Spending - PowerPoint Presentation

Slide1

Spending and the Exchange Rate in the Keynesian Model

Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

Course in International finance

International Master in Quantitative FinanceSlide2

OutlineTransmission of disturbances under different FX regimesExpenditure-switching

and

Expenditure-reducing

policies

Types

of

policies

SWAN

diagram

Monetary

factors

IS-LM

curve

Policy

options

:

monetary

expansion

,

fiscal

expansion

and

/

or

devaluationSlide3

Transmission of Disturbances Under Fixed Exchange Rates

How

changes

in

spending are transmitted from one country to another? What is the role of the FX in that process?Internal disturbance in a small country:Multiplier is smaller than in the closed economy, due to import leak-outExternal disturbance in a small country:Shock in foreign aggregate demand transmitted to domestic income, through trade balanceTwo-country model: spending multiplier would be a little higher (import leakage returns in the form of exports). The same holds for export multiplier.Under fixed FX regime, disturbances are generally transmitted positively from the country of origin to the trading partners, via trade balanceSlide4

Transmission of Disturbances Under Floating Exchange Rates

Assumptions

: KA=0, no

central

bank interventions, so the FX adjusts automatically to ensure BP=0 (TB=0)Fixed FX: internal disturbance (fall in Investment) causes decline in income, triggering trade surplus (due to decline in imports)Floating FX: in response to TB surplus, the price of foreign currency falls (domestic currency appreciates), thus stimulating imports and discouraging exports, until the TB is brought to equilibrium (TB=0)Whatever the FX change, the TB remains at 0 (ΔTB=0)Slide5

Transmission of Disturbances Under Floating Exchange Rates

Downward

shift

in

net export due to appreciation should be sufficient to offset derease in imports due to lower income, so the change in income is as followsInternal disturbances have greater effect under floating exchange rates than under fixed ratesWhen exchange rate fluctuates to keep TB=0, it reproduces the effects of closed economyAll disturbances are bottled up inside the country rather than being partially transmitted abroad (change in income by Slide6

Transmission of Disturbances Under Floating Exchange RatesSlide7

Transmission of Disturbances Under Floating Exchange Rates

External

disturbance

(

decline in exports demand), triggers decrease in income and a trade deficit, causing domestic currency depreciation, shifting net exports back upwards until the trade balance is restoredIn this case the effect on income is eliminated (ΔY=0)The floating exchange rate insulates the economy against foreign disturbancesFloating exchange rate restricts the effects of disturbances to the country of originIf shock originates from abroad, floating FX is preferred to fixedIf country is prone to domestic shocks, fixed FX is preferredSlide8

Expenditure-Switching and Expenditure-Reducing PoliciesAdjustment to a

Current

Account

Deficit

In case of a currenct account (CA) deficit, there are two choices: financing or adjustment How to reduce CA deficit: expenditure-reducing or expenditure-switching policiesExpenditure-reducing policies: cut in government expenditure or rise in taxes (or monetary contraction), triggers decline in imports demand (to some extent)Expenditure-switching policies: switching expenditures away from foreign goods to domestic goods (e.g. devaluation)Expenditure-reducing policies reduce income and employment, while expenditure-switching policies raise income and employmentSlide9

Expenditure-Switching and Expenditure-Reducing PoliciesTypes

of

Expenditure-Switching

policiesPrice deflationDue to minimum wage laws, unions, contracts, etc. this option is usually rulled outDevaluationDirect trade controls (tarrifs or exports subsidies)10% tarrifs + 10% exports subsidies = 10% devaluation (in terms of relative prices)e.g. Smoot-Hawley tarrif in the USA in 1930s („beggar-thy-neighbour“ policies), which has triggered strategic response of trade partners, leading to collapse of world trade. After WWII GATT was set to reduce the tarrifsNontarrif barriers (quantitative restrictions or quotas)Tarrifs yield tax revenues, thus inducing expenditure-reducing effects, while quotas have only expenditure-switching effects, which

is why tarrifs are more efficient Advanced deposits on importsThe same effect

as tarrifs („tarrif“ equal to the interest on deposited money), thus

triggering also expenditure-reducing effectsSlide10

Expenditure-Switching and Expenditure-Reducing PoliciesThe two-tier exchange rate

One

exchange

rate for

current

account transactions (fixed FX) and another one for capital-account transactions (market-based FX)Difficult to administer (spillover effects from current account to capital account FX market)Capital controls…keep capital from moving where it earnes a higher return. If the difference in returns faced by lender is a difference in real social productivity, then there are social welfare costsWhen the central bank is influencing the price of credit, the connection between the market price and social productivity is no longer certainMultiple exchange ratesUsing alternative exchange rate for imports of luxury goodsSlide11

Expenditure-Switching and Expenditure-Reducing PoliciesTHE SWAN DIAGRAMTwo policy goals external balance (TB=0)Internal balance (output equal to full employemnt or to potential output)

Expansionary fiscal policy leads to internal balance, but triggers external balance

The opposite holds for contractionary

fiscal

policyWhat determines the efficiency of fiscal policy in providing internal balance?Devaluation raises output and improves trade balanceRevaluation leads to internal balance at the expense of external imbalanceDevaluation leads to external balance, but at the expense of internal imbalanceTwo policy goals require two policy tools (Tinbergen; Meade, Mundell)Expenditure switching (devaluation), andExpenditure reducing (government expenditure)Slide12

