Topic 18: Financial Shocks Flashcards
What four financial shocks does this course consider?
- Capital flight. (modelled as inc. r*)
- Increased home money holding (contracts MS, potentually not possible to reverse through monetary policy).
- Pessimism about future income. NFI decreases.
- Investmente pessimism. NFI decreases.
Show the effects of a capital flight shock.
Rebalancing of assets reduced demand for home bonds, so the KA surplus contracts, and the CA deficit also constracts. Home bond yields must then rise, and there is a higher real interest rate on long term debt.
There is reduced net inflows decreases demand for all corn, but as foreign is more elastically supplied, the relative price of home corn falls - there is a real depreciation.
If the monetary target is PY there must be a nominal depreciation also.
The increased interest rate decreases money supply holdings, as the opportunity cost of holding money increases. To stop PY from inflating, MS must then contract.
If the monetary target is E then PY will decrease, and MS will decrease even more. Defending the exchange rate is tough in these scenario’s. The contraction in PY causes an output contraction.
Model an increased money holdings shock.
There is a monetary contraction - if the central bank can’t fight it (because it is ‘pushing on a piece of string’), then there will be a deflation, and workers will be fired as firms face decreased revenue, and can’t adjust wages.
eeModel a pessimistic shock over future income
YFe decreases. Households consumption smooth, so save more. NFI decreases.
Additional demand for home bonds raise their prices, decreasing yeilds and so decreasing the real interest rate. The reduced net inflows in the capital account then reduce the deficit in the current account.
As inflows have decreased, there is a lower demand for all corn. Because foreign corn is supplied more elastically, the price of home corn relative to foreign will decrease (a real depreciation).
In the money market, lower interest rate means lower opportunity cost of holding money, so mS icncreases.
Monetary policy determines what follows.
Summarise the reuslts of the financial shocks
- Capital Flight: concractionary for E regimes
- Increased money holding: contractionary if MB can’t hold MS steady.
- Pessimism over future income: contractionary if MS increase can’t be achieved.
- Investment Pessimism ^ ditto.
Outline the two real world financial shocks we analyse
- Asian Financial Crisis, 1997-98 - occured while the remainder of the gloobal economy was pretty healthy. No increase in home money holding. Combined capital flight, pessimism about future income & investment pessimism.
- The GDC of 2008 - occured simultaneously in the US & UK. Spread to other countries via financial capital & trade flows. In the US, all four shocks applied (capital flight, home money holding, pessimism about future income, investment pessismism).
Is there a role for fiscal expansions to counter financial shocks?
- By issuing bonds during a downturn, gov’s can redirect money to goods or investment which otherwise would have just increased money stocks.
- When private savings increase, the expenditure on capital goods tend to leak abroad so that home demand falls. A fiscal expansion can reverse this.
- Timing is key, increased G works during the downturn, but it’s pretty bad if it crowds out new private investment.
What is a good policy response to capital flight?
Best is to run down official foreign reserves to create an offsetting inflow, eliminate chagnes in the KA curve. A sufficient drop could restore both the home interest rate and the real exchange.
Requires the central bank to steralise the changes in it’s balance sheet, and it requires enough reserves to begin with. Specifically, it causes a monetary contraction. (it recieves money)
How effective is a fiscal expansion in fighting capital flight scenarios?
Feasible in thoery, but
- Government has to be able to sell new bonds
- Central bank has to reduce nominal money supply by selling government bonds
- But nobody wants G-bonds in a capital flight scenario.
- If the central bank buys the government bonds then it can no longer have an E or PY target. PY will inflate.
- This means an even bigger nominal depreciation.
How effective are fiscal expansions in fighting GFC style pessimism shocks?
If monetary policy is working, then pretty crap. (crowds out private investment, increases public debt, increases economic waste through rent seeking activities).
But when monetary policy is exhausted, a fiscal expansion lessens the deflation and hence the output contraction. So it’s possibly justified in the US & UK.
