Irish Economy 2009

1. Irish Economy 2009 Solutions

2. Question 1a • In an open economy with free capital flows, under what conditions is it possible for domestic and world interest rates to diverge? • Basic answer: Uncovered Interest Rate parity. • Interest rates may deviate if the exchange rate is expected to appreciate or depreciate.

3. The capital account CP To understand the flow of cash to buy and sell assets, consider an investor contemplating buying a one-year bond: Should she invest at home or abroad? Invest at home – at end of year €1 becomes €(1+i) Invest abroad -

4. Uncovered interest parity (UIP) Requires that the expected return from investing at home is the same as the expected return from investing abroad, so

5. Question 1b • Under floating exchange rates the balance of payments will balance in the sense that the sum of the current account and cap account will be zero: Curr +cap=0 • So if there is a current account deficit there must be a cap account surplus (inflow) • This must be the case because there is a free market in currency so flows. So if curr+cap <0 for an instant there would be excess demand for foreign currency ($) and excess supply of domestic currency (€) • Basic micro theory tells us that the price of $ must rise in response to the excess demand i.e. the domestic currency depreciates. • This depreciation will make the country a more attractive investment (cap inflows increase) and boost next exports (current account improvement).

6. If the e rate is truly freely floating it will adjust fully and immediately to close the deficit or surplus in this manner. Obviously in the short run most of the adjustment will take place through the capital account. • If the e rate is not free floating then the whole of the deficit or surplus may not be cleared. In the extreme case of a fixed rate, the deficit will remain. The continuing excess demand for $ will be met by the central bank supplying $ from its reserves • So for fixed or floating e we can say that the BOP balances in the sense that the following is always true: cap + cur – change reserve = o • In the case of floating e the change in reserves is identically zero • Sometimes the change in reserves (or “official financing”) is considered as part of the capital account.

7. Question 1c • Comment on how the balance of payments reflected the boom and property market bubble in Ireland during 2002-7. • Basic answer is that a boom in the domestic property market shifted the AD curve to the right. This lead to an increase in wages and price reducing competitiveness and net exports

8. LRAS P SRAS(Pe=PA) SRAS(Pe=Pc) C B A AD1 AD0 Y* Y

9. Prices (Competitiveness) • Real Exchange Rate • Compare price levels of different countries • Simple example is the Hamburger index • Do for all goods in a basket and calculate the ratio • i.e. CPI or GDP or wages Look at R for Ireland over time • Level doesn’t tell much • Trend does: we get expensive • Trade weighted real e rate rises by about 30% from 2000, having fallen by 20% the previous decade  Leddin and Walsh Macroeconomy of the Eurozone, 2003

11. Crowding Out • The consequence of the housing boom was the misallocation of resources i.e. crowd out other aspects of the economy • Exports • Boom forces up prices and competitiveness suffers • Don’t notice during boom (because I is high) • Notice now!

12. A caveat • Balassa-Samuelson theory • Expect richer countries to be more expensive • Nevertheless, Ireland became more expensive than countries of a similar level of wealth. • See graphs

13. 2000

14. 2004

15. Cap flows • Extra credit for this • International Credit conditions fuelled the bubble in some countries • Ireland • Huge capital inflows to Ireland • Cap a/c surplus reflects insufficient savings • Banks foreign borrowing • On the way up this financed the boom

16. National Savings • Two identities • Y=C+I+G+NX • Y=C+S+T • This imply • S+(T-G)+NX=I • So insufficient domestic savings were supplemented by capital inflows • Boom financed by cap inflows via banks

18. Question 2 • These are short questions so students don’t have time to give the full answer as outlined below • So be generous!

