12

expansion occurs, the recovery begins. Qutput increases from Yy to Yor
with the short and long rates rising to converge to C. The financial.
market's anticipation of the future fiscal expansion raises the present

long-term interest rate and throws the economy into an anticipatory
recession.

Anticipation of the future effects of. the 1981 budget and tax package
cannot be the only cause of the 1982 recessicn, however. In Figure 4,
the long rate rises and the short rate falls in the recession, and the
short rate is below the long rate throughout. However, in the data of
Table 2 we see that the short rate rose above the long rate in late 1979
and again ie the fourth quarter of 1980 to the third quarter of 1981,

after which it has remained below the long rate. So current tight

monetary policy in 1980-81 mst also be part of the story.

Tight Money and Anticipated Fiscal Ease : -

To explain the movements in the term structure in 1980-84, as well
as the recession and recovery, we need a scenario that combines a monetary
policy tightening in 1981 with the effects of anticipated fiscal ease.

In fact, growth of Ml slowed to 54 percent, annual tate, from December
1980 to July 1982, so this may be a fairly accurate scenario.

The combination of an actual tightening of monetary policy and an
anticipated easing of fiscal policy is illustrated in Figure 5. For
expositional convenience, we assume there that the two policies have an
offsetting effect on demand in the final equilibrium, that is, that after

the recession and recovery, real GNP is back to its initial level rela-‘

tive to trend.



Figure 5.2Ashows the deterioration of the trade balance over this
period. Figure 5.3 reveals the impact of the simulated policies on
output. The money squeeze in 1979 induces some recessionary behavior but
the severe "expectations recession" begins with the announcement of the
fiscal program in 1981 and reaches bottom at the end of 1982 with particu-

larly deleterious effects on the foreign and interest sensitive sectors.


24

that output begins to recover. This trajectory of output in response to
expected future fiscal expansion is attributable to the contrasting
assumptions employed in modelling the behavior of financial markets with
actions in the goods and factor markets.

We have assumed in our specification that agents in the real economy
“believe what they see" whereas in the financial markets, participants
“see what they believe." Thus an anticipated fiscal expansion may produce
movements along a demand function as the cost of capital increases but the
expected policy does not produce a shift in demand prior to the implemen-
tation of the policies either because of increased expected profitability

or, in the case of consumption, because of expected increases in future

income. :

We will now turn to the examination of the impact of monetary
contraction upon the variables ‘in our model before attempting to compare
our. fiscal experiments with the time series data discussed above.
Following that, we will model the combined influence ‘of monetary and
fiscal policies with a better understanding of how each policy instrument

contributes to our simulated view of the causes of the recession of 1982.

Reduction in the Growth Rate of Money if

The simulation of an unanticipated permanent reduction in the rate
of growth of money from 5.3percent to 2 percent is plotted in figures
3.1 - 3.3. Figure 3.1 reveals that upon announcement the long rate R

jumps downward, reflecting the expectation of falling interest rates in‘

the long run, as some of the inflation premium is “wrung ouc”TM of nominal


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14

Price Dynamics

The next step is to add price dynamics 'to the model. We adopt a
mcdel of "core inflation," in which inflation adjusts gradually to. .
monetary disturbances and is also sensitive to output disturbances. We
use this model to reflect the idea that inflationary expectations are
adaptive, rather than forward-looking. In our specification, the infla-
tion rate is a geometric average of past money growth rates. This can be
taken to represent a credibility effect, where a policy change is not
immediately assumed to be ‘permanent, as well as an element of stickiness
on the supply side, such as would be implied by staggered wage contracts.
People believed in the early 1980s that inflation was coming down only
when they saw lie come down.

The inflation equations are two:

GG)  .hen(@-h): Adjustment of Core Inflation,

(6) pah+ oy - yy): Phillips Curve.

Equation (5) has the core inflation rate h adapting to deviations of
money growth from h. Equation (6) says the actual inflation rate is the
core rate plus a Phillips-curve term for deviations of output from its
natural level y.
For solutions of the dynamic model we will turn to computer simula-
tion after introducing open-economy aspects in section III. But the
solution algorithm for the dynamic closed-economy model is clear. The
ISLM equilibrium is on a trend inflation rate given by MH. Core inflation
is {so h in (5) is zero. Equilibrium output is ¥, so p in (6) is equal’ to h.

Demand and output are equal so y in (3) is also zero. With R = r from


29

In the final simulation experiment conducted above we have chosen a
particular configuration and timing of changes in monetary and fiscal policy
instruments to represent a stylized view of U.S. macroeconomic policy in the
early 1980's. The implications of these actions for key simulated variables,
given our structural specification, were then compared with the actual
historical behavior of those variables, to assess the correspondence between
the two series.

The quality of our "fit" in the simulation <apeciment is affected by
several limitations which we would like to stress briefly. They fall into
two groups: methodological limitations, and omitted events.

The dynamic simulation methodology utilized here constrains one's
modeling of forward-looking events by requiring that upon announcement of
a new policy environment, stretching indefinitely into the future, agents
have complete and immediate perfect foresight. Thus, new policies are
completely credible upon announcement, and there is no time lag between
the announcement and "belief," because of lags in the diffusion of infor-
mation.

In our experiment this methodological restriction implies that changes
in such variables as the term structure of interest rates occur in discrete
and discontinuous jumps as new information is revealed. For instance, the
announcement of the future fiscal expansion in 1981 produced an instantaneous
jump in long rates of interest, whereas the historical data on Table 2 show

that the rise took place gradually over the second and third quarters of

1981.

While we are comfortable with the assumption that new information

propagates through the financial markets relatively more quickly than through


follows a positively-sloped saddle path. This framework shows clearly
the principles involved in analyzing expectations dynamics. We then
proceed to add a model of core inflation and a short-run Phillips curv:
in order to incorporate price dynamics.

