-17-

equals p, the exogenously-given return on foreign bonds.

(12) p=rte- er

Adding together the demand for domestic and foreign bonds
gives

(13) S(r,y,Z) = Tle,y)

Cd t+

where S is the total flow demand for bonds minus domestic investment.
This private national saving will be an increasing function of the
interest rate and income and a decreasing function of animal spirits.
Since the interest parity condition (12) contains only two
endogenous variables, e and r, it will be useful to eliminate the third
endogenous variable, y, from (13) as well. The LM curve can be solved
for income as a function of the interest rate, the exchange rate, and the
money supply. We do not substitute for the exchange rate as we have

previously.

(14) H(r,y,e) =H; y = y(r,e,H)
-++ +--+

Putting (14) into (13) gives an IS-LM equilibrium relationship between

the interest rate and the exchange rate:

(15) S(r,e,H,Z) = T(r,e,H)
+o +- -+-


-ll-

capital in the U.S.) and an asset-preference shock (an increase in A, the
preference for U.S. bonds over foreign bonds of equal return and risk of
default) is illustrated in figures (2a) and (2b).

The profitability increase shown in figure (2a) raises
investment demand, leading to the same overall results as a fiscal
expansion: a rise in income and interest rates, and a capital inflow.

Part of the increased investment (new office buildings in Houston) is

financed from abroad.

(2a) (2b)
a profitability increase an asset preference shift

Figure (2b) illustrates the effect of a shift in international
preferences regarding the currency denomination of assets (assuming that

dollar-denominated assets ultimately must be hacked by investments in the


-21-

capital inflow could occur. This would put upward pressure on interest
rates that conceivably could more than offset any downward pressure:
coming from the actual slowdown in investment.

To summarize, I have shown the following:

1) An actual increase in investment demand in the United
States (due, for example, to an increase in the perceived marginal
product of capital) will draw in savings from abroad, appreciating the
dollar. The increase in perceived profitability shifts the IS curve to
the right, leading to higher interest rates in the U.S.

2) An anticipated increase in investment demand also results
in a capital inflow and an appreciation. However, unlike the actual
investment boom, the anticipatory capital inflow lowers interest rates by
causing a contractionary shift in the trade balance and by reducing
prices and the demand for money.

3) The high value of the dollar and the upward-sloping term
structure of international interest rate differentials in 1984 are
consistent with anticipated as well as actual high investment demand in
the United States.

4) Should a slowdown in investment be associated with reduced
expectations of future profitability, a reversal in capital flows could
occur that would tend to boost interest rates, even though the investment

slowdown itself exerts a moderating influence on rates.


-3-

I. A Puzzle in the International Term Structure
Let me review a popular explanation for the strength of the
dollar, the real interest parity hypothesis. This hypothesis can be

illustrated using figure (la).

real interest real interest

differential differential /

o- — —- J—- — — — —

1985 1995 1985 1995
(1a) (1b)

theoretical and apparent actual shape of the term structure
of international real interest differentials

The horizontal axis measures time. The vertical axis measures the short-
term real interest differential expected to obtain between the 1.S. and
its major trading partners. Thus, the figure plots a hypothetical term
structure of real interest rate differentials, derived by comparing bonds
of different maturities to a measure of expected inflation.

The real interest parity hypothesis is that the percent
deviation of the dollar from its steady-state value (which could be taken
as the level consistent with trade balance) is equal to the area under
the curve in figure (la). Under the assumption that investors anticipate

a return to steady state (in which real interest differentials fall to


-18-

Equation (15) states that in order to increase private national saving we
must run a trade surplus. An increase in the interest rate, which boosts
private saving, must be a matched by a depreciation of the exchange rate
(a rise ine). Thus, this IS-LM equation is upward-sloping when it is

plotted in figure (3) in e-r space.

Ts-Ln |
DS-LN
WA \
e vA e
/ interesr parity interest Parity
v (3) vr
an increase in profitability an expected increase in profitability

In addition, I have plotted the interest parity condition (12).
For now, we take the expected level of the exchange rate, e*, to be its
steady-state value. The interest parity equation is downward-sloping in
e-r space.

