a nk A B ank B

R e se rve s - $ 15 D e p o sits $ 75 R e se rve s $35 D e p o s its $125

O th e r N et O th e r N et
a sse ts 85 w o rth -5 a sse ts 100 w orth 10

Securities Transfers th a t s e r v e a s t h e i r c l e a r i n g b a n k s f o r s e c u r i t i e s
tr a n s f e r s .
A f e w b a n k s i n c u r la r g e d a y lig h t o v e r d r a f ts b e ­
D a y l i g h t o v e r d r a f ts o f t h e c l e a r i n g b a n k s ’ r e s e r v e
c a u s e o f th e tr a n s a c tio n s th e y c o n d u c t f o r c u s ­
a c c o u n ts r e f le c t th e p r a c tic e s o f th e g o v e r n m e n t
t o m e r s t h a t d e a l i n U .S . g o v e r n m e n t s e c u r i t i e s .
s e c u r i ti e s d e a l e r s in m a n a g in g th e i r in v e n to r ie s o f
T h e s e tr a n s a c tio n s w a r r a n t s p e c ia l e x a m in a tio n . A
g o v e r n m e n ts s e c u r itie s . D e a le r s h o ld la r g e in v e n ­
f e w la r g e b a n k s ( c a lle d c le a r in g b a n k s ) s p e c ia liz e
to r i e s o f s e c u r i ti e s d u r in g th e d a y to m e e t th e
in s e r v in g g o v e r n m e n t s e c u r itie s d e a le r s ; th e s e
a n tic ip a te d d e m a n d s o f th e ir c u s to m e r s . T o m in i­
b a n k s g e n e r a te a la r g e s h a r e o f th e to ta l d a y lig h t
m iz e th e c o s t o f h o ld i n g th e in v e n to r ie s , th e d e a l­
o v e r d r a f ts o f b a n k r e s e r v e a c c o u n t s . I n t h e s e c o n d
e r s s e ll m o s t o f th e ir s e c u r itie s b y th e e n d o f th e
q u a r te r o f 1 9 8 8 , f o r e x a m p le , f o u r c le a r in g b a n k s
d a y th r o u g h r e p u r c h a s e a g r e e m e n ts . T h e in v e s ­
a c c o u n te d f o r a b o u t 7 0 p e r c e n t o f th e d a y lig h t
to r s w h o e n t e r in to th e s e a g r e e m e n ts " o w n ” th e
o v e r d r a f ts a t t r i b u t a b l e to t r a n s a c t i o n s i n b o o k -
s e c u r i t i e s o v e r n i g h t a n d “ r e s e l l ” th e m to d e a l e r s
e n tiy s e c u r itie s .
e a r ly th e n e x t d a y . T h u s , th e d e a le r s b u ild th e ir
in v e n to r ie s o f g o v e r n m e n t s e c u r i ti e s in th e m o r n ­
B u s i n e s s P r a c t i c e s o f D e a l e rs a n d C l e a ri n g
in g o f e a c h b u s in e s s d a y b y re c e iv in g s e c u r itie s
B an k s — G o v e rn m e n t s e c u r itie s d e a le rs w h o b u y
r e tu r n e d b y th e o v e r n ig h t r e p o in v e s to r s a n d b u y ­
a n d s e ll s e c u r itie s f o r th e ir c u s to m e r s h a v e n o
in g a d d itio n a l s e c u r itie s o f f e r e d f o r s a le .1
d i r e c t a c c e s s to t h e b o o k - e n t i y s y s t e m f o r t r a n s f e r ­
r in g o w n e r s h ip o f g o v e r n m e n t s e c u r itie s . In s te a d , T h e f o llo w in g f e a tu r e s o f th e b u s i n e s s p r a c ti c e s
th e y m a i n ta in b o o k - e n ti y s e c u r i ti e s a c c o u n ts a n d o f g o v e rn m e n t s e c u r itie s d e a le r s e x p la in w h y th e y
d e m a n d d e p o s it a c c o u n ts w ith c o m m e r c ia l b a n k s g e n e r a lly w a it u n til e a r ly a f te r n o o n to b e g in r u n -

'F o r a m o re c o m p le te d is cu ss io n o f th e p ra ctice s o f c le a ring

b an k s and d ea lers, se e A s so c ia tio n o f R e se rve C ity B a n ke rs
(1986).

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve BankFEDERAL
of St.RESERVE
Louis BANK OF ST. LOUIS
 15

n in g d o w n th e i r in v e n to r y o f s e c u r itie s . S a l e s m e n a c c o u n ts o f th e c le a r in g b a n k s r is e a s th e b o o k -
f o r a d e a l e r m a k e c o m m i tm e n ts to d e liv e r s p e c if ic e n tr y s e c u r itie s a r e tr a n s f e r r e d to th e a c c o u n ts o f
s e c u r i t i e s to i t s c u s t o m e r s b y t h e e n d o f t h e d a y . o th e r b a n k s a n d re s e rv e b a la n c e s a re s im u lta n e ­
T h e d e a l e r i s t h e n v u l n e r a b l e to l o s s e s i f it c a n n o t o u s l y t r a n s f e r r e d to t h e a c c o u n t s o f t h e c l e a r i n g
f u lf ill th e s e c o m m i tm e n ts . T h e c u s to m e r s r e c e iv e b a n k s . T h e ti m in g o f tr a n s a c ti o n s in b o o k - e n tr y
in te r e s t o n th e p r o m is e d s e c u r itie s f o r th a t d ay , s e c u r itie s f o r th e d e a le r s c a u s e s th e r e s e rv e a c ­
e v e n if th e d e a le r d o e s n o t m a k e d e liv e iy . T h e c o u n ts o f th e c l e a r in g b a n k s to b e o v e r d r a w n b y
c u s t o m e r s , h o w e v e r , m a k e p a y m e n t s to t h e d e a l ­ b illio n s o f d o lla rs d u r in g p a r t o f th e d a y .
e r s o n ly w h e n th e s e c u r itie s a r e d e liv e re d . T h e
I m p l i c a ti o n s f o r R is k — T h e c l e a r i n g b a n k s
d e a l e r w o u l d f a i l to m a k e d e l i v e i y i f i t c o u l d n o t
e x t e n d c r e d i t to g o v e r n m e n t s e c u r i t i e s d e a l e r s
l o c a t e th e d e s i r e d s e c u r i t i e s in its i n v e n to i y o r in
d u r in g th e d a y b y a llo w in g th e m to o v e r d r a w th e i r
th e m a r k e t, o r i f it s e n t th e w r o n g s e c u r i ti e s to a
d e m a n d d e p o s it a c c o u n ts . T h e b a n k s lim it th e ir
c u s to m e r a n d h a d th e m r e tu r n e d . E a c h d e a le r
r is k b y o b ta in in g a lie n a g a in s t th e s e c u r itie s h e ld
a t t e m p t s to m i n i m i z e t h e p r o b a b i l i t y o f s u c h
f o r th e a c c o u n t o f th e d e a le r s . T h u s , a c le a r in g
“ f a i l s ” b y w a i t i n g u n t i l e a r l y a f t e r n o o n t o d i r e c t i ts
b a n k c o u l d c l a i m th e s e c u r i t i e s c r e d i t e d to th e
c l e a r i n g b a n k to s e n d i t s s e c u r i t i e s to t h e b o o k -
a c c o u n t o f a d e a l e r to c o v e r a n y l o s s e s o n i t s d e ­
e n tr y a c c o u n ts o f th e b a n k s th a t s e rv e th e c u s ­
p o s i t o v e r d r a f t. 2
to m e r s th a t h a v e b o u g h t th e m .
T h e F e d e r a l R e s e rv e h a s c o n s id e r e d v a rio u s
A n o th e r r e a s o n th e d e a le r s h o ld th e ir s e c u r itie s
m e th o d s o f e s ta b lis h in g lie n s a g a in s t th e s e c u r i­
u n til e a r ly a f te r n o o n in v o lv e s p o te n ti a l p r o f its
ti e s in th e b o o k - e n tr y a c c o u n ts o f b a n k s b u t h a s
f ro m s p e c ia l o r d e r s . O n s o m e d a y s , c e r ta in is s u e s
n o t in itia te d s u c h c o lla te r a l a r r a n g e m e n ts . T h u s ,
o f g o v e r n m e n t s e c u r itie s a r e in re la tiv e ly h ig h
th e F e d is v u ln e r a b le to l o s s e s o n th e f u ll a m o u n t
d e m a n d . T h e d e a l e r s c a n m a k e la r g e r p r o f its if
o f a b a n k ' s r e s e r v e o v e r d r a f t, w h e t h e r t h e o v e r d r a f t
th e y h a v e s e c u r i ti e s a v a ila b le to m e e t th e s e s p e c i a l
w a s g e n e r a te d th r o u g h f u n d s tr a n s f e r s o r t r a n s a c ­
o r d e r s . In c o n t r a s t to th e s p e c i f i c r e q u i r e m e n ts f o r
tio n s in b o o k - e n tr y s e c u r itie s .3
s p e c ia l o r d e r s , d e a le r s m a y s u b s titu te a w id e v a r i­
e ty o f s e c u r itie s a s a c c e p ta b le c o lla te r a l f o r r e p o s .
T h e r is k i m p l i c a t i o n s o f b o o k - e n t r y o v e r d r a f ts
E f f e c ts o n I n tra d a y R e s e rv e B a l a n c e s — c a n b e illu s tr a te d b y e x a m in in g th e b a la n c e s h e e t
T h e s e d e a le r p r a c tic e s a f f e c t th e in tr a d a y p a tte r n s e n tr ie s in ta b le A 2 . B a n k A is a c le a r in g b a n k f o r a
o f th e ir d e m a n d d e p o s it b a la n c e s a n d th e re s e rv e g o v e r n m e n ts s e c u r itie s d e a le r . T h e d e a le r r e c e iv e s
b a la n c e s o f th e c le a r in g b a n k s th a t s e rv e th e m . $ 2 5 in b o o k - e n tr y s e c u r i ti e s a n d h a s its d e m a n d
W h e n a r e p o i n v e s t o r r e t u r n s t h e s e c u r i t i e s to t h e d e p o s i t a c c o u n t d e b i te d b y $ 2 5 , le a v in g it o v e r ­
d e a le r , th e r e is a n i n c r e a s e in th e s e c u r i ti e s a c ­ d r a w n a t th a t ti m e . S u p p o s e th e d e a l e r g o e s b a n k ­
c o u n t o f th e d e a l e r a t its c le a r in g b a n k a n d a n r u p t a f te r th i s tr a n s a c ti o n is c o m p le te d . B a n k A
e q u a l r e d u c tio n in its d e m a n d d e p o s it a c c o u n t. c l a i m s t h e $ 2 5 i n s e c u r i t i e s t h a t w e r e c r e d i t e d to
O n th e b o o k s o f th e F e d e ra l R e se rv e , th e r e is a n t h e s e c u r i t i e s a c c o u n t o f t h e d e a l e r to c o v e r a n y
i n c r e a s e in th e s e c u r itie s in th e b o o k - e n tr y a c ­ p o s s i b l e l o s s e s o n t h e d e p o s i t o v e r d r a f t. T h e b a n k
c o u n t o f th e c l e a r in g b a n k a n d a r e d u c ti o n in th e is s p a r e d a n y lo s s e s , a n d th e F e d e r a l R e s e r v e s u f ­
re s e rv e a c c o u n t o f th e c le a r in g b a n k . T h e s a m e f e rs n o lo s s e s .

tr a n s a c tio n s o c c u r w h e n th e d e a le r b u y s s e c u r i­
T h i s b o o k - e n t r y d a y l i g h t o v e r d r a f t, h o w e v e r ,
ti e s to h o l d i n its i n v e n to r y t h a t d a y . T h e d e a l e r
d o e s l e a v e t h e F e d e r a l R e s e r v e v u l n e r a b l e to a l o s s
b u i l d s its i n v e n to r y o f s e c u r i t i e s b y o v e r d r a w in g
o n th e r e s e r v e o v e r d r a f t. S u p p o s e t h a t a f te r th e
i ts d e m a n d d e p o s i t a c c o u n t d u r i n g t h e d a y . T h e
d e a le r r e c e iv e s th e $ 2 5 in b o o k - e n tiy s e c u r itie s ,
d e a l e r s d o n o t c o n tr o l th e tim in g o f th e s e in f lo w s
th e r e is a n a n n o u n c e m e n t th a t i m p li e s a $ 1 5 l o s s
o f s e c u r i t i e s to t h e i r a c c o u n t s a n d t h e o u t f l o w s
in th e v a lu e o f th e o th e r a s s e ts o f B a n k A , a s in th e
f ro m th e ir d e m a n d d e p o s it a c c o u n ts , s in c e th e
o th e r il lu s tr a ti o n s . U n d e r c u r r e n t a r r a n g e m e n ts ,
p a r ty th a t h o ld s th e s e c u r i ti e s in i ti a te s th e tr a n s f e r
th e F e d h a s n o c la im o n th e $ 2 5 in b o o k - e n tr y
o f s e c u r itie s a n d r e s e r v e s th r o u g h th e F e d w ire
s e c u r i t i e s t h a t h a d b e e n t r a n s f e r r e d to B a n k A , to
s y s te m .
o f f s e t its $ 5 lo s s . T h u s , c o l la te r a l a g r e e m e n ts b e ­
T h e p r o c e s s o f o v e rd ra w in g re s e rv e a n d d e p o s it tw e e n c le a r in g b a n k s a n d th e d e a le r s m a k e F e d ­
a c c o u n ts is r e v e rs e d la te r in th e d a y a s th e d e a le r s e r a l R e s e r v e l o s s e s d u e to d e f a u l ts b y g o v e r n m e n t
s e ll th e ir in v e n to r ie s o f s e c u r itie s . T h e r e s e r v e s e c u r itie s d e a le r s u n lik e ly , b u t th e d a y lig h t re s e rv e

2T a s k F o rce (1988), p. 69. 3T a s k F o rce (1988), p. 7 0 - 7 2 .

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T a b le A 3
Th e Effects of Issuing C om m erical Paper on the B alance S h eet of an A gent B ank
B ala nce shee ts at s tart o f day:

B ank A B ank B

R e se rve s $10 D e p o sits $100 R e se rve s $ 10 D e p o sits $ 10 0

O th e r N et O th e r N et
a ss ets 100 w o rth 10 a sse ts 100 w o rth 10

B a nk A tra ns fers $ 2 5 to B a nk B, cred ited to th e ac co u n t of th e firm th at issue s co m m ercia l paper:

B a nk A B a nk B

R e se rve s -$ 1 5 D e p o sits $100 R e se rve s $35 D e p o sits $125

R ese rve s O th e r N et
re c eiva b le 25 a ss ets 100 w orth 10

O th e r N et
a ss ets 100 w o rth 10

B a nk A rece ives $2 5 fro m purcha se r o f com m ercial paper:

B a nk A B a nk B

R e se rve s $10 D e p o s its $ 10 0 R e se rv es $ 10 D e p o sits $ 10 0

R e se rve s O th e r N et
re ce iva ble 0 a ss ets 100 w orth 10

O th e r N et
a ss ets 100 w o rth 10

o v e rd ra f ts o f th e c l e a ri n g b a n k s e x p o s e th e F e d to m e r c i a l b a n k s b e c a u s e o f th e i r e f f e c ts o n o th e r
p o te n ti a l l o s s e s i n th e e v e n t o f l a rg e , u n a n ti c i ­ d e p o s i to r y in s titu tio n s a n d th e f in a n c i a l m a r k e ts
p a te d d e c l i n e s i n th e v a l u e o f th e a s s e ts o f th e in g e n e r a l. A lie n o n th e b o o k - e n tiy s e c u r itie s o f
c l e a ri n g b a n k s th e m s e l v e s . b a n k s m ig h t m a k e th e s u p e r v is o r y a u th o r itie s
m o r e r e l u c t a n t to c l o s e a la r g e b a n k th a t a ls o
A lie n b y th e F e d e r a l R e s e r v e a g a in s t th e b o o k -
se rv e s a s a c le a r in g b a n k f o r g o v e rn m e n t s e c u r itie s
e n tiy s e c u r itie s in th e a c c o u n ts o f th e c le a r in g
d e a le rs .
b a n k s m i g h t h a v e l i t t l e p r a c t i c a l s i g n i f i c a n c e in
lim itin g F e d ris k . S u p p o s e th e p u b li c le a r n s d u r in g Issuing and Redeeming Commercial
th e d a y th a t a c l e a r in g b a n k m a y b e b a n k r u p t.
Paper
W o u ld th e F e d e r a l R e s e rv e s u d d e n ly s e iz e th e
b o o k - e n tr y s e c u r itie s in th e a c c o u n t o f th e c l e a r ­ T h e ti m in g o f p a y m e n ts b y b a n k s in v o lv e d in

in g b a n k ? D o in g s o w o u ld d is r u p t th e b u s in e s s o f is s u in g a n d r e d e e m in g c o m m e r c ia l p a p e r c r e a te s
th e g o v e r n m e n t s e c u r itie s d e a le r s s e r v e d b y th e r e s e r v e o v e r d r a f ts .4 S e v e r a l b a n k s a c t a s a g e n ts f o r

c l e a r in g b a n k a n d , g iv e n th e h ig h c o n c e n tr a ti o n o f f irm s th a t is s u e c o m m e r c i a l p a p e r . T h e a g e n t

b u s in e s s a m o n g c le a r in g b a n k s , w o u ld d is r u p t b a n k s c o lle c t f u n d s f r o m th o s e p u r c h a s in g th e
tr a d in g in th e w h o le g o v e r n m e n t s e c u r itie s m a r ­ c o m m e r c i a l p a p e r a n d t r a n s f e r th e m to t h e a c ­

k e t. T h e F e d a n d t h e o t h e r f e d e r a l s u p e r v i s o r y c o u n ts o f th o s e f irm s is s u in g th e p a p e r . W h e n th e
a u th o r itie s h a v e b e e n r e lu c ta n t to c l o s e la r g e c o m ­ p a p e r m a tu r e s , th e a g e n t b a n k s c o l le c t f ro m th e

“ F o r a d isc u s s io n o f ho w d a y lig h t o v e rd ra fts re fle ct tra n s a c tio n s

in c o m m e rcia l p a p e r a nd o th e r fin an c ial instru m e nts, see
L a rg e -D o lla r P aym e n ts S ys te m A d v iso ry G ro u p (1988).

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 17

p a p e r i s s u e r s a n d m a k e p a y m e n t s to t h e h o l d e r s s h e e t o f th e a g e n t b a n k a r e il l u s tr a te d in ta b l e A 3.
o f th e p a p e r. A f irm r a is e s $ 2 5 b y is s u in g c o m m e r c i a l p a p e r .
B a n k A is th e a g e n t b a n k , a n d b o th th e i s s u e r a n d
W h e n a f irm is s u e s c o m m e r c i a l p a p e r , th e a g e n t p u r c h a s e r o f th e p a p e r h a v e th e ir d e m a n d d e p o s it
b a n k g e n e r a lly p a y s th e f ir m b e f o r e it r e c e iv e s a c c o u n ts a t B a n k B. E a rly in th e d a y o n w h ic h th e
p a y m e n t f ro m th o s e b u y in g th e p a p e r . D u rin g th e c o m m e r c i a l p a p e r is i s s u e d , B a n k A t r a n s f e r s $ 2 5
p e r io d b e tw e e n th e p a y m e n t to th e i s s u e r a n d th e to B a n k B, to b e c r e d i t e d to t h e d e m a n d d e p o s i t
r e c e ip ts f r o m th e p u r c h a s e r s , th e re s e r v e a c c o u n t a c c o u n t o f t h e i s s u e r . A f te r t h a t t r a n s a c t i o n , t h e
o f th e a g e n t b a n k f a lls b y th e a m o u n t o f th e f u n d s r e s e r v e a c c o u n t o f B a n k A is o v e r d r a w n b y $ 1 5 . In
r a is e d b y is s u in g th e c o m m e r c ia l p a p e r . T h e r e ­ th i s e x a m p l e , th e o f f s e ttin g tr a n s a c t i o n is a $ 2 5
s e r v e b a l a n c e o f th e a g e n t b a n k a ls o f a lls b y th e in c r e a s e in a n a c c o u n t c a lle d “ re s e rv e s r e c e iv ­
f a c e a m o u n t o f th e is s u e w h e n th e p a p e r m a tu r e s ; a b l e .” L a te r th a t d a y , th e p u r c h a s e r o f th e p a p e r
t h e a g e n t b a n k g e n e r a l l y m a k e s p a y m e n t to t h o s e a r r a n g e s f o r B a n k B to s e n d $ 2 5 to B a n k A o v e r
h o ld in g th e p a p e r b e f o r e r e c e iv in g p a y m e n t f ro m F e d w ir e , e lim in a tin g th e r e s e r v e o v e rd ra f t b y th e
th e is s u e r. e n d o f th e d a y . A s in th e o th e r b a la n c e s h e e ts , th e
F e d e r a l R e s e r v e is a g e n e r a l c r e d ito r o f B a n k A
T h e e f f e c ts o f th e s e tr a n s a c tio n s o n th e b a la n c e w h ile its r e s e r v e a c c o u n t is o v e r d r a w n .

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 18

Keith M. Carlson

K e ith M . C a rls o n is a n a s s is ta n t v ic e p r e s id e n t a t th e F e d e ra l
R e s e rv e B a n k o f S t. L o u is . T h o m a s A. P o llm a n n p r o v id e d re ­
s e a r c h a s s is ta n c e .

F e d e ra l B u d g e t T re n d s a n d th e
1 9 8 1 R e ag an E co n o m ic Plan

I n EA R L Y 1 9 8 1 , a n e w ly in a u g u r a te d R o n a ld T H E 1 9 8 1 EC O N O M IC FO R E C A S T IN
R e a g a n a n n o u n c e d a n e c o n o m ic p la n w h ic h in ­
R ET R O S PEC T
c l u d e d g o a ls o f “ a n im m e d ia te , s u b s ta n tia l, a n d
s u s ta i n e d r e d u c ti o n in th e g r o w th o f f e d e r a l e x ­ W h e n th e R e a g a n a d m in is tr a tio n b e g a n p r e p a r ­
p e n d itu r e s [a n d ] a s ig n if ic a n t r e d u c tio n in f e d e ra l i n g i t s b u d g e t i n l a t e 1 9 8 0 a n d e a r l y 1 9 8 1 , t h e U .S.
ta x r a te s . . A f t e r tw o t e r m s i n o f f i c e , i t s e e m s e c o n o m y w a s re c o v e rin g f ro m a b r ie f r e c e s s io n in
ti m e to e x a m i n e t h e o r ig in a l R e a g a n b u d g e t p l a n th e f ir s t h a l f o f 1 9 8 0 . O u tp u t w a s g r o w in g s lu g ­
in lig h t o f th e a c tu a l p e r f o r m a n c e o v e r th e 1 9 8 0 s . g is h ly f o r a r e c o v e ry p h a s e o f th e b u s in e s s c y c le ,
A lth o u g h th e b u d g e t p l a n h a d f a r - r e a c h i n g e c o ­ u n e m p lo y m e n t w a s w e ll a b o v e 7 p e r c e n t o f th e
n o m ic a n d s o c ia l c o n s e q u e n c e s , th is a r tic le f o ­ l a b o r f o r c e a n d p r o d u c tiv ity , a s m e a s u r e d b y o u t ­
c u s e s o n th e e x te n t to w h i c h th e in i ti a l b u d g e t p u t p e r h o u r, w a s d e c lin in g . P ric e s g e n e r a lly w e re
p r o je c t i o n s w e r e r e a l i z e d . 2 in c r e a s in g a t d o u b le - d ig it r a te s a n d in te r e s t r a te s
r e f le c te d th e h ig h r a te o f in f la tio n . T h e f e d e r a l
b u d g e t d e f ic it f o r f is c a l 1 9 8 0 w a s $ 6 0 b illio n a n d
F ir s t, th e 1 9 8 1 e c o n o m i c s e ttin g , w h i c h p r o v id e d
t h e o u t g o i n g a d m i n i s t r a t i o n ’s e s t i m a t e f o r 1 9 8 1
t h e u n d e r l y i n g r a t i o n a l e f o r t h e R e a g a n p l a n , is
w a s a b o u t $ 5 5 b illio n .
s u m m a r iz e d . T h e n , b e c a u s e th e b u d g e t a n d e c o ­
n o m i c c o n d i tio n s a r e in te r r e l a te d , th e 1 9 8 1 e c o ­ T h e in c o m in g p r e s id e n t d e s c r ib e d th e s itu a tio n
n o m ic a s s u m p tio n s a r e e x a m in e d in r e tr o s p e c t. a s “ th e m o s t s e r io u s s e t o f e c o n o m ic p r o b le m s
T h is is f o llo w e d b y a c o m p a r is o n o f p la n n e d a n d s in c e th e 1 9 3 0 s .” 3 T h e m o s t im p o r ta n t c a u s e o f
r e a liz e d c h a n g e s in f e d e r a l o u tla y s a n d r e c e i p ts . th e s e p r o b le m s , h e s u g g e s te d , w a s th e g o v e r n ­
T h e a r tic le c o n c lu d e s w ith a n e v a lu a tio n o f th e m e n t its e lf : th r o u g h ta x e s , s p e n d in g , r e g u la to r y

1 9 8 1 b u d g e t p la n . p o li c i e s a n d m o n e ta r y p o li c i e s , it h a d s a c r if ic e d

1A m e r ic a ’s N e w B e g in n in g . . . (1981), pp. 1 -3 . F or fu rth e r 3A m e ric a ’s N e w B e g in n in g . . . (1 9 8 1 ), p. 4.

d e tails, se e O ffic e o f M a n ag em e n t and B u d g e t (1981a) and
C a rlso n (M a y and N o v e m b e r 1981).

2F or m o re e x ten sive a n a lyse s o f th e R e agan ye a rs, se e B oskin

(1987), M ills and P a lm e r (1984), M o d ig lia n i (1988) and
N is ka n e n (1988).

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 19

F ig u re 1
A c tu a l M o v e m e n ts vs. R e a g a n F o re c a s ts o f
K ey E c o n o m ic V a r ia b le s
G ro s s N a tio n a l P r o d u c t (p e r c e n t c h a n g e )

G ro s s N a tio n a l P r o d u c t D e fla to r (p e rc e n t c h a n g e )

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lo n g - te r m g r o w th a n d p r i c e s ta b ili ty f o r e p h e m e r a l F in a lly , a s in d i c a te d in th e b o tto m ti e r o f f ig u re

s h o r t- te r m g o a ls . T o c o m b a t th e s e p r o b l e m s , th e 1, t h e T r e a s u r y b i l l r a t e w a s a l s o u n d e r e s t i m a t e d .

a d m in is tr a tio n p r o p o s e d a p r o g r a m th a t w a s i n ­ T h e B e a g a n a d m in is tr a tio n f o r e c a s t a s te a d y d e ­

t e n d e d to : c lin e in th e T r e a s u r y b ill r a te f ro m m o r e th a n 1 1
p e r c e n t i n 1 9 8 0 to 5 .7 p e r c e n t i n 1 9 8 6 ; th e a c tu a l
r e s t o r e f i s c a l i n te g r i ty ; i n c r e a s e i n c e n t i v e s f o r
s a v in g , i n v e s tm e n t, a n d p r o d u c t i o n ; a t t a i n m o n e ­ r a t e r o s e s h a r p l y i n 1 9 8 1 , b e f o r e f a l l i n g t o 6 .4 p e r ­
ta r y a n d f i n a n c i a l s ta b i l i ty ; a n d e n h a n c e t h e r o l e o f c e n t in 1 9 8 6 .
t h e m a r k e t p l a c e a s th e p r i n c i p a l f o r c e i n t h e a l l o ­
c a t i o n o f r e s o u r c e s .4 T h e s e k e y e c o n o m ic v a ria b le s g e n e r a lly m o v e d
u n f a v o ra b ly d u r in g th e 1 9 8 0 - 8 6 p e r io d in te r m s o f
A n i m p o r t a n t p a r t o f e v e r y b u d g e t p r o g r a m is
th e ir e f f e c t o n th e f e d e r a l b u d g e t. T h e s lo w e r-
th e s e t o f u n d e r ly in g e c o n o m i c a s s u m p ti o n s .3
th a n - f o r e c a s t g r o w th o f n o m i n a l G N P s l o w e d th e
F i g u r e 1 s h o w s t h e a d m i n i s t r a t i o n ’s 1 9 8 1 f o r e c a s t s
g r o w th o f r e c e i p t s a n d c o n t r i b u t e d to a l a r g e r
f o r a v a r ie ty o f k e y e c o n o m i c v a r ia b le s a lo n g w ith
d e f ic it. A l th o u g h s l o w e r - t h a n - e x p e c t e d i n f l a ti o n
th e i r a c tu a l p e r f o r m a n c e . A s th e to p ti e r s h o w s ,
h e l p e d to r e d u c e t h e g r o w th o f b u d g e t o u tla y s ,
th e a d m in i s tr a tio n o v e r e s tim a te d th e g r o w th in
s lo w e r r e a l G N P g r o w th a n d h ig h e r - th a n - f o r e c a s t
n o m i n a l G N P f r o m 1 9 8 0 to 1 9 8 6 b y a s u b s ta n t i a l
u n e m p lo y m e n t r a te s i n c r e a s e d o u tla y s , p a r tic u ­
a m o u n t.6 In p a r tic u l a r , it d id n o t f o r e c a s t th e
la r ly f o r u n e m p l o y m e n t in s u r a n c e . M e a n w h ile , th e
1 9 8 1 - 8 2 r e c e s s i o n n o r d i d it f o r e s e e t h e s h a r p
h ig h e r - th a n - e x p e c te d T r e a s u r y b ill r a te a ls o
r e d u c ti o n in n o m in a l G N P g r o w th a f te r 1 9 8 4 . B y
b o o s te d o u tla y s , e s p e c ia lly w h e n th e g o v e r n m e n t
1 9 8 6 , th e c u m u la tiv e e r r o r f o r G N P w a s o v e r $ 8 0 0
w a s b o r r o w in g m o r e th a n p la n n e d . T h u s , m o s t o f
b illio n , o r a lm o s t 2 0 p e r c e n t o f th e a c tu a l le v e l o f
t h e e r r o r s i n t h e a d m i n i s t r a t i o n ’s f o r e c a s t w e r e
G N P in 1 9 8 6 . T h is e r r o r r e f le c te d a n a c tu a l G N P
o n e s th a t in c r e a s e d th e d e f ic it m o r e th a n
g r o w t h r a t e o f 7 .8 p e r c e n t o v e r t h e 1 9 8 0 - 8 6 p e r i o d ,
p r o je c t e d . 9
q u ite a b it lo w e r th a n th e a s s u m e d g r o w th r a te o f
11 p e r c e n t.7
T H E B U D G ET T O T A L S :
T h e o v e r e s tim a te o f n o m in a l G N P r e f le c te d o v e r­
e s tim a te s o f b o th r e a l g r o w th ( s e c o n d ti e r o f f ig u re
R EA L IZ A T IO N S V S . T H E R EA G A N
1) a n d i n f l a t i o n ( t h i r d t i e r o f f i g u r e 1 ) . T h e c u m u l a ­ PLA N
ti v e e r r o r i n f o r e c a s t s o f r e a l G N P b y 1 9 8 6 w a s 7
A s f ig u re 1 in d i c a te d , th e R e a g a n a d m in i s tr a ­
p e r c e n t w h ile th e G N P d e f la to r w a s o v e r e s tim a te d
t i o n ’s 1 9 8 1 e c o n o m i c a s s u m p t i o n s w e r e e r r o n e ­
b y 1 1 p e r c e n t. T h e 1 9 8 1 a d m in is tr a tio n f o r e c a s t f o r
o u s . A r e la te d q u e s tio n is to w h a t e x te n t w e r e th e
i n f l a t i o n f o r t h e 1 9 8 0 - 8 6 p e r i o d w a s a 7 .1 p e r c e n t
b u d g e t p r o je c t i o n s a l s o e r r o n e o u s ? A n o b v i o u s
a n n u a l r a te ; th e a c tu a l in f l a tio n r a te d u r in g th i s
m e a s u r e o f th is p a r tic u la r e r r o r is th e d if f e r e n c e
p e r i o d w a s 5 .1 p e r c e n t . 8
b e tw e e n th e p l a n n e d a n d th e a c t u a l s u rp lu s /
T h e f o u r th ti e r o f f ig u re 1 in d i c a te s th a t th e u n ­ d e f ic it. F ig u r e 2 s h o w s th e s iz e o f th is d is c r e p a n c y .
e m p lo y m e n t r a te w a s u n d e r e s tim a te d in e a c h o f T h e R e a g a n p l a n p r o je c t e d a s t e a d y m o v e t o w a r d
th e y e a r s f r o m 1 9 8 1 to 1 9 8 6 . T h e a d m in i s tr a tio n a b a la n c e d b u d g e t b y 1 9 8 6 ; th e a c tu a l d e f ic it f o r
f o r e c a s t th a t th e u n e m p lo y m e n t r a te w o u ld r is e in 1 9 8 6 w a s $ 2 2 1 b i l l i o n . 10 T o b e t t e r u n d e r s t a n d w h y
1 9 8 1 , t h e n f a ll to 5 .6 p e r c e n t b y 1 9 8 6 ; th e a c t u a l t h e 1 9 8 1 b u d g e t p l a n ' s p r o je c t i o n s w e r e i n e r r o r ,
1 9 8 6 r a t e w a s 7 .1 p e r c e n t . in d iv id u a l b u d g e t c a te g o r ie s a r e e x a m in e d b e lo w .”

