~19-

endogenous in order to meet the target path for output Monetary policy
was assumed to be at least partially accommodating in Germany and Japan
and less so in the United States.

Figure 6 shows the results for the current account balances for
the three countries in the two full MCM simulations. The results are
broadly similar to those for the partial equilibrium simulation (compare
Figures 5 and 5), but there are some interesting differences. In the
potential output simulation, the U.S. balance deteriorates much more
sharp'y in the full model simulation, reaching $100 billion by the end of
the exercise, as compared with $80 billion in the partial-equilibrium
case. This difference can be traced to the behavior of U.S. interest
rates---which rise substantially compared to foreign rates--and their
impact: on the exchange rate. As indicated in Tables 6 - 8, the impact
on U.S. interest rates exceeds that on Japanese and German rates by over
100 basis points in 1985 and nearly 300 basis points in 1986,22/ This
interest differential leads to a real appreciation of the dollar vis-a-
vis the yen and the DM, and U.S. goods imports rise relatively more than
exports. (Net investment income receipts are also up substantially with
the rise in U.S. interest rates.) The relative depreciation of the yen
and the DM improves the current account in both Japan and Germany, so
that Japan runs a larger surplus, and Germany a smaller deficit, than in
the partial equilibrium results.

In the simulation involving growth to the normal path U.S.
output. stays fairly close to its baseline, and no interest differentia
develops. There is very little change in exchange rates, and the results

for all three countries are very similar in the partial equilibrium and


1

Figure 6
CURRENT ACCOUNTS: ALTERNATIVE OUTPUT PATHS
FULL MEM ANALYSIS

U.S. BILLIONS OF $US
A TTTT TIT TTT

ie)

20
40
60
80

100 —_———__ +
BASELINE PATH

LEGEND

GERMANY BILLIONS OF $US

REACH POTENTIAL OUTPUT
IN 8604

REACH NORMAL OUTPUT
IN 8604

JAPAN BILLIONS OF $US

t— COC rer) 8
1982 1984 1986



-13-

IV. Calculation of Cyclically Neutral GNP paths

In defining our measures of cyclically neutral output we begin
with the concept of potential GNP. That is, at any one time there exists
a sustainable level of real output at which resources in the economy are
"fully" employed. We further assume that the level of potential GNP
grows at a rate that is roughly constant over the period we are
investigating. Full employment growth is defined not in any absolute
sense, but rather using recent experience as a standard.

An implication of this approach is that there is no inherent
business cycle. Deviations of output from its potential path can, in
principle, be eliminated by selecting an appropriate policy mix.

However, the policies needed to maintain this level of output in the face
of various exogenous shocks might require unacceptably large deficits or
increases in the money supply; we do not argue that it is necessarily
desirable to achieve potential GNP. Furthermore, in an uncertain world
it is difficult for policy makers either to specify or to implement the
“appropriate policy mix."

One measure we use, as an approximation of potential output, is
a pea<-to-peak trend. This is a simple linear interpolation between the
two highest peaks in actual output over the period 1972-1982. The series
is extended through 1986 using the same growth rate. Although the
details differ across countries, the two peaks roughly precede the two
OPEC oi] price shocks of 1974 and 1979. (Our interpretation is thus that
while potential growth may have been altered by the earlier price shock,
it was not substantially affected by the more recent one.) We have
chosen to abstract from the levels of capacity utilization and

unemployment prevailing at the two peaks, because of the statistica


Table 1
Baseline Assumptions for GNP, Prices, Exchange Rates

and Current Accounts

GNP Growth Rates (%)

1983 3-1/4 3 1-1/4
1984 5 3-1/2 3
1985 4 3-1/2 3
1986 3-1/2 3-1/2 3

CPI Inflation Rates (%

1983 4 2 3
1984 5 2 3
1985 5 2-1/2 3
1986 5 2-1/2 3

Exchange Rate Changes (%)

$/Yen $/om
1983 3 -3
1984 10 10
1985 5 5
1986 0 0

Current Account Balances (billions of dollars)

U.S. Japan Germany
1983 -40 20 5
1984 -70 20 8
1985 -70 20 8

1986 -70 20 8


-4-

foreign rates, the dollar appreciates, and the cyclically adjusted U.S.
current account becomes more negative, while those of other countries
become more positive.

We found in analysing recent trends in exports to developing
countries, that U.S. exports to these countries fell about $5 billion
more than German and Japanese exports between 1981 and the first half of
1983. This accounts for only a small part of the total swing in the
relative current account positions of these countries over this period.

We conclude that the relative movements in the U.S. and
Japanese current accounts over the period 1982-83 and beyond are likely
to have been predominantly the result of movements in real exchange
rates. Cyclical factors do appear to have played a role in increasing
the German current account surplus, although exchange rate chances also
appear to have contributed significantly. The implication of this
conclusion is that even if major industrial countries succeed iri
attaining cyclically normal output paths in the next few years, relative
current account positions, particularly those of the United States and
Japan, could remain roughly unchanged for some time. Significant
readjustment in current account positions probably would require a
significant reversal of the real exchange rate movements that have taken
place in recent years.

Such a change in exchange rates could be brought about: by any
number of possible events. Our simulation results suggest that a shift
in policy mixes toward fiscal restraint in the United States and fiscal
easing in other industrial countries would tend to reduce U.S. real
interest rates relative to foreign rates, and put downward pressure on

the dollar. Shifts in market expectations about the long-run


Figure 4

CURRENT ACCOUNTS: ALTERNATIVE OUTPUT PATHS

PARTIAL EQUILIBRIUM ANALYSIS

U.S. BILLIONS OF
A ] TITTT TTT TT
—
eo
GERMANY BILLIONS OF
= =
4

Tiritiyi ti it
1982 1984 1986

sus
10

10

20
30
40
50
60
70

50

sus
20

15
10

10
15

sus

LEGEND

BASELINE PATH

AT POTENTIAL OUTPUT
FROM 8201 ON

AT NORMAL OUTPUT
FROM 8201 ON


full MCM simulations. It is noteworthy that in this case the U.S.
current account increases substantially more than the U.S. trade balance.
This is because the Canadian output gap is relatively larger than those
of other countries in the normal case. and Canadian activity has a
disproportionately large impact on U.S. direct investment income
receipts.