The open-economy version of the model is presented in section IV,
with equations for the current account and an “open interest parity”
condition with exchange-rate expectations and a ‘risk premium that
depends on the stock of government debt. This reflects our assumptiors
that dollar-dominated and foreign-exchange assets are imperfect substi-
tutes so that U.S. interest rates can move relative to foreign rates.
The open-econ}my model shows how the anticipated fiscal package could
cause a jump in the real long-term rate and the dollar, splitting the
financing between domestic investment and the current account.

The simulation version of the model is presented in section V.
There we illustrate the dynamic effects of a variety of monetary and
fiscal policies, and then combine them to produce a simulated view of
the U.S. economy from 1980 to 1983. The results of this final simlation
experiment are then compared with the stylized facts presented at the
outset. Finally, we conclude with a discussion of the strengths and
shortcomings of our approach, highlighting a number of policy events

"vind eccurred during this period, but are not integrated into this

exercise.


22

\
Table 4: THE COMPLETE MODEL

\
(1) d = ay+i+ruf - 6(R-b) +x
4 Parameter values
- - +r
(2) r (ty - a)/e a = 20
: é& = .80
. = wd-y)
(3) y wd = y. uel
a y = 1.00
(4) R= R-r
y = -80
(5) b= n= a) cr 8
AK = 9
a = ws
(6) P= b+ oly - y) 0.2
| coe R = 110
(7) £ = oe/p + ly* - wy tei
. - € =
(8) x os YC - x) P= .02
a ¢ = .50
(9) Ee = xr - (r* + 9b).
"> 8.0
(10) bos £- Tu-D Mn *
r = .02

Note: For simulation purposes, equation (10) in the text was linearized to

obtain equation (10) here.


-1l2a-

Expected Fiscal Expansion

Figure 4:


15

(4), we can solve (1) for R and then (2) for P: The saddle path into this
solution gives the motion of the real long-term interest rate R-h. The
jump in the long-term real interest rate over the first half of 1981, and
its continued upward movement since the bottom of the recession in the
fourth quarter of 1982 can be seen in the data in Table 1. The is consis-
tent with an interpretation of Figure 5 as showing the path of the real

long-term interest rate.

Iv. ‘The Open Economy

In addition to the historically high level of long-term real interest
rates since the first half of 1981, the economy has experienced an appre—
ciation of the dollar, in real effective terms, of some 30 percent since
then. The data, using the IMF's index, are shown in the fifth colum of
Table 2. Since we define the exchange rate as U.S. dollars per unit of
foreign exchange, an appreciation means the real effective vate in Table 2
goes down. Again, the major movement in the exchange rate comes across
the first half of 1981, consistent with the movement of real interest rates.
To build this into the model, we have to open it up.

Trade Flows

We assume gradual adjustment of real net exports x toward an equi-
librium level x that is a function of competitiveness, domestic income,
and foreign income. Competitiveness is measured by the exchange rate
relative to the domestic price level (e/p), with the foreign price level,

fixed at unity. The equations for trade flows are:


In Figure 5, the shift of the LM curve is current and unanticipated,
while the IS shift is announced for the future. This creates a new cur-
rent equilibrium at point B, and a future equilibrium at point D with a
saddle path RR into it. At the initial level’ of income Ya? the short
vate jumps to Ty on the new LM curve. The long rate rises, seeking the
unstable branch relative to the new equilibrium B that will take the
economy to RR whea the IS curve actually shifts . So the long rate rises
to point 1 to put the economy on the recessionary path from 1 to C.

Now we see that initially the short rate moves above the long rate.
In the recession, as y falls from y, toy, the short rate falls along the
LM curve to The moving below the long rate at the bottom of the latter's
path from 1 ta C. The economy bottoms at point C when the actual fiscal
stimilus comes on line. During the tecovery period the two rates rise,
converging to point D:

The essential feature of this scenario is the reversal of the term
structure. At first short rates rise above long rates, and then fall
below then, bottoming when the recession bottoms. Then in the recovery
both rise with the long rate above the short. This is essentially the
pattern of the data of Table 1. In the fourth quarter of 1980 the short
rate jumped above the long rate. The crossover came in the first quarter
of 1982, and the short rate remained below the long rate after that,
bottoming with the recession in the fourth quarter of 1982. Both rates
rose after that. Thus the scenario of an actual monetary tightening
combined with anticipated fiscal ease is consistent with the broad move-

ments of the term structure and GNP.


23

exchange rate and, because of sticky prices, the real exchange rate“

jump appreciates upon announcement of the fiscal stimulus and then depre-
ciates continuously. The trade balance deteriorates following the real
exchange appreciation and gradually offsets the impact of fiscal stimlus
upon aggregate demand. Output y is shown in figure 1.3. Initially
output rises as the direct fiscal effect dominates reduced demand in the
interest sensitive and foreign sectors. Thereafter the latter two effects

predominate and the economy slackens.

Anticipated Fiscal Stimulus

Figures at - 2.3 exhibit the results of the simlation of a fiscal
expansion announced one year before its actual implementation. Figure
‘2.1 shows that, just as when the fiscal stimlus is unanticipated, the
long rate of interest jumps in anticipation of future bond supply
increases. A comparison of figures 1.1 and 2.1 reveals that when .economic
agents anticipate the fiscal expansion one year before implementation, the
resulting jump in the long-rate is smaller upon announcement. Similarly
the appreciation of the real exchange rate is smaller initially when
the announcement precedes the implementation of the policy. This can be
seen by comparing figures 1.2band 2.2b,

The impact of the announcement of future fiscal stimulus upon current
output is shown in figure 2.3. Unlike the immediate fiscal expansion
shown in figure 1.3, anticipated expansion produces an "expectations
recession" with output initially falling in response to both the rise in

interest rates and the deterioration of international compet

itiveness. §

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III. The Basic Model, Closed Economy sf

\
We begin the exposition with the simplest fixed-price IS-LM model

of a closed economy. The basic idea of how expectations dynamics in
financial markets can generate a recession from an expected fiscal expan-
sion can be easily outlined in this framework. Then we will go on to price

dyaamics and open-economy aspects of the model.

