Macroeconomics Understanding the Global Economy, 3rd Edition Solution Manual

Macroeconomics Understanding the Global Economy, 3rd Edition By Miles, Scott, Breedon

CHAPTER 1

What is Macroeconomics?

CHAPTER 1: WHAT IS MACROECONOMICS? INTRODUCTION As might be expected, this first chapter sets the scene for the whole textbook and attempts to motivate the study of macroeconomics. Although there is probably only enough material here for about fifteen minutes of lecture, it obviously needs to be well delivered.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter is likely to form only the first part of a lecture and should probably be combined with the material in Chapter 2. The chapter can be tailored to your audience. For example, if the students are mainly working in business, give examples of how macroeconomics influences business decisions. Think about touching on the key macroeconomic issues in the news at the time e.g. tax policy, the business cycle etc.

CHAPTER GUIDE 1.1 What is Macroeconomics About? It is a good idea to contrast a recent short-term macroeconomic issue (like the latest change in monetary policy) with the longer-term issue of growth and inequality between regions.

The Background Material below gives more information on comparative world growth since 1500.

1.2 But What about that Definition? Milton Friedman’s favorite description of the wonders of the price mechanism (the invisible hand) is “I Pencil” by Leonard Reed (see www.econlib.org/library/Essays/rdPncl1.html ). However, business students may find it a little patronizing.

1.3 The Difference between Macro and Microeconomics. Like most distinctions, this one is somewhat blurred around the edges. It may be worth underlining that good macroeconomics tend to have strong microfoundations (i.e. based on microeconomic analysis and built up to macroeconomic behavior).

1.4 Why Should People Interested in Business Study Macroeconomics? There are many good examples of how macro economic analysis can help solve real world problems. The case study below gives a lighter example; how macroeconomics can help to predict the next U.S. president.

2

CHAPTER 1

What is Macroeconomics?

CASE STUDY: ECONOMIC EVENTS AND PRESIDENTIAL VOTING Introduction Not only is economic policy a key issue in presidential politics, the state of the economy is a key determinant of the outcome of the election. To illustrate this point, Professor Ray Fair has devised a simple model of presidential voting based on macroeconomic and political variables.

The model correctly predicted the outcome of 20 out of 22 elections since 1916 (NixonKennedy 1960 and Bush-Clinton 1992 were its two failures). Its prediction for the 2012 election (made in early 2012) was for an Obama victory with a marginally reduced share of the vote The Model Fair’s original model considers the following questions in respect of each presidential candidate ➢ Is your party already in power and has the economy been doing well in the last three quarters? – Positive impact ➢ Is your party already in power and has the economy grown 3.2% p.a. or more in the last 15 quarters? – Positive impact. ➢ Is your party already in power and has inflation been low over the last 15 quarters? – Positive impact. ➢ Are you an incumbent? – Positive impact. ➢ Is America involved in a world war? – Forget the economy.

It is perhaps troubling that such simple determinants seem to explain so many election results, particularly since short term factors - such as growth over the last 9 months - seem so important (see also “It’s the economy stupid” in the Background Material for Chapter 2).

Source Fair(1998) “The Effect of Economic Events on Votes for President” http://fairmodel.econ.yale.edu/vote2012/index2.htm Discussion Questions 1) Why is voting so influenced by economics events? Can politicians really improve/worsen economic outturns over a normal electoral cycle?

2) If economics is the key to political success how come so few politicians have an economics training?

Additional Questions Question 1) Look at the chart below of per capita GDP (1990 US dollars) for a number of regions.

1) Why did the world economy grow so slowly before the 20th Century?

2) Why was growth concentrated in a few regions? Africa and the US had the same output per capita in 1500.

3) Is increasing inequality between countries inevitable? .. .

3

CHAPTER 1

What is Macroeconomics?

GDP per capita 1500-1998 (in 1990 US dollars) 30000 25000

United States Japan Western Europe

20000

Latin America Former USSR

15000

China Africa

10000 5000 0

00 530 560 590 1 1 1 15

20 650 680 1 1 16

10 740 770 17 1 1

00 830 860 18 1 1

90 920 18 1

50 980 1 19

Source: OECD Answer 1) There is of course no accepted answer to these questions. A poor reflection on economics as a science

Question 2) If per capita income in Ethiopia grows 3% per annum for the next fifty years and per capita income in the US grows at 3% per annum for the next fifty years, what will happen to the income gap (in dollars) between Ethiopia and the US? Answer 2) the gap will widen. 3% of a big number (i.e. US GDP) is more than 3% of a small number (i.e. Ethiopian GDP)

.. .

4

CHAPTER 2

The Language of Macroeconomics: The National Income Accounts

CHAPTER 2: THE LANGUAGE OF MACROECONOMICS: THE NATIONAL INCOME ACCOUNTS INTRODUCTION This chapter is more interesting than its title implies as it offers opportunities to discuss current issues. As with several chapters, one can either give a worldwide view with lots of comparative statistics or focus on aspects of a particular economy.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter takes the logical route of discussing how to measure output before going on to its time series properties – it is hard to teach any other way. Output trends and business cycles naturally combine with material from Chapters 4 and 14.

Welfare and output can be discussed either at the beginning or end of a lecture and can be extended by discussing the Human Development Index in more detail. It is useful to point out the two types of problem with GDP measures. First, it is simply a narrow measure of what is produced in the economy and so would not correspond precisely to welfare even if well measured. Second, it does not even measure output properly since it cannot include components such as non-remunerated services and the underground economy.

CHAPTER GUIDE 2.1 What Do Macroeconomists Measure? The discussion concerning output versus welfare (which reappears at the end of the chapter) is easy to motivate. The ecological damage of higher output is a current example and can be used to extend the discussion to missing markets (i.e. properly measured output could include pollution costs if these were tradeable).

2.2 How do Macroeconomists Measure Output?

URL’s for National Accounts data: USA http://www.bea.gov/ Euro-Area http://sdw.ecb.europa.eu/browse.do?node=2018805 Japan http://www.esri.cao.go.jp/index-e.html UK http://www.statistics.gov.uk/hub/economy/national-accounts/national-income-expenditure-and-output/index.html Canada http://www.statcan.ca/ 2.3 Output as Value Added Figure 2.2 in the main text is worthy of discussion. By showing how rich countries tend to have small agriculture sectors (i.e. only a small proportion of value added comes from agriculture), it illustrates why many economists have argued that industrialization is the key to growth. Certainly, the Asian tigers followed this route to .. .

5

CHAPTER 2

The Language of Macroeconomics: The National Income Accounts

success. Whilst in principle there is now reason why a country cannot transition from being poor to rich by becoming a highly efficient agricultural producer – no country in the world has managed this transition in practice (New Zealand is a rich economy that is largely dependent on agriculture, but its development was largely due to colonization).

2.4 National Income Accounts Further explanations for some of the big GNP/GDP differences shown in figure 2.5 are given in the Chart and Table tips. Students find that a practical discussion of individual countries extremely useful as a way of understanding the concepts.

2.5 How Large Are Modern Economies? A useful way of expanding this section is to discuss the data on national economies published by the World Bank http://www.worldbank.org/poverty/wdrpoverty/report/index.htm 2.6 Total Output and Total Happiness. To stimulate discussion here it is worth getting hold of some Human Development Index (HDI) figures (http://hdr.undp.org ). The tables give comparisons between the HDI and standard GDP figures. Generally speaking, the HDI and GDP are pretty similar, with some interesting exceptions Oil exporters: Far higher GDP than HDI USA: Top in GDP but not in HDI. Cuba: Far higher on the HDI than on GDP. Brunei: Higher GDP than HDI since a large proportion of total GDP goes exclusively to the Sultan.

The Case Study “It’s the Economy, Stupid” shows how data errors and the slow dispersion of economic data influenced the 1992 US presidential election. Details on the release of US data are given in the Case Study to Chapter 15.

TABLE & CHART TIPS Figure 2.5. GDP is generally higher than GNP for recipients of foreign investment who have to remit profits (e.g. US). As we shall see in Chapter 14, recipients of substantial foreign investment have been amongst the fastest growing economies in the world (Chile, Ireland).

Ireland in particular has benefited from huge investments by US firms (e.g. Dell).

Oil exporters like Kuwait tend to be net investors in the rest of the world and therefore receive net interest profits and dividends from overseas. Norway is now an oil exporter and is rapidly moving towards a larger GNP than GDP as it uses oil receipts to invest overseas.

A significant proportion of the population of Bangladesh work overseas and their remittances back home substantially boost GNP. The Philippines is an even more extreme example of this phenomenon.

Figure 2.9 Economists have used three main methods of measuring the underground economy.

1) Statistical discrepancies. In most countries, figures for the expenditure measure of GDP are higher than the income measure even though they should in fact be the same. This .. .

6

CHAPTER 2

The Language of Macroeconomics: The National Income Accounts

discrepancy arises because people tend to attempt to avoid or evade income tax and so income is under-recorded. There can be similar discrepancies between the recorded labor force (people in employment or claiming benefit) and the actual labor force as people in the shadow economy withdraw from the official labor market. However, these discrepancies tend to capture only a small part of the shadow economy.

2) Cash demand. As we shall see in Chapter 12, economists often analyze the relationship between cash circulating in the economy and total transactions in the economy. If cash demand is much higher than recorded output, it may be because the shadow economy prefers the anonymity of cash. In fact, a very high ratio of cash to bank deposits suggests the presence of a large shadow economy.

3) Physical input. Since the shadow economy still needs to use measured inputs such as electricity, it is possible to gauge the size of the shadow economy by looking at the demand for such inputs. If the demand outstrips what is necessary for official output, it is a good indication that the shadow economy is important.

The chart in the text shows figures for the electricity-input method only, as this gives the broadest sample of countries.

Figure 2.13 Further information on environmental accounting can be found at http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/ENVIRONMENT/EXTDATASTA/0,,content MDK:21060933~menuPK:7333796~pagePK:64168427~piPK:64168435~theSitePK:2875751,00.h tml

CASE STUDY: “IT’S THE ECONOMY, STUPID” In 1992, campaign adviser James Carville came up with the slogan that is thought to have won Bill Clinton his first presidential election- “it’s the economy, stupid”. Under President George Bush (senior), the economy had suffered a mild recession (negative output growth) after the Gulf War. However, by the time of the election, the economy had already begun to recover strongly (growth was 3.2% in 1992) and so Bill Clinton’s campaign slogan should probably not have struck home as strongly as it did. Why didn’t Bush get the credit for the recovery?

1) Slowly changing expectations. Even after you come out of a recession you don’t feel better off. This makes sense because if output has fallen, it may take a year or more to get income back up to its pre-recession level.

2) Data collection lags. Although US GDP data are amongst the most rapidly compiled in the world, it still takes several months for the final data to be reported. So in 1992, although the preliminary Q3 GDP figures were available in late October, the final numbers were not reported until much later.

3) Preliminary data errors. When the preliminary Q3 GDP figures arrived, they were a pleasant surprise for Mr. Bush - the economy had supposedly grown by 2.7% (at an annualized rate). However, many commentators dismissed them as incorrect. For example, CBS reporter Susan Spencer filed from the Bush campaign: "He crowed today .. .

7

CHAPTER 2

The Language of Macroeconomics: The National Income Accounts

at upbeat news of a third quarter growth rate of 2.7 percent, though some economists warned that may not hold.” In the event she was right to be suspicious of the Q3 number it was subsequently revised up to 3.9%! By the end of 1992, a year that some had predicted would see GDP fall by almost 2%, a healthy 3.2% growth rate had been posted.

US GDP Growth: 1988 to 2000 7 6 5 4 3 2 1 0 -1 -2 88

89

90

91

92

93

94

95

96

97

98

99

00

01

US GDP Growth (Annual % change) Source: EcoWin

Discussion Questions 1) What possible defense could Bush have mounted to the economic attack made on him

by Clinton?

2) Should the budgets of the statistical agencies have been increased or reduced after this incident?

.. .

8

CHAPTER 2

The Language of Macroeconomics: The National Income Accounts

Additional Questions Question 1) Look at the chart below and describe what happened to Indonesia in 1998

Indonesia, Real and Nominal GDP growth 60 50 40

Percent

30 20 10 0 -10 -20 90

91

92

Nominal GDP growth

93

94

95

96

97

98

99

00

01

02

Real GDP Growth

Source: EcoWin

Answer1) The Asian currency crisis in 1997 triggered a recession in Indonesia so that real GDP fell by over 10%. At the same time, the decline in the Indonesian currency (the Rupiah) led to a dramatic rise in prices as imported goods cost more in Rupiah terms and these import prices fed through into domestic prices and wages (note that if the import price rise had been the only source of price inflation then nominal GDP would have been unaffected since it excludes imported goods). The rise in inflation meant that nominal GDP rose dramatically even though real GDP was falling.

Question 2) Analyse the recent sectoral composition (agriculture, industry and services as a % of GDP) of output GDP for a selection of countries of your choice using either national sources or the World Bank’s World Development Indicators [http://data.worldbank.org/data-catalog -> WDI databank].

Is the sectoral breakdown what you would expect given the country’s level of development (see Figure 2.2)?

.. .

9

CHAPTER 3 The Wealth of Nations

CHAPTER 3: THE WEALTH OF NATIONS – THE SUPPLY SIDE INTRODUCTION This chapter is excellent for motivating the study of economics and so is a key chapter in the book. By looking at growth from a historical and international perspective it offers students new insights and shows how important economics can be. Given that many students are impatient to focus on monetary policy and the business cycle (i.e. the stuff they read in the newspapers), it is important to motivate this topic well.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER The first three sections of this chapter give an entertaining account of the history of economic growth and could therefore be included in a separate opening lecture. The following sections introduce material that is analyzed in more detail in Chapters 4,5,6 and 7 and could be combined with lectures on those chapters. However, since these sections offer an overview of those later chapters, it would be natural to start with them or use this chapter as pre-lecture reading..

CHAPTER GUIDE 3.1 The Importance of Economic Growth. It is worth motivating this section by looking at economic reports in newspapers. Most of them will be concerned with cyclical rather than long run issues (e.g. the next move in interest rates). Although most students will not have heard of Thomas Malthus, they may have heard of economics described as “The Dismal Science”. Malthus’s theory of population was the inspiration for that description. It may also be worth noting that many of Marx’s dismal prophecies were predicated on the consequences of limited economic growth.

3.2 The Impact of Long-Run Growth. The relationship between growth and poverty reduction is a key one to those who are skeptical about the importance of economic growth. It is interesting to contrast the fact that global poverty reduction has been largely due to poverty reduction in China, despite the fact that China has actually experienced increased inequality (section 4.8) 3.3 Explaining Cross-Country Income Differences. In developing countries, the phenomenon of underemployment is relatively common. This is where people who are notionally employed work fewer hours than they would wish. Often this occurs when a large extended family works on a small farm. As a result, drawing labour out of the agricultural sector (often during the process of industrialization can raise measured productivity in the agricultural sector.

3.4. The Production Function and Factor Inputs This, and the following sections, introduce material that will be covered in detail in the following four chapters. It also introduces the key supply side concept of the production function.

.. .

10

CHAPTER 3 The Wealth of Nations

3.5 Growth Accounting. The key point of this section is to show how output growth can be decomposed into Labor, Capital and TFP. Moreover, if students properly understand this section, it will provide an excellent foundation for Chapters 4 to 7.

3.6 Growth Accounting an Application. The Case Study below “The Productivity Challenge” reviews an exercise in growth accounting, but focuses on the level of productivity rather than growth.

CASE STUDY: “THE UK PRODUCTIVITY CHALLENGE” In June 2001, the newly re-elected UK Labour Government published a report on its strategy for productivity over the next Parliament. The report begins by outlining the UK’s poor labor productivity performance (i.e. GDP per worker). As the chart below shows, UK labor productivity is significantly below that of other major economies (even though the figures for Germany include the less efficient East) and, although there has been some catch-up with continental Europe since 1995, US labor productivity is actually increasing relative to the UK. Productivity per worker (UK=100)

160 140 120 100 1995 1999

80 60 40 20 0 US

Germany

France

Of course, one of the important factors behind the high productivity per worker in the US is the greater number of hours worked. As the chart below shows, when you compare output per hour worked rather than output per worker, the US and Continental Europe look more comparable. However, the UK still remains well below all of them.

.. .

11

CHAPTER 3 The Wealth of Nations

Productivity per worker and per hour worked (UK=100) 160 140 120 100 GDP per worker

80

GDP per hour worked

60 40 20 0 US

France

Germany

What explains the UK’s poor productivity performance? Standard Growth Accounting points to two key weaknesses. Firstly, low levels of physical capital per worker. The average UK worker has access to far less physical capital than his German and US counterpart. Secondly, low levels of innovation - the UK is less effective at innovating in the production process. Relative to the US this may not be surprising, given that the US leads in most areas of technology. However, Germany also has a far stronger record of innovation which, added to its more skilled labor force, explains much of the gap.

The table below summarizes the evidence on the UK productivity gap showing how each element of the production function helps explain the gap between UK and other countries’ labor productivity. It shows how the contribution of each factor to the gap shown in the chart above (i.e. in the case of the UK relative to the US, it shows the percentage contribution of each factor to the 21% shortfall of UK productivity).

.. .

12

CHAPTER 3 The Wealth of Nations

Explaining the UK productivity Gap (% contribution to the UK’s lower productivity relative to the US and Germany) Relative to US Relative to Germany Physical Capital 31 55 TFP 69 45 Of Which: 65 17 Innovation Skills 0 14 Other 4 14 Total 100 100 Armed with this evidence, the Labor government has focused its productivity enhancing measures on encouraging innovation (e.g. a newly introduced research and development tax credit for large firms) and investment (e.g. lower capital gains tax).

Source: “Productivity in the UK” HM Treasury and DTI

Discussion Questions 1) What factors might explain the UK’s low rate of innovation, skills and other elements of TFP? 2) What policies might help deal with the UK’s productivity gap?

Background Material THE LORENZ CURVE AND GINI COEFFICIENT. The standard measure of income inequality is the Gini coefficient. It is based on a comparison of actual income distribution with a perfectly even one. The easiest way to understand the Gini Coefficient is first to construct a Lorenz curve.

.. .

13

CHAPTER 3 The Wealth of Nations

The Lorenz Curve % Share of National Income

Line of Perfect Equality

Lorenz Curve

% of population

The Lorenz Curve is constructed by ranking the population by income. Starting at the lowest income, the curve shows how the share of national income rises as we move up the income distribution and include more people. If income was perfectly equally distributed, the Lorenz curve would be the 45-degree line shown above. In practice however, the curve will always tend to be below the 45-degree line.

The Gini coefficient is the ratio of the area between the 45-degree line and the Lorenz curve to the whole area under the 45-degree line (i.e. the shaded area in the diagram as a ratio to the whole area under the 45-degree line).

The table below displays Gini coefficients for a range of countries. Note that income inequality has increased in almost all countries during the 1990’s (most notably in Russia and other former soviet union countries), and that the US has the highest Gini coefficient of the major economies.

Gini Coefficients Across the World Gini country index country Namibia 70.7 Turkmenistan Botswana 63.0 United States Sierra Leone 62.9 China Brazil 60.7 Turkey South Africa 59.3 Ghana Chile 57.5 Mozambique Colombia 57.1 Portugal Zimbabwe 56.8 Germany Zambia 52.6 Tanzania Mexico 51.9 Uganda Nigeria 50.6 New Zealand

Gini index 40.8 40.8 40.3 40.0 39.6 39.6 38.5 38.2 38.2 37.4 36.2

Country Pakistan France Netherlands Spain Bangladesh Korea, Rep. of Poland Canada Belarus Indonesia Romania

Gini index 33.0 32.7 32.6 32.5 31.8 31.6 31.6 31.5 30.4 30.3 30.3

.. .

14

CHAPTER 3 The Wealth of Nations

Venezuela 49.1 Viet Nam 36.1 Ethiopia 48.6 Italy 36.0 Cameroon 47.7 United Kingdom 36.0 Peru 46.2 Ireland 35.9 Philippines 46.1 Israel 35.5 Russian Federation 45.6 Greece 35.4 Kenya 44.5 Algeria 35.3 Hong Kong 43.4 Australia 35.2 Thailand 43.2 Egypt 34.4 Iran, Islamic Rep. of 43.0 Yemen 33.4 Singapore 42.5 Switzerland 33.1 Source: UNDP. Note: Survey dates range from 1995 to 2000

Ukraine Rwanda Uzbekistan Norway Finland Czech Republic Belgium Sweden Japan Denmark Hungary

29.0 28.9 26.8 25.8 25.6 25.4 25.0 25.0 24.9 24.7 24.4

Additional Questions Look at Figure 3.1.

Question 1a) What might explain the surge of growth in the 19th and 20th centuries Question 1b) What might explain the rise in world growth in the 14th century Answer 1a) Although the causes of this rise in growth are unclear, the process did seem to be triggered off by the industrial revolution in the UK and the subsequent spread of industrialization to other countries Answer 1b) The spike in the 14th century is probably attributable to the Black Death which not only increased GDP per capita of the survivors, but also led to more recorded transactions as workers entered paid employment rather than being tied to their local lord.

Look at the two charts below both showing the level of the Dow Jones index since the early 20 th Century one on a liner scale one on a log scale Question 2) which of the two charts do you think gives a fairer picture of what has happened to share prices?

.. .

15

CHAPTER 3 The Wealth of Nations

The Dow Jones Index In the 20th Century (LINEAR SCALE) 12000 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 Source: EcoWin

The Dow Jones Index In the 20th Century (LOG SCALE) 12800 6400 3200 1600 800 400 200 100 50 25 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 Source: EcoWin

Answer 2) The two charts demonstrate the very different visual impression given by log and linear scales. Note how the 1929 crash is the most extreme event in the log chart but is barely visible in the linear version.

A close look at the charts below shows the key difference between log and linear scales. In a linear scale, the gap between 1000 and 2000 is half the size of that between 2000 and 4000.

With a log scale, the gaps are equal so that a doubling in the value of the stock market shows up as the same movement in the chart irrespective of the starting level. More generally, any .. .

16

CHAPTER 3 The Wealth of Nations

given percentage change in the series results in an identical movement in the line with a log scale. In the case of the linear scale, percentage changes result in larger line movements as the level of the series rises. Algebraically ΔX/X  ∆ln(X) where ΔX/X = the change in X divided by X ∆ln(X) = the change in the log of X Generally speaking log scales are better for looking at economic data over long periods since most economic series show steady percentage growth that on a log scale would appear as a straight line.

Question 3) Find a range of economics statistics including the Gini coefficient for a selection countries from the CIA Factbook [ https://www.cia.gov/library/publications/the-worldfactbook/ , select a country and then click on Economy for a range of economic statistics]. How unequal the countries you have chosen compared with those shown in Figure 3.8? What might explain there different levels of inequality

.. .

17

CHAPTER 4 Capital Accumulation and Economic Growth

CHAPTER 4: CAPITAL ACCUMULATION AND ECONOMIC GROWTH

INTRODUCTION Following on from the overview in Chapter 3, this is the first of four chapters that examine the three main factors of production in detail. Many of the themes here re-appear in the investment section of Chapter 10.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As indicated above, much of the material in this chapter overlaps with Chapter 13 and they could therefore be combined. Alternatively, the material on convergence here could be usefully contrasted with the endogenous growth analysis in Chapter 6.

The chapter could be re-cast as a case study on the Asian growth miracle. Starting with section 5.9 and the case study material below, the ideas emerging from the previous sections could be presented as aspects of the Asian model.

CHAPTER GUIDE 4.1 Capital Accumulation and Output Growth. Although the concept of diminishing returns is important, it is seriously questioned in Chapter 6. It should therefore be presented as ‘standard theory’ or, alternatively, as theory that is applicable in some, but not all, situations 4.2 Savings, Investment and Interest Rates. This issue is covered in more detail in Chapter 13 and could be avoided at this stage if investment is to be discussed later on.

4.3 Why Poor Countries Catch Up with the Rich. Once again, this idea will be re-examined in Chapter 6 so at this stage it is worth pointing out that the examples shown in this section relate to countries or regions with similar technologies.

4.4 Growing Importance of Total Factor Productivity. The Background Material looks in more details at Germany’s post-war re-construction and how capital became less important in the later stages.

4.5 The End of Growth through Capital Accumulation. This is a key question for the Asian economies as the Case Study shows.

4.6 Why Bother Saving? An example of low level of investment leading to lower output in the UK is given in the Case Study for Chapter 3.

4.7 How Much Should a Country Invest? The Golden Rule is often described as the economic version of the biblical injunction usually expressed as “do unto others as you would have others do unto you”. Thus, in Biblical terms the Golden Rule might say “provide the same consumption unto the current generation as unto future generations”. .. .

16

CHAPTER 4 Capital Accumulation and Economic Growth

4.8 China – A Big Tiger. The ‘Asian Miracle’ of the original tiger economies is described in the case study below CASE STUDY: THE EAST ASIAN GROWTH MIRACLE BEFORE AND AFTER THE CRISIS Introduction Even though the Asian currency crisis occurred as long ago as 1997, we are still not sure that the Asian Miracle is over. The recovery of most of the Asian tigers in the direct aftermath of the crisis was spectacular. South Korea, for example, saw industrial production fall over 15% in late 1997 and early 1998 as a result of the crisis but had recovered all of that loss by the end of 1998. Since then however, Asian growth has been subdued (by historical standards) and has raised questions once again about the viability of the Asian growth model.

As Europe’s post-war recovery and Japan’s 1970’s growth miracle have proved, very rapid output growth tends only to occur in periods of catch-up. Outside such periods, sustained growth of more than 3% p.a. is difficult to achieve. Therefore, the key to the Asian growth is the catch-up factor which must eventually come to an end. The convergence process implies that rapid growth becomes increasingly difficult as the productivity gap is closed.

Elements of the Growth Miracle Looking in more detail at East Asia’s growth path reveals one major advantage Asia enjoyed over previous catch-up economies i.e. a favorable demographic transition. In line with many developing economies, Asia has experienced rapidly increasing life expectancy followed – in time – by a fall in the birth rate. This phenomenon leads to a natural increase GDP per capita and is estimated to have added 1.5% to 1.9% to Asian growth. However, this demographic bonus is only temporary and a period of pay-back starts as the Asian ‘baby boomers’ reach retirement.

Another key element of the Asian growth miracle is capital accumulation. Asian economies have a remarkably high level of saving (due partly to the demographic transition) that has sustained the very high rates of investment discussed in Miles and Scott.

.. .

17

CHAPTER 4 Capital Accumulation and Economic Growth

Asian Savings

Source: World Bank 1995 The Asian growth miracle and the European “golden age” One way of assessing the balance of growth in Asia is to compare it with another period of rapid catch-up – namely Europe’s golden age of post-war reconstruction. As the table below shows, although Europe’s growth performance in that period was not as spectacular, the contribution of TFP in Europe was far more significant. In Asia, the contribution of TFP to economic growth remains worryingly small.

Sources of Growth: European Golden Age vs. Asian Growth Miracle Total Of Which Output: Capital Labor TFP Golden Age 195073 France 5.0% 1.6% 0.3% 3.1% UK 3.0% 1.6% 0.2% 1.2% W. Germany 6.0% 2.2% 0.5% 3.3% Asian Miracle 1960-94 China 6.8% 2.3% 1.9% 2.6% Hong Kong 7.3% 2.8% 2.1% 2.4% Indonesia 5.6% 2.9% 1.9% 0.8% Korea 8.3% 4.3% 2.5% 1.5% Thailand 7.5% 3.7% 2.0% 1.8% Singapore 8.5% 4.4% 2.2% 1.5% Source: Crafts(1998) “East Asian Growth Before and After the Crisis” IMF Working Paper 98/137

.. .

18

CHAPTER 4 Capital Accumulation and Economic Growth

Discussion Questions 1) Is the Asian Miracle Over?

2) How much of the experience of these countries can be carried over to other regions. Africa for example?

Additional Questions A puzzling and politically crucial question is why Germany’s First World War reconstruction performance was so feeble in comparison with that following the Second World War. The historical importance of this question cannot be understated as it was Germany’s persistently low income and high unemployment after the First World War that nourished the rise of fascism.

German Economic Growth and its determinants Average Output Growth 1913-1929 0.6% 1929-1938 3.4% 1950-1960 8.0% 1960-1973 3.5% Source: OECD, Author’s calculations

Contribution of: Capital 0.0% 1.2% 3.8% 2.2%

Labor -0.1% 0.5% 0.3% -0.6%

TFP 0.7% 1.7% 3.9% 1.9%

The table above compares the two growth paths. It shows how Germany’s post WW2 performance followed a classic catch up process with high levels of capital accumulation added to substantial TFP leading to rapid growth. After WW1, low levels of investment meant that growth remained subdued.

Question 1) What possible explanations could there be for the difference in Germany’s economic performance after the two world wars?

Answer 1) Two main arguments have been put forward, one related to developments within Germany and the other to external events.

1. Internal Developments. This argument suggests that the institutional weakness of the Weimar republic increased the influence of special interest groups (unions, political parties and business associations) which imposed rigidities on the economy and encouraged rent-seeking. After WW2, the combination of prolonged Nazi dominance followed by the Allied occupation broke the strangling influence of these groups – producing an environment in which rapid growth could take place. The argument runs that these groups began to re-assert themselves in the 1960’s and explains Germany’s less impressive subsequent growth performance.

2. External Developments. This argument suggests that Germany was particularly susceptible to the Great Depression emanating from the USA because the Versailles .. .

19

CHAPTER 4 Capital Accumulation and Economic Growth

Treaty left Germany highly dependent on capital flows from the US. The constriction of such flows caused by the Depression resulted in the economic weaknesses in which fascism flourished. By the time the US economy had begun to recover, Germany had already to a large extent isolated itself from the world economy. After WW2, the external environment was far more favorable and, by increasing its trade links (with the rest of Europe in particular) and utilizing external capital (e.g. via the Marshall Plan), Germany was able to benefit from an export-led recovery.

Evidently, these two approaches are not mutually exclusive and so it is quite likely that both factors played a part.

Source: Paqué (1996) “Why the 1950’s and not the 1920’s?” in Economic Growth in Europe since 1945 Eds. Crafts and Toniolo, CEPR and CUP Question 2) look at the chart below. Is it consistent with the model of capital accumulation discussed in the text?

Profitability and capital accumulation in German Manufacturing 40

% 30

10 % p.a.

