Topic 2: Economic & Financial Policies Flashcards
Macroeconomic Objectives
- Benchmark for economic policy = ?
- Potential growth = ?
- Benchmark for economic policy = achieve actual growth as close to potential as possible and the fastest potential economic growth as possible
- Potential growth = that sustainable rate of growth that keeps inflation and employment both as low as possible (internal balance) and avoids balance of payments crises (external balance).
- Potential growth rate is fixed in the short term but adjustable in the long term
- Potential growth is estimated but not observable
- Output gap = difference between actual and potential growth. If negative, there is spare capacity. If positive, there is excess demand which could increase inflation and decrease unemployment. In the BoP: excess domestic demand, buy from o/s, deficit.
Key drivers of potential GDP (4)
top 3 are main
- Population
- Labour force participation
- Productivity (technology shifts production frontier +vely)
- Politics / policy reform
Labour productivity
vs
Multi Factor Productivity
- Labour productivity = real GDP per hours worked & is the most commonly used measure of productivity and the most straightforward to calculate
- affected by amt of capital available per worker per hour worked + changes in efficiency when labour & capital are combined
- Therefore - Multi Factor Productivity: measured in terms of real GDP per unit of labour & capital (better reflection of overall efficiency)
- Australia’s productivity slowdown has been masked by the terms of trade surge
NAIRU
Non Accelerating Inflation Rate of Unemployment
Phillips Curve
Phillips curve = trade off between inflation and unemployment.
Lower unemployment means higher inflation. In the long run, higher inflation leads to lower growth and higher unemployment
Fiscal Policy
Discuss surplus and deficit
A country in surplus can pay off debt. G - T < 0.
Principals of sound fiscal management:
Australian Charter of Budget Honesty 1998
- manage financial risks prudently, maintain debt at prudent levels, ensure FP contributes to adequate national saving & cyclical fluctuations are moderate
- pursue spending & taxation consistent with stability & predictability, maintain integrity of tax system, have regard for future generations
- financial risks include excessive net debt, commercial risks from ownership of PTEs, erosion of tax base, management of assets & liabilities.
Sustainability requires increased Fiscal / Govt savings
- why
- how
Why: create room to manoeuvre - insurance against future shocks. Create stronger, more balanced growth over longer term.
How:
- deficit reduction - increasing world savings to lower equilibrium world real interest rate and promote growth
- lower distortionary taxes / subsidies (on labour & capital) that discourage investment & lower potential effetcs on investment & growth.
- tax consumption & raise efficiency of government spending
- credibility
What determines what is sustainable growth/
1 / (r - g)
p + r = real interest rate - (g+p*)
g is determined by the 4ps.
Watch out if r>g
MOnetary Policy
- Aims of central banks
- Price stability (low & stable inflation)
- high inflation is negative for growth & stability (creates uncertainty, transfers wealth away from those with nominal incomes) - Provides nominal anchor for the economy
- stabilise inflation expectations, stabilise interest rates, stabilise the fundamental value of the exchange rate - Other nominal anchors
- gold, money supply, fixing exchange rates
Monetary Policy
Aims of central banks
- Price stability
- HIgh / Full employment
- Economic Growth
- Stability in Financial Markets
- Interest rate stability
- Exchange rate stability
Monetary Policy
US Federal Reserve
- 12 Regional Banks & Board of Governors.
- FOMC comprised of 7 members of the Board of Governors and Reserve Bank presidents, 5 of whom serve as voting members on a rotating basis.
