International Finance
Master in International Economic Policy
Exchange rates, output in open
economies and the role of policies
Nicolas Coeurdacier
Lectures 8-9
[email protected]
Motivation
•
Providing a framework to understand how exchange
rate and output are determined
•
Study the role of economic policies in such a
framework. Focus first on flexible exchange rates.
In the present financial crisis, is monetary or fiscal
policy most efficient? Does globalization make
national macro policies less efficient?
Lecture 8 and 9
Exchange rates, output in open economies and
the role of policies
1. Exchange rate and output in the short/medium-run
2. The effects of monetary and fiscal policies
3. Policies during the financial crisis
Lecture 8 and 9
Exchange rates, output in open economies and
the role of policies
1. Exchange rate and output in the short/medium-run
2. The effects of monetary and fiscal policies
3. Policies during the financial crisis
Exchange rate and macroeconomic fundamentals
• Do macro fundamentals matter?
•Much of the exchange rate volatility seems
uncorrelated with macroeconomic factors
• However, macroeconomic news still have an
impact.
• At short horizons there are many non-macro
events that affect exchange rates.
• But at longer horizons, macroeconomics
dominate!
What Drives Exchange Rates?
Intraday
Medium Run (up
to 6 months)
Long Run (over 6
months)
Bandwagon Effects
51
13
1
Over reaction to
news
57
1
0
Speculative Forces
44
42
3
Economic
Fundamentals
1
43
80
Technical Trading
18
36
11
Other
3
2
2
Proportion of respondents answering the question: Select the single most important factor that
determines exchange rate movements in each of the three horizons listed.
Source: Cheung, Chinn and Marsh ‘How do UK based foreign
exchange dealers think their market operates?
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-term
horizon and reversion towards PPP takes years
•Deviations from PPP linked to price rigidities
• How can we interpret quarterly/yearly fluctuations
in exchange rates? Impact on output when prices
are rigid?
From Lecture 6: BOP Theory of Exchange Rates
• Simple framework, helps to understand how some macro
events move exchange rates and current accounts but…
• … exogenous production, no dynamics, no role for
expectations, no role for asset markets.
• Need to integrate asset markets. We will make use of
lectures 3/4.
Asset and Forex Market Equilibrium
•Focus on flexible exchange rates first.
•Need to build the combinations of exchange rate and output
that 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$ + (Ee –E)/E
Exchange rate €/$: E
€ asset return
expected $ asset return< €
asset return
r$+ (Ee –E)/E
E
Expected $ asset
return
Expected return on $ > € asset
return
r€
Return in units of €
Return on Euro asset
E
r€
E
Expected return of US
asset
E’
Returns in € units
r€
r’€
L(r€,Y€)
L(r€,Y’€)
M€/P€
Real money
demand
Money
supply
The effect of GDP on exchange rate E
Asset and Forex Market Equilibrium
Building the AA curve:
• Higher GDP raises money demand and appreciates
the exchange rate
Y€ → L€ → r€ → E (euro appreciaFon)
• AA curve: negative relation between Y€ and E
• AA curve describes combinations between Y€ and E
such that asset markets are in equilibrium
E
AA
Y€
Combination of E and Y€ such that asset markets are in equilibrium
E
AA
Y€
Increase of MS€ : interest rate falls, depreciation of euro for a given GDP
Goods Market Equilibrium
Back to basics:
• Aggregate Demand (AD) determines production and income
levels when prices are rigid.
• Keynesian assumption valid in short-term (one year) because
adjustment takes place through quantities and not prices
• Components of aggregate demand:
Y€ = C€ + I€ + G€ + EX€ – IM€
To simplify : I€ and G€ are given
Note: in fact, I€ is a decreasing function of r€ (the marginal cost of investment)
Goods Market Equilibrium
• C€ = C(Y€d)= (1-s) Y€d
where Y€d = Y€ - T€ is disposable income and (1-s) propensity to
consume
True if agents are financially constrained.
Otherwise, permanent income depends on wealth and expected
future disposable incomes.
• Remember from lecture 6:
CA€ = CA(q, Y€d, Y$d) = (EX€ - IM€ )
+
with q = E P$/P€ : real exchange rate = relative price of US goods
with respect to European goods
Goods Market Equilibrium
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$)
Output and income is determined by demand (fixed
prices in the short run)
Aggregate demand D€ = D(q, Y€ - T€, I€ , G€,Y$ - T$)
q
D€
A euro depreciation
makes European goods
cheaper - net exports,
aggregate demand and
output increases with q
45°
Y€
Y’€
GDP, Y€
Goods Market Equilibrium
• 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
E
DD
Y€
Combination of E and Y€ such that goods market is
equilibrium
E
DD in a more closed
economy
DD in a more
open economy
Y€
Combination of E and Y€ such that goods market is equilibrium
Openness (size) of economy determines the slope of the DD curve
E
DD
DD’
Y€
Fiscal expansion: increase in G€
For a given E, the demand and GDP increase
E
DD
E1
AA
Y€
Y1€
Short term equilibrium for E and Y€ such that both goods
and asset markets are in equilibrium
How the Economy Reaches Its Short-Run Equilibrium
Exchange rates
adjust immediately
so that asset
markets are in
equilibrium.
The domestic
currency
appreciates and
output increases
until output markets
are in equilibrium.