Expenditure-Switching and Expenditure-Reducing PoliciesSlide13

Expenditure-Switching and Expenditure-Reducing PoliciesTHE SWAN DIAGRAM: EXTERNAL IMBALANCEAnother option – starting point is external and internal balanceIf government increases expenditures, it must devalue to maintain external imbalance

For

TB=0,

both G and E must vary together (BB upward sloping line)

If the economy is not in

balance (e.g. any point off the BB line), E is to low or G is to high for external balance (TB<0)It is necessary to cut G or to increase E, in order to restore external balanceThe opposite holds if TB>0 (point S)Only under floating FX regime will the economy be at the BB line, as the FX adjusts automatically to maintain external balanceSlide14

Policy Combinations That Give External BalanceSlide15

Expenditure-Switching and Expenditure-Reducing PoliciesTHE SWAN DIAGRAM: INTERNAL IMBALANCEStarting from external and internal balance and than changing G, means that E must also change in the reverse manner, to maintain balance

Rise in G implies the need for revaluation

Higher G must be accompanied by a lower E

Internal balance maintained at YY curve

If the economy is not in internal balance (e.g. any point off the YY line), E is to high or G is to low for internal balance

It is necessary to cut G or to reduce E (to decreasse foreign demand), in order to restore internal balanceThe opposite holds if there is a missing demandSlide16

Policy Combinations That Give Internal BalanceSlide17

Expenditure-Switching and Expenditure-Reducing PoliciesTHE SWAN DIAGRAM: EXTERNAL AND INTERNAL IMBALANCEZone I: trade deficit and excess demandZone II: deficit and unemploymentZone III: trade surplus and unemploymentZone IV: surplus and excess demandOnly one equilibrium: point AWhat if the country is at the P1 point (trade deficit and unemployment)?

It should cut expenditures and to devalue to attain internal and external balance simultaneously

P2 is almost the same case, but the correct strategy would be to raise expenditures and to devalue, to reach A

It is a matter of experimentation to discover the optimal strategy (i.e. to devalue and wait to see whether G should be increased or decreased)Slide18

The Swan Diagram of Internal and External BalanceSlide19

Effect of a Fall in the Interest Rate, I

Monetary Factors

Money supply affects income, via

interest

ratesThe lower the interest rates, the higher investment and expenditure and the lower savingNegative relationship between the interest rate and income (IS curve)Central bank sets the interest rateIn the 1980s it was setting the money supplySlide20

Monetary Expansion

Monetary Factors

Portfolio optimization: money vs other assets

Demand for money decreases as the real return to alternative assets rises, represented by the interest rate

Demand for real money is increasing function of real income

Positive relationship between the interest rate and income (LM curve)Intersection of IS and LM curve gives equilibrium level of Y and IThere is unique level of income that implies TB=0Slide21

Monetary Factors

IS-LM equilibrium at the point which implies TB=0

Three policy options: monetary expansion, fiscal expansion and devaluation

MONETARY EXPANSION

Monetary expansion shifts LM curve to the right (fall in interest rate

and rise in Y), i.e. fall in interest rate encourages investments and thus triggering rise in incomeNew equilibrium is at point MThe higher level of expenditure induced by monetary expansion has shifted a country to the trade deficitSlide22

Fiscal Expansion with Crowding-Out of InvestmentMonetary

Factors

FISCAL EXPANSION AND CROWDING-OUT

G rises, shifting the IS curve to the right (rise in trade deficit and income)

By how much fiscal expansion shifts the IS curve to the right? – Keynesian multiplier

Increase in expenditure and income raises money demand, forcing interest rate to go up, thus discouraging private investmentNew equilibrium at point F, i.e. income is still higher than before fiscal expansion, but some effects have been offset by the crowding-out of investmentSlide23

Monetary Factors

LIQUIDITY TRAP AND JAPAN IN THE 1990s

Keynesian model neglects the effects of fiscal expansion on inflation, interest rates and rising public debt

…but it showed to be relevant in the Japan crisis in 1990s

Colapse of stock and real estate bubble triggering deflation, unemployment

and slow growth, but the goods prices did not decline enough to restore equilibriumBank of Japan reduced interest rate to zero: further increases in money supply absorbed by the public withouth bringing reduction of the interest rate – liquidity trapLM curve became flatTwo important implications:Monetary policy becomes ineffectiveFiscal policy becomes more effectiveAs LM curve is flat, fiscal expansion triggers no increase in the interest rate to crowd out private investment – full mupltiplier shows upIn 1997 the government raised taxes to cut the deficit, which pushed the economy back to recessionSlide24

Monetary Factors

DEVALUATION WITH CROWDING OUT

Devaluation

shifts the X-M line up, so the new equilibrium is at higher level of income (for any interest rate

)By how much does the X-M curve shift to the right?If LM curve was flat, devaluation shifts the equilibrium to point L, thus improving the trade balance by:Slide25

Monetary Factors

The marginal propensity to import times the increase in income is only a partial offset to improvement in trade balance

If LM has some slope change in income is less due to crowding out

Income would not

have

increased in the first place if devaluation did not stimulate trade balance