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MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
The Wealth of Nations
The Supply Side
3-2
Key Concepts
 GDP Growth


Total output
Output per capita
 Elements of Growth



Labor
Capital
Total Factor Productivity
3-3
The Importance of Economic Growth
"No society can surely be flourishing and
happy, of which the far greater part of the
members are poor and miserable."
--Adam Smith
3-4
GDP Growth
 An increase over time in the quantity of goods
and services produced by an economy
 Rate of growth


Real GDP: adjusts for inflation
Real GDP per capita: adjusts for size of
population
3-5
World GDP Growth by Century
350%
300%
250%
200%
150%
100%
50%
0%
-50%
0 to
10th
11th
12th
13th
14th
15th
16th
17th
18th
% change in GDP per capita over each century
19th
20th
3-6
Rise In GDP per capita by Region
35000
GDP per Capita (1990 $)
30000
25000
20000
15000
10000
1820
2010
5000
0
3-7
Relative importance of trend
growth and business cycles
3-8
Importance of Growth
 Growing population
 Life expectancy
 Improving standards of living
 Poverty reduction
3-9
Growth rate, 1980 – 2000 (per annum)
Growth rate and Level of GDP
6%
4%
2%
0%
-2%
-4%
-6%
0
5,000
10,000
15,000
20,000
GDP per capita, US $$
25,000
3-10
Growth rate, 1980 – 2000 (per annum)
Growth rate and Level of GDP
China
6%
India
4%
2%
0%
-5000
-2%
5000
15000
25000
-4%
-6%
GDP per capita, US $$
Points are weighted by size of population in 1980
3-11
World GDP per capita and Life
Expectancy
10000
70
GDP per Capita (LHS, Log Scale)
GDP per capita (1990 $)
Life expectancy (RHS)
50
40
1000
30
20
10
100
0
0
200
400
600
800
1000
1200
1400
1600
1800
2000
Life expectancy at birth (years)
60
3-12
World Population Growth
10000
Asia
Africa
Europe
Latin America
N. America
Oceania
Millions of People
8000
6000
4000
2000
0
3-13
Trends in Global Inequality
1
0.8
Global inequality
0.6
0.4
Within-country
inequality
0.2
0
1820
Between-country
inequality
1850
1870
1890
1910
1929
1950
1960
1970
1980
1992
2000
3-14
Trends in Global Poverty
1600
1400
millions of people
1200
China
1000
Rest of E. Asia
Latin America
800
India
Rest of S. Asia
600
Sub-Saharan Africa
Rest of World
400
200
0
1981
1984
1987
1990
1993
1996
1999
2002
2005
Population with income of less than $1 a day
3-15
Inequality and Growth
More Inequality 
0.80
0.70
0.60
0.50
0.40
0.30
0.20
-10
-5
0
5
10
Growth Rate
15
20
3-16
Which enhances welfare?
 Eliminate business cycle movements
 Enhance growth rate
3-17
Compounding is a wonderful thing…
1999 GDP per
capita
(US = $30600)
Years to attain US 1999 level
Actual
growth
rate
(1990-99)
1% growth
3% growth
6% growth
9% growth
20 years
7 years
4 years
3 years
1.5%
$22640
32 years
11 years
6 years
4 years
2.1%
Brazil
$4420
196 years
66 years
34 years
23 years
1.7%
China
$780
370 years
145 years
64 years
44 years
9.8%
$100
577 years
194 years
99 years
67 years
2.2%
Germany
UK
Ethiopia
$25350
3-18
Analysis of Growth
Capital
(buildings,
infrastructure
and
machines)
Output (GDP)
Labor
(Hours worked, number
of workers)
Total Factor
Productivity
(technological
knowledge
and
efficiency)
3-19
GDP per capita
GDP per capita =
GDP
Population
GDP
Hours
Number Employed Labor Force




Hours Number Employed
Labor Force
Population
Labor Productivity
Average Hours Worked
Employment Rate
Labor Force
Participation Rate
3-20
GDP per capita
 Labor productivity
 Average hours worked
 Employment rate = 1 – Unemployment Rate
 Labor force participation rate
3-21
US Population by Labor Market
Status (2011)
Not working age
23%
Employed
45%
Unemployed
5%
Not in labor
force
27%
3-22
Decomposition of GDP per capita
(2008)
3-23
Total Employment
256000
Thousands of People
128000
64000
UK
USA
Japan
32000
Italy
France
Canada
16000
8000
3-24
Average Annual Hours Worked
Average annual hours worked
2300
2100
1900
1700
1500
1300
Canada
France
Japan
Sweden
UK
W. Germany
USA
3-25
Role of Inputs
 More inputs means more output
 Diminishing returns



1 worker = $10 in output
2 workers = $18 in output
3 workers = $24 in output
Marginal return is
$8 in output
Marginal return is
$6 in output
3-26
The Production Function
3-27
Production Function
Output = TFP  Capital Stocka  Labor Hours(1-a)
Real GDP
Total Factor Productivity
A parameter
(a number, 0 < a < 1)
3-28
Cobb-Douglas example
1000
Real GDP
900
800
700
TFP = 1
Capital = 500
a=0.6
600
500
400
300
200
100
0
0
500
1000
1500
2000
2500
Hours worked
3-29
Output  (500)0.6  (Labor Hours)0.4
Real GDP
1000
900
800
700
600
500
400
300
200
100
0
0
500
1000
1500
2000
2500
Hours Worked
3-30
Output  (Capital Stock)0.6  (1000)0.4
1800
Output
1600
1400
1200
1000
800
600
400
200
0
0
500
1000
1500
2000
2500
Capital Stock
3-31
Implications for labor productivity
Output = TFP  Capital Stocka  Labor Hours(1-a)
 Capital 
GDP
 TFP  

Labor Hours
 Labor Hours 
Labor Productivity
a
3-32
Changes in Labor Productivity
 Total Factor Productivity
 Capital per Labor Hour
3-33
Labor Productivity
Labor Productivity = TFP  (Capital Stock/Labor Hours)a
12
8
500
1000
Capital Stock per labor hour
3-34
Output Growth
% GDP per capita = % Labor Productivity
and
 Capital 
% Labor Productivity = % TFP  a  % 

 Labor Hour 
3-35
Increase in TFP
Output/Labor Hour = TFP  (Capital/Labor Hour)a
Labor Productivity
y2
y1
k1
Capital Stock per Labor Hour
3-36
Growth in Output
 Increase in labor supply
 May have no impact on GDP per capita
 Not sustainable
 Increase in capital stock

Must increase at faster rate than labor
 Increase in TFP

No diminishing returns in this framework
3-37
Growth accounting for Japan, Germany, the UK, and the United
States, 1913–1950.
3
TFP
Labor
Capital
2
1
0
Japan
UK
US
Germany
3-38
Growth accounting for Japan, Germany, the UK, and the United
States, 1950–1985.
8
TFP
Labor
Capital
7
6
5
4
3
2
1
0
Japan
UK
US
Germany
3-39
Growth accounting for Japan, Germany, the UK, and the United
States, 1985–2008.
4
TFP
Labour
Capital
3
2
1
0
Australia
-1
Canada
France
Germany
Italy
Japan
Sweden
UK
US
3-40
Growth Accounting
Asian Tigers, 1966 - 1990
3-41
Europe and Asia
Total Output:
Of Which
Capital
Labor
TFP
Golden Age 1950-73
France
UK
W. Germany
Asian Miracle 1960-94
5.0%
3.0%
6.0%
1.6%
1.6%
2.2%
0.3%
0.2%
0.5%
3.1%
1.2%
3.3%
China
Hong Kong
Indonesia
Korea
Thailand
Singapore
6.8%
7.3%
5.6%
8.3%
7.5%
8.5%
2.3%
2.8%
2.9%
4.3%
3.7%
4.4%
1.9%
2.1%
1.9%
2.5%
2.0%
2.2%
2.6%
2.4%
0.8%
1.5%
1.8%
1.5%
Europe relied on capital and TFP
– Asian countries have relied on capital
3-42
Growth Accounting
 Japan


Capital growth important through out
Labor, TFP important ’50 – ’85
 US


TFP important until ’85
Labor important after ’85
 UK and Germany rely less on labor
3-43
Growth accounting in the BRIC
Economies.
10
TFP
9
Labour
Capital
8
7
6
5
4
3
2
1
0
Brazil
China
India
Russia
3-44
Summary
 Importance of Growth
 Sources of Growth
 GDP per capita
 Hourly productivity
 Number of hours worked
 Productivity
 Capital Accumulation
 TFP
 Growth Accounting
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Endogenous Growth and Convergence
45
3-46
Key Concepts
 Endogenous growth
 Conditional convergence
 Poverty traps
 Steady state determinants
3-47
Sources of growth
 Exogenous growth (Solow model)



Capital produces growth until economy
reaches steady state
Continuous growth arises from technological
progress
Technological progress is exogenous to model
 Endogenous growth

Provide explanation internal to the model
3-48
Constant MPK
Output
Output = AK
K: Capital
Y: Output
A: Parameter
s: Investment Rate
Investment = sY
Depreciation
Capital Stock
3-49
Constant MPK
Output
Output = AKLb
Investment = sY
Depreciation
K0
K1
Capital Stock
3-50
Does constant MPK make sense?
 Interaction between physical and human
capital


Suppose increase in K induces increase in
human capital?
Consider IT investment and education
 This represents a spillover effect
3-51
In equation form
Output = A x (Human capital)b x Ka x Lc
Output = A x (DxK)b x Ka x Lc
Output = A x (D)b x Ka+b x Lc
3-52
Social versus Private Return
Output = A x (DxK)b x Ka x Lc
Private Return
measured by this
term
3-53
Social versus Private Return
Output = A x (DxK)b x Ka x Lc
Extra return due to
spillover effect
3-54
Marginal product of capital
Case: a + b < 1
Cost of Capital, r/p
Social MPK
Private MPK
KP
KS
Capital Stock
3-55
Marginal product of capital
Effect of subsidy
Private MPK
Social MPK
Cost of Capital
Cost of Capital with subsidy
KP
KS
Capital Stock
3-56
Poverty Traps
Marginal product of capital
 Increasing MPK
MPK
Cost of Capital, r/p
K0
Capital Stock
MPK is less than cost of capital, so capital decreases to zero
3-57
Poverty Traps
Marginal product of capital
 Increasing MPK
MPK
Cost of Capital, r/p
K0
Capital Stock
MPK is higher than cost of capital, so capital increases continuously
3-58
Why increasing MPK?
 Agglomeration
 Interdependencies in inputs
 Spillovers
Increasing MPK leads to income
divergence between sectors
(states, countries, etc.)
3-59
Just the facts, Ma’am
 What does the data say about convergence?
 What does convergence mean empirically?


