The world economy.

Gurney, Andrew ; Veld, Jan Willem In't ; Barrell, Ray 等

CHAPTER II. THE WORLD ECONOMY

Recent developments and short-term prospects GNP growth in the major seven economies continues to decline from the cyclical peak reached in 1988. The latest national accounts statistics show that all major seven economies are now growing more slowly than they did last year, with the United States, United Kingdom and Canada in recession. This slowdown in activity appears to have been caused primarily by the tightening of monetary policy that occurred between 1988 and 1990. Short-term interest rates rose by 4.4 percentage points in Germany between 1987 and 1990, by 3 percentage points in Japan between 1987 and 1990, and by 2.2 per cent in the United States between 1987 and 1989.

The Gulf crisis contributed to the slower growth of economic activity in the second half of 1990. Uncertainties over the future supply of oil caused world oil prices to rise from $16 per barrel in June to $40 per barrel at the beginning of October. Uncertainty generated by the crisis also contributed to a drop in consumer confidence, especially in the United States, and in investor confidence.

Concern about the economic consequences of the crisis was dispelled by the outbreak of hostilities in January, when the oil price fell to below $20 per barrel. With the conclusion of the war consumer confidence has recovered and stock markets in the United States and the United Kingdom have registered record highs. This may be attributed not only to the reversal of negative impulses arising from the Gulf crisis, but also to the reduction in US interest rates which took place in February.

We are still too close to the events of the Gulf crisis to estimate how important an effect they have had on the world economy. However as the negative impulses generated by the crisis were reversed within six months it is unlikely that there will be significant lingering effects on world economic prospects. A significant slowdown in economic activity was already in prospect before the crisis, as a result of the tightening of monetary policy between 1988 and 1990. We are forecasting that economic activity will begin to grow more rapidly in the second half of this year. As with the slowdown that we are experiencing now, the main cause of this recovery is the evolution of monetary policy.

Table 1 summarises our forecast. GNP growth in the major seven economies is expected to decline from 2.5 per cent in 1990 to 0.9 per cent in 1991, before rising to 2.8 per cent in 1992. The pattern of lower growth in 1991 but a recovery in 1992 is common to all seven major economies, but the scale differs markedly. GNP growth in the major four economies will range from zero in the United States to 3 per cent in Japan for 1991, and from 2.4 per cent in the United States to 3.7 per cent in Japan for 1992. [Tabular Data Omitted]

The United States experienced a 2.8 per cent (annual rate) fall in GNP in the first quarter of 1991, indicating that the recession there is deeper than had been expected. Our forecast of zero growth for 1991 as a whole arises because recovery is expected to occur in the latter part of this year. The main force behind this recovery should be renewed growth in domestic demand, in response to lower interest rates.

Recent developments in interest rates are shown in charts 1 and 2, and our forecast for short-term interest rates also shown in table 4. The fall in US GNP in the first quarter of 1991 prompted the Federal Reserve Board to reduce its discount rate by 0.5 percentage points to 5.5 per cent on 30 April. Monetary easing by the Fed reduces the risk that the US recession will be prolonged by a credit crunch. We are forecasting that three-month interest rates in the United States will average 6.2 per cent in 1991, down 1.9 percentage points from 1990, and 2.9 percentage points from 1989. Our expectation that interest rates have now fallen sufficiently to stimulate domestic demand is supported by recent increases in the Department of Commerce leading indicators index and a recovery in the Conference Board index of consumer confidence. [Tabular Data Omitted]

While monetary policy has become less restrictive in the United States, it remains tight in both Japan and Germany. At the G7 finance ministers' meeting at the end of April the United States indicated that it would like to see other countries reduce their interest rates as well. This proposal was not taken up, on the grounds that both Japan and Germany feel that their economies are still operating close to their current supply potential, and are therefore unwilling to risk the inflationary consequences of a premature monetary easing. In Box 1 we report two simulations of our econometric model GEM(1). The first simulation shows the effects of an interest-rate reduction in the interest-rate reduction. Our results indicate that a global reduction would add little to US GNP growth, but would lead to higher demand and inflation in other countries, most notably Japan.

Chart 3 shows capacity utilisation rates in the major four economies. Capacity utilisation remains high in Germany and Japan, and inflation is forecast to rise in Japan in 1991, with the prospect of a renewed rise in inflation in Germany in 1992 after a small decline in 1991 (see table 1 and chart 4). These indicators provide a case for maintaining high interest rates, although there is a danger that if monetary policy is held tight for too long then policy will exacerbate the business cycle, driving the economy into recession rather than merely dampening excess demand. On these grounds a reduction in interest rates in Japan may occur later this year.

The situation in Germany is complicated by the pressures caused by reunification. In the absence of reunification GNP growth in western Germany would have declined in 1990 to around 3 per cent, instead of rising to 4.5 per cent. In 1990 the German economy benefited from an initial stimulus resulting from monetary union and unification, as east Germans gained access to western markets, especially for durable goods. In 1991 that initial stimulus will no longer apply, and indeed rising unemployment and short-term working in the eastern Lander will cause demand from the east to fall. It will also increase the German budget deficit to around DM170bn. Increased government borrowing will entail some upward pressure on interest rates, especially as the Bundesbank appears determined to ensure that the government acts to reduce the budget deficit in the medium term. Money market rates indicate that in the short run German interest rates may have further to rise, but there is again a risk that maintaining a tight policy for too long could be destabilising. In our forecast we have assumed that German interest rates remain unchanged for this year, but that some relaxation occurs next year, conditional on clear evidence that the rate of growth has slowed to around 3 per cent per annum.

The French and Italian economies are both growing more slowly. The French economy has slowed in response to higher interest rates, which have been required both to restrain domestic inflationary pressure and to maintain the value of the franc within the exchange-rate mechanism. Italian interest rates only rose by 1.2 percentage points between 1987 and 1989, and fell in 1990. In the last three years, interest-rates in both France and Italy have converged on German interest rates, as foreign exchange markets have become increasingly convinced of their governments' determination to maintain the value of their currencies against the D-Mark. Convergence on German interest rates has also occurred in other European countries. Interest rates in Austria and the Netherlands are now virtually identical to German rates. Belgian rates are around 0.5 per cent higher. Italian domestic demand growth has slowed because of a tighter fiscal policy stance, and net exports have worsened because of the loss of competitiveness arising from relatively high inflation. Although France and Italy have both benefited from the stimulus to German GNP, the net impact on both economies of higher German GNP growth is not great. Simulations on our econometric model, GEM, show that fiscal expansion equivalent to 1 per cent of GNP in Germany leads to increases of 0.03 per cent of GNP in France and 0.05 per cent in Italy in the first year of the simulation, and 0.05 per cent and 0.08 per cent respectively after 3 years (table 1 of Barrell and Gurney (1991a)). In this regard the often quoted metaphor of the German economy as a European locomotive exaggerates its significance.

The slowdown in economic activity within the European Community has caused the various central banks to contemplate a less restrictive monetary policy. Their ability to reduce interest rates is constrained by the need to maintain ERM parities. In recent weeks this constraint has become binding for the French authorities, since if the franc weakens further it will breach its 6 per cent divergence limit with respect to the Spanish peseta. While the peseta remains strong within the exchange-rate mechanism, Spanish economic policy will continue to act as a constraint on monetary policy within the rest of Europe. We report on recent developments within the Spanish economy in Box 2.