An increase in Z, the profitability of investment, shifts the
IS-LM equilibrium to the right, as the investment requires both more
domestic saving (and thus higher interest rates) and a capital inflow
(leading to an exchange rate appreciation). If the interest-parity

condition were vertical (as in the no-foresight case), the exchange rate


-24-

References

Blanchard, Olivier J. and Lawrence H. Summers, "Perspectives on High
World Real Interest Rates," Brookings Papers on Economic Activity
1984:2, 273-334.

Branson, William H., Arminio Fraga, and Robert A. Johnson, "Expected
Fiscal Policy and the Recession of 1982," unpub., Feb., 1985.

Dooley, Michael P. and Peter Isard, "The Appreciation of the Dollar: An
Analysis of the Safe-Haven Phenomenon," International Monetary Fund
‘Departmental Memorandum 85/20, April, 1985.

Dornbusch, Rudiger, "Expectations and Exchange Rate Dynamics," Journal of
Political Economy 84 (Dec., 1976), 1161-1176.

Fleming, J. Marcus, "Domestic financial policies under fixed and under
floating exchange rates," International Monetary Fund Staff Papers,
9 (Nov., 1962), 369-380.

Frankel, Jeffrey A.,"The Dazzling Dollar," Brookings Papers on Economic
Activity 1985:1, 199-218.

Gavin, Michael, "The Stock Market and Exchange Rate Dynamics," unpub.,
Sept., 1984.

Glassman, James E., "The Influence of Exchange Rate Movements on
Inflation in the United States," Economic Activity Section Working
Paper No. 46, Federal Reserve Board, April, 1985.

Kling, Arnold, "Simulating Exchange Rate Shocks in the MPS and MCM
Models: An Evaluation," IFDP #260, August, 1985.

Krugman, Paul, "Is the Strong Dollar Sustainable?" NBER Working Paper No.
1644, June, 1985.

Mundell, Robert A., "Capital Mobility and Stabilization Policy under
Fixed and Flexible Exchange Rates," Canadian Journal of Economics
and Political Science 29 (Nov., 1963), 475-485.

_.» "A Reply: Capital Mobility and Size," Canadian Journal of
‘Economics and Political Science 30 (Aug., 1964), 421-431.

Sachs, Jeffrey D., "The Policy Mix and the Dollar: 1985," Brookings
Papers on Economic Activity 1985:1, 117-198.

Tobin, James and Jorge Braga de Macedo, "The short-run macroeconomics of
floating exchange rates: an exposition," in John S. Chipman and
Charles P. Kindleberger, eds., Flexible Exchange Rates and the
Balance of Payments, Essays in Memory of Egon Sohmen. Amsterdam:
‘North-Holland, 1980.



-20-

Conclusion

The recent economic environment can be viewed as a combination
of both an actual investment boom and an expected investment boom. The
actual investment boom shifts the IS-LM schedule in figure (3) to the
right, while the anticipated investment boom shifts the interest parity
condition to the left. The exchange rate is bound to have appreciated,
but some of the upward pressure on interest rates due to strong
investment is relieved by the anticipatory capital inflow. This may
serve to explain why the interest differential is lower in the near term
than in the long term.

Thus, it appears that the puzzling term structure of interest
differentials depicted in figure (1b) can be viewed at least in part as a
result of anticipations of continued high investment profitability in the
United States. These expectations may not be validated if technological
innovation in computers reaches a point of diminishing returns, office
building reacts to soaring vacancy rates, etc. The entire expected
future path of interest rate differentials, as well as the current
differential, might be affected. The result of a slowdown in investment
accompanied by a change in expectations would be an exact reversal of the
shifts described in the preceding paragraph. The IS-LM schedule would
shift to the left and the interest parity condition would shift to the
right. The exchange rate would depreciate, but the effect on interest
rates in the near term would be ambigous. In fact, this analysis
indicates that the near-term interest rate could rise in the United
States, even though current investment demand falls. As expectations of

profitable future investment dissipate, an anticipatory slowdown in the


-15-

A rise in e* (drop in the expected level of the dollar) creates an
expectation of depreciation of the dollar, lowering the demand for
domestic bonds.

Mathematically, e* enters the system of equations (11) and (9)
in the same way (but with the opposite sign) as the asset preference
shift parameter in the static model. That is, a drop in e* (rise in the
expected level of the dollar) increases the preference for dollar bonds
and generates a capital inflow, shifting the IS curve to the left (by
strengthening the dollar and reducing the trade balance) and the LM curve
to the right (by restraining domestic prices and money demand).

