ECON2004 Macroeconomics Term 2 Notes PDF

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ECON2004 Term 2 ECON2004 – Macroeconomics Term 2 Notes Lecture 1: Carlin & Soskice (2015), Ch 9, 9.2 9 Overview Intro: From now we are going to look at how an inflation targeting central bank achieves stabilisation in an open economy – allowing for a flexible exchange rate and financ...

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ECON2004(–(Macroeconomics(Term(2(Notes( !

Lecture(1:(Carlin(&(Soskice((2015),(Ch(9.1,(9.2.1(( 9.1(Overview( Intro:( From!now!we!are!going!to!look!at!how!an!inflation!targeting!central!bank!achieves!stabilisation!in!an!open! economy!–!allowing!for!a!flexible!exchange!rate!and!financial!flows!across!borders.!As!before,!we!continue! to!assume!that!central!banks!are!forward!looking!with!rational!expatiations!and!attempting!to!forecast!the!IS! and!PC!curves!in!the!next!period!so!that!they!can!set!the!interest!rate!for!this!period!–!this!is!because!we! assume!a!one!period!lag!on!the!effect!interest!rates!have!on!the!macroeconomy.!Now!that!we!have!an!open! economy,!we!shall!assume!that!foreign!exchange!traders!are!also!forward!looking!and!rational.!! ! Arbitrage,opportunities,,FOREX,market,and,govt,bond,market:, Traders!look!to!take!advantage!of!differences!in!rates!across!government!bonds.!To!do!this!they!need!access! to!the!forex!market!to!purchase!the!currency!the!bond!is!denominated!in.!Arbitrage!opportunities!do!not! exist!for!long!because!of!the!integration!of!international!capital!markets!that!now!exists.!! ! Defining,the,nominal,and,real,exchange,rate:, We!shall!use!e!to!describe!the!home’s!nominal!exchange!rate,!that!is!the!amount!of!home!currency!that!can! be!bought!we!one!unit!of!foreign!currency.! ! 𝑒" ≡ "

#"%&'()"*+ ",*-."/%00.&/1 *&. "%&'("*+ "+*0.'2&"/%00.&/1

!!!!!!!!!!!!(home’s!nominal!exchange!rate)!

! ! An!increase!in!e!means!that!one!unit!of!USD!buys!more!GBP,!therefore!we!say!the!pound!has!depreciated.! To!measure!the!rate!at!which!domestic!and!foreign!goods!and!services!can!be!exchanged!for!each!other!we! also!need!to!take!account!of!the!relative!price!level!between!two!economies.!This!is!where!we!introduce!the! real!exchange!rate.! ! 𝑃∗𝑒 𝑝𝑟𝑖𝑐𝑒"𝑜𝑓 "𝑓𝑜𝑟𝑒𝑖𝑔𝑛 "𝑔𝑜𝑜𝑑𝑠"𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑒𝑑 "𝑖𝑛"ℎ𝑜𝑚𝑒"𝑐𝑜𝑢𝑛𝑡𝑟𝑦 =" ! 𝑄" ≡ " 𝑃 𝑝𝑟𝑖𝑐𝑒"𝑜𝑓 "ℎ𝑜𝑚𝑒"𝑔𝑜𝑜𝑑𝑠 ! P*!=!foreign!price!level!!!!!!!!P!=!home!price!level!!!!!!e!=!home’s!nominal!exchange!rate!(as!before)! ! The!real!exchange!rate!Q!is!a!measure!pf!the!price!competitiveness!between!two!countries.!If!Q!increases! this!reflects!a!fall!in!the!price!of!home!goods.!This!depreciation!makes!home!goods!more!attractive!to!the! foreign!buyers!and!makes!imports!less!attractive!to!those!in!the!home!country.!This!results!in!an!increase!in! net!exports!and!thus!an!increase!in!AD.!! ! Two,stabilization,channels,in,the,open,economy:,interest,rate,and,exchange,rate:, Previously!in!the!closed!economy!model!the!central!bank!had!one!channel!of!attack!for!tackling!inflation,! using!the!bank’s!overnight!rate.!Now!however!there!are!two!channels.!In!response!to!a!shock!there!will!be! both!movements!in!both!the!interest!rate!and!forex!markets.!As!an!example,!let!us!assume!that!there!is!a! shock!to!the!UK!economy!that!pushes!inflation!above!target.!In!response,!the!central!bank!will!have!to!raise! interest!rates.!However,!the!forex!traders,!assuming!they!are!rational!and!forward!looking,!will!know!that! the!central!bank!is!going!to!raise!rates!and!so!will!look!to!take!advantage!of!this!arbitrage!opportunity!by! selling!USD!and!purchasing!GBP.!This!appreciation!of!the!pound!will!make!domestic!exports!less! internationally!competitive!and!will!also!reduce!the!price!of!imports.!As!a!result,!net!exports!fall!and!this! suppresses!AD.!This!means!that!there!are!two!channels!working!to!produce!the!desired!negative!output!gap!

