Macroeconomics

1
Macroeconomic Imbalances
Gavin Cameron University of Oxford
OUBEP Topical Economics 2006
2
macroeconomic policy
Source Carlin Soskice, p12
3
what 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).

4
the 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.

5
shocks 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.

6
fiscal 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.

7
the 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)?

8
fiscal 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.

9
monetary 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.

10
transmission mechanisms
Lending rates
Domestic demand
Domestic inflationary pressure
Total demand
Asset prices
Official rate
Net external demand
Inflation
Expectations confidence
Import prices
Exchange rate
11
Euro 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
12
the 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?

13
a policy problem data revisions!
Revisions to level of UK market sector output
between May and June 2005
Source Inflation Report, August 2005
14
higher interest rates do not always tighten
financial conditions
Source Goldman Sachs FCI index of 3 month LIBOR,
corporate bond index, and trade-weighted dollar.
15
Taylor 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.

16
UK inflation performance
Source Carlin and Soskice (2006)
17
recent 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!

18
recent performance
Source CESifo (2006).
19
recent loose monetary policy
Source CESifo (2006).
20
even on a real basis
Source CESifo (2006).
21
breaking the rules?
Source CESifo (2006).
22
rising debt
Source CESifo (2006).
23
bond yields low despite rule-breaking!
Source CESifo (2006).
24
inflationary pressure
Source BIS Annual Report (2006)
25
contango!
Source BIS Annual Report (2006)
26
rising yield expectations
Source BIS Annual Report (2006)
27
excess liquidity?
Source BIS Annual Report (2006)
28
focus on the USA
Source BIS Annual Report (2006)
29
focus on Japan
Source BIS Annual Report (2006)
30
focus on Euro Area Junker vs Trichet
Source BIS Annual Report (2006)
31
global imbalances
Source CESifo (2006)
32
global 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.

33
prospects for the world macroeconomy