Open economies in PK theory

1. Open economies in PK theory Mundell-Fleming vs Compensation and sterilization

2. Outline • Balance sheets of central banks (Overdraft vs asset-based economies) • The Mundell-Fleming neoclassical point of view of fixed exchange rates • The compensation thesis or endogenous sterilization • Balance sheets reconsidered • The compensation thesis within the Canadian LVTS • China’s more recent example

3. The neoclassical balance sheet of central banks

8. Mundell-Fleming model • The short-run neoclassical model is essentially the Mundell-Fleming model (the IS/LM/BP model). • Being based on the neoclassical synthesis, it contains many Keynesian features. • Its main assertion is that an economy operating with fixed exchange rates would lose control of the money supply, and hence that monetary policy is ineffective. • By contrast, with flexible exchange rates, an expansionary monetary policy could achieve higher levels of output and employment.

9. The Mundell-Fleming stabilizing mechanism • Suppose a country has a balance of payment surplus. • To keep its exchange rate fixed, the central bank needs to purchase foreign currency. • This means that the central bank is adding foreign reserves to its assets. • The increase in foreign reserves leads to an increase in the monetary base (HPM) • The increase in the monetary base leads to an increase in the money supply (and a fall in interest rates). • This leads to an increase in nominal income (through quantities or prices). Net exports fall. • The balance of payments goes back to zero.

10. Implications for monetary policy • Monetary policy with fixed exchange rates is powerless. • An expansionary monetary policy (a higher supply of high powered money) drives interest rates below their world levels, and it increases output and imports. • Both of these effects drive the balance of payments into a deficit situation, thus leading to a reduction of the central bank foreign reserves, as the central bank attempts to sustain the value of its domestic currency on exchange markets. • The reduction in the foreign reserves diminishes the assets of the central bank, thus inducing a reduction in the monetary base and hence in the money supply of the economy. • The autonomous expansionary policy of the central bank is thus counter-balanced by this endogenous reduction in the monetary base and money supply. • The money supply is endogenous, but supply-led. • (in the PK view the money supply is endogenous, but demand-led)

11. Mundell quote • “…To prevent the exchange rate from falling the central bank intervenes in the market, selling foreign exchange and buying domestic money….[] Forcing the central bank to intervene by buying foreign reserves and increasing the money supply.... When the central bank buys or sells foreign exchange the money supply increases or decreases” • (Mundell, 1963, p. 479).

12. More recent quote • “But the main point is that, in behaving in this way, the central bank loses control over the home country’s money stock. This is because each exchange by the central bank of dollars for foreign currency has the effect of changing the home country’s stock of ‘high-powered money’ (alternatively referred to as ‘base money’ or the ‘monetary base’). And as most readers will know from their study of money and banking, changes in high-powered money tend strongly to induce changes – approximately equal percentage changes – in the stock of money ....” • (McCallum, 1996, p. 137)

13. Quote continues • “Let us conclude this section by reiterating its central and fundamental message: in order to maintain a fixed exchange rate, a central bank must engage in foreign exchange transactions that prevent it from managing the monetary base so as to achieve other macroeconomic objectives. If monetary policy is dedicated to pegging the exchange rate, it is then unavailable (except on a highly temporary basis) for application to other goals.” • (McCallum, 1996, pp. 139-140).

14. Hume’s specie flow mechanism • This mechanism is similar to Hume’s specie-flow mechanism and related to the theory of comparative advantage. A country with a balance of payments deficit will suffer from an outflow of gold, which will induce a fall in its money supply, and this in turn will lead to a general fall in prices. A general absolute disadvantage will be turned into a comparative advantage for some products. • Similarly, the country with an absolute competitive advantage will show a balance of payments surplus, which will generate an inflow of gold and a continuous increase in the stock of money and in prices, until the dearer prices bring back to equilibrium the balance of payments.

15. The Rules of the game • A similar mechanism is provided by the modern “monetary approach to the balance of payments” of the monetarists, where full employment is explicitly assumed. Indeed, neoclassical economists claim that the Rules of the Game must be such that “a balance of payments deficit should be fully reflected in a reduction in the supply of money, and a surplus should be fully reflected in an increased money supply” (Ethier 1988: 341). • The balance of payments is self-adjusting both in fixed and flexible exchange rate regimes.

