Econs graphs and notes for the final - Survey Of International Economics (Survey-International Economics) PDF

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important graphs and notes with explanations. Professor Terrell...

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Chapter14                                          

                                          

  PolicyConstraintsAfixedexchangeraterulesoutuseofmonetarypolicy.Otherfirmmonetary orfiscalpolicyrules,suchasinterestrateorbalancedbudgetrules,limitonpolicy. IncompleteInformationandtheInsideLagIttakesweeksormonthsforpolicymakersto understandthestateoftheeconomytoday.Then,ittakestimetoformulateapolicyresponse (thelagbetweenshockandpolicyactionsiscalledtheinsidelag ) . PolicyResponseandtheOutsideLagIttakestimeforwhateverpoliciesareenactedtohave anyeffectontheeconomy(thelagbetweenpolicyactionsandeffectsiscalledtheoutsidelag ) . LongHorizonPlansIftheprivatesectorunderstandsthatapolicychangeistemporary,there maybereasonsnottochangeexpenditures.Atemporaryrealappreciationmayalsohavelittle effectonwhetherafirmcanprofitinthelongrunfromsalesintheforeignmarket. WeakLinksfromtheNominalExchangeRatetotheRealExchangeRateChangesinthe nominalexchangeratemaynottranslateintochangesintherealexchangerateforsomegoods andservices. PeggedCurrencyBlocsExchangeratearrangementsinsomecountriesmaybecharacterized byamixoffloatingandfixedexchangeratesystemswithdifferenttradingpartners. WeakLinksfromtheRealExchangeRatetotheTradeBalance:Changesinthereal exchangeratemaynotleadtochangesinthetradebalance.Thereasonsforthisweaklinkage includetransactioncostsintrade,andtheJcurveeffects. •Theseeffectsmaycauseexpenditureswitchingtobeanonlinearphenomenon:itwillbeweak atfirstandthenmuchstrongerastherealexchangeratechangegrowslarger. •Forexample:PricesofBMWsintheU.S.barelychangeinresponsetochangesinthe dollareuroexchangerate

TheaggregateU.S.fiscalstimulushadfourmajorweaknesses: 1. Itwasrolledouttooslowly,duetopolicylags. 2. Theoverallpackagewastoosmall,giventhemagnitudeofthedeclineinaggregate demand. 3. Thegovernmentspendingportionofthestimulus,forwhichpositiveexpenditureeffects werecertain,endedupbeingclosetozero,duetostateandlocalcuts. 4. Thisleftalmostalltheworktotaxcuts,thatrecipients,forgoodreasons,weremore likelytosaveratherthanspend. Withmonetarypolicyimpotentandfiscalpolicyweakandilldesigned,theeconomyremained miredinitsworstslumpsincethe1930sGreatDepression.  KeyPoints: 1. Intheshortrun,weassumepricesarestickyatsomepresetlevelP.Thereisthusno inflation,andnominalandrealquantitiescanbeconsideredequivalent.Weassume outputGDPequalsincomeYorGDNIandthatthetradebalanceequalsthecurrent account(therearenotransfersorfactorincomefromabroad). 2. TheKeynesianconsumptionfunctionsaysthatprivateconsumptionspendingCisan increasingfunctionofhouseholddisposableincomeY−T. 3. TheinvestmentfunctionsaysthattotalinvestmentIisadecreasingfunctionofthereal ornominalinterestratei. 4. Thetradebalanceisassumedtobeanincreasingfunctionoftherealexchangerate EP*/P,whereP*denotestheforeignpricelevel. 5. Thenationalincomeidentitysaysthatnationalincomeoroutputequalsprivate consumptionC,plusinvestmentI,plusgovernmentspendingG,plusthetradebalance TB:Y=C+I+G+TB. a. Therighthandsideofthisexpressioniscalleddemand,anditscomponents dependonincome,interestrates,andtherealexchangerate. b. Inequilibrium,demandmustequalthelefthandside,supply,ortotaloutputY. 6. Iftheinterestratefallsinanopeneconomy,demandisstimulatedfortworeasons. a. Alowerinterestratedirectlystimulatesinvestment. b. Alowerinterestratealsoleadstoanexchangeratedepreciation,allelseequal, whichincreasesthetradebalance. i. Thisdemandmustbesatisfiedforthegoodsmarkettoremainin equilibrium,sooutputrises. c. ThisisthebasisoftheIScurve:declinesininterestratesmustcallforthextra outputtokeepthegoodsmarketinequilibrium.EachpointontheIScurve representsacombinationofoutputYandinterestrateiatwhichthegoodsand FXmarketsareinequilibrium.BecauseYincreasesasidecreases,theIScurve isdownwardsloping. 7. Realmoneydemandarisesprimarilyfromtransactionsrequirements.Itincreaseswhen thevolumeoftransactions(representedbynationalincomeY ) increases,and decreaseswhentheopportunitycostofholdingmoney,thenominalinterestratei, increases.