We also ran a simulation with the full MCM in which mcnetary
policy was assumed not to be accommodating--we exogenized M2 in Japan and
central bank money in Germany. In this case Japanese real interest rates
rise somewhat more than U.S. rates and German rates almost as much as
U.S. rates. As a result, the dollar depreciates slightly against the yen
and appreciates only slightly against the mark. By 1986 the Japanese
current account is about $3 billion lower, the German current ac.count
about $2 billion lower and the U.S. current account about $4 billion
higher than in the accommodating case.

It is also of some interest to consider the simulations as
policy packages. The exercises presented in Tables 6-8 can be viewed as
a coordinated use of fiscal policy to achieve potential output by 1986.
It should be stressed that the MCM in general. and these simulations in
particular, were designed with most attention given to the international
linkages among the countries in the model. The domestic sectors of the
country models in the MCM are highly aggregated, and embody a fairly
conventional neo-Keynesian, IS-LM model of the macro economy. Moreover,
inflation expectations are specified only very crudely (general'y as a
function of a distributed lag of past inflation). As with any
econometric model, the interpretation of the simulation results is

conditional on the theoretical and empirical structure of the model.


Table 4

U.S., Japanese and German Exports to Developing Countries

(Billions of dollars, annual rates

U.S. Exports

Total

To Developing Countries
To Major Debtor Countries~/
Japanese Exports

Total

To Developing Countries

*
To Major Debtor Countries—

German Exports
Total
To Developing Countries

*
To Major Debtor Countries—

1978 1979 1980 1981
143.8 182.0 220.8 233.8
55.0 66.1 87.0 95.0
19.7 26.5 35.9 39.1
98.4 102.3 130.4 =151.5
59.8 46.9 60.9 70.0
12.5 11.4 12.1 13.4
142.5 171.8 192.8 176.1
33.5 36.4 40.6 42.5
4.1 5.1 5.9 5.5

1982

ML He
224.6 200.0
92.0 81.8
28.4 34.0
140.8 136
63.6 62.2
11.6 9.8
182.6 170.2
41.6 38.8

4.8 3.8

1983

138.5
61.7
9.7

173.1
36.9

4.0

*/ Argentine, Brazil, Chile, Korea, Mexico, Peru, Phillippines, Venezuela

Source: IMF Direction of Trade Statistics, (various issues)



-?2-

output is essentially determined by aggregate demand, along the usual
Keynesian lines with adaptive expectations. In these exercises we have
assumed part of the answer by specifying that some higher path for output
is within the productive capacity of the economy and that factor markets
are flexible enough that output could be expanded to meet demand at this
level without generating excessive inflation. The model does not provide
a framework for evaluating these assumptions, but some judgement must be

made about them in evaluating the policy package as a whole.


Figure 5

CURRENT ACCOUNTS: ALTERNATIVE OUTPUT PATH:

PARTIAL EQUILIBRIUM ANALYSIS

U.S. BILLIONS OF $US
TIT] TITTY ITT
ATI 0

= — 20
LEGEND

= — 40

= _-——— =} 60 BASELINE PATH

= 80

GERMANY BILLIONS OF $US REACH POTENTIAL OUTPUT
20

= 4 15
Z 4 410 REACH NORMAL OUTPUT

a IN 8604
= tN a45

A => fa)

LE =] 5

“110

JAPAN BILLIONS OF $US
“| 60

r | “Ase
— “ov 440
= ao =| 30
= 20
= — 10

U I Dorit ti ©
1982 1984 1986



-17-

countries are smaller and thus the differential impact on the U.S.
current account is much smaller than in 1982.

The second simulation shown on this figure is the case where
real output is assumed to foilow the norma? growth path, starting in
1982. for all countries. The U.S. current account initially goes further
into deficit, as compared with the baseline case, but in 1984 the trend
is reversed and the deficit is gradually reduced through 1986. Again,
this is because the United States has a relatively large output gap in
1982. However, the baseline output path for the United States reaches
the rormal growth path by 1986, while Germany and Japan remain somewhat
below their normal paths. Thus in the normal growth simulation foreign
output eventually increases more than U.S. output, and U.S. exports rise
more than U.S. imports.

The implication of this exercise is that the relative cyclical
position of the United States has made the U.S. current account deficit
over the past two years smaller than it would have been if full output at
home and abroad had been maintained at peak-to-peak (or even normal)
trenc levels during this period, ceteris paribus. The outlook for the
U.S. current account in 1986 would be somewhat stronger if the world
follcwed a normal growth path over 1982-86, but a large deficit would
nonetheless exist. If output remained at peak-to-peak levels throughout
this period the U.S. deficit would exceed its baseline value even in
1986.

The second panel of Figure 4 shows the results for Germany. As
for the United States the peak-to-peak output scenario raises German
output relative to the average. raising imports more than exports and

causing the current account balance to deteriorate. In the German case


economic forecasting concerns 2! These paths were imposed on the model
by adjusting residuals in the model's behavioral equations. The numbers
given in Table 1 deviate somewhat from the published forecasts inasmuch
we tried to make the assumed paths for GNP, prices and exchange rates at
least roughly consistent with those for current accounts, given the
mod21's structure. We emphasize that our intention here was not to make
point forecasts but to derive plausible paths for key variables as a
baseline for the simulations presented.

