Monetary Policy needs help

September 28, 2016 Leave a comment

In the 1970’s and 1980’s the global economy was battling the menace of stagflation – high inflation and high unemployment. In order to counteract this, monetary policy was seen as responsible for controlling the inflation rate through the adoption of targeting. The New Zealand government was the first country to introduce this through the Reserve Bank Act 1989 which gave the responsibility of the central bank to keep inflation between 0-2% (later changed to 1-3%). Monetary policy should therefore play the lead role in stabilizing inflation and unemployment with fiscal policy playing a supporting role with automatic stabilisers –  economic stimulus during economic downturns and economic contractions during high growth periods. Fiscal policy is therefore focused on long term objectives such as efficiency and equity.

In the post financial crisis world the usefulness  of monetary policy is dubious. The natural rate of interest has now dropped to historical low levels. The natural rate of interest being a rate which is neither expansionary or contractionary. The issue for the central banks is how to bring about a stable inflation rate when the natural rate of interest is so low.

Historical Natural Rates of Interest 

inflation-n-rate-of-interest

In the 1990’s the natural rate of interest globally was approximately between 2.5% and 3.5% but by 2007 these rates had decreased to between 2 – 2.5% – see graph. By 2015 the rate had dropped sharply and as can be seen from the graph near zero in the USA and below zero in the case of the euro zone. The reasons for this decline in the natural rate were related to the global supply and demand for funds:

 

  • Shifting demographics and the ageing populations
  • Slower trend productivity and economic growth
  • Emerging markets seeking large reserves of safe assets
  • Integration of savings-rich China into the global economy
  • Global savings glut in general

Therefore the expected low natural rate of interest is set to prevail when the economy is at full capacity and the stance of monetary policy in neutral. However this lower rate means that conventional monetary has less ammunition to influence the economy and this will mean a greater reliance and other unconventional instruments – negative interest rates. In this new environment recessions will tend to be more severe and last longer and the risks of low inflation will be more likely.

Future strategies by to avoid deeper recessions.

Governments and central banks need to be a lot more creative in coping with the low natural rate environment. Fiscal policy could be used in conjunction with monetary policy with the aim of raising the natural rate. Therefore long-term investments in education, public and private capital, and research and development could be more beneficial. More predictable automatic stabilisers could be introduced that support the economy during boom and slump periods. Additionally unemployment benefit and income tax rates could be linked to the unemployment rate. The reality is that monetary policy by itself is not enough especially as the natural rate of interest  and the inflation rate are so low. What can be done:

  1. The Central Bank would pursue a higher inflation target so therefore experiencing a high natural rate of interest which leaves more room to cut to stimulate demand. The logic of this approach argues that a 1% increase in the inflation target would offset the harmful effects of an equal-sized decline in the natural rate
  2. Inflationary targeting could be replaced by a flexible price-level of nominal GDP, rather than the inflation rate.

Conclusion

Monetary policy can only do so much but with global interest rates at approximately zero there needs to be the support of the politicians to enlist a much more stimulatory fiscal policy. Monetary policy has run out of ammunition and we cannot rely on central banks to fight recessions. However a less politicised fiscal policy, which is free to act immediately, has the ammunition to revive the economy.

Sources:

Monetary Policy in a low R-star World – FRBSF Economic Letter

The Economist: September 24th 2016 – The low-rate world

AS Economics Unit 4 – Fixed exchange rates and the end of the Gold Standard

September 26, 2016 Leave a comment

Currently doing some revision on fixed exchange rates which is now part of Unit 4 in the new CIE AS syllabus. The following post is an explanation of how fixed exchange rates worked. For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of NZ can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZdollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

The arrival of the floating exchange rate system – 15th August 1971

Under the Bretton Woods regime, world currencies were pegged to the dollar, which in turn was tied to a set price of gold. Central banks had the right to convert their dollar holdings into bullion. But on August 15th 1971 Nixon, in the face of economic difficulties, closed the gold window, devalued the dollar against bullion and imposed a 10% surcharge on imports. The era of paper money and floating exchange rates had arrived. Below is a news clip of President Nixon announcing the end of trading gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed.

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Indifference Curves and Giffen Goods

September 23, 2016 Leave a comment

New to the A2 CIE syllabus is indifference curves and my A2 class recently had a multiple-choice question concerning indifference curves and giffen goods. A giffen good occurs when a rise in price causes higher demand because the income effect outweighs the substitution effect.

Suppose you have a very low income and eat two basic food stuffs rice and meat. Meat is a luxury and is much more expensive than rice. If rice increased in price, your disposable income is effectively reduced significantly therefore, you buy less meat, to compensate for less meat you buy more rice to gain enough calories. Source: www.economicshelp.org

Griffen good and indifference curves

indiff-giffen

  • Good B falls in price – hence budget line moves from: 50 A – 30 B to: 50 A – 60 B.
  • The move from point J to point K is the substitution effect which = +16
  • The move from point K to point L is the income effect which = -20
  • These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = -4

As income effect is negative, substitution effect positive and overall price effect negative Good B is a giffen good.

Summary of income and substitution effects of price changes

sub-income-effect

Go to eLearn Economics for more notes on Indifference Curves.

