4. Policy issues in the SOE: some theretical considerations

1. 4. Policyissues in the SOE: somethereticalconsiderations 4.1 Externaladjustment in the classicalmodel 4.2 Adjustmentproblems in a simple open economyKeynesian model 4.3 Monetarypolicy and centralbankindependence

2. 4.1 Externaladjustment in the classicalmodel: the pricespecieflowmechanism (David Hume) • Productionassumed to be at fullemploymentdue to rapidadjustment in allmarketstowardsequilibrium (also labour markets) • The pricelevel is thendeterminedaccording to the quantititytheory of money: L = kPY, where L is the stock of money (gold), P is the pricelevel, Y the level of output (at fullemployment) and k is a constant (depends on the paymenttechnology); thus, the pricelevel is proportional to the stock of money in circulation (as Y is at the fullemploymentlevel) • The gold standard (one version of fixedexchangerates) with the pricespecieflowmechanism: money supply is changingdue to the infloworoutflow of gold as a consequence of a tradebalancesurplusordeficit (dL/dt = B), giventhat gold production is insignificant in volume • Rising (falling) money supplyraises (lowers) the pricelevel, which, according to the classicaltradetheoryworsens (improves) the tradebalance, therebyconstituting a self-equilibratingmechanism operating untilpricelevelsaresuchthattradebalancesare in equilibrium • In practicecentralbanksensured the operation of the ”rules of the game” byraisingdiscountrateswhen gold wasflowing out, therebygenerating a capital inflow (and the decline in demandreducedalsoincome and imports and improved the tradebalance)

3. The gold standard as an automaticadjustmentmechanism Balance of paymentsdisequilibrium Decline of money supply and the pricelevel in countries with BoP-deficit, the converse in surpluscountries Improvement of pricecompetitiveness in countries with BoP-deficit, the contrary in surpluscountries

4. The line L = kPYdetermines the pricelevel for a givenstock of money. The horizontalline is the domesticpricelevel at whichexternalbalanceprevails, implying un unchanged money stock and pricelevel. At a domesticpricelevelabovethis, therewillbe an externaldeficit and outflow of gold, leading to a decline in the domesticpricelevel; viceversa for a pricelevelbelowethis. The result: notonlyfullemploymentbutalsoa self-equilibratingmechanismfor the pricelevel and externalbalance. The arithmetics: B = PX(P/P*) - P*M(Y,P/P*) , where Y is constant at the full employment level . ∂B/∂P = X + XP – MP = X(1 + XP/X – MP/M) = X(1 - ɛX - ɛM) < 0 (the “Marshall-Lerner condition). Here it is assumed that prices initially are = 1, and that X = M initially. The symbols ɛXand ɛMrefer to the price elasticity of demand of exports and imports respectively. In combination with dL/dt = B, where B = B(Y, P/P*), with ∂B/∂P < 0 as above, this gives the dynamics of the figure. P L = kPY PE L1 LE L2 L

5. 4.2 A simpleKeynesian open economymodel Assumethat output is demanddetermined in the shortrunsothat output Y is equal to domesticdemand E plus publicspending G plus netexports T. Assumethatnetexports is a positivefunction of the level of competitiveness, measuredby the ratio of the pricelevel of foreigngoods to domesticgoods (in the samecurrency), which is mainly a funciton of the ratio of foreign to domesticwagelevels (corrected for differences in productivity, whichareassumedconstant). The level of output and incomewill in the shortrunthendependpositively on pricecompetitiveness, the ratio of foreignprices (wages) to domesticprices (wages), and itwillalsodepend on monetary and fiscalpolicy. Monetaryexpansionor a reduction in policyinterestrateswillincreasedomesticdemand (possiblybyweakening the exchangerate). An increase in publicspendingand/or a decline in taxrateswillincreasedomesticdemand and therefore output. Expansionaryfiscalpolicywill, however, alsoworsen the budgetdeficit as well as the tradebalance. At fixedexchangeratesor in a MU the single country has no monetaryautonomy. Givingupyourmonetarypolicy and yourexchangeratemayincrease the difficulties of stabilizingoveralleconomicdevelopments, at leastifwagesdonotadjustflexiblyso as to maintainhighemployment.