The baseline can be described as follows. The strong recovery
of .S. GNP in the second half of 1983 continues into early 1984 and then
begins to taper off. By 1986 the growth rate has fallen almost to the
rate of growth of potential output (as defined in the next section). GNP
growth rates in Japan and Germany pick up somewhat in 1984 (in line with
recent growth), but remain in the neighborhood of those countries'
potential growth rates through 1986.

Our assumption for U.S. GNP growth in 1985-86 is about 1
percentage point above the Blue Chip panel's average, while that for
Japan is 1/2 percentage point below the average. These paths were
selected to be consistent with unchanged current accounts through 1986
and to emphasize the cyclical differences among countries.

CPI inflation rates are for the most part extrapolated at
recently reported rates. The U.S. inflation rate rises in 1984,
reflecting the effects of an assumed depreciation of the dollar. The
inflation assumptions are well within the range of the Rlue Chip
forecasts but are about 1/2 - 1 percentage point below the average of the

forecasts for each country. The published forecasts predict a moderate


Figure 2

POTENTIAL GNP

U.S, BILLIONS OF $US
TTTTETTTTITITrrer.
= v aad

R
bt)
=
>
z
<

PTTTTTI

Littl i nek

JAPAN

ol

ftititiiiititiiG
1974 1980

1900
1700

1500

1300

18Sd

BILLIONS OF DM

1200
1100

1000
900

800
730

BILLIONS OF YEN

160000
140000

120000

100000

98686

1986

LEGEND

HISTORICAL GNP

BASELI NE FORECAST

PEAK- TO-PEAK
POTENTIAL GNP

NORMAI. GNP


Table 7: High Employment Growth - Germany
amounts shown are deviations from the baseline path, annual

averages, in percentage terms unless noted.

growth to potential output in 1986

1983 1984 1985 1986
real GNP 0.2 2.8 6.1 9.6
real government spending 0.8 7.7 12.7 16.8
government deficit ($b) -0.6 -2.7 4.5 15.3
price level 0.0 0.2 0.9 2.2
interest rate (100 basis points) 0.0 0.1 0.2 0.3
central bank money 0.0 0.5 1.5 2.9
exchange rate - $/DM (%) -0.0 -0.6 -1.8 -3.6
real imports 0.2 2.9 6.3 9.8
real exports 0.1 1.6 4.0 6.6
trade balance ($b) -0.2 -2.6 -5.5 -8.0
current account balance ($b) -0.2 -3.7 -7.9 -11.4
growth to normal output in 1986

1983 1984 1985 1986
real GNP 0.1 1.4 3.1 4.9
real government spending 0.4 4.9 8.6 11.7
government deficit ($b) -0.4 -2.8 -1.3 1.8
price level 0.0 0.1 0.4 1.0
interest rate (100 basis points) 0.0 0.0 0.1 0.2
central bank money 0.0 0.2 0.7 1.4
exchange rate - $/DM (%) 0.0 0.0 -0.3 -1.1
real imports 0.1 1.6 3.5 5.4
real exports 0.0 0.2 0.7 1.5
trade balance ($b) -0.2 ~2.4 5.3 -8.1

current account balance ($b) -0.2 -3.2 -7.4 -11.5


-6-

In the present paper we also introduce a more general
methodology that treats all of the major determinants of the current
account endogenously and takes into account the effects of cyclical
fluctuations in prices, interest rates and exchange rates, as well as
real activity. This methodology, which we label the "full-model
approach", involves solving the model for policy paths across countries
that achieve predetermined levels of cyclically-adjusted output in those
countries. The policy shifts also affect the other variables in the
model. An important implication of this approach is that the estimated
cyclical component of the current account can vary depending upon which
policies are used to achieve the given cyclically-adjusted income
paths .2/ This is because the effects on non-income determinants of the
current account (prices, interest rates and exchange rates, etc.) will
vary under different policy settings.

The model employed in our analysis is the Federal Reserve Board
staff's Multicountry Model (MCM). The MCM consists of a system of fully
developed macro models of five countries--the United States, Japan,
Germany, Canada and the United Kingdom--as well as an abbreviated rest-
of-world sector. The major determinants of current accounts (GNP,
capacity utilization, prices, interest rates, exchange rates and stocks
of real and financial foreign claims and liabilities) are treated
endogenously. The rest-of-world sector includes the determination of
income and prices (which are linked to income and prices in the five MCM
countries), trade flows and some (OPEC) financial flows 2/

One significant adjustment was made to the basic structure of

the MCM for purposes of the full-model exercise. The exchange rate


-5-
sustainability of large current account imbalances, or in preferences for
dollar-denominated assets could also bring about a substantial

depreciation of the dollar.

Il. Design of Experiment and Description of Model

The concept of cyclical adjustment of current account positions
is by no means new, although the published literature on this subject is
scant. During the Bretton Woods era of pegged exchange rates analysts in
natiorial governments and international organizations made such
computations for policy makers for the purpose of assessing the
appropriateness of underlying demand management policies. Since the move
to more flexible exchange rates in the early 1970's, the analysis has
been used instead as an indicator of movements in real exchange rates
needec| to achieve “sustainable” long-run current account positions.

To date, attempts to quantify the cyclical components of
currerit account balances have focused on the effects of cyclical swings
in real activity on trade flows. (See, for example, Artus (1978) and
Williamson (1983)). The methodology typically involves relating the
components of trade or current account balances to income or activity at
home and abroad, relative prices, exchange rates and other factors in a
model framework. Cyclically-adjusted balances are then computed by
substituting cyclically-adjusted paths of home and foreign income or
activity for the actual cyclical paths of these variables, and deriving

the model's prediction under the alternative paths 2/
p

Henceforth, we
shall refer to this methodology as the "partial-equilibrium approach",
since it treats the various determinants of external balances as

exogenous variables in partial-equilibrium models of those balances.


~18-

the deterioration is enough to send the current account into deficit
after a few quarters. German output in both high-output cases is well
above the baseline through 1986; this means that the deterioration in the
current account continues throughout the simulation.

