EC230 Lent Term Notes

Peso Crisis and Fixed Exchange Rate

"A fixed exchange rate however is like moving the house around the paintbrush..."

Domestic interest rate is fixed

(1) A small economy cannot influence the world interest rate. (2) An open economy has its domestic interest rate fixed at the world rate. (1) + (2) means the domestic interest rate in our small, open economy does not change in equilibrium.

Phillips Curve

*Inverse relationship between inflation and unemployment. Government can boost demand in order to reduce unemployment: - but this puts upward pressure on wages. - hence firms increase prices and inflation increases. *Thus, policymakers face an inevitable trade-off between inflation and unemployment. In short-run: have choice between low inflation and low unemployment.

A currency union is an agreement amongst members to share:

- A common currency. - A common interest rate. - A common exchange rate. There are two famous examples in history: - The "Dollarzone" - The "Eurozone"

Policy effectiveness

- A key factor affecting the choice of exchange rate regime is how they impinge on the effectiveness of monetary and fiscal policy. - We can study this in the Mundell-Fleming model of the open economy.

Size of fiscal multiplier

- A large fiscal multiplier means that austerity cuts can actually exacerbate debt sustainability: - although debt decreases, output decreases proportionately more.

Asset price bubbles

- A speculative asset price bubble occurs when: *Asset prices depart from their fundamental values. *As measured by the stream of future cashflows generated by the asset. - During 1997-2006, US house prices increased by 132%

Asymmetric shocks

- An asymmetric shock hits one country harder than others. - These can occur due to differences in countries' economic structures. - e.g. UK was hit harder than Germany during the financial crisis, due to the predominance of financial services. - But there are other reasons...

Technological progress

- An extension of the Solow model shows that long run growth arises through technological progress. - Technological progress means innovations which increases the productivity of labour and capital inputs. - Effectively, the production function shifts up and the steady state capital stock increases. - Thus, ongoing technological advancement creates long run economic growth. But this leaves several questions unanswered: - where does the technological progress come from? - why is the policy? The Solow model cannot answer these questions: - because it simply assumes technological progress appears out of nowhere!

Anchoring inflation

- Anchoring means the central bank can control inflation without actually increasing interest rates! - The credible threat of raising rates is enough to keep inflation expectations in check.

Consequences for the real economy

- And so a vicious circle of asset price collapse and deleveraging ensued. - Consequences for the global economy: - Credit crunch - House price crash - Financial meltdown - Global recession

How savings affects income levels

- Another possible explanation for observed income disparities is differences in savings rates. - What happens if the savings rate increases? - the investment function shifts up. - investment now outstrips depreciation - such that the capital stock grows to a higher steady state A higher savings rate is therefore associated with a higher long run income level. - Intuitively, an economy with savings rate trades off lower short run consumption for higher long run consumption. - But an increase in the savings rate does not generate long run growth. - Hence the question remains: - why do the US and other advanced economies keep on growing?

Argentina peso crisis 2018 -

- Argentina is currently undergoing a devastating currency crisis. Soaring public debt sparked concerns about default: - exacerbated by higher US interest rates. This provoked an increase in the country risk premium: - interest rates increased to 40% in May 2018. Concerns about the viability of this policy led to capital flight: - peso depreciated by 50% during 2018. June 2018: Argentina received an IMF bail-out package of $57bn: - conditional on FX market non-intervention. Aug 2018: - peso faced speculative attack - interest rates increased to 60% - In 2019 Q1: economy contracted 5.8%. - Concerns about full-blown banking crisis. - Aug 2019: Argentina entered technical default on its $101bn of foreign debt. - Sep 2019: Central Bank of Argentina imposes capital controls to stem capital flight.

PS-FS model

- At point E, the economy is above the credit target but below the inflation target. - An increase in the interest rate would achieve the credit target (point F), but the economy would fall deeper into recession and hence inflation would fall further below target. - But with the right combination of an increase in K and cut in R, we can move to point A and achieve macro-financial equilibrium.

Portfolio rebalancing

- Banks are holding excess reserves from the QE operations. - Yields on government and corporate bonds have fallen. - This induces a banks to boost lending to firms instead, which earns a higher rate. - The supply of credit shifts right hence reducing bank loan rates, inducing firms to borrow more.

Liquidity regulation

- Basel III also introduced liquidity regulation. - The "Liquidity Coverage ratio" requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days.

The Interbank Market

- But nobody knew which banks were on the brink of insolvency. - This uncertainty about where subprime losses were held had serious implications from the interbank In this market, banks lend to other banks experiencing a liquidity shortage: - Charging the LIBOR rate. The subprime losses led to a climate of fear and suspicion that some banks were teetering on the brink of insolvency: - So that in August 2007 the interbank market seized up. A major casualty of this was the UK bank Northern Rock.

Borrowing constraints

- But suppose households are unable to borrow. - Here, they cannot smooth consumption over time. - In this situation, they can use tax cuts to boost current spending... - ...i.e. tax cuts act like a loan from the government. - Hence, Ricardian Equivalence does not hold under borrowing constraints.

Capital flows and the exchange rate

- Capital flows are a key driver of exchange rate movements. - Capital flows are driven by interest rate differentials. - Hence an increase in UK interest rates (relative to rest of world): - induces capital inflows - leading to appreciation of the sterling exchange rate

Perfect Capital Mobility

- Capital flows freely between countries. - There are no restrictions or transaction costs on borrowing/investing abroad. - Domestic and foreign financial assets are considered perfect substitutes. - Hence no one will invest in UK bank accounts or bonds if the interest rate is lower than on US bank accounts or bonds.

Currency Manipulator?

- Capital outflows from China to the U.S. cause the dollar to appreciate against the renminbi. - So China is not a currency manipulator! The key to reducing China's trade surplus is to increase domestic demand: - which will reverse the capital outflows - and lead to dollar depreciation against the renminbi.

Central Bank independence

- Central bank independence is an effective method for governments to "tie themselves to the mast." - Unaffected by short run electoral concerns, the central bank's commitment to low inflation is credible.

What makes a good currency union?

- Countries should form a currency union if the benefits of joining exceeds the costs. - The costs and benefits depend on the degree of economic integration between these countries. Economic integration means trade flows of: - goods and services (trade) - labour (immigration and emigration) The decision boils down to the trade-off between: - microeconomic benefits (of fixed exchange rates) vs. - macroeconomic costs (of sacrificing monetary policy).

Claessen, Kose and Terrones

- Credit booms accompanied by house price bubbles last longer and are more pronounced.

Currency Risk

- Currency risk is the risk of exchange rate fluctuations when investing in foreign assets. - Suppose Ruk = 15% and Rus = 5%. Why would anyone invest in US bonds? - Amy buys a UK bond which she must convert back to dollars at the end of the year. - If sterling depreciates agains the US dollar, she makes a capital loss. - Hence, investors require a higher interest rate to compensate for the risk of exchange rate depreciation. - This extra amount is known as the currency risk premium. - It is determined by the uncovered interest rate parity (UIP) condition: Ruk - Rus = % dep - Where % dep denotes expected exchange rate depreciation in percentage terms.

LM curve

- Curve represents all possible combinations of (Y, r) for which money market is in equilibrium - Equilibrium in the economy requires both goods and money markets are simultaneously in equilibrium *LM curve is upward-sloping

Greece's demands

- Debt relief (30% write-off of outstanding public debt). - Postpone all debt repayments for 2 years. - Austerity measures were sapping aggregate demand from the economy. - They should be postponed until economic recovery took hold.

Graphical Analysis of the Peso Devaluation

- Devaluation is achieved by selling pesos and buying dollars. - Hence money supply expanded and LM* shifted right. - Net exports increased hence output would have increased. - But devaluation prompted concerns about future devaluations, hence the currency risk premium increased. - This increased the domestic interest rate, which decreased investment spending, hence IS* shifted left. - To maintain the exchange rate fix, BoM intervened, hence money supply contracted and LM* shifted left. - Exchange rate reverted to its target level, hence no offsetting effect in terms of net exports. - Hence output fell.

Mop up the mess (cleaning) - Monetary Policy

- Do nothing during the boom phase - But cut interest rates aggressively should the asset price bubble burst

UK's fixed exchange rate experience

- During 1989-92, Britain entered a fixed exchange rate regime called the European Exchange Rate Mechanism. - Sterling was pegged to the German deutschmark. -The UK economy was in recession, but the govt. was unable to provide monetary stimulus. - Britain became the victim of a "self-fulfilling currency crisis": - the weakness of the economy led market speculators to believe that exit from the ERM was inevitable, hence they launched a speculative attack.

Endogenous growth theory

- Endogenous growth theory was developed to address the shortcomings of the Solow model. - It explains the source of long run growth. - The definition of the capital stock is broadened to include knowledge. - This importance because creation exhibits a positive production externality: - a positive production externality occurs when one firm's production benefits other firms. For example, when a scientist creates a new drug, her underlying research becomes part of the capital stock. - Other scientists can exploit this knowledge to create even better drugs. - As the stock of knowledge expands, the more ideas there are for entrepreneurs to build upon and create even better inventions.

