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It is a report-like writing question about MEXICO

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It is a report-like writing question about MEXICO.

Analyze how the three positive exogenous shocks of 1988 affected Mexico’s economy during 1988 – 1993. Be sure to discuss

1.Mexico’s GDP and the four major expenditure components.

2.Mexico’s current and financial accounts, national saving & investment (S- I), and competitiveness

a.Don’t forget to consider subcomponents of the current & financial accounts.

3.Government finances (& national savings) including deficits & external debt

4.Exchange rate management, money supplies, interest rates, and inflation.

a.Don’t forget to consider the possibility of sterilized intervention

b.Note: velocity is not an important part of this story

5.The private banks.

NEED TO USE the concepts and skills in international economics such as monetary policy(money supply, money multiplier, etc), inflation, the economy, competitiveness & the balance of payments, international capital movements to EXPLAIN what was going on.

Be specific and detailed for each point. Add the charts for the thing you explained.

 

Mexico, 1987 through 1993: Trace the consequences of the economic reform and others positive shocks beginning 1988. You should analyze this real-world setting using the conceptual frameworks developed in class. The setting is fully general: countries around the world engage in economic reform all the time. Greece went through it recently, in 2010 – 2016. For each segment of your analysis, write out and name the relevant conceptual framework. There is no need to explain any of the frameworks. You may choose whatever sequence of topics, subtopics, and thoughtful musings works best for communicating your analysis. The economy is a big interconnected machine, so there is no single best way of explaining what happens. You must, however, begin with the exogenous shocks. If you prefer a question framed with greater specificity, you are welcome to use this prompt: Analyze how the three positive exogenous shocks of 1988 affected Mexico’s economy during 1988 – 1993. Be sure to discuss 1. Mexico’s GDP and the four major expenditure components. 2. Mexico’s current and financial accounts, national saving & investment (S- I), and competitiveness a. Don’t forget to consider subcomponents of the current & financial accounts. 3. Government finances (& national savings) including deficits & external debt 4. Exchange rate management, money supplies, interest rates, and inflation. a. Don’t forget to consider the possibility of sterilized intervention b. Note: velocity is not an important part of this story 5. The private banks. For a bonus, identify parallels & differences between (i) the effects of the three positive shocks of 1988 and (ii) the effects of the symmetric negative shocks of 1994. Note: BE SPECIFIC about dates and magnitudes. Note: Careless or ill-informed reasoning will compromise your score. Mexico, 1988: Economic Reforms and Other Positive Shocks 1988 was a big year for Mexico. First, they elected a new president, Carlos Salinas de Gotari. That election is now considered to have been rigged, but Salinas used his six years at President to implement important economic reforms. Most importantly, Salinas accelerated the process of privatizing Mexico’s state-owned enterprises (SOEs). The number of SOEs fell from 1,155 in 1982 to 220 in 1993, with most of the decline happening under Salinas. This can be viewed as an exogenous increase in relative returns to Mexican assets, as investors saw profitable opportunities in the restructuring of those firms. Selling off the SOEs brought multiple important benefits to the government’s finances. First, the privatized firms no long had to be subsidized. (SOEs are often unprofitable but the government does not close them fearing public opposition to job losses). Second, the privatized firms grew far faster and generated substantial future tax revenues. Third, revenues from the equity sales reduced the government’s need to borrow to fund operating budgets, for a total savings in excess of 30% of GDP. This can be viewed as an exogenous increase in national savings. The other big development for Mexico in 1988 was the end of the debt crisis that began in 1982, known as the 1982 Less Developed Country (LDC) Debt Crisis. From the late 1970s through early 1982, Mexico and many other emerging markets took out far too many dollar-denominated loans from developed-world banks. In August of 1982 that debt party came to a “sudden stop” when Mexico partially defaulted. It was quickly recognized that neither Mexico nor the other overly-indebted countries could repay the full amount of their debts on time. In a process known as “rescheduling” the maturity dates for much of the debt were extended farther into the future. Some of that debt was never going to be repaid