9 8 7 6

20

5 4

10

3 2

Profit Rate (LHS)

1 0

51 54 57 60 63 66 69 72 75 78 81 84 87 19 19 19 19 19 19 19 19 19 19 19 19 19

0

Capital Stock Growth (RHS)

Answer 2) The chart shows how in the early stages of Germany’s post WW2 reconstruction, the manufacturing capital stock grew rapidly and the return on capital investment was high. As the capital stock increased in size, the profit rate declined and the growth of the capital stock began to stabilize towards a steady state. Therefore the pattern of capital accumulation seems consistent with the model of capital accumulation described in the text.

Source: Carlin (1996) “West German Growth and Institutions, 1945-90” in Economic Growth in Europe since 1945 Eds. Crafts and Toniolo, CEPR and CUP Question 3) Find the rate of investment (investment as a % of GDP) for some selected economies. Using the World Bank’s World Development Indicators [http://data.worldbank.org/data-catalog -> WDI databank].

What do these imply about future growth in these economies? .. .

20

CHAPTER 4 Capital Accumulation and Economic Growth

Question 4) Find the current and forecast dependency ratio for a range of countries using data from the UN population division [http://esa.un.org/unpd/wpp/unpp/panel_indicators.htm].

Are any benefiting from a demographic transition?

.. .

21

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

CHAPTER 5: TOTAL FACTOR PRODUCTIVITY, HUMAN CAPITAL, AND TECHNOLOGY INTRODUCTION As is the nature of TFP, this is a bit of a catch all chapter. Institutions and social capital may resonate with many students.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As with the previous chapter, this can be recast as a case study covering the key issues. In this case, a discussion of the importance of institutions and corruption can highlight many of the theoretical concepts in the chapter.

The issue of FDI and growth could be discussed in this chapter using material from Chapter 9.

CHAPTER GUIDE 5.1 The Role of Total Factor Productivity The key point about total factor productivity is that it does not suffer from diminishing returns.

5.2 Human Capital The discussion of education in developing countries is an important one since although most economists agree that education is key to economic development, a major international effort to raise education standards in Africa and Latin America in the 1960s and ‘70s had no impact on their economic success (in fact a region that had barely increased it education spending – East Asia – proved far more economically successful.

5.3 Total Factor Productivity. The importance of institutions in TFP is highlighted again in Chapter 6 that shows how the quality of institutions left behind after the colonial period is still a significant determinant of the success of developing countries today.

5.4 The Importance of Technological Progress Further figures on R&D expenditure are shown in the Background Material below.

5.5 Scarce Resources and the Production Function. Although slightly out of place in this chapter, the issue of scarce resources helps balance the seemingly unlimited growth that comes from TFP. It also give some more technical material for students to think about.

.. .

21

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

CASE STUDY: “IS THE INTERNET BETTER THAN ELECTRICITY?” Introduction “The Internet is just a tool they use to do business incredibly efficiently and quickly. It flows through the whole operation, just like electricity. A retailer doesn’t say to customers: ‘Come to my store because I’m wired up to electricity or because I keep the air-conditioning on’” Michael Dell, Jan 2000.

“Sir, I do not know what it is for. But of one thing I am certain: someday you will tax it” Michael Faraday in response to a question from a British MP about the uses of his new invention – electricity.

The slump in Internet share prices at the beginning of the 21 st century took much of the shine off the Internet revolution. However, if the history of electricity is anything to go by, falling share prices are no guide to the economic impact of new inventions. Although the Internet is unlikely to have such a huge impact as electrification at the beginning of the 20 th century, the example of electricity shows that the knock-on effects of important inventions are slow to materialize, but can continue for decades. They may even overshadow the direct effect of the original invention.

The History of Electrification in the USA In 1882, Thomas Edison’s Edison Electric Illuminating Company built a power station in Pearl Street New York City in order to provide electricity to local businesses. Initially, electricity was supplied free of charge. However, as the chart below shows, the process of electrification did not really take off until the beginning of the 20th century (by which time Edison’s company had become General Electric and Westinghouse Electric had developed the technology to convey AC electricity over long distances).

The initial impact of electricity was to change the nature of the central source of power to the factory. But in the 1920’s in particular, it spurred the fundamental redesign of factories. Before electricity, the typical factory would have one single source of mechanical power (normally water or steam) which would be distributed throughout the factory via a system of belt drives.

The belt drive system severely constrained the design of factories. For instance, the whole plant often had to be turned on simply to drive a single machine. Furthermore, the positioning of machines was likely to be dictated by energy need rather than the logical order of the production process. This meant that half-finished articles often had to be moved around the factory to the next stage of the production process.

.. .

22

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

The Spread of Electrification in the US (% of total) 80%

60%

Factory Mechnical Drive Household Lighting

40%

20%

0% 99 01 03 05 07 09 11 13 15 17 19 21 23 25 27 29 18 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19

Source: Brookes and Wahhaj (2001) To begin with, factories simply replaced their single source of power with electricity and continued to distribute power using their existing belt systems. However, they quickly realized that electricity could be delivered to each machine individually (with its own electric motor or ‘unit drive’). The unit drive radically altered factory design making them more efficient, reliable and safer.

It was this period of re-design that provided the real productivity enhancement through electricity as shown in the table below.

US GDP and TFP growth GDP growth (average TFP growth (average % p.a.) % p.a.)

18903.8% 0.8% 1900 18993.8% 0.9% 1913 19130.7% -0.6% 1920 19204.4% 2.7% 1929 1929-0.4% 1.0% 1937 Source: Brookes and Wahhaj (2001)

.. .

23

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

Electricity and the Stock Market The dramatic productivity gains associated with electricity and its complete domination of the power market made the new electricity operating companies sound like the greatest investments ever. However, that was not the case. After an initial spurt, their stock market performance became worse than other industrial companies (see chart below). This was not just market pessimism; the earnings of these companies were actually below average.

Although, a number of factors were involved in this under-performance, the key factor was competition. Having a new technology is not enough to make excess profits; you need to be able to protect it from competition. As Warren Buffett recently remarked (in relation to Internet companies) “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors” In the case of electricity, GE and Westinghouse did build those moats by protecting their patents. As a consequence, their market sector (electrical equipment) outperformed other industrials.

Electricity operating companies share price relative to industrials 250

200

150

100

50

18 90 18 92 18 94 18 96 18 98 19 00 19 02 19 04 19 06 19 08 19 10 19 12 19 14 19 16 19 18 19 20 19 22 19 24

0

Source: Brookes and Wahhaj (2001)

.. .

24

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

Electricity and the Internet In many ways, the example of electricity is an encouraging one for the Internet. Low productivity growth in the early stages of development was true for both innovations.

Moreover, even if the direct benefits are not substantial (recent estimates put total GDP benefits of business to business internet use at 5% in the long run), should the Internet encourage other forms of re-organization, the overall growth benefit could be much larger. In fact, recent research has confirmed that firms which undergo organizational change whilst introducing IT (Internet and B2B in particular) derive greater benefit1.

As a result, even if the Internet is never likely to match electricity in terms of economic benefits, the poor performance of internet companies need not make us pessimistic about its potential to add to growth.

Source: Brookes and Wahhaj (2001) “Is the Internet Better than Electricity?” World Economics Discussion Questions 1) Have most of the spillovers from the internet (in terms of more efficient working practices) already been exploited?

2) Was the dotcom bubble in the stock market a help or hindrance to the development of the internet?

3) Is the internet better than electricity?

Background Material THE DISTRIBUTION OFSKILLS IN THE MAIN ECONOMIES The chart below indicates how the distribution of skills varies across countries and time. The most notable difference is between the US and Germany. The US is has large pools of high skill and low skill workers but little in the middle. Germany, on the other hand, has a large pool of intermediate skill workers.

Brynjolfsson and Hitt (2000) “Beyond Computation: Information Technology, Organizational Transformation and Business Performance” Journal of Economic Perspectives 14 1

.. .

25

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

Employee Skill Levels 1978 to 1999 100%

75%

low 50%

intermediate high

25%

0% 78

93

UK

98

78

93

98

78

US

93

98

Germany

Source: “Productivity in the UK” HM Treasury and DTI

.. .

26

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

ADDITIONAL QUESTIONS Question 1) Do you think the following stylised facts apply to the impact of FDI on the recipient country a) FDI encourages domestic investment b) FDI encourages growth c) FDI worsens environmental standards d) Volatility of capital flows has no impact on growth Answer 1) a) Foreign Direct Investment encourages domestic investment. Recent studies have shown that FDI tends to be accompanied by an almost equal increase in domestic investment. This is a much higher than with other types of capital flow.

Impact of cross-border flows on domestic investment in developing countries 100% 75% 50% 25% 0% FDI

Portfolio

Loans

Source: Bosworth and Collins(1999) “Capital Flows to Developing Economies: Implication for Saving and Investment” Brookings Paper on Economic Activity However, this relationship is not constant across countries or conditions. On a regional basis, the investment effect is much stronger in sub-Saharan Africa than in either East Asia or Latin America (where the impact is smallest). Further, there is evidence that the impact of FDI is related to the absorptive capacity of the country. In particular, there is a strong relationship between levels of schooling and the investment impact of FDI.

.. .

27

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

Relationship between FDI, Schooling and Domestic Investment 30% Investment /GDP 25%

20% High Medium

15% Low School Enrollment

Low Medium

FDI

High

Source: World Bank Global Development Finance (2001) b) FDI encourages growth. As with the investment effect, absorptive capacity is crucial to the growth effect of FDI. Countries with low educational attainment seem to benefit far less from such flows. Partly as a result, cross-border flows seem to focus on a small group of countries. As the chart below shows, the top ten developing country recipients of cross-border flows (Argentina, Brazil, Chile, China, India, Indonesia, Korea, Malaysia, Mexico and Thailand) demonstrate a strong growth performance which more detailed analysis has shown is partly related to those flows. However, these top ten recipients accounted for about 80% of all flows to developing countries.

Average growth rates in the 1990’s

6% 4% 2% 0% Low Income

Middle Income

Top 10 recipients

Source: World Bank Global Development Finance (2001)

.. .

28

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

c) No evidence that FDI is associated with poorer environmental standards. It is often argued that FDI is attracted by weaker environmental standards - encouraging an environmental race to the bottom. However, the opposite argument – that growth encourages better standards – seems to be the case. The chart below shows the evidence for China, but similar results have emerged in Brazil and Mexico.

Average Urban Air Pollution and FDI in China

500

40 35

450

30 25

400

20 15

350

Pollution Index FDI

10 5

300

0 1989 1990 1991 1992 1993 1994 1995 1996 1997

Source: World Bank Global Development Finance (2001) d) Volatility of capital flows is negative for growth. Although FDI is the least volatile form of cross-border flow, generally speaking, volatile flows have had a negative effect on growth. World Bank research shows that, while the volatility of flows was high in the 1990’s, the growth impact has been less than in previous decades.

Capital flow volatility and growth 5% 4% 3% 2%

Average volatility of capital flows

1%

Contribution of volatility to growth

0% -1%

1970s

1980s

1990s

-2%

Source: World Bank Global Development Finance (2001) Question 2) Does corruption have a significant impact on growth?

.. .

29

CHAPTER 5 Total Factor Productivity, Human Capital and Technology

Answer 2) The link between corruption and growth is a contentious one – as the chart below indicates, there is a weak correlation between corruption and growth, indicating perhaps that other factors are more important. However, reducing corruption is a major aim of the World Bank.

Corruption and Average GDP growth (1990-99)

GDP Growth (%)

10

5

0

-5

-10 0

2

4

6

8

10

Corruption Index

Source: Author’s calculations, Transparency International & World Bank

Question 3) Find the governance scores for a range of economies using the World Bank’s World Governance Indicators [http://info.worldbank.org/governance/wgi/sc_country.asp] Identify the key governance strengths and weaknesses for the countries you have chosen

.. .

30

CHAPTER 6 Endogenous Growth, and Convergence

b

CHAPTER 6: ENDOGENOUS GROWTH AND CONVERGENCE

INTRODUCTION This is a central chapter offering a synthesis of competing growth theories and combining various elements of previous chapters. Students also normally find the progression into development issues of particular interest.

Although the labor market is not covered in detail until the next chapter, this chapter effectively concludes the treatment of the determinants of sustained economic growth. Since endogenous growth theory offers some contrasting predictions to the neo-classical propositions discussed in previous chapters, it may be a little confusing for students at first.

This is nevertheless a key chapter for courses that have a development economics slant.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER The approach to this chapter is dependent on the orientation of the course. For students with an interest in development economics, this chapter is important and can be extended into two lectures (one on endogenous growth and the other on African development and aid). For a more domestically or developed economy oriented course, this chapter can be merged into other lectures. Focusing on the development of the theories around the issue of convergence is a good way of motivating student interest.

As with previous chapters, the material here can be given as a case study (e.g. on African development), with the theoretical material being introduced as necessary.

CHAPTER GUIDE 6.1 Endogenous Growth. Since endogenous growth theory suggests that government intervention can help improve growth prospects, it has been widely cited by social democrat politicians as a justification for enhancing the role of government. (In the UK, one of New Labour’s leading politicians – Gordon Brown - famously made a speech extolling the virtues of the new theories of endogenous growth. Kenneth Clarke, the Conservative Chancellor at the time, deliberately misquoted this idea as “erogenous” growth theory).

6.2 Poverty Traps. Normally, a poverty trap describes a situation where the tax and benefit system causes people on low incomes to find that increases in their pre-tax income reduce their post-tax (or post-benefit) income. This situation discourages effort to find work or better-paid work. The parallels of this situation with that of increasing returns are strong since poverty traps discourage effort/investment only when income is below a certain threshold.

.. .

30

CHAPTER 6 Endogenous Growth, and Convergence

A good way to motivate this topic is to talk about urban areas i.e. why some persist as ghettos while others remain rich. Discussing ways of overcoming such problems covers many of the key issues at an intuitive level.

6.3 Convergence or Divergence? Having focused on decreasing marginal product for four chapters, students might be a little confused at this point by the introduction of constant and increasing returns. This section should help resolve that confusion by distinguishing between developed and developing countries. Certainly, it is hard to explain Africa’s low income and poor growth performance without moving beyond decreasing returns.

6.4 Determinants of the Steady State. The Background Material below looks at the determinants of the steady state from a historical perspective - assessing how the US overtook the UK as the leading economy in the late 19th century.

6.5 Why is Africa So Poor? As well as its importance to the welfare of millions of people, the disappointing economic growth of Africa is a real challenge to economists and economics.

A brief look at the UN HDI tables (see chapter 2 for details shows that the bottom 19 countries in those table are all in Africa (The lowest scoring country outside Africa is East Timor). Given the focus of aid on the poorest countries, the effectiveness of aid is of key importance for Africa. For example, in 1999, of the 22 officially designated HIPC (Heavily Indebted Poor Countries), 17 were in Africa.

6.6 The Curse of Natural Resources. Students are usually very interested in this topic, the is more on natural resources in chapters 8 and 21 6.6 Does Aid Work? The case study examines overseas aid and debt relief CASE STUDY: AID AND DEBT RELIEF IN THE 21st CENTURY. Introduction Over most of the 1990’s, aid declined significantly as a percentage of developed country GDP. Not only did the end of the Cold War reduce politically motivated aid programs, but an increasing body of evidence suggesting that aid was not effective in stimulating growth or reducing poverty reduced the incentive to donate aid. In particular, the US, which among the major economies gives the smallest share of GDP in aid, has deployed this argument.

.. .

31

CHAPTER 6 Endogenous Growth, and Convergence

Aid as a share of GDP for the major economies 0,7 0,6 0,5

France Germany

0,4

Japan 0,3

United Kingdom

0,2

United States

0,1 0 1986-87 average

1991-92 average

1998

1999

2000

2001

2002

Source: World Bank By the end of the 1990’s however, the level of aid again began to increase (the UK, for example, committed to increase aid to 0.33% of GDP by 2003-4). However, the maintenance of these aid commitments will depend upon improvements in its allocation which lead to significant reductions in poverty. This has now become the major objective of the larger development agencies like the World Bank.

The Impact of Aid World Bank research suggests that, in terms of stimulating domestic investment, aid is as successful as foreign direct investment (see Background Material to Chapter 5). Every dollar of aid stimulates almost an equal amount of domestic investment. However, unlike foreign direct investment, this extra investment rarely seems to generate improved productivity. It seems that the issue of absorptive capacity (whether the country has the necessary social and physical infrastructure to benefit from more investment) is, once again, vital. Since aid is usually targeted at the very poorest countries with low educational attainment and poor government, it fails to foster growth. Equally, it seems that aid cannot ensure good government policies, although in countries already pursuing such policies aid can be effective.

The new approach to aid is based on three principles. The first and most important is that aid shall be directed to countries with good economic policy ratings (the ratings are based on macro-economic policies; other anti-poverty programs; the quality of governance; and institutional capacity). As the charts below show, in the period between 1992 and 1994, more aid went to countries with a low policy score than to those with a high score. By 1998 however, the situation had been reversed. Some models predict that this development will increase the effectiveness of aid for poverty alleviation by more than two and a half times.

.. .

32

CHAPTER 6 Endogenous Growth, and Convergence

Aid receipts as a percent of GNP relative to policy and income indicators 1998 Aid/GNP.

Aid/GNP.

1992 to 1994

25%

20%

25%

20%

15%

15%

10%

10%

5%

5%

High

High Middle

0% Low

Bottom Third Middle Third Income Group

Top Third

Country Policy Rating

Middle 0% Middle Third Income Group

Country Policy Rating

Low

Bottom Third

Top Third

Source: World Bank The charts above also give an indication of the second important criterion for aid – the extent of poverty. Although this is not a new criterion (the poorest countries have always received the highest levels of aid as a percentage of their GNP), the share of aid going to the poorest nations has increased in recent years. The third key criterion is aid as an offset to specific structural weaknesses such as vulnerability to economic shocks The HIPC Initiative In addition to directing aid towards countries with better policy performance, the HIPC (Heavily Indebted Poor Countries) initiative has attempted to encourage debt relief for the poorest and most indebted countries. Before 1996, countries with an unsustainable debt burden could negotiate re-scheduling of their bi-lateral debt (i.e. private sector and government-togovernment) through the “Paris Club” - a talking shop for agreeing the terms of debt repayment. However multi-lateral debt (i.e. loans from the IMF and World Bank) was not negotiable - it had to be paid on time and in full. The HIPC initiative allows debt relief on all types of debt for countries whose debt burden is judged to be unsustainable.

The main sustainability criterion used in assessing HIPC is the debt/exports ratio (in fact, it is the net present value of debt that is used). Under the original initiative, a country with a debtexport ratio greater than 200%-250% was eligible for debt relief (open economies could get more favorable terms). In 1999, the enhanced HIPC program reduced that threshold to 150%.

The main economic justification for the HIPC initiative lies in the debt relief Laffer curve. This curve relates the level of debt to repayment. As with other Laffer curves, the key insight is that when the burden of debt becomes excessive, there is no point in trying to pay it back. At that .. .

33

CHAPTER 6 Endogenous Growth, and Convergence

point, debt relief will actually improve debt repayment and help the country institute poverty reduction programs.

The Debt Relief Laffer Curve Debt repayment

Debt repayment

Debt Stock

The debt relief Laffer Curve is not just a statement about debtors’ willingness to repay debt when the burden becomes excessive, it also relates to the countries’ economic ability to pay.

Since high debt levels will tend to reduce spending on areas such as education and health which are known to promote growth, a country with a longstanding debt obligation will tend not to be able to engender the growth rate that would facilitate debt repayment. The chart below gives an example of this effect for Mozambique – one of the early beneficiaries of the HIPC initiative.

Mozambique: Expenditure on Social Programs and Debt Service (US$ million)

200

150 Debt Service

100

Social Spending

50

0 1995

1996

1997

1998

1999

2000

Source: World Bank On this basis, the $30 billion projected to be spent on the HIPC initiative seems like money well spent, potentially benefiting both borrower and lender. However, it has a drawback. Since debt .. .

34

CHAPTER 6 Endogenous Growth, and Convergence

relief is an attractive option to the lender, the incentive for borrowers to overborrow is enhanced.

Discussion Questions 1) Should the aid budgets of the developed countries be increased?

2) Is debt relief an efficient way to spend aid funds?

Additional Questions Question 1) How did the US overtake the UK at the beginning of the 20 th Century?

THE US AND UK ECONOMIES – 1870 to 1913 1990 US$ equivalent Income per Capita Income per Capita 1870 1913 US 2457 5307 UK 3263 5032

Average annual growth rate Per Capita TFP income 1.82% 0.8% 1.01% 0.5%

Answer1) In the late 19th and early 20th century, the US drew level with and then overtook the UK as the richest major nation in the world. Whilst convergence easily explains how the US came to join the richer nations of the world during the 19 th century, convergence cannot explain why the US overtook those nations. Before endogenous growth theory, the only explanation available was that the UK investment rate was too low and the US therefore acquired a larger capital stock. However, this explanation implies that the UK economy had gone through a period of stagnation which seems inconsistent with the fact that the UK investment rate was at it highest ever level over this period.

Endogenous growth offers a different explanation. Partly because of its endowment of natural resources, the United States found itself with a comparative advantage (see Chapter 9 for a detailed definition) in some key growth industries such as car production and electricals. The UK, on the other hand, was still specializing in textiles, rail and ships. The US industries not only had growth potential, they also tended to enhance human capital through learning by doing (for example, the introduction of mass production techniques). This know-how then spilled over into other industries and encouraged further growth.

Why didn’t the UK simply copy US techniques? There are two key reasons. First, as communications were less advanced, international knowledge spillovers were limited. Second, the UK management and union structure was better suited to craft-based production which made mass-production techniques more difficult to introduce.

Source: Crafts (1996) “Endogenous Growth: Lessons for and from Economic History” CEPR Discussion Paper No. 1333 Question 2) Calculate aid as a share of GDP for a range of donors and recipients. Aid figures (Official Development Assistance of ODA) are available on stats.oecd.org [under Development>Aggregate Aid Statistics]. GDP data are available in the World Development Indicators .. .

35

CHAPTER 6 Endogenous Growth, and Convergence

database [http://data.worldbank.org/data-catalog -> WDI databank]. Be careful to match, currencies, current/constant price and units (millions vs. billions)

.. .

36

CHAPTER 7 Unemployment and the Labor Market

CHAPTER 7: UNEMPLOYMENT AND THE LABOR MARKET INTRODUCTION Although the beginning of this chapter reflects the previous four chapters on growth, it is mainly concerned with the determinants of the natural rate of unemployment. It is therefore largely a stand-alone chapter tackling many issues that students should find relevant and stimulating. It is however worth pointing out the link with other chapters as it continues the focus on long run supply side issues and the level of output an economy can produce.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Given the link with previous chapters, the first two sections could be covered in an earlier lecture. This would leave a lecture dedicated to unemployment. European students will probably find the material on unemployment of greater interest. US students, on the other hand, may wish to spend more time on inequality issues. In a shorter course, this chapter would most naturally be paired with Chapter 16.

Starting the lecture with a discussion of different unemployment experiences in different countries or over time is an effective way of approaching the subject. This is particularly true if there are clear indications why unemployment is so low/high in your own country.

CHAPTER GUIDE 7.1 Labor Market Data. The distinction between unemployment and labor market participation is not as clear cut as it first seems. Many people choose not to join the labor force if employment prospects are not good. They may choose to stay in education, retire early or stay at home. This discouraged worker effect leads to a negative correlation between the unemployment rate and the growth of the labor force. (See Additional Questions below).

7.2 A Long-Run Model of the Labor Market. The diminishing marginal product of labor will be very familiar from the discussion of capital in previous chapters. Fortunately, constant returns and increasing returns are not an issue in this case which is a simple examination of the quantity of labor not its quality (i.e. human capital).

Although the vertical labor supply curve is easy to communicate, the idea of a backwardbending supply curve may be interesting to some. As the chart shows, the curve is based on the idea that as the real wage rises, the income effect begins to dominate the substitution effect. This curve is consistent with historical facts but offers the alternative prediction that average hours worked will now steadily decline as real wages rise.

.. .

35

CHAPTER 7 Unemployment and the Labor Market

Wage Rate

Hours worked

7.3 The Natural Rate of Unemployment. Students may be a little surprised to learn that they are the ones with monopoly power over their employers through their threat to resign. In some cases this is a hollow threat, as the prospect of prolonged unemployment will make resignation more costly to the employee than to the employer. Clearly, the employment prospects for the employee are crucial here. If a new job is easy to find, then the monopoly power rests with the employee.

A good way of introducing this section is to discuss the remuneration of sports stars or entertainers. Actors in the hit series “Friends” were rumored to be seeking $1 million per episode. Getting students to explain how this can happen gets them to reflect on wider labor market issues.

7.4 A Diagrammatic Analysis. The fact that inflation has a tendency to rise if unemployment is below the natural rate and fall if unemployment is above it explains why the natural rate of unemployment is also called the “Non-Accelerating Inflation Rate of Unemployment” (NAIRU). The inflationary consequences of deviation from the natural rate are discussed in detail in Chapter 16.

7.5 Determinants of the Natural Rate. The impact of long-term unemployment on the natural rate is an example of hysteresis. Hysteresis occurs when a short-term deviation has longterm consequences. Thus, in the case of long-term unemployment, a severe recession can raise the proportion of long-term unemployed and so permanently raise the natural rate.

The hysteresis effect was one of the concepts used to explain why unemployment in many countries failed to fall significantly after the late 1970’s recession.

7.6 What Lowers Unemployment? The Background Material below contains charts showing the relationship between centralization of wage bargaining and unemployment found in Calmfors and Driffill(1988).

7.7 A Flow Approach to the Natural Rate of Unemployment. The minimum wage is another labor market measure that is widely supposed to have an important impact on unemployment. (See Case Study below). .. .

36

CHAPTER 7 Unemployment and the Labor Market

7.8 Labor Market Reform. More detail on the UK and Dutch experience of reducing unemployment can be found in the Background Material. Certain countries with very low unemployment (e.g. in 2001 - Switzerland with 2%, Iceland with 1% and Norway with 2.5% unemployment) rely on a pool of overseas workers to keep real wages low in the more unpleasant occupations.

.. .

37

CHAPTER 7 Unemployment and the Labor Market

CASE STUDY: MINIMUM WAGES, POVERTY AND UNEMPLOYMENT. Introduction Despite being a highly controversial area of labor market policy, almost all the developed economies have some form of minimum wage legislation, though its level varies greatly (see table). In principle, minimum wages look like an effective way of reducing poverty that has little impact on overall employment - but is this true?

Minimum Wages in selected economies (1997) Minimum wage per hour Minimum wage as % of average pay in in US$ manufacturing.

US $5.15 39% Japan $5.11 45% Franc $6.82 71% e UK $5.73 50% Canad $4.65 39% a Minimum Wages and Poverty As a starting point, the evidence that a minimum wage reduces low pay is quite strong. A number of studies in different countries have confirmed this. The chart below demonstrates the relationship between low pay and the minimum wage for a range of countries.

Minimum Wages and Low Pay (mid 1990’s).

30 Korea

Incidence of low pay.

25

US Canada Hungary

Spain 20 15

Czech Rep.

Japan NZ

10

France Netherlands Belgium

5 20

30

40 50 Minimum Wage Index

60

70

Incidence of low pay = % of full-time workers receiving less than 2/3’s of median earnings Minimum wage index = Minimum wage as a % of median full-time earnings

.. .

38

CHAPTER 7 Unemployment and the Labor Market

However, the evidence becomes far weaker when we move on to overall poverty. Many studies have found an equalizing effect on the incomes of working households (i.e. households with at least one working member), but have not found any significant impact on the overall poverty rate of all households (since a substantial number of poor households have no working members).

Minimum Wages and Employment.

Until the late 1980’s, the US consensus on the impact of the national minimum wage held that it had a small but significant negative effect on employment (with a larger negative effect on youth employment). However, at the beginning of the 1990’s, the federal minimum wage was increased substantially (after having been kept constant through the 1980’s) but most studies could find no employment impact of this increase, thereby undermining the previous consensus.

In countries with a very high minimum wage the evidence seems stronger. In France, for instance, most studies have found a significantly negative employment impact of the minimum wage (the Salaire Minimum Interprofessionnel de Croissance - SMIC). For example, the OECD finds that a 10% rise in the SMIC leads to an increase in structural unemployment of about 0.9%.

Conclusion On the basis of these results, the OECD has made the following recommendations to countries considering introducing a minimum wage 1) Above a certain level, a statutory minimum wage reduces employment.

2) A lower minimum should be set for young workers.

3) Since a minimum wage can reduce low pay but has less impact on overall poverty, it should be seen as part of an overall poverty alleviation policy along with changes in the tax and benefit system.

Source: “OECD Submission to the Irish National Minimum Wage Commission” WP No. 186, 1997 Discussion Questions 1) Is there a minimum wage in your country? How does it operate?

2) If you have one, do you think it should be increased lowered or abolished?. If not should one be introduced and at what level?

.. .

39

CHAPTER 7 Unemployment and the Labor Market

Background Material CENTRALIZATION OF WAGE BARGAINING Calmfors and Driffill (1988) examine the idea of a hump-shaped relationship between the centralization of wage bargaining and labor market performance. Their argument is based on the general idea that organized interests (in their case - unions) are at their most harmful when they are strong enough to cause major disruption but not sufficiently encompassing to bear their share of the cost of their actions. They suggest that an intermediate level of centralization will be associated with higher real wages and higher unemployment.

The two charts below show empirical estimates of their proposition using their rankings of centralization (1 equals most centralized) and unemployment. The first simply shows the relationship between the level of unemployment (1974-85 average) and centralization, while the second looks at the rise in unemployment between the 1963-73 average and the 1974-85 average. This measure can be seen as a quantification of labor market flexibility in response to an adverse supply shock (the oil price rises of the 1970’s). .Unemployment and Centralization The Rise in Unemployment and Centralization 10 UK

Level of unemployment (%).

Denmark 8

Neth.

Canada Italy US

Australia 6

Finland

France Germany

4 Austria Sweden Norway

2

NZ

Japan

8

Rise in unemployment (% points).

R 2 = 0.141

Belgium

Neth.

6

Australia 4

Finland

Germany

UK France Canada Italy

2

NZ Norway Sweden

Japan Switz.

0

0

5

10 Centralization Ranking

15

20

US

Austria

Switz.

0

R 2 = 0.301

Belgium

Denmark

0

5 10 Centralization Ranking

15

20

Both charts show some hump-shaped relationship though it appears stronger for the change in unemployment (perhaps because this relationship effectively strips out other idiosyncratic influences on unemployment). The charts include the R-squared for the fitted relationship (a 2nd order polynomial); this is a measure of the total variation explained by the fitted line. In the case of the change in unemployment, the hump-shaped relationship explains over 30% of the total variation of unemployment between countries.

