Open Economy AS/AD: Applications

Transcription

1 Open Economy AS/AD: Applications Econ 309 Martin Ellison UBC

2 Agenda and References Trilemma Jones, chapter 20, section 7 Euro crisis Jones, chapter 20, section 8 Global imbalances Jones, chapter 29, section 8

3 The Trilemma Proposition: Following three objectives cannot be achieved at same time 1. Domestic monetary policy independence 2. Stable exchange rates 3. Free international capital flows

4 The Trilemma Proposition: Following three objectives cannot be achieved at same time All three objectives may be desirable 1. Domestic monetary policy independence Deals with domestic shocks 2. Stable exchange rates Reduce uncertainty 3. Free international capital flows Allocate resources efficiently

5 The Trilemma China EMU US, UK

6 The Trilemma Country that wants to fix exchange rate needs to hold reserves of foreign currency Buys and sells foreign currency at fixed price Loses control of domestic monetary policy Unless imposes capital controls Follows from uncovered interest rate parity No arbitrage relation between investing in domestic and foreign bond

7 Uncovered Interest Rate Parity ii tt = EE(ee tt+1) ee tt ii tt ii tt = Domestic nominal interest rate ii tt = Foreign nominal interest rate ee tt = Nominal exchange rate Invest 100 in one-year UK bond (return ii tt ) Invest 100 in one-year US bond (return ii tt ) Today convert in $ at ee tt Next year convert back at ee tt+1

8 Trilemma and UIP ii tt = EE(ee tt+1) ee tt ii tt Fixed exchange rate: EE ee tt+1 = ee tt ii tt = ii tt Lose monetary policy independence Domestic CB needs to track Foreign CB Unless domestic country imposes limits to capital mobility No arbitrage relationship breaks down Cannot convert for $ freely

9 The Trilemma Country that wants to fix exchange rate needs to hold reserves of foreign currency Buys and sells foreign currency at fixed price Loses control of domestic monetary policy Unless imposes capital controls Fixed exchange rate regimes often associated with currency crises South America in s European Monetary System

10 Currency Crises

11 Mexican Crisis (1994) Large capital inflows and a stable exchange rate, resulting in economic growth until 1994 Political turmoil and large foreign borrowing led to fears of devaluation Mexican CB tried to keep exchange rate fixed against USD USD reserves fell very low Government forced to devalue

12 South-East Asian Crisis (1997) South-East Asia boom in 1990s partly financed by influx of foreign capital Large external deficits Currency speculation leads to declines in exchange rates Loans denominated in USD become very expensive to repay Result: Large recessions in Asia

13 Argentinian Crisis (2001) Fixed exchange rate (currency board) successful in overcoming hyperinflations Negative AD shock via NX when Brazil s currency value declined Large stock of public debt in USD Lenders worried about country s ability to repay Interest rates spiked Government defaulted on its debt Argentina devalued and allowed peso to float

14 Fixed Exchange Rate and IS-LM Consider negative demand shock Mexico 1994: Negative confidence shock South-East Asia late 1990s: Negative investment shock (higher cost of borrowing) Argentina 2001: Negative foreign demand shock In all cases, IS shifts left because aa

15 Fixed Exchange Rate and IS-LM R t IS' IS LM r Shocks that caused crises shift IS inward 0 YY

16 Fixed Exchange Rate and IS-LM R t IS' IS With flexible exchange rate, CB could cut interest rate and avoid recession LM r LM 0 YY

17 Fixed Exchange Rate and IS-LM R t IS LM r Exchange rate depreciates, trade balance improves, and economy moves back to initial equilibrium 0 Y

18 Fixed Exchange Rate and IS-LM R t IS' IS LM LM r With fixed exchange rate, nominal interest rate must remain at same level as foreign 0 YY

19 Fixed Exchange Rate and IS-LM LM R t IS' IS LM r Indeed, if shock is deflationary, real interest rate may actually increase, worsening recession 0 YY

20 Fixed Exchange Rate and IS-LM Consider negative demand shock Mexico 1994: Negative confidence shock South-East Asia late 1990s: Negative investment shock (higher cost of borrowing) Argentina 2001: Negative foreign demand shock In all cases, IS shifts left because a Fixed exchange rates prevent monetary easing Can exacerbate recession if shock is deflationary