4I b id ., p. 9. 7S uch a p ro je c tio n w a s not u n u su a l in e a rly 1981. F or ex am p le ,

th e C o n g re s s io n a l B u d g e t O ffice p ro je c te d a 1 9 8 0 -8 6 n o m inal
5A lth o ug h su ch a s su m p tio n s are a b s o lu te ly n e c e s sa ry to p ro je ct
G N P g ro w th rate in e x c es s o f 11 p e rce n t. S e e C B O (1981).
o u tla ys and re c eip ts, e c o n o m ic co n d itio n s th e m s e lv e s are
influ en c ed b y c o n gre s sio n a l and le g isla tiv e d ec is io n s th a t 8B y co m p ariso n , th e C B O p ro je cted a 2.8 p e rce nt rate o f real
a ffec t th e bu d g e t. T h is w a s th e a d m in istra tio n ’s re a so n in g in G N P g ro w th and an 8 .5 p e rc e n t rate o f inflation.
1981; its b u dg e t p ro g ra m s w e re d e s ig n e d to h ave a fa vo ra b le
9F or a sta tistica l in v e s tig a tio n o f b ia s in g o ve rn m e n t e co n o m ic
e ffec t on th e e co n o m y. In fact, its e c o n om ic a ssu m p tio n s w e re
fo re c asts, se e B e lo n g ia (1988).
so o p tim istic , it fe lt co m p elle d to say:
In d e e d th e y do re p re s e n t a d ra m a tic d e p a rtu re fro m th e
' “T h ro u g h o u t th is a rtic le re fe re n ce s to th e “ R e a g an p la n " are to
tre n d s o f r e c e n t y e a r s — bu t s o d o th e p ro p o s e d p o lic ie s . In th e sp e n d in g p ro gra m th a t e x c lu d e d w h a t th e y ca lle d “ u n a llo­
fa ct, if e a c h po rtion of this c o m p re h e n s iv e e c o n o m ic p ro ­ c ated s a v in g s .” T h e se w e re c u ts in s pe n d in g fo r w h ich d e ta il
g ra m is pu t in p la c e — q u ic kly a n d c o m p le te ly — th e e c o ­ w a s to be p ro v id e d later.
n o m ic e n v ir o n m e n t co u ld im p ro v e e v e n m o re rap id ly th a n
e n v is io n e d in th e s e a s s u m p tio n s . [Ib id ., p. 2 5 .]
" T h e re su lts o f an a lte rn a tive a n a lys is u sin g a sm a ll m odel of
b ud g e t d e te rm in a tio n a p pe ars in a p p e nd ix A.
G e n e r a lly , fro m th is p o in t on, all re fe re n ce s to y e a rs a re to
fis c a l y ea rs , i.e., th e 1 2 -m o n th p eriod e n d ing S e p te m b e r 30.

Digitized for FRASER

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Federal Reserve FEDERAL
Bank of St.RESERVE
Louis BANK OF ST. LOUIS
 21

F ig u re 2
Federal S u rp lu s/D eficit
B illio n s o f d o lla r s F is c a l Y e a r s B illio n s o f d o lla r s
5 0 -------- --- --- --- -- --- --- --- --- --- --- - ------------------- 50

- 100 - 100

-150 -150

-2 0 0 -200

-250 -250
1955 60 65 70 75 85 1990

N O T E : R e a g a n p la n d o e s n o t in c lu d e “ u n a llo c a te d s a v in g s . ’

Outlays F ig u re 3 s h o w s th e R e a g a n p la n f o r r e a l f e d e ra l
o u tla y s a lo n g w ith a c tu a l r e a l o u tla y s . T o ta l o u t­
O n e m a jo r o b je c t i v e o f R e a g a n ’ s e c o n o m i c p r o ­
la y s in r e a l te r m s c le a r ly d id n o t s lo w a s m u c h a s
g r a m w a s to
p la n n e d . F ro m 1 9 7 6 to 1 9 8 0 , th e a v e r a g e g r o w th
r e d u c e th e r a te a t w h i c h g o v e r n m e n t s p e n d i n g r a t e o f r e a l f e d e r a l o u t l a y s w a s 3 .5 p e r c e n t . T h e
i n c r e a s e s . . . . T h u s , t h e b a d l y n e e d e d e f f o r t to
a c t u a l r a t e o f i n c r e a s e f r o m 1 9 8 0 to 1 9 8 8 w a s 2 . 9
" c u t” t h e b u d g e t r e a l l y r e f e r s to r e d u c t i o n s i n th e
p e r c e n t , o n l y s l i g h t l y s l o w e r t h a n f r o m 1 9 7 6 to
a m o u n t o f i n c r e a s e in s p e n d i n g r e q u e s te d f ro m
o n e y e a r to th e n e x t . 12
1 9 8 0 a n d w e l l i n e x c e s s o f t h e 1 .1 p e r c e n t r a t e t h a t
t h e a d m i n i s t r a t i o n h a d p r o je c t e d i n 1 9 8 1 .

T h e 1 9 8 1 p r o g r a m f o r r e d u c in g th e g r o w th o f o u t­ A s f ig u r e 4 s h o w s , a n o t h e r w a y to s u m m a r i z e
l a y s w a s s u b je c t to s o m e c o n f u s i o n , h o w e v e r , b e ­ b u d g e t t r e n d s i s to e x a m i n e t h e r a t i o o f o u t l a y s to
c a u s e a ta r g e t c e i l i n g w a s s e t w h i c h i n c l u d e d s u b ­ G N P . F r o m 1 9 5 5 to 1 9 8 0 , t h e r a t i o o f t o t a l o u t l a y s
s t a n t i a l “ u n a l l o c a t e d s a v i n g s ” t h a t w e r e to b e t o G N P r o s e , a l b e i t i r r e g u l a r l y . 13 A l t h o u g h t h e
s p e c i f i e d la te r . In th e f o llo w in g d i s c u s s i o n , th e s e R e a g a n p l a n i n t e n d e d to r e v e r s e th i s tr e n d s h a r p l y
u n a l lo c a te d s a v in g s a r e ig n o r e d . a f t e r 1 9 8 1 , t h i s d i d n o t ' o c c u r . 14

^ A m e r ic a 's N e w B e g in n in g . . . (1981), p. 10. 14T h e d is cre p a n c y in th e 1980 ratio b e tw e e n th e R e a g an plan

a nd th e rea liz ed o u tco m e re fle cts th e u pw a rd re visio n s o f G N P
13T h is irre g u la r m o v e m e n t reflects, a m o n g o th e r fa cto rs, the
th a t have o cc urre d sin ce 1981.
b u s in e ss c ycle a s it a ffe c ts both G N P and to ta l o u tlays.

Digitized for FRASER

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 22

F ig u re 3
Total O utlays (constant 1982 dollars)
R a tio S c a le R a t io S c a le
B illio n s o f d o lla r s F is c a l Y e a r s B illio n s o f d o lla r s
900 900

300 300
1955 1990
N O T E : R e a g a n p la n d o e s n o t in c lu d e “ u n a llo c a te d s a v in g s . ”

Receipts F ig u re 5 s h o w s th e R e a g a n p la n f o r to ta l r e ­
c e ip ts a lo n g w ith a c tu a l r e c e ip ts , b o th c o n v e r te d
to c o n s ta n t 1 9 8 2 d o lla r s . C le a r ly , th e tr e n d o f re a l
A n o th e r k e y p a r t o f th e 1 9 8 1 e c o n o m ic ; p r o g r a m
to ta l r e c e i p ts s lo w e d a f te r 1 9 8 1 a n d w a s m u c h
w a s a s e t o f ta x p r o p o s a l s t h a t w a s i n t e n d e d " t o
s l o w e r th a n p l a n n e d . R e a l r e c e i p t s p l u m m e te d in
i m p r o v e t h e a f t e r - t a x , a f t e r - i n f l a t i o n r e w a r d s to
1 9 8 2 a n d 1 9 8 3 d u e b o t h to t h e r e d u c t i o n i n t a x
w o r k , s a v i n g , a n d i n v e s t m e n t . ” 15 A m o n g t h e s e p r o ­
r a te s a n d th e 1 9 8 1 - 8 2 r e c e s s io n . S in c e th e n , r e ­
p o s a l s w e r e r e d u c t i o n s in m a r g in a l ta x r a te s f o r
c e ip ts h a v e g r o w n f a s te r th a n in th e 1 9 8 1 R e a g a n
in d iv id u a ls o f 1 0 p e r c e n t a y e a r f o r th r e e y e a r s
f o r e c a s t; b e c a u s e th e y f e ll s o m u c h in 1 9 8 2 a n d
s t a r t i n g Ju l y 1, 1 9 8 1 . F o r c o r p o r a t i o n s , t h e c h i e f
1 9 8 3 , h o w e v e r , th e i r 1 9 8 6 le v e l w a s s till b e l o w th a t
f e a tu r e o f th e p r o p o s e d ta x c h a n g e s w a s a n a c c e l ­
p r o je c t e d b y t h e a d m i n i s t r a t i o n i n 1 9 8 1 .
e r a te d r e c o v e r y r a te f o r th e c o s t o f m a c h i n e r y a n d
e q u i p m e n t a n d c e r ta i n s tr u c tu r e s to b e p h a s e d in W h e n to ta l r e c e i p ts a r e c h a r te d r e la tiv e to G N P
o v e r f iv e y e a r s . I n g e n e r a l , t h e e f f e c t o f t h e p r o ­ ( fig u re 6), th e d if f e r e n c e b e tw e e n w h a t w a s
p o s e d ta x c h a n g e s w a s to s l o w t h e g r o w th o f f e d ­ p l a n n e d in 1 9 8 1 a n d w h a t a c tu a l l y h a p p e n e d is
e r a l r e c e i p ts b y r e d u c in g th e r o le o f in d iv id u a l q u ite p r o n o u n c e d . In a n a lte r n a tiv e w a y , th i s d if ­
in c o m e ta x e s a n d c o r p o r a te in c o m e ta x e s in th e f e r e n c e s h o w s th e in f lu e n c e o f th e r e c e s s io n a n d
re v e n u e s tr u c tu r e . h o w i t s u p p r e s s e d f e d e r a l r e c e i p t s r e la tiv e to G N P .

15A m e ric a 's N e w B e g in n in g . . . (1981), p. 9.

Digitized for FRASER

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Federal ReserveF E Bank
D E R of
A LSt.
R ELouis
S E R V E B A N K O F S T. LO U IS
 23

F ig u r e 4
Total O u tlay s R e la tiv e to G ro ss N a tio n a l P ro d u c t

.16 .16
1 9 55 60 65 70 75 1990
N O T E : R eagan pian d o e s n o t in c lu d e “ u n a llo ca te d s a v in g s .”

F ig u r e 5
T o ta l R e c e ip ts (c o n s ta n t 1 9 8 2 d o lla rs)
R a tio S cale R a tio S cale
B illio n s o f d o lla rs F is ca l Y e a rs B illio n s o f d o lla rs
800 800

300 300
1955 1990

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 24

F ig u re 6
Total R e c e ip ts R e la tiv e to G ro ss N a tio n a l P ro d u c t
2 2 ---------------------------------------------------------------------------------------------------------------------------------------------------------- .2 2

Reagan
p la n
.21 A .21

.1 6 I- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -- - -------------- - -- -- -- -- 1 .1 6
1955 60 65 70 75 80 85 1990

T H E C O M PO S IT IO N O F T H E T h e p r o je c t e d c o m p o s i t i o n o f t o t a l r e c e i p t s
r e f l e c t e d t h e tw o m a jo r t a x c h a n g e s : t a x r e l i e f f o r
B U D G E T : R EA L IZ A T IO N S V S . T H E
in d iv id u a ls a n d g r e a te r ta x in c e n tiv e s f o r in v e s t­
R EA G A N PLA N
m e n t b y b u s in e s s e s .

T h e 1 9 8 1 R e a g a n p la n c a lle d f o r b o th a s lo w in g
Outlays
in th e g r o w th o f g o v e r n m e n t o u tla y s a n d a c h a n g e T a b l e 1 s h o w s t h e m a jo r c o m p o n e n t s o f o u t l a y s
in th e c o m p o s itio n o f s p e n d in g a n d r e c e ip ts . T h e r e la tiv e to to ta l o u tl a y s .'7 T h e f ir s t c o l u m n s h o w s
c h a n g e in th e c o m p o s itio n o f o u tla y s w a s in ­ t h a t t h e R e a g a n a d m i n i s t r a t i o n p l a n n e d to i n ­
t e n d e d to : c r e a s e n a ti o n a l d e f e n s e o u tla y s f r o m 2 2 .9 p e r c e n t
o f t o t a l o u t l a y s i n 1 9 8 0 to 3 5 .7 p e r c e n t i n 1 9 8 6 .
s h if t F e d e r a l b u d g e t p r io r itie s s o th a t F e d e r a l
A lth o u g h d e f e n s e o u tla y s d id r is e , th e i n c r e a s e f e ll
r e s o u r c e s a r e s p e n t f o r p u r p o s e s t h a t a r e tr u l y th e
s h o r t o f th e p l a n n e d le v e l; b y 1 9 8 6 , d e f e n s e o u tla y s
r e s p o n s i b i l i t y o f th e n a t i o n a l g o v e r n m e n t . . . o u r
b u d g e t p la n s re f le c t th e in c r e a s e d im p o r ta n c e w e r e 2 7 .6 p e r c e n t o f t o t a l o u t l a y s . L o o k i n g a t i t i n a
a tta c h e d to n a ti o n a l d e f e n s e , m a i n ta i n th e F e d e r a l d if f e r e n t w a y , th e p l a n n e d g r o w th o f r e a l d e f e n s e
G o v e r n m e n t’ s s u p p o r t f o r t h e tr u l y n e e d y , a n d o u t l a y s w e r e p r o je c t e d t o g r o w a t a n 8 .6 p e r c e n t
f u lf il l o u r r e s p o n s i b i l i t i e s f o r i n t e r e s t p a y m e n t s o n
a n n u a l r a te f ro m 1 9 8 0 to 1 9 8 6 ; th e i r a c tu a l r a te o f
t h e n a t i o n a l d e b t. T h e s p e n d i n g r e d u c t i o n s w il l
i n c r e a s e w a s 6 .2 p e r c e n t . T h e a c t u a l d e f e n s e
r e s tr a i n F e d e r a l in v o lv e m e n t in a r e a s th a t a re
p r o p e r l y l e f t to S t a t e a n d l o c a l g o v e r n m e n t s o r to b u ild - u p , w h ile s lo w e r th a n p l a n n e d , d id m a r k a
t h e p r i v a te s e c t o r .16 r e v e rs a l o f th e p r e v io u s tr e n d .

'elbid., p. 11. ,7S ee a p p e n d ix B fo r a dd ition a l detail on th e s e com po nents.

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Federal ReserveFEDERAL
Bank of St. Louis
RESERVE BANK OF ST. LOUIS
 25

Tab le 1
C om position of Federal O utlays (percent of total)
P aym e nts
National d efe n se to ind ividuals All o th e r g rants N e t interest All othe r

Y ear A ctual R eagan plan A c tual R eagan plan A ctual R eagan plan A ctual R eagan plan A ctual R eag an pi

1955 6 2 .4 % 2 0 .9 % 2 .3 % 7.2 % 7 .2 %
1960 52.2 2 6.2 4.9 7.5 9.2
1965 42.8 2 8.0 6.1 7.3 15.8
1970 41.8 33.1 7.9 7.4 9.9
1975 26.0 4 6.2 10.0 7.0 10.8
1980 2 2.7 2 2 .9 % 4 7.0 4 5 .7 % 10.1 9.6 % 8.9 8 .8 % 11.4 13.0%
1981 23.2 23.9 4 7.7 4 6.8 8.5 8.1 10.1 9.4 10.4 11.8
1982 24.8 26.5 47.8 4 7.4 6.7 6.6 11.4 9.6 9.2 9.9
1983 26.0 29.3 48.9 4 7.3 6.3 5.9 11.1 8.9 7.7 8.6
1984 26.7 31.0 4 6.9 4 7.6 6.2 5.4 13.0 8.2 7.1 7.8
1985 26.7 34.0 4 5.0 4 6.9 6.1 4.9 13.7 7.3 8.5 6.9
1986 27.6 3 5.7 4 5.4 4 6.4 6.0 4.7 13.7 6.5 7.3 6.8
1987 28.1 4 6.7 5.2 13.8 6.3
1988 27.3 46.9 5.1 14.3 6.5

T h e n o n d e f e n s e p o r tio n o f th e b u d g e t w a s r e ­ f o r e c a s t . 18 B e c a u s e o u t l a y s g r e w f a s t e r t h a n
d u c e d , b u t , a g a i n , n o t to t h e e x t e n t t h a t w a s p l a n n e d w h ile r e c e i p ts r o s e m o r e s lo w ly , n e t in ­
p l a n n e d . T h e p l a n c a l le d f o r n o n d e f e n s e o u tla y s te r e s t o u tla y s w e r e tw ic e a s la r g e a s p l a n n e d in

t o f a l l to 6 4 . 3 p e r c e n t o f t h e t o t a l b y 1 9 8 6 ; t h e a c ­ 1 9 8 1 . E r r o r s i n r e c e i p t s ( o v e r e s ti m a t e d ) a n d o u t ­
tu a l p r o p o r t i o n w a s 7 2 .4 p e r c e n t . T a b l e 1 p r o v id e s la y s ( u n d e r e s tim a te d ) , c o m b i n e d w ith a n u n d e r e s ­
f u r th e r d e ta il o n n o n d e f e n s e o u tla y s . W h ile th e tim a te o f in te r e s t r a te s , p r o d u c e d th e s e la r g e
p l a n f o r p a y m e n t s t o i n d i v i d u a l s , r e l a t i v e to t o t a l e rro rs.
o u tla y s , s e e m s c l o s e to t h e m a r k , th e g r o w th r a te
T h e f in a l “ a ll o th e r ” c a te g o r y o f o u tla y s s h o w s a
c o m p a r i s o n s h o w s a d if f e r e n t s to r y . In d iv id u a l
d e c l i n e v e r y c l o s e to , b u t g e n e r a l l y s o m e w h a t l e s s
p a y m e n t o u tla y s r o s e f a s te r th a n p l a n n e d in re a l
th a n p la n n e d .
t e r m s ; t h e p l a n n e d i n c r e a s e w a s a 1 .6 p e r c e n t
a v e r a g e a n n u a l r a te f r o m 1 9 8 0 to 1 9 8 6 c o m p a r e d Receipts
w i th th e a c t u a l 2 .8 p e r c e n t r a te o f i n c r e a s e .
T a b le 2 s h o w s th e c o m p o n e n ts o f r e c e ip ts r e la ­
F o r th e c a te g o r y o f “ a ll o t h e r g r a n t s ” ( th e th i r d ti v e t o t h e t o t a l . T h e f i r s t c o l u m n , i n d i v i d u a l i n ­
c o l u m n o f ta b l e 1), th e p l a n n e d d e c l i n e w a s r e a l ­ c o m e ta x e s , r e f l e c ts th e a m b i ti o u s n a tu r e o f th e
i z e d i n t h e f i r s t t w o y e a r s , b u t n o t a f t e r w a r d . A l­ 1 9 8 1 ta x p r o p o s a l. T h e a d m in is tr a tio n p r o p o s e d a
th o u g h g r a n ts in r e a l te r m s f e ll r a th e r d r a m a tic a l ly 3 0 p e r c e n t r e d u c ti o n in m a r g in a l ta x r a te s f o r i n d i ­
a t a 4 . 8 p e r c e n t r a t e f r o m 1 9 8 0 to 1 9 8 6 , t h i s w a s v i d u a l s o v e r a t h r e e - y e a r p e r i o d b e g i n n i n g Ju l y 1 ,

s till l e s s t h a n th e 1 0 .7 p e r c e n t r a te o f d e c l i n e 1 9 8 1 . M a r g i n a l r a te s w e r e to b e r e d u c e d f r o m a n

p l a n n e d b y th e 1 9 8 1 a d m in is tr a tio n . e x i s ti n g r a n g e o f 1 4 p e r c e n t to 7 0 p e r c e n t to a
r a n g e o f 1 0 p e r c e n t to 5 0 p e r c e n t b y Ja n u a r y 1 ,
T h e f o u r th c o l u m n o f ta b l e 1 s h o w s th e m o s t
1 9 8 4 . T h i s p r o p o s a l w a s e x p e c t e d to r e d u c e i n d i ­
d r a m a tic d e p a r tu r e f ro m th e 1 9 8 1 p la n . N e t in te r ­
v id u a l i n c o m e ta x e s f r o m n e a r 4 7 p e r c e n t o f to ta l
e s t o u t l a y s w e r e f o r e c a s t to d e c l i n e s h a r p l y ; i n ­
r e c e i p t s in 1 9 8 0 to 4 3 .9 p e r c e n t i n 1 9 8 3 ; th e p e r ­
s te a d , h o w e v e r , th e y r o s e s h a r p ly . B e c a u s e th is
c e n t a g e w a s t h e n f o r e c a s t t o r i s e to 4 6 . 7 i n 1 9 8 6
c o m p o n e n t o f o u tla y s c u ts a c r o s s a ll f a c to r s th a t
b e c a u s e o f its e x p e c t e d s ti m u l u s to a c tiv i ty v ia
a f f e c t th e b u d g e t a n d r e f le c ts th e g e n e r a l in te r a c ­
i n c e n t i v e s to w o r k a n d i n v e s t.
tio n o f th e b u d g e t w ith th e e c o n o m y , th is f o r e c a s t
e r r o r s e r v e s a s a s u m m a r y m e a s u r e o f th e a c c u ­ T h e g e n e r a l m o v e m e n t o f in d iv id u a l in c o m e

r a c y o f b o th th e b u d g e t p la n a n d th e e c o n o m ic t a x e s r e l a t i v e t o t h e t o t a l w e n t a c c o r d i n g to p l a n ;

18S ee a p p e n d ix A.

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 26

T a b le 2
C om position of Federal R eceipts (percent of total)
Individual C orp oratio n S ocial
inc om e tax es inco m e tax es ins uran ce taxes E xc ise tax es O th e r

Y ear A ctual R eagan plan A ctual R eag an plan A ctual R eagan plan A ctual R eagan plan A ctual R e aga n plan

1955 4 3 .8 % 2 7 .3 % 12 .1% 1 3.9% 2 .9 %

1960 4 4 .0 2 3 .2 15.9 12.6 4.2
1965 4 1 .8 2 1 .8 19.0 12.5 4.9
1970 4 6 .9 17.0 23 .0 8.1 4.9
1975 43 .9 14.5 3 0 .3 5.9 5.4
19 80 47 .2 4 6 .9 % 12.5 1 2.4% 3 0 .5 3 0 .9 % 4.7 4 .7 % 5.1 5 .1 %
1981 4 7.7 46 .2 10.2 10.8 3 0 .5 31.1 6.8 7.3 4.8 4 .7
1982 4 8 .2 4 4 .3 8.0 9.6 3 2 .6 3 3 .0 5.9 8 .6 5.4 4 .5
19 83 48.1 4 3 .9 6 .2 9 .7 3 4 .8 3 3 .8 5.9 8 .0 5.1 4.6
19 84 44 .8 44.1 8 .5 9.3 3 5 .9 3 4 .2 5 .6 7.6 5.2 4 .9
1985 4 5 .6 45.1 8 .4 8.4 36.1 3 4 .8 4 .9 7.0 5.1 4.6
1986 4 5 .4 4 6 .7 8 .2 7.7 3 6 .9 3 4 .8 4 .3 6.4 5.2 4 .3
19 87 46 .0 9.8 3 5 .5 3.8 4.9
1988 44.1 10.4 36 .8 3.9 4.8

th e ti m in g , h o w e v e r , w a s s u b s ta n t i a l l y d if f e r e n t f o r m e n ts th a t a c c e l e r a te d c o l l e c ti o n s to k e e p th e
s e v e r a l r e a s o n s . O n e o f th e s e w a s th e tim in g o f th e s o c i a l s e c u r i t y p r o g r a m a f l o a t.
a c t u a l l e g i s l a t i o n . W h a t ’s m o r e , a n u n a n t i c i p a t e d
T h e f o u r th c o lu m n o f ta b le 2 s h o w s th e p r o p o r ­
r e c e s s io n o c c u r r e d , a n d th e a n tic ip a te d b o o m in
ti o n o f e x c i s e ta x e s to to ta l r e c e i p ts . T h e 1 9 8 1
e c o n o m i c a c t i v i t y t h a t w a s e x p e c t e d to f o l l o w o n
R e a g a n a d m in i s tr a tio n f o r e c a s t a s h a r p i n c r e a s e in
t h e h e e l s o f t h e ta x p r o g r a m f a i l e d t o d e v e l o p .
1 9 8 1 a n d 1 9 8 2 , f o llo w e d b y a s te a d y d e c lin e . T h is

T h e s e c o n d c o l u m n o f ta b l e 2 s u m m a r i z e s c o r ­ g e n e r a l p a tte r n o c c u r r e d , e x c e p t th a t th e p e a k
p o r a t e i n c o m e ta x e s . A g a in , th e R e a g a n p l a n w a s w a s in 1 9 8 1 a n d w a s a t a m u c h lo w e r le v e l th a n

b r o a d ly r e a liz e d . C o r p o r a te ta x e s w e r e r e d u c e d f o r e c a s t. T h e d is c r e p a n c y b e tw e e n w h a t w a s
a n d t h e i r r o l e in th e ta x s y s te m w a s r e d u c e d , a t p la n n e d a n d w h a t a c tu a lly o c c u r r e d w a s m a in ly

le a s t th r o u g h 1 9 8 6 . T h e p l a n n e d a n d th e a c tu a l th e r e s u lt o f m u c h s m a lle r th a n e x p e c te d g a in s

p e r c e n ta g e s w e r e q u ite c lo s e in 1 9 8 6 , a lth o u g h th e f r o m th e w in d f a ll p r o f its ta x ; o il p r i c e f o r e c a s ts

a c t u a l p a t h o f a r r iv a l f r o m 1 9 8 1 to 1 9 8 6 w a s s o m e ­ w e re e rro n e o u s.

w h a t d if f e r e n t th a n p la n n e d . C o r p o r a te in c o m e
ta x e s w e r e s e v e re ly a f f e c te d b y th e 1 9 8 1 - 8 2 r e c e s ­ F in a lly , th e “ a ll o th e r ” c a te g o r y , w h ic h is u n i m ­

s io n , d r o p p in g a s a p e r c e n ta g e o f to ta l r e c e ip ts in p o r ta n t r e la tiv e to th e to ta l, w a s u n d e r e s tim a te d .

1 9 8 2 - 8 3 . D e s p ite th e e r r o n e o u s e c o n o m i c f o r e c a s t, T h e m a jo r t a x e s i n t h i s c a t e g o r y a r e e s t a t e a n d g if t

h o w e v e r, th e g e n e r a l c o n to u r s o f th e R e a g a n c o r ­ ta x e s , c u s to m s d u tie s a n d F e d e r a l R e s e r v e d e ­

p o r a te ta x p l a n s w e r e r e a l i z e d . T h i s p a t te r n h a s p o s i ts . T h e d o lla r a m o u n t o f a ll o th e r r e c e i p ts w a s

b e e n r e v e r s e d s in c e 1 9 8 6 , h o w e v e r ; th e T a x R e f o r m f o r e c a s t a c c u r a te l y ; b e c a u s e th e to ta l w a s o v e r e s ti­

A c t o f 1 9 8 6 tig h te n e d p r o v is io n s f o r a c c e l e r a te d m a te d ( f ig u re s S a n d 6), h o w e v e r , “ a ll o th e r ” r e ­

d e p r e c ia tio n o f p la n t a n d e q u ip m e n t a n d r e p e a le d c e ip ts a s a p r o p o r tio n o f th e to ta l w a s

th e in v e s tm e n t ta x c r e d it. T h e s e r e s u l ts h a v e c a n ­ u n d e r e s tim a te d .

c e l l e d , to s o m e e x te n t, th e e f f e c ts o f t h e 1 9 8 1 ta x
a c t.
S U M M A R Y EV A LU A T IO N O F 1 9 8 1
T h e e v o lv in g r o le o f s o c i a l i n s u r a n c e c o n t r i b u ­
R EA G A N B U D G E T PLA N
tio n s in th e ta x s y s te m is s h o w n in th e th ir d
c o l u m n o f ta b l e 2 . T h e a c tu a l r a tio f o llo w e d th e T a b le 3 s u m m a r iz e s th e 1 9 8 1 R e a g a n b u d g e t
p l a n v e ry c l o s e l y th r o u g h 1 9 8 2 , b u t m o v e d w e ll p l a n a n d c o m p a r e s its in d i v id u a l c o m p o n e n t s
a b o v e th e f o r e c a s t a f te r th a t. T h i s d iv e r g e n c e w ith tr e n d s p r io r to 1 9 8 1 a n d w h a t a c tu a lly o c ­

r e f le c te d m a in ly th e 1 9 8 3 s o c ia l s e c u r ity a m e n d ­ c u r r e d a f te r 1 9 8 1 . R a te s o f c h a n g e f o r b u d g e t to ta ls

Digitized for FRASER

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Federal ReserveF E D E R of
Bank A LSt.
R ELouis
S E R V E B A N K O F S T. LO U IS
 27

T a b le 3
Federal B udget Trend s and the Reagan Plan (constant fiscal ye ar 1982 prices,
annual rates of change)
C o n sis ten t
1 9 7 6 -8 0 1981 R eag an plan 1 9 8 0 -8 8 w ith R eagan
T ren d 1 9 8 0 -8 6 Trend pla n? 1

O u tla ys
T o ta l 3 .5 % 1.1% * 2 .9 % No
D e fen se 1.7 8.6 5.6 Y es
N o nd efe n se 4.1 -1 .8 2.0 No
P a y m e nts fo r in d ivid u als 2 .7 1.6 2.6 No
A ll o th e r grants 1.6 -1 0 .7 -5 .5 Y es
N et in tere st 9.6 -5 .5 9.1 No
A ll o th e r 8 .7 -9 .2 -3 .9 Y es

R e ce ipts
T otal 5.8 3.0 2.6 Y es
Individual in co m e 7.6 2.9 1.7 Y es
C o rp ora te incom e 3.0 -4 .8 0.3 No
S o cial in su ra nce 5.8 5.1 5.0 Y es
E xcise 0.8 8.5 0.2 No
A ll o th e r 2.3 0.2 1.9 No

11f 1 9 8 0 -1 9 8 8 tre n d is c lo s e r to R e a g an p la n th a n to 1 9 7 6 -8 0 tre n d, y es; o th e rw ise , no.

in c lu d in g “ u n allo ca te d s a v in g s ,” th e ra te o f c h a n g e w a s 0.3 percent.