The Japanese results. shown in the third panel, complement
those for the United States and Germany. Because Japanese output remains
very close to both the normal and peak-to-peak paths in the baseline
case, both simulations increase foreign output much more than Japanese
output, leading to a large and continuing surplus on current account .20/

Figure 5 shows the results of two forward looking simulations
run with the partial-equilibrium model. In these simulations output in
each MCM country is assumed to grow steadily from the current (1983Q3)
value to the potential, or normal, level in 198604. The results follow
the general pattern of the first exercise: growth along the higher
output paths leads to a continued deficit for the United States. On the
potential growth path the U.S. deficit is increased; on the normal path
it is reduced. In Germany the current account balance deteriorates and
eventually goes into deficit on both paths, while in Japan the surplus
increases steadily. By 1986 the two sets of simulations reach roughly
the same points for all countries; in the second set the adjustment
toward that point is more gradual, because the change in output paths is
more gradual.

The next set of simulations was run using the fully linked MCM.
In these exercises each country was assumed to follow a growth path in
which real output reached its cyclically neutral (potential or normal)

path by the end of 1986. Fiscal policy (government spending) was made


working from 2 baseline of actual historical data, though the results may
be of limited value to the formulation of economic policy currently, that
will have an impact over the next few years.

The forward-looking estimates involve comparing a baseline
projection through 1986 with a projection in which incomes grow to
cyclically-adjusted or potential levels by the end of 1986. (The
baseline projection is described in the next section.) This exercise has
the disadvantage of working from a projected or hypothetical baseline
path, but the advantage of being of greater relevance to current policy
decisions.

The full model approach was employed only in forward-looking
simulations. In this case several different policy paths were chosen to
achieve potential or cyclically-neutral output levels by 1986. These
included, a mix of monetary and fiscal stimulus and a pure fiscal

stimulus (with no monetary accommodation).

III. Baseline Projections

In order to run forward-looking partial-equilibrium and full
model simulations out to 1986, baseline paths for the current accounts
and their key determinants had to be constructed. We chose not to use
the model itselt to produce paths for the key variables (current
accounts, trade flows, GNP, prices, and exchange rates). Rather. paths
for these variables were for the most part’ assumed a priori and imposed
on the model.

The assumed paths, presented in Table 1, were based largely on
actual values and linear extrapolations of forecasts published by Blue

Chip Worldscan, which surveys the regular forecasts of some forty private


Table 2
Trade and Current Account Balances
U.S. Japan and Germany

(Billions of U.S. dollars, seasonally adjusted annual rates)

1980 1981 1982 1983 1983
HI a 2 &

United States

Trade Balance 25.5 -28.1 -36.4 -46.9 35,2 -58.6 -71.6

Net Services and Transfers 26.0 32.7 -25.2 20.4 20.9 19.8

Current Account 0.4 4.6 -11.2 -26.5 -14,3  -38.8
Japan

Trade Balance 20.1 18.8 29.2 26.0 32.4 35.2

Net Services and Transfers -15.3 -11.9 -10.2 -12.0

Current Account -10.7 4.8 6.9 19.0 14.0 24.0 24.4
Germany

Trade Balance 11.9 20.6 19.2 22.4 16.0

Net Services and Transfers -4.6 -17.0  -14.2 -15.6 -12.8

Current Account -16.5 -7.3 3.6 5.0 6.8 3.2



International Finance Discussion Papers
Number 236

January 1984

THE CURRENT ACCOUNT OF THE UNITED STATES, JAPAN, AND GERMANY:
A CYCLICAL ANALYSIS

by

Peter Hooper
Ralph Tryon

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 materials)
should be cleared with the author or authors.


-ll-

The increase in the U.S. deficit has heen attributed to three
factors: the appreciation of the dollar in real terms since 1980, a
sharp decline in the imports of developing countries (particularly those
burdened with large debt service payments), and the relative strength of
the U.S. recovery (that is, cyclical factors).

As indicated in Table 3, in the past five years the dollar has
appreciated by 61 percent in real terms against the yen and 65 percent
against the mark. Although these movements followed a general decline in
the dollar during the mid-1970's, they substantially altered U.S. price
competitiveness relative to that of Japan and Germany in the past few
years. This shift in price competitiveness not only reduces the U.S.
trace position, but also contributed to the increase in the Japanese and
German surpluses. The effects on Japan and Germany have been less
proriounced because their currencies fell considerably less in real terms
(anc in some cases rose) against non-dollar currencies.

The effects of the second factor, the debt problem and the
contraction of demand in developing countries, are illustrated in Table
4. The table lists U.S., Japanese, and German exports to all countries,
to all developing countries, (including OPEC) and to eight major debtor
countries. Between 1981 and the first half of 1983, U.S. exports fell by
by almost $12 billion. All of this was accounted for by a drop in
exports to developing countries, of which $8.5 billion was to major
debtor countries. Part of the decline could have reflected the decline
in U.S. price competitiveness, but it is noteworthy that over the same
period, Japanese and German exports to developing countries and major
debtor countries fell (proportionally) at about the same rate as U.S.

exports to these areas. Nevertheless, U.S. exports were affected more


-10-

decline (of about ten percent) in the dollar against the mark and yen
next year; we have assumed a slight additional depreciation of the dollar
in 1985 in light of current account considerations.

Recent historical and baseline current account paths are
illustrated in Figure 1. The U.S. current account deficit increases to
about $70 billion in 1984. This is somewhat above the Blue Chip rarige
(several forecasters had $60 billion). We have made this adjustment. in
view of the sharp increase in the U.S. trade deficit in recent months,
and the likelihood that continued rapid U.S. growth will widen the
deficit further in the near term, The U.S. deficit remains unchanged at
$70 billion through 1986, as the effects of higher growth in the United
States (as well as higher import elasticities there than in the other
countries) are offset by the effects of the depreciation of the dollar in
real terms. Likewise, Japan's surplus remains at about $20 billion and
Germany's at $8 billion, both slightly ($1-2 billion) above the Blue Chip
average for 1984.

