Transcript Two-Country Stock-Flow-Consistent Macroeconomics

TWO-COUNTRY STOCKFLOW-CONSISTENT
MACROECONOMICS
GODLEY AND LAVOIE
MONETARY ECONOMICS (2007)
CHAPTER 12 AND AFTER
Outline
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Notes on the open economy model, in particular
price elasticities of exports and imports
Experiments in two closures: What happens
when domestic exports fall exogenously:
 In
the fixed exchange rate regime with endogenous
foreign reserves
 In the flexible exchange rate regime
A complex model with several
endogenous variables
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Import prices, export prices, domestic sales
deflator, GDP deflator, (exchange rate);
Exports, imports, output, consumption, domestic
sales, disposable income
Taxes, interest payments, money stock,
holdings of bills and money (portfolios), wealth
Trade balance, current account balance, capital
account balance, (foreign reserves)
… but still elementary model
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The simplifying assumptions are
enormous.
 There
is no domestic or foreign investment in
fixed or working capital
 No holdings of financial assets by firms;
 No wage inflation
 No commercial banking
 No “hot money”.
 The treatment of expectations is rudimentary.
Yet the model contains nearly 90 equations!
Balance sheet of US country
HH
Cash
+H$
# Bills
+B$£.xr£
$ Bills
+B$$
Firm
Govt
Central
bank
-H$
-B$
Gold
Balance
Sum
+Bcb$
+or$.pg$
-V$
-NWg$=+B$
0
0
0
0
The net worth of the US central bank has to be zero (all profits are distributed
to government, and the price of gold in dollars is assumed constant).
Balance sheet of the UK country
HH
B1 Cash
+H£
B2 # Bills
+B££
B3 $ Bills
+B£$.xr$
Firms
Govt
Central
bank
-H£
-B£
+Bcb£$.xr$
B4 Gold
B5 Balance
B6 Sum
+Bcb£
+or£.pg£
-V£
-NWg£ = +B£
-NWcb£
0
0
0
The net worth of the UK central bank may become positive, because
The central bank can achieve a capital gain when the $ currency
appreciates, that is when the number of pounds per dollar xr$ goes up
A fully-consistent stock-flow model
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Here we skip the behavioural equations tied to portfolio
choices, as well as the explanations about asset
supplies.
The main dynamic equation is the one that ties
consumption to disposable income and wealth.
We also skip the transactions-flow matrix, which records
the accounting flows arising from the model.
One also needs a revaluation matrix, to take capital
gains into account.
For each closure, one can identify an accounting
redundant equation, which is not part of the simulation
model, but which must be satisfied for the model to be
fully coherent.
Trade prices
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pm£ = 0 − 1.xr£ + (1 − 1).py£ + 1.py$
0 < 1 nu < 1
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px£ = 0 − 1.xr£ + (1 − 1).py£ + 1.py$
0 < 1 upsilon < 1
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where pm is import prices, px is export prices,
py is the GDP deflator, while bold characters
denote natural logs of these variables.
Why? (1 − 1).py£ + 1.py$
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If there were a simultaneous addition of
some given amount to domestic inflation in
both countries with no change in the
exchange rate, then there would be an
equivalent addition to export and
(therefore) import prices in each country –
hence the constraint that the coefficients
on domestic and foreign inflation sum to
unity.
Why ? −1.xr£ + (1 − 1).py£
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If depreciation were exactly paralleled by a
simultaneous and equal addition to
domestic inflation, it is reasonable to
expect that import prices would rise by the
full amount of the depreciation – hence the
sum of the coefficients on the (negative of
the) exchange rate and domestic inflation
must also sum to unity
Trade flows
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x£ = 0 − 1(pm$-1 − py$-1) + 2.y$
im£ = μ0 − μ1(pm£-1 – py£-1) + μ2.y£
First equation says that the volume of UK
exports (x£) responds with an elasticity of 1
(epsilon1) with respect to US import prices
relative to US domestic prices, and 2 with
respect to US domestic output (y$).
Second equation says that UK imports (im£)
respond with elasticities μ1 (mu1) with respect
to UK import prices (pm£) relative to UK
domestic prices (py£), and μ2 with respect to
UK domestic output (y£).
Marshall-Lerner conditions
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It is usually asserted that the sum of the elasticities with
respect to relative prices (here, ε1 + μ1) must sum to at
least one if the trade balance is to improve following
devaluation (the Marshall-Lerner condition). This
however is based on the assumption that import prices in
domestic currency will fall by the full amount of the
devaluation (a full pass-through), while export prices in
domestic currency won’t change.
A modified Marshall-Lerner condition
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In verity the sum of these elasticities need be no greater
than the elasticity of terms of trade with regard to
devaluation.
For instance if, following a devaluation of 10%, terms of
trade were to decrease by 2% (as is assumed in our
simulations, with ν1 − 1 = 0.2), then the sum of the price
elasticities need be no more than 0.2.