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the!central!bank!requires!to!return!inflation!back!to!target.!The!amount!the!CB!will!have!to!raise!interest! rates!by!then!is!less!than!what!they!would’ve!had!to!raise!them!by!in!a!closed!economy.!Stabilization!is!thus! a!role!which!is!shared!between!exchange!rate!and!interest!rate!adjustments.!It!is!important!to!note!that! forex!traders’!decisions!are!not!made!in!the!hope!of!tackling!inflation,!they!are!profit!seeking!agents!who!are! acting!rationally!to!take!advantage!of!arbitrage!opportunities.!! ! How,are,the,key,aspects,of,the,open,economy,reflected,in,the,3-equation,model?, ! IS#relation## In!an!open!economy,!we!must!now!include!net!exports!as!a!factor!in!determining!demand.!Imports!depend! on!the!level!of!activity!in!the!home!economy,!any!rise!in!incomes!will!likely!see!some!leakages!abroad!as! households!spend!some!of!their!additional!income!on!imports.!This!means!that!the!higher!the!marginal! propensity!to!import!the!lower!the!multiplier!will!be.!The!presence!of!imports!makes!the!IS!curve!steeper! (lower!multiplier),!a!change!in!the!interest!rate!has!a!smaller!effect!on!output.!A!depreciation!of!the!home! currency!(an!improvement!in!international!competitiveness)!shifts!the!IS!curve!to!the!right.!! ! Phillip’s#Curve,#PC# This!continues!in!the!same!way!as!in!the!closed!economy!model!as!households!use!domestic!inflation!in!their! wage!setting!calculations.!We!continue!to!work!with!a!situation!where!the!equilibrium!rate!of! unemployment!is!unique.!! ! Central#Bank#Behaviour:#MR### There!should!be!no!change!in!the!policy!maker’s!preferences!and!we!continue!to!assume!the!bank!suffers!a! loss!of!utility!according!to!how!far!inflation!is!from!target.!The!only!thing!to!consider!is!which!form!of! inflation!measurement!should!they!use!–!CPI!which!includes!the!price!of!imports,!or!domestic!inflation.!We! shall!assume!for!now!that!the!CB!targets!domestic!inflation!and!that!workers!use!domestic!inflation!when! calculating!their!WS!curve.!! ! How,does,capital,market,openness,affect,stabilization,policy?, Two!elements!of!global!flows!of!capital!play!a!crucial!role:!forex!and!the!ability!of!home/foreign!economic! agents!to!buy!home/foreign!assets.!Without!financial!markets!the!forex!market!would!be!determined!solely! by!the!demand!for!goods!and!services.!However,!since!1980s!the!value!of!financial!assets!traded!in! international!markets!far!exceeds!that!which!is!from!demand!for!goods!and!services.!Therefore,!trade!in! financial!markets!dominates!the!forex!market.!We!shall!assume!that!the!only!financial!assets!being!traded! are!government!bonds.!! ! To!understand!the!aspects!of!international!financial!markets!we!shall!make!some!simplifying!assumptions;! • There!is!perfect!international!capital!mobility.!This!means!that!home!residents!can!buy!or!sell!foreign! bonds!with!the!fixed!nominal!world!interest!rate!i*,!in!unlimited!quantities!at!low!transaction!costs.! • The!home!country!is!small!and!cannot!affect!the!world!interest!rate!! • We!assume!there!are!just!two!assets!households!can!hold!–!money!and!bonds!(we!assume!they!only! hold!home!money!however)! • There!is!perfect!substitutability!between!foreign!and!home!bonds,!this!means!we!assume!identical! riskiness!and!that!the!only!differential!is!the!expected!return!!! ! How,do,forex,traders,respond,to,interest,rate,differences?,The,uncovered,inter ncovered,interest,parity est,parity ,(UIP),condition:, The!only!difference!between!expected!return!on!two!different!bonds!depend!on!two!factors:! • Any!expected!difference!in!interest!rates!over!a!specified!time!horizon!! • A!view!about!likely!development!of!the!exchange!rate!over!the!same!time!horizon!! !

