session 10. open economyfaculty.insead.edu/fatas/mge/session 10.pdf · when the bank of england had...

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Macroeconomics in the Global Economy Antonio Fatás

Session 10. Open Economy Flexible Exchange Rates

v The Great Depression and Deflation

v The IS/LM Model in an Open Economy

v The case of Flexible Exchange Rates

v The US dollar appreciation of the 80s.


The Great Depression: The Background

v  The Gold Standard. The birth date of the standard is considered 1819 when the Bank of England had to resume the exchange of gold for paper currency. Effectively the gold standard was adopted in most countries around the world in the years between 1870 and 1900. This adoption ended a long period of bi-metallic standard in which both gold and silver were used to back the money in circulation.

v  During WWI several countries suspended the gold standard but later it was resumed again (e.g. Britain resumed the gold standard in 1925). In general, the gold standard did not require 100% cover ratio. Instead, ratios varied between 29 and 40%.

v  The Great Depression was a world-wide phenomenon – every industrialized country underwent some decline in economic activity. For the United States the Great Depression led to a sharp increase in unemployment, decline in output and in 1933 abandonment of the Gold Standard. Usually we consider the years 1929-1933 as the period that we call The Great Depression.

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The Great Depression: Deflation and Banking crises

v  Deflation is defined as a decline in the aggregate price level. Hence deflation is simply negative inflation. Although the economy should operate similarly under deflation or inflation, empirically there are stark differences. One important illustration of the dangers of deflation is the Great Depression.

v  Because nominal interest rates cannot become negative, real interest rates increase as inflation becomes more and more negative. Traditional monetary policy (lowering interest rates) is not possible and the economy enters a spiral of decreased demand, lower GDP and even more deflation.

v  In addition, deflation raises the real value of debt which might lead to financial and banking crisis.


The Great Depression

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The Great Depression as a Financial Crisis

v  The Great Depression was associated with a deep banking crisis.

v  Banks operate in a fractional-reserve system (their liquidity or reserves do not cover all deposits). Their business is to transform short-term liabilities (deposits) into long-term assets (loans, mortgages).

v  In the absence of insurance on bank deposits, customers will run to the bank to withdraw all their deposits if they see signs of insolvency. Insolvency and illiquidity are difficult to separate.

v  A bank run will lead to a collapse of the banking system as well as the sharp contraction in monetary aggregates and lending.

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5000

8000

11000

14000

Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36

Monetary Base (Currency + Reserves)

25000

30000

35000

40000

45000

50000


Money Supply (M1)

40

45

50

55

60

65


Price level

600

700

800

900

1000


Real money balances (M1/P)



3

4

5

6

7

8


Money Multiplier (C/D + 1)/(C/D+ R/D)

5



6

10

14

18

22


Ratios

Currency-to-deposit ratio (C/D)

Reserves-to-deposit ratio (R/D)


The Great Recession

500

700

900

1100

1300

1500

1700

1900

2100

2300

2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03

Monetary Base

M1

Monetary Base (C+R) and Money Supply M1 (C+D)

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The Great Recession

0.8

1

1.2

1.4

1.6

1.8

2

2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03

Money Multiplier = Money Supply / Monetary Base= = (C/D + 1)/(C/D+ R/D)


The Great Recession

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03

Currency-to-deposit ratio (C/D)

Reserves-to-deposit ratio (R/D)

Ratios

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Assets 2007 2009 2010 Liabilities 2007 2009 2010

Loans to banks Securities 755 1,846 2,159 Govt. 755 777 1,010 Agency+MBS 0 1,069 1,149

Currency 760 861 915 Reserves 43 1,139 1,078

Balance sheet of a Central Bank

Assets 2007 2009 2010 Liabilities

Securities Loans Reserves 43 1,139 1,078

Deposits Loans from Central Bank

Balance sheet of commercial banks

U.S. Monetary Aggregates What happened in the Fall of 2008?

All figures from US Federal Reserve. End of the year. Billions of USD.


