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Table of Contents

Equilibrium of the Open Economy: Ch9.1, 9.2.1................................................................. 2

Supply side, demand side and real exchange rates: Ch9.2.2-3 ........................................... 5

The 3-equation model in the Open Economy: Ch9.2.4-5, 9.3-4 ........................................... 9

Demand Side and Trade Balance in the Open Economy: 10.1, 10.2.1 ................................17

The Supply Side and the AD-BT-ERU Model: Ch10.1.2, 10.2.2, 10.3, 10.4 ..........................22

Oil Shocks: Ch11.1.1-2, 11.2.1-2, 10.1.1 ...........................................................................27

External Imbalances: Ch11.1.2-4, 11.2.3-5, 11.3 ...............................................................34

Economics of a Common Currency Area: Ch12.1-4 ...........................................................40

Crises, macroeconomic models and policy regimes: Ch12.5-6, 7 .......................................44

Eurozone – essay questions .............................................................................................47

Questions .............................................................................................................................. 47

Information ........................................................................................................................... 48

Formulae ........................................................................................................................53

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Open Economy Equilibrium of the Open Economy: Ch9.1, 9.2.1 The foreign exchange market Just like the Central Bank, trades in the foreign exchange market are assumed to be forward looking and rational. We assume interest rates and real exchange rates affect the economy with a one period lag. The CB takes into account the forex market reaction when setting interest rates. The forex market moves when policy expectations change. Investors will buy government bonds in another country depending on different rates of return. This drives demand for that country’s currency. The exchange rate depends on supply and demand in the forex market. This is based on desire to buy and sell government bond, which comes from differences in the exchange rates. Profit opportunities based on different rates of return (arbitrage opportunities) on bonds in different countries will be short-lived. E.g. if the Bank of England increased the UK interest rate such that return on UK bonds were higher than returns on US bonds, there would be a rush into UK pounds and out of US dollars until the profit opportunity had vanished. Exchange rates Nominal exchange rate is the amount of home currency that can be bought with one unit of currency. It is therefore valued in terms of the foreign currency.

e ≡no.units of home currency

one unit of foreign currency home’s nominal exchange rate

e increases → one unit of foreign currency can buy more units of home currency → depreciation e decreases → one unit of foreign currency can buy fewer units of home currency → appreciation Real exchange rate measures the price competitiveness between two economies:

Q ≡price of foreign goods expressed in home currency

price of home goods=

P∗e

P home’s real exchange rate

Q increasing would be a depreciation of the real exchange rate, boosting competitiveness, net exports and AD, and would occur because of:

• A fall in the price of home goods (P) relative to foreign goods (P*)

• An increase in e (depreciation of the nominal exchange rate) Demand in the open economy: y = C + I + G + (X – M) Two stabilisation channels in the open economy: interest rate and exchange rate The response to a shock will be a combination of interest rate set by CB and a change in the exchange rate due to forex traders.

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E.g. a positive inflation shock: the CB raises interest rates to depress next period’s output level and bring inflation down. In the open economy, forex traders take advantage of the interest differential so there is a rush into UK pounds and out of, say, US dollars. The result is an appreciation in the UK pound. The appreciated currency (strong pound) reduces demand for exports and increases demand for imports, making the British economy less competitive, depressing AD. Therefore, inflation is brought down in two ways:

• Interest rate channel

• Exchange rate channel The exchange rate channel means the CB has to raise interest rates by less than they would’ve in a closed economy to achieve the same negative output gap. This assumes rational expectations of CB and forex traders. Assumptions:

1. Perfect international capital mobility – home residents can hold domestic currency but can trade foreign bonds with the fixed nominal world (foreign) interest rate, i*, in unlimited quantities and at low transaction costs

2. Home country is too small – its behaviour cannot affect i* 3. Households can hold only two assets – bonds (foreign/home) and money (home) 4. Perfect asset substitutability – foreign and home bonds have identical default risk

and investors don’t care about portfolio composition, only difference is expected return

The 3-equation model curves in the Open Economy IS Curve

• Higher marginal propensity to import: households, firms and government spend on imports and domestic goods. Foreigners buy domestically produced goods. Because home agents spend on imports, some additional income will leak abroad and the multiplier will be lower → IS curve is steeper

• Changes in competitiveness: depreciation of real exchange rate will increase home’s competitiveness → shifts IS to the right

PC Curve

• As in closed economy, domestic inflation is used in wage-setting calculations, so imports have an impact, and there is a unique equilibrium unemployment rate

MR Curve

• CBs have the same loss function as in a closed economy and target domestic inflation rather than CPI which incorporates import prices

Uncovered Interest Parity (UIP) Condition Only difference between holding home and foreign bonds is expected return. Expected return depends on:

1. Expected different in interest rates 2. Expected development of exchange rates over same time

i – i∗ =et+1

E – et

et UIP Condition: interest gain = expected depreciation

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This equation tells that the interest gain/loss from holding the home currency = the depreciation/appreciation to offset any potential arbitrage opportunities. E.g. suppose UK (home) and US (foreign) initially have a 4% rate on bonds. Suppose the Bank of England raises interest rates to 6.5%. The interest rate rise makes UK bonds more attractive so investors sell US dollars and purchase UK pounds in order to buy bonds. The move out of dollars and into pounds increases the strength of the pound. Investors try to maximise their returns, so the UK pound will appreciate by exactly 2.5% (the change in interest rate). At the end of the year period for which the US investor holds the bond, they will have to convert their money back to US dollars. However, the pound will depreciate by 2.5% over this time period as we assume the underlying expected exchange rate is constant. Therefore, the investor loses 2.5% to this depreciation which offsets the 2.5% gain they made from holding the bond.

Fig 9.2: Arbitrage in the international bond market UIP: the exchange rate will jump so as to eliminate differences in expected returns on bonds Interest gain from holding home currency = loss from expected home currency depreciation Using approximations:

i – i∗ =et+1

E – et

et= log(et+1

E ) – log(et) UIP condition

Rewriting the UIP condition allows us to draw the UIP condition as a line with a -45° slope (because the change in interest rate must lead to the exact same change in exchange rate).

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Fig 9.3: The uncovered interest parity condition

Point A: i = i*, exchange rate expectations are fulfilled, log(e1E) = log(e0), exchange rate

does not change Point B: i1 > i*, assuming expected exchange rate remains fixed, the actual exchange rate must change from log(e0) immediately to log(e1) such that expected depreciation = interest rate differential Key features of UIP diagram:

• UIP curve has a slope of -45° and crosses [log(eE), i*]

• Change in home’s interest rate causes a movement along the curve

• For a given expected exchange rate, a change in the world interest shifts the curve

• For a given world interest rate, a change in expected exchange rate shifts the curve E.g. suppose there is a fall in the world interest rate that lasts one period but no change in home’s interest rate. The UIP curve will shift left. The economy is initially at A. The fall in world interest rate and relatively higher home interest rate creates arbitrage which leads to an appreciation of the home exchange rate (e falls). This leads to point B on the new UIP curve. At the end of the period, i* reverts to its initial level as does the exchange rate, and the UIP curve shifts back to A. If the CB in the home country were to immediately follow the interest rate move by the foreign CB, the economy would shift from A to C and the exchange rate does not change. This move would be reversed at the end of the period if the home CB followed the foreign CB’s interest rate rise.

Supply side, demand side and real exchange rates: Ch9.2.2-3 Medium-run equilibrium in the open economy and the AD-ERU model Equilibrium on the supply side occurs at constant inflation at the intersection between the WS and PS curves where wage and price setters have no incentive to change their behaviour. This pins down the equilibrium rate of unemployment (ERU).

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The ERU curve captures the supply side of the economy where inflation is constant. The demand side is represented by the aggregate demand curve, where the goods market is in equilibrium and the real interest rate equals the world real interest rate (r = r*). The medium-run equilibrium (MRE) applies to both fixed (e is chosen and maintained by government through forex buying and selling) and flexible (e is determined by forex market, i is set by CB) exchange rates. The only difference arises in how the MRE is determined. We focus here on flexible exchange rates and assume inflation is domestic. Supply-side (ERU):

Fig 9.5: Supply-side equilibrium and the ERU curve The ERU curve shows the combinations of the real exchange rate and output at which there is supply-side equilibrium. The WS and PS curves are the same as in the closed economy. y = ye(zW, zP) ERU curve zw: factors shifting the WS curve (unionisation, labour regulations, unemployment benefits) zP: factors shifting the PS curve (tax rate, labour productivity, competition) Demand-side (AD): The AD curve is derived from the IS curve. The IS curve capture that AD responds negatively to a rise in r (real interest rise) and q (depreciation), both with a one-period lag: yt = At – art-1 + bqt-1 open economy IS curve

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A includes the multiplier and demand variables such as world trade, Government spending, investment and consumption. The AD curve also incorporates the UIP condition:

i – i∗ = log(et+1E ) – log(et) UIP Condition

r – r∗ = qt+1E − qt Real UIP Condition

y = A – ar* + bq AD curve given r = r* The AD curve is derived by finding the output level for different levels of q at r*.

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Shocks

Fig 9.6: What determines the medium-run real exchange rate? Whereas in the closed economy there is a new stabilising real interest rate at MRE following a permanent demand/supply shock, in the small open economy r is set at r* so real exchange rate varies instead. Supply shock A positive supply shock (e.g. new technology) raises productivity, shifts PS up, shifting ERU to the right, causing a higher real exchange rate (depreciation to q’) and higher equilibrium output, y’e. Demand shock A positive demand shock (e.g. an investment boom) shifts the AD to the right. At the new equilibrium there is a lower real exchange rate (appreciated to q’), but the same equilibrium output, ye. Exchange Rate Regimes MRE is determined by supply side which is unaffected by exchange rates, so the MRE is independent of the exchange rate regime.

