ECON 2180 Marymount College International Economics & Investment Demand Discussion

Problem Set #6 Economics 2180 Due on December 11th. Please put your name, your section and your TA’s name on the problem set. You are allowed to work together, but each student must hand in their own problem set in their own words. Please make sure to do all problems. Skipping a problem is much worse than getting one wrong. Late problem sets will face a substantial penalty. #1 Suppose that American firms become more optimistic and decide to increase investment expenditure today in new factories and office space. How will this increase in investment affect output, interest rates, the exchange rate, and the current account? (show on ISLM with FX diagram & explain) [assume shock is temporary] #2 a. Use the ISLM to illustrate the impact on Y, i, E, and the trade balance if there was a sudden temporary increase in consumer confidence (they feel better about their job prospects and debt levels). Draw the shock, and then explain what happened to each variable. b. do the same as in a), but assume that the home country has a fixed exchange rate maintained by the central bank. #3 a. Use the ISLM to illustrate the impact on Y, i, E, and the trade balance if there was a temporary fall in foreign government spending. b. Explain what policy response you would take if you were allowed to adjust either fiscal or monetary policy and had as your goal maintaining full employment. (assuming NO fixed exchange rate in this scenario) #4 use the symmetry integration diagram to place the following countries on the diagram and say if they should peg or not (just use your general knowledge about them, no outside research is required). That is, draw up the diagram and place four points (one for each below) and then just write a sentence for each as to whether it seems they should peg or not. a. b. c. d. Should El Salvador peg to the U.S. Should Brazil peg to the U.S. Should Lithuania peg to the euro Should El Salvador peg to the euro OPTIONAL PRACTICE PROBLEM #5 Lithuania was pegged to the euro. Using the IS-LM-FX model for home (Lithuania) and foreign (euro) show how each of the following impact Lithuania: a. The Eurozone reduces its money supply b. Lithuania cuts government spending Lectures for Chapter 18 Summary of intervention • Central banks frequently intervene • Often sterilized and often ineffectual • If they want to move E, they can, by doing unsterilized intervention (or just moving the interest rate). • They MIGHT have an impact if they sterilize, but usually only if there are special circumstances (capital controls) or if they can somehow move expectations – Joint operations are much more successful 2 So far… • Thought about trade flows and impacts on firms and factors of production • Considered how to think about the current account • Developed a model for the exchange rate • Thought about price levels and money • In the end though, what matters to firms and people? – Output • Jobs, Standard of living • Business conditions, profit opportunities 3 Output in the short run • Again, two countries (or home and RoW) • Short run so prices are… – Sticky • If prices are sticky, and we are in a long run equilibrium, we’ll say expected inflation is zero • We assume fiscal policy (G & T) are set by policy (they are exogenous) – Recall, G is just spending, not transfers • Other parts of Y=C+I+G+(X-M) will fluctuate with different variables. – Holding transfers and foreign income at zero so – CA = X-M – Assume all in rest of world (RoW, or “foreign”) are constant unless we state otherwise 4 What determines consumption? • Consumption = C(Y-T) – That is, consumption is a function of income – People consume income at some rate (the marginal propensity to consume or MPC) 5 Reasonable? • YES! People due tend to consume a particular amount of their income • It can change: – – – – – – We’ll often “shock” the MPC Fear of a recession or losing job >>> MPC falls Fear of having too much debt >>> MPC falls Optimism >>> MPC rises Sudden ability to borrow more >>> MPC rises More wealth means MPC may rise • Key point is MPC is constant unless we give you a story saying how/why it changed 6 What determines investment • Firms investment is a decreasing function of the real interest rate. That is, investment falls when the real interest rate rises. 