A Macroeconomic Summary of the Open Economy

A Macroeconomic Summary of the Open Economy DeLisle Worrell SALISES, UWI and IMF November 2007 Contents • 1. A Framework for Macroeconomic Analysis and Policy • 2. Formulating Sustainable Policy • 3. Base Money Targeting • 4. Indicators of Macroeconomic Performance and Sustainability 1. A Framework for Macroeconomic Analysis and Policy Rev, Credit Real And Nominal GDP, Prices Liquidity, Credit Demand Credit Reserve Money Govt Exp And Rev, Balance Financial Sector Central Bank Residual Demand for Credit Foreign Reserves Exports & Imports of Goods and Services Balance Of Payments Tradables & Nontradables Tradables Agriculture Manufacturing Mining Tourism Imports Nontradables Government Public utilities Transport Distribution Financial, other services Other Nominal & Real GDP, Prices Tradables Nontradables Sn0 St Sn1 Pn10 Dt Pn00 Dn1 Dn0 Pw Qn00 Qn10 Nominal & Real GDP, Prices - 2 Pt = Pf*ER Tradables: Pt = Pf*ER Qt: capacity Q Nontradables Qn <= Q(-1), dH, Pn/Pt, r Pn <= Qn, Pt, s, r Pt, Qt Q*P = Y Pn, Qn Y => fiscal, BoP, banks It(-1) => capacity The model - production 1. qt = qt(pt, s, r) 2. qn = qn(q, pn/pt, r, dh) 3. pn = pn(qn, pt, s, r) Identity 4. dh = dCRGMA/p + dFXR/p Inferences from GDP Block • Sustained growth depends on investment in tradables • Qt provides FX needed to buy imported inputs for Qn, so limits medium term growth of Qn Fiscal Y, tax rates Revenue Nondiscretionary Expenditure Discretionary Expenditure Balance Banks BoP CRG from banks Foreign project, other loans CRG From Central bank dH Banks Y Deposits Excess Liquidity CRG from banks NFA of banks Reserve deposits at CB r(f) r(TB) Credit Central Bank Balance Sheet Assets NFA NDA CRG-DG CR to banks OAN Liabilities Currency Reserve deposits Money Growth & Spending XGS, FDI, foreign loans NFA Of CB CC + BR => M3 CRP CRG From CB Excess Reserves NFA of banks Demand For Qt, Qn Pn inflation Imports, -NFA Implications for Monetary Policy • Impact of increase in RR: banks can draw down excess reserves, NFA w/o affecting credit • Trying to increase TB rate: will attract an inflow of funds • Increases in CRG by CB will inevitably lead to deterioration in BoP and inflation Crowding Out Probable shape Interest Premium on Gov’t Paper Unlikely Gov’t => Lending <= Pte Sector Balance of Payments Receipts Y, H Qt Payments minus XGS + Imports + = FDI + Foreign Project loans + Private Debt service Gov’t Interest payment + + Change In NFA (FXR) Foreign Market loans Gov’t amortisation BoP 15. m = m(q, pn/pt, r, dh) 16. x = x(qt) Identity 17. dFXR = (x – m)pt + Kp + Kg + OTH Reserve Adequacy and the Exchange Rate • If NFA of CB is considered insufficient by mkts, the ER will depreciate, by official devaluation or informally • However, devaluation will not cure the NFA deficiency, and may aggravate it, by stimulating capital flight Three Interacting FX Markets – ER Policy is Ineffective Goods & Svcs FDI Financial Assets Sy if UIP does not hold Dm ER Dm Sy Sy E0 Sy if UIP holds FX1 US$ FX2 US$ + US$ Foreign Reserves & the Exchange Rate Does market consider FXR adequate for BoP contingencies? Yes: no action needed No: increase FXR; danger of capital flight +r Financial inflow Reduce imports To reduce imports Cut Discretionary Spending Lowers CRG from CB Reduces Income & spending Lowers imports, with lag 2. Formulating Sustainable Policy Sustainable Growth • Base Qt projection on in-depth analysis of main export growth sectors - Growth and competitiveness by market - Capacity utilisation and new investment - Changes in tastes and technology - Strategies for market segmentation • Derive Qn projection from past relationship to Qt Rev, Credit Real And Nominal GDP, Prices Liquidity, Credit Demand Credit Reserve Money Govt Exp And Rev, Balance Financial Sector Central Bank Residual Demand for Credit Foreign Reserves Exports & Imports of Goods and Services Balance Of Payments Implications for the BoP • Set target inflation = world inflation, derive nominal GDP (Y) • Derive imports • From