Session 16. Review Session

Transcription

1 Session 16. Review Session The long run [Fundamentals] Output, saving, and investment Money and inflation Economic growth Labor markets The short run [Business cycles] What are the causes business cycles? How does the economy respond to shocks? How to stabilize business fluctuations? Extending the model [Policies, exchange rates, currency unions] Basic Definitions Output in the economy is distributed between consumption, investment, government purchases and net exports: GDP = C + I + G + NX Production leads to income and income gets allocated to For the world (closed economy) GDP+NFP = C+ S priv + T S gov + S priv = S = I This equation represents the balance between those who want to transfer current income to the future and those who want to bring future income into the present. The real interest rate is the price that equilibrates these two flows. 1

2 Saving and Investment: Loanable Funds r Investment Saving Saving increases if: 1. Current output increases 2. Expected future output decreases 3. Wealth decreases 4. Taxes increase 5. Government spending decreases Equilibrium Real interest rate Investment increases if: 1. Productivity increases 2. Taxes on capital decrease Saving, Investment Growth in the Long Run GDP Per Capita (US) New Economy World War I 1981 monetary contraction World War II Industrialization Railroads Oil Shocks Constant growth (1.85%), but based on continuous effort to innovate, to improve processes, and bounce back after shocks The Depression of the The Great Depression 1890s

3 Long-run Growth: Catching up (or not) GDP Per Capita (PPP) US 10 Singapore 9.5 Venezuela Long-run Growth: Investment Growth is about the ability to use current resources into building a productive stock of physical capital, human capital and knowledge. Growth GDP per capita (%) Sierra Leone Investment and Growth USA Brazil France Chile India Botswana Mauritania Singapore 0 Venezuela Niger -2 Investment in physical capital (% of GDP) Period: Korea China 3

4 2 Institutions Matter Institutions are the main determinant of investment and growth. Oil Producing Countries Norway 1.5 Chile Poland Singapore 1 India USA Institutional Quality Liberia Niger Indonesia Namibia Brazil Greece UAE Saudi Arabia Lebanon Russia China -1.5 Venezuela GDP Per Capita (2010) Summary on Economic Growth: The Four I s Innovation Initial conditions Investment Institutions The incentives to innovate (e.g. respect of intellectual property rights) will shift the technology frontier. This is the main force behind growth in the developed countries. Provides the potential for catching up. Poor countries can grow faster when they set on a convergence path to the rich economies A key ingredient in the process of convergence is the building up of the capital stock. This requires high investment rates. Miracles are countries with investment of over 25% of GDP. In addition to physical investment, it is important to invest in human capital, efficiency, technology What drives investment: stability, institutions. The best way to ensure sound macroeconomic policies (i.e. stability) and political stability is to build institutions that create incentives for stability: Independent central bank, checks and balances, rule of law, transparency. US, Japan, France, Germany China today, Singapore in 80s High growth (Korea) 35%; Steady state (US, Germany) ~ 18% There is not a single country that has become rich with poorquality institutions 4

5 The Long-Run Dichotomy %ΔM + % Δ V = Inflation + Real growth Inflation rate (percent, logarithmic scale) 10,000 1,000 Georgia Democrati c Re publ Ni caragua of Congo Angola Brazil 100 Bulgaria 10 Kuwait Germany 1 USA Oman Japan Canada ,000 10,000 Money supply growth (percent, logarithmic scale Percentage change in nominal exchange rate Inflation and the Nominal Exchange Rate Long-run Dichotomy % change in RER = % change in NER + Domestic inflation - Foreign inflation Sweden Australia New Zealand Spain Ireland Canada South Africa France UK Belgium 0-1 Germany Netherlands - 2 Switzerland - 3 Japan Inflation differential Italy Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar Source: Mankiw (Fig.5.13). Averages for

6 The Long-Run Dichotomy Why did Italy have consistently higher nominal interest rates than Germany and a depreciating currency when they had their own monetary policy? Because inflation was higher in Italy (and inflation was the result of faster money growth) Germany Italy Nominal Interest Rate 7.2% 11.8% Money Growth 6.5% 10.1% Inflation 3.2% 7.7% Depreciation of Nominal Exchange Rate (average annual depreciation of the Italian Lira relative to the German Mark) 4.9% Average over From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies 6

