Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University MACRO REVIEW THE KEYNESIAN MODEL Part 1: Introduction to Keynesian Model: Derivation, and National Saving Identity. Part 2: Multipliers for spending & exports Part 3: International transmission under fixed vs. floating exchange rates Part 4: Adjustment of a CA deficit via expenditure-reducing vs. expenditure-switching policies Part 5: Monetary factors

Imports & exports depend on income: Y TB as does consumption: Keynesian consumption function assuming E & Y* fixed, for now. where slope = -m ≡ - marginal propensity to import TB falls in expansions… …and rises in contractions

Determination of equilibrium income in open-economy Keynesian model whereand Now solve:

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Derivation of National Saving Identity Income ≡ Output (assuming no transfers) Y ≡ GDP S + (T-G) ≡ I + X – M / / NS ≡ S + BS ≡ I + TB National Saving Identity C + S + T ≡ C + I + G + X -M

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University US National Saving, Investment, & Current Account as Shares of GDP, Gap widened, as NS fell relative to I

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Keynesian Consumption Function: or, expressed as a saving function: where s ≡ 1 – c }

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Closed economy: NS – I = 0 Fiscal Expansion 1 < Closed-economy multiplier 1/s < ∞

Open economy: NS – I = TB = X – M Imports: for simplicity Exports: for simplicity

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Open economy Fiscal Expansion slope = s

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Part 2: KEYNESIAN MULTIPLIERS AND THE TRANSFER PROBLEM The multiplier for an increase in, e.g., due to a fiscal expansion. The multiplier for an increase in, e.g., due to a devaluation. The Transfer Problem

SUMMARY OF MULTIPLIERS + Keynesian model of S + M => Fiscal Expansion open-ec. multiplier = 1/(s+m)<1/s Devaluation Equation (17.11). Note misprint in 10 th ed. of WTP.)

API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Part 3: MACROECONOMIC INTERDEPENDENCE International transmission under fixed vs. floating exchange rates of a disturbance originating domestically. of a disturbance originating abroad.

Fix Float Fix International Transmission ↓ ↓ Floating increases effect on Y Floating decreases effect on Y => appreciation => depreciation = “insulation”

API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Conclusions regarding transmission (with no capital mobility) Trade makes economies interdependent (at a given exchange rate). –TB can act as a safety valve, releasing pressure from expansion:. –Disturbances are transmitted from one country to another:.

API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Conclusions regarding transmission (with no capital mobility), continued Floating exchange rates work to isolate effects of demand disturbances within the country where they originate: –Effects of a domestic disturbance tend to be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier:.. – The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy:.

Goals and Instruments Policy goals: Internal balance & External balance Policy instruments Parts 4 & 5: POLICY INSTRUMENTS The Swan Diagram The principle of goals & instruments Introduction of monetary policy The role of interest rates Monetary expansion Fiscal expansion & crowding out

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Goals and instruments Policy Instruments Expenditure-reduction, e.g., G ↓ Expenditure-switching, e.g., E ↑ Policy Goals Internal balance: e.g., Y = ≡ potential output Y unemployment > Y > ≡ ED => “overheating” => inflation and/or asset bubbles External balance: e.g., BP=0 or CA=0

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y <<. Source: IMF, via Economicshelp, 2009 UK US France Output gap, as percentage of GDP, 2009 Ir Jpn Internal balance

Output gap in eurozone periphery Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions ) Greece & Ireland overheated by 2007: Y >> and crashed in : Y << Like Italy, Spain & Portugal in 1992, but the devaluation option is now gone.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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 = ? => Need 2 independent instruments: expenditure-reduction & expenditure-switching.

Financing By borrowing or running down reserves. RESPONSES TO CURRENT ACCOUNT DEFICIT Adjustment Expenditure-reduction (“belt-tightening”) e.g., fiscal or monetary contraction vs. or Expenditure-switching e.g., devaluation.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Starting from current account deficit at point N, policy-makers can adjust either by (a)cutting spending, or (b) devaluing. ● ● ● ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University (a) If they cut spending, CA deficit is eliminated at X; but Y falls below potential output. => recession ● ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University (b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Y above potential output. => overheating ● ●

Devaluation Experiment: increase in Ă (e.g. G↑) Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0. DERIVATION OF SWAN DIAGRAM What would have to happen to reduce trade deficit? ● ● ● ● ● ●

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

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University. What would have to happen to eliminate trade deficit? E ↑. If depreciation is big enough, restores TB=0 at point B. We have just derived upward-sloping external balance line, BB. To repeat, at F, some of higher demand falls on imports. ● ● ●

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

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

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

Swan Diagram has 4 zones: I.ED & TD II.ES & TD III.ES & TB>0 IV.ED & TB>0 ●

Summary: combination of policy instruments to hit one goal slopes up, to hit the other slopes down.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Example: Emerging markets in 1990s Excgange rate E YY: Internal balance Y=Potential ED & TD ED & TB>0 ES & TD ES & TB>0 Mexico 1994 or Korea 1997 Mexico 1995 or Korea 1998 Spending A BB: External balance CA=0 Classic response to a balance of payments crisis: Devalue and cut spending ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Example: China in the past decade Excgange rate E YY: Internal balance Y = Potential ED & TD ES & TD ES & TB>0 China 2010 BB: External balance CA=0 China 2002 ED & TB>0 Spending A At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES. By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, due in part to G stimulus, shifted China again into ES. ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Part 5: 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 & consumer durables. Or it can be defined in terms of money supply M. –In which case an expansion is a rightward shift of the LM curve –Which itself slopes up (because money demand depends negatively in i and positively on Y). i Y LM E.g., Taylor Rule sets i. E.g., Quantitative Easing sets MB.

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.

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