Deflation in Japan

-8

-6

-4

-2

0

2

4

6

8

Real GDP Growth Inflation

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Exchange rates: Definitions

  Nominal Exchange rate  Relative price of the currencies of two countries  How many units of foreign currency one can buy with one unit of

domestic currency

  Real exchange rate  How many foreign goods one can buy with one unit of a domestic good

ε =e PP *

ε – real exchange rate e – nominal exchange rate

P – price of a domestic good (basket of goods) P* – price of a foreign good (basket of goods)


Let’s determine the real exchange rate between a Microsoft Xbox 360 Kinect sold in France and in the US (source: Amazon.com and Amazon.fr on May 8, 2012) (France is the home country in this example)

PFrance = €186; PUS = $199; e = 1.30$/€

Exchange rates: PPP

ε =1.30*186199

=1.21

According to this example is the euro over/undervalued? What is the nominal exchange rate that will preclude arbitrage?

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Exchange rates: PPP


Exchange rates: PPP

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v  When the value of the domestic currency increases/decreases under a flexible exchange rate regime, then this currency appreciates/depreciates.

v  Under a fixed exchange rate regime the corresponding terms are revaluation and devaluation.

v  We can represent the link between nominal (NER) and real exchange rates (RER) in terms of percentage changes:

% change in RER = % change in NER + Domestic inflation - Foreign inflation

Exchange rates: Movements


Inflation and the Nominal Exchange Rate Long-run Dichotomy

% change in RER = % change in NER + Domestic inflation - Foreign inflation

Percentage change in nominal exchange rate

10 9 8 7 6 5 4 3 2 1 0

- 1 - 2 - 3 - 4

Inflation differential

Depreciation relative to U.S. dollar

Appreciation relative to U.S. dollar

- 1 - 2 - 3 1 0 2 3 4 5 6 8 7

France Canada

Sweden Australia

UK Ireland

Spain

South Africa

Italy New Zealand

Netherlands Germany

Japan

Belgium

Switzerland

Source: Mankiw (Fig.5.13). Averages for 1972-2000.

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M P

= L(i,Y)

*PPe

=ε

r = i

Aggregate Demand in an Open Economy

In an open economy aggregate demand consists of four components: consumption, investment, government expenditures and net exports

Y = C (Y, Ye T, r, wealth) + I (r) + G + NX (εε, Y, Yf) Where Yf is foreign demand for domestic goods and ε is the real exchange rate: We also have the usual money market equation Assumptions: As before, we will assume that in the short run prices are fixed so P and P* are given (exogenous). Inflation is zero and the real and nominal interest rates are the same (also, changes in nominal and real exchange rates are identical):


M

P = L(r,Y)

We have two equations Y = C (Y, Ye T, r, wealth) + I (r, future productivity) + G + NX (εε, Y, Yf)

But we have three unknowns to solve for (endogenous variables): Y, r and e To close the model we need one more assumption: If there is capital mobility, the domestic interest rate cannot be independent of world interest rates. Strong assumption: perfect capital mobility, arbitrage makes domestic and foreign interest rates equal

r = r*

Aggregate Demand in an Open Economy

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Floating and Fixed Exchange Rates

v  To close the model we need to think about the determination of exchange rates

v  In a system of flexible exchange rates, e is allowed to fluctuate in response to changing economic conditions.

v  In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.

v  Examples:   Floating: U.S., Japan, the Euro zone, Chile, Singapore …   Fixed: China (until July 2005, post-2008), Hong Kong, Bulgaria, …


v Under floating exchange rates, the nominal exchange rate is endogenous. Assuming perfect capital mobility, we have two equations and two unknowns (Y and e)

M

P = L(r,Y)

Remember that prices are constant and that capital mobility implies:

r = r*

Y = C (Y, Ye T, r, wealth) + I (r, future productivity) + G + NX (εε, Y, Yf)

Floating Exchange Rates

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The IS/LM Model for a Small Open Economy

r

Y Output

IS

Interest rate

LM

Foreign interest rate

r*

The key assumption is that if the domestic interest rate (i.e. the point where the IS and LM curves cross) is different from the world interest rate, then this difference will trigger immediate capital outflows or inflows, which in turn will depreciate or appreciate the currency. This leads to a change in NX and a shift in the IS curve.

