Debt stabilization (Ch. 17) Asset prices (Ch. 14) & the - - PowerPoint PPT Presentation

2013

Debt stabilization (Ch. 17) Asset prices (Ch. 14) & the Interest Rate Parity Condition (Ch. 15)

Outline

Chapter 17

1.

Stabilization of public debt Chapter 14

1.

Introduction

2.

Bond prices and yields

3.

Stock prices and yields

4.

Market efficiency

5.

Bubbles Chapter 15

6.

Foreign exchange market

7.

Interest rate parity condition

8.

Adjustment of the exchange rate

Introduction

Public debt (% of GDP), 2009

Source: http://en.wikipedia.org/wiki/Government_debt

• 3. Public debt and deficit financing

The evolution of public debt

 Definitions

 B: stock of outstanding public debt  B/Y: public debt as percentage of GDP

 To compare the level of debt across countries, we need to normalize

the absolute levels by some measure of the country size (GDP).

• Intertemporal budget constraint of government:

 primary deficit should be followed by primary surpluses (Chapter 7)  (G – T): primary deficit (G >T = deficit, G<T = surplus)  r: real interest rate  Total budget deficit = (G – T) + rB

• 3. Public debt and deficit financing

The evolution of public debt

• Stabilization of debt: B (or B/Y) is not increasing

 ΔB = 0 or ΔB/Y = 0

 No growth & no inflation

 Here focus on changes in debt level:

ΔB=(G-T)+rB

 If ΔB > 0: total budget deficit and rising debt

 Self-feeding mechanism  Explosive debt growth

 Higher B means higher interest payments: rB   Even if G-T=0 debt continues to increase

 If ΔB < 0: budget surplus and declining debt

• 3. Public debt and deficit financing

The evolution of public debt

 For the stock of debt not to grow (ΔB = 0), the primary

surplus needs to cover the real cost of servicing the debt (T-G)=rB (T-G)/Y=r(B/Y)

 Debt stabilization: Primary surplus = debt service

Here the surplus is big enough to stop debt of growing,

but it is still not enough to reduce the debt.

• 3. Public debt and deficit financing

The evolution of public debt

 Growth & no inflation

 growth rate of GDP (ΔY/Y) = g  Growth rate of (ΔB/B)=(G-T)/B + r

 Change in debt ratio over GDP

growth in (B/Y)= ΔB/B – ΔY/Y =(G-T)/B + r - g  Δ (B/Y)=(G-T)/Y+(r-g)B/Y

If Δ(B/Y)=0  (T-G)/Y=(r-g)B/Y

If the economy is growing: it is easier to keep the debt/GDP

ratio stable over time.

If g>r the government doesn’t even need to run a primary

surplus to stabilize the debt over GDP ratio

• 3. Public debt and deficit financing

The evolution of public debt

 Growth & inflation (study at home)

 Additional revenue of the government: Seigniorage  Money that is created is worth more than it costs to

produce it.

 Example: if it costs the US government $0.05 to produce a $1

banknote, the seigniorage is $0.95 (gains of CB belong to government)  Government can use this revenue to finance part of its

expenditures.

 Higher seigniorage gains means more money printing 

higher inflation (inflation tax) i = r + πe

 lower real interest payments rising inflation

• 3. Public debt and deficit financing

The evolution of public debt

 Growth & inflation  Here the deficit can be financed also by increasing

money supply. ΔB+Δ(M0/P)=(G -T)+rB Δ(B/Y)+Δ(M0/P)/Y=(G-T)/Y+(r-g)B/Y

The government creates inflation by issuing money With inflation: it is even easier to maintain the debt/GDP

ratio stable over time.

Financing the budget deficit with new borrowing Financing the budget deficit with newly printed money

• 3. Public debt and deficit financing

Net debts and primary budget balances, 2004

(% of GDP)

Net debt Actual primary budget Required primary surplus:

b

in 2004 surplus in 2004 ...to stabilize absolute ...to stabilize size of debt debt/GDP ratio Belgium 89.9 5.1 4.9 2.5 Germany 52.4

• 0.2

3.3 1.7 Ireland 31.4

• 1.1

1.6 0.8 Italy 93.9 1.5 5.9 3.0 Netherlands 41.8 0.3 2.6 1.3

a

These are forecasts produced in 2003 by the OECD.

b

The required surplus assumes a 5% real interest rate and a 2.5% real GDP growth rate.

Source: OECD, Economic Outlook

• 3. Public debt and deficit financing

How much countries need to improve their primary budget surplus?

• 3. Public debt and deficit financing

Stabilizing the public debt

 Short-run: three possible approaches

 all involve “costs” for the private sector! 1.Cut the deficit by increasing taxes/reducing public

expenditure

 Virtuous road, but costly!

