Download Mundell-Fleming vs Compensation and sterilization

Open economies
in PK theory
Mundell-Fleming vs
Compensation and sterilization
Outline
► Balance
sheets of central banks (Overdraft vs
asset-based economies)
► The Mundell-Fleming neoclassical point of view of
fixed exchange rates
► The compensation thesis or endogenous
sterilization
► Balance sheets reconsidered
► The compensation thesis within the Canadian LVTS
► China’s more recent example
The neoclassical balance sheet of
central banks
Assets
Liabilities
Foreign reserves
Banknotes (cash)
+
Bank reserves =
Government securities
(claims on domestic
government)
High powered money M0
Monetary base
Mundell-Fleming model
► The
short-run neoclassical model is essentially the
Mundell-Fleming model (the IS/LM/BP model).
► Being based on the neoclassical synthesis, it
contains many Keynesian features.
► Its main assertion is that an economy operating
with fixed exchange rates would lose control of the
money supply, and hence that monetary policy is
ineffective.
► By contrast, with flexible exchange rates, an
expansionary monetary policy could achieve
higher levels of output and employment.
The Mundell-Fleming stabilizing
mechanism
Suppose a country has a balance of payment surplus.
► To keep its exchange rate fixed, the central bank needs to
purchase foreign currency.
► This means that the central bank is adding foreign
reserves to its assets.
► The increase in foreign reserves leads to an increase in the
monetary base (HPM)
► The increase in the monetary base leads to an increase in
the money supply (and a fall in interest rates).
► This leads to an increase in nominal income (through
quantities or prices). Net exports fall.
► The balance of payments goes back to zero.
►
Implications for monetary policy
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Monetary policy with fixed exchange rates is powerless.
An expansionary monetary policy (a higher supply of high powered
money) drives interest rates below their world levels, and it
increases output and imports.
Both of these effects drive the balance of payments into a deficit
situation, thus leading to a reduction of the central bank foreign
reserves, as the central bank attempts to sustain the value of its
domestic currency on exchange markets.
The reduction in the foreign reserves diminishes the assets of the
central bank, thus inducing a reduction in the monetary base and
hence in the money supply of the economy.
The autonomous expansionary policy of the central bank is thus
counter-balanced by this endogenous reduction in the monetary
base and money supply.
The money supply is endogenous, but supply-led.
(in the PK view the money supply is endogenous, but demand-led)
Mundell quote
► “…To
prevent the exchange rate from falling the
central bank intervenes in the market, selling
foreign exchange and buying domestic money….[]
Forcing the central bank to intervene by buying
foreign reserves and increasing the money
supply.... When the central bank buys or sells
foreign exchange the money supply increases or
decreases”
► (Mundell, 1963, p. 479).
More recent quote
“But the main point is that, in behaving in this way, the
central bank loses control over the home country’s money
stock. This is because each exchange by the central bank
of dollars for foreign currency has the effect of changing
the home country’s stock of ‘high-powered money’
(alternatively referred to as ‘base money’ or the ‘monetary
base’). And as most readers will know from their study of
money and banking, changes in high-powered money tend
strongly to induce changes – approximately equal
percentage changes – in the stock of money ....”
► (McCallum, 1996, p. 137)
►
Quote continues
► “Let
us conclude this section by reiterating its
central and fundamental message: in order to
maintain a fixed exchange rate, a central bank
must engage in foreign exchange transactions that
prevent it from managing the monetary base so as
to achieve other macroeconomic objectives. If
monetary policy is dedicated to pegging the
exchange rate, it is then unavailable (except on a
highly temporary basis) for application to other
goals.”
► (McCallum, 1996, pp. 139-140).
Hume’s specie flow mechanism
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This mechanism is similar to Hume’s specie-flow
mechanism and related to the theory of comparative
advantage. A country with a balance of payments deficit
will suffer from an outflow of gold, which will induce a
fall in its money supply, and this in turn will lead to a
general fall in prices. A general absolute disadvantage
will be turned into a comparative advantage for some
products.
Similarly, the country with an absolute competitive
advantage will show a balance of payments surplus,
which will generate an inflow of gold and a continuous
increase in the stock of money and in prices, until the
dearer prices bring back to equilibrium the balance of
payments.
The Rules of the game
►A
similar mechanism is provided by the modern
“monetary approach to the balance of payments”
of the monetarists, where full employment is
explicitly assumed. Indeed, neoclassical
economists claim that the Rules of the Game must
be such that “a balance of payments deficit should
be fully reflected in a reduction in the supply of
money, and a surplus should be fully reflected in
an increased money supply” (Ethier 1988: 341).
► The balance of payments is self-adjusting both
in fixed and flexible exchange rate regimes.
The rules of the game are not
automatic
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Mundell (1961), whose other works are often invoked to
justify the relevance of the rules of the game in
textbooks and the IS/LM/BP model, was himself aware
that the automaticity of the rules of the game relied on a
particular behaviour of the central bank.
