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IX. Open economy, oil shocks and disinflation policies (1973-1985)
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IX.1 Open economy stabilization
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Reminder: net export, aggregate demand and real ExR Open economy: AD = C+I+G+NX –NX = net exports: export - import In the short-run, export depends on foreign demand and real exchange rate, import depends on domestic AD and real exchange rate –Real ExR = nominal ExR.(P * /P), appreciation of currency means lower numerical value of both real and nominal ExR, depreciation vice versa –Marshall-Lerner condition, i.e. net export depends on real exchange rate only Standard asssumption: –Real appreciation (nominal appreciation and/or stronger foreign inflation than domestic one) less competitive domestic goods and services higher the current account deficit (NX drops) And vice versa AD: depends on domestic policy parameters (fiscal and monetary) AND real ExR
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Reminder: Mundell-Fleming model The efficiency of fiscal, monetary and trade policy differs according the exchange rate regime Flexible exchange rate (float) –Fiscal policy very little efficient –Monetary policy very efficient Fixed exchange rate –Fiscal policy very efficient –Monetary policy very little efficient
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Policy goals in the open economy Internal balance – full employment and price stability –Fiscal and monetary stabilization policies External balance – definition: it does not have to coincide with zero current account –High CA deficit might be (very) desirable, when country is able to repay the debt financing (loans) in the future –High CA surplus might be a problem: Too low domestic investment, given total domestic savings Too many foreign claims, risk as to future payments Target for protections from abroad –Assume “some desirable” CA deficit
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Policy choices under B-W fixed ExR Goal: simultaneous achievement of external and internal balance Under B-W, policy tools limited –Internal balance: monetary policy little efficient, fiscal policies only available –External balance: fixed ExR, devaluation options very limited Four possible situation, away form both balances –I: over-employment and inflation, CA surplus too high –II: over-employment and inflation, CA deficit too high –III: underemployment and deflation, CA deficit too high –IV: underemployment and deflation, CA surplus too high All four imply both ExR and fiscal adjustment
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E Fiscal expansion Internal balance, Y f External balance, NX=NXX I II III IVE
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Policy adjustment If economy away from both lines, combination of both fiscal adjustment and change of ExR is needed Change in fiscal policy – expenditure changing –Changes the overall level of aggregate demand in the economy Change in ExR (devaluation/revaluation) – expenditure switching –Switches demand between domestic output and imports Policy dilemma at fix: fiscal policy too slow, ExR adjustment faster, but limited by B-W system
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IX.2 The End of Bretton-Woods System
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1950s B-W system: –Countries limited in their monetary policies –Adjustment to disequilibria via international reserves (gold, but mainly USD) → need for keeping reasonable level of reserves To keep reserves → limits of convertibility and of capital flows Special position of US –USD as reserve currency, main task – keeping the USD price of gold (35 USD per oz.) –Need to keep gold reserves enough –Potential constraint on US macroeconomic policy – when economies grow, will there be enough US gold reserves? Confidence problem
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1960s Gradual achievement of convertibility Increase of international capital flows (despite controls), more and more of speculative nature, because of expected devaluations More frequent balance of payments crises, accompanied by losses of foreign exchange reserves Devaluations, indeed (Britain November 1967) Need for policies to achieve both internal and external balance All this: crucially dependent on the performance of the US economy
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US economy in 1960s Vietnam War, “moon racing” and Great Society program of President Johnson → strong fiscal expansion → inflation → worsening of CA → monetary policy only temporary contracted, later eased → further inflation → expected rise in USD price of gold Private speculators started to buy gold → two-tier gold market (private, where price of gold allowed to float; official, where fixed) → end of automatic constraint on worldwide monetary growth
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US recession in 1970 1970: US recession with increase of unemployment, output falling, CA deficit → need for real devaluation of USD vis-à- vis major other currencies –Fall US prices – no way because of recession –Second option – nominal devaluation of USD, uneasy, as all other countries should be willing to peg their currency to USD at new (devalued) rate –August 15, 1971 – President Nixon stopped automatic exchange of gold for dollars and introduced import surcharge Multilateral negotiation → Smithonian agreement in December 1971 –USD devalued by 10 % against foreign currencies, price of gold increased to 38 USD per oz. Not the end of the story yet: because of continuing disequilibria, another speculative attack on USD in February 1973 → European currencies abandoned fix and by March 19, 1973 Japan and Europe floated their currencies against USD → end of B-W system
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IX.3 Oil shocks and stagflation
