Macroeconomics: Policy, 31E23000, Spring 2018

Transcription

1 Macroeconomics: Policy, 31E23000, Spring 2018 Lecture 7: Intro to Fiscal Policy, Policies in Currency Unions Pertti University School of Business March 14, 2018

2 Today Macropolicies in currency areas Fiscal policy, competitiveness Safe asset

3 In a monetary union monetary policy stabilizes the union wide disturbances. At a member country level the country specific shocks should be stabilized by national policies: fiscal policy, labor market policies etc. National policies have usually spillovers to other member countries, which can be negative. National fiscal policies can be used, but they are restricted, ceilings to deficits etc. Are the spillovers from fiscal policies negative?

4 Fiscal policy, short and long run Fiscal policy and the long run: Taxation (income redistribution, funding supply of public goods, resource reallocation) Social welfare system, education, public infrastructure, military (and alternative service) Impact on the supply side Fiscal policy and the short run: Automatic stabilization of aggregate demand Discretionary changes in public expenditure: timing of expenditure (intertemporal reallocation of planned expenditure), discretionary actions (temporary changes in public expenditure). Connection: public debt, fiscal policy rules

5 Fiscal policy in the short run 1 Should fiscal policy be used for short term stabilization besides automatic stabilization? The consensus view: Monetary policy is the main instrument for short run stabilization. Why? Some theoretical and practical reasons. Theoretical: under normal circumstances monetary policy has some positive supply side effects helping stabilization: In a boom raising interest rate shifts demand for goods and leisure from present to future. Reducing leisure is equivalent to increasing labor supply which reduces inflationary pressure. The reverse holds in the recessions.

6 Fiscal policy in the short run 2 Practical reasons 1: Lags in implementation: fiscal policy may not be able to respond as fast as monetary policy to changes in the economy than monetary policy. In addition to the implementation lag the lags in the effects may depend on the way the fiscal policy is implemented (the speed of the impacts may e.g. depend on the type of government expenditure which is changed) implying more uncertainty in the effects than by using standard monetary policy. Practical reasons 2: Deficit bias: There may be reasons why deficits tend to be too large for long run fiscal sustainability.

7 Fiscal policy in the short run 3 Reasons for deficit bias (Portes and Wren-Lewis Issues in design of fiscal policy rules, Manchester School, September 2015, working paper version ac.uk/materials/papers/13342/paper704.pdf: Informational asymmetry: a) Hard to forecast future tax revenues etc., (over-) optimistic forecasts allow reduction of taxes, b) Take actions that imply future commitments while immediately implying cuts in expenditure and less borrowing. e.g. Public Private Partnerships in public infrastructure investment Impatience: How far does the perspective of government agencies reach? Exploiting future generations Electoral competition: Governments have finite lifetimes. Why do conservative governments run large deficits (Persson-Svensson)?

8 Fiscal policy in the short run 4 Deficit bias cont.: Common pool problem: Different government ministries/agencies compete for the use of governemnt revenue, costs of individual actions small, but no agency internalizes the total costs. Expenditure frames used in Finland since 1995 one solution? Time inconsistency: policies have implications for future generations, but policies can be changed, promises are not respected. Solution(s)?: Fiscal policy rules, fiscal councils.

9 Fiscal policy in the short run 5 But: Monetary policy can be ineffective in some circumstances: Large demand shocks and the ZLB-problem Structural stagnation? In some circumstances there is no possibility for national monetary policy: Monetary unions without common fiscal policy including income transfers across member countries with differing business cycle conditions. In this case national fiscal policy including national automatic stabilization the only possibility to carry out stabilization policies at the national level. Automatic stabilization is passive policy, no active policy decisions have to be made.

10 Fiscal policy in the short run 6 Passive: automatic stabilization: Because of progressivity of income taxation and social policies taxes are reduced and welfare programs expanded automatically in a downturn, the reverse happens in upturn. The net change in fiscal stance due to automatic stabilizers can then be captured by the equation AD ast = a (y e y t ) (1) Government net expenditure increases with the output gap. But this would happen without any actions taken by the government.

11 Fiscal policy in the short run 7 The impacts of automatic stabilization as a stabilizer of income is quite big (IMF Fiscal Monitor, April 2015) It also increases economic growth. The next three figures come from the report.