8. ThemoneymarketequilibriumsaysthatthedemandforrealmoneybalancesLmust equaltherealmoneysupply:M/P=L(i)Y. a. ThisequationisthebasisfortheLMcurve:anyincreasesinoutputYmustcause theinterestratetorise,allelseequal(e.g.,holdingfixedrealmoneyM/P). b. EachpointontheLMcurverepresentsacombinationofoutputYandinterest rateiatwhichthemoneymarketisinequilibrium.BecauseiincreasesasY increases,theLMcurveisupwardsloping. 9. TheISLMdiagramcombinestheISandLMcurvesononefigureandshowstheunique shortrunequilibriumforoutputYandtheinterestrateithatdescribessimultaneous equilibriuminthegoodsandmoneymarkets. a. TheISLMdiagramcanbecoupledwiththeforexmarketdiagramtosummarize conditionsinallthreemarkets:goods,money,andforex. b. ThiscombinedISLMFXdiagramcanthenbeusedtoassesstheimpactof variousmacroeconomicpoliciesintheshortrun. 10. Underafloatingexchangerate,theinterestrateandexchangeratearefreetoadjustto maintainequilibrium.Thus,governmentpolicyisfreetomoveeithertheISorLMcurves. Theimpactsareasfollows: a. Monetaryexpansion:LMshiftstotheright,outputrises,interestratefalls, exchangeraterises/depreciates. b. Fiscalexpansion:ISshiftstotheright,outputrises,interestraterises,exchange ratefalls/appreciates. 11. Underafixedexchangerate,theinterestratealwaysequalstheforeigninterestrateand theexchangerateispegged.Thus,thegovernmentisnotfreetomovetheLMcurve: monetarypolicymustbeadjustedtoensurethatLMisinsuchapositionthatthese exchangerateandinterestrateconditionshold.Theimpactsareasfollows: a. Monetaryexpansion:notfeasible. b. Fiscalexpansion:ISshiftstotheright,LMfollowsitandalsoshiftstotheright, outputrisesstrongly,interestrateandexchangerateareunchanged. 12. TheabilitytomanipulatetheISandLMcurvesgivesthegovernmentthecapacityto engageinstabilizationpoliciestooffsetshockstotheeconomyandtotrytomaintaina fullemploymentlevelofoutput. a. Thisiseasiersaidthandone,however,becauseitisdifficulttodiagnosethe correctpolicyresponse,andpoliciesoftentakesometimetohaveanimpact,so thatbythetimethepolicyeffectsarefelt,theymaybeineffectiveoreven counterproductive.      

Chapter15

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● thegreaterthe degreeofeconomic integrationbetween marketsintwo countries,thegreater willbethevolumeof transactionsbetween thetwo,andthegreater willbethebenefitsthe homecountrygains fromfixingitsexchange ratewiththebase country.Asintegration rises,theefficiency benefitsofacommon currencyincrease.  Thegenerallessonwecandrawisthatforahomecountrythatunilaterallypegstoa foreigncountry,asymmetricshocks  imposecostsintermsoflostoutput. Asintegrationrises,theefficiencybenefitsofacommoncurrencyincrease. Assymmetryrises,thestabilitycostsofacommoncurrencydecrease. ○ AboveFIXline:betteroffbyfixingcurrency→Belowline,betterofffloating itappearsthatfixedexchangeratesareneithernecessarynorsufficienttoensuregood inflationperformanceinmanycountries. ○ Themainexceptionappearstobeindevelopingcountriesbesetbyhighinflation, whereanexchangeratepegmaybetheonlycredibleanchor. Originalsin:incountriesthatcannotborrowintheirowncurrency,floatingexchange ratesarelessusefulasastabilizationtoolandmaybedestabilizing. ○ Thisoutcomeappliesparticularlytodevelopingcountries,andthesecountries willpreferfixedexchangeratestofloatingexchangerates,allelseequal.  ←Solutionstothetrilemmabeforeandafter WWI        