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The!importance!that!future!expectations!have!is!the!reason!we!assume!agents!are!fully!forward!thinking!and! take!advantage!of!all!available!information!when!forming!their!expectations.!! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Any!opportunity!for!arbitrage!is!recognised!almost!immediately!and!the!currency!will!appreciate!just!as! quickly!–!in!seconds.!The!diagram!above!illustrates!how!markets!react!to!an!increase!in!the!interest!rate!of! the!home!country.!! ! With!the!home!interest!rate!being!revised!up!to!above!the!world!rate!for!one!period,!the!UIP!condition! states!that!the!exchange!rate!will!jump!immediately!to!eliminate!the!arbitrage!opportunity.!The!change!in! the!exchange!rate!will!be!by!exactly!the!same!magnitude!as!the!change!in!the!interest!rate.!The!depreciation! of!the!currency!over!the!period!is!equal!again!to!the!difference!in!rates!for!the!period.!All!market! participants!are!assumed!to!believe!that!the!exchange!rate!will!return!to!its!initial!level!at!the!end!of!the! period.!The!UIP!condition!tells!us!that!the!unwinding!of!the!initial!change!in!the!exchange!rate!is!equal!to!the! interest!rate!differential.!! ! The,reaction,of,the,CB,and,forex,markets,to,an,inflation,shock;, As!mentioned!previously,!the!central!bank!reacts!to!the!shock!in!a!normal!way!by!raising!interest!rates.! However,!unlike!before,!they!raise!it!by!a!smaller!magnitude!now!that!we’re!in!an!open!economy!the!forex! markets!account!for!some!of!the!required!adjustments!–!by!surprising!AD.!Therefore,!the!CB!makes!a!smaller! adjustment!to!the!interest!rate!than!it!did!previously.!! !

9.2(Modelling(( The,foreign,exchange,market,and,the,UIP,condition:, The!UIP!condition!can!be!represented!as:! ! J − 𝑒( 𝑒(HI """""""""""""""𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡"𝑔𝑎𝑖𝑛" 𝑙𝑜𝑠𝑠 = "𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑"𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛"(𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)! 𝑖( − 𝑖 ∗ = 𝑒( so!far!we!do!not!have!a!model!of!what!determines!the!expected!exchange!rate,!we!simply!assume!that!it’s! expected!to!return!to!its!previous!value!after!one!period.!! ! We!make!use!of!the!fact!that!we!can!approximate!the!percentage!growth!of!the!exchange!rate!by!the! change!in!the!natural!log!of!the!exchange!rate:! !

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! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! The!UIP!line!has!a!gradient!of!-45!degrees!such!that!any!difference!in!the!home!interest!rate!to!the!world! rate!is!exactly!offset!by!the!amount!of!appreciation!in!the!currency!–!demonstrated!by!the!two!double! headed!arrows!being!equal.!! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! The!key!features!of!the!UIP!diagram!with!i!and!log!e!on!the!axes!are:! • Each!curve!must!have!slope!-450!and!must!pass!through!point![log(eE),!i!]! • A!change!in!home!interest!rate!causes!a!movement!along!the!UIP!curve!! • For!a!given!expected!exchange!rate,!any!change!in!world!interest!rate!shifts!the!UIP!curve!! • For!a!given!world!interest!rate,!any!change!in!expected!exchange!rate!shifts!the!UIP!curve! !