Slower growth of the major countries' GNP will also result in slower growth of world industrial production and world trade in 1991. We are forecasting that OECD industrial production will grow by 0.5 per cent this year, its lowest growth rate since 1982. World trade in manufactures is forecast to grow by 4 per cent, and total world trade by 4.5 per cent, marginally higher than last year, but well below the 7.1 per cent per annum average growth between 1985 and 1989. Chart 5 shows that growth in world trade in manufactures has tended to follow the same cyclical pattern as the growth of major seven GNP, although the amplitude of the cycle is approximately twice as large. A simple extrapolation of this pattern would suggest that our forecast for world trade in 1991 is optimistic. However there are two special factors that are likely to keep world trade growth strong in relation to G7 GNP growth. The first of these is the collapse of east German and east European manufacturing industry, which will mean that their demand for manufactured goods will be met by foreign producers. The second stimulus to world trade arises from oil producing countries spending some of the extra revenue they received in the second half of last year, when oil prices rose to $40 per barrel. In 1992 we are forecasting that G7 GNP growth will be close to trend. This will also allow industrial production, world trade in manufactures and total world trade to grow at around trend values. In 1992 we are expecting growth of 3.4 per cent in industrial production, 5.7 per cent in total world trade and 6.3 per cent in world trade in manufactures.

Our forecast for commodity prices is shown in table 2 and illustrated in charts 6 and 7. Slower growth in world economic activity has been reflected in slower growth in demand for commodities, which has resulted in a general weakening of commodity prices. [Tabular Data Omitted]

The prices of metals declined in the fourth quarter of 1990 and the first quarter of 1991, although there has been a recovery in copper prices since February. Metals prices are expected to continue to weaken in 1991, as mining and production capacity have expanded following the large increase in prices between 1987 and 1989.

Coffee and cocoa prices have weakened significantly since the second quarter of last year. Stocks remain strong in both commodities. Low prices have led coffee producers to reduce their production, which should enable prices to recover, but surplus production of cocoa looks likely to continue, keeping prices depressed. Sugar prices fell by around 30 per cent in 1990, but could rise in 1991 as a result of reductions in sugar production.

The International Cotton Advisory Committee estimate that cotton production will exceed consumption by 3 million bales in 1991/92 and 2 million bales in 1992-93. If this trend continues there will be downward pressure on prices, but this may not be evident in the short term as world cotton stocks are currently low. The price of wool fell 40 per cent in 1990 following the suspension of wool price support in Australia.

The price of oil is forecast to average $17 per barrel in 1991. The Gulf crisis has temporarily reduced Iraqi and Kuwaiti oil production, but there has been no decrease in world supply, as other producers, notably Saudi Arabia, have raised their production. In the short term this development gives Saudi Arabia more leverage over the oil market, although this will be reduced when Iraqi and Kuwaiti production is restored. In the medium term we expect real oil prices to grow at around 3 per cent per annum.

Exchange-rate developments

Chart 8 shows recent movements in exchange rates. Between November and the end of April the US dollar appreciated by 18 per cent against the D-Mark and by 7 per cent against the yen. Annex 1 looks at the volatility of exchange rates between the major seven currencies since the Louvre accord of 1987. A degree of exchange-rate stability was achieved in the second half of 1988 and first half of 1989, but there has been renewed volatility in 1990 and early 1991.

This new volatility has had a number of causes. The most important is probably the unification of Germany and proposed market liberalisation in eastern Europe. These changes have caused foreign exchange markets to reassess exchange rates in the light of the implied long-term current account and capital account flows. In particular Germany will export less capital, but should also become more competitive in the long term, as the increase in its supply of skilled labour should reduce the level of real wages in the German economy. Reduced capital exports imply a higher long-run equilibrium real exchange rate, while the latter implication is that unchanged nominal exchange rates would lead to lower real exchange rates. The appreciation of the D-Mark at the end of 1989 reflected these developments.

A second cause of exchange-rate volatility appears to have been a re-evaluation of the returns available from investing in Japan compared to abroad. The yen depreciated by 22 per cent between February 1989 and April 1990 but has since appreciated by 16 per cent. The scale of depreciation was puzzling, and may have been caused by a temporary increase in capital outflow relative to current account surpluses. This development may have been triggered by the European Commission's single market programme, causing Japanese firms to increase their investment abroad. The effect was to give Japanese firms a competitive advantage which, if it had been maintained, would have caused current account surpluses to exceed long-term capital outflows. On this reading the subsequent exchange-rate appreciation has taken the yen back towards a sustainable exchange-rate path.

BOX 1. THE EFFECTS OF LOWER INTEREST RATES

We have run two simulations on our econometric model, GEM, to illustrate the effects of a co-ordinated reduction in interest rates, and the effects of a reduction in interest rates in the United States alone. In both simulations exchange-rates are held unchanged from their base values. In each simulation interest rates are reduced by 1 percentage point for the first two years of the simulation.

Table A1i shows the effect of a reduction in interest rates in the US alone. US GNP is 0.5 per cent above base in year 2 of the simulation but has returned to base by year 5. Inflation increases in the US, by a maximum of 0.2 percentage points in year 3 of the simulation. The increases in US GNP and inflation compared to the rest of the world causes the US current account to GNP ratio to deteriorate compared to the simulation base, by 0-12 percentage points in year 2 of the simulation, but only 0-01 percentage points in year 5.

The US interest-rate reduction increases GNP and inflation in the other major 7 economies, and causes their current account to GNP ratios to improve. Canada experiences the greatest changes with GNP 0-2 percentage points above base in year 2, inflation 0-08 percentage points above base in year 3, and the current balance to GNP ratio 0-14 percentage points above base in year 2. France experiences the lowest increase in its GNP. Japan the lowest increase in inflation and the UK the smallest improvement in its current account to GNP ratio.

The USA has recently been pressing for global reduction in interest rates, as shown in Table A1ii. However our model suggests that this would have only increased US GNP by a further 0-12 percentage points in year 2 of the simulation and 0-22 percentage points in year 5 of the simulation. There would be an additional increase in US inflation of 0-16 percentage points by year 5 of the simulation, and the US current account balance would not deteriorate as much as in the first simulation. From year 3 onwards the US current account ratio would actually have improved compared to the simulation base.

However the co-ordinated interest rate reduction would also increase GNP and inflation in the rest of the world. GNP in all seven would be more than 0-4 percentage points above base in year 3 of the simulation, with Germany 1-1 per cent above base and Japan 1-5 per cent above base. In year 3 the increases in inflation range from 0-19 to 0-62 percentage points above base, and in year 5 from 0-13 to 0-48 percentage points. The stimulus to inflation is greatest in Japan and the United Kingdom, and least in Canada and the United States. Japan also experiences the greatest deterioration in its current account to GNP ratio while the United States has the greatest improvement. [Tabular Data Omitted]

BOX 2. RECENT DEVELOPMENTS AND PROSPECTS FOR THE SPANISH ECONOMY

Table B1 shows that the Spanish economy has been transformed since 1987. In each of 1987, 1988 and 1989 GDP grew by over 5 per cent per annum. In the previous twelve years GDP growth had never exceeded 3-5 per cent, and had been greater than 2 per cent in only four of those years. Furthermore this improved growth performance occurred with inflation had below 5-5 per cent in 1987 and 1988, compared with 16-6 per cent in 1980.

