Transcript XIV - IES

IX. Open economy, oil shocks and
disinflation policies (1973-1985)
IX.1 Open economy stabilization
Reminder: net export, aggregate demand and
real ExR
• Open economy: AD = C+I+G+NX
– NX = net exports: export - import
• In the short-run, export depends on foreign demand and real
exchange rate, import depends on domestic AD and real
exchange rate
– Real ExR = nominal ExR.(P*/P), appreciation of currency means lower
numerical value of both real and nominal ExR, depreciation vice versa
– Marshall-Lerner condition, i.e. net export depends on real exchange
rate only
• Standard asssumption:
– Real appreciation (nominal appreciation and/or stronger foreign
inflation than domestic one)  less competitive domestic goods and
services  higher the current account deficit (NX drops)
• And vice versa
• AD: depends on domestic policy parameters (fiscal
and monetary) AND real ExR
Reminder: Mundell-Fleming model
• The efficiency of fiscal, monetary and trade
policy differs according the exchange rate
regime
• Flexible exchange rate (float)
– Fiscal policy very little efficient
– Monetary policy very efficient
• Fixed exchange rate
– Fiscal policy very efficient
– Monetary policy very little efficient
Policy goals in the open economy
• Internal balance – full employment and price stability
– Fiscal and monetary stabilization policies
• External balance – definition: it does not have to
coincide with zero current account
– High CA deficit might be (very) desirable, when country is
able to repay the debt financing (loans) in the future
– High CA surplus might be a problem:
• Too low domestic investment, given total domestic savings
• Too many foreign claims, risk as to future payments
• Target for protections from abroad
– Assume “some desirable” CA deficit
Policy choices under B-W
fixed ExR
• Goal: simultaneous achievement of external and internal
balance
• Under B-W, policy tools limited
– Internal balance: monetary policy little efficient, fiscal policies only
available
– External balance: fixed ExR, devaluation options very limited
• Four possible situation, away form both balances
– I: over-employment and inflation, CA surplus too high
– II: over-employment and inflation, CA deficit too high
– III: underemployment and deflation, CA deficit too high
– IV: underemployment and deflation, CA surplus too high
• All four imply both ExR and fiscal adjustment
External balance, NX=NXX
E
I
IV
E
II
III
Internal balance, Yf
Fiscal expansion
Policy adjustment
• If economy away from both lines, combination of
both fiscal adjustment and change of ExR is needed
• Change in fiscal policy – expenditure changing
– Changes the overall level of aggregate demand in the
economy
• Change in ExR (devaluation/revaluation) –
expenditure switching
– Switches demand between domestic output and imports
• Policy dilemma at fix: fiscal policy too slow, ExR
adjustment faster, but limited by B-W system
IX.2 The End of Bretton-Woods
System
1950s
• B-W system:
– Countries limited in their monetary policies
– Adjustment to disequilibria via international reserves (gold, but
mainly USD) → need for keeping reasonable level of reserves
• To keep reserves → limits of convertibility and of capital flows
• Special position of US
– USD as reserve currency, main task – keeping the USD price of
gold (35 USD per oz.)
– Need to keep gold reserves enough
– Potential constraint on US macroeconomic policy – when
economies grow, will there be enough US gold reserves?
• Confidence problem
1960s
• Gradual achievement of convertibility
• Increase of international capital flows (despite
controls), more and more of speculative nature,
because of expected devaluations
• More frequent balance of payments crises,
accompanied by losses of foreign exchange reserves
• Devaluations, indeed (Britain November 1967)
• Need for policies to achieve both internal and external
balance
• All this: crucially dependent on the performance of the
US economy
US economy in 1960s
• Vietnam War, “moon racing” and Great Society
program of President Johnson → strong fiscal
expansion → inflation → worsening of CA →
monetary policy only temporary contracted, later
eased → further inflation → expected rise in USD
price of gold
• Private speculators started to buy gold → two-tier
gold market (private, where price of gold allowed
to float; official, where fixed) → end of automatic
constraint on worldwide monetary growth
US recession in 1970
• 1970: US recession with increase of unemployment, output
falling, CA deficit → need for real devaluation of USD vis-àvis major other currencies
– Fall US prices – no way because of recession
– Second option – nominal devaluation of USD, uneasy, as all other
countries should be willing to peg their currency to USD at new
(devalued) rate
– August 15, 1971 – President Nixon stopped automatic exchange of
gold for dollars and introduced import surcharge
• Multilateral negotiation → Smithonian agreement in
December 1971
– USD devalued by 10 % against foreign currencies, price of gold
increased to 38 USD per oz.
• Not the end of the story yet: because of continuing
disequilibria, another speculative attack on USD in February
1973 → European currencies abandoned fix and by March
19, 1973 Japan and Europe floated their currencies against
USD → end of B-W system
IX.3 Oil shocks and stagflation
IX.3.1 Stagflation
• Stagflation: inflation + unemployment + low
growth
– US as well as Europe
• Trigger: oil shocks, 1973 and 1979
– In 1973-4 and in 1979-1982, two dramatic
increases in price of oil: 1960: 100, 1972: 93, 1974:
135, 1982: 264
– Increase in oil price → substantial increase in P
without a link to change in wages (and
unemployment)
• Economic policies were not able to react
immediately → problems lasted till 1980s
Main indicators, 1963-2005
63-72
73-82
83-92
93-02
03
04
05
inflation
USA
3.3
8.7
4.0
2.6
2.3
3.0
3.0
Europe
4.4.