a n d t h e i r m a jo r c o m p o n e n t s a r e c a l c u l a t e d f r o m s h o w e d a s h a r p re v e rs a l f ro m th e p r io r f o u r y e a r s ,
t h e c o n s t a n t d o l l a r m e a s u r e s . A b r o a d ju d g m e n t i s a lth o u g h n o t a s m u c h a s w a s p la n n e d .
r e a c h e d o n w h e th e r a c tu a l p e r f o r m a n c e w a s c o n ­
T h o u g h r e a l to ta l r e c e i p ts m o v e d c o n s i s te n tl y
s is te n t w ith th e R e a g a n p la n d e p e n d in g o n
w i t h t h e R e a g a n p l a n , t h e c o m p o n e n t s o f t h e to t a l
w h e th e r th e a c tu a l 1 9 8 0 - 8 8 tr e n d w a s c l o s e r to th e
s h o w e d m ix e d r e s u lts . R e a l in d iv id u a l in c o m e
R e a g a n p la n th a n th e p r io r 1 9 7 6 - 8 0 tr e n d .
ta x e s r o s e m o r e s lo w ly th a n p la n n e d , c h ie f ly b e ­
T h e 1 9 8 0 - 8 8 to ta l o u tla y p e r f o r m a n c e w a s i n ­ c a u s e e c o n o m i c g r o w th w a s o v e r e s tim a te d , b u t
c o n s i s te n t w ith th e 1 9 8 1 p l a n . A lth o u g h th e a n ­ th e i r g r o w th w a s d o w n s h a r p ly f r o m th e 1 9 7 6 - 8 0
n u a l g r o w th r a te o f to ta l r e a l o u tla y s s lo w e d f ro m tr e n d . R e a l c o r p o r a te i n c o m e ta x e s s lo w e d , b u t
a 3 .5 p e r c e n t r a t e t o a 2 .9 p e r c e n t r a t e , t h i s w a s n o t to th e e x t e n t o u t l i n e d i n t h e 1 9 8 1 p l a n . R e a l
s t i l l s u b s t a n t i a l l y a b o v e t h e R e a g a n e s t i m a t e o f 1 .1 s o c ia l in s u r a n c e c o n tr ib u tio n s g re w a t r a te s v e ry
p e r c e n t. T o ta l r e a l r e c e i p ts , o n th e o th e r h a n d , c l o s e to w h a t w a s f o r e c a s t i n 1 9 8 1 . B o t h t h e e x c i s e
g re w a t a r a te c o n s i s te n t w ith th e 1 9 8 1 p la n ; th e y a n d “ a ll o th e r " c o m p o n e n ts o f to ta l r e c e i p ts w e r e
a c tu a lly s lo w e d m o r e th a n p la n n e d b e c a u s e o f th e e s tim a te d in c o r r e c tl y , b u t th is h a d little c o n s e ­
1 9 8 1 - 8 2 r e c e s s io n . q u e n c e s in c e th e y a r e s u c h s m a ll p r o p o r tio n s o f
to ta l r e c e ip ts .
A n e x a m i n a ti o n o f th e g r o w th o f th e c o m p o ­
n e n ts o f r e a l o u tla y s s h o w s th a t s o m e m o v e d in a
d ir e c tio n c o n s i s te n t w ith 1 9 8 1 p la n . R e a l d e f e n s e C O N C LU S IO N
o u tla y s d id n o t r is e a s m u c h a s p l a n n e d ; h o w e v e r ,
th e i r g r o w th a c c e l e r a te d s u b s ta n tia ll y f ro m th e In 1 9 8 1 , th e n e w ly in a u g u r a te d R e a g a n a d m i n i s ­
1 9 7 6 - 8 0 p e r i o d . A l th o u g h r e a l n o n d e f e n s e o u tla y s tr a ti o n f o r m u l a te d a b u d g e t p l a n d e s i g n e d to s lo w
g r e w m u c h m o r e slo w ly , th e R e a g a n p la n c a lle d th e g r o w th o f g o v e r n m e n t a n d b o o s t in c e n tiv e s
f o r a d e c lin e . T h e c o m p o n e n ts o f re a l n o n d e f e n s e ( v ia ta x e s ) t o s a v e , i n v e s t a n d w o r k . I n c l u d e d i n t h e
o u tla y s s h o w e d m i x e d r e s u l ts . G r o w th in r e a l p a y ­ p r o je c t i o n s w a s a m o v e m e n t t o w a r d a b a l a n c e d
m e n ts f o r in d iv id u a ls a n d n e t in te r e s t s lo w e d o n ly f e d e r a l b u d g e t b y 1 9 8 6 . T h e a c tu a l r is e in th e f e d ­
s l i g h t l y . T h e o t h e r tw o c a t e g o r i e s , h o w e v e r , e r a l d e f ic it s in c e 1 9 8 1 , c u lm in a tin g w ith a $ 2 2 1

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 28

b illio n d e f ic it in 1 9 8 6 , s u g g e s ts th a t th e R e a g a n l a y s ” c o n t i n u e d to d e c l i n e f r o m t h e i r p e a k s i n t h e
b u d g e t p r o g r a m f a ile d . E x a m in a tio n o f th e f a c to r s l a t e 1 9 7 0 s o r 1 9 8 0 . T h e m a jo r e x c e p t i o n t o t h e 1 9 8 1
c o n t r i b u ti n g to th e d e f i c i t a s w e l l a s th e c o m p o s i ­ p la n w a s th e r is e in n e t i n te r e s t o u tla y s p r o d u c e d
tio n o f b o th o u tla y s a n d r e c e ip ts , h o w e v e r , in d i­ b y f a i l u r e s to f o r e c a s t t h e 1 9 8 1 - 8 2 r e c e s s i o n
c a te s b r o a d ly w h y th is r e s u lt o c c u r r e d a n d p o in ts ( w h ic h s lo w e d th e g r o w th o f r e c e ip ts ) , th e le v e l o f
o u t th a t th e r e w e r e a n u m b e r o f s u c c e s s e s a s w e ll in te r e s t r a te s , a n d th e c u m u la tiv e e f f e c t o n o u tla y s
a s f a ilu r e s w h e n in d iv id u a l c o m p o n e n ts o f th e o f c o m p o u n d in g in te r e s t o n a g ro w in g n a tio n a l
fe d e ra l b u d g e t a re c o n s id e re d . d e b t . 19

T o ta l r e c e i p ts i n 1 9 8 6 w e r e o v e r e s tim a te d b y
a b o u t $ 1 7 0 b illio n , m a in ly b e c a u s e th e 1 9 8 1 - 8 2
r e c e s s i o n w a s n o t a n t i c i p a t e d . T h e m a jo r t a x p r o ­
R E FE R E N C E S
p o s a l s w e r e a d o p te d , a lth o u g h n o t in th e i r e x a c t
f o r m n o r a c c o r d i n g to t h e p r o p o s e d t i m e t a b l e . A m e ric a 's N e w B e g in n in g : A P ro g ra m fo r E c o n o m ic R e c o v e r y
(T he W h ite H ouse, O ffice o f th e P re ss S e c re ta ry, F e b ru ary
B e c a u s e o f d if f e r e n c e s in tim in g a n d s u b s e q u e n t
1 8 ,1 9 8 1 ).
le g is la tio n , th e a c tu a l c o m p o s i ti o n o f to ta l r e c e i p ts
B e longia, M ich a e l T. “ A re E c on o m ic F o re c a s ts b y G o v e rn m e n t
v a r i e d s o m e w h a t f r o m t h e 1 9 8 1 p r o je c t i o n s . T h e
A g e n c ie s B ia s ed ? A c c u ra te ? ” th is R e v ie w (N o v e m b e r/D e c e m ­
d i r e c ti o n o f m o v e m e n t, h o w e v e r , w a s g e n e r a lly a s ber 1988), pp. 1 5 -2 3 .
p r o je c t e d f o r i n d i v i d u a l i n c o m e t a x e s , c o r p o r a t e B o skin, M ich a e l J. R e a g a n a n d th e E c o n o m y (IC S Press,
in c o m e ta x e s a n d s o c ia l in s u r a n c e c o n tr ib u tio n s . 1987).

T h e l a r g e s t e r r o r i n t h e p r o je c t e d c o m p o s i t i o n o f C a rlso n , K eith M. “ T re n d s in F e d e ra l R e ve nu e s: 1 9 5 5 -8 6 ,”
to ta l r e c e i p ts w a s f o r e x c is e ta x e s , c h ie f ly b e c a u s e th is R e v ie w (M a y 1981), pp. 3 1 -3 9 .

th e f o r e c a s t o f o il p r i c e s w a s in e r r o r w ith th e -------------- “ T re nd s in F ederal S p e n din g : 1 9 5 5 -8 6 ,” th is

R e v ie w (N o ve m b e r 1981), pp. 1 5 -2 4 .
r e s u lt th a t th e w in d f a ll p r o f its ta x d id n o t p r o d u c e
re v e n u e s a s e x p e c te d . -------------- “ T he C ritic al R ole o f E c o n om ic A s su m p tio n s in th e
E va lua tio n o f F ederal B u dg et P ro g ra m s,” th is R e v ie w (O cto ­
T o ta l o u tla y s w e r e u n d e r e s tim a te d b y a b o u t $ 3 0 b er 1983), pp. 5 -1 4 .

b illio n in 1 9 8 6 ( o r m o r e th a n $ 7 0 b illio n if th e 1 9 8 1 -------------- “ M o n ey G ro w th a nd th e S ize o f th e F e d e ra l D e b t,”

th is R e v ie w (N o ve m b e r 1984), pp. 5 -1 6 .
e s t i m a t e i n c l u d e s “ u n a l l o c a t e d s a v i n g s ” ). F u r t h e r
e x a m in a tio n o f o u tla y s r e v e a le d a $ 7 3 b illio n e r r o r C o n g re s s io na l B u dg e t O ffice . A n A n a ly s is o f P re s id e n t
R e a g a n ’s B u d g e t R e v is io n s fo r F is c a l Y e a r 1 9 8 2 , S ta ff W o rk ­
i n t h e p r o je c t i o n o f n e t i n t e r e s t . T h i s e r r o r w a s ing P a p e r (M a rch 1981).
la r g e ly o f f s e t, h o w e v e r , b e c a u s e t h e a c t u a l d e f e n s e
M ills, G re g o ry B., a n d J o h n L. P alm er, eds. F e d e r a l B u d g e t
b u i l d - u p f e l l a b o u t $ 6 9 b i l l i o n b e l o w p r o je c t i o n s P o lic y in th e 1 9 8 0 s (T h e U rban In stitu te P ress, 1984).
b y 1 9 8 6 . T h e n o n in te r e s t p o r tio n o f n o n d e f e n s e M o d ig lia n i, F ranco. “ R e a g a n ’s E co no m ic P o licies: A C ritiq u e ,"
s p e n d in g w a s u n d e r e s tim a te d b y $ 1 5 b illio n , o r 5 O x fo r d E c o n o m ic P a p e rs (S e p te m b e r 1988), pp. 3 9 7 -4 2 6 .

p e r c e n t. N iska n e n , W illia m A . R e a g a n o m ic s (O x fo rd U n ive rs ity Press,

1988).
In g e n e r a l, if o n e lo o k s a t b u d g e t o u tla y s , th e
O ffice o f M a n a g e m e n t and B u d g e t. F is c a l Y e a r 1 9 8 2 B u d g e t
R e a g a n p r o g r a m e n jo y e d s o m e s u c c e s s : t h e d e ­ R e v is io n s (M a rch 1981a).
c l i n e i n th e r e la tiv e r o l e o f d e f e n s e o u tla y s w a s
________ F e d e r a l G o v e r n m e n t F in a n c e s (M a rch 1981 b).
r e v e r s e d ; p a y m e n ts f o r in d iv id u a ls r e la tiv e to to ta l
________ H is to ric a l T a b le s , B u d g e t o f th e U n ite d S ta te s
o u tla y s c o n ti n u e d r o u g h ly a s p l a n n e d ; a ll o th e r G o v e r n m e n t F is c a l Y e a r 1 9 9 0 (U .S . G o v e rn m e n t P rinting
g r a n ts a n d th e r e s id u a l c a te g o r y o f “ a ll o th e r o u t­ O ffice , 1989).

19S ee a p p e n d ix A and C a rlso n (1984).

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A p p e n d ix A
T h e I m p a c t o f E c o n o m i c A s s u m p ti o n s o n th e 1 9 8 1
R eag an Bu d g et Plan

A n a lte r n a tiv e m e th o d o f e v a lu a tin g th e 1 9 8 1 g r o w th o n r e c e i p ts a n d o u tla y s a s w e ll a s th e e f ­

b u d g e t p l a n i s to s i m u l a t e t h e e f f e c t o n t h e b u d g e t f e c t o f in te r e s t r a te c h a n g e s .
o f e c o n o m ic c o n d itio n s d if f e re n t f ro m th o s e a s ­
s u m e d in p la n n in g th e b u d g e t. A n u p d a te d v e r ­ F ir s t, th e 1 9 8 1 R e a g a n b u d g e t p l a n w a s s e p a ­
s io n o f a b u d g e t m o d e l p re v io u s ly p r e s e n te d in r a te d in to p r im a r y r e c e ip ts , p r im a r y o u tla y s a n d
th is Review w a s u s e d to d o t h i s . 1 T h e m o d e l c o n ­ n e t i n te r e s t ( s e e ta b le A l ) . T h e e f f e c ts o f a c tu a l
s is ts o f th r e e p a r ts : a n e s tim a te o f th e im p a c t o f in f la tio n , r e a l g r o w th a n d i n te r e s t r a te s th e n w e r e
i n f l a t i o n a n d r e a l g r o w t h o n b o t h (1) p r i m a i y r e ­ c a lc u la te d , y ie ld in g s im u la te d v a lu e s o f p r im a r y
c e i p t s a n d (2) p r i m a i y o u t l a y s , a n d (3) a n e s t i ­ r e c e ip ts a n d o u tla y s a n d in te r e s t c o s t f o r th e
m a te d e q u a tio n f o r n e t in te r e s t o u tla y s . T h e la tte r 1 9 8 1 - 8 6 p e r io d . T h e s e s im u la tio n r e s u lts a re
r e f l e c ts th e i n d i r e c t e f f e c ts o f in f la tio n a n d r e a l s h o w n in ta b le A 2.

T ab le A1
The 1981 Reagan B udget Plan (billions of dollars)
Federal
P rim ary P rim ary P rim ary R e serve Total Net Total S u rplus /
Y ear receipts o utlays surplu s/d efic it depos its receipts interest o utlay s deficit

1980 $ 5 0 8 .3 $ 5 4 1 .4 $ -3 3 .1 $ 1 1 .8 $520.1 $ 5 2 .5 $ 5 9 3 .9 $ -7 3 .8
1981 5 8 7 .7 6 1 4 .7 - 2 7 .0 12.6 6 0 0 .3 64.1 67 8 .8 - 7 8 .5
1982 63 7.0 64 3.8 -6 .8 13.3 6 5 0 .3 68 .2 71 2 .0 - 6 1 .7
1983 6 9 4 .0 70 3 .5 -9 .5 15.1 709.1 6 8 .9 7 7 2 .4 - 6 3 .3
1984 75 2.2 756.1 -3 .9 18.5 7 7 0 .7 67 .8 8 2 3 .9 - 5 3 .2
1985 83 1.2 8 3 0 .2 1.0 18.7 8 4 9 .9 64 .9 895.1 - 4 5 .2
1986 92 1.3 8 9 8 .4 22 .9 18.9 9 4 0 .2 62 .8 96 1.2 -2 1 .0

T ab le A 2
The 1981 R eagan B udget Plan; S im ulate d1 (billions of dollars)
Federal
P rim ary P rim ary P rim ary R e serve Total Net Total S u rp lu s/
Y ear receipts o utlay s surplus/d efic it d ep o s its 2 receipts interest outlay s deficit

1980 $ 5 0 8 .3 $ 5 4 1 .4 $ - 3 3 .1 $ 1 1 .8 $520.1 $ 5 2 .5 $ 5 9 3 .9 $ - 7 3 .8
1981 5 9 1 .2 6 1 3 .4 - 2 2 .2 12.8 60 4.0 70 .9 6 8 4 .3 -8 0 .3
1982 6 1 6 .0 6 5 0 .2 -3 4 .2 15.2 6 3 1 .2 8 6 .5 7 3 6 .7 -1 0 5 .5
1983 611.1 7 1 1 .3 -1 0 0 .2 14.5 6 2 5 .6 9 7 .0 8 0 8 .3 -1 8 2 .7
1984 63 8.6 7 4 7 .6 -1 0 9 .0 15.7 65 4 .3 11 1.3 8 5 8 .9 -2 0 4 .6
1985 6 8 9 .0 8 1 0 .4 -1 2 1 .4 17.1 706.1 12 4.3 9 3 4 .7 -2 2 8 .6
1986 7 2 5 .5 8 6 4 .7 -1 3 9 .2 18.4 74 3.9 13 4.5 9 9 9 .2 -2 5 5 .3

'U s in g a ctua l va lu es o f e c o n o m ic v a ria b le s (real g ro w th, in fla tio n and in te re s t rates)

2A c tu a l

'S e e C a rlso n (1984), a p pe nd ix B, fo r a s u m m a ry o f th e m odel.

T h e o n ly d iffe re nc e from th a t m odel is th a t th e in te re s t co st
e qu atio n w a s re e stim a te d w ith d a ta th ro u gh 1986. F o r an e x ­
te n d e d d is cu s sio n o f th e role o f e c o n o m ic a s su m p tio n s in
b u dg e t e stim a te s, s ee C a rlso n (1983).

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Federal Reserve Bank of St. Louis
 30

T a b le A 3
A ctual B udget Results (billions of dollars)
Federal
P rim a ry P rim ary P rim ary R eserve Total Net Total S u rp lus /
Y ea r receipts o utlays surp lu s/d eficit dep osits re ceipts interest o utlays d efic it

1980 $ 50 5 .3 $ 53 8 .4 $ -3 3 .1 $ 1 1 .8 $517.1 $ 5 2.5 $ 5 9 0 .9 $ -7 3 .8

1981 5 8 6.5 6 0 9 .5 -2 3 .0 12.8 5 9 9 .3 6 8.7 6 7 8 .2 -7 8 .9
1982 6 0 2 .6 6 6 0 .7 -5 8 .1 15.2 6 1 7 .8 8 5.0 7 4 5 .7 -1 2 7 .9
1983 586.1 7 1 8 .5 -1 3 2 .4 14.5 6 0 0 .6 8 9.8 8 0 8 .3 -2 0 7 .8
1984 6 5 0 .8 7 4 0 .7 -8 9 .9 15.7 6 6 6 .5 111.1 85 1 .8 -1 8 5 .3
1985 7 1 7.0 8 1 6 .9 -9 9 .9 17.1 734.1 129.4 94 6 .3 -2 1 2 .3
1986 7 5 0 .7 8 5 4 .3 -1 0 3 .6 18.4 769.1 1 3 6.0 99 0 .3 -2 2 1 .2
1987 8 3 7 .3 8 6 5 .2 -2 7 .9 16.8 854.1 138.6 1003.8 -1 4 9 .7

T h e r e s u l ts in d i c a te th a t h a d th e 1 9 8 1 b u d g e t m a i y o u tla y s i n c r e a s e d to th e e x te n t o r ig in a lly
p l a n b e e n f u l l y i m p l e m e n t e d , it w o u l d h a v e p la n n e d ; to ta l o u tla y s in c r e a s e d m o r e th a n
y ie ld e d a d e f ic it o f a b o u t $ 2 5 5 b illio n in 1 9 8 6 . p la n n e d b e c a u s e o f la r g e e r r o r s in e s tim a tin g n e t
T h e s e r e s u lts a r e b a s e d o n th e a c tu a l c o u r s e o f in te r e s t. T h u s , th e a c tu a l b e h a v io r o f k e y e c o n o m ic
in f la tio n , r e a l g r o w th a n d i n te r e s t r a te s f r o m 1 9 8 1 v a r ia b le s " o v e r e x p l a i n s ” th e d e f ic it. T h a t is , i f p r i ­
to 1 9 8 6 . S i n c e t h e a c t u a l 1 9 8 6 d e f ic it w a s $ 2 2 1 b i l ­ m a r y r e c e i p ts a n d o u tla y s h a d p e r f o r m e d a c c o r d ­
lio n ( s e e ta b le A 3), a p p a r e n tl y th e 1 9 8 1 p r o g r a m in g to t h e 1 9 8 1 p l a n , t h e 1 9 8 6 d e f i c i t w o u l d h a v e
w a s n o t im p le m e n te d a s p la n n e d . S p e c if ic a lly , b e e n m u c h l a r g e r t h a n it t u r n e d o u t t o b e .
f r o m 1 9 8 1 to 1 9 8 6 , n e i th e r to ta l r e c e i p ts n o r p r i-

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 31

A p p e n d ix B
C o m p o s i ti o n o f F e d e ra l O u tl ay s

F e d e r a l o u t l a y s c a n b e c l a s s i f i e d i n t e r m s o f tw o
a n a l y t i c a l s t r u c t u r e s : b u d g e t f u n c t i o n a n d m a jo r T a b le B1
p r o g r a m c a te g o r y . T h e f u n c tio n a l c la s s if ic a tio n
1988 Federal O utlays (billions of
p r e s e n t s o u tla y s a c c o r d i n g to t h e p u r p o s e t h a t a
f e d e r a l p r o g r a m is i n te n d e d to s e r v e . T h e s e f u n c ­
dollars)
tio n s in c lu d e , f o r e x a m p le , n a tio n a l d e f e n s e , in te r ­ C a te g ory A m oun t
n a ti o n a l a f f a irs , e n e r g y p r o g r a m s , tr a n s p o r ta tio n ,
T o ta l $ 1 ,0 6 4 .0
h e a lth , i n c o m e s e c u r ity , e tc . T w o a d d itio n a l c a t e ­
g o r ie s — n e t i n te r e s t a n d u n d i s tr i b u te d o f f s e ttin g N a tio n al d e fe n se 2 9 0 .4
r e c e ip ts — d o n o t a d d r e s s s p e c if ic f u n c tio n s , b u t
a r e i n c l u d e d to c o v e r t h e e n t i r e b u d g e t . B e n e fit p a ym e n ts fo r in d iv id u a ls 1 5 01 .4
H e a lth a nd m e dica re 1 23.4
T h e c l a s s i f i c a t i o n o f f e d e r a l o u t l a y s b y m a jo r S o c ia l se cu rity 2 1 9 .3
p r o g r a m c a te g o r y f o c u s e s o n th e m e th o d o f c a r r y ­ In c om e s e c u rity 129.3
V e te ra n s b e n e fits a n d se rv ice s 2 9.4
i n g o u t a n a c t i v i ty . T h e m a jo r p r o g r a m c a t e g o r i e s
a r e n a tio n a l d e f e n s e , b e n e f it p a y m e n ts f o r in d iv id ­
O th e r g ra nts to s ta te a nd local g o ve rn m e n ts ' 5 0.0
u a ls , g r a n ts to s t a t e a n d l o c a l g o v e r n m e n t s ( o th e r N a tura l re s o u rc e s a nd e n viro n m e n t 3 .7
th a n f o r b e n e f i t p a y m e n ts ) , n e t i n te r e s t a n d a ll A g ric u ltu re 2.1
o th e r o u tla y s . N a tio n a l d e f e n s e a n d n e t in te r e s t T ra n s p o rta tion 18.1
C o m m u n ity a n d reg io n a l d e ve lo p m e n t 4.3
c o r r e s p o n d to th e f u n c tio n a l c a te g o r ie s o f th e
E du c ation , tra in in g , e m p lo ym e n t and socia l
s a m e n a m e , b u t t h e r e m a i n i n g m a jo r p r o g r a m
se rv ice s 19.9
c a te g o r ie s d o n o t c o r r e s p o n d to a s i m p le s u m ­ G e n e ral g o ve rn m e n t 1.9
m in g o f f u n c tio n a l c a te g o r ie s . N o n e th e le s s , a p ­
p r o x im a tio n s c a n b e m a d e . T h e a c c o m p a n y in g N et in te re st 1 5 1.7

ta b le g r o u p s 1 9 8 8 o u tla y s b y f u n c ti o n to p r o v id e
A ll o th e r' 7 0.4
a d d e d i n f o r m a t i o n a b o u t t h e m a jo r p r o g r a m c a t e ­
In te rn a tio n a l a ffa irs 10.5
g o r ie s d i s c u s s e d in th e te x t. G e ne ra l scie n ce , s p a c e a nd te c h n o lo g y 10.8
E n e rg y 2 .3
N a tura l re s o u rc e s and e n v iro n m e n t 10.9
A g ricu ltu re 15.1
C o m m e rc e a n d h o u s in g c re d it 18.8
T ra n sp o rta tio n 9.2
C o m m u n ity and reg io n a l d e v e lo p m e n t 1.0
E d u ca tio n , tra in in g , e m p lo y m e n t an d social
se rvice s 12.0
A d m in istra tio n o f ju s tic e 9.2
G e ne ra l g o ve rn m e n t 7.6
U n distrib ute d o ffs e ttin g re ce ip ts -3 7 .0

'A m o u n ts sh ow n are th e s u m s fo r th e fu n c tio n s liste d u n d er

th em a n d d iffe r s lig h tly fro m th e c a te g o rie s d is c u ss e d in th e
text.

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Federal Reserve Bank of St. Louis J A N U A R Y /F E B R U A R Y 1989
 32

Cletus C. Coughlin
and Geoffrey E. Wood

C le tu s C . C o u g h lin is a s e n io r e c o n o m is t a t th e F e d e ra l R e s e rv e
B a n k o f S t. L o u is a n d G e o ffre y E. W o o d is a p r o fe s s o r o f
e c o n o m ic s a t C ity U n iv e rs ity , L o n d o n . T h o m a s A . P o llm a n n p r o ­
v id e d r e s e a r c h a s s is ta n c e .

A n I n tro d u c ti o n to N o n - T arif f
B a rri e rs to T ra d e

S T R IC T IO N S o n i n t e r n a t i o n a l t r a d e , d u c tio n a n d c o n s u m p tio n th a t r is k s r e ta lia tio n

p r im a r ily in th e f o r m o f n o n - ta r if f b a r r ie r s , by th e a f f e c te d c o u n tr y .
h a v e m u ltip lie d ra p id ly in th e 1 9 8 0 s .1 T h e
A s a ty p e o f p r o te c ti o n i s t p o lic y , n o n - ta r i f f
Ja p a n e s e , f o r e x a m p l e , b e g a n r e s t r i c t i n g
b a r r i e r s p r o d u c e th e g e n e r a l c o n s e q u e n c e s id e n ­
a u to m o b i l e e x p o r t s to t h e U n ite d S ta te s in 1981.
tif ie d a b o v e ; h o w e v e r , th e r e a r e n u m e ro u s
O n e y e a r l a t e r , t h e U .S . g o v e r n m e n t , a s p a r t o f
re a s o n s , b e s id e s th e ir p r o lif e r a tio n , to f o c u s a t­
its o n g o in g in te r v e n tio n in th e s u g a r m a r k e t,
te n tio n s o le ly o n n o n - ta r i f f b a r r i e r s . 3 N o n - ta r if f
im p o s e d q u o ta s o n s u g a r im p o r ts .
b a r r i e r s e n c o m p a s s a w id e r a n g e o f s p e c if ic
m e a su re s, m an y o f w h o s e e f f e c ts a r e n o t e a s ily
T h e in c r e a s in g u s e o f p r o te c tio n is t tr a d e
m e a s u re d . F o r e x a m p le , th e e f f e c ts o f a g o v e r n ­
p o lic ie s r a is e s n a tio n a l a s w e ll a s in te r n a tio n a l
m e n t p r o c u r e m e n t p r o c e s s t h a t is b i a s e d to w a r d
is s u e s . A s m a n y o b s e r v e r s h a v e n o te d , i n t e r n a ­
d o m e s tic p r o d u c e r s a r e d if f ic u lt to q u a n ti f y . In
tio n a l tr a d e r e s tr i c tio n s g e n e r a lly h a v e c o s tly
a d d itio n , m a n y n o n - ta r i f f b a r r i e r s d is c r im in a te
n a tio n a l c o n s e q u e n c e s .2 T h e n e t b e n e f i ts r e ­
a m o n g a c o u n tr y 's tr a d in g p a r tn e r s .
c e iv e d b y p r o te c te d d o m e s t i c p r o d u c e r s ( t h a t is ,
b e n e f its r e d u c e d by lo b b y in g c o s ts ) te n d to be T h i s d is c r im in a ti o n v io la te s th e m o s t- f a v o r e d -
o u tw e ig h e d b y th e lo s s e s a s s o c ia te d w ith e x ­ n a tio n p r in c ip le , a c o r n e r s to n e o f th e G e n e r a l

c e s s iv e p r o d u c tio n an d r e s tr ic te d c o n s u m p ti o n A g r e e m e n t o n T a r i f f s a n d T r a d e (G A T T ), th e

o f th e p r o te c te d g o o d s . P r o te c tio n is t tr a d e m u ltin a tio n a l a g r e e m e n t g o v e r n in g in te r n a tio n a l

p o lic ie s a ls o c a u s e f o r e i g n a d ju s t m e n t s i n p r o ­ tr a d e . N o t o n ly d o e s th e m o s t- f a v o r e d - n a tio n

1S ee P a g e (1987) fo r a g e n e ra l d is c u s s io n in d ic a tin g th a t A b s tr a c t o f th e U n ite d S ta te s (va rio u s e d itio n s ) fo r th e

th e p ro life ra tio n o f tra d e re s tric tio n s in re c e n t y e a rs has fig u re s fo r o th e r ye a rs .
ta k e n th e fo rm o f n o n -ta riff, a s o p p o se d to ta riff, b a rrie rs.
2F or e x a m p le , s ee C o u g h lin e t a l. (1988).
A re c e n t C o n g re s s io n a l B u d g e t O ffic e s tu d y (1987) n o tes
th a t th e a v e ra g e ta r iff ra te fo r m o st d e ve lo p e d c o u n trie s is 3S ee c h a p te r 1 in L a ird a n d Y e a ts (fo rth c o m in g ) fo r a
le s s th a n 5 p e rc e n t. T h e re is no e v id e n c e o f ris in g ta riff d is c u s s io n o f th e p o lic y is s u e s ra ise d b y n o n -ta riff b a rrie rs.
ra le s o r c o v e ra g e . F o r e x a m p le , U .S . ta r iff re v e n u e a s a
p e rc e n ta g e o f to ta l im p o rts h a s c h a n g e d v e ry little b e ­
tw e e n 1 975 (3 .9 % ) a nd 1986 (3 .6 % ). S e e th e S ta tis tic a l

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http://fraser.stlouisfed.org/
Federal Reserve BankFEDERAL RESERVE BANK OF ST. LOUIS
of St. Louis
 33

p r in c ip le r e q u i r e th a t a c o u n tr y t r e a t its tr a d in g c o u n tr ie s g e n e r a lly . T w o e x a m p le s illu s tr a te

p a r tn e r s id e n tic a lly , b u t it a ls o r e q u i r e s th a t th e s e d i f f e r e n t c h a r a c te r i s ti c s . T h e U n ite d S ta te s
tr a d e b a r r i e r r e d u c tio n s n e g o tia te d on a im p o s e s a g e n e r a l q u o ta o n d r ie d m ilk im p o r ts ;
b ila te r a l b a s is b e e x te n d e d to a ll G A T T m e m ­ lic e n s e s a r e g r a n te d to c e r ta in U .S . tr a d i n g co m ­
b e r s . B y s u b s titu tin g b ila te r a l, d is c r im in a to r y p a n ie s , w h o a r e a llo w e d to im p o r t a m a x im u m
a g r e e m e n ts f o r m u ltila te r a l a p p r o a c h e s to tr a d e q u a n tity o f d rie d m ilk b a s e d o n th e ir p re v io u s
n e g o tia tio n s a n d d is p u te s e ttle m e n t, c o u n tr i e s im p o r ts . In a d i f f e r e n t s i tu a ti o n U .S . s u g a r i m ­
r a i s e d o u b ts a b o u t t h e l o n g - r u n v i a b il ity of p o r ts a r e lim ite d b y a q u o ta th a t s p e c if ie s th e
G A TT. s h a r e s o f in d iv id u a l c o u n tr i e s ; th e r i g h t to s e ll
s u g a r to th e U n ite d S ta te s is g iv e n d ir e c tly to
T h i s p a p e r p r o v id e s a n in tr o d u c ti o n to non-
th e g o v e r n m e n ts o f th e s e c o u n tr ie s .
t a r i f f b a r r i e r s . W e b e g in b y id e n tif y in g n u m e r ­
o u s n o n - ta r if f b a r r ie r s a n d d o c u m e n t th e ir p r o ­ Voluntary Export Restraints and
lif e r a tio n . W e th e n u s e s u p p ly a n d d em an d
the M ultifiber A rrangement
a n a ly s is to id e n ti f y t h e g e n e r a l e f f e c t s o f tw o
f r e q u e n tly u s e d n o n - ta r i f f b a r r i e r s : q u o ta s a n d V o lu n ta r y e x p o r t r e s tr a in ts , w h ic h a r e n e a r ly
v o l u n t a r y e x p o r t r e s t r a i n t s . N e x t, w e c o n s i d e r id e n ti c a l to q u o ta s , a r e a g r e e m e n ts b e tw e e n an
w h y n o n - ta r if f b a r r ie r s a r e u s e d in s te a d of e x p o r tin g an d a n im p o r tin g c o u n tr y lim itin g th e
ta r if f s . A b r i e f h is to r y o f G A T T ’s a t t e m p t s t o m a x im u m a m o u n t o f e x p o r ts in e i th e r v a lu e o r
c o u n te r a c t th e e x p a n s io n o f n o n - ta r if f b a r r i e r s q u a n ti ty te r m s to b e s o ld w ith in a g iv e n p e r io d .
c o m p le te s th e b o d y o f th e p a p e r . C h a r a c te r iz in g t h e s e r e s t r a i n t s a s " v o l u n t a r y ” is
s o m e w h a t m is le a d in g b e c a u s e th e y a re f re ­
q u e n tly d e s ig n e d to p r e v e n t o f f ic ia l p ro te c tiv e
N O N - T A R I FF B A R R I E R S :
m e a s u r e s b y th e im p o r ti n g c o u n tr y . In th e
T Y PES A N D U SE
1 9 8 0 s , f o r e x a m p l e , e x p o r t s b y t h e Ja p a n e s e

A t a r i f f is a ta x im p o s e d o n f o r e ig n g o o d s as a u to m o b ile in d u s tr y to th e U n ite d S ta te s a n d

th e y e n te r a c o u n tr y ; n o n - ta r if f b a r r i e r s , o n th e t h e U n ite d K in g d o m h av e b ee n lim ite d “ v o lu n ­

t a r i l y ” to p r e v e n t th e g o v e r n m e n ts o f th e s e
o th e r h a n d , a r e n o n - ta x m e a s u r e s im p o s e d b y
g o v e r n m e n ts to f a v o r d o m e s tic o v e r f o r e ig n c o u n tr ie s f r o m d ir e c tly lim itin g im p o r ts o f

s u p p lie r s . N o n - ta r if f b a r r i e r s e n c o m p a s s a w id e Ja p a n e s e a u t o s .

r a n g e o f m e a s u r e s . S o m e h a v e r e la tiv e ly u n im ­ A n e x a m p le o f a v o lu n ta r y e x p o r t r e s tr a in t o n
p o r ta n t tr a d e e f f e c ts . F o r e x a m p le , p a c k a g in g a m u c h b r o a d e r s c a le is t h e M u l ti f i b e r A r r a n g e ­
an d la b e lin g r e q u ir e m e n ts c a n im p e d e tr a d e , m e n t. O rig in a lly s ig n e d in 1 9 7 4 a s a te m p o r a r y
b u t u s u a lly o n ly m a r g in a lly . O th e r n o n - ta r if f e x c e p ti o n to G A TT an d re n e w e d t h r e e tim e s
m e a s u r e s s u c h a s q u o ta s , v o lu n ta r y e x p o r t s in c e , th e M u ltif ib e r A r r a n g e m e n t a llo w s f o r
r e s tr a i n ts , tr a d e r e s tr a i n ts u n d e r th e M u ltif ib e r s p e c ia l r u le s to g o v e r n tr a d e in te x tile s a n d ap ­
A r r a n g e m e n t, n o n - a u to m a tic im p o r t a u th o r i z a ­ p a r e l. U n d e r th i s a g r e e m e n t, q u o ta s a r e s e t o n
tio n s a n d v a r ia b le im p o r t le v ie s h a v e m u c h m o s t im p o r ts o f te x tile s a n d ap p are l b y
m o r e s ig n if ic a n t e f f e c ts .4 T h e s e " h a r d - c o r e " n o n - d e v e lo p e d c o u n tr ie s f r o m d e v e lo p in g c o u n tr ie s ,
ta r if f m e a s u r e s a r e d e s ig n e d to r e d u c e im p o r ts w h ile im p o r ts o f te x tile s a n d ap p are l fro m o th e r
a n d , th e r e b y , b e n e f i t d o m e s tic p r o d u c e r s . T h e d e v e lo p e d c o u n t r i e s e x c e p t Ja p a n a re n o t su b ­
d is c u s s io n b e lo w f o c u s e s o n th e s e h a r d - c o r e je c t t o an y r e s tr i c ti o n s . M u l tila te r a l v o lu n ta r y
b a rrie rs . e x p o r t r e s tr a in t a g r e e m e n ts a r e f r e q u e n tly

Quotas c a lle d " o r d e r ly m a r k e tin g a g r e e m e n ts .”

