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

2 This page is intentionally left blank

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