and needed to be written off by the banks. However, if it happened too fast this could have triggered a banking crisis in the developed world: the banks had lent far too much to these countries for their own health. For the six years from 1982 to 1988 this problem festered, and in the meanwhile these emerging markets had little access to new external capital. By 1988 the big banks were healthier and it was possible to make further progress on writing off the countries’ loans. U.S. Treasury Secretary Nicholas Brady devised a clever solution, in collaboration with the banks and the overly-indebted countries themselves. The original bank loans were replaced with new “Brady Bonds,” securities that could be traded on secondary markets. This benefitted the banks because it allowed them to get the loans off their books. The countries benefited because the agreement included additional debt forgiveness. The Brady solution to LDC debt functioned as an exogenous reduction in country risk, and foreign capital began to flow into emerging markets again. Mexico was an early and attractive destination for such capital because it was privatizing huge and previously-inefficient domestic firms, such as the national communications company, and because it was undertaking substantial economic reforms. During the years from 1988 through 1994 the Banco de Mexico attempted to maintain the peso within a range. During (roughly) 1989 through 1993 the peso was typically at the strong edge of the band, which meant the Banco de Mexico had to intervene to avoid further strengthening. Though 1988 was a good year, the trends it set in motion ultimately generated another debt crisis. During 1994 there was a presidential election and, consistent with standard practice in Mexico, the existing government began spending heavily in ways that would please voters. This can be considered an exogenous decrease in national savings. To fund this spending Mexico’s central government borrowed heavily in international markets. This time they issued international bonds rather than taking out loans, but the end result was ultimately the same: Mexico’s government became over-indebted and that debt was excessively denominated in US dollars. Private banks were deregulated around 1993 – another exogenous shock − and they, too, borrowed heavily from external as well as domestic creditors. Bank credit within the economy surged rapidly relative to GDP, a situation that stimulates investment and creates jobs but eventually brings unwise and excessive lending. In 1994 Mexico experienced a series of exogenous adverse shocks. First there was an exogenous rise in country risk: violent political unrest led to the assassination of a major candidate for president and persisted through the year. Second, there was an adverse shock to relative returns: interest rates in the US, which had been low following the 1990 recession, finally rose substantially. By late spring 1994 investors began selling Mexican assets and there was downward pressure on the peso’s value. The peso was at the weak edge of its allowable range, however, so the central bank had to intervene again, this time to avoid further weakening. In mid-December 1994, when Mexico’s FX reserves had already fallen greatly, there was suddenly a mad rush among investors to sell Mexican assets. On December 22 Mexico floated the peso, which immediately depreciated 50%. This exploded the peso value of all that dollar-denominated external debt, precipitating a major banking crisis in which the Banco de Mexico had to support the private banks. 1. Growth in Real GDP 10 8 6 Percent 4 2 0 -2 -4 -6 -8 2. Shares of GDP (%) 3. Real GDP Components 160 100 Index, 1987=100 140 80 120 60 C GFCF G NetX 40 100 20 80 0 60 -20 -40 GFCF ? I = Gross Fixed Capital Formation = Creation of new Productive Capacity The difference is inventory growth C GFCF G 4. Competitiveness 1000 70 5. Effective Exchange Rate and Effective Competitiveness Index, 1987 = 100 60 50 40 100 Competitiveness 10 Nominal Exchange Rate 30 20 1 7. Exports & Imports of Goods 6. Current Account & Financial Account 12% (Fin Acct = Net K INflows) 10% Current Account 8% Financial Account 30% 25% 20% 6% 4% 15% 2% 10% 0% -2% -4% -6% -8% (% GDP) 5% 0% Exports of Goods Imports of Goods Balance of Payments 8. Current Account Components as % GDP 10% 8% 6% 4% 2% Nothing but Net Exports of Goods is available before 1978 0% -2% -4% -6% -8% 10 Net Exports of Goods Net Exports of Services Net Primary Income Net Secondary Income 9. Financial Account & Components (%GDP) 8 6 4 2 0 -2 -4 -6 Net FDI Inflows Net Portfolio Inflows Net Loans & Deposits 10. FX Reserves (% GDP) 20.0 17.5 Percent 15.0 12.5 10.0 7.5 5.0 2.5 0.0 11. Central Bank Holdings of Gov't Bonds 25 20 15 10 5 0 (as % GDP) 12. External Debt / GDP (%) 13. Government Debt (% GDP) 100 80 External Debt Percent Total Debt 60 40 20 0 14. Government's Debt Service Interest + Principal (% GDP) 15. IMF Credit & Loans Outstanding to Mexico 18,000 25 15,000 20 12,000 15 9,000 10 5 0 6,000 3,000 0 16. Gov’t Surplus / GDP (%) 17. National Savings and Investment (% GDP) 50 40 30 20 10 National Savings Domestic Investment 0 19. Number of Firms Privatized 100 90 80 70 60 50 40 30 20 10 0 18. Tequila Crisis Financial Flows 20. Government Debt / GDP (%) Ouch Ugh Note: Mexico’s operating budget does not include revenues from privatization of State-owned enterprises. However, those revenues definitely reduced the public sector borrowing requirement. This difference is apparent in the way the operating budget balance rises by far less than the borrowing requirement during, say, 1987 – 1992. 