This dynamic version allows for interesting distinctions
between anticipated and unanticipated shocks as well as between
transitory and permanent shocks. The static model may be viewed as a
special case suited to the analysis of unanticipated, permanent shocks.

As an example of a transitory shock, consider a temporary
investment boom. An unanticipated shock occurs at the start of period
one that raises the demand for office buildings in Houston. At the end
of this period, the excess demand is satisfied, and the economy returns
to steady state. Part of the investment boom is financed by a capital
inflow that drives up the value of the dollar. With myopic expectations
(corresponding to the static model), investors act as if. the investment
boom were permanent, and the return of the dollar to its steady state
value comes as a surprise, creating ex post profits (losses) on foreign
(domestic) bonds bought during the investment boom. However, to the
extent that investors anticipate the depreciation that will occur as the
economy returns to steady state, their initial willingness to shift from

foreign to domestic bonds will be reduced. Relative to the static case,


When international capital flows are added to a standard IS-LM
macro model, both the IS and IM curves become flatter than their closed-
economy counterparts. The IS curve is flatter because the tradable-goods
sector becomes interest sensitive. An increase in our interest rate
relative to foreign rates tends to cause a capital inflow, an exchange
rate appreciation, and a decline in the trade balance. A fiscal
expansion or monetary contraction "crowds out" tradable manufactures as
well as interest-sensitive domestic spending.

Exchange-rate movements also add to the interest sensitivity of
money demand. An appreciation of the dollar helps to hold down prices in
the United States, reducing money demand. Thus, an increase in interest
rates lowers money demand not only directly through liquidity preference
but indirectly through its effect on the exchange rate and the price
level.”

The equations of the model, shown in the box on the next page,
employ a "flow-of-funds" variation of the standard IS-LM model, ©
augmented by an aggregate supply curve. In the usual presentation, the
IS curve is represented by the saving-investment equality, and the
domestic bond-market equilibrium condition is omitted by Walras' Law.

The flow-of-funds framework follows the opposite strategy.

In the model, there are three assets: money, domestic bonds,
and foreign bonds. Even though the United States is a large country in
the international scene, our model will have several "small-country"
features in order to simplify notation and algebra.? In particular, the
foreign interest rate and foreign income are taken as fixed, and domestic
bonds are treated as if they were held only by domestic residents.

Nonetheless, because domestic and foreign bonds are not taken to be


Whatever the intrinsic appeal of the inflation-expectations and
risk-premium resolutions to the term structure puzzle, each implies that
(risk-adjusted) real long-term interest rates in the United States are
not as high as they appear to be. If U.S. real interest rates are not
high, then we are left without an explanation for the strength of the
dollar. By the same token, it becomes more difficult to explain other
apparent symptoms of high real interest rates, such as weak commodity
prices. If the U.S. financial system were risky and inflation-prone,
one would expect a flight from dollar assets into gold and other real
commodities, rather than the other way around.

If, as I would argue, figure (1b) truly portrays the term
structure of real interest differentials, then it does not appear that
investors appreciate the need to return to steady state. Implicitly,
they expect capital to yield a higher return in the United States than in
othe: countries for the foreseeable future. The capital inflows that the
United States is experiencing serve to direct funds toward these
perceived profit opportunities.

If the term structure of real interest differentials does not
embody a return to steady state, then it seems likely that this term
structure was generated in the markets by a mechanical extrapolation
process. Implicitly, the market is projecting the recent macroeconomic
past into the indefinite future, even though this past contains several
elements that are not together sustainable: a steady rise in the U.S.
fiscal deficit relative to GNP, anti-inflationary monetary policy, and an
unusually high perceived rate of return on capital.

Blanchard and Summers (1984) argue that the fiscal and monetary

policy mix alone cannot explain high real interest rates in the United


zero) some time within the next ten years, the area under the curve in
figure (la) can be approximated by multiplying 10 times the real interest
differential on ten-year bonds. Frankel (1985) argues that the latter is
around 3 percentage points, implying that the market views the dollar as
overvalued by 30 percent.