12 SugarSync/Luennot/Macro2016/Crisis5.pdf

13 SugarSync/Luennot/Macro2016/Crisis6.pdf

14 SugarSync/Luennot/Macro2016/Crisis7.pdf

15 Fiscal policy in the short run 8 At the same time, automatic stabilization may also have contributed to the increase in public debt. Automatic stabilization may have reduced the need to take discretionary fiscal policy actions, Fatas and Mihov 2012, working paper version fatas/fiscal_stabilization.pdf They also confirm that larger automatic stabilization is connected with larger public sector size.

16 Fiscal policy in the short run 9 The short run impacts of fiscal policy in the form of increasing government expenditure depend on The size of impact effects. The degree to which other policies (especially monetary policies but also tax policies) accommodate the fiscal policy. The prevailing business cycle situation. If the monetary policy reacts fast and strongly to changes in inflation and output gap, the final multiplier, the realized impact of change in fiscal policy, is small. If the output is at its equilibrium level or higher, an increase in government expenditure creates only a short term increase in income but creates inflation. This is seen in the next figure (right side) where it is assumed that the government has an unrealistically high estimate of the production potential, y H > y e

17 Fiscal policy in the short run 10 To understand the figure, assume that fiscal policy, when used for stabilization, is guided by the same principles as monetary policy. Given this, policy choices can be described by the P(olicy)R(ule)- curve.

18 SugarSync/Luennot/Macro2016/Fipo1.pdf Figure 14.1

19 Fiscal policy in the short run 11 The diagram in the LHS of the figure shows the impacts of increasing public expenditure after a negative demand shock leading to recession. Clearly, the impact on output is positive, while in the previous case it is 0: in the previous case public expenditure crowds out private expenditure. The figure also confirms, in this theoretical framework, that the multiplier depends on the phase of the business cycle. But how is it in reality? Next figure shows the results using results from a meta-analysis by Gechert-Hughes Hallett, and Rannenberg 2015, policy_insights/policyinsight79.pdf

20 SugarSync/Luennot/Macro2016/Fipo2.pdf

21 Fiscal policy in the short run 12 Obviously, if the economy is in a ZLB-equilibrium, fiscal policies have a large multiplier: Monetary policy accommodates strongly the fiscal expansion. The nominal interest rate is at 0 and is kept there until the demand has increased enough. Fiscal expansion and in itself increasing demand also reduces deflation, reducing real interest rate. The reasonable fiscal policy rule for stabilization clearly implies that discretionary fiscal policy should be expansionary of output is below the equilibrium output, and should be contractionary when the output is above the equilibrium output. Has it been so?

22 Fiscal policy in the short run 13 Let us return to the question of how to measure the size and sign of discretionary fiscal policy. Recall that the problem of using actual data on government expenditure and tax revenue (G (y) T (y)) as a measure for discretionary fiscal policy is flawed because of automatic stabilization. To correct this, one uses the full (or equilibrium) employment fiscal surplus for measuring the discretionary policy: G (y e ) T (y e ) = (G (y) T (y)) a (y e y), a > 0 (2) Here the term a (y e y) measures the size of automatic stabilization.

23 Fiscal policy in the short run 14 Note that the deficit/surplus does not include the interest payments on government debt: they are determined by past decisions. Thus, only the primary balance G T is taken into account. The measures rely heavily on the estimated equilibrium output, output gap estimates can vary a lot with the method of calculating them. Then also estimates of a vary also. If G (y e ) T (y e ) < 0 the fiscal policy stance is contractionary, but the change in G (y e ) T (y e ) from one year to the other measures in what direction policy has moved. Also, quite often figures from international institutions give numbers for T (y e ) G (y e ), expansionary fiscal policy increases full employment deficit.

24 Fiscal policy in the short run 15 What kind of fiscal policies have been conducted during the Great Recessions? The following figure for the Eurozone has been taken from Francesco Saraceno s blog, the-quest-for-discretionary-fiscal-policy/:

25 SugarSync/Luennot/Macro2016/Fipo3.pdf

26 Competitiveness and Adjustment 1 We showed in one of the first lectures that active monetary policy is needed to stabilize the economy, with the real rate of interest the equilibrium would be unstable. Small open economies or an individual country in a monetary union, with free capital mobility, face a given foreign real interest rate: are they doomed in instability? No, as long as their inflation rates can differ from those in the rest of of the world or from those in the rest of a monetary union. With differing inflation rates the relative prices of goods and services produced in different countries change with impacts on demand. These changes in relative prices are called changes in real exchange rates. Competitiveness is measured by the real exchange rates or by the factors determining the relative prices.

