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A State-Centered Approach to Monetary and Exchange-Rate Policies International Political Economy Prof. Tyson Roberts 1 Goals • Macroeconomic Trilemma Review • State-centered approach to macroeconomic policy • Central Bank Independence • Argentina case – the beginning… • The Political Trilemma of the Global Economy 2 What is macroeconomic policy? • Monetary policy (interest rate, inflation rate) • Exchange rate policy (fixed vs. floating) • Fiscal policy (government borrowing & spending) 3 Monetary Policy • Why would lower interest rates reduce unemployment? • Why would lower interest rates increase inflation? 4 Limits of Monetary Policy • What is the “Zero Lower Bound”? • What challenges does this pose to monetary policy? • What options are available as one reaches the zero lower bound? – Quantitative Easing – Forward Guidance – Fiscal Policy (not available to central banks) 5 THE U.S. PHILLIPS CURVE (annual data, 1953 to 1969) CPI inflation 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.02.0 3.0 4.0 5.0 6.0 Unemployment 7.0 8.0 9.0 10.0 11.0 6 Downsides to monetary stimulus • Why does inflation increase rapidly at a certain level of unemployment? – (~4% in the previous graph) • What is the real interest rate? • What will mobile capital do if nominal interest rates fall and inflation rises? • What must interest rates do to maintain fixed exchange rate if capital is mobile & leaving the country? 7 Macroeconomic policy trilemma “The Unholy Trinity” Fixed exchange rate Capital mobility Floating exchange rate Monetary autonomy 8 More on Monetary Policy (inflation is not all bad) • Why does deflation discourage consumption? • Why does deflation discourage investment? • Why does deflation undermine the effectiveness of monetary policy? 9 Capital mobility can amplify monetary policy if floating exchange rate • Lower interest rates => – More borrowing for investment => jobs – Weaker currency => more exports => jobs 10 How does capital mobility constrain fiscal policy? • Large budget deficits signal – Future tax increases, or – Future default, or – Future inflation Why? 11 How does capital mobility constrain fiscal policy? • Large budget deficits deter capital from lending to governments • To attract capital, governments must pay higher interest rates, raising the cost of borrowing to stimulate the economy • Unless… (Which countries can continue to borrow even when budget deficits are large?) 12 Politics of Exchange Rates (Frieden 1997) 1. Exchange rate is a policy variable 2. Policy variables are determined politically 3. There is no such thing as a technically unsustainable exchange rate 13 Politics of Exchange Rates (Frieden 1997) 4. The sustainability of a nominal exchange rate is a purely political concept 5. Pressures on the making of currency policy are both general (broad & popular) and specific (from concentrated groups) 6. There are specific interest groups with currency policy preferences (PARTISAN & SECTORAL MODELS) 14 Politics of Exchange Rates (Frieden 1997) 7. Broad political pressures are especially important for exchange rate policy (public good) 8. The exchange rate is not an inherent measure of a government’s credibility 9. Government policy can make the currency a repository of credibility 10.Credibility cannot be “purchased” by technical measures 15 State-centered model • Persistently high inflation … – Undermines effectiveness of monetary policy – Undermines willingness of domestic and foreign actors to hold currency reserves 16 But high inflation is a temptation for governments • Fiscal stimulus (tax cuts, high spending) • Monetary stimulus (low interest rates, increased money supply) 17 Time consistency problem example Professor payoffs • Top choice: Students study, no exam to grade = 4 • 2nd choice: Students don’t study, no exam to grade = 3 • 3rd choice: Students study, exam to grade = 2 • Last choice: Students don’t study, exam to grade = 1 Student payoffs • Top choice: Don’t study, no exam = 4 • 2nd choice: Study, exam = 3 • 3rd choice: Don’t study, exam = 2 • Last choice: Study, no exam =1 18 At the beginning of the semester, professor announces final exam to motivate students to study Exam S: P: No Exam S: P: Exam S: P: P Study S Don’t P No Exam S: P: 19 Solving sequential games in game theory • Players make choices sequentially • Payoffs are result of choices made by each player • To solve, look at last move first and work backwards • Subgame perfect equilibrium: Actions each player would choose at each decision node 20 At beginning of the semester, professor prefers final exam At end of semester, professor prefers no exam Exam S: 3 P: 2 No Exam S: 1 P: 4 Exam S: 2 P: 1 P Study S Don’t P No Exam S: 4 P: 3 21 At beginning of the semester, professor prefers final exam At end of semester, professor prefers no exam Time inconsistency problem => credible commitment problem Exam S: 3 P: 2 No Exam S: 1 P: 4 Exam S: 2 P: 1 P Study S Don’t P No Exam S: 4 P: 3 22 Time consistency problem example 2 Capital-holder payoffs • Top choice: Save if inflation stays low = 4 • 2nd choice: Don’t save if inflation goes