1. LECTURES 7 & 8: POLICY INSTRUMENTS
Goals and Instruments
Policy goals: Internal balance & External balance
Policy instruments
The Swan Diagram
The principle of goals & instruments
Introduction of monetary policy
The role of interest rates
Monetary expansion
Fiscal expansion & crowding out

2. Goals and instruments Policy Goals Policy Instruments
Internal balance: Y = ≡ potential output.
Y < ≡ ES ≡ “output gap” => unemployment >
Y > ≡ ED => “overheating” => inflation or asset bubbles.
External balance:
e.g., CA=0 or BP=0.
Policy Instruments
Expenditure-reduction,
e.g., G ↓
Expenditure-switching,
e.g., E ↑ .
ITF-220, Prof.J.Frankel

3. Internal balance
Output gap, as percentage of GDP, in the Great Recession, 2009 US
Jpn
France UK Ir
In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << .
Source: IMF, via Economicshelp, 2009
ITF-220, Prof.J.Frankel

4. Output gap in eurozone periphery Source: IMF Economic Outlook, Sept
Output gap in eurozone periphery Source: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions)
Greece & Ireland overheated by 2007: Y >>
and crashed in : Y <<
ITF-220, Prof.J.Frankel

5. 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 = ?
=> Need 2 independent instruments:
expenditure-reduction &
expenditure-switching.
ITF-220, Prof.J.Frankel

6. vs. Financing Adjustment RESPONSES TO CURRENT ACCOUNT DEFICIT
By borrowing
or running down reserves.
vs.
Adjustment
Expenditure-reduction (“belt-tightening”)
e.g., fiscal or monetary contraction
or Expenditure-switching
e.g., devaluation.

7. ● ● ● ● Adjustment Starting from current account deficit at point N,
policy-makers can
adjust either by
cutting spending, ● ● or
(b) devaluing. ● ●
ITF-220, Prof.J.Frankel

8. ● ● If they cut spending, CA deficit is eliminated at X;
but Y falls below
potential output . ● ●
=> recession
ITF-220, Prof.J.Frankel

9. ● ● (b) If they devalue, CA deficit is again eliminated, at B,
but with
the effect of pushing Y above
potential output. ● ●
=> overheating
ITF-220, Prof.J.Frankel

10. ● ● ● ● ● ● Only by using both sorts of policies simultaneously
DERIVATION OF SWAN DIAGRAM
Only by using both sorts of policies simultaneously
can both internal & external balance be attained, at point A. ● ●
Experiment: increase in Ă
(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? ● ●
Devaluation
ITF-220, Prof.J.Frankel

11. Again,
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. ●
ITF-220, Prof.J.Frankel

12. We have just derived upward-sloping BB curve.
To repeat, at F, some of higher demand falls on imports.
We have just derived upward-sloping BB curve. .
What would have to happen to eliminate trade deficit? ●
E ↑ . If depreciation is big enough, restores TB=0
at point B. ● ●
We have just derived upward-sloping external balance line, BB.
ITF-220, Prof.J.Frankel

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

14. Experiment:
Fiscal expansion, cont.
At F, Y > .
What would have to happen to eliminate excess demand? ● ●
E ↓ . ●
If appreciation is big enough,
restores Y=
at point C.
ITF-220, Prof.J.Frankel

15. We have just derived downward-sloping YY curve.
At F, some of higher demand falls on domestic goods.
What would have to happen to eliminate excess demand? ● ●
E ↓.
If appreciation is big enough, restores at C. ●
We have just derived downward-sloping internal balance line, YY.
ITF-220, Prof.J.Frankel

16. ● Swan Diagram has 4 zones: ED & TD ES & TD ES & TB>0 ED & TB>0
ITF-220, Prof.J.Frankel

17. Summary: combination of policy instruments to hit one goal slopes up,
to hit the other
slopes down.
ITF-220, Prof.J.Frankel

18. Example 1: Emerging markets in 1990s
Classic response to a balance of payments crisis:
Devalue and cut spending
Excgange rate E
YY:
Internal balance
Y=Potential
ED & TD
ED & TB>0
ES & TD
ES & TB>0
Mexico 1994
or Korea 1997
Mexico 1995
or Korea 1998
BB:
External balance
CA=0 ●
Spending A
Could be the “fragile 5” in : India, Turkey, Indonesia, S.Afr., Brazil

19. Example 2: China in the past decade
Excgange rate E
YY:
Internal balance
Y = Potential
ED & TD
ES & TD
ES & TB>0
China
2010
BB:
External balance
CA=0
2002
ED & TB>0 ●
Spending A
By 2007, rapid growth had pushed China into ED.
But by 2010, a strong recovery, due in part to G stimulus,
shifted China again into ED.
Spending A
At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES.

20. Example 3: US over 33 years ● US 1981,1991, or 2008-13 US 1987 or 2007
Excgange rate E
YY:
Internal balance
Y = Potential
ED & TD
ED & TB>0
ES & TD
ES & TB>0
US 1987 or 2007
US 1981,1991, or
BB:
External balance
CA=0 ●
Spending A
ITF-220, Prof.J.Frankel

21. 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 such as I and consumer durables.
Or it can be defined in terms of money supply M.
In which case it is a rightward shift of the LM curve
Which itself slopes up (because money demand depends negatively in i and positively on Y).
E.g., Taylor rule sets i. LM
E.g., Quantitative Easing sets MB. i Y
ITF-220, Prof.J.Frankel

22. ● ● Monetary expansion ● ● 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

23. ● ● ●D 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. ● ●D
ITF-220, Prof.J.Frankel

24. Targets and Instruments
End of Lectures 7 & 8:
Targets and Instruments
ITF-220, Prof.J.Frankel

25. Appendix: Internal balance, before & after the 2001 recession
2000 US
Jpn
In 2000 most countries were operating above full employment: Y >
Ireland was the strongest case; Japan was the biggest exception.
ITF-220, Prof.J.Frankel

26. By 2002, most countries were operating below full employment: Y <US
Jpn
By 2002, most countries were operating below full employment: Y <
ITF-220, Prof.J.Frankel
Source: The Economist, June 22, 2002