The cause of this transformation was Spanish accession to the EEC in January 1986. The table shows that this provided the stimulus for investment growth in excess of 10 per cent per annum for four consecutive years, compared with an average annual growth rate of -1.4 per cent per annum in the five preceding years. Spain is now well integrated into the European economy with around 75 per cent of its exports and 60 per cent of its imports traded with other European economies.

Spain strengthened its commitment to European integration by joining the exchange rate mechanism in June 1989. The peseta is allowed to deviate by up to 6 per cent from its central rate within the ERM. Ever since joining the ERM the peseta has been one of the strongest currencies, and at the start of May 1991 was at its 6 per cent ceiling with respect to the weakest currency in the ERM, the French franc. The continuing strength of the peseta has resulted in the liberalisation of controls on outward capital flows, but this has not weakened the currency.

The main reason for the strength of the peseta is the high level of interest rates in Spain. Three-month interest rates exceeded 15 per cent from the third quarter of 1989 until the first quarter of this year. Monetary policy has remained tight in order to exert downward pressure on domestic demand. This strategy appears to be working as growth of consumer's expenditure and investment both slowed considerably in 1990. Inflation has averaged 6-7 per cent in the last two years, and wage settlements remain high. Nonetheless signs that demand is growing more slowly, combined with the desire to weaken the value of the peseta, enabled the Bank of Spain to reduce its assistance rate by 1 percentage point in March.

It is likely that 1991 will be another year of more moderate growth in Spain. The OECD forecast growth of 2-7 per cent. Domestic demand growth will continue to be held in check by high interest rates, and it is likely that interest rates will be reduced further later in the year. Slower growth of domestic should also prevent further deterioration in the current account deficit, although slower growth in the rest of the world will restrain the growth of spanish exports.

Prospects for 1992 are somewhat brighter. There are a number of special events which will keep Spain in the news and boost Spanish export earnings. Barcelona will stage the Olympic Games, Sevillea world fair and Madrid becomes the European City of Culture. We expect GDP growth in 1992 to be around 4 per cent which is just a little above estimates of the growth of capacity. However, in the longer term high interest rates may have to be maintained unless the government budget deficit is reduced. These events have led to considerable improvements in Spanish infrastructure which will enable Spain to enhance its growing significance in the European economy. [Tabular Data Omitted]

PHOTO : Chart 1. 3-month interest rates

PHOTO : Chart 2. Long rates

PHOTO : Chart 3. Capacity utilisation rates

PHOTO : Chart 4. Inflation rates

PHOTO : Chart 5. GNP and world trade growth

PHOTO : Chart 6. Recent commodity prices

PHOTO : Chart 7. Real commodity prices

PHOTO : Chart 8. Recent exchange rates

A third reason for recent exchange-rate volatility is the uncertainty generated by the Gulf crisis. It is not clear which of the major seven currencies should have been revalued or devalued as a consequence of the crisis, and indeed market sentiment may have shifted as particular risks rose and fell in significance.

The recent strength of the dollar and weakness of the D-Mark could reflect changing assessments of their long-term prospects in the light of emerging |news' about the depth of the US recession, and the length of time that it will take before the eastern Lander are fully integrated into the German economy. In the latter case it appears that the competitive gains will emerge more slowly than was first thought, and that German inflation will stay higher for longer. Both reasons would justify the recent depreciation of the exchange rate.

Table 3 presents our exchange-rate forecasts. In forecasting exchange rates we normally adopt the convention that exchange rates change in line with current market expectations, as given by the uncovered interest parity condition, which states that the expected exchange-rate depreciation should be equal to interest-rate differentials. Econometric studies indicate that this forecasting rule performs as well as any other, even though the forecasting error often turns out to be large. This is because foreign exchange markets revise exchange rates in the light of |news', that is information that is newly available to the market. Our model also allows us to assess whether the exchange-rate path is plausible, since the model generates forecasts of long-term current account flows, which we can compare with our own assessments of long-term capital account flows. The function of the exchange rate is to ensure that the two types of flow balance, and this comparison will sometimes suggest that a given exchange-rate path is implausible. In the current forecast we would judge that current exchange rates do not appear to be out of line with a sustainable exchange-rate path. In 1999 our forecast shows current account deficits equivalent to 1.2 per cent of GNP in the United States and Italy, and 1.5 per cent of GNP in France, and a surplus of 1.3 per cent of GNP in Japan, with Germany close to current account balance. [Tabular Data Omitted]

The United States

US GNP fell for the second successive quarter in the first quarter of 1991, and hence the US economy now fulfils the statisticians' definition of a recession. The preliminary estimates suggest that GNP fell by 2.8 per cent at a seasonally adjusted annual rate between the fourth quarter of 1990 and the first quarter of 1991, following a 1.6 per cent fall between the third and fourth quarters of 1990. Such large falls after a year of sluggish growth have taken GNP to its lowest level since the second quarter of 1989.

The recession has been caused by a collapse in domestic demand, which fell by 4.4 per cent (SAAR) between the third quarter of 1990 and the first quarter of 1991. The biggest decline has occurred in stock-building which fell by more than 0.5 per cent of GNP in both the fourth quarter of 1990 and the first quarter of 1991. Consumer spending fell by 3.4 per cent (SAAR) in the fourth quarter of 1990, and by 1.4 per cent in the first quarter of 1991. Housing investment fell by more than 20 per cent (SAAR) in both quarters, although in absolute terms this decline contributed less to the decline in GNP than the fall in consumers' expenditure. Business investment remained flat in the fourth quarter of 1990, but fell by 14 per cent (SAAR) in the first quarter of 1991. The decline in domestic demand has contributed to a decline in imports, but exports have continued to grow, so that net exports have increased as a proportion of GNP. Net exports have contributed to GNP growth since 1987, following the major decline in the dollar between 1985 and 1987.

Even though the US economy entered recession in the final quarter of last year, inflation continued to rise. The increase in oil prices following the Iraqi invasion of Kuwait contributed to this, but underlying consumer price inflation, which excludes energy and food prices, also continued to rise. Indeed the underlying rate of inflation reached an 8 year high of 5.7 per cent as recently as February 1991.

Inflationary pressures were increased by the depreciation of the US dollar in the second half of 1989 and through most of 1990. Between June 1989 and November 1990 the dollar effective exchange rate fell by 17 per cent, including falls of 25 per cent against the D-Mark and 10 per cent against the yen. The dollar has however recovered strongly since November. At the end of April the effective exchange rate had risen by 11 per cent, the exchange rate against the D-Mark by 18 per cent and the exchange rate against the yen by 7 per cent.

The combination of a recession with rising inflation presented the US monetary authorities with a policy dilemma. A reduction in interest rates appeared necessary to support domestic demand growth, but would also have risked further dollar weakness and hence a possible increase in inflationary pressure. In 1990 the Federal Reserve Board appeared to attach greater weight to the inflationary threat. The discount rate was held at 7 per cent until December, although there was a slight easing of the federal funds rate from 8.2 per cent in July to 7.8 per cent in November. Since November the Federal Reserve has acted to counter the recession, reducing the discount rate to 6.5 per cent in December, 6 per cent on 1 February, and 5.5 per cent on 30 April. By the beginning of May the federal funds rate had fallen to 5.75 per cent. This change in policy was motivated by evidence that the recession was becoming more severe than had previously been anticipated, but was also enabled by the strong recovery of the dollar between November and April, which has reduced the inflationary risk. Nevertheless the level of inflation remains a concern.

