MFE Macroeconomics Option

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MFE Macroeconomics Option

• Week 6, Lecture 1
• Macroeconomic Policy in the Open Economy

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What are the key differences between an open and
closed economy?

• Trade in Goods
• Output can now differ from domestic demand
  because of net exports
• Net exports depends on the real exchange rate
  national competitiveness CS 9.1
• Trade in Assets
• Uncovered Interest Parity
• Common Link is the Exchange Rate
• Two alternative policy regimes
• Flexible exchange rate
• Fixed exchange rates or Monetary Union

e competitiveness
AD or ISXM curve
y output
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Uncovered Interest Parity (CS 9.2.2)

• elog real exchange rate
• Rise implies real depreciation, or gain in
  competitiveness, due to
• Nominal depreciation
• Lower home prices
• Higher overseas prices
• rdreal interest rate differential
• Overseas-home
• Note in steady state or fixed rate regime, rd0
• Could add a constant for risk premia

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Implications of UIP

• With nominal inertia, monetary policy can control
  rd in short run (while prices are sticky)
• Expectations about future monetary policy are
  crucial in determining current exchange rates
  (the real exchange rate is a jump variable)
• Use different theory to determine long run real
  exchange rate
• Simplest PPP e is constant

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How to be a macro pundit

• Interest rates rise, and you are asked to comment
  on the impact on the exchange rate
• If the exchange rate appreciates
• The interest rate increase was unexpected
  greater yields on domestic assets is increasing
  the demand for the currency
• If the exchange rate does nothing
• The market had already discounted this increase
• If the exchange rate depreciates
• The market was expecting a larger increase in
  rates, so the news is that rates are lower than
  expected
• As the expectations of those in the market is
  almost never measured, you will not be proved
  wrong. Moral UIP is difficult to test

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An example of using UIP Dornbusch overshooting

• Fixed money supply nominal inertia
• x increase in money supply will lead to x
  higher prices in long run
• PPP implies x nominal depreciation in long run
• In short run increase in money supply implies
  lower interest rates (IS/LM)
• Lower expected interest rates imply additional
  depreciation
• See also CS 9.5.1.4
• UK 1980 (or was this oil, or both)?

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International Risk Sharing

• Modern consumption theory suggests consumption
  growth positively related to interest rates
• UIP implies high interest rates also associated
  with real depreciation
• So UIP implies real depreciations go with
  positive consumption growth
• International Risk Sharing applies this to
  levels level of consumption (relative to
  overseas) positively related to national
  competitiveness
• Requires complete international markets for risk
• Obstfeld and Rogoff Foundations of International
  Macroeconomics, Chapters 5 and 6

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Mundell Fleming (CS 9.5)

• Extends IS/LM to open economy
• Implies under flex rates, monetary policy
  effective, fiscal policy ineffective
• Money demand M/pf(Y,r). If M and p are fixed,
  and r is fixed in steady state by UIP, then Y is
  also fixed in steady state QED
• If IS curve shifts in short run, higher interest
  rates imply real appreciation, crowding out next
  exports, returning IS curve to its original
  position in long run
• Assumes fixed M unrealistic today
• Under fixed exchange rates, monetary policy
  ineffective, fiscal policy effective
• Obvious there is no independent monetary policy
  under fixed exchange rates
• Equilibrium given by IS curve and overseas
  interest rates, LM curve endogenous

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3 Eqn model in open economy

• Interest rates impact on IS curve through real
  exchange rate as well as direct effects
• Phillips curve unchanged if based on output
  prices
• Difference between consumer prices and output
  prices may lead to labour supply or bargaining
  effects
• Monetary rule unchanged if objectives are still
  output and inflation
• Jury still out on whether this is enough to
  completely capture social welfare in an open
  economy

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Responding to an unexpected, temporary demand
shock, if transmission mechanism is only through
exchange rate
Initial demand shock pushes output and inflation
from A to B. This shifts the Phillips curve.
Policy then moves the economy to C the optimal
output inflation combination embodied in the MR
curve. Economy then moves gradually from C to A,
as inflation expectations gradually fall.
PC(E?gt?)
?
PC(E??)
B
C
?
A
How does policy get to the point C, if the IS
curve was vertical? Use a decline in
competitiveness (e), operating through aggregate
demand. This is achieved by raising interest
rates, which requires an expected depreciation,
so we get a jump appreciation to C on the UIP
curve.
MR
y
ye
e
ADISXM
e
UIP
Expected depreciationr-rw
A
C
rw
y
r
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What if the demand shock was permanent? (see CS
9.5.1.2 and 9.5.1.3)

• Permanent IS shift requires permanent
  appreciation to crowd out net exports, assuming
  no change in natural rate i.e. ADISXM curve
  shifts to the right (AD)
• UIP curve would now cross rrw line at a lower
  level of competitiveness (D)
• If expectations in the Phillips curve were still
  sticky, interest rates would still need to rise
  to bring inflation down. This would lead to a
  further appreciation in the exchange rate (C)
• Another example of exchange rate overshooting

ADISXM
e
e
AD
A
Expected depreciationr-rw
D
D
C
y
r
rw
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Monetary policy in an open economy under flexible
exchange rates

• UIP implies that there are now two transmission
  mechanisms through which interest rates influence
  demand
• Through direct effects on investment and
  consumption
• Through UIP, which changes the real exchange
  rate, which in turn influences net exports i.e.
  the demand for domestic production
• Under UIP, the impact of an increase in interest
  rates on demand will depend on expectations about
  how long interest rates will remain high.
• This gives policy extra leverage, but it also
  creates problems of managing expectations
• However, if consumption is forward looking, then
  we have similar problems with direct interest
  rate effects.