2.Printing money and taxing holders of nominal assets

(works if government bonds are long-term and not linked to inflation).

 Effective only if inflation is not anticipated.  Less likely with independent central bank  Worked nicely for the U.K> in the 19th century; not anymore

• 4. How to stabilize the public debt

Stabilizing the public debt

3.

Default on debt

 Advantage: reduce expenditures today  Disadvantage: it gets harder to borrower in the future

 Popular: default on foreign debt

 To pay back debt: you need to run a primary current account

(PCA) surplus  PCA >0

 In case of defaulting: country will not get any new foreign

credit in the near future, cannot borrow abroad  PCA = 0

 Default on domestic debt: very unpopular among population

 Conclusion: the country can be tempted to default on the

foreign debt.

• 4. How to stabilize the public debt

Stabilizing the public debt

 Medium and long run:

1.

Interest rate relief (r)

 Higher default risk  higher interest rate  higher default risk (self-

fulfilling prophesy)

 European Stability Mechanism (ESM): offers countries in need to

borrow at lower rates in exchange for structural reforms (Greece, Portugal, Ireland, Cyprus) 1.

Economic growth (g)

 Increase growth rate to increase GDP  lower debt/GDP ratio

• 4. How to stabilize the public debt

Chapter 14: Expectations and asset prices

Introduction

 Today:

 Asset markets: focus on the role of expectations  Durability of assets implies that asset markets are implicitly

forward looking, and are driven by the uncertainty about the future

 Prices (& interest rates) depend on expectations on future events

 Bonds  Stocks  Exchange rate

 Literature:

 Chapter 14: NOT relevant: 14.5.1, 14.5.2, 14.6.1, boxes 14.2 & 14.3  Burda and Wyplosz: ONLY relevant sections 15.1, 15.2 (not 15.2.3),

15.3.1 – 15.3.3 Introduction

Stylized facts

 Two very important assets are traded on the financial markets

 Stocks (=shares)  “A claim on a part of the profits or earnings of a firm after operating

costs and interest have been paid”

 Bonds  “Recognition of debt by the borrower along with a schedule of

payments concerning both interest and principal”

 Entitles the holder to fixed future interest payments (coupons) and the

repayment of the principal (face value) at the end of the period

 Negative correlation between price and return (yield)

• 1. Stylized facts

Bond prices and yields

• How to obtain the price and the yield of a bond?

 I can buy a bond with a one year maturity with a face value of V=

100€

 Two possibilities:

 Invest P€ today in a bond  receive V next year  Invest P€ today at the bank  receive (1+i)P next year

 No-profit rule: Equivalent financial operations carry the same

interest rate. P(1+i) = V P=V/(1+i)

 Price of bond, Pt: present value of total expected payment  The lower P relative to V the higher the yield (i)

• 2. Asset prices and yields - Bonds

Bond prices and yields

 Option 1: bond with 2-years maturity

 iL: long run interest rate for a bond with a L years maturity  Interest I receive for my bond when L=2: (1+i2)(1+i2) -1≈2*i2  Assumption for the moment: absence of a maturity premium

 Option 2: two consecutive bonds with one year maturity each

 i1: today’s rate of return on a one year bond  ie

t+1: expected rate of return on a one year bond that is expected to prevail next

year.

 Interest I receive for two 1-year bonds: (1+i1)(1+ie

t+1) -1≈ i1+ie t+1

• The interest rate on a LT bond = average of the short term

interest rate that people expect to occur over the life of the LT bond

• 2. Asset prices and yields - Bonds

Term structure of interest rates

No-profit rule:

 Equivalent financial operations carry the same interest rate.

(2*i2) = i1+ie

t+1

return on the 2-year investment = the expected return on two consecutive one year investments  Formally, the yield curve can be written as:

 iL

t : long term interest rate

 Ψ: maturity premium  Any expected change in future interest rates will have an effect on the

long term interest rates prevailing today.

 Both actual and anticipated actions by the central bank will have an effect

• n the current interest rates.

L t L t e t L t

L i i    

1

• 2. Asset prices and yields - Bonds

Yield curves

 What is the link between short (ST) and long-term (LT)

interest rate?

