Transcript Reserve flows & the gold standard

LECTURE 9:
The Monetary Approach to the Balance of Payments
• Sterilization definitions
• Price-specie flow mechanism
• Income-money flow mechanism
• Brief history of the Gold Standard
• Appendix: China sterilizes inflows, 2004-10
ITF-220 - Prof.J.Frankel
The Monetary Approach to the Balance
of Payments (MABP)
Defining assumption: Reserve flows are not sterilized.
Another assumption sometimes associated with MABP:
Goods prices are flexible => PPP holds.
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 ,
D NDA = - DR, so MB unchanged.
Non-sterilization: D MB = DR.
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.
ITF-220 - Prof.J.Frankel
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.
ITF-220 - Prof.J.Frankel
Mundell’s Income-Flow Mechanism,
continued
A Monetary Expansion, and Its Aftermath
NS-I
NS-I´
+
0
Y
-
TB
i
LM
LM
´
IS
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.
In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending.
Suffered recession, but equilibrated BP at point A.
ITF-220 - Prof.J.Frankel
The Gold Standard
Definition: Central banks peg the values of their currencies
in terms of gold (and so in terms of each other).
Pros and Cons
Pro: prevents excess money
creation and 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.
ITF-220 - Prof.J.Frankel
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.
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
Appendix -Example of sterilizing money inflows:
China, 2004-08 & 2010
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
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
12
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
ITF-220 - Prof.J.Frankel
Sterilization of foreign reserves:
People’s Bank of China sold sterilization bills,
thereby taking RMB out of circulation.
Source: Zhang, 2011 ,
Data: CEIC
ITF-220 - Prof.J.Frankel
Fig.4, p.45.
In 2003-04, forex
inflows accelerated rapidly.
Initially, the PBoC had no trouble sterilizing the inflows.
=> The MB growth rate was kept down to the growth rate of the
real economy (≈ 10%/year), so there was little inflationary pressure.
In 2007-08 China had more trouble
sterilizing the reserve inflow
• 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 serious problem in 2007-08.
• Also a “bubble” in the Shanghai stock market.
ITF-220 - Prof.J.Frankel
Sterilization faltered in 2007 & 2008
Growth of China’s monetary base
& its components:
Money growth
accelerated sharply,
2007-08
Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008
ITF-220 - Prof.J.Frankel
China’s CPI accelerated in 2007-08
Inflation 1999 to 2008
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
ITF-220 - Prof.J.Frankel
Sterilization of foreign reserves:
Decreases in PBoC’s domestic assets
offset increases in foreign assets
Source: Zhang, 2011,
ITF-220 - Prof.J.Frankel
Fig.7, p.47.
China’s inflation broke sharply in 2009,
(<= big one-year loss of China’s exports due to global recession),
But took off again in 2010-11.
Inflation 2001 to 2011
ITF-220 - Prof.J.Frankel
After the interruption of mid-2008 to mid-2009
overheating resumed: rapid rise of land prices in 2010
Real Beijing land prices
ITF-220 - Prof.J.Frankel
When house prices rise relative even to rents,
that suggests a bubble or easy money
ITF-220 - Prof.J.Frankel
Scott Reeve blog
China in 2010 resumed attempts to sterilize money
inflows by raising banks’ reserve requirements
-- to slow M1 growth even while MB is growing rapidly.
ITF-220 - Prof.J.Frankel