- President appoints Board of Governors of the Federal Reserve System
- Goals: “In setting monetary policy the Committee seeks to mitigate deviations of inflation from its longer-run goal (core inflation 2% and deviations of employment from the Committee’s assessments of its maximum level” (unemployment - 6%)
Monetary Policy
ECB
- ECB is responsible for MP covering 17 member states of Eurozone. Established by EU in 1998. HQ = Frankfurt
- Governing Council composed of 6 members of executive board and governors of national central banks that have adopted the euro
- Meets monthly to make MP decision
- Maastricht Treaty: overriding long term goal is price stability (primary objective)
- Support high level of employment & sustainable & non inflationary growth
- ECB have defined price stability as target inflation of below but close to 2%
- “Whatever it takes” Draghi, 2012
Monetary Policy
RBA
- Reserve Bank Act of 1959: “ the powers of the Bank… are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to
- the stability of the currency of AUstralia
- the maintenance of full employment in Australia; and
- the economic prosperity and welfare of the people of Australia”
- 9 members: 3 RBA officials, Secretary to the Treasury, 6 external members who are appointed by the Treasurer
- meets 11 times per year, 1st Tues of month
- aims to keep inflation 2 - 3% over the cycle
Monetary Policy
Council of Financial Regulators
- role is to contribute to efficiency & effectiveness of financial regulation & promote stability of Aus financial system
- RBA chair; APRA, ASIC & Treasury
Monetary Policy
People’s Bank of China
- est 1948
- Needs to report to State Council its decisions concerning annual money supply, interest rates and other important issues specified by the State COUncil. Must also submit work report to the Standing Committee of the National People’s Congress on conduct of MP
- Objective: maintain the stability of the value of the currency and thereby promote economic growth
- Tools: FX, deposit & lending rates, reserve requirements
Monetary Policy - China
China has managed exchange rate and price & quantity instruments. Also active macroprudential tools
Monetary Policy Transmission Mechanisms (3)
- Impacts via real variables (real interest rate, real exchange rate)
- Money supply and the money multiplier (Friedman and MV = PY)
Money * velocity = price * output - Short and long term interest rate changes impact
- cost of capital for investment & housing
- wealth effects via shifting asset prices
- cashflows - household & business income after (net) interest payments
Monetary Policy
Central Bank tools
- Money supply…. quantitative easings
- Reserve ratios and lending requirement
- Short term interest rates
- Exchange rates
What happens when real interest rates rise:
- decrease C, decrease I, increase exchange rate.
Increase imports, decrease exports
Displace domestic demand (demand curve shifts to the left
Displaced demand curve leads to increased unemployment and decreased wages, and lower pressure on inflation.
Fisher effect (monetary policy, look at real rates
Fisher: increases in expected rate of inflation should generally result in higher nominal rates of interest because inflation redistributes purchasing power between debtors and creditors.
1 + r = (1 + i) / (1 + p)
if p is very low; r = i - p
r = long run real interest = potential / trend output rate
p = expected rate of inflation
Judge whether MP is tight by:
judge whether MP is tight by real interest rate.
Fisher Rule: cash rate = neutral real rate + rate of inflation
Taylor Rule
Monetary Policy
- Rule for monetary policy
- Equilibrium real interest rate (r), nominal interest rate (i), inflation rate (p), actual GDP growth (y), potential GDP growth (y) and inflation target (p)
EQUATION: i = p + r + 0.5 x ((y - y) + (p - p)) (note the 0.5 can be changed)
Qn, when does Fisher Rule = Taylor Rule
Taylor Rule needs modification, flexibility, judgment:
- shifts in potential growth (y* ie GDP)
- shift in equilibtrium real interest rate (r)
- changes in intermediation costs/ borrowing spreads (central bank rate i c bank borrowing rates)
- availability of credit and its impact on growth (y)
- Exchange rate targets (impact p & y)
- Temporary shifts in p (v core / underlying cpi)
- one-off shift in p (tax change)
- financial instability risks - upward bias during busts
why are policy rates lower than what would be indicated by the taylor rule?