IS-LM with Short- and Long-Term Interest Rates

The basic model can be stated in four equations

(1) d=ay+it+uf - 6(R -h): IS Curve,

(2) re (ry - m)/e: LM Curve,
(3) y= Wd - y): Gradual Output Adjustment,
(4) ER=R- vt: . _ Path of Long Rate, or. Term Structure.

Variable definitions are given in Table 3. Equation a) gives
aggregate demand d as a function output y, autonomous investment i, the
exogenous component of fiscal policy f£, and the real long-term (actually
consol) bond rate. Consumption is assumed to be a function of current
income, in Keynesian fashion. This is clearly an important assumption
for our analysis of fiscal policy. If infinitely-lived consumers take
into account fully all future tax liabilities, including those related
to debt service, then a shift from tax-financing to debt-financing of
government spending will have no effect on aggregate demand. See Barro
(1974) for a discussion of this case. For a variety of reasons such as .
liquidity constraints and uncertainty regarding remaining years of life ‘

(see Blanchard, 1984), we chink the neutrality assumption is too strong.


20

V. Dynamic Policy Simlations

In this section we will examine the results of a variety of dynamic
simulation experiments using the model developed in the previous sections.
For convenience, this model and the parameter values we have used are
reproduced in Table 4. The simlations will be performed using the
computer program of Austin and Buiter (1983), as modified by Johnson
(1985). The program similates linear, dynamic, perfect-foresight models
applying the methods developed by Dixit '(1980) and Buiter (1984).

First we will compare and contrast the impact of anticipated versus
unanticipated fiscal stimulus. We will then explore the implications of
monetary conttaction, alternatively modelled as an unanticipated fall in
the rate of growth of money and as an unanticipated fall in real balances.
Finally, we will combine the elements of unanticipated monetary contrac
tion followed by anticipated fiscal stimulus and compare the dynamic
paths of the variables in our model with the data series which were dis-

cussed in section II above.

Unanticipated Fiscal Stimilus

Figures 1.1 -1.3 illustrate the result of a fiscal expansion which
is unanticipated. The stimulus to aggregate demand and the concomitant
increase in the future supply of bonds to finance the deficit lead to an
immediate jump in the long rate of interest as the policies are announced.
The short-term rate of interest rises as the increase in demand increases

the transaction demand for money. Figure 1.2 shows that the nominal


Long-run Equilibrium : .

The long-run equilibrium of the open-economy model can be solved
as follows. From equation (5) with h = 0, the core inflation raté-is
h-= a, which is fixed exogenously. From (6) with y = y> B =h also,
and m = M/p is constant. From (3) with y = 0, d= y- In long-run
equilibrium the real exchange rate e/p will be constant, so é = Bp =h
= em Combined with the long-run bond stock b, this gives us the equi-
librium value of the short rate r from (9), and from (4) with R = 0, the
long rate and the short rate are equal. With M given exogenously, and
y and r determined, the price level P comes from money-market equilibrium
(2), and the is equation (1) can be solved for net exports x. With x =0
in (8), x= x; and finally equation (7) can be solved for the level of
the nominal exchange rate e that yields a real exchange rate (e/p)

consistent with equilibrium x. This completes the long-run equilibrium

solution.

Intuitive Dynamics of a Temporary Fiscal Expansion

The dynamics of fiscal and monetary policy will be studied using a
simslation version of the model in section V. Here we will outline the
intuition behind the results using the example of an unanticipated and
temporary fiscal expansion. It must be temporary so that the real bond
stock reaches a new long-run equilibrium value rather than going off to
infinity. So consider a temporary increase in f that creates a permanent
increase in b, with no change in money growth. This fixes long-run

nominal growth rates é = 3 shew


Table 1: U.S. NATIONAL INCOME ACCOUNTS, 1979.1 - 1984.2

Net Net
Government Foreign Domestic Private Private

Deficit Saving Saving Investment Saving

1979.1 22.1 2.3 15.4 415.1 399.7
2 20.1 5.4 17.4 428.3 410.9

3 712.9 -1.6 14.6 431.9 417.3

4 ~2.1 5.7 715.6 416.3 401.2
1980.1 7.5 4.1 7.3 422.0 414.7
2 38.1 6.7 43.0 394.3 437.3

3 43.3 *=20.3 61.3 379.5 440.8

4 33.9 72.3 37.1 411.7 448.3
1981.1 8.1 -11.3 13.3 455.5 468.8
2 { 10.6 0.5 13.1 472.1 485.2

3 | 25.2 0.3 37.8 495.8 531.6

4 ' 63.7 5.5 76.6 476.2 552.8
1982.1 79.7 4.8 91.2 422.9 514.1
2 81.2 8.7 88.2 432.5 520.7

3 127.0 24.8 99.6 * 425.3 524.9

4 175.3 21.9 149.2 377.4 526.6
1983.1 142.9 6.7 137.4 404.1. 541.5
2 114.4 33.0 84.9 450.1 535.0

3 133.5 41.5 96.7 491.9 588.6

4 129.3 59.1 75.0 540.0 615.0
1984.1 107.4 77.7 27.5 623.8 651.3
2 nea. 83.5 nea. 631.5. nea.