Given the contradictory risks faced by the Federal Reserve, the timing of interest-rate cuts was always going to be problematic. The delay in enacting the cuts almost certainly exacerbated the decline in domestic demand. The sharp fall in the level of domestic demand revealed in the national accounts for the first quarter of 1991 carries the risk of further declines invoked by the accelerator - multiplier responses of investment and inventory accumulation.

The existence of these responses makes it notoriously difficult to predict the turning-points of a boom or recession accurately. Our forecast, presented in table 5, suggests, however, that the United States economy will have started to grow again in the second quarter, and that recovery in the latter half of the year will compensate for the effects of the recession at the start of the year, leaving the level of GNP for 1991 as a whole unchanged from that of 1990. [Tabular Data Omitted]

Our forecast for 1991 is more optimistic than many United States forecasters. We think that there are a number of grounds to justify our relative optimism. The Department of Commerce's leading indicators index rose by 1.1 per cent in February, the first increase since July. The Conference Board index of consumer confidence has also risen dramatically from 54 in January to 81 in March, but fell back slightly in April. The National Association of Purchasing Managers' index rose by 41.5 in March from a low of 37.7 in January. However the NAPM interpret values below 44 as evidence of a contracting economy.

There are also some signs of recovery in housing investment. The level of housing starts fell for the fourth consecutive year in 1990, and in January 1991 was 45 per cent down from a year previously. However the level of starts was higher in both February and March, and the level of building permits was also higher in these two months. The level of housing investment in the first quarter of 1991 was the lowest recorded for 8 years, and down 25 per cent from its peak in the fourth quarter of 1986. The recent reductions in interest rates should provide an additional stimulus for the long-awaited recovery.

Our forecast for business investment is less optimistic. This category of expenditure continued to grow through 1990, and only declined in the first quarter of 1991. We therefore expect that it may have further to decline, especially as the recession has reduced the level of capacity utilisation in manufacturing, mining and utilities to 78.7 per cent, its lowest level since 1986. Lower interest rates and our forecast of a recovery in GNP in the second half of this year, should however reverse the decline in business investment towards the end of the year.

We expect inflation to decline gradually during the course of the year. The decline in oil prices following the Gulf war and the appreciation of the dollar in the first four months of this year, combined with the depressed level of domestic demand, will all exert downward pressure on inflation, which is expected to fall below 4 per cent in the fourth quarter of the year.

One benefit of the recent weakness of economic activity has been an improvement in the trade and current account deficits. This improvement has also been aided by the depreciation of the dollar through most of 1990. Even after its marked appreciation since November, the dollar remained lower at the end of April 1991 than it had been a year previously. The trade deficit for 1990 of $100 bn was the lowest since 1983, and the current account deficit of $99 bn the lowest since 1984.

Our forecast for US trade and balance of payments is presented in table 6. We expect that export volumes will grow at 6.4 per cent, and that import volumes will actually decline. This will enable a further significant reduction in the current account deficit to below $50 bn, taking it below 1 per cent of GNP. Chart 9 shows the evolution of the US current account deficit in the 1980s. The deficit deteriorated rapidly in 1983 and 1984, as a consequence of the very strong growth in US GNP, combined with the lagged effects of a real exchange-rate appreciation since 1980. The deterioration of the current account deficit continued until 1987, albeit at a less rapid rate. The real exchange rate reached a peak in 1985, and its subsequent depreciation enabled the current account deficit to stabilise at the end of 1986, and subsequently to diminish. This improvement will accelerate as a result of the current US recession. [Tabular Data Omitted]

We expect that the recovery in GNP should be well under way by 1992, leading to growth of 2.4 per cent for the year as a whole. Domestic demand is expected to grow by 2.8 per cent, but net exports are expected to reduce GNP growth by 0.4 per cent. The deterioration in net exports is due to a combination of higher domestic demand, and a further appreciation of the exchange rate, in line with the uncovered interest parity condition. This appreciation should enable the rate of inflation to be held at 4 per cent, but will also contribute to a renewed deterioration in the current account. In the longer term we anticipate that the US economy will grow 2 to 2.5 per cent per annum, with interest rates increasing from their current crisis levels to around 7 per cent, but inflation falling below 3 per cent per annum. The current account deficit as a proportion of GNP is expected to remain constant at around 1.2 per cent.

Japan

The rate of growth of the Japanese economy slowed markedly in the fourth quarter of 1990. GNP grew at an annualised rate of 2.1 per cent, compared to the rates of 6.6 per cent, 5.6 per cent and 4.6 per cent achieved in the first three quarters of the year. Investment expenditures grew much less rapidly than earlier in the year, and consumers' expenditure actually fell by 0.3 per cent in the fourth quarter. This was the first decline in consumer spending since the fall in the second quarter of 1989, which was caused by the introduction of the sales tax.

The cause of the current slowdown appears to be the monetary tightening experienced during 1989 and 1990. The Gensaki rate rose from 4.2 per cent in the first quarter of 1989 to 7.6 per cent in the first quarter of 1991, its highest level since 1981. This monetary tightening followed clear signs of overheating that stemmed from growth in excess of 4.5 per cent in each of 1988, 1989 and 1990.

Even though it now appears to be growing more slowly, the Japanese economy remains close to capacity output. Business survey evidence indicates that rates of capacity utilisation in manufacturing continued to rise in the fourth quarter of 1990. Unemployment remains low, and the ratio of vacancies to job seekers stood at 1.44 in January 1991, only marginally down from the 16-year high reached in June 1990.

Labour shortages have led to higher wages and upward pressure on prices, especially in the service sector. Wage increases in the annual Spring wage round averaged just under 6 per cent in 1990, with a similar outturn likely to occur this year. Higher wage costs combined with higher oil prices caused consumer price inflation to rise to 4.5 per cent in January 1991. The fall in oil prices since the start of the Gulf war will provide some relief, but domestic price pressures are likely to remain strong.

Our forecast(2), presented in table 8, is for Japanese GNP growth of 3 per cent in 1991. The growth of domestic demand is forecast to be 3.1 per cent, down from 5.7 per cent in 1990, with net exports remaining at -0.1 per cent of GNP. The main components of slower growth in domestic demand are consumers' expenditure and business investment, which will continue to be restrained by the high level of interest rates. We expect interest rates to remain at current levels until there is clear evidence that the current high levels of capacity utilisation and labour market shortages have been reduced. [Tabular Data Omitted]

We expect that continued high interest rates will significantly reduce the growth rate of business investment, which along with consumers' expenditure has been the main component of Japanese growth in the last three years. A survey of investment intentions conducted by the Japan Development Bank in February indicated that Japanese firms expected to increase investment by only 4.4 per cent this year. The reduced growth of investment is due to high interest rates and an expected decline in demand in both domestic and world markets. The rate of inflation is forecast to be 3.9 per cent in 1991. The effects of slower growth in domestic demand will reduce inflationary pressure during the course of the year, leading to inflation of 2.2 per cent in 1992.

