Economic Policies in Open Economies Lecture 7 PDF

Economic Environment Analysis Lecture 7 Last weeks 1. Financial side of globalization. 2. Balance of Payments. 3. Money and exchange rates. This week: Economic Policies in Open Economies Providing a framework to understand how exchange rate and output are determined. Study t...

Economic Environment Analysis Lecture 7 Last weeks 1. Financial side of globalization. 2. Balance of Payments. 3. Money and exchange rates. This week: Economic Policies in Open Economies Providing a framework to understand how exchange rate and output are determined. Study the role of economic policies in such a framework. Focus first on flexible exchange rates. How do monetary or fiscal policy work in open economies? How does globalization affect the efficiency of macro policies? This week 1. The real exchange rate and competitiveness 2. Exchange rate and output 3. The effects of monetary and fiscal policies 4. Policies in times of crisis Exchange Rates & Competitiveness The Law of One Price (LOP) On competitive markets, in absence of transport costs and tariffs, two identical goods must be sold at the same price (expressed in the same currency). Law of one Price = long term arbitrage mechanism. Consider a good indexed by i: 𝑃𝑖€ = 𝑃𝑖$ 𝐸 Else, if 𝑃𝑖€ > 𝑃𝑖$ 𝐸: buy the US produced good, sell it in Europe; increase demand in US, increase supply in Europe: prices converge. Same pricinciple that leads to price convergence in trade. Purchasing power parity (PPP) Purchasing power parity is the application of the law of one price across countries for all goods and services or for representative groups (“baskets”) of goods and services. Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices € price of a reference € price of a reference basket in Europe 𝑃€ = 𝑃$ 𝐸 basket in the US With 𝑃€ being average prices in Europe and 𝑃$ in the US. Price levels of different countries are equalized when measured in the same currency. PPP exchange rate: 𝐸 = 𝑃 $ൗ. 𝑃€ Purchasing power parity (PPP) Purchasing power parity (PPP) comes in two forms: 1. Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal the level of relative average prices across countries: 𝑃€ 𝐸= $ 𝑃 2. Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods: 𝐸𝑡 − 𝐸𝑡−1 = 𝜋€ − 𝜋$ 𝐸𝑡−1 with 𝜋 being the inflation rate. The PPP exchange rate We’ll focus on absolute PPP: 𝐸 = 𝑃 $ൗ. 𝑃€ Empirical validity of PPP LOP fails in short run: not puzzling for non-traded goods (haircuts); but also fails for traded goods. Transport costs, trade barriers (tariffs and regulations): make arbitrage more difficult. Imperfect competition: firms segment markets (to have high prices where price elasticity of demand is low) : “pricing to market”. “Branding”. Many goods considered to be highly traded contain nontraded components. Retail and wholesale costs (distribution costs) account for around 50% of final consumer price. Empirical validity of PPP Studies overwhelmingly reject PPP as a short-run relationship. The variance of floating nominal exchange rates is an order of magnitude greater than the variance of relative price indices. Failure of short-run PPP partly attributed to the stickiness in nominal prices (short run). Works much better in the long term. The Yen/$ exchange rate and the relative price ratio over the long term The Real Exchange Rate Real exchange rate (RER = q) is defined as the relative price index of goods and services between two countries 𝑃$ 𝑞 = 𝐸 × € 𝑃 A real depreciation of € vis a vis the $ (q ↑) can come from: nominal depreciation (E ↑), an increase in 𝑃$ , or an decrease in 𝑃€. The Real Exchange Rate Real exchange rate (RER = q) is defined as the relative price index of goods and services between two countries 𝑃$ 𝑞 = 𝐸 × € 𝑃 What happens to RER if PPP holds? Constant! Absolute: immediate. Relative 𝑞𝑡 − 𝑞𝑡−1 𝐸𝑡 − 𝐸𝑡−1 ≈ − 𝜋€ + 𝜋$ 𝑞𝑡−1 𝐸𝑡−1 The USD($)/GBP(£) real exchange rate (logs) Higher values means a (real) dollar depreciation (or a £ appreciation) Empirical test of PPP in the long-run Looking across countries over a long time period [0;T]. Run the following regression where (i) is a country: (Relative) PPP: 𝛽 is expected to be = 1 (and 𝛼 = zero). 