21 Euro Crisis (2011) Single currency solves some problems related to credibility of fixed exchange rates But introduces inflexibility of single monetary policy for large, heterogeneous economic area

22 Euro Crisis (2011) Single currency solves some problems related to credibility of fixed exchange rates But introduces inflexibility of single monetary policy for large, heterogeneous economic area EMU seemed to work well until 2010 Problems crept up when Greece found to have manipulated fiscal deficits Crisis quickly spread to other periphery countries (Portugal, Ireland, Spain, Italy) Example of contagion

23 Cause of Euro Crisis Fiscal problems Irresponsible fiscal policy in Greece and Portugal High deficits in Ireland and Spain due to credit bubble burst and subsequent bailouts High (but stable) debt and low growth in Italy Compounded by lack of competitiveness Structural imbalances in European periphery

24 EMU and IS-LM Consider positive demand shock Greece, Portugal, Italy: Fiscal expansions Spain and Ireland: Housing boom In all cases, IS shifts right because aa Same analysis as before in reverse Inflation differentials in periphery amplify boom ECB sets nominal interest rate for all EMU but inflation higher in periphery => Lower real interest rate

25 Euro Crisis and Fiscal Policy In late 2010, clear that Greece fiscal deficit much worse than earlier reported Greek debt restructuring (default) Concerns about fiscal sustainability of all countries in EMU periphery Spreads of Euro-periphery sovereign debt over German bonds from 0 to more than 5%

26 Primary Surplus in EMU Periphery 10 Greece Ireland Italy Portugal Spain % of GDP

27 Government Debt in EMU Periphery 180 Greece Ireland Italy Portugal Spain % of GDP

28 Spreads in EMU Periphery 18 Greece Ireland Italy Spain Portugal year yield spread relative to Germany Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q3

29 Euro Crisis and Fiscal Policy Different fiscal conditions in periphery Large deficits and increase in debt in Ireland and Spain following banks bailouts Long-term structural problems in Greece, Italy, and Portugal Common element: Lack of competitiveness Real exchange rate appreciation Large trade/current account deficits

30 Lack of Competitiveness

31 EMU External Imbalances GERMANY GIPSIs Greece Ireland Italy Portugal Spain 8.00 Current Account (% of GDP)

32 ECB Response to Euro Crisis European Central Bank has responded with various measures Liquidity provision to banks Commitment to act and avoid disaster scenarios Whatever it takes (Draghi, 2012) Quantitative Easing (QE) International institutions provided bailout packages to Greece, Portugal and Ireland Crisis has been contained but EMU far from recovery (low growth, risk of deflation)

33 External Imbalances Two motives for external deficits based on consumption smoothing idea 1. Risk sharing: Country borrows if bad shock hits 2. Permanent income: Country borrows if expectations of future growth rate are high U.S. ran large external deficits pre-crisis Period of high expected growth

34 External Imbalances Accounting Rewrite national income identity Define total savings as sum of private and government savings Trade balance and capital flows are related

35 External Imbalances Accounting Trade deficit: Additional borrowing to finance gap between investment and savings Net flow of goods associated with net flow of financial assets in opposite direction Global imbalances (late 1990s to mid 2000s) Large trade deficits in U.S. (up to 6% of GDP) Large surpluses in China, Germany, and OPEC

36 Global Imbalances U.S. ran large trade deficits Sells financial assets to foreign countries Claims to future goods in return for imports today China ran large trade surpluses Excess of domestic savings Ships goods abroad Accumulates U.S. financial assets Exacerbated by China pegging RMB to USD

37 Why Large U.S. Imbalances?

38 Twin Deficits Private savings roughly equal to investment But large government budget deficits Trade deficits to compensate budget deficits Twin Deficits Not always true: Early and late 1990s, mid 2000s

39 Global Imbalances Large external imbalances likely to emerge in globalized world Can fuel asset price boom-bust cycles Can be exacerbated by fixed exchange rates Pose challenges to policymakers Restrictions to free capital mobility? Domestic policies to avoid bubbles? More international policy coordination?

40 Summary Trilemma: Impossible to reconcile Domestic monetary policy independence Stable exchange rate Free international capital flows Fiscal policy, cyclical factors and fundamentals behind Euro crisis Are large external deficits a problem? Depends on source and circumstances