Macroeconomic Imbalances Gavin Cameron University of Oxford OUBEP

Macroeconomic Imbalances Gavin Cameron University of Oxford OUBEP Topical Economics 2006 OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 1

macroeconomic policy Source: Carlin & Soskice, p 12 OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 2

what drives aggregate demand? • • Aggregate expenditure comprises five components: ‐ consumption ‐ investment ‐ primary government spending (i. e. net of transfers) ‐ net exports (i. e. exports minus imports) ‐ inventories (i. e. changes in stocks held by businesses) The level of income (both current and expected) is a major determinant of consumption, government spending and net exports. The real exchange rate is a major influence on net exports. Monetary and fiscal policy are major influences on consumption and investment (with the latter being also dependent upon output expectations and ‘animal spirits’). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 3

the inflation‐output tradeoff • In 1958, A. W. Phillips of the LSE found relation an empirical relationship between unemployment and inflation in the UK – the Phillips curve. • Original interpretation: ‐ There is a permanent trade‐off between inflation and unemployment/output. • Problem: ‐ After sustained inflation, the empirical relationship broke down. • New interpretation: ‐ There is a trade‐off between output and unexpected inflation: output=equilibrium output+ b(unexpected inflation) • Therefore output deviates from its equilibrium level by the extent to which inflation deviates from its expected level. • But in the long‐run, there is no such trade‐off. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 4

shocks to the economy • Why might the economy get ‘shocked’ away from equilibrium? • Aggregate Demand shocks ‐ an investment boom; ‐ a pre‐election government spending spree; ‐ a sudden rise in the real exchange rate; ‐ a consumer boom abroad; ‐ a boom in the housing market; ‐ an unexpected cut in interest rates; ‐ a slump in share prices; ‐ a sudden rise in commodity prices. • Inflation and supply shocks ‐ a sudden rise in oil prices; ‐ the invention and diffusion of a new technology; ‐ labour market changes. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 5

fiscal policy • ‘If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled up with town rubbish, and leave them to private enterprise… to dig them up again, there need be no more unemployment. It would, indeed, be more sensible to build houses and the like, but if there are political and practical difficulties in the way of this, the above would be better than nothing’ J. M. Keynes, 1936. • Changes in the government’s fiscal stance (that is, the difference between government spending and taxation) will change the level of aggregate demand. If economy is at equilibrium output, increases in spending (or tax cuts) will lead to an inflationary boom, which eventually will lead only to higher prices. If economy is below equilibrium output, increases in spending (or tax cuts) will tend to raise output (as well as prices) and shift the economy back to equilibrium. • • OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 6

the limits to fiscal policy • But there are problems with the use of fiscal policy: ‐ Measurement of output: where are we? where are we going? how fast? will we know when we get there? ‐ Lags in the fiscal policy process: implementation (recognition & administrative lags) and operational; ‐ What kind of fiscal policy? Spending (on what? ) or tax cuts (for whom? ); ‐ Will spending ‘crowd‐out’ other spending, either directly or indirectly (through interest rates, inflation, the exchange rate, or Ricardian Equivalence)? OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 7

fiscal rules • • • Even now that most monetary policy is conducted by independent monetary authorities, there is still the problem that politicians may pursue fiscal policies that are incompatible with stable inflation. Consequently, some countries have adopted fiscal rules. The two most famous are: ‐ The Stability and Growth Pact (revised!): countries should aim to run no more than a 1% deficit over the business cycle; cannot borrow more than 3% of GDP (cf. France and Germany!) in any one year; government debt should be kept below 60% of GDP. ‐ Gordon Brown’s Golden Rule: over the business cycle borrowing should equal net government investment; government debt should be kept below 40% of GDP. A fiscal rule that states that debt must be kept below a level of X% of GDP implies that the average deficit over the cycle must be approximately equal to the average growth rate of GDP times the target level of X%. For Britain, with an average growth rate of 2% and a target of 40%, the average deficit must be kept around 0. 8%. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 8

monetary policy • ‘Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former that are not obtainable from the latter’ J. M. Keynes, 1936. • Monetary policy can be implemented through either changes in the money supply or interest rate, or through direct controls on lending. Changes in the interest rate will affect the interest‐sensitive components of aggregate demand. The exact size and timing of these effects will differ from country to country. If economy is at equilibrium output, interest rate cuts will lead to an inflationary boom, which eventually will lead only to higher prices. If economy is below equilibrium output, interest rate cuts will tend to raise output (as well as prices) and shift the economy back towards equilibrium. Typical lag effect on output one year, inflation two years. • • OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 9

transmission mechanisms Lending rates Domestic demand Total demand Asset prices Official rate Expectations& confidence Domestic inflationary pressure Net external demand Inflation Import prices Exchange rate OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 10