HowdidtheworldreacttothecollapseoftheBrettonWoodssystem? ● Mostadvancedcountrieshaveoptedtofloatandpreservemonetarypolicyautonomy. ● AgroupofEuropeancountriesinsteaddecidedtotrytopreserveafixedexchangerate systemamongthemselves. ● Somedevelopingcountrieshavemaintainedcapitalcontrols,butmanyofthem (especiallytheemergingmarkets)haveopenedtheircapitalmarkets ● Somecountries,bothdevelopedanddeveloping,havecampedinthemiddleground: theyhaveattemptedtomaintainintermediateregimes,suchas“dirtyfloats”orpegswith “limitedflexibility.” ● Finally,somecountriesstillimposesomecapitalcontrolsratherthanembrace globalization.  KeyPoints 1. Thebenefitsforthehomecountryfromafixedexchangerateincludelowertransaction costsandincreasedtrade,investment,andmigrationwiththebaseorcentercountry. 2. Thecoststothehomecountryfromafixedexchangerateariseprimarilywhenthetwo countriesexperiencedifferenteconomicshocksandhomewouldwanttopursue monetarypoliciesdifferentfromthoseofthebaseorcentercountry. 3. Thecostsandbenefitsoffixingcanbesummeduponasymmetryintegrationdiagram. Athighlevelsofsymmetryand/orintegration,abovetheFIXline,itmakessensetofix. Atlowlevelsofsymmetryand/orintegration,belowtheFIXline,itmakessensetofloat. 4. Afixedratemayconferextrabenefitsifitistheonlyviablenominalanchorina highinflationcountryandifitpreventsadversewealthshockscausedbydepreciationin countriessufferingfromacurrencymismatch.  Usingthesetoolsandthetrilemma,wecanbetterunderstandexchangerateregimechoicesin thepastandinthepresent: ● Before1914itappearsthegoldstandarddidpromoteintegration,andpoliticalconcern forthelossofstabilizationpolicieswaslimited.Inthe1920sand1930s,increased isolationism,economicinstability,andpoliticalrealignmentsunderminedthegold standard. ● After1945anduptothelate1960s,theBrettonWoodssystemoffixeddollarexchange rateswasfeasible,withstrictcontrolsoncapitalmobility,andwasattractiveaslongas U.S.policieswerenotatoddswiththerestoftheworld. ● Since1973differentcountriesandgroupsofcountrieshavegonetheirownway,and exchangerateregimesreflectthesovereignchoiceofeachcountry.       

  Chapter16 Eurooptimists: currencyunionwill eventuallypromote enoughtradetofulfil OCAcriteria Europessimists:more trademightalsoleadto morespecializationby eachcountry.shocks wouldlikelybecome moreasymmetric→   CaseforOCAisweaker, notstronger,after accountingforlongrun effects   Conclusions  Eurooptimists ●

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Fortrueoptimists,theeuroisalreadysomethingofasuccess:ithasfunctionedina perfectlyadequatewayandcanbeexpectedtobecomeonlymoresuccessfulastime goesby. MorecountriesarelininguptojointheEurozone.Eveniftherearecostsintheshortrun, theargumentgoes,inthelongrunthebenefitswillbecomeclear. TheeurowillcreatemoretradeintheEurozone.Itmayalsocreatemorelaborand capitalmobility. CrossborderassettradeandFDIflowsintheEurozonealsohaveincreased. TheECBwillprovetobeastrong,credible,independentcentralbank. Theeuroisincreasinglybecomingareservecurrencyforforeigncentralbanks,andis nowthedominantcurrencyusedininternationalbondmarkets. Theoptimistsbelievethattheadoptionoftheeuro,likeentrytotheEUitself,means“no goingback”:thereissimplynoimaginablepoliticalfutureforEuropeapartfromunion.

 EuroPessimists ● Fortruepessimists,theprecedingargumentsarenotconvincing. ● Theimpactoftheeuroon(alreadyhigh)intraEUtradelevelswillbesmall.

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Culturalandlinguisticbarrierswillpersist,labormigrationwillbelimitedandheldbackby inflexiblelabormarketinstitutionsinmostcountries.Regulatoryandotherfrictionswill remain. Ifintegrationstopsforlackofpoliticalsupport,akeyeconomicrationalefortheeuro unravels. ThereiswidedivergenceinthecountriesoftheEurozonewithrespecttomonetary policy. WhentheECBwasputtothetestafterthe2008crisis,theECBcavedinandcontinued tolendagainstperipheralcountrygovernmentdebtofdecliningquality. In2012theECBsaiditwoulddo“whateverittakes”tosavetheeuro,launchingthe OutrightMonetaryTransactionbondbuyingprogram,whichhasyettobedeployed. Atbest,eveniftheeurosurvives,pessimistsbelievetheregionwillsufferslowgrowth andongoinginternalconflicts. Atworst,thetensionscouldbesogreatastocausethebreakupoftheEurozoneinto blocsorthereintroductionoftheformernationalcurrencies.

