Ch 19 Flashcards
Internal balance
Macroeconomic goal of producing at potential output (full employment) and of price stability (low inflation)
Y > Yf
Overemployment -> P rises -> inflation rises
Hi inflation
Pi > 10!! Price volatility (std deviation less predictable) + borrower wins
Y < Yf
Underemployment -> P falls -> possible recession/deflation
Low inflation
Borrowers LOSE and LIQUIDITY TRAP (economy slowing and cannot lower R further)
External Balance
Achieved when CA is balanced
Negative CA
Pros: financing + good investment projects
Cons: borrower to rest of world, can lose in bad investment project, and paying interest on debt (accumulating debt piles R further)
Positive CA
Pros: You’d rather be a lender for more power + investment opportunities
Cons: Money doesn’t go into domestic (losing K), cannot collect taxes from abroad, recovery issues, and trade wars
Sudden Stop
County unable to pay debt -> foreigners reluctant to lend new funds + possible demand repayment of earlier funds (take back their money -> shrink GDP)
Intertemporal consumption smoothing
Limits each country’s spending over time to levels it can repay w interest (borrowing -> make consumption smoother)
Can a country borrow forever?
Yes, if it’s growth rate is near the interest it’s paying on its debt (I.e. New Zealand)
Open economy trilemma
Can only achieve two of the following:
1) Exchange Rate stability
2) MP (oriented towards domestic goals)
3) Freedom of Intl K movements
Under Breton Woods System, where on trilemma are we?
IMF took freedom of financial flows (we have MP and fixed E)
Gold Standard (1870-1914
Prices adjusted according to amount of good circulating in economy which affected CA
Price specie flow mechanism
Adjustment of prices as gold flows in/out of country, reducing CA surplus/deficit
Inflows -> Inflate P
Outflows -> deflate P
If UK had CA > 0 how does it go back to CA = 0?
Gold earned from X flows into UK > Raises Puk lowers foreign P > goods from UK become expensive + foreign cheap > reduces CA surplus of UK (and deficits of foreign countries)
Did UK CA SURPLUS go away in reality?
NO, kept gold by keeping high R using sterilized intervention to pay w comp of assets
Rules of Game
Another adjustment process carried out by CBS
1) sell domestic assets to get money when imports cause gold outflows. Ms falls and R rises, attracting financial inflows to match CA deficit (REVERSED outflows)
2) buy d assets w gold inflow-> Ms rise and R falls -> reduces inflows to match surplus
Who had the strongest incentive to practice rules of the game?
Banks with low gold reserves -> cannot redeem currency w/o gold and gold earns no interest
GS in practice + drawbacks
CBS w hi gold reserves seldom followed rules and often sterilized gold flows to prevent affects on Ms and P. Caused recession + higher unemployment
Drawbacks: NO MP and limited gold
Interwar Years
GS stopped in 1914 and resumed 19-33. Halves:
1: Churchill messed up > pulled £ from market to get to prewar levels of E > recession
2: countries that left GS did better > created beggar thy neighbor policies to benefit their currencies at others expense (ie Arg > Bra) and countries became islands to counter this
Breton Woods System (1944 - 1973)
Just like GS but w $ > fixed E against US $ and fixed $ price of gold
Established
1) IMF (international monetary fund)
2) WB (world bank)
3) GATT (general agreement on trade and tariffs)
IMF role?
Central role w 3 facilities:
1) conditionality > lend to countries to devalue their currency
2) fundamental disequilibrium > sustained inflow ≠ outflow; devaluation/revaluation permission
3) capital control > CANNOT freely flow (trilemma)
Principal tools for external/internal balance?
Internal: FP
External: borrow from IMF + restrict financial flows + infrequent changes in E
Policies for internal + external balance
1) Expenditure switching > E, depends on IMF
2) Expenditure changing > G (lose MP, only move horizontal on graph)
Why did BW collapse?
Capital controls breached > leads and lags in trade > heavy speculation US currency would depr by fundamental disequilibrium so investors bought large quantities of foreign currency to SHORTSELL
How is Great Depression linked to GS?
GS played a central role in starting GP and spreading it. US tried to slow economy by lowering Ms while France faced larger fin inflows after an inflationary period and both countries absorbed gold at alarming rates. Other GS countries had to sell domestic assets to raise R and conserve their gold. Result: WW Ms contraction and recession
Case for Floating Exchange Rates (did they hold after 1973?)
1) MP Autonomy (YES)
2) Automatic Stabilization (Yes - Reagan FP expansion)
3) prevent speculation (no)
4) symmetry (no - $ still held as reserved currency and foreigners affected by US policy)
GS vs BW
GS = free flow of K + G
BW = MP but no free K flow
Case Study: 1933 - 85
OPEC shock > Us lowers R and EU raises R > EU angry since dollar is weaker
2nd shock: US rises R which appreciates dollar, EU imports inflation and raises R which causes WW recession
Reagan fixes this through FP expansion
Case Study: 85 - Now
1) JP depr currency by lowering Ms too much > asset price bubble > recession > spreads to East Asia (trilemma)
2) ERM crisis > speculation > Germany reunification raises R > UK had to raise R since they are pegged
3) Saving Glut > Chinese growth > $ assets bought > lots of inflow to Us
4) 2008-9 crisis > asset bubbles in housing > lower R > P lowers > crisis
5) Pandemic > deep recession > inflation rises > Trump: cut taxes and import tariffs
