SOME EFFECTS OF EXCHANGE RATE
FLEXIBILITY ON UNITED STATES AGRICULTURE

BY
EDWARD CANLER

A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL

OF THE UNIVERSITY OF FLORIDA IN

PARTIAL FULFILLMENT OF THE REQUIREMENTS

FOR THE DEGREE OF DOCTOR OF PHILOSOPHY

UNIVERSITY OF FLORIDA
1983

ACKNOWLEDGEMENTS

Very special thanks are expressed to my committee chairman, Dr.
Emilio Pagoulatos, for his teaching, guidance, and patience without
which this dissertation would have never been completed. Gratitude is
also expressed to the other members of my committee, Drs. Evan Drummond,
Carlton Davis, and William Bomberger, for their comments and
supervision. And April Burk, who diligently typed eyery page and helped
with submission procedures while I was away from campus, should not be
forgotten.

n

TABLE OF CONTENTS

Page

ACKNOWLEDGMENTS 11

LIST OF TABLES v

LIST OF FIGURES vi

ABSTRACT vi 1

CHAPTER

I INTRODUCTION ]

II EXCHANGE RATES AND THE BRETTON WOODS SYSTEM 4

Exchange Rates in the Adjustments of the Balance of

Payments 4

The Bretton Woods System 7

III FLEXIBLE EXCHANGE RATES 12

Exchange Rate Instability 12

International Trade and Investment 16

Inflation and Flexible Exchange Rates 19

Flexible Exchange Rates and External Adjustment 24

Macroeconomic Policy Under Flexible Exchange Rates 28

Exchange Rate Determination 32

Branson's Exchange Rate Determination Model 37

Frankel's Exchange Rate Determination Model 44

Summary of Flexible Exchange Rate Issues 49

IV EXCHANGE RATE ISSUES IN THE AGRICULTURAL ECONOMICS

LITERATURE 5]

Introduction 51

The Agricultural Economy and Discreet Dollar

Devaluations: Theoretical Studies 52

Protection in Trade Models 61

Summary of Theoretical Studies 67

The Agricultural Economy and Discreet Dollar

Devaluations: Empirical Studies 68

Flexible Exchange Rates and the Agricultural Economy ... 80

Linkages with Exchange Rates Excluded 82

Linkages with Exogenous Exchange Rates 83

Linkages with Endogenous Exchange Rates 85

Page

CHAPTER

V INTERRELATION OF THE EXCHANGE RATE LITERATURE 93

VI THE EMPIRICAL MODEL 99

Presentation of Equations 100

Exchange Rate Determination 100

The Agricultural Sector 105

Domesti c di sappearance 1 07

Domestic stocks 108

Export demand 1 08

The identities Ill

Data and Model Estimation 1 1 1

Empirical Estimates 113

The Exchange Rate Equations 113

The Structural Equations 117

Reduced-Form Equations 124

Empirical Estimates and Objectives of the Study 131

VII SUMMARY AND CONCLUSIONS 1 36

Conclusions ]39

Suggestions for Further Research 140

APPENDIX

VARIABLE DEFINITIONS AND DATA SOURCES 142

REFERENCES 146

BIOGRAPHICAL SKETCH 1 52

LIST OF TABLES

Page

1 Assumptions of Exchange Rate Determination Models 35

2 Effects of Increases on Asset Stocks on Short-Run
Equilibrium Interest Rate (r) and Exchange Rate (e) 42

3 Empirical Model Linking the Determinants of the Exchange

Rate to the Agri cul tural Sector 112

4 Estimates of the Models for the Determination of the
Agricultural and Federal Reserve Effective Exchange

Rates 116

5 Estimates of Structural Equations using AGER Exchange

Rate Measure ^ 9

6 Estimates of the Structural Equations using FEDER

Exchange Rate Measure 1 20

7 Estimates of the Reduced-Farm Equations using the AGER
Exchange Rate Measure 1 25

8 Estimates of the Reduced-Farm Equations using FEDER

Exchange Rate Measure '"

9 Impact Elasticities of Selected Predetermined Variables

on the Agricultural Endogenous Variables 128

LIST OF FIGURES

Page

1 The Phillips Curve in an Open Economy 31

2 Graphical Representation of Branson's Model 39

3 Graphical Representation of Open-Market Purchase of

Domestic Assets by Central Bank in Branson's Model 39

4 Demand and Supply Conditions for Industry Producing

for Both the Domestic and Foreign Markets 53

5 Maximum Effect on Export Quantity as a Result of a
Devaluation According to Kost [1976] 56

6 Maximum Effect on Export Price as a Result of a

Devaluation According to Kost [1976] 56

7 Exchange Rate Effects on Trade Assuming Governmental

Dumpi ng of Excess Stocks 63

8 Exchange Rate Effects on Trade Assuming Governmental
Sales Respond to Price and Government Stocks Remain at

the Support Price 63

9 Interrelation of the Exchange Rate Literature 94

10 Plot of the Effective Exchange Rate for U.S. Agricultural
Exports (AGER) at the Federal Reserve Bank's Effective
Exchange Rate 1 ! 5

VI

Abstract of Dissertation Presented to the Graduate Council
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy

SOME EFFECTS OF EXCHANGE RATE
FLEXIBILITY ON UNITED STATES AGRICULTURE

By

Edward Canler

August 1983

Chairman: Emilio Pagoulatos

Major Department: Food and Resource Economics

The system of flexible exchange rates which was adopted in 1973 has
been the subject of considerable discussion in the general economic
literature. Both proponents and critics of the system have offered
numerous theoretical and empirical contributions on the subject. By
contrast, the recent U.S. agricultural economic literature on exchange
rates has concentrated on the impact of the dollar devaluations of the
early 1970s on the surge of agricultural exports registered during the
decade. Little discussion has taken place about the issue of the
effects of exchange rate flexibility £er se on U.S. agriculture. This
study addresses said issue.

The review of the literature indicates that the flexible exchange
rate is determined in the short run by financial market variables. To
the extent that an export-dependent agricultural sector such as that of
the United States is affected by flexible dollar exchange rates, then
financial market variables indirectly affect the agricultural sector.

vn

Among the objectives of the empirical analysis of this study has been to
obtain an indication of the importance of this linkage between
agriculture and the financial market.

The principle tool for the empirical analysis is a two-block
recursive system of equations estimated via ordinary least squares and
three-stage least squares. Impact elasticities are derived using the
reduced-form coefficients.

The main empirical findings are the following:

a) No special advantages are found in constructing an effective
exchange rate for U.S. agricultural exports;

b) Exchange rate volatility has had no statistically significant
impact on agricultural exports;

c) Changes in agricultural export flows are largely absorbed in the
short run by changes in domestic consumption;

d) The flexible exchange rate and its determinants affect
agricultural exports but account only for a minor part of
registered export fluctuations during the study period;

e) There is no perceptible delay in response in the agricultural
sector to changes in financial market conditions;

The general conclusion of the study is that although flexible
exchange rates have tied U.S. agriculture to the international financial
market, their importance to agriculture can be overstated.

vm

CHAPTER I
INTRODUCTION

The exchange rate— the price of one nation's currency in terms of
another—has been a research issue of great concern during the last
decade. A great number of contributions to the literature have dealt
with many aspects of exchange rates. A motivating factor behind this
research activity has been the adoption of flexible exchange rates
during the early 1970s after decades of a pegged rate regime.

This dissertation is also motivated by the change in exchange rate
regimes. It focuses on an area that has heretofore received little
attention: the relationship between a flexible dollar exchange rate,
its determinants, and an American agricultural economy heavily dependent
on income from export sales. The general research objective is to
examine how an exchange rate that is free to change constantly and the
factors that explain its movements affect the American agricultural
sector. The more specific objectives are a) to examine the implications
that the exchange rate literature poses for the relationship between
flexible exchange rates and agriculture, b) quantify the relationship
between the determinants of the exchange rate, exchange rate volatility
and agriculture, and c) obtain an indication of the extent to which the
financial markets have contributed to agricultural income instability
during the flexible exchange rate period.

This dissertation is divided into seven chapters including these
introductory remarks. Chapter II presents a discussion of the role of

1

the exchange rate in the adjustment of the balance of payments. Also, a
short historical account is given of the international (Bretton Woods)
monetary system that was established after World War II. Special
emphasis is placed on how the economic thinking of the World War II
period led to the Bretton Woods system and how the system started to
disintegrate in the early 1970s.

Chapter III is an overview of the research issues dealing with the
flexible exchange rate system which replaced the pegged rates of the
Bretton Woods system. The issues have been divided into the categories
of exchange rate instability, international trade and investment,
national and international inflation, external adjustment, macroeconomic
policy, and the determination of flexible exchange rates. Special
attention has been given to the latter issue because of its relevance to
agricultural economics. However, since the literature on exchange rates
is so voluminous, no attempt has been made to be exhaustive on every
issue. Rather, the purpose is to present the problems that have been of
concern and some of the research results that have been obtained thus
far.

Chapter IV deals with exchange rate issues in the agricultural
economy. The chapter is divided into two broad categories: literature
dealing with fixed exchange rates and that dealing with the flexible
rate system. The category on fixed rates has by far the larger number
of publications and is thus subdivided into theoretical and empirical
contributions. The second category focuses on how flexible exchange
rates serve to link the agricultural economy with the general economy.

Chapter V is a brief section that endeavors to interrelate the
numerous articles reviewed in Chapters II, III, and IV. The purpose

is to show the similarities and differences between the various articles
either in their objectives or in their view of the role of flexible
exchange rates in the national economy.

Chapter VI presents the empirical analysis of the dissertation.
The specific objectives of the empirical research are presented along
with the model designed to meet those objectives. A series of tables
then report the estimated coefficients for the several equations of the
model. The latter section of the chapter relates these findings to the
objectives of the dissertation, i.e., an indication is obtained of the
extent to which the research objectives have been fulfilled. Chapter
VII endeavors to draw some conclusions from the research undertaken.

CHAPTER II
EXCHANGE RATES AND THE BRETTON WOODS SYSTEM

This chapter is devoted to a brief overview of exchange rate theory
and institutions during the Bretton Wood fixed exchange rate system. It
starts by briefly describing the role of exchange rate changes in the
adjustment of the balance of payments. A short historical account is
next given of the international monetary system that was established
after World War II in accordance with the then predominant views on the
exchange rate, and how that system evolved in the early 1970s.

Exchange Rates in the Adjustments of the
Balance of Payment?

How changes in the exchange rate— defined as the local currency
price of foreign currency—serve to equilibriate the balance of payments
can be more easily illustrated with the assumption of a world composed
of two countries, Northland and Southland. Northland denominates its
currency in dollars and Southland in pesos. At some given exchange rate
there is an excess supply of dollars and an excess demand of pesos. A
depreciation of the dollar raises the dollar price of Southland's
exports and lowers the peso price of Northland's exports to Southland.
The general effect is that Northland's imports are restrained and its
exports expand.

In the "normal" adjustment process (the "abnormal" cases are
discussed below) the higher dollar price of goods flowing to Northland

reduces that country's quantity demanded, thus lowering their peso
price. For goods flowing to Southland the lower peso price increases
the quantity demanded, and thereby their dollar price increases. In
short, Northland's traded goods rise in price relative to domestic goods
while the opposite is true in Southland. These changes in relative
prices lead Northlanders to reduce their consumption of imports and to
increase production of exports. Also, the vague line between domestic
and export goods shifts as more goods become profitable for export. The
opposite trend occurs in Southland where relative price changes caused
by the depreciation produce higher incentives to consume imports. Thus,
the increase in Northland's net exports serves to reduce the excess
supply of dollars, and the decrease in Southland's net exports reduces
the excess demand for pesos. A move is made toward a balance of
payments equilibrium in both countries.

This equilibriating mechanism requires an implicit assumption about
the elasticities of import demand and export supply. The assumption is
that the elasticities are large enough so that the rise in the dollar
cost of Northland's imports is followed by a sufficiently large
reduction in imports to lower the total import bill. Inelastic import
demand and export supply may bring about the condition that the
depreciation in a country's currency actually aggravates its balance of
payments deficit. The condition which the elasticities must satisfy in
order to bring about a balance of payments improvement appears in Sohmen
[1969, 16]. A country's trade balance, in terms of domestic currency,
is defined as BD = p X - q M. In terms of foreign currency, it is
BF = BD/ r. The condition for improvement for the domestic currency is

dBn 6 (a +1) a(& -1)

_D=X x x - + Mn m m > 0 (1)

dr 0 a +6 "0 o+a v ;

xx mm

where a = the elasticity of export supply

a = the elasticity of import supply

6 = the elasticity of export demand

6 = the elasticity of import demand
m

X = physical quantity of exports

M = physical quantity of imports

r = exchange rate (defined as units of domestic per unit of
foreign currency) .
All values are measured at initial equilibrium, and all elasticities are
in absolute value. Domestic currency is defined as the numerator in the
exchange rate ratio. The condition improvement for the for foreign
currency is defined as

dBr o (6 -1) 6m(°+l)

_E - v x x M _mliL__ > o (2)

dF X0 a +6 + N0 o+6m u v ;

xx mm

Modern authors such as Yeager [1976, 167-172] and Sohmen [1969,
20-28] have argued that stable equilibrium levels of exchange rates must
exist, i.e., elasticities cannot remain perversely low over the entire
range of demand and supply. Furthermore, real world situations indicate
that very probably exchange rates have only one, and this a normal,
equilibrium. However, the school of "elasticity pessimism" had
considerable influence among economists in the years following World War
II. Their pessimism led them to oppose devaluations as a means for
correcting balance of payments deficits. They argued that the demand
elasticities might not. -be high enough to guarantee that the deficits
would be reduced or eliminated. They also drew the further conclusion

that flexible exchange rates are not feasible in light of these low
elasticities which they thought to prevail; free market forces would
only lead to instability and chaos in an international market faced with
persistent disequilibrium. Their thinking was to greatly influence
international monetary relations for 30 years.

The Bretton Woods System*

The international monetary system that was to endure for almost 30
years following World War II was given form by the Articles of Agreement
of the International Monetary Fund (IMF). The system came to be
commonly known as the Bretton Woods system, after the town in New
Hampshire where the articles were signed by 44 countries in 1944. The
Articles contained two important provisions. First, contributions were
made by all member countries to a fund from which any member could
borrow to meet temporary balance of payments deficits. Second, each
member established a par value of its currency in relation to the 1944
gold content of the U.S. dollar and maintained its exchange rate within
plus or minus one percent of its parity value. Changes in parity values
were allowed only in instances of "fundamental disequilibrium" in the
balance of payments. Under any circumstance, changes in the exchange
rate of more than 10 percent from the initial parity needed the prior
approval of the IMF.

The Bretton Woods system was a compromise reached between the con-
cepts of exchange rate stability and national independence in fiscal and
monetary policy. While national governments wanted that independence,
letting exchange rates move freely in response to market forces was

*This historical account largely follows Yeager [1976].

8

deemed unacceptable in light of the prevailing "elasticity pessimism"
described in the previous section. Consequently, the Bretton Woods
system pegged rates to given parities but allowed adjustments in those
parities when called for by fundamental economic conditions. Strictly
speaking, this system was one of adjustable pegs rather than one of
truly fixed exchange rates.

By historical standards world trade grew rapidly during the postwar
years up to the 1970s. The extent to which the Bretton Woods system is
responsible for this growth is a matter for debate. Yeager [1976] has
argued that special postwar circumstances were factors underlying the
growth in trade. Whether coincidental or not, the association between
growth in trade and the Bretton Woods system did not impede the latter
from showing increasing signs of strain after 1965.

The compromise between independent national macroeconomic policies
and the system of pegged exchange rates became increasingly difficult to
maintain. Independence in economic policy led to accentuated
differences in underlying economic conditions between industrialized
countries, i.e., more frequent "fundamental disequilibria" in the
balance of payments. At the same time, an increasing integration of the
world economy, a relaxation of control in capital movements, and
difficulties in the attempts to control them allowed speculative capital
flows to become more responsive to those disequilibrium conditions. The
necessary compensatory movements by central banks became more frequent
and larger.* In order to diminish these flows, governments reverted to

*See Willett [1977, 16-17] for a list of known reserve movements in the
1960-73 period. These movements by central banks were designed to
neutralize the flow of funds initiated by individuals, e.g. an outflow
of dollars can be compensated by a purchase of dollars overseas by the
U.S. Federal Reserve Bank.

more frequent changes in the par values of their currencies. The need
to revalue became so frequent that countries eventually adopted a system
of allowing rates to float within a band of values beyond which official
intervention took place.

The 1970-73 dollar movements are an important illustration of the
increasing difficulties experienced in maintaining the viability of the
Bretton Woods system. During the late 1960s the United States experi-
enced a loss in competitiveness in world markets and a consequential
deterioration in its trade balance. The 1970 recession brought about a
recovery in the trade balance. However, the recovery of $1.5 billion
contrasted with the recovery of $3.8 billion in the earlier recession
year of 1960 when U.S. trade was half as large. Furthermore, only a
small part of the divergence in export price trends between the U.S. and
foreign trends was reversed by the recession. In 1970, U.S. and
European monetary policies started to move in opposite directions.
Stagnation in real output and higher unemployment brought a shift toward
monetary ease in the U.S. while Europe maintained tight monetary
control. A drop in U.S. interest rates relative to those in Europe
resulted in a large outflow in capital; the U.S. official settlements
deficit reached $5.6 billion in the first quarter of 1971.

Throughout 1971 exchange rate expectations also turned against the
dollar as analysts realized that the improvement in the trade balance in
1970 was the result of demand conditions and not of fundamental reverses
in export price trends. As expectations were confirmed by new American
trade deficits in early 1971, movement out of the dollar in internation-
al portfolios resulted in the upward floating of several European
currencies in May.. By August liquid dollar liabilities to foreign

10

official institutions were three times as large as U.S. official
reserves. In that month President Nixon announced a price-and-income
freeze, suspended the gold convertibility of the dollar, and imposed a
10 percent import surcharge. After a week's closure, foreign exchange
markets experienced a floating of most major currencies. The one
exception was the yen, which remained pegged. After absorbing $4.4
billion in August alone, the Japanese authorities finally gave up and
allowed the yen to float.

The culmination of these events was the Smithsonian Agreements
signed in December of 1971. The dollar was devalued 7.89 percent in
relation to gold, and the import surcharge was removed. Other countries
soon announced official appreciations of their currencies against the
dollar. The trade-weighted average devaluation relative to America's 14
major trade partners was 10.35 percent. In yet another attempt to keep
the Bretton Woods system alive, allowed divergences from parity rates
were increased from plus or minus one percent to 2.25 percent.

It should be apparent that the Smithsonian Agreements did not
address any of the fundamental reasons for the slide of the dollar
(decreasing competitiveness of American products in international
markets and persistent American balance of payments deficits). Thus it
is not surprising that bearish expectations continued. U.S. money
supply grew by 8.3 percent in 1972 after registering a growth of 6.6
percent in 1971 and 6.0 percent in 1970. Price and wage controls went
from a more restrictive Phase II to a looser Phase III. A strong
business recovery in the U.S. continued swelling its trade deficit.
These facts help explain the further deterioration of the dollar in
1973.

11

In January, 1973, pressure on the Swiss franc resulted in the
interruption in the support of the dollar by Swiss authorities. Efforts
to exit out of the dollar then concentrated on other currencies.
Pressure kept mounting in February. On March 12, the U.S. announced a
10 percent devaluation against Special Drawing Rights (SDR), an IMF
basket of currencies, and the Japanese allowed their currencies to
float, emulating Canada, Britain, and Switzerland. On March 11,
Germany, France, Belgium-Luxembourg, Holland, and Denmark had agreed to
float their currencies jointly, i.e., member's currencies could float
against outside currencies but not against each other. Shortly
thereafter, Norway and Sweden also entered the joint float.

It is evident that the increasing burden of compensatory capital
flows by central banks resulted in an involuntary, piecemeal floating of
exchange rates. The cost of preventing what was feared as the chaotic
nature of market-determined rates was deemed too large to absorb. Thus
floating rates became a passive outcome, not one especially desired. It
was not until January, 1976, that authorities officially accepted the
float with the Jamaica Agreements of the Interim Committee of the
Governors of the International Monetary Fund.

CHAPTER III
FLEXIBLE EXCHANGE RATES

Since 1973, exchange rate flexibility has been adopted by most of
the developed countries but not by centrally planned economies.
Exchange rates have had the freedom to be determined by market forces,
albeit with varying degrees of intervention by governments interested in
controlling large movements. This control is especially applicable to
countries in the European joint float. Many articles, both critical and
supportive of the performance of flexible exchange rates have been
published. Others have concentrated on elucidating the relationship
between market forces and the exchange rate, i.e., how the former
determine the latter. This section comprises a review of the major
issues dealing with flexible exchange rates.

Exchange Rate Instability

A major criticism that has been levied against the system of
exchange rate flexibility is that it has allowed "excessively" volatile
movements in exchange rates. "Excessive" has been defined as those
movements which substantially and persistently exceed changes in
underlying economic conditions. For example, Bernstein [1978] points
out that the dollar-deutsche mark rate has risen and fallen
alternatively by 10 to 20 percent over a three-to-four-month period,
only to return to its original position. It is pointed out that
obviously economic conditions cannot change that rapidly.