A q u o ta is s im p ly a m a x im u m li m ita tio n , Non-Automatic Import

s p e c if ie d in e i th e r v a lu e o r p h y s ic a l u n its , o n
Authorizations
im p o r ts o f a p r o d u c t f o r a g iv e n p e r io d . It is e n ­
fo rc e d th r o u g h lic e n s e s is s u e d to e ith e r im ­ N o n - a u to m a tic im p o r t a u th o r iz a tio n s a r e n o n ­
p o r te r s o r e x p o r te r s a n d m a y b e a p p lie d to im ­ ta r i f f b a r r i e r s in w h ic h th e a p p r o v a l to im p o rt
p o r ts f r o m s p e c if ic c o u n tr ie s o r f r o m a ll f o r e i g n is n o t g r a n t e d f re e ly o r a u to m a tic a lly . T h e r e

4T h is s u b s e t o f n o n -ta riff b a rrie rs is ta k e n fro m L a ird and a t c u s to m s , h e a lth a n d s a n ita ry re g u la tio n s , te c h n ic a l s ta n ­

Y e a ts (fo rth c o m in g ). T h is s u b s e t e x c lu d e s a n u m b e r o f d a rd s , m in im u m im p o rt p ric e re g u la tio n s , ta r iff q u o ta s and
n o n -ta riff b a rr ie rs th a t ca n a ls o h ave s iz e a b le e ffe cts. m o n ito rin g m e as ure s. S e e a p p e n d ix 4 in L a ird a n d Y e a ts
A m o n g th e s e a re g o v e rn m e n t p ro c u re m e n t p o lic ie s , d e la y s fo r a g lo s s a ry o f te r m s a s s o c ia te d w ith n o n -ta riff b a rrie rs .

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 34

a r e tw o g e n e r a l c a te g o r ie s o f n o n - a u to m a tic d o m e s tic ta r g e t p r ic e . T h e le v ie s a r e v a r ia b le so
lic e n s in g . th a t a s th e w o r ld p r i c e o f a p r o d u c t f a lls ( ris e s ) ,
th e le v y r i s e s ( f a lls ) .7 T h e r e s u l t is t h a t p r i c e
D is c r e tio n a r y lic e n s in g , o f te n c a lle d lib e ra l
c h a n g e s in th e w o r ld m a r k e t w ill n o t a f f e c t
l i c e n s i n g , o c c u r s w h e n a n i m p o r t e r ’s g o v e r n ­
d ir e c tly th e d o m e s tic p r ic e . T h e s e m e a s u r e s a r e
m e n t m u s t a p p r o v e a s p e c i f i c im p o r t; h o w e v e r ,
a n in te g r a l a s p e c t o f th e E u r o p e a n C o m m u n ity ’s
p r e c i s e c o n d itio n s to e n su re ap p ro v al a re n o t
C o m m o n A g r ic u l tu r a l P o lic y . F o r e x a m p le , in
s p e c if ie d . F r e q u e n tly , th is f o r m o f l i c e n s i n g is
M a rc h 1 9 8 7 , t h e E u r o p e a n C o m m u n i t y ’s p r i c e
u sed to a d m i n i s te r q u a n ti ta ti v e lim its . U n d e r th e
f o r w h e a t w a s $ 8 .5 3 p e r b u s h e l, w h ile th e
c u r r e n t r e s t r a i n t s o n U .S . i m p o r ts o f s te e l , a
w o rld p r ic e w a s $ 1 .9 5 p e r b u s h e l. P r o s p e c tiv e
d o m e s tic u s e r c a n r e q u e s t a u th o r iz a tio n to ex­
im p o r te r s w e r e f a c e d w ith a le v y o f $ 6 .5 8 p e r
ceed th e m a x im u m im p o r t lim ita tio n i f th e
b u s h e l.8
s p e c i f i c p r o d u c t is u n a v a il a b l e d o m e s tic a ll y a t a
r e a s o n a b le c o s t. E x a c tly h o w a v a ila b ility an d The Use and Expansion o f Non-
c o s t c o n s id e r a tio n s a f f e c t th e p r o b a b ility o f a n Tariff Barriers
a p p r o v a l a r e l e f t to th e d is c r e tio n o f th e In a c u r r e n t s tu d y , L a i r d a n d Y e a ts ( f o r th c o m ­
a u th o r itie s . in g ) m e a s u r e t h e s h a r e o f a c o u n t r y ’ s i m p o r t s
s u b je c t t o h a rd - c o re n o n - ta r if f b a r r ie r s . B e c a u s e
The sec o n d c a te g o r y o f n o n - a u to m a tic im p o r t
c o u n tr ie s f r e q u e n tly im p o s e n o n - ta r if f b a r r i e r s
lic e n s in g r e q u i r e s th e im p o r te r to m e e t s p e c ific
o n th e im p o r ts o f a s p e c if ic g o o d fro m a
c o n d i tio n s , s u c h a s m in im u m e x p o rt p e rfo r­
s p e c if ic c o u n tr y , b u t n o t o n im p o r ts o f th e
m a n c e , th e u s e o f th e im p o r te d g o o d fo r a
sam e g o o d fro m a n o th e r c o u n tr y , th e y d is a g ­
s p e c ific p u rp o s e o r re q u ire d p u rc h a se s o f
g r e g a te d each c o u n t r y ’s i m p o r t s b y b o t h p r o ­
d o m e s tic p r o d u c ts . In a n e x p o r t- i m p o r t lin k a g e
d u ct an d c o u n tr y o f o r ig in to p e r m it c a lc u la tio n
s c h e m e , a f i r m ’s v a l u e o f i m p o r t e d c o m p o n e n ts
o f t h e t o t a l v a l u e o f a c o u n t r y ’ s i m p o r t s s u b je c t
is lim ite d to a m a x im u m p e r c e n ta g e o f th e v a lu e
to n o n - ta r if f b a r r ie r s . E a c h c o u n t r y ’s " c o v e r a g e
o f its e x p o r ts . T h is m e a s u r e is in te n d e d to im ­
r a t i o ” i s s i m p l y t h e v a l u e o f i m p o r t s s u b je c t t o
p ro v e a c o u n tr y ’s tr a d e b a la n c e a n d p r o te c t
n o n - ta r if f b a r r i e r s d iv id e d b y th e to ta l v a lu e o f
d o m e s tic p r o d u c e r s o f c o m p o n e n ts .5 E x p o r t-
im p o r ts .9
im p o r t lin k a g e r e q u ir e m e n ts a r e n u m e r o u s . F o r
e x a m p le , in Y u g o s la v ia d u r in g th e e a r ly 1980s, T a b le 1 s h o w s th e tr a d e c o v e r a g e r a tio fo r 10
a u th o r iz e d i m p o r te r s o f a u to m o b ile s w e r e r e ­ E u r o p e a n C o m m u n ity a n d s ix o th e r in d u s tr ia l
q u ire d to e x p o r t g o o d s to ta li n g a t le a s t 3 0 p e r ­ c o u n tr ie s f o r 1 9 8 1 a n d 1 9 8 6 . I n c o m p u t i n g th i s
c e n t o f th e v a lu e o f e a c h im p o r te d a u to m o b ile .6 r a tio , th e 1 9 8 1 a n d 1 9 8 6 n o n - ta r if f m e a s u r e s a r e
a p p lie d to a c o n s ta n t 1 9 8 1 tr a d e b a s e . T h u s , th e
Variable Import Levies f i g u r e s i d e n ti f y c h a n g e s i n t h e u s e , b u t n o t t h e
V a r ia b le im p o r t le v ie s a r e sp e c ia l c h a r g e s s e t in te n s ity , o f s p e c if ic n o n - ta r i f f m e a s u r e s , w h ile
to e q u a liz e th e im p o r t p r ic e o f a p r o d u c t w ith a h o ld in g c o n s ta n t th e e f f e c ts o f tr a d e c h a n g e s .

5S e e H e ra n d e r a nd T h o m a s (1986) fo r a th e o re tic a l re c e iv e a lo w e r w e ig h t in th e c o n s tru c tio n o f th e c o v e ra g e

d e m o n s tra tio n th a t an e x p o rt-im p o rt lin k a g e s c h e m e m ig h t ra tio th a n le s s -re s tric tiv e o n e s . F o r e x a m p le , a n o n -ta riff
n ot im p ro v e a c o u n tr y ’ s tra d e b a la n c e . b a rrie r th a t e lim in a te d a ll im p o rts o f a g oo d fro m a c o u n try
w o u ld h a ve a s m a lle r im p a c t on th e c o v e ra g e ra tio th a n a
6F or d e ta ils o n th e p o lic ie s o f Y u g o s la v ia a s w e ll as
le s s -re s tric tiv e m e a su re . A s s u m e th a t o n e c o u n tr y ’s im ­
n u m e ro u s o th e r c o u n tr ie s , se e “ S u rv e y o f A u to m o tiv e
p o rts a re v a lu e d a t $ 1 0 0, $ 15 o f w h ic h c o m e s fro m c o u n ­
T ra d e R e s tric tio n s M a in ta in e d b y S e le c te d N a tio n s ”
tr y A , a n d th e r e a re no n o n -ta riff b a rrie rs . In th is c a s e , th e
(1982).
c o v e ra g e ra tio is ze ro . S u p p o s e th a t a n o n -ta riff b a rr ie r is
A /a ria b le im p o rt le vie s , w h ic h a re a c tu a lly v a ria b le ta riffs , n ow im p o se d o n im p o rts o f g o o d s fro m c o u n try A . In th e
a re c o n s id e re d n o n -ta riff b a rr ie rs in th is s tu d y fo r tw o firs t c a s e, a ss u m e th a t im p o rts fro m c o u n try A d e c lin e
re a so ns. F irs t, th e in te rn a tio n a l tra d e lite ra tu r e g e n e ra lly fro m $ 1 5 to $ 10; a lte rn a tiv e ly , s u p p o s e th a t im p o rts
c h a ra c te riz e s v a ria b le im p o rt le v ie s a s n o n -ta riff b a rrie rs . d e c lin e fro m $ 1 5 to ze ro . T h e n o n -ta riff b a rrie r in th e s e c ­
S ee N o g u e s e t a l. (1986) fo r a n o th e r lis t o f n o n -ta riff b a r­ o n d c a s e is m o re re s tric tiv e ; h o w e v e r, th e c h a n g e in th e
rie rs th a t in c lu d e s v a ria b le im p o rt le vie s . S e co n d , L a ird c o v e ra g e ra tio d o e s n o t re fle c t th is fa c t. T h e c o v e ra g e
a n d Y e a ts (fo rth c o m in g ) p ro v id e th e m o st u p -to -d a te d a ta ra tio b e c o m e s 1 0.5 p e rc e n t ($ 1 0 /$ 95 ) in th e firs t c a s e and
o n n o n -ta riff b a rrie rs a n d w e h ave no w a y to re m o ve z e ro p e rc e n t ($0 /$8 5 ) in th e s e c o n d . T h u s, th e “ in te n s ity ”
v a ria b le im p o rt le vie s fro m th e ir d a ta . o f th e p ro te c tio n p ro v id e d b y n o n -ta riff b a rrie rs is not
m e as u re d a c c u ra te ly b y th is c o v e ra g e ratio. A n a lte rn a tiv e
8T h e n u m e ric a l e x a m p le is fro m C o u g h lin a n d C a rra ro m e a su re fo c u s in g o n th e s h a re o f tr a d e “ a ffe c te d ” b y n o n ­
(1988). ta r iff b a rrie rs , w h ic h a ls o h ig h lig h ts th e p ro life ra tio n of
9O n e w e a k n e s s o f th e c o v e ra g e ra tio a s a m e a su re o f p ro ­ n o n -ta riff b a rrie rs , c a n b e fo u n d in L a ird a nd Y e a ts (1989).
te c tio n is m is th a t m o r e -re s tric tiv e n o n -ta riff b a rrie rs te n d to

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve FBankE D E RofA St.
L RLouis
E S E R V E B A N K O F ST. LO U IS
 35

1 9 8 6 . T h i r d , t h e U n ite d S ta te s h a d th e la r g e s t
p e r c e n ta g e - p o in t i n c r e a s e , a s its c o v e r a g e r a tio
T a b le 1
in c re a s e d fro m 1 1 .4 p e r c e n t in 1 9 8 1 to 1 7 .3

N o n -ta riff T ra d e C o v era g e R atio s fo r p e r c e n t in 1 9 8 6 . T h e 5 .9 p e r c e n ta g e - p o in t in ­

O EC D C o u n tries c r e a s e w a s m o r e th a n d o u b le th e in c r e a s e f o r
a ll c o u n tr i e s .
T ra d e C o v e ra g e R a tio 2
L a ird a n d Y e a ts p r o v id e e v i d e n c e th a t e x p o r ts
Im p o r te r1 1981 19 86 D iffe re n c e
fro m d e v e lo p in g c o u n tr i e s to in d u s tr ia l c o u n ­

B e lg iu m -L u x e m b o u rg 1 2 .6 % 1 4 .3 % 1 .7 % tr ie s a r e a f f e c te d to a la r g e r e x te n t th a n tr a d e
D e n m a rk 6 .7 7.9 1.2 a m o n g in d u s tr ia l c o u n tr ie s . F o r e x a m p le , th e
G e rm a n y , Fed. R ep. 11.8 15.4 3.6 1981 tr a d e c o v e r a g e r a tio w a s 1 8 .8 p e r c e n t f o r
F ra n ce 1 5.7 18.6 2.9
d e v e lo p in g c o u n tr y e x p o r ts to in d u s tr i a l c o u n ­
G re e c e 16.2 20.1 3 .9
tr ie s a n d 1 4 .3 p e r c e n t f o r in tr a - in d u s tr ia l c o u n ­
G re a t B rita in 11.2 12.8 1.6
Ire lan d 8 .2 9 .7 1.5 tr y tr a d e . A s im ila r p a tte r n p re v a ile d in 1986
Italy 17.2 18.2 1.0 w ith a c o v e r a g e r a tio o f 2 0 .6 p e r c e n t f o r
N e th e rla n d s 19.9 2 1 .4 1.5 d e v e lo p in g c o u n tr y e x p o r ts to in d u s tr ia l c o u n ­
E C (10)3 13.4 15.8 2 .4
tr ie s a n d 1 7 .5 p e r c e n t f o r in tr a - in d u s tr ia l c o u n ­
tr y t r a d e . 10
S w itz e rla n d 19.5 19.6 0.1
F in la n d 7.9 8.0 0.1 T a b le 2 c o n ta in s c o v e r a g e r a tio d a ta o n a p r o ­
Japan 2 4 .4 2 4.3 -0 .1
d u c t b a s is . A s a r e s u l t o f th e M u ltif ib e r A r ­
N o rw a y 15.2 14.2 -1 .0
r a n g e m e n t, tr a d e in te x tile s a n d c lo th in g is s u b ­
N e w Z e a la n d 4 6.4 3 2 .4 -1 4 .0
U n ite d S ta te s 11.4 17.3 5.9 je c t t o n o n - ta r i f f b a r r i e r s . F o r e x a m p l e , s lig h tly
m o r e th a n o n e - th ir d o f E u r o p e a n C o m m u n ity
A ll a b o ve 15.1 17.7 2.6 an d U .S . i m p o r ts o f t e x ti l e s a r e a f f e c t e d , w h il e
a p p r o x i m a te l y tw o - th i r d s o f E u r o p e a n Com ­
N O T E : N o n -ta riff m e a s u re s in c lu d e v a ria b le im p o rt m u n ity a n d t h r e e - q u a r t e r s o f U .S . i m p o r ts o f
le v ie s, q u o ta s , n o n -a u to m a tic im p o rt a u th o riz a tio n s in­
c lo th in g a r e a f f e c te d . S in c e th e s e g o o d s a r e
c lu d in g re s tric tiv e im p o rt lic e n s in g re q u ire m e n ts , q u a n ­
tita tiv e “ v o lu n ta ry ” e x p o rt re s tra in ts a nd tra d e re s tra in ts a m o n g th e m o s t im p o r ta n t m a n u f a c tu r e d ex­
u n d e r th e M u ltifib e r A rra n g e m e n t. p o r ts f r o m d e v e lo p in g c o u n tr ie s , c o v e r a g e r a tio s

’ T h e fo llo w in g O r g a n iz a tio n fo r E c o n o m ic C o o p e ra tio n f o r im p o r ts f r o m d e v e lo p in g c o u n tr ie s r e la tiv e

a nd D e v e lo p m e n t (O E C D ) c o u n trie s — A u s tra lia , to in d u s tr ia l c o u n tr ie s te n d to b e h ig h e r .
C a n a d a a n d S w e de n — w e re e x c lu d e d fro m th e c o m ­
p u ta tio n s b e c a u s e o f p ro b le m s in c o m p ilin g th e ir n o n ­ T a b l e 2 a ls o id e n tif ie s s o m e o th e r m a n u f a c ­
ta r iff m e as ure s. tu r e d g o o d s a f f e c te d s u b s ta n tia ll y b y n o n - ta r i f f
2T h e s h a re o f to ta l im p o rts (by v a lu e) s u b je c t to h a rd ­ b a r r ie r s , e s p e c ia lly ir o n an d s te e l a n d tr a n s p o r t
c o re n o n -ta riff m e a s u re s . In c o m p u tin g th is in d e x , 1981
e q u i p m e n t. M o r e th a n t h r e e - q u a r t e r s o f U .S . i m ­
a n d 1986 n o n -ta riff m e a s u re s a re a p p lie d to a c o n s ta n t
1981 tra d e b ase. P e tro le u m p ro d u c ts h ave b ee n e x c lu d ­ p o r ts o f ir o n a n d s te e l a n d m o r e th a n 4 0 p e r­
e d fro m th e c a lc u la tio n s . c e n t o f tr a n s p o r t e q u ip m e n t a r e a f f e c te d . T h e
3E u ro p e a n C o m m u n ity in tra -tra d e is e x c lu d e d . c o r r e s p o n d in g f ig u r e s f o r th e E u r o p e a n C o m ­

S O U R C E : L a ird a n d Y e a ts (fo rth c o m in g ). m u n ity a r e 4 6 .2 p e rc e n t an d 2 3 .6 p e r c e n t.

W h ile tr a d e in m a n u f a c tu r e d g o o d s is a f f e c t e d
A n u m b e r o f f a c ts e m e r g e . F ir s t, th e c o v e r a g e s u b s ta n tia ll y b y n o n - t a r i f f b a r r i e r s , tr a d e in
r a ti o v a r i e s s u b s ta n tia ll y a c r o s s c o u n tr i e s . In a g r ic u l tu r a l g o o d s is a f f e c t e d to a n e v e n g r e a te r
1 9 8 1 , th e c o v e ra g e r a tio ra n g e d fro m 6 .7 p e r ­ e x te n t. T h e c o v e r a g e r a tio s f o r a g r ic u ltu r a l
c e n t in D e n m a r k to 4 6 .4 p e r c e n t in N e w Z ea­ g o o d s s h o w n in ta b le 3 a r e s u b s ta n tia lly a b o v e
la n d a n d , in 1 9 8 6 , fro m 7 .9 p e r c e n t in D e n m a r k th o s e f o r m a n u f a c tu r e d g o o d s s h o w n in ta b le 2 .
to 3 2 .4 p e r c e n t in N e w Z e a la n d . S e c o n d , f o r T h e a g r ic u ltu r a l c o v e r a g e r a tio s f r e q u e n tly ex­
m o s t c o u n tr ie s , th e c o v e r a g e r a tio h a s in c re a s e d . ceed 7 0 p e r c e n t ; s e e , f o r e x a m p l e , t h e U .S .
T h is c a u s e d th e c o v e ra g e ra tio u s in g th e w o rld ra tio s f o r s u g a r a n d h o n e y ( 9 1 .9 p e r c e n t) , d a ir y
tr a d e f ig u r e s o f a ll 1 6 c o u n tr i e s to in c re a s e p r o d u c ts ( 8 7 .8 p e r c e n t) a n d o il s e e d s a n d n u ts
fro m 1 5 .1 p e r c e n t in 1 9 8 1 to 1 7 .7 p e r c e n t in ( 7 4 p e r c e n t) . E v e n h ig h e r a g r ic u ltu r a l c o v e r a g e

10W h ile th is d iffe re n tia l m a y re fle c t d is c rim in a tio n d ire c te d at e x a m p le , s h o w th a t th e re la tiv e ly h ig h e r ta r iff ra te s fa c e d
d e v e lo p in g c o u n tr ie s , a n o th e r in te rp re ta tio n is th a t th e d if- b y d e v e lo p in g c o u n trie s c an be e x p la in e d b y p ro d u c t
fe re n tia l is p ro d u c t-b a s e d . C h o w a nd K e llm a n (1988), fo r c h a ra c te ris tic s .

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Federal Reserve Bank of St. Louis JA N U A R Y /F E B R U A R Y 1989
 36

T a b le 2
C o v era g e R a tios o f S e le c te d N o n -ta riff M eas u re s on S e le c te d M a n u fa c tu re d
G oods: 1986
U n ite d
S IT C D e s c rip tio n EC (1 0 )' S w itz e rla n d F in la n d Japan N o rw a y N e w Z e a la n d S ta te s

61 L e a th e r p ro d u c ts 7 .7 % 3 0 .8 % 0 .0 % 4 7 .0 % 0 .0 % 5 9 .9 % 0 .0 %
62 R u b b e r p ro d u c ts 9.1 0 .0 0 .0 13.6 0 .7 5 3 .9 0 .0
63 W o o d a nd c o rk 1.0 1.9 0 .0 0 .0 0.0 5 3 .0 0 .0
64 P a p e r a nd a rtic le s 5 .9 0 .0 0 .0 0 .0 0.0 4 8 .6 0 .0
65 T e x tile s 3 4 .7 0 .0 1.6 5 5 .5 6.1 2 7 .4 3 4 .5
66 C e m e n t, c la y a n d g la s s 2.9 0 .0 0 .0 24.1 0 .0 5 4 .5 0.1
67 Iron a n d ste e l 4 6 .2 1.0 0.0 0 .0 0 .0 64.1 7 6 .3
68 N o n -fe rro u s m e ta ls 0 .8 1.9 3 .5 0 .4 0 .0 8 .7 0 .0
69 M e ta l m a n u fa c tu re s , n.e.s. 2.1 5 .6 0 .0 1.0 0 .0 3 5 .3 11.0
71 N o n -e le c tric m a c h in e ry 3.1 4 .7 0 .0 4 .4 0 .0 3 5 .9 0 .0
72 E le c tric m a c h in e ry 11.1 0 .0 0 .0 0.3 0 .0 6 4 .0 1.4
73 T ra n s p o rt e q u ip m e n t 2 3 .6 8 4 .7 0 .0 17.3 0 .0 22.1 41.1
81 P lu m b in g & lig h tin g fix tu r e s 0 .0 0 .0 0 .0 0.0 0 .0 6 8 .2 0 .0
82 F u rn itu re 0 .3 0 .0 0 .0 0.0 0.1 0 .0 1.1
83 T ra ve l g o o ds 0 .9 5 3 .0 0 .0 0 .0 0 .0 10 0.0 18.9
84 C lo th in g 6 5 .7 18.6 12.1 11 .3 8 6 .5 5 2 .2 7 6 .4
85 F o o tw e a r 11 .3 74 .6 0 .0 6 .9 0 .3 8 2 .9 0.1
86 In s tru m e n ts 3 .8 0.0 0 .0 14.1 0 .0 5.3 0 .0

N O T E : S e e ta b le 1 fo r th e lis t o f h a rd -co re n o n -ta riff m e a s u re s. T h e c o v e ra g e ra tio is, fo r e a ch g iv e n p ro d u c t a n d c o u n try ,

th e im p o rts s u b je c t to a h a rd -c o re n o n -ta riff m e a su re d iv id e d b y to ta l im p o rts.

'E u ro p e a n C o m m u n ity in tra -tra d e is e x clu d e d .

S O U R C E : L a ird a nd Y e a ts (fo rth c o m in g ).

T a b le 3
C o v e ra g e R a tios of N o n -ta riff M e as u re s on S e le c te d A g ric u ltu ra l G oods: 1 9 8 6
U n ite d
S IT C D e s c rip tio n E C (1 0 )' S w itz e rla n d F in la n d Ja p a n N o rw a y N e w Z e a la n d S ta te s

00 L ive a n im a ls 6 0 .2 % 1 0 0 .0 % 9 5 .3 % 1 .2 % 9 8 .0 % 0 .0 % 0 .0 %
01 M eat 7 7 .8 9 7 .8 8 9 .3 6 5 .7 9 9 .7 14 .4 0 .0
02 D a iry p ro d u c ts 9 9 .7 4 5 .5 10 0,0 7 3 .2 82.1 12.7 8 7 .8
03 F is h a nd se afo o d 4 .6 5 8 .3 9 .7 10 0.0 8 0 .4 3 .6 0 .0
04 C e re a ls a n d p re p a ra tio n s 9 6 .9 87 .8 8 3 .4 3 2 .5 10 0.0 5.1 0 .0
05 F ru its a n d v e g e ta b le s 3 6 .0 4 4 .8 5 1 .6 18.3 10 0.0 3 9 .2 0 .9
06 S u g a r a n d h o n ey 8 5 .8 0 .0 89.1 84 .6 10 0.0 0.9 9 1 .9
07 C o ffe e a n d c o c o a 17.5 0.0 0 .0 0.0 10 0.0 0 .9 2 .3
08 A n im a l fe e ds 11.9 30 .9 5 .3 13 .7 9 2 .7 16.9 0 .3
09 F ood p re p a ra tio n s 10.2 13.4 0 .0 17.3 10 0.0 7 3 .7 0 .4
11 B e v e ra g e s 2 4 .9 7 6 .4 88 .0 7 0 .7 10 0.0 5 .6 0 .0
12 Tobacco 0 .0 0 .0 0 .0 8 4 .3 0 .0 5.1 0 .0
21 H id e s a n d s kin s 0 .0 99.1 0 .0 18.1 0.0 0 .0 3.2
22 O il s e e d s a nd n u ts 2 4 .8 5 6 .0 10 0.0 4 .3 10 0.0 0 .0 7 4 .0
23 Rubber 0.0 0.0 0 .0 0 .0 0.0 0.0 0 .0
24 W o o d a n d c o rk 0.6 39 .6 0 .0 0 .0 0.0 2 .4 0 .0
25 P u lp a nd p a p e r 0.0 0.0 0.0 0 .0 0.0 0 .0 0 .0
26 S ilk, w o o l, c o tto n , etc. 9.0 24 .8 0.0 1.2 4 .6 16.4 2.1
29 C ru d e a n im a l & v e g e ta b le m a tte r 19.0 7 8 .0 5 .3 5 1 .8 69.1 11.2 11.0

N O T E : S e e ta b le 1 fo r th e list o f h a rd -c o re n o n -ta riff m e a su re s . T h e c o v e ra g e ra tio is, fo r e a c h g iv e n p ro d u c t a n d c o u n-

try , th e im p o rts s u b je c t to a h a rd -c o re n o n -ta riff m e a su re d iv id e d b y to ta l im p o rts.

'E u ro p e a n C o m m u n ity in tra -tra d e is e x clu d e d .

S O U R C E : L a ird a nd Y e a ts (fo rth c o m in g ).

Digitized for FRASER

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Federal Reserve BankFE D E of
R ASt.
L RLouis
E S E R V E B A N K O F ST. LO U IS
 37

T a b le 4
T h e U se o f S e le c te d N o n -ta riff M eas u re s ________________________________
C h a n g e in th e S h a re o f Im p o rts
S h a re o f Im p o rts F a c in g N T M s , 1 9 8 1 1 F a c in g N T M s , 19 81 -86 =
Im p o rte r QUOT VER MFA N A IA V IL QUOT VER MFA N A IA V IL

B e lg iu m -L u x e m b o u rg 0 .3 % 5 .1 % 1 .2 % 5 .7 % 5 .2 % 1 .1 % 2 .2 % 0 .0 % 0 .0 % 0 .0 %
D e n m a rk 0 .3 2 .6 2 .3 1.1 1.4 0.1 1.2 -0 .1 0 .0 0 .0
G e rm a n y , Fed. R ep. 0 .5 3.0 4.9 3 .0 2 .0 0 .4 2 .0 -0 .6 0 .0 0 .0
F ra n ce 5 .8 1.2 1.8 7.1 2 .2 1.6 1.8 0 .0 0 .0 0 .0
G re e c e 8 .2 4 .8 1.2 3 .9 3 .8 0 .4 4 .4 0.0 0 .0 0 .0
G re a t B rita in 2 .2 2 .0 2.9 5.1 4 .4 -0 .9 2 .3 0 .0 0 .0 0.0
Ire la nd 0.1 4 .6 1.3 2 .2 2 .2 0.1 1.5 0 .0 0 .0 0.0
Italy 7 .5 0 .8 1.8 7.0 6 .6 0 .6 1.2 -0 .1 0 .0 0 .0
N e th e rla n d s 0 .4 2 .0 3.0 14.0 6 .3 2 .5 3 .6 -0 .2 0 .0 0 .0
E C (1 0 )3 2.6 2 .3 3 .0 5 .6 3 .7 0 .5 2.1 -0 .2 0 .0 0 .0

S w itz e rla n d 2 .5 0 .0 0 .4 2 .8 0.5 0.0 0 .0 0 .0 0 .0 0 .0

F in la n d 0 .9 0 .0 0 .2 6 .7 1.8 0 .0 0 .0 0.1 0 .0 0 .0
Japan 1 4.2 0 .0 0 .0 7 .7 1.8 0.1 0 .0 0 .0 0 .0 0 .0
N o rw a y 5 .2 0 .0 0 .0 2 .2 0 .0 -0 .5 0 .0 0 .0 1.1 0 .0
N e w Z e a la n d 2 5 .3 0 .0 0 .0 2 5 .6 0 .0 1.6 0 .0 0 .0 -8 .8 0 .0
U n ite d S ta te s 0 .5 6.9 3.2 0 .0 0.0 1.5 4 .4 0 .0 0 .0 1.4

A ll a b o ve 4 .0 3.1 2.3 4 .2 2 .0 0 .7 2 .2 -0 .1 -0 .1 0 .4

'P e tro le u m p ro d u c ts h ave b e e n e x c lu d e d fro m th e c a lc u la tio n s . T h e a b b re v ia tio n s fo r th e n o n -ta riff m e a s u re s a re a s fo llo w s :

Q U O T — q u o ta s ; V E R — v o lu n ta ry e x p o rt re s tra in ts ; M F A — re s tric tio n s u n d e r th e M u ltifib e r A rra n g e m e n t; N A IA — n o n -a u to m a tic
im p o rt a u th o riz a tio n s ; a nd V IL — v a ria b le im p o rt levies.
2T he c h a n g e is th e 1986 s h a re less th e 1981 sh a re .
3E u ro p e a n C o m m u n ity in tra -tra d e is e xc lu d e d .

