SEM 2 - LEC 6 - OPEN ECONOMY macroeconomics Flashcards
WHAT DO WE USE THE we use the AD-BT-ERU model to look at
- before the Great Recession, inflation targeting + labour market reforms ⇒
- low and stable inflation + low unemployment in advanced economies
- relatively easy absorption of oil shocks
- but also external macroeconomic imbalances in many countries
- global imbalances ⇐⇒ global interdependence
describe the AD-BT-ERU model
whats this equation used to do
whats the AD in the AD-BT-ERU model
AD: combinations of y and q at which goods market is in equilibrium (& UIP)
whats bt in the AD-BT-ERU model
BT: combinations of y and q at which trade is balanced, i.e. value of exports = value of imports
show and describe the downward sloping ERU
show the impact of a supply shock on the AD-BT-ERU model
show the impact of a demand shock on the AD-BT-ERU model
show the impact of a positive external trade shock on the AD-BT-ERU model
show and describe the external trade effects of a rise in price of oil
show and describe a neg supply shock - an increase in oil price shifts the eru curve to the left
show and describe an expansion of govt spending in response to a rise in the price of oil
consider fiscal stimulus to offset negative AD shock (to achieve point A)
• under ERU′, new equilibrium unemployment is still higher
• at A, real wage pushed down by higher energy prices,
→ wage setters get higher money wages,
inflation not constant
(A is to the right of ERU′)
@B, higher unemployment, deteriorated external balance (compared to BT′), deteriorated fiscal balance because of discretionary and automatic fiscal policy
• expansionary monetary policy ⇒lower
interest rate and depreciation stimulate AD in fixed exchange rate system, similar effect from devaluation
economy goes back to initial point A
• but since A to the right of ERU′, again
inflationary pressures
loss in competitiveness would, again, depress the economy
in 1970s-80s, not all countries experienced high inflation & high unemployment
• Scandinavian countries implemented
supply-side policy: wage accord
• tripartite agreement between
government, employers, employees • employees accept wage restraint to
keep employment high
• WS shifts downward offsetting downward shift in PS ⇒ERU does not shift leftward smaller or no rise in inflation and unemployment
- between 2002 and 2008, real oil prices almost doubled, but inflation and unemployment stayed low
- why?
• smaller AD and ERU shifts, less proactive policy than in
the past
• behaviour of financial institutions allowed dampening
negative demand effect
• less compensation to workers for higher oil prices
• declining role of unions
• inflation targeting ⇒ no looser monetary policy
how do interdependence and inflation targeting combine to generate imbalances?
two-bloc AD-BT-ERU model to show the response to a shock of an inflation targeting central bank in bloc A can affect the economy and the policymaker in bloc B
• both blocs achieve their inflation targets, but under different shocks or demand patterns, current accounts and real exchange rates diverge
describe and show the different growth strategies - one bloc pursuing expansionary policies and other pursuing restrictive policies
• US economy experienced consumption and housing booms and rising government spending • we have seen above that a constant inflation equilibrium is compatible with external imbalance • under downward sloping ERU, government can encourage domestic demand (lower unemployment and higher real wages) consistently with stable inflation (very tempting especially next to elections) • however, if all countries did the same, world IS would shift outwards and there would not be constant inflation
bloc A (US, UK and Spain) supported growth through domestic demand constant inflation equilibrium with lower unemployment and external deficit • bloc B (China, Germany) depressed domestic demand to keep q depreciated and support growth through “export-led” strategies constant inflation equilibrium with higher unemployment and trade surplus • under opposite symmetric demand shifts, world economy remains at unique constant inflation equilibrium
whats the difference between export-oriented vs finance-oriented growth strategies
• BLOC A (e.g. US, UK, Spain): financial deregulation propelled house price boom (credit to low income households)
in Spain, the euro additionally allowed low cost borrowing
• BLOC B (China, Germany, emerging markets)
China: investment rate very high, but saving rate even higher (especially by firms). Government favoured export-led strategies by preventing real exchange rate appreciation and real wage and consumption to rise
Germany: concentrated on restoring competitiveness post-reunification. Tight fiscal policy and labour market reforms to encourage wage restraint
• China was growing fast, Germany slowly, but both had national savings higher than national investment and experienced trade surplus
• emerging markets and oil exporting countries had surpluses that were recycled in BLOC A (see Byrne, Fazio and Fiess, 2012, 2013)
can a current account imbalance be benign?
- can assimilate to behaviour of household under permanent income hypothesis
- borrowing/lending when income is below/above expected long-term level
- ability to borrow allows household to improve welfare compared to the situation when consumption is tied to current income.
example: property price boom
• households feel wealthier and consumption increases • imports increase and the trade balance deteriorates
• but the house price boom does not create wealth that can be used to repay the external debt
• eventual burst of the bubble implies that the country has to find ways to service the debt ⇒ fall in living standards
can a current account imbalance be benign?
- can assimilate to behaviour of household under permanent income hypothesis
- borrowing/lending when income is below/above expected long-term level
- ability to borrow allows household to improve welfare compared to the situation when consumption is tied to current income.
example: property price boom
• households feel wealthier and consumption increases • imports increase and the trade balance deteriorates
• but the house price boom does not create wealth that can be used to repay the external debt
• eventual burst of the bubble implies that the country has to find ways to service the debt ⇒ fall in living standards
solution to a Current Account deficit requires either
• adjustment of quantities (public and/or private savings,
income, X − M)
• adjustment of prices (exchange rate)
explain why there’s nothing nothing intrinsecally wrong with a CA deficit.
• a country may be borrowing foreign funds for good or bad
reasons.
explain diverging paths: CA deficit (and the accumulation of foreign debt)
- good, sustainable and lead to higher long-run growth
* bad,eventuallyunsustainableandleadtocurrencyanddebtcrisis
further factors of ca sustainability
capital account size and composition, size of foreign
exchange reserves, financial system soundness, political instability,
exchange rate policies.
