-16-

contributed to a decline in world savings and upward pressure on real
interest rates.

However, the magnitude of the shift in world savings associated with
these effects may not have been large relative to total world savings.
Based on the data in Table 2, even at its peak in 1980 the portion of OPEC
savings available for investment elsewhere (OPEC's current account
surplus) amounted to only 6 per cent of gross national savings in OECD
countries. Over the period 1973-1980 OPEC's surplus averaged about 3-1/2
per cent cf OECD savings.

III.B. MCM Simulations

In order to analyze the relationship between OPEC's surplus and real
interest rates quantitively, a number of simulations have been run with
the MCM. The simulations involve subjecting the MCM to various exogenous
shocks. The particular shocks were selected partly on the basis of the
statistics presented above, and partly to compliment the theoretical
analysis of the previous section.

As noted above, much of the decline in OPEC's surplus during 1980-82
was the result of delayed response to the earlier (1979) price increase,
including increased OPEC absorption, reduced oi] consumption and increased
production in non-OPEC countries. We begin, therefore, with an oi] price
shock, in order to investigate the subsequent pattern of adjustment of
OPEC's surplus and real interest rates. Next we consider two policy
shocks similar to those addressed in our theoretical section. One
involves a monetary contraction, which has been cited as a factor
underlying both the decline in OPEC's surplus (by depressing output in of]

consuming countries) and the rise in real interest rates. The other


-13-

the real interest rate is required in order to eliminate the resulting
excess demand for goods. In the case of a monetary contraction, then, we
expect to observe a negative relationship between OPEC's current account
surplus and the real interest rate.

An Expansionary U.S. Fiscal Policy

In our model, an expansionary U.S. fiscal policy takes the form of a
temporary increase in U.S. government spending accompanied by the
issuing of an equal amount of U.S. government debt. The increase in
spending causes a rise in U.S. output, as shown by equation (14). This is
accompanied by an increase in U.S. oi] imports and, therefore, OPEC's oi]
revenues. Since OPEC's short run marginal propensity to save is assumed
to be equal to one, its savings -- and current account surplus -- rise by
the amount of the increase in its income. Thus, we see in equation (17)
that a U.S. fiscal expansion induces an OPEC current account surplus.

From equation (16) we see that the fiscal expansion also raises the
real interest rate. Accordingly, the implied correlation between OPEC's
surplus and the real interest rate is positive. The intuition behind this
result is as follows: At an unchanged real interest rate, the fiscal
expansion produces an increased desire to save on the part of both U.S.
private residents and OPEC. For U.S. residents, this occurs because
current income is raised above permanent income by the fiscal disturbance.
For OPEC, as discussed above, it is because the increase in-U.S. output is
accompanied by a rise in OPEC's income which, in turn, is fully reflected
in a rise in OPEC's saving. However, there is an offsetting decrease in
U.S. government saving equal to the amount of the increase in U.S,
government spending. In fact, in the model of this section, the fall in

U.S. public saving more than offsets the increased desired saving on the


~-19-

OPEC's current account initially rises substantially and real interest
rates fall. After about a year and a half, however, the rise in OPEC's
surplus peaks and begins to diminish. This pattern is remarkedly close to
the actual pattern that OPEC's surplus followed during 1979-80, as
illustrated in Chart 1. Real interest rates reach a low point somewhat
earlier (after about three quarters) and then begin to rise. Real
interest rates bottom out and begin to rise in advance of the OPEC surplus
peak because income (hence savings) in oi] consuming countries is falling.
The oil price increase reduces U.S. income by nearly 1/2 per cent after
one year and 2 per cent after three years.

OPEC's surplus declines with the rise in OPEC consumption and the
fall in oi] consumption elsewhere. This reduces ex-ante world savings,
which along with the continued recession in industrial countries, further
stimulates the rise in real interest rates. The total simulated swing in
short term real rates amounts to nearly 6 percentage points between mid-
1979 and mid-1981 for the United States and slightly less for the MCM
countries combined.2/ This movement amounts to somewhat more than one-
half of the actual swing in short term rates observed during that period.
In 1982, the simulation results show a continued fall in OPEC's surplus
but at a rate that is less than what is estimated actually to have
occurred. This is due, at least in part, to the fact that oi] production
in non-OPEC countries was held fixed throughout the simulation experiment.
Toward the end of the simulation period, both the decline in income in
non-OPEC countries and the rise in real interest rates (relative to the
historical control) are diminishing noticeably.

The simulated response of real interest rates to an oi] price

increase depends critically on the stance of monetary policy following the


-4-

which is held only by U.S. residents, and a real bonal/ that is held by
the residents of both countries. The model includes three exogenous
policy variables: the real price of oil, the rate of growth of the U.S.
money stock, and the level of U.S. government spending (bond financed).
"Shocks" to the model take the form of unanticipated once-and-for-all
changes in these three policy variables. Such disturbances cause short
run (one period) deviations of output, the price level, the balance of
trade, and interest rates from their full equilibrium, flexible wage
values.