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Lecture(2:(( 9.2.2( Medium-run,equilibrium,in,the,open,economy,and,the,AD-ERU,model:, Before!we’re!able!to!bring!together!the!exchange!rate!model!with!the!three!equation!model!we!must!first! analyse!the!characteristics!of!the!constant!inflation!equilibrium!in!the!open!economy.!In!the!closed!economy! model!we!know!that!for!inflation!to!be!constant!there!must!be!equilibrium!in!the!medium!run!supply!side.! This,!as!we!know,!occurs!when!the!PS!curve!is!equal!to!the!WS!curve!and!sets!the!equilibrium)rate)of) unemployment!–!we!shall!refer!to!this!medium!run!supply!side!model!as!the!ERU!model.!We!use!this!model! when!describing!the!open!economy!as!well!with!output!along!the!horizontal!axis!and!real!exchange!rate!on! the!vertical!axis.!We!shall!introduce!the!full!model,!which!includes!the!trade!balance,!shortly.!! ! The!MRE!in!the!open!economy!is!defined!by!values!of!output,!unemployment,!and!the!real!exchange!rate.!In! the!MRE!(intersection!between!ERU!and!demand!curves)!output!and!the!real!exchange!rate!are!at! equilibrium!and!inflation!is!constant.!The!nature!of!the!exchange!rate!regime!does!not!effect!the!medium! run!model!but!does!however!influence!the!dynamics!of!adjustments!to!shocks,!available!policy!instruments! and!how!the!medium!run!inflation!rate!is!determined.!We!shall!however!be!focusing!on!flexible!exchange! rate!model.!! ! For!the!time!being,!the!ERU!model!is!exactly! the!same!in!the!open!economy!as!in!the! closed!economy!model.!! ! For!reasons!that!will!become!clearer!later,! we!use!q!to!denote!the!natural!log!of!the! real!exchange!rate.!! ! i.e.!!q!=!log(Q)! ! we!can!write!the!ERU!curve!as:! ! 𝑦 = " 𝑦. (𝑧 P , 𝑧 R )! ! where!Zw!is!the!set!of!supply!side!factors!that! shift!the!wage!setting!curve,!such!as! unionization,!labour!market!regulation!and! unemployment!benefits.!ZP!represents!the! supply!side!policies!that!shifts!the!price! setting!curve,!such!as!the!tax!rate,! technology!levels!and!the!degree!of! competition.!! ! 9.2.3:(AD(Curve(( the!AD!curve!incorporates!both!the!demand!side!and!UIP!condition!in!the!MRE.!To!derive!the!AD!we!use!the! IS!curve!from!the!closed!economy!model!and!build!on!it!by!saying!it!responds!negatively!to!the!real!interest! rate!(r)!and!positivily!to!a!depreciation!of!the!real!exchange!rate!(q)!–!both!with!a!one!period!lag.! Open!economy!IS!curve!formula:"""""""""""""𝑦( = " 𝐴( − 𝑎𝑟(TI + 𝑏𝑞(TI ! ! ‘A’!in!this!model!includes!the!multiplier!and!demand!shift!variables!in!the!open!economy,!such!as!world! trade,!as!well!as!the!variables!that!shift!the!consumption!and!investment!functions,!such!as!wealth!and! Tobin’s!Q.!!!

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We!now!want!financial!integration!in!our!AD!model.!At!MRE,!the!real!exchange!rate!is!constant.!This!implies! that!r!=!r*!and!because!we’re!considering!a!small!open!economy!we!shall!assume!that!they!cannot!affect!the! world!interest!rate.!To!see!why!r!=!r*!we!begin!by!recalling!the!UIP!condition:! ! J 𝑖( − 𝑖 ∗ = 𝑙𝑜𝑔𝑒(HI − 𝑙𝑜𝑔𝑒( ! ! we!want!the!nominal!exchange!rate!to!go!unchanged!(i.e!the!RHS!=!0)!therefore,!it!=!i*.!We!can!derive!the! UIP!condition!in!terms!of!the!real!rather!than!nominal!exchange!rates!! ! J − 𝑞( !!!!!!!!!(real!UIP!condition)! 𝑟( − 𝑟 ∗ = 𝑞(HI ! This!tells!us!that!if!the!home’s!real!interest!rate!is!above!the!world!rate!then!it’s!real!exchange!rate!is! expected!to!depreciate.!Since!for!the!MRE!we!require!the!real!exchange!rate!to!be!constant!it!is!clear!that!rt! =!r*!and!from!this!we!can!produce!the!AD!equation:! ! y!=!A!–!aR*!+!bq!!!!!(no!time!scripts!because!everything!is!constant!over!time)! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