Equilibrium in the open economy

- Equilibrium in the open economy requires the goods and money markets are simultaneously in equilibrium. - Hence, equilibrium occurs at the intersection of the IS* and LM* curves. - This point of intersection determines the equilibrium level of income and the exchange rate.

How effective was QE?

- Evidence suggests it decreases UK & US long term yields by about 1%. - BoE best estimate is that QE raised UK GDP by approx 2 1/2% and inflation by approx. 1% (peak impacts). - But the effectiveness of QE in boosting retail lending and aggregate demand has been hotly debated. - Some commentators have argued that the additional money creation has been diverted into other assets creating bubbles: - real estates; shares; Bitcoin

Devaluation of the peso

- Exchange rate interventions drained the Bank of Mexico's foreign exchange reserves, such that it ran out of US dollars end-1994. - Devaluation followed shortly afterwards, which prompted concerns about future devaluations. - This led to capital flight: the widespread sell-off of financial assets by foreign investors. - This increased the currency risk premium even more, which decreased aggregate demand and deepened the recession.

Active Credit view (Mian and Sufi, 2014)

- Expansion of credit availability by banks drove house price increases - Banks lowered their lending standards - Credit growth was supply-driven Is expansion in observable quantities traded in the market driven by supply or demand?: - This is known as an identification problem - E.g. was the 1990s US crack cocaine epidemic driven by an increase in demand or supply?

Laeven and Valencia (IMF, 2013)

- Financial crises have led affected economics into deep recessions. - They have often been preceded by excessive credit booms.

Production function

- Firms use labour and capital inputs to produce goods and services. - The production function tells us how much output is produced for a given level of input: Y = F (K, L) Y = output; K = capital stock; L = Labour *For simplicity, we assume labour is constant. - Hence, we can express the production function per worker (p.w. terms) terms: y = f (k) y = Y/L; k = K/L

The mechanics of a bank run

- First, reserves are depleted. - Then, loans must be liquidated at "fire sale value" (i.e. below their market value because the bank needs the cash in a hurry). - The bank cannot meet all withdrawal demands, because: Reserves + fire sale venue of loans < deposits - So eventually the bank runs out of money and must be closed down by the financial regulator.

Mechanics of fixed exchange rates

- Fixed exchange rate means that the BoE must intervene in the FX market to defend the fix. - Suppose the exchange rate increases above target. - BoE must buy foreign currency which it pays for through money creation. - Hence, FX intervention expands/contracts the money supply.

Steady state capital

- For poor countries (with small k), investment exceeds depreciation hence capital is growing over time. - But at some point, when investment is exactly offset by depreciation, capital stops growing. - This called the steady state capital stock k*: - this is where the economy reaches long run equilibrium. -Hence, in the long run, economic growth grinds to a halt.

Time inconsistency

- Forward guidance implicitly pledges to keep interest rates at a lower level than required to meet the inflation target. - This pledge suffers from a time inconsistency problem. - As soon as economic recovery is underway, the BoE would be tempted to renege and raise rates to curb inflationary pressures. - Markets anticipate this, hence the yield curve does not flatten as much as desired. - In reality, the policy was abandoned in both UK and US as the unemployment target was reached quicker than expected.

What is forward guidance?

- Forward guidance is an implicit commitment by the central bank to hold policy rates "lower for a longer period". - Bank of England: "we will not raise Bank Rate from its current level of 0.5% at least until the unemployment rate has fallen to 7%." - BoE was implicitly pledging to postpone rate rises beyond the point when inflationary pressures were rising.

China's trade surplus

- From late 1990s onwards, China has run persistently large trade surpluses with the US. - Thus, ex-President Trump has labelled China as the "world champion" of currency manipulation.

Mortgage Securitisation

- Globally low interest rates drove a "search for yield", which made subprime mortgage lending an attractive prospect. - Banks dealt with the high risk of default through a process known as mortgage securitization. Mortgage securitisation was carried out through the "originate-and-distribute" model: - Originators banks made loans to subprime borrowers - They then "securitized" these loans, i.e. repacked them into tradable bonds known as mortgage-backed securities (MBS) - Then sold them on to other investors

Historical Context - Fiscal Stimulus vs Austerity

- Governments which run persistent budget deficits risk the public debt becoming unsustainable. - At this point, they can longer afford the interest payments on debt, leading to default. In the aftermath of the global financial crisis, many governments face such a problem: - tax revenues collapsed - unemployment benefits soared - large scale bank bail-outs were required

Tax cuts under borrowing constraints

- Greece had suffered a severe financial crisis. - Banks cut lending due to deleveraging and sudden stop of capital flows. - Fiscal stimulus would have boosted spending, by giving cash to credit-constrained consumers. - Fiscal multipliers tend to be larger in the aftermath of financial crises: - IMF estimates fiscal multiplier at close to 2 during these episodes.

Trump Trade War

- He has retaliated by engaging in a savage tariff war with China. - Feb 2018: 24% tariff on all steel imports and 7.7% on aluminium. - Sept 2018: 10% tariff on $200bn Chinese imports, China retaliates with $60bn on US imports. - June 2019: US increases tariff on $200bn Chinese imports from 10% to 25%. - August 2019: US Treasury officially labels China a currency manipulator. - Jan 2020: US and China sign deal to pause trade war. - But it's not over yet...

Liquidity Premium

- Hence interest rate risk is the risk of price fluctuations due to unexpected changes in interest rates. - Long term bonds are subject to greater interest rate risk due to the greater uncertainty over the future path of the policy rate. - Hence their yield must be higher to induce investors to hold them. - This extra amount is known as the liquidity (or term) premium.

Inflation targeting

- Hence, an inflation target makes the Governor accountable for their actions. Price stability has emerged as the dominant mandate for central banks across the world: - About 27 countries now operate fully-fledged inflation-targetting regimes - But some countries do not have an explicit inflation target.

The Brexit Campaign

- Hence, immigration was a recurrent theme during the Brexit campaign. - Exemplified by the populist slogan: "Take Back Control." - This was central to Stiglitz's hypothesis that the euro crisis led to Brexit.

Graphical Understanding of Peso Crisis

- Higher domestic interest rate decreased investment spending, hence IS* shifted left. - Fall in income decreased demand for money, so domestic interest rate started to fall. - Hence the exchange rate depreciated. - But Bank of Mexico intervened by buying pesos and selling dollars. - This contracted the money supply, hence LM* shifted left. - Exchange rate reverted to its target level, hence no offsetting effect in terms of net exports. - Hence output fell.

Keynesian view

- Households base their spending decisions on current income alone. - If the government cuts taxes, households spend most of the extra disposable income. - Hence the fiscal multiplier is large. - But this means tax increases can have damaging negative spillover effects on aggregate demand. - Hence Keynesians oppose austerity measures during a recessions.

Passive credit view (Foote, et al., 2012):

- Housing bubble was driven by speculative investors - Hence credit growth was an effect, not a cause, of the housing bubble - Credit growth was demand-driven

Conservative Central Banker

- However, a dual mandate works well in the hands of a Fed Chair with a strong aversion to inflation: - known as Rogoff's conservative central banker. - If a conservative Chairman cuts interest rates and inflation rises, is it: - accommodation of supply shock, or - Fed is inflating the economy due to political pressure? - Accommodation of supply shock is the more likely scenario. - The Chair's fervent dislike of inflation means she has less temptation to inflate the economy. - Thus we get the best of both worlds: - inflation expectations remain anchored - flexibility in policy response in the face of a severe supply shock.

Labour mobility

- If labour is mobile, adjustment can occur through shifts in labour supply instead: - migration from recession-hit economies to booming economies. But this comes at a price: - social upheaval - falling real wages and rising living costs in host country - anti-immigration sentiment Britain was recovering nicely from the financial crisis, hence experience a surge in EU migration during the late 2000s.

The "Dollarzone"

- In 1775, the Continental Congress of the United States authorized the issuance of the US dollar. - It was a successful currency union which: - created an economic superpower. - became the international reserve currency. - endured for over 200 years.

The "Eurozone"

- In 1999, 11 member states of the EU entered into monetary union, creating the single European currency. - "...the event would meet the classical definition of tragedy: arrogance; folly; destruction", Martin Wolf, Financial Times (1991)

The Greek Debt Crisis

- In 2010, Greece's debt to GDP ratio stood at 148%. - Greece had enjoyed a substantial reduction in its risk premium when it joined the euro. - The government took advantage of cheaper borrowing costs and splurged.. - But the Maastricht Treaty of 1992 had built in safeguards to prevent such profligacy: - a 3% cap on budget deficits. - However, the Greek government had concealed the extend of its borrowing through creative accounting. - In 2010, an EU report revealed the true state of the Greek public finances. - This prompted concerns about insolvency, which led to: - soaring borrowing costs - sudden stop of capital flows - Greece was on the brink of default. - EU leaders decided Greece must be rescued. - It received bailout loans of 110bn euros from the Troika: - IMF - ECB - European Commission (mainly Germany) - A second bailout package of 130 bn euros was required in 2012 - In June 2015, Greece defaulted on IMF loan repayments of $1.7 bn. - Greece needed a third bailout package, but the Troika insisted on swingeing austerity cuts: - public spending cuts and tax increases. - But Greek was forced back to the negotiating tables with Troika. - So Greece was forced back to the negotiating table with the Troika.

