ISSN O0756407

BUSINESS
33rd

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RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1988

KOBE
ECONOMIC & BUSINESSREVIEW
33rd

ANNUAL REPORT

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RESEARCH INS'IITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1988

CONTENTS
Page
Agency Problems and Accounting Communication ••••••''•-••••'' Isao NAKANo 1
Strategic Corporate Innovation andJapanese Management •••''''''"'''•••••••••••••''''''••'••• Hideki YOSHIHARA 9
Financial Deregulation and Financial

Relationships between Japan and Australia ••'''•••••"'''' Kenichi ISHIGAKI 23

Keynes' User Cost and the Theory ofInternational Trade •••••••••''"•"''''•••••••••••••'••••''' Kazuo SHIMOMURA 63

A Note on International Transmission ofDisturbances and Policy Interdependence
under Flexible Exchange Rates ''''•••••••••••••'•••••''•••••"' Hideki IzAwA 75

Monetary Policy and Foreign Disturbances

in a Small Open Economy under Flexible
Exchange Rates and Rational Expectations •'••••••••••••••'•• Hideki IzAwA 89
A Sketch of the Theory of Trade Cycle '•••••••••••• •••t'' ••••• Nobuo OKISHIo 1O3

AGENCY PROBLEMS AND ACCOUNTINGCOMMUNICATION
Isao NAKANO

In the realm of theory of firm, the so-called "agency theory" has emerged andattracted the attention of many scholars. Its influence has outgrown the sphereof economics. Business accounting theory also is being reexamined from theview-point of this new perspective. This article is a report of such a reconsideration on business accounting disclosure.

Our major point is a proposal of "distrust dissolution" accounting. We
believe there exist at least three different, though interrelated, financial

accounting objectives. But among them, the most fundamental one is "dissolution of the investors' distrusts". We will start by analyzing those threesocial functions of financial accounting measurement.

1. Social Functions of Accounting Measurement - Accounting forDistrust Dissolution and Accounting for Provision of Incentives
There exist many different interest groups around the business firms. Hence,
oppositions of their interests occur, and its adjustment becomes necessary. The

most important relationship among them, however, may be said to be thatbetween management and investors. The purpose of this section is to pursue
the social meaning of accounting measurement by an application of agency
theory and to thereby form the foundation and the framework for our accounting
theory. We hope, above all, that the idea of distrust dissolution accounting will
become the starting-point for our study.

Consider accounting problems due to separation of ownership and management in corporations. As is well known, Husband unfolded an agency approachto business enterprises.i) According to it, the corporation is regarded as anagent organization for the investors. The stockholders as investors entrust use
of funds to the manager as his agent. And then, it is expected that a profit isobtained by it. Therefore, the manager bears the duty of making accounting
reports to the stockholders.
1) G.R. Husband, "The Entity Concept in Accounting", The Accounting Review, October, 1954.

2 , ISAO NAKANO
In this case, what business income concept and what capital maintenanceconcept are appropriate? The amount of money that should be maintained
before recognizing a profit is the nominal monetary capital that the investors
have provided and that they expect the firm to return in the future. And it has

been insisted that a realized surplus gained exceeding the capital is theenterprise income concept here.

This author insists that three important factors do derive from the capital
investors entrusting the use of their money to the management as their agents.
They are: (1) absence, (2) distrust and (3) lack of incentives.

First of all, consider absence. This means absence of the investors on the

spot of management actions. A shortage of business information occurs forinvestors because of this absence. For the purpose of decreasing this difficulty

and helping their judgrnents and decision makings, provision of businessinformation is required of the firm. It becomes difficult for the investors to
predict if the firm doesn't respond to this requirement. This enlarges the risk
burden of the investors excessively, making it difficult for the firm to obtaincapital. A business information provision for the judgments and decision makingsof the investors has naturally come to be formed as a social system to copewith this problem. We call this "accounting for absence dissolution".

Distrust comes next. The investors entrust the important job of management
to the manager who is another person. Therefore, it is quite natural that theinvestors should embrace the feeling of disbelief or anxiety about the capability,

the sihcerity and the extent of effort inputted of the agent manager. This
distrust is a factor of disutility, which will lower the investors' utilities about theinvestment compensation from the company. This utility reduction will lower themarket price of securities that the manager offers for sale. Consequently, it will

be more difficult for the firm to raise capital. Therefore, dissolution of thedisbelief of the investors is profitable to the manager, too. Hence, thedisclosure of business information has become a social institution so as tofunction as a "monitoring" device to prevent various aberrant management
actions (such as perquisite seeking and shirking, etc.,) as well as to provide
managers' bonding against such moral hazards or bonding for their repaying ofsuch losses. We call this accounting function "accounting for distrust dissolution".

Lastly, let us consider the third factor, "a lack of incentives". This is aproblem concerning the management entrusted with the managing of the firm.

Suppose that managers are working in the absence of investors and othersupervisors. And moreover, suppose their compensations do not respond to3
AGENCY PROBLEMS AND ACCOUNTING COMMUNICATION

their efforts or achievements. We must say that in this situation a lack of
incentives does exist which hinders the managers from making sufficient efforts.

Then, in actuality, the management result realized in each fiscal year is communicated to the investors and other interested parties as accounting information.

This will provide an informational basis for management compensation contracts
and payments which will take their efforts and achievements into account, stimulatmg
their self-interests and producing incentives for business activities.

Secondly, reportings on management results function as an a posteriori check(monitoring device) about the managers' capabilitie, s and their input efforts.
From this aspect, too, the accounting information will accomplish the function ofraising the managers' incentives which are apt to be short under the absence of
the investors in the firm. Certainly, the creation and provision of such information is very costly to the enterprise and its investors. But an information reportingof this kind will pay to the investors if an increase of the equity capital value by astimulus on the management actions should exceed the amount of the cost involved.

As another problem, a strengthening of supervision by an information
publication produces a feeling of burden to the managers. But the information
reporting is beneficial to the managers, too, because it facilitates formation of aproper management compensation which will correspond to their management
efforts and achievements. Therefore, we can suppose rationally that information
provision to the investors is being made to the degree that the interests of theinvestors and the managers come to an equilibrium.
Thus far, we have indicated three aspects of the social meanings of financial
accounting. They are: (1) accounting for absence dissolution: (2) accounting for
distrust dissolution: (3) accounting for incentive provision. We don't have new

findings about the accounting for absence dissolution (accounting for decision
makmg). In the following, we will consider the distrust dissolution functions ofaccounting by applying agency theory.

2. Accounting Measurement for Distrust Dissolution
The accounting for distrust dissolution aims to decrease the possible distrust on

the part of capital investors which arises from separation of ownership andmanagement of the firm. First, we wi11 consider why and in which forrn the

distrust will be generated. Then, we study which role can be taken byaccounting for such distrust dissolution.

4 ISAO NAKANO(1) Moral Hazards and Agency Costs
First of all, let us defme an agency relationship as a starting point. This is acontract where a man employs another man (agent) to request him to perform
some services for his benefit. And it contains a transfer to the agent of certain

decision making powers.2) A manager can be interpreted as the agent and theequity holders (stockholders and creditors) as the principals in the case of acorporation.3).

Because of the agency relationship, the investors are generally absent at

the spot of management activity, from which the problem of moral hazards
occurs. That is, this absence prevents the investors from monitoring themanager actions. The absence has also made it possible for the managers to
obtain much superior and richer business information than would be available tothe investors. Consequently, the investors naturally suspect that the agent

managers may exploit this information asymmetry in an attempt to maximize
their own benefits (utilities) at the sacrifice of the capital suppliers. This iscalled the problem of moral hazards.4)

The moral hazards can occur in various forms. For example, frauds andnegligence in the work: private consumption of the firrn's assets; a pursuit ofprofit maximization for the manager himself rather than that for the stock-holders in selecting the firm's investment projects. Therefore, the moral
hazards bring a reduction in the capital value of the enterprise.

In this case, the investors will consider monitoring the management behaviors by expending some money. If this can result in an increase in the firm's

capital value which will exceed the above monitoring costs, then thestockholders will decide to bear the expenditure.

On the other hand, from the manager's side, if this expenditure prevents
the private consumption of the business assets which occurs from the manager's
exploitation of his status, his utility will be reduced to the ektent. But a rise of

the firm's value occurs simultaneously. Therefore, if he possesses common
stocks of the company, he can obtain a gain because of the price rise. Even if

he doesn't have any stocks of the company, his non commital of moral hazard
deeds wi11 bring .about an improvement of people's confidence in him andstabilization of his position as a manager. And it will raise the ptesent value of2) M.C. Jensen and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs andOwnership Structure", lournal ofFinancial Econoinics, 3 (1976), p.308.

3) L. Kelly-Newton, Accounting Policy Fomaulation: The Role of CotPorate Management, Addison-

Wesley, 1980, p.23.
4) W. Beaver, FinancialAccounting: An AccountingRevolution, Prentice-Hall, 1981, p.48.

AGENCY PROBLEMS AND ACCOUNTING COMMUNICATION 5
his future personal income. If the sum of these profits exceeds the tota! income

from the above unethical actions, management can enjoy a net increase in its
utility from those expenditure for preventing the moral hazards. Therefore,
management will agree and cooperate to the expenditure for this purpose, too.

If it is so, why doesn't the agent manager stop moral hazard deeds from thefirst? Agency relation produces moral hazards inevitabiy irrespective of the
manager's determination toward sincerity since it is a relationship between

strangers. And that lowers the market value of the firm's securities
correspondingly. Therefore, as far as he does not incur the expendituredescribed above, the manager will inevitably suffer from a fall of the security
value.

The investor group must pay peculiar various expenditures in this agency
relation.

(a) Monitoring cost that the investors bear to repress the selfish (egoistic)

action of the agents.

(b) Bonding costs expended to promise that the agent manager will not makeany actions disadvantageous to the principals or that he will compensate to
the principals the losses from such actions if he did.

(c) Despite the above two kinds of expenditures made, there would remain adifference between the decisions actually made by the management andthose which would maximize the principal's utility. A decrease in theinvestors' security price arising from this difference is also a cost associated with the agency relationship. This is called a "residual loss". Itmeans that this is an agency cost which remains even after those costburdens.
Jensen and Meckling call the sum of the above three kinds of costs "agency
costs".5) As the costs of (a) and (b) are increased, the residual loss (c) will

decrease gradually. However, the sum of those three costs, i.e. the agency
costs, will be minimized at some finite level of monitoring and bonding costs.

(2) The Function of Accounting Information to Reduce Agency Costs
Management behaviors become more transparent, if the business informationthat reflects the results of their actions is adequately disclosed to the society. It

exposes the moral hazard deeds of managers more easily. And, it will preventthese actions beforehand. This is the management supervision function ofbusiness information disclosure. And when the auditing system of disclosed5) M.C. Jensen and W.H. Meckling, op. cit., p.308.

6 ISAO NAKANO
accounting information has been introduced, it has made the function of making

monitoring on management by information reporting to the public much more
effective. In short, establishment of a business accounting system, its operation
and auditing can be regarded as facilitating the investors' supervision action on

management activities as agent behaviors.
Now, it is equal to assuring the investors of not commiting moral hazards inthe future, if the managers agreed to an introduction of an financial accounting

system. In this sense, an eStablishment of an accounting system, its operationand its auditing mean provision to the society of the assurance that less moral
hazards will be done in the future.

That is, while a business accounting system including auditing and its
disclosure is directly a monitoring mechanism on management, it is indirectly ameans of bonding on the morals of management actions. In this sense, the cost
necessary for such accounting activities can be interpreted as both a monitoring
cost and bonding cost simultaneously. It is difficult to classify the expense to asingle category.

The moral hazard deeds of a manager will be suppressed by the burden ofthese accounting cost and by the monitoring and bonding functions of accountancy. In consequence, the risk of asset value reduction of an enterprisewi11 be lowered, and reflecting that, the equity security values (values of stocks

and bonds) of the enterprise will rise. In other words, a decrease of residualloss occurs. As far as this evaded loss exceeds the costs of monitoring andbonding, it means a decrease of the total agency costs. Hence, in this case, themonitoring and bonding through accounting measurement and reporting may besaid to pay the investors who have to ultimately bear those costs.

Further, if the manager should estimate that his utility loss from detectionof his moral hazards would be greater than his utility from his possible private

consumption of the business assets, then he would also positively prefer theabove stated accounting monitoring and bonding services. And when we
consider strictly, the gain that accounting monitoring and bonding will bring to

the manager extends beyond what we said above. As Beaver states,"In the limit, if the concern over moral hazard is suthciently great, theprincipal may be unwilling to enter into a contract with the agent. Hence, thedemand for the agent's service may increase with the agreement to provide theadditional information. As a resuit, management may be willing to pay for6) W. Beaver, op. cit., p.49.

AGENCY PROBLEMS AND ACCOUNTING COMMUNICATION 7
The emphasis on the reduction function of management's moral hazards andagency costs by the accounting system may be said to conform to our common
sense, which has contributed to deepening and developing our implicitly sharedideas. But the most positive contribution of agency theory lies in its success inshowing that accounting measurement, its reporting and auditing service canprovide net benefit to management as well as to the external interest groups,
and hence that management also has a motivation and reason to actively commit
itself to social development of business accounting system.

(3) Various Aspects of Accounting for Distrust Dissolution
Agency costs as a value expression of distrusts that occurs because of anagency relationship arise from, above all, the following two sources.

(a) Relationships between management and investor groups (stockholders andcreditors). •(b)Relationships arnong groups within the investors, that is, relations
between the shareholders and creditors.
On (a) first of all. If there does not exist any assurance to adequately

maintain and administer the monetary capital which the stockholders andcreditors have contributed to the firm, and if no systems are available tosupport the assurance, no investors wi11 be motivated to provide capital to thefirm. Or alternatively, if they should prefer to invest, they wi11 give the firm's

securities those market prices which incorporate the discount reflecting thismoral hazards (that is, occurrence of residual loss in the amount of the market

price decline). Stated another way, there exists a mechanism in current income

calculation that assures the maintenance of invested monetary capital andreports as the distributable profit only a surplus remaining after the
maintenance. This monitors the management about the extent of restraint of
their moral hazards, and it also gives a measure of prior assurance against
those deeds to the society. In consequence, a value reduction of the equity

securities of the enterprise is prevented. . ,(b) Let us consider about depreciation. Fixed assets were once regarded as

semipermanent property in the old days. Therefore, annual allocation ofdepreciation expenses was not done. But when this idea was adopted, the past
cost or the replacement cost of the property was charged to the expense at the•time of its removal. Therefore, a profit before the scheduled recovery of theinvested capital to the fmed assets was calculated in each of the interim years.
If a considerable part of this profit was appropriated to dividends, it meant thata corresponding part of the creditors' capital turned out to become the8 - ISAO NAKANO
stockholders' equity through its change into a profit and then into dividends. In
this case, a part of the stockholders' invested capital also turned into a profit, ofwhich, however, what was paid as dividends ended by returning to them again.

Therefore, no losses exist here for the stockholders. In this way, thenon-accrual accounting principle that is founded upon cash flows invites thedanger that creditors' capital is often transferred into the hand of thestockholder group.7) This can be understood as an unbalance of interests

between both groups. But according to another interpretation, we canunderstand that the creditor group, perceiving this risk, agree to accept the

firm's bonds only after a price reduction has been made corresponding to therisk, which results in the occurring of an agency cost (residual loss).

After all, the point is that the historical development from the cash basis tothe accrual basis consists in a process of restraining the agency costs from
unbalance of interests between the creditors and the stockholders, by bearing

the costs of monitoring and bonding which have been generated by the growing
complexity of the accounting procedures.

3. Conclusion
What are the relationships between our "distrust dissolution" accounting
objective and the more prevalent "decision aid" objective?

Consider the every-day fact that the words of unreliable men are neverrefiected in the decision-makings of others. A prerequisites for usefulaccounting information, therefore, is that management as the preparer offinancial reporting can sornehow gain and maintain a sufficient degree of
reliability from the investors.

Unreliable men can never influence others and hence cannot achieve any
great success in their persuit of self-interests. Our proposition therefore is thatthe maximization of one's self-interest requires a certain optimal degree of
distrust dissolution. Stated another way, the investors' decision aid cannot be
achieved without prior dissolution of their distrusts for managers' possible moral
hazard losses.

7) R. L. Watts and J. L. Zimrnerman, "The Demand for and Supply of Accounting Theories: The
Demand for Excuses", The Accounting Review, Apnl, 1979, p.277.

STRATEGIC CORPORATE INNOVATION
AND JAPANESE MANAGEMENT
Hideki YosHIHARA

1. Aims of the Paper
This paper deals with the diversification ofJapanese firms during the post-WorldWar ll period and has three main objectives, as follows.
First, based on empirical analysis of diversification of Japanese enterprises,

this paper presents new facts concerning the management of Japanese firms.
These new facts are related to strategic management and corporate innovation.

Second, this paper explores implications of these new facts for thearguments relating to the management of Japanese firms. The author hopes to
add a new dimension to the study of Japanese management.

Third, by comparing Japanese and American firms, this paper attempts tomake clear the distinctive features of strategic management at Japanese firms.

The author wants to approach the study of management of Japanese companies
from the standpoint of an international comparison.

2. Missing Elements in the Theories of Japanese Management
As Japanese enterprises have grown to take a very active role in international
markets, Japanese management has become a focus of attention for researchers,

both Japanese and foreign. What are the specific characteristics of Japanesemanagement which emerge from such studies?

At first, attention was concentrated on cultural and social aspects ofJapanese management. The so-called three sacred tools of Japanese management, i.e., lifetime employment, seniority system, and company unions, became
the subject of active arguments. These characteristics are rooted in Japaneseculture, history and society. Abegglen, in the early days, and, recently, Ryushi
Iwata are representative scholars of this school of thought.i)

Subsequently, when Japanese factories started to produce highly competitive

1) Abegglen (1958), Iwata (1977).

10 HIDEKI YOSHIHARA
products in fields such as consumer electronics, automobiles, and officemachines, the attention of scholars was centered on the Japanese factory. QC
circle activities, constant presence of management in the plant, maintaining
cleanliness and order, great attention to detail, etc. were singled out as reasonsfor success.2)

Japanese management is good at motivating workers not only to do theiroperating jobs, but also to think in order to improve their jobs. Japanese stylefactory management may be labeled bottom-up management or "mass mobilization

management."
A recent development in the field of Japanese management is evolutionary
management. According to this view, middle management plays, or should play,a centrai role in innovation, particularly new product development.3) Since in theJapanese firm the "kacho" (chief of a section) is the representative of middle

management, evolutionary management is on occassions cal!ed "kacho management."

Up to now, we have been looking at main theories on Japanesemanagement, but in all of them there is a missing element. It is a role of top

management. Since World War ll Japanese businesses have experienced
remarkable growth. What has been the role of top management in the growth
process? Has it been the role for top management to build an harmonious
organizational climate and cooperative labor relations? Or, has it been its role tocreate suitable conditions for middle and lower management? Has not Japanese
top management, by exercising its own leadership, been deeply involved in theprocess of initiating, designing and implementing strategy?

3. Growth through Diversification
Diversification Strategy as Growth Strategy
Table 1 shows the trends in diversification for the largest 118 industrial
companies for the 15-year-high growth period from 1958 to 1973.

Single-business companies are those which derive 959o or more of total
sales from one field of business, i.e., they are non-diversified enterprises.

During the 15-year period, the component ratio of these companies decreased

2) Research was done by Yoshihara (1985), Hayes (1981), Schonberger (1982), White and Trevor(1983), among others.

3) Nonaka (1985) and Kagono (1983) can be mentioned among the advocates of evolutionary

management.

STRATEGIC CORPORATE INNOVATION 11

AND JAPANESE MANAGEMENT

by 9.49o. On the other hand, the ratio of companies which actively pursued
diversification into related fields (RC, RL) and unrelated fields (U) shows a fairincrease from 39.59o in 1958 to 46.69o in 1973. In 1973, 55 companies,
comprising almost half of the largest 118, were rather highly diversified.

We might ask then, what was the result of diversification?

Table 1. Strategy Compositon
Strategy

TypeYear 1958

1963

1968

# of firms(percentage)

s

v

DC
DL
RC
RL

U

1973 U.S.A: U.S.A. U.S.A.
(l949) (1959) (1969)

30

29

23

20

(26.39e)(24. 69e)(19.59e)(16.99e)

15

18

22

22

(13.2)(15.3)(18.6)(18. 6)

17

13

12

13

(14.9)(11.0)(10.2)(11.0)

7

7

10

8

(6. 1)(5.9)(8. 5)

(6.8)

17

23

17

17

(14.9)(19. 5)(14.4)(14.4)

18

19

26

30

(15. 8)(16. 1)(22.0)(25.4)

10

9

(8.8)

8

(7. 6)(6. 8)

8

16. 29e

6.29e

15.7

14.8

15.6

18.0

16.0

7.1

L8

6.4

6.5

18.8

29.1

21.6

7.9

10.9

23.6

3.4

6.5

19.4

3.4
o.o

5.3

100.0

100.0

8.5
10.9
100.0

(6.8)

Non-conglomerate
Conglomerate
Total

34.59o

114

118

118

118

(100.0)(100.0)(100.0)(100.0)

L2

Notes: 1. S: Single Business, V: Vertical Integration, DC: Dominant-Constrained, DL: DominantLinked, RC: Related-Constrained, RL: Related-Linked, U: Unrelated
2. To compare with Japanese data, Rumelt's DLU is combined into DL and DV is shown asv.
3. Data sources: Japanese data are from Yoshihara et al. (1981) and US data from Rumelt(1974).

Companies which diversified following a related-concentrated (RC) strategy
experienced the highest rate of growth in sales, whereas companies pursuing a
related-linked (RL) strategy experienced the highest rate of growth in profits(operating profits). Against this, single-business and vertically integrated
companies showed lower rates of growth in both saies and profits.4)

4) If we consider vadous factors other than diversification strategy, and !ook at the net effect of thediversification strategy on performance, a somewhat different conclusion can be reached.
Nonetheless, there is no change as far as the following fact: the performance of diversified firms is
better than that of single-business and vertically integrated firms. For details, see Yoshihara et al.

(1981, Ch. 4).

12

HIDEKI YOSHIHARA

In brief, diversification contributed to the growth of the firm. Diversification

was a growth strategy.

Three Key Success Factors for Diversification
The author's case studies on the diversification of five companies revealed thefollowing three key success factors.5)

O Dynamic synergy of managerial resources@ Unconventional strategy@ Top management leadershipFirst, taking as a basis its existing managerial resources, a company
branches out into new business fields. While conducting business in these new

fields, it accumulates new managerial resources. Now, taking as a basis boththe original and newly developed managerial resources, the company branches
out again into new fields. Among those companies which realized high growth in
the long term through diversification, there are many which followed this cycie:
diversification . accumulation of resources --> diversification. This is diversifica-tion through dynamic synergy of managerial resources, and is a desirable
diversification process.6)

Second, successful companies generally have unique strategies different
from the conventional practices in the industry and the generally accepted ideas

in society. The uniqueness can be seen in the choice of product markets thatshould be penetrated, the timing for the entrance into new markets, or thecompetitive strategy to be pursued.

Third, top management leadership is another key success factor for
diversification. Groupism and bottom-up management are often mentioned ascharacteristics of the Japanese management style. It is unusual, according to thecommon view, for top management to elaborate an idea, hand the decision
down, and have it forcefuily impiemented in a top-down style.

Some scholars point out that Japanese executives are not analysts and do
not formulate strategies clearly.7) It is rare for a specific individual such as acompany president to go out to the front and display strong leadership. For thisreason, it is not uncommon that top management Ieadership is invisible, not5) See Yoshihara (1986). The five cornpanies are rusho -Kogyo, Yoshikawa Oil and Fat, Hoya, Ibiden

and Canon.
6) The concept of dynamic synergy has been developed by H. Itami (1984, p. 247-253).

7) Okumura (1982).

STRATEGIC CORPORATE INNOVATION 13

AND JAPANESE MANAGEMENT

only to outsiders, but to the company employees as well. Thus, it is argued
that "invisible leadership" is a typical feature of Japanese style top management
leadership.

However, as evidenced by my case studies of five different companies, top
management leadership is essential in order to conduct successful diversification

moves. In what follows, I will try to elaborate on the reasons why top
management leadership is important in the diversification process.

4. The Importance of Top Management Leadership
Diversification as Corporate Innovation
The term "diversification" is used with a variety of meanings such as market
diversification, product diversification, etc. Diversification may be generally

defined as "an increase in product or business components of a company." In
this paper, diversification refers to product line diversification or to business-field
diversification.

In Japan, diversification is practically synonymous with entering a new fieldof business. It is possible for a firm to enter a new field while at the same time
withdrawing from its existing }ine of business. But, in practice, this withdrawal

rarely happens, due to a variety of reasons, such as employment problems andlong-term quasi-orgainizational relations with suppliers and distributors.
Moreover, the market for buying and selling a part of a firm is not welldeveloped. For these reasons, in most cases, new businesses are added to
exlstmg ones.
Incidentally, innovations that take place in the firm are not limited todiversification. There are at least two other types of innovation.

The first one consists of improvements in existing products or in the

manufacturing process. These are small innovations. The second type ofinnovation involves new product development. If we compare it with the first

type of innovation, i.e., product improvement or process improvement, it
implies a higher level of innovation, whose impact extends over a wider sphereof influence. But if we compare it with diversification, then the level ofinnovation is lower, and its impact weaker and smaller.

Since, as we have already defined, diversification means entrance into new
business fields, diversification brings about, first of all, changes at product-mar-ket level. Next, when entering new business fields, changes begin to occur intechnology and marketing. Furthermore, while dealing with the new businesses
and striving to make them successful, changes in the organizational culture are14 HIDEKI YOSHIHARA
very often required. The new culture is born as a result of entering new
business fields, and this new culture is more or less different from the previousorganizational culture.

Thus, diversification usually produces three types of changes at the sametime: @ product line or business changes, @ technological and marketingchanges, and @ changes in the organization's culture. As a result, diversification

often alters the enterprise as a whole in a fundamental way. When that occurs,
diversification means corporate innovation.8)

Resistance to Change
An essential feature of diversification is that it demands change. Maintenance or

expansion of existing businesses may be seen as continuance, but, in contrast,

diversification means change. And, as we have already seen, it is not just asmall change, but a big, fundamental change.

Human beings, and consequently organizations, often avoid change andoppose it.9) Due to this resistance to change, diversification does not occur
naturally. If left alone, organizations tend to preserve and expand their existing

businesses. In organizations, a kind of inertia is at work and exercises a
powerfu1 effect. In order to overcome resistance to change and organizational
inertia and to be able to bring about in an organization a change as important as

diversification, strong power is required. One element of this strong power is

top management leadership. For this reason we can argue that top management
leadership is one of the key success factors for diversification.

5. Strategic Management vs. Evolutionary Management
Corporate Innovation and Product Innovation
One of the influential new theories in the field of business administration is thetheory of evolutionary management. It argues that middle management plays acentral role in conducting innovation in organizations.

However, findings from the author's case studies on diversification
contradict the assertion of evolutionary management; that is, the central role in8) Yoshihara (1986, p. 224).

9) The viewpoint that organizations often avoid and oppose change is based on H.A. Simon's view onorganizaitons. As for the principle of satisfying human behavior, see March and Simon (1958).

STRATEGIC CORPORATE INNOVATION ls

AND JAPANESE MANAGEMENT

innovation is not played by middle management, but rather by the president of

the company and other members of top management. One of the key successfactors for diversification is leadership from top management.

Thus, strategic management and evolutionary management differ in theirview of who plays the central role in deciding and performing innovation in thefirm. Why do we find these opposite statements concerning who plays thecentral role in innovation?

One reason is that the concept of innovation differs in the two theories. In
strategic management, innovation is concretely diversification. As we have seen
before, diversification implies large innovation. It brings about not only changes
in product lines or business fields, but also in technology and marketing, and in
the organization's culture. Diversification fundamentally changes the organization
as a whole; it means corporate innovation.

On the other hand, the type of innovation that evolutionary management
considers is centered around new product development.iO) As opposed todiversification, which is a large innovation, we can say that new productdevelopment is innovation of medium range. In this connection, product andprocess improvements are small innovations.

Let us take as an example Hoya, one of the companies included in my casestudies, and compare the two types of innovation in order to highlight therelationship between the two.ii) In 1962, the company made its entry into thebusiness of eyeglass lenses. The diversification decision was handed down by

President Suzuki. The innovation which is the focal point of strategic
management is this type of diversificaiton decision.

After the decision to enter the eyeglass lenses business was made, they
not only dealt with ordinary lenses, but also developed, produced and marketed

specialized products such as coated lenses, progressive lenses, photochromic
lenses, high-refractive index glass lenses, plastic lenses, and contrast lenses.

These individual product developments are the main object of discussion in
evolutionary management. As a matter of fact, at Hoya, the central role inproduct development was played by managers and engineers belonging to
middle management; President Suzuki did not actively participate in thedevelopment process.

When the development teams were about to work on new productdevelopment, President Suzuki spelled out basic directions based on the10) See Ishii et al. (1985, p. 243).

11) For details, see Yoshihara (1986, p. 86-87, p. 231-232).

