4. SOME KEYNESIAN ANALYSIS

Transcription

1 4. SOME KEYNESIAN ANALYSIS Fiscal and Monetary Policy... 2 Some Basic Relationships... 2 Floating Exchange Rates and the United States... 7 Fixed Exchange Rates and France The J-Curve Pattern of Current Account Adjustment Central Bank Intervention Fixed vs. Flexible Exchange Rates Bretton Woods and International Institutions Reviewing U.S. Fiscal and Monetary Policy Experience Reviewing U.S. Intervention Experience The Assignment Problem Conclusion References Table 1 Countries Adopting the Euro Table 2 U.S. Monetary and Fiscal Policy Figure 1 The Keynesian View Some Basic Relationships... 3 Figure 2 U.S. Real Money Growth and Gov t Deficit/GNI Real L/T Rates, Income and Currency Figure 3 U.S. Reserves and $/SDR... 30

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3 Some Keynesian Analysis A major feature of the Keynesian view is that market prices do not adjust quickly to excess supply and demand conditions. The potential failure of markets to correct these conditions opens the issues of monetary, fiscal and exchange rate policy intervention. Keynes, effectively, argued for a larger government role (beyond maintaining defense, infrastructure and equal market access). He suggested that an activist government can (in some situations) improve upon market performance by managing aggregate spending, demand, and GNI. The primary GNI management tool is government spending (the G component of GNI.) The Keynesians' view also suggests more activist management of money supply. Their suggestion is based on an assumed inflexibility of prices and the interest rate sensitivity of the liquidity component of money demand. Exchange rate management also finds support under Keynesian analysis. Critical to the applicability of the Keynesian approach is some lack of flexibility in the money, product, capital, and labor markets. Others have argued that individuals can and do offset government policy initiatives, and that in both the medium- and long-run, these policy initiatives have no positive effects. Some examples of such offsetting individual responses are increasing prices as money supply is increased, demanding higher wages in the face of greater government spending, and lowering current spending to save for future tax liabilities or decreased services, which will result from current government spending and deficits. It is important to note that Keynesian analysis only requires that some of the activities listed do not occur. The activities offsetting government policy are assumed to be less than full. The less individuals offset government policy and the less sensitive market Some Keynesian Analysis - 1

4 prices are to changing conditions, the more Keynesian analysis is relevant. Fiscal and Monetary Policy The Keynesian view concentrates on the impact of monetary and fiscal policy initiatives on the domestic economy's mix of income, employment, prices, investment, and trade. Specifically, the Keynesian approach defines the transmission of policy initiatives and shocks to the economic system. Our predominant concern is to see how these initiatives and shocks affect exchange rates, interest rates, and output. Some Basic Relationships Figure 1 presents the basic linkages in a Keynesian model. In graph 1, the first link states that consumption grows with income, but at a less than one to one ratio. (Since some additional income is saved, consumption does not increase dollar for dollar with income.) The proportion of income spent on consumption is known as the marginal propensity to consume (MPC), which is less than one. The definition of the MPC leads to the multiplier concept. The multiplier concept works in the following way. Increased government spending, decreased taxes, increased investment or increased exports provide increased income to companies or individuals. These companies and individuals will, in turn, spend a proportion of this income equal to their MPC on other goods and services. As each subsequent consumer spends a proportion of their greater income on consumption, the multiplier process feeds on itself, albeit at a declining rate. An initial dollar of government expenditure stimulus leads to multiple increases in dollar income. Some Keynesian Analysis - 2

5 Some Keynesian Analysis - 3 FIGURE 1: The Keynesian View - Some Basic Relationships

6 Based on the multiplier principle, a $1 increase in government spending can lead to a large increase in GNI. (A bit lower than 1/(1- MPC), e.g. MPC equaling 0.8 yields a little less than $5 in GNI growth.) This large potential impact of government spending or tax cuts on GNI is known as the spending multiplier effect. The multiplier effect on GNI is largest when consumers spend most of their increased income on increased consumption of domestic products (MPC is high.) If consumers save a good deal out of an addition dollar of income, then the multiplier will be relatively low. The multiplier effect of increased government spending is decreased by the marginal propensity to import, MPI. A high MPI means that consumers buy a large proportion of imported goods with an additional dollar of income. Since increases in imports lower GNI, a high MPI implies that the government spending multiplier effect will be lower than it would be if increased domestic income is predominantly used to buy proportionately more domestically produced goods. Of course, imports from one country are the exports of another country. Since these imports stimulate the foreign economies, they also lead to domestic exports and greater domestic income from them. Therefore, the effect of the domestic country propensity to import in lowering the domestic multiplier is lessened by the foreign country propensity to import. Since the MPI helps to determine the effect of changing income on the trade account, the marginal propensity to import out of a dollar of income is also important for exchange rate determination. The measure of the sensitivity of imports to income changes is known as the income elasticity of imports. The relationship between income and imports is shown in Figure 1-graph 5. The relationship is positive, higher income leads to greater imports. Figure 1, graph 2 shows the relationship between investment in new projects and real interest rates. When real interest rates are low, Some Keynesian Analysis - 4