Macroprudential policy

- In 2012, the Bank of England's Financial Policy Committee was given powers to control macroprudential policy. - Macroprudential policy is the application of financial regulation to protect the economy from swings and cycles in the financial system. - Its primary objective is to restrain credit growth during the boom phase.

Recession turns into depression

- In 2015, the debt to GDP ratio rose to 170%, hence the Troika forced further spending cuts. - A lethal cocktail of debt-deflation and austerity cuts reduced aggregate demand catastrophically. - Greece entered fully-fledged depression.

A new monetary policy framework

- In May 1997, a new Labour Government was elected. -The Bank of England was granted independence from political control. - It was given a mandate to target inflation 2 and a half %.

Risk Premium

- In our small open economy, the domestic interest rate can be higher than the world interest rate: r = r* + 0 - Where 0 denotes the risk premium from both country and currency risk. - So the Venezuelan interest rate must be higher than the world interest rate, in order to prevent capital outflows.

Death of the Phillips curve?

- In recent years, many advanced economies have experienced declining unemployment but without inflation increasing: - this is known as the low wage growth puzzle. - Normally, expansionary policy: - decreases unemployment - inducing labour market tightness - hence workers increase wage demands. - What has caused this? - One explanation is based on the growth of part-time employment: - effectively unemployment is being underestimated in the official statistics. - A more fundamental hypothesis is based on the rise of robots in the workplace. - In recent decades, workers' wage bargaining power has diminished significantly.

Reforms to financial regulation

- In the aftermath of the financial crisis, a raft of reforms were introduced to bolster the stability of the financial system. - Chief of these were the reforms to regulatory capital requirements. - These are the minimum amount of capital banks must hold as percentage of total assets: - set by the Basel Committee on Banking Supervision - and adhered to by banks across the world.

Costs of inflation targetting

- Inflation targetting implies a narrow focus on price stability. - Not a problem with demand shocks due to the divine coincidence. - However, with a supply shock the central bank faces a fundamental trade-off between inflation and output stabilization. - A negative supply shock causes stagflation: - inflation combined with recession. - An "inflation nutter" exacerbates fluctuations in output and employment. - Conversely, an "unemployment nutter" exacerbates increase in inflation.

Country Risk

- Is the risk of default on debt interest payments due to political instability. - Investors require a higher interest rate for investing in politically unstable countries such as Venezuela, compare to safe countries such as US. - This extra amount is known as the country risk premium. - The risk premium must be sufficiently high so that the expected (average) return from investing in Venezuelan bonds equals the return from investing in US bonds. An example: - US int. rate = 5%, Venezuela int. rate = 15% - Probability of Venezuelan default = 2/3 - Expected return in Venezuela = (1/3)*15% + (2/3)*0% = 5%

An example of leveraging

- Jim and Jen both have $100,000. They expect house prices to increase 20%. - Jim buys a house worth $100,000 - Jim's profit is $20,000, his return is 20% - Jen borrows $400,000 and buys a house worth $500,000, which she posts as collateral. - Jen's profit is $100,000, her return is 100%. - Thus, by leveraging, Jen has quintupled her return

Why Fix?

- Key benefit: it reduces exchange rate volatility. It is harmful to trade flows, especially with free capital flows: - A surge in capital inflows can be destructive for exporters. - A surge in capital outflows increases insolvency risk for firm/banks holding foreign currency debt. Key costs: - Loss of monetary independence. - Vulnerability to a speculative attack.

Risk Diversification

- Lohman's lends to thousands of other subprime borrowers. - Their interest and principal payments are all pooled together into a common mortgage pool. - This mortgage pool is split up into thousands of small pieces: - Each serving as the underlying collateral for thousands of MBS bonds. - The MBS bonds are then sold on to investors. - The risk of investing has been dramatically reduced: - because the MBS bonds are effectively made up of small bits of many different mortgages - Whose risks are uncorrelated

Tranching

- MBS bonds were bonds were sold as different varieties known as tranches, bearing different degrees of risk. - Investment grade bonds had the lowest risk: they were first in line to receive payments payments from the mortgage pool - Higher risk equity grade bonds were compensated with a higher interest rate. Different tranches were distinguished by different credit ratings to reflect their riskiness. *Bottoms (Bs to double Bs get payed last...)Defaults... *All failed eventually (end of day all subprime) even those with AAA thought to be payed first, failed in the subprime crisis

Where was QE used: ECB

- March 2015 onwards. - Late adopter due to 1992 Maastricht Treaty prohibition of monetary financing of members states: - but more likely due to the ECB's strong anti-inflationary bias... - €2.5 trillion in total: - government bonds - asset backed securities - corporate bonds - covered bonds

Eurozone Historical Context

- Member states which adopted the euro ceded control of monetary policy to the European Central Bank (ECB). - The euro prospered for a decade. - But in 2010, the European sovereign debt crisis erupted.

Peso Crisis

- Mexico had fixed her exchange rate to the US dollar since 1954. - But in 1994, assassination of presidential candidate Luis Donaldo Colosio led to political turmoil. - This sparked concerns that the Mexican government might default on debt repayments. - Hence, the country risk premium on Mexican financial assets soared. - Domestic interest rates increased, which decreased aggregate demand.

Collateralized Debt Obligations

- Mezzanine MBS were usually re-packaged and sold as new securities: collateralized debt obligations (CDOs). - A CDO is essentially created through a subsequent round of securitisation: - they (supposedly) diversified risk even further

Two targets and two instruments

- Monetary policy can focus on targeting inflation using interest rates. - Macroprudential policy can focus on controlling credit growth using LTV ratios etc.

The subprime mortgage crisis

- Mortgage securitisation relied on the flawed assumption that individual mortgage risks were uncorrelated: - i.e. not all borrowers would default simultaneously - But this failed to take into account that: - sometimes all borrowers default simultaneously - due to economy-wide factors - Hence, even investment grade bondholders can lose out.

Volcker Rule

- Other regulations were introduced to curb excessive risk-taking by banks. - Chiefs of these was the Volcker Rule in the US: - Part of the 2010 Dodd-Frank Act - Bans commercial banks from proprietary trading - I.e. engaging in risky trades for their own profit - But the Trump administration relaxed the rules.

World Interest Rate

- Perfect capital mobility implies that interest rates across all countries are the same. - This common interest rate is known as the world interest rate r*. - The world interest rate is determined at the intersection of the world supply and demand for money. - To simplify, think of it as the interest rate in a large economy such as the US.

Perfect capital mobility

- Perfect capital mobility implies that the interest rate r in our domestic economy must equal the world interest rate r = r* - We CANNOT have r > r*, capital inflows would drive down the domestic interest rate back to the world interest rate. - We CANNOT have r < r*, capital outflows would drive up the domestic interest rate back to the world interest rate.

Interest rate differentials

- Perfect capital mobility means that interest rates should be the same everywhere. - But in the real world, interest rates vary significantly across different countries.

Quantitative Easing

- QE is asset purchases from the private sector (mostly banks) financed by central bank (CB) money creation. - Asset purchased were mostly government bonds, but also corporate and MBS bonds - Central bank buys bonds from commercial banks, paid, for by creating additional reserves. - Reserves are a component of the monetary base, hence QE increases the money supply. - The goal was that this new money would eventually boost lending to firms and households.

Real Wage Depreciation

- Reduction in real wages reduces labour costs. - Firms respond by boosting production and cutting prices. Fall in prices boosts aggregate demand through two effects: - Real money supply (M/P) increases hence LM shifts right. - Export competitiveness increases. - Greece duly implemented these labour market reforms. - Real wages fell 20% during 2009-12. But the policy was unsuccessful: - the recession deepened. *Under conditions of high indebtedness, falling prices do not stimulate economic recovery due to the concept of debt deflation.

Leveraging

- Rising prices induce new investors to engage in the practice of leverage. - Leverage is the use of borrowed funds for the purpose of investment in financial assets. - To ensure that borrowers repay their loans, banks require they post collateral: - Usually their house (e.g. Francis Ford Coppola) - Leveraging multiple returns if prices are expected to increase

The Northern Rock Bank Run

- Rumours were circulating that Northern Rock was insolvent. - Concerned that others might believe the rumours: - I run to the bank in order to get to the head of the queue to withdraw my savings. *But everyone else behaves like me, so they all run to the bank too. - But if everybody runs to the bank simultaneously, the bank cannot meet all withdrawal demands. - If everybody had just stayed at home, northern Rock would have been fine! This is an example of a self-fulfilling crisis: - Bad things happen because everyone believes that bad things will happen. - Alistair Darling, then-Chancellor of the Exchequer, gave a temporary government-backed guarantee on all deposits at Northern Rock. - But in 2008, Northern Rock was nationalized by the Bank of England.

