Macroeconomic Policy and Short Term Interdependence in the Global Economy

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1 Macroeconomic Policy and Short Term Interdependence in the Global Economy Beggar thy Neighbor and Locomotive Policies and the Need for Policy Coordination Prof. George Alogoskoufis, International Macroeconomics, 2016

2 Interdependent Economies Our analysis up to now related to small open economies, which took developments in the rest of the world as given, since they were too small to influence them. In this lecture we analyze a short run Keynesian model of interdependent economies. This model is a two country variant of the Mundell Fleming model and the Dornbusch model for the global economy. Policies in one country affect macroeconomics developments in both the country itself, and the other country. Thus, they affect the path of the global economy. Prof. George Alogoskoufis, International Macroeconomics,

3 A Two Country Global Economy We assume that the world economy consists of two identical interdependent economies. Global variables such as international interest rates, international inflation and international output and employment levels are determined by the average of the monetary and fiscal policies of the two economies. Differences in monetary and fiscal policy between the two economies determine the nominal and real exchange rate of the currency of each country relative to that of the other, and the corresponding relative interest rates, relative inflation rates and relative output and employment levels. Prof. George Alogoskoufis, International Macroeconomics,

4 Global Monetary and Fiscal Policy A coordinated global monetary expansion leads to lower global interest rates, a rise in global output and employment and higher global inflation. A coordinated global fiscal expansion leads to a rise in global output and employment and higher global inflation, but also higher global interest rates. If these policies are perfectly symmetrical, then there is no impact on nominal and real exchange rates and the current accounts of the two economies. Prof. George Alogoskoufis, International Macroeconomics,

5 Unilateral Monetary and Fiscal Policies A unilateral monetary expansion in one country leads to a short-term nominal and real appreciation of its currency against the rest of the world, resulting in a short-term increase in output and employment in the country that undertakes it, an improvement in its current account, but at the expense of output and employment in the rest of the world, whose real exchange rate appreciates and whose current account deteriorates. ( beggar thy neighbor policy). A unilateral fiscal expansion in one country leads to a short and long term real appreciation of its exchange rate, an increase in international interest rates an increase in its output and employment and a deterioration of its current account. The current account deterioration mitigates the effects of the fiscal expansion on output and employment in the economy undertaking the fiscal expansion, and leads to an increase in output and employment in the rest of the world. ( locomotive policy) Prof. George Alogoskoufis, International Macroeconomics,

6 International Interdependence and the Need for Coordination of Monetary and Fiscal Policies The international interdependence of economies and the international spillovers of macroeconomic policies constitute grounds for coordination of monetary and fiscal policies worldwide, as the independent determination of monetary and fiscal policy by each country, does not take account of the spillovers to the rest of the world. The result is the excessive use of beggar thy neighbor policies, which have negative spillovers in the rest of the world, and the excessive avoidance of policies of locomotive policies, which have positive spillovers in the rest of the world. Prof. George Alogoskoufis, International Macroeconomics,

7 A Short Run Model of Interdependent Economies Equilibrium in the Goods and Services Market e y 1 = αg 1 β(i 1 p 1 e y 2 = αg 2 β(i 2 p 2 ) + γ y 2 + δ (s + p 2 p 1 ) ) + γ y 1 δ (s + p 2 p 1 ) Equilibrium in Domestic Money Markets m 1 p 1 = y 1 * εi 1 m 2 p 2 = y 2 * εi 2 Prof. George Alogoskoufis, International Macroeconomics,

8 The Determination of Nominal Interest Rates and Inflation Equilibrium in the Foreign Exchange Market (uncovered interest parity) i 1 = i 2 + s Gradual Price Adjustment p 1 p 2 = π 1 + λ(y 1 y 1 * ) = π 2 + λ(y 2 y 2 * ) Prof. George Alogoskoufis, International Macroeconomics,

9 Definitions y is the log of real aggregate income, p the log of the price level, g the log of the aggregate fiscal stance, and i the nominal interest rate. s is the nominal exchange rate (units of the currency of country 1 relative to the currency of country 2). The log of full employment income y* is assumed exogenous. π is long term inflation, also assumed exogenous. λ is the speed of adjustment of prices to excess demand for goods and services. α,β,γ,δ and λ are positive constant parameters. The two economies are interdependent because, 1. aggregate income in each of them affects the aggregate income of the other, through the demand for imports, 2. the real exchange rate affects the income of each economy trough net exports, and 3. their interest rates and exchange rates are linked through uncovered Prof. George Alogoskoufis, International Macroeconomics,

10 Macroeconomic Interdependence The two economies are macroeconomically interdependent through three channels: 1. Aggregate output and income in each of them affects aggregate demand, output and income in the other, through the demand for net exports. 2. The real exchange rate affects aggregate demand, output and income of each economy through the demand for net exports 3. Their interest rates and exchange rates are linked through uncovered interest parity. Prof. George Alogoskoufis, International Macroeconomics,

11 Solution of the Model: The Aoki Method Because of the symmetry that characterizes this model, we can analyze the behavior of the global economy as the sum (average) of the two economies, and the behavior of economy 1 in relation to economy 2 as the difference between the two economies. For each variable x, we define its global value as x A =(x 1 +x 2 )/2. For each variable x, we define its relative value as, x R =(x 1 -x 2 )/2 We can then characterize the behavior of economy 1 from the sume, x 1 =(x A +x R ) that of economy 2 από, x 2 =(x A- x R ). This solution method was proposed by Aoki (1981) and simplifies the analysis of dynamic models of symmetric interdependent economies significantly. Prof. George Alogoskoufis, International Macroeconomics,