12

13

This view glosses over the role of expectations and asset markets
in the determination of exchange rates. As will be discussed in the
section on exchange rate determination, expectations play an important
role in determining rates by affecting asset preferences. These
expectations tend to be very unstable. Forecasting monetary and fiscal
variables in different countries is at best a matter of guesswork [Artus
and Young, 1979]. The basis for forecasts is normally yery tenuous
information which is easily amended by a new piece of information. Thus
expectations are subject to frequent and substantial revisions, and
exchange rates change accordingly. However, these movements are not an
indication of an inappropriately working market. Expectations may be
properly formed ex ante even though they may overstate underlying
conditions ex post [Willett, 1977].

Closely related to the issue of expectations is the question of
destabilizing speculation under flexible exchange rates. This subject
has received a great deal of attention by economists. A fair conclusion
that can be drawn from the literature is that while cases of destabi-
lizing speculation are hypothetical ly conceivable, quite general
conditions would lead to stabilizing speculation. The point was
succintly stated by Friedman:

People who argue that speculation is generally destabilizing
seldom realize that this is largely equivalent to saying that
speculators lose money, since speculation can be destabilizing
in general only if speculators on the average sell when the
currency is low in price and buy when it is high. It does not,
of course, follow that speculation is not destabilizing;
professional speculators might on the average make money while
a changing body of amateurs regularly lost larger sums. But
while this may happen, it is hard to see there is any
presumption that it will; the presumption is rather the opposite.
[1953, 175]

14

A more refined criticism deals with bandwagon speculation
[Bernstein, 1978]. This view holds that bandwagon effects accentuate
divergences around equilibrium rather than divorce exchange rates from
equilibrium. Exchange speculators, according to the view, operate on a
very short time span. They measure their opportunities for profit in
the next few days or weeks, not months. Thus, once a decline starts,
even for sound economic reasons, bearish speculators enter the market as
sellers, hoping for a further decline during the next few days. This
process continues until it becomes too risky to hold a short position
even for a brief time period. Then the currency begins to appreciate
until it becomes too risky to hold a long position even for a brief time
period, presumably above equilibrium value. The result is a wider
fluctuation than called for by either economic conditions or reasonable
expectations focused on a longer time frame. Artus and Young [1979]
maintain it is difficult to explain exchange market developments in
October 1978 without referring to bandwagon effects.

Empirical studies have so far failed to determine whether
fluctuations in exchange rates can be explained in terms of efficient or
inefficient speculation [Willett, 1977]. Thus neither theory nor
observation can lead to any definite conclusion about the possible
detrimental effects of speculation on exchange rates. However, some
authors argue that this indeterminancy does not damage the case for
preferring flexible over pegged exchange rates. Sohmen [1969] argues
that under a flexible system authorities still have at their disposal
all the traditional means for correcting excesses; central banks can
always employ their policy tools for guiding international flows in such
a way that the desired time path of exchange rates comes about. Yeager

15

[1976] argues that pegged rates give speculators a one-way option that
offers the possibility of profit at low risk: the timing or the size of
the exchange rate change may not be known, but the direction of movement
of a currency under pressure is known with a high degree of certainty.
Speculators thereby have a low risk mechanism with which to put further
pressure on a currency and create a change larger than necessary for
achieving equilibrium.

Additional reasons besides speculation have been offered for the
observed instability of exchange rates. McKinnon [1976] has pointed out
that there might be an inadequate supply of private capital available
for taking net positions in the market on the basis of long-term
expectations. Thus shorter term variations in the demand for foreign
exchange lead to large short-term variations in exchange rates,
regardless of bandwagon effects. Dornbusch [1980] has hypothesized that
the slow speed of adjustment of the goods market leads the exchange
market to overshoot equilibrium rates in response to a change in
monetary policy. Finally, another possible source of instability deals
with the multicurrency international reserves of central banks [Artus
and Young, 1979]. The banks are aware that any major shift in the
composition of reserves can lower the value of their portfolios.
Consequently, they may hold larger stocks of a given currency than they
would choose to have. The possibility that some of these balances might
come in the market creates uncertainty for both private and official
holders of the overhanging currency.

Wide movements in exchange rates since the breakup of the Bretton
Woods system are an observable fact. What is more open for debate is
how much these movements have been an efficient response to rapid

16

changes in the goods and asset markets and how much by an inherent
erratic nature of the exchange market. A tentative conclusion could be
that reached by a conference sponsored by the American Enterprise
Institute for Public Policy Research and the U.S. Department of the
Treasury:

The results ... at the conference, although far from being
unchallengeable, tend to indicate that foreign exchange
markets are essentially efficient. On the basis of this
evidence, the often sharp fluctuations of exchange rates
around the long-term trend would seem to reflect the
instability of underlying economic conditions and policies,
rather than defects inherent in the working of foreign
exchange markets [Dreyer 1978, 283].

International Trade and Investment

The reason for concern over exchange rate volatility has been its
potential detrimental effect on foreign trade and international
investment. Regarding trade, exchange rate variability poses two types
of risk to importers and exporters. One is the exchange risk where
rates change disadvantageously in the period between contract and
settlement. For example, an American importer of Japanese cameras
contracts in June for shipment and payment in yen in August. If in July
the dollar depreciates, the dollar payment for the shipment increases.
A likewise disadvantageous change occurs on the export side. A less
obvious risk deals with changes in price competitiveness. If that same
importer makes a contract in June for delivery and settlement in August,
but the dollar appreciates in September, the value of his inventory is
lowered. His competitors are able to purchase cameras at a lower dollar
price. Regarding investment, possible exchange rate changes make it
more difficult to estimate the expected future stream of returns. Thus
any investment becomes more risky. All this exchange- rate-induced risk,

17

it can be argued, curtails international trade and investment as agents
shift from international to domestic economic activities.

This argument would be a great deal stronger were it not for a
variety of tools available which traders can use to reduce their
exchange risk. These include a) hedging via either currency futures or
forward purchases and sales of currencies in banks, b) borrowing and
lending in foreign countries (for example, an exporter raises a loan in
the pertinent foreign country, exchanges it at the current spot rate,
and then repays the loan when the foreign currency receivables come in),
c) invoicing in the home currency, d) contractual clauses on the
revision of prices subject to changes in exchange rates, e) lagging and
leading payables and receivables, and f) compensation among subsidiaries
of multinational corporations.

These tools for exchange risk reduction do not deny that business
has become more complicated for traders. In a survey reported by Teck
[1978] almost all respondents felt that foreign exchange risks had
become more of a problem in the 1970-75 period and could no longer be
ignored. A total of 60 percent reported an increased commitment in
exchange rate exposure management since 1970. However, these added
complications do not seem to have had a significant effect on trade.
Statistical evidence tends to be negative, but of course cannot
accurately measure the potential trade inhibited by flexible rates.
Hooper and Kohlhagen [1978] introduced several proxies for exchange rate
uncertainty in import and export volume equations for the U.S. and West
Germany for 1965-1975 and found they did not play a significant role.
Artus and Young [1979] report that various tests making use of the
International Monetary Fund's world trade model have also failed to

18

identify any systematic effect of exchange rate uncertainty on
disaggregated trade flows for industrial countries through 1977. An
explanatory factor behind these findings may be that the variability of
purchasing power parities has actually decreased since floating was
initiated [Balassa 1979]. Thus exchange rate changes that have been
unfavorable to traders have in general been offset by favorable price
movements and vice versa.

On the subject of foreign direct investment, Artus and Young [1979]
also report that little evidence has accumulated suggesting that
financial and non-financial enterprises have significantly curtailed
international capital movements in response to exchange rates.
Balassa's findings of offsetting price and exchange rate movements would
indicate that other determinants of investment flows, e.g., access to
material inputs, labor with appropriate skills, and output markets,
would dominate investment decisions. However, if an investment decision
places a large emphasis on the stream of returns during the first few
years, then exchange rate instability during that period could be a
crucial factor in decision-making.

In comparing trade and investment effects under truly pegged and
flexible exchange rates, it is incontrovertible that, ceteris paribus,
pegged rates facilitate trade and investment. Flexible rates do
increase risk relative to fixed rates, since exposure management reduces
but does not eliminate that risk. Also, the resources expended in
exposure management create an additional cost for traded goods.
However, the new international environment does not seem to have
overburdened producers. Surveys have shown a general satisfaction by
business with floating [Burtle and Mooney, 1978], and there has been no
extensive lobbying for a return to pegged rates.

19

Yet the comparison of flexible exchange rates with fixed rates
under ceteris paribus conditions is largely artificial. Any useful
comparison must consider the real world where national governments
follow disparate macroeconomic policies in pursuit of domestic rather
than international goals. Under these conditions fixed exchange rates
tend toward disequilibrium. The policies necessary to keep fixity at
disequilibrium may well impede trade more severely than the risk of
fluctuations. Trade barriers often arise in these instances [Yeager,
1976]. Furthermore, keeping nominal exchange rates fixed would result
in changing real rates that can inhibit trade. A country that has a
rapid inflation relative to a trading partner but keeps its exchange
rate fixed soon loses export competitiveness. If its exports are
reduced, imports must also be reduced, lest there be accumulating
balance of trade deficits.

The overall indication from the evidence is that if flexible
exchange rates have curtailed international trade and investment, the
effect has been mild and perhaps less severe than could have been
experienced under a continuation of the adjustable peg.

Inflation and Flexible Exchange Rates

A traditional argument for exchange rate flexibility is that it
insulates a country from outside inflationary influences while bottling
its own inflation within its borders. For example, Southland suddenly
increases its money supply by 50 percent, ceteris paribus. Conse-
quently, inflationary pressures push up the price of its products
including exports. As export prices rise, foreign customers will turn
to other sources of supply. As the prices of domestic import-competing

20

products also rise, Southlanders shift to imports. The result is an
increase in demand for foreign currency and a decrease in demand for
Southland's currency. If exchange rates have the flexibility to respond
to market forces, Southland's currency will depreciate to the point
where its demand and supply are again in equilibrium. The result of the
process is that Southland's expansion of its money supply resulted in a
solely internal inflation; prices in other countries were not affected.

Consider the same change in money supply under fixed exchange
rates. As Southland's prices rise, it will develop a balance of
payments deficit when foreign customers buy less of its now more
expensive products and its citizens buy more of the relatively cheaper
imports. The deficit translates into a surplus of Southland's currency
abroad. This surplus increases money income overseas (unless sterilized
by central banks) and, therefore, foreign prices rise. Inflation is
thereby transmitted abroad.

In a detailed review of this issue, Salant [1977] concludes that
one can a priori expect a country will be less vulnerable to external
inflationary influences if its exchange rate is flexible rather than
fixed, except in two cases: a) where there is a rise in the world price
of imports for which the demand is price-inelastic and b) where the
external inflation generates a capital outflow. In the first case a
rise in the world price of imports results in a depreciation of the home
currency which aggravates the import price rise and raises the home
price of exportable output. These effects can trigger an inflationary
process by a repetition of a price-of-tradeables-exchange rate-general
price-wage-exchange rate spiral until arrested by monetary restriction
or until import prices move to the elastic range of demand. Under fixed

21

rates a price rise of inelastic imports would induce a balance of
payments deficit and thereby a contraction of the monetary base. This
contraction serves to counteract the initial inflationary move and
thereby to reduce the vulnerability to outside inflation. Salant
regards this case as unlikely, but perhaps it is very relevant to
developing countries where the elasticity of imports may be reduced by a
severely limited domestic industrial base.

The second case deals with a capital outflow generated by profit
opportunities abroad that are increased by external inflation. Under a
fixed exchange rate this effect is unambiguously deflationary. Under
flexible rates, however, the currency depreciates, increasing the
domestic price of traded goods. This price effect reduces the real
money supply if nominal money rises less than the average domestic price
level. Nevertheless, this monetary contraction may not be enough to
reduce the prices of domestic products sufficiently to counteract the
rise in tradeables. Then the domestic price level as a whole rises
while output and employment may decrease. If the monetary authorities
respond with an expansion in money supply, then any mitigating effects
on inflation of the initial contraction are reduced or eliminated.
Again, Salant considers this case as special. He concludes that in
general floating rates block the market mechanism by which inflation is
transmitted. In a different analysis Willett arrives at a similar
conclusion:

There are some types of episodes in which greater inflation-
ary pressures would be generated under freely floating rates
than under realistic alternative exchange rate regimes. In
actual practice, however, episodes of any great significance
are more the exception than the rule. [1977, 66]

22

A separate question deals with whether the rate of world inflation
is likely to be greater under a fixed or a flexible exchange rate
system. The arguments suggesting that flexible rates promote world
inflation have two basic elements. One is an asymmetry in response to
exchange rate changes. Depreciating countries see the domestic price of
tradeables rise after the depreciation. There follows pressure to
increase income and wages to maintain their purchasing power, creating
another round of price rises. In the appreciating countries, on the
other hand, the domestic price of tradeables drops, but a downward
rigidity in incomes and wages makes any general price decrease less than
the increase in the depreciating country. Consequently, world inflation
as a whole rises. Under fixed exchange rates the net inflationary
effect would have been avoided.

The second element is implied in the first: monetary and fiscal
policy allows the price-wage spiral to continue in the depreciating
country. These accommodating policies may or may not have also led to
the initial depreciation.

Willett [1977] argues that these asymmetries are relevant only when
the value of a country's currency changes because of circumstances other
than the country's underlying economic conditions. If only the
"relevant" ones are considered, their magnitude can be easily
exaggerated because, unlike with wages, there does exist a downward
flexibility in the prices of internationally traded goods. If the
exchange rate change is then persistent enough to be incorporated into
wages, then it is unlikely to be caused by other than fundamental
economic factors.

23

Willett's analysis is then focused on macroeconomic policy. He
emphasizes the importance of discerning cause and effect. If a currency
depreciates in response to monetary and/or fiscal policy, it is improper
to blame the depreciation for the rise in the price of tradeables. Even
if the depreciation gives rise to a demand for higher wages, a
continuing exchange rate-price-wages-price-exchange rate spiral is
possible only in light of an accommodating macroeconomic policy. Thus
the problem lies with the policy and not with the flexibility of
exchange rates.

Salant [1977] agrees that in a narrow, almost mechanical sense, a
flexible exchange rate system allows every country to control its
national price level. Through the appropriate policy a nation can keep
stable prices despite exchange rate changes caused from the outside.
Thus, world inflation could conceivably be eliminated. But, he adds,
this view assumes that monetary and fiscal policies are determined
solely with the view of avoiding inflation. Although a conclusion such
as Willett's is correct in light of this assumption, he feels the view
taken is too narrow; most countries are not completely unresponsive to
changes in the demand for output and employment.

The arguments above lead one to infer that flexible exchange rates
can promote control of world inflation by giving countries the option to
a) adopt a noninflationary domestic macroeconomic policy and b) allowing
them to isolate themselves from outside inflationary sources. However,
if controlling inflation is only one of several economic goals, these
conclusions become more controvertible. If broader economic goals are
considered, then the conclusions become more equivocal. For example,
Dornbusch and Krugman [1976] argue that the short-run Phillips curve is

24

steeper under flexible than under fixed exchange rates. If they are
correct, countries with the economic goal of full employment must be
willing to accept a higher rate of inflation under flexible rates than
under fixed rates.

Flexible Exchange Rates and External Adjustment

Before their adoption in 1973, it was expected that flexible
exchange rates would greatly facilitate the international adjustment
process. It was anticipated that exchange rate movements would ensure
that financing flows would be available to offset any short-run excess
demand or supply for foreign exchange originating from the current
account. In the long run, flexible rates would ensure that the demand
and supply of foreign exchange would be consistent with the foreign
investment flows that reflect differences in propensities to save and
differences in investment opportunities between countries. On the
whole, flexible rates were expected to prevent the occurence of the
protracted maladjustments experienced in the late 1960s and early 1970s.

Artus and Young [1979] argue that these expectations were not met
because the usefulness of flexible rates in facilitating external
adjustment implied three conditions which were also not met. These
conditions are: a) a supportive aggregate demand-management policy, b)
sustained changes in the relative prices of foreign and domestic goods,
and c) changes in relative prices that lead to a switch in domestic and
foreign demand between foreign and domestic goods. The first condition
was often not met as countries with current account surpluses such as
West Germany placed a large emphasis on controlling inflation even if it
reduced the demand for foreign goods, while deficit countries such as

25

the United States placed its emphasis on reducing short-term
unemployment. While not necessarily disagreeing with the need for
proper demand management (although perhaps emphasizing monetary
control), Willett [1977] regards as a truism the fact that countries
with differing rates of inflation cannot achieve adjustment with a
one-shot move in exchange rates. Under these circumstances a continuous
change in exchange rate is needed in order to prevent greater
imbalances. If inflation in the U.S. is higher than in West Germany,
the dollar should face a long-term downward trend in relation to the
mark, not just a short-term adjustment.

Artus and Young's second condition deals with the fact that the
absence of money illusion induces workers to demand higher wages in
response to a depreciation. Unless foreign goods form a small portion
of a country's consumer basket, a depreciation will be regarded as an
increase in the cost of living and consumers will demand compensating
adjustments in wages. These wage hikes will undermine the needed change
in relative prices between foreign and domestic goods caused by the
change in exchange rate; the price of domestic relative to foreign goods
will rise again. As explained in the section on world inflation, this
exchange rate-foreign prices-wages-price spiral can only occur in light
of an accommodating monetary and/or fiscal policy. Restrictive policies
would lead the economy to properly respond to the change in exchange
rate.

The third condition is that demand for foreign and domestic goods
must change when their relative prices change. Artus and Young point
out that this shift has often not materialized. They provide the
extreme example of Switzerland, whose export volume kept increasing in
1978 despite a 30 to 50 percent loss in cost and price competitiveness

26

in the preceding five years due to appreciation of the Swiss franc.
They claim the Swiss have highly specialized exports which cannot be
easily shifted to the domestic market. Instead, they shifted toward
highly technical exports with low price elasticities.

McKinnon [1981] makes the altogether different argument that modern
international economic conditions make exchange rates no longer the most
direct instrument for influencing the trade balance. His position is
that both proponents of fixed and flexible exchange rates have in mind
the elasticities approach (discussed in the first section of this
chapter) when considering an equilibrium exchange rate. The implied
assumptions of this approach no longer hold in the modern world.
McKinnon summarizes these assumptions as those of an "insular economy,"
one where a country engages in foreign trade but a) trade is a small
proportion of GNP such that exchange rate changes do not influence
prices, b) net domestic wealth holdings of financial or real assets are
not much influenced by the foreign sector, and c) the national monetary
system is insulated from foreign exchange. These conditions prevent
exchange rate changes from having price or income effects in a country,
thereby limiting the determinants of exchange equilibrium to the
elasticities of export and import demand and supply. These conditions,
however, do not apply to today's world characterized by integrated
capital markets and industries more open to commodity trade than in the
past.

McKinnon offers a model of an "open economy" more appropriate to
modern economic situations; i.e., the above assumptions no longer hold.
He begins with the familiar identities of national income, assuming that

27

the current account and the trade balance are the same while foreign and
domestic prices are initially set to unity:

Y = C + Id + G + X - R'Z (3)

where Y = national income,

C = private consumption,
Id = total domestic investment,

G = government consumption,

X = exports in domestic currency,

R = domestic cost of foreign exchange,

Z = imports in foreign currency.
Define social saving to be

S = Y - C - G (4)

so that

S - Id = X - R'Z = If (5)

where If = net foreign investment.

Define Sp as private saving and Sg as government saving. If T is total

tax less transfers, then public sector saving is

Sg = T - G (6)

and total saving is

S = Sp + (T - G) (7)

The final result is

Sp + (T - G) - Id = X - R'Z = If. (8)

28

The elasticities approach emphasized the right-hand side of equation
(8). However, it can be seen that an improvement in the trade balance
must involve either a rise in private saving, a rise in public saving,
or a fall in domestic investment. Public saving enters as a wedge
between the private actions of saving and investment and the net claim
on foreigners.

McKinnon further argues that a) there is no change in private
saving (Sp) with respect to a depreciation (R increase), b) there is a
positive change in government saving (T - G) with respect to a
depreciation, and c) there is also a positive change in domestic
investment (Id) with respect to a depreciation. The conclusion to be
drawn from equation (8) is that a change in the exchange rate will exert
an ambiguous change in the trade balance; government saving becomes the
most direct instrument for public officials to influence the trade
balance (assuming that they do not interfere with private saving and
investment). Since the effect of exchange rates on external adjustment
is indeterminate, external imbalances can persist despite freely
floating exchange rates.

Macroeconomic Policy Under Flexible Exchange Rates

This section deals with the nature of fiscal and monetary policy in
economies with floating exchange rates and fairly unrestricted capital
markets (characteristic of developed economies). One theme was already
introduced in the previous section: the importance of fiscal policy to
the trade balance. In accordance with McKinnon's [1981] arguments, a
persistent imbalance in the trade account does not necessarily imply a
disequilibrium exchange rate. An increase in a country's budget deficit
will decrease the net trade surplus while a change in the exchange rate

29

will have an ambiguous effect. In the modern economy fiscal policy
takes on an international dimension in addition to its traditional role
in domestic demand-management.

The international dimension, according to the model, makes it
imperative for fiscal authorities to consider the international effects
of their policies. McKinnon uses the example of the depreciation of the
dollar in relation to the yen in the late 1970s. U.S. government
dissaving rose in the 1973-75 recessionary period in response to a fall
in private investment. Investment recovered in 1976-77, but government
continued to be a large dissaver even in the 1977-79 inflationary boom.
During the 1977-78 period the dollar faced a real depreciation of 25
percent (35 percent nominal), but there was not predictable effect in
the trade balance with Japan.