7 Reasonable? • YES: firms often borrow to make their marginal investment. They’ll have an expectation about “rate of return”, as borrowing costs rise, they’ll undertake fewer projects. • This is just a repeat from our S, I, CA model • It can change: – Again, many things can change it • “animal spirits” • Optimism / pessimism • State of the financial sector (ability to borrow at a given interest rate) 8 What determines the trade balance? • What should determine the trade balance? – The real exchange rate (q) recall q = EP*/P (up is a depreciation) • Increasing function: as our goods get cheaper, we export more and import less • Referred to as expenditure switching – Home income (how much can we spend) • Decreasing function: as our income rises, we consume more imports – Foreign income (how much can they spend) • Increasing function: as their income rises, they can buy more of our stuff. 9 Trade balance * * * TB = TB(  E P / P , Y − T , Y − T    ) Increasing function Decreasing function Increasing function • Upward sloping against q, changes in Y or Y* are seen in a shift in the curve 10 A bit more careful • If home depreciates, what happens to the volume and price of home exports? – P: Nothing – Volume: up – Goods stayed same price at home, but got cheaper to world, so volume up. • If home depreciates, what happens to the volume and price of home imports? – P: up (same price in foreign currency, now more expensive here) – Volume: down (due to increase in price) • Overall, volume effect says TB improves, BUT, price effect is negative: we’re paying more for our imports. • KEY ASSUMPTION: we will assume the volume effect wins out at least over time. • We’ll return to these issues 11 Still… you do see effects • Over time, a change in E should change prices people face, and you do see a broad correlation between q and TB. – Operates with a lag – Lots of omitted variables • Expenditure switching does happen and is important, but is not as simple as it may 12 sound at first. Exogenous shocks • In addition to changes in G or T (or Y*), we can also let the curves shift • E.G., could be optimism about economy >>> more consumption, or more investment, or a taste shock towards home • Means that the curves shift. 13 Equilibrium in economy • We know that Y=C+I+G+(X-M) • We also know that the amount we demand or spend must be equal to our production / income (having taken into account (X-M)). – In a closed economy, it is obvious. – In an open economy, the CA tracks the gap • So, we can think about all of these things we’ve determined make up demand and know they must = income (Y). 14 Putting it together • Equilibrium is where Demand equals supply in the overall economy ( ) Y = C (Y − T ) + I (i ) + G + TB EP * / P , Y − T , Y * − T *  D 15 intuition • Slope of D line is more flat b/c as income rises, demand for home production does not rise 1 for 1 • Always need to be where D = Y • At point 3. we’re in excess supply – Inventories will build up, firms produce less, shift over to 1 – Opposite if at point 2 16 What happens if I goes up? (surge in optimism) • Moves I function out, which shifts demand up which leads to higher output 17 Factors that shift the demand curve • What would shift out the demand curve? Fall in taxes T Rise in government spending G Fall in the home interest rate i Rise in the nominal exchange rate E Rise in foreign prices P* Fall in home prices P Any shift up in the consumptio n function C Any shift up in the investment function I Any shift up in the trade balance function TB        Demand curve D  up  shifts  Increase in demand D  at a given level of outputY      • Anything that would make demand at home rise 18 How are i and Y related i IS Y • We will sketch out the relationship that when i is high, Y is lower (and vice verse) • Changing “i“ is a slide along the curve • Other things can shift the curve (things that will change Y at any given i) 19 Putting everything together • We will use the cross diagram to motivate what is happening with demand (IS curve) • THEN use the interest rate we get to figure out what is going on in the FX market • Just like using our MS/MD diagram next to the FX market. • After 5 minutes from now, won’t draw the cross, it is just in the background. 20 Cross will operate in the background • • We’ll think about the relationship between i and Y, and use the goods market to derive it first. [the IS curve] AND will keep track of what happens to E. When i falls, Y goes up BOTH due to the investment impact AND due to the trade balance (via the interest rate impact on E) 21 Anything else that moves demand, moves the IS curve • Nothing happens to the interest rate or FX yet until we put another curve on the IS diagram • Note: change in i is how we derive IS (slides along curve) the rest shift it 22 Factors that move IS out • What shifts the IS out? Fall in taxes T Rise in government spending G Rise in foreign interest rate i* Rise in future expected exchange rate E e Rise in foreign prices P* Fall in home prices P Any shift up in the consumptio n function C Any shift up in the investment function I Any shift up in the trade balance function