Monetary and Exchange-Rate Policies READING ASSIGNMENT: Oatley – Chapter 13

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 doesn’t matter Commitment problem Phillips curve A solution: independent central banks

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 it’s interest groups that pressure the government…

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

Electoral models Partisan models Sectoral models What will governments choose? Society-based models of monetary & XR politics Electoral models Partisan models Sectoral models

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?v=loBe0WXtts8 Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation) http://www.douglas-hibbs.com/HibbsArticles/Welt-am-Sonntag-2008-08-22.pdf

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

Consider, however, The Median Voter Model Maybe left and right parties will adopt the same policies!

Downs offers a “spatial” model of party competition. Based on Hotelling’s (1929) model Where should PUMA locate if people shop at stores closest to their house? NIKE PUMA Dems 민주당 Reps 한나라당 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

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”

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*

Domestic economic autonomy Inflation concerns XR stability NIKE PUMA Employment concerns Domestic economic autonomy Inflation concerns XR stability

Strong currency Domestic economic autonomy XR stability Weak currency

Four domestic interest groups Export-oriented producers Import-competing producers Nontraded-goods producers Financial services industry

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 

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

Sectoral XR preferences summary XR stability preference High/fixed low/float/ monetary autonomy XR strength preference Strong currency   Nontradable Weak currency Export-oriented Import-competing Imperialist colonial powers? Get them out of our countries! Exporters in other countries – keep them out of our elections! ??? Financial services

Strong currency Domestic economic autonomy XR stability Weak currency

Oatley’s “state centered” approach to Monetary and XR politics It’s all about commitment!

Show me the money!

Show me the money! It’s 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)>U(B2) Time 2: U(A2)<U(B2) The “sirens”: electoral pressures The commitment: Independent central banks

First – the “sirens” policy mechanism: Monetary & Unemployment Assume there’s 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”

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

http://www. andrew. cmu. edu/course/88-301/phillips/phillips_curve http://www.andrew.cmu.edu/course/88-301/phillips/phillips_curve.gif Courtesy of Peter Thompson Intermediate Macroeconomics, Carnegie Mellon. Also see Oatley, p289, fig 13.2 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 In the early 1960s, the Phillips curve trade-off was favorable: low unemployment with low inflation 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 By 1971, the short-run Phillips curve had shifted out! Too many years of creeping inflation had destroyed the Federal Reserve’s credibility as an inflation fighter, and had raised expected inflation The 1973 tripling of of world oil prices caused a further outward shift in the Phillips curve 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 In the early 1980s, Federal Reserve Chair Paul Volker decided to attempt to reestablish the Federal Reserve’s inflation-fighting credibility by doing whatever was necessary to reduce inflation By 1985, it was clear that Volcker disinflation had “succeeded.” At the price of a few years of high unemployment, Federal Reserve’s inflation-fighting credibility had been restored and the short-run Phillips curve had shifted inward But even so, the Phillips curve of the late 1980s & early 1990s was not as favorable as that of the 1960s The mid-1990s, however, saw a further inward shift of the Phillips curve: an apparent fall in the natural rate of unemployment (welfare reform?)

What is the real cost? P290*** Oatley: How do we solve this problem? 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

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 Brazil’s 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!!

Commitment mechanisms Central bank independence measured: CB’s freedom to decide which economic objectives to pursue CB’s 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 (where’s Switzerland?)

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 won’t pay me! My commitment was credible after all…

Take aways Phillips curve Commitment problem Sectoral models: export-oriented prefers weak, fixed import-competing prefers weak, float non-tradable prefers strong, float finance prefers float (strength doesn’t matter Phillips curve Commitment problem A solution: independent central banks

Thank you