high = 3 • 3rd choice: Don’t save if inflation stays low = 2 • Last choice: Save if inflation goes high= 1 Government payoffs • Top choice: Capitalists save, stimulate hiring= 4 • 2nd choice: Capitalists save, don’t stimulate = 3 • 3rd choice: Capitalists don’t save, don’t stimulate = 2 • Last choice: Capitalists don’t save, stimulate = 1 23 Gov’t announces it will keep inflation low to encourage saving But after capitalists save & deposit in banks, Gov’t has incentive to lower interest rates to encourage hiring Save Stimulate C: 1 G: 4 No stimulate C: 4 G: 3 Stimulate C: 3 G: 1 G C Don’t G No stimulate C: 2 G: 2 24 In 1970s, the PHILLIPS CURVE seemed to disappear (stagflation) CPI inflation 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.02.0 3.0 (annual data, 1953 to 1969) 74 79 75 78 73 70 77 76 7.0 8.0 71 72 4.0 5.0 6.0 Unemployment 9.0 10.0 11.0 25 If people expect inflation to rise, they will demand higher wage increases Expectations-adjusted Phillips curve: 26 Expectations-Adjusted PHILLIPS CURVES (annual data, 1960 to 1999) 27 Unpredicted inflation => successful monetary stimulus • Future nominal wages negotiated based on low inflation • High inflation => low real wages => jobs 28 Predicted inflation => unsuccessful monetary stimulus • Future nominal wages negotiated based on high inflation • High inflation => no change in real wages => no change in jobs • “Solution”: accelerating inflation • Outcome: hyperinflation 29 Why Fed aggressively applied monetary stimulus to recent crisis • Low interest rates increase inflation because – Low unemployment, high capacity utilization increases costs of production – High demand for finished goods increases prices • For many years, unemployment remained high, capacity underutilized, demand fairly flat • Result: Low inflation expectations, low real wage gains 31 Why Fed aggressively applied monetary stimulus to recent crisis • Low interest rates increase inflation because – Low unemployment, high capacity utilization increases costs of production – High demand for finished goods increases prices • Today, unemployment high, capacity underutilized, demand fairly flat • Result: Low inflation expectations, low real wage gains • Therefore, monetary stimulus has power But, if capital-holders believe that monetary stimulus will continue after inflation rises, they will not hold investments in dollars 33 Investors must therefore be reassured “Confidence game” “The ropes that tied Odysseus are what lend credibility to his long-term objective (return home), despite the short-term temptations.” 34 Commitment Mechanisms • Central bank independence • Fixed exchange rates – Peg (to gold or other currency) + convertibility • Examples: Argentinian “dollarization,” EMS • Political will important in short run – Currency union • Examples: Ecuadorian “dollarization,” EMU • Technical challenges reinforce political will 35 To kill inflation, change expectations 36 37 To lower real interest rates when nominal interest rates already near zero, change expectations • Conventional Fed tool – Buy & sell short term treasuries • Quantitative Easting – Buy long-term securities (private & public) – Increase money supply to avoid deflation • Forward guidance – Announce long-term plans to keep interest rates low 38 High central bank independence => low inflation (1970-1998; 1 = High CBI, 3 = Low CBI 39 High CBI ≠> high economic growth (1970-1998; 1 = High CBI, 3 = Low CBI) 40 Macroeconomic policy trilemma “The Unholy Trinity” Fixed exchange rate Argentina dollarization Capital mobility Floating exchange rate Monetary autonomy 41 Argentina introduced convertibility (including currency board) to kill inflation Domingo Cavallo “a man of action” 42 Some pros and cons of “dollarization” • Pros – Low inflation – Greater savings/investment (if capital believes dollarization is credible) • Cons – Loss of monetary autonomy (interest rates set to maintain peg) – Reduced fiscal autonomy (deficits signal inflation) 43 Wage inflation in advanced economies (relatively labor scarce) can also be tamed by globalization Source: Bank of England 44 Conclusions • Globalization brings economic benefits: – Increased trade, increased access to capital or investment opportunities • However, globalization also constrains governments – To attract capital, must limit fiscal deficits and inflation • Some win more than others 45 Conclusions • Capital owners benefit from capital mobility and low inflation rates • Workers in labor-abundant countries may benefit from higher wages, but lose political power • Countries with developed financial institutions, capital abundance, & high credibility can attract capital even with deficits • Countries lacking these attributes face trade-off between national control of their economy, democracy, and the attraction of capital 46 Conclusions • Capital mobility enables capital flows, which encourages reduced regulations (including capital reserves) to attract capital • High capital flows and low capital reserve requirements enables deep borrowing • If deep borrowing is used unwisely (e.g., for consumption or illiquid investments), financial crises will follow 47