Source: CITIBASE

Net Domestic Saving = Gross Private Saving (GPS) minus
‘ Gross Private Domestic Investment (GPI)


II. Economic Policies and the Unusual Characteristics of the 1982 Recession

The 1982 U.S. recession coincided with major shifts in monetary and
fiscal policies. In this section we will present a brief description of
the main policy changes, as well as of the corresponding movements in some
key endogenous variables. In. particular, we will focus on the financing
of the deficit, and on the behavior of prices, production, interest rates,
and the exchange rate. .

In March of 1981 the new budget and tax package was announced. It
included a major increase in defense spending to be phased in over several
years, a three-stage tax cut to begin in 1982, and some cuts in non-defense
spending. The package as a whole implied a growing "structural" deficit
in the Federal Government's budget from $40 billion in the first half of
1981 to about $180 billion by the end of 1984. The financing of the over-
all government deficit can be seen in Table 1. As required by the national
income identity, a budget deficit must be financed by a combination of
excess domestic saving over domestic investment, and a current account
deficit (net foreign saving). Until the third quarter of 1982 most of the
deficit was financed by net domestic saving. Investment fell from a peak
of $495.8 billion in 1981:3 to $377.4 billion in the last quarter of 1982.
In 1983, however, as the recovery gained momentum and the dollar continued
to appreciate, a larger share of the deficit began to be financed by
foreign saving.

Unlike fiscal policy, it is harder to characterize monetary policy in
this period of financial innovation and deregulation. Even though the 4
monetary authorities made explicit their intention of reducing inflation,

the main monetary indicators did not exhibit signs of larger policy shifts.


ll

with the short rate above the long. As y falls, the two interest rates
also fall, converging to point B.

The effect of an unanticipated fiscal expansion is shown in Figure 3.
Again the equilibrium point moves from A to B. With y at Ya? initially
the short rate remains at T, But in anticipation of the future rise in

both rates, the long rate jumps to R: As output then rises to Yy? beth

interest rates rise to R,» Th:

Expected Fiscal Folicy

The Reagan Administration's future budget package, which implied a
rising structural deficit, was announced in March 1981. The potential
recessionary befects of an announcement of a future fiscal expansion are
illustrated in Figure 4. With the economy at point A, a future fiscal
expansion is announced. The financial markets come to understand that
the future equilibrium is at point C, with higher interest rates. . This
means the long rate will jump immediately. But onto what path? The
future saddle path will be RR at the time of the actual fiscal expansion.
The long rate will rise seeking an unstable branch relative to the exist-
ing equilibrium A that has the following property: as the economy moves
along that unstable branch, it will reach the new saddle path at the
time the announced fiscal expansion actually takes place, i.e., when equi-
librium C comes into existence.

Thus the long rate jumps to Ry in Figure 4 with output at Yat This
depresses investment and sends the economy into recession along the
unstable branch from point 1 to point B. Output and the short rate fall:

to yas Tye while the long rate rises to Ro: When the actual fiscal


Table 2: ECONOMIC INDICATORS, 1979.1 - 1984.2 .

GNP

INFL SR LR RIR RER r

1979.1 8.7 9.4 9.0 0.3 101.9 100.5 99.0
2 8.7 9.4 9.1 0.4 99.6 100.0 98.8

3 9.1 9.6 9.0 “0.1 101.9 100.0 100.0

4 9.5 11.8 10.2 0.7 100.1 99.8 100.1
1980.1 10.0 13.5 11.8 1.8 100.0 99.6 100.6
2 10.2 10.0 10.6 0.4 100.0 91.6 98.3

3 10.3 9.2 10.9 0.6 102.9 94.5 - 98.4

4 10.2 13.7 ° 12.1 2.0 98.2 98.4 99.4
1981.1 9.5 14.4 12.7 3.2 92.6 99.6 101.5
2 8.9 14.5 13.5 4.6 85.8 100.1 101.7

3 84 - 15.1 14.5 6.1 81.8 99.2 102.6

4 748 12.0 14.1 6.3 85.9 93.9 101.3
1982.1 7.0 12.9 14.3 7.3 83.7 92.7 99.9
2 6.1 12.4 13.7 7.6 82.0 90.8 100.1

3 5.7 9.7 12.9 7.2 78.6 89.9 99.9

4 4.9 7.9 10.7 5.8 78.0 88.5 99.6
1983.1 4.0 8.1 10.9 6.9 80.4 91.6 . 100.2
2 4.1 8.4 10.8 6.7 79.1 . 95.8 -102.5

3 3.5 9.2 11.8 8.3 76.2 100.7 104.4

4 3.0 8.8 11.7 8.7 75.7 102.4 105.7
1984.1 “3.5 9.2 11.9 8.4 75.4 105.2 108.3
3.0 9.7 13.2 10.2 107.3 110.2

Sources: GNP: CITIBASE
Others: IFS Data tape, IMF.

INFL = % increase in PCE deflator over the same quarter a year earlier.

SR = T-bill 3-month.

LR = T-bond 20-year.

RLR = real long rate (LR - INFL).

RER = index of real effective exchange rate using WPIs (dow = $ appreciation);
this is the inverse of the IMF index. ;

IP = industrial production, indexed to 1979.3 = 100.

GNP = GNP at 1972 prices, indexed to 1979.3 = 100.


Qe

Pa ata

at

Rese,

-l3a-

Figure 5: Actual Monetary and

Expected Fiscal Policy


International Finance Discussion Papers
Number 272

December 1985

EXPECTED FISCAL POLICY AND THE RECESSION OF 1982

by

William H. Branson
Arminio Fraga
Robert A. Johnson

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.


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10

IS curve, following equation (3). This gives the horizontal arrows in
Figure 1. The short-term rate clears the money market, so it moves along
the LM curve following output.