1. Flexible → e determined in forex, no intervention, CB chooses i 2. Fixed → e chosen by government who buy and sell forex to maintain the peg

et+1E = et = ePEG

Flexible: πMRE = π* Fixed: πMRE = πT In between regimes: Dirty float, pegged by adjustable, ceiling, etc. → some controls on trading

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Arbitrage is not complete → not PCM Reasons for nominal and real exchange rate deviations:

• Nominal exchange rate is volatile so the real exchange rate is too

• Relative prices/costs change significantly

The 3-equation model in the Open Economy: Ch9.2.4-5, 9.3-4 Policymaking in the Open Economy

1. Which exchange rate regime? a. Fixed b. Flexible

i. Is monetary policy available? 1. No – due to ZLB/liquidity trap: use QE or forward guidance 2. Yes – interest rate adjusts and q jumps

Difference between open and closed economies

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e.g. “The dollar rose the most against the euro in a month on speculation government reports tomorrow will show faster inflation in the U.S., underscoring the potential for the Federal Reserve to raise interest rates more than some traders had expected.”

• Higher expected inflation → US interest rates likely to remain relatively higher → people buy dollar

The 3-equation model In the closed economy:

• CB minimises its loss function (which is based on its objectives) subject to the Phillips Curve (which is a constraint from the supply side) to produce the monetary rule function, pinning down the optimal output gap, which is then implemented by setting the interest rate r using the IS equation (best response Taylor-rule)

In the open economy:

• CB minimises its loss function (which is based on its objectives)

L = (yt – ye)2 + (πt – πT)2 subject to the Phillips Curve (which is a constraint from the supply side)

πt = πt–1 + (yt – ye) to produce the optimal monetary rule function, pinning down the optimal output gap

(yt – ye) = – (πt – πT) which is then implemented by setting the interest rate r using the IS equation which now includes q) yt = At – art–1 + bqt–1 and by taking account of the reaction of forward-looking agents in the forex market (best response Taylor-rule for the open economy)

Comparing inflation shocks in the closed and open economy Because shocks will affect both the central banks and the forex market, instead of adjusting back to equilibrium along the IS curve as in the closed economy, the CB will adjust along a flatter ‘interest rate – exchange rate’ curve called RX. Smaller interest rate changes will be needed as the exchange rate channel also operates.

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Fig 9.8: Inflation shock; closed and open economies Closed Economy:

• Period 0 – economy starts at A (bliss point). Inflation shock hits, shifts PC up to PC(inflation shock) and the economy moves from A to B. B is not on the CB’s MR curve, so the CB forecasts next period’s PC(𝜋1

𝐸 = 𝜋0) such that they will be able to locate back on the MR curve at C – this PC is the same as PC(inflation shock). They therefore set interest rate r0 to affect the economy with a one-period lag. Period 0 ends with inflation π0, output ye, interest rate r0.

• Period 1 – the new, higher interest rate has come into effect, dampening investment and reducing output, moving the economy to point C. Output is now below equilibrium at y1 and inflation is at π1. The CB forecasts next period’s PC based on period 1’s inflation; PC(𝜋2

𝐸 = 𝜋1). The CB would like to locate on point D, so they set interest rate r1. Period 1 ends with inflation π1, output y1, interest rate r1.

• Period 2 and onwards – the economy moves to point D as the lower interest rate stimulates demand. This process repeats as the economy gradually moves down the MR curve, back to point Z

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Open Economy:

• Period 0 – economy starts at A and, as before, an inflation shock pushes up the PC curve. The CB determines the best response at C, on their MR curve. The forex market foresees the interest rate rise and the UIP condition implies an immediate appreciation of the home currency as a result. This allows the currency to depreciate the whole period during which there is a positive interest differential between home and foreign bonds. The CB therefore sets r0 on the RX curve (taking into account the appreciation which makes the IS curve shift to the left). Period 0 ends with inflation π0, interest rate r0, exchange rate q0.

• Period 1 – the new interest and exchange rates have had time to affect AD. Higher interest dampens investment, appreciated exchange rate reduces exports. Therefore, output falls to point C. The CB forecasts next period’s PC, on which they would like to locate at D. They set the interest rate according to this and the depreciation that will hold in every period. They set interest at r1 and exchange rate depreciates to q1. Period 1 ends with inflation π1, interest rate r1, exchange rate q1.

• Period 2 and onwards – economy moves to D as the lower interest rate and depreciated exchange rate stimulates demand. Output rises, inflation falls. IS curve shifts right towards the original point due to the depreciation, down the RX curve. This process continues until the economy is back at its original point at MRE and the interest rate equals the world interest rate.

The open economy differs in that we must now consider the real exchange rate effects, but the initial interest rate rise is smaller because of this. Also note that the IS curve shifts in each period in the open economy due to the exchange rate change associated with the interest rate change, whereas in the closed economy the interest rate change causes only a movement along the IS curve. The RX curve shows the adjustment path of a small open economy with flexible exchange rates along which the UIP condition always holds. The RX curve:

• Crosses the r* and ye intersection so shifts only when one of these changes

• Slope reflects the interest and exchange rate sensitivity of the AD curve, CB preferences and the PC slopes

o Flatter than the IS curve o The flatter the IS curve, the flatter the RX curve o The steeper the MR curve, the flatter the RX curve

Permanent Demand Shocks to the Open Economy CB reaction to a permanent demand shock:

1. Use AD-ERU model to work out new equilibrium q Permanent negative demand shock causes a leftward shift of the AD curve. It brings about a reduction of A in the IS curve, which tells the CB how much the AD curve shifts up by and shows the new real exchange rate at equilibrium, so the CB knows what interest rate to set satisfying UIP.

2. Use 3-equation model to work out CB’s response and dynamic adjustment to shock

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Fig 9.11: Dynamic adjustment to a negative permanent demand shock The above graph shows a permanent negative demand shock

• Period 0 – economy starts at A (bliss point) and is hit by a negative permanent demand shock. IS curve shifts far left, output and inflation fall to y0 and π0. Economy moves from A to B, but B is not on the CB’s MR curve. CB forecasts next period’s PC in line with current period’s inflation and the equilibrium output level, on which the CB would like to locate at C on the MR curve. At C, output is above equilibrium, so the CB reduces interest rate to stimulate investment and boost output in the next period, which the forex market foresees so there is an immediate depreciation in the real exchange rate so that it can appreciate for the rest of the period. The CB sets the interest rate at r0 to get back onto the MR curve the next period. Note that because the interest rate set is below r*, C is slightly off the AD curve as the AD curve is for r = r*. Period 0 ends with inflation at π0, output y0, interest rate r0, exchange rate q0

• Period 1 and onwards – the lower interest rate has boosted investment, the depreciated exchange rate has increased exports, so the economy moves to C. The depreciated exchange rate shifts the IS curve further right than the original IS curve. The IS curve gradually shifts left up the RX curve and the economy moves up the MR

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curve, slowly adjusting the interest rate back to r*, and the exchange rate appreciates to the new equilibrium rate, at which the economy is at MRE at Z

The label 2 shows the difference between the initial and equilibrium movements in the real exchange rate, which is real exchange rate overshooting. In the case of a supply shock, the ERU curve will shift, causing a new equilibrium real exchange rate and output level. The MR curve and PC curves also shift. The RX curve shifts to intersect the new equilibrium output level and r*. Positive Inflation Shock Following a positive inflation shock, the MPC would increase r to reduce inflation, then gradually reduce r which would result in the below graph.

Negative demand shock AD curve shifts left, IS curve shifts left, economy moves from A to B at lower output, same exchange rate. Lower output, lower inflation, movement left along PC curve to B. New PC predicted by using current level of inflation and equilibrium output, which gives optimal point on MR curve at C, requiring lower interest rate, so currency depreciates and q rises to point C off the AD curve (because interest rate is lower than r*, according to RX). The change in q shifts the IS curve. Exchange rate gradually appreciates, IS moves left and economy recovers to point Z.

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Slope of the RX

IS: y = A – ar + bq a – interest sensitivity of AD b – responsiveness of demand to real exchange rate

– slope of WS, slope of PC, sensitivity of wages to changes in employment and output

– inflation aversion Deriving the RX curve using the CB’s optimisation problem: The CB wishes to minimise their loss function,

L = (yt – ye)2 + (𝜋t – 𝜋T)2 Loss Function

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subject to

𝜋t = 𝜋t–1 + (yt – ye) Phillips Curve

→ (yt – ye) = – (𝜋t – 𝜋T) Optimal MR Function The CB chooses r knowing that yt = A – art–1 + bqt–1 and rt – r* = qE

t+1 – qt Given the real UIP condition, the greater r is set than r*, the more q must be expected to depreciate in ever period, so the greater the initial appreciation must be. The sum of the difference between the interest rates must be equal to the change in exchange rate in the same period. This gives: ∑ 𝑟𝑡 − 𝑟∗ = �� − 𝑞𝑡𝑡=0 Noting that the left hand side is a geometric series because the gap decreases every period and using the IS curve gives us:

y1 – ye = –(a + b/(1–))(r0 – r*) RX curve This formula allows r0 to be set depending on the desired point on the MR curve. The CB and forex market solve this model as they have rational expectations. The RX curve goes through ye and r* and is flatter than the IS curve because the change in the interest rate required for the same effect on output is lower because the change in exchange rate reinforces it on the RX curve. Overshooting Overshooting is where the normal and real exchange rates jump by more than the adjustment to equilibrium. For example, in an inflation shock the final equilibrium exchange rate is the same, so the initial exchange rate appreciation due to the interest rate rise is overshooting. In a permanent demand shock, the equilibrium real exchange rate depreciates if the AD curve shifts left, but in the adjustment process the change in exchange rate exceeds this. Overshooting occurs because of:

• International capital mobility (PCM)

• Rational expectations and prices which jump in the forex market

• Prices wages, output and employment adjust slowly in the goods and labour markets Thatcher recession and overshooting Thatcher announced a cut in the money supply by 10% which was intended to reduce prices by 10%. For this, due to the UIP condition, the nominal exchange rate would had to have appreciate by 10% so that the real exchange rate would not change and output would therefore not change. However, the reduction in money supply didn’t immediately reduce inflation, so there was anticipation of a high interest rate to reduce inflation. This meant the exchange rate had overshot because inflation didn’t fall the amount expected. This caused an increase in unemployment and then there was a fall in inflation. This shows us that the forex market acts quickly (causing a jump in the exchange rate) but the labour market acts slowly (as W and P fall slowly over a period).

