Monetary Policy, Economic Liberalisation and the Balance of Payments: - PowerPoint PPT Presentation

Monetary Policy, Economic Liberalisation and the Balance of Payments: UK Experience seen from a Bayesian Panel VAR Approach Martin Weale and Tomasz Wieladek PRELIMINARY. PLEASE DO NOT QUOTE

Overview • The long expansion in the UK was preceded by economic liberalisation in financial, labour & product markets – How does that affect the impact of monetary policy on the current account? – Which shocks/structural changes were responsible for the evolution of the balance of payments? – Use a varying coefficient Bayesian Panel VAR to answer these questions

External Balance in the UK Real FX rate over time Current Account/GDP over time 160 6 150 4 140 2 130 120 0 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 110 ‐ 2 100 ‐ 4 90 80 ‐ 6 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1

Index of Financial liberalisation 1.20 Australia Belgium 1.00 Canada Finland 0.80 France Italy 0.60 Japan Netherlands 0.40 Norway Portugal 0.20 Sweden United Kingdom 0.00 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 United States Index is taken from Abiad et al (2010) and consists of: credit controls, interest rate controls, entry barriers, state ownership in the banking sector, prudential regulation, securities market policy and capital account restrictions. Each component can take the values {0,1,2,3} with higher values mean less restrictions .

Index of Labour Market Liberalisation Australia 10 Belgium 9 Canada 8 Finland 7 France 6 Italy 5 Japan 4 Netherlands 3 Norway 2 Portugal 1 Sweden United 0 Kingdom 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 United States Index taken from Fraser Institute. Reflects minimum wage regulation, hiring and firing practices, the share of the labour force whose wages are set by centralized collective bargaining, unemployment benefits, use of conscription to obtain military personnel. Higher values indicate greater liberalisation.

Index of Product Market Liberalisation Australia 6 Belgium Canada 5 Finland 4 France Italy 3 Japan Netherlands 2 Norway Portugal 1 Sweden United 0 Kingdom 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 United States ETCR index constructed by Conway and Nicoletti (2006). Captures the level of regulation in seven non ‐ manufacturing sectors: airlines, telecommunication, electricity, gas, post, rail and road freight, taking into into account characteristics of the markets, such as the presence of barriers to entry, public ownership, vertical integration, monopolies and the presence of legally imposed price controls. Lower values mean greater liberalisation.

Index of FX Regime Flexibility 14 Australia Belgium 12 Canada 10 Finland France 8 Italy Japan 6 Netherlands 4 Norway Portugal 2 Sweden 0 United Kingdom 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 United States We use the de ‐ facto fine classification from Ilzetzki, Reinhart and Rogoff (2012). Higher values indicate greater flexibility.

Economic Theory Fall in Loan Rates Imports > Exports Rise in [Income – Domestic Absorption effect] Demand Rise in Fall in Asset Prices Official Rate Depreciation in Exports > Imports Current Account Real FX Rate & [Expenditure – Reaction ? Rise in External Switching effect] Demand

Economic theory (ii) Type of Liberalisation Impact of current account reaction to monetary policy Effect via loosening liquidity constraints  Financial greater fraction of the population responding to interest rate changes  income absorption effect becomes stronger Removal of wage rigidity makes  makes Labour i) income ‐ absorption effect weaker ii) But rise in labour force participation may make aggregate income ‐ absorption stronger iii) Overall direction unclear Product Removal of nominal rigidities (prices less sticky) will make effect of monetary policy on consumption & income ‐ absorption smaller Greater FX flexibility  Adjustment of Current Exchange Rate Account should be smaller

VAR Model • We estimate the following panel VAR model: • where – contains the lags of the variables in – – is a lower triangular matrix – is a diagonal variance ‐ covariance matrix – Note: and are allowed to vary by country and over time

VAR Model (II) • and are modelled as: – where – if  country by country estimation – if  pooling – Model estimated via Gibbs sampling with 4 lags – All model coefficients are allowed to vary with observables  allows for conditional impulse responses