Interest rate

Maturity

Theory

3.5 4.0 4.5 5.0 2 4 6 8 10 12 14 16 18 20

Years

Euro area

Ceteris paribus, loans with longer maturity are characterized by higher interest rate 1. Due to impatience 2. Longer maturity implies more uncertainty (Most people are risk averse)

• 2. Asset prices and yields - Bonds

Bond prices and yields

 In the table below:  Face value V = 1€  An increase in i  lower P

Yield given price P: Price in euros given yield i: Description of the payment stream

• D. Consol paying 1 euro per annum, forever

1 i

1 P

• A. One year pure discount bond paying 1

euro at end of year

 

1 1 i  1 1 P 

• B. Two year pure discount bond paying 1

euro at end of 2nd year

 

2

1 1 i 

1 2

1 1 P 

• C. Ten year pure discount bond paying 1

euro at end of 10th year

 

10

1 1 i 

1 10

1 1 P 

1 V

• f

lue present va    P V i P

• 2. Asset prices and yields - Bonds

Stock prices

 Stock returns are uncertain, as they depend on the

uncertain future profitability of a firm.

 Stocks (= shares): riskier than bonds, but higher yield

possible

 pays dividends depending on the firm’s profits

 How are stock prices and returns determined?

 No-profit rule:

 return i on a government a one-year bond should be equal to the

total return on shares after one year.

 dt : dividend paid on the stock at the end of each period  qt: stock price in the beginning of period t.  qt+1: stock price if I want to sell stock in the next period.

• 3. Asset prices and yields - Stocks

 No-profit rule:

 return i on a government a one-year bond should be equal to

the total return on shares after one year. 

 BUT tomorrow’s stock price will depend on the stock price

prevailing the day after tomorrow, pretty much in the same way as it does for today.

Stock prices

i q d q

t t t

  



1

1

 

t t t t t

q q q q d i /

1 

 



Dividend yield Capital gain Yield on safe bond

) 1 (

1

2 1 1



  

  

t

e t t t

i q d q

• 3. Asset prices and yields - Stocks

Stock prices



 

       

1

1 1

t t t

d i q

 If the stock price doesn’t grow too fast, then we can

write the current stock price q0 as

 In other words, the market values a company on the basis

• f what it earns today and what it will earn in the future.

 This is the so called the fundamental value of an asset.

 Definition: present value of expected dividends

• Expectations of market participants drive prices
• 3. Asset prices and yields - Stocks

Information and market efficiency

 Expectations about the future are formed using all available

information

 New information changes expectations of future dividends and thus

changes immediately the prices today.

 but only if unexpected! Otherwise it’s no new information

• Changes in stock prices should thus not be predictable!

 Efficient market hypothesis

 a market is efficient if prices fully reflect all available information

 Implication: publicly available information cannot earn consistently

above average returns  Market price is an unbiased estimate of the true value of the

investment

 Deviations of the market price from the fundamental value are random.

• 4. Market efficiency

Bubbles

 Are financial markets really efficient?  Prices of assets can differ from their fundamental value

through

 noise traders

 Misinformed or act irrational and can influence the price of an asset.  The asset then has for a short time a value different from what was

expected  speculative bubbles

 Overly optimistic expectations  Asset prices raise as long as people believe that they will raise

• 5. Bubbles

i q d q

t t t

  



1

1

Tulipmania, 1637

• 5. Bubbles

Housing Prices in Ireland, 1978:Q1 – 2010:Q4

Housing Price Index, 1978:Q1=100

• 5. Bubbles

Bubbles

 Credit driven bubbles

 Driven by credits: more credits  buy more assets  asset prices

increase  higher asset prices make loans easier because higher collateral or more capital  upward spiral

 Asset prices are well above their fundamental value  When bubble burst  difficult to pay back credits and lenders reduce

supply of credit  prices decline  downward spiral  The bubble of the subprime:

 Asset prices rose following growth in credit  When asset prices fell  people couldn’t reimburse  Endangered the health of financial institutions and put into danger the

whole financial system

 Dire consequences for the whole (world) economy

• 5. Bubbles

The role of the exchange rate markets

 Foreign exchange markets

 Supply and demand of the currency determines its price =

nominal exchange rate

 Monetary authorities intervene on the exchange rate market

 Fixed exchange rate regimes

 Financial intermediaries buy and sell currencies on the

behalf of their customers who need currencies for their transactions

 The volumes traded on the exchange rate markets are very large  Reminder: S is the number of foreign currency units per domestic unit

 Example: S= 1.5  1€ = 1.5$

• 6. Foreign Exchange markets - introduction

Forward and spot exchange rate

 The basic deal involves simply exchanging immediately

• ne currency for another

 Spot exchange rate (S) is the exchange rate for currency

exchanges “on the spot”, or when trading is executed in the present.

 An alternative is to agree now on the exchange rate for a

transaction at a specified future date

 Forward rates (F) are exchange rates for currency

exchanges that will occur at a future (“forward”) date.

 Forward dates are typically 30, 90, 180, or 360 days in the future.  Rates are negotiated between two parties in the present, but the

exchange occurs in the future.