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MFE Macroeconomics Option

• Week 6, Lecture 2
• The exchange rate and current account in the
  medium term

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PPP, net exports and the real exchange rate

• No one thinks PPP holds in the short run
• Nominal inertia stops prices adjusting
• Evidence on PPP in medium/long run mixed
• Nominal exchange rate clearly moves to compensate
  for inflation differentials
• Real exchange rate may still vary in medium/long
  run
• New open economy macro
• Assumes international goods market is imperfectly
  competitive

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Output, the real exchange rate and the trade
balance
AD curve (CS ISXM curve) If PPP held, this
curve would be flat in the long run.
Competitivenessreal exchange rate
BT curve combinations of output and
competitiveness at which trade is
balanced. Flatter than AD curve NX-aYbC BT
curve YbC/a YDD-aYbC AD curve
Y(1a)DDbC Note that as AD and AS shift, no
reason for BT0
Trade surplus
Trade deficit
AS curve (CS ERU curve) may be vertical, but
may slope because of wage bargaining effects,
labour supply effects, cost of capital effects
(CS 10.2)
Unless PPP holds, real exchange rate adjusts to
equate demand and supply for domestic output.
output
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Does a current account deficit matter?

• In short run, excess demand will raise imports,
  creating a deficit
• As it also generates inflation, no reason to be
  concerned about the deficit in itself
• Deficits can represent optimal private or public
  sector net saving
• Examples oil, demographics, infrastructure
• Under fixed exchange rates, deficits may be an
  indicator of exchange rate misalignment
• Under flex exchange rates, deficits might suggest
  an irrational bubble

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The current US deficit
1980s Appreciation in dollar (tough US monetary
policy) led to deficit, subsequent depreciation
corrected it (with lags) 2000s Initial
appreciation not so large, and partially
reversed, but deficit keeps on rising.
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US deficit - explanations

• There is still some dollar overvaluation, against
  Far East economies rather than with the Euro
• A crucial additional factor is the rapid growth
  of the US over the last decade compared to other
  major economies.
• GDP growth rates in the US, Euro Area and Japan

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Relative output growth and competitiveness
AD (ISXM)
Competitivenessreal exchange rate
BT
Outward shift in AS curve alone leads to
depreciation and a surplus. Need an outward
shift in aggregate demand to generate
appreciation and a deficit
AS
output
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US private sector and current account deficits
data and a projection
1990s US net savings decline substantially 2000s
some recovery, but growing fiscal deficit under
Bush Projection assumes further correction of
private deficit, followed by decline in fiscal
deficit. The soft landing.
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Twin deficits? Are the fiscal and current account
deficits connected?

• As national savings current account, then if
  private sector savings were unchanged, a fiscal
  deficit would lead to an equal current account
  deficit.
• However, private sector will react to fiscal
  deficit
• Extreme example Ricardian response to tax cut,
  where all the tax cut is saved by consumers
• No change in national saving, so no change in
  current account following fiscal deficit
• In practice, correlation will be between 0 and 1,
  but it will depend on the nature of the fiscal
  change

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US deficit and the dollar

• Soft landing
• AD curve shifts back as private and public
  deficits decline, reducing deficit but also
  depreciating dollar. However shift in AS curve
  may be permanent, requiring lower dollar than in
  1990
• Continuing to fly
• Large deficits continue, despite growing
  indebtedness
• Dollar will still fall (but more gradually at
  first) as trade surplus will be required to
  service interest on overseas debts
• Hard landing
• Current problem is that UIP appears not to be
  holding no allowance for likely dollar
  depreciation.
• Will market suddenly wake up, and the dollar
  crash?

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The current Chinese surplus

• Cannot maintain a currency peg with growing
  deficits, because central bank runs out of
  reserves
• Potential asymmetry China is accumulating
  dollar reserves rapidly
• So far, any inflationary consequences have been
  contained
• Is this a successful export led growth
  strategy, or a prelude to rapid inflation in
  China?

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International Policy Cooperation (CS Chapter
12)

• The US/China debate on the Renmindi/Dollar is
  an example of international policy spillovers
• Economists have long debated the merits of
  international policy coordination
• Results tend to find that gains are small if
  policy makers are benevolent
• Coordination may be more useful as a way of
  constraining non-benevolent policy
• Analysis uses same framework as single country,
  but now we have scope for game playing.

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The Stability and Growth Pact of European
Monetary Union

• Currency union as the ultimate fixed exchange
  rate regime
• Implies single monetary policy for union
• Individual countries vulnerable to asymmetric
  shocks, or asymmetric response to common shocks
• Obvious solution is to use fiscal policy to
  stabilise economy at the national level.
• Implies fiscal policy in a currency union should
  be more flexible
• Stability and Growth Pact put additional
  constraints on fiscal policy why?
• If fiscal deficits in one country became too
  large, pressure on ECB to relax monetary policy
• As some costs of fiscal expansion now spread
  across union, uncoordinated equilibrium may be
  sub-optimal (standard externality argument)
• Means of avoiding deficit bias see preceding
  lecture

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Coordination through rules or institutions?

• Originally rules were pretty tight (3 max
  deficit), potential penalties large (0.5 of GDP)
• But policy not credible penalties never
  enforced, because a majority thought it could be
  me.
• Now policy is more flexible, leaving more to
  negotiated discretion
• Does this overcome the credibility problem?
• Alternative route set up watchdog
  institutions at the national level, and
  coordinate these?
• Calmfors, Lars What Remains of the Stability
  Pact and What Next?, Swedish Institute for
  European Policy Studies, 2005 from website
  www.iies.su.se/lcalmfor