Equation 5 represents an adaptive adjustment mechanism for normal
or long-run inflationary expectations depending upon the difference
between the rate of money growth and the current expected rate of
inflation. It reflects an assumption that inflationary expectations are
only significantly altered by a change in the growth rate of money
after the altered rate of money growth has persisted for some time (See
Dixit (1980)). As money growth increases, M rises above h and fi becomes
positive. The sensitivity of economic agents to changes in the rate of
money growth is governed by the parameter 7m. In the simulations taat
follow I will assume that 7 is large so that changes in money growth
induce a rapid, but not instantaneous, adjustment in inflationary
expectations. Note that this assumption implies that financial market
participants, who have perfect foresight, incorporate goods markets
participants' systematic errors in predicting expected inflation in the
short run into their expectation formation when jumping onto asset
price saddlepaths. Equation 6 is an expectations-augmented Phillips
curve.

Also shown are the steady state solutions to the system. In the
steady state, real balances are constant so inflation, 5, is equal to
the rate of money growth, M. Inflationary expectations, h, are equal to
the rate of money growth according to equation 5. Output is equal to
Y, and both the long and short rates of nominal interest are equal
to M + (uf -(1-a)y)/6.

Before examining the simulation results produced by the model, let
us use graphical methods to illustrate its workings in response to. an
anticipated fiscal contraction. First I will examine the stability of

the system in R-y space and then conduct the policy exercise. This


23a

Table 3.: The Complete Model

(1) d=ay + uf - 6(R-h) + x
(2) r= (ty - m/e

°
(3) y =.0(d - y)

(4) ER=R-gr

(5) A= n(f-n)
(6) S2h+ oly -F)
(7) X = oc + Ty* - ay
(8) & = @(k - x)

(9) Ee =r - (r* + ab)

(10) b= € - ME(1-m) - afm
(11) G¢=8-5

4 e
(12) m=a-58

Parameter Values

+80 R= .I9 6 = .80
1 o = .15 @ = .80
8.0 r* = .02 Q= .20
+02 @ = .50 Tr = 0:0
1.0 e = 2.0 @ = 1.0


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26

stock is set to .02, which implies that a doubling of b from an
initial value of 1 will increase interest rates by 2 percentage
points. Other parameters added in this open economy specification are
o, which measures the sensitivity of the trade balance to the
exchange rate; 2, the sensitivity of the trade balance with respect
to home income; and Y, the speed of adjustment of the trade balance
in response to changes in income and relative international prices.
In the simulation exercises, o is set to .15, 2 is set to .2, and Y
is set to .80 so that the "half life" of a disturbance is slightly

under one year.

With the open economy version of the model one can conduct
simulations of policy experiments of the type performed witn the
closed economy version in the previous section. A direct comparison
of the dynamic behavior of the variables in response to the same
policy change can be made, beginning from the same initial 2onditions
and using the same parameter values, in order to illuminate the
differences in the adjustment processes for the two models.

Before turning to the simulation results it is instructive to

compare the differences between the steady state solutions of the two

systems.
Closed Economy Open Economy
P= ReM+((a-1) y+ uf )/6 Pe R= Mtrt+ab

@ = ((1-a-2)¥-pf+6(r¥+ab))/o


interest rates, might have remained high as the risk premium associated
with the expected future supply of government bonds was replaced by an
expected inflation premium by those investors fearing that an :.ncrease
in the rate of money growth would be the instrument chosen to bring the
dollar down. Following this line of argument, it was only after the G5
announcement and the passage of GRH that market participants were
convinced that fiscal contraction, rather than an increase in money
growth, would be the instrument chosen to bring the dollar down in
order to avert an escalation of impediments to international trade. At
that time, interest rates could fall along with the dollar as it was no
longer necessary to fear renewed inflation as the inevitable cost of
stemming the tide of protectionist pressure.

In the simulation exercises that follow, the announcement of a
multistage future fiscal contraction will take place at one particular
moment. In other words, GRH will be treated as an unanticipated shock
to expectations about future policy, where all participants in
financial markets and foreign exchange markets will be assumed
instantly to comprehend the entire future of fiscal policy and its
implications for asset prices. This is clearly an oversimplification of
the way in which information diffuses through the economy. While the G5
meeting in September and the passage of GRH may have been the most
important events that convinced the markets of the altered trajectory
of U.S. macroeconomic policy, debate over budget reform was ongoing
throughout the period and most likely affected the price of financial
instruments well before these two key events.

In summary, the stylized facts of the period surrounding the GRH

legislation are: 1) a sharp flattening of the term structure of


36

V. CONCLUSION

The simulation exercises presented above were conducted to
illustrate the behavior of an open economy in response to an announced
fiscal contraction, with and without a temporary increase in the rate
of money growth. The predictive value of these experiments, even ina
qualitative sense, hinges on several assumptions about economic
behavior which are embedded in the model specification and the
simulation technology used. I would like to reflect for a moment on
some of these considerations.

First, the assumption that financial markets see everything
instantly and that announcements are immediately believable is quite
strong. It begs the issue of the predictability of fiscal policy in an
environment of legislative uncertainty, which may be a serious omission
in the case of the GRH bill. Moreover, questions concerning struggles
over the constitutionality of GRH and the fight over where the cuts
will fall provide sufficient reason to proceed somewhat cautiously in
betting on policy outcomes, at least in the short run. Perhaps a
specification which permitted some adjustment of the real sector in
response to expected future developments while preserving a relatively
more rapid, but not instantaneous, adjustment to information in the
financial markets would acknowledge the spirit of the analysis
presented above and at the same time diminish the hard corners of
discrete jumps upon announcement.

A second omission which is of considerable importance in the
current policy environment is the suppression of factor markets in the
particular model specification used. The disinflationary consequences

of the recent fall in oil prices is of central importance to any


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29

‘reflects the fact that the interest rate is used to clear the goods
market in the steady state in a closed economy and will therefore
fall as fiscal dissaving diminishes. In contrast, in the open economy
the interest rate does not fall as far because the depreciation of
the exchange rate sustains demand, and therefore short rates, through
an increased transactions demand for money. The evolution of the
exchange rate is shown in figure 5.4. The trade balance improves
following the exchange rate depreciation but backslides a bit tecause
the anticipatory expansion increases absorption transitorily before
the fiscal cuts are implemented. Note that in response to this
anticipated fiscal contraction the path of output over the first five
years is strikingly similar, as shown in figure 5.3. While interest
rates fall much further in the closed economy at the time of
announcement, the improvement in the trade balance resulting from the
depreciation of the exchange rate compensates for the relatively
milder response of interest-sensitive sectors in the open economy.
Figure 6.1 shows long-term and short-term interest rates in
response to an unanticipated increase in the rate of money growth.
Surprisingly, the open economy long rate jumps up further upon
announcement than does its closed economy counterpart, even though
the steady state long rate is lower in the open economy than it is in
the closed economy (because the monetization of the debt due to
faster money growth reduces the real bond stock). Despite the higher
long rate, initially the open economy's output rises more rapid:y
than does output in the closed economy, as is shown in figure 6.3.
The difference arises because the exchange rate depreciates in tne

open economy and produces an additional source of stimulus to


30

aggregate demand and concomitantly a higher transaction demani for
money.

The response of the real exchange rate and the trade balance
are shown in figures 6.4 and 6.5. The increase in the rate of money
growth produces an initial sharp depreciation in the real exchange
rate, that results entirely from a depreciation of the nominal
exchange rate, which overshoots the long-term level of the real
exchange rate. The trade balance improves markedly in the short run
and then returns to zero in the steady state. In figure 6.3 the peak
difference in output between the closed and open economy models
oceurs early in the fourth year and the expansion of the tradeable

goods sector accounts for more than all of that difference.

