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4. Policy issues in the SOE: some theretical considerations 4.1 External adjustment in the classical model 4.2 Adjustment problems in a simple open economy Keynesian model 4.3 Monetary policy and central bank independence 1

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4.1 External adjustment in the classical model: the price specie flow mechanism (David Hume) Production assumed to be at full employment due to rapid adjustment in all markets towards equilibrium (also labour markets) The price level is then determined according to the quantitity theory of money: L = kPY, where L is the stock of money (gold), P is the price level, Y the level of output (at full employment) and k is a constant (depends on the payment technology); thus, the price level is proportional to the stock of money in circulation (as Y is at the full employment level) The gold standard (one version of fixed exchange rates) with the price specie flow mechanism: money supply is changing due to the inflow or outflow of gold as a consequence of a trade balance surplus or deficit (dL/dt = B), given that gold production is insignificant in volume Rising (falling) money supply raises (lowers) the price level, which, according to the classical trade theory worsens (improves) the trade balance, thereby constituting a self-equilibrating mechanism operating until price levels are such that trade balances are in equilibrium In practice central banks ensured the operation of the rules of the game by raising discount rates when gold was flowing out, thereby generating a capital inflow (and the decline in demand reduced also income and imports and improved the trade balance) 2

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The gold standard as an automatic adjustment mechanism Decline of money supply and the price level in countries with BoP-deficit, the converse in surplus countries Improvement of price competitiveness in countries with BoP-deficit, the contrary in surplus countries Balance of payments disequilibrium

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L = kPY P LELE L1L1 L2L2 PEPE L The line L = kPY determines the price level for a given stock of money. The horizontal line is the domestic price level at which external balance prevails, implying un unchanged money stock and price level. At a domestic price level above this, there will be an external deficit and outflow of gold, leading to a decline in the domestic price level; vice versa for a price level belowe this. The result: not only full employment but also a self-equilibrating mechanism for the price level and external balance. The arithmetics: B = PX(P/P *) - P * M(Y,P/P * ), where Y is constant at the full employment level. B/P = X + X P – M P = X(1 + X P /X – M P /M) = X(1 - ɛ X - ɛ M ) < 0 (the Marshall-Lerner condition). Here it is assumed that prices initially are = 1, and that X = M initially. The symbols ɛ X and ɛ M refer to the price elasticity of demand of exports and imports respectively. In combination with dL/dt = B, where B = B(Y, P/P * ), with B/P < 0 as above, this gives the dynamics of the figure. 4

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4.2 A simple Keynesian open economy model Assume that output is demand determined in the short run so that output Y is equal to domestic demand E plus public spending G plus net exports T. Assume that net exports is a positive function of the level of competitiveness, measured by the ratio of the price level of foreign goods to domestic goods (in the same currency), which is mainly a funciton of the ratio of foreign to domestic wage levels (corrected for differences in productivity, which are assumed constant). The level of output and income will in the short run then depend positively on price competitiveness, the ratio of foreign prices (wages) to domestic prices (wages), and it will also depend on monetary and fiscal policy. Monetary expansion or a reduction in policy interest rates will increase domestic demand (possibly by weakening the exchange rate). An increase in public spending and/or a decline in tax rates will increase domestic demand and therefore output. Expansionary fiscal policy will, however, also worsen the budget deficit as well as the trade balance. At fixed exchange rates or in a MU the single country has no monetary autonomy. Giving up your monetary policy and your exchange rate may increase the difficulties of stabilizing overall economic developments, at least if wages do not adjust flexibly so as to maintain high employment. 5

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The simple Keynesian open economy model (cont.) Assume (for the time being) that output is purely demand determined. Aggregate demand is an increasing function of competitiveness (and of fiscal spending). c YD c0 c1 Y1 Y0 The simple message is that if you wish to keep your exchange rate unchanged (or if you are in a monetary union), then wages should not rise in a way that harms competitiveness, you should maintain roughly the same inflation rate as in competitor countries. Otherwise you will sooner or later be in trouble. 6 Originally the economy is at Y0 with competitiveness c0, then wages/prices rise and c declines from c0 to c1: bad for Y and employment (possibly after a time lag). Unless e adjust so to restore c0, but then there may be an inflationary spiral: wages/prices rise more and more

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What if there is a negative export shock? c YD YD c0 Z c1 H X Y1 Y0 Y Message: Export shocks are manageable if wages adjust to keep c at the level required for full emplyment. If they dont, then there will be instability. If wages dont adjust, or adjust very slowly, then giving up your own currency is a problem. With a flexible exchange rate the required c may be achieved through a depreciation. (NB that fluctuations in e, unrelated to exports etc., may be a source of nuisance.) 7 Foreign demand for our exports declines for a given level of c (shifting YD to YD). Output declines from X to H (or from Y0 to Y1). But if wages fall so that c improves enough, from c1 to c0, then the economy will move (possible with a time lag) from H to Z (restoring the same level of output Y0 as in X thanks to better c, c0 rather than c1) Alternatively, fiscal expansion could be used to shift YD back in spite of the fall in exports. The level of output could be restored but there might now be a trade deficit and/or a budget deficit.