Levels of income should coincide in the long
run
Low income countries grow faster than high
income countries

Higher MPK for low income countries
3-60
Growth and per capita GDP
9%
Average GDP growth 1960-2007
8%
7%
6%
5%
4%
3%
2%
1%
0%
0
500
1000
1500
2000
2500
3000
GDP per capita 1960, USD
3500
4000
4500
3-61
Income per Capita and Growth
Rank of Income in 1960
top
2nd
3rd
bottom
2
2.1
2.2
2.3
2.4
Annual GDP per capita growth 1960-2007 %
2.5
3-62
Convergence in OECD Economies
Average GDP growth 1060-2007
6%
5%
4%
3%
2%
1%
0%
0
1000
2000
3000
GDP per capita 1960 USD
4000
5000
3-63
Convergence across US States
3-64
Conditional Convergence
 Little evidence of convergence across all
countries
 Some evidence of convergence for select,
similar countries
 Countries may have different steady states
3-65
Two Steady States
Output
Real GDP
Depreciation
Investment (30% of GDP)
Investment (20% of GDP)
SS 1
SS 2
Capital Stock
3-66
What determines the steady state?
 Level of investment and savings
 Accumulation of human capital (education)
 Government policies
 Economic environment (e.g., corruption,
property rights, crime)
3-67
Empirical Evidence
 Data supports conditional convergence
 Investment, education, health have positive
effects on growth
 Effects of other variables are harder to
discern in available data
3-68
Determinants of steady state for selected
countries.
3-69
Determinants of steady state for selected
countries.
3-70
Why is Africa so poor?
1999-2011
1973–98
1950–73
1913–50
World
Africa
Latin America
1870–1913
Asia (exc. Japan)
Western Europe
1820–70
0
2
4
6
Average GDP per capita growth
8
3-71
Possible explanations
 Ethnic/linguistic diversity
 Climate and disease
 Colonial influence
 The impact of aid
3-72
Institutional Quality in Africa
Africa is characterized by poor governance and institutional
quality, although there are some exceptions. Countries are
ranked by percentile (0 is the worst and 100 is the best).
3-73
Artificial Borders
Europe Asia
Percent of population belonging to groups
partitioned by border
Fractal Index of borders (low figure =
straighter borders)
Africa
North
South
America America
19.9
20.6
48.0
7.6
15.2
0.052
0.037
0.028
0.027
0.036
Although North America has the most artificially
straight borders, Africa’s borders separate a far
higher share of its ethnic groups.
3-74
Geographical Characteristics of
Selected Regions
3-75
GDP per Capita by Latitude
70
60
50
40
Latitude
30
20
10
Equator
-5
-15
-25
-35
-45
0
5000
10000
15000
20000
GDP per capita 2005-2007 $
25000
30000
3-76
Urbanization in 1500 versus GDP
per capita in 2008
$64,000
SINGAPORE
USA
AUSTRALIA
CANADA
LOG GDP PER CAPITA, PPP, 2010
$32,000
HONG KONG
NEW ZEALAND
ARGENTINA
MALAYSIA
PANAMA
CHILE
MEXICO
URUGUAY
COSTA RICA
BRAZIL
PERU
VENEZUELA JAMAICA
TUNISIA
COLOMBIA
DOMINICAN REP.
EL SALVADOR
ECUADOR
BELIZE
GUYANA
EGYPT
SRI LANKA
ALGERIA
GUATEMALA
PARAGUAY
INDONESIA
BOLIVIA
$16,000
$8,000
$4,000
PHILIPINNES
INDIA
VIETNAM
MOROCCO
HONDURAS
NICARAGUA
LAOS PAKISTAN
$2,000
BANGLADESH
HAITI
$1,000
0
2
4
6
8
10
12
URBANISATION IN 1500
14
16
18
20
3-77
The Curse of Natural Resources
3-78
Major Aid Donors
20
15
$ billion p.a. (LHS)
% of GNI (RHS)
1.0%
0.8%
0.6%
10
0.4%
5
0
0.2%
0.0%
3-79
Major Aid Recipients
7
6
35%
$ billion p.a. (LHS)
% of GNI (RHS)
30%
5
25%
4
20%
3
15%
2
10%
1
5%
0
0%
3-80
Evidence on the Impact of Aid
Hypothesis Tested
Number of Studies evaluated Consensus of Results
Does aid increase Saving
and Investment?
43
75% of aid is crowded out by
lower saving.
Does aid increase Growth?
103
No significant effect
Is aid effective in moderation
but harmful in excess?
22
No evidence
Is aid more effective when
policy is good?
28
No evidence
Is aid effective when local
institutions are strong?
10
Some evidence but too few
studies
The balance of evidence suggests that development aid
has no significant effect on economic development.
3-81
Summary
 Constant MPK
 Increasing MPK (spillovers and interactions)
 Poverty traps
 Factors affecting steady state
 The example of Africa
 Aid
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MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
International Trade
82
3-83
Key Concepts
 Comparative Advantage


Terms of trade
Opportunity Cost
 Heckscher – Ohlin model
 New Trade Theory
3-84
Patterns of World Trade
Top ten exporters (2009)
Exporters
Rank
1
2
3
4
5
6
7
8
9
10
EU trade with rest of world
China
United States
Japan
Korea, Republic of
Hong Kong, China
domestic exports
re-exports
Canada
Russian Federation
Singapore
domestic exports
re-exports
Mexico
value($bn)
1528
1202
1056
581
364
329
17
313
317
303
270
138
132
230
share of world
trade
16.2
12.7
11.2
6.2
3.9
3.5
0.2
3.3
3.4
3.2
2.9
1.5
1.4
2.4
3-85
Patterns of World Trade
regional Trade Flows (2009)
Destination
Origin
World
North
Latin
America America Europe
CIS
Middle
East
Africa
Asia
World
2026
437
5105
311
391
510
3197
12178
N. America
769
128
292
9
28
49
324
1602
S. & Central
America
115
120
90
6
13
11
96
459
Europe
366
75
3620
147
162
154
426
5016
(CIS)
23
5
239
87
7
14
63
452
Africa
66
9
149
1
45
12
85
384
Middle East
60
5
76
4
34
107
357
690
627
95
641
57
102
163
1846
3575
Asia
3-86
Patterns of World Trade
Growth rate in world output and volume of world trade
10%
trade
8%
output
6%
4%
2%
0%
1950-63
1963-73
1973-90
1990-01
2001-09
3-87
Comparative Advantage
 Focus on activities in which disadvantage is
least
 Trade benefits all countries
3-88
Example
Eurasia
Oceania
Coffee
1
4
Cloth
2
2
Number of workers to produce one
pound of coffee or one yard of cloth
3-89
Production possibilities
Eurasia
Oceania
Coffee
10
1
10
4
Cloth
2
5
20
2
Assume Eurasia has 10 workers
and Oceania has 40 workers.
3-90
Production Possibilities
Coffee
10
Eurasia
Oceania
5
20
Cloth
Suppose a trade agreement says that 1 cloth trades for 1 coffee
3-91
Trade Possibilities, Eurasia
Eurasia produces at this point
10
Coffee
But can trade to any point on this line
Eurasia
Oceania
5
10
20
Cloth
Suppose a trade agreement says that 1 cloth trades for 1 coffee
3-92
Trade Possibilities, Oceania
But can trade to any point on this line
Coffee
10
Oceania produces at this point
Eurasia
Oceania
5
20
Cloth
Suppose a trade agreement says that 1 cloth trades for 1 coffee
3-93
Comparative Advantage
 ALL countries benefit from free trade
 However, not all countries will be equally well
off
 Gains may not be equal
 Not all citizens benefit


Coffee producers in Oceania
Cloth producers in Eurasia
3-94
Trade Possibilities, Oceania
10
Eurasia consumes at this point
Coffee
Oceania consumes at this point
Oceania produces at this point
Eurasia
Oceania
5
10
15
20
Cloth
Suppose Oceania trades 5 of its cloth for 5 coffee
3-95
Terms of Trade
 Ratio of the price of a country’s exports to the
price of a country’s imports
 Gains from trade rise with terms of trade
 Prebisch-Singer hypothesis

Hypothesis that commodity prices fall in value
over time so developing countries (often
commodity exporters) tend to lose out to
developed ones.
 Decline in terms of trade for commodity
exporters has been dramatically reversed in
recent years
3-96
Terms of Trade
180
160
Australia
140
United States
120
United
Kingdom
Japan
100
80
60
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
3-97
Real Agricultural Commodity
Prices
300
250
200
150
100
50
3-98
Contribution to global demand
growth for major crops
4
Other developing economies
China
Percentage Points
3
Advanced economies
2
1
0
1998
-1
2000
2002
2004
2006
2008
2010
3-99
Natural Resource Exports
Forestry Fish
2%
3%
Mining
18%
Fuels
77%
3-100
The Hotelling Rule
Price
e
PBe
r
T
The rule predicts that the price of an exhaustible natural
resource rises at the rate of interest (r) to reach the
backstop price (PB) when it is economically exhausted.
3-101
Oil Prices
120
dollars
100
2010 dollars
80
60
40
20
0
1861 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001
3-102
Heckscher-Ohlin model
 Comparative advantage is in good whose
production requires factor input which is
abundant
 Examples