A comparison of open and closed economy adjustment patterns
reveals the following. Monetary policy changes produce a wider swing
in the long-term rate of interest in the open economy than in the
closed economy because the change in monetary policy produces an
exchange rate effect which reinforces the effect of monetary policy
on interest-sensitive expenditure. The higher demand from the
tradeable goods sector supports the transactions demand for money and
raises the short rate. Fiscal policy changes produce less-wide
variation in the long rate of interest in the open economy because
the exchange rate adjusts to offset the effect of fiscal policy on
aggregate demand and therefore dampens the demand for money and the
magnitude of the changes in the short rate necessary to clear the
money market. Overall, the response to fiscal policy changes in the

open economy appears to rely heavily on adjustments to the tradeable


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future decline in fiscal stimulus. At the same time, the short-term
rate moves along the LM curve at all times as y and m determine the
value of r, which clears the money market as shown by equation 2 above.
Upon announcement r does not move because output and real balances are
fixed. It then rises to point ro before falling back towards the
equilibrium interest rate r3(=R3). Thus the term structure, as measured
by the difference between the long and short rates of interest, inverts
upon the announcement of the fiscal contraction, at time to. It then
becomes more steeply inverted until time t; when the fiscal cutback is
implemented, before narrowing back to zero in the steady state.

The peculiar "anticipatory expansion" produced by the anticipated
fiscal contraction in this model is the result of the assumption that
goods markets are not forward-looking and therefore do not react to the
future implications of a reduction in the fiscal deficit while
financial market participants do react to the information instantly and
incorporate the information into their pricing decisions. In this
example of an anticipated fiscal contraction in a closed economy, the
realization that the fall in the fiscal deficit will reduce interest
rates in the future informs financial market participants that the
yield on consols which prevailed at the instant just prior to the
announced fiscal contraction is higher than the yield that will be
available on a perpetual sequence of short-term bonds. As a result, the
consol price is bid up instantly upon announcement of the fiscal
contraction. The goods market then receives the information that the
cost per dollar of borrowing for projects of any duration has fallen as
R drops. At the same time that demand increases because one moves along

the demand schedule as the interest rate falls, goods demand does not


23b

Table 4: Definitions

Y = the log of aggregate output
h = inflationary expectations

m = the log of real balances

f = real budget deficit
R = long term interest rate
r = short term interest rate
x = trade balance
x = equilibrium trade balance tee
M = money supply
p = the log of the price level
e = the nominal exchange rate
b = stock of real bonds
L = the level of real balances
¢ = the real exchange rate
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 the foreign variable.


35

smaller initial expansion of traded goods in the absence of monetary
accommodation. As the higher money growth rate persists, one can
observe that aggregate output reaches a higher peak and the downturn in
economic activity is less severe through 1992 with easier money.
Thereafter, as the disinflation begins in the early 1990s, output falls
relative to the case when money growth is held constant throughout.

In summary, monetary accommodation that is transitory affords
greater levels of output during the fiscal contraction at the expense
of both a greater subsequent recession as inflation is wrung out of the

econony and greater inflation in the interin.


foreign sector and then compares the simulation of closed and open
economies in response to: 1) an anticipated fiscal contraction and
2) an increase in the growth rate of money, to illustrate the
influence of the international economy on the macroeconomic
adjustment process. Section IV then uses the open economy model to
simulate two scenarios which have been discussed in conjunction with
the GRH bill; an anticipated staged reduction in the fiscal deficit
ani an anticipated fall in the fiscal deficit coupled with a
temporary increase in the rate of money growth. The concluding
section discusses the shortcomings of the model developed in this

paper and suggests possibilities for future research.


38

trace the effects of these changes on the external position of
developing countries. These issues were clearly presented in a
prescient study of the current period produced by a panel of economists
in conjunction with the Institute for International Economics; see
IIE(1982). Recent work by Buiter(1985), McKibbin and Sachs (1985) and
Kenen (1985) has made significant progress in this direction.

In conclusion, the announced fiscal contraction in December of
1985 was associated with a reduction of long-term interest rates and a
fall in the exchange value of the dollar. The agreement between this
set of stylized facts and the results generated by the simulations
above suggests that a specification emphasizing the role of
forward-looking asset markets is of great value in explaining the

macroeconomic effects of policy changes in the short to medium term.


37

assessment of the outlook for inflation over the next several years. In
addition, capital accumulation is not considered. The consequences of
fiscal policy changes for investment and hence output capacity in the
medium and long run is certainly an important consideration when
weighing the relative merits of alternative policy actions.

A third aspect of the model used above that is not wholly
satisfactory is the rather crude specification of fiscal policy. A more
disaggregated specification which allows for discrimination between tax
changes and expenditure changes and which includes the endogenous
changes in the deficit that result from change in aggregate income, and
the interest burden of federal indebtedness, would enhance the
analysis. For instance, the analysis of the relative merits of monetary
accommodation could be altered if prolonged expansion were to reduce
the deficit and therefore reduce the risk premium which is associated
with increases in the supply of bonds. This is only one of many such
possibilities. Similarly, a more elaborate specification of the current
account which considers the interest payments to foreigners and the
wealth effects of prolonged current account imbalance would also be
desirable.

Finally, this modeling apparatus would be improved by efforts to
endogenize the behavior of the rest of the world and to make the U.S.
the large country that it most surely is in the current international
commercial system. In particular, wide variations in the behavior of
exchange rates could result from simply modifying the reaction of
foreign interest rates to a change in the interest rate at home. It
would also be useful to analyze the consequences of alterations in the

matrix of policy variables in several countries simultaneously and to


40

response to a fiscal contraction, or similarly, an anticipatory
recession in response to an announced fiscal expansion are found in
Blanchard(1981) and Gavin(1985). In those papers the stock market
falls in response to an announced fiscal expansion when the interest
rate effects dominate the output effects on profitability. This is
the so-called "bad news" case.

6. This relationship is similar to the results developed in Sachs
and Wyplosz(1984). In that paper they showed that imperfect
substitutability between domestic and foreign securities could lead
to a depreciation of the real exchange rate upon announcement of a
fiscal expansion. In this paper if a is very large or the deficit
runs for a long period of time then the indirect interest rate effect
could outweigh the direct effect of government spending and lead to a
depreciation upon announcement of fiscal expansion.

Consider an unanticipated permanent increase in f which begins
at time tg and is evaluated at time T. Integrating (10), the bond
accumulation equation, reveals that;

pits | fCe(s)-Avsrb(s) a8 +b(tg)-

Assuming that M is constant and that f is constant between tg and T
at for+df. One obtains;

b(T)= [fort J*LT-to] “Ai {[L(s)-to}as ~fiLolT-to] +0(to).

Presuming that 8=0 before to, then the increment to the bond
stock equals

b(T)-b(to)= df#LT-to] - a thb(s)-bo las.

The relationship of L(s) to Lo will depend upon the evolution of r
and y between to and T. An increase in f will increase d on impact
and increase y. The increase in output will cause real balances Lo
fall. This can be seen from equations (6) and (12) of table 3. Nove
that m=ln L.

t=L=M-B=-o(y-J) <0.

Thus if L(s) is less than Lo, the increment in the bond stock will
exceed df*[T-tg]. The case of an anticipated fiscal shock is more
difficult to analyze because the anticipatory effects of the
announcement of future policy will produce variations in L before the
implementation of the fiscal change. But as T, the point of
examination, gets sufficiently large the results will be similar to
the those in the case of an unanticipated change in fiscal policy.


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14

analytic apparatus, which was developed through joint efforts by
Miller (1984) and Branson, Fraga, and Johnson (1985), is adapted for
use in this paper to provide a more intuitive grasp of the workings of
‘his model than can be seen through simulation results alone.