16 HIDEKI YOSHIHARA
company's competitive strategy. The company's strength was rooted in thetechnology of optical glass. Based on this technological advantage, President
Suzuki thought the company should develop functionally differentiated lenses.

Thus, R & D people did not develop things in an autonomous and independentway. Creative ideas produced by engineers indeed played an important role in
the new product development process, but their creative ideas basically had tofollow the strategic directions decided by the president.

Differences in the Organizational View
Another difference between strategic management and evolutionary management
can be seen in their respective views of organizations.

According to the theory of strategic management, there are many reasonsthat produce resistance to change and for these reasons big changes such as
diversification do not take place if the company is left to run by itself. In

initiating and implementing diversification moves, top management leadershipand its strategic decisions are essential.

On the other hand, evolutionary management considers that organizations,or the people who belong to them, are intrinsically endowed with creativity. If
the purpose is to allow this creativity to be fostered, management and control

may be detrimental, and creativity can be much better promoted by leaving
people's creative capacities so that they can operate in a natural way. One of

the key concepts of evolutionary management is self-organization. In its

extreme view, it asserts that ideal management should be the lack ofmanagement or the lack of control.i2)

Differences between strategic management and evolutionary management
are also found in the way each theory looks at the environment. According to
the theory of strategic management, it is not so difficult to forecast the longterm general situation of the environment surrounding the company. For
example, forecasting the long term trend of the company's business - will thebusinesses grow in the long run?, will they reach a mature stage? or will they
decline? - is not very dithcult, Also, one can rather easily predict such broad

macro changes: globalization, development in information technology including

computers, growth of the service industry, advances in female social
participation, etc. Strategic decisions such as diversification are made on the12) Nonaka (1985, p. 264-265). Recently a few changes have occurred and the role of top'management
is beginning to get more attention than in the past. See Takeuchi et al. (1986).

STRATEGIC CORPORATE INNOVATION 17

AND JAPANESE MANAGEMENT

basis of this kind of long term forecasting of the general environmental situation.

Evolutionary management has a different view on the environment. The
environment is fi11ed with uncertainty. Identifying relevant changes that wiil takeplace in the environment, and forecasting what kind of impact these changes will

exert on the company is very difficult, and an accurate forecast is nearly
impossible. Since the level of environmental uncertainty is high and forecastingis difficult, a large number of middle level managers and technicians forecast theenvironment in various ways, instead of adopting a method that allows one or a

few individuals to forecast the enviroument. One of the reasons why
evolutionary management asserts that innovations are initiated and implemented

by a large number of middle managers, rather than by a few top managers, isthis way of viewing environmental uncertainly.

6. Comparison of Japanese and American Strategic Management
Gradualism vs. Radicalism
Table 1 shows data on diversification strategies of Japanese and Americancompanies. There are differences in the distribution pattern of strategic types,
as well as differences in the speed at which the company proceeds to diversify.
Also, there is a considerable difference in the degree of diversification, with

American companies diversifying to a considerable extent more than Japanese.
companles.
One of the remarkabie differences lies in the existence or non-existence of
conglomerate diversification. In the case ofJapanese companies, the component
percentage of unrelated diversification does not reach 109o. In the case of the
U.S., in 1949, unrelated diversification accounted for a mere 3.49o of the total,but 20 years later, in 1969, it had shown a marked increase to 19.49o. Looking

in more detail at this diversification strategy, one can see that in 1949
conglomerate diversification was zero, but by 1969 it had expanded to reachmore than 109o of the total. Conglomerate diversification has considerable

weight among the total number of diversification moves done by American
The conglomerate diversification basically has two features. The first one is13) The conglomerate diversification is treated in some detail below since the author thinks that theexistence and the non-existenÅëe of this type of diversification represent differences between
Japanese and US diversification.

18 HIDEKI YOSHIHARA
the diversification into unrelated fields. Diversifying into fields that bear no (ornearly no) relationship to the company's existing business, technology ormarketing system is conglomerate diversification. The second feature is theacquisition of an existing company as a method to advance into new businesses.

A number of other related features emerge in connection with these twobasic features of conglomerate diversification. One of them is the speed ofdiversification. If a company acquires an existing company, diversification speed
can be higher than in the case of a company that diversifies into new businesses
by developing internally on the basis of its existing managerial resources suchas marketing and technological capabilities. It is possible to enter a new
business on a rather large scale in a short period of time.

Another feature is that the company's business portfolio can be drasticallychanged. Recently, restructuring is being pursued. Restructuring represents
fundamentally changing the structure of the company's businesses. In conglomerate diversification it is not unusual for a company to buy an existing business,but also at the same time to sell off some of its existing businesses. By buying

and selling, the business portfolio of the firm can be greatly changed in a
relatively short period of time.

On the other hand, in the case of the internal development approach taken
by most Japanese companies, a relatively long time period is required. Since it
is an internal development, it normally takes 5 to 10 years for a new business toreach the point where it contributes 10 or 209o to the company's total sales.

And, in the case of companies that do not sell off an existing business, even
if it is stangant, it is not unusual to continue its activities for long periods oftime. A company's business portfolio can change by adding new businesses tothe existing ones, or by giving relatively less weight to stagnant businesses andrelatively more weight to growing ones.

Thus, compared with American companies, not oniy the speed of change inthe business portfolio composition is slower in the Japanese case, but also there

is almost no room for drastic changes such as restructuring. Japanese firms
change their business portfolio in an incremental way.

Another difference is that, in the case of American companies, financial
considerations are very important at the time of deciding diversification, but forJapanese 'firms, this is not the case. The important consideration for Japanesefirms in the diversification decision is related to managerial resources, to theuse of existing technical and marketing know-how already accumulated, and to

the desjre to acquire new know-how. To say it simply, diversification ofAmerican companies has a strong financially-oriented character, whereas that of

STRATEGIC CORPORATE INNOVATION 19

AND JAPANESE MANAGEMENT

Japanese companies is heavily oriented towards actions aimed at using andaccumulating managerial resources.

Reasons for the Differences in Strategic Management
Up to this point, we have looked at a number of differences in thediversification of Japanese companies compared with American companies. Now,
let us see why these differences exist.

One of the reasons lies in the differences regarding economic growth.
During the period of this study, since the 1950's to the early 1970's, there wasa considerable difference regarding rates of economic growth; the Japanese rate

being higher. In Japan, which as a whole was attaining high growth rates,
companies were able, in general, to grow within their existing businesses, andfor this reason there was not a strong need to pursue diversification. On theother hand, the American economy as a whole was experiencing a lower growthrate, and in that environment companies with a zest and ability to grow foundstrong motives to diversify into new high growth fields.i4)

After the first oil shock in 1973, Japanese economic growth decreased
sharply, and given the recent conditions of low economic growth, many more
Japanese firms, in comparison with the past, are actively promoting diversification. Also, Japanese firms have recently reached a stage of diversification thathas, to a considerable extent, the characteristics that we previously attributed

to the diversification of American firms. Many companies are entering businessfields that are quite different from their existing field. Also there are more andmore cases of companies taking action leading to a restructuring of theirbusiness portfolio by buying growth businesses and selling or withdrawing fromstagnant businesses.

The second reason is related to differences in the degree of capital market
development as well as differences in the character of the capital markets.i5) Oneof the reasons for the large number of cases in which American companies
diversify through acquisition of other companies is the fact that capital markets

are well developed in America and they facilitate buying other companies orbusinesses that are part of a company. Since that kind of capital market is notas yet as developed in Japan, diversification through acquisition is difficult.

As a third reason we can mention differences in the labor markets. In the14) See Yoshihara et al. (1981, p. 58).

15) Kagono et aL (1985).

20 HIDEKI YOSHIHARA
case of Japan, due to the so-called life-time employment system, it is notpossible to simple lay off employees just because they become surplus labor. As

a consequence, it is almost impossible in a short time period to drasticallychange the business structure of a company.

In the fourth place we can mention differences in vertical business
relationships within the two countries. There are considerable differences
between the US and Japan in the business relationships with distributors or
suppliers of parts and raw materials. In the case of US firms, both suppliers anddistributors are independent companies that maintain a business relationshipresting upon terms of equality with the manufacturing firm.

On the other hand, the vertical relations that can be seen in Japanesecompanies are of a different nature. There exists a quasi-organizational andtightly knit relationship between a specific manufacturing firm and specificdistributors. Also, regarding the relationship between a manufacturing firm andits suppliers of parts and raw materials, it can be said that they are cooperative

subcontractor-type relations which are not relations on an equal footing between
independent companies. Rather it is a hierarchical or quasi-organizational type of
relationship.

Vertical and quasi-organizational links among firms are not simple todissolve. Vertical relationships among firms in Japan are one of the importantreasons for resistance to change. It is not rare for a firm to continue its
stagnant businesses due to the relationship with its distributors or subcontracting
suppliers.

The aforementioned four differences, i.e., differences in growth rates,

capital markets, labor markets, and vertical interfirm relationships, aredifferences in the environment in which the firm operates.

One more reason which causes differences in diversification patterns
between American and Japanese firms can be attributed to the different
orientation of top management in both countries. There are many finance-oriented people among American executives. They manage the firm from afinancial standpoint and think of the firm as a collection of just one managerial

resource: money. The management's basic problem is how to invest that moneyin the most efficient way. Of course, this description of American management
is open to the charge of oversimplifying, but nonetheless it is probably true to aconsiderable extent.

What would be the reason for this basic financial orientation of American top

management? One of the reasons that can be mentioned is thit, among
American executives, there are few that, in their youth, worked in production

STRATEGIC CORPORATE INNOVATION 21

AND JAPANESE MANAGEMENT

activities at the factory floor levei or in sales activities in the sales department.

There are many people who, immediately after graduating from business schools

such as Harvard and Stanford, are assigned to the finance or planningdepartments, and later reach the top echelons of the firm without having had
direct experience with production and sales.

On the other hand, Japanese top management is basically operation-oriented.
Japanese executives think that their job is to manage the business adequately.

The company embodies different managerial resources, such as people,
equipment, production facitities, money, information, etc., but money does not
enjoy the highest priority. Rather great importance is attached to resources thathave a strong bearing on operations, such as human resources, technology andmarketing know-how.
The roots of this operation orientation of Japanese executives can be foundin their career paths. After graduating from college and joining a firm, they are

first assigned to the field, be it the factory, the sales department, thelaboratory, etc. Then, in these kind of posts, they are exposed during rather
long periods to production activities, sales activities, R & D activities, and soon, and they acquire valuable experience. Japanese top management is basicallyfield-oriented. In contrast with American executives, many of whom do not havefield experience, Japanese executives with no field experience are the exception.

References[1] J.C. Abegglen, ThelaPanese Factory, The MIT Press, 1958.

[2] R.H. Hayes, "Why Japanese Factories Work," Harvard Business Review, July-

August, 1981. '[3] J. Ishii, A. Okumura, T. Kagono and I. Nonaka, Keiei Senryaku Ron (Theory of
Corporate Strategy), Yuhikaku, 1985.
[4] Hiroyuki Itami, Shin Keiei Seniyaleu no Ronri (Logic of Corporate Strategy, New
Edition), Nihon Keizai Shinbun Sha, 1984.

[5] Ryushi Iwata, Nihonteki Keiei no Hensei Genri (Underlying Principles of JapaneseManagement), Bunshindo, 1977.
[6] Tadao Kagono, "Bunka Shinka no Process Model to Soshiki Riron (Process Modelof Evolution of Culture ,and Organization Theory)," Organizational Science, vol. 17,

No. 3, 1983.
[7] T. Kagono, I. Nonaka, K. Sakakibara and A. Okumura, Strategic vs. Evolutionaiy

Management: A US-laPan ComParison of Strategy and Stracture, North-Holland,

1985.

22

HIDEKI YOSHIHARA'[8]

J.G. March and H.A. Simon, Organi2ations, John Wiley & Sons, 1958.

[9]

Ikujiro Nonaka, Kigyo Shinlea Ron (Theory of Corporate Evolution), Nihon Keizai
Shinbun Sha, 1985.

[10]

Akihiko Okumura, Nihon no ToP Management Uapanese Top Management),
Diamond Sha, 1982.

[11]

R.P. Rumelt, Strategy, Structure and Economic Performance, Division of Research,
Harvard Business School, 1974.

[12]

Richard J. Schonberger, lapanese Manufacturing Techniques, Free Press, 1982.

[13]

H. Takeuchi, K. Sakakibara, A. Okumura, T. Kagono, I. Nonaka, Kigyo no Ziko
Kaleushin (Self Innovation of Enterprises) Chuo Koron Sha, 1986.

[14]

[15]

M. White and M. Trevor, UnderJaPanese Management, Heinemann, 1983.

H. Yoshihara, A. Sakuma, H. Itami and T. Kagono, Nihon Kigyo no Taleakuka
Sentyaleu (Diversification Strategy of Japanese Companies), Nihon Keizai Shinbun
Sha, 1981.

[16]

Hideki Yoshihara, "Japanese Production Management Abroad," in Y. Monden, etal., eds., Innovations in Management: The laPanese Coil)oration, Industrial
Engineering and Management Press, 1985.

[17]

Hideki Yoshihara, Senryakutelei Kigyo-kaleushin (Strategic Corporate Innovation),
Toyo Keizai Shinpo Sha, 1986.

FINANCIAL DEREGULATION AND FINANCIAL
RELATIONSHIPSBETWEEN JAPAN AND AUSTRALIA*
Kenichi ISHIGAKII Introduction
In the 1960s the basis of the Japan-Australia economic relationship was thetrade relationship. Recently, however, some important changes have occurred.

Although Japan is still the most important trade partner for Australia andAustralia is also an important trade partner for Japan, their importance to eachother is declining except for Japanese export to Australia. On the other hand,
capital and, in particular, the financial relationship between the two countries is

becoming more important.

These changes are closely related to the deregulation of the financial
system in both countries. For example, this deregulation, especially Australia,

has made it possible for banks to establish local banks or branches in eachcountry and conduct banking business.

The main purposes of this paper are as follows; @ to review the content of
deregulation in both countries (part ll) and examine its effects on financial flows

between the countries (part M); @ to make clear the banking business ofAustralian banks in Tokyo and Japanese banks in Australia, and examine theproblems which they are facing now (part IV and V-1--3); @ to find out the*This paper is revised version of my paper issued in Dec. 1987 by the Japan Economic ResearchCenter as Japan - Australia Relation Project Study Series No.2. An earlier version of this paper
was presented to the JARC-AJRC Joint Committee at Australian National University in Aug.1987. I
benefitted from comments and suggestions by the participants, especially Prof. A. Watanabe, Prof.

I. Yamazawa, Prof. H.W. Arndt and Dr. C.R. McKenzie. This research is supported by the Japan
Economic Research Center, the Mitsubishi Bank Foundation, the Australia-Japan Foundation and
the Australia-Japan Research' Centre. Much of the material for this paper was gathered during myinterviews to Australian banks and Australian Embassy in Tokyo, Japanese-owned financial
institutions in Australia, Reserve Bank of Australia and the Treasury. Banks and financial
institutions which I visited were as follows; Tokyo branches of Australia New Zealand Banking

Group, Commonwealth Bank' of Australia, National Australia Bank, and Westpac Banking
Corporation (in Japan), Bank of Tokyo Australia, IBJ Australia, Mitsubishi Bank Australia, Nikko

Securities Australia, Nippon Credit Australia, Nomura Australia, Sanwa Australia, Sumitomo
International Finance, Taiyo Kobe Australia, representative office of Nippon Life Insurance (inAustralia). I express my thanks for these insititutions. However the responsibility for the views
expressed is solely my own.

24 ,KENICHI ISHIGAKI'

effects of the entry of banks especially Japanese banks into the Australianmarket on Australia-Japan economic relationships (part V - 4). 'll Financial Deregulation in Australia and JapanOne of most remarkable and common economic changes in Australia and Japan
during the last decade is deregulation of the financial system in both countries.

ll -1 Australian Case
Australian monetary authorities had strictly controlled financial institutions,especially banks up until the end of the 1970's. At the same time, the State
governments had not so severely restricted activities of non-bank financial
institutions such as finance companies, building societies, credit unions and soon. This asymmetry of regulation on banks and non-bank financial institutions

resulted not only in the decrease of importance of the former as financial
intermediaries and increased the importance of the latter but also decreased theefficiency of resource allocation because of restrictions on competition among
financial institutions. Government securities market and the foreign exchange

market also were regulated strictly by the authorities. In addition, thecircumstances surrounding the Australian financial system had changed very
drastically during the preceeding three decades. The Australian economy had
enjoyed prosperity durjng the 60s, however it suffered from high inflation andsevere unemployment during the 70s. The high inflation rate induced highinterest rates. The effects of the development of international financial markets

and financial innovation were permeating into the Australian financial markets.

Money supply control policy, which was adopted in replacement of a Keynesiantype monetary policy in 1976, was not conducted particularly well under the
regulated financial system.

Against this background, the Conservative Government established theCommittee of Inquiry into the Australian Financial System (the Campbell

Committee) in January 1979. Since then, both the Liberal and Labor
government have advanced deregulation of the Australian financial system very

rapidly. The deregulation is divided into three main parts; banking sector,
government securities market and foreign exchange market.i)

1) See Commiittee of Inquiry into the Australian Financial System [1], [2] and the Review Group[14].

FINANCIAL DEREGULATION AND FINANCIAL 2s

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA
a. Deregulation of Banking Activities

The main deregulations on banking activities which have been implemented
since 1979 are deregulation of interest rates, maturity of deposits, bankportfolios and entry to banking.

At the beginning of the 1980s, the Australian monetary authorities decided
to take steps to liberalize the financial system. The first big step, in Dec. 80,

was to abolish the ceiling on interest rates on bank deposits except checking

accounts. The abolition of the ceiling resulted in a narrowing of the margin
between market interest rates and interest rates on bank deposit. In August
1984, the prohibition of bearing interest on checking accounts was lifted. Now

both trading banks and savings banks can freely set interest rates on alldeposits.

The Reserve Bank of Australia had controlled interest rates of lending,especially overdrafts, as well as interest rates on deposits although its controlson the former were not as strict as on the latter. Traditionally, Australian banks

provided finance to customers through overdraft, and the Reserve Bank had
imposed a ceiling on the interest rate. The Reserve Bank gradually eased its
controls on the interest rate of lending, and in April 1985, it advised banks thatthese remaining ceilings on their lending interest rate other than for housing

loans had been removed. Finally in 1986, the ceiling on housing loan wereabolished.

For many years the Reserve Bank had controlled maturities of fixeddeposits between 3 months and 24 months. However, with the deregulation offinance in the 80s, maturity controls on fixed deposits of trading banks andsaving banks were eased and finaliy abolished in August 1984. Thisderegulation made it possible for banks to raise funds at the market interest
rate in the short term money market and manage their liabilities very flexibly
and efficiently.

Monetary authorities had controlled bank portfolios in various ways in orderto implement monetary policy. Direct controls on portfolios of trading banks andsaving banks through the quantitative guidance on lending of trading banks and

SRDILGS control very severely restricted lending activities and portfolio

management of both banks. However almost all these controls were eased
during the first half of the 1980s. Trading and savings banks have extended
financial activities and improved the management of assets and liabilities since
the deregulation of financial activities.

The Australian Government had prohibited foreign banks' entry into theAustralian banking sector except for the Bank of New Zealand and the National

26 KENICHI ISHIGAKI'de Paris which had been permitted to enter into banking business before WorldWar ll. In addition, there was no bank entry from domestic interest until the70s. At the end of the 1970s, there were only six major trading banks and six

small banks. Furthermore, monetary authorities controlled the price of theirproducts and restricted their activies. Therefore the Australian banking market
was a typical conservative oligopolistic market.

However the establishment of the Campbell Committee, together with otherfactors, made it feasible for foreign banks and domestic interests to enter into

the banking market. The Australian Bank was established in February 1981.

The process and development of the investigation and discussion at theCommittee revealed that the Committee and the monetary authourities had apositive attitude toward foreign bank entry into the banking system. Taking

account of possible invasion of powerful foreign banks, after complicatednegotjation, the two big mergers finally occurred in 1981. 0ne was the merger

between the Bank of NSW and the Commercial Bank of Australia, and the otherwas the merger between the National Bank of Australia and the Commercial

Banking Company of Sydney. The former is now named Westpac Banking
Corporation, the latter the National Australia Bank. ANZ Bank, who did not

succeed in mergering with domestic bank, took over an English bank, theGrindly bank in 1983 in, order to strengthen its international banking business.
On the recommendation of the Campbell Report in 1981 and the Martin
Report in 1984, the Treasurer issued a statement in February 1985 that
following consideration of 42 appiications, the Government had selected 16 newbanks including 3 Japanese banks which would be invited to establish local banksrather than branches in Australia. The Australian government had particularregard to the need to secure an appropriate regional distribution taking accountof trade and other economic factors, foreign relations and reciprocity
consideration. In September 1985, the Chase ManhattanlAMP bank started its
banking business as the first new foreign bank entry and was followed by
Barclays Bank in the October, the Bank of Tokyo jn November, and City Bankin December 1985. N6w 16 new foreign banks including the bank of China aredoing banking business in Australia.2)- At the same time, the Australian Government temporarily eased regulations

on foreign investment of merchant banks and authorized 65 new foreign
merchant banks in Australia.
2) 16 new foreign banks were authorized to conduct banking business, but the Morgan Bank does
not start the business yet. Besides them, Bank of China was permitted to open its branch and it

already started banking business in Australia •FINANCIAL DEREGULATION AND FINANCIAL 27

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIAIn addition to entry of foreign interests to the banking market, new entries

from domestic interests occurred. In February of 1985, the NSW Building
Society submitted a plan to become a savings bank (Advanced Australian Bank)and was authorized by Treasurer. In March of 1983, a merchant bank, Hill
Samuel Australia started its trading banking business as the Macquarie Bank.

New entries from both domestic and foreign interests, together with otherderegulations of the financial market, contributed to the change from
non-competitive oligopolistic banking market to a competitive one.

b. Deregulation of Foreign Exchange Market
The second major aspect of the deregulation of the Australian financial system

is related to the government intervention into the foreign exchange rate andtransactions in the foreign exchange market. At the beginning of the 70s, majorcountries adopted a fioating exchange rate system in place of a fixed exchange
rate system. The Australian exchange rate system aiso changed during the 70s,

but the system was not the same as a floating rate system because theexchange rate was not determined by the supply and demand for foreignexchange in the market but by the monetary authorities. They intervened inboth spot and forward market in order to restrict the speculative and disturbing

movement of short-term capital fiow. Exchange controls on the spot market
included 30 days rule, variable deposit requirement, embargo on short-termborrowing, restriction on foreign investment by Australian residents, control oninterest-bearing investments in Australia by nonresidents, and so on. Exchange

control on forward markets included 7 days rule, embargo on entry to forward
markets by nonresidents, prohibition of risk cover with capital transaction in
official market.

In the 70s and the early part of the 1980s, however, the need for andeffectiveness of exchange controls came to be widely questioned. In addition,monetary authorities had recognized the confiict between the money supply
control policy and the foreign exchange policy.

The first big step toward liberalization of the foreign exchange market wasin October 1983. The Reserve Bank phased itself out of direct involvement inforward exchange. The next big step was the Government's decision to float
the Australian dollar and tQ abolish a major part of the existing exchange control

in December 1983. The third big step was in June of 1984. Forty companies
were authorized to deal in foreign exchanges on the same term as bank dealers.
Apart from the tax screening provision and foreign investment policy, the only
controls retained in terms of the Banking (Foreign Exchange) Regulations as at

28 KENICHI ISHIGAKI'
the end of June 1984 related to investments in Australia by foreign
govemments, their agencies and foreign banks including central banks and on
the carrying or sending of Australian notes and coins out of Australia.

These three steps toward the liberalization of the foreign exchange market
made the Australian foreign exchange market wider, deeper and more flexible
and increased freedom of capital flow in and out of Australia.

c. Deregulation of Government Securities Market

The third major aspect of deregulation of the Australian financial system isrelated to the government .securities market. The Australian Government's
intervention was based on its willingness to depress the interest rate below themarket rate which would prevail otherwise. This system had some merit if themonetary authorities conducted monetary policy based on interest rate
targeting. However, they abandoned the interest rate targeting policy andadopted monetary targeting policy in 1976 because of high inflation andunemployment at the time. 'In December 1979, the Treasurer notified the change in the issuing system

for Treasury notes from a tap system to a tender system. The next step inApril 1980 was the change in the issuing system of Treasury bonds, that is
medium and long term government bonds, from a periodical issues system to atap system. It was followed by the Loan Council's determination in June 1982 tomanage the issuing method of Treasury bonds from a tap system to a tendersystem. The Loan Council approved that the Treasurer would determine thetiming of the tenders and the quantity of the Treasury bonds sold. Prior to this,the Loan Council had determined aggregate annual borrowing programmes of
the authorities of the Commonwealth and State Government as well as of thoseof governments themselves. It prescribed maximum terms and conditions forvarious categories of public sector borrowing, determined the allocation ofprogrammes between States, regulated the timing of public loans in Australia
and approved the term, conditions and tiihing of overseas borrowing. However,after some easing of those regulations, in June 1983, the Loan Council freed all

the larger semi-government borrowers from its control as to the term,
conditions and timing of their borrowing. Although the overall annual totai would
still be set, a former chairman described the changes as `a de facto dissolutionof the Loan Council'.

In addition to the deregulation of the issuing market of government
securities, the Treasury Iiberalized their secondary markets, especially theeasing of compulsory or tax induced holding of government securities by

FINANCIAL DEREGULATION AND FINANCIAL 29

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

financial institutions such as authorized money market dealers, life insurancecompanies, savings banks. Further, transaction arrangements between the
Reserve Bank and financial institutions have changed. Until the end of 1984, theBank dealed in government securities with the authorized money market dealers
alone. In January 1985, the Bank started to deal in securities beyond one year
maturity through a variety of financialLinstitutions selected from amongst thetrading banks, merchant banks, life insurance companies and authorized dealers.

The deregulation of government securities transactions together with theintroduction of the new arrangement for transactions means that the interest
rates of government securities are determined in the market and it stimulates
the width, depth and flexibility of the government securites market.

ll - 2 Japanese Case
In Japan as well as in Australia, deregulation of the financial system has
advanced during the last decade. The driving forces behind the deregulation of

the Japanese financial system is the issues of a large amount of government
deficit bonds since 1975 and internationalization of the financial system. The

first step toward deregulation was induced by the issue of a large amount of
national bonds and the development of a secondary market for national bonds.
In the 1980s, while the national bond problem is still significant, internationaliza-tion of finance has begun to make wide and deep effects on the deregulation of
the financial system.

The deregulation of the financial system in Japan is divided into three mainparts; (1) interest rate control, (2) demarcation of financial institutions and entryof foreign financia! institutions to the market, (3) international capital flow.3)

a. Deregulation of Interest Rate

Since 1975, the Government has been offering massive amount of bonds tocover big budget deficits, acting as the largest borrower in the market. A
number of measures have been taken to help in the floating of government
bonds (Table 1). In the process, issuing interest rates have become more andmore consistent with the prevailing market yields. This deregulation of theinterest rate on government bonds has stimulated the liberalization of interest

rates in the banking business. While lending rates except the prime rate were
not regulated by the government, interest rates on all kinds of deposits were

controlled strictly by the government. In additon, Japanese customers have3) See Kinyu Mondai Kenkyukai [5], Ministry of Finance [6]KENICHIISHIGAKI

so

Table 1. Measures Taken to Help
Offering Government

Table 2. Deregulating Capital Flows

Bonds

Dec. '75 elssue of deficit-financing bonds

Dec.

started.

Jan. '77 eFive-year discount notes werefirst offered.

June,
July

Apr. '77 eResale of deficit-financing bonds

held by syndicate banks wereNov.

abowed. (one year or more after

Financial Markets.
Apr.

exchange contracts was abolished.

and CDs were allowed.
eRestrictions on the issue of Yen-

cost method and the lower-of-

May

Jan. '80 eMedium-term government bondJunecompanles.
May '80 eRestriction on resale was eased.
(7-9 months after issue)'84 eRestrictions on the issue of Yen-Nov.

relaxed.
'84 eForeign currency, exposure limit

denominated foreign bonds were(around 100 days after issue)of authorized forex banks were

were first offered to trust banks.

Apr. '83 eDirect sale of govemment bonds
by syndicate banks to individuals

raised.
Dec.

only, resale of other bonds wereallowed in Oct.)

residents Euro-yen Bond issues
was eased.

Sept. '83 eTwenty-year fixed rate bonds
companles.

Apr.

June '84 eBanks were allowed to act as

June

dealers in the markets. (bonds
with maturity of less than two

Jan.

June '85 eFull-scale bank dealing started.

June'86 eForeign commercial banks wereDec.

'86 eTokyo Offshore Markets UOM)

allowed to issue Euro-yen bonds.

introducted.
Feb. '86 e Treasury bilis were first auctioned.

Mar. '86 eLong-term government bond fund
was introduced.

