Transcript L7-9

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
Lecture 7: Goals and instruments
Policy Goals
• Internal balance: Y = 𝑌 ≡ potential output.
≡ ES ≡ “output gap” => unemployment > 𝑢
Y > 𝑌 ≡ ED => “overheating” => inflation
Y<𝑌
• External balance:
or asset bubbles.
e.g., CA=0 or BP=0.
Policy Instruments
• Expenditure level,
e.g., G or tax rate
• Expenditure-switching,
e.g., E.
ITF-220, Prof.J.Frankel
Internal Balance
Output gap, as % of GDP, in the 2009 Great Recession
UK
Port Spn
Swe
Can Fra
Jpn Bel US It
Ir
In 2009, after the global financial crisis, most countries suffered
larger output gaps than in preceding recessions: Y << 𝑌 .
Source: IMF estimation, via Economicshelp, 2009
Prof.J.Frankel
Output gaps and unemployment rates
have improved since the height of the GFC,
but remain high in some Mediterranean countries.
IMF WEO, Oct.2016, Figure 1.10.
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.
Prof.J.Frankel
Possible Responses to a Current Account Deficit
Financing
• By borrowing
• or running down reserves.
vs.
Adjustment
• Expenditure-reduction
(“belt-tightening”)
• esp. fiscal or monetary contraction
• or Expenditure-switching
• esp. devaluation.
Adjustment
Starting from current
account deficit at point N,
policy-makers can adjust
either by:
(a) cutting spending
●
●
=> 𝑨↓
or
(b) devaluing.
=> 𝑿 ↑
●
A dilemma?
Prof.J.Frankel
●
(a) If they
cut spending,
CA deficit is
eliminated at X;
but Y falls below
potential output 𝑌.
●
●
=> recession
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
Prof.J.Frankel
Derivation of
Swan Diagram
𝐴↑
(i) External balance
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.
●
●
●
Prof.J.Frankel
At F,
some of higher demand
falls on imports.
We have just derived
the upward-sloping
external balance curve, BB.
.
What would have to
happen to eliminate
trade deficit?
●
●
E↑.
If depreciation is big
enough, restores TB=0
at point B.
Prof.J.Frankel
●
Experiment:
Fiscal expansion,
continued
(ii) Internal balance
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.
●
●
Prof.J.Frankel
●
At F, some of higher
demand falls on
domestic goods.
We have just derived
downward-sloping internal
balance line, YY .
What would have to
happen to eliminate
excess demand?
●
E ↓.
●
●
If appreciation is big
enough, restores at C.
Prof.J.Frankel
Swan Diagram
has 4 zones:
I.
II.
III.
IV.
●
ED & TD
ES & TD
ES & TB>0
ED & TB>0
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.
ED & TD
Mexico
1995
or Korea
1998
●
ES & TB>0
ES & TD
Mexico
1994
or Korea
1997
YY: Internal
balance Y=𝑌
Spending A
It could be South Africa or Turkey in 2017.
Example 2: China in the last decade
ED & TB>0
Exchange rate E
China
2010
ES & TB>0
China
2002
2015
●
ES & TD
BB: External
balance CA=0.
ED & TD
YY: Internal
balance Y=𝑌
Spending A
By 2007, rapid growth pushed China into ED.
In 2008-09, an abrupt loss of X,
due to global recession, shifted China to ES.
Spending
A
By 2010, a strong
recovery,
due in
part to G stimulus, moved into ED.
In 2015, back into ES.
Example 3: US over 30 years
Exchange rate E
ED & TB>0
BB: External
balance CA=0.
ES & TB>0
ED & TD
●
2000, 2007
or 2017
1991,
or 2008-09
?
YY: Internal
balance Y=𝑌
ES & TD
ITF-220, Prof.J.Frankel
Spending A
Example 4: Greece & Ireland gave up their
ability to devalue when they joined the euro.
Exchange rate E
ED & TB>0
BB: External
balance CA=0.
ES & TB>0
ED & TD
●
2010-16
2003-07
YY: Internal
balance Y=𝑌
ES & TD
ITF-220, Prof.J.Frankel
Spending A
Appendix 1: More graphs of 𝒀 and output gap
US GDP (Y) & potential (𝑌): 1979-2015
}output gap
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 in 2007: Y >> 𝑌
and crashed in 2009-12: Y << 𝑌
ITF-220, Prof.J.Frankel
Output gap remains worse in eurozone than elsewhere.
1997-2015
Exhibit 3: A Large Output Gap Remains in the Euro Area
Global Economics Analyst: Meeting the Low Bar (Stehn/Hatzius), GS Macro Economics Research, February 19, 2016
Appendix 2: Recap Swan
Diagram derivation
• Only by using both sorts
of policies simultaneously
can both internal & external
balance be attained, at point A.
• Experiment: increase in 𝑨
(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?
External balance.
●
●
●
●
● ●
Devaluation 𝑬 ↑ ⇒ 𝑿 ↑
ITF-220, Prof.J.Frankel
Recap, continued
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
Derivation of the Swan Diagram
Summary: the combination of policy instruments to hit one
goal slopes up; the combination to hit the other slopes down.
Fiscal expansion (G↑)
(or monetary expansion),
at a given exchange rate =>
Y↑
Devaluation (E ↑)
Y↑
=>
and
and
TB↓.
TB ↑.
If we are to maintain:
Internal balance,
Y=𝑌
External balance,
TB=0
then G & E must vary:
inversely.
together.
=>
Internal balance
line slopes down.