Figure 1 shows a dynamic IS-LM diagram with the directions of
motion as indicated by the arrows. The IS curve is defined as the ¥=0
‘locus in R-y space and has slope -(1-a)/é. Above the IS curve, ata
given level of y, the higher interest rate reduces demand and d is less
than y. This causes output to fall.

The LM curve defines the equilibrium in r-y space according to
equation 2 and also defines the R=0 locus since it is assumed that the
economy is always on the LM curve and that the R=0 locus in R-Y space
20ineides with the r-y locus because R=0 only when R=r, according to
equation 4. Above (below) the LM curve R is greater (less) than r and
3 is therefore inereasing(decreasing).

Let us now turn to the graphical analysis of an anticipated fiscal
vontraction. For the moment let us suspend the use of equations 5 and 6
and hold B, the rate of inflation, and h, the expected rate of
inflation, constant at rate x.

In figure 2, an anticipated fiscal contraction is shown. At time
t=tg the fiscal contraction is announced for implementation at a ‘later
time t=t,. At t=to the long rate jumps downward from Ro to Ry.
Thereafter the long rate of interest continues to fall and output rises
along an unstable branch which will intersect the new saddlepath, RR,
at the time t=t; when the fiscal contraction is implemented.4 Thus the
anticipated fiscal contraction produces an anticipatory expansion

detween to and t; prior to the decline in output that accompanies the


18

As a result, in an annual model one could decide that one half of the
initial disequilibrium would be eroded by market adjustment in a
year. Setting t-to=1 yields

o = -1n(.5) = .69
While this does not give one an ironclad scientific means to derive
adjustment speeds it does facilitate choosing parameters that are
within a reasonable range.

The adjustment speed parameters chosen for this section's
simulation exercises are: $=1, and m=8. A value of 8 for 1 implies
rapid adjustment of inflationary expectations to changes in the rate
of money growth. It implies that market participants adjust their
expectations of inflation in response to a change in the growth rate
of money by ninety percent of the difference between the former and
new rate of money growth in a little over a quarter. The "half life"

of « disturbance to aggregate demand is set to slightly less than
three quarters;
t-to = -1n(.5)/1 =.69

The income elasticity of the demand for money, t, is set to
unity and the semi-elasticity of money demand with respect to the
short-term rate of interest, «, is set to 2. The sensitivity of
aggregate demand to changes in the fiscal deficit, u, is set to unity
and the semi-elasticity of aggregate demand with respect to the
long-term real rate of interest, 6, and the sensitivity of aggregate
demand to variations in income are both equal to .80. The parameter
, which measures the sensitivity of the rate of inflation to a

deviation of output from its steady state levet, is set equal to .5.


14b

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Barro (1974). For several reasons, including informational
imperfections, liquidity constraints, and uncertainty regarding the
remaining years of life (see Blanchard (1985)), I believe that the
neutrality assumption is too strong.

The specification of the long-term real interest rate in the
aggregate demand relationship is of great importance in evaluating the
simulation results below. The basis for this specification is that many
projects are of an extended duration, and the cost of borrowing for
durable goods should either reflect the expected sequence of short-tern
rates that would be applicable to a continuous rollover of the debt or
it should be a rate that is applicable for the term of the project.
Secondly, the applicable borrowing cost is the real rate ratrer than
the nominal rate of interest. R-h is one measure of the real rate and
its specification as the expected long-term real rate is constructed to
be consistent with the vision that goods markets are myopic.
Projections of expected inflation, h are conditioned on past rates of
money growth and R is assumed to be determined in financial markets. An
important implication of this specification is that "news" will change
the real long rate of interest as the long-term nominal rate jumps and
the expected rate of inflation does not change instantaneously.

Equation 2 is an inverted LM equation in log form solved for the
short-term rate of interest. It shows the short rate to depend
positively on transactions demand, which is represented by output, and
negatively upon the supply of the real transactions medium, m. The
short rate represents the opportunity cost of holding the transaction
medium, and e represents the semi-elasticity of the demand for real

money balances with respect to the short-term rate of interest. Tt


39

Footnotes

*the author is a staff economist in the International Finance
Division. This paper represents the views of the author and should
not be interpreted as reflecting those of the Board of Governors of
the Federal Reserve System or other members of its staff. I would
like to thank Alan Blinder, William Branson, Michael Gavin, Bonnie
Loope3ko and Dwight Jaffee for comments and helpful suggestions.

1. Tne emerging consensus described in the text finds its
intellectual foundations in the Mundell-Fleming model developed in
the early 1960s. More sophisticated dynamic descendants in that
tradition have been developed since. See Dornbusch(1976),
Sachs(1980), and Branson and Buiter(1984). Also note that the
relationship between fiscal policy and interest rates in an open
economy with a high degree of capital mobility may depend upon global
fiscal dissavings rather than just U.S. fiscal deficits. For the
argument that an increase in global fiscal dissavings did not cause
high real interest rates because foreign fiscal contraction offset
U.S. fiscal expansion in recent years, see Blanchard and

Summers (1984).

2, ‘the fiscal stimulus is measured as a fraction of total private
demarid. Consider Y=A+F, where A is total private sector demand. This
is equal to Y=A(1+F/A). Converting this expression into logs reveals,

y=1n(A) + In(1+F/A).
Provided that F/A is small a Taylor approximation would yield,
y=ln(A) + F/A.

Similarly, if Y=A+F+X, where X represents the trade balance, one can
construct, Y=A(1+F/A)(1+(X/(A+F))). Converting to logs and using the
Taylor approximation yields,

y=ln(A) + F/A +X/(F+A).

In the open economy section developed below I make use of this in
specifying the trade balance. I would like to thank Alan Blinder for
suggesting this method to me,

3. Consider a simple specification with y=0(N) and Ne-a(d-y), where
N=inventories and $'is less than zero. Then y=o'*(-2)(d-y). A more
sophisiticated specification would also include some influence of
demand on desired inventories.

4, For a proof of the result that the non-predetermined variable
will, intersect the saddlepath into the terminal equilibrium at the
time of implementation of the changes which create the terminal
saddlepath see Rogoff (1980).

5. The specification utilized here is not necessary to generate an
anticipatory recession. Other examples of anticipatory expansions in


32

IV. SIMULATION OF FISCAL CONTRACTION IN THE OPEN ECONOMY

Using the model of the open economy I will present two simulation
exercises corresponding to two policy scenarios that have been
discussed recently. The first consists of a fiscal contraction,
announced today and implemented over five years to eliminate the fiscal
deficit in stages, in essence an approximation of the GRH bill. The
second simulation exercise consists of the same five-year fiscal
contraction but this time accompanied by a temporary increase in the
rate of money growth of 2% during the five years of fiscal contraction.

