Policy In an LOE • MP & FP in a Large Open Economy – Think of US (LOE) vs. Ireland (SOE) • If we think of the purpose of policy is to control Y then we get Fixed e Fiscal Effective Monetary Ineffective Float e Less Effective Effective • The reason is the automatic effects of BP • For LOE the results not so stark as for SOE 1 Fiscal Policy Fixed e • • • • G up: IS shifts to right (why?) Internal balance at B BP>0 (why?) Under fixed e this leads to expansion of the money supply – LM shifts down – Interest rate falls • Balance restored at C • Basically the same as SOE but… – Interest rates increases – Output increases, but by less than in SOE (why?) 2 Fiscal policy: Fixed e r B BP C A LM0 LM1 IS1 IS0 Y 3 Monetary Policy & Fixed e • Expand money supply: purchase bonds – LM shifts down • Internal balance at B – BP<0 – Net currency out flow – Money supply falls back • Return to A – MP is ineffective – Only change is in central banks balance sheet • Same as SOE 4 Monetary Policy: Fixed e r BP A B LM0 LM1 IS0 Y 5 Fiscal Policy with Floating e • G up: IS shifts to right (IS0IS1) – Internal balance at B • BP>0 • excess supply of $ and/or excess demand for € – Under float e this leads to an appreciation of € – Exports fall – IS curve shifts left (IS1IS2) • For LOE there is additional effect – The appreciation causes the BP=0 curve to shift up – NX fall so higher r necessary and world interest rates are affected because LOE • This meets the IS curve coming back from B to give a new eqm at C • Note contrast with other regimes – – – – fiscal policy has an effect on output Smaller than closed economy or fixed e rate Larger than float e rate with SOE (which was zero) Interest rates rise 6 Fiscal policy: float e, LOE r IS2 BP1 B C BP0 A LM0 IS1 IS0 Y 7 Monetary Policy with Float e • Expand the Money supply – LM shifts down – Internal balance at B • BP<0 – net outflow of funds – Excess demand for $ (or supply of €) • Price of € falls: e falls depreciation in the € – Net exports rise – IS curve shifts to the right • For LOE there is an additional effect – The depreciation causes the BP=0 curve to shift down – NX rise so need lower r to balance • This meets the IS curve coming back from B to give a new eqm at C • Note contrast with other regimes – – – – monetary policy has an effect on output Larger than closed economy or fixed e rate Could be smaller or larger than float e rate with SOE Interest rates may rise or fall 8 Monetary policy: Float e r BP0 BP1 A C LM0 LM1 B IS0 IS1 Y 9 Summary of Policy • Policy effectiveness depends on three things 1. SOE or LOE: can we affect the world interest rate 2. Exchange rate regime: Fixed or Float 3. MP or FP • The reason for the complication is the automatic effects of BP • This gives 16 possible scenarios, don’t try to learn them off 10 Apply the Model • The Asian Crisis 1997 – Currency crisis that affects almost every east Asian country from July 1997 • Follows the general pattern of currency cries (see over) but – Huge devaluations – Added problems with banking systems – Allegations of market over-reaction 11 General Structure of Currency Crises • Country in a recession with fixed e rate • Markets expect that gov will try to boost economy • Monetary Policy: require floating exchange rate and depreciating exchange rate – See previous section – Owners of domestic currency try to get out • Fiscal policy – Work under fixed e – but government may not be able to borrow – Crises usually happen in debt-ridden countries 12 Monetary Policy with Float e • Expand the Money supply – LM shifts down – Internal balance at B • BP<0, r<r* – net outflow of funds – Excess demand for $ (or supply of €) • Price of € falls: e falls depreciation in the € – Net exports rise – IS curve shifts to the right • Overall Balance at C • Note contrast with closed economy and fixed e – No change in r – Larger change in Y – Net exports are “crowded in” 13 Monetary policy: Float e, SOE r BP A LM0 LM1 C B IS0 IS1 Y 14 Risk • Expectation of devaluation leads to higher interest rates • Interest rates affected by risk – Worried we get paid back in lower vlaue currency • SOE r=r* normally – But if there is a risk then r=r*+p – Where p is “risk premium” • Extra premium if risk of bank failure 15 Risk and BP • As we will see this makes recession worse • The premium is like an increase in world interest