Open economy macroeconomics and exchange rates Part II

Transcription

1 Understanding the World Economy Master in Economics and Business Open economy macroeconomics and exchange rates Part II Lecture 11 Nicolas Coeurdacier

2 Lecture 11 : Open economy macroeconomics and exchange rates Part II 1. Asset markets and exchange rates 2. Stabilization policies in open economies 3. Fixed exchange rates and currency unions

3 Asset Market Approach to Exchange Rates PPP and BOP theory of exchange rates emphasises real trade flows But with modern financial markets, capital flows swamp trade flows. Thus about $2 trillion a day are traded spot in forex markets morethantheannualgdpofitalyortheuk Another Italy is traded each day in forward and futures forex markets.

4 Exchange rates and the return on assets Uncovered interest parity condition (UIP) The link between the exchange rate E euro/dollar today, the expected exchange rate E e (one year) and the interest rate differential An investor has the choice between: Invest one euro in (riskless) bond (treasury bond) or euro interbank interest rate : 1+r Buy dollars with this euro at rate E, invest it in US Treasury bonds or dollar interbank markets at rate 1+r $ In one year, at what rate, can she sell her dollars? E e

5 Two possible investments In one year 1 euro (1+r ) euros Expected return 1/E dollars In one year (1+r $ )/E dollars E e (1+r $ )/E euros E e : expected euro/dollar exchange rate

6 Uncovered interest parity condition A risk neutral investor should be indifferent between the two: Or: (1+r ) = E e (1+r $ )/E E e /E = (1+r )/ (1+r $ ) (E e E)/E = (r -r $ )/ (1+r $ ) r -r $ If E e >E, an investor in euro must be compensated by a higher interest rate in euro than in dollar = Condition for equilibrium on the FOREX market Example: If r = 5% and r $ = 3% (per annum). The euro is expected to depreciate by 2% in the following year.

7 Uncovered interest parity condition Return on asset r = r $ + (E e E)/E Expected return on $ asset Otherwise:expectedreturnson assetsand$assets Profit maximizer investors would buy the asset with higher expected return(if free capital movements) If E ( depreciates today) : return on $ assets r $ + (E e E)/E : relatively asset return Why? If depreciates (cheaper), $ appreciates (for given interest rates and E e given): more expensive to buy and invest in $ assets today: return in $ falls

8 Exchange rate /$: E asset return expected $ asset return< asset return E 1 E 3 r $ + (E e E)/E E Expected return on $ > asset return 2 Expected $ asset return r Return in units of

9 Exchange rate /$: E asset return An increasein r generatesan appreciation(e ) of the euro $ asset return < asset return E E 2 2 r $ + (E e E)/E Expected $ asset return r 1 r 2 Returns in units

10 Exchange rate /$: E asset return Increasein r $ Generates a depreciation of the euro E 2 2 E 1 1 r $ + (E e E)/E Expected $ asset return r 1 Asset returns in

11 Nb of $ per euro Interest rate shock Federal Reserve annonces a decrease of 50 basis points (25 basis points were expected): 5.25% to 4.75% of interest rate. Depreciation ofdollarofalmost 1%

12 Exchange rate /$: E E 2 asset return 2 Expecteddepreciation: E e Generates a depreciation (E ) of euro today E 1 1 r $ + (E e E)/E Expected $ asset return r 1 Returns in units

13 Empirical evidence on UIP Exchange rates much more volatile than interest rates in the data. UIP does not hold well in the data at short term horizon. Realized changes do not match expected ones on average. Expected exchange rate changes should be related one for one with interest rate differentials (when investors are risk neutral and there are no transaction costs nor capital controls). Investors are risk averse and they have to be compensated for risk: = r $ + (E e E)/E + p r p=riskpremium,whichisempiricallyfoundtobetimevarying.

14 Lecture 11 : Open economy macroeconomics and exchange rates Part II 1. Asset markets and exchange rates 2. Stabilization policies in open economies 3. Fixed exchange rates and currency unions

15 Asset and Forex Market Equilibrium We now use the asset market equilibrium to build a simple model of exchange rate in the short/medium term when prices are rigid. Open economy equivalent of a Keynesian model with rigid prices. Allow us to study the impact of stabilization policies in open economies and their transmission across countries.