Lecture 8 and 9
Exchange rates, output in open economies and
the role of policies
1. Exchange rate and output in the short/medium-run
2. The effects of monetary and fiscal policies
3. Policies during the financial crisis
Monetary and Fiscal Policies
Monetary and fiscal policies in an open economy
An important distinction:
Temporary and permanent: if permanent, changes
expectations 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
E
DD
E2
AA’
E1
AA
Y1
€
Y2€
Temporary monetary policy shock
Y€
Monetary and Fiscal Policies
• Monetary policy: very efficient (in stimulating demand)
in an open economy
• In addition to effect on I, ↓ in interest rate → E
(depreciaFon) → 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)
E
DD
DD’
E1
E2
AA
Y1
€
Y2€
Temporary expansionary fiscal policy
Y€
Monetary and Fiscal Policies
• 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 out
on investment)
• Fiscal policy is even more inefficient in more open
(smaller) economies to stabilize economy
Monetary and Fiscal Policies
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)
Monetary and Fiscal Policies
How has globalization changed macro-policy?
• Financial openness makes domestic fiscal policy less efficient
– Go to the extreme:
Financial autarky means the interest parity condition does
not hold and E is not affected by interest rate differential.
No appreciation and no fall in net exports
Monetary and Fiscal Policies
How has globalization changed macro-policy?
• Trade openness makes monetary policy more efficient
– Fall 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 more
efficient
– Go to the extreme: financial autarky means the interest
parity condition does not hold and E is not affected by
interest rate differential. No depreciation and no increase
in net exports
Monetary and Fiscal Policies
How has globalization changed macro-policy?
• In past 20 years, monetary policy has become the prime
policy instrument; fiscal policy much less used (also issues of
delay).
• Globalization means domestic fiscal expansion not very
expansionary 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 spillovers
of domestic policies (externalities)
• Requires international coordination
Spillover effects of fiscal policies
Payoff matrix
EU
US
No fiscal
expansion
Fiscal
expansion
No fiscal
expansion
(0,0)
Fiscal
expansion
(+15,-5)
(-5,+15)
(+5,+5)
G ↑ ; ↑ of debt, imports (through appreciation + ↑ demand): benefit
trade partners
Nash equilibrium: no fiscal expansion; international cooperation
important and difficult (free rider problem)
In euro zone: spillover through demand (no exchange rate effect)
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 stimulus
needed by each country is reduced (and provides a political economy argument
for a collective fiscal effort)”
Fiscal Policies: some evidence on fiscal multipliers
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 1
says that after 20 quarters a 1 €
increases in G increases output
by 1€.
Source: E. Ilzetzki, E. Mendoza
and C.Vegh, 2009
Cumulative fiscal multiplier in open and closed economies
Source: E. Ilzetzki, E. Mendoza and C.Vegh, 2009
Lecture 8 and 9
Exchange rates, output in open economies and
the role of policies
1. Exchange rate and output in the short/medium-run
2. The effects of monetary and fiscal policies
3. Policies during the financial crisis
Policies in the recent crisis
• Conventional monetary policy has been used heavily: interest
rates brought to 0-1% in US and euro zone
• But present situation may have required even more monetary
policy 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
E
DD’
DD
E2
E1
AA
Y2
Y1
Y
Recession : drop in aggregate demand
E
DD’
DD
E3
E2
E1
AA’
AA
Y2
Y3
Y1
Y
Standard monetary response: lowers interest rates
Interest rate r
Monetary policy looses power: the liquidity trap
at r =0, the demand for money is infinitely elastic because money and bonds
become perfectly substitutable at zero interest rate
L(r,Y)
r =0
M/P
M/P’
Real money demand
Conventional Monetary Policy
Interest rate response
Fiscal Response
Source OECD
Fiscal Response
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
accommodative monetary policy.
Ricardian Equivalence
• 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 a
delay in when they pay taxes
• Therefore in response to government borrowing consumers are forward
looking 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 – Is it True?
Private and public saving: raw correlations1
Data suggests around 50% crowding out on average at 1 year horizon
Source: OECD 2002
Fiscal Adjustment
• After large fiscal stimulus in 2008-2010. Fiscal
adjustment necessary in most countries
• Will the adjustment trigger a recession? Likely vary
across countries, as adjustments tend to be more
painful in large, closed economies (and countries
with fixed exchange rates; see later). Less painful if
accommodative monetary policy but not possible if
rates are already at the lower bound
• Also more painful in highly indebted economies.
• Now or later?
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
Unconventional Monetary Policy
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-bank
transactions
• Provide liquidity to banks and corporations
Money market rate spreads
Spread between interbank deposit and OIS rates at 3-month maturity
4
3.5
4
emergence of
money market
tensions
failure of
Lehmann Bros.
3.5
USD
3
3
2.5
2.5
2
2
GBP
1.5
1.5
1
1
0.5
0
1/1/2007
0.5
EUR
0
7/1/2007
1/1/2008
7/1/2008
1/1/2009
7/1/2009
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 for
money market mutual funds.”
Unconventional Monetary Policy
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
Federal Reserve
balance sheet
2400
2400
2000
2000
1600
1600
1200
1200
800
800
400
400
USD billions
• Post-Lehmann:
Expand total
balance sheet
Accumulate reserve
balances
Large outright
purchases
0
0
-400
-400
-800
-800
-1200
-1200
-1600
-1600
-2000
-2000
-2400
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
-2400
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
Unconventional monetary policy and inflation
• Is unconventional monetary expansion inflationary?
NO, as long as credit does not find its way in the economy and
the economy is very weak
• Banks are hoarding cash; so are companies
• Large increase in liquidity (in “base money”) has not led to a
corresponding increase in credit
• Velocity of money has fallen in the US. Reminiscent of the
Great Depression
Increase in liquidity (in “base money”) and increase in credit (M2)
Unconventional monetary policy and exchange rates
External channel of quantitative easing? Should ‘credit
easing’ or ‘quantitative easing’ weaken the currency?
r$- r€ = (Ee –E)/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
Distribution of households’ inflation expectations one year ahead
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 exchange
rate expectations.