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Exchange rate volatility The Forex market can generate shocks (bubbles, panics, etc.) which means the exchange rate can move for reasons other than changes in the equilibrium real exchange rate and overshooting following shocks. For example, following the 2011 Eurozone crisis there was a stampede into the Swiss Franc which appreciated so much that its manufacturing sector became uncompetitive. The Swiss National Bank then started buying a great deal of euros to weaken their Franc. Their credibility shifted pressure to other currencies.

Demand Side and Trade Balance in the Open Economy: 10.1, 10.2.1 The open economy accounting framework The trade balance records the difference between exports and imports: BT = X – M Trade Balance The balance of payments records the sources and uses of foreign exchange and sums to zero. It is divided into the current account and the capital and financial account: BP = (BT + net interest receipts) + (private net capital inflows – change in official forex reserves) BP = (BT + INT) + (F – ∆R) = 0 e.g. trade surplus:

• X > M → home economy increasing its wealth

• Current account surplus creates foreign exchange which must be used to either purchase foreign assets (–F) or increase foreign currency reserves (+∆R) [both of these create wealth for the home economy as assets can be used to later increase consumption]

If in a fully flexible exchange rate, ∆R = 0 as the government nor CB will intervene in the forex market.

(BT + INT) > 0 and ∆R = 0 (BT + INT) > 0 and F = 0

F < 0, purchasing foreign assets A capital account outflow Home increases wealth

∆R > 0 Foreign reserves increasing Home increases wealth

Trade surpluses and deficits can be good or bad depending on the economic context. For example, a trade deficit may be required as a fast-growing country must borrow from abroad. Similarly, a trade surplus may mean residents are lending abroad to take advantage of better, foreign investment opportunities. The demand side, trade balance and supply side Demand for imports and exports depends on relative prices (price competitiveness) measured by the Q value (the price of foreign goods expressed in home currency; [P*e]/P). Two effects of a real depreciation (higher Q):

1. Volume effect – price competitiveness improves, exports rise and imports fall, IS curve shifts right, trade balance improves

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2. Relative price effect – a given quantity of imports becomes more expensive so more will be spent on the same amount of imports, net exports fall, trade balance worsens

e.g. 10% exchange rate depreciation raises the cost of a given volume of imports by 10%. For the volume effect to outweigh this relative price effect and improve the trade balance, the boost to exports and fall in imports must add up to more than 10%. This is called the Marshall-Lerner Condition. We will assume this always holds. Key points to note on the demand side:

• Open economy IS curve is steeper because leakages cause a smaller multiplier

• Open economy IS curve shifts in response to change in Q

• BT depends on Marshall-Lerner condition holding Goods market equilibrium y = yD goods market equilibrium yD = c0 + c1(1 – t)y + I(r) + G = C + I(r) + G aggregate demand, closed economy yD = (C + I(r) + G) + X – M = (C + I(r) + G) + BT aggregate demand, open economy Assume exports are exogenous (X = X) and imports depend on output (M = my). At goods market equilibrium: y = yD = (C + I(r) + G) + X – my

y + my = c0 + c1(1 – t)y + I(r) + G + X y + my – c1(1 – t)y = c0 + I(r) + G + X y[1 + m – c1(1 – t)] = c0 + I(r) + G + X y = 1/[1 – c1(1 – t) + m] x [c0 + I(r) + G + X] goods market equilibrium (GME) open economy multiplier (k) autonomous, independent of y The open economy multiplier is the same as the closed economy multiplier but includes m. GME can be represented by showing that leakages = injections: y = 1/x [c0 + I(r) + G + X] [1 – c1(1 – t) + m]y = c0 + I(r) + G + X] Leakages = injections

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In this economy at the GME (red intersection) there is a negative trade balance (blue intersection). The trade balance at GME depends on the size of consumption, investment and government spending. Price and Cost Competitiveness Since relative prices affect net exports, we need to know how they are set in the open economy. We assume:

• Imperfect competition

• Differentiated products

• Segmented markets Two pricing rules:

1. Home-cost pricing: price of exports is based on domestic costs Px = P = (1 + c) x unit cost

Where is a mark-up

Where ULC (unit labour cost) = WN/y = W/

Px = P = (1 + ) x W/

2. World pricing: price of exports based on prices of similar products abroad Px = P*e Consider an increase in home cost only or a fall in labour productivity:

1. ULC increases → price rise → fall in price competitiveness → lower value of Q 2. Export prices wouldn’t change because these are based on foreign products so

home’s price competitiveness is unaffected, but they are not still as competitive because ULC increases → fall in home’s profit margins → fall in investment → non-price competitiveness falls

This allows an alternative way of defining the real exchange rate based on relative costs rather than prices: Relative Unit Labour Costs RULC = foreign unit labour costs expressed in home currency / home unit labour costs = (ULC*e)/ULC cost competitiveness

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Higher home costs reduce home’s competitiveness and cause RULC to fall, so:

• Rise in RULC → lower ULC, rising competitiveness, real depreciation

• Fall in RULC → higher ULC, falling competitiveness, real appreciation Just as with Q. The Law of One Price and Absolute Purchasing Power Parity Law of One Price: the common currency price of a traded good is identical in different countries Pi = Pi*e for all goods i Law of One Price (LOOP) International trade should equalise prices in different countries as long as transport costs aren’t too high, as profits can be made by transporting a good from where the price is low and selling it where the price is high. LOOP is distorted by transport costs and barriers to trade. If LOOP holds for all goods and services in the economy, Absolute Purchasing Power Parity holds (PPP): P = P*e so Q = 1. If we add a further assumption of perfect competition: P = MC = MC*e = P*e so RULC = 1, neither price nor cost competitiveness can vary. In reality, firms’ use a strategy in between home cost and world pricing. How economies react to shocks is the same under both, but the transmission varies. We do not assume LOOP or PPP. We do assume home cost pricing as this allows us to use the real exchange rate. We assume exports are charged as a mark-up on domestic labour costs.

Export price: PX = P = (1 + ) x W/ Import price: PM = P*e Export and Import Functions: note the export and import prices just above

Xnom = PX[(P*e)/P]y* = price index of exports x volume of exports. Volume of exports =

[(P*e)/P]y* = home’s share of world output (depending on price competitiveness) x world output. Divide by P to give;

X = [(P*e)/P]y*

X = (Q)y* export function Mnom = PMm(Q)y = marginal propensity to import x domestic output Dive by P to give; M = [(P*e)/P]m(Q)y M = Qm(Q)y import function

BT = X – M = (Q)y* – Qm(Q)y = volume – terms of trade x volume BT = X(Q, y*) – QM(Q, y) balance of trade Terms of Trade (ToT):

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PX/PM = P/(P*e) = 1/Q terms of trade As ToT increases (PX rises, PM falls), the terms of trade improve because a greater volume of imports can be bought for the same amount of exports. An increase in Q means a rise in the price of imports, which worsens the ToT. A rise in Q for the home economy is a:

• Rise in price competitiveness (volume effect)

• Deterioration of the ToT (relative price effect) Therefore, a real depreciation is good as it increases exports but bad as it harms the standard of living by raising prices. As long as the M-L condition holds, this will improve the balance of trade. The M-L condition states that the sum of price elasticity of demand for exports and imports must exceed one. It depends on goods being in perfect elastic supply so volume changes do not affect price. The volume effect causes a rise in BT, relative price effect (ToT effect) causes a fall in BT. We write down BT to identify which of the two effects are larger;

BT = (Q)y* – Qm(Q)y Since dToT/dQ = 1, for the BT to improve with rising Q, (i.e. dBT/dQ > 0), then the price elasticities for imports and exports must sum to greater than 1

In the short term the volume effect is minimal but the ToT works immediately due to fixed contracts for certain quantities of imports at the new exchange rate. This causes BT to worsen before it improves (J curve effect).

The BT curve is positively sloped (because of M-L condition) and flatter than AD:

y = [1/(1 – c1(1+t) + Qm(Q)] x [c0 + I(r) + G + (Q)y* Open economy IS curve

yBT = [1/(Qm(Q))] x [(Q)y*] BT curve 1/1 – c1(1+t) + Qm(Q) < 1/(Qm(Q)) An increase in Q will have a smaller effect on output on AD curve than BT curve, so BT curve is flatter. This is because some of the increase on the AD curve will go towards taxes and imports. This is comparing k, the multiplier, with the reciprocal of the marginal propensity to import; k must be smaller. Consider a unit increase in Q. If M-L holds, AD and BT are both positively sloped because net exports rise. If the new output is lower than the new trade balance, there must be a surplus (AD must be higher than BT) at the goods market equilibrium, meaning BT must be flatter than AD.

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The Supply Side and the AD-BT-ERU Model: Ch10.1.2, 10.2.2, 10.3, 10.4 UK Economy, 1992 Phase 1: unemployment was rising and inflation was falling Phase 2: UK leaves ERM (fixed European Exchange Rate Mechanism) and unemployment falls with stable inflation. CB begins to target constant inflation. How did the unemployment and inflation relationship in phase 2 occur? We can explain this using the closed economy model. The fact that there is stable inflation indicates an MRE, which implies that for falling unemployment, the equilibrium level of unemployment must have also been falling. This can be caused by supply-side effects in two ways:

• Hypothesis 1: Supply side improvement beginning with Thatcher reforms shifted the ERU curve right

Fig 10.8a: What determines the medium-run equilibrium? Positive supply shock The lagged effect of Thatcher’s supply-side reforms (reduction of union power, deregulation to encourage competition) shifts the ERU curve right (through the WS–PS curves), leading to a depreciated exchange rate, trade surplus and higher equilibrium output.

