MACRO REVIEW THE KEYNESIAN MODEL Part 1: Introduction to Keynesian Model: Derivation, and National Saving Identity. Part 2: Multipliers for spending & exports Part 3: International transmission under fixed vs. floating exchange rates Part 4: Adjustment of a CA deficit via expenditure-reducing vs. expenditure-switching policies Part 5: Monetary factors API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Imports & exports depend on income: assuming E & Y* fixed, for now. Y TB + - …and rises in contractions where slope = -m ≡ - marginal propensity to import TB falls in expansions… as does consumption: Keynesian consumption function

Determination of equilibrium income in open-economy Keynesian model Now solve: where and

Derivation of National Saving Identity Income ≡ Output (assuming no transfers) Y ≡ GDP / / C + S + T ≡ C + I + G + X -M S + (T-G) ≡ I + X – M NS ≡ S + BS ≡ I + TB National Saving Identity API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

US National Saving, Investment, & Current Account as Shares of GDP, 1949-2010 Gap widened, as NS fell relative to I API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

} Keynesian Consumption Function: or, expressed as a saving function: where s ≡ 1 – c } API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Closed economy: NS – I = 0 Fiscal Expansion 1 < Closed-economy multiplier 1/s < ∞ API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Open economy: NS – I = TB = X – M Imports: for simplicity Exports: for simplicity

Open economy Fiscal Expansion slope = s API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Part 2: KEYNESIAN MULTIPLIERS AND THE TRANSFER PROBLEM The multiplier for an increase in , e.g., due to a fiscal expansion . The multiplier for an increase in , e.g., due to a devaluation . The Transfer Problem API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

SUMMARY OF MULTIPLIERS + Keynesian model of S + M => Fiscal Expansion Devaluation open-ec. multiplier = 1/(s+m)<1/s Equation (17.11). Note misprint in 10th ed. of WTP.)

MACROECONOMIC INTERDEPENDENCE Part 3: MACROECONOMIC INTERDEPENDENCE International transmission under fixed vs. floating exchange rates of a disturbance originating domestically. of a disturbance originating abroad . API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

International Transmission ↓ Fix Float ↓ Float Fix => depreciation => appreciation Floating increases effect on Y Floating decreases effect on Y = “insulation”

Conclusions regarding transmission (with no capital mobility) Trade makes economies interdependent (at a given exchange rate). TB can act as a safety valve, releasing pressure from expansion: . Disturbances are transmitted from one country to another: API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Conclusions regarding transmission (with no capital mobility), continued Floating exchange rates work to isolate effects of demand disturbances within the country where they originate: Effects of a domestic disturbance tend to be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: . . The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: . API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Parts 4 & 5: 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

Goals and instruments Policy Goals Policy Instruments Internal balance: e.g., Y = ≡ potential output Y < ≡ ES ≡ “output gap” => unemployment > Y > ≡ ED => “overheating” => inflation and/or asset bubbles External balance: e.g., BP=0 or CA=0 Policy Instruments Expenditure-reduction, e.g., G ↓ Expenditure-switching, e.g., E ↑ API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Internal balance Output gap, as percentage of GDP, 2009 Jpn Ir US Jpn France UK Ir In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << . API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Source: IMF, via Economicshelp, 2009 Copyright 2007 Jeffrey Frankel, unless otherwise noted

Output gap in eurozone periphery Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated by 2007: Y >> and crashed in 2009-12: Y << Like Italy, Spain & Portugal in 1992, but the devaluation option is now gone.

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. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

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.

current account deficit at point N, policy-makers can adjust either by Starting from current account deficit at point N, policy-makers can adjust either by cutting spending, ● ● or (b) devaluing. ● ● API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

CA deficit is eliminated at X; but Y falls below potential output . If they cut spending, CA deficit is eliminated at X; but Y falls below potential output . ● ● => recession API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

is again eliminated, at B, but with the effect of pushing Y above (b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Y above potential output. ● ● => overheating API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

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

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. ●

● ● ● To repeat, at F, some of higher demand falls on imports. 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. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

● ● 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 ↓ . ●

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.

● ● ● 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.

Swan Diagram has 4 zones: ED & TD ES & TD ES & TB>0 ED & TB>0 ●

Summary: combination of policy instruments to hit one goal slopes up, to hit the other slopes down.

Example: 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 API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Example: 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 ● 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 ES. Spending A At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Part 5: 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 & consumer durables. Or it can be defined in terms of money supply M. In which case an expansion 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 API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

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.

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