S O U R C E : L a ird a nd Y e a ts (fo rth c o m in g ).

r a tio s a r e f o u n d f o r th e E u r o p e a n C o m m u n ity 1 1 .3 p e r c e n t o f U .S . i m p o r ts w e r e a f f e c t e d by
a n d Ja p a n . v o lu n ta r y e x p o r t r e s tr a i n ts ; G r e e c e , w i th 9 .2
p e r c e n t, h a d th e n e x t- h ig h e s t s h a r e o f its im ­
A n o th e r d im e n s io n o f th e u s e o f n o n - ta r if f
p o r ts a f f e c te d b y th e s e r e s tr a in ts .
b a r r i e r s c o n c e r n s d if f e r e n c e s in th e u s e o f
s p e c if ic b a r r i e r s a c r o s s c o u n tr ie s . T a b le 4 s h o w s
S U P P L Y A N D D EM A N D A N A L Y S I S
th e s h a r e o f im p o r ts ( b y c o u n tr y ) th a t f a c e d d if ­
U S IN G Q U O T A S A N D V O L U N T A R Y
f e r e n t n o n - ta r if f m e a s u r e s in 1981 an d how th is
sh a re ch an g ed by 1 9 8 6 . A n u m b e r o f f a c ts E X P O R T R ES T R A IN T S
e m e r g e . In 1 9 8 1 , n o n - a u to m a tic im p o r t a u th o r i­ A l th o u g h t h e q u a n ti ta ti v e e f f e c t s o f n o n - t a r i f f
z a tio n s a n d q u o ta s a f f e c te d th e la r g e s t s h a re o f b a r r i e r s a r e n o t a lw a y s e a s ily id e n tif ie d and
im p o r ts w h e n a ll 1 6 c o u n tr i e s a r e c o n s i d e r e d ; m e a s u r e d , a th e o r e tic a l id e n tif ic a tio n o f th e ir
by 1 9 8 6 , th is w a s n o lo n g e r th e c a s e . V o lu n ta r y m a jo r e f f e c t s c a n b e d e r i v e d u s in g s u p p ly a n d
e x p o r t r e s tr a i n ts , w h o s e u s e in t h e U n ite d d em an d a n a ly s is . W e b e g in b y e x a m in in g th e e f ­
S ta te s , G r e e c e , th e N e th e r la n d s a n d G re a t B ri­ f e c t s o f a q u o ta , th e n d is c u s s h o w a v o lu n ta r y
ta i n r o s e s u b s ta n tia lly , a f f e c te d th e la r g e s t s h a re e x p o r t r e s tr a in t c a n b e a n a ly z e d s im ila rly .
o f i m p o r t s ( 5 .3 p e r c e n t ) b y 1 9 8 6 . M e a n w h ile ,
In f ig u r e 1, D D r e p r e s e n t s t h e U .S . i m p o r t
th e s h a r e o f im p o r ts a f f e c te d by q u o ta s r o s e
d em an d c u rv e fo r so m e g o o d p ro d u c e d by U .S .
fro m 4 p e r c e n t in 1 9 8 1 to 4 . 7 p e r c e n t b y 1986.
an d f o re ig n p ro d u c e r s . T h e f o r e ig n s u p p ly
C o m p a ris o n s o f th e s p e c if ic m e a s u r e s a c r o s s c u r v e ( th a t is , t h e s u p p ly c u r v e f o r i m p o r ts in to
c o u n tr ie s in d ic a te th a t v o lu n ta r y e x p o rt r e ­ th e U n ite d S ta te s ) f o r t h e g o o d is SS. W i th f r e e
s tr a in ts w e r e u s e d m o r e e x te n s iv e ly b y th e tr a d e , th e U n ite d S ta te s w ill im p o r t Qf u n its o f
U n ite d S ta te s th a n b y o th e r c o u n tr ie s . B y 1 9 8 6 , th e g o o d a n d p a y a p ric e p e r u n it o f Pp .

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 38

ta r y e x p o r t r e s tr a in t r e d u c e s th e q u a n tity o f im ­
p o r ts , w h ic h , in tu r n , c a u s e s th e d o m e s tic p r i c e
Figure 1 to r i s e a n d th e f o r e ig n p r i c e to f a ll a s s h o w n in
T h e P ric e a n d Q u a n tity E ffe c ts o f a Q u o ta f ig u r e 1 . A g a in , t h e h i g h e r d o m e s tic p r i c e
a n d a V o lu n ta r y E x p o rt R e s tra in t b e n e f i t s U .S . p r o d u c e r s o f th i s g o o d a t th e e x ­
p e n s e o f U .S . c o n s u m e r s . F in a ll y , t h e d i f f e r e n c e
P ric e
b e tw e e n w h a t d o m e s tic a n d f o r e ig n c o n s u m e rs
p ay , Pb PQ; is a p r e m i u m p e r u n it o f im p o r ts
th a t c a n b e c a p tu r e d by e x p o r te r s , im p o r te r s o r
g o v e r n m e n t.

W h ile th e s u p p ly a n d d em an d a n a ly s is is o la te s
t h e m a jo r e f f e c t s o f t w o f r e q u e n tly u sed non-
t a r i f f b a r r i e r s , it c o n v e y s v ir tu a lly n o in f o rm a ­
ti o n a b o u t e i th e r th e m a g n itu d e o f th e c o s ts a n d
b e n e f its o f n o n - ta r if f b a r r i e r s o r th e ir d y n a m ic
c o n s e q u e n c e s . 12 V a r i o u s c a s e s t u d i e s , h o w e v e r ,
h a v e p ro v id e d e s tim a te s o f th e s e c o s ts a n d
b e n e f its . A r e v ie w o f th is l i te r a tu r e c a n b e
fo u n d in L a ir d a n d Y e a ts . T w o c a s e s tu d ie s a r e
p ro v id e d in th e s h a d e d in s e r ts o n p a g e s an d
Q q Qf Q u a n tity o f
a s e x a m p le s o f s u c h a n a ly s e s . T h e f ir s t e x a m ­
Im p o r ts
p l e e x a m i n e s th e i m p a c t o f t h e U .S . q u o ta o n
s u g a r im p o r ts ; th e se c o n d e x a m in e s th e e f f e c t

N o w , s u p p o s e t h a t a n i m p o r t q u o t a o f Q q is o f t h e U . S . - Ja p a n e s e a g r e e m e n t t o l i m i t Ja p a n e s e

im p o s e d b y t h e U n ite d S ta te s . T h is r e s tr i c t i o n a u to m o b ile e x p o r ts to th e U n ite d S ta te s .

c a u s e s th e im p o r t s u p p ly c u r v e to b eco m e v e r­
A s a p r o te c tio n is t p o lic y , n o n - ta r if f b a r r i e r s
tic a l a t th e r e s tr i c te d q u a n tity . T h u s , th e im p o r t
a r e a m e th o d f o r r e d is tr ib u tin g w e a lth fro m
s u p p ly c u r v e is t h e k in k e d c u r v e S C S '. T h e
c o n s u m e r s in g e n e r a l to s e le c te d f ir m s a n d
r e s tr ic tio n r e d u c e s th e q u a n tity o f im p o r ts f r o m
w o r k e r s . T h i s r e d i s tr i b u ti o n is a b e t te d by co n­
O p to Q q , th e d o m e s tic p r i c e to ris e fro m P p to
s u m e r ig n o r a n c e a n d th e c o s ts o f m o b iliz in g a n
P q a n d th e f o r e i g n p r i c e to d e c lin e f r o m P p to
e f f e c tiv e f o r c e to c o u n te r a c t p r o te c tio n is t
P g . 11 T h e h i g h e r d o m e s t i c p r i c e r e d u c e s t o t a l
d e m a n d s . A s C o u g h lin e t a l. ( 1 9 8 8 ) h a v e d e m o n ­
U .S . c o n s u m p ti o n o f th e g o o d , b u t i n c r e a s e s
s tr a te d r e c e n tly , th e b e n e f its r e c e iv e d by se­
U .S . p r o d u c ti o n ; th u s , U .S . p r o d u c e r s o f t h e
le c te d g r o u p s o f f ir m s a n d w o r k e r s a r e f a r o u t­
g o o d b e n e f i t a t t h e e x p e n s e o f U .S . c o n s u m e r s
w e ig h e d b y th e c o s ts b o r n e b y th e r e s t o f th e
in g e n e r a l. T h e d if f e r e n c e b e tw e e n w h a t
p o p u la tio n .
d o m e s tic a n d f o r e i g n c o n s u m e r s p a y , P b P q , is a
p re m iu m p e r u n it o f im p o r ts th a t c a n b e a p ­
p r o p r ia te d by e x p o r te r s , im p o r te r s o r g o v e r n ­
m e n t. T h e m e th o d u s e d to a llo c a te im p o r t
W H Y U S E N O N - T A R I FF B A R R I E R S
lic e n s e s d e te r m in e s th e d is tr ib u tio n o f th e s e IN S T EA D O F T A R IFFS ?
p r e m iu m s a m o n g th e p o te n tia l c la im a n ts .
S in c e n o n - ta r if f b a r r i e r s h a v e b e e n u s e d in ­
A v o lu n ta r y e x p o r t r e s tr a i n t h a s th e s a m e c re a s in g ly in r e c e n t y e a r s , a n o b v io u s q u e s tio n
g e n e r a l e f f e c ts a s a n e q u iv a le n t q u o ta . A v o lu n ­ is w h y n o n - t a r i f f b a r r i e r s r a t h e r th a n t a r i f f b a r -

11F ig u re 1 ca n a lso b e u se d to illu s tra te a v a ria b le im p o rt te x t, tw o o f w h ic h a re m e n tio n e d b elo w . S in c e m a ny

le vy. W h ile a q u o ta lim its th e q u a n tity o f im p o rts , a m a rk e ts fo r in te rn a tio n a lly tra d e d g o o d s a re im p e rfe c tly
v a ria b le im p o rt le vy is u se d to fix th e p ric e . A s s u m in g a c o m p e titiv e , a s ta n d a rd to p ic in in tro d u c to ry in te rn a tio n a l
ta r g e t (d o m e s tic ) p ric e o f P q , w h en w o rld p ric e s fa ll b e lo w tra d e te x ts is to id e n tify th e e ffe c t o f a n im p o rt q u o ta in
th is p ric e , th e le vy w ill b e a lte re d a u to m a tic a lly to m a in ta in th e p re s e n c e o f m o n o p o ly. S ee K ru g m a n a nd O b s tfe ld
th e p ric e o f P q . T h u s, no m a tte r h o w fa r w o rld p ric e s (1988) fo r an e le m e n ta ry d is c u s s io n . S in c e v o lu n ta ry
d e c lin e , th e q u a n tity o f im p o rts w ill n o t rise a b o ve Q q . e x p o rt re s tra in ts d is c rim in a te a m o n g tra d in g p a rtn e rs , th e
C o n s e q u e n tly , a v a ria b le im p o rt le v y a n d a q u o ta h a ve th e e ffe c ts o f th is d iffe re n tia l tr e a tm e n t h a v e b e e n e x p lo re d .
s a m e e ffe c t, e ve n th o u g h th e y a re im p le m e n te d d iffe re n tly . S e e J o n e s (1984) fo r s u c h an a n a ly sis .

1t h e o r e t i c a l re s ea rch on th e im p a c t o f n o n -ta riff b a rrie rs

h a s e x p lo re d v a rio u s is su es th a t w e d o n o t m e n tio n in th e

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Federal Reserve Bank FEDE ofRSt.
A L Louis
R E S E R V E B A N K O F ST. L O U IS
 39

A V o l u n ta ry E x p o rt R e s tra i n t i n P ra c ti c e : T h e U .S .
Ja p a n e s e A u to m o b i l e A g re e m e n t

O n e w e ll- k n o w n e x a m p le o f a v o lu n ta r y ex­ s o ld in th e U n ite d S ta te s a n d c o m p lic a te th e

p o r t r e s t r a i n t i s t h e Ja p a n e s e r e s t r a i n t o n e s tim a tio n . F o r a ll n e w c a r s s o ld in 1 9 8 4 , C o l­
a u to m o b ile e x p o r ts to th e U n ite d S ta te s . In ly n s a n d D u n a w a y ( 1 9 8 7 ) e s tim a te d an
e a r ly 1 9 8 1 , t h e Ja p a n e s e i m p o s e d r e s tr a in ts a v e r a g e in c r e a s e o f $ 1 ,6 4 9 ( 1 7 p e r c e n t) ,
to p r e e m p t m o r e r e s tr ic tiv e m e a s u r e s a d ­ w h ic h c o n s is te d o f a p u re p ric e e f f e c t o f
v o c a te d b y m a n y , e s p e c ia lly la b o r g ro u p s , $ 6 1 7 p e r c a r an d a q u a lity e f f e c t o f $ 1 ,0 3 2
w ith in th e U n ite d S ta te s .1 T h e s e p r o te c tio n is t p e r c a r . T h e h i g h e r p r i c e le d to a r e d u c tio n
p re s s u r e s in c re a s e d d u r in g th e la te 1970s an d in 1 9 8 4 p u r c h a s e s o f a p p r o x im a te ly 1 .5
e a r ly 1 9 8 0 s a s a u to m o b ile s a le s b y U .S . p r o ­ m illio n .
d u c e r s d e c lin e d an d f o re ig n p ro d u c e r s c a p ­
tu r e d l a r g e r s h a r e s o f t h e U .S . m a r k e t. A s s u g g e s te d a b o v e , th e e x p o r t r e s tr a in ts
h ad d if f e r e n tia l e f f e c ts . F o r e x a m p le , th e
C o lly n s a n d D u n aw ay ( 1 9 8 7 ) , a s w e ll a s
p r i c e in c r e a s e f o r d o m e s tic a lly p r o d u c e d
m a n y o th e r s , e s tim a te d th e e f f e c ts o f th e
a u to m o b il e s o f $ 1 ,1 8 5 ( 1 2 p e r c e n t) w a s le s s
r e s tr a in ts . T h e s e a u th o r s e x a m in e d th e
th a n th e in c r e a s e f o r im p o r ts f r o m Ja p a n o f
r e s tr a in ts f r o m 1 9 8 1 to 1 9 8 4 . T h e e x a m in a ­
$ 1 ,7 0 0 ( 2 2 .5 p e r c e n t) . T h is r e la tiv e p r i c e
tio n r e v e a l e d th a t th e e x p e c te d r e s u l t s d id
c h a n g e a ll o w e d t h e U .S . p r o d u c e r s to in ­
m a te r ia liz e .
c r e a s e th e ir m a r k e t s h a r e b y 6 .7 5 p e r c e n ta g e

W ith th e r e s tr a i n ts , th e p r ic e s p a id b y U .S . p o in ts , e n o u g h to le a v e d o m e s tic a lly p r o d u c ­

c o n s u m e r s f o r Ja p a n e s e a u t o m o b i l e s r o s e . e d u n it s a le s u n c h a n g e d d e s p ite a d e c lin e o f

T h is re d u c e d th e c o m p e ti ti v e p r e s s u r e s o n u n i t s a le s in th e U n ite d S ta te s . T h u s , th e U .S .

U .S . p r o d u c e r s a n d n o n - Ja p a n e s e e x p o r t e r s t o r e d u c tio n in 1 9 8 4 p u r c h a s e s o f 1 .5 m illio n

th e U n ite d S ta te s w ith th e e f f e c t o f i n c r e a s ­ w a s b o r n e b y f o r e ig n p ro d u c e r s . T h e s e p r o ­

in g p r i c e s f o r th e s e a u to m o b ile s , b u t n o t a s d u c tio n c h a n g e s w e r e e s tim a te d to g e n e r a te

m u c h a s t h e r i s e i n Ja p a n e s e p r i c e s . T h e in c re a s e d U .S . a u to m o ti v e e m p l o y m e n t i n a

h i g h e r a u to m o b il e p r i c e s r e d u c e d U .S . p u r ­ ran g e fro m 4 0 ,0 0 0 to 7 5 , 0 0 0 jo b s .

c h a s e s , b u t t h e e f f e c t s o n U .S . a n d non-
T h e h ig h e r a u to m o b ile p r i c e s r e p r e s e n t o n e
Ja p a n e s e p r o d u c e r s w e r e m i t i g a t e d b y t h e
f a c e t o f th e lo s s e s f o r c o n s u m e r s . T h e p u r e
r e l a t i v e l y l a r g e r r i s e i n t h e p r i c e s o f Ja p a n e s e
p ric e e f f e c t c a u se d U .S . c o n s u m e r s t o su ffe r
a u to m o b ile s a n d th e r e s u ltin g s h if t a w a y
a lo s s o f c o n s u m e r s ’ s u r p lu s o f $ 6 .6 b illio n in
fro m Ja p a n e s e a u t o m o b i l e s .
1984. In a d d itio n , U .S . c o n s u m e r s w e r e w o r s e
T h e r e s tr a i n ts a ls o in d u c e d q u a li ty c h a n g e s o f f to th e e x te n t th a t q u o ta s lim ite d th e ir
a s Ja p a n e s e p r o d u c e r s s h i f t e d t h e i r m i x o f r a n g e o f a u to m o tiv e c h o i c e s . P u r c h a s e s o f i n ­
e x p o r ts to w a r d la r g e r a n d m o r e lu x u rio u s cre ase d q u a lity r e s u ltin g fro m th e q u o ta to ta l­
m o d e ls th a t g e n e r a te d m o r e p r o f i ts p e r u n it. ed $ 1 0 .7 5 b illio n in 1 9 8 4 . T h e w e l f a r e lo s s
In a d d itio n , m o r e " o p ti o n a l ” e q u i p m e n t w a s a s s o c ia te d w i th th e s e q u a li ty e x p e n d i tu r e s
in s ta lle d in e a c h u n it. C o n s e q u e n tly , th e w a s n o t e s t i m a t e d , b u t i t is c l e a r t h a t t h i s
a v e r a g e t r a n s a c t i o n p r i c e o f Ja p a n e s e lo s s is p o s s i b ly g r e a t e r th a n t h e l o s s a s s o ­
a u to m o b ile s in c r e a s e d b e c a u s e o f th e p u r e c ia te d w ith th e p u r e p r ic e e f f e c t.
p r i c e e f f e c t a s w e l l a s th e q u a li ty e f f e c t s
T h e l o s s e s o f U .S . c o n s u m e r s a r e p r i m a r i l y
a s s o c ia te d w ith th e r e s tr a in ts .
tr a n s f e r s f r o m c o n s u m e r s to d o m e s tic a n d
In f a c t, th e f a c to r s u n d e r ly in g th e p r i c e f o r e ig n p r o d u c e r s . E s ti m a te s o f th e b e n e f i ts
c h a n g e a f f e c t t h e p r i c e s o f a ll a u to m o b ile s f o r d o m e s tic a n d f o r e ig n p r o d u c e r s h in g e o n

1F e e n s tra (1985) p ro v id e s n u m e ro u s d e ta ils c o n c e rn in g ta ry e x p o rt re s tra in t o f 1 .68 m illio n . O th e r p ro p o s e d

le g is la tio n d e s ig n e d to re s tric t im p o rts . In e a rly 1981, le g is la tio n w a s m o re re s tric tiv e in p ro v id in g fo r s m a lle r
S e n s. D a n fo rth a nd B e n ts e n in tro d u c e d a b ill to re s tric t im p o rt q u o ta s a nd in s p e c ify in g th e m in im u m c o n te n t o f
a u to m o b ile im p o rts fro m J a p a n to 1.6 m illio n u n its a n ­ A m e ric a n p a rts a nd la b o r fo r a u to m o b ile s s o ld in th e
n u a lly d u rin g 1981-83, w h ic h is v e ry c lo se to th e v o lu n - U n ite d S ta te s.

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Federal Reserve Bank of St. Louis IA K II I A D V / C C D D I I A D V 1Q O Q
 40

th e a s s u m p tio n a b o u t th e d is tr ib u tio n o f th e p r o d u c e r s g a in e d $ 1 .2 5 b illio n in 1984 an d

p u r e p r i c e e f f e c ts . If t h e e x p o r t r e s t r a i n t s le d f o r e ig n p r o d u c e r s g a in e d $ 5 .5 b illio n . O f th e
to e q u iv a le n t p u r e p r ic e e f f e c ts o n d o m e s tic f o r e i g n p r o d u c e r s ' g a i n , Ja p a n e s e p r o d u c e r s
an d im p o r te d c a r s , th e n U .S . p r o d u c e r s g a i n ­ re c e iv e d $ 5 .2 5 b illio n . If a c c u r a te , th is f ig u r e
ed $ 5 b illio n in 1 9 8 4 a n d f o r e ig n p ro d u c e r s p r o v i d e s a n o b v i o u s r e a s o n w h y t h e Ja p a n e s e
g a in e d $ 1 .5 b illio n . O f th e f o r e ig n p r o d u c e r s ’ g o v e r n m e n t c o n tin u e d th e r e s tr a in ts b e y o n d
g a i n , Ja p a n e s e p r o d u c e r s r e c e i v e d $ 1 b illio n . e a r ly 1 9 8 5 w h e n th e R e a g a n a d m in is tr a tio n
O n th e o th e r h a n d , if th e e x p o r t r e s tr a in ts d e c id e d n o t to r e q u e s t a n e x te n s io n o f th e
le d to e q u i v a l e n t q u a l i t y e f f e c t s , t h e n U .S . a g r e e m e n t.2

2ln e a rly 1985, th e R e ag an a d m in is tra tio n d e c id e d th a t level a n d in 1 987 e x te n d e d th e re s tra in ts fo r a n o th e r

th e d o m e s tic a u to m o b ile in d u s try had a d ju s te d to y e a r w ith o u t a fu rth e r in c re a s e in th e c e ilin g . T h e
fo r e ig n c o m p e titio n a n d a n n o u n c e d th e y w o u ld n o t a sk u n ila te ra l d e c is io n to e x te n d th e re s tra in ts is a c le a r in ­
fo r a n e x te n s io n . N e v e rth e le s s, in e a rly 1985, th e d ic a tio n th a t th e J a p a n e s e , e s p e c ia lly a u to m o b ile p ro ­
J a p a n e s e g o v e rn m e n t e x te n d e d th e re s tra in ts th ro u g h d u c e rs , w e re b e n e fitin g fro m th e re s tra in ts .
e a rly 1 987 a t a level 2 4 p e rc e n t a b o ve th e p re v io u s

r i e r s h a v e b e c o m e s o p o p u l a r . 13 A re v ie w by Certainty o f Domestic Benefits

D e a r d o r f f (1 9 8 7 ) c o n c lu d e s th a t th e r e c u r r e n tly
is n o d e f in itiv e a n s w e r to th i s q u e s tio n ; h o w ­ D e a r d o r f f ( 1 9 8 7 ) s u g g e s ts th a t n o n - ta r if f b a r ­

e v e r, n u m e ro u s re a so n s h av e b e e n s u g g e s te d . rie rs a re p re fe rre d to ta r if f s b e c a u s e p o lic y ­

m a k e rs an d d e m a n d e r s o f p r o te c tio n b e lie v e
th a t th e e f f e c ts o f ta r i f f s a r e le s s c e r ta in . T h is
p e r c e p tio n c o u ld b e d u e to v a rio u s re a s o n s ,
so m e re a l an d s o m e illu s o r y . F o r e x a m p le , it
The Impact o f GATT: An Institu­ m a y b e m u c h e a s ie r to s e e th a t a q u o ta o f 1
tional Constraint on the Use o f m illio n lim its a u to m o b ile im p o r ts to 1 m illio n

Tariffs th a n to d e m o n s tr a te c o n c lu s iv e ly th a t a ta r i f f
o f, sa y , $ 3 0 0 p e r c a r w o u ld r e s u l t in im p o r ts o f

G A T T is a n i n s t i t u t i o n w h o s e o r i g i n a l m i s s i o n o n ly 1 m illio n a u to m o b ile s .

w a s to r e s t r i c t th e u s e o f ta r i f f s . G iv e n th is c o n ­ In p a r t, d o u b ts th a t ta r i f f s w ill h a v e th e
s tr a in t, p o lic y m a k e r s w illin g to re sp o n d to p ro ­ d e s ire d e f f e c t is b a s e d o n th e p o s s ib ility o f ac­
te c tio n is t d e m a n d s w e r e f o r c e d to u s e n o n - ta r if f ti o n s th a t c o u ld b e ta k e n to o f f s e t th e e f f e c ts o f
d e v ic e s . T h u s , in th is c a s e , n o n - ta r if f b a r r i e r s h ig h e r ta r if f s . F o r e x a m p le , th e im p o s itio n o f a
a re s im p ly a s u b s ti tu te f o r t a r i f f s . In f a c t , r e ­ ta r if f m a y in d u c e th e e x p o r tin g c o u n tr y to su b ­
se arch b y R a y ( 1 9 8 1 ) in d ic a te s th a t n o n - ta r if f s i d i z e t h e e x p o r t i n g f i r m s i n a n a tt e m p t to
b a rrie rs h av e b e e n u s e d to r e v e r s e th e e f f e c ts r e d u c e t h e t a r i f f ’s e f f e c ti v e n e s s . T h e e f f e c t s o f
o f m u ltila te r a l t a r i f f r e d u c tio n s n e g o tia te d q u o ta s , o n th e o th e r h a n d , a r e n o t a lte r e d by
u n d e r G A T T . 14 su ch s u b s i d i e s . 15

13D a tin g fro m B h a g w a ti’s s e m in a l d is c u s s io n in 1965, c o m ­ 15D e a rd o rff’s (1987) re v ie w p ro v id e s a n o th e r p e rs p e c tiv e on

p a ris o n s o f th e th e o re tic a l e ffe c ts o f ta riffs a n d n o n -ta riff th e ro le o f u n c e rta in ty . T h e o p tim a lity o f tra d e p o lic y to o ls
b a rrie rs h a v e b een a fre q u e n t to p ic in th e in te rn a tio n a l h a s b e e n e x p lo re d e x te n s iv e ly u s in g tra d e m o d e ls w ith
tr a d e lite ra tu re . U n d e r v a rio u s c irc u m s ta n c e s , a ta r iff and u n c e rta in ty . T h e s e m o d e ls , w h ic h re ly on risk a v e rs io n
a s p e c ific n o n -ta riff b a rrie r, say, a q u o ta , ca n c a u s e d if­ (th a t is, a n in d iv id u a l re q u ire s a h ig h e r e x p e c te d re tu rn as
fe re n t fin a l p ric e s a n d p ro d u c tio n d e s p ite re d u c in g tra d e c o m p e n s a tio n fo r an in c re a s e in risk ) a n d u n c e rta in ty
b y e q u al a m o u n ts. T h e s e c irc u m s ta n c e s p ro d u c e w h a t is o rig in a tin g o u ts id e a c o u n try , c o n c lu d e th a t q u o ta s a re
te rm e d n o n e q u iv a le n c e . T a riffs a nd q u o ta s a re e q u iv a le n t p re fe rre d to ta riffs . T h e c o u n try is in s u la te d fro m th e
w h e n m a rk e ts a re p e rfe c tly c o m p e titiv e . In th is c a s e , th e re u n c e rta in ty s te m m in g fro m ra n d o m n e s s in w o rld p ric e s o r
is no re a so n to p re fe r o n e to th e o th e r. im p o rt s u p p ly c u rv e s b y a q u o ta th a t s ta b iliz e s th e p ric e
B h a g w a ti (1965, 1968) has d e m o n s tra te d th a t th e a nd q u a n tity o f im p o rts . O n e p ro b le m w ith th is e x p la n a ­
e q u iv a le n c e o f ta riffs a nd q u o ta s b re a k s d o w n in im p e r­ tio n , h o w e v e r, is th a t th e q u o ta is in s titu te d b e fo re th e
fe c tly c o m p e titiv e m a rke ts . N u m e ro u s s itu a tio n s c a n be u n c e rta in s ta te o f th e w o rld is kn ow n , w h ile in th e real
c h a ra c te riz e d a s im p e rfe c tly c o m p e titiv e . T o d a te , h ow ­ w o rld p ro te c tio n is g e n e ra lly p ro v id e d a fte r a c h a n g e in th e
e ve r, th e lite ra tu re h a s p ro v id e d no c o m p e llin g re a s o n s fo r w o rld m a rke t.
p re fe rrin g n o n -ta riff o v e r ta r iff b a rrie rs . F or a re c e n t e x a m ­
p le fro m th is lite ra tu re , se e K ris h n a (1985).

14A q u e s tio n re m a in s , h ow e v er, as to w h y th e fra m e rs o f

G A T T c h o s e to fo c u s p rim a rily o n ta riffs ra th e r th a n n o n ­
ta r iff b a rrie rs.

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Federal Reserve Bank F E D of
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R E S E R V E B A N K O F ST. LO U IS
 41

A N o n - T a ri f f B a r r i e r i n P ra c ti c e : T h e U .S . S u g a r
I m p o rt Q u o ta
S i n c e 1 9 8 2 , th e U n ite d S ta te s h a s im p o s e d
q u o ta s o n s u g a r im p o r ts to su p p o rt a
d o m e s tic p r ic e g u a r a n te e b y th e f e d e r a l
F ig u re 2
g o v e r n m e n t th a t e x c e e d s w o rld m a rk e t
T h e E ffe c ts o f T r a d e R e s tric tio n s on th e U .S .
l e v e l s .1 T h e h ig h p r i c e h a s s tim u la te d U .S .
S u g a r M a rk e t
s u g a r p r o d u c tio n a n d s h if ts in d e m a n d
P ric e
to w a r d o th e r s w e e te n e r s , w h ic h h a s n e c e s ­ (c e n ts p e r po u n d )

s ita te d la r g e r e d u c tio n s in s u g a r im p o r t
q u o ta s in r e c e n t y e a r s .

T a rr an d M o r k r e ( 1 9 8 4 ) e s tim a te d th e c o s ts
o f th e s u g a r im p o r t q u o ta f o r f is c a l y e a r
1983 ( O c to b e r 1 9 8 2 - S e p te m b e r 1 9 8 3 ) . A c tu a l­
ly , th e q u o ta is c o m b i n e d w ith a ta r if f , so
t a r i f f r e v e n u e s a s w e ll a s q u o ta r e v e n u e s
a r is e . T h e q u o ta r e v e n u e s a r e c a p tu r e d by 24
f o r e ig n c o u n tr ie s w h o h a v e th e r i g h t to s e ll
s u g a r in th e U n ite d S ta te s .

F ig u r e 2 illu s tr a te s s o m e o f th e e f f e c ts o f
t h e U .S . t r a d e r e s t r i c t i o n s in 1 9 8 3 . T h e lin e s
S o u r c e : K r u g m a n a n d O b s t f e id (1 9 8 8 ).
SS a n d D D a r e th e U .S . s u p p ly a n d d em an d
c u r v e s f o r s u g a r. T h e w o rld p ric e w a s 15
c e n ts p e r p o u n d , a n d U .S . p u r c h a s e s w e r e
assu m ed to hav e n o e f f e c t o n th is p r ic e . W ith
f r e e t r a d e , U .S . p r o d u c ti o n , c o n s u m p ti o n a n d n u e , w h ic h is r e p r e s e n te d by a r e a i. C o n s e ­
im p o r ts w o u ld h a v e b e e n 6 .1 4 b illio n p o u n d s , q u e n tly , th e n e t e f f e c t f o r th e U n ite d S ta te s
1 9 .1 8 b illio n p o u n d s a n d 1 3 .0 4 b illio n p o u n d s . is a lo s s o f $ 4 8 3 m illio n , w h i c h is t h e s u m of
To r a i s e t h e i n t e r n a l ( U .S .) p r i c e t o 2 1 .8 c e n ts are as g, j an d h . A r e a g is th e lo s s d u e to in ­
p e r p o u n d , a ta r i f f o f 2 .8 c e n ts p e r p o u n d e f f ic ie n t p r o d u c tio n a n d a r e a j is th e lo s s d u e
and a q u o ta o f 5 .9 6 b illio n p o u n d s w e r e u s e d . to i n e f f i c i e n t c o n s u m p ti o n . A r e a h , w h i c h is
T h e v a l u e o f t h e q u o t a is 4 . 0 c e n t s p e r e q u a l to $ 2 3 8 m illio n , is t h e v a lu e o f t h e im ­
p o u n d , b e c a u s e 2 .8 c e n ts p e r p o u n d o f th e p o r t lic e n s e s r e c e iv e d by f o r e ig n s u p p lie r s . In
6 .8 c e n ts p e r p o u n d d if f e r e n tia l b e tw e e n th e o th e r w o r d s , th e q u o ta e n ta ils a tr a n s f e r
U .S . p r i c e a n d th e w o rld p r i c e is d u e to th e fro m U .S . c o n s u m e r s to f o r e ig n p ro d u c e rs o f
ta r if f . $ 2 3 8 m illio n .