Since the focus of our analysis is on the current account
position of the United States, Japan and Germany, it is useful briefly to
review the recent movements in those series and their underlying factors.
As indicated in Table 2, the U.S. current account fell by $30 billion at
an annual rate from its peak in 1981 to the first half of 1983. Of this
decline roughly two-thirds was in terms of merchandise trade, and one-
third in terms of net services and transfers. By the third-quarter of
1983, the trade balance had fallen another $25 billion, to a deficit of
more than $70 billion. Given early indications of continued robust U.S.
recovery in the fourth quarter, the deficit seemed likely to widen

further.


Figure 1

CURRENT ACCOUNT BALANCE

U.S.
pT

BILLIONS OF
|

aa

GERMANY

=

BILLIONS OF

BILLIONS OF

4

e\ 7 |

V4

1980

Clit i ii tit
1974

sus
20

fs)
— 20
— 40

— 60
80

sus LEGEND

— 10

PA 4

Ss ee =

HISTORICAL CURRENT ACCOUNT
5

10

1S

BASELINE PROJECTION

sus
20

1S
10
5
6)
5
10

1986


Table 8 High Employment Growth - Japan

amounts shown are deviations from the baseline path, annual

averages, in percentage terms unless noted.

growth to potential output in 1986

real GNP

real government spending
government deficit ($b)

price level

interest rate (100 basis points)
money supply - M2

exchange rate - $/Yen (%)

real imports

real exports

trade balance ($b)

current account balance ($b)

growth to normal output in 1986

real GNP

real government spending
government deficit ($b)

price level

interest rate (100 basis points)
money supply - M2

exchange rate - $/Yen (%)

real imports

real exports

trade balance ($b)

current account balance ($b)

1983 1984 1985 1986
0.1 1.1 2.3 3.6
0.5 2.4 -1.2 <7
0.2 1.1 -10.2 -30.2
0.0 0.1 0.4 0.8
0.0 0.0 0.1 0.1
0.0 0.5 1.0 1.6
-0.0 -0.5 -1.4 -2.4
0.1 1.2 2.4 3.6
0.2 3.8 8.8 14.6
0.2 4.4 11.3 21.3
0.3 5.5 16.0 34.7
1983 1984 1985 1986
0.0 0.3 0.7 11
0.3 2.0 2.0 0.2
0.2 1.0 -0.1 “3.9
0.0 0.0 0.1 0.2
0.0 0.0 0.0 0.0
0.0 0.2 0.3 0.5
0.0 0.0 -0.1 0.4
0.0 0.4 0.8 1.2
0.0 0.5 1.7 3.3
-0.0 0.4 1.8 4.3
-0.0 0.5 2.4 6.4


-7-

determination sector was replaced with a set of simplified equations in
which bilateral rates of the dollar against the currencies of the other
four countries were constrained to move proportionally with each
country's prices relative to U.S. prices and with real interest
differentials.”/ This adjustment was made in order to simplify the

the analysis. In the original version of the model exchange rates also
respond to shifts in current accounts in an equilibrating direction (i.e,
a deficit causes a depreciation, which reduces the deficit). Since part
of the reason for undertaking this exercise was to draw implications
about the exchange rate, we decided to abstract from the response that
was built into the model.

In Section V we present estimates of cyclically-adjusted
current accounts based on both the partial-equilibrium and full model
approaches described above. For purposes of the partial-equilibrium
estimates, most of the determinants of the current account were treated
exogenously (i.e. equations for incomes, prices, interest rates, etc.,
were dropped from the model). However, we did allow for changes in net
foreign asset stocks resulting from shifts in current account positions.
(These asset stocks enter directly into the determination of net
investment income.)

The partial-equilibrium approach was used to calculate both
historical and forward-looking estimates of cyclically-adjusted deficits.
The historical analysis involved setting output in the five MCM countries
plus the rest-of-world sector to cyclically-adjusted paths (defined in
Sectior IV below) during 1982-83 to determine the cyclical components of

current accounts over that period. This exercise has the advantage of


-21-

The top half of Table 6 shows that in the United States,
government spending (at all levels) rises steadily, to a level 17% above
the baseline in 1986. This raises the aggregate government deficit by
$60 billion and raises real output by 5 percent. The increase in
inflation which results is relatively small, 8 percent by the end of
1986; the price impact is moderated somewhat by the appreciation of the
dollar. The (nominal) short-term interest rate rises by 3.5 percentage
peints by the end of the simulation; this which gives some measure of the
"crowding out" of private investment that would occur. The increase in
the real interest rate is 2.8 percentage points. The money supply
increases by only 1.9% over the baseline path in 1986; this is
consistent with the slight increase in prices. As noted above, the
current account deficit increases by $25 billion in 1986.

Tables 7 and 8 show similar results for Germany and Japan; in
both countries fiscal expansion brings output to its potential level with
relatively small increases in inflation and interest rates. In 1986,
interest rates rise by 0.3 and 0.1 percentage points in Germany and
Japan, respectively, and the price level rises by 2.2 and 0.8 percent.
Again, these changes are with respect to the baseline path.

The results for the normal growth case are essentially a scaled
down version of the peak-to-peak case, although in this scenario most of
the expansion occurs in Germany since the baseline case for the U.S. and
Japan is fairly close to the normal growth path.