Conditional Impulse Response Analysis • Model can be used to answer: How does monetary policy affect the economy under financial repression/ liberalisation? – First, within , evaluate at a high value (90% percentile) and all other variables at their medians – Use model equations to obtain and – Impose identification restriction and generate impulse responses for each draw – Repeat by evaluating at a low value (10% percentile) – Compare the two distributions to assess significance

Historical Decomposition • To answer: Which shocks are responsible for macroeconomic outcomes? – Use where are structural shocks – Note: for purpose of illustration the above shows a VAR (1) • To answer: How would the data look like, given historical shocks, with financial liberalisation unchanged? – use where and are calculated with Financial liberalisation held constant at the first period

Historical Decomposition (II) • To answer: How would the shocks need to look like to deliver the same outcomes, but had financial liberalisation not changed? – Use where the structural shocks

Identification scheme • There are several ways of identifying monetary policy shocks. • We use sign restrictions following Canova and De Nicolo (2002) and Uhlig (2005) which are shown below • All results are robust to using lower ‐ triangular/Choleski identification instead Consumption Consumer prices interest rates Current Real exchange Account rate Supply Shock ? Demand Shock ? Monetary Policy Shock ?

How does Monetary policy affect the Current account balance? Consumption CPI Short Rate CA/GDP Real FX Rate 3 8 2 2 1 2 6 1 1 0 bas eline 1 4 0 0 -1 0 2 -1 -1 -2 -1 0 -2 -2 -3 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Median 16th Quantile 84th Quantile

Does the effect vary with financial liberalisation? Consumption CPI Short Rate CA/GDP Real FX Rate 2 5 1 2 2 Fin Repressed 1 0 0 0 0 0 -1 -2 -1 -5 -2 -2 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 4 10 4 2 5 Fin Liberalised 2 2 5 0 0 0 0 -2 0 -2 -2 -5 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 2 5 2 1 2 Difference 1 1 1 0 0 0 0 0 -1 -5 -1 -1 -1 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Median 16th Quantile 84th Quantile

Does the effect vary with labour market liberalisation? Consumption CPI Short Rate CA/GDP Real FX Rate 2 6 1 2 2 Rigid Labour Market 1 4 0 1 0 0 2 -1 0 -2 -1 0 -2 -1 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 6 10 4 2 4 Flexible Labour Market 4 2 2 0 2 5 0 0 -2 0 -2 -2 0 -2 -4 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 2 4 1.5 0.5 1 1 0 0.5 Difference 1 2 0.5 -0.5 0 0 0 0 -1 -0.5 -1 -2 -0.5 -1.5 -1 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Median 16th Quantile 84th Quantile

Does the effect vary with product market liberalisation? Consumption CPI Short Rate CA/GDP Real FX Rate Regulated Product Market 4 10 2 2 2 1 1 2 0 5 0 0 0 -2 -1 -1 -2 0 -2 -2 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate Deregulated Product Market 2 4 2 2 2 2 0 1 0 1 0 -2 0 -2 0 -2 -4 -1 -4 -4 -1 -6 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 2 2 0.5 2 1 0 0 Difference 1 1 0 -2 -0.5 0 0 -1 -4 -1 -1 -6 -1.5 -1 -2 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Median 16th Quantile 84th Quantile

Does the effect vary with FX Regime? Consumption CPI Short Rate CA/GDP Real FX Rate 2 8 2 2 2 6 1 1 Fixed FX 1 0 4 0 0 0 -2 2 -1 -1 -1 0 -2 -2 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 4 10 2 2 2 3 1 1 Flexible FX 0 2 5 0 0 -2 1 -1 -1 0 0 -2 -2 -4 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Consumption CPI Short Rate CA/GDP Real FX Rate 1.5 3 1 1 2 1 2 0.5 Difference 0.5 1 0.5 1 0 0 0 0 0 -0.5 -0.5 -1 -0.5 -1 -1 0 10 20 0 10 20 0 10 20 0 10 20 0 10 20 Median 16th Quantile 84th Quantile