• Hypothesis 2: Positive AD shocks shifted the AD curve right, down the ERU

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Fig 10.8b: What determines the medium-run equilibrium? Positive demand shock The AD curve shifts down the sloped ERU curve, resulting in higher output, depreciation and a trade deficit. The BT curve in these diagrams is flatter than the AD curve because:

• A real depreciation boosts net exports (M-L condition) and raises AD. If the economy is initially in trade balance, a depreciation will therefore result in a trade surplus, which requires AD to be above BT, so the BT curve must be flatter

• The multiplier is less than the reciprocal of the marginal propensity to import. This means the multiplier process will not drive output up by enough to lead to increased imports equal to the boost to net exports due to the depreciation because only a proportion of any increase in output is spent on imported goods

The downward sloping ERU curve This new ERU curve means there is a range of equilibrium unemployment rates in the open economy. The ERU curve comes from the labour market and the way in which the PS and WS curves interact. Because workers buy both domestic and foreign goods, the price level relevant in calculating real wage is nominal wage in terms of CPI (PC). We assume foreign goods cost P*e and domestic goods cost P. The imported share of the consumption bundle is ∅. w = W/PC real wage PC = (1–∅)P + ∅P*e consumer price index (CPI) The WS curve is defined in terms of this new real wage. It is upward sloping just as in the closed economy – as employment rises so does real wage. The WS curve shows the real wage employers must pay at a given level of employment to get workers to exert effort in the efficiency wage model. The same factors as in the closed economy shift this.

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The PS curve must now be defined in terms of the real consumption wage. It becomes dependent on the real exchange rate. The PS curve shows the real wage workers get after firms have set prices, P. Consider a depreciation of the real exchange rate, q, through the nominal exchange rate, e: this increases the real cost of imports (doesn’t affect domestic goods), increasing PC, reducing the real consumption wage, so the PS curve shifts down to indicate a lower real wage. Graphically:

Fig 10.6: The AD-BT-ERU model Algebraically:

P = PX = = (1 + ) x W/ price of home (and exported) goods = mark-up x unit cost PC = (1 – ∅)P + ∅P*e CPI

• Sub P into PC

PC = (1 – ∅)(1 + ) x W/ + ∅P*e

• Divide by P = (1 + ) x W/

PC/[(1 + )W] = (1 – ∅) + (∅P*e)/P

• Use w=W/PC and Q = (P*e)/P

/[(1 + )w] = (1 – ∅) + ∅Q

• Invert

[(1 + )w]/ = 1/[(1 – ∅) + ∅Q]

• Use the approximation 1/(1 + ) = 1 –

w/[(1 – )] = 1/[(1 – ∅) + ∅Q]

• Rearrange so price-setting real wage is on LHS

w = [(1 – )]/[1 + ∅(Q – 1)] PS, price-setting real wage equation The ERU curve is traced by where wWS = wPS

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The wage-setting curve is defined by wWS = B(y, zW), which is upward sloping. So the ERU curve is:

B(y, zW) = [(1 – )]/[1 + ∅(Q – 1)] ERU curve

Note that the PS curve reverts to the closed economy equation [wPS = (1 – )] if there are no imported goods (∅ = 1) or prices of foreign and home goods are identical (Q = 1). If inflation is not on the ERU, it is not constant and there is a bargaining gap between wage on WS and PS, so we use PC curves. Left of ERU is downwards pressure on inflation, right of the ERU is upwards. Analysing the UK Economy (1992) using the AD-BT-ERU model Hypothesis 1: supply-side

10.13a: Hypothesis for the UK’s shift to lower unemployment without inflationary problems; supply-side reforms shift ERU Supply shock shifts the ERU curve right. The economy is to the left of the new ERU curve at A, causing downward pressure on inflation so the CB adopts loose monetary policy (r < r*). The lower interest rate causes a depreciation of q (q rises) to B, off the AD curve (to the right because r < r*). The CB gradually pushes the interest rate back up to r* and the exchange rate appreciates in line with the UIP condition. End result: BT improves, real depreciation, lower unemployment. Hypothesis 2: positive AD shock

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10.13b: Hypothesis for the UK’s shift to lower unemployment without inflationary problems; demand shock shifts AD Under a flexible exchange rate, a positive demand shock would boost output and inflation (A→B). The CB would respond by raising the interest rate and the exchange rate would appreciate (B→C). C is off the AD curve as r > r*. The combined appreciation and rise in interest rate lowers output. Once inflation falls, the CB lowers the interest rate and the exchange rate depreciates according to the real UIP condition, so we move from C to Z. At point Z there is an appreciated exchange rate and trade deficit. Combining these hypotheses provide an explanation for the growth of the UK economy post-reform up until the GFC:

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Fig 10.14: UK from 1997, synthetic hypothesis Medium and Long Run Equilibrium At MRE the economy does not have to be on the BT curve (it can be in surplus, balance or deficit). At LRE, economic and political forces drive the economy towards a trade balance.

If the economy begins at A which is the MRE, it is expected that the real exchange rate will depreciate to move to B, trade balance. The CB will react by raising interest rates, thus moving from B to C and gradually dropping them to get back to the MRE at A. The LRE is Z, which requires the AD curve to shift left such that a trade balance occurs along the ERU curve. This shows the importance of exchange rate expectations in pinning down equilibria.

Oil Shocks: Ch11.1.1-2, 11.2.1-2, 10.1.1 Historic Oil Shocks (price rises)

1. 1973 OPEC I: high inflation, high unemployment (stagflation)

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2. 1979 OPEC II: high disinflation, high unemployment 3. 2002 – 2008: low inflation, low unemployment

The 2002 shock was less damaging because:

• Previously, shocks had been analysed as a negative AD shocks rather than a supply-side shock

• New monetary policy targeted inflation, anchoring expected inflation and preventing the PC curve shifting up

• Labour market reforms had weakened unions which limited the supply-side consequences of the shock by weakening real-wage resistance

An oil shock is a deterioration in home’s terms of trade (ToT = PX/PM) due to the increase in the price of raw materials (PRM) and has the following effects;

1. AD shock and external trade shock Rise in PM → rise in spending on imports (M) as oil is a necessity → fall in net exports (X–M) → fall in AD and BT

Fig 11.1: The external trade effects of a rise in the price of oil

2. External supply shock Rise in PM → fall in real wage (W/PC) → PS curve shifts down → ERU curve shifts left

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Fig 11.2: A negative supply shock; an increase in the oil price shifts the ERU curve to the left Following an oil shock, the AD curve shifts left as the cost of imports rises and the ERU curve shifts left because of the fall in the PS curve. BT curve must also shift left such that trade balance occurs at the same output (shown by A’). We move from A to B due to the oil shock affecting AD, so output and employment falls. Pre-2000s, the supply-side shock (ERU shift) was not accounted for so ye was sought as the target. Interest rates were dropped, demand rose (due to M-L condition) and output rose back to the mistaken target. Since the resulting point was right of the ERU, there was upward pressure on inflation which caused a rise in q to qbar’:

Impact on demand side

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Defining external ToT between raw materials and manufactured goods assuming all imports are raw materials so that PM is the price of raw materials:

PM = (P*RM/P*MF) x P*e = P*e

Where = (P*RM/P*MF) World price of oil Q = (P*MFe)/PMF = (P*e)/P

PX/PM = P/(P*e) = 1/(Q) Home’s ToT

M = (PM/P) x M(Q, y) = (P*e)/P x M(Q, y) = Q x M(Q, y) M = ToT x volume effect (where the imports of raw materials is very inelastic)

X – M = X(Q, y*) – QM(Q, y) Net exports

A rise in (world price of oil) increases the import bill due to the inelasticity, increasing M, depressing net export demand. Impact on supply side

Pc = P + vP*e V = oil units / y (unit materials requirement of output – fixed in short run)

WPS = [(1 – )] / [1 + vQ] PS curve

A rise in therefore reduces the price-setting real wage.

Fig 11.7: A negative supply shock: an increase in the price of oil shifts the ERU curve left

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The above diagram shows the Terms of Trade effect where 1 > 0.

• ERU shifts left when rises if workers seeks compensation in rising W for cuts in real wages due to higher oil prices (real wage resistance)

• We have W/PC on the vertical axis on the WS/PS diagram, so have to take into account ToT effect

1973 Oil Shock

• Flexible exchange rates • No inflation targeting

AD shifts left due to higher import costs. BT curve shifts left due to the ToT effect where the intersection with AD’ is vertically above the old equilibrium. ERU curve shifts left due to the fall in the PS. Policy focussed on offsetting negative AD effects → loose monetary policy

• At B, interest rates were dropped → depreciation of real exchange rate (rise in q) → B to A’ (off the AD curve slightly as r<r*)

• A’ is to the right of the ERU curve → rising inflation as workers’ real wage expectations are not being met (positive bargaining gap) → appreciation of the real exchange rate via Q = P*e/P → movement leftwards down the AD curve as net exports fall towards new MRE Z

• Because getting to the new MRE (where there was higher unemployment) required higher inflation to reduce demand, there was stagflation. Policies such as compensating workers for the rising cost of living (real wage resistance) exacerbated the stagflation because firms sought to protect their profit margins so the wage-price spiral continued

1979 Oil Shock

• Flexible exchange rates • Tight monetary policy to prevent exchange rate depreciation and thus inflation

o Allow unemployment to rise as necessary to keep inflation down o No change in interest rates, so unemployment was kept high to bring

inflation down by a negative bargaining gap 2002 – 2008 Oil Shock

• Inflation targeting monetary policy o CB would not allow a depreciation/inflation spiral o Helped anchor inflation expectations

• Impact of higher import costs offset by increased households access to credit so AD shifted left by less (PIH; constant income path could be executed as banks were more keen to lend)

• Flexible labour markets meant less real wage resistance, made it harder for nominal wages to rise (downward shift of WS with PS), meant ERU curve didn’t shift as far left

Open economy accounting From before: BP = current account + capital account = 0

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= [BT + INT] + [F – R] = 0 Current account surplus → capital account deficit Current account deficit → capital account surplus BP must by definition be 0. We care about the current account because wealth is changing. Because the BP must sum to 0,

If BT + INT + F < 0 → R > 0

If BT + INT + F > 0 → R < 0 this can be a problem as forex reserves may run out

Intertemporal approach to current account – how countries can smooth consumption Assumptions

1. Perfect international capital mobility 2. Domestic consumption determined by PIH

ICA: intertemporal current account – represents the CA as a forward-looking function of income and asset returns:

CAt = − ∑(1

1+r∗)i∆yt+i

E

y = aggregate household net income, including net income from abroad CA = BT + INT = X – M + INT X – M = y – C – I – G so, CA = y + INT – C – G = y – C where y = y + INT – I – G The cumulative past CA balances is defined as the net foreign asset (NFA) position Scenarios:

1. Temporary negative exogenous shock to exports → unexpected fall in y → expectation of future income is higher than current income

CA deficit reflects optimal borrowing at world interest rate, r*, to smooth consumption against adverse income shock (borrow now to maintain consumption). The borrowing gets repaid in the future as the country runs a series of small CA surpluses (NFA returns to 0) If the fall in exports is permanent, current consumption should be reduced.