The model can be summarized as follows:

Notation

Note: With the exception of interest rates, lowercase letters
denote the log value of a variable and uppercase letters denote the
variable itself.

x U.S. real output

the composite input, consisting of equal numbers of units of
labor and oil

labor employed in production of x
oil employed in production of x
U.S. nominal wage rate

U.S. price level

real price of oi]

U.S. consumption of x

oo 20D BO

OPEC's consumption of x
U.S. permanent income
U.S. current income

b OPEC's net holdings of bonds issued by U.S. residents or the
U.S. government

r the real interest rate

<“<«<


-17-

involves a fiscal expansion, which has been viewed as contributing
significantly to the jump in US real interest rates.

The salient features of the version of the MCM used for these
simulations are described elsewhere! We note here only that the MCM
differs from the theoretical model outlined in section II in a number of
important respects. It contains substantially greater structural detail
both in its country coverage and in the specification of goods, money and
labor markets within each country. In particular, it allows for lags in
the adjustment of demands and supplies to changes in prices in each of the
markets. Unlike the theoretical model, goods prices are sticky in the
short run and the marginal propesity to consume out of current income is
nonzero. Moreover, OPEC's consumption, in particular, responds to changes
in its income with a distributed lag, so that OPEC's marginal savings
rate, while near 1.0 in the very short run, is closer to zero in the long
run,

The greater detail in the MCM comes at the cost of some
inconsistency in the treatment of expectations, however. Price
expectations are functions of lagged prices in some cases, and static in
other cases, rather than rational. This leaves the model open to the
Lucas critique, that changes in expectations due to large changes in
exogenous variables are not well captured. Moreover, the real interest
rate typically is disaggregated into its components, and the estimated
response of consumption and invesmtent expenditures to the nominal rate
component often differs from the response to the expected inflation
component. This makes it difficult to identify a particular real rate
that clears the goods market. The simulation results obtained here must

therefore be interpreted with caution. In our judgment, the model


-22-

IV. Summary and Conclusions

We have analyzed the relationship between the recent decline in
OPEC's surplus and the rise in real interest rates both theoretically and
empirically. In the theoretical analysis it was shown that under some
conditions a decline in OPEC's surplus can lead to a fall in world savings
and, ceteris paribus, a rise in real interest rates. A higher ex-ante
savings rate in OPEC than elsewhere was a necessary condition for this
result. However, it was also noted that both the surplus and interest
rates are endogenous variables that reflect the influences of other
variables, and that in some cases a positive correlation can be expected,
even if OPEC's savings rate exceeds the rest of the world's.

A review of recent data suggested that OPEC's savings rate has
exceeded that in OECD countries, on average. We also analyzed the recent
decline in OPEC's surplus, finding that it reflected rises in OPEC
absorption and non-OPEC oi] production and declines in world oi1
consumption. It was reasoned that these factors represented to a
significant extent continuing adjustments to the 1979 OPEC price hike. In
addition, we noted that recession in industrial countries, which
contributed to the decline in oil consumption, could have been induced as
much by a shift in economic policy in oi] consuming countries as by the
oil price shock.

An effort was then made to quantify these relationships using
simulations with the MCM. In simulating the 1979 oil price shock, OPEC's
surplus was observed to rise sharply after the shock, and then fall, about
in line with the actual movement in the surplus over this period. Real
interest rates initially fell and then rose noticably as both OPEC's

surplus and income in of] consuming countries fell. This swing in real


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-15-

surplus was completely in terms of increased OPEC imports. The decline in
exports in 1980-82 was all in terms of volume.. While oil prices fell
somewhat during the latter part of this period, they were still above
their 1980 level in mid-1982. The decline in export volume reflects three
factors: 1) reduced consumption in response to higher oi] prices (which
for convenience, we will refer to as "conservation", 2) increased
production elsewhere, and 3) recession in oi] consuming countries.

The rise in OPEC's imports in 1981 and 1982 was almost all in terms of
volume, reflecting a delayed response: to the earlier jump in OPEC income.
OPEC's import prices (in dollars) rose very little between mid-1980 and
mid-1982. The dollar prices of OPEC's imports from countries other than
the United States were held down by the substantial appreciation of the
dollar during this period.

As discussed in the theoretical section a negative relationship
between OPEC's surplus and real interest rates can he expected, under
certain conditions, if OPEC's savings rate is greater than savings rates
elsewhere. Available data on OPEC and world savings, listed in Table 2,
provide evidence that OPEC's savings rate has been greater than those
elsewhere. At the time of the 1973-74 oi] price shock, OPEC's marginal
savings rate appears to have been substantially greater than the aggregate.
savings rate of the rest of the world. OPEC's savings rate declined
sharply during the latter 1970's as its consumption capacity grew, but
jumped again with the 1979 oil price hike, to a level well in excess of
savings rates in the United States and other OECD countries. OPEC's
savings rate may have dropped, of course, as its consumption rose during
1980-82. But as long as it remained above savings rates elsewhere, such

factors as rising non-OPEC oil production and conservation will have


-9-

II.B. The Response of the Model to Shocks

The solution to our model is summarized below.-/ (Complete
definitions of the coefficients entering the solution are set out in the
appendix.) It should be noted that the solution presented here is for the
special case in which OPEC's initial (pre shock) bond holdings are set
equal to zero. This assumption removes some of the ambiguities associated
with the general solution to the model, while leaving intact the results

we are concerned with.