16 Asset and Forex Market Equilibrium Building the AA curve: Higher GDP raises demand for money and the interest rate and appreciates the exchange rate (think UIP) Y r E (euro appreciation) AA curve: negativerelation betweeny and E AA curvedescribescombinationsbetweeny and E such that asset markets are in equilibrium

17 E AA Combination of E and Y such that asset markets are in equilibrium Y

18 E AA Increase of M S : interestrate falls, depreciationof euro for a givengdp Y

19 Aggregate demand Aggregate Demand(AD) determines production and income levelswhenpricesare rigid. Keynesian assumption valid in short-term(one year) because adjusment takes place through quantities and not prices Components of aggregate demand: Y = C + I + G + EX IM Net exports are increasingin q [as in lecture 10] EX IM = CA (q, Y -T,Y $ -T $ ) + Note: to simplify, I and G are takengiven

20 Aggregate demand D = C(Y -T ) + I + G + CA(q, Y -T,Y $ -T $ ) D = D(q, Y -T, I, G,Y $ -T $ ) Equilibrium: Aggregate Demand = Output Y = D = D(q, Y -T, I, G,Y $ -T $ ) Output and income is determined by demand(fixed pricesin the short run). In reality, short-run supply is(slightly) upward sloping but weassume itto behorizontal.

21 Aggregate demand D = D(q, Y - T, I, G,Y $ - T $ ) q D A euro depreciation makes European goods cheaper -net exports, aggregate demand and output increases with q 45 Y Y GDP, Y

22 Aggregate demand a nominal depreciamon generates an in demand via an in net exports CA = (EX -IM ) DD curve: positiverelation betweene and Y Necessary for the goods market to be in equilibrium

23 E DD Combination of E and Y such that goods market is equilibrium Y

24 E DD in a more closed economy DD in a more open economy Combination of E and Y such that goods market is equilibrium Openness(size) of economy determines the slope of the DD curve Y

25 E DD DD Y Fiscal expansion: increase in G For a given E, the demand and GDP increase.

26 E DD E 1 AA Y 1 Short term equilibrium for E and Y such that both goods and asset markets are in equilibrium Y

27 Monetary and Fiscal Policies Monetary and fiscal policies in an open economy An important distinction: Temporary and permanent: if permanent, changes expectations on the exchange rate E e Monetary policy shock : increase in money supply Fiscal policy shock: increase in G Focus on temporary shocks for simplicity

28 E DD E 2 E 1 AA AA Y 1 Y 2 Y Temporary monetary policy shock

29 Monetary and Fiscal Policies Monetary policy: very efficient (in stimulating demand) in an open economy. In addition to effect on I, in interest rate E (depreciamon) in net exports EX -IM Y Exchange rate channel of monetary policy. Monetary policy is even more efficient in more open (smaller) economies to stabilize economy (stimulating demand after a demand slump).

30 E DD DD E 1 E 2 AA Y 1 Y 2 Y Temporary expansionary fiscal policy

31 Monetary and Fiscal Policies Fiscal policy: less efficient (in stimulating demand) in an open economy Appreciation of the currency and deterioration of CA (themoresoddisflatter,moreopeneconomy) Crowding out of net exports (on top of crowding out on investment). Fiscal policy is even more inefficient in more open (smaller) economies to stabilize economy.

32 Monetary and Fiscal Policies How has trade globalization changed macro-policy? Trade openness makes domestic fiscal policy less efficient. demand generated by fiscal expansion leaks more (increase in imports, larger propensity to import m): shift inddissmaller. Exchange rate appreciation affects negatively net exports: crowding out effect stronger the more open the economy (the more aggregate demand depends on net exports) Trade openness makes monetary policy more efficient. Fall in interest rate generates depreciation and increase in net exports ; DD is more flat, this has large effect on output

33 Monetary and Fiscal Policies How has trade globalization changed macro-policy? Globalization means domestic fiscal expansion not very expansionary for domestic economy BUT very expansionary for foreign economy! Globalization means domestic monetary expansion very effective at Home but at the expense of Foreign economy: appreciation and fall in net exports. In both cases: globalization increases international spillovers of domestic policies(externalities). Requires international coordination.

34 Fiscal policy coordination for the crisis Olivier Blanchard (12 th February 2009) The international dimension of the crisis calls for a collective approach. There are several spillovers that could limit the effectiveness of actions taken by individual countries, or create adverse externalities across borders. Countries with a high degree of trade openness may be discouraged from fiscal stimulus since it will benefit less from a domestic demand expansion. The flip side of these spillovers is that if all countries act, the amount of stimulus needed by each country is reduced (and provides a political economy argument for a collective fiscal effort)

35 Cumulative fiscal multipliers in open and closed economies Source: E. Ilzetzki, E. Mendoza and C.Vegh, 2009

36 Lecture 11 : Open economy macroeconomics and exchange rates Part II 1. Asset markets and exchange rates 2. Stabilization policies in open economies 3. Fixed exchange rates and currency unions

37 Capital mobility, fixed exchange rate and monetary policy autonomy Interest parity condition (arbitrage with free capital mobility):r-r*=(e e E)/E=0orr=r* Suppose restrictions on capital movements (taxes on capital inflows and outflows): breaks the interest parity condition. The interest can be lower (with taxes on capital outflows) or higher (with taxes on capital inflows) that foreign interest rate with less capital outflows or inflows.