7 more investments have positive real risk-adjusted net present values. Hence more projects are undertaken, and the total value of these projects, which is investment, increases. Note here, that we are not saying that domestic saving is increasing with real interest rates. We must remember that the equilibrium real interest rate must be looked upon as the rate which equates the marginal values of current consumption and future consumption. For example, a high preference for current consumption will mean that savings are low, despite high real rates. Graphs 3, 4, 5, and 6 in Figure 1 are drawn under the assumption that the price and income elasticities of imports are relatively high. Imports increase with domestic income, and exports increase with the dollar value of foreign currency (S=$/FX). Imports rise with foreign income and a higher dollar value (low S=$/FX). These relationships show how the trade balance responds to exchange rate and income changes. Our implicit elasticity assumptions imply that rising income and imports worsen the current account, while a lower domestic currency value raises the current account. Though we have assumed that price levels are relatively constant, the impact of price changes on the current account can be interpreted similarly. Higher domestic prices lower the current account balance, just as a domestic currency appreciation does. Graph 7 shows a very important determinant of exchange rates in the Keynesian model. This determinant is the capital account. The real interest rate differential between the domestic and foreign countries is seen as changing the level of capital inflows and outflows. When domestic real interest rates are relatively high, foreign capital flows into the domestic country on net. The response of net foreign investment to real interest differentials is determined by the interest rate elasticity. When small real interest rate differentials lead to large net capital flows, net foreign investment is said to be elastic. Some Keynesian Analysis - 5

8 Finally, graphs 8 and 9 depict how interest rates and income affect money demand. Liquidity preference implies that money demand falls with increases in real interest rates (graph 8). The transaction demand for money implies that money demand increases with income (graph 9). When money demand falls, all else equal, inflation occurs and the domestic currency depreciates. Taken together, these nine relationships imply that equilibrium will only be sustainable at certain sets of incomes, rates and exchange rates. For example, high income will only be attained with high real interest rates. Otherwise, there will not be enough real money available to conduct the large number of transactions. Additionally, the high income will lead to a relatively large current account deficit. Only with high differential real rates will large net investment inflows offset the current account deficit in the balance of payments accounts. Therefore, a high income growth, high real interest rate, trade deficit and capital surplus scenario is sustainable. The Keynesian approach also allows us to interpret the trade-offs in the economy that are implied by different levels of income, investment, money supply and the balance of payments. We will outline the Keynesian approach through a particular set of scenarios. We do this analysis separately for floating and fixed exchange rate environments. The scenarios analyzed are based on a set of assumptions. The most important of these assumptions, and the one that we will state explicitly, is that prices are relatively stable. Currently, the stability of the general price level is not that bad an assumption. However, relative prices of different goods have changed markedly recently, as reflected by oil, metals, and agricultural commodities. In this case, then other monetary and long-run factors need to be considered. 1 1 A specific application of this assumption is in the money section (graph 8). Note that liquidity money demand is written as a function of real, not nominal, rates. This relation is only correct with little or no inflation. Some Keynesian Analysis - 6

9 Floating Exchange Rates and the United States In 1981, the U.S. faced unemployment and excess capacity. The resulting Reagan-led "supply-side" policy led to a massive fiscal expansion. This expansion came about predominantly from increased defense spending and decreased taxes. The expansion was accomplished with a policy of relatively tight money. The presence of excess capacity allowed this growth without inflation, as money growth was relatively low and stable. From 1981 to 1983, the following transmission of effects seems to have occurred. There was a massive increase in government spending, g. This increase led through the multiplier to an increase in income, an increase in imports, and a fall in the dollar (all else equal.) This chain of events is shown as row (1) in the diagram below. However, the increase in government spending led to massive government borrowing, and a rise in real U.S. interest rates as depicted in (2), below. Though this effect tended to decrease investment and then income, excess capacity existed at the time so that "crowding out" of private investment funds by government borrowing was not as severe as it might otherwise have been. The linkages discussed above and below are the following: g (1) gni (ex - im) = current account S (2) r i multiplier feedback (3) i f X M/P sterilization (4) S... (current account more) U.S. income began to grow strongly. However, the increase in real U.S. interest rates led to a huge net foreign investment inflow to the U.S., (3). Furthermore, the impact of this capital inflow on money supply was largely sterilized. Real money supply remained relatively constant, inflation slowed, and the capital inflow did not lower real rates. With sterilization, the large net foreign investment flows led to Some Keynesian Analysis - 7

