Open economies in PK stock-flow consistent models Applying the principle of endogenous sterilization to stock- flow consistent models

Open economies and PK models ► There are three traditions of PK analysis regarding open economies macroeconomics ► The Paul Davidson tradition, regarding the architecture of the world monetary system ► The Tony Thirlwall tradition, regarding external constraints on growth ► The Wynne Godley tradition, regarding stock-flow consistency

The Paul Davidson tradition (1972) ► Concerns with whether exchange rates should be fixed or flexible. ► Concerns with the need to have capital controls, Tobin taxes on international transactions, etc. ► Concerns with the present architecture, which has no mechanism inducing surplus countries to balance their current account ► Concerns with the role of the US dollar

The Tony Thirlwall tradition (1979) ► Inspired by the Harrodian trade multiplier (1933). ► Has given rise to many econometric tests ► Claims that growth is constrained by the need to balance the trade account ► Claims that growth of a country over the medium run is equal to the growth rate of exports divided by the local income elasticity of imports (Thirlwall’s law). ► The growth rate of country X exports is equal to the growth rate of world income multiplied by the income elasticity of demand for products of country X.

The Wynne Godley tradition (1974, 1999) ► Also inspired by Harrod’s trade multiplier ► Based on a national income identity, identified in 1974, that says that financial balances are such that:  Private saving minus investment + government surplus = current account surplus  Private lending + government lending + non-residents lending = 0  Private lending = government borrowing + non-residents borrowing ► Sometimes called the New Cambridge approach ► The other breakthrough is the Godley 1999 Levy Institute working paper, that introduces these ideas in a stock-flow consistent model ► Also an interesting paper by Lance Taylor (2004), based on the above.

Heuristic proof of the identity ► GDP = PX + G + (X – IM) ► GNP = PX + G + X – IM + YF ► (GNP – PX – T) = (G – T) + (X – IM + YF) ► NAFA = PSBR + CAB ► Net Accumulation of Financial Assets = Public Sector Borrowing Requirements + Current Account Balance ► Private surplus = Government deficit + non- residents borrowing ► (YF = Net foreign income; PX private expenditures)

Financial balances (net lending) of US economy Non-residents lending = current account deficit

Financial balances, Canada

The stock-flow model ► Integrates flows and stocks ► Integrates portfolio decisions (Tobin) ► Links up with portfolio “static” models: Allen and Kenen (1980), Branson and Henderson (1985), that are now back in fashion ► Goes beyond the standard models, where the rest of the world is a given, by describing two interrelated economies

Kinds of open-economy SFC models ModelGovernments Central banks Regime Reserves, others Godley 1999A 22 Fixed, Flexible Gold Lavoie Lavoie currency board Fixed US $ G&L 2006 JPKE 22 Fixed, with and without capital flows; Flexible US$, no interest payments flows G&L 2007 book ch6 22Fixed Gold, no capital flows G&L 2007 book ch Fixed and flexible US $, pricing equations

Further Kinds of open-economy SFC models ModelGovernments Central banks RegimeReserves Izurieta DollarizationUS$ Lequain 2003 (UofO) 32Fixed US $ G&L 2006 CJE 32Flexible US $ Zhao 2006 (UofO)33 Fixed between China and US, flexible otherwise US $

The G&L 2007 Chapter 6 model ► Contains broadly the same equations as the chapter 4 model  No investment, no banks  Consumption depends on current income and past wealth  Portfolio choice between bills and money  Interest rate targeting ► There are now exports and imports ► Imports are a direct function of local GDP ► The imports of one country are necessarily the exports of the other country ► There are capital controls: households of the north (Canada) cannot hold bills issued in the south (USA) and vice-versa ► Gold reserves ► Fixed exchange rates

The redundant equation ► It describes the equivalence between reserve gains by one country and reserve losses by the other, as can be seen in the last row of the transactions-flow matrix. ► Δor S = −Δor N

Simulations ► We start from a full stationary state, where both economies are in a balance of payments position (a trade balance, since there are no private capital transactions). ► When a shock is being imposed upon this fixed-exchange rate model, the economies reach a quasi stationary state, where flows reach a constant, but where some stocks are changing.

Impact of an increase in the propensity of the South to import

The twin deficits !

The compensation thesis in action ► The South has a trade deficit, therefore it is losing gold. ► The South has a government deficit, therefore, its government needs to issue bills. ► The central bank purchases the bills, at about the same rhythm that it is losing gold, acting simply to keep the interest rate on bills constant. ► There is endogenous sterilization of the gold losses (the compensation thesis). ► Despite being on a gold exchange standard, the “Rules of the game” do not apply. Hume’s “price-specie flow” mechanism has no bite.

The compensation thesis in action

Compensation again

Limits of compensation ► Obviously this mechanism can go on only as long as there are gold reserves in the South country. ► Note that the North country has no reason to change its behaviour, as long as it does not object to accumulating gold reserves. ► It can be shown that gains or losses of gold reserves will continue as long as the following equality is not fulfilled for each country: ► Y = G NT /θ = X/μ  Where G NT are total government expenditures net of taxes collected on interest payments;  and where θ is the tax rate and μ is the propensity to import.

Policies to stop losing gold ► Y = G NT /θ = X/μ ► The first term is the Blinder fiscal stance equation; the second term is the Harrod trade equation. ► If the propensity to import is overly high, this means that the fraction is overly small; the other fraction (the fiscal stance) must thus be reduced, either by raising the tax rate of reducing government expenditures (the IMF solution to all problems of emerging economies!) ► The following graph assumes a mechanism that reduces government expenditures when losing gold.

Evolution of the balances of the South country – net acquisition of financial assets by the household sector, government budget balance, trade balance – following an increase in the South propensity to import, with fiscal policy reacting to changes in gold reserves

A more complex model ? ► What if there was a more complex model, with capital flows, dollar reserves, etc. ► This is the chapter 12 model. ► Results will be essentially the same, except that due to interest payments on foreign debt, the current account balance will rise exponentially (while the trade balance remains constant) if nothing is done.

Effect of an increase in the US propensity to import on UK variables

Effect of an increase in the US propensity to import, within a fixed exchange rate regime with endogenous foreign reserves, on the UK current account balance and elements of the balance sheet of the Bank of England (the UK central bank): change in foreign reserves, stock of money, holdings of domestic Treasury bills

Using interest rates ► What if a country has a current account deficit problem, and tries to solve it by raising interest rates instead of decreasing government expenditures ? ► Will this also bring the economy back to a full steady state ? ► The answer is no

Interest rates are destabilizing

Contradicting received wisdom ► Alan Greeenspan and others have been saying that Chinese accumulation of US Treasury bills is making it difficult for them to manage their monetary policy; but the above analysis strongly suggests that they are mistaken. ► Mainstream authors would say that the UK (or Chinese) central bank of our model is “sterilizing” foreign reserves, by selling domestic Treasury bills on the open market. In a way, it is true. But this is not the result of any intentional policy, where central bankers are actively intervening in financial markets. ► The UK (Chinese) central bank, just like the US one, is simply attempting to keep interest rates constant. Bills are provided to those who demand them at the set rate of interest. The central bank provides cash on demand to its citizens.

What about flexible exchange rates? ► This is discussed in G&L JPKE ► Also in the G&L book, chapter 12, with a full model, complete with partial exchange-rate pass through, price and income import elasticities, etc.