Euro area responses to a 1% rise in ECB repo rate for two years Real GDP Year 1 Year 2 Consumer prices Year 3 Year 1 Year 2 Year 3 ECB -0. 34 -0. 71 -0. 15 -0. 30 -0. 38 NCB -0. 22 -0. 38 -0. 31 -0. 09 -0. 21 -0. 31 NIGEM -0. 34 -0. 47 -0. 37 -0. 06 -0. 10 -0. 19 Note: The table shows responses of real GDP and consumer prices to a two-year increase of 100 basis points in the policy-controlled interest rates of the euro area. Figures are expressed in per cent from baseline. Simulations are performed using the ECB’s area-wide model, the national central banks’ macroeconometric models and the multi-country model of the NIESR Source: ECB Monthly Bulletin, October 2002, p 45 OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 11

the limits to monetary policy • But there also problems with the use of monetary policy: ‐ Measurement of output: where are we? where are we going? how fast? will we know when we get there? ‐ Lags in the monetary policy process: implementation (recognition & administrative lags) and operational; ‐ What kind of monetary policy? Interest rates, open‐market operations, quantitative controls, credit controls. ‐ The liquidity trap & credit channel – will policy actually affect the interest rates and lending policies faced by agents? OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 12

a policy problem – data revisions! Revisions to level of UK market sector output between May and June 2005 Source: Inflation Report, August 2005 OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 13

higher interest rates do not always tighten financial conditions Source: Goldman Sachs FCI index of 3 month LIBOR, corporate bond index, and trade-weighted dollar. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 14

Taylor rules and inflation targeting • • • After the inflationary difficulties of the 1970 s and 1980 s, many countries moved towards having independent central banks and the use of inflation targets. This form of ‘constrained discretion’ seems to work because it takes control of monetary policy out of the hands of politicians! In practice, most monetary authorities operate something called a ‘Taylor rule’. That is, they raise the real interest rate (the nominal rate minus expected inflation) whenever inflation is above target or when capacity constraints appear in the economy (since these may predict future inflation). We can think of a monetary policy reaction function, where r= inflation target + equilibrium real r + a(output – equilibrium output) + b (inflation – inflation target) The coefficient a measures how averse the monetary authority is to output deviations and b measures how averse it is to inflation deviations. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 15

UK inflation performance Source: Carlin and Soskice (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 16

recent developments • Euroland growth has been slow since 2000; • US recovery from recession in 2000‐ 1 has been good, although employment has not recovered as much as output; • The UK has grown steadily; • Japan may be picking up; China and India continue to grow rapidly. • World monetary policy has been extraordinarily relaxed since 2000, with interest rates of around 0% in Japan, 1% in the USA and 2% in Euroland. Commodity prices have boomed. • But short‐term interest rates are now rising around the world: ‐ ECB lending rate raised on 9 August to 3%, Bo. E rate raised on 3 August to 4. 75%, Fed last raised on 29 June to 5. 25%, Bo. J raised its basic loan rate on 14 July to 0. 4%! OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 17

recent performance Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 18

recent loose monetary policy Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 19

…even on a real basis Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 20

breaking the rules? Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 21

rising debt Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 22

bond yields low despite rule‐breaking! Source: CESifo (2006). OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 23

inflationary pressure Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 24

contango! Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 25

rising yield expectations Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 26

excess liquidity? Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 27

focus on the USA Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 28

focus on Japan Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 29

focus on Euro Area: Junker vs Trichet Source: BIS Annual Report (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 30

global imbalances Source: CESifo (2006) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 31

global prospects • • • While the US continues to run such large ‘twin deficits’, there is the possibility of a disorderly correction to global imbalances. Not clear how different Bernanke will be to Greenspan yet. In the absence of such a correction, continued broad growth with some inflationary pressure is likely. Corporate profits have been very strong in the USA and wage growth has been weak – not much more scope for profits to outperform revenues, and risks to housing market. In Europe, on the other hand, corporate profits may rise faster than revenues as the economy picks up – assuming no more oil price rises. Very hard to predict changes in China. Likely to be modest upward movement of renminbi and modest decline in share of investment in GDP (46% in 2005!). Current policy hugely distorts price mechanism: credit too cheap, exchange rate too low, labour market distortions. The need for reform of Chinese banking and credit allocation, and to deal with inflation and excess capital investment, must be balanced against risk of sudden adjustment. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 32

prospects for the world macroeconomy OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME 33