Monopsony power in the labour market and the minimum wage

September 19, 2016 Leave a comment

Min Wage 2011In 1894 New Zealand made history by being the first developed nation to introduce a minimum wage. The Economist had an article on minimum wages and the fact that they might in fact be good for an economy. Most economists believe that a higher minimum wages = the artificial increase in labour costs and therefore lower demand for labour.

Some economists have suggested that minimum wages can increase employment and obviously pay. However if employees have monopsony power as buyers of labour and are able to influence wages they can keep the wages lower below its competitive rate – see graph below.

Two economists (David Carr & Kruegger) found out in New Jersey that when the minimum wage was raised employment in fast-food restaurants actually increased. The Economist suggests that if firms are not reducing the number of their employees with higher minimum wages they must be employing a number of strategies such as raising prices of their goods/services or saving money from reduced revenue. The IMF state that a moderate minimum wage (30-40% of the median wage – see graph) doesn’t have a significant negative effect on employment numbers and may do some good.

Monopsony in the Labour Market

Monopsony Lab

A monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. Unlike other examples we have looked at, in this situation we are now dealing with an imperfect rather than a perfectly competitive market. The monopsonist will hire workers where:

Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)

From the perspective of the monopsonist firm facing the supply curve directly, if at any point it wants to hire more labour, it has to offer a higher wage to encourage more workers to join the market – after all, this is what the ACL curve tells it. However, the firm would then have to pay that higher wage to all its workers so the marginal cost of hiring the extra worker is not just the wage paid to that worker, but the increased wage paid to all workers as well. So the marginal cost of labour curve (MCL) can be added to the diagram.

If the monopsonist firm wants to maximise profit, it will hire labour up to the point where the marginal cost of labour is equal to the marginal revenue product of labour. Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.

In this situation the power of the employer in the labour market is of overriding importance and the employer can set a low wage because of this buying power.

Sharemarket investors and the endowment effect

September 17, 2016 Leave a comment

I cover the endowment effect as part of the Behavioural Economics course that I teach. The example that I use was aired on the PBS TV channel and was an experiment at the University of Chicago where students are told to work out how much they would be prepared to pay for a travel mug – they offered an average price of US$6 per mug. Then some of the students were given the same mug for nothing and an hour later, asked how much they’d be willing to sell it for. In rational economics, the price should be exactly the same but when asked they now wanted US$9 for the mug. The emotional pleasure of owning something for just an hour pushed the price up by 50 percent. It’s an unexpected outcome, suggesting we are unaware of the emotions that drive this behaviour.

Endowment effect in the Indian stockmarket

Recent research (Endowment effects in the field: Evidence from IPO lotteries in India Santosh Anagol, Vimal Balasubramaniam, Tarun Ramadorai – 2016) use a real life experiment in the Indian stockmarket to study the endowment effect. It focuses on the floatation of new companies on the Indian stockmarket referred to as initial public offerings (IPOs). When the Indian IPO’s are oversubscribed issuers use a lottery to ensure that winners received a fixed number of shares of the IPO stock whilst the losers in the lottery receive zero shares.

  • Winning investors are allocated shares on the floatation of the company
  • Losing investors can buy only after the issue of the IPO’s start trading.

The researchers tracked the behaviour of 1.5 million winners and losers in the lottery following the random endowment of the stock in lotteries in 54 IPOs occurring between 2007 and 2012. What they are tracking is the propensity of winners and losers to hold IPO stock following random allocation. The randomisation ensures that winners and losers are (based on forecasts) identical in terms of their information sets, beliefs, and preferences. Moreover, they have equal opportunities to trade once the stock is listed in the market. If endowment effects do not exist in this setting, holdings of the randomly allocated stock amongst winners and losers should converge rapidly over time.

Findings

endowment-effect

The authors also find that the estimated endowment effect has little relationship with listing gains on the first day – the average IPO increase in price is 52% suggesting among other things that these effects are not driven by a wealth effect accruing to lottery winners. However, after 12 months the IPO price falls by 54% so you would expect lottery winners to off load their shares after the first day’s trading and for the losers to buy stock which is much cheaper.

Another finding is that when IPO returns are substantially greater than a winner’s previously experienced returns they are more likely to sell the IPO stock, and losers are more likely to buy the stock. That is to say, the endowment effect reduces considerably when past personally experienced returns are taken into account, suggesting that experience-based learning plays an important role in individual decision-making.

Inertia effect?

The Economist has suggested that the inertia effect could be present as investors are too busy to make time to buy or sell shares once they have been successful or unsuccessful with the lottery issue. However the authors shows that the endowment effect is still present when they study investors who make more than 20 other stockmarket trades in the month of the IPO floatation. The research also looked at those experienced investors who have taken part in 30 IPOs and found there was still a significant endowment effect with winners being four times more likely than losers to hold shares at the end of the first month of trading.

Winning the lottery seems to make investors more likely to hold onto shares regardless of profit or loss.

A2 Revision: Keynes 45˚ line

September 14, 2016 Leave a comment

With the Cambridge A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

Globalisation not what it used to be

September 11, 2016 Leave a comment

Below is a very good short video by Martin Wolf of the FT on Globalisation. He discusses the following and uses graphs to illustrate the decline of global trade and other related variables.

  • Global trade has stalled in volume
  • Cross border financial assets have declined
  • Global foreign direct investment has fallen
  • Trade liberalization has stopped and the DOHA round of trade talks has failed

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