As with fiscal policy, monetary policy also has an international
dimension in the open economy. In the same reference McKinnon uses the
same dollar-yen episode to cite an illustration of the international
aspect. As is discussed below, expectations of future exchange rate
movements can affect interest rates today. During the 1977-78 period
expectations of further decline of the dollar increased U.S. interest
rates as a flight out of dollars took place, and a liquidity squeeze was
created. At the time the Federal Reserve Bank was keying on interest
rates (federal funds rate) as their instrument of monetary control.
When interest rates rose because of the exodus out of the dollar,
monetary authorities proceded to expand the money supply further to
reduce the interest rates. This expansionary policy has the perverse
effect of aggravating the flight out of the dollar, since a further
depreciation was then more assuredly expected. Again, there was an

30

upward pressure on U.S. interest rates. The failure by the Federal
Reserve Bank to recognize the decrease in the international demand for
the dollar while recognizing only domestic interest rates resulted in a
loss of monetary control. McKinnon also argues that maintaining the
monetarist principle of fixed money growth would have had a similar
effect in light of the slack in the demand for dollars.

In another vein, Dornbusch and Krugman [1976] propose that the
short- run Phillips curve is much steeper in an open economy when using
monetary policy to achieve an expansion in output. In terms of Figure
1, the schedule PP represents the traditional inflation-unemployment
tradeoff in a given country. In an effort to increase output and
decrease unemployment from U° to U' an expansionary monetary policy is
put into place. The immediate effect is a depreciation of the currency.
Consequently, the price of imports is immediately increased, and wage
pressures surge. As a consequence of the depreciation and resulting
price increases, the new Phillips relationship is represented by the
schedule P'P1; the MM schedule covers the period before and after the
depreciation. Thus an attempt to move from A° to A' via monetary
expansion results in a move to A". In the open economy reductions in
unemployment are brought about by higher rates of inflation than in the
insular economy. In Figure 1 the difference is lu~V . More effective
attempts to increase short-run output would have to involve a monetary-
fiscal policy mix where a fiscal expansion is applied along with an
accommodating monetary policy to maintain exchange rates.

In light of their arguments, both Dornbusch and Krugman and
McKinnon argue for a need to offset exogenous disturbances of the
exchange rate. Dornbusch and Krugman [1976] hold that exchange rate

31

Figure 1. The Phillips Curve in an Open Economy

32

movements can disrupt price performance just as commodity inflation due
to crop failures can. And just as inventories can be used to assuage
the shocks, inventories of foreign exchange or the ability to borrow can
be used to peg the exchange rate while the shock is in place. The
inflationary impact of a depreciation is thus avoided. There is also
the option of using a single-minded monetary policy to wring out
inflation regardless of the output effect. This option may be preferred
by authors such as Willett [1977], who would doubt the frequency and
magnitude of truly exogenous exchange rate changes.

Exchange Rate Determination

The literature discussed heretofore concerned itself with the
impact of flexible exchange rates on various aspects of national and
international economies. Frequent reference was made to the fact that
the exchange rate depends on "underlying economic conditions." Many
authors considered these conditions to be the proper focus of attention
when concerned about the detrimental impact of exchange rate movements.
Another branch of the literature has looked specifically at these
linkages between the "underlying economic conditions" and the exchange
rate. Its purpose has been to explain and model how economic variables
determine the exchange rate. The result of this effort has been the
contribution of many alternative models, each with its own assumptions
about how the economy functions or with simplified assumptions for
facilitating modeling. The attempt to compare and contrast these many
models has become an arduous task in itself, a task undertaken by Murphy
and Van Duyne [1980]. It is useful to share their overview before
looking in detail at two alternative models.

<

33

Murphy and Van Duyne acknowledge that the recent models emphasize
the role of the financial or asset markets (but also include the goods
market) in the short-run determination of exchange rates. This emphasis
contrasts with previous approaches which concentrated exclusively on the
goods market, e.g., the elasticities approach. The authors group the
models on the basis of the models' assumptions on asset substitutability
and the role of wealth in asset demand functions. One group of models,
labeled as the "portfolio balance approach," assumes that foreign and
domestic bonds are imperfect substitutes and stresses portfolio balance
considerations in asset or financial markets. Specifically, portfolio
holders try to have the optimal balance of domestic and foreign assets
in light of their returns and risk differentials. The other group of
models, the "monetary approach," assumes that foreign and domestic
assets are perfect substitutes, so that portfolio holders are
indifferent between the two. Additionally, the monetary models assume
wealth effects to have no effect in determining the exchange rate.
Consequently, it is possible to focus only on money market equilibrium
for exchange rate determination. The portfolio balance approach group
includes the models by Henderson [1977], Kouri [1976], Isard [1978], and
Branson et al . [1977]. The monetary approach group includes the models
by Dornbusch [1976], Bilson [1978] and Frankel [1979].

Murphy and Van Duyne [1980] distinguish between the models in each
group on the basis of three types of assumptions. First are
substitutability assumptions. If two assets are perfect substitutes,
they can be aggregated, thereby reducing the number of assets one has to
deal with. The second type of assumptions deals with the speed of
market adjustment. All the presented models assume that asset markets

H

34

adjust immediately, but various assumptions are made about the speed of
price and output adjustment in the goods market. Specialization
assumptions are the third type. These restrict the number of inter-
nationally traded assets or the number of goods produced in each
country. Table 1 includes the assumptions made by the different models
under these three categories.

Several highlights can be discerned from Table 1. It can be
readily seen that all models in the portfolio balance group explicitly
consider foreign and domestic assets. Henderson's [1977] asset market
is simple in that only domestic and foreign monies are considered. No
distinction is made between interest-bearing and non-interest-bearing
assets, since he assumes all interest rates are pegged. Isard's [1978]
model is more realistic in that neither foreign nor domestic interest
rates are fixed. However, he disregards the goods market by assuming it
does not achieve a short-run equilibrium. The model by Branson et al .
[1977] is a simpler version of Isard's model in that the former assumes
that both domestic money and domestic bonds are held only domestically.
Isard makes the assumption only for domestic money.

The contrast between the monetary and portfolio balance models is
also readily seen as all of the former assume perfect substitutability
between foreign and domestic interest-bearing assets, i.e., bonds. The
models differ with each other in their market adjustment and
specialization assumptions. Dornbusch [1976] assumes a slowly adjusting
goods market while Bilson [1978] assumes perfectly substitutable foreign
and domestic goods and sufficient price flexibility to constantly
maintain purchasing power parity (i.e., the price of a good in terms of
a given currency is identical in all countries). Regarding

35

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00

oo ai -a

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co oi a_o>_

00 -M
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c ai
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en •!-
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Ll_ _Q 00

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CD JD I Q. r

•i- 3 -M
Q) O0 S-
S- O •

O ■»-> J= >>■

0j_ <_> 00 -P •

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rO OI -Q

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37

specialization, Dornbusch makes a typical small country assumption:
foreign prices and foreign interest rates are fixed to the domestic
country. Bilson does not make this assumption and allows foreign
interest rates to vary. Frankel 's [1979] model is a mixture of
Dornbusch and Bilson; he makes the market adjustment assumptions of
Dornbusch while making the same specialization assumptions as Bilson.

Table 1 presents the general distinguishing features of the
different models but does not give a precise indication of the nature of
the models. To allow a more precise familiarity with the models, a
representative from the balance approach and one from the monetary
approach will be reviewed in detail. Branson's model will serve as the
portfolio balance approach representative, while Frankel 's model will
shed light on the monetary approach. Both of these models have had
empirical applications.

Branson's Exchange Rate Determination Model

Branson et al . [1977] begin the theoretical formulation of their
model by assuming a small country which faces a fixed interest rate on
world-traded assets. In the short-run, i.e., at each instant in time,
the exchange rate is determined as part of the financial or asset market
system which equates the quantity demanded for assets with the existing
stock. Assets are aggregated into two categories: domestically issued
assets B bearing interest rate r and foreign-issued assets F bearing
fixed interest rate F. Domestic portfolio balancers also hold domestic
money M. It is assumed that neither B nor M is traded; only F is traded
but cannot be swapped for B or M. The stock of B, M, and F is
predetermined by history. F can be accumulated only by running a
current account surplus over time.

38

Short-run asset market equilibrium is attained when the following
conditions are met:

Supply = Demand

M = m (r, F) W (Money market) (9)

B = b (r, F) W (Home asset market) (10)

eF ■ f (r, r) W (Foreign asset market) (11)
W = eF + B + M (Balance sheet constraint) (12)
The exchange rate e is defined as the home currency price of foreign
currency. Both B and F are short-run fixed price assets so that they
accrue no capital gains as r and r change.

The balance sheet constraint (12) and an assumption of imperfect
substitutability between assets imply

mr + fr = -br 0 mr + br = -fr 0

where a subscript denotes a partial derivative. Given the balance sheet
constraint (12), the three market equilibrium conditions (9) - (11)
contain two independent equations in e and r. Any pair of (9) - (11)
with W substituted from (12) can be used to determine equilibrium values
of e and r.

The model is represented graphically in Figure 2 where the pair of
e and r satisfying the three market conditions is plotted. MM reflects
equilibrium in the money market. As the domestic interest rate r
increases, portfolio balancers will want to move out of non-interest-
bearing domestic money. To maintain money market equilibrium, the
exchange rate has to depreciate (e must rise) to increase the attraction
of domestic money relative to foreign bonds. (The depreciation has made
them more expensive.) The MM has a positive slope. BB represents

39

Figure 2. Graphical Representation of Branson's Model

Figure 3. Graphical Representation of Open-Market Purchase of
Domestic Assets by Central Bank in Branson's Model

Source: Murphy and Duyne [1980].

40

equilibrium in the domestic bond market. As the domestic interest rate

r rises, portfolio balancers will want to increase their holdings of

domestic bonds. To maintain equilibrium (since the stocks of bonds and

money are fixed in the short run), the domestic currency must appreciate

(e decreases) to cheapen foreign bonds and thereby increase their

attraction relative to domestic bonds. BB has a negative slope. FF

represents equilibrium in the foreign bond market where the (foreign)

interest rate r is fixed. If domestic interest rate r increases, the

attraction to foreign bonds relative to domestic bonds will diminish.

To maintain equilibrium, the home currency must appreciate (e falls) to

make foreign assets cheaper and thereby increase their attraction again.

FF must have a negative slope. Finally, at the intersection of MM, BB,

and FF there is equilibrium in the financial or asset market.

The mechanics of the model can also be graphically represented.

Figure 3 illustrates the case where the domestic money supply is

increased by a purchase of domestic bonds. Initial equilibrium occurs

at r , e . The open-market operation shifts MM to M'M' and BB to B'B'.
oo

The shift occurs because the domestic interest rate must decline in
order to persuade portfolio holders to shift out of bonds and into
money. (The shift in MM is larger than in BB because the decline in
interest rate necessary to reestablish equilibrium in the domestic bond
market is smaller than the decline needed to reestablish equilibrium in
the money market. Imperfect substitutability implies that own-price
elasticities of demand are larger than cross-elasticities.) The decline
in interest rate, however, creates attraction for a fixed supply of
foreign bonds with a fixed interest rate. The increased demand for
foreign bonds causes a depreciation of the domestic currency so that the

41

value of foreign assets matches the value demanded. The result is that
the equilibrium exchange rate and domestic interest rate shift from rQeQ
to r,e,. The important conclusion is that raising the domestic money
supply directly changes the exchange rate e in order to achieve
equilibrium in the financial market. The depreciation comes quickly,
before any effects on the price level are seen.

Branson et al . experiment with the effect on r and e of changes in
any one of the asset stocks, leaving the others constant. The results
are reported in Table 2 along with those of open-market operations.

The model thus far has focused on one country facing a world
market. Branson et al . translate it into an operational theory of
determination of one bilateral exchange rate. If the analysis is
extended to two countries, each with J earning assets and a money, the
interaction of demand for the fixed supply of 2J + 2 assets determines
2J rates of return (no returns to the two monies) plus one exchange rate
e. The equilibrium exchange rate occurs when the two private sectors
are willing to hold the stocks of the two national monies.

As reported in Table 1, an increase in the domestic stock of bonds
has an indeterminate effect on the exchange rate. The authors proceed
to eliminate this variable from the bilateral model. Only the foreign
and domestic money stocks and net foreign assets are considered.
Because of the symmetry, only one F should be included for one bilateral
exchange rate. For example, in modeling the U.S. dollar-deutsche mark
rate only net claims by Germans on the U.S. should be considered.
However, a lack of data availability forces the authors to include both
countries' total private stock of net foreign assets, i.e., net claims
by Germans on the world and net claims by Americans on the world. (The

42

Table 2. Effects of Increases on Asset Stocks on Short-Run Equilibrium
Interest Rate (r) and Exchange Rate (e)

Effects of Accumulation Effects of Open-Market

_._ , of Stocks Operations

Effects on: -^ =| £p AB = - AM eAF = - aM

r - +

e

?

Source: Branson et al . [1977],

43

implicit assumption is that third-country assets are perfect substitutes

for German assets in the eyes of U.S. portfolio holders, and vice

versa.) Considering these limitations and the information in Table 1,

the exchange rate determination equation in this example becomes

+ - - +
e ($/DM) = h (Mu, Mg, Fu, Fg) (13)

where M = U.S. money stock

M = W. German money stock

F = total net foreign assets held by U.S.

F = total U.S. net foreign assets held by W. Germany
9

and the signs over the arguments indicate the sign of the partial
derivatives.

Branson, therefore, focuses on the financial market as the
determinant of the exchange rate in the short run. The market is
constituted of domestic and foreign non-interest-bearing monies and
domestic and foreign interest-bearing bonds. The assets are gross
substitutes, but no domestic asset is traded in the world market, and
foreign interest rates are fixed. The important result of the model is
that the exchange rate along with the domestic interest rate
equilibriate the quantity of assets demanded with their predetermined
stock. Therefore, changes in stocks will directly affect the exchange
rate in order for the latter to help maintain equilibrium.

*For a critique and revision of this model see Bisignano and Hoover
[1982].

44

Frankel's Exchange Rate Determination Model

Frankel's [1979] model arises out of the contradictory predictions
obtained by different models within the monetary framework. One school
which he labels the "Chicago theory" assumes prices are perfectly
flexible. For example, if the nominal money supply is increased by 10
percent, prices immediately increase by 10 percent, ceteris paribus,
leaving the real money supply constant. Therefore, if the domestic
interest rate rises relative to the foreign rate, it is because the
domestic currency is expected to lose value through inflation, not
because the real money supply has changed. If the local currency is
expected to lose value, demand for it falls relative to the foreign
currency, causing an immediate depreciation (the exchange rate e rises).
Consequently, there is a positive relationship between the exchange rate
and the nominal interest differential between countries.

The other type of model Frankel labels as the "Keynesian theory"
because it assumes that prices are sticky in the short run. Thus if the
nominal money supply rises, the real money supply also rises, at least
in the short run. Therefore, a change in the domestic interest rate
reflects changes in the tightness of monetary policy; real money supply
has changed. A contraction of the nominal money supply, for example,
results in a contraction of the real money supply and a rise in the
interest rate. The higher interest rate attracts a capital inflow,
which in turn causes an appreciation of the currency (the exchange rate
e decreases). Consequently, there is a negative relationship between
the exchange rate and the nominal interest differential.

It is this discrepancy between the "Chicago" and the "Keynesian"
theories which Frankel endeavors to reconcile. In doing so he combines

45

the assumption of sticky prices with the assumption that there are
secular rates of inflation in both the domestic and foreign countries;
neither the domestic nor the foreign interest rate is fixed.

Frankel makes two fundamental assumptions in the development of his
model. The first is that domestic and foreign bonds are perfectly
substitutable so that interest rate parity is maintained:

d = r - rf (14)

where d = forward discount,

r = log of one plus the domestic rate of interest,

rf = log of one plus the foreign rate of interest.
The forward discount is the expected rate of depreciation; there are no
risk premiums for foreign relative to domestic bonds.

The second fundamental assumption is that the expected rate of
depreciation is a function of the spot rate and of the expected long-run
inflation differential between the domestic and foreign countries:

d = z (e - e) + LI - LIf (15)

where e = log of spot exchange rate,

e - log of equilibrium exchange rate,
LI = current rate of expected domestic long-run inflation,
LIf = current rate of expected foreign long-run inflation.
Equation (15) states that in the short run the exchange rate is expected
to return to equilibrium at a rate which is proportional to the current
gap. And when in long-run equilibrium (e = e~) , the rate of depreciation
is equal to the long-run inflation differential (LI - LIf). Combining
equations (14) and (15), one obtains

46

e - e = -1/z [(r - LI) - (rf - LIf)]. (16)

Frankel calls the expression in brackets the real interest differential.

The author next assumes that purchasing power parity holds in the
long run:

e=p-pf (17)

where p" and p"f are the logs of the equilibrium price levels at home and
abroad, respectively. The equation states that in the long run domestic
prices are identical with the foreign ones deflated by the exchange
rate.

Conventional money demand equations are also assumed for both
countries:

m = p + hy - gr (18a)

mf = pf + hyf - grf (18b)

where m, mf = logs of domestic and foreign money supply,
P» Pf = Togs of domestic and foreign price levels,
y» yf = logs of domestic and foreign output,
r, rf = logs of domestic and foreign interest rates.

Subtracting (18b) from (18a):

m - mf = p - pf + h (y - yf) - g (r - rf) (19)

Using bars to denote equilibrium, we obtain the long-run relationship

e = p - pf = m - mf - h (y - yf ) + g (7 - rf ) . (20)

equation (20) illustrates the monetary theory of the exchange rate: the
latter is determined by the relative demand for and supply of the two

47

currencies. In full equilibrium an increase in the money supply
inflates prices and depreciates the currency proportionately; an
increase in income and a decrease in the expected rate of inflation will
appreciate the currency.

By substituting equation (20) into equation (16) and assuming that
current actual levels are current equilibrium values, the model of the
real interest theory of exchange rate determination is obtained:

e = m - mf - h (y - yf) - 1/z (r - rf) + (1/z + g) (LI - LIf) (21)

By letting a = (-1/z) and b = (1/z + g) and adding an error term, the
model is converted to

e = m - mf - h (y - yf) + a (r - rf) + b (LI - LIf) + u. (22)

Frankel considers his model to be a general monetary model in that
both Dornbusch's [1976] and Bil son's [1978] models are special cases of
the present one. If one lets b = 0, one is left with a model that is
yery similar to Dornbusch's "Keynesian theory" model where secular
inflation is not a factor. The difference remains that Dornbusch holds
foreign interest rates fixed while Frankel does not. The former is a
small country case while the latter is a two-country case.

In a model like Bil son's "Chicago theory" the interest rate
differential can be viewed as the inflation differential, i.e.,
(r - rf) = (LI - LIf). Logical transition leads to this conclusion.
First, purchasing power parity insures that the rate of depreciation is
equal to the difference in inflation between countries so that the
relative purchasing power of the currencies is unaffected. For example,
if the inflation in the U.K. is five percent higher than in the U.S.,

48

then a yearly five-percent devaluation of the pound relative to the
dollar would maintain relative prices in both countries equal. Second,
interest rate parity, equation (14), insures that the depreciation is
equal to the difference in interest rate between countries. Then by
transition one can logically argue that a) since the inflation
differential is equal to the depreciation and b) since the depreciation
is equal to the interest differential, it follows that c) the inflation
differential (LI - LI-) equals the interest differential (r - rf). One
of these terms in equation (22) would be redundant in Bilson's view. If
one lets a = 0, one is left with a form of Bilson's model. Frankel's
model can thus be collapsed into one representing the "Chicago theory."

Whereas the "Keynesian theory" would hypothesize a < 0, b = 0 and
the "Chicago theory" that a = 0, b > 0, Frankel hypothesizes that a < 0,
b > 0. In other words, there is a negative relationship between the
exchange rate and the nominal interest differential, but inflationary
expectations also play a role in the determination of exchange rates.

Frankel's model, in conclusion, represents a generalized framework
for the monetary approach to exchange rate determination. As in all the
monetary models, foreign and domestic interest-bearing assets are
considered perfectly substitutable, and only the money market is
included. It also combines the short-run price stickiness of some
approaches with the variable foreign interest rate assumption of others.
It additionally considers long-run inflation expectations as an explicit
explanatory factor in exchange rate determination. In so doing, Frankel
accepts the "Chicago theory" notion that the rate of change on the price
levels affects the exchange rate, but without also assuming perfect
price flexibility and continuous purchasing power parity. He thus

49

combines the more credible assumptions of the monetary approach while
discarding some of the more unrealistic ones.

Summary of Flexible Exchange Rate Issues

The literature on flexible exchange rates reviewed in this chapter
has indicated the following:

a) Much of the exchange rate instability experienced since the
inception of the float can be attributed to unstable underlying
economic conditions;

b) Bandwagon speculative forces seem to have played a role in
registered oscillations around equilibrium values,

c) Exchange rate flexibility has added to the risk faced by
traders, but that added risk does not seem to have significant-
ly curtailed international trade and investment;

d) Flexible exchange rates can insulate countries from external
inflationary shocks, isolate national inflationary pressures
from the international economy, and reduce world inflation.
But these salutary effects necessitate single-goal monetary
policies aimed at controlling inflation regardless of output
and employment effects;

e) Flexible exchange rates can alleviate external imbalances, but
there must be congruent fiscal and monetary policies to attain
the desired changes in the current account;

f) Flexible exchange rates reduce the need for compensatory
financial flows from central banks (freely floating rates
obviate the need entirely), but they add international
dimensions to fiscal and monetary policy which complicate
policy-making;

50

g) Recent theories of flexible exchange rate determination have
the common element of emphasizing the financial rather than the
goods markets in determining exchange rate equilibrium.
However, there is considerable divergence as to how to model
the structure of the financial markets and the role of the
exchange rate in them.
The overall evidence seems to indicate that the performance of the
flexible exchange rate has been neither as poor as its critics at first
feared nor as excellent as its proponents first suggested.

