Title: Macroeconomics
1Macroeconomic Imbalances
Gavin Cameron University of Oxford
OUBEP Topical Economics 2006
2macroeconomic policy
Source Carlin Soskice, p12
3what drives aggregate demand?
- Aggregate expenditure comprises five components
- consumption
- investment
- primary government spending (i.e. net of
transfers) - net exports (i.e. exports minus imports)
- inventories (i.e. changes in stocks held by
businesses) - The level of income (both current and expected)
is a major determinant of consumption, government
spending and net exports. - The real exchange rate is a major influence on
net exports. - Monetary and fiscal policy are major influences
on consumption and investment (with the latter
being also dependent upon output expectations and
animal spirits).
4the inflation-output tradeoff
- In 1958, A.W. Phillips of the LSE found relation
an empirical relationship between unemployment
and inflation in the UK the Phillips curve. - Original interpretation
- There is a permanent trade-off between inflation
and unemployment/output. - Problem
- After sustained inflation, the empirical
relationship broke down. - New interpretation
- There is a trade-off between output and
unexpected inflation - outputequilibrium output b(unexpected
inflation) - Therefore output deviates from its equilibrium
level by the extent to which inflation deviates
from its expected level. - But in the long-run, there is no such trade-off.
5shocks to the economy
- Why might the economy get shocked away from
equilibrium? - Aggregate Demand shocks
- an investment boom
- a pre-election government spending spree
- a sudden rise in the real exchange rate
- a consumer boom abroad
- a boom in the housing market
- an unexpected cut in interest rates
- a slump in share prices
- a sudden rise in commodity prices.
- Inflation and supply shocks
- a sudden rise in oil prices
- the invention and diffusion of a new technology
- labour market changes.
6fiscal policy
- If the Treasury were to fill old bottles with
bank notes, bury them at suitable depths in
disused coal mines which are then filled up with
town rubbish, and leave them to private
enterprise to dig them up again, there need be
no more unemployment. It would, indeed, be more
sensible to build houses and the like, but if
there are political and practical difficulties in
the way of this, the above would be better than
nothing J.M. Keynes, 1936. - Changes in the governments fiscal stance (that
is, the difference between government spending
and taxation) will change the level of aggregate
demand. - If economy is at equilibrium output, increases in
spending (or tax cuts) will lead to an
inflationary boom, which eventually will lead
only to higher prices. - If economy is below equilibrium output, increases
in spending (or tax cuts) will tend to raise
output (as well as prices) and shift the economy
back to equilibrium.
7the limits to fiscal policy
- But there are problems with the use of fiscal
policy - Measurement of output where are we? where are
we going? how fast? will we know when we get
there? - Lags in the fiscal policy process implementation
(recognition administrative lags) and
operational - What kind of fiscal policy? Spending (on what?)
or tax cuts (for whom?) - Will spending crowd-out other spending, either
directly or indirectly (through interest rates,
inflation, the exchange rate, or Ricardian
Equivalence)?
8fiscal rules
- Even now that most monetary policy is conducted
by independent monetary authorities, there is
still the problem that politicians may pursue
fiscal policies that are incompatible with stable
inflation. - Consequently, some countries have adopted fiscal
rules. The two most famous are - The Stability and Growth Pact (revised!)
countries should aim to run no more than a 1
deficit over the business cycle cannot borrow
more than 3 of GDP (cf. France and Germany!) in
any one year government debt should be kept
below 60 of GDP. - Gordon Browns Golden Rule over the business
cycle borrowing should equal net government
investment government debt should be kept below
40 of GDP. - A fiscal rule that states that debt must be kept
below a level of X of GDP implies that the
average deficit over the cycle must be
approximately equal to the average growth rate of
GDP times the target level of X. For Britain,
with an average growth rate of 2 and a target of
40, the average deficit must be kept around 0.8.
9monetary policy
- Having regard to human nature and our
institutions, it can only be a foolish person who
would prefer a flexible wage policy to a flexible
money policy, unless he can point to advantages
from the former that are not obtainable from the
latter J.M.Keynes, 1936. - Monetary policy can be implemented through either
changes in the money supply or interest rate, or
through direct controls on lending. - Changes in the interest rate will affect the
interest-sensitive components of aggregate
demand. The exact size and timing of these
effects will differ from country to country. - If economy is at equilibrium output, interest
rate cuts will lead to an inflationary boom,
which eventually will lead only to higher prices. - If economy is below equilibrium output, interest
rate cuts will tend to raise output (as well as
prices) and shift the economy back towards
equilibrium. - Typical lag effect on output one year, inflation
two years.