10 an appreciating dollar. (The X indicates that a link, that normally exists, was broken by government action or otherwise not operative.) In the end, the increase in U.S. government spending led to an income effect which tended to lower the value of the dollar, and a real interest rate effect which tended to raise the dollar's value. The determinant of the predominant effect is the size of the interest elasticity of net investment flows relative to the marginal propensity to import (or income elasticity of trade.) With relatively open capital markets, the U.S. capital account interest elasticity is great, and the net foreign investment effects were predominant. During this period, the large capital inflows led to a rising dollar, which exacerbated the current account deficits which were set off by the income effect, (4). The rising dollar resulted in a shrinkage of the economic sector producing exports and competing with importers, the traded goods sector. Therefore, the ensuing expansion in the non-traded components of the service sector may not be that surprising. With a lower dollar, the traded manufacturing sector may rise again. Of course, structural changes also take place in an economy to accelerate or offset these resource reallocations. In countries that do not have open capital markets, the interest rate elasticity of foreign investment will be low. In these countries, an expansion of government spending with sterilization leads to a current account deficit, which can overcome the capital account effects. In this case, and unlike the U.S. in the early Reagan era, a depreciating currency is likely to result. We turn to consider government monetary policy, and, as an example, stylize the 1983 U.S. situation. During January of 1983, U.S. money supply growth increased a good deal. Since this nominal money supply growth did not lead to significant inflation, real money supply grew in The effects of real money supply growth can be traced out, in a manner similar to that used to analyze the effects of expansionary fiscal policy. Some Keynesian Analysis - 8

11 When real money supply is increased, more money is available for transactions than is needed. Individuals use some of this money to buy financial assets, and nominal interest rates fall. With no inflation, real interest rates drop also. This link is depicted, below, in line (1). M/P (1) r i gni ( im with multiplier feedback effects) (2) i f S dependent on capital flow elasticity (3) im (& 1 im ) current account S (income effect predominates) The fall in real interest rates stimulates investment and income (both directly and via the multiplier effect). The fall in real interest rates also leads to a negative change in net foreign investment flows and a decline in the value of the dollar, (2). Furthermore, increased income leads to more imports, a worsening current account balance, and another source of a declining currency value, (3). Therefore, real money supply increases cause real interest rates to fall and the domestic currency to depreciate. growth is signaled. In this case, the traded sector The two scenarios that we have analyzed highlight the linkages between government fiscal and monetary policy expansions, output, the exchange rate and real interest rates. Decreases in money supply and government spending stimulus can be analyzed similarly. Some Keynesian Analysis - 9

12 Based on these links and an assumption of relatively elastic capital flows for the United States, we have the following suggested linkages between policy initiatives and foreign currency value changes relative to the dollar: Tight M/P gni r elastic capital flows S dominate income effect Loose g r gni Loose M/P gni r raise income, while the S interest effect is mixed Loose g r gni Loose M/P gni r mixed income effect interest S rate effect will dominate Tight g r gni Tight M/P gni r mixed interest rate effect S dominant income effect Tight g r gni From 1981 to 1985, with the exception of January 1983, tight money growth and loose government spending led to high real interest rates and a high dollar value. With more money growth and large federal deficits (i.e. g, the dollar fell through In 1989, the dollar rose again. Certainly during this period of exchange rate changes, resources were reallocated between the traded and nontraded sectors. To the extent that these shifts were costly, the U.S. may have lost out from policies that didn't consider and incorporate exchange rate changs. Unless world income growth and interest rate growth differentials come more into line, real exchange rates will continue to change, and a series of resource shifts are likely to continue. Fixed Exchange Rates and France Our consideration of fixed exchange rates will center on an historical relationship between the French franc and the Deutschemark. The value of the franc was pegged to the Belgian/Luxembourg franc, Danish krone, Deutschemark, Dutch Some Keynesian Analysis - 10

13 guilder, Italian lira, Irish pound, Portuguese escudo and the Spanish peseta. This system of pegged exchange rates is known as the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). ERM currency values were first fixed in 1979, and the parities were reset from time to time. The longest period of stability ran from This fixing of exchange rates necessitated coordination of monetary, fiscal, investment and trade policies among the countries with currencies in the ERM. Changes in the parities indicated that this coordination was not being achieved. A major revaluation occurred in 1987, and the lire was devalued in January During the period, the French franc remained fixed in value relative to the Deutschemark. This situation was caused by some basic changes in the economic policy of the Socialist government. To see what necessitated this policy, we will use the Keynesian view to depict the economic policy alternatives and their effects. The ERM was also known as "the snake", as the exchange rates between the currencies had to remain within agreed upon bounds around their assigned parities (or the inside of the snake). Importantly, the values of these currencies floated as a basket together against the dollar, and most other currencies. The ERM rates and the ranges around these rates (divergence limits) in which the currencies had to trade relative to each other were reported regularly. In 1992, the current rates and divergence limits were the following: Some Keynesian Analysis - 11

