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Revision & links to debates in positive and normative international macro MSc International macro Birmingham, Autumn 2015 Tony Yates Plan • Quick revision of basic themes of lectures. • Look back and see WHY these things were on the course. • Establish links with debates in – ‘positive’ international macro [how the world works] NB the OR ‘puzzles’ of international macro – ‘Normative’ [what would be a better world and how can policy help?] L1: THE DORNBUSCH-MUNDELFLEMMING MODEL L1: The Dornbusch, Mundell Fleming model • Model with perfect foresight, rational expectations, 1 period sticky prices, long run money neutrality, short run non-neutrality. • Motivated by nominal exchange rate volatility at the end of Bretton Woods. • Nominal exchange rates overshoot their long run destinations, where e moves proportionately with m and p. • This causes large REAL exchange rate fluctuations. DMF model: proof of overshooting by contradiction • Informal proof by contradiction of the overshooting result. • Assume falsely that e moves proportionately with p and m. • Deduce that msupply goes up > mdemand • …requiring an interest rate rise, and expected depreciation to compensate. • Which violates constancy of the exchange rate over the future that we assumed. DMF: links with ongoing policy and econ controversies • Cause and consequence of nominal and real exchange rate volatility • Optimal exchange rate regime. • Methodological debates about how to do macro: microfounded or not? Rational expectations or not? DMF: links to today • Causes and consequences of real exchange rate volatility: – Eg Eurozone crisis. – Huge rise in real exchange rate [measured by nominal wages] between core and periphery…. Pre-crisis looked like real exchange rate [eg measured by nominal wages] convergence… But post crisis, prob a bubble, painful correction afterwards as nominal wages often viewed as downwardly rigid. See, SGU ‘Case for temporary inflation….’ JEP, on reading list. DMF: links to today • What is the optimal exchange rate regime? • History of EZ creation and crisis reflects debates about this. • A focal point for DMF, which was written post Bretton Woods, and worried about XS nominal ER and real ER volatility. Exchange rate regimes Source: Rose (2011) Exchange rate regimes Source: Rose (2011) XR Regime switchers Source: Rose (2011) DMF: links to debate about optimal exchange rate regimes. • RE and speculative attacks on managed, fixed exchange rate regimes. • Optimal Currency Area Theory: – Need either similarity of shocks – Or flexible prices, free movement of goods/labour – Or fiscal transfers to compensate for lack of monetary policy flexibility Source: The Economist, 2011 • Eurozone Stability and Growth Pact involved tight restrictions on domestic fiscal policy…. [though often breached] • No provision for significant cyclical fiscal transfers across countries. • Failed to anticipate huge real exchange rate changes that would be needed, v painful without fiscal stimulus, price/wage flexibility. DMF: links to debates about macro methodology • ‘Old fashioned’ non-micro-founded model • DMF written at time microfounded models in infancy; Lucas, Kydland, Prescott beginning a revolution. • ‘Lucas Critique’ paper of 1976. • Sims critique of 1980: ‘incredible identification’ • Debate won by pre-crisis period, but now reopened with apparent neglect of finance in DSGE models. L2 TESTING THE DMF MODEL USING LONG RUN VAR RESTRICTIONS L2 Testing the DMF model using long run restrictions • Long run restrictions emerged out of a problem of identification. • Money stock changes were not exogenous, but themselves the product of central banks using instrument in response to, and to stabilise the macro economy. • VAR identification problem; v-covariance matrix estimated consistently, but has too few independent elements, because of symmetry, to pin down the elements of the structural model. L2/ctd… • We realised that IF we were prepared to write the LR impact matrix as a lower triangular cholesky factor [and therefore restrict some long run impacts=0]…. • We could get an expression for this cholesky factor in terms of things we know from reduced form VAR. • Restrictions; open economy versions of long run money neutrality. L2/ctd…. • Potential links to today’s debates – Use of VARS as a critique of ‘Cowles Commission models – Use of long run restrictions generally – Pervasive identification problem – Substantive q of causes of real exchange rate movements… Sims and Cowles Commission models • Cowles Commission was research institute