Figures 7.1-7.3 portray a simulation of deficit reduction which is
announced at the beginning of 1986 and implemented in five steps
beginning one year later. As initial conditions I have assuned that
output is slightly higher than trend but is decelerating, that the
trade balance is in substantial deficit, and that the term structure,
as measured by the difference between the short and long rates, is
nearly 500 basis points. These initial conditions are consistent with
the simulation runs produced in Branson, Fraga and Johnson (1985) and
correspond to the conditions that would have prevailed in early
December 1985 as a result of the policies of the late 1970s and early
1980s modeled in that paper. Figure 7.1 shows the behavior of interest
rates and inflation. Upon announcement of the fiscal contraction, the
long rate of interest jumps downward by nearly 100 basis points,
reflecting the expected reduction in the real bond stock. The short
rate does not jump because neither y, nor, p, nor m, jumps in the short
run. As time proceeds, the term structure inverts as both the short
rate and inflation rise, reflecting an increase in the transactions

demand for money and excess goods demand, respectively. Thesie increases


1989 12
1990 36
1991 0

The movements in asset prices during the period of buildup to and
enactment of GRH can be seen in charts 1a, 1b, and 2, which exhibit
U.S. short-term and long-term interest rates, the term structure of
interest rates, and the weighted average exchange value of the dollar
from the beginning of 1985 through the early part of 1986. It is here
in the asset markets that many economists believe that new information
is most quickly incorporated into pricing decisions. Chart ‘a shows
that the long rate of interest fell substantially in the fourth quarter
of 1985 and the first few weeks of 1986. This is also reflected in
chart 1b, which shows the term structure, measured here as the
difference between the 30-year and 6-month rates on U.S. government
securities. The 30-year U.S. government bond rate fell neariy 150 basis
points between late July 1985 and January 1986. In particular, the bond
rate fell 66 basis points during December while the short rate rose 8
basis points.

Chart 2 shows that the reduction in the exchange value of the
dollar began in late February of 1985 and continued through the first
few weeks of 1986. The G5 announcement on September 22 prodiced the
largest single drop in the exchange rate but the tendency was for the
dollar to fall throughout the period. It might be argued that the need
to bring the dollar down to diffuse protectionist pressures was well
known in early 1985 but the method of inducing depreciation was still

uncertain. Under that scenario, interest rates, particularly long-term


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34

expected inflation premium and the expansionary impact of eventual
reductions in the real interest rate as h, the expected rate of
inflation increases. Secondly, beginning in 1987 the rate of inflation
increases with monetary accommodation, reaching a peak difference
relative to the non-accommodation scenario of nearly 3% in 1988-89.
Comparing figures 7.2a and 8.2a one finds that the instantaneous jump
in the real exchange rate, which is solely attributable to a jump in
the nominal exchange rate, is slightly higher with monetary
accommodation. The higher equilibrium price level in the steady state
resulting from the increased money growth necessitates a greater
nominal depreciation to obtain a comparable steady state reai exchange
rate; the real exchange rate in each case will differ slighty because
of the differential effect on the steady state real bond stock produced
by the differences in inflation,

The real exchange rate is not depreciated in figure 8.2a relative
to figure 7.2a over the entire simulation period because the increase
in inflation resulting from faster money growth in the former case
appreciates the real exchange rate after 1988. A comparison of the
relative trade balances in the two simulations reveals a slight
improvement relative to the non-accommodation case in 1987 and early
1988 because of the transitory increase in competitiveness, but by 1989
the greater domestic absorption of imports and the decline in
competitiveness combine to produce a slower improvement in the U.S.
trade balance with monetary accommodation than without it (see figures
7.2b and 8.2b). Finally, a comparison of figures 7.3 and 8.3 reveals
that the anticipatory expansion will be of very similar size with a

Slightly greater stimulation of interest-sensitive sectors ard a


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IFDP
NUMBER

277

276

275

274

273

272

271

270

269

268

267

266

265

International Finance Discussion Papers

TITLES

Can Debtor Countries Service Their Debts?
Income and Price Elasticities for Exports
of Developing Countries

Post-simulation Analysis of Monte Carlo
Experiments: Interpreting Pesaran's (1974)
Study of Non-nested Hypothesis Test Statistics

A Method for Solving Systems of First Order
Linear Homogeneous Differential Equations
When the Elements of the Forcing Vector
are Modelled as Step Functions

International Comparisons of Fiscal Policy:
The OECD and the IMF Measures of Fiscal
Impulse

An Analysis of the Welfare Implications of
Alternative Exchange Rate Regimes: An
Intertemporal Model with an Application

1985
(partial listing)

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

44

AUTHOR(S).
Jaime Marquez

Caryl McNeilly

Neil R. Ericsson

Robert A. Johnson

Garry Schinasi

Andrew Feltenstein
David Lebow
Anne Sibert

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


ba

TABLE 1
NATLTONAL INCOME FLOWS, INTEREST RATES, AND EXCHANGE RATES

YEAR CURRENT EXCESS TOTAL REAL LT REAL RATIC
DOMESTIC BUDGET INTEREST EXCHANGE BUDGET DEF.
DEFICIT SAVINGS DEFICIT RATE RATE TO GNP
(billions) (billions) (billions) (%) ($/composite) (4)
$ $ $ :
197921 15.4 722.2 0.5 1.01 O.4
197932 -17.4 -20.1 -.2 0.99 0.2
1979 :3 14.6 -12.9 0.3 1.03 0.7
197924 -15.6 2.1 1.6 1.01 1.1
1980:1 -7.3 7.5 3.6 T.00 1.5
1980:2 43.0 38.1 2.1 0.99 2.5
1980 :3 61.3 43.3 1.9 1.02 2.8
1980.4 37. 33.9 3.0 0.99 2.5
198131 9.5 9.7 2.5 0.95 1.6
198132 5.1 11.4 2.9 0.88 1.7
198133 19.5 23.3 5.1 0.83 2.0
1981:4 69.0 62.4 yy 0.87 3.2
1982:1 84.6 73.3 5.3 0.83 3.5
1982:2 91.8 17.6 6.4 0. 80_ 3.6
1982:3 12.4 122.5 5.8 0.76 5.3
1982:4 147.8 166.8 5.2 0.76 6.8
1983:1 140.1 150.0 6.6 0.78 5.8
1983:2 83.5 123.8 6.4 0.76 5.1
1983 :3 96.7 127.0 8.1 0.74 5.4
1983:4 75.9 122.2 8.4 0.74 5.2
198431 25.5 93.8 8.3 0.73 4S
1984:2 . 5.3 97.3 9.6 0.72 Wy
1984:30 119.4 20.9 116.0 9.0 0.68 4.8
198424 81.5 24.1 126.8 7.8 0.66 5.1
1985:1 97.0 20.1 99.4 7.8 0.63 2.8
1985:2 110.8 50.8 151.9 7.2 0.64 4.3
1985 :3 121.8 15.7 Was 7.2 0.68 4.0

Data from Citibase and EFS tapes. The reai long term interest rate is the net of the
long term (20 year) bond rate and inflation. The real exchange rate series (IFS) is
based on relative normalized unit labor costs. A decrease in the real exchange rate
represents an appreciation. The Total Sudget Deficit series include the federal
balance as well as the state and local balances. The CA8 is from the National Income
and Products Accounts and is constructed when net foreign investment is added to net
capital grants received by the U.S. Domesti¢ Investment in the U.S.


I. THE GENESIS OF GRAMM-RUDMAN-HOLLINGS

The basis for the enactment of the GRH legislation, and the
reaction of financial markets to its announcement, can be illumirated
by an examination of the recent behavior of the U.S. economy. Tables 1
and 2 give some background on U.S. economic developments since the
beginning of the decade. From Table 1 one can observe the steep
increase in real interest rates and the substantial real appreciation
of the dollar over that period. At the same time, the government budget
grew to over 5 percent of GNP and the current account deficit increased
steadily, ultimately exceeding $100 billion in 1985. Table 2 highlights
the dispersion in the performance of several sectors in the economy
through the end of 1984. The general pattern reveals reasonable
aggregate growth over the period but wide variation across sector's as

tradeable goods and interest-sensitive sectors were adversely affected.

