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G-20
• The Group of 20, or G-20, is an international
body that meets to discuss economic issues.
• Its members -- 19 countries with some of the
gg
industrial and emerging
g g
world's biggest
economies, plus the European Union -represent about 90 percent of the world's
gross national product, 80 percent of world
trade (including trade within the European
Union) and two-thirds of the global population.
• The G-20 was established as a response to
the Asian financial crisis of the late 1990s.
PP542
Macroeconomic Policy
Coordination
K. Dominguez, Winter 2010
London Summit Goals
From Brad DeLong’s Blog
http://www.londonsummit.gov.uk/en/summit-aims/
http://delong.typepad.com/sdj/2009/04/g-20-meeting-forecast.html
• At the Summit, countries need to come
together to enhance global coordination in
order to help restore global economic growth.
World leaders must make three commitments:
G-20 London Summit Meeting Forecast
• Obama will tell the G-20 leaders what they ought to
do.
• They will complain.
• They will do about half of itit.
• That they do half of it will be an extraordinarily good
outcome--the best episode of international policy
coordination since Bretton Woods itself.
• Will them doing half of what they ought to do be good
enough?
 First, to take whatever action is necessary to
stabilise
t bili financial
fi
i l markets
k t and
d enable
bl ffamilies
ili and
d
businesses to get through the recession.
 Second, to reform and strengthen the global
financial and economic system to restore
confidence and trust.
 Third, to put the global economy on track for
sustainable growth.
K. Dominguez, Winter 2010
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Interdependence
of “Large” Countries (cont.)
Interdependence of “Large” Countries
• Previously, we assumed that countries are “small” in
that their policies do not affect world markets.
•
If the US permanently increases the money supply,
the DD-AA model predicts for the short run:
1. an increase in U.S. output and income
2. a depreciation of the U.S. dollar.
 For example, a depreciation of the domestic currency was
g
influence on aggregate
gg g
assumed to have no significant
demand, output and prices in foreign countries.
•
 For countries like Costa Rica, this may be an accurate
description.
What would be the effects for Japan?
1. an increase in U.S. output and income would raise demand
of Japanese products, thereby increasing aggregate
demand and output in Japan.
2. a depreciation of the U.S. dollar means an appreciation of
the yen, lowering demand of Japanese products, thereby
decreasing aggregate demand and output in Japan.
 The total effect of (1) and (2) is ambiguous.
• However, large economies like the U.S., EU, Japan,
and China are interdependent because policies in one
country affect other economies.
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Interdependence
of “Large” Countries (cont.)
Interdependence
of “Large” Countries (cont.)
If the U.S. permanently increases government
purchases, the DD-AA model predicts:
•
–
• In fact, the U.S. has depended on saved
funds from many countries, while it has
borrowed heavily.
an appreciation of the U.S. dollar.
What would be the effects for Japan?
p
•
–
The U.S. has run a current account deficit
for many years due to its low saving and
high investment expenditure.
an appreciation of the U.S. dollar means an depreciation of
the yen, raising demand of Japanese products, thereby
increasing aggregate demand and output in Japan.
What would be the subsequent effects for the U.S.?
•
–
Higher Japanese output and income means that more
income is spent on U.S. products, increasing aggregate
demand and output in the U.S. in the short run.
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Global External Imbalances,
1999–2006
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Interdependence of “Large” Countries
(cont.)
• But as foreign countries spend more and
lend less to the U.S.,
interest rates are rising
g slightly
g y
the U.S. dollar is depreciating
the U.S. current account is increasing
(becoming less negative).
Source: International Monetary Fund, World Economic Outlook, April 2007.
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U.S. Real Interest Rate, 1997–2007
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Two-country model
• Assume that the world is made up of two
“large” countries (for example, the US and
Japan)
• Allow the current account of each country to
be influenced by foreign disposable income:
 SP *

CA  CA 
,Y  T ,Y *  T * 
 P

Source: Global Financial Data. Real interest rates are defined as ten-year government bond rates less average inflation
over the preceding twelve months. The data are twelve-month moving averages of monthly real interest rates so defined.
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Two-country model (cont.)
Two-country model (cont.)
• Graphically, this suggests that as foreign income rises (Y*),
home exports rise and home aggregate demand and therefore
income rises (Y). The HH curve shows home and foreign output
levels at which AD=AS in the home country.
• If the world is made up of just two countries, then
the foreign current account must be the mirror
image of the home current account when both CAs
are expressed in the same currency units.
Y*
HH
 SP *