12 The Global Economy Equilibrium in the Global Market for Goods and Services e y A = αg A β(i A p A ) + γ y A Equilibrium in the Global Money Market m A p A = y A * εi A Adjustment of the Global Price Level p A = π A + λ(y A y A * ) Prof. George Alogoskoufis, International Macroeconomics,

13 Solving the Global Economy Model Assuming that expected inflation is equal to actual inflation, y A = e p A = π A + λ(y A y A * ) Substituting in the equilibrium condition for the global market for goods and services, 1 1 βλ γ αg * A β(i A π A ) βλy A ( ) Combining this relation with the equilibrium condition in the global money market, we can analyze the model. Prof. George Alogoskoufis, International Macroeconomics,

14 Solving the Model for the Global Economy i A IS' IS i 0 0 LM 0 i E E LM E y 0A y* A y A Prof. George Alogoskoufis, International Macroeconomics,

15 The Relative Model Economy 1 Relative to Economy 2 Equilibrium in the Relative Markets for Goods and Services y R = αg R β 2 (se e 2 p R ) γ y R + δ (s p R ) Equilibrium in the Relative Domestic Money Markets m R p R = y * R ε 2 se Adjustment of the Relative Price Levels p R = π R + λ(y R y R * ) Prof. George Alogoskoufis, International Macroeconomics,

16 Solution of the Relative Model Assuming Rational Expectations, the model is reduced to, s = 2 ( ε m p y * ) R R R p R = π R + λ 1+ γ + λβ αg + β R ε (m p y * R R R) + δ s p R ( ) y R * Those two differential equations describe the evolution of the exchange rate and the relative price levels in the two economies. Prof. George Alogoskoufis, International Macroeconomics,

17 Properties of the Short and Long Run Equilibrium of the Model First, the long-run equilibrium characterized by monetary neutrality. A shift in the relative money supply of one country has no long run real effects. It causes a change at the same rate of the relative price levels and the nominal exchange rate. Secondly, there is a unique saddle path that leads to this long-run equilibrium. The long run equilibrium is stable, because the relative price level is a predetermined variable and the exchange rate is a non predetermined variable. Third, a change in the relative money supply of one country has shortterm real effects, as relative price levels cannot adjust immediately, but only gradually, while the exchange rate adjusts immediately. The relative model behaves exactly like the Dornbusch model. Prof. George Alogoskoufis, International Macroeconomics,

18 Solving the Model for the Exchange Rate and Relative Price Levels s s=0 p R =0 E 45º p R Prof. George Alogoskoufis, International Macroeconomics,

19 Short Run and Long Run Effects of a Relative Increase in the Money Supply of Country 1 s s=0 p R =0 Ε 0 E E 45º Prof. George Alogoskoufis, International Macroeconomics, p R

20 Short Run and Long Run Effects of an Increase in the Relative Fiscal Stance of Country 1 s s=0 p R =0 Ε 0 E Ε 1 E 45º Prof. George Alogoskoufis, International Macroeconomics, p R

21 Conclusions from the Model A unilateral monetary expansion in one country leads to a short run nominal and real depreciation of its currency against the rest of the world and an improvement in its current account, resulting in a short-term increase in its output and employment. However, this is at the expense of output and employment in the rest of the world ( beggar thy neighbor"). A unilateral fiscal expansion in one country leads to a short and long run real appreciation of the exchange rate, a deterioration in the current account and an increase in international interest rates and global output and employment. The appreciation of the real exchange rate and the current account deterioration of the country undertaking the fiscal expansion leads to an increase in output and employment in the rest of the world ( locomotive ). Prof. George Alogoskoufis, International Macroeconomics,

22 Dynamic Simulations of the Model We simulate the model dynamically, assuming the following values of the parameters: α=1, β=0,5, γ=0,25, δ=0,5, ε=0,5, λ=0,5 We consider the following alternative policies: 1. A unilateral 10% monetary expansion in Country 1 2. A unilateral 10% fiscal expansion in Country 2 3. A coordinated 5% monetary expansion in both Countries 4. A coordinated 5% fiscal expansion in both Countries Prof. George Alogoskoufis, International Macroeconomics,

23 A Dynamic Simulation of a 10% Monetary Expansion in Country 1 Prof. George Alogoskoufis, International Macroeconomics,

24 A Dynamic Simulation of a 10% Fiscal Expansion in Country 1 Prof. George Alogoskoufis, International Macroeconomics,

25 A Dynamic Simulation of a 5% Monetary Expansion in both Countries Prof. George Alogoskoufis, International Macroeconomics,

26 A Dynamic Simulation of a 5% Fiscal Expansion in both Countries Prof. George Alogoskoufis, International Macroeconomics,

27 Shortcomings of Short Run Models One of the main shortcomings of such short-term models, particularly with respect to fiscal policy, investment and the balance of payments is that they cannot analyze the relationship between short-term imbalances and the evolution of stocks such as capitulant public and external debt of a country. This weakness is addressed by long-term growth models, based on the inter-temporal approach. Prof. George Alogoskoufis, International Macroeconomics,