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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. © Stephen Hall, Imperial College London 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 Page 3 © Stephen Hall, Imperial College London 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 Page 4 © Stephen Hall, Imperial College London 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. Page 5 © Stephen Hall, Imperial College London 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. Page 6 © Stephen Hall, Imperial College London 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 Page 7 © Stephen Hall, Imperial College London 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. Page 8 © 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. Page 9 © Stephen Hall, Imperial College London 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 Page 10 © Stephen Hall, Imperial College London 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. Page 11 © Stephen Hall, Imperial College London This Week • • • • Some Selected topics Macroeconomics in perspective An Independent Central Bank Europe and EMU Page 12 © Stephen Hall, Imperial College London Macroeconomics in perspective • There is a spectrum of views about the macroeconomy – especially with regard to – market clearing – expectations formation – speed of adjustment Page 13 © Stephen Hall, Imperial College London 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. Page 14 © Stephen Hall, Imperial College London 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 Page 15 © Stephen Hall, Imperial College London 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 Page 16 © Stephen Hall, Imperial College London 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 Page 17 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 Page 18 Unemployment © Stephen Hall, Imperial College London 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. Page 19 © 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. Page 20 © Stephen Hall, Imperial College London 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. Page 21 © Stephen Hall, Imperial College London • 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 Page 22 © Stephen Hall, Imperial College London Fiscal deficit Monetary reaction function Banks Bliss point Interest rate Nash equilibrium Fiscal reaction function Treasury Bliss point Page 23 © Stephen Hall, Imperial College London • 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. Page 24 © Stephen Hall, Imperial College London 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. Page 25 © Stephen Hall, Imperial College London 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? Page 26 © Stephen Hall, Imperial College London 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) Page 27 © 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 Page 28 © Stephen Hall, Imperial College London 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 Page 29 © Stephen Hall, Imperial College London 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) Page 30 © Stephen Hall, Imperial College London 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. Page 31 © Stephen Hall, Imperial College London 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 Page 32 © Stephen Hall, Imperial College London 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 Page 34 © Stephen Hall, Imperial College London 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 Page 35 © Stephen Hall, Imperial College London 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. Page 36 © Stephen Hall, Imperial College London 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$ Page 37 © Stephen Hall, Imperial College London 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. Page 38 © Stephen Hall, Imperial College London 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 Page 39 -5 19 300 200 100 0 0 19 % p.a. 5 91 % p.a. Inflation Poland Bulgaria -15 Hungary Romania Poland Bulgaria © Stephen Hall, Imperial College London