19. 2a Discretionary FP • Changes in the AS/AD curves cause actualreal GNP to swing around natural real GNP. • Keynesians advocate an active fiscal policy (changes in government expenditure and/or taxes) to try to stabilise the business cycle.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

20. The Stance of Fiscal Policy • A recession automatically worsens the budget deficit. Tax revenues fall and social welfare spending rises. • Diagram shows how the budget balance varies as GNP changes. • Boom period, the deficit falls. • Positive relationship between Net Taxes and GNP. • Current spending (G) is assumed to be constant. • Note distinction between automatic and discretionary changes in the budget balance. Discretionary change occurs when the government deliberately changes G, T or SW.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

21.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

22.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

23. 2b: Laffer Curve • Changes in taxes can give unpredictable results.Refer to the Laffer curve. • Examine relationship between tax rate and tax revenue. • Optimal tax rate: T* • Below optimal: normal positive relationship. • Above optimal: an increase in tax rate may lead to a decrease in tax revenue. High taxes affect the “incentive to work” and drive industry into the black economy, as we saw in Ireland in the mid-1980’s.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

24. Laffer Curve Average tax rate 100% A T 1 Revenue maximizing Z * T tax rate T B 2 0 % R R 1 2 Tax revenue £m  Leddin and Walsh Macroeconomy of the Eurozone, 2003

25. Problem with Laffer Curve • Not clear where the revenue max tax rate is • Peak of curve • Is it above or below current rates? • Highly ideological debate • Current government policy implies they think we are at max as they didn’t raise or reduce taxes in budget • Is this likely? Do they have any evidence for this?

26. 2c: Growth in Celtic Tiger Convergence due to • Rapid rise in ratio of non-agricultural employment to population • This in turn due • Demographic factors • Decline in proportion aged under 15 • Exceptional growth in numbers at work outside agriculture • Reasonable growth in productivity • High by some standards • But no miracle

27. Demographics The fall in birth rate after 1980 could be regarded as • Ireland’s belated convergence to the demographic norm for a developed country • Facilitated by rising female educational levels and • Changes in attitudes and laws concerning contraception • Triggered by rise in unemployment in early 1980s?

28. Where did the economic growth come from in the 1990s?

29. 2d: PPP • PPP: equal value for money for goods and services. • Prices of similar goods expressed in a common currency should be the same. • Based on arbitrage. Buy cheap, sell expensive to make profit. • Actions should lead to a convergence of prices  Leddin and Walsh Macroeconomy of the Eurozone, 2003

30. Absolute PPP • Pirl e = Pw • Prices, adjusted for the exchange rate, should be the same in different countries. • Example: Levi Jeans, • Pirl = €10 in Dublin, • Pus = $20 in New York. • If e = $/€ = 2 then PPP holds. • If e  2, PPP does not hold.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

31. Real Exchange Rate • Compare price levels of different countries • In a common currency (usually US$) • Related to the concept of purchasing power parity (PPP) • Law of one price • Simple example is the Hamburger index • What is the US$ price of a Big Mac in various countries • $PIRL=€ PIRL*e • Is $PIRL >$PUS

32. What does this tell you? • “competitiveness” • Are one country’s goods cheaper than another’s? • Do for all goods in a basket and calculate the ratio • i.e. CPI or GDP or wages • Look at R for Ireland over time • Level doesn’t tell much • Trend does

33. Relative PPP • Total differentiation of the absolute PPP equation gives: •  Pirl +  e =  Pw • Or irl + e = w • Inflation rates, adjusted for changes in the exchange rate, should be similar across countries. • Weak form of PPP. • Prices can be initially different, but change at the same rate over time.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

34. PPP as a Economic Theory: Under Flexible Exchange Rates • PPP becomes a theory of exchange rates. •  e = w - irl • Inflation is the most important determinant of e. Country’s with high inflation rates will experience weak exchange rates and visa versa. • Why? • Very relevant in the case of large countries: USA, Japan and EMU.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

35. PPP as an Economic Theory: Under Fixed Exchange Rates • PPP becomes a theory of inflation. • irl = w -  e • If e is fixed, irl is determined by w. • Ireland is a price taker on international markets. • One of the main reasons for fixed e • EMS & EMU. • Used by small countries world-wide.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

36. Q3: Irish vs US FP • Basic answer • The US government is applying standard Keynesian demand management to the current crisis. • The Irish government is doing the opposite because it believes that the debt is already too high and any further increase will reduce confidence and hence AD • Figure 1 shows what the US government is doing i.e. applying an increase in aggregate demand to a demand shock.