𝛽 is fairly close to one for a sample of countries over decades. Convergence towards PPP: slow reversion towards PPP (from 3 to 5 years to eliminate half of the gap). Empirical test of PPP in the long-run Relative PPP: short-run vs long-run 1 Year Window 5 Year Window 20 Year Window Relative PPP prevails in the very long-run but fails in the short-run. Current Account and Real Exchange Rate Two country model: Europe-US. 𝐶𝐴€ = 𝐶𝐴(𝑞, 𝑌€ , 𝑌$ ) 𝑃$ 𝑞 = 𝐸 € = real exchange rate = relative price of US goods with respect to 𝑃 European goods. q ↑ = real depreciation of euro. Current Account and Real Exchange Rate 𝐶𝐴€ = 𝐸𝑋€ − 𝐼𝑀€ = Net exports in euros Suppose there is a real depreciation of euro (q ↑ or E ↑): How do exports (foreign demand for European goods) and imports (European demand for foreign goods) react ? Depends on two main factors: 1. How substitutable are domestic and foreign goods? if goods are highly (poorly) substitutable: large (small) effect. 2. In which currency exporters fix their prices? How much ‘pass-through’ of exchange rates to consumer prices? if exports are fixed in Producer (Local) Currency: large (small) effects. Current Account and Real Exchange Rate If q ↑ → volume of imports↓, exports↑: substitution. But if slow response of volumes (empirically 6 months-1 year): value of imports↑. Volume versus Value effect. In short term, the value effect can dominate. Net effect on the CA of q? J-curve: initially worsening of the trade balance before improvement after q ↑. Improvement under the Marshall-Lerner condition stating a large enough response of volumes (the sum of import and export elasticities to exchange rate > 1) Current Account and Real Exchange Rate Current Account and Real Exchange Rate We assume from now on: € nominal or real depreciation (E ↑ or q ↑) generates an ↑ in demand via an ↑ in net exports 𝐶𝐴€ 𝑞 = 𝐸𝑋€ − 𝐼𝑀€ ↑ A depreciation of the real exchange rate improves competitiveness: Net exports increase. Current Account and Real Exchange Rate Exchange rate and output Exchange rate and output In the long-run, think in terms of Purchasing Power Parity. Nominal exchange rate neutral. But PPP deviations are large at medium term horizon and reversion towards PPP takes years. Deviations from PPP linked to price rigidities. Impact on output when prices are rigid? Build a theory of exchange rate and output in short/medium term. Asset and Forex Market Equilibrium Focus on flexible exchange rates. Need to build the combinations of exchange rate and output that are consistent with equilibrium in the domestic money market and the foreign exchange market (AA Schedule). Use uncovered interest parity: 𝐸𝑒 − 𝐸 𝑟€ = 𝑟$ + 𝐸 Asset and Forex Market Equilibrium Asset and Forex Market Equilibrium A booming economy Asset and Forex Market Equilibrium Building the AA curve: Higher GDP raises money demand and appreciates the exchange rate 𝑌€ ↑ → 𝐿€ ↑ → 𝑟€ ↑ → E ↓(euro appreciation) AA curve: negative relation between 𝑌€ and E AA curve describes combinations between 𝑌€ and E such that asset markets are in equilibrium Asset and Forex Market Equilibrium Combination of E and 𝑌€ such that asset markets are in equilibrium. An increase in money supply Increase of 𝑀€𝑆 : Interest rate falls, depreciation of euro for a given GDP. Goods Market Equilibrium Back to basics: Aggregate Demand (AD) determines production and income levels when prices are rigid. Keynesian assumption valid in short-term (one year) because adjustment takes place through quantities and not prices Components of aggregate demand: 𝑌€ = 𝐶€ + 𝐼€ + 𝐺€ + 𝐸𝑋€ + 𝐼𝑀€ To simplify : 𝐼€ and 𝐺€ are given. Note: in theory, 𝐼€ is a decreasing function of 𝑟€ (= marginal cost of investment). Goods Market Equilibrium Keynesian consumption function: 𝐶€ = 𝐶 𝑌€𝐷 = 𝑐0 + (1 − 𝑠)𝑌€𝐷 where 𝑌€𝐷 = 𝑌€ − 𝑇€ is disposable income and (1-s) propensity to consume out of extra disposable income. 