Outline Conduct of Economic Policy The Implementation of Economic Policy. Macroeconomic Policy. Bilgin Bari

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2 1 The Policy Framework The Policy Interactions 2

3 The Policy Framework The Policy Interactions There are two major types of macroeconomic policies are used to control aggregate demand. growth of money supply and interest rate government spending and taxation

4 The Policy Framework The Policy Interactions is the main policy. Because price stability is important. Price Stability reduce uncertainty better investment climate economic growth cannot change potential growth rate price stability output stability (Divine Coincidence) (Blanchard and Gali, 2005)

5 The Policy Framework The Policy Interactions Fiscal policy support monetary policy by controlling government budget. budget deficit and inflation excess demand issued money (printing money)

6 The Policy Framework The Policy Interactions Macro-prudential Policy Monetary policy s second goal is financial stability (after global financial crisis) Financial system is important for investments and economic growth. Problems in the financial system raise sovereign debt People like risk-taking - especially expansion term in the economy - Economic policy or policy makers should prevent risks

7 Central Banks use a very short-term interest rate as their primary policy tool. The interest rate is overnight interest rate at which banks lend to each other. Central bank can determine the real interest rate in the short-run. i = π (π π T ) + 0.5(Y Y P )

8 Interest Rate I

9 Interest Rate II

10 Interest Rate III

11 Interest Rate IV

12 The Government Budget I Government Spending = Government purchases + Transfer payments + Interest payments Government purchases = Government investment + Government consumption Government investment : spending on capital goods (highways and school) to improve capital stock and promote economic growth Transfer payments : direct payments to individuals ( unemployment insurance + social security ) Interest payments : interest payments made to holders of government debt Revenue = Personal taxes + contributions for social insurance + Taxes on production and imports + Corporate taxes

13 The Government Budget II Budget deficit = SPENDING - TAX REVENUES Budget deficit = (Government purchases + Transfer payments + Interest payments) - (Tax revenues) BD = (G+TR+INT) - T Government Budget Constraint Government sells (issues) bonds to finance budget deficit. Budget deficit = B This equation is referred to as the government budget constraint.

14 Government I

15 Government II

16 Government III

17 Government IV

18 Government V

19 Sovereign Debt Crises Sovereign debt crises is a collapse in the market for the government debt. The debt-to-gdp ratio of a sovereign government rises to the point where investors become concerned. As the probability of default rises, investors pull out of the country s bonds. The resulting decline in the bond price leads to surge in interest rates on this debt. Debt to GDP PoD Interestpayments Deficit Debt to GDP PoD Interestpayments Deficit...

20 The Effects of Government Debt in the Long-run High government debt is not a burden investment in government capital increases economy s future productivity. investment in human capital increases worker productivity. High government debt is a burden Reduction in national saving : National saving = Private saving + Government saving = (Y-T-C) + (T-G) Reductions in national saving causes to reduct in private saving. (crowding out) Indebtness to foreigners exchange rate volatility Redistribution effects income inequality Negative incentive effects inefficient economic environment

21 Budget Deficits and Inflation There are two options to finance budget deficit: BudgetDeficit = BD = B investors + B centralbank The government bonds are sold to private investors : B investors The central bank pay for the bonds by issuing money : B centralbank = M Printing money is referred as monetizing the debt. In the long-run, the inflation rate will move very closely with the growth rate of the money supply : π = M M Large budget deficits financed by printing money lead to high inflation.

22 Inflation

23 Budget Dynamics I

24 Budget Dynamics II

25 Budget Dynamics III

26 Budget Deficits and Ricardian Equivalence I Robert Barro of Harvard University Budget deficits resulting from tax cuts may not have much impact on the economy. His argument suggests that tax cuts have no effect on spending and national saving. Ricardian equivalence is based on in the view that consumers are very forward-looking behavior Consumers factor their current disposable income and future income into decisions about the amount they want to spend. The government cut taxes = Budget deficit = higher future taxes

27 Budget Deficits and Ricardian Equivalence II Forward-looking consumers recognize that they will have lower disposable income in the future. As a result, they will not change their spending behavior and will save more today in order to pay those future taxes. Ricardian equivalence implies that tax cuts will have little impact on household spending and therefore will not lead to an increase in aggregate demand.

28 Current Account Deficit The current account can be expressed as the difference between the value of exports of goods and services and the value of imports of goods and services. Current account deficit means that the country is importing more goods and services than it is exporting The current account can also be expressed as the difference between national (both public and private) savings and investment. Current account deficit therefore reflect a low level of national savings relative to investment or a high rate of investment (or both).