6. The simpleKeynesian open economymodel (cont.) Assume (for the timebeing) that output is purelydemanddetermined. Aggregatedemand is an increasingfunction of competitiveness (and of fiscalspending). c YD c0 c1 Y1 Y0 The simplemessage is thatifyouwish to keepyourexchangerateunchanged (orifyouare in a monetaryunion), thenwagesshouldnotrise in a waythatharmscompetitiveness, youshouldmaintainroughly the sameinflationrate as in competitorcountries. Otherwiseyouwillsoonerorlaterbe in trouble. Originally the economy is at Y0 with competitiveness c0, thenwages/pricesrise and c declinesfrom c0 to c1: bad for Y and employment (possiblyafter a time lag). Unless e adjustso to restore c0, butthentheremaybe an inflationaryspiral: wages/pricesrisemore and more

7. Whatifthere is a negativeexportshock? Foreigndemand for ourexportsdeclines for a givenlevel of c (shifting YD to YD’). Output declinesfrom X to H (orfrom Y0 to Y1). Butifwagesfallsothat c improvesenough, from c1 to c0, then the economywillmove (possible with a time lag) from H to Z (restoring the samelevel of output Y0 as in X thanks to better c, c0 ratherthan c1) Alternatively, fiscalexpansioncouldbeused to shift YD back in spite of the fall in exports. The level of output couldberestoredbuttheremightnowbe a tradedeficitand/or a budgetdeficit. c YD’ YD c0 Z c1 H X Y1 Y0 Y Message: Exportshocksaremanageableifwagesadjust to keep c at the levelrequired for fullemplyment. Iftheydon’t, thentherewillbeinstability. Ifwagesdon’tadjust, oradjustveryslowly, thengivingupyourowncurrency is a problem. With a flexibleexchangerate the required c maybeachievedthrough a depreciation. (NB thatfluctuations in e, unrelated to exports etc., maybe a source of nuisance.)

8. Whatifthere is an interestrateshock? Assumethat the country underconsiderationhas a big publicdebt and largedeficit, and that the financialmarketgetsnervousabout the capacity of the government to honouritsdebt. Therewillthenbepotentiallylargeriskpremia in the interestratespaid for governmentborrowing, and thiswillraise the general level of interestrates as well (eventhough the ECB wouldkeepitspolicyrateunchanged). c YD’ YD c0 Y1 Y0 Message: youneed to preserveyourcreditworthiness, otherwiseinterestratesmayrisedue to riskpremia. (Improvedcompetitivenesscalled for obviously – orfinancialassistance?) Originally the economy is at Y0 with a level of competitiveness c0. Thenit is hitby a lack of confidence in financialmarkets, drivingupriskpremia and interestrates. Thisreducesdomesticdemand (privateconsumption and investment), shifting the YD-curve to YD’. At an unchangedlevel of competitiveness output hasnowdeclined to Y1. Fiscalexpansion is no solution, as the riskpremiaarosedue to highpublicdebt in the firstplace.

9. The Keynesian open economymodel: implications for EMU • a decline in exports is notsuch a big problemifithitsallmembers of a monetaryunion (MU), becausethen the common currencywilldepreciate (and the centralbankwilllowerinterestrates); the moredifficultprobem is an asymmetricshock, notably a ”negativeasymmetricshock” • For c to improve, the realwagewillhave to declinethroughnominalwagedeclinesorthrough a depreciationraising the pricelevel: having a currency of yourowndoesnotdoaway with thisrequirement, itonlyfacilitates the neededdecline in realwagesifnominalwagesaresticky • A country hitby a negativeexportshockcouldpursueexpansionaryfiscalpolicy, butthatwouldthenweakenitsbudgetarysituation; it is thereforenot a viablesolution in the long term (but ok for cyclicalproblems) • The situation is easierifthere is in the MU a big centralbudgetsothat a country hitby a negativeasymmetricshockcanbenefitfrom the ”federalbudget” (acting as a shockabsorber) • The situation is alsomoremanageableiflabormovesswiftlyfromcountriesexperiencingproblems to othercountries (cf. the USA)