14 Currency Parities in the EMS Exchange Rate Mechanism (Financial Times, 7/31/92) One EMS Divergence unit costs Limit (±) One DM costs Belgian/Luxembourg franc % British pound sterling % Danish krone % Deutschemark % ( EMS unit = 1 DM) French franc % Dutch guilder % Irish punt % Italian lira % Portuguese Escudo % Spanish Pesata % Historically, the ERM French franc value was devalued relative to the Deutschemark. In 1982, the French government was pursuing expansionary monetary and fiscal policies, while other ERM countries were not. Furthermore, the French also restricted foreign capital flows. Symbolically, we can analyze this scenario as follows: g (1) gni im current account pressure S (relative to $) (reserve outflow in ERM) (2) r X i f tendency for S but capital flow restricted and M (3) r X if S (capital flow restricted, but some left, relative to $) (reserve outflow in ERM) (4) P current account S tendency from PPP We find that the income and price effects led to pressure on the franc to devalue, and France had to run down its reserves unless capital in-flows compensated. Instead, net capital outflows fluctuated wildly. S/T capital inflows decreased. Foreign direct and other L/T investment were negative balances, while portfolio investment was positive. The net effect was that the expansion failed to bring in foreign investment at levels sufficient to sustain the huge income- (and price-) driven current account deficits. Some Keynesian Analysis - 12

15 Due to the reality of exchange restrictions, less net foreign investment occurred. Without this effect, link (2) above, this potential franc demand failed to buoy the currency s value. The fact that exchange restrictions limited the foreign net investment response to real interest rate changes is indicated by the X breaking the link. Net capital inflows did not occur, and the franc was overvalued. As a result, the Central Banks of the other countries in the ERM were required to buy French francs. When these reserve flows grew too large, the ERM revalued the DM and Dutch guilder and devalued the other currencies. (Revaluation is increasing a fixed currency s relative value, the opposite of devalue.) Under fixed exchange rates, foreign exchange reserves are a measure of the likelihood of devaluations. Furthermore, when exchange rate changes do come between two "fixed" or pegged currencies, a jump in the relative values of the currencies occurs. With the rundown in French reserves and run up in German and Dutch reserves, the franc was devalued in March Over the 1990s, the need for such adjustments diminished, and 11 European Union countries decided to adopt a common currency on January 1, The adopting countries and associated valuations are listed in bold in Table 1 below: Some Keynesian Analysis - 13

16 Table 1 Countries Adopting the Euro Currency Exchange Currency Date of Rate Rate Currency Name Abbreviation Country Establishment 1 EUR = Austrian schilling ATS Austria 31 December Belgian franc BEF Belgium 31 December Danish krone 3 DKK Denmark 31 December Deutsche mark DEM Germany 31 December Finnish mark FIM Finland 31 December French franc FRF France 31 December 1998 Monégasque franc MCF Monaco Irish pound IEP Ireland 31 December Italian lira ITL Italy 31 December 1998 Sammarinese lira SML San Marino Vatican lira VAL Vatican City Luxembourg franc LUF Luxembourg 31 December Dutch guilder NLG Netherlands 31 December Portuguese escudo PTE Portugal 31 December Spanish peseta ESP Spain 31 December Greek drachma GRD Greece 19 June Estonian kroon 3 EEK Estonia 27 June Lithuanian lita 3 LTL Lithuania 27 June Slovenian tolar SIT Slovenia 27 June Cypriot pound CYP Cyprus 29 April Latvian lat 3 LVL Latvia 29 April Maltese lira MTL Malta 29 April Slovak koruna SKK Slovakia 25 November 2005 Countries in bold are the original 11 members on January 1, Subsequently, Greece (2001), Slovenia (2007), Cyprus (2008), Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014) adopted the Euro, and Lithuania is scheduled for adoption in Denmark and the U.K. are exempted from adopting the Euro under the Maastricht Treaty of 1992, though Denmark still maintains its ERM parity. All other countries must meet the ERM parity conditions for twoyears prior to adopting the Euro. 1. Before 17 March 2007, the exchange rate was 1 EUR = SKK. 2. Before 8 July 2008, the exchange rate was 1 EUR = SKK. 3. Euro adoption has not yet taken place for Denmark, Estonia, Latvia and Lithuania. The experience of the countries using the Euro as their currency has been mixed. Trade, labor mobility, and cross-country investment and wealth have flourished. However, production has tended to center in areas that were most productive prior to the common currency. Furthermore, a well-worn path of adjustment for poorer nations has been precluded. Some Keynesian Analysis - 14

