1. L7: Goals and Instruments Policy goals: Internal balance & External balance LECTURES 7 - 9: POLICY INSTRUMENTS, including MONEY The Swan Diagram The principle of goals & instruments L8: Introduction of monetary policy The role of interest rates Monetary expansion Fiscal expansion & crowding out Policy instruments L9: The M onetary A pproach to the B alance of P ayments

2. ITF-220, Prof.J.Frankel Goals and instruments Policy Instruments Expenditure-reduction, e.g., G ↓ Expenditure-switching, e.g., E ↑. Policy Goals Internal balance: Y = ≡ potential output. Y unemployment > Y > ≡ ED => “overheating” => inflation or asset bubbles. External balance: e.g., CA=0 or BP=0.

3. ITF-220, Prof.J.Frankel 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, in the Great Recession, 2009 Ir Jpn Internal balance

4. Output gap in eurozone periphery Source: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions) http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated by 2007: Y >> and crashed in 2009-11: Y << ITF-220, Prof.J.Frankel

5. 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.

6. 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.

7. ITF-220, Prof.J.Frankel Starting from current account deficit at point N, policy-makers can adjust either by (a)cutting spending, or ● ● ● ● Adjustment (b) devaluing.

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

9. ITF-220, Prof.J.Frankel (b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Y above potential output. => overheating ● ●

10. 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? ● ● ● ● ● ● ITF-220, Prof.J.Frankel

11. 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 ↑. ● ● ● ITF-220, Prof.J.Frankel

12. . 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. ● ● ● We have just derived upward-sloping BB curve.

13. 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 ↓. ● ITF-220, Prof.J.Frankel

14. 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 ↓. ● ● ● ITF-220, Prof.J.Frankel

15. 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. ● ● ● ITF-220, Prof.J.Frankel We have just derived downward-sloping YY curve.

16. Swan Diagram has 4 zones: I.ED & TD II.ES & TD III.ES & TB>0 IV.ED & TB>0 ● ITF-220, Prof.J.Frankel

17. Summary: combination of policy instruments to hit one goal slopes up, to hit the other slopes down. ITF-220, Prof.J.Frankel

18. Example 1: 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 ● Could be the “fragile 5” in 2013-14: India, Turkey, Indonesia, S.Afr., Brazil

19. Example 2: 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 ED. ● Spending A

20. ITF-220, Prof.J.Frankel Example 3: US over 33 years Excgange rate E YY: Internal balance Y = Potential ED & TD ED & TB>0 ES & TD ES & TB>0 US 1987 or 2007 US 1981,1991, or 2008-13 BB: External balance CA=0 ● Spending A

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

22. ITF-220, Prof.J.Frankel In 2000 most countries were operating above full employment: Y > Appendix: Internal balance, before & after the 2001 recession I Jpn Ireland was the strongest case; Japan was the biggest exception. US 2000

23. By 2002, most countries were operating below full employment: Y < Source: The Economist, June 22, 2002 I Jpn US 2002 ITF-220, Prof.J.Frankel

24. 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). i Y LM E.g., Taylor rule sets i. E.g., Quantitative Easing sets MB.

25. 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 ● ● ● ●

26. New equilibrium: At point D if monetary policy is accommodating. Fiscal expansion shifts IS out. At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓  Rise in Y < full Keynesian multiplier. ITF-220, Prof.J.Frankel ● ● ● ● ●D●D

27. LECTURE 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Brief history of the Gold Standard Appendix: China sterilizes inflows, 2004-10 ITF-220 - Prof.J.Frankel

28. The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. Another assumption sometimes associated with MABP: Goods prices are flexible => PPP holds.

29. ITF-220 - Prof.J.Frankel Sterilization: Changes in reserves (i.e., BP) offset by NDA,  NDA = -  R, so MB unchanged. Non-sterilization :  MB =  R. 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

30. ITF-220 - Prof.J.Frankel David Hume’s Price Specie-Flow Mechanism 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. Initially, Spain piles up gold, from the New World (mercantilism).

31. ITF-220 - Prof.J.Frankel Hume’s Price Specie-Flow Mechanism If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. continued

32. ITF-220 - Prof.J.Frankel 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. ITF-220 - Prof.J.Frankel Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath Y +0-+0- NS-I i LM IS NS-I´ LM´ TB 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.

34. ITF-220 - Prof.J.Frankel Example: response to the 1994 tequila crisis i LM´ IS M A Y Argentina was on a currency board => no sterilization. In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December..

35. ITF-220 - Prof.J.Frankel The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). Pros and Cons Pro: prevents excess money creation and inflation. Cons: prevents response to cyclical fluctuations long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK.

36. Capsule History of the Gold Standard 1844 – Britain adopts full gold standard. 1879 -- US restores gold convertibility. From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices. 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. 1944 -- Bretton Woods system, based on gold as the reserve asset. 1945-1971 -- de facto: based on $. 1958 -- Start of US BoP deficits. US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $. Solutions: raise price of gold, or create SDRs. 1971 -- Nixon suspends convertibility & devalues. ITF-220 - Prof.J.Frankel

37. Appendix -- Example of sterilizing money inflows: China, 2004-08 & 2010

38. 38 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 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 ITF-220 - Prof.J.Frankel

39. FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html ITF-220 - Prof.J.Frankel

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-220 - Prof.J.Frankel

41. => The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure. In 2003-04, forex inflows accelerated rapidly. Initially, the PBoC had no trouble sterilizing the inflows.

42. ITF-220 - Prof.J.Frankel In 2007-08 China had more trouble sterilizing the reserve inflow 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 serious problem in 2007-08. Also a “bubble” in the Shanghai stock market.

43. ITF-220 - Prof.J.Frankel Sterilization faltered in 2007 & 2008 Growth of China ’ s monetary base & its components: Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 Money growth accelerated sharply, 2007-08

44. ITF-220 - Prof.J.Frankel China ’ s CPI accelerated in 2007-08 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Inflation 1999 to 2008

45. Sterilization of foreign reserves: Decreases in PBoC’s domestic assets offset increases in foreign assets Source: Zhang, 2011, Fig.7, p.47. ITF-220 - Prof.J.Frankel

46. China ’ s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession), But took off again in 2010-11. Inflation 2001 to 2011

47. ITF-220 - Prof.J.Frankel After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices

48. When house prices rise relative even to rents, that suggests a bubble or easy money ITF-220 - Prof.J.Frankel Scott Reeve blog

49. China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly. ITF-220 - Prof.J.Frankel