38 The impossible trinity of Mundell Independent monetary policy China 1990s US/JP/Euro Fixed exchange rate Free capital movements Denmark/Argentina 1990s/within Eurozone

39 Policies under fixed exchange rate Lossof monetaryautonomyif capital mobility. What about fiscal policy? Fiscal policy becomes more efficient under fixed exchange rates if capital mobility. But : necessity of policy coordination Laxistfiscal policycanthreatenthe pegand leads to speculative attacks (see currency and debt crisis in lecture 12)

40 E Fiscal policy with fixed exchange rate AA AA DD DD Ē r Y Fiscal policy becomes efficient due to accommodative monetary policy

41 Cumulative fiscal multiplier in fixed and flexible exchange rate regimes Source: Ilzetzki, Mendoza, and Vegh (2009).

42 Fixed or Floating exchange rates? The case for fixed exchange rate: Discipline on price stabilization Reduces speculation and money market disturbances Promotes international trade and investment Coordination of economic policies But Loss of monetary policy autonomy Exchange rate movements act as an automatic stabilizer Fixedexchange rate regimescanbesubjectto large adjustments(currency crisis)

43 Flexible exchange rate regimes as an automatic stabilizer: reaction to a fall of demand in flexible and fixed exchange rates E AA DD DD E AA DD DD AA Ē Y Y

44 Currency Union: Optimum Currency Area (Mundell) Two regions constitute an optimum currency area if Transaction costs considerations are important Thereisalotoftradebetweentheregions There are macroeconomic shock absorbers other than the exchange rate -High labor mobility -Large fiscal transfers The two regions have a similar production structure, so there is little need for macroeconomic shock absorbers.

45 Mundell s Analysis 2 countries, 2 regions Shocks common across regions Western Canada Manufacturing Eastern Canada Agriculture Agriculture Manufacturing Western US Eastern US

46 Mundell s Analysis Other ways to cushion shock of fall-off in demand for Western goods Western Canada Labor Transfers Eastern Canada Eastern US Western US Transfers Labor

47 Macroeconomic costs of currency union Loss of monetary instrument and of the nominal exchange rate as a stabilization tool (exchange rate is irremediably fixed) Thislossisallthemorecostlyif: Wagesandpricesarerigid:ifnot,demandshockshave norealeffectandmonetarypolicyisnotveryuseful. Macroeconomic shocks are asymmetric. Business cycles are not synchronized across regions. Laborforceisnotverymobileand/orfiscaltransfersare difficult.

48 An asymmetric negative demand shock in Italy but not Germany E: between It. and G. AA DD DD E AA DD DD AA Ē Y Y Flexible exchange rates or multiple currencies Irremediably fixed exchange rate: single currency

49 Symmetric/Asymmetric shocks Asymetric negative shock in Italy but not Germany: Euro depreciates(stabilizes) but not as much as Lira would The ECB can react by monetary expansion but not as much as a Italian national central bank would Cost for Italy: not enough depreciation, stabilization and monetary response Cost for Germany: too much depreciation and monetary expansion ; inflation (imported through depreciation and direct through monetary expansion)

50 Currency Union: current tensions in the euro area Southern Europe (Italy, Spain, Portugal, Greece) face adjustment problems(fiscal and external). Large current account deficits and negative shocks cannot be offset by an exchange rate depreciation. Cost of fiscal adjustment larger with fixed exchange rates. International transfers and labor mobility are not large. One way of adjusting seems to have real wage growth slower than other euro area economies. Tough in a low inflation environment. Other solutions?

51 Does it hurt? Macroeconomic effects of fiscal consolidation Source: IMF 2010

52 Summary In the short-term, exchange rates are influenced by interest rate movements, expectations, risk premia. However, the majority of exchange rate fluctuations are difficult to explain bymacrofactorsintheshortrun. With flexible exchange rates, globalization reduces the effectiveness of fiscal policy for stabilization but increases the effectiveness of monetary policy. Globalization increases the international spillovers of policies and the needs for international coordination. Countries with fixed exchange rates and free capital mobility loose their monetary policy autonomy. Currency unions are less costly if (i) business cycles are synchronized, (ii) fiscal transfers across regions are easily implemented,(iii) labor is mobile across regions.