Apr. '86 eRestriction on resaie by banks
was eased. (around 10 days for
dealing account, around 40 days
for investment account.)
Source; Nomura Research Centre [7]'85 e Long-term Euro-yen Ioans to nonresidents were permitted.
'85 eDual currency bond, floating ratebond, etc., were allowed to issue.
'86 eDomestic sales of warrants issued

by Japanese companies were permitted.

years only)

Oct. '85 eGovernment bond futures were

'84 eShort-term Euro-yen CD issues
were allowed.
eThe eligibility standard for non-were allowed. (long-term bonds

were first offered to life insurance

denominated foreign bonds wereeased.
'84 eFinal report of the Yen-Dollar
Committee was submitted.
'84 e Swap quotas were removed.
eShort-term Euro-yen loans werepermitted.

JulyApr. '81 eRestriction on resale was eased.
Fed. '83 eFifteen-year fioating rate bonds'84 eReal-demand rule in forward
eDomestic sales of foreign CPs

to allow the choice between thefund was introduced by securities'83 eFinance Ministers of the U.S.
and Japan agreed to set up the

deregulation of the Japanese

Oct. '77.)

June '78 eAuction of three-year government

cost-or-market method for valuation of government bond holdings.

'82 elnsurance cornpanies are allowed
to hold foreign CPs and CDs.

so-called Yen-Dollar Committee topromote internationalization andissue, the same measure wastaken for construction bonds innotes started (two-year notes andfour-year notes followed in June
'79 and June '80, respectively)
Dec. '79 e Bank accounting rule was changed'80 eRelaxation of Forejgn Exchange
Control Law.

started.
Source;Nomura Research Center [7]FINANCIAL DEREGULATION AND FINANCIAL
RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA
become sensitive to interest rates when they chose their portfolios. Banks haverecognized that if they are not able to offer attractive interest rates tocustomers, they will lose deposits. CD, of which interest rate are not regulatedby the government, were first issued in 1979. In April 1985, the minimum unitof CD were reduced from 300 million yen to 100 million yen and the maturity of

CD was extended from 3--6 months to 1-12 months. Secondly, in March 1985
MMC (Money Market Certificated), of which interest rate is linked with CD
rate, were issued. Initially their minimum unit was 50 million yen, and was
reduced to 20 million yen at the begiming of 1987. Regulation on large size time
deposits above 1 billion yen with maturity of more than 2 years was abolished in

1985. The minimum unit is gradually being decreased to 100 million yen. At thesame time, monetary authorities are also deregulating interbank deposits (aswell as large size time deposit). However regulation on small size deposits still

remain. With deregulation of interest rates, the short term money market has

also developed. However, in comparision with the US money market, the sizeof the market is still small relatively. In addition, the interbank market in Japanis not as fiexible as the US Federal Fund market. The call market serves as avehicle for the settlement of banks reserve position, while the bill discountmarket serves the longer term needs ranging from one to four months, ofparticipating financial institutions. These markets are part of the larger
short-term money market and, as such, differ from the CD and Gensaki market
in that they are closely involved in monetary and credit control by the Bank ofJapan, as well as the fact that participation is limited to financial institutions.

The rates are influenced by the BOJ's basic monetary policy. Thus compared toother short-term money markets, these markets are relatively closed toarbitrage activities.

b. Deregulation of the Line of Demarcation between Financial Institutions

Japanese banking system has a structure based on ordinary commercial banks 13 city banks and 64 regional banks - as it nucleus and various specialized
financial institutions in charge of international finance, long-term credit, sma!1

business finance, and credit for agriculture, forestry, and fishery. In the same

way as in the United State, but unlike in European countries, there is a sharp

distinction between banking business and securities business based on the
Article of the Security Transaction Law in Japan, except for the underwriting

and dealings of public bonds such as government bonds. Insurance is also aseparate area (Chart 1). However recent developments in the deregulation of
the financial market and changes in financial structure are contributing to

31

KENICHIISHIGAKI

32

Chart 1. 0rganization

Mapof Principal

Financial

Institutions(As of the end of 1984)

The Bank of Japan

Centra! Bank

PrivateOrdinary (Commercial) Banks

City Banks (12)Regional Banks (64)Financial
Institutions

Foreign Banks (65)
All Banks (86)Specialized
Financial
Institutions

Financial lnstitution -Specialized Foreign -Finance Exchange Bank (1)c,,d,tTl ,g,-tfi',M.k,C(r7e)dz'tB:aTB",,k.nS,k,(m3,Gi,a)fc)

Sogo (mutual) Banks (69)Credit Associations (456)Credit Co-operatives (448)
Shoko Chukin Bank (Central

Bank for Commercial

andIndustrial Co-operatives) (1)Norinchukin Bank (Central
for Agriculture and Forestry)

Forestry and Fishery Fcredit Federations
LAgricultural Co-operatives

Co-operative Bank

(1)of Agricu}tural Co-operatives (47)

(4,305)

Other Financial
Institutions

Insurance CompanieS T kio/en.ILni?eUrlannsCueraCnOc:PanieS(23)

Companies (23)Securities Companies (212)

Housing Finance Companies (8)Government
Financial
Institutions

Banks (2)Corporations (10) (including Shoko Chukin Bank)others T \?:t,,O"fi.'C.e,S,(.2,3,'2:O(),)

Note: The number of institutions

appears in the parenthesis.

Source; Federation of Bankers
Associations of Japan [3]FINANCIAL DEREGULATION AND FINANCIAL 33

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

blurring the line of demarcation. The line of demarcation between financial
institutions providing short-term credit such as ordinary banks, mutual banks
and credit association and financial institutions providing long-term credit suchas long-term credit banks and trust banks is gradually blurring. The former areextending long-term credit and the latter are enlarging short-term credit. In
addition the line of demarcation between financial institutions for small businessand other financial institutions is also blurring. The weight of small business loans

from the former is declining and rising the latter. Finally the line of demarcation

between the banking business and the securities business is blurring. Securities

companies were authorized to introduce medium-term government bond funds,
similar to time deposits, in January 1980. 0n the other hand, direct sale ofgovernment bonds by syndicate banks to individuals was permitted in April
1983, and banks were allowed to act as dealers in the market.

Although the Japanese Government had authorized seventy-seven foreignbanks including four Australian banks to establish their branches in Japan basedon reciprocity, it had not permitted them to participate in trust banking inJapan. Access of foreign banks to the Japanese financial market, however, has

gradually come to be eased. The Government authorized nine foreign banks tooperate trust banking in Japan in 1985.

In addition, access to the securities business and membership to the Tokyo

Stock Exchange has also been eased recently. At the end of 1984, there were
only 10 foreign securities companies in Japan. Thirty-eight foreign securities

companies opened their branches in 1987. Although Article 65 of the Security

Transaction Law prohibits banks from operating securities business, theJapanese Government authorized some foreign banks to establish Tokyo
branches of affiliated securities companies of which they own no more than 50
percent of capital.

Although lines of demarcation, as mentioned above, are blurring in Japan,
deregulation is not advancing very rapidly. Differences in financial systems
based on historical circumstances and laws between Japan and foreign countries
are producing some financial conflicts.

'

c. Deregulation of lnternational Capital Flows •The deregulation of capital transactions, mainly direct investment into and fromJapan proceeded during the 70's, but the Japanese Government, based on
foreign exchange control laws controlled portfolio investment and short-term
capital flows very strictly. Relaxation of the Exchange Control Law in December
1980, made capital infiow and outflow free in principle except in special cases

34 KENICHI ISHIGAKI(Table 2). It abolished controls on impact loans and promoted foreign currency

deposit transactions and enlarged the Tokyo dollar market. In July 1982,

insurance companies were allowed to hold foreign CPs and CDs. Financemmisters of the U.S. and Japan agreed to set up the so-call the Yen-Dollar
Committee to promote internationalization and deregulation of the Japanesefinancial markets in November 1983. In 1984, real-demand rule for forward
exchange contracts was abolished. Domestic sales of foreign CPs and CDs wereallowed and banks including foreign banks were able to make yen denominatedforeign loans without
any controls. .
'The Final Report of the Yen-Dollar Committe recommended the deregulationof Euro-yen market. Short-term Euro-yen loans to residents, and short-term
Euro-yen CD issue were allowed, and the eligibility standard for nonresident

Euro-yen bond issues was eased in 1984. Long-term Euro-yen loans tononresidents were allowed and foreign commercial banks were allowed to issueEuro-yen bonds. In addition, the Japan Offshore Market started to promoteinternationalization of yen. Deposits in the market are not subject to interest

rate control, regulation of deposit insurance or reserve requirements. However

income and local tax rate is relative high (52--549o) and stamp duty isnecessary. Deregulation of international capital flows by the authorities tappedhuge liquidity into foreign securities. Outstanding foreign securities held byfinancial institutions reached \32 trillion or US$ 202 billion at the end of 1986.

'

M Financial Aspects of Japan-Australia Economic Relationship'
Chart 2 shows a simplified flow chart of funds between Australia and Japan.
There are three main routes of fund flow: (1) flow with trade payments (RouteI), (2) fiow with direct investment (Route ll), (3) flow with portfolio investment

and institutional loans (Route M). The third one is divided into three smaller, financial market (Route M a), (2) route
routes; (1) route through the Australianthough the Euro market (Route M b), (3) route through the Japanese market(Route M c). It should be noted that these three markets are not separated but
linked (Route M ab, Route M bc and Route M ac).

M - 1 Financial Flow with Trade Payments (Route I)
Substantial complementarity in resource endowments, a strong interdependence
in industry and trade structures and a shared recognition of the 6enefits ofstable economic growth have been central to the development of Australia-Japan

FINANCIAL DEREGULATION AND FINANCIAL
RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

35

Chart 2. Flow of Funds between Japan and Australia
Japan

Australia

Route I

Trade payment

Route ll

Direct investment

Securities investments & Institutional loans

Australian financia

1 market

Government bonds
Public authorities securities

Route M a

Private bonds and shares---t------e----Japanese financial institutions

in Australia

Route M ab
Euro market

Route

Mb

Euro yen bonds

ee----e--------e
Tokyo, Singapore, Hong Kongand other offshore markets

Route M bc
Japanese financial market

Samurai bonds
Shibosai (private placement)

Route Mc

Shogun bonds--------e------Financial institutions(including Australian bank branches)36 KENICHI ISHIGAKI
economic relationship over the last thirty years. However, the long-term
restructuring of Japanese economy and the slow down in Japanese economic
growth impacted on Australia export performance to Japan. Australia's share of

total Japanese imports (by value) has fallen from a peak of 9.49o in 1972 toaround 59o in the period since 1980. Although Australia is still important toJapan as a supplier of specific commodities such as coal, iron ore, beef andwool, the importance is declining. Australian trade surplus with Japan isdecreasing. While it was US$ 3050 million in 1976, it was US$ 1750 million in1986. Net flow of funds with trade payments is shrinking gradually.

'

M-2 Direct Investment and Portfolio Investment from Japan toAustralia (Route ll and Route III)The importance of direct investment and other portfolio investment from Japanand the financial relationship between the two countries has been increasing.
Japanese direct investment in Australian enterprises increased gradually during
1960s and 1970s, and it increased more rapidly from US$ 146 million in 1977 to
US$ 566 million in 1979 because of increase in investment in the manufacturingindustry and mining industry. It remained at a high level in 1980-82. However it

drastically declined in 1983 and 84 because of recessions in Australia and therest of the world. 'Japan's relative importance as a source of direct investment in Australianenterprises has remained largely unchanged since the late 1970s, ranking third

behind U.K. and U.S.
The main thrust of Japanese direct investment in Australian enterprises isstill directed towards mineral and energy exploration and development. However

other investments have recently shifted from manufacturing toward service
industries such as finance and insurance, and the tourism industry. Of the total

stock of Japanese foreign investments in the Oceanian Area, where Australia is

main country, at the end of 1985, US$ 1351 million (339o) was in the mining
sector, US$ 1551 million (379o) in the service industry, and US$ 1054 million(259o) in the manufacturing industry.

However the main route of financial flows from Japan to Australia is notdirect investment (Route ll) but portfolio investment and institutional loans(Route Ma). As Table 3 shows, Japanese direct investment in Australianenterprises is only 309e of total Japanese investment in Australia and the shareseems to be declining. The main form of capital flow is now the portfolio
investment and institutional loans. It comprises mainly of borrowing (969o), withthe remainder in corporate equities (39o).

Table 3.

1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
Ten Year Totalz

Japanese Foreign Investment in Australian Enterprises 1974-75 to 1983-84

JaPanese direct inves tment in

JaPanesePorVfolio investment and institutional

TotallaPaneseinvestment

Austratianenterptisesloans in Australian enterprises

InAttstralianenterprises

Share of total

laPan's share of

Share oftotal

laPan 's share of

1mpan's share of

1mpanese

directforeign

JaPanesepa,Vfalioforeign

investmentin

investmentin

investmentin
Australianenterptises

investmentin

totalforeign
investmentin

Atcstralinn

Australianenterprzses

enterPrises$mPercent

55
84
85
119
66
218
320

82.1
85.7
61.6
60.4
23.7

5L7

427
405
394

40.7
34.7
18.5
34.4

2173

33.2

14.6

$m
12
14

14.2
13.4
19.5
45.4
17.8

53
78
213
204
466
801
1786
750

Percent

8,4
8.0
IL4
4.9

15.6 4377

Austratian

Attstralianenterprises

enterPrises

Ee
2Z
:>
-Tr
mV
iz
2,S

Percent

Percent$m

Percent

17.9
14,3
38.4
39.6
76.3
48.3
59.3
65.2

3.5
5.0

67
98

11.4

li

14.9
14.3
14.0
13.0
13.1
25.7
13.2

>Z
zv
V>Z
i'i'

15.5

11.0
28.0
34.4
13.8
12.8

8L5

65.6

23.4
11.6

138
197
279
422
786
1229
2191
1144

66.8

15.4

6551

ILI

6.7
8.5

>
Source; Treasury [16]EtS

38 KENICHI ISHIGAKIOne of features of recent Japanese investments including direct investment inAustralian enterprises is the sharp decrease in corporate equity holding. It
reflects the lack of domestically available capital for big energy and resource

development projects and large increase in borrowing by public authorities. It
also indicates that foreign investors including Japanese prefer bonds to equities

in view of high interest rates on bonds and relative low profits rate on equity
because of recession in the first half of 1980s.

Another feature of recent Japanese investments in Australia is increase ininvestment in the Australian dollar securities in the form of bonds issued byAustralian public authorities and the Australian Government. Prior to 1982,
Japanese institutional investors were not very interested in Australian dollar

securities. In 1981, they invested only US$ 148 million in Australian dollar

securities, only 1.49o of total Japanese investment in foreign currency
securjtjes. However in 1982, they invested US$ 1906 mllion, 10.59o. Since
then investment remained at a high level although the share is declining.
Japanese investment in Australian doliar denominated public sector securities

has represented a substantial proportion of all foreign investments in suchsecurities. As of 30 June 1984, Japanese investments in Commonwealthgovernment securities were AU$ 1066 million, 699o of totai investments in suchsecurities by overseas investors. The main Japanese buyers are life insurancecompanies, general insurance companies and trust banks.

Reasons for the huge increase in investment in Australian dollar denominatedsecurities are as follows. Firstly, in 1980-82, major Japanese insurancecompanies and trust banks established representative offices in Australia andthey gathered information about the Australian economy and Australian securities.

Secondly, in contrast with the rise in the credit risk of developing countries,
Australia's name and credit standing was still high. Japanese investors recognizedthat not many countries had such a low country risk as Australia. Thirdly,
taking into consideration expectation of exchange rates and interest rates,

Japanese investors preferred Australian securities to other foreign bonds.
Fourthly, in the beginning of the 1980s the Japanese Government arnended theForeign Exchange Control Law and deregulated investment in foreign currency
denominated securities (Table 2, Fig. 1).

The Australian public sector has raised funds not only in domestic markets
but also in overseas markets. In 1972 the Australian Government initially issued

govemment bonds in the Samurai market in Japan (Route M c). Until the end of.
1985, a total of 9 yen-denominated borrowings
by Australian Government
amounted to \340 billion. It also had a total of 5 yen syndicated institutional

FINANCIAL DEREGULATION AND FINANCIAL
RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

39

Fig. 1 Deregulation of Foreign Securities Investment(U.S.S bil.)

40

Banks a11owed to invest wla hedging.

t

35
Securities Investment
Trusts allowed to mvest.

Loan Trusts allowed to invest.

l30
Agricultural Cooperatives andCredit Associations allowed to invest.

25

Postal Life Insurance allowed
to mvest.

20

Pension Trusts allowed to invest.
15
Investment in foreign securities
freed in principle.

10

Insurance Companies
allowed to invest.

Banks allowed to invest.
5o1970 '71. '72 '73 '74 '75 '76 '77 '78'79 '80 '81 '82 '83 '84 '85'86

Source; Nomura Research Institute[9]Table 4.

Australian

Bond Issue Related with Japan

8(!)AustralianBondinYen{SamuraiBond,Publiulssue}
Date

Amount(100ml}

C.R.(9,)IssuePrice(Yen)Term(Year)

6,EO

100.oo10

6.900(No,2)

1972.7
1978.2

1(H)

5(X}

6,60

99,30

12

6.705

3(X)

1978.12

200

5,60
6.50

99.75
99.25

510

(No.3)

5.664
6.624

(No.4)

1979.12

:soo

8.20

99.50

12

8.283

(No.5)

200

8.50

99.45

12

8.593

2(M)

8.(ro

99.95

10

8.009

2(Xj

8.(ro

100.00

10

8.000

5(X)

7.70

99.75

10

7.744

VictoriaP.A.F.A.

1981.6
1982,5
1983.6
1984.8
1985.2:300

6,70

1oo.OO

10

6.700

AustralianNationalBond(No.9)

1985.10900

6.40

100.00

12

6.4oo

30
42
30

7.80
8.{ro

&20

1oo.OO
1oo.OO
1oo.ooAustralianNationalBond{No.1)(No.6)(No.7)(No.8)

Yield(%)

xtn
z
g
a
:
as
:
a
>
x
-

@AustralianBondinYen(Shibosai,PrivatePlacement)
1979.10

Qantas1981,3
1982.I
1982.6

P.A.(W.A)
P.A.(Qu)
P.A.(Vic)

75

5812

7.8oo
8.000
8.2oo

8.70

99.40

15

](ro

8.60

99.75

12

8.642

100

8,50

1oo,oo

12

8.500

8.792

P.A.(NSW)

1982.1150

9,OO

1oo,oo10

9.000

P.A.(W.A)

50

8.70

loo.oo10

8.700

P.A.(Qui)

1983.1
l983.6sc

8.50

IOO.oo10

8.500

P.A.(Qu)

1984.650

7.90

1oo.oo10

7.900

P.A.(Melborne)

1984.12

50

7,50

99.45

10

7.596

P.A.(W.A)@EuroAustratianBondinYen

1985.101oo

6.50

100.oo10

6.5oo

AustrahanNationalBond(No.1)

1981.7150

8,50

1oo,OO10

8.5oo(London)(No.2)

1982.10

150

8.625

1oo.oo10

8.625(London)Source; Ministry of

Finance [6]FINANCIAL DERE6ULATION AND FINANCIAL 41

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

loans amounting to \240 billion. The Victorian Public Authorities FinanceAgency also issued Samurai bonds in the market in 1985 (Table 4-(!)).

In addition to public issues in the Samurai market, Australian publicauthorities raised Yen funds through private placement of `Shibosai' bonds inJapan. In 1979 Qantas initially issued Shibosai amounting to \72.7 billion at theend of 1985.
Borrowing by public authorities in international capital markets including theyen market had been controlled by the Australian Loan Council. If firstpermitted access to overseas markets in conjunction with the adoption of asystem of `global' limits on both their domestic and overseas borrowings in

1984. Access to the Samurai market by public authorities was permitted in
September 1984.
At the same time, the Samurai market began operating under more liberal
guidelines desigried to achieve further internationalization of the yen. The
Japanese government had strictly controlled the size and frequency of bondissue and maturity,of Samurai bonds. However the recent deregulation in Japanrelaxed the issue conditions, especially issue amount and timing. This also
benefitted Australian public and private borrowers.

Commonwealth Government raised funds not only in the Japanese capital
market but also in the Euro market (Route M b). It raised funds in 1981 and in1982 (Table 4-@). Since then, the Australian Government has not raised funds

in this market. However the Euro yen bond market has been growing very
rapidly, especially since 1985. At the end of 1984, the Japanese Government

relaxed non-resident bond issues in the Euro yen market. Previously, onlyinternational organizations and sovereign governments ranked `AAA' by the US

credit rating agencies and who had accessed the Samurai market on at least
three occasions were able to borrow in this market. From 1 December 1984,
non-resident private corporation, sovereign govemment, government agencies
and international organization were allowed to issue bonds in the market andJapanese and foreign banks were permitted to issue Euro yen CDs. In April

1985 the Japanese government further eased restrictions in the Euro yenmarket. As a result, the amount of issues of Euro yen bonds increased
drastically from \227 billion in 1984 to \1446 biilion in 1985.

Shogun Bonds (foreign currency denominated bonds) market (Route M c) inJapan was reopened in 1985 reflecting a rapid increase in Japanese investment

in foreign securities. This opening enabled issuers including Australianborrowers to directly tap Japanese demand for foreign currency denominatedbonds. Unlike Samurai and Shibosai issue, there are no fixed rules regarding42 KENICHIISHIGAKI'
Shogun bonds as to issue amounts, maturities, coupon rates, and the currency.
However they are subject to approval by Japanese authorities. Three Australianauthorities and one trading bank issued Shogun bonds in this market in 1985 and
86 (Table 5).

IV Activities of Australian Banks in Japan4)'

IV- 1 Establishment of Tokyo Branches by Australian Banks 'Four branches of Australian banks, that is Westpac, ANZ, NAB, CBA are now
operating in Tokyo. The Westpac branch was the first to be established in

September 1985, followed by ANZ and NAB in December 1985, and CBA in
June 1986. These establishnents were based on the reciprocity that theAustralian Treasurer authorized 16 foreign banks including 3 Japanese banks,

namely Mitsubishi Bank Ltd., (in partnership with The City Mutual Life
Assurance Society limited and Howard Smith Limited), and The Industrial Bankof Japan Limited (in partnership with Western Australian Development
Corporation, Town and Country Western Australian Building Society and The

State Government Insurance Office of Western Australia) and the Bank ofTokyo Limited (a wholly-owned subsidiary), to establish full banking operations
in Australia.

The main purposes and motives for the establishment of these branches are
as follows. Firstly, Japan is a major trading partner and Australian banks have

had strong customer relationship with Japanese companies in Australia. One ofmain purposes of establishing a branch in Tokyo is not only to strengthen
customer relationship with Japanese corporations in Japan but also to protect
business relationship with Japanese customers in Australia. Secondly, since theTokyo market is one of most important international finance centres, theestablishment of branch makes it possible to take business chances and expand

their financial activities. Thirdly, the establishment of a Tokyo branch isconnected with the glbbal strategy of Australian banks. In the 1980s, Australianbanks have expanded their international banking in the world. In addition to the

traditional London and New York, four major Australian trading banks haveestablished new branches and subsidiaries in Singapore, Hong Kong, Los
Angeles and so on. The extension of their international network is one of the

key elements for banks survival in the severe competition stimulated by the4) This part is rnainly based on my interviews to Australian bankers in Tokyo.

FINANCIAL DEREGULATION AND FINANCIAL
RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA
Table 5.

43

Issue List of Shogun Bonds

Signing

ClosingAmountMaturity

CQupon

Date

Date

(miL)

(years)Rate (9e)World Bank

7126

8/15

US$3oo10

10.5StudentLoanMarketingAssociation

8/22

8129

US$10059.75

European lnvestment Bank

9X3

9118

ECUIoo10

8.875

FinanceAgency(Vicfin)

9f20

IO/4

A$60

7

13.625* New South Wales Treasury Corp.

9f27

10f9

US$1oo7

10.375

BankofChina

9f27

10f18

US$15010

10.0Southem Califomia Edison Company

10130

11f7

US$100

8

10.5

12119

12127

US$100

10

9.625

3112

3X19

Can$90109.125

MortgageAssociation

3126

4/3

\27, OOO (D)

10

7.2

Bank ofChina

3126

4/3

\20,OOO(D)

10

7,2

' State Bank of New South Wales

4/24

5f14

US$1oo7

7. 125

Hydro-Quebec

7!18

7X31

C$150

10

9.25

Federal Business Development Bank

8X7

8X14

C$75

5

9.0
9.0

*VictorianPublicAuthorities

China International Trust andinvestmentCorporation
FarrnCreditCorp.
FederalNational

WorldBank

8/28

9/3

C$1oo

10

*NewSouthWalesTreasuryCorp.

10117

11/12

US$1oo7

7.75WorldBank

12110

12f19

US$2oo7

7.375

The Standard Oil Company

12f19'87 1/13

US$50

10

7.875

The Standard Oil Company

12f19'87 1113\8,ooO(D)

7

7,875

'87 1/13

1/21\20,Ooo (D)

5

7.875

ChinaInternationalTrustandInvestmentCorporation
Ciba-GeigyInternatiomal
Nederland B. V.

1/28

214

US$50

7

7.5

FHLB

2f13

2126

US$2oo10

7.75

GTE Finance Corporation

2118

313

US$1oo78.0(D): Dual Currency* Australian Issues

Source;NomuraResearch Institute,[8]

44 KENICHIISHIGAKI'
development of the Euro market and the liberalization of financial systems inmany countries including Australia and Japan. A Tokyo branch is a very
important link for global strategy for Australian banks because of Japan's
position in world economy.

Each chief or general manager of the Tokyo branches is Australian. The

number of employees of each branch is 66, 62, 40, 28 including 3, 4, 4, 5
Australians respectively. Some branches also employ a few English. The
number of employees seems to depend on scales, character of banking businessof the Tokyo branch and the date of its establishment.

IV - 2 Banking Business Operation in Japana. Fund Raising

In March 1987, 79 foreign banks conducted business through 115 branches.
Total loans and discounts are \5602 billion, which is equal to only 2.09o of totalloans and discounts of all Japanese banks. Total deposits of foreign banks are
only O.89o of total deposits of all Japanese banks. Although these figures havenot changed significantly over the last ten years, the former figure has been
declining recently. This means that the position of foreign banks in the Japanesefinancial market is still a marginal one.

One of distinctive features of the banking business of foreign banks inJapan, especially funds raising is that, in comparison with Japanese banks, theproportion of deposit and CD is very low and the proportion of call money isvery high. Table 6 shows that the proportion of fund raising of foreign banks bydeposits in only 12.09o in contrast with 58.29e of all Japanese banks. The main

sources of funds for the foreign banks in Japan are short term money market

raising - mainly call money -, and overseas branch borrowing. Although theweight of the two sources is different for each foreign bank, on average, thelatter is rather larger than the former. The figure for city banks, which are themost internationalized Japanese banks is very interesting. More than 709o offunds are raised in Japanese market.

This feature is reflected in Australian banks activities in Japan. The
proportion of deposit and CD in total liability of Australian banks is only 3.59e.

This is very small in comparison with not only the figure for Japanese banks but
also the figure for all foreign banks in Japan. Australian banks can not receive

enough deposits because they are new comers and are not familiar to Japanesecustomers, even though interest rate ceilings on large size deposits and CD

were abolished. They can not collect yen deposits easily not only in thewholesale deposit market but also in the retail market. Some Australian banks,

Table 6.

Balance sheet of banks in

WP

ANZ

NAB

% (\100ml)(\100ml)

Japan (31 March, 1987)% (\100ml)

TOTAL

C.B.A.

% (\1ooml)% (\100ml)

ForeignbanksinJP% (\10bl)

AllbanksinJP% (\10bl)

%

Asset

cash&depositwithotherbanks

71

6.0

401

27.9

98

14.1

237

28.4

808

19.5

375

22.5

371

8.2

callloans

124

10.6

102

7.1

26

3.7

192

23.0

445

10.7

185

ILI

158

3.5

bMpurchased

20

L7

30

2.0

50

L2

80

4.8

4

O.1

securities

165

14.1

126

8.8

72

10.3

1

o.o

363

8.7

oo

5.4

736

16.3

loan&discount

199

17.0

661

46.0

"o

62.9

261

31.2

1561

37.7

560

33.7

2743

60.8

foreignexchange

42

3.6

48

3.4

3

O.5

1

O.1

95

2.3

41

2.5

49

LO

Sundryaccounts

27

2.3

32

2.2

12

16.9

17

2.0

88

2.1

169

3.7

realestatesetc.

5

O.4

4

"

2.6

O.3

6

O.8

2

O.3

18

O.4

7

O.4

ss

O.7

customers'skabhityundersacep&guarantee

448

4L6

13

O.9

16

2.3

11

L3

528

12.7

74

4.4

213

4.7

laanstootherbranchesMeadofficeandbranch)

31

2.6

18

L2

26

3.7

113

13.6

188

4.5

205

12.2

3

1171

100.0

1437

1oo.O

699

1oo.O

836

1oo.O

4143

1oo.O

1660

1oo.O

4509

1oo.O

68

5.8

15

1.0

19

2.7

"

5.2

145

3.5

199

12.0

2624

58.2

19

1.0

95

2.1

othersTotalAssets

Liabilties&Networth
depositsCD
cadmoney

215

18.3

541

37.6

285

40.8

bil1sold

18

15

so

2.1

se

7.2

borrowedmoney

21.2

210

25.1

1250

30.2

450

27.0

210

4.7

98

2.4

37

2.2

153

3.4

451

10.9

173

10.4

sc

Ll

7

O.1

8

O.5

7

O.2

145

12.3

99

6.9

148

foreignexchangeaccounts

5

O.4

1

O.1

3

Sundryaccounts

25

2.1

291

20.2

8

Ll

17

2,O

341

8.2

51

3.1

285

6.3

reserveforloanlossetc.