2. Country discovers natural resources → raises its wealth and permanent income → country can borrow before extraction to smooth consumption

Current consumption rises due to expectation of higher future wealth. Domestic investment increases to enable extraction. Nominal and real exchange rates appreciate because FOREX market anticipates the real exchange rate that will balance the current account will be an appreciated one. The discovery is a positive external trade shock. Following the discovery, the country will have a current account deficit which will improve once revenue from the resource extraction begins to flow. It will eventually move to a small surplus which continues until the country has repaid the debt built up during the initial phase.

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Fig 11.10: Resource windfall and the current account Pressure on Current Account Imbalances:

1. Consumption effects of changes in wealth Changes in lifetime wealth can result in changes in consumption in the current period, e.g. consumers in a country with a persistent trade deficit may feel that tightening will be required in the future to repay the debt. This could lead to adjustment down of expected permanent income which would shift AD to the left and move economy back to the long-run equilibrium.

2. Willingness of financial markets to fund deficits If lenders see trade deficit as high home consumption or wasteful investment then funding from abroad will stop. The assumption of perfect international capital mobility then breaks down which will dampen private investment and force the government to tighten demand policy to reduce the deficit.

3. Exchange rate expectations In the fixed exchange rate case, the peg cannot forever be defended as foreign reserves are limited and borrowing to supplement may be difficult. Eventually, a currency crisis happens causing devaluation and fiscal tightening moving the economy back towards trade balance. In the flexible exchange rate case, if we assume expected exchange rate is influenced by trade balance, inflation targeting is undermined as seen in the diagram. A trade deficit becomes destabilising because the exchange rate will depreciate from MRE along the AD curve to the BT curve. This means being to the right of the ERU curve which causes inflationary pressure and home becomes less competitive, implying a real appreciation. The

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economy then moves back down to the MRE at C and the process repeats (exchange rate is unanchored). There would need to be a contractionary fiscal policy to shift AD left.

Fig 11.11: Medium-run equilibrium at C (trade deficit) is disturbed by exchange rate depreciation

4. Political pressures Common in surplus countries where population urges the government to boost activity and operate at lower unemployment.

External Imbalances: Ch11.1.2-4, 11.2.3-5, 11.3 Sector Financial Balances The goods market equilibrium can be arranged to show the balances of different financial sectors:

• Private (private savings net of investment expenditure)

• Government (taxation net of government expenditure)

• Trade balance (external financial balance = net investment abroad) y = yD = C + I + G + X – M C + I + G = X – M (S – I(r*)) + (T – G) = X – M (s1ydisp – c0 – I(r*)) + (ty – G) = X – M where ydisp = (1 – t)y (private sector financial balance) + (government financial balance) = BT e.g. US: 1980 – 2017

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There is nothing causal in the financial balances. Section 1: Dotcom boom and bust in US BOOM – 1995

• High I from private sector due to tech boom → private sector balance falls

• Clinton uses private sector boom to consolidate public finances → government budget balance rises

• Some of the private sector boom is financed from abroad, so net investment abroad falls → current account balance falls

BUST – 2000

• Bubble bursts, I falls → private sector balance rises

• Recession, automatic stabilisers mean T falls and G rises → government budget balance falls

• Recession, M falls → current account balance rises

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Section 2: Bush Push – taxes cut, wars + housing boom then bust BOOM – 2004, in consumption and housing, financed by credit

• Boom financed by credit, so is a private sector boom → private sector surplus falls

• Bush cuts taxes and increases military spending → government budget balance increases (but not as much as under Clinton)

• Deficits financed from abroad → current account balance falls

TRIPLE DEFICIT – deficit in all three sectors BUST – 2006, Global Financial Crisis

• C falls (S rises), I falls → private sector balance rises

• G rises, T falls → government budget balance falls

• Recession, M falls → current account balance rises Twin Deficits

• In goods market equilibrium, assume a balance in all financial sectors

• A rise in G shifts AD right → higher output → increased imports → BT deficit

• A rise in G → fall in government budget balance → fiscal deficit

• So, higher G → fiscal and trade deficit – twin deficit 2-bloc model with inflation-targeting central banks Assumptions

• Only 2 trade blocs in the whole world

• Vertical ERU curves, same ye in both blocs

• In AD curve, a = b = 1 Note that a depreciation in bloc A = an appreciation in bloc B MRE: AD = ERU, r = r*, q = q ye = AA – r* + q (bloc A) ye = AB – r* – q (bloc B) q is positive in A and negative in B q = log(PBe/PA) where e = $A/$B Assume AA > AB (autonomous demand is higher in bloc A) By equating the right hand side of the two AD equations above: AA – r* + q = AB – r* – q q = (AB – AA)/2 < 0

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The role of q: When demand in bloc A increases, the real exchange rate appreciates because q < 0. In order for world output to stay constant, there must be an equalising effect in bloc B so their exchange rate must depreciate. Bloc A’s trade deficit will be equal to bloc B’s trade surplus at the new MRE following an AD shock in bloc A. So, changes in the real exchange rate between blocs ensures that in each bloc, AD is at equilibrium and inflation is constant. If AA = AB, q = log(Q) = 0 → real exchange rate Q = 1 and common currency prices are identical in each bloc → trade is balanced. The role of r*: The world interest rate adjusts so that in both blocs demand is consistent with output at equilibrium; AA + AB = 2ye AA – r* + q* + AB – r* – q = 2ye

AA + AB – 2r* = 2ye 2r* = AA + AB – 2ye

r* = (AA + AB)/2 – ye

This shows that world real interest rate adjusts to ensure a constant inflation equilibrium for the world as a result of central banks in both blocs adjusting the rate to guide inflation back to target. Permanent Demand Shock in Bloc A We begin with a symmetric equilibrium:

Fig 11.14a: The 2-two bloc model with a symmetric equilibrium (AA = AB) We assume a marginal propensity to import of 0 (changes in demand of one bloc do not affect imports from the other bloc). The three actors in this set up are the CB’s of the two blocs and the forex market.

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Fig 11.14a: The 2-two bloc model with a symmetric equilibrium (AA’ > AB) Assume a positive permanent demand shock in bloc A in period 0 which pushes up output and inflation. A’s CB responds to get the economy on the path back to target inflation so raises its interest rate to dampen activity. This is accompanied by an appreciation of the real exchange rate. In period 1, bloc A is on the MR curve on the path back to target inflation. Bloc B’s CB observes the shock in period 0 and knows that there will be an appreciated real exchange rate in A, which means a depreciated real exchange rate for B. Unless the CB in bloc B raises its interest rate to offset the depreciation effect on AD, bloc B’s inflation will rise. So to maintain equilibrium inflation, bloc B’s CB raises their interest rate. Period 0 – both economies start at bliss point A. An AD shock moves block A to point B with

output y0 and inflation 0. The CB forecasts their Phillips curve in the next period based on

ye and 0. To get on the MR curve on point C, (off the AD curve) they need to raise their interest rate to r0

A. In bloc B, the CB note that bloc A’s actions will lead to an appreciation in A’s currency, meaning a depreciation in B’s. To counter this effect and keep the economy at its bliss point, the CB of bloc B must raise interest rates to r0

B (which is slightly lower than A’s new interest rate). The interest rate change is the exact amount to offset the boost in output that would arise from depreciation. As there is no pressure on inflation, the PC stays the same. Period 1 and onwards – the new interest rates and exchange rates have taken effect and both blocs move to point C. In bloc A, the economy adjusts along the RX curve to Z by reducing the interest rate, taking into account depreciation as the UIP condition holds. In bloc B, the CB slowly reduces the interest rate until the economy is at Z. The new MRE as the same output by higher world interest rate. Each period sees bloc B remain at bliss point. All they have to do is adjust interest rate each period to offset the real exchange rate affects arising from bloc A’s adjustment path.