Problems with securisation

- Securitisation was enormously successful - In the US, the amount of MBS and related securities reached 20% of GDP in 2007 - But what did sophisticated investors fail to understand the risks they were taking? One reason was the lack of transparency: - Securitization resulted in a major increase in complexity of financial products - Making it difficult to estimate the risk involved

Self-fulfilling crisis

- Short-selling: selling a (borrowed) asset when the price is high, and buying it back when the price subsequently falls. - Speculators engaged in a wave of short-selling of sterling. - George Soros was the most prominent of these, he made £1bn profit from short-selling sterling

Effectiveness of forward guidance?

- Some doubt its effectiveness, arguing it is fundamentally flawed. - Paul Krugman has dubbed it "credibly promising to be irresponsible". - Other financial bloggers have likened it to "Jedi mind tricks".

Monetary Policy

- Suppose the BoE expands the money supply. - This shifts the LM* curve to the right. - The economy moves to a new equilibrium, in which the exchange rate has depreciated, and income has increased. - Hence, in a small open economy, monetary policy is effective in stimulating the economy. - However, the monetary transmission mechanism is different from the closed economy.

Price stability - Financial stability model

- The Bank of England recently developed the Price Stability - Financial Stability (PS-FS) model to illustrate the interactions between monetary policy and macroprudential policy - R: interest rates; K: macroprudential tool (e.g. LTV ratio) PS curve: - Traces out all combinations of R & K for which the economy satisfies the inflation target - Downward sloping because an increase in R means inflation falls below target, which requires an offsetting easing in K to return to the PS curve.

Optimal currency area

- The GG-LL model can also be used to determine whether a group of countries form a currency union. - An optimal currency area (OCA) is a group of countries whose economies are sufficiently integrated by trade and labour mobility such that the benefits of forming a currency union outweigh the costs.

Mundell-Fleming Model

- The Mundell-Fleming (M-F) model extends IS-LM to the case of the open economy, incorporating: - Trade in goods and services - Capital flows - Assuming a small open economy with a perfect capital mobility It is similar to IS-LM: - It assumes the price level is fixed (short-run) - It focuses on aggregate demand (supply adjusts automatically)

Solow growth model

- The Solow model is a benchmark theory of economic growth. - In this model, countries grow through capital accumulation. - Poorer countries grow faster than richer countries. - Hence, they eventually catch up to income levels of rich countries. - This process is called convergence.

Convergence

- The Solow model predicts that poor countries eventually catch up to the income levels of rich countries. - This process is known as convergence. - Poor countries grow faster than rich countries, because capital is more productive when there is not much of it around. Specifically, an extra unit of capital yields a large increase in output: - generating a large increase in savings. - Thus, investment hugely outstrips depreciation. - Hence, capital and therefore income grows faster. - So China is not an "economic", it was just at a lower starting point. The Solow model predicts that poor countries grow faster than rich countries: - This is known as absolute convergence. - But this is not borne out by real world evidence. However, for countries with similar institutional frameworks: - poor countries do grow faster than rich countries. - this is known as conditional convergence - similar institutions include: legal systems; political stability; competitive markets.

Brexit from the ERM

- The UK government tried to defend the fix by increasing interest rates to 15%. - But on 16 Sept 1992 ("Black Wednesday") Britain exited the ERM and sterling began to float freely. - Chancellor of the Exchequer Norman Lamont subsequently declared he had been "singing in the bath" that evening.

Dual mandate

- The US Federal Reserve has a dual mandate to achieve both price stability and maximum employment. - This allows greater flexibility in trading off inflation stabilization for output & employment stabilization. - However, a dual mandate can decrease transparency of the monetary policy framework. - Suppose inflation is rising and the Fed cuts interest rates: - public does not know if supply shock has occurred, - so, is it accommodation of supply shock or - is the Fed inflating the economy due to political pressure? - Hence a dual mandate might undermine anchoring of inflation expectations.

Fixed Rate Exchange System

- The central bank announces a target for the exchange rate, and "defends" it by intervening in the foreign exchange (FX) market. - Usually fixed against one specific foreign currency. - e.g. China's exchange rate was fixed at 8.28 yuan to the US dollar during 1994-2005. - But there are sometimes (infrequent) adjustments to the fix: devaluation/revaluation.

Costs of currency union

- The costs of joining a currency union arise due to the loss of monetary independence. - The ECB sets a common interest rate on the basis of economic conditions across the Eurozone as a whole: a "one size fits all" policy. - If economic conditions were similar across all economics, there would be no costs of joining a currency union. - But in reality they are not, due to the existence of asymmetric shocks.

Fiscal stimulus vs. austerity

- The debate about fiscal stimulus vs. austerity is essentially a debate about the size of the fiscal multiplier. - The fiscal multiple tells us that given a $1 tax cut, how much does overall income increase? - The size of fiscal multiplier depends crucially on how much of the tax cut is saved. - There are two schools of thought on this: - Keynesian view - Expansionary austerity view.

A Keynesian revival

- The debate on fiscal stimulus vs. austerity has recurred throughout history. -Keynes had it right all along: - "The boom, not the slump, is the right time for austerity at the Treasury."

Debt delfation

- The debt-deflation theory was developed by Irving Fischer. Deflation increases the real value of debt: - a creditor with savings of $100,000 is better off. - a debtor who has borrowed $100,000 is worse off. - since debtors have higher marginal propensity to consume than creditors, the net effect is a reduction in spending. - Greek firms and households had accumulated significant debts during the boom years. - So they cut spending and paid down debt, hence the impact on aggregate demand was significantly diminished. - Effectively, the AD curve steepened.

Floating Exchange Rate System

- The exchange rate is determined by market forces. - It adjusts freely in responses to changing market conditions.

Expansionary austerity view

- The fiscal multiplier is small. - Hence the adverse effect of austerity would be limited. - This means the costs of austerity are outweighed by the benefits: - i.e. austerity is actually expansionary. - This is due to Ricardian Equivalence. - Households base spending decisions on both current income and expected future income.

Effects of a tax cut

- The following example illustrates the effects of a tax cut on aggregate demand in Ricardian world. - Tom lives in a two period economy, he receives constant income of $1000. Suppose the government cuts taxes by $100 in Y1, financed by issuing debt.

Ricardian equivalence

- The government must balance its books over the long term. Hence, a tax cut today requires an offsetting tax increase in the future. - Households will save more to pay the higher tax bill they expect in the future.

Effects of fiscal policy

- The increase in government spending increases income. - This increases the demand for money, hence the domestic interest rate starts to increase to choke off the excess demand for money. - However, as r > r*, this causes capital inflows, which has two effects: - r falls back to r* - the higher demand for domestic currency causes the exchange rate to appreciate

Effects of monetary policy

- The increase in the money supply causes excess supply of money. - Hence the domestic interest rate starts to fall to restore money market equilibrium. - However, as r < r*, this induces capital outflows, which has two effects: - r reverts to r* as capital flows out - the decreased demand for domestic currency causes the exchange rate to depreciate. - This makes domestic goods inexpensive relative to foreign goods, hence net exports increases. - Thus income increases. - This is called the exchange rate channel of monetary policy. - This is different to the interest rate channel of monetary policy in the closed economy. - To summarize, in a small open economy with floating exchange rates: - fiscal policy is completely ineffective, - monetary policy is effective, and operates purely through the exchange rate channel. *The higher the degree of capital mobility, the more effective is monetary policy relative to fiscal policy.

Bond yields

- The interest rate on a bond is known as the yield (to maturity) e.g. 1 year bond: Yield = Coupon + Principal / Price *There exists a negative relationship between bond prices and yields. Short term interest rates (e.g. on bank deposits) are determined by the policy rate: - This is how conventional monetary policy operates - Investors can chose between buying a bond or depositing in the bank. - Hence, the yield on a LT government must equal an average of the policy rates expected over the lifetime of the bond. - This is called the "no arbitrage condition."

Forward Guidance and how it works

- The key objective of forward guidance was to depress long term yields by depressing market expectations of future interest rate rises. - But wasn't that the whole point of QE? - In summer 2013, the US economy witnessed a "taper tantrum" when Fed Chairman Ben Bernanke informed Congress he may scale down Fed QE asset purchases. - Hence, forward guidance was implemented in order to re-inforce the effectiveness of QE and prevent further tantrums.

Nominal Exchange Rate

- The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. - The nominal exchange rate is defined as the foreign price of domestic currency.

Flattening the yield curve

- The primary objective of QE was to flatten the yield curve... - ...by compressing the liquidity premium. - Central bank purchases meant demand for government bonds increased, hence demand exceeded supply. - Long term yields fell to clear the bond market

Marginal product of capital

- The production function is upward-sloping: - an increase in capital p.w. increases output p.w. - The marginal product of capital (MPK) is defined as the extra output of a worker produces with a extra unit of capital. - It is measured by the slope of the production function. - The production function becomes flatter as k increases, i.e.: - it exhibits diminishing marginal product of capital.