21. 22. 23. Inflation 120 24. M1 Growth and Inflation (y-o-y, %) 100 100 M1 Growth Rate 75 Percent Percent 80 60 Inflation Rate 50 40 25 20 0 0 25. Growth in Monetary Base and M1 26. M1 Velocity and Inflation 100 80 Inflation Rate Inflation, Percent Percent 60 40 20 0 -20 75 -60 15 10 25 0 Monetary Base M1 20 M1 Velocity 50 -40 -80 25 5 0 Velocity 100 50 27. Real Overnight Interest Rate (R - Inflation) 28. Overnight Interest Rate and Inflation 150 O/N Interest Percent 120 Percent 25 0 Inflation (y-o-y) 90 60 30 0 -25 -50 4.0 3.0 29. Measures of Caution in Banking System 3.0% Bank Reserve Ratio, M1 Currency Preference 2.0 1.0 30. Central Bank Credit to Private Banks 2.5% 2.0% 1.5% 1.0% 0.5% 0.0 0.0% (% GDP) 31. Private Bank Credit Outstanding 35% 32. Net Private Bank Debt to Foreigners (% GDP) (% GDP) 30% 30% 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% Credit to Private Sector Credit to Central Government -5% 33. Bank Credit & Liabilities to Foreigners (MXN Mns) 1,000,000 100,000 10,000 1,000 100 Liabilities to Foreigners Credit to Foreigners 10 1 Applied International Macroeconomics: Review Balance of Payments ? ? System to track international transactions has 2 main elements ? Current Account (CA) Recurring Flows ? Financial Account & Reserve Changes Principal Flows Mental Benchmark Current Account ? − Financial Account = Net K Outflows ? ? When funds flow in, bookkeeping entry > 0 If Current Account < 0, Capital must be flowing in, on balance ? ? Contemplate this: US – a big, very-rich country -- has a current account deficit every year Vice versa Truth Curr. Acc’t + Finan. Acc’t + DReserves + Emergency + Capital Acc’t + Errors/Omissions = 0 Argentina: Crisis 2001-2002 Prior to 1999, capital inflows roughly matched current account deficit Argentina: International Accounts 20000 10000 0 Millions USD ? -10000 1995 1997 1999 2001 2003 2005 -20000 -30000 -40000 -50000 Private Financial Inflows Current Account -60000 Current Account ? − Financial Account = Net K Outflows Mental Benchmark: Current Acc’t ? - Financial Acc’t ? Current account deficit associated with international borrowing: Why? Current Account ? − Financial Account = Net K Outflows ? Argentina National Income and Product Accounts, 1999 (billions of pesos) ? Y = C + I + G + (EX - IM) ? 280 = 200 + 50 + 40 + (-10) ? Domestic demand in 1999: 290 ? Output in 1999: 280 ? Difference = Net Exports: -10 ? To get the extra 10, Argentina had to borrow from other countries Net Int’l Investment Income (NII-Income) & Net Int’l Investment Position (NII-Position) ? Net Int’l Investment Position (NII-Position: stock concept) Net International Investment PositionHome = Domestic Holdings of Assets Abroad − Foreign Holdings of Assets at Home ? Net Int’l Investment Income (NII-Income: flow concept, current acct) NII-IncomeHome = RFOR* Home Investments Abroad − RHome * Foreign Investments In Home RFOR = Yield on Home Investments Abroad ? RHome = Yield on Foreign Investments in Home If RFOR = RHome = R, then ? NII-IncomeHome = R * [Home Investments Abroad − Foreign Investments in Home] NII-IncomeHome = R * NII-Position Argentina’s Capital Flows ? 1991-2000: Capital was flowing into Argentina, on net, so … ? ? Net Int’l Investment Position ? ? Net Int’l Investment Income Argentina: International Investment Position NII-IncomeHome ≈ R * NII-Position 300000 If RFOR ≈ RHome ≈ R 200000 150000 100000 50000 0 1991 1996 2001 Liabilities, Stock 2006 0 Assets, Stock Millions USD Millions, USD 250000 Argentina: Net Income From Investments 1991 -10000 -20000 1996 2001 2006 2011 Capital Flows & Balance of Payments Current Account ? − Financial Account = Net K Outflows Net Capital Outflows = D Home Investments Abroad − D Foreign Investments in Home = D NII-Position Argentina: International Investment Position 300000 Argentina: International Accounts 20000 200000 150000 10000 100000 0 50000 0 1991 1996 2001 Liabilities, Stock 2006 Assets, Stock Millions USD Millions, USD 250000 -10000 1995 1997 1999 2001 2003 -20000 -30000 -40000 -50000 -60000 Private Financial Inflows Current Account 2005 Argentina: Crisis 2001-2002 ? Prior to 1999, capital inflows roughly matched current account deficit ? In 1999, Brazil drastically devalued real, ? ? Argentina’s competitiveness ? Private capital inflows began to dry up No longer available to finance Current Account 0) Truth: Current Acct + Financial Acct + Capital Acct + "Statistical Discrepancy" = 0 Balance of Payments & GDP Output = C + I + G + Net Exports ? Define National Savings S = Output - C - G S – I = Net Exports ? Y = C + I + G + (EX - IM) ? Y - C - G = S = I + (EX - IM) “Identity” – happens automatically – given GDP definition S – I = Net Capital Outflows ? If S > I, extra domestic savings gets invested abroad, Net K Outflows > 0 ? If S < I, foreign capital is needed to fully fund I, Net K Outflows < 0 Net Exports =[S− I = Net K Outflows Savings, Investm’t, & Curr’t Acc’t Did S – I match Net Exports, as required for “General Equilibrium”? Net Exports =[S− I = Net K Outflows We know Argentina had ? Net Exports . What happened to S & I ? ? ? S, ? I Argentina: Savings, Investment, CA 30% 25% 20% 15% 10% 5% Nat'l Savings Nat'l Investment 2010 -10% 2006 -5% 2002 0% 1998 ? Share of GDP ? Net Exports Why Did Current Acc't Balance Rise? How did Argentina achieve ? S = Y – C - G? ? ? S = (Y – T – C ) + (T – G) = SPriv + SGov Argentina: Savings, Investment, CA 30% 25% 75% 5% 0% -5% 18% -10% 16% Nat'l Savings 70% Nat'l Investment 2010 Argentina: C and G 10% 2006 =Y-T-C 2002 ??C?? 15% 1998 ? SPriv Share of GDP 20% Net Exports 14% 65% 12% C/GNP 8% G/GNP 55% 6% 1993 ? Argentina: Government Surplus/GDP 10% 60% 1998 2003 2008 ? G ? ? SGov = T - G Percent C as % GNP ? 3 2 1 0 -1 -2 -3 -4 -5 -6 Surplus Deficit Argentina: Crisis 1999-2002 ? Before 1999: Argentina had strong net capital inflows ? 1999: Brazil drastically devalued real, Argentina’s private capital inflows slowed ? Portfolio capital is most flexible, pulled out first ? Direct investment continued to flow in ? Bank loans modest throughout the period Argentina: Capital Inflows 20000 10000 0 1995 1997 1999 -10000 -20000 Direct Investment -30000 Portfolio Investment -40000 Bank Loans 2001 2003 2005 Argentina: Crisis 1999-2002 ? Before 1999: Strong net capital inflows ? 1999: Brazil drastically devalued real, private capital inflows slowed ? But Argentina had currency board! Total central bank assets still determined by requirement of fixed exchange rate Central bank assets legally restricted to foreign currency reserves That is, currency board not allowed to purchase domestic government bonds But also: Not free to intervene actively in currency markets Vending machine A Central Bank L $500 Home Gov’t Securities $600 Bank Reserves €500 Foreign Currency (=$500) $400 Local Currency A Currency Board_ L $1000 Foreign Currency (=$100) $600 Bank Reserves $400 Local Currency Argentina: Crisis 1999-2002 ? 1999: Brazil drastically devalued real, private capital inflows slowed ? But Argentina had currency board! ? Not free to intervene pro-actively ? Not free to create funds like a central bank ? But needed more $$ reserves to for investors selling pesos ? To passively fulfill FX transaction demands at parity ? So borrowed from IMF ? Is that “Financial Account” or something else? (seems to be something else) Argentina: International Financial Inflows 20000 10000 10000 8000 0 6000 -10000 1995 1997 1999 2001 2003 2005 -20000 -30000 -40000 Millions USD Millions USD Argentina: International Accounts 4000 2000 0 -2000 1995 -50000 -4000 -60000 -6000 Private Financial Inflows Current Account 1997 1999 Currency Board 2001 2003 IMF Funds 2005 Argentina: Crisis 2001-2002 Despite borrowing from IMF in 2000 & 2001, forex reserves ? ? ? What do we infer? ? Argentina: International Financial Inflows 10000 Millions USD 8000 6000 4000 2000 0 -2000 1995 1997 1999 2001 2003 -4000 -6000 Currency Board ? IMF Funds What likely happened to H & M? 2005 We infer MASSIVE sell-off of pesos by locals & international investors Intervention (or Currency Board Trades) and H ? Steps to think about intervention ? Option 1: Memorize a few basics. No thinking at all Intervention to strengthen home currency ? H & M ? ? Option 2: Work it out carefully 1. Sketch central bank & private bank balance sheets – on paper or in your mind 2. Is central bank buying or selling foreign exchange? 3. How is the purchase of foreign exchange paid for? 4. What happens to H? 5. What happens to M, R, and/or inflation? Note: This requires you to know Select normal central-bank bal. sheet Definitions of H & M Intervention (or Currency Board Trades) and H 1. 2. Sketch central bank & private bank balance sheets Is central bank buying or selling foreign exchange ($$$)? Selling $$$ Assets Assets Forex A.C.B. $3,000 Liabilities Bk Reserves P 1,000 Currency Public P 2,000 Reserves Gov’t bonds Loans Forex Santander P 500 P 1,000 P 3,000 P 500 Liabilities Deposits P5,000 Intervention (or Currency Board Trades) and H 1. Sketch central bank & private bank balance sheets 2. Is central bank buying or selling foreign exchange? Selling 3. How does this transaction affect central bank & private bank balance sheets? Argentine Currency Board sells $100 (“forex”) to private bank ? Bank pays for $$ by having currency board reduce bank reserve account ? ? Reserves disappear Assets Forex Assets Forex A.C.B. $3,000 Assets Liabilities Bk Reserves P 1,000 Currency Public P 2,000 A.C.B. Liabilities $2,900 Bk Reserves P 900 Currency Public P 2,000 Reserves Gov’t bonds Loans Forex Assets Santander P 500 P 1,000 P 3,000 P 500 Santander Reserves P 400 Treasuries P 1,000 Loans P 3,000 Forex P 600 Liabilities Deposits P5,000 Liabilities Deposits P5,000 Intervention (or Currency Board Trades) and H 1. 