A particular uncertainty in constructing a forecast of Japan is to predict the course of the exchange rate. Our usual forecasting rule, which we have again used in this forecast, is to predict future exchange rates from current exchange rates and interest-rate differentials. This is consistent with economic theory concerning the determination of exchange rates by rational, forward-looking, exchange-rate markets. In the course of the last two and a half years, however, the Japanese exchange rate has been especially volatile. Between the fourth quarter of 1988 and the second quarter of 1990 the yen depreciated by 21 per cent, but has since appreciated by 11 per cent. However in the last six months the yen has been much more stable, and now appears to be at a level which will allow a medium-term current account surplus of 1.5 per cent of GNP, which we judge to be around the level needed to match long-term capital account outflows.

Our forecast for trade and the balance of payments is shown in table 9. Export growth was constrained in 1990 by the slow growth in demand from Japan's export markets. This helped to reduce the current balance surplus to $36 billion, or 1.2 per cent of Japanese GNP. Export markets are expected to grow more rapidly in 1991, particularly in the second half of the year when the US economy is projected to grow again. Japanese import volumes are forecast to grow more slowly in response both to slower growth in Japanese domestic demand, and to the appreciation of the yen since the second quarter of last year. [Tabular Data Omitted]

We expect that 1991 will be primarily a year of consolidation for the Japanese economy, in which monetary policy will remain tight. If current policy proves successful in curbing inflation, there should be scope for interest-rate reductions later in the year which will provide a stimulus for domestic demand growth in 1992. The Japanese economy will also benefit in 1992 from higher economic activity in the rest of the world. However we judge that the Japanese economy will remain close to capacity output, and consequently that the authorities will aim to keep GNP growth below 4 per cent per annum in order to ensure long-term non-inflationary growth.

Germany

GNP rose by 4.5 per cent in the western Lander in 1990, but declined dramatically in the eastern Lander. Economic and monetary union between the two parts of Germany fuelled demand in the western Lander, particularly as the conversion rate of Ostmarks into D-Mark was favourable to east German consumers. However much of east German industry was rendered uncompetitive, through a combination of too high a conversion rate, workforce demands that monetary union should entail west German wage rates, and not least by the interior quality of east German goods.

For the western Lander monetary union and the subsequent unification of Germany led to the highest rate of economic growth since 1976. Consumers' expenditure rose by 4.2 per cent and business investment by 10.3 per cent. While extra demand from the east was the main stimulus, consumers' expenditure also benefited from a DM24 billion cut in income taxes at the start of the year. These factors enabled strong growth despite interest rates rising from 7 per cent in 1989 to 8.5 per cent in 1990, a marked slowdown in the growth of export markets and an exchange rate appreciation of 8.1 per cent between 1989 and 1990.

The outlook for 1991 is much less favourable. The collapse of the eastern economy will reduce demand for western goods and services. Monetary policy will remain tight and fiscal policy will also tighten as the German authorities attempt to moderate demand in the western Lander. In addition recession in the United States combined with slower growth in western Europe and Japan will reduce external demand.

The German authorities are faced with two distinct problems arising from unification. The first problem is to prevent the western economy from overheating. GNP growth has now exceeded 3.5 per cent in each of the last three years, leading to capacity utilisation rates increasing from 84.9 per cent in the fourth quarter of 1987 to 90 per cent in the fourth quarter of 1990. Unemployment has fallen from 2.22 million in 1988 to 1.67 million in February 1991, in spite of the substantial immigration that occurred in both 1989 and 1990. Inflationary pressures have also emerged in the labour market. The largest trade union, IG Metall, obtained a 6 per cent increase in wages in both 1990 and 1991. Some unions are demanding 10 per cent increases.

The second problem posed by unification is the need to reconstruct the eastern economy. It is estimated that industrial production in the east has fallen by around 50 per cent. Unemployment in the east had reached 800,000 in March 1991, with around 1.8 million on short-time working. Ths rise would have been even higher if substantial numbers of easterners had not started commuting to jobs in the west. A further substantial increase in unemployment is expected to occur in July when guarantees against redundancy in the year after monetary union are due to expire. New investment in the eastern Lander has not occurred on as large a scale as had been hoped, and there is a danger that the east will prove to be a drain on the German economy, as we commented in the August 1990 issue of the Review. Nevertheless it was always likely that there would be a big decline in economic activity in the east, since it was necessary to get rid of the dead wood before reconstruction could get under way. We expect that increased investment from western firms faced with labour shortages or high wage costs will lead to recovery in the east, although the scale of the present disjunction will mean that it will take some years before the two economies are effectively integrated.

The German public sector deficit is estimated to have been DM87bn in 1990. A further deterioration will occur in 1991, caused by higher spending in the east. Higher spending in the east is in part the consequence of high unemployment, but it also reflects the regional tax transfer system that has been established for some time. Income tax payments by commuters to the west are automatically transferred to eastern Lander, and 95 per cent of VAT revenue is shared out in proportion to population. This alone implies a substantial transfer to the east. We are embedding a small model of the east into our German section, and the public sector component reflects these transfer rules. Despite his election promises, Chancellor Kohl has raised indirect taxes, and imposed a 7.5 per cent surcharge on income and corporate taxes beginning on 1 July. These two measures are expected to yield DM36bn. An increase in VAT is scheduled for January 1993.

Monetary policy is likely to remain tight through 1991. German three-month interest rates remained at around 8.3 per cent in the first ten months of 1990, as the Bundesbank adopted a wait-and-see response to unification. However evidence that the budgetary costs of unification were going to be higher than had been expected has led to further monetary tightening. The Lombard rate was increased by 0.5 percentage points on 2 November 1990 and on 1 February, and now stands at 9 per cent. The discount rate was also raised 0.5 percentage points on 1 February to 6.5 per cent.

The tight monetary policy has kept inflation in check. In March the annual rate of inflation was 2.5 per cent, compared with 2.7 per cent in 1990. However the planned increases in indirect taxes and the weakening of the D-Mark since the fourth quarter of 1990 are likely to cause inflation to pick up again in the second half of the year.

A major effect of German reunification has been the reduction of the German current account surplus. The compilation of current account and trade statistics has altered since monetary union in July 1990, so that the statistics cannot be directly compared with previous figures. Nevertheless whereas in 1989 west Germany had a current account surplus of DM104 billion, or 4.6 per cent of GNP, the new Germany was in deficit in January and February of this year. Between July 1990 and February 1991 the visible trade balance declined from DM9.9bn to DM2.6bn, while the invisible balance improved from DM - 5.9bn to DM - 4.8bn. The deterioration of the visibles balance reflects the continued strength of demand in Germany, and the weakening of demand in its major trading partners.

Our forecast for Germany is shown in table 10. Our forecast for GNP is for the western Lander only, since national accounts are not yet available on an all-German basis. Western Lander GDP will grow by around 3 per cent, but GNP will grow by only 2.4 per cent. The difference arises because of the increase in factor payments to the eastern Lander, as a result of an increase in the number of residents in the eastern Lander who earn their income by working in the western Lander. We expect the growth of domestic demand in the western Lander to fall from 4.9 per cent in 1990 to 3.9 per cent in 1991. Consumers' expenditure is expected to grow by 2.8 per cent compared with 4.2 per cent last year. Slower growth here is caused by a combination of tax increases in 1991 compared with tax cuts in 1990, higher interest rates and a decline in spending by east Germans. Business investment is also expected to grow less rapidly due to high interest rates, and as a result of lower growth in economic activity, both within Germany and abroad. We expect that housing investment will continue to grow strongly, in spite of high interest rates, as immigration into western Germany has generated severe housing shortages. [Tabular Data Omitted]

Even though the rate of growth is expected to fall, the west German economy remains close to capacity output and we expect that inflation will rise later in the year. For the year as a whole inflation is forecast to be 3.3 per cent. Towards the end of the year we expect that demand from eastern Germany and from the rest of the world will begin to pick up. This will generate extra inflationary pressures on Germany. The Bundesbank is expected to maintain a tight monetary policy and may need to raise interest-rates further. However we expect that rates will remain unchanged, as we judge that policy is already sufficiently tight. Nevertheless inflation may rise further in 1992 as recovery in the east gets under way.