The Real Exchange Rate

- The real exchange rate is the rate at which a person can trade the goods of one country for the goods of another. - It is the relative price of domestic goods in terms of foreign goods. - The real exchange rate is a more useful measure of export competitiveness.

Brexit and the Euro

- The roots of the Brexit decision lie in the structural flaws of the Euro project. - Mass migration from depressed Eurozone economies fuelled anti-immigration sentiment in the UK. European leaders realized that monetary union cannot work without the institutional infrastructure that exists in the US. Hence they have called for: - fiscal federalism (fiscal stability treaty) - political union. Britain was alarmed at the prospect of being ruled by distant and politically unaccountable technocrats. Thus, on June 23rd 2016, Britain, voted "No".

Yield Curves

- The yield curve plots the yield on government bonds of different maturities. - If the 10 year yield is 4%, whereas the 3 month yield is 0.5%: - The sequence of expected policy rates averaged over the next 10 years is high than currently, hence - markets BoE to increase rates in the coming years - markets "price in" this information, hence the yield curve slopes upwards. *The slope of the yield curve is a powerful tool for predicting the future path of monetary policy.

Too big to fail?

- These concerns were compounded when the US government refused to bail out Lehman Brothers. - This overturned the widely-held "too big to fail" assumption. - So banks replenished their capital ratios by the process of deleveraging: - selling assets and repaying debts.

Deleveraging

- They sold MBS bonds, corporate bonds, stocks and also cut lending. - But deleveraging had averse consequences, as banks dumped assets their prices plummeted. - Consequently, banks still holding those assets saw their capital further eroded.

Propagation of asset price bubbles

- This herding behaviour generates an excessive optimism that house price inflation will persist: *Which encourages further leveraging, and further boosts credit growth *Which fuels further price inflation *Which perpetuates excessive optimism, and so on... But eventually optimism turns to pessimism, and the bubble bursts

Consumption smoothing

- This is due to consumption smoothing: households prefer to maintain a constant level of spending over time. Consumption smoothing arises due to diminishing marginal utility, e.g.: - Homer and Marge Simpson each buy a year's supply of doughnuts. - Homer scoffs his all at once (and then starves), but Marge sensibly eats one doughnut every day. - She derives greater satisfaction from her doughnut consumption than Homer.

Fiscal policy

- This makes domestic goods expensive relative to foreign goods, hence net exports fall. - The fall in net exports exactly offsets the effects of the expansionary fiscal policy on income, i.e. there is total crowding-out - In a small open economy with floating exchange rates, fiscal policy is rendered completely ineffective.

Proponents of austerity

- Tom prefers to smooth his consumption over time. - Hence, he borrows this year (when poor) and repays the loan next year (when rich). - Thus, proponents of austerity argue that immediate tax hikes would not harm economic recovery. - Households would simply increase their borrowing in order to spread the cost of a higher tax bill over a number of years.

Ricardian Equivalence

- Tom realizes that a tax cut today means a higher tax bill next year. - He therefore saves the tax cut in order to smooth his consumption over time. - Under Ricardian Equivalence, tax cuts have no impact on consumption and aggregate demand... - ...because the decrease in public saving is offset by an increase in private saving: - hence, Labour's 2013 proposed temporary cut in VAT was heavily criticized.

Conditions for an Optimal Currency Area (OCA)

- Trade integration - Real wage flexibility - Labour mobility - Fiscal federalism - Banking union.

Floating of the Peso

- Unable to roll over some of its debt that was maturing, the Mexican government was on the brink of default. - In Dec 1994, the Bank of Mexico allowed the peso to float freely. The aftermath of the peso crisis saw: - financial crisis - deep recession *But the freedom to pursue currency depreciation meant the economy eventually recovered.

Regulatory capital requirements

- Until recently, they were determined by the Basel 11 accord: - imposed minimum capital requirement (MCR) of 2% - i.e. shareholder equity/total assets >2% - Bit more complicated than that, the denominator measured risk-weighted assets: - lower risk assets are downweighted - e.g. government bonds 0% weight, AAA corporate bonds 20% weight. Basel II also allowed banks to estimate their own risk exposure and self-report their required regulatory capital: - resulting in under-capitalization during the boom phase of the credit cycle. - In 2013, Basel III was introduced to address these deficiencies. - MCR was increased by 4.5%

The Venezuelan Crisis

- Venezuela is a state of political crisis. - Interest rates on Venezuelan govt. bonds are 22%, compared to 3% on US govt. bonds.

Floating exchange rates

- What are the effects of fiscal policy under a floating exchange rate? Suppose government spending increases: - This shifts the IS* curve to the right. - The economy moves to a new equilibrium, in which the exchange rate has appreciated, but there is no effect on income. - Hence in a small, open economy, fiscal policy is completely ineffective.

Debt sustainability

- What constitutes a sustainable level of debt? - According to Reinhart and Rogoff (2010): - a debt to GDP ratio of 90%. - Above this level, economic growth slows sharply. - Paul Ryan, Republican Speaker of the House cited this as "conclusive empirical evidence". - But the figure was wrong due to an Excel coding error! The corrected figure was 120% What are the costs of an excessively high debt level? - The government competes for scarce loanable funds, which drives up real interest rates and crowds out investment spending. It also raises concerns about default: - increase in country risk premium. - which can also cause a currency crisis (e.g. Argentina, 2018-2020).

Transmission mechanism of QE

- What is the primary channel through which QE boosts the real economy? - By decreasing long term government bond yields. - Yields on long term bonds are normally higher than those on short term bonds. But why? - To explore this further, we must first understand a bit more about what determines bond yields.

Contagion mechanisms

- Why was the contagion so rapid and so far-reaching? There were two key mechanisms at play. Self-fulfilling equilibrium: markets re-assessed country risk in the criss economies because: - Greece's default overturned the "too rich too fail" assumption of advanced economies. - Eurozone economies could not print money to finance government debt: seignorage.

Financial Stability Curve

- traces out all combinations of R & K for which the economy satisfies the credit growth target - downward sloping because a decrease in R means credit growth increases above target, which requires an offsetting tightening in K to return to the FS curve. - FS curve is flatter than PS curve because a 1 p.p. increase in K has a larger impact on credit growth than inflation, hence requiring a larger offsetting reduction in interest rates. - At the intersection of the FS and PS curves, the economy is at both the inflation and credit targets. This is known as macro-financial equilibrium.

Insolvency vs illiquidity

A bank is insolvent if: - Assets less than liabilities - i.e. it owes more than it owns - Lehman Bros was insolvent A bank is illiquid (a.k.a liquidity shortage) - If it does not have the resources to meet its current obligations. - I.e. it is temporarily unable to pay its bills - Northern rock was solvent but illiquid. The Bageot dictum states that a central bank must provide emergency lending to an illiquid bank: - but only if it is solvent - This role is known as lender of last resort - The emergency lending is known as liquidity support.

Banking union

A banking union requires common arrangements across countries for: - bank supervision - bank resolution - deposit insurance. - A common resolution mechanism compensates for the loss of seignorage implied by monetary union. -The EU adopted banking union in 2012, helping Europe to escape from the doom loop.

Bond price

A bond pays the investor a fixed interest payment (coupon) every year until the maturity date, when the principal is repaid: - e.g. a 3 year bond which pays $100 per year and a principal repayment of $1000 in year 3. Payments received far in the future are worth less than those received today: - due to the time value of money. The bond price reflects the value of this sequence of interest payments to the investor in today's money.

Real wage flexibility

A country in currency union can devalue her real exchange rate by reducing real wages. This is known was real wage depreciation. - an asymmetric demand shock means labour demand falls. - unemployment increases and real wages fall. - firms decrease prices due to lower labour costs. - hence export competitiveness increases. - Germany improved labour market flexibility during early 2000s (the Hartz reforms), leading to a sharp decline in unemployment and superior economic performance. - But most EU economies have inflexible labour markets. - Hence, real wages do not fall in response to a negative demand shock. - Hence, high unemployment persist.

The IS curve

Aggregate demand consists of: - Consumption (increasing in Y) - Investment (decreasing in r) - Government spending (fixed) Graphical representation of IS curve: - Represents all possible combinations of (Y, r) for which goods market is in equilibrium *Downward-sloping curve

Shifts in aggregate demand

Aggregate demand weak: - Prices falling (inflation low) - Output below natural rate (unemployment high) Aggregate demand strong: - Prices rising (inflation high) - Output above natural rate (unemployment low) *Inverse relationship between inflation and unemployment

AD-AS model

Also studies short run economic fluctuations and the role of policy. Focuses on the behaviour of two key variables: - Output (Q) - Prices (P) Consists of two key components: - AD curve: quantity of goods and services households want to buy at given prices. - AS: quantity of goods and services firms want to produce at given prices.

excessive optimism

An asset price bubble occurs through: - Misperception that rising prices are driven by fundamentals - Whereas in reality they are drive by speculation *Sustained asset price inflation generates excessive optimism that an improvement in fundamentals has occurred. *A classic example is the 17th century Dutch tulip bubble.