The!basic!medium!run!model!consists!of:! • The!demand!side!represented!by!the!AD!curve.!The!goods!market!is!in!equilibrium!and!r!=!r*! • The!supply!side,!represented!by!the!ERU!curve.!Inflation!is!constant!! • In!MRE!the!economy!is!at!the!intersection!between!the!AD!and!ERU!curves:!r!=!r*,!y!=!ye!and!the!real! exchange!rate!is!equal!to!the!expected!exchange!rate.!! ! ! ! ! ! !

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Implications!to!MRE!of!demand!and!supply!side!shocks:! ! Rise!in!productivity! Fall!in!union! bargaining!power! Equilibrium! unemployment! Real!exchange!rate! Real!wage!

Term!2!

Down!

Down!

Increase!in! autonomous! consumption! No!change!

Depreciation! UP!!

Depreciation! no!change!!

Appreciation! No!change!

! In!the!closed!economy,!following!a!demand!or!supply!shock!there!exists!a!new!stabilizing!interest!rate.! However,!in!the!open!economy,!the!real!interest!rate!is!pinned!down!by!the!world!interest!rate!in!MRE!and! it!tis!therefore!the!real!exchange!rate!that!must!vary!in!response!to!demand!and!supply!shocks.!! ! A#supply#shock:#a!positive!supply!shock!(new!tech)!shifts!the!PS!curve!upwards,!let!us!also!assume!it!takes! time!for!the!trend!productivity!to!make!its!way!into!wage!setters!behavior.!As!a!result,!the!ERU!curve!shifts! to!the!right!and!the!real!exchange!rate!depreciates.!The!intuition!behind!it!is!that!if!all!the!other!components! of!AD!go!unchanged!then!the!real!exchange!rate!must!depreciate!in!order!for!net!exports!to!rise!and!for!the! economy!to!rest!at!the!new!level!of!higher!output.!! ! A#demand#shock:#a!positive!demand!shock!shifts!the!AD!curve!to!the!right!and!causes!the!real!exchange!rate! to!appreciate.!From!the!equation!y!=!A!–!aR*!+!bq!!we!can!say!that!a!demand!shock!(lets!say!investment! boom)!will!increase!the!‘A’!component!of!the!equation.!Since!R!is!pinned!down!by!the!world!interest!rate!we! know!that!q!must!fall!(appreciation)!in!order!for!y!to!remain!constant.!! !

Lecture(3( 9.2.4( Stabilization,under,flexible,exchange,rates:,3,equation,model,and,RX,curve., To!model!stabilization!we!use!the!AD-ERU!model!for!the!MRE!and!an!extension!of!the!3!equation!model!to! study!how!the!central!bank!responds!to!shocks.!We!shall!now!introduce!a!new!curve,!called!the!RX!curve,! which!gives!the!central!bank’s!best!interest!rate!response!taking!into!account!the!FOREX!market.!To!simplify! this!we!shall!continue!to!assume!that!the!central!bank!targets!domestic!inflation!as!apposed!to!CPI!(as!it! actually!does).!! ! Quick!reminder!of!closed! economy:!Central!bank! minimizes!loss!function,! which!aims!to!keep!inflations! close!to!target!whilst!being! constrained!by!the!supply! side!(PC).!This!then!gives!the! banks!monetary!rule! function!(MR!curve).!This! changes!in!the!open! economy!because!the!bank! must!now!take!into!account! the!forward!looking! (rational)!behavior!of!the! FOREX!markets!and!the! effects!that!a!change!in!the! exchange!rate!can!have!on! AD.!!