29 National Savings Private saving : S P = Y T C Government saving :S G = T G National saving is the sum of private saving and government saving: S = Y C G S = (C + I + G + NX ) C G S = I + NX Net capital outflow identity : S I = NX Current account deficit : S<I

30 Saving-Investment Dynamics I

31 Saving-Investment Dynamics II

32 Saving-Investment Dynamics III

33 Saving-Investment Dynamics IV

34 Saving-Investment Dynamics V

35 at the Zero Lower Bound We have so far assumed that a central bank can always lower its policy rate. The policy rate can never fall below zero, which is referred to as the zero lower bound.

36 AD curve at the Zero Lower Bound One segment of the MP curve becomes downward sloping. The zero lower bound produces a kinked aggregate demand curve.

37 The disappearance of the Self-Correcting Mechanism The self-correcting mechanism is no longer operational at the zero-lower bound. If output, Y, is below its potential, Y P, and if policy makers do nothing, then both output and inflation will go into downward spirals. Y < Y P π r Y Y << Y P π r y

38 Unconventional and Quantitative Easing I At the zero lower bound, conventional expansionary monetary policy is no longer an option. Monetary authorities can use unconventional monetary policy: liquidity provision, asset purchases, and management of expectations. These policy tools raise aggregate output and inflation by lowering financial frictions, f, in the real interest rate for investment. r i = r + f

39 Unconventional and Quantitative Easing II Liquidity Provision The zero lower bound often arises when there is a sudden shortage of liquidity, rising financial frictions and so shifting the AD to the left. The central bank can increase its lending facilities to provide liquidity to impaired markets, lowering f Asset Purchases The monetary authorities can also lower f by lowering credit spreads through asset purchases. The purchase of an asset or security raises its price and thus lowers its interest rate and the real interest rate of investment.

40 Unconventional and Quantitative Easing III

41 Unconventional and Quantitative Easing IV Management of Expectations Management of expectations refers to its strategy to lower the market expectations for future short-term interest rates by committing to a future policy action of keeping the policy rate at zero for an extended period. The falling long-term interest rate will lower f, causing the AD curve to shift rightward. Management of expectations can also operate through the AS curve for raising inflation expectations.

42 Unconventional and Quantitative Easing V

43 Policy and practice: Japanese I By 2012, the Japanese economy has experienced more than 10 years of low growth, deflation, and the policy rate was at the zero lower bound. In 2013, there were two major changes in monetary policy by the Bank of Japan: (1) raising its inflation target from 1% to 2% (2) committing to the 2% inflation target within two years with massive asset purchases. The program would : (1) shift the AD curve to the right by lowering f (2) shift the short-run AS curve to the left by raising expected inflation.

44 Policy and practice: Japanese II

45 at the Zero Lower Bound I When the policy interest rate hits the floor of the zero lower bound, monetary policy work differently. This is also case for fiscal policy. We examine how fiscal multipliers change when the zero lower bound on the policy rate is reached.

46 at the Zero Lower Bound II There are two cases: (1 )When expansionary fiscal policy leads to rise in inflation, central bank follow Taylor principle and the real interest rate rises: G π r I Y by a smaller amount (2) When the policy rate is at the zero lower bound, the monetary authorities would prefer that the policy rate be below that level, and so when inflation rises, they keep the rate fixed at zero. G π policyrate = 0% r I Y by a larger amount

47 at the Zero Lower Bound III

48 The Effects of Exchange Rate I Change (rise) in exchange rate has an effect on foreign debt of banking system foreign debt of private sector and government production inflation

49 The Effects of Exchange Rate II

50 Equilibrium in the Foreign Exchange Market I Two approaches to determining exchange rates in the short run. Asset market approach that emphasizes the demand for the stock of domestic assets. An approach that emphasizes the demand for flows of exports and imports over short periods. The asset market approach is more accurate because export and import transactions are small relative to the amount of domestic and foreign assets at any given time.

51 Exchange Rates in the Long Run I Law of One Price : If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same in both countries no matter which country produces it. Theory of Purchasing Power Parity (PPP) : Exchange rate between any two currencies will adjust to reflect changes in the price levels of the two countries. PPP is an application of the law of one price. If PPP holds, the real exchange rate always equal to 1, so the purchasing power of the dollar is the same as the purchasing power of other currencies.

52 Big Macs and PPP Every year, The Economist magazine publishes data on the cost of a Big Mac in both local currency and US dollars in different countries. If PPP held exactly, then the real exchange rate would be 1.0 and all prices in terms of dollar would be identical. ɛ = Ex(P/P ) Reel Dviz Kuru = Nominal doviz Kuru x Nispi Fiyat Duzeyleri

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