These simulations suggest that there is some scope for
coordinated expansion among these three countries. However, it should be
unde*stood that behind this relatively optimistic result lies a

relatively optimistic set of assumptions. In the MCM, the level of real


Footnotes

*/ Economists, Federal Reserve Board. This paper initially was prepared
for presentation at the Fourth International Workshop of the Applied
Econometric Society, Brussels, Belgium, December 8-9, 1983. The views
presented here are the authors' and do not necessarily represent the
views of the Board of Governors of the Federal Reserve System or anyone
else on its staff. We have benefitted from discussions with William L.
Helkie, Karen Johnson, Ray Lubitz and Jaime Marquez, and especially Dale
W. Henderson and Steven Symansky. We also thank Edwin M. Truman for
his comments on an earlier draft, and we are grateful to Caryl McNeilly,
Sarah Lee and John E. Keniley for their able research assistance.

1/_ An analogous methodology is used in the computation of cyclically-
adjusted budget deficits. See, for example, deLeeuw and Holloway
(1983).

2/ Klein (1983) makes a similar point with respect to the calculation of
full-employment or structural budget deficits.

3/ The MCM is described in detail in Stevens, et. al. (1983) and

Federal Reserve Board (1983).

4/_ The prototype exchange rate equation employed in this paper is
written:
Tog(iER) = log(iP/UP) + logl(1 + URS)/(1 + iRS)]
+ log((1 + in)/(1 + Un)1 + Resid

where:
iER = Exchange rate (country i's currency/dollar).
iP = Country i's consumer price index.
iRS = Country i's short-term (3-month) interest rate.
in = Country i's CPI annual inflation rate over the past

six quarters.
Resid = residual
where i = Japan, Germany, Canada and the U.K.; variables
preceded by "U" denote U.S. variables.
Note that the second and third right-hand-side terms combined represent
an estimate of the short-term real interest differential.

5/ Blue Chip Economic Worldscan, P.J. Eggert, ed. Capitol Publication
Inc., Arlington Va., October 15 and November 15, 1983.

§6/ OECD Economic Outlook, July 1983, p. 60.

7/' Analytical Appendix to Structural Budget Deficits and Fiscal Policy

Responses to the Recession, OECD Secretariat, CPE/WP1(83) 2

8/ This treatment of developing countries, and debtor countries in
Particular, implicitly assumes that adjustments to lower import levels
necessitated by debt servicing are fully accounted for in the baseline,
and that these countries’ imports would expand in line with their export
revenues if industrial countries grew faster.


-F2-

9/ The income elasticities of U.S. imports from other regions in the MCM
range between 1.5 and 2.0, while the elasticities of other countries’
demand for U.S. goods range between 1.0 and 1.5. These elasticities
generally were estimated over the period 1967-1980.

10/ The longer-run impact on the Japanese current account is probably
overstated by about $10 billion in this simulation (and by 1986 in all of
the forward-looking peak-to-peak simulations discussed below) because of
an implausibly high parameter that leads to a longer-run instability in
the Japanese service account sector.

11/ Japanese interest rates rise little because they are essentially
pegged to the official discount rate. German rates rise much less than
U.S. rates because the interest elasticity of money demand is
substantially higher in the German model than the U.S. model. A recently
updaed version of the U.S. monetary sector, which was not completed in
time for these simulations, would have yielded a noticeably smaller
impact on U.S. interest rates.

12/_ In the simulations, Canada and the U.K., as well as the rest-of-
world sector, were assumed to be expanding towards potential or normal
output.


Canada
Germany
Japan
U.K.

U.S.

Table 5: Potential Output Measures for the MCM Countries

annual growth
rate of potential
Current output gap (%) GNP_(%)

average annual

growth needed to

reach potential
by 1986

peak to normal
peak growth

10.1 6.2 2.9
10.7 5.8 2.7
2.7 -0.1 3.9
7.2 2.7 1.3
8.4 3.5 2.9

peak to normal
peak_ = growth

6.4 5.1
6.3 4.7
4.8 3.9
3.6 2.1

6.0 4.3


-3-

component of the U.S. current account is surprisingly small, and that the
cyclical components of both the U.S. and Japanese current accounts could
be in the "wrong" direction. That is, if output were adjusted to the
cyclically neutral paths we have defined, both the U.S. deficit and the
Japanese surplus would be larger than currently expected.

This result is obtained for two reasons. First, despite its
strony recovery in 1983, U.S. output still has further to go to reach its
cyclically neutral path than does output in other major countries on
averaje, and in Japan in particular. This is partiy because the recent
recession was relatively deeper in the United States. Also, Japan's
output gap is small, based on our definition of cyclically neutral growth
in terms of the trend observed during the 1970's. This trend yielded a
cyclically adjusted growth rate of about 4 percent for Japan, somewhat
below the average observed during the 1960's. In our judgment the more
recent experience provided the more realistic basis for defining an
attainable growth path for Japan in the near term. Even so, we did make
an effort to maximize Japan's output gap by assuming a relatively low
baseline growth rate of 3-1/2 percent.

The second reason for our estimate of a small cyclical
component in the U.S. case, is that the MCM's estimated income
elasticities of import demand are somewhat larger for the United States
than for other countries, on average.

Our simulation results also suggest that the estimated cyclical
component of current accounts can differ significantly if allowance is
made for cyclical movements in other variables besides GNP, depending
upon the mix of policies employed to achieve the cyclically neutral
GNP. If, for example, fiscal stimulus is used in the linited States and

monetary stimulus abroad, U.S. real interest rates rise relative to


-14-

problems associated with measuring capacity utilization, and because of
the considerable variance over time in measured natural (noninflationary)
rates of unemployment. While the peak-to-peak trend may lie below the
maximum possible level of output at any given point in time, our
intention is to define a feasible and sustainable path for the near
future, based on recent historical experience.

A second measure we employ, termed "normal output", uses the
rate of growth of potential output implied by the peak-to-peak measure,
but reduces the calculated level of that path by a constant percentage.
The reduction is such that the means of the actual and cyclically
adjusted output paths are equal over the period 1973-1982. This
adjustment is made since it seems conceivable, and perhaps even probable,
that peak levels of output could not be sustained over time under
reasonable policy regimes.