𝐶𝐴€ = 𝐶𝐴(𝑞, 𝑌€𝐷 , 𝑌$𝐷 ) 𝑃$ 𝑞 = 𝐸 € = real exchange rate = relative price of US goods with respect to 𝑃 European goods. Goods Market Equilibrium 𝐷€ = 𝐶 𝑌€ − 𝑇€ + 𝐼€ + 𝐺€ + 𝐶𝐴 𝑞, 𝑌€ − 𝑇€ , 𝑌$ − 𝑇$ 𝐷€ = 𝐷(𝑞, 𝑌€ − 𝑇€ , 𝐼€ , 𝐺€ , 𝑌$ − 𝑇$ ) Equilibrium: Aggregate Demand = Output 𝑌€ = 𝐷€ = 𝐷(𝑞, 𝑌€ − 𝑇€ , 𝐼€ , 𝐺€ , 𝑌$ − 𝑇$ ) Output and income is determined by demand (fixed prices in the short run).  Goods Market Equilibrium Equilibrium is at point 1, aggregate demand is equal to aggregate output. Point 2: demand > output, firms expand their output. Point 3: demand < output, firms reduce their output.  Goods Market Equilibrium A euro depreciation makes European goods cheaper. Net exports, aggregate demand and output increases with q. Goods Market Equilibrium A € nominal depreciation improves competitiveness. Generates an ↑ in demand via an ↑ in net exports 𝐶𝐴€ = (𝐸𝑋€ − 𝐼𝑀€ ) ↑. Multiplier effect through consumption. DD curve: positive relation between E and 𝑌€ Necessary for the goods market to be in equilibrium. The DD Curve Combination of E and 𝑌€ such that goods market is equilibrium The DD Curve and fiscal policy Fiscal expansion: increase in 𝐺€. For a given E, the demand and GDP increase  Equilibrium in assets and goods market Short term equilibrium for E and 𝑌€ such that both goods and asset markets are in equilibrium. The effects of monetary and fiscal policies Monetary and Fiscal Policies in an open economy Monetary policy shock: increase in money supply, 𝑀 𝑆. Fiscal policy shock: increase in government spending, 𝐺. Both have been used heavily to stabilize the economy (e.g. during the 2008 financial crisis, during the Covid pandemic). An important distinction: temporary vs permanent. What effect have permanent policies than temporary ones don’t? Changes expectations on the exchange rate 𝐸 𝑒. Focus on temporary shocks for simplicity. Monetary policy in an open economy Temporary monetary policy shock: 𝑀 𝑆 ↑ Monetary policy in an open economy Monetary policy: very efficient (in stimulating demand) in an open economy. In addition to effect typical effect on the closed economy on I and C, ↓ in interest rate → E ↑ (depreciation) → ↑ in net exports EX- IM → Y ↑. Monetary policy even more efficient in more open (smaller) economies to stabilize the economy (stimulating demand after a demand slump). Exchange rate channel of monetary policy. Fiscal policy in an open economy Temporary fiscal policy shock: 𝐺 ↑ Fiscal policy in an open economy Fiscal policy: less efficient (in stimulating demand) in an open economy. Appreciation of the currency and deterioration of CA (the more so DD is flatter, more open economy). Hence crowding out of net exports (on top of crowding out on investment). Fiscal policy even more inefficient in more open (smaller) economies to stabilize economy. How has globalization changed macro-policy? Trade openness makes domestic fiscal policy less efficient. Demand generated by fiscal expansion leaks more (increase in imports): shift in DD is smaller. Exchange rate appreciation affects negatively net exports: crowding out effect stronger the more open the economy. Financial openness makes domestic fiscal policy less efficient. Go to the extreme: Financial autarky means the interest parity condition does not hold and E is not affected by interest rate differential. Limited appreciation and limited fall in net exports.  How has globalization changed macro-policy? How much of an additional € in government spending deliver of additional output? Short-term effect: 0.24 on impact for high-income countries. Cumulative impact: a value of 1 says that after 20 quarters a 1 € increases in G increases output by 1€. Source: E. Ilzetzki, E. Mendoza and C.Vegh, 2009. Cumulative fiscal multiplier in open and closed economies Source: E. Ilzetzki, E. Mendoza and C.Vegh, 2009. How has globalization changed macro-policy? Trade openness makes monetary policy more efficient. Fall in interest rate generates depreciation and increase in net exports ; if more open economy (DD flatter), larger effect on output. Financial openness makes monetary policy more efficient. Go to the extreme: financial autarky means the interest parity condition does not hold and E is not affected by interest rate differential. No depreciation and no increase