CHAPTER IV

EXCHANGE RATE ISSUES IN THE AGRICULTURAL

ECONOMICS LITERATURE

Introduction

The exchange rate did not become a major issue of research concern
in the agricultural economics literature until the early 1970s. The
devaluations of the dollar at that time were followed by a great surge
in agricultural exports and prices. A research focus was naturally
placed on the exchange rate as a possible explanatory factor behind
these trade effects. A consequence has been that the literature has
concentrated almost exclusively on the effects on agriculture of a
discreet, one-shot change in the exchange rate. This focus developed
despite the fact that by the time the research was conducted, exchange
rate flexibility had been adopted and the value of currencies was
changing continuously. The issue of exchange rate variability has
received minimal and delayed attention.

This review will group the references into two broad categories.
The first group includes the references that deal with discreet
devaluations in 1971 and/or 1973 and encompasses most of the publica-
tions. The category is subdivided into theoretical and empirical
contributions. The second group is a part of the literature which
focuses on the linkages of the agricultural economy with the general
economy under flexible exchange rates. As will be clarified below, the
exchange rate provides one of these linkages.

51

52

The Agricultural Economy and Discreet Dollar
Devaluations: Theoretical Studies

Seminal work in this area was provided by Schuh [1974], although
the article itself concentrated on the broad effects on U.S. agriculture
of the overvaluation of the dollar in the 1950s and 1960s. Schuh
postulated that the overvaluation had four major impacts on the U.S.
agricultural economy: a) an undervaluation of U.S. agricultural
resources in relation to their world opportunity cost, b) this
undervaluation forced a more rapid rate of technological change than
would have otherwise occurred, c) a larger share of the benefits from
technical change accrued to U.S. consumers than under an equilibrium
exchange rate, and d) the 1971 and 1973 devaluations and the subsequent
float implied structural changes for U.S. agriculture.

Schuh' s reasoning can be illustrated with the aid of Figure 4.
Curves DD and SS represent domestic demand and supply conditions,
respectively. Id represents the international demand for agricultural
products. The line is drawn horizontally to facilitate exposition.
Schuh presumes that demand is highly, but not perfectly, elastic. If Id
prevails, the price of output will be P, with quantity Q4 produced. Of
this total Q,Q4 is exported, while OQ-j is consumed locally. Export
earnings would include Q-.ABQ,, while domestic earnings include OP-jAQ-j ,
yielding total gross earnings 0P-,BQ4- Now assume the currency is
overvalued. Viewed externally, the overvaluation signifies a rise in
product prices in terms of foreign currency which reduces demand to I'd.
The consequence to the farm sector is that output price drops to P2 and
quantity supplied, to Q3, indicating the product is undervalued in
relation to its equilibrium exchange rate alternative. Gross income is

53

Q4 Quantity

Figure 4. Demand and Supply Conditions for Industry Producing for
both the Domestic and Foreign Markets

Source: Schuh [1974].

54

reduced to 0P2CDQ3. Export earnings are reduced by an amount equal to
the shaded area. The magnitude of the declines will depend on the
respective elasticities of demand and supply and the extent of the
overvaluation.

Schuh concentrates on the effects of this overvaluation on the rate
of technical change and the structural effects of technical change, e.g.
the rate of release of labor from the farm sector. However, he went on
to hypothesize that "an important share of the rise in agricultural
prices in mid-1973 is the result of monetary phenomena [i.e., the
exchange rate] which induced an export boom" [Schuh 1974, 12]. He also
specifically predicted that a devaluation would result in a rise in the
relative price of food and a shift in the U.S. agricultural product mix
toward export products. These price and export quantity effects of a
devaluation comprised a minor portion of the paper. But they elicited a
great deal of controversy in the literature that has not been completely
resolved to date.

Grennes [1975] directly responded to Schuh's article. He expressed
concern over the poor evidence presented to claim that the dollar had
been overvalued during the 1950s and 1960s. He also argued that a
dollar overvaluation causes a positive terms-of- trade effect (by
extracting more foreign exchange per unit of product) whose gains may or
may not dominate losses due to production and consumption inefficiencies
(arising from a reduction in foreign demand), but at least the losses
are mitigated. Grennes makes the additional comment that the export
subsidy programs in place during the period also helped counteract the
effects of a possible overvaluation. A conclusion from his arguments is
that a dollar overvaluation, even if present, may not have had the

55

pervasive impacts Schuh suggested. The implication can be that a
devaluation would also not produce pervasive effects.

An analysis by Kost [1976] also contradicted Schuh's work. Kost
examines four cases: a) a devaluation by the exporter, b) a devaluation
by the importer, c) a revaluation by the exporter, and d) a revaluation
by the importer. He concentrates on the first case as the one of
interest to U.S. agriculture. This case is represented by an increase
in import demand from the perspective of the export country (in a
two-country model). This shift in demand will be equal to the
percentage devaluation change; thus, according to Kost, there are upper
limits to the export price and quantity changes. As illustrated in
Figure 5 (where %Ae indicates the devaluation in percentage terms), the
maximum increase in quantity exported occurs when export supply ES is
perfectly elastic (Id representing import demand). Then the upper limit
in the increase in exports is equal to the devaluation in percentage
terms. As illustrated in Figure 6, the maximum change in price occurs
when export supply is perfectly inelastic. The upper limit in price
change will also be equal to the devaluation in percentage terms. When
there is a maximum change in price there is no change in quantity, and
vice versa.

Kost argues that both the elasticity of demand and supply is very
low for U.S. agricultural products, particularly in the short run.
Therefore, one can only expect a small impact on agricultural trade as a
result of a change in the exchange rate, and what effect there is will
be primarily reflected in prices. Kost's arguments imply that the
exchange rate could not have had the pervasive impacts Schuh suggested
and that devaluations would not produce the price and quantity effects
Schuh predicted.

56

Quantity

Figure 5. Maximum Effect on Export Quantity as a Result of a
Devaluation, According to Kost [1976]

Quantity

Figure 6. Maximum Effect on Export Price as a Result of a
Devaluation According to Kost [1976]

57

Kost's line of reasoning is disputed by Bredahl and Gallagher
[1977]. They draw different conclusions from a simple two-country,
one-product free trade model:

QD = a2 + (b2 x) $P (b2 .< 0) (23)

QS = a] + b] $P (b1 >0) (24)

QD = QS (25)

where QD = excess quantity demanded,

QS = excess quantity supplied,
x = foreign currency price of the dollar,

$P = product price in dollars.
The effect of an exchange rate is determined by totally differentiating
each equation and solving for the appropriate differential at
equilibrium. The total differential for the price in dollars is

d$p = 1 (26)

b, - xbp

Since the numerator is positive and the denominator is negative, a
depreciation (a drop in x) results in a dollar price increase. The
expression can also be stated in what the authors call the reduced- form
elasticity of equilibrium price for the exchange rate (or, alterna-
tively, the exchange rate elasticity of price) E^p x:

EQD

where EQS and EQD are the elasticities of excess supply and excess
demand, respectively. E*p is bounded by 0 and -1, indicating the

58

percentage change in equilibrium price due to a change in the exchange

rate will at most equal the latter in percentage terms. At this point

there is not disagreement with Kost.

Next the authors derive the elasticity of the equilibrium quantity

with respect to the exchange rate (E ). Noting that the excess supply

q »x

curve does not shift in response to a devaluation:

tES " ED

This elasticity has an upper bound of zero but has no lower bound.
Therefore, in contrast to Kost, the authors conclude that the change in
equilibrium quantity may exceed the percentage change in the exchange
rate. Through further algebraic manipulation the authors also note that
if the elasticity of supply is greater than one and the elasticity of
excess demand is not zero, the percentage change in quantity will exceed
that of price in response to an exchange rate change. This result also
contrasts with Kost's finding that the exchange rate will affect price
primarily.

Bredahl and Gallagher emphasize that the elasticities of the excess
relationships determine the quantity and price effects of an exchange
rate change. These elasticities of excess demand and supply may be
elastic even if the underlying domestic relationships are inelastic.
Thus noting that U.S. agriculture has highly inelastic demand and supply
is not sufficient reason to conclude, as Kost does, that excess demand
and supply are inelastic. Furthermore, the authors show that the
elasticity of export demand for a particular country's product (such as
the U.S.) can be much larger than the excess relationships which, in
turn, may be more elastic than the underlying domestic relationships.

59

The conclusion to be drawn from these theoretical findings is that
the export sector of U.S. agriculture can be very responsive to a change
in the exchange rate. Prices may not exhibit more than unitary
elasticity, but export quantities may respond quite elastically. The
exchange rate could be as important to the agricultural sector as Schuh
suggested it could be.

A common result obtained by Kost [1976] and Bredahl and Gallagher
[1977] is that the export price change due to an exchange rate change
must be less than or equal to the exchange rate change (in percentage
terms). Disputing this conclusion was a major purpose of an article by
Chambers and Just [1979]. According to these authors, the source of the
divergence of conclusions is the model presented in equations (23)-(25).
In their view the excess demand relationship in equation (23) can be
derived from standard neoclassical theory only under the assumption of
zero cross-price elasticities between the traded commodity and all other
goods for which prices are not constant.

Since neoclassical demand functions are obtained by maximizing an
individual's preference function subject to a budget constraint, an
individual's demand for a commodity is a function of the price of that
commodity, income, and all other prices. Therefore, excess demand
functions ought to be respecified as

QD = f (H, M) (23a)

where H is a vector containing the prices of all commodities in the
importing country, and M is income. Similarly, excess supply functions
such as equation (24) ought to be respecified to include the prices of
all alternative production possibilities:

60

QS = g (P) (24a)

where P is a vector containing the prices of all commodities in the
exporting country. The authors additionally invoke the law of one
price:

G = xP (29)

With these respecifications and assuming no change in income the
authors arrive at a new term for the exchange rate elasticity of export
price (derivation details appear in an appendix to Chambers and Just
[1979]):

(Wn ' E$P,x +^(E£D)' (« + E|piX) " (%)' (Efp,x)] (30)

where (E*p ) = net exchange rate elasticity of export price in the
n-commodity case,
E?D = the vector of cross-price elasticities of excess
demand,
s = a vector of ones,
E|p = the vector of exchange rate elasticities of exporter's
cross-prices,
E?s = vector of cross-price elasticities of supply.
(E*p ) can be larger in absolute value than E*p . If the latter has
a lower bound of -1, then it follows that in the n-commodity case a
change in the exchange rate can cause a more than proportional change in
export price. According to Chambers and Just, it is the overly
restrictive assumptions of the single-commodity model which leads to the
result that the change in price cannot be more than proportional.

61

In response to these findings, Bredahl et al . [1979a] also develop
an n-commodity model. After lengthy development and manipulation, they
arrive at what could be a surprising conclusion: "the restrictions
suggested by the free trade simple [one-commodity] model are appropriate
regardless of the number of commodities included in the model" [Bredahl,
et al . , 1979a, 15]. Regardless of the number of commodities the
exchange rate elasticity of the export price is bound within the [0, -1]
interval .

Protection in Trade Models

The models discussed thus far have assumed free trade conditions
which often do not describe actual conditions for agricultural trade.
Some efforts have been made to examine the theoretical impact on U.S.
agriculture of an exchange rate movement in the presence of market
interference by government. Dobbins and Smeal [1979] have hypothesized
exchange rate effects under two forms of market interference: price
support and supply-management programs.

To determine the exchange rate effects under a price support
program, assumptions need to be made about government stocks policy. A
reasonable assumption is that government buys any excess supply produced
domestically at the support price (Ps). Imports are banned at all lower
prices. The government then has the option of either dumping its stocks
on the rest of the world (ROW) at whatever price it can fetch or to
release increasing quantities with increasing ROW prices. With the
first policy export supply will be completely inelastic up to the
support price and then it resumes a normal positive slope at higher
prices; there is a discontinuity in export supply. With the second

62

policy export supply up to the support price has a positive slope
determined by the government's decision on how much to sell in the ROW
market at what price. If at the support price the government still
holds stocks, then it will sell all at that price. At higher prices the
normal positively sloped curve is resumed, reflecting the response of
private producers.

It should be apparent that the trade effects of an exchange rate
change will depend on the government's stocks policy and the magnitude
of the exchange rate change. Possible situations are illustrated in
Figures 7 and 8. Figure 7 represents a government dumping policy.
Devaluations that create changes in ROW demand such as ED' will not
affect quantity traded but will increase export receipts. Shifts such
as ED" result in ROW prices higher than the support price and quantity
traded will increase. Figure 8 represents a government policy of higher
releases with higher prices, assuming that there are remaining stocks at
the support price and that government will exhibit a higher supply
response to price than will private producers. Obviously, the effect of
an exchange rate change will depend on its magnitude (i.e., the percent
shift in ROW export demand).

An example of the second case, supply-management policies, is a
scheme of land retirement. If government establishes a trigger price
beyond which payments for land retirement cease, the long-run export
supply will be almost completely elastic at that price until a level of
output is reached which includes that of all the previously retired
acreage. Export supply would then become less elastic at all higher
output levels. The effect of a devaluation will depend on whether the
higher resulting price reaches the land-release trigger price. Clearly,

63

Export Quantity

Figure 7. Exchange Rate Effects on Trade Assuming Government
Dumping of Excess Stocks

Row
Price

Export Quantity

Figure 8. Exchange Rate Effects on Trade Assuming Government
Sales Respond to Price and Government Stocks Remain
at the Support Prices

64

there will also be short- and long-run effects since the retired acreage
cannot produce instantaneously. A devaluation can increase price beyond
the trigger point in the short run, but as planted acreage increases,
there will be a subsequent downward pressure on price.

A third form of market interference is used by the European
Economic Community (EEC). Bredahl and Womack [1977] have developed a
model appropriate for this actual trade condition. The EEC explicitly
restricts agricultural imports by imposing a variable levy. The
Community establishes a minimum import price termed the threshold price.
The variable levy is the amount by which the threshold price is greater
than the price at which imports enter, c.i.f. Rotterdam. Under these
conditions an appropriate model would be

QS = a1 + b] $P (b] > 0) (24)

QD = a2 + b2 TP (t>2 < 0) (31)

QD = QS (25)

where TP is the threshold price, an exogenous variable. The Community-
wide threshold prices are quoted in "units of account" which are defined
in terms of gold. For agricultural products the value of a member
country's currency is fixed in relation to the unit of account (the
"green" exchange rate). The variable levy assures that changes in world
prices that are under the threshold price (the usual case) do not affect
the flow of goods into the Community.

A result from this trade policy is that a devaluation by a non-
member country such as the U.S. will not affect equilibrium values. If
the dollar devalues by 10 percent such that the c.i.f. price in units of

65

account drops 10 percent, then the variable levy increases by 10
percent. No further adjustments are necessary within the Community. On
this basis, excess demand equation (31) can be rewritten

QD = a2 + xb2 (MCP/x) (b2 < 0) (32a)

where MCP is the member country's price in its own currency. Changes in
the exchange rate x cancel each other.

Another effect of the EEC's trade policy is that revaluations may
have different effects from devaluations. The authors consider two
cases of revaluation by an importing member country. The first involves
a revaluation of a member country's currency against both the dollar and
the unit of account. The second case is one of revaluation against the
dollar only.

The mechanics of the first case can be better illustrated by again
rewriting the excess demand equation to reflect the relationship of the
member country's currency with the unit of account:

QD = a2 + xb2 ((UAP) (z)/x) (b2 < 0) (32b)

where UAP is the threshold price in units of account and z is the member
country's price of one unit of account. Since the dollar price is
canceled out in (32b) and excess supply is a function of the dollar
price, then excess supply plays no role in the determination of
equilibrium; the differential of the excess demand function determines
the change in equilibrium quantity which expressed as a reduced- form or
net elasticity is

Eq,z ■ V (33)

66

This result contrasts with the analogous free trade condition (equation
(28)):

EQD EQS .

The member country revaluation in this case produces a larger change in
equilibrium price than under free trade conditions.

The authors also derive the net elasticity of equilibrium price
with respect to the revaluation:

'$P.z - 'f ■ <*>

This result also contrasts with the analogous free trade condition
(equation (27)):

EQD > =1_ •

t5ri-, fas

The revaluation also produces a larger effect in equilibrium price than
under free trade conditions.

In the second case, where the member country currency revalues
against the dollar but not against the unit of account, the variable
levy does not change since the dollar price at Rotterdam has not
changed. Nevertheless, the imports are cheaper to the revaluing
country. The excess demand relationship must again be rewritten to
reflect the now fixed variable levy:

QD = a2 + b2 x (($P + VL • z)/x) (b2 < 0) (32c)

where VL is the variable levy. Now the dollar price enters again the
excess demand equation so that equilibrium quantity and price must be

67

calculated in conjunction with excess supply (equation (24)) which is
also a function of dollar price. However, the total differential of
(32c) is identical with the differential of excess demand under free
trade. Consequently, the result in this case is the same as under free
trade.

Summary of Theoretical Studies

Schuh [1974] elicited much theoretical response on the issue of
exchange rate effects on the U.S. agricultural sector. Although Schuh
concentrated on the effect of a dol.lar overvaluation on the structure of
U.S. agriculture, the response was mostly limited to the importance, in
terms of output price and export quantity effects, of the devaluations
of the early 1970s. Kost's [1976] conclusion that under free trade the
percentage change in quantity exported must be less than or equal to the
percentage change in the exchange rate has been subsequently refuted by
the literature. However, the response of price to an exchange rate
change has remained controversial. Chambers and Just [1979] assert that
the restrictive assumptions of a one-commodity model lead to the
conclusion that the exchange rate elasticity of price must be unitary or
inelastic; a more realistic n-commodity case would not put lower bounds
on the values of the elasticity. Bredahl et al . [1979a] answer that
even the n-commodity case gives the result that the elasticity must be
bound to the (0, -1) interval.

Models of trade under market interference indicate that the
interference can alter the response of export price and quantity to a
movement in the exchange rate. They also show that the nature of the
alteration in response depends on the nature of the interference, so

68

that no generalized conclusions can be made. Furthermore, in an
environment of trade restrictions, the response to a devaluation will
not necessarily be the opposite to that of a revaluation of an equal
magnitude. Consequently, making more realistic assumptions about the
conditions of agricultural trade complicate any theoretical
corroboration of Schuh's arguments.

The Agricultural Economy and Discreet Dollar
Devaluations: Empirical Studies

The first empirical study to deal with the effects of the
devaluations of the early 1970s on the U.S. agricultural economy was by
Greenshields [1974]. The study consisted of estimating through ordinary
least squares (OLS) procedures the Japanese demand for four American
agricultural products: wheat, corn, soybeans, and sorghum. After
estimating the parameters, he estimated predicted import demand in
1971-1973 by alternatively using actual exchange rates and constant 1970
rates. The difference in quantity demanded under the two alternatives
was attributed to the exchange rate. Greenshields concluded that a
32-percent increase of the purchasing power of the Japanese yen in U.S.
export markets in 1971-73 produced a three-percent increase in wheat
sales, a seven-percent increase in soybean sales, and no significant
response in sales of corn and sorghum. His findings did not lend
empirical support to the importance of exchange rates to agriculture but
were the subject of later criticism by Chambers and Just [1979]. They
felt that to the extent that Japan could influence individual grain
prices, OLS procedures were inappropriate and yielded biased results.

The first empirical response to Schuh [1974] was by Vellianitis-
Fidas [1976]. One part of this reference included a cross-sectional

69

study using OLS with a stepwise procedure. Exchange rate changes were
included as an independent variable. Its importance was judged by its
level of significance and whether it was dropped by the stepwise
procedure. Vellianitis-Fidas' first conclusion was that almost none of
the variation in agricultural products exported from 1971 to 1973 can be
explained by the variation in exchange rates, and that the U.S. did not
export relatively more or less to countries whose currencies had changed
the most in relation to the dollar.

The author also performed a time-series study which included trade
in wheat, corn, cotton, tobacco, and oilseeds during the 1954 to 1969
period. The explanatory variables used were the exchange rate as a
dummy variable and a trend variable as a "proxy" for all other
structural variables. Her finding was that the majority of countries
that imported these crops did not significantly change their level of
trade with the U.S. or from the world after they had changed their
exchange rates.

These findings minimize the importance of the exchange rate, but
they, too, were the subject of criticism centered around the lack of
theoretical basis for the models used. Indeed Vellianitis-Fidas [1976,
108] recognized as much: "the purpose of this analysis is not to build
a model explaining agricultural exports, but simply to look at the
significance of one variable— the exchange rate." Unfortunately,
statistical procedures do not allow the proper estimation of one
explanatory variable in isolation from other influencing variables.
Accordingly, Schuh [1975, 698] responded to an earlier version of the
paper by noting that the procedures were '"ad hoccery' of the worst
sort. Her model does not have the power to discriminate an exchange

70

rate effect, and therefore her results should be taken with a grain of
salt." Schuh also noted that representing reality in trade in the time-
series model with a trend and a dummy variable would lead to meaningless
conclusions. Chambers and Just [1979] levied similar criticisms.