7 Global Imbalances Output in the economy is distributed between consumption, investment, government purchases and net exports: We can rewrite this equation as: Y = C + I + G + NX S - I = CA Trade and capital flows are recorded in the balance of payments Global Imbalances CA surplus Saving Saving World Real interest rate Investment CA deficit Investment Saving, Investment Saving, Investment 7

8 Global Imbalances Current Account as % of World GDP Income - Spending US Europe Deficit OIL DEU+JPN CHN+EMA Others Europe Deficit: Bulgaria, Greece, Hungary, Ireland, Portugal, Spain, United Kingdom, From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies Increases in oil price: surplus in oil economies High saving rates Global Savings Glut Global imbalances Low Interest Rates Increase in borrowing and spending in some advanced economies (US) 8

9 Business Cycles: Definitions, Characteristics Business cycles are transitory deviations of output from its trend. Business cycles do NOT affect output trend Output and potential output UK 6 Output gaps UK GDP Potential Germany Japan United Kingdom United States The IS/LM Model Changes in the economic environment lead to changes in demand. In the short run demand determines output. If demand is below potential, the economy is in a recession, if demand is above potential the economy is in an expansion. Real interest rate Long-run aggregate supply Recession Overheating Y potential Output 9

10 General Equilibrium Real interest rate Long-run aggregate supply LM Equilibrium Real interest rate IS Y LR Output Phillips Curve (Japan) 10

11 Changes in the Economic Environment The long-run aggregate supply curve shifts to the right whenever the potential output in the economy increases: 1. Productivity in the economy increases 2. Factors of production (capital or labor) increase 3. Other growth conditions improve (political, macroeconomic stability, distortions) IS curve shifts to the right whenever the demand for goods goes up: 1. Government spending goes up 2. Taxes go down (including taxes on capital) 3. Investment or consumer confidence go up 4. Wealth increases 5. In the open economy demand for country s exports increases (or for imports decreases) LM curve shifts to the right whenever the liquidity in the economy increases: 1. Money supply increases 2. Prices decrease 3. Financial markets innovation reduces the need to hold money (velocity goes up) From the Great Moderation to the Perfect Storm Global Savings Glut Low Interest Rates Increase in borrowing and spending in some advanced economies (US) Increase in wealth Increase in asset prices 11

12 From the Great Moderation to the Perfect Storm Global Savings Glut Low Interest Rates Increase in borrowing and spending in some advanced economies (US) Financial innovation Search for Yield Central Bank faith in their model Increase in wealth Increase in leverage of financial institutions and investors Increase in asset prices Consumption and Wealth During those years, US wealth was increasing at a much faster rate than income (GDP). As a ratio to wealth, consumption decreased from 17% to 15% during But the collapse of housing prices and stock prices in 2008 revealed a very different scenario Wealth (% of GDP) US 12

13 r The expansion years As the world interest rate decreases, consumption in the US increases. In addition, financial innovation provides access to credit to more individuals. The increase in asset prices (wealth) increases consumption further. The central bank accommodates the increase in output as (CPI) inflation was never a problem. But this growth was unsustainable and ultimately leads to a recession when asset prices collapse. LM Interest rate World interest rate r* r* new IS Y Output Aggregate Demand Management Business cycle fluctuations might be an inevitable companion to economic progress but they do impose costs on the society: Output grows too fast Output grows slowly Inflation* Unemployment * But not in 2000 or 2007! Tools to stabilize business cycles Monetary policy: Fiscal policy: lower interest rates in recessions increase interest rates in expansions increase spending or cut taxes in recessions decrease spending or increase taxes in expansions 13

14 How Is Monetary Policy Conducted? The Taylor Rule. Interest rate target = Inflation + r N *(Inflation π T ) + 0.5*(GDP gap) 40 Monetary Policy: UK Central Bank Interest Rate Taylor Rule The Great Moderation: New Zealand Volatilit y Inflation Volatility Growth Volatility Inflation Inflation 14

