Chapter 9

1. Chapter 9

2. Chapter 9 Essential macroeconomic tools

3. Output and prices • Economic activity is measured by the GDP (gross domestic product) • GDP = sum of all production = sum of all sales = sum of all incomes • Nominal GDP (measured) vs. Real GDP (computed taking into account inflation) • GDP trend is increasing • Actual GDP is above or below trend, according to business cycles

4. Output gap: the difference between trend and actual GDP

5. Choice of exchange rate • The business cycles are undesired and the most governments try to iron them out through fiscal and monetary policies • Does the exchange rate regime, i.e. selecting a system with fixed or floating exchange rates, influence the effect of macroeconomic policies? • Let us look at this Aggregate Demand (AD) and aggregate supply (AS) setting: • Aggregate supply (AS): upwards sloping. As output gap increases threat of unemployment moderates wages and firms cut price • Aggregate demand (AD): downward sloping. Higher prices erode purchasing power and external competitiveness and output gap decreases • Changes in aggregate demand, e.g. a boom abroad: shifts aggregate demand up (AD’)

6. The AD-AS diagram

7. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland Year to year: Nothing really visible

8. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland Five-year averages: Something emerges

9. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland

10. PPP: An Implication of Long Term Neutrality • The real exchange rate: • defined as  = EP/P* • PPP: E offsets changes in P/P* • so  is constant. • Equivalently:

11. The real exchange rate Example: real exchange rate of euro in terms of dollar • Price of basket of European goods: P= €100 • Nominal exchange rate ($/€): E = 1.3$/€ • Price of basket of American goods: P*= $130 • real exchange rate: = E x P/P* = €100x 1.3$/€ : $130 = 1 basket of American goods for 1 basket of European goods NOTE: when real exchange rate appreciates, competitiveness declines as more baskets of goods in the USA would need to be traded for 1 basket of European goods.

12. Real versus nominal exchange rate appreciation

13. The Balassa-Samuelson Effect Increasing real exchange rates in new EU members (Annual % change, 1996-2008)

14. Short Term Non-Neutrality of Money • From AD-AS: the short-run AS schedule. • So monetary policy matters in the short run. • Channels of monetary policy: • the interest rate channel • the credit channel • the stock market channel • the exchange rate channel.

15. Open economy and interest rate parity condition • Financial integration • Free capital mobility • Lower interest rates at home than abroad cause financial outflows and nominal exchange rate drops HENCE, • Interest rate parity condition: Domestic interest rate = Foreign interest rate + expected exchange rate depreciation

16. Exchange Rate Regimes and Policy Effectiveness

17. IS-LM framework Initial Equilibrium: where goods and money markets are simultaneously in equilibrium

18. Fiscal and Monetary Policy in IS-LM • (Expansionary) Fiscal Policy effects • IS shifts right to IS’ as aggregate demand strengthens • Economy moves equilibrium to A’ • Consequence: output and interest rate rise • (Expansionary) Monetary Policy effects • Central bank increases money supply • Interest rates decline at initial output (B) • LM shifts down to LM’ • Economy moves equilibrium to C

19. Fiscal and Monetary Policy in IS-LM Equilibrium with fiscal expansion A’

20. Fiscal and Monetary Policy in IS-LM Equilibrium with monetary expansion

21. Monetary policy and free floating (open economy) • Increase in money supply • LM shift to right and economy moves to C with lower interest rates • In open economy, capitals flow out and exchange rate depreciates • Result: higher exports and demand • IS shifts right and economy moves to D, where interest parity is re-established

22. Exchange Rate Regimes and Policy Effectiveness • Fixed exchange rate: • government keeps exchange rate fixed through reserves and buying and selling currency • Flexible exchange rate: • currencies continuously priced by foreign exchange markets • Monetary policy with capital flows • Works with floating exchange rates • No autonomy in fixed exchange rate regimes

23. Monetary Policy with floating exchange rates

24. Monetary Policy with floating exchange rates (cont.)

25. Monetary policy and fixed exchange rates (open economy) • Increase in money supply • LM shift to right and economy moves to C, with lower interest rates • Capitals flow out and government intervenes against currency depreciation • Result: money supply shrinks and LM shifts back • IS does not move as competitiveness is unchanged (economy is back to initial point A) • Conclusion: monetary policy ineffective given offsetting exchange market operation!

26. Monetary Policy with fixed exchange rates

27. Monetary Policy with fixed exchange rates (cont.)

28. Exchange Rate Regimes and Policy Effectiveness

29. When Does the Regime Matter? • In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky. • In the long run,  is independent of E: P adjusts. • If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy. • Put differently, the choice of an exchange rate regime has mostly short-run effects because prices are sticky.