Some of the later empirical models began to explicitly account for
restrictions in agricultural trade. Among the first was a spatial world
trade model presented by Johnson et al . [1977]. The model consisted of
a) a set of demand equations, b) a set of price relations, and c) a set
of market clearing equations:

Q.j = f (P° Z.) for i, j = 1,..., n (35)

P?j " rPl + *1J (36)

wlj Qlj + w2j Q2j +-%j Qnj = Sj *»■ J • l.....n ewij = 1. (37)

where Q. . = quantity consumed in country i of wheat originating in
country j ,
P.. = consumer price in country i of wheat from country j,

Z. = exogenous demand shifter for country i,

c
P. = supply price of country j,

t. . = exogenous shifters affecting difference between origin price

and consumer prices,

r = exchange rate between i and j ,

w. . = fraction of exports from country j that go to country i,

S. = exogenous supply in j.

The exogenous shifters are Z. , S., and t. .. The latter include all

the important trade policy changes and changes in transportation costs.

Although the model consists of six endogenous countries (U.S.A., Canada,

71

Australia, Argentina, EEC, and Japan) and an exogenous rest of the
world, making 32 endogenous variables, the authors concentrate on how
the domestic U.S. price of wheat is affected by a) a 10-percent dollar
devaluation with respect to Europe and Japan, b) a lowering of the EEC
variable levy (discussed in the previous section), c) higher export
taxes by Canada and Australia, and d) a rise in transportation costs of
U.S. exports to Europe and Japan due to restrictive U.S. shipping
policy.

The authors concluded that the combined trade policies of the EEC,
Canada, Australia, and Japan induced a 40.8-percent increase in the
price of U.S. wheat. On the other hand, the 10-percent dollar
devaluation produced a 7-percent increase in U.S. wheat price.
(Findings were for the year 1972/73-1973/74.) They also estimated that
a 30-percent rise in shipping costs due to U.S. shipping policy (a
reasonable assumption in the authors' view) induced a 7-percent decrease
in U.S. wheat price, thereby neutralizing the exchange rate effect. The
conclusion drawn from the study was that the role of the exchange rate
should neither be ignored nor exaggerated. Changes in trade policy had
a much larger impact on wheat prices in the early 1970's than the dollar
devaluations.

An empirical issue ancillary to the trade sector effects of
exchange rate movements has been the magnitude of the elasticity of
foreign demand for U.S. agricultural products. In support of his
argument that the exchange rate is indeed important to agricultural
trade, Schuh [1975] cited foreign demand elasticity computations by
Tweeten [1967] which were quite large: a maximum of -15.85 under free
trade and -6.42 under assumptions of restricted trade. Johnson [1977]

72

also produced large estimates of free trade elasticities, ranging from
-2.8 for soybeans to -10.18 for feed grains. Bredahl et al . [1979b]
consider these large estimates the result of improperly accounting for
the price transmission effect, i.e., the adjustment of foreign prices in
response to changes in U.S. prices. Domestic price insulation reduces
or altogether eliminates price transmission effects and, in turn,
reduces the elasticities of export demand. The authors estimate the
elasticity of export demand for several crops by explicitly considering
the effects of price insulation. They alternatively assume for each
crop a maximum price transmission elasticity of 1.0 and a minimum of
zero. The lowest estimate they obtained for an elasticity of export
demand was -0.09 for corn while the maximum estimate obtained was -2.36
for sorghum. These relatively low estimates imply that the exchange
rate effects on quantity traded may not be as large as Schuh [1974] had
suggested.

Meyers et al . [1979] make use of the notion of price transmission
effects to show how trade restrictions have an impact on exchange rate
trade effects. They develop a model for the computation of these
effects which includes a) the estimation of foreign internal demand
elasticities, and b) the estimation of price transmission effects which
make the exchange rate explicit. For the small country case the
exchange rate effect on quantity exported in percentage terms (i.e.,

Eq.x» 1S

dQD, dr(

" <EdH Epli + Ed21 Ep21> "77 (38)

QDi v dli pli d2i "p2i ri

1 import demand,
E., . = own-price elasticity of demand,

where QD. = total import demand,

73

E d2- = cross-price elasticity of demand,

E ,. = elasticity of price transmission for pli,

E 2l- = elasticity of price transmission for p2i ,
i = subscript for ith country,
r = foreign price of the dollar.
The authors make note of two implications of this model. First, in all
countries which insulate all relevant prices (E , . = E 2- = 0), no
exchange rate effects should be expected. Regardless of the magnitude
of the domestic price elasticities, the price transmission elasticities
would be zero and there would be no change in import demand for that
country. Second, even if demand is homogeneous of degree zero in
prices, an exchange rate adjustment can have an impact if not all price
transmission elasticities are of similar magnitude.

Meyers et al . [1979] estimate the effects of the appreciation of
the Japanese yen in relation to the dollar. They apply the model to
wheat, feed grains (corn and sorghum), and soybeans. Since Japanese
prices for wheat and its substitute, rice, are fixed above the world
price, the price transmission elasticities are zero for both
commodities, and exchange rates would not be expected to have any impact
on Japanese wheat imports. For soybeans and feed grains the Japanese
domestic demand elasticities were estimated to be -0.23 and -0.44,
respectively. The price transmission elasticities were 0.90 and 0.96
for feed grains and soybeans, respectively. Using the above small
country model which provides maximum exchange rate effects, the authors
compute the exchange rate elasticity for quantity traded to be -0.21 for
feed grains and -0.42 for soybeans. The trade response to an exchange
rate change is inelastic, contrary to Schuh's [1974] suggestions.

74

In further work along these lines, Collins [1980] estimated a) the
foreign price effects in elasticity form of a change in the U.S. price
of wheat, corn, and soybeans and b) the foreign price effect of a change
in the exchange rate. These are the elasticity of price transmission
and the now familiar exchange rate elasticity of price (E*D ). The

■!>r ,X

study included 47 countries. Collins found these estimates to run the
whole range from zero to one. These findings complement the work by
Bredahl et al . [1979b] who had used the price transmission extremes of
zero and one to compute maximum and minimum estimates of elasticities of
export demand.

Additional sophistication was brought to the issue by Collins et
al . [1980] by including inflation in an analysis of exchange rate
changes under free and restricted trade. The authors specified a world
market equilibrium system for each of four commodities: wheat, corn,
soybeans, and cotton. The system consisted of a domestic demand and
supply relation for each country engaged in trade, a market clearing
world equilibrium condition, and price linkage equations based on a
numeraire
country (U.S.) :

D. = D. (P^OPj) (39)

si ■ St (yOP^ (40)

Sus-DuSi <Di- V <41>

Pi = 9i <ei Pus) <42>

75

where D- = domestic demand in country i,

S. = domestic supply in country i,

P. = own-price in country i,

OP. = general level of output prices in country i,

-1 = one year lag,

S = supply of the U.S. ,

D = demand of the U.S.,

= summation of operator excluding the U.S.,

i

e. = value of ith country's currency per U.S. dollar,

P, „ = U.S. price,
us r

By taking the total differential of these four equations and solving for
real (deflated) U.S. commodity price, the authors note that this price
depends on a) changes in the general price levels and exchange rates in
the current period and b) a supply effect due to price and exchange rate
changes in the previous period.

The authors first use the model to compare the impacts of
inflation-adjusted exchange rate changes in a world characterized
alternatively by a) free trade, b) nominal-price insulating trade
policies, and c) real-price insulating trade policies. They find that
the impact of exchange rate changes is largest under nominal -price
insulation conditions. They conclude from this exercise that if foreign
countries had tried to hold real prices fixed during the 1970s, the
inflation-adjusted exchange rate impact on U.S. prices would not have
been different than if they had engaged in free trade.

Their next step is to decompose the inflation-adjusted exchange
rate impact on real U.S. wheat prices into demand, supply, and nominal
exchange rate effects in an environment of restricted trade. They find

76

that in five of the seven years between 1970 and 1978 the nominal
exchange rate impact was negative, i.e., it reduced output price. This
result is explained by the fact that much of U.S. wheat exports is
destined to developing countries whose currencies depreciated against
the dollar as the dollar depreciated in relation to other major
currencies. The authors thus caution on the inappropriateness of using
simple exchange rate measures to infer exchange rate impacts for
individual commodities. In analyzing demand and supply effects, they
conclude that the real exchange rate impacts during the 1970s depended
on both current and past exchange rate changes and that the economic
impact of these changes in any one year have been offsetting; e.g. an
exchange rate movement last year might induce a supply effect this year
which neutralizes a demand effect caused by a movement this year.

Finally, the authors compared the real exchange rate effects on
U.S. prices for wheat, corn, cotton, and soybeans (under the trading
conditions most appropriate to the individual commodity) with the
actual, registered real price change. They concluded that real exchange
rates had a minor role in the large registered increases in commodity
prices during the period. For example, of the 108-percent increase in
real wheat prices from 1972/73 to 1973/74 only 7 percent can be
attributed to the change in the real exchange rate.

Lessons to be drawn from the study were among the authors'
concluding remarks:

The alluring simplicity of being able to announce exchange
rate impacts on trade, hence prices, as simply large or small
is rejected. Their size depends on the crop, the year, the
countries considered, the degree of government influence on
markets, the underlying elasticities, the price variable that

77

is measured, whether real or nominal, the alternative prices
considered, and importantly, the definition of the exchange
rate effect. [Collins, et al 1980, 664]

A completely different form of empirical analysis—and not one
adhering to the recommendations above by Johnson et al [1980]— was
undertaken by Chambers and Just [1981]. Their focus was on the dynamic
effects of an exchange rate change on both the domestic and the trade
sectors of U.S. agriculture. For the purpose they built a simultaneous
system of 15 equations for the corn, wheat, and soybean markets. The
system included for each of the three crops a disappearance, inventory,
production, export, and an identity equation. The latter merely states
that production plus lagged inventory must equal (domestic)
disappearance plus exports plus current inventory. The exchange rate is
included as a simple SDR (Special Drawing Right)/dollar separate
regressor in the export equations. This treatment implies that exports
respond to the exchange rate independently of prices; the separate
exchange rate regressor prevents the exchange rate from being a simple
price deflator. Also, no attempt is made to discriminate between
multiple exchange rate changes. No attempt is made to explicitly model
restrictions in agricultural trade. However, the inventory and
disappearance equations represent an attempt to measure the domestic
impact of an exchange rate change and not just export quantity and price
effects. The approach is more in line with the concerns originally
expressed by Schuh [1974].

The authors derive three-stage least squares reduced-form estimates
of the coefficients along with the elasticities of the different
explanatory variables. Their results agree with the arguments made in
Chambers and Just [1979]: they find that the exchange rate elasticity

78

of price is elastic in all cases. They thus cite a substantial effect
of the exchange rate on grain prices. They estimate that between 1971
and 1975 about 70 percent of the increase in deflated wheat price can be
explained by short-run adjustments to the exchange rate. The effects on
export quantity are also large: the dollar depreciation over the period
accounts for all of the increase in wheat and soybean exports and over
90 percent of the increase in corn exports. Regarding the domestic
impacts, the authors note that the production impact of an exchange rate
is nil. The wheat and corn markets respond to the rise in exports
(caused by the depreciation) by drawing on inventories while the soybean
market curtails domestic consumption relatively more.

The analysis of dynamic effects via dynamic multipliers lead the
authors to conclude that peak effects are registered soon after a
depreciation, generally during the first quarter. But the effects of
later quarters add to the effects of earlier quarters. Therefore
short-run elasticities are smaller than those of the long run. For
example, the short-run exchange rate elasticities of wheat, corn, and
soybean prices are -1.242, -1.903, and -2.643, respectively. The
respective long-run elasticities are -0.790, -1.377, and -2.165. The
authors note that corn and soybean prices remain elastic, while the
long-run elasticity of wheat is similar to the estimate by Johnson et
al. [1977].

These findings lend empirical support to Schuh [1974]. In the
authors' words [Chambers and Just, 1981, 45]: "The results . . . imply
that the devaluation and subsequent floating of the dollar may have had
important allocational effects in the U.S. economy."

An earlier and simpler reference also lent support to the
importance of exchange rates. Konandreas et al . [1978] simply estimated

79

the export demand for U.S. wheat from several regions of the world.
Neither simultaneities nor wheat trade restrictions were modeled. Using
the coefficient estimates, they calculate the exchange rate elasticity
of export demand. They find that the demand for U.S. exports of wheat
is responsive to currency realignments; the elasticity for each region
is estimated to be greater than one in absolute value. They also find
that the less developed the region, the greater is the response to
currency changes.

Finally, Loseby and Venzi [1979] take a multinational approach to
the measurement of exchange rate effects. On a worldwide basis they
record the actual price effect of an exchange rate change between an
exporter and an importer in the trade of six crops: wheat, cocoa, corn,
coffee, cotton, and tea. Their focus of attention is the price movement
after import demand and export supply adjust to the exchange rate
change. These movements are categorized into three groups: a)
movements that are ameliorated by the exchange rate change (e.g. an
importer appreciates by 10 percent, and its import commodity price drops
by 5 percent), b) movements that are reinforced by the exchange rate
change (e.g. an importer appreciates by 10 percent, and its import price
drops by 15 percent), and c) price moves contrary to expectations (e.g.
an importer appreciates by 10 percent, and price increases by, say, 2
percent).

It is interesting to note that case b) implies that the exchange
rate elasticity of price is positive, while case c) implies it is
greater than one in absolute value. Both of these cases contradict the
results of two-country models such as that of Bredahl et al . [1979a]
where the elasticity is determined to be bound to the (-1, 0) interval.
Loseby and Venzi list conditions in a multinational environment which

80

can lead to results that fall in b) or c) (to which the reader can

refer) .

The authors find that out of 24 observations during 1973-76, two
fit in category a), 14 in category b), and eight in category c). These
results suggest that the exchange rate elasticity of price can include a
large range of positive and negative numbers and contrast sharply with
the results of previous models that have concentrated on U.S. trade with
the rest of the world.

The empirical studies reviewed have mostly concentrated on the
measurement of the export price and quantity effects of the dollar
devaluations of the early 1970s. The indications obtained have been
varied and contrasting. Generally, the studies which have considered
the complications of agricultural trade-various forms of restrictions,
divergent multilateral exchange rates, differential inflation rates
between countries, restricted shipping-have found that the exchange
rate plays a minor although not insignificant role in agricultural
trade. Studies that have abstracted from these complications have
tended to lend greater importance to exchange rates. One study with
many importers and exporters reaches findings obtained by none of the

others.

One can conclude that empirical research has not led to a synthesis
of professional opinion on the effect of exchange rate changes on
agriculture.

Flexible Exchange Rates and the Agricultural Economy

The articles reviewed above compose the bulk of exchange rate
research in the agricultural economic literature. Despite their

81

disparate approaches and conclusions, they have had the common trait of
having dealt with discreet changes in the exchange rate in an
adjustable-peg environment. However, as indicated earlier, the real
international monetary environment when all the articles were published
was one of flexible exchange rates whose movements occur in continuous
rather than discreet fashion. And more importantly, the section on
exchange rate determination showed that these continuous changes occur
much more at the behest of financial market forces than the discreet
changes. In other words, flexible rates are endogenous to financial
market conditions in the general economy.

This endogeneity implies that if the exchange rate affects
agricultural trade, then the financial market forces that affect the
exchange rate must also have an indirect impact on agriculture. The
flexible exchange rate becomes one vehicle by which the financial forces
of the general economy affect the agricultural economy.

The linkages between the national and agricultural sectors have
been the subject of an increasing number of articles in the agricultural
economics literature. However, few have recognized the flexible
exchange rate as one of those linkages. The agricultural economics
literature on macroeconomic linkages has taken three forms: a) no
reference to exchange rates, b) treatment of the exchange rate as a
financial factor that affects agricultural trade but one which is
exogenous both to the agricultural and general economies, and c)
treatment of the exchange rate as a financial factor that affects

82

agricultural trade and one which is endogenously determined in the
general economy. Some examples for each type are described below.

Linkages with Exchange Rates Excluded

The examination of linkages is not a new activity. Doll [1958]
looked at the efficacy of using an expansionary money policy to
alleviate the cost-price squeeze induced by the recession of the late
1950s. He found for the ten previous years a poor relation between
prices paid by farmers and money supply. He thus concluded that an
expansionary policy was not an effective way of alleviating the cost-
price squeeze. Gramm and Nash [1971] studied whether the general and
agricultural economies responded differently to changes in monetary
conditions. Using 1919-1966 data they find that both sectors respond in
similar fashion to money stock changes; farm and nonfarm income
experience equivalent changes as a result of changes in the money stock.

Neither of these studies considered the exchange rate as a possible
vehicle of connecting monetary policy with the agricultural economy, but
the omission was probably not important, since the studies were
performed during the period of adjustable-peg exchange rates which were
to a large extent determined by exogenous government decisions.
However, some recent contributions to the linkage issue have also
neglected proper consideration of the exchange rate. For example,
Barnett et al . [1981] examine the causal linkage between the quantity of
money in circulation and agricultural prices, using the quantity theory
of money as a theoretical foundation. Consideration of flexible
exchange rates is omitted, even though the quantity theory of money can
certainly be related to exchange rate determination.

83

Perhaps it is this omission which leads to a puzzling conclusion.
The authors find that during 1971-1979, U.S. prices follow reserves of
developed countries by 16 months; i.e., there is a causal link between
U.S. agricultural prices and changes in the money stock of developed
countries. In an environment of fixed exchange rates, -this result is
understandable; increased money stocks abroad increase foreign demand
for U.S. agricultural products whose prices rise accordingly. But in an
environment of multilateral flexible exchange rates, price effects of
foreign money supply changes tend to be offset by exchange rate
adjustments [Balassa, 1979].

It also appears that sectoral models of U.S. agriculture are
incomplete in terms of the treatment of exchange rates and the financial
markets. In a review of agricultural models and the linkages to the
general economy Subotnik [1981] laments that the models ignore foreign
trade's effect on the exchange rate and that the theories of exchange
rate determination have not yet been analyzed in the context of
agricultural models.

Linkages with Exogenous Exchange Rates

This group probably composes the largest number of contributions
dealing with macro-linkages. A sophisticated example is the work by
Shei [1978]. He constructed a 24-equation general equilibrium model of
the U.S. economy. The model included both the financial and goods
markets and was sufficiently disaggregated to capture simultaneities
between the agricultural sector and the general goods and financial
markets. The model included a composite exchange rate (SDR/$), but it
was exogenously determined. With this model Shei could obtain a

84

measurement of the impact of monetary phenomena on the agricultural
sector as the former affected interest rates but could not measure the
additional impact of these phenomena as they express themselves via the
exchange rate. As an exogenous variable, Shei found that the exchange
rate did affect agriculture, but its effect was dominated both
absolutely and proportionately by monetary effects.

In another contribution Gardner [1981] tried to gauge the
significance for agriculture of macroeconomic events in the 1980s. In
doing so he categorized the macroeconomic linkages to agriculture in
three groups: a) "Walrasian" influences, b) "Marshallian" influences,
and c) "Keynesian" influences. The Walrasian influences are the forces
associated with the attainment of general equilibrium between sectors,
especially the equalization of rates of returns in factor markets. The
Marshallian influences are composed of standard shifters of demand and
supply such as income and population. The Keynesian category was a
catch-all for "nonstandard hypotheses" [Gardner 1981, 877]. In this
category the author includes recessions and the exchange rate. The
latter, merely regarded as an "export related variable" [Gardner 1981,
875], is again treated as exogenous to both the agricultural and general
economies. In single-equation regressions intended to explain changes
in farm prices received, the exchange rate is a separate regressor
independently accompanying other regressors such as inflation. The
implication is that there is no joint-dependence between farm prices,
inflation, and the exchange rate. The exchange rate in this view is not
a vehicle for transmitting financial market influences to the
agricultural sector. Thompson [1981] noted and criticized this
single-equation approach.

85

In another recent reference Grennes and Lapp [1981] try to
determine whether the exchange rate affects real agricultural prices.
Their approach is to consider the purchasing power parity condition:

PA - b0 PJt h 2 (43)

where P. and P* are nominal U.S. and foreign agricultural prices and E
is a trade-weighted exchange rate. The authors test whether purchasing
power parity holds: b, = b« ■ 1 (products sell everywhere for the same
price expressed in a given currency). The authors reject this
hypothesis.

The validity of this test is questionable for two reasons. First,
nominal prices are used in the estimation of the equation so that the
latter can say little about real price behavior. Second, purchasing
power parity, as expressed above, is at best an equilibrium identity.
If tested as a behavioral equation, it implies that a) U.S. farm prices
depend on foreign farm prices and the exchange rate, b) foreign farm
prices do not depend on U.S. farm prices, and c) the exchange rate does
not depend on U.S. farm prices; it is exogenous to the relation
considered. It is difficult to imagine the real world satisfying all
these conditions.

Linkages with Endogenous Exchange Rates

Schuh [1976, 1979, 1982] was the first to recognize the importance
to agriculture of flexible exchange rates that are endogenous to
financial market conditions. He has couched his arguments in terms of
the instability that monetary policy can bring to agriculture via the
exchange rate [Schuh, 1982, 84]:

86

The change in how monetary policy affects agriculture comes
about because changes in monetary policy are reflected in
changes in the value of the dollar. A tight monetary policy,
other things being equal, leads to a rise in the value of the
dollar and a decline in the competitiveness of the export
sector in international markets. An easy monetary policy, on
the other hand, leads to a decline in the value of the dollar
and increased competitiveness. To put it simply, the trade
sectors bear the adjustment of changes in monetary policy, and
trade is now important to agriculture.