The RR saddle path can be derived as follows. I£ the long rate R
were to adjust along the LM curve, ER would be zero throughout, from equa-
tion (4) with R= xr. This is inconsistent with rational expectations; to
the left of E, r and R are expected to rise and to the right of E to fall.
Therefore, to the left of E, for example, with ER > 0, R mst exceed r.
This gives the vertical arrows that show the motion of R. If R is.above
LM, R > r and ER mst be positive for equilibrium between short and long
rates; vice versa below LM. There is then only one saddle path RR that is
consistent with a rational expectations equilibrium. It is positively
shaped but flatter than LM. Along it, to the left of point E, FR =R-r>0
and to the right of E, it is negative. Other paths.of R,y are "bubble" paths
that cross IS vertically (eo = 0) or LM horizontally (ER = 0) and explode to
the northwest or southeast. These “unstable branches" will play ‘an important

role in the analysis of anticipated fiscal policy.

Unanticipated Monetary and Fiscal Policy

As a prelude to an analysis of the 1982 recession, we can use the
diagram of Figure 1 to characterize the effects of unanticipated monetary
or fiscal policy on demand and the term structure of interest rates.

This is the usual textbook case. Consider first the effects of a contrac-
tionary monetary policy (dM 0), illustrated in Figure 2. The LM curve
shifts up, so the equilibrium moves from point A to point B. At the

initial levei of income Ya? the two interest rates rise to Th Ry


The expected, or “core inflation rate h is given exogenously in equation

(1), and set at zero for the time being. It will be endogenized later.
Equation (2) is the LM curve normalized on the short-term interest rate
tr. The short rate is assumed to clear the money market at all times. In
the LM curve m is real balances M/P, and € is the semi-elasticity of the
demand for money with respect to r. Equation (3) gives the change in
output over time as a partial adjustment to the excess of demand over
output. A more precise model would include inventory dynamics, but the
specification here is sufficient to maintain a focus on expectations;

Equation (4) specifies the term structure of interest Tates, pro-
viding one link with the future, and thus bringing expectations dynamics
into the model. Aside from a risk premium, which we set to zero, any
long-short differential mist be equal to the expected rate of change of
the long rate. If R- r > 0 in equation (1), then the long rate must be
expected to rise (i.e. consol price to fall) to generate a capital loss
that offsets the rate differential, for the bond market to be in equi-
librium.

The dynamics of the model are described in the IS-LM diagram of
Figure 1. The short-term rate r and the long-term rate R are measured on
the vertical axis; output is on the horizontal axis. The stationary
equilibrium is at point E, where R=randd-=y. Away from equilibrium,
y and R move along the "saddle path" RR, and r moves along the LM curve.

The innovation in Figure 1 is the RR saddle path. This comes from
the combination of equation (4) and the assumption of rational expecta—
tions in financial markets. In this non-stochastic model, rational

expectations is the same as perfect foresight. Output adjusts toward the


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31

References

Austin, G. A. and Willem H. Buiter (1982), “'Saddlepoint': A Programme
for Solving Continuous-Time Rational Expectations Models," Univer-
sity of Bristol Working Paper No. 82/132, November.

Barro, Robert J. (1974), "Are Government Bonds Net Wealth," Journal of
Political Economy, 82:1095-1117, November/December.

Baumol, William J. (1959), Economic Dynamics, MacMillan.

Blanchard, Olivier J. (1984), "Debt, Deficits and Finite Horizons," NBER
Working Paper No. 1389, June. -

(1981), “Output, the Stock Market, and Interest Rates,"
American Economic Review, 71:132-143, March.

Buiter, Willem H. (1984), "Saddlepoint Problems in Continuous-Time Rational
Expectations Models: A General Method and Some Macroeconomic Examples,"
Econometrica, 52:665-680, May. .
=conometrica

\
and Marcus H. Miller (1984), "Real Exchange Rate Overshooting
and the Output Cost of Bringing Inflation Down: Some Further Results,"
in Jacob Frenkel (ed.), Exchange Rates and International Macroeconomics,
University of Chicago Press, Chicago.

(1983), "Changing the Rules: Economic Consequences of the
Thatcher Regime," Brookings Papers on Economic Activity, 2:305-365.

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

Dixit, Avinash K. (1980), "A Solution Technique for Rational Expectations
Models with Applications to Exchange Rate and Interest Rate Deter-
mination," mimeo, University of Warwick, November.

Johnson, Robert A. (1985), "A Note on the Solution of Linear Saddlepaths
when the Forcing Vectors are Modelled as a Step Function," mimeo,
Federal Reserve Board.

Miller, Marcus H. (1980), "What Does Forward-Looking Behaviour in the
Gilt's Market Imply for (a) the Price of Consols and (b) Monetary
and Fiscal Policy?" mimeo, University of Warwick, December.

Wilson, Charles A. (1979), "Anticipated Shocks and Exchange Rate Dynamics,"
Journal of Political Economy, 87:639-647, June.



19

First we consider long-run equilibrium. With a larger bond stock
and no change in the equilibrium @, rand R mst rise, from (9) and (4).
The rise in long-run equilibrium r means the entire price path mst. rise
to reduce real balances. With a higher real interest rate R - h, net
exports must rise, so e/p mst rise. This implies that the e path rises
more than the p path. So in the long rum interest rates rise and the
exchange rate depreciates.

