Transcript Summary of IS-LM

Policy In an LOE
• MP & FP in a Large Open Economy
– Think of US (LOE) vs. Ireland (SOE)
• If we think of the purpose of policy is to control Y
then we get
Fixed e
Fiscal
Effective
Monetary Ineffective
Float e
Less Effective
Effective
• The reason is the automatic effects of BP
• For LOE the results not so stark as for SOE
1
Fiscal Policy Fixed e
•
•
•
•
G up: IS shifts to right (why?)
Internal balance at B
BP>0 (why?)
Under fixed e this leads to expansion of the
money supply
– LM shifts down
– Interest rate falls
• Balance restored at C
• Basically the same as SOE but…
– Interest rates increases
– Output increases, but by less than in SOE (why?)
2
Fiscal policy: Fixed e
r
B
BP
C
A
LM0
LM1
IS1
IS0
Y
3
Monetary Policy & Fixed e
• Expand money supply: purchase bonds
– LM shifts down
• Internal balance at B
– BP<0
– Net currency out flow
– Money supply falls back
• Return to A
– MP is ineffective
– Only change is in central banks balance sheet
• Same as SOE
4
Monetary Policy: Fixed e
r
BP
A
B
LM0
LM1
IS0
Y
5
Fiscal Policy with Floating e
• G up: IS shifts to right (IS0IS1)
– Internal balance at B
• BP>0
• excess supply of $ and/or excess demand for €
– Under float e this leads to an appreciation of €
– Exports fall
– IS curve shifts left (IS1IS2)
• For LOE there is additional effect
– The appreciation causes the BP=0 curve to shift up
– NX fall so higher r necessary and world interest rates are affected
because LOE
• This meets the IS curve coming back from B to give a new eqm
at C
• Note contrast with other regimes
–
–
–
–
fiscal policy has an effect on output
Smaller than closed economy or fixed e rate
Larger than float e rate with SOE (which was zero)
Interest rates rise
6
Fiscal policy: float e, LOE
r
IS2
BP1
B
C
BP0
A
LM0
IS1
IS0
Y
7
Monetary Policy with Float e
• Expand the Money supply
– LM shifts down
– Internal balance at B
• BP<0
– net outflow of funds
– Excess demand for $ (or supply of €)
• Price of € falls: e falls depreciation in the €
– Net exports rise
– IS curve shifts to the right
• For LOE there is an additional effect
– The depreciation causes the BP=0 curve to shift down
– NX rise so need lower r to balance
• This meets the IS curve coming back from B to give a new eqm at C
• Note contrast with other regimes
–
–
–
–
monetary policy has an effect on output
Larger than closed economy or fixed e rate
Could be smaller or larger than float e rate with SOE
Interest rates may rise or fall
8
Monetary policy: Float e
r
BP0
BP1
A
C
LM0
LM1
B
IS0
IS1
Y
9
Summary of Policy
• Policy effectiveness depends on three things
1. SOE or LOE: can we affect the world interest rate
2. Exchange rate regime: Fixed or Float
3. MP or FP
• The reason for the complication is the automatic
effects of BP
• This gives 16 possible scenarios, don’t try to learn
them off
10
Apply the Model
• The Asian Crisis 1997
– Currency crisis that affects almost every east Asian
country from July 1997
• Follows the general pattern of currency cries
(see over) but
– Huge devaluations
– Added problems with banking systems
– Allegations of market over-reaction
11
General Structure of Currency Crises
• Country in a recession with fixed e rate
• Markets expect that gov will try to boost economy
• Monetary Policy: require floating exchange
rate and depreciating exchange rate
– See previous section
– Owners of domestic currency try to get out
• Fiscal policy
– Work under fixed e
– but government may not be able to borrow
– Crises usually happen in debt-ridden countries
12
Monetary Policy with Float e
• Expand the Money supply
– LM shifts down
– Internal balance at B
• BP<0, r<r*
– net outflow of funds
– Excess demand for $ (or supply of €)
• Price of € falls: e falls depreciation in the €
– Net exports rise
– IS curve shifts to the right
• Overall Balance at C
• Note contrast with closed economy and fixed e
– No change in r
– Larger change in Y
– Net exports are “crowded in”
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Monetary policy: Float e, SOE
r
BP
A
LM0
LM1
C
B
IS0
IS1
Y
14
Risk
• Expectation of devaluation leads to higher
interest rates
• Interest rates affected by risk
– Worried we get paid back in lower vlaue
currency
• SOE r=r* normally
– But if there is a risk then r=r*+p
– Where p is “risk premium”
• Extra premium if risk of bank failure
15
Risk and BP
• As we will see this makes recession worse
• The premium is like an increase in world interest
rates
• Shift BP up
– BP <0 (see “Imbalance” section)
–
–
–
–
net outflow of (foreign) currency
Money supply falls
LM curve shifts up
Interest rate rises to stem the outflow of funds
• New eqm at B: output is lower
• Note Change in money supply is automatic – not
policy
• Mechanism: CB buys € with $ from reserves
16
r
LM2
B
LM1
BP2
r*+p
r*
A
BP1
IS1
Y
17
Recession & Risk
• This effect of risk is exactly what you don’t want
when you face a recession anyway.