focused on large scale non-microfounded, simultaneous eq macro models. • Dominated macro policy work in academia until mid 1970s, and survived in central banks, finance ministries, and consultancies. • Sims: no evidence for the exclusion restrictions that made up these equations. • VARs more ‘credible’ as more agnostic, less reliance on bogus identifying restrictions. VARs and LR restrictions • Came under fire for biases in small samples. Debate between Chari, Kehoe, McGratten and Christiano, Eichenbaum, Evans. • Proliferation of other identification methods. Short run/recursive, sign restrictions, heteroskedasticity, external instruments. • Other uses: measuring core inflation, identifying technology shocks. Pervasive identification problem [in macro] • UK/US: measuring the impact of fiscal policy, the ‘multiplier’. • ‘Neo Fisherian’ arguments about whether low inflation is caused by current low interest rates, or boosted by them. Causes of real exchange rate movements • As we already noted: – Were non-traded/labour price increases in EZ periphery ‘convergence’ or a bubble driven by excessive, under-priced borrowing? • Another recent example: Kirsten Forbes paper wondering about the impact of rise in £ and concluding that this was related to its cause. L3 EGGERTSON-KRUGMAN’S MODEL OF DEBT-DELEVERAGING IN A 2 COUNTRY MODEL EK: the story • Impatient borrowers, patient lenders. • Financial crisis causes the debt limit to contract. • Borrowers consumption drops as they repair balance sheets. • Drives down real rates, perhaps even negative. • Which might mean deflation. • Which could aggravate the problem with nominal debt. Links to contemporary events • The paper is transparently linked to the crisis; it’s a model of why the real equilibrium rate is so low and won’t rise until balance sheets repaired. • Related to debates about how to stop ‘debt limit’ from falling. Stop borrowing in the first place? Or prudential regulation to prevent sudden stops? • Contrasts with ‘secular stagnation’ as an account of low equilibrium real rates. • SS implies low real rates persist even after balance sheets repair. Other causes of low real rates • Rates are low because – Productivity growth lower [less income to bring forward, so demand for borrowing lower] ‘secular stagnation’ – Investment goods cheaper [so need to borrow less to finance firms – Demographic bulge of those saving for retirement [increased supply of savings drives down real rates]… tho this coming to an end. – Supply of safe savings assets has fallen. Cheaper investment goods lowers size of funds required to finance production Middle aged savings glut Source: Bean (2015) [MMF] Cross-country evidence of middle-aged effect on savings Source: Bean (2015) [MMF] Source: Bean (2015) [MMF] L4 INTERTEMPORAL APPROACH TO THE CURRENT ACCOUNT SOE microfounded model • Infinite period, representative agent, small open economy, random, exogenous endowment. • Stationary endowment; in good times, consumer saves some, and current account improves. • Non-stationary endowment; in good times, consumer borrows from the future to share in the benefits of the higher level tomorrow. SOE model: link to debates about performance of microfounded models • Model part of scrutinising the microfounded approach. • 3 basic types: closed economy; 2 country; SOE model • Debates brought together in the 6 puzzles of international macro paper by Obstfeld and Rogoff. SOE model: capital flows and capital controls • Related literature focuses on optimality of free or regulated capital flows in emerging and Western economies. • Pre-crisis orthodoxy = liberalise everything. • Post-crisis: capital flows may be helpful if prudential standards can be strained, or expectations that fuel borrowing are unfounded. Macro effects of sudden stops Source: Mendoza, (2010) ‘Sudden stops…’ Inflows before a sudden stop Source: Calvo and Reinhardt (2000) The stop in a sudden stop Source: Calvo and Reinhardt (2000) Clearing up the mess from a sudden stop Source: Calvo and Reinhardt (2000) Capital inflow controls Source: Fernandez et al (2015), IMF. Capital outflow controls Source: Fernandez et al (2015), IMF. L5 TIME SERIES TESTS OF THE INTERTEMPORAL APPROACH TO THE CURRENT ACCOUNT • Covered most recently, so not worth revising! • Paper shd be seen as part of wider effort to test models, and improve them. • Wider literature focuses on appropriate frictions in otherwise perfect microfounded models; appropriate model of expectations. • Policy conclusions often rest on sorting these things out. Eg whether business cycles should be smoothed or not. • Purpose