Table 5 shows the current (198303) output gaps, measured as a
percentage of current real output, for each country using the two
alternative measures of cyclically neutral output. The table also shows
the estimated annual growth rate of potential output, and the rate of
growth that would be needed to reach potential by the end of 1986.

Japan stands out with by far the smallest output gap among the
five countries. Japanese output is currently running very slightly above
its "normal" path, and is only 2.7% below projected peak-to-peak
potential. The other countries range from 2.7 to 6.2 percent below
normal output, and 7.2 to 10.7 percent below peak-to-peak potential. The
United States is in the middle of the group; it is “ahead" of Canada and
Germany in the business cycle, but the difference is not striking,

compared with the relative position of Japan.


-16-

developing countries) would move in proportion to activity in the five
MCM countries .2/ The results, for the most part, are reported in terms
of deviations from the historical and projected baseline. We first
employ the international accounts sectors of the U.S., German, and
Japanese models in the MCM for partial-equilibrium analysis. In these
simulations only the variables determined in the balance of payments
accounts are endogenous. Real incomes change exogenously but prices,
interest rates, exchange rates, and all other variables not determined
directly in the balance of payments accounts are fixed. In Figure 4 we
show the results of two “historical” simulations in which real output is
assumed to follow potential and normal output paths starting in 1982.
The figure shows the results for the current account, compared with the
historical baseline, for the three countries. (All current accounts are
measured in billions of U.S. dollars, at annual rates.)

The top panel of Figure 4 shows the paths for the U.S. current
account. In the potential output simulation the U.S. deficit is
substantially larger than in the baseline case. This is chiefly because
in 1982 the U.S. had a larger output gap than its trading partners,
particularly Japan. Raising all countries to potential in 1982 raises
U.S. income by more than the increase in the average of its trading
partner's income, and U.S. imports increase more than do U.S. exports.
Another factor that contributes to the initial widening of the U.S.
deficit is that the MCM's !J.S. income elasticity of import demand is
somewhat higher than the import elasticities in other countries .2/ Thus,
even if all countries grew at the same rate, the U.S. deficit tends to

widen. By the end of the simulation period the output gaps for all


also considers, briefly, the relative importance of the drop in exports
to developing countries.

Our method of analysis, outlined in Section II, is to estimate
how the current accounts of the three countries would differ from
baseline paths if output in the three countries (and the rest of the
world) reached "cyclically neutral" paths over the next three years. The
estimates are made using two versions of the Federal Reserve Board
Staff's Multicountry Model (MCM). The results obtained depend
importantly upon the structure and parameters of the model employed, as
well as on the projected baseline and cyclically neutral paths fcr output
we have chosen. One version of the model treats GNP and all other
determinants of each country's balance of payments as exogenous
variables. The other treats non-GNP determinants of the balance of
payment accounts endogenously. In this case the desired GNP paths are
reached through the application of monetary and fiscal policy measures:
other factors that affect the current account, including prices, interest
rates and exchange rates, are allowed to fluctuate endogenously.

The baseline path, described in Section III, is for the most
part taken from available published forecasts. The cyclically neutral
output paths are described in Section IV. In view of the inherent
difficulties involved in measuring cyclically-neutral or potential output
paths, we have chosen two measures. These include a "peak-to-peak"
trend and a "normal" trend, both calculated from historical data over the
past ten years. Our intention here was not to derive precise measures of
potential output, hut rather to define paths tnat appeared to be both
free of cyclical fluctuations and realistically attainable over the next
three years.

The results, presented in Section V, suggest that the cyclical


References

Artus, J.R., "Methods of Assessing the Long-Run Equilibrium Value of an
Exchange Rate". Journal of International Economics, 1978, 227-299

deLeeuw, F. and Thomas M. Holloway, "Measuring and Analyzing the
Cyclically Adjusted Budget", Federal Reserve Bank of Boston
Conference on the Trend and Measurement of the Structural Deficit,
October 1983.

Federal Reserve Board, "FRB Multicountry Model", Quantitative Studies
Section, Division of International Finance, Federal Reserve Board,
Washington, D.C., August, 1983.

Klein, L.R., "The Deficit and the Fiscal and Monetary Policy Mix",
Federal Reserve Band of Boston Conference on the Trend and
Measurement of the Structural Deficit, October 1983.

Stevens, Guy V.G., et.al., The U.S. Economy in an Interdependent World: A
Multicountry Model, Federal Reserve Board, Washington, D.C., 1983.

Williamson, John, The Exchange Rate System, Institute for International

Economics, Washington, D.C., 1983.



Table 3

Nominal Exchange Rates, Relative CPIs and Real Exchange Rates

Nominal Exchange Rates Relative CPI's Real Exchange Rates

(197804 = 1.0) (Col. 1 x Col. 2,

indexed in

197804 = 1.0)

Yen/$ DM/$ US/JAP US/GER Yen/$ DM/$
197804 190 1.87 1.00 1.00 1.00 1.00
197904 238 1.76 1.07 1.07 1.35 1.01
198004 210 1.91 1.12 1.15 1.24 1.17
198194 224 2.25 1.18 1.18 1.39 1.42
198204 259 2.50 1.20 1.18 1.64 1.57
1983Q3 249 2.61 1.23 1.18 1.61 1.65

Percentage Changes

. 197904/7394 24.9 -5.8 7.5 6.7 34.3 a)
198004/7304 -11.6 8.2 4.3 7.5 -7.8 16.3
198104/81994 6.6 7.7 5.3 2.9 12.3 21.1
198204/8104 15.3 11.3 2.1 -.2 17.7 11.0
1983Q3/8204 -3.6 4.2 1.6 0.0 -1.9 4.2
198393/8004 18.6 36.6 9.3 2.6 29.6 40.2

1983Q3/7804 31.1 39.6 22.6 18.0 60.7 64.7


The Current Accounts of the United Stated, Japan
and Germany: A Cyclical Analysis

by

Peter Hooper and Ralph Tryon=/

I. Introduction and Summary

The current account positions of the major industrial countries
have undergone very large swings in the past three years. Most observers
now expect the U.S. current account, which was in surplus in 1981, to
show a record deficit in 1983, and an even larger deficit in 1984.