Further evidence for the hump-shaped relationship comes from the Dutch and UK experience described below. As the chart shows, in the 1970’s and early 80’s both the UK and Netherlands (Neth.) were at average levels of centralization. The reforms they introduced in the 1980’s and 1990’s sent the UK towards greater decentralization and the Netherlands towards greater centralization. Both experienced a dramatic fall in unemployment.

Source: Calmfors and Driffill (1988) “Centralization of wage bargaining” Economic Policy No. 6 .. .

40

CHAPTER 7 Unemployment and the Labor Market

DUTCH AND UK EXPERIENCE OF LOWERING UNEMPLOYMENT The pattern of Dutch and UK unemployment has been remarkably similar for many years.

Having both had unemployment above the EU average in the early 1980’s, they matched the average by the mid 1980’s and are now (2001) both well below it with unemployment of around 4% as compared with the EU average of around 8% (see chart).

Unemployment Rates In UK, Netherlands and EU 12 11 10 9 8 7 6 5 4 3 2 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

UK Unem ploym ent Dutch Unem ploym ent EU Unem ploym ent Source: EcoW in

How ever, their paths to lower unemployment have been completely different. The key to the Dutch success was a collaboration between unions, employers and the government. This co-operation began with the Wassenaar Agreement of 1982. With unemployment rising and employment falling, employers agreed to a shortening of the workweek and unions agreed to moderate wage claims. It was also agreed that obstacles to temporary work should be removed. Whilst the government was not directly involved in the Wassenaar agreement, they were committed to stabilize government finances and reform social security. Additionally, government reductions in unemployment benefit and substantial investment in active labor market programs (about 1.4% of GDP) supported the approach embodied in the Wassenaar agreement.

The government’s co-operative approach stemmed from the conciliatory attitude of ex-union Prime Minister Wim Kok. The UK approach was far less co-operative and far more free market – as different from the Dutch approach as Margaret Thatcher was from Wim Kok. It involved a substantial reduction in union power (most notably around the time of the miner’s strike in 1984), dramatic reductions in unemployment benefit and the tax wedge. Although labor market programs were less substantial than the Dutch example, they did amount to around 0.5% of GDP and were targeted at reducing long term unemployment.

.. .

41

CHAPTER 7 Unemployment and the Labor Market

Which approach was more successful? On paper at least the ‘Dutch miracle’ was more impressive as it was accompanied by large increases in employment and dramatic reductions in the numbers claiming invalidity benefit (invalidity had been a form of hidden unemployment in the Netherlands). In the UK, the suspicion remains that ‘the English fiddle their figures’ (as Jacques Chirac put it). Certainly, the issue of the rising number of people claiming invalidity benefit is only now being addressed in the UK. However, the ‘Dutch miracle’, based as it was on a highly co-operative approach between formerly opposed institutions, seems unlikely to be widely applicable to other larger European countries.

Additional Questions Question 1) what explains the apparent negative correlation between unemployment and labor force growth shown in the chart below?

US Labor Force Growth and Unemployment 11

3.5

10

3.0

9

2.5

8

2.0

7

1.5

6 5

1.0

4

0.5

3

0.0 76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

Growth of Civilian labor force, % p.a. (RHS) Unemployment % of total labour force (LHS) Source: EcoWin

Answer 1) The chart demonstrates the ‘discouraged worker’ effect whereby the labor force shrinks when unemployment is high. The effect occurs because higher unemployment means lower prospects of finding work. Workers are thereby discouraged from even looking for a new job and leave the labor force altogether (e.g. early retirement).

Question 2) Look at forecasts for employment as a share of total population and unemployment as a share of the labor force for a selection of countries using the latest World Economic Outlook (WEO) database produced by the IMF. www.imf.org [under Data and Statistics].

.. .

42

CHAPTER 8 International Trade

CHAPTER 8: INTERNATIONAL TRADE INTRODUCTION Despite the introduction of a number of theoretical concepts, this should be an easy chapter to teach. By and large, students tend to be interested in trade issues. It should be easy to find good current examples to motivate this material as there is almost always some important trade dispute going on.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Although the historical perspective on trade is a good introduction, you may prefer to start by referring to current events such as recent trade talks and disputes, or recent protectionist measures. Showing how comparative advantage works then highlights the potential gains from trade. The Case Study on globalization below could be used to generate useful discussion.

CHAPTER GUIDE 8.1 Introduction: Patterns of World Trade. The Background Material includes more data on the share of services in trade.

8.2 Comparative Advantage – How Countries Benefit from Trade. The discussion of US and UK comparative advantage before the second World War links with the Background Material of Chapter 6 (How did the US overtake the UK at the beginning the 20th century?).

8.3 The Terms of Trade. The Prebisch-Singer Thesis is discussed in more detail in Chapter 9.

Also, some of the issues are discussed in the case study on Vietnamese Coffee Production.

8.4 What Goods Will Countries Trade In? Note that the tendency for developed countries to import and export similar goods means that their terms of trade are very stable. Only huge commodity price shocks like the oil price inflation of the 1970’s have a significant effect.

Developing countries on the other hand tend to have much more specialized trade patterns and therefore face far more volatile terms of trade. Macroeconomic policy-making is accordingly far more problematic.

8.5 Distributional Impacts of Trade. The analysis in this section parallels the discussion of immigration in the previous chapter. In economic terms immigration and trade have almost identical effects in terms of equalizing factor returns (i.e. raising wages and lowering the return on capital in labor abundant countries whilst lower wages and raising the return on capital in capital abundant countries.

8.6 Competitiveness. Krugman cites many examples of politicians who misuse the idea of competitiveness. President Clinton described a nation as being “like a big corporation .. .

43

CHAPTER 8 International Trade

competing in the global marketplace”. Jacques Delors (former head of the EU) ascribed Europe’s unemployment problems as being due to a “lack of competitiveness with the US and Japan” 8.7 Strategic Trade Theory. Another possible economic justification for protectionism is the establishment of industries that have important knowledge spillovers into the rest of the economy (e.g. Technology). Certainly, the example of the US and UK at the beginning of the 20th century shows the benefits of being in the right industries (see Background Material to Chapter 7). The track record of such policies, however, is not good.

8.8 Political Economy and Vested Interest. In practice, the two areas most subject to protection by developed countries are agriculture (through systems like the European Common Agricultural Policy - CAP) and textiles (through restrictions like the Multi-Fiber Arrangement, MFA). Although these are amongst the lowest paid industries in the developed world they have strong pressure groups in support. They are also key industries for developing countries. Textiles in particular have been important growth industries for countries in the early stages of development. As a result, pressure to remove restrictive protection is growing, and the MFA is now virtually dismantled.

CASE STUDY: ANTI-DUMPING Introduction Although trade restrictions such as the European protection of agriculture (the CAP) and worldwide restriction of textile trade (the MFA) are widely discussed and disputed, both of these have now probably been overtaken, in terms of economic impact, by the use of antidumping legislation as a way of restricting trade. Not only do the number of anti-dumping cases dwarf all other trade disputes (Between 1995 and 2000, WTO members reported 61 safeguard investigations, 115 countervailing duty investigations, and 1441 antidumping investigations), their impact can be substantial – the duties imposed after a successful case often reduces trade from the affected country by over 50%. Added to this, although other forms of restriction on trade are gradually being eliminated, as the chart below shows, anti-dumping cases are steadily rising.

.. .

44

CHAPTER 8 International Trade

Number of Anti-Dumping Cases Filed 1600 1400 1200 1000 800 600 400 200 0 1980-84

1985-89

1990-94

1995-99

2000-04

What is Anti-Dumping and can it be justified?

Anti-Dumping legislation is used by a country who suspects that goods being exported to their country are being sold at bargain basement prices as a way of driving out the local competition (i.e. dumped on their market). If the recipient country can prove that the price of the imported good is in some sense too low, then it can impose special duties on that exporting country with the full blessing of the WTO. On the face of it, anti-dumping legislation seems justified as an extension of normal competition policy (anti-trust). In most countries, the government can act against predatory pricing when a large company tries to kill of the competition by setting its price below cost for a temporary period. Therefore it seems a logical extension to say that a government can stop a foreign company doing the same. However, a more detailed look at anti-dumping shows that is goes a lot further than predatory pricing. In predatory pricing, a company is usually only convicted if it can been shown that it set prices below marginal cost (i.e. below the cost of producing one extra unit). In anti-dumping cases, not only are average costs used as a benchmark (i.e. not just the cost of producing an extra unit but also a share of the fixed cost of the business – such as the cost of buildings etc.) but often a ‘normal’ level of profit is added as well. As a result, a company making profits can be found guilty of dumping (in fact if antidumping criteria were applied to judge domestic predatory pricing cases then it is likely that most companies could be convicted!). This system can easily result in a company being charged with dumping in foreign markets even if the price it sells good abroad is higher than in its home market.

With this system, it is perhaps unsurprising that that most anti-dumping cases are successful and over the last 25 years around 98% of US anti-dumping cases have been successful.

.. .

45

CHAPTER 8 International Trade

Trends in the use of Anti-Dumping Given its weak economic justification, it is perhaps surprising that anti-dumping cases are so prevalent. One argument for their success is that, up until recently, almost all cases were brought by four major economies (largely against Asia) - 25 years ago Canada, US, EU, and Australia brought 98% of all cases. Thus it is possible that anti-dumping was effectively protectionism by the back door for these countries. Recently, however, new users such as India and China have become active users of anti-dumping legislation so that the original four now only account for 40% of all cases.

Growth in Anti-Dumping (AD) legislation No. of countries with AD No. of countries filing % of cases from ‘new statute actions users’ 198034 8 1% 84 198538 10 11% 89 199045 24 36% 94 199561 32 61% 99 200087 30 60% 02 Notes: countries with statute calculated at beginning of period, ‘New users’ = not US, EU Canada Australia Whilst these new users have been responsible for the dramatic rise in anti-dumping cases filed in recent years, it is possible that now most countries have anti-dumping legislation, the perceived economic advantage the original users saw from it use is now declining suggesting perhaps that some international agreements to curtail it may be on the way

Discussion Questions 1) Should Anti-Dumping legislation be abolished?

2) Do you think Anti-Dumping is an example of how the rich countries write the rules in their favor?

Source “The Growing Problem of Anti-Dumping”(2004) Prusa R. © NBER International Trade, East Asia Seminar on Economics Volume 14

.. .

46

CHAPTER 8 International Trade

Background Material TRADE-SPEAK GLOSSARY Some additional terms not covered in the main text : ACP Countries A group of African, Caribbean, and Pacific less developed countries that were included in the Lomé Convention and now the Cotonou Agreement. As of July 2000, the group included 77 countries.

Cairns Group A group of agricultural exporting countries, currently (2001) numbering 18, that was formed in 1986 to act as a counterweight especially to the EU in international negotiations on agriculture. Named after the city in Australia where the group first met.

Common Agricultural Policy (CAP) The regulations of the European Union that seek to merge their individual agricultural programs, primarily by stabilizing and elevating the prices of agricultural commodities. The principal tools of the CAP are variable levies and export subsidies.

Countervailing Duty. A retaliatory duty placed on imports from a country that subsidizes its exporters.

Dumping. Selling surplus goods overseas for less than it costs to produce.

Entrepot trade The import and then export of a good without further processing.

European Economic Area (EEA) The group of countries comprising the EU and EFTA. The two groups have agreed to deepen their economic integration.

European Free Trade Association (EFTA). Free trade area made up of countries in Europe that have not joined the European Economic Community. EFTA was established in 1960 between Austria, Denmark, Norway, Portugal, Sweden, Switzerland, and the United Kingdom. As of 2000, it includes only Iceland, Liechtenstein, Norway, and Switzerland.

General Agreement on Trade in Services (GATS) An agreement that brings international trade in services into the WTO..

Generalized System of Preferences Tariff preferences for developing countries, by which developed countries let certain manufactured and semi-manufactured imports from developing countries enter at lower tariffs than the same products from developed countries.

Marshall-Lerner condition The condition that the sum of the elasticities of demand for exports and imports exceed one. Under certain assumptions, this is the condition for a real exchange rate depreciation to improve the trade balance.

.. .

47

CHAPTER 8 International Trade

Mercantilism An economic philosophy of the 16th and 17th centuries which held that international commerce should primarily serve to increase a country's financial wealth especially of gold and foreign currency. To that end, exports are viewed as desirable and imports as undesirable unless they lead to even greater exports.

MERCOSUR A common market comprising Argentina, Brazil, Paraguay and Uruguay, known as the "Common Market of the South" ("Mercado Comun del Sur"). It was created by the Treaty of Asunción on March 26, 1991, and added Chile and Bolivia as associate members in 1996 and 1997.

Most Favored Nation (MFN) status Countries charged the lowest tariffs.

Multifiber Arrangement An agreement between developed country importers and developing country exporters of textiles to regulate and restrict the quantities traded. It was negotiated under GATT as an exception to the rules that would otherwise apply.

Nontariff barrier Any policy that interferes with exports or imports other than a simple tariff, prominently including quotas and Voluntary Export Restraints (VERs).

North American Free Trade Agreement (NAFTA) A free trade area comprising the United States, Canada, and Mexico that went into effect January 1, 1994.

Quota A government-imposed restriction on quantity, or sometime total value. An import quota specifies the maximum amount of an import per year - typically administered by import licenses that may be sold or directly allocated to individuals or firms, domestic or foreign.

Section 301 The provision of U.S. trade law that permits private parties to seek redress through the U.S. government if their commercial interests have been harmed by illegal or unfair actions of foreign governments.

Tariff A tax on trade, usually on imports but sometimes used to denote an export tax.

World Trade Organization A global international organization that specifies and enforces rules for the conduct of international trade policies and serves as a forum for negotiations to reduce barriers to trade. Formed in 1995 as the successor to the GATT, it had 136 member countries as of April 2000.

.. .

48

CHAPTER 8 International Trade

Additional Questions Question 1) The chart below shows the share of trade taken by commercial services over a range of countries. What explains the share of trade in services in the UK and US. Is this the same explanation as for countries like Egypt and Turkey?

Commercial Services as percentage of total trade 70 60 50 40 30 20 10

W or C ld Un an ite ad a d St at es Br az M il ex ico Fr an c G er e m an y Ita ly Sp a Sw in e Sw d itz en er la nd Un T ite ur k d Ki ey ng do m So Egy ut pt h Af ric a Tu ni s Au ia st ra lia Ch Ho in ng a Ko ng In di a Ko Ja re p a a, R n Ne ep . w Ze of ala n Si ng d ap o Th re ai la nd

0

Source: WTO Answer 1) The US and UK also have high proportions of trade in services largely due to the financial sector. For the others, tourism is the main contributor.

Question 2) Study the table below Productivity per Worker in each good (number of units produced per worker) Good Good Good 1 2 3 Country 4 4 4 A Country 2 1 1 B Country 3 2 3 C a) Spot each country’s comparative advantage b) Which country will end up poorest? .. .

49

CHAPTER 8 International Trade

c) Can any country be made worse off with trade than without it?

Answer 2) a) Country A’s comparative advantage is in good 2, Country B’s comparative advantage is in good 1 and Country C’s comparative advantage is in good 3 b) Country B will end up poorest since despite the fact it has a comparative advantage in good 2 it has no absolute advantage in anything. It will have to sell good 1 at quite a low price in order to stop countries A or C producing it themselves, but since productivity is quite low, wages will have to be very low. c) No, since no country is forced to engage in trade.

Question 2) Analyse the trade profile of a selection of countries using the WTO trade profile tool http://stat.wto.org/Home/WSDBHome.aspx?Language=E. How important is trade to each of these countries? What are theirs main exports and trading partners?

.. .

50

C H AP T E R 9 G l o b a l i z a t i o n

CHAPTER 9: GLOBALIZATION INTRODUCTION A hot topic that should be easy to teach. However, since the anti-globalization lobby does not have a clearly argued case against globalization, the economic discussion often ends up being somewhat one-sided.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Both chapters 8 and 9 could be put into one lecture under the heading globalization. Asking the question what are the anti-globalization protestors concerned about – and are they right to be concerned. The Case Study on globalization below give more detail on the impact of the first wave of globalization in the 19th and early 20th century.

CHAPTER GUIDE 9.1 Globalization – A Long-term Perspective. The case study below gives more analysis of the first wave of globalization.

9.2 The Benefits of Trade Liberalization. The issue of whether variable X (in this case trade liberalization) causes variable Y (growth) is one of the key empirical issues in economics.

The problems discussed in this case are general to almost any empirical study of causality 9.3 Foreign Direct Investment and Multinationals. The background material to chapter 5 gives more material on the impact of FDI. Two other criticisms often leveled at MNE’s are their poor labor standards in developing countries (sweat shops) and transfer pricing (avoiding tax).

On the question of labor standards, many economists would argue that it is precisely the cheaper labor, longer hours and limited employment protection that encourages firms to locate in developing countries in the first place, and the fact that the local population willing take jobs in these ’sweat shops’ implies that the alternative (e.g. long hours and low pay in farming) is worse than working for the MNE. Many labor organizations accept this point but argue that MNE’s could dramatically improve working standards without reducing their profits (e.g. a healthy workforce is more productive so a company sponsored health plan could actually raise labor standards and profits).

Transfer pricing occurs because the profits of an MNE can be taxed differently in different countries. So, for example, if country A has a very low rate of corporation tax (tax on profit) while country B has high corporation tax, an MNE located in both countries might wish to report low profits in country B and so higher profits in country A. It can do this by an internal pricing scheme that means that intermediate goods produced in country A and sent on to country B are pricing at such a high level that the subsidiary in country B reports no profits. .. .

49

C H AP T E R 9 G l o b a l i z a t i o n

9.4 Immigration Data on source of net emigration and destination of immigrants is shown in pie charts after the index of the book 9.5 Problems of Globalization. Some more background on the IFIs The World Bank. Note that IDA assistance is financed by grants from the shareholders whilst IBRD loans are financed from the World Bank’s own borrowings. The millennium development targets are described in more detail in the background material.

The IMF. It is hard to go into much detail about the operation of the IMF before having reviewing currency issues in chapters 19 20 & 21. Discussion of the HIPC initiative is also contained in the case study of chapter 6.

Mission Creep. The most remarkable case of mission creep by an IFI is the Bank for International Settlements (BIS). This was set up after the First World War to help administer the payment of reparations by Germany to the allies. However, it still exists today even though it stated purpose was completed well over fifty years ago. The BIS has managed to re-invent itself as a forum for Central Banks and for the discussion of Banking Issues.

9.6 The WTO and the future of Trade Liberalization.

While some anti-globalization protestors argue that the WTO is biased against developing countries, there is little evidence for this in practice. However, a more valid criticism is that developing nations do not have the resources to use the mechanisms of the WTO effectively. Certainly, most cases brought to the WTO for adjudication come from developed countries (see additional questions below).

CASE STUDY: GLOBALIZATION AND INEQUALITY. Introduction Over the last two centuries, the world economy has become more unequal. Moreover, this phenomenon is entirely due to increases in inequality between countries. Within country inequality has barely changed. Over the same period, the world economy has become more integrated - prima facie evidence that the globalization has caused greater inequality.

However, a more detailed look at trends in globalization and inequality seems to contradict that conclusion and reveals three key points 1. Income gaps have probably been reduced rather than increased by globalization – at least, for those countries that have been integrated into the world economy.

2. Inequality between countries rose most rapidly during the period of isolationism between 1914 and 1950. .. .

50

C H AP T E R 9 G l o b a l i z a t i o n

3. The era of dramatic globalization in the 19th and early 20th century increased equality for labor-abundant countries and reduced it for the labor-scarce countries – as the StoplerSamuelson theory predicts.

We now look at these three lessons in turn Growth and openness We have seen in previous chapters (e.g. Chapter 7) that although economic convergence does not seem to be manifest at the global level, there is convergence between the rich and poor nations with more open economies. The table below gives a further demonstration of the growth benefits of openness for developing nations Trade orientation and growth in developing countries Average growth of GDP per capita 1963-73 1973-1985 1980-1992 Strongly open to 6.9% 5.9% 6.4% trade Moderately open 4.9% 1.6% 2.3% Moderately anti- 4.0% 1.7% -0.2% trade Strongly anti-trade 1.6% -0.1% -0.4% Inequality since 1820 Long run trends in inequality show a surprising pattern. Although global inequality has been on a steadily increasing trend, inequality between countries accelerated in the protectionist period between 1914 and 1945 but inequality within countries fell dramatically over the same period.

As a result, although it is clear that the retreat from globalization in the middle of the 20 th century did not decrease inequality between countries, its effects on overall inequality are unclear.

.. .

51

C H AP T E R 9 G l o b a l i z a t i o n

Global Inequality trends

Coefficent of inequality.

0.9

0.6 Global inequality Inequality between countries Inequality within countries

0.3

0

20 18

40 18

60 18

80 18

00 19

20 19

40 19

60 19

80 19

Inequality and initial factor endowments If we characterize the owners of land as rich and workers as poor, then the Stopler-Samuelson theory gives us a clear prediction about the impact of globalization on inequality. Increased international trade will tend raise the price of the most abundant local factor and so landabundant countries will tend to see internal inequality increase with globalization (since the owners of land see their property increase in value). Labor-abundant countries will see inequality decrease as wages rise.

The charts below demonstrate this effect for the 19 th / early 20th century period of globalization.

.. .

52

C H AP T E R 9 G l o b a l i z a t i o n

Rent to Wage ratios 250

110

Australia

Denmark

USA

Sweden UK

Rent to wage ratio .

Rent to wage ratio .

Canada

90

70

200

150

100

50

50

70 75 80 85 90 95 00 05 10 15 20 25 30 39 18 18 18 18 18 18 19 19 19 19 19 19 19 19

70 75 80 85 90 95 00 05 10 15 20 25 30 39 18 18 18 18 18 18 19 19 19 19 19 19 19 19

Land-abundant Countries

Labor-Abundant Countries

The first two charts illustrate how the opening up of the land-abundant New World allowed rents to rise relative to wages in the New World and wages to rise relative to land in the Old World. This process ended and was partially reversed as a result of protectionism in the 19131945 period GDP per capita to unskilled wage ratio

160

160

USA

140

GDP per capita/unskilled wage .

GDP per capita/unskilled wage .

Australia

Canada 120

100

80

60

140

120

100

80 Denmark 60 Sweden

40

Land-abundant Countries

1939

1930

1925

1920

1915

1910

1905

1900

1895

1890

1885

1880

1875

1870

1939

1930

1925

1920

1915

1910

1905

1900

1895

1890

1885

1880

1875

1870

40

Labor-Abundant Countries

The charts above show how the factor price equalization effect caused inequality to rise in the New World and fall in the Old. The ratio of per capita GDP to the unskilled wage is a crude measure of inequality. .. .

53

C H AP T E R 9 G l o b a l i z a t i o n

Source: Lindert and Williamson (2001) “Does Globalization make the world more unequal?” © NBER WP 8228

Discussion Questions 1) Do you think Globalization is increasing or decreasing inequality within developing countries?

2) Is it increasing inequality in developed countries?

Background Material MILLENIUM DEVELOPMENT TARGETS Goal 1. Eradicate extreme poverty and hunger Target 1. Halve, between 1990 and 2015, the proportion of people whose income is less than one dollar a day Target 2. Halve, between 1990 and 2015, the proportion of people who suffer from hunger Goal 2. Achieve universal primary education Target 3. Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling Goal 3. Promote gender equality and empower women Target 4. Eliminate gender disparity in primary and secondary education, preferably by 2005, and in all levels of education no later than 2015 Goal 4. Reduce child mortality Target 5. Reduce by two thirds, between 1990 and 2015, the under-five mortality rate Goal 5. Improve maternal health Target 6. Reduce by three quarters, between 1990 and 2015, the maternal mortality ratio Goal 6. Combat HIV/AIDS, malaria and other diseases Target 7 Have halted by 2015 and begun to reverse the spread of HIV/AIDS Target 8. Have halted by 2015 and begun to reverse the incidence of malaria and other major diseases Goal 7. Ensure environmental sustainability Target 9. Integrate the principles of sustainable development into country policies and programmes and reverse the loss of environmental resources Target 10. Halve, by 2015, the proportion of people without sustainable access to safe drinking water and sanitation Target 11. By 2020, to have achieved a significant improvement in the lives of at least 100 million slum dwellers .. .

54

C H AP T E R 9 G l o b a l i z a t i o n

Goal 8. Develop a global partnership for development Target 12. Develop further an open, rule-based, predictable, non-discriminatory trading and financial system.

Includes a commitment to good governance, development and poverty reduction - both nationally and internationally Target 13. Address the special needs of the least developed countries.

Includes: tariff and quota-free access for least developed countries' exports; enhanced programme of debt relief for heavily indebted poor countries (HIPC) and cancellation of official bilateral debt; and more generous ODA for countries committed to poverty reduction Target 14. Address the special needs of landlocked developing countries and small island developing States (through the Programme of Action for the Sustainable Development of Small Island Developing States and the outcome of the twenty-second special session of the General Assembly) Target 15. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable in the long term.

TAX REGIMES AND FDI As a simple demonstration of how net inflows of foreign direct investment are encouraged by lower corporation tax, the chart below shows net FDI for the developed countries by tax regime.

Net FDI and tax regimes for OECD countries (% of GDP) 0 -0.5 -1 -1.5 -2 -2.5 -3 -3.5 -4 -4.5 -5

Low Tax Countries High tax Countries

1990

1991

1992

1993

1994

1995

1996

1997

Source: OECD Additional Questions Question 1) Who has a higher rate of tariff protection, the high income or developing countries? Would you answer differ for agricultural goods as opposed to manufactured goods?

.. .

55

C H AP T E R 9 G l o b a l i z a t i o n

Answer 1) Developing countries have a high rate of protection for both agricultural goods and manufactured goods. Overall protection against agricultural goods is significantly higher than against manufactured goods

Question 2) Who brings the most disputes to the WTO? Do developing countries have more cases brought against them than they bring against other countries?

Answer 2) Over the period 1995-2000 the US brought most cases to the WTO closely followed by the EU. In fact, the US brought more cases than all developing countries put together.

Developing countries have many more cases brought against them than they bring against other countries. Some argue that this shows that the system is biased against developing countries because they do not have the resources to bring cases to the WTO for adjudication.

.

Question 3) find that latest data on global capital flows in McKinsey Global Institute “mapping global capital markets” report. .. .

56

C H AP T E R 9 G l o b a l i z a t i o n

http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets. What are the key differences between developed and developing market flows.

.. .

57

CHAPTER 10 Consumption & Investment

CHAPTER 10: CONSUMPTION & INVESTMENT INTRODUCTION This is the first of four chapters that focus largely on the business cycle. It is the most theoretical of the four, but outlines a number of models that will be used again later. Time used to absorb these will therefore be well spent.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Since the Keynesian model is introduced largely to be knocked down, it may be worth starting immediately with the permanent income model (which itself could be summarized for a less theoretical course). Since IS-LM analysis is first introduced in this chapter it could be gone through in detail at this stage (See case study) or could wait until the LM curve is outlined in Chapter 13.

CHAPTER GUIDE 10.1 The Importance of Consumption. The relationship between US GDP and consumption is shown in the Background Material below.

10.2

The Basic Keynesian Model. An intuitive explanation of the multiplier is shown in the Background Material. It is worth bearing in mind that the multiplier effect was one of the reasons why active demand management policy seemed attractive before the 1980’s. Each dollar spent on fiscal stimulus supposedly added several dollars to GDP.

10.3

The Permanent Income Model. This is a tough section and can be skipped or summarized if required. However, the general ideas here should be familiar from Chapter 10.

10.4

The Importance of Current Income Revisited. The Background Material gives more detail on the UK’s experience of financial liberalization in the 1980’s.

10.5

The Influence of Interest Rates. The possibility that higher interest rates could stimulate consumption is actively discussed in relation to Japan. There, most households have high levels of savings and so the income effect could be large. One member of the Bank of Japan monetary policy committee was convinced of this argument and consistently voted for higher interest rates as a way of helping Japan to recover. However, the other members of the committee did not share Ms. Shinotsuka’s view.

10.6

The Role of Wealth and Capital Gains. Another country where wealth effects (particularly from housing wealth) seem to have been important recently is the UK.

.. .

78

CHAPTER 10 Consumption & Investment

Some characteristics of the recent UK experience are brought out in the additional question below.

10.7

Demographic Influences in the Life Cycle Model. Another approach to understanding life cycle effects on consumption is offered in the Background Material - US consumption and World War III.

10.8

Investment and the Capital Stock. This chapter largely focuses exclusively on fixed capital. Inventories are discussed in the Case Study below.

10.9

The Optimal Capital Stock. The Modigliani-Miller theorem states that it makes no difference to the value of the firm how investment is financed, so in theory the source of funds is not important. In practice, the impact of corporate taxation etc. means that Modigliani-Miller does not hold – see Chapter 16.

10.10 Declining Marginal Product of Capital. This section relates back to the material on Chapter 4 10.11 Investment and the Stock Market. Most studies have found a weak, but significant, effect of Q on investment. For example Summers (“Taxation and Corporate Investment: A q-theory approach” Brookings Papers 1:1981) finds that a 10% rise in the stock market increases the ratio of investment to capital stock by 0.009. Cash flow variables have a much stronger effect.

10.12 Cash Flows and Investment. The Background Material shows the relationship between profitability and investment in the US. The importance of cash flow can even be seen within divisions of multi-division firms.

Shin and Stulz (NBER © WP 5639) find that within a multi-division firm 1. Investment by the smallest division depends significantly on the cash flow of the other divisions.

2. There is no evidence that divisions in industries with better investment opportunities receive more cash flow.

These seemingly inefficient investment policies indicate that a division’s share of the firm’s investment budget is sticky and is related to total cash flow rather than underlying investment opportunities. The authors call this the ‘bureaucratic rigidity hypothesis’.

The Background Material gives some results from the Poterba and Summers analysis of Fortune’s survey of firms’ investment planning.

10.13 Building Up the IS curve. More detail on IS-LM analysis is presented in the case study.

.. .

79

CHAPTER 10 Consumption & Investment

CASE STUDY: THE IS-LM MODEL Introduction John Hicks developed the IS-LM model in the 1930s as a simple exposition of some of the ideas in Keynes’ seminal General Theory of Employment Interest and Money. It analyses equilibrium in both the goods and money market and is based initially on a fixed price level.

It is most easily thought of as an analysis of aggregate demand - bringing in aggregate supply then allows us to drop the assumption of fixed prices.

IS-LM has became a staple of macroeconomic analysis ever since Hicks introduced it.