Our forecast for German trade and balance of payments is shown in table 11. We expect some improvement in the current account balance during the year as the rate of growth moderates in Germany, while demand from the United States and the United Kingdom begins to pick up. For the years as a whole [Tabular Data Omitted]

PHOTO : Chart 9. US current account we are forecasting a current account surplus of $6bn, or 0.4 per cent of German GNP. Small surpluses are expected to continue throughout the decade. This is in contrast with the large west German surpluses prior to monetary union, and reflects the fact that west German savings will be primarily directed to reconstruction in the east.

Table 12 shows our forecast for the German public sector deficit. The deficit is expected to increase from DM87bn to DM171bn in 1991. This deterioration partly reflects the fact that 1991 will be the first complete year of German unification, and partly our expectation that conditions in the east are likely to deteriorate further during the course of 1991. In the first instance the deterioration of the deficit will be curbed by the tax increases that have already been announced. In the longer term recovery in the eastern economy will lead to a gradual but continuing reduction in the budget deficit. [Tabular Data Omitted]

France

In the fourth quarter of 1990, real GDP fell by 0.4 per cent, for the first time since early 1987. For the year as a whole, real GDP grew by 2.8 per cent, compared with 4 per cent in 1989. The fall in the fourth quarter was associated with declines in industrial output, which fell by 2.3 per cent, and total investment, which fell by 0.8 per cent - the first decrease for four years. Almost all sectors showed declines in output, but the sharpest drop was found in car production. For the first quarter of 1991 no significant improvement is expected. Business investment fell sharply by 2.7 per cent.

Import volumes fell by 0.5 per cent, due to lower domestic demand and a fall in energy imports, but export volumes grew by 2.5 per cent. Industrial production grew by 1.1 per cent in 1990, the lowest growth for four years, compared with 3.6 per cent in 1989. The signs for the first quarter of 1991 indicate that no recovery can be expected. Industrial production in the three months to February fell by 1.2 per cent, compared with a 1.4 per cent drop in the previous three months. New company registrations were unchanged in March but had dropped to a six year low in February. Total starts in 1990 were 2 per cent lower than in 1989, with the sharpest drop in industry and trade. The INSEE survey showed that business confidence remains very weak, stocks have built up again, and order books remain poor.

Unemployment started to rise in September and the sharpest rise was in February when the number of unemployed rose by 45,000. The increase in March was 15,900, bringing the total number of unemployed to 2.6 million. The rate of unemployment rose to 9.3 per cent. In 1990 the rate of unemployment was 9.0 per cent on average, down from 9.4 per cent in 1989 and 10 per cent in 1988. The rise in unemployment is expected to continue as less jobs are created due to slower economic growth both at home and abroad, and despite government efforts to boost job creation through reducing labour costs.

The annual inflation rate continues to fall. For 1990, inflation, excluding energy, reached its lowest point since 1966 and although the rate of inflation edged up slightly in the beginning of this year, the overall inflation rate has continued its decline in recent months. We expect the annual inflation rate for 1991 to fall below the German rate. This reflects both the success of the French efforts to tame inflation through its commitment to a strong currency in the ERM, and the increase in the rate of inflation in Germany.

The trade deficit widened to FF49.8 billion in 1990, compared with FF44.7 bn in 1989 and was the worst trade balance since 1982. The current account showed a FF31.1 bn deficit last year, compared with a FF25.0 bn deficit in 1989. The worsening of the current account can be attributed to the widening trade deficit and a decline in the invisibles surplus, with a marked deterioration in the balance of investment income, caused by the appreciation of the franc.

Our forecast for the French economy is set out in tables 13 and 14. In our last forecast we expected real GDP to grow by 1.6 per cent in 1991. Our latest forecast is only slightly lower at 1.5 per cent, compared with 2.8 per cent in 1990. Although domestic conditions have deteriorated the recent improvement in competitiveness will in part offset this decline in the projected rate of growth of domestic demand. Domestic demand is projected to grow by 2.2 per cent, compared with 2.9 per cent in 1990. Rising unemployment and lower wage growth means lower disposable income growth and as a result consumption is expected to grow by only 2.0 per cent. Private investment is forecast to grow by 2.9 per cent, 1 per cent lower than 1990 and 3 points lower than 1989. [Tabular Data Omitted]

We expect exports to grow by 3.3 per cent, much less than in previous years. This is mainly due to the slowdown in foreign markets. The effective exchange rate rose almost 8 per cent in 1990 due to the decline of the dollar. This has made French exports more expensive and French industry has lost competitiveness vis-a-vis its major competitors. The recent recovery of the dollar and the decline of the franc means that the French economy has regained some of its lost competitiveness and we expect a drop in relative export prices almost offsetting last year's rise. Imports are expected to grow by 4.9 per cent and this, combined with the expected worsening of invisibles, leads to a projected current account deficit of 1.1 per cent of GDP.

Italy

The Italian economy is growing at a much slower pace than in previous years. Real GDP grew by 0.7 per cent in the third quarter of 1990, compared with a 0.6 per cent fall in the second quarter. For 1990, real GDP is expected to have grown by 2 per cent, compared with 3.2 per cent in 1989 and 4.1 per cent in 1988. The first indications of an economic slowdown were seen in 1989 and the economic situation worsened in 1990 with a sharper slowdown in consumption, investment growth and net exports. Consumers' expenditure grew modestly by 2.8 per cent, with a marked slowdown in expenditure on consumer durables. New car deliveries fell by 10 per cent, compared with an increase of 8.1 per cent in 1989. There was a sharp decline in private investment growth to 2.1 per cent, compared with 5.1 per cent in 1989.

Inflation accelerated again and rose to 6.3 per cent in 1990. The inflation differential vis-a-vis Germany has risen from 2.8 points to 3.7 points, while the differential with France has increased from 2.7 to 3.3 points. The indications for the first months of 1991 are not much better, with inflation rising to 6.6 per cent in March. Inflation increased as a result of higher energy prices, although the acceleration is mainly due to domestic factors. Hourly earnings rose by 7.3 per cent in 1990. Despite an improvement in hourly labour productivity over the last years, unit labour costs have risen substantially as the growth in hourly wage costs has exceeded growth in productivity. This has further eroded the profitability of Italian firms, which have been limited in their ability to pass the rise in unit labour costs on to prices. There are indications of further wage increases, with the sharpest increases in sectors that are protected from international competition, like earnings per employee in the public sector that grew by 14 per cent last year. With these wage increases there is no prospect of the unemployment rate coming down significantly from the 11 per cent recorded in 1990.

The lira appreciated substantially against the dollar and yen in 1990 and this, combined with the increased inflation differential vis-a-vis its major European partners, led to a fall in Italy's competitiveness. The volume of exports grew by 5.6 per cent in 1990, while imports grew by 6 per cent.

