New monetary economics

•Commitment•Rules (Taylor)•Fiscal theory

Research and Regimes

Regimes

•Peg? •Currency board? •Dollarize?•Float? •Interest rate rule (Taylor)? •Exchange rate rule? •Banks lender of last resort? •Borrow domestic or foreign?

( ,.)MV r PY

1/ (t t tP P f Y Y *)

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f t tt t j t j

jt

B MB E s

P

Money demand

Phillips curve

“Gov’t budget constraint”

Foreign or indexed debt + Nominal debt/price level = PV of future primary surpluses

Or

Price level shows up in two places

And

(1)

(2)

Was: (1) drives P, (2) follows along.

Now: (2) can drive P, (1) follows along. Especially for developing countries

Debt + # shares x price per share = E pv future earnings

• Nominal debt (including currency) is like corporate equity. • Real (foreign, indexed) debt is like corporate debt.• If s declines:

1. Nominal debt (= equity): P rises2. Real debt (= debt): Explicit default

• (2) Is a valuation equation, can determine P from B,M,s, just like stock value.

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B MB E s

P

Dramatic implications for monetary economics:

• Passive M↔B (real bills), interest rate targets ok!• Price level ok even in a cashless, frictionless economy (M=0)!• Only government M, B matter. Private M (checks), foreign M (dollarized), private

B (“liquidity”) do not matter for P. • Exchange rate reflects “faith in government,” not money stocks, and is volatile.• Inflation still feels like excess “aggregate demand” or “money chasing goods.”

Fiscal-dominant regime for price level

(2)

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Empirical example: 1997 Asia. Large prospective (not current) deficits led to crashes. Bad loans, governments will bail out banks. Can’t (won’t) raise taxes.→“Default’’ (via devaluation/inflation) on outstanding nominal debt.

Country Bad loan / Gov’t revenue

Cost / GDP

Exch rate fall

Indonesia 66% 66% 85%

Korea 128% 24% 60%

Malaysia 79% 22% 40%

Phillippines 34% 35% 40%

Thailand 195% 40%

Hong Kong 18% 0%

Singapore 12% 15%

Fiscal roots of inflation/devaluation

Source: Burnside, Eichenbaum, Rebelo JPE 2001

Fiscal roots: Could any open market operation (exchange money for nominal debt) have saved East Asia 1997, Russia 1998, Argentina 2002? IMF view.

Note: danger of conventional accounting. Inflation tax not on books. Korea “paid” for bank crisis by devaluing won salaries. (BER 2002).

Monetary regimes

1. Maximize inflation tax regime

Primary surplus s = tax – spending + nominal interest x monetary base

Characteristics:1. Own country fiat money (not dollarize, peg, gold standard, etc.) 2. Chronic high inflation3. Legal restrictions to boost demand for base money

a) Currency controls, then trade controls (Hold M, not $)b) Banking, finance, interest rate controls (Hold M, not bank deposits, stocks)c) Anti- “hoarding”, “speculation” measures. (Hold M instead!)d) Price controls, then quantity allocation

Occurs when tax < spendinga) Wars. (US too.)b) Communist countries. c) Developing countries.

“Bad” (huge distortions), but …Must solve underlying fiscal problem to get away from it!

Low High

2. Interest rate rules (Taylor)

Characteristics:Fiat currency, floating exchange rate, large or closed economy.

Advantage: 1. Can, in principle, smooth real shocks

Difficulties:1. (US) Must raise interest rate more than 1-1 with inflation -Even in bad times – tempted always to “fight recession” →Time consistency, rules, central bank independence, inflation targets,…2. Theory a mess. Does it really stabilize inflation?

3. (Developing) Needs lots of fiscal slack. - Fiscal equation is still there, tax/spend (s) must adjust to follow P. - Example: Suppose central bank deflates. Treasury must raise taxes to pay off outstanding nominal debt! - Will not solve fiscal temptation to inflate (“default” on debt). - Not an option for countries with intractable fiscal problems Even if commitment problem is solved

Monetary regimesLow High

3. Exchange rate peg, currency board

Reserves do not matter! The ability to borrow reserves (against future taxes) is all that matters!Good s? Can borrow reservesBad s? Must eventually “Default” on M,B, grab reserves, even if 100%

Peg: reserve crises, “speculative attack”? Currency board: all MB 100% backed by dollar assets. What could be safer?

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Absent primary surpluses s, board/peg must collapse sooner or later!Argentina: Explicit default on Bf, abrogate board to “default” on B,M.

Monetary regimesLow High

4. Dollarization

Pro:1. Hard to go back. 2. No money or nominal debt to devalue. → Solves commitment problem and fiscal temptation to inflate! 3. Use global standard units. Makes trade, capital much easier.

Con:1. (Traditional) Can’t offset real shocks. But…How many hyperinflations/crashes is this ability worth? “If depreciating the currency were the key to prosperity, Brazil would be the

richest country in the world.”

Solution: Dollarize transactions (including clearing).“Government equity.” Reserve currency, or variable coupon debt. “Stock” advantages, dollarization advantages.

Monetary regimes

2. (Fiscal -- Sims) No shock absorber. In trouble? Must explicitly default. Like a debt-only firm. Stock (nominal debt) is good! Optimal currency area depends on fiscal transfers. - US states. EU?

Low High

1. Money and nominal debt are like corporate equity. Foreign or real debt are like corporate debt.

2. “Stock value” can drive inflation. Composition effects (money vs. nominal debt) under central bank control can be secondary.

3. Fiscal considerations and “debt/equity” drive choice and structure of monetary regime!

Low High

Monetary regimes

Inflation tax Taylor ruleBoardDollarize Peg

Summary