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IX. Stabilization policies 1980 - 2007 IX.1 Disinflation in 1980s beyond the USA Example 1: Israel • June 1985 – Monthly inflation 10-15% – Rapid decrease of foreign reserves due to capital flight – Stagnation of real growth and productivity – Continued growth of consumption and public expenditure - increase of foreign debt – Reduction in investment Genesis (1) • Main roots – Deterioration of BoP (at the beginning, namely deterioration of current account) and growth rates, since 1973 – Large public sector (not only military expenditures), deficit financing and increase of public debt • All kind of subsidies – export financing, production prices, etc. – Wage and other indexation • COLA, even credit indexation • Pre-1985 policies – To improve BoP: devaluation – To alleviate public finance deficit: subsidies cuts, but not too successful in wage taming, Genesis (2) • Pre-1985 policies fueled the inflation further on • Loss of foreign reserves continued even after current account deficits substantially improved – Capital flight continued • Two major sources of almost-hyperinflation in 1985: – Large government deficit, persistently increasing both internal and external debt – Automatic linkage the nominal value of wages, but also other liquid assets (credits, etc.) to inflation and automatic adjustment of ExR (devaluation) – loss of nominal anchor Solution • Budget deficit reduction • Initial further devaluation, but immediate freezing of all nominal aggregates – Combination of two nominal anchors: USD exchange rate and nominal wages • Central bank: nominal credit restriction • Ministry of Commerce and Industry: price controls • Avoiding indexation Very quick stabilization Israel - summary • Main stabilization tools: nominal anchor and fiscal austerity • Quick stabilization of all main macroeconomic parameters • Credible program, compared with previous attempts Example 2: Bolivia 1984-1985 Hyperinflation it was • Strongest hyperinflation since 1947, no match with other rapid inflations – Between May and August 1985, inflation surged to annualized figure of some 60.000% • Roots: political situation and shift in external conditions – Relative economic stability under military regime in 19711978: favorable terms of trade, strong (and relatively cheap) international borrowing, strong direct foreign investment – Difficult transition to political democracy: unstable and ineffective governments, under populist pressure • Pressure for increases in social spending, public sector employment and pay, without mandate to increase taxes – At the same time, much more difficult external conditions: higher interest rates, falling commodity prices, tight credit Three fundamental causes • Cutoff in international lending and increase of international interest rates – Need to repay the debts without new borrowing led to outflow of financial resources form the country – As a reaction, since January 1985 Bolivia stopped every debt repayment, including the debt servicing • As a consequence, recourse to inflation tax (seignorage), resulting in further inflation acceleration • Collapse of the tax system Four stabilization steps • Devaluation, managed ExR floating, convertibility of both current and financial accounts • Fiscal deficit reduction, achieved mainly through sharp increase of public sector prices and wage freeze in public sector • Tax increases: broadening tax base and tax rates increase • IMF stand-by arrangement and Paris club debt rescheduling Sudden end of hyperinflation • Stabilization launched on August 29, 1985 • Price level stabilized almost immediately • Main reason: stabilization (at least temporarily) the USD ExR – During the hyperinflation, prices were set in USD, people used USD as a store of value, inly transaction were carried in Bolivian peso, according spot (black)market rate • Credibility: achieved later, when government convinced people that it is serious about fiscal austerity and fiscal adjustment Bolivia - summary • “Simple” solution: given specific role of USD, stabilizing dollar ExR was necessary condition for immediate drop of Bolivian inflation to the US one • Long term stability: convince the public about credibility of fiscal stabilization – Maintain political support Disinflation - summary • Examples above - Israel, Bolivia, even US in 1980, but many other countries (Argentina, Brazil, etc.) suffered with the same disinflation problem as well • High inflation (Bolivia even hyper-), in each case disinflation policies differ to some extent, but some general lessons: – Nominal anchors: need to stabilize decisive nominal values (Bolivia one anchor - USD ExR, Israel even two - USD ExR and nominal wages) – Credibility: abrupt exit from deficit financing and seigniorage (inflation tax) • Macroeconomic remainder: seigniorage • In