LECTURES 7-9: POLICY INSTRUMENTS, including MONEY

LECTURES 7-9: POLICY INSTRUMENTS, including MONEY L7: Goals and Instruments Policy goals: Internal balance & External balance Policy instruments The Swan Diagram The principle of goals & instruments L8: Introduction of monetary policy The role of interest rates Monetary expansion Fiscal expansion & crowding out L9: The Monetary Approach to the Balance of Payments

Lecture 7: Goals and instruments Policy Goals Internal balance: Y = Y potential output. Y < Y ES output gap => unemployment > u Y > Y ED => overheating => inflation or asset bubbles. External balance: e.g., CA=0 or BP=0. Policy Instruments Expenditure level, e.g., G or tax rate Expenditure-switching, e.g., E. ITF-220, Prof.J.Frankel

Internal Balance Output gap, as % of GDP, in the 2009 Great Recession Port Spn Jpn Bel US It UK Can Fra Swe Ir In 2009, after the global financial crisis, most countries suffered larger output gaps than in preceding recessions: Y << Y. Source: IMF estimation, via Economicshelp, 2009 Prof.J.Frankel

IMF WEO, Oct.2016, Figure 1.10. Output gaps and unemployment rates have improved since the height of the GFC, but remain high in some Mediterranean countries.

THE PRINCIPLE OF TARGETS AND INSTRUMENTS Can t normally hit 2 birds with 1 stone. Have n targets? => Need n instruments, and they must be targeted independently. Have 2 targets: CA = 0 and Y = Y? => Need 2 independent instruments: expenditure-reduction & expenditure-switching. Prof.J.Frankel

Possible Responses to a Current Account Deficit Financing By borrowing or running down reserves. vs. Adjustment Expenditure-reduction ( belt-tightening ) esp. fiscal or monetary contraction or Expenditure-switching esp. devaluation.

Adjustment Starting from current account deficit at point N, policy-makers can adjust either by: (a) cutting spending => A or (b) devaluing. A dilemma? => X Prof.J.Frankel

(a) If they cut spending, CA deficit is eliminated at X; but Y falls below potential output Y. => recession Prof.J.Frankel

(b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Y above potential output. => overheating Prof.J.Frankel

Derivation of Swan Diagram A At F, TB<0. What would have to happen to eliminate trade deficit? E. If depreciation is big enough, restores TB=0 at point B. (i) External balance Prof.J.Frankel

At F, some of higher demand falls on imports. We have just derived the upward-sloping external balance curve, BB.. What would have to happen to eliminate trade deficit? E. If depreciation is big enough, restores TB=0 at point B. Prof.J.Frankel

Experiment: Fiscal expansion, continued At F, Y > Y. What would have to happen to eliminate excess demand? E. If appreciation is big enough, restores Y = Y at point C. (ii) Internal balance Prof.J.Frankel

At F, some of higher demand falls on domestic goods. We have just derived downward-sloping internal balance line, YY. What would have to happen to eliminate excess demand? E. If appreciation is big enough, restores at C. Prof.J.Frankel

Prof.J.Frankel Swan Diagram has 4 zones: I. ED & TD II. ES & TD III. ES & TB>0 IV. ED & TB>0

Example 1: Emerging markets in 1990s Classic response to a balance of payments crisis: Devalue and cut spending Excgange rate E ES & TB>0 Mexico 1995 or Korea 1998 ED & TB>0 ES & TD Mexico 1994 or Korea 1997 BB: External balance CA=0. YY: Internal balance Y=Y ED & TD It could be South Africa or Turkey in 2017. Spending A

Example 2: China in the last decade ED & TB>0 Exchange rate E ES & TB>0 China 2002 2015 China 2010 BB: External balance CA=0. ED & TD ES & TD YY: Internal balance Y=Y By 2007, rapid growth pushed China into ED. In 2008-09, an abrupt loss of X, due to global recession, shifted China to ES. Spending A By 2010, a strong Spending recovery, A due in part to G stimulus, moved into ED. In 2015, back into ES.

