The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
Questions
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
The article below looks at the economy of Brazil. The statistics do not look good. Real output fell last year by 3.8% and this year it is expected to fall by another 3.3%. Inflation this year is expected to be 9.0% and unemployment 11.2%, with the government deficit expected to be 10.4% of GDP.
The article considers Keynesian economics in the light of the case of Brazil, which is suffering from declining potential supply, but excess demand. It compares Brazil with the case of most developed countries in the aftermath of the financial crisis. Here countries have suffered from a lack of demand, made worse by austerity policies, and only helped by expansionary monetary policy. But the effect of the monetary policy has generally been weak, as much of the extra money has been used to purchase assets rather than funding a growth in aggregate demand.
Different policy prescriptions are proposed in the article. For developed countries struggling to grow, the solution would seem to be expansionary fiscal policy, made easy to fund by lower interest rates. For Brazil, by contrast, the solution proposed is one of austerity. Fiscal policy should be tightened. As the article states:
Spending restraint might well prove painful for some members of Brazilian society. But hyperinflation and default are hardly a walk in the park for those struggling to get by. Generally speaking, austerity has been a misguided policy approach in recent years. But Brazil is a special case. For now, anyway.
The tight fiscal policies could be accompanied by supply-side policies aimed at reducing bureaucracy and inefficiency.
Article
Brazil and the new old normal: There is more than one kind of economic mess to be in The Economist, Free Exchange Economics (12/10/16)
Questions
- Explain what is meant by ‘crowding out’.
- What is meant by the ‘liquidity trap’? Why are many countries in the developed world currently in a liquidity trap?
- Why have central banks in the developed world found it difficult to stimulate growth with policies of quantitative easing?
- Under what circumstances would austerity policies be valuable in the developed world?
- Why is crowding out of fiscal policy unlikely to occur to any great extent in Europe, but is highly likely to occur in Brazil?
- What has happened to potential GDP in Brazil in the past couple of years?
- What is meant by the ‘terms of trade’? Why have Brazil’s terms of trade deteriorated?
- What sort of policies could the Brazilian government pursue to raise growth rates? Are these demand-side or supply-side policies?
- Should Brazil pursue austerity policies and, if so, what form should they take?
The IMF has just published its six-monthly World Economic Outlook. It expects world aggregate demand and growth to remain subdued. A combination of worries about the effects of Brexit and slower-than-expected growth in the USA has led the IMF to revise its forecasts for growth for both 2016 and 2017 downward by 0.1 percentage points compared with its April 2016 forecast. To quote the summary of the report:
Global growth is projected to slow to 3.1 percent in 2016 before recovering to 3.4 percent in 2017. The forecast, revised down by 0.1 percentage point for 2016 and 2017 relative to April, reflects a more subdued outlook for advanced economies following the June UK vote in favour of leaving the European Union (Brexit) and weaker-than-expected growth in the United States. These developments have put further downward pressure on global interest rates, as monetary policy is now expected to remain accommodative for longer.
Although the market reaction to the Brexit shock was reassuringly orderly, the ultimate impact remains very unclear, as the fate of institutional and trade arrangements between the United Kingdom and the European Union is uncertain.
The IMF is pessimistic about the outlook for advanced countries. 
It identifies political uncertainty and concerns about immigration and integration resulting in a rise in demands for populist, inward-looking policies as the major risk factors.
It is more optimistic about growth prospect for some emerging market economies, especially in Asia, but sees a sharp slowdown in other developing countries, especially in sub-Saharan Africa and in countries generally which rely on commodity exports during a period of lower commodity prices.
With little scope for further easing of monetary policy, the IMF recommends the increased use of fiscal policies:
Accommodative monetary policy alone cannot lift demand sufficiently, and fiscal support — calibrated to the amount of space available and oriented toward policies that protect the vulnerable and lift medium-term growth prospects — therefore remains essential for generating momentum and avoiding a lasting downshift in medium-term inflation expectations.
These fiscal policies should be accompanied by supply-side policies focused on structural reforms that can offset waning potential economic growth. These should include efforts to “boost labour force participation, improve the matching process in labour markets, and promote investment in research and development and innovation.”