2

O.2

3

O.2

2

O.2

1

O.2

8

O.2

6

O.3

sc

O.8

acceptance&guarantee

488

4L6

13

LO

16

2.3

11

1.2

528

12.7

74

4.4

213

4.7

borrowingsfromotherbranches

206

17.6

445

31.0

171

24.5

496

59.3

1317

318

M2

38.9

233

5.2

481

10.7

1171

99.9

1437

99.9

699

99.9

839

1oo,4

4145

1oo.O

1657

99.9

4385

97.2

26

O.6

52

O.04

44

O.03

16

O.02

-4

-O.4

-3oo

-O.1

2

O.1

oo

7,2

o

othersTotal
capitalreserveprofits
othersGrandtotal

1171

100.0

1437

1oo.O

699

1oo.O

836

1oo.O

4143

1oo.O

1660

100.0

en

L9

14

O.3

4509

1oo.O

z

s:

8Z
g,2
:s
Er
ge
$Q
mc
mr
z>
,- H
k5
>z
Z>
ig
VT
>Z
c>
va Z
-a
geF
rr
-

ta v
co m

>

pt

a

46

KENICHI ISHIGAKI

however, try to take advantage of retailing AU dollar deposits and NZ dollar
deposits to Japanese customers. All banks can sell foreign currency deposits

without any regulation of the interest rate. ANZ bank in particular offers
attractive high interest rates on AU dollar and NZ dollar time deposit, of whichmaturity is between one month to 2 years. Although the development of thisbusiness depends directly on the movement of interest rates and exchange
rates, it may become a profitable business in the future because of highJapanese saving ratio and diversification of their portfolios. Australian banks inJapan raise funds mainly from call money and bill sold, borrowings from theiroverseas branches and loans from Japanese fmancial markets. Call money andbill sold means short-term interbank raising through the interbank market. The

Japanese short-term money market is composed of two parts. One is ainterbank market where only banks and other financial institutions canparticipate and the other is an open market where not only banks and financial
institutions but also general corporations and institutions are participants.
Australian banks raise a third of their funds through this interbank market. The

other main route of fund raising is borrowing from their overseas branches.

Banks can now take Euro yen borrowing from their overseas branches or take
Euro dollar borrowings and convert them into yen fund in the exchange market
without any govemment restriction. They arbitrate borrowing in domestic shortterrn markets and in overseas market such as Singapore, Hong Kong, London,
New York (Route M bc). Other route, which is not as important as the above
two routes, is borrowing directly from Japanese banks and non-bank financial
institutions such insurance companies and securities companies. This borrowing
includes long-term borrowings.

A very distinguishing feature is that foreign banks depend on funds raised

not through deposits but short term money market borrowing in the Japanese
domestic market and Euro currency market in comparison with the behaviour ofJapanese banks. The share of deposits in total funds of Australian banks is verylow (3.59o) even in comparison with foreign banks (12.09o). This means that

Australian banks are new comers and, therefore markets do not know themvery well.

b. Use of Funds
The Australian banks invest raised funds mainly in loans and discount (37.79e).

According to my interviews at Australian banks, their main customers for loans
are Japanese companies, other foreign companies in Japan, other banks in Japanand overseas branches and companies. One of the distinguishing features of

FINANCIAL DEREGULATION AND FINANCIAL 47

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

their loan activity is that they can not have Australian customers in Japan. This

contrasts with Japanese banks activities in foreign countries such as Australia.

Japanese banks are able to have Japanese companies as important customers
from the outset of business in foreign countries. This fact is reflected in
the motive to establish a Tokyo branch, one of which is to protect business
relationship with Japanese customers in Australia and to strengthen business
relationships with Japanese companies in Japan. It is, however, not an easy task

for Australian banks to penetrate the Japanese loan market where Japanesebanks have had strong customer relationship with Japanese companies and thedemand for loans are not so strong as in 1960s. Although Australian banks facedifficulties, their main assets are loans and discounts and its share is on

average, above that of foreign banks. The short term loans are dominant intheir loans. Some banks replied that 909o of their loans are short term. Thismeans that the maturity composition of loans is matched to the maturity
composition of their funds.

The second largest asset of Australian banks, on average, is cash anddeposits with other banks. The assets are reserve assets and very short term
deposits. The third largest is customers' liability for acceptance and guarantee.

Call loans are also important (10.79o). Foreign banks including Australian banks

are not only active borrowers in the interbank market but also active lenders.
They arbitrate very eagerly various short-term money markets in Japan and theEuro market and try to take very small margins between lending rates andborrowing rates. Fifth is securities although one Australian bank had only a verysmall amount of securities. Japanese govemment securities are most importantfor Australian banks and shares are not held by them. Some quantities of bills
and short term securities and private bonds are held.

c. Foreign Exchange Dealing

Banks conduct other business such as dealing in foreign exchange besides
lending and borrowing although the business is not necessarily presented on
their balance sheets. It is a very important business especially for Australianbanks in Japan. Foreign exchange dealings of an Australian bank in Tokyo iscomposed of dealing in US dollar-yen, AU dollar-yen, NZ dollar-yen, mark-yen
and so on. US dollar-yen dealing is dominant, occupying approximately 809o of
total foreign exchange dealing, and AU dollar-yen dealing is about 109o.

48 ' KENICHI ISHIGAKIIV ' 3 Some Problems for Australian Banks in Japana. Risk Problem •In operating banking business such as fund raisings, lending and dealing inforeign exchange, they have to face risk mainly exchange risk, interest rate risk

and default risk. Australian banks in Tokyo are supervised by Japanesemonetary authorities and subject to some limits on exposure to exchange risk.
In addition, they are subject to rigid internal limits in order to avoid exchange

loss. They are exposed to exchange risk during inter day and overnight.

They also carefu11y watch interest rate risk which resulted from mismatchingof maturity of borrowings and lendings. Australian banks try to match thematurity structures of lendings and borrowings to avert interest rate risk.
However, if they match completely maturity structures, they are not able to
make profits. Therefore they undertake some mismatching of maturity structure
ei XheM'raliyhOrstpgearkMin'g,thadteiSauiY:sOkntlsS' very important and common for in
OniYGWbanking now but the Japanese economy is still comparatively stable and themain part of loans and discounts of Australian banks are short term, therefore
default risk is not explicit.

b. Main Business and Profits' Problem

wnat is the main business for Australian banks in Japan? The most dominant

and profitable business is dealing in foreign exchange. Trade finance andcorporate lendings business follows. Table 7 shows statements of incomes andexpenses of Australian banks and all foreign banks. If we neglect operating
expenses, net incomes from lendings and borrowings of four Australian banks in

the 1986 fiscal year is only \1505 million. Net incomes from lendings andborrowings of all foreign banks (Table 7, (B + C + D)-(G + H)) is only
\34600 million. On the other hand, net non interest incomes of Australianbanks and all foreign banks in Japan (Table 7, E-J), the main part of which iscomposed of foreign exchange dealing income, is respectively \21100, 102900
million.

If exact data on incomes from dealings of foreign exchange and cost
components were available, net profits attributable to foreign exchange dealings

could be calculated. Unfortunately, we can not get this information. However,
the above data and my interviews with Australian bank officials suggests thatthe margin of lendings and borrowings business for foreign banks including
Australian banks is thin (around O.19o) and foreign exchange business is nowTable 7.

Statement of incomes and expenses (lst April 1986-- 31 March 1987)(\10 mn)(*100 mn)

ANZ

W.P.

NAB

CAB

Total

Foreignbank'(A)Totalordinaryincomes

698

802

319

287

2107

9462

(B)Interestonloans

145

267

111

74

596

3042

2

(C)Interestanddividendsonsecurities

139

130

40

309

529

Ee

(D)Otherinterestincome

2M

258

117

180

819

4404

(E)Otherordinaryincome

151

147

50

sc

383

1485

(F)Totalordinaryexpenses

629

'777

316

325

2047

9275

,g,

(G)Interestondeposits

14

5

9

46

74

984

IE

(H)Otherinterestexpenses

528

538

236

198

1499

6645

(I)Operatingexpenses

80

107

52

65

304

1189

(J)Otherordinaryexpenses

7

128

19

17

170

456

(K)Ordinaryprofits

69

25

4

-38

59

187

g

(L)Extraordinaryprofitsandloss

8

1

9

179

ii

(M)Extraordinarylosses

35

2

36

43

(N)Profitsbeforetax

42

25

4

32

323

(O)Reservefortax

39

17

3

59

194

(P)Profitsfortheterm

3

8

1

-26

129

(B+C+D)-(G+H)

4

112

24

151

346

144

19

31

211

1029

(E)-(J)

g•z

-38

-38

17

g,g

l2

>

$

50 KENICHI ISHIGAKI
dominant in Japan. It also should be noted that eighteen of all foreign banks andone of four Australian banks made losses in Japan in the 1986 fiscal year.

The data mentioned above indicates that it is not easy for Australian banks
and other foreign banks to operate banking business and make profits in Japan.
What kind of dithculties and limitations of Austalian banks face in promoting
banking business in Tokyo? How does the deregulation of the Japanese financial
system effect their business? Prior to the deregulation in the 1980s, foreignbanks had some privilege in comparison with Japanese banks. Japanese
authorities authorized foreign banks to take impact loans from overseas market
and gave preferential treatment of yen conversion to them. They enjoyed theirbusiness in the regulated market. However, the deregulation of the financial
system, especially deregulation of foreign exchange dealings by the amendmentof the Foreign Exchange Control Law in December 1980, deprive theseprivilege of them.

Foreign banks arbitrate between these short term market and Euro yen or
Euro dollar markets. However Japanese call market and bill market are not sodeveloped as the Federal Fund market in the USA. One of reason is thatinterest rates in the interbank market are not necessarily determined by market

forces. Sometimes the Bank of Japan intervenes in order to implementmonetary policy through money market companies and leaving dissatisfied
borrowers in the market. Foreign banks are usually marginal borrowers.
Therefore they often become dissatisfied borrowers. In addition, when theywant to borrow money in the interbank market, they have to prepare collaterals
or, they have to pay a higher interest rate. Usually Australian banks don't haveenough collaterals, can not raise funds in the bill discount market or have to pay

higher interest rates in the call market. Otherwise, they have to go to the Euro

market even when interest rates in the Euro market are relatively high. Under

these conditions foreign banks jn Japan can not make sufficjent profit.
Therefore, from foreign banks' point of view, one of the most important
problem in doing business is the underdeveloped nature of the short-termmoney market.
Another problem for foreign banks is that customer relationship between
lender and borrowers is very strong in Japan. It is important not only in theloans market but also in the deposit market. If foreign banks offer the sameinterest rate on deposit as Japanese banks, they do not necessarily get thesame quantity of deposits. The ceiling on interest rate of CD and large size
deposits was abolished, therefore theoretically even foreign banks might receive
enough deposit if they offered an attractive interest rate on deposits. However

FINANCIAL DEREGULATION AND FINANCIAL sl

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

the spread of interest rates between lending and borrowing is very thin andeven if they succeed in obtaining a large amount of deposits, it is not so easy

for them to seek out profitable borrowers without a strong customer
relationship. Australian banks are rather new and there are not many Australiancompanies and individuals in Japan through various ways such as making use of

their customer relationship with Japanese companies in Australia and traderelations with Japan and Australia and their international network of branches.

The third problem for Australian banks in Tokyo is that Australian banks
are not able to conduct securities business in Japan because of Anicle 65 of the

Securities Transaction Law. In Australia, banks can deal in public bonds. In
Japan, Japanese banks and some foreign banks can deal in government securities

but Australian banks are not permitted to deal in both Japanese government
securities and Australian government securities in Japan. Some Australian banks
wish to sell Australian government securities in Japan. The future of dealings insecurities depend on the amendment of Article 65 of the Security Transaction
Law.5)

Australian banks in Japan have some problems as mentioned above.
However it seems they are not too pessimistic about their business in Japan.
The reasons are as follows. Firstly while they recognize that it is not easy topenetrate the market, the Japanese market is so big that there are manypotential business opportunities. Secondly, although they are facing difficult

problems as mentioned above, three of four Australian banks, in fact, made aprofit in the 1986 fiscal year even though it was the first year of accounting inJapan. One bank made a loss in the year but we can discount this because it

just started business in June 1986. Thirdly, their Japanese branch is an
important link in their international banking network. International lendings andborrowings, foreign exchange dealings, financial futures are activities that
operate continuously around the clock and around the world. An individual bankas a whole may not be able to make a profit in the international banking
business without an international business network. Even if the Tokyo branchitself does not make enough profit, the branch contributes to profit of the bankas a whole. Fourthly, they think that the deregulation of the Japanese financial

system wil1 advance more in the furture and this wi11 be benefical for theirbusiness in Japan.
5) Recently Ministry of Finance has deregulated securities business, especially acceptance anddealing in public bonds, of foreign banks. In addition, it authorized some foreign banks toestablish securities companies subject to no more than 509o ownership. At this stage, Australianbanks are not authorized to conduct securities business in Japan. If they apply for public bonds
business in near future, they will be expected to be authorized to conduct the business.

52 KENICHI ISHIGAKI
V Activities of Japanese banks in Australia6)

V -1 Establishment of Japanese Trading Banks and Merchant Banks
As shown in Table 8, there are three Japanese trading banks, namely Bank ofTokyo Australia (BTA), Mistubishi Bank of Australia (MBA) and IBJ (Industrial
Bank of Japan) Australia. In addition, twenty-five Japanese merchant banks arein operation. Almost all of these trading banks and merchant banks were
established after deregulation in 1985. Since then, many foreign banks andfinancial institutions have established banks and merchant banks in Australia.

Now there are twenty-eight trading banks and more than 150 merchant banks in

The purposes and motives for the establishment of Japanese financial
institutions in Australia are as follows. Firstly, the Australia-Japan traderelationship has been very important, and trade finance including foreignexchange dealings is attractive for Japanese banks. Secondly, Japanese direct

inverstments have increased steadily since the 1970s and many Japanesecompanies already have been operating business. Thirdly, Australia is a
resource rich country and resource-related developments would be expected toincrease in the future, therefore it is attractive for Japanese financial
institutions. Fourthly, especially in the case of merchant banks of Japanese

securities companies, they have the chance to sell Japanese shares andconvertible bonds in Australia. Fifth, there is one hour or two hours timedifference between Tokyo and Sydney or Melbourne. Sixth, deregulation ofentry of foreign financial institutions to the Australian market has had mostimportant direct effects on decisions to establish financial institutions inAustralia. Especially, ease of merchant banks entry was thought as one year
temporary measure so that many Japanese financial institutions hastened toestablish their fully owned financial institutions.

Of three Japanese-owned trading banks, only Bank of Tokyo Australia is

fu11y owned by its parent bank, Bank of Tokyo. MBA and IBJA are jointly
owned by their parents bank and Australian companies. On the other hand,almost all Japanese merchant banks are fully owned by Japanese financial
institutions. As showned in Table 9, the number of employees at three tradingbanks is 95, 52 and 65 including 11, 8, 8, Japanese staff respectively. The
average number of emp!oyees of merchant banks 34 is less than trading banks,

but some merchant bank such as Sanwa Australia have a large number
6) This part is mainly based on my interviews to Japanese bankers and staffs of Reserve Bank ofAustralia and the Treasury in Australia.

FINANCIAL DEREGULATION AND FINANCIAL s3

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA
Table 8.

Establishment ofJapanese trading banks and merchant banks in Australia

TradingBank

MerchantBank

21

12

CityBank
Long-termCreditBank
TrustBank

3541

SecuritiesCompany

LifeInsuranceCompany
3

Total

Table 9.

25

Employees of Japanese trading banks and rherchant banks

TotalNumber

Japanesestaff

Localstaff

BankofTokyoAus.

95

11

84

MitsubishiB.A.

52

88

44

IBJ.A.

65

Average70

NikkoSecu.

10

NomuraSecu.
SanwaAus.
Sumitomo
TaiyoKobe
NipponCred.

21

Average
JapanLifeIns.(rep)* exclude Sanwa

57
9

61

64333441711723613

120

26
917

34

4

30

17

4

13*

4

2

2

54 KENICHI ISHIGAKI
employees 120. 0n the other hand, some merchant bank such as Taiyo Kobe
Australia have less than 10 members. The variance in the number of staff ofmerchant banks is very large compared with trading banks. These figure reflect
not only the difference in business character of trading bank and merchant bank

but also existence of a large variety of business among merchant banks
themselves. Merchant banks are permitted to do everything which tradingbanks can do except checking account business. Although they are subject tothe general company Law and supervision of the National Companies andSecurities Commission, they are not controlled by the Reserve Bank ofAustralia.

V-2 Financial Activities of Japanese-Owned Trading Banks inAustralia
a. Fund Raising

Main sources of funds for Japanese-owned trading bank is raising of money
market funds and raising of Euro money funds in the overseas market. Theyborrow funds in domestic short-term money market, of which players are not
only financial institutions such as trading and merchant banks but also generalcompanies. They also raise short-term funds and sometimes long term funds inEuro market such as Singapore, Tokyo and Europe. They convert foreign
currency funds, typically US doliars into Australian dollars by swap. They

actively arbitrage domestic finance and Euro market finance. 'Japanese trading banks also take deposits denominated in AU dollar,
Japanese yen and US dollar mainly in the wholesale market. In retail market it
is very difficult for Japanese banks to take deposits from Australian customers.

Their balance sheets in 1986 show that, except for Mitsubishi Bank Australia,
deposits are approximate 309o of total assets. Almost all of these deposits arecollected in wholesale markets and short-term deposits. In the wholesalemarket, in fact, deposit taking is not different from borrowing in the short-term

market. An important point is that Japanese trading banks are not able topenetrate retail deposit market at this stage therefore they have to raise almost

all funds through the short-terrn domestic market and Euro money market.

b. Use of Funds
The balance sheets of Japanese trading banks in 1986 indicate that their main

assets are loans and advances. The share of loans to total assets of BTA,

MBA, IBJ is 689o, 599e, 659o respectively. According to my interview atJapanese trading banks, their main customers are not only Japanese companies

FINANCIAL DEREGULATION AND FINANCIAL 55

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

but also Australian companies. Both types of customers have similar weight intheir loans. Their loans to Japanese companies and Australian customer
fundamentally is based on Australia-Japan trade relations, however they aretrying to expand their loans to new Australian customers, especially semi-top
Australian companies because the top Australian companies have already strong

customer relationship with the four major domestic trading banks and haveaccess to oversea market.

. These loans are composed of mainly short-terrn loans, they need to raise
long-term funds. When they are not able to raise long-term funds, they try toborrow short and lend long, if short-term interest rates are lower thanlong-term interest rates. Actually however, short-term interest rates have been

higher than long term interest rates during 1980s. Therefore they have had tolimit their loans to short-term loans.

They also invest some funds in securities including government securities
and semi government securities, however the ratio is not very large. Instead ofholding the securities as a portfolio for long period, they deal in the securities

actively. They have few private bonds and share except their subsidiaries
shares.

c. Foreign Exchange Dealings

Before the floating of AU dollar and the associated removal of almost all
exchange control in 1983, turnover in this market was thought to be around $2
billion dollars per day. Now the total turnover in the Australian market is $ 30

billion dollars (US$ 20 billion) per day. This market size rates well incomparison with the London market (US$ 90 billion per day), New York market(US$ 60 billion) and Tokyo market (US$ 50 billion). Along with thisdevelopment of the foreign exchange market, the market itself is becoming very

competitive. Before deregulation, trading banks -14 in all- were the only
authorized dealers of foreign exchange. There are now 89 authorized foreignexchange dealers. Interbank spread of foreign exchange dealing was reduced
from 10 points pre-float to 7 points in early 1984 and now is five points. Under
this severe competition, Japanese banks try to deal in foreign exchange actively.

Foreign exchange dealings of one Japanese banks is composed of 709o AU dollar- US dollar, and 309o AU dollar-Yen dealing.

d. Main Business of Japanese Trading Banks
The most important business for Japanese trading banks in Australia is loans,especially short-term. This is confirmed by balance sheet as mentioned above

56 KENICHI ISHIGAKI'
and statement of Incomes and Expenses (Table 10). Net interest income ofJapanese trading banks, on average, is higher than non-interest incomes whichwere earned from non-borrowing-lending business, that is off-balance business.

However each bank's performance is different. BTA's main source of income is

non-interest income rather than interest income. On the other hand, IBJA's
interest income and expenses are huge compared with two other banks and its
net interest income is larger than non-interest income. Interest income andexpense of MTB is not as large as llBA, but its net interest income is larger
than its non-interest income. Comparatively speaking, BTA concentrates on feebase business or off balance business more than the other two banks.

At this stage, the main business of Japanese trading banks, as a whole islending rather than off ballance business such as dealing in foreign exchange andgovernment securities. This perforrnance contrasts with the performance ofAustralian banks in Japan. The later's most important and profitable business isforeign exchange dealing (See Table 10).

V -3 Some Problems for Japanese-Owned Trading Banks in Australia
Since the second half of 1985, fifteen new foreign banks have begun tradingbank business, Recently the performance of these new foreign banks have been
published. According to this data, five of the fifteen new banks including one

Japanese bank (IBJ Australia) made losses in 1986. The other ten new banks
made profits, however the amount of profit is small except for Bankers Trust(Australia).

This poor performance of new foreign banks indicates that it is not an easytask for new Japanese trading banks to do business in Australia. What kind ofdifficulties and 1imitations do Japanese trading banks face now in Australia?

a. Small Market Size and Severe Competition

The Australian financial market, especially, the foreign exchange market hasdeveloped since the deregulation, but the Australian economy itself shows slow
growth so that financial demand from real sector is still weak and real market

size is still not very large. Many trading banks, merchant banks, financecompanies, building societies etc. are competing very severely for the same cakewhich is not getting any bigger. As a result, the margin between lending rate
and borrowing rate has been 19oe-39e, however it declined to O.5t--O.79o and is
now O.39o. In addition, as mentioned above, dealing fee is also declining. Under

these conditions, some new banks actively deal in government securities andforeign exchange on their own accounts. Sometimes these business, make bigTable 10.

Incomes, Expenses and profits of J.T.B. and A.T.B.

e

E:

(I)

(ll)

(m)

(IV)

(v)

(VI)

(VII)

Total

Interest

Interest

NetInterest

Operating

Pre-tax

Asset

Incomes

Expenses

Incomes

NonInterest
Incomes

ExpensesProfits

BankofTokyoA.

276.7

16.0

10.5

5.5

7.6

10.4

2.6

IBJAustralia

309.9

49.5

4L3

8.2

1.5

13.3

-3.3

MitsubishiB.A.

245.1

20.8

16.8

4.0

1.9

5.4

O.4

Average

278.0

29.0

22.3

6.3

3.7

9.7

-O.08

EE

A.N.Z.

117L4

54.8

54.2

O.6

15.1

8.7

7.0

#

W.P.

1437.0

65.5

54.3

11.2

14.7

23.5

2.4

g,

N.A.B.

698.8

26.8

24.5

2.3

5.0

7.1

O.2

C.B.A.

835.5

25.4

24.4

LO

3.4

8.2

-3.8

Average1035.6

43.1

39.4

3.7

9.6

IL8

1.5

JapaneseTradmgBanksinAust.

g•2.

Aust.TradmgBanksinJapan

geg

IZ

ii
>

(AU$ million)s:

58 KENICHI ISHIGAKI
profits, but other times take serious losses. For example, National MutualRoyal Bank suffered an unpleasant loss because of government bond dealing.
Under severe competition, a lot of pressure on staff to do well forced them totake extra risk.

Jab a5tSskePtrrOabdii•enMg banks face some risk such as interest rate risk, defauit riskp'and exchange risk. As mentioned above, their main assets are short term loans
and their main liabilities are short-term liabilities. They match the short terrn

and long term maturity between assets and liabilities. Even if there are somemismatching of maturity between liabilities and assets, they are able to avoid
interest rate risk by fioating rate loans. In this sense, they avoid almost allinterest rate risk. They take the risk of mismatching only within short-termborrowing and lending. On the other hand, they try to deal in short-term
government securities and make profits through these dealing on their own
account. In this case, they also take some risk.

Japanese trading banks make loans not only to Japanese affiliated companies

but also to Australian companies. Japanese trading banks are new comers anddo not have enough information of Australian companies. In addition, inAustralia there are not high-quality rating companies such as the Moodies
Investor Companies in USA. Japanese trading banks have to face default risk
and estimate it by themselves. They collect information about the borrowing
firm and send it to head office in Japan. Head office makes the final decision on

the loan. However sometimes they do not have enough inforrnation aboutborrowing companies and severe competition forces them to take extra risk.
Default risk problem under a deregulated and very competitive market is very
important for new Japanese trading banks.

Japanese trading banks deal in foreign exchange actively. If the dealings isbased on customers' order, they earn dealing fee and they do not take any risk.

However, they some times try to take a risk on their own accounts.
Sometimes, this risk is very high.

c. Regulation on Trading BanksThe Reserve Bank of Australia imposes prudential controls on trading banks
even under the deregulated financial system. They are minimum capital ratio tototal assets (6.59e for new banks, 6.09o for the established trading banks), PAR(Prime Asset Ratio) control, SRD (Statutory Reserve Deposit) regillaltion andlimitation on large credit exposure (309o of Total Assets). These prudential

FINANCIAL DEREGULATION AND FINANCIAL 59

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIA

controls have an effect on the cost of fund-raising and limits scope on financial

activities in Australia. In addition, such controls are not imposed on merchantbanks so that these regulations weaken the competitive position of tradingbanks. However it should be noted that the status of trading banks make itpossible for them to raise funds at the lower cost than merchant banks inshort-terrn money markets.

d. Joint Concern Problem

Two of three Japanese trading banks are owned partly by local companies.
Mitsubishi Bank owns 77.59o of shares of Mitsubishi Bank of Australia, andIndustrial Bank of Japan owns 759o of shares of IBJ Australia. This joint concern

has two different effects. One is the problem of management related to joint

concern. Even if the Japanese bank has final decision making power, themanagement within a joint concern is not as simple as in the case of a fully
owned bank. It might take a long time for management to reach a final decision.

On the other hand, in the case of a joint concern, Australian companies which

partly own the bank are able to contribute to the business through theirinforrnation on and relationship with Australian customers. It is not clear at thisstage which effect is dominant for the Japanese trading bank. In the long term,

they must solve the problem.

Japanese trading banks in Australia have some problems as mentioned
above, however almost all of the problem are not applicable for only to Japanesebanks but to for all new foreign banks. On the other hand, Japanese tradingbanks have a comparative advantage over other foreign banks. The JapanAustralia trade relationship is most important for Australia. In addition, Japanese

direct investment is now increasing. Japanese trading banks expand their loanbusiness to Japanese companies and Australian companies based on thisrelationship. In the retail market, they do ,not have a strong position, however

they focus on the wholesale market and they are constructing a lending base,especially trade finance.

On the other hand, their fee base business seems to be not as developed asother foreign banks. They are trying to strengthen this business. At this stage,

the performance of Japanese trading banks compared with other foreign banks is
not very favorable. However the problems should not persist in the long-term.

Some Japanese banks have modest confidence in their ability to penetrate
Australian market in the long-terrn.

60 KENICHIISHIGAKI''
V -4 Some Implications of Financial Deregulation, Especially Entryof Japanese Trading Banks for Japan-Australia Economic Relationship

There are two separate effects, a direct effect and an indirect effect of theentry of Japanese trading banks on Japan-Australia economic relationship.

a. Direct Effect(1) Direct investment into the financial sector increases employment by morethan 500 persons. .
(2) Direct investment and overseas borrowing by Japanese banks contribute toAustralian capital account.

(3) Trade finance services by Japanese trading banks contribute to AustraliaJapan trade because their main business in Australia is loans and discountrelated to trade.

(4)Accumulation of macro and micro level information on the Australianeconomy through banking business, especially loan business may makeeffects on direct investment such as recent real estate investment.

(5) Entry of Japanese trading banks introduces innovation in management andnew finance techniques etc.
b. Indirect EffectIndirect effect means that the effect is difficult to be separated from others
because financial deregulation or entry of foreign banks is a general phenomenon.

(1)It contributes to increase of efficiency in the financial market; margin
between lending and borrowing and spread of dealings between selling andbuying becomes narrower. On the other hand, if deregulation promotes
speculative movement which in turn leads to a collapse, market efficiency

itself vanish. At this stage, the first is occurring, but nobody knows
whether the second will or not.