Example 3: US over 30 years Exchange rate E ES & TB>0 ED & TB>0 BB: External balance CA=0. ED & TD 1991, or 2008-09 2000, 2007 or 2017? ES & TD YY: Internal balance Y=Y ITF-220, Prof.J.Frankel Spending A

Example 4: Greece & Ireland gave up their ability to devalue when they joined the euro. Exchange rate E ES & TB>0 ED & TB>0 BB: External balance CA=0. ED & TD 2010-16 2003-07 ES & TD YY: Internal balance Y=Y ITF-220, Prof.J.Frankel Spending A

Appendix 1: More graphs of Y and output gap US GDP (Y) & potential (Y): 1979-2015 }output gap

Output gap in eurozone periphery Source: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated in 2007: Y >> Y and crashed in 2009-12: Y << Y ITF-220, Prof.J.Frankel

Output gap remains worse in eurozone than elsewhere. 1997-2015 Exhibit 3: A Large Output Gap Remains in the Euro Area Global Economics Analyst: Meeting the Low Bar (Stehn/Hatzius), GS Macro Economics Research, February 19, 2016

Appendix 2: Recap Swan Diagram derivation Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. Experiment: increase in A (e.g., G ). Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0. What would have to happen to reduce trade deficit? External balance. Devaluation E X ITF-220, Prof.J.Frankel

ITF-220, Prof.J.Frankel Recap, continued Now consider internal balance. Return to point A. Experiment: increase A Expansion moves economy rightward to point F. Some of higher demand falls on domestic goods => Excess Demand: Y > Y. What would have to happen to eliminate excess demand? E.

Derivation of the Swan Diagram Summary: the combination of policy instruments to hit one goal slopes up; the combination to hit the other slopes down. Fiscal expansion (G ) (or monetary expansion), at a given exchange rate => Y and TB. Devaluation (E ) => Y and TB. If we are to maintain: Internal balance, Y=Y External balance, TB=0 then G & E must vary: inversely. together. => Internal balance line slopes down. => External balance line slopes up. Prof.J.Frankel

End of Targets and Instruments ITF-220, Prof.J.Frankel

Lecture 8: Monetary policy is another instrument to affect the level of spending. It can be defined in terms of the interest rate i, which in turn affects i-sensitive components of A, such as construction, other I, and consumer durables. Or in terms of the quantity of money: M1 cash + checking account deposits Prof.J.Frankel

Determination of income when A depends on i Aggregate output = Aggregate Demand + net foreign demand: Y = A + TB Trade Balance: Let A = Ā - b(i) + cy TB = X(E) my. where the function -b( ) captures the negative effect of the interest rate i on construction, consumer durables, etc. Combining equations, Y = Ā - b(i) + cy + X E - my. Now solve to get the IS curve: Y = Ā b(i) + X E s+m.

IS curve: An inverse relationship between i and Y consistent with supply = demand in the goods market. IS: Y = A b(i) + X s+m i A decrease in i, (monetary expansion) stimulates A & so Y. IS IS' ΔA /(s + m) Y An increase in spending, Ā, e.g., a fiscal expansion, shifts IS to the right by the multiplier 1/(s+m).

The LM curve: Money supply = money demand. M1 P = L(i, Y) where money demand function L(i, Y) captures a negative effect of i & positive effect of Y. i LM Do central banks actually set the money supply? LM A monetary expansion (M1 ) shifts the LM curve to the right. Their policy was to set M1 in the 1980s, the heyday of monetarism. Also the monetary base made a comeback after 2008: Quantitative Easing. Y Y

Equations for IS-LM with a fixed exchange rate IS: Y = A b(i) + X s+m LM: M1 P = L(i, Y) i IS LM Y Prof.J.Frankel

IS: Y = A b(i) + X s+m Monetary expansion: M1 LM: M1 P = L(i, Y) IS LM i LM' Or think of the central bank setting i directly. Y Prof.J.Frankel

Spending expansion: A IS: Y = A b(i) + X s+m LM: M1 P = L(i, Y) i IS IS' Taylor rule LM Or the central bank may follow a Taylor Rule: setting i systematically in response to Y & inflation. Y Prof.J.Frankel

When the GFC hit, the Fed cut its policy interest rate to 0 (followed by other major central banks). US Economics Analyst: From ZLB to ELB, GS, Feb. 26, 2016. Data source: FRB

