Transcript L7-9 InstrumentsMABP..

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.
≡ ES ≡ “output gap” => unemployment > 𝑢
Y > 𝑌 ≡ ED => “overheating” => inflation
Y<𝑌
• External balance:
or asset bubbles.
e.g., CA=0 or BP=0.
Policy Instruments
• Expenditure level,
e.g., G or tax rate
• Expenditure-switching,
e.g., E .
ITF-220, Prof.J.Frankel
Internal balance
US GDP (Y) & potential (𝑌): 1979-2015
}output gap
Output gap, as % of GDP, in the 2009 Great Recession
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 in 2007: Y >> 𝑌
and crashed in 2009-12: 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
Possible Responses to a Current Account Deficit
Financing
• By borrowing
• or running down reserves.
vs.
Adjustment
• Expenditure-reduction
(“belt-tightening”)
• esp. fiscal or monetary contraction
• or Expenditure-switching
• esp. 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.
●
• Experiment: increase in 𝑨
(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
the upward-sloping
external balance curve, BB.
.
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
●
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,
continued
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 internal
balance line, YY .
What would have to
happen to eliminate
excess demand?
●
E ↓.
●
●
If appreciation is big
enough, restores at C.
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
Derivation of the Swan Diagram
Summary: the combination of policy instruments to hit one
goal slopes up; the combination to hit the other slopes down.
Fiscal expansion (G↑)
(or monetary expansion),
at a given exchange rate =>
Y↑
Devaluation (E ↑)
Y↑
=>
and
and
TB↓.
TB ↑.
If we are to maintain:
Internal balance,
Y=𝑌
External balance,
TB=0
then G & E must vary:
inversely.
together.
=>
Internal balance
line slopes down.
=>
External balance
line slopes up.
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
Mexico
1995
or Korea
1998
BB: External
balance CA=0.
ED & TD
●
ES & TB>0
ES & TD
Mexico
1994
or Korea
1997
YY: Internal
balance Y=𝑌
Spending A
It could be Brazil or South Africa in 2013-16.
Example 2: China in the last decade
ED & TB>0
Exchange rate E
China
2010
ES & TB>0
China
2002
2015
●
ES & TD
BB: External
balance CA=0.
ED & TD
YY: Internal
balance Y=𝑌
Spending A
By 2007, rapid growth pushed China into ED.
In 2008-09, an abrupt loss of X,
due to global recession, shifted China to ES.
Spending
A
By 2010, a strong
recovery,
due in
part to G stimulus, moved into ED.
In 2015, back into ES.
Example 3: US over 35 years
Exchange rate E
ED & TB>0
BB: External
balance CA=0.
ES & TB>0
ED & TD
●
1987, 2000,
2007 or
2016
1981,1991,
or 2008-09
YY: Internal
balance Y=𝑌
ES & TD
ITF-220, Prof.J.Frankel
Spending A
End of Targets and Instruments
ITF-220, Prof.J.Frankel
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 expansion is a rightward shift of the LM curve
– which itself slopes up (because money demand depends
negatively in i and positively on Y).
LM
i
E.g., Quantitative Easing sets MB.
ITF-220, Prof.J.Frankel
Y
Equations for IS-LM
IS: Y =
𝐴 − 𝑏𝑖 + 𝑋 − 𝑀
𝑠+𝑚
LM:
IS
𝑀1
=
𝑃
L(i, Y)
LM
i
Y
ITF 220 Prof.J.Frankel
Monetary stimulus
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
The Monetary Approach
to the Balance of Payments
• Sterilization definitions
• Price-specie flow mechanism
• Income-money flow mechanism
• Historical case of non-sterilization:
the Gold Standard
• Appendix – Historical case of sterilization:
China’s inflows, 2004-13
ITF-220 - Prof.J.Frankel
The Monetary Approach
to the Balance of Payments (MABP)
Defining assumption: Reserve flows are not sterilized.
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 ,
ΔNDA = - ΔR, so MB unchanged.
Non-sterilization: ΔMB = ΔR.
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.
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.
Mundell’s Income-Flow Mechanism, continued
A Monetary Expansion, and Its Aftermath
NS-I
+
NS-I′
0
Y
-
TB
i
LM
LM′
IS
Y
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.
Allowed 1995 reserve outflows to shrink the money supply, raise i, contract spending.
Suffered recession, but equilibrated BP at point A.
ITF-220 - Prof.J.Frankel
Historical example of non-sterilization:
The Gold Standard
Definition: Central banks peg the values of their currencies
in terms of gold (and so in terms of each other).
“Rules of the game”: Don’t sterilize. Allow adjustment to work.
Pros and Cons
Pro: prevents excess money creation & 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.
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 & wages.
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
Example of sterilizing money inflows:
China 2004-2013
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
BoP
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
API-120 - Prof. J.Frankel, Harvard
http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down
Sterilization of foreign reserves:
People’s Bank of China sold sterilization bills,
thereby taking RMB out of circulation.
Data: CEIC
Source: Zhang, 2011 ,
ITF-220 - Prof.J.Frankel
Fig.4, p.45.
In 2003-06, the PBoC had little trouble sterilizing
the rising reserve inflows.
Growth of monetary base & its components:
\
But money growth
accelerated sharply,
in 2007-08.
FX reserve contribution
Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008
API-120 - Prof. J.Frankel, Harvard
To be continued… in Lecture 14
(Starting in 2007, China had more trouble
sterilizing the reserve inflow.)
• The 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 problem in 2007-08.
- Prof. J.Frankel, Harvard