China – labor
Mexico – fruits and vegetables
US – pharmaceuticals, chemicals
3-103
Chinese–US Merchandise Trade
2009
3-104
Composition of US merchandise
imports, 2009
Other
goods
Foods,
feeds and
beverages
Industrial
supplies
Consumer
goods
Automotive
vehicles
Capital
goods
3-105
Assumptions of the H-O model
 No differences in tastes for goods among
countries
 Free trade (no trade restrictions)
 All countries use same technology
 No intra-industry trade
3-106
Extent of intra-industry trade
A very high proportion of trade for developed
countries represents exports of types of goods or
services that the country also imports
3-107
Distributional Effects of Trade
 Distribution of income
 National competitiveness
 New Trade Theory
 Interest Groups
3-108
Is trade a good thing?
Egypt
United States
Italy
Mexico
Japan
South Africa
France
Indonesia
Turkey
Poland
Nigeria
Britain
Sweden
Canada
Russia
Pakistan
Australia
Brazil
South Korea
Israel
Spain
Kenya
India
Germany
Malaysia
Kuwait
China
50%
60%
70%
80%
90%
100%
Percentage who agree that trade is a good thing by country
3-109
Competitiveness
 Trade as a zero-sum game
 Countries do not go bankrupt
 Trade is not adversarial
3-110
Strategic Trade Theory
Airbus
Enter
Enter
Boeing
Don’t enter
Don’t Enter
-$100m -$100m $500m
0
$500m
0
0
0
3-111
Strategic Trade Theory
Airbus
Enter
Boeing
Enter
$100m
Don’t enter
0
Don’t Enter
$100m $500m
0
$500m
0
0
Suppose both governments subsidize to the tune of $200m
3-112
Summary
 Trade is an increasing feature of the world
economy
 Comparative advantage and terms of trade
 Heckscher-Ohlin model


Features
Issues
 Strategic trade theory
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Globalization
113
3-114
Key Concepts
 Growth in trade


Inward-looking policies
Liberalization
 Liberalization and Growth
 Foreign Direct Investment and Multinationals
 Immigration
 Problems with Globalization
 Role of the WTO
3-115
Market Liberalization
0.9
0.8
0.7
0.6
Electricity and Telecoms
Domestic Financial Sector
0.5
Agriculture
0.4
Capital flows
Trade (ex. rate)
0.3
Trade (tariff)
0.2
0.1
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
0
Globalization has been associated with significant
deregulation of many markets by most countries.
1882
1885
1888
1891
1894
1897
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
3-116
Annual Growth in World Trade
15%
10%
5%
0%
-5%
-10%
-15%
3-117
Trade Liberalization
 Comparative advantage

One-time increase in output
 Growth


Theory
Data
3-118
Inward-looking policies
 Develop domestic industries


Prebisch-Singer hypothesis
Infant industry argument
 Import substitution

Substitute imports with domestic goods
 Concerns


Raises price of capital
Decrease TFP growth
3-119
Average Tariff Protection
25
20
15
10
5
0
3-120
Evidence
 Tariffs and GDP
 Geography as a proxy for openness
 Impact of openness on GDP growth


China
Hong Kong, Singapore, Malaysia
3-121
Tariffs & GDP per Capita
Average Tariff Rate 2007-2009 (%)
25
20
15
10
5
0
100
400
1600
6400
25600
Average GDP per capita 2007-2009 ($), Log Scale
102400
3-122
Liberalization and Growth
5
Average economic growth
4
3
2
1
0
-1
-2
-25
-20
-15
-10
-5
0
5
10
years before and after liberalization
15
20
25
3-123
Liberalization: The Case of India
140
1
0.9
120
0.8
100
0.7
0.6
80
0.5
60
0.4
40
Average Tariff Rate (%) LHS
20
Non-Tariff Barriers (share of trade
covered) RHS
0
0.3
0.2
0.1
0
India undertook a rapid liberalization process in
the early 1990’s
3-124
Liberalization: The Case of India
600
GDP per capita (index 1960=100)
GDP per capita
1960-80 trend
500
400
300
200
100
Liberalization Period
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
0
Trend Growth seems to have increasing
significantly since then
3-125
Global Capital Flows
12
10
8
$ trillion
6
fdi
4
equity securities
2
debt securities
0
lending & deposits
-2
% of Global GDP
4.7 5.4 13.5 9.4
7.8 9.9 13.3 15.9 17.3 20.7 3.1
1990
2002
-4
1995
2000
2001
2003
2004
2005
2006
2007
2008
Global capital flows increased steadily until the
financial crisis
3-126
Foreign Direct Investment
500
Western Hemisphere
Sub-Saharan Africa
400
Middle East & North Africa
Developing Asia
300
Former Soviet Union
Central & E. Europe
200
100
0
FDI tends to be more stable than other types of
capital flow
3-127
Tax and Multinatnationals
Multinational firms can respond in a number of ways to changes in
taxation in host nations. For example, they can restructure
themselves so that profits can be shifted to lower tax locations, or
they can change their level of investment in new or existing
locations. The consensus of studies suggests that firms engage in
all three.
3-128
Immigration
% of resident OECD population
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1986
1991
1996
2001
Immigration into OECD (richer) countries has
risen steadily
3-129
The Economic Impact of
Immigration
3-130
Globalization and Inequality
New Zealand
United States
Norway
Germany
Italy
Sweden
Canada
Czech Republic
OECD average
Japan
Netherlands
Denmark
United Kingdom
Spain
France
-0.04
-0.02
0.00
0.02
0.04
0.06
0.08
Inequality has risen in most OECD Economies
3-131
WTO and Tariff Reduction
3-132
WTO and Tariff Reduction
50
$ billion (2004 prices)
40
30
20
10
Agriculture
and
Manufacturing
Agriculture,
Manufacturing
and Services
0
Estimated impact on World GDP of implementing
the Doha Round
3-133
World Trade Organization
 Administer trade agreements
 Deal with trade disputes
 Provide technical assistance and training
 Facilitate trade meetings
3-134
World Trade Organization
 Member countries committed to following all
rules and agreements
 Enforcement mechanism
 Legislation



GATT
GATS: General agreement on trade in
services
TRIPS: Trade related aspects of intellectual
property rights
3-135
Summary
 Importance of Globalization
 Impact of Economic Liberalization
 Global Capital Flows
 Immigration
 WTO
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Business Cycles
136
3-137
Key Concepts
 Business Cycle characterization
 Recessions and Depressions
 Frisch-Slutsky Paradigm
 Real Business Cycle Theory
3-138
Business Cycle
 Periodic fluctuations in macroeconomic
variables, particularly GDP
 Measurement … growth versus cycle


De-trend
Consider growth rate
3-139
Italian Real GDP
1600
Billion Euros (base year 2000)
GDP
Trend
800
400
200
3-140
Italian Business Cycle
6
Percentage deviation from trend
4
2
0
-2
-4
-6
3-141
Co-movement in Macro Variables
Rising
Investment
Rising
GDP
Rising
Employment
Rising
Consumption
3-142
French GDP, Consumption and Investment
15
Consumption
Investment
GDP
% Growth
10
5
0
1997
1993
1989
1985
1981
1977
1973
1969
-10
1965
1961
-5
3-143
5
1.5
4
1
3
0.5
2
0
1
-0.5
0
-1
2000
1998
1996
1994
1992
1990
1988
-2
1986
-1
-1.5
-2
Change in Unemployment Rate
GDP Growth
French Real GDP and Unemployment
3-144
Business Cycle Facts
 Expansions are longer than recessions
 Recessions are sharper than expansions
3-145
Expansions last longer than recessions
Luxembourg
Recessions
Expansions
Ireland
Netherlands
Belgium
Spain
Italy
UK
France
Germany
Japan
Canada
USA
0
50
Duration in Months
100
3-146
Recessions are sharper
Ireland
Belgium
Italy
France
Decline in Contraction
Growth in Expansion
Japan
USA
0
0.5
1
1.5
2
3-147
Business Cycle Facts
 Cycles are correlated across regions and across
countries
 GDP is less volatile in more industrialized
countries
3-148
Business Cycle Characteristics
3-149
Business Cycle Characteristics
20%
Government
15%
Manufacturing
Services
10%
Construction
5%
0%
-5%
-10%
-15%
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
All sectors rise and fall together over the business
cycle, but volatility is most pronounced in manufacturing
and construction (UK data)
3-150
Real GDP, Germany and Peru
15
10
5
0
-5
-10
Germany
Peru
-15
3-151
Okun’s Law (US data)
Unemployment (percentage pt. devaition from
trend)
6
-8
2009 Q4
2010 Q4
2010 Q2
2010 Q1
2010 Q3
4
2
0
-6
-4
-2
0
-2
-4
Output gap %
2
4
6
8
3-152
Regional Correlations
3-153
Global Correlations
60%
50%
40%
30%
20%
10%
0%
Share of countries with falling output
3-154
Have Business Cycles Changed?
1.8
1.5
1.2
"The Great
Moderation"
0.9
0.6
0.3
0
Rolling 5-year standard deviation of quarterly
US output growth
3-155
Impact of Recession on
consumption by Age
3-156
Impact of Recession on
consumption by occupation
3-157
Distribution of Consumption costs
of Recession
3-158
Trend Growth and business cycles
volatility 1961-2009
Standard Deviation of Growth
20
15
10
5
0
0
1
2
3
4
5
Average Growth
6
7
8
3-159
Business Cycle Paradigm
Impulse
Propagation
Business Cycle
3-160
AD – AS Model
Price Level
AD = C + I + G + X - IM
AS = production
P0
Y0
Real GDP
3-161
Shift in AD
AD = C + I + G + X - IM
Price Level
AS = production
P1
P0
Y0 Y1
Real GDP
3-162
Shift in AS
AD = C + I + G + X - IM
Price Level
AS = production
P0
P1
Y0 Y1
Real GDP
3-163
Fluctuations
 Increase in demand