(14) 6x = -948q + p96z + 9369

where Py» Pas 23 > 0
(15) Sp = 9484 + 956z + 9669

where m4 is unsigned and 25> P65 > 0
(16) 6r = p76q - pgdz + pgSg

where e7 is unsigned and Pg, Pg > 0

(17) 8b = p498q + 94462 + P4969

where P10 and p44, P42 > 0

Here 6q, 6z, and 6g denote unanticipated changes in the real price of oil,
U.S. monetary policy, and U.S. fiscal policy. Equations (14) through (17)
show the way in which these three policy shocks produce deviations of U.S.
output, the U.S. price level, the real interest rate, and OPEC's surplus
from their full equilibrium values. The remainder of this section is

devoted to interpreting these results. The focus of our discussion will


-28-

Appendix
Definitions of the Coefficients Entering Equations (14) Through (17)

Note: These coefficients apply to the special case in which the pre shock

level of OPEC's bond holdings is zero.
01 = (1/A){BA00(1-a) + (1+A)(1-a) (1-8) (1-7) oY}
bp = (1/4) {8 (1-a)(1+a)?(1-r) oY}
03 = (1/4) {8A(1-a)(1-r) 6}
bq = (1/4) { (1-0-8 AQ + u(1-a) (1-8 )(1-F)o¥}
ps = (1/A){a(144)2(1-r)o¥}
06 = (1/4) {ar(1-r) 6}
67 = (1/4){QOL(1+A)(1-a-rB) - vB (1-0) J}
bg = (1/4) {8 (1-0) (1+2)2( 1-78 )X}
bg = (1/4){ (1-r)GL(us (1-0) + (14A)a]}

(1/4){oYE(1+A)(1-a-r8) - uB(1-a)] + 82(1-a)aX + B(1+A)(1-r)o¥}

°10

(1/4) (1/¥°) {a (1-2) (1-8 ) (14a) 20X¥}

P11
ey = (1/A)(1/¥") {8 (1-a) (1-8 ) GX}

where A = (1-r)o¥[up(1-a) + (1+A)] + B(1-a)a(1-r8)X


-25-

9.1/ The solution of equations (1) through (12) of the text requires
calculating the one period ahead expectation of the U.S. price level.
This expectation appears in equation (10) as a determinent of the nominal
interest rate. To find SP _y> we begin by substituting equations (9),

(10), and (11) into (12) and updating the result by one period.

s
dm, - 8Py, = wex,, - ASP - A(SP49 - 5P41)

As already noted, 6x and ér are expected to be equal to zero in the post
shock equilbrium. The term (8P,5 - 8P41) is simply the change in the
expected rate of inflation in the post shock equilbrium, which is simply
equal to the change in the rate of growth of money, or 6z. The term
amy is the deviation of the money stock in the post shock period from
the value it would have assumed in the absence of shocks. Since the post
shock period is the second period in which altered money growth rate

is applicable, this term is equal to 26z. Substituting these values into

the equation above and simplifying gives
Pay = (2+A)6z

Once this equation is substituted into equation (10) of the text, the
solution of the model is a matter of straightforward algebra.

12.1/ Note that U.S. savings can fall more than OPEC's rises even with a
lower savings rate in the U.S. because U.S. savings falls due to the

decline in U.S. output as well as the transfer to OPEC.


-6-

(11) 6mS = &z

(12) 6mS 4

aw

ém

Equation (1) gives the U.S. production technology. Output of the
consumption good is proportional to the amount of the composite input
employed in production. One unit of the composite input consists of one
unit of labor and one unit of oil, which are used in fixed proportions.

The long-run supply of labor is assumed to be completely inelastic
with respect to the real wage. Consequently, the full equilibrium levels
of output and employment are the same before and after the oil price
shock. In the short-run, however, the amount of labor and oi] employed in
production is completely demand determined. The underlying assumption
here is that the supply of labor is infinitely elastic in the short-run,
where the short-run is defined by the length of labor contracts. The
derived demand for’ the composite input, as well as the derived demands for
labor and oil, are obtained from the conditions for profit maximization
and are given in equation (2). These demands depend on the price of the
composite good in terms of the consumption good -- that is, on the sum of
the real wage rate and the real price of oil. Since the nominal wage rate
is fixed, the real wage rate varies inversely with the U.S. price level.
Thus, equation (2) shows these derived demands to be positively related to
the U.S. price level and negatively related to the real price of oil.