(2)We can think of a scenario that if other conditions remain unchanged,
financial deregulation increases competition in the market and reduces thecost of finance, that is interest rate on borrowing and financial fees, andincreases real investment. As a result, domestic business conditions

improve and Australia-Japan trade and direct investment frorn Japan
increases. However, in my opinion, the scenario stops on the way. The
effect of change in the monetary sector still remain inside its sector andhas only a weak effects on the real sector.

FINANCIAL DEREGULATION AND FINANCIAL 61

RELATIONSHIPS BETWEEN JAPAN AND AUSTRALIAVI Conclusion

Japan and Australian financial relationships have been becoming closer andcloser against a background that Japan became a big capital export country andfinancial systems in both countries have been deregulated recently. Financial
deregulation has increased capital fiow such as portfolio investment from Japan
to Australia. Australia can raise more easily her needed funds in the deregulatedTokyo market and Japan is able to invest more freely her excess savings toAustralia. It does contribute increase of welfare of people in both countries.

In addition, financial deregulation in both countries made it possible forbanks in each other countries. A main business of Japanese banks in Australia isloan business, especially related to trade, to Japanese subsidiaries and local
customers in Australia. They also intend to expand fee base business, however
it is not necessarily successfu1 at this stage. On the other hand, Australianbanks in Tokyo are conducting mainly international banking business such as
foreign exchange business rather than traditional banking business such as loans

to Japanese customers. More than half of their profits is based on nonborrowing-lending business.
They expected a scenario that financial deregulation increases competition ina market and reduces the cost of finance and, as a result, increases real
investment and international trade between the two countries. However it stops
on the way. At this stage, financial deregulation did contribute capital flow suchas portfolio investments from Japan to Australia, but it did not necessarily resultin increases of trade and real direct investment between two countries.

62

KENICHI ISHIGAKI
References[1] Committee of Inquiry into the Australia Financial System, Inten'm RePort, AGPS,

1980.
[2] Committee of Inquiry into the Australia Financial System, Australian Financial
System, Final RePort, AGPS, 1981.
[3] Federation of Bankers Associations of Japan, Payment Systems in laPan, 1985.
[4] Federation of Bankers Associations of Japan, laPanese Banles, 1986.

[5] Kinyu Mondai Kenkyukai, Koleusaika no Shinten ni Tomonau Wagaleuni Kinyu
Kilean no Arikata, Kin Zai, 1984.
[6] Ministry of Finance, Kokusai Kinyu Kyoleu NenPo, various issues.

[7] Nomura Research Institute, The laPanese Financial Markets under Structural
Change, Apri1 1987.
[8] Nomura Research Institute, Seekingfor the BetterFinancings, April 1987.
[9] Nomura Research Institute, laPan and Inter7iational CaPital Flows, Apri1 1987.
[10] Peat Marwick Australia, 1987 Survey ofFinanciat Institutions Australia, 1987.

[11] Peat Marwick Minato, Published Financiat Statement of Foreign Banle Branches inlaPan, various years.

[12] Reserve Bank of Australia, `The Australian Foreign Exchange Market' Bulletin,

Aug. 1987.
[13] Reserve Bank of Australia, RePort and Financial Statement, various issues.

[14] The Review Group, Australian Financial System, AGPS, 1984.
[15] Treasury, `Japan and Australia-Trade Flows' the Round-uP, June 1985.
[16] Treasury, `Japan and Australia-Financial Flows' the Round-uP, July 1985.

KEYNES' USER COST AND THE THEORY OF
INTERNATIONAL TRADE*
Kazuo SHIMOMURA

Abstract
A unit-cost function is generated from the constant-returns technology in which
exhaustible resources are indispensable as factors of production. It depends on

expected as well as current factor prices. By using the unit-cost function, weconstruct a general equilibrium model involving exhaustible resources in termsof cost functions and examine how the expected variables may affect factor
price, the outputs and the pattern of international trade.

1. Introduction
The purpose of this paper is to present a fairly simple model of international

trade involving exhaustible resources. So far there have been a lot ofcontributions to the topic of exhaustible resources, and we do not insist on thenovelty of the topic itself. The emphasis is laid rather on the way we deal withthe topic.

Now let us outline our main idea. Suppose that there is a firm which owns

some finite volume of an exhaustible resource (say, crude oil) and which
produces a good (say, refined oil) by combining the resource with non-exhaustible inputs (say, capital and labour). Then, the following question emerges: what

cost should the firm incur at each period? In a word, what is the average costof the product which becomes equal to the price of the product undercompetition?

It is obvious that what the firm has to pay for the current employments of"The present paper was completed while the author was staying at the University of New South
Wales during 1985-1986. The financial assistance from the University and Japanese Ministry of
Education, which supported rny stay there is quite acknowledged. The valtiable cornments andsuggestions from professors M.C. Kemp and N.V. Long have improved the present paper verymuch. The author is also indebted to T. Hagiwara, T. Nakatani and Y. Ochi for usefu! comments.
Needless to say, the author alone is responsible for all errors possibly remaining in it.

64 KAZUO SHIMOMURA
the non-exhaustible factors of production is at least a part of the current cost.

However, it needs further consideration to answer the question of whether thispaymet is the whole of the current cost.

Now, in order to make our argument clearer, we assume, for the time
being, that the firm cannot either sell or purchase the exhaustible resource fromoutside. That is to say, the firm can use only the initial stock of the resource
for the future as well as present production. Then, if the firm raises the level ofpresent production and if, as a result, more of the resource is consumed during
the current period, then the future production-possibility of the firm might be

reduced. As a result, the capital-value of the firm at the end of the current

period might be also reduced. This reduction rnust be regarded as the otherpart of the current cost. Even if the firm is supposed to be able to buy and tosell the resource, the foregoing argument can be established as far as the
expected prices take on some particular values, as will be stated.

This cost concept is not entirely novel. It is nothing but the one which J.M.

Keynes regarded as user cost 50 years ago. See Chapter 6 and its Supplementin Keynes' General Theoirv.

By using the current cost which is the sum of the two cost-concepts justmentioned, one can construct a fairly simple general equilibrium model in termsof cost functions and then one may be tempted to examine the implications of
exhaustible resources for some important relationships between the terms oftrade and the rewards of the non-exhaustible factors of production and between

the volumes of the products and the (non-exhaustible) factor-endowments.

Furthermore, one may wish to know how the existence of the exhaustible
resource affects the pattern of international trade. These things are consideredin this paper.

In Section 2, the cost function of the firm involving exhaustible resources

and, based on the function, its supply curve are obtained. In Section 3, a

two-commodity, two-primary factor and one-exhaustible resource model isformulated, and some comparative statics propositions are obtained.

2. Cost Function
Now, suppose that the firm examplified in the previous section stands at the
beginning of the current period (say, period O) with the initial stock of theexhaustible resource, Mo. The firm, as a price-taker, is facing with the current
price of its product, po, the current wage rate, wo, the current rental rate, ro,

the current resource price, qo, and their expected variables in subsequentKEYNES' USER COST AND THE THEORY OF INTERNATIONAL TRADE 65
periods; Pt, wt, nt, and qt, t l 1• In what foilows, the technology of production

is supposed to be unchanged over time and to be described by the production
function(1) Y, == F[L,, K,, E,] t)O
where Yt the output of the firm at period t, Lt the volume of labour employedby the firm at period t, Kt the volume of capital hired and Et the volume of theresource extracted at period t. The production function is assumed to be aconcave, constant-returns function.

As stated in the previous section, PVo Lo+ro Ko is no longer the whole ofthe current cost. Consider the optimum problem[PO] L,,Kl}},a.,K,., -V -== ,iil,Rt{Pt F[Lt, Kt,Et]-wt Lt-rt Kt-qt xt]-q, x,

Xt ;t20sub. to Mt = Mt -,+Xt -,-Et-, t k 1
Mo,Eo; given, Lt l O, Kt ;O, Et lO, Xt iO
where R i itp and p is the rate of time preference(>O). Xt is the net
purchase of the exhaustible resource at period t. Note that in this problem Eo isregarded as a parameter. The optimum value of the objective function V is, if

exists, the capital-value of the firm, which is measured (evaluated) at the
beginning (the end) of the current period, under the condition that the firm

spends E,-amount of the resource; The optimum value may be represented at

V[Mo -Eo]. Thus, V[Mo]-V [Mo -Eo] can be regarded as the other part ofthe current cost. Thus, the current cost is(2) C ! Wo Lo +ro Ko +{ -V [Me]-V[Mo -Eo]}
REMARK: Using Keynes' terminology in General Theory, (2) is Prime cost. The
first two terms of the RHS are factor cost, and the last one is user cost. In fact,

the last one exactly corresponds to his definition of user cost. See Chapter 6 inGeneral Theory.

Now, let us obtain {-V[Mo ]--V[M, -Eo]}. Defining
f[l,, le,] E F[l,, le,, 1 ]

N Lt

l, =E
and

- Lt

let=:-IZi';

one can reformulate[Po]as

66 KAZUO SHIMOMURA
oo ,[Po ]tmax -V -= 2 R'{flt Et -qt Xt }-qo Xoxt,t)o t--1
Et,t)1

sub. to M, = M, -, +Xt., -E,-, t2 1
M, 2 O, X, iO
Mo, Eo; given

where,Bt i IJ,}F,X, {Ptf[lt, let]-wt lt -rt let}Let us concentrate on [Po]' The first problem which we come across isunder what conditions the optimal V can be finite.
LEMMA 1 The optimal tz is finite if the following condition is satisfied;[A] For t)- 1,

either qt or Bt is not greater thanmin{qt, R+iqt-i, ......, R"qo}
Proof At first, suppose that[A]is not satisfied.
That is,(i) ther exists t*() 1)such thatfit* > min{qt*, R-iqt*" i ..., R-t'qo}

and/or(ii) there exists t**(l 1 ) such that

qt** > min{R"qt*-* i.,... R-t"qo }If (i) is established, then for some integer le,Og fe <t*,flt*>R-(t"-k)qk.

Therefore, V can be infinite by buying an unlimited amount of the resource
during period k and using it in production during period t*. On the other hand,
if (ii) is established, then for some integer k,O $h < t**,qt**> R-{`'"'k)qfa.

Therefore, V can be jnfinite by buying an unlimited amount of the resource
during period le and selling it during period t**.

Next, suppose that [A] is satisfied. Suppose also that for some tl 1, Xf<
O. We have two possibilities:(a) Rtqi = Rt-' qi.i = ... = qo(b) Rt qf $ Rt -i qf-i S ... $ qo and for some le ; O $ k < t,
Rt-k4t-k < Rt-k-' qt--lemi

If (b), then one can choose new(Et,Xt)which makes Mv greater. That is, byletting x7eW be zero and lettingX?EWle-ibexO-,irdk-,+x7ids -v"ewbecomes greater than

67
KEYNES' USER COST AND THE THEORY OF INTERNATIONAL TRADE-VOid.Let us repeat this as far as there exists Z such that Xf<O with (b)•Moreover, since for any t) 1 there exists t(> t) such that E7- X7 ) O(otherwise 7 wM be fmite), one can easily let E, - X, ) O for any t ) 1 bychanging Xt properly and without reducing the level of V. Then, we arrive at(Xt, Et)where for Xt ) 1(a) Xt l O or Xt < O with (a)and(b) E, - Xt ) O for any t) 1
For this(Xt, Et),we havei7" .= E, D-O., (R'P, E, -R' q, X, ) - qo Xo$E, :i R' qt (Et - Xt )- qo Xo

S qo(Et:i Et HE,:iXt -Xo)
S- qo( Mo -Eo )<cx)

as was to be proved. Q.E.D.
Let us suppose that condition [A] holds, which implies that qo 2 x =- Rqi. If

qo > x then, referring back to problem[Po]',the best thing the firm can do issell Mo - Eo during the current period. Thus, "user cost" must be V[Mo] V[Mo -Eo] =qo Eo. Next, let qo be equal to x. Then, it makes no differe,nce

in V whether or not some portion of Mo - Eo is kept for future sale orproduction. Hence, we have the following lemma.

LEMMA 2 Suppose that [A] in LEMMA 1 holds. Then

(3) V[Mo]rmV[Mo-Ee] =: qo Eo
From (2) and (3), the current cost is(4) C =- VVo Lo+ro Ko+qo Eo
One can obtain the current cost function by solving the optimum problem[Pi]min (4)
Lo,Ke,Eosub. to Yo $ F[Lo, Ko, Eo][Pi] is simple enough to yield the following proposition.

PROPOSITION 1 Undet condition [A] of LEMMA 1 the current cost functionis(5) C[wo, ro,4o, Yo]= c[wo, ro, qo]Yo
where c[wo, ro, qo] ii ,Ip2,n. wo L+ro K+qoE sub to 1 g F[L, K, E].

KAZUO SHIMOMURA

os

Intuitively, it

may be obvious that the costfunctioncan be depreted

as in

Figure 1.

Figure 1
c
tD
tt

B

t

tl'
At

G//

/

/

t

OFAB: the cost function
OGAB: C(wo, ro, qo) Yo
OFAD: min woL+ ro K

Z

L,K

sub. to Yo $ F(L, K, Mo)

/

/

/

/

/

/F

o•

Yo

3. A General Equilibrium Model
Based on the cost function presented in the previous section, let us construct a

simple general equilibrium model of a small open economy. Suppose there are
two industries in the economy. The first industry prgduces a good (the firstgood) by spending an exhaustible resource with the aid of labour and capital, andthe second industry the second good with the aid of labour and capital. Thus
the general equilibrium model to be examined is just the ordinary HeckscherOhlin-Samuelson model except for.the additional assumption that this is thefirst-industry-specific exhaustible resource. That is, each firm in the firstindustry owns some amount of the exhaustible resource and it can be sold andbought within the firms in the first industry.

Now let us formulate the model mathematically. Suppose that condition [A]in LEMMA 1 holds. There can exist the following types of general equilibrium.

[a] p = ci (wo, ro, qo)

1 = c2(wo, ro)
L = cb (wo, ro, qo)•Yi+cZ (wo, ro)Y2
K= c; (wo, re, qo) Yi+c2, (wo, ro)Y2

E= di}(wo, ro,qo) Yi = Mo, qo>x
unknowns ; wo, ro, qo, Yi, Y2, E

KEYNES' USER COST AND THE THEORY OF INTERNATIONAL TRADE69[b]p = ci (wo, ro, qo)

1 = c2(wo, ro)
L = ch (wo, ro,qo) Yi+cZ (wo, ro) Y2
K == c; (wo, ro, qe)Yi +cZ (wo, ro) Y2

qo= x
E = Åëb(wo, ro, qo)Yi < Mo
unknowns ; wo, ro,qo, Yi, Y2, E

where P theprice of the first good measured by the second

w thewage rate measured by the second goodr therental rate measured by the second goodi acicy =- blgood.

, i= 1,2 y= wo, ro,qo

Lthe workforce
K the
E the
Y,, i=

volume of capitalcurrent extraction of the exhaustible resource

1, 2, the volume of output

Which equilibrium
system [a] or [b] is established depends

on the levels

and x. As will be shown, there exists a border on (Mo,x)plane which d ecidesof Mo

which of [a] or [b] is established. See Figure 2.

Figure 2x
Nthough both [a] and [b] are possible, [a] is not so interesting as [b].

For,[a] implies that the whole initial stock of the resource is used up withinthecurrent period. Thus, in what follows, let us concentrate on [b].

REMARK Let condition [A] not hold. If qo <x then there istheexcess-demand for the resource, and qo must rise until qe 2 x. As in [a],thewhole initial stock of the resource is used up within the current period.

70 KAZUO SHIMOMURA'
Focussing on [b], one may verify that the two relationships, the one

between commodity prices and factor-rewards and the other between thevolume of products and the factor endowments, depend on the (non-exhaustible) factor-intensity-conditions. That is, if P rises, then the reward of the(non-exhaustible) factor which is intensively used rises. However, there is no"magnification effect." For c'( ) is not homogeneous in wo and ro.

In what follows, let us examine the implications of x, for factor rewards,

the volume of products, the volume of current extraction and the pattern oftrade. Totally differentiating the equations in [b],
[b]

'

(6)

cb c; OOO dwo -ce
cZ c9 OOO dro' O
CwwYi+c2tvwY2 cbrYi+cZrY2 cb CZ O dYi == -chqYi dqo
C;wYi +CZ,rY2 c;rYi +C2rrY2 c; c2r O dY2 -c}qYi

cew Yi ce, Yi ce O-l dE -ceq Yi•1-84= -cbqYi dx-c;q Yi
where c}, =- sOx2Ce, 'i= i,2;x, y= w, r, q.

Factor rewarcls From (6), we havedwo--tc;(7)

dx ch c2r -ck cL

dro - ce c?
dx cb c2, -c2. c;

Noting that c} > O, one may immediately obtain the propositjon.

PROPOSITION 2 The change of expectation which causes the rise of x makes
the reward of the fator which is intensively used in the first industry decline andthe reward of the factor which is not intensively used in the first industry rise.

Volume ofproducts From (6), we have

71
KEYNES'USERCOSTAND THE THEORY OF INTERNATIONAL TRADE:ii=7Co cz c?
cZ clvw Yi +cZ to Y2 cbr Yi +CZ,r Y2

C? C;w Yi +C;tv Y2 C;r Yi +C;r Y2(8)-J/!ggLg!li=glg!ocic2o}c2c'].gth-2[!Y!

[cb c?-cZ c;] ci

where d E [cbc;-c;cZ]2>O andoSry is the Allen-Uzawa elasticity of
substitution. One can prove that the first term on the RHS of (8) is negative.
This term represents the effect of x in P= ci[we, ro,x] on Yi., The effects ofx in the third and fourth equations in [b] on Yi are represented by the second
term on the RHS of (8), which is negative if obq == o>q > O.

g\2=t' o ck c?
C lv clvw Yi +ck tv Y2 c;w Yi +c9w Y2(9) c; chrYi +cZrYT2 c;rYi +C2rrY2-g/g2g=!leQgg-gLgl!o a']cicici[cb c2r-ck c; ]c'

One can prove that if abris positive then the first term of the RHS of (16) is
positive.

PROPOSITION 3 If o'., > O, X, Y= w, r, q, X = Y and obq = a;q, then thechange of expectation which causes the rise of x makes the volume of the first(second) good decrease (increase).

Volume ofCurrentExtraction From (6), we have
' -ldE(10) d.=.,A O c;-pc; chc;-Pc? c}rYi+c9rY2 C;qYi

C} C;q Yi C;r Yi
which can be proved to be negative. Thus, one obtains Figure 2.

PROPOSITION 4 The change of expectation which causes the rise of x makes
the current extraction of the resource decline.

Pattern of Trade Assuming homothetic preferences for the two commodities,

we haveY,(11) D(P)=-yl,
D'>O
as the autarkic equilibrium condition. See Figure 3. L' can be regarded as a
Se:.:els,E'l{g,.f"g.ct&'g.o,fgiJ,tegg•,T,2es};h,s.g.q"mefi"7,,trh,?e.,zh,?.,w,3.bg,t?•fs'.o.el

nse for gtvenP. Thus, the new equilibflum can be shown by a pomt 1ike E m

KAZUO SHIMOMURA

72

Figure 3
D(P)

1 Y2
Yl

P
Figure 3. Thus, we have(i2) ft.>O
Now suppose that there are two countries in the world, with the same
preferences, technology and (non-exhaustible) factor endowment and supposethat each country does not use up the whole amount of its stock of theexhaustible resource during the current period. Then (12) implies that if x is

greater at home than abroad then the home country exports the second goodand imports the first good.

PROPOSITION 5 If the firms in the home country expect the future P (w andr) to be greater (smaller) than the foreign firms expect, then the home country
imports (exports) the first good.

4. A Final Remark
Kemp and Long [Essay 13, 14 and 15 in Exhaustible Resources, OPtimality andTrade] exampled the implications of exhaustible resources for the theory ofinternational trade. In the present paper the way of examining this topic isdifferent from theirs, i.e. we adopt a cost-function approach.

Compared with Kemp and Long, the production technology which isassumed here is more general. For, they assume that production functions areof a partially-separable constant-returns kind. In the present paper, some
propositions are established under fairly general production functions and almost
all propositions are under some slight restricitions on the Allen-Uzawa elasticity
of substitution.

The model constructed in the present paper is of a temporary equilibrium

KEYNES' USER COST AND THE THEORY OF INTERNATIONAL TRADE 73
kind; well-known from Hick's Value and CaPitat. As a result, the implications of

exhaustible resources for current variables are entirely represented by an
expected variable, x, which is regarded as exogenous. On the other hand, Kemp
and Longs' model is of a perfect-foresight kind, and the expected variables are,as it were, endogenous.

References[1] Kemp, M.C. and N.V. Long (1980), Exhaustible Resources, OPtimality and Trade(North-Holland).

[2] Keynes, J.M. (1936), The General Theo7y of EmPloyment Interest and Money(Macmillan).

A NOTE ON INTERNATIONAL TRANSMISSION OF
DISTURBANCES AND POLICY

INTERDEPENDENCE UNDERFLEXIBLE EXCHANGE RATES*
Hideki IzAwA

I. Introduction'
Many countries have undoubtedly become more and more interdependent
through international trade and finance. After the collapse of the Bretton Woods

system, several advanced countries adopted the flexible exchange rate systemin the early 1970's. The flexible regime has not performed as well as had been

expected. It could not insulate the domestic country from monetary and realshocks abroad. The policy-maker in each country can not ignore these
disturbances transmitted from other countries.

Hamada recognized the importance of the interactions between two
countries and analyzed the strategic behavior of monetary interdependence,
applying concepts of game theory. Canzoneri and Gray (1985) developed thegame theoretic aspects that are played by the monetary authorities in two
countries because of the existence of spillover effects of monetary policy.

It is well known that in the absence of policy coordination or binding
precommitment with punishment, the non-cooperative Nash solution is inferior
to the cooperative Pareto optimum. However, each player has an incentive todefect from the Pareto solution. There is a difficulty in agreeing with andenforcing international policy coordination; for example, historical incidents suchas the competitive devaluation in the 1930's and the beggar-thy-neighbor policy.

The purpose of this paper is to examine the insulation effect in a small open

and two-country macro models under flexible exchange rates and rational
expectations. Then the role of wage indexation is emphasized, extending Gray's

paper (1976) on the closed economy. In the following sections, (i) the
asymmetric model consisting of a large country and a small open country and (ii)'
*I would like to thank Carl Christ, Louis Maccini for helpful comments andsuggestions. Remaining errors are my own.

76 HIDEKI IZAWA
the symmetric, identical two-country model are presented. The main conclusions
and further research suggestions are given in the last section.

ll. The Asymmetric Economies Model
We shall assume that there is one large country which is treated as if it were aclosed economy, and one small open country which does not affect the variables

in a large country. Also, there exists perfectly integrated goods and bondmarkets. Thus purchasing power parity and uncovered interest rate parity holdover tlme.

The model is as follows. The behavior of the system is expressed indeviations from an initial steady-state equilibrium.

The Large Country

Yt*=ai Yt* -ct2[lt*-(EtPt*+i-Pt*)]+ut*a, ==marginal propensity to consume O < ct, < 1(A)
Mt*-P,* = B, Y,*-P, I,*

Yt* = r[Pt*-Et-i Pt*]+wt*
The Small Open Country

Pt = Pt*+St
Mtm Pt : ni Yt-n2 It(B)
It = It*+Et St.,-St
Y, = S[P,-E,-, P, ]+w,
Notation:y == real output as a deviation from the natura! rate level;p = price of domestic output;s == exchange rate (measured in terms of units of domestic currency perunit of foreign currency);

l == nominal interest rate;

M = nominal money suppy;
E = mathematical expectation operator;u = demand shock;w = supply shock.

A NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 77
INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES
a*, w, and w*have zero means and constant variances. Each is serially
uncorrelated and statistically independent of the other.

Foreign variables are denoted with asterisks.
All variables except interest rates are expressed in logarithms.

I*and Pt* are exogenous to the small open country.
The system (A) can be expressed in matrix form.

1-cti ct2 a2 Yt* [ct2EtPt*+i+ut*

C' i, -g2 ;,Z' ==[-rE,-YSt"+wf

Assuming Et-i Pt*+i==O fOr i= O, 1, •••, for all tin order to obtain a stablerational expectations solution for Pt*.

The solutions are the following:Yt* = i {ra2 Mt"+rP2 ut"+a2(1+32)wt*]
Pt* =: t {ct2 Mt*+B2ut*-[(1-ai )32+ct2 fii]wt"}

It" =-i{[ct2+r(lrcti)]Mt*-(1+rfii)ut*+[(1-ct,)-ct,B,]zvf}

where d= ct,(1+fl2+rfii)+r(1-ai)P2 > OThe system (B) can be expressed in the following form:

O1 -1 Y, P,'
ni 1 n2 Pt = Mt +q2 It*+n2 Et St+i

1 -6 O St -SE,-,P,+wt
We know that Pf is identically and independently distributed for all t. Hence,

E,., P, = E,-, S, (E,", P,* = O)

78 HIDEKI IZAWA
Pt and St are generated by a simple stochastic process consistent with rational
expectations. It implies Et-i Pt = O, Et St+i = O•

Solving for Yt, Pt,and St,

Yt : IS-[n26Pt'+op26It*+6Mt+(1+ny2)wt]'

Pt = 2)-[n2 Pt'+n2 It"+Mt'ni wt]
St = llJ-[-(1+ni 6)Pt'+op2 lt*+Mt-ni wt]

where D == 1+rp2+ni6> O•
Substituting Pt* and It*,Yt = Åë, M,+ Åë2 Mt* + Åë, ut*+Åë4 Wt+Åës wt*

where 6
Åëi =i> On2(1-a,)<O
6r
Åë2=D•dÅë, == -BZ:.{li6A(1+fi2+rBi) > oÅë,..:ILffza+ >o6Åës = - Dop2. d (i-a, )(1+fi2) < o

P, = e, M,+e, M,*+4, u,*+4, wt+e,wt*

where ei = ll)' >og2 = - 131.-l;A (1-cti) < oe3 == Dop.2d (1+fi2+rp,) > oe, -- -Zs-< o
4s = - lziftl.-zd (1-ct,)(1+fi,) < O

S, = pt, M,+pt,M,*+pt, ut*+pt, wt+ptswt*

A NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 79
INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES

where Lti=S>O
1 {rp2[at2+r(1 -cti )]+a2 (1 +ni 6)} < O
pt2 = - D.d
pt3 = Dl. d {n2(1+rPi)- fi2(1 +nyi 6)} i opt4 ==t> O
pts = 1-D.d {n2(1-ai-a2 fli)-(1+q, S) •(P2-ai fl2+a2 fii)} <> O
The increase in M leads to increases in Y and P and depreciation of theexchange rate. On the other hand, the increase in M* leads to decreases in Y
and P and appreciation of the exchange rate. It follows that the increase in M*

causes an increase in P* and a decrease in I*, but the impact of M* on I* islarger than the impact of M* on Pt Therefore, the decrease in I* results indecreases in both Y and P through appreciation of the exchange rate.

We assume that the monetary authority in the small open country chooses
its money supply so as to minimize the following loss function, taking the money
supply in the large country as given.

The optimization problem is

MinL=0Y3+(1-e)P3 O<e<1.

Mt

The first order condition is

oaML -- to, M,+to, M,*+tu,u,*+w,w,+oswt* = O

where wi = eÅëi dii+(1-e)Ei 8i (i -- 1, ...5)
tui > O, to2 < O, te3 > O, 04i O, to5 < O•
The optimal monetary policy rule isth, = L -L (to, M,*+to,u,*+o,w,+to,wt*)(L)1

80 HIDEKI IZAWA
And the reaction function for the small open country is

0th'* .. -91L, > o.

OM, Q)1
The reaction function has a positive slope. It implies that a monetary expansion

in the large country induces a monetary expansion in the small country in orderto stabilize the economy. It is noteworthy that the large country is by definition

independent of the monetary policy in the small open country.

We have employed a Lucas supply function. However, as Flood (1979)
pointed out, the assumption of a Lucas island model may be inappropriate forthe open economy. Rather, the aggregate supply function may be justified interms of the wage contract model based on Gray (1976). It still gives us anaggregate supply function which resembles a Lucas supply function, but thecoefficient (6) of the unanticipated price movement depends on the degree ofindexation, R (see Appendix). In turn, the slope of the aggregate supply function

has important implications on whether the fiexible exchange rate regime
effectively can insulate domestic output from foreign disturbances.

We can determine what degree of wage indexation will minimize the loss
function (arbitrarily chosen as a variance of Yt) for the small open country under

the flexible exchange rate regime, following the paper by Flood and Marion(1982).

Mi'nL =: E(Yb assuming zero covariances= D21. A2 {A 262ok+ op g62r2(1 -ct, )2a:.

+n:62(1+fl2+rBi)2oZ*+ri2(1+n2)2oZ+oZ S2(1 -ai )2 (1 +fi2)2oZ*}
where a2 stands for a variance.

Since S is a linear function of a, choosing the optimal value of a isequivalent to choosing the optimal value of 6. So, setting gi/-= O, the optimalvalue of 6 is

S- id2(1+ 2)o2.

A2oZ+o:r2(1-ati)2a:*+rp;(1+P2+r,ei)2a;*+ny3(1+cti)2(1+,e2)2aZ*'
degree of wage indexation is obtained by
From 6= 1 ,i"(1-A), the optimal'
A =: 1- ,-ct.S.

A NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 81
INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES
Because of OAA< 6< 1, 1 t 1 means that the optimal degree of wage indexation
is not complete but partial. If a takes a value of unity, then 6 becomes zero andan unanticipated price prediction error does not affect Yt; only domestic supply

disturbance affects Yt. In this case, full indexation permits the domestic
economy to be insulated from all foreign disturbances, but does not minimize
the variance of output. On the other hand, the optimal partial wage indexation
does not provide the full insulation effect, but can minimize the loss function.

We will proceed to the symmetric two-country model.

III. The Symmetric Two-Country Model
The theoretical framework is based on Turnovsky and d'Orey (1986b) but
different in terms of incorporating wage indexation. It deals with two perfectly

symmetric, identical countries with imperfect substitutability of goods andperfect substitutability of bonds.

The system is expressed in deviation form, subtracting the steady-state
equilibrium.

Yt = cti Yt-a2{lt-[Et Ct+i-Ct]}+a3(Pf+St-Pt )+ut. (1)Yt* = ai Yt*-ct2{It*- [Et Ct"+i-Ct" ]}-a3 (Pt" +St-Pt )+ut'. (Do< ct, < 1, a, > o, ct, >o

Mt -Pt=Yt-fi2 It +vt. (2)M,*-P;,iC= Y,*-P, I,* +v,*. fi,>O (2)I, =: I,*+E, S,.,-S,. (3)Yt = n(Pt-Et-i Pt )+r2(Et-i Pt-Et-i Ct)-2ri (Ct-Et-i Ct )+wt. (4)Yt*= ri (Pt'-Et-i Ptl'`)+r2(Et-i Pt*-Et-i Ct*)

-Rri (C t*TEt-i Ct")+wt". (4')
1-ct
rl =ctC,=•e P,+(1-e)(P,'+S, ). (5)C,*= eP,*+(1-e)(P, -S, ). (5')

HIDEKI IZAWA

82

Endogenousvariables:

Y,, Y,*, I,, I,*)•

P,, P f' S,, C,, Ct*'

Notation:Y = real output as a deviation from the natural ratelevel ;

P = price of domestic output;

C = consumer price index;
S = exchange rate (measured in terrns of units ofdomestic currency perunit of foreign currency);

I = nominal interest rate;

M = nominal money supply;
E == mathematical expectation operator;u = demand shock in output market;

v = demand shock in money market;
w = supply shock in output market;a = a degree of wage indexation;u, v, and w have zero means and constant variances. Each is serially
uncorrelated and statistically independent of the other. Foreign variables aredenoted with asterisks.
All variables except interest rates are expressed in logarithms.

Equations (1) and (1') represent the goods market equilibrium conditions.

Demand for output depends on the income in the home country, the expected
real interest rate, terms of trade (or relative pfice), and stochastic disturbancein demand. Equations (2) and (2') describe the money market equilibrium
conditions. The money supply is determined exogenously by the monetary
authority under a flexible exchange rate regime. We assume that the elasticity
of money demand with respect to income is unity and that the residents of eachcountry do not hold the foreign currency. I use here c(C*) as a deflator insteadof P(P*)which they employed, although they state, "Little would be changed,
except for additional detail." Equation (3) describes the uncovered interest rate
parity condition. Equation (4) and (4') describe aggregate supply functions. (Seemy another paper in this Review). A stochastic disturbance in supply is included
additively.

An assumption of rational expectations yields, in deviation form,

Et Pt+i = Et Pt*+i = Et St+i =O for all t
The solutions for Pt, Pt*, and Stcan be expressed by the following matrix.

A NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 83

INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES

abb
b a -bP*c -c dsP-(i-ct,+7/)w
u- !L'(-M+v)fi2* ct2= (-M*+v*)-(1-ct,+f/)w*

B2u-'(M-M*)-(vLv*)-(w-w*)
where

a = (1 -ai + :1)ri (1 -2e )+ ct2(ilT, +e)+ ct3 > O
b = -(i -cti+ iiil )ri R (i 'e )+ ct2 (i -e )- a3 ,lg,9.i.g

c = 1+r, (1 -ae )+r, 2(1 -e) > od = -2ri 2(1 -e )•+ fl2 > O

assummg
Hence,

det > O.

Solvingfor' Pt,Pi and St, weobtainPt= Åë, Mt +Åë2 Mt*+Åë3 Ut+di4 Ut*-ipi Vt -Åë2Vt*+Åës Wt+Åë6 Wt*•

Pt*

= Åë2 Mt +Åëi Mt*+Åë4 Ut+Åë3Ut*-Åë2 Vt-ipi Vt*+Åë6 Wt+Åës Wt*•st= vi (Mt - Mt*)+n2 (utTut* )- nyi (vt-v t*)+n3 (wt -wt* )•Åëi :=: liÅí,5Zt {i}tl(ad-bc)-b(a+b)} >owhereÅë2 = (}l,Sl { i}tl b(c+ d)-b(a+b )} < oÅëi > la521

Åë3 = -z t}zt (ad-bc) > oÅë4 = Iiiil;2t b(c+d) > oÅës == :i}t;I {(1'ai+IStl)(ad-bc)-b(a+b)} < oÅë6 = 1Åí,51t {(i ff ai + li;tl )b (c+ d)-b(a +b )} < oHIDEKI IZAWA

84

ni = i,t {(a4b )(- 'iltl c+ a+b)} > on2 -1= det c(a+b) <O
n3 = iet ((a+b)[(lpcti+Sl)c-(a-b)]} <> O

Solving for Yt

and Yt",Yt == pt, Mt+pt, Mt*+pt3ut+pt4uf-pt, vt-pt2vt*+pt5 Wt+pt6 Wt*
Y;tl` == pt, Mt+pt, Mt*+pt,ut+pt3Ut*-pt2Vt-pti Vt*+pt6 Wt+pt5 Wt*

wherept, = r,{(1-ae)Åë,-R(1-e)(Åë,+rp,)} >< O
pt2 = r, {(1 -Re )Åë2-R (1 -e)(Åë,-ni )} >< O

,ct, = r, {(1-Re)Åë,-a(1-e)(Åë,+n,)}pt, = r, {(1-Re)Åë4-R(1-e)(Åë3-n2)}pt, = r, {(1-Ze)Åë,-R(1-e)(Åë,+rp,)}+1
pt, == r,{(1-Re)Åë,-R(1-e)(Åë,-op,)}

It is seenthat output in each country depends on domestic money,

and supply shocks as well as those shocks abroad. The
stochastic demandcoefficients are

symmetric given the structure of symmetric economies. The

As Canzoneri and Gray (1985) specified, there are cases
signs are ambiguous.
of syrnmetric-posltlve'' spillover (locomotive) effect of monetary policy and.
' spillover (beggar-thy-neighbor) effect. The sign of thesymmetnc-negatlve
spillover effect(pt2) depends on the relative importance of some channels
through which a country's monetary policy is transmitted abroad; a channel
through terms of trade, a channel through the interest rate because of perfectcapital mobility.

An expansionary monetary policy in the domestic country generates infiation
and a depreciation of the domestic currency against the foreign currency. In thecontext of interdependent economies, a game-theoretic strategy of monetary
policy results from the lack of independence from foreign disturbances evenunder the perfectly flexible exchange rate system.

When a degree of wage indexation is fu11 (R =1), both pti, and pt2 becomeA NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 85
INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES
zero. Then, Yt and Yt* are independent of monetary shocks (Mt,Mi vt, andvt* ). However, in the presence of demand shocks (utand vt*) and supply shocks(wt and wt*), a full wage indexation can not stabilize Yand Y*. An optimal wage

indexation must be chosen, depending on the nature of the shock and a loss
function, as non-cooperative or cooperative equilibria. We will analyze theproblem in details in the near future.

IV. Concluding Remarks
We have examined in the asymmetric and symmetric models the internationaltransmission of disturbances and policy interdependence under a flexible
exchange rate system. Furthermore, we considered the implication of wage
indexation which can minimize the loss function.

' We discussed the two country situation. But, there are in the world morethan one hundred countries which differ in terms of the size and structure of
the economy. If every country eooperates, the member countries are better off
in a Pareto optimal sense. However, each individual country has an incentive tocheat on the agreement. In an infmite repeated game rather than a one-shot
game, an equilibrium might exist in which the threat of reprisal enforces
something close to cooperation. However, these games have many equilibria,
and it is not clear that the policy makers unanimously agree with cooperation.

Stable international monetary arrangements or rules of the game areindispensable to all nations engaged in international trade and finance. Theinternational monetary system can be regarded as a kind of global public goods
to all the member countries participating in, for example, the IMF. While eachmember country enjoys the benefits, she must take some burdens as the costs.
The free rider problem of adjustment naturally takes place.

It is time to search for not only alternatives to the exchange rate system(e.g., return to the fmed rate, target zone), but also the methods for achieving
international policy coordination.

APPENDIX
The production function isy, == e, •L}-a o< ct <1
Lt = labor input
et = productivity factor

86 HIDEKI IZAWA
Taking logarithms,

ln Yt = yt =: (1-ct)lt+et
The first order condition is-a - I!ZMPLoyt= 6L, = (1 -a)et Lt - p

The labor demand is
i f = - -l}' (wt-pt )+ l} in(i-ct )+ 2}et

The labor supply is

li = fi (wt -P,) fi > O
The wage contract scheme isw, = -w ,+a(p,-Et-, pt)
wt is set at time t - 1. to equate the expected labor demand and the

expectedlabor supply given et = O to ensure that the labor market is expected

to clearunder the one-period wage contract setting.

In (1 -ct)
wMt = Et-i pt+

1+ctB

wt is the actual nominal wage at timetand2 is the parameterof wageindexation.

In (1 -a)w, = (1-R)Et-iPt+RPt+ 1+a/g
Substituting wt into the Iabor demand function (since labor isdetermined),i, = iia (p,-Et-i pt )+ afi24i -i+i 'in(imct)+ illet

Substituting lt into yt,

yt = (1-ct)lt+et

demandA NOTE ON INTERNATIONAL TRANSMISSION OF DISTURBANCES AND POLICY 87
INTERDEPENDENCE UNDER FLEXIBLE EXCHANGE RATES,= xe(i+ctp) in(i-a)+ (iia)(i-D[pt-Et-ipt]+i2et= I+6[p,-E,", p,]+w,
where(1 -R ).
6=1-act

References[1] Bryant, R.C., Money and Monetaiy Poldy in InterdePendent Nations (The Brookings
Institution, 1980).

[2] Cooper, R., "Economic Interdependence and Coordination of Economic Policies," in

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[3] Canzoneri, M. and J. A. Gray, "Monetary Policy Games and the Consequences ofNon-cooperative Behavior," International Economic Review, 26, no. 3 (October1985), pp. 547-564.

[4] , "Some Aspects of the Adjustment Problem in an Interdependent World,"
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[5] Carlozzi, N. and J. B. Taylor, "International Capital Mobility and the Coordination of

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[7]Daniel, B. C., "The International Transmission of Economic Disturbances under

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[11]Hamada, K., "Alternative Exchange Rate System and the Interdependence ofMonetary Policies," in Robert Z. Aliber (ed.), National Monetary Policies and theInternational Finance System (Chicago University Press, 1974).

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[25] , "Monetary Policies in Interdependent Economies with Stochastic Disturbances: A Strategic Approach," Economic Journal, 96, no. 383 (September 1986b),

pp. 69a721.

MONETARY POLICY AND FOREIGN DISTURBANCES INA SMALL OPEN ECONOMY UNDER FLEXIBLEEXCHANGE RATES AND RATIONAL EXPECTATIONS*
Hideki IzAwA

1. Introduction
The purpose of this paper is to examine the effects of monetary policy andforeign disturbances on a small open economy under flexible exchange rates andrational expectations. We will extend the rational expectation model of theclosed economy developed by Lucas (1972), and Sargent and Wallace (1975)
into an open economy and investigate whether the so-called policy ineffectiveness proposition holds. Furthermore, we will examine the insulation effect of aflexible exchange rate system from foreign disturbances. When several
countries adopted the flexible exchange rate system in the early 1970's, some

economists expected it to insulate the economy from foreign disturbances.
However, it in fact did not perform as well as had been expected. We will begin
with a brief review.

The pioneering works of Mundell (1963) and Fleming (1962) show that
under the assumptions of perfect capital mobility and a fiexible exchange rate,monetary policy in a small country is effective while fiscal policy is not effective,and vice versa under a fixed rate. They also assume a fixed price level andstatic expectation of the exchange rate which makes the domestic interest rate

be equal to the world interest rate. An expansionary monetary policy iseffective in increasing output via depreciation of the real exchange rate andincreasing exports (a kind of beggar-thy-neighbor policy). On the other hand,fiscal policy is not effective since an increase in government expenditure leads
to appreciation of the exchange rate thereby reducing net exports.

Dornbusch (1976) extended Mundell's model and explained the `overshooting'phenomenon of the exchange rate due to the slow adjustment of the goods
market relative to the asset market. To note, he used regressive expectationof the exchange rate which is consistent with rational expectation about the"I would like to thank Prof. Louis Maccini and Masahiro Kawai for helpful comments andsuggestions. Remaining errors are due to me.

90 HIDEKI IZAWA
long-run equilibrium exchange rate. In his model, a monetary expansion jnduces

an immediate depreciation in the exchange rate in a small open economy under
perfect capital mobility and has the effects on the interest rate, the terms oftrade, aggregate demand, and output. In the long-run, a monetary expansion
causes and equiproportionate increase in prices and the exchange rate.

Kouri (1976) analyzed the determination of the exchange rate by themonetary approach and emphasized the role of the process of asset
accumulation through current account in the dynamic model.

Mathieson (1977) compared under various types of expectation formation
the effects of monetary policy and fiscal policy on the exchange rate and theprice of the domestic goods, based on Dornbusch's model. However, in his
model it is assumed that real income is fixed at the fu11 employment level.

Sachs (1980) shows that the Mundell-Fleming proposition mentioned earlier
holds only when real wage can be altered by nominal exchange rate movements,
and that if the real wage is rigid, their conclusion is reversed. When the real

wage is fixed, fiscal policy improves the terms of trade and raises aggregate

supply while monetary policy has no effect on the terms of trade. It
demonstrates that more attention must be paid to the wage structure and labormarket conditions when we discuss macroeconomic policies for an open
economy.
In the next section, the theoretical framework of a small open economy ispresented and in the following sections, the effects of monetary policy and theinsulation effect of flexible exchange rates from foreign disturbances are
examined. In the last section, the conclusion and further research suggestions
are briefly mentioned.

2. The Small Open Economy Model
The theoretical framework is based on Turnovsky (1981).i) We shall modify themodel by adding a foreign income and a foreign interest rate as well as a foreign

price, and allowing for wage indexation which he ignores. We deal with a small
open economy with imperfect substitutability of goods and perfect substitutabilityof bonds under a flexible exchange rate system, assurned to be determined by
the monetary approach to exchange rate.

1) A recent survey paper by Marston (1985) is comprehensive. In the section on a model ofseoncgfi2ennOIRtaYteUnodneihrea/raOpneari.eXPeCtatiOnS, he draws most on a study by Turnovsky qgsi). so we

aOIPMONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN 91
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONSThe system is expressed as follows:

Y, = ct, Y,-ct,[I,-(E, C,.,-C,)]+ct,(P,* +S,-P, )+ ct, Y,* (1)O< ct, < 1, ct,, ct,, ct4 >O

C,=eP,+(1-e)(P,*+S,) (2)o<e<1M,-C,=0, Y,-P, I, (3)3i, 3, >O

I,=I,* +E, S, ., -S, (4)Yt = Y+ri (PtmEt-i Pt )+r2(Et-i Pt-Et-i Ct)-6ri (Ct-Et-i Ct) (5)ri, r2 >O, O {6S1
Endogenous variables: Yt,Ct, lt, ]Pt,St

Exogenous variables: Mt, Yi Ii Pt*
Notation:
Yt == real output at timel
It == nominal interest rate

Pt = price of output
st = spot exchange rate, measured in units of the domestic currency perunit of foreign currency.
Ct = consumer price (cost of living)

Mt = nominal money supply
E =mathematical expectation operator
Foreign variables are denoted with asterisks.
All variables except interest rates are expressed in logarithms.

Equation (1) represents the goods market equilibrium condition. The
demand for domestic output depends on domestic income, the expected real
rate of interest, the relative price (or the reciprocal of terms of trade), andforeign income. Equation (2) defines the consumer price index as a weighted

average of the price of domestic goods and the price of imported goods.
Equation (3) describes the money market equilibrium condition. We assume that

92 HIDEKI IZAWA
domestic residents do not hold foreign currency and we abstract from wealtheffects. Equation (4) describes the uncovered interest rate parity condition fromthe assumption of a perfectly integrated bond market. The domestic nominalinterest rate is equal to the world nominal interest rate plus the expected rateof exchange depreciation. Finally, equation (5) represents the aggregate supply

function which looks like a Lucas supply function. However, as Flood (1979)
pointed out, this rationale for (5) is inappropriate for an open economy where
contemporaneous trading between countries is permitted. Rather, it is derived
from the wage contract model with wage indexation following Gray (1976). (seeAppendix)

The system can be expressed in deviation forrn, subtracting an initialsteady--state equilibrium. Eliminating It.

(1-cti )yt = -a2[(Et st+i-st )+it* -(Et ct+i-ct )]+ct3(Pt"+St-Pt) +ct4 Y: (1 )'c, =- ep,+(1-e)(p,*+s,) (2)'m,-ct =P, y,-p,(E, s,.,-s,+tr) (3 )'yt=: n<Pt-Et- Pt )+r2 (Et-i Pt-Et-i ct )-5ri (ct-Et-i ct )(5)tEliminating ct, the system can be reduced into three equations
the following matrix.

['J,,ct' rgs,t,ct-2ge) -Xi3;i.a-18,)'] [il]-ct, it*+ct2 eEt zt+,+ct2 Et pt*. ,+[ct,-ct2(1-e)]pt*+a,yt*= -ri S(1 -e )p t"+ [ri (6e-1 )+r2 (1 -e)]Et-i gt+ri (6-1 )Et-i Pt"+ri (6-1 )Et-i st
mt+ fl, it*-(1 -e)pt*+ fi 2 Et st+,and expressed inMONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN 93
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONS
where zt = PtmPt*-st

D = -(1-ct, )r,{(1-e)+B,(1-6e)}-(ct,+a2 e){1+P,+ fi , r, (1-S)} < O

We must first solve for the rational expectation solutions. Taking
expectations of the three equations for an arbitrary date't, formed at an initialperiod O:(1ncti)EoYt := -ct2Eoit*+ct4EoN;+a2 eEo gt+i- (a2 e+ct3)Eo zt+ct2 (Eo Pt*+i-Eo Pt") (6a)Eo yt=r2 (1 -e)Eo zt (6 b)
Eo mt = 'B2 Eo it'+Eo Pt*+(1+P2)Eo st-fl2Eo st+i+eEo gt+Bi Eo yt (6c)
Substituting (6b) into (6a), we obtain the first order difference equation.
ct, eE, z,., - [ct, e+ (1 ---- ct, )r, (1 -e )+ ct,]E, z,=: -ct2(Eo Pt*+i-Eo Pt* )+a2 Eo it*-a4 Eoyt"
The solution isE, z, = b ie=e, rf (E, p,*. i-E, p,*. ,-, )mb tff.i, rfEo it*+t+ act,`e ,\, rfEoyt"+iassuming the transversality condition holds, i. e.

Iim nfEe zi = O
i-•ee
where pt = a, e+ (1 . ctct, 2)er,(1 -e )+ ct, < 1

Next, from the equations (6b) and (6c),fl2 Ee st+i-(1+fi2)Eo st = [e+Pi r2(1-e)]Eo gt-Eo mt+Eo Pt*- fl2 Eo it*94 HIDEKI IZAWA
The solution is
Eo st = i +i fl, jEr, (Eo mt+i"Eo pt*+ ,• +fi2 4o it*+j)2 i'-1 +ls, [e+iei r2(1-e)] ,2, R,E, g,.j

where z =-E2- < i1+fi2
Here we assume stochastic foreign disturbances which havezero means,are serially independent, and uncorrelated with each other.

EoPr+i=Eoi*t+i=Eoyt*+i=O for all O and t+i
hence

'

Eo 2t == O for all t
Eost = itk, j:r, Eo mt+i 'Rf

The solutions for yt,pt, and st can be expressed.
ptt = B'- {ct,[(1 -e)+B, (1 -6e )]-p,(1 -6)(ct,+ ct, e)} i,*+B {-a4ri[(i-e)+p2(i-6e)]}yt'+-ES' {[ct,-ct,(1-e)][(1-e)+fl,a-Se)]+(1-e)(ct,+ct,e)(1+6fi,)}P,*- r, (1 -6 )Sa3+ct2 e) { '(m,-E,m, mt )+S (E, m,.,-E,-, m,.,)A]} (7)s=1

The real output responds to foreign disturbances, forecast
supply, and the revision of forecasts for future periods.

errorsof money

MONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN
95
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONS
pt =-B{ct,[(i-e)(i-Bi ri 5)+fi2]- fi ,[(1 - ct, )r, 6(1 -e )+ ct,+ ct, e]}i,*- S' [(1 -0)(1-fl, r, 6)+P2 ]y t"+b{ct,(i -e)(i-fli ri 6)+B,[ct,(l -e )- ct,- (1 -e)r, 6(1-ct, )]}P,*[(1 -ai )ri 6(1-e)+ct3+a2 e]- D {(mt-E,-, m,)co (Et mt+j-Et-i mt+j)aj}+ Åí]=1 ee+ 1lfl, j--, Et-i mt+j • x)'

(8)

-1

st -un -D {a2Pirt(1-6e)+fi2[n(1-6e)(1-ct,)+ct,]}it"+ :i'L [e+ fl, r, (1-6e)]y t*+ i{1[a3-a2 (1 -e)][e+3, r, (1 -6e )]+ (1- 0)[ri (1 -ai )- (ct3+a2 e)(1 -6fii ri )]}Pt*- [r,(1-6e)(1-ct, )+ct,+ct2e]D{(m,-Et-, m,)+co
Z (E, m,+j-E,-, m,.j)zj}
j=1+ i Ii fl, trv., Et-i mt+i• •ai'

(9)

where
D = -(a3+a2 e)[1+fl2+fli ri (1-6)]- (1 -ct, )r, [(1 -e )+G,(1 -6e )] < O

3. The Effects of Monetary Policy and Foreign Disturbances
We can analyze the effects of various types of domestic monetary expansions
and examine whether policy ineffectiveness proposition holds in the small open
economy model or not. We will also consider the role of wage indexation (6).

Case 1. A purely unanticipated increase in money supply, which is notexpected to continue beyond the current period t, i.e.

96 HIDEKI IZAWA
dmt>O,
dEt-i mt.j -- O for 1' = O, l, 2,......

dEt mt+, = O for ]' = 1, 2, ......
From equations (7), (8), and (9),!aL21! = -ri (1-S)(a3+ct2 e) >- oamtDapt = - (1-a, )r,6(1-e)+ct3+a2e > oDamt
6st=-2zLL(,=.yzz.s,Ll 6e)(1 ct )+ct+ct 0>oamtDAn unanticipated, temporary increase in mt causes the increases in domestic
output and the domestic price, and the depreciation of the exchange rate. The
bigger 6 is, the bigger an increase in Pt is. But a full indexation (6 = 1) can

insulate output from the change in the money supply. From the equation (s)'Yt =ri(1-e) a, holds for6=1.Pt and s, change in the' same way, so thatozt/ amt = o.
Case 2. An initially unanticipated increase in money supply, which is
expected to continue permanently at the time t. i.e.

dmt = dEt mt+j > O for ]' = 1, 2,......

dEt-i mt+j=O for ]' = O, 1, 2,......
6amY t, = -ri (1 W6D/ (a3+ct2 e) (1 + j".e, Aj)= -ri (1 -SD) (a3+ct2 e) (1+fl,) ) o (= if 6 == 1)
oO.Pt, = -. (1-cti)ri 6(B-e)+ct3+ct2e (1+pi) > oaO.sl = - n (i-6e)(iscti )+ ct3+a2 e (i +p,)
- 1+ (ct3+ ct2 e)[ 2+ i ri (1 -6)]+ rs(1-cti )[-e(1 -6)+ ,(1 -6e )] > oSuch a monetary disturbance leads to mcreases in yt,Pt, and st if 6 l 1. Everyeffect in case 2 is greater than in case 1. The overshooting of the exchange

MONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN 97
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONS
rate depends on whether the numerator of the second term is negative or not.
Case 3. An anticipated increase in money supply, which ex ante at time t - 1 is

expected to be permanent, but ex post at time tturns out to be expected to be
only transitory, i.e.

dmt = dEt-i mt+j > O for 7' = O, 1, 2,......

dEt mt+j=O for 7'= 1, 2,""H
60mY`, = ri(1-5)D/ct3+ct2e) fi, <v o (a contractionary effect)
Under a full wage indexation, a change in money supply has no effect on yt. It
is the same result as Gray's.

apt - (1-a, )r, 6(1-e)+a3+ct2e• fi,+1 > O

am,- Dost - r, (1-6e)(1-ct, )+a3+a2 e

amt- D 'fl2+i >O

Case 4. A fully anticipated increase in money supply which is expected to
be both ex ante and ex post transitory, i.e.

dmt == dEt-i mt,
dEt-i mt+j = dEt mt+j = O for 7' = 1,......

oamN`, = o (no real effect)
OP, - 1>oOm, - 1+fl,

Os, 1

Omt = 1+fl, > O
Case 5. A fully anticipated increase in money supply which both ex ante andex post is expected to be permanent, i.e.

dmt = dEt-i mt+j -- dEt mt+j, forV]'-90LZ.t ..o (no real effect)amt
oOmPt, = 8mS', =i (equiproportionate change)

98 HIDEKI IZAWA'

Case 6. Suppose that the monetary authority announces at time O that it

will increase the money supply by dm permanently at time T and that theprivate sector believes the announcement, i.e.

'dm, =O• t= 1,... T-1
dE, m,, =O t = 1, ...
1tT-1 t<t

dmt = dm t= T, T+1, ...
dEt mt'=dm t' = T, T+1, ..., t< t'dy,=O t= 1, ... T-1=O t= T, ...
''dPt :lt p, j]iEl.. ,dm Rj = 2T-t dm t = 1, ... T-1=ltfi, i.O., dm Rj=dm t= T, ...
'dst=RT-t dm t= 1, ... T'1
t tt

'

'
=dm •. 't=-T,...

At time O, the announcement date itself, real output will be affected since
expectations are revised. But, during the transition before time T, real output
remains unaffected since there is no reason to update forecasts. Both the priceand the exchange rate increase monotonically and rise at time T by the sameamount (dm).
When the private sector attaches partial credibility to an announcement, theeffects wil1 be complicated;

We turn now to the effects of foreign disturbances on the domestic
economy. By the comparative statics,'
g;l.>o,
O,S,,i>o, ,Oii.<oThe signs of the other derivatives are ambiguous.

It is clear from the equation (7), (8), and (9) that the small open economy

under a perfectly flexible exchange rate cannot be insulated from foreign
disturbances which are expected to be transitory.

MONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN 99
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONS
A full indexation (6 = 1 ) can not insulate the international transmission offoreign disturbances while it can insulate the output from changes in the money

supply. The private sector wi11 choose an optimal degree of wage indexationsuch that minimizes a loss function which depends on yt and ct. This isanalogous to Gray's idea in the presence of domestic monetary and real shocks.

4. Concluding Remarks'

We have seen that the policy ineffectiveness proposition holds also in thesmall open economy, but a flexible exchange rate system with a full wage
indexation can not insulate the economy from foreign disturbances transmitted
while a fu11 wage indexation can insulate the economy from domestic monetaryshocks.

When we assume that the monetary authority can observe the current
stochastic foreign disturbances, we can deal with the issue of optimal foreignexchange market intervention policy, in other words, `managed' float, as a toolof stabilization policy in a small open economy, subject to such disturbances.
This also raises the question of what exchange rate regime is optimal.

The analysis of fiscal policy is left unfinished. Then we will have toincorporate a government budget constraint and consider how government
spending is financed. Also, wealth effects were abstracted from this model for
simplicity. To note, wealth effects may be a source of non-neutrality of moneyin the short run. .

Finally, domestic bonds and foreign bonds are likely to be imperfect

substitutes because of exchange risk, default risk, political risk, and so on.

Hence, we should employ the portfolio-balance approach of exchange rate
determination as an alternative. These are subjects for future research.

' '
'

'

'
'

'
Appendix

The production function isyt = L} 'a o<a<1
rm Wt
oYt
oL, = (i-a-a)Lt- 7s;
ln (1 -a )-al9 = wt-Pt

1oo HIDEKI IZAWA
The labor demand is
lf = i { ln(1 -a )- (wt-Pt )}'y; = (i-a)if == i7a{in(i-a)-(wt-pt)}

The labor supply is

li = no+b(wt-ct ), b > O
The actual wage is

wt = w-t+6(ct-Et-i ct), O f{; 6 s{: 1where 6 is a parameter of indexation.

