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Transcript
LECTURES 7 - 9: POLICY INSTRUMENTS, including MONEY L7: Goals and Instruments • Policy goals: Internal balance & External balance • Policy instruments • The Swan Diagram • The principle of goals & instruments L8: Introduction of monetary policy • The role of interest rates • Monetary expansion • Fiscal expansion & crowding out L9: The Monetary Approach to the Balance of Payments Goals and instruments Policy Goals • Internal balance: Y = Y ≡ potential output. Y < Y ≡ ES ≡ “output gap” => unemployment > u Y > Y ≡ ED => “overheating” => inflation or asset bubbles. • External balance: e.g., CA=0 or BP=0. Policy Instruments • Expenditure-reduction, e.g., G ↓ • Expenditure-switching, e.g., E ↑ . ITF-220, Prof.J.Frankel Internal balance Output gap, as percentage of GDP, in the Great Recession, 2009 Jpn UK US France Ir In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << Y . Source: IMF, via Economicshelp, 2009 ITF-220, Prof.J.Frankel Output gap in eurozone periphery Source: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated by 2007: Y >> Y and crashed in 2009-11: Y << Y ITF-220, Prof.J.Frankel THE PRINCIPLE OF TARGETS AND INSTRUMENTS • Can’t normally hit 2 birds with 1 stone • Have n targets? • => Need n instruments, and they must be targeted independently. • Have 2 targets: CA = 0 and Y = Y ? • => Need 2 independent instruments: expenditure-reduction & expenditure-switching. ITF-220, Prof.J.Frankel RESPONSES TO CURRENT ACCOUNT DEFICIT Financing • By borrowing • or running down reserves. vs. Adjustment • Expenditure-reduction (“belt-tightening”) • e.g., fiscal or monetary contraction • or Expenditure-switching • e.g., devaluation. Adjustment Starting from current account deficit at point N, policy-makers can adjust either by (a) cutting spending, ● ● A or (b) devaluing. X ● ITF-220, Prof.J.Frankel ● (a) If they cut spending, CA deficit is eliminated at X; but Y falls below potential output Y. ● ● => recession ITF-220, Prof.J.Frankel (b) If they devalue, CA deficit is again eliminated, at B, ● but with the effect of pushing Y above potential output. ● => overheating ITF-220, Prof.J.Frankel DERIVATION OF SWAN DIAGRAM • Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. ● A •Experiment: increase in Ă (e.g. G↑) Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0 . What would have to happen to reduce trade deficit? Devaluation ● ● E X ITF-220, Prof.J.Frankel ● ● ● Again, A At F, TB<0 . What would have to happen to eliminate trade deficit? E↑. If depreciation is big enough, restores TB=0 at point B. ● ● ● ITF-220, Prof.J.Frankel To repeat, at F, some of higher demand falls on imports. We have just derived upward-sloping BB curve. . What would have to happen to eliminate trade deficit? ● E↑. If depreciation is big enough, restores TB=0 at point B. ● We have just derived upward-sloping external balance line, BB. ITF-220, Prof.J.Frankel ● Now consider internal balance. Return to point A. Experiment: increase A Expansion moves economy rightward to point F. ● ● Some of higher demand falls on domestic goods => Excess Demand. Y > Y What would have to happen to eliminate excess demand? ● ● ● E↓. ITF-220, Prof.J.Frankel Experiment: Fiscal expansion, cont. At F, Y > Y. What would have to happen to eliminate excess demand? E↓. If appreciation is big enough, restores Y= Y at point C. ● ● ● ITF-220, Prof.J.Frankel At F, some of higher demand falls on domestic goods. We have just derived downward-sloping YY curve. What would have to happen to eliminate excess demand? ● E ↓. If appreciation is big enough, restores at C. ● ● We have just derived downward-sloping internal balance line, YY. ITF-220, Prof.J.Frankel Swan Diagram has 4 zones: I. II. III. IV. ● ED & TD ES & TD ES & TB>0 ED & TB>0 ITF-220, Prof.J.Frankel Summary: combination of policy instruments to hit one goal slopes up, to hit the other slopes down. ITF-220, Prof.J.Frankel Example 1: Emerging markets in 1990s Classic response to a balance of payments crisis: Devalue and cut spending Excgange rate E ED & TB>0 BB: External balance CA=0 Mexico 1995 or Korea 1998 ED & TD ● ES & TB>0 ES & TD Mexico 1994 or Korea 1997 YY: Internal balance Y=Potential Spending A Could be the “fragile 5” in 2013-14: India, Turkey, Indonesia, S.Afr., Brazil Example 2: China in the past decade ED & TB>0 Excgange rate E China 2010 ES & TB>0 China 2002 ● ES & TD BB: External balance CA=0 ED & TD YY: Internal balance Y = Potential Spending A By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, Spending A due in part to G stimulus, At the end of 2008, an abrupt loss of X, shifted China again into ED. due to the US crisis, shifted China into ES. Example 3: US over 33 years Excgange rate E ED & TB>0 BB: External balance CA=0 ES & TB>0 ED & TD ● US US 1987 or 2007 1981,1991, or 2008-13 ES & TD ITF-220, Prof.J.Frankel YY: Internal balance Y = Potential Spending A End of Targets and Instruments ITF-220, Prof.J.Frankel Appendix: Internal balance, before & after the 2001 recession I 2000 US Jpn In 2000 most countries were operating above full employment: Y > Y Ireland was the strongest case; Japan was the biggest exception. ITF-220, Prof.J.Frankel 2002 I US Jpn By 2002, most countries were operating below full employment: Y < Y ITF-220, Prof.J.Frankel Source: The Economist, June 22, 2002 Monetary policy • is another instrument to affect the level of spending. • It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I