In equation (3), U.S. demand for the consumption good is written as
an increasing function of U.S. permanent income and a decreasing function
of the real rate of interest. Permanent income, in turn, is defined to be

the level of income expected to prevail in subsequent periods in the


-5-

Notation (continued)

on 3a

the nominal interest rate

the level of U.S. government spending on x
the U.S. money stock

the rate of growth of the U.S. money stock

denotes the deviation of the current value of a variable

from its full equilibium value. Thus, for example, 6x represents
the deviation of the log value of output from the log value of its
full equilibrium (or full employment) level. For small changes, 6x
approximates the percentage deviation of output from it's full
equilibrium value. .

The Model

Note: The model has been log-linearized around the initial (pre-

shock) equilibrium. A bar over a variable indicates its initial

equilibrium value. Unless otherwise indicated, Greek letters represent

parameters.

(1) 6x = (1-a)éh

(2) 6h = 81 = 60 = -(1/a)[s6p + (1-8)8q], 8 = (W/P)L/E(W/P)L + 00]
(3) 6c = 6yP - odr

(4) dyP = =(007¥)8q - (rB/Y) 6b

(5) 6y = (X/¥)éx ~ (00/¥)(8q + 60) - (rB/Y)éb - (B7Y)ér
(6) 6° = 0

(7) 6b = (¥/B)(éc - by) + (G/B) 8g

(8) 6x = (C/X)6c + (C°7X)sc° + (G/X)éq

(9) m4 - Sp = wox - r64

(10) 64 = 6r + 6p.) - 6p


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-8-

deficit financed. Accordingly, public dissaving is equal to the change in
government spending.

Equation (8) is the log deviation form of the goods market
equilibrium condition: The supply of output must equal the sum of the
demands for output by U.S. residents, the U.S. government, and OPEC.

Equations (9) through (12) describe the U.S. money market. Real
money demand is given in equation (9) as a function of real income and the
nominal interest rate. The nominal interest rate is given in equation
(10) as the sum of the real interest rate plus the expected rate of
inflation. U.S. monetary policy takes the form of setting a constant rate
of growth, z, of the money stock. The log of the money stock in any

period t, then, is given by

(13) me = mp_

Equation (11) simply restates this relationship in deviation form. Any
change in monetary policy -- that is, any change in z -- is assumed to be
unexpected and, once it occurs, permanent. Equation (12) state the
equilibrium condition for the money market.

The model outlined in equations (1) through (12) above involves
expectations of the future price level and policy variables. To complete
the model the manner’ in which agents form their expectations must be
specified. It is assumed that agents' expectations are "rational" given
their assumptions about U.S. monetary and fiscal policies and OPEC's oil
pricing policy. If their views about these policies are correct, then

their price predictions will be realized.


-20-

disturbance. To see this, it is useful to trace through the behavior of
inflation and nominal interest rates in this simulation and note the
sensitivity of the results to the maintained assumptions about monetary
policy. Domestic inflation rises fairly steadily following the oi] price
shock, reaching a peak of about 3 per cent above control by the fourth
quarter of 1979, and then declines, eventually falling below the
historical rate for a time as the oil price shock works through the goods
and labor markets in the model. The decline is abetted by the recession
that is also induced by the oi] price shock. Nominal interest rates rise
with the price-induced rise in nominal domestic expenditures, which
stimulate demand for money. The rise in nominal rates varies across
countries, depending upon the stance of monetary policy. It is greatest
in the United States, where money is assumed to be least accommodating.
Had a more accommodating monetary policy been assumed, the simulation
would have shown a smaller initial rise in nominal U.S. interest rates and
a higher response of domestic inflation. On balance the level of real
interest rates would have been somewhat lower during the period of dynamic
adjustment to the oil price shock. This lower level of real rates during
the adjustment period would have been associated with a less pronounced
decline in U.S. income and saving.

U.S. Monetary Contraction

This shock involved a sustained exogenous 1 per cent reduction in
the rate of growth of the U.S. money stock (M1). The effect is eventually
to raise U.S. short-term nominal interest rates by about 500 basis points
in order to reduce money demand and equilibrate the money market. With
Prices adjusting slowly, measured real interest rates rise by a similar

amount in the near term. (The movement in "world" real rates principally


International Finance Disucssion Papers
Number 215

January 1983

OPEC'S SURPLUS AND REAL INTEREST RATES

by

Jo Anna Gray and Peter Hooper :

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished
material) should be cleared with the author or authors.


-11-

cases in which a fall in the real price of oi] leads to decline in OPEC's
oil revenues and current account surplus.