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9.2.5,Inflation,Shock:,Comparing,Closed,and,Open,Economies, As!we!know,!an!inflation!shock!shifts!the!Philip’s!curve!up!for!one!period!and!for!the!central!bank!to!correct! this!they!must!push!output!below!and!target!inflation!above!equilibrium!by!raising!the!interest!rate.!This! means!that!in!the!AD-ERU!model!the!new!equilibrium!is!exactly!back!to!where!it!first!was!–!meaning!no! change!in!MRE.!We!shall!now!compare!the!difference!between!the!problem!a!central!bank!faces!during!a! temporary!inflation!shock!in!closed!and!open!economy.!! # Closed#Economy:# Period!1:! • Starts!from!A!and!then!shock!cause!PC!to!shift!to! PC(inflation!shock)! • Point!B!not!on!CB’s!MR!curve!! • CB!forecasts!PC!for!next!period!and!concludes!they! would!like!to!be!at!point!C!on!their!MR!curve! • They!set!the!corresponding!interest!rate!! Period!2:! • New!interest!rate!has!had!time!to!take!affect!on!AD! • The!higher!rate!reduces!output!to!point!C!! • The!CB!forecasts!the!PC!for!the!next!period!based!on!last! periods!rate!of!inflation! • They!lower!the!interest!rate!to!point!D,!so!that!they! remain!on!the!MR!curve!! • Interest!rate!only!effect!with!one!period!lag,!so!period! finishes!at!P1!Y1!(both!point!C)!and!r1!(point!D)! Period!3!(onwards):! • Effect!of!lower!rate!takes!hold!and!stimulates!demand,! economy!moves!to!point!D!with!lower!inflation!and!higher! output! • The!process!continues!along!the!MR!curve,!with!one!period!lag! each!time! • Process!end!when!economy!is!back!at!point!Z,!where!it!began! ! Open#Economy:#Including#the#RX#curve# Period!1:! • Economy!starts!at!point!A,!after!inflation!shock!the!CB!assesses! that!the!best!response!output!gap!is!at!point!C,!on!their!MR! curve!–!same!as!in!closed!economy! • The!FOREX!market!foresees!that!the!higher!inflation!will!mean! a!prolonged!period!of!higher!interest!rates!above!world!rates! • The!UIP!condition!implies!an!immediate!appreciation!of!the! currency!and!subsequent!depreciation!over!the!entire!period! there!is!an!interest!rate!differential!between!home!and!world! rates! • The!economy!forecasts!PC!for!the!next!period!at!point!C!and! sets!interest!rate!accordingly!from!the!RX!curve! o However,!now!that!we!are!in!the!open!economy,!the! IS!curve!shifts!leftwards!as!a!result!of!the!appreciated! currency!–!an!effect!which!we!can!see!on!the!AD-ERU! curve!

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ECON2004!

Term!2!

The!exchange!rate!and!interest!rate!only!effect!inflation!and! output!with!one!period!lag!so!the!economy!finishes!the!first! period!at!!P0!Ye!r0!and!q0! Period!2:! • The!new!rate!and!exchange!rate!have!had!time!to!take!effect! on!AD! o Higher!interest!rates!reduces!investment!and!net! exports!–!through!appreciated!currency! • The!economy!moves!to!point!C,!with!lower!output!and!higher! inflation! • The!IS!curve!has!shifted!to!the!left!on!account!of!the!new! exchange!rate!(q)! • The!CB!again!forecasts!the!PC!for!the!next!period!and!wants!to! locate!at!point!D!for!the!next!period,!back!on!their!MR!curve.! The!adjust!interest!rates!accordingly,!taking!into!account!the! FOREX!markets! • The!CB!foresees!the!depreciation!of!the!currency!in!tandem! with!falling!rate!of!interest!–!as!the!UIP!condition!must!always! hold.!They!therefore!move!to!point!D!on!the!RX!curve!–! although!this!takes!a!one!period!lag!to!take!effect! Period!3!Onwards:!! • The!economy!now!moves!to!point!D...