The argument made is that monetary policy affects agriculture not
only through the effects on interest paid on operating capital, the
level of business activity, etcetera. It also produces an impact by
affecting agriculture's trading sector via induced movements of the
flexible exchange rate. The magnitude of the impact will depend on the
importance of the trade sector to agriculture.

To ellucidate the difference in approaches between Schuh [1976,
1979, 1982] and most of the other references in agricultural economics,
the simple two-country model of the other references in agricultural
economics, the simple two-country model presented by Bredahl and
Gallagher [1977] is useful. The model includes the standard demand and
supply relations and a market-clearing condition.
Remembering that x is the foreign price of the dollar:

QD = a2 + (b2 x) $P (b2<0) (23)

QS = a, + b1 $P (b^O) (24)

QD = QS. (25)

This set of equations indicate that a change in the exchange rate will
cause a change in the trade flow, but nothing in the system of equations
affects the exchange rate x. Following Schuh's reasoning, one more
equation can be added:

87

x=f (VMus' Fi'Fus> (44)

where M. and M are foreign and U.S. foreign money supply and F.. and
F are foreign and U.S. asset market variables. The exact choice of
asset variables would depend on which theory of exchange rate
determination one would wish to apply (e.g. monetary or portfolio-
balance). Equation (44) serves to make the exchange rate endogenous to
the financial conditions in the general economy. These financial
conditions then affect the agricultural trade flow by producing an
impact on the exchange rate x.

The effect of flexible exchange rates on the agricultural sector is
also given special importance by Starleaf [1982]. The author traced the
instability of farm income during the 1970s to the variability in farm
prices (in contrast to farm output, which experienced relatively little
change). He then highlighted a high positive correlation between money
supply and farm prices. His explanation for the correlation follows
Schuh: an expansion of the money supply leads to a depreciation of the
dollar which boosts the price (in dollar terms) of the farm output with
an export market.

Probably the most thorough theoretical work to data on the
relationship between flexible exchange rates and the agricultural sector
has been provided by Chambers [1982]. The author assumed a two-country
world and a financial market very similar to that described by Branson
et al. [1977]. To the financial market Chambers added an agricultural
and a nonagricultural production sector for both the domestic and
foreign countries. Agricultural stocks are also explicitly considered.
Chambers' main deviation from the exchange rate determination models
that predominate in the literature is that he allows the agricultural

goods market to achieve equilibrium in the short run. The usual
assumption is that the financial and not the goods market is able to
achieve short-run equilibrium. Under these assumptions six equilibrium
conditions are derived:

f*W* + EfW = F* (45)

mW = M + R (46)

m*W* = M* + ER* (47)

h + XA " DA " SA " SA + DA " XA " SJ (48)

PN = CN (qL, qK) (49)

PA = CA (qL, qK) (50)

where f = demand function for foreign securities,

F = supply of securities,

W = nominal private wealth,

E = the foreign/domestic exchange rate,

m = money demand function,

M= central bank liabilities,

R = country's reserve asset holdings,

S. = agricultural stocks at the beginning of the period,

S» = agricultural stocks at the end of the period,

X. = agricultural production,

Dn = aggregate demand for agricultural products,

p = output price,

C = cost function,

q = input price,

89

A,N = subscripts for agricultural and nonagri cultural sectors,
respectively, and

K,L = subscripts for capital and labor, respectively.
Asterisks denote a foreign country variable. To perform a comparative
statics analysis, Chambers also assumes that the law of one price (i.e.,
p* = p.E) holds even in the short run. Most previous models make this
assumption only for the long run.

The results of the model underscore the complexity of the
interaction between the various markets and the difficulty in arriving
at definite conclusions. In modeling the effects of a contractionary
open market operations (0M0) by the domestic central bank the author
finds that it is impossible to unambiguously establish whether the
operation leads to an increase or decrease in the exchange rate E or in
the foreign or domestic interest rates r* and r. However, by assuming
that a) a country's currency is a better substitute for its own bonds
than for the other country's bonds and b) that an appreciation of the
domestic currency does not create a permanent excess supply of the
foreign currency, chambers establishes that the 0M0 raises E and r (the
domestic currency appreciates) and probably decreases r*. This 0M0, in
turn, pulls agriculture in two directions. The appreciation of E and
the rise in r depress agricultural price and income. The fall in r*
boosts agricultural price and income. For the price strengthening
effect of the fall in r* to dominate, foreign stocks must play a
dominant role in international price determination. Chambers believes
this is not the case, and tentatively concludes that a contractionary
0M0 depresses agricultural price and income.

The first authors to endogenize the exchange rate in an empirical
agricultural trade model were Chambers and Just [1982]. The model

90

contained three recursive blocks: a) an agricultural block with the
wheat, corn, and soybean marktes, b) a block for the current account
trade balance net of the value of wheat, corn, and soybean exports, and
c) a reduced-form model of exchange rate (SDR/$) determination. This
latter model follows ad hoc procedures rather than any specific theory
of exchange determination appearing in the literature. The exchange
rate is considered to be a function of the balance of trade, domestic
credit, the discount rate, the general price level, and aggregate
income. The agricultural block follows the procedures in Chambers and
Just [1981]. The export equations are regarded as reduced-form
equations that "do not represent either demand or supply of exports but
rather the overall quantity of exports resulting from demand and supply
interaction" [Chambers and Just, 1982, 237].

The authors analyze the results in terms of the dynamic, long-run
impact of changes in domestic credit on agricutural exports and prices.
They find an elastic long-run response in the exports of wheat and corn
but an inelastic one for soybeans. They also find that grain prices are
very responsive to fluctuations in the level of domestic credit. It is
interesting to note, however, that the models of exchange rate
determination explain the relationship between domestic credit and the
exchange rate only in the short run. There is a lack of theoretical
foundation for determining the long-run effects of domestic credit on
agricultural trade via the exchange rate. Thus, these long-run
empirical results need cautious interpretation. It is also interesting
to note that the results of this empirical model contrast with the more
ambiguous theoretical results found by Chambers [1982].

91

Van Duyne [1979] has been another of the few authors that have
considered endogenous exchange rates in conjunction with agriculture.
However, his focus was a problem that is a mirror-image of the problems
usually treated by agricultural economists: whether shocks in the
agricultural sector can have repercussions in the general economy.

To answer the question, Van Duyne constructs a theoretical
two-country model with and agricultural and a manufactured good. Each
country specializes in the export of one good. The three assets
included were commodity stocks, domestic money, and foreign exchange.
They are imperfect substitutes in portfolios, as asset holders allocate
their wealth among the three assets. Since asset stocks are fixed in
the short run, spot prices and the exchange rate have to adjust so that
asset holders are willing to hold existing stocks. The exchange rate
and prices are therefore determined simultaneously in asset markets and
are subject to shocks such as bad harvests. Van Duyne finds that
agricultural shocks of the magnitude of 1973-74 have significant effects
on prices, exchange rates, and capital flows. These effects persist
long after the initial shock. It should be noted, however, that the
simplification that one country specializes in the export of one
commodity reduces the applicability of the conclusions to a country such
as the U.S. with a mix of agricultural and manufactured exports.

The articles cited in this section compose the few contributions
which have explored the linkage between the financial markets and the
agricultural sector which is provided by the exchange rate. The dearth
of research in this area is the subject of a review by Chambers:

. . . perhaps too much time was spent arguing about the theoreti-
cally plausible size of the effect of the devaluation of the
early 1970s on agricultural commodity trade. Altogether too

92

little time was spent on the next logical step in the pro-
gression—the investigation of the effect of the current
determinants of the exchange rate on agricultural commodity
trade. [1981, 935]

CHAPTER V
INTERRELATION OF THE EXCHANGE RATE LITERATURE

The research areas of the articles covered in Chapters III and IV
can be related in terms of a schematic diagram, Figure 9. The diagram
contains four points of interest: a) monetary policy, b) fiscal policy,
c) the financial markets, and d) the goods market. The latter has two
subdivisions: the agricultural and the trade sectors. These two have a
common area, namely, the agricultural trade sector. The arrows denote
linkages between the points of interest and chart the flow of causation
from the agent to the subject of change. The arrows are numbered to
facilitate exposition.

The first three arrows refer to what is traditionally regarded as
the "monetarist" view of macroeconomics. Arrow 1 indicates the effect
of monetary policy on the financial markets. For example, a restrictive
policy causes a shortfall of money relative to bonds. In order to
maintain financial equilibrium, interest rates must rise to induce
portfolios to hold bonds. Higher real interest rates cause a reduction
in real activity, Arrow 2 (at least in the short run). Arrow 3 points
to the "crowding out" effect of fiscal policy. Higher government
deficits raise demand for available loanable funds, raising interest
rates and reducing real activity.

Arrow 4 refers to the traditional " Keynes i an" view of
macroeconomics. The level of economic activity can be regulated by
government via its fiscal policy. In case of an economic downturn due

93

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to, say, reduced investment activity, government can take up the slack
by increasing deficit spending. Conversely, inflationary impulses can
be controlled by reduced deficits.

Arrow 5 is indicative of the elasticities approach to exchange rate
determination as described by Sohmen [1969] and Yeager [1976]: the flow
of goods in the trade sector determines the exchange rate. Negative net
exports induce a balance of payments deficit which could be temporarily
covered by finite foreign currency reserves. To correct a persistent
deficit, the domestic currency must depreciate to make domestic goods
cheaper relative to foreign goods both at home and abroad. The deficit
is thereby shrunk. An equilibrium exchange rate is achieved when the
deficit is zero. Causation flows from the trade sector to the exchange
rate.

Arrow 6 encompasses the literature on exchange rate instability and
how that instability may affect international trade. This issue
involves the role of speculation in exchange rate determination and
includes the work by Bernstein [1978] on destabilizing speculation, by
Friedman [1953] on stabilizing speculation, and by McKinnon [1976] on
insufficient stabilizing speculation. The topic also covers the
practical issue of whether unstable flexible exchange rates are a
detriment to international businesses as treated by Teck [1978], the
econometric study by Hooper and Kohlhagen [1978], and the examination of
movements in international prices and exchange rates by Balassa [1979],

Arrow 6 can also refer to the question of external adjustment under
flexible exchange rates. Artus and Young [1979] discuss the reasons for
Arrow 6 to represent a weak link in this regard: flexible rates did not
facilitate adjustment as well as originally expected. McKinnon [1981]

96

also considers Arrow 6 to be a weak linkage and argues for the linkage
represented by Arrow 7. He concludes from his analysis that in an open
economy government savings are the most direct instrument for public
officials to affect the trade balance; manipulating the exchange rate
yields indeterminate results. Thus fiscal policy becomes an important
determinant of the trade balance.

Arrow 8 refers to the question of whether flexible exchange rates
promote inflation. Salant [1977] considers that the flow of causation
as indicated by Arrow 8 is possible but unlikely. A more plausible flow
would be indicated by Arrows 1 and 9 along with 8. For example, an
expansionary money policy fuels domestic inflation (Arrow 1), which
forces the exchange rate to depreciate (Arrow 9). This depreciation
makes traded goods more expensive and aggravates inflation (Arrow 8).
Willett [1977] was even more forceful in arguing that this flow of
causation has been the one of relevance, and not Arrow 8 in isolation of
the other two. (This part of the literature also included the issue of
exchange rate variability and world inflation, but this topic cannot be
encompassed by a schematic diagram of one national economy.)

The asset approach to exchange rate determination is a detailed
examination of the linkage represented by Arrow 9. The different
contributions in this field differ as to the assumptions made about the
composition of the financial markets. The monetary school, e.g. Frankel
[1979], assumes perfectly substitutable foreign and domestic interest-
bearing assets, while the portfolio-balance approach, e.g. Branson et
al . [1977], make the two imperfectly substitutable and requiring
explicit treatment. Despite these differences all the models include
the linkage represented by Arrow 1: monetary policy is regarded as a

97

primary factor determining conditions in the financial markets and,
therefore, the exchange rates. The linkage denoted by Arrow 3 is
usually disregarded.*

Arrow 10 represents the linkages treated by the bulk of the
agricultural economics literature on exchange rates. The latter are
treated as exogenous variables that move in discreet form and affect the
agricultural trade sector. The different articles contained different
theoretical and empirical approaches to the quantification of the
linkage represented by Arrow 10. As has been previously discussed, the
results have been contrasting and have depended on the assumptions made
about exchange rates (e.g. whether they were treated as simple or
multiple) and about agricultural trade (e.g. whether it was treated as
restricted or free). Despite their widely different approaches,
however, most of these studies have had the common element of studying
the linkage of Arrow 10 in isolation of all the others; exchange rates
were determined by an exogenous force.

Schuh [1976, 1979, 1982] suggests an approach more relevant in an
era of flexible exchange rates. He suggests a linkage provided by
Arrows 1, 9, and 10. That is, he first involves monetary policy and the
financial markets (Arrows 1 and 9) in the determination of exchange
rates that experience the constant incremental movements of the flexible
system. Then he considers the exchange rate effects on agricultural
trade (Arrow 10). This approach contrasts with the one taken by the

*A more precise diagram would need to include at least the monetary
policy and financial market "boxes" of a foreign country, or more
completely still, the whole diagram for a foreign country. However, it
was deemed that the gains in precision would be outweighed by the loss
of clarity.

98

bulk of the agricultural economics literature where rates are assumed to
experience large (e.g. 10 percent) one-shot changes. But more congruous
with the general economics literature which has been dealing with the
problem of flexible exchange rate determination since soon after the
adoption of the float. Chambers and Just [1982] provide an empirical
analysis of this linkage.

This type of macro-linkage proposed by Schuh differs markedly from
the sort usually suggested in the agricultural economics literature.
For example, Doll [1958] and Gramm and Nash [1971] assume a linkage
represented by Arrows 1 and 11. Monetary policy affects the financial
markets, and these, in turn, affect the agricultural sector with no
specific impact on the trade sector of agriculture. A tight money
policy raises interest rates, which raise the cost of production, and
consequently the agricultural supply curve shifts upward.

The more recent work by Gardner [1981] considers a variety of
macro-linkages. The latter includes exogenous inflation which can be
represented by Arrow 11 and exogenous exchange rates, Arrow 10. Again,
the linkage between exchange rates and financial variables is
disregarded. Gardner also considers other linkages such as nonfarm
wages which lie beyond the scope of the diagram in Figure 9.

Finally, the federal agricultural commodity and research programs
could conceivably be considered as part of fiscal policy (as Gardner
[1981] seems to do) where money from the general economy is funnel ed
into the agricultural sector. Treated as such, fiscal policy would then
be directly linked to agriculture in a form represented by Arrow 12.

CHAPTER VI
THE EMPIRICAL MODEL

The literature reviewed in the previous chapters suggests that very
little empirical work has investigated the linkage between the financial
markets and the agricultural sector that is provided by the flexible
exchange rate. Following along the lines of the initial endeavor
provided by Chambers and Just [1982], a model will be presented here
which a) is more consistent with the literature on exchange rate
determination, b) is more complete in the specification of an agri-
cultural export equation, and c) addresses several issues excluded from
their study.

The specific objectives of the present model are

1) to determine the usefulness of constructing an effective
exchange rate for U.S. agricultural exports;

2) to measure the impact of exchange rate volatility on
agricultural real export prices and export volume;

3) to measure the impact of changes in financial market conditions
on agricultural exports, real export prices, and income;

4) to investigate the secondary effects on domestic consumption and
stockholding as export flows change;

5) to investigate the delay, if any, of response in the
agricultural trade sector to changes in financial market
conditions;

99

100

6) to obtain an indication of the extent to which the exchange rate
and the financial markets have contributed to instability in the
agricultural sector after the adoption of flexible exchange
rates .

Presentation of Equations

The model is composed of two recursive blocks. One block consists
of a single equation for the determination of the exchange rate. The
other block models the agricultural sector, and is composed of five
equations with five endogenous variables.

The contemporary theories on the determination of the flexible
exchange rate are generally limited to the short-run, largely because in
the long-run the exchange rate and many of its determinants begin to
affect each other: modeling becomes very complex. Thus any model that
intends to explain the effects of the financial markets on the
agricultural sector via the exchange rate should limit itself to the
short run. The present model, in particular, limits itself to a time
frame of one quarter.

This time frame limitation imposed by the state of the arts in
exchange rate determination theory allows agricultural production to be
treated as fixed and exogenous to the system. Since production in
agriculture is a yearly event, the supply of agricultural products
within any one quarter is considered predetermined.

Exchange Rate Determination

Although the literature on exchange rate determination has
concentrated on bilateral rates, there have also been contributions on
multilateral or effective exchange rates. These rates usually are

101

composites constructed by taking a weighted average of different
exchange rates. The weights reflect the importance of different
countries to a nation's trade. The model presented here is an
adaptation of the work contributed by Larson [1980] and Porter [1979].

Following their arguments, movements in the exchange rate can be
explained by four determinants: a) the supply of money M, b) the
general price level P, c) aggregate real income Y, and d) the cumulative
current account deficit. The reasoning for this conclusion follows
monetary lines.

All currencies in circulation are held in the wealth portfolios of
individuals. The proportions in which people hold the currencies of
different countries in their portfolios depend on their needs and
desires based on present and future economic conditions. The exchange
rate is an important factor behind the mix of currencies they will want
to hold in their portfolios: they will want to hold currencies they
expect not to depreciate so that they will not suffer a loss in wealth.
As the exchange rate changes, people's expectations about which
currencies will appreciate or depreciate may change. Therefore, people
may want to readjust the currency mix in their portfolios. An
equilibrium exchange rate is achieved when people are willing to hold
the existing stock of each money; i.e., no one wants to adjust their
currency mix further [Larson, 1980].

With this portfolio approach the determination of the exchange rate
can be explained fairly simply. Consider the demand and supply of cash
balances. The demand is partly determined by people's income and the
general price level. The higher incomes and prices are, the higher is
the demand for money. More cash is needed to meet transaction needs at

102

higher incomes and prices. This need can be met by obtaining dollar
cash balances through the sale of foreign currencies. The movement out
of foreign currencies drives down their value relative to the dollar.
The relative value of the dollar rises until people become unwilling to
sell off more foreign currencies. Following this reasoning, aggregate
income Y and the general price level P are positively related to the
exchange rate [Larson, 1980].

Conversely, the supply of money M is negatively related to the
exchange rate. An increase in the money supply finds people holding
more dollars than they desire. They attempt to sell dollars for other
currencies, precipitating a fall in dollar prices. The fall will
continue until people are satisfied with the value of the stocks of
dollars and foreign currencies they hold. A log-run model would need to
consider the feedback effects of changes in the money stock on prices
and income but are assumed unimportant within the one-quarter framework
of the present model .

If the United States begins to run a current account deficit,
financial wealth is transferred to foreigners who have less need than
Americans to hold dollar cash balances (relative to total financial
wealth). Since the people receiving dollars are less willing to hold
them, they attempt to sell. The price of the dollar is driven down
until everyone is again satisfied with the dollar content of their
portfolios. Thus the current account balance CCA is positively related
to the value of the dollar. However, a lagged effect can be expected,
since an outflow of dollars must first occur before foreigners begin to
feel they are holding too many dollars.

103

It can also be hypothesized that the interest rate paid on dollar
accounts affects the willingness to hold dollars. As the dollar
interest rate rises, people in search of higher returns will try to buy
dollars, driving up its price. At the same time, however, higher
interest rates induce people to economize on cash balances. This
reluctance to hold dollars adversely affects the exchange rate. It can
also be argued that the interest rate is a variable that represents the
demand and supply conditions in the money market, conditions which are
already explicitly treated in the model. The effect of international
interest differentials, namely, the international transfer of capital is
also captured by the current account balance. Thus the interest rate
may be considered a superfluous variable which can be safely excluded.

Larson's [1980] model basically follows a monetary approach, since
it does not include foreign or domestic interest-bearing assets. The
implicit assumption is that these assets are perfectly substitutable by
foreign and domestic money. The model can be further generalized by
assuming imperfect substitutability and including the net outflow of
capital as an explanatory variable. An increased net outflow can be
expected to depreciate the dollar.

The level of the exchange rate in the previous period is also
included. It is assumed that the financial market conditions which made
an exchange rate "high" or "low" are not quickly reversed. Therefore, a
high exchange rate in the previous quarter is associated with a high
rate in the current quarter and vice versa. The coefficient should have
a positive sign.

The resulting equation for the determination of the exchange rate
ER in the current time period t is

104

ERt=f (Mt, Pt. Yt, CCAt_r Bt, ER^) (51)

where the sign over the argument indicates an expected negative or
positive partial derivative.

Two alternative measures of the exchange rate are used. One is the
effective dollar exchange rate FEDER published by the Federal Reserve
Bank (Federal Reserve Bulletin).* The other is an effective exchange
rate for U.S. agricultural exports AGER which has been constructed for
the purpose of the present study. This exchange rate is a weighted
average of the nine largest importers of U.S. agricultural products
which have had floating currencies in relation to the U.S. dollar since
the inception of the float.** The weights are calculated by the value
of exports to each country as a proportion to the total for the nine
countries. These weights change yearly to reflect changes in the export
pattern.

The reason for constructing this effective exchange rate for
agricultural exports is that agricultural trade flows are often very
different from the flow of trade in nonagri cultural products. For
example, in 1973-81 Japan represented 15.3 percent of the total U.S.
agricultural export market but only 8.0 percent of the nonagri cultural
export market [ERS, several years]. With differences in the relevant
weights an effective exchange rate for agricultural exports may differ

*For details on the computation of this exchange rate, see Federal
Reserve Bulletin (1978): 700.

