Presentation on theme: "Macroeconomic Policy Objectives"— Presentation transcript:
1Macroeconomic Policy Objectives Internal balanceFull employment…maximum outputStable prices“Overemployment” rising pricesLess-than-full-employment falling pricesVolatile aggregate demand and output lead to volatile prices.Price level volatility uncertainty inefficiencyExternal balance: Current accountnot so much in deficit to be unable to repay foreign debtnot so much in surplus that foreigners can’t repay their debts
2Achieving Internal and External Balance Pegged ratesFiscal policy effectiveExchange rate can be changedDevaluation/revaluationTools:Expenditure changing: fiscal policyExpenditure switching: exchange rate settingNeed as many tools as you have objectivesFor external balance, XXG up Y up CA down … unless E up (devaluation)For internal balance, IIE down (revaluation) CA down Y down … unless G up
3Internal Balance (II), External Balance (XX) “Four Zones of Economic Discomfort”
4The Open-Economy Trilemma The Impossible Trilogy Impossible for a country to achieve more than two items from the following list:1. Exchange rate stability…fixed (or managed) rates2. Monetary policy for internal balance.3. Freedom of international capital movements.
6Macroeconomic Policy Under the Classical Gold Standard: 1870–1914 Mechanisms keeping official gold flows (the balance of payments) from becoming too positive or too negative.Gold stock Money supply Price level Current accountHume’s Specie Flow MechanismGold stock Money supply Output&income Current accountGold stock Money supply Interest rate Capital flowsCentral banks management of bank rateKeep private capital flows ≈ Current account“Rules of the game” not followedGold stock Financial influence Sterilize gold inflowsCentral bank cooperationLending to keep gold stocks stable
7The Gold Standard and Internal Balance The US economy, 1873 – 1913DeflationFrequent financial crisesFrequent recessions1890 – 1913 unemployment: 6.8% on average1946 – 1992 unemployment: 5.7% on average
8Restore London dominance WW I: Capital flight breakdown of gold standardInterwar turbulenceLegacies of WW IRedrawn borders disrupted trade patternsOverhang of “Old Debts”:reparations/inter-allied loansLabor empowered: The eight hour dayExcessive claims hyperinflationGold Standard NostalgiaRestore London dominance
9$ Dominance/New York Dominance Classical gold standard, 1870 – 1914£ dominant despite US economic prowessUS banks couldn’t branch overseasBimetalism and its legacy $ looked riskyWW I £ instability$ denominated transactions w/Latin America, AsiaFederal Reserve fostered market in int’l acceptancesBenjamin Strong and his legacyPost-war credit in $sEuropean government bonds denominated in $sNational City Bank/Others/Branching AbroadUS financial dominance: from mid-1920sInternational economy disrupted in depression, WWII
10‘20s Halting return to gold Prelude to depression General Strike The Economic Consequences of Mr. Churchill General StrikeUS monetary expansion – help to Britain Roaring ’20sCapital flow reversal European downturnBubble and collapse‘30s World in Depression: Who Leads?UK couldn’t …US wouldn’t Protection … beggar thy neighbor1931 European banking crises and contagionCreditanstalt German banks British investment banks Flight from the £September 1931: Britain leaves gold – US defends gold standard Crisis and the Great DepressionGolden fettersHalting recovery: monetary expansion/fiscal measures/rearmament
11Postwar: Restore Stability Bretton Woods System IMF a bank/World Bank a fund$ pegged to gold … N – 1 currencies pegged to an elastic $IMF: International lender of last resortsupport pegsallow devaluation when fundamental disequilibriumCapital controls on international financial transactionsProtect financial account/Prevent balance of payments crisisCurrencies were convertible to encourage trade in goods and servicesFiscal policy the principal tool for internal balancePrincipal tools for external balanceborrowing from the IMFrestrictions on financial asset flowsinfrequent changes in exchange rates.
12Policy Mix for Internal and External Balance: 2 Goals – 2 Tools Starting with CA Deficit and Underemployment Fiscal stimulus + DevaluationUnder the fixed exchange rates of the Bretton Woods system, devaluations were supposed to be infrequentfiscal policy was supposed to be the main policy tool to achieve both internal and external balance.In general, fiscal policy cannot attain both internal balance and external balance at the same time.A devaluation, however, can move toward both internal balance and external balance at the same time.Speculator anticipation of devaluation greater internal or external imbalances.