Benefits of inflation targetting

An explicit inflation target helps to "anchor" inflation expectations in the face of a supply shock. A temporary increase in inflation does not become permanent: - because inflation expectations are "tethered" to the target. Transparency of the target also helps the public fix their inflation expectations at the right level.

Troika's demands

An immediate reduction in public debt to sustainable levels through: - tax increases (VAT) - spending cuts (wages and pensions) - sale of state assets - Greece also needed to improve labour market competitiveness through supply-side reforms. - The alternative was Grexit - So Greece capitulated and received a third bailout package of 86 bn euros.

Effectiveness of fiscal policy

An increase in government spending leads to an increase in income under fixed exchange rates: - IS* shifts right - increase in interest rate induces capital inflows - higher demand for domestic currency causes exchange rate appreciation - but CB intervenes by creating money and buying foreign currency - hence money supply increases and LM* shifts right - exchange rate unchanged; output increases.

October 2008

Bank bailout programme

September 2008

Bankruptcy of Lehman Brothers

Insolvency Risk

Banks exposed to subprime losses were concerned about erosion of their capital ratios. Capital = assets - liabilities - liabilities: mostly deposits & bonds Capital ratio = capital/assets - Banks hold capital to create a cushion against losses and thus reduce the risk of insolvency. - A bank becomes insolvent when capital is depleted to zero. Banks create capital by issuing shares on the stock exchange: - hence capital is also known as shareholder equity - instead of borrowing from depositors to fund their lending - debt is much cheaper than equity - but it bears the risk of insolvency Banks which had incurred subprime losses were anxious to rebuild their capital ratios.

What causes bank runs?

Banks keep only a small percentage of deposits as reserves: - They lend out the rest to firms and households - This is known as fractional reserve banking They only need to hold a small percentage as reserves: - Because normally only a small fraction of depositors will need to withdraw their cash at any given moment. *However, in exceptional circumstances, all depositors rush to the bank simultaneously to withdraw - Known as a bank run - A bank run can cause a solvent bank (healthy bank) to become insolvent (unhealthy bank). Reserves are depleted...Loans are liquidated... and the banks become insolvent *fire sale

European debt crisis

Banks' assets grew rapidly in the run-up to the financial crisis: - in some cases to staggering sizes, e.g. Bank of Ireland; Banco Santander. - Credit growth fuelled, and was in turn fuelled by, massive housing booms. - But following the US, the European house price bubble also burst. - Banks made huge losses and faced insolvency. - Government bailouts led to dramatic increases in public debt. - Hence several EU economies were on the brink of default. - They required bailouts from the ECB, IMF and other EU countries. *The roots of the crisis lay in the structural flaws underlying the euro's creation.

Borrowing Constraints

But in China, consumers face borrowing constraints due to the inefficient state- controlled banking system: - dominated by the "big four" banks - lending mostly to state-owned enterprises - and not much to the private-sector.

Exchange Rate System

Can operate under: - Floating exchange rate - Fixed exchange rate

Investment Function

Capital accumulation occurs through the process of investment: - defined as expenditure on plant and equipment. *Investment is determined by the level of savings in the economy: - households save a fixed fraction of their income, where s denotes the savings rate. - savings are channelled to firms for investment through the market for loanable funds. - Mathematically, the investment function is expressed as: inv = sy = sf (k) - Given that investment is a fixed fraction of output: - the investment function always lies below production function, and - it has a similar profile

Basel III Accord

Capital conservation buffer of 2.5% was also introduced: - banks cannot pay dividends if they fall into this buffer zone. Counter-cyclical capital buffer also introduced: - requires banks hold additional 2.% of capital during boom phase. - to curb excessive credit growth and dampen the credit cycle

A Greek tragedy

Chancellor Merkel argued that Greece's economic stagnation was due to: - failure of aggregate supply not aggregate demand. Greek industry had lost competitiveness: - high minimum wage - strong employment protection and union power - excessive wage inflation during the boom years. Higher labour costs were passed on in prices: - leading to real exchange rate appreciation. - Greece needed to implement labour market reforms. - This would lead to real wage depreciation and improve export competitiveness. - Germany undertook similar labour market reforms in early 2000s, leading to an "economic miracle".

Who was right?

Chancellor Merkel got it wrong: - The greek economy contracted by more than 25% - Unemployment rose to 25% - 40% were below the poverty line - Economic recovery finally took hold in 2017. - Govt. borrowing costs have fallen to 4%. - Greece exited its bailout package in Aug 2018. - But debt to GDP ratio still stands at 180% Supply-side reforms were necessary but should have been combined with expansionary macroeconomic policy: - as happened in Germany during 2000s. - Hence, a fiscal stimulus was required. - Tsipras was right all along...

fiscal policy

Changes in government spending and taxes. - An increase in government spending (G) boosts aggregate demand and income. *The overall increase in income is larger than the initial increase in G: - because the initial boost to income induces second round effects on consumer spending - this is called the Keynesian multiplier effect

monetary policy

Changes in money supply An expansion of money supply: - Induces excess supply of money which decreases the interest rate - Which increases investment spending - Thus increasing aggregate demand and income - This is known as the interest rate of channel of monetary policy

China's savings glut

China has an extremely high savings rate: - 46% of GDP (2018). She exports her excessive savings to the US: - investing in U.S. financial assets. - The supply of loanable funds shifts right decreasing U.S. interest rates. This encourages excessive borrowing and spending by U.S. government and consumers: - leading to a trade deficit.

Financial Globalisation

China needs to embrace financial globalisation: - dismantle capital controls - open up the economy to capital inflows and financial firms from abroad - like the Asian tiger economies during the 1990s. *This would shift China away from the investment-led export-led growth model to a consumption-led growth path. *There are better ways to tackle the trade surplus than a trade war!

Corporate bond market

Consider he corporate bond market: - Demand for funds comes from firms issuing bonds to finance investment spending. - Supply of funds come from investors seeking to buy bonds. *Assume that corporate bonds and government bonds are perfect substitutes.

Monetary contraction

Contraction in money supply: - AD curve shifts leftwards - Prices and output fall - Unemployment rises - Hence the economy goes into recession

These interest rate differentials are due to:

Country risk and currency risk.

Autumn 2008-Spring 2009

Crisis transmitted to the real economy

GG-LL model

Developed by Paul Krugman to analyse whether or not a country should join a currency union. - It consists of two components: GG curve and LL curve. - The GG curve shows how the benefits of joining vary depending on the level of economic integration. - The GG curve is upward sloping.

A role for policy?

Did banks or speculators cause the US housing - what is the consensus?: - Both played significant part. This has important policy implications: - Policymakers cannot do much to curb speculative - but they can restrain bank credit expansion through macroprudential regulation - The expansion in credit supply and speculative investment fuelled house price inflation

EU vs US on optimal currency area

EU only meets banking union criteria meaning it is not an optimal currency area! US, however, meets all five criteria's and hence is an optimal currency area!

Costs of currency union.

Economic stabilisation in the face of asymmetric shocks can arise through other adjustment mechanisms: - trade integration - real wage flexibility - labour mobility - fiscal transfers - banking union *Hence, the costs of currency union depend on the effectiveness of these mechanisms.

AD and AS curves

Equilibrium: Aggregate demand = aggregate supply Price adjust in order to equate aggregate supply and demand - So the economy converges back to equilibrium *AS curve is upward-sloping in the short-run BUT in the long run it is vertical and AD, SRAS & LRAS all intersect *In the long-run, aggregate supply depends on the productive potential of the economy: - labour supply, capital stock and productivity Natural rate of output = fixed level of output in the long-run Short-run = economy might deviate from the natural rate (i.e. recession) *But over time, wages and prices adjust *hence in the LR, the economy reverts back to the natural rate

Effectiveness of monetary policy

Expansion of the money supply has no effect on output under fixed exchange rates: - LM* shifts right hence exchange rate depreciates - CB intervenes by selling foreign currency in exchange for pounds - hence money supply contracts and LM* shifts back left - exchange rate and output both unchanged. *A fixed exchange rate regime implies loss of a powerful tool of macroeconomic stabilization

Autumn 2007

Failure of 2 large hedge funds Northern Rock band run

Summer 2008

Fannie Mae and Freddy Mac nationalized

What caused the US credit boom?

Financial crises often arise from an interplay between credit and housing market bubbles

Fiscal federalism

Fiscal transfers can be used to cushion against asymmetric shocks: - tax revenues from prospering states are redistributed to depressed states. - the US uses federal income tax for this purpose. In the EU, there is much less scope for fiscal federalism due to limited taxation powers: - EU federal budget is 1% of GDP compared to 20% in US.

The IS* Curve

Goods market equilibrium: aggregate supply = aggregate demand (consumer + investment + government + net exports). 2 key differences from IS-LM: i) aggregate demand included net exports - net exports are decreasing in the exchange rate. ii) investment depends on the world interest rate and is therefore constant. Graphically: The IS* curve plots all combinations of (Y,e) where the goods market is in equilibrium. *The IS* curve is downward sloping - An increase in the exchange rate decreased net exports. - This deceased aggregate demand, which decreased output and income. - Which took us to a new equilibrium at B, where e has increased and y has decreased. - Hence the IS* curve is downward-sloping.