,Y  T ,Y *  T * 
CA 
P
*


CA 
SP *
P
Y
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K. Dominguez, Winter 2010
Two-country model (cont.)
Y*
Y
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Effects of Home Fiscal Expansion when
the Foreign Country is Interdependent
• The FF curve shows home and foreign output levels at which
AD=AS in the foreign country. FF will be less steep than HH
because a rise in foreign income has a greater influence on the
foreign output market than the domestic output market
Along HH a large increase in
Y* is needed to remove the
excess supply of home
output caused by a rise in Y
K. Dominguez, Winter 2010
HH
FF
Along FF a large increase in Y
is needed to remove the excess
supply of foreign output caused by
a rise in Y*
Y
• A domestic fiscal expansion will raise
domestic income and lead to a domestic
currency appreciation.
• The home fiscal expansion
p
leads to an
outward shift (to the right) in the HH curve.
• The home currency appreciation makes home
goods more expensive relative to foreign
goods, raising foreign exports and income.
The rise in home income also leads to higher
foreign exports. These lead to a outward shift
(to the left) in the FF curve.
At the intersection of the two curves AD=AS in both countries
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Effects of Home Fiscal Expansion when
the Foreign Country is Interdependent
Y 1*
Home fiscal
expansion is an
“engine of growth”
for both countries
Y 0*
Y0
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Y1
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Effects of Home Fiscal Expansion when
the Foreign Country is Interdependent
HH0 HH
1
FF1
FF0
Y*
K. Dominguez, Winter 2010
Y
17
• The change to a more expansionary fiscal
policy in the home country resulted in a rise in
output in both home and foreign. This is a
positive feature of flexible exchange rates.
• How would our analysis change if we had
fixed rates? The positive effect of the home
currency appreciation on foreign output would
not arise.
• One can think of fiscal policy as producing a
positive externality in a floating exchange rate
two-country world.
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Effects of Home Monetary Contraction when
the Foreign Country is Interdependent
Effects of Home Monetary Contraction when
the Foreign Country is Interdependent
HH1 HH0
Y*
• The home money contraction leads to an
inward shift (to the left) in the HH curve.
• Home output falls for every level of foreign
p
output.
• The fall in home output would be expected to
also decrease home demand for imports
• If we assume the substitution effect (due to
the foreign currency depreciation) outweighs
the income effect, foreign income rises,
leading to a outward shift (to the left) in the FF
curve.
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Effects of Home Monetary Contraction when
the Foreign Country is Interdependent
• The Home monetary contraction had a negative effect
on home output and employment and a positive effect
on foreign output.
• However, there may also be some negative effects on
the foreign economy not captured in our simple
model.
d l
• The stronger home currency makes the price of home
imports higher in the foreign country which may
influence the foreign inflation rate through both price
and wage effects.
• The home currency appreciation helps lower home
inflation but at the same time exports inflation to the
foreign country. This is called the beggar-thy
neighbor effect.
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Problems with discretion-based regimes:
the illusion of autonomy (cont.)
Home monetary
contraction
will lower home
income and raise
foreign income (due
to the foreign
currency depreciation)
Y1*
Y 0*
Y1 Y0
Y
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Problems with discretion-based regimes:
the illusion of autonomy
• In the early 1980s the industrial countries hoped to
reduce inflation by slowing monetary growth, but the
situation was complicated by the influence of
exchange rates on the price level.
• A governmentt that
th t adopts
d t a less
l
restrictive
t i ti monetary
t
policy than its neighbors is likely to face a currency
depreciation (a spillover from the policies taken by the
other countries) that partially frustrates its attempt to
disinflate. Imports will be more expensive and these
higher prices will influence the overall price level.
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Game Theoretic Example
• With hindsight it is clear that each individual
country's attempt to resist currency
depreciation, led the industrial countries as a
group to adopt overly tight monetary policies
that in turn
that,
turn, deepened the world recession
recession.
• All governments would have been better off if
everyone had adopted looser monetary
policies, but given the policies that other
governments did adopt, it was not in the
interest of any individual government to
change course.
K. Dominguez, Winter 2010
FF1
FF0
• THE STYLIZED MODEL:
 2 countries: the US and Japan;
 2 policies: somewhat and very restrictive monetary
policy
• ASSUMPTIONS:
 If both countries adopt somewhat restrictive
monetary policies, inflation falls by 1% and
unemployment rises by 1% in both countries.
 If the US shifts to a very restrictive monetary
policy, US inflation falls by 2% and unemployment
rises by 1.75%.
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Hypothetical Effects of Different Monetary
Policy Combinations on Inflation and
Unemployment
Game Theoretic Example (cont.)
• ASSUMPTIONS (cont.):
 If the US adopts a very restrictive monetary
contraction, however, there will be a spillover effect
on Japan through the exchange rate.
• The dollar appreciation for the US is a yen depreciation
for Japan; causing inflation in Japan to rise back up to the
pre-disinflation level, unemployment falls to .5%.
 The US's sharper monetary contraction has a
beggar-thy-neighbor effect on Japan.
 If both countries adopt very restrictive monetary
policies, inflation falls by 1.25% and unemployment
rises by 1.5% in both countries.
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Payoff Matrix for Different
Monetary Policy Moves
Game Theoretic Example (cont.)
• Assume that both countries want to maximize
the decrease in inflation and minimize the
increase in unemployment.
• Define the payoff to each policy combination
for each country as the change in inflation
over the change in unemployment: -∆π/∆U.
• The payoff matrix that corresponds with our
earlier assumptions is on the next slide.
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Game Theoretic Example (cont.)
Game Theoretic Example (cont.)
• If both countries go it alone, they would pick
the policy that maximizes their own payoff
given the other countries policy choice (this is
called the Nash equilibrium).
q
)
• If the US adopts a somewhat restrictive policy,
Japan does better with a very restrictive
policy.
• The payoff in this case is 8/7 which is greater
than 1, the payoff Japan will receive if it
adopts a somewhat restrictive policy
• Likewise, the US will be better off adopting a
very restrictive monetary policy because the
payoff: 5/6 is greater than 0, the payoff the US
will receive if it adopts a somewhat restrictive
policy while Japan adopts a very restrictive
policy.
• So, no matter what the US does, Japan will
pick the very restrictive monetary policy.
• The US is in the same position, so both
countries will choose very restrictive monetary
policies, and each will get a payoff of 5/6.
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Game Theoretic Example (cont.)
• Had the two countries agreed to cooperate
with one another, they both could be better off
by adopting somewhat restrictive policies with
payoffs
p
y
of 1.
• The game theory illustrates that even with a
floating exchange rate, countries are implicitly
constrained in their monetary policy choices.
• Exchange rate spillovers insure that one
country's policy choices will influence other
countries.
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