17 Nations using the Euro can no longer allow their home currency to depreciate to improve the competitiveness of their local production for export. At the same time, this depreciation makes imports more expensive. Both of these changes improve the trade balance, and return domestic production competitiveness, albeit at a lower profit level. The massive credit default of the PIGS (Portugal, Italy, Greece, Spain) might not have occurred or at least have been less violent if the floating exchange rate buffer had remained. The 50% write down of Greek debt was a defacto devaluation of the Euro for the purpose of repaying Greek debt. Of course, the heavy-handed debt renegoation wasn t called a selective Euro devaluation. Despite the difficulties of some countries that have adopted the Euro, more countries seek to adopt the currency. The J-Curve Pattern of Current Account Exchange Rate Adjustment By assuming that a depreciating domestic currency value corrects a balance of payments deficit (and appreciation corrects surplus), we have assumed that immediate substitutes are available for traded goods and services. Lower export prices may not lead to significant export growth or import reduction. A measure of this trade characteristic is known as the Marshall-Lerner condition (which is named after its developers). This condition is based on the sensitivity of export and import demands to exchange rate changes. These sensitivities are measured as the export and import elasticities with respect to exchange rate changes. When the absolute value of the sum of the export and import exchange rate demand elasticities of a country is less than one, then a domestic currency depreciation will worsen, not improve, the trade balance. When this absolute value is greater than one, then a depreciation should improve the trade balance. The condition, in which elastic demand responses to a depreciation improve the trade Some Keynesian Analysis - 15

18 balance, is known as the Marshall-Lerner Condition. It is stated algebraically as d x + d m > 1 and s x = s m = and d x elasticity of demand for domestic country s exports d m elasticity of demand for imports by domestic country s x elasticity of supply of domestic country s exports s m elasticity of supply of foreign country producing imports infinity If d x + d m > 1, then the depreciation of a country's currency relative to its trading partners improves the country's balance of payments. Since elasticities of demands are determined by the availability of substitutes, (the more substitutes, the more elastic is demand), the Marshall-Lerner condition is likely to hold across countries with substitutes for their import needs. 2 In the short-run, is it reasonable to assume such a relatively high price sensitivity for trade flows? Probably not. Instead, we should recognize that import substitution takes some time. Many purchases cannot be adjusted immediately following a price change. Therefore, a price increase leads, first, to an increase in seller's revenue. Overtime, substitution occurs, sales fall, and revenue falls. For countries, price may be viewed as the exchange rate deviation from purchasing power parity value, and net international revenue is the current account surplus or deficit. Analogously, limited trade substitution should imply that domestic currency appreciation is followed immediately by current account improvement. In the medium- to long-run, the current account should worsen. For domestic currency depreciations, a pattern of a rapidly falling current account, and then a significant rebound and rising current account should result. This phenomenon has been called the J-Curve. 2 Developing countries may have inelastic demands for the very commodities needed for their development (no substitutes). Therefore, a devaluation may well worsen these countries trade deficits. In these cases, managed exchange rates are all but necessary. Some Keynesian Analysis - 16

19 Specifically, the J-Curve is an empirical phenomenon, which documents how the trade balance responds to a devaluation under fixed exchange rates or a significant depreciation under flexible exchange rates. The response is hypothesized to resemble a "J" over a period of 6 months to 2 years. After a devaluation or depreciation, the trade balance worsens before finally improving. In the short run, it is harder to change buying practices than in the long run. (This is especially true internationally since order delivery and payment lags can run to a year or more.) As a result of this difficulty, substitution is much harder in the short run than in the long run. Therefore, short-run import demand elasticities are lower than long-run elasticities. Short-run demand elasticities, as reflected in the ability to substitute, are not likely to satisfy the Marshall-Lerner condition. Initially following a devaluation, the trade balance worsens until substitution can occur readily. After a period of six months to two years, the trade balance deficit will finally improve (if the longer-run import demand elasticities are great enough in absolute value to satisfy the Marshall-Lerner condition). The J-curve phenomenon is important, because it implies that a country that is devaluing its currency must have reserves available to support the resulting short-run worsening of the current account balance. Otherwise, a series of devaluations or other measures may have to be used to correct a balance of payments deficit problem. The J-curve also has implications for floating rate currencies. When a currency depreciates, increasing export demand and decreasing import demand are two things that will cushion its descent. However, the J-curve phenomenon suggests that when a currency depreciates, an increase in exports or decrease in imports will take a while to materialize. As a result, a currency is likely to overshoot its longer-run equilibrium level. Some Keynesian Analysis - 17

20 Production efficiencies, resource availability, tastes and money growth largely determine the long-run exchange rate. Overshooting the long-run exchange rate means that transitory factors have led to current account or basic balance account imbalances, which actually feed on themselves to drive the current exchange rate away from its long-run value. In a completely free market, an alternative to J-Curve-linked overshooting is an officially managed currency depreciation. Of course, this policy requires that the policy makers in the associated country's central bank have a pretty good idea about the size of the import demand and export supply elasticities and the longer-run equilibrium exchange rate. They must also be willing to subsidize speculators, who will trade against them. Needless to say, the existence of this knowledge and resources may not be the case. Incorrect intervention may only postpone a further and more dramatic currency value change with tremendous overshooting and adjustment costs. Central Bank Intervention The Keynesian view highlights a trade-off between short-run exchange rate changes and central bank intervention. If the short-run costs of flexible exchange rate-induced resource reallocation is high, then central bank intervention, which maintains the exchange rate at or near its long-run equilibrium level, can be justified. For example, net foreign investment inflows can lead to a higher domestic currency value and a current account deficit. In response to the short-run investment demand shift, the central bank of the country facing the domestic currency appreciation is likely sell the domestic currency to keeps its value near the long-run current account-determined equilibrium. The central bank will sell its currency to offset the increased investment demand. Such intervention against current market direction is known as "leaning against the wind." However, if the central bank is not right Some Keynesian Analysis - 18

