exchange rates, output in open eco

7/29/2019 Exchange Rates, Output in Open Eco

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Exchange rates, output in open

economies and the role of policies

Lectures 8-9

Nicolas Coeurdacier

[email protected]

International Finance

Master in International Economic Policy


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Motivation:

Providing a framework to understand how exchangerate and output are determined

Study the role of economic policies in such aframework. Focus first on flexible exchange rates.

In the present financial crisis, is monetary or fiscal

policy most efficient? Does globalization makenational macro policies less efficient?

Motivation and roadmap


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Roadmap:

Asset markets and exchange rates Goods markets and exchange rates

Integrating the three markets: asset market, foreignexchange market and goods market The effects of monetary and fiscal policies

Policies during the financial crisis

Motivation and roadmap


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Do macro fundamentals matter?Much of the exchange rate volatility seemsuncorrelated with macroeconomic factors

However, macroeconomic news still have animpact.

At short horizons there are many non-macroevents that affect exchange rates.

But at longer horizons, macroeconomics

dominate!

Exchange rate and macroeconomic fundamentals


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Proportion of respondents answering the question: Select the single most importantfactor that determines exchange rate movements in each of the three horizons listed.

Intraday Medium Run (up

to 6 months)

Long Run (over 6

months)

Bandwagon Effects 51 13 1

Over reaction to

news57 1 0

Speculative Forces

44 42 3

Economic

Fundamentals1 43 80

Technical Trading

18 36 11Other 3 2 2

What Drives Exchange Rates?

Source:Cheung, Chinn and Marsh How do UK based foreignexchange dealers think their market operates?


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Determinants of the real exchange rate

In the long-run, you should think in terms of

Purchasing Power Parity

But PPP deviations are large at medium-termhorizon and reversion towards PPP takes years

Deviations from PPP linked to price rigidities

How can we interpret quarterly/yearly fluctuationsin exchange rates? Impact on output when prices

are rigid?


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Simple framework, helps to understand how some macro

events move exchange rates and current accounts but

exogenous production, no dynamics, no role forexpectations, no role for asset markets.

With modern financial markets, capital flows swamp tradeflows. About $2 trillion a day are traded spot in forex

markets more than the annual GDP of Italy or the UK

Need to integrate asset markets. We will make use oflectures 3/4.

From Lecture 6: BOP Theory of Exchange Rates


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Focus on flexible exchange rates first.Need to build the combinations of exchange rate and outputthat are consistent with equilibrium in the domestic money

market and the foreign exchange market (AA Schedule)

Use uncovered interest parity (see lecture 3/4)

r = r$ + (EeE)/E

Asset and Forex Market Equilibrium


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Exchange rate /$: E

Return in units of

asset return

r

Expected $ asset

return

expected $ asset return< asset return

Expected return on $ > assetreturn

E r$+ (EeE)/E


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E

Returns in units

Return on Euro asset r

Expected return of USasset

E

r

Money

supplyM/P

L(r,Y)

Real moneydemand The effect of GDP on exchange rate E

E

rL(r

,Y

)


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Building the AA curve:

Higher GDP raises money demand and appreciatesthe exchange rate

Y

L

r

E (euro appreciation)

AA curve: negative relation between Y

and E

AA curve describes combinations between Y and Esuch that asset markets are in equilibrium

Asset and Forex Market Equilibrium


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E

Y

AA

Combination of E and Y such that asset markets are in equilibrium


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E

Y

AA

Increase of MS

: interest rate falls, depreciation of euro for a given GDP


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Back to basics:

Aggregate Demand (AD) determines production and incomelevels when prices are rigid.

Keynesian assumption valid in short-term (one year) becauseadjusment takes place through quantities and not prices

Components of aggregate demand:

Y = C + I + G + EX IM

To simplify : I and G are givenNote: in fact, I

is a decreasing function of r

(the marginal cost of investment)

Goods Market Equilibrium


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C = C(Yd)= (1-s) Y

d

where Yd = Y - T is disposable income and (1-s) propensity to

consume

True if agents are financially constrained.