The trade deficit fell to 14 billion lire, compared with 17 billion in 1989, due to the improvement in the terms of trade. The current account deficit is expected to have widened in 1990 to around 2 per cent of GDP. This reflects the worsening of the deficit on invisibles due to a marked decline in the surplus on services. In the second half of the 1980s the surplus on tourism has declined steadily, due to the loss of competitiveness and the growth in Italian expenditure on foreign travel that has accompanied the removal of foreign exchange restrictions.

Our forecast for the Italian economy, presented in table 15, indicates a further deterioration in the economic situation compared with 1990. Real GDP is projected to rise by only 1.1 per cent. We expect consumption growth to slow down further to 2.1 per cent, due to the acceleration of inflation that reduces real earnings growth. Inflation is expected to rise further given the wage increases, and we see little prospect of a rapid convergence of Italian inflation to that of its major European partners. With fiscal policy directed towards bringing the ratio of public debt to GDP under control, there is not much scope for a counter-cyclical policy. As monetary policy is committed to a stable exchange rate, interest rates are expected to remain high and we see no recovery of investment growth in 1991. In our forecast, exports suffer from the loss of competitiveness and the slowdown in Italy's export markets. Exports to Germany account for 19 per cent of total exports and given the slowdown in Germany, exports are not expected to grow at the same rate as over the previous years. We expect the deficit on invisibles to widen further. The current account deficit may fall to 1.1 per cent of GDP as the terms of trade improve. [Tabular Data Omitted]

The long-term outlook for the Italian economy remains hampered by the relatively high wage inflation, which hinders any prospect of a decline in the inflation differential vis-a-vis its European partners, and by the high public sector deficits and rising public debt to the GDP ratio. This may make it difficult to maintain the value of the Lira within the exchange-rate mechanism. In our forecast the Lira is devalued within the ERM in the mid 1990s.

Canada

The Canadian economy is in severe recession. Real GDP fell in each of the last three quarters of 1990. For the year as a whole, real GDP rose by 0.9 per cent but in the fourth quarter it was 16 per cent below its peak level in the first quarter of 1990. However, this is less severe than the 2.8 per cent decline experienced in the last three quarters of the 1981/2 recession. Consumers' expenditure grew by 1.3 per cent in 1990, but total domestic demand did not grow as private investment fell sharply, due to high interest rates. This slowdown in the US has contributed to a deterioration in the contribution of net exports.

The signs for the first quarter of 1991 are not encouraging. Industrial production in January was almost 5 per cent below its level of a year before, and housing starts have continued to decline in the first three months of this year. Unemployment has risen by 161,000 in the first quarter of 1991, bringing the total number of unemployed in March to 1.44 million. The unemployment rate has risen sharply over the last year to 10.5 per cent in March, compared with 9.3 per cent in December and 7.2 per cent in March 1990. There is however some evidence that the first quarter of 1991 may be the bottom of the recession. Consumer confidence, as measured by the Conference Board of Canada, increased slightly at the end of 1990, and the decline in petrol prices will benefit the energy intensive Canadian economy.

These indications of a severe recession have led the monetary authorities to ease monetary conditions further and lower interest rates. Inflation rose sharply to over 6 per cent in January and February, due to the replacement of the Manufacturers Sales Tax by a Goods and Services Tax (GST). This more broadly based value added tax has added approximately 1.25 percentage points to the inflation rate and will further reduce growth of real personal disposable income.

Our forecast for Canada is set out in table 16. Real GDP is expected to decline by 1.6 per cent. We expect consumers' expenditure to drop by 0.4 per cent this year, due to higher unemployment and the adverse effect of higher inflation on real personal disposable income. Domestic demand is expected to fall by 0.8 per cent, as private investment is also forecast to fall. We expect a further negative external contribution, as export volumes are projected to fall slightly due to the slowdown in the United States. The current account deficit is expected to remain unchanged, around 2.4 per cent of GDP. [Tabular Data Omitted]

NOTES

(1) The latest version of GEM includes new equations for business investment in which we find

long-run effects from

long-term interest rates. These equations are discussed in Annex 2 to this chapter. Some

standard simulations using the

new version of GEM are reported in Barrell and Gurney (1991b). (2) Detailed forecast tables are available from the National Institute. These include rebased

Japanese national accounts data.

REFERENCES

Barrell, R. and Gurney, A. (1991a), |Fiscal and monetary policy simulations with forward-looking

exchanges using the National

Institute Global Econometric Model (GEM)', National Institute discussion paper no. 200. Barrell, R. and Gurney, A. (1991b), |Standard simulations', Paper prepared for SPES macromodelling

conference, Paris, June

1991.

ANNEX 1 EXCHANGE-RATE VOLATILITY 1987-1991

The appreciation of the US dollar in the last six months has given the issue of exchange-rate volatility renewed topical interest. This is an issue which has been debated over many years. A recent summary of the debate can be found in Krugman (1989). In this note we review the volatility of exchange rates for the major seven economies in the period since January 1987. This date has been chosen for two reasons. Firstly it covers the period since the last major international agreement on exchange rates, the |Louvre accord' of February 1987. Secondly it also covers the period since the last major realignment in the european exchange-rate mechanism, which occurred in January 1987. The analysis uses monthly averages of exchange rates. The measure of volatility over a sample period is taken as CV = 100xSD/Mean

where CV = Coefficient of Variation

Mean = Mean value of exchange rate over the sample period

SD = Standard deviation of the exchange rate over the sample period

Alternative methods for analysing exchange-rate volatility can be found in Wadhwani (1987) and Artis and Taylor (1988). Haldane (1991) provides a survey of literature on the EMS, including the effects of the exchange-rate mechanism on volatility. Table 1 shows mean exchange rates over the whole sample period, and table 2 the coefficients of variation. The most general measure of each country's exchange rate is its effective exchange-rate index. Table 2 shows that the most volatile G7 currency, measured in terms of the coefficient of variation of its effective exchange rate between January 1987 and March 1991, has been the Japanese yen, followed by the US and Canadian dollars. The least volatile G7 currency has been the Italian lira, followed by the French franc and the German mark. Table 2 also shows the effect of the European exchange-rate mechanism in securing this low currency volatility for Germany, France and Italy. Taking individual cross exchange rates against the US dollar, the German mark and Japanese yen appear the most volatile currencies, and the Canadian dollar the least volatile, while in terms of exchange rates against the mark, the yen is the most volatile and the franc the least volatile. More importantly the coefficient of variation for the franc and the lira against the D-Mark are 0.8 per cent and 1.5 per cent respectively, whereas the lowest coefficient of variation for a currency measured against the US dollar is 5.3 per cent for the Canadian dollar, and for a currency measured against the yen is 5.6 per cent for the lira. [Tabular Data Omitted]

Tables 3 and 4 show the mean value and coefficient of variation for each country's effective exchange rate over overlapping sub-samples, each spanning 12 monthly observations. In table 3 it is clear that movements in exchange rates have not been systematic, in the sense that none of the exchange rates has been consistent appreciating or depreciating since 1987. Table 4 shows that there have been periods of greater and lesser exchange-rate volatility. In most periods either the yen or the US dollar has a coefficient of variation in excess of 3.5 per cent, but in the two periods January-December 1988 and July 1988-June 1989 all seven currencies had coefficients of variation less than 3.5 per cent, representing periods of less exchange-rate volatility. In contrast July 1989-June 1990 and April 1990-March 1991 were periods of greater exchange-rate volatility, in which the coefficient of variation of the yen effective exchange rate exceeded 5.0 per cent. [Tabular Data Omitted]