From equation (16) we see that the effect of a decline in the real
price of oi] on the real interest rate is ambiguous. Consequently, the
correlation between OPEC's current account surplus and the real interest
rate following an oi] price shock may be either positive or negative. The
intuition behind this result is as follows: The real interest rate may be
viewed as the price that adjusts to equate the world demand for goods to
the world supply of goods. Alternatively, it adjusts to eliminate any
incipient excess supply of world saving. If the oil price shock causes an
ex ante increase in desired world saving, the real interest rate will
fall to eliminate the associated excess demand for goods. If it brings
about a decrease in desired world saving, the real interest rate wil
rise.

Because OPEC's short run marginal propensity to save is equal to
one, the decline in its income following a fall in the price of oil
results in an equal decline in its desired saving. This, in turn, will
lead to a decrease in desired world saving and upward pressure on the real
interest rate only if OPEC's reduced desire to save is not fully (or more
than fully) matched by an increased desire to save in the United States.
An increased desire to save is, however, a likely outcome for the United
States. The oil price decline raises current income in the United States
above its (new higher) level of permanent income. If consumption depends
on permanent income, savings will rise in order to maintain consumption at
a level consistent with permanent income. If the increased desire to save
by the United States is less than the decreased OPEC desire to save,

desired world saving will fall, with consequent upward pressure on the


~10-

be on the correlation in the responses of the real interest rate and
OPEC's surplus to the three policy disturbances.

A Decline in the Real Price of Oil

Among the consequences we generally expect to observe following a
decline in the real price of oi] is an increase in output in those
countries that import oi] and a fall in OPEC's oi] revenues. Examination
of equation (14) shows that the first of these expectations is confirmed
by our model. A fall in the the real price of oi] unambiguously raises
U.S. output because it lowers the price U.S. firms must pay for the
composite input.

On the other hand, OPEC's oi] revenues do not necessarily fall with
a decline in the price of oi]. Under the assumption that OPEC saves all
changes in income in the short run, the change in OPEC's oi] revenues is
equal to the change in its current account surplus, as given by
equation (17). From equation (17) we see that the impact of a decline in
the price of oi] on OPEC's surplus (or, equivalently, its oi] revenues) is
ambiguous. The reason for this is straigtforward. At an unchanged level
of output (and, therefore, oil imports) in the U.S., OPEC's oil earnings
would fall as the real price of of] falls. But U.S. output and oil
utilization rates rise as the price of oil falls. If they rise by enough,
OPEC's total oi] revenues will actually increase following an oil price
decline. Since it is generally assumed that OPEC is operating in the
inelastic portion of its demand curve, we choose to rule out by assumption
this latter possibility. Formally, this can be achieved by assuming that
a and ® are large enough -- that oi] is not "too" important in the

production process. Thus, we are restricting our attention to only those


-27-

21.1/ In our theoretical analysis, we consider a temporary fiscal shock
that persists for only one period. One period in our theoretical model,
however, corresponds to the duration of a "typical" labor contract. The
typical union contract in the U.S. runs for approximately 2 years, or
eight periods in the quarterly MCM model. For our purposes, then,
subjecting the MCM to a sustained fiscal disturbance approximates the

theoretical fiscal exercise carried out in section II.


-26-

14,1/ This result is unambiguous because the marginal propensity to
consume out of current output in our model is zero. This, in turn, is due
to the assumption that the marginal propensity to consume out of current
income is zero for both OPEC and the U.S. At an unchanged price level and
real interest rate, then, the increase in government spending will
generate an equal increase in demand for U.S. output (the simple
government spending multiplier is unity). This excess demand will be met
only in part by an increase in output, all of which will be saved.
Accordingly, if the real interest rate is held constant, the increased
private saving generated by this fiscal disturbance is less than the
decreased saving of the government. It follows that the real interest
rate must rise in order to equilibrate the goods market.

14.2/ Both of the measures of real interest rates we employ are only
proxies for actual "real" interest rates. In principle, the real interest
rate should be measured as the nominal rate minus the expected future rate
of inflation. To the extent that expectations were either realized or
influenced primarily by current inflation, the error in these proxies is
likely to have been small.

17.1/ See Tryon (1983) and Hooper and Tryon (1982).

18.1/ OPEC's average contract price rose fairly steadily from about

$13 dollars per barrel in the fourth quarter of 1978 to $30 per barrel in
the second quarter of 1980. By the fourth quarter of 1981 it had reached
$34.50 per barrel.

19,1/ The five main industrial countries that are modelled explicitly in
the MCM are Canada, Germany, Japan, the United Kingdom, and the United
States. In addition, the MCM includes abbreviated sectors for OPEC and
the ROW.