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What if there is an interest rate shock? Assume that the country under consideration has a big public debt and large deficit, and that the financial market gets nervous about the capacity of the government to honour its debt. There will then be potentially large risk premia in the interest rates paid for government borrowing, and this will raise the general level of interest rates as well (even though the ECB would keep its policy rate unchanged). c YD YD c0 Y1 Y0 Message: you need to preserve your credit worthiness, otherwise interest rates may rise due to risk premia. (Improved competitiveness called for obviously – or financial assistance?) 8 Originally the economy is at Y0 with a level of competitiveness c0. Then it is hit by a lack of confidence in financial markets, driving up risk premia and interest rates. This reduces domestic demand (private consumption and investment), shifting the YD-curve to YD. At an unchanged level of competitiveness output has now declined to Y1. Fiscal expansion is no solution, as the risk premia arose due to high public debt in the first place.

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The Keynesian open economy model: implications for EMU a decline in exports is not such a big problem if it hits all members of a monetary union (MU), because then the common currency will depreciate (and the central bank will lower interest rates); the more difficult probem is an asymmetric shock, notably a negative asymmetric shock For c to improve, the real wage will have to decline through nominal wage declines or through a depreciation raising the price level: having a currency of your own does not do away with this requirement, it only facilitates the needed decline in real wages if nominal wages are sticky A country hit by a negative export shock could pursue expansionary fiscal policy, but that would then weaken its budgetary situation; it is therefore not a viable solution in the long term (but ok for cyclical problems) The situation is easier if there is in the MU a big central budget so that a country hit by a negative asymmetric shock can benefit from the federal budget (acting as a shock absorber) The situation is also more manageable if labor moves swiftly from countries experiencing problems to other countries (cf. the USA) 9

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The simple Keynesian open economy model: arithmetics Output is demand-determined: Y = E(Y,r) + G + T, where T = X(c) - cM(Y,c) with c = eP * /P Y is output (=income), r the rate of interest (assumed to be decided by the central bank), G public expenditure, T the trade balance (in terms of domestic output). Differentiating gives dT = X c dc - Mdc - M Y dY - M c dc = -M(1 - X c /X + M c /M) – mdY or dT = θdc – mdY, where θ = -M(1 - ɛ X - ɛ M ) θ > 0 if the so called Marshall-Lerner condition is fulfilled (the sum of the absolute value of the price elasticities of exports and imports is bigger than 1) and where m = M Y denotes the marginal propensity to import. Differentiating Y and denoting s = 1 – E Y gives dY = (dG + θdc)/(s+m) Note that the cost of external adjustment by fiscal policy is smaller the more open the dT = (sθdc - mdG)/(s+m) economy (the bigger the import propensity) Under fixed exchange rates Y is now a positive function of G and c, while T is positive in c and negative in G. Under flexible exchange rates and no capital flows, dT = 0 and we solve for Y and c and find that dY/G = 1/s. In the Fleming-Mundell version it is assumed that r is determined by M = L(Y,r), where M is the money supply as fixed by the central bank and L is demand for money. Assuming free capital movements and static exchange rate expectations implies that Y is determined by M only, thus fiscal policy has no effect on output (under flexible exchange rates and perfect capital mobility). 10

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Modern central banks are typically independent from political decision makers. The governor or the board of an independent CB is accountable in the sense of having to report to the parliament, but the governor or the board of an indpendent CB cannot be removed by politicians except in case of seriour misconduct, not because of dissatisfaction with the monetary policy pursued. The CB must also be financially independent. The Bundesbank has traditionally been considered a particularly independent CB; it has functioned as a role model for the ECB The central argument for CB independence is that it allows credible commitment to price stability, which is helpful since it improves the functioning of the price mechanism, lowers inflation premia in interest rates and helps avoid arbitrary redistributions of income and wealth. Decisions on monetary policy should be independent from politicians because the latter cannot resist the temptation to aim at a short term boost of growth at the cost of higher future inflation – and without gaining anything in terms of growth in the longer term. Countries with a history of rapid inflation (and devaluations) and difficulties of estabishing credibility for stability oriented monetary policies may wish to join the monetary union in order to achieve credibility for price stability (giving up the power of domestic decision makers, not to be trusted). 4.3 Monetary policy and central bank independence 11