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Fig 11.16: The 2-two bloc model: the IS-RX and PC-MR diagrams for bloc A and bloc B using the example of a permanent positive demand shock in bloc A

Fig 11.15: The 2-two bloc model: the AD-ERU diagrams for bloc A and bloc B using the example of a permanent positive demand shock in bloc A

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Global real interest rates and account imbalances:

• +ve demand shock in bloc A only → r* rises, A’s BT < 0, B’s BT > 0

• +ve demand shock in bloc A, -ve demand shock in bloc B → r* unchanged, A’s BT < 0, B’s BT > 0

• +ve demand shock of equal size in blocs A and B → r* rises, BTA = BTB = 0

Economics of a Common Currency Area: Ch12.1-4 Microeconomic benefits:

• Monetary integration → eliminates forex risk (UIP condition: interest rate differentials = sum of forex risk and default risk)

o higher trade and investment o companies don’t need to operate in two countries to hedge this risk. Instead

they can pick the best location and reap economies of scale

• Currency doesn’t need to be converted → lower transaction costs

• Greater ease of price and wage comparisons → increased competition in labour and goods markets → static and dynamic efficiency gains

• Increased liquidity of financial markets which particularly benefits small countries Cost of joining a CCA: policy maker no longer able to use monetary policy to adjust to country-specific shocks. The more integrated a country is in a CCA, the lower this cost. Factors which affect integration and how quickly country-specific shocks can be stabilised against without domestic monetary policy include:

• Degree of wage and price flexibility – more flexibility → lower wage or price growth → increased competitiveness → net exports boost

• Labour mobility – more integration → more mobility which can substitute for exchange rate instrument

• Size of fiscal transfers – the bigger the central tax and transfer system, the more automatic stabilisation there is for country-specific shocks

Macroeconomic benefits:

• Reduced exchange rate volatility and no exchange rate overshooting in adjustment

• Provides a credible, low inflation monetary policy regime to countries who would not be able to successfully establish one themselves

• Other countries in CCA can’t competitively devalue Eurozone (‘98-‘08):

• Close to target inflation as a whole with most countries at a small positive output gap

• Greece, Spain, Ireland, Portugal all had much higher than average inflation rates and output gaps though whilst Germany had a negative output gap, showing how each individual country performance was diverse

• Nominal exchange rate was fixed but real exchange rate (in terms of relative unit labour costs, i.e. competitiveness) and inflation rate diverged – reflected in build-up of current account imbalances (Spain/Italy, large deficit. Germany, large surplus). A

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CCA country with higher than average inflation has a lower real interest rate which may reinforce rather than offset shocks

• Real exchange rate movements also affect net exports and trade balance, that country’s indebtedness (if CA is in deficit), and eventually their terms of borrowing (bond yield). Real exchange rate appreciation reversed by slower nominal wage growth and faster productivity growth than the union average

Fixed exchange rate regime If we assume no fiscal policy under a fixed exchange rate, the MRE is independent of the exchange rate regime. Important equations:

1) Fisher equation: r = i – πE 2) ∆Q/Q = ∆P*/P =∆P/P + ∆e/e = π* – π

∆e/e = 0 3) IS and AD curves

Country-specific negative AD shock: AD shifts left, economy goes from A to B. Output is below equilibrium so inflation falls below π*. The economy moves to the dot (left of AD curve). Economy is left of ERU so there is deflationary pressure and prices increase less each period relative to π*. Implies increasing Q → increasing (X–M) → increasing y → economy moves back to ye.

Whereas under flexible exchange rates e can jump using a nominal interest rate change, the adjustment process here is much slower as it relies on wage-setting rounds. Eurozone Policy Regime Maastricht Policy

• Monetary policy: European Central Bank (responsible for responding to Eurozone-wide shocks and delivering low/stable inflation through monetary policy)

• Fiscal policy: national government (responsible for fiscal sustainability and stabilising against country-specific shocks s.t. Stability and Growth Pact [prevented policies which would threaten ECB’s inflation objective]; budget deficit < 3%, national debt < 60% GDP)

• Lisbon Strategy (2000-2010): supported supply-side reforms, aiming to make the EU the most competitive and dynamic knowledge-based economy in the world

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Monetary Policy

• ECB is single monetary policy maker for all of Eurozone

• ECB is politically independent of governments, more so than Fed or BoE

• Inflation target is close to but below 2% achieved via interest rate (means they’re more vulnerable to deflation)

• Growth of money supply target is 4.5%

• ECB delivered lower inflation bias than some members could’ve achieved alone due to credibility

Fiscal Policy

• Fears of spill overs from national policy decisions to the Eurozone → SGP o A country may run a deficit to boost AD, move down the sloping ERU curve

and reduce unemployment. But if all countries did this, the rightward shift in the IS curve for the Eurozone would increase inflation and ECB would have to raise interest

o Once default risk rises in one country, this can happen to other members Stabilisation in the Eurozone Common Shocks:

• Eurozone has a freely floating exchange rate with rest of world, but fixed between members

• Therefore, adjustment is same as in a country with flexible exchange rate

• MRE: r = rrow Country-Specific Shocks:

• Real exchange rate channel (RER) o Members have no control over nominal interest/exchange rates o E.g. inflation rate rise

As nominal exchange rates are fixed, an inflation rise causes the real interest rate to appreciate which reduces competitiveness which dampens net exports and the economy returns to equilibrium without policy. Assume πE = πT so interest rate is always at r*. ∆q = πT – π yt = At – art-1 + qt-1 π increases → q falls → y decreases → π falls until π < πT, after which q increases → y increases until πT = π

• Real interest rate channel (RIR) o When a member’s inflation is above the Eurozone average, expected inflation

in that economy may rises → real interest rate falls → boosts output → additional upwards pressure on inflation. Under such circumstances, government must intervene via fiscal policy to restore equilibrium

Assume IS curve does not shift with a change in RER. π increases → πE increases → r falls → y increases → π increases and repeats

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Fig 12.7: Inflation shock; the real exchange rate and real interest rate channels Fiscal policy may be needed to stabilise because:

• Sluggish wage and price adjustment → RER slow and costly in terms of unemployment

• RIR effect > RER effect → instability The government minimises the loss function subject to the PC:

Lt = (y – ye)2 + (π – π*)2 Loss function

πt = πt-1 + (y – ye) Phillips Curve

PR = yt – ye = – (πt – πT) Policy Rule E.g. inflation shock

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Fig 12.8: Inflation shock; comparison between the use of monetary policy (a flexible exchange rate economy) and fiscal policy (CCA member) In a CCA, the government will tighten fiscal policy while taking into account the higher πE → lower r and higher π → lower q. It will have spending G’ < G. The government will then increase spending to get equilibrium back to output. Inflation is still above π* so q is still appreciating but r is increasing as π is decreasing. When the economy returns to equilibrium, r = r* but q is more appreciated than q meaning net exports are lower and as demand must be sufficient for ye, and G’’ > G. Fiscal policy is difficult to use because it is more political (parliament, lag) and can cause twin deficits (G is greater than before and net exports fall due to appreciated q).

Crises, macroeconomic models and policy regimes: Ch12.5-6, 7 Eurozone governance, sovereign risk and the banking system CCA members are vulnerable to sovereign (government) debt crises. A member’s interest rate will exceed the CCA rate to the extent that its nominal exchange rate is expected to depreciate and its risk of default on government debt exceeds that of the benchmark CCA government. The difference between bonds in different CCA countries reflects only the difference in default risk as the exchange rate risk is zero. Default risk disappeared when the Eurozone was created because everyone believed there was no risk of default and there would be a bailout if one was threatened (even though there was a no bail-out clause).

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Following the GFC, the markets began to differentiate between bonds issued by different members due to lost confidence in a bail-out. Government arrangements Central Bank is lender of last resort (LOLR) to the government so can mitigate fear of government debt default as money can be printed to buy government bonds → increased demand for bonds → increased bond prices → lower risk premiums. In the Eurozone the ECB was not a LOLR to governments under the Maastricht Agreement. The ECB was LOLR to the banking system to prevent a run on the banks, however. But once the GFC began, national governments had to borrow to pay to recapitalise their country’s banks. National governments were responsible for solvency but the ECB was responsible for liquidity and was a LOLR to these banks. This meant the burden on governments increased, but they could not rely on the central bank unlike countries outside of the Eurozone. This created the fear of illiquidity of the government so interest rates on their bonds increased. This creates a negative feedback loop (which can only be disrupted by a LOLR). The ECB supported the European banking system during the GFC and sovereign debt crisis. 1st Banking crisis → fiscal crisis Countries had to deal with bank solvency on their own which led to the sovereign debt problem as

• these banks were so large compared to their own countries

• cross-border banks meant multiple governments were responsible for dealing with solvency issues

2nd Feedback: fiscal crisis In the Eurozone, banks are major holders of government bonds compared to outside the EZ which added vulnerability to the system, which exacerbated the crisis. Compared to the US, if a large state defaults it is a small shock to US GDP. But if a large EZ state defaults, it is a much larger shock. Governance solutions Government to government: the bail-outs and the Fiscal Compact During the GFC, Greece, Ireland and Portugal were all bailed out and forced to pursue austerity policies. Thus the Fiscal Compact was introduced to prevent another taxpayer bailout. It provides a timetable for reducing debt and balancing the budget. This balanced budget rule could destabilise EZ countries where the real exchange rate channel does not operate well as it requires discretionary fiscal policy in economic downturns. Many things made the Compact’s credibility questionable: countries were bailed out, the Stability and Growth Pact failed, lack of a legitimate enforcement mechanism, high levels of government debt. Recent proposals include to create a euro-area fund to stabilise large shocks but with incentives to minimise drawing from it and create euro-bonds from a portfolio of national bonds. Fiscal union proposes to centralise fiscal policy with automatic stabilisers.