27 Competitiveness and Adjustment 2 Real exchange rates are affected by changes in the nominal exchange rates and/or (marginal) costs of production. In a monetary union, from an individual member country point of view, nominal exchange rates are given, they are affected by the common monetary policy. With country specific shocks, the adjustment can take place through fiscal policy or real exchange rates, or both. We build next a model for short term determination of output, real interest rate and competitiveness in a monetary union member country. By doing this we ignore the relationship between competitiveness and equilibrium output, but return to it.

28 Competitiveness and Adjustment 3 The open economy national income identity is Y = C + I + G + (X M) (3) It says that domestic output must equal domestic demand for it plus the foreign demand. The latter equals exports X, while the former equals the total domestic demand corrected for the part that goes to buying foreign goods = imports M. We assume that the total domestic demand is like before d h = A ar t 1 (4)

29 Competitiveness and Adjustment 4 The net demand coming from abroad is given by the trade balance, X M. We assume that this depends on aggregate foreign demand and other foreign factors not affected by the home country, and by the competitiveness of the home economy. Recall that competitiveness is measured by the real exchange rate, which for countries in common currency is Q = P P (5) The higher foreign prices P are relative to domestic prices, the more depreciated the real exchange rate is and the more competitive the home economy is.

30 Competitiveness and Adjustment 5 Take logs from both sides of (5) for two consecutive periods and then take differences and you get q t q t 1 = logp t logp t 1 (logp t logp t 1 ) (6) Here q = logq. But logp t logp t 1 = π t, logp t logp t 1 = π t (7) Thus the real exchange rate changes when the inflation rates differ between the home country and the rest of the currency union. This is one key to understand the short term dynamics of an individual country in currency union.

31 Competitiveness and Adjustment 6 The other key is to remember that the joint monetary policy determines the nominal interest rate for the individual member country. The real interest rate is determined by the given nominal interest rate and the expectations on expected inflation. There are two possibilities: expectations are either on domestic inflation or the currency area inflation. We first look at the first case. r = i CU π e (8) This is again determined by domestic inflation if inflation expectations depend on realized inflation as we have been assuming.

32 Competitiveness and Adjustment 7 Thus, in a monetary union a member country can adjust to shocks as shocks have an impact on domestic inflation and changes in domestic inflation rate have an impact on domestic real exchange rate and real exchange rate (competitiveness). Will the adjustment lead the economy back to equilibrium output and inflation rate equaling the union wide target inflation? Assume that improved competitiveness (real depreciation) increases demand for domestic output, both because export demand increases and domestic demand for imports declines, and domestic demand shifts towards domestic goods. Consider a demand shock, take it to be negative and assume that initially domestic inflation is at the target level.

33 Competitiveness and Adjustment 8 The negative demand shock reduces domestic inflation below the target level and thus improves competitiveness, the real exchange rate depreciates, domestic goods become relatively cheaper. This increases demand for domestic goods and mitigates the impact of the demand shock. But at the same time real interest rate increases, if inflation expectations are determined by the current inflation, π e t = π t 1. This effect reduces demand and pushes the economy further away from the equilibrium. Which effect dominates? But what this tells is that some policy tool is needed to ensure that the impact of shocks can be stabilized and the economy can get back to equilibrium.

34 Competitiveness and Adjustment 9 This potential instability was first pointed out by Alan Walters. There may also be the problem that adjustment by changes in competitiveness may be slow. Obviously the problem would not arise if expectations are on the union wide inflation and the central bank keeps it close to the target π T. Then the real interest rate would stay constant. The first case could be relevant if the domestic consumption basket radically differs from the average consumption basket in the union and large share of goods consumed at home are produced in the closed sector=sector producing only for home demand. This would point towards structural differences between countries: Is monetary union then reasonable in this case?