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Time inconsistent monetary policy It may be optimal ex ante to choose a solution, which is no good in retrospect. U is the rate of unemployment and p is the rate of inflation. Assume that the economy initially is at point A with zero inflation (and at the level of SR3unemployment compatible wtih p = 0. Then the SR2 LR government orders the CB to aim for full p SR1 employment, which brings the economy to point B along the short run (Phillips) curve SR1. E However, the SR-curve starts shifting upwards because of higher inflation expectations, and D the short run equilibrium passes from, say, B to C C to D to E. At E, however, inflation does not B accelerates any more, since the level of employment is now compatible with Δp = 0. But why choose E over A? Only because it may be rational in the SR for politicians. U F U 0 A U Bottom line: commit the CB credibly to price stability to avoid (harmful)inflation; independence helps. NB: Points like B etc will be lower on the curve if the CB gives a lot of weight to the inflation objective. 12

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Time inconsistent monetary policy To make the same point in another way. Assume that inflation is equal to the expected rate of inflation and a negative function of the difference between the rate of unemployment and the natural rate of unemployment (NAIRU): (1) p = p(-1) – k(U – UN) or Δp = - k(U – UN) Assume also that the rate of growth of money supply m, reflecting policy preferences, is a positive function of the difference between the rate of unemployment and full employment and a negative function of inflation: (2) m = α(U – UF) – βp and assume that in the long run p = m. In the long run U = UN (p cant forever accelerate) and p = (α/(1+β))(U – UF), so a high weight given to U only raises p but not U. 13

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Price versus job stability SR p A B U 0 U 14 Assume the economy is initially at point A with inflation at its target level and stable (at the level of unemplyment compatible with stable inflation). The the SR shifts to SR got some reason. If the CB cares only about inflation, it will tighten monetary policy so as to prevent the rise inflation, the economy will move to point B. But this means that price stability is achieved at the cost of job stability, as unemplyoment is higher at B than A. For temporary shocks it would be better for the CB not to overreact, i.e. it should give some weight also to job stability. So there is a trade of after all: high weight to the inflation objective risks increasing job instability. This is not an argument against CB independence but against giving weight only to price stability.

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Questions Assume that a small open economy is hit by an exogenous fall in demand for its exports. What will happen according to the classical model? Ditto as above. What problems might arise in a simple Keynesian framework? What are some options for maintaining activity (output and income levels) in spite of the fall in exports? Why might some of these options not work or not be viable? What is the meaning of time inconsistent monetary policy? 15

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L = kPY P LELE L1L1 L2L2 PEPE L The line L = kPY determines the price level for a given stock of money. The horizontal line is the domestic price level at which external balance prevails, implying un unchanged money stock and price level. At a domestic price level above this, there will be an external deficit and outflow of gold, leading to a decline in the domestic price level; vice versa for a price level belowe this. The result: not only full employment but also a self-equilibrating mechanism for the price level and external balance. 16 An exogenous fall in exports will shift the PE-curve downwards, there will be an import surplus, money will flow out, prices will fall, and balance will gradually be restored at a lower price level and lower money supply level

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What if there is a negative export shock? c YD YD c0 Z c1 H X Y1 Y0 Y Message: Export shocks are manageable if wages adjust to keep c at the level required for full emplyment. If they dont, then there will be instability. If wages dont adjust, or adjust very slowly, then giving up your own currency is a problem. With a flexible exchange rate the required c may be achieved through a depreciation. 17 Foreign demand for our exports declines for a given level of c (shifting YD to YD). Output declines from X to H (or from Y0 to Y1). But if wages fall so that c improves enough, from c1 to c0, then the economy will move (possible with a time lag) from H to Z (restoring the same level of output Y0 as in X thanks to better c, c0 rather than c1) Alternatively, fiscal expansion could be used to shift YD back in spite of the fall in exports. The level of output could be restored but there might now be a trade deficit and/or a budget deficit.

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Some final comments on monetary and fiscal policies in the SOE The classical model ensures automatic external adjustment through variations in the money supply (a channel which is hardly operative in todays EMU) The simple Keynesian model articulates the policy dilemmas It needs to be combined with the supply side, the implication being that short-term effects may differ from long-term effects Discretionary monetary policy may run into credibility problems, which central bank independence can help to overcome The bottom line is that MU is ok if schocks are symmetrical or if wages adjust quickly, or if shocks are only short-term in character (can be dealt with by fiscal policy). If not, then monetary autonomy may be valuable by allowing a recession to be offset through monetary expansion that lowers interest rates and weakens the exchange rate. A MU may also be less problematic if there is a politcal union to back it up, which has a big federal budget, and/or if labor moves flexible between countries in response to differences in unemployment rates. This is roughly the message of the OCA literature (optimum currency area) 18

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