AN INTEGRATED APPROACH TO THE STUDY OF RESERVE EARNING ECONOMIES

1. AN INTEGRATED APPROACH TO THE STUDY OF RESERVE EARNING ECONOMIES ÁNGEL GARCÍA BANCHS University of Siena, Annual Meeting 27-06-2008, Siena, Italy

2. STRUCTURE OF THE PRESENTATION Introduction (motivation and objectives). Methodology: Stock-flow consistency approach to macroeconomics. The Neoclassical versus the Post Keynesian model. Features of my model − exogenous and endogenous variables. Final remarks.

3. INTRODUCTION (Motivation) Interesting findings from previous work: “International Monetary Asymmetries and the Central Bank”, forthcoming in Revista Investigación Económica, UNAM, Mexico, Jul-Sep 2008. (García, Mata and Nell, 2008). • The international monetary system is asymmetric.

4. INTRODUCTION (Motivation) Interesting findings from previous work: • All national states can circulate domestically their own currencies but not all of them can do so internationally. • The world has become divided among reserve issuing and reserve earning economies. • This transformation occurred after WWII, when the elastic supply of US dollars arrived to replace the scarce supply of gold as international means of settlement.

5. INTRODUCTION (Motivation) Interesting findings from previous work: • The quantity effect and the price effect. • The former means reserve earning economies must be concerned with the preservation of a minimum stock of foreign currency assets, while the latter implies they must be concerned with the stability of the foreign exchange rate.

6. INTRODUCTION (Motivation) Interesting findings from previous work: • A strong supply side connection between the short-term rate of interest, the exchange rate, and the stock of foreign reserve assets of the central bank. • Different from traditional demand-side link.

7. Reserve Issuing Economies Reserve Earning Economies Local Currency Reserves Foreign Currency Reserves Local Currency Reserves Interest Rate FX Rate Interest Rate • INTRODUCTION (Motivation)

8. INTRODUCTION (Motivation) Interesting findings from previous work: • Monetary policy is more flexible but less influential in reserve issuing economies, and less flexible but more influential in reserve earning ones. • The degree of interest rate exogeneity is much lower in reserve earning economies than in reserve issuing ones. • Caveat: International monetary asymmetries affect the behavior and balance sheet structure of the institutional sectors in the economy.

9. INTRODUCTION (Objective) Simulate changes in parameters so as to compare the two models: reserve earning and reserve issuing economies. Two different papers. • Firms (F), Households (H), Commercial Banks (B), the Central Bank (CB) the Government (G) and the Rest of the World (ROW). • How the rate of growth differs in the two economies. • How stocks of wealth, flows of consumption and investment and prices evolve over time.

10. 2. METHODOLOGY: STOCK-FLOW CONSISTENCY APPROACH Two views but same methodology: The New Haven School, led by James Tobin at Yale University, in the US, and The Cambridge School, led by Wynne Godley, in the UK (Godley and Lavoie, 2007). The methodology is exactly the same. But the behavior of their models differ. The former is an orthodox approach and the latter is a Post Keynesian heterodox approach. (What variables are exog/endog?)

11. 2. METHODOLOGY: STOCK-FLOW CONSISTENCY APPROACH (Cont) • Sectoral budget and system wide constraints: “The fact that money stocks and flows must satisfy accounting identities in individual budgets and in an economy as a whole provides a fundamental law of macroeconomics analogous to the principle of conservation of energy in physics”. Godley and Cripps (1983: p. 18)

12. 2. METHODOLOGY: STOCK-FLOW CONSISTENCY APPROACH (Cont) • Stock-flow norms which may be self-imposed or inflicted by other institutional sectors. • Appropriate use of lagged dynamics to make sure causes precede effects. • Several assets and rates of returns both, private and public, and short and long (Brainard and Tobin, 1968). • Financial and monetary policy is considered.

13. 2. METHODOLOGY: STOCK-FLOW CONSISTENCY APPROACH (Cont) • Sectoral Budget constraint (Vertical): • System wide constraint (Horizontal N-1 sectors): • Balance sheet, revaluation and transactions matrices.