16. The rules of the game are not automatic • Mundell (1961), whose other works are often invoked to justify the relevance of the rules of the game in textbooks and the IS/LM/BP model, was himself aware that the automaticity of the rules of the game relied on a particular behaviour of the central bank. • Indeed he lamented over the fact that modern central banks were following the banking principle instead of the bullionist principle, and hence adjusting ‘the domestic supply of notes to accord with the needs of trade’ (1961, p. 153), which is another way to say that the money supply was endogenous and that central banks were concerned with maintaining the targeted interest rates.

17. Sterilization or neutralization • Students are sometimes told that such a situation need not occurred, however, if the impact of the deficit on official foreign reserves is being neutralized or sterilized. • In the case of the balance of payments deficit, this would imply that monetary authorities retain control over the monetary base by engaging into counter-balancing open market operations, by purchasing government securities from the market. • These sterilization operations allow central banks to keep their assets at a constant level, thus halting any endogenous decrease in the money supply.

18. Can sterilization be pursued for long? • It is usually argued that sterilization cannot be pursued for very long or is ineffective. • For Claassen (1996, p. 51) for instance, ‘in the context of “perfect capital mobility” ... sterilized intervention policies are doomed to be ineffective’. • In our opinion, such statements confuse perfect capital mobility with perfect asset substitutability. • They also do not distinguish between countries that are in a current account deficit situation and losing reserves (say some Latin American countries) and those that are in a surplus situation and gaining reserves (say China).

19. The standard view • “The effect on the stock of base money of a purchase of foreign currency could be undone, for example, by a sale by the central bank of government bonds. Such an action is termed a sterilization of the foreign exchange purchase, which becomes a sterilized intervention’. It is the case, then, that central bank interventions in the foreign exchange market may not affect the home country money stock if they are sterilized. Most research on this issue has indicated, however, that the effects on exchange rates of sterilized market interventions are both weak and short-lived. Thus a central bank can keep its nation’s exchange rate fixed only by engaging in non-sterilized interventions”. • (McCallum, 1996, p. 138)

20. Another, new, argument against sterilization • In the context of Latin American countries, Frenkel (2006, p. 587) writes that sterilization operations: “consist in the selling of public-sector or central bank papers with the objective of money absorption. They imply a financial cost to the treasury or the central bank, proportional to the difference between the interest rate of those papers and the interest rate earned by the central bank’s international reserves”.

21. The opportunity cost of sterilization if interest rates are high in the domestic economy (the case of a surplus economy)

22. History shows that the rules of the game never held, even during the gold exchange regime • Bloomfield (1959, p. 49) shows that when looking at year-to-year changes in the period before the First World War – the heyday of the gold standard – the foreign assets and the domestic assets of central banks moved in opposite directions 60% of the time. Foreign assets and domestic assets moved in the same direction only 34% of the time for the eleven central banks under consideration. • The prevalence of a negative correlation thus shows that the so-called Rules of the Game were violated more often than not, even during the heyday of the gold standard. Indeed, ‘in the case of every central bank the year-to-year changes in international and domestic assets were more often in the opposite than in the same direction’ (Bloomfield, 1959, pp. 49-50).

23. Further results • Almost identical results were obtained in the case of the 1922-1938 period. • Ragnar Nurkse (1944, p. 69) shows that the foreign assets and the domestic assets of twenty-six central banks moved in opposite direction in 60% of the years under consideration, and that they moved in the same direction only 32% of the time. • Studying the various episodes of inflows or outflows of gold and exchange reserves, Nurkse (1944, p. 88) concludes that ‘neutralization was the rule rather than the exception’. Without saying so, Nurkse adopts the compensation principle as the phenomenon ruling central banks in an open economy. The rules of the game as they were to be endorsed in the modern IS/LM/BP models of Mundell are an erroneous depiction of reality.

24. The compensation thesis • Bloomfield and Nurkse have uncovered what was later to be called the compensation thesis. • The compensation thesis is sometimes called the Banque de France view, because in its modern incarnation it was endorsed by Pierre Berger, who was the general director of research at the Banque de France. • Berger (1972a, p. 94, 1972b, p. 171), points out that the compensation phenomenon that can be observed in modern economies could already be observed in the 19th century. • Berger argues that when France had large external surpluses, and hence was accumulating gold reserves, the peaks in the gold reserves of the Banque de France were accompanied by throughs in credits to the domestic economy. • As a result, despite the wide fluctuations in gold reserves, the variations in the monetary base and the money supply were quite limited.

