Open economies in Open economies in PK stock-flow PK stock-flow

consistent modelsconsistent models

Applying the principle of Applying the principle of endogenous sterilization to endogenous sterilization to

stock-flow consistent modelsstock-flow consistent models

Open economies and PK Open economies and PK modelsmodels

►There are three traditions of PK analysis There are three traditions of PK analysis regarding open economies regarding open economies macroeconomicsmacroeconomics

►The Paul Davidson tradition, regarding the The Paul Davidson tradition, regarding the architecture of the world monetary systemarchitecture of the world monetary system

►The Tony Thirlwall tradition, regarding The Tony Thirlwall tradition, regarding external constraints on growthexternal constraints on growth

►The Wynne Godley tradition, regarding The Wynne Godley tradition, regarding stock-flow consistencystock-flow consistency

The Paul Davidson tradition The Paul Davidson tradition (1972)(1972)

►Concerns with whether exchange rates Concerns with whether exchange rates should be fixed or flexible.should be fixed or flexible.

►Concerns with the need to have capital Concerns with the need to have capital controls, Tobin taxes on international controls, Tobin taxes on international transactions, etc.transactions, etc.

►Concerns with the present architecture, Concerns with the present architecture, which has no mechanism inducing which has no mechanism inducing surplus countries to balance their surplus countries to balance their current accountcurrent account

►Concerns with the role of the US dollarConcerns with the role of the US dollar

The Tony Thirlwall tradition The Tony Thirlwall tradition (1979)(1979)

► Inspired by the Harrodian trade multiplier (1933).Inspired by the Harrodian trade multiplier (1933).► Has given rise to many econometric testsHas given rise to many econometric tests► Claims that growth is constrained by the need to Claims that growth is constrained by the need to

balance the trade accountbalance the trade account► Claims that growth of a country over the medium Claims that growth of a country over the medium

run is equal to the growth rate of exports divided by run is equal to the growth rate of exports divided by the local income elasticity of imports (Thirlwall’s the local income elasticity of imports (Thirlwall’s law).law).

► The growth rate of country X exports is equal to the The growth rate of country X exports is equal to the growth rate of world income multiplied by the growth rate of world income multiplied by the income elasticity of demand for products of country income elasticity of demand for products of country X.X.

The Wynne Godley tradition (1974, The Wynne Godley tradition (1974, 1999)1999)

► Also inspired by Harrod’s trade multiplierAlso inspired by Harrod’s trade multiplier► Based on a national income identity, identified in Based on a national income identity, identified in

1974, that says that financial balances are such that:1974, that says that financial balances are such that: Private saving minus investment + government surplus = Private saving minus investment + government surplus =

current account surpluscurrent account surplus Private lending + government lending + non-residents Private lending + government lending + non-residents

lending = 0lending = 0 Private lending = government borrowing + non-residents Private lending = government borrowing + non-residents

borrowingborrowing► Sometimes called the New Cambridge approachSometimes called the New Cambridge approach► The other breakthrough is the Godley 1999 Levy The other breakthrough is the Godley 1999 Levy

Institute working paper, that introduces these ideas in Institute working paper, that introduces these ideas in a stock-flow consistent model a stock-flow consistent model

► Also an interesting paper by Lance Taylor (2004), Also an interesting paper by Lance Taylor (2004), based on the above.based on the above.

Heuristic proof of the identityHeuristic proof of the identity

► GDP = PX + G + (X – IM) GDP = PX + G + (X – IM) ► GNP = PX + G + X – IM + YFGNP = PX + G + X – IM + YF► (GNP – PX – T) = (G – T) + (X – IM + YF)(GNP – PX – T) = (G – T) + (X – IM + YF)► NAFA = PSBR + CABNAFA = PSBR + CAB► Net Accumulation of Financial Assets = Net Accumulation of Financial Assets =

Public Sector Borrowing Requirements + Public Sector Borrowing Requirements + Current Account BalanceCurrent Account Balance

► Private surplus = Government deficit + non-Private surplus = Government deficit + non-residents borrowing residents borrowing

► (YF = Net foreign income; PX private (YF = Net foreign income; PX private expenditures)expenditures)

Financial balances (net lending) Financial balances (net lending) of US economy 1970-2006of US economy 1970-2006

Non-residents

Government sector

Private sector

-10

-8

-6

-4

-2

0

2

4

6

8

10

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Years

Net

Len

ding

(Per

cent

of G

DP)

Non-residents lending = current account deficit

Financial balances, Canada 1970-Financial balances, Canada 1970-20072007

Persons and Unincorporated

Business

2007

Corporations and Government

Business Enterprises

Government

Non-residents

-15

-10

-5

0

5

10

15

1970 1975 1980 1985 1990 1995 2000 2005

Years

Net

Len

din

g (

Perc

en

t o

f G

DP

)

The stock-flow modelThe stock-flow model

► Integrates flows and stocksIntegrates flows and stocks► Integrates portfolio decisions (Tobin)Integrates portfolio decisions (Tobin)►Links up with portfolio “static” models: Links up with portfolio “static” models:

