1. 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

2. 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

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

4. Output gap, as % of GDP, in the 2009 Great RecessionUS
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

5. 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)
Greece & Ireland overheated in 2007: Y >> 𝑌
and crashed in : Y << 𝑌
ITF-220, Prof.J.Frankel

6. 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

7. 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.

8. ● ● ● ● 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

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

10. ● ● (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

11. ● ● ● ● ● ● 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

12. 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

13. 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

14. ● ● 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

15. 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

16. 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

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

18. 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

19. 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 : India, Turkey, Indonesia, S.Afr., Brazil.

20. 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 , an abrupt loss of X, due to the global crisis, shifted China to ES.

21. ● 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
BB: External balance CA=0. ●
YY: Internal balance Y= 𝑌
Spending A
ITF-220, Prof.J.Frankel

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

23. 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

24. ● ● 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

25. ● ● ●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

26. 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

27. 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,
ITF Prof.J.Frankel

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

29. 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 Prof.J.Frankel

30. 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.

31. 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 Prof.J.Frankel

32. 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.

33. Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its AftermathLM 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 Prof.J.Frankel

34. 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 Prof.J.Frankel

35. 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., , no gold discoveries => prices fell 53% in US, 45% in UK.

36. Capsule History of the Gold Standard
1844 – Britain adopts full gold standard US restores gold convertibility.
From , the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices & wages.
ill-fated UK return to gold <= misplaced faith in flexible prices.
Bretton Woods system, based on gold as the reserve asset de facto: based on $.
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.
Nixon suspends convertibility & devalues $.
ITF Prof.J.Frankel

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

38. 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 Prof.J.Frankel 38

39. API-120 - Prof. J.Frankel, Harvard
FX reserves of the PBoC climbed higher than any central bank in history
API Prof. J.Frankel, Harvard

40. 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 Prof.J.Frankel

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

42. API-120 - Prof. J.Frankel, Harvard
To be continued… in Lectures (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
API Prof. J.Frankel, Harvard