-7-

absence of any further shocks to the system. Changes in the model's three
policy variables affect permanent income in two ways: Changes in the real
price of oil alter the share of U.S. output that goes to OPEC in payment
for oil. And changes in any of the three policy variables alter OPEC's
net. holdings of U.S. bonds, thereby altering the level of U.S. interest
Payments. Accordingly, equation (4) shows deviations in permanent income
to be negatively related to deviations in both the real price of oi] and
OPEC's net holdings of bonds. Other factors that might be expected to
enter into the determination of U.S. permanent income, including U.S.
output, U.S. oi] imports, and the real ‘interest rate, do not enter
equation (4). This is because the: full equilibrium values of these
variables are assumed to be invariant with respect to the policy variables
we consider.t/ In the short run, however, output, oi] imports, and the
real interest rate do respond to policy shocks and therefore can influence
current income. In equation (5) current income is written as a function
of these three variables as well as the real price of oi] and OPEC's
holdings of U.S. bonds.

A critical feature of the model is the assumption that OPEC is
unable immediately to adjust its level of consumption to changes in the
level of its permanent income. Specifically, OPEC is assumed to have a
short-run marginal propensity to save (out of both current and permanent
income) of one. This assumption is captured by equation (6), with short-
run deviations in OPEC consumption set equal to zero.

Equation (7) states that OPEC's net accumulation of bonds -- or,
equivalently, its current account surplus -- is equal to the sum of U.S.
private and public dissaving. Changes in the level of U.S. government

spending are assumed to be temporary (one period in duration) and to be


-18-

nevertheless provides a useful empirical framework for modelling flows of
savings between major industrial countries and OPEC and analyzing the
dynamics of adjustment to oi] shocks.

The results of the simulations are reported in Table 3, which lists
the impacts of each shock over a 4-year period on the OPEC current
account, the U.S. short-term real interest rate, and an average of short-
term real interest rates in the MCM's industrial countries, weighted by
GNP shares. The U.S. real interest rate is the three-month Treasury bill
rate minus the realized (one-quarter ahead) domestic inflation rate.
Foreign real rates were defined analogously, for each of the four non-U.S.
MCM countries.

The design of each simulation and the results are summarized below.
All of the shocks were started in the first quarter 1979 and run through
the fourth quarter 1982. In each of the simulations the money supplies of
the MCM countries were held to their historical paths. The paths varied
considerably across countries. Most notably, nominal interest rates in
countries other than the U.S. were generally less sensitive to the various
shocks than U.S. rates.

OPEC Price Increase

This simulation involved comparing the model's prediction of what
transpired over the period 1979-82 with its prediction of what would have
happened if the 1970-80 oi] price increase had not taken place (i.e.,
holding nominal oi] prices to a 5 per cent annual rate of inflation after
the fourth quarter of 1978) .2/ The results of this simulation in the
short run are consistent with the theoretical analysis of an oi] price
decline discussed in Section II, given that OPEC's marginal savings rate

is substantially above that elsewhere. Following the oil price increase,


-23-

rates was equivalent to more than half of the actual increase during
1980-1982. The simulated rise in real interest rates was more pronounced
in countries that maintained relatively tight monetary policies in the
face of the oil price shock. Next we simulated shifts in monetary and
fiscal policy. These shocks had small impacts on OPEC's surplus, but
large near term effects on real interest rates, principally through
channels other than the shift in OPEC's surplus.

Based on this analysis we conclude that the change in OPEC's surplus
was not the ultimate casual factor underlying the rise in real interest
rates in 1980-82. However, the relationship between the two variables
during 1980-82 was more than a chance correlation. Movements in both
variables to a considerable extent reflected the continuing pattern of
adjustment of the world economy to the 1979 oil price shock. It also
seems likely that a tightening of U.S. monetary policy and easing of U.S.
fiscal policy contributed significantly to the rise in real rates, at
least in the United States, quite independently of movements in OPEC's

surplus.


-3-

expansionary fiscal policy in. the U.S. Because of the simplicity of the
model employed, the. analysis excludes any assessment of the dynamic
adjustment of OPEC's surplus.and real interest rates to the various
shocks. This. is. left to simulation analysis with the MCM in the next
section,

To summarize-the results, only in one.of the cases --that of a
monetary contraction -- do we find that OPEC's surplus falls and the real
interest rate rises unambiguously.. In the case of an oil price decline,
the surplus falls but the real interest rate may either rise or fall. And
in the case of a fiscal expansion, both the real interest rate and OPEC's
surplus rise. We conclude, then, that a fall in OPEC's surplus need not
be associated with a rise in real interest rates. In those cases in which
it is not, the impact cn ex-ante world savings of the fall in OPEC's
surplus is more than offset by an increased desire to save on the part of
U.S. citizens or their government. A fall in the real interest rate is
required to eliminate the incipient excess supply of goods.

II.A. The Model , ,

The one period, discrete time model described in this section is a
modification of the framework developed in Canzoneri and Gray (1983).
There are two countries, one oi] producing country called OPEC and one oi]
importing country called the U.S. Oi] is an intermediate good that is
used by the U.S to produce a single consumption good that is consumed in
both countries. Labor is the only other variable input employed in the
production of the consumption good ; it is used in fixed proportions with
oil. The nominal wage rate is set contractually at the beginning of each
period, introducing the possibility of short run deviations of output from

its fuli employment level. There are two assets in the system: U.S. money


-14-

part of U.S. residents and opec.t/ The result is a decline in desired
world saving and a rise in the real interest rate. Thus, in the case of a
fiscal expansion, we expect to observe a positive relationship between

OPEC's current account surplus and the real interest rate.