2. 3. Sketch central bank & private bank balance sheets Is central bank buying or selling foreign exchange? How does this transaction affect central bank & private bank balance sheets? Bank pays for $$ by reducing total bank reserves 4. What happens to H? H = Bank Reserves + Currency of Public. ? H Assets Assets Forex A.C.B. $3,000 Liabilities Bk Reserves P 1,000 Currency Public P 2,000 Reserves Gov’t bonds Loans Forex Santander P 500 P 1,000 P 3,000 P 500 Liabilities Deposits P5,000 H = $3,000 Assets Forex A.C.B. Liabilities $2,900 Bk Reserves P 900 Currency Public P 2,000 H = $2,900 Assets Santander Reserves P 400 Treasuries P 1,000 Loans P 3,000 Forex P 600 Liabilities Deposits P5,000 Argentina: Crisis 2001-2002 ? ? Despite borrowing from IMF in 2000 & 2001, forex reserves ? ? What likely happened to H & M? H likely fell Argentina: Money Base Growth 20 15 ? Were they “sterilizing”? ? No. Why not? ? They couldn’t sterilize with a currency board Percent 10 5 0 -5 -10 -15 -20 -25 1995 1996 1997 1998 1999 2000 2001 How Much M From Given H? • It depends on money multiplier • Levels: M = mm * H • Growth rates: %DM = %Dmm + %DH • Money multiplier depends on caution of individuals & banks • Individual caution: c = currency/deposits = CU/D • Banker caution: q = bank reserves/deposits = BR/D • q = Required reserve ratio (set by central bank) + Excess reserve ratio (set by banks) • M = mm * H = (c +1) H ? H (c +q ) Argentina: Crisis 2001-2002 ? Despite borrowing from IMF in 2000 & 2001, forex reserves ? ? What likely happened to H & M? H likely fell …. M likely fell, too Dynamic relation %DM = %Dmm + %DH If %Dmm ≈ 0, %DM ≈ %DH Argentina: Money Growth 20 10 Percent ? 0 -10 -20 -30 M1 Money Base Argentina: Crisis 2001-2002 Did it happen? Money-market equilibrium: ? M ?? R? ? Argentina: Money Growth R = PY 20 V (OCM = R) 10 Percent M Demand 0 -10 1995 1996 1997 1998 1999 2000 2001 -20 -30 Argentina: Interest Rate 50 40 MD Percent ? 30 20 10 0 1995 1997 1999 2001 2003 2005 Argentina: Crisis 2001-2002 Did it happen? ? Money-market equilibrium: ? M ?? R ? ? Goods-market equilibrium: ? R ? ? Y? ? Argentina: Economic Stress Pre-Crisis 50 40 Percent 30 20 10 0 -10 1995 1997 1999 2001 -20 Interest Rate GDP Growth 2003 2005 Phillips Curve: Short-run Determinants of p Phillips Curve p = pe + ? ? − ?? + ?????? Inflation “Expectations-Augmented Phillips Curve” pe = 2%, ?????? = ?% pe = 4%, ?????? = ? pe = 2%, ?????? = ? Boom Recession pe = 2%, ?????? = −?% Unemployment Rate 26 Phillips Curve Did it happen? ? Money-market equilibrium ? M ?? R ? ? Goods-market equilibrium ?R ??r ??Y ? ? Phillips Curve: ? Y ? ? Inflation? ? Argentina: Economic Stress PreCrisis 60 Percent 40 Argentina: Inflation 20 35 30 0 1995 1997 1999 2001 2003 2005 25 Interest Rate GDP Growth Percent -20 20 15 10 5 0 -5 1994 1996 1998 2000 2002 2004 Inflation Shock p = pe + ?(Y-YP) + pshock ? Expectations-augmented Phillips Curve ? 2003: Inflation shock from peso devaluation, ?????? > 0 PImport = PUS * EPeso/USD Before devaluation, EPeso/USD = 1 ? ? ? Argentina: Inflation After devaluation, EPeso/USD = 3 ? ? PImport = Peso 1000 = $1000 * 1 PImport = Peso 3000 = $1000 * 3 Higher import prices go directly into the CPI Devaluation was one-time shock ? 35 Influence on inflation quickly disappeared 30 25 Percent ? 20 15 10 5 0 -5 1994 1996 1998 2000 2002 2004 Short-Run & Long-run Equilibrium for E ? Goods-&-services traders determine long-run E ? They determine long-run equilibrium competitiveness, LRComp ? They push E slowly to level required to achieve LRComp, given prices ? ? By buying goods where they’re cheapest Investors determine short-run E ? Exchange rate settles (briefly) in one place when investors are indifferent ? ? Equivalently, when expected risk-adjusted returns are the same Why are investors so important? ? Exchange rate responds to net capital flows between 2 countries ? Exchange rate stops moving (i.e., short-run equilibrium) if net capital flow = 0 ? Net capital flows = 0 when investors are content to leave funds where they are ? In long run, investors sell whatever they buy so they have little net effect on E Interest Parity Defines Short-run E ? Short-run exchange-rate equilibrium: E settles down briefly at one level ? Short-run equilibrium happens when investors are indifferent where to invest ? ? Then they stop flowing money one direction, exchange rate settles