13Reserve Currencies in Int’l Monetary System Bretton Woods: $ Standard…more flexible than goldEach central bank fixed the dollar exchange rate of its currency through foreign exchange market trades for $sExchange rates between any two currencies fixed by arbitrage.The US could use M-policy for macroeconomic stabilization despite fixed rates.Purchase of domestic assets by the Federal Reserve leads toExcess US demand for foreign currencies in the foreign exchange marketPurchases of $s by foreign central banks to keep $ from depreciatingExpansionary monetary policies by all other central banksHigher world output … and/or INFLATION
14Speculative attacks against weak currencies Gold & $ Shortage $ Glut Bretton Woods SystemProblems/breakdown:Speculative attacks against weak currenciesGold & $ ShortageBuildup of $ reserves > US gold stock$ GlutVietnam era expansion Pus up overvalued $ Rush out of $s…try to redeem gold the US doesn’t haveNixon Economic Program, August 15, 1971Close gold window…8% devaluation against gold in 12/71Import surchargeWage/price controls1973 Collapse of Bretton Woods systemForeign central banks refused to buy overvalued $ assets
16Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P* The “simple” solution for the £, DM,¥, FF, …Revalue against the $
17The Case for Floating Exchange Rates Monetary policy autonomy…w/o capital controlsEach country can choose “appropriate” long-run inflation rateSymmetry$ can “devalue” as necessary…not constrained as leaderOther countries can use monetary toolExchange rates as automatic stabilizersFloating cushions output against real shocksSomething’s gotta adjust…if not E, then YDepreciation in the face of reduced demand for a nation’s exports restores equilibrium automaticallyUnlike Bretton Woodsthere would be a “fundamental disequilibrium”and ongoing CA deficit and loss of reservesuntil price level fell or currency devalued
18The Case for Floating Exchange Rates Effects of a Temporary Fall in Export DemandOutput, YExchange rate, E(a) Floatingexchange rateDD2Depreciationleads to higherdemand for andoutput ofdomestic productsAA1DD1E22Y2Y1E11Output, YExchange rate, E(b) Fixedexchange rateDD2AA1DD1Fixed exchangerates mean outputfalls as much asthe initial fall in aggregate demandAA2Y33Y1E11
19The Case Against Floating Exchange Rates Lack of discipline… but a floating exchange rate bottles up inflation in a country whose government is “misbehaving”.Destabilizing speculationHot money…but “fundamental disequilibrium” one-way bet under fixed ratesCountries can be caught in a “vicious circle” of depreciation and inflation. E deprec Pim up CoL up W up P up E deprecFloating exchange rates make a country more vulnerable to money market disturbances: L up R up E-apprec. CA & Y downFixed rates cushion output against monetary shocksL up M up nothing shifts under fixed rates
20The Case Against Floating Exchange Rates A Rise in Money Demand Under a Floating Exchange RateOutput, YExchangerate, EDDAA1AA2E1Y11E2Y22
21What really matters? Recall: With fixed rate, monetary policy is ineffective (given free capital flows)Similarly, monetary shocks have no real effectWith floating rates, fiscal policy is ineffectiveSimilarly, temporary real shocks [like drop in demand for exports] have little real effectPermanent real shocks have “no” real effects
22The Case Against Floating Exchange Rates Injury to International Trade and InvestmentExporters and importers face greater exchange risk.But forward markets can protect traders against foreign exchange risk.International investments face greater uncertainty about payoffs denominated in home country currency.Uncoordinated Economic PoliciesCountries can engage in competitive currency depreciations.…under Bretton Woods, policies “coordinated” via US privilegeA large country’s fiscal and monetary policies affect other economies…aggregate demand, output, and prices become more volatile across countries if policies diverge.Free Float Really Managed FloatFear of depreciation – inflation spiral intervention
23The Case Against Floating Exchange Rates Speculation and volatility in the foreign exchange marketIf traders expect a currency to depreciate in the short run, they may quickly sell the currency to make a profit, even if it is not expected to depreciate in the long run.Expectations of depreciation lead to actual depreciation in the short run.The assumption we’ve been using that expectations do not change when temporary economic changes occur is not valid if expectations change quickly in anticipation of even temporary economic changes.In fact, exchange rate volatility has increased since 1973
24Macroeconomic Data for Key Industrial Regions, 1963–2009
25The Case Against Floating Exchange Rates Floating and Discipline:Inflation Rates in Major Industrialized Countries, (percent per year)
26Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2006 Purchasing Power Parity??? Source: International Monetary Fund, International Financial Studies.