Qt, infer exports, G&S • Best info on FDI, project loans; or eliminate outliers & project on trend; assume market borrowing = 0 • Estimate debt svc based on outstanding debt, new projects, f’cast US int. rates • Derive change in FXR – will NFA be adequate? Balance of Payments Receipts Y, H Qt Payments minus XGS + Imports + = FDI + Foreign Project loans + Private Debt service Gov’t Interest payment + + Change In NFA (FXR) Foreign Market loans Gov’t amortisation Rev, Credit Real And Nominal GDP, Prices Liquidity, Credit Demand Credit Reserve Money Govt Exp And Rev, Balance Financial Sector Central Bank Residual Demand for Credit Foreign Reserves Exports & Imports of Goods and Services Balance Of Payments Setting Gov’t Budget Limit • Derive revenue f’cast from nominal GDP • Deduce financing available from banks by projecting excess liquidity • Include expected foreign project finance • Assume no additional financing from CB • Add f’cast revenue and financing to obtain an upper limit for spending Fiscal Y, tax rates Revenue Nondiscretionary Expenditure Discretionary Expenditure Balance Banks BoP CRG from banks Foreign project, other loans CRG From Central bank dH Rev, Credit Real And Nominal GDP, Prices Liquidity, Credit Demand Credit Reserve Money Govt Exp And Rev, Balance Financial Sector Central Bank Residual Demand for Credit Foreign Reserves Exports & Imports of Goods and Services Balance Of Payments Financial Sector – Consistency Check • F’cast growth of deposits (M3), private credit from nominal GDP growth, calculate excess liquidity (= CRG) • Derive growth in reserve deposits at CB from M3 growth • Project currency • Derive NFA from BoP (= change in FXR), previous NFA • Check that change in NDA = 0 Banks Y Deposits Excess Liquidity CRG from banks NFA of banks Reserve deposits at CB r(f) r(TB) Credit Central Bank Balance Sheet Assets NFA NDA CRG-DG CR to banks OAN Liabilities Currency Reserve deposits Rev, Credit Real And Nominal GDP, Prices Liquidity, Credit Demand Credit Reserve Money Govt Exp And Rev, Balance Financial Sector Central Bank Residual Demand for Credit Foreign Reserves Exports & Imports of Goods and Services Balance Of Payments Second Round F’cast • If change in NDA is -ve, f’cast implies that gov’t must repay CR to CB • Gov’t expenditure will have to be cut, or taxes increased • Third alternative, more foreign borrowing, only if the dip in NDA is projected to be temporary • Also if NFA < 3 months’ imports Monetary and ER Policies Instead? Increase RR - If there are excess reserves, there is no impact on NDA or NFA - Required increase in RR is usually too large Raise short term int. rates - May stimulate inflow of funds, but ‘permanent’ adjustment still necessary ER devaluation - Will not increase the net supply of FX 3. Base Money Targeting Money Growth & Spending XGS, FDI, foreign loans NFA Of CB CC + BR => M3 CRP CRG From CB Excess Reserves NFA of banks Demand For Qt, Qn Pn inflation Imports, -NFA Central Bank Balance Sheet Assets NFA NDA CRG-DG CR to banks OAN Liabilities Base Money Currency Reserve deposits Required reserves (RR) Excess (XR) Central Bank CDs Effectiveness of Base Money Targeting Using CDs • Is there a stable relationship between base money and M3? • Do banks have excess reserves? Policy has first to sterilise them. • Will the interest rate on CDs attract funds from abroad, rather than a reduction in credit? • What evidence is there on the elasticity of substitution between CPS and CDs? 4. Indicators of Macroeconomic Performance and Sustainability Macroeconomic Indicators • Real GDP growth rate (trend, is it positive?) • Rate of CPI inflation (trend, compare with US inflation) • Unemployment rate • Fiscal deficit to GDP ratio • BoP current account deficit to GDP ratio • [Human development index] Indicators of Economic Sustainability • Level (import coverage) & monthly change in FXR • Level and monthly change in CRG by CB • External debt service, % of XGS (interest, amortisation) • percentage annual growth in Qt > percentage in Qn?