10transmission mechanisms
Lending rates
Domestic demand
Domestic inflationary pressure
Total demand
Asset prices
Official rate
Net external demand
Inflation
Expectations confidence
Import prices
Exchange rate
11Euro area responses to a 1 rise in ECB repo rate
for two years
Real GDP
Consumer prices
Year 1
Year 2
Year 3
Year 1
Year 2
Year 3
ECB -0.34 -0.71
-0.71 -0.15 -0.30
-0.38
NCB -0.22 -0.38
-0.31 -0.09 -0.21
-0.31
NIGEM -0.34 -0.47
-0.37 -0.06 -0.10
-0.19
Note The table shows responses of real GDP and
consumer prices to a two-year increase of 100
basis points in the policy-controlled interest
rates of the euro area. Figures are expressed in
per cent from baseline. Simulations are performed
using the ECBs area-wide model, the national
central banks macroeconometric models and the
multi-country model of the NIESR
Source ECB Monthly Bulletin, October 2002, p45
12the limits to monetary policy
- But there are also problems with the use of
monetary policy - Measurement of output where are we? where are
we going? how fast? will we know when we get
there? - Lags in the monetary policy process
implementation (recognition administrative
lags) and operational - What kind of monetary policy? Interest rates,
open-market operations, quantitative controls,
credit controls. - The liquidity trap credit channel will policy
actually affect the interest rates and lending
policies faced by agents?
13a policy problem data revisions!
Revisions to level of UK market sector output
between May and June 2005
Source Inflation Report, August 2005
14higher interest rates do not always tighten
financial conditions
Source Goldman Sachs FCI index of 3 month LIBOR,
corporate bond index, and trade-weighted dollar.
15Taylor rules and inflation targeting
- After the inflationary difficulties of the 1970s
and 1980s, many countries moved towards having
independent central banks and the use of
inflation targets. - This form of constrained discretion seems to
work because it takes control of monetary policy
out of the hands of politicians! - In practice, most monetary authorities operate
something called a Taylor rule. That is, they
raise the real interest rate (the nominal rate
minus expected inflation) whenever inflation is
above target or when capacity constraints appear
in the economy (since these may predict future
inflation). - We can think of a monetary policy reaction
function, where - r inflation target equilibrium real r
- a(output equilibrium output) b (inflation
inflation target) - The coefficient a measures how averse the
monetary authority is to output deviations and b
measures how averse it is to inflation
deviations.
16UK inflation performance
Source Carlin and Soskice (2006)
17recent developments
- Euroland growth has been slow since 2000
- US recovery from recession in 2000-1 has been
good, although employment has not recovered as
much as output - The UK has grown steadily
- Japan may be picking up China and India continue
to grow rapidly. - World monetary policy has been extraordinarily
relaxed since 2000, with interest rates of around
0 in Japan, 1 in the USA and 2 in Euroland.
Commodity prices have boomed. - But short-term interest rates are now rising
around the world - ECB lending rate raised on 9 August to 3, BoE
rate raised on 3 August to 4.75, Fed last raised
on 29 June to 5.25, BoJ raised its basic loan
rate on 14 July to 0.4!
18recent performance
Source CESifo (2006).
19recent loose monetary policy
Source CESifo (2006).
20even on a real basis
Source CESifo (2006).
21breaking the rules?
Source CESifo (2006).
22rising debt
Source CESifo (2006).
23bond yields low despite rule-breaking!
Source CESifo (2006).
24inflationary pressure
Source BIS Annual Report (2006)
25contango!
Source BIS Annual Report (2006)
26rising yield expectations
Source BIS Annual Report (2006)
27excess liquidity?
Source BIS Annual Report (2006)
28focus on the USA
Source BIS Annual Report (2006)
29focus on Japan
Source BIS Annual Report (2006)
30focus on Euro Area Junker vs Trichet
Source BIS Annual Report (2006)
31global imbalances
Source CESifo (2006)
32global prospects
- While the US continues to run such large twin
deficits, there is the possibility of a
disorderly correction to global imbalances. Not
clear how different Bernanke will be to Greenspan
yet. - In the absence of such a correction, continued
broad growth with some inflationary pressure is
likely. - Corporate profits have been very strong in the
USA and wage growth has been weak not much more
scope for profits to outperform revenues, and
risks to housing market. - In Europe, on the other hand, corporate profits
may rise faster than revenues as the economy
picks up assuming no more oil price rises. - Very hard to predict changes in China. Likely to
be modest upward movement of renminbi and modest
decline in share of investment in GDP (46 in
2005!). Current policy hugely distorts price
mechanism credit too cheap, exchange rate too
low, labour market distortions. - The need for reform of Chinese banking and credit
allocation, and to deal with inflation and excess
capital investment, must be balanced against risk
of sudden adjustment.
33prospects for the world macroeconomy