27 growing US CA deficit & rest-of-world capital shortage Due to contractionary monetary policy (Volcker disinflation) and expansive fiscal policy (Reagan tax cut and military buildup, the $ appreciated by about 50% relative to 15 currencies from 1980–1985. growing US CA deficit & rest-of-world capital shortageMajor efforts to influence exchange rates:The 1985 Plaza Accord reduced the value of the dollar relative to other major currencies… “bringing down dollar”The 1987 Louvre Accord: intended to stabilize exchange ratesSpecified zones of +/- 5% around which current exchange rates were allowed to fluctuate.Quickly abandonedThe October 1987 stock market crash made production, employment and price stability the primary goals for the U.S.Did tightening to support $ trigger “Black Monday”?After Black Monday, exchange rate stability became less important.New targets were (secretly) made after October 1987, but central banks had abandoned these targets by the early 1990s.
28Large Country => Locomotive Macroeconomic Interdependence Under Floating Rate The Large Country CaseEffect of a permanent monetary expansion by US$ depreciates, US output risesForeign output may rise or fall.Foreign’s currency appreciates Foreign’s output fallsUS economy expands Foreign sells more to USEffect of a permanent fiscal expansion by USUS output rises, US currency appreciatesForeign output risesForeign’s currency depreciates Foreign’s output risesUS economy expands Foreign sells more to USLarge Country => Locomotive
29Exchange Rate Trends and Inflation Differentials, 1973–2009 Source: International Monetary Fund and Global Financial Data.
30Global External Imbalances, 1999–2009 Source: International Monetary Fund, World Economic Outlook database.The U.S. has run a current account deficit for many years due to its low saving and high investment expenditure.Rebalancing: As foreign countries spend more and lend less to the U.S.,interest rates may risethe U.S. dollar will depreciatingthe U.S. current account will improve (becoming less negative).
31Long-Term Real Interest Rates for the United States, Canada, and Sweden, 1999–2010 Source: Global Financial Data and Datastream. Real interest rates are six-month moving averages of monthly interest rate observations on ten-year inflation-indexed government bonds.
32Macroeconomic Interdependence Under Floating Rate Unemployment Rates in Major Industrialized Countries,(percent of civilian labor force)
33What Has Been Learned Since 1973? After 1973 central banks intervened repeatedly in the foreign exchange market to alter currency values.To stabilize output and the price level when certain disturbances occurTo prevent sharp changes in the international competitiveness of tradable goods sectorsMonetary changes had a much greater short-run effect on the real exchange rate under a floating nominal exchange rate than under a fixed one.The international monetary system did not become symmetric until after 1973.Central banks continued to hold dollar reserves and intervene.The current floating-rate system is similar in some ways to the asymmetric reserve currency system underlying the Bretton Woods arrangements … exorbitant privilege
34What Has Been Learned Since 1973? The Exchange Rate as an Automatic StabilizerExperience with the oil shocks of 1973 and 1979 favors floating exchange rates.The effects of the U.S. fiscal expansion after 1981 provide mixed evidence on the success of floating exchange rates.DisciplineInflation rates accelerated after 1973 and remained high through the second oil shock.The system placed fewer obvious restraints on unbalanced fiscal policies.Example: The high U.S. government budget deficits of the 1980s.
35What Has Been Learned Since 1973? Destabilizing SpeculationFloating exchange rates have exhibited much more day-to-day volatility.The question of whether exchange rate volatility has been excessive is controversial.In the longer term, exchange rates have roughly reflected fundamental changes in monetary and fiscal policies and not destabilizing speculation.Experience with floating exchange rates contradicts the idea that arbitrary exchange rate movements can lead to “vicious circles” of inflation and depreciation.International Trade and InvestmentFor most countries, the extent of their international trade shows a rising trend after the move to floating.
36Many fixed exchange rate systems have developed since 1973. European monetary system and euro zoneThe Chinese central bank currently fixes the value of its currency.ASEAN countries have considered a fixed exchange rates and policy coordination.