Articles
IMF Sees Subdued Global Growth, Warns Economic Stagnation Could Fuel Protectionist Calls IMF News (4/10/16)
The World Economy: Moving Sideways IMF blog, Maurice Obstfeld (4/10/16)
The biggest threats facing the global economy in eight charts The Telegraph, Szu Ping Chan (4/10/16)
IMF and World Bank launch defence of open markets and free trade The Guardian, Larry Elliott (6/10/16)
IMF warns of financial stability risks BBC News, Andrew Walker (5/10/16)
Backlash to World Economic Order Clouds Outlook at IMF Talks Bloomberg, Rich Miller, Saleha Mohsin and Malcolm Scott (4/10/16)
IMF lowers growth forecast for US and other advanced economies Financial Times, Shawn Donnan (4/10/16)
Seven key points from the IMF’s latest global health check Financial TImes, Mehreen Khan (4/10/16)
Latest IMF forecast paints a bleak picture for global growth The Conversation, Geraint Johnes (5/10/16)
IMF Report, Videos and Data
World Economic Outlook, October 2016 IMF (4/10/16)
Press Conference on the Analytical Chapters IMF (27/9/16)
IMF Chief Economist Maurice Obstfeld explains the outlook for the global economy IMF Video (4/10/16)
Fiscal Policy in the New Normal IMF Video (6/10/16)
CNN Debate on the Global Economy IMF Video (6/10/16)
World Economic Outlook Database IMF (October 2016)
Questions
- Why is the IMF forecasting lower growth than in did in its April 2016 report?
- How much credibility should be put on IMF and other forecasts of global economic growth?
- Look at IMF forecasts for 2015 made in 2013 and 2012 for at least 2 macroeconomic indicators. How accurate were they? Explain the inaccuracies.
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the main factors determining a country’s long-term rate of economic growth?
- Why is there growing mistrust of free trade in many countries? Is such mistrust justified?
The pound has fallen to its lowest rate against the euro since July 2013 and the lowest rate against the US dollar since 1985. Since August 2015, the pound has depreciated by 23.4% against the euro and 22.2% against the dollar. And since the referendum of 23 June, it has depreciated by 15.6% against the euro and 17.6% against the dollar.
On Sunday 2 October, at the start of the Conservative Party conference, the Prime Minister announced that Article 50, which triggers the Brexit process, would be invoked by the end of March 2017. Worries about what the terms of Brexit would look like put further pressure on the pound: the next day it fell by around 1% and the next day by a further 0.5%.
Then, on 6 October, it was reported that President Hollande was demanding tough Brexit negotiations and the pound dropped significantly further. By 7 October, it was trading at around €1.10 and $1.22. At airports, currency exchange agencies were offering less than €1 per £ (see picture).
With the government implying that Brexit might involve leaving the Single Market, the pound continued falling. On 12 October, the trade-weighted index reached its lowest level since the index was introduced in 1980: below its trough in the depth of the 2008 financial crisis and below the 1993 trough following Britain’s ejection from the European Exchange Rate Mechanism in September 1992.
So just why has the pound fallen so much, both before and after the Brexit vote? (Click here for a PowerPoint of the chart.) And what are the implications for the economy?
The articles explore the reasons for the depreciation. Central to these are the effects on the balance of payments from a possible decline in inward investment, lower interest rates leading to a net outflow of currency on the financial account, and stimulus measures, both fiscal and monetary, leading to higher imports.
Worries about the economy were occurring before the Brexit vote and this helped to push sterling down in late 2015 and early 2016, as you can see in the chart. This article from The Telegraph of 14 June 2016 explains why.
Despite the short-run effects on the UK economy of the Brexit vote not being as bad as some had predicted, worries remain about the longer-term effects. And these worries are compounded by uncertainty over the Brexit terms.
A lower sterling exchange rate reduces the foreign currency price of UK exports and increases the sterling price of imports. Depending on price elasticities of demand, this should improve the current account of the balance of payments.
These trade effects will help to boost the economy and go some way to countering the fall in investment as businesses, uncertain over the terms of Brexit, hold back on investment in the UK.