in net exports. How has globalization changed macro-policy? In past forty years, monetary policy has become the prime policy instrument. Fiscal policy less used (issues of delay) unless desperate times. Globalization means: domestic fiscal expansion not very expansionary for domestic economy BUT very expansionary for foreign economy. domestic monetary expansion very effective at Home but potentially at the expense of foreign economies: appreciation and fall in net exports. Finally, globalization: increases international spillovers of domestic policies (externalities). requires international coordination. Policies in times of crisis Normal Times: Monetary Policy Stabilization Recession : drop in aggregate demand  Normal Times: Monetary Policy Stabilization Standard monetary response: lowers interest rates. On the top of effects on domestic aggregate demand, increases external demand due to depreciated currency. Policies in crisis time Conventional monetary policy has been used heavily: interest rates brought to zero globally, in US and euro zone during the 2008 crisis and during the Covid-19 pandemic. But recession may have required even more monetary policy easing. Not possible to have negative nominal interest rates (= zero lower bound). Global recession limits the exchange rate channel. Standard monetary policy has reached its limits. Large fiscal expansion globally, both in EU and US. In a crisis, firms and households have difficulty to borrow/save for precautionary reasons: consumption and investment falls heavily. Important to replace falling private demand by public demand. Unconventional Monetary Policy Fiscal policy coordination for the 2008 crisis “The international dimension of the crisis calls for a collective approach. There are several spillovers that could limit the effectiveness of actions taken by individual countries, or create adverse externalities across borders. Countries with a high degree of trade openness may be discouraged from fiscal stimulus since it will benefit less from a domestic demand expansion. The flip side of these spillovers is that if all countries act, the amount of stimulus needed by each country is reduced (and provides a political economy argument for a Olivier Blanchard collective fiscal effort).” (12th February 2009) Spillover effects of fiscal policies: an example Fiscal expansion (G↑): ↑ of debt, imports (through appreciation + ↑ demand): benefit more trade partners. Nash equilibrium: no fiscal expansion; international cooperation important and difficult (free rider problem).  Fiscal Response to the 2008 financial crisis Source: OECD. Fiscal policy coordination for the Covid crisis “Governments should continue and expand these efforts to reach the most affected people and businesses—with policies including increased paid sick leave and targeted tax relief. Beyond these positive individual country actions, as the virus spreads, the case for a coordinated and synchronized global fiscal stimulus is becoming stronger by the hour.” Kristalina Georgieva, IMF Managing Director (16th March 2020) Fiscal Response to Covid-19 crisis Very large in magnitude. Larger than the fiscal response to the 2008 crisis. 2.5 trillion USD in the US in 2020. More than twice the 2009 Obama stimulus plan. 1.9 trillion for Biden in early 2021. Combination of various policies. Both demand and supply side policies. Gov’t spending: health spending, spending for a “Green Recovery”, for digitalization of the economy. Support for people (partial unemployment, cash transfers, tax breaks, … ). Support for businesses (tax breaks, subsidized loans/credit and financial help, ….). Additional supply side policies (lower production taxes in France).  