Increase in C, I, G
Increases prices and output
 Increase in supply


Increase in labor, capital, TFP
Decreases prices and increases output
3-164
Real Business Cycle
 Both growth and business cycles are caused
by supply shocks
 Business cycles are outcome of market
mechanism
 No role for government in changing the
nature of business cycles
3-165
Increase Supply
Price Level
AD
AS
P0
P1
Y0 Y1
Real GDP
3-166
Decrease Supply
Price Level
AD
AS
P2
P0
Y2 Y0
Real GDP
3-167
Role of labor
 RBC story depends on shifts in labor
 Increase in supply requires increase in
quantity of labor
 Increase in labor demand


Increase in wage
Increase in quantity of labor
3-168
Labor Market
Labor Demand
Real Wage
Labor Supply
W1
W0
N0 N1
Employment
3-169
Labor Market
Real Wage
Labor Demand
Labor Supply
W1
W0
N0
N1
Employment
3-170
Keynesian View
 Prices, wages or interest rates may be sticky
… may not adjust to equilibrate markets
 Recessions caused by low demand for goods
and services
 Government must step in to shore up
demand … policy can alter the business
cycle.
3-171
Increase Demand
Price Level
AD
AS
P1
P0
Y0
Y1
Real GDP
3-172
Decrease Demand
Price Level
AD
AS
P0
P2
Y2
Y0
Real GDP
3-173
Increase Demand
Price Level
P1
AD
P0
AS
Y0
Y1
Real GDP
3-174
Increase Demand
AS
Price Level
AD
P1
P0
Y0Y1
Real GDP
3-175
Increase Demand
AS
AD
Price Level
P2
P1
P0
Y0 Y1 Y2
Real GDP
3-176
Keynesian story
 Increase in output due to increase in demand
 In long run


Supply curve is vertical
Increase in AD just increases prices
3-177
How do firms respond to increased
demand (UK)?
3-178
Frequency of Price Reviews (UK)
3-179
Frequency of Price Changes over
one year (UK)
3-180
Summary
 Characteristics of the cycle
 Shocks and propagation
 Explanations


Demand side (Keynesian)
Supply side (Real Business Cycle)
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Monetary Policy
181
3-182
Key Concepts
 Targets
Inflation
 Intermediate


Policy Goals
 Open Market Operations
 LM Curve
 Transmission Mechanism
 Quantitative Easing
3-183
The Growth of Central Banks
 Number of Central Banks
200
160
120
80
40
0
1870
1890
1910
1930
1950
1970
1990
2010
3-184
Basic Structure of a Central Bank
 Key feature of a Central Bank is it ability to
create Monetary Base (only supplier)
Assets
Liabilities
Government Debt
Currency
Other Domestic Assets
Reserves
Monetary
Base
Foreign Exchange Reserves Other Debt and Equity
3-185
Goal of Monetary Policy
 Price stability
 Low unemployment
 Real GDP growth
Policy Targets
3-186
Central Bank instruments & targets
3-187
Federal Reserve System
“High employment consistent with stable prices”
 Organization
 Board of Governors – 7 Members
 12 Federal Reserve District Banks
 Federal Open Market Committee (FOMC)
 Instrument
 Short term market interest rates (Discount rate)
 Reserve Requirements
 Open Market Operations
 Federal Funds rate
 Rate charged on interbank loans
3-188
European Central Bank
Price stability with inflation under 2%
 Organization
 The European System of Central Banks (ESCB) -- 6
members of the executive board and 15 national
Central Banks of the European Union.
 Interest rate decisions are made at fortnightly council
meetings
 Instruments
 Repo rate – overnight interest rate
 Discount rate and Lombard rate (rates at which
commercial banks acquire or deposit reserves)
 Intermediate Target – Inflation and M3
3-189
Bank of England
Keep inflation at rate set by government (2.5%)
 Organization
 The Monetary Policy Committee (MPC)
 9 members, 5 full time Bank of England employees
and 4 external experts
 Instruments
 Repo rate
 No reserve requirement, but no bank overdrafts
 Intermediate target: An Inflation target based on a
two-year-ahead inflation forecast
3-190
IS Curve
 A combination of interest rate and output (or
income) such that investment is consistent
with savings)
 When interest rate falls: investment rises
 This rise in investment must be accompanied
with a rise in saving
 Since saving is a portion of income: a rise in
savings can only happen with a rise in
income
 Hence, the IS curve is upward-sloping.
3-191
LM Curve
 Equilibrium in the money market
 Demand for money


Opportunity cost of holding money
Interest rate increase means hold less money
 Supply of money


Role of Federal Reserve
Role of banks
3-192
Recall quantity theory
MV = PY
Md/P = (1/V)Y
Real Money Demand Velocity, depends on interest rate
3-193
Money Market
Nominal Interest
Rate
Money Supply
R0
Money Demand
M0
Quantity of Money
3-194
Money Market
Increase in Income
Nominal Interest
Rate
Money Supply
R1
R0
Money Demand
M0
Quantity of Money
3-195
Money Market
Increase in Money Supply
Nominal Interest
Rate
Money Supply
R0
R1
Money Demand
M0
M1
Quantity of Money
3-196
LM curve
 Increase in income is associated with rise in
interest rates
 For a fixed income, increase in money supply
lowers interest rate
3-197
IS-LM model
 The equilibrium in the market comes at the
intersection between the IS curve and the LM
curve.
 The IS curve fails to take into account the
financial market -> need of the LM curve
3-198
IS-LM Model
Interest Rate
LM Curve
Decrease in Money Supply
Increase in Money Supply
Output
3-199
IS-LM Model
LM Curve
Interest Rate
R0
IS Curve
Y0
Output
3-200
Increase in money
LM Curve
Interest Rate
R0
R1
IS Curve
Y0 Y1
Output
Lowers the interest rate and increases income
3-201
IS-LM Model
Money Supply Targeting
LM Curve
Interest Rate
R1
R0
IS Curve
Y0
Y1
Output
3-202
IS-LM Model
Interest Rate Targeting
LM Curve
Interest Rate
R0
IS Curve
Y0
Y1
Output
3-203
Monetary Policy Targets
 GDP growth
 Unemployment
 Price Stability



New Zealand
England
European Central Bank
 Why not target zero inflation?
3-204
The Risk of Deflation
3-205
Intermediate Targets
 Variable which


Tracks policy goal (e.g., inflation)
Over which central bank has reasonable
control
 Three main targets



Money supply
Exchange rate
Inflation
3-206
Monetary Policy Targets
(IMF countries)
100%
Other
Inflation Target
80%
Money & inflation
60%
Money supply
Exchange rate &
money
40%
Exchange Rate
20%
0%
2002
2004
2006
2008
3-207
Money Supply Targeting
 Quantity Theory implies direct relationship
between money supply growth and inflation


Assume velocity constant
Assume real output controlled by real factors
 US: money targeting used in early 1980s
3-208
Difficulties in targeting money
 Which aggregate to use?
 Is velocity constant or at least predictable?
 Can central bank control the money supply?
 What role do banks play (is money supply
vertical)?
 What about supply shocks?
3-209
Growth in US monetary aggregates
20.0
M1
M2
15.0
10.0
5.0
-5.0
-10.0
05/10
11/07
05/05
11/02
05/00
11/97
05/95
11/92
05/90
11/87
05/85
11/82
0.0
3-210
UK Velocity of Money
2
34
1.5
30
1
26
Broad Money (M4)
Narrow Money (Notes and Coins)
0.5
06/82
22
06/85
06/88
06/91
06/94
06/97
06/00
06/03
06/06
06/09
3-211
Exchange Rate Targets
 Fix exchange rate against another currency

Will tie domestic inflation to foreign inflation
 Cost is lack of flexibility in influence on
domestic economy
3-212
Inflation Targeting
 Specified a target range for realized inflation
 Allows for discretion in implementation
 Discretion comes at a price
3-213
Operational Instruments
 Short term interest rate
 Base money
 Central bank can supply money to or drain
money from the monetary system
3-214
ECB Interest Rates
6
Repo rate
5
Discount Rate
Deposit rate
4
3
2
1
0
01/99
01/00
01/01
01/02
01/03
01/04
01/05
01/06
01/07
01/08
01/09
01/10
01/11
3-215
Open market operations
 Expand money supply


