Assignment:
1. Global Imbalances
How a wealth shift to emerging countries may lead to instability in developed countries. Investors exposed to expropriation risk are willing to pay a safety premium to invest in countries with good property rights. Domestic intermediaries compete for such cheap funding by carving out safe claims, which requires demandable debt. While foreign inflows allow countries to expand their domestic credit, risk-intolerant foreign investors withdraw even under minimal uncertainty. We show that more foreign funding causes larger and more frequent runs. Beyond some scale, even risk-tolerant domestic investors are induced to withdraw to avoid dilution. As excess liquidation causes social losses, a domestic planner may seek prudential measures on the scale of foreign inflows.
Topics to study:
• Investment / risk - relationship
• Global Imbalances
• Factors to attract foreign investment
• Safety-seeking foreign funding
1. An increasing scale of foreign funding may induce runs even by risk-tolerant investors since they seek to avoid dilution.
2. Result supports a mandate for introducing a macroprudential regulator to oversee the nature of foreign inflows because the socially preferred funding structure would involve less credit volume and more stability than the private choice.
3. Global imbalances shaped the credit boom and, ultimately, the financial crisis
4. The accumulation of wealth in countries with a weak protection of property rights creates a demand for absolute safety provided by intermediaries in developed countries.
5. The safety-seeking nature of foreign flows creates risk.
Global Imbalances and the Financial Crisis: Products of Common Causes
This paper makes a case that the global imbalances of the 2000s and the recent global financial crisis are intimately connected. Both have their origins in economic policies followed in a number of countries in the 2000s and in distortions that influenced the transmission of these policies through U.S. and ultimately through global financial markets. In the U.S., the interaction among the Fed's monetary stance, global real interest rates, credit market distortions, and financial innovation created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis. Outside the U.S., exchange rate and other economic policies followed by emerging markets such as China contributed to the United States' ability to borrow cheaply abroad and thereby finance its unsustainable housing bubble.
Topics to study:
1. Global imbalances and the financial crisis are intimately connected
2. A key challenge is to devise a set of reasonably simple and transparent rules for macroprudential interventions
How to correct global imbalances
One of the side-effects of the global crisis has been a temporary narrowing of current account imbalances among the world's major countries and economic areas. This is good news, but will it last? Policy actions may be needed.
Topics to study:
1. Larger imbalances are not a problem as long as they reflect a more efficient reallocation of savings between surplus and deficit countries.
2. Globalisation and financial market deepening may have made it easier for savings to flow from surplus to deficit countries
3. people in surplus countries may find higher rates of return for their savings and investments abroad
4. To maintain a stable exchange rate with the US, certain countries with high domestic savings have accumulated international reserves
5. High savings in several emergingmarket economies tend to reflect caution. Households save-probably more than they need-because they cannot rely on social safety nets, such as healthcare and unemployment insurance that would allow them to smooth consumption when confronted with an illness or a job loss. They also need to save for retirement, because pension schemes are usually underdeveloped.
6. Actions directed at savings and investment: strengthening social protection in surplus emergingmarket economies, for instance, and financial and product market reforms to encourage companies to invest
7. Induce less heated consumption and higher savings in deficit countries
2. FISCAL AND MONETARY POLICY RESPONSE TO CRISIS
Constanza S. Liborio, Research Analyst
Research Library of the Federal Reserve Bank of St. Louis
The recent financial crisis and recession prompted unconventional and aggressive actions by monetary and fiscal policymakers. Monetary policymakers turned to quantitative easing. Fiscal policymakers increased government spending and reduced taxes. To better understand these widely debated actions, it is helpful to know the underlying intent of the decisions and the separate functions of monetary and fiscal policy.
Topics to study:
• During economic slowdowns, monetary policy is expansionary
• During economic slowdowns, fiscal policy is often expansionary
• To stimulate the economy, in early 2009, Congress passed the $787 billion American Recovery and Reinvestment Act, a temporary stimulus that included $288 billion in tax cuts and benefits and more than $150 billion for sectorssuch as education, energy, and transportation
• The fiscal stimulus package and the deep recession increased the government budget deficit.
Fiscal and Monetary Policy in Times of Crisis
Antonio Spilimberg
INTERNATIONAL MONETARY FUND
The current crisis calls for two main sets of policy measures. First, measures to repair the financial system. Second, measures to increase demand and restore confidence. While some of these measures overlap, the focus of this note is on the second set of policies, and more specifically, given the limited room for monetary policy, on fiscal policy.
The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another "Great Depression" requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets. Looking at the content of the fiscal package, in the current circumstances, spending increases, and targeted tax cuts and transfers, are likely to have the highest multipliers. General tax cuts or subsidies, either for consumers or for firms, are likely to have lower multipliers.
Topics to study:
• successful policy pacage should address both the financial crisis and the fall in aggregate demand
• The fall in aggregate demand is due to a large decrease in real and financial wealth, an increase in precautionary saving on the part of consumers, a wait and see attitude on the part of both consumers and firms in the face of uncertainty, and increasing difficulties in obtaining credit
• the role of monetary policy should be to support the fiscal stimulus by avoiding increases in the policy interest rate until output begins to recover, not to less traditional dimensions, such as quantitative easing
A fiscal stimulus should be:
• timely (as there is an urgent need for action),
• large (because the drop in demand is large),
• lasting (as the recession will likely last for some time),
• diversified (as there is uncertainty regarding which measures will be most effective),
• contingent (to indicate that further action will be taken, if needed),
• collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and
• Sustainable (to avoid debt explosion in the long run and adverse effects in the short run).
