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

Fiscal Monetary Fixed e

Effective 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 LM 0 LM 1 A B C IS 0 Y IS 1 BP 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 LM 0 LM 1 A B IS 0 Y BP 5

Fiscal Policy with Floating e • G up: IS shifts to right (IS 0  IS 1 ) – 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 (IS at C because LOE – Interest rates rise 1  IS 2 ) • 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 • This meets the IS curve coming back from B to give a new eqm • 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) 6

r LM 0 IS 2 C A Fiscal policy: float e, LOE B BP 1 BP 0 IS 0 IS 1 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 LM 0 LM 1 A B C IS 0 IS 1 Y BP 0 BP 1 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

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 LM 0 LM 1 A B C IS 0 IS 1 Y BP 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 r*+p r* B A LM 2 LM 1 BP 2 BP 1 Y IS 1 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 – IS 1  IS 2 A  B – BP<0 – LM shift up: B  C • But if risk premium increases at the same time – BP 1  BP 2 – Still in BP<0 at C – LM shifts up again • New equilibrium at D – nasty recession • Process may repeat 19

r r*+p r* D C B LM 3 LM 2 A LM 1 BP 2 BP 1 IS 2 Y IS 1 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

Countries

• Thailand: – 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<0  r 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