Otherwise, permanent income depends on wealth and expectedfuture disposable incomes.

Remember from lecture 6:

CA = CA(q, Yd, Y$

d) = (EX - IM )

with q = E P$/P : real exchange rate = relative price of US goods

with respect to European goods


+


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D = C(Y - T) + I + G + CA(q, Y - T,Y$ - T$)

D = D(q, Y - T, I , G,Y$ - T$)

Equilibrium: Aggregate Demand = Output

Y = D = D(q, Y - T, I , G,Y$ - T$)

Output and income is determined by demand (fixedprices in the short run)



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Aggregate demand

GDP, Y

D = D(q, Y - T, I , G,Y$ - T$)

45

D

Y

q

Y

A euro depreciation

makes European goods

cheaper - net exports,

aggregate demand and

output increases with q


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As in lecture 6, a nominal depreciation generates an

in demand via an in net exports CA = (EX - IM)

DD curve: positive relation between E and Y

Necessary for the goods market to be in equilibrium



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E

Y

DD

Combination of E and Y such that goods market is

equilibrium


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E

Y

DD in a moreopen economy

Combination of E and Y such that goods market is equilibrium

Openness (size) of economy determines the slope of the DD curve

DD in a more closed

economy


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E

Y

DD

Fiscal expansion: increase in G

For a given E, the demand and GDP increase

DD


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E

Y

AA

Short term equilibrium for E and Y such that both goods

and asset markets are in equilibrium

DD

E1

Y1


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How the Economy Reaches Its Short-Run Equilibrium

The domestic

currencyappreciates andoutput increasesuntil output marketsare in equilibrium.

Exchange rates

adjust immediatelyso that assetmarkets are inequilibrium.


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Monetary and fiscal policies in an open economy

An important distinction:

Temporary and permanent: if permanent, changesexpectations on the exchange rate Ee

Monetary policy shock : increase in money supply

Fiscal policy shock: increase in G

Focus on temporary shocks for simplicity

Today: both have been used heavily to stabilize the

economy

Monetary and Fiscal Policies


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E

Y

AA

DD

E1

Y1

Temporary monetary policy shock

AA

E2

Y2


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Monetary policy: very efficient (in stimulating demand)

in an open economy In addition to effect on I, in interest rate E

(depreciation) in net exports EX

- IM Y

Monetary policy is even more efficient in more open(smaller) economies to stabilize economy (stimulating

demand after a demand slump)



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E

Y

AA

DD

E1

Y1

Temporary expansionary fiscal policy

E2

Y2

DD


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Fiscal policy: less efficient (in stimulating demand) in an

open economy Appreciation of the currency and deterioration of CA

(the more so DD is flatter, more open economy)

Hence crowding out of exports (on top of crowding outon investment)

Fiscal policy is even more inefficient in more open

(smaller) economies to stabilize economy



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How has globalization changed macro-policy?

Trade openness makes domestic fiscal policy less efficient

demand generated by fiscal expansion leaks more(increase in imports, larger propensity to import m): shift

in DD is smaller

Exchange rate appreciation affects negatively net exports:crowding out effect stronger the more open the economy

(the more aggregate demand depends on net exports)



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Financial openness makes domestic fiscal policy less efficient

Go to the extreme:Financial autarky means the interest parity condition doesnot hold and E is not affected by interest rate differential.

No appreciation and no fall in net exports



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Trade openness makes monetary policy more efficientFall in interest rate generates depreciation and increase in

net exports ; DD is more flat, this has large effect on output

Financial openness makes domestic monetary policy moreefficient

Go to the extreme: financial autarky means the interest

parity condition does not hold and E is not affected byinterest rate differential. No depreciation and no increase

in net exports



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In past 20 years, monetary policy has become the prime

policy instrument; fiscal policy much less used (also issues ofdelay).