The difficulties associated with divergent sectoral performance in
the U.S. economy may have combined with several other influences to
raise the costs of maintaining a policy mix that perpetuated the U.S.
external imbalance. As dissatisfaction grew in some sectors,
protectionist pressures and pressure for greater monetary accommodation
appeared to increase. While the U.S. Treasury sought to minimize the
costs of borrowing large sums by introducing innovations designed to
make U.S. securities more attractive abroad, such as special foreign
targeted issues and the elimination of the withholding tax on interest
payments to foreigners, concern mounted within the policymaking
community over the willingness of foreign residents to continue to

accumulate dollar-denominated securities and the possible consequences


12

represents the income elasticity of the demand for real balances. It
will be assumed throughout the analysis that the short rate clears the
money market continuously so that, for any given level of real balances
and economic activity, r will be instantaneously determined.

Equation 3 is the differential equation governing the gradual
adjustment of output in response to an excess of demand over output. A
more elaborate specification would reflect the consumer's problem of
the optimal adjustment of desired spending, d, to actual spending, y,
or would be developed from the microeconomic foundations of inventory
dynamics.3 But for the sake of simplicity and to preserve the focus on
expectational aspects of multi-market behavior I have chosen to rely on
this simple specification.

Equation 4 is an arbitrage relation between the holding period
return on long-term bonds and the short-term interest rate. It is
derived as follows:

Let pp be the consol bond price per dollar of coupon payment.
Pp=1/R.

Then the holding period yield = capital gain + yield.

(d(pp)/dt)/pp + R.

d(pp)/dt = d(1/R)/dt
= (-1/R2)*dR/dt.
Thus, equating the holding period yield on the long bond to the yield
on short-term instruments, r, implies;
r = R -(dR/dt)/R.

Or equivalently, R-R-r. -


of an abrupt change in confidence in the dollar. At the same time, a
gradual consensus appeared to emerge among policymakers, academics and
businessmen that the high real interest rates and the overvalued dollar
were related to the unprecedented federal budget deficit.! Foreign
governments also urged the United States to reduce its fiscal dissaving
in order to alleviate the interest burden associated with developing
country debt and to stimulate growth in other industrial countries,
particularly in Europe where unemployment has been quite substantial
and capital formation has been sluggish.

By the end of the third quarter of 1985, the multiple pressures
for fiscal reform came to a head. The meeting of finance ministers and
central bank governors from the Group of Five countries in late
September emphasized the desirability of coordinating fiscal
policies among leading industrial countries, with particular
emphasis on the desirability of fiscal contraction in the United
States. At the same time it was announced that efforts would be made by
the monetary authorities of the G5 countries to reduce the foreign
exchange value of the dollar. Shortly thereafter, legislation was
proposed in Congress by Senators Gramm, Rudman, and Hollings to reduce
the federal government deficit over a period of 6 years. On December
11, 1985 Congress passed the GRH bill, which set out the following

schedule for reduction of the budget deficit:

Fiscal Year Target Deficit ($ billion)
1986 172
1987 144 -

1988 108


shift in response to the future implications for firms and consumers of
the upcoming reduction in fiscal stimulus. Thus the reduction in
interest rates stimulates demand and causes economic expansion prior to
the reduction in fiscal stimulus. It is only after the fiscal
contraction is implemented at time t, that the goods demand function
falls, reflecting the effects of the fiscal contraction on income that
in turn affects consumption and investment spending.

This preliminary exercise may yield a more tangible feel for the
underlying logic of the modeling approach used here. Let us now turn to
simulation methods to examine the effects of several types of policy
changes before broadening the model to include the elements of
structure that reflect the influences of international trade in both

goods markets and financial markets.


International Finance Discussion Papers
Number 291

Revised: July 1986

ANTICIPATED FISCAL CONTRACTION: THE ECONOMIC
CONSEQUENCES OF THE ANNOUNCEMENT OF
GRAMM-RUDMAN-HOLLINGS

by

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 that the writer has had access to unpublished material)
should be cleared with the author or authors.


28

goods market by pof, but at the same time the real stock of
government bonds will increase by at least af*(T-to), where T-to is
the duration of the fiscal expansion.® This will in turn raise real
interest rates by at least adf*(T-tg) and reduce demand by not less
than éadf*(T-tg). Thus the longer the fiscal deficit increase
persists, the greater will be bond accumulation and the greater will
be the crowding out of interest sensitive expenditure relative to the
crowding out of tradeable goods. For example with 6=.8, u=1, and
a=.02, a fiscal shock lasting 10 years will increase demand at year
10 by 9f but the bond accumulation effects on interest rates will
reduce demand by at least 1.6*df. This will necessitate depreciation
of the real exchange rate to clear the goods market.

Figures 5.1-5.5 and 6.1-6.5 exhibit the results of two policy
simulation experiments corresponding to two policy changes which are
discussed in conjunction with the GRH legislation. The first, of
course, is the anticipated fiscal contraction. The second is an
inerease in the growth rate of money, a policy change often mentioned
as a likely complement to fiscal contraction so as to lean against,
the recessionary wind. Ironically, if the analysis of this paper is
correct, the monetary stimulus, if implemented prior to the
implementation of the fiscal cuts, would serve to exacerbate the
anticipatory expansion rather than attenuate the effects of a
recession.

The behavior of interest rates in both the closed and open
economies in response to an anticipated fiscal contraction is shown
in figure 5.1. Most noticeable is the much greater fall in long-term

interest rates in the closed economy upon announcement, which


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31

goods sector and less so on the crowding in and crowding out of

interest sensitive sectors than does the closed economy. Monetary
changes tend to have an amplified effect on output because of the
added stimulus to the traded goods sector because of real exchange

rate overshooting, despite greater volatility of the long rate of

interest in the short run.


24

response to increases in the outstanding real stock of government
bonds, b. This term can also capture the effect on world interest
rates, r*, of an increase in b.

For example, if r*(b) is expanded using a first order Taylor
series approximation around the value bo the equation would look
like;

r¥(b)=r*(bo) +(dr*(bo)/db)*(b-bg)
Setting r* in equation 9 to r*(bg) and bo to O will yield the result
equation 9 above provided that a=dr*(0)/db. One would then interpret
equation 9 as an open interest parity condition where the difference
between the home interest rate, r, and the world interest rate, r¥,
which equals r* +ab, would be the expected rate of depreciation of
the home currency.

Equation 10 is a linearization of the identity relating the
rate of change of the real bond stock to the rate of money growth end
the stock of real balances. Equation 11 and 12 are the identities
relating the rate of change of both the real exchange rate and real
balances to their components. Note once again that the foreign price
level is not included in the measure of the rate of change of the
real exchange rate because it is assumed to be constant.

The steady state behavior of the system of equations in table 3
is shown in table 5. The inflation rate, the nominal exchange rate,
and the expected rate of inflation are all equal to the rate of
growth of money, M. Output and demand are both equal to Vy in the
steady state. The short and long rates of interest are both equal to
the rate of money growth plus the foreign real interest rate and the

risk premium. Note that r* is both the real and nominal foreign rate


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20

in demand upon announcement output rises rapidly for nearly 12
quarters as real long-term rates fall. Thereafter real long-term ;
rates increase gently as economic activity eases back to its steady
state level.

A second characterization of a monetary policy change is a
change in the stock of money that leaves the growth rate of money
unaltered. Figures 2.1 and 2.2 exhibit the results of a one time 5%
unanticipated increase in the money stock. Figure 2.1 shows that
unlike the case of a money growth rate change, an increase in the
money stock causes the short rate to jump as the change is
implemented. In addition the long rate jumps downward reflecting the
ower expected sequence of short term rates resulting from the higher
quantity of real balances. In the longer term both the short and long
rates return to their steady state level of 8%. Inflation increases
transitorily because of the excess demand generated by the initial
fall in interest rates. Figure 2.2 shows the jump in demand resulting
from the fall in long rates and the transitory increase in economic
activity.