Allen and Kenen (1980), Branson and Allen and Kenen (1980), Branson and Henderson (1985), that are now back in Henderson (1985), that are now back in fashionfashion

►Goes beyond the standard models, where Goes beyond the standard models, where the rest of the world is a given, by the rest of the world is a given, by describing two interrelated economiesdescribing two interrelated economies

Kinds of open-economy SFC modelsKinds of open-economy SFC modelsModelModel GovernmenGovernmen

tstsCentral Central banksbanks

RegimeRegime Reserves, Reserves, othersothers

Godley Godley 1999A1999A

22 22 Fixed, Fixed, FlexibleFlexible

GoldGold

Lavoie Lavoie 20052005

22 11 ---- ----

Lavoie Lavoie 20062006

22 1+ 1+ currency currency boardboard

FixedFixed US $US $

G&L 2006 G&L 2006 JPKEJPKE

22 22 Fixed, with Fixed, with and without and without capital capital flows; flows; FlexibleFlexible

US$, no US$, no interest interest payments payments flowsflows

G&L 2007 G&L 2007 book ch6book ch6

22 22 Fixed Fixed Gold, no Gold, no capital capital flowsflows

G&L 2007 G&L 2007 book ch 12book ch 12

22 22 Fixed and Fixed and flexibleflexible

US $, US $, pricing pricing equationsequations

Further Kinds of open-economy SFC Further Kinds of open-economy SFC modelsmodels

ModelModel GovernmenGovernmentsts

Central Central banksbanks

RegimeRegime ReservesReserves

Izurieta Izurieta 20032003

22 22 DollarizatioDollarizationn

US$US$

Lequain Lequain 2003 2003 (UofO)(UofO)

33 22 FixedFixed US $US $

G&L 2006 G&L 2006 CJECJE

33 22 FlexibleFlexible US $US $

Zhao 2006Zhao 2006

(UofO)(UofO)33 33 Fixed Fixed

between between China and China and US, flexible US, flexible otherwiseotherwise

US $US $

The G&L 2007 Chapter 6 The G&L 2007 Chapter 6 modelmodel

► Contains broadly the same equations as the Contains broadly the same equations as the chapter 4 modelchapter 4 model No investment, no banksNo investment, no banks Consumption depends on current income and past wealthConsumption depends on current income and past wealth Portfolio choice between bills and moneyPortfolio choice between bills and money Interest rate targetingInterest rate targeting

► There are now exports and importsThere are now exports and imports► Imports are a direct function of local GDPImports are a direct function of local GDP► The imports of one country are necessarily the The imports of one country are necessarily the

exports of the other countryexports of the other country► There are capital controls: households of the north There are capital controls: households of the north

(Canada) cannot hold bills issued in the south (USA) (Canada) cannot hold bills issued in the south (USA) and vice-versaand vice-versa

► Gold reservesGold reserves► Fixed exchange ratesFixed exchange rates

The redundant equationThe redundant equation

► It describes the equivalence between It describes the equivalence between reserve gains by one country and reserve gains by one country and reserve losses by the other, as can be reserve losses by the other, as can be seen in the last row of the seen in the last row of the transactions-flow matrix.transactions-flow matrix.

► ΔΔororSS = − = −ΔΔororNN

SimulationsSimulations

►We start from a full stationary state, We start from a full stationary state, where both economies are in a where both economies are in a balance of payments position (a trade balance of payments position (a trade balance, since there are no private balance, since there are no private capital transactions).capital transactions).

►When a shock is being imposed upon When a shock is being imposed upon this fixed-exchange rate model, the this fixed-exchange rate model, the economies reach a quasi stationary economies reach a quasi stationary state, where flows reach a constant, state, where flows reach a constant, but where some stocks are changing.but where some stocks are changing.

Impact of an increase in the Impact of an increase in the propensity of the South to importpropensity of the South to import

Impact of an increase in the Impact of an increase in the propensity of the South to propensity of the South to

importimport

The twin deficits !

The compensation thesis in The compensation thesis in actionaction

► The South has a trade deficit, therefore it is losing The South has a trade deficit, therefore it is losing gold.gold.

► The South has a government deficit, therefore, its The South has a government deficit, therefore, its government needs to issue bills.government needs to issue bills.

► The central bank purchases the bills, at about the The central bank purchases the bills, at about the same rhythm that it is losing gold, acting simply to same rhythm that it is losing gold, acting simply to keep the interest rate on bills constant.keep the interest rate on bills constant.

► There is endogenous sterilization of the gold losses There is endogenous sterilization of the gold losses (the compensation thesis). (the compensation thesis).

► Despite being on a gold exchange standard, the Despite being on a gold exchange standard, the “Rules of the game” do not apply. Hume’s “price-“Rules of the game” do not apply. Hume’s “price-specie flow” mechanism has no bite.specie flow” mechanism has no bite.

The compensation thesis in The compensation thesis in action action

Compensation againCompensation again

Limits of compensationLimits of compensation

► Obviously this mechanism can go on only as Obviously this mechanism can go on only as long as there are gold reserves in the South long as there are gold reserves in the South country.country.