some countries less dramatic situation, but given the stagflation experience from 1970s and Phillips curve fallacy in 1960s, US, Europe and Japan faced similar questions – how to stabilize business cycle after dramatic 1970s and first half of 1980s? – Accepting the concept of natural unemployment, policies need to steer the economy close – Short term inflation x unemployment exists, but long term need to avoid high inflations – Basic question: what should be the workable concept of “desirable” unemployment? NAIRU • One possibility: try to specify an unemployment rate that keeps inflation constant • Remember expectations-augmented Phillips curve: π = π-1 – ε(u-u*) or π - π-1 = - ε(u-u*) • If u*= u, then inflation is constant (π - π-1 = 0) • Possible interpretation of natural rate of unemployment: Non-Accelerating Inflation Rate of Unemployment (NAIRU) IX.2 Inflation and output volatility New trade-off • Prior 1973 (1st oil shock), stabilization policies focused on demand management – Keynesian vs. monetarist arguments about efficiency of stabilization policies • Oil shocks in 1973/1979 – shocks to aggregate supply – Increasing price level and, at the same time, depressing output and employment – Policy makers had to choose between stabilizing either output or inflation, i.e. to consider a compromise between volatility of output (and (un)employment) and of inflation – a different trade-off compared to Phillips curve By the way – what’s so wrong about inflation? (1) • At the first sight, if both prices and wages increase with the same rate, not much – However … • Difference between expected and unexpected inflation • Expected: – money becomes inferior measure of future economic transactions – distortion of tax system – due to change in relative costs, firms must change prices more often (“menu costs”) – due to reduced real value of money, larger number of bank withdrawals (“shoeleather costs”) By the way – what’s so wrong about inflation? (2) • Unexpected – Wealth redistribution among people – Higher inflation – debtors gain, creditors loos, but fixed income recipients (pensioners, etc.) suffer, state gains – Lower inflation – vice-versa – In general: problem of nominal contract, indexation (see case of Israel above) Difficult legacy • 1960s and 1970s – excessive optimism as to policy effects on output: by (namely) monetary policies, permanently low unemployment levels can be achieved – Inflation, on the contrary, believed to be driven by non-monetary factors (supply shocks, oligopoly, trade unions) – policy makers underestimated their ability to cope with inflation • Both assertion above proved to be wrong, stop and go policies increased volatility – High- and hyperinflations appeared much more often, calling for emergency type of policies – see above IX.3 Inflation targeting • The most important monetary policy lesson from stagflation period • Neither rule or discretion – The central bank estimates and announces a target for inflation (kind of a rule) – Steering the actual inflation towards the target by changing nominal basic interest rate and/or using other tools (open market operations, etc.) – It is expected to perform policy credibly to achieve this target – Target within an interval to give the Central Bank a certain level of discretion • Independence of the Central Bank Advantages • Clear accountability of Central Banks • Transparency and predictability • Stability for the investors: relatively easy to predict future interest rates • No link to political cycle • Emerging countries: safeguard against high and hyper inflations Shortcomings (1) • Targeting CPI and assumption of causal link: growth of money supply → CPI – CPI accurately reflects money supply (?) – In case of exogenous shock (e.g. oil or food price shock) → sharp increase of CPI possible, but no relation to domestic economic events → Central Banks acts against inflation → needless slowdown of domestic economic growth, deepening of the negative effect of exogenous shock Shortcomings (2) • Inflation targeting is not consistent with any long term growth theory/strategy – Policy just smoothes the cycle • No explicit set of monetary policy recommendations – One attempt – Taylor rule, see next slides Taylor’s rule (1) • Rule, stipulating how much Central Banks should change nominal interest rate, reacting to two important signals: – Divergence of actual inflation from target inflation – Divergence of actual GDP from its potential • π* - inflation target, r* - equilibrium real interest (i.e. consistent with inflation target and implying desired nominal interest i*), y and y* - log of actual, respectively potential output Taylor’s rule • The rule (2) i r a - b y - y • a, b > 0 • Originally Taylor: a=b=0.5 • In case of stagflation, when monetary policy goals may conflict, Central Banks should change the weights for reducing