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

2. 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

3. 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…

4. 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

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

6. 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
Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation)

8. 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

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

10. 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

11. 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”

12. 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*

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

14. Strong currency
Domestic economic autonomy
XR stability
Weak currency

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

16. 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 

17. 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

18. 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

19. Strong currency
Domestic economic autonomy
XR stability
Weak currency

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

21. Show me the money!

22. 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

23. 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”

24. 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

26. http://www. andrew. cmu. edu/course/88-301/phillips/phillips_curve
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?)

27. 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

28. Commitment mechanisms
Argentine Currency Board ( )
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!!

29. 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?)

30. 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…

31. 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

32. Thank you