Buy treasury bonds from public
Supply public with cash
 Decrease money supply


Sell treasury bonds to public
Remove cash from circulation
3-216
Money Market
Interest
Rate
Money targeting
Money Supply
R1
R0
Money Demand
Increase in Money Demand M0
produces rise in interest rate if
Money Supply is fixed
Quantity of Money
3-217
Money Market
Interest
Rate
Money targeting
Money Supply
R1
R0
Money Demand
Increase in Money Demand M0
produces no rise in interest rate if
Money Supply is allowed to
increase
Quantity of Money
3-218
Transmission Mechanism
Market Rates
Asset Prices
Domestic
Demand
Net
External
Demand
Official Rate
Expectations
and
Confidence
Exchange
Rate
Import
Prices
Domestic
Inflationary
Pressure
Inflation
3-219
Estimated Impact of a 1%
increases in interest rates
3-220
Taylor Rules
Nominal Interest Rate
= Equilibrium Nominal Interest Rate
+ λ x Output Gap
+ α x (Inflation – Inflation Target)
Classic Taylor Rule λ = 0.5 , α = 1.5
3-221
US Interest Rates
10
US
8
6
4
2
0
-2
Taylor Rule
Official Rate
-4
-6
01/91
01/93
01/95
01/97
01/99
01/01
01/03
01/05
01/07
01/09
01/11
3-222
UK Interest Rates
16
UK
Taylor Rule
14
Official Rate
12
10
8
6
4
2
0
01/91
01/93
01/95
01/97
01/99
01/01
01/03
01/05
01/07
01/09
01/11
3-223
Euro Interest Rates
8
Euro Zone
6
4
2
0
Taylor Rule
-2
Official Rate
-4
12/98
12/00
12/02
12/04
12/06
12/08
12/10
3-224
Japanese Interest Rates
10
Japan
Taylor Rule
8
Official Rate
6
4
2
0
-2
-4
-6
01/91
01/93
01/95
01/97
01/99
01/01
01/03
01/05
01/07
01/09
01/11
3-225
Quantitative Easing
Interest Rate
MD
M
Quantitative
Easing
R
Quantity of
money
MQE
3-226
Quantitative Easing
 Monetary Base expanded dramatically during
quantitative easing
16%
14%
% of GDP
12%
10%
8%
UK
6%
US
4%
Euro Zone
2%
0%
05/06
05/07
05/08
05/09
05/10
3-227
Summary
 Targets



Intermediate
Instrumental
Policy
 IS-LM model
 Intermediate targets
 Transmission mechanism
 Quantitative Easing
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Stabilization Policy
228
3-229
Key Concepts
 Phillips Curve
 Credibility
 Rules versus Discretion
 Time Consistency
3-230
Overview
 Business Cycle and the AD-AS analysis
 Monetary policy and the IS-LM analysis
 Arguments against stabilization policy
 The Inflation Output trade-off
 Time-Inconsistency
 Monetary policy as a game
 Rules versus Discretion
3-231
Output Gaps
7
5
3
1
CAN: Canada
DEU: Germany
-1
JPN: Japan
GBR: United Kingdom
-3
USA: United States
-5
-7
-9
1972
1978
1984
1990
1996
2002
2008
3-232
The causes of business cycle
 Demand shocks


Decrease in Demand
Increase in Demand
 Supply shocks
 Increase in supply
 Decrease in supply
3-233
Decrease in Demand
Keynesian view
LRAS
Price Level
AD
AS
P0
P1
Y1
Y0
Real GDP
3-234
Decrease in Demand
Keynesian view
LRAS
Price Level
AD
Government
responds by
increasing demand
AS
Increase G
Decrease T
Increase M
P0
P1
Y1
Y0
Real GDP
3-235
Increase in Demand
Keynesian view
LRAS
Price Level
AD
AS
P1
P0
Y0
Y1
Real GDP
3-236
Increase in Demand
Keynesian view
LRAS
Price Level
AD
Government responds
by decreasing
demand
AS
Decrease G
Increase T
Decrease M
P0
Y0
Real GDP
3-237
Decrease in supply
Keynesian stabilization response
LRAS
Price Level
AD
Government responds
by increasing demand
AS
Big
increase in
price
P0
Y0
Real GDP
3-238
Using Monetary Policy to offset
higher spending
3-239
Using Monetary Policy to offset
lower spending
3-240
Arguments against Stabilization Policy
 Uncertainty
 Policy Lags (mostly with fiscal policy)
 Problems with Fiscal Policy
 Ricardian Equivalence
 Consumer Expectations
 Crowding Out
 Monetary Policy
3-241
Policy lags
 Recognition lag
 Legislative lag
 Administration lag
3-242
Phillips Curve
Inflation = Expected Inflation
+ A*(Natural Rate Unemployment – Actual Unemployment)
Rate of Inflation
Anticipated by
Consumers
    A(U  U )
e
N
Rate of
Unemployment
when all
resources are
fully employed at
long-run level
3-243
What do we see in the data?
 Inflation versus Unemployment
 Wage Inflation versus Unemployment
 Is the relationship exploitable in the short
run?
3-244
US Phillips Curve, 1945 - 1970
8
Unemployment.
7
6
5
4
3
2
0
2
4
6
Wage inflation.
8
10
3-245
Inflation & unemployment,1980–2009
United States
16
14
12
Inflation (%)
10
8
6
4
2
0
0
2
4
6
-2
Unemployment (%)
8
10
12
3-246
Inflation & unemployment,1980–2009
Japan
10
8
Inflation (%)
6
4
2
0
0
1
2
3
-2
Unemployment (%)
4
5
6
3-247
Inflation & unemployment,1980–2009
Germany
7
6
5
Inflation (%)
4
3
2
1
0
0
2
4
6
-1
Unemployment (%)
8
10
12
3-248
Inflation & unemployment,1980–2009
United Kingdom
18
16
14
Inflation (%)
12
10
8
6
4
2
0
0
2
4
6
8
Unemployment (%)
10
12
14
3-249
UK Inflation & unemployment,
1856–1997
Point a denotes observations in period
1856–1956; point b in period 1957–97.
3-250
The Long Run Phillips Curve
3-251
Graphically…   e  A(U N  U )
Inflation
  0  A(U  U )
N
10%
5%
U < UN
U > UN
0%
Natural Rate
Unemployment
3-252
Graphically…
  0  A(U  U )
Inflation
N
5%  0  A(5%  2%)
10%
5
A

 3
5%
5%
Natural Rate
2%
0%
Unemployment
3-253
Expectations catch up with
reality
Inflation
10%
5%  5%  A(U N  U )  U N  U
5%
0%
Natural Rate
Unemployment
3-254
Disinflation
3-255
Unemployment (percentage points)
Sacrifice Ratios
10
8
6
4
2
0
Estimates of the unemployment cost of
reducing inflation 1pp (1980-2010)
3-256
Time Inconsistency Scenario
 Your child, Laura, has just graduated from
high school, and is planning to attend State U
in the fall. How should she spend her
summer?


Working to help pay for tuition (parents’
preference)
Playing computer games (Laura’s preference)
 You tell her the following
 If she works, you will help with tuition
 If she plays, she’s on her own in August
3-257
Time Inconsistency
 Will you do what you say you’re going to do?
Pay for College
Don’t Pay
What you say…
Laura
Pay for College
Don’t Pay
3-258
Time Inconsistency
 Will you do what you say you’re going to do?
What Laura thinks…
Pay for College
Don’t Pay
Laura
Pay for College
Don’t Pay
3-259
What is likely to happen?
?
3-260
Time Consistency & Credibility
Points on this line are
ones where
expectations are the
same as reality
Inflation
5%
Preferences of Monetary
authority
2%
Natural Rate
Unemployment
3-261
Prisoner’s Dilemma
Prisoner 2
Don’t Talk
Talk
Don’t Talk
-1, -1
-9, 0
Talk
0, -9
-6, -6
Prisoner 1
3-262
Stabilization Policy
Citizens’ Expectations
Policy
Maker
High Inflation
Low Inflation
High Inf.
-3,0
3, -3
Low Inf.
-5, -3
0, 0
•If expectations = reality, then unemployment = natural rate
• If expectations < reality, then unemployment is low
•If expectations > reality, then unemployment is high
3-263
Stabilization Policy
Citizens’ Expectations
Policy
Maker
High Inflation
Low Inflation
High Inf.
-3,0
-3, -3
Low Inf.
0, -3
0, 0
•If expectations = reality, then unemployment = natural rate
• If expectations < reality, then unemployment is low
•If expectations > reality, then unemployment is high
3-264
Inflation Bias
3-265
Rules versus Discretion
 Can rules solve time consistency problem?
 Can rules solve credibility problem?
 Two examples of rules


Central Bank Independence
Fiscal Stability rules
3-266
Summary
 Stabilization Policy
 Difficulties with stabilization policy
 Phillips curve and discretionary policy
 Time inconsistency
 Rules and Discretion
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Sovereign Debt and Default
267
3-268
Key Concepts
 Debt and deficits
 Deficits and the Business Cycle
 Long Run Debt Sustainability

The Intertemporal Budget Constraint
 Sovereign Default


Credit Risk and Credit Agencies
Debt Forgiveness
3-269
Government Borrowing
 Deficit: debt issued in a particular fiscal year

