Knowledge that Transforms

IT is generally recognized that the international monetary crises of late 1967 and early 1968 were precipitated by large, continuing deficits in the United States balance of payments. Underlying these deficits was a steady erosion of the United States surplus on current account, which fell from 8.5 billion dollars in 1964 to 4.8 billion dollars in 1967. Despite government programs restricting foreign investment by United States residents,1 therefore, the overall deficit on a liquidity basis reached a level of 3.6 billion dollars in 1967. The resulting outflow of dollars and gold greatly reduced the confidence of speculators and central banks in the ability of the United States to maintain the international value of its currency. It is of course no coincidence that this deterioration in the current account position of the United States accompanied a rapid expansion of its military commitments in Southeast Asia. But the amount of the deterioration which may be attributed to the War in Vietnam is a point at issue. The Administration has estimated the direct foreign exchange cost of the War to be about 1.5 billion dollars.2 Many have argued, however, that if secondary and indirect effects are taken into account, the total impact on the balance of payments has been much greater. In this paper, we shall attempt to reach a more satisfactory estimate -or range of estimates -of the total effect of the War on the balance of payments. In so doing, we shall try to answer the question: What would the United States balance on current account have been in 1967 if real expenditures had been lower by the amount channeled into the military effort in Southeast Asia? The wording of this question perhaps requires further explanation. We shall assume that the multiplier effects of this hypothetical difference in expenditures could have been completely and precisely offset by monetary and fiscal policy. Thus we suggest that in the absence of the military build-up, expenditures for consumption, investment and government purposes other than the War would have been identical with those that actually occurred. In addition, it must be recognized that part of the increase in military expenditures would have been spent even without the Vietnam War build-up. The men now serving in the armed forces would have eaten, for example, regardless of whether they were in military or civilian roles. For this reason, we exclude domestic expenditures on military pay, provisions and accommodation from our calculations, and consider only those expenditures which may clearly be assigned to the expanded campaign in Vietnam.3 One may note several possible effects which this military spending may have had on the United States current account balance: 1) Increased direct foreign purchases of food, services and finished goods to supply the military effort. 2) Greater purchases of foreign goods to be used as inputs in United States defense production. 3) Deterioration in the United States net exports, due to both war-stimulated inflation and to supply bottlenecks in those sectors of production most affected by the increased spending. In the following sections, we shall examine each of these effects in turn. By summing the three components we hope to provide a relatively accurate and comprehensive picture of the balance of payments impact of the War. * The authors are grateful to Robert Triffin and Richard Cooper for their helpful comments and suggestions. 1 Note that this practice of restricting capital cannot be continued indefinitely without worsening the balance on current account, because it will of course reduce United States earning assets abroad. 2 U.S. Treasury Department, Maintaining the Strength of the U.S. Dollar in a Strong Free World Economy (Washington, 1968), p. 103. 'As noted below, foreign military purchases of food, etc., by the United States will be included in the direct current account impact of the War.

We do not find the relatively large prediction errors for all the regressions tested in 1965-IV surprising since the HWI rose an unprecedented 40 points from 1965-III to 1966-1, and other measures Rfi p1a1tSin., kbt, 1,,zr -nkaA,t,q npont,d t.0njrwor heating. In this same period, the nonfarm job openings series of the Bureau of Employment Security also increased dramatically, as did new hires in manufacturing. (Possibly there is a greater impact of the industrial cycle on the nonindustrial job market than has been previously recognized.) Moreover, the build-up of conventional type arms for Vietnam which got underway at the same time resulted in a shift of procurements from the West Coast to the Great Lakes and New England regions, which together have a heavier weight in the HWI.8 Tltis inip-esJing, tlit evem cru&de measures of tob vacancies may be quite sensitive indicators of pressures in the labor market. Certainly, job vacancy measures, when analyzed with care, deserve much more attention than they have received in the past.

CONSIDERABLE attention has recently I ~~been given to the theory of foreign exchange operations and its implications for government policy. Central to this is the analysis of forward exchange speculation.' Although the essence of speculative behavior is the balancing of uncertainty and expected gain, the analysis of uncertainty in the current theory of forward exchange speculation has generally been less rigorous than other parts of that theory. The purpose of this paper is to present a more explicit theory of the role of uncertainty in forward exchange speculation in the framework of von Neumann-Morgenstern expected utility maximization and to explore its implications for speculator behavior and government policy. Section I is a brief review of the contemporary analysis of foreign exchange speculation. Section II presents the expected utility maximization theory and derives a mean-variance framework for analyzing speculator behavior. The effects of changes in the mean and variance of anticipated gain is discussed in section III, with speculation assumed to occur only in terms of one currency. The theory is extended to multiple currency speculation in section IV. Some policy implications are discussed in section V. Finally, section VI provides a brief summary.