Figures 3.1, 3.2, 4.1 and 4.2 show the results of an
unanticipated and an anticipated fiscal contraction of the same size.
The two experiments differ only in that the anticipated fiscal
contraction is implemented three years after it is announced whereas
tthe unanticipated fiscal contraction is implemented immediately. A
comparison of Figures 3.1 and 4.1 reveals that the fall in the long
rate of interest is much greater when the fiscal contraction is
unanticipated. This is not surprising. The more striking result is

the qualitative difference in the behavior of short-term interest


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Table 2

Percent Change in Production, Imports,
and Exports for Selected Sectors

Industrial 2
Production Imports Exports 2

80/4 82/4 82/4 82/4

to to to to

84/4 84/4 84/4 84/4
Total
Manufacturing 12.5 24.3 59.6 16.0
Ordinance 36.8 19.3 nea. n.a.
Motor vehicles 3
and parts 33.6 61.2 57.1 3 -4.5
Electrical
Machinery 29.5 35.1 76.4 18.3
Nonelectrical
Machinery 14.2 33.8 79.0 6.2
Textile mill
Products 0.1 9.5 57.5 -3.0
Leather and
Products -18.1 -1.0 57.0 n.a.
Iron and
Steel -27.4 48.4 50.5 -16.1
Mining -7.3 7.0 nea. n.a.
Real GNP 12.4 12.3

1 ~ would like to thank Peter Isard for letting me use this
chart which comes from his work at the Federal Reserve Board.

2 «Imports and exports are measured in current dollars;
unit value deflators are not available by industry. From 198294
to 198404, the unit values of non-oil imports and nor.agricultural
exports each increased by about 2 percent.

3 Excludes trade with Canada


l4a

Figure 1 : Dynamics

and Stability


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22

incorporate the influences of the international economy and to assess

the qualitative differences in the adjustment mechanism that

"openness" creates.


41

References

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

+ and Lawrence H. Summers (1984) ,"Perspectives
on High World Real Interest Rates," Brookings Papers on
Economic Activity, 2:1984, pp. 273-324.

Branson, William H. (1985), “Causes of Appreciation and
Volatility of the Dollar," NBER Working Paper No. 1777,
December.

, and Willem H. Buiter (1984), "Monetary and Fiscal
Policy with Flexible Exchange Rates," Chapter 9 in Economic
Interdependence and Flexible Exchange Rates, edited by
Jagdeep S.Bhandari and Bluford H. Putnam, M.I.T. Press, 1984

io-,-Arminio Fraga, and Robert A. Johnson (1985),
“Expected Fiscal Policy and the Recession of 1982,"
International Finance Discussion Paper No. 272.

Buiter, Willem H. (1985), "Macroeconomic Policy Design in an
Interdependent World Economy: An Analysis ‘of Three
Contingencies," NBER Working Paper No. 1746, October.

Collins, Robert M. (1981), The Business Response to Keynes,

~~ ++---"1929-1964," Columbia University Press.

Dornbusch, Rudiger (1976), “Expectations and Exchange Rate

Dynamics," Journal of Political Economy, 84, No. 4,
Pp. 665-705, August.

Feldstein, Martin (1986), "U.S. Budget Deficits and The European
Economies: Resolving the Political Economy Puzzle," NBER
Working Paper No. 1790, January.

Ferguson, Thomas, and Joel Rogers (forthcoming 1986), Right
Turn: The Democrats and the Future of American Politics,
Hill and Wang Publishers.

Gavin, Michael (1986), “The Stock Market and Exchange Rate
Dynamics," mimeo, Federal Reserve Division of International
Finance.

Institute for International Economics (1982), Promoting World
Recovery: A Statement_on Global Economic Strate: , @ report
by 26 economists from 14 countries, Institute for
International Economics, December.


23

III." COMPARATIVE ADJUSTMENT: OPEN VERSUS CLOSED ECONOMIES

Before turning to an examination of the effects of the GRH bill
on the U.S. economy, I will introduce the international influences
into the goods and asset markets of the model used in the previous
section. I will describe how the steady state behavior of the new
model differs from the closed economy model. Then simulation
experiments will be shown comparing the open and closed economy
adjustment mechanisms in response to: 1) an anticipated fiscal
expansion, and 2) an increase in the growth rate of money.

The open economy extension of the model, variable definitions,
and the steady state behavior of the model are shown in tables 3,4
and 5 respectively. Equation 1 is identical to equation 1 in the
previous section, with the exception of the addition of the trade
balance as a fraction of total domestic demand, x (henceforth "the
trade balance"). The trade balance is assumed to adjust gradually to
deviations of the equilibrium trade balance, x, from the actual trade
balance as in equation 8. This specification is intended to reflect
the initial "J curve" effects of the exchange rate on trade. It is
consistent with the perspective embodied in most recent work on Open
economy macroeconomics which emphasizes the role of asset markets in
the determination of the exchange rate coupled with the slow
adjustment of goods markets to changes in the exchange rate. The
equilibrium trade balance, x, is shown in equation 7 to depend upon
both domestic and exogenous foreign income as well as on the real
exchange rate, c. The foreign price level is assumed to be fixed at
1. Equation 9 represents the open interest parity condition augmented

by a term which allows for the emergence of a risk premium in


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19

Using the model outlined above in conjunction with the computer
program "JAB" (See Johnson (1985), and Austin and Buiter (1982).) we
ean conduct a series of simulation experiments to illustrate the
response of the system to a variety of exogenous policy changes. In
this section I will examine the dynamic response of the model to the
following policy experiments: 1) An unanticipated increase in the
rate of money growth, 2) an unanticipated increase in the money
stock. 3) an unanticipated fiscal expansion, and 4) an anticipated
fiscal expansion.

Figures 1.1 and 1.2 illustrate the results of an unanticipated
increase in the rate of money growth from 6% to 10%. The model is
assumed to be in steady state equilibrium with 6% money growth at
time to when the increase is implemented. Figure 1.1 exhibits the
behavior of interest rates and inflation. When the money growth rate
change is announced and implemented the long rate jumps up nearl].y 250
basis points reflecting the eventual incorporation of a four percent
inflation premium into the steady state interest rates. The short
rate does not jump because neither real balances nor output change
discontinuously with a money growth rate change. The short rate
begins declining gradually, reflecting a diminished transactions
demand for money resulting from the decline in interest-sensitive
expenditure following the jump in long rates. The sharp initial
increase in real long-term rates does not persist because economic
agents quickly revise their inflationary expectations according to
equation 5. In the longer term both the long and short rates rise
from 8 to 12 percent reflecting the increase in inflation produced by

faster money growth. Figure 1.2 shows that after the abrupt decline


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33

are both results of the anticipatory expansion of economic activity
that stems from the announcement of the fiscal contraction. The real
exchange rate also depreciates upon announcement as shown in figure
7.2a. This leads to a gradual improvement in the trade balance as shown
in figure 7.2b.

Figure 7.3 shows the results of the various changes in prices on
demand and output. The announcement of fiscal contraction reduces the
instantaneous real long-term interest rate, R-h, and causes an
immediate jump in demand leading to an expansion of interest-sensitive
sectors. The subsequent implementation of fiscal contraction in five
stages reduces demand and produces a downturn in 1988 which persists
into the early 1990s.