The contract wage thtis determined so as to equate expected labor demandand expected labor supply for time t formed at t-lbecause of the one-period
length of wage contracts.

Et-i lf = i{ ln(1 -a )- (w-t-Et-i Pt )}Et-i li = no+b(tht-Et-i ct)
From Et-i lf = Et--i li' ta` = ltab{(Et-i Pt+abEt-i ct)+ln(1-a)-noa}
The amount of labor supply is deterrnined by the demand for labor once thelabor contract has taken place. Substituting wt into yi, the aggregate supply isyi == Y+ri (Pt-Et-i Pt )+r2(Et-i Pt-Et-i ct)'6ri (ct -Et-i ct )where i7 {b=, ln(11-a -a )+no }

1+ab

1-a
a
(1-a)br2 ==1+abrl =MONETARY POLICY AND FOREIGN DISTURBANCES IN A SMALL OPEN lol
ECONOMY UNDER FLEXIBLE EXCHANGE RATES AND RATIONAL EXPECTATIONS
References[1] Branson, W.H. and W.H. Buiter, "Monetary and Fiscal ,Policy with Flexible
Exchange Rates", in J.S. Bhandari and B.H. Putnam (eds.) Economic InterdePen-

dence and Flexible Exchange Rates, Chapter 9, pp. 251-285. The MIT Press,(1983).
[2] Buiter, W.H., "Fiscal Policy in Open Interdependent Economics", IVBER Worleing,PaPer, No. 1429 (August 1984).

[3] Dornbusch, R., "Expectations and Exchange Rate Dynamics", lournal of Politicai

Economy, VoL 84, No. 6 (December 1976), pp. 1161-1176.
[4] Fleming, J.M., "Domestic Financial Policies Under Fixed and Under Floating

Exchange Rates", International Moneta7y Fund Staff PaPers, Vol. 9, No. 3(November 1962), pp. 369-379.

[5] Flood, R.P., "Capital Mobility and the Choice of Exchange Rate System",International Economic Review, Vol. 20, No. 2 Uune, 1979), pp. 405-416.

[6] Gray, A., "Wage Indexation: A Macroeconomic Approach", Jo"rnal of Monetaiy
Economics, VoL 2, No. 2 (April, 1976), pp. 221-235.

[7] Kouri, P., "The Exchange Rate and the Balance of Payments in the Short Run andin the Long Run: A Monetary Approach", Scandinavian lournal ofEconomics, Vol.
78, No. 2 (May, 1976), pp. 280-304.

[8] Lucas, R.E., "Expectations and the Neutrality of Money", lournal of Economic
Theory, Vol. 4, No. 2 (April, 1972), pp. 103-124.
[9] Marston, R.C., "Stabilization Policies in Open Economies", in R.W. Jones and P.B.

Kenen (eds.), Handbook of International Economics, Vol. ll, Chapter 17, pp.
859-916. North-Holland (1985).

[10] Mathieson, D.J., "The Impact of Monetary and Fiscal Policy Under Flexible
Exchange Rates and Alternative Expectations Structures", IMF Staff PaPers, Vol.
24, No. 3 (November, 1977), pp. 535-568.
[11] Mundell, R.A., "Capital Mobility and Stabilization Policy Under Fixed and Flexible

Exchange Rates", Canadian lournal of Economics and Political Science, Vol. 29,
No. 4 (November, 1963), pp. 475-485.
[12] Sachs, J., "Wages, Flexible Exchange Rates, and Macroeconomic Policy", Quarterlylournal ofEconomics, Vol. 94, No. 4 Uune, 1980), pp. 731-747.

[13] Sargent, T.J. and N. Wallace, "`Rational' Expectations, the Optimal Monetary
Instrument, and the Optimal Money Supply Rule", lournal of Political Economy,
Vol. 83, No. 2 (April, 1975), pp. 241-254.

102

[14]

HIDEKI IZAWA
Turnovsky, S.J., "Monetary Policy and Foreign Price Disturbances

Under Flexible

Exchange Rates: A Stochastic Approach", lournal of Monay, Credit

and Banking,Vol. 13, No. 2 (May, 1981), pp. 156-176.

A SKETCH OF THE THEORY OF TRADE CYCLE
Nobuo OKISHIO

1. Problems on the Crisis Theory
In my opinion problems to be solved concering the crisis theory are thefollowing three.
(1) Crisis and trade cycle are characteristic phenomena in a capitalistic society.

(2) Crisis and trade cycle are indispensable for the reproduction of capitalistic(3) 30rCig stY5nd trade cycle create the conditions to abolish capitalistic society

and bring forth new relations of production.

These three subjects are derived from the problems of the political
economy of capitalism, whose main problems are to reveal the following threethemes. (1) Capitalism is a peculiar social form which appeared on a particular

stage in the history of human beings. (2) Capitalism has a self-reproductive
mechanism in itself. (3) Capitalism creates conditions to abolish itself and bring

forth new social form. By making these themes clear political economy cangrasp capitalism historically and totally. To grasp capitalism historically it is not

sufficient simply to show that capitalism is a particular historicai form of
human beings' society. It is also necessary to elucidate that the self-reproductive
activity of capitalism brings forth new conditions which are incompatible with theexistence of capitalism and then abolish itself. On the other hand to grasp
capitalism totally it is necessary to show the very grounds of the existence ofcapitalism, to make clear the mechanism by which capitalism keeps andreproduces itself, and to show that capitalism creates the conditions to abolishitself.i) Illustrating the above three problems, we get the following Figure.

We have had a great amount of literature on crisis theory. Though none ofthese covered the above three problems explicitly, I think there may be few
Marxian economists who have denied these three problems.

1) The third problem is the most important task of economics. In this point my opinion is different

from the so-called "Uno- theory".

NOBUO OKISHIO

104

Crisis, Trade Cycle

Capitalism

Marx stated that the method of his economics was dialectic, and dialectic"includes in its comprehension an affirrnative recognition of the existing state ofthings, at the same time also, the recognition of the negation of that state, of
its inevitable breaking up; because it regards every historically developed social

form as in fluid movement, its momentary existence".2)

However so far a tremendous emphasis has been laid on problem (1), andproblems (2) and (3) have not been treated properly. Though it is natural toemphasize problem (1), which is a basis of the crisis theory, problems (2) and(3), especially the latter, must be explored more deeply to grasp capitalism

historically and totally. •2. Characteristics of Capitalism'
One of the main characteristics by which capitalism is distinguished from othersocial forms is that capitalism is a class society. Here class society means asociety where the decisions on production, (what, how much, how, when andhow to dispose) are monopolized by a few members of the society and theother members are excluded trom this decision making. People excluded trom
the decision making are compelled to work subject to the decisions made byprivileged few and to be exploited their surplus labour, The decisions on
production are exercised in order for them to be exploited by the privileged
who monopolize them. Labourers receive only a part of the net output which is

the residual of output after deducting the replacement of production goods
required to reproduce at the same scale in the next period. And the exploitingclass obtain the rest (surplus output) and spend it for their consumption,"non-reproductive exhaustion" to maintain the class society, the additional
investment for the increase in the production after the next period, and otherwaste.

2) K. Marx KaPital in volume I, the afterword of the second edition.

A SKETCH OF THE THEORY OF TRADE CYCLE
Another main characteristic by which capitalism is distinguished from othersocial forms is that the production of commodities is in prevalence. In spite of
the fact that the social division of labour prevails there, means of production ineach sector of the division of labour are owned privately, hence decisions on
production become private and dispersive and the products are owned privately.

Therefore the products are fated to be commodities produced for exchange
purposes, and the social and material reproduction is obliged to be carried oUt

through the exchange of commodities. However the overall exchange ofcommodities is carried out only by the following indirect exchange with themedium of money.3)

Commodity A - Money - Commodity B
Consequently each exchange is decomposed into the simple exchange (purchaseand sale) : Commodity - Money. Any commodities cannot be obtained without
money. Labourers, who are alienated from the private ownership of means of

production and own nothing but labour power, must exchange theirlabour power into money, that is, sell it, and they become wage workers. Thus

not only all products but also labour power become commodities and they arevalued in terms of money and priced. Then the private and dispersive decisionsof capitalists are made on the basis of the rate of the profit which is the ratio

between the advanced money and profit (proceeds minus cost).
The problem (1) is to derive the inevitability of crisis and trade cycle fromthe above two characteristics of capitalism.

3) The owner of commodity A can get commodity B in direct exchange for commQdity A, only when

the owner of commodity B wants to exchange commodity B for commodity A. But the owner ofcommodity B may possibly want commodity C. In this case the owner of commodity A may beforced to examine the possibility of getting commodity B in indirect exchange. That is to say, if

all goes well, he first exchanges commodity A for commodity C, and next gets commodity B in
exchange for commodity C. But if the owner of commodity C wants something else, another indirect
exchange is required, then the series of indirect exchanges becomes so long that a lot of informationand time is necessary for these exchanges. Therefore such a series of exchanges makes the
reproduction of society difficult. But these dithculties can be solved with the simplest way of unified

indirect exchange, where all owners exchange their commodities for money. This makes it
possible for any commodity to be exchanged for any other.

105

106 . NOBUO OKISHIO
3. Anarchy of Production and Disequilibrium
Social division of labor prevails in capitalism. Various kinds of means of

production are necessary to produce a commodity, but those means of
production must be produced as commodities in other sectors. Moreover inorder to reproduce the labor power daily necessities must be produced in othersectors. These means of production and daily necessisties must not only be
produced but also be properly assigned in order to make reproduction in thenext period possible.

In capitalism, however, there does not exist a central decision on all of
production in the society. Each process of the division of labor is left to theprivate and dispersive decisions of capitalists. Capitalists are obliged to decide

production on the basis of profit rates which are predicted on the basis of thelimited local information they get.4) It is almost a miracle that production
decided in such a way just coincides with social equilibrium. Disequilibrium

always occurs. Commodities produced may not be able to find demand at theprice predicted at the decision of production, and conversely may not fill thedemand. Excess demand or excess supply occurs. Labor expended on the basisof private decision (private labor) cannot obtain social recognition on the priorpredicted condition, but obtains recognition in the market on better or worse
conditions.

But this disequilibrium does not cause crisis and trade cycle immediately.

Capitalism has a mechanism which revises this disequilibrium. The prices ofcommodities in excess demand rise, and reversely the prices of commodities inexcess supply fall. This may induce capitalists to alter their decision and may
clear the market by increasing production in the former case or by decreasing
production in the latter case. Even in the case that prices are infiexible to thetightness of markets, information of unfi11ed demand in the case of excess
demand or goods left unsold in the case of excess supply may induce capitalists

to increase production in the former case or decrease production in the lattercase. If the mechanism of this sort always works smoothly, the disequilibrium
which is caused from the anarchy of production in capitalism is always dissolved
without crisis and trade cycle.

Therefore, in order to insist that crisis and trade cycle are
inevitable in capitalism, we must show why the disequilibrium which is caused
4) Since the 1970's, an economic theory based on "Rational Expectation" has prevailed. In sucheconomics alt members of capitalism are assumed to behave in perfect expectation of the future
economic situation. This theory ignores one of the characteristics of capitalism.

AsKETcH OF THE THEORY OF TRADE CYCLE • lo7
from the anarchy of production in capitalism cannot be smoothly adjusted toequilibrium but cumulates unilaterally in spite of the existence of the mechanism

mentioned above.

4. Conditions of Equilibrium'

Capitalism is a class society where the production of commodities prevails. The

aggregated products must be sold as commodities. A part of these aggregatedproducts is bought by capitalists for the replacement of production goods. A
part of the rest (net products) is bought by the wages of labourers. But that is
only a part of the net products. Because laborers are exploited, so they cannot

repurchase net products totally. The residual which remains after deducting
laborers' consumption from net output is surplus products. In order for these tobe sold out, consumption demand of capitalists is not enough. This is because
the capitalists who are the exploiting class in capitalism, being different from the

exploiting class in previous class society, exploit laborers not only for their own

consumption but for accumulation of surplus value itself expressed by money.
Therefore the consumption demand of capitalists is only a part of the profit, so

the surplus products cannot be exhausted by the consumption of capitalists. In
order for the surplus products to be realized, another demand of capitalists oraccumulation demand (an additional demand to expand production from next
period forth) is indispensable.5)

The problem here is why disequilibrium becomes cumulative in capitalism.

To show this, we shall consider how capitalistic economy must move to keep

equilibrium in every period. Marx gave the answer to this problem by his
famous scheme of extended reproduction. We shall show in a simpler form.6)

5) We neglect the demand of government and foreign countries.

6) Though Marx gave, as is well known, a reproduction scheme of two sectors, we u$e here theaggregate scheme for simplicity. Note that though the equation C = aX means the technicalrelation, the equation V = bX, means not only technical relation but exploitation. Denoting
living labour and surplus value by N and M respectively, we have N = V + M. And fromv- -Y •K•x

web=have'Nlii'1+M/v
So b depends upon technical relation NfX and the rate of exploitation M/V.

108 NOBUO OKISHIO
X=C+V+Mk +I (1)Mk =k(X-C-V) (2)

C=aX (3)
V=bX (4)I=(a+b)dX (5)The LHS of equation (1) denotes aggregated products value and the RHS

denotes demand. C is replacement dernand, V is consumption demand oflaborers, Mk is consumption demand of capitalists and I is accumulation
demand. Therefore equation (1) indicates that aggregate supply equals
aggregate demand. (2) indicates that consumption of capitalists is a fixed portionof profit. (3) and (4) indicate the nomial relations among constant capital,
variable capital and aggregated products value. (5) shows that the additional

capital procured by accumulation demand in this period works normally next
period. dX denotes the difference between aggregate product of next period

and that of this period. In order that commodities supplied are equal toaggregate demand and capital works normally every period, the above fiveequations must hold. From (1) - (5), we have

AX I (1-fe )(1 'a-b)

X= (a+b)x= a+b (6)The rate of profit r is given by

X-C-V

r == C+V

So, (6) can be written asdX
x= I(.+b)x := r(1-h)= g* (7)In order that supply equals demand and capital works norrnally every period,
the growth rate of production and capital must be r(1-k), where r is profit
rate and (1-k) is the saving rate of capitalists, which we shall write as g*hereafter.

5. Curnulative Disequilibrium
Now let us suppose that the growth rate of capital (the rate of capital
accumulation) is larger (smaller) than equilibrium rate g* given by (6) or (7).
What situation will come about?

A SKETCH OF THE THEORY OF TRADE CYCLE 109
If the growth rate of capital is greater than g*, then by (6)I> (1-le )(1-a-b) X,
which can be rewritten by (2) -- (4) as

I>X-C-V-Mh,
This means

X< C+V+ Mk + l,
which shows that there occurs excess demand. On the contrary if the growthrate of capital is less than g*, then we have excess supply in the commodity
market.

Thus, the state of the economy definitely depends upon the growth rate ofcapital. What determines the capitalists' demand for accumulationI? Not a few
people still insist on the false idea that accumulation demand is identical}y equal
to the residual surplus value after capitalists' consumption.

i= M- M, = (1-le)(X-C-V)
If this is true, M:=: Mh +L Considering M= XTC-V, the equality X=C+V+ Mk + I holds identically. It means that aggregate demand forcommodities is always equal to aggregate supply (Say's "market law").
Therefore, it becomes impossible for general over-production to occur.
These people have the false idea that residual surplus value after capitalist

consumption is always directed to additional demand for commodity as
accumulation demand. However, those residuals are not always spent forcommodity but some of them may take the form of increase in money or
financial assets holding. Being financed by credit, accumulation demand forcommodities may exceed those residuals (M-Mk).

Another cause of their fallacy is that they believe the demand foraccumulation in this period is financed by the surplus value which is realized inthis period. As shown above, capitalists' consumption and accumulation isnecessary in order to realize surplus product in this period. Therefore therealized surplus value in this period depends on demands for accumulation. So it
is wrong to say that demand for accumulation in this period depends on realized
surplus value in this period.

Capitalists determine accumulation demand expecting realized surplus value
in the future and considering various factors: existing capital stock, market
situations and finance conditions etc. The most important factor for expectation
formation is the latest economic state. They form an expectation by interpreting
this state. Factors for expectation formation are the tightness of market, prices,
the rate of wage, the rate of profit and so on.

NOBUO OKISHIO

110

As mentioned above, if the growth rate of capital is larger (smaller) thanthe equilibrium rate g*, excess demand (excess supply) occurs in thecommodity markets. When commodity markets are in excess demand (excess
supply), prices are higher (lower) relative to the rate of wage and the rate ofprofit is higher (lower) too. Capitalists wi11 increase (decrease) the growth rateof capital further responding to the excess demand (excess supply) in thecommodity market.7) Accordingly the degree of excess demand (excess supply)is accelerated. In this way, disequilibrium in the commodity market cumulates.

6. Necessity of Crisis and Business Cycle

In capitalism, owing to the prevalence of commodity production, social
reproduction wholly depends on realization of commodities at markets. Besides,
because of the existence of exploitation, accumulation demand plays a decisiverole for realization of commodities. And since this accumulation demand isdetermined by individual capitalists privately and disintegratedly, the capitalist

economy accumulates disequilibrium in spite of the existence of a priceadjustment mechanism,8)If such cumulative process of disequilibrium is left as it is, capitalism
eventually becomes unable to reproduce itself. The upward cumulative process

in which excess demand is accelerating may seem to be happy for everybody.

Capitalists experience a high rate of profit, excess demand for theircommodities and an abnormally high rate of utilization of their capital. At thesame time, labourers experience increasing employment and increasing real
wage earning. Indeed seemingly it is the very "prosperity".9) But eventually

the upward cumulative process of disequilibrium makes reproduction ofcapitalism impossible, for the department of means of production sector grows
faster than consumption goods sector in this process, and the rate of real wage

(quantity of consumption goods purchasable with money wage per unit labor)

7) It is the condition of cumulative disequilibrium that capitalists increase (decrease) the growth rateof capita1 in response to excess demand (supply). The mere increase (decrease) of the level ofaccumulation demand does not always accumulate disequilibrium.
8) In capitalism crisis is inevitably caused by cumulative disequilibrium. And the disequilibrium isaccumulated, not only because there exists "the production of commodities", but thq exploitation
and a special way of decision making of accumulation demand. It is important to understand this,when we consider the role which the production of commodities plays in socialism.

A SKETCH OF THE THEORY OF TRADE CYCLE
begins to decrease. At last the absolute amount of consumption goods which
labourers can consume decreases.iO) Consequently reproduction of labour power
becomes impossible. And then reproduction of capitalism becomes impossible.

In the downward cumulative process of disequilibrium in which excess
supply accelerates, unemployment increases and the realized rate of profit falls.

When the capitalist class loses the ability to employ wage labour, capitalism
becomes fragile. The reason why the capitalist class can rule the labour class isthat wage labourers cannot live without selling their own labour and that
capitalists can buy labour and pay labourers wages by which they can get ameans of livelihood.

Therefore, capitalism must switch the cumulative process of disequilibriumin order to reproduce itself. It must switch upward cumulative process into

downward cumulative process. And it must switch downward process mto
upward process. Thus capitalism is obliged•to have a business cycle. The
necessity of crisis and business cycle are found here.

7. Switching of Upward Cumulative Process of Disequilibrium
The moments to switch upward cumulative process of disequilibrium cannot bepredetermined a priori. Most authors on crisis have discussed various
moments to switch upward cumulative process and regarded these studies as a
proof of the necessity of economic crises. In my opinion, however, a proof of

the necessity of economic crises is completely given by showing, as alreadydiscussed, that cumulative process of disequilibrium inevitably arises and thatthe reproduction of capitalistic society becomes impossible unless such a
process is reversed.

It is not correct to pick only one specific moment which switches the9) In a boom, consumption is always depressed relatively to additional production goods foraccumulation. Therefore the boom is a "hard" period in which people are forced the sacrifice foraccumulation. But in capitalisrn the boom appears as a prosperous time for capitalists, and evenfor labourers because unemployment decreases despite a rise of the exploitation rate.
10) This is easily undestood from the following extrerne case. In full employment the upward cumulative
process is carried out through the shift of labours to the sector of means of production from thatof consumption goods. So the amount of product of consumption goods decreases, then consumption

goods earned by the working class would decrease even if they could receive all product ofconsumption goods.

111112 NOBUO OKISHIO
cumulative process and then discuss generally that the cumulative process isnecessarily reversed by this moment. We cannot deduce the unique moment toreverse merely from the fundamental characteristics of the capitalistic society.

More detailed and concrete studies are needed to identify the moment. Thatman must necessarily die can be proved from the characteristics of human body.

However the moments for death are not necessarily pre-determined. In which
moment it takes place, cancer, suicide or killed by nuclear bombs, depends on
concrete conditions. Some possible and probable moments are considered here.
(1) a fall in the rate of profit in consumption goods sector

At the beginning of an upward cumulative disequilibrium process, demand
exceeds supply and the rate of profit rises in both means of production sector

and consumption goods sector. While this process is going on, however, thefollowing circumstances may arise. Accumulation demand being mainly formeans of production, in an upward cumulative process, prices of means of
production rise faster than the price of consumption goods. Owing to this therate of profit in consumption goods sector may fall, even if the price ofconsumption goods rises compared to the money wage rate and the rate of
exploitation rises.ii) Capitalists in consumption goods sector decrease theaccumulation demand corresponding to a fall in their profit rate and if thecapitalists in means of production sector follow it, then the upward cumulative
disequilibrium process may be reversed.
(2) bottleneck of production goods

In an upward cumulative process demand for means of production rapidly
increases as a result of accelerated accumulation demand. The amount of meansof production which can be used for the purpose of accumulation is, however,restricted by the surplus means of production which remains after deducting

displacement demand in both sectors. Production takes time. Therefore thesurplus means of production are fixed at a given time. When demand exceeds
this, surplus means of production can be increased with time lags but for thetime being there arises a bottleneck of means of production and the planned
accumulation demand cannot be satisfied totally. This may result in a downward

revision of accumulation plans and the corresponding retardation of the11) In this case the capitalists of consumption goods sector exploit labourers further, then their surplus. value produced increases. However they are squeezed by the capitalists of means of production
sector through a rise in its prices, so their surplus value obtained may decreases.

A SKETCH OF THE THEORY OF TRADE CYCLE 113
investment demand. Thus the upward cumulative disequilibrium process may bereversed.
(3) restriction of labour force

The rate of unemployment falls and the money wage rate rises in an upward
cumulative process. Its effect on the rate of profit depends upon the movementof commodity prices. If commodity prices rise more rapidly than the money
wage rate, the real wage rate falls and the rate of profit rises. The movementof commodity prices depends upon the demand-supply conditions in commodity
markets. When capitalists accelerate their accumulation demand, commodity

prices rise relatively more rapidly than the money wage rate. But after
unemployment is totally absorbed, it becomes impossible to increase employment

as a whole (although possible to some extent by extending the length of aworking day). In order for capitalists in some firms or sectors A to increase

their employment they need to pull out workers employed in other firms or
sectors B. In order to succeed A must increase the money wage rate enough tomake the real wage rate in terms of products B greater than labour productivity

in B. In sectors B the capitalists are obliged to part with their workers as aresult of rising real wages, there occur idle capacity of equipment and a fall of

the rate of profit and thus a decline in the accumulation demand. In sectors A
the capitalists succeed in acquiring additional workers, the rate of profit does

not necessarily fall and the accumulation demand will continue to increase.i2)

This may, however, bring the cumulative process to a halt as a result of
declining accumulation demand in those sectors where workers are pulled out.
And this may cause a crisis.

(4) credit restriction

An upward cumulative process is caused by an accelerated increase inaccumulation demand by capitalists. This acceleration, however, needs anacceleration in credit, as has already been stated. If the accumulation demand isfinanced by the remainder of profits which is not spent on consumption,12) The rate of profit in some sectors depends upon the real wage rate measured by that sector's
product. In the sector deprived of labourers (consumption goods sector) the' money wage rate
rises relative to prices of consumption goods, then the rate of profit declines. Conversely in the

sector depriving of labourers (means of production sector) the price rises relative to money
wage rate, then real wage rate measured by means of production may decline.

114 NOBUO OKISHIO
additional credit is not necessary. In this case, however, even an equilibrium

growth cannot be guaranteedi3), and a downward, not upward, cumulative
process follows. Credit expansion is generated by firms and banks. There is amutual close relationship between credit expansion and the demand-supply
condition in commodity markets. Credit expansion guarantees an accelerated

increase in accumulation demand and a continuance of excess demand incommodity markets. On the other hand, a continuance of excess demand incommodity markets giving optimistic expectation brings about further credit
expansion. Therefore both factors become causes and effects of each other inthe upward cumulative process. If credit extension is slowed down for somereason, the interest rate rises and the acceleration of accumulation demand may
come to a standstill.

8. Switching of Downward Cumulative Process of Disequilibrium'
Moments to switch a downward cumulative process of disequilibrium are notpredetermined. Some possible and probable moments are listed below.
(1) a rise of profit rate in consumption goods sector

We have already stated the possibility of switching of an upward cumulative
process caused by a fall in the rate of profit in the consumption goods sector.

There the price of means of production rises faster than that of consumption
goods which rises faster than the money wage rate, and this results in a fall in

the rate of profit in the consumption goods sector. The exact converse mayarise in a downward process. Namely an accelerated contraction in accumulation
demand results in excess supply and prices fall in commodity markets. And theprice of means of production falls faster than the price of consumption goods

which falls faster than the money wage rate. Therefore in the consumption
goods sector there may occur a rise in the rate of profit as a result of a relative

decrease of the price of means of production to the price of consumption goods,

notwithstanding a rise in the real wage rate in terms of consumption goods.

13) Capitalists certainly decide the amount of demand for their consumption and accumulation in
expectation of the profit realized in this period. But such demands cannot be financed by the profit
realized in this period. Because the profit of this period are realized by the demands of capitalists'

consumption and accumulation of this period. If the demands are financed by the profit realized in
the last period, the profit realized in this period is no more than that in the last pe,riod. And as
the production capacity of this period is larger than that of the last period by the accumulation,
there necessarily arises excess supply or under-utilization of capital equipments.

ASKETCH OF THE THEORY OF TRADE CYCLE 115
Thus accumulation demand in the consumption goods sector may be increased

and for this reason an overall accumulation demand may increase, whichswitches the downward process into upward.
(2) enforced introduction of new technologies

In a downward cumulative process unemployment increases and the money
wage rate decreases. The real wage rate, however, increases as a result ofmuch greater decrease in commodity price caused by the accelerated
contraction in accumulation demand. An increase in real wage rate brings about

a fall in the rate of exploitation, which eventually diminishes to zero if
production technologies remain the same. Here the capitalists are compelled tochoose either bankruptcy or introduction of new technologies. The introductionof new technologies requires a minimum fund necessary and the capitalists who
cannot afford it are obliged to drop out. Those who can afford to introduce newtechnologies can prevent the rate of exploitation from declining and evensucceed in raising it by increasing labour productivity. An accumulation demandfor introducing new technologies results in a recovery and even an increase ofaggregate demand, which may reverse the downward cumulative process.
(3) capitalists' consumption demand

In a downward cumulative process such kinds of demand as replacement
demand, labourers' consumption and accumulation demand are contracted
respectively. Capitalists' consumption demand also decreases according to a fallin realized profits. Capitalists' consumption, however, differs in character fromlabourers' consumption in the sense that capitalists' consumption is not
restricted by their actually realized profit income. Their consumption demanddoes not decrease beyond some minimum level however severely their realized

profits decrease. To this minimum amount of capitalists' consumption there
corresponds a certain production level. When capitalistic economy goes down tothis extremely low level, there is no replacement demand for durable equipment
and capitalists continue to produce using existing equipment. As time goes on,

however, existing equipments gradually depreciate and eventually cannot
Maintain the required level of production which corresponds to the capitalists'

consumption. Then the demand for means of production must rise again and thismay result in a recovery and an increase of accumulation demand.

116 NOBUO OKISHIO
9. Fundamental Contradiction in Capitalism and Crisis
Capitalism is a class society in which commodity production prevails. In
commodity production there arises the problem of realization and disequilibrium

inevitably occurs. This is because decisions on production are grasped byindividuals privately in spite of the social division of labour. This economic
anarchy is a necessary condition for crisis and trade cycle.i4) However it is nota sufficient condition. For difficulties of realization and disequilibrium do notnecessarily induce crisis and trade cycle. Even if disequilibrium occurs, it can beequilibrated by price adjusting mechanism without crisis, unless disequilibrium iscumulative towards one direction.

The cumulativeness of disequilibrium comes from the fact that capitalism is

not merely a commodity production society but also a class society too.
Decisions on production are grasped by private capitalists, who make decisions
for profit with local and short-sighted information. On the other hand labourers

are excluded from decision-making and obliged to become wage-labourers
condemned to be exploited. As labourers are exploited, in order to realize valueof commodities, capitalists' accumulation demand becomes indispensable. And it

becomes an important determinant of aggregate demand. As decisions on
accumulation demand are grasped by private capitalists, accumulation demand
moves so as to cumulate disequilibrium. And this cumulative process must benecessarily switched by crisis and trade cycle for capitalism to be reproduced.
Thus crisjs becomes jnevitable in capitalism.