Inflation Targetting

Governments are accountable to the electorate for economic mismanagement: - whereas an unelected Governor is not Hence, central bank independence is often combined with an inflation target: - an explicit numerical target for inflation over the medium term Usually with a penalty for missing the target: - e.g. contract termination (NZ); open letter (UK)

Time inconsistency

Governments understand that a low inflation policy is in the long term interests of society: - But they cannot stick to it due to their short term electoral incentives - This is known as the time inconsistency of monetary policy Time inconsistency - long term objectives are incompatible with short term temptations: - E.g. most New Year's resolutions are broken by January 12th!

Information cascades and bubbles

Hence, in an information cascade people adopt an excessively optimistic view: - Because they are mistakenly judging the quality of information that others have. So even investors who are pretty sure that house prices were over-valued might be persuaded to buy: - On the basis that other were willing to pay such exorbitant prices

Portfolio Rebalancing

How did falling government bonds yields feed through to the real economy? - The main transmission mechanism of QE was through the portfolio re-balancing channel: - Changing the mix of assets held by the private sector There are two aspects to this: - falling government bond yields spill over to other markets (e.g. corporate bonds) through a process of general equilibrium - banks use their excess reserves to buy private sector assets and increase lending to firms and households.

IS-LM Accronym

I = Investment S = Saving L = Liquidity M = Money

IS and LM curve

IS curve = goods market and determines the equilibrium income (Y) LM curve = money market and determines the equilibrium interest rate (r) Equilibrium: Aggregate Supply (AS) = Aggregate Demand (AD)

inverted yield curve

If the yield curve is inverted: - Long term yields are lower than short term yields. - Which means the sequence of expected policy rates averaged over the next 10 years (say) is lower than, currently, - hence, markets are expecting BoE to decrease rates in the coming years, - signalling an oncoming recession.

Trade integration

If there are strong trade links with the currency area, the afflicted country can export her way out of recession.

Benefits of currency union

In 2003, Sweden voted in a referendum not to join the euro. Why? The benefits from joining the euro equal the efficiency savings from: - eliminating transaction costs. - eliminating exchange rate uncertainty. *This "monetary efficiency gain" is increasing in the degree of economic integration between the joining country and the currency area.

Bubble trouble

In 2005, US house prices had increased by 25% in the past two years.

What triggered the subprime crisis?

In 2007, subprime borrowers started defaulting on their loans in significant numbers. There were two reasons for this: - 2004-07 US Fed increased interest rates by 4 p.p. - Aug 2006: US house prices started falling in annual terms. - As the underlying collateral became impaired, banks holding subprime MBS bonds incurred significant losses. *Housing bubble burst (house collateral became worthless)... Detroit example, banks started selling houses for $5

A role for monetary policy

In addition to an inflation target, the central bank would be required to meet a credit growth target. - The CB would increase interest rates if credit growth exceeds target: - higher borrowing costs should decrease leveraging.

Unconventional tools

In contrast, long term rates were significantly above zero: - In 2009, the UK-10 year government bond yield was 4%. Policymakers were therefore forced to implement unconventional tools for monetary policy: - Quantitative Easing - Forward Guidance They were designed to decrease long term interest rate, i.e. flatten the yield curve.

Long Run Phillips Curve

In the long-run, there is no trade-off between inflation and unemployment. *The curve is vertical - Unemployment is fixed at the natural rate of unemployment.

Lean Against the wind (LATW) - Monetary Policy

Increase interest rates higher than required t meet the inflation target during the boom phase.

Credit market

Investors switch out of govt.bonds and into higher-yielding corporate bonds until their yields are equalized: - i..e the "no arbitrage condition" holds. - Hence, the increase in demand for corporate bonds means their yields also fall.

The "Doom Loop"

Investors were concerned that government borrowing difficulties would constrain: - bail-out funds - deposit insurance commitments. Hence, the doom loop induced a "sudden stop" in capital flows. Affected economies fell into deep recession due to: - High interest rates, credit crunch, austerity packages.

Subprime mortgages

Involved lending to high risk borrowers with: - Poor creditworthiness - Low income - High LTV ratios - "NINJA" loans

Mundell-Fleming

It consists of two key components: - IS* curve represents good market equilibrium. - LM* curve represents money market equilibrium. *It studies the behaviour of two key variables: - Income (Y) - Exchange rate (e) - But not the interest rate (r) *Equilibrium in the open economy is determined where the goods and money markets are simultaneously in equilibrium.

General Equilibrium Model

It is a unique equilibrium which occurs at the intersection of the IS and LM curves. *IS-LM is useful for understanding role of policy in stabilizing economic fluctuations

short run equilibrium

Jan 2020: Inflation expectations and wage demands remain low Feb 2020: Government boosts aggregate demand and output through an inflation surprise May 2020: - Unemployment falls - Inflation expectations remain low - Government wins election!

Long run equilibrium

Jan 2021: - Inflation expectations increase and SRPC shifts up - Inflation has increased, but unemployment is unchanged. *Hence, there is no trade-off between inflation and unemployment in the long run. *Overall, society is worse off from the pre-election boom: - Because the economy is stuck in high inflation equilibrium

AD-AS model advantages

Key Shortcomings of IS-LM model: - Prices are fixed. - The equilibrium level of output is determined purely by aggregate demand. In AD-AS model however: - Prices are flexible. - Aggregate supply also plays a role in determining the equilibrium level of output.

Macroprudential tools

Key tools: - Counter-cyclical capital requirements or reserve requirements (China) - Caps on loan-to-value (LTV) (UK, Canada, India) - Caps on debt-to-income (DTI) ratios (UK, Korea) - Ceilings on credit growth (Hong Kong) *They all operate by forcing banks to restrict the supply of credit: e.g. in June 2014, BoE imposed DTI limit of 4.5 due to concerns about increasing debt levels.

The role of banks

Mian and Sufi argue there is "tons of evidence" to support the active credit view: - Subprime mortgage origination expanded from 10% to 40% of market share during 2000-2006 (Levitin and Wachter) - Justiniano et al. (2016) found a sharp decline in mortgage interest rates during 2002-2005. From 2002-2005, banks massively expanded mortgage credit to marginal households: - Not based on improvements in income - Driven by fall in bank funding costs Increased lending to borrowers with poor credit histories and high loan to value ratios: - LTV - max.loan amount/collateral value - E.g. LTV = 75% means if you buy $100,000 house, you can only borrow $75,000

Monetary Policy vs Macroprudential tools

Monetary policy is a blunt tool for dealing with a credit boom: - A few p.p. increase in interest rates will have little impact in curbing speculative investment. Macroprudential tools are more targeted weapon: - it cuts off credit supply at the source

The LM* Curve

Money market equilibrium Money supply = money demand - Graphically: the LM* curve plots all combinations of (Y,e) where the money market is in equilibrium. The LM* curve is vertical - The domestic interest rate does not vary. - Hence, there is a unique level of income consistent with money market equilibrium. - This is determined at the intersection of the LM curve and the world interest rate r*. - Changes in the exchange rate do not affect money supply or demand, hence the LM* curve is vertical.

The problem with Northern Rock

Northern Rock was a medium-sized UK mortgage bank: - with minimal exposure to subprime assets. - It relied heavily on borrowing from the interbank market: - rather than traditional retail deposits - which decreased from 60% to 20% of total liabilities during 1998-2007. When the interbank market froze, it experienced a liquidity shortage: - temporarily unable to roll-over its debts - but not insolvent - Hence, it was forced to seek liquidity support from the Bank of England - This initiated rumours that Northern Rock was insolvent due to subprime losses - which in Sep 2007 culminated in the first UK bank run since 1866.

One Child Policy

One child policy: high savings act as a substitute for old-age support from offspring (Keyu Jin et al., 2017): - the transfer channel - evaluated through a counterfactual twin experiment. In advanced economies, saving by the middle-aged are offset by dissaving (i.e. borrowing) by the young: - Modigliani's life-cycle hypothesis.

Crowding out

Overall changes in income (from fiscal policy) is smaller than the full effect of the Keynesian multiplier: - Increase in income induces excess demand for money, hence interest rate increases. - But this decreases investment spending which partially offsets the increase in aggregate demand. *Crowding out reduces the effectiveness of fiscal policy as a tool of economic stabilisation.

Where was QE used: US

QE1: Dec 2008 to March 2010: - $1.35 trillion agency MBS and corporate bonds. QE2: Nov 2010 to June 2011 - $600 billion in long-maturity date Treasury securities. QE3: September 2012 to October 2014: - $40 billion per month for MBS and $45 billion per month for Treasuries - Total Fed assets increased from 6% of U.S. GDP in 2007q4 to 23.5% of GDP in 2017q1.