25. Nurkse and the compensation thesis • “There is nothing automatic about the mechanism envisaged in the “rules of the game”. We have seen that automatic forces, on the contrary, may make for neutralization. Accordingly, if central banks were to intensify the effect of changes in their international assets instead of offsetting them or allowing them to be offset by inverse changes in their domestic assets, this would require not only deliberate management but possibly even management in opposition to automatic tendencies.” • (Nurkse, 1944, p. 88)

26. Active sterilization or passive compensation? • Nurkse’s rejects the standard interpretation in terms of a ‘sterilization’ operation initiated by the central bank. • Nurkse considers that it would be ‘quite wrong to interpret [the inverse correlation] as a deliberate act of neutralization’ on the part of the central bank. • On the opposite, Nurkse considers that the neutralization of shifts in foreign reserves is caused by ‘normal’ or ‘automatic’ factors, and that the compensation principle operates both in overdraft financial systems and in the asset-based ones. • In the overdraft system, Nurkse (1944, p. 70) notes that ‘an inflow of gold, for instance, tends to result in increased liquidity on the domestic money market, which in turn may naturally lead the market to repay some of its indebtedness to the central bank’.

27. Active sterilization or passive compensation? (2) • But Nurkse also observed compensating phenomena that were consistent with the operation of an asset-based financial system. • In the case of an inflow of gold and foreign exchange, foreign investors (or the banks where their deposits would be held) would purchase new government securities. • This would allow Government to reduce its debt to the central bank, as would be the case in an open-market operation. • However, as Nurkse (1944, p. 77) points out, in contrast to the usual open-market operation, the manoeuvre ‘did not come about at the Bank’s initiative’. • Alternatively, Nurkse (1944, p. 76) points out, gold inflows could also be neutralized by an increase in government deposits held at the central bank, as the Bank of Canada used to do.

28. Even Keynes recognized the compensation principle • Keynes (1930, ch. 32) was also keenly aware of the compensation phenomenon. • He points out that year after year the Bank of England would gain £10,000,000 of gold in the spring and lose a similar amount in the autumn. This should have caused concern to all, but it did not, because these inflows and outflows were compensated by corresponding seasonal outflows and inflows arising from the Treasury. • In the spring, with the receipts of income tax, the Treasury would buy back its securities from the public and from the Bank of England, thus reducing the domestic credit entry in the balance sheet of the Bank of England.

29. A PK, more realistic, balance sheet of central banks

30. An obvious case of endogenous sterilization: Germany

31. Peoples’ Bank of China balance sheet (B of yuan): the role of central bank bonds and govt deposits • June 1999 Nov. 2007 • Assets • Foreign assets 1,388 12,217 • Claims on central government 158 882 • Claims on banks 150 2,226 • Liabilities • Currency and bank reserves 3,020 9,243 • Central government deposits 3 2,315 • Central bank bonds 12 3,566 • Foreign liabilities 3 6 • Others …

32. Table 4: The balance sheet of the People’s Bank of China, in 100 million RMB • December 1999November 2007Assets35349165299Foreign assets14458122170Total Claims Claims on government Claims on banks and other financial institutions20337 1582 1920731412 8825 22260Liabilities35349165299Reserve Money Currency Deposit of financial33620 15069 1472892433 31389 60775Bond Issues11835667Deposits of Government178523159Source: People's Bank of China

33. The Canadian case, before giving up exchange rate interventions

34. The LVTS • In one of its background papers, the Bank of Canada (2003) explains that when it conducts exchange rate operations, moderating a decline in the Canadian dollar for instance, it must sterilize its purchases of Canadian dollars by ‘redepositing the same amount of Canadian-dollar balances in the financial system’, in order ‘to make sure that the Bank’s purchases do not take money out of circulation and create a shortage of Canadian dollars, which could put upward pressures on Canadian interest rates’. • Similarly, when the Bank wishes to slow down the appreciation of the dollar and sells Canadian dollars on the exchange markets, thus acquiring foreign currency, ‘to prevent downward pressure on Canadian interest rates ... the same amount of Canadian-dollar balances are withdrawn from the financial system.’. Thus sterilization is not a matter of choice, it is a necessity as long as the central bank wants to keep the interest rate at its target level.

35. Impact of foreign exchange intervention: central bank buys foreign currency (to stop CDN $ from rising)

36. Impact of foreign exchange intervention: central bank needs to bring LVTS balances back to zero

37. Next week … • A stock-flow consistent model of endogenous sterilization • And a flexible exchange rate model