and consumer durables. E.g., Taylor rule sets i. • Or it can be defined in terms of money supply M. – In which case it is a rightward shift of the LM curve – Which itself slopes up (because money demand depends negatively in i and positively on Y). E.g., Quantitative Easing sets MB. ITF-220, Prof.J.Frankel LM i Y Monetary expansion lowers i, stimulates demand, shifts NS-I down/out. New equilibrium at point M. ● In lower diagram, which shows i explicitly on the vertical axis, We’ve just derived IS curve. ● ● If monetary policy is defined by the level of money supply, then the same result is viewed as resulting from a rightward shift of the LM curve. ● ITF-220, Prof.J.Frankel Fiscal expansion ● shifts IS out. ● New equilibrium: At point D if monetary policy is accommodating. At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓ Rise in Y < full Keynesian multiplier. ● ITF-220, Prof.J.Frankel ● ●D LECTURE 9: The Monetary Approach to the Balance of Payments • Sterilization definitions • Price-specie flow mechanism • Income-money flow mechanism • Brief history of the Gold Standard • Appendix: China sterilizes inflows, 2004-10 ITF-220 - Prof.J.Frankel The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. Another assumption sometimes associated with MABP: Goods prices are flexible => PPP holds. ITF-220 - Prof.J.Frankel Definitions: Monetary Base: Liabilities of CB assets held by CB MB Res + NDA where Res ≡ International Reserves & NDA ≡ Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking Sterilization: Changes in reserves (i.e., BP) offset by NDA , D NDA = - DR, so MB unchanged. Non-sterilization: D MB = DR. ITF-220 - Prof.J.Frankel David Hume’s Price Specie-Flow Mechanism Initially, Spain piles up gold, from the New World (mercantilism). But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level. ITF-220 - Prof.J.Frankel Hume’s Price Specie-Flow Mechanism continued If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. ITF-220 - Prof.J.Frankel Mundell’s Income-Flow Mechanism • • • • MB↑ => M1 ↑ => (via i ↓ => I ↑) => A ↑ => Y ↑ But A ↑ => TB<0 => Res then falling gradually over time + nonsterilization MB falling over time A falling over time. • In the long run, TB=0 and everything is back to where it was. ITF-220 - Prof.J.Frankel Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath NS-I NS-I´ + 0 Y - TB i LM LM ´ IS As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion. ITF-220 - Prof.J.Frankel Example: response to the 1994 tequila crisis Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December. LM´ i A M . IS Y Argentina was on a currency board => no sterilization. In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. ITF-220 - Prof.J.Frankel The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). Pros and Cons Pro: prevents excess money creation and inflation. Cons: • prevents response to cyclical fluctuations • long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK. ITF-220 - Prof.J.Frankel Capsule History of the Gold Standard 1844 – Britain adopts full gold standard. 1879 -- US restores gold convertibility. From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices. 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. 1944 -- Bretton Woods system, based on gold as the reserve asset. 1945-1971 -de facto: based on $. 1958 -- Start of US BoP deficits. <= European growth > US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $ . Solutions: raise price of gold, or create SDRs. 1971 -- Nixon suspends convertibility & devalues. ITF-220 - Prof.J.Frankel Appendix -Example of sterilizing money inflows: China, 2004-08 & 2010 ITF-220 - Prof.J.Frankel The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 38 FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html ITF-220 - Prof.J.Frankel Sterilization of foreign reserves: People’s Bank of China sold sterilization bills, thereby taking RMB out of circulation. Source: Zhang, 2011 , Data: CEIC ITF-220 - Prof.J.Frankel Fig.4, p.45. In 2003-04, forex inflows accelerated rapidly. Initially, the PBoC had no trouble sterilizing the inflows. => The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure. In 2007-08 China had more trouble sterilizing the reserve inflow • PBoC began to have to pay higher domestic interest rates – and to receive lower interest rate on US T bills – => “quasi-fiscal deficit” or “negative carry.” • Inflation became a serious problem in 2007-08. • Also a “bubble” in the Shanghai stock market. ITF-220 - Prof.J.Frankel Sterilization faltered in 2007 & 2008 Growth of China’s monetary base & its components: Money growth accelerated sharply, 2007-08 Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 ITF-220 - Prof.J.Frankel China’s CPI accelerated in 2007-08 Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 ITF-220 - Prof.J.Frankel Sterilization of foreign reserves: Decreases in PBoC’s domestic assets offset increases in foreign assets Source: Zhang, 2011, ITF-220 - Prof.J.Frankel Fig.7, p.47. China’s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession), But took off again in 2010-11. Inflation 2001 to 2011 ITF-220 - Prof.J.Frankel After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices ITF-220 - Prof.J.Frankel When house prices rise relative even to rents, that suggests a bubble or easy money ITF-220 - Prof.J.Frankel Scott Reeve blog China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly. ITF-220 - Prof.J.Frankel