down briefly When are investors indifferent? When expected risk-adjusted returns are same ? Expected returns to foreign-currency investments include expected currency appreciation/depreciation ? E e Arg / $ − E Arg / $ ? RArg − ?R$ + ? = rp Arg − rp$ = rrp Arg / $ E Arg / $ ?? ?? ? ? Floating E ? Endogenous variable: E. ? Exogenous variables: RArg, R$, Ee, rrp Necessary to ensure equilibrium can be achieved Fixed E ? Endogenous variable: RArg. ? Exogenous variables: E, R$, Ee, rrp Necessary to ensure equilibrium can be achieved Fixed Exchange Rates and Monetary Policy: R ? ? Fixed E ? Endogenous variable: RArg. ? RArg must be flexible to ensure equilibrium can be achieved ? Exogenous variables: E, R$, Ee, rrp Implications of fixed E for interest parity ? Ee = E = Official parity exchange rate ? ? ? −? ? =0 RA − RB = rrp A / B Fixed Exchange Rates and Monetary Policy: R Riyal/$ Saudi Arabia ? 3.8 3.7 Fixed ERiyal/$ beginning 1986… …. 3.6 3.5 3.4 . 3.3 3.2 3.1 3.0 ? and Interest Rates: US and Saudi Arabia 10 9 8 RI − R$ = rrpI / $ ? 0 Percent Per Annum ? 7 6 5 4 3 2 1 0 32 US Deposit Rate SA Deposit Rate Fixed Exchange Rates and Monetary Policy: R RArg − R$ = rrp Arg / $ ? 0 ? Under fixed E ? Did this hold for Argentina? Under “hard peg” = currency board ???? was close to ?$ Short run: Further, ???? − ?$ =??????/$ > 0 but small which implies Argentina was riskier – Logical! Interest Rates 80 60 40 20 0 Argentina US Yes 2001: RArg > R$ With Fixed E ? Argentina had fixed E ? In 1990s, RArg ? R$ ? As crisis approached, RArg >> R$ ? For explanation, rewrite UIP: RArg − R$ = E e Arg / $ − E Arg / $ E Arg / $ + rrp Arg / $ 1. Argentina looked very risky rp Arg − rp$ = rrp Arg / $ ? 0 2. Investors didn’t trust the parity to hold ? They expected a big peso devaluation ? e ? ? E Arg / $ − E ? Arg / $ ? ? ?0 ? ? E Arg / $ ? ? ? ? Key Lesson: With Fixed E, Country Cannot Control Inflation ? Competitiveness has a strong, stable central tendency CompetitivenessArg = ? ????????? ?????? ?????? ????????? ???????? ?????? = ??? ????/$ ???? In the long run, stability in competitiveness implies 0 ? %DCompetitivenessArg ? InflationUS − InflationArg +%D????/$ ? This is the same as Relative PPP: %DEArg/$ ? InflationArg — InflationUS ? Under fixed EArg/$, %DEArg/$ ? 0, stable competitiveness / Rel-PPP implies: InflationArg ? InflationUS 35 Fixed Exchange Rates and Monetary Policy ? Long run: InflationArg ? Inflation$ Under fixed rates Did this hold for Argentina? Yes! Inflation was no longer painfully high Inflation: Argentina & US 3500 30 3000 25 Argentina 20 US 2500 Argentina 2000 US 1500 1000 Percent Percent Inflation: Argentina & US 15 10 500 5 0 0 -5 InflationArg & Inflation$ were not identical year by year Because this is a long-run relationship ? Notable: Arg’s deflation in 1999-2000 was a slight internal devaluation Fixed Exchange Rates and Monetary Policy: H & M Argentina had little control over domestic monetary policy ? Other than controlling E Argentina: Money Growth 20 15 10 5 Percent ? 0 -5 -10 -15 -20 -25 M1 Money Base Fixed Exchange Rate Arrangements ? ? Soft pegs: Central bank has discretion whether to maintain parity ? Central bank picks a parity rate, E I / $ ? Perhaps to hold for years, perhaps to hold for a month ? Uses monetary policy tools to maintain market exchange rate, E, at or near parity rate ? Standard fixed E E within a band, E I / $ ? x% ? Crawling peg, E I / $ moves slowly Crawling band ? Various other clever arrangements Hard pegs: No discretion in maintaining parity Fixed Exchange Rate Arrangements ? Soft pegs: Central bank has discretion whether to maintain parity ? Hard pegs: No discretion in maintaining parity ? ? ? Currency Board: Not permitted to trade government securities ? Central bank no longer exists by law ? All growth in domestic H backed by foreign currency ? Currency board passively converts domestic to foreign currency & vice versa ? Cannot create H at will, does not intervene in FX market ? Limited lender-of-last resort function "Dollarization”: Country gives up own currency ? Limited lender-of-last resort function ? No seignorage ? Local central bank has no influence over country’s money or monetary policy Currency Unions: Country shares currency with other countries ? Shared monetary policy decision-making ? Shared seignorage ? Shared lender-of-last resort function Capital Controls: A Third Exchange-Rate Policy Choice ? Benefits ? Allow central banks to control R and E separately ? ? ? Permits (some) monetary autonomy even with fixed exchange rates Can impede effects of speculation on exchange rate Costs ? Effectiveness usually temporary ? Undermine rule of law in the long run: Can be a big deal ? ? Encourage corruption, dishonest accounting, illegal currency trading Impede efficient allocation of capital and risk: In the long run, a big deal Capital Controls: A Third Exchange-Rate Policy Choice ? Attitudes towards capital controls ? 