Globalization means domestic fiscal expansion not veryexpansionary for domestic economy BUT very expansionary

for foreign economy! Globalization means domestic monetary expansion very

effective at Home but at the expense of foreign economy:appreciation and fall in net exports

In both cases: globalization increases international spilloversof domestic policies (externalities) Requires international coordination



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Spillover effects of fiscal policies

No fiscalNo fiscal

expansionexpansionFiscalFiscal

expansionexpansion

No fiscalNo fiscalexpansionexpansion

(0,0)(0,0) (+15,(+15,--5)5)

FiscalFiscal

expansionexpansion((--5,+15)5,+15) (+5,+5)(+5,+5)

EU

US

G ; of debt, imports (through appreciation + demand): benefittrade partners

Nash equilibrium: no fiscal expansion; international cooperation

important and difficult (free rider problem)

In euro zone: spillover through demand (no exchange rate effect)

Payoff matrix


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Fiscal policy coordination for the crisis

Olivier Blanchard (12th February 2009)

The international dimension of the crisis calls for a

collective approach. There are several spillovers that could limit the effectiveness

of actions taken by individual countries, or create adverse externalities across

borders. Countries with a high degree of trade openness may be discouraged from

fiscal stimulus since it will benefit less from a domestic demand expansion. The

flip side of these spillovers is that if all countries act, the amount of stimulusneeded by each country is reduced (and provides a political economy argument

for a collective fiscal effort)


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How much of an additional in

government spending deliver of

additional output?

0.24 on impact for high-income

countries.

Cumulative impact: a value of 1says that after 20 quarters a 1

increases in G increases output

by 1.

Fiscal Policies: some evidence on fiscal multipliers

Source: E. Ilzetzki, E. Mendoza

and C.Vegh, 2009


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Cumulative fiscal multiplier in open and closed economies

Source: E. Ilzetzki, E. Mendoza and C.Vegh, 2009


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Conventional monetary policy has been used heavily: interestrates brought to 0-1% in US and euro zone

But present situation may have required even more monetarypolicy easing.

Not possible to have negative nominal interest rates.

Standard monetary policy has reached its limits

Large fiscal expansion in both EU and US:

In a financial crisis, firms and households have difficulty to borrow (financially

constrained): their demand for durable goods and investment falls heavily.Important to replace falling private demand by public demand

Unconventional Monetary Policy

Liquidity provision to disrupted markets

Policies in the recent crisis


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E

Y

AA

DD

E2

Y2

Recession : drop in aggregate demand

E1

Y1

DD


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E

Y

AA

DD

E

2

Y2

Standard monetary response: lowers interest rates

E1

Y1

DD

Y3

E3

AA


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Interest rate r

Real money demandM/P

L(r,Y)

r =0

M/P

Monetary policy looses power: the liquidity trap

at r =0, the demand for money is infinitely elastic because money and bondsbecome perfectly substitutable at zero interest rate

C i l M P li


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Conventional Monetary Policy

Interest rate response

Fi l R


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Fiscal Response

Source OECD

Fi l R


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Does fiscal stabilization work?

Yes, fiscal multipliers are non-zero (but quite uncertain).

Why might fiscal policy be inefficient?

Lags involved

Ricardian equivalence

Crowding out of investment

Crowding out of net exports

Debt sustainability and sovereign risk

Low multipliers for highly indebted economies. Importance of

accomodative monetary policy.

Fiscal Response

Ricardian Equivalence


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Economy not affected by way government finances its activities.Government can either finance its expenditure through current taxes or

issuing debt but debt is just postponed taxes

When governments cut taxes consumers are not better off just face adelay in when they pay taxes

Therefore in response to government borrowing consumers are forwardlooking and save more possible for multiplier to be zero

Ricardian equivalence fails if

(i) consumers are myopic

(ii) future generations pays the debt burden

(iii) consumers face borrowing constraints

Ricardian Equivalence


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Private and public saving: raw correlations1

Ricardian Equivalence Is it True?