III, Empirical Analysis

This section provides a quantitative analysis of the relationship
between OPEC's surplus and real interest rates. We begin with a review of
recent data on movements in real interest rates, OPEC's surplus and OPEC
and world savings rates. We then attempt to gauge the magnitude of the
effects of the various shocks discussed in the previous section, using
simulations with the MCM.

III.A. Data Review

Chart 1 plots OPEC's surplus and the three-month U.S. Treasury bill
rate adjusted for both current and realized (led) CPI inflation rates.

By either measure, short term real dollar interest rates rose by as much
as 10 percentage points between mid-1979 and mid-1 982.2/ This movement
was clearly negatively correlated with the sharp decline in OPEC's
surplus during 1980-82. These two variables also were negatively
correlated during much of 1973-75, following the 1973 oi] price shock.
However, during much of the latter 1970's the two variables were
positively correlated.

Movements in OPEC's surplus over the past decade are analyzed in
Table 1. These data show that of the estimated decline of more than $100
billion in OPEC's surplus between 1980 and 1982, about 60% was due to a
decline in exports and 40% to a rise in imports and net service payments.

This contrasts with the 1974-78 episode, when the disappearance of OPEC's


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-2-

decline in OPEC's surplus and the relative magnitudes of OPEC and non-OPEC
savings and savings rates. The simulation analysis is then employed to
assess quantitatively the response of both OPEC's surplus and real
interest rates to several exogenous shocks relevant to the time period
under consideration.

A summary of the results and some concluding remarks are contained

in Section IV.

II. Theoretical Considerations

In analyzing the relationship between OPEC's surplus and real
interest rates, it must be recognized that both variables are endogenous
in the world economic system and that the relationship between the two
depends crucially on the nature of the shocks impinging on that system.

As we shall see, theory suggests that the correlation between the surplus
and real interest rates can be either positive or negative, depending upon
the particular shock involved, and the way in which the structure of the
world economy is specified.

The analysis presented in this section is organized as follows: We
begin by outlining a simplified general equilibrium framework in which
both OPEC's surplus and a (single,-world) real interest rate are
endogenously determined. For simplicity, the model consists only of OPEC
and one large oi] consuming region which is referred to as the us!
This analytical framework is then used to study the effects of three
different disturbances, each of which has been cited as a factor
underlying the recent decline in OPEC's surplus or the rise in real
interest rates or both. The disturbances include a decrease in the real

Price of oi1, a contractionary monetary policy in the U.S., and an


-21-

reflects the U.S. rate; real rates in other MCM countries move relatively
little.) The rise in the interest rate depresses domestic expenditure and
output, reducing the demand for oil. OPEC's surplus falls, but by less
than $5 billion. The relatively large impact on real interest rates and
small impact on OPEC's surplus suggests that the monetary shock
significantly affects real interest rates independently of its impact on
OPEC's surplus.
U.S. Fiscal Expansion

This shock was a sustained increase in real government spending
equal to 1 per cent of GNP in the first quarter of 1979, with the money
supply treated exogenously! Consistent with the theoretical discussion
in Section II, this shock generates a positive correlation between OPEC's
surplus and real interest rates. The fiscal expansion initially
stimulates U.S. income and imports of oi1, which also raises OPEC's
exports and current account surplus. U.S. real interest rates rise by
200-300 basis points, however, partly because of money market effects
(increased demand in the face of unchanged supply), and partly because of
an ex-ante decline in private world saving (crowding-out effects of
increased government deficit). The reader may note that OPEC's surplus
evenually turns negative. This is simply an artifact of the model 's
dynamic adjustment pattern; convergence to the steady state is not
monotonic. The point of this simulation is to illustrate that real
interest rates could have been influenced significantly by factors other

than those underlying the decline in OPEC's surplus.


OPEC's Surplus and Real Interest Rates

by

Jo Anna Gray and Peter Hooper*

I, Introduction

Over the two year period beginning in 1980, OPEC's current account
surplus is estimated to have declined by $100 billion or more, to about
zero in 1982. This sharp decline has been cited as a possible explanation
for the equally dramatic increase in real interest rates (as measured by
nominal rates minus actual inflation rates) that took place over the same
period. It is argued that the disappearance of OPEC's surplus generated
upward pressure on real interest rates by inducing an incipient fall in
world savings relative to investment. The theoretical and empirical bases
for this argument are examined in the present paper.

The paper begins, in section II, with a theoretical analysis of the
relationship between OPEC's surplus and real interest rates. The analysis
is intended to show that OPEC's surplus and the real interest rate are
endogenous variables, and that the observed relationship between the two
depends on both the types of shocks impinging on the world economic system
and the pattern of economic adjustment to these shocks. The results of
this theoretical analysis also indicate that the correlation between
OPEC's surplus and real interest rates may be expected to be positive in
some circumstances and negative in others.

