response will also occur with a lag. Thus, the outlook is for an increased variability of interest rates.
There is one additional variable to consider in the outlook for monetary policy.
If our analysis is correct, the terms of trade effect will produce downward
pressure on the U.S. dollar during 1989, just as it did during 1985-87. The
decline in the dollar in 1989 need not be inflationary. Insofar as the Fed gets
worried about the decline in the dollar, the response will be to slow the rate of
growth of the monetary base in order to stabilize the dollar's value. This could be
extremely bullish for bonds, and 1989 could well be a good year for the bond
SUMMARY IMPLICATIONS: IMPACT OF TAX RATE
CHANGES ON THE INTERNATIONAL SECTOR
Tax rate cuts result in higher after-tax rates of return for domestically located
assets. The higher after-tax return will result in a net capital inflow. Ultimately
the capital inflow will reduce the after-tax return to its long-run equilibrium.
Under a floating exchange rate system, the balance of payments must always be
zero. Hence, the capital inflow will mirror the trade balance. Therefore, our
framework predicts that:
|• ||A tax rate reduction will lead to the gradual appreciation of domestic currency. However, the surge in the foreign exchange value of the currency will ultimately be reversed.|
|• ||The tax rate reduction and capital inflow will generate a corresponding deterioration of
the trade balance.|
|• ||Initially, the domestic stock market will surge relative to the rest of the world.|
|• ||A sectorial effect will also become evident. During the appreciation phase, the nontraded sector industries will outperform the traded sector industries while during the
depreciation phase, the relative performance will be reversed.|
The U.S. experience during the 1980s is entirely consistent with our framework. Since they are lowering their personal income tax rate from 60 percent to
40 percent, our analysis suggests that during the next several years, the British
economy will experience many of the symptoms experienced by the United
States during the 1980s.
For an analysis of the policies of this period see: Arthur B. Laffer, "Balance of
Payments and Exchange Rate Systems," Financial Analysts Journal, August 1974; "Monetary Policy and the Balance of Payments," Journal of Money, Credit and Banking, February 1972; "The United States Balance of Payments--A Financial Center View," Journal of Law and Contemporary Problems, August 1969; "The Economic Consequences of Devaluation of Reserve Currency Country," World Monetary Disorder, ed. Patrick Boarman and
David Tuerck ( New York: Praeger, 1976); "Two Arguments forFixed Rates,"