10.7
5.1
2.4
2.0
2.2
2.0
Japan
5.6
8.6
1.8
0.2
-0.2
-0.2
-0.2
Unemployment
USA
4.7
7.0
6.8
5.2
6.0
5.5
5.4
Europe
1.9
5.5
9.4
9.6
8.9
9.0
8.7
Japan
1.2
1.9
2.5
3.9
5.3
4.7
4.5
per capita real GDP growth
USA
2.8
0.9
2.4
2.1
2.0
3.3
2.5
Europe
3.9
2.0
3.0
2.0
-0.1
1.9
1.9
Japan
8.5
2.9
3.4
0.7
2.3
4.3
2.3
US data
What policies?
• Stagflation: challenging framework for policy
decisions
• Keynesian: so far based on inflation vs.
unemployment trade-off, no use
• Monetarist: provided credible explanation what
happened, but the advice for stable increase of
money supply was not of much help either
Rational expectations and policy
credibility
• Anticipated policies → immediate adjustment
towards new equilibrium, consistent with
natural values
• Un-anticipated → new equilibrium, but not at
natural values, i.e. with higher inflation or
higher unemployment
• Effective policy: must be credible, i.e. agents
must believe that authorities will indeed pursue
that policy that they announce
Difficult policy options after 1973
• Oil shocks: un-anticipated, economy reacted
according new-classical theory
– Price increase, contraction, higher
unemployment
– Policy response: difficult, see Case study I bellow
• Disinflation after 1979: mainly the problem
of credibility – will the authorities hold
monetary contraction?
– See Case study II bellow
IX.3.2 Policies 1973-1979
Monetary expansion
Effect on prices
• Oil and energy inputs more expensive → all
prices oil importing countries up
• Expectations: price increases will continue
• Both in US and Europe – accumulated
inflationary pressures via wage negotiations
already from 1960s
• Speculative hoarding of commodities stocks
Effect on output
• Sharp price increase → fall of AD → fall of
output
• Sharp increase of unemployment
• Stagflation: inflation with unemployment
Effect on CA
• Oil importing developed countries: sharp decrease
(deficit), later improvement (as spending on
imports fell down)
• OPEC countries: sharp increase (surplus), investing
the revenues (“petrodollars”) in developed
countries
• Oil importing developing countries: mild deficits
(lower energy intensity)
• No problem how to finance deficits (out of
petrodollars)
Policy options
• Both internal and external disequilibria, need
for action, options
• Return to fix?
– Danger of speculative attacks
• Monetary contraction to fight inflation?
– It seemed as politically unfeasible
• Monetary expansion to fight unemployment
– Selected policy, consequences?
Monetary expansion
• US immediately 1974, Europe much later (1978)
• US:
–
–
–
–
Output recovery, unemployment improved
Further inflation, larger than Europe
Depreciation, both nominal and real
CA deficit: contrary to model, as depreciation helps
exports; here domestic expansion fostered imports
(despite that more expensive), due to continuing
recession in Europe, no demand for exports →
deterioration of the deficit
Crucial consequences for developed
countries
• Weak dollar – psychological impact on US
population
• Entirely different understanding about
scarcity of energy resources
• US – growth resumed and unemployment –
at least partially – improved
• Europe – growth resumed as well (not as in
US), unemployment persistent
IX.3.3 Policies 1980-1985
Disinflation
The burden of inflation
• Very high US inflation through 1970s
– Due to monetary expansion when fighting unemployment of
1970s
• Eroding the health of US economy
• 1979: new FED’s chairman Paul Volcker
– Strong commitment to monetary contraction to lower
inflation
– Credibility problem
• January 1981: President Ronald Reagan
– New economic policies, based on tax cuts, anti-inflationary
policies and support to private business
– Later (1983): fiscal expansion, mainly due to political reasons
(military expenditures)
Supply side economics
• Lower taxes ↔ incentives to private sector to
increase both effort and productivity
• Strategy: lower tax means higher budget deficit
now, but stronger growth in the future and
larger tax revenues with deficit improvement in
the future
• Supply side economic, Laffer curve
Tax
revenue
0%
100%
Tax
rate
The data
1980
1981
1982
1983
1984
GDP growth %
-0.5
1.8
-2.2
3.9
6.2
Unemployment %
7.1
7.6
9.7
9.6
7.5
Inflation – CPI %
12.5
8.9
3.8
3.8
3.9
Nominal interest %
11.5
14.0
10.6
8.6
9.6
Real interest%
2.5
4.9
6.0
5.1
5.9
Real ExR (73=100)
117
99
89
85
77
Trade surplus
-0.5
-0.4
-0.6
-1.5
-2.7
Budget surplus
-1.8
-2.0
-3.5
-5.6
-4.5
A detour: policies in large open
economies
• No longer small country assumption
– No prevailing world interest rate
– Changes in inflation and output do influence inflation and
output in other economies
• Changes to policy effects compared to M-F model
– Monetary expansion: domestic output up, domestic
currency depreciates, foreign outputs ambiguous
– Fiscal expansion: domestic output up (different from
standard M-F model in Lecture XII), home currency
appreciates, foreign output up
XVI.3.1 Reducing the inflation
The costs of disinflation
• Sacrifice ratio: the amount of lost output during the