However, in recent years its popularity has waned. Robert King has gone so far as to say “the IS-LM model has no greater prospect of being a viable analytical vehicle in the 1990s than the Ford Pinto has of being a sporty reliable car for the 1990s”1. The key weakness is its static approach that ignores important factors such as expectations of the future. Chapter 12 describes this weakness in more detail.

The Goods Market: The IS Curve In the case of a closed economy, equilibrium in the goods market is the familiar Y = C+I+G

(See Chapter 2)

These elements are most simply determined by the following linear equations.

C = a +b(Y-T) Consumption is determined by disposable income. b is the marginal propensity to consume (Chapter 13) I = c -d(r) Investment is negatively related to the level of interest rates (Chapter 14) G= G Government spending is fixed –exogenous- in this model (Chapters 10 and 11) T= T Taxation is a fixed lump sum (i.e. not related to income) Given these elements, we arrive at a simple relationship between interest rates and output.

It implies that saving must equal investment and since savings is positively related to income and investment is negatively related to interest rates, higher output implies lower interest rates.

1 King(1993) “Will the New Keynesian Macroeconomists Resurrect the IS-LM Model?” Journal of Economic Perspectives 7.

The Ford Pinto – Ford’s answer to cheap Japanese imports - went out of production in the 1980s though still has a small but committed fan club. .. .

80

CHAPTER 10 Consumption & Investment

Interest rate (r)

The IS Curve

IS Curve

Output (Y)

Algebraically  1  Y = (a + c + G − bT − d ( r ) )  1− b 

The Money Market: The LM Curve Equilibrium in the money market requires that the demand for money equals the supply of money Ms =Md

Demand for money must equal the exogenous supply (Chapters 12

and 17) M d = e(Y ) − f ( r ))

Money demand increases with output, decreases with interest rates (Chapters 12 and 17) So r = (e/f)Y – (1/f)M The second equation here is known as the Theory of Liquidity Preference. It shows how greater output increases the need for money in transactions (the transactions demand for money) and how higher interest rates reduce the demand for money relative to interestbearing assets like bonds (the speculative demand for money).

Liquidity preference implies that higher output is associated with higher interest rates (increased transactions demand for money requires a lower speculative demand in order to keep total money demand fixed). The LM curve therefore slopes upwards.

The chart below shows overall equilibrium at the intersection of the IS and LM curves.

.. .

81

CHAPTER 10 Consumption & Investment

Interest rate (r)

The IS-LM model

LM Curve

IS Curve

Output (Y)

Or.     1 d (a + c + G − bT ) +   M Y =  1 − b + ( de / f ) f ( 1 − b ) + de    

This model can be used to show the effects of: 1) Expansionary Monetary policy (an increase in Ms). By moving the LM curve out to the right, expansionary monetary policy increases output and lowers interest rates. It increases output by encouraging investment.

2) Expansionary fiscal policy (an increase in G or decrease in T). By moving the IS curve to the right, expansionary fiscal policy increases output and raises interest rates (when the money supply is fixed).

The IS-LM model and Aggregate Demand Since the simple IS-LM model assumes prices are fixed, it is only limited in its approach. With a flexible price level, the two key equations become Md

P

= e(Y ) − f ( r )

doubles money demand I = d – e(r-π) rate ,r ,minus inflation, π)

Demand for money is in real terms. A doubling in the price level Investment determined by real interest rates (nominal interest

In this framework, overall demand falls as prices rise and so is consistent with a standard aggregate demand curve.

.. .

82

CHAPTER 10 Consumption & Investment

CASE STUDY: TAKING STOCK: THE ECONOMIC IMPACT OF INVENTORIES. Introduction Inventories are one of the more problematic areas of economic analysis. They are too small to be worth much attention in their own right, but their extreme volatility makes them one of the key drivers of business cycles. The other problem which they present is that their behavior does not fit most economic models.

Inventories and the economy.

US Business Inventories as a % of GDP 19 18 17 16 15 14 13 12 11 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Source:

EcoW in

As the chart above shows, inventories make up a small and shrinking share of GDP. Their steady decline is a testament to the success of ‘just in time’ stock control methods. At present, the value of stocks held by producers and retailers only amounts to some 12% of GDP. Given that we are comparing a stock of inventories (the value of all inventories in the economy), with the flow of GDP (how much the economy produces in a year) these numbers are tiny in economic terms.

However, anyone studying the business cycle in detail will be acutely interested in their behavior. Changes in stocks (stockbuilding) are one of the key drivers in the business cycle and the extreme volatility in inventory behavior means that this tiny part of the economy has a significant impact on overall GDP. As the chart below shows, taking changes in inventories out of GDP reduces its volatility substantially (in fact, about half of the recent volatility of GDP growth is due to inventories).

.. .

83

CHAPTER 10 Consumption & Investment

US GDP growth – with and without inventories 9 8 7 6 5 4 3 2 1 0 -1 -2 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 GDP Growth (%p.a.)

GDP Growth exc. inventories (%.p.a) Source: EcoWin

Understanding Inventories The standard model of inventory behavior is the production smoothing/buffer stock model.

This ostensibly sensible model suggests that inventories are held as a buffer against changes in demand. If marginal production costs are increasing and sales vary over time, then a firm would quite understandably wish to hold some inventories. Even if the changes in demand are forecastable, inventories can help smooth the production cycle; whilst if they are not easily forecastable, inventories are a buffer to satisfy surges in demand and a place to store production if demand slumps.

Like many plausible sounding economic theories however, the production smoothing/buffer stock model is completely destroyed by a few hard facts 1) Production is more variable than sales in most industries. So much for production smoothing!

2) Sales and inventory adjustment are normally positively correlated. (i.e. inventories tend to rise when sales rise), if inventories are a buffer they should fall when sales rise.

3) Inventories of finished goods are the smallest and least volatile element of total inventories (the other elements are inventories of unfinished goods and inventories of raw materials). If volatility of demand is the main reason for inventory adjustment, why do stocks of raw materials and unfinished goods vary so much?

Surely production requirements are more predictable.

The S,s model of inventory behavior To reconcile the three facts above, one needs to turn the production-smoothing/buffer stock model on its head. Whereas the production-smoothing model focused on increasing marginal cost, the S,s model is based on decreasing marginal cost. Take the example of ordering more raw materials for your plant. Is it cheaper to get a van to deliver once a day or a lorry to deliver once a month? The S,s model assumes the latter. If that is the case, then .. .

84

CHAPTER 10 Consumption & Investment

purchasing managers will wait until inventories have almost been exhausted (point s on the chart below) and then build up stocks until the inventory is re-maximized (S on the chart) The (S,s) Model of Inventory Behavior Inventory

S s

s

Time

This model can generate production that is more volatile than sales as well as a positive relationship between inventories and sales - provided that the surge in sales sends a firm to its lower trigger point. It can also explain the large stocks of unfinished goods and of raw materials. If the cost of delivering such goods falls and more are delivered at a time, then large inventories are just a way of exploiting reduced delivery costs.

Unfortunately, although the (S,s) model seems to fit the facts, it is a very difficult model to apply to the whole economy. For example, how firms will react to a surge in demand depends crucially on how close they are to a trigger point - something that macroeconomists cannot easily ascertain. As a result, aggregate behavior of inventories remains largely obscure – a troubling conclusion given that fluctuations in inventories account for about one half of business cycle fluctuations. Fortunately, since ‘just in time’ management techniques are reducing both the level and volatility of inventories, their impact on GDP is probably declining (see Background Material to Chapter 14) Source: Blinder and Maccini (1991) “Taking Stock: A Critical Assessment of Recent Research on Inventories” Journal of Economic Perspectives vol. 5.

Discussion Questions 1) Is the fact that production is more volatile than sales for most industries indicative of bad planning in those industries?

2) Do you think the S,s model is a fair description of how companies manage inventories?

.. .

85

CHAPTER 10 Consumption & Investment

Background Material CONSUMPTION AND GDP GROWTH IN THE US US Consumption and GDP Growth 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 GDP growth (% p.a.)

Consumption growth (% p.a.)

Source: EcoWin

As a supplement to Figures 12.3a and b, the chart above shows US GDP and consumption growth. It reveals the expected pattern. The two series move closely together but GDP is slightly more volatile than consumption (as predicted by the permanent income model). The importance of stable and rising consumption for the long 1990’s upswing is clear.

THE MULTIPLIER: A DIAGRAMMATIC APPROACH. For students who find the algebra of section 13.2 daunting, a simple exposition of how the multiplier works in practice may help. The diagram below shows the example of an increase in government spending of $100 dollars when the marginal propensity to consume is 0.8

.. .

86

CHAPTER 10 Consumption & Investment

The Multiplier Process (MPC = 0.8) CUMULATIVE GDP INCREASE

$100

$180

$244

$500

Government spends $100 on roadbuilding.

Road building contractors spend $80 save $20

Retailers spend $64 save $16

After all the rounds of spending are complete

$20

$36

$100

CUMULATIVE INCREASE IN SAVING

FINANCIAL LIBERALIZATION: THE UK EXPERIENCE. The table below outlines the UK experience of financial liberalization in the 1980’s. An important aspect of the UK case (and most other cases) was the interaction between liberalization and asset price inflation. In the UK case, liberalization of the housing market not only allowed individuals to overcome borrowing constraints by using their home as collateral, it also sparked a period of rapid house price inflation that encouraged an even more rapid growth of consumption.

The UK Consumer Boom Consumption growth

1970’ s

3.2%

1980 1981 1982

-0.1% -0.1% 1%

1983

4.2%

1984 1985

1.6% 3.5%

1986

5.4%

House Price Inflation (real terms in brackets)) (3.1%) 15.4 % 20.8 (4.6%) 4.8% (-6.4%) 1.3% (-7.4%)

Savings Ratio

(8.6%)

9.8%

(4.4%) (3.5%)

10.2% 9.5%

(9.7%)

8.2%

(12.6%)

5.7%

13.6 % 9.5% 8.7%

10.2%

1979 Exchange controls lifted

13.5% 12.6% 11.6%

‘corset’ removed

14.1 % 1987

5.6%

Liberalization Measures

Hire Purchase restrictions removed

Building society access money market Building society lending controls lifted

16.7 % .. .

87

CHAPTER 10 Consumption & Investment

1988 1989

6.7% 3.5%

25.6 19.4

(20.8%) (13.8%)

4.2% 5.1%

The key to the UK consumer boom was the liberalization of the housing market, although the end of hire-purchase restriction (lending for purchase of consumer durables) added to the effect. The liberalization started with the removal of the ‘corset’ on bank lending which allowed banks to enter the mortgage market aggressively (the mortgage market was formerly dominated by building societies – a UK form of thrifts). By 1982, banks were providing over one-third of new mortgage lending. To balance the scales, a number of restrictions on building societies were lifted. First, they were allowed access to money markets effectively increasing the pool of funds available for lending. More importantly, in 1986, a number of further restrictions were lifted which had the effect of allowing them to make general loans using housing as collateral. This measure permitted individuals to access the wealth tied up in the value of their homes and was the key to the subsequent collapse in the savings ratio.

The boom was rapid but short-lived. By late 1990, the UK was entering a recession.

Source: Muellbauer and Murphy (1990) “Is the UK balance of payments sustainable?”

Economic Policy No.11 US CONSUMPTION AND WORLD WAR III An alternative approach to the life cycle hypothesis is to see how life expectancy influences consumption. If life expectancy shortens and intergenerational transfers are ruled out, saving should fall. The chart below shows an estimate of this effect as the US savings ratio shows some relationship to the threat of nuclear war. A survey of the risk of war (“minutes to midnight”) was regularly published in the Bulletin of Atomic Scientists.

.. .

88

CHAPTER 10 Consumption & Investment

Fear of Nuclear War and US savings 14

Minutes to Midnight (LHS) Saving Rate (RHS)

12 10

14 13 12 11

8

10

6

9 8

4

7 2

6

0

1990

1986

1988

1982

1984

1980

1976

1978

1974

1970

1972

1966

1968

1964

1960

1962

1956

1958

1954

1950

1952

1948

5

Source: Slemrod(1986) “Savings and the fear of nuclear war” Journal of Conflict Resolution Vol. 30 PROFITS AND INVESTMENT The importance of internal resources for investment is highlighted in the chart below. There is a strong (though by no means perfect) correlation between the growth in profits and the growth in investment. If anything, profits are a leading indicator of investment.

USA company profits and investment 40 35 30 25 20 15 10 5 0 -5 -10 -15 90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

Growth of Non-Residential Investment (% p.a) Growth in Real Corporate post-tax profits (% p.a.)

Source: EcoWin

HURDLE RATES AND PLANNING HORIZONS FOR US FIRMS In 1990, Fortune magazine asked 1000 CEOs about their hurdle rates (minimum expected profitability) and planning horizons for investment. The results identified an average real hurdle rate of 12.2% - well above the likely cost of borrowing. It also found that about 21% of .. .

89

CHAPTER 10 Consumption & Investment

R&D expenditure was allocated to projects with no expected payoff in the next five years.

This was a smaller proportion than both their European and Asian competitors.

Survey of US CEO’s attitudes to investment Survey question Fraction of R&D in long term projects Importance of hurdle rates in capital budgeting (on a scale 0=unimportant, 2= very important) Real hurdle Rate Time Horizon relative to own of: US Competitors (on a scale 5=longer, 1=shorter) European Competitors(on a scale 5=longer, 1=shorter) Asian Competitors (on a scale 1=longer, 1=shorter)

.. .

Resul t 21.1 % 1.6 12.2 % 2.5 3.2 3.8

90

CHAPTER 10 Consumption & Investment

Investment Horizons

Hurdle Rates 50% Share of Firms .

Share of Firms .

50% 40% 30% 20%

40% 30% 20% 10%

10%

0%

0% 0-10%

10-30%

30-50%

50-70%

70%+

0-5%

5-10%

% of budget devoted to long-term projects

10-15% 15-20% 20-25% 25-30% 30-35%

Real Hurdle Rate

Source: Poterba and Summers (1995) “A CEO Survey of US Companies Time Horizons and Hurdle Rates” Sloan Management Review vol 37.

Additional Questions UK GDP and Consumer spending growth 10.0

7.5

Percent

5.0

2.5

0.0

-2.5

-5.0 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 GDP Growth

Consumption growth

Source: EcoWin

Question 1) The chart above shows how UK consumer spending grew significantly faster than GDP over the late 1990’s (even more so than in the late 1980’s) what does this imply about a) UK net savings b) future UK consumption.

Question 2) what is the most likely cause of the UK’s rapid rise in consumption?

Answer 1) a) the saving ratio fell dramatically partly through falling saving and partly through rising debt (see chart) b) Presumably, UK consumer spending may have to slow down below .. .

91

CHAPTER 10 Consumption & Investment

GDP growth some time in the future in order to return the saving ratio back to its historical average.

UK Household saving ratio 13 12 11

PERCENT

10 9 8 7 6 5 4 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Source: EcoWin

Answer 2) Wealth effects – particularly housing wealth Question 3) What is the difference between FDI and buying shares in a foreign firm?

Answer 1) FDI is defined as a cross-border investment in which a resident in one economy (the direct investor) acquires a lasting interest in an enterprise in another economy (the direct investment enterprise). The lasting interest implies a long-term relationship between the direct investor and the direct investment enterprise and usually gives the direct investor an effective voice, or the potential for an effective voice, in the management of the direct investment enterprise. By convention, a direct investment is established when the direct investor has acquired 10 percent or more of the ordinary shares or voting power of an enterprise abroad.

.. .

92

CHAPTER 11 Business Cycles

CHAPTER 11: BUSINESS CYCLES INTRODUCTION This chapter moves on from analyzing the individual elements of demand to looking at business cycles as aggregate phenomena. Although the chapter is looking at broad themes, the Case Study below on US economic indicators can be used to analyze the current state of the business cycle in the US. The main aim of the chapter is to characterize business cycles - focusing on what causes them and their welfare implications.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter has a clear logical structure (from ‘what do business cycles look like’ to ‘how can we explain them’) which is worth following. An alternative approach would be to start with the question “Is the business cycle dead?” and to draw on both historical evidence and theory to arrive at a negative conclusion – even though cycles may be becoming less pronounced for developed countries.

CHAPTER GUIDE 11.1 What is a Business Cycle? The calculation of output gaps ranges from the simplistic (fitting a time trend through GDP and naming the difference between trend and actual the ‘output gap’), to the detailed (based on an estimated production function). Output gaps published by the OECD in their Economic Outlook are based on the production function approach. This entails evaluating potential labor and capital supply and TFP. 11.2

Measuring the Business Cycle. Although the performance of the Japanese economy over the last decade is sometimes called a depression, output has actually risen on average by just over 1% p.a. since 1992 Another term often heard alongside recession is ‘stagflation’. Stagflation is usually defined as a period of low or negative growth and high or rising inflation (stagnant output and rising inflation).

11.3

Characterizing Business Cycles. Higher GDP volatility in developing countries is largely related to their less diversified economies. As a result, they are subject to extreme sectoral shocks (e.g. poor harvests or rapid changes in their terms of trade). The Background Material looks at GDP and terms of trade volatility for the major groupings in the world economy.

11.4

Business Cycles as Aggregate Fluctuations. The link between inflation, unemployment and the business cycle will be dealt with in detail in Chapter 16’s discussion of the Phillips Curve.

.. .

92

CHAPTER 11 Business Cycles

11.5

Have Business Cycles Changed? The lengthening of expansions is evinced by the fact that the US upswing which began in March 1991 and persisted into 2001 is the longest on record. The previous longest expansion was 106 months between February 1961 and December 1969.

Although the evidence of a reduction in business cycle volatility from the pre-1950’s period is open to question, the evidence for a fall in business cycle volatility in the 1980s and ‘90s as compared with the 1960s to ‘80s is stronger (see Background Material).

11.6

Are Business Cycles Bad? As well as the negative impact of volatility, many argue that hysteresis effects are important. A deep recession will cause firms to scrap capital that would be productive during an upturn simply because no one will buy it. Similarly, a deep recession will create long term unemployment that erodes human capital (see Chapter 8).

11.7

The Frisch-Slutsky Paradigm. A demonstration of thick market effects is shown in the Background Material where a clear cyclical pattern can be seen in US new home sales.

11.8

Aggregate Demand and Aggregate Supply. US survey results on price stickiness are also contained in the Background Material.

11.9

So What Causes Business Cycles? As shown in the Background Material, developing countries tend to be more prone to terms of trade shocks (as well as poor harvests etc.).

These are aggregate supply shocks.

.. .

93

CHAPTER 11 Business Cycles

CASE STUDY: MONITORING THE BUSINESS CYCLE. A Guide to US Economic Indicators Importanc e

Frequency

Available

Volatility

Comments

Initial Unemployment Claims



Weekly

Every Thursday for the week ending previous Saturday

Moderate

Car/Truck Sales



Monthly

1-3 business days after end of month

Moderate

National Association of Purchasing Management (NAPM) survey Payroll employment (non-farm payrolls)



Monthly

First business day of the month

Moderate



Monthly

First Friday of the month

Moderate

Producer Index (PPI)



Monthly

9th-16th of the month

Moderate

Retail Sales



Monthly

11-14th of the month

High

Industrial Production



Monthly

14th-17th of the month

Low

Consumer Sentiment (University of Michigan) Housing Starts/ Building Permits



Monthly

Preliminary 13-20th Final: two weeks later

Moderate



Monthly

16th-20th of the month

Moderate

Consumer Index (CPI)

Price



Monthly

15th-21st of the month

Moderate

Durable Orders

Good



Monthly

22nd-28th of the month

High

Personal Income and Consumption Expenditures Index of Leading Indicators



Monthly

22nd-31st of the month

Moderate

The first hint we receive about the economy for any given month. A leading indicator that helps predict payroll employment Another early indicator. This sector is quite sensitive to the business cycle A survey of manufacturing optimism.

Supposedly forward-looking but can give bad signals First complete picture of the economy. Includes total (non-farm) employment, earnings and unemployment.

First inflation indicator of the month, can be a leading indicator of CPI inflation Key indicator of consumer spending, but can be subject to large revisions Complete picture of manufacturing, but is predictable using other indicators One of three consumer sentiment measures. Can be a leading indicator of consumer spending Key indicator of a highly cyclical sector. Can be volatile in winter months Most important inflation measure. Core CPI strips out more volatile elements Potential leading indicator of the manufacturing sector but volatile and subject to revision First complete sighting of consumer spending



Monthly

Last Business day of the month

Low

New Home Sales



Monthly

Moderate

Construction Spending



Monthly

28th- 4th of following month 1st business day of the month for two months

.. .

Price

High

A compilation of other indicator that are supposed to be leading indicators of the business cycle Similar in role to housing starts 20% of GDP but revisions can be enormous

94

CHAPTER 11 Business Cycles

Merchandise Trade



Monthly

GDP



Quarterly

prior 9th-16th of the month Advance Estimate: 21st30th of month Preliminary estimate second month Revised Estimate: third month

Moderate Moderate

Trade increasingly important part of GDP The ‘bottom line’ that all other indicators are helping us predict.

Source: Slifer and Carnes (1995) “By the Numbers” Published by International Financial Press Discussion Questions 1) Look at the recent indicators for the US, what do they imply about the current state of the US business cycle?

2) Look at financial markets reaction to a recent big indicator (e.g. payrolls).Does the reaction make sense?

Background Material Have a look at the OECD’s Business Cycle Clock to see a visualization of business cycles and economic indicators http://stats.oecd.org/mei/bcc/default.html Additional Questions Question 1) Do you think output volatility is greater in developed or developing countries?

What reason might there be for any differences?

Answer 1) The chart below shows how output volatility is over twice as high in developing countries. Terms of trade volatility is a major cause of that difference. The Terms of trade are the ratio of export prices to import prices and are far more volatile for developing countries whose exports are usually dominated by a few commodities. Some studies suggest that about half of GDP volatility is due to terms of trade movements.

.. .

95

CHAPTER 11 Business Cycles

GDP growth Volatility and Terms of Trade Volatility (Standard Deviations in %, un-weighted country averages) 14% 12%

GDP Terms of Trade

10% 8% 6% 4% 2% 0% High Income

Low- and East Asia South Asia Middle Latin Middle and Pacific East and America Income North and Africa Caribbean

SubSaharan Africa

Source: World Bank Question 3) Think about the pricing behavior of US Firms. How often do they change prices?

How quickly do prices respond to changes in market conditions ( such as higher demand or rising costs). What factors do you think might explain any price stickiness?

Answer 3) The following tables show the results of a US survey of price setting. As well as the frequency of price reviews, respondents were asked to rank the determinants of price stickiness.

.. .

96

CHAPTER 11 Business Cycles

Survey of Prices and Costs of 200 US Firms Pricing Policy Median Number of price changes a year Mean Lag (months) before adjusting price to: Demand Increase Demand Decrease Cost Increase Cost Decrease Percent of firms which Report annual price reviews Have non-trivial costs of adjusting prices Costs Percent of firms that can estimate costs at least moderately well Mean percentage of costs which are fixed Percentage of firms for which marginal costs are Increasing Constant Decreasing

.. .

1.4 2.9 2.9 2.8 3.3 45% 43% 87% 44% 11% 48% 41%

97

CHAPTER 11 Business Cycles

Reasons for Price Stickiness (1=totally unimportant, 4=very important) 12 Theories of price stickiness Coordination Failure: Firms hold back on price changes waiting for other firms to go first Cost-based Pricing: Price rises delayed until costs rise, delays cumulate through production process Nonprice competition: firms vary nonprice elements such as delivery lags, service or quality Implicit Contracts: Firms tacitly agree to stabilize prices Nominal Contracts: Prices are fixed by contract Costly Price Adjustment: Firms incur costs in changing prices Procyclical Elasticity: Demand curves become less elastic as they move in (loyal customers remain) Pricing Points: Certain prices (like $9.99) have a psychological significance Constant Marginal Cost: Marginal cost is flat, markups are constant Inventories: Firms vary inventory rather than price Hierarchy: Internal bureaucracy slows down decisions Judging Quality by Price: Firms fear that price cuts will be seen as a reduction in quality

Mean Score 2.77 2.66 2.58 2.40 2.11 1.89 1.85 1.76 1.57 1.56 1.41 1.33

Source: Blinder, Canetti, Lebow and Rudd (1998) “Asking About Prices” Russell Sage Foundation, New York

.. .

98

CHAPTER 12

Money and Prices

CHAPTER 12: MONEY AND PRICES INTRODUCTION This chapter is a natural introduction to Chapter 13 (Monetary Policy) and in a shorter course can be combined with it. The key difference between the two is that this chapter looks at long run issues and highlights the classical dichotomy between the real and nominal economy.

Chapter 13 looks at short run, business cycle issues where the dichotomy does not hold.

Although much of the material is theoretical and technical, this is a relatively easy chapter to communicate and discussions of the costs of inflation and hyperinflation usually work well.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Opening the lecture with a discussion of hyperinflation should generate interest and lead on naturally to the quantity theory and inflation tax. This is a particularly good route for a shorter course where the history, measurement and costs of inflation have been dropped or compressed.

CHAPTER GUIDE 12.1 Rising Prices. As with most chapters, the opening section is designed mainly to set the scene and encourage discussion. The historical episodes will help in explaining the theoretical issues discussed later on. For example, the long history of prices in Figures 1 to 3 gives some useful background on the gold standard (see Case Study on the Wizard of Oz.). More recent history can be used to introduce the distinction between supply and demand shocks.

12.2

Measuring Inflation. The distinction between CPI and the GDP deflator is key here as it links back into Chapter 2.

See Background Material for more on mis-measurement.

12.3

The Costs of Inflation and the Dangers of Deflation. There is, of course, a huge and largely inconclusive literature on the costs of inflation but the idea that they are small but significant is a useful one to leave with students whilst the Barro study gives some useful concrete numbers.

12.4

The Nature of Money. Money is legal tender since a law has been passed saying that a creditor cannot refuse payment in the form of cash though he can legally refuse payment in bricks – or anything else that is not legal tender.

12.5

The Money Supply. A discussion of Divisia Money helps illustrate two principal themes of this section - the concept of liquidity and the arbitrary nature of broad money definitions. In it simplest form, Divisia money is a weighted measure of broad money

.. .

70

CHAPTER 12

Money and Prices

where relative rates of return are used as weights. The idea is that forms of money that offer low rates of return must offer high liquidity or people would not hold them. For example, notes and coins get the highest weight in a Divisia index since they offer no interest. Whilst theoretically superior to conventional broad money measures, Divisia money has not proved popular (Data and further information on Divisia for the US is available on the Federal Reserve Bank of St Louis Web Site, www.stls.frb.org).

12.6

How Banks Make Money - The Money Multiplier. As well as the technicalities of the money multiplier, the main distinction to be brought out in this section is between reserve money and broad money since these concepts are used in later sections and chapters.

The chart of the Japanese money multiplier (see Background Material) can be used to illustrate that the multiplier is not fixed and to bring in current issues such as the poor performance of the Japanese banking sector.

12.7

Seigniorage and the Inflation Tax. Background Material below.

12.8

Hyperinflation. A simple Seigniorage Laffer Curve is shown in the Background Material.

Dollarization is a good example of how the Laffer curve works in practice. The curve also shows why hyperinflations tend to be relatively short-lived since revenue quickly dries up.

Germany’s notorious post-WW1 hyperinflation only lasted 26 months, but the average monthly inflation rate of 322% meant that the price level was 10,200,000,000 times higher by the end. It was ended by the introduction of the Retenmark = 10 12 old marks and a new Central Bank.

12.9

Monetarism and the Quantity Theory of Money. This is one of the key topics of the chapter. It recurs in Chapter 17 and it worthy of emphasis. Consider highlighting the triviality of the Fisher Identity by replacing M with something else (e.g. number of MBAs) and showing that the definition of V means that the identity always holds. This example exposes the importance of causation in economics.

It is very easy to stray into money targeting in this section. Decide early therefore how you want to link this chapter with Chapter 13.

Further data on seigniorage is shown in the

TABLE & CHART TIPS Figure 12.2. The volatility of prices pre-1930 (Figure 12.2) seems to contradict Figure 12.9 (low inflation related to low volatility). The reason, of course, is that the monetary regime – the gold standard – resulted in price fluctuations related to changes in the supply of gold.

Table 12.7. It may be worth discussing the high inflation/hyperinflations that occurred after the breakup of the Soviet Union (1993-4). This was partly due to the ruble zone system in which each country had the right to print its own currency and use rubles for trade. Thus, a free rider .. .

71

CHAPTER 12

Money and Prices

problem was created as Gresham’s Law suggests. Rapid printing of local currencies caused rubles to migrate to other countries and contribute to inflation there.

CASE STUDY:THE WIZARD OF OZ AND THE QUANTITY THEORY OF MONEY Although the subject of some controversy, many economic historians believe that the Wizard of Oz is an allegory on the bimetallist debate that occurred in the US at the end of the 19 th century.

Historical Background In the early 1890’s, the supply of gold began to dry up. As a result, the US money supply began to shrink and prices to fall. At the same time, unemployment began to rise (Chapter 16 discusses the short term relationship between inflation and output). See table below.

.. .

72

CHAPTER 12

The US Economy 1890-1900 Year Price Money Level Stock (1869=10 ($ bill.)

0) 1890 70 1891 69 1892 66 1893 68 1894 64 1895 63 1896 61 1897 61 1898 63 1899 65 1900 68 Source: Rockoff (1990)

3.92 4.08 4.43 4.26 4.28 4.43 4.35 4.64 5.26 6.09 6.60

Reserve money ($ bill.)

1.39 1.461 1.533 1.561 1.582 1.499 1.451 1.554 1.682 1.812 1.954

Real Income ($ bill, 1869 prices) 16.82 17.506 19.117 18.373 17.259 19.248 18.758 20.563 20.924 23.353 24.121

Unemploy ment % of labour force 4.0 5.4 3.0 11.7 18.4 13.7 14.4 14.5 12.4 6.5 5.0

Money and Prices

Ratio gold silver price

of to

19.8 20.9 23.6 26.4 32.8 31.7 30.8 34.6 35.5 39.6 38.6

As a result, a populist movement - led by the democratic presidential candidate William Jennings Bryan - advocated the return to a bimetallic standard (silver dollars had been abolished in 1873) at the ratio of 16 to 1. This meant that the currency could be backed by either gold or silver and that the official rate of exchange between the two would be 16oz. of silver for 1oz. of gold. Since the prevailing market price of gold and silver suggested a conversion rate closer to 30, this would have resulted in a huge inflow of silver into the US (as people traded in their silver for a more valuable amount of gold) thus boosting the US money supply.