• Supposing there is a pre-existing recession anyway
– IS curve shifts left (why?)
• One way to get out of recession is to dump fixed e
and expand money supply
• So risk premium rises
• Makes recession worse
• Makes monetary expansion more attractive
• Vicious circle
18
A Crisis Evolves…
• Diagram gets complicated but its just the confluence of
the two effects
• A recessionary shock
– IS1IS2 AB
– BP<0
– LM shift up: BC
• But if risk premium increases at the same time
– BP1BP2
– Still in BP<0 at C
– LM shifts up again
• New equilibrium at D – nasty recession
• Process may repeat
19
LM3
r
LM2
LM1
D
BP2
r*+p
r*
A
C
BP1
B
IS1
IS2
Y
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Examples of Crises
• 2010: Ireland
– Initial shock: housing bubble
– Risk premium: rise quickly fear of default
• 2010: Greece
– Initial shock: public debt lies
– Risk premium: rise quickly fear of default &
devaluation
• 1992: UK
– Recession followed by rise in interest rates
– Risk premium: fear of devaluation
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1997 Asian Crisis
• Recession?
– Asian tigers phenomenal growth
• Kor Thai HK
• Underlying real problems
– Bubble
– Banks
• Bursting of bubble leads to recession
• Expectation of a devaluation
• Speculators move
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Summary of Pre-existing Factors
• Construction boom financed by foreign borrowing
• Bubble in Real Estate
– GDP boom: apparent not real
– Inflation & lost competitiveness
• Financed by $ borrowing
– Lower interest rates < apparent return to property
– Short term via the banking system
– One big hedge fund: $ liabilities, domestic assets
• Sounds familiar?
• Reasons not to trust the governments?
– Investors unfamiliar with economies rush to judgement
– Clear examples of corruption
23
Catalyst
• What starts the crisis?
–
–
–
–
For Asia it was US int rate rise
Fixed e implies Asian interest rates rise
BP curve shifts up
Recession (why?)
• Exchange rate under immediate pressure
– CB can maintain e rate with reserves
– Begin to run low on reserves
24
Role of Bubble
• Bubble would eventually burst with or without
crisis
– Some debate as to whether already started to burst
in Thailand before crisis
• Bursting of bubble will reduce GDP
– Construction sector falls
– IS shifts left
– Recession
25
Self-reinforcing
• Investors expect a devaluation
– MP under floating e could rescue economy
• Risk premium rises
• Leads to higher interest rates
– BP shifts up
• Recession worse under fixed e
• Self-fulfilling prophecy
• This is the standard speculative story
26
Role of Contagion
• Crisis spread from one country to another
• Fundamental problems were less true of later
countries – but they still had a crisis
• Contagion is “psychological”
– Investors make judgement about one invest based
on performance of another
– Not always rationale
– Lump “emerging markets” together
• So Thailand’s problem increase likelihood of bad
investment
– Racist?
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• Thailand:
Countries
– 1986-96: growth of 9% (not a recession!)
– Inflation of 2-6%: loss in competitiveness
– Devalued by 50%
• Indonesia:
– Devalued by 80%
– GDP declined by 13%
– Suharto over-thrown
• Korea
–
–
–
–
Less real problems
Depreciated by 50%
Numerous bankruptcies
Quick bounce back
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• Hong Kong
–
–
–
–
–
Defeated speculators – did not devalue
Strongest economy in region
Strongest legal framework
“almost one of us”
Real issue: inflation implying loss in
competitiveness
– Contagion gone too far
– HK played dirty
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Conclusions
1. BOP equilibrium is given by BP curve
–
Y up BP<0r up  cap inflows BP=0
2. IS-LM-BP give overall equilibrium
– Adjustment mechanism depends on exchange rate
regime
3. Effectiveness of FP and MP depends on exchange
rate regime
– MP with floating e, FP with fixed e
4. Effectiveness of FP and MP depends on the
SOE\LOE assumption
5. Apply it to some real world cases
–
Explains currency crises
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What’s Missing?
1. Expectations or forward looking behaviour
2. No price adjustment
– Very simplistic approach to supply side
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