21 (and the short-run is not relatively short), then it will be unsuccessful and lose money. In this scenario, the bank initially runs down reserves. It buys its own depreciating currency and sells the appreciating foreign currency. If unsuccessful, the central bank buys back more expensive foreign currency. Sell low-buy high strategies lose money. Over time, central banks have lost money. If their intervention is unsuccessful, then the cost of replenishing foreign currency reserves will be high. As these losses have been pervasive, they lead to an interesting exchange rate forecasting implication. A current account deficit associated with an investment account surplus should be accompanied, initially, by a reserve inflow, to be followed by a reserve outflow. With time, the current account deficit reserve inflow will be paid off as interest or dividends on the capital inflow, or exports (which may rise from increased international competitiveness). Correcting the current account deficit necessitates a currency depreciation in both cases. (The effects of capital outflows are analogous, but opposite.) These links indicate that an increase in domestic foreign exchange reserves should be associated with a domestic currency appreciation for two reasons. First, increases in foreign currency reserves indicate that the central bank is leaning against the wind and the domestic currency is undervalued on a capital account basis. This imbalance indicates that the currency is likely to rise in value in the future. Subsequently, the current account will be in deficit due to the overvaluation of the domestic currency for trade purposes. The resulting reserve inflows are indicative of a needed domestic currency depreciation. The links associated with intervention to support a depreciating currency are the opposite. In both cases, reserve flows may provide information on future exchange rate movements. 3 3 A complication arises with this interpretation because reserves are foreign currency. Countries with predominantly dollar reserves will find reserves "increasing" as the dollar rises. (U.S. currency reserves rise with a falling dollar.) Some Keynesian Analysis - 19

22 Due to the relationship between foreign exchange reserve balances and successful central bank intervention, a potential flaw exists in this interpretation. When a country supports its currency, it will draw down its reserves. With successful intervention, increases or decreases in domestic foreign exchange reserves should lead to a relatively stable domestic currency. Successful interpretation of the link from reserve flows to potential exchange rate changes requires identification of intervention as "leaning against the wind" or "successful." Over the long run, the status of the domestic currency's purchasing power and the country's basic balance should provide evidence on the likelihood of central bank "success." Central bank support for a currency that is overvalued on a purchasing power basis and that has a weak basic balance is likely to be "leaning against the wind." (To put it the nice way.) The issue of whether or not central bank intervention is warranted is brought out clearly by the alternative money-based and current account-based Keynesian exchange rate models. In the first case, all that needs to be and can be managed is the differential impact of money growth on relative inflationary expectations. In the second case, real costs are associated with short-run currency market disequillibria, and a much broader role can be justified. This difference of views is only one point of argument between the Keynesian and monetarist-neoclassical view. Under the first view, broad government economic and market intervention is warranted. Under the second view, it is not. Historically, the differences in these views have focused on the efficacy of activist monetary, fiscal, and exchange rate policies. Fixed vs. Flexible Exchange Rates The issue of whether to have fixed or floating exchange rates is a complicated one. Basically, fixed exchange rates are best for allowing an economy to respond to transitory changes in international Some Keynesian Analysis - 20

23 competitiveness (price changes), and when changing external factors dictate that a domestic policy response is in order, i.e. a country's fiscal policy is way out of line with its trading partners' policies, e.g. France in the early 1980 s and the U.K. in With fixed exchange rates, the foreign sector has a direct effect on the domestic economy. For countries sharing a large amount of trade and investment, the coordination necessary to maintain these links is probably warranted. The gains are the reduction of short-run uncertainty and the coordination of market conditions. The countries in the Euro area provide a good example. Another issue on whether fixed or flexible exchange rates are more appropriate for a country is linked to the change or shock to which the economy is exposed. When shocks come from external demand for an export item, such as tin, copper, oil or coffee, flexible exchange rates allow a country to adjust to this shock more slowly. The effect on the money supply is lessened, while changes in relative prices can signal a reallocation of resources. When shocks are internally motivated, due to policy initiatives, flexible exchange rates will limit fiscal policy initiatives, and fixed exchange rates will limit the effectiveness of monetary policy. These limitations will be especially strong when capital flows are elastic. In the end, the choice of flexible over fixed exchange rates comes down to allowing the governments to retain one extra policy tool to manage external and internal shocks, or not. The costs of this extra tool are short-run exchange rate variability, and potentially longrun misallocation of resources when government policy is out of step with changes in international markets. Though obvious, the fact that a stable economic environment is needed for stable interest rates and exchange rates is often forgotten. Historically, this stability has come when one power is so strong economically that it can keep its currency's value relatively fixed. Given this ability, other countries use this stable currency as the means to quote prices. These countries also attempt to keep their Some Keynesian Analysis - 21