► Note that the North country has no reason to Note that the North country has no reason to change its behaviour, as long as it does not change its behaviour, as long as it does not object to accumulating gold reserves.object to accumulating gold reserves.

► It can be shown that gains or losses of gold It can be shown that gains or losses of gold reserves will continue as long as the following reserves will continue as long as the following equality is not fulfilled for each country:equality is not fulfilled for each country:

► Y = GY = GNTNT//θθ = X/ = X/μμ Where Where GGNTNT are total government expenditures net of are total government expenditures net of

taxes collected on interest payments; taxes collected on interest payments; and where and where θθ is the tax rate and is the tax rate and μμ is the propensity to is the propensity to

import.import.

Policies to stop losing goldPolicies to stop losing gold

► Y = GY = GNTNT//θθ = X/ = X/μμ► The first term is the Blinder fiscal stance The first term is the Blinder fiscal stance

equation; the second term is the Harrod trade equation; the second term is the Harrod trade equation.equation.

► If the propensity to import is overly high, this If the propensity to import is overly high, this means that the fraction is overly small; the other means that the fraction is overly small; the other fraction (the fiscal stance) must thus be fraction (the fiscal stance) must thus be reduced, either by raising the tax rate of reduced, either by raising the tax rate of reducing government expenditures (the IMF reducing government expenditures (the IMF solution to all problems of emerging economies!) solution to all problems of emerging economies!)

► The following graph assumes a mechanism that The following graph assumes a mechanism that reduces government expenditures when losing reduces government expenditures when losing gold.gold.

Evolution of the balances of the South country – net acquisition Evolution of the balances of the South country – net acquisition of financial assets by the household sector, government budget of financial assets by the household sector, government budget

balance, trade balance – following an increase in the South balance, trade balance – following an increase in the South propensity to import, with fiscal policy reacting to changes in propensity to import, with fiscal policy reacting to changes in

gold reservesgold reserves

A more complex model ?A more complex model ?

►What if there was a more complex model, What if there was a more complex model, with capital flows, dollar reserves, etc.with capital flows, dollar reserves, etc.

►This is the chapter 12 model.This is the chapter 12 model.►Results will be essentially the same, Results will be essentially the same,

except that due to interest payments on except that due to interest payments on foreign debt, the current account balance foreign debt, the current account balance will rise exponentially (while the trade will rise exponentially (while the trade balance remains constant) if nothing is balance remains constant) if nothing is done.done.

Effect of an increase in the US propensity to import on UK variablesEffect of an increase in the US propensity to import on UK variables

Effect of an increase in the US propensity to import, within a fixed Effect of an increase in the US propensity to import, within a fixed exchange rate regime with endogenous foreign reserves, on the UK exchange rate regime with endogenous foreign reserves, on the UK

current account balance and elements of the balance sheet of the Bank current account balance and elements of the balance sheet of the Bank of England (the UK central bank): change in foreign reserves, stock of of England (the UK central bank): change in foreign reserves, stock of

money, holdings of domestic Treasury billsmoney, holdings of domestic Treasury bills

Using interest ratesUsing interest rates

►What if a country has a current What if a country has a current account deficit problem, and tries to account deficit problem, and tries to solve it by raising interest rates solve it by raising interest rates instead of decreasing government instead of decreasing government expenditures ?expenditures ?

►Will this also bring the economy back Will this also bring the economy back to a full steady state ?to a full steady state ?

►The answer is noThe answer is no

Interest rates are Interest rates are destabilizingdestabilizing

Contradicting received Contradicting received wisdomwisdom

► Alan Greeenspan and others have been saying that Alan Greeenspan and others have been saying that Chinese accumulation of US Treasury bills is making Chinese accumulation of US Treasury bills is making it difficult for them to manage their monetary policy; it difficult for them to manage their monetary policy; but the above analysis strongly suggests that they but the above analysis strongly suggests that they are mistaken.are mistaken.

► Mainstream authors would say that the UK (or Mainstream authors would say that the UK (or Chinese) central bank of our model is “sterilizing” Chinese) central bank of our model is “sterilizing” foreign reserves, by selling domestic Treasury bills foreign reserves, by selling domestic Treasury bills on the open market. In a way, it is true. But this is on the open market. In a way, it is true. But this is not the result of any intentional policy, where central not the result of any intentional policy, where central bankers are actively intervening in financial markets. bankers are actively intervening in financial markets.

► The UK (Chinese) central bank, just like the US one, The UK (Chinese) central bank, just like the US one, is simply attempting to keep interest rates constant. is simply attempting to keep interest rates constant. Bills are provided to those who demand them at the Bills are provided to those who demand them at the set rate of interest. The central bank provides cash set rate of interest. The central bank provides cash on demand to its citizens. on demand to its citizens.

What about flexible exchange What about flexible exchange rates?rates?

► This is discussed in G&L JPKE 2005-6.This is discussed in G&L JPKE 2005-6.►Also in the G&L book, chapter 12, with Also in the G&L book, chapter 12, with

a full model, complete with partial a full model, complete with partial exchange-rate pass through, price and exchange-rate pass through, price and income import elasticities, etc. income import elasticities, etc.