46

The ECB to government: establishing a LOLR 2012: Draghi stated the ECB would do “whatever it takes to preserve the euro” and the ECB announced the Outright Monetary Transactions programmed which promised to buy bonds on secondary markets until pressure in the bond markets eased off. Bond yields fell after this even though OMT was not used because the separation between the ECB and member governments had been removed, i.e. ECB became LOLR to governments. Banks to governments: the banking union The interconnectedness of banks and governments played a significant role in the sovereign debt crisis. A banking union would mean members are jointly responsible for EZ bank solvency – Single Resolution Mechanism. This union requires banking reform:

• well-capitalised and safely structured banks

• measures to break the doom loop by incentivising banks to diversify away from holding government bonds as assets

• creating a European deposit insurance system Where will this growth come from? If the government sector moves towards a surplus, for growth not to fall then one of the following must occur:

• Private sector: expenditure and investment rise

• External sector: net exports rise (competitiveness issues, RER) The 3 Global Economic Crises

1. Great Depression – aggregate demand based a. Mistakenly employed contractionary monetary/fiscal policy and increased

global protectionism b. Led to Keynes’ general theory c. Weakness of economy’s self-stabilising mechanisms meant stabilisation

policy was necessary. New policy regime i. National: demand management

ii. International: Bretton Woods d. Led to two decades of growth and stability (the golden age)

2. Stagflation – inflation based a. Low unemployment and increased economic security via the welfare state

increased labour’s bargaining power through strikes. By late 1960s, wages were pushed up, profits were squeezed, equilibrium unemployment was higher, exacerbated by weakened productivity growth and followed by oil/commodity shocks in the 1970s

b. Supply-side effects on unemployment were neglected and policy was used to sustain AD, so were unprepared for inflationary shocks

c. From this came the new classical assumptions of perfect competition, rational expectations, flexible prices and Real Business Cycle models (used to describe growth, cycles and technology shocks, but doesn’t explain persistence inflation and unemployment costs of disinflation) → New Keynesian model which combines RBC methods with sticky prices and wages

d. Policy following the great stagflation: i. Inflation targeting CBs

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ii. Flexible exchange rates and capital mobility e. Led to two decades of growth and stability (the great moderation)

3. Global Financial Crisis – private debt based a. Low unemployment but wage squeezing, financial liberalisation,

interdependent global growth patterns (through exports and finance) b. Problems for prevailing paradigm:

i. Success of inflation targeting reduced macro risk and fuelled leverage cycle (expansion of household and bank debt)

ii. Policy inattention and the view that aggregate risk had fallen fuelled more borrowing

iii. Reliance on sub-prime lending to sustain AD What keeps the post-GFC IS curve depressed at the global level?

• Depressing investment o S-side: falling innovation potential, slowing labour force growth o D-side: coordination problem of low AD

• Raising savings: o S-side: ageing populations, increasing inequality, rising risk aversion

Eurozone – essay questions Questions

1. “Although the ECB performed well in its first decade, the inflation performance of member

countries has been linked to the Eurozone crisis."

a. Discuss.

i. Briefly discuss the ECB's performance in the context of a model of an inflation targeting central bank.

ii. Explain how joining a CCA can be attractive to a country that finds it

difficult to establish credible inflation targeting.

iii. Explain how a member country's inflation rate can diverge from the CCA's

inflation target.

iv. Discuss the role of country-level inflation behaviour as a factor behind the

Eurozone crisis.

b. Draw conclusions for the future of the Eurozone

2. What conclusions do you draw from the Eurozone's sovereign debt crisis for the design of a successful CCA? Although you do not have to restrict your answer to these points, you are

advised to include the following elements:

a. A brief explanation of the sovereign debt crisis in the Eurozone in which you make

reference to the uncovered interest parity condition.

b. A discussion of the relationships among the central bank, government(s) and banks in

a country inside and outside a common currency area.

3. “The Eurozone crisis was the outcome of a lack of fiscal discipline on the part of member

governments.” Evaluate this statement. Explain

a. the role of public and private debt accumulation in the years preceding the Eurozone

crisis

b. the role that fiscal policy can play as a stabilization tool for a member of a common

currency area.

4. “For a country to thrive in a common currency area, it either needs to be very similar to the other members or to have institutions that enable wages and prices to respond rapidly to

country-specific shocks.” Use economic models to explain the logic of this claim and to

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critically evaluate its value as a guide to the decision of a country to join. In the course of

your answer, you should explain

a. what a common currency area is and how responsibility for different macroeconomic

policies is assigned

b. how membership affects the response of a country to a shock

c. the relevance of wage and price adjustment to the benefits of membership

d. important omissions in the statement that affect a country's ability to thrive in a common currency area

e. how examples from the Eurozone shed light on the statement.

Information • CCA: a group of countries which cede independent control of monetary policy to an

independent supranational body (e.g., the ECB). They share the same nominal currency but may have different real currency values. The ECB uses monetary policy to affect AD which influences the exchange rate via the UIP condition

• ECB targets o inflation close to but below 2% o growth of money supply of 4.5%

• Microeconomic benefits of joining the Eurozone: (TEFF) o Transaction costs: no exchange rate transaction costs → wasting less economic

resources which could be used for consumption and investment o Economies of scale: the ability to achieve significant cross border economies of scale o Flexibility: greater wage and price flexibility due to ease of job comparison and a

larger number of firms competing for labour o Free movement: free movement of capital → greater financial market liquidity

• Macroeconomic benefits (DIVC) o Devaluation: Germany was also willing to join the Eurozone to stop competitive

devaluation by the Italian and French which negatively affected its automotive industry

o Instability: elimination of exchange rate instability → more efficient investment planning → boosts growth and productivity

o Volatility: less exchange rate volatility (think Swiss Franc) o Credibility: countries such as Greece and Italy who had soaring inflation during the

90s were able to anchor inflation expectations and reduce volatility in it due to the ECB taking on many of the features of the very credible German Bundesbank which had a pedigree of successful inflation and monetary targeting

• Cost of joining o Sovereigns lost control of monetary policy as this was delegated to the supranational

ECB which only responds to symmetric shocks which affect the whole Eurozone → asymmetric, country-specific shocks can only be countered with fiscal policy (which may have spill-over effects onto other countries so is restricted) or through the real exchange rate channel of stabilisation

▪ Higher integration reduces the effect of these shocks

• Wage and price flexibility substitutes for flexible exchange rate so helps RER (occurs more in North than South)

• Mobile labour dampens shocks (unlikely due to barriers)

• Bigger transfer system creates more automatic stabilisers (but EU budget is small)

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• SGP: sovereigns retain control of fiscal policy but are subject to limits of 3% deficit and 60% debt:GDP ratio. Periphery countries didn’t adhere to this and prospered through large public and private sector debt which fuelled consumption and house price bubbles

o This was intended to prevent countries running large deficits to lower unemployment, as it would raise EZ inflation if they all did

o Once the risk of default rises, contagion can occur to other members

• Maastricht treaty: o Stipulated convergence criteria for members to ensure new entrants to the bloc were

economically similar. However Greece joined in 2001 with inflation above average o Stated responsibility of ECB for low and stable inflation and national governments for

fiscal sustainability and asymmetric shock stabilisation o Stated governments could not bail out other governments and ECB was not LOLR to

governments o Governments dealt with bank insolvency (assets worth less than liabilities) and ECB was

LOLR for bank liquidity (bank can’t afford to cover its due liabilities)

• Lisbon strategy: aimed to make the EU the world’s most competitive dynamic knowledge-based economy by supporting supply-side policies

• What happened in the Eurozone? o First 10 years: significant sector imbalances between countries → average inflation

close to the 2% target o Periphery countries prospered because core countries (predominantly Germany)

funded their consumption and triple deficits through exercising wage restraint and wage coordination and lending

o Greece ▪ Rising unemployment benefits ▪ Falling retirement age → rising pension payments ▪ Rising real wages ▪ Union power → nominal rigidity

o Periphery countries (Portugal, Ireland, Greece, Spain, Italy) initially prospered due to loss of competitiveness

o Fuelled by ▪ large positive output gaps ▪ rising inflation ▪ similarity to Germany in financial markets

o Funded through ▪ cheap credit ▪ low bond yields: PAS held in EZ until 2011 sovereign debt crisis. Greek

government bonds were viewed to be as safe as German government bonds because

• currency risk was eliminated

• no bail out clause in the Eurozone was perceived incredible ▪ this meant periphery countries could borrow on the same terms as Germany

o E.g. Spain: cheap credit fuelled housing boom/bubble (Spain demanded 60% of all concrete in the EU). Modelled as rising inflation. Contractionary monetary policy couldn’t be used. Fiscal contractions didn’t occur because no-one realised a bubble was occurring. Low nominal interest rate + high domestic inflation pushed down the real interest rate to add to this through the RIR.

• Rising inflation in a CCA member: o 𝜋T = 𝜋* = inflation target of the EZ = ECB's target

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• Rising inflation in periphery countries was a major source of lost competitiveness

• High nominal rigidities → RIR > RER as output won’t adjust back to equilibrium. Germany’s wage setting system → RER stronger as they use wage restraint to substitute for flexible exchange rates + their external sector is larger so ∆trade balance affect the RER channel more than the RIR channel.

• RIR, destabilising. Walter’s critique, why Britain didn’t join the EZ: o ↑π → ↑πE → ↓r by Fisher equation (r = i – πE) → ↑y → ↑π and the process repeats

• RER, stabilising: o ↑π → ↑P → real appreciation by 𝑄 = P*e/P → ↑PX so ↓X and ↓PM so ↑M → net

exports fall by M-L condition (∑price elasticities of X and M > 1) as volume effect (fall in net exports) > ToT effect (rise in export bill) → ↓BT → ↓AD → ↓y → ↓π

• Ireland: o After adopting the euro, it depreciated against the US dollar and pound sterling.

