Transcript IPE F2015 Lecture 14 State approach to macro policies

A State-Centered Approach to
Monetary and Exchange-Rate
Policies
International Political Economy
Prof. Tyson Roberts
1
Goals
• Macroeconomic Trilemma Review
• State-centered approach to macroeconomic
policy
• Central Bank Independence
• Argentina case – the beginning…
• The Political Trilemma of the Global Economy
2
What is macroeconomic policy?
• Monetary policy (interest rate, inflation rate)
• Exchange rate policy (fixed vs. floating)
• Fiscal policy (government borrowing &
spending)
3
Monetary Policy
• Why would lower interest rates reduce
unemployment?
• Why would lower interest rates increase
inflation?
4
Limits of Monetary Policy
• What is the “Zero Lower Bound”?
• What challenges does this pose to monetary
policy?
• What options are available as one reaches the
zero lower bound?
– Quantitative Easing
– Forward Guidance
– Fiscal Policy (not available to central banks)
5
THE U.S. PHILLIPS CURVE
(annual data, 1953 to 1969)
CPI inflation
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.02.0
3.0
4.0
5.0
6.0
Unemployment
7.0
8.0
9.0
10.0
11.0
6
Downsides to monetary stimulus
• Why does inflation increase rapidly at a
certain level of unemployment?
– (~4% in the previous graph)
• What is the real interest rate?
• What will mobile capital do if nominal interest
rates fall and inflation rises?
• What must interest rates do to maintain fixed
exchange rate if capital is mobile & leaving the
country?
7
Macroeconomic policy trilemma
“The Unholy Trinity”
Fixed exchange rate
Capital mobility
Floating exchange rate
Monetary autonomy
8
More on Monetary Policy
(inflation is not all bad)
• Why does deflation discourage consumption?
• Why does deflation discourage investment?
• Why does deflation undermine the
effectiveness of monetary policy?
9
Capital mobility can amplify monetary policy if
floating exchange rate
• Lower interest rates =>
– More borrowing for investment => jobs
– Weaker currency => more exports => jobs
10
How does capital mobility constrain
fiscal policy?
• Large budget deficits signal
– Future tax increases, or
– Future default, or
– Future inflation
Why?
11
How does capital mobility constrain
fiscal policy?
• Large budget deficits deter capital from
lending to governments
• To attract capital, governments must pay
higher interest rates, raising the cost of
borrowing to stimulate the economy
• Unless…
(Which countries can continue to borrow even when
budget deficits are large?)
12
Politics of Exchange Rates
(Frieden 1997)
1. Exchange rate is a policy variable
2. Policy variables are determined politically
3. There is no such thing as a technically
unsustainable exchange rate
13
Politics of Exchange Rates
(Frieden 1997)
4. The sustainability of a nominal exchange rate
is a purely political concept
5. Pressures on the making of currency policy
are both general (broad & popular) and
specific (from concentrated groups)
6. There are specific interest groups with
currency policy preferences (PARTISAN &
SECTORAL MODELS)
14
Politics of Exchange Rates
(Frieden 1997)
7. Broad political pressures are especially
important for exchange rate policy (public
good)
8. The exchange rate is not an inherent
measure of a government’s credibility
9. Government policy can make the currency a
repository of credibility
10.Credibility cannot be “purchased” by
technical measures
15
State-centered model
• Persistently high inflation …
– Undermines effectiveness of monetary policy
– Undermines willingness of domestic and foreign
actors to hold currency reserves
16
But high inflation is a temptation for
governments
• Fiscal stimulus (tax cuts, high spending)
• Monetary stimulus (low interest rates,
increased money supply)
17
Time consistency problem example
Professor payoffs
• Top choice: Students study,
no exam to grade = 4
• 2nd choice: Students don’t
study, no exam to grade = 3
• 3rd choice: Students study,
exam to grade = 2
• Last choice: Students don’t
study, exam to grade = 1
Student payoffs
• Top choice: Don’t study, no
exam = 4
• 2nd choice: Study, exam = 3
• 3rd choice: Don’t study,
exam = 2
• Last choice: Study, no exam
=1
18
At the beginning of the semester, professor announces
final exam to motivate students to study
Exam
S:
P:
No Exam
S:
P:
Exam
S:
P:
P
Study
S
Don’t
P
No Exam
S:
P:
19
Solving sequential games in game
theory
• Players make choices sequentially
• Payoffs are result of choices made by each
player
• To solve, look at last move first and work
backwards
• Subgame perfect equilibrium: Actions each
player would choose at each decision node
20
At beginning of the semester, professor prefers final exam
At end of semester, professor prefers no exam
Exam
S: 3
P: 2
No Exam
S: 1
P: 4
Exam
S: 2
P: 1
P
Study
S
Don’t
P
No Exam
S: 4
P: 3
21
At beginning of the semester, professor prefers final exam
At end of semester, professor prefers no exam
Time inconsistency problem => credible commitment problem
Exam
S: 3
P: 2
No Exam
S: 1
P: 4
Exam
S: 2
P: 1
P
Study
S
Don’t
P
No Exam
S: 4
P: 3
22
Time consistency problem example 2
Capital-holder payoffs
• Top choice: Save if inflation
stays low = 4
• 2nd choice: Don’t save if