24 currency value fixed relative to this benchmark. Usually, the strong currency will not be actively devalued or revalued. Instead, the lesser trading partners adjust their currency values as needed. The U.K. served the dominant country role in the late 1800 s and early 1900 s (the Victorian and Edwardian eras), as did the U.S. in the post-world War II period until As long as these countries were able to keep their monetary and fiscal houses in order, fixed exchange rates were feasible. Of course, the maintenance of a "fixed" currency value required that these countries adjusted their economies to international investment and trade factors. (In actuality, other countries adjusted their economies.) To the extent that the U.K. and U.S. were dominant world economic forces, the necessity of their adjusting to external factors was limited. Once their relative strength waned, the implications of necessary adjustments caused the abandonment of fixed rates. Unless such a dominant economic entity does exist, fixed exchange rates require coordinated policy across countries, as well as institutions that encourage long-term coordination. Bretton Woods and International Institutions At the Bretton Woods Conference in 1944, the need for monetary policy coordination was recognized. Despite the predominance of the dollar and its use as the reference currency, the difficulty of orchestrating the necessary economic harmony to maintain fixed exchange rates was apparent. Therefore, a set of institutions was established to help countries maintain their agreed-upon currency values. The most important of these institutions were the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD or World Bank). The IMF is a central banks credit union. Each country's vote in this union is based on its contributions to the Fund. The size of the contribution is determined by economic power and share of world trade. The member countries' funds are deposited as "quotas" of Some Keynesian Analysis - 22

25 gold, convertible currencies, and their own currency. Then, should any of the member countries encounter Balance of Payments problems, they can draw on these funds to augment their reserves. However, the ability to draw on these reserves is restricted. The borrowing restrictions are delimited by the existence of borrowing tranches. The first tranche is backed by the country's own gold and foreign currency deposits. An amount of foreign currency equivalent to the value of the first reserve tranche, at current exchange rates can be borrowed indefinitely. The second tranche, which is up to 25% of own currency deposited, is also pretty much unrestricted. The maximum borrowing is 125% of the gold and convertible currency deposits. However, borrowing beyond the 25% level requires IMF approval. This approval is forthcoming when the country experiencing the balance of payments problem is reviewed by an economic team from the IMF. This team makes macro-economic policy suggestions and sets targets which become conditions to be satisfied before additional funding is given. This basis for significant IMF lending is known as conditionality. After the early 1970's, it become apparent that many countries, and especially the non-oil exporting less developed countries (LDC's), faced protracted balance of payments problems. Quotas were significantly expanded. Nevertheless, the IMF conditions that were necessary to correct these problems in a relatively short time would have killed any hope for growth and political stability in these countries. Therefore, members of the IMF voted to establish special funding facilities to assist in overcoming balance of payments difficulties arising from commodity price, oil, and other economic shocks. The funds deposited in these facilities are available to countries experiencing balance of payments problems arising from these shocks. The funds themselves were initially drawn from two sources. First, new deposits were made by the countries with stronger Some Keynesian Analysis - 23

26 economies. borrowers. Second, the IMF issued its own paper money to the IMF money is known as special drawing rights (SDR). Holders of SDR's are entitled to exchange them for the currencies in the basket underlying the SDR. Originally 16 currencies made up the SDR basket with varying weights. In the 1980's, the SDR currency basket was changed to include only five currencies. These currencies are the U.S. dollar, British pound, Deutschemark, Japanese Yen and French Franc. The issuance of SDR's transferred some of the benefit of issuing world-wide currency, or seignorage, from the U.S. to the set of countries with currencies in the SDR. The lending of the SDRs to LDCs provided a means to give the seignorage benefits to these borrowing countries. As the issue of SDR's is just the creation of more money, the outstanding SDR stock can be tracked to measure world-wide inflation pressures. Unfortunately, the IMF and its associated programs are not viewed as having been successful agents for development. Of course, this goal was not their mandate. The institution has been successful in encouraging currency convertibility. One of its publications, the Survey of Foreign Exchange Controls has been a force in moving towards this goal. As well as being an indispensable guide for those exchanging currencies in international business, the survey serves as a central bankers report card. Based on the IMF review, countries have been motivated to improve the convertibility of their currency. Under the Bretton Woods system, the task of development aid was given to the World Bank. A potential World Bank advantage in undertaking this task is their use of project-based financing. On this basis, as long as projects undertaken with their funds are profitable, they can be and generally have been repaid. Some Keynesian Analysis - 24

