Download Fiscal policy under floating exchange rates

Economic
Environment
Lecture 9
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
Page 1
© Stephen Hall, Imperial College London
Revision: The foreign exchange market
- the international market in which one national currency can be exchanged for another.
Exchange rate ($/£)
The price at which two currencies exchange is the
exchange rate.
DD shows the demand for
Suppose 2 countries: UK & USA pounds by Americans wanting
to buy British goods/assets.
SS
SS1
e0
Equilibrium exchange rate is e0
e1
DD
Quantity
of pounds
Page 2
SS shows the supply of pounds
by UK residents wishing to buy
American goods/assets.
If UK residents want more $
at each exchange rate, the
supply of £ moves to SS1
New equilibrium at e1.
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Purchasing Power Parity
• Basic trade relationship
• Law of one price. If a car costs £1000 in the UK
and DM3000 in Germany then the exchange rate
should be 3DM/£.
• Qualification; Transportation costs, Tarrifs,
Taxes
• A long term relationship
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Uncovered Interest Parity
• Basic speculative model
• If interest rates in the UK are 5% and in Germany
they are 4% then an investor must expect the DM/£
rate to devalue by 1%
• Expected change in exchange rate= interest diff.
• Qualification: Risk aversion
• Dominates exchange rates in the short run
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Alternative exchange rate regimes
• In a fixed exchange rate regime
– the national governments agree to maintain the
convertibility of their currency at a fixed exchange
rate.
• In a flexible exchange rate regime
– the exchange rate is allowed to attain its free
market equilibrium level without any government
intervention using exchange reserves.
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Macroeconomic policy under fixed exchange rates
• Under fixed exchange rates, there is a crucial link
between external imbalance and domestic money supply.
• When the government intervene to maintain the exchange
rate, there is a direct effect on money supply.
• Sterilization
– an open market operation between domestic money
and domestic bonds to neutralize the tendency of
balance of payments surpluses and deficits to change
domestic money supply.
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Monetary policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in nominal money supply
– tends to reduce interest rates
– leads to a capital outflow
– reducing money supply as the government seeks
to maintain the exchange rate
• so monetary policy is powerless
– the government cannot fix independent targets for
both money supply and the exchange rate
– domestic and foreign interest rates cannot diverge
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Fiscal policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in government expenditure;
• in the short run
– stimulates output
– but also increases interest rates
– which leads to a capital inflow
– money supply expands to maintain the exchange rate
– there is no crowding-out
– as interest rates cannot rise
• in the long run:
– wages and prices adjust, affecting competitiveness
– the economy returns to potential output.
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© Stephen Hall, Imperial College London
Monetary policy
under floating exchange rates
e
e3
e2
Suppose the economy begins in equilibrium
with the nominal exchange rate at e1.
At time t, nominal money
B
supply is halved...
C e will be the new equilibrium
2
e1
exchange rate once the
economy has adjusted
A
t
Time
But prices are sluggish, so
in the short run, real money
supply falls and domestic
interest rates rise
To maintain equilibrium in the forex market, the exchange
rate overshoots to e3 , adjusting along BC with wages & prices.
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Monetary policy
under floating exchange rates (2)
• This analysis suggests that with floating
exchange rates,
• monetary policy is highly effective in the
short run
• but the effect is only transitional
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Fiscal policy under floating exchange rates
• Following an increase in government
expenditure ...
• the crowding-out effect of higher interest
rates is enhanced by appreciation of the
exchange rate
– which dampens export demand
• so fiscal policy is less effective under
floating exchange rates.
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This Week
•
•
•
•
Some Selected topics
Macroeconomics in perspective
An Independent Central Bank
Europe and EMU
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Macroeconomics in perspective
• There is a spectrum of views about the
macroeconomy
– especially with regard to
– market clearing
– expectations formation
– speed of adjustment
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Market clearing
• The question of whether all markets clear is
critical in macroeconomics
• In a Classical view of the world, all markets clear
– so the economy is at full employment and at potential output.
• In a Keynesian world, markets do not clear
(especially the labour market)
– and there is more scope for the government to influence the
macroeconomy.
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Expectations formation
• Beliefs about the future shape today’s decisions
– but how do people form expectations about the future?