inflation goes high = 3
• 3rd choice: Don’t save if
inflation stays low = 2
• Last choice: Save if inflation
goes high= 1
Government payoffs
• Top choice: Capitalists save,
stimulate hiring= 4
• 2nd choice: Capitalists save,
don’t stimulate = 3
• 3rd choice: Capitalists don’t
save, don’t stimulate = 2
• Last choice: Capitalists don’t
save, stimulate = 1
23
Gov’t announces it will keep inflation low to encourage saving
But after capitalists save & deposit in banks,
Gov’t has incentive to lower interest rates to encourage hiring
Save
Stimulate
C: 1
G: 4
No stimulate
C: 4
G: 3
Stimulate
C: 3
G: 1
G
C
Don’t
G
No stimulate
C: 2
G: 2
24
In 1970s, the PHILLIPS CURVE seemed to
disappear (stagflation)
CPI inflation
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.02.0
3.0
(annual data, 1953 to 1969)
74
79
75
78
73
70
77
76
7.0
8.0
71
72
4.0
5.0
6.0
Unemployment
9.0
10.0
11.0
25
If people expect inflation to rise, they will
demand higher wage increases
Expectations-adjusted Phillips curve:
26
Expectations-Adjusted PHILLIPS CURVES
(annual data, 1960 to 1999)
27
Unpredicted inflation => successful
monetary stimulus
• Future nominal wages negotiated based on
low inflation
• High inflation => low real wages => jobs
28
Predicted inflation => unsuccessful
monetary stimulus
• Future nominal wages negotiated based on
high inflation
• High inflation => no change in real wages =>
no change in jobs
• “Solution”: accelerating inflation
• Outcome: hyperinflation
29
Why Fed aggressively applied
monetary stimulus to recent crisis
• Low interest rates increase inflation because
– Low unemployment, high capacity utilization
increases costs of production
– High demand for finished goods increases prices
• For many years, unemployment remained
high, capacity underutilized, demand fairly flat
• Result: Low inflation expectations, low real
wage gains
31
Why Fed aggressively applied
monetary stimulus to recent crisis
• Low interest rates increase inflation because
– Low unemployment, high capacity utilization
increases costs of production
– High demand for finished goods increases prices
• Today, unemployment high, capacity
underutilized, demand fairly flat
• Result: Low inflation expectations, low real
wage gains
• Therefore, monetary stimulus has power
But, if capital-holders believe that monetary
stimulus will continue after inflation rises, they
will not hold investments in dollars
33
Investors must therefore be reassured
“Confidence game”
“The ropes that tied Odysseus are what lend credibility to his long-term objective
(return home), despite the short-term temptations.”
34
Commitment Mechanisms
• Central bank independence
• Fixed exchange rates
– Peg (to gold or other currency) + convertibility
• Examples: Argentinian “dollarization,” EMS
• Political will important in short run
– Currency union
• Examples: Ecuadorian “dollarization,” EMU
• Technical challenges reinforce political will
35
To kill inflation, change expectations
36
37
To lower real interest rates when nominal interest rates
already near zero, change expectations
• Conventional Fed tool
– Buy & sell short term treasuries
• Quantitative Easting
– Buy long-term securities (private & public)
– Increase money supply to avoid deflation
• Forward guidance
– Announce long-term plans to keep interest rates
low
38
High central bank independence => low inflation
(1970-1998; 1 = High CBI, 3 = Low CBI
39
High CBI ≠> high economic growth
(1970-1998; 1 = High CBI, 3 = Low CBI)
40
Macroeconomic policy trilemma
“The Unholy Trinity”
Fixed exchange rate
Argentina dollarization
Capital mobility
Floating exchange rate
Monetary autonomy
41
Argentina introduced convertibility
(including currency board) to kill inflation
Domingo Cavallo
“a man of action”
42
Some pros and cons of “dollarization”
• Pros
– Low inflation
– Greater savings/investment (if capital believes
dollarization is credible)
• Cons
– Loss of monetary autonomy (interest rates set to
maintain peg)
– Reduced fiscal autonomy (deficits signal inflation)
43
Wage inflation in advanced economies (relatively labor
scarce) can also be tamed by globalization
Source: Bank of England
44
Conclusions
• Globalization brings economic benefits:
– Increased trade, increased access to capital or
investment opportunities
• However, globalization also constrains
governments
– To attract capital, must limit fiscal deficits and
inflation
• Some win more than others
45
Conclusions
• Capital owners benefit from capital mobility and
low inflation rates
• Workers in labor-abundant countries may benefit
from higher wages, but lose political power
• Countries with developed financial institutions,
capital abundance, & high credibility can attract
capital even with deficits
• Countries lacking these attributes face trade-off
between national control of their economy,
democracy, and the attraction of capital
46
Conclusions
• Capital mobility enables capital flows, which
encourages reduced regulations (including
capital reserves) to attract capital
• High capital flows and low capital reserve
requirements enables deep borrowing
• If deep borrowing is used unwisely (e.g., for
consumption or illiquid investments), financial
crises will follow
47