35 Competitiveness and Adjustment 10 To get back to modelling recall the demand equation for domestic goods y = A ar t 1 + bq t 1, a, b > 0 (9) Thus the IS-curve shifts with changes in competitiveness:

36 SugarSync/Luennot/Macro2016/Comp1.pdf r Δq<0 Δq>0 r* y

37 Competitiveness and Adjustment 11 We keep the supply side as before, in effect assuming that changes in competitiveness show up in the supply side much later than in the demand side. We again assume that that instead of monetary policy fiscal policy is used in exactly the same way as monetary policy would be used. Thus, the preferred policy for any output level is shown by the PR-curve exactly analogous to the monetary policy reaction curve MR. Let us have a look at how the policy, changes in the real interest rate and competitiveness interact after a temporary decline in demand:

38 SugarSync/Luennot/Macro2018/Comp2.pdf r r* dr>0 dg>0 B Temporary demand shock dq>0 π y e PC π T A π 1 π 0 PR

39 Competitiveness and Adjustment 12 Figure shows the first round effects after the shock: The initial shock reduces output thereby lowering inflation to π 0. This improves competitiveness but increases the real interest rate, both of which have an impact on aggregate demand next period. We also assume that changes in public expenditure will have an impact with one period lag. The Phillips-curve valid in the next period shifts down due to reduced expectations of inflation. Assuming that policymaker knows all these, the optimal state of the economy in next period is point A. The only decision to be made is on the change in government expenditure to get the next period s IS-curve shifting correctly.

40 Competitiveness and Adjustment 13 The difference to the cases we have handled before is that now policy maker must take also into account both the change in the real interest rate and in competitiveness given to it from the period when the shock hits. Since the demand shock is temporary demand shifts back but rises above the initial demand as competitiveness has improved: At the initial real interest rate there would now be excess demand. But that demand level would exceed the best choice by the policy maker who also knows that the real interest rate is higher than r. The policy maker must increase government expenditure to make the improvement in competitiveness and the increase in the real interest rate compatible, increase demand beyond the one improved competitiveness has created.

41 Competitiveness and Adjustment 14 This policy increases inflation. It shifts the Phillips-curve up, reduces the real interest rate but also reduces competitiveness, which still is above the equilibrium level of competitiveness. These changes alone move the economy towards the equilibrium. This means that public expenditure can be cut. By how much? In the flexible exchange rate case no change in government expenditure is needed: the economy returns to the original equilibrium.

42 Competitiveness and Adjustment 15 Note, that in both policy regimes the net adjustment in inflation and output is the same as policymakers are assumed to have the same policy preferences (MR- and PR-curves are identical) In the flexible exchange rate system the initial adjustment in competitiveness is bigger, due to initial overshooting through nominal exchange rate jump (price adjust slowly). In CU government expenditure must be initially increased, which is not completely reversed during the adjustment process: competitiveness in the flexible exchange rate is through the adjustment process higher. Thus, fiscal stabilization, in this case, increases public debt. The reverse holds for the policy reacting to positive demand shock: initially government expenditure is reduced, after the adjustment process government expenditure is still lower than initially.

43 Competitiveness and Adjustment 16 Of course the reverse happens when there is a positive demand shock: the government would reduce expenditure over the cycle. Note also that if the currency union countries are in ZLB, expansionary fiscal policy by one country will definitely hurt its competitiveness: inflation increases. Its policy has positive impacts on other countries both because of the direct demand effect and indirectly through deterioration of competitiveness. Vice versa, if the country engages in austerity policy, more so if this policy is accompanied by reductions in production costs. The usual solution to externalities is to coordinate policies, but?:

44 SugarSync/Luennot/Macro2016/Comp3.pdf

45 Competitiveness and Adjustment 17 But one can argue that there are potential mechanism of automatic adjustment (recall the assigned article by Hume). Take the medium run open economy model we built and argued that it also can be seen as model for a monetary union member, next figure: The solid lines give the initial equilibrium 0 at which exports equal imports (trade balance is 0). Assume that the aggregate domestic demand increases (the dashed AD): output increases but competitiveness is reduced. Trade balance shows deficit also because some of the demand goes to imports. What happens?

46 SugarSync/Luennot/Macro2018/L7, 18/Comp and Adj 1.pdf Competitiveness and Automatic Adjustment 1 q ERU AD BT 0 1 y

47 Competitiveness and Adjustment 18 With trade balance in deficit, the country s foreign debt increases. As the debt must be serviced and interest paid, aggregate demand begins to fall. This cuts also the demand for foreign goods. The AD-curve starts to shift back as does the BT-curve. Competitiveness improves while output declines. This goes on until the trade balance is back in equilibrium. This is the adjustment that was supposed to take place in the gold standard, that is why it can be called the specie-flow mechanism.