International Monetary Economics - Stephen...

International Monetary EconomicsLecture 5

Stephen Kinsella

Dept. Economics,University of [email protected]

February 23, 2010

Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 1 / 30

Agenda

Last Time

1 Price changes: inflation, disinflation, hyperinflation, deflation

2 Link from money supply/demand to domestic price levels to nominaland real exchange rates

3 Central Bank behaviour in all of this (inflation targeting at ECB)

Today

1 Crises

2 Currency Crises

3 Asset/Debt Crises

Admin: Tutorial Times


In the News

TDs dropping like flies

Greek bonds v.close to Junk status

Consumer confidence falling in US and EU


Ireland’s GDP/GNPSee http://www.cso.ie/releasespublications/documents/economy/current/qna.pdf

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

% Change

Year on year growth rates

GNP

GDP

Q3 2009

Jan-Sept

2009 Q3 2009

Jan-Sept

2009

GDP 42,506 128,247 -7.4 -8.1

GNP 33,941 104,192 -11.3 -12.1

GDP and GNP at constant prices

Annual % changeAmount €m

17 December 2009

Quarterly National AccountsQuarter 3 2009

GNP down 1.4 per cent but GDP shows small increase,seasonally adjusted, in Q3

Initial estimates of Gross Domestic Product (GDP) and Gross National Product(GNP), on a seasonally adjusted basis, for the third quarter of 2009 show a declineof 1.4 per cent in GNP and a small increase of 0.3 per cent in GDP compared withthe previous quarter. In comparison with the corresponding quarter of 2008, GDPat constant prices was 7.4 per cent lower while GNP was 11.3 per cent lower.

Some of the main features of the results are:

! Consumer spending (personal consumption of goods and services) involume terms was 7.3 per cent lower in Q3 2009 compared with thesame period of the previous year.

! Capital investment, in constant prices, declined by 35 per cent in Q32009 compared with Q3 2008.

! Net Exports (exports minus imports) in constant prices were €2,813million higher in Q3 2009 compared with Q3 2008.

! The volume of output of Industry (incl. Construction) decreased by 9.6per cent in Q3 2009 compared with Q3 2008. Within this the output ofthe Construction sector fell by 34.4 per cent over the same period.Output of Distribution, Transport and Communications was down 9.0per cent, while Output of Other Services was 3.4 per cent lower in thethird quarter of 2009 compared with the same period of last year.

GNPThe estimate of GNP is derived by adjusting GDP for income flows betweenresidents and non-residents. The timing of these flows can be variable. Theyinclude, in particular, the profits of foreign owned enterprises which increased by€1,054m between Q3 2008 and Q3 2009. The increase, in this quarter, in the netfactor income flows is also affected by (a) reduced credits (inward flows),compared to Q3 2008, to Irish outward direct investment enterprises and (b)increased interest payments on government debt. As a result, the decline in GNPwas more severe than that in GDP.

The calculation methods for quarterly accounts are similar to those used in the annual National

Income and Expenditure. As some of the available sources are of lesser reliability than those used

for the annual national accounts, the quarterly estimates are subject to a greater margin of error

than the annual figures. These preliminary estimates will therefore be revised when the next

detailed annual results are published.

For more information contact Gordon Cavanagh at 01 498 4307 or AndrewMcManus at 01 498 4368.

Published by the Central Statistics Office, Ireland.

Ardee Road Skehard RoadDublin 6 CorkIreland Ireland

LoCall: 1890 313 414 (ROI)0870 8760256 (UK/N

Tel: +353 1 498 4000 Tel: +353 21 453 5000Fax: +353 1 498 4229 Fax: +353 21 453 5555

Both offices may be contacted through any of thesetelephone numbers.

CSO on the Web: www.cso.ie

and go to

Economy: National Accounts

Director General: Gerard O'Hanlon

Enquiries:

National Accounts National Accounts, ext [email protected]

Queries and Sales Information Section, ext [email protected]

" Central Statistics OfficeThe contents of this release may be quoted provided thesource is given clearly and accurately. Reproduction for ownor internal use is permitted.