• 6. Foreign Exchange markets - introduction

Interest rates and exchange rates

 Under the assumption of perfect capital mobility investors

can buy assets denominated in any currency

 Suppose that you buy a foreign bond expecting to obtain an

interest rate i*, where i* is ‘evaluated’ in terms of foreign currency

 An exchange rate must be used to convert the return of the

foreign asset in terms of domestic currency

The return on the foreign bond (= interest payments converted

in to domestic currency) crucially depends on the exchange rate between domestic and foreign currency

• 6. Foreign Exchange markets - introduction

Interest rates and exchange rates

 What is the link between domestic return (i), foreign

return (i*) and the exchange rate?

 To answer this question, we will re-explore the interest

parity condition considering now the exchange rate. In particular, we will discuss

 The uncovered interest rate parity condition (UIRP), which

involves risk-taking

 The covered interest rate parity condition (CIRP), which

involves no risk-taking behavior

• 7. Interest rate parity condition

Uncovered interest rate parity

 Netherlands  USA

1€ (1+i)€ (1+i*)St $ (1+i*)St/Se

t+1 €

St$ = t+1 t

t t e t t t e t

S S S i i S S S i i       

  1 1 *

*

expected appreciation

• f € vis-à-vis $

If i<i*  € expected to appreciate

1€

• 7. Interest rate parity condition -UIRP

Uncovered interest rate parity

 Netherlands  USA

1€ (1+0.03)€ (1+0.04)St $ (1+0.04)2/2.02 € 2$ = t+1 t

01 . 2 2 02 . 2 0.03 04 .

1 *

       

 t t e t

S S S i i

i<i*  $ depreciates /€ appreciates (by 1%): t: 1€=2$ t+1: 1€=2.02$

1€

• 7. Interest rate parity condition -UIRP

Uncovered interest rate parity

 UIRP:

 Foreign exchange risk is not covered

• 1. The Dutch investor invests in $
• 2. The return on his investment is (1+i*)$. He then needs to

convert this amount back into €

 When i = i*:

 If the € has depreciated, the Dutch investor makes a profit  If the € has appreciated, the Dutch investor realizes a loss

• 7. Interest rate parity condition -UIRP

Covered interest rate parity

 Netherlands  USA

1€ (1+i)€ (1+i*)St $ (1+i*)St/Se

t+1

1€ = t+1 t (1+i*)St/Ft € Agree today on St+1Ft

t t t t t t

S S F i i S S F i i       

* *

St$

Ft is set so that we get the same return abroad and at home

• 7. Interest rate parity condition -CIRP

CIRP versus UIRP

 CIRP

 Agents cover themselves against the exchange rate risk  Empirically verified

 UIRP

 Agents are willing to take risks  Empirically not verified

 One possible explanation is that individuals are not risk neutral, i.e.

they are risk-averse

 An augmented version of the uncovered interest parity that

controls for a time-varying risk premium performs better empirically

t t t e t

S S S i i     

1 *

• 7. Interest rate parity condition -CIRP

UIRP and exchange rate adjustment

e t t t t t e t t t

S i i S i S S i

1 * * 1

1 1 ) 1 ( 1

 

     

 One important implication of the UIRP is that the current

exchange rate St depends on current interest rates i and i* but also on the expected exchange rate Se

t+1

 Behavior similar to stock prices.

 Driven by expectations

• 8. Exchange rate adjustment

Forward looking exchange rate

e n t n t n t t t t t t t t e t t t t t t t t e t t t t e t t t t t t e t t t t e t t t t

S i i i i i i i i S S i i i i i i S S i i S S i i i i S S i i S S i i S

                       

                                

* * 2 2 * 1 1 * 3 * 2 2 * 1 1 * 3 * 2 2 2 2 * 1 1 * 2 * 1 1 1 1 *

1 1 ..... 1 1 1 1 1 1 ..... 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

• 8. Exchange rate adjustment

Exchange rate adjustment

 Suppose you have a sudden increase of the domestic

interest rate: i  (i > i*)

 Then St should immediately raise (i.e. appreciate)  However: UIRP tells us that i > i* should be associate with an

expected depreciation of the domestic currency

e t t t t

S i i S

1 *

1 1



  

• 8. Exchange rate adjustment

t t e t

S S S i i   

1 *

Exchange rate adjustment

• Is there a contradiction?

 In fact, not!

 When i increases above i*, St instantaneously jumps up  But as UIRP requires a depreciation of the domestic

currency, after the jump, the exchange rate depreciates

 Interest rate at home decreases while currency depreciates

• 8. Exchange rate adjustment

Time Nominal exchange rate, interest rates i* i i,i* S

Exchange rate adjustment

 Jump in i is followed by a depreciation of S and a decrease

in i.

• 8. Exchange rate adjustment