The tendency for the cheaper silver to drive out gold is an example of Gresham’s Law – bad money drives out good. The law dates back to Henry VIII’s debasement of the currency (he ordered lead to be inserted into gold coins and the gold so recovered given to him).

Consequently, pure gold coins ceased circulating (and were hoarded) and only debased coins were used as money.

Gresham’s Law meant that critics of bimetallism argued that a true bimetallic standard was almost impossible. If gold was more valuable than the official conversion rate implied, only silver currency would circulate. If silver were more valuable, only gold would circulate. Only if the bullion price and the conversion rate were identical could both circulate together.

Proponents countered by saying that the US was large enough to influence the conversion rate (i.e.purchases of silver for US circulation would drive up the price and so validate the conversion rate).

.. .

73

CHAPTER 12

Money and Prices

As it turned out, William Jennings Bryan lost the election and the bimetallic standard was not introduced. However, the supply of gold began to increase independently and so ended the deflation.

What about the Wizard of Oz? The Wizard of Oz is full of gold and silver images (the yellow brick road, Dorothy’s silver slippers – changed to ruby in the film version in order show off the wonders of Technicolor). Economic historians have done an impressive job of interpreting the cast of characters Dramatis Personae Dorothy – America Toto – The Prohibition Party (teetotalers) supporters of the bimetallist cause The Cowardly Lion – William Jennings Bryan (A great orator but cowardly because he dropped the bimetallist cause after the election).

The Scarecrow – The Western Farmer The Tin Man – The Urban Worker The Wicked Witch of the West – President McKinley The Wicked Witch of the East – Grover Cleveland (pro-gold democrat defeated by Bryan in the 1896 convention) The Good Witches of the North and South – New England and Southern support for the bimetallists The Wizard of Oz – Marcus Hanna, a key adviser to McKinley The Munchkins – Citizens of the East Plot Summary After acquiring the silver slippers from the dead wicked witch of the east, Dorothy sets off to the Emerald City (Washington DC) down the yellow brick road. After meeting her new companions (The Cowardly Lion, Scarecrow and Tin Man), they face various challenges that prove their worth - including the mysterious poppy field in which the Cowardly Lion falls asleep - (Bryan was easily distracted onto the issue of anti-imperialism – represented by the opium poppies). After arriving at the Emerald City, the Wizard of Oz enlists them to confront the Wicked Witch of the West but they are captured.

The Wicked Witch of the West steals one of the silver slippers from Dorothy (McKinley did not rule out a bimetallic standard completely but argued that it must occur through an international agreement – an agreement that was very unlikely). Dorothy then pours a bucket of water over her which kills the witch (water to cure the drought facing western farmers or, arguably, a symbol for inflation).

After discovering that the wizard cannot help her, Dorothy meets the Good Witch of the South who tells her she need only click the heels of her silver slippers together three times in order to get home. .. .

74

CHAPTER 12

Money and Prices

Source: Rockoff (1990) “The Wizard of Oz as a monetary allegory” Journal of Political Economy Vol. 98, no. 4, pp 739-760 Discussion Questions 1) Do you agree that Bryan’s bimetallist proposal would have been a good policy for the US? 2) If you had to recast the wizard of Oz today. Who would be the Wizard (Alan Greenspan?) and other characters?

Background Material INFLATION MIS-MEASUREMENT: CROSS COUNTRY EVIDENCE Inflation mis-measurement in major economies Country Overstatement of Inflation (% p.a.)

Point Estimate Range USA 1.1% 0.8%-1.6% Germany 0.75% 0.5%-1.5% Japan 0.9% 0.35%-2% UK 0.35%-0.8% Canada 0.5% Sources: - [Boskin Commission] (1996), Hoffmann (1998) Bundesbank Discussion Paper, Shiratsuka (1999) Bank of Japan Monetary and Economic Studies, Cunningham (1996) Bank of England Working Paper No. 47, Crawford (1998) Bank of Canada Spring Review THE BOSKIN COMMISSION IN THE US The US Senate Advisory Commission to study the consumer price index (The Boskin Commission) found that US inflation was probably overstated by 1.1%. One recommendation suggested was that social security which had been indexed to inflation should move to a CPI minus 1.1% formula. It was calculated that such a move would reduce the federal deficit by almost $1.7 billion by 2008 (with increasingly large reductions from then on). The AARP (American Association of Retired People) quickly hit back noting that this formula would make the average 65 year old retired couple almost $40,000 worse off over their lifetime.

Furthermore, the average individual, 10 years from retirement, would need to save an extra $214 a month to make up the shortfall.

In the end, the CPI minus 1.1% idea was dropped, but changes to the calculation of CPI since the Boskin Commission have knocked about 0.5% p.a. off measured CPI.

.. .

75

CHAPTER 12

Money and Prices

FURTHER DATA ON SEIGNIORAGE Average Annual Rates of Seigniorage (1971-1990) Country Seigniorage Seigniorage Country Seigniorage Seigniorage % of GDP % Gov. % of GDP % Gov. Spending Spending USA 0.43 1.96 Philippines 1.23 8.96 Canada 0.44 2.01 El Salvador 1.53 10.89 UK 0.47 1.28 Nigeria 1.57 11.12 France 0.55 1.39 India 1.72 11.82 Switzerland 0.62 6.74 Ecuador 2.17 15.81 Cameroon 0.64 3.38 Greece 3.13 10.51 S. Africa 0.65 2.53 Ghana 3.31 22.01 Germany 0.69 2.35 Turkey 3.58 15.20 Burundi 0.85 6.12 Bolivia 3.81 19.76 Japan 0.96 5.62 Peru 4.99 28.23 Thailand 1.09 6.30 Argentina 9.73 62.00 Source: Click (1990) "Seigniorage in a Cross-section of Countries" Journal of Money Credit and Banking: 30(2) pp 154-71 Additional Questions Question 1) Look at the chart below, describe what this implies about the Japanese Banking system in recent years?

Japanese Money Multiplier 14 13 12 11 10 9 8 7 6 68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

Source: EcoWin

Note: M2+CD’s divided by monetary base. Data not seasonally adjusted

.. .

76

CHAPTER 12

Money and Prices

Answer 1) The chart below shows the money multiplier for Japan – broad money as a multiple of base money. Two features stand out. First, the multiplier is very seasonal with cash demand surging around holiday periods. Second, the multiplier has been drifting down over the 1990s due to the problems of the banking system and 0% interest rates. This encourages people to hold more cash themselves thus leaving less of the total stock of cash in the banking system, and also means that banks are happy to hold considerable amounts of cash in their vaults.

Question 2) look at the charts of Indonesian money supply growth and inflation and Bulgarian money supply growth and inflation. What do they tell you about the relationship between the money and inflation?

Indonesia: Money and Inflation 70 60

Percent

50 40 30 20 10 0 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 MONEY GROWTH

INFLATION

Source: EcoWin

.. .

77

CHAPTER 12

Money and Prices

Bulgarian Money and Inflation 1200 1100 1000 900

Percent

800 700 600 500 400 300 200 100 0 90 91

92

93

inflation

94

95

96

97

98

99

00

01

02

03 04

M0 growth

Source: EcoWin

Answer 2) The Indonesian chart shows how the relationship between money growth and inflation is not always that reliable at low rates of inflation, though it shows up strongly at higher rates of inflation. The Bulgarian Chart reinforces the second point – it is not possible to have very high inflation without high money growth as well.

Question 3 )a) the official definition of hyperinflation is inflation of 50% or above at a monthly rate (i.e. prices rising by at least 50% a month). What is that at an annual rate? b) One of the highest monthly rates of inflation recorded was 30,000% in the German hyperinflation. What annual rate of inflation would that translate to?

Answer 3) Monthly Rate 1% 5% 10% 50% 100% 1000% 10,000% 30,000%

.. .

Equivalent Annual rate 12.7% 79.6% 213.8% 12,874.6% 409,500% 313,842,837,672,000% 112,682,503,013,000,000,000,000,000% 55,309,272,631,100,000,000,000,000,000,000%

78

C H A P T E R 1 3 Monetary Policy

CHAPTER 13: MONETARY POLICY INTRODUCTION Deriving directly from Chapter 12 and leading to 15, this is a ‘payoff’ chapter which draws from (and reinforces) material from other chapters. As a result, the key to teaching this chapter is to make it relevant to students. The material in this section is as up-to-date as possible, but it makes sense to supplement it with current topics in your country.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As little of the material in this chapter is directly required to let students understand later chapters, almost any element can be by-passed though the transmission mechanism and Taylor Rules are probably the easiest to leave out. Combining intermediate targets with the section on credibility in Chapter 16 and final targets and the operation of monetary policy into Chapter 11 would make sense for a shorter course.

Opening the lecture with the operation of monetary policy and final targets and then moving to intermediate targets, Taylor rules and the transmission mechanism is a logical route that would lead naturally to a discussion of current issues at the end of the lecture.

CHAPTER GUIDE 13.1 The Influence of Central Banks. Although this chapter is all about Central Banks, the reasons for the increased number and independence of Central Banks is covered in Chapters 12 and 15 respectively. The increased number comes largely from the end of commodity-based currencies (the gold standard) and independence stems from the value of credibility in eradicating inflationary bias.

13.2

Monetary Policy and the LM Curve. See case study to chapter 12 for a complete discussion of IS-LM analysis

13.3

What Does Monetary Policy Target? The debate over the appropriate target rate of inflation is still an active one. The Background Material below summarizes a strong argument for positive inflation by Akerlof, Dickens and Perry (1996).

13.4

What Intermediate Targets Should Central Banks use? The increased use of intermediate targets reinforces the popularity of rules over discretion discussed in Chapter 16. Some more detail on intermediate targets for the main economies is given in the Background Material

13.5

Money Supply Targeting. The Case Study “Mrs. Thatcher’s Monetarist Experiment” can be used to bring out most of the arguments in this section.

.. .

96

C H A P T E R 1 3 Monetary Policy

13.6

Exchange Rate Targets. This section – though important – is difficult to teach in much detail until Chapters 18 and 19 have been covered. But currency boards are very interesting special cases of money supply targeting. Of course, a further discussion of currency boards later on can be used to help reinforce students’ understanding.

13.7

Inflation Targeting. Given the huge popularity of inflation targets (Norway, Iceland and South Africa are some of the other inflation targeters), it is worth adding a note a caution here with regard to aggregate supply shocks. The argument is simply that a central bank that raises interest rates in a boom and cuts them in recessions has an easy job, but in the face of an aggregate supply shock, they may have to raise interest rates in a recession – something that might dent the popularity of inflation targeting regimes.

Certainly, the set-up of the first inflation targeting regime (New Zealand) recognizes this and has a number of get-out clauses covering aggregate supply shocks (see Background Material).

13.8

The Operational Instruments of Monetary Policy. Details on the US, UK and Euro monetary operating procedures can be found in the Background Material.

13.9

Controlling the Money Supply or Interest Rates? This section does not make an explicit distinction between money base control and broad money targeting. Money base control (where the Central Bank supplies a pre-set amount of liquidity into the money market and then lets interest rates move) as formerly practiced in Switzerland and as effectively practiced by many currency boards, is a system in which the Central Bank gives up control of interest rates in return for control of the money supply. Broad money targeting is a little less transparent as Central Banks with broad money targets will tend to control interest rates in the short term but move them in order to hit the longer-term money target. You should judge whether the distinction between these two types of money targeting is one which your students will find useful.

13.10 The Transmission Mechanism. The Background Material on Japan and the liquidity trap can be a useful way of applying some of the ideas in this section to a current economic situation.

13.11 Monetary Policy in Practice. Taylor rules make a good starting point for a discussion of monetary policy in the run up to the crisis. They suggest rates were too low – is this right? If so to what extent was monetary policy responsible for the crisis?

13.12 Quantitative Easing. Clearly, the assessment of QE is still an ongoing research topic with a burgeoning literature on both theoretical and empirical aspects TABLE & CHART TIPS Figure 13.10. Not only is the trend away from no explicit target interesting, but also the extent to which exchange rate targets remain as popular as ever despite the ERM and Asian crises. .. .

97

C H A P T E R 1 3 Monetary Policy

Figure 13.12 UK Broad money velocity is discussed in the Case Study. Of interest also is the fact that M0 velocity has started falling (i.e. more cash held per head) for the first time in recorded history. The Bank of England likes to argue that this change is due to low and stable inflation that has reduced the opportunity cost of holding cash.

CASE STUDY: MRS THATCHER’S MONETARIST EXPERIMENT In 1979 the conservative government of Margaret Thatcher was elected in the UK with a commitment to reduce inflation then running at nearly 15%. The centerpiece of this antiinflation policy was the Medium Term Financial Strategy (MTFS) which set rigorous targets for the growth of £M3 (UK broad money). The government was fully convinced of the value of credibility and so stated their pre-commitment to these money supply targets in no uncertain terms. “[There can be] no question of departing from the money supply policy, which is essential to the success of any anti-inflationary strategy” they stated in their first budget. The policy soon acquired the acronym TINA (there is no alternative).

It didn’t take long to realize that the policy was running into some serious technical problems.

The first was a direct consequence of one of the government’s other aims – deregulation of the banking system. Having abolished exchange controls in 1979 (i.e. ending limits on foreign exchange transactions), they moved on to abolish the ’corset’ - a set of quantitative limits on bank lending. Unsurprisingly, once the ‘corset’ had been removed, monetary expansion was dramatic. £M3 jumped 5% in one month alone sending it way out of the target range (see table). What was worse, the sudden surge in money supply growth was not just a one-year wonder but continued. As a result M3 seriously overshot its target for the first two years of the MTFS – not quite the demonstration of credibility the government had hoped for.

In 1982, the government adopted a dual strategy to retrieve the situation. First, despite falling inflation (and a crippling recession), they chose to raise the target range for money growth – recognizing that the trend in velocity had changed (see chart). Secondly, they implemented a policy of overfunding. This arcane practice involved selling more government debt to the private sector than was required to fund government spending. The extra funds were then used to reduce government borrowing direct from the banking system and so reduce the banks’ requirement to raise deposits. In effect, despite rapidly growing bank lending to the private sector (almost 20% p.a. between 1980-4), the cut-back in bank lending to the government meant that total money supply was kept under control (averaging about 12% p.a. between 1980-84).

By 1985, the government had overfunded so much that the banking system was beginning to come under strain. As banks had no more government debt to give up, the Bank of England actually acquired £18bn of private sector assets instead – the so-called ‘bill mountain’. In addition to the problem of the bill mountain, the government now realized that the velocity of circulation of £M3 was too unpredictable to be useful. Added to these problems, the fact that unemployment had more than doubled in the early years of the MTFS was a pretty clear indication that the hoped-for credibility benefits had not materialized. Unsurprisingly in 1985, .. .

98

C H A P T E R 1 3 Monetary Policy

the UK government effectively abandoned monetary targeting. It did not employ a rules-based monetary policy again until 1990 when the UK joined the European Exchange Rate Mechanism (ERM).

The UK economy 1978 - 1985 Year £M3 target £ M3 GDP range outurn growth 197 3.40 8 197 2.75 9 198 7-11 18.5 -2.15 0 198 6-10 13 -1.25 1 198 8-12 11.5 1.80 2 198 7-11 10 3.75 3 198 6-10 12 2.45 4 198 5-9 15 3.78 5

Unemploy ment 5.90

Inflatio n 8.42

5.32

13.75

6.99

17.69

10.56

11.90

12.28

8.24

12.13

4.67

11.51

4.93

11.73

6.04

3.6 3.2 2.8 2.4

74 q1 75 q1 76 q1 77 q1 78 q1 79 q1 80 q1 81 q1 82 q1 83 q1 84 q1 85 q1

2

UK £M3 Velocity of Circulation Discussion Questions 1) Should the Thatcher government have postponed financial liberalization until the monetary targeting regime had been properly established?

2) Since the Thatcher government earned a reputation for being tough on all economic and social issues, did the monetarist experiment benefit the UK in the longer term?

.. .

99

C H A P T E R 1 3 Monetary Policy

Background Material NEW ZEALAND’S CENTRAL BANK CONTRACT. New Zealand’s Central Banks (the RBNZ) has one of the clearest formulations of an inflation target. It is also unusual in having some ‘get-out’ clauses for aggregate supply shocks such as livestock disease outbreaks.

Below is a summary of the RBNZ’s 1990 Policy targets agreement Target Inflation target of 0% to 2% inflation on the All Items CPI by year ending December 1992.

Variations to targets 1. If CPI inflation diverges by more than ½% from the RBNZ own core CPI measures, the target may be re-negotiated.

2. Any increase/decrease in GST (sales tax) expected to impact inflation may cause the target to be re-negotiated.

3. A significant change in the terms of trade arising from an increase or decrease in either export prices or import prices may trigger a re-negotiation.

4. A crisis situation - such as a natural disaster or a major disease-induced fall in livestock numbers - may trigger a re-negotiation.

ORGANISATION AND OPERATING PROCEDURES FOR THE MAIN CENTRAL BANKS. THE US FEDERAL RESERVE Final Objective of Monetary Policy: “High employment consistent with stable prices” (Humphrey Hawkins Act) Intermediate Target: None that are operationally important.

Organizational Structure. The Federal Reserve System consists of 7 members of the Board of Governors in Washington D.C. and 12 Federal Reserve District Banks. Interest rate decisions are made at the Federal Open Market Committee (FOMC) which meets eight times a year and consists of 12 members (The 7 members of the board of governors, the president of the Federal Reserve Bank of New York and 4 other Reserve Bank Presidents, who serve in rotation).

Operating Procedures. The Federal Reserve sets two interest rates, the Discount Rate and the Fed Funds rate. The Fed Funds market is an interbank market for bank reserves and is based on an overnight interest rate. The Federal Reserve can therefore influence the Fed Funds rates by injecting or removing liquidity with open market operations (purchase or sale of government securities in exchange for reserves). Banks must maintain their level of reserves above the reserve requirement over a two-week averaging period.

The Discount Rate is the interest rate charged on emergency lending of reserves through the discount window. Discount window lending is usually only given in special circumstances. But since the discount rate is below the Fed Funds rate (i.e. offers cheaper funds) the Federal .. .

100

C H A P T E R 1 3 Monetary Policy

Reserve uses “moral suasion” to ensure that banks do not access the discount window too regularly.

THE EUROPEAN CENTRAL BANK Final Objective of Monetary Policy: Price Stability – defined by the ECB itself as inflation below 2%. “Without prejudice to this objective, it shall support the general economic policies in the Community and act in accordance with the principles of an open market economy”.

Intermediate Target: An inflation target and an M3 target. Called the “Twin Pillars” approach.

Organizational Structure. The European System of Central Banks (ESCB) consists of the 6 members of the executive board and the 15 national Central Banks of the European Union.

Interest rate decisions are made at fortnightly council meetings where all executive board members and National Central Banks Presidents in the Euro-Area can vote (Sweden, Denmark and UK are in the ESCB but not in the eurosystem and so cannot vote on Euro interest rates).

Operating Procedures. The ECB sets three interest rates, the Repo rate and two marginal lending rates (often called the Discount and Lombard rates). The Repo rate is set in the market for bank reserves and is based on an overnight interest rate. The ECB set this rate through regular Repo auctions where it injects or removes liquidity with open market operations (purchase or sale of securities in exchange for reserves). Banks must maintain their level of reserves above the reserve requirement over a one-month averaging period.

The two marginal lending rates are special rates at which commercial banks may either borrow reserves (the discount rate) or deposit surplus reserves (the Lombard rate) at national Central Banks. The discount rate is above the Repo rate and the Lombard rate below. They therefore form a corridor within which the Repo rate can fluctuate.

THE BANK OF ENGLAND Final Objective of monetary policy: An inflation objective set by the government, currently 2.5%.

Intermediate Target: An Inflation target based on a two-year-ahead inflation forecast.

Organizational Structure. The Monetary Policy Committee (MPC) of the Bank of England meets to set interest rates once a month. The MPC consists of 9 members, 5 full time Bank of England employees and 4 external experts.

Operating Procedures. The Bank of England sets the overnight Repo rate through daily open market operations. There is no reserve requirement, but commercial banks are not allowed to run overdrafts on their accounts at the Bank of England. There will generally be a daily shortage of liquidity in the interbank market, so commercial banks must enter the Bank of England’s daily operations in order to keep liquidity in balance. .. .

101

C H A P T E R 1 3 Monetary Policy

Additional Questions Question 1) Read the mini-case below. Having read it , what rate of inflation do you think that Central Banks should target.?

Akerlof, Dickens and Perry (1996) give one of the most coherent arguments against targeting zero inflation. They start by reviewing the evidence on downward wage rigidity and then analyze the impact of alternative inflation rates in a model that reflects these rigidities. One of the many pieces of evidence which they reviewed was a survey that the authors themselves undertook in the Washington area. They asked if the last pay change the respondent had received was positive, negative or no change. Their results are summarized below.

Survey of Reported Change in Base Pay (Washington Area) Negative No Positive Change Total 2.7% 30.8% 66.5% Private 2.4% 34% 63.6% Sector Public 3.1% 25.8% 71.1% Sector The table indicates a clear skew in responses, with cuts in wages far rarer than no change.

Further questioning revealed that wage cuts were usually only contemplated when a firm was close to bankruptcy. Money illusion seems an important reason for the aversion to wage cuts.

Other surveys, for instance, found that workers felt that wage cuts were unfair if a company was in profit even though they felt small wage rises in times of high inflation were acceptable.

Putting downward wage rigidity into a simulation model that is subject to heterogeneous demand and supply shocks (i.e. different shocks to different firms calibrated on historical experience), they emerge with a relationship between low inflation and unemployment as shown in the table below.

.. .

102

CH A PT E R 1 5 Monetary Policy

Unemployment and Firms Constrained by Rate of Inflation Inflatio Unemployment Rate Proportion of firms n constrained 5% 5.8% 1% 4% 5.8% 2% 3% 5.9% 5% 2% 6.1% 10% 1% 6.5% 19% 0% 7.6% 33% The table reveals that with inflation at zero, a large number of firms will wish to cut nominal wages but be unable to do so. This constraint makes the equilibrium rate of unemployment higher than it otherwise would be. The implication of this study is that even inflation of 2% is too low a target, and perhaps Central Banks should be happy with inflation of 3% or higher.

Source Akerlof, Dickens and Perry(1996) “The Macroeconomics of Low Inflation” Brookings Papers on Economic Activity 1:1996 Answer 1) there is no right answer to this one!

Question 2) Should the US Federal Reserve adopt an inflation target?

Answer 2) What would inflation targeting mean in the U.S.?

If the Fed adopted an inflation target, it would commit to achieve a numerical goal for inflation (a target point or range) within a set time. Inflation targeting would not impose a rigid simple rule for the Fed; instead, policy could employ some discretion to take into account special shocks and situations. However, the organizing principle for monetary policy would be focused on inflation and inflation forecasts.

Arguments pro 1. The announcement of an explicit inflation target would provide a clear monetary policy framework that would focus attention on what the Fed actually can achieve. For example, few economists believe that monetary policy can be used to lower the average rate of unemployment permanently, but central banks often are pressured to achieve just that. Explicit inflation targets would help to insulate the Fed from such political pressure.

2. Transparent inflation targets in the U.S. would help anchor inflation expectations in the economy, reducing the size of inflation "surprises" and their associated costs. Inflation targets also likely would boost the Fed's credibility about maintaining low inflation in the long run, in part, because they mitigate the political pressure for expansionary policy. .. .

103

CH A PT E R 1 5 Monetary Policy

3. The establishment of inflation targets in the U.S. would help institutionalize good monetary policy. Recent U.S. monetary policy has been generally considered excellent, but some extent, that reflects the skills and attitudes of the people involved rather than the institutional structure. Inflation targets can provide this institutional structure and help ensure that monetary policy is not dependent on always having the good luck to appoint the best people.

4. Inflation targets increase the accountability of Central Bankers. Given forecasts of future inflation, it is easy to compare them to the announced inflation target and. Also, on a retrospective basis, an explicit target allows Fed performance to be easily monitored. Thus, Congress and the public will be able to assess the Fed's performance and hold it accountable.

Arguments con 1. The purpose of inflation targeting is to focus the attention of monetary policy on inflation.

However, concentrating on numerical inflation objectives (even with caveats or escape clauses) also reduces the flexibility of monetary policy, especially with respect to other policy goals.

2. Because monetary policy actions affect inflation with a lag, inflation targeting means, in practice, that the Fed would need to rely heavily on forecasts of future inflation. Given the uncertainties the Fed faces, an inflexible and undue reliance on inflation forecasts can create policy problems.

3. Proponents of inflation targeting argue that it promotes accountability. However, low inflation is only one of the objectives of monetary policy .For example, it can help to stabilize the economy. Making the Fed publicly accountable for only one policy goal may make it harder for Congress to monitor the Fed's overall contribution 4. Similarly, with regard to the transparency and public understanding of policy, inflation targeting highlights the inflation objective of central banks but tends to obscure the other goals of policy.

Source Rudebusch & Walsh, FRBSF economic letter May 1998

.. .

104

CH A PT E R 1 4 F is ca l Policy and the Role of Government

CHAPTER 14: FISCAL POLICY AND THE ROLE OF GOVERNMENT INTRODUCTION This chapter covers a lot of material though not all of it need be covered since fiscal policy is sometimes seen as a ‘dry’ subject. The material here leads naturally on to Chapter 16.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As this chapter relates to many others, almost any subject covered can be used elsewhere. Tax smoothing, can be combined into a lecture on stabilization policy. Debt and Deficits could be included in a lecture on sovereign debt.

CHAPTER GUIDE 14.1 Government Spending. These data set the scene and can be presented in as much or as little detail as desired. Some further data on US government spending is included in the additional questions 14.2

The rationale for government’s role and the failure of the invisible hand. This discussion of governments’ role in reducing corruption omits to mention that governments often induce corruption. The Background Material contains further evidence.

14.3

Taxation and distortions. Material on the structure of government revenue in developing and developed countries is included in the Background Material. It is also worth noting that the amount of distortion is related to the elasticity of demand and supply. Inelastically demanded goods such as tobacco make excellent targets for taxation.

The Case Study “Reaganomics” gives an example of how the Laffer Curve was used to guide fiscal policy.

14.4

Deficits and Taxes. More data on gross and net debt (as well as a definition) appear in the background material.

14.5

Intergenerational Redistribution and Fiscal Policy. The case study on pensions gives further material on this issue.

14.6

Long-Run Sustainability The algebra in this section could be challenging to some students. However, the essential point is that debt sustainability depends crucially on interest rates and growth rates and this should be easy to communicate. Some simple exercises like the one below could also help.

.. .

56

CH A PT E R 1 4 F is ca l Policy and the Role of Government

In recent years, Argentina is a good example of a country that has run into fiscal problems due to low growth and high interest rates. Japan is another good example (although there, the primary deficit is large too). See Background Material for further information on Japanese debt sustainability.

14.7

The Intertemporal Budget Constraint. This section is largely just reinforcing the message on the previous section and so could be skipped (especially for more mathsadverse students)

14.8

Optimal Budget Deficits. The fact that constant taxes are less distortionary than volatile taxes results from the non-linear relationship between the level of taxes and the welfare loss from taxes.

CASE STUDY: REAGANOMICS Reagan’s supply-side miracle After the slow growth and high inflation of the Carter administration, Ronald Reagan began his presidency with promises of a supply-side revolution. At the core of this approach was the idea that low inflation and lower taxes (smaller government) would boost growth. Thanks to the Laffer curve, he hoped that lower taxes could increase tax revenue and help balance the budget. It didn’t take long for those hopes to be dashed.

In August 1981, soon after Reagan came into office, the Economic Recovery Tax Act (ERTA) was passed. This implemented major tax cuts for individuals and businesses (e.g. reducing the average tax rate for the median family to 17% from 20%). On the spending side, although Reagan tried (unsuccessfully) to persuade Congress to make some cutbacks, he himself instigated a large increase in defense spending (such as the “star wars” program). As a result, although economic growth did eventually help scale back social security spending (transfers), rising debt interest costs meant that total spending was barely changed as tax revenue fell (see table).

US Central Government Spending and Receipts (% of GNP)* 198 198 198 198 198 0 1 2 3 4 Total Spending 22.0 22.8 24.0 25.0 23.7 Debt Interest 1.9 2.0 2.6 2.7 3.0 Non-Interest 20.1 20.6 21.4 22.3 20.7 Spending Defense 5.1 5.4 6.0 6.3 6.2 Transfers 8.8 9.2 9.7 10.2 9.3 Other 6.2 6.0 5.7 5.8 5.2 Total Receipts 20.2 20.8 20.5 19.4 19.2

198 5 24.4 3.3 21.1

198 6 24.6 3.2 21.3

6.5 9.1 5.5 19.6

6.5 9.4 5.5 19.8

.. .

57

CH A PT E R 1 4 F is ca l Policy and the Role of Government

Personal Tax Corporate Tax Social Insurance Other BALANCE * Fiscal years.

9.4 2.6 6.8 1.4 -1.8

9.6 2.3 7.1 1.8 -2.0

9.9 1.6 7.3 1.7 -3.5

8.8 1.6 7.4 1.6 -5.6

8.2 2.0 7.5 1.5 -4.5

8.7 1.7 7.7 1.5 -4.8

8.6 2.1 7.8 1.3 -4.8

The Fed’s response Even before Ronald Reagan had been elected President, the Federal Reserve under Chairman Paul Volker had decided to bring inflation under control. However, Reagan’s expansionary fiscal policy made this task all the harder and the Fed were forced to raise interest rates sharply in the early days of the Reagan Presidency.

At the time , the Fed were using money supply targets as part of their disinflation program which – in common with most other developed countries – they missed more often than they hit (see Case Study). However, in the Fed’s case, the adherence to money supply targets was more window-dressing than the centerpiece of policy. They needed an excuse to raise interest rates without coming under too much political pressure. Possibly for the same reason, the Fed followed reserve targets much more strongly in the early eighties than they do now. This meant that if the demand for reserves rose too quickly they let interest rates rise rather than simply supplying that demand in order to keep interest rates steady. As a result, interest rates (the Fed Funds Rate in particular) were quite volatile over this period (see table and compare with the average volatility since 1955 of about 0.8). This was useful to the Fed as it allowed them to portray rising interest rates as simply the result of an automatic process rather than as a deliberate policy action.

.. .