An aside on the government debt market
 Debt: accumulation of past deficits and
surpluses
3-270
Deficit
Debt
Debt
3-271
Surplus
Debt
Debt
UK Government Debt
% of GDP
300
250
200
Debt GDP ratio
3-272
150
100
50
0
1692 1712 1732 1752 1772 1792 1812 1832 1852 1872 1892 1912 1932 1952 1972 1992
Government Debt – IMF Forecast
% of GDP
120
Advanced Economies
100
Emerging and Developing Economies
80
% of GDP
3-273
60
40
20
0
1995
2000
2005
2010
2015
3-274
Gross Government Debt (2012)
% of GDP
250
200
150
100
50
0
3-275
Government Borrowing (2012)
% of GDP
2
0
-2
-4
-6
-8
-10
3-276
Government Borrowing (2011)
% of GDP
Fiscal Balances,
Primary
Balances
Debt Interest
Payments
U.S.
-10.1
-8.2
1.9
Japan
-8.9
-7.3
1.6
Germany
-2.1
0.0
2.1
France
-5.6
-3.1
2.5
Italy
-3.9
0.5
4.4
U.K.
-8.7
-6.1
2.6
Canada
-4.9
-4.2
0.7
Spain
-6.3
-4.6
1.7
All OECD
-6.7
-4.9
1.8
3-277
Structural Deficits
α = elasticity of government revenue with respect to output
Β = elasticity of government spending with respect to output
1970
1972
1973
1975
1976
1978
1979
1981
1982
1984
1985
1987
1988
1990
1991
1993
1994
1996
1997
1999
2000
2002
2003
2005
2006
2008
2009
2011
2012
% of GDP
3-278
US Structural Deficits
2
0
-2
-4
-6
-8
Budget Deficit
-10
Structural Budget Deficit
-12
Crowding Out
Recall ‘cost of capital’ model
Interest Rate
3-279
Private Savings
5%
Investment
I0
Output
Crowding Out
Deficit = Negative Savings
Private Savings + Government Savings
Interest Rate
3-280
Private Savings
Deficit
6%
5%
Investment
I1
I0
S1
Output
3-281
Perfect Crowding Out
Interest Rate
Private
Savings +
Government
Savings
Private Savings
Deficit
6%
5%
Investment
I1
I0 = S1
Output
Dynamic Response
Suppose savings increases with the deficit
Private
Savings +
Government
Savings
Interest Rate
3-282
Private Savings
6%
5%
Investment
I1
I0 = IS11
S1
Output
3-283
Intertemporal Budget Constraint
Year 2005: D(2005) = G(2005) - T(2005)
Suppose debt is paid off in Year 2006
Year 2006: T(2006) = G(2006) + D(2005)x(1+R)
Hence, taxes are higher in 2006
T(2006) - G(2006) = D(2005)x(1+R)
Year 2005: G(2005) = T(2005) + T(2006)/(1+R)
3-284
Implications
 Countries with high debt must


Default
Run tighter fiscal policy in future
 Debt levels should vary across countries
 Purpose of spending (consumption versus
public investment)
 Role of expected future liabilities (pensions)
 Intergenerational equity
3-285
Generational Accounts
Present value of net tax payments (until death) by different generations
indexed by age in 1995.
3-286
Ricardian Equivalence
 Only G matters, not T or D
 Thought experiment …. G1 = $1000, G2 = 0
 Year 1: T1 + D1 = $1000
 Year 2: T2 = (1 + r)D1
 T1(1 + r)+ T2= $1000(1 + r)= G1 (1 + r)+ G2
The budget constraints in two periods are:
C1 + S1 = Y1 – T1
C2 = Y2 + S1(1+r) – T2
3-287
Ricardian Equivalence
 The inter-temporal budget constraint is
C1 (1+r)+ C2 =(Y1 – T1) (1+r)+ Y2– T2
 Since T1(1 + r)+ T2=G1 (1 + r)+ G2 we have
C1 (1+r)+ C2 = Y1 + Y2 + G1 (1 + r)+ G2
 There is no role for taxes T: the timing of taxes does not
matter
 There is no role for deficits: deficits or not makes no
difference.
3-288
Ricardian Equivalence
 Savings expands to match the deficit
 Holds when



Taxation is non-distortionary
Fiscal debt is held domestically
The savers are the same people that get taxed
– intergenerational equity
 What is the sustainable level of debt?
3-289
Optimal Budget Deficits
 For what purpose is spending being used?


Consumption
Investment
 Cyclical considerations


Recessions mean low tax collections, high
payouts
Should taxes increase during recessions?


Distortionary effects of taxation
Tax smoothing
3-290
Sustainability of Debt
p=(r-g)d
p = primary surplus required to stabilize the
debt/GDP ratio
r = real interest rate
g = real growth rate of GDP
d = debt/GDP ratio
3-291
Sustainability of Debt
p=(r-g)d
 If r > g, must have primary surplus
 If r < g, can run deficit indefinitely
 Abstracts away from cyclical movements in
deficit
3-292
Sustainability of Debt
GDP
Public
Debt
Deficit
Interest
Debt/
GDP
Deficit
GDP
Interest/
GDP
Year 1
$700bn
$350bn
$35bn
$10.5bn
50%
5%
1.5%
Year 2
$735bn
$395.5b
$36.8bn
$11.9bn
53.8%
5%
1.6%
Year 3
$771.8b
$444.1b
$38.6bn
$13.3bn
57.5%
5%
1.7%
Year 4
$810.4b
$496.0b
$40.5bn
$14.9bn
61.2%
5%
1.8%
Year 1
$700bn
$350bn
$7bn
$10.5bn
50%
1%
1.5%
Year 2
$735bn
$367.5b
$7.35bn
$11.0bn
50%
1%
1.5%
Year 3
$771.8b
$385.9b
$7.72bn
$11.6bn
50%
1%
1.5%
Year 4
$810.4b
$405.2bn
$8.1bn
$12.2bn
50%
1%
1.5%
Unsustainable
Sustainable
3-293
Countries in Sovereign Default
50%
Share of World GDP
Share of Countries
40%
30%
20%
10%
0%
1820
1840
1860
1880
1900
1920
1940
1960
1980
2000
3-294
Serial Defaulters since 1800
Year of
Independence
Number of
Defaults/restructurings
% of years in
default/restructurings
Africa
Nigeria
1960
5
21%
Europe
Greece
Portugal
Russia
Spain
Turkey
1829
Pre-1800
Pre-1800
Pre-1800
Pre-1800
5
6
5
8
6
51%
11%
39%
24%
16%
1816
1825
1822
1818
1819
1821
1945
1830
1821
1821
1821
1821
1811
1821
1811
1830
7
5
9
9
7
9
7
9
5
7
8
6
6
8
8
10
33%
22%
25%
28%
36%
38%
29%
58%
26%
34%
45%
45%
23%
40%
13%
38%
Latin America
Argentina
Bolivia
Brazil
Chile
Columbia
Costa Rica
Dominican Republic
Ecuador
El Salvador
Guatemala
Mexico
Nicaragua
Paraguay
Peru
Uruguay
Venezuela
3-295
Some Recent Debt Haircuts
Country
Date of
Exchange
Amount of debt
($ mill.)
Pakistan (external bonds)
Ecuador
Russia
Uruguay
Serbia & Montenegro
Argentina
Belize
1999
2000
2000
2003
2004
2005
2006
610
6,700
31,943
3,127
2,700
1,100
516
Estimated
reduction in debt
value
14%
38%
53%
11%
71%
77%
25%
3-296
Original Sin
Advanced
Economies
Emerging
Economies
Share of Debt in
Foreign Currency
1%
42%
Average Maturity of
Local Currency Debt
7.1 years
4.9 years
Original Sin means that Emerging Economies are required to
undertake a significant proportion of their borrowing in foreign
currency of in short term instruments.
3-297
Borrowing Costs around a Crisis
Cost of borrowing relative to normal (percentage
points)
16
12
8
4
0
-36 -32 -28 -24 -20 -16 -12
-4
-8
-4
0
4
8
Months relative to Crisis
12
16
20
24
28
32
36
3-298
Debt Levels at Default
40%
share of defaulters
30%
20%
10%
0%
0 to 20%
20% to 40%
40% to 60%
60% to 80%
80% to 100%
Debt GDP ratio in year before default
above 100%
3-299
Debt and Growth
5%
Developing Countries
Developed Countries
4%
Average Growth
3%
2%
1%
0%
below 30%
-1%
30% to 60%
60% to 90%
Debt GDP ratio
above 90%
3-300
Borrowing Costs (10 year Yields)
35
Portugal
30
France
Germany
25
20
Greece
Ireland
Spain
15
10
5
0
2006
2007
2008
2009
2010
2011
2012
3-301
Credit Ratings
2001
2002
2003
2004
2005
2006
USA
Spain
Japan
Italy
Ireland
Iceland
2007
2008
2009
Greece
2010
2011
July
3-302
Expected Debt Service
The Debt Relief Laffer Curve
Level of Debt
3-303
Summary
 Debt and deficits
 Deficits and the Business Cycle
 Long Run Debt Sustainability

The Intertemporal Budget Constraint
 Sovereign Default


Credit Risk and Credit Agencies
Debt Forgiveness
MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Exchange Rate Determination I –
The Real Exchange Rate
304
3-305
Key Concepts
 Real and Nominal Exchange Rates
 Law of One Price
 Purchasing Power Parity
 Current account and capital account
3-306
Exchange Rate
 Nominal Price of one currency in terms of
another currency (bilateral)
 Real Purchasing power of a currency

Price of currency adjusted for cross-country
differences in prices of goods and service
 Effective Average exchange rate over several
other currencies

Trade weighted When averaging, use
amount of trade to weight the currency
3-307
Euro Effective Exchange Rate
Hong Kong 1.8%
Denmark 2.7%
Czech Republic 4.2%
China 14.1%
Hungary 3.2%
Japan 8.3%
Norway 1.3%
Poland 4.8%
Romania 1.7%
Singapore 1.7%
South Korea 3.9%
Sweden 5.0%
Canada 1.8%
Switzerland 6.5%
Rest of the World 2.0%
United States 19.2%
United Kingdom 17.8%
3-308
$ effective exchange rate
2% Brazilian Real
2% Thai Baht 2% Australian Dollar
3% Malaysian 2% Sw iss Franc
Ringgitt
3% Hong Kong
Dollar
1% Indonesian
Rupiah
1% Philippine Peso
19% Canadian
Dollar
3% Singapore dollar
4% Korean Won
4% Taiw anese
Dollar
5% Pound Sterling
9% Mexican Peso
7% Chinese Yuan
18% Euro
16% Japanese Yen
3-309
Nominal exchange rate
 Appreciation of $: rise in value of $, so $1
buys more foreign currency