Indeed he lamented over the fact that modern central
banks were following the banking principle instead of the
bullionist principle, and hence adjusting ‘the domestic
supply of notes to accord with the needs of trade’ (1961,
p. 153), which is another way to say that the money
supply was endogenous and that central banks were
concerned with maintaining the targeted interest rates.
Sterilization or neutralization
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Students are sometimes told that such a situation need not
occurred, however, if the impact of the deficit on official
foreign reserves is being neutralized or sterilized.
In the case of the balance of payments deficit, this would
imply that monetary authorities retain control over the
monetary base by engaging into counter-balancing open
market operations, by purchasing government securities
from the market.
These sterilization operations allow central banks to keep
their assets at a constant level, thus halting any
endogenous decrease in the money supply.
Can sterilization be pursued for long?
► It
is usually argued that sterilization cannot be
pursued for very long or is ineffective.
► For Claassen (1996, p. 51) for instance, ‘in the
context of “perfect capital mobility” ... sterilized
intervention policies are doomed to be ineffective’.
► In our opinion, such statements confuse perfect
capital mobility with perfect asset substitutability.
► They also do not distinguish between countries
that are in a current account deficit situation and
losing reserves (say some Latin American
countries) and those that are in a surplus situation
and gaining reserves (say China).
The standard view
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“The effect on the stock of base money of a purchase of
foreign currency could be undone, for example, by a sale
by the central bank of government bonds. Such an
action is termed a sterilization of the foreign exchange
purchase, which becomes a sterilized intervention’. It is
the case, then, that central bank interventions in the
foreign exchange market may not affect the home
country money stock if they are sterilized. Most research
on this issue has indicated, however, that the effects on
exchange rates of sterilized market interventions are
both weak and short-lived. Thus a central bank can keep
its nation’s exchange rate fixed only by engaging in nonsterilized interventions”.
(McCallum, 1996, p. 138)
Another, new, argument against
sterilization
► In
the context of Latin American countries, Frenkel
(2006, p. 587) writes that sterilization operations:
“consist in the selling of public-sector or central
bank papers with the objective of money
absorption. They imply a financial cost to the
treasury or the central bank, proportional to the
difference between the interest rate of those
papers and the interest rate earned by the central
bank’s international reserves”.
The opportunity cost of sterilization if interest
rates are high in the domestic economy
(the case of a surplus economy)
Assets
Liabilities
Foreign reserves (US
Treasury bills at 1%) ↑
Banknotes (cash)
+
Bank reserves =
Domestic government
securities (at 5%) ↓
High powered money M0
Monetary base
History shows that the rules of the game never held,
even during the gold exchange regime
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Bloomfield (1959, p. 49) shows that when looking at
year-to-year changes in the period before the First World
War – the heyday of the gold standard – the foreign
assets and the domestic assets of central banks moved
in opposite directions 60% of the time. Foreign assets
and domestic assets moved in the same direction only
34% of the time for the eleven central banks under
consideration.
The prevalence of a negative correlation thus shows that
the so-called Rules of the Game were violated more
often than not, even during the heyday of the gold
standard. Indeed, ‘in the case of every central bank the
year-to-year changes in international and domestic
assets were more often in the opposite than in the same
direction’ (Bloomfield, 1959, pp. 49-50).
Further results
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Almost identical results were obtained in the case of the
1922-1938 period.
Ragnar Nurkse (1944, p. 69) shows that the foreign
assets and the domestic assets of twenty-six central
banks moved in opposite direction in 60% of the years
under consideration, and that they moved in the same
direction only 32% of the time.
Studying the various episodes of inflows or outflows of
gold and exchange reserves, Nurkse (1944, p. 88)
concludes that ‘neutralization was the rule rather than
the exception’. Without saying so, Nurkse adopts the
compensation principle as the phenomenon ruling
central banks in an open economy. The rules of the
game as they were to be endorsed in the modern
IS/LM/BP models of Mundell are an erroneous depiction
of reality.
The compensation thesis
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Bloomfield and Nurkse have uncovered what was later to be called the
compensation thesis.
The compensation thesis is sometimes called the Banque de France
view, because in its modern incarnation it was endorsed by Pierre
Berger, who was the general director of research at the Banque de
France.
Berger (1972a, p. 94, 1972b, p. 171), points out that the
compensation phenomenon that can be observed in modern
economies could already be observed in the 19th century.
Berger argues that when France had large external surpluses, and
hence was accumulating gold reserves, the peaks in the gold reserves
of the Banque de France were accompanied by throughs in credits to
the domestic economy.
As a result, despite the wide fluctuations in gold reserves, the
variations in the monetary base and the money supply were quite
limited.
Nurkse and the compensation thesis
► “There
is nothing automatic about the mechanism
envisaged in the “rules of the game”. We have
seen that automatic forces, on the contrary, may
make for neutralization. Accordingly, if central
banks were to intensify the effect of changes in
their international assets instead of offsetting
them or allowing them to be offset by inverse
changes in their domestic assets, this would
require not only deliberate management but
possibly even management in opposition to
automatic tendencies.”
► (Nurkse, 1944, p. 88)
Active sterilization or
passive compensation?
Nurkse’s rejects the standard interpretation in terms of a
‘sterilization’ operation initiated by the central bank.