10. The simpleKeynesian open economymodel: arithmetics Output is demand-determined: Y = E(Y,r) + G + T, where T = X(c) - cM(Y,c) with c = eP*/P Y is output (=income), r the rate of interest (assumed to bedecidedby the centralbank), G publicexpenditure, T the tradebalance (in terms of domestic output). Differentiatinggives dT = Xcdc - Mdc- MYdY- Mcdc= -M(1 - Xc/X + Mc/M) – mdY or dT = θdc – mdY, where θ = -M(1 - ɛX-ɛM)θ > 0 if the so called “Marshall-Lerner condition” is fulfilled (the sum of the absolute value of the price elasticities of exports and imports is bigger than 1) and where m = MY denotes the marginal propensity to import. Differentiating Y and denoting s = 1 – EY gives dY = (dG + θdc)/(s+m) Note that the cost of external adjustment by fiscal policy is smaller the more open the dT = (sθdc - mdG)/(s+m) economy (the bigger the import propensity) Under fixed exchange rates Y is now a positive function of G and c, while T is positive in c and negative in G. Under flexible exchange rates and no capital flows, dT = 0 and we solve for Y and c and find that dY/G = 1/s . In the Fleming-Mundell version it is assumed that r is determined by M = L(Y,r), where M is the money supply as fixed by the central bank and L is demand for money. Assuming free capital movements and static exchange rate expectations implies that Y is determined by M only, thus fiscal policy has no effect on output (under flexible exchange rates and perfect capital mobility).

11. 4.3 Monetarypolicy and centralbankindependence • Moderncentralbanksaretypicallyindependentfrompoliticaldecisionmakers. The governoror the board of an independent CB is accountable in the sense of having to report to the parliament, but the governoror the board of an indpendent CB cannotberemovedbypoliticiansexcept in case of seriourmisconduct, notbecause of dissatisfaction with the monetarypolicypursued. The CB mustalsobefinanciallyindependent. • The Bundesbank hastraditionallybeenconsidered a particularlyindependent CB; ithasfunctioned as a rolemodel for the ECB • The centralargument for CB independence is thatitallowscrediblecommitment to pricestability, which is helpfulsinceitimproves the functioning of the pricemechanism, lowersinflationpremia in interestrates and helpsavoidarbitraryredistributions of income and wealth. Decisions on monetarypolicyshouldbeindependentfrompoliticiansbecause the lattercannotresist the temptation to aim at a shorttermboost of growth at the cost of higherfutureinflation – and withoutgaininganything in terms of growth in the longerterm. • Countries with a history of rapidinflation (and devaluations) and difficulties of estabishingcredibility for stabilityorientedmonetarypoliciesmaywish to join the monetaryunion in order to achievecredibility for pricestability (givingup the power of domesticdecisionmakers, not to betrusted).

12. Time inconsistentmonetarypolicy Itmaybeoptimal ex ante to choose a solution, which is no good in retrospect. U is the rate of unemployment and p is the rate of inflation. Assumethat the economyinitially is at point A with zeroinflation (and at the level of SR3 unemploymentcompatiblewtih p = 0. Then the SR2 LR governmentorders the CB to aim for full p SR1 employment, whichbrings the economy to point B along the shortrun (Phillips) curve SR1. E However, the SR-curvestartsshiftingupwards because of higherinflationexpectations, and D the shortrunequilibriumpassesfrom, say, B to C C to D to E. At E, however, inflationdoesnot B acceleratesanymore, since the level of employment is nowcompatible with Δp = 0. But whychoose E over A? Onlybecauseitmaybe rational in the SR for politicians. UF U0 A U Bottomline: commit the CB credibly to pricestability to avoid (harmful)inflation; independencehelps. NB: Pointslike B etcwillbelower on the curveif the CB gives a lot of weight to the inflationobjective.

13. Time inconsistentmonetarypolicy To make the samepoint in anotherway. Assumethatinflation is equal to the expectedrate of inflation and a negativefunction of the differencebetween the rate of unemployment and the ”natural” rate of unemployment (”NAIRU”): (1) p = p(-1) – k(U – UN) orΔp = - k(U – UN) Assumealsothat the rate of growth of money supply m, reflectingpolicypreferences, is a positivefunction of the differencebetween the rate of unemployment and ”fullemployment” and a negativefunction of inflation: (2) m = α(U – UF) – βp and assumethat in the long run p = m. In the long run U = UN (p can’tforeveraccelerate) and p = (α/(1+β))(U – UF), so a highweightgiven to U onlyraises p butnot U.