Usually the "fundamental contradiction of capitalism" is formulated as thecontradiction between the social characteristics of production and private
capitalistic appropriation. This formulation is considered to be a summary of thetwo basic characteristics of capitalism: commodity production and class society.
Therefore we can say that crisis and trade cycle are an inevitable result of thefundamental contradiction of capitalism.

Most Marxian economists regard "the contradiction between production andconsumption" as the most important factor to explain crisis.i5) It is said that inspite of the fact that capitalists accelerate production seeking for profit,
labourers' consumption is depressed owing to exploitation, and capitalists'
14) K. Marx discussed "the abstract possibility of crisis" in volume I of KaPital.
15) "The ultimate reason for all real,crises always remains the poverty and restricted consumption of
the masses as opposed to the drive of capitalist production to develop productive forces as though

only the absolute consuming power of society constituted their limit." K. Marx,KaPital involume M part IV chapter 30.

A SKETCH OF THE THEORY OF TRADE CYCLE 117
consumption is limited by accumulation, so inevitably there arises the difficultyof realization of commodity values. However this reasoning is erroneous. Even

if production is accelerated to increases and the consumption demands oflabourers and capitalists are limited, the difficulty of realization does notnecessarily occur. Because, as shown above, accelerated increase of production
can be absorbed by a further increase of accumulation demand.

We consider "the contradiction between production and consumption" as adispensable factor to explain crisis by different reason from the above. First let

us interpret "the contradiction" as the existence of gap between production andconsumption. Which of the following does "production" mean? (a) Production of

consumption goods, (b) Aggregate products including consumption goods andmeans of production, or (c) Net products which are the remainder of aggregate

products after deducting replacement of means of production, If (a), "thecontradiction" means production of consumption goods > consumption demand.

But the excess supply in the consumption goods sector cannot be observed
always, and the crisis does not necessarily starts from the consumption goods

sector. If (b), it means consumption products + production of means of
production > consumption demand. But this inequality must holds in every

society, because for reproduction it is necessary to produce means of
production to replace the means of production. So it is not a contradiction.
Therefore "production" must mean net products (c). Net product > labourers'

consumption + capitalists' consumption implies net products > labourer's
consumption. Assuming labourers' consumption = wage, it means net product> wage: exploitation. Thus it becomes clear that "the contradiction between
production and consumption" thus interpreted is nothing but the existence of
exploitation. As repeatedly stated exploitation is a basic factor in causing crisis.

Owing to exploitation, capital accumulation demand becomes indispensable torealize commodity values and this is one of the main causes of cumulative
disequilibrium.

If we interpret "the contradiction between production and consumption" notas the existence of gap between production and consumption but as the gap

between the rate of growth of production and consumption, how can we show
the relationship between "the contradiction" and crisis? Here "production"means net product (c). The thus interpreted "contradiction" means increase of

the gap between net product and consumption. For this gap to continue toincrease, capitalists must increase accumulation demand acceleratively. In the

upward cumulative process of disequilibrium we observe this very fact.
However, as shown in 7, the thus interpreted "contradiction" can not last

118 NOBUO OKISHIO
forever, because it makes capitalism unable to reproduce itself. Therefore its
switching by crisis becomes inevitable.

10. Capitalistic Reproduction and Crisis
Capitalism has the nature to produce a cumulative process of disequilibrium.
And un!ess this process is switched in due time, capitalism cannot reproduce
itseif. This switching is carried out by crisis and trade cycle. In this sense crisis

plays a necessary and indispensable role for capitalistic reproduction. Let us
consider this aspect from several aspects.

(1) equilibrating "the gap between production and consumption"

Owing to exploitation, capitalism always has a gap between net products andconsumption. This gap is accelerativeiy widened in the upward cumulative
process. Unlimited widening of this gap makes capitalism unable to reproduce
itself. It is crisis that switches the upward process into downward. By this•switching the gap between net product and consumption begins to shrink. In
other words an equilibrating process of contradiction between production andconsumptlon starts.

However this equilibrating process is also fu11 of contradictions. In the

upward cumulative process, though consumption is depressed, the increasing

part of the net product is absorbed by accumulation demand. Accumulation

accelerates the jncrease of productive capacity. When by some moment
accumulation demand is contracted, the aggregate demand shrinks and theconsumption demand of labourers also decreases. Consequently the production

capacity which has been piled up by depressing labourers' consumption (bystrengthening exploitation) cannot be utilized normally and there appears an

excess supply in the commodity market. Corresponding to this, capitalists
decrease accumulation demand further, and aggregate demand and production
shrink stil1 more. It is true that the gap between net product and consumption
shrinks in this process, however it is done not by increasing consumption but16) The gap between production and consumption is not smoothly adjusted in capitalism. We caneasily understand the peculiar character of the adjustment process if we make a comparison
between such processes in socialism and capitalism. The period of accelerated accumulation, as

stated in note (10), is a hard time for socialism. And when peopie require no moreaccumulation, they decide to utmaze the production capacity accumulated til1 then for theirconsumption. When the gap between production and consumption disappears, they will have a
happy time. On the contrary in capitalism the halt of accumulation causes crisis, downward
cumulative process, unemployrnent and hard living.

ASKETCH OF THE THEORY OF TRADE CYCLE 119
by decreasing production which is accompanied by severe unemployment andidle capacity.i6)(2) equalizing profit rates

In the upward cumulative process, owing to accelerative increase of accumulation

demand, the degree of excess demand and over-utilization of productive
capacity is much severer in the sector of means of production than in the
consumption goods sector. Then the rate of profit in the means of production

sector rises more rapidly than that in the consumption goods sector. Being
guided by these movement of profit rates, the weight of means of production

sector increases relatively to consumption goods sector (The so-called
preferential progress of means of production sector). When accumulation
demand begins to shrink, this movement is switched to the opposite direction.

Prices of means of production begin to decrease faster than prices ofconsumption goods and the money wage rate. The rate of profit in the
production means sector declines more rapidly than in the consumption goods
sector. And the weight of consumption goods sector increases relatively to themeans of production sectgr. Through such switchings the difference of profit
rate in both sectors is prevented from accumulating and rates of profit areapproximately equalized.i7)(3) reproduction of wage labour
The most important thing for capitalism to reproduce is that labourers regularly
and repeatedly appear at the labour market to sell their labour power. In orderto guatantee this it is necessary that real wage and employment are confinedwithin a certain range.i8) As to real wage, it must not be less than the minimum
level determined physically and socially. On the other hand it must not be great17) One of the propositions which constitute "the labour theory of value", is that prices of commodities

are mainly determined by the value (social standard bestowed labour). This proposition is deduced
from the tendency that equalizes the rate of profit of each sector (the theory of production price).
However the equal rate of profit is not realized through the smooth adjustment process: high (low)rate of profit --ÅÄ entrance (withdrawal) of capitals . excess-supply (-demand) . decline (rise) ofprice --> decline (rise) of rate of profit. But it is realized through crisis and trade cycle. In thispoint our theory is different from neo-classical price adjustment theory (or Uno-theory).

18) "The value of labour power", which plays an important part in KaPital by K. Marx, means thevalue of consumption goods necessary to reproduce labour power. Here the reproduction of
the labour force must be the reproduction of "the wage Iabour power". In order to reproduce
it, it is not necessary for real wage rate to keep a certain level but to be confined within acertain range, where wage labourers are compelled to reappear at labor market even if money
wage rates rise or decline.

120 NOBUO OKISHIO
enough for labourers to afford to buy back the means of production. At thesame time it must not be too great for capitalists to be able to exploit
labourers. As to the level of employment, the rate of unemployment must not
be lower than a certain level. Otherwise capitalists can not force labourers tofollow their lead by threat of firings. On the other hand the rate ofunemployment must not be higher than a certain level. Because if it becomes
extremely high, labourers no more expect to be employed and capitalists lose
their hegemony.

The mechanism for confining real wage and employment into a suitable
range is crisis and trade cycle. In the upward cumulative process a decrease in

unemployment and a decline in the real wage rate compared with labour
productivity occur. In the downward cumulative process an increase in
unemployment and a rise in the real wage rate relative to labour productivity
occur. Switching from one to the other, real wage and employment are confined
into the appropriate range for capitalism to reproduce itself.

12. Transcendence of Capitalist System and Crisis
Crisis and trade cycle are necessary to the reproduction of the capitalist

system. In this sense crisis and trade cycle work as the reproductive
mechanism of the capitalist system. However, in contrast with this we must
consider whether this movement, which is indispensable for the reproduction of
the system, creates factors that necessitate replacing the capitalist system withother new relations of production or not. That is the question.

(1) incompatible production power

The capitalist system cannot reproduct itself if the downward cumulative
process were not reswitched upward, and it is a revival or increase of an
accumulation demand for an introduction of new technologies that is mostimportant in the turnaround moments. In the capitalist system new techniques

are introduced and production equipments embodying old ones are scrapped in

the process of trade cycle. In this way production power increases in thecapitalist system.

The increase of production power brought about by the introduction of newtechniques plays an important part in the reproduction and survival of thecapitalist system. By raising labor productivity through an introduction of newtechniques, capitalists can prevent profit rate from declining even if they

concede to increase real wage rate for laborers. And by increasing labour

A SKETCH OF THE THEORY OF TRADE CYCLE 121
productivity and technical composition of capital it becomes possible in the longrun for the capital accumulation rate and the growth rate of products to riseover the limitations of the increasing rate of labour supply in the capitalist
system.

But capitalistic relations of production cannot be compatible with any
production power. In general, it is necessary that production power is kept in acertain range in order for any specific relations of production to work. If it

exceeds the upper limit, it becomes difficult for the specific relations of
production to reproduce themselves. Of course this is valid for the capitalist
system also.

With the increase of production power, new production power whichbecomes incompatible with the capitalist system appears. (a) With the increaseof labour productivity the probiem of unemployment and realization becomesacute, then the capitalist system becomes unstable. (b) As enormous funds arenecessary to develop or introduce new techniques, the necessary funds exceed
the limits of private ones. This leads to an introduction of public funds bynational power; it contradicts the principle of private capital investment, andthus bribery and corruption prevail.,(c) New techniques bring a wide andserious change into the life environment of human beings, the human body andNature. Under these conditions, it endangers human beings' survival to entrust
decisions on production to anarchic private capitalists. (d) New techniques haveremarkably increased the abilities of information processing. Not only material

conditions which support advanced data processing emerge but the averageability of members of society of information processing increases remarkably.

Then it becomes difficult to exclude majorities possessing the ability fromdecision-making on production, though this exclusion is the foundation ofcapitalism.i9)(2) formation of revolutionary people •As the production power of the human being comes to have a character
incompatible with capitalistic relations of production, human society cannot helpchoosing either of the following two alternatives. One is to maintain capitalistic

relations of production by any and every means (interventions of state,
maneuvers over working class, suppression, and military power etc.). The
other is to replace the relations with new ones, which are characterized by

See N. Okishio "Notes on Technical Progress and Capitalist Society" Cambridge Journal of
Economics 1977, 1.

122 NOBUO OKISHIO'

making fundamental decisions on production socially, not privately. The former
is to deepen the inconsistency between characters of new production power andrelations of production, and to endanger the very survial of human beings
sooner or later. The latter is to create new relations of production which

conform with new production power and to guarantee the survival of humanbeings. Therefore we must choose the latter alternative for the survival of
human society in the future.

Undoubtedly this important choice has to be made by human beings
themselves. How are such people who choose the latter alternative brought up?
Crisis and trade cycle play an important ro!e in the formation of these people.

The working classes are compelled to be unemployed in a downward cumulative
process. And production capacity, which is accumulated by raising the rate of

exploitation of labourers in upward cumulative process, remains idle. In the
upward cumulative process, unemployment of labourers declines but the rate of

exploitation rises. An introduction of new techniques compels labourers tounemployment and reshuffie, and makes former skMed labourers worthless. A
pressure upon capitalists in the downward cumulative process leads minor
capital unable to raise funds for new technique introduction to bankruptcy. The

increase of new production power raises the information processing ability,
which is the foundation of the decision making capacity, of ordinary people
including working class. And now production power entrusted to capitaiists'

decisions brings about wide, serious and irreversible dangers in the 1ife

environment, human body and Nature. These occurrences increases thenumbers of people who recognize that replacement relations of production arenecessary.
Of course it is one-sided, if we do not see the counteraction of capitalism tostop the increase of such people. When working class or minor capital gets into

trouble economically, they are apt to try to beg "big men" who exploit thesechances. In spite of these counteractions the majority of people gradually or
rapidly recognize the necessity of new relations of production for the survival of

human beings.

KOBE ECONOMIC & BUSINESSREVIEW
CONTENTS
NO. 24 (1978)
The Dernand for International
Currencies and Reserves ••••••••••••••'''"'•''••••••••••••••"'''"'••••••••• Masahiro Fnjita

Nobuo Miyata
Studies for the Prediction of Shipping Markets-A Survey and their Applications- ••'''''`••••••••••••••••••'•••••••••••••••• Tetsnji Shimojo

A Note on the International Transmission of
Policy Effects under Flexible Exchange Rates ••••••••••••••••••••••••••••• Kazuhiro Igawa

A Control Estimation Approach toTime-varying Parameter Models •••••''''•'••••••••••••••••••••••••••••••••••••• Yuhio Uchida

NO. 25 (1979)
Redundancy of Seafarers and the Practiceof Permanent Employment ••••••••••-••••••••••••••••••••••••••••••••••• Hiromasa Yamamoto
Japanese Multinational Enterprises:

AView from Outside •••••••••••••••••••'•••••••••••••••••• ''ny Hidelei Yoshihara

A Comment on the Bayaraa's Algorithm ••''''"••••••••••••• • '•• -•• KomayuleiItow
Effects of Ship's Size and Cargo Lotson the Ocean Freight Rates •••••••••••••••••••••••••••••••••••••••••••••••••••• Tetswfi Shimojo

Direct Foreign Investments and Foreign Exchange Rate:
A Model of Specific Factors and Non-tradable Goods •••••••••••••••••••• Kazuhiro Igawa

NO.26 (1980)
Economic Policies under the Flexible Exchange

Rate System: a Stock Approach and a Long-run
Government Budget Constraint ••••••''•'••••••••••••••••••••••••••••••••••••• Kazuhiro Igawa

Estructura de les ventajas comparativasy
politica comercial-El caso de las exportaciones deproductos industriales el Brasil •••••••''•'"'•'••••••••••••••`' '''••••••••••• Shoji Nishi'ima

Technological Progress and Capital Accumulation ''''""'''''•'' ''''''' Ka2uo Shimomura

NO. 27 (1981)
Accounting Systems of Non-Market Oriented Activities ••••••'''''''''•••••••••• Nobuko IVosse

Current Situations of World Economy andGlobal Adjustment of Industries ••••••''•••••••••••••••••••••''•••••'''''•••••••• Hikoji Katano

Current Cost Accounting and the Conceptof Specific Purchasing Power Capital •••••••••••••••••••••••-•••••••''••••••••••• Isao Nakano

An Input-Output Table for Evaluation of the
Shipping Activities '"•••••••••••••••••••i•••••••••••••••••••••••••••••••••••••••• Tetsnji Shimojo

The Function of Modern Corporate Financial Reportingin a Mass Democratic Society ••••••••••••••••••••••••••••••••••••••••••••••• Hidetoshi Yamal`iNO.28 (1982)
The Internationalization of Japanese Commercial Banking-Experiences in the 70's- ••••••••••••••••••••••••••••••••••••••••••••••••••••• Masahiro Fwfita

Kenichi Ishigaki
A Synthesis of Simultaneous Equations Estimators •••••••••••••••••''''' •• Hiroshi Sadamichi
A Database System of Economic Time Series ••••••••••••••••••••••''''''• • Hiroshi Sadamichi

Yasuo Nunokami

NO. 29 (1983)
An Interpretation of Conventional Accounting

Income Information ••••••••'••••••••''''''''.••••••••••• •• • •'•• Isao IVakano
A Production System for Transport Services ••••••••••••• ••••• •• Tetswfi Shimoio
Some Evidences between Foreign Direct Investments
and Foreign Exchange Rates:
APreliminary Note ••••••""•••••••''''''•'•••••••••••••••'••••••••••"'''•••-•• Kazuhiro Igawa

Two Types of Railroad Regulation by Statesin the 19th Century of the U.S.

-Search for the Social Foundation of Modern 'Corporate Financial Reporting- ••'•••••••••••••••••••••••••••••••••••••••••• Hidetoshi Yamal'iNO. 30 (1984)
National Monetary Policy in an International
Capital Market ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 1dirg Niehans

Craft Unions, Wages and Employment ••••••''•••••••••••••'''•••••••••••••'••••• Murray C. Kemp
On the Applicability and Implementability ofthe (Finite) Compensation Principle ••'•• ••••••''••••••••••••'''•••• Murray C. KemP
Internationalization of Japanese Commercial Banking-The Recent Experience of City Banks- ••••••••••••''•••••••••••••''••••• Masahiro Fnjita

Kaiaya Mizushima
Ryoichi Mikitani
Efficiency of the Least Squares, Estimators in

Linear Models with Idempotent CovarianceMatrix of the Error Terms ••••••••••••••••••••••••••••••••••••••••••••••••• Hiroshi Sadamichi

Diversification of Large Japanese .
Manufacturing Firms •••••••'`•-••••••••••"'•••••••••••'•''•••••••••••••'''•••• Hidelei Yoshihara

Indexing Policies and Macroeconomic Stability in
Brazil: Rational Expectation Model ••••••••••••••••••••••••••••-•••••••'•••••• Shoji NishiJ'ima

A Simp!e General Equilibrium• Model Involving
a Maximizing Labour Union ••••••'''''''''•••••••''"''"•••••••••'''''"•• Kazuo Shimomura

NO. 31 (1985)
Toward the Nagative Picture Theory of Commercial
Double-entry Bookkeeping and Financial Accounting •••••• ••'''''••••••••'• Isao IValeano
Stability of the Demand for Money: Australian Experiences ••• •••'''' ••••• Kenichi Ishigalei"Empirical Study of Changes in Accounhng Policy" in the Case ofJapanese Enterprises •••••••••••••••ttt••••••••t•••titt•••••••••••• •••t••••• Hidetoshi Yamal'i

An Empirical Study on International Short-Term Capital
Movements in Japan •••••••-•••••••••••••••••••••••••••••••••••••••••••••••••••••''' Hidelei Jzawa

NO. 32 (1986)
Import Demand Structural Change in the PacificBasin Countries ••••••••••••'••••••••••••••'''••••••••••••••••••••••••••••••••••• Seiichi Katayama

Kenichi Ishigalei
A Synthetic Analysis of Structuralist and Monetarist

Theory of Latin Arnerican Inflation "''''•••••••• • ••••••••••••••• Shoji Nishi'ima
Stagflation-Causes and Policies- •••••••••"'••••"'' ••••••••••••••••••••••••• • Nobuo Okishio

A Computable General Equilibrium Model of theJapanese Economy ••••••''"••••••••••''''''••••••••'''•'''••••••••••••••••••••••••• Mitsuo Ezalei

KOBE UNIVERSITY ECONOMIC REVIEW 33, 1987
Edited by Faculty of Economics,
Kobe University, Kobe, JapanCONTENTS
Theoretical Foundations of International Macro-Economic Model ••••••••••••••••••• Nobuo Ohishio

The Role of Commodity Prices in the Worldwide
Infiation and Disinflation '''-'"'"'"•••••••'•""""""'••••••••••"""''•-•••••• HidayuleiAdachi
Structural Change in Oil Consumption in Japan:

An Econometric Analysis of Effects of Two Toshihisa Toyoda
Oil Crisis ••••-•••••••••••••''''''''''''''''"''''''''""""'''''''''''''''''''''''''''' Kazuhiro Ohtani

Seiichi Katayama
A Comparison of Conventional and General

Equilibrium Growth Accounting: The Case Mitoshi Yamagnchi

of Japanese Agriculture, 1880 - 1970 ''""''""'''''""""""" George Kennedy

The Classical Economics from the Classical Viewpoint ••••••••••••-•••••••••••• Toshitaka 17uhiharu
l--llt----tlt-ttttY--ei-lttiltij}tte-lthi-teltt-t--tll--l-llP-e-ttl)-tt--ltl--ltt)itl"ilte-l-tht-tPllt-Itlllltetilt-t-tnlhlt-tlllllttlt-lt"11-tl-ltt--tl-tlle-"11-leelltettit)I-l--tte--t-ett)-tttlt--tltt"-t--tte-e-tltlltellt)-tltlet-t--tei

THE ANNALS OF THE SCHOOL OF BUSINESS ADMINISTRATIONKOBE UNIVERSITY No. 32, 1988
Edited by the School of Business Administration, '' Kobe University, Kobe, JapanCONTENTS
Measurement of the Non-Equivalent Exchange and theRate of Surplus Value, in Japan andWest Germany (1980) ••''''•••••••••••••••••••''•"••••••••••••••••••••-•••••••••• Kazuhisa Matsuda

NeubegrUndung der Betriebswirtschaftslehre
aus Unternemerfunktionen •••••••••••••••••••••••••••••••••••••••••••••••••••••••••• DieterSchneider

Values and Attitudes of Japanese Production

Engineers toward Workers under Microelectronics Innovation ••'••••••••••••••••••••••''•••"•••••••••••••••••••••••••••••••• Koji Oleubayashi

Foreign Investment and Intermediate Goods Trade ''•'••••••••••••••''••••••••••••••••••••• Fumio Dei

Entrepreneurial Networking at the MIT Enterprise
Forum: Analysis of Paradoxes '"'••'••••••••'''''''"'''''•••••••••'''''''''''''''' Toshihiro Kanai-t"lt,,-t'tl}t--la"-e"'ei,th-te"l-}N"t"e"1-t,"Iets-nptade,tt,tls,-tdll,te-,tt,,tt-tee--tw,l,let,,ti,lte,)hell,tt,ge,,e,tlt-teee"t-t"--,wle-th,--11t'-tttlt,e-,lll'l"eee,i--'ie-""dl,t"ll"-t,tlt,-"11"-,

KOBE UNIVERSITY LAW REVIEWInternational Edition No. 21, 1987
Edited by Faculty of Law
Kobe University, Kobe, JapanCONTENTS
Rechtsvergleichung - Methoden, Wege, M6glichkeiten'''''''"'''"''•••••••••'•••••••••••••••• Hans-AlbrechtSchwarz-Liebermann von VVahlendorf
Surrender, Occupation, and Private Property
in International Law (2)-An Evaluation of Some United States Practices
during the Occupation of SurrenderedJapan- •••••••••••••••••'''''''••••'''''''•• Nisuke And6
The Gist of Labor Relations Law in Japan: Its Universalities
and Pecurialities •••••••••''''••••••••••••••••••••••••••••••••••••••••••'•••••t••••••••••• Fnjio Hamada

Umweltschutz in Japan •••-•••''''''"•••••••••••••••"'''''''''''''''"''''''''''''•••-••• Yoshihisa Okoshi

RESEARCH INSTITUTE FOR ECONOMICS AND
BUSINESS ADMINISTRATION, KOBE UNIVERSITYHISTORICAL SKETCH
In 1919, a research organization named the Institute for Commerce wasfounded in Kobe Higher Commercial School, one of the chief predecessors ofKobe University, with a gift made by F. Kanematsu & Company, a leading
mercantile firm in Kobe. The organization was designed to carry on andfacilitate integrated research on business and commerce and to formulate andpublish the results of these studies and investigations in such form as to makethem available to the business community.

With the founding of Kobe University of Commerce, successor of Kobe
Higher Commercial School, in 1929, the Institute extended its research
activities by adding several divisions. One was the famous Latin-American
Library, which soon became the center of research in this field in Japan. A
room for statistics equipped with various computing machines was establishedand began publication of 1dyO Keizai TOleei and Sekai Bbeki TOkei annual!y. A
filing room was prepared to deposit press clipping files systematically arranged

by topics and dates. Another room was designed to become the center of all
possible original records and data having to do with the beginning and• progressof Japanese business.

On the campus of Kobe University of Commerce, another organization named
the Institute for Business Mechanization was founded in 1941 utilizing businessrnachines donated by the IBM Corporation and others. With Professor Yasutaro
Hirai as its head a broad and forward-looking plan for business mechanization in

Japan was developed.

In 1944, Kobe University of Commerce changed its name to Kobe Universityof Economics. After the War, however, the University was consolidated withthree other colleges in Hyogo Prefecture to become Kobe University. With thisdevelopment, the two Institutes were also amalgamated into the ResearchInstitute for Economics and Business Administration, Kobe University. At
present, the Institute, with its twenty full-time professional st'aff members,
carries on studies and investigations in international economics, internationai

environment, international comparative economics, international business andmanagement information systems.

ORGANIZATIONThe Institute consists of six sections. Each section and its researchsubjects

are as follows:

1. International Economic Studies
International Economics, International Monetary Economics,
Maritime Economics, International Labor Relations

2. International Environmental Studies
Resource Development, Intemational Organizations,International Industrial Adjustment

3. International Comparative Economic Studies
Pacific Basin I (Oceanian Economy),
Pacific Basin ll (Latin American Economy),

Pacific Basin M (North American Economy)

4. International Business Studies
Comparative Business, Multinational Enterprise,International Business Finance

5. Management Information Systems
Business and AccouRting Information, Information Processing

System,International Comparative Statistics

6. International Cooperation

In addition to the ordinary work of each section, several

research

committees, whose members are not limited to the Institute staffs, areregularily held to carry on joint studies. At present, there are ten standing

research committees, as follows: Committee of International Economics,
Committee of International Finance, Committee of Maritime Economics,
Committee of Labor Market, Committee of International Studies on Economic
and Industrial Structure, Committee of World Link Model, Committe ofInternational Comparative Economics, Committee of International Business
Finance, Committee of Management and Accounting Information Systems, andCommittee of Interfiational Comparative Statistics.

For convenience and great6r efficiency in carrying out its research activities,
the Institute has a general office which is responsible for 1) the collection andpreservation of a comprehensive collection of books, periodicals, pamphiets, andoriginai records and data of finance, trade, commerce, industry and businessgenerally; 2) the•classification, cataloguing, indexing, arranging, annotation andcompilation of these research materials; and 3) the formulation and publicationof the results of the inv'estigations and studies accomplished by the professional
staff members of the Institute.

As an affiliated institute, the Documentation Center for Business Analysis has
been established in 1964. It is the first systematic information facilities in thefield of business administration in Japan that has been recognized and authorized

by the Ministry of Education. The purpose is to collect and to make intensive
control of ali kinds of materials on business administration and to make themavailable to scholars, universities, governments, and business world with the aidof modern documentation techniques. 'RESEARCH INSTITUII!E RORECONQMZCS & BVSINESS ADurNISTRATIONKOBE UNIVERSITY

Director: Hiromasa

Secretary: Takeo

YAMAbeOTO

KrSHIDArNTERNATIONAL ECONOMIC STUD!ESInternational Econoraics

rnternational Monetary Economics

Marititue Econoraics

Prof.
Prof.
Prof.

Kazuhiro IGAWA
Masahiro FUJrTA

Prof.

Hiromasa YAbCAMOTO'

Prof.

Nobuo OKISHIO

Hiroruasa YmmOTO

Assoc . Prof. Masahiro TOMIMA

International Labor Relations

Assoc. Prof. Kazuo SHIMOMURArNTERNATrONAL ENVIRONMENTAL STUDIES
Resource Developrttent

Znternational Organizations
rnternational Industrial Adjustment

Prof. Hikoji KATANO
Prof. Masahiro FUJrTA
Assistant Hideki rZAWA
Proi. Hiroshi SADAMrCHI
Assistant Ko MIYAZAKr
Prof . Akira

STUDrESINTERNATIONAL COMPARINTIVE ECONOMIC
Pacific Basin I(Oceanian Economy}
Pacific Basin rr(Latin Arnerican Economy)
Pacific Basin ZII(North Arnerican Economy}

INTERNATrONAL BUS!NESS STUDrES
Comparative Business
Multinational Enterprise
Znternational Business EinanceProf. Keniehi !SH:GAKI
Prof. Yoshiaki NrSHrMUKAIAssoc. Prof. Shoji NISHWr"aA
Prof. Yoshiaki NISHrMUKAIAssoc. Prof. Se"chi KATAYAbeiA
Prof. Hideki
Assoc . Prof•
Prof. Hideki
Assoc. Prof•Prof . Akio
MANAGEMENT TNFORbCATION SYSTEMSBusiness and Accounting Information
lntorrnation Processing Systemrnternational Comparative StatistÅ}cs

rNTERNATIONAL
COOPERATION
Office:NEGISHr

YOSHrHARA
Kenji KoJrbaAYOSHIHARA
Hidetoshi YAMAJZ

MoRrProf. rsao NAKANO
Prof. Isao NAKANOAssoc. PrOf• Komayuki ITOW
Prof. Nobuko NOSSE
Assoc. Prof• Yasuo KONrSHr
Prof. Peter David DRYSDALE(scheduled}

The Kanernatsu Memorial Hall
KOBE UNIVEIRSI!VY
ROKKO, KOBE, JILPIDI