The Covid-19 U.S. Fiscal Deficit (% of GDP) Source: CBO, 2023 Fiscal Response Does fiscal stabilization work? Yes, fiscal multipliers are positive (but quite uncertain). Why might fiscal policy be inefficient? Lags involved. Ricardian equivalence. Crowding out of private consumption. Crowding out of investment. Crowding out of net exports. Debt sustainability and sovereign risk. Low multipliers for highly indebted economies. Fiscal Austerity After large fiscal stimulus, fiscal adjustment might be necessary in many countries. Is the adjustment recessionary? Likely vary across countries, as adjustments tend to be more painful in large, closed economies (and countries with fixed exchange rates). Also more painful in highly indebted economies. More painful if worldwide. More painful if combined with more restrictive monetary policy. Will it hurt? Macroeconomic effects of fiscal consolidation Will it hurt? Macroeconomic effects of fiscal consolidation Will it hurt? Macroeconomic effects of fiscal consolidation Unconventional Monetary Policy Central Banks response to a crisis: 1. Conventional response: Cut “policy” interest rates substantially. 2. Non conventional responses: ‘Quantitative and Credit Easing’. Act to prevent a complete collapse of the financial system. Through central bank intermediation, maintain inter-bank transactions and liquidity provision to banks/firms. Reduce borrowing costs and stimulate credit in the economy when interest rates are at zero. Typically, through asset purchases and direct lending to firms/banks. When conventional monetary policy has run its course “The Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds.” Ben Bernanke (13th January 2009) When conventional monetary policy has run its course “We will explore all options and all contingencies to support the economy through this shock. […]. We are fully prepared to increase the size of our asset-purchase programs and adjust their composition, by as much as necessary and for as long as needed.” Christine Lagarde (19th March 2020) Unconventional Monetary Policy  Unconventional Monetary Policy The balance sheets of the ECB and the Fed, Assets. Unconventional monetary policy and inflation Is unconventional monetary expansion inflationary? No, as long as credit does not find its way in the economy and the economy is very weak. Banks/Companies are hoarding cash. Large increase in liquidity (“base money”) has initially not led to a corresponding increase in credit. However, can affect future inflation and inflation expectations. Along the recovery, credit increases = inflationary pressures due to the large amount of liquidity in circulation. Unconventional monetary policy and exchange rates Exchange rate channel of quantitative easing? Should “credit/quantitative easing” weaken the currency? 𝐸𝑒 – 𝐸 𝑟€ − 𝑟$ = = 0 𝑎𝑠 𝑟$ = 𝑟€ = 0 𝐸 Must go through expectations (𝐸 𝑒 ↑ ) If investors expect higher inflation in the future, then they should expect a depreciation of the currency. Key aspect: how does quantitative easing affect inflation expectations? Unwinding quantitative easing Central Banks do not want to unwind too fast (Fed tightened too early in the Great Depression). But rising inflation risk (lot of liquidity may find its way in the economy). Strong recovery post-Covid and rising energy prices. Need to raise interest rates to stabilize inflation. Delicate balance to achieve: speed up of recovery (and later on stability of this recovery) versus price stability. More recessionary if global monetary tightening. Exchange rate effect depends on the magnitude and speed of monetary tightening relative to other countries. Summary Summary In the long-term, purchasing power parity equalizes prices across borders. Nominal exchange rate changes reflect inflation differentials across countries. It does not hold in the short-run leading to real exchange rate fluctuations. A depreciation of the real exchange rate improves competitiveness, net exports and thus aggregate demand, at least in the medium-run (J-curve). Globalization reduces the effectiveness of fiscal policy as a stabilization tool but increases the effectiveness of monetary policy through the exchange rate channel. Globalization increases the international spillovers of policies and the need for international policy coordination. In exceptional times, when interest rate is at zero or near zero, monetary policy use other tools such as liquidity provision. The international aspects of such policies depend on exchange rate expectations.