Appendix 1: IS-LM again, while also following TB in the upper graph TB => TB = X (M + my) + 0 - Y where slope = -m ITF-220, Prof.J.Frankel

Monetary stimulus lowers i, stimulates demand, shifts NS-I down/out. New equilibrium at point M. In lower diagram, which shows i explicitly on the vertical axis, We ve just derived IS curve. If monetary policy is defined by the level of money supply, then the same result is viewed as resulting from a rightward shift of the LM curve. ITF-220, Prof.J.Frankel

Fiscal expansion shifts IS out. New equilibrium: At point D if monetary policy is accommodating. At point F, if the money supply is unchanged, so we get crowding out: i => I Rise in Y < full Keynesian multiplier. ITF-220, Prof.J.Frankel D

Appendix 2: When at the Zero Lower Bound (i) Monetary expansion has little effect, because it can t drive i lower. (ii) Fiscal expansion has big effect, because no crowding out from i. i IS IS LM LM Y Prof.J.Frankel

Lecture 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Historical case of non-sterilization: the Gold Standard Appendix Historical case of sterilization: China s inflows, 2004-13 ITF-220 - Prof.J.Frankel

The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. Prof.J.Frankel

Definitions: Monetary Base: Liabilities of CB assets held by CB MB Res + NDA where Res International Reserves & NDA Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking Sterilization: Changes in reserves (i.e., BP) offset by NDA, Δ NDA = - Δ R, so MB unchanged. Non-sterilization: Δ MB = Δ R. ITF-220 - Prof.J.Frankel

David Hume s Price Specie-Flow Mechanism Initially, Spain piles up gold, from the New World (mercantilism). But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level.

Hume s Price Specie-Flow Mechanism continued If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. - Prof.J.Frankel

Mundell s Income-Flow Mechanism MB => M1 => (via i => I ) => A => Y. But A => TB<0 => Res then falling gradually over time + nonsterilization MB falling over time A falling over time. In the long run, TB=0 and everything is back to where it was.

Prof.J.Frankel Mundell s Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath NS-I + 0 - NS-I Y i LM TB LM IS As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion. Y

ITF-220 - Prof.J.Frankel Example: response to the 1994 tequila crisis Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December. i LM A M. IS Argentina was on a currency board => no sterilization. Allowed 1995 reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. Y

Historical example of non-sterilization: The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). Rules of the game : Don t sterilize. Allow adjustment to work. Pros and Cons Pro: prevents excess money creation & inflation. Cons: prevents response to cyclical fluctuations long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK.

Capsule History of the Gold Standard 1844 Britain adopts full gold standard. 1879 -- US restores gold convertibility. From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices & wages. 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. 1944 -- Bretton Woods system, based on gold as the reserve asset. 1945-1971 -- de facto: based on $. 1958 -- Start of US BoP deficits. <= European growth > US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $. Solutions: raise price of gold, or create SDRs. 1971 -- Nixon suspends convertibility & devalues $. ITF-220 - Prof.J.Frankel

Appendix -- Example of sterilizing money inflows: China, starting in 2004 ITF-220 - Prof.J.Frankel

The Balance of Payments rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves BoP Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 49

FX reserves of the PBoC climbed higher than any central bank in history. http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html API-120 - Prof. J.Frankel, Harvard http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down

Sterilization of foreign reserves: People s Bank of China sold sterilization bills, thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011, Fig.4, p.45. ITF-220 - Prof.J.Frankel

In 2003-04, forex inflows accelerated. Initially, the PBoC had no trouble sterilizing the inflows. Source: UBS => The MB growth rate was kept down to the growth rate of the real economy ( 10%/year), so there was little inflationary pressure.

Despite PBoC success at sterilizing inflows 2003-06 money growth accelerated sharply in 2007-08. FX reserve contribution Prof.J.Frankel

To be continued Starting in 2007, China had more trouble sterilizing the reserve inflow. The PBoC began to have to pay higher domestic interest rates and to receive lower interest rate on US T bills => quasi-fiscal deficit or negative carry. Inflation became a problem in 2007-08. - Prof. J.Frankel, Harvard