Monetary and Exchange-Rate Policies

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Monetary and Exchange-Rate Policies

• READING ASSIGNMENT Oatley Chapter 13

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Plan for today

• Review electoral models. Especially
• The Sectoral model of voter-preferences
• export-oriented prefers weak, fixed
• import-competing prefers weak, float
• non-tradable prefers strong, float
• finance prefers float (strength doesnt matter
• Commitment problem
• Phillips curve
• A solution independent central banks

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The saga continues

• The story of the contemporary international
  monetary system is the story about the search for
  the elusive ideal balance between domestic
  economic autonomy and exchange rate stability
• So, how do governments make the decision?
• Society-based approach says its interest
  groups that pressure the government

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Trade international capital flows lead to
imbalances

• How do governments deal with these imbalances?
• Fixed exchange rate ? sacrifice monetary policy
• OR
• Floating exchange rate ? sacrifice certainty in
  international exhanges
• Trade-off between
• exchange rate stability
• versus
• domestic price stability with monetary policy
  autonomy

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What will governments choose?Society-based
models of monetary XR politics

1. Electoral models
2. Partisan models
3. Sectoral models

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1. Electoral models

• Prediction Democracies choose floating XR ?
• monetary autonomy used to manipulate
  political-business cycles
• If there is a fixed XR ?
• commitment may not be credible before elections
  (elections like the Sirens!)
• Pocketbook voter model people vote according to
  changes in their income
• http//www.youtube.com/watch?vloBe0WXtts8
• Sociotropic model voters consider macro
  performance (economic growth, unemployment,
  inflation)
• http//www.douglas-hibbs.com/HibbsArticles/Welt-am
  -Sonntag-2008-08-22.pdf

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2. Partisan models

• Left-wing parties are pro-employment
• Tied to organized labor
• Right-wing parties are anti-inflation
• Tied to business interests
• Prediction
• Right-wing governments more likely than left-wing
  governments to establish maintain a fixed XR
• It is possible to connect this to the electoral
  model
• Voters choose left-wing parties during recessions
  right-wing parties under inflation

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Consider, however,The Median Voter Model

• Maybe left and right parties will adopt the same
  policies!

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Downs offers a spatial model of party
competition.

• Based on Hotellings (1929) model
• Where should PUMA locate if people shop at stores
  closest to their house?

NIKE
PUMA
Dems ???
Reps ????
Employment concerns
Inflation concerns
Vote single-peaked preferences
In a 2-party system, where will the left right
parties locate?
What happens when somebody decides not to vote?
Median preference shifts away from the absent
voter
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Final thought on partisan models

• As we move into sectoral models,
• Consider that in the partisan model, we have
• Left labor-oriented parties
• VS
• Right business oriented parties
• What does this ontology recall from our trade
  models?
• What model is based on labor owners of capital?
• FACTOR MODEL
• So, you can think of the partisan model as
  analogous to the factor model

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3. Sectoral models

• Interest groups have different preferences on the
  trade-off between domestic
• economic autonomy XR stability
• Some groups prefer XR stability
• Others groups prefer domestic economic autonomy
• Obviously (given the name of the model) the
  interest groups are based on sector

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NIKE
PUMA
Domestic economic autonomy
Employment concerns
XR stability
Inflation concerns
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Strong currency
Domestic economic autonomy
XR stability
Weak currency
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Four domestic interest groups

1. Export-oriented producers
2. Import-competing producers
3. Nontraded-goods producers
4. Financial services industry

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Fixed or Float / Strong or Weak?

• Export-oriented producers prefer
• Fixed XR stability for their international
  transactions
• Weak XR keeps the price of their products world
  markets low (keeps demand high) ?
• Import-competing producers prefer
• Floating XR prefers monetary policy to address
  recessions/inflation
• Weak XR keeps the price of imports high! This
  spurs domestic demand ?
• Nontraded-goods producers prefer
• Floating XR prefers monetary policy to address
  recessions/inflation
• Strong XR consume more traded goods, travel
  more, pay for tuition ?

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Fixed or Float / Strong or Weak?

• Financial services industry prefer
• XR stability leads to more international
  transactions
• But XR volatility leads to XR-risk business
• And monetary autonomy helps maintain a stable
  domestic banking system, low inflation, and more
  stable interest rates
• So A weak preference for Floating XR
• As for currency strength buy foreign assets when
  XR is strong, repatriate returns when the XR is
  weak
• So No preference on XR strength

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Sectoral XR preferences summary
XR stability preference XR stability preference
High/fixed low/float/ monetary autonomy
XR strength preference Strong currency   Nontradable
XR strength preference Weak currency Export-oriented Import-competing
Exporters in other countries keep them out of
our elections!
Imperialist colonial powers? Get them out of our
countries!
???
Financial services
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Strong currency
Domestic economic autonomy
XR stability
Weak currency
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Oatleys state centered approach to Monetary
and XR politics

• Its all about commitment!

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Show me the money!
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Show me the money!