37. Start from LR eqm • Y=Y* • Pe=P • The fall in AD • Eqm moves from A to B • Y<Y* • Recession • We could wait for the economy to adjust automatically to C • Prolonged recession • Alternatively we can increase aggregate demand by increasing G and/or decreasing Taxes • This will shift AD curve to right and economy will move from B to A • This is US policy

38. Policy for a AD shock LRAS p SRAS(Pe=PA) SRAS(Pe=PC) A B C AD0 AD1 Y* Y

39. Differences between US and Ireland • Or between any large country and a small open economy • US issues debt in its own currency • Can use inflation if necessary • Possibility of a dynamically unstable debt in ireland • Borrowing to pay interest • Burden of €35,000 per worker already • FP policy likely more effective (see later) • US can depreciate its currency • Could expand economy by depreciation • Control deficit by cutting G, raising T • US can reduce interest rates

40. What is to be done? • For any SOE conflict between two basic issues • Stabilisation policy • Deficit control • Empirical question • Stabilization policy • Ideally we would want to increase the deficit in a recession • Shift AD to right and restore full employment • Some of deficit is the automatic stabiliser but could do more • Blanchflower argued this recently • Deficit control • Irish deficit this year heading towards €30bn = 13%GDP • 13% not sustainable forever

41. The Multiplier • A key detail ails of stabilization policy are key • What is the multiplier? • The effect of any G on Y • Theory suggests low in SOE • Reason: any increase in G will lead to an increase in imports so that the stimulus will be lost to the Irish economy

42. Negative Multiplier • Expansionary Fiscal Contraction • Multiplier negative in times of crisis • Failure to deal with debt causes people to cut back consumption • AD shift to left • Very controversial idea • Some evidence for it including Ireland in 1987 • Small multiplier argues against traditional stabilization policy • If Neg mult no conflict between the two goals

43. Deficit Control • If the multiplier is positive cutting deficit now will make recession worse • If mult is negative there is no conflict • So why do it now as distinct from postponing to the future? • Dynamically unstable debt • 13% of GDP is unsustainable • End up borrowing to pay interest • Lenders might refuse loan

44. If we decide to control deficit there are two questions • How much how soon? • By taxes or expenditure? • Time • Do not have to close all the gap immediately • Governments plan is to bring within 3% of GDP within 4 years • That is actually quite quickly • Automatic stabiliser will close some as the economy improves • So plan should concentrate on the structural deficit

45. Tax or Expenditure • The Big question today is whether we choose to close the gap by increasing taxes or cutting expenditure or in what combination • All these actions have multipliers • Probably all positive (assuming no EFC) • Some bigger than others • Lane suggests inv > wages • Government seems to favour expenditure cuts. Why? • Philosophy: ideology supplants evidence • Multipliers: unlikely • Laffer Curve

46. International Evidence • Empirical matter whether tax based or exp based budget is better • Policy makers remember Ireland’s experience of 1980s and 1990s • But that is just one observation • There is a large literature looking at deficit control worldwide • Conclusion is that expenditure based more likely succeed • Evidence is not overwhelming

47. Q4 Celtic Tiger • Note that the student is free to talk about any 5 (or more) of the policies outlined below • If they don’t show how these policies affect the AS-AD (last slide) then award no more than 60%

48. Economic Policy in the Tiger • Distinguish between pre-boom factors: • 1. Foreign direct investment (Industrial policy). • 2. External assistance. • 3. Investment in education. • Factors that combined to ignite the boom: • 4. Centralised wage bargaining. • 5. Fiscal policy. • 6. Upturn in World (US) economy. • 7. Achieving EMU entry criteria. • 8. Exchange rate policy. • 9. Small is beautiful.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

49. 1. Industrial Policy • Success of IDA in attracting high-tech foreign multinational companies (MNCs): microelectronics, pharmaceuticals, medical instrumentation, computer software, financial services, telemarketing. • However, the contribution of MNC’s can easily be exaggerated. • Need to take into account their high level of imports (including payments for patents and royalties) and repatriated profits. • Contribution to GNP in 1998 was only €4.8 billion. Considerably less than the sales figure.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

50. 2. External Assistance • 1973-2001: • Total net receipts = €33,853.5 million. • Annual average of €1,167.4 million or 3.9 % of GNP. • The peak was 6.6% of GNP in 1991. • Paid under a variety of headings: agriculture, social, regional and cohesion funds. • Money mostly spent on roads, railways, telecommunications. • Greatly improved the country’s productive capacity.  Leddin and Walsh Macroeconomy of the Eurozone, 2003