T h e w e lf a r e e f f e c ts o f th e tr a d e r e s tr ic tio n s T h e p re c e d in g a n a ly s is , w h ile e f f e c tiv e ly

a r e i n d i c a t e d b y t h e a r e a s f , g , h , i a n d j. T h e h ig h lig h tin g th e w in n e r s a n d lo s e r s f r o m th e
p r ic e - in c r e a s in g e f f e c ts o f th e tr a d e r e s tr ic ­ U .S . s u g a r p r o g r a m , is n o t t h e e n t i r e s to r y .
ti o n s c a u s e c o n s u m e r s to s u f f e r a lo s s o f c o n ­ T h e s e e s tim a te s p e r ta i n to o n e y e a r o n ly .
s u m e r s u r p lu s e q u a l to $ 1 ,2 6 6 b illio n , th e S i n c e th e U .S . s u g a r p o l i c y is o n g o i n g , t h e
su m o f a r e a s f , g , h , i a n d j, 2 P r o d u c e r s g a in , lo s s e s a r e o n g o in g a s w e ll. In a d d itio n , i m p o r ­
in t h e f o r m o f p r o d u c e r s u rp lu s , a r e a f ta n t d y n a m ic in te r r e la tio n s h ip s b e tw e e n
w h o s e v a l u e is $ 6 1 6 m i l l i o n . T h e U . S . g o v e r n ­ p o lic y c h a n g e s a n d p r o d u c tio n an d tr a d e
m e n t a ls o g a in s $ 1 6 7 m illio n in ta r i f f re v e - c h a n g e s e x i s t.

1M a s k u s (1987) c o n c lu d e d th a t U .S . s u g a r p ro d u c tio n s tu d ie s . M a s k u s (1987) s u rve y e d s tu d ie s o f th e c o s ts

a nd tra d e h ave b e e n d ire c te d b y g o v e rn m e n t p o lic ie s b o rn e b y U .S . c o n s u m e rs a n d fo u n d e s tim a te s ra n g in g
a lm o s t c o n tin u o u s ly fo r 2 00 ye a rs. fro m $1 b illio n to $ 2 .7 b illio n .

2T a rr a nd M o rk re ’s (1984) e s tim a te o f th e c o n s u m e r c o s t
o f th e U .S . s u g a r p ro g ra m is c o n s is te n t w ith o th e r

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Federal Reserve Bank of St. Louis
 42

M a s k u s ( 1 9 8 7 ) h a s id e n tif ie d a n u m b e r o f T h e in c re a s in g ly r e s tr ic tiv e im p o r t b a r r ie r s
t h e d y n a m i c c o n s e q u e n c e s o f t h e U .S . s u g a r h av e p ro d u c e d te n s io n s w ith n u m e r o u s e x ­
p ro g ra m , m an y s te m m in g f r o m th e f a c t th a t p o r te r s o f su g a r, m o s t o f w h o m a r e d e v e lo p ­
s u g a r h a s s e v e r a l c lo s e s u b s titu te s . C o r n in g c o u n tr i e s . T o c o n fo rm w ith th e G e n e r a l
s w e e te n e r s ; n o n - c a lo r ic s w e e te n e r s , h o n e y A g r e e m e n t o n T a r if f s a n d T r a d e , th e im p o r t
and s p e c ia lty s u g a r s a r e a ll c l o s e s u b s ti tu te s . q u o ta s m u s t b e a p p lie d in a n o n -
H ig h e r s u g a r p r ic e s h a v e in d u c e d th e p r o d u c ­ d is c r im in a to r y f a s h io n . T h e U n ite d S ta te s a p ­
ti o n o f a lte r n a tiv e s w e e te n e r s th a t c o m p e te p lie d th i s p r o v i s io n b y b a s i n g its q u o ta a ll o c a ­
w ith a n d , c o n s e q u e n tly , th r e a te n U .S . s u g a r tio n o n im p o r ts d u r in g th e r e la tiv e ly f r e e -
p ro d u c e rs. m a r k e t p e rio d o f 1 9 7 5 - 8 1 . A tte m p ts to m a in ­
ta in c o n s ta n t s h a r e s f o r m o s t c o u n tr ie s ,
T h e f a c t t h a t s u g a r is u s e d in d i f f e r e n t
h o w e v e r, ra n in to p r a c tic a l p r o b le m s . C o u n ­
g o o d s h a s s e t in m o tio n a n u m b e r o f a d ­
tr ie s e x p e r ie n c in g r a p id g r o w th in s u g a r e x ­
ju s t m e n t s . E x a m p l e s a b o u n d o f th e d is to r tio n s
p o r ts to t h e U n ite d S ta te s b e tw e e n 1 975 an d
in d u c e d b y t h e a r t i f i c i a l l y h i g h U .S . s u g a r
1981 w e r e s u b je c t e d to s u b s ta n tia l c u ts b e t ­
p r ic e . F o r e x a m p le , th e la r g e p r ic e d if f e r e n ­
w e e n th e e n d o f th e f r e e - m a r k e t p e rio d and
ti a l b e t w e e n U .S . a n d f o re ig n s u g a r p ro v id e s
th e b e g in n in g o f th e q u o ta s . F o r e x a m p le ,
a c o s t a d v a n ta g e to f o r e ig n , e s p e c ia lly C a n a ­
s u g a r e x p o r ts f r o m H o n d u ra s w e re re d u c e d
d ia n , f o o d - p r o c e s s in g f ir m s . T h e s u g a r p o lic y
fro m 9 3 ,5 0 0 to n s in 1 9 8 1 to 2 8 ,0 0 0 to n s in
c a n b e v ie w e d a s a t a x o n U .S . r e f i n e r s a n d
1983.
p r o c e s s o r s th a t w a s n o t le v ie d o n f o re ig n
f irm s .
T h e e f f e c t o f th is c u t w a s m itig a te d so m e­
T r a d e f lo w s re s p o n d e d to th e s e p r i c e
w h a t in 1 9 8 3 w h e n th e U n ite d S ta te s tr a n s ­
c h a n g e s a s a ra p id e x p a n s io n in im p o r ts o f
fe rre d 5 2 p e r c e n t o f N i c a r a g u a ’s q u o t a t o
s u g a r - c o n ta in in g g o o d s e n s u e d . In f a c t, th e
H o n d u r a s , a n a c tio n th a t s im u lta n e o u s ly
d i f f e r e n t i a l b e t w e e n U .S . a n d w o r l d su g ar
p u n is h e d th e S a n d in is ta r e g i m e a n d re w a rd e d
p r ic e s b e c a m e s o la r g e a t o n e tim e th a t
a n e ig h b o r in g s ta te th o u g h t to b e in d a n g e r
s u g a r - c o n ta in in g g o o d s w e r e im p o r te d s o le ly
fro m th e N i c a r a g u a n - s u p p o r te d re b e llio n .
f o r th e ir s u g a r c o n te n t. F o r e x a m p le , d u r in g
T h i s a c ti o n v io la te d G A T T ru le s a n d g ene­
1 9 8 5 , w o rld s u g a r p r ic e s d e c lin e d so s h a rp ly
ra te d m u c h c r itic is m o f th e U n ite d S ta te s .
t h a t , i n Ju n e 1 9 8 5 , t h e U .S . s u g a r p r i c e w a s
Su c h a q u o ta s y s te m i n c r e a s e s th e lik e lih o o d
7 7 6 p e r c e n t o f th e w o r ld p r ic e . T h is d if ­
t h a t t r a d e p o l i cy is u s e d f o r n o n e c o n o m i c
f e r e n c e in d u c e d s o m e f i r m s in t h e U n ite d
re a so n s.
S ta te s to im p o r t C a n a d ia n p a n c a k e m ix ,
w h i c h w a s n o t s u b je c t t o t h e q u o ta , a n d p ro ­
T h e le s s o n s f r o m t h e U .S . s u g a r p r o g r a m
c e s s it to e x tr a c t th e su g a r.
a r e s tr a ig h tf o r w a r d . F ir s t, s ig n if ic a n t c o s ts
T h e in d u c e d c h a n g e s in p r o d u c tio n a n d h a v e b e e n im p o s e d o n U .S . c o n s u m e r s . S e ­
tr a d e h a v e f o r c e d a n u m b e r o f a d d itio n a l c o n d , th e r e s u ltin g d is to r tio n s in e c o n o m ic in ­
U .S . a c ti o n s to m a in ta in th e s u g a r p r ic e s . F o r c e n tiv e s h a v e h a r m e d U .S . p r o d u c e r s d e p e n ­
f i s c a l y e a r 1 9 8 5 , t h e U .S . s u g a r i m p o r t q u o ta d e n t o n s u g a r . T h i r d , e c o n o m ic r e s p o n s e s to
w as re d u c e d 1 7 p e r c e n t. T h is w a s f o llo w e d th e le g is la tio n h a v e r e v e a le d a nu m ber o f
by r e d u c tio n s o f 2 7 .6 p e r c e n t in 1 9 8 6 a n d lo o p h o le s th a t h a v e n e c e s s ita te d a d d itio n a l
4 5 .7 p e r c e n t in 1 9 8 7 . T r a d e r e s tr ic tio n s o n r e s tr ic tio n s a n d d i s t o r ti o n s s o t h a t U .S . s u g a r
s u g a r s u b s titu te s a ls o h a v e r e s u lte d . T w o of p r o d u c e r s c o u ld c o n ti n u e to b e n e f it. F o u r th ,
th e s e a r e : 1) a n e m e r g e n c y b a n o n im p o r ts o f U .S . a tt e m p ts to e n s u r e f a irn e s s h a v e n e c e s s i­
c e r ta in s y ru p s a n d b le n d e d s u g a r s in b u lk in ta te d s u b s ta n tia l r e s o u r c e s to a s c e r ta in p r o ­
Ju n e 1983; an d 2) e m e rg e n c y q u o ta s o n a d u c tio n a n d tr a d e b e h a v io r . F in a lly , th e p r o ­
b ro a d r a n g e o f s u g a r - c o n ta in in g a r ti c l e s in g ra m h as b e e n u sed f o r p o li ti c a l p u r p o s e s to
b o th b u lk a n d r e t a i l f o r m s i n Ja n u a r y 1985. re w a rd an d p u n is h f o r e ig n c o u n tr ie s .

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Benefits to O ther Parties v o l u n t a r y e x p o r t r e s t r a i n t . 16 A s im p lif ic a tio n in

th is m o d e l, w h o s e im p o r ta n c e is d is c u s s e d
T h e s u p p ly a n d d em an d a n a ly s is o f q u o ta s b e lo w , is t h a t r iv a l p o litic a l c a n d i d a te s p l a c e n o
a n d v o lu n ta r y e x p o r t r e s tr a i n ts h ig h lig h ts th e v a lu e o n t a r i f f r e v e n u e . A s s u m e a v o lu n ta r y e x ­
d if f e r e n c e p e r u n it o f im p o r t b e tw e e n w h a t p o r t r e s tr a in t a n d a t a r i f f g e n e r a te id e n tic a l
d o m e s tic a n d f o r e ig n c o n s u m e rs p ay . T h is p ric e d o m e s tic p r o d u c e r b e n e f i ts . P o litic ia n s w ill s u p ­
d if f e r e n tia l r e f l e c ts th e e x te n t o f th e g a in s th a t p o r t th e v o lu n ta r y e x p o r t r e s tr a in t o v e r th e
a r e a v a ila b le f o r s o m e g r o u p to a p p r o p r ia te . t a r i f f b e c a u s e th e v o lu n ta r y e x p o r t r e s tr a i n t
W ith ta r i f f s , th e p r i c e d i f f e r e n ti a l is c a p tu r e d by g e n e r a te s b e n e f its f o r f o r e ig n p r o d u c e r s th a t, in
th e d o m e s tic g o v e r n m e n t in th e f o r m o f ta r if f tu r n , c a n b e a p p r o p r ia te d p a r tia lly b y th e p o liti­
r e v e n u e . W ith n o n - ta r if f b a r r i e r s , th e d o m e s tic c ia n s in th e f o r m o f c a m p a ig n c o n tr ib u tio n s . O n
g o v e r n m e n t is n o t a d ir e c t b e n e f i c i a r y u n le s s it t h e o th e r h a n d , t h e t a r i f f r e v e n u e is a s s u m e d to
s e lls th e r ig h ts to im p o r t to th e h ig h e s t b id d e r s . h a v e n o v a l u e f o r p o li ti c i a n s . C a n d id a te s f o r
O th e r w is e , d o m e s tic im p o r te r s , f o r e ig n e x ­ e le c tiv e o f f ic e a r e v ie w e d a s a n n o u n c in g tr a d e
p o r te r s a n d f o r e ig n g o v e r n m e n ts c a p tu r e th e s e p o li c y p o s itio n s to m a x im iz e c a m p a ig n c o n tr ib u ­
g a in s . T h e p o te n tia l d is tr ib u tio n o f th e s e b e n e ­ tio n s f r o m d o m e s tic a n d f o r e ig n p ro d u c e r
f its c a n i n f l u e n c e th e d o m e s tic g o v e r n m e n t's in te r e s ts .
c h o ic e b e tw e e n ta r if f a n d n o n - ta r if f b a r r ie r s .

In a d d itio n to in c r e a s in g th e p r o b a b ility th a t
W ith v o lu n ta r y e x p o r t r e s tr a in ts , th e p r ic e d if ­ p ro te c tio n is m w ill ta k e th e f o r m o f v o lu n ta r y
f e r e n ti a l id e n tif ie d a b o v e is ty p ic a lly c a p tu r e d e x p o r t r e s tr a i n ts r a t h e r th a n ta r if f s , th e a r g u ­
by th e e x p o r tin g f ir m s f r o m th e f o r e ig n c o u n ­ m e n t r e v e a ls a w a y th a t p o litic a l c a n d id a te s c a n
tr y . T h is r e s u l t m a y r e d u c e th e lik e lih o o d th a t p e r s o n a lly c a p tu r e r e v e n u e s th a t, w ith ta r if f s ,
th e f o r e ig n c o u n tr y w ill r e ta lia te a g a in s t s u c h w o u ld h a v e a c c r u e d to th e d o m e s tic g o v e r n ­
r e s tr i c tio n s . G iv e n c e r ta i n d em an d c o n d itio n s in m e n t. N o n e th e le s s , t h e a s s u m p tio n a b o u t th e
b o t h t h e U .S . a n d f o r e ig n m a r k e ts , v o lu n ta r y ex­ p e r c e iv e d v a lu e o f ta r i f f r e v e n u e to p o litic ia n s
p o r t r e s tr a i n ts c a n e n ta il a s u b s ta n tia l r e d i s tr ib ­ a n d th e f a c t th a t c o n s u m e r i n te r e s ts a r e ig ­
u tio n f r o m c o n s u m e r s in th e im p o r tin g c o u n tr y n o re d in th e a n a ly s is s u g g e s ts o n e s h o u ld b e
to s e le c te d p r o d u c e r s in th e e x p o r tin g c o u n tr y . c a u tio u s in g e n e r a liz in g th is r e s u lt.
F o r e x a m p le , C o lly n s a n d D u n aw ay (1987)
e s t i m a t e t h a t t h e U . S . - Ja p a n e s e v o l u n t a r y e x p o r t T h e p o s s ib le b e n e f i ts to d o m e s tic p o litic ia n s o f
r e s tr a i n t o n a u to m o b ile s y ie ld e d in c r e a s e d u s in g n o n - ta r if f r a th e r th a n ta r if f b a r r i e r s a r e
b e n e f i ts to s e le c te d Ja p a n e s e a u t o p r o d u c e r s
n o t r e s tr ic te d to c a m p a ig n c o n tr ib u tio n s . F o r e x ­
r a n g in g f r o m $ 1 b illio n to $ 5 .2 5 b illio n in 1984.
a m p le , a t a r i f f is a n e x p l ic it ta x o n c o n s u m e r s
w h il e a q u o ta is a n im p lic it ta x o n th e m . P o lic y ­
H illm a n a n d U rsp ru n g ( 1 9 8 8 ) e x te n d th e m a k e r s m ig h t f in d it e a s ie r to s u p p o r t q u o ta s
p re c e d in g id e a u s in g a s im p le m o d e l o f tr a d e an d o t h e r n o n - t a r i f f b a r r i e r s b e c a u s e th e y w ill
p o lic y f o r m u la tio n in w h ic h a d e m o c r a tic n o t b e d ir e c tly a s s o c ia te d w ith a ta x in c r e a s e
g o v e r n m e n t is c h o o s i n g b e t w e e n a ta r if f a n d a t h a t c o n s u m e r s , a s v o t e r s , m i g h t r e s i s t . 17

16H u ste d (1986) a lso c o n n e c ts fo r e ig n lo b b y in g to th e he a lso fo u n d s o m e m a jo r d iffe re n c e s . T a riffs a re b ia se d

d o m e s tic e co n o m y. H e fin d s th a t th e d o lla r v a lu e o f to w a rd lo w -sk ill ra th e r th a n c a p ita l-in te n s iv e in d u s trie s a nd
fo re ig n lo b b y in g in th e U n ite d S ta te s is sm a ll re la tiv e to a re u n re la te d to p ro d u c t h e te r o g e n e ity a nd th e
o th e r tra d e d s e rv ic e flo w s a nd th a t th e re tu rn s to fo re ig n g e o g ra p h ic a l d is p e rs io n o f d o m e s tic p ro d u c tio n fa c ilitie s .
lo b b y in g g e n e ra te la rg e re tu rn s. F o r e x a m p le , H u ste d O n th e o th e r h a n d , n o n -ta riff b a rrie rs a re b ia se d to w a rd
c a lc u la te d th a t th e e x p e n d itu re in th e U n ite d S ta te s o f c a p ita l-in te n s iv e in d u s trie s p ro d u c in g fa ir ly h o m o g e n e o u s
$ 1 .4 m illio n o n fo r e ig n lo b b y in g b y th e w o rld a u to m o b ile p ro d u c ts . P ro d u c tio n in th e s e in d u s trie s te n d s to be
in d u s try c a m e p rim a rily fro m J a p a n . G ive n th e e stim a te s d is trib u te d a c ro s s re g io n s c o n s is te n t w ith th e d is trib u tio n
b y C o lly n s a n d D u n a w a y (1 9 8 7 ) a n d o th e rs in d ic a tin g o f p o p u la tio n .
J a p a n e s e a u to m o b ile re n ts e x ce e d e d $1 b illio n in 1984,
U .S . p o litic ia n s d o n o t a p p e a r to be c a p tu rin g m u c h o f
th e s e rents.

17A n e g le c te d issu e in th e p re c e d in g c o m p a ris o n o f n o n ­

ta r iff b a rrie rs w ith ta riffs is th e d is trib u tio n o f th e s e re s tric ­
tio n s a c ro s s in d u s trie s . W h ile R a y (1981) fo u n d th a t n o n ­
ta r iff b a rrie rs a n d ta riffs a re b ia s ed to w a rd in d u s trie s in
w h ic h th e U n ite d S ta te s h a s a c o m p a ra tiv e d isa d v a n ta g e ,

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Federal Reserve Bank of St. Louis JA N U A R Y /F E B R U A R Y 1989
 44

G A T T A N D N O N - T A R I FF u n le s s th e s u b s id iz e d g o o d s a r e s h o w n to b e
c a u s in g ( o r t h r e a t e n i n g ) “ m a t e r i a l ” i n ju r y t o a
B A R R IER S
d o m e s tic p r o d u c e r . T h is c o d e a ls o a llo w s a
T h e h i s to r y o f m u ltila te r a l tr a d e n e g o tia tio n s c o u n tr y to s e e k r e d r e s s f o r c a s e s in w h ic h
d e a l i n g w i t h n o n - t a r i f f b a r r i e r s i s b r i e f . 18 a n o t h e r c o u n t r y ’s s u b s i d i z e d e x p o r t s d i s p l a c e its
M u l ti la te r a l tr a d e n e g o ti a ti o n s a r e c o n d u c te d e x p o r ts in th ir d - c o u n tr y m a r k e ts .
u n d e r th e a u s p ic e s o f th e G e n e r a l A g r e e m e n t
T h e c o d e o n g o v e r n m e n t p r o c u r e m e n t s ta te s
o n T a r if f s a n d T r a d e , w h ic h w a s c r e a te d s h o r t­
th a t, f o r q u a lif y in g n o n m ilita r y p u r c h a s e s ,
ly a f t e r W o r l d W a r II. G A T T , a t e r m th a t e n ­
g o v e r n m e n ts ( in c lu d in g g o v e r n m e n t- c o n tr o lle d
c o m p a s s e s th e m u ltila te r a l a g r e e m e n t g o v e rn in g
e n titie s ) m u s t tr e a t f o r e ig n a n d d o m e s tic p r o ­
in te r n a tio n a l tr a d e , th e b o d ie s a d m in is te r in g th e
d u c e r s a lik e . In a d d itio n to r e s o lv in g d is p u te s ,
a g r e e m e n t, a n d a ll a s s o c i a te d tr a d e - r e l a te d ac­
th e c o d e e s ta b lis h e s p r o c e d u r e s f o r o p e n in g and
tiv itie s , h a s f o c u s e d o n th e r e d u c tio n o f ta r if f
a w a r d in g b id s .
r a t h e r th a n n o n - ta r if f b a r r i e r s . T o d a te , s e v e n
r o u n d s o f G A T T n e g o ti a ti o n s h a v e b e e n co m ­ T h e c o d e o n t e c h n i c a l s t a n d a r d s a tt e m p ts to
p le te d , w ith th e f i r s t s ix c o n c e r n e d a lm o s t e x ­ e n s u r e th a t te c h n ic a l r e g u la tio n s a n d p ro d u c t
c l u s i v e l y w i t h t a r i f f s . 19 s ta n d a r d s s u c h a s la b e lin g , s a f e ty , p o llu tio n a n d
q u a lity r e q u i r e m e n ts d o n o t c r e a te u n n e c e s s a r y
o b s ta c le s to tr a d e . T h e c o d e d o e s n o t s p e c if y
The Toky o Round
s ta n d a r d s ; h o w e v e r , it e s ta b lis h e s r u le s f o r s e t­

The Tokyo R o u n d , th e m o s t r e c e n tly co m ­ ti n g s ta n d a r d s a n d r e s o lv in g d is p u te s .

p le te d ro u n d la s tin g f r o m 1 9 7 3 to 1979, w as a
T h e c o d e o n im p o r t lic e n s in g p r o c e d u r e s ,
c o m p r e h e n s iv e e f f o r t to r e d u c e tr a d e o b s ta c le s
s im ila r to t h e c o d e o n t e c h n i c a l s ta n d a r d s , is
s te m m in g f r o m ta r if f s a n d n o n - ta r if f m e a s u re s .
n o t s p e lle d o u t in d e ta il. G e n e r a lly s p e a k in g ,
N ew o r r e in f o r c e d a g r e e m e n ts , c a lle d " c o d e s ,”
g o v e r n m e n ts s ta te d th e i r c o m m i tm e n t to s im ­
w e re re ac h e d o n th e f o llo w in g n o n - ta r if f m e a ­
p lif y th e p r o c e d u r e s th a t im p o r te r s m u s t f o llo w
s u r e s : 1) s u b s i d i e s a n d c o u n te r v a il in g d u tie s ; 2)
to o b ta in lic e n s e s . R e d u c in g d e la y s in lic e n s in g
g o v e r n m e n t p r o c u r e m e n t; 3) te c h n i c a l s ta n ­
an d p a p e r w o r k a r e tw o a r e a s o f sp e c ia l
d a r d s ; 4 ) i m p o r t lic e n s in g p r o c e d u r e s ; 5) c u s ­
in te r e s t.
to m s v a l u a ti o n ; a n d 6 ) a n t i - d u m p i n g . 20
T h e c o d e o n c u s to m s v a lu a tio n e s ta b lis h e d a
T h e c o d e o n s u b s id ie s a n d c o u n te r v a ilin g
u n ifo rm s y s te m o f r u le s to d e te r m in e th e c u s ­
d u tie s p r o h ib its d ir e c t e x p o r t s u b s id ie s , e x c e p t
to m s v a lu e f o r im p o r te d g o o d s. T h is c o d e u se s
u n d e r c e r ta in s itu a tio n s in a g r ic u l tu r e . T h is
tr a n s a c tio n p r ic e s to d e te r m in e v a lu e a n d is
c o d e is n o te w o r t h y in e x te n d in g G A T T 's p r o h i b i ­
d e s ig n e d to p re c lu d e th e u s e o f a r b itr a r y v a lu e s
ti o n o f e x p o r t s u b s id ie s to tr a d e in r a w m a te r ­
th a t in c r e a s e th e p r o te c tiv e e f f e c t o f a ta r i f f
ia ls . B e c a u s e n e a r l y a ll g o v e r n m e n t s s u b s id iz e
r a te .
d o m e s tic p r o d u c e r s to s o m e e x te n t, th e c o d e e s ­
ta b lis h e d c r i t e r i a to d is tin g u is h b e tw e e n a d o ­ F in a lly , t h e a n ti- d u m p in g c o d e p r e s c r i b e s r u l e s

m e s tic a n d a n e x p o r t s u b s id y . D o m e s tic s u b s i­ f o r a n ti- d u m p in g in v e s ti g a tio n s , t h e im p o s itio n

d ie s th a t t r e a t d o m e s tic a n d e x p o r t a c tiv itie s o f a n ti- d u m p in g d u tie s a n d s e ttlin g d is p u te s .

id e n tic a lly a r e g e n e r a lly a llo w e d . C o u n te r v a ilin g The s t a n d a r d s f o r d e t e r m i n i n g i n ju r y a re c la ri­

d u tie s , w h ic h a r e ta r i f f s to o f f s e t a s u b s id y f ie d . T h is c o d e o b lig a te s d e v e lo p e d c o u n tr i e s to

re c e iv e d by a f o re ig n e x p o r te r , a r e p r o h ib ite d tr e a t d e v e lo p in g c o u n tr ie s p r e f e r e n tia lly .

18F o r a b rie f h is to ry o f m u ltila te ra l tra d e n e g o tia tio n s , a s w ell P ric e s , w h ic h a p p lie d a ta r iff rate fo r c e rta in im p o rts to an
as d e ta ils o n th e c u rre n t n e g o tia tio n s , se e T he G A T T a rtific ia lly h ig h d u tia b le v a lu e . T h e d u tia b le v a lu e w a s set
N e g o tia tio n s a n d U .S . T ra d e P o lic y , a 1 987 s tu d y b y th e e q ua l to th e p ric e o f a c o m p e tin g g oo d p ro d u c e d
C o n g re s s io n a l B u d g e t O ffic e . F o r a d d itio n a l d e ta ils o n th e d o m e s tic a lly in s te a d o f to th e im p o rt’s a c tu a l in v o ic e p ric e .
c u rr e n t m u ltila te ra l n e g o tia tio n s , see A n ja r ia (1986) a n d T h is s y ste m w a s a p p lie d to a sm a ll p o rtio n o f to ta l im p o rts,
th e 1987 re p o rt b y th e U n ite d S ta te s In te rn a tio n a l T ra d e p rim a rily b e n z e n o id c h e m ic a ls a n d ru b b e r fo o tw e a r. B o th
C o m m is s io n , O p e r a tio n o f th e T ra d e A g re e m e n ts P ro g ra m . a g re e m e n ts w e re b lo c k e d b y C o n g re s s , b u t w e re a c c e p te d
in th e n e xt ro u nd o f n e g o tia tio n s .
19T h e s ix th ro u n d , kn o w n as th e K e n n e d y R o u n d , m a rke d
th e firs t tim e fo r a G A T T a g re e m e n t on n o n -ta riff b a rrie rs. 20N o n -ta riff b a rrie rs w e re a lso re d u c e d in c iv il a irc ra ft and
A g re e m e n ts w e re re a ch ed o n an a n ti-d u m p in g c o d e a nd s e le c te d a g ric u ltu ra l g o o d s, p rim a rily m e a t a nd c he e se .
th e e lim in a tio n th e U .S . s y ste m o f A m e ric a n S e llin g

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Federal Reserve BankF E D Eof
RASt.
L Louis
R E S E R V E B A N K O F ST. L O U IS
 45

The Uruguay Round re fo rm w ill b e m e t w ith m u c h r e s i s t a n c e f r o m

th e s e g ro u p s .
The Tokyo Round c o d e s h a v e r e lie d on good-
f a ith c o m p lia n c e , w h ic h h a s te n d e d to u n d e r ­
m in e th e ir e f f e c tiv e n e s s . S tr e a m lin in g a n d C O N C L U S IO N
re s o lv in g d is p u te s is a p r i o r ity d u r in g th e c u r ­
N o n - ta r i f f b a r r i e r s h a v e e f f e c t s s i m i l a r to
re n t ro u n d o f m u ltila te r a l n e g o tia tio n s , th e
th o s e o f ta r if f s : th e y in c r e a s e d o m e s tic p r ic e s
U ru g u a y Round . The To kyo Round c o d e s w ill
an d im p e d e tr a d e to p r o t e c t s e l e c te d p ro d u c e rs
b e r e v ie w e d a n d p o s s ib ly m o d if ie d d u r in g th e
a t th e e x p e n s e o f d o m e s tic c o n s u m e r s . A s
U r u g u a y R o u n d . In p a r tic u l a r , b r o a d e n i n g th e
s h o w n in th e c a s e s tu d ie s o f s u g a r a n d a u to m o ­
g o v e r n m e n t p r o c u r e m e n t c o d e to in c lu d e s e r ­
b ile s , th e y a ls o h a v e o th e r e f f e c ts , g e n e r a lly
v ic e c o n t r a c t s w ill b e d is c u s s e d . C o n c e r n in g th e
ad v e rse .
te c h n i c a l s ta n d a r d s c o d e , a g r e e m e n ts d e a lin g
w i th th e m u tu a l a c c e p ta n c e o f te s t d a ta g e n e r ­ D e s p ite th e a d v e r s e n a tio n a l c o n s e q u e n c e s ,
a te d b y o th e r p a r tie s a n d th e o p e n n e s s o f th e th e u s e o f n o n - ta r if f b a r r i e r s h a s in c r e a s e d
a c tiv itie s o f s ta n d a r d s b o d ie s w ill b e s o u g h t. A s h a r p ly in r e c e n t y e a r s . T h e c h a n c e s f o r a r e ­
m a jo r i s s u e i n t h e a n t i - d u m p i n g c o d e i s h o w to v e r s a l o f th is tr e n d a p p e a r to b e s m a ll. T h e
h a n d le in p u t d u m p in g ( th a t is , e x p o r t s a l e s o f v a r ie ty o f n o n - ta r if f m e a s u r e s , th e d if f ic u ltie s o f
p r o d u c ts th a t c o n ta in in p u ts p u r c h a s e d at id e n tif y in g a n d m e a s u rin g th e ir e f f e c ts a n d th e
d u m p ed p ric e s ). b e n e f its re c e iv e d by s p e c i f i c g r o u p s c o m b i n e to
m a k e a s ig n if ic a n t r e d u c tio n o f n o n - ta r if f b a r ­
T h e U r u g u a y R o u n d , b e g u n in S e p te m b e r
r i e r s in th e o n g o in g U r u g u a y R o u n d n e g o tia ­
1 9 8 6 , h a s a n d w ill d is c u s s a n u m b e r o f n o n -
tio n s u n lik e ly .
ta r i f f b a r r i e r is s u e s , m a n y o f w h ic h e x te n d
bey o nd th e c o d e s o f th e T o k y o R o u n d . T ra d e T h e o r ig in a l m is s io n o f G A T T , w h ic h h as b een
is s u e s in v o lv in g a g r ic u l tu r e a n d s e r v ic e s ( b a n k ­ la r g e ly a c h ie v e d , w a s to r e d u c e ta r if f s . T h e
in g , c o n s t r u c ti o n , i n s u r a n c e a n d tr a n s p o r ta tio n ) q u e s tio n , h o w e v e r , o f w h y p o lic y m a k e r s h a v e
a r e o f p a r a m o u n t im p o r ta n c e . T h e U n ite d S ta te s p re fe rre d to u s e n o n - ta r if f b a r r i e r s r a t h e r th a n
h a s p r o p o s e d t h e e lim i n a ti o n o f a ll tr a d e - a n d ta r if f s in r e c e n t y e a r s r e m a in s . T h e m o r e c e r ­
p r o d u c tio n - d is to r tin g a g r ic u ltu r a l p o lic ie s . W h ile t a i n p r o t e c t i v e e f f e c t s o f n o n - t a r i f f b a r r i e r s is
t h e m a jo r a g r i c u l t u r a l n a t i o n s h a v e a g r e e d to o n e p la u s ib le e x p la n a tio n . A s e c o n d e x p la n a tio n ,
th e p r in c ip le o f lib e r a liz in g a g r ic u ltu r e , th e w h ic h f o c u s e s o n th e d is tr ib u tio n o f th e b e n e ­
s w e e p i n g n a t u r e o f t h e U .S . p r o p o s a l h a s b e e n f its , is t h a t th e b e n e f i ts o f n o n - t a r i f f b a r r i e r s
r e s is te d b y s o m e n a tio n s , e s p e c ia lly th e E u r o ­ c a n b e c a p tu r e d b y f o re ig n p ro d u c e rs an d
p ean C o m m u n ity . W ith r e s p e c t to s e r v ic e s , th e d o m e s tic p o litic ia n s . S u c h a n a llo c a tio n o f b e n e ­
p r i m a r y g o a l is to e s ta b lis h p r in c ip le s f o r e x te n ­ f its i n c r e a s e s th e p r o b a b i l i ty t h a t th e p o litic a l
d in g G A T T c o v e r a g e to th is tr a d e . p r o c e s s g e n e r a te s la r g e r a m o u n ts o f n o n - ta r if f
b a r r i e r s r e la tiv e to t a r i f f s . A f i n a l e x p l a n a ti o n is
A r e c e n t s tu d y b y th e C o n g r e s s io n a l B u d g e t
th a t th e ir a d v e rs e e f f e c ts a r e g e n e r a lly le s s o b ­
O f f ic e ( 1 9 8 7 ) p r e d ic ts th a t th e p e r f o r m a n c e o f
v io u s to c o n s u m e r s th a n th e e f f e c ts o f ta r if f s .
th e U ru g u a y Round w i l l b e ju d g e d la r g e ly o n its
h a n d lin g o f n o n - ta r if f b a r r i e r is s u e s . G A T T h a s
n o t e f f e c tiv e ly c o m b a tte d ris in g n o n - ta r if f b a r ­
rie rs f o r m a n y re a so n s. T w o r e a s o n s a r e th a t R E FE R E N C E S
th e e f f e c ts o f n o n - ta r if f b a r r i e r s a r e le s s tr a n s ­
A n ja ria , S .J . “ A N e w R o un d o f G lo b a l T ra d e N e g o tia tio n s ,”
p a r e n t th a n th e e f f e c ts o f ta r if f s a n d , in m a n y F in a n c e a n d D e v e lo p m e n t (Ju n e 1986), pp. 2-6.
c a s e s , n o n - ta r if f b a r r ie r s a r e d e s ig n e d to s a tis f y
B h a g w a ti, J a g d is h N. “ O n th e E q u iv a le n c e o f T a riffs and
a d o m e s tic r a t h e r th a n a n i n t e r n a t i o n a l o b je c ­ Q u o ta s ,” in R .E . C a v e s e t al., e d s. T ra d e , G r o w th , a n d th e
ti v e . A m a jo r o b s t a c l e i s d e t e r m i n i n g a t w h a t B a la n c e o f P a y m e n ts : E s s a y s in H o n o r o f G o ttfr ie d H a b e r le r
(R a n d M c N a lly , 1965), p p . 53-67.
p o in t a n a tio n a l e c o n o m ic p o lic y , w h o s e i n te r n a ­
tio n a l e f f e c ts a r e s o m e w h a t u n c e r ta in , b e c o m e s _ _ _ _ _ _ _ _ “ M o re on th e E q u iv a le n c e o f T a riffs and
Q u o ta s ,” A m e r ic a n E c o n o m ic R e v ie w (M a rc h 1968),
a n in te r n a tio n a lly u n a c c e p ta b le n o n - ta r if f b a r ­
pp. 142-46.
r i e r . T h e s e n a tio n a l e c o n o m ic p o lic ie s h a v e f r e ­
C h ow , P e te r C . Y ., a nd M itc h e ll K e lim a n . “ A n ti-L D C B ia s in
q u e n tly r e s u lte d fro m th e lo b b y in g e f f o r ts o f th e U .S . T a riff S tru c tu re : A T e s t o f S o u rc e V e rs u s P ro d u c t
s tr o n g d o m e s tic c o n s titu e n c ie s s u c h a s C h a ra c te ris tic s ,” R e v ie w o f E c o n o m ic s a n d S ta tis tic s
(N o v e m b e r 1988), pp. 648-53.
a g r i c u l t u r a l i n t e r e s t s . T h u s , m a jo r t r a d e p o l i c y

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C o lly n s , C h a rle s , a n d S te ve n D u n aw a y. “ T h e C o st o f T ra d e L a ird , S a m , a nd A le x a n d e r Y e a ts. “ N o n ta riff B a rrie rs o f

R e stra in ts : T h e C a se o f J a p a n e s e A u to m o b ile E x p o rts to D e v e lo p e d C o u n trie s , 1 9 6 6 -8 6 ,” F in a n c e & D e v e lo p m e n t
th e U n ite d S ta te s ,” In te r n a tio n a l M o n e ta r y F u n d S ta ff (M a rch 1989), pp. 12-13.
P a p e rs (M a rc h 1987), pp. 150-75.
L a ird , S a m , a nd A le x a n d e r Y e a ts . Q u a n tita tiv e M e th o d s fo r
C o u g h lin , C le tu s C ., a n d K e n n e th C . C a rra ro . “ T h e D u b io u s T ra d e B a r r ie r A n a ly s is (M a c m illa n , fo rth c o m in g ).