Ref 222/2009 ISSN 1393-9017


Recap

Causal story

Causality: Money Supply and Demand interact, → Price Level → Inflationrate → Nominal Interest rate → Money Demand.

Macroeconomic Pathologies

“our credit system [is] much more delicate at some times than at others ...panics come according to a fixed rule ... every ten years or so we musthave one of them” Walter Bagehot


Part I

Crisis


1st Gen Models of Currency Crises

1 Simple monetary flexible price model, fixed exchange rates, outputassumed constant, token real side

2 Policy maker wants to run budget deficit each period, ∆D > 0

3 Fixed exchange rates plus money financing of budget totallyunsustainable, crisis in currency inevitable.

4 Model asks: when and where does the crisis happen?


Model

m − p = α× i (money marketeqm)

m = d + r (CB balance sheet)

p = e + P∗ (PPP)

i = i∗ + ė (UIP)

ḋ = µ (govt chooses this)

m money supply

p flexible price level

i interest rate

d domestic assets held by CB

r CB foreign reserves

e exchange rate

µ budget deficit


Implications of 1st Gen models

Policy Trilemma

Fixed exchange rates, Monetary Policy oriented toward domestic goals, orInternational capital mobility (capital account convertibility). Pick two.Three is impossible.


2nd Gen Currency Crises Models

Big Idea

Expectations and policymaker’s incentives play key role in shaping policiesthat lead to crises

1 If policymaker finds upholding the peg costly in the first place

2 and if a devaluation is suddenly expected, adding to cost of peggedexchange rate

3 Devaluation! Self-fulfilling expectations

Policy wonk must minimise this loss function:

L = (a× ( e∗︸︷︷︸optimal ex.rate

−peg︷︸︸︷ē ) + b × ( �︸︷︷︸

exp.deval

))2 + C (∆e) (1)

C (∆e) = 0 if no devaluation, C (∆e) = C if a devaluation


Implications of 2nd Gen Models

1 Multiple equilibria (sunspots) possible, see Woodford (2003)

2 Self-fulfilling expectations / prophecies

3 Open Issue: Coordination of market expectations


3rd Gen models

1 Take account of huge increase in financial globalisation since 1960s.

2 Show crises as balance sheet mismatches (Krugman (1989))

Assume Owners of firms are the only investors, and their investmentdepends on their net wealth, and firms are leveraged partly in foreigncurrency: balance sheet effects of exchange rate changes.

1 Goods: y = D(Y , i ,EP/P∗) + NX (EP/P∗,Y )

2 Money:M/P = L(Y , i)

3 Interest parity: i = i∗

4 Static expectations and risk neutrality, fixed prices

5 The real exchange rate effects demand through currency mismatcheson investors’ balance sheets for any given P. (Can you see the linkwith the last lecture?)


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EMU MONITOREMU Monitor providesinformed debate onmacroeconomics in theeuro area by a group ofacademic experts. EMUMonitor started in 1998 asone of the first ECB watchgroups. Its backgroundpapers and pressconferences contributed tothe debate onmacroeconomic policy inEMU throughout the years.

Alan AhearneBruegel andNUI Galway

BarryEichengreen

University ofCalifornia,Berkeley

Stefan GerlachUniversity ofFrankfurt

Paul deGrauweK. U. Leuven

Jürgen vonHagenUniversity ofBonn

PatrickMinfordCardiffBusinessSchool

ManfredNeumannUniversity ofBonn

RobertoPerotti

IGIER,BocconiUniversity

Jean Pisani-FerryBruegel

Georg RichRichInternationalConsulting

06.01.2009

IRELAND'S PAINFUL ADJUSTMENT

By: Alan Ahearne, NUI Galway and Bruegel

For small European countries such as Ireland, the experience of the past decade demonstrates thatmembership of EMU can bring significant benefits. At no time have these benefits been more evident thanover the last 18 months. Notwithstanding domestic banking problems, membership of a large currencyunion has provided considerable insulation to euro area economies against the turmoil on global financialmarkets. The joke currently doing the rounds that the only difference between Iceland and Ireland is oneletter and about 6 months fails to recognise that small countries with their own domestic currencies aremuch more vulnerable to changes in investor confidence.