14. 2.1 Balance Sheet Matrix of a REE

15. 2.1 Balance Sheet Matrix of a REE (Cont)

16. 2.2 Revaluation Matrix of a REE

17. 2.2 Revaluation Matrix of a REE (Cont)

18. 2.3 Transactions Matrix of a REE

19. 2.3 Transactions Matrix of a REE (Cont)

20. 2.3 Transactions Matrix of a REE (Cont)

21. 2.3 Transactions Matrix of a REE (Cont)

22. 2.3 Transactions Matrix of a REE (Cont)

23. THE NEOCLASSICAL MODEL VERSUS THE POST KEYNESIAN MODEL Both share the same methodology, but: • In the Neoclassical model (NCM) agents maximize utility and profits. There is need and room for the rational expectations hypothesis. • In the Post Keynesian model (PKM), procedural rationality and adjustment to disequilibrium is assumed.

24. THE NEOCLASSICAL MODEL VERSUS THE POST KEYNESIAN MODEL (Cont) • In the NCM: perfect information assumption. • In the Post Keynesian model (PKM): generic uncertainty, liquidity preference, norms and targets which determine behavior. • For instance: inventories to sales ratio, bills and reserves to deposits, income to wealth, foreign reserves to imports, debt to GDP, foreign debt to exports, etc…although Tobin and some Neoclassical Keynesians have also used stock-flow norms.

25. THE NEOCLASSICAL MODEL VERSUS THE POST KEYNESIAN MODEL (Cont) • The particular shape of expectations is not crucial, as any mistaken expectations lead to unexpected variations in inventories, money and wealth, signaling the need for a change in behavior. • Other features of the PKM: the principle of effective demand, imperfect competition, mark-up pricing, fixed technical coefficients, conflictive income distribution, the role of capacity utilization and retained profits, among many others

26. THE NEOCLASSICAL MODEL VERSUS THE POST KEYNESIAN MODEL (Cont) • But above all, the fact that money is endogenous. • For any good or asset, if quantities are endogenous, prices must be exogenous, and the converse. • Thus, if money is endogenous, the interest rate must be exogenous. • This will never be accepted by neoclassical economists, as their theory of prices and distribution would collapse.

27. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. • My model incorporates our previous findings, namely that international monetary asymmetries are largely responsible for determining the behavior and balance sheet structure of the institutional sectors in the economy. • 327 equations. Why? The old answer is also the best one: the real world is complex, and computational power makes non-analytical results from simulations possible and amenable.

28. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Firms (125 equations – 3 dummy variables). Production and Real Investment Decisions: • Capital, intermediate and final goods are produced and imported, locally consumed and exported, and it is assumed there are inventories only in the latter case. Inventories act as a buffer stock (asset side). • Intermediate goods are required in accordance to fix technical coefficients.

29. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Production and Real Investment Decisions: • Investment in capital goods depends on an exogenous component and on capacity utilization. • Both “ig” and “kg” are locally produced and imported in some fixed proportions that are assumed to depend on the structure and degree of development of the economy, and not on relative prices.

30. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Costs of Production: • Inflation is a conflictive-claims process. • Workers aim at a real wage rate-target whose size varies continuously with average trend productivity and discontinuously with aggregate demand (e.g. with the employment rate), a sort of discontinuous Phillips curve with an inelastic segment. For simplicity, productivity is assumed to grow at an exogenous rate.

31. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Costs of Production: • The desired level of employment depends on average productivity and output. Yet, actual employment adjusts only partially towards target. • Unit costs of sales depend on the value of the wage bill and imports bill. Historic unit costs apply on in the case of final goods, as only those goods are accumulated in inventories.

32. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Pricing: • There is a total sales price, domestic price, export price and imports price for every good. Total sales prices are a mark-up over historic unit costs. Two alternative cases: Argentina, China?. • The ideal mark-up is that which would hypothetically generate the exact amount of profits required by firms to satisfy target retained earnings and dividend payoffs when realized profits are equal to planned profits.

33. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Financial Considerations: • Most of the investment expenditure is financed by profits, but the remaining part is financed by new issues of local and foreign currency debt and equities. • Firms structure their portfolio of assets and liabilities in accordance to interest rates and degrees of liquidity preference in local and foreign currency. Rates paid by corporate sector are market determined (endogenous). • Credit acts as a buffer stock (liability side).

34. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Households (48 equations). Consumption and Real Investment Decisions: • Modigliani consumption function with propensities to consume out income (and consumer loans) and (expected) wealth. • Investment in real estate and durables also depends on income, loans and wealth.

35. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Financial Investment Decisions: • Households receive wage payments from firms, banks and the government. • They place their savings across diverse lc and fc financial assets in accordance with their rates of interest and liquidity preference in lc and fc.

36. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Financial Investment Decisions: • In line with the CRL, credit to households is constrained by income in a way which is inversely related to the real interest rate (the burden of debt). • Current account deposits are the buffer stock of households.

37. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Banks (55 equations – 3 dummy variables). Monetary and credit aggregates: • Cash is held in fixed proportion to CA and SA deposits. • Bank reserves within the central bank are held in fixed proportions to CA, SA and CDs. • Banks also hold a fraction in secondary reserves (PA bills).

38. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Monetary and credit aggregates: • They cannot control directly the amount of bills they hold, as the latter is a residual the central bank accommodates once the demand for T-bills on the part of the other sectors has been satisfied. • Yet, they can indirectly influence the amount of bills they hold: in the short-run resorting to the discount window and in the long-run adjusting the rate they pay on deposit certificates, increasing it when the ratio is below target and reducing it when it is above.

39. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Monetary and credit aggregates: • Banks accommodate holdings of (demand for) deposits, setting/paying a mark-up rate above the rate on PA bills. • They also accommodate the demand for credit in lc and fc on the part of F & H, setting the rate on loans as a spread over the deposit rate. The spread depends on CAR and profit targets. • Bills and (only temporarily) CB advances act as buffer stocks (on the asset and liability sides).

40. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Government (36 equations – 5 dummy variables). • Tax revenue (direct taxes paid by F, H, B, and indirect taxes over fg). • Nominal pure govt. expenditure: current (wage bill and purchases of final goods) and capital expenditure in infrastructure. • Both are initially assumed to grow at exogenous rates.

41. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. • The primary deficit plus interest payments determine the financial deficit. • Clearly, as money is endogenous and interest rates are exogenous, fiscal monetary expansions arising from government deficits must be absorbed: government may increase its fraction of deposits at CB, the latter may increase the legal rate of reserve requirements, and bills and bonds must be issued. Otherwise r↓, GIR↓, xr↑. • Govt. bonds are supplied on demand. But bills are supplied in accordance to cash flow requirements.

42. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. • Short-term rate, GIR and foreign currency debt: FCD r FCD to GDP or to exports ratio Inflation or loss of competitiveness Flexible Non flexible Flexible Non flexible ΔGIR>0ΔFCD>0 ΔGIR=0 ΔFCD=0 ΔGIR>0 ΔFCD<0 e.g. China e.g. China Whole Economy Whole Economy Public Admin Public Admin GIR GIR

43. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. • Foreign reserves and foreign currency debt act as buffer stocks. • So doing the government is able to stabilize the xr and preserve a minimum level of GIR. But all depends on the possibility to place more fc debt. • Why would a RIE (like the EU or the US) issue debt in fc? That would only be “una pazzia”.

44. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. Central Bank (36 equations – 5 dummy variables). • Accommodates the overall demand for base money. • Yet, it sets the rate on reserve requirement, adjusting to absorb/sterilize foreign currency inflows (e.g. China). • Holdings of GD within the CB are also accommodated.

45. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. • CB makes effective short-term rate by managing the supply of bills of the PA. Opposed to the case of RIEs, this is mainly done on the liability side. • The fact is the demand for T-Bills on the part of REE CBs is rather small, sometimes even negligible due to regulation or self-imposed restrictions. • Thus, in REEs base money is created through the increase in foreign reserves on the asset side. But it is destroyed on both the asset side and the liability side through reductions in foreign reserves and increases in CB bills and GDs within CB.

46. FEATURES OF MY MODEL − EXOG VS ENDOG VARIABLES. ROW (42 equations). • Foreign currency assets supplied by the ROW accommodate demand, except for the supply of bank loans to subsidiaries which are assumed to grow at the rate of exports. And, for simplicity, it is assumed domestic fc deposits held by non residents grow at the rate of imports. • Foreign interest rates are treated exogenously and domestic fc rates on government and corporate bonds are market-determined.

47. FINAL REMARKS. • My next paper will study the much simpler case of RIEs (like the US or the EU). • I will run diverse simulations for this model and the next model to compare the results in both artificial economies. • How the rate of growth differs in the two economies under different conditions (fc inflows and outflows)? • How stocks of wealth, flows of consumption and investment and prices evolve over time, and many, many, other.

48. APPENDIX

49. Table 1. The Balance Sheet Matrix of a REE

50. Table 1. The Balance Sheet Matrix of a REE (Continued)