• Its all about commitment
• Insulate policy-makers from short-term political
  pressures
• Time 1 beginning of your term in office
• Time 2 right before elections
• Option A sound monetary policy
• Option B drop interest rates
• Time 1 U(A2)gtU(B2)
• Time 2 U(A2)ltU(B2)
• The sirens electoral pressures
• The commitment Independent central banks

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First the sirens policy mechanismMonetary
Unemployment

• Assume theres a natural rate of unemployment
• New entrants, labor unions, minimum wages, hiring
  firing practices, unemployment compensation
  (raise the wage, lower the demand for labor)
• Workers care about their REAL wage (purchasing
  power), but paid a NOMINAL wage
• An unanticipated reduction of the interest rate ?
  unexpected increase in inflation ? lower REAL
  wage ? reduce unemployment ?
• (An unanticipated increase of the interest rate ?
  unexpected decrease in inflation ? increase REAL
  wage ? increase unemployment ?)
• In the long-run, labor market adjusts and changes
  are reversed ? return to the natural rate of
  unemployment

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But is there a cost???...

• If a government continually uses monetary policy
  to keep unemployment below the natural rate, it
  must continually increase the rate of inflation
  (accelerationist principle)
• The Phillips curve illustrates this

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http//www.andrew.cmu.edu/course/88-301/phillips/p
hillips_curve.gif Courtesy of Peter Thompson
Intermediate Macroeconomics, Carnegie Mellon.
Also see Oatley, p289, fig 13.2

1. Over the past 40 years, the Phillips curve has
   shifted first out then in again, as changes in
   the natural rate of unemployment and in expected
   inflation have altered the terms of the short-run
   trade-off between inflation unemployment
2. In the early 1960s, the Phillips curve trade-off
   was favorable low unemployment with low
   inflation
3. The new economics of the 1960s led to an
   attempt to move to the upper right end of the
   Phillips curve, in the hope of exploiting a
   presumed permanent not just a short-run
   trade-off between inflation unemployment
4. By 1971, the short-run Phillips curve had shifted
   out! Too many years of creeping inflation had
   destroyed the Federal Reserves credibility as an
   inflation fighter, and had raised expected
   inflation
5. The 1973 tripling of of world oil prices caused a
   further outward shift in the Phillips curve
6. By 1975, the short-term inflation-unemployment
   trade-off had become unfavorable to keep
   unemployment down at 5 would require 12
   inflation, to reduce inflation to 3 would
   require 10 unemployment
7. In the early 1980s, Federal Reserve Chair Paul
   Volker decided to attempt to reestablish the
   Federal Reserves inflation-fighting credibility
   by doing whatever was necessary to reduce
   inflation
8. By 1985, it was clear that Volcker disinflation
   had succeeded. At the price of a few years of
   high unemployment, Federal Reserves
   inflation-fighting credibility had been restored
   and the short-run Phillips curve had shifted
   inward
9. But even so, the Phillips curve of the late 1980s
   early 1990s was not as favorable as that of the
   1960s
10. The mid-1990s, however, saw a further inward
    shift of the Phillips curve an apparent fall in
    the natural rate of unemployment (welfare reform?)

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What is the real cost?

• P290 Oatley
• Inflation raises uncertainty among firms unions
• This uncertainty can reduce investment
  economic growth
• This, in turn, raises the natural rate of
  unemployment
• Consider Oatley, p291, fig 13.3
• How do we solve this problem?
• We commit to low inflation with independent
  central banks (more on that next slides)
• However, also consider p298
• Countries with more independent central banks
  have experienced lower rates of economic
  growth
• Consider Oatley, p298, fig 13.6
• Conclusion Governments can impact/control
  inflation. Not so much influence on economic
  growth

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Commitment mechanisms

• Argentine Currency Board (1991-2002)
• Pegged the Argentine peso to the U.S. dollar in
  an attempt to eliminate hyperinflation
• Credibility? Required legislative vote to change
  the value of the currency (public discussion
  undermines the point of a devaluation!)
• Then current account deficit widens (after
  Brazils 1998/9 crisis)
• And deficit spending ultimately undermined
  confidence
• Tied hands prevented the government from acting
• Commitment was, perhaps, too strong
• Run on the currency in 2002 ? disaster!!

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Commitment mechanisms

• Central bank independence measured
• CBs freedom to decide which economic objectives
  to pursue
• CBs freedom to decide how to set monetary policy
  (in pursuit of the above objective)
• Whether CB decisions can be reversed by other
  branches of the government
• Examples
• Swiss National Bank highly independent
• No provision whatsoever for the government to
  influence monetary policy
• Reserve Bank of Australia highly subordinate
• Secretary of the Treasure has final authority
  over monetary-policy decisions must approve any
  interest-rate changes proposed by the Reserve
  Bank
• Does it work? Consider Oatley p296 fig 13.5
  (wheres Switzerland?)

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Time-inconsistent preference problem

• Exams force students to study solves their
  time-consistent preference problem
• But the prof has a time-consistency problem too!
• The day of the exam, my optimal strategy is to
  cancel the exam
• I can use my time for other things
• Students are also better off they did their
  studying, but are spared the exam-anxiety
• But if I cancelled all my exams, my reputation
  would suffer
• Imagine you had heard that I often cancel my
  mid-term, would you have studied?
• Then the exam would not have worked to solve your
  time-consistency problem
• So my campus reputation encourages me to be
  credible
• Summer campus problem? A one-shot game! Forget
  grades!
• KU Institutional solution to force me to give you
  a final exam?
• KU wont pay me!
• My commitment was credible after all

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Take aways

• Sectoral models
• export-oriented prefers weak, fixed
• import-competing prefers weak, float
• non-tradable prefers strong, float
• finance prefers float (strength doesnt matter
• Phillips curve
• Commitment problem
• A solution independent central banks

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Thank you