58

CH A PT E R 1 4 F is ca l Policy and the Role of Government

US Monetary Policy 1979 1980 1981 1982 Interest rates 10.0 11.5 14.0 10.6 Interest Rate 1.6 3.8 2.3 2.6 Volatility* Growth of M1b Target Range 1.54.03.52.54.5 6.5 6.0 5.5 Actual 5.0 7.3 5.7 8.5 Growth of M2 Target Range 5.06.06.06.08.0 9.0 9.0 9.0 Actual 9.0 9.8 9.4 9.8 Growth of M3 Target Range 6.06.56.56.59.0 9.5 9.5 9.5 Actual 9.8 9.9 11.4 10.3 * Standard deviation of end-month Fed Funds Rate.

1983 8.6 0.4

1984 9.5 1.1

1985 7.5 0.3

1986 5.9 0.6

4.0-8.0 4.08.0 7.2 5.2

4.07.0 11.9

3.08.0 15.3

7.010.0 8.3

6.09.0 7.7

6.09.0 8.6

6.09.0 9.1

6.5-9.5 6.09.0 9.7 10.5

6.59.5 7.4

6.09.0 9.0

The Economic Consequences of Reaganomics The combination of Reagan and Volker led to a classic tight money-loose fiscal policy mix – a recipe for exchange rate appreciation. Unsurprisingly, the dollar started to appreciate – rising by about 30% on a trade-weighted basis by 1983. More surprisingly, it didn’t stop. It kept going until 1985, (well after the Fed had cut rates and Reagan’s fiscal boost was coming to an end), sending the dollar up to 50% higher than it was before Reagan came to power.

US Trade-weighted real exchange rate 200 190 180 170 160 150 140 130 120 110 78

79

80

81

82

83

84

85

86

87

88

USA Real effective exchange rate Source: EcoWin

.. .

59

CH A PT E R 1 4 F is ca l Policy and the Role of Government

In the early stages of the Reagan supply side program, the worsening current account deficit was more than explained by the worsening fiscal deficit (see chart), but as the dollar continued to soar, US competitiveness became a problem in its own right. The current account deficit continued to worsen despite some improvement in the government accounts (see Chapter 18 for further detail).

The US “Twin Deficits” 1 0 -1 -2 -3 -4 -5 -6 77 78 79 80 81 82 83 84 85 86 87 88 89 90 US US

Current Account Fiscal Deficit (% Source: EcoWin

Defic of G

Despite their free market principles, the Reagan economic team was gradually convinced that the market had got it wrong and the dollar was significantly over-valued. As a result, a G-5 meeting (Finance Ministers and Central Bank Governors of US, Japan, Germany France and UK) in 1985 at the Plaza Hotel in New York agreed to weaken the dollar or, as they put it, “an orderly appreciation of non-dollar currencies is desirable”. This statement was accompanied by large-scale foreign exchange intervention by all the major central banks to sell dollars and buy other currencies. Within a year, the dollar had fallen back below where it had been under President Carter. The Plaza accord seemed to have worked.

Source: “Reaganomics” O. Blanchard, Economic Policy 1987 Discussion Questions 1) Was Reagan’s economic experiment a failure?

2) Should the Fed have supported the Reagan Program by cutting interest rates?

.. .

60

CH A PT E R 1 4 F is ca l Policy and the Role of Government

Background Material US GOVERNMENT SPENDING. US government spending, which had remained roughly constant at around 32% of percent of GDP since the 1960’s, has recently began to decline. However, this decline is almost entirely due to the “peace dividend” of declining defenses expenditure.

US Government Spending (% of GDP) 35.0 32.5 30.0 27.5 25.0 22.5 20.0 17.5 15.0 12.5 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Total Government Spending (% of GDP) Government Spending exc. defense (% of GDP) Source: EcoWin

GOVERNMENTS AND CORRUPTION Although the government’s role in enforcing the rule of law should make it an agent against corruption, in certain countries corruption is centered around government activities. Overall however, the chart below indicates that larger governments tend to induce lower levels of corruption (a high score on the corruption index indicates low levels of corruption). Of course, it may also be the case that richer countries can afford bigger governments and have less corruption.

Studies of government and corruption show how corrupt governments tend to spend more on non-productive areas such as defense and less on health, education and infrastructure.

.. .

61

CH A PT E R 1 4 F is ca l Policy and the Role of Government

Government Consumption (% of GDP) .

Governments and Corruption 35

25

15

5

0

2

4

6

8

10

Corruption Index

TAX STRUCTURE IN DEVELOPED AND DEVELOPING COUNTRIES The table below shows average government revenue as a percent of GDP. Developing countries not only have smaller overall revenues but the share of revenue from broad-based taxes is also very small. They rely more on non-tax revenue and trade taxes. Expanding the tax base of poorer countries to a broader range of goods and individuals is one of the major issues in their development.

Average tax structure as % of GDP Total Revenue Tax Revenue Income, profit and capital gains taxes Social Security tax Payroll tax Property tax Sales, VAT Turnover taxes Excise Import taxes Export taxes Non-Tax revenue Source: IMF

Developed Countries 33.3% 29.7% 9.7%

Developing Countries 24.4% 18.7% 6.1%

8.0% 0.3% 0.7% 5.8% 3.0% 0.8% 0.0% 3.5%

2.6% 0.3% 0.4% 3.6% 1.9% 3.7% 0.5% 5.7%

HISTORIC DEBT GDP RATIOS The charts below show estimated debt to GDP ratios for the major economies (other than the US which is shown in Figure 1.11)

.. .

62

CH A PT E R 1 4 F is ca l Policy and the Role of Government

German Government Debt to GDP ratio 50% 40% 30% 20% 10%

19 30 19 35 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85

0%

Japanese Government Debt to GDP ratio 80% 60% 40% 20%

19 80

19 70

19 60

19 50

19 40

19 30

19 20

19 10

19 00

18 90

18 80

0%

Sources OECD, Mitchell and Deane(1962) “Abstract of British Historical Statistics” Additional Questions Question 1) Look at the following charts, which good should face a higher tax? Why? GOOD 1 GOOD 2 Price

S

D

Quantity

Price

S

D Quantity

.. .

63

CH A PT E R 1 4 F is ca l Policy and the Role of Government

Answer) Good 2 since a high tax rate will result in a smaller distortion in this case (see figure 14.4)

.. .

64

CH A PT E R 1 5 St ab il iza ti on Policy

CHAPTER 15: STABILIZATION POLICY INTRODUCTION This chapter is about how governments can use monetary and fiscal policy to help stabilize the economy. It focuses on the issues of expectations and credibility and how these influence policy. This chapter is relatively theoretical and quite difficult in places. However, the concepts, once understood, are useful and interesting to most students.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER The core of this chapter, which moves from the Phillips curve to the role of expectations, is a logical progression that is hard to split up. However, the discussion of stabilization policy at the beginning is reasonably self-contained and so could be by-passed or added to a fiscal policy lecture. In a shorter course, the material in this chapter could be combined with the material in Chapter 15 or even Chapter 14 CHAPTER GUIDE 15.1 Output Fluctuations and the Tools of Macroeconomic Policy. IS-LM analysis is discussed in more detail in the case study to Chapter 12.Up-to-date numbers for the output gap are available in the latest OECD Economic Outlook. The numbers are useful for discussing the present cyclical position of the major economies.

Note that the distinction between the short-run upward sloping and the long-run vertical aggregate supply curve already hints at the Phillips curve analysis later in this chapter.

15.2

General Arguments against Stabilization Policy. Recent US policy gives a good example of the relative implementation lags of monetary and fiscal policy. Fed Chairman Greenspan at first disapproved of presidential candidate George W. Bush’s proposed tax cuts on the grounds that they would stimulate an already fast growing economy. By the end of the 2000 presidential campaign, Chairman Greenspan had not only changed his view of the economy but had already cut interest rates.

15.3

The Inflation Output Tradeoff. The US Phillips curve is shown in the Background Material below.

15.4

The Phillips Curve and Shifting Expectations. This section is quite difficult - take it slowly!

15.5

Credibility. The Case Study discusses New Zealand’s attempt to gain credibility for its disinflation policy.

.. .

104

CH A PT E R 1 5 St ab il iza ti on Policy

15.6

Time Inconsistency. Although this is another difficult section, most students will have already come across the Prisoner’s Dilemma so it may be worth highlighting the parallels with that game.

15.7

Rules versus Discretion. The Background Material outlines the Euro-area fiscal rules in detail.

CASE STUDY: NEW ZEALAND’S DISINFLATION In the ten years before 1986, New Zealand inflation averaged 13% - high for an OECD country.

As a result, the New Zealand government instituted a number of reforms aimed not only at bringing inflation down but doing so with maximum credibility. The key credibility enhancing reform was the Reserve Bank of New Zealand (RBNZ) Act that gave the Central Bank full independence and a clear mandate to reduce inflation. The key components of the RBNZ Act were ➢ Inflation target of 0% to 2% by 1992 with interim targets for each year of the disinflation (with some get-out clauses for extreme events such as livestock disease outbreaks– see Background Material for Chapter 17) ➢ A facility to sack the RBNZ Governor if the inflation target was not achieved.

In fact inflation fell faster than the act suggested (see chart) and had hit the target range by 1991 (despite the fact that a new government had already deferred the objective to 1993). Was this due to the benefits of credibility?

Unfortunately, not all the faster-than-expected fall in inflation can be ascribed to the credibility benefits of the RBNZ Act because, not only had inflation fallen faster than expected, unemployment had risen faster than expected too (see table). Unemployment rose from a 1977-86 average of 4.3% to around 11% by 1991 and so most of the fall in inflation was probably due the disinflationary effects of high unemployment. In fact, during the disinflation, a popular comment predicted that by 1992, there would only be one person in New Zealand left with a job - the Governor of the RBNZ! Although the RBNZ achieved its aim of reducing inflation, the RBNZ Act was perceived to have failed in terms of enhancing credibility. Estimates of the sacrifice ratio in New Zealand do not indicate an improved inflation output trade-off after the act was passed. However, there is some evidence that the trade-off has improved since inflation was brought under control. This implies that credibility is built by actions not words.

.. .

105

CH A PT E R 1 5 St ab il iza ti on Policy

Inflation and Unemployment in New Zealand 20.0

12

17.5

11

15.0

10 9

12.5

8 10.0 7 7.5

6

5.0

5

2.5

4

0.0 3 86 87 88 89 90 91 92 93 94 95 96 New New

Zealand Zealand

Source:

Inflation (Le Unem ploym

EcoWin

Discussion Questions 1) Was New Zealand’s disinflation process worth undertaking?

2) Would a quicker (or slower) disinflation worked better?

Background Material FISCAL RULES IN THE UK AND EURO AREA. THE EURO-AREA’S GROWTH AND STABILITY PACT At the EU Dublin and Amsterdam summits of 1996 and 1997, the prospective members of the Euro agreed on a number of guidelines for “excessive” fiscal deficits. The main reason for these guidelines was that low deficit countries like Germany feared that they may at some time be required to bail out high deficit countries like Italy. Even though there is a “no bail out” clause in the Maastricht Treaty, Germany wished to make doubly sure that they would not be presented with a potential bankruptcy in the Euro-area.

The essence of the excessive deficit procedure is that a fiscal deficit of over 3% can only be run in exceptional circumstances. The circumstances laid down by the pact are 1. Natural Disasters 2. Temporary overshooting (e.g. associated with a one-off payment) 3. Serious economic decline. (GDP decline of 0.75% or more with declines between 0.75% and 2% subject to the discretion of the Council of Ministers) If the deficit is not justified by one of these three conditions, then the offending country must make a non-interest bearing deposit of 0.2% of GDP with a further 0.1% for every percentage point above the 3% mark in subsequent years. If the deficit is still excessive after two years, the deposit becomes a fine.

In practice, this pact has been ignored for many years now. Ironically, Germany was the first country to openly flout the pact. .. .

106

CH A PT E R 1 5 St ab il iza ti on Policy

THE US PHILLIPS CURVE The chart below shows the US Phillips curve before the inflation of the 1970s and ‘80s.

The US Phillips Curve 1949-1970 8

Unemployment.

7 6 5 4 3 2 0

2

4 6 Wage inflation.

8

10

Additional Questions Question 1) The chart below shows UK inflation and unemployment during the disinflation instituted in the first Thatcher Government. Looking at the chart do you think it was a credible disinflation?

11

20.0

10

17.5

9

15.0

8 Percent

Percent

UK Inflation and Unemployment in the Thatcher Disinflation 22.5

12.5

7

10.0

6

7.5

5

5.0

4

2.5

3 80 Inflation

81

82

83

84

85

86

Unemployment Rate

Source: EcoWin

Answer 1) Although the disinflation was successful in bring inflation down, the sharp rise in unemployment suggests that the approach was not credible (in the sense that unions and .. .

107

CH A PT E R 1 5 St ab il iza ti on Policy

employers believed that inflation would fall and so no rise in unemployment was required to bring about a new Philips Curve). In fact even after inflation had stabilized at a new lower level, unemployment stayed high.

Question 2) Look at the chart of actual and perceived inflation in Germany (perceived inflation taken from surveys). What does it tell you about the credibility of the European Central Bank Actual and perceived inflation in Germany 7.0 6.0 5.0 4.0 3.0 2.0 1.0

Actual Inflation

04Q1

03Q1

02Q1

01Q1

00Q1

99Q1

98Q1

97Q1

96Q1

95Q1

94Q1

93Q1

92Q1

91Q1

90Q1

89Q1

88Q1

87Q1

86Q1

85Q1

0.0

Perceived Inflation

Answer 2) the rise in perceived inflation around the introduction of the euro is not good news for the ECB. Of course the widely held belief that the introduction of euro notes and coins was accompanied by a price hikes didn’t help. However, the fact that perceived inflation has been above actual throughout the existence of the ECB suggests that its credibility is well below that of its predecessor (the Bundesbank) and may go some way to explain the poor performance of the German economy since EMU.

.. .

108

CH A PT E R 1 6 F ina nc ia l M a rket s

CHAPTER 16: FINANCIAL MARKETS INTRODUCTION Although this chapter is almost exclusively concerned with finance issues, it still relates to ideas previously dealt with such as investment and global capital markets. It is, of course, easy to motivate but gives disappointingly few investment tips! The dividend discount model is one of the harder models in this book but is worth mastering not just for this chapter but for Chapter 18 which present related models.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Recent events in the equity market can be used to motivate students on this chapter and also to introduce concepts like the dividend growth model. In a shorter course, this chapter can be combined either with Chapter 10 on consumption and investment or Chapters 17 and 18 on banking and sovereign debt.

CHAPTER GUIDE 16.1 The Financial Sector: An Overview Look at the McKinsey Global Institute website for a recent overview of global financial markets 16.2

Debt and Equity The Background Material contains a glossary of equity market terms.

16.3

International Comparisons of Equity Markets. Share of world stock market capitalization by country is shown in one of the pie charts after the index.

16.4

The Determination of Stock Prices. This is a tough section and one that may leave students with the impression that all you need to know about share prices today is what they will be tomorrow! It is important to introduce some useful insights. For example, the dividend discount model shows how internet shares that are promising to pay large dividends in the distant future should be more sensitive to interest rates than established firms with high dividend yields. During the Internet Bubble, these shares seemed to be unaffected by changes in interest rates (any puzzlement this caused was countered with the phrase “new economy, new rules”).

The derivation shown in this section is challenging. Less mathematically advanced students could be given an intuitive explanation instead.

16.5

On the Unpredictability of Share Prices Technically speaking share prices do not follow a pure random walk since the tendency for dividends to rise through time (due to inflation and growth) means that share prices also rise through time. Prices are more likely to follow a random walk with upward drift. However, over short periods this trend will not be apparent.

.. .

109

CH A PT E R 1 6 F ina nc ia l M a rket s

16.6

Risk, Equity Prices, and Excess Returns. The UK equity premium (equity over bond returns) is estimated at 4.7% for the twentieth century.

16.7

Are Stock Prices Forecastable? Goetzmann and Jorion’s idea of survivorship bias could also be important for excess volatility. Share prices could have been volatile because they were responding to the remote possibility of a dramatic event (e.g. World War III).

The risk of a rare, extreme event is called the ‘peso problem’ (after the Mexican peso that was stable for many years and then depreciated massively).

16.8

Speculation or Fundamentals? In fact, Cutler, Poterba, and Summers found both long term mean reversion and short term positive autoregression (if stock went up in one month, they were more likely to go up again in the next). These momentum effects imply that trend followers (“the trend is your friend”) can make money in the short term but eventually lose out when markets revert to their long run mean.

16.9

Bubbles. The Case Study looks at a few famous early bubbles and possible explanations for them.

16.10 What is a Bond? The distinction between primary markets (the initial sale by the issuer) and the secondary market (where outstanding claims are bought and sold) is important to both bond and equity markets. The Case Study gives some information on both the primary and secondary market for US government debt.

16.11 Prices, Yields and Interest Rates This is the toughest section in the chapter and it is worth taking slowly. If students are hungry for more, the Background Material contains a glossary of terms including duration and convexity.

16.12 Inflation and the Bond Market The fact that inflation is bad for bonds links back to the issue of time inconsistency discussed in Chapter 15. A government can, in principle, use inflation to reduce the real value of its debt burden (existing bonds still have the same face value, but inflation increases the nominal value of tax receipts). The debt-reducing effect of surprise inflation adds to the time inconsistency problem.

16.13 Government Policy and the Yield Curve. Unfortunately, high quality up-to-date yield curves are hard to acquire without access to a market data provider like Reuters or Bloomberg, though simple ones can be found on sources like the FT website.

CASE STUDY: FOREVER BLOWING BUBBLES Tulipmania After their introduction from Turkey in the mid-1500’s, the Netherlands became an important center for the cultivation of new tulip varieties. Professional growers and collectors created a market for the rarest varieties that traded at high prices. In 1625, the Semper Augustus bulb, .. .

110

CH A PT E R 1 6 F ina nc ia l M a rket s

for example, sold for 2000 guilders. This compares with an average merchant’s annual salary of 1500 guilders; 1600 guilders paid for Rembrandt’s greatest masterpiece in 1646; and the average daily wage of an Amsterdam cloth-shearer of less than 1 guilder.

By 1636, rapid prices rises had attracted speculators and prices surged upward from November 1636 through to January 1637 (when prices as high as 5,200 guilders are recorded). In February 1637, prices suddenly collapsed and bulb prices fell below 10% of their peak value. The collapse didn’t stop there and by 1739 no bulb sold for more than 0.1 guilder - making the Semper Augustus worth 0.005% of its value 100 years previously.

The rapid rise in tulip bulb prices, their astonishingly high values at the peak and their sudden crash all make Tulipmania look like the classic irrational bubble. However, there is another explanation. The rare bulbs that achieved such high prices were unique (having been transformed by the mosaic virus) and could only be propagated from the bulb itself. In these circumstances, it is perfectly reasonable to expect the first bulbs to be immensely valuable but the price to fall steadily as the variety became more common. This effect is certainly consistent with the steady decline in bulb prices in the century after the peak and so the behavior of species such a Semper Augustus is actually quite rational. The only irrational period was possibly the period between November 1636 to February 1637.

The Mississippi Bubble Both the Mississippi and South Sea Bubbles were classic financial bubbles in which increasing share prices and share issuance helped finance a dramatic expansion of the companies involved. In both cases moreover, the central aim of the companies concerned was to help refund the national debt.

In the early 19th century, the French Government was effectively bankrupt by virtue of the wars of Louis XIV. It had repudiated part of its debt, forced a reduction in interest payments on the remainder and was still in arrears on its debt servicing. Thus, when John Law (an exiled Englishman and economist) proposed a scheme that would dramatically reduce debt interest, he was keenly listened to. At the heart of Jon Law’s scheme was the notion that the funds should be raised first and that the actual commercial scheme would follow once the “fund of credit” had been established.

Law began by opening a note issuing bank (the Banque Generale) and the Compagnie d’Occident which took over the monopoly on trade with Louisiana and the trade in Canadian beaver skin (hence the Mississippi of the Mississippi bubble). To finance this initiative, Law took subscriptions on shares paid for partly in cash but mainly in government debt. Having acquired the debt, he converted it into rentes that offered the government an interest rate reduction.

The Compagnie d’Occident did expand its commercial activities, acquiring the tobacco monopoly and the Senegalese Company (trade in Africa) in 1718. In 1719, the Banque General was taken over by the Regent and re-named the Banque Royale. The company then acquired the East India and China companies and re-organized under the name Compagnie des Indes. .. .

111

CH A PT E R 1 6 F ina nc ia l M a rket s

However, in 1719 a number of key developments in Law’s project occurred. In July, the Compagnie purchased the right to mint new coinage for 50 million Livres Tournais; in August, the Company acquired the right to collect all French indirect taxes for 52 million Livres per year and in October the rights to direct taxation were purchased. Law was convinced that by improving the efficiency of these operations, he could make substantial profits. He therefore simplified the tax code by reducing the number of taxes but making them broader in coverage.

The last step in Law’s plan was to acquire the whole French National Debt which despite having a face value of about 2000 million Livres, traded well below par and could be acquired for about 1500 million Livres. To finance this purchase, the Compagnie undertook three stock sales of 100,000 shares at 5,000 Livres each (payable in twelve monthly installments). Law hoped that after acquiring the Debt, the reduced rate of interest that he charged the government (3% p.a.) would fund further commercial projects. In the meantime, Law’s political influence increased and he was nominated Controller General and Superintendent General of Finance. This meant he was not only in charge of all government finance, but also acquired the right of money creation through the Banque Royale.

Compagnie des Indes Stock Price

Share Price (Livres Tournois) .

12000 10000

Banque Royale Notes Made Legal Tender

Law's Deflation Plan

8000 6000

First Stock Sales for Debt Refunding

Share Price Pegged

4000 2000

Acquisition of the Mint

0

0 9 9 20 19 20 19 19 20 20 72 71 71 -17 -17 -17 pr-17 -17 -17 -17 t-1 t-1 r-1 c g g b n n c c p e u u e u u o o j j f a a d a a

Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Rather than undertaking new trading activity, Law decided that printing money was the simplest way to make a profit - the King having allowed further note issue along with each share sale. In early 1720, shareholders began to take the profits on their holdings in the Compagnie by selling their shares for gold. Law attempted to persuade these shareholders that the future dividends of the company justified the retention of the shares. When that failed, he first imposed a limit on the number of shares that could be sold for gold. He then organized a massive share support operation by pegging the price per share at 9000 Livres and printing .. .

112

CH A PT E R 1 6 F ina nc ia l M a rket s

notes to finance purchases of shares at that price. The natural consequence was a sudden surge in inflation with prices doubling by September 1720 and Law was forced to devalue the Livre Tournais against gold.

Realizing that he had set the price too high, Law announced that the share price would be steadily devalued to 5000 Livres. However, by this time, Law’s power was waning and his enemies were gaining influence. As a result, two-thirds of the Compagnie shares were confiscated and by September 1721, the share price had fallen to 500 Livres.

The South Sea Bubble.

The South Sea Bubble was largely the UK version of the Mississippi Bubble – though much more straightforward in its operation. The South Sea Company - holding some worthless trading rights with the Spanish Colonies in South America - was solely involved in the purchase of government debt. Having won in competitive bidding against the Bank of England, the company was given the right to refund the debt (through the Refunding Act). In return it agreed to pay the government £7.5 million if it succeeded in acquiring the £31 million of debt in noncorporate hands. It also agreed to take only 5% interest on the debt (falling to 4% in 1728) – a substantial reduction on the normal market rate of interest on government securities.

To finance these purchases, the company was allowed to issue shares with a face value of £100 proportionately to the amount of debt acquired. As its share price rose rapidly to over £300, the company was able to offer generous conversion terms and still keep substantial profits for itself. However, it became clear that its balance sheet did not add up. With assets largely consisting of government bonds paying a paltry 5%, the book value of the company in September 1720 was about £100 million (largely made up of £70 million in funds due from subscribers), whilst its market value was £164 million.

However, the success of the South Sea company had spawned a host of imitators. These ranged from legitimate business enterprises for declared purposes such as: For the importation of Swedish Iron For Importing Walnut Trees from Virginia For a Grand American Fishery to the altruistic, such as: For the buying and fitting out of ships to suppress pirates For improving of Gardens For insuring and increasing of Children’s fortunes For employing poor artificers, and furnishing merchants and others with watches. to the faintly ludicrous: For furnishing funerals to any part of Great Britain .. .

113

CH A PT E R 1 6 F ina nc ia l M a rket s

For Improving the Art of making Soap For trading in hair Puckle’s Machine Company for discharging round and square cannonballs and bullets to the totally fraudulent such as: For a wheel for perpetual motion For carrying on an undertaking of great advantage but nobody to know what it is.

(The latter attracted a thousand investors in its first five hours of trading before the promoter shut up shop and departed for the Continent, never to be seen again.)

In order to prevent the creation of such companies, the government passed the Bubble Act. However, the act had the side effect of ‘pricking’ the South Sea Bubble, and the added failure of the Compagnie des Indes in France precipitated large losses for investors who then sought to liquidate their South Sea stock. The government then turned against the company and forced the sale of part of its holdings to the Bank of England.

South Sea Shares 1000 Share Price in

Bubble Act Enforced

800 600 400 200

1st Passage of Act authorizing refunding Conversion terms announced for Annuitants

0 0 0 0 0 0 0 0 0 0 0 0 0 72 172 172 172 172 172 172 172 172 172 172 72 -1 b-1 l t r r v c y g p n n a ju au ja oc ju fe ap ma no se de m

Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Conclusion Even though the South Sea Company’s existing assets were clearly overvalued, investments in this company and the Compagnie des Indes were not so completely foolish as many have characterized them to be. This is probably not true for most other bubble companies. The combination of a large pool of available funds (from subscribers), at a time of immense commercial expansion and the almost unqualified support of government, made the potential of both companies enormous. Hindsight allows us to classify these events as bubbles, but at the time, their failings were not so evident. .. .

114

CH A PT E R 1 6 F ina nc ia l M a rket s

Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Mackay(1841) “Extraordinary Popular Delusions and the Madness of Crowds”

Discussion Questions 1) Do you accept the argument that these three bubbles can be explained as rational behaviour?

2) Would you have invested in ‘For carrying on an undertaking of great advantage but nobody to know what it is.’?

CASE STUDY: A BRIEF INTRODUCTION TO THE US GOVERNMENT BOND MARKET Introduction The market for US treasury securities is effectively the largest in the world. At the end of September 1999, total outstanding treasury debt was $5.6 trillion, of which $3.2 trillion was in marketable securities (the rest was in non-marketable form such as the government account series in which the social security surplus is invested).

Total Outstanding Treasury Debt, 1851-1999 $ billion, log scale 10000 1000 100 10 1 0.1

18 51 18 60 18 70 18 80 18 90 19 00 19 10 19 20 19 30 19 40 19 50 19 60 19 70 19 80 19 90 19 99

0.01

The Treasury issues four main types of marketable securities 1. Bills. Bills are issued in maturities of one year or less. They are discount securities that pay no coupon. (They are called discount securities since they must always sell at a discount to their face value - the discount being the yield on that security.)

2. Notes. Notes are issued in maturities of one to ten years. They pay a semi-annual coupon and make up over half the total stock of marketable debt.

.. .

115

CH A PT E R 1 6 F ina nc ia l M a rket s

3. Bonds. Bonds are issued in maturities of more than ten years and also pay a semi-annual coupon. A few of these are ‘callable’ securities - which means that the Treasury has the right to redeem them before maturity under certain circumstances.

4. Indexed-securities. Since 1997 the Treasury has also issued inflation-indexed bonds whose coupons and principal is uprated by the rate of inflation. Indexed securities tend to be issued at longer maturities.

Bills 20%

Indexed 3%

Other <1%

Bonds 20%

Notes 57%

Distribution of Marketable Securities (September 1999) The Primary Market for Treasury Securities The US Treasury raises funds through a series of regular auctions. These range in frequency from weekly for shorter maturities bills to half-yearly for the longest maturity (30 year) bond.

Even though in 2001 the government had a large budget surplus, these auctions continued partly for refinancing maturing debt and partly in the form of debt buybacks (reverse auctions) in which the Treasury purchases some of its outstanding debt. The decision to continue auctioning new debt while simultaneously buying back existing debt was made both to maintain the continuity of the auction program and to concentrate remaining debt in a smaller number of large issues.

The auction process begins when the Treasury announces the size and exact maturity of the next security to be issued (these currently range from under $7 billion for the shortest maturity bill to $15 billion for five-year notes). The announcement is made several days before the auction itself. Following the announcement, a when-issued market opens so that investors can agree to purchase the security at a known price before the auction. This market is important for the main bidders at the auction – called primary dealers – since they can assess the underlying demand for the securities before bidding at the auction. On auction day itself, the primary dealers submit bids for the security. These state the amount they are prepared to buy and the price that they are willing to pay. The bids are then accepted, starting with the highest price bid and working down to the lowest price (highest yield) at which all the securities offered can be .. .

116

CH A PT E R 1 6 F ina nc ia l M a rket s

sold (this is called the stop-out yield). The way in which the auction price is determined has recently changed from bid-price to uniform price: 1. Bid-Price Auctions Prior to November 1998, each successful bidder was allocated the securities at the price at which they bid.

2. Uniform Price Auctions. Since November 1998, each successful bidder is allocated the securities at the stop-out yield (i.e. the lowest accepted price).

At first sight the uniform price auction may seem an odd system for the Treasury to adopt since it ends up selling securities to bidders at a price lower than they would be prepared to pay.

However, auction theory suggests that bidders will be far more aggressive in their bidding if they know they will get the best price in the end. As a result, the higher bids that the Treasury receives will more than offset the fact that they dispose of the securities at the lowest accepted price.

Smaller bids (by individuals), called non-competitive bids, can be submitted without a specified price and will also obtain the stop-out yield.

The Secondary Market for Treasury Securities As well as bidding in auctions, many primary dealers are active in ‘making markets’ for existing treasury securities. This means that they will post bid (buying) and offer (selling) prices for existing treasury securities. An investor who wishes to buy a security that has already been auctioned may contact a market maker and buy at their offer price. Similarly, an investor wishing to sell securities may sell at the (slightly lower) bid price. Thus, the market maker who offers this service benefits from the difference between buying and selling prices (called the bid-offer spread). Although market makers tend to hold a small inventory of treasury securities in order to be able to facilitate trading, large institutional investors hold the majority of the stock of debt. As the chart below shows, the majority is held by foreign and international investors (Japanese investors in particular hold a significant proportion of the US federal debt).

A significant proportion is also held by the Federal Reserve who purchase government securities in their open market operations (see Chapter 17).

.. .