The second experiment includes the same fiscal experiment shown in
the first set of figures but also includes an announced increase in the
rate of money growth from 6% to 8% introduced in 1987, when the fiscal
cuts begin, and lasting until 1991 when the reduction of the fiscal
spending is complete. At that time the money growth rate returns to 6%.
Note that the entire trajectory of this temporary monetary expansion is
announced at the time of fiscal announcement so that all surprises come
at the beginning of 1986 for forward-looking sectors. The behavior of
the economy in the second exercise is qualitatively similar to that in
the first simulation, but there are some quantitative and timing
differences in the trajectories of macroeconomic variables shown in
figures 8.1-8.3 when compared with figures 7.1-7.3-

First, comparing figures 7.1 and 8.1, one can observe that the
fall in the consol rate is smaller with monetary accommodation,

reflecting the greater eventual rise in the short rate because of the


legislative branches of the federal government will adhere to the GRH
deficit reduction schedule, the bill appears to reflect a serious
effort to reduce the fiscal deficit in the years ahead. It is as
clear-cut an example of an announcement of future policy at specified
dates as we have ever observed in the United State. It therefore seems
appropriate, in light of the announcement of GRH, to investigate the
macroeconomic consequences of anticipated fiscal contraction, or at
very least the short-run macroeconomic consequences of announced fiscal
contraction.

This paper examines the implications of an anticipated fiscal
contraction in a forward-looking open economy simulation model of the
U.S. macroeconomy and to compare the predictions of the model with
the stylized facts surrounding the announcement of the GRH bill. The
analysis presented here is similar to that contained in a companion
paper by Branson, Fraga and Johnson (1985) on the implications of the
Economic Recovery Tax Act of 1981, in which an anticipated change in
fiscal policy was also the focus of analysis.

The paper is organized as follows. Section I discusses the
buildup to the GRH bill, the provisions of the legislation, its
timing, and the stylized facts characterizing the reaction of
financial markets and foreign exchange markets to the bill's
announcement in the fourth quarter of 1985. Section II presents a
simple closed economy simulation model with a term structure of
interest rates and examines a variety of policy experiments including
both an unanticipated and an anticipated fiscal contraction, an
increase in the growth rate of money, and an increase in the level of

the money stock. Section III extends the model to take account of the


27

In both closed and open economy specifications the growth rate
of money plays a role by contributing a direct inflation premium to
the steady state interest rates. In addition, in the open economy,
provided that Me is less than unity, the increase in the growth rate
of money will reduce interest rates by decreasing the real stock of
bonds through an inflation tax as well as through increased
monetization of the debt.

Fiscal policy can have quite different effects in the two models
when the risk premium, a is small. In the closed economy the steady
state interest rate is raised by an increase in the real budget
deficit f. The magnitude of the increase depends upon the ratio of
u/é. The larger the response of aggregate demand to changes in fiscal
policy the greater will be the rise in interest rates necessary to
equilibrate the goods market. A larger semi-elasticity of aggregate
demand with respect to the real long term rate of interest
necessitates a smaller rise in interest rates to accomplish the
necessary crowding out to clear the goods market in the steady state.
In the open economy, both the tradeable goods and interest sensitive
sectors can be crowded in or out in the steady state in order to
clear the goods market. At one extreme, if the risk premium, a, is
equal to zero then all steady state adjustment will be done by the
tradeable goods sector. In that case it is the ratio of y/o which
determines the extent of the adjustment of the real exchange rate.
The greater the sensitivity of demand to the real exchange rate the
smaller will be the necessary change in the exchange rate required to
clear the goods market. If a is nonnegligible an unanticipated

increase in the fiscal deficit will directly raise demand in the


25

of interest under the assumption that the foreign price level is
constant. Real balances in the steady state are a function of steady
state output, and the nominal interest rate, which in turn depends on
the rate of money growth. The steady state real exchange rate, 6,
depends upon full employment output, the fiscal deficit, and the real
interest rate, r* +ab. Note that a reduction in the deficit will tend
to depreciate the real exchange rate, as pressure in the goods market
is relieved, but it will also lower the expected risk premium as the
expected future stock of real bonds is reduced. This latter effect
will tend to appreciate the steady state real exchange rate, for
lower real interest rates imply greater demand and necessitate an
appreciation of the real exchange rate to equilibrate the goods
market. The final equation of table 5 shows that the real bond stock
will remain stationary only if f=ML. An increase in the rate of money
growth has two effects on the rate of growth of the real bond stock.
The term ML will increase because of the increased rate of money
growth but at the same time the equilibrium level of real balances,
L, falls because of the non-superneutrality of money. On net, the
rate of growth of the real bond stock will fall provided that Me is
less than 1, where e is the semi-elasticity of real balances with
respect to the short-term interest rate. With M less than or equal to
-10 and e=2 the real bond stock will fall when money growth increase
in the simulations presented here.

Additional parameter values must also be chosen for the
simulation exercises. These values are shown along with those used in
the previous section at the bottom of Table 3. In particular, a, the

sensitivity of short-term interest rates to changes in the real bond


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interest rates, principally because of a fall in the long-term rate of
interest, during the fourth quarter of 1985 when the term structure
declined from 320 basis points to 210 basis points; and 2) an
acceleration in the rate of decline of the dollar following the G5
announcement and the enactment of GRH. Let me now turn to a small
macroeconomic model to illustrate the logic of what I believe underlies

the behavior revealed by the data above.


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10

y is defined as the log of real aggregate output.

represents the log of real demand.

R represents the rate of interest on consols.

yr is the short-term rate of interest.

h represents inflationary expectations.

represents a measure of the real fiscal deficit as a fraction of
private demand.

m represents the log of real balances.

p is the log of the price level.

¥Y is the log of full employment output.

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i

is the expectations operator.

"¥" denotes the derivative with respect to time of variable x.
"%" denotes the percentage change in variable x.

"%" denotes the steady state value of variable x.

T,€,7,¢,%,5,u, and a are parameters.

Equation 1 shows demand as a function of the long-term real
interest rate, fiscal stimulus, and income.2 The constituents of
demand, whether they represent consumption or investment, are modeled
as a function of current income rather than as a function of wealth or
some other forward-looking proxy for purchasing power. This is clearly
an important assumption for the analysis of fiscal policy changes. If
consumers were assumed to take into account all future tax
liabilities, then a shift from tax financing to debt financing, which
would increase f in this model, would be fully-offset by increased

saving to provide for future tax payments. This case is developed by


Anticipated Fiscal Contraction: The Economic Consequences
of the Announcement of Gramm-Rudman-Hollings

by

Robert A. Johnson*

In recent years macroeconomic analysis has placed great emphasis
on the influence of expectations. While arguments about the relative
importance of expectational phenomena are complicated by the fact that
it is difficult to assess precisely when and how expectations of a
future event are formed as well as to assess the ex-ante weight placed
on any of a variety of possible scenarios, it is clear that the
influence of expectations of future developments may be a significant
determinant of economic behavior.

Unfortunately, the influence of expectations can rarely be
observed directly. Two episodes, both associated with recent changes in
U.S. fiscal policy, provide economists with a rare opportunity to
assess the importance of expectational effects and to refine our
understanding of their influence on macroeconomic outcomes. The first
episode was associated with the Economic Recovery Tax Act of 1981, the
so-called Kemp-Roth tax cut. In the middle of 1981 a three-stage tax
cut was announced that would be implemented 2, 6, and 10 quarters after
the announcement. The second episode is associated with the Budget
Balance and Deficit Control Act of 1985, better known as the
Gramm-Rudman-Hollings bill (henceforth GRH), which was enacted on
December 11, 1985. The GRH bill announces a five-stage fiscal
contraction to be implemented over the period from 1986 to 1991.

Although there is currently considerable variation in the

degree of market participants' confidence that the executive and


21

rates and inflation in the two cases. When the fiscal policy is
anticipated, economic activity expands in the period between the
announcement and the implementation of the cuts in government
dissaving because of the fall in the long-term rate. This in turn
increases the pressure on the price level and the transactions demand
for money. After the fiscal cut takes place, the pressure of economic
activity recedes and the interest rate declines to a new, lower,
steady state level that reflects the diminished crowding out by the
government deficit. In contrast, the larger initial fall in the long
rate initially when the fiscal contraction is unanticipated is not,
by itself, stimulative enough to offset the direct contractionary
effects of the cut in the fiscal deficit. In that case short-term
interest rates and inflation fall from the outset, reflecting the
recessionary influence on both inflation and the transactions demand
for money.