The use of effective exchange-rate indices inevitably masks the volatility in individual cross exchange rates. These are illustrated in tables 5-7. A summary of the results is also shown in table 8, which divides the results from tables 5-7 into four categories. The division of the categories is arbitrary, but useful as a way of visualising the results. Some interesting observations can be made. Firstly with the exception of the Canadian dollar, volatility against the US dollar generally falls in the medium-high or high categories. Again with the exception of the Canadian dollar, currencies have tended to be less volatile against the yen than against the US dollar, with the UK pound showing greater stability against the yen than against the D-Mark. This result is unlikely to persist now that sterling has joined the european exchange-rate mechanism. The success of the exchange-rate mechanism in limiting exchange-rate volatility between the French franc, Italian Lira and the German mark is also apparent in table 8. The pound has been noticeably more stable against the mark than against the dollar. [Tabular Data Omitted]

Our analysis of exchange-rate volatility since 1987 has revealed that the exchange-rates of the US dollar and the Japanese yen have tended to be the most volatile in this period, both because they are the most heavily traded currencies and because they have been outside any formal exchange-rate arrangement. While Canada is not formally part of an exchange-rate agreement, its economy is highly integrated with that of the United States, and hence the value of the Canadian dollar has been relatively stable against the US dollar.

In the last four years the most difficult country to categorise has been the United Kingdom, since the pound has tended to be more stable against the yen than against the mark, despite the greater level of integration of the UK economy with that of continental Europe. The French and Italian results indicate that the ERM has been effective in limiting the volatility of European cross exchange rates. Now that the pound has joined the ERM the major currencies of the world can be more readily divided into three distinct blocks. This study finds no evidence to suppose that exchange-rate volatility is diminishing. This reflects continuing divergences in both the economic structure and the stance of economic policy between the three main currency blocks.

REFERENCES

Artis, M. and Taylor, M. (1988), |Exchange rates, interest rates, capital controls and the European

monetary system', in

Giavazzi et al (eds), The European Monetary System, Cambridge University Press. Haldane, A. (1991), |The exchange-rate mechanism of the European monetary system: a review of the

literature', Bank of

England Quarterly Bulletin, vol. 31, no. 1. Krugman, P., (1989), |The case for stabilising exchange rates', Oxford Review of Economic Policy,

vol. 5, no. 3. Wadhwani, S. (1987), |Are exchange rates |excessively' volatile?', Journal of International

Economics, vol. 22, no. 314.

ANNEX 2. THE EFFECTS OF CHANGES IN LONG-TERM INTEREST RATES

ON BUSINESS INVESTMENT

In the last year we have included long-term interest rates in our econometric model GEM. These are modelled as a geometric average of future short-term interest rates in forward-looking simulations of the model, and hence provide an additional channel in which expectations of future interest rates can affect current economic behaviour. One of the ways in which we expect such expectations to influence current behaviour is through changes in investment decisions. We have therefore re-estimated our business investment equations to allow for changes in response to variation in long-run interest rates.

On GEM total investment is disaggregated into business investment, housing investment and government investment for all 7 major economies with the exception of Italy. We have chosen to model total Italian investment in the same way as we model business investment for the other major 7 economies. We assume that the main determinants of investment are the level of economic activity, as measured by either GDP or GNP, and interest rates. In equilibrium we would expect that business investment would be a constant proportion of total GNP. This requires a long-run unit elasticity with respect to GNP. Our econometric methodology was to test down from a general model which allowed short-run effects from lagged changes in business investment and current and lagged changes in GNP and interest rates, and long-run effects from the levels of GNP and long-term interest rates. Our aim was to estimate an equation over the period 1970Q1-1990Q2, but in some cases we were unable to obtain a satisfactory econometric representation, and we have accordingly reduced the period of estimation.

In all cases except Japan we have found equations that are statistically well-specified. The Japanese equation marginally fails the test for normality of residuals at 5 per cent significance levels. Tests for parameter instability are all insignificant at 5 per cent significance levels. The restriction of a long-run unit elasticity is statistically acceptable in all cases except the United Kingdom. We have nonetheless retained the unit elasticity restriction in our equation for the United Kingdom in order to ensure sensible forecasting and simulation properties when used in GEM.

The equations for the United States and Canada include a dummy variable C79, which takes the value zero up to 1978Q4 and 1 from 1979Q1 onwards, indicating a possible step increase in the equilibrium business investment to GNP ratio from 1979 on. The Japanese equation includes a dummy variable that takes the value 1 in 1974Q1 to account for an outlier. The United Kingdom equation includes a dummy variable with values 1 in 1985Q1 and - 1 in 1985Q2, which accounts for the switch in business investment between those two quarters as a result of a charge in company taxation.

The dynamic responses of business investment to changes in the level of economic activity and the long-term rate of interest are summarised in Tables D1 and D2. Table D1 shows business investment in the US, Germany and France responds rapidly to changes in the level of activity, with an elasticity exceeding 0.9 achieved within a year. Italy and Canada reach an elasticity of 0.9 after about 3 years, the United Kingdom after 6 years and Japan after 7 years. The slow speed of response in these last two countries appears rather odd, and may indicate that the equations are missing important explanatory variables, even though they are statistically well-specified. [Tabular Data Omitted]

Table D2 reveals a considerable range of both speed and magnitude of response to changes in 10 year interest rates. [Tabular Data Omitted]

The short-run semi-elasticity ranges from -0.001 in Italy to -0.013 in Germany, and the long-run semi-elasticity ranges from -0.007 in the United States to -0.184 in Japan. However the mean lag in the United States is much lower than in the other countries while the mean lag in Japan is the highest. In Italy and Canada also a relatively low long-run semi-elasticity is combined with a relatively low mean lag.

In simulations of GEM, long term interest rates are modelled as a geometric average of expected future short-term interest rates. This means that the relationship between short-term and long-term interest rates will vary according to how long the short-term interest rate is expected to remain at a given level. Table D3 shows that a 1 percentage point increase in short-term interest rates will only result in a 1 percentage point increase in long-term interest rates if it is expected to persist for 10 years or more. If the increase is expected to persist for 5 years, then long-term interest rates will initially rise by 0.5 percentage points, and then decline by 0.025 percentage points per quarter. An increase that is expected to last for 1 year only will cause long-term interest rates to rise by only 0.1 percentage points. [Tabular Data Omitted]

Table D4 shows the effects of this differential response on the simulation properties of the model. Two simulations have been run for each country. In both simulations short-term interest rates are raised by 1 percentage point. In simulation A the increase is expected to persist for 1 year and in simulation B for 5 years, so that long-term interest rates respond differently in the two simulations. In each country business investment falls by more in simulation B, but the effect ranges from an additional fall of 0.08 percentage points in Italy to 0.61 percentage points in Germany. This range reflects primarily the short-run semi-elasticities shown in Table D2. The effect on GNP depends on the proportion of business investment in GNP. GNP declines by an additional 0.08 percentage points in Japan and 0.07 percentage points in Germany but by less than 0.02 percentage points in Italy, the United States and France. In all countries the differences in inflation between the two simulations is negligible. [Tabular Data Omitted]