Conclusions
• The solution to the current financial and macroeconomic crisis requires bold initiatives aimed at rescuing the financial sector and increasing demand.
• The analysis of previous cases of severe financial distress shows the critical role of early resolution of financial sector problems as a prerequisite for a return to sustained economic growth. It also shows the critical role of an early, strong, and carefully thought out, fiscal response. Time and action are of the essence.
Key messages
• The room for discretionary fiscal action over prolonged periods of time is limited even in countries where the initial fiscal position appeared to be strong.
• Preventing future spillovers from weaker economic activity into financial markets should be considered when designing fiscal stimulus packages.
Monetary Policy after the Crisis
In the aftermath of the financial crisis of 2008 and 2009 there has been a lively debate about what caused the crisis and how the risks of future crises can be reduced. Some blame loose monetary policy for laying the foundations for the crisis. There is also a lively debate about the future of monetary policy, whether it needs to be modified in the light of the crisis, and what its relation to financial stability should be. Here I will discuss the lessons for monetary policy from the financial crisis, the relation between monetary policy and financial stability, the role of monetary policy instruments other than the policy rate, and some issues for emerging markets arising from capital flows and exchange rate movements.
The crisis was not caused by monetary policy but by other factors, mainly regulatory and supervisory failures in combination with some special circumstances, such as low real interest rates due to global imbalances and U.S. housing and housing finance policy. Easy monetary policy in the United States did not cause the crisis.
A lesson from the crisis is that price stability is not enough to achieve financial stability. But, importantly, interest rate policy is not enough to achieve financial stability. A separate financial stability policy is needed for financial stability.
Topics to study:
• Trying to use monetary policy to achieve financial stability leads to poorer outcomes for monetary policy and is an ineffective way to achieve and maintain financial stability.
• Monetary policy should be conducted taking the conduct of financial stability policy into account, and vice versa
• This is similar to how monetary policy is conducted taking fiscal policy into account, and vice versa
• Monetary policy should be the last line of defense for financial stability, not the first
Flexible Inflation Targeting Still Best-Practice Monetary Policy
• to stabilize inflation around a low level and
• Resource utilization around the highest sustainable level.
• consistent with the dual mandate of maximum employment and stable prices of the Federal Reserve
• Is the financial crisis a reason to modify this framework of flexible inflation targeting?; Good flexible inflation targeting by itself does not achieve financial stability
• interest rate policy is not enough to achieve financial stability; The use of the policy rate to prevent an unsustainable boom in house prices and credit growth poses major problems for the timely identification of such an unsustainable development
• it was financial stability policy that failed, not monetary policy
Global Interest Rates and Emerging Market Capital Inflows
• net capital flows to emerging markets have been strongly correlated with changes in global financing conditions, rising sharply during periods with relatively low global interest rates.
• All countries cannot depreciate their currency against each other, but all countries can conduct more expansionary policy if they prefer, with conventional (lower policy rates) or unconventional methods (such as asset purchases). More expansionary monetary policy will increase real activity, world trade, and both exports and imports, which in a situation of underutilized resources is to the benefit of all
• Monetary policy is not a zero-sum game
3. GLOBAL FINANCIAL CRISIS / SOLUTIONS AND LESSONS
In response to the global financial crisis, governments around the world introduced large fiscal stimulus packages. There was much debate about the size and timing of the response. Today, the widely-held view is that the introduction and the intention of a temporary stimulus were appropriate. However, efforts were insufficient to consolidate public finances as the crisis faded. Fiscal deficits have persisted, debt has climbed, and fiscal buffers have been depleted. This experience has taught us valuable lessons; some of these are old forgotten ones. With risks of another crisis looming on the horizon, it is not too late to apply these lessons.
Topics to study:
• Lesson 1. Counter-cyclical fiscal policy can be an effective tool in crises; its impact is country- and situation-specific.
• Lesson 2. Fiscal policy should be counter-cyclical in both good and bad times.
• Lesson 3. To be effective, fiscal stimulus must be large enough, temporary, and targeted.
• Lesson 4. Fiscal policy alone cannot x structural problems, and it may exacerbate them.
Financial System Policy Responses to the Crisis (BofC_2009)
• Macroprudential Approach to the Procyclicality ofFinancial Market Prices
• From August 2007 to August 2008, the Bank of Canada made two significant changes to support liquidity, and thereby the stability of the Canadian financial system:
o introduced a term purchase and resale agreement (PRA) facility to purchase securities from primary dealers and resell them to the original owners at term
o broadened the range of securities acceptable as collateral for the Standing Liquidity Facility
• Liquidity is essential to a well-functioning economy, and central banks have an important and evolving role in helping to maintain the liquidity of key markets.
• Macro financial stability is equally essential to a well-functioning economy, and central banks are in a unique position to promote it through the development of macroprudential policy.