A comparison of figures 3.2 and 4.2 reveals the markedly
different trajectories of output in the two cases. The anticipated
fiseal contraction induces wide variation in output beginning with
the anticipatory expansion produced by the fall in interest rates and
followed by a steep contraction in output after the decline in
government stimulus sets in. The unanticipated fiscal contraction
creates a recession from time tg and the variations in output growth
are much less extreme.

This series of policy experiments serves to illustrate the
essential operation of the model in response to a variety of policy
changes. But to address the question of the influence of the GRH bill

on the U.S. economy it is vital to broaden the analysis to


42

Johnson, Robert A., Gerry B. Austin and Willem H. Buiter
(forthcoming 1986), "JAB: A Program for the Simulation of
Continuous Time Rational Expectations Models," mimeo, Board
of Governors of the Federal Reserve System.

Johnson, Robert A. (1986), " A Method for Solving Systems of
First Order Linear Homogeneous Differential Equations When
the Elements of the Forcing Vector are Modelled as Step
Functions," International Finance Discussion Paper No. 275.

Kenen, Peter B. (1985), “Aspects of Policy Coordination Under
Alternative Exchange Rate Regimes," mimeo, Pririceton
University, November.

Krugman, Paul (1985), "Is the Strong Dollar Sustainable ?",, NBER
Working Paper No. 1716, May.

Marris, Stephen (1986), Deficits and the Dollar: The World
Economy at Risk, Institute for International Economics.

Miller, Marcus H. (1984), " What Does Forward-Looking Behavfor in
the Gilt's Market Imply for (a) the Price of Consols and (b)
Monetary and Fiscal Policy ?," mimeo, University of Warwick,
December.

Sachs, Jeffrey D. (1985), “External Debt and Macroeconomic
Performance in Latin America and East Asia," Brookings Panel
on Economic Activity, 1985 No.2 pp. 523-564.

and Warwick McKibbin (1985), "Macroecononic
Policies in the OECD and LDC External Adjustment," NBER
Working Paper No. 1534, January.

, and Charles Wyplosz (1984), "Real Exchange
Rate Effects of Fiscal Policy," NBER Working Paper No. 1255,
January.

Schumpeter, J.A. (1918), " The Crisis of the Tax State,"

International Economics Papers, 1951, pp. 6-38, Trans: ated
from German by W.F. Stopler and R.A. Musgrave.

Stigler, George (1971), " The Theory of Economic Regulation," The

Bell Journal of Economics and Management Science, vol. 2

No. 1 pp. 3-21. Reprinted in, The Political Economy:
Readings the Politics and Economics of American Public:

Policy, edited by Thomas Ferguson and Joel Rogers, -
M.E. Sharpe 1984.



17

SIMULATION ANALYSIS OF THE CLOSED ECONOMY

This section reports the results of the simulation of equations
1-6 under a variety of different policy experiments, includirg a change
in the money growth rate, a change in the money stock, and both an
anticipated and an unanticipated change in fiscal stimulus. Before
turning to those results let us discuss the values of the parameters
chosen for the simulations.

The parameters fall into two groups. First are the structural
parameters. These include the estimates of the magnitudes of the
sensitivity of the various economic variables to one another, and
plausible values can be chosen with some confidence through reference
to econometric evidence. The second group consists of adjustment speeds
in equations 3 and 5. Choosing them can be aided by the following
procedure,

For an equation of the form X = -o(x-X), the solution is of the
forn,

x(t)-x = (x(tg)-x)*e CE t0)

where x is the steady state value of x.
If one desires to set an adjustment speed so that in a period of time
equal to t-to the initial disequilibrium is reduced to the fraction z
of its initial value, where z = (x(t)-k)/(x(tg)-x), then the
adjustment speed, o becomes

o = -1n(z)/(t-to).
For example, when one half of the initial disequilibrium is closed
the relationship becomes

1n(.5) = ~o(t-tg).


ABSTRACT

The announcement of a plan to cut the U.S. federal budget
deficit through the Gramm-Rudman-Hollings legislation provides an
excellent opportunity to examine the influence of expectations on
economic behavior. This paper presents a small forward-looking
macroeccnomic model and simulates the effects of the announcement
of a multistaged reduction in the fiscal deficit. Open and closed
economy specifications are compared and contrasted to highlight
the importance of international transmission mechanisms in
macroeconomic adjustment. The results of the simulations are
compared with the stylized facts of the U.S. macroeconomy over
the period surrounding the passage of the Gramm-Rudman-Hollings

legislation.


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IFDP
NUMBER

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290

289

288

287

286

285

284

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282

281

280

279

278

International Finance Discussion Papers

TITLES

1986

Anticipated Fiscal Contraction: The
Economic Consequences of the Anouncement
of Gramm-Rudman-Hollings

Deposit Risk Pooling, Irreversible
Investment, and Financial Intermediation

The Yen-Dollar Relationship: A Recent
Historical Perspective

Should Fixed Coefficients be Reestimated
Every Period for Extrapolation?

An Empirical Analysis of Policy
Coordination in the U.S., Japan and
Europe

Comovements in Aggregate and Relative
Prices: . Some Evidence on Neutrality

Labor Market Rigidities and Unemployment:

the Case of Severance Costs

A Framework for Analyzing the Process
of Financial Innovation

Is the ECU an Optimal Currency Basket?

Are Foreign Exchange Forecasts Rational?
New Evidence from Survey Data

Taxation of Capital Gains on Foreign

Exchange Transactions and the Non-neutrality

of Changes in Anticipated Inflation

The Prospect of a Depreciating Dollar
and Possible Tension Inside the EMS

The Stock Market and Exchange Rate Dynamics

43

AUTHOR(s)

Robert A. Johnson

Robert A. Johnson

Manuel H. Johnson
Bonnie E. Loopesko

P.A.V.B. Swamy
Garry J. Schinasi

Hali J. Edison
Ralph Tryon

B, Dianne Pauls
Michael K. Gavin
Allen B. Frankel
Catherine L. Mann

Hali J. Edison

Kathryn M. Dominguez

Garry J. Schinasi

Jacques Melitz

Michael K. Gavin

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

the Federal Reserve System, Washington, D.C. 20551.


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II. THEORETICAL BACKGROUND

Before turning to the simulation exercises below I will present a
description of the model. This specification envisions a macroeconomic
environment where financial markets respond very quickly to new
information and clear very quickly while goods and factor markets
adjust to disequilibrium more gradually. In what follows I will make
the extreme assumption that financial markets, including foreign
exchange markets, adjust to new information instantaneously, while the
price setting behavior in goods markets is governed by slow adjustment.
First I will present a theoretical model that incorporates this
behavioral hypothesis and then illustrate the implications of monetary
and fiseal policy changes under this specification in a simple IS-LM
framework that draws extensively on the work of Miller (1984) and the
joint work of Branson, Fraga, and Johnson (1985). In the next section I
will shift to a simulation analysis using this model and examine a

variety of policy changes and their macroeconomic consequences.

Consider the system shown in equations 1-6 below.

Equations Steady State Values
(1) d = ay +uf -6(R-h) d=y=jy
(2) r= (ty - m/e r= R= M+ ((a-t)¥tut)/6
(3) ¥ = oa - y) n= B =f

(4) ER = R-r = ty MH - ((a-1)F+ut)/6

BI

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(5) B = wi - h)

(6) B = h +0(y - ¥)