POLICY INSTRUMENTS, including MONEY LECTURES 7 - 9: POLICY INSTRUMENTS, including MONEY L7: Goals and Instruments Policy goals: Internal balance & External balance Policy instruments The Swan Diagram The principle of goals & instruments L8: Introduction of monetary policy The role of interest rates Monetary expansion Fiscal expansion & crowding out L9: The Monetary Approach to the Balance of Payments

Goals and instruments Policy Goals Policy Instruments Internal balance: Y = 𝑌 ≡ potential output. Y < 𝑌 ≡ ES ≡ “output gap” => unemployment > 𝑢 Y > 𝑌 ≡ ED => “overheating” => inflation or asset bubbles. External balance: e.g., CA=0 or BP=0. Policy Instruments Expenditure level, e.g., G Expenditure-switching, e.g., E . ITF-220, Prof.J.Frankel

US GDP (Y) & potential ( 𝑌 ): 1979-2014 Internal balance US GDP (Y) & potential ( 𝑌 ): 1979-2014 }output gap ITF-220, Prof.J.Frankel

Output gap, as % of GDP, in the 2009 Great Recession US Jpn France UK Ir In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << 𝑌 . Source: IMF, via Economicshelp, 2009 ITF-220, Prof.J.Frankel

Output gap in eurozone periphery Source: IMF Economic Outlook, Sept Output gap in eurozone periphery Source: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated in 2007: Y >> 𝑌 and crashed in 2009-11: Y << 𝑌 ITF-220, Prof.J.Frankel

THE PRINCIPLE OF TARGETS AND INSTRUMENTS Can’t normally hit 2 birds with 1 stone. Have n targets? => Need n instruments, and they must be targeted independently. Have 2 targets: CA = 0 and Y = 𝑌 ? => Need 2 independent instruments: expenditure-reduction & expenditure-switching. ITF-220, Prof.J.Frankel

vs. Financing Adjustment Possible Responses to a Current Account Deficit Financing By borrowing or running down reserves. vs. Adjustment Expenditure-reduction (“belt-tightening”) e.g., fiscal or monetary contraction or Expenditure-switching e.g., devaluation.

● ● ● ● Adjustment => 𝑨 ↓ => 𝑿 ↑ Starting from current account deficit at point N, policy-makers can adjust either by cutting spending, ● ● => 𝑨 ↓ or (b) devaluing. => 𝑿 ↑ ● ● ITF-220, Prof.J.Frankel

● ● If they cut spending, CA deficit is eliminated at X; but Y falls below potential output 𝑌 . ● ● => recession ITF-220, Prof.J.Frankel

● ● (b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Y above potential output. ● ● => overheating ITF-220, Prof.J.Frankel

● ● ● ● ● ● Derivation of Swan Diagram Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. ● ● ● Experiment: increase in 𝑨 (e.g., 𝐺 ↑). Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0 . ● What would have to happen to reduce trade deficit? ● ● Devaluation 𝑬 ↑ ⇒ 𝑿 ↑ ITF-220, Prof.J.Frankel

Again, 𝐴 ↑ At F, TB<0 . What would have to happen to eliminate trade deficit? ● E ↑. ● If depreciation is big enough, restores TB=0 at point B. ● ITF-220, Prof.J.Frankel

We have just derived the upward-sloping external balance curve, BB. To repeat, at F, some of higher demand falls on imports. . What would have to happen to eliminate trade deficit? ● ● ● E ↑ . If depreciation is big enough, restores TB=0 at point B. ITF-220, Prof.J.Frankel

● ● Now consider internal balance. Return to point A. Experiment: increase 𝐴 ● Expansion moves economy rightward to point F. ● Some of higher demand falls on domestic goods => Excess Demand: Y > 𝑌 . What would have to happen to eliminate excess demand? ● ● E ↓ . ● ITF-220, Prof.J.Frankel

Experiment: Fiscal expansion, continued At F, Y > 𝑌 . What would have to happen to eliminate excess demand? ● ● E ↓ . ● If appreciation is big enough, restores Y= 𝑌 at point C. ITF-220, Prof.J.Frankel

We have just derived downward-sloping internal balance line, YY . At F, some of higher demand falls on domestic goods. What would have to happen to eliminate excess demand? ● ● E ↓. If appreciation is big enough, restores at C. ● ITF-220, Prof.J.Frankel

● Swan Diagram has 4 zones: ED & TD ES & TD ES & TB>0 ED & TB>0 ITF-220, Prof.J.Frankel

Derivation of the Swan Diagram Summary: the combination of policy instruments to hit one goal slopes up; the combination to hit the other slopes down. Fiscal expansion (G↑) (or monetary expansion), at a given exchange rate => Y ↑ and TB↓. Devaluation (E ↑) => Y ↑ and TB ↑. Internal balance, Y= 𝑌 External balance, TB=0 If we are to maintain: then G & E must vary: inversely. together. => Internal balance line slopes down. => External balance line slopes up. ITF-220, Prof.J.Frankel

Example 1: Emerging markets in 1990s Classic response to a balance of payments crisis: Devalue and cut spending Excgange rate E ED & TD ED & TB>0 ES & TD ES & TB>0 Mexico 1994 or Korea 1997 Mexico 1995 or Korea 1998 BB: External balance CA=0. ● YY: Internal balance Y= 𝑌 Spending A Could be the “fragile 5” in 2013-15: India, Turkey, Indonesia, S.Afr., Brazil.