► Nurkse considers that it would be ‘quite wrong to
interpret [the inverse correlation] as a deliberate act of
neutralization’ on the part of the central bank.
► On the opposite, Nurkse considers that the neutralization
of shifts in foreign reserves is caused by ‘normal’ or
‘automatic’ factors, and that the compensation principle
operates both in overdraft financial systems and in the
asset-based ones.
► In the overdraft system, Nurkse (1944, p. 70) notes
that ‘an inflow of gold, for instance, tends to result in
increased liquidity on the domestic money market, which
in turn may naturally lead the market to repay some of
its indebtedness to the central bank’.
►
Active sterilization or
passive compensation? (2)
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But Nurkse also observed compensating phenomena that
were consistent with the operation of an asset-based
financial system.
In the case of an inflow of gold and foreign exchange,
foreign investors (or the banks where their deposits
would be held) would purchase new government
securities.
This would allow Government to reduce its debt to the
central bank, as would be the case in an open-market
operation.
However, as Nurkse (1944, p. 77) points out, in contrast
to the usual open-market operation, the manoeuvre ‘did
not come about at the Bank’s initiative’.
Alternatively, Nurkse (1944, p. 76) points out, gold
inflows could also be neutralized by an increase in
government deposits held at the central bank, as the
Bank of Canada used to do.
Even Keynes recognized the
compensation principle
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Keynes (1930, ch. 32) was also keenly aware of the
compensation phenomenon.
He points out that year after year the Bank of England
would gain £10,000,000 of gold in the spring and lose a
similar amount in the autumn. This should have caused
concern to all, but it did not, because these inflows and
outflows were compensated by corresponding seasonal
outflows and inflows arising from the Treasury.
In the spring, with the receipts of income tax, the Treasury
would buy back its securities from the public and from the
Bank of England, thus reducing the domestic credit entry in
the balance sheet of the Bank of England.
A PK, more realistic, balance sheet of
central banks
Assets
Liabilities
Foreign reserves
Banknotes
Bank deposits (bank
reserves)
Government deposits
Claims on domestic
government (Treasury bills)
Claims on domestic banks
(advances)
Central bank bills
An obvious case of endogenous
sterilization: Germany
Peoples’ Bank of China balance sheet (B of yuan):
the role of central bank bonds and govt deposits
June 1999
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Assets
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Foreign assets
1,388
Claims on central government 158
Claims on banks
150
►
Liabilities
►
Currency and bank reserves
Central government deposits
Central bank bonds
Foreign liabilities
Others …
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Nov. 2007
12,217
882
2,226
3,020
3
12
3
9,243
2,315
3,566
6
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Table 4: The balance sheet of the People’s Bank of China,
in 100 million RMB
December 1999November
2007Assets35349165299Foreign
assets14458122170Total Claims Claims on government
Claims on banks and other financial institutions20337
1582 1920731412 8825
22260Liabilities35349165299Reserve Money Currency
Deposit of financial33620 15069 1472892433 31389
60775Bond Issues11835667Deposits of
Government178523159Source: People's Bank of China
The Canadian case, before giving up
exchange rate interventions
The LVTS
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In one of its background papers, the Bank of Canada (2003)
explains that when it conducts exchange rate operations,
moderating a decline in the Canadian dollar for instance, it must
sterilize its purchases of Canadian dollars by ‘redepositing the
same amount of Canadian-dollar balances in the financial
system’, in order ‘to make sure that the Bank’s purchases do not
take money out of circulation and create a shortage of Canadian
dollars, which could put upward pressures on Canadian interest
rates’.
Similarly, when the Bank wishes to slow down the appreciation
of the dollar and sells Canadian dollars on the exchange markets,
thus acquiring foreign currency, ‘to prevent downward pressure
on Canadian interest rates ... the same amount of Canadian-dollar
balances are withdrawn from the financial system.’. Thus
sterilization is not a matter of choice, it is a necessity as long as
the central bank wants to keep the interest rate at its target level.
Impact of foreign exchange intervention: central bank
buys foreign currency (to stop CDN $ from rising)
Chartered bank (BMO)
LVTS
Assets
Assets
Liabilities
LVTS balances Deposits of
exporter
+ $60 M
+ $60 M
Liabilities
LVTS balances of
BMO
+$60 M
LVTS balances of
Bank of Canada
− $60 M
Bank of Canada
Assets
LVTS balances − $60 M
Foreign reserves +$60 M
Liabilities
Impact of foreign exchange intervention: central bank
needs to bring LVTS balances back to zero
Chartered bank (BMO)
LVTS
Assets
Assets
Liabilities
Liabilities
LVTS balances Deposits of
exporter
+ $60 M
+ $60 M
LVTS balances of
BMO
$0
LVTS balances Government
− $60 M
deposits
− $60 M
LVTS balances of
Bank of Canada
$0
Bank of Canada
Assets
Liabilities
LVTS balances 0
Foreign reserves +$60 M
Government deposits +$60 M
Next week …
►A
stock-flow consistent model of
endogenous sterilization
► And a flexible exchange rate model