The validity of multiplying 10 times 3 to get the area under
the term structure curve is questionable when one looks at figure (1b).
As noted by Sachs (1985), among others, figure (1b) offers a more
realistic illustration of the term structure of international real
interest differentials: the long-term differential exceeds the short-
term differential, and the term structure appears to flatten out in the
long term. This contrasts sharply with the shape of the term structure
curve in (la), which must be downward-sloping at some point in order to
return to zero. The contrast between the theoretical and actual shape of
the real term structure represents a puzzle.

One objection to (1b), raised by Obstfeld,? is that inflation
expectations may alter the shape of the real term structure relative to
the nominal term structure. Certainly, the use of recent past inflation
as a proxy for expected inflation may be incorrect. In particular, if
investors expect inflation in the U.S. to increase sharply over the next
decade, the term structure of real interest differentials may look more
like that in (1a).

Another possibility, raised by Nordhaus,” is that the high
long-term rate represents a risk premium attached to long-term bonds.

One could argue that the unsustainable policy mix in the United States

has added to the uncertainty about long-term U.S. financial assets.


-16-

this reduces the magnitude of the capital inflow, requiring more of an
increase in domestic interest rates to generate domestic saving and
dampen the investment boom.

Next, consider what happens if the investment is delayed by
physical lags in the construction process. !! The perception of a
shortage of office buildings occurs in the first period, but the actual
construction occurs in the second period, after which the economy returns
to steady state. If investors are myopic in period one (after the shock
but before construction takes place), the appreciation of the dollar that
accompanies the construction boom will cause ex post. profits (losses) to
accrue to buyers of domestic (foreign) bonds. On the other hand,
anticipation of the construction boom and the stronger dollar would raise
the demand for domestic bonds in period one, causing an early
appreciation of the dollar and a drop in the interest rate in order to
eliminate the incipient excess saving.

To treat these stories formally, I will make the simplifying
assumption that domestic and foreign bonds are perfect substitutes. This
special case corresponds to the strand of literature that follows
Dornbusch (1976);!2 also, the model can be reduced to a diagram on which
it is possible to see the contrast between static and dynamic models.

Perfect substitutability implies that domestic and foreign
bonds are indistinguishable to investors. Therefore, we rewrite the
model by adding together the domestic and foreign bond market equations
and by representing the foreign bond market equilibrium condition with

an interest parity condition that the expected return on domestic bonds


II. The Basic Static Model

This section sets up a static model to analyze the
macroaconomic effects of various types of shocks that could lead to a
capital inflow. The model uses an IS-IM framework that is static in the
sense that exchange rate expectations play no role, Expectations are
introduced in the next section. In order to analyze a shift in asset
preferences, the model differs from the standard Mundell-Fleming model®
by allowing by allowing assets to be imperfect substitutes.

In addition to the mix of fiscal and monetary policy, several
"stories" have been developed to explain the strength of the dollar in
the early 1980's. These stories relate to investment and international
capital allocation: the return on capital is alleged to have increased
in the United States, due to tax changes, more favorable regulation, and
technological innovation; meanwhile, perceptions of capital profitability
abroad have been dampened, as indicated by the terms "Europessimism," and
“safe haven effect." All of these stories are consistent with
international investors deciding that office buildings in Houston, for
instance, appeared to have a higher return than analogous investments
overseas. The capital inflow into the United States is nature's way of
directing investment funds to where they are perceived to be most
productive,

Another type of story concerns a change in asset preferences
related to currency of denomination rather than perceived rate of return.
That is, on bonds with an equal probability of default, an increase in
preference is shown for U.S. dollar-denominated securities over yen-
denominated securities. While this story probably has little direct
empirical relevance, a comparative statics analysis will serve useful

later in illustrating the impact of anticipatory capital inflows.


-22-

Footnotes

1. See Sachs (1985) as well as other papers and comments in
that Brookings volume. Krugman (1985) argues that the dollar could fall
spontaneously, without a drop in interest rates. Among some non-academic
economists, there seems to be a belief that a flight from the dollar
would force an increase in interest rates in the United States in order
to retain foreign capital. The academic viewpoint, correct or otherwise,
is that a depreciation by itself would be sufficient to restore the
willingness of investors to hold United States assets.

2. While I regard as apt the intellectual deference to Keynes
suggested by my choice of terminology, I wish to emphasize that this is
incidental to the substance of the paper.