117

CH A PT E R 1 6 F ina nc ia l M a rket s

State and Local Government 7%

Depository institutions 7%

Foreign and International 33%

Federal Reserve 12%

Others 14% Institutional Investors 27%

Distribution of Treasury Securities, by ownership, March 31 1999 Source: Dupont and Sack(1999) “The Treasury Securities Market: Overview and Recent Developments” Federal Reserve Bulletin Discussion Questions 1) Is the fact that one third of US government debt is held overseas a cause for concern?

2) The average maturity of US government debt is quite short – should it be longer?

Background Material GLOSSARY OF EQUITY MARKET TERMS Below are a few equity market terms that may come up in the course of a lecture.

ADR (American Depository Receipt). A security created by a US bank that gives the holder ownership of a specified number of shares in a foreign country. Since they have all the characteristics of US shares, some investors prefer them to holding shares in a foreign country directly.

Common Stock. Standard shares that pay variable dividends and give the holder ownership (voting) rights in the firm.

Debt to Equity Ratio. Long term debt divided by shareholder’s equity. It shows the share of long term funds supplied by creditors relative to shareholders. A high ratio may indicate higher risk and volatility for shareholders.

Dividend. Distribution of earnings (profits) to shareholders. The board of directors decides the size of the dividend. .. .

118

CH A PT E R 1 6 F ina nc ia l M a rket s

EBITDA. Earnings before interest, taxes , depreciation and amortization.

EPS (Earnings per share). Company profit divided by the number of outstanding shares IPO (Initial Public Offering). First public sale of shares by a formerly private company.

Market Capitalization. Number of shares outstanding multiplied by their price.

P/E Ratio (Price Earnings Ratio). Price of shares divided by earnings per share Preferred stock. A type of stock that pays a fixed dividend rather than one related to profit.

Owners of preferred stock do not have voting rights.

Retained Earnings. Profits retained in the firm for investment etc. rather than allocated to dividends Rights Issue. Sale of further shares in a company. Existing shareholders have first refusal on these issues.

GLOSSARY OF BOND MARKET TERMS As well as those described in the chapter and case study, the following are some terms that are commonly used in bond markets Bearer Bonds. Although most government bonds must have a registered owner whose name is recorded in a central system, bearer bonds simply belong to whoever happens to be holding them (though in fact even registered bonds are not usually registered to their actual owner).

Clean and Dirty Price. When you buy a bond which is about to pay a coupon (coupons are normally paid once very 6 months) you are not entitled to all of that coupon because you have not owned the bond over the whole six-month period prior to the coupon being paid. The price you pay therefore is the actual price (clean price) plus the accrued interest (the pro-rated value of the coupon you are about to receive). Clean price plus accrued interest produces the dirty price Convexity: Since the relationship between the price of a bond and its yield is non-linear, the effect of a fall in yields on the price of the bonds is different from the effect of an equivalent increase in yields (see diagram). In fact, a bond's price goes up more for a given fall in yields than it goes down for an equivalent increase in yields. This makes convexity an attractive property of bonds since you stand to make more from a fall in yields than you lose from an increase. Bonds with greater convexity (a less linear relationship) command a premium in the market.

.. .

119

CH A PT E R 1 6 F ina nc ia l M a rket s

Convexity: The relationship between bond yields and bond prices (A rise in yield from Y to Y1 has less impact on price than a fall in yield from Y to Y2) Price

P2

P P1

Y2

Y

Y1

Yield

Duration: In the case of a bond which pays both coupons and principal, the average maturity of the cash flows is actually shorter than the maturity of the bond (since the coupons are paid regularly before the bond matures). Duration is a measure of average maturity of cash flows and is simply the weighted average of those cash flows (with weights equal to the present value of those cash flows). Only a zero-coupon bond has a duration equal to its maturity, all coupon bearing bonds have a duration shorter than their maturity.

Eurobond. A market for corporate bearer bonds usually denominated in dollars, but based outside the US. Forward Rate Imagine that you had the choice of investing in a one-year bond that yielded 10% and a two-year bond that yielded 11%. If your only aim is to maximize your returns, the key consideration in assessing these two bonds is what you could earn on a one-year bond in one year’s time. This is because a two year bond gives you an average return over two years while the one year bond gives you one year of return and leaves you free to re-invest for a second year. If you believe that in one year’s time the one-year bond yield will still be 10%, then the two-year bond is a much better bet. Only if you expect the one-year bond yield to be above 12% in the second year will you wish to choose the one-year bond today.

In this example, 12% is the one year, one year forward rate, i.e. it is the one year bond yield in one year’s time that makes you indifferent between buying a one year or two year bond today.

Junk bond A junk bond is a corporate bond with a very high credit risk and thus a very high yield (also called high yield bond).

.. .

120

CH A PT E R 1 6 F ina nc ia l M a rket s

Repo. A repo is an agreement to buy (or sell) a security while simultaneously agreeing a date on which to sell (or buy) it back. Thus, an investor engaged in a repo transaction simultaneously sells a particular security to another investor and agrees to repurchase that same security at a specified price at a later date (often the next day). This investor is said to “repo out” the security. In essence the security is being used as collateral to borrow cash and the proportionate difference between the current price and the (higher) repurchase price is the repo rate – a very short term interest rate. Central Banks often use repo transactions in their open market operations.

Strip. Many bond markets offer a facility whereby an investor can trade the individual cash flows in a bond (i.e. the individual coupons and repayment) rather than the whole set of payments that a coupon-paying bond represents. Trading in these individual cash flows is called the strip market.

Swap. An investor who holds a security paying a variable rate of interest (called floating rate securities because their interest is re-fixed – usually to the prevailing three month interest rate – every few months) can swap those variable payments for the fixed return offered by a long term bond provided he can find an investor who wishes to undertake the opposite transaction.

This is called an interest rate swap.

Additional Questions Question 1) Was the US the only country to have a stock market internet bubble?

Answer 1) No, the chart below shows how the UK and German bubbles were comparable with, if not larger than, the US bubble (though since the NASDAQ index contains a large number of safe long-standing companies it is not directly comparable with the other two indices). In fact someone has calculated that if instead of buying shares in new German high tech companies in the year 2000 one had bought crates of German beer instead, the deposit on the empty bottles would have ended up being worth more than your share portfolio.

.. .

121

CH A PT E R 1 6 F ina nc ia l M a rket s

Technology Indices (1998=100) 450 400 350

Index

300 250 200 150 100 50 0 98

99

UK techMARK100 Index Germany, TecDAX Index

00

01

02

03

04

United States, Nasdaq Composite Index

Source: EcoWin

.. .

122

CH A PT E R 1 7 T he Ba nk in g S ect or

CHAPTER 17: THE BANKING SECTOR INTRODUCTION This chapter makes a brief survey of what is a huge subject. As with other chapters in this section, the main aim is to show how financial markets and institutions can be important for the economy as a whole. Thus, issues such as the credit crunch and banking crises are the principal focus.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Having dealt with Financial Markets (Chapter 16) and Monetary Policy (Chapter 13), this chapter returns to those issues but from a banking perspective. The material here could easily be folded into an issues-based lecture on the recent crisis.

CHAPTER GUIDE 17.1 The Role of Banks Many commentators draw attention to the distinction between the Anglo-Saxon model of financing – based on equities and bonds - and the Continental European and Japanese approach - based on banks. Advocates of the Anglo-Saxon model point to the advantages of open competition and robustness to shocks (i.e. lower impact of credit crunches). However, the bank model is arguably more useful to small businesses because banks can afford to spend time building business relationships in the knowledge that they are the sole source of finance rather than as one shareholder amongst many.

17.2

Problems in Banking Markets. Recent events will be in the forefront of most students’ minds, but the Background Material below also outlines a recent banking collapses before the recent crisis.

The story of Mary Poppins is a good example of how self-fulfilling bank panics can occur - Michael Banks’ refusal to put two pence into his father’s bank precipitates a bank run.

17.3

Banking Crises. An important issue to highlight in the recent crisis is how bank runs can occur in the wholesale markets as well as retail.

17.4

Credit Crunches. Again, recent events are a good example, but the case study broadens the evidence of credit crunches.

.. .

135

CH A PT E R 1 7 T he Ba nk in g S ect or

Additional Resources CASE STUDY: THE US CREDIT CRUNCH OF 1989-92 This case looks at the evidence that a tightening in bank regulation caused a credit crunch in the US. Introduction After the US thrift crisis of the late 1980s, US bank regulators were understandably keen to tighten up standards (see Background Material below). This process, fortified by the new Basle Capital Adequacy standards (see Background Material), put banks under some pressure – making them less willing lenders. As the chart below shows, the consequent decline in bank lending over this period was severe.

The Bush economics team soon realized that a credit crunch was underway and than the economic recession was being prolonged by the unwillingness of banks to lend. However, other than exhorting the Federal Reserve to cut interest rates (which they did), there was little to be done.

US Bank Lending Growth and Real interest rates 15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Lending Growth (% real interest rate Source:

p.a.

EcoWin

Evidence on Supervisory Standards.

How important was the tightening of supervisory standards in inducing the credit crunch? One way to answer this question is to look at the actual ratings that supervisors gave banks at the time - a high level of weak ratings would indicate that supervisors were getting tough.

The core of the US banking supervisory system is the ‘CAMEL’ rating scheme. As the acronym implies, this has five elements: Capital Adequacy: A bank’s capital and leverage are the most important part of the rating.

Asset Quality: Based on expected future losses on the bank's loans. .. .

136

CH A PT E R 1 7 T he Ba nk in g S ect or

Management: Management is evaluated on compliance with regulations, and on internal and external controls.

Earnings: The bank’s expected future earnings should be sufficient to absorb possible losses.

Liquidity: Based on the bank’s ability to obtain money cheaply and quickly.

Having evaluated these elements, the supervisor then gives the bank a CAMEL rating from 1 to 5. Banks with ratings of 1 or 2 are basically sound, while ratings of 3 upwards warrant increasing concern (3 implies some weakness and 5 implies imminent failure).

The Chart below shows the proportion of banks with CAMEL ratings of 3 and below between 1986 and 1998. Although poor ratings were common in the 1989-1991 ‘credit crunch’ period, it cannot be said that there was a significant increase in poor ratings over that period.

Proportion of Banks with CAMEL ratings of 3 or below 40%

30%

20%

10%

0% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Overall, although supervisory standards were a factor in the US credit crunch of the early 1990’s, they were clearly not the most important constituent. Overall, it would seem that banks chose to restrict lending on their own behalf rather than at the behest of the regulators.

Perhaps having seen so many banks and thrifts fail over the preceding years, they acted quickly to tidy up their own balance sheets.

Source: Berger, Kyle and Scalise (2000) “Did US bank supervisors get tougher during the credit crunch?” NBER © Working Paper 7689 Background Material SOME OTHER BANK FAILURES

.. .

137

CH A PT E R 1 7 T he Ba nk in g S ect or

The recent banking crisis is very well documented and each instructor is likely to have their own take on events. This section gives a description of other bank failures that have occurred in the last 50 years or so Franklin National Bank (FNB) In May 1974, FNB - the 20th largest bank in the US - was refused permission to take over another financial institution by the Federal Reserve. The Fed told FNB that it had expanded too quickly and needed to re-trench its operations. A few days later, FNB announced that it had suffered a large foreign exchange loss and could not pay a dividend. When it further transpired that the bank had made a number of unsound loans as a result of its rapid growth strategy, large depositors began to withdraw funds. FNB offset this loss by borrowing $1.75 billion from the Federal Reserve. Fortunately, since its smaller depositors were protected by the Federal Deposit Insurance (FDIC) scheme, they did not withdraw their funds. In October 1974, what remained of the bank was taken over by a consortium.

It later transpired that FNB had been used by its largest shareholder, Michele Sindona, to move funds illegally around the world. Sindona died (from poisoning) shortly after being sentenced to life imprisonment for arranging the murder of a banking investigator.

Continental Illinois (CI) and Penn Square.

In July 1982, the small ($465 million in deposits) Penn Square Bank collapsed. Since Penn Square had been passing on many of its loans to CI, there was little surprise when CI announced a loss and that non-performing loans had doubled to $1.3 billion. However, more alarm was generated when these non-performing loans which were expected to shrink after the Penn Square failure, actually grew and reached $2.3 billion by 1984 (7.7% of total loans). Since CI had a small base of domestic depositors, it had relied heavily on overseas (and uninsured) deposits.

In May 1984 these depositors took fright, forcing CI to borrow about$44.5 billion from the Federal Reserve to cover the outflow. Although the prospects looked bleak, the Federal Reserve and a number of commercial banks organized a large bail-out operation. In essence, they felt that CI was ‘too big to fail’.

US Thrift Crisis Between 1980 and 1993 there were about 1300 thrift (or S&L) failures in the US. However, the problems actually began in the mid-1960’s when interest rates rose and thrifts found that the return on their long term fixed rate mortgages was lower than the prevailing deposit interest rate. Although various government interventions (such as regulation Q) tried to help the thrifts, the situation continued to deteriorate. The thrift problem was actually aggravated by regulatory forbearance. The thrift regulators not only turned a blind eye to the worsening financial problems, but the deposit insurance fund (FSLIC) kept them afloat by purchasing their equity. By 1985, the FSLIC itself was in financial difficulties. Eventually, the Bush plan of 1989 was implemented - closing down insolvent thrifts and tightening up the regulation of the remainder. The final bill for dealing with the thrift crisis was around $300 billion.

Bank of Credit and Commerce International (BCCI) .. .

138

CH A PT E R 1 7 T he Ba nk in g S ect or

In July 1991, the Bank of England and regulators in Luxembourg and the Cayman Islands closed all branches of BCCI around the world. Despite the decisiveness of this action, the Bank of England came under heavy criticism for not acting earlier. Certainly, the “Bank of Cocaine and Criminals International” had a pretty appalling track record.

1975 - the US authorities block a BCCI takeover of an American bank since BCCI refused to disclose details of its operations.

1983 - BCCI buys a Colombian bank with branches in Medellin and Cali.

1988 - the bank is indicted in Florida for money laundering. It later transpired the bank had laundered $32 million of drug money.

January1991 - the Bank of England receives a report linking BCCI to the international terrorist Abu Nidal.

An independent report criticized both the Bank of England and the auditors Price Waterhouse for acting too slowly and secretly. The BCCI case dramatically highlighted the need for international co-operation amongst regulators.

Barings Bank In 1995 Barings Bank was closed down with a loss of over £800 million on derivatives trading against a capital base of £540 million. These losses were attributable to one trader in its Singapore Branch – Nick Leeson. From 1992 onwards, Leeson had managed to deceive Barings' management into believing that he was making large profits from futures arbitrage (a supposedly riskless form of trading that exploits small differences between identical financial instruments1). In fact he was making losses from ever larger and ever riskier trades. Since Barings had allowed him to be in charge of both trading (front office) and settlement of those trades (back office), Leeson continued to hide his losses in a secret account - number 88888.

Although initially the losses were relatively small (£23 million by the end of 1993), 1994/5 saw Leeson caught up in a huge loss. Initially, he placed trades that would make money if the Japanese stock market remained relatively stable. However in early 1995, an earthquake hit Kobe in Japan. As the stock market began to fall, Leeson attempted unsuccessfully to support it by purchasing stock market futures on an enormous scale. The market slumped and Leeson had to admit the losses.

THE SOUTH EAST ASIAN BANKING CRISIS The four main crisis-hit countries had an exceptionally large increase in short term capital flows in the run-up to the crisis. This meant that by the time the crisis hit, short-term liabilities were larger than foreign exchange reserves in all countries except Malaysia. To add to the problem, most of these liabilities were in foreign currencies, so that when the crisis hit and exchange rates began to fall, all four countries experienced a dramatic rise in debt exposure in local currency terms.

1

In Leeson’s case he was supposedly arbitraging the difference in price between the Nikkei futures contract quoted in Osaka (OSE) and an identical contract quoted in Singapore (SIMEX). .. .

139

CH A PT E R 1 7 T he Ba nk in g S ect or

These problems centered on the banks so that when the crisis hit, confidence in local banking was quickly eroded and a large scale run by domestic depositors occurred in Indonesia. To restore confidence, all four countries made massive liquidity injections into their banks and instituted a form of deposit insurance (none had had a formal deposit insurance scheme before the crisis). These policies, supported by IMF funds, helped offset a full scale banking collapse although the losses involved were enormous.

The South East Asian Banking Crisis (figures are %of GDP) Indonesia Foreign Exchange Reserves (1996) 7.8% Short-term debt (1996) 15% Foreign Liabilities of domestic banks 5.6% (1996) Peak–trough fall in reserves 5.3% (6/972/98) Liquidity support to financial 31.9% institutions (6/97-6/99) IMF-supported packages (actually 8.8% disbursed) Assets of closed banks 16% Source: IMF

S. Korea 6.4% 12% 8.7%

Malaysia 26% 11.2% 11.2%

Thailand 20.5% 25.1% 27.1%

3.4% (7/9712/97) 6.9%

16.5% (3/971/98) 13.8%

7.3% (1/978/97) 22.5%

6%

-

7.9%

45%

-

25%

BANKING PROBLEMS IN JAPAN An indication of the severity of the Japanese Credit Crunch is given in the chart below. It shows firms’ responses to a business survey (the ‘Tankan’) question on the lending attitude of financial institutions. The index shows the percentage of firms saying the lending attitude of financial institutions was "accommodative" minus those who said it was "severe". Given that interest rates are currently 0% in Japan, the fact that firms class lending attitudes as severe strongly suggests that credit rationing is taking place.

.. .

140

CH A PT E R 1 7 T he Ba nk in g S ect or

Lending Attitude of Japanese Financial Institutions (Above zero = accommodative, below zero = severe) 40 30 20 10 0 -10 -20 -30 82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

Source: EcoWin

.. .

141

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

CHAPTER 18: SOVEREIGN DEBT AND DEFAULT INTRODUCTION A very topical subject, though some important theoretical topics are covered. The material here links naturally to Chapter 17 and chapter 14.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As this chapter relates to many others, almost any subject covered can be used elsewhere. For example, external financing and debt sustainability could be included in a lecture on currency crises.

CHAPTER GUIDE 18.1 Sovereign Debt and Default. This section follows on quite closely from chapter 14 18.2

Deficits and the Business Cycle. The UK objective of eliminating the structural deficit and how that objective is ascertained by the Office of Budget Responsibility is a useful practical example here

18.3

Long-Run Sustainability The algebra in this section could be challenging to some students. However, the essential point is that debt sustainability depends crucially on interest rates and growth rates and this should be easy to communicate. Some simple exercises like the one below could also help. However, the relationship between growth and debt sustainability has been an important one recently.

18.4

The Intertemporal Budget Constraint. This section is largely just reinforcing the message on the previous section and so could be skipped (especially for more mathsadverse students)

18.5

Sovereign Default. An account of early English default can be found here: http://www.bbc.co.uk/iplayer/episode/b01b9jnp/The_Long_View_Sovereign_Debt_and _Default/

18.6

Credit Risk and Credit Agencies. Sovereign Credit defaults swaps offer and alternative way of assessing financial markets view of default risk. Some information on these is in the background material. Data on these is available on Bloomberg

18.7

Debt Forgiveness More background on HIPC appears here: http://www.imf.org/external/np/exr/facts/hipc.htm

.. .

56

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

CASE STUDY: THE PENSIONS CRISIS In virtually all developed countries, there will be a steep rise in the proportion of elderly people in the first 50 years of this century (see chart). This is likely to put strain on the public finances of all those countries as pensions provision exacts an increased share of total public spending.

Already, the 20% rise in the elderly population in OECD economies from 1980 to 1995 has led to a 25% increase in total government spending on this age group.

In this study, we look at two aspects of the pensions problem. First, the determinants of the cost of public pensions and second, the impact of public pensions on the income of the elderly.

Determinants of the pensions problem Two factors determine the extent of the fiscal strain felt as an increasing share of the population reaches pensionable age.

1) The proportion of pensioners to total working population 2) The generosity of the public pension scheme 1) The proportion of pensioners to total working population. Although the surge in elderly populations is common to almost all developed countries, the extent of the rise varies hugely. Differences between countries are largely due to the extent of the baby boom and to immigration policy. Countries directly involved in World War II tend to have the most pronounced baby boom and thus face the largest demographic problem. The relatively small rise in the Swedish elderly population may be partly due to its neutral status in WWII. Immigration policy is also important, as immigration serves to smooth out the demographic profile. The difference between Japan’s and USA’s forecast demographic profile is partly due to differing rates of immigration.

.. .

57

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Population 65 and over as percentage of population 20 to 64 70% 60% 50%

Now

40%

2020 30%

2050

20% 10% 0%

m iu lg e B

a ad an C

ce an r F

y an

m er G

ly Ita

n pa Ja

s nd la r he et N

n ai Sp

en ed w S

S U

2) The generosity of the public pension scheme. In addition to the total amount spent on pensioners, the generosity of early retirement schemes is key to the fiscal cost of public pensions. If early retirement is encouraged, the state stands to lose twice over. First from the loss of tax revenue from an early retiree and second from the additional pensions it will need to pay out. The table below shows the current approach to early retirement for some of the major economies.

.. .

58

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Features of Public Pensions Schemes Country Early Retirement Normal Age Retirement Age Belgium 60 65 Canada 60 65 France 60 65 Germany 60 65 Italy 55 60 Japan 60 65 The 60 65 Netherlands Spain 60 65 Sweden 60 65 UK 60 70 USA 62 65 * Pension as a % of average income before retirement

Replacement Rate at Early Retirement* 77% 20% 91% 62% 75% 54% 91% 63% 54% 48% 41%

The table shows some marked contrasts. The French and Dutch pension systems are remarkably generous to early retirees - offering them over 90% of their pre-retirement income.

The Italian system is also very generous - allowing as it does early retirement at 55 and 75% of pre-retirement income. Whilst the relatively small increase in the elderly population makes the Dutch system less problematic, pension reform in Italy and Germany is urgent but politically perilous.

The UK, Canada and US, on the other hand, have managed to contain the pension problem simply by offering less generous support. In these countries, political pressure for more generous schemes is now becoming more intense.

.. .

59

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

% of GDP Currently Spent on Elderly (2000)* 18% 16% 14% 12% 10% 8% 6% 4% 2%

U S

U K

Ja pa N et n he rla nd s Sp ai n Sw e Sw den itz er la nd

Ita ly

Au st ra lia Be lg iu m C an ad a Fr an ce G er m an y

0%

* including health care etc.

The Impact of public pension provision on income of the elderly.

One major criticism of public pension provision is that it simply offers an insurance system that could easily be created privately. A demonstration of this effect is shown in the chart below. If generous public pensions were necessary, we should see higher incomes for pensioners (relative to non-pensioners) in countries with such provision. In fact, as the chart shows for a subset of nine countries, if anything we see the opposite which suggests that public pensions simply “crowd out” private saving for retirement.

.. .

60

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Elderly Income relative to non-Elderly Income vs. Spending on elderly

Elderly Income /Non-Elderly Income

110

100

90

80

70 3%

5%

7%

9%

11%

13%

% GDP on Elderly

The chart above seems to produce a very strong argument against the public provision of pensions. For example, Canada and Germany have similar ratios of elderly to non-elderly incomes despite Germany spending twice as much on the elderly.

However, the chart below gives a slightly different picture. It relates poverty amongst the elderly (income less than 40% of the country median) with spending on the elderly for a selection of countries. In this case, higher public pension provision does seem to reduce poverty amongst the elderly.

Poverty amongst the elderly vs. spending on the elderly % of elderly below 40% of median income

30% 25% 20% 15% 10% 5% 0% 0%

2%

4%

6%

8%

10%

12%

14%

% of GDP on elderly

Source: Gruber and Wise(2001) An International Perspective on Policies for an Aging Society, NBER © discussion Paper 8103

.. .

61

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Discussion Questions 1) Is generous pension provision by governments desirable? It is achievable?

2) Who should pay for pensions the recipients or their children or some combination?

Background Material DIGGING YOURSELF OUT OF A HOLE: JAPANESE FISCAL POLICY IN THE 1990’s When the Japanese “bubble” economy burst in 1990, Japan entered a prolonged period of low growth. The response of the Japanese Government was to try and stimulate growth through fiscal policy. The table below outlines the seven major stimulus packages that the Japanese Government undertook in the 1990s.

Japanese Economic Stimulus Packages Date announced Apr. 1993 Total Package (% of GDP) 2.8% Of which tax reductions (% 0.0% of GDP) Source: IMF * Temporary measures

Sep. 1993 1.3% 0.0%

Feb. 94 3.2% 1.2%*

Sep. 95 3.0% 0.0

Apr. 98 3.3% 0.9*%

Nov. 98 4.8% 1.2%

Nov. 99 3.6% 0.0%

However, as the chart below shows, these packages seem to have had little effect on the economy. Certainly, the fact that most tax reductions were explicitly introduced as temporary measures and that taxes were raised substantially in 1997 when a recovery seemed underway should have alerted Japanese consumers that the inter-temporal budget constraint was very much in operation. As a result, Ricardian Equivalence seems to be at work.

.. .

62

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Japanese Fiscal Policy and Growth 8 7 6 5 4 3 2 1 0

Tax increase

-1 -2

Fiscal Stimulus

-3 87

88

89

90

91

92

93

94

95

96

97

98

99

00

Japanese GDP growth (% p.a.)

Source: EcoWin

Japanese Fiscal Sustainability The combination of slow growth and a series of deficit-financed fiscal stimuli have had a significant impact on Japanese public finances. Over the 1990’s, gross government debt doubled from around 60% of GDP to 125% of GDP. However, as the table below shows, the situation is not quite as serious as these figures imply since the Japanese government hold a huge stock of assets as well as bearing a heavy burden of debt. On a net basis, Japanese public debt is not extreme by international standards – even though its deficit is.

General Government Finances 1999 (% of GDP) Canad Franc Germa Italy a e ny Fiscal Deficit 2.8% -1.8% -0.7% -1.9% Structural 3.3% -0.8% 0.7% -0.5% deficit* Gross Debt 88.1% 58.6% 61.1% 114.9 % Net Debt 56.7% 49.0% 52.4% 108.8 % * Fiscal Deficit adjusted for the business cycle

UK

US

Japan

0.3% 0.1%

0.0% -9.2% -0.2% -8.1%

44.8 % 39.0 %

62.4 % 50.6 %

125.4 % 38.1%

However, even though Japan holds a large stock of pension fund assets (net debt excluding these is 88% of GDP), they are still not sufficient to cover growing future pension liabilities. As a result, the IMF calculates that Japan will need to undertake a huge fiscal consolidation in order to stabilize its debt. Their analysis uses a version of equation 5 in Chapter 11, Section 5. p = (r-g)/(1+g)d

.. .

63

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

p = primary surplus required to stabilize the debt/GDP ration r = real interest rate g = real growth rate of GDP d = debt/GDP ratio Also allowing for gradual adjustment (i.e. they do not expect that Japan will be able to generate a primary surplus instantaneously) they calculate the following table of required primary surpluses for different growth and real interest rate scenarios.

Primary Surplus required to achieve debt stabilization in Japan (% of GDP) Real interest rate 2 3 3.5 4 5 Real 0.5 6.5 7.2 7.5 7.8 8.5 GDP 1 5.9 6.5 6.8 7.2 7.8 Growth 2 4.6 5.3 5.6 6.0 6.6 Rate 3 3.5 4.2 4.5 4.8 5.4 4 2.5 3.1 3.4 3.7 4.3 The bolded figure in the center is their central projection.

Source: IMF Article IV material 2000 SOVEREIGN CREDIT DEFAULT SWAPS Mechanics of a CDS • • •

Protection buyer (e.g. a bank) purchases insurance against the event of default (of a reference security or loan that the protection buyer holds) Agrees with protection seller (e.g. an investor) to pay a premium In the event of default, the protection seller has to compensate the protection buyer for the loss

.. .

64

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Consider a 1-year CDS contract and assume that the total premium is paid up front Let S: CDS spread (premium), p: default probability, R: recovery rate The protection buyer has the following expected payment: S His expected pay-off is (1-R)p When two parties enter a CDS trade, S is set so that the value of the swap transaction is zero, i.e.

S=(1-R)p S/(1-R)=p Example: If the recovery rate is 40%, a spread of 200 bp would translate into an implied probability of default of 3.3%.

Additional Questions Question 1) Look at the chart of South African GDP growth and fiscal deficits below. What explains the correlation between the two series?

.. .

65

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

Percent

South Africa: Government Borrowing and the Cycle 8

0.25

7

0.00

6

-0.25

5

-0.50

4

-0.75

3

-1.00

2

-1.25

1

-1.50

0

-1.75

-1

-2.00

-2

-2.25

-3

-2.50 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 GDP growth (LHS) [ar 4 quarters]

Budget Deficit % of GDP (RHS)

Source: EcoWin

Answer 1) As GDP rises tax revenues rise and expenditures (such as unemployment benefit) fall so the deficit shrinks. The opposite occurs in a recession. This is an example of automatic stabilizers since the fact that the deficit rises in a recession means that the government is partially offsetting the recession by an automatic move to deficit financed expenditure.

Question 2) The chart below shows net and gross government debt for a number of countries in 2000. What is explains the difference between net and gross debt?

.. .

66

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

150

100

50

0 in m ny da ce dom ece land lia giu ana rm a Spa ran ra l t re Ire s ng F G C Ge Be Ki Au d -50 ite Un

n ly s s y Ita apa and rwa land den tate J e lr e No Zea Sw ed S th e it w N Un Ne

-100

Answer 2) Gross debt is the total debt outstanding while net debt nets off any assets held by the government. So for example, the Norwegian government has a huge portfolio of shares it has purchased with it tax revenue from oil production (called the petroleum fund). Thus, although the government still has some debt outstanding, that debt is dwarfed by the stock of assets it holds.

Question 3) The table below shows OECD data for 2004 for four countries Countr y A B C D

debt/gdp ratio Primary (%) balance (% of GDP) 49.54 -3.43 85.66 -5.02 33.33 -1.37 54.51 -1.01

Nominal interest rate (%) 1.48 0.04 4.38 2.00

Inflation rate (%)

GDP growth (%)

1.74 -0.18 1.67 0.36

4.25 1.76 2.68 1.40

Calculate the sustainable primary surplus/deficit for each country and identify which countries (if any) have a potential debt crisis on their hands.

Answer 3)

.. .