n a pioneering paper in 1958 Phillips [6] advanced the proposition that in the United Kingdom there is a statistically significant relationship between the level and the rate of change of unemployment (U and A U) and the rate of change of money wage rates (AW) which has been remarkably stable during the hundred years since 1862.1 Phillips, Lipsey [5] and others have advanced theoretical grounds on which it has been concluded that unemployment is the causal variable in the observed relationship. There is reason to believe that this proposition is widely accepted today and there is evidence to suspect that it has reinforced arguments in favour of controlling the price level through the level of unemployment. The Phillips hypothesis has been the subject of considerable discussion. Kaldor [3] in 1959 accepted the empirical evidence which supports it but disputed the postulated chain of causation. His argument may be taken to mean that the observed relationship between AW and U is consistent with the hypothesis of no causal connection between the two variables since, within certain limits, both could be concomitants of variations in the level of activity. Dicks-Mireaux and Dow [1] in 1959, Hines [2] in 1964, and others have drawn attention to factors such as the rate of change of the price level (AP) and the rate of change of the percentage of the labour force unionised (AT) which may affect AW independently of U and AU. Knowles and Winsten [4] in 1959, doubted whether the results of Phillips had any implication for public policy. They observed that, on his own data, the critical range of unemployment, between 0 and 3 'A per cent of the labour force, is compatible with any range of inflation between 2 per cent and 28 per cent per annum, while a stable wage level is compatible with between 2 per cent and 22 per cent of the labour force being unemployed. In this paper, we propose to re-examine the hypothesis and the statistical evidence concerning the relationship between the level of unemployment and the rate of change of money wage rates. Specifically, it will be shown that although there was a strong relationship between unemployment and changes in money wage rates in the 19th century, in subsequent years, the association has been very much weaker. Moreover, in the post 19th century years, the level of unemployment does not make a significant contribution to the explanation of the variance in money wage rates in models which include such variables as changes in the cost of living and the level and the rate of change of unionisation. Further, when the coefficients of the unemployment variables are used to predict subsequent values of AW conditional on U and AU, rather poor predictions are obtained. It will be suggested that there are good reasons why these results should have been obtained. In the years since the 19th century, new institutions and relationships have come to dominate the wage bargain. Since unemployment is now a relatively unimportant determinant of wage rate changes, its role in the control of wage inflation must in consequence be severely reduced.

the value of exports. The analysis is based on cross-sectional value and quantity series, and it is conceivable that the quantity data, from which our unit value series are constructed, contain a fair margin of errors. The reliability of unit values with respect to the aggregation problem is examined, and measurement errors in the quantity series may have biased our estimates of elasticities towards minus one. Since it is often the case that the estimation of price elasticities in international trade has to rely on unit value series, we maintain that bias due to inaccurate quantity data should be taken seriously.

EMPIRICAL studies of the investment decision have been restrained by the lack of data to the examination of investment expenditures anticipated or realized. A consequence of this empirical bias may be the diversion of attention away from the complete decision-making process and to the misleading impression that the investment decision is primarily and essentially one of timing and financing investment outlays. (See, however [2, 5, 6, 12-14].) The underlying hypothesis of this paper is that there are two investment decisions: The first, reflecting long-run plans and expectations, is whether or not to invest at all; the second, chronologically, is when to make and how to finance the actual expenditures. The latter is likely to be a function of the actual market conditions faced or the short-term expectations of those market conditions. While the need to include plans and expectations into the analysis may be fairly obvious, the necessary algebra remains elusive. However, objective data can capture most of what we need to know about expectations, leaving the algebra to be uncovered by empirical research. All that is needed are data that can be deemed to embody expectations without necessarily specifying their origin. Accordingly, a rather general model will be developed using capital appropriations data and initial conditions, which will illustrate the method proposed. In this paper, only the first decision, the formal commitment to invest, will be examined further. Given the capital appropriation, the question is what constitutes the set of relevant initial conditions and how much of the capital appropriations can be accounted for by reference to it. If the hypothesis of two investment decisions is correct, then there is a subset of initial conditions influencing this first investment decision and another subset which does not. This is essentially an empirical question. To examine the relationship between capital appropriations and initial conditions, cross-section data are used. They are generally regarded as reflecting long-run tendencies, and since the first decision is more or less a stock one, variables which vary over time and thus more appropriate for the flow decision prices, interest rates are eliminated. Two years have been selected for study 1956 and 1961-which are the best years available in the basic data. These years exhibit roughly the same movements in the business cycle and are far enough apart so that structural changes are permitted. The initial approach to the data and the immediate task for the present is to determine: (a) What the relationship is between capital appropriations and various selected variables for selected industries in each of the two years; (b) Whether the structure of expectations the same variables dominating was the same for each industry in 1956 as in 1961; (c) Whether there are significant differences among industries in the variables which are important. The data used were supplied by the National Industrial Conference Board (NICB) which since 1953 has conducted a quarterly survey of capital appropriations for the top corporations in the United States. These are large corporations and account for a sizeable proportion of investment expenditures. For a more detailed description of the data see Cohen [13]. Out of seventeen industrial groups of NICB, seven were selected for study: Primary Iron and Steel, Primary Nonferrous Metals, Machinery (except electrical), Fabricated Metals, Food and Beverages, Textiles Mill Products, and Paper and Allied Products. These industries were selected for their possible differing structure of expectations and because they rep* The author is an Assistant Professor of Economics at the University of Vermont. Parts of this paper are based on his Ph.D. dissertation, Expectations and The Investment Function (Rutgers The State University, Jan. 1966). He is indebted to Rutgers The State University for grants received, and to The Bureau of Economic Research at Rutgers University for additional financial support. The author is also indebted to K. K. Kurihara and M. Dutta for many helpful suggestions.