3. Obstfeld's comment appears on p. 195 of Sachs (1985).

4. Nordhaus' comment. appears on p. 196 of Sachs (1985).

5. In fact, Fleming (1962) did not assume perfect
substitutability, although Mundell (1963, 1964) used such an assumption.

6. Dooley and Isard (1985) present the safe haven effect as a
fear of confiscatory taxes on capital, which would correspond to a change
in the perceived marginal product of capital in my framework. However,
as Krugman (1985) points out, the safe haven story is not well suited to
explaining the appreciation of the dollar against other OECD currencies.

7. Sachs (1985) and Glassman (1985) survey the empirical
literature on the effect of exchange rate changes on the domestic price

level.


ANTICIPATORY CAPITAL FLOWS AND THE BEHAVIOR OF THE DOLLAR

Arnold S. Kling
Board of Governors of the
Federal Reserve System
Washington, D.C. 20551

August 1985

I have received helpful comments from numerous colleagues at the Federal
Reserve Board. I would like to single out Dave Stockton for suggestions
tha: greatly improved the paper's organization and Charles Struckmeyer
for pointing out several mistakes. I alone am responsible for errors

tha: remain. Views expressed in this paper are not necessarily those of
the Federal Reserve Board or its staff.


perfect substitutes, the domestic interest rate may vary from the foreign
rate. Further simplicity could be achieved, at no cost to the results of
this paper, by taking prices as fixed and ignoring the impact of the
exchange rate on prices and thereby money demand. However, I believe
that the aggregate supply schedule adds considerably to the realism of
the model.

The first equation is the equilibrium condition for the
domestic bond market. The demand for domestic bonds, which depends
positively on the interest rate, income, and an asset-preference shift
parameter, is equal to last period's stock of bonds outstanding plus the
new supply of bonds needed to finance this period's investment, which
depends negatively on the interest rate and positively on income anc!
“animal spirits". (For simplicity, I omit equity finance or government
deficits.)

The second equation is the equilibrium condition for the
foreign bond market. Our net increase in foreign bond holdings is equal
to our trade surplus. This also can be thought of as a balance-of-
payments condition equating trade flows and capital flows. The trace
balance depends positively on the real exchange rate and negatively on
income. The demand for money, H, depends negatively on the interest
rate, positively on income, and positively on the price level, which in
turn depends positively on income and on the real exchange rate.

The strategy for solving this model will involve treating
equation (1) as the IS curve and solving the other three equations for a
reduced-form LM curve. The IS curve is flatter than its closed-economy
counterpart: the interest sensitivity of the demand for domestic bonds
is increased by the fact that there is substitution from foreign bonds as

well as from money.


The Static Model

(1) Blr,y,A) - B= I(r,y,2) (domestic bond market)
+++ -++

(2) F(r,y,A) - F = Tle,y) (foreign bond market)
-+- +=

(3) H(r,y,p) = H (money market)
-++
(4) p = Ple,y) (aggregate supply)
++

Notation:

B demand for domestic bonds

B initial stock of domestic bonds

I private investment

xr domestic interest rate

y real income

A a parameter representing asset preferences or a risk premium

Z animal spirits

F demand for foreign bonds

F initial stock of foreign bonds

e real exchange rate (a rise in e represents a depreciation for the
home country)

H demand for money

H stock of money



States. They note that expansionary fiscal policy and contractionary
monetary policy would be unlikely to strengthen the stock market,

yet the stock market has performed well since 1978. Moreover, they argue
that investment has exceeded what would have been predicted using
conventional econometric models. I would add to this latter point that
the major sources of recent strength in investment, such as computers and
office construction, reflect specific perceptions about profitability
more than general macroeconomic considerations.

Suppose that I am correct in suggesting that the term structure
puzzle reflects an unrealistic expectation of high profitability for
investment in the United States. Why does the term structure slope
upward? What would be the macroeconomic consequences of an adverse shift
in these perceptions? In particular, would a slowdown in the investment
boom be likely to raise or lower real interest rates in the United States
in the near term? In the following sections, I develop models that can

be used to address such questions.


-19-

would move further and the interest rate would remain fixed at p. ‘this
demonstrates the point that foresight serves to moderate exchange-rate
adjustments.