These benefits, however, come at a price. Ireland has an export-dependent economy -- and not having aseparate exchange rate as a tool for coping with the economic shocks clobbering the country raisesenormous challenges for policymakers. The past year or so has seen the bursting of Ireland’s housingbubble, the collapse of housing-related tax revenues and an accompanying rapid deterioration in the publicfinances, turmoil on international financial markets, deepening recessions in many of Ireland’s largesttrading partners including the United Kingdom and the United States, and a sharp rise in the value of theeuro against sterling and the dollar. The agility of the Irish economy and its capacity to adjust to suchshocks through internal flexibility will be severely tested over the next few years.

Chart 1: Nominal and real effective exchange rates - Ireland

Flexibility will be required to reverse the loss of international competitiveness that the country experiencedduring the boom (see Chart 1). Given the projected paths for monetary policy in Britain and the US overthe near term, it is difficult to foresee a strong rebound in sterling and the dollar. Along with Ireland’smembership of the single currency, this means that the necessary real exchange rate adjustment can onlybe brought about through changes in domestic prices and wages. In other words, the so-called“competitiveness channel” will be the key economic adjustment mechanism. For this mechanism to workproperly, two things must happen. First, wage and price inflation have to ease to rates below those inIreland’s largest trading partners. Since low (or even negative) inflation is projected in Europe and theUnited States, this implies deflation is required in Ireland. Second, the improvement in competitivenessmust affect trade performance.

How likely is it that both these conditions will be met? Honohan and Lane (2005) find that the nominaleffective exchange rate and output gap are important determinants of inflation differentials in the euro

Figure: Real Exchange Rate for Ireland.


Crisis Literature

1 Corporate finance and macroeconomics – Bernanke and Gertler(1989)/ Kiyotaki and Moore (1997, 2000)/SuarezSussman (1997,2007)

2 Role of liquidity for corporations

3 Complete contracts: Holmstrom/Tirole (1998, 2008)

4 Spot markets: Caballero/Krishnamurty (2001, 2003, 2004), Lorenzoni(2008)

5 Equilibrium supply of liquidity – Gorton/Huang (2004), Fostel/Geanakoplos (2008), Acharya, Shin/Yorulmazer (2009)


How did balance sheets get so out of whack?

1 Poor corporate governance/Regulation

2 Crony capitalism

3 Moral Hazard

4 Herding behaviour

Contagion through

Trade flows

Capital flows and financial institutions balance sheets

Financial market participants minds and “herding behavior”

Becomes a systemic risk through interconnectedness


Credit Crunch?

The largest financial Meltdown since the Great Depression US$6trillion lost on US Stock Exchange The Collapse of major financialfirms: Merrill Lynch, Bear Stearns, Lehman Brothers

International Contagion- Europe and Asia

Impact on Commodity prices

Worldwide recession


Part II

Minsky


Minsky’s Big Idea

Idea

Credit markets create their own reversal.

How?

1 Cheap interest rates lead to increased lending.

2 This leads to increases in leverage (L/D ratio).

3 Perverse incentives breed dodgy lending via financial innovations(Junk bonds/CDOS) ensues.

4 Something changes, dodgy loans default, banks fail, unless they getbailed out by Big Bank/Big Govt.


The Financial Instability HypothesisSee debtdeflation.com

Economy in historical time

Debt-induced recession in recent past

Firms and banks conservative re debt/equity ratios, asset valuation

Only conservative projects are funded

Recovery means conservative projects succeed

Firms and banks revise risk premiums

Accepted debt/equity ratio rises

Assets revalued upwards


Economy gets Euphoric

Self-fulfilling expectations

Decline in risk aversion causes increase in investment

Investment causes economy to grow faster

Asset prices rise

Speculation on assets becomes profitable

Increased willingness to lend increases money supply

Credit money endogenous

Riskier investments enabled, more asset speculation

Emergence of “Ponzi” financiers

Cash flow always less than debt servicing costs

Profits made by selling assets on a rising market

Interest-rate insensitive demand for finance


Asset Boom/Bust

Initial profitability of asset speculation:

reduces debt and interest rate sensitivity

drives up supply of and demand for finance

market interest rates rise

But eventually:

rising interest rates make many once conservative projects speculative

forces non-Ponzi investors to attempt to sell assets to service debts

entry of new sellers floods asset markets

rising trend of asset prices falters or reverses


Crisis/Aftermath

1 Ponzi financiers go bankrupt:

2 can no longer sell assets for a profit

3 debt servicing on assets far exceeds cash flows

4 Asset prices collapse, drastically increasing debt/equity ratios

5 Endogenous expansion of money supply reverses

6 Investment evaporates; economic growth slows or reverses

7 Economy enters a debt-induced recession ...

8 High Inflation?

9 Debts repaid by rising price level

10 Economic growth remains low: Stagflation

11 Renewal of cycle once debt levels reduced


The Big Bank again

1 Low Inflation?

2 Debts cannot be repaid

3 Chain of bankruptcy affects even non-speculative businesses

4 Economic activity remains suppressed: a Depression

5 Big Government?

6 Anti-cyclical spending and taxation of government enables debts tobe repaid

7 Renewal of cycle once debt levels reduced


Simple Model

1 Lit : index of liquidity measurement for one economic unit i at time t.

2 Liquidity at any t is the difference between unit i ’s inflows, Init , andoutflows, OUTit .

3 L∗it be the expected solvency of unit i between point t and a laterpoint t + m.

4 The funding ratio at any moment is given by Lit = INit/OUTit .

5 Long term financial sustainability requires that L∗it < 1.


Simple Model, contd.

1 Liquidity threshold, µ, which each unit holds.

2 If a unit perceives itself as beyond safety margin 1− µi , it reacts byreducing its current illiquidity margin 1− Lit with a resulting decreaseof L∗it .

3 Whenever a unit is within the safe zone L∗it < 1− µi , the unit ispushed by competition to increase the financial outflows more than itsinflows, and thus its Lit , in order to increase utility or returns.

4 An increase of Lit beyond the liquidity line (where Lit > 1), inprinciple, deteriorates L∗it , by increasing debt while worseningexpectations, and vice versa.

L̇it/Lit = −αi [L∗it − (1− µi )], (2)

andL̇∗it/L

∗it = βi (kit − 1). (3)

Here α and β are simple speeds of adjustment of each economic unit overtime.


Cyclical behaviour

Figure: We can think about financial fragility as the smallest shock to INit and/orOUTit that produces insolvency.

Leverage Ratios

0

5

10

15

20

25

30

35

2005 2006 2007 2008

Bank of Ireland AIB IL&P Anglo Irish

Figure: Leverage ratios (shareholder capital/equity)


Central Bank Behaviour in a Minsky WorldSee http://www.frbsf.org/news/speeches/2009/0416.html

1 CBs must bail out system to keep liquidity flowing. Why?

2 Banks too big/too Interconnected To Fail

3 Lack of regulation of new/esoteric products: Credit default swaps(CDS) ( 98% of credit derivatives) had a large role in creating currentcrisis.

4 Question for the class: Should central banks attempt to deflate assetprice bubbles before they get big enough to cause big problems?


Bank Behaviour, again

Monetary PolicyRate

Inflation Expectations

Market i. ratesterm structures

Money/CreditAggregates

Asset Prices (Wealth)

Nominal ExchangeRate

Output Gap, Employment

Absorbtion/Income Gap (current account)

Real Exchange Rate

Monetary Policy Rate

Project of Core target inflation gap

Core Inflation

Target Inflation

Figure: Central Bank Behaviour.


In Class exercise

Classification

Classify the Years 1998-2010 into the Minsky schema above.


Summary

Please write down 2 things you remember from today.

My Summary1 Crises can be self fulfilling

2 they are little understood, but much new and good work is going ontrying to explain why they occur (and reoccur).


CrisisMinsky

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