inflation vs. increasing output ad hoc (according the situation) * * * Taylor’s rule (3) • Alternatively (natural unemployment u*): ~ * * ~ i i a - - b u - u ~ ~ 1 a a 1, b 0 b 0 * • Why a>0 ? – for spending, real interest rate is important, i.e. when inflation raises, then real interest should raise to slow-down the economy • Following the rule: increase of π by 1% implies that Central Bank increases nominal interest by more than 1% Application and performance • Since 1990, many countries, both developed and developing, use Taylor rule – First country: New Zealand 1990, Czech Republic since 1999 – Not FED (different role, given by US Constitution) • Till the crisis in 2008, Taylor rule produced seemed to work satisfactorily • One seed of the crisis? – See Lecture XII IX.4 Deficits, debts and fiscal rules • Simultaneously, albeit in different (but not always) countries, problem of permanent public finance deficits and mounting public debts emerged – Welfare state, health systems, demographics • Europe as a particular example – See also next Lecture • Creeping problems that persist till today Is deficit and/or debt wrong? • No, especially in a growing economy, when deficits serve as a financing tool to increase future productivity and competitiveness • Balanced budget deficit – Sometimes popular, but not a good idea for today’s economies – Need for higher flexibility • Stabilization role • Tax smoothing • Inter-temporal solutions Basic concepts • Actual budget deficit (BD) = government revenues minus government expenditures • Primary deficit – BD minus interest payments • Structural deficit (actual or primary) – adjusted for short-term fluctuations of economic cycle (determination of potential output required!) • Financing of deficit = government borrowing • Government debt = accumulation of past borrowings Fiscal sustainability • More useful concept than balanced budget • Different definitions – – – Ratio of government net assets to GDP remains constant Debt/GDP over time repeatedly converges to a constant value Fiscal sustainability is not consistent with permanently increasing tax rate • Prevailing practice today – intertemporal definition of solvency of the country: – Given starting debt, discounted value of current and future primary expenditures today does not exceed discounted value of current and future revenues today Fiscal rule • Permanent restriction of fiscal policy through simple numerical limits for budgetary aggregates Features: • – – – – • Taxonomy of the rules – – – • Long term – numerical target for long period Tool for fiscal policy control Fiscal indicator for practical application Simple - easy monitoring and communication with broad public Budget deficit limits Debt restriction, e.g. limit for a maximum debt, legally binding (e.g. 60% GDP, given by Constitution in Poland today) Rules, restricting maximum expenditures or minimum revenues Most widespread: budget deficit limits: primary deficit > (nominal interest – nominal GDP growth) * (debt/GDP) IX.5 Great Moderation Post-1980 decline of volatility • See previous slide: variability in quarterly growth of main macroeconomic parameters was substantially reduced, sometimes even by one half • This applies not only to output, but to inflation as well • Economists and policy makers started even to ask “is the business cycle dead?” Volatility decline - data GDP growth, q-data, yoy, % GDP growth contributions – durables q-data, yoy, % GDP growth contributions – nondurables q-data, yoy, % GDP growth contributions – services q-data, yoy, % Three basic reasons – Bernanke 2004 • Structural changes – Better functioning of economic institutions, improvement in technology, business practices, inventories management, increased openness to trade and capital flows – Stronger shock absorption capacity of modern economies • Better macroeconomic policies – All lessons from previous Lectures – Better understanding of short term stabilization policies, namely a monetary one • “Good luck” – Less hostile external environment, lack of profound external shocks, like oil shocks in 1970s Mistake of the century? • Hard to say, we are just at the beginning of second decade … • … but see Lecture X Literature to Lecture IX Textbooks •Mankiw, Macroeconomics, Ch. 14-15 •Blanchard, Macroeconomics, Ch. 25-27 Disinflation – Israel •Bruno, Michael, Generating a Sharp Disinflation: Israel 1985, NBER working paper 1892, January 1986 Disinflation – Bolivia •Sachs, Jeffery, The Bolivian Hyperinflation and Stabilization, NBER Discussion Papers Series 2073, November 1986 Inflation Targeting •Bernanke, Laubach, Mishkin, Posen: Inflation Targeting, Princeton University Press, 1999 – Mostly case studies, but very useful general chapters 1-3. Great Moderation •Speech of Governor Bernanke, 2004: http://www.federalreserve.gov/Boarddocs/Speeches/2004/20040220/