=>
External balance
line slopes up.
Prof.J.Frankel
End of Targets and Instruments
ITF-220, Prof.J.Frankel
Lecture 8:
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 of A,
such as construction, other I, and consumer durables.
• Or in terms of the quantity of money:
M1 ≡ cash + checking account deposits
Prof.J.Frankel
Determination of income when A depends on i
Aggregate output = Aggregate Demand
Y
=
A
+ net foreign demand:
+
TB
Trade Balance:
TB = 𝑋(E) – mY.
Let A = Ā - b(i) + cY
where the function -b( ) captures
the negative effect of the interest rate i
on construction, consumerdurables, etc.
Combining equations,
Y = Ā - b(i) + cY + 𝑋 𝐸 - mY.
Now solve to get the IS curve:
Y =
Ā − b(i) + 𝑋
𝑠+𝑚
𝐸
.
IS curve: An inverse relationship between i and Y
consistent with supply = demand in the goods market.
IS: Y =
i
𝐴 − 𝑏(𝑖) + 𝑋
𝑠+𝑚
IS
IS'
A decrease in i,
(monetary expansion)
stimulates A & so Y.
Δ𝐴/(𝑠 + 𝑚)
Y
An increase in spending, Ā, e.g., a fiscal expansion,
shifts IS to the right by the multiplier 1/(s+m).
The LM curve: Money supply = money demand.
𝑀1
=
𝑃
i
L(i, Y)
where money demand function L(i, Y) captures
a negative effect of i & positive effect of Y.
LM
→
• Do central banks actually set the money supply?
LM´
A monetary
expansion
(M1↑) shifts
the LM curve
to the right.
Y
• Their policy was to set M1 in the 1980s, the heyday of monetarism.
• Also the monetary base made a comeback after 2008: Quantitative
Easing.
Y
Equations for IS-LM with a fixed exchange rate
IS: Y =
𝐴 − 𝑏(𝑖) + 𝑋
𝑠+𝑚
LM:
IS
𝑀1
=
𝑃
L(i, Y)
LM
i
Y
Prof.J.Frankel
Monetary expansion: M1↑
IS: Y =
𝐴 − 𝑏(𝑖) + 𝑋
𝑠+𝑚
LM:
IS
𝑀1
𝑃
= L(i, Y)
LM
i
LM'
Or think of the
central bank
setting i directly.
Y
Prof.J.Frankel
Spending expansion: 𝐴↑
IS: Y =
IS
𝐴 − 𝑏(𝑖) + 𝑋
𝑠+𝑚
IS'
LM:
𝑀1
𝑃
= L(i, Y)
Taylor
rule
i
LM
Or the central bank may
follow a Taylor Rule:
setting i systematically
in response to Y & inflation.
Y
Prof.J.Frankel
When the GFC hit, the Fed cut its policy interest rate to 0
(followed by other major central banks).
US Economics Analyst: From ZLB to ELB , GS, Feb. 26, 2016. Data source: FRB
Appendix 1:
IS-LM again,
while also following TB in the upper graph
=> TB = 𝑋 − (𝑀 +mY)
TB
+
0
-
Y
where slope = -m
ITF-220, Prof.J.Frankel
Monetary stimulus
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
Appendix 2: When at the Zero Lower Bound
(i) Monetary expansion has little effect, because it can’t drive i lower.
(ii) Fiscal expansion has big effect, because no crowding out from i .
IS
IS′
LM
i
LM′
Y
Prof.J.Frankel
Lecture 9: The Monetary Approach
to the Balance of Payments
• Sterilization definitions
• Price-specie flow mechanism
• Income-money flow mechanism
• Historical case of non-sterilization:
the Gold Standard
• Appendix – Historical case of sterilization:
China’s inflows, 2004-13
ITF-220 - Prof.J.Frankel
The Monetary Approach
to the Balance of Payments (MABP)
Defining assumption: Reserve flows are not sterilized.
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 ,
ΔNDA = - ΔR, so MB unchanged.
Non-sterilization: ΔMB = ΔR.
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.
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.
- 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.
Mundell’s Income-Flow Mechanism, continued
A Monetary Expansion, and Its Aftermath
NS-I
+
NS-I′
0
Y
-
TB
i
LM
LM′
IS
Y
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.
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.
Allowed 1995 reserve outflows to shrink the money supply, raise i, contract spending.
Suffered recession, but equilibrated BP at point A.
ITF-220 - Prof.J.Frankel
Historical example of non-sterilization:
The Gold Standard
Definition: Central banks peg the values of their currencies
in terms of gold (and so in terms of each other).
“Rules of the game”: Don’t sterilize. Allow adjustment to work.
Pros and Cons
Pro: prevents excess money creation & 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.
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 & wages.
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, starting in 2004
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
BoP
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
49
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
API-120 - Prof. J.Frankel, Harvard
http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down
Sterilization of foreign reserves:
People’s Bank of China sold sterilization bills,
thereby taking RMB out of circulation.
Data: CEIC
Source: Zhang, 2011 ,
ITF-220 - Prof.J.Frankel
Fig.4, p.45.
Source: UBS
In 2003-04, forex inflows accelerated.
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.
Despite PBoC success at sterilizing inflows 2003-06
money growth accelerated sharply in 2007-08.
FX reserve contribution
Prof.J.Frankel
To be continued…
Starting in 2007, China had more trouble
sterilizing the reserve inflow.
• The 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 problem in 2007-08.
- Prof. J.Frankel, Harvard