15 From the Great Moderation to the Perfect Storm Low Inflation Low Interest Rates Low inflation expectations Financial innovation Central Bank faith in their model Great Moderation Increase in leverage of financial institutions and investors The IS/LM Model for a Small Open Economy There are two modifications relative to the closed economy: (1) The IS curve depends on Net Exports, and thus on the real exchange rate and on foreign income. (2) There is capital mobility: Domestic interest rates cannot be independent of world interest rates. Perfect capital mobility (driven by arbitrage) makes domestic and foreign interest rates equal: r = r* r World interest rate r* LM IS Y Appreciation Depreciation 15

16 The Open-Economy IS/LM Model The key mechanism in the open economy model is the following: 1. The change in the economic environment implies a change in the interest rate. 2. The new interest rate induces capital outflows (if it is below the world interest rate) or inflows (if it is above). 3. Capital inflows lead to appreciation of the currency (foreigners want to buy the currency to invest in the country), while capital outflows lead to depreciation. 4. In an economy with a floating exchange rate the appreciation will lead to decline in (net) exports and lower demand (while depreciation will have the opposite effect). 5. In an economy with a fixed exchange rate regime appreciation or depreciation is not allowed, hence monetary policy must intervene. The Impossible Trinity Key lesson: In a world with high capital mobility a country cannot fix the exchange rate of its currency and run at the same time independent monetary policy unless they restrict capital mobility. Independent monetary policy Fixed exchange rate Capital mobility A country can select only two of these options. 16

17 From the Great Moderation to the Perfect Storm Preference for liquid (US) assets Attempt to control exchange rates (China) Accumulation of foreign reserves (China, Japan) Global imbalances Low Interest Rates From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies Increases in oil price: surplus in oil economies Preference for liquid (US) assets Attempt to control exchange rates (China) Increase in World productive capacity High saving rates Global Savings Glut Low Interest Rates Low Inflation Accumulation of foreign reserves (China, Japan) Global imbalances Increase in borrowing and spending in some advanced economies (US) Low inflation expectations Financial innovation Search for Yield Central Bank faith in their model Increase in wealth Great Moderation Increase in leverage of financial institutions and investors Increase in asset prices 17

18 The confidence in financial markets Frederic Mishkin (Federal Reserve Board of Governors Member, ) in August 31, 2007: The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions. Policy response Policy in advanced economies had to focus on: - Avoiding an even deeper financial crisis (liquidity!) - Bringing the economy close to potential as soon as possible: Expansionary monetary and fiscal policies. Ideally we also want to improve potential growth (pro-growth reforms). 18

19 When a recession meets the risk of deflation (real) Interest Rate Investment Saving The lack of spending relative to income (the excess of saving relative to investment) might require a negative (real) interest rate. With deflation this becomes impossible! Central banks had to ensure that they did not get into a deflation/ liquidity trap. Need to raise inflation expectations. The End of the Euro Bubble 19

20 Before the crisis Low and stable inflation is the best policy (great moderation) Limited role for fiscal policy (lags, implementation) Financial regulation should be independent of monetary policy What we have learned Stabilizing inflation is not enough We might need more room to deal with major crisis (higher inflation target?) Financial sector is key to propagation of business cycles We need tools to deal with bubbles Fiscal policy is an important tool, but if we start with high debt levels, we are in trouble! Sovereign default crisis are possible in advanced economies Scenarios for the World Economy If we insist on austerity for everyone 1. Growth will remain weak. 2. Countries will be unable to stick to deleveraging plans. 3. Financial markets will have no confidence in governments. 4. Elections will be won by populist parties. 5. Bank runs will make some national financial markets unstable and lead some Euro countries to leave the Euro area. 6. The World Economy will go into a deep recession. 20

21 Scenarios for the World Economy If we understand that the long-run recipe is different from the short one 1. We stop co-ordinated austerity and we allow growth to come back. 2. Countries will be able to stick to (realistic) plans even if adjustment is slow. 3. Financial markets will stabilize and improve. 4. And if emerging countries get it right, the World economy will grow. 5. The Euro area will remain stable and return to growth. 21