**The countries included are Japan, Netherlands, United Kingdom, France,
West Germany, Italy, Canada, Spain, and Belgium. See the data appendix
for the values computed.

105

markedly from the usually published effective rates and may yield
different results in agricultural trade models.

The Agricultural Sector

The agricultural block consists of a simultaneous system of three
structural equations and two identities. The three equations are for
domestic disappearance, domestic stocks, and export demand. The five
endogenous variables are the quantities demanded for domestic
disappearance, domestic stocks, and exports plus the current real export
price and the exchange rate. Agricultural commodities are aggregated
into a single variable with a single price. The aggregation is done in
order to determine whether anything meaningful can be said about the
effects of the financial market on agricultural trade as a whole rather
than the trade in particular products. The aggregate consists of wheat,
corn, soybeans, barley, oats, rye, and rice. Livestock products are
excluded from the model, but this group composes a small fraction of
total exports. For example, animal and animal product exports totaled
only 10.8 percent of total agricultural exports in 1979 [ERS, 1980].

An important deviation from previous modeling efforts is that
importance is placed on the possible influence of price and exchange
rate values in previous periods on current quantities demanded. This
influence may exist for two reasons. One is the prevalence of
contractual agreements for future delivery, especially in international
trade. Current market price, whether spot or futures, will influence
the terms of the current contract, even though delivery may not take
place months into the future. For the same reason the current exchange
rate can also influence future deliveries.

106

This market friction explains the observed J-curve effects in the
general international economy: because the levels of current exports
have been precontracted, a depreciation of a nation's currency actually
aggravates that nation's balance of trade in the short run. Export
receipts remain steady because neither the precontracted quantity nor
the export price changes. Yet more must be paid for the (precontracted)
imports. This worsening of the trade balance is gradually alleviated
with time as new contracts are signed. The effect plotted on a graph
with the trade balance on the vertical axis and time on the horizontal
axis takes the shape of a "J," hence its name.*

The second reason why previous prices can affect current quantity
demanded is the role of price expectations. These expectations may be
especially relevant in a sector like agriculture where production
generally occurs only annually and (grain) commodities are storable.
For example, if current price has increased because of an apparent
harvest failure, then quantity demanded for storage may also increase
with the expectation of even higher future prices. Likewise, price
developments in previous periods (as well as the current period) can
play a role in the formation of expectations about future prices.

These expectations are relevant not only for domestic stocks but
also for exports, since export demand in the current period can be
destined both for current foreign consumption and for foreign stocks.

In line with the above arguments the equations will contain a price
series for one year which includes the current period and each of the

*For empirical work on J-curve effects see Dornbusch and Krugman [1976]
and Spi taller [1980].

107

three past periods. The inherent assumption is that neither contracts
nor expectations are formed with more than a year's anticipation.

Domestic disappearance

Domestic disappearance in the current period QD. is considered to
be a function of current real export price PRI. and price in the past
three periods. In this equation expectations are not considered
relevant, but contracting may impose frictions. The expected sign is
negative for the price coefficients in all periods. Livestock and
livestock prices are deemed to also pay a role in domestic
disappearance. As livestock prices COWPRI increase, slaughter rates
increase and the quantity of feed grain demanded decreases. A counter-
vailing influence might be an increase in feeding rates. The number of
livestock on feed CATTLE is expected to play a positive role in the
demand for feed [Meilke and de Gorter, 1978]. The U.S. population USPOP
should also play a positive role, as should real U.S. aggregate income
Y. However, Chambers and Just [1981] have argued that once use in feed
has been accounted for, grains might be an inferior good (implying a
negative relationship with domestic disappearance). Seasonal shifters
are also included in the model to allow for seasonal variability in
demand. The resulting equation for the current period t is

QDt = g(PRIt, PRIt_r PRIt_2, PRIt_3, C0WPRIt, CATTLEt>

(52)
+ + +
+ +

P0PUSt, Yt, WNt, SPt, SMt)

108

where WN, SP, SM represent the seasonal shifters for winter, spring, and
summer, respectively.

Domestic stocks

Current stocks ST0CKSt are taken to be a function of the stock
level in the previous period, assuming stock adjustment is not
instantaneous. A high level in the previous period results in a high
level in the current period, and vice versa. Thus, a positive
relationship is expected. Because of expectations and future prices,
the equation includes price in the current and the previous three
periods. The signs of the particular price coefficients cannot be
expected a priori , but all coefficients cannot be positive. (The
implication of the latter would be that stockholders always sell off at
lower prices.) The pattern of signs on the price coefficients will
depend on how expectations are formed. The interest rate INTR should
have a negative sign, since it represents a cost of holding stocks.
Seasonal variability can also be expected in the demand for stocks
because of the seasonality in agricultural production. The resulting
equation for the demand for stocks in the current period t is

+ ++ + + _+ + +

ST0CKSt=h(ST0CKSt_1 ,PRIt,PRIt_1 ,PRIt_2,PRIt_3,INTRt,WN"t,SPt,SMt) (53)

Export demand

One of the goals of the present model is to specify a more complete
export equation than that specified by Chambers and Just [1982]. The
specification in the present model is for the demand for U.S.
agricultural exports. This demand is the variable affected by

109

fluctuations in the exchange rate and, thereby, the determinants of the
exchange rate.

As with the previous equations, export demand is expected to be
influenced by price in the current period and the three previous
periods. This friction can occur because of international contracting
and by the formation of expectations by foreign holders of agricultural
stocks who may import on a speculative basis. No signs can be expected
a priori on the particular price coefficients, but, again, all of them
should not be positive.

Since the local foreign price depends not only on the U.S. price
but also on the exchange rate, the current rate and the rates for the
last three periods are also included. No specific signs are expected on
the coefficients a priori. In any given period the price and exchange
rate coefficients may have different signs if the formation of exchange
rate expectations differ from price expectations. For example, if
foreigners expect a trend in the exchange rate to have a shorter
duration than a trend in price, they may be willing to wait for a more
favorable trend in the exchange rate but may not be willing to wait for
a change in price trend. The model will use the two exchange rate
measures already described: the Federal Reserve Bank measure FEDER and
the effective exchange rate for agricultural exports AGER.

A largely unexplored issue in agricultural economics has been the
effect of exchange rate volatility on agricultural trade. Following the
arguments made by Hooper and Kohlhagen [1978], the price risk faced by
an importer of U.S. products will depend on changes in the U.S. price
and the dollar exchange rate. As the exchange rate becomes more
volatile, a risk-averse importer will ceteris paribus lower the quantity

no

he imports. However, the demand-depressing effects of exchange rate
volatility can be attenuated by the use of risk-reducing tools such as
forward markets. A negative relationship can be expected between export
demand and the exchange rate risk ERV.

Another important factor affecting export demand is the level of
per capita agricultural output in the rest of the world WOP. Since
export demand reflects an excess demand in the rest of the world, an
increase in output can be expected to decrease excess demand abroad and
the need for U.S. exports. The coefficients for WOP should thus have a
negative value.

The price value of competitors for the foreign market FORPRI can
also be expected to play a role in the demand for U.S. exports. As the
price in a competing country rises, foreign customers are diverted to
U.S. exporters in search of a better price. Thus the level of U.S.
exports should be positively related with the agricultural export price
level in countries competing with the United States for the
international market.

Foreign real income levels FORY and seasonality should affect
export demand. As foreign incomes rise, the foreign demand for
agricultural products rises, creating an increase in excess demand.
This higher excess results in an increased demand for U.S. agricultural
exports. Thus FORY should have a positive coefficient. Finally,
seasonality can also be expected in export demand, since foreign
agricultural production is also seasonal. Foreign harvest periods
should be associated with a lower need to demand U.S. exports.

The resulting equation for the demand for U.S. agricultural exports
in the current time period t is

Ill

EXPORTSt = k(PRIt, PRIt_1 , PRIt_2, PRIt_3. AGERt, AGERt_r

+ + + - - +

AGERt_2, AGERt_3, FORYt> ERVt> WOPt> FORP~RIt, (54)

+ + +
WNt, SPt, SMt).

The identities

The agricultural block contains an identity which relates exports,
domestic stocks, and domestic disappearance to the fixed level of
production PROD:

PR0Dt = ST0CKSt - ST0CKSt_1 + QDt + EXPORTS^ (55)

The second identity consists of the exchange rate as an equality
using the independently estimated coefficients of the exchange rate
determination equation (51). This equality serves to incorporate the
determination of the exchange rate into the model of the U.S.
agricultural sector.

Table 3 presents the complete system of equations in compact form.
To simplify notation, the time subscripts have been supressed, and the
magnitude of the lags is appended to each variable.

Data and Model Estimation

All data have been obtained from a variety of secondary sources.
Appendix A contains the definition for each variable used in the model
and the source for its data series.

An assumption of the model is that the agricultural market does not
affect the values of the determinants of the exchange rate. This

112

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113

assumption seems reasonable in light of the small size of the
agricultural economy in relation to the general economy. The assumption
allows the two blocks, i.e., the exchange rate and the agricultural
market blocks, to be estimated independently [Pindyck and Rubenfeld,
1976, 269]. The exchange rate equation can be estimated through
ordinary least squares (OLS) procedures while the system of equations in
the agricultural block is estimated via three-stage least squares
(3SLS).

The quarterly data used for estimation covered the period from 1973
II to 1981 IV. This period reflects the era of exchange rate
flexibility and the availability of data up to the time of estimation.

The empirical results are presented in several sections. First,
the estimates of the exchange rate measures (AGER and FEDER) are
reported. Then the estimation of the structural equations of the
agricultural block are presented, followed by the presentation of the
reduced-form estimates. Again, there are two sets of structural and
reduced-form equations: one for each measure of the exchange rate. A
final section relates the empirical estimates to the objectives of the
study as presented in this chapter.

Empirical Estimates

The Exchange Rate Equations

The effective exchange rate for agricultural exports was computed
as described in the present chapter under the subheading "Exchange Rate
Determination." To facilitate a comparison between the two exchange
rates, the agricultural rate was indexed with the same base month (March
1973) as the Federal Reserve Board's effective rate. A plot of the two

114

appears in Figure 10. It seems evident from the plot that AGER and
FEDER have followed similar paths since the inception of the float
(roughly since March 1973). An exception appears to be the inflationary
period during the late 1970s. The AGER exchange rate began a recovery
while FEDER continued to depreciate. Both experienced a sharp
appreciation beginning in 1980. It is interesting to note that the
general rate FEDER experienced a much sharper depreciation than AGER
when the currencies began to float. The indication is that in the early
1970s the exchange rate of more relevance to agricultural exporters was
less overvalued than for those engaged in the trade of nonagri cultural
products.

The exchange rate determination equations for both AGER and FEDER
were estimated in double-log form with OLS procedures. However,
Durbin's "h test" indicated the presence of first degree auto-
correlation.* A Cochrane-Orcutt procedure was then used, and the
results are presented in Table 4.

The general conclusion from the estimated equations is that the
coefficient estimates are quite similar in both equations. This result
might be expected from the close association over the sample period of
the two exchange rates as suggested earlier. This association might be
explained by the fact that Europe, Canada, and Japan are major buyers of
both U.S. agricultural and nonagri cultural exports.

All coefficients in both equations have the expected signs. The
coefficient for the net change in U.S. assets abroad (B) was not
significant at standard levels in both equations. This result coupled

*The usually reported Durbin-Watson statistic is biased toward rejecting
autocorrelation when a lagged endogenous variable is used as a regressor
[Maddala, 1977, 371].

115

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117

with the statistical significance of the remaining explanatory variables
indicates that the "monetary" rather than the "asset" approach provides
a better explanation of U.S. effective exchange rates during the period
of the float.

The results presented in Table 4 also indicate that, although
important, the role of the money supply (M) in the determination of the
agricultural exchange rate can be exaggerated. During the period
studied in this apper, the average quarterly change in M was 1.53
percent whereas the average change in AGER was 3.1 percent. Using the
estimate of the elasticity of AGER with respect to M(.36), it can be
shown that changes in the money supply accounted for about 18 percent of
the average change registered in AGER. Thus, the other variables— the
inflation rate, the real GNP, and the cumulative current account
balance—also played a role in the determination of the effective
agricultural exhcange rate.

The results of the exchange rate equations show that variables in
the financial market can help explain a variable of relevance to U.S.
agricultural exporters, i.e., the value of the dollar in relation to the
value of the currencies of the countries to which they export. The next
step in the study is to determine the degree of importance that this
exchange rate has for agricultural exports. This task is an objective
of the system of equations in the agricultural block.

The Structural Equations

The estimates of the structural equations are presented in Tables 5
and 6. Table 5 reports the estimates when AGER is used as the
exchange rate measure, and Table 6 contains the estimates with the FEDER
measure. Comments will concentrate on the export equation.

118

The results reported in Table 5 are revealing. The price
coefficients for the current and previous periods in the export equation
are positive while those for periods t-2 and t-3 are negative. However,
only the current and the t-3 periods are significant (at the 95-percent
level). These estimates suggest that there are frictions in the
agricultural export market; price in a previous period affects current
exports. Moreover, the positive sign for the current price coefficient
indicates that a rise in current price must lead to an expectation of an
even higher future price and an increase in exports, presumably for
foreign stock holding. The negative coefficient for PRI3 indicates that
a price rise three periods ago resulted in export quantity contracted
for delivery in the current period. PRI1 and PRI2 do not seem to play a
significant role in current exports.

The coefficients for AGER imply that the exchange rate does play a
role in export demand: AGER is negative and significant while AGER1 is
positive and significant.* An appreciation in the current period will
decrease export demand in the current period; the response is quick.
However, this appreciation will increase exports in the next period.
This result suggests that a one-shot change in the exchange rate can
delay or advance the decision to import but will not tend to affect
demand permanently. Today's appreciation reduce today's exports while
importers hope for a depreciation in the following quarter. But given
no further changes in any of the variables, including the exchange rate,
exports will increase in the following quarter.

*The equations were estimated with AGER and FEDER in log form. The
implicit assumption is that as the magnitude of change in the exchange
rate increases, its incremental impact on exports becomes smaller.

119

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121

The insignificant coefficients for AGER2 and AGER3 suggest that
exports respond with less friction to the exchange rate than to price.
This result is congruous with the fact that agricultural prices are to a
large extent the function of supply which is affected by annual
harvests. Agricultural price trends can be expected to have a longer
duration than exchange rate trends which respond quickly to changes in
the financial market. Thus, an exchange rate movement today is less
indicative of a future exchange rate movement than today's price
movement is of a future price. Considering this fluidity of the foreign
exchange market, it is not surprising that AGER2 and AGER3 are
insignificant.

The coefficient for exchange rate risk ERV has the expected
negative sign, but it is insignificant. This statistically
insignificant impact of exchange rate risk on agricultural trade implies
that traders are probably using risk-reducing tools for foreign exchange
(see Chapter II: "International Trade and Investment").

Although Gupta [1980, 66-107] has extensively justified the measure
of exchange rate risk employed in the present analysis, other equally
acceptable measures are conceivable. Therefore, the obtained results
must be interpreted as an initial empirical finding on a previously
unexplored subject in agricultural trade.

Per capita world output has the expected negative coefficient and
is significant. This result indicates that export demand for U.S.
agricultural products is definitely an excess demand that depends on the
level of agricultural output abroad. Agricultural trade models that
fail to incorporate this variable would appear to be incomplete in their
specification.

122

Foreign price has the expected positive sign and is also
significant. It appears that foreign buyers are willing to substitute
agricultural exporters if there is a price incentive.

The positive but insignificant foreign income coefficient suggests
that either a poor proxy was used (see Appendix A) or that the demand
for foreign exports has a fairly low income elasticity. If increases in
foreign incomes are reflected in increases in demand for livestock
products, perhaps the number of livestock abroad would be a more
suitable variable to be included in export demand. As livestock numbers
increase, the need for feed grain imports may also increase.

Finally in the export demand equation, the significant seasonal
variables indicate that there is seasonality in export demand.

The estimate of the domestic stocks equation shows that the price
measures that significantly affect stock holding are those for periods
t-1 and t-2. Price increases in the last quarter but not in the current
quarter, induce profit-taking and stock reductions. Stock levels in the
previous period also appear to influence current levels; adjustments do
not occur instantaneously. The seasonal variables indicate a strong
seasonality in stockholding. An unexpected result is the positive but
insignificant coefficient for the interest rate; a negative coefficient
was expected, since interest rates reflect a cost for stock holding. If
stock adjustments occur with a delay, as suggested by the negative and
significant coefficient for PRI1 , perhaps the interest rate in the
previous period would be a relevant variable to include in the stocks
model .

The domestic disappearance equation gives a very weak performance.
All price coefficients are insignificant and those for the current and

123

t-1 periods are unexpectedly positive. The only significant
coefficients are those for livestock price and the seasonal variables.
This weak result is not surprising given that domestic disappearance was
calculated from an identity (equation 55) and would collect errors from
the other variables. The estimated model obviously cannot be used to
accurately explain domestic disappearance.

Table 6 reports the results obtained with the FEDER measure of the
exchange rate. This measure appears to yield results similar to AGER
but somewhat weaker. There are no sign reversals for any of the
coefficients, but the T values are generally lower when FEDER is used.
Indeed COWPRI in the disappearance equation and PRI in the export
equation become insignificant. In terms of these structural equations
AGER seems to perform better than FEDER even though the two rates have
followed similar paths during the period of exchange rate flexibility.

These structural estimates present a fairly complex picture of U.S.
agricultural exports even in the short run. They highlight the
prevalence of frictions in the marketplace and the ability of events in
previous periods to affect export flows in the current period. For
example, they support the conclusion by Chambers and Just [198]] that
current exchange rates have an inverse elastic impact on current
exports. However, they also indicate that the exchange rate in the
previous quarter has a positive elastic impact on exports. The results
support the conclusion by Collins et al . [1980] that previous exchange
rate levels affect current exports. However, these authors emphasized
friction in supply whereas the present model indicates friction in
demand; supply is exogenous.

124

The present results also lend support to Collins et al . [1980] in
indicating the importance of foreign agricultural production in
determining their demand for U.S. exports. This variable was not
emphasized by Chambers and Just [1981]. The latter authors' findings of
seasonality in both the domestic and international economics are further
evidenced by the present findings.

The insignificant estimates for ERV suggest that the failure in
previous studies to consider the issue of exchange rate volatility in
exchange rate agricultural markets does not appear to be a serious
omission.

Reduced-Form Equations

The estimates of the reduced-form equations using AGER and FEDER
are reported in Tables 7 and 8, respectively. These equations treat the
endogenous variables as a function of all predetermined variables
(exogenous and lagged endogenous). One of the several available
measures for detecting how well a reduced-form equation explain the
endogenous variable is the root mean percent error (RMPE) (Pindyck and
Rubenfeld, [1976]).* The RMPE statistic is also reported in Tables 7
and 8. As might be expected, the equation for domestic disappearance
does poorly while the equations for stocks, exports, and price have an
error of less than or equal to ten percent. Since AGER and FEDER were
estimated independently, their "reduced-form" is the same as reported in
Table 4. Their goodness-of-fit are measured by their respective R
statistic.

* 1

■I yP y3 p p p

RMPE = [rr ( " ) 3 where N is the number of observations and r and

-N v ya

Ya are the predicted and actual values of the endogenous variable.

125

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127

By measuring the effect of all the predetermined variables on the
endogenous variables the reduced-form equations can provide an estimate
of the impact of the determinants of the exchange rate on agricultural
exports and price. Their4flipact on disappearance and stocks are also
reported. However, because of the poor performance of the domestic
disappearance equation, its results have to be interpreted with caution.

Table 9 reports other impact elasticities of selected predetermined
variables. They are calculated at the mean of all variables and are
obtained by interpreting the reduced-form coefficients as impact
multipliers [Intrilligator, 1978].

The impact elasticities yield interesting results. They are
suggestive of a complex relationship between the endogenous variables
and previous prices. The magnitude of the price elasticities for
disappearance, stocks, and exports decreases as the time internal
between variables increases. This result might suggest that a geometric
lag distribution is relevant in these demand functions. However, the
impact elasticities for the price equation increase in magnitude as the
time interval increases; the lag distribution is completely different
than for the other variables. The price equation also indicates
friction in the agricultural market; a one-percent increase three
quarters ago raises current price by 0.6 percent.

The relationship between current and past variables is also
complicated by the varying patterns of the signs of the elasticities for
price in previous periods. The price and domestic disappearance
endogenous variables have negative elasticities for prices in periods
t-2 and t-3. Stocks have a negative elasticity for price in t-1 and
positive in t-2 and t-3. This pattern is reversed for exports which

128

Table 9. Impact Elasticities of Selected Predetermined Variables on
the Agricultural Endogenous Variables

Endogenous __^ Predetermined Variables

Variables PRTI PRI2 PR73 AGERT WOP FORPPJ M~

QD 2.639 -2.355 1.187 -0.331 2.515 -0.321 -0.154 0.088

STOCKS -1.010 0.845 0.363 -0.013 0.101 -0.013 -0.0006 0.0006

EXPORTS 0.847 -0.408 -0.140 0.737 -5.604 0.708 0.343 -0.196

PRICE 0.406 -0.489 0.597 -0.117 0.913 -0.109 -0.054 0.031

129

have a positive elasticity for price in t-1 but negative for periods t-2
and t-3.