• Exogenous expectations
– not explained within the model
• Extrapolative expectations
– assumes that the future will be similar to the recent past
• Rational expectations
– assumes that on average people guess the future correctly
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Points along the macro spectrum
• New Classical macroeconomics
– instantaneous market clearing
– rational expectations
• Gradualist monetarists
– full employment will be restored within a few years
– the main effect of higher money is higher prices
• Moderate Keynesians
– economy will eventually get back to full employment
– but wage and price adjustment is fairly sluggish
• Extreme Keynesians
– markets fail to clear in the short run
– and fail to clear even in the long run
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A stylized view of the competing views
New
Classical
Market clearing
Expectations
Long run/
short run
Very fast
Rational –
adjust quickly
Not much
difference
Full employment Always close
Hysteresis
No problem
Policy
conclusion
Demand
management
useless; need
supply-side
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Gradualist
monetarist
Moderate
Keynesian
Extreme
Keynesian
Quite fast
Quite slow
Very slow
Adjust
more slowly
Could be fast or Adjust
slow to adjust slowly
Long run more Don’t neglect Short run
short run
important
v. important
Never too
far away
No problem
Could be
far away
Could
stay away
Might be
big problem
Not a big
problem
Supply-side
Demand
more important; management
avoid wild swings important
in demand
too
Demand
management
is what
counts
© Stephen Hall, Imperial College London
An Independent Central Bank?
• The argument for delegating monetary policy to an independent
decision making body is founded on the idea that politicians will
be tempted to make temporary gains in output and
unemployment at the expense of longer term increases in
inflation. Delegating the control of monetary policy to an
independent body will remove this inflation bias.
inflation
LRPC
SRPC
Gov. Utility
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Unemployment
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Because of this process of delegation, two costs
arise:
1. We are no longer able to properly co-ordinate the
response of fiscal and monetary policy to economic
events.
2. If the fiscal authorities retain their inflation bias then
the two groups of policy makers will be working
towards different objectives.
3. This contention may be formalised in a game context.
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© Stephen Hall, Imperial College London
• A game is simply an economic problem where more
than one agent is able to take an independent action.
Most economics is about a single economic agent
and how he maximises some objective).
• A game analyses the interaction of two or more
individual decision-makers.
• The basic game solution is the NASH solution or the
co-operative solution.
• In Nash equilibrium each player does the best he can
assuming the other player will also do the best thing
for him.
• In a co-operative they get together and co-operate.
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The Game analysis for an independent
central Bank
Here we consider a game context where two policy
makers are inter-acting with each other:
• One player (The MPC) has control of Interest rates,
the other (The Treasury) has control of fiscal policy.
• The objective functions of the two players are similar
in that they both involve inflation and output but the
MPC has a much higher relative weight on inflation
and is thus less likely to cheat and produce an
inflation bias in the system. We can then trace out the
reaction functions of each player to any decision of
the other player.
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• The Nash equilibrium of the system is where
the two reaction functions cross. This will
generally involve higher interest rates and a
higher budget deficit than either player would
want if they were in sole command of the
economy
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Fiscal
deficit
Monetary reaction
function
Banks Bliss point
Interest rate
Nash equilibrium
Fiscal reaction
function
Treasury Bliss point
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• In this figure we have interest rates on the horizontal axis
and fiscal policy on the vertical axis defined in such a
way that down and to the left implies more expansionary
fiscal and monetary policy (lower interest rates and a
higher budget deficit). The bliss points of the monetary
and fiscal authorities are defined by their objective
function and we assume that the two differ. We assume
that the monetary authority controls interest rates and the
fiscal authority controls fiscal policy. If the two cooperated the resulting solution would be somewhere on
the contract curve linking the two bliss points depending
on the relative weights of their objective functions in the
co-operative solution. The two reaction functions define
what each player will do given a particular policy stance
of the other player. The resulting Nash equilibrium is
where the two reaction functions cross.
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Conclusion
• This is not an argument for abolishing the
MPC but rather extending the arrangements
to allow for this problem of incompatible
objectives.
• It also illustrates the nature of an economic
game.
• This argument is of course relevant to
developments in the European Union and the
operation of the European Central Bank.
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European Integration
• The European Single Market
– what difference did it make?
• Economic and Monetary Union (EMU)
– why did it happen?
– What difference will it make?
• Reform in Eastern Europe
– how are these countries faring in their transition
from central planning to market economies?