TB • •        Demand curve D IS curve   shifts right up shifts    Increase in Increase in demand D  equilibrium outputY at any level of outputY  at a given and at a given home interest rate i home interest rate i     i* and Ee are on here because it shifts FR out and thus depreciates home currency, increasing the TB Prices move q and therefore move TB too. 23 How else are Y and i related? • Money demand. • An increase in Y leads to an increase in money demand and an increase in i. That is our “LM” curve 24 LM will move if i changes for a given Y Rise in (nominal) money supply M Any shift left in the money demand function L LM curve   down or right  shifts   Decrease in equilibrium home interest rate i at given level of outputY 25 Reality check • There are some other ways of conceptualizing the LM – Think of it as the Fed’s “reaction function” • If Y goes up more than they wanted, the would raise interest rates (hence upward slope) • If they decided to be more aggressive with monetary policy (i.e. cut rates) that is shifting the LM curve down • Some rename it the “MP” curve (monetary policy), but really winds up working fairly similarly – To avoid confusion, we’ll use the “LM” terminology, but you should know it can be more broadly applied with similar results 26 Equilibrium • Wind up where both goods and money markets are in equilibrium. • The interest rate coming out of that will give us the exchange rate. • Now, we can have a variety of shocks and variety of policies and can keep track of what happens to Y, i, and E. 27 Using the framework • Goal is to let us have a range of shocks that will give us a new Y, i, and E 28 Temp Increase in the MS • What moves? – LM moves out (lower interest rate for a give level of output in our MS/MD model) • What happens? – Lower i, higher Y, higher exchange rate (more depreciated home currency) 29 Temp Increase in the MS • Money supply rises, LM goes out, i falls, exchange rate depreciates, and Y rises • NOTE: not moving IS curve, sliding along. The increase in investment and exports is built into the IS slope 30 Same as last week (but now we see Y too) • This is what we did last time. Temp MS up got us a lower interest rate and a more depreciated exchange rate • Note this picture is holding Y constant. Innovation this week is endogenous Y 31 Temp increase in G • What moves? – IS curve shifts out (greater demand) • What happens? – i goes up, Y goes up, E goes down (home appreciates) 32 Increase in G • Note the crowding out as both the interest rate rises and exchange rate appreciates – If interest rate did not go up, Y would have gone out more – This is what the upward slope of the LM gets us 33 What about holding E fixed? • As we’ll discuss next class, sometimes the central bank may want to hold the exchange rate fixed. • That will greatly change how things work. 34 What if CB didn’t want to let E change • They CAN’T increase the MS – Doing so would change E, and they don’t want to – So you can’t use monetary policy 35 Temp increase in G (E fixed) • A soon as i goes up, E starts to move, CB must respond. How? • Increase M so LM shifts out and i stays same so E stays same • Y has gone up a lot (no crowding out) 36 Fiscal policy if E is constant • Here, if G goes up, there’s pressure for i to rise and hence E to fall (home appreciate) (shift from IS1 to IS2) • CB must shift out LM to get to point 2 so E stays fixed. • We never get to that equilibrium at IS2 and LM1. CB responds right away 37 Other shocks • Note: increase in G or M are just two of many shocks • BUT, in a lot of ways, they all work the same. • Any of our shocks that shift up demand will look like those fiscal shocks – And don’t forget things can expand OR contract demand 38 The Long Run • Note: everything in this model is short run • Book largely is stopping there when it comes to stabilization policy. • In the long run, what happens? – PRICES ADJUST! • What does that do? – Will eventually get us back to equilibrium 39 Prices rise in response to permanent MS increase Long run Short run • • Short run is a big depreciation with Y up and i down (FR moves due to expectations) In Long Run, prices should rise, bringing M/P back to balance, so LM comes back. – ISLM equilibrium is back at 1 • Note: FR moves out permanently (just as in the overshoot), so we wind up at a more depreciated exchange rate in the long run despite going back to the same Y and i in the ISLM figure 40 A Drop in Investment with no response • • • If IS falls back and nothing is done, there is some cushion right away due to more depreciated E and lower interest rate (so IS does not go back as far as it would) Also, though, once people realize nothing will be done, they expect P to fall, FR shifts out, over time