for putting L5 on the course: – You can see the SOE model in action – Brings together two main tools of modern macro, namely, microfounded theory, and VARs L7 DEVIATIONS FROM PPP AND LOOP EXPLORED AND EXPLAINED Lecture in brief • Unspecified multi-good price index to diagnose source of real exchange rate deviations as wedge between ratio of traded to non traded goods prices. • Balassa-Samuelson model: – Labour mobile between sectors, not countries. – Traded goods productivity rise drives up nontraded wages and prices. Links: EZ crisis causes and consequences • We already covered this…. • Periphery in EZ; very large rises in real exchange rate. • Before crisis, looked like convergence as technology advanecd. • After crisis, looks like boom created by unwarranted capital inflow. • Subsequent correction in real exchange rate very painful. Links: global income convergence or not? Recent convergence? Source: Rodrick (2013) Longer run, lack of convergence Source: Rodrick (2013) Convergence within manufacturing Source: Rodrick (2013) Convergence at aggregate and disaggregated levels… 3 different inequality concepts Source: Milanovic (2013) Global inequality falls Source: Milanovic (2013) Source: Milanovic (2013) Income and institutional quality Source: IMF (2003) Economic performance and institutional quality Source: IMF (2003) Income and institutions Source: IMF (2003) Rule of law improvements L6 UIP/CIP IN A 2 STATE MICROFOUNDED SOE MODEL UIP Lecture in brief • Microfounded small open economy model. • 2 period, 2 states, good and bad. • Consumer decides how much to save, and how much savings to insure by buying the foreign exchange in advance, and how much not to insure. • Derive CIP, UIP. UIP Lecture in brief/ctd • For CIP to imply UIP required F=E(S) • But this generally wasn’t possible because of risk, and in particular covarianve between exchange rates and the stochastic discount factor [ratio of m utility today compared to tomorrow]. Link from UIP to OR puzzles • • • • Home equity bias puzzle Feldstein Horioka puzzle Consumption correlations puzzle These puzzles refute the basic framework of agents engaging in perfect goods and asset markets and achieving perfect risk sharing/insurance… • Which is also implicit in UIP/CIP. Feldstein-Horioka puzzle • Saving should flow round the globe to where investment opportunities are best. • And should be unrelated to domestic investment. • But Feldstein-Horioka regressions reveal high correlation between domestic savings and investment. Feldstein-Horioka regressions Source: Obstfeld and Rogoff (2000) 2 Home bias in trade NB : consumers should be indifferent between traded goods produced by their own country and those produced elsewhere. Home bias in portfolios • Model predicts should be indifferent between geographic nature of investments. Risk and return is all that matters. • Controversies over measurement. • Basic idea is that share in home equities should equal share in global market capitalisation. Simple home bias calculations Source: Sercu and Vanpee (2009) Home equity bias, ctd… Consumption correlations puzzle • Arises out of ‘incomplete risk sharing’. • Perfect international macro model involves agents insuring against idiosyncratic shocks to domestic output • …and consumption rising and falling with aggregate shocks only… • …meaning consumption perfectly correlated across countries, output not. Consumption correlations Source: Obstfeld and Rogoff (2000) Output [net] correlations Source: Obstfeld and Rogoff (2000) L8 SOVEREIGN DEBT AND DEFAULT Sov default lecture in brief 1 • Many sovereign defaults. Which are very costly in terms of trade, access to future finance, domestic recession, etc. • With commitment: perfect insurance optimal. Implies a state-contingent sovereign debt, not a simple IOU like we normally see? • No-commitment; no insurance. No positive payment to lender credible; only 0 balances lenders books in expectation, therefore. Sov default lecture in brief 2 • Sanctions can generate some of benefits of commitment. • Partial insurance for endowment draws that are worse than the sanctions level. Links to modern concerns and developments • International rules for workouts and holdouts. • Ukranian default. • EZ crisis defaults – Ireland, Portugal, Greece, Cyprus. Concluding points • Have a look at all the sources in the revisions section of the reading list. • Sample end of year exam questions by end March, posted on teaching homepage. • MCQ exam Tues Jan 12th [provisional]. 2 hours, 40 questions. • Advice on PhD? Come and see me. Look at self-study PhD course materials on my homepage.