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Goals and Instruments Policy goals: Internal balance & External balance

LECTURES 7 & 8: POLICY INSTRUMENTS. Goals and Instruments Policy goals: Internal balance & External balance. Policy instruments. The Swan Diagram The principle of goals & instruments. Introduction of monetary policy The role of interest rates Monetary expansion

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Goals and Instruments Policy goals: Internal balance & External balance

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  1. LECTURES 7 & 8: • POLICY INSTRUMENTS • Goals and Instruments • Policy goals: Internal balance & External balance • Policy instruments • The Swan Diagram • The principle of goals & instruments • Introduction of monetary policy • The role of interest rates • Monetary expansion • Fiscal expansion & crowding out

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

  3. Internal balance Output gap, as percentage of GDP, in the Great Recession, 2009 US Jpn France UK Ir In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << . Source: IMF, via Economicshelp, 2009 ITF-220, Prof.J.Frankel

  4. Output gap in eurozone peripherySource: 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. ITF-220, Prof.J.Frankel

  6. RESPONSES TO CURRENTACCOUNT DEFICIT • Financing • By borrowing • or running down reserves. vs. • Adjustment • Expenditure-reduction(“belt-tightening”) • e.g., fiscal or monetary contraction • or Expenditure-switching • e.g., devaluation.

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

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

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

  10. DERIVATION OF SWAN DIAGRAM • Only by using both sorts of policies simultaneously • can both internal & external balance be attained, at point A. ● ● • Experiment: increase in Ă • (e.g. G↑) ● Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0 . ● What would have to happento reduce trade deficit? ● ● Devaluation ITF-220, Prof.J.Frankel

  11. Again, • At F, TB<0 . • What would have to happen to eliminate trade deficit? E ↑ . ● ● If depreciation is big enough, restores TB=0 at pointB. ● ITF-220, Prof.J.Frankel

  12. To repeat, at F, some of higher demand falls on imports. We have just derived upward-sloping BB curve. . • What would have to happen to eliminate trade deficit? ● E ↑ . If depreciation is big enough, restores TB=0 at pointB. ● ● We have just derived upward-sloping external balance line, BB. ITF-220, Prof.J.Frankel

  13. Now consider internal balance. Return to point A. Experiment: increase Expansion moves economy rightward to point F. ● ● Some of higher demand falls on domestic goods => Excess Demand. Y > What would have to happen to eliminate excess demand? ● ● ● E ↓ . ITF-220, Prof.J.Frankel

  14. Experiment: Fiscal expansion, cont. • At F, Y > . • What would have to happen to eliminate excess demand? ● ● E ↓ . ● If appreciation is big enough, restores Y= at pointC. ITF-220, Prof.J.Frankel

  15. We have just deriveddownward-sloping YY curve. At F, some of higher demand falls on domestic goods. • What would have to happen to eliminate excess demand? ● ● E ↓. If appreciation is big enough, restores atC. ● We have just derived downward-sloping internal balance line, YY. ITF-220, Prof.J.Frankel

  16. Swan Diagram has 4 zones: • ED & TD • ES & TD • ES & TB>0 • 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. ED & TB>0 Excgange rateE Mexico 1995 or Korea 1998 ED & TD Mexico 1994 or Korea 1997 ES & TB>0 YY: Internal balance Y=Potential ES & TD Example 1: Emerging markets in 1990s Classic response to a balance of payments crisis: Devalue and cut spending BB: External balance CA=0 ● Spending A Could be the “fragile 5” in 2013-14: India, Turkey, Indonesia, S.Afr., Brazil

  19. ED & TB>0 BB: External balance CA=0 Excgange rate E China 2010 China 2002 ED & TD ES & TB>0 YY: Internal balance Y = Potential ES & TD Example 2: China in the past decade ● Spending A 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 At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES.

  20. ED & TB>0 Excgange rate E ES & TB>0 ED & TD US 1981,1991,or 2008-13 US 1987or2007 YY: Internal balance Y = Potential ES & TD Example 3: US over 33 years BB: External balance CA=0 ● Spending A ITF-220, Prof.J.Frankel

  21. 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). E.g., Taylor rule sets i. LM i E.g., Quantitative Easing sets MB. Y ITF-220, Prof.J.Frankel

  22. 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

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

  24. End of Lectures 7 & 8: Targets and Instruments ITF-220, Prof.J.Frankel

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

  26. 2002 I US Jpn By 2002, most countries were operating below full employment: Y < Source: The Economist, June 22, 2002 ITF-220, Prof.J.Frankel

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