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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
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$/P : real exchange rate = relative price of US goods
with respect to European goods
Goods Market Equilibrium
+
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D = C(Y - T) + I + G + CA(q, Y - T,Y$ - T$)
D = D(q, Y - T, I , G,Y$ - T$)
Equilibrium: Aggregate Demand = Output
Y = D = D(q, Y - T, I , G,Y$ - T$)
Output and income is determined by demand (fixedprices in the short run)
Goods Market Equilibrium
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Aggregate demand
GDP, Y
D = D(q, Y - T, I , G,Y$ - 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
Goods Market 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)
Monetary and Fiscal Policies
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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
Monetary and Fiscal Policies
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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)
Monetary and Fiscal Policies
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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 doesnot hold and E is not affected by interest rate differential.
No appreciation and no fall in net exports
Monetary and Fiscal Policies
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How has globalization changed macro-policy?
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
Monetary and Fiscal Policies
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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 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
Monetary and Fiscal Policies
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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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Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
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Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
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Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
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Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
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Will it hurt? Macroeconomic effects of fiscal consolidation (IMF 2010)
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Unconventional Monetary Policy
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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
Unconventional Monetary Policy
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.
Unconventional Monetary Policy
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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.