27 This record will be harder to keep in the future as the World Bank is forced to take on economy-wide problems. However, the Bank segregates its less economically viable projects in the International Development Agency (IDA). The massive trade-offs existing at the macroeconomic level between the environment, market structure and growth will be examined there. Another World Bank subsidiary is also of interest, the International Finance Corp (IFC). This subsidiary is involved in encouraging and funding world capital markets. Since a very high percentage of World Bank projects are backed by general debt obligations of the World Bank, the innovativeness and success of its own funding is important. In this area, the World Bank has hired some solid market-oriented finance talent. Along with the IMF and World Bank, three other international institutions should be mentioned. First, the General Agreement on Trade and Tariffs (GATT) is a strong force for free trade. Its mandate is to coordinate agreements for less restrictive trade, and to serve as a review board for trade complaints. Under the GATT, the Uruguay round of talks established the World Trade Organization (WTO) in Second, the Bank for International Settlements (BIS) is the central bankers' bank. The bank clears and invests central bank funds. These investments are profit motivated. Like the World Bank in managing its funding task, the BIS has been successful in performing its investment management function. As an unbiased party, its Annual Report provides one of the best reviews of the world economy s past and potential performance. Third, the Organization for Economic Cooperation and Development (OECD) serves the purpose stated in its name among the major non-ex-communist industrialized countries, Yugoslavia was an exception, now out. Given recent trends, its membership base is broadening. Besides providing a forum for discussion among the policy makers from its member countries, the OECD publishes a Some Keynesian Analysis - 25

28 broad range of statistics, analysis and reports on the state of the world economy. Like the BIS reports, OECD analysis and reports are relatively unbiased. To conclude this section, we revisit the statement that economic cooperation and coordination are necessary for stable exchange rates and interest rates. The institutions that we have discussed were predominantly created after World War II under the Bretton Woods agreement to accomplish this aim. Though relatively successful, new initiatives are needed to reach the goals of Bretton Woods. Assuming that these goals make sense in the current economic environment, we do not envision a stable exchange rate system until these institutions are significantly strengthened. Reviewing U.S. Fiscal and Monetary Policy Experience Our interpretation of the Keynesian view suggests that real interest rates, real income and the exchange rate should be related to the levels of monetary and fiscal policy. Figure 2 depicts the history of U.S. policy variables in the first panel, and real rates, real income and foreign currency values in the second panel. The real money growth variable is calculated as growth of money and quasi-money in excess of inflation. The deficit variable is the government cash deficit as a percentage of GNI. Looking at the data since1970, there are 17 policy intervals. These intervals are listed chronologically in Table 2. Policy changes are identified relative to the 1970 to 2015 period averages. We look to see if the policy initiatives are related to yields and income changes as suggested by the Keynesian view: Tight g Loose M/P Loose g Tight M/P r gni S gni r r gni S gni r Loose g r gni S Loose M/P gni r Tight g r gni S Tight M/P gni r In Table 2, we find six periods in which policy was stable for three years or more is the first such period. Some Keynesian Analysis - 26

29 Tight g-loose M/P: During the period, fiscal policy was tight, while monetary policy was relatively loose. A Keynesian view has real rates falling, income mixed and foreign currency rising in value. During this period, yields were low in three out of four years, but the yield change was high in two out of three years. Income growth was high in all three years, and foreign exchange was both up and down in two year sub-periods. However, FX was up roughly 10% overall. The level of yields, and the exchange rate changes roughly match theory, whereas income growth and yield changes don t match as well and are the other tight fiscal and loose monetary policy periods. Yields are high in the first period and low in the second, while yield changes are uniformly low (negative) in the first and mixed in the second. In both cases, real yield was lower by period end, which is consistent with the Keynesian view had strong income growth, but had mixed income growth that averaged less than the full period average. Income growth is undetermined for the tight g/loose M case. With regard to currency, the dollar strengthened in the first sub-period, and weakened in the second consistent with the hypothesized relation. Some Keynesian Analysis - 27

30 Some Keynesian Analysis - 28 FIGURE 2 - U.S.

31 Table 2 U.S. Monetary and Fiscal Policy Changes in Fiscal & Monetary Real Yield Real Yield income FX Reserves tight, loose low #N/A #N/A up spend low high high up spend high high high down buy low low high up spend tight, tight low low low up buy loose, tight low high low down buy loose, loose low high high down buy tight, loose low low high up spend low low high up spend tight, tight low low low down buy low low low down buy high high high down buy loose, loose high high low down buy high high high down buy high high high down buy high low high up buy high low low up spend loose, tight high low high up spend high high high down buy tight, tight high low low down buy loose, tight high low low up buy high high low down spend high high high down spend high low low down spend tight, tight high high high up spend tight, loose high low high up buy high low high down spend high high high down spend high low high up buy high low high down spend high low high down spend low low low down buy tight, tight high high low up buy loose, tight low low low up spend low low high up spend tight, loose low low high down spend low high high up spend low high low up spend low low low down spend loose, tight high high low up buy low low high down spend loose, loose low low low down buy low high low down spend high high low down spend low low low down spend low high low up spend 2015 Loose, tight, high, and low are assigned relative to the period averages. Some Keynesian Analysis - 29