Articles
Pound Nears Three-Decade Low as May Sets Date for Brexit Trigger Bloomberg, Netty Idayu Ismail and Charlotte Ryan (3/10/16)
Sterling near 31-year low against dollar as May sets Brexit start dat Financial Times, Michael Hunter and Roger Blitz (3/10/16)
Sterling hits three-year low against the euro over Brexit worries The Guardian, Katie Allen (3/10/16)
Pound sterling value drops as Theresa May signals ‘hard Brexit’ at Tory conference Independent, Zlata Rodionova (3/10/16)
Pound falls as Theresa May indicates Brexit date BBC News (3/10/16)
The pound bombs and stocks explode over fears of a ‘hard Brexit’ Business Insider UK, Oscar Williams-Grut (3/10/16)
Pound Will Feel Pain as Brexit Clock Ticks Faster Wall Street Journal, Richard Barley (3/10/16)
British Pound to Euro Exchange Rate’s Brexit Breakdown Slows After Positive Manufacturing PMI Halts Decline Currency Watch, Joaquin Monfort (3/10/16)
7 ways the fall in the value of the pound affects us all Independent (4/10/16)
The pound and the fury: Brexit is making Britons poorer, and meaner The Economist, ‘Timekeeper’ (11/10/16)
Is the pound headed for parity v US dollar and euro? Sydney Morning Herald, Jessica Sier (5/10/16)
Flash crash sees the pound gyrate in Asian trading BBC News (7/10/16)
Flash crash hits pound after Hollande remarks Deutsche Welle (7/10/16)
Sterling mayhem gives glimpse into future Reuters, Swaha Pattanaik (7/10/16)
Sterling takes a pounding The Economist, Buttonwood (7/10/16)
Government must commit to fundamental reform The Telegraph, Andrew Sentance (7/10/16)
Data
Interest & exchange rates data – Statistical Interactive Database Bank of England
Questions
- Why has sterling depreciated? Use a demand and supply diagram to illustrate your argument.
- What has determined the size of this depreciation?
- What is meant by the risk premium of holding sterling?
- To what extent has the weaker pound contributed to the better economic performance than was expected immediately after the Brexit vote?
- What factors will determine the value of sterling over the coming months?
- Who gain and who lose from a lower exchange rate?
- What is likely to happen to inflation over the coming months? Explain and consider the implications for monetary and fiscal policy.
- What is a ‘flash crash’. Why was there a flash crash in sterling on Asian markets on 7 October 2016? Is such a flash crash in sterling likely to occur again?
The Bank of England has responded to forecasts of a dramatic slowdown in the UK economy in the wake of the Brexit vote. On 4th August, it announced a substantial easing of monetary policy, but still left room for further easing later.
Its new measures are based on the forecasts in its latest 3-monthly Inflation Report. Compared with the May forecasts, the Report predicts that, even with the new measures, aggregate demand growth will slow dramatically. As a result, over the next two years cumulative GDP growth will be 2.5% lower than it would have been with a Remain vote and unemployment will rise from 4.9% to around 5.5%.
What is more, the slower growth in aggregate demand will impact on aggregate supply. As the Governor said in his 
opening remarks at the Inflation Report press conference:
“The weakness in demand will itself weigh on supply as a period of low investment restrains growth in the capital stock and productivity.
There could also be more direct implications for supply from the decision to leave the European Union. The UK’s trading relationships are likely to change, but precisely how will be unclear for some time. If companies are uncertain about the future impact of this on their businesses, they could delay decisions about building supply capacity or entering new markets.”
Three main measures were announced.
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A cut in Bank Rate from 0.5% to 0.25%. This is the first time Bank Rate has been changed since March 2009. The Bank hopes that banks will pass this on to customers in terms of lower borrowing rates. |
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A new ‘Term Funding Scheme (TFS)’. “Compared to the old Funding for Lending Scheme, the TFS is a pure monetary policy instrument that is likely to be more stimulative pound-for-pound.” The scheme makes £100bn of central bank reserves available as loans to banks and building societies. These will be at ultra-low interest rates to enable banks to pass on the new lower Bank Rate to customers in all forms of lending. What is more, banks will be charged a penalty if they do not lend this money. |
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An expansion of the quantitative easing programme beyond the previous £375 billion of gilt (government bond) purchases. This will consist of an extra £60bn of gilt purchases and the purchase of up to £10bn of UK corporate bonds. |
The Bank recognises that there is a limit to what monetary policy can do and that there is also a role to play for fiscal policy. The new Chancellor, Philip Hammond, is considering what fiscal measures can be taken, including spending on infrastructure projects. These are likely to have relative high multiplier effects and would also increase aggregate supply at the same time. But we will have to wait for the Autumn Statement to see what measures will be taken.
But despite the limits to monetary policy, there is more the Bank of England could do. It already recognises that there may have to be a further cut in Bank Rate, perhaps to 0.1% or even to 0% (the ECB has a 0% rate). There could also be additional quantitative easing or additional term funding to banks.