IS shifts back in some and LM out (as M/P goes up with falling prices) Gets messy: model is really about the short run and assumes you WON’T just sit in a recession indefinitely 41 In the Long Run • What is going to matter is productive capacity – Population growth – Productivity • We’re abstracting from these for the short run, but in the long run, they create the “Speed Limit” • Think of Yf as the “full employment Y” effectively the maximum potential output of the economy without overheating • If Y < Yf, eventually prices fall to accommodate that. If Y>Yf eventually prices rise to accommodate that. 42 So…. • Use ISLM to think about shocks to the economy or policy shocks and responses • Remember that there is a long run anchor based on Yf. • Will turn next to thinking about policy a bit more carefully and thinking a bit about the special challenges of policy in the current crisis. 43 Stabilization policy • In general, we will often assume the economy is at some Yf (full employment level of output) to begin with. • A shock hits taking us below Yf. Now what? • What can the CB do? – Can try to counteract the shock by increasing M • Will everything go back to where it was? – Depends on the shock. If an IS shock, no, monetary policy leaves a different end result 44 What does it look like? • What would a negative shock to consumption look like? • What would the CB response look like ? 45 Shock and response • Note: Monetary Policy does not just put things back to where they started if shock is to IS (fiscal would) 46 Example: Latvia vs. Poland • Poland aggressively used Monetary and Fiscal Policy to cushion the crisis. Latvia did neither 47 So how should CB behave? • Different choices: – – – – Target P (or inflation) Target GDP (or unemployment) Target E Some combination • Many CB simply target inflation and leave the rest. • Others also look at GDP or employment (FED has a dual mandate officially) – (and many inflation targeters do this de facto) • One way to look at this is something called the “taylor rule” or a “monetary policy reaction function” – Basically assumes the CB raises rates when inflation goes up and lowers them when unemployment goes up, and that you get some sort of function that averages these. 48 For example • fed funds = 8.8 + 1.65*π – 1.65*Unemployment – Using core inflation and full time worker unemployment • Wide variety of different rules depending on the weight on inflation or employment 49 CB tools • We are saying CB just adds / subtracts money • Again, more realistically: – Can change interest rates (that’s what taylor rule is emphasizing) • In some countries both borrowing and lending, various Repo rates, etc. In general, changes the overnight borrowing rate to change banks cost of funds. – Can change behavior by banks which alters how they generate money 50 Running out of room • How do we think about policy at the zero lower bound? • What should it look like on ISLM ? 51 Back to ISLM, but LM is flat • • The idea is that LM is bounded by zero, and given where we are, shifts in IS don’t affect interest rates: calls for fiscal policy This suggests shifting LM can’t do any good. There are other ways to think about it once we acknowledge not ALL interest rates are at zero (just short risk free) 52 How do we get there? i=0 • Shift back IS far enough AND start with i1 not too far above zero • Desired money market outcome is below zero, but you can’t get there. • Again, means shifting LM out does nothing and shifting IS out only affects Y, not i or E. 53 Basic Fed Balance Sheet • “Normal” Fed balance sheet • Could change this to try to do something else – Change expectations of E or inflation – Change the long run interest rate by buying those assets – The latter one doesn’t really go on the ISLM framework 54 Fiscal Policy • Thus far we’ve tried to respond to shocks with monetary policy • Could also try fiscal (changes in G or T) 55 Most simple case • In a simple world, consumption could shift in, but government spending increases or taxes drop and we’re right back to where we were. 56 If we just increase G, though, many things change • What is different? – i goes up and E goes down – Crowding out (I falls, TB weakens) • So, if C fell and G goes up in response, you may wind up with lower I than before. – Same Y, but different composition 57 Not all cases are simple • If shock is to LM, don’t get back to initial E – LM shock could be surge in money demand OR MS contraction • Could also have a shock to FR (say foreign interest rate goes down) 58 Foreign interest rate shock (down) (no CB response, but G up in response) • Shock moves in FR and moves in IS, government increases G in response to get IS back to its starting place • Note: if no response, E goes down (home appreciates) and Y falls a bunch. With response, E goes down MORE, but no change in Y. >>> Distributional impacts 59 Quick note • Can get confusing. • Earlier, we had FR move after a MS shock, but we did not go back and move the IS with it. • Key point is if the shock originates in domestic – (in which case the exchange rate impact is already built into the slopes of the lines) • or in the foreign – (in which case we move FR and the impact on E feeds back into a move in IS) 60 Raises an issue of coordination • In theory, who should respond to what shock? – Fiscal to IS shocks, Monetary to LM or foreign money market shocks • What are some problems? – Hard to tell which shocks sometimes (lots of things happening at once) – Different preferences from CB and fiscal authority – CB may want to “make” the government do something • Issue right now in Europe 61 What if CB CAN’T respond • Recall liquidity trap – Here all the pressure is on the fiscal to respond – BUT, no crowding out, so fiscal policy should be more effective 62 What other policy challenges • What’s the magnitude of the shock • Lags in policy implementation – M policy operates with a lag – Fiscal policy may take a while to pass/spend • Other country responses – If you expect a depreciation to help, they may expand M too! – Can’t all export out of a shock at the same time • Private sector offsets – Ricardian equivalence issues • should only be an issue with temporary tax cuts, spending impacts go through as do permanent tax cuts or temp tax cuts to liquidity constrained households – Market responses • If market fears inflation too much, short term rate cut may not lower long rates (either expecting rate reversal or inflation) • If market fears long run solvency, rates could rise a lot when fiscal expands • Lower level government responses: – State and local may be liquidity constrained and may cut while Federal expands AND if you spend through them, they may not spend all of it. 63 Fiscal policy catch 22 • If close to a solvency border, there’s a challenge: – Stimulate economy, could lead to rising interest rates which constrain economy – DON’T stimulate economy hurts solvency by constraining growth 64 Change in E and change in TB • There are two other issues that ISLM skips • The first is the “J-curve” – The idea is that when the exchange rate first changes, we likely don’t see quantities move right away • Contracts already signed • Takes a while to find new customers – That means buy same number of imports, but they cost more (they got more expensive in local currency terms when exchange rate depreciated). >>> total value of imports rises – Value of exports unchanged in local currency at first – So at first X-M goes DOWN from a depreciation – After the brief period (6 months?) the quantities adjust, and Trade Balance improves • Looks like a “J” 65 The J-curve • We are skipping the transition and just assuming depreciation for home leads to CA improves 66 Pass-through We see evidence for this in how much trade is invoiced in foreign currencies • Another issue is that prices don’t always change 1 for 1 with exchange rates (pass-through = 1 if change in E is passed through into change in P) – Foreign firms might price in local currency so as not to lose market share due to volatility – If so, the price consumers see won’t move – No expenditure switching from exchange rate changes • NYT article gets at this: – Crate and barrel buyer “we certainly won’t import less” – If firms and consumers don’t change, then impact from a change in E is limited – Very little impact on IS when E changes 67 Evaluating fiscal policy • What is the multiplier – The extent to which Y goes up when G goes up • In a normal (non liquidity trap) economy, what is the multiplier ? – Should be less than 1 if there is any crowding out – Multiplier > faster bounce, but hard to disentangle from other things going on – G20 tried to get coordination: Why? 72 Impact of G* going up • • • • G* up means Y* goes up means i* goes up This shifts out FR, and depreciates home currency. Shifts out the IS curve (i* up moves out IS is one of our shocks) Implication: great if the other country spends. You get some benefit, but none of the debt. To avoid free-riders, major economies all agreed to act 73 When to do stimulus • In a recession – Especially a long and severe one • When monetary policy is constrained – Especially at the zero bound • When market responses are not going to wipe it out – When you have “fiscal space” • When there are things you “need to do” anyway – Can simply accelerate spending from future on things like infrastructure. In that case, have not changed the long run budget picture. • In a larger country – Smaller the country, more of the spending goes to spillover into foreign economy. 