Swings in the Japanese and German current accounts have been equally
dramatic in the opposite direction, moving from deficit to surplus. The
possible continuation of these deficits is a source of concern to
policymakers to the extent, for example, that they and the factors
underlying them give rise to protectionist pressures or involve
significant adjustment costs in tradable goods sectors.

Several factors have been cited for the projected increase in
the U.S. current account deficit on one side and the surpluses of Japan
and Germany on the other. One involves exchange-rate developments: the
appreciation of the dollar in real terms against the yen and the mark
since 1980 has led to a substantial loss in U.S. price competitiveness.
A second involves cyclical developments: the U.S. recovery from the 1982
recession has been and is expected to continue to be significantly
stronger than the recovery elsewhere, leading to a relative boom in U.S.
import demand. A third concerns the effects of the sharp drop in the
impots of debt-burdened developing countries.

The present paper focuses on the cyclical factor, and attempts
to gauge the quantitative importance of the cyclical components of the

recent and expected current account positions in the three countries. It


Figure 3

- POTENTIAL GNP

CANADA BILLIONS OF $C
TTTTTTTTTrTiririry i
tle 160

UK BILLIONS OF STG.
- =] 70

65

60

55
Pipitipipipit |e 52
1974 1980 1986

LEGEND

HISTORICAL GNP
BASELINE FORECAST
PEAK-TO-PEAK POTENTIAL GNP
NORMAL GNP



Table 6: High Employment Growth - United States

amounts shown are deviations from the baseline path, annual

in percentage terms unless noted.

growth to potential output in 1986

real GNP

real government spending
government deficit ($b)

price level

interest rate (100 basis points)
money supply - M1

exchange rate-foreign currency/$
real imports

real exports

trade balance ($b)

current account balance ($b)

growth to normal output in 1986

real GNP

real government spending
government deficit ($b)

price level

interest rate (100 basis points)
money supply - M1

exchange rate-foreign currency/$
real imports

real exports

trade balance

current account balance

averages,
1983 1984 1985 1986
0.1 1.3 3.3 5.6
0.2 2.9 8.3 17.0
1.0 7.6 23.7 59.7
-0.0 -0.0 0.1 (.8
0.0 0.4 1.5 3.5
0.0 0.2 0.8 1.9
0.0 0.5 1.6 3.0
0.1 2.1 6.5 12.4
0.1 2,0 4.3 6.3
-0.1 -2.5 -11.1 -26.7
0.1 -0.1 -7.3 -25.0
1983 1984 1985 (1986
-0.0 -0.1 0.2 0.8
-0.2 -0.9 -0.8 0.4
-0.9 -6.0 -8.2 -8.0
0.0 0.0 0.0 0.0
-0.0 -0.0 -0.0 0.3
-0.0 -0.0 -0.0 0.1
-0.0 -0.0 0.1 0.7
-0.1 -0.7 -0.6 0.8
0.0 0.6 1.5 2.3
0.3 3.1 5.0 2.9
0.4 4.9 9.3 3.0


-12-

than either German or Japanese exports in absolute terms, because debtor
countries account for a higher portion of U.S. exports.

The third factor, cyclical swings in income and other variables
is the focus of the remainder of this paper. It should be noted that
service flows can be significantly affected by cyclical factors, just as
trade flows are. Most of the decline in U.S. net services between 1981
and the first half of 1983 was accounted for by a drop in direct
investment income receipts, reflecting the decline in economic activity
and profits in other countries during that period.

Finally, before turning to the cyclical analysis, we should
caution that analysis of current account positions is subject to
potentially severe statistical constraints. Most notable is the
existence of a very large discrepancy in the aggregation of global
current accounts. That is, the total of all countries’ current account
positions, which in principle should sum to zero, summed to -$56 billion
in 1981, - $100 billion in 1982 and possibly an even greater magnitude in
1983,0/ Analyses by the OECD and IMF suggest that a substantial part of
this discrepancy involves the underreporting of service account receipts
in the current accounts of industrial countries and OPEC. Based on a
purely mechanical allocation of the discrepancy by shares in the trade of
industrial countries, the U.S. current account deficit in 1983 could be
overstated hy as much as $20 billion, while the surpluses of Japan and
Germany could be understated by roughly $10 billion and $15 billion,

respectively.


-15-

Japan also has the fastest growth rate of peak-to-peak growth
at 3.9%. It is a full percentage point higher than the values for the
United States, Germany, and Canada, which are grouped at around 2.8%.
The figure for the United Kingdom is 1.3%. The growth rates needed to
reach potential are in the range of 4 - 6-1/2% per year, except for the
United Kingdom; this would require a strong recovery, but not one that
is outside the bounds of historical experience.

Figures 2 and 3 illustrate the alternative potential output
paths as well as our baseline paths for real GNP. In all countries but
Germany the baseline case is for output to come near to its “normal” path
by 1986; in Germany the output gap remains roughly constant.

The definition and measurement of potential output raises
difficult conceptual problems, and the measurements proposed here are to
some extent arbitrary. We also ran the simulations reported in this
paper using measures of potential output reported by the oeco.Z/ The
results did not differ significantly from those reported here, which
gives us some confidence that our measures of potential output are at
least plausible. Again, they attempt merely to define a reasonable path
for the economy at high employment, not necessarily to measure the

ultimate capacity of the economy.

V. Simulation Results

This section describes the results of the model simulations
outlined in Section II. The simulations involve moving real output from
historical or projected baseline paths to cyclically-adjusted (potential
and normal) paths as defined in the preceding section. For this exercise

we assumed that real activity in the rest-of-world sector (including