Some economists argue that the Bank should go further still and, in conjunction with the Treasury, provide new money directly to fund infrastructure spending or tax cuts, or even as cash handouts to households. This extra money provided to the government would not increase government borrowing.
We discussed the use of this version of ‘helicopter money’ in the blogs, A flawed model of monetary policy, Global warning and People’s quantitative easing. Some of the articles below also consider the potential for this type of monetary policy. In a letter to The Guardian 35 economists advocate:
A fiscal stimulus financed by central bank money creation [which] could be used to fund essential investment in infrastructure projects – boosting the incomes of businesses and households, and increasing the public sector’s productive assets in the process. Alternatively, the money could be used to fund either a tax cut or direct cash transfers to households, resulting in an immediate increase of household disposable incomes.
Webcasts and podcasts
Inflation Report Press Conference Bank of England, Mark Carney (4/8/16)
Bank spells out chance of further rate cut this year BBC Radio 4 Today Programme, Ben Broadbent, Deputy Governor of the Bank of England (5/8/16)
Broadbent Ready to Back Another BOE Rate Cut Amid Slowdown Bloomberg, Chris Wyllie (5/8/16)
What’s Top of Mind? ‘Helicopter Money’ Goldman Sachs Macroeconomic Insights, Allison Nathan (April 2016)
Articles
Bank of England measures
Interest rate cut: What did the Bank of England announce today and how will it affect you? Independent, Ben Chu (5/8/16)
This is the Bank of England’s all-action response to Brexit The Guardian, Larry Elliott (4/8/16)
Bank of England unveils four-pronged stimulus package in bid to avoid Brexit recession The Telegraph, Szu Ping Chan (4/8/16)
Record-breaking Bank of England Financial Times, Robin Wigglesworth (4/8/16)
The Bank of England has delivered – now for a fiscal response Financial Times (4/8/16)
Bank of England Cuts Interest Rate to Historic Low, Citing Economic Pressures New York Times, Chad Bray (4/8/16)
Sledgehammer? This is more like the small tool to fix a fence The Telegraph, Andrew Sentance (5/8/16)
All eyes are on Hammond as Bank runs low on options The Telegraph, Tom Stevenson (6/8/16)
Bank of England’s stimulus package has bought the chancellor some time The Guardian, Larry Elliott (7/8/16)
Helicopter money
A post-Brexit economic policy reset for the UK is essential Guardian letters, 35 economists (3/8/16)
Cash handouts are best way to boost British growth, say economists The Guardian, Larry Elliott (4/8/16)
Helicopter money: if not now, when? Financial Times, Martin Sandbu (2/8/16)
The helicopters fly on for now, but one day they will crash The Telegraph, Tom Stevenson (23/7/16)
Is the concept of ‘helicopter money’ set for a resurgence? The Conversation, Phil Lewis (2/8/16)
Helicopter money talk takes flight as Bank of Japan runs out of runway Reuters, Stanley White (30/7/16)
Helicopters 101: your guide to monetary financing Deutsche Bank Research, George Saravelos, Daniel Brehon and Robin Winkler (15/4/16)
Helicopter money is back in the air The Guardian, Robert Skidelsky (22/9/16)
Bank of England publications
Inflation Report, August 2016 Bank of England (4/8/16)
Inflation Report Press Conference: Opening Remarks by the Governor Bank of England, Mark Carney (4/8/16)
Inflation Report Q&A Bank of England Press Conference (4/8/16)
Inflation Report, August 2016: Landing page Bank of England (4/8/16)
Questions
- Find out the details of the previous Funding for Lending (FLS) scheme. How does the new Term Funding Scheme (TFS) differ from it? Why does the Bank of England feel that TFS is likely to be more effective than FLS in expanding lending?
- What is the transmission mechanism between asset purchases and real aggregate demand?
- What factors determine the level of borrowing in the economy? How is cutting Bank Rate from 0.5% to 0.25% likely to affect borrowing?
- If the Bank of England’s latest forecast is for a significant reduction in economic growth from its previous forecast, why did the Bank not introduce stronger measures, such as larger asset purchases or a cut in Bank Rate to 0.1%?
- What are the advantages and disadvantages of helicopter money in the current circumstances? If helicopter money were used, would it be better to use it for funding public-sector infrastructure projects or for cash handouts to households, either directly or in the form of tax cuts?
- How does the Bank of England’s measures of 4 August compare with those announced by the Japanese central bank on 29 July?
- What effects can changes in aggregate demand have on aggregate supply?
- What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
