Classes and Lectures - PDF Free Download

Classes and Lectures There are no classes in week 24, apart from the cancelled ones You ve already had 9 classes, as promised, and no doubt you re keen to revise Answers for Question Sheet 5 are on the module website There is no EC1001 lecture this Friday 11 May. There will be 2 revision-based lectures in week 24 (17 and 18 May)

The Euro (Chapter 38 in Mankiw and Taylor) Plus in this lecture we will run through the AD/SRAS,LRAS model again since this should have come up in your assessed essay and you need to know this model for the exam

But first, as this is important looking forward to the exam, we ll run through the coursework essay In particular, we will re-consider the AD/SRAS,LRAS model and consider how it lets us distinguish the likely short and long run effects of QE

How can the Bank of England increase the money supply? OMOs: buy government bonds (outright) Refinancing (repo) rate: An OMO but not outright; a loan. Decrease this rate encourages banks to borrow from the money market Reserve requirements (money multiplier). Decrease the reserve requirement (if they exist) to increase the money created by bank QE: involves purchase of longer-dated bonds than traditional OMOs. Also wider set of assets bought

How precisely can the Bank of England increase the money supply? Cannot control the broad money supply perfectly Money multiplier is not under the BoE s control, in a fractional reserve banking system The BoE does not control the amount of currency that households choose to hold relative to deposits If households decide to hold relatively more currency, banks have fewer reserves and the money supply decreases The BoE cannot control the amount banks choose to hold as excess reserves If bankers decide to lend out less of their deposits, the money supply will decrease Currently banks are rebuilding their balance sheets

What should we expect to be the macroeconomic consequences of the quantitative easing recently undertaken by the Bank of England? Make a short versus long run distinction Use economic models to formalise your argument QE designed to boost nominal AD Transmission mechanism is it encourages banks and others who receive this central bank money to lend it out (loanable funds increase) and thereby stimulate AD (improve banks balance sheets, their liquidity) Focus on macro not finance implications

Long run (LR) Quantity Theory (Friedman) effect on inflation. One-for-one if V (velocity of circulation) constant. Could use MS/MD graph, with P or 1/P on y-axis Classical dichotomy and Monetary Neutrality : Money increase has no effect on real variables, including real GDP, unemployment, real wages and real interest rates (but via the Fisher effect the nominal rate increases) Exchange rate effects: PPP inflation leads to depreciation

Short run (SR) IS/LM (interest rates and real income, as LM shifts to the right) AD-SRAS curve (real output, prices, extent depending on slope of SRAS curve) SR Phillips Curve (unemployment as inflation ) Also open economy effects, as QE leads to exchangerate depreciation, via uncovered interest rate parity in SR and PPP (and inflation) in the LR Use graph in Mankiw & Taylor p.695 which sees supply of loanable funds increase (in book it decreases, so reverse the conclusions), hence with r lower, NCO is higher so real exchange rate falls

Integrated analysis: AD/SRAS,LRAS model The short run effects may be quite persistent (i.e. the long run effects maybe a long time coming) in the current climate, given the economy is in recession and arguably there s lots of spare capacity in the economy (so the SRAS curve is pretty flat) A SR effect on real output depends on inflation being higher than expected (surprise/unexpected inflation) Due to sticky wages, sticky prices or misperceptions Shifts AD to the right, along SRAS curve for fixed inflationary expectations; explained by LM curve shifting to the right along a given IS curve (so r lower and y higher)

QE is expected to boost AD, to some degree A Monetary Injection Interest (a) The Money Market rate Money supply, MS 1 r 1 MS 2 1. When the BoE increases the money supply... Price level P (b) The Aggregate-Demand Curve r 2 0 2.... the equilibrium interest rate falls... Money demand at price level P Quantity of money Quantity of output In panel (a), an increase in the money supply from MS 1 to MS 2 reduces the equilibrium interest rate from r 1 to r 2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y 1 to Y 2. Thus, in panel (b), the aggregate-demand curve shifts to the right from AD 1 to AD 2. 0 Y 1 Y 2 AD 2 Aggregate demand, AD 1 3.... which increases the quantity of goods and services demanded at a given price level.

The likely short and long run effects of QE An increase in Aggregate Demand Price Level Long-run aggregate supply AS 2 3.... but over time, the shortrun aggregate-supply curve shifts up as P expectations Short-run aggregate supply, AS 1 P 3 P 2 A C B 4.... and output returns to its natural rate. P 1 1. An increase in aggregate demand... AD 1 AD 2 Y 1 Y 2 Quantity of Output 2.... causes output to rise in the short run... A rise in aggregate demand is represented with a rightward shift in the aggregate-demand curve from AD 1 to AD 2. In the short run, the economy moves from point A to point B. Output rises from Y 1 to Y 2, and the price level rises from P 1 to P 2. Over time, as the expected price level increases, the short-run aggregate-supply curve shifts to the left from AS1 to AS 2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level rises to P 3, and output returns to its natural rate, Y 1 as the Quantity Theory and monetary neutrality imply

Similar story with short and long run Phillips Curves Surprise AS curve: Quantity of output supplied = = Natural rate of output + a(actual price level Expected price level)

European Monetary Union 1. The Euro 2. The benefits and costs of a common currency 3. The theory of optimum currency areas 4. Is Europe an optimum currency area? 5. Fiscal policy and common currency areas

The Euro The euro officially came into existence on 1 January 1999 and on 1 January 2002 the first euro notes and coins began to circulate EA countries adopted fixed (in principle irrevocably) exchange rates Why did they give up their own currencies? Economic as well as political arguments

The benefits and costs of a common currency

The Benefits of a Single Currency The transaction cost involved in converting currencies is a deadweight loss, so reducing these costs by adopting a single currency provides a clear gain to society It is less likely that there will be price discrimination between countries because a single currency makes it more difficult to disguise price differences Price discrimination again involves a deadweight loss to society