130 Yen/$ to 140 Yen/$
 Depreciation of $: decline in value of $, so $1
buys less foreign currency

133 Yen/$ to 118 Yen/$
3-310
Importance of Exchange Rates
 Determines price at which we buy imported
goods



French wine costs 20.40 Euro
Exchange rate is 1.02 Euro/$
US price is 20.40/1.02 = $20
 But we care about aggregate prices
3-311
Real Exchange Rate
$
Domestic Price Level
Real Rate = Nominal Rate x
Foreign Price Level
¥ /$
¥
Note that the real rate is unit-less
1964
1965
1966
1968
1969
1970
1972
1973
1974
1976
1977
1978
1980
1981
1982
1984
1985
1986
1988
1989
1990
1992
1993
1994
1996
1997
1998
2000
2001
2002
2004
2005
2006
2008
2009
2010
3-312
Nominal and Real UK Effective
exchange rate
220
Nominal Effective Exchange Rate
180
Real Effective Exchange Rate
140
100
60
3-313
Law of One Price
 Identical commodities sell at same price no
matter where they are sold


Gas in Minneapolis, gas in St. Paul
Big Mac index
 Implies real rate = 1
 Based on idea of arbitrage
3-314
Law of One Price
 Transportation costs

US/Japan prices imply distance of 43 million
miles.
 Border effects (tariffs, non-tradeables, etc.)
 Goods prices are “sticky”, nominal exchange
rates aren’t


Pricing to market
Exchange rate pass-through
3-315
Estimated transport cost for global trade
Figure 19.2
3-316
Price differences between US and Canadian Cities.
Figure 19.4
3-317
Purchasing Power Parity
UK Price Level
PPP Nominal Rate (£/$) =
US Price Level
US Price Level
Real Rate = Nominal Rate (£/$) x UK Price Level
Real Rate = 1
3-318
Purchasing Power Parity
Big Mac price
in local
currency
Australia
Brazil
Canada
China
Egypt
Euro-Area
Japan
Malaysia
Pakistan
Poland
Russia
S. Africa
Sweden
Turkey
UK
USA
A$ 4.35
R$ 8.71
C$ 4.17
¥ 13.2
E£ 13.0
€3.38
¥ 320
RM 7.05
Rs 210
Zł 8.30
P. 71
R 18.42
kr 6.50
Tl 5.95
£ 2.29
$ 3.73
PPP exchange rates against
dollar
Implied Big
Mac PPP
0.85*
2.33
1.12
3.54
3.48
1.10*
85.7
1.89
56.3
2.22
19.0
4.94
13.0
1.59
1.63*
-
IMF PPP
1.16*
1.68
1.22
3.89
2.59
1.18*
108.4
1.82
35.3
1.98
21.3
5.41
9.53
1.225
1.49*
-
Actual
Exchange
Rate mid
2011
Under/over valuation of actual
exchange rate against
Big Mac PPP
1.06*
1.64
0.97
6.51
5.94
1.42*
80.8
3.00
85.5
2.76
28.0
7.00
6.34
1.59
1.62*
Actual and PPP exchange rates against the dollar in 2011
*quoted as number of US dollars per unit of local currency
25%
42%
15%
-46%
-41%
29%
6%
-37%
-34%
-20%
-32%
-29%
105%
0%
-1%
IMF PPP
-9%
2%
26%
-40%
-56%
20%
34%
-39%
-59%
-28%
-24%
-23%
50%
-23%
9%
3-319
PPP
Change in exchange rate (£/$)
= UK Inflation – US Inflation
Increase in UK inflation implies $ appreciation
Increase in US inflation implies $ depreciation
3-320
Inflation and Currency Depreciation
Five Year Window
Currency Depreciation (% pa)
30
23
17
10
3
-3
-10
-20
-10
0
Inflation Differential
10
20
30
3-321
Inflation and Currency Depreciation
Twenty Year Window
12
Currency Depreciation (% pa)
9
6
3
0
-3
-6
-10
-5
Inflation Differential
0
5
10
15
3-322
Balassa-Samuelson Effect
 Prices tend to be higher in industrialized
countries
 Industrialized countries



Higher productivity growth in tradeable goods
sector
Higher wage growth in non-trade sector
Thus, higher inflation in non-trade sector
3-323
Balassa-Samuelson Effect
GDP Per Capita relative to US (US=100)
256
64
16
4
1
25
50
100
Price Level relative to US (US=100)
200
3-324
Trade Accounts
 Current account


Records net transactions in goods and
services
Exports - Imports
 Capital & Financial account


Records net transactions in assets
Net Saving
3-325
Current Account
 Exports – Imports


Goods
Services
 Investment income and dividends
 Net transfers
3-326
Capital & Financial Account
 Capital transfers
 Financial account




Direct investment
Portfolio investment
Other investment
Reserve Assets
 Errors and omissions

Fudge factor
© Shutterstock Images
3-327
Balance of Payments
Capital and Current Account Flows, 2009 ($bn)
Balance on Goods
Balance on Services
Balance on Goods & Services
Net Investment Income
Net Transfers
Current Account
Capital Account
Net Direct Investment
Net Portfolio Investment
Net Other Investment
Financial Account
Net Errors and Omissions
Overall Balance
Reserve Assets
U.S.
-504
129
-375
121
-125
-378
-0
-134
-27
429
268
163
52
-52
China
250
-29
220
43
34
297
4
34
39
70
143
-43
401
Euro-Area
32
43
75
-12
-140
-77
12
-112
259
-44
104
-33
6
-401
-6
1977
1979
1980
1981
1982
1984
1985
1986
1987
1989
1990
1991
1992
1994
1995
1996
1997
1999
2000
2001
2002
2004
2005
2006
2007
2009
2010
% of GDP
3-328
Net Financial Asset Positions
USA
50%
-10%
-30%
Japan
Euro-Area
30%
UK
10%
3-329
Net Financial Asset Positions
Creditors
(100% of GDP+)
Creditors
Debtors
Debtors
(100% of GDP+)
Kuwait (+311%)
Norway (+59%
Canada(-2%)
Jamaica (-100%)
Hong Kong (+234%)
Japan (+50%)
Russia (-11%)
Portugal (-101%)
UAE (+208%)
Iran (+37%)
US (-17%)
Greece (-104%)
Singapore (+170%)
Venezuela (+32%)
UK (-20%)
Iceland (-113%)
Switzerland (+141%)
Germany (+26%)
Italy (-21%)
Lebanon (-130%)
Taiwan (+137%)
China (+22%)
India (-25%)
Rep. of Congo (-139%)
Saudi Arabia (+101%)
Nigeria (+15%)
Brazil (-41%)
Seychelles (-232%)
Botswana (+100%)
France (+12%)
Australia (-65%)
Liberia (-767%)
3-330
Trade Accounts
PS = GDP + NIFA – C – T
GDP = C + I + G + (X – M)
X – M = T – G + PS – I – NIFA
X – M = S – I – NIFA
3-331
Trade Accounts
X – M + NIFA = S – I
Net Exports =
Current Account
Surplus
Net Saving =
Capital Account
Deficit
Current Account + Capital Account = 0
3-332
Net Export Market
Real Exchange Rate
S-I
₤/$
E0
E1
X – M + NIFA
Net Exports
Increase in net savings reduces real exchange rate
3-333
Net Export Market
Real Exchange Rate
S-I
₤/$
E0
E1
X – M + NIFA
Net Exports
Decrease in net savings increases real exchange rate
3-334
Net Export Market
Real Exchange Rate
S-I
₤/$
E1
E0
X – M + NIFA
Net Exports
Increase in current account increases real exchange rate
3-335
Real Exchange Rate Movements
 Decrease in Net Savings

Causes




Decrease in private savings
Increase in investment spending
Fiscal Deficit
Effect


Increases real exchange rate (dollars buy more
pounds)
Increases current account deficit
3-336
Real Exchange Rate Movements
 Increase in Net Exports

Causes



Increase in Exports
Decrease in Imports
Effect

Increases real exchange rate (dollars buy more
pounds)
3-337
Summary
 Definitions of exchange rates
 Law of one price

