MGE #6 - Fiscal and Exchange-rate Policies to manage demand. Governments and Fiscal Policy Exports, Real Exchange Rate and Foreign Demand

Transcription

1 MGE #6 - Fiscal and Exchange-rate Policies to manage demand Governments and Fiscal Policy Exports, Real Exchange Rate and Foreign Demand 1

2 From last session The short-run in the economy Set prices imply the economy reacts to demand shocks through changes in output, which generate adjustments in labor markets. This creates an effect on income that sustains the decline in demand. The effect of demand shocks creates a vicious cycle that compounds the initial shock (the multiplier effect). Adjustments in the short-run are much more painful than in the long-run, because short-run price rigidities produce effects on output and employment. may require demand policies Rises in unemployment due to price rigidity are a pure waste of resources in an economy. In addition, they have negative social consequences. Policies that manage to prevent such rises in unemployment, by keeping demand from falling, are a pure gain to the economy. 2

3 From last session Components of Demand: Y = C + I + G + NX Consumption Depends on Disposable Income (Y-T) (+), Consumer Confidence (+), Wealth (+) and Real Interest Rates (-) Shocks emerging from Business Confidence and Wealth (stock markets, property prices) create fluctuations (contractions/expansions) in the economy Investment Depends on Real Interest Rates (-) and on Business Confidence (+) Shocks emerging from Business Confidence on future demand and productivity conditions create fluctuations (contractions/expansions) in the economy Policies by Central Banks to lower interest rates have expansionary effect on Consumption and Investment. They can help sustain demand, in the case of a strong, unexpected shock. 3

4 Components of Demand Demand = Expenditure in domestically produced goods: Expenditure = C + I + G + NX C : consumption (durable goods + non-durable goods + services) I : investment (residential fixed investment + business fixed investment + inventory investment) Note: this is very different from the usual usage, like: I will invest in the stock market! G : public expenditure and investment NX : net exports = exports imports In equilibrium: Expenditure = Output Y = C + I + G + NX 4

5 The government budget Expenditures Goods and services (G) Wages (G) Capital spending (G) Transfers (-T) Social security payments Subsidies (-T) Revenues Direct taxes (T) Social Security Taxes Capital Taxes Income Taxes Households Business Indirect taxes (T) Other Net interest payments (-T) 5

6 Government Revenues and Expenditure Components of Gov Revenues, 2000 (%GDP) Components of Gov. Expenditure, 2000 (%GDP) US US Korea Korea Japan Japan UK UK France France Germany Germany Australia Australia Capital tax Direct Taxes, Households Direct Taxes, Business Social Security and Other Transfers* Indirect Taxes Consumption, Exc Wages Wages* Fixed Investment Subsidies Social Benefits Net Interest Payments Source: OECD Economic Outlook, *not available for Australia 6

7 Budget deficits are financed through Government Debt Government Debt (% GDP) US JAPAN GERMANY KOREA ITALY UK US JAPAN GERMANY KOREA ITALY UK Financial balance Primary balance 2003 The primary balance reflects the difference between expenditures and revenues excluding interest payments (on the government debt) 7

8 Government Budget and Demand Y = C (Y -T) + I + G + NX T - G: budget surplus or government savings Expansionary Fiscal Policy An increase in government purchases (G) Increases domestic expenditure Y, i.e. stimulates the economy A decline in taxes net of subsidies & transfers (T) Raises disposable income and, thus, consumption, i.e. stimulates the economy Fiscal policy can help stabilize demand, in the wake of an unexpected shock 8

9 Fiscal Policy: Automatic Stabilization Automatic stabilizers Progressive taxation automatically stabilizes the economy when income declines, after-tax income declines by less Unemployment benefits automatically increase in recessions, stabilizing the demand in the economy create cyclical budget deficits Budget Deficit increases when economic activity declines The Structural Deficit measures the budget deficit at potential output Automatic stabilizers reduce the size of the multiplier 9