Source: OECD 2002

Data suggests around 50% crowding out on average at 1 year horizon

Fiscal Adjustment


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After large fiscal stimulus in 2008-2010. Fiscaladjustment necessary in most countries

Will the adjustment trigger a recession? Likely varyacross countries, as adjustments tend to be morepainful in large, closed economies (and countries

with fixed exchange rates; see later). Less painful ifaccommodative monetary policy but not possible ifrates are already at the lower bound

Also more painful in highly indebted economies. Now or later?

Fiscal Adjustment

Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)


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Central Banks response to the crisis

Conventional response:

Cut policy interest rates substantially

Non conventional responses: Quantitative and Credit Easing

Acted to prevent a complete collapse of the financial system

Through central bank intermediation, maintained inter-banktransactions

Provide liquidity to banks and corporations


Money market rate spreads


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0

0.5

1

1.5

2

2.5

3

3.5

4

1/1/2007 7/1/2007 1/1/2008 7/1/2008 1/1/2009 7/1/2009

0

0.5

1

1.5

2

2.5

3

3.5

4emergence ofmoney market

tensions

failure ofLehmann Bros.

USD

GBP

EUR

y p

Spread between interbank deposit and OIS rates at 3-month maturity

When conventional monetary policy has run its course


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When conventional monetary policy has run its course

Ben Bernanke (13th January 2009)

The Federal Reserve has developed a

second set of policy tools, which

involve the provision of liquidity directly to

borrowers and investors in key credit markets. Notably, we have

introduced facilities to purchase highly rated commercial paper

at a term of three months and to provide backup liquidity formoney market mutual funds.



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y y

Fed balance sheet after credit easing

Assets Liabilities

Government securities Currency in circulation

Discount Loans Banks reserves

Gold

Foreign currency swaps

Commercial Papers

AIG, TAF, AMLF

AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; TAF:

Term Auction Facility

2000

2400

2000

2400

Federal Reserve


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-2400

-2000

-1600

-1200

-800

-400

0

400

800

1200

1600

Jan 3 2007 Apr 25 2007 Aug 15 2007 Dec 5 2007 Mar 26 2008 Jul 16 2008 Nov 5 2008 Feb 25 2009 Jun 17 2009

-240

-200

-160

-120

-800

-400

0

400

800

1200

1600

US Treasury bills currency in circulation

US Treasury coupons reserve balances

Agency debt reverse repos

MBS deposits other than reserve balances (incl. Treasury deposits)

Repurchase agreements Other liabilities and capital

TAF hhh

other loans hhh

other facilities hhh

Swaps hhh

other assets (incl gold / SDRs and treasury currency) Series20

balance sheet

USD billions

Post-Lehmann:Expand total

balance sheet

Accumulate reservebalances

Large outright

purchases

Unconventional monetary policy and inflation


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Is unconventional monetary expansion inflationary?

NO, as long as credit does not find its way in the economy andthe economy is very weak

Banks are hoarding cash; so are companies

Large increase in liquidity (in base money) has not led to acorresponding increase in credit

Velocity of money has fallen in the US. Reminiscent of theGreat Depression

y p y

Increase in liquidity (in base money) and increase in credit (M2)


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Unconventional monetary policy and exchange rates


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External channel of quantitative easing? Should credit

easing or quantitative easing weaken the currency?

r$- r = (EeE)/E = 0 as r$= r =0

Must go through expectations (Ee )

Purchasing Power Parity: if investors expect higher

inflation in the future in the US, then they should expect

a depreciation of the dollar.

Key aspect: how does quantitative easing affect inflation

expectations?

Inflation expectations in UK


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Distribution of households inflation expectations one year ahead

Brief summary


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Brief summary

Globalization reduces the effectiveness of fiscal policy as a

stabilization tool but increases the effectiveness of monetary

policy.

Globalization increases the international spillovers of policies

and the needs for international coordination.

In exceptional time, when interest rate is at zero or near zero,

monetary policy can use other tools such as liquidity provision.

The international aspects of such policies depend on exchangerate expectations.

exchange rates, output in open eco

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