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

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

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

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) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated by 2007: Y >> and crashed in 2009-11: Y << ITF-220, Prof.J.Frankel

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

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.

● ● ● ● 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

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

● ● ● ● ● ● 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

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

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

● ● 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

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

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

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

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

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 2013-14: India, Turkey, Indonesia, S.Afr., Brazil

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.

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 2008-13 BB: External balance CA=0 ● Spending A ITF-220, Prof.J.Frankel

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

● ● 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

● ● ●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

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

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

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