Now let us consider the shorter run, while the budget is in deficit,
but y=2d-= y. In this short-run equilibrium, some combination of an
increase in the real interest rate (R ~h) and decrease in (e/p) are
required in order to reduce investment and net exports to make room for
the increase in f. Total differentiation of equation (1) with yandd

given, p set at unity, and (7) for x results in

(12) udf - 6dR + ode = 0,

In the R,e space of Figure 6, equation (12) is the LX curve with slope
o/6 and an upward shift when f increases. But in the short-run equi-
librium r = R, and equation (11) says that if market participants expect
rto rise, the exchange rate will immediately fall. This gives the
negatively-sloped am (for asset markets) line in Figure 6. The two
conditions together give the increase in R and decrease in e that split
the financing of the f deficit between investment and net exports in the
short run. This is a partial explanation of the increase in real interest
rates and appreciation of the dollar that was shown in Table 2, in order
to obtain the shift in the private saving-investment balance and net

exports that was shown in Table 1.


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Figure 6: Short-run Adjustment with

Temporary Fiscal Expansion

48


The growth rate of the money supply (Ml as currently defined) decreased
from an annual rate of 8.32 between 1976.3 and 1979.3 to 6.1% between
1979.4 and 1982.3. In particular, from the second quarter of 1981 to the
third quarter of 1982 Ml grew at an average annual rate of 5.4Z. Finally,
if we correct the money supply for the introduction of NOW accounts on
December 31, 1980, we find that for the year 1981 the adjusted figure drops
from 6.4% to 2.32, indicating a severe mcnetary “squeeze. :

The behavior of the main macroeconemic variables in this period is
summarized in Table 2. By mid-1981 nominal short-term interest rates had
risen by about 5 percentage points over mid-1980, and long-term rates by
3.5 points, even as the inflation rate began to decline. In the third
quarter of 1981 the recession began, and short rates dropped slightly.
Long rates, however, remained high, a fact that we will discuss at length
below. Almost simultaneously with the announcement of future fiscal
policy and the rise in interest. rates, the dollar started ‘tts appreciation,
which has continued to the end of 1984. The recession began in the third
quarter of 1981 and ended in the fourth quarter of 1982, with a decline in
industrial production of about 11.5%.

- If tight money were the sole cause of the recession, we would have
expected to see the short-term interest rate remain above the long-term
vate. However, since the fourth quarter of 1981, the short rate has teen
below the long rate. The severity of the recession, the inversion of

the term structure of interest rates, and the appreciation of the dollar
in recession are the puzzle that we attempt to solve in the next two

sections, focusing on expectations dynamics and future fiscal policy.




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IFDP

NUMBER

272

271

270

269
268

267
266

265
264

263

262
261

260

International Finance Discussion Papers

TITLES

1985

Expected Fiscal Policy and the Recession
of 1982

Elections and Macroeconomic Policy Cycles

Assertion Without Empirical Basis: An
Econometric Appraisal of Monetary Trends
in... the United Kingdom by Milton Friedman
and Anna J. Schwartz

Canadian Financial Markets:
Proposal for Reform

The Government's

Was It Real? The Exchange Rate Interest
Differential Relation, 1973-1984

The U.K. Sector of the Federal Reserve's
Multicountry Model: The Effects of
Monetary and Fiscal Policies

Optimal Currency Basket in a World of
Generalized Floating: An Application to
the Nordic Countries

Money Demand in Open Economies:
Substitution Model for Venezuela

A Currency

Comparing Costs of Note Issuance Facilities
and Eurocredits

Some Implications of the President's Tax
Proposals for U.S. Banks with Claims on
Developing Countries

Monetary Stabilization Policy in an Open
Economy

Anticipatory Capital Flows and the Behaviour
of the Dollar

Simulating Exchange Rate Shocks in the MPS
and MCM Models: An Evaluation

AUTHOR(s)

William H. Branson
Arminio Fraga
Robert A. Johnson

Kenneth Rogoff
Anne Sibert

David F. Hendry
Neil R. Ericsson

Garry J. Schinasi

Richard Meese
Kenneth Rogoff

Hali J. Edison

Hali J. Edison
Erling Vardal

Jaime Marquez

Rodney H. Mills

Allen B. Frankel

Marcus H. Miller

Arnold Kling

Arnold Kling

Please address requests for copies to International Finance Discussion
Papers, Division of International Finance, Stop 24, Board of Governors of

the Federal Reserve Board, Washington, D.C.

20551.


26

steady-state tate of money growth. Figures 4.1 - 4.3 exhibit the results
of an experiment where the stock of money falls at time t = 0 by 3 per-
cent.

In Figure 4.1 we see that the inversion of the term structure, as
measured by the difference between the long and the short rates of
interest, is primarily attributable to a jump in the short rate though
the long rate also moves at the time of the announcement.

On the other hand, the inversion of the term structure of interest
rates in figure 3.1 was primarily attributable to a fall in the long rate
of interest in anticipation of falling inflation. In this simulation
steady-state {inflation does not decline.

Figure bounce again reveals that the real exchange-rate jump
-appreciates due to the expectation of a lower price level brought about
by transitory disinflation resulting from the money stock decline. There-
after the real exchange rate depreciates back toward its initial level.

The trade balance, shown in figure 4.4 follows the exchange rate
with a lag. Figure 4.3 shows that, unlike a money~growth rate decline,
the drop in the stock of real balances produces an unambiguous immediate
decline in aggregate. demand as both the real exchange appreciation and

the rise in interest rates depress expenditure.

Policy Simulation and the Recession of 1982

In this section we combine the various monetary and fiscal policy
influences in a manner which we feel roughly corresponds to the macro-—
economic policies which influenced the U.S. economy between the third

quarter of 1979 and the end of 1984. The principal policy events which


27

we try to capture are:
1. A contraction of the money stock in October of 1979.
2. A tendency for the monetary authorities to reduce the growth rate
of money over the period.
198i to be impiemented over the years 1982-85.