The elasticities for AGER1 indicate that the exchange rate in the
previous period has a marked effect on current exports. A one-percent
appreciation in the previous quarter increases current exports by 0.74
percent. This effect is probably indicative of the delay in the
decision to import with the expectation of a future depreciation. The
variable AGER1 has an understandably much smaller impact on the other
endogenous variables.

The impact elasticity for exports with respect to world per capita
agricultural output is instructive. This variable has been excluded
from many previous modeling efforts, e.g. Chambers and Just [1981,1982].
Yet the indication from the present model is that the variable has a
large impact on U.S. agricultural exports: a one-percent increase in
world output decreases exports by 5.6 percent. This loss of export
market is apparently alleviated by increases in domestic disappearance,
since its elasticity with respect to per capita world output is 2.5
while for stocks it is only 0.10.

The export elasticity with respect to FORPRI suggests that there is
some substitution of sources of supply by foreign buyers. An increase
in the foreign price increases U.S. exports. The inelastic response
suggests that the substitutability is not perfect.

The structural elasticity of exports with respect to the current
exchange rate is estimated at -1.13; exports respond elastically to an
exchange rate movement. However, it is important to recall that the
impact elasticity of exports with respect to the exchange rate in the
previous period is 0.73. The effects of an exchange rate movement in
the current quarter are largely counteracted in the following quarter.

130

A puzzling result is that the signs of the price elasticities with
respect to the nonprice variables are opposite to those that would be
expected. An appreciation in the exchange rate decreases exports in the
current period but decreases price. An increase in world output
decreases current exports but increases price. Another feature is that
although the price elasticities are inelastic, their magnitudes (i.e.,
the absolute value of the elasticities) have a positive relationship
with the magnitudes of the export elasticities. As the effect on
exports increases, the effect on price also increases.

An explanation for these results lies with both the short-run
nature of the model and the positive price coefficient obtained in the
structural equation for domestic disappearance. In the short run
expansions and reductions in the export market have to be taken up by
changes in stocks and domestic disappearance. The elasticities show
that disappearance tends to respond more elastically than stocks. The
obtained positive price coefficient forces price to move in the same
direction as disappearance. Thus an increase in domestic disappearance
due to a decrease in results in a higher price. However, because the
positive coefficient for current price in the structural domestic
disappearance equation runs counter to a priori expectations, the
model's results for price cannot be emphasized.

Dynamic multipliers are not reported because the theoretical
underpinning of exchange rate determination being limited to the short
run make an economic interpretation of these multipliers tenuous. In a
time framework longer than one quarter the variables in the exchange
rate equation (51) begin to assume mutual dependence. For example, over
several quarters money supply can affect the general price level as can

131

movements in the exchange rate. Thus equation (51) is inadequate for
describing exchange rate movements in the long run. Although dynamic
multipliers could be mechanically computed from the reduced-form
estimates, it would be difficult to attach economic meaning to them.
Meaningful multipliers will be feasible only with the advent of
determination theories that can successfully explain the exchange rate
over a longer time framework, e.g., two to eight quarters.

Empirical Estimates and Objectives of the Study

The empirical estimates reported in the previous pages can be
related to the specific objectives of the study as listed at the
beginning of the chapter. The first objective was to determine the
usefulness of constructing an effective exchange rate for U.S.
agricultural exports. The results indicate that there are no clear
advantages. Although FEDER performed more poorly in the structural
equations, some of the reduced-form equations performed better with
FEDER than with AGER. The Federal Reserve Bank effective rate is
apparently a good measure to use for an effective exchange rate in
agricultural trade models. A possible explanation for this result is
that Europe, Japan, and Canada are the United States' major trade
partners in both agricultural and nonagricultural trade.

The second objective of the study was to measure the impact of
exchange rate volatility on agricultural trade. The estimates of the
structural equations showed volatility to have little or no impact on
exports. The estimates carried the hypothesized sign (negative) but
were statistically insignificant. These results are consistent with
empirical studies on general trade, e.g., Gupta [1980] and Hooper and

132

Kohlhagen [1978]. If agricultural traders are risk averse they are
apparently availing themselves of risk-reducing tools such as currency
futures. This result is an initial empirical finding using one well-
substantiated measure of exchange rate risk. Further exploration of
this issue may use other acceptable measures of exchange rate risk.

The third objective of the study was to measure the impact of
changes financial market conditions on agricultural exports, prices, and
income. The results show that a one-percent change in the agricultural
exchange rate will lead to a -1.13 percent change in agricultural
exports. The results for this exchange rate effect is a middle ground
for results obtained in previous studies for specific commodities. The
study of trade with Japan by Meyers et al. [1979] found the absolute
value of the exchange rate elasticity to be 0.21 and 0.42 for- feed
grains and soybeans, respectively. On the other hand, Chambers and Just
[1981] found short-run exchange rate elasticites for wheat, corn, and
soybeans to be 2.045, 5.227, and 1.311, respectively. The only other
empirical study to date that has explained the impact of money supply on
exports, Chambers and Just [1982], unfortunately does not report
reduced-form elasticities. Reduced-form coefficients are not directly
comparable since this study used a double log function to estimate the
exchange rate determination equation.

Since the reduced- form equation for agricultural price possessed
signs contrary to a priori expectations, the empirical results do not
shed light on the relationship between financial market variables and
agricultural prices and income. Thus the model was able to meet only
part of the third objective.

133

The fourth objective was to investigate the secondary effects on
domestic consumption and stockholding of changes in the financial
markets. It is important to emphasize that the effects considered here
are only those caused via the export sector; i.e., the line of causation
is from the financial variables to the flexible exchange rate to the
export sector to domestic consumption and stockholding. Financial
variables can also impact the agricultural sector through domestic
effects such as interest rates and credit availability which are
excluded from this study. The present results indicate that in a
one-quarter time period changes in export flows have a larger impact on
domestic consumption rather than stockholding. Commodities which in the
short run do not find a foreign market tend to find a domestic
destination although stocks also increase some.

The fifth objective was to investigate the possible delay of
response in the agricultural trade sector to changes in the financial
markets. The different current theories of exchange rate determination
have the common element of assuming a fast-clearing financial market.
It is clear from the estimated exchange rate equations that financial
market changes in the current quarter affect the current exchange rate.
The estimated structural equations show that the exchange rate also
affects agricultural trade quickly, i.e., in the current quarter. Thus
no delay of impact is detected between the financial markets and the
agricultural sector. However, it is indicated that an opposing effect
appears in the following quarter. An export-increasing depreciation in
the current quarter becomes export-inhibiting in the following quarter.
This result indicates that a one-shot change in the exchange rate serves
to advance or delay the decision to import but does not tend to

134

permanently alter the pattern of export demand. This view is consistent
with the notion that the flexible exchange rate is a constantly changing
value and may not represent a permanent price change for agricultural
imports from the importing country's perspective.

The last objective of the study was to obtain an indication of the
extent to which the flexible exchange rate and the financial markets
have contributed to income instability in the agricultural sector. The
results indicate that a one-shot change in the exchange rate has a
bumpy, unstable impact on exports. However, this impact seems to
account for only a relatively small portion of the registered
fluctuations in exports. The average quarter-to-quarter change in
exports during the study period was 12.1 percent. The average change of
the agricultural exchange rate was 3.1 percent which, using the
estimated exchange rate elasticity, can be estimated to induce an
average change in exports of 3.5 percent. Regarding monetary policy in
particular, the average change in money supply (Ml) was 1.5 percent from
quarter to quarter, inducing an average impact on exports of 0.52
percent. One can conclude that somewhat over a fourth of the historic
fluctuation in exports can be attributed to the current exchange rate
and less to changes in monetary policy. Since the exchange rate in the
short run can affect agricultural price and income only via export
demand, one can also conclude that the current exchange rate has been
responsible for only about a fourth of the total income instability that
can be attributable to fluctuations in export flows. An even smaller
impact has been exerted by monetary policy via the exchange rate. The
results are complicated by the fact that the exchange rate in the
previous quarter also affects current exports. The effect is opposite

135

to the effect in the current period. This result suggests that the
total exchange rate effect on exports and income will be greater in
periods of successive appreciations and depreciations than in periods
where movements occur in only one direction. Using the elasticities for
the current (t) and previous (t-1) periods, it is estimated that the
total exchange rate impact averaged 4.1 percent from quarter to quarter.
Thus the total exchange rate impact accounts for about a third of the
registered fluctuation in agricultural exports.

CHAPTER VII
SUMMARY AND CONCLUSIONS

This study has investigated the relationship between flexible
dollar exchange rates and the U.S. agricultural sector. A preliminary
part of this investigation was a review of the exchange rate literature
as it applies both to the general and the agricultural economies. The
review of the literature on exchange rate flexibility reveals that the
flexible system adopted in 1973 has performed neither as well as its
proponents as first suggested nor as poorly as its critics first feared.
Much of the registered instability in exchange rates can be ascribed to
unstable underlying economic conditions, but bandwagon speculative
effects may have amplified the oscillations in rates. Flexible rates
can insulate a country from world inflation but only if output and
employment effects are disregarded in the formulation of monetary
policy. Flexible rates reduce the need for compensatory financial flows
but add international dimensions to the already complex world of fiscal
and monetary policy-making.

Another important conclusion to be drawn from the flexible exchange
rate literature is that financial market forces now to a large extent
determine exchange rates, whereas they were largely determined by
governmental decree under the Bretton Woods system. Although there are
several different coexisting hypotheses as to exactly how exchange rates
are determined in the marketplace, there is general agreement that in
the short run the financial rather than the goods market has a decisive
role in determination and that these markets are fast-clearing.

136

137

A review of the exchange rate issues in the agricultural economic
literature reveals that the main topic of concern has been the role of
the dollar depreciations during the early 1970s in the rapid expansion
of U.S. agricultural exports during the same decade. The literature
does not arrive at a consensus on the importance of these devaluations.
Generally speaking, authors who took account of the restrictions
prevalent in agricultural trade tended to downplay the importance of
these devaluations. Authors whose models abstracted from trade
restrictions tended to report a more influential role for exchange
rates.

The issue of U.S. agriculture in a world of exchange rate
flexibility attracted attention only belatedly and by only a few
authors. The review of this issue yields the interesting result that
the flexible exchange rate serves as an additional vehicle by which
monetary policy and financial market conditions can affect the
agricultural sector. Heretofore financial market conditions were seen
as possibly affecting agriculture only through domestic variables such
as the cost and availability of production credit. However, since
financial market conditions also affect the flexible exchange rate and
the latter affects the ability to sell in foreign markets, exchange rate
flexibility has added a new link between the agricultural sector and the
macroeconomy. Obtaining an indication of the importance of this link
was among the empirical objectives of the study.

The principal tool used for the empirical analysis was a two-block
recursive system of equations. One block consisting of a single
equation was estimated using ordinary least squares followed by
Cochrane-Orcutt procedure. The second block containing five equations

138

including two identities was estimated via three-stage least squares.
The entire system was estimated twice, once for each of two alternative
measures for an effective exchange rate.

The empirical findings of the study include

a) The Federal Reserve Board's effective exchange rate appears to
be an appropriate effective exchange rate measure to use in
agricultural trade models. No special advantages were found in
constructing an effective exchange rate for agricultural
exports;

b) Consistent with findings for the general economy, exchange rate
volatility was found to have no significant impact on
agricultural exports. The indication is that risk-averse
agricultural traders are using risk-reducing tools such as
billing in dollars or using the forward exchange markets;

c) Changes in agricultural export flows are largely absorbed by
changes in domestic disappearance in the short run with a minor
role played by changes in stocks;

d) The flexible exchange rate and its determinants are found to
affect agricultural export flows. However, these variables
account for only a minor portion of the registered fluctuation
in export flows during the study period;

e) There was no perceptible delay in response in the agricultural
export market to changes in financial market conditions.
Financial market changes in the current quarter affect exports
in the current quarter via the exchange rate.

139

Conclusions

Both the review of the literature and the empirical analysis that
form this study support the argument that exchange rate flexibility is
an issue deserving the attention of agricultural economists. No longer
can the exchange rate be treated as an exogenous variable determined
solely by governmental entities. Any future analysis that uses the
exchange rate as an explanation of some economic event will immediately
lead to the issue of the determinants of the exchange rate as the
ultimate explanatory factors. The linkage between the agricultural
trade sector, the exchange rate, and the latter' s determinants should
not be analytically fractured so long as the flexible exchange rate
system remains in place.

However, another conclusion that can be derived from this study is
that the importance to agriculture of the exchange rate and its
determinants can be overstated. Other variables such as world
agricultural output and seasonal variability account for the larger
portion of the quarterly fluctuation in U.S. agricultural exports.
Exporters should be concerned about the variables that make the exchange
rate change, but traditional points of attention such as developments in
foreign agriculture remain important.

Of the contributions which have focused on the impact of the
determinants of the flexible exchange rate on U.S. agriculture, almost
exclusive emphasis has been placed on money supply. Perhaps this
emphasis has been placed because money supply to a large degree is the
product of public policy-making. Yet the results of this study indicate
that money supply plays only a partial role in the determination of the
exchange rate. Attention should also be payed to other relevant

140

economic indicators, i.e., national income, the current account balance,
and the general price level.

The general conclusion that can be drawn is that exchange rate
flexibility has added another dimension to the already complex nature of
agricultural trade. The traditional explanatory variables for trade
remain important, but exchange rate flexibility interjects all the
determinants of the exchange rate as additional pertinent variables.
Interposed is also the theoretical mechanism by which these variables
are deemed to determine the exchange rate; a theory of exchange rate
determination has to be considered before the particular determinants
can be discerned.

Variables which could previously be disregarded in the analysis of
agricultural trade and financial market relationships which could
previously be ignored must now enter the analysis. The adoption of
exchange rate flexibility has multiplied the difficulties facing
international agricultural economists.

Suggestions for Further Research

This study obtained an indication needing much further exploration:
frictions in the agricultural export markets. It was found that price
two and three quarters previous affect exports in the current quarter.
Some friction was also detected with the exchange rate. Although
frictions in the international market has attracted the attention of the
general economic literature, agricultural economics seems to have paid
little attention to this issue. An elucidation of the nature of these
frictions and their sources would be a noteworthy contribution to the
body of knowledge about trade in agricultural commodities.

141

A concommitant analysis would be the determination of the current
U.S. agricultural price level. An export-dependent U.S. agricultural
economy may have agricultural prices determined to a large extent by
events in the international economy. The presence of frictions at the
international level would indicate that events in previous periods can
affect current prices. The exploration of the validity of incorporating
a time dimension to price determination may be a fruitful exercise in
future research efforts.

APPENDIX
VARIABLE DEFINITIONS AND DATA SOURCES

AGER

The effective exchange rate for agricultural exports calculated by
taking a weighted average of the U.S. dollar exchange rates of Canada,
Japan, Italy, France, West Germany, Belgium, Netherlands, Spain, and the
United Kingdom. The (yearly) weights were calculated as the proportion
of each country's imports of U.S. agricultural products with respect to
total imports for the group. These countries were the largest importers
with floating currencies. Sources: International Financial Statistics,
U.S. Foreign Agricultural Trade.

B

Net outflow of capital measured by the net change in U.S. assets abroad
minus the net change in foreign assets held in the United States. A
constant of 30,000 was added to all observations to allow estimation in
log form. Source: Survey of Current Business.

CATTLE

Number of cattle and calves on feed (1,000 head). Source: Livestock

and Meat Statistics.

CCA

Cumulative balance on the current account since 1981 I (million
dollars). A constant of 30,000 was added to all observations to allow
estimation in log form. Source: Survey of Current Business.

142

143

COWPRI

The real price of livestock proxied by the U.S. livestock price index

deflated by the producer price index. Source: Agricultural Prices.

ERV

The exchange rate risk. The calculation of risk followed suggestions

made by Gutpa [1980]:

12 ^

ERV = [yi I (AGERt_._1 - AGERt_.)2]

where t refers to the current month. The monthly figures were averaged
for each quarter. An identical procedure was followed with FEDER.
Sources: International Financial Statistics, Federal Reserve Bulletin.

SM

Dummy variable for the third quarter of the year.

STOCKS

Ending stocks of wheat, barley, oats, corn, soybeans, and rice (million

bushels). Source: Survey of Current Business, Fats and Oils Situation,

WN

Dummy variable for the first quarter of the year.

WOP

Per capita world agricultural output calculated by subtracting U.S.
production from world cereal production (million metric tons). Total
production was divided by world population (millions) minus U.S.
population. Sources: Agricultural Production Yearbook, UN Monthly
Bulletin of Statistics.

144

Y

Gross national product in constant 1972 dollars. Source: Survey of

Current Business.

FORPRI

Foreign agricultural prices were proxied by the Canadian agricultural
export price index (1975=100). Lack of availability of aggregate export
price composites for other countries prevented use of a more
encompassing measure. Source: Statistics of Foreign Trade Monthly
Bulletin (OECD).

FORY

Real foreign income proxied by the sum of the real incomes of Canada,
Japan, Real France, Germany, Italy, and the United Kingdom. Each
currency was converted to U.S. dollars using a constant exchange rate
(1976 IV). The restricted number of countries keeping quarterly income
statistics prevented the construction of a more encompassing measure.
Source: Quarterly National Accounts Bulletin (OECD).

INTR

T+ie real interest rate calculated by the interest paid on the 12-month
T-Bill, deflated by the producer price index. The average of monthly
rates was taken for each quarter. Source: Federal Reserve Bulletin.

M

Ml definition of money supply (billion dollars). Monthly figures were

averaged for each quarter. Source: Federal Reserve Bulletin.

145

POPUS

Population of the United States (millions). Source: "Population

Estimates and Projections."

P

Producer price index for all commodities (1967=100). Source: Survey of

Current Business.

PRI

The real price of agricultural exports proxied by the U.S. crop price
index (1977=100) deflated by the producer price index. Source:
Agricultural Prices.

SP

Dummy variable for the second quarter of the year.

REFERENCES

Artus, Jacques R. and John H. Young. "Fixed and Flexible Exchange
Rates: A Renewal of the Debate." IMF Staff Papers 26(1979):
654-698.

Balassa, Bela. "Flexible Exchange Rates and International Trade."
Working Papers in Economics 50. Johns Hopkins Univ., 1979.

Barnett, Richard C. , David A. Bessler and Robert L. Thompson.

"Agricultural Prices in the 1970's and the Quantity Theory of
Money." Paper presented at AAEA meetings, 1981.

Bernstein, Edward M. "The Economics of Fluctuating Exchange Rates."

Exchange Rate Flexibility, eds. Jacob S. Dreyer, Gottfired
Haberler, and Thomas D. Willet. Washington: American Enterprise
Institute, 1978.

Bilson, John F.O. "The Monetary Approach to the Echange Rate: Some
Emprical Evidence." IMF Staff Papers 25(1978) :48-75.

Bisignano, Joseph and Kevin Hoover. "Some Suggested Improvements to a
Simple Portfolio Balance Model of Exchange Rate Determination with
Special Reference to the U.S. Dollar/Canadian Dollar Rate."
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Branson, William H., Hannu Halttunen, and Paul Masson. "Exchange Rates
in the Short Run: The Dollar-Deutschemark Rate." Eurp. Econ. Rev.
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Bredahl , Maury E. and Paul Gallagher. "Comment on 'Effects of an
Exchange Rate Change on Agricultural Trade'." Agr. Econ. Res.
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Bredahl, Maury E., Francis McCamley, Keith J. Collins, and William H.
Meyers. "The Impact of Currency Value Changes Given Free Trade,
Non-Tariff Barriers, and Non-Traded Goods." Unpublished, 1979a.

Bredahl, Maury, William Meyers, and Keith Collins. "The Elasticity of
Foreign Demand for U.S. Agricultural Products." Amer. J. Agr.
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BIOGRAPHICAL SKETCH

Edward E. Canler was born in Havana, Cuba, on March 7, 1951. He
received his B.A. in philosophy from California State University,
Dominguez Hills, in 1972. As a Peace Corps volunteer, he worked as a
basic grains extensionist in Costa Rica. He obtained his M.S. in food
and resource economics from the University of Florida in 1979. He is
currently an export specialist with the Latin American Division of
Textile Rubber and Chemical Company.

152

I certify that I have read this study and that in my opinion it
conforms to acceptable standards of scholarly presentation and is fully
adequate, in scope and quality, as a dissertation for the degree of
Doctor of Philosophy.

Emilio Pagoulato^< Chairman
Professor of Foda and Resource
Economics

I certify that I have read this study and that in my opinion it
conforms to acceptable standards of scholarly presentation and is fully
adequate, in scope and quality, as a dissertation for the degree of
Doctor of Philosophy.

Carlton G. Day/

Professor of Food and Resource
Economics

I certify that I have read this study and that in my opinion it
conforms to acceptable standards of scholarly presentation and is fully
adequate, in scope and quality, as a dissertation for the degree of
Doctor of Philosophy.

/)

Evan Drummond
Professor of Food and Resource
Economics

I certify that I have read this study and that in my opinion it
conforms to acceptable standards of scholarly presentation and is fully
adequate, in scope and quality, as a dissertation for the degree of
Doctor of Philosophy.

C i .1 " f *

William A. Bomberger '

Associate Professor of Economics

This dissertation was submitted to the Graduate Faculty of the College
of Agriculture and the Graduate Council, and was accepted as partial
fulfillment of the requirements for the degree of Doctor of Philosophy.

August 1983

Ilk SLx *^W

Dean-y College of AgrcTculture

Dean for Graduate Studies and
Research

UNIVERSITY OF FLORIDA

3 1262 08553 4401