Where was QE used: UK

QE1: Nov 2009: - $200 billion in gilts (UK government bonds). QE2: Nov 2010 - $175 billion in gilts QE3: Aug 2016: - $60 billion in gilts and $10 billion in corporate bonds. Total assets purchases of $435 billion: - BoE balance sheet had expanded to 24% of GDP by Dec 2016. *$ is pound in this case

Where was QE used: Japan

QE: 2001 to 2006 - Japanese Government Bonds (JGBs) - BOJ increased commercial bank reserves ¥5 trillion to ¥35 trillion - limited effectiveness as banks hoarded these excess reserves - Japan experienced the "lost decade" during the 2000s. QQE: 2013 (Abenomics) - Japan Government Bonds (JGBs), corporate bonds, Japanese REITs, and equity ETFs (peaked at ¥80 trillion p.a.). BoJ balance sheet had expanded to 88% of GDP by Dec 2016

Money Market Equilibrium

Requires: money supply = money demand Demand for money is derived from Keynes' Liquidity Preference Theory: - People hold money in order to undertake transactions (medium of exchange) - Increasing in Y: Higher income means increased spending - Decreasing r: Higher interest rate increases the opportunity cost of holding money Money supply is fixed by the central bank *it is independent of the interest rate Money market equilibrium occurs at the intersection of the demand and supply curves. Suppose there is an increase in income: - Money demand curve shifts outwards - Inducing excess demand for money - Hence r increases to restore equilibrium

Summer 2007

Rising defaults in subprime mortgages

A tale of two crises

Sep 2007 Northern Rock crisis: - Bailed out by the Bank of England Sep 2008 Lehman Bros crisis: - Not bailed out by US Federal Reserve *Understood reasoning via balance sheet. Lehman was insolvent while Northern Rock was solvent but illiquid *Northern Rock temporary problem

Information Cascades

Speculative bubbles may be propagated by "information cascades" (Bikhchandani, Hirshleifer and Welch, JPE 1992). - An information cascade (a.k.a. herding) occurs when people disregard their own individually collected information: - Because they feel that everyone else simply couldn't be wrong. - I.e. they follow the crowd

Contingent convertibles

The Bank of England has implemented this counter-cyclical capital buffer: - under the EU capital requirements directive (CRD). - Creation of contingent convertibles (cocos)/ - Bonds which convert to equity when bank capital falls too low. - Combines benefits of cheap debt finance and loss-absorbing equity finance.

Costs of currency union on LL curve

The LL curve shows how the costs of economic instability due to asymmetric shocks vary depending on the level of economic integration. The LL curve is downward-sloping. - higher trade integration reduces economic instability. - higher labour mobility reduces economic instability.

Inflation bias

The UK economy was plagued by time inconsistent policies during the 1970s and 80. - The public realized that the government was perpetually tempted to inflate the economy: - So inflation expectations and inflation itself were ratcheted permanently higher - This is known as inflation bias *Hence, the UK economy suffered from chronic inflation bias during the 1970s and 80s.

Depreciation

The capital stock is also affected by depreciation: - the wearing out of old capital. A fixed proportion of the capital stock depreciates every year, hence: depr = SK - where & denotes the depreciation rate. - Graphically, the depreciation is depicted as a straight line.

Capital accumulation

The change in the capital stock depends on the balance of these two effects: - if investment exceeds depreciation, capital increases. - if depreciation exceeds investment, capital decreases. Which effect dominates? - It depends on the current level of the capital stock.

Argument against LATW

The credit cycle is defined as expansion and contraction in the availability of credit over time: - The credit cycle has a lower frequency (16-20 years) than the business cycle (5-8 years). - They are typically not synchronized - Hence, LATW might require tightening monetary policy during a recession. - This is known as the problem of "two targets and one instrument."

What are the effects of an increase in the risk premium?

The domestic interest rate increases, which means: - investment spending decreases. - money demand decreases. *But for now we will ignore the effects on money demand.

Robots in the workplace

The threat of automation has eroded wage bargaining power.

Interest Rate Risk

The yield curve is normally upward-sloping: - Even when the BoE is not planning on tightening monetary policy. Interest rates are higher on long term bonds than short term bonds because they incur greater interest rate risk. - E.g. Mary buys a 10 year bond, expecting BoE to keep rates constant - But suppose there is a surprise increase in the policy rate. - Due to the inverse relationship between bond yield and price, the price of Mary's bond falls and she suffers a capital loss.

Exchange rates

There are two different types of exchange rates: - nominal exchange rate - real exchange rate

Government bond market

Think of the government bond market in terms of the supply and demand for funds: - Demand for funds comes from the government seeking to finance its budget deficit. - Supply of funds come from investors (including the Bank of England) seeking to buy bonds. - The market yield on government bonds is determined at the intersection of supply and demand. - Excess supply of funds means government bond yields fall in order to restore market equilibrium.

Benefits are increasing in:

Trade integration: higher export share means larger efficiency savings from elimination of transaction costs and exchange rate uncertainty. Labour mobility: lower transaction costs of repatriating earnings and lower income volatility.

IS-LM Model

Useful tool for: - Understanding the effects of macroeconomic shocks - The role of policy in economic stabilisation - It focuses on equilibrium behavior of the economy in the short-run. - Equilibrium is a state of rest, where there is no force in the economy acting for change *Two key components = IS curve and LM curve

Cause of the euro crisis

What are the asymmetric shock which led to the euro crisis? - The housing boom and subsequent bust were more severe in some countries than others: - especially Ireland and Spain. Hence the "one size fits all" monetary policy of the ECB proved to be lacking. This resulted in soaring unemployment in crisis-hit economies: - Ireland: 15%; Spain: 26%

Robotisation and the Phillips Curve

What are the economic effects of this? 1) The Phillips Curve flattens: - a decrease in unemployment yields a smaller increase in inflation - because workers are afraid to ask for wage increases. 2) Natural rate of unemployment decreases: - workers cannot offset real wage erosion due to their weakened bargaining power. *Hence, unemployment falls permanently without inflation increasing much

Capital Controls

Why not fix exchange rate but also impose capital controls: - restrictions on the free movement of capital across borders. This impedes the flow of capital to its most productive uses. Misaligned exchange rates combined with capital controls can also cause global economic imbalances: - leading to political tensions...

Negative Interest Rates

Why not go below zero? - Banks are required to deposit reserves at the central bank. - Several countries have set negative interest rates on commercial bank reserves. But charging negative rates to retail customers is more difficult due to the alternative of holding cash. Why not abolish cash? - India embarked on an experiment in monetization in 2016 - The effects were disastrous! - The world is not yet ready for monetization - The conventional tool of monetary policy is the policy rate, which influences short-term interest rates. - Policy rates were stuck at zero

Inflation Expectations

Workers need to form an expectation of future inflation when negotiating wage increases. *An increase in inflation expectations leads to higher inflation because: - Workers raise wage demands to maintain real wages. - Firm's labour costs increase, hence they push up prices and inflation increases - SR Phillips curve shifts upwards *At the intersection of SRPC and LRPC, inflation expectations equal actual inflation

Endogenous growth theory

•Due to knowledge spillovers, capital no longer suffers from diminishing marginal productivity. •Effectively, the production function and investment function becomes straight lines. •Given that investment is always greater than depreciation, there is no steady-state. •Hence capital and output continue to grow in the long run.

Growth Policies

•In EGT, there exists a role for policy. •Policies which encourage R&D activity should enhance growth performance. •A framework of intellectual property (IP) rights creates incentives to innovate: - a patent gives a temporary monopoly to inventors - so they can recoup their investment costs. •But to patent an idea, you must publish it: §risking intellectual property theft.

Government intervention

•Is IP enforcement even a good thing? •The trade-off is that it prevents knowledge spillovers: §the source of long run growth. •So how can the government prevent under-investment in R&D activity?: §tax breaks for firms engaging in R&D §industrial policy - government promotion of high-tech industries NOT a trade war!

Liberal Politicians

•Liberal politicians sometimes appoint conservative central bankers for this reason: - Jimmy Carter appointed Paul Volcker - Bill Clinton appointed Alan Greenspan

Intellectual property theft

•Most trade secret thefts involve insiders. •How can you remove the knowledge from the brain of the scientist or engineer who created the invention? •This problem was highlighted in the 2003 Hollywood film "Paycheck".

Trump trade war

•President Trump has accused China of intellectual property theft on a massive scale: §a 2011 report by the U.S. ITC estimated that IP-intensive firms lost $48 billion in 2009 because of Chinese infringements. •He has retaliated by engaging in a savage trade war with China. •The Economic Espionage Act was passed in 1996 to enforce IP protection: §but there have only been 125 indictments.

Taylor Rule

•The Fed's dual mandate serves to mitigate fluctuations in both inflation and output/unemployment. •The Fed's conduct of monetary policy is described by the Taylor Rule, i.e. interest rates should increase by ½%: - for each 1% increase in inflation above target - for each 1% increase in output above the natural rate.

Global economic imbalances

•e can see the reason for China's trade surpluses in the national income accounts identity: Y≡ C + I + G+NX Y - C - I - G ≡ NX Y -T-C - I +(T- G)≡NX *Assuming a balanced budget (T = G): S-I≡NX