For the purpose of the simulation experiment we have sought to capture
these policy ‘influences as follows. We begin the simulation in October of
1979 by implementing an unanticipated drop in the money stock. Then, in
March of 1981 we similtaneously introduce a2.3percentage-point reduction in the
growth rate of money and a three-stage anticipated fiscal expansion to be
implemented ah steps, 3, 7, and 11 quarters in the future. The results
are shown in figures 5.1 - 5.3 and can be compared with the data for the
U.S. economy from Table 2 above.

Initially the short rate of interest increases by over 100 basis
points while the long rate rises by 20 basis points. The. inversion of
the term structure persists until the announcement of a fiscal stimlus
produces a rise in the long rate in anticipation of rising interest rates
due to bond finance of the prospective deficit. .

Figure 5.2hshows the pattern of the real exchange rate and can be
compared with the fifth column of Table 2. The marked event is the large
real exchange-rate appreciation upon announcement of the fiscal program
and monetary deceleration. In our stylized view this event roughly
corresponds to the period between the election in the fourth quarter of
1980 and the third quarter of 1961 when the fiscal program of the Reagan
Administration was formed and the information diffused into the market-

place.


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16

(7)
(8)

me

=ae/p + dAy* - wy : Equilibrium Trade Balance,

Me

=y(%-x): , Gradual Trade Adjustment.

The partial adjustment model is used to reflect the assumption that auJ-

justment of trade flows to changes in competitiveness takes time. Eova-

ticn (1) should be rewritten to include the trade balance:

q1') ds ayt+titypf + 6(R -h) +x.

Asset Markets

The central aspect of our model of exchange-rate determination is
imperfect substitutibility between assets denominated in U.S. dollars md
in foreign exthange. With imperfect substitutability, an accumulation of
U.S.-government debt can increase U.S. interest rates relative to "woxid"
interest rates by increasing the risk premium on U.S. bonds. With
rational expectations, financial markets can look ahead to this implica-
tion of a shift in the full-employment deficit, and move the interest
rate and exchange rate at the time when the implication becomes clear.

Imperfect substitutability and a risk premium that is positively

related to the bond’ stock are given by
(9) Ee = r - (r* + 9b),

where @ is the rate of change of the exchange rate, r and r* are the i'.S.
and world short-term interest rates, and b is the real bond stock. This
is the standard open interest parity condition with a flexible exchang2

rate and a risk premium.


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and if hoods markets are "Keynesian" but financial markets are forward-
looking, ‘the announcement can cause a recession, which will end when
the actual fiscal action begins to stimlate the economy. In the actual
context of 1981, a shift toward monetary tightness also contributed to
the recession.

The models we use to analyze these policy changes have many ante-
cedents. Wilson (1979) analyzed the effect of anticipated policies iin
Dornbusch's (1976) model of expectations and exchange rate dynamics.
Buiter and Miller (1984 and references therein) have used similar models
to analyze the theoretical effects of disinflation policies, as well as
the actual events of the Thatcher period (1981, 1984). Miller (1980) and
Blanchard (1981) have constructed closed~economy models which include an
expectational term-structure of interest rates, and are simple enough to
be treated analytically. In particular, the initial model of ‘section IIL
begins with Marcus Miller's (1980) four-equation closed-economy medel,
and we have benefitted greatly from discussions with him on this topic
(and many others). The paper is structured as follows.

In section II we begin with some "stylized facts" about the reces-
sion. The important things to notice are the sharp rise. in real long-
term interest rates and the real appreciation of the dollar in early
1981, and the subsequent split of financing of the budget deficit between
domestic saving and foreign borrowing--the current account balance.

Section III begins by incorporating a term structure based on expec-
tations of future movements in interest rates into a standard fixed-price
closed-economy IS-LM model. This is the model of Miller (1980). In it‘

the short-term rate moves along the LM curve, but the long-term rate


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Figure 3:

Expansionary Fiscal Policy


I. Introduction

The Economic Recovery Tax Act of 1981 had one aspect that is
unusually useful for economic analysis. It provided an example of a
clear-cut announcement of future policy actions at specified dates.

This provides an opportunity to apply recent advances in the analysis
of expectations dynamics to data that have been generated in an environ-
ment: that includes such anticipated policy action.

, A three-stage future tax cut was announced in the Tax Bill in March
1981. In a Keynesian model with liquidity-constrained consumers or
investors, or with uncertainty, this would normally be expected to provide a
stimulus to the economy when the tax cuts actually appear. But the
financial markets could look ahead to the stimulus and the shift in the
high-employment deficit brought about by the tax cuts, and their implica-

tions for bond prices and interest rates. In this paper we argue that

this happened during the first half of 1981. As market participaits came
to understand that the tax and budget actions of March 1981 implied a
future shift of the high-employment—now "structural"—deficit by some

5 percent of GNP, they revised their expectations of future real interest
rates upward. This caused a jump in real long-term rates then, in 1981.
And, we argue in section IV below, it also caused a sudden and unanti-
cipated real appreciation of the dollar at the same time. The jump in
rea]. long-term interest rates and the dollar appreciation in the first
half of 1981 were essential features of the recession that began in July
1981.

This paper points out the possibility of a purely anticipatory

recession. If the only policy action had been the fiscal announcement,


interest rates. The short-term rate does not move discontinuously from

the initial position of 8 percent, reflecting the fact that a change in

the rate of money growth does not imply an instantaneous change in the

stock of money and that prices and income adjust gradually. As the new

lower growth rate of money translates into a smaller nominal money stock ~~~ ~~~
while prices adjust sluggishly, the short rate is driven up as real

balances decline.

The magnitude of the rise in short rates is also increased because
aggregate demand is stimilated by the fall in long interest rates and
produces a greater transactions demand for money in the short run. .