1800s – early 1900s: Didn’t exist ? Post WWII: Assumed to be good practice, fairly universal ? ? In 1980s-1990s: Considered Very Bad, dismantled in many countries ? Since Asia crisis: Some re-evaluation of extreme no-controls view ? ? Written into IMF Articles of Agreement as expected practice Now used sometimes to ? Slow inflows in capital tsunamis – Chile, early 2000s ? Slow outflows in sudden stops – Iceland, GFC Consensus: Benefits of TEMPORARY controls may outweigh costs ? Must apply to all capital flows to be effective Policy Trilemma ? ? Policy Trilemma: 3 goals of international macro policy 2 tools: Traditional monetary policy & capital controls At most 2 goals can be achieved ? Countries must choose Exchange Rate Stability Saudi Arabia Malaysia During Asia Crisis Monetary Policy Independence Cannot control R & M Floating Exchange Rates Free Capital Flows US: Cannot control E Still controls R & M Freedom of Capital Movement Gold Standard of Late 1800s ? Pinnacle of precious metal standard ? ? Shift from silver to gold for money in 1600-1800s Formal international rules established 1820s – 1870s ? ? US $20/oz Each currency had fixed parity in gold weight ? “Convertibility”: Central banks should honor currencies from other countries ? ? ? Adoption date varied by country $4/£ If I submit paper currency worth £5 to Bank of England BoE must give me 1 oz of gold, according to official parity Gold UK £5/oz Paper currency came into common use ? Exchange rates became the focus Ffr24/£ France FFr120/oz JP¥ SKR Key Things to Know about Gold Standard ? Market forces stabilized exchange rates and prices ? Not central banks or governments ? ? Because official gold parities were trusted to hold Stabilization happened through arbitrage by private agents ? Arbitrage only profitable if market prices were beyond “gold points” US $20/oz ? Problems $4/£ ? GDP and prices were NOT stable Inconsistent with theoretical arguments of today’s (few) advocates of Gold Standard Gold ? UK £5/oz Insufficient flexibility In Depression, countries only recovered after giving up old gold parities Ffr24/£ France FFr120/oz JP¥ SKR 44 Bretton Woods: 1944-1971 ? Goals of Bretton Woods ? Stable prices ? Stable exchange rates ? Flexibility to adjust exchange rates in cases of “fundamental disequilibrium” ? Structure ? U.S. fixed price of dollar in terms of gold (as before) ? Other countries required to maintain parity between local currency & USD ? If US maintains price stability, rest-of-world enjoys price stability too ? IMF would allow parity change if verified “fundamental disequilibrium” ITL Gold $4/£ $35/oz US MXP UK Ffr6/$ ¥300/$ France JPY 45 Risk: General Equilibrium & Market Forces ? ? Risk ? ? Net K Outflows ? Domestic investors try to put wealth in a safer place ? Foreign investors try to repatriate wealth and invest in a safer place RNXDP (Compet) + RestOfCAcct = S − I = Net K Outflows ? ? General equilibrium logic: Equilibrium requires ? S − I & ? Current Account ? I falls as it becomes harder to secure credit: S − I rises ? For Current account to rise, RNXDP must rise ? For RNXDP to rise, higher Competitiveness will make it happen Market forces: Interest parity. Relative risk of Argentininan assets rises ? Frantic investors sell Mexican assets & pesos ? Peso depreciates ? Mexico’s Competitiveness rises ?? ???/$ − ????/$ ???? − ?$ + = ??????/$ ????/$ 46 Argentina: General Equilibrium ? Exogenous shift: Sudden stop of foreign capital inflows RNXDP (Compet) + RestOfCAcct = S − I = Net K Outflows ? ? General Equilibrium ? Investment collapsed so S − I rose as required ? Current account needed to rise, so Competitiveness needed to rise -- & it did ? Lower peso demand Fewer foreign investors buying Argentine assets ? Higher demand for USD Argentines trying to buy US assets ? Competitiveness: Argentina Market forces in FX 25 20 15 10 5 0 Currency board was forced to reduced H, which was painful ? ? Ultimately, Argentina let peso depreciate from 1 to 3.15 & dismantled currency board Argentina: Sudden Stop ? Exogenous shift: Sudden stop of foreign capital inflows RNXDP (Compet) + RestOfCAcct = S − I = Net K Outflows ? Peso depreciation ? ? Compet ? ? NetXDP Current Account Components Argentina: Current Account 10000 20,000 Goods 15,000 Millions USD 5000 0 10,000 5,000 0 -5000 -5,000 -10000 Note: Little change in other components of Curr Acc’t -15000 -- they’re essentially -20000 exogenous ? -10,000 Net Interest + -15,000 Goods Services Primary Income (Wages, Net Interest) Other (Remittances, Aid) General Equilibrium & Competitiveness ? Higher Terms of Trade (TOT) = Higher price of major export commodity RNXDP (Compet) + EXCM TOT + RestOfCurrAcct = S − I = Net K Outflows ? General Equilibrium ? No changes in S − I or Net K Outflows Components in RestOfCurrAcct are largely exogenous ? RNXDP must fall ? ? ? Lower Competitiveness will achieve lower RNXDP Market Forces ? ? The country receives more dollars from commodity exports Converts those dollars to local currency, to be used at home Those conversions raise demand for local currency ? Local currency appreciates, Competitiveness falls ? 