74 Using ISLM • The key lessons from this material: • ISLM can let us look at all sorts of shocks – Changes in government spending or money supply – Changes in optimism, consumption, investment, preferences etc. • We can make different assumptions about a shock and then the policy response – Could ask you to think about a fiscal (G,T) or monetary (M) policy response to a shock – Could ask you to think about a fixed E response or float • Should know the model and how to manipulate it AND some of the aspects that are simplifications – Should be able to tell me what happens to E, i, Y, and trade balance 75 Chapter 15 slides Where we are • We’ve introduced the concept of exchange rates as asset prices where investors decisions are based on expected returns • We’ve introduced the notion of PPP as a guide for long run behavior of the exchange rate. • We’ve introduced money and output (largely via the quantity equation) as the driving forces behind prices in the long run. • Also, though, money and output can drive interest rates via influence on money supply and money demand. • NOW: put everything together to get a model for what is happening to exchange rates in the short run and long run. 2 Recall • Fundamental equation of UIP. • We’ll say Ee is anchored (by PPP) and i and i* are anchored by CB policy and macro shocks. • Now, we’ll let shocks to these things alter the exchange rate 3 Poll Question • Home i is 5%, foreign is 3% Ee is 1.224 and E is 1.16. Would you rather hold – A: Home – B: Foreign – C: makes no difference 4 Simple calculations • Note: i, i* and Ee don’t change. • By changing E, the expected depreciation of home changes, so the expected return on the foreign bond changes • Equilibrium is where the expected return is the same – That is, where column 1 = column 6 5 Example • • Take bottom row: If Ee is 1.224 and E is at 1.24, you’d be expecting APPRECIATION of home. – Hence -1.3% in column 5 • If Home has higher interest rate too, you’d win twice – Foreign earns 3% + expecting home to APPRECIATE 1.3% >> return on foreign = 1.7% much worse than return on home (5%) • Calculate expected change in E, add to i*, compare to home i. Should be the same. 6 We can graph it • The more appreciated home is to begin with, the better deal foreign is. – If we were at point 2, everyone wants to hold euros, so they sell dollars and buy euros such that dollar depreciates (E goes up) • Or, the cheaper home is today, the better deal home is today – If we were at 3, dollar is too cheap, everyone wants to buy it, so dollar appreciates 7 Key concept: we know the future • The idea is we know where the exchange rate is going, so if the dollar depreciates today, that doesn’t signal a run on the dollar, but signals an appreciation in the future. • Think of it like a stock. You have a long run price target (say 50$). If Stock is below 50, you buy. If the price rises, it makes you less likely to buy. 8 Three shocks: what happens • Home interest rate rises • Foreign interest rate falls • Expected exchange rate goes down (we now expect a more appreciated exchange rate in the future) • In all three cases, we’ll want to think how the graph works, what the intuition is, and how it works in the equation 9 Home interest rate rises: what happens • 1. DR line shifts up (home rate is higher) • 2. we find new equilibrium where home and foreign returns are equal (up where E is lower or home more appreciated) 10 3 shocks: 1. home interest rate • Home increases interest rate: – E goes down – Sets up larger expected depreciation of the dollar, making foreign deposits more attractive (makes up for the higher home interest rate) 11 Is this right? • i = i* + %ΔeE – At first: .05 = .03 + .02 – Now: .07 = .03 + ??? Has to be .04 – If Ee didn’t change, E must have APPRECIATED, setting up a bigger depreciation expectation – E goes down roughly 2% • INTUITION: – At first I was happy with money in either place – Home rate goes up, so I (and everyone else) move money to home, making it appreciate – In equilibrium, homes expected depreciation offsets the higher interest rate. 12 Foreign interest rate falls: what happens • 1. FR line shifts down (lower return on foreign) • 2. we find new equilibrium where home and foreign returns are equal (up where E is lower or home more appreciated) 13 3 shocks: 2. foreign interest rate falls • Foreign cuts interest rate: – E goes down – Sets up larger expected depreciation of the dollar, making foreign deposits more attractive, which makes up for their lower interest rate 14 Is this right? • i = i* + %ΔeE – At first: .05 = .03 + .02 – Now: .05 = .01 + ??? Has to be .04 – If Ee didn’t change, E must have APPRECIATED, setting up a bigger