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The Single Market
– which was met
350
5000
300
4000
250
200
3000
150
2000
100
1000
50
0
0
EU
USA Japan
GDP (LH scale)
Population (RH scale)
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© Stephen Hall, Imperial College London
millions
• with December 1992 as
the target date for
completion
400
6000
billions of ECUs
• Established under the
Single European Act of
1987
Objectives of the Single Market
• Abolition of remaining foreign exchange controls
on capital flows
• removal of non-tariff barriers within the EU
• elimination of bias in public sector provisioning
• removal of frontier controls
– with some provisos
• progress towards harmonization of tax rates
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Benefits of the Single Market
• Improved resource allocation
– removal of non-tariff barriers allows more exploitation of
comparative advantage
• Scale economies
– larger potential market increases the scope for economies
of scale
• Intensified competition
– may stimulate greater cost efficiency
• Factor mobility
– enables greater efficiency through mobility of labour and
capital
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Gains from the Single Market
% of initial GDP
25
20
15
10
5
0
F, D, I,
UK
Den
Low
2
2
3
High
3
5
4
NL, Sp B,Lux
Ire
Gr
Port
4
4
5
19
5
10
16
20
Source: Allen, Gasiorek and Smith (1998)
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From EMS to EMU
• A monetary union has
– permanently fixed exchange rates within the union
– an integrated financial market
– a single central bank setting the single interest rate for the
union.
• The Maastricht Treaty set criteria for EMU entry
– to define ‘convergence’
• The single currency area began in January 1999 with 11
member countries.
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The Maastricht criteria
• Inflation rate
– no more than 1.5% above the average of the inflation
rate of the lowest 3 countries in the EMS
• Long-term interest rate
– no more than 2% above the average of the lowest 3
EMS countries
• Exchange rate
– in the narrow band of ERM for 2 years
• Budget deficit
– no larger than 3% of GDP
• National debt
– no greater than 60% of GDP
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Sterling and Europe
UK trade patterns
The UK’s business cycle was out
of phase with the rest of Europe.
Page 33
ld
or
fw
to
Re
s
Black Wednesday and the ERM crisis
No
r
th
The UK has a greater tradition of
macroeconomic sovereignty.
ic
a
– but this is changing ...
% of UK
trade
er
The UK is less integrated
with the rest of Europe
60
50
40
30
20
10
0
Am
North Sea oil made the UK different
EU
UK membership of ERM/EMU?
1972
1998
© Stephen Hall, Imperial College London
The economics of EMU
• Optimal currency area
– a group of countries better off with a common
currency than keeping separate national
currencies
• 3 key attributes (Mundell)
– countries that trade a lot with each other
– countries with similar economic and industrial
structures
– flexibility in labour markets
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So is Europe an optimal currency
area?
• Europe is ‘quite’ but not very closely
integrated
• Some countries are more closely
integrated than others
• but the act of joining may itself feed the
process of integration
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Macroeconomic policy
for a small member of Euroland
A small Euroland member
faces a horizontal LM curve,
given that interest rates are
fixed by the ECB.
Suppose an external shock
moves the IS curve to IS1
r0
If the country is too small
to influence the ECB to alter
interest rates, either the
country must wait for wage &
prices to shift IS back via
improved competitiveness,
IS1
IS0
LM
Y1
Y0
or fiscal policy will be required to
enable more rapid adjustment.
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Central and Eastern Europe
GDP per capita in 1988/89
W
Port
Ger
EC
Rom
Pol
Bulg
Hun
h.
Czec
r
E Ge
0
5000
10000
15000
20000
US$
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Eastern Europe: some key issues
• On the eve of transition
– low per capita income
– high international debt
• Supply-side reforms
– crucial for prices to reflect true scarcity
• Trade and foreign investment
– markets needed for products
– and physical capital/management skills
• Macroeconomic conditions
– firm and credible macro policy needed
– especially to avoid excessive inflation.
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A progress report on the transition economies
Growth of real GDP
700
600
500
400
10
98
19
97
19
96
19
95
19
94
19
93
19
19
19
92
98
19
97
19
96
95
19
94
19
93
19
19
92
91
19
90
-10
Hungary
Romania
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-5
19
300
200
100
0
0
19
% p.a.
5
91
% p.a.
Inflation
Poland
Bulgaria
-15
Hungary
Romania
Poland
Bulgaria
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