49 General Equilibrium & Competitiveness ? Higher remittance receipts RNXDP(Compet) + EXCM TOT + Remittances + ROCAcct = S − I = NetKOutflows ? General Equilibrium ? ? ? RNXDP must fall to maintain general equilibrium Lower Competitiveness will achieve lower RNXDP Market Forces ? The country receives more dollars from relatives abroad ? Those dollars converted to local currency to be used at home ? Higher demand for local currency in FX market ? ? Local currency appreciates, Competitiveness falls Higher foreign aid receipts (OtherCAcct) ? Lower competitiveness ? By analogy 50 General Equilibrium & Competitiveness ? Capital Tsunami = Foreign capital flows in rapidly, Net K Outflows fall RNXDP (Compet) + RestOfCAcct = S − I = Net K Outflows ? ? General Equilibrium ? S − I falls because I expands rapidly with greater availability of credit ? RNXDP must fall, which can be generated by a fall in Competitiveness Market Forces ? Investors flood buy local currency in order to buy local assets ? Local currency appreciates, Competitiveness falls 51 General Equilibrium & Competitiveness ? Capital Tsunami = Foreign capital flows in rapidly, Net K Outflows fall RNXDP (Compet) + RestOfCAcct = S − I = Net K Outflows ? ? General Equilibrium ? S − I falls because I expands rapidly with greater availability of credit ? RNXDP must fall, which can be generated by a fall in Competitiveness Market Forces ? Investors flood buy local currency in order to buy local assets ? Local currency appreciates, Competitiveness falls 52 Gov’t Deficits, Competitiveness, & Current Acct Deficits ? Suppose Biden succeeds and US infrastructure spending rises ? This raises gov’t purchases, G, & reduces gov’t savings, Sgovt = T ? S − I falls − G RNXDP (Compet) + RestOfCAcct =[Spriv + Sgovt− I = Net K Outflows ? With lower S − I, Net Capital Outflows and the Current Account must fall ? ? Net Capital Outflows falls naturally ? If S > I, US has less extra savings (relative to I) and sends less savings abroad ? If S < I , US imports more foreign capital to fund our investments GE: For the Current Account to fall, Compet must fall so RNXDP can fall ? ? MF: Compet falls because US buys fewer foreign assets, foreign currency weakens “Twin deficits”: Government deficits bring current account deficits Cheat Sheet RNXDP(Compet) + EXCM TOT + Remittances + RestOfCurrAcct = Spriv + Sgovt − I = NetKOutflows Shock Shock Competitiveness Competitiveness Current Account Account Current Net K K Outflows Outflows Net SS -- II Current-Acct Shocks Shocks Current-Acct TOT ??TOT “Dutch Disease” Disease” “Dutch ? Remittances ?? Remittances ? Financial-Acct Shocks Shocks Financial-Acct Capital Tsunami Tsunami Capital ? ? ? ? Sudden Stop Stop Sudden ? ? ? ? govt) G or or ?? TT (?S (?Sgovt ?? G ) ? ? ? ? priv ?? SSpriv ? ? ? ? Domestic Economy Economy Domestic To save mental effort in the future, memorize those in bold plus CurrAcct = S – I = NetKOutflows Business Cycle Patterns Did it happen? Investment most cyclical (biggest % changes)? Yes Government spending offset economic trend? No! Investment contributes most to downturn? No! ? ? ? Percent 20 Argentina: (Real) GDP Growth Argentina: Growth in Expenditure Components 0 1995 1997 1999 2001 2003 2005 -20 Argentina: Real Expenditure Components 350 300 250 200 150 Consumption Investment Gov't Spending 20 Percent 400 0 1995 -20 100 50 0 Consumption Investment Government Spending 40 -40 1997 1999 2001 2003 Volatility in Argentina’s Crisis ? Why was consumption so volatile? The “corralito” ? The government effectively froze all bank accounts for twelve months ? Only minor sums of cash could be withdrawn, initially $250 a week. ? Argentina recession intensified by ? G ? Usually, fiscal policy used to smooth economic activity ? Argentina couldn’t do that: They had exhausted their ability to borrow ? Foreigners could not reasonably lend to the private sector … ? ? Foreigners could not reasonably lend to the government ? ? The country was in economic & financial collapse The government was defaulting on debt ? G because the IMF insisted on austerity ? “Austerity”: Higher taxes, lower government spending to eliminate a big government budget deficit 56 Argentina: Crisis 2001-2002 ? Recap: Exogenous shock = ? Capital inflows ? Fixed exchange rate ? Capital inflows ? ? Forex reserves ? Intervention & monetary policy ? Forex reserves ? ? H ? Money supply process ?H??M ? Money market equilibrium ? M ?? R ? Aggregate demand ?R ??r ??Y ? Normal business cycle ? Y ? ? I fastest ? Phillips curve ? Y ? ? Inflation ? Things were awful. So government gave up the 1-to-1 parity peso/USD ? Peso devaluation brought banking crisis …. Monetary Policy: Typically Stabilizes Business Cycles ? YP YD is the “Output Gap” YD>0 YD>0 YD>> Exports Int’l demand for currency