Next, consider the case of an anticipated investment boom. The
only effect this has on the current-period equilibrium is through
expectations concerning the exchange rate.!3 ‘The anticipated investment
boom leads to the expectation of an appreciation of the exchange rate,
meaning a drop in e*. This shifts the interest parity condition to the
left, requiring either a drop in the domestic interest rate or an early
appreciation of the dollar in order to keep investors indifferent between
holding domestic and foreign bonds. Thus, an anticipated investment: boom
has the opposite effect on interest rates as an actual investment boom.
The expected increase in investment stimulates an anticipatory capital
inflow that drives down the interest rate. In the concluding section of
this paper, I argue for the relevance of this result to the actual

behavior of asset markets at present.


-2-

Section two of the paper presents a static model which may be
used to analyze four types of shocks that would produce a capital inflow:
a fiscal expansion, a monetary contraction, an increase in perceived
profitability, and an asset-preference shift. The latter is a pure
increase in preference for bonds denominated in U.S. dollars, holding
rates of return and default risk constant. It is shown that such a shock
plausibly affects the LM curve as well as the IS curve.

Section three allows for exchange rate expectations anc
dynamics. It is shown that a profitability shock anticipated to occur
next period acts like an asset-preference shock in the current period.

In the final section, I use the results of the model exercises
to argue that a slowdown in investment could put upward pressure on real
interest rates in the United States in the near term. I then review the

key points of the paper.


-12-

United States). The supply of capital to the United States increases,
putting downward pressure on the interest rate. As the rate falls from
Xr to Ty, more investment takes place in the United States. The new
capital helps back the increased claims on the U.S. demanded by
foreigners. The capital inflow drives up the exchange rate, reducing the
trade balance and shifting the IS curve to the left. In addition, the
strong dollar reduces prices and the demand for money, so that the LM
curve shifts to the right and the interest rate falls to ry. The effect
on income is ambiguous, depending on the relative magnitude of the
"fiscal" (trade balance) and "monetary" (real money supply) effects of
exchange rate movements.!9 the interest rate unambiguously falls, and
this in turn reduces U.S. national saving, even though only a shift in
preferences concerning the composition of bond holdings initiated the
adjustment process.

The "real world" analogue to a shift in asset preferences would
appear to be a change in the risk premium on foreign bonds. However, we
shall see below that in a dynamic context, any event that changes
expected interest rates can have a current-period impact corresponding to

that of a shift in asset preferences.


-14-

(7) Blp,r,y) = B(rte-e*,r,y) = I(r,y,Z) +B
+e + + t+ -~+ +

(8) F(p,y) = F(r+e-e*,y) = Tle,y) + F
- + - + t-

Because p affects the choice between domestic and foreign bonds, Bo + FO
= 0. The additional term in r in the domestic bond demand equation
reflects substitution between domestic bonds and money.

The money demand and aggregate supply equations are the same as
before. Solving for the reduced-form LM curve using (8) rather than (2)

gives

(9) H(r,y,e*) = H
-++

Solving (8) for the exchange rate as an implicit function of the interest

rate, income, and the expected level of the exchange rate, we have
10 T, - F )de = F dr + (F - T )dy - F de*
(10) ¢ e o> le ° ¢ y y ly pte

The important results from (10) are that the derivative of e with respect
to e* is positive but less than one and that the derivative of e with
respect to r is negative but less than one in absolute value. These

results allow us to rewrite (7) as

(11) B(r,y,e*) - B= I(r,y,z)
ter -+ +


-1-

Introduction

International capital flows and the appreciation of the dollar
were central characters in the macroeconomic drama of the early 1980's.
Moreover, many economists expect the dollar to experience a large
depreciation over the latter half of the decade, in which case movement
in the exchange rate will remain on center stage. While some economists
suggest that the dollar's fall will be associated with lower real
interest: rates caused by a change in the mix of fiscal and monetary
policy ,~ in this paper I suggest that a decline in the dollar could be
accompanied by higher real interest rates. I argue that the value of
the dollar is influenced by the "state of long-term expectation" and that
market expectations do not appear to embody a return to steady state. I
suggest that the recent strength of investment in the United States

reflects "animal spirits"?

and that investors appear to expect the
investment boom to be sustained indefinitely. Finally, I show how an
adverse shift in perceptions concerning the profitability of investment,
by altering this state of expectations and thereby affecting
international capital flows, conceivably could put upward pressure on
interes!: rates that would outweigh the downward pressure coming from the
actual slowdown in investment.