S u c c e s s o f E x p o rt S u b s id ie s fo r W h e a t,” th is R e v ie w
M a sku s, K e ith E. “ T h e In te rn a tio n a l P o litic a l E c o n o m y o f
(N o v e m b e r/D e c e m b e r 1988), pp. 38-47.
U .S . S u g a r P o lic y in th e 1 9 8 0 ’s ,” U n ite d S ta te s D e p a rt­
m e n t o f S ta te , B u re a u o f E c o n o m ic a n d B u s in e s s A ffa irs ,
C o u g h lin , C le tu s C ., K. A le c C h ry s ta l, a n d G e o ffre y E. W o od .
P la n n in g a n d E c o n o m ic A n a ly s is S ta ff, W o rk in g P a p e r #1
“ P ro te c tio n is t T ra d e P o lic ie s : A S u rve y o f T h e o ry, (S e p te m b e r 1987).
E v id e n c e a n d R a tio n a le ,” th is R e v ie w (J a n u a ry /F e b ru a ry
1988), pp. 12-29. N o g u e s, J u lio J ., A n d rz e j O le c h o w s k i, a nd L. A la n W in te rs .
“ T h e E x te n t o f N o n ta riff B a rrie rs to In d u s tria l C o u n trie s '
D e a rd o rff, A la n V. “ W h y d o G o v e rn m e n ts P re fe r N o n ta riff Im p o rts ,” T h e W o rld B a n k E c o n o m ic R e v ie w (1986),
B a rrie rs ? ” in K arl B ru n n e r a n d A lla n H. M e ltze r, eds. pp. 181-99.
B u b b le s a n d O th e r E s s a y s , C a rn e g ie -R o c h e s te r C o n ­
fe r e n c e S e rie s o n P u b lic P o lic y (N o rth -H o lla n d , 1987), P a g e , S h e ila . “ T h e R ise in P ro te c tio n S in c e 1 9 7 4 ,” O x fo r d
p p . 191-216. R e v ie w o f E c o n o m ic P o lic y (S p rin g 1987), pp. 37-51.

R ay, E d w a rd J o h n . “ T h e D e te rm in a n ts o f T a riff a n d N o n ta riff

F e e n s tra , R o b e rt C . “ A u to m o b ile P ric e s a n d P ro te c tio n : T h e
T ra d e R e s tric tio n s in th e U n ite d S ta te s ,” J o u r n a l o f
U .S .-Ja p a n T ra d e R e s tra in t,” J o u r n a l o f P o lic y M o d e lin g
P o litic a l E c o n o m y (F e b ru a ry 1981), pp. 105-21.
(S p rin g 1985), pp. 49-68.
“ S u rv e y o f A u to m o tiv e T ra d e R e s tric tio n s M a in ta in e d by
H e ra n d e r, M a rk G ., a n d C h ris to p h e r R. T h o m a s . “ E x p o rt S e le c te d N a tio n s .” O ffic e o f In te rn a tio n a l S e cto ra l P o lic y,
P e rfo rm a n c e a n d E x p o rt-lm p o rt L in k a g e R e q u ire m e n ts ,” U .S . D e p a rtm e n t o f C o m m e rc e , in h e a rin g s on F a ir
Q u a rte r ly J o u r n a l o f E c o n o m ic s (A u g u s t 1986), 5 9 1 -6 0 7 . P r a c tic e s in A u to m o tiv e P ro d u c ts A c t b e fo re th e S u b c o m ­
m itte e on C o m m e rc e , T ra n s p o rta tio n a n d T o u ris m , M a rc h
H illm a n , A rye L., a nd H e in ric h W . U rs p ru n g . “ D o m e s tic 2, 1982, pp. 113-23.
P o litic s , F o re ig n In te re s ts , a nd In te rn a tio n a l T ra d e P o lic y ,”
A m e r ic a n E c o n o m ic R e v ie w (S e p te m b e r 1988), p p . 729-45. T a rr, D a v id G ., a n d M o rris E. M o rkre . A g g r e g a te C o s ts to th e
U n ite d S ta te s o f T a riffs a n d Q u o ta s o n Im p o rts : G e n e r a l
H u ste d , S te v e n . “ F o re ig n L o b b y in g a n d th e F o rm a tio n o f T a riff C u ts a n d R e m o v a l o f Q u o ta s o n A u to m o b ile s , S te e l,
D o m e s tic T ra d e P o lic y ,” p a p e r p re se n te d a t W e s te rn S u g a r, a n d T e x tile s , B u re a u o f E c o n o m ic s S ta ff R e p o rt to
E c o n o m ic A s s o c ia tio n M e e tin g , S an F ra n c is c o , J u ly 1986. th e F e d e ra l T ra d e C o m m is s io n (D e c e m b e r 1984).

U .S . C o n g re s s, C o n g re s s io n a l B u d g e t O ffic e . T h e G A T T
J o n e s , K e n t. “ T h e P o litic a l E c o n o m y o f V o lu n ta ry E x p o rt
N e g o tia tio n s a n d U .S . T ra d e P o lic y (G P O , J u n e 1987).
R e s tra in t A g re e m e n ts ,” K y k lo s (1984), p p . 82-101.
U .S . D e p a rtm e n t o f C o m m e rc e , B u re a u o f th e C e n ­
K ris h n a , K. “ T ra d e R e s tric tio n s a s F a c ilita tin g P ra c tic e s ,” s u s .S ta tis tic a l A b s tra c t o f th e U n ite d S ta te s: 1 988 (G P O ,
N a tio n a l B u re a u o f E c o n o m ic R e se a rc h , W o rk in g P a p e r 1987).
# 1 54 6 (1985).
U .S . In te rn a tio n a l T ra d e C o m m is s io n . O p e ra tio n o f th e T ra d e
K ru g m a n , P aul R ., a nd M a u ric e O b s tfe ld . In te rn a tio n a l A g re e m e n ts P ro g ra m — 3 9 th R e p o rt, 1 987 (U S IT C , J u ly
E c o n o m ic s (S co tt, F o re sm a n , 1988). 1988).

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Federal Reserve Bank F E D Eof
RASt.
L Louis
R E S E R V E B A N K O F ST. LO U IS
 47

Michael T. Belongia
and W erner Hermann

M ic h a e l T. B e lo n g ia is a r e s e a r c h o ff ic e r a t th e F e d e r a l
R e s e rv e B a n k o f S t. L o u is . W e rn e r H e rm a n n , a n e c o n o m is t a t
th e S w is s N a tio n a l B a n k in Z u r ic h , is a v is itin g s c h o la r a t th e
F e d e ra l R e s e rv e B a n k o f S t. L o u is . D a w n P e te rs o n a n d L a u r a
P riv e s p r o v i d e d re s e a rc h a s s is ta n c e .

G an a C e n tra l B a n k I n f l u e n ce
I ts C u rre n cy 's R e a l V alu e ?
T h e S w is s C as e

T JL H E S W I S S N a t i o n a l B a n k ( SN B ) i s o n e o f g r o w th o v e r th e sam e sev en y e a rs h av e b e e n
th e f e w c e n tr a l b a n k s th a t c o n d u c ts m o n e ta r y 2 .0 p e r c e n t a n d 2 .3 p e r c e n t, r e s p e c tiv e ly .
p o lic y b y a n n o u n c in g a n d g e n e r a lly a c h ie v in g a
D e s p i te its c o m m i tm e n t to m o n e y g r o w th
ta r g e te d g r o w th r a te f o r th e m o n e y s to c k .
ta r g e ts , th e SN B r e a l i z e s S w i tz e r l a n d is a s m a ll
P o lic y is c o n d u c te d in th is m a n n e r b e c a u s e SN B
o p e n e c o n o m y th a t e x p o r ts a b o u t 4 0 p e r c e n t o f
o f f ic ia ls , b e lie v in g th a t e x c e s s iv e g r o w th in th e
G r o s s N a tio n a l P r o d u c t (G N P). T h u s , d o m e s tic
m o ney s to c k is th e c a u s e o f in f la tio n , h a v e
r e a l a c tiv ity c a n b e a f f e c t e d a d v e rs e ly b y ap ­
e s ta b lis h e d lo n g - r u n p r i c e s ta b ility a s th e c e n tr a l
p r e c ia tio n s o f th e S w is s f r a n c th a t r a is e th e r e a l
b a n k 's p r im a r y o b je c t i v e . M o r e o v e r , b e c a u s e
p r i c e o f S w is s g o o d s to f o r e ig n b u y e r s r e la tiv e
la r g e , u n e x p e c te d c h a n g e s in m o n e y g r o w th a re
to p ric e s c h a rg e d by c o m p e tin g f o r e ig n su p ­
th o u g h t to c r e a te u n c e r ta in ty th a t c a n ra is e r e a l
p l i e r s . If , f o r e x a m p l e , S w i s s e x p o r t e r s r e s p o n d
in te r e s t r a te s a n d r e d u c e o u t p u t , SN B o f f i c i a l s
to a n e x c h a n g e r a te a p p r e c ia tio n b y r e d u c in g
b e lie v e th e a v e r a g e r a te o f m o n e y g r o w th n o t
S w is s f r a n c p r i c e s ( w h ic h w ill m a i n ta in th e
o n ly s h o u ld b e lo w ( to a c h i e v e l o w in f la tio n
f o r e ig n c u r r e n c y p r ic e o f th e ir g o o d s), th e
r a te s ) b u t s ta b le a s w e ll.1 T h u s , in S w itz e r la n d ,
q u a n ti ty o f e x p o r ts s o ld w ill n o t c h a n g e b u t
b o th ra p id m o n e y g r o w th a n d la r g e , u n e x p e c te d
t h e i r p r o f i t m a r g in s w ill s h r i n k . O n t h e o th e r
c h a n g e s in th e m o n e y s to c k h a v e b e e n ra re .
h a n d , i f e x p o r te r s m a in ta in c u r r e n t S w is s f r a n c
T h e h is to r ic a l e v id e n c e c le a r ly in d ic a te s th a t p r i c e s , th e p r i c e s p a id b y f o r e i g n b u y e r s w ill
S N B a c t i o n s h a v e m e t t h e i r o b je c t i v e s : g r o w t h in ris e ( b e c a u s e o f th e e x c h a n g e r a t e a p p r e c ia tio n )
th e m o n e ta r y b a s e s in c e 1 9 8 2 , f o r e x a m p le , h a s an d th e q u a n ti ty o f e x p o r ts s o ld w ill d e c li n e .2
b e e n ta r g e te d a t r a te s b e tw e e n 2 p e rc e n t an d 3 T h e s e s p e c if ic e f f e c ts o n S w is s e x p o r te r s p o s e a
p e r c e n t a n d h a s b e e n , o n a v e r a g e , 2 .4 p e r c e n t p o lic y p r o b le m b e c a u s e , in th e a g g r e g a te , th e y
o v e r th e s e s e v e n y e a r s . T h e a v e r a g e r a te s o f in ­ a r e lik e ly to c a u s e s o m e r e d u c tio n in r e a l G N P
f la tio n a n d r e a l G r o s s D o m e s ti c P r o d u c t (G D P ) g r o w th .

1S ee, fo r e x a m p le , th e a rg u m e n ts p u t fo rth b y M a s ca ro a n d s o m e e s tim a te s o f th e re s p o n siv e n e s s o f S w is s e x p o rts to

M e ltz e r (1983). e x c h a n g e rate c h a n g e s .
2W h e th e r p ro fits rise o r fa ll w ill d e p e n d o n th e e la s tic ity o f
d e m a n d fo r e xp o rts . S e e B e lo n g ia a nd H e rm a n n (1989) fo r

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Federal Reserve Bank of St. Louis
 48

W h a t m a k e s th e S w is s c a s e i n te r e s ti n g in th is a f f e c t th e n o m in a l s p o t r a te a n d p r ic e le v e ls
c o n t e x t is t h a t a c e n tr a l b a n k c o m m i tte d to a c r o s s c o u n tr i e s w ith d i f f e r e n t la g s a n d in d if ­
m o n e y g r o w th ta r g e ts a n d a lo w , s ta b le i n f l a ­ f e r e n t w a y s , h o w e v e r , th e r e a l e x c h a n g e r a te
ti o n r a t e m a d e a n a b r u p t, b u t te m p o r a r y , p o lic y g e n e r a lly v a r i e s th r o u g h tim e . M o v e m e n ts in
s h if t b e c a u s e o f e x c h a n g e r a te p r e s s u r e s . S p e c if ­ th e r e a l e x c h a n g e r a te , th e r e f o r e , r e p r e s e n t
i c a l l y , t h e SN B a b a n d o n e d its m o n e y g r o w th th o s e c h a n g e s in th e n o m in a l r a te th a t c a n n o t
ta r g e ts in 1 9 7 8 - 7 9 in a n a tte m p t to r e d u c e th e b e a ttr ib u te d to in f la tio n d if f e r e n tia ls . S p e c if ic a l­
r e a l v a lu e o f th e S w is s f r a n c in f o r e ig n e x ­ ly , c h a n g e s in th e r e a l e x c h a n g e r a t e r e f l e c t
c h a n g e m a r k e ts a n d a v e r t a r e c e s s io n .3 A s s tr u c tu r a l c h a n g e s in r e a l e c o n o m ic p e r f o r ­
f ig u r e 1 sh o w s, th e f r a n c h a d a p p r e c ia te d m a n c e a c r o s s c o u n tr ie s .
s h a r p ly b o th a g a in s t th e D e u ts c h e m a r k (D M )
D is tin g u is h in g b e tw e e n th e r e a l a n d n o m in a l
a n d th e d o lla r, w h ic h r e p r e s e n t th e tw o m o st
e x c h a n g e r a t e is c r u c i a l to a n y a n a ly s is o f th e
i m p o r ta n t c u r r e n c i e s f o r S w is s tr a d e . In
e f f e c ts o f e x c h a n g e r a te m o v e m e n ts b e c a u s e o n ­
r e s p o n s e to th is c u r r e n c y a p p r e c ia tio n , th e
ly c h a n g e s in a c u r r e n c y 's r e a l v a lu e a f f e c t
S w is s m o n e ta r y b a s e w a s e x p a n d e d at an an ­
tr a d e f lo w s . A c h a n g e in th e n o m in a l e x c h a n g e
n u a l r a t e o f 9 5 p e r c e n t b e t w e e n Ju l y 1978 an d
Ja n u a r y 1979. r a t e a lo n e w ill n o t a f f e c t tr a d e f lo w s ; th e p o te n ­
tia l b e n e f i ts f r o m im p o r tin g S w i s s g o o d s d u e to
T h e ra p id m o n e y g r o w th a n d e x c h a n g e r a te th e d e c lin e in th e f r a n c ’s n o m in a l v a lu e w ill b e
m o v e m e n ts s h o w n in th e f ig u r e p r o v id e a c a s e o f f s e t e x a c tly b y th e h ig h e r p r i c e s f o r S w is s
s tu d y to h e lp a n s w e r th e ty p e o f q u e s tio n fac e d g o o d s th a t c a u s e d th e n o m in a l d e p r e c ia tio n .5
by m a n y c o u n tr i e s , in c lu d in g th e U n ite d S ta te s , T h u s , i f a c e n t r a l b a n k ’s a c ti o n s a r e i n te n d e d to
in r e c e n t y e a r s : If th e r e a l v a lu e o f a n a tio n 's in f lu e n c e tr a d e f lo w s — n o t s im p ly to ch an g e
c u rre n c y h a s r i s e n “ to o h ig h ,” o v e r w h a t tim e th e r e la tio n s h ip b e tw e e n f o r e ig n a n d d o m e s tic
h o riz o n a n d b y w h at am o u nt can a c tio n s b y th e p r i c e le v e ls — th e a n a ly s is m u s t f o c u s o n w h a t
c e n t r a l b a n k r e d u c e t h e r e a l e x c h a n g e r a t e ? 4 In h a p p e n s to th e r e a l e x c h a n g e r a t e .6 M o r e o v e r ,
th is a r tic le , w e u s e th e S w is s e x p e r ie n c e o v e r b e c a u s e w e a r e in te r e s te d in h o w m o n e ta r y ac­
th e p e rio d o f f le x ib le e x c h a n g e r a te s a n d so m e ti o n s m ig h t a f f e c t th e r e a l e x c h a n g e r a te , w e
o r th o d o x r e s u lts f r o m e c o n o m ic th e o r y to su g ­ m u s t e x a m in e e c o n o m ic m o d e ls th a t p e r m it c e n ­
g e s t g e n e r a l c o n c lu s io n s a b o u t th e e f f e c ts o f tr a l b a n k a c tio n s to do so .
m o n e ta r y a c tio n s o n th e r e a l e x c h a n g e r a te .

N O M IN A L A N D R E A L E X C H A N G E T H EO R E T IC A L M O D ELS O F

R A T ES EX C H A N G E R A T E R E S P O N S E S T O
M O N E T A R Y C H A N G ES
T h e r e a l e x c h a n g e r a t e is d e f i n e d a s th e
n o m i n a l s p o t r a t e a d ju s t e d f o r p r i c e le v e l E s ta b lis h in g a r e la tio n s h ip b e tw e e n c h a n g e s in
d if f e r e n c e s a c r o s s c o u n tr ie s . If p u r c h a s in g th e m o n e y s to c k a n d r e a l e c o n o m ic m a g n itu d e s
p o w e r p a r ity (P P P ) c o n d itio n s w e r e m e t c o n ­ p ro d u c e s so m e c o n f lic t a m o n g c o m p e tin g
ti n u o u s l y , t h e r e a l e x c h a n g e r a t e w o u l d b e e c o n o m i c th e o r i e s . O n e c l a s s o f m o d e ls p o s its
c o n s ta n t. B e c a u s e e c o n o m ic d e v e lo p m e n ts o f te n d i f f e r e n t s p e e d s o f a d ju s t m e n t a c r o s s m a r k e t s

3S e e R ich and B e g u e lin (1985, p. 85) fo r a d is c u s s io n o f c h a n g e s — n o m in a l e x c h a n g e ra te c h a n g e s a lso w ill be

th is e p is o d e a n d , in p a rtic u la r, S N B re fe re n c e to a c h a n g e s in th e real e x c h a n g e rate. F or s o m e s im p le e x ­
D M /S w is s fra n c e x c h a n g e rate lo w e r b o u n d o f 0 .8 0 (th e ir p o s itio n s o f th e s e re la tio n s h ip s a nd th e d is tin c tio n b e tw e en
fo o tn o te 9). real a n d n o m in a l e x c h a n g e ra te s, se e B a tte n a nd L u ttre ll
(19 8 2 ) a n d B a tte n a n d B e lo n g ia (1986).
4N o te th a t, in m a n y re sp e cts , th e S w is s d e b a te p a ra lle ls
th a t o f th e U n ite d S ta te s in th e e a rly 1980s. D u rin g th a t 6A t le a s t tw o im p o rta n t is su e s a re ig n o re d fro m th is
p e rio d , a n a ly s ts d is c u s s e d th e re la tio n s h ip s b e tw e e n e x ­ p e rs p e c tiv e . F irst, th e ra p id m o n e y g ro w th a s s o c ia te d w ith
c h a n g e ra te s a nd e x p o rts [see, fo r e x a m p le , B a tte n and th e 1 978-79 in te rv e n tio n w a s fo llo w e d b y a ra p id in c re a s e
B e lo n g ia (1986)] a n d th e a p p ro p ria te re s p o n s e s o f b o th th e in th e S w is s in fla tio n rate. S e co n d , S w is s im p o rte rs a n d
F e d e ra l R e s erve a n d fo r e ig n c e n tra l b a n k s to a ris in g c o n s u m e rs , w h o b e n e fit fro m a h ig h e r e x c h a n g e ra te, w ill
d o lla r [se e B a tte n a n d K a m p h o e fn e r (1982) a nd B a tte n b e m a d e w o rs e o ff if th e e x c h a n g e ra te d e c lin e s . T h u s , a
a n d O tt (1984)]. T h is a tte m p t to c h a n g e th e level o f th e e x ­ d is c u s s io n o f th e n e t b e n e fit o f a lo w e r e x c h a n g e ra te is
c h a n g e ra te is to b e c o n tra s te d w ith e ffo rts to re d u c e e x­ c o n s id e ra b ly m o re c o m p lic a te d th a n a n a rro w fo c u s o n th e
c h a n g e ra te v o la tility . G a rtn e r (1987) o ffe rs s o m e e v id e n c e w e lfa re o f S w is s e x p o rte rs a lo n e.
o n th e la tte r c a s e fo r th e S N B .

5U n le s s w e a re d e a lin g in v e ry s p e c ia l c a s e s — s u c h as a
w o rld w ith in d e x e d c o n tra c ts o r no u n e x p e c te d p ric e

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 49

F ig u r e 1
R eal E x c h a n g e R ate o f th e S w is s F ra n c /$ , S w is s F ra n c /D M
and th e S w is s M o n e ta ry B ase

in r e s p o n s e to a m o n e ta r y c h a n g e . In th i s c a s e ,
Fully Anticipated M onetary
r e a l m a g n itu d e s c a n b e a f f e c te d b y f u lly -
a n tic ip a te d m o n e ta r y c h a n g e s b e c a u s e , say ,
Changes: The D ornbusch M odel
p r ic e s o f f in a n c ia l a s s e ts r e a c t m o r e q u ic k ly
O n e m o d e l th a t r e la te s e x c h a n g e r a te m o v e ­
th a n p r ic e s o f d u r a b le g o o d s a n d , a s a c o n s e ­
m e n ts to a c tu a l c h a n g e s in th e m o n e y s to c k is
q u e n c e , r e la tiv e p r ic e s , o u tp u t a n d o th e r re a l
th e D o r n b u s c h ( 1 9 7 6 ) m o d e l o f o v e r s h o o tin g
m a g n itu d e s m a y b e a f f e c te d in th e sh o rt ru n .
r e a l e x c h a n g e r a t e s . T h e m o d e l is d e r i v e d fo r a
A n o th e r c la s s o f m o d e ls h y p o th e s iz e s th a t f u lly
sm a ll c o u n tr y w h o s e a c tio n s c a n n o t a f f e c t th e
a n tic ip a te d e v e n ts w ill n o t a f f e c t r e a l v a r ia b le s
w o r ld e c o n o m y ; m o r e o v e r , it is a s s u m e d th a t
b e c a u s e th e y a lr e a d y w ill in c o r p o r a te th e s e e x ­
p e r f e c t c a p ita l m o b ility e x i s ts ( th a t is , i n t e r e s t
p e c ta tio n s in to c u r r e n t v a lu e s . T h u s , o n ly
r a te p a r ity h o ld s c o n tin u o u s ly ) a n d p e o p le f o r m
" s h o c k s ” o r " s u r p r i s e s ” a r e a llo w e d to a ffe c t re al
e x p e c ta tio n s r a tio n a lly . T h e m o d e l in c lu d e s a
m a g n itu d e s . D e s p i te t h e i r p a r t i c u l a r d i f f e r e n c e s ,
m o ney m a r k e t w ith a s ta n d a r d m o ney d em an d
h o w e v e r , m o d e ls f r o m b o th c la s s e s p r e d ic t th a t
f u n c tio n a n d a m a r k e t f o r d o m e s tic g o o d s .
m o n e ta r y c h a n g e s w ill a f f e c t r e a l v a r ia b le s o n ly
te m p o r a r ily .7 W e d is c u s s s p e c if ic m o d e ls o f e a c h In th e lo n g r u n , th is m o d e l a s s u m e s th a t e x ­
ty p e in th e s e c ti o n s b e lo w . c h a n g e r a t e s w ill b e c o n s i s te n t w ith p u r c h a s in g

7N o te th a t th is a lso im p lie s tra d e w ill be a ffe c te d , if a t all,

o n ly te m p o ra rily a nd a fte r s o m e lag.

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 50

is e x a c tl y in li n e w ith i n c r e a s e s b o th in th e
d o m e s tic p r i c e le v e l a n d th e d o m e s tic n o m in a l

Figure 2 i n te r e s t r a te . In th e s h o r t r u n th e m o n e y

E x c h a n g e R a te A d ju s tm e n ts in th e m a r k e t w ill d o m in a te th e g o o d s m a r k e t b e c a u s e
it r e a c ts in s ta n ta n e o u s ly to a m o n e ta r y ch an g e
D o rn b u s c h M o d e l
an d f in d s its n e w e q u ilib riu m im m e d ia te ly . T h e
g o o d s m a r k e t, h o w e v e r , is o u t o f e q u i li b r iu m in
t h e s h o r t r u n b e c a u s e p r i c e a d ju s t m e n t s l a g a n d
th e q u a n tity o f g o o d s d em an d ed e x c e e d s q u a n ti­
ty s u p p lie d a t th e e x is tin g p r i c e le v e l.

T h i s e x c e s s liq u id ity w ill c a u s e s h o r t- te r m in ­

t e r e s t r a t e s to f a ll a n d , th u s , w ill m a k e th e
d o m e s tic c u r r e n c y le s s a ttr a c tiv e to h o ld . F u r ­
th e r m o r e , in v e s to r s k n o w th a t th e c u r r e n c y
m u s t d e p r e c i a te to r e s to r e a n e q u ilib riu m be­
tw e e n th e g o o d s m a r k e t a n d m o n e y m a r k e t.
T h e r e f o r e , th e y w ill m o v e to s h if t p o r tf o lio s im ­
m e d ia te ly f r o m d o m e s tic a s s e ts in to f o re ig n
a s s e ts . T h is p o r tf o lio s h if tin g , in d u c e d b y th e e x ­
c e s s s u p p ly o f d o m e s tic c u r r e n c y , w ill c a u s e
b o th n o m in a l a n d r e a l e x c h a n g e r a te s to d e p re ­
c ia te u n til in te r e s t r a te p a r ity is r e e s ta b li s h e d .
A t t h i s i n t e r m e d i a t e s t a g e o f t h e a d ju s t m e n t
p r o c e s s , in d ic a te d b y p o in t B in f ig u r e 2 ,
d o m e s tic in te r e s t r a te s a r e b e lo w f o r e ig n in ­
te r e s t r a te s , a n d th e d o m e s tic p r i c e le v e l h a s
n o t y e t a d ju s t e d . W h e n t h e p r i c e l e v e l e v e n t u a l ­
p o w e r p a r ity . In th e s h o r t r u n , h o w e v e r , th e
l y d o e s a d ju s t , t h e r e i s a m o v e m e n t a l o n g Q , i n
p o s s ib ility th a t e x c h a n g e r a te s m a y o v e r s h o o t
th e f ig u r e to w a r d th e n e w lo n g - te r m
th e i r lo n g - r u n P P P v a lu e s is i n tr o d u c e d th r o u g h
e q u ilib riu m , C . A t C , th e n o m in a l e x c h a n g e r a te
d i f f e r e n t s p e e d s o f a d ju s t m e n t i n f i n a n c i a l a n d
h a s d e p r e c ia te d b u t th e r e a l e x c h a n g e r a te h a s
g o o d s m a r k e ts .
r e tu r n e d to i ts in i ti a l v a lu e .