- high savings
- slower growth
- gearing / leverage is too high
- lower level of equilibrium real interest rates
Quantitative Easing:
- injecting money (large scale asset purchases funded by central bank reserves) so to increase nominal spending consistent with inflation target
- aim: encourage spending and avoid deflation
QE impacts asset prices and increases wealth of asset holders via 3 channels:
- announcement effects (consistent with keeping cash rates low for an extended period
- lower long term bond yields & beneficial impact on other asset values
- lower liquidity premium
Forward Guidance - added stimulus and reduce risk
- need to clarify policy path
- clear - spell out conditionality
- credible/believable to public / markets
- correctly interpreted by markets - risks
- conditionality - necessitates credible revisions
- disruptive financial market reactions
- encourage excessive risk taking
Current issues with monetary policy
- shown little ability to reduce asset & financial bubbles
- size of financial sector relative to real economy
- growing proportion of financial assets on b/s - Moral hazard & Greenspan put
- central banks favour growth over LT financial stability with speed & size of easing
- regulators tend to keep institutions afloat rather than unwind
Difference between microprudential and macroprudential
Microprudential: individual rules for individual banks
Macroprudential: rules around entire financial system, eg GSIBs capital rules
3 characteristics of bubbles
- rapid credit growth
- rapid asset price growth, relative to income / earnings
- physical over-build of the asset (excessive supply)
Depreciation of currency, vs appreciation
Depreciation: financial conditions are easier and activity improved; a permanent fall in real A$ will increase inflation 0.25 to 0.5% over next 2 years because cost of imported goods increases and indirectly through demand for domestic goods & higher prices
Appreciation: financial conditions are tighter. Temporarily, a decline in cost of imports leads to a decrease in inflation.
FX styles
- Capital controls: difficult to be pervasive / effective, prohibitive costs, setback to financial devt
- Free floating: best in theory - automatic stabiliser to external shocks; but prone to under / overshooting with effects on real economy & financial conditions
- Managed: could be set too high / low; fear of floating eg small countries
Exchange rate drivers; purchasing power parity
The purchasing power between two economies drives the exchange rate
PPP: nominal exchange rate (e) is a simple product of the price level in one currency (p) in terms of the price level in the other currency (p)
e = p/p
Actual exchange rate can move a long way from PPP for many years and in wrong direction
Terms of trade =
Terms of trade = price of exports / price of imports
Drivers of A$
- interest rates (Aus) minus interest rates in the world (real interest)
- foreign direct investment
- commodity prices
- terms of trade ((price exports / price imports), difficult to forecast)
Impact of real exchange rate depreciation
- lower the price that foreigners face when buying exports from a country
- raise the price of imports
- depreciation should therefore improve the trade balance.
Real exchange rate: impact on trade balance
There is a differential impact of exchange rate on tradeable goods & services and non tradeables
Tradeables prices usually rise quite soon if local currency depreciates (quick passthrough).
Non tradeables respond more slowly
Nominal vs real trade weighted index
TWI = weighted bilateral pairs by importance of foreign country in domestic country’s total external trade
Published TWI by RBA is NOMINAL
If it is adjusted for inflation, then th TWI would be REAL
Current Account Deficits
- Developed countries often run deficits while emerging countries run surpluses
- Can reduce CAD by increasing X vs M
- Sometimes considered living beyond your means - but not always bad
- CAD means country is importing more G & S than it is exporting
- Can also be viewed as a difference between national savings and investment - ie may reflect low level of net savings relative to investment; or a high rate of investment; or both
Current account: define
Part of balance of payments
Current account = X & M of G&S and income payments to/from countries
Capital account: define
part of balance of payments
Capital account = transfers of capital (mainly debt & equity) into or out of the country
A current account deficit in Australia must be balanced by:
If sufficient private capital flows do not flow in of their own accord:
A current account deficit in Australia must be balanced by: capital account surplus
If sufficient private capital flows do not flow in of their own accord: either the exchange rate will have to fall to attract required inflows, or central bank will have to run down foreign exchange reserves (sell foreign assets buy A$)
Purchasing Power Parity
- semi strong
- strong
-
- very important property of mean reversion
Strong: - exchange rate should be = price level in one currency in terms of the other
Semi Strong - exchange rate will change to EXACTLY offset a change in relative price levels between to currencies to maintain price competitiveness. In doing so, the CHANGE IN NOMINAL EXCH RATE LEABES REAL EXCH RATE UNCHANGED. Not a reliable forecasting tool.