14. Priceversusjobstability Assume the economy is initially at point A with inflation at itstargetlevel and stable (at the level of unemplymentcompatible with stableinflation). The the SR shifts to SR’ gotsomereason. If the CB caresonlyaboutinflation, itwilltightenmonetarypolicyso as to prevent the riseinflation, the economywillmove to point B. Butthismeansthatpricestability is achieved at the cost of jobstability, as unemplyoment is higher at B than A. For temporaryshocksitwouldbebetter for the CB not to overreact, i.e. itshouldgivesomeweightalso to jobstability. Sothere is a trade of afterall: highweight to the inflationobjectiverisksincreasingjobinstability. This is not an argumentagainst CB independencebutagainstgivingweightonly to pricestability. SR’ p A B U0 U

15. Questions • Assumethat a small open economy is hitby an exogenousfall in demand for itsexports. Whatwillhappenaccording to the classicalmodel? • Ditto as above. Whatproblemsmightarise in a simpleKeynesianframework? • Whataresomeoptions for maintainingactivity (output and incomelevels) in spite of the fall in exports? • Whymightsome of theseoptionsnotworkornotbeviable? • What is the meaning of ”timeinconsistent” monetarypolicy?

16. The line L = kPYdetermines the pricelevel for a givenstock of money. The horizontalline is the domesticpricelevel at whichexternalbalanceprevails, implying un unchanged money stock and pricelevel. At a domesticpricelevelabovethis, therewillbe an externaldeficit and outflow of gold, leading to a decline in the domesticpricelevel; viceversa for a pricelevelbelowethis. The result: notonlyfullemploymentbutalsoa self-equilibratingmechanismfor the pricelevel and externalbalance. P L = kPY An exogenousfall in exportswillshift the PE-curvedownwards, therewillbe an import surplus, money willflow out, priceswillfall, and balancewillgraduallyberestored at a lowerpricelevel and lower money supplylevel PE L1 LE L2 L

17. Whatifthere is a negativeexportshock? Foreigndemand for ourexportsdeclines for a givenlevel of c (shifting YD to YD’). Output declinesfrom X to H (orfrom Y0 to Y1). Butifwagesfallsothat c improvesenough, from c1 to c0, then the economywillmove (possible with a time lag) from H to Z (restoring the samelevel of output Y0 as in X thanks to better c, c0 ratherthan c1) Alternatively, fiscalexpansioncouldbeused to shift YD back in spite of the fall in exports. The level of output couldberestoredbuttheremightnowbe a tradedeficitand/or a budgetdeficit. c YD’ YD c0 Z c1 H X Y1 Y0 Y Message: Exportshocksaremanageableifwagesadjust to keep c at the levelrequired for fullemplyment. Iftheydon’t, thentherewillbeinstability. Ifwagesdon’tadjust, oradjustveryslowly, thengivingupyourowncurrency is a problem. With a flexibleexchangerate the required c maybeachievedthrough a depreciation.

18. Somefinalcomments on monetary and fiscalpolicies in the SOE • The classicalmodelensuresautomaticexternaladjustmentthroughvariations in the money supply (a channelwhich is hardlyoperative in today’s EMU) • The simpleKeynesianmodelarticulates the policydilemmas • Itneeds to becombined with the supply side, the implicationbeingthatshort-termeffectsmaydifferfromlong-termeffects • Discretionarymonetarypolicymayrun into credibilityproblems, whichcentralbankindependencecan help to overcome • The bottomline is that MU is ok ifschocksaresymmetricalorifwagesadjustquickly, orifshocksareonlyshort-term in character (canbedealt with byfiscalpolicy). Ifnot, thenmonetaryautonomymaybevaluablebyallowing a recession to be offset throughmonetaryexpansionthatlowersinterestrates and weakens the exchangerate. • A MU mayalsobelessproblematicifthere is a politcalunion to backitup, whichhas a big federalbudget, and/oriflabormovesflexiblebetweencountries in response to differences in unemploymentrates. This is roughly the message of the OCA literature (optimumcurrencyarea)