Goods should sell at the same price
everywhere
 PPP

Real exchange rate = 1
 Balance of Payments
 Capital account + current account = 0
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MACROECONOMICS
UNDERSTANDING THE GLOBAL ECONOMY
Currency Crisis and Exchange Rate
Systems
338
3-339
Key Concepts
 1st & 2nd Generation Currency Crisis Models
 FX intervention and Reserves
 Sovereign Wealth Funds
 The Role of the IMF
 Capital Account Liberalization
 Currency Regimes
3-340
Currency Crisis
 Sudden and dramatic currency depreciation,
accompanied by decline in the real exchange
rate Number of Currency Crises per year
30
(here defined as a depreciation of more than 15% in a year )
25
20
15
10
5
0
1800
1820
1840
1860
1880
1900
1920
1940
1960
1980
2000
Source: Reinhart and Rogoff, “This Time It’s Different: Eight Centuries of Financial Folly” (Princeton).
3-341
Currency Crisis
 Currency Crises tend to lead to dramatic
declines in GDP
GDP Growth around Currency Crises
Year Before Crisis
Argentina (2001)
Iceland(2008)
Indonesia (1997)
Year of Crisis
Year After
-0.8
-4.4
-10.9
6.0
1.0
-6.5
8
4.5
-13.1
South Korea (1997)
6.8
5
-6.7
Philippines (1997)
5.8
5.2
-0.6
Russia (1998)
1.4
-5.3
6.3
Thailand (1997)
5.9
-1.4
-10.5
Turkey (2001)
7.4
-7.5
7.8
3-342
First Generation Model
 Inconsistent Economic Policy
 Nominal exchange rate constant…
 …But Central Bank forced to lend to government
(to finance fiscal Deficit)
 Outcome
 Initially Central Bank can run down foreign
reserves to finance government, but eventually
must resort to money printing which is inconsistent
with fixed exchange rate
 Because financial markets are forward-looking,
they attack the peg before it fails naturally
3-343
First Generation Model
D
exchange
rate
A
B
Shadow floating rate
(consistent with risk of money
printing)
C – Point at which
exchange rate peg will fail
naturally
C
time
foreign
reserves
Exchange rate:
Reserve
depletion
Moves from A to B and then
speculative attack breaks peg
so follows D from then on
time
3-344
Vicious circle
Fiscal Deficit and
Monetization
Inflation and
downward pressure
on exchange rate
3-345
End game
 Government eventually runs out of reserves
 Currency traders anticipate a currency
depreciation
 Speculative attack
3-346
Second generation model
 Again starts with a fixed exchange rate
 Government undertakes cost benefit analysis of
keeping the peg (i.e. decides if peg has economic
benefits that outweigh its cost) will drop peg if
costs too great.
 Defending the peg from speculative attack raises
the cost of keeping the peg (e.g. forced to raise
interest rates and incur higher unemployment)
 Outcome: Self-fulfilling equilibria
 An attack can raise the cost of keeping the peg
and so cause an exit that would not have occurred
without the attack.
3-347
Tradeoff
Fixed Rate
No Fixed Rate
Low and
Stable
Inflation
Lower
interest
rates, more
growth
3-348
Snowball effect
Slow
Growth
Incentive to
abandon
fixed rate
Investors sell
currency
Interest rate
must rise
3-349
Second Generation Model
3-350
The ERM Crisis
3-351
Foreign Exchange Intervention
Stylised Central Bank Balance Sheet
Assets
Liabilities
A. Foreign Exchange Reserves
C. Monetary Base
B. Other Domestic Assets
D. Other Debt and Equity
Unsterilized Intervention:
Change in FX Reserves (A) = Change in Monetary Base (C)
Sterlized Intervention
Change in FX Reserves (A) = Change in other domestic assets (B) (or D).
3-352
Foreign Exchange Reserves
Shares of Global FX reserves
Switzerland
Brazil 3%
Hong Kong
2%
S. Korea 3%
India 3%
3%
Saudi Arabia
4%
RoW
34%
Russian Federation
5%
US
5%
Japan
10%
China
28%
3-353
Foreign Exchange Reserves
Import cover:. Conventional wisdom (and IMF advice) was that
reserves should exceed three months of imports to cover for a
temporary loss of export revenue).
Global Reserves: Import Cover (months)
3-354
Foreign Exchange Reserves
Reserves to short term debt. This measure focuses on the role of reserves
in mitigating the impact of financial crises in which countries are unable to refinance their foreign debt. The so so-called Greenspan-Guidotti rule
suggests that reserves should be equal to external debt coming due
within the next year.
Reserves to Short Term Debt
3-355
Foreign Exchange Reserves
Reserves to M2. As well as problems in refinancing external debt,
financial crises are often characterised by capital flight when domestic
citizens attempt to convert domestic assets into foreign ones. Thus a
reserves to M2 ratio of around 20% is often recommended .
Global Reserves: Reserves to M2
3-356
Foreign Exchange Reserves
Estimated Currency shares of Global Reserves (exc. Gold)
100%
90%
80%
Other
Japanese Yen
70%
Swiss Franc
60%
50%
Euro/former Euro-area
currencies
40%
UK Pound
30%
20%
10%
0%
US Dollar
3-357
Sovereign Wealth Funds
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Total assets (1)+(2)
86
123
150
484
797
1,023
1,364
1,793
2,547
2,915
Of which: total external assets
86
123
150
484
765
972
1,302
1,738
2,375
2,712
Total: Commodity Funds(1)
28
48
74
408
600
795
1,088
1,475
1,960
2,321
n.a.
28
n.a.
n.a.
n.a.
n.a.
4
n.a.
43
n.a.
n.a.
n.a.
n.a.
6
n.a.
69
n.a.
n.a.
n.a.
n.a.
6
2
94
85
21
n.a
.1
200
8
4
115
148
37
n.a
.2
286
14
5
140
192
19
60
1
10
354
59
0
59
0
0
n.a.
75
0
75
0
0
n.a.
76
0
76
0
0
n.a.
75
0
75
0
0
n.a.
197
0
74
0
0
123
229
0
78
13
0
137
29
1
8
160
238
44
126
8
3
20
452
276
0
77
15
20
163
46
9
14
200
306
82
197
19
5
35
571
318
0
88
18
20
182
49
14
20
250
384
181
271
33
8
56
708
587
200
98
26
20
223
64
20
28
265
326
209
433
33
8
60
875
594
200
98
26
25
245
Algeria
Chile
Kazakhstan
Kuwait
Norway
Russia
Saudi Arabia
Venezuela
Oman
Qatar
UAE
Total: Excess Reserve Funds(2)
China
Hong Kong
Malaysia
Korea
Singapore
3-358
Sovereign Wealth Funds
3-359
International Monetary Fund
 Established in 1946

Bretton Woods, 1944
 Lender of last resort
 184 member countries
http://www.imf.org/
3-360
Elements of IMF lending
 Special Drawing Rights (SDR)
 Member quota
 Emergency lending service
Wednesday
August 4, 2004
1 SDR =
1.456 USD
1 USD =
0.686811 SDR
SDR Interest Rate =
1.91%
3-361
IMF Intervention and GDP growth
Figure 21.8a
3-362
IMF Intervention and Fiscal Deficits
Figure 21.8b
3-363
IMF Intervention and Interest Rates
Figure 21.8c
3-364
Capital Account Liberalization
Advantages of Liberalization
 Financing investment and stimulating growth
 Risk diversification
 Improving government policy
 Increasing efficiency of financial sector
3-365
Pre-crisis IMF Statements
 In October 1998 the IMF argued that “Capital
controls may also turn out to be an important
setback not only to that country’s [Malaysia]
recovery and potentially to its future
development, but also to other emerging
market economies”
3-366
Michael Mussa -- IMF’s former
chief economist
 “High openness to international capital flows,
especially short-term credit flows, can be
dangerous for countries with weak or
inconsistent macro-economic policies or
inadequately capitalized and regulated
financial systems”
3-367
Evidence on Liberalization
8%
Capital Mobility (LHS)
Index of Capital Mobility
0.8
6%
Countries entering crisis
(RHS)
0.6
4%
0.4
2%
0.2
0
1820
% entering banking crisis (10-year moving average)
1
0%
1840
1860
1880
1900
1920
1940
1960
1980
2000
Source: Reinhart and Rogoff, “This Time It’s Different: Eight Centuries of Financial Folly” (Princeton).
3-368
Evidence on Liberalization
3-369
Evidence on Liberalization
Capital Controls: An Evaluation NBER
3-370
The Impossible Trilogy
 Independent monetary policy
 Fixed exchange rate
 Absence of capital controls
3-371
Exchange Rate Regimes
100
90
80
70
60
Floating
50
40
30
20
10
0
Intermediate
Soft Peg
Hard Peg
3-372
Exchange Rate Regimes
3-373
Fixed Rate
 Exchange rate fixed at constant level
 Advantages




Provides a nominal anchor
Encourages trade and investment
Avoids speculative bubbles
Reduces risk premium
3-374
Choice of Anchor Currencies
100%
90%
80%
70%
60%
Other
DEM
50%
40%
EUR
FRF
GBP
30%
20%
10%
0%
USD
3-375
Floating Rate
 Let nominal exchange rate adjust to market
conditions
 Like US, Canada, Australia
 Advantages




Independent monetary policy
Automatic adjustment to trade shocks
Seignorage
Avoid speculative attacks
3-376
Intermediate Regime
 Float, but within boundaries
Exchange
Rate
Time
3-377
Hard Peg
Fix one bilateral nominal exchange rate
 Dollarize (Ecuador)


Abandon own currency and use another nation’s
currency
No more seignorage!
 Currency Board (Argentina)


Central bank holds interest-bearing foreign assets
Will exchange domestic currency for foreign
currency at a fixed exchange rate, backed by
assets
3-378
Currency Board
 Role of Central Bank



Exchange domestic currency for foreign
reserves at fixed rate of exchange
Can never produce fiat money
Cannot issue liquidity of domestic banks
 Goals?
 If FX reserves fall, domestic money supply
falls
3-379
Performance of Currency Boards
3-380
Why go Euro?
© Shutterstock Images
3-381
The euro
 Optimal Currency Area




Degree of trade between countries
Similarity of economic shocks
Labor market mobility
Nature and amount of fiscal transfers
3-382
The road to Euro
 1979 European Monetary System
 Establishes the Ecu
 Blueprint for monetary union
 1986 European Single Act
 Free movement of people, goods, capital
 1992 Maastricht Treaty (Treaty on European Union)
 Provides legal basis for EMU
 Provides for single currency
 2002 Euro replaces domestic currencies
3-383
Convergence Criteria
 Inflation

Rate cannot be more than 1.5% above average inflation rate
of three lowest Member states
 Public Budget Deficit

Can’t exceed 3% of GDP
 Public Debt

Can’t exceed 60% of GDP
 Interest Rate

Rate cannot be more than 2% higher than the average of the
three states with the lowest inflation rates
 Currency

No currency fluctuations outside the normal EMS margins for
two years
3-384
Benefits
 Reduce business costs for intra-EU trading
 Ease purchases for tourists and people in
bordering areas
 Decrease prices
 Increase stability in EU
3-385
Countries and Trade
60
250
50
200
Number of countries
40
150
30
100
20
50
10
0
1900
0
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Number of Countries in the World
World Merchandise trade to GDP (%)
Trade to GDP ratio
3-386
Summary
 Currency crises
 Models – 1st generation, 2nd generation
 FX Intervention
 IMF
 Exchange rate regimes
 Euro