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IX.3.1 Stagflation Stagflation: inflation + unemployment + low growth –US as well as Europe Trigger: oil shocks, 1973 and 1979 –In 1973-4 and in 1979-1982, two dramatic increases in price of oil: 1960: 100, 1972: 93, 1974: 135, 1982: 264 –Increase in oil price → substantial increase in P without a link to change in wages (and unemployment) Economic policies were not able to react immediately → problems lasted till 1980s
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Main indicators, 1963-2005 63-7273-8283-9293-02030405 inflation USA3.38.74.02.62.33.0 Europe4.4.10.75.12.42.02.22.0 Japan5.68.61.80.2-0.2 Unemployment USA4.77.06.85.26.05.55.4 Europe1.95.59.49.68.99.08.7 Japan1.21.92.53.95.34.74.5 per capita real GDP growth USA2.80.92.42.12.03.32.5 Europe3.92.03.02.0-0.11.9 Japan8.52.93.40.72.34.32.3
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US data
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What policies? Stagflation: challenging framework for policy decisions Keynesian: so far based on inflation vs. unemployment trade-off, no use Monetarist: provided credible explanation what happened, but the advice for stable increase of money supply was not of much help either
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Rational expectations and policy credibility Anticipated policies → immediate adjustment towards new equilibrium, consistent with natural values Un-anticipated → new equilibrium, but not at natural values, i.e. with higher inflation or higher unemployment Effective policy: must be credible, i.e. agents must believe that authorities will indeed pursue that policy that they announce
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Difficult policy options after 1973 Oil shocks: un-anticipated, economy reacted according new-classical theory –Price increase, contraction, higher unemployment –Policy response: difficult, see Case study I bellow Disinflation after 1979: mainly the problem of credibility – will the authorities hold monetary contraction? –See Case study II bellow
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IX.3.2 Policies 1973-1979 Monetary expansion
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Effect on prices Oil and energy inputs more expensive → all prices oil importing countries up Expectations: price increases will continue Both in US and Europe – accumulated inflationary pressures via wage negotiations already from 1960s Speculative hoarding of commodities stocks
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Effect on output Sharp price increase → fall of AD → fall of output Sharp increase of unemployment Stagflation: inflation with unemployment
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Effect on CA Oil importing developed countries: sharp decrease (deficit), later improvement (as spending on imports fell down) OPEC countries: sharp increase (surplus), investing the revenues (“petrodollars”) in developed countries Oil importing developing countries: mild deficits (lower energy intensity) No problem how to finance deficits (out of petrodollars)
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Policy options Both internal and external disequilibria, need for action, options Return to fix? –Danger of speculative attacks Monetary contraction to fight inflation? –It seemed as politically unfeasible Monetary expansion to fight unemployment –Selected policy, consequences?
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Monetary expansion US immediately 1974, Europe much later (1978) US: –Output recovery, unemployment improved –Further inflation, larger than Europe –Depreciation, both nominal and real –CA deficit: contrary to model, as depreciation helps exports; here domestic expansion fostered imports (despite that more expensive), due to continuing recession in Europe, no demand for exports → deterioration of the deficit
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Crucial consequences for developed countries Weak dollar – psychological impact on US population Entirely different understanding about scarcity of energy resources US – growth resumed and unemployment – at least partially – improved Europe – growth resumed as well (not as in US), unemployment persistent
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IX.3.3 Policies 1980-1985 Disinflation
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The burden of inflation Very high US inflation through 1970s –Due to monetary expansion when fighting unemployment of 1970s Eroding the health of US economy 1979: new FED’s chairman Paul Volcker –Strong commitment to monetary contraction to lower inflation –Credibility problem January 1981: President Ronald Reagan –New economic policies, based on tax cuts, anti-inflationary policies and support to private business –Later (1983): fiscal expansion, mainly due to political reasons (military expenditures)
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Supply side economics Lower taxes ↔ incentives to private sector to increase both effort and productivity Strategy: lower tax means higher budget deficit now, but stronger growth in the future and larger tax revenues with deficit improvement in the future Supply side economic, Laffer curve Tax revenue Tax rate 0%100%
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The data 19801981198219831984 GDP growth %-0.51.8-2.23.96.2 Unemployment % 7.17.69.79.67.5 Inflation – CPI %12.58.93.8 3.9 Nominal interest %11.514.010.68.69.6 Real interest%2.54.96.05.15.9 Real ExR (73=100)11799898577 Trade surplus-0.5-0.4-0.6-1.5-2.7 Budget surplus-1.8-2.0-3.5-5.6-4.5
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A detour: policies in large open economies No longer small country assumption –No prevailing world interest rate –Changes in inflation and output do influence inflation and output in other economies Changes to policy effects compared to M-F model –Monetary expansion: domestic output up, domestic currency depreciates, foreign outputs ambiguous –Fiscal expansion: domestic output up (different from standard M-F model in Lecture XII), home currency appreciates, foreign output up