If there were no change at all in the terms of trade
following devaluation – not an impossible outcome – the
sum of the elasticities need be no greater than positive
for the balance of trade to improve.
The modified condition itself questioned
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In reality, things are more complicated, as the recovery
in the trade balance implies larger domestic income, and
hence income effects on the trade balance.
The conditions are thus stricter than indicated in the
previous slide. For instance, in our simulations, with our
parameters, the trade balance improved only when the
sum of the price elasticities exceeded 0.35 (when terms
of trade went down by 0.2).
In addition, while the trade balance may keep improving,
the current account may deteriorate due to interest
payments on foreign debt
Devaluation as a response to a drop in exports, when the
sum of price elasticities are only 0.70: the trade balance
recovers after a lag (J-curve)
Shock
Devaluation
The fixed exchange rate closure
(with endogenous foreign reserves)
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The non-US central bank must settle any
residual discrepancy between the country’s
current account balance and net private
purchases of foreign issued assets by
accumulating reserves in the form of US
Treasury bills.
Alternatively expressed, it describes the
purchases of US Treasury bills which the nonUS central bank must make in order to prevent
its exchange rate from floating up.
Effect of an increase in the US propensity to import on UK variables,
within a fixed exchange rate regime with endogenous foreign reserves:
Effect of an increase in the US propensity to import, within a fixed exchange
rate regime with endogenous foreign reserves, on the UK current account
balance and elements of the balance sheet of the Bank of England (the UK
central bank): change in foreign reserves, stock of money, holdings of domestic
Treasury bills
Comparision with simplest SFC model
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Similarities
There are no Rules of the
game: the money stock
does not change with a
BP surplus or deficit
A twin surplus arises in
the steady state
There is a compensation
mechanism at work: the
rise in CB reserves is
compensated by the fall
in domestic credit
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Differences
The current account surplus
and the govt budget surplus
are not constant anymore
They both grow at the rate of
the interest rate
In the case of the deficit
country, the US, there is no
limit to this process: there is no
fall in the Fed reserves, since
the US dollar is the
international currency
Contradicting received wisdom
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Alan Greeenspan and others have been saying that
Chinese accumulation of US Treasury bills is making it
difficult for them to manage their monetary policy; but the
above analysis strongly suggests that they are mistaken.
Mainstream authors would say that the UK (or Chinese)
central bank of our model is “sterilizing” foreign reserves,
by selling domestic Treasury bills on the open market. In
a way, it is true. But this is not the result of any
intentional policy, where central bankers are actively
intervening in financial markets.
The UK (Chinese) central bank, just like the US one, is
simply attempting to keep interest rates constant. Bills
are provided to those who demand them at the set rate
of interest. The central bank provides cash on demand
to its citizens.
The Chinese situation
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In reality, compensation is mainly done in
China either through commercial banks
reducing their debt vis-à-vis the People’s
Bank of China (a reduction in domestic
credit compensating for the increase in
credit to foreigners), or with banks
purchasing central bank bills (issued by
the People’s Bank of China).
Flexible exchange rates closure
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To transform the model into a flexible exchange rate
model, we must inverse or « bump » a small series of
equations, because reserves cannot change anymore.
Eventually one equation becomes:
xr£ = B$£d/B$£s
The endogeneity of the exchange rate only finds itself
expressed in one single equation. But the effect works its
way round so that the supply and demand for all
internationally-traded assets are all brought into
equivalence at (and by) the new exchange rate, until all
stock changes revert to zero. The equation will also be
found to satisfy all the trade equations.
Effect of a decrease in the UK propensity to export, within a flexible
exchange rate regime, over various UK variables (with high price
elasticities): current account balance, trade balance and budget deficit
Effect of a decrease in the UK propensity to export, within a
flexible exchange rate regime
Effect of a decrease in the UK propensity to export, within a
flexible exchange rate regime, over UK prices
Effect of a decrease in the UK propensity to export, within a
flexible exchange rate regime, over UK and US real GDP
The real GDP of UK is higher in the
long run
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This is because the exchange rate brings the
current account into equilibrium
But the UK has had a sequence of current
account deficits, accumulating foreign debt
The trade balance (in £ pounds) is in surplus
(near the steady state)
The terms of trade have worsened, with exports
now relatively cheaper than imports
So real net exports are much higher than in the
baseline case (where they were zero)
Same experiment, but with low export and
import price elasticities (sum of which is
equal to 0.70)
 With the same export shock as before and
as in the fixed exchange rate model
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Effect of a decrease in the UK propensity to export, within a flexible
exchange rate regime, (with low price elasticities):
The trade balance recovers, but the current account balance explodes
A large depreciation of the UK currency won’t do
(In the fixed exchange rate regime, a fall to $0.65
was enough)
Some final lessons
The exchange rate is being asked to do
too much.
 The flexible exchange rate regime cannot
stabilize this economy, whereas the fixed
exchange rate regime could.
 Countries with low price elasticities should
stick to fixed exchange rate regimes
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