The relationship between OPEC's surplus and real interest rates is
examined quantitatively in Section III, both by reviewing recent data and
by running simulations with the Federal Reserve Board staff's Multicountry

Model (MCM). The data review considers both the factors underlying the


-29-
References

Canzoneri, Matthew and Jo Anna Gray, “Oil Price Changes and Monetary
Policy in a Three-Country Framework," (forthcoming).

Hooper, Peter and Ralph Tryon, "Macroeconomic and Exchange Rate Effects of
an Oi] Price Shock under Alternative OPEC Investment Scenarios,"

Supply-Side Shocks, the Balance of Payments and Monetary Theory

(Proceedings of the Fifth Pacific Basin Central Bank Economists
Conference, September 1981), Kevin Clinton, editor, Bank of Canada,

September 1982,

Tryon, Ralph, “Modeling 011 Price Shocks in the FRB Multicountry Model",
(forthcoming).


-24-

Footnotes

*/ The views presented here are the authors and do not necessarily
represent the views of the Federal Reserve Board or its staff. Lois
Stekler, Ralph Tryon, John Underwood and Julie Withers contributed
significantly to the work presented here. We are also indebted to Cathy
Crosby, John E. Keniley and Caryl McNeilly for their able research
assistance. Any errors that remain are our own.

2.1/ The model presented in this section is a modification of the model
developed in Canzoneri and Gray (1983). Their framework includes two oil-
importing countries rather than the one oil-importing country of the
Present paper. In addition, consumption depends on permanent income in
the present paper, while in Canzoneri and Gray the consumption of the two
oil-importing countries depends on current income.

4.1/ This real bond pays a variable rate of interest; it is like a
savings account that pays a real return that is adjusted each period to
equal the return on newly issued bonds.

7.1/ The long run supply of labor is assumed to be completely inelastic
with respect to the real wage rate. Consequently, the amount of labor and
oil employed in production (recall that labor and oil are used in fixed
Proportions) is fixed in the long run. Since none of the three
disturbances we consider affect the production function, the long run
equilibrium level of output is invariant in this model. Similarly, the
long run equilibrium real interest rate is that rate which equates demand
for the consumption good to the economy's permanent income. In the
absence of permanent changes in government spending, this rate is a

constant in our model.


~12-

real interest rate. In this case, a negative correlation between OPEC's
surplus and the real interest rate would be observed. However, if the
increased desire to save by the United States exceeds the reduction in
OPEC's desired savings, the opposite result would hold and a positive .
correlation would be observed./

A Contractionary U.S. Monetary Policy

Because nominal wage rates in the U.S. are contractually fixed in
the short run, a decrease in the rate of growth of the U.S. money supply
raises the U.S. real wage rate by lowering the U.S. price level. (See
equation (15).) This, in turn, leads to a fall in current U.S. output, as
shown by equation (14). The reduction in U.S. output is accompanied by a
fall in U.S. oi] imports and, accordingly, OPEC's oil revenues. Because
OPEC's short run marginal propensity to save is one, OPEC's saving -- and
its current account surplus -- decline by the same amount as the fall in
its income. Thus, we see in equation (17) that a U.S. monetary
contraction induces OPEC to run a current account deficit.

From equation (16) we see that a U.S. monetary contraction raises
the real interest rate. Accordingly, the implied correlation between
OPEC's surplus and the real interest rate following a monetary shock is
negative. The intuition behind this results is as follows: At an
unchanged real interest rate, the U.S. contraction produces a decreased
desire to save in both the U.S. and OPEC. For the U.S., this occurs
because current income is reduced below permanent income by the monetary
disturbance. For OPEC, as already discussed, it is because the reduction
in U.S. output is accompanied by a fall in OPEC's oi] revenues which, in
turn, is fully reflected in a decline in saving. Thus, desired world

saving falls following a decline in the real price of oil, and a rise in


CHART 1

‘The OPEC Current Account! and US Real Interest Rates?!
Percent Billions $
12 . 4125
OPEC current account, 1974-1981
OPEC current account, 1982 projection
US real interest using lagged inflation
. US real interest using led inflation
ok 100
7 Jat-June
a Jat-March
“6 4 75
3h — 50
N
bb WN 25
\
VON
.
N
.
\
ak “oN oe
\ : Sf ay”
NS we
6 ! N l ! ! N 1 l I 25

1972. 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

1 Calculation of the current account balance is given in Table 1.

2/ The real interest rates are annual statistics representing the average

~ monthly rate. Monthly real interest rates are calculated as the
average market yield of 3-month Treasury bills less the unadjusted
CPI inflation rate which is either lagged (over the previous 3 months)
or led (over the following 3 months). All data are taken from the FRB
macro data base.