The Benefits of a Single Currency Reduction in foreign exchange rate fluctuations that create uncertainty for businesses engaging in trade between EMU countries Businesses could always deal with such uncertainty by engaging in forward foreign exchange contracts with their banks, but the banks charge for this service and a single currency eliminates this (deadweight) cost (loss) Encourages trade and investment as the absence of exchange rate fluctuations makes business planning easier and may boost investment, with benefits for long-run economic growth

The Costs of a Single Currency The major cost is that a country joining a currency union gives up: 1. its freedom to set its own monetary policy (interest rate) 2. and the possibility of macroeconomic adjustment through movements in the external value of its currency

The Costs of a Single Currency Suppose there is a shift in consumer preferences away from German goods and in favour of French goods The aggregate demand curve will shift to the left in Germany and to the right in France, leading to increased unemployment and downward pressure on prices in Germany, and lower unemployment and upward pressure on prices in France

Figure 1 A Shift in Consumer Preferences Away from German Goods Towards French Goods If the governments do nothing then the economies will, in the long run, return to their natural rates of unemployment as wages and prices fall (relatively) in Germany and SRAS shifts

The Costs of a Single Currency But if the two countries had retained separate currencies then the short-run fluctuations in aggregate demand would have been alleviated by a movement in the exchange rate i.e. AD can shift as the real exchange rate changes, reflecting changes in the relative demand for the two currencies

The Costs of a Single Currency Without this adjustment mechanism, German policy makers may wish to see a cut in interest rates to boost aggregate demand, while French policy makers will be more likely to favour a rise in the interest rate to contain inflation The ECB would be unable to satisfy both countries Euro implies a one size fits all monetary policy

Optimum Currency Area Theory An optimum currency area is a group of countries for which it is optimal to adopt a common currency and form a currency union OCA theory attempts to specify criteria for the optimality of a currency union for a given group of countries The qualifier optimal is used loosely and should be taken to refer to the ability of the countries concerned to limit the costs of monetary union and enhance the benefits

OCAs: Characteristics That Reduce the Costs of a Single Currency There s only a short run trade-off between unemployment and inflation, so the more quickly an economy moves to its long-run equilibrium after a shock the better A high degree of real wage flexibility so that wages respond strongly to fluctuations in unemployment will ensure that long-run equilibrium will be restored quickly following any macroeconomic disturbance A high degree of labour mobility between the member countries of a currency union will also ensure macroeconomic stability In the earlier example, the migration of labour from Germany to France would alleviate inflationary pressure in France and keep down unemployment in Germany

OCAs: Characteristics That Reduce the Costs of a Single Currency A high degree of capital mobility can also help alleviate the problems of asymmetric shocks Residents of a country experiencing recession may borrow money from residents of a country experiencing a boom to make up for their temporary fall in income - without domestic interest rates rising Clearly if the demand shocks hitting the EA are symmetric there is no problem

OCAs: Characteristics that Increase the Benefits of a Single Currency A high degree of trade integration among a group of countries will lead to greater benefits should those countries establish a currency union As there s more of a gain from both no transactions costs and the reduction in exchange rate volatility

Is Europe an Optimum Currency Area? There is lots of within-europe trade (we can think of the ratio of intra-eu exports and imports to GDP as a measure of trade integration) But labour and wage flexibility are low in the EA So, as we have seen recently, if strong differences emerge between the EA countries the lack of independent monetary and exchange rate policy do matter Think of Greece Perhaps EA will not survive

Fiscal Policy and Common Currency Areas While monetary union prevents independent monetary policy, countries might retain control of fiscal policy and use it to ameliorate the loss of monetary policy So Germany could expand AD and France reduce it Need to think about this possibility both in a fiscal union and when countries have independent fiscal policies Fiscal federalism involves a common fiscal budget and system of fiscal transfers across countries If a currency union had a common fiscal policy then fiscal policy in the currency union would work much as fiscal policy in a single national economy works The problem might be that taxpayers in one country may not be happy to see their taxes spent on transfers to residents of another country

Fiscal Policy and Common Currency Areas When countries conduct independent fiscal policy there is a potential free rider problem in a currency union A government issuing a large amount of government debt pays a lower interest rate on it than it would have outside the union As the other (solvent) countries are seen by the markets to underwrite the profligate country s debt Unless there was a credible no bail-out agreement, so that the markets do charge the profligate countries higher interest rates And other countries pay higher interest rates For this reason currency unions may impose rules on national fiscal policies ongoing debate in EA

Summary A common currency area (a.k.a. currency union or monetary union) is a geographical area through which one currency circulates and is accepted as the medium of exchange

Summary The formation of a common currency area can bring significant benefits to the members of the currency union, particularly if there is already a high degree of international trade among them (i.e. a high level of trade integration) This is primarily because of the reductions in transaction costs in trade and the reduction in exchange rate uncertainty

Summary There are, however, costs of joining a currency union, namely: the loss of independent monetary policy and the loss of the exchange rate as a means of macroeconomic adjustment These adjustment costs will be lower the greater is the degree of real wage flexibility, labour mobility and capital market integration across the currency union, and also the less the members of the currency union suffer from asymmetric demand shocks

Summary A group of countries that has a high level of trade integration, high labour mobility and real wage flexibility, a high level of capital market integration and whose member countries do not suffer from asymmetric shocks, is termed an optimum currency area (OCA) An OCA is most likely to benefit from currency union

Summary It is possible that a group of countries may become an OCA after becoming a currency union, as having a common currency may further enhance trade integration, thereby helping to synchronise members economic cycles, and having a single currency may also help to foster increased labour mobility and capital market integration