depreciation expectation – E goes down roughly 2% • INTUITION: – At first I was happy with money in either place – Foreign rate goes down, so I (and everyone else) move money to home, making it appreciate – In equilibrium, homes expected depreciation offsets the higher interest rate. 15 3 shocks: 3. Ee falls • Expected exchange rate goes down (more appreciated for home): – E goes down – Since home is expected to depreciate less than before, it needs to appreciate some right now to get us back to the same expected change in E that we had before 16 Is this right? • i = i* + %ΔeE – At first: .05 = .03 + .02 – Now: .05 = .03 + ??? Has to still be .02 – If Ee changed (appreciated), E must have APPRECIATED by the same amount, keeping the same depreciation expectation – E goes down roughly 2% (same as expected E) • INTUITION: – At first I was happy with money in either place – I think home will be more appreciated in the future, so I (and everyone else) move money to home, making it appreciate – In equilibrium, homes expected depreciation offsets the higher interest rate. 17 Expectations matter • You can trace many exchange rate movements to shocks to expectations. • Famous example is the value of the confederate dollar during the civil war. 18 Fleshing out the model • Right now, only E can change unless we change it. – In economics jargon, we say everything else is exogenous • Now, we’d like to expand the model so we have fundamental shocks that move both the interest rate, the exchange rate, and expectations • More moving parts. – First up: interest rates 19 A key assumption • Prices are sticky (nominal rigidity) • We’ve mentioned this a few times: Why are they sticky? – “menu prices” • Literally changing prices • Making decisions – Wage contracts – Supply contracts • We will tend to talk about the “short run” as a time period when prices are sticky. – You can think of it as about a year or so. • Asset prices (exchange rates, interest rates, etc.) are flexible 20 Interest rates • There are all sorts of interest rates in the economy • We are going to focus on the short term interest rate, think of it as a money market rate set overnight. • A longer term rate might be more expensive (or perhaps less), and riskier borrowers would be charged more, but we’ll think of these gaps as consistent across the world and focus on 1 rate per economy. 21 Interest rates • Last time, we talked about money supply having to be equal to money demand. – – – – – We’re going to focus on real money supply and real money demand: Recall our money demand equation We just replace MD with MS and… d M Have an equation where = L   Y P real MS equals real MD A constant Real income  Demand for real money • What would make that happen? • Interest rates can change so make supply and demand equal. • Think of the interest rate as the “price of money” • So, “L” is going to be a function of the interest rate 22 Remember our money demand • Downward sloping money demand – Less money demand if interest rate is higher • Money demand can move with output 23 Interest rates MS i i1 MD M/P • How will we determine home interest rate? – Start with our money demand and add…. • Money supply (vertical line) – Interaction of home money supply (set by CB) and home money demand (based on L function derived last time) 24 Money Market Equilibrium • Note that at 2. and 3. there is no equilibrium • Why not? – MS does not equal MD 25 Interest rates: getting to equilibrium • At point 3: what is wrong? – Too much money demand – People sell bonds (price of bonds fall, interest rate goes up) – Eventually we’re at 1. 26 Changes in M in the short run MS1 MS2 i i1 i2 MD M1/P1 M2/P1 M/P • We are going to largely define the short run as the period when prices are sticky. • So, what happens to M/P when the MS goes up? – In the short run, M changes, P is constant so M/P goes up (shifts out) – i goes down. 27 Intuition • CB increases supply of M • In the short run, P is sticky, so it is a REAL increase (ie real MS goes up) • If supply of money goes up, price of money should fall, so interest rate goes down. • Note: this is different than case with an increase in the growth rate where you are primarily affecting expectations of inflation and hence and increase in M growth >> R going up. – Our diagram is “static” we’re looking at just Short Run, not thinking about ongoing inflation 28 Increase in Y in the short run MS i i2 i1 MD M/P • So, what happens to M/P when the Y goes up? – NOTHING, MS is set by CB • What happens on the figure then? – MD shifts out (because of an increase in Y which increases transactions demand for cash) – In the short run, i goes up 29 Some implications • CB in this example can directly control the interest rate and does so by changing