Figure 3i2breveals that the real exchange-rate jump appreciates
in response es the announcement of reduced money growth. This jump
appreciation corresponds to a jump in the nominal exchange rate to a new
“dynamic path because of the expected lower path of prices.

Figure 3.3 plots the path of output after the fall in the growth rate
of money. Initially output is stimulated by the jump decline in the long
rate of interest. Thereafter the downward adjustment of inflationary
expectations increases the perceived long real rate of interest and at the
same time the trade balance deteriorates following the initial exchange-
rate appreciation. In the long run the real rate of interest is restored
to its equilibrium value and the trade balance improves following a

depreciation of the real exchange rate.

Fall in the Level of Real Balances M/P

p
A second characterization of a monetary contraction consists of an:

unanticipated fall in the level of the money stock without altering the




EXPECTED FISCAL POLICY AND THE RECESSION OF 1982

William H. Branson
Professor of Economics,
Princeton University

Armino Fraga
Graduate Student,
Princeton University

Robert A. Johnson
Economist,
Board of Governors
of the Federal Reserve System

December 1985

We would like to thank Ivy Ellenberg and Cathy Crosby-Fitzgerald for
research assistance. This paper represents the views of the authors and
should not be interpreted as reflecting the views of the Board of
Governors of the Federal Reserve System or other members of its staff.


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21

Table 3: VARIABLE DEFINITIONS .

d aggregate demand *.
y output

tL autonomous investment -

£ budget deficit

R long-term interest rate

r short-term interest rate

kh expected or "core" inflation

x trade balance

x equilibrium trade balance

m ‘ real balances

M money supply

Pp price level

e exchange rate .
b stock of real bonds

E conditional expectations operator

Note: a bar over a variable denotes the steady-state value, a hat denotes
proportional rate of change, a dot the time derivative, and a star a

foreign (and exogenous) variable.


30.

goods and factors markets, we feel that the assumption of instantaneous
perfect foresight imposed by the methodology introduces distortions into
the simulation.

The other source of discordance between simulation and historical
variables is the omission of several key aspects of the policy environment
over the period under study. In particular, in order to retain simplicity
and facilitate exposition we have omitted some important financial events.
The Credit Control program of 1980 introduced limitations on the behavior
of participants in U.S. financial markets which we have not incorporated
into the simlation. Similarly, we have not introduced the deregulation
of interest rates on instruments included in money aggregates, nor have
we sought to ‘eal with any aspect of what might be termed “financial inno-
vation." Finally, in this version of the Paper we have not modeled the
so-called “safe-haven effect" or dealt with the rapid growth in the money
supply, both of which occurred in the third quarter of 1982, Studies of
these additions to our stylized view of policy events constitute an agenda

for future research.


17

The real bond stock accumlates as the mon-monetized part of the

budget deficit, following
(10) b=f-i

where f is the current real deficit, fis the growth rate of money,

and L is real balances. Agents in financial markets are
assumed to look ahead to the consequences of shifts in £ or b through equation
(io). .

With perfect foresight, equation (9) says that the current level of
the exchange rate must reflect the integral of future expected interest
differentials, adjusted for the risk premium. In the solution of the
open-econony bodel, agents look ahead to the path of r - r* - pb.
Throughout the analysis, we hold r* constant. If this integral is posi-
tive, the expected value of @ mst be positive, so the current exchange
rate mist fall below its equilibrium value given the current fundamentals.
Thus for sufficiently small p, the announcement of a future fiscal deficit
combined with a current shift to tighter monetary policy, by increasing
the expected future short-term interest rate, will yield an appreciation
of the dollar, at the time of the announcement. Buiter and Miller (1983)

give the forward integral of (9) as

(11) ee) = a(t) + | E.(z* + pb(s) ~ r(s))ds,
t
where e(t) is the current long-run equilibrium exchange rate. When the

expected integral becomes negative, e(t) falls relative to @(t) so the

expected rate of increase of the exchange rate,e(t), is positive.


-9a-

Figure lL:

Basic Expectations Dynamics


IFDP
NUMBER
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International Finance Discussion Papers

TITLES

Trade Policy for the Multiple Product
Declining Industry

Long Memory Models of Interest Rates, the
Term Structure, and Variance Bounds Tests

Currency Substitution and the New Divisia
Monetary Aggregates: The U.S. Case

The International Transmission of Oil Price
Effects and OPEC's Pricing Policy

U.S. Banks' Lending to Developing Countries:
A Longer-Term View

Conditional Econometric Modelling:
An Application to New House Prices
in the United Kingdom

Low Pushing: Doctrine and Theory

1984
(partial listing)
Postwar Financial Policies in Taiwan, China

Foreign Exchange Constraints and Growth
Possibilities in LDCs

The Determination of Front-end Fees on
Syndicated Eurocurrency Credits

Monetary Policy Games and the Role of Private
Information

The Macroeconomic Implications of Labor
Contracting with Asymmetric Information

Cooperative Policies among the North, the
South, and OPEC: An Optimal Control Approach

International Repercussions of the U.S. Budget

Deficit

Can Exchange Rate Predictability Be Achieved
Without Monetary Convergence?~- Evidence from
the EMS

Domestic Saving, Current Accounts, and
International Capital Mobility

AUTHOR(s)

Catherine Mann
Gary S. Shea

Jaime Marquez
Jaime Marquez

Henry S. Terrell
Rod Mills

Neil R. Ericsson
Davia F. Hendry

William Darity, Jr.

Robert F. Emery

Jaime Marquez

Rodney H. Mills
Henry S. Terrell
Matthew B. Canzoneri
Matthew B. Canzoneri

Anne C. Sibert

Jaime Marquez
Peter Pauly

Peter Hooper

Kenneth Rogoff

Gerard Caprio, Jr.
David H. Howard


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