period of reducing inflation
• Keynesian view: sacrifice ratio large, due to price
and wage rigidities
• Monetarist view:
– there is always some sacrifice ratio
– Probably much lower than Keynesians believe
– Depends on institutional adaptations and – mainly – how
quickly people adapt their expectations (AEH)
• New classical school (rational expectations)
– If policies credible (anticipated) → sacrifice ratio might be
close to zero
– If policies not credible (un-anticipated) → sacrifice ratio
might be substantial
Monetary restriction after 1979
• Strong, convincing commitment to monetary restriction,
quick change of expectations and quick impact:
– Real interest ↑, Y↓, P ↓, real (and nominal) appreciation of USD
– The credibility problem: most people did not believe that
Reagan/Volcker team will be politically strong to reduce inflation
quickly
– Behaviour according rational expectation models: un-anticipated
policy → decrease of output and increase of unemployment
– Whenever credibility established → growth resumed and
unemployment started to fall
• Strong monetary contraction and subsequent volatility of
macroeconomic parameters → impact on the position of
USD
• Originally, very strong commitment towards floating ExR
without intervention (“benign neglect”)
Other countries’ reaction
• Usually: appreciation of domestic currency seen as
welcome by foreign countries (positive effect on
exports)
• Different attitude in 1980-81: low US inflation
relatively increased inflation in foreign (European)
countries → additional inflationary pressure in
European economy → monetary contraction in
Europe (and Japan) as well
– Technically, contraction as a result of intervention
against USD’s appreciation → sale of USD assets (to
undermine USD), i.e. money restriction
Effects of Monetary Contraction
• 1980-1982 – US economic development
dominated by the effects of monetary
contraction
• M.-F. model’s prediction: in case of flexible
exchange rate monetary policy is efficient, see
data:
– Output contraction
– Real appreciation of USD
– Inflation sharply down
• Remark: US is large economy, interest rate is not
fixed on the “world” level
World recession after 2nd oil shock
Difficult coincidence:
• Second oil shock
• Monetary restrictions in all major parts of
the world
• Lack of forex policy coordination
→ deep recession worldwide, the most serious
after Great Depression
Effects of Fiscal Expansion
• After 1982 – stronger effect of fiscal expansion
– Reagan: additional military expenditures
• M.-F. model: fiscal policy less efficient, but here
model’s predictions did not come true fully
– There was a further appreciation of USD, in accord with
M.-F.
– There was a strong expansion of output, contrary to
original version of M.-F. model
• US is a large economy, interest rate is not fixed and
appreciation is consistent with interest rate decrease →
stimulation of AD and output
IX.4 Exchange rate policies under
floating
Twin deficits and consequences
• Increased military expenditures outweighed
increased tax revenues due to faster growth
– The budget deficit further deteriorated
• Continuing USD appreciation slowed exports and
increased imports
– Trade deficit started to increase
• Result: US economy started to mount both trade
and budget deficits → the problem of twin
deficits
• Strong deficit and strong USD → calls for
protectionism in the US, threat to overall world
trading system → need for ExR adjustment, i.e.
need for an intervention
Plaza Agreement
• September 22, 1985: officials from US, UK, France and
Germany announced a joint intervention to depreciate
USD
• Given strong commitment → change in expected ExR →
drop of USD immediately next day
• Accompanied by slight monetary expansion → continuous
decline of USD in 1986-87, US interest rates down relative
to other countries
• Second half of 1980s:
–
–
–
–
much stronger growth, world out of recession
lower unemployment
resumption of world trade
macroeconomic stabilization
XVI.4 Conclusions from oil shocks
• Stagflation – a phenomena, neither known and
expected by both economists and public
• Keynesian economics (and policies) on retreat
• Disinflation policies of 1980s opened a new era in
economic policies
– Success in reducing the inflation
– International economics and coordination
– The role monetary policies and of Central Banks
• Twin deficits and period of weak USD
Open issues
• Fix of float? – never ending story
• Should there be an international coordination on
exchange rates policies?
• Anti-inflationary policies emerged as a pivotal
element in economic policy making
• Expectations as a central notion both in economic
theory and practice (see next Lecture)
• The start of formation of the framework of
macroeconomic policies for 21st century (see the
last Lecture)
Literature to Ch. XVI
• Krugman, Obstfeld, ch.19
• Snowdon, Vane, Modern Macroeconomics,
Edvard Elgar, 2005 (part 5.5.3)
• Romer, Ch., Romer, D., Reducing Inflation,
The University of Chicago Press, 1997