67

CH A PT E R 1 8 So ver ei gn D ebt & D efa ult

a ) Formula is:

Primary Deficit = debt/gdp ratio * (g – r)

Where g and r are expressed as fractions (i.e. 1% = 0.01) and r is in real terms Note the answer gives sustainable deficit so a positive figure = a deficit Country A: 49.54*((4.25-(1.48-1.74))/100) = 2.24% Country B: 5.02*((1.76-(0.04+.18))/100) = 1.32% Country C: 1.37*((2.68-(4.38-1.67))/100) = -0.01% Country D: 1.01*((1.40-(2.00-0.36))/100) = -0.13% All four countries are running unsustainable primary deficits (deficits larger than formula allows) for countries A & B, the fact that growth is greater than the interest rate means that a primary deficit is allowed but the actual deficit is too large. For C & D growth below the interest rate means they should be running a primary surplus.

A, C and D are all only about 1% away from sustainability, so their problems do not look to severe, Country B is almost 4% away, indicating a significant debt problem. .

.. .

68

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

CHAPTER 19: EXCHANGE RATE DETERMINATION I INTRODUCTION This is the first of two chapters covering exchange rate issues. It contains considerable preliminary material on definitions etc. but has enough interesting ideas to keep it from being too dry. Even though the balance of payments is always quite heavy going, most students do appreciate the opportunity to understand concepts that they have read about in newspapers etc.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER To put exchange rate determination into context, it may help to start with the material at the beginning of Chapter 20 on the size of the FX market.

CHAPTER GUIDE 19.1 Types of Exchange Rate. Historically, Sterling, The Euro, The Australian and New Zealand dollars were quoted in terms of US dollars per unit of local currency because one unit of these currencies was worth more than one US dollar. Now only sterling and the Euro are worth more than one dollar (and the Euro was below 1 dollar for much of its short history).

19.2

Law of One Price. Recent estimates of the border effect suggest that the price differences between Japan and the US are equivalent to a pure distance effect of 43 trillion miles! (i.e. prices differ by as much as you would expect between two places in the same countries that are 43 trillion miles apart).

19.3

Purchasing Power Parity. The OECD also publishes estimates of PPP (based on a basket of goods, not just Big Macs!).

Note how poorer countries tend to look undervalued relative to their PPP rates in both the Big Mac and OECD figures (e.g. the Chinese Yuan is worth roughly half its Big Mac rate). This is due to the Balassa Samuelson effect.

19.4

The Balance of Payments. Another useful balance of payments definition is the Basic Balance. This is the current account plus long term capital flows (i.e. FDI and Portfolio flows). It is an important figure if you think 1) that shorter term flows (e.g. short term bank lending) are more likely to leave rapidly (they are often called ‘hot money’) 2) that longer-term flows such as FDI are more growth enhancing (see Background Material to Chapter 5). If these propositions are valid, countries with a large current account deficit but a basic balance near zero or in surplus do not have an underlying balance of payments problem (see the Case Study on Chile).

.. .

123

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

The IMF has calculated that adding together all the world’s current accounts produces an overall deficit of about $40 billion. Unless some countries are engaging in extraterrestrial trade, this is an indication of errors in data collection. The Background Material contains further information on the global balance of payments.

19.5

Who is Rich and Who is Poor? The Case Study on Chile shows how the acquisition of foreign debt can actually be good for growth. The experience of highly indebted countries is less favorable (see Case Study to Chapter 7).

19.6

Current and Capital Accounts and the Real Exchange Rate Note that the rise in Germany’s real exchange rate around the time of German Re-unification was one of the key underlying causes of the ERM crisis. Other European countries pegged to the DM could not justify a comparable exchange rate appreciation.

CASE STUDY: THE REAL PROBLEM WITH THE EURO. It is arguable that the current problems experienced by a subset of Euro-area countries related to their lack of competitiveness. What evidence is there for this view? If it is true, how did it come about?

Exhibit 1 shows the relationship between relative price levels and GNI per capita (see figure 19.6) for a number of European countries either in the Euro or applying to enter the euro.

Countries on the right of the line have, arguably, overvalued real exchange rates (and vice versa for those on the left)

.. .

124

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

Exhibit 1: EXCHANGE RATE VALUATION: SELECTED EUROPEAN COUNTRIES Ratio of Market Real Exchange Rate to PPP rate (2010)

Current account data seem to support this interpretation (overvalued countries have large deficits)

.. .

125

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

Exhibit 2: Current Account Balances (% of GDP) 2011

Exhibit 3 suggests that it was higher inflation post EMU entry that was the course of these overvaluations Exhibit 3: Total increase in Consumer Prices since the introduction of the Euro

And the developing overvaluations may explain the low growth in some euro countries post 2005

.. .

126

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

Exhibit 4: Average Growth since the introduction of the Euro and since 2005

Discussion Questions 1) Is exchange rate competitiveness the key problem within the Euro-Area?

2) Why has inflation continue to vary within the Euro-area?

3) What action can policy-makers take to deal with differences in competitiveness with the euro-area?

.. .

127

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

Background Material THE GLOBAL CURRENT ACCOUNT The table below shows the global current account which, of course, should be in balance.

Although the global current account deficit seems to be declining (there was even a surplus in 1997), this is not due to an overall improvement in data collection but simply to increasing and offsetting errors in the income balance and the trade balance figures.

The Global Current Account ($bn) 199 199 1 2

Current Account -102 -102 Balance Trade Balance 33 39 Services Balance -40 -28 Income Balance -65 -70 Current transfers -30 -42 balance Source: IMF

199 3

199 4

199 5

199 6

199 7

199 8

-62

-36

-34

-19

32

-37

Averag e 199198 -45

67 -18 -67 -44

97 -4 -74 -56

115 -13 -88 -48

98 -1 -84 -31

117 17 -83 -19

80 12 -109 -20

81 -9.6 -80 -36

Additional Questions Question 1) The Table below shows balance of payments data for Sri Lanka in 2001 ($ million). a) Fill in the cells marked y) and z) b) How could have Sri Lanka financed its overall balance of payments deficit Balance of Trade Balance of Services Investment Income Net Transfers Current Account

-1406 272 -251 1097 y)

Capital Account Net direct Investment Net Portfolio Flow

55 252

Net Other Errors & Omissions Overall Balance

-456 z) -331

2

Answer 1a) y) = -290 (simply the sum of all the figures above) z) = 106 (overall balance - current account - sum of all figures above errors & omissions) Answer 1b) It could run down its FX reserves or get some financing from the IMF .. .

128

CH A PT E R 1 9 E xch ang e R ate De term in ati on I

Question 2) Look at the chart of Malawi’s real and nominal effective exchange rate (REER and NEER respectively). Describe what is happening to Malawi’s inflation rate and overall competitiveness

Malawi: real and nominal effective exchange rate 1750

1500

Index Number

1250

1000

750

500

250

0 76

78

REER

80

82

84

86

88

90

92

94

96

98

00

02

04

NEER

Source: EcoWin

Answer 2) Over the period 1980 to 2000, Malawi’s inflation rate is clearly far higher than that of its trading partners, thus the NEER declines sharply whilst the REER declined only marginally.

However, the fact that the REER is declining indicates that Malawi’s competitiveness is improving (though in periods of high inflation, price mis-measurement may be a problem)

.. .

129

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

CHAPTER 20: EXCHANGE RATE DETERMINATION II INTRODUCTION This chapter introduces some tough concepts such as uncovered interest rate parity. However, the material is empirically very relevant so that creating interest in these concepts should be no problem. Getting students fully to understand them may prove a trifle more difficult.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter has two distinct sections - UIP and currency crises - which could be covered in two separate lectures. For example, UIP could be discussed along with the material in Chapter 19.

CHAPTER GUIDE 20.1 The Importance of Asset Markets. The introduction of the Euro has probably resulted in a decrease in total turnover in the FX market. The Background Material shows some estimates of turnover in the DM and Euro.

20.2

Covered Interest Parity. The Background Material shows a real example of forward rates based on the market convention of quoting forward points.

20.3

Uncovered Interest Parity. FX trades that involve borrowing a low interest rate currency and investing in a high interest rate one are called ‘carry trades’. This is because you earn more interest on the investment than you have to pay on your borrowings and even if the exchange rate doesn’t move, you still earn the ‘carry’. In recent times, borrowing Japanese Yen (0% interest rates) and investing in US dollars (5% interest rates) has been a popular carry trade since Japan’s current economic weakness leads many to think that the Yen is unlikely to appreciate against the dollar.

20.4

Pinning Down the Exchange Rate with UIP. This is one of the toughest sections in the book and students who struggle with it are going to be mortified to learn that it doesn’t work in practice!

20.5

The Role of Expectations. The Background Material shows some diagrams relating to the effect of nominal and real interest rate increases

20.6

Does UIP Hold? In order to minimize the disappointment that students could feel when UIP is shown not to work, it may be worth pointing out the up-side i.e. this is a moneymaking strategy.

20.7

Introducing Risk-Averse Investors. Another way to look at this issue is to ask students whether the excess returns shown in the chart below are worth the volatility.

.. .

129

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

20.8

What Are Exchange Rate Markets Really Like? Although many economists dismiss technical analysis (the study of charts for certain patterns that are supposed to predict future movements), there is some evidence that it actually works. For further information on technical analysis see Neely(1997) “Technical Analysis in the Foreign Exchange Market: A Layman’s Guide” Reserve Bank of St Louis Review Vol. 79 no. 5.

20.9

Global Capital Markets The second case study looks at Malaysia’s experience with capital controls.

20.10 A Home Bias Puzzle The fact the people are exposed to their own economy both through their labour income and through non-financial assets such as housing makes the home bias puzzle in financial assets even more puzzling CASE STUDY: DOES FOREIGN EXCHANGE INTERVENTION WORK? What is foreign exchange intervention?

In its simplest form, foreign exchange intervention involves a Central Bank buying currency A and selling currency B with the aim of increasing the value of A against B. When currency A is the local currency, the Central Bank must run down its reserves of foreign exchange in order to buy its own currency. If it is trying to weaken it own currency, it builds up its foreign exchange reserves by selling its own currency.

However, within that simple definition, there are many different forms of intervention. Below is a list that is ordered roughly in terms of effectiveness.

1) Unsterilized intervention. If a Central Bank is supporting its own currency by purchasing it using foreign exchange reserves, this will tend to reduce the money supply. If the Central Bank does nothing else (i.e. leaves the intervention unsterilized), the reduction in the money supply will increase interest rates – potentially, quite sharply. Clearly, this form of intervention - combining foreign currency intervention with interest rate changes - can be very effective.

2) Sterilized intervention. In the majority of cases, foreign exchange intervention is sterilized. The purchase of domestic currency with foreign exchange will be followed (two days later when the FX transactions settle) by the open market operation of buying domestic bonds to increase the money supply by an offsetting amount. This open market operation is said to ‘sterilize’ the money supply impact of FX intervention.

The following – highly stylized – Central Bank balance sheet helps show the difference between sterilized and unsterilized intervention.

Simple Central Bank Balance Sheet Assets FX reserves

Liabilities Money

.. .

130

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

Government Bonds Since the balance sheet has to balance (assets = liabilities), if the central bank changes FX reserves (i.e. undertakes FX intervention it must change some other part of its balance sheet as well. In unsterilized FX intervention, the change in FX reserves leads to an equal change in money supply (so an increase in FX reserves leads to an equal increase in money supply). In sterilized intervention, the Central Bank simply reconfigures the asset side of the balance sheet leaving total assets (and so total liabilities) unchanged. This means that an increase in FX reserves is offset by a decrease in holding of domestic assets (government bonds) and vice versa for a decrease in FX reserves.

3) Concerted Intervention. Since Central Banks and Finance ministries around the world are in constant contact, two or more Central Banks may choose to intervene in a certain currency together. The purpose of such concerted intervention is to demonstrate international agreement that a certain currency is out of line. G7 meetings are traditionally the venue where such agreements are made.

4) Overt or Reported intervention. Since a Central Bank only undertakes foreign exchange intervention with counterparties who are required not to reveal that the transaction has taken place, it can elect whether or not to reveal its own intervention activity. In recent years, almost all intervention in the major currencies has been overt.

5) Covert or Secret intervention. A Central Bank will sometimes choose not to reveal that it has intervened. It may so decide if it feels that foreign exchange market participants are concerned that foreign currency reserves are falling dangerously low.

Is Foreign Exchange Intervention Effective?

For many years, the general view of foreign exchange intervention was that unsterilized intervention could influence exchange rates but that sterilized intervention could not. In a foreign exchange market that trades over $1 trillion a day, it was argued, a few billion dollars of foreign exchange intervention is neither here nor there.

The evidence for this notion lies in currency movements on a day of unsterilized intervention.

There is often a tendency for the exchange rate to react initially but to fall back to its original level by the end of the day. However, as the charts below show, over longer horizons intervention does appear to work. In the major currencies at least, Central Banks have tended to buy currencies when they were low and sell them when they were high. Thus, if we use the simplest measure of effectiveness – whether the currency intervention was profitable for the Central Bank – sterilized intervention has been largely effective over the long term.

In detail, the charts below show periods of dollar buying (lighter shaded) and dollar selling (darker shaded) against the Japanese Yen and German DM. Although the shaded areas show when the period of intervention began and ended, there were only a few days of actual intervention in each period. In the case of Dollar/Yen, intervention has been quite common (the Japanese authorities have long aimed to stabilize this exchange rate) and conducted over long .. .

131

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

periods. However, the chart shows how most periods of intervention were eventually followed by exchange rate moves in the desired direction so that the Bank of Japan has generally made a profit from its intervention.

Intervention in Dollar/DM has been more infrequent, but does seem to have been successful.

Furthermore, the recent intervention by the ECB to support the Euro (shown at the end of the chart) does appear to have succeeded.

Intervention History: Dollar/Yen 160 150 140 130 120 110 100 90 80 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Source:

EcoWin

Intervention History: Dollar/DM 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Sourc e:

Ec oWin

Despite this successful longer-term record, economists and policy-makers are still unclear about what factors determine the success of sterilized intervention. Generally, it is felt that .. .

132

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

intervention is more successful if it is concerted and/or signals a future change in monetary policy.

Allocation of Foreign Exchange Reserves.

In order to be prepared to undertake foreign currency intervention, most Central Banks hold large amounts of foreign currency (usually invested in the government bonds of the relevant foreign country). As the table below shows, Far East economies in particular tend to hold large amounts of foreign currencies.

.. .

133

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

Foreign Exchange Reserves: Selected Countries 1999 Country Gross Reserves US$ Import Cover billion (months)* Australia 21.6 2 Brazil 37.8 5 Canada 37.2 1 China 297.7 10 France 61.7 2 Germany 89.1 1 Japan 469.6 13 Mexico 50.7 3 Mozambique 0.8 5 Russia 48.3 6 United 42.8 1 Kingdom United 157.8 1 States Zimbabwe 0.1 0 * Import Cover is the number of months of imports that could be financed solely by foreign exchange reserves Source: World Bank Although most of these reserves are held in US dollars, many commentators expected the introduction of the Euro to alter the balance of holdings by inducing Central Banks to hold more Euros in their reserves. As the chart below shows, this has not yet happened.

Currency Allocation of Global Foreign Exchange Reserves 80% 70% 60%

USD

50%

Euro Area

40% 30% 20% 10%

JPY

19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02

0%

Source: IMF Discussion questions 1) Does sterlized FX intervention work?

2) Will the US dollar lose its dominant position as the world’s reserve currency? Does it matter if it does? .. .

134

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

Background Material FORWARD RATES IN PRACTICE The table below shows how forward rates are quoted in practice. The convention is to quote forward points – number of units that need to be added to or subtracted from the current spot rate. Confusingly, 10 forward points is actually 10/10000 for currencies quoted to four decimal places and 10/100 for currencies quoted to two decimal places. So, for example, if the spot rate is 1.0000 and the 3 month forward points are 100, the 3 month forward rate is 1.0100.

Euro Forward Rates (22/7/04) Spot eur/usd US Interest Euro interest Eur/Usd Forward 0.8837 rate rate points 1 month 1.4% 2.1% -7.0 3 month 1.6% 2.1% -19 1 year 2.3% 2.3% -2 FX TURNOVER AND THE INTRODUCTION OF THE EURO FX Turnover in Euro and DM (Daily turnover in $bn)

65 $/DM turnover in 1998

55

45 EUR/$ turnover in 1999

35

25 January

April

July

October

Source: EBS The chart shows how turnover in the Euro/dollar in 1999 was lower than the dollar/DM turnover in 1998 (according to data from the EBS brokerage system). This decline added to the

.. .

135

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

loss of turnover in all the other legacy currencies (e.g. French Francs and Italian Lira) implies that total FX turnover has declined since the introduction of the Euro.

Additional Questions Question 1) Assuming the uncovered interest rate parity and PPP hold, sketch the predicted impact of a) a temporary rise in real interest rates b) a temporary rise in nominal interest rates matched by an equal rise in inflation Answer 1) The diagrams below go through two examples of the theoretical impact of increased interest rates on exchange rates. The first shows an increase in interest rates that is also an increase in real interest rates. The second shows an increase in nominal interest rates that is accompanied by an equal increase in inflation (i.e. unchanged real interest rates).

Real and nominal interest rate increase increase only

Nominal Ex. Rate

Nominal Ex. Rate

Real Ex. Rate

Real Ex. Rate

Nominal Interest Rate

Nominal Interest Rate

Time

Nominal interest rate

Time

The key lesson from the diagrams is that the exchange rate will not react to an increase in interest rates if it is simply offsetting an increase in inflation. In market terms, this is called being “behind the curve” because if the Fed is seen as raising interest rates after inflation has already taken hold, the exchange rate need not rise. If they are “ahead of the curve” – raising interest rates to prevent the onset of inflation – the exchange rate may rise.

Question 2) What share of currency transactions involve the US dollar?

Answer 2) About 90%. Almost all exchange rates actually traded have the US dollar on one side of the transaction. So, for example, if you wanted to sell Thai Baht and buy Israeli Shekels in the FX market you would actually have to sell Thai Baht and buy US dollars and then sell US dollars and buy Israeli Shekels. Thus the US dollar acts as a vehicle currency since no market participants directly trade the Baht against the Shekel..

.. .

136

CH A PT E R 2 0 E xch ang e R ate De term in ati on II

% share of currency transactions involving the major currencies 100 90 80 70 60

Dollar Euro Yen

50 40 30 20 10 0 1992

1995

1998

2001

euro = sum of legacy currencies prior to 1999

.. .

137

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

CHAPTER 21: CURRENCY CRISES & EXCHANGE RATE SYSTEMS INTRODUCTION As the final chapter of the three devoted to exchange rate issues, it is something of an overview of exchange rate systems. Its discussion of global capital markets returns us to the theme of the pros and cons of international capital flows.

Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Like the previous chapter, this one has two distinct sections - currency regimes and international capital flows. Currency regimes have a natural link with the material on monetary policy in Chapter 17, whilst international capital flows link into several previous chapters e.g.

Chapter 7.

CHAPTER GUIDE 21.1 Currency Crises. We saw in Chapter 13 (figure 13.10) that despite a number of currency crises, the popularity of fixed exchange rate regimes has hardly diminished.

21.2

First Generation Models This model shows how fiscal policy can be at the heart of currency crises and justifies the IMF’s tendency to focus on fiscal issues when it is dealing with currency crises situations (remember “Its Mostly Fiscal” from chapter 9.

21.3

Second-Generation Models Just prior to the ERM crisis, the UK government took out a large foreign currency loan – since the loan would become more expensive to pay back if sterling devalued, the loan could have been seen as a way for the UK government to publicly increase the costs of devaluation and thus make an attack less likely.

21.4

Twin Crises: Banking and Currency The IMF has been criticized heavily for its part in the Asian Crises. First by encouraging financial liberalization without a corresponding focus on improving banking regulation many argue that it sowed the seeds for the crisis.

Second, when the crisis occurred, those that followed IMF advice generally did worse than those that ignored it (see case study below).

21.5

Foreign Exchange Rate Intervention see chapter 20 case study for more on FX intervention.

21.6

Sovereign Wealth Funds This can be linked to the curse of natural resources discussed in chapter 6.

.. .

135

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

21.7

The Role of the IMF The IMF has other roles as well as lending to deal with short term balance of payment crises, though many of these are arguably the result of ‘mission creep’.

21.8

Capital Account Liberalization see case study below for the Malaysian experience.

21.9

Exchange Rate Regimes Note that dollarization has a significant financial disadvantage relative to a dollar-based currency board. A currency board is backed by interest-bearing dollar assets (such as US government bonds) while using actual US dollars is effectively giving the US government an interest free loan (i.e. greater seignoirage income). It is estimated that about two-thirds of all US dollar notes are held outside the US and that the US Treasury earns 0.2% of GDP every year from these interest free loans from foreigners (partly from dollarized economies but mainly from the black market use of US dollars).

Some countries have implicit currency boards that act as a single currency. For example, Scottish pound notes (issued by the Scottish commercial banks) are backed one-for-one

by Bank of England notes and are accepted almost universally as interchangeable (with the exception of London taxi drivers who presumably fear an imminent Scottish currency crisis).

21.10 Currency Boards The background material gives some details on the unsuccessful attack on the Hong Kong Currency Board during the Asian Crisis 21.11 Currency Unions The case study in chapter 20 discusses the issue of real exchange rate misalignment in the euro-area CASE STUDY: CAPITAL CONTROLS IN MALAYSIA In the middle of the Asian Crisis, Malaysia decided to impose capital controls. Although widely criticized at the time, the Malaysian experience suggests that the controls may have helped in their recovery.

Introduction There is a growing acceptance that limited capital controls can be used as a prudential measure – to prevent the build-up of short-term foreign liabilities that can be de-stabilizing. In the words of the IMF’s former chief economist (Michael Mussa) “high openness to international capital flows, especially short-term credit flows, can be dangerous for countries with weak or inconsistent macro-economic policies or inadequately capitalized and regulated financial systems”. However, their use as a crisis-resolution measure, as in Malaysia in 1998, is far more controversial.

The introduction of capital controls When Malaysia instituted capital controls in September 1998, the Malaysian Ringgit was under heavy speculative pressure. The measures were draconian - banning all offshore trading in .. .

136

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

Ringgit assets and imposing an exchange rate of 3.8 ringgit to the dollar. The regime was eased somewhat in 1999 in order not to penalize foreign direct investment. The overseas reaction to these measures was hostile - Forbes International declared that “Foreign investors in Malaysia have been expropriated, and the Malaysians will bear the cost of their distrust for years”. In October 1998 the IMF argued that “Capital controls may also turn out to be an important setback not only to that country’s recovery and potentially to its future development, but also to other emerging market economies”. The criticism intensified later that year when Malaysian Prime Minister Mahathir Mohammed had his free-market rival and deputy prime minister Anwar Ibrahim arrested.

However, the criticism quickly subsided as, against all predictions, the Malaysian economy began a strong recovery. By October 1999, the IMF was forced to admit “a strong recovery is also now under way in response to fiscal and monetary stimulus and the pegging of the exchange rate at a competitive level”.

Malaysia’s recovery – domestic or regional?

While very few would argue that capital controls held back Malaysia’s recovery, was that recovery supported by controls or was it simply part of a wider regional recovery? The chart below shows that the exchange rate imposed by capital controls was little different to that experienced elsewhere in the region. The 50% appreciation of the US dollar against the Ringgit experienced after 1996 was almost identical to that experienced by Thailand and South Korea whilst the currency stability that strict capital controls created was also partially experienced by those two countries. It should however be noted that whilst both Thailand and South Korea had a partial system of capital controls in place over this period, Indonesia with no controls experienced a far sharper depreciation. Overall, however, capital controls may not have significantly altered the path of the Malaysian Ringgit.

Asian Currencies against the US dollar (Index, 1996=100) 250 225 200 175 150 125 100 75 Apr Jul Oct Apr Jul Oct Apr Jul Oct 98 99

Malaysi a Exchange rat Thailand Exchange rate South Korea Exchange Sourc e:

Ec oWin

.. .

137

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

The chart below also shows that the Malaysian recovery, though strong, was not greatly different from that of other countries involved in the crisis.

GDP in the Asian Crisis Countries (Index 1996=100) 125 120 115 110 105 100 95 90 85 80 75 94

95

96

97

98

99

00

Malaysi a GDP (1996=1 Thailand GDP (1996=1 South Korea GDP (199 Indonesi a GDP (1996= Sourc e:

Ec oWin

However, Kaplan and Rodrik (2001), argue that capital controls did help Malaysia’s recovery.

They point out that Korea and Thailand had just received large IMF loans that had begun to restore investor confidence. Malaysia, on the other hand, was just about to enter its own economic crisis. Since PM Mahathir was probably already considering imprisoning Anwar before imposing controls, it is clear that the controls prevented the huge outflow of foreign capital that such an event would have instigated. Given that background, one can imagine that Malaysia could easily have entered the sort of vicious circle of political and economic crisis experienced in Indonesia.

While Kaplan and Rodrik’s argument is plausible, it is a counterfactual and hard to prove either way (i.e. compares the actual outcome with one that did not occur). Firmer evidence in favor of capital controls comes from Malaysian interest rates. As the table below shows, capital controls allowed Malaysia to cut their interest rate well below that of other Asian economies which needed high interest rates to prevent outflows of capital.

.. .

138

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

Asian Interest rates (January 2000) Malays ia Nominal Interest 3.1% Rate Real Interest 1.5% Rate

South Korea 7.1%

Thailan Indones d ia 5.2% 9.9%

5.5%

4.6%

9.3%

Conclusion Despite heavy criticism at the time, Malaysia’s experience of imposing capital controls in the midst of a regional crisis seems to have been favorable. It is hard to argue that the controls did any harm to the economy and it seems likely that the lower interest rates that the controls allowed probably helped the economy to recover. However, their longer-term effects on foreign direct investment have yet to be seen.

Kaplan and Rodrik (2000) “Did the Malaysian Capital Controls Work?” NBER © WP8142 Background Material CURRENCY BOARDS UNDER PRESSURE: HONG KONG IN 1997/98 The failure of the Argentinian currency board was the first cases of a successful speculative attack against a board. Hong Kong in 1997/98 is a good example of how currency boards can resist speculative attacks, as Hong Kong managed to keep its link to the US dollar despite of the Asian currency crises that brought down many of its near neighbors (see additional questions for more on Hong Kong’s adjustment to the asian currency Crises.

Hong Kong’s peg against the US dollar (HK$7.8 = US$1) was almost bound to come under pressure during the asian currency crises. However, the pressure lasted far longer than expected and came to a head in August 1998. It was the vulnerability of Hong Kong’s huge equity market to speculative pressure that proved to be the weak point. Speculators realized that sending the Hang Seng Index spiraling down was the best way to attack the peg. In the end, the Hong Kong Government abandoned its free market principles and undertook a massive share support operation – buying $15 billion of shares in Hong Kong companies.

Hong Kong Crisis Timeline July 1997 August 1997 October 1997 January 1998

Hong Kong handed over to China followed a day later by the collapse of the Thai Baht.

Hong Kong spends US$1bn defending its currency.

Hong Kong dollar comes under renewed pressure following the float of the New Taiwan Dollar.

Speculation that the Chinese Renminbi will devalue hits the Hong Kong Dollar.

.. .

139

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

June 1998 August 1998

Government announces a US$4bn housing market support program.

Hong Kong government spends $15 billion purchasing local shares after the Hang Seng Index falls 60% in a year. The Hang Seng then begins to recover.

US and Hong Kong 1 month interest rates

50 45 40 35 30 25 20 15 10 5 0 May Sep May Sep May Sep May Sep May Sep 97 98 99 00 01

Hong Kong 1 m onth HIB USA 1 m onth LIBOR inte Source:

EcoWin

Additional Questions Question 1) Study the chart below showing Hong Kong Exchange Rates around the Asian currency crisis. Describe what happened to Hong Kong’s competitiveness before, during and after the crisis. What were the key drivers of Hong Kong’s competitive position?

.. .

140

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

Hong Kong Exchange Rates 117.5

9.00

115.0 112.5 110.0

8.00

USD/HKD

Index

107.5 105.0 102.5

7.00

100.0 97.5 95.0 92.5

6.00 Jan

May Sep Jan May Sep Jan May Sep Jan May Sep 96 97 98 99 US Dollar/Hong Kong Dollar Exchange Rate (LHS) Hong Kong Nominal Effective Exchange Rate Index (RHS) Hong Kong Real Effective Exchange Rate Index (RHS)

Jan

May Sep 00

Source: EcoWin

Answer 1) Since Hong Kong is in a currency board pegged to the US dollar, its dollar exchange rate was unchanged throughout this period (though it did come under some pressure – see background material). However, both its nominal and real effective exchange rates changed considerably. Before the crisis the nominal exchange rate was rising (due mainly to a dramatic weakening of the Japanese Yen against the dollar – and therefore the Hong Kong Dollar between 1994 and 1997). At the same time, the real effective exchange rate rose even faster indicating the Hong Kong’s inflation was rising faster than its trading partners (as the Hong Kong economy was over-heating). This meant that even before the Asian currency crisis occurred, Hong Kong exchange rate was quite uncompetitive.

When the crisis occurred Hong Kong’s nominal and real effective exchange rates rose sharply as a number of its trading partners (e.g. Thailand, Malaysia, Indonesia and Singapore) saw their exchanges rates fall significantly against the US and Hong Kong Dollar.

After the crisis, Hong Kong’s nominal effective exchange rate stayed at quite high levels, but its real exchange rate fell significantly. This occurred because of a huge disinflation in Hong Kong (by 1999 prices in Hong Kong were falling by over 7% p.a.!), the disinflation thus allowed Hong Kong to regain its competitiveness without having to devalue its currency. It is a testament to the flexibility of the Hong Kong economy that such a rapid disinflation was achieved so quickly.

In the case of Argentina, the economy was not so flexible and so its inflation rate remained above that of it competitors even in the midst of recession. .. .

141

CH A PT E R 2 1 Curr enc y Cr i ses an d E xch ang e Rat e S yst ems

Question 2) Look at the chart of the Ukrainian Hryvania exchange rate against the euro and dollar below. a) can you tell from the chart what type of exchange rate regime is operated by the Ukrainian National Bank? b) Do you think this is an appropriate currency regime for Ukraine?

7 6 5 4 3 2 1 95

96

97

98

99

00

01

02

03

04

US dollar/Ukrainian Hryvania Exchange Rate Euro/Hryvania Exchange rate

Source: EcoWin

Answer 2a) From the fact the to Hryvania is largely stable against the US dollar but has periodic shifts, it looks like an adjustable (or intermediate) peg against the US dollar.

Answer 2b) Although it is hard to make any comments about the currency regime without a detailed knowledge of the Ukrainian economy, it is worth pointing out that intermediate regimes such as this are becoming rarer and rarer. Also, a peg against the dollar is always problematic for a country that does not undertake much trade with the US (Ukraine’s major trading partners are Russia and the Euro-area.

.. .

142