Goals and Instruments• Policy goals: Internal balance & External balance

LECTURES 7 & 8:POLICY INSTRUMENTS

• The Swan Diagram• The principle of goals & instruments

Introduction of monetary policy • The role of interest rates • Monetary expansion • Fiscal expansion & crowding out

• Policy instruments

ITF-220, Prof.J.Frankel

Goals and instruments

Y

Policy Instruments• Expenditure-reduction,

e.g., G ↓ • Expenditure-switching,

e.g., E ↑ .

Policy Goals• Internal balance: Y = ≡ potential output.

YY uY < ≡ ES ≡ “output gap” => unemployment >

Y > ≡ ED => “overheating” => inflation or asset

bubbles.• External balance: e.g., CA=0

or BP=0.

ITF-220, Prof.J.Frankel

In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << .Y

Source: IMF, via Economicshelp, 2009

UK

US

France

Output gap, as percentage of GDP, in the Great Recession, 2009

Ir

Jpn

Internal balance

Output gap in eurozone peripherySource: IMF Economic Outlook, Sept.2011 (note: data for 2012 are predictions)

http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html

Greece & Ireland overheated by 2007: Y >>

and crashed in 2009-11: Y <<

Y

Y

ITF-220, Prof.J.Frankel

ITF-220, Prof.J.Frankel

THE PRINCIPLE OF TARGETS AND INSTRUMENTS

• Can’t normally hit 2 birds with 1 stone

• Have n targets? • => Need n instruments,

and they must be targeted independently.

Y• Have 2 targets: CA = 0 and Y = ?• => Need 2 independent instruments:

expenditure-reduction & expenditure-switching.

Financing• By borrowing

• or running down reserves.

RESPONSES TO CURRENT ACCOUNT DEFICIT

Adjustment• Expenditure-reduction (“belt-tightening”)

• e.g., fiscal or monetary contraction

vs.

• or Expenditure-switching • e.g., devaluation.

ITF-220, Prof.J.Frankel

Starting from current account deficit at point N,policy-makers can adjust either by (a) cutting spending,

or

A

X

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Adjustment

(b) devaluing.

ITF-220, Prof.J.Frankel

(a) If they cut spending,CA deficit is eliminated at X;

but Y falls belowpotential output . Y

=> recession●

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ITF-220, Prof.J.Frankel

(b) If they devalue,CA deficit is again eliminated, at B,

but with the effect of pushing Y abovepotential output.

=> overheating

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●

Devaluation

•Experiment: increase in Ă

(e.g. G↑)

• Only by using both sorts of policies simultaneouslycan both internal & external balance be attained, at point A.

Expansion moves economy rightward to point F.Some of higher demand falls on imports. => TB<0 .

XE

DERIVATION OF SWAN DIAGRAM

What would have to happento reduce trade deficit?

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●

ITF-220, Prof.J.Frankel

A

At F, TB<0 .

What would have to happen to eliminate trade deficit?

Again,

If depreciation is big enough, restores TB=0 at point B.

E ↑ .

A

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●●

ITF-220, Prof.J.Frankel

ITF-220, Prof.J.Frankel

.

What would have to happen to eliminate trade deficit?

E ↑ . If depreciation is big enough, restores TB=0 at point B.

We have just derived upward-sloping external balance line, BB.

To repeat, at F, some of higher demand falls on imports.

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We have just derived upward-sloping BB curve.

Now consider internal balance.

Return to point A. A

Expansion moves economy rightward to point F.

Y

What would have to happen to eliminate excess demand?

Some of higher demand falls on domestic goods => Excess Demand. Y >

●

●

●

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Experiment: increase

E ↓ . ●

ITF-220, Prof.J.Frankel

Experiment: Fiscal expansion, cont.

At F, Y > .

What would have to happen to eliminate excess demand?

Y

Y

If appreciation is big enough, restores Y= at point C.

E ↓ .

●

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ITF-220, Prof.J.Frankel

What would have to happen to eliminate excess demand?

E ↓.

We have just derived downward-sloping internal balance line, YY.

At F, some of higher demand falls on domestic goods.

If appreciation is big enough, restores at C.

● ●

●

ITF-220, Prof.J.Frankel

We have just deriveddownward-sloping YY curve.

Swan Diagram has 4 zones:

I. ED & TDII. ES & TDIII. ES & TB>0IV. ED & TB>0

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ITF-220, Prof.J.Frankel

Summary:

combination of policy instruments

to hit one goal slopes up,

to hit the other slopes down.

ITF-220, Prof.J.Frankel

Example 1: Emerging markets in 1990s

Excgange rate

E

YY:Internal balance

Y=Potential

ED & TD

ED & TB>0

ES & TD

ES & TB>0

Mexico 1994

or Korea 1997

Mexico 1995

or Korea 1998

Spending A

BB:External balance

CA=0

Classic response to a balance of payments crisis:Devalue and cut spending

●

Could be the “fragile 5” in 2013-14: India, Turkey, Indonesia, S.Afr., Brazil

Example 2: China in the past decade

Excgange rate E

YY:Internal balance

Y = Potential

ED & TD

ES & TD

ES & TB>0

China2010

BB:External balance

CA=0

China2002

ED & TB>0

Spending AAt the end of 2008, an abrupt loss of X,

due to the US crisis, shifted China into ES.

By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, due in part to G stimulus,

shifted China again into ED.

●

Spending A

ITF-220, Prof.J.Frankel

Example 3: US over 33 years

Excgange rate E

YY:Internal balance

Y = Potential

ED & TD

ED & TB>0

ES & TD

ES & TB>0

US 1987 or 2007

US 1981,1991

,or 2008-13

BB:External balanceCA=0

●

Spending A

ITF-220, Prof.J.Frankel

Monetary policy

• is another instrument to affect the level of spending.

• It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I and consumer durables.

• Or it can be defined in terms of money supply M.– In which case it is a rightward shift of the LM curve

– Which itself slopes up (because money demand depends negatively in i and positively on Y).

iY

LM

E.g., Taylor rule sets i.

E.g., Quantitative Easing sets MB.

Monetary expansion lowers i,stimulates demand, shifts NS-I down/out.

New equilibrium at point M.

In lower diagram, which shows i explicitly on the vertical axis, We’ve just derived IS curve.

If monetary policy is defined by the level of money supply,then the same result is viewed as resulting from a rightward shift of the LM curve.

ITF-220, Prof.J.Frankel

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New equilibrium:

At point D if monetary policy is accommodating.

Fiscal expansion shifts IS out.

At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓ Rise in Y < full Keynesian multiplier.

ITF-220, Prof.J.Frankel

●●

●● ●D

ITF-220, Prof.J.Frankel

End of Lectures 7 & 8: Targets and Instruments

ITF-220, Prof.J.Frankel

In 2000 most countries were operating above full employment: Y > Y

Appendix: Internal balance, before & after the 2001 recession

I

Jpn

Ireland was the strongest case; Japan was the biggest exception.

US

2000

By 2002, most countries were operating below full employment: Y < Y

Source: The Economist, June 22, 2002

I

Jpn

US

2002

ITF-220, Prof.J.Frankel