Example 2: China in the last decade Exchange rate E ED & TD ES & TD ES & TB>0 China 2010 2002 ED & TB>0 BB: External balance CA=0. ● YY: Internal balance Y= 𝑌 Spending A By 2007, rapid growth pushed China into ED. By 2010, a strong recovery, due in part to G stimulus, moved into ED. In 2015, back into ES. Spending A In 2008-09, an abrupt loss of X, due to the global crisis, shifted China to ES.

● Example 3: US over 33 years US 1981,1991, or 2008-13 US 1987 or 2007 Excgange rate E ED & TD ED & TB>0 ES & TD ES & TB>0 US 1987 or 2007 US 1981,1991, or 2008-13 BB: External balance CA=0. ● YY: Internal balance Y= 𝑌 Spending A ITF-220, Prof.J.Frankel

End of Targets and Instruments ITF-220, Prof.J.Frankel

Monetary policy is another instrument to affect the level of spending. It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I and consumer durables. Or it can be defined in terms of money supply M. In which case it is a rightward shift of the LM curve Which itself slopes up (because money demand depends negatively in i and positively on Y). E.g., Taylor rule sets i. LM E.g., Quantitative Easing sets MB. i Y ITF-220, Prof.J.Frankel

● ● Monetary expansion ● ● lowers i, stimulates demand, shifts NS-I down/out. New equilibrium at point M. ● ● In lower diagram, which shows i explicitly on the vertical axis, We’ve just derived IS curve. ● If monetary policy is defined by the level of money supply, then the same result is viewed as resulting from a rightward shift of the LM curve. ● ITF-220, Prof.J.Frankel

● ● ●D Fiscal expansion ● ● shifts IS out. New equilibrium: At point D if monetary policy is accommodating. At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓ Rise in Y < full Keynesian multiplier. ● ● ●D ITF-220, Prof.J.Frankel

IS: Y = 𝐴 − 𝑏𝑖 + 𝑋 − 𝑀 𝑠+𝑚 LM: 𝑀1 𝑃 = L(i, Y) Review of IS-LM i Y IS ITF 220 Prof.J.Frankel

The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Historical case of non-sterilization: the Gold Standard Historical case of sterilization: China’s inflows, 2004-10 ITF-220 - Prof.J.Frankel

The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. ITF-220 - Prof.J.Frankel

Definitions: Monetary Base: Liabilities of CB  assets held by CB MB  Res + NDA where Res ≡ International Reserves & NDA ≡ Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking Sterilization: Changes in reserves (i.e., BP) offset by NDA , Δ NDA = - Δ R, so MB unchanged. Non-sterilization: Δ MB = Δ R. ITF-220 - Prof.J.Frankel

David Hume’s Price Specie-Flow Mechanism Initially, Spain piles up gold, from the New World (mercantilism). But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level.

Hume’s Price Specie-Flow Mechanism continued If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. ITF-220 - Prof.J.Frankel

Mundell’s Income-Flow Mechanism MB↑ => M1 ↑ => (via i ↓ => I ↑) => A ↑ => Y ↑. But A ↑ => TB<0 => Res then falling gradually over time + nonsterilization MB falling over time A falling over time. In the long run, TB=0 and everything is back to where it was.

Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath LM IS NS-I´ LM´ TB Y + - NS-I As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion. ITF-220 - Prof.J.Frankel

Example: response to the 1994 tequila crisis LM´ IS M A Example: response to the 1994 tequila crisis Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December. . Y Argentina was on a currency board => no sterilization. Allowed 1995 reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. ITF-220 - Prof.J.Frankel

Historical example of non-sterilization: The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). “Rules of the game”: Don’t sterilize. Allow adjustment to work. Pros and Cons Pro: prevents excess money creation & inflation. Cons: prevents response to cyclical fluctuations long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK.

Capsule History of the Gold Standard 1844 – Britain adopts full gold standard. 1879 -- US restores gold convertibility. From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices & wages. 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. 1944 -- Bretton Woods system, based on gold as the reserve asset. 1945-1971 -- de facto: based on $. 1958 -- Start of US BoP deficits. <= European growth > US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $ . Solutions: raise price of gold, or create SDRs. 1971 -- Nixon suspends convertibility & devalues $. ITF-220 - Prof.J.Frankel

Example of sterilizing money inflows: China after 2003 ITF-220 - Prof.J.Frankel

The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves BoP Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 38 ITF-220 - Prof.J.Frankel 38

API-120 - Prof. J.Frankel, Harvard FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html API-120 - Prof. J.Frankel, Harvard http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down

Sterilization of foreign reserves: People’s Bank of China sold sterilization bills, thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011, Fig.4, p.45. ITF-220 - Prof.J.Frankel

API-120 - Prof. J.Frankel, Harvard In 2003-06, the PBoC had little trouble sterilizing the rising reserve inflows. Growth of monetary base & its components: But money growth accelerated sharply, in 2007-08. \ FX reserve contribution Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard

API-120 - Prof. J.Frankel, Harvard To be continued… in Lectures 14-15 (Starting in 2007, China had more trouble sterilizing the reserve inflow.) The PBoC began to have to pay higher domestic interest rates and to receive lower interest rate on US T bills => “quasi-fiscal deficit” or “negative carry.” Inflation became a problem in 2007-08. API-120 - Prof. J.Frankel, Harvard