rates • Shift BP up – BP <0 (see “Imbalance” section) – – – – net outflow of (foreign) currency Money supply falls LM curve shifts up Interest rate rises to stem the outflow of funds • New eqm at B: output is lower • Note Change in money supply is automatic – not policy • Mechanism: CB buys € with $ from reserves 16 r LM2 B LM1 BP2 r*+p r* A BP1 IS1 Y 17 Recession & Risk • This effect of risk is exactly what you don’t want when you face a recession anyway. • Supposing there is a pre-existing recession anyway – IS curve shifts left (why?) • One way to get out of recession is to dump fixed e and expand money supply • So risk premium rises • Makes recession worse • Makes monetary expansion more attractive • Vicious circle 18 A Crisis Evolves… • Diagram gets complicated but its just the confluence of the two effects • A recessionary shock – IS1IS2 AB – BP<0 – LM shift up: BC • But if risk premium increases at the same time – BP1BP2 – Still in BP<0 at C – LM shifts up again • New equilibrium at D – nasty recession • Process may repeat 19 LM3 r LM2 LM1 D BP2 r*+p r* A C BP1 B IS1 IS2 Y 20 Examples of Crises • 2010: Ireland – Initial shock: housing bubble – Risk premium: rise quickly fear of default • 2010: Greece – Initial shock: public debt lies – Risk premium: rise quickly fear of default & devaluation • 1992: UK – Recession followed by rise in interest rates – Risk premium: fear of devaluation 21 1997 Asian Crisis • Recession? – Asian tigers phenomenal growth • Kor Thai HK • Underlying real problems – Bubble – Banks • Bursting of bubble leads to recession • Expectation of a devaluation • Speculators move 22 Summary of Pre-existing Factors • Construction boom financed by foreign borrowing • Bubble in Real Estate – GDP boom: apparent not real – Inflation & lost competitiveness • Financed by $ borrowing – Lower interest rates < apparent return to property – Short term via the banking system – One big hedge fund: $ liabilities, domestic assets • Sounds familiar? • Reasons not to trust the governments? – Investors unfamiliar with economies rush to judgement – Clear examples of corruption 23 Catalyst • What starts the crisis? – – – – For Asia it was US int rate rise Fixed e implies Asian interest rates rise BP curve shifts up Recession (why?) • Exchange rate under immediate pressure – CB can maintain e rate with reserves – Begin to run low on reserves 24 Role of Bubble • Bubble would eventually burst with or without crisis – Some debate as to whether already started to burst in Thailand before crisis • Bursting of bubble will reduce GDP – Construction sector falls – IS shifts left – Recession 25 Self-reinforcing • Investors expect a devaluation – MP under floating e could rescue economy • Risk premium rises • Leads to higher interest rates – BP shifts up • Recession worse under fixed e • Self-fulfilling prophecy • This is the standard speculative story 26 Role of Contagion • Crisis spread from one country to another • Fundamental problems were less true of later countries – but they still had a crisis • Contagion is “psychological” – Investors make judgement about one invest based on performance of another – Not always rationale – Lump “emerging markets” together • So Thailand’s problem increase likelihood of bad investment – Racist? 27 • Thailand: Countries – 1986-96: growth of 9% (not a recession!) – Inflation of 2-6%: loss in competitiveness – Devalued by 50% • Indonesia: – Devalued by 80% – GDP declined by 13% – Suharto over-thrown • Korea – – – – Less real problems Depreciated by 50% Numerous bankruptcies Quick bounce back 28 • Hong Kong – – – – – Defeated speculators – did not devalue Strongest economy in region Strongest legal framework “almost one of us” Real issue: inflation implying loss in competitiveness – Contagion gone too far – HK played dirty 29 Conclusions 1. BOP equilibrium is given by BP curve – Y up BP<0r up cap inflows BP=0 2. IS-LM-BP give overall equilibrium – Adjustment mechanism depends on exchange rate regime 3. Effectiveness of FP and MP depends on exchange rate regime – MP with floating e, FP with fixed e 4. Effectiveness of FP and MP depends on the SOE\LOE assumption 5. Apply it to some real world cases – Explains currency crises 30 What’s Missing? 1. Expectations or forward looking behaviour 2. No price adjustment – Very simplistic approach to supply side 31