Transcript L7-9InstrumentsMABP

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.
Y < Y ≡ ES ≡ “output gap” => unemployment > u
Y > Y ≡ ED => “overheating” => inflation
or asset bubbles.
• External balance:
e.g., CA=0 or BP=0.
Policy Instruments
• Expenditure-reduction,
e.g., G ↓
• Expenditure-switching,
e.g., E ↑ .
ITF-220, Prof.J.Frankel
Internal balance
Output gap, as percentage of GDP, in the Great Recession, 2009
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 by 2007: Y >> Y
and crashed in 2009-11: 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
RESPONSES TO CURRENT ACCOUNT DEFICIT
Financing
• By borrowing
• or running down reserves.
vs.
Adjustment
• Expenditure-reduction
(“belt-tightening”)
• e.g., fiscal or monetary contraction
• or Expenditure-switching
• e.g., 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.
●
A
•Experiment: increase in Ă
(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
upward-sloping BB curve.
.
What would have to
happen to eliminate
trade deficit?
●
E↑.
If depreciation is big
enough, restores TB=0
at point B.
●
We have just derived
upward-sloping
external balance line,
BB.
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,
cont.
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 YY curve.
What would have to
happen to eliminate
excess demand?
●
E ↓.
If appreciation is big
enough, restores at C.
●
●
We have just derived
downward-sloping
internal balance line, YY.
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
Summary:
combination
of policy instruments
to hit one goal
slopes up,
to hit the other
slopes down.
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
BB:
External balance
CA=0
Mexico
1995
or Korea
1998
ED & TD
●
ES & TB>0
ES & TD
Mexico
1994
or Korea
1997
YY:
Internal balance
Y=Potential
Spending A
Could be the “fragile 5” in 2013-14: India, Turkey, Indonesia, S.Afr., Brazil
Example 2: China in the past decade
ED & TB>0
Excgange rate E
China
2010
ES & TB>0
China
2002
●
ES & TD
BB:
External balance
CA=0
ED & TD
YY:
Internal balance
Y = Potential
Spending A
By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery,
Spending A
due in part to G stimulus,
At the end of 2008, an abrupt loss of X,
shifted China again into ED.
due to the US crisis, shifted China into ES.
Example 3: US over 33 years
Excgange rate E
ED & TB>0
BB:
External
balance
CA=0
ES & TB>0
ED & TD
●
US
US
1987 or
2007
1981,1991,
or 2008-13
ES & TD
ITF-220, Prof.J.Frankel
YY:
Internal balance
Y = Potential
Spending A
End of Targets and Instruments
ITF-220, Prof.J.Frankel
Appendix: Internal balance, before & after the 2001 recession
I
2000
US
Jpn
In 2000 most countries were operating above full employment: Y > Y
Ireland was the strongest case; Japan was the biggest exception.
ITF-220, Prof.J.Frankel
2002
I
US
Jpn
By 2002, most countries were operating below full employment: Y < Y
ITF-220, Prof.J.Frankel
Source: The Economist, June 22, 2002
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 it is a rightward shift of the LM curve
– Which itself slopes up (because money demand depends
negatively in i and positively on Y).
E.g., Quantitative Easing sets MB.
ITF-220, Prof.J.Frankel
LM
i
Y
Monetary expansion
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
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
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
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