Ap

preciation

Dep

reciation


Monetary Policy and Flexible Exchange Rates

r

Y Output

IS

Interest rate

LM


r*

A monetary expansion, by lowering interest rates, causes a capital outflow and a depreciation of the currency. The depreciation of the currency increases exports and leads to an expansion in output. As output expands, money demand increases. As money demand increases interest rates return to initial values (*).

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Fiscal Policy and Flexible Exchange Rates

In a small open economy fiscal policy has no effect on output unless monetary policy accommodates fiscal policy. An increase in government spending or a tax cut shifts the IS curve to the right and pushes up interest rates leading to an appreciation of the currency. The appreciation of the currency leads to falling exports. Unless the money supply increase, the decrease in exports will perfectly offset the increase in output caused by government spending.

r

Y Output

IS

Interest rate

LM


r*


With the support of President Reagan, the US Congress passed legislation in 1981 that substantially cut personal income taxes. Because these tax cut were not met with a cut in spending – to the contrary spending increased during these years – the federal budget went into deficit for a long period of time.

-6

-5

-4

-3

-2

-1

0

1

1979 1980 1981 1982 1983 1984 1985

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16.5

17

17.5

18

1979 1980 1981 1982 1983 1984 1985

Budget balance (% of GDP) Government spending (% of GDP)

The US Dollar Appreciation in the Early 1980s

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The real interest rate changed as predicted:

The Synthetic Euro/$ exchange rate

1979 1980 1981 1982 1983 1984 1985

-0.98 -1.11 4.61 6.93 7.29 7.67 6.14

And so did the exchange rate:

0.6

0.8

1

1.2

1.4

1.6

Jan-

79

Jul-

79

Jan-

80

Jul-

80

Jan-

81

Jul-

81

Jan-

82

Jul-

82

Jan-

83

Jul-

83

Jan-

84

Jul-

84

Jan-

85

Jul-

85

The US Dollar Appreciation in the Early 1980s


Session 10. Summary

v  Inappropriate monetary policy can destabilize the economy and generate a long period of uncertainty and slow growth. Both when monetary policy is excessively loose (hyperinflation) or excessively tight (deflation) the economy slows down.

v  The IS/LM model for an open economy introduces two modifications: v Demand (Y) includes also Net Exports, which depend on the real

exchange rate v  Perfect capital mobility is assumed (r = r*).

v  In an open economy with a flexible exchange rate regime, macroeconomic policies have the following effects: v  Fiscal policy cannot change the level of output. Fiscal expansions cause

appreciation of the currency. v Monetary policy is very powerful – it works both through its effects on

interest rates and also through the exchange rate

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To solve the model we assume perfect capital mobility, so that the domestic and foreign interest rates are equal

r = r* Remember that we are assuming no inflation, so this also implies that nominal interest rates are equal across countries

i = i* In reality, what matters for arbitrage opportunities is the difference in returns between domestic and foreign assets. The return in foreign assets is equal to the foreign interest rate (i*) plus the expected appreciation of the currency in which the foreign asset is denominated. It is this return that has to be equal to the domestic (nominal) interest rate. So the true equation that implies no arbitrage in foreign exchange markets is

i + expected change in nominal exchange rate = i*

This equation implies that if a country has high interest rates, only an expected depreciation of its currency will stop arbitrage (and capital flows) to happen. We will come back to this more realistic arbitrage equation in Session 14. For the next sessions we will use the simplified version that assumes interest rates being equal as the no-arbitrage condition.

Appendix: Capital Mobility: Interest Rates and exchange rates

(to be continued in Session 14)

session 10. open economyfaculty.insead.edu/fatas/mge/session 10.pdf · when the bank of england had...

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