Ireland had stronger trade relations with them than average, the rise in cost of imports triggered domestic wage increases (asymmetric inflation shock). Highlights the RIR destabilisation

• As RER may be slow and costly in terms of unemployment and to avoid RIR, contractionary fiscal policy may be used following an inflation shock. It will result in equilibrium being reached again, but at an appreciated exchange rate meaning lower net exports and higher government spending to sustain AD. This shows that even if Spain or Ireland had contracted spending, they would’ve created a twin deficit anyway

• Why did imbalances build up? o Germany: suppression of growth through tight fiscal policy and coordinated wage

setting to meet a real exchange rate target and a trade surplus. Germany have historically been very competitive and efficient in manufacturing

o Periphery: lack of wage restraint o Divergences of competitiveness were reflected in the build-up of current account

imbalances. Spain and Italy built up large CA deficits, Germany ran large surplus

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o Government spending imbalance dangerous due to unsustainability of government

debt: ∆b = d + (r – )b

• Banking problems: o Banks are major holders of government bonds (2011: 28% in Spain, 2% in US)

▪ fall in bond prices → bank insolvency (collateral risk) o Bank insolvency (GFC) → government insolvency → sovereign debt crisis as

▪ EZ banks were large proportions of their country’s GDP (e.g. Bank of Ireland = 99% GDP in 2007, so debt:GDP doubled upon their bail-out)

▪ Cross-border banks put pressure on two governments

• Sovereign debt crises: o No LOLR to sovereigns in EZ → undid the prosperity in the periphery through

sovereign debt crises after the 2008 crash o GFC → markets realised that default risk in periphery bonds > German bonds → PAS

broke down, bond yields diverged o Financial crisis + breakdown of PAS → long rates for Greek bonds rose over 20% in

2011 → negative effect on Greek prosperity compared to German prosperity (e.g. Greek unemployment = 25%)

o When a country has control over monetary policy, CB can buy sovereign bonds which had to be sold previously due solvency concerns → lower bond yields → government could recapitalise lenders and maintain core banking provisions

o Germany: continued exporting throughout the crisis by maintaining low wage growth and targeting a depreciated exchange rate.

o Spain: upon housing boom collapse, they became insolvent as they couldn’t pay back Germany. They want to export more but they’re not as competitive as countries like Germany. They can’t competitively devalue.

• Results of Sovereign debt crisis o Greece, Ireland, Portugal were bailed out and forced into pursuing austerity to bring

default risk down o Outright Monetary Transaction (2012) – Draghi promised to do whatever it takes to

preserve the Euro and ECB promised to buy bonds conditionally until pressure eased (became LOLR) → lower default risk → lower borrowing costs

▪ Conditional policy though, so is a cause for concern in the future o Fiscal Compact (2013) – timeline to reduce government debt and balance the budget

(negative consequences if RER doesn’t operate well). Not credible ▪ moral hazard → countries know they’ll be bailed out ▪ high debt upon entering Fiscal Compact ▪ lack of enforcement mechanism

o Single Resolution Mechanism (2013) – raises funds from national banks to resolve failing EU banks

• Had periphery nations met initial convergence criteria for joining the EZ, instability created by their uncompetitive supply sides may have been mitigated as competitiveness could have aligned with Germany

• Unlikely as Greek exports are mainly characterised by tourism which is less valuable and more cyclical than Germany’s auto industry

• Fundamental differences in culture → imbalance → debt crises throughout the EZ

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• EZ: poor governance structure, no bail out clause, no LOLR to sovereigns → instability during the financial crises and didn’t allow fiscal policy to be used as a method of stabilisation → weak recovery and austerity in periphery countries

• Solutions o Banking Union

▪ Make EZ members jointly responsible for solvency of all banks ▪ SRM is gradual phase, so short-term problem remains ▪ Create Eurobonds to make governments jointly responsible for debt. But this

would raise borrowing cost in Northern Europe creditor nations o Political/Fiscal Union

▪ Unlikely as no natural solidarity across countries like in US and vast cultural differences

▪ Would prevent reckless fiscal policy as seen in Greece

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Formulae Closed economy AD function yD = C + I + G Keynesian consumption function C = c0 + c1(1–t)y

Closed economy multiplier k = 1

1−𝑐1(1−𝑡)

Closed economy AD equation 1

1−𝑐1(1−𝑡)× (𝑐0 + 𝐼 + 𝐺)

Fisher equation r = i – πE

Investment function I = a0 – a1r Closed economy IS curve y = k(c0 + a0 + G) – ka1r = A – ar

Expected present value of lifetime wealth 𝜓𝑡𝐸 = (1 + 𝑟)𝐴𝑡−1 + ∑

1

(1+𝑟)𝑖 × 𝑦𝑡+𝑖𝐸∞

𝑖=0

PIH consumption function 𝐶𝑡 =𝑟

1+𝑟× 𝜓𝑡

𝐸

Capital input Kt+1 = (1–𝛿)kt + vt

Tobin’s marginal q 𝑞 =

𝑀𝐵(𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

𝑀𝐶(𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)=

𝑃𝑓𝑘

𝛿 + 𝑟

Tobin’s marginal q for Y = AF(K) MB = 𝐴𝐹𝑘

1+𝑟+

(1−𝛿)𝐴𝐹𝑘

(1+𝑟)2 + ⋯

MC = 1

Tobin’s average Q = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚

𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Inflation from labour market π = πE + bargaining gap

WS curve WWS = 𝑊

𝑃𝐸

Labour demand curve (perfect competition) 𝑊

𝑃= 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟

PS curve WPS = 𝑊

𝑃 = (1 – ), =

1

𝜂−1

Phillips curve πt = πt-1 + (yt – ye)

Adaptive expectations 𝜋𝑡𝐸 = 𝜋𝑡−1

CB loss function L = (yt – ye)2 + (πt – πT)2

> 1 → inflation aversion

< 1 → unemployment aversion Dynamic IS curve y = At – art–1

Rational expectations Phillips curve πt = 𝜋𝑡𝐸 + (yt – ye) + t

Lending rate r = (1 + B)rp

Fundamental asset value 𝑝𝑡∗ = ∑

𝑑𝑡+𝑖𝐸

(1+𝑟)𝑖∞𝑖=0

Asset price pt = 𝑝𝑡∗ + zt

Government budget constraint Gt + itBt–1 = Tt + ∆Bt + ∆Mt

Real government budget constraint gt + (1+rt)bt–1 = tt + bt

Intertemporal real government budget constraint

(1+r)bt–1 = ∑1

(1+𝑟)𝑖∞𝑖=0 (𝑡𝑡+𝑖 + 𝑔𝑡+𝑖)

Primary deficit Dt = Gt – Tt

Expected lifetime wealth (households) 𝜓𝑡𝐸 = (1 + 𝑟)𝐴𝑡−1 + ∑

1

(1+𝑟)𝑖 × (𝑦𝑡+𝑖𝐸 −∞

𝑖=0

𝑡𝑡+𝑖𝐸 )

Change in debt to GDP ratio ∆b = d – (r – )b

Quantity theory of money Py = MV

Monetarism theory 𝜋 =∆𝑃

𝑃=

∆𝑀

𝑀

54

Narrow money M0 = currency + CB reserves Broad money M3 + M4 = M0 + demand deposits + savings

deposits + time deposits

Taylor Rule 𝑟0 – 𝑟𝑠 =1

𝑎(𝛼+1

𝛼𝛽)

×(π0 – πT)

MR curve yt – ye = –(πt – πT)

Nominal exchange rate e = 𝑛𝑜.𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

1 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

Real exchange rate 𝑄 =𝑃∗𝑒

𝑃

Open economy AD function y = C + I + G + X – M

UIP i – i* = log(𝑒𝑡+1𝐸 ) – log(et)

Real UIP r – r* = 𝑞𝑡+1𝐸 – qt

Open economy IS curve yt = At – art–1 + bqt–1

Open economy AD equation yt = A – ar* + bq

RX curve y1 – ye = –𝑎+𝑏

1−𝜆(r0 – r*)

Trade balance BT = X – M

Balance of payments BP = (BT + INT) + F – ∆R = 0 = current + capital + financial accounts INT = net interest receipts F = private net capital inflows R = foreign currency reserves

Open economy multiplier 1

1−𝑐1(1−𝑡)+𝑚

Goods market equilibrium y = 1

1−𝑐1(1−𝑡)+𝑚× (𝑐0 + 𝐼(𝑟) + 𝐺 + ��)

Home-cost pricing Px = (1+)𝑊

𝜆

World pricing PX = P*e

Cost-competitiveness Relative ULC =𝑈𝐿𝐶∗𝑒

𝑈𝐿𝐶

Law of one price Pi = 𝑃𝑖∗e

Export function X = (Q)y*

Import function M = Qm(Q)y Terms of trade 𝑃𝑋

𝑃𝑀=

𝑃

𝑃∗𝑒=

1

𝑄

BT curve yBT = 1

𝑄𝑚(𝑄)× (𝑄)𝑦∗

= share of world output Consumption wage (living standards) w =

𝑊

𝑃𝑐

CPI (1–)P + P*e

= imported share of consumption bundle PS curve with input costs 𝜆(1−𝜇)

1+(Q−1)

World price of oil = 𝑃𝑅𝑀

∗

𝑃𝑀𝐹∗

Home’s ToT with oil 𝑃𝑋

𝑃𝑀=

𝑃

𝑃∗𝑒=

1

Q

PS curve with oil WPS = 𝜆(1−𝜇)

1+vQ

55

Intertemporal current account CAt = − ∑ (1

1+𝑟∗)𝑖∆��𝑡+𝑖𝐸∞

𝑖

�� = y + INT – I – G External imbalances Private sector financial balance +

government financial = BT [s1ydisp – c0 – I(r*)] + [ty – G] = [X – M] [S – I] + [T – G] = [X – M]

Inflation in terms of exchange rate changes ∆𝑄

Q= 𝜋∗ +

∆𝑒

e– 𝜋𝑇 = 0 𝑎𝑡 𝑀𝑅𝐸

Exchange rate in 2-bloc model �� =

𝐴𝐵 − 𝐴𝐴

2

Interest rate in 2-bloc model ��∗ =

𝐴𝐴 + 𝐴𝐵

2− 𝑦𝑒

Real exchange rate channel ∆q = π* – π No arbitrage condition pt = dt +

𝑝𝑡+1𝑒

1+𝑟

MC = MB

ERU y = ye(zw,zp)

Current account: say you want to increase your consumption as a small open economy. You can either produce and consume domestically or increase imports. Increasing imports requires you to give up your currency for foreign currency and use it to purchase imports. This makes foreigners collect all your currency. Importing large amounts from China means you lose currency and gain Chinese goods, but China gains your currency. Your consumption is being built by them. The difference between consumption and production is what you borrow from another country’s output. Chinese can use your currency to purchase your government’s bonds, so you then owe them interest. Loss of competitiveness: allowed PIIGS to prosper, because of appreciated exchange rate, less competitive. High inflation, high wage growth, consumption boom financed by borrowing from abroad and CA deficit.