In the first section of the paper, I argue that several
features of international asset prices appear to be consistent with the
hypothesis that investors anticipate a high rate of return on capital in
the United States to persist for several years. In particular, the term

structure of international interest differentials appears to embody such

an expectation. This raises the issue of how a change in the pattern of

sions could affect the near-term equilibrium of the economy.


-23-

8. This formulation is adapted from Tobin and Macedo (1980).

9. A two-country model will yield the same set of results as
long as the interest elasticity of substitution between domestic and
foreign bonds is strong relative to that between bonds and money.

10. For an empirical evaluation of whether or not an exchange
rate appreciation is expansionary for the United States, see Kling
(1985).

1l. Other stories that might give rise to an anticipated shift
of the IS curve include a pre-announced fiscal expansion, as analyzed by
Branson, Fraga, and Johnson (1985).

12. Behind the foliage, the model in the appendix to Dornbusch
(1976) is the system of equations (12) and (15) below.

13. Branson, Fraga, and Johnson (1985) also allow expected
future interest rates to affect current investment through their effect

on the long-term rate.


Abstract

In this paper, I argue that the value of the dollar is
influenced by the "state of long-term expectation" and that market
expectations do not appear to embody a return to steady state. I suggest
that: the recent strength of investment in the United States reflects
"an:mal spirits” and that investors appear to expect the investment boom
to be sustained indefinitely. Finally, I show how an adverse shift in
perceptions concerning the profitability of investment, by altering this
state of expectations and thereby affecting international capital flows,
conceivably could put upward pressure on interest rates that would
outweigh the downward pressure coming from the actual slowdown in

investment.


-10-

Combining equations (2)-(4), we have

(5) H(r,y,A) =H
+ =

Because the exchange rate affects aggregate supply which affects the
demand for money, this model does not necessarily yield the results that
ace standard in the Mundell-Fleming analysis. In a two-country model,
for example, the Mundell-Fleming model would predict that the mix of
loose fiscal policy and tight monetary policy pursued in the United
States should be expansionary for our major trading partners, because it
would strengthen the dollar and boost their trade balance. Evidently,
this stimulus was offset by a leftward shift of the LM curve in those
countries, due to policy moves as well as an effect of the exchange rate
on foreign money demand analogous to that outlined here.

Furthermore, we see that incorporating the effect of the
exchange rate on prices opens up an indirect channel through which a pure
shift in preferences from foreign to domestic bonds reduces money demand.
In addition, putting (2) and (4) into (3) increases both the income and
interest sensitivity of money demand. To the extent that domestic and
foreign bonds are close substitutes, the latter effect will be larger,
and the IM curve becomes flatter.

Although the IS and LM curves are flatter than in the closed-
economy case, fiscal and monetary policy have their usual effects (with
regard to sign) on interest rates and income. The difference between a

profitability shock (an increase in Z, the perceived rate of return on


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III. Dynamic Analysis

The main difference between this section and the previous one
is that we allow investors to hold expectations about exchange rates and
interest rates. Exchange rate expectations yield a Dornbusch (1976) link
between interest rates and exchange rates. Furthermore, interest-rate
expectations can cause anticipated expansionary shocks to have a
contractionary short-run impact, as shown by Branson, Fraga, and Johnson
(1985) and Gavin (1984).

When the exchange rate is expected to move, the dollar return
from holding yen bonds depends positively on the expected rate of dollar
depreciation, e* - e, where e* is the expected level of the exchange
rate. Introducing exchange-rate expectations into the bond demand
equations has two noteworthy results: the effect of fiscal, moretary,
and profitability shocks on the exchange rate is moderated. A fiscal
expansion, for example, results in a smaller capital inflow and a larger
rise in interest rates (to generate private saving and less investment)
than in the static model; also, an increase in the expected real value of
the dollar (a drop in e*) tends to act like an increase in A, the asset
preference parameter of the static model.

The choice between domestic and foreign bonds is a furction of

p, interest on domestic bonds plus expected currency appreciaticn.

(6) p=r-(e*¥-e) =rt+e- ek

Putting p into the demand equations for domestic and foreign bonds gives