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Policy Instruments in Macroeconomics Analysis

Learn about internal and external balance, monetary policy roles, balance of payments, and various policy instruments in economic studies.

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Policy Instruments in Macroeconomics Analysis

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  1. LECTURES 7 - 9: • POLICY INSTRUMENTS, including MONEY • L7: Goals and Instruments • Policy goals: Internal balance & External balance • Policy instruments • The Swan Diagram • The principle of goals & instruments • L8: Introduction of monetary policy • The role of interest rates • Monetary expansion • Fiscal expansion & crowding out L9: The Monetary Approach to the Balance of Payments

  2. Goals and instruments • Policy Goals • 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 level, • e.g.,G • Expenditure-switching, • e.g.,E . ITF-220, Prof.J.Frankel

  3. Internal balance US GDP (Y) & potential (): 1979-2014 }output gap ITF-220, Prof.J.Frankel

  4. Output gap, as % of GDP, in the 2009 Great Recession 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

  5. Output gap in eurozone peripherySource: 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 in 2007: Y >> and crashed in 2009-11: Y << ITF-220, Prof.J.Frankel

  6. 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

  7. Possible Responses to a Current Account Deficit • Financing • By borrowing • or running down reserves. vs. • Adjustment • Expenditure-reduction(“belt-tightening”) • e.g., fiscal or monetary contraction • or Expenditure-switching • e.g., devaluation.

  8. 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

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

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

  11. Derivation of SwanDiagram • Only by using both sorts of policies simultaneously • can both internal & external balance be attained, at point A. ● ● ● • Experiment: increase in • (e.g.,↑). Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0 . ● What would have to happento reduce trade deficit? ● ● Devaluation ITF-220, Prof.J.Frankel

  12. Again, • At F, TB<0 . • What would have to happen to eliminate trade deficit? ● E ↑. ● If depreciation is big enough, restores TB=0 at pointB. ● ITF-220, Prof.J.Frankel

  13. We have just derived the upward-sloping external balance curve, BB. 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 pointB. ITF-220, Prof.J.Frankel

  14. 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

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

  16. We have just deriveddownward-sloping internal balance line, YY . 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 atC. ITF-220, Prof.J.Frankel

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

  18. Derivation of the Swan Diagram Summary: the combination of policy instruments to hit one goal slopes up; the combination to hit the other slopes down. Fiscal expansion (G↑) (or monetary expansion), at a given exchange rate => Y↑ and TB↓. Devaluation (E ↑) => Y↑ and TB↑. Internal balance, Y= External balance, TB=0 If we are to maintain: then G & E must vary: inversely. together. => Internal balance line slopes down. => External balance line slopes up. ITF-220, Prof.J.Frankel

  19. ED & TB>0 Excgange rateE Mexico 1995 or Korea 1998 ED & TD Mexico 1994 or Korea 1997 ES & TB>0 ES & TD Example 1: Emerging markets in 1990s Classic response to a balance of payments crisis: Devalue and cut spending BB: External balance CA=0. ● YY: Internal balance Y= SpendingA Could be the “fragile 5” in 2013-15: India, Turkey, Indonesia, S.Afr., Brazil.

  20. ED & TB>0 Exchange rate E China 2010 China 2002 ED & TD ES & TB>0 ES & TD Example 2: China in the last decade BB: External balance CA=0. ● YY: Internal balance Y= Spending A By 2007, rapid growth pushed China into ED. By 2010, a strong recovery, due inpart to Gstimulus, moved into ED. In 2015, back into ES. Spending A In 2008-09, an abrupt loss of X, due to the global crisis, shifted China to ES.

  21. ED & TB>0 Excgange rate E ES & TB>0 ED & TD US 1981,1991,or 2008-13 US 1987or2007 ES & TD Example 3: US over 33 years BB: External balance CA=0. ● YY: Internal balance Y= Spending A ITF-220, Prof.J.Frankel

  22. End of Targets and Instruments ITF-220, Prof.J.Frankel

  23. 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 i E.g., Quantitative Easing sets MB. Y ITF-220, Prof.J.Frankel

  24. 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

  25. 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

  26. Review of IS-LM IS: Y = LM: = L(i, Y) IS LM i Y ITF 220 Prof.J.Frankel

  27. The Monetary Approachto the Balance of Payments • Sterilization definitions • Price-specie flow mechanism • Income-money flow mechanism • Historical case of non-sterilization: the Gold Standard • Historical case of sterilization: • China’s inflows, 2004-10 ITF-220 - Prof.J.Frankel

  28. The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. ITF-220 - Prof.J.Frankel

  29. Definitions: Monetary Base: Liabilities of CB  assets held by CBMB  Res + NDAwhere Res ≡ International Reserves & NDA ≡ Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking • Sterilization: • Changes in reserves (i.e., BP) offset by NDA ,ΔNDA = - ΔR, so MB unchanged. • Non-sterilization: ΔMB = ΔR. ITF-220 - Prof.J.Frankel

  30. David Hume’s Price Specie-Flow Mechanism Initially, Spain piles up gold, from the New World (mercantilism). But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level.

  31. Hume’s Price Specie-Flow Mechanism continued If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. ITF-220 - Prof.J.Frankel

  32. Mundell’sIncome-Flow Mechanism • MB↑ => M1↑ => (via i ↓ => I↑) => A↑ => Y↑. • But A↑ => TB<0 • => Res then falling gradually over time • + nonsterilization • MB falling over time • A falling over time. • In the long run, TB=0and everything is back to where it was.

  33. NS-I NS-I´ + 0 - Y TB LM LM´ i IS Mundell’s Income-Flow Mechanism,continuedA Monetary Expansion, and Its Aftermath As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion. ITF-220 - Prof.J.Frankel

  34. LM´ i M A IS Example: response to the 1994 tequila crisis Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December. . Y Argentina was on a currency board => no sterilization. Allowed 1995 reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. ITF-220 - Prof.J.Frankel

  35. Historical example of non-sterilization:The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). “Rules of the game”: Don’t sterilize. Allow adjustment to work. Pros and ConsPro: prevents excess money creation & inflation. • Cons: • prevents response to cyclical fluctuations • long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK.

  36. Capsule History of the Gold Standard • 1844 – Britain adopts full gold standard.1879 -- US restores gold convertibility. • From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices & wages. • 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. • 1944 -- Bretton Woods system, based on gold as the reserve asset.1945-1971 -- de facto: based on $. • 1958 -- Start of US BoP deficits. <= European growth > US growth • Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $ .Solutions: raise price of gold, or create SDRs. • 1971 -- Nixon suspends convertibility & devalues $. ITF-220 - Prof.J.Frankel

  37. Example of sterilizing money inflows: China after 2003 ITF-220 - Prof.J.Frankel

  38. The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves BoP Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 38 ITF-220 - Prof.J.Frankel

  39. FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html API-120 - Prof. J.Frankel, Harvard http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down

  40. Sterilization of foreign reserves: People’sBank of China sold sterilization bills,thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011,Fig.4, p.45. ITF-220 - Prof.J.Frankel

  41. In 2003-06, the PBoC had little trouble sterilizing the rising reserve inflows.Growth of monetary base& its components: But money growth accelerated sharply, in 2007-08. \ FX reserve contribution Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard

  42. To be continued… in Lectures 14-15(Starting in 2007, China had more trouble sterilizing the reserve inflow.) • The PBoCbegan to have to payhigher domestic interest rates • and to receive lower interest rate on US T bills • => “quasi-fiscal deficit” or “negative carry.” • Inflation became a problem in 2007-08. API-120 - Prof. J.Frankel, Harvard

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