10 Fiscal Policy: Active Stabilization By discretionarily increasing spending or reducing taxes (raising the structural deficit) the government affects Demand. Limitations of discretionary fiscal policy Lags in implementation Discounting of future taxes: High deficits today mean taxes tomorrow, and agents may save to pay for them. Institutional controls on deficits and/or spending (e.g. Maastricht Criteria) Debt and other constraints on borrowing 10

11 Fiscal Policy during the last recession Automatic stabilization caused a cyclical increase in budget deficits, which undermined the Maastricht criteria. EMU governments were unable to use active stabilization, making the recession longer in Europe. 4 Government Budget Balances (% of GDP) 2 0 UK -2 Euro -4 US -6 Japan Automatic Stabilizers Active Stabilization Source: OECD Economic Outlook 11

12 The trade balance or Net Exports: NX NX (= Exports Imports) represents net exports or the trade balance Exports and imports of goods and services The current account is a related concept that includes also the net transfers from the rest of the world (e.g. Aid received, Profits of domestic MNC s abroad) What causes changes in net exports? 12

13 Exchange rates: Definitions I Nominal Exchange rate (e) How many units of foreign currency one can buy with one unit of domestic currency the price of domestic currency The value of the domestic currency increases = the currency appreciates = the exchange rate rises The value of the domestic currency decreases = the currency depreciates = the exchange rate falls Note: sometimes, the exchange rate is defined as the price of foreign currency. In this case, an appreciation means a decline in the exchange rate. 13

14 Exchange rates: Definitions II Real exchange rate (ε) : How many foreign goods one can buy with one unit of a domestic good P price of (basket of) domestic goods P* price of (basket of) foreign goods Example: What is the real exchange rate implicit in a CDs (France vs. US) e = 1.20$/ ; P France = 16.59; P US = $13.49 RER = ε = ep P * 1.20*16.59 ε = =

15 The trade balance (NX) and the RER How does the RER affect the trade balance? An appreciation of the RER lowers the price of foreign goods relative to the domestic goods hurts the competitiveness of the economy reducing exports and expanding imports thus leading to a deterioration of the trade balance. What changes the real exchange rate? %RER ~ %e + π - π* An appreciation of the RER can occur due to a NOMINAL APPRECIATION ( %e) or INFLATION DIFFERENTIALS (π- π*). 15

16 Solutions for the US trade deficit Trade Balance, United States X/GDP, M/GDP in % Imports/GDP Exports/GDP 16

17 Solutions for the (US) trade deficit Depreciation of the real exchange rate of the US dollar Lower inflation in the US than in trading partners (unlikely) Nominal depreciation of the US dollar (already happening) Appreciation of Asian currencies and/or EURO But also, Stronger growth in main importers of US goods (e.g. Europe; already happening) Slowdown of US economy will reduce demand for imports and lower the trade deficit. In sum, Trade deficit rises with real appreciation, Trade deficit rises with increase in domestic demand Trade deficit declines with increase in foreign demand 17

18 Expansionary effects of the Trade Balance 1. A depreciation in the real exchange rate (ε) shifts expenditure/demand to domestic goods (e.g. nontradables) from foreign goods, thus stimulating output and creating a multiplier effect. Exchange rate policies to stimulate the economy are beggar-thy-neighbor policies, which may lead to retaliation by trading partners (e.g. East-Asian crisis) 2. An increase in foreign income (Y*) increases foreign expenditure/demand on domestically produced goods (exportables), thus stimulating output and creating a multiplier effect. The effect arises early, as the domestic stock market is affected by the performance of exporting firms, creating a wealth effect that stimulates the economy. This contributes to the international transmission of business cycle. 18

19 Summary Fiscal Policy and Demand for Domestic Goods Expenditure (G) ; Taxes net of subsides and transfers (T) Active and automatic stabilization; Cyclical and Structural Deficits Constraints on the effectiveness of Fiscal Policy Lags in implementation; Expectation of future taxes; Inability to fund government deficits Government Debt, Primary Balances and Interest Payments Net exports (trade balance) Nominal and the real exchange rates. Real depreciation improves trade balance Domestic demand and foreign demand also affect the trade deficit Real depreciations and growth in trading partners have expansionary effect, contributing to the international transmission of business cycle 19