MS. • In practice, CB USUALLY sets a target interest rate for very short end of yield curve and lets MS adjust to get the rate it wants • Complications – Long rates may not obey the CB – If short rate hits zero, now what? 30 For Example • • • Here we see the failure of long rates to respond to the Fed raising rates and subsequently fail to respond when it cut rates. This makes monetary policy appear ineffective Need to consider the counterfactual (where would rates be without the Fed actions) 31 A bit more traction • On a number of other rates we see a response to Fed Funds 32 rate (the rate the Fed sets) A bit more traction • • Enough that we will assume that the CB can control rates to some extent Exception will be the zero lower bound at which point it may need to do more 33 From the book • You do see some things (treasury and mortgages) moving with fed funds rate • Others, though, you likely see a re-pricing of risk at the point of the crisis. Makes it harder to tell what’s going on 34 Changes in M in the short run MS1 MS2 i i1 i2 MD M1/P1 M2/P1 M/P • We are going to largely define the short run as the period when prices are sticky. • So, what happens to M/P when the MS goes up? – In the short run, M changes, P is constant so M/P goes up (shifts out) – i goes down. 35 Increase in Y in the short run MS i i2 i1 MD M/P • So, what happens to M/P when the Y goes up? – NOTHING, MS is set by CB • What happens on the figure then? – MD shifts out (because of an increase in Y which increases transactions demand for cash) – In the short run, i goes up 36 Putting it together • We now have a way to set the local and foreign interest rate in the money market • Shocks to the money supply, output, expectations, etc. can all generate changes in the exchange rate, interest rates, or both. • CRUCIAL ASSUMPTION: capital (or financial) mobility. If no one can move money across borders, all the talk of “moving money to take advantage of better returns” is moot. 37 Recall our ForEx market • Now add our money market as the thing driving DR 38 Putting i and E together • Now we just let the interest rate be determined in the money market and then trace things to the ForEx market • FOREIGN money market is not shown, changes there just show up in a change of the FR curve 39 What happens if??? • Temporary increase home money supply ? • Temporary increase foreign money supply ? • Note: temporary for now because we don’t want to have to think about what happens if prices move yet. 40 Home money supply up • 1. MS line shifts out • 2. interest rate falls • 3. exchange rate goes up (home depreciates) 41 Home MS up • Two steps: – Start with impact on money market. – Take new interest rate to the FX market to get new E 42 May look complicated, but… • All we’ve done is taken two figures that are (hopefully) fairly intuitive • Money supply going up pushes interest rates down • Lower interest rate means the home currency depreciates immediately • What happens in the long run? – Everything just goes back. Temporary shock 43 Foreign MS up • Change in foreign has no impact on domestic Money market • Now everything is going on in the FX market • Now it is just a change in foreign interest rate (already done) 44 What happens if M up permanently • We know the short run impact on MS • What else moves? – Expectations of prices – Which means expectations of the exchange rate move – So the FR curve moves • Crucial thing is that expectations move on NEWS. Once people know prices WILL move in the long run, expectations for the future change NOW (even before prices start moving) 45 M up permanently • • • • 1. MS line out 2. interest rate falls 3. AND !!!! FR line moves out (Ee goes up) So E goes up A LOT 46 Short run after permanent shock • Still short run, but fact that it will be permanent means expectations move right away – Prices have not moved yet, but we know they will 47 Short run after permanent shock • So, we have both the MM response lowering interest rate AND an expectations shift – So a permanent shock has an even bigger impact that temporary EVEN IN THE SHORT RUN 48 What happens in the Long Run? • Prices adjust – (that’s always the answer to “what happens in the long run) • So what moves ? – M/P goes back – E adjusts 49 Splitting out the variables • Note: prices are adjusting slowly – M/P and hence i moves with it 50 Overshooting • Very famous result: overshooting of the exchange rate (can help explain some of the volatility) 51 Is this “OK” • Is it sensible to have this expected appreciation after the overshoot? – Yes, UIP still holds. Need the expected appreciation to balance out the lower interest rate. – If we increase the home money supply, home interest rate falls. If we started at i=i*, we now have i