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XVI.3.1 Reducing the inflation
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The costs of disinflation Sacrifice ratio: the amount of lost output during the period of reducing inflation Keynesian view: sacrifice ratio large, due to price and wage rigidities Monetarist view: –there is always some sacrifice ratio –Probably much lower than Keynesians believe –Depends on institutional adaptations and – mainly – how quickly people adapt their expectations (AEH) New classical school (rational expectations) –If policies credible (anticipated) → sacrifice ratio might be close to zero –If policies not credible (un-anticipated) → sacrifice ratio might be substantial
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Monetary restriction after 1979 Strong, convincing commitment to monetary restriction, quick change of expectations and quick impact: –Real interest ↑, Y↓, P ↓, real (and nominal) appreciation of USD –The credibility problem: most people did not believe that Reagan/Volcker team will be politically strong to reduce inflation quickly –Behaviour according rational expectation models: un-anticipated policy → decrease of output and increase of unemployment –Whenever credibility established → growth resumed and unemployment started to fall Strong monetary contraction and subsequent volatility of macroeconomic parameters → impact on the position of USD Originally, very strong commitment towards floating ExR without intervention (“benign neglect”)
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Other countries’ reaction Usually: appreciation of domestic currency seen as welcome by foreign countries (positive effect on exports) Different attitude in 1980-81: low US inflation relatively increased inflation in foreign (European) countries → additional inflationary pressure in European economy → monetary contraction in Europe (and Japan) as well –Technically, contraction as a result of intervention against USD’s appreciation → sale of USD assets (to undermine USD), i.e. money restriction
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Effects of Monetary Contraction 1980-1982 – US economic development dominated by the effects of monetary contraction M.-F. model’s prediction: in case of flexible exchange rate monetary policy is efficient, see data: –Output contraction –Real appreciation of USD –Inflation sharply down Remark: US is large economy, interest rate is not fixed on the “world” level
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World recession after 2 nd oil shock Difficult coincidence: Second oil shock Monetary restrictions in all major parts of the world Lack of forex policy coordination → deep recession worldwide, the most serious after Great Depression
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Effects of Fiscal Expansion After 1982 – stronger effect of fiscal expansion –Reagan: additional military expenditures M.-F. model: fiscal policy less efficient, but here model’s predictions did not come true fully –There was a further appreciation of USD, in accord with M.-F. –There was a strong expansion of output, contrary to original version of M.-F. model US is a large economy, interest rate is not fixed and appreciation is consistent with interest rate decrease → stimulation of AD and output
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IX.4 Exchange rate policies under floating
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Twin deficits and consequences Increased military expenditures outweighed increased tax revenues due to faster growth –The budget deficit further deteriorated Continuing USD appreciation slowed exports and increased imports –Trade deficit started to increase Result: US economy started to mount both trade and budget deficits → the problem of twin deficits Strong deficit and strong USD → calls for protectionism in the US, threat to overall world trading system → need for ExR adjustment, i.e. need for an intervention
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Plaza Agreement September 22, 1985: officials from US, UK, France and Germany announced a joint intervention to depreciate USD Given strong commitment → change in expected ExR → drop of USD immediately next day Accompanied by slight monetary expansion → continuous decline of USD in 1986-87, US interest rates down relative to other countries Second half of 1980s: –much stronger growth, world out of recession –lower unemployment –resumption of world trade –macroeconomic stabilization
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XVI.4 Conclusions from oil shocks Stagflation – a phenomena, neither known and expected by both economists and public Keynesian economics (and policies) on retreat Disinflation policies of 1980s opened a new era in economic policies –Success in reducing the inflation –International economics and coordination –The role monetary policies and of Central Banks Twin deficits and period of weak USD
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Open issues Fix of float? – never ending story Should there be an international coordination on exchange rates policies? Anti-inflationary policies emerged as a pivotal element in economic policy making Expectations as a central notion both in economic theory and practice (see next Lecture) The start of formation of the framework of macroeconomic policies for 21 st century (see the last Lecture)
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Literature to Ch. XVI Krugman, Obstfeld, ch.19 Snowdon, Vane, Modern Macroeconomics, Edvard Elgar, 2005 (part 5.5.3) Romer, Ch., Romer, D., Reducing Inflation, The University of Chicago Press, 1997
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