 Summary ● TheEurozonemaybeaworkablealbeiteconomicallycostlycurrencyunion. ● Onthedownside,EUenlargementundercutstheOCAlogicintheshortrunandcould maketheECB’sgovernancemoredifficult.Thereisariskofaclashbetweenthefiscal goalsofthegovernmentsandmonetarygoalsoftheECB. ● TheresultsofsuccessiveEurobarometerpollsindicatethatonlyabout50%to60%of thecitizensoftheEurozonethinkthattheeurohasbeenbeneficial. ● Theeuroremainsanexperiment—itsarrivaldidnotmarktheendpointofEuropean monetaryhistory,anditslongrunfateisnotentirelycertain.  KeyPoints 1. Acurrencyunionoccurswhentwoormoresovereignnationsshareacommoncurrency. Sometimesthesearrangementsareunilateral,suchaswhenacountrylikeEcuador adoptstheU.S.dollar.Butsomearemultilateral,themostprominentexamplebeingthe Eurozone. 2. Theeurois(asof2014)thecurrencyof18EuropeanUnion(EU)countries,andthey manageitcollectivelybyacommonmonetaryauthority,theEuropeanCentralBank (ECB).MostoftheEU’s28countriesareexpectedtojointheeuroeventually. 3. Accordingtothetheoryofoptimumcurrencyareas(OCAs),regionsshouldemploya commoncurrencyonlyiftheyarewellintegratedandfacefairlysimilar(symmetric) economicshocks.Ifthesecriteriaaremet,efficiencygainsfromtradeshouldbelarge, andthecostsofforgonemonetaryautonomysmall. 4. Acurrencyunionisusuallyamoreirreversibleandcostlystepthansimplyfixingthe exchangerate.TheOCAthresholdisthereforehigherthanthethresholdforafixed exchangerate.

5. AdditionaleconomicfactorscanstrengthenthecaseforanOCA.Ifregionshavehigh labormobilityorlargefiscaltransfers,thesemechanismsmaymakethecostsofa currencyunionsmallerforanygivenasymmetricshock. a. Inaddition,countrieswithapoornominalanchormaybeeagertojoinacurrency unionwithacountrywithabetterreputationforinflationperformance. 6. Politicalconsiderationscandrivemonetaryunions,aswhencountriesfeeltheyhavea commondestinyandwishtotreatmonetaryunionaspartofabroadergoalofpolitical union 7. OCAcriteria a. TheEurozonehasfairlyhightradeintegration,althoughnotquiteashighasthat oftheUnitedStates.TheEurozonemightormightnotpassthisOCAtest. b. Verylowlabormobility:doesnotpassthistest c. Farilysymmetricshocksbetweencountries:probablydoespassthistest 8. TheOCAcriteriamayfailexante,buttheymaybeselffulfilling:thankstothecommon currency,aftersomeyears,tradeandlabormobilitymayincrease,tippingthebalancein favorofanOCAexpost.Butincreasingspecializationduetotrademaycausemore asymmetricshocks,whichwouldpushintheoppositedirection. 9. Thelackofcompellingeconomicargumentsfortheeuroleadsustostudyitshistorical andpoliticalorigins.TheEUmustbeunderstoodasapoliticalproject,andtheeuroisan importantpartoftheconceptionoftheEU.AlthoughmanyEUcitizenshavetrustinthis project,pollsshowthatsuchaviewisheldbyonlyabaremajority. a. ECB:Ifitcandeliverlowinflationandeconomicstabilitycomparabletothe Germancentralbank,afterwhichitwasdesigned,theeuroismorelikelyto succeedasacurrencyintheEUandasaglobalcurrency. b. AttemptstoexertpoliticalinfluenceontheECBcontinueandtheCouncilof Ministershaveoftenprovedweakatpunishingcountriesthatbreaktherulesof theEurozone(theMaastrichtcriteriaandtheStabilityandGrowthPact). 10. Theglobalfinancialcrisisof2008andGreatRecessionwerethefirstrealtestofthe euro,andasterntestatthat. a. Likeothereconomies,theEurozonesufferedfromexcessivelending,financial bubbles,fiscalindiscipline,bailoutsofbanks,and(asaresult)pressureonthe centralbanktodeviatefromestablishedpoliciestosupporttherealeconomy, banks,andgovernments. b. TheseproblemsweredifficulttohandlebecausetheyaffectedEurozone countriesinanasymmetricfashion. i. Asaresult,ECBandEUauthoritiesstruggledtodeviseeffectivepolicy responsesbasedonbroadcooperationexceptinthedirestmoments. ii. Theeconomicandpoliticalsituationremainsfragile,especiallyinthe hardhitperipheraleconomiesofGreece,Ireland,Portugal,andSpain c. Adoublediprecessionbeganin2011makingmattersevenworse:slowgrowth damagedfiscalpositions,governmentambitionswerelimited,theECBwas reluctanttotryaggressiveorunconventionaltactics,andtheEuropeanbanking systemremainsfragile

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