F ig u r e 2 illu s tr a te s th e e f f e c ts o f a m o n e ta r y T h e m e c h a n ic s o f th e D o r n b u s c h m o d e l—
c h a n g e o n t h e r e a l e x c h a n g e r a t e , e / P, ( t h e p r i c e s p e c i f i c a l l y , t h e i n i t i a l a d ju s t m e n t f r o m p o in t A
o f th e f o r e ig n c u r r e n c y d iv id e d b y th e d o m e s tic to p o in t B f o l lo w e d b y t h e p e r m a n e n t, lo n g - r u n
p r i c e l e v e l ; t h e f o r e i g n p r i c e l e v e l i s a s s u m e d to a d ju s t m e n t t o p o i n t C — i m p l y t h a t t h e SN B c a n
b e c o n s ta n t) a n d th e d o m e s tic p r ic e le v e l, P. A t in f lu e n c e r e a l e x c h a n g e r a te s in th e s h o r t r u n
a ll p o in ts o n C ^ , th e m o n e y m a r k e t is in e q u i li b ­
a t th e p r ic e o f a te m p o r a r y in f la tio n . T h e m o d e l
r i u m , th a t is , i n t e r e s t r a t e p a r i ty h o ld s . T h e a ls o in d ic a te s th a t, in th e lo n g r u n , m o n e ta r y
g o o d s m a r k e t e q u ilib riu m is r e p r e s e n t e d by th e p o lic y h a s n o e f f e c t o n r e a l e x c h a n g e r a te s .
v e r tic a l lin e la b e le d P P P b e c a u s e , o n th is lin e , B o th c o n c lu s io n s a r e v a lid , h o w e v e r , o n ly i f
p u r c h a s i n g p o w e r p a r i ty h o ld s . M o r e o v e r , i t is
o th e r c e n tr a l b a n k s d o n o t o f f s e t th e m e a s u r e s
assu m ed th a t th e g o o d s m a r k e t e q u ilib r iu m o c­ ta k e n b y th e SN B . O v e r a l l , g i v e n c e r t a i n s i m p l i ­
c u r s f o r a g iv e n r e a l e x c h a n g e r a te . A m o n e ta r y
f y in g a s s u m p tio n s , th e D o r n b u s c h m o d el o ffe rs
e x p a n s io n im p lie s th a t Q 0 s h if ts u p w a r d to Q r tw o te s ta b l e p r o p o s itio n s : D o m o n e ta r y a c tio n s
T h e new lo n g - r u n e q u i l i b r iu m , a t p o in t C , is
c a u s e c h a n g e s in th e r e a l e x c h a n g e r a te a n d , if
g iv e n b y th e in te r s e c tio n o f PPP an d Q , a t th e so , o v e r w h a t p e r io d o f ti m e ?
s a m e r e a l e x c h a n g e r a t e b u t a h ig h e r d o m e s tic
p r i c e le v e l. T h is im p lie s th a t a n e x p a n s io n a r y An Alternative M odel o f the Real
m o n e ta r y p o lic y c h a n g e d o e s n o t a f f e c t r e a l
Exchange Rate: The Influence o f
v a r i a b le s in th e lo n g r u n .
Unexpected M onetary Changes
T h e tr a n s itio n fro m t h e o ld to th e n e w e q u i­
lib r iu m , h o w e v e r , d o e s n o t ta k e p la c e th r o u g h a A n o th e r s tr a te g y in m o d e lin g th e r e a l e x ­

d e p r e c ia tio n o f th e n o m in a l e x c h a n g e r a te th a t c h a n g e r a t e , c o n s i s te n t w ith t h e e a r l i e r d is c u s -

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R ASt.
L RLouis
ESERVE B A N K O F S T . L O U IS
 51

sio n a n d f o llo w in g th e a s s e t a p p r o a c h to ex­ tio n o f b o th th e d o m e s tic - f o r e i g n re a l in te r e s t

c h a n g e r a t e d e te r m i n a ti o n , h a s b e e n to fo c u s o n d if f e r e n tia l a n d th e c u m u la tiv e c u r r e n t a c c o u n t
u n ex pected c h a n g e s in a s s o r te d m a c ro e c o n o m ic b a la n c e .
v a r i a b le s . In c o n t r a s t to th e D o r n b u s c h m o d e l,
E q u a t i o n 1 i n i t s c u r r e n t f o r m , h o w e v e r , is
w h ic h a llo w s a c tu a l d i f f e r e n c e s b e t w e e n d o m es­
n o t d ir e c tly u s e f u l f o r o u r p u r p o s e s b e c a u s e th e
t i c a n d f o r e i g n v a r i a b l e s to h a v e s h o r t- r u n r e a l
p o lic y q u e s tio n a p p lie s to changes in th e r e a l e x ­
e f f e c t s t h r o u g h a d ju s t m e n t l a g s , o t h e r m o d e l s
c h a n g e r a te , n o t its le v e l. M o r e o v e r , w e a r e in ­
h av e fo c u se d o n d if f e r e n c e s b e tw e e n a c tu a l a n d
te r e s te d o n ly in th e s im p le b iv a r ia te r e la tio n s h ip
e x p e c te d v a lu e s o f e x p la n a to r y v a r ia b le s in f o r ­
b e tw e e n m o n e ta r y a c tio n s a n d e x c h a n g e r a te
e ig n a n d d o m e s tic e c o n o m ie s . In th is c a s e , a l­
c h a n g e s . F in a lly , a n d p e r h a p s m o s t im p o r ta n t,
th o u g h d if f e r e n c e s in th e c o m m o d ity m a r k e t
e q u a tio n 1, a s w r itte n , h a s n o s p e c ific r e f e r e n c e
an d c u rre n c y m a r k e t a d ju s t m e n t p r o c e s s e s s t i l l
to m o n e ta r y p o lic y a c tio n s .
m a y b e im p o r ta n t, t h e e m p h a s is is d ir e c te d
m o r e to th e in f lu e n c e o f " s u r p r is e s ” o n th e e x ­ To a p p ly e q u a tio n 1 to th e c u r r e n t in v e s tig a ­
c h a n g e r a te . V a r ia b le s in c lu d e d , a m o n g o th e r s , tio n o f m o n e ta r y p o l i c y ’s i n f l u e n c e o n t h e r e a l
h a v e b e e n u n e x p e c te d c h a n g e s in th e m o n e y e x c h a n g e r a te , th e C A B te r m w a s d ro p p e d an d
s to c k , th e g o v e r n m e n t b u d g e t s u rp lu s ( o r th e r e m a in in g te r m s w e r e d if f e r e n c e d so th a t
d e f ic it) a n d r e a l G N P. c h a n g e s in th e r e a l e x c h a n g e r a te w e r e r e la te d
to c h a n g e s in th e r e a l in te r e s t d if f e r e n tia l .8
In e a c h c a s e , th e v a r ia b le s f o r th e s e m o d e ls
T h a t is :
w e r e th o u g h t to d e te r m in e o r m e a s u r e d if ­
f e r e n c e s in r e a l a c tiv ity a c r o s s c o u n tr i e s s o th a t
(2) A R ER = A (r - n ') - A (r* - t i'*).
a n u n e x p e c te d c h a n g e in th e m w o u ld sig n a l a
re a sse ssm e n t o f re al p e rfo rm a n c e a c ro ss c o u n ­ A f te r th e s e s im p lif y in g a s s u m p tio n s a n d m a n ip ­
tr ie s a n d , h e n c e , a r e a s s e s s m e n t o f r e la tiv e c u r ­ u la ti o n s , w e h a v e , in e q u a ti o n 2, re d u c e d th e
re n c y v a lu e s . D e s p ite t h e i r th e o r e ti c a l a p p e a l, p ro b le m to o n e in w h ic h c h a n g e s in e i th e r th e
h o w e v e r , m o d e ls o f th i s ty p e h a v e h a d lim ite d d o m e s tic o r f o r e ig n r e a l i n te r e s t r a te s , o r b o th ,
s u c c e s s in e x p la in in g s u b s ta n tia l a m o u n ts o f th e c a u s e a c h a n g e in th e r e a l e x c h a n g e r a te .9
v a r ia tio n in r e a l e x c h a n g e r a te s . S u r v e y s b y
Bo m h o ff an d K o r te w e g (1983) an d Bo m h o ff To a llo w a r o le f o r m o n e ta r y p o lic y a c tio n s in

( 1 9 8 7 ) h a v e p ro v id e d e c o n o m ic a n d e c o n o m e tr ic e q u a tio n 2 , a lo n g h is to r y o f e c o n o m ic lite r a tu r e

r e a s o n s to e x p la in th e d e c id e d e m p iric a l f a ilu re s s u g g e s ts th a t u n e x p e c te d c h a n g e s in m o n e y

o f th e o r e tic a l e x c h a n g e r a te e q u a tio n s . g r o w th c a n a f f e c t th e r e a l in te r e s t r a te , a t le a s t
te m p o r a r ily , b y a lte r in g in f la tio n a r y e x p e c ta ­
F o r o u r i n t e r e s t in th e n a r r o w i s s u e o f SN B
ti o n s o r th r o u g h a liq u id ity e f f e c t. M o r e o v e r , if
m o n e ta r y p o lic y a n d th e r e a l e x c h a n g e r a te , a
e q u a ti o n 2 is a g e n e r a lly c o r r e c t e x p re s s io n f o r
m o d e l a d o p te d b y H o o p er (1983) an d Sh afe r an d
th e r e a l e x c h a n g e r a te , a n a n n o u n c e d , c r e d ib le
L o o p esk o ( 1 9 8 3 ) o f f e r s a s tr a ig h tf o r w a r d ap ­
p o lic y b y th e SN B t o i n c r e a s e m o n e y g r o w t h t o
p r o a c h . S ta r tin g w ith c o n d itio n s o f u n c o v e r e d
r e d u c e t h e f r a n c ’s r e a l v a l u e s h o u ld h av e no e f­
in te r e s t p a r ity a n d a lo n g - r u n e q u ilib r iu m c u r­
f e c t b e c a u s e r a tio n a l a g e n ts w ill in c o r p o r a te th e
r e n t a c c o u n t b a la n c e o f z e ro , a n e x p re s s io n f o r
in f o r m a tio n in to re v is e d e x p e c ta tio n s f o r h ig h e r
th e lo g o f th e r e a l e x c h a n g e r a t e (R ER ) c a n b e
f u tu r e in f la tio n a n d , a s a c o n s e q u e n c e , h ig h e r
w r itte n as:
n o m in a l in te r e s t r a te s a n d a lo w e r n o m in a l e x ­

(1) R ER = (r - t i‘ ) - (r* - n '*) + aX C A B, c h a n g e r a te . B u t, w ith a ll n o m in a l m a g n itu d e s

a d ju s t i n g b y t h e e x a c t a m o u n t s a n d w i t h o u t
w h e re r an d n' d e n o te th e n o m in a l in te r e s t r a te
la g s , th e r e is n o la titu d e f o r a te m p o r a r y
an d e x p e c te d in f la tio n , r e s p e c tiv e ly , * d e n o te s a
c h a n g e in th e r e a l e x c h a n g e r a te .
f o r e ig n v a ria b le a n d a l C A B is th e c u m u la tiv e
c u r r e n t a c c o u n t b a l a n c e . T h u s , th e lo g o f th e B e c a u s e th is s e c o n d m o d e l s u g g e s ts th a t f u lly

r e a l e x c h a n g e r a t e is s ta te d a s a p o s itiv e f u n c ­ a n tic ip a te d m o n e ta r y p o lic y a c tio n s w ill le a v e

8D ro p p in g th is v a ria b le is ju s tifie d on tw o g ro u n d s . F irst, o f a s ta b le C A B level a n d th e e x c h a n g e rate, se e M u ssa

th e S w is s c u rre n t a c c o u n t b a la n c e h a s b ee n n e a rly c o n s ­ (1985 ).
ta n t o v e r tim e s u c h th a t v a ria tio n s in it a re u n lik e ly to be
9T h is a b s tra c ts fro m th e s p e cia l c a s e in w h ic h th e d o m e s tic
an im p o rta n t s o u rc e o f e x c h a n g e rate flu c tu a tio n s . T h e s e ­
a n d fo re ig n ra te s c h a n g e in a w a y th a t le a ve s th e d iffe re n ­
c o n d re a s on is th e th e o re tic a l re s u lt th a t it is a p e rs is te n t
tia l u n c h a n g e d .
c h a n g e in C A B — n o t its level — w h ic h w ill a ffe c t th e real
e x c h a n g e rate. F or a d is c u s s io n o f th is in d e p e n d e n c e

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 52

th e r e a l in te r e s t d if f e r e n tia l a n d , h e n c e , th e re a l w a s c h o s e n a s th e b a s ic m e a s u r e o f m o n e ta r y
e x c h a n g e r a te u n a f f e c te d , e q u a tio n 2 s u g g e s ts a c tio n s in a ll t h r e e c o u n tr i e s . B y a llo w in g c o n ­
th a t a s u c c e s s f u l a tte m p t b y th e SN B t o re d u c e te m p o r a n e o u s v a lu e s o f m o n e ta r y a c t i o n s to
th e f r a n c 's r e a l v a lu e m u s t b e b o th u n a n tic ­ e n t e r th e s e r e g r e s s io n s , w e e x p lic itly a s s u m e
ip a te d a n d n o t o f f s e t b y th e a c tio n s o f o th e r th a t m o n e ta r y p o lic y d e c is io n s a r e e x o g e n o u s .
c e n tr a l b a n k s . W h e th e r th e p r e d ic tio n s o f e i th e r
To te s t th e D o r n b u s c h m o d e l, th e B v a r ia b le
m o d e l a r e s u p p o r te d b y th e d a ta is in v e s ti g a te d
in e q u a tio n 3 w a s m e a s u r e d a s th e d if f e r e n c e
in th e n e x t s e c tio n .
b e tw e e n S w is s a n d G e r m a n o r S w is s a n d U .S .
m o n e ta r y b a s e g r o w th r a te s . F o r th e s e c o n d
m o d e l, m e a s u r e s o f u n e x p e c te d c h a n g e s in th e
EM PIR IC A L A D A PT A T IO N
b a s e g r o w th r a te s w e r e n e e d e d . In f a c t, th e
r e la tio n s h ip s d is c u s s e d e a r lie r in d ic a te d th a t B
B e c a u s e t h e s o l e q u e s t i o n o f i n t e r e s t is w h e t h ­
s h o u ld b e r e p r e s e n te d a s th e d if f e r e n c e b e ­
e r m o n e ta r y a c tio n s , h o w e v e r m e a s u r e d , a f f e c t
tw e e n S w is s a n d G e r m a n o r S w is s a n d U .S .
t h e r e a l e x c h a n g e r a t e , w e d i d n o t a t t e m p t to
m o n e ta r y s u rp ris e s . T o c o n s tr u c t th e s e m e a s ­
e s tim a te s tr u c tu r a l e q u a tio n s d e r iv e d fro m
u re s, se c o n d d if f e r e n c e s o f lo g a r ith m s w e r e
e ith e r o f th e th e o r e tic a l m o d e ls d is c u s s e d
u s e d to r e p r e s e n t u n a n tic ip a te d c h a n g e s in e a c h
e a r l i e r . In s te a d , w e c h o s e to e x a m in e s ta tis tic a l
in d iv id u a l m o n e ta r y b a s e s e r ie s . T h e n th e s e in ­
te s ts th a t in d ic a te w h e th e r m o n e ta r y a c tio n s
d iv id u a l s e r ie s w e r e u s e d to c o n s tr u c t th e d if ­
" c a u s e ” a c h a n g e i n t h e r e a l e x c h a n g e r a t e . 10
f e r e n c e s b e tw e e n S w is s a n d G e r m a n o r S w is s
M o re o v e r, b e c a u se S w is s m o n e ta r y a c tio n s th a t,
an d U .S . m o n e t a r y p o lic y s u r p r i s e s . 12
ceteris paribus, w o u ld a f f e c t th e r e a l e x c h a n g e
r a te m a y b e o f f s e t b y a c tio n s o f o th e r c e n tr a l T h e r e la tio n s h ip s d e s c r ib e d by e q u a tio n 3
b a n k s , o u r c a u s a lity te s ts w e r e e s tim a te d b a s e d w e r e e s tim a te d w ith m o n th ly d a ta o v e r a
on differen c es b e tw e e n c h a n g e s in th e g r o w th 1 9 7 3 - 8 6 s a m p le p e r io d ; t h e r e s u l ts a r e s h o w n in
r a te s o f th e m o n e ta r y b a s e a c r o s s c o u n tr ie s . ta b le 1 . S e c tio n A o f th e ta b le , b a s e d o n d if ­
f e r e n c e s b e tw e e n a c tu a l g r o w th r a te s o f th e
T h e g e n e ral fo rm o f th e e q u a tio n s e s tim a te d
m o n e ta r y b a s e a c r o s s c o u n tr ie s , in d ic a te s a
f o r t h e s e t e s ts is d e p i c te d as:
m a rg in a lly s ig n if ic a n t e f f e c t o f m o n e ta r y a c tio n s
o n th e r e a l S w is s f r a n c e x c h a n g e r a te . T h e F P E
(3) A R ER , = a + £ b iB t_ i + I c , A R E R .^ + £(; c r ite r io n , p ic k e d o n ly c o n te m p o r a n e o u s
i= o j= l m e a s u r e s o f m o n e ta r y a c tio n s a s th e b e s t
r e p r e s e n ta tio n o f th e m o d e l in th e U .S . c a s e ; f o r
w h e r e R E R is th e r e a l S w is s f ra n c / D M o r S w is s th e G e r m a n c a s e , c o n te m p o r a n e o u s a n d tw o
f r a n c / d o lla r e x c h a n g e r a t e , B is a m e a s u r e o f la g g e d v a lu e s o f r e la tiv e m o n e ta r y a c tio n s w e r e
r e la tiv e m o n e ta r y a c tio n s , a , b ( a n d c ; a r e c o e f f i­ c h o s e n . 13 A l t h o u g h t h i s v a r i a b l e w a s m a r g i n a l l y
c i e n ts to b e e s tim a te d a n d £, i s a r a n d o m e rro r s i g n i f i c a n t i n t h e U .S . c a s e , t h e s ig n o f t h e
te r m . L a g le n g th s f o r th e e x p la n a to r y v a ria b le s , e s tim a te d c o e f f ic ie n t f o r r e la tiv e m o n e ta r y ac­
p an d q, w e re c h o se n b y a f in a l p r e d ic tio n e r ­ tio n s is i n c o r r e c t. S in c e th e o r y s u g g e s ts a
r o r ( F P E ) c r i t e r i o n . 11 T h e r e a l e x c h a n g e r a t e s p o s itiv e r e s p o n s e f o r th i s s p e c i f i c a ti o n o f th e
u sed a r e m o n th ly a v e r a g e s o f th e S w is s d a ta , ( r e l a t i v e l y f a s t e r S w i s s m o n e y g r o w t h w ill
f r a n c / d o lla r a n d S w is s f ra n c / D M n o m in a l r a te s i n c r e a s e th e n u m b e r o f S w is s f r a n c s p e r d o lla r)
a d ju s t e d b y r a t i o s o f t h e r e s p e c t i v e c o u n t r i e s ’ t h e n e g a ti v e s ig n i n t h e U .S . c a s e is p u z z li n g .
c o n s u m e r p r ic e in d e x e s . T h e m o n e ta r y b a s e F o r th e G e rm a n c a s e , th e e s tim a te d c o e f f ic ie n ts

10S e e J a c o b s , e t al. (1979) fo r s o m e o f th e m o re co m m o n s e c o n d d iffe re n c e s o f lo g a rith m s o f e a c h c o u n tr y ’ s

c ritiq u e s o f c a u s a lity te s tin g . A ls o se e Z e lln e r (1979) fo r a m o n e ta ry b ase s e rie s had th is c h a ra c te ris tic .
m o re g e n e ra l d is c u s s io n o f c a u s a lity te s ts a n d th e ir a p ­
13A n a lte rn a tiv e w o u ld be to e s tim a te m o d e ls fo r a v a rie ty o f
p lic a tio n . A lth o u g h F ra tia n n i, e t al. (1987) a p p ly th is te s tin g
lag le n g th s a n d lo o k fo r p a tte rn s in th e re s u lts . T h is a lso
p ro c e d u re to th e m o n e y -e x c h a n g e ra te re la tio n s h ip , th e ir
w a s d o n e fo r a ll p a irs o f p o s s ib le la g s, up to 12 m o nth s ,
s tu d y d o e s n o t in c lu d e th e S w is s fra n c a n d u se s th e
fo r b o th th e m o n e ta ry v a ria b le a nd th e e x c h a n g e ra te (144
n o m in a l, ra th e r th a n re al, e x c h a n g e rate.
re g re s s io n s fo r e a c h o f th e fo u r e q u a tio n s re p o rte d ). T h e
11S ee, fo r e xa m p le , B a tte n a n d T h o rn to n (1985). g e n e ra l fin d in g w a s th a t s ig n ific a n t e ffe c ts o f m o n e ta ry
a c tio n s — w h e th e r a c tu a l o r u n a n tic ip a te d — w e re fo u n d fo r
12T h e se m e a s u re s o f u n a n tic ip a te d m o n e ta ry c h a n g e s
a ll lag p a irs u p to s ix m o n th s.
s h o u ld b e “ w h ite n o is e ,” s e rie s w h o se m o v e m e n ts c a n n o t
b e e x p la in e d b y th e ir o w n p a st b e h a v io r o r th e b e h a v io r of
o th e r v a ria b le s . T e s ts fo r w h ite n oise in d ic a te d th a t th e

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DERofASt.
L RLouis
E S E R V E B A N K O F S T . L O U IS
 53

T a b le 1
E stim ate d R ela tio n s h ip s B e tw e e n M o n e ta ry A c tio n s and C h a n g e s in th e
R eal S w iss Fra nc E x c h a n g e R ate_____________________________________
A . T h e E ffe c ts o f A c tu a l M o n e ta ry A c tio n s (B is s p e c ifie d as Ain S W M B - Ain U S M B o r Ain S W M B - Ain G E M B )

S w is s fra n c /$ : Ain R ER , = - 0 .0 0 2 - 0 .1 7 2 ( B , ) + 0 .3 1 0 Ain R ER ,_,

(1.02 ) (1.85) (4.21)

_2
R = 0.11

S w iss fra n c /D M : Ain R E R , = - 0.001 + 0 .0 4 3 ( B , ) - 0 .0 3 6 ( B ,_ ,) + 0 .1 4 9 (B ,_2 ) + 0 .4 4 9 Ain R E R ,„ - 0 .1 9 7 Ain R E R ,.2

(1 .0 4 ) (0.99) (0 .84 ) (3.48 ) (5 .98 ) (2.60)

_2
R = 0 .2 0

B . T h e E ffe c ts o f R e la tiv e M o n e ta ry S u rp ris e s (B is s p e c ifie d a s AAln S W M B - AAln U S M B o r AAln S W M B - AAln G E M B )

S w is s fra n c /$ : A in R E R , = - 0 .0 0 2 - 0 .1 4 8 ( B , ) + 0 .3 3 0 Ain R ER ,_,

(0.75 ) (2 .17 ) (4.51)

_2
R = 0 .1 2

S w is s fra n c /D M : Ain R E R , = - 0.001 + 0 .0 1 5 ( B , ) - 0 .0 3 2 (B,_, ) + 0 .0 9 5 (B ,_2 ) + 0 .0 8 0 ( B ,_ ,) + 0 .4 6 0 Ain R E R ,.,

(1 .39 ) (0 .39 ) (0 .70 ) (2.06 ) (2.07 ) (5.98)

- 0 .1 7 8 Ain R E R ,.2
(2.29)

_2
R = 0 .2 0

N O T E : A b s o lu te v a lu e s o f t-s ta tis tic s a re in p a re n th e s e s.

f o r th e c o n te m p o r a n e o u s a n d la s t la g o f th e B r e la tiv e ly s m a ll a n d s h o r t- li v e d e ffe c t w as
v a r ia b le ta k e th e e x p e c te d p o s itiv e s ig n b u t o n ly f o llo w e d , h o w e v e r , b y tw o d is tin c tly d if f e re n t
th e la tte r te r m is s i g n i f i c a n t l y d if f e re n t fro m p a th s f o r th e d o lla r a n d DM a g a in s t th e Sw is s
z e r o . In g e n e r a l, th e c o n c lu s io n s e e m s to b e f r a n c , w ith th e d o lla r ris in g s h a r p ly u n til e a r ly
th a t d if f e r e n c e s b e tw e e n a c tu a l m o n e ta r y 1 9 8 5 a n d th e D M r e tu r n i n g to a p a th o f s m a ll,
c h a n g e s a c r o s s c o u n tr i e s h a v e w e a k , s h o r t- liv e d g r a d u a l d e p r e c i a t i o n s . A l s o r e c a l l t h a t t h e SN B
a n d u n p r e d ic ta b le e f f e c ts o n th e r e a l e x c h a n g e d is c u s s e d its p o li c y s ta n c e o v e r th is i n te r v a l in
r a te . te r m s o f a 0 .8 lo w e r b o u n d f o r th e Sw is s
fra n c / D M e x c h a n g e r a te . T h e D M , o f c o u rs e ,
In te r p r e tin g th e s e i n c o n s i s te n t r e s u l ts is m a d e d o m in a te d o t h e r c u r r e n c i e s i n SN B d e c i s i o n s
so m e w h a t e a s ie r, h o w e v e r, b y r e t u r n i n g to b e c a u s e G e rm a n y is S w i t z e r l a n d ’s l a r g e s t
f ig u r e 1 an d s o m e p o in ts m a d e e a r li e r in th e tr a d in g p a r tn e r . O v e r a ll, th e s e b its a n d p ie c e s o f
p a p e r . T h e f ig u r e s h o w s th a t th e la r g e in c r e a s e e v id e n c e — th e p a th f o r th e S w is s fra n c / D M ex­
in th e S w is s m o n e ta r y b a s e d u r in g 1978-79 w as c h a n g e r a t e in th e f i g u r e , SN B p o lic y s ta te m e n ts
a s s o c ia te d w ith te m p o r a r y a p p r e c ia tio n s o f b o th r e g a r d in g a S w is s f ra n c / D M o b je c t i v e , a n d t h e
th e d o lla r a n d DM a g a in s t th e S w is s f r a n c . T h is " c o r r e c t” sig n f o r m o n e ta r y a c tio n s in th e Sw is s

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 54

fra n c / D M e q u a t i o n — s u g g e s t t h a t SN B a c t i o n s c o o p e r a te — m a y h a v e li ttle e f f e c t o n th e c u r r e n ­
d e s ig n e d to r e d u c e t h e f r a n c ’ s r e a l v a l u e d id c y ’s r e a l v a lu e , e c o n o m ic p o lic y s u m m its o v e r
h a v e s o m e w e a k e f f e c t r e la tiv e to its ta r g e t c u r ­ r e c e n t y e a r s o f te n h a v e d is c u s s e d th e p o s s ib ility
r e n c y . 14 T h a t e f f e c t , h o w e v e r , w a s d i s s i p a t e d o f c o o r d in a te d m o n e ta r y a c tio n s to affe c t ex ­
q u ic k ly . c h a n g e r a te s . In th i s c o n te x t, th e S w is s e x ­
p e r ie n c e p r e s e n ts a n in te r e s tin g c a s e s tu d y o f
S e c tio n B o f th e ta b le , w h ic h r e d e f i n e s th e
m o n e ta r y e f f e c ts o n e x c h a n g e r a te s .
m o n e ta r y v a ria b le a s th e d if f e r e n c e b e tw e e n
u n a n tic ip a te d m o n e ta r y ch an g es ac ro ss c o u n ­ O u r e m p ir ic a l e v id e n c e s u g g e s ts th a t m o n e ­
tr ie s , s h o w s m o n e ta r y e f f e c ts th a t a r e m o re ta r y a c tio n s m ig h t b e r e la te d s i g n i f i c a n t l y to
s tr o n g ly s i g n i f i c a n t b u t s till o f p u z z lin g s ig n s . r e a l e x c h a n g e r a t e m o v e m e n ts in th e s h o r t r u n .
T h e c h o s e n la g le n g th s a r e r e la tiv e ly s h o r t, s u g ­ T h e tr o u b le w ith th is r e s u l t is th a t th e s e e f f e c ts
g e s tin g th e tr a n s ito r y n a tu r e o f m o n e ta r y ac­ a p p e a r to b e u n p r e d i c ta b l e a n d n o t e n ti r e l y
tio n s o n th e r e a l e x c h a n g e r a te . c o n s is te n t w ith s ta n d a r d m o d e ls o f e x c h a n g e
r a t e d e te r m i n a ti o n . C a u s a lity te s ts i n d i c a te d th a t
N o n e th e le s s , th e g e n e r a l r e s u l ts a g a in a r e p r o b ­
c h a n g e s in r e la tiv e m o n e y g r o w th r a te s b e ­
le m a tic . T h e o r y s u g g e s ts th a t a n u n e x p e c te d in ­
tw e e n c o u n tr ie s — w h e th e r a c tu a l o r
c r e a s e in S w is s b a s e g r o w th t h a t is l a r g e r th a n
u n a n tic ip a te d — in f lu e n c e th e r e a l e x c h a n g e r a te
a n u n e x p e c te d c h a n g e in f o r e ig n b a s e g r o w th in
f o r u p to s ix m o n th s . B u t w h ile s h o r t- r u n r e l a ­
th e s a m e d ir e c tio n s h o u ld b e r e la te d p o s itiv e ly
tio n s h ip s a r e c o n s is te n t w ith th e c o n c lu s io n th a t
to a c h a n g e in th e r e a l e x c h a n g e r a te s p e c ifie d
m o n e ta r y a c tio n s a r e n o t lik e ly to h av e e x ­
a s f r a n c / f o r e i g n c u r r e n c y . T h u s , t h e p o s itiv e
c h a n g e r a te e f f e c ts o f a s iz e o r d u r a tio n th a t
s ig n s in th e G e r m a n c a s e a r e c o n s is te n t w ith
w ill b r i n g a b o u t s u b s ta n tia l in c r e a s e s in e x p o r ts ,
th i s r e s u l t w h il e th e n e g a tiv e s ig n f o r la g g e d
th e c o n c lu s io n s f o r p o lic y m a k e rs a r e le s s c le a r .
r e la tiv e m o n e ta r y s u r p r i s e s i n t h e U . S . c a s e is
T h e la c k o f c o n s is te n c y in th e s ig n o f th e r e l a ­
n o t. T h e i n c o n s i s t e n t U .S . r e s u l t, a s in t h e
tio n s h ip b e tw e e n m o n e ta r y a c tio n s a n d ex­
p r e v io u s c a s e , m ig h t b e e x p la in e d b y th e in ­
c h a n g e r a te s a c r o s s c o u n tr i e s d o e s n o t g iv e a
s tr u m e n ts a n d o b je c t i v e s a r g u m e n t d i s c u s s e d in
c l e a r s ig n a l a s to w h ic h m o n e ta r y a c tio n s h o u ld
f o o tn o te 1 4 . E v e n th e G e r m a n r e s u l t is tr o u b l e ­
b e ta k e n to p r o d u c e a g iv e n e x c h a n g e r a te
s o m e , h o w e v e r , in th a t lagged v a lu e s o f
re sp o n se .
m o n e ta r y s u r p r is e s h a v e a s ig n if ic a n t im p a c t o n
th e r e a l e x c h a n g e r a te . P re s u m a b ly , a s u r p r is e
s h o u ld h a v e its e f f e c t f e l t o n ly in th e p e r io d it R E FE R E N C E S
o c c u r s b u t, in th is c a s e , its e f f e c ts o c c u r o n ly
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w ith la g s o f tw o a n d t h r e e m o n th s . A s w ith th e
th e M a x im u m L ik e lih o o d P rin c ip le ,” in B o ris N. P e tro v a nd
r e s u lts in S e c tio n A o f th e ta b l e , th e s e r e s u l ts
F rig y e s C sa k i, e d s., S e c o n d In t e r n a tio n a l S y m p o s iu m o n In ­
in d ic a te s ig n if ic a n t b u t u n p r e d ic ta b le in f lu e n c e s fo r m a tio n T h e o ry . B u d a p e s t, 1973.
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P o lic y, R eal E x c h a n g e R a tes, a n d U .S . A g ric u ltu ra l E x­
p o rts ,” A m e ric a n J o u r n a l o f A g r ic u lt u r a l E c o n o m ic s (M a y
C O N C LU S IO N S 1986), pp. 422-27.
B a tte n , D a lla s S ., a n d J a m e s E. K a m p h o e fn e r. “ T h e S tro n g
T e n y e a r s a g o , t h e SN B t e m p o r a r i l y ab an ­ U .S . D o lla r: A D ile m m a fo r F o re ig n M o n e ta ry A u th o ritie s ,”
d o n e d its m o n e ta r y ta r g e ts a n d p u rsu e d w hat th is R e v ie w (A u g u s t/S e p te m b e r 1982), p p . 3-12.

h a s b e e n in te r p r e te d a s a s u c c e s s f u l in te r v e n ­ B a tte n , D a llas S ., a n d C lifto n B. L u ttre ll. “ D o e s ‘T ig h t’

M o n e ta ry P o lic y H u rt U .S . E x p o rts ? ” , th is R e v ie w
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(A u g u s t/S e p te m b e r 1982), pp. 24-27.
r e s t o r e e x p o r t s e c to r c o m p e ti ti v e n e s s . A lth o u g h
B a tte n , D a lla s S ., a n d M a ck O tt. “ W h a t C a n C e n tra l B a n k s
e c o n o m ic th e o r y g e n e r a lly s u g g e s ts th a t s u c h a n D o A b o u t th e V a lu e o f th e D o lla r? ” , th is R e v ie w (M a y
in te r v e n tio n — e v e n w h e n o th e r c e n tr a l b a n k s 1984), pp. 16-26.

14A b a s ic ru le fo r p o lic y a c tio n s is th a t p o lic y m a k e rs m u st c o u ld n o t s im u lta n e o u s ly m o ve to h it a S w is s fr a n c /d o lla r

h a ve a t le a s t a s m a n y in s tru m e n ts a s th e n u m b e r o f o b je c ­ o b je c tiv e . T h is la c k o f in s tru m e n ts to h it m u ltip le o b je c tiv e s
tiv e s th e y h op e to a c h ie v e . T h e S N B h a s o n ly o ne c o u ld e x p la in th e “ c o rr e c t” re s u lts fo r th e S w is s fra n c /D M
in s tru m e n t— th e m o n e ta ry b ase — a n d c o u ld u se it to c a u s a lity te s ts a n d th e a n o m o lo u s re s u lts fo r th e S w iss
a c h ie v e o n e e x c h a n g e rate o b je c tiv e , s u c h a s th e S w iss fr a n c /d o lla r case.
fra n c /D M rate. W ith o u t m o re in s tru m e n ts , h o w e v e r, it

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F ra tia n ni, M ich e le, H y u n g -D o h Hur, a nd H e ejo o n Kang. Shafer, J e ffre y R ., a n d B o n n ie E. Loopesko. “ F lo a tin g E x­
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J a c o b s , R odney, E d w a rd L ea rn e r a n d M